Participants in the multibillion-dollar market for distressed claims and securities had ample reason to keep a watchful eye on developments in the bankruptcy courts during each of the last three years. Controversial rulings handed down in 2005 and 2006 by the bankruptcy court overseeing the chapter 11 cases of failed energy broker Enron Corporation and its affiliates had traders scrambling for cover due to the potential that acquired claims/debt could be equitably subordinated or even disallowed, based upon the seller’s misconduct. Although the severity of the cautionary tale writ large in the bankruptcy court’s Enron decisions was ultimately ameliorated on appeal in the late summer of 2007 by district court judge Shira A. Scheindlin, the 20-month ordeal (and the uncertainty it spawned) left a bad taste in the mouths of market participants. 2008 has so far proved to be little better in providing traders with any degree of comfort with respect to claim or debt assignments involving bankrupt obligors. This time, moreover, the trouble concerns standard provisions contained in nearly every bank loan-transfer agreement, which have rarely been subject to challenge or analysis in the courts. In In re M. Fabrikant & Sons, Inc., a New York bankruptcy court recently took a hard look at the standard transfer forms and definitions to determine whether a seller’s reimbursement rights were transferred along with the debt.
Distressed Claims/Debt Trading
Although the distressed-securities market is largely unregulated, industry participants and trade consortia—such as the Loan Syndications and Trading Association (“LSTA”); the Securities Industry Association; the International Swaps and Derivatives Association, Inc.; and the Bond Market Association—have implemented standards, forms, and procedures to govern purchase and sale transactions. LSTA’s standardized Purchase and Sale Agreement for Distressed Trades, LSTA Standard Terms and Conditions (the “LSTA Standards”), provides a fairly comprehensive boilerplate for most sale/assignment transactions. Even so, as demonstrated by the bankruptcy court’s ruling in In re M. Fabrikant & Sons, Inc., parties relying on the LSTA Standards must be vigilant to ensure that transfer documentation unambiguously distinguishes between rights that are being transferred and rights that are to be retained by the seller/assignor.
M. Fabrikant & Sons, once one of the world’s largest manufacturers and distributors of diamonds, filed for chapter 11 protection together with its subsidiary Fabrikant-Leer International, Ltd. (collectively referred to as “Fabrikant”), in New York on November 17, 2006. Shortly thereafter, the bankruptcy court entered an order authorizing Fabrikant to use cash collateral pledged to a consortium of bank lenders (collectively, the “original lenders”) as security for nearly $162 million in pre-petition loans. The cash collateral order, which conferred administrative-priority status upon claims asserted by the original lenders for reimbursement of certain expenses (the “Reimbursement Rights”), provided as follows:
In addition to the fees, costs, charges and expenses authorized under the Pre-Petition Agreements, the Debtors shall pay in accordance with the procedures set forth in the following sentences, as allowed post-petition administrative expenses entitled to the priority and security afforded to the Adequate Protection Claim, all of Collateral Agent’s and each Lender’s reasonable (in all respects) attorneys’ and other professionals’ fees and reimbursable expenses arising from or related to (a) this Order, including without limitation the negotiating, closing, documenting and obtaining of Court approval thereof, (b) all proceedings in connection with any Disposition (as such term is defined below), (c) all proceedings in connection with the interpretation, amendment, modification, enforcement, enforceability, validity or implementation of the Pre-Petition Agreements or this Order at any time, (d) all other matters and proceedings arising in or related to the Debtors’ bankruptcy cases, and (e) all reasonable expenses, costs and charges in any way or respect arising in connection with the foregoing (collectively, the “Lender Expenses”).
Shortly after entry of the cash-collateral order, the original lenders sold their loans on the secondary market to other entities (collectively, the “current lenders”). The sale transactions were effected by means of transfer documents that in form or substance incorporated the LSTA Standards. The transfer agreements defined “Transferred Rights” to include:
any and all of Seller’s right, title, and interest in, to and under the Loans and Commitments (if any) and, to the extent related thereto, the following (excluding, however, the Retained Interest, if any)
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(e) all claims (including “claims” as defined in Bankruptcy Code Section 101(5)), suits, causes of action, and any other right of Seller . . . that is based upon, arises out of or is related to any of the foregoing, including, to the extent permitted to be assigned under applicable law, all claims (including contract claims, tort claims, malpractice claims, . . . ) suits, causes of action, and any other right of Seller . . . against any attorney, accountant, financial advisor, or other Entity arising under or in connection with the Credit Documents or the transactions related thereto or contemplated thereby.
The “Retained Interest” carved out from the transfer was defined as follows:
the right retained by Seller to receive . . . payments or other distributions, whether received by setoff or otherwise, of cash (including interest), notes, securities or other property (including Collateral) or proceeds paid or delivered in respect of the Pre-Settlement Date Accruals or the Adequate Protection Payments (if any); provided that Retained Interest shall not include any PIK Interest.
“Adequate Protection Payments” was defined in the transfer agreements to be amounts (other than payment-in-kind interest) ordered to be paid by the bankruptcy court as adequate protection under an “Adequate Protection Order.” Finally, each seller agreed to indemnify the buyer (and pay its attorneys’ fees and expenses) if the buyer was forced to disgorge or reimburse any payments or property received by the seller in connection with the “Transferred Rights” or any other claim that the seller might have against Fabrikant.
In October 2007, Fabrikant’s official creditors’ committee sued the original lenders, seeking, among other things, to avoid the liens securing their pre-petition loans. The original lenders incurred substantial legal fees in connection with the litigation. When Fabrikant proposed a chapter 11 plan that failed to provide for payment of these legal fees, the original lenders objected to the plan. They contended that the legal fees constituted Reimbursement Rights that were Retained Interests not transferred to the buyers under the LSTA Standards and that the failure to provide for payment in full of the fees violated various provisions of the Bankruptcy Code governing plan confirmation. According to the original lenders, the Reimbursement Rights were not transferable because the rights: (i) do not qualify as “claims” under the Bankruptcy Code’s definition, which excludes claims that arise after the bankruptcy petition date, such as the Reimbursement Rights; (ii) are personal to the sellers, such that they could not have intended to transfer the rights while leaving themselves open to a lawsuit by the committee; (iii) are “counterclaims” expressly preserved for the original lenders in the court’s cash collateral order; and (iv) are future rights that cannot be assigned.
The Bankruptcy Court’s Ruling
Chief bankruptcy judge Stuart M. Bernstein overruled the objections to plan confirmation interposed by the original lenders, which had standing to object by virtue of their alleged Reimbursement Rights as administrative claims against the estate. In doing so, he rejected their arguments against a finding that the Reimbursement Rights were transferred to the current lenders as part of the loan-sale transaction, ruling, as a consequence, that the Reimbursement Rights need not be paid in full under the plan. Observing that the LSTA Standards represent an “all-encompassing assignment of rights,” Judge Bernstein concluded that the Reimbursement Rights fell squarely within the definition of “Transferred Rights.” Such rights, the judge emphasized, are contingent indemnification rights related to and arising in connection with the original loan documents or related transactions and therefore fall within the Bankruptcy Code’s broad definition of “claims” as well as the even broader category of rights or claims that qualified as Transferred Rights under the LSTA Standards. The judge found the original lenders’ remaining arguments to be unpersuasive, explaining that: (i) the Reimbursement Rights, which covered a much broader category of expenses than avoidance-litigation costs, were valuable to whomever held the debt, not merely the sellers; (ii) to the extent that such rights could be characterized as “counterclaims,” they were transferred by the original lenders along with the debt; and (iii) the Reimbursement Rights were not unassignable future rights because they were created prior to the debt-sale transaction.
Until Fabrikant, none of the definitions in the LSTA Standards had been tested by the courts. Judge Bernstein’s ruling indicates that the rights assigned to a buyer using the LSTA Standards are broad and include both contingent (and even post-petition) claims. The decision also fortifies the conventional wisdom that transfer documents should be drafted carefully to spell out explicitly which rights, claims, and interests are not included in the sale. Sellers, for example, that may be subject to lender liability exposure should ensure that they preserve reimbursement or similar rights by negotiating explicit carve-outs in connection with the sale transaction. Fabrikant represents yet another cautionary tale for distressed-market participants. Unlike the Enron rulings, however, which focus on the risk of equitable subordination or disallowance of claims asserted by an assignee or buyer based upon the seller’s misdeeds, the message borne by Fabrikant is “seller beware” rather than “caveat emptor.”