Junior Creditors Beware: Third Circuit Awards Damages For Breach Of Turnover Provision

• Published date: 27 May 2022
• Subject Matter: Finance and Banking, Insolvency/Bankruptcy/Re-structuring, Financial Services, Insolvency/Bankruptcy
• Law Firm: Cadwalader, Wickersham & Taft LLP
• Author: Ms Ingrid Bagby, Michele C. Maman, Thomas Curtin and Marc Veilleux

On April 13, 2022, the Court of Appeals for the Third Circuit ruled in CoFund II LLC v. Hitachi Capital America Corp. that a junior creditor breached a turnover provision in an intercreditor agreement when it applied a senior creditor's collateral to satisfy the junior creditor's claims before the senior creditor's claims had been fully paid.¹ The Third Circuit also affirmed a judgment that awarded the senior creditor damages for the misapplication of such collateral proceeds in violation of the intercreditor agreement's turnover provision. The Hitachi decision serves as a useful reminder to both junior creditors and senior creditors alike as to how their dealings in an intercreditor arrangement may play out following a debtor's bankruptcy, and provides important insight into the potential remedies that a senior creditor may have available should a junior creditor breach a turnover provision.

Factual Background

Forest Capital LLC ('Forest') provided financing to small businesses through 'factoring arrangements,' whereby Forest purchased its clients' unpaid accounts receivable at a discount and, in turn, received the right to collect the full amount owed on those accounts.² But Forest needed financing to acquire these accounts. Forest thus entered into a Master Participation Agreement with CoFund II LLC ('CoFund'), pursuant to which CoFund had a participation interest in Forest's factoring arrangements. These participation interests were secured by a 'first-priority security interest in the collateral relating to each factoring transaction to the extent of [CoFund's] pro rata interest in those transactions' (such collateral, the 'CoFund Priority Collateral').³

Thereafter, Forest borrowed a line of credit from Hitachi Capital America Corporation ('Hitachi'). Forest provided Hitachi with a security interest in its factoring arrangement proceeds, subject to CoFund's first priority security interest in certain of those proceeds. Under its loan agreement, Forest agreed that all factoring arrangement proceeds would be deposited into a 'blocked account' controlled by Hitachi, including the CoFund Priority Collateral. Forest did not have the right to make any withdrawals from this blocked account, including to pay CoFund under its Master Participation Agreement.

To account for the fact that CoFund Priority Collateral could be commingled with Hitachi's collateral in the blocked account, Hitachi and CoFund entered into an intercreditor agreement. That intercreditor agreement 'established CoFund's right of first recovery' for CoFund's 'pro rata participation interests in' the CoFund Priority Collateral.⁴ Notably, the intercreditor agreement contained a turnover provision, which provided that if Hitachi received CoFund Priority Collateral, it would 'hold it in trust' for CoFund and Hitachi was obligated to 'immediately turn it over to' CoFund.⁵

Eventually, 'Forest became financially distressed' and unsecured creditors initiated an involuntary chapter 7 bankruptcy proceeding against Forest in the Maryland bankruptcy court.⁶ Both prior to and after the commencement of Forest's involuntary chapter 7 proceeding, factoring arrangement proceeds were deposited into the blocked account controlled by Hitachi, and some of these proceeds constituted CoFund Priority Collateral.⁷ Rather than send these monies to CoFund as required under the turnover provision, Hitachi applied the monies to 'pay down its extension of credit to Forest,' and 'without paying anything to CoFund, Hitachi released [the] remaining funds' in the blocked account to Forest.⁸

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