Opinion ID: 8414542
Heading Depth: 1
Heading Rank: 3

Heading: Transfer of Primary or Direct Risk as the Hallmark of a True Sale

Text: The Second, Fourth, and Fifth Circuits conclude a transfer of the primary or direct risk of non-payment on the accounts stands as the hallmark of a true sale. Nickey Gregory, 597 F.3d at 601-03; Reaves Brokerage, 336 F.3d at 417; Endico Potatoes, 67 F.3d at 1068-69. In addition, these courts (as well as the regulations under PACA) focus upon trust asset encumbrance and dissipation in relation to what the terms of a factoring agreement could permit rather than how the parties actually performed under a factoring agreement. See, e.g., 7 C.F.R. § 46.46(a)(2) (“ ‘Dissipation’ means any act or failure to act which could result in the diversion of trust assets or which could prejudice or impair the ability of unpaid suppliers, sellers, or agents to recover money owed in connection with produce transactions.” (emphasis added)). This focus is important because, although a factoring agent might pay to a distributor/PACA trustee sums adequate for the trustee to pay the beneficiaries, and although those amounts might represent a commercially reasonable discount from the accounts’ face values, the payment of such amounts should be immaterial if (1) the trustee does not pay the beneficiaries in full; and (2) the accounts receivable and their proceeds remain trust assets. In assessing whether a true sale occurred, the Fourth Circuit adopted the transfer-of-risk test as set forth and explained by the Second Circuit in Endico Potatoes. Nickey Gregory, 597 F.3d at 600-03. There, the Second Circuit distinguished between direct risk, on the one hand, and secondary or derivative risk, on the other. Endico Potatoes, 67 F.3d at 1068-69. The Second Circuit stated it was appropriate to examine several factors such as “[1] the right of the creditor to recover from the debtor any deficiency if the assets assigned are not sufficient to satisfy the debt, [2] the effect on the ereditor’s right to the assets assigned if the debtor were to pay the debt from independent funds, [3] whether the debtor has a right to any funds recovered from the sale of assets above that necessary to satisfy the debt, and [4] whether the assignment itself reduces the debt.” Endico Potatoes, 67 F.3d at 1068. The court concluded, “The root of all of these factors is the transfer of risk.” Id. at 1069. Finally, the court summarized: Where the lender has purchased the accounts receivable, the borrower’s debt is extinguished and the lender’s risk with regard to the performance of the accounts is direct, that is, the lender and not the boiTower bears the risk of nonperformance' by the account debtor. If the lender holds only a security interest, however, the lender’s risk is derivative or secondary, that is, the borrower remains liable for the debt and bears the risk of non-payment by the account debtor, while the lender only bears the risk that the account debtor’s non-payment will leave the borrower unable to satisfy the loan. Id, We conclude this transfer-of-risk test must apply to avoid reliance on self-serving labels inserted into factoring agreements to defeat clear congressional intent. We also conclude it follows quite naturally that it is not even possible to assess the commercial reasonableness of a factoring agreement without first understanding the true nature of the transferred risks and transferred rights. A factoring agent who accepts risk of non-payment on the transferred accounts is the owner of the accounts, for better or worse. See Nickey Gregory, 597 F.3d at 601 (“The purchaser assumes the risk of collection, betting that its success in collecting on the accounts receivable will yield a return exceeding the discounted price it paid for the asset.”); id. at 598 (“Obviously, under this scenario, [the factoring agent] would own the accounts receivable and would be able to do with them what it wished.”). That risk will be reflected in the price. A factoring agent who functionally serves only as a lender and collection firm, however, accepts accounts for collection but enjoys the right to force the distributor to repurchase nonperforming accounts. Such a factoring agent faces much less risk — risk measured only by the limitations on the repurchase provisions and by the distributor’s solvency and ability to perform under the agreement. Common sense dictates that the price paid for the accounts with and without recourse will differ. Common sense also dictates that commercial reasonableness cannot be assessed without first examining the substance of the transaction. Agricap nevertheless argues adoption of the transfer-of-risk test would lead to absurd results in which a factoring agent remains liable to growers even though the factoring agent’s payments to a distributor were sufficient, in theory, for the distributor to pay growers. Agricap overstates its case in characterizing such a scenario as absurd. It is merely the result of a clear policy choice set forth by Congress. In fact, such a result is not even uncommon. To see an everyday example where a similar scenario plays out, it is only necessary to look to the relationship between general contractors, subcontractors, and property owners in the context of mechanics’ liens. It is well established beyond the need for citations that a property owner who makes final payment to a general contractor without first securing a release of subcontractors’ mechanics’ liens holds the property subject to those liens and faces direct exposure to the subcontractors’ claims. This is true regardless of whether the amount the property owner paid to the general contractor was suffi-eient to pay the subcontractors. If the subcontractors are not paid, their interests prevail over the property owner (who may seek recourse against the general contractor, but who still faces direct liability to the subcontractors). State legislatures made the policy choice to put the interests of subcontractors ahead of those of property owners. Property owners, of course, may guard against this risk by performing due diligence and ensuring subcontractors’ liens are released before making final payment to a general contractor. Similarly, by putting the burden of due diligence on lenders rather than growers, Congress was well aware of the effect it was imposing on the lending industry. Congress concluded, however, that lenders could adapt. The House Committee expressly noted that anticipated improvements to commerce would offset the lenders’ anticipated burdens. H.R. Rep. No. 98-543, at 4 (“[T]he statutory trust requirements ... will be known to and considered by prospective lenders in extending credit. The assurance the trust provision gives that raw products will be paid for promptly and that there is a monitoring system provided for under [PACA] will protect the interests of the borrower, the money lender, and the fruit and vegetable industry.”). The propriety of comparing the PACA situation to mechanics’ liens is shown by examining the longstanding regulations promulgated under PACA. These regulations do not ask whether a factoring arrangement in fact resulted in a transfer of funds sufficient to pay growers throughout the course of performance under a factoring agreement. Rather, the regulations ask whether such an arrangement “could” impair trust assets. 7 C.F.R. § 46.46(a)(2). Just as a property owner must conduct due diligence to avoid liability to a subcontractor before making final payment to a general, a factoring agent with knowledge of PACA must act with diligence. It does not matter that a factoring agent paid a distributor sufficient funds to pay growers any more than it matters that a property owner paid a general contractor sufficient funds to pay subcontractors. In light of these protections, it cannot be the case that a distributor and factoring agent may defeat trust beneficiaries’ rights merely by invoking the labels “sale” or “factoring agreement.”