On September 3, 2014, the United States Court of Appeals for the Fifth Circuit entered an opinion vacating various orders of the United States Bankruptcy Court and District Court for the Southern District of Texas (the “Bankruptcy Court” and the “District Court”) in the bankruptcy cases of TMT Procurement Corporation and its affiliated debtors (the “Debtors”), including a final order approving the Debtors’ post-petition debtor in possession financing (the “DIP Order”) with Macquarie Bank Limited (the “DIP Lender”), notwithstanding that these orders contained findings that the DIP Lender had acted in good faith and was entitled to the protections of Sections 363(m) and 364(e) of the Bankruptcy Code.

Concern has been expressed that this opinion will put a chill on the willingness of lenders to enter into debtor in possession financing facilities in cases filed within the jurisdiction of the Fifth Circuit – Texas, Louisiana and Mississippi. We believe these concerns to be unfounded in the context of usual and customary debtor in possession financing.

The facts of TMT Procurement are complex and unusual. Vantage Drilling Company (“Vantage”), an offshore drilling company, entered into a business arrangement with a Taiwanese national, Hsin-Chi Su (“Su”) in consideration for which Vantage issued approximately 100 million shares of Vantage stock to F3 Capital (“F3”), an entity solely owned and controlled by Su, and granted Su three Vantage board seats. Relations soured and in 2012, Vantage brought litigation against Su in Texas state court1 alleging breach of fiduciary duty, fraud, fraud in the inducement, and other similar causes of action (the “Vantage Litigation”). As part of the relief requested in the Vantage Litigation, Vantage sought a constructive trust on all profits or benefits obtained by Su, including on the stock issued to F3.

Meanwhile, in 2013, the Debtors, twenty-three foreign marine shipping companies owned directly or indirectly by Su, filed for Chapter 11 relief in the Bankruptcy Court. Certain creditors of the Debtors moved to dismiss the cases, alleging the cases had been filed in bad faith, jurisdiction in the Southern District of Texas had been manufactured, and that the Debtors had no reasonable likelihood of reorganizing. It appeared that the Debtors, who were part of a larger international shipping company conglomerate, were attempting to thwart collection efforts by their foreign lenders. The Debtors had no connections or business operations with or in the U.S., no U.S. creditors and no assets in the U.S., other than certain legal retainers. A U.S. shell company had been set up on the eve of bankruptcy to lease office space in Houston.

At the evidentiary hearing on the motion to dismiss, in order to assuage the concerns of creditors and the Court that there was nothing to insure the Debtors’ compliance with Chapter 11, Su offered to place approximately 25 million of the Vantage shares held by F3 into escrow with the Bankruptcy Court to ensure the Debtors’ compliance with Court orders and to serve as collateral for post-petition financing. The Bankruptcy Court, in denying the motion to dismiss for all but two debtors, ordered that “non-estate property” with a fair market value of $40.75 million be provided to the estate, and that if not in all cash, at least 25 million shares of Vantage stock be included. This transaction was effectuated through a court-approved Escrow Agreement (the “Escrow Order”) by which F3 would deposit 25 million Vantage shares (the “Vantage Shares”) with the clerk of the Bankruptcy Court to be held in custodia legis for the benefit of the Debtors. F3 and Su represented that the Escrow Agreement did not violate any requirement or injunctive relief in the Vantage Litigation.

Vantage objected to all matters and relief. Vantage sought relief in the Vantage Litigation, but the District Court indicated that while Su could not sell, transfer, encumber or pledge the Vantage Shares without court permission, complaints about the encumbrance of Vantage Shares in the bankruptcy cases must be addressed to the Bankruptcy Court. Vantage also objected to all relief being requested in regards to the Vantage Shares in the Bankruptcy Court, appearing as a party-in-interest because it was not a creditor of any of the Debtors. The Bankruptcy Court overruled all objections posed by Vantage, and expressly determined that the Vantage Shares held by F3 were not subject to a constructive trust as a matter of law.

While Vantage was seeking interlocutory review of the Escrow Order, the Debtors filed an emergency motion seeking interim and final approval of a $20 million debtor in possession financing facility with the DIP Lender. Pursuant to both the interim and final DIP Order, the DIP Lender was (i) granted a first priority lien and security interest in the escrowed Vantage Shares, (ii) found to have extended the financing in good faith, and (iii) found to be entitled to the protections of Sections 363(m) and 364(e), which essentially provide that unless an order authorizing use, sale or lease of property of the estate or a post-petition financing order is stayed pending appeal, the reversal of such order does not affect the validity or enforceability of the sale or of any debts incurred or liens granted. The Bankruptcy Court further determined that no subsequent orders in the Vantage Litigation could impair the DIP Lender’s interests in the Vantage Shares, and that any rights of Vantage in the Vantage Shares were subordinate to those of the DIP Lender.

After entry of the DIP Order, the Bankruptcy Court ordered F3 to increase the escrowed Vantage Shares by an additional 4 million (collectively with the original 25 million shares, the “Vantage Shares”), and entered an order affirming the escrow agreement (the “Escrow Affirmation Order”) which provided that the Vantage Shares would remain under the control of the Bankruptcy Court.

Vantage was authorized to directly appeal the DIP Order and the Escrow Affirmation Order to the Fifth Circuit, where the appeal was consolidated with Vantage’s other related appeals. The Debtors sought to have Vantage’s appeal dismissed as moot under Sections 363(m) and 364(e) of the Bankruptcy Code.

As a threshold matter, the Court of Appeals had to determine if the appeal was moot under Sections 363(m) and 364(e) because Vantage had never obtained a stay pending appeal. Vantage argued that notwithstanding the findings of the Bankruptcy Court, the DIP Lender was not entitled to the protections of Sections 363(m) and 364(e) because it had not acted in good faith.

The Fifth Circuit analyzed the meaning of “good faith” under Sections 363(m) and 364(e), and determined that in the context of the statute sections, a good faith purchaser or a good faith lender is one who acts without notice of an adverse claim.2 While both Sections 363(m) and 364(e), by their very nature, contemplate knowledge of an objection and an appeal, the Court distinguished between knowledge of an objection to a transaction by a creditor and knowledge of an adverse claim asserted by a third party otherwise unrelated to the bankruptcy case in separate litigation with non-debtor third parties.

The Court then analyzed whether the DIP Lender had notice of an adverse claim. The Court determined that because Vantage had repeatedly asserted, before both the Bankruptcy and District Courts, that F3 had fraudulently obtained the Vantage Shares, the DIP Lender had notice of the adverse claim and did not come within the meaning of good faith as contemplated by Sections 363(m) and 364(e).

After determining that the appeal was not moot, the Court addressed Vantage’s arguments that neither the Bankruptcy Court nor the District Court had subject matter jurisdiction over either the Vantage Shares or the Vantage Litigation.

In regards to the Vantage Shares, the Court determined that they were not property of the estate under either Section 541(a)(1), (6) or (7). Clearly the Debtors had no legal or equitable interest in the Vantage Shares on the date the cases were commenced and the Vantage Shares were not some form of profit or proceeds from property of the estate, thereby eliminating Sections 541(a)(1) and (6).

The Court then analyzed whether the Vantage Shares constituted an interest in property acquired after the commencement of the case under Section 541(a)(7). The Court determined that the Vantage Shares did not meet the test for property of the estate under Section 541(a)(7). Firstly, property interests in bankruptcy are determined by applicable state law. The Vantage Shares had been deposited in escrow in custodia legis; however, F3 retained ownership and control over them. In fact, the Escrow Order had expressly required that “non-estate property” be deposited with the Bankruptcy Court. The fact that the Vantage Shares were used to collateralize a post-petition financing facility did not change the analysis as nothing prohibits non-estate property, such as letters of credit and surety bonds, from being used as collateral.

The Court then found that regardless of the state law issues, Section 541(a)(7) was premised on post-petition property becoming property of the estate when it is “created with or by property of the estate,” “acquired in the estate’s normal course of business,” or “traceable to or arise out of any prepetition interest included in the bankruptcy estate.” The Vantage Shares did not meet this test, and therefore, were not property of the estate. Because the Vantage Shares were not property of the estate, neither the Bankruptcy Court nor the District Court had subject matter jurisdiction to enter orders over them.

The Fifth Circuit next addressed the Vantage Litigation and whether the Bankruptcy Court and District Court had jurisdiction to adjudicate Vantage’s claims in the Vantage Litigation. The Debtors argued that the matters that had been adjudicated by the Bankruptcy Court were “related to” the bankruptcy cases and constituted core proceedings under 28 U.S.C. §157(b)(2)(A), (D) and (M). The Fifth Circuit made clear that regardless of whether a matter was core or non-core, a court still had to first have subject matter jurisdiction over the matter under 28 U.S.C. §1334. A matter is “related to” a bankruptcy proceeding if the outcome could conceivably affect the debtor’s estate. The Vantage Litigation – state law litigation to determine the rights of non-creditor Vantage over shares ostensibly owned by non-debtor F3 because of the alleged fraud of non-debtor Su – does not come under “related to” bankruptcy litigation just because the Debtors and F3 share a common owner. Nor does the definition of “core proceeding” cover unrelated and independent state court actions such as the Vantage Litigation.

Therefore, the Fifth Circuit determined that the Bankruptcy Court and District Court had improperly interfered with the Vantage Litigation by ordering that the Vantage Shares be deposited with the clerk of the Bankruptcy Court and by finding that no subsequent orders in the Vantage Litigation could impair the DIP Lender’s interests in the Vantage Shares, that any rights of Vantage in the Vantage Shares were subordinate to those of the DIP Lender and that the Vantage Shares were not subject to a constructive trust as a matter of law. These findings by the Bankruptcy and District Courts had clearly determined matters at issue in the Vantage Litigation to Vantage’s detriment.

Thus, the Fifth Circuit (i) denied the Debtors’ motion to dismiss the appeal; (ii) vacated the Escrow Order, the Escrow Affirmation Order and the DIP Order; and (iii) remanded for proceedings consistent with the opinion. What will happen on remand is as yet unknown. The Fifth Circuit’s interpretation of what constitutes post-petition acquired property of the estate under Section 547(a)(7) was not landmark, as it relied on its own 2008 opinion in In re McLain,3 as well as the opinions of other courts. Some commentators have expressed concern that a final debtor in possession financing order was vacated notwithstanding findings of good faith, thereby forever chilling the ability of debtors in Fifth Circuit jurisdictions to obtain debtor in possession financing. This “parade of horribles” seems unlikely. While it is certainly true that this DIP Lender has lost its collateral, most debtor in possession financing facilities are collateralized with property which is undisputedly property of the estate or within the court’s jurisdiction. A finding of good faith should be more than mere boilerplate in an order, and future debtor in possession lenders should take caution if their only collateral is not only not property of the estate but subject to litigation involving both non-debtors and non-creditors in another court.