By now, most lenders and their counsel have heard about the February 16, 2021 decision of the U. S. District Court for the Southern District of New York in Citibank N.A. v. Brigade Capital Management, L.P, which held that certain lenders to Revlon who received payments by mistake from Citibank were in fact entitled to keep those payments. 

The magnitude of the funds transferred is just one of the eye-catching elements of the case.  On August 11, 2020, Citibank, which had been the agent for a syndicate of term lenders to Revlon, mistakenly transferred approximately $900 million to a group of the lenders.  According to Citibank, it had intended to send a much smaller amount, around $7 million, solely to cover an interest payment then due on the loans, but a problem with its loan processing system resulted in the overpayment.  Typically, you would expect lenders receiving the money by mistake just to return it—after all, you never know when you might be the one mistakenly sending the money.  And, in fact, a number of the lenders did just that—but one group, did not. 

There is a bit of a backstory.  The financing of Revlon has not been without its share (perhaps more than its share) of drama. Until the accidental transfer of $900 million by Citibank, there had been an ongoing battle among Revlon, Citibank, Jefferies (Revlon’s investment banker) and others with certain of the 2016 term loan lenders to Revlon.  The dispute arose from certain “J. Crew” type “liability management exercises” by Revlon in May of 2020.  Having done it with its American Crew brand in 2019, in May of 2020,  Revlon transferred most of its intellectual property, names like Elizabeth Arden, Almay, Mitchum, CND, Creme of Nature, Curve, Charlie, and others to a new subsidiary which then used the value of this intellectual property not only to obtain additional loans, but also to “roll up” loans of some of the existing lenders, but not others, so some lenders lost the benefit of the intellectual property, while others did not.

On August 12, 2020, UMB Bank, as the replacement for Citibank as agent, on behalf of those 2016 term loan lenders opposed to the 2020 transaction (and the process of replacing Citibank as agent had its own share of controversy), which included Brigade Capital, HPS, Symphony and others, filed a 117-page complaint in the U.S. District Court for the Southern District of New York.  The complaint includes 22 separate causes of action against Revlon, former administrative agent Citibank, Jefferies, and others in connection with “stealing away” valuable intellectual property.

Then came the mistaken transfer of funds.  At this point, you can probably anticipate which of the lenders that received some of the $900 million from Citibank did not return it.  Brigade, HPS and Symphony, all part of the ad hoc group of 2016 term loan lenders that brought the action against Revlon for the May 2020 debt restructuring, refused to return the funds on the basis that the payments were intended to pay off the principal balance of the 2016 term loans owing by Revlon and “matched the accrued interest and remaining outstanding principal under the 2016 Term Loans to the penny.”

In order to get the money back, on August 17, 2020, Citibank filed a lawsuit in the U.S. District Court for the Southern District of New York—the same court where the litigation with UMB and the term lenders was pending—which led to the somewhat surprising ruling by Judge Jesse Furman on February 16, 2021 that in fact under New York law the lenders could keep the payments that they received as a result of what he characterized as “one of the biggest blunders of banking history.”  

Regardless of the size of the “blunder” or perhaps even more so because of the size of it, most lenders would certainly have expected that the lenders receiving the money would be required to return it.   And the Judge noted that the law typically treats a failure to return money that is wired by mistake as unjust enrichment or conversion and requires that the recipient of those funds return the money to its sender.  But, there is a somewhat unique twist in New York law that is an exception: the “discharge-for-value” defense.

This doctrine allows the recipient to keep funds if:

• the funds discharge a valid debt,
• the recipient made no misrepresentations to induce the payment, and
• the recipient did not have notice of the mistake.

As to the first requirement, there did not seem to be much controversy about the validity of the debt, but there was a question as to whether the debt must be due at the time the mistaken payment is received.  The Judge found that there was no “present entitlement” to the money required to be shown as an element of the defense. On the second requirement, there was no misrepresentation by the receiving lenders—they were as surprised to receive the funds from an adversary in a litigation as you would expect—which leads to the third requirement where most of the time in the case was focused.

On this last element, the Judge was convinced by the testimony of the receiving lenders noting that where a lender “receives an unexpected and unscheduled payment from a borrower that matches exactly the amount of the borrower’s outstanding debt, it is reasonable to assume that the borrower has intentionally paid off the debt.  In fact, it might even be unreasonable to assume otherwise.”  This reasoning certainly seems subject to debate, even in the category of “if it is too good to be true, it probably isn’t.”  The Judge also rejected Citibank’s arguments that the time to determine whether the receiving lender had notice of the error was when the funds were formally credited to the lenders, rather than actually received and he found that to the extent that the lender had a duty to inquire about the payment, it was satisfied here.  There is more of course.  The decision is on appeal so the final chapter has yet to be written.

In the meantime, with remarkable speed, the lending industry has reacted to the decision.  While the particular combination of events that led to the unexpected conclusion that the recipients of a mistaken funds transfer are entitled to keep the money may be unlikely, obviously the consequences can be significant.

Consequently, lenders have developed new provisions to be included in a credit agreement to address the possibility of “erroneous payments,” including provisions developed by individual institutions and as of March 19, 2021, a version proposed by the Loan Syndication and Trading Association (LSTA).

Here are some of the features of these provisions:

• If the Agent notifies a Lender or a bank issuing a letter of credit under the facility (an “issuing bank”) that the Agent has determined that any funds received by the lender or issuing bank were “erroneously transmitted” to them and the Agent demands return of the funds, then:

• the payment remains the property of the Agent, and the Lender will segregate the payment and hold it in trust for the Agent, and

• within two Business Days after the request by the Agent for the   return of the payment the recipient will return it to the Agent together with interest at the federal funds rate or another rate used for interbank compensation as determined by the Agent.

• If (i) a Lender or issuing bank or any other person receives a payment that is in a different amount or on a different date from any notice sent by the Agent as to the timing and amount of such payment, or (ii) a Lender or issuing bank receives a payment that was not accompanied by a notice of payment from the Agent, or (iii) the Lender or other party otherwise becomes aware that the payment was made in error, then the error is presumed and the Lender will notify the Agent within one Business Day of its knowledge of such error.

• The Agent is authorized to setoff, net and apply any amounts owing by the Lender that has received the erroneous payment against amounts otherwise payable to such Lender.

• In the event that the erroneous payment is not recovered by the Agent after its demand for the return of it, then upon notice by the Agent to the receiving Lender, the receiving Lender is “deemed” to have assigned it loans (but not commitments) in the amount of the erroneous payment to the Agent plus interest and deemed to have executed a standard Assignment and Assumption Agreement.

• The Agent as the assignee of the Lender that received the erroneous payment, but failed to return it, becomes a “Lender” under the credit agreement to the extent of such assigned loans,

• The Agent may sell the loans, and upon receipt of the proceeds of such sale, the amounts otherwise required to be paid by the Lender that received the erroneous payment back to the Agent is reduced by such amount.

• The Agent is also subrogated to the rights of the Lender that received the erroneous payment to the extent of any amounts that have not been recovered by the Agent in respect of such payment.

• The Lender that receives the erroneous payment agrees not to assert any claim or set off with respect to any demand by the Agent for the return of the erroneous payment and in particular waives any defense based on the “discharge-for-value” or any similar doctrine.

There is actually quite a bit in these provisions.

First, although not mentioned in the summary above, the sample provision from the LSTA offers an option to limit the time within which the Agent must make the demand for the return of the “erroneous payment” and there is a blank for the number of days within which the demand must be made.  Obviously, there are two sides to this issue.  On the one hand, there does not seem to be a reason to let a Lender keep funds that it is not entitled to, no matter when the Agent discovers the error.  On the other hand, a Lender receiving funds should be able to have some certainty that it may keep the funds.  Either way may not be particularly significant as a practical matter, since the error should be discovered quickly.

Another interesting feature that is not in the LSTA provision, but some institutions have been employing, is having the Lender that fails to return the funds be a “Defaulting Lender,” which then gives the Agent the ability to redirect funds that might otherwise be payable to such Lender, and has other additional negative consequences for the Lender that has not returned the funds, like the loss of the right to vote on amendments and to receive certain fees.

The new provision includes the express right of the Agent to set off against amounts it would otherwise be required to pay to the Lender receiving the “erroneous payment” for the amounts that the Lender should have returned to the Agent.  This could actually be quite useful in an asset-based facility, where there are customarily weekly settlements among the Lenders so that as of the settlement date each Lender has its pro rata share of the then-outstanding loan.  If the borrowings have decreased over the week or other applicable settlement period so that each Lender will be receiving a pay down on its pro rata share of the outstanding loans, the Agent can simply apply the receiving Lender’s share to repay the Agent the amount of the erroneous payment. Of course, when loans are going up, so that funds are required to be paid in by the Lenders it is another matter.  But even if the loans are not going down, interest and fees would seem to be fair game, to the extent helpful to the Agent.

Having the Agent become a Lender for purposes of the amounts it has erroneously paid to a Lender certainly has a logic in terms of treating the payment as if it were the purchase price for those loans, and then gives the Agent the benefit of the interest on those loans and a right to the applicable portion of distributions of payments on those loans as and when made by the Borrower.  However, the provisions for distributions of payment may expressly refer to such distributions being made based on each Lender’s “pro rata share” or “applicable percentage” of the credit facility which is usually calculated based on a Lender’s “commitment” relative to the total amount of the commitments of all Lenders, and since the erroneous payment provision is clear that the Agent is not assuming the “commitment” of the receiving Lender, it is unclear whether this will work as is perhaps intended in such circumstances.

There are at least two other provisions of a typical credit agreement that would seem to be implicated by the Revlon case.

First, most credit agreement require the pro rata sharing of payments.  It may depend in any given instance on how the provision is drafted but, in general, these clauses typically provide that if any Lender exercising a right of set off “or otherwise,” obtains payment of its loans resulting in such Lender receiving payment of the loans greater than its pro rata share (determined based on its commitment to total commitments) that Lender is required to purchase a participation or make other adjustments in sharing such payments with the other Lenders so that each Lender gets its pro rata share.

Second, most credit agreements include an indemnification by both the borrower and the Lenders of the Agent for any loss that it suffers in such capacity.  Again, it may depend on how the particular provision is drafted in a specified credit agreement but in general the borrower agrees to indemnify the Agent (and the Lenders) for any loss incurred by such “indemnitee” in connection with the credit facility.  There are exceptions for any loss determined by a court of competent jurisdiction to have resulted from the gross negligence or willful misconduct of the “indemnitee”.  Perhaps in the Revlon case, that exception would have doomed an argument by Citibank, but in other circumstances it might still be available.  And there is a separate indemnification by the Lenders of the Agent that might still be available.

The express contractual “subrogation” of the Agent to the Lender receiving the erroneous payment included in the new provisions is a clever angle.  The principle is that as a result of the Agent having paid the Lender, the Agent “steps into” the position of the Lender, including all of the rights of the Lender as against the borrower, as against the collateral and such Lender’s rights under the Credit Agreement, including rights to receive payments, etc.  In effect, this accomplishes the same function as the “deemed” assignment of the receiving Lender’s loans provided for in the “erroneous payment” provision. 

The ability to sell the loans acquired by the Agent provides another exit for the Agent from its inadvertent exposure arising from the erroneous payment.  If one of the other Lenders is interested in purchasing those loans, it may provide an easy exit for the Agent.

So, it is relatively safe to assume that another provision will now become part of credit agreements, along with LIBOR replacement provisions, terms relating to “MIRE” events, and more substantive provisions that have arisen to respond to cases like J. Crew, and its more recent progeny, like Travelport, Revlon and Cirque du Soleil and cases like Serta, Boardriders and Trimark.