A 2013 change to Louisiana’s revocatory action now exposes a secured lender’s collateral and guarantees to the risk of avoidance litigation for ten years, up from three years, after the closing date.
Start here if you just asked, “What is a revocatory action?” This post explains how the revocatory action effects multi-party secured loans, and how the 2013 legislative change has only become relevant since August 2016.
Below is a diagram of a common secured loan structure, where an existing family of organizations borrows money for a newly formed subsidiary to purchase assets:
The loan is supported by upstream and cross-stream security. The signatures and collateral granted by the subsidiaries are “upstream” security grants as they support the parent’s obligations. Each is a “cross-stream” security grant as it supports the other subsidiaries’ obligations. The parent’s obligations and collateral grants are “downstream” as they support the subsidiaries’ loan obligations. Downstream security grants are typically not at risk, because a benefit to one of the subsidiaries increases the value of the parent’s ownership interest in the subsidiary.
Upstream and cross-stream security grants can be annulled where, as in many transactions, the loan does not benefit all loan parties in perfectly equal proportions. Louisiana’s “revocatory action” allows a subordinate creditor to avoid, or “claw back,” an obligation or grant of collateral if it causes or increases the grantor’s insolvency. In the example shown above, the economic value of the loan flows disproportionately to the parent and newly formed subsidiary. Under these circumstances, the upstream and cross-stream security grants increase the liability side of the existing subsidiaries’ balance sheet without a proportionate increase in the value of the assets of those entities. This disproportionate flow of value and liability subjects the upstream and cross-stream grants to annulment in a revocatory action if the grants caused or increased the existing subsidiaries’ insolvency.
Why is a Three-Year-Old Change Relevant Only Since August 2016?
Before August 1, 2016, Louisiana law limited a lender’s avoidance risk to, at most, three years after the closing date. After three years the Louisiana “revocatory action” expired without exception.
On August 1, 2013, the Louisiana Legislature created an exception to the three-year limitations period. Under the new law, the three-year limitations period does not apply in “cases of fraud.” The phrase “cases of fraud” is not defined, and courts have thus far skirted the question by interpreting the 2013 legislative change as a substantive change, not procedural. According to that interpretation, the fraud exception only applies to transfers closing after August 1, 2013. Since the three-year limitations periods on those loans began to expire on August 1, 2016, the meaning of “fraud” has become very relevant to bankruptcy trustees and unsecured creditors looking to expand the limitations period to attack loans that closed over three years ago.
As we get further from August 1, 2016, more loans will become subject to litigation over what is a case of fraud.
The Change Adds (at Least) Seven Years and Uncertainty to Avoidance Risk
In effect, the “cases of fraud” exception expands a three-year risk to a ten-year risk for secured lenders. If the three-year peremptive period does not apply in cases of fraud, the general prescriptive period rule in Louisiana provides that “[u]nless otherwise provided by legislation, a personal action is subject to a liberative prescription of ten years.” Moreover, unlike the three-year limitations period which is a peremptive period (which for our non-Louisiana readers is similar to a “statute of repose”), the ten-year prescriptive period is subject to interruption. It takes no imagination to think of the changes that can occur in a borrower’s business over a ten-year period compared to a three-year period. And if that change is negative, a bankruptcy trustee or unsecured creditor will want to attack the upstream and cross-stream grants to the secured lender.
In addition to enjoying an expanded limitations period, bankruptcy trustees and unsecured creditors now enjoy a blank slate in litigating what the Louisiana Legislature meant by “cases of fraud.” Is this a constructive fraud concept or does the plaintiff need to show actual fraudulent intent? As the case law develops on this question, the uncertainty advantages the unsecured creditors and bankruptcy trustees in negotiations with secured lenders.
Extra Diligence to Consider
In light of the heightened avoidance risk in Louisiana, some diligence practices which may have been reserved for larger loan transactions now look more reasonable for smaller loans that involve multiple obligors.
For example, the lender may require a solvency opinion by a financial expert to establish that as of the closing date the upstream or cross stream guarantees did not create or increase the grantor’s insolvency. In addition, a fairness opinion is often used in other jurisdictions to establish evidence that the borrower obtained sufficient value from the loan to support its guarantee or collateral grant. Whether a debtor received equivalent value to its security grant is relevant in jurisdictions that follow the Uniform Fraudulent Transfer Act, but is not particularly relevant to the balance sheet test in a revocatory action. However, because we do not know how courts will interpret “cases of fraud,” a fairness opinion in addition to a solvency opinion may be warranted for transactions subject to Louisiana’s revocatory action for evidence that a particular grant was supported by the particular value of the loan flowing to the subsidiary.
The new exposure also warrants a re-examination of the secured lender’s standard loan documents to ensure that the credit departments understand and are actively conducting the solvency and debt-coverage tests provided in their forms.
More generally, the expanded reach of the Louisiana revocatory action warrants closer scrutiny and diligence expense that was not as critical to preventing transfer avoidance before the legislative change.
 La. Civ. Code art. 2036.
 La. Civ. Code art. 2041.
 In re Robinson, 541 B.R. 396, 400 (Bankr. E.D. La. 2015); Cotter v. Gwyn, No. CV 15-4823, 2016 WL 4479510, at *12 n.102 (E.D. La. Aug. 25, 2016).
 La. Civ. Code art. 3499.