A key concern of ours when representing a lender is understanding how the lender will get its money back if the loan goes into default. If the loan is secured, the lender can foreclose the collateral in order to recover the debt. Oftentimes however, foreclosure or a secured party sale is not the only step necessary to obtain repayment of a loan.
If a lender is considering legal action against a borrower or a guarantor to recover the debt, one of the first things a lender will need to determine is whether the collateral securing the loan (assuming it is a secured loan) will be sufficient to satisfy the outstanding loan amount. If the loan is unsecured or under-secured (i.e., the pledged collateral is not sufficient to repay the debt thus resulting in a likely deficiency) a lender may want to consider seeking injunctions or attachments against the assets of the borrower (or any guarantor) while the lender works through the court system to obtain a judgment against the obligors on the debt. This process is referred to as pursuing pre-judgment remedies and security. Even if the loan is sufficiently collateralized, a lender may still need to file a lawsuit and obtain pre-judgment relief to enable the lender to specifically enforce its rights to take possession and to dispose of the collateral without interference from the borrower. This is especially true where the collateral is inventory or equipment rather than real estate, since at least in Massachusetts, a real estate foreclosure of a commercial property is typically a non-judicial process. In this issue of our Why Do We Care series, we will set forth a short primer on Massachusetts pre-judgment remedies and how they are obtained.
(A) Injunctive Relief. A creditor with a security interest in personal property (as opposed to real property) ordinarily has, by the terms of the security agreement and pursuant to the Uniform Commercial Code (the “UCC”), the right to take possession of and liquidate any inventory, equipment and other items securing a loan. While a lender may exercise these rights without resort to the courts if the debtor cooperates, if a debtor opposes or interferes with a lender’s exercise of its rights, a lender will have to seek court assistance in the form of “repossession injunctions” or “repo orders.” These types of court orders command the debtor not to interfere with the lender’s exercise of its rights as a secured party and may even direct the debtor to assemble and make available the collateral to the lender.[1] This is because the UCC limits the rights of a lender to use “self-help” only to those circumstances which will not result in a “breach of the peace.” Under Massachusetts law, a breach of the peace is deemed to exist if a debtor does not consent to and opposes the lender’s recovery actions.
In order to obtain injunctive relief, even if the loan documents provide otherwise, Massachusetts law requires that a lender show that the lender (i) has a likelihood of success on the merits, (ii) will suffer irreparable harm if injunctive relief is not granted, and (iii) that the balance of the harms to lender and debtor justify entry of the requested injunction. Likelihood of success on the merits is ordinarily demonstrated through the language in the loan documents and the existence of an event of default. The harder prong of this test is showing that the lender may suffer “irreparable harm”. This can be shown by way of an affidavit of anticipated deficiency from the lender setting forth why the lender believes it is under-secured and needs more collateral (this is not needed in the event of an unsecured loan) and that delay in repossession of the collateral may cause monetary harm to a lender which would be difficult to calculate or recover if repossession is delayed. This proof can take many forms, but typically involves an analysis that the collateral is depreciating significantly with time or is being expended by the debtor and not being replenished. Even more convincing to a court is evidence that the debtor has hidden funds or assets or has otherwise engaged in improper conduct, which if allowed to continue, will render recovery by the lender even more difficult. A court will also conduct a “balancing of the harms” analysis when faced with a request for a repossession injunction. The debtor will likely assert the injunctive relief could put it out of business while the lender will argue that the lender needs immediate relief in spite of the potential consequences to the debtor.
Often if a lender seeks to enforce its right to directly collect a borrower’s accounts receivable, injunctive relief is needed to ensure the borrower will not try to thwart such efforts by directing its account debtors (i.e., its customers) to ignore the bank’s demands for payment directly to the lender. A lender does have some protections in this situation though, as an account debtor that ignores a proper notice to pay the lender as a secured party does so at its peril, as the UCC may require that account debtor to pay the amount of the account to the lender even if it has already paid it to the borrower.
The denial of a request for prejudgment injunctive relief in aid of repossession by a court does not impact the ability of a lender to seek such relief in the future if circumstances change or as part of a final judgment, at which stage of the proceedings, irreparable harm is no longer ordinarily an issue.
Lenders may also need preliminary injunctive relief for loans secured by real estate. For example, if a lender is seeking to collect rents from tenants of a mortgaged property under a mortgage or collateral assignment of leases and rents, a lender can request an injunction prohibiting the borrower from advising tenants to ignore the lender and continue to pay rent to the borrower. Injunctive relief can also be used in circumstances where the loan documents permit a lender to gain access to a building to perform an inspection, testing or other assessments pre-foreclosure, to preserve the collateral, or to complete construction, but the borrower is not cooperating and has denied such access to the lender.
Finally, if a lender believes a borrower is being stripped of value by its shareholders, members, partners, or officers (as the case may be) or that fraud is occurring, a lender could seek a “standstill injunction” or a “status quo injunction” directing the borrower not to enter into any transactions, transfer assets or to expend funds other than in the ordinary course of business. In extreme circumstances, or if the loan documents permit, a lender could also seek appointment of an equitable receiver to preserve and liquidate a business and its assets.[2]
(B) Real Estate Attachments. Under Massachusetts law, a lender is entitled to seek an attachment of a borrower or guarantor’s real estate to secure a debt simply by meeting the following criteria: (i) the plaintiff has a likelihood of success on the merits for its claim against the obligor (which is usually the case in lawsuits involving commercial paper); (ii) the requested attachment is needed because the lender is under-secured; and (iii) the claim being pursued is not the subject of insurance coverage (loan obligations are not ordinarily covered by insurance). In order to obtain the real estate attachment, the lender must show that the obligor owns real estate against which the lender wishes to place a lien. It is important to note the property need not be exclusively in the borrower or guarantor’s name in order to be attached. Partial ownership interests in real estate as well as property held in the name of another party (usually as a so-called “straw owner” for the borrower or guarantor), can also be attached. The real estate records can be examined to try to determine whether any property was fraudulently conveyed by the borrower or guarantor within the prior four (4) years and thus, under Massachusetts law, be made subject to the lender’s lien.[3]
The value of a real estate attachment against a borrower or guarantor will depend on the amount of all senior liens encumbering that property at the time of the attachment. The attachment will only attach to the debtor’s equity in the property. Even more significant, in regard to residential property occupied by an individual obligor as a primary residence, is the presence of the Massachusetts homestead exemption shielding a portion of the equity from attachment, or if the residential property is held by “husband and wife as tenants by the entirety” in which case the property can be attached but cannot be sold by the creditor following entry of judgment so long as it remains the marital home. Placing the attachment lien on the marital home is still somewhat useful as it may cause issues with senior liens or refinancing efforts of the debtor.
Following conclusion of the action in which a real estate attachment was obtained, a successful lender may record the judgment execution against the real estate to perfect the attachment lien, and if warranted, direct the sheriff to schedule an auction of the property (a so-called “Sheriff’s Sale”) to recover funds if there is sufficient equity in the property, or alternatively suspend the execution and permit the property to remain subject to the lender’s lien in the hopes of a payment if and when the property is sold or refinanced in the future.
(C) Trustee Process Attachment. A trustee process attachment is simply the formal name for the attachment of a bank account by a creditor. Of course, a lender need not pursue trustee process attachments in order to set-off a borrower’s or guarantor’s bank account held by it. The right of set-off exists at common law, by statute and usually in the loan documents. No court action is needed for a lender to set-off an account it is holding in partial or full satisfaction of a defaulted loan. Similarly, if the lender has a properly perfected security interest in an account held at another institution (which requires a duly executed control agreement – a so-called “DACA”), a lender does not need to commence a court action to recover these funds. A simple notice to the custodial bank is all that is required to exercise this remedy.
Instead, a trustee process attachment is used if the funds sought to be attached are held by a third-party bank where there is no DACA in place. The standard for being granted a bank account attachment is the same as that for a real estate attachment – a likelihood of success on the merits. However, given how easy it is for an obligor to transfer funds from an account to avoid a trustee process attachment, a lender’s best chance to successfully attach bank accounts is to proceed on an ex parte basis, that is without prior notice to the borrower or guarantor. Otherwise, if a borrower or guarantor receive prior notice of a pending trustee process hearing, all funds held in the account could be withdrawn or expended prior to the hearing. A lender must allege the existence of “exigent circumstances” to obtain ex parte relief which circumstances may exist if the lender can show prior fraudulent or questionable conduct of the obligor, or a misstatement by such party to the lender. Occasionally, if the account at a different bank was opened by the obligor in violation of the covenants in the loan documents, that may suffice as grounds for ex parte relief, as it shows an intent to keep the funds from the lender.
A successful trustee process attachment will act to “freeze” the borrower’s funds and the custodial bank is required to act as a trustee for the attaching lender with respect to the frozen account until the attaching lender can obtain judgment against the obligor. Following entry of judgment, the court will direct the custodial bank to pay over those attached funds to the attaching lender.
(D) Reach and Apply Actions. If another party owes money to a borrower and such obligations are not covered by the lender’s security interest, a lender can pursue a “reach and apply” attachment. Actions to reach and apply are somewhat of a hybrid between an actual attachment and a preliminary injunction. Reach and apply actions are ordinarily used to attach assets of a borrower such as shares of stock or other types of equity interests in a corporation, a limited liability company or a realty trust, or debts or other obligations (such as insurance proceeds) owed to the borrower by third parties. To “reach” such assets a lender must request that the court enjoin any disposition of those assets during the course of the litigation against the borrower (thus “freezing” any payments from being made to a borrower), and that at the conclusion of the court action the lender be permitted to dispose of that asset at auction and “apply” the proceeds towards the debt. Because the reach and apply relief is reflected in a preliminary injunction, courts generally require a showing of not just a likelihood of success on the merits, but also some manner of irreparable harm that will result if the requested relief is not granted.
(E) Keeper or Personal Property Attachments. A creditor can, on occasion, seek either a “keeper attachment” whereby a sheriff stands next to the cash register and takes the receipts for the benefit of the creditor, or a personal property attachment whereby the sheriff takes possession of a borrower’s machinery, equipment and inventory. This remedy is like a real estate attachment, though it is rarely used since such assets are often already encumbered by other lien holders and the cost of a sheriff working full time to protect and preserve such collateral is generally not viable.
(F) Other remedies. In this article we have provided an overview of a few typical pre-judgment remedies in Massachusetts. This summary, however, is not intended to address all possible pre-judgment remedies, nor to explain all of the nuances and issues involved in the process of obtaining the pre-judgment remedies discussed here. We hope this review will be helpful in formulating a strategy for dealing with a defaulted loan obligation. If you are a lender or other creditor and are seeking advice on any of the pre-judgment remedies which may be available in a particular situation or any other loan enforcement issues, please feel free to contact one of our attorneys for guidance.
This communication is for informational purposes only and should not be construed as legal advice on any specific facts or circumstances.
[1] Massachusetts like many other states has a statutory replevin process which provides that a lender can recover its collateral after posting a bond for twice the value of that collateral. While this remedy is often used in many other states, it is rarely used in Massachusetts practice, primarily due to the expensive bonding requirement.
[2] Following entry of a final judgment against an entity, a creditor in possession of an execution/order which remains unsatisfied after demand by a sheriff, may seek appointment of a “statutory receiver” to liquidate the assets of the debtor to pay off its outstanding debts, including the judgment obtained by the creditor, on a pro rata basis. This is different from the equitable receiver discussed here.
[3] Generally, under the Uniform Fraudulent Transfers Act, a transfer of property is fraudulent if made with the intent to “hinder, delay or defraud creditors” or if as a result of a transfer for “inadequate consideration” the borrower or guarantor is rendered insolvent or if he/she/it was insolvent at the time of the transfer.
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