Maryland Legal Alert for Financial Services

In This Issue:

TILA RESCISSION CLAIM MAY BE PRECLUDED BASED ON RES JUDICATA

SECURED CREDITORS' RIGHTS IN CHAPTER 11 CRAMDOWN

BUSINESS LENDER LOAN STACKING DECISION

CFPB ARBITRATION RULE REPEALED

MORE BLOCKCHAIN DEVELOPMENTS FOR INITIAL COIN OFFERINGS

CFPB RELEASES PAYDAY LOAN RULE

TILA Rescission Claim May Be Precluded Based on Res Judicata

Recently, the Maryland Court of Special Appeals, Maryland’s intermediate appellate court, considered issues related to the right of rescission under the federal Truth in Lending Act (TILA).

Essentially, the borrowers argued that giving a TILA notice of rescission immediately makes the lien on their property null and void, and because the lien on the property is null and void, the doctrine of res judicata cannot preclude the rescission. 

In its decision issued August 30, 2017, the Court of Special Appeals disagreed.

Under a theory of res judicata, a claim will be precluded (not allowed) if: (1) the parties in the current litigation are the same or in privity with the parties to prior litigation; (2) the claim presented in the current litigation is identical or substantially identical to a claim litigated or that could have been litigated in the prior litigation; and (3) there was a final judgment on the merits in the prior litigation.

The Court of Special Appeals observed that in December 2008, the borrowers filed a lawsuit claiming, among other issues, that TILA was violated and that the lien on their property was unenforceable.

While that lawsuit was pending, the borrowers sent letters in March 2009 and August 2009 stating that they were rescinding the loans secured by their property. That lawsuit was dismissed with prejudice in April 2010 and was not appealed.

The borrowers pursued no fewer than tw additional lawsuits and defended no fewer than two foreclosure actions over the next seven years, all relating to the same loans and the same property, claiming in some of these actions that the letters they sent in 2009 had the effect of rescinding the loans and making the lien on their property null and void. 

In its August 30, 2017 decision, the Court of Special Appeals agreed with the lower court that, based on the first lawsuit (and perhaps based on claims in the subsequent actions), all of the elements for applying the doctrine of res judicata to the TILA rescission claim existed. The Court concluded that “[a]ll of the TILA claims the [borrowers] attempted to raise in the current case clearly ‘could have been litigated in the’ December 30, 2008, suit” and “under the principles applicable to claim preclusion, . . . [the borrowers were] required to assert all claims that ‘could have been litigated’ in a proceeding once they voluntarily initiated suit on December 30, 2008.”

The Court rejected the borrowers’ contention that the Supreme Court’s decision in Jesinoski et al. v. Countrywide Home Loans, Inc. et al. established that regardless of whether they had a legitimate basis for rescission, the lien against their property became void as soon as they gave notice of their demand for rescission in 2009.

The borrowers further contended that because under Jesinoski there is no obligation to bring a lawsuit in order to rescind a loan, the claim of rescission cannot be subject to the preclusive effect of res judicata.  The Court found that nothing in Jesinoski alters the common law requirement that once litigation is initiated by a party, the party must assert all claims that pertain to the particular subject matter of that litigation to ensure courts do not waste time adjudicating matters that have already been decided or could have been decided fully and fairly.

The borrowers filed a Petition for Writ of Certiorari with the Maryland Court of Appeals on October 4, 2017.

For any questions, please contact Christopher Rahl.

Contact Christopher Rahl

Secured Creditors' Rights in Chapter 11 Cramdown

Under Chapter 11 of the United States Bankruptcy Code, a secured creditor may be required to comply with a debtor’s plan of reorganization so long as the plan’s treatment of the secured claim is “fair and equitable.” 

If the plan proposes to pay the claim over a period of time, then the Bankruptcy Code provides that the creditor must receive the present value of its claim.

However, the Bankruptcy Code does not specify how interest that must be paid on the claim is to be calculated.  

In a 2004 decision, the U.S. Supreme Court, in Till v. SC Credit Corp., held (in a plurality opinion) that the appropriate interest rate for a  “cramdown” of a secured creditor should be calculated by using the national prime rate of interest and adjusting it upward to account for the risk of nonpayment. Till was a Chapter 13 case involving a $4,000 truck loan at a 21% contract rate. In a footnote, the Supreme Court noted that its “formula rate” may not be applicable to Chapter 11 where “it might make sense to ask what an efficient market would produce.” 

Nevertheless, since the decision in Till, many bankruptcy courts have used the formula approach to calculate the interest rate to cramdown a secured creditor under a Chapter 11 plan. The formula rate is usually lower than the rate that would be charged if the debtor were to obtain exit financing.

On October 20, 2017, the U.S. Court of Appeals for the Second Circuit reversed confirmation of a Chapter 11 plan that crammed down senior lien holders by using the formula rate. The Second Circuit held that the bankruptcy court should have used the market rate if it is shown by the creditors that an efficient market exists for comparable debt financing. 

The Second Circuit stated that it was not bound by the Till decision and referred to the Supreme Court’s footnote regarding whether the formula rate should be used in Chapter 11. The case was remanded, so the lower courts could consider whether an efficient market exists for the making of loans to a Chapter 11 debtor.

The method of calculation of the interest rate for cramdown of a secured creditor’s claim is an open issue in the Fourth Circuit where Maryland is located. If the Second Circuit’s approach is followed, then secured creditors who prove that an efficient market exists for the making of loans to a Chapter 11 debtor should benefit by receiving a higher rate on their claims than would be the case if interest is calculated using the formula approach.

For any questions, please contact Christopher Rahl.

Contact Christopher Rahl

Business Lender Loan Stacking Decision

A recent Maryland Business and Technology Case Management Program decision in the Montgomery County Circuit Court offers insight into disputes between lenders with competing security interests in accounts receivable.

The plaintiff, as the senior lender, provided financing to the borrower to be repaid through automatic debits from the borrower’s bank account. The senior lender also obtained a security interest in the borrower’s personal property and proceeds (including its accounts receivable).

Later, the borrower applied to a subsequent lender for additional financing. The subsequent lender purchased the borrower’s future accounts receivable and obtained a security interest in the borrower’s property. The borrower eventually defaulted under both agreements, and the senior lender brought a lawsuit against the subsequent lender, claiming tortious interference with contract and liability under Article 9 of the UCC (Md. Code Ann., Comm. Law §9-625) for violating the senior lender’s rights in its collateral.

The court denied the subsequent lender’s motion for summary judgment, thus permitting the senior lender to proceed to trial on both claims. In support of its decision, the court stressed the following facts:

1. The senior lender had filed a financing statement that included an admonition to third parties that interference with the collateral would constitute interference with the senior lender’s contract rights;
2. The senior lender sent notice letters to numerous small business finance lenders (including the subsequent lender) notifying them of the senior lender’s loan agreement terms and warning that additional financing that violated the senior lender’s loan terms constituted an interference with its contracts; and
3. The borrower had disclosed to the subsequent lender the existence of the senior lender’s loan.

It is not uncommon for certain distressed businesses to obtain financing secured by their accounts receivable from multiple lenders in short succession, resulting in those lenders fighting over the same diminishing collateral.

This case demonstrates that a senior lender may have recourse against aggressive junior lenders, provided that the senior lender can demonstrate that it took sufficient steps to put third parties on notice of its rights under contract and in its collateral. For junior lenders, this case demonstrates the risk of stacking additional liens on the borrower’s accounts receivable.

Notably, the court flatly rejected the subsequent lender’s argument that the senior lender’s claims must fail, because (1) the subsequent lender determined during its underwriting process that the borrower could afford all of its debt service (and thus no interference was intended), and (2) the borrower made a representation and warranty to the subsequent lender that the borrower was not violating any other agreement. Please contact Bryan Mull with any questions about this topic.

Contact Bryan Mull

CFPB Arbitration Rule Repealed

While many thought it was unlikely to happen, the U.S. Congress voted to repeal the Consumer Financial Protection Bureau’s final arbitration rule. We wrote in our August 2017 Maryland Legal Alert about the final rule banning consumer class action waivers. The rule was scheduled to take effect on September 18, 2017, and would have applied to consumer arbitration agreements entered into (and new products/services obtained) on and after March 19, 2018.

The U.S. House of Representatives first voted to repeal the final rule under the Congressional Review Act. Then, on October 24, 2017, Vice President Michael Pence cast a tie-breaking vote in the Senate to similarly repeal the final rule. If you would like more information concerning the status and use of arbitration provisions in consumer contracts, please contact Christopher Rahl.

Contact Christopher Rahl

More Blockchain Developments for Initial Coin Offerings

In our October 2017 Maryland Legal Alert, we noted recent developments concerning virtual currency initial coin offerings (ICOs) and the United States Securities and Exchange Commission’s (SEC) view that ICOs constituted the offer of securities.

On October 24, 2017, a subsidiary of Overstock.com, announced details about a proposed initial coin offering (ICO) to raise funds for further development of the company’s alternative trading system. The trading system is intended to enable SEC compliant trading of virtual currencies or “tokens.”

In the ICO, rather than directly offering tokens, the company proposes to offer a standardized investment contract for the future delivery of tokens known as a Simple Agreement for Future Tokens (SAFT). Many ICOs offer a type of token known as a “utility token” that is intended to function through a network of distributed ledgers developed by the seller to provide the buyer goods or services. For example, utility tokens can function as cryptographic coupons to be exchanged for goods, act as currencies like bitcoin or evidence membership or access to commercial services. ICOs for utility tokens frequently take place before a seller has established a functional network for the tokens offered (Utility Token Presales).

The proceeds from such Utility Token Presales are then used by the seller to further develop its network and the accompanying utility tokens. Under current law, an instrument is an “investment contract” and thus a security subject to United States securities laws when it constitutes an investment of money in a common enterprise with a reasonable expectation of profits to be derived from the efforts of others.

Although the SEC has not ruled on the categorization of utility tokens, there is an argument that the direct sale of utility tokens that are functional on the seller’s network when sold are not likely securities, since the utility tokens predominantly derive their value immediately from their functionality on the seller’s network rather than the future efforts of others.

However, the sale of to-be-developed utility tokens in Utility Token Presales may constitute the sale of securities because the purchase is in expectation of value to be derived predominantly from the efforts of others (the seller’s future efforts in developing their network upon which the utility tokens function). As a result, many Utility Token Presales may run afoul of securities laws.

The motivation for SAFTs is to enable SEC compliant investment in Utility Token Presales. SAFTs are intended to be investment contract securities to be offered in SEC compliant private placements to accredited investors. In such an offering, the investors provide funding under the SAFT in exchange for the future delivery of utility tokens on a functioning network. Once the network is launched, the utility tokens can be delivered to the investors under the SAFT. The seller and the investors may then also offer utility tokens directly to the public with lower risk of violating securities laws since the utility tokens are delivered on a functioning network.

The use of SAFTs or similar documents in conjunction with ICOs is likely the first of many steps in the evolution and formalization of token-based investment. We will continue to provide updates as this space evolves. For more information concerning blockchain and how it can impact your business, please contact Ned T. Himmelrich, and for questions concerning securities offerings and raising capital, please contact Michele Walsh.

Contact Ned T. Himmelrich

Contact Michele Walsh

CFPB Releases Payday Loan Rule

On October 5, 2017, the Consumer Financial Protection Bureau (CFPB) released its long-awaited “payday” loan rule in a 1,690-page release. 

The rule targets certain short-term payday loans, and certain longer-term vehicle title and high-cost consumer installment loans and open-end credit plans.

The final rule applies to “covered loans” that are either closed-end or open-end extensions of credit to a consumer for personal, family or household purposes that: (1) must be substantially repaid within 45 days of consummation/advance; (2) must be substantially repaid more than 45 days after consummation/advance through at least one payment that is more than twice as large as any other payments; or (3) has an Annual Percentage Rate greater than 36% and the lender obtains a “leveraged payment mechanism.”

The rule defines “leveraged payment mechanism” to include: (a) a loan agreement that provides that a borrower (at some point in the future) must authorize the lender or a service provider to debit the borrower’s deposit account on a recurring basis; (b) a loan agreement that provides that in the event of default a borrower must authorize the lender or a service provider to debit the borrower’s deposit account on a one-time or a recurring basis; and (c) any authorization where the lender obtains the ability to initiate a transfer from a borrower’s deposit account (either on a one-time or recurring basis).

Examples in the commentary to the rule include: checks or other instruments written by the borrower, auto-debit authorizations, remotely created checks/payment orders and transfers initiated by a lender that is also the depository holding the borrower’s deposit account. 

There are carve-outs from the “leveraged payment mechanism” definition for “single immediate payment transfers” that are initiated at a borrower’s request. This would cover a written debit authorization that is provided by a borrower for a one-time payment that is processed within one day of when the borrower provides it. This would also appear to cover a pay by phone debit authorization that is processed within one day of when the borrower provides it.

In addition, carve-outs from the “covered loan” definition include: purchase money loans to finance motor vehicles/goods; home mortgage loans; credit cards; student loans; non-recourse pawn loans (where the consumer has no possession of the pawned goods); overdraft lines of credit; wage advance loans (only for accrued wages); no-cost advances; payday alternatives (following specified parameters); accommodation loans; and business-to-business loans.

The rule imposes requirements on lenders to determine a borrower’s ability to repay certain covered loans to verify that the borrower will be able to meet the loan terms and still meet basic living expenses (both during the term of the covered loan and for 30 days after the highest payment on the covered loan). Lenders must verify income and major financial obligations of a borrower and estimate basic living expenses.

The rule also caps the number of shorter-term covered loans that can be made in rapid succession at three.

In addition, the rule requires lenders to submit specified periodic reporting to the CFPB, provide certain notices before debiting payments from a consumer’s deposit account, and requires lenders to obtain new debit authorizations after two failed debit attempts or if any payment amount or timing changes. The rule takes effect 21 months after it is first published in the Federal Register (resulting in a likely effective date in August or September of 2019). Please contact Christopher Rahl for questions concerning the new rule.

Contact Christopher Rahl