On August 23, 2016, the US Court of Appeals for the Sixth Circuit (the court) in In re: Fair Finance reversed a lower court and ruled in favor of a bankruptcy trustee in a Chapter 7 bankruptcy case alleging, among other things, fraudulent transfer based on an amended and restated loan and security agreement being a novation.

Fair Finance Company (debtor) is an Ohio based financial services company. To finance the purchase of accounts receivable, the debtor sold investment certificates, or V-Notes, to unsophisticated investors. In 2001, just before the debtor was sold to its current owners, it held title to approximately $51 million in accounts receivable and owned $31 million in V-Notes.

The debtor was sold to Fair Holdings, Inc. (FHI), which became a holding company for the debtor, and in 2002, the debtor and FHI entered into a loan and security agreement (2002 L&SA) with Textron Financial Corporation and United Bank.

The terms of the 2002 L&SA included the creation of a $22 million revolving credit line made available to FHI and the debtor in exchange for Textron and United Bank receiving interest and fees on the amount borrowed. Payments made on debtor-owned accounts receivable would be made into a lockbox and appropriate funds would be transferred to Textron and United Bank. In order to secure the loan, FHI pledged all of its present and future assets. The scope of the security interest created under the 2002 L&SA extended to all future obligations of FHI, including obligations intended as replacement or substitutions for the obligations existing under the 2002 L&SA. The court said that the continued efficacy of the security interest created by the 2002 L&SA was at the heart of the fraudulent transfer claim.

As the 2004 maturity date for the 2002 L&SA approached, all parties involved began discussions on whether to renew the agreement. Textron bought out United Bank’s position and entered into an amended and restated loan and security agreement (2004 ARL&SA).

The terms of the 2004 ARL&SA included:

Textron did not file a UCC financing statement on execution of the 2004 ARL&SA, but did file a UCC financing statement amendment.

The debtor and FHI were able to secure an alternative source of funding from an asset sale transaction in 2007, and part of the proceeds were used to pay the remaining balance to Textron under the 2004 ARL&SA, releasing all of Textron’s liens. This payment ended Textron’s relationship with the debtor and FHI.

In 2009, the FBI raided the debtor's headquarters. After the debtor's operations collapsed, certain V-Note holders filed a petition for involuntary bankruptcy against the debtor. The trustee filed a number of adversary proceedings against Textron (and other defendants) in the Bankruptcy Court for the Northern District of Ohio. The claims included aiding and abetting, conspiracy, claims to avoid and recover actual and constructive fraudulent transfers, and equitable subordination and disallowance claims.

Textron and the trustee moved to have the proceedings withdrawn to the US District Court for the Northern District of Ohio (the district court) and, once removed, Textron moved to dismiss the trustee’s claims for lack of standing, failure to state a claim, and failure to timely file the claims within the applicable statute of limitations. The district court referred the adversary proceeding to the bankruptcy court.

The bankruptcy court issued a report and recommended denying the Textron's motion to dismiss in full. Textron objected and the district court rejected the report's recommendation and granted Textron's motion to dismiss. As to the trustee's fraudulent transfer claims, the district court concluded as a matter of law that the 2004 ARL&SA was not a novation and, as a result, the security interest conveyed pursuant to the 2002 L&SA continued in full force. Accordingly, neither the 2004 ARL&SA, nor the payments made under it, could qualify as transfers for the purposes of a fraudulent transfer claim. Other aspects of the district court's decision are not discussed here.

On appeal to the court, the trustee argued that the district court improperly dismissed the fraudulent transfer claim. The court granted a review de novo on whether the district court properly granted Textron’s motion to dismiss. Other aspects of the court's decision are not discussed here.

The trustee asserted pursuant to the Ohio Uniform Fraudulent Transfer Act (UFTA) that the debtor could avoid the obligations incurred and payments made under the 2004 ARL&SA because the security interest conveyed by the debtor and payments made by the debtor in accordance with the 2004 ARL&SA qualify as either actual or constructive fraudulent transfers. Since the court found that the trustee’s constructive fraudulent transfer claim was barred by the applicable statute of limitations, the discussion was limited to the trustees claim of actual fraudulent transfer.

To state a claim for relief under the Ohio UFTA in this case, the court said that the trustee must allege facts plausibly suggesting that the assets or interest in assets conveyed by the debtor pursuant to the 2004 ARL&SA were not already encumbered by a valid lien. On appeal, the trustee put forward three independent grounds for nullifying or invalidating the lien granted under the 2002 L&SA. The trustee argued that:

The court found merit in the trustee’s first argument, noting that the district court erred in determining as a matter of law that the parties did not intend the 2004 ARL&SA as a novation of the 2002 L&SA. So the court reversed the district court's judgment and remanded it for further proceedings without examining the merits of the trustee's other arguments.

The court looked at the elements of intent, knowledge and consent to determine if there had been a novation of the 2002 L&SA. The court found support for a novation in the text of the 2004 ARL&SA, where several provisions evidenced the intent of the parties for the 2004 ARL&SA to extinguish and wholly replace the 2002 L&SA. The court also found supporting circumstantial evidence, such as the timing of the entering into the 2004 ARL&SA, which occurred at the maturity of the 2002 L&SA. Additionally, new terms in the 2004 ARL&SA all signified the intent of the parties to extinguish the 2002 L&SA. The court discussed and distinguished the TOUSA case where the agreement at issue included express language that the security interest continued in full force. When all the facts were examined together, the court found there existed an ambiguity as to whether the parties intended the 2004 ARL&SA to extinguish the 2002 L&SA.

Further, the court stated that the trustee demonstrated with sufficient evidence that the security interest granted by the debtor pursuant to the 2004 ARL&SA, along with all payments made by the debtor in accordance with the 2004 ARL&SA, amounted to fraudulent transfers under the Ohio UFTA because each transaction was “undertaken in an effort to perpetuate a Ponzi scheme that inevitable collapsed and left hundreds of unsophisticated Ohio investors holding the bag.”

It would be prudent for parties to include language in an amended and restated security agreement that it is the intent of the parties that the security interest and liens granted in the collateral under the original security agreement continue in full force and effect and that the agreement is not intended by the parties to be a novation. This language might have helped the court reach a different decision in this case.