• Whose Credit Report Can You Look At Before Extending Credit to a Business Customer
  • May 7, 2003
  • Law Firm: Dinsmore & Shohl LLP - Cincinnati Office
  • One might assume that you can at least obtain a consumer credit report for the individual who is guaranteeing the loan? Or at least for the individual who is the principal, owner, or officer of a company that is seeking a commercial loan? However, on July 26, 2000 the Federal Trade Commission (FTC) issued staff opinion letter which states that Pursuant to the Fair Credit Reporting Act, a consumer credit report may not be obtained or used for any purpose, even for a business or commercial loan transaction, without the prior written consent of the consumer. The opinion letter can be obtained from the FTC internet site http://www.ftc.gov.

    Every standard credit application should be legally reviewed to make sure it is in compliance with the FTC's opinion. The National Association of Credit Managers (NACM) has suggested sample language to insure that an individual's written permission to access his or her credit history in connection with a business transaction complies with the FTC opinion.

    The following language must be in a separate paragraph following the signature at the bottom of the credit application, be conspicuous. Another signature line must be inserted at the end of the following paragraph to be signed by the individual whose credit report will be used.

    The undersigned individual who is either a principal of the credit applicant or a sole proprietorship of the credit application, recognizing that his or her individual credit history may be a factor in the evaluation of the credit history of the applicant, hereby consents to and authorizes the use of a consumer credit report on the undersigned by the above named business credit grantor, from time to time as may be needed, in the credit evaluation process.
    Signature of Individual

    The NACM indicates that a guaranty should contain the following language in a separate paragraph and it should be conspicuous by the use of either bold type or larger type: The undersigned personal guarantor, recognizing that his or her individual credit history may be a necessary factor in the evaluation of this personal guarantee, hereby consents to and authorizes the use of a consumer credit report on the undersigned, by the above named business credit guarantor, from time to time as may be needed, in the credit evaluation process.
    Signature of Individual

    In addition, all of the credit application forms and guarantee forms should be reviewed to make sure that the other language contained in those documents do not contradict or vary the suggested language or the principles set forth in the FTC opinion.

    Two IRS Proposed Regulations

    There continues to be a split of authority concerning whether or not a trustee can claim the capital gains exclusion allowed by the Internal Revenue Code, following the sale or exchange of a debtor's principal residence. In seeking to resolve this conflict, the Internal Revenue Service (IRS) has published proposed regulations which adds the capital gains exclusion to the list of tax attributes of the bankruptcy estate of an individual in a Chapter 7 or 11 bankruptcy case can takes into account in computing the taxable income of the estate. A public hearing is scheduled for January 23, 2001.

    Temporary regulations have also been issued by the IRS covering the assumption of liabilities in certain corporate transactions where there are distributions made by a corporation to its shareholders. The regulations provide that the amount of the distribution will be reduced by the amount of any liability that is assumed under the definitions provided in the Internal Revenue Code. The proposed regulation only affect distributions by corporations in which liabilities are assumed by the shareholders or in which property that is distributed is subject to liabilities. Written comments must be received by May 10, 2001 and a public hearing has been scheduled for May 31, 2001.

    Additional information regarding these proposed regulations, as well as numerous other proposed IRS regulations can be obtained at the IRS Internet site at http://www.irs.gov/tax-regs/regslist.html.

    Can the Family Farmer Still File Bankruptcy?

    Chapter 12 (Farm Bankruptcy) no longer exists in the bankruptcy code because of political wrangling over the comprehensive 2000 Bankruptcy Bill which was vetoed by President Clinton. Chapter 12 was enacted in 1986 with a 5 year expiration. It as been extended in a piecemeal fashion ever since 1991 but has never been made a permanent part of the Bankruptcy Code. The last major extension authorizing Chapter 12 bankruptcies expired Oct. 1, 1999.

    During the 2000 legislative session, Congress included chapter 12 as a permanent part of the Bankruptcy Code during the debate over the all encompassing Bankruptcy Bill. Congress decided to temporarily extend authority for Chapter 12 until June 30, 2000. In late June 2000, a stop-gap measure that would authorize an extension until Oct. 1, 2000 failed in the Senate. As a result, since July 1, Chapter 12 no longer exists as a viable option for farmers to reorganize their financially troubled farming operations.

    Even though Chapter 12 no longer exists, a farming operation may still file a Chapter 11 bankruptcy or a Chapter 13 bankruptcy if certain qualifications are met. For instance, although a Chapter 11 is available to the family farmer, it is more difficult to reorganize a farming operation under chapter 11 due to the difficulty in confirming a case and the extra cost of administering the estate.

    Filing a Chapter 13, is available as long as the farmer qualifies as an "individual with regular income" as defined by the bankruptcy code. Corporations are not allowed to reorganize in a Chapter 13 plan. In addition, there are smaller income and debt limitations in a Chapter 13 as compared to the more liberal levels contained in the former Chapter 12.

    Prepayment Premiums

    In today's loan securitization market, commercial loans (especially commercial mortgage loans) generally contain a prepayment premium provision to protect the original lender in the event the borrower decides to refinance the loan as a result of declining interest rates. If the borrower chooses to refinance, the purpose of the prepayment premium provision is to ensure that the lender will receive its contractual rate of interest over the term of the loan (i.e., the benefit of the bargain).

    In everyday refinancing transactions outside of a bankruptcy proceeding, prepayment premiums are rarely challenged by borrowers; and if they are, courts tend to uphold such premiums by enforcing the terms of the contract as a provision which was negotiated at arms-length by sophisticated parties. When a lender's borrower files for bankruptcy, however, the lender must be prepared for a rigorous challenge to the recovery of its prepayment premium from several opposing parties in the bankruptcy proceeding, including, the borrower, other secured creditors and the general unsecured creditors.

    The Bankruptcy Code permits a secured creditor to collect post-petition interest on its claim (i.e., the amount the lender is owed under the loan) and any reasonable costs and fees that are provided for in the loan documents to the extent that the lender's claim is oversecured. This is the basis for allowing a prepayment premium as part of the lender's claim in the borrower's bankruptcy. However, bankruptcy courts apply several factors in determining if a prepayment premium is an allowable claim. Each bankruptcy court will decide the issue on a case-by-case basis, but the general criteria can be summarized as follows.

    First, the lender must establish that it is oversecured and an "equity cushion" exists. Such an equity cushion exists when the value of the lender's collateral exceeds the amount of its claim. Second, the prepayment premium provisions in the loan agreement must clearly provide for the recovery of such a charge and the amount of the premium can be reasonably calculated. Third, the bankruptcy courts may be asked by an opposing party to make a determination as to whether the prepayment penalty is an enforceable liquidated damages provision or an unenforceable charge in the nature of a penalty. This analysis will be made under the state law governing the loan documents. Fourth, if the bankruptcy court determines that the prepayment premium is enforceable under applicable state law then the court will analyze whether it is a "reasonable" charge under the Bankruptcy Code.

    The first two factors utilized by the bankruptcy courts in their analysis are generally matters of factual determination. With respect to the existence of an equity cushion, the lender will present evidence of the value of the collateral to establish that the value exceeds the amount of the lender's claim. With respect to the provisions in the loan agreement which provide for a prepayment premium, the court will analyze such language to make certain that it is clear and unambiguous. In analyzing the other two factors, the bankruptcy courts will look to case law as well as applicable statutes.

    State Law Analysis
    Several bankruptcy courts have examined the prepayment premium in the context of liquidated damages under the applicable state law. The main issue is whether a prepayment premium is a reasonable approximation of the lender's damage as a result of an early pay-off of the loan. The parties to the loan agreement are not required to make the best estimate of damages, just one that is reasonable.

    Generally, liquidated damages clauses are allowable if the liquidated amount bears a "reasonable proportion" to the calculated loss. The lender should be prepared to present evidence of actual damages in support of its claim; not damages that could be anticipated. The actual damages include the loss of interest to which the lender is entitled and the expense and risk of lending the repaid funds to a new borrower. The loss of interest is calculated from the date of the prepayment to the scheduled maturity date.

    The "Reasonable" Standard
    The reasonableness of a prepayment premium is decided on a case-by-case basis in accordance with the Bankruptcy Code and not sate law (the state law analysis only determines if the premium is allowable, not reasonable). There is no general threshold for what is or is not reasonable for a prepayment premium. A prepayment penalty equal to 10% of the principal amount of the loan was held to be reasonable, as well as a prepayment penalty of 25%. One of the key factors in demonstrating reasonableness is the language of the prepayment premium provision. To survive scrutiny, the calculation of the prepayment premium should contain (i) a discount for present value (a bankruptcy court has held that a prepayment premium which failed to provide for a discount to present value was an unreasonable forecast of damages and resulted in a windfall to the creditor), (ii) a rate index that is comparable to the type of loan being prepaid, and (iii) language that is clear and unambiguous. The bankruptcy courts generally will enforce a contractually bargained-for result; but they are concerned about awarding a windfall to the secured creditor at the expense of the debtor and other unsecured creditors.

    Does Bankruptcy Filing Trigger the Prepayment Premium?
    As noted, one of the factors used by the Bankruptcy Court in their analysis is the actual language of the prepayment premium provision. An issue that arises is whether the filing of a bankruptcy petition by the borrower (and the subsequent acceleration of the loan by the lender) entitles the lender to assert a claim for a prepayment premium. Bankruptcy courts generally have held that there must be an actual prepayment of the note by the borrower in order for the lender to be entitled to claim a prepayment premium. A prepayment can be triggered by a refinancing or a "due-on-sale" clause if the property (the lender's collateral) is sold. Some courts have also held that the prepayment must be voluntary. One bankruptcy court has held that if the lender files a motion for relief from the automatic stay, such conduct will be deemed a waiver of the right to a prepayment premium.

    The Three R's: Reclamation, Rights and Remedies

    A customer, who you are aware that is having financial difficulty, places and order. You decide to fill the order and deliver the goods to the customer. A few days later, you hear that the customer is preparing to file for bankruptcy, you receive notice that a check from the customer has bounced, or the customer calls to tell you it is unable to pay on the invoice for the shipment. How can you protect yourself and try to obtain payment for the recent order?

    The Uniform Commercial Code, adopted in all states except Louisiana, allows a seller to reclaim goods from a buyer on credit where the seller determines that the buyer is insolvent. To make a demand for reclamation, it is essential that the buyer must be insolvent. Insolvency can be determined by several means with the most readily available being the buyer's inability to pay its debts as they come due. However, insolvency can also be demonstrated through financial analysis including examination of the balance sheet. Merely receiving unfavorable reports regarding the buyer's credit does not prove insolvency for purposes of making a demand for reclamation.

    Once aware that a buyer is insolvent, a seller must make a demand for reclamation within ten days after the buyer received the goods. If the buyer files for bankruptcy protection after receiving the goods but before the ten day period expires, the seller has twenty days from the date of delivery in which to make the demand for reclamation. This extended period is a function of the federal Bankruptcy Code and not the Uniform Commercial Code. In addition, there is some authority to suggest that where the buyer has filed for bankruptcy, a seller making a demand for reclamation must file litigation in the bankruptcy court in order to pursue the reclamation demand.

    The ten day period begins to run on the day that the buyer obtains physical possession of the goods. Goods are in the buyer's physical possession once they are on its property, regardless of whether they must be unloaded or unpacked from the truck, railcar or other mode of transport. It should be noted that the rule regarding physical delivery of the goods specifically ignores the transfer of title terms of the sales agreement, such as "fob shipper."

    The ten day time period begins to run on the day the buyer receives the goods and ends on the tenth day from that day. If the tenth day falls on a weekend or a holiday on which the buyer's offices are closed, the seller has until the next business day to make a demand for reclamation. For purposes of determining when the reclamation demand is made, the "mailbox" rule is generally in effect. That is, the seller must transmit the demand for reclamation by the end of the tenth day. However, hand delivery, facsimile or overnight express delivery should be used to insure the buyer receives the demand quickly. These forms of delivery are also easier to track if proof of the demand date must be made in court.

    If the buyer makes written misrepresentation of solvency to the seller within three months of the date the goods were delivered, the ten day limitation is inapplicable. Whether a writing constitutes a written representation of solvency is a highly factual question and often leads to litigation. However, if a written misrepresentation of solvency can be shown, the seller can reclaim up to three months of deliveries rather than ten days. Some courts have held that a check returned for insufficient funds is a misrepresentation of insolvency. However, it should be noted that checks drafted prior to a bankruptcy filing but presented for payment to the buyer's bank after the bankruptcy filing will generally be returned under requirements of the Bankruptcy Code preventing payment on pre-filing obligations. The return of a check under these circumstances will not be seen as a misrepresentation of solvency.

    Other instances of misrepresentations insolvency include false financial statements, statements of fact regarding the ability to pay for the goods, false statements made to commercial agencies who pass the statement on to the buyer, and false statements made by the buyer's agent. Other issues arise when a buyer makes a true statement that, due to changed circumstances or the passage of time, becomes false when it reaches the seller. This difficult situation is highly fact intensive and courts will often look to whether the buyer was obligated to update the relevant information. Finally, the seller must have relied on the false statement of solvency in making the sale to the buyer.

    The demand for reclamation should specifically contain the words "reclaim" or "reclamation" as well as reference to the relevant sections of the U.C.C., state law and, if relevant, the Bankruptcy Code. The demand should also specifically identify the goods subject to reclamation. The identification should, if possible, include serial numbers, seller invoices, buyer purchase orders, proof of the delivery dates and any other information that will assist the buyer in recognizing the exact goods subject to reclamation. A demand for reclamation can be invalidated, in whole or in part, if the buyer is unable to determine the goods which are subject to the demand for reclamation.

    A buyer may prevent reclamation of goods through several defenses. First, the goods must still be in intact, identifiable and in the hands of the buyer. If the goods were processed from their original state prior to the time the seller made the demand for reclamation, the demand must fail. Processing includes changing the physical structure of the goods in such a way that they become a new product and cannot be returned to the seller in their original state.

    Second, the goods must also be identifiable. That is, the seller must be able to prove the goods it seeks to reclaim come from the seller. Fungible goods may be identifiable if the seller's goods were commingled with similar goods from other sellers if the goods are of the same type and quality, are commingled in an identifiable mass and the seller can demonstrate that the goods subject to reclamation have not yet been consumed. For example, jet fuel that is commingled in common pipelines and storage tanks may be reclaimed so long as the seller can trace its own jet fuel through the system. The seller must also prove, through first-in-first-out or other relevant methods, that the commingled goods subject to the reclamation demand have not been consumed, altered or sold by the buyer.

    Third, the goods must still be in the hands of the buyer. If the buyer sells the goods to a good-faith purchaser before the demand for reclamation is made, the seller's right to reclamation is terminated. In addition, if the goods are subject the lien of a senior secured creditor, the seller cannot assert a demand for reclamation for the goods. It should be noted that a seller who has a properly perfected purchase money security interest may be able to make reclamation over a senior secured creditor.

    As a practical matter, although reclamation is technically a demand for the return of goods, a demand for reclamation often results in the buyer's payment for the goods. This is particularly true if the goods have a short shelf-life, are turned quickly or are key product or raw materials for the buyer. In many instances, sellers do not realize the buyer is insolvent until a bankruptcy petition has been filed. However, the buyer is not obligated to inform the seller that bankruptcy has been declared. Therefore, the seller should closely monitor the buyer, the courts or news sources to determine if a bankruptcy case has been initiated. Unfortunately for the seller, if bankruptcy has been filed, the buyer/bankruptcy debtor may not be required to resolve the reclamation claim for many months. This does not, however, relieve the seller of the duty to demand reclamation in the time limitations discussed above.