Big Bucks Bank had a long-standing relationship with Fossil Fuels, Inc., and its experience was entirely satisfactory. Information in the credit file indicated that Fossil Fuels was a marketer - a buyer and seller - of natural gas, and recently, the bank made available a $1.75-million line of credit for Fossil Fuels. As collateral, a security interest was taken in accounts, chattel paper, and general intangibles. The bank was comfortable with its collateral position since Fossil Fuels' stated accounts receivable were always at least 200% of the balance outstanding under the credit line.
However, trouble ignited when one of Fossil Fuels' largest producers could not fulfill a contract, and Fossil Fuels was forced to buy a substantial amount of natural gas on the open market. As a result, Fossil Fuels experienced a significant loss. Although the loss did not affect its ability to make interest payments on the credit line (which was fully drawn), it did trigger a violation of the minimum net worth covenant in the loan agreement.
The covenant violation spurred the originating loan officer to meet with the borrower. At this meeting, the loan officer found out that the loss was so substantial Fossil Fuels was considering either a Chapter 11 bankruptcy petition or selling itself to Hydrocarbon Inc. The bank declined the opportunity to finance the acquisition and preferred, instead, to exit the relationship. So, the loan officer referred the credit to a valued member of the workout group, Sam Digger.
Although on the surface, it appeared that the bank's collateral position afforded complete protection, Digger, following the bank's standard practice in workout situations, reviewed in detail Fossil Fuels' documentation, public record filings, and credit file. Digger noticed that Fossil Fuels' income statement referred to the company's income as "net fees on gas transactions" as the starting point from which expenses were deducted - a major contrast to the more traditional method of presenting an income statement by starting with total sales less cost of goods sold to arrive at gross profit, from which expenses are then deducted.
The spreadsheet accompanying Fossil Fuels' financial statements, also found in the bank's credit files, showed the figures for both gross sales and gross profit as identical to those reported on Fossil Fuels' statements as "net fees on gas transactions." The spreadsheet also showed inventory as a negative item.
Accordingly, Digger looked at the contracts between Fossil Fuels and natural gas producers and between Fossil Fuels and buyers. He wanted to find a clear indication that Fossil Fuels was, indeed, a marketing company. Digger knew there was an important difference between a marketer of natural gas and a broker. A marketer buys gas and then sells it; a broker simply marries a buyer and a seller for a fee and never actually owns the gas.
Digger discovered that the language in a significant number of contracts was ambiguous: Fossil Fuels was referred to alternately as a marketer and as a broker. And several contracts specifically referred to Fossil Fuels' estimated profit as a "fee."
In addition, Digger also unearthed that a large number of contracts to sell natural gas were unconditional and for a fixed price; whereas, a large number of contracts to purchase natural gas (to fill the contracts) were conditional on production capabilities. This is why Fossil Fuels found itself having to fill fixed-price contracts on the open market (and was considering filing for bankruptcy. …