We hope you are emerging from your sugar coma and ready for some easy to digest morsels of the Weil Bankruptcy Blog.  With this entry, we summarize the blog entries from the second half of October. 

In a Twist, Court Finds That Junior Stakeholders Violated Their Implied Duties Under an Indenture

Although not directly related to a bankruptcy issue, Debora Hoehne published a post dealing with an attempt by out of the money holders of preferred equity to use their consent rights to obtain an economic benefit to the detriment of the noteholders in a CDO.  As she discussed, though, in Court Tells Junior Investors in CDO “You Gotta Have Faith” – Good Faith and Fair Dealing, That Isthe CDO’s preferred holders were deemed to have violated the implied duty of good faith and fair dealing.  The preferred holders had the right to direct the sale of the CDO’s collateral if two offers were received.  The first offer contained a proposed $250,000 “consent payment” to the preferreds for consenting to the sale of the collateral for $500,000 (less than 1% of the $318.5 million outstanding on the notes).  Even though the preferreds directed that the trustee accept a second offer (which would have paid $800,000 – still less than 1% – to the noteholders), the court ruled that the first offer was not a legitimate offer because it “invited and induced the Preferred Shareholders to disregard their duties of good faith and fair dealing.”

No Benefit to Being an Alter Ego of a Debtor, Even Under the Automatic Stay

If a plaintiff in a non-bankruptcy action asserts that the defendants essentially are all one and the same entity under an alter ego theory, should all of those defendants have the benefit of the automatic stay if one of the defendants later commences a bankruptcy case?  That was the issue discussed by Doron Kenter inNondebtor Alter Egos Don’t Automatically Benefit from the Automatic Stay, Says New York’s Eastern District.  As Doron explained, after a bankruptcy court in a prior bankruptcy of one of the defendants had characterized individual debtor and his corporations as “at all relevant times one and the same entity,” the defendants later tried to use this argument to stay subsequent litigation commenced against them and pending when one of the corporations commenced a bankruptcy case.  Nice try, but no dice.  Judge Cogan of the United States District Court for the Eastern District of New York held that the automatic stay applies only to debtors, and not to nondebtors – even if they are alter egos of the debtor.  Moreover, the court noted that extending the automatic stay to alter egos would mean that the automatic stay could only be given effect with the benefit of hindsight and could result in the litigation against nondebtors being invalidated if the court subsequently determined that such nondebtors were alter egos of the debtor.

Private Agreements to Maintain Confidentiality Don’t Necessarily Hold Up in Bankruptcy Cases

Outside of bankruptcy, parties may agree among themselves to keep a settlement agreement confidential.  As Charlie Chen noted in Want to Know a Secret? Go to Bankruptcy Court, if that agreement becomes an issue in a subsequent bankruptcy case, the bankruptcy court isn’t bound to keep the agreement confidential and, in fact, may require its disclosure.  The plain language of section 107(a) of the Bankruptcy Code creates a strong presumption in favor of public access to all papers filed in a bankruptcy case.  As a result, notwithstanding the debtor’s contractual obligation to maintain the confidentiality of the settlement agreement, the United States Bankruptcy Court for the Central District of California denied the debtor’s application to file the settlement agreement under seal.  Although section 107(a) protects “commercial information” (among other things), a settlement agreement only constitutes commercial information if it contains information that would cause “unfair advantage to competitors by providing them information as to the commercial operations of the debtor.”

Non-Executory Nature of Master Service Agreement Benefits Debtor’s Estate

What exactly is an executory contract, and why should you care?  This is a recurring theme in bankruptcy, and often it is the debtor that is arguing for a contract to be considered “executory.”  In Bankruptcy Court Makes ‘Executive’ Decision, Rules Master Service Agreement Ineligible for Rejection, Abigail Lerner wrote about the bankruptcy court’s conclusion that a master service agreement was not deemed rejected in a debtor’s chapter 7 case because it was not an executory contract.  The bankruptcy court reasoned that the agreement did not require performance by either party, but, instead, set forth an agreement to comply with the terms of the agreement to the extent the parties entered into contracts in the future.  Accordingly, the nondebtor party’s insurer was required to defend the debtor’s estate as an “additional insured” because the master service agreement was “in effect” during the coverage period.

It May Be a Bit Easier to Surcharge a Creditor’s Collateral in California

Maurice Horwitz noted in California Court Holds Implied Consent Is a Valid Alternative Basis to Surcharge Secured Creditors’ Collateral that the Supreme Court in Hartford Underwriters Ins. Co. v. Union Planters Bank N.A left open the question of whether a secured creditor’s consent may form the basis for surcharge under section 506(c) of the Bankruptcy Code.  A recent decision in California, though, held that a secured creditor’s consent – even implied consent – may still give rise to a right to surcharge.  In that case, secured creditors got what they asked for when they said they would only consent to the use of cash collateral if either a chapter 11 trustee or some equivalent fiduciary were appointed.  After the court appointed a trustee, the trustee sought to surcharge the creditors’ collateral.  The bankruptcy court found that the secured creditors impliedly had consented to such surcharge, noting that the secured creditors had “orchestrated the preservation, liquidation, and/or recovery of their collateral through the trustee and the trustee’s professionals” and had sought the trustee’s appointment early on in the case, motivated solely by a desire to have the trustee preserve and rapidly liquidate their collateral, with knowledge that the debtors’ estates were administratively insolvent.

Do Debtors’ Prisons Still Exist?  (According to This Landlord, They Do.)

Pop quiz:  Is it OK for a landlord to threaten a debtor with criminal prosecution for having failed to pay her rent so long as the landlord does not continue to pursue his pending civil action against the debtor?  If you said yes, read Matt Goren’s entry, Busted! Sixth Circuit Holds Creditor’s Threat to Pursue Criminal Charges Against Debtor Falls Outside Criminal Prosecution Exception to Automatic Stay.  Although section 362(b)(1) of the Bankruptcy Code exempts from the automatic stay the “commencement or continuation of a criminal action or proceeding against the debtor,” the bankruptcy court court concluded that the landlord’s postpetition letters (which included statements that the debtor would face substantial jail time and intimated that she might lose her position as a public school teacher) were not in the nature of a criminal prosecution, but demonstrated that they served no other purpose other than “to threaten, harass and intimidate the Debtor in an effort to coerce her into paying him.” The Sixth Circuit agreed and upheld the bankruptcy court’s imposition of punitive damages on the ground that the landlord’s threats were for the purpose of inducing payment and clearly ran afoul of the automatic stay.

363(m) Does Not Help Estate Avoid Review of a Sale When the Purchaser Is Not at Risk

On Friday, we summarized Chris Hopkins’ entry on the Third Circuit’s decision to allow money that the Third Circuit concluded was not property of the estate to be distributed in a manner contrary to the absolute priority rule in connection with a 363 sale.  In a subsequent entry, Das Moot – Debtors’ Argument that 363(m) Moots Creditors’ Appeal of Sale Order Gets Sunk by Third Circuit, Chris explained why the Third Circuit even had the opportunity to consider the issue in light of the protection in section 363(m).  The Third Circuit concluded that it could review “any sale-challenge that doesn’t affect the validity of the sale,” but noted that, if the government prevailed on appeal, the court could redistribute funds “without disturbing the sale.”  Although the debtors and the committee argued that such a result would disturb a “fundamental term of the transaction,” and the committee argued it would not have withdrawn its objection to the sale absent the settlement, the Sixth Circuit held that section 363(m) moots only those challenges that would claw back the sale from a good faith purchaser.

The Right to Marry Reduces Bankruptcy Options for Same-Sex Domestic Partners

One question that has come up in the wake of same-sex partners having the constitutional right to marry is whether domestic partners that choose not to marry will be afforded the same rights that they may have enjoyed previously when they did not have the right to marry.  Abigail Lerner wrote about how this has played out in bankruptcy court in Bankruptcy Court Holds That Same-Sex Couples in Registered Domestic Partnerships Are Not “Spouses.  Two prior cases have concluded that same-sex married couples are “spouses” for the purpose of commencing a joint case under section 302 of the Bankruptcy Code.  In the most recent decision, though, the Bankruptcy Court for the Central District of California held registered domestic partners could not be considered “spouses.”  Even though the two partners had had their same-sex domestic partnership registered in California before California recognized or permitted same-sex marriage, the partners did not marry after they had the legal right to do so.  Notwithstanding that the California Family Code grants registered domestic partners the same rights as “spouses,” the bankruptcy court concluded that other provisions of California law distinguish between domestic partnerships and marriages. The court rejected the partners’ argument that denying rights under section 302 to same-sex domestic partners constituted discrimination, remarking that “[b]ecause both same- and opposite-sex couples can get married and, as a result, file a joint petition, denying same-sex domestic partners the ability to jointly file is no different than denying an unmarried, cohabitating opposite-sex couple the same.”

Good Faith/Bad in Bankruptcy Cases

Various applications of “good faith” and “bad faith” exist in bankruptcy cases, although “good faith” is more commonly found explicitly in the Bankruptcy Code.  For example, a plan must be proposed in “good faith” under section 1129(a)(3) of the Bankruptcy Code.  That definition of “good faith” differs from that used in section 550(b)(1), which protects a subsequent transferee against recovery of an avoided transfer if the transferee took for value, in good faith, and without knowledge of the voidability of the transfer.  It is this concept that Charlie Chen addressed in his entry, House Wins!  7th Circuit Holds That “Good Faith” Defense Under Section 550(b)(1) Applies to Casino in Fraudulent Transfer Action.  Charlie discussed a case before the Seventh Circuit in which former owners of a debtor gambled away at a casino funds that they had obtained fraudulently from the debtor.  Although various red flags existed to make the debtors’ gambling habits suspicious, the Seventh Circuit concluded that the casino lacked knowledge of the potential voidability of the first transfer – from the debtor to the former owners – and, therefore, was protected by the “good faith transferee” defense in section 550(b)(1)

The Third Circuit has been at the forefront of reading “bad faith” into the Bankruptcy Code and was among the first circuits to recognize a right to seek dismissal of a voluntary bankruptcy petition filed in “bad faith.”  It was, therefore, not surprising to see the Third Circuit join with the Fourth Circuit and the Eighth Circuit BAP to apply a similar concept to involuntary filings, as Debra McElligott discussed in No Bad Blood in the Bankruptcy Court:  Third Circuit Holds That Bad Faith Is a Basis for Dismissing Involuntary Petitions.   Section 303 of the Bankruptcy Code does contain a reference to “bad faith,” but that is only in permitting damages and punitive damages to be assessed against petitioning creditors that filed an involuntary petition in bad faith after the court dismisses a petition for failure to meet the standard in section 303(h).  The Third Circuit, however, went one step further and held that, even if the standard under section 303(h) is met, an involuntary petition could be dismissed on the independent grounds that the petitioning creditor or creditors acted in bad faith (here, using the involuntary petition as a litigation tactic and an attempt to collect on a debt).

Insurers Can’t Get Off the Hook That Easily

What happens to an insurer’s obligation to provide coverage when the debtor is unable to meet the deductible or self-insured retention under the insurance policy?  In Please, SIR, the Plaintiffs Want Some More:  The Southern District of Ohio Weighs in on the Treatment of Self-Insured Retentions in Bankruptcy, Alana Heumann gave us the answer from one court:  Simply deduct the deductible or self-insured retention from the allowed claim and require the insurance company to pay the rest.  This decision validates treatment commonly provided by debtors when they agree to relief from the automatic stay to allow plaintiffs to collect only against the proceeds of insurance policies.

Are Escrowed Funds Property of the Estate?

The treatment of escrowed funds in bankruptcy – and, specifically, whether the escrowed funds are property of the debtor’s estate – is often a thorny issue and frequently depends upon the application of state law.  Danielle Donovan discussed one such dispute over escrowed funds in Don’t Count Your Escrows Before They Hatch.  Applying Oklahoma law, the Tenth Circuit in one case held that funds deposited into escrow by the debtor prepetition did not constitute property of the estate when the conditions to releasing the funds to the debtor had not been met, although the debtor’s contingent interest in the fund did constitute property of the estate.  In so holding, the Tenth Circuit stressed that it was applying Oklahoma state law, and emphasized that no uniform federal law applies to the determination of the status of funds in escrow.