ILC e-Bulletin: BAP holds that a lender’s claim is unsecured because the Debtor-borrower had no direct ownership interest in the property she purported to pledge as collateral for the related loan

These materials were prepared by ILC member Joseph Boufadel.

ILC E-Bulletin: Ninth Circuit BAP holds that a lender’s claim is unsecured because the Debtor-borrower had no direct ownership interest in the property she purported to pledge as collateral for the related loan

March 18, 2020

Dear constituency list members of the Insolvency Law Committee, the following is a recent case update:

SUMMARY

In Norio, Inc. v. Thomas H. Casey, Chapter 7 Trustee, 2019 WL 6331564 (9th Cir. BAP 2019), the Bankruptcy Appellate Panel for the Ninth Circuit held in an unpublished opinion that a lender’s claim was unsecured because the Debtor-borrower had no direct ownership interest in the property (membership interests in a limited liability company and a limited partnership, collectively the “Membership Interests”) she purported to pledge as collateral for the related loan. The Membership Interests were owned by a holding company which in turn was partially owned by the Debtor. In attempting to pledge the Membership Interests as collateral for a loan, Debtor mistakenly assumed that the incomplete dissolution of the company effected a transfer of the company’s assets (including the Membership Interests) to her personally, and thus, that she could pledge the Membership Interests as collateral for the loan. In affirming the bankruptcy court’s order sustaining the Chapter 7 Trustee’s objection to the lender’s claim as secured, the BAP ruled that the company remained the owner of the Membership Interests because it failed to complete the formal process for dissolution under California law — notwithstanding that the Debtor intended and believed that the company was in fact dissolved. A copy of the memorandum is available here.

FACTUAL BACKGROUND

Debtor and her then-husband (the “Downs”) co-owned Downs Holdings, Inc. (“Downs Holdings”) as a holding company for their investments. In turn, Downs Holdings held interests in two entities: Ten Twenty University, LLC (the “LLC”) and VPM Westchester LP (the “LP”).

After the breakdown of their marriage, the Downs adopted a unanimous shareholder resolution to dissolve Downs Holdings and to assign the non-debtor spouse with the responsibility of implementing the resolution. At the same time, Downs Holdings directed all payments due to it from the LLC and the LP to the Downs as individuals. In response, the LLC confirmed that it would direct the distributions as requested, but clarified that Downs Holdings would still remain a member of the LLC and that further documentation would be required for a formal transfer of the LLC’s interests from Down Holdings to the Downs.

After receiving the distributions, the Downs took no further action to wind up and dissolve Downs Holdings or to distribute the remainder of its assets to themselves as shareholders.

Years later, Debtor borrowed $50,000 from Norio, Inc. (“Norio”), ostensibly secured by the Membership Interests.

Three days later, Debtor filed a chapter 11 petition. Debtor’s case was ultimately converted to a chapter 7 proceeding, where Norio filed a $50,000 secured claim based upon the loan and Debtor’s pledge of her Membership Interests as collateral for the loan.

The Chapter 7 Trustee objected to Norio’s claim on the grounds that it was not secured because the Debtor could not personally pledge the Membership Interests as collateral for the loan where she did not in fact own them. In opposition, Norio argued that Downs Holdings had dissolved in 2012, causing the Membership Interests to transfer to the Downs, as shareholders, by operation of California law.

The bankruptcy court sustained the Trustee’s objection and classified Norio’s claim as unsecured. The BAP affirmed.

REASONING

The critical question before the BAP was whether Downs Holdings had transferred its assets to the Downs by formally electing to wind up and dissolve, even though it took no further steps to actually wind up the company. In holding that electing to wind up and dissolve alone is insufficient to transfer the company’s assets to its shareholders as a matter of law, the BAP provided an instructive primer on the general three-stage process of corporate dissolution in California.

In the first stage, a corporation elects to wind up and dissolve. (Cal. Corp. Code § 1900). This election to dissolve may be revoked before the corporation begins distributing its assets. (Corp. Code § 1902(a)). Among other notification provisions, when a corporation elects to dissolve, it usually files a certificate “evidencing” this election to wind up with the Secretary of State. (Corp. Code § 1901(a)). The BAP noted that these notification provisions “were enacted for the convenience of the Secretary of State and the public, and for the protection of the directors and trustees, but strict compliance therewith is not necessary.” Herschfelt v. Knowles-Raymond Granite Co., 130 Cal.App.2d 347, 351 (1955). Downs Holdings failed to file this certificate with the Secretary of State.

In the second stage, assuming the proceeding is voluntary, the corporation winds up. (Corp. Code § 1903(a)). The BAP explained that during the wind-up process, the company’s board “shall continue to act as a board and shall have full powers to wind up and settle its affairs, both before and after the filing of the certificate of dissolution.” (Corp. Code § 1903(b)). Furthermore, the company during this time shall cease to carry on business except necessary for the beneficial winding up of the company and except as the board deems necessary to preserve the goodwill and going-concern value pending a sale. (Corp. Code § 1903(c)).

In the third stage, the corporation files a certificate of dissolution with the Secretary of State once the company has been completely wound up (Corp. Code § 1905(a)). In this certificate, the directors also certify that the company’s final tax return has been filed. Thus, upon the filing of the certificate of dissolution, the company’s powers, rights and privileges cease. (Corp. Code § 1905(b)).

With this framework in mind, the BAP concluded that Downs Holdings remained the owner of the Membership Interests because the interests were never transferred to the Downs. The BAP noted that there was no dispute that the Downs unanimously voted to dissolve Downs Holdings or that the Downs intended to dissolve the corporation. Nevertheless, the BAP rejected Norio’s argument that Downs Holdings fully dissolved in 2012 as a matter of law when it elected to dissolve.

The BAP determined that Norio failed to provide any authority in support of this argument that a statement of an intent to wind up and dissolve acts as an asset transfer as a matter of law. Instead, the statutory language provides for the company’s continued existence during the wind up process while it formally divides and conveys its assets. (Corp. Code § 2010(a)). And, if a company forgets to administer or otherwise distribute assets during the wind up process, those omitted assets remain corporate assets of the dissolved company until they have been properly distributed. (Corp. Code § 2010(c)).

Ultimately, the BAP agreed with the bankruptcy court that Downs Holdings never formally dissolved because it failed both to file a final certificate of dissolution with the Secretary of State and to file its final tax return. Indeed, Downs Holdings never sought to formally transfer its assets and did not otherwise take any action to wind up its business. And, even if Downs Holdings did actually wind up and dissolve, its omission of the Membership Interests from the dissolution process meant that they remained assets of the dissolved corporation under Corp. Code section 2010(c).

Therefore, Downs Holdings remained the owner of the Membership Interests and the Debtor could not have pledged these assets as collateral for the loan, resulting in Norio having only an unsecured claim.

AUTHOR COMMENTARY

This case reminds us of the value of good checklists for the lender during the initial due diligence process. While not discussed in the opinion, it would be interesting to see what documentation and representations were made by the Debtor in securing the loan, especially since the chapter 11 petition was filed only three days after the Debtor received the funds. Was there fraud in the loan documentation or was this just sloppy vetting by the lender?

In hindsight, it appears that the lender could have avoided the loss of the secured status of its claim and the attendant litigation and appellate costs by verifying whether the corporation actually dissolved -- through the filing of a final tax return or of a final certificate of dissolution with the Secretary of State -- or by verifying that the Membership Interests were properly transferred through an assignment or other formal documentation.

This case also provides a useful primer on the general dissolution process under California law. The BAP reminds us that the statutory dissolution process requires more than simply electing and agreeing to dissolve a company. The BAP emphasized that corporate assets remain corporate assets of the dissolved company absent their actual disposition; there is no automatic transfer of assets upon dissolution as a matter of law.

These materials were prepared by ILC member Joseph Boufadel of Salvato Law Offices in Los Angeles (JBoufadel@salvatolawoffices.com), with editorial contributions from ILC member Michael W. Davis of Brutzkus Gubner in Woodland Hills (mdavis@bg.law).