Sometimes a case outside the bankruptcy context can have some interesting ramifications in bankruptcy. A Fifth Circuit decision from this summer has attracted very little attention, but it could be a pivotal case in some hard-hitting litigation over asset securitization that is sure to come.

The case is Reaves Brokerage Co. Inc. v. Sunbelt Fruit & Vegetable Co. Inc., 336 F.3d 410 (5th Cir. 2003). Reaves sells and brokers fresh fruits and vegetables, and Sunbelt was one of its many buyers. In March 2000, Sunbelt ceased operations, owing Reaves $195,060.55 in unpaid invoices for produce delivered in June, July and December of 1999. Reaves immediately filed suit against Sunbelt seeking damages under PACA. It later added Fidelity Factors, a self-claimed factor that contends it had purchased particular accounts receivable from Sunbelt. The paperwork clearly treated the transaction between Sunbelt and Fidelity Factors as a sale, but the Fifth Circuit saw it differently. After engaging in a careful analysis of the economic allocations of the contract, the court concluded that, at least in the context of a PACA claim, the factoring agreement evidenced a secured loan rather than a sale.

The three-judge panel—Judges Jones, Weiner and DeMoss—went straight to substance over form. The court affirmed the district court's finding that, "in spite of its label and the terminology used, the agreement executed between Fidelity and Sunbelt was not truly a sale of accounts receivable, but was in substance a secured lending agreement under which Fidelity held all of Sunbelt's accounts (and other assets) as collateral and Sunbelt remained personally liable for any shortfall." The Fifth Circuit added its own emphasis: "Characterization of the agreement at issue turns on 'the substance of the relationship' between Fidelity and Sunbelt, 'not simply the label attached to the transaction.'"

The reason this case could be a sleeper is that the billions of dollars changing hands through asset securitization and bankruptcy remote vehicles typically depend on a rock-solid conclusion that the transaction involved a true sale, not a disguised security interest or other device. If the courts are willing to look past form to substance, a number of these so-called bankruptcy remote financing devices would be swept back into bankruptcy—much to the consternation of those who set up the deals and the attorneys who wrote the opinion letters.

What makes the Fifth Circuit's opinion particularly important is that Texas has adopted one of those asset-protection statutes that the industry wanted. Article 9, as adopted by the Texas legislature, has a non-uniform provision, §9.109(e):

For all purposes, in the absence of fraud or intentional misrepresentation, the parties' characterization of a transaction as a sale of such assets shall be conclusive that the transaction is a sale and is not a secured transaction and that title, legal and equitable, has passed to the party characterized as the purchaser of those assets regardless of whether the secured party has any recourse against the debtor, whether the debtor is entitled to any surplus or any other term of the parties' agreement.

That seems about as clear a statement as possible that the courts are not supposed to recharacterize transactions once the parties have declared that they engaged in a sale. The intent is unmistakable: to bulletproof asset-securitization deals that cannot withstand a substance-over-form review. The effect of Reavis Brokerage, however, also seems unmistakable. The Fifth Circuit gave the statute the back of its collective hand.

We understand that the attorney for the factor had jumped up and down (metaphorically, of course) both in its brief and reply, emphasizing the potent language of §9-109(e). The Fifth Circuit remained unmoved, never making the slightest reference to §9-109(e) or to state law at all. The court just kept right on talking about substance over form.

Indeed, the limitations the Fifth Circuit put in its decision have a certain resonance for bankruptcy:

We also stress that our decision is guided by the policies behind PACA, which mandate protection of suppliers of fresh fruit and other perishable commodities. We express no opinion on the proper construction of factoring agreements in non-PACA contexts.

Isn't the same kind of policy favoring equality of distribution and protection for debtors and unsecured creditors at work in bankruptcy? The point remains that the Fifth Circuit embraced the principle of substance-over-form as trumping a statute that explicitly tells courts to rely only on form and not to review substance.

The case may put billions of dollars at risk as the companies most loaded up with asset securitizations plunge into bankruptcy. In re LTV Steel Co., 274 B.R. 278 (N.D. Ohio 2001), sent a shudder through the industry, a shudder that prompted a heavy lobbying effort to get the state legislatures to adopt façade statutes like Texas §9-109(e). A post-adoption case like Reavis Brokerage should be triggering some spine-tingling as well.

We note a strategic implication to Reavis Brokerage in future cases. The debtor may have agreed to an asset-securitization deal, but when the business collapses, the debtor-in-possession (DIP)—or now the trustee and the creditors' committee—will be looking to break the stranglehold that asset securitization imposes by removing substantial assets from the estate. (That was the crux of LTV, after all.) So, if Texas courts have given some indication that they will not be trapped into looking at form over substance, then Texas becomes a more attractive venue of choice for troubled debtors. Of course, Texas is a long way away from that nirvana, but the Fifth Circuit put it on the road.

Meanwhile, in the Third Circuit

Delaware had a recharacterization case last year too, this time in bankruptcy court—In re Pillowtex Inc., 349 F.3d 711 (3d Cir. 2003). Duke Energy wanted the bankruptcy court to force Pillowtex to continue making lease payments under its Master Energy Service Agreement. Pillowtex refused, claiming that the transaction was actually a disguised secured interest. Citing the "economic realities," the Third Circuit affirmed the district court in holding that the transaction that was denominated a lease was, in fact, a security agreement. The court didn't find it hard to elevate substance over form.

The opinion differs from the Fifth Circuit's opinion in Reavis Brokerage in one critical respect: The Third Circuit repeatedly says it is applying state law, in this case New York law, per the terms of the contract. It focused on the UCC distinction between leases and security interests. By contrast, the Fifth Circuit said it was carrying out the policy objectives of a federal statute, with no mention of the provisions in the UCC that seemingly would have given a different result.

It is possible, of course, to give the differences another spin. Both cases embraced the fundamental principle "substance matters, not form." The Third Circuit reached that conclusion by applying state law, the UCC on leases versus security interests, which says, in effect, that substance controls over form. The Fifth Circuit reached the result by ignoring the UCC on the form of the sale, and looking instead to federal policy. So what is a result for a securitization case in Delaware, where the legislature has adopted a façade statute like the one in Texas? The Fifth Circuit analysis leaves room for the Third Circuit to distinguish the use of state law in Pillowtex and to ignore the Delaware law that seems to create a safe harbor for securitization.

Will this mean the end of asset securitization? Betting money would go with the influence that a trillion-dollar industry can exercise on the legal system. Even so, maybe our students should ask the law firms how many dollars' worth of true-sale opinion letters they have issued before accepting an offer.