By: Camilla N. Andrews & Amy R. Brownstein 

On January 14, 2013, in Riverisland Cold Storage v. Fresno-Madera Production Credit Assn., 2013 Cal. Lexis 253 (2013) ("Riverisland"), the California Supreme Court overturned Bank of America etc. Assn. v. Pendergrass,4 Cal.2d 258 (1935) ("Pendergrass") which, for nearly 80 years, has limited borrowers' ability to challenge contracts based on alleged oral promises made by a lender that contradict the terms of the loan documents. This change in California law will make it harder for California lenders to quickly dispose of such borrower allegations by demurrer or summary judgment, and is likely to result in increased litigation costs - and longer times to complete liquidation - for California lenders. 

In Riverisland, the borrowers alleged that the lender's vice president had met with them two weeks before a loan modification agreement was signed, and that he represented to them that the lender would extend the loan for two years in exchange for two pieces of additional real property collateral. The borrowers further alleged that when they signed the agreement, which they did not read (although they initialed the pages setting forth the legal descriptions), the lender's vice president assured them that the term of the agreement was two years, and that the two additional pieces of real property were the only additional collateral being taken. In fact, however, the written agreement provided for only three months of forbearance by the lender, and identified eight additional pieces of real property collateral. The borrowers subsequently failed to make payments as agreed, and the lender recorded a notice of default. After the borrowers repaid the loan and the foreclosure proceedings were dismissed, the borrowers filed an action against the lender seeking damages for fraud and negligent misrepresentation. Causes of action included reformation of the restructuring agreement and rescission. 

Under California law, the parol evidence rule (set forth in California Code of Civil Procedure §1856) prohibits the introduction of outside evidence, such as oral statements or earlier writings, to contradict the terms of a final written agreement. The parol evidence rule is subject to exceptions, however, and allows for evidence challenging the validity of an agreement, or evidence to establish fraud. The decision in the Pendergrass case limited the parol evidence rule's fraud exception, requiring that the evidence offered to show fraud relates to fraud in procuring the written agreement and not a promise that was different from the terms of the agreement. 

In Riverisland, the lender filed a motion for summary judgment, seeking to have the case dismissed based upon the Pendergrass rule. The California Supreme Court overruled Pendergrass, finding it to be inconsistent with California law, an "aberration," and a potential shield for fraud. 2013 Cal. LEXIS 253, 25-27. Consequently, borrowers will be able to offer additional evidence, such as oral statements allegedly made by a representative of the lender as to the terms of loan documents, to support allegations of lender fraud.

What are the ramifications for lenders? Quite simply, lenders may be unable to quickly dispose of claims of oral promises differing from the terms of written loan documents through demurrer or summary judgment. Such claims will most likely result in time-consuming and costly litigation, with most cases brought by borrowers expected to include allegations of fraud, and more cases expected to go to trial. 

What actions might a lender take to protect itself? While the facts of Riverisland indicate that the initialing of loan documents will likely not be sufficient to support a lender's defense that borrowers had knowledge of the contents of loan documents, there are a number of protective measures that lenders can take to protect themselves from allegations of fraud.

• Some experts have recommended the inclusion of arbitration or judicial reference clauses in loan documents which, if enforced, would allow the lender to have the dispute heard by an arbitrator or judge rather than a jury that might have more sympathy for a borrower. 

• Experts have also recommended that loan documents be provided to the borrower in advance of closing to allow the borrower time to read the documents, possibly coupled with an acknowledgment that the borrower has been encouraged, and has been provided an opportunity, to have the documents reviewed by its own legal counsel. 

• A lender might require the borrower to re-execute a commitment letter at closing, confirming the pertinent terms of the loan. 

• A lender might obtain an affidavit, to be signed under penalty of perjury, which is read to the parties and signed by them prior to the execution of loan documents, to specifically disclaim reliance upon oral representations and warranties made by the lender. 

• Lenders should ensure that their personnel, including outside brokers and agents, are aware of the state of the law on this issue. All employees and agents who interact with borrowers and other loan parties must understand that misrepresentations to these parties may result in a court determining that the borrower and other loan parties are not bound by the terms of the loan documents. Terms and conditions of a loan or loan documents should never be misrepresented to any borrower party. 

Solutions will vary for each lender and each loan. Please feel free to contact Camilla at (949) 333-4108 or Amy at (215) 542-7070 for additional assistance in addressing this issue. 

candrews@starfieldsmith.com

Starfield & Smith, P.C. | Irvine, CA Office
2955 Main Street, Second Floor | Irvine, CA 92614
(949) 333-4108 

By Theodore (Ted) J. Hamilton, Esq.

The debtor’s bank account is flush with cash!    After months of searching and work you finally have it, a payday!   You get the garnishment paperwork done the same day and serve it on the neighborhood bank.  But the banker looks at it differently.  The banker says, hold on a minute.  What is wrong with my client? They can’t pay their bills?  How did this judgment happen without my knowledge?   What about me?  What am I to do?  Although that loan I have to the debtor isn’t in default and they are current, my loan documents say that a judgment or garnishment results in a default. I have to protect myself. As a result, when the banker receives the garnishment, they freeze the account and file a response to the garnishment stating there are no funds available due to the bank lien on the account.  Who gets the money is what both the lawyer for the bank and the lawyer for the creditor are asked.  The answer lies in the Uniform Commercial Code and in the facts of each case. 

A.      Perfecting a security interest in a bank account.  

The Uniform Commercial Code outlines how to perfect a security interest in a bank account.   Particularly UCC section 9-314 states that a security interest in a bank account is perfected by control and the security interest is lost when control is lost.  UCC section 9-104 defines control of a bank account and states as follows:

  A secured party has control of a deposit account if:

(1) the secured party is the bank with which the deposit account is maintained;

(2) the debtor, secured party, and bank have agreed in an authenticated record that the bank will comply with instructions originated by the secured party directing disposition of the funds in the deposit account without further consent by the debtor; or

(3) the secured party becomes the bank's customer with respect to the deposit account.

Thus,  once the account is an account at the bank,  the bank has control of the account sufficient to establish a security interest if the loan documents so provide for such a security interest. 

B.     What controls the right of a Bank with a security interest to set off against the deposit account?

But what controls whether the bank can setoff the amounts in the deposit account against a debt due to the bank?    Uniform Commercial Code section 9-340 gives the bank who has “control” over the deposit account the right to setoff amounts in the account against amounts due to the bank. 

C.     When can the bank exercise its setoff rights?

If at the time garnishment hits, all loan amounts due to the bank are current, how can the bank claim a setoff right that would take priority over the garnishment lien on the account?

Assuming the bank’s documents give the bank the right to a setoff upon default and the loan is in default at the time of the garnishment, the bank will have the right to set off against the deposit account in the bank’s control. 

But what if the loan is not in default at the time the garnishment hits?  The language of the Bank’s loan document must be reviewed on a case by case basis to determine whether the bank takes priority.  In the case of In re Szymanski, the court found the term “material adverse change” as defined in loan documents did not allow the bank claim priority over a garnishment on a non-demand note where no evidence existed that the judgment impaired the debtor’s ability to pay the forty thousand dollar loan which happened to also be secured by  real property worth over 1.2 million.  In re Szymanski, 413 B. R. 232 (Bankr. E.D. PA 2009). 

Other courts have determined that only if the debt has matured can a setoff occur.   See Carbajal V. Capital One, 219 F.R.D. 437 (N.D. Ill E. Div , 2004).    Some courts have said that if the debtor is insolvent the bank has a setoff right.   Elizarraras v. Bank of El Paso, 631 F.2d 366 (C.A.5. Tex., 1980). 

In the case of All American Auto Salvage v. Camp’s Auto Wreckers and Citibank, South Dakota, N.A., the New Jersey Supreme Court considered whether the bank had the right to set off funds on deposit against the fees the bank charged on the account as a result of the execution writ hitting the account.  679 A.2d 627 (N.J. Sup Ct., 1996).  The court, going through an excellent analysis of the right of the bank to setoff, determined that in equity the bank should have the right to set off for such fees.  Id. at 633.   

The Florida court in the case of Barsco, Inc. v. H.W.W. Inc., examined cases from both Florida and out of Florida for a determination as to whether a bank could prevail against a garnishment of an account. 346 So.2d. 134 (Fla. 1st DCA, 1977)   In this case, the holder of the account was not in default on the loans at the time the garnishment hit.  The court examined one line of cases involving the loans which gave the bank the right to off-set the depositor’s account without demand or notice.  In such cases, this line of cases held the bank still has the duty to take some affirmative action to accelerate when the note has not matured prior to the time of the service of the garnishment writ.  Id. at 135.    The Barsco court found the UCC leaves it to the security agreement to determine what constitutes an event of default.  The Court also found the bank note required the borrower not to dispose of the security without written consent of the bank.  Ultimately, the court held the bank’s setoff right took priority over the right of the garnishee to the funds. 

Each state will have a different version of the Code as adopted and may also have a specific code section dealing with the priority issue on a garnished bank account.  These must be reviewed for the state at issue.

D.     Conclusion

A levy or garnishment on a bank account may take priority over a bank’s set off claim against the account if the bank documents are not specific as to the right to set off when the loan is not in default.  For bankers this means they must ensure their loan documents give them the right to set off upon a garnishment or execution.   Loan documents should include broad language creating a security interest in the account and ensuring the entire amount of the loan will be due if the garnishment hits or if the banker is insecure in the discretion of the bank.    The creditor attorney will want to review the loan documents and state law to ensure the bank has the right to set off and claim priority over the garnishment.  In the end, the account may still be flush with cash and you may still be entitled to it.  

Ted Hamilton is a frequent contributor to InsideBanking and Inside Banking - Lending Group on LinkedIn. Ted is AV Rated by Martindale Hubbell, its highest rating. His practice focuses on business representation, business planning, real estate transactions and litigation, commercial litigation, bankruptcy and business litigation, secured transactions and loan documentation and transactions. 


Attorneys at Law
Theodore J. Hamilton, Esq.
P.O. Box 172727
Tampa, FL 33602
813-225-2918 ext 14
813-225-2531-fax
tjh@whhlaw.com

This article will appear in the Fall edition of the Commercial Law League publication, Commercial Law World. Permission to reprint provided by Commercial Law World.

 

By Jeffrey Feldman   

There comes a time in every lender's portfolio when its workouts are no longer working out, and the only commercially reasonable course of action is to sue the obligors. When a lender participating in the SBA's 7(a) program sees that time approaching, it must work closely with its counsel to ensure that its litigation plans fully comply with the SBA's requirements.

           The first step towards a valid litigation plan is the retention of qualified collections counsel. The SBA requires that the attorney hired by the 7(a) lender have expertise in debt collection and bankruptcy law, be licensed to practice law where the litigation will be conducted, maintain adequate malpractice insurance, and have no conflicts of interest. In addition, the attorney's fees must reasonable for the locality where the litigation is being brought, and his or her billing practices must conform to the SBA's requirements. A lender should confirm these understandings in its written engagement agreement with its counsel.

            The most important threshold issue to be addressed by the lender and its counsel in formulating a litigation strategy on a 7(a) loan is whether it is necessary to submit a litigation plan to the SBA for approval. In general, a written litigation plan must always be prepared and submitted for approval in advance by the SBA unless: (1) the litigation qualifies as "Routine Litigation," or (2) the SBA grants a limited waiver of the need for a litigation plan. "Routine Litigation" is uncontested litigation for which the estimated legal fees do not exceed $10,000 in the aggregate. A limited waiver of the written litigation plan requirement may be granted by the SBA in its discretion upon request if certain extraordinary circumstances exist that warrant granting a temporary waiver.

            The form and content of any litigation plan submitted by a lender and its counsel should follow the template used in the SBA's official form, which is available at www.sba.gov. Every section of the form should be completed in order to avoid delays in its processing. Although the form is completed by counsel, the lender is responsible for providing its counsel with a variety of information and documentation related to its loan that must be included in the plan.

             If the litigation plan involves a bankrupt obligor or a claim against a deceased obligor's estate, the SBA requires that a specific series of steps be taken to protect the SBA's interests. Where applicable, lenders should ensure their proposed litigation plan references and fulfills those requirements. In addition, a lender should also review its litigation plan to ensure that it does not incur legal fees that the SBA either will not pay or has the discretion not to pay. Finally, the lender should also review any proposed pro-rata application of legal fees and recovery between the SBA loan and any other loans.

            When the plan is complete, it should be promptly submitted to the SBA for approval via e-mail to loanresolution@sba.gov. Once received, the SBA will generally approve or deny the litigation plan within 15 business days. If the SBA fails to do so, however, that cannot be deemed an implied consent by the SBA - it must provide its express consent to the lender in writing.

            After the plan is approved, a lender must monitor its litigation to determine whether (a) it has taken any actions that materially deviate from, or were not included in, the original litigation plan, and/or (b) it has incurred any expenses that exceed the estimates in the existing plan by more than 15%. If either has occurred, the lender must submit an amended litigation plan to the SBA for approval prior to taking any further action. Similarly, a lender who has been pursuing Routine Litigation without an approved plan must submit a litigation plan when (a) it incurs legal fees in excess of $10,000 or (b) other changes occur that render its litigation "Non-Routine."

            SBA lenders should select qualified litigation counsel who are experienced with the regulations governing the liquidation of SBA loans to ensure that their pursuit of the obligors' assets does not inadvertently jeopardize their own most valuable asset - the SBA's guarantee.

           For more information regarding litigation plans, please contact Jeff at JFeldman@StarfieldSmith.com or
(215) 542-7070. 

Starfield & Smith, P.C. protects the interests of its lender clients through a staff of experienced attorneys and paralegal loan processors. Their expertise in SBA guaranteed loans encompasses the breadth of the SBA's lending options, including the 7(a), 504, Express and Export Working Capital programs. If you would like to learn more about Starfield and Smith, PC visit their website at http://www.starfieldsmith.com/.

A special thanks to Jeffrey for sharing this article with our members and Camilla Andrews who originally introduced us to this article on the Inside Banking - Lending Group.