When negotiating and drafting payoff letters, outgoing lenders should be wary of the risks of potential preference liability to a bankruptcy trustee with certain clawback rights for payments previously made. This event may result in an outgoing lender holding an unsecured claim against the borrower despite having previously been secured.  

Definition of a Payoff Letter and Typical Use in Loan Transactions
A payoff letter typically sets forth the total amount owed, along with the certain obligations of the outgoing lender following payment in full. These actions often include executing lien terminations and releases and filing UCC-3 termination statements. Payoff letters also usually contain survival provisions and releases by the borrower. 

Survival provisions ensure that certain loan obligations survive the payoff and remain enforceable. Common examples include indemnification obligations and provisions relating to the revival and reinstatement of obligations and liens. These are particularly important in scenarios where a payment made by an account debtor is later challenged as void, voidable, or otherwise subject to recovery under applicable bankruptcy laws. Such survival provisions often state that any previously released or terminated liens shall be reinstated and enforceable.

The Role of Outgoing and Replacement Lenders
In many refinancing transactions, a borrower will request a payoff letter from its existing lender (the “Outgoing Lender”) when obtaining a new lender (the “Replacement Lender”). The key terms of a payoff letter from the Replacement Lender’s perspective are: (i) an obligation, upon receipt of the full payoff amount, to release all liens granted in favor of the Outgoing Lender; (ii) disclosure of any borrower obligations to the Outgoing Lender that will survive the payoff (e.g., contingent obligations and indemnities); (iii) identification of any liens in favor of the Outgoing Lender that will remain in effect after the payoff; and (iv) any requirements for the borrower to provide cash collateral to the Outgoing Lender post-payoff.

The Outgoing Lender’s concerns in this arena are potential avoidable transfer risks (including preference liability) in addition to the actual payoff amount and outstanding letter of credit obligations that are not assumed or reissued by the Replacement Lender.

Preferential Transfers
The relationship discussed herein, involves an account debtor, which owes funds to the borrower, the borrower, and the borrower’s lender. In particular, we will analyze the risk of payments by an account debtor within 90 days prior to such account debtor’s bankruptcy filing. The risk analyzed below is the risk that a payment by an account debtor is deemed to be an avoidable transfer in favor of the bankruptcy trustee and/or the bankruptcy estate.

Bankruptcy trustees may, under certain circumstances, avoid payments by the debtor, in this case the account debtor, to its creditor within 90 days prior to the bankruptcy. Under 11 U.S.C. §547(b), the trustee can generally avoid payments made for the benefit of a creditor based on an antecedent debt made while the debtor was insolvent within 90 days before filing bankruptcy that enables the creditor to receive more than they would get in a pro rata Chapter 7 distribution.  

Preference Claim Scenarios In the context of payoff letters, the Outgoing Lender should be acutely aware of circumstances that may give rise to avoidable transfer liability. One key scenario involves the following two conditions: 

(1) the borrower maintains a collection account with a depository institution, and the Outgoing Lender exercises sole control over that account—either at the outset of the transaction or as a result of a springing event under the terms of a DACA (defined below) where payments are swept to an account maintained by the Outgoing Lender to repay outstanding loan obligations, and 

(2) one or more of the borrower’s account debtors shows signs of financial distress that may lead to such account debtors filing bankruptcy prior to the payoff date.

If both conditions are present, the Outgoing Lender may be exposed to avoidable transfer risks, as a result of the Outgoing Lender’s dominion over the payments made by the account debtors, and payments received during the 90-day period being subject to clawback by a bankruptcy trustee based on a preference claim.

Initial Transferee v. Subsequent Transferee
Under 11 U.S.C. §550(a) of the Bankruptcy Code, a bankruptcy trustee may recover a preferential payment made from either an initial transferee or, in some cases, an immediate or mediate transferee of an initial transferee. The most interesting aspect of the initial transferee v. subsequent transferee analysis is that a payment instrument designating the borrower as the payee deposited in borrower’s account where Outgoing Lender is a depository institution could fall on either side of the fence depending on the circumstances. The same is also true for an Outgoing Lender that utilizes a DACA (defined below). 

Please click here to continue reading the article, (continues on page 46)

Visit SFNet's Deal Table