Bankruptcy Court Again Reminds Debt Purchasers to do their Due Diligence

August 22, 2018

The Bankruptcy Court for the District of Delaware in In re Woodbridge Group of Companies, LLC1 held that an assignment of a promissory note acquired by Contrarian Funds, LLC through a trade was void and of no force or effect as a result of the original contracting parties’ failure to comply with the anti-assignment provisions governing the promissory note and loan documents.

Background

On December 4, 2017, the Woodbridge Group of Companies LLC and affiliated debtors (collectively, “Woodbridge” or the “Debtors”) filed for Chapter 11 bankruptcy protection (the “Petition Date”). Prior to the Petition Date, Debtor Woodbridge Mortgage Investment Fund 3 A, LLC issued three promissory notes to Elissa and Joseph Berlinger (collectively, the “Berlingers”) in the principal amount of $25,000 each (the “Promissory Notes”). The Promissory Notes contained the following anti-assignment clause:

14. No Assignment. Neither this Note, the Loan Agreement of even date herewith between Borrower and Lender, nor all other instruments executed or to be executed in connection therewith (collectively, the “Collateral Assignment Documents”) are assignable by Lender without the Borrower’s written consent and any such attempted assignment without such consent shall be null and void.

Similarly, the attendant loan document contained similar language:

(d) This Agreement shall be binding upon and inure to the benefit of the parties hereto and their respective successors and assigns, provided, however, that Lender shall not assign, voluntarily, by operation of law or otherwise, any of its rights hereunder without the prior written consent of Woodbridge and any such attempted assignment without such consent shall be null and void . . . .

On February 13, 2018, the Berlingers and Contrarian Funds, LLC (“Contrarian”) entered into an agreement in which the Berlingers would “sell, convey, transfer and assign” the Promissory Notes and rights thereunder to Contrarian (the “Note Transfer”).  On March 1, 2018, Contrarian filed a proof claim (the “Claim”) asserting a secured claim in the amount of $75,000. On March 21, 2018, the Debtors filed a notice imposing a ninety day moratorium on transfers of notes. Then, on April 16, 2018, the Debtors filed an objection to Contrarian’s Claim.

Issues before the Bankruptcy Court

Before the Bankruptcy Court were the following three issues: (i) whether an anti-assignment clause in the Promissory Notes is consistent with Delaware law and public policy; (ii) whether a non-breaching party to a promissory note in default is still bound by an anti-assignment clause when seeking to enforce the promissory note through the bankruptcy claims reconciliation process; and (iii) whether the Uniform Commercial Code (“UCC”) overrides the anti-assignment clause.

Bankruptcy Court Analysis

First, the Bankruptcy Court held that the anti-assignment provision in the Promissory Notes and collateral loan documents was valid pursuant to Delaware law and public policy. The Bankruptcy Court explained that no provision in the Bankruptcy Code or overarching bankruptcy policy impairs the Bankruptcy Court’s authority to enforce non-bankruptcy law concerning the provisions in contracts that prevent the transfer or assignment of claims. At the same time, the Bankruptcy Court acknowledged that Delaware courts narrowly construe anti-assignment provisions because of the importance of “free assignability.” The Woodbridge Court continued to explain that Delaware courts distinguish between the “power to assign and the right to assign.” Because the Promissory Notes contained language that would deem any assignment void, the provision restricted the power to assign, and as a result, the assignment was void. Contrarian argued in response to the claim objection that it purchased the Promissory Notes “claims” and “causes of action” and that this is an important distinction because Section 322(1) of the Restatement (“Restatement”) of Contracts does not bar the Berlingers from transferring the rights, claims or causes of action under the Promissory Notes. The Bankruptcy Court disagreed with Contrarian. The Bankruptcy Court disagreed because Section 322(1) is inapplicable because it is based on UCC Section 2-210 which deals with contracts for the sale of goods, not debt instruments such as the Promissory Notes.

Second, the Bankruptcy Court held that the non-payment by the Debtors did not result in the anti-assignment provision being unenforceable by the Debtors. The Bankruptcy Court relied on In re Diamondhead Casino Corp., 2016 WL 3284674 (Bankr. D. Del. June 7, 2016), which examined whether one party’s breach of a promissory note rendered the note’s provisions unenforceable. The Diamondhead court rejected the argument that a party’s breach could modify or improve the rights of the non-breaching party. The Woodbridge Court, relying on Third Circuit precedent and the Diamondhead court, noted that there are no circumstances where a non-breaching party may stop performance and continue to take advantage of the benefits of the contract. The Berlingers and their assignee are not able to emerge post-breach with more rights than they had pre-breach. In quoting In re K.B. Toys, Inc., 470 B.R. 331 (Bankr. D. Del. 2012) (also decided by Bankruptcy Judge Carey), the Woodbridge Court explained that “a trade claim purchaser holds the claim subject to the same rights and disabilities under Bankruptcy Code § 502(d) as does the original claimant.” Here the “disability” was the Berlingers violation of the anti-assignment provision. As a result, that “disability” traveled with the transferred Claim to Contrarian and as a result, Contrarian did not have the right to file the Claim.

Third, the Bankruptcy Court rejected Contrarian’s argument that UCC Section 9-408 limits the effectiveness of terms restricting assignments. The Bankruptcy Court noted that there was little case law on the issue and relied upon the statute and comments to the statute to overrule Contrarian’s argument by holding that the provisions of the UCC were inapplicable because Contrarian did not have a security interest in the Promissory Notes and it had not lent money to the Berlingers repayment of which was secured by an interest in the Promissory Notes.

Takeaways

Bankruptcy Judge Carey’s second claims trade decision reinforces the importance that claims purchasers do their diligence before executing a purchase of a claim based on a promissory note in a bankruptcy case. The Woodbridge decision provides important guidance for purchasers in the secondary claims trading market. Importantly, claims traders should require indemnification provisions in the trade document in the event the transfer is deemed void by a court and require a representation from the seller that it is authorized to sell the claim.

The Woodbridge case is currently on appeal at the District Court for the District of Delaware. Although the Bankruptcy Court held that Section 9-408 applied only to the grant of a security interest in a promissory note as collateral for a debt, it remains to be seen whether the District Court will take the same approach given the provisions of Article 9 that provide that sales of a promissory note are governed by Article 9 except for a few exceptions none of which were applicable in this case.

 


12018 WL 3131127, Case No. 17-12560 (KJC) (Bank. D. Del., June 20, 2018).