Secured Creditors Beware: Liability Lurks in Lockboxes

Lenders and secured creditors often require that debtor-customers direct all receivable collections into a lockbox, hoping to wrangle any available proceeds to apply to their debtors’ outstanding debt. In requiring a debtor or its customer to remit payments to a lockbox, however, creditors may be overlooking a potential source of significant liability. A creditor using a lockbox may unwittingly expose itself to greater risk and liability than just a debtor’s default if it receives funds that were collected as sales tax on a debtor’s goods or services.

As a lender or secured creditor, how do you know if you are at risk? First and foremost, understand your debtor’s business and whether its goods or services are taxed. Second, know what the laws provide for in the jurisdiction where your debtor is conducting business – particularly with respect to third-parties that collect or receive sales tax.

By way of example, the State of Texas treats anyone who collects or receives money that is collected as a tax as a strict, statutory trustee, holding the collected tax for the benefit of the taxing authority. Recipients and holders of such proceeds may be liable for the full tax amount collected – plus any accrued interest and penalties. See Tex. Tax Code Ann. § 111.016 (2007).

A central issue in determining liability in your jurisdiction may be how your lockbox is structured, as is the case for Texas. If a debtor’s customers pay receipts with sales tax directly to a lockbox, in Texas such a creditor is a strict, statutory trustee. If, however, a debtor’s customers pay receipts with sales tax first to the debtor and then those funds are transferred to a lockbox, a creditor still risks being liable as a transferee if they have the requisite “knowledge.” In determining whether to impose liability on a third-party, Texas courts consider whether the recipient knew that it received sales tax funds.  Knowledge is not just whether you had actual notice that the receipts contained sales tax funds. Instead, it is an “inquiry notice” standard, which requires a court to consider whether there was sufficient information available to cause you to inquire whether the funds received contained tax receipts. Courts consider a third-party as being on “inquiry notice,” and thus having the requisite knowledge to be held liable, where, if you pursued an issue, you would or could have ascertained the truth.

Do you have enough information to be on “inquiry notice?” Lenders and secured creditors often require that debtors provide various periodic reports and/or copies of invoices to monitor the financial health of their operations. As a careful and proactive creditor, you may already have sufficient information to be on “inquiry notice” that you are holding commingled funds in your lockbox. The case In re Amber’s Stores, Inc., 205 B.R. 828 (Bankr. N.D. Tex. 1997), presents an interesting analysis of “knowledge” in the context of lender-liability for receipts commingled in a lockbox with collected sales tax.  There, the debtor-vendor in that case received money from its customers (which included collected sales tax) and the debtor then sent the money directly to its secured lender’s lockbox; the lender in turn applied the receipts to the debtor’s outstanding loan and extended the debtor additional credit. The taxing authority sued the debtor’s lender to recover unpaid sales tax that was part of the receipts directed to the lender’s lockbox. The court determined that since the debtor first had dominion and control over the funds, and only then transferred them to the lender, that the lender was not a strict statutory trustee. However, the court found the lender could be a trustee who held the tax proceeds for the benefit of the taxing authority. The central issue was whether the lender could assert a good faith transferee defense, which hinged on whether the lender had “inquiry notice” that the lockbox contained collected sales tax. “Inquiry notice” could be attributed even if additional work or due diligence was required to uncover the existence of sales tax in the lockbox. The case ended up before the bankruptcy court on a summary judgment motion and the court ultimately held that there remained an issue of fact as to whether the lender had knowledge about the nature of the funds.  Despite the lender’s Vice President testifying that he was not aware of whether the debtor had, prior to remittance, segregated out its sales tax and that the debtor had not asked the lender to create a separate account to segregate the funds, the court found that there remained a question as to whether the lender was on “inquiry notice” and thus knowledge could potentially be imputed to the lender.  Although that case was ultimately settled in advance of trial, it is instructive because of the court’s clear analysis of the potential pitfalls facing lenders and secured creditors that use lockboxes without considering their potential exposure. It also highlights the distinction between lenders who receive payments directly from a debtor’s customer, which are strict statutory trustees, versus lenders who receive funds from a debtor, after they were collected from a customer, which still risk being deemed transferees potentially liable for the return of funds.

Ultimately, if you receive collected tax directly from a customer, you may be strictly liable for the return of such funds, as is the case in Texas. Even if you receive the funds indirectly, you may have liability for the failed remittance of taxes unless you can establish a lack of knowledge. That may be challenging, however, because jurisdictions, like Texas, may require lenders and secured creditors to first segregate funds to remove trust funds (like taxes) from a mixed account before applying funds on hand to overdrafts or liabilities.  See State Bank v. Valley Wide Elec. Supply Co., Inc., 752 SW 2d 661, 665 (Tex. App. 1988); see also Alon USA, LP v. State, 222 SW 3d 19, 30 (Tex. App. 2005), rehearing denied (2007).  Notably, if a lender or creditor is aware that any of the funds it applies to offset an overdraft or prior debt are trust-funds, like taxes, the lender/creditor will lose any asserted immunity. The end result is that it will be treated as a party liable for the collected tax.  See Alon, supra at 30-31.

Many lenders and secured creditors conduct business with debtors located in states other than their own. Creditors should consider the varying statutory requirements and, to the extent they use a lockbox, they should consider how best to segregate out any collected tax to avoid potential exposure.