In a recent decision [1] arising from the In re Residential Capital LLC, et al. bankruptcy cases, the Bankruptcy Court for the Southern District of New York considered dueling motions to dismiss certain claims and counterclaims filed by the Debtors and the Official Committee of Unsecured Creditors (the “Committee,” together with the Debtors, the “Plaintiffs”) on one hand and an ad-hoc group of junior unsecured noteholders (the “JSNs”) on the other.  Prior to the filing of the Debtors’ chapter 11 cases, one of the Debtors (“ResCap”) entered into various transactions in connection with the issuance of approximately $4 billion of 9.625% Junior Secured Guaranteed Notes Due 2015 (the “Notes”), which were guaranteed by certain other Debtors and secured by “all-asset” liens in favor of the JSNs, subject to significant exclusions and carve-outs.  Subsequently, in connection with another financing entered into by certain Debtor entities (the “AFI LOC”) and a related intercreditor agreement, the Collateral Agent for the Notes executed releases of certain of the JSNs’ collateral, which was later pledged as support for the AFI LOC.  After the commencement of the Debtors’ chapter 11 cases, the Debtors stipulated to the validity of the JSNs’ liens pursuant to an order allowing the Debtors to use cash collateral (the “Cash Collateral Order”), subject to challenge by the Committee.  The Committee initiated an adversary proceeding seeking, among other things, determination of the extent of the JSNs’ liens and whether the JSNs are oversecured and entitled to post-petition interest. 

At issue here were two motions to dismiss.  The first was filed by the JSNs with respect to Plaintiffs’ claims for (i) declaratory judgment that the JSNs do not have a lien on collateral released by the Collateral Agent and (ii) declaratory judgment that the JSNs are undersecured because in order to be oversecured the JSNs must show they are oversecured with respect to any individual Debtor entity holding assets against which the JSNs assert liens.  The second was filed by the Plaintiffs seeking dismissal of certain counterclaims asserted by the JSNs, including: (i) declaratory judgment that certain settlement recoveries constitute JSN collateral, (ii) various declarations relating to the Collateral Agent’s release of JSN collateral, e.g. that the release was ineffective, the release breached applicable agreements, the JSNs retained legal or equitable title in the released collateral, and the JSNs’ liens extend to proceeds of the released collateral.

The Court first denied the JSNs’ motion to dismiss without prejudice on the ground that both counts that the JSNs sought to dismiss required the development of a further factual record.  In particular, with respect to the declaration sought by the Plaintiffs that the JSNs must show they are oversecured on an individual Debtor-by-Debtor basis, the Court held that section 506 of the Bankruptcy Code “does not specify whether debtors’ various estates should be aggregated for purposes of valuing a secured creditors’ collateral.”  Decision at 16.  Instead, the Court noted that section 506(a)(1) provides that the value of a secured creditor’s claim “shall be determined in light of the purpose of the valuation and the proposed disposition or use of such property.”  Because the record was thus far insufficient for the Court to properly determine the appropriate method for evaluating the JSNs’ secured claim, the Court denied the JSNs’ motion to dismiss this count.

The Court next granted Plaintiffs’ motion to dismiss the JSNs’ counterclaim for a declaration that they are entitled to liens on recoveries on postpetition settlements entered into by the Debtors.  The Court dismissed the counterclaim on the bases that (i) avoidance actions (accounting for a certain portion of the settlement recoveries) are postpetition, after-acquired property of the Debtors and, thus, not subject to prepetition liens under section 552 of the Bankruptcy Code, and (ii) under the relevant security documents, the JSNs did not have liens on commercial tort claims (accounting for the remaining settlement recoveries).

The Court next addressed the Plaintiffs’ motion to dismiss the JSN’s claims relating to collateral released by the Collateral Agent.  The Court granted the Plaintiffs’ motion to dismiss those claims on a number of grounds.  First, the Court found that, as a matter of law, the executed releases and UCC-3 filings by the Collateral Agent were effective and enforceable.  The JSNs did not contend that the Collateral Agent intended to release the collateral or that the releases were ambiguous.  Instead, the JSNs argued that the releases breached certain applicable agreements.  The Court rejected this argument on the ground that the “argument is irrelevant here because it only implicates a potential claim against the Collateral Agent, not a claim against the Plaintiffs that would somehow render the releases ineffective.”  Decision at 23.  The Court also noted that the JSNs’ never previously contested the UCC-3s, which were filed years before the commencement of the Debtors’ bankruptcy cases and that, although there is a possibility that the UCC-3 filings do not capture all of the disputed collateral, the lenient requirement under the Uniform Commercial Code that they “reasonably identify” the collateral was met and the UCC-3s were thus effective.

Lastly, the Court considered Plaintiffs’ motion to dismiss numerous counterclaims relating to the Debtors’ use of cash collateral.  The JSNs sought a declaration, among others, that because the Debtors waived their right under section 506(c) of the Bankruptcy Code to charge the JSNs for the costs and expenses of preserving or disposing of the JSNs’ collateral, the Debtors cannot use cash collateral to administer the JSNs’ collateral without providing corresponding adequate protection.  The Court rejected this argument on the basis that since, under the Cash Collateral Order, the Court had already found that the JSNs were adequately protected so long as the Debtors only used cash collateral pursuant to the terms of the order, “by definition, there is no surcharge and section 506(c) does not come into play.”  Decision at 31.