Lenders’ risk: Who really owns the collateral?
Unlike real estate transactions where a lender can obtain title insurance, secured lenders are often relying upon the representations and warranties in their loan agreement and the borrower’s audited financial statements, if and when determining whether the collateral securing their loans is owned by the borrower or another pledgor. After default, a lender may find itself in a precarious position whereby it is unable to foreclose on the collateral because it is not owned by its borrower and it does not have a pledge from the person that actually does own the property. According to the Third Circuit, however, certain oversights may not affect the lender’s position as a secured creditor. In In re WL Homes 534 Fed. Appx. 165 (3d Cir. 2013), the court dealt with the issue of whether or not a deposit account owned by a wholly-owned subsidiary of the debtor was properly pledged despite the fact that the owner of the deposit account did not sign a pledge agreement.
In 2007, WL Homes LLC (“WL Homes”) and Wachovia Bank (“Wachovia”) entered into a transaction pursuant to which Wachovia extended a $20 million revolving line of credit to WL Homes secured by among other things various deposit accounts, including a $10,000,000 deposit account opened at Wachovia after the loan closed and owned by and in the name of JLH Insurance Corp., a wholly-owned subsidiary of WL Homes (“JLH”). JLH was formed as a pure captive insurance company—it’s sole purpose was to pay claims brought against WL Homes by insuring the risk of WL Homes. The purpose of the deposit account was to meet a requirement under Arizona law dealing with captive insurance companies. Although the JLH account was owned by and in the name of JLH, WL Homes transferred all of the funds into that account. The two entities had separate books and records and organic documents, but there was significant overlap in their board compositions, and the President of JLH was also the CFO of WL Homes and had negotiated the loan documents with Wachovia in such capacity. The WL Homes balance sheet treated the deposit account as an asset of WL Homes.
In early 2009, WL Homes filed for Chapter 11 bankruptcy, which was subsequently converted to Chapter 7, in the Bankruptcy Court for the District of Delaware. Promptly thereafter, Wachovia filed an action with the court seeking a declaratory judgment that it had an enforceable security interest in the pledged JLH deposit account. The Bankruptcy Court granted Wachovia’s motion for summary judgment, finding that (i) Wachovia had use and control over the deposit account and (ii) JLH had consented to the pledge of the deposit account as collateral. After the District Court for the District of Delaware ruled that Wachovia did not in fact have use and control over the account, but nonetheless affirmed the outcome in the Bankruptcy Court on the grounds that JLH had consented to the pledge, the case was appealed to the Third Circuit.
In ruling in favor of Wachovia under California Law, the Third Circuit first opined that the debtor need not fully own the property that it pledges in a secured transaction, but it may only pledge the rights that it actually has in that property—a security interest attaches to the debtor’s rights, which need not amount to full ownership. Furthermore, the court opined that consent of the owner of the property is one way in which the debtor may obtain rights in such property, and thus the defining issue became whether or not JLH had consented to the pledge of its deposit account; in order to consent, it first had to have knowledge of the pledge.
In applying certain principles of the law of agency, including the “doctrine of imputed knowledge”, the court held that an agent’s knowledge, in this case the President of JLH, will be imputed to the principal, JLH, if knowledge of the fact is material to the duties to the principal. Such knowledge must be acquired in the scope of the agent’s duties to the principal, and only knowledge that is actually material to such duties will be imputed. Furthermore, even knowledge obtained in a different capacity can be imputed if such knowledge is present in the mind of the agent while acting for the principal. In applying these principles to the facts, the court held that JLH had sufficient knowledge because its President was the CFO of WL Homes and he had sufficient knowledge when acting in his capacity as an agent of JLH. Because it had sufficient knowledge, JLH was deemed to have consented to the pledge, thus giving WL Homes rights in the deposit account and resulting in an enforceable security interest in favor of Wachovia.
The cases cited by the Third Circuit were situations where a lender would be hard pressed to know which company or individual owned a particular piece of equipment. In those cases, courts would impute the consent of the owner, who generally owned the borrower and signed the documents, to granting a lien as well. This case extends the concept because here the account was not in the name of the borrower and the lender had knowledge of that fact.
Despite the fact that the lender overcame what could have been a deleterious mishap, it nonetheless could have saved itself from the risk of being an unsecured creditor, as well as the high cost of litigation, had the parties set up the account at closing and properly identified the source of all collateral being pledged. In addition to properly identifying the owner or rights-holder of all collateral, ensuring that an express consent is acquired or adding such party as a signatory to the loan documents helps mitigate the likelihood that the debtor will challenge the enforceability of a lender’s security interest.