The Tragedy of Bailey Tool & Manufacturing Company v. Republic Business Credit, LLC Part 2—The Result and Lessons
Since I posted the first article about this case, the International Factoring Association Annual Conference was held in Boston. At that conference, Republic spent a whole session talking about this. Keep in mind the bankruptcy court issued this bombshell opinion two days before Christmas 2021. Being willing to relive that trauma to help the industry takes a lot of courage, so I want to commend Republic for doing that.
In part 1, we discussed the story behind the case. As a summary, Republic’s client, Bailey Tool & Manufacturing Company, became over-advanced immediately after funding, although the evidence was apparently contradictory on that issue. In the process of undertaking a workout, Republic reportedly took extensive control of the company, obtained funds from the sale of the company president’s homestead, and attempted to replace the president of the company with their handpicked successor. Once the workout was complete, Bailey Tool refused to release Republic from liability so Republic took the position that the factoring agreement never terminated and continued collecting accounts receivable. Eventually, Bailey Tool ended up in bankruptcy court.
After its Chapter 11 bankruptcy converted to a Chapter 7 liquidating bankruptcy, the bankruptcy trustee and president of Bailey Tool filed a lawsuit against Republic in bankruptcy court. After a roughly one-week trial, the bankruptcy court found in favor of Bailey Tool and its former president—John Buttles. These two plaintiffs were collectively awarded judgments against Republic in excess of $18,000,000. So what did Republic do wrong?
The bankruptcy court found that Republic did a lot wrong. The court held that the financing agreements terminated once Republic collected a termination fee so Republic was never entitled to hold out for a release. Likewise, Republic did not own and was not entitled to collect Bailey Tool’s accounts receivable on or after November 5, 2015. Below is a list in the court’s words of what it found Republic did wrong.
- “Refused to advance funds under the Factoring Agreements in good faith”;
- “Stopped sending any funds directly to Bailey Tool and instead started paying third party vendors and employees of Republic’s choosing (despite there being no documentation authorizing this change in protocol)”;
- “Exercised excessive control over the Debtors’ business, seemingly causing its failure”;
- “Misled Bailey [Tool] about there being no accounts receivable/funding availability, without being transparent that it was prepaying the Inventory Loans, which was what was eliminating ‘availability’ from the cash generated by the receivables”;
- “Wrongfully placed a lien on Buttles’ exempt homestead and extorted Buttles’ equity from it with a false promise to resume funding to the Company”;
- “Called a default, arguably with no reasonable basis (i.e., because the Company had been temporarily shut down) when Republic essentially had caused the shut down by arbitrarily withholding funding based on a false premise that there was no funding availability”;
- “Took an undisclosed termination fee of $75,000 at the same time Republic had just taken Buttles’ homestead proceeds, with representations that Republic would resume funding after getting the homestead proceeds”;
- “Wrongfully held out for a release”;
- “Wrongfully exercised control over proceeds of Accounts Receivable created on or after November 5, 2015”;
- “Wrongfully withheld $584,250”;
- “Exercised control over funds withheld based on undisclosed fees, charges, penalties and unexplained ‘over-advances’ (unexplained in that they could not be seen with any reasonable specificity from the portal)”;
- “Knowingly violated the automatic stay”;
- “Thwarted the Debtors’ ability to obtain debtor-in-possession financing by maintaining the insupportable (and now judicially refuted) claim that Republic owned Bailey [Tool]’s Accounts in perpetuity”; and
- “Thwarted the Debtors from maintaining existing customers or developing new customers and from reorganizing.”
The court found Republic liable to the Trustee on behalf of Bailey Tool for breach of contract, breach of the duty of good faith and fair dealing, tortious interference with customer relations, fraudulent misrepresentation, violation of the automatic stay. The total damages awarded to the trustee were $16,966,928[i]. Also, any claims Republic had against the bankruptcy estate were equitably subordinated to all other claims and interests. The court also held that Republic was liable to John Buttles and awarded him damages of $1,160,000[ii].
Of the total damages awarded by the court, far and away the largest damages were for lost current and future business opportunities. Those are approximately $14 million of the total amount awarded. Lender liability issues from Republic interfering with and taking control of the debtor’s business led to these damages. That means almost 80% of the damages related to Republic interfering with Bailey Tool’s business.
The next largest category is punitive damages. For both plaintiffs combined, that is approximately $2.2 million of the damages awarded. These damages were awarded because Republic was held to have violated the bankruptcy automatic stay and interfered with the homestead owned by Buttles. Violating the bankruptcy automatic stay is a hot button, high risk issue with bankruptcy courts. Likewise, interfering in any way with a person’s homestead is a hot button, high risk issue in the state of Texas which is a debtor-friendly state. Being aggressive with both of these issues created a lot of risk for Republic.
With these damages in mind, what can we learn? Some lessons are obvious, but others are subtle. Also, is there a fundamental problem for Republic overlaying all of this?
My overall impression from reading the opinion is that Republic offended the judge’s sense of fairness. The judge’s comments seem to indicate that she thinks Republic’s actions were unethical, and too sharp.
Judges have more discretion than people realize to curb what they perceive to be injustices. This is especially true of bankruptcy judges who, in many instances, have much broader powers than other courts. If a judge thinks you are being greedy or unreasonable, then he or she will be skeptical of everything you say. You do not want to be required to fight the judge and opposing counsel.
Although I have questions about whether some of the judge’s rulings would hold up on appeal, the point is to avoid being in this situation. As I studied this opinion, there are seven lessons that stood out.
- Be able to explain your accounting records and the factoring agreement.
This is an ongoing problem for factors. Courts often have an expectations gap about factoring. Courts think factoring is fairly simple. The client should receive all non-factored funds and factors should only keep factored funds. Courts have a hard time understanding how factors can collect both factored and non-factored funds and then not remit all non-factored funds to the client. Factors usually point to the reserve report to explain this, but these reports can be extremely complicated. In fact, the reports are often so complicated that the factors themselves cannot explain them. This breeds suspicion and mistrust.
You need to be able to explain why you are owed money without relying solely on what your accounting software says. Courts need a clear, understandable explanation of everything regardless of how many transactions are involved. The court is not going to just rely on whatever your software says as being correct.
In this case, the court consistently criticized Republic’s ability to fully explain its argument that it was overadvanced, and never understood Republic’s argument about a lack of funding availability. The court even referred to the records on Republic’s portal as incomprehensible. Likewise, the court held that no one from Republic, including its own expert, could adequately explain Republic’s accounting records. This caused the type of mistrust of factors that is unfortunately common in courts.
The court cynically believed the records were designed to allow Republic to do whatever Republic wanted to do. At one point, the court noted it was so bad that the bankruptcy trustee’s attorney had to abandon the records and use standard forensic accounting techniques to find the true balances. Republic even reportedly admitted that there was no way to prove what was eligible or ineligible on any given date from any of the records they produced. Who knows if this was correct, but the point is not what Republic actually said to the court, but what the court thought it heard.
If Republic had been able to explain its accounting records to the court’s satisfaction, it would have had a much better chance of prevailing or at least having a more manageable judgment. Republic seemed to lose credibility with the court because of this common problem.
- Emails matter.
Emails proved to be a huge part of Republic’s undoing. In an unusual move, the court inserted actual emails into its opinion 66 times. It is no secret that emails often provide a wealth of information about a case. When lawsuits are filed, normally one of the first things that happens is the plaintiff sends a “litigation hold” letter to the defendants. This warns a defendant not to lose or destroy any documents because the documents could be used as evidence. Among the key documents to preserve are emails.
The court consistently cited emails where Republic was telling Bailey Tool one thing but saying something very different internally. The emails made Republic look like it was lying to Bailey Tool. For example, Republic was telling Bailey Tool that it had no funding availability when Republic’s internal emails seemed to say the opposite. These discrepancies were very damaging for Republic.
The court also cited emails that were not necessarily relevant to the case but revealed bad behavior or bad intentions. For example, the court cited with indignation an email where an employee of Republic sent Bailey Tool’s president an email calling him a “dummy.” Likewise, the court seemed appalled by an email where the employees of Republic seemed to be rejoicing in Bailey Tool’s troubles and were looking forward to the “company’s implosion.” Although these are either irrelevant or only tangentially relevant to the legal issues in the case, the emails made it look like Republic was vindictively trying to ruin Buttles and the company. The emails created a bad impression on the judge which made punitive damages a very real possibility. Be careful what you put in emails because they often provide some of the most important evidence for or against you in a case.
- Do not take too much control of a company.
A discussed earlier, almost 80% of the total damages awarded were related to lender liability issues. Unfortunately, this case is close to a worst-case scenario. Although I am not aware of a bright-line rule saying how much control is too much, the court found that Republic went too far in this case. The court found that Republic controlled decisions about which vendors, suppliers and employees would be paid and which would not be paid. Then they paid vendors, suppliers, and even Bailey Tool’s employees directly and not through Bailey Tool. Republic also reportedly tried to undermine and replace the current president with their handpicked successor. In addition, Republic brought in armed security guards and security technology into Bailey Tool’s facility.
The opinion never really explains why Republic did any of this, but the court believed hiring armed guards was an intimidation tactic. Whether or not that was true, this created a terrible visual for the judge and fed into what she perceived as Republic’s strong-arm, and deceitful tactics.
Many of you have had workout situations where you try to bring in a new CFO or become more involved in handling payables. I am not suggesting that you should avoid doing this in all situations. Different situations may call for this. But this case should serve as a warning that becoming more involved with the daily operations of a company comes with significant risk. If you take too much control, you may ultimately be responsible for the results—good or bad.
- You may not able to afford to prove that the judge was wrong.
The temptation in a case like this is to ask the question of whether the judge is “right.” Although that is helpful for evaluating whether you would win on appeal, the first question needs to be whether you can afford to appeal.
To prove the judge was wrong, you will have to appeal the decision to a higher court.[iii] But appealing alone will not stop the plaintiff from being able to collect on the judgment. To stop the plaintiff from collecting while you appeal, you need to do something more, like filing for bankruptcy protection or filing a bond superseding the judgment.[iv] Different federal judicial districts require different bond amounts. Generally, courts require a bond sufficient to cover the judgment plus interest.
Finding a surety to post a bond can be difficult. If you are able to find a surety, then you will pay the surety a percentage of the judgment as a premium each year while the appeal is outstanding. The premium percentage depends on the surety company and other factors including your creditworthiness. The premiums can be very expensive with large judgments. If you cannot find a surety, then you will need to file a cash bond. That could mean posting cash in the amount of the judgment plus interest or whatever amount the district requires. If your finances render you unable to post a bond, you can petition the court for a lower bond amount, but there is no guarantee that the court will lower your bond. The rules governing the required amount of a supersedeas bond are different for state courts but can be equally expensive.
If you cannot post a bond, then even if the judge is wrong, you cannot afford to prove it so you are stuck with satisfying the judgment while you appeal. That usually means that you will need to attempt to settle the case rather than appeal. Those negotiations are not usually about the merits of the case or what the judge was wrong about. What you can afford without going into bankruptcy is normally the only relevant issue. That means convincing a trial court that you should win at the trial level may be your only chance because you cannot afford to prove that the court got it wrong.
- Do not risk violating the automatic stay.
The total actual and punitive damages from violating the automatic stay was almost $2 million. This is an example of how taking actions that have the potential of violating the automatic stay are usually high risk and low reward.
The automatic stay is the primary tool that Bankruptcy courts use to create room for a debtor to reorganize. There would be no point in a bankruptcy filing if the courts could not stop the frenzy that occurs when multiple creditors start trying to collect from debtors. As a result, violating the automatic stay is taken very seriously in bankruptcy court. Fees are mandatory if you are found to have violated the stay. The court found that taking the position that it still owned Bailey Tool’s receivables led Republic to repeatedly violate the automatic stay. Bailey Tool filed lawsuits against account debtors to collect outstanding receivables and refused to release any funds they were holding to the trustee, both of which were held to be violations. The court later ruled that Republic was wrong about the agreement not terminating.
But even if Republic had been correct about the termination, it still could have been sanctioned for violating the automatic stay. In the Fifth Circuit, if the debtor has an arguable right to the property, then you need to file a motion for relief from the stay. Republic probably could have avoided this if it would have stopped and immediately filed a motion for relief from the stay to allow it to collect accounts receivable or keep the cash. The bankruptcy court could have had a hearing and issued a ruling. The court may not have ruled in their favor, but Republic would not have been liable for violating the automatic stay. Because they were held to have violated the stay, however, the court sanctioned Republic $490,000 for administrative fees from the chapter 11 case that were wasted because of Republic’s actions and an additional $1,470,000 for punitive damages for violating the automatic stay. Although this is overshadowed by the total amount of the verdict, this is still a large sum. If the opinion had just been about violating the automatic stay, it would still be significant.
- Be very careful with people’s homesteads.
The court assessed $1.196 million in actual and punitive damages from the homestead issues. Most of these damages were punitive damages. Homesteads are considered sacred, especially in Texas. They are protected from almost all classes of creditors.[v] In fact, obtaining a first mortgage against someone’s home is difficult and subject to a number of state constitutional safeguards. A court applying Texas law will be skeptical of any attempt to encourage someone to sell their home to pay a creditor when the home is exempt from foreclosure. Of course, people can voluntarily choose to liquidate exempt assets to pay debts, but you need to be very careful how you approach this. Any sort of strong-arm tactics, perceived or real, are exactly what the Texas constitution and legislature are trying to prevent.
- Charging excessive fees may not be a good idea.
I realize fees are part of your agreements, and you are contractually allowed to charge all sorts of fees. But sometimes, just because you can charge a fee does not mean you should charge it. The court paid particular attention to Republic having over 15 different fees listed in its agreement as an example of how one-sided the contract is. Republic calling a default, paying itself from collected accounts, then charging Bailey Tool a prepayment fee also created a bad impression with the court. Likewise, charging Bailey Tool a termination fee then taking the position that the contract was not terminated proved to be a critical decision. The court repeatedly cited charging the termination fee as evidence that the contract had terminated which undermined Republic’s argument that the agreement had not terminated. This position seemed to offend the court and resulted in the court awarding more damages against Republic. Although charging these fees was contractually allowed, it may not have been worth the heartburn that it created later.
It is naïve for factors to look at this case and say they would never do any of this. I will grant you that some of this seemed excessive. But how many of you have relied on your factoring software for answers to questions without really understanding why? How many of you have started paying bills directly for clients or tried to install a turnaround person to take over for a client without understanding the risks? How many of you have made statements in emails that could seem unprofessional if taken the wrong way? These are not uncommon problems. Unfortunately for Republic, everything came together in one big storm and made for a very stressful Christmas.
Scot Pierce, Esq. is a trial lawyer and transactional attorney. Click on his picture for his profile page.
Disclaimer: This post contains general opinions and analysis, is solely for educational purposes, and should not be treated as advice for any specific case.
[i] The court also awarded attorney fees but postponed determining the amount of fees to be awarded until a hearing to be set at a later date.
[ii] The court also awarded attorney fees but postponed determining the amount of fees to be awarded until a hearing to be set at a later date.
[iii] You can also ask for the judge to reconsider their ruling but those motions are usually only granted when you have new evidence to present or a new ruling has been issued in the interim from a higher court clarifying or changing the law on some issue in your case.
[iv] This is referred to as a supersedeas bond.
[v] Homesteads are not protected from a purchase money mortgage lender and some other mortgage lenders.