November|December 2011

Subordination Agreements… Losing the Upper Hand

Here’s something to think about: Does the UCC create a limit on the damages a senior credit presumes it can recover from a junior creditor if the junior creditor breaches? This article addresses a particular circumstance when a senior creditor’s contractual expectation may not be protected vis-à-vis a subordinate junior creditor as a result of the senior creditor’s misplaced reliance on a less than well-crafted subordination agreement.

Subordination agreements allow “one who holds an otherwise senior interest to subordinate that interest to a normally lesser interest,” [1] and are common in the factoring industry, as well as the secured financing world at large. Compared to many other areas in the secured transactions arena, there is relatively little reported litigation involving disputes in respect to subordination agreements. At least one authority on the subject considers this “a testament perhaps to their commercial utility and the efficacy with which commercial entities, when left alone, can develop their own scheme of contractual priorities.”[2] Section 9-339 of the Uniform Commercial Code (UCC), which is entitled Priority Subject to Subordination, expressly recognizes the rights of senior priority creditors to enter into subordination agreements when it states, “[t]his article does not preclude subordination by agreement by a person entitled to priority.”

Although subordination agreements are routinely mutually beneficial to all parties involved, this article discusses a particular circumstance when the senior creditor’s contractual expectation may not be protected vis-a-vis a subordinate junior creditor as a result of the senior creditor’s misplaced reliance on a less than well-crafted subordination agreement. Specifically, this article addresses a situation where the subordination agreement is silent on the methodology of determining damages and impliedly relies on the damage methodology contained in the UCC which, under the scenario below, is likely to limit the senior creditor’s right to recover damages against a junior creditor.

Let’s consider the following scenario: Creditor A enters into an asset-based lending relationship with ABC Co., a company that sells clothing to several brand name department stores throughout the United States. Creditor A is the first to file its UCC financing statement against inventory[3] and accounts[4] and does so in the state that ABC Co. is located, duly perfecting its security interest in those categories of collateral. Several months later, after giving notice to Creditor A of its intention to seek additional working capital from a third-party factoring company, ABC Co. seeks to enter into a separate relationship with Creditor B, a factoring company, whereby Creditor B offers to assist ABC Co. to purchase goods and in exchange demands a senior security interest in ABC Co.’s future acquired accounts relating to the purchase order goods.

Creditor A and Creditor B enter into a subordination agreement due to Creditor A standing to benefit since ABC Co. will receive working capital to sustain its operations and Creditor B agrees to pay Creditor A a fee in exchange for Creditor A agreeing to subordinate its first priority security interest in the inventory and accounts that arise from ABC Co. acquiring the purchase order goods. The subordination agreement does not contain any provision governing damage methodology in the event that either Creditor A or Creditor B breach the subordination agreement, thus relying on the damage methodology contained in the UCC and, perhaps, general common law applicable to contracts.

Creditor B begins funding ABC Co. for the purchase of goods it needs to satisfy its customer purchaser orders and receives timely payments from all of its customers (i.e., account debtors[5]) for the first few months; however, after that period of time Creditor B begins to notice that certain of its account debtors are refusing to pay due to delivery issues and problems with respect to the quality of goods failing to conform to specifications. Accordingly, due to self-preservation interests, Creditor B begins to collect out on not only the accounts for which it received a subordination but also on the non-subordinated accounts in which Creditor A hold a first priority security interest. In other words, Creditor B declared ABC Co. in default under its purchase order funding agreement and notified all account debtors to pay Creditor B directly, notwithstanding Creditor A’s first priority security interest.

Creditor A is not aware that Creditor B has issued notification to receive payment since Creditor A, an asset-based lender, is operating on a non-notification[6] basis. Several months later ABC Co. defaults on its payment obligations to Creditor A and notifies Creditor A that it is in the process of preparing to file for bankruptcy relief. Creditor A, for the first time, notifies the account debtors to pay it directly, but the account debtors have already directed all of their payments to Creditor B. Creditor A has only one avenue of recourse left and decides to sue Creditor B for all damages arising from the accounts Creditor B collected in violation of its first priority security interest in an amount equal to ABC Co.’s total outstanding indebtedness (i.e., the entire debt that Creditor A is due from ABC Co.).

What are Creditor A’s damages as a result of Creditor B issuing notification to the account debtors and collecting the non-purchase order accounts? A relatively unused but highly likely argument that Creditor B might use to defend itself in its litigation with Creditor A is that the UCC’s damage methodology limits the damages Creditor B can be held liable for. UCC§9-625, states, in relevant part that:

(b) [Damages for noncompliance.] …a person is liable for damages in the amount of any loss caused by a failure to comply with this article.

Note, the language reads, “caused by a failure to comply.” There is no dispute that Creditor B collected non-purchase order accounts in which, from the perspective of the UCC’s priority scheme, Creditor A had a duly perfected senior security interest. However, the issue is did Creditor B’s collection of those non-purchase order accounts “cause” Creditor A damage? Creditor A elected not to give a notice of assignment to any of the account debtors until after it received notice that ABC Co. would be filing for bankruptcy; therefore, if all of the accounts that Creditor B collected would have otherwise never been paid to Creditor A (i.e., remember, Creditor A’s relationship was non-notification and the account debtors would have paid ABC Co.), how can Creditor A show any damage “caused” by Creditor B’s conduct.

Creditor A failed to recognize that it entered into the subordination agreement that should have protected it against this damage methodology defense but failed to do so. Although too numerous to list, as an example, the following provision could be included in a subordination agreement to protect senior creditors like Creditor A:

Upon a default under the purchase order funding agreement, all accounts receivable that Creditor B collects from any account debtor, except those in which Creditor B has received a subordination, shall be held by Creditor B for the benefit of Creditor A, and must remain segregated for the benefit of Creditor A.

Next time you contemplate entering into a subordination agreement, consider it critical to anticipate what your contractual expectations are, how they can be achieved and how they can be protected. A carefully crafted provision within the subordination agreement should greatly reduce or eliminate the limitations placed on creditors that either incorrectly assume they will be protected or mistakenly rely on the UCC or general common law.

Michael Ullman, Esq., principal, established the law firm Ullman & Ullman, P.A., located in Boca Raton, FL., in 1980, and has overseen its evolution into a premier boutique firm serving its clients’ commercial transactions and litigation needs, and specializing in the factoring and asset-based lending industries. He received his undergraduate degree from the University of Florida and received his Juris Doctor degree from Nova Law School in 1979, with honors. During law school, Ullman served as a member of and authored a published article for the Law Review. He is a member of the Florida Bar, and represents his clients throughout the U.S. in both complex litigation and arbitration proceedings. Ullman currently serves as co-counsel to and has been a frequent lecturer and contributor for the International Factoring Association for over a decade. He has published numerous articles.

Jared Ullman, Esq. is an associate at Ullman & Ullman, P.A. Prior to joining the firm, he practiced law in Harrison, NY for a law firm that specialized in bankruptcy and restructuring law. Ullman received his Bachelor of Science degree in Finance from Florida State University in 2003 and in 2009 received his Juris Doctor degree, cum laude from Pace Law School. He is admitted to practice in both Florida and New York. During law school, Ullman participated in the Seventeenth Annual Chief Judge Conrad B. Duberstein Bankruptcy Moot Court Competition at St. Johns Law School. Prior to attending Pace Law School, he worked in New York City for C.I.B.C. World Markets, in the Agency Services Group where he managed securitized institutional loans ranging from $50 million to $1 billion.

[1] See Black’s Law Dictionary (9th ed. 2009).

[2] See 9 Hawkland UCC Series §9-316:1.

[3] See UCC §9-102(48) “Inventory” means goods, other than farm products, which: a.) are leased by a person as lessor; b.) are held by a person for sale or lease or to be furnished under a contract of service; c.) are furnished by a person under a contract of service…

[4] See UCC §9-102(2) “Account” means a right to payment of a monetary obligation, whether or not earned by performance, (i) for property that has been or is to be sold, leased, licensed, assigned, or otherwise disposed of…

[5] See UCC §9-102(3) “Account debtor” means a person obligated on an account … or general intangible.

[6] See UCC §9-406(a) “Non-notification” routinely means that a creditor that holds a security interest in accounts elects not to notify the account debtors of its assignment of and its right to receive payment, as authorized by §9-406(a) of the UCC.