Do Your Duty As You See It: Recent Decisions on Board Duties and Corporate Governance
Although fiduciary duties of boards of directors and corporate governance questions might initially seem like topics that should be covered on a Delaware Chancery Court blog, questions in these areas frequently arise in bankruptcy cases as well. So far this year on the Weil Bankruptcy Blog, we have examined a number of different board and corporate governance topics. In Is Your Child Controlling You? Delaware Bankruptcy Court Holds that Subsidiaries Can Owe Fiduciary Duties to their Parents, we discussed a United States Bankruptcy Court for the District of Delaware decision holding that subsidiaries can, and sometimes do, owe fiduciary duties to their parent corporations. Our post The Rural/Metro Decision and its Relevance to Reorganization examined when advisors to a board of directors may be liable for aiding and abetting a breach of fiduciary duty in consummating a merger. Bankruptcy waivers in an LLC operating agreement were the topic of the day in Wave Goodbye to Bankruptcy Waivers? (Court Rules LLC’s Prepetition Waiver of Bankruptcy Protection Contrary to Public Policy). Last but not least, in No Confirmation Without Representation: New Test Is Proposed for Approval of a Debtor’s Proposed Slate of Post-Confirmation Officers and Directors, we discussed a decision from the United States Bankruptcy Court for the Southern District of Texas holding that public policy requires that any proposed post-confirmation directors and officers adequately represent the reorganized debtor’s stakeholders and be able to run the reorganized entity “without self-dealing.”
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Is Your Child Controlling You? Delaware Bankruptcy Court Holds that Subsidiaries Can Owe Fiduciary Duties to Their Parents
“So make your life a little easier; When you get the chance, just take; Control”
– Janet Jackson We know that a corporate parent cannot use its control
over its subsidiary to deplete it of value and render the
entity insolvent. Veil-piercing and claims to recover fraudulent transfers or for breach of fiduciary duty (among others) can remedy such wrongful acts. But can a subsidiary corporation wrongfully manipulate its parent? If so, what is the remedy?
In Burtch v. Owlstone, Inc. (In re Advance Nanotech, Inc.),1 the United States Bankruptcy Court for the District of Delaware concluded that yes, children can control their parents, and yes, they can owe “upstream” fiduciary duties to their shareholders. Consequently, the parties controlling a transaction should take particular care in ensuring that they are aware to whom exactly they owe their duties and that the various parties to any transaction are all at appropriate arm’s length.
The facts in Owlstone are important. AVNA was an investment vehicle for several early stage companies, including Owlstone, Inc. Until 2007, AVNA owned approximately 60% of Owlstone’s stock. Then, in 2007 and 2008, AVNA issued notes secured by its Owlstone stock, the proceeds of which were downstreamed to Owlstone in the form of equity and debt, making AVNA the owner of 83.1% of Owlstone’s stock and holder of $2.64 million of Owlstone debt. Also in 2008, AVNA fired its own executives and hired Brett Bader and Thomas Finn, Owlstone’s CEO and CFO (respectively), to run AVNA.
Burtch v. Owlstone, Inc. (In re Advance Nanotech, Inc.), No. 11- 10776, Adv. No. 13-51215, 2014 WL 1320145 (Bankr. D. Del. Apr.
Not long after these transactions, as both AVNA and Owlstone were facing liquidity problems, the AVNA board tasked Bader and Finn with developing and implementing a strategy to raise funds for the cash-strapped entities. In the meantime, Ingalls & Snyder, LLC (“I&S”) provided AVNA with bridge loans aggregating $1.3 million. AVNA explored several restructuring options, including a conversion of the senior secured noteholders’ debt to equity and the issuance of new stock, but neither of these initiatives materialized. Finally, in November 2009, Owlstone issued additional stock to resolve its liquidity problems. Even though Owlstone noted in the stock offering that it would use a portion of the new funds to pay off the remaining intercompany debt owed to AVNA in cash, it instead satisfied the intercompany debt by assuming certain of AVNA’s obligations, including the I&S bridge loan and certain “deferred compensation” claims, including Bader’s, but not the claims of AVNA’s senior secured noteholders.
As a result of these transactions, AVNA ended up owning just 37.98% of Owlstone’s stock (down from 81.3%), while Owlstone assumed I&S’s and Bader’s claims against AVNA (indeed, Bader and Finn resigned from AVNA and continued their employment with Owlstone). A group of senior secured noteholders then commenced an involuntary bankruptcy proceeding against AVNA, and AVNA’s chapter 7 trustee brought an action against, among others, Owlstone, I&S, Bader, and Finn, alleging claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, and equitable subordination of Owlstone’s claims against AVNA – all relating to the underlying allegation that the defendants had reduced AVNA to a minority shareholder of Owlstone and assumed less than all of AVNA’s obligations, rendering AVNA insolvent, while keeping I&S and Bader safe by making Owlstone itself liable for those debts.
In ruling on the defendants’ motions to dismiss the trustee’s action, Judge Walrath recognized the principle under Delaware law that, as a general rule, no fiduciary relationship exists between a debtor and a creditor. However, citing to a 1983 decision from the United States Bankruptcy Court for the Eastern District of New York, the court also noted that a creditor is, in fact, a fiduciary of the debtor when it “exercises such control over the decision- making processes of the debtor as amounts to a domination of its will.” Accordingly, if any of the
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defendants had actually controlled AVNA, a fiduciary duty existed and could have been breached.
Turning specifically to the claims against Owlstone, the court again began by recognizing that under Delaware law, corporations generally do not owe duties to their shareholders, which would seem to suggest that Owlstone would not owe any duties to its shareholder – i.e., AVNA. However, the court concluded that Owlstone did, in fact, owe fiduciary duties to AVNA because – at least on the facts as alleged – it had actually controlled AVNA’s decision-making with respect to the transactions that allegedly rendered AVNA insolvent. And even though
one would generally assume that “subsidiaries are subject
Judge Walrath’s decision is a stern warning to corporate actors throughout an enterprise to respect corporate separateness and to be keenly aware of where their duties lie and in whose interests they should be sure to act.
The Rural/Metro Decision and Its Relevance to Reorganization
The recent decision by Vice Chancellor Laster of the Delaware Chancery Court, In re Rural/Metro Corp.
to the direction and control of their parent entities,” the
has generated substantial
court rejected that assumption, in light of the control that Owlstone, acting through Bader and Finn, had allegedly exercised over AVNA.
Importantly, the court noted that AVNA’s board’s decision to accept or reject the options put before it did not necessarily mean that AVNA acted of its own volition and outside of Owlstone’s control. Instead, the court concluded that the complaint had adequately alleged that Owlstone had controlled AVNA and its board because the fundraising process was exclusively assigned to Bader and Finn, who had allegedly (i) controlled the options that were put before the board; (ii) misled the board regarding the application of the proceeds of the new stock issuance; and (iii) “switched sides” and acted in Owlstone’s favor, rather than AVNA’s. This last factor was particularly pronounced in light of the benefits that Bader and Finn stood to realize from their proposed transaction by continuing their employment with Owlstone (and, at least in Bader’s case, by ensuring payment in full of $600,000 in deferred compensation).
Accordingly, the court concluded that the trustee had adequately pled that Owlstone, acting through Bader and Finn, had controlled AVNA and rendered it insolvent. Notwithstanding the fact that AVNA was Owlstone’s majority shareholder at the time, and had an apparently independent board of directors charged with acting in AVNA’s best interests, the court allowed the claims against Owlstone, Bader, and Finn to proceed. Even though it remains to be seen whether the trustee will be able to demonstrate that the defendants actually exercised this control over AVNA and its board in furtherance of their scheme to deplete AVNA’s assets,
interest and discussion within the legal and investment
banking communities. In that decision, the court held the principal investment bank advisor to the target company’s board of directors liable for aiding and abetting the directors’ breach of their fiduciary duties in consummating a merger and failing to disclose certain material information in connection therewith. Although not in the restructuring context, the decision, with its focus on the importance of conflicts disclosure and fair process to the integrity of a major corporate transaction, contains lessons with universal application.
Rural is a leading provider of ambulance and fire protection services throughout the United States. Prior to its take-private acquisition in the summer of 2011 (which became the subject of the relevant litigation), Rural was a public company with a clear, but not yet fully borne out, growth strategy. Its board was comprised of seven members, six of whom were facially independent and disinterested outside directors. Beginning in the summer of 2010, Rural’s board formed a special committee to explore acquiring Rural’s lone, national competitor, American Medical Response (AMR), a subsidiary of the publicly-traded Emergency Medical Services Corporation (EMS). EMS rejected Rural’s offer, but by the fall, Rural found itself on the receiving end of purchase offers by various private equity funds.
Rural rejected these offers, but the market’s interest in the emergency medical ambulatory space — and Rural
In re Rural/Metro Corp. Stockholders Litigation, 88 A.3d 54 (Del. Ch. Mar. 7, 2014).
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specifically — was not left unnoticed by certain of Rural’s directors. Specifically, a director, who also served as chair of the special committee, had been placed on the board as a result of his hedge fund’s investment. The court characterized this director’s fund’s return strategy as “taking concentrated positions in small-cap companies, obtaining influence, and then facilitating an exit in three to five years.” Accordingly, the court characterized his view of an “M&A event” as the “next logical step” in his fund’s involvement with Rural. Another director faced resignation for being “over-boarded,” or being a director on too many boards, and a Rural sale would relieve him of his role without penalty to his equity interests in Rural. Lastly, even the one director who initially resisted a sale — Rural’s CEO and President — ultimately concluded that a sale would be in his better interests because he hoped that new owners were more likely to support a long-term growth strategy of Rural’s business. Therefore, the court found that at least three of the directors had “personal circumstances that inclined them to a near-term sale” of Rural and that, although there were no allegations of breaches of the duty of loyalty, this was the “boardroom environment” at the time that an investment bank was brought on board to assist the special committee in considering strategic alternatives.
Consequently, in December 2010, the investment bank reached out to the hedge-fund affiliated director (with whom it had a prior relationship) and the CEO and President to inform them that EMS was officially “in play” and that certain private equity funds viewed Rural as a strategic partner in the acquisition. Internally, the investment bank realized that a private equity firm that acquired EMS could either (a) sell AMR to Rural or (b) seek to purchase Rural. It recognized that it could “use its position as sell-side advisor” to Rural to secure buy-side roles (financing) to a bidder for EMS.
In any event, the hedge fund-affiliated director advised the board of what was happening with respect to EMS, and outlined three strategic alternatives for Rural in light of those facts: (i) sticking with Rural’s current standalone business plan; (ii) pursuing a sale of Rural; and (iii) pursuing an acquisition of AMR. Although he professed no preference for any one strategy, he did recommend that Rural’s board approve reconstitution of the special committee and retention of advisors to help its exploration. At that meeting, the director also took over as chairman of the board.
What exactly happened next became the subject matter of a four day trial. In short, the court found that the hedge- fund affiliated director took control of the process, and convinced the special committee – rather than the board – to retain the investment bank as its advisor to explore various strategic alternatives, including the possibility of a Rural sale in which the investment bank could provide staple financing to potential buyers. Generally speaking, staple financing is a pre-arranged financing package offered to potential bidders in an acquisition by the investment bank advising the selling company. In these scenarios, the investment bank has the opportunity to not only make fees in its stead as an advisor, but also in its role as a lender. In the Rural case, the court determined that if the investment bank were able to take a piece of all sides in any EMS/Rural deal, it could have earned up to
$60.1 million in fees — rather than simply $5 million in advisory fees for its representation of Rural. The court found this to be a “powerful reason” for the investment bank to “take steps to promote itself as a financing source at the expense of its advisory role” from the very beginning of its engagement. Indeed, the board minutes reflected that Rural’s counsel advised the board that it would have to be “active and vigilant” in ensuring the integrity of the process given the possibility of a conflict of interest for the investment bank. The board, however, did not authorize the special committee to hire a “‘sellside’ advisor or initiate a sale process. It only authorized the special committee to retain the investment banker to analyze the range of strategic alternatives available and make a recommendation to the board.”
Shortly after the investment bank’s retention and without the board’s approval, the hedge-fund affiliated director and the investment bank quickly put Rural “in play.” From the court’s perspective, the investment bank created a “parallel-process” that favored its interest in fee maximization, despite the “readily foreseeable” problem that financial sponsors who participated in the EMS process would be limited in their ability to consider Rural simultaneously because they would be constrained by confidentiality agreements they signed as part of the EMS process. At the same time, another investment bank advisor to Rural provided management with a presentation that concluded it was premature to sell the business and that it should execute on a long term growth strategy that would ultimately ensure that, when and if it was sold, it would obtain the highest price possible.
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Neither the members of the special committee nor the board were provided with this report.
After receiving six bids of interest, the special committee
— not the board — held a meeting to discuss each and relevant next steps. One of the potential bidders had won the EMS process and asked to push back the bid deadline for Rural so that certain of the confidentiality issues could be resolved. However, other bidders refused to agree to such an extended process, as that would result in increased competition (and an increased price) for Rural.
The board was finally called to convene and discuss the offers approximately three months after the investment bank had initiated the sellside process. To the court, it was clear from the evidence presented that counsel to Rural was concerned that the process was not “defensible.” The investment bank did not provide a valuation analysis to the board and the minutes falsely claimed that the special committee had held formal meetings to discuss the various bids. The board considered extending the deadline for bids, but declined same in fear of losing other bidders. At the same time, the investment bank sought internal approval to fully underwrite a deal with the entity it had identified as the likely winner in any auction. It did not disclose this fact to the board.
Ultimately, the board received two bids — one from the bidder for which the investment bank sought to provide staple financing (which the bidder did not include as part of its bid) and the other from the entity that had won the EMS acquisition. The latter bidder, however, asked for additional time as it was unable to fully commit to a Rural transaction until it had closed on the EMS deal. It expressed its continued belief that a merger with it would have resulted in the highest price for Rural shareholders, but, in the court’s view, this was no longer relevant to the investment bank, who “just wanted a deal” to close. It was at this time that the interests of the investment bank and the hedge-fund affiliated director diverged. The director believed that Rural merited a higher sale price per share than what the investment bank’s preferred bidder had offered. The investment bank did not provide a valuation opinion, but rather circulated a one-page transaction summary that compared the metrics implied by the preferred bidder’s offer to the “metrics implied by Rural’s closing market price” of the previous day, which made the offered price look “great in comparison.” The
special committee therefore authorized the investment bank to engage in final negotiations over price with the preferred bidder. The investment bank again did not disclose that it was seeking to provide staple financing to the deal if its preferred bidder won.
The preferred bidder increased its offer slightly to get the board of directors to a “quick consensus” on approving the sale, but said its offer would expire within three days. At this time, the investment bank made a “final push” to provide the staple financing, while also providing the fairness opinion (which, it again, did not disclose). It ultimately provided a written (and ultimately found to be defective) valuation analysis to the board less than twelve hours prior to the offer’s expiration. The board approved the merger. Shortly after its public announcement, shareholder litigation challenging the transaction was filed. The deal closed ultimately with 72% of shareholder approval.
The Court’s Legal Analysis
Prior to reaching the merits of the plaintiffs’ allegation that the investment bank aided and abetted a breach of the directors’ fiduciary duties on two grounds (defective process and materially false disclosures), the court faced a factual conundrum — the individual board members had settled with plaintiffs prior to the trial, but a predicate element of finding the investment bank liable was determining that the directors had breached their fiduciary duties in the first instance. Because judicial review of directors’ decisions in the M&A context in cash for stock deals requires “heightened scrutiny” under Delaware law, the burden of persuasion is generally on the director- defendants to show that their “actions were reasonable in relation to their legitimate objectives.” In order to do so, directors generally have to establish the reasonableness of the process employed and the actions taken in light of the particular circumstances at issue. Because, however, the claim was for aiding and abetting, the court explained that the burden of proof rested with the shareholders.
The investment bank argued that the exculpatory provisions in Rural’s certificate of incorporation barred the plaintiffs from proving a breach. Pursuant to section 102(b)(7) of Delaware General Corporation Law, a Delaware corporation may provide for the elimination of a director’s personal liability for monetary damages resulting from his or her breach of the fiduciary duty of care. The court clarified, however, that the existence of
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such an exculpatory provision does not eliminate the underlying duty of care; rather it places a limitation on liability. Further, the court explained that the exculpatory provisions only protect directors, and not aiders and abettors. Therefore, the investment bank could not rely upon the exculpation provisions to foreclose a determination of the predicate breach.
Given the evidence presented, the court determined that certain decisions by the board fell outside the range of reasonableness. The court explained that, in merger proceedings, a board cannot be passive. Rather, its members must be active, informed, and knowledgeable participants that consider all alternatives, and have a “reasonable understanding” of the value of engaging in the transaction — as well as not engaging in the transaction at all. The court further noted that adequate time to consider the terms of a transaction is essential as “[h]istory has demonstrated [that] boards [that] have failed to exercise due care are frequently boards that have been rushed.” Lastly, the court emphasized that an essential element of being active and engaged includes providing “direct oversight” of advisors and to “learn about actual and potential conflicts faced by directors, management and their advisors.” Because of the “central role” played by investment banks as “gatekeepers” in the M&A process, this oversight requirement is of even greater importance.
The court found that there were a number of errors committed by the board in the sale process, such as (i) the fact that the board had never actually authorized the investment banker or the special committee to pursue a sale (and yet permitted its pursuit); (ii) its deference to the hedge-fund affiliated director in pursuing a sale transaction in the first instance; and (iii) the failure of the board to oversee the investment banker’s actions in conducting the sale. Indeed, the court characterized certain of the investment bank’s ostensibly deceptive actions (such as its “secret lobbying” to provide staple financing to the successful bidder) as being the direct result of the board’s “failure to place meaningful restrictions” on it. The court concluded that it was the combination of the investment bank’s “behind the scenes maneuvering, the absence of any disclosure to the board” of same, and the “belated and skewed valuation deck” provided by the investment bank that caused the board’s decision to approve the successful bid to “fall short” under the heightened scrutiny standard. Because the process
was defective, the court reasoned, the directors’ actions were unreasonable.
Turning to whether the investment bank knowingly assisted the board in breaching its fiduciary duties, the court found that it was not essential to establish the investment bank’s fraudulent intent or self-dealing; purposeful inducement was enough. Because the investment bank’s actions were a “substantial factor” in the directors’ breach and the investment bank “created the unreasonable process and informational gaps” that lead to the breach, the court found that the investment bank knowingly participated in the breach. Further, the court determined that the investment bank’s engagement letter — which disclosed its potential interest in providing such staple financing in generic, rather than specific, terms — was not adequate disclosure under the circumstances and could not be used as a general “non- reliance disclaimer.”
Lastly, the court had to determine whether the shareholders were damaged by the aided-and-abetted breach. The court found that the evidence at trial established that the price paid for Rural’s stock at the time of the sale exceeded the successful bidder’s price. The court determined that Rural was taken to a fabricated and uncompetitive market prematurely, and that its going concern value exceeded what stockholders received on the merger, establishing the requisite harm.
As to plaintiffs’ disclosure claims, the court found that the plaintiffs established that the investment bank’s valuation analysis and failure to fully disclose its conflicts of interest were additional grounds for finding aiding-and- abetting breach. As the court noted “a disinterested board with a disinterested advisor” would likely not have reached the same conclusions that the Rural board reached.
In closing, the court determined that it was not yet ready to fashion a remedy, but asked for additional briefing and revised evidence on damages, claims for contribution by the investment banker against the directors, and the plaintiffs’ request for fee shifting.
The Bankruptcy Take-Away
Advisors in bankruptcy are familiar with the disinterestedness provisions of the Bankruptcy Code. Under well-established precedent, the general rule to establish disinterestedness is “disclose, disclose,
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disclose!” Further, directors of debtors in possession understand that their fiduciary obligations flow to the estate and its stakeholders. Accordingly, per well- established precedent, the best practice is to ensure that both the process and the actions taken are reasonable, based on informed judgment, and consistent with one’s fiduciary and professional responsibilities. Interestingly, in the context of sales or mergers in bankruptcy, the Rural/Metro decision could potentially be used by constituents challenging the debtor’s business judgment to advocate for a more careful review of a board’s decision. Where there are potential conflicts of interest, some may advocate that such additional review is appropriate to ensure that the estate receives the highest and best price. Ultimately, time will tell what the effect, if any, Rural/Metro may be in the context of bankruptcy law. The Weil Bankruptcy Blog will provide updates as additional information on the case unfolds.
Rural/Metro commenced cases for chapter 11 bankruptcy in the Delaware Bankruptcy Court on August 4, 2013. Its plan of reorganization, which gave equity to creditors in the reorganized business and cancelled existing equity interests, became effective as of December 31, 2013. It continues to operate today.
Wave Goodbye to Bankruptcy Waivers? (Court Rules LLC’s Prepetition Waiver of Bankruptcy Protection Contrary to Public Policy)
Erika del Nido
Secured creditors naturally want to be repaid. Sometimes secured creditors go as far as asking a debtor to waive its right to seek bankruptcy protection. Although such clauses are frequently held to be unenforceable, we
previously have discussed3 exceptions for LLCs. A recent
case from the United States Bankruptcy Court for the
District of Oregon, In re Bay Club Partners-472, LLC,4 joins the debate, albeit holding just the opposite — an “astute creditor’s” “cleverly insidious” bankruptcy waiver in an LLC operating agreement is not enforceable.
Bay Club Partners-472, LLC is a limited liability company that was formed to renovate and operate an apartment complex in Arizona. Prepetition, Legg Mason Real Estate CDO I, Ltd.’s predecessor loaned $23.6 million to Bay Club for the purchase of the apartment complex, and several years later, Bay Club defaulted.
Bay Club is a “member-managed” LLC organized under the laws of Oregon, which means that any matter relating to the LLC’s business may be exclusively decided by the manager. Although Bay Club’s LLC operating agreement grants broad authority to the manager, it contains a “Special Purpose Entity Restriction,” which provides that Bay Club “shall not institute proceedings to be adjudicated bankrupt or insolvent … or file a petition seeking … relief under any applicable federal or state law relating to bankruptcy” until such time as the Legg Mason loan has been repaid in full. Prepetition, Legg Mason requested the inclusion of this provision in Bay Club’s operating agreement.
In January 2014, Bay Club sought chapter 11 protection in the United States Bankruptcy Court for the District of Oregon. Bay Club’s chapter 11 petition was signed by its manager, and a consent resolution was prepared that reflected the support of three of four of Bay Club’s members, constituting 80% of the membership interests. Trail Ranch Partners, LLC, a 20% member owner of Bay Club, opposed the bankruptcy filing.
Legg Mason filed a motion to dismiss Bay Club’s chapter 11 case for cause pursuant to section 1112(b) of the Bankruptcy Code, arguing that Bay Club’s LLC operating agreement prohibited the bankruptcy filing and that Bay Club’s manager was not authorized to file for bankruptcy absent approval of 100% of the LLC members. Trail Ranch joined Legg Mason’s motion to dismiss.
See Chapter 11? No Thank You! Courts Find Restrictions on Bankruptcy Filings in LLC Agreements Enforceable dated April 20, 2011 on the Weil Bankruptcy Blog.
In re Bay Club Partners-472, LLC, No. 14-30394-RLD11, 2014 WL 1796688, slip op. (Bankr. D. Ore. May 6, 2014).
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Legg Mason Has A Leg To Stand On
Bay Club argued that Legg Mason, as a creditor, lacked standing under section 1109(b) of the Bankruptcy Code to prosecute its motion to dismiss the case. The bankruptcy court acknowledged that courts are split on whether creditors have standing to challenge corporate bankruptcy filings as unauthorized. Some courts have held that section 1109(b)’s “expansive” language provides for standing (“[a] party in interest, including … a creditor … may raise and may appear and be heard on any issue in a case under this chapter”). In contrast, other courts have held that creditors lack standing, based on a pre- Bankruptcy Code Supreme Court decision in Royal Indem.
Co. v. Am. Bond & Mortg. Co.,5 and based on such courts’
concern that creditors are seeking dismissal out of self- interest and not the best interests of all creditors. The Bay Club court observed that, in the Ninth Circuit, only those “who are directly and adversely affected pecuniarily” by an issue before the bankruptcy court have standing to challenge requested relief, citing the Ninth Circuit’s decision in Fondiller v. Robertson (In re
Fondiller),6 which held that an insolvent debtor does not
have standing to appeal order affecting the size of his estate because such order would not diminish debtor’s property or affect his rights.
Applying the plain language of section 1109(b) and the Fondiller standard, the court found that Legg Mason, as the primary (and possibly only) secured creditor, had “a direct pecuniary interest” in whether Bay Club can proceed in chapter 11 and concluded that it had standing to prosecute the motion to dismiss.
Bay Club Sails Into Bankruptcy
Turning to the prepetition waiver of the right to file a bankruptcy case, the court commented that the Ninth Circuit “has been very clear” that such waivers are unenforceable as a violation of public policy. Without such a rule, creditors likely would always require debtors to waive their bankruptcy rights. According to the court, the fact that the bankruptcy waiver was contained in the
operating agreement, as opposed to the loan agreement, was a “cleverly insidious” “maneuver of an ‘astute creditor.’” The court held that the provision is unenforceable as a matter of public policy.
Next, after holding the bankruptcy waiver unenforceable, the court turned to the question of whether Bay Club’s chapter 11 filing was authorized. Referring to the manager’s broad authorities in the operating agreement, the court concluded that the manager’s attempts to seek approval from all members was merely an effort to avoid disputes such as the motion to dismiss, but it did not detract from the manager’s powers to “take all actions necessary to further the business interests of Bay Club.” In denying the motion to dismiss, the court held that the manager had the authority to commence Bay Club’s chapter 11 case and that the case was properly authorized.
Courts are wavering on bankruptcy waivers! Bay Club Partners reminds us that some “bankruptcy remote” provisions carry a not-so-remote risk that the court will find the provision unenforceable and contrary to public policy. Although the case contributes to the dialogue on bankruptcy waivers, it likely is not the last word. What bankruptcy waiver provisions are reasonable? Where is the line between legitimate creditor protection and a violation of public policy? Do small LLC’s and large companies face different rules? Who has standing to enforce such provisions? We will keep you informed of the latest developments.
289 U.S. 165, 171 (1933) (holding that creditors lack standing to challenge an adjudication entered upon a voluntary bankruptcy petition on the grounds that such petition violated shareholders’ rights).
6 707 F.2d 441, 442 (9th Cir. 1983).
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No Confirmation Without Representation: New Test Is Proposed for Approval of a Debtor’s Proposed Slate of Post-Confirmation Officers and Directors
“I’ll be representing, representing”
– Ludacris feat. Kelly Rowland Section 1129 of the Bankruptcy Code is chock full of
requirements for confirming a plan of reorganization.
Most plan proponents are aware of the requirement that they must identify any individuals expected to serve as a director, officer, or voting trustee of the reorganized debtor, as set forth in section 1129(a)(5)(A)(i) of the Bankruptcy Code. Often taken for granted, however, is subsection (ii), which mandates that any such appointments (or proposed continuation of service) be “consistent with the interests of creditors and equity security holders and with public policy.” But what exactly does this mean? Under what circumstances would the proposed leadership of the reorganized debtor be so problematic as to warrant a denial of confirmation?
In a recent decision, Chief Judge Bohm of the United States Bankruptcy Court for the Southern District of Texas was faced with this very question. Given the relative paucity of case law on point, Judge Bohm explored the contours of this requirement and offered a series of factors to be considered in determining whether the proposed post-confirmation management would call for rejection of an otherwise confirmable plan.
In In re Digerati Technologies, Inc.,7 the debtor proposed a plan of reorganization pursuant to which the debtor’s CEO and CFO would continue to serve as the sole officers and directors of the debtor, a publicly-traded holding company. Two of the debtor’s other shareholders objected to the plan, arguing that the debtor’s self-dealing necessitated better oversight and that the continued employment of the CEO and CFO was not in the best
interest of the estate and failed to satisfy public policy. Moreover, the proposed plan did not propose to appoint any new independent directors, and the plan proposed to assume the officers’ lucrative employment agreements, which the shareholders argued was inconsistent with their interests.
In addressing the shareholders’ objection, Chief Judge Bohm recognized the paucity of case law dealing with the “public policy” requirement in connection with the appointment of the reorganized debtor’s directors and officers. Indeed, even the decisions that did address this requirement did not include extensive analysis of what this “public policy” requirement actually means.
Importantly, one of the cited cases, In re Machne Menachem, Inc.8 recognized the specific requirement that the appointment of the reorganized debtor’s new leadership – and not just the overarching plan of
reorganization – be consistent with public policy. For example, in that case, the bankruptcy court specifically concluded that it would be in the public’s overall interest to confirm the proposed plan and reopen the debtor, a children’s summer camp with a “noble purpose” and which enjoyed great support from the community. Because, however, the plan’s proposed procedures for appointment of new board members conflicted with the New York law governing not-for-profit corporations, the court concluded that the plan conflicted with public policy and could not be confirmed.
Also of note, the court in Machne Menachem cited to legislative history regarding the term “public policy,” noting that the Senate Report accompanying the Chandler Act (i.e., the Bankruptcy Act of 1938) commented that the revisions to the Bankruptcy Act “direct[ed] the scrutiny of the court to the methods by which the management of the reorganized company is to be chosen, so as to ensure, for example, adequate representation of those whose investments are involved in the reorganization.”
Given the minimal case law discussing when the appointment of proposed directors and officers would conflict with public policy, Chief Judge Bohm, guided by the existing case law and the legislative history cited in Machne Menachem, concluded that public policy mandates that any proposed post-confirmation directors
7 In re Digerati Technologies, Inc., No. 13-33264 (JB), 2014 WL 2203895, slip op. (Bankr. S.D. Tex. May 27, 2014).
8 304 B.R. 140 (Bankr. M.D. Pa. 2003).
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and officers must adequately represent the reorganized debtor’s stakeholders and must be likely to run the company competently and without self-dealing, and that for the reasons noted above, he could not confirm the debtor’s plan because the continued service by the CEO and CFO would violate public policy. Moreover, the appointment and service of the directors and officers must not conflict with existing state law. In light of these public policy goals, Chief Judge Bohm proposed that courts considering this public policy requirement in section 1129(a)(5)(A)(ii) be guided by the following nine non- exhaustive factors:
￭ Would the proposed plan keep the debtor in existence as a going concern?
￭ Is the debtor publicly-held or privately-held?
￭ Would continue service by the debtor’s leadership “perpetuate incompetence, lack of direction, inexperience, or affiliations with groups inimical to the best interests of the debtor?”
￭ Would the individual provide adequate representation of all creditors and equity holders?
￭ Does the proposed retention violate state law?
￭ Is the individual “disinterested”?
￭ Is the individual “capable and competent to serve” in the proposed capacity?
￭ Are salaries and benefits reasonable based on the debtor’s circumstances?
￭Areanynewindependentdirectorsbeingappointed? To be sure, this nonexclusive list of factors may yet be
supplemented, revised, or ignored by other courts. And, as with any multi-factor balancing test, application of these questions is more of an art than a science. But plan proponents would be well-advised to consider these questions in determining who is proposed to lead the reorganized debtor and in whose interest’s management should act when establishing a path out of chapter 11.
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In this section:
￭ A Recent Decision in the Fisker Case Brings New Life to the Credit Bidding Debate, dated January 27, 2014
￭CreditBiddingCappedAgain:The Fisker Factors Create a “Perfect Storm” in Virginia, dated April 22, 2014
￭ The Post-Fisker Credit Bidding Debate Continues: Two More Decisions Leave Unanswered Questions about the Significance of Fisker, dated May 19, 2014
Credit Bidding: A Rocky Start in 2014
The first half of the year brought a group of new decisions limiting creditor rights to credit bid their debt in bankruptcy, raising questions about the scope of this important right. The year started with the Fisker Automotive case in January, where Judge Gross limited a secured creditor’s right to credit bid its debt in connection with a sale of Fisker’s assets. As we wrote in A Recent Decision in the Fisker Case Brings New Life to the Credit Bidding Debate, Judge Gross’s decision surprised many in the restructuring community, and observers questioned whether Judge Gross redefined what constitutes sufficient “cause” to limit or deny credit bidding. Others argued that the Fisker decision was nothing more than an application of long-established law to unfavorable facts. The Weil Bankruptcy Blog has continued to follow post- Fisker decisions limiting credit bidding, including in Credit Bidding Capped Again: The Fisker Factors Create a “Perfect Storm” in Virginia and The Post- Fisker Credit Bidding Debate Continues: Two More Decisions Leave Unanswered Questions about the Significance of Fisker. These post-Fisker decisions have done little to answer these questions, however, and do not clarify the significance of Judge Gross’s decision. In light of the unanswered questions, some predict that we may see another credit bidding decision make its way up to the Supreme Court. As always, we will keep you posted!
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A Recent Decision in the Fisker Case Brings New Life to the Credit Bidding Debate
We previously blogged1 about the Supreme Court’s 2012 decision2 upholding a secured lender’s general right to credit bid in a plan sale — a unanimous decision resolving a split among the Third, Fifth, and Seventh Circuits. Judge Gross’ recent ruling in In re Fisker Automotive Holdings, Inc., Case No. 13-13087 (Bankr. D. Del. Jan. 17, 2014) [Docket Nos. 482–83] may, however, revive the
credit bidding debate with a focus on when a court can limit a lender’s statutory right to credit bid “for cause.”
Credit Bidding – A Brief Overview
A secured lender’s ability to credit bid its claim when its collateral is sold in a bankruptcy case is a fundamental right provided by section 363(k) of the Bankruptcy Code that not only reduces a lender’s need for liquidity at the time of the sale, but ensures that the collateral pledged to the lender is not sold for less than the amount of such lender’s secured claim. Nevertheless, section 363(k) of the Bankruptcy Code also provides that a court may abrogate a lender’s right to credit bid “for cause.” What constitutes cause is not defined in the Bankruptcy Code and is thus left for courts to determine on a case-by-case basis.
Some courts3 have found cause exists to deny credit bidding when there is a formal dispute as to the validity or
See RadLAX: The Decision Is In – Supreme Court Rules That a Secured Lender Must Be Permitted To Credit Bid If Its Collateral Is Sold Pursuant To a Chapter 11 Plan dated May 29, 2012 on the Weil Bankruptcy Blog. RadLAX Gateway Hotel, LLC v. Amalgamated Bank, 132 S. Ct. 2065 (U.S. 2012). See, e.g., In re L.L. Murphrey Co., No. 12-03837-8-JRL, 2013 WL
2451368 (Bankr. E.D.N.C. June 6, 2013), slip op. at *5 (finding that cause existed to deny a lender the right to credit bid because the allegations advanced by the trustee in the draft adversary complaint submitted to the court showed that the basis of such creditor’s claim was clearly disputed); Morgan Stanley Dean Witter Mortg. Capital, Inc. v. Alon USA LLP (In re Akard Street Fuels), No. 3:01-CV-1927-D, 2001 U.S. Dist. Lexis 21644 (N.D. Tex. Dec. 4, 2001) (denying the right to credit bid
the amount of a creditor’s claim or lien or when a rapid sale of the assets is necessary to preserve value. Under similar conditions, other courts4 have preferred to allow credit bidding subject to certain limitations intended to
protect the estate in the event that a creditor’s secured claim or lien turns out to be invalid. Some of these limitations have included directing a creditor to (i) place cash in the amount of all or part of the bid in an escrow account; (ii) furnish an irrevocable letter of credit equal to the disputed amount; or (iii) post a bond equal to the disputed amount. In deciding whether to impose
conditions on credit bidding, courts have considered5 (i)
the effect credit bidding will have on the estate; (ii) whether other claimants will be harmed should a lender’s disputed claim later be disallowed; and (iii) the practical effect that such conditions will have on the secured creditor.
Still, although denying and/or limiting a secured lender’s right to credit bid is not uncommon, Judge Gross’ recent decision to cap a credit bid in In re Fisker at the amount the secured lender paid for the claim on the secondary market came as a surprise to many observers.
when there were complex issues surrounding the validity of the creditor’s liens and a rapid sale of the assets was necessary to preserve value).
See, e.g., In re Octagon Roofing, 123 B.R. 583, 589 (Bankr. N.D. Ill. 1991) (finding that there was no cause to deny credit bidding, but that a secured creditor was required to post an irrevocable letter of credit drawn on another bank to protect the trustee if such creditor’s disputed mortgage was set aside as a preference); Neptune Orient Lines v. Halla Merchant Marine Co., No. 97-3828, 1998 U.S. Dist. LEXIS 3745, at *18 (D. La. March
20, 1998) (requiring a secured creditor to post a bond equal to the disputed amount to provide possible recourse for other claimants).
See, e.g., In re Merit Group, Inc., 464 B.R. 240, 255 (Bankr. D.
S.C. 2011) (noting that there was “no evidence or indication that the estate would suffer measurable harm” if the creditor does not credit bid); In re Akard Street Fuels, at *15 (determining that cause existed to disallow credit bidding because the time it would have taken to resolve the existing claim dispute would have undermined the need to prevent a sharp decline in the value of the estate through a rapid sale of the debtor’s assets); Neptune Orient Lines, at *18 (noting that, although it was unlikely that the mortgage would be found defective, posting a bond would provide recourse for the other claimants should that be case).
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The Fisker Decision
Prior to filing for protection under chapter 11 in November of 2013, the debtors in In re Fisker were equipment manufacturers of plug-in hybrid electric vehicles. In 2010, the United States Department of Energy (DOE) extended to the debtors a secured loan, $168 million of which remained outstanding when the DOE sold the loan to Hybrid Tech Holdings, LLC (Hybrid) for $25 million in October 2013. Following the DOE auction, the debtors agreed to sell all of their assets to Hybrid in exchange for a credit bid of $75 million. To that end, the debtors filed a sale motion seeking court approval of the private sale to Hybrid and arguing that the cost and delay that would result from an auction process would be unlikely to increase value for the debtors’ estates.
The recently-appointed Official Committee of Unsecured Creditors immediately opposed the motion and proposed, instead, a competitive auction, noting that Wanxiang America Corporation (Wanxiang) had already expressed interest in Fisker. Because Wanxiang had recently purchased certain assets of A123 Systems, a seller of lithium ion batteries (a primary component of Fisker cars), the Committee argued that Wanxiang had a genuine interest in purchasing Fisker and, more importantly, that its offer would encourage competitive bidding.
Importantly, at the January 10, 2014 hearing on the disputed sale motion, the debtors and the Committee announced several stipulated agreements to limit the areas for dispute, including, among other things, that: (i) if Hybrid’s credit bid was capped or denied, there would be a strong likelihood of an auction that would create substantial value for the estates; (ii) if Hybrid’s credit bid was not capped or denied, Wanxiang would not place a bid and there would be no realistic possibility of a competitive auction; (iii) the highest and best value for the estates would be achieved only through the sale of all of the debtors’ assets as an entirety; and (iv) a material portion of the assets being sold were not subject to a property perfected lien in favor of Hybrid or were subject to a lien in favor of Hybrid that is in bona fide dispute.
Judge Gross ultimately limited Hybrid’s credit bid to what Hybrid paid for the DOE loan — $25 million — and ordered an auction of the debtors’ assets. He provided three bases for his ruling. First, Judge Gross emphasized that if he did not limit Hybrid’s credit bid, the auction process would not only be chilled, but it would likely not occur at all, which
would undermine the importance of promoting a competitive bidding environment. Second, he noted that because Hybrid’s claim is partially secured, partially unsecured, and partially of uncertain status, it would not be unprecedented to limit credit bidding in this case. Third, in issuing his decision, Judge Gross criticized the timing of the proposed sale, noting that the debtors provided a mere 24 business days for parties-in-interest to challenge the sale motion and even less time for the Committee (given its late appointment). The court highlighted that neither the debtors nor Hybrid were able to provide a satisfactory reason for why the sale of a non- operating debtor required such haste. Indeed, Judge Gross stated that “it is now clear that Hybrid’s ‘drop dead’ date … was pure fabrication” and found that the proposed sale timing on which Hybrid insisted was “inconsistent with the notions of fairness in the bankruptcy process.”
The decision to cap the bid has been criticized by some (including Hybrid) as being in direct conflict with Third Circuit law allowing secured creditors to bid the full amount of their claim. Following the ruling (and before the court’s order was entered), Hybrid filed an emergency motion seeking leave to appeal and a motion for expedited consideration of the foregoing arguing, among other things, that the court’s opinion “attempts to sidestep recent Supreme Court precedent reiterating the significant role of credit bidding.” Hybrid also asserted that the court issued its decision based on “no facts whatsoever” regarding the legitimacy of Hybrid’s claim and that neither the Supreme Court nor the Third Circuit has addressed whether a bankruptcy court can limit a credit bid to the purchase price of the claim. The court has yet to rule on Hybrid’s appeal.
Consistent with its opinion, on January 23, 2014, the court entered an order establishing February 7, 2014 as the deadline to submit bids for the debtors’ assets and February 12, 2014 as the auction date.
The Fisker decision, if not overturned, could have serious implications for future auctions and for the claims trading market in general. Indeed, at the hearing Judge Gross stated that the bankruptcy auction would, among other things, help determine whether the price paid for the DOE loan was in fact “fair and reasonable and in the best interests of the debtors’ estates.” It is unclear whether under the Fisker decision, the interest of promoting a fair auction is by itself sufficient cause to limit credit bidding
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without the additional factors of liens being in dispute and the secured creditor’s insistence on an unfair process. Would two of the three factors be sufficient? The wheels will be turning as bankruptcy practitioners test the limits of the ruling, and we will be watching to see how this plays out in Fisker and future cases.
Credit Bidding Capped Again: The Fisker Factors Create a “Perfect Storm” in Virginia
The highly publicized Fisker credit bidding decision has received much attention on our blog.6 As we previously wrote, while some may argue that post-Fisker credit bidding concerns are unwarranted, the decision at least raises the question of what constitutes sufficient “cause”
to limit credit bidding. Well, it did not take long for the first Fisker domino to fall.
The issue resurfaced last week when Judge Huennekens, United States Bankruptcy Court Judge for the Eastern District of Virginia, entered his Memorandum Opinion7 citing to Fisker as support for his decision to cap a secured lender’s ability to credit bid in the bankruptcy case of Free Lance-Star Publishing Co. Although some of the same factors that existed in Fisker existed in that case (a less- than-complete collateral package, inequitable conduct on the part of the secured creditor), the court’s very harsh
language directed at the mere use of a loan-to-own strategy may have distressed debt investors fearing a Fisker avalanche.
The Free Lance-Star is a family owned publishing, newspaper, radio, and communications company located in Fredericksburg, Virginia. In 2006, the debtors borrowed approximately $50.8 million from Branch Banking and Trust (BB&T). As security for the loan, the debtors granted liens on, and security interests in, certain of the
See A Recent Decision in the Fisker Case Brings New Life to the Credit Bidding Debate dated January 27, 2014 and Fisker Credit Bid Controversy Update: Hybrid Leave to Appeal Denied; Wanxiang Wins Auction; Court Approves Sale dated February 20, 2014 on the Weil Bankruptcy Blog. The Free Lance-Star Publishing Co. of Fredericksburg, VA, 512
B.R. 798 (Bankr. E.D. Va. 2014).
debtors’ real and personal property, but not on the parcels of real estate known as the “Tower Assets.” Subsequently, due to strained economic conditions, Free Lance-Star fell out of compliance with certain of its loan covenants.
In June 2013, following Free Lance-Star’s various attempts to abide by its loan covenants and obtain replacement financing, BB&T sold its loan to Sandton Capital Partners. In July 2013, Sandton informed Free Lance-Star that it wanted the company to file for bankruptcy and sell substantially all of its assets. Further, Sandton indicated that it intended to buy all of the debtors’ assets as part of what Judge Huennekens called Sandton’s loan-to-own strategy.
The debtors began discussions with DSP (an affiliate of Sandton that is operated by Sandton) to implement a plan whereby the debtors would sell all of their assets to DSP. In the course of these discussions, Sandton requested, among other things, that the debtors execute three deeds of trust to encumber the Tower Assets and insisted that the debtors include on the cover of their marketing materials a note indicating that DSP had the right to a $39 million credit bid (the balance of the BB&T loan). According to the court’s opinion, DSP also pressured the debtors to implement a hurried sale process without properly marketing the assets. Further, unbeknownst to the debtors, during the negotiations, DSP filed UCC financing statements covering fixtures on the Tower Assets. The parties’ negotiations ultimately fell through and, on January 23, 2014, the debtors commenced a bankruptcy case without DSP’s support.
On March 19, 2014, the debtors filed a motion requesting that the court limit the amount of DSP’s credit bid to the amount Sandton paid BB&T for the loan. In doing so, the debtors explained that DSP did not have a lien on all of the company’s assets and engaged in “inequitable conduct” by trying to unilaterally expand the scope of its security interest after its requests for the debtors to grant liens on the Tower Assets failed. Further, the debtors cited to Fisker for the proposition that the right to credit bid is not absolute and may be limited where there is an “unfair process.” The debtors explained that “[a]s in Fisker, DSP’s attempts to place the Company into a chapter 11 bankruptcy case shortly after its purchase … are inconsistent with the notions of fairness in the bankruptcy process.” Separately, the debtors argued that the court
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should limit DSP’s right to credit bid to foster a competitive bidding environment.
At the hearing on the credit bidding motion, DSP failed to produce any evidence to show that it was the legal owner of the BB&T loan or to refute the debtors’ allegations that DSP’s conduct was inequitable. Indeed, Judge Huennekens stated that “the fact that there was an attempt to expand … a grant of security that did not previously exist … was something that the lender  set out to accomplish … in an improper manner.” The court also condemned DSP’s failure to disclose in a cash collateral hearing the fact that it had filed the additional financing statements. Additionally, the court was “bothered” by DSP’s attempts to shorten the marketing period and to “put ledgers on all marketing materials” advertising DSP’s credit bidding rights in an effort to discourage other potential bidders.
In his written opinion, Judge Huennekens noted that, in addition to the fact that DSP did not have valid liens on all of the debtors’ assets, he was highly “displeased” with DSP’s inequitable conduct and, more importantly, its “loan-to-own” strategy. He stated that “[f]rom the moment it bought the loan from BB&T, DSP pressed the Debtor ‘to walk hand in hand’ with it through an expedited bankruptcy sales process” and that “DSP planned from the beginning to effect a quick sale … at which it would be the successful bidder for all of the Debtors’ assets utilizing a credit bid.” Thus, Judge Huennekens explained that “[t]he confluence of (i) DSP’s less than fully-secured lien status; (ii) DSP’s overly zealous loan-to-own strategy; and (iii) the negative impact DSP’s misconduct has had on the auction process has created a perfect storm, requiring curtailment of DSP’s credit bid rights.”
The court found that the facts and circumstances of the case established sufficient cause to cap DSP’s right to credit bid at just under $14 million — less than half of what was left outstanding on the BB&T loan, an amount that would “prevent DSP from credit bidding its claim against assets that are not within the scope of its collateral pool.” (Note that it is unclear from the opinion how the $14 million was calculated). Notably, at the credit bidding hearing, the court noted that it wished it had more information with respect to the amount that was paid for the loan. This leads us to wonder whether the court would have capped DSP’s bid at the price it paid for the loan had the information been available.
What is most interesting is that rather than base the credit bidding limitations on the issues with the lender’s liens (which would have made it much less controversial), Judge Huennekens emphasized the notion of “fairness” and the importance of “fostering a competitive sale,” as Judge Gross did in Fisker. Additionally, in language that will send shivers through the spines of distressed debt investors, the court stated the following:
The credit bid mechanism that normally works to protect secured lenders against the undervaluation of collateral sold at a bankruptcy sale does not always function properly when a party has bought the secured debt in a loan-to- own strategy in order to acquire the target company. In such a situation, the secured party may attempt to depress rather than to enhance market value. Credit bidding can be employed to chill bidding prior to or during an auction or to keep prospective bidders from participating in the sales process. DSP’s motivation to own the Debtors’ business rather than to have the Loan repaid has interfered with the sales process. DSP has tried to depress the sales price of the Debtors’ assets, not to maximize the value of those assets. A depressed value would benefit only DSP, and it would do so at the expense of the estate’s other creditors. The deployment of DSP’s loan-to-own strategy has depressed enthusiasm for the bankruptcy sale in the marketplace.
Where does that leave us? The Free Lance-Star decision leaves many of the same unanswered questions that Fisker did. For example, which of the Fisker factors would be enough by themselves to create a “perfect storm”? Would the inequitable conduct alone have been enough? Would the pursuit of a loan-to-own strategy by the secured creditor be enough? One thing that is clear is that the emphasis that both courts placed on “fairness” and stimulating “enthusiasm for the bankruptcy sale in the marketplace” should serve as a cautionary tale to lenders who may try to “rush” a debtor’s sale process or limit competitive bidding. It also seems that in a post- Fisker, post-Free Lance-Star world, credit bidders are likely to see additional scrutiny in future bankruptcy sales. We will continue to monitor the quickly evolving credit bidding jurisprudence and keep our readers up to speed on any developments.
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The Post-Fisker Credit Bidding Debate Continues: Two More Decisions Leave Unanswered Questions About the Significance of Fisker
Whether or not you believe that Fisker set a new standard for what constitutes cause sufficient to abrogate a lender’s right to credit bid, we can all agree that the question has become a “hot topic” in the bankruptcy
community, meriting numerous blog entries.8 We now
have two more post-Fisker decisions to add to the analysis: (i) a district court’s opinion9 denying a lender’s request for an expedited appeal of a recent credit bidding decision and (ii) a bankruptcy court’s ruling10 allowing a lender to credit bid subject to certain limitations. Although the judges in both cases referenced Fisker in their opinions, neither case clarifies whether or not Fisker actually redefined what constitutes cause to deny or limit
The Free Lance-Star Appeal
Previously we blogged11 about Judge Huennekens’ decision to deny DSP Acquisition, LLC’s (DSP) right to credit bid in a sale of substantially all of Free Lance-Star’s assets. Following the decision, DSP filed, among other things, an emergency motion for certification and leave to appeal requesting that the district court consider Judge Huennekens’ ruling before the proposed auction date — May 15, 2014. On May 7, 2014, Judge Hudson of the United States District Court for the Eastern District of
See See A Recent Decision in the Fisker Case Brings New Life to the Credit Bidding Debate dated January 27, 2014 and Fisker Credit Bid Controversy Update: Hybrid Leave to Appeal Denied; Wanxiang Wins Auction; Court Approves Sale dated February 20, 2014 and Credit Bidding Capped Again: The Fisker Factors Create a “Perfect Storm” in Virginia dated April 22, 2014 on the Weil Bankruptcy Blog. DSP Acquisition, 512 B.R. 808 (E.D. Va. 2014).
In re Charles Street African Methodist Episcopal Church of Boston, 510 B.R. 453 (Bankr. E.D. Mass. 2014). See Credit Bidding Capped Again: The Fisker Factors Create a “Perfect Storm” in Virginia dated April 22, 2014 on the Weil Bankruptcy Blog.
Virginia denied DSP’s motion, relying heavily on the United State District Court for the District of Delaware’s refusal to consider Hybrid Tech Holdings’ appeal of the Fisker credit bidding decision.
In response to DSP’s argument that it would suffer “irreparable harm” if the credit bidding issues are not resolved before the sale of Free Lance-Star’s assets, Judge Hudson noted that, similar to the situation in Fisker, there is “no risk of irreparable harm if the issues are not resolved before the auction because there are no pending issues regarding the assets … and the Bankruptcy Court will determine who receives the proceeds (and how much) after the sale.” Further, Judge Hudson found that the bankruptcy court’s decision was not final because “[w]ho has liens, the amount of those liens, the full extent of DSP’s liens, and other issues remain to be determined.”
In addressing whether it is appropriate to grant leave for an interlocutory appeal, Judge Hudson explained that the bankruptcy court’s decision in Free Lance-Star did not involve a controlling question of law for which there is substantial grounds for a difference of opinion. Judge Hudson cited to the Fisker district court decision in noting that a bankruptcy court may deny a lender’s right to credit bid to foster a competitive bidding environment. Judge Hudson then explained that in Free Lance-Star, the court not only sought a “robust and competitive bidding environment,” but also a “preliminary resolution of the extent of some of DSP’s liens.” Judge Hudson found that if he granted an interlocutory appeal of the Free Lance- Star decision, there “would be neither material advancement of the ultimate termination of the litigation nor savings of judicial or estate resources.” Moreover, DSP did not show that there were “exceptional circumstances” justifying an interlocutory appeal in the case.
In re Charles Street AME Church
While Fisker made a prominent appearance in the Free Lance-Star appeal (and underlying decision), it only played a minor role in the credit bidding decision issued in the chapter 11 case of Charles Street African Methodist Episcopal Church of Boston (CSAME).
CSAME is the owner of two adjoining parcels of real property. Following denial of its first proposed plan of reorganization, CSAME filed a motion requesting (i) authority to sell all of its assets free and clear of all liens
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to a stalking horse bidder (ABCD), and (ii) an order either
(x) barring one of its creditors, OneUnited, from submitting a credit bid at the sale of CSAME’s assets, or (y) to the extent the court permitted credit bidding, requiring OneUnited to submit at least $210,000 in cash as a deposit to pay ABCD’s break-up fee. CSAME also filed an objection to OneUnited’s proof of claim, which was based on a loan to CSAME secured by CSAME’s assets. In its claim objection, CSAME asserted three setoff counterclaims against OneUnited that, if successful, would have eliminated OneUnited’s claim.
CSAME argued that its claim objection evidenced that OneUnited’s claim is subject to a bona fide dispute and, therefore, created sufficient cause to deny OneUnited’s right to credit bid under the case law interpreting section 363(k). The bankruptcy court acknowledged that the existence of a bona fide dispute often constitutes cause to deny credit bidding, but found that the counterclaims asserted in CSAME’s objection “[did] not amount to cause to prohibit credit bidding.” The court explained that “CSAME does not dispute the validity of the underlying loan agreements, the validity, perfection or priority of OneUnited’s mortgages, the amounts claimed to be due, or anything intrinsic to either of OneUnited’s claims. Nor does CSAME allege that the mortgages or loan agreements may be avoided.” Because the court determined that there was no dispute about the “validity or extent of OneUnited’s secured claims,” it permitted OneUnited to credit bid. With respect to the break-up fee, the court agreed that the need to fund the break-up fee constituted cause to limit (but not deny) OneUnited’s right to credit bid. Thus, the court required OneUnited to include $50,000 in cash with any bid (not $210,000). Notably, in its opinion the court stated that because CSAME “expressly disavow[ed] any reliance on [Fisker] and its rationale,” it did not need to address the “types of ‘cause’” at issue in Fisker.
What Does It All Mean?
In denying DSP’s request for immediate appeal, Judge Hudson relied heavily on the district court’s opinion in Fisker and noted that the cases were “strikingly similar.” Judge Hudson even cited to Fisker for the proposition that credit bidding can be denied to promote a competitive bidding environment but, notably, did not address whether the presence of other factors (such as a lien dispute) would be necessary. The In re Charles Street AME
decision, on the other hand, reads much more like the pre- Fisker line of cases12 where credit bidding was only limited or denied when there was a genuine dispute as to the validity or extent of a lender’s lien. Still, the court expressly stated that it was not addressing the “types of
‘cause’” at issue in Fisker, leaving open the question of whether Fisker created additional “types of cause” to deny credit bidding.
Interestingly, in both Free Lance-Star and Fisker, the creditors were engaged in a loan-to-own strategy and were found to have participated in “inequitable conduct” by trying to either rush a private sale (Fisker) or improperly expand its lien on the debtor’s assets (Free Lance-Star). We are left to wonder: What is the significance of those factors? Should investors who purchase secured debt at a discount in the secondary market for the purpose of credit bidding be concerned? Or is more than just a loan-to-own strategy needed for a court to find cause?
Unfortunately, despite the recent case law on credit bidding, we still don’t have answers to many of our questions. Some commentators have predicted that, in light of these open issues, another credit bidding decision may make its way to the Supreme Court. We will continue to monitor the case law and keep you posted!
See, e.g., In re L.L. Murphrey Co., No. 12-03837-8-JRL, 2013 WL 2451368 (Bankr. E.D.N.C. June 6, 2013), slip op. at *5 (finding that cause existed to deny a lender the right to credit bid because the allegations advanced by the trustee in the draft adversary complaint submitted to the court showed that the basis of such creditor’s claim was clearly disputed); Morgan Stanley Dean Witter Mortg. Capital, Inc. v. Alon USA LLP (In re Akard Street Fuels), No. 3:01-CV-1927-D, 2001 U.S. Dist. Lexis 21644 (N.D. Tex. December 4, 2001) (denying the right to credit bid when there were complex issues surrounding the validity of the creditor’s liens and a rapid sale of the assets was necessary to preserve value).
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In this section:
￭ Ignoring Its Own Precedent, Seventh Circuit Refuses to Allow Tax Lien to Ride Through Chapter 13 Case, dated January 23, 2014
￭TheSecondCircuitUpholds Madoff Trustee’s Release of Derivative Claims, dated February 21, 2014
￭ Liens Will Survive — All Goes Well for Secured Creditor When Ninth Circuit Extends Dewsnup Principles to Chapter 12, dated March 13, 2014
￭ Rejecting Frenville (again), Third Circuit Extends Grossman’s and Broadens Scope of Prepetition Claims, dated March 27, 2014
￭ Ceci n’est pas une institution financière: Existential Crisis For Distressed Debt Focused Hedge Funds, dated April 28, 2014
￭ Supreme Court Declines to Hear Appeal of Conclusion that PE Funds are Potentially Liable for Pension Obligations of Portfolio Companies, dated May 6, 2014
￭ Code vs. Contract: Fifth Circuit holds that Section 506(b) Governs Recovery of Proceeds from a Foreclosure Sale After the Automatic Stay Has Been Lifted, dated July 15, 2014
Debt Trading, Claims and Claims Trading
Debt and claims trading is an increasingly important factor in restructurings today, and the Weil Bankruptcy Blog keeps a close eye on cases in this arena. We’ve seen some interesting cases in the past six months, from disputes over whether distressed debt funds are financial institutions for the purposes of determining whether they can trade in the debt of a borrower in the Meridian Sunrise Village case, to a further confirmation in the Third Circuit’s Ruitenberg case, if one was needed, that prepetition claims arise at the time of exposure or conduct giving rise to the injury, and not when the underlying state law cause of action accrued. Of interest to the buy-side, the Supreme Court recently declined to hear an appeal of the First Circuit Court of Appeals decision in the Sun Capital Partners III case, which holds that a private equity fund may become liable for certain pension liabilities of its portfolio companies. Other areas of interest include new cases treating when liens may “ride through” a bankruptcy case, the debtor’s ability to release derivative claims, and the treatment of claims for attorney’s fees when the automatic stay is modified to allow a foreclosure.
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Ignoring Its Own Precedent, Seventh Circuit Refuses to Allow Tax Lien to Ride Through Chapter 13 Case
Previously, we have examined the concept that liens may “ride through” a bankruptcy case where a creditor does not “participate” in the case, even where a secured creditor does not act to preserve its lien1 or where the secured creditor’s claim was disallowed for untimeliness.2 Although we believe this concept to be a relic of the
former Bankruptcy Act that should not be applicable under the Bankruptcy Code, both the Fifth Circuit3 and the Seventh Circuit4 recently embraced the principle. Recently, however, the Seventh Circuit deviated from its own precedent and held in In re LaMont, No. 13-1187 (7th Cir. Jan. 7, 2014),5 that a tax sale purchaser’s tax lien could be treated in a chapter 13 plan, resulting in the lien being extinguished, even though the secured creditor did not participate in the case prior to the confirmation of the debtors’ chapter 13 plan. Notably, the Seventh Circuit did
not discuss or attempt to distinguish its “liens ride through” precedent in this most recent decision.
In Illinois, if the owner of real property fails to pay property taxes, the taxing authority may sell the property at an annual tax sale. The tax sale purchaser pays the outstanding taxes, the taxing authority releases its lien, and the tax purchaser receives a “Certificate of Purchase.” The taxpayer is given two and a half years to redeem the
See Is This What Passive – Aggressive Means? Fifth Circuit Allows Secured Creditor that Took No Action During Chapter 11 Case to Protect Its Lien to Exercise Rights Post Emergence dated August 21, 2013 on the Weil Bankruptcy Blog. See Claim Disallowance and Lien Avoidance: A Distinction with a Difference dated November 13, 2013 on the Weil Bankruptcy Blog. Acceptance Loan Co. v. S. White Transportation, Inc. (In re S. White Transportation, Inc.), 725 F.3d 494 (5th Cir. 2013). Ryan v. U.S. (In re Ryan), 725 F.3d 623 (7th Cir. 2013).
In re LaMont, 740 F.3d 397 (7th Cir. 2014).
property by paying the tax purchaser all amounts due, including interest. Six months before the redemption period expires, the tax purchaser is required to file a petition for a tax deed. Once the redemption period has expired, the tax purchaser may apply for an order granting the petition for a tax deed and obtain title to the property. Alternatively, the tax purchaser may apply for a declaration that the tax sale was a “sale-in-error” for one of several statutory reasons, including that the taxpayer filed for bankruptcy after the tax sale but before the tax deed was issued. If the sale is deemed a sale-in-error, the taxing authority is required to reimburse the tax purchaser the purchase price plus interest.
The debtors owned a home in Grundy County, Illinois and failed to timely pay property taxes. In November 2008, the property was sold at an annual tax sale, and the purchaser assigned its interest to Lyubomir Alexandrov. The debtors filed a voluntary chapter 13 petition in December 2008. It is unclear if Alexandrov received notice of the bankruptcy because the debtors listed the taxing authority as the creditor for the unpaid property taxes. On August 2, 2011, Alexandrov filed a petition for a tax deed, and on January 13, 2012, after the redemption period had run, Alexandrov applied for an order directing the county clerk to issue a tax deed. When the county court refused to enter an order while the bankruptcy case was pending, Alexandrov filed a motion in bankruptcy court seeking a declaration that the automatic stay did not prevent him from obtaining a tax deed. At the time Alexandrov filed his motion, the debtors’ chapter 13 plan had been confirmed for nearly three years. By the time the Seventh Circuit heard oral arguments, the debtors had made all of the required payments under their plan, which provided for payment of the delinquent property taxes directly to the taxing authority.
The bankruptcy court held that Alexandrov’s interest was properly classified as a secured claim treated under the debtors’ plan and that the automatic stay prevented Alexandrov from obtaining a tax deed. Section 362(c)(2) of the Bankruptcy Code provides that the automatic stay applies to the debtor and any property of the debtor “until the earliest of (a) the time the case is closed; (b) the time the case is dismissed or (c) … the time a discharge is granted or denied.” In a case under chapter 13, the debtor is only discharged after making all payments provided for under the debtor’s plan. Here, the debtors had yet to receive their discharge, and accordingly the automatic
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stay remained in effect as to the debtors’ property, even though the debtors’ plan had been confirmed. On appeal to the Seventh Circuit, Alexandrov argued that the lower courts had improperly characterized his interest as a claim and had erred in finding that the automatic stay applied.
Debtors’ attempts to provide treatment for claims under a plan generally are subject to constitutional due process, and a creditor that does not receive constitutionally adequate notice generally would not be bound by a plan. For reasons that are unclear, Alexandrov first raised the question of notice in a motion for reconsideration of the bankruptcy court’s ruling on the automatic stay question. The bankruptcy court characterized the inclusion of the notice argument in a motion for reconsideration as an inappropriate attempt to add an additional ground for appeal. The Seventh Circuit found that the notice argument was waived because Alexandrov raised it for the first time on appeal.
The Seventh Circuit’s Decision
Alexandrov asserted that his interest was a real property interest that automatically divested the debtors of title to their home upon the expiration of the redemption period and that he was entitled to a tax deed. The Seventh Circuit noted two problems with Alexandrov’s position. The first was that courts in Illinois consistently treat the tax purchaser’s interest as a tax lien rather than an executory interest in real property. The second was that property sold at a tax sale still belongs to the debtor so long as the redemption period has not expired. The debtor retains legal and equitable title, and the property becomes part of the bankruptcy estate. A tax purchaser merely holds a lien for taxes.
Section 101(5) of the Bankruptcy Code defines a claim as a right to an equitable remedy or a right to payment. The Seventh Circuit noted that although under state law Alexandrov did not have a right to payment, the Bankruptcy Code includes a right to payment from the debtor’s property within its definition of “claim,” and Alexandrov had a right to payment from the property. In other words, if the debtors redeemed the property, Alexandrov had a right to payment from the money paid to redeem the property. The Seventh Circuit further noted that Alexandrov had a right to an equitable remedy for
breach of performance because Alexandrov had stepped into the shoes of the county. When the debtors failed to timely pay their property taxes, that breach gave rise to certain equitable remedies, such as the right of the county to sell the property at a tax sale. Alexandrov held a non- recourse tax lien that could be equitably enforced by obtaining a tax deed to the debtors’ home. Accordingly, the Seventh Circuit held that Alexandrov held a right to payment or, in the alternative, a right to an equitable remedy against the debtors’ property, and therefore held a claim that could be treated in the debtors’ bankruptcy case.
The debtors’ chapter 13 plan treated Alexandrov’s secured claim by providing for payment in installments to the taxing authority. Alexandrov disputed this treatment, arguing that this was not a proper redemption of the property and that once the redemption period expired, the debtors lost their ownership interest in the property. The Seventh Circuit disagreed, noting that in chapter 13 (as in chapter 11), a plan may modify a secured claim and provide for its payment over time. Here, the debtors’ plan had been confirmed, and the debtors had completed making payments under the plan. The Seventh Circuit therefore found that Alexandrov’s claim had been satisfied, notwithstanding that the taxing authority, and not Alexandrov, received the payments. Therefore, Alexandrov no longer had the right to a tax deed. The Seventh Circuit held that because Alexandrov’s attempts to obtain a tax deed amounted to attempts to obtain possession of property of the debtors, the automatic stay properly applied. The Seventh Circuit did note that if Alexandrov was dissatisfied with the debtors’ treatment of his claim he was entitled to seek a sale-in-error and obtain reimbursement from the taxing authority.
Interestingly, the Seventh Circuit neither addressed nor distinguished its prior “liens ride through” decisions. There are several reasons why the Seventh Circuit may not have felt these prior decisions were relevant, or needed to be distinguished. First, tax purchasers drawn into a bankruptcy case have an out of court alternative; they may apply for a sale-in-error and recoup their entire investment plus interest. In fact, the Seventh Circuit noted that the sale-in-error provision indicates that the Illinois legislature specifically anticipated adverse treatment of a tax purchaser’s interest in bankruptcy. Because Alexandrov could have been made whole through recourse to the taxing authority, it seems that the Seventh
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Circuit implicitly treated the taxing authority, and not Alexandrov, as the real party in interest. Of course, extending such reasoning to other situations in which a creditor’s claim is guaranteed would upset established notions of what constitutes a “party in interest.” Second, the Seventh Circuit noted several times that Alexandrov had only appealed from the lower court’s refusal to modify the automatic stay or declare it inapplicable and had not challenged the debtors’ chapter 13 plan or its treatment of his claim. It is possible that any of these factors were deemed significant enough to differentiate this case from others where the Seventh Circuit has held that a lien rode through.
The Second Circuit Upholds Madoff Trustee’s Release of Derivative Claims
Bernard Madoff’s historic Ponzi scheme has spawned court opinions of an ever increasing number of fascinating precedent, from subjects such as the doctrines of comity6 and in pari delicto.7 In January, in Marshall v. Picard (In re
Bernard L. Madoff Investment Securities LLC),8 the United
States Court of Appeals for the Second Circuit handed down a decision validating the Madoff trustee’s release of claims against alleged Madoff co-conspirators that Madoff customers were trying to enforce.
After his notorious Ponzi scheme was revealed, and Bernard Madoff was arrested, the Securities Investor Protection Corporation placed Bernard Madoff’s broker- dealer, Bernard L. Madoff Investment Securities LLC (BLMIS), into a liquidation proceeding and appointed a trustee to oversee its liquidation. In connection with the
See COMI Maybe? The Second Circuit Examines the Relevant Date for Determining a Debtor’s “Center of Main Interests” dated May 9, 2013 on the Weil Bankruptcy Blog. See Second Circuit: SIPA Trustee’s Attempt to Bring Claims Against Financial Institutions Fails Because He Stands in the Shoes of Madoff and Not Madoff’s Customers dated July 10, 2013 on the Weil Bankruptcy Blog. In re Bernard L. Madoff Investment Sec., 740 F.3d 81 (2d Cir. 2014).
liquidation, the trustee was responsible for liquidating BLMIS so that the claims of its customers could be satisfied. For the trustee, however, this was no easy task. Because BLMIS customer account statements were fictitious and did not reflect actual securities positions that could be liquidated, there did not appear to be a definitive way to determine how much customers were owed. The trustee’s solution was to use the “net investment method;” that is, if a customer withdrew more than they invested, they were considered a “net winner” and their claims against BLMIS would be denied; customers that invested more than they withdrew would have their claims allowed.
In order to recover money from one of BLMIS’s largest “net winners,” the trustee commenced an adversary proceeding in May 2009 against the estate of Jeffry M. Picower, one of Madoff’s alleged co-conspirators, and related defendants. The trustee alleged that the Picower defendants had made improper withdrawals from BLMIS totaling approximately $7.2 billion and sought to recover those amounts. In December 2010, the trustee and the Picower defendants settled the adversary proceeding, and the Picower defendants agreed to return $5 billion to the BLMIS estate. In exchange, the trustee agreed to seek court approval of a release of claims he might have had against the Picower defendants and to seek an injunction from the Bankruptcy Court preventing third parties from suing the Picower defendants on account of claims that are “duplicative or derivative of the claims brought by the Trustee.”
While settlement negotiations between the trustee and the Picower defendants were ongoing, former BLMIS customers filed complaints in the United States District Court for the Southern District of Florida “on behalf of putative classes allegedly adversely affected by the Trustee’s method for calculating net equity.” The Florida actions were enjoined by the bankruptcy court on the basis that they violated a prior protective order, “usurped causes of action belonging to the estate in violation of the
… automatic stay … and undermined the Bankruptcy Court’s jurisdiction over the administration of the BLMIS estate.” The Trustee sought to enjoin these actions as being within the scope of the release he sought to obtain in connection with his settlement with the Picower defendants.
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In January 2011, the bankruptcy court approved the release and enjoined the Florida Actions. The bankruptcy court further stated that the claims of the former BLMIS customers were “subsumed” in the release language. On appeal by the customers, the District Court for the Southern District of New York affirmed the release and injunction. The customers appealed the district court’s decision to the United States Court of Appeals for the Second Circuit.
The Second Circuit’s analysis began with its clarification that the BLMIS estate includes causes of action possessed by the trustee, as well as claims based on rights derivative of, or derived from, the trustee’s. In light of the fact that derivative claims are property of trustee’s estate, the court observed that “the parties have not objected, nor could they have objected, to the plain text of the injunction” because “by its own terms, [it] is limited to third party claims based on derivative or duplicative liability or claims that could have been brought by the Trustee against the Picower releasees.”
While the release given by the trustee was limited by its own terms to claims that were estate property, the appellants contended their claims were individual claims rather than derivative. The court, however, disagreed. Derivative claims, the court wrote, are those that “‘arise from harm done to the estate’ and that ‘seek relief against third parties that pushed the debtor into bankruptcy.’” More specifically, derivative injuries are “based upon ‘a secondary effect from harm done to [the debtor],’” while particularized injuries (that do not constitute estate property) are those that “can be ‘directly traced to [the third party’s] conduct.’”
The appellants argued that their complaints “assert[ed] non-derivative conspiracy-based claims predicated upon the Picower defendants’ direct participation in the theft of BLMIS customers’ funds.” The court disagreed. The court stated that the appellants’ complaints alleged nothing more than steps necessary to effect the Picower defendants’ fraudulent withdrawals of money from BLMIS and that their complaints in the Florida Action even cited “the factual allegations contained in the Trustee’s complaint in New York’s bankruptcy court multiple times in support of their claims.” Indeed, the court wrote that the “appellants’ alleged injuries are inseparable from, and predicated upon, a legal injury to the estate — namely, the
Picower defendants’ fraudulent withdrawals from their BLMIS accounts of what turned out be other BLMIS customers’ funds.” As such, the court did not agree that the appellants alleged any particularized harm, such as misrepresentations made by the Picower defendants to the appellants directly. The court concluded that the claims the appellants sought to pursue in the Florida action were within the scope of the release approved by the bankruptcy court and were properly enjoined. The court did, however, state that the appellants could “conceivably” allege a sufficiently particularized claim to bring their claims outside the realm of the injunction.
While the court took care to clarify that releases of the independent claims of third party non-debtors are still subject to higher scrutiny, the court’s ruling serves as a reminder that releases of derivative claims by a debtor or trustee may be upheld as valid.
Liens Will Survive — All Goes Well for Secured Creditor When Ninth Circuit Extends Dewsnup Principles to Chapter 12
Erika del Nido
In the Ninth Circuit’s recent decision, Va Bene Trist, LLC v. Washington Mutual Bank,9 the United States Court of Appeals for the Ninth Circuit held that secured creditors were not required to file proofs of claim in a chapter 12
case to preserve their liens because liens ordinarily “pass through” a bankruptcy case unaffected. This default rule was most famously discussed in Dewsnup v. Timm,10 a chapter 7 case in which the court relied on that same rule
in holding that “lien-stripping” to the value of collateral securing a loan was impermissible because such liens historically survive bankruptcy. Dewsnup’s applicability outside the chapter 7 context has been debated in the courts, and the Ninth Circuit’s recent decision indicates that Dewsnup’s rationale reaches chapter 12 cases.
Va Bene Trist, LLC v. Washington Mutual Bank, 556 Fed. Appx. 647 (9th Cir. 2014).
10 502 U.S. 410, 418 (1992).
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Va Bene Trist, LLC, acquired a ranch in satisfaction of a loan that it made to a third party. The manager of Va Bene Trist resided at the ranch and obtained two loans, including a $1.19 million loan, in his name — not Va Bene Trist’s. The loans, however, were secured by deeds of trust on the property, which was held by Va Bene Trist, not the manager. After no mortgage payments were made for several months, a trustee’s sale was noticed, and Va Bene Trist filed for chapter 12 bankruptcy, which covers the adjustment of debts for family farmers.
The key issue before the bankruptcy court was whether the holder of the $1.19 million note, which had not filed a timely proof of claim against the debtor, held a valid secured claim against the debtor. The bankruptcy court held that it did. In a one-sentence response, the district court concluded that the argument was without merit because “[a]ppellees, as secured creditors, were not required to file a proof of claim.” In so holding, the district
court cited Brawders v. County of Ventura.11 Although the
Ninth Circuit’s opinion in Brawders does not expressly cite to Dewsnup, it supports the same principles set forth in that famous Supreme Court case. Specifically, without significant analysis of the provisions of the Bankruptcy Code, it quotes the Bankruptcy Appellate Panel: “Absent some action by the representative of the bankruptcy estate, liens ordinarily pass through bankruptcy unaffected, regardless whether the creditor holding that lien ignores the bankruptcy case, or files an unsecured claim when it meant to file a secured claim, or files an untimely claim after the bar date has passed.” Furthermore, the first case that Brawders cites in support of this proposition based its holding in part on Dewsnup.
The Ninth Circuit looked to Brawders in affirming the district court’s ruling that secured creditors are not required to file a proof of claim to preserve a lien in a chapter 12 case. The court simply asserted that the claimants were secured creditors, so failure to timely file a proof of claim would not bar them from asserting their secured claim.
In holding that a secured creditor is not required to file a proof of claim in a chapter 12 case to preserve its lien, the Ninth Circuit followed a long line of cases holding that liens generally survive a bankruptcy case unaffected. As
11 503 F.3d 856 (9th Cir. 2007).
we have noted in a previous blog entry,12 though, many of these decisions suffer from a lack of in-depth discussion about the specific provisions of the Bankruptcy Code that may affect the decision.
But how does Va Bene relate to chapter 11? Notably, the effect of confirmation of a chapter 12 plan, as set forth in section 1227(c) of the Bankruptcy Code, is different from the effect of confirmation of a chapter 11 plan, as set forth in section 1141(c) of the Bankruptcy Code. Section 1227(c) only vests property in the debtor “free and clear of any claim or interest of any creditor provided for by the plan” (emphasis added). Section 1141(c), however, does not require that the creditor be provided for by the plan, but states that “property dealt with by the plan” revests in the reorganized debtor free and clear. Few courts have yet to address this distinction, and it remains to be seen how far Dewsnup applies in the chapter 11 context. Nevertheless, the legacy of Dewsnup lives on in this opinion and extends Dewsnup’s principles to chapter 12 cases.
Rejecting Frenville (again), Third Circuit Extends Grossman’s and Broadens Scope of Prepetition Claims
As our readers may recall, two years ago, Judge Ambro of the Third Circuit opined that “[t]he shadow of Frenville fades, but more slowly than we would like.” In Frenville,13 the Third Circuit established that a claim arose, for
bankruptcy purposes, when the underlying state law cause of action accrued. Recognizing the flaws of the accrual test, the Third Circuit overruled Frenville in JELD- WEN, Inc. v. Van Brunt (In re Grossman’s),14 and held that a prepetition claim arises at the time of exposure or
conduct giving rise to the injury. Although Frenville was
See Is This What Passive-Aggressive Means? Fifth Circuit Allows Secured Creditor that Took No Action During Chapter 11 Case to Protect Its Lien to Exercise Rights Post-Emergence dated August 21, 2013 on the Weil Bankruptcy Blog. Avellino & Bienes v. M. Frenville Co. (In re Frenville Co.), 744 F.2d 332 (3d Cir. 1984), cert. denied, 469 U.S. 1160 (1985).
14 607 F.3d 114 (3d Cir. 2010).
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overruled, it left its footprints behind.15 Recently, however, in In re Paul Ruitenberg, III,16 the Third Circuit has again rejected the Frenville accrual test, this time with respect to a debtor’s spouse’s interest in a pending divorce proceeding. Explicitly expanding the scope of Grossman’s beyond tort claims, the Third Circuit — which included Judge Ambro, Judge Smith and retired Associate
Justice for the Supreme Court of the United States, Sandra Day O’Connor — broadened the scope of prepetition claims and firmly rejected application of the accrual test.
In Ruitenberg, the debtor commenced a chapter 7 case while a divorce proceeding with his spouse was pending in New Jersey state court. At the time of the debtor’s bankruptcy filing, the state court had not yet entered a judgment apportioning the couple’s marital assets. Nevertheless, the debtor’s spouse timely filed a proof of claim for her anticipated share of marital property.
The chapter 7 trustee for the debtor’s estate sought to expunge the spouse’s proof of claim. The trustee argued that the wife’s interest in the marital property was not a claim under bankruptcy law because the state court had not entered a final divorce decree prior to the commencement of the debtor’s bankruptcy case. The characterization of the spouse’s interest as either a prepetition claim or a postpetition claim would significantly impact her potential recovery. If the interest was a prepetition claim, the spouse would be eligible to receive a share of any distribution made to general unsecured creditors from the debtor’s estate. If the interest was a postpetition claim, however, the spouse’s recovery would be limited to the assets available after the debtor’s liquidation — a recovery that might be substantially less than she would receive from the estate as a general unsecured creditor. (We note that this may seem backwards to most situations we encounter in the chapter 11 context, where the debtor argues that a claim is a prepetition claim while the creditor argues that it is a postpetition claim.)
See Frenville Leaves Its Footprints Behind as Third Circuit Refuses to Discharge Latent Claims dated May 30, 2012 on the Weil Bankruptcy Blog. In re Ruitenberg, 745 F.3d 647 (3d Cir 2014).
The United States Bankruptcy Court for the District of New Jersey concluded that the spouse’s interest in a potential distribution of marital assets arose prepetition and, therefore, was an allowable claim. The district court certified the case for direct appeal to the Third Circuit.
At the outset of its analysis, the appellate court explained that the Bankruptcy Code is the starting point for determining whether a spouse’s interest in an equitable distribution of marital assets in a divorce proceeding constitutes a claim. Section 101(5)(A) defines a claim (in pertinent part) as a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured[.]” According to the Third Circuit, when the debtor filed for bankruptcy, even though the state court had not entered a final judgment for the spouse, “her interest was, at the least, unliquidated and contingent on a final decree apportioning marital property, perhaps unmatured, and likely disputed. But, no matter, it literally [was] a ‘claim’ under [section] 101(5).”
In support of this view, the Third Circuit relied on its analysis in Grossman’s, in which it concluded that an asbestos-related claim — and thus a right to payment under the Bankruptcy Code — arises at the time of exposure even if the injury manifests postpetition. The Third Circuit reiterated that Congress and the Supreme Court have instructed that the term claim under the Bankruptcy Code should have “the broadest possible definition.” The court went on to explain that in Grossman’s it overruled the Frenville accrual test (pursuant to which a claim arose, for bankruptcy purposes, when the underlying state law cause of action accrued) because the Frenville test interpreted the definition of a claim under the Bankruptcy Code too narrowly. Grossman’s expanded the definition of a claim, and the spouse’s interest fell within the expanded definition.
The Third Circuit firmly rejected the chapter 7 trustee’s argument that the court should apply the Frenville accrual test because Grossman’s was limited to tort- related claims, and that under New Jersey state law a spouse’s claim to apportioned martial property arises upon entry of a judgment of divorce. Judge Ambro acknowledged that the formulation of the Grossman’s test
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was tailored to common law tort claims, but noted that in that decision the Third Circuit had highlighted the flaws of the accrual test, and that such test was inconsistent with section 101(5). Consequently, the court found that the underlying rationale of Grossman’s and the language of section 101(5) warranted a “broader rejection of the Frenville accrual test.”
The appellate court went on to note that allowing the spouse’s claim did not raise the due process concerns addressed in Grossman’s (e.g., adequacy of notice). Rather, the debtor and the spouse were fully aware of the pending divorce proceeding and the potential distribution of marital assets at the time of the bankruptcy filing.
The Ruitenberg decision has implications far beyond divorce proceedings. The Third Circuit’s expansive application of Grossman’s not only sounds a second and final death knell for Frenville (to the extent Frenville had any life post-Grossman’s), but also should be a warning to potential creditors in any proceeding in which an adverse party files for bankruptcy. Parties to proceedings commenced prior to another party’s bankruptcy filing should timely file proofs of claim if they seek a recovery from the bankruptcy estate, or else run the risk of their claims being discharged.
Ceci n’est pas une institution financière: Existential Crisis for Distressed Debt Focused Hedge Funds
Meridian Sunrise Village, LLC v. NB Distressed Debt Investment Fund Limited, No. 13-5503RBL, 2014 WL 909219 (W.D. Wash. March 7, 2014).
What You Need To Know
Buyer beware: Distressed debt investors who purchase the debt of a borrower in bankruptcy, where the borrower’s underlying loan agreement contains an “Eligible Assignee” restriction, may be at risk of not being able to hold such debt and exercise the rights of a lender. Meridian Sunrise turned on a choice between two competing interpretations of “financial institution” under a
$55 million loan agreement governed by Washington state law. In this case, distressed debt funds were held not to
be “financial institutions” by the United States District Court for the Western District of Washington and were therefore not “Eligible Assignees.” It may seem obvious, but purchasers of distressed debt from debtors/borrowers in the secondary market should review loan agreements governing the debt they purchase, confirm they are permitted assignees of the paper, and ensure they have recourse against the seller of the debt in the event of ambiguity or challenge.
Meridian, a builder and manager of shopping centers, entered into a loan agreement in 2008 with U.S. Bank to finance the construction of a shopping center in Washington. Shortly after originating the loan, and as contemplated by the parties, U.S. Bank assigned portions of the loan to each of Bank of America, Citizens Business Bank and Guaranty Bank & Trust Company, while maintaining its role as administrative agent for the loan.
In light of the expected assignment of portions of the loan, Meridian negotiated for, and received, additional protection in the loan agreement, restricting the parties to which U.S. Bank could assign portions of the loan. The loan agreement included the following provision: “[n]o Lender shall at any time sell, transfer or assign any portion of the Loan…to any Person other than an Eligible Assignee.” “Eligible Assignee” was defined as follows:
Eligible Assignee” means any Lender or any Affiliate of a Lender or any commercial bank, insurance company, financial institution or institutional lender approved by Agent in writing and, so long as there exists no Event of Default, approved by Borrower in writing, which approval shall not be unreasonably withheld.
In early 2012, U.S. Bank called a non-monetary default under the loan agreement based on the breach of a financial covenant by Meridian. Later that year, U.S. Bank requested that Meridian agree to waive the “Eligible Assignee” restriction in its loan documents to facilitate a sale of the loan. Meridian declined to do so. As is common, prior to an Event of Default, Meridian had the right to withhold consent to any assignee (as long as it was acting reasonably); after an Event of Default, Meridian’s consent was not necessary, but an assignment remained subject to the rest of the restrictions in the Eligible Assignee definition. In January 2013, U.S. Bank
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notified Meridian that it had elected to commence charging default interest on the loan as a result of the non-monetary default, leading Meridian to file for bankruptcy protection.
During the course of Meridian’s chapter 11 case, and despite Meridian’s repeated objections, Bank of America transferred its portion of the loan to NB Distressed Debt Fund Limited, which subsequently assigned one half of its interest to Strategic Value Special Situations Master Fund II, L.P., and another part to NB Distressed Debt Master Fund L.P. The three funds were, as their names would suggest, investment funds with a focus on acquiring the debt of troubled borrowers.
Meridian objected to Bank of America’s transfer and sought an injunction in Bankruptcy Court to enjoin the distressed debt funds from exercising Eligible Assignee rights, including voting on its plan of reorganization. The Bankruptcy Court granted the injunction, which the distressed debt funds then appealed. The District Court denied the distressed debt funds’ motion for a stay. Voting on Meridian’s plan of reorganization progressed, with the distressed debt funds being denied the opportunity to vote, and Meridian’s broader lender group voted in favor of Meridian’s plan of reorganization, which was confirmed by the Bankruptcy Court in September 2013.
The distressed debt funds appealed the Bankruptcy Court’s preliminary injunction, and confirmation of Meridian’s plan of reorganization.
The District Court’s Decision
In a decision that seems to take a dim view of distressed debt funds generally, the District Court declined to adopt a broad interpretation of the term “financial institution,” as such a result would permit an assignment of Meridian’s loan to any entity that manages money, and thereby drain any force from the Eligible Assignee restriction. The District Court agreed with the Bankruptcy Court that applicable rules of contract interpretation in Washington state required courts to interpret words in a way that harmonizes with their context. Thus, the term “financial institution,” when taken in context, was understood by the District Court to mean an entity that makes loans, rather than any entity that manages money.
The District Court rejected the distressed debt funds’ arguments that only an abstract dictionary definition
could be used when interpreting the term “financial institutions,” and considered the course of dealings between the parties relevant when considering the term. Prior to Meridian’s chapter 11 filing, U.S. Bank had sought to consensually eliminate the definition of “Eligible Assignee” from the loan agreement, demonstrating that the Eligible Assignee restriction was not interpreted by the parties in a broader sense. The filing for chapter 11 itself by Meridian, instead of caving in to U.S. Bank’s demands, also demonstrated the importance of the “Eligible Assignee” restriction to the borrower.
In short, because the District Court found that the distressed debt funds were not in the business of loaning money, but instead were businesses that invested and held investment assets, they did not qualify as “financial institutions” under the loan agreement. The distressed debt funds have appealed the District Court’s judgment to the United States Court of Appeals for the Ninth Circuit.
The District Court’s decision in Meridian relies on a somewhat tenuous distinction to define the term “financial institution”: in the District Court’s view, entities that make loans are financial institutions, and entities that manage money are not. Such a distinction may create problems when larger credit funds that are active as both lenders and investors are considered. As distressed credit markets have evolved, and credit funds have grown in assets under management and experience, we have seen competition to traditional lenders from other non- traditional financing sources. Language lives and breathes the realities of its time; even a quick survey of the various uses of the term “financial institution” in both a statutory and colloquial context betrays a trend towards a more expansive use of the term.
Does such a blurring of the lines mean that distressed debt funds should be included under the umbrella of the term “financial institution”? Meridian, as many borrowers in the same situation might, argued that it had affirmatively chosen to face a plain vanilla lender when entering into its banking relationship, and not a “predator,” as it (and the District Court) described the distressed debt funds. The District Court’s decision in favor of Meridian and its narrower interpretation of the term “financial institution” reflects this commercial reality.
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As for Meridian’s business justification for distinguishing between traditional lenders and non-traditional financing sources, are banks any friendlier than distressed debt funds when dealing with a borrower in distress? Although a “financial institution” like U.S. Bank might, just like a distressed debt fund, seek to liquidate collateral on a default, some argue that because traditional lenders have relationships with borrowers and care about their reputation in the market, they might be less aggressive when facing a borrower in default. A lender may indeed find it harder to attract borrower clients in the future if it develops a reputation in the market as being overly aggressive. Distressed debt funds, on the other hand, do not necessarily face such a quandary. Clearly they are institutions engaged in the business of finance, but not of the type, as Meridian convinced the Bankruptcy Court and District Court, that Meridian would have chosen to face given the choice.
The Bankruptcy Court and District Court decisions are definitely pro-borrower and pro-debtor, but they make sense within the Court’s broader interpretation of what was intended when the borrower entered in to a relationship with its lender in that case – even if the District Court’s wider proposition of what is and is not a financial institution is debatable. And that’s what this case really comes down to: Meridian was able to convince the Bankruptcy Court and the District Court that it intended to restrict the universe of potential lenders capable of holding its loan when it entered into its loan agreement with U.S. Bank, and it specifically contemplated excluding any “financial institution” that was not a plain vanilla lender. I’m not so sure, as commentators have argued, that courts in other districts wouldn’t also rule the same way given the facts of that particular case. The District Court’s ruling paints distressed debt funds negatively, but the legal arguments are clear and logical: when interpreting the term “financial institution” under Washington state law (or any term for that matter), courts are able to look at extrinsic evidence and consider the disputed terms in context. And the context in this case led to a particular result. Nothing particularly groundbreaking about that (although other states’ laws might vary on when extrinsic evidence can be consulted).
Where does this leave us? Standard form loan agreements, to the extent they use an “Eligible Assignee” construct rather than a schedule of “black-balled” entities
(or a “Disqualified Institutions List”), will need to evolve to encompass the new normal of non-traditional financing sources being active in traditional lending markets. After all, it may have been possible for the District Court in this case to find that the individual distressed debt funds involved were not financial institutions given its view of that term, but what if the institutions involved were hedge funds with tens of billions of dollars under management that make regular loans from one arm, while playing actively in the distressed debt markets with another? I can think of quite a few hedge funds that fit the bill.
Borrowers are lucky that, for now, courts are on their side. They should not rely on luck alone to ensure that lenders they consider predatory are kept away from their collateral when they get in to trouble. Indeed, the general trend in the syndicated loan markets is to move away from “Eligible Assignee” clauses altogether. In most deals now in the syndicated loan market, assignments are permitted to any person (other than a natural person) other than a person listed on the Disqualified Institutions List that is part of the loan agreement. To the extent that an Eligible Assignee clause is used, more precise language to clarify the types of lenders that are, and are not, eligible to participate in their loans is recommended. Borrowers should also ensure that they maintain a record of their intent when it comes to “Eligible Assignee” restrictions, in case the restrictions are ever challenged.
On the other hand, lenders who value liquidity and the ability to trade their debt freely, are advised to negotiate for “Eligible “Assignee” definitions that are expansive and clearly permit them to trade to hedge funds, especially following an Event of Default.
As for distressed debt investors, although paying legal fees may eat into returns, paying close attention to underlying credit documents prior to acquiring positions will help avoid this type of situation in the future. There’s a reason the term caveat emptor comes from Latin: unwary buyers have been around since the dawn of time.
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Supreme Court Declines to Hear Appeal of Conclusion that PE Funds Are Potentially Liable for Pension Obligations of Portfolio Companies
In March 2014, the U.S. Supreme Court17 declined to hear an appeal from Sun Capital Partners Inc. of the decision by the First Circuit Court of Appeals in Sun Capital Partners III, L.P. et al. v. New England Teamsters & Trucking Industry Pension Fund,18 an important 2013 case under
the Employee Retirement Income Security Act of 1974 (ERISA) relating to the potential for “controlled group” liability of private equity funds for underfunded pension plans of portfolio companies. In that case, the First Circuit held that a private equity fund with an investment in a portfolio company managed by the fund’s general partner would be considered a “trade or business” with potential joint and several liability under ERISA for that portfolio company’s withdrawal liability from a multiemployer pension plan. As such, it continues to be the case (in the First Circuit, and in other jurisdictions if this precedent is followed) that a private equity fund may become liable for certain pension liabilities of its portfolio companies if the additional “common control” tests under ERISA’s controlled group rules are satisfied.
“Controlled Group” Liability under ERISA
Under Title IV of ERISA, significant pension liabilities can arise upon the withdrawal by a participating employer from a union multiemployer pension plan (at issue in the Sun Capital case), as well as upon the termination of an underfunded single employer pension plan (i.e., in a “distress” or “involuntary” plan termination under ERISA). Under the “controlled group” liability rules of ERISA, an entity other than the direct employer is also responsible for these liabilities, on a joint and several basis, if the entity is (i) a “trade or business” and (ii) under “common control” with the employer, which generally requires
common ownership of at least 80 percent. The Sun Capital decision deals with the first such test.
In this case, two private equity funds sponsored by the same firm, Sun Capital Advisors, Inc. (Sun Capital), acquired a 100 percent ownership interest in Scott Brass, Inc. (SBI) in 2007: “Fund IV” acquired a 70 percent interest, and “Fund III” acquired a 30 percent interest. These respective ownership interests apparently were arrived at with a view toward avoiding ERISA’s 80 percent common control test. When SBI subsequently withdrew from a union-sponsored multiemployer pension plan, the plan sought to collect SBI’s withdrawal liability from the two funds under ERISA’s controlled group liability rules.
Private Equity Fund as a “Trade or Business”
The First Circuit held that Sun Capital Fund IV constituted a “trade or business” and thus could potentially be treated as a member of the controlled group for purposes of ERISA. In reaching its conclusion, the court held that Sun Capital was more than merely a passive investor (which would not be deemed a “trade or business” under ERISA) by applying the “investment plus” test to the activities of Sun Capital and Fund IV. This test looks at whether, unlike a mere passive investor, the investor is also exercising control over the management and operations of that company. The court acknowledged that this is a facts and circumstances test and requires a case-by-case determination.
Implications of the Sun Capital Case
As a result of the Supreme Court’s refusal to hear an appeal of the Sun Capital case, it continues to have important implications for private equity firms, private equity fund investors, and their portfolio companies. If a single fund holds more than 80 percent of the equity of a portfolio company, that fund and even its other 80 percent-owned portfolio companies could become liable for the pension liabilities of the company, if the Sun Capital precedent is followed. This will put additional emphasis on due diligence, pricing, indemnities, and structuring in transactions involving significant potential pension liabilities.
Sun Capital Partners III, L.P. et al. v. New England Teamsters
& Trucking Industry Pension Fund, No. 134 S. Ct. 1492 (U.S. 2014).
18 724 F.3d 129 (1st Cir. 2013).
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Additional details regarding the Sun Capital case can be found in a prior blog post.19 We will continue to stay apprised of this matter and update you on any further developments in this area.
Code vs. Contract: Fifth Circuit Holds that Section 506(b) Governs Recovery of Proceeds From a Foreclosure Sale After the Automatic Stay Has Been Lifted
When an oversecured creditor forecloses on a debtor’s property after the automatic stay has been lifted, does the Bankruptcy Code (as opposed to state law) govern recovery of attorney’s fees and other amounts from the sale proceeds? Does the bankruptcy court have jurisdiction over the distribution of such proceeds? In
Goldsby v. 804 Congress LLC (In re 804 Congress),20 the
United States Court of Appeals for the Fifth Circuit answered both questions in the affirmative, citing, among other things, the legislative intent of the Bankruptcy Code and the bankruptcy court’s role in resolving lienholder disputes.
Foreclosure and Dispute Over Proceeds
In 804 Congress, the debtor’s only significant asset was an office building upon which Wells Fargo had a first- priority lien through a deed of trust. Another creditor, VIA Lending, had a second-priority lien. The debtor sought bankruptcy protection after Wells Fargo scheduled a foreclosure sale on the building, which led Wells Fargo to file an emergency motion for relief from stay to proceed with a nonjudicial sale of the property. The United States Bankruptcy Court for the Western District of Texas issued an order permitting the sale “in accordance with applicable state laws” if the debtor had not met certain conditions before a certain date. After the debtor failed to
See Federal Appeals Court Concludes PE Funds are Potentially Liable for Pension Obligations of Portfolio Companies dated August 12, 2013 on the Weil Bankruptcy Blog. Goldsby v. 804 Congress LLC (In re 804 Congress), 756 F.3d
368 (5th Cir. 2014).
meet these conditions, the trustee under the deed of trust conducted a sale of the property.
The bankruptcy court exercised jurisdiction over the sale, and the creditors filed proofs of claim for the amounts to which they were entitled under the deed of trust. The debtor, however, disagreed with the distribution of the proceeds under the deed of trust (specifically, Wells Fargo’s recovery of attorney’s fees and the trustee’s commission), and sought an order to direct the trustee to pay only the principal and interest due to both lienholders and to pay the remaining funds to the debtor pending resolution of claims against those funds. The bankruptcy court both decreased the trustee’s commission and disallowed recovery of Wells Fargo’s requested attorneys’ fees, finding that neither amount could be considered reasonable under section 506(b) of the Bankruptcy Code, which allows creditors to recover “any reasonable fees, costs, and charges” provided for in an agreement under which a claim arises. Wells Fargo appealed, and the United States District Court for the Western District of Texas reversed and remanded, holding that the bankruptcy court no longer had jurisdiction over the property and sale proceeds once the stay was lifted. The debtor appealed to the Fifth Circuit.
Section 506(b) vs. Texas State Law
The Fifth Circuit first held that section 506(b) governs distributions to an oversecured creditor and that its application is not limited to sales under section 363. The court cited to its decision in Blackburn-Bliss Trust v. Hudson Shipbuilders, Inc. (In re Hudson Shipbuilders
Inc.),21 in which it held that section 506(b) applies to the
recovery of prepetition attorneys’ fees even if a valid contract provides otherwise. In that case, the court stated that when Congress enacted section 506(b), it “intended that federal law should govern the enforcement of attorneys’ fees provisions, notwithstanding contrary state law,” and that leaving the bankruptcy court without the power to decide whether a fee is reasonable is not only contrary to that legislative intent, but “contrary to the weight of judicial precedent.” The 804 Congress court found Blackburn-Bliss to be controlling even though that case applied only to prepetition fees and 804 Congress involved both pre- and postpetition fees. The court relied
794 F.2d 1051 (5th Cir. 1986), overruled in part by Stern v.
Marshall, 131 S. Ct. 2594 (2011).
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on dicta in the United States Supreme Court’s opinion in
U.S. v. Ron Pair Enterprises22 for the premise that section 506(b) governs postpetition claims as well.
With respect to the question of whether the bankruptcy court had jurisdiction over the distribution of the sale proceeds, the court stated that it could not find any congressional intent within section 506(b) to treat oversecured creditors who are permitted to foreclose differently from those whose claims are satisfied within the bankruptcy. The court noted that strictly applying the terms of the deed of trust would have given the trustee the power not only to determine its own recovery and that of Wells Fargo, but also to determine the recovery of subordinate lienholders. Such an application would leave the bankruptcy court without the power to resolve disputes about claims of junior lienholders.
The court also cited to Hudson Shipbuilders, noting that the congressional mandate in section 506(b) gave the bankruptcy court jurisdiction to resolve attorneys’ fees issues by preventing senior lienholders “from getting a windfall by extracting attorneys’ fees in excess of what could legitimately be demanded in a bankruptcy proceeding.” Ultimately, the court found that although lifting the stay allowed Wells Fargo to avail itself of foreclosure proceedings under Texas state law, it did not insulate the debtor or its creditors from the reach of section 506(b).
The decision in 804 Congress reinforces the bankruptcy court’s power to determine the reasonableness of fees, costs, and charges under section 506(b), even where a creditor’s claim arises out of an agreement or proceeding governed by state law. The opinion also suggests that even where the parties agree upon fees, costs, and charges before a bankruptcy, under certain circumstances, section 506(b) may trump the provisions of their contract.
489 U.S. 235 (1989), see also Weil Bankruptcy Blog July 3,
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In this section:
￭ Unanimous Supreme Court Closes Statutory Gap, Leaves Other “Core” Stern Questions For Another Day (Executive Benefits Insurance Agency v. Arkison), dated June 2, 2014
￭ “Thank You, SCOTUS; It’s About Time!”: Supreme Court Grants Cert to Decide Meaningful Stern v. Marshall Questions, dated July 2, 2014
￭ The Stern Files: Uncertainty Abounds Regarding Consent to Bankruptcy Court Adjudication, dated July 9, 2014
The Stern Files: And the Beat Goes On
The first half of this year has been eventful for the team at the Stern Files. First, we were saddened to see the Supreme Court’s narrow decision in Executive Benefits Insurance Agency v. Arkison, but we were encouraged by its final determination that there is no “statutory gap” that would deprive bankruptcy courts of authority to issue reports and recommendations in connection with so-called Stern claims (i.e., core matters as to which the bankruptcy courts lack final adjudicatory authority as a constitutional matter). We were then uplifted by the Court’s decision to grant certiorari in Wellness International Network v. Sharif, as well as its apparent promise to decide (hopefully conclusively) whether the bankruptcy courts’ constitutional infirmities with respect to Stern claims can be cured by the parties’ consent, or whether final adjudication by an Article III court is a structural right not subject to waiver under any circumstances. Lastly, we reminded readers of the ongoing uncertainty in the courts regarding the nature and extent of bankruptcy courts’ judgments and the practical considerations that must be taken into account unless and until we receive further clarity from the Supreme Court. We eagerly await the upcoming developments and a return to the substance of bankruptcy matters, rather than the threshold issues that continue to be raised at all turns in light of Stern and its progeny.
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Unanimous Supreme Court Closes Statutory Gap, Leaves Other “Core” Stern Questions for Another Day (Executive Benefits Insurance Agency v. Arkison)
The Supreme Court recently issued its hotly anticipated decision in Executive Benefits Insurance Agency v. Arkison.1 Since Stern v. Marshall,2 issues of bankruptcy courts’ constitutional authority have been debated up and
down court systems throughout the country, and have, in one court’s colorful words, generated a “nationwide constipation of case-processing delays.”3 Although the Supreme Court’s decision today in Arkison ends the discussion on one of these issues, many questions remain.
First, the good news. It seems that the Supreme Court has finally realized that in Stern, it created a new sub- class of bankruptcy issues. Those claims, which the Court now calls “Stern claims,” are claims that would otherwise be “core matters” designated for final adjudication in the bankruptcy court as a statutory matter, but are nonetheless “prohibited from proceeding in that way as a constitutional matter” because the bankruptcy court lacks final constitutional authority over such claims. And thankfully, the Court recognized that in creating that new sub-class of claims, Stern did not provide adequate guidance regarding how such claims should proceed. For example, if those Stern claims cannot be finally decided by a bankruptcy court, can they be subject to reports and recommendations for adoption by the district court? Or is that option only available for true “non-core” claims because the Judicial Code only explicitly grants such authority with respect to non-core claims?
1 Exec. Bens. Ins. Agency v. Arkison, 134 S. Ct. 2165 (U.S. 2014).
2 131 S.Ct. 2594 (2011).
See A Scatological Analysis of Bankruptcy Court Jurisdiction and Authority After Stern v. Marshall dated August 1, 2012 on the Weil Bankruptcy Blog.
Indeed, several courts have held4 that there is a “statutory gap” because bankruptcy courts are not explicitly authorized to issue proposed findings of fact and conclusions of law in these core matters as to which bankruptcy courts lack final constitutional authority. Most courts, however, have rejected that approach and permit bankruptcy courts to issue those proposed findings and conclusions in those matters, subject to approval by the district court. The Supreme Court agreed, concluding that such an approach is consistent with the Court’s position regarding “severability” – i.e., that it will “ordinarily give effect to the valid portion of a partially unconstitutional statute so long as it “remains fully operative as a law and so long as it is not evident from the statutory text and context that Congress would have preferred no statute at all” (citations and quotation marks omitted). Accordingly, because nothing made it “evident” that Congress desired to leave these Stern claims “in limbo,” they may be treated as though they are non-core claims.
And now, the bad news. The Supreme Court did not offer much else. Indeed, it specifically noted that the case before it did not require it to address the issue of whether
EBIA consented to the bankruptcy court’s adjudication of a Stern claim and (ii) whether Article III of the Constitution permits a bankruptcy court, with the consent of the parties, to enter final judgment on a Stern claim. Instead, the Court “reserve[d] that question [or those questions?] for another day.” In other words, we still don’t know whether bankruptcy courts can hear and finally determine Stern claims when all parties consent to same, and if so, whether consent may be implied from parties’ conduct, or whether it must be expressly provided.
Moreover, the court declined to address whether fraudulent transfer claims fit within the category of “Stern claims,” or whether bankruptcy courts may issue final judgments in those matters. Instead, it simply noted that “[t]he [Ninth Circuit] Court of Appeals held, and we assume without deciding, that the fraudulent conveyance claims in this case are Stern claims.” Of course, this does not constitute a decision on the merits of that argument, and parties will undoubtedly continue to aggressively
See Stern Files: Seventh Circuit Sides with Sixth Circuit in Holding that Consent Does Not Cure Bankruptcy Courts’ Lack of Final Constitutional Authority dated August 27, 2013 on the Weil Bankruptcy Blog.
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litigate the issue of whether fraudulent transfer claims fit within this category at all.
These undecided issues remain the subject of ongoing circuit splits,5 and we would welcome additional clarity – and soon – regarding Stern’s implications. The Stern Files team will continue its ongoing analysis of Stern, Arkison, and their progeny (which will, no doubt, be abundant), and further analysis will follow. But for the moment, we’ll reiterate our unanswered questions6 and hope for more clarity on these and the other questions that will undoubtedly arise in the coming weeks and months:
￭ Can parties consent to entry of a final judgment in matters as to which bankruptcy courts otherwise lack final constitutional authority?
￭ Can such consent be implied (from a party’s course of conduct or otherwise), or must it be explicitly granted?
￭ Are fraudulent transfer actions within the bankruptcy court’s final adjudicatory authority? Preference actions?
Just what did the Court mean when it first issued Stern [and now Arkison]? What is the intended effect on the division of authority between Article III judges and non- Article III judges?
“Thank You, SCOTUS; It’s About Time!”: Supreme Court Grants Cert to Decide Meaningful Stern v. Marshall Questions
We at the Stern Files recently expressed our disappointment7 with the lack of more meaningful guidance in Executive Benefits Insurance Agency v.
See The Ninth Circuit Waits for No One dated August 13, 2014 on the Weil Bankruptcy Blog. See Are You There, Chief Justice Roberts? It’s Us, the Bankruptcy Courts dated January 14, 2014 on the Weil Bankruptcy Blog. See Unanimous Supreme Court Closes Statutory Gap, Leaves Other “Core” Stern Questions For Another Day (Executive Benefits Insurance Agency v. Arkison) dated June 9, 2014 on the Weil Bankruptcy Blog.
Arkison8 regarding the nature and extent of bankruptcy judges’ authority, and it seems our prayers have been answered.
The Supreme Court recently granted certiorari9 in Wellness Int’l Network v. Sharif, in which the Seventh Circuit Court of Appeals held, among other things, that bankruptcy courts cannot issue a final judgment in core matters as to which they lack final authority, even where the parties provide their express consent to same. Our
prior coverage of Sharif is available here.10 Though the
Court did not certify all four questions posed in the cert petition,11 it agreed to take up two central questions emanating from Stern and its progeny. Specifically, the Court will address the following two questions:
Whether the presence of a subsidiary state property law issue in a 11 U.S.C. § 541 action brought against a debtor to determine whether property in the debtor’s possession is property of the bankruptcy estate means that such action does not “stem from the bankruptcy itself” and therefore, that a bankruptcy court does not have the constitutional authority to enter a final order deciding that action.
Whether Article III permits the exercise of the judicial power of the United States by the bankruptcy courts on the basis of litigant consent, and if so, whether implied consent based on a litigant’s conduct is sufficient to satisfy Article III.
With respect to question #2, as we’ve noted, the Supreme Court did not grant cert12 in Waldman v. Stone,13 which raised many of the same questions as did Sharif and was
Exec. Bens. Ins. Agency v. Arkison, 134 S. Ct. 2165 (U.S. 2014).
Wellness Int’l Network v. Sharif, No. 13-935, Pet. for Writ of Cert. (U.S. Feb. 5, 2014). See Stern Files: Seventh Circuit Sides with Sixth Circuit in Holding that Consent Does Not Cure Bankruptcy Courts’ Lack of Final Constitutional Authority dated August 27, 2013 on the Weil Bankruptcy Blog. Wellness Int’l Network v. Sharif, No. 13-935, Pet. for Writ of Cert. (U.S. Feb. 5, 2014). See Stern Files: Back to the Supreme Court! dated June 25, 2013on the Weil Bankruptcy Blog. See The Stern Files (Seventh Edition) dated December 18, 2012 on the Weil Bankruptcy Blog.
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the progenitor, with Arkison, of the existing circuit split14 regarding the effect of consent on “Stern claims” and on bankruptcy courts’ constitutional authority. But regardless of the Supreme Court’s reasoning for first tackling Arkison on a limited basis, and then addressing the broader questions of consent, we will anxiously await the Supreme Court’s decision in Sharif regarding these ... ahem … core issues.
Turning back to question #1, it will also be interesting to see how the Court comes out on the question of whether bankruptcy courts have constitutional authority to finally determine all actions implicating section 541 of the Bankruptcy Code. It may be still more interesting to learn about what types of matters, in the Supreme Court’s eyes, “stem from the bankruptcy itself” (in the words of Stern)
–n,tstlstethtllttsthtt esdnatyseoleannof soest)ngtyofthestt”r ,htfatrlsatnortnnr ston4,hfystoortte t,thothrffesstohthe ntyotodnothefnljtoy thot? htotnetons? hod fnetonsewthnthetyots’fnl thotysetytesonsofste tyndthfoe“st”fmtetys, heflnttnsfrtonsedotfomte ntyots’ltytontrafnljt?t fothssoftonesst)
Of the two other questions raised in the Sharif petition, one has already been resolved by Arkison – namely, whether bankruptcy courts may issue proposed findings of fact and conclusions of law in core matters as to which they lack final constitutional authority (yes). The final question asked whether the filing of a voluntary bankruptcy petition necessarily constitutes consent by the debtor to adjudication of claims by a non-Article III court. Presumably, this question depends in large part on the threshold question of whether the parties’ consent can confer on the bankruptcy court an ability to finally resolve these “Stern matters” (i.e., core matters as to which the bankruptcy court is otherwise constitutionally barred from
See Stern Files: The Circuit that Originally Gave Us Stern Creates the First Stern Circuit Split dated December 6, 2012 on the Weil Bankruptcy Blog.
issuing a final judgment), which the Court has agreed to address.
As always, we at the Stern Files will continue to provide insightful coverage of further developments as we await briefing, argument, and a (hopefully meaningful) decision in Sharif.
The Stern Files: Uncertainty Abounds Regarding Consent to Bankruptcy Court Adjudication
Recently, the Bankruptcy Court for the Eastern District of Louisiana stayed its own judgment pending an appeal to resolve doubt over the bankruptcy court’s authority to enter judgment on counterclaims related to a management agreement among Highsteppin’ Productions,
L.L.C. (HSP) and debtors George Porter, Jr., Brian Stoltz, David Russell Batiste. The bankruptcy court issued the stay despite HSP’s consent to the bankruptcy court’s entry of judgment and HSP’s failure to object to the bankruptcy court’s authority until losing at trial because the law “is in a serious state of flux and is subject to
varying interpretation.” The bankruptcy court’s decision15
highlights the reluctance of certain bankruptcy courts to enforce their own judgments given the uncertainty of whether Article III of the Constitution permits the exercise of judicial power by bankruptcy courts on the basis of party consent. The Supreme Court’s grant of certiorari in Wellness Int’l Network v. Sharif on this issue, which we
discussed on July 2,16 could not come soon enough.
Making Music and Litigation
What started with an agreement to manage a New Orleans funk trio soon went south and has landed in post- Stern limbo. Starting on May 8, 2006, Massachusetts- based HSP managed the group Porter, Batiste, and Stoltz. When the group broke up in 2009, HSP and its principal,
Highsteppin’ Productions, LLC v. Porter (In re Porter), 511 B.R. 785 (Banks. E.D. La. 2014). See “Thank You, SCOTUS; It’s About Time!”: Supreme Court Grants Cert to Decide Meaningful Stern v. Marshall Questions dated July 2, 2014 on the Weil Bankruptcy Blog.
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Greg Stepanian, filed suit against the debtors in Massachusetts for repayment of personal advances, deferred commissions, and reimbursement of expenses incurred by HSP on behalf of the debtors. The debtors filed chapter 7 petitions in Louisiana and removed HSP’s lawsuit to the bankruptcy court. The debtors counterclaimed for breach of contract, breach of fiduciary duty, copyright violations, violation of the Massachusetts Unfair Trade Practices Act (MUTPA), and attorneys’ fees and costs recoverable under their MUTPA claims. HSP filed adversary cases against each of the debtors seeking to determine the dischargeability of the debtors’ debt to them, which were consolidated with its original lawsuit. HSP filed proofs of claim in the Porter and Stoltz bankruptcy cases for $608,878.28 and sought recognition of its proof of claim against Batiste in its adversary complaint.
The bankruptcy court denied HSP’s claims, found for the debtors on their breach of contract, MUTPA, negligence, and breach of fiduciary duty counterclaims, and denied the debtors’ copyright infringement claims. In a second trial phase, the court awarded the debtors attorneys’ fees and costs for their MUTPA claims and denied HSP’s request for attorneys’ fees and costs for their defense of the copyright claim. Despite their previous consent to the bankruptcy court entering judgment, after losing at trial, HSP and Stepanian sought a stay pending appeal alleging in support of their motion that the bankruptcy court lacked constitutional authority to enter judgment on the debtors’ counterclaims under Stern v. Marshall. Although HSP and Stepanian later withdrew their Stern argument and informed the bankruptcy court that they would not argue Stern on appeal, the bankruptcy court nonetheless addressed the issue because HSP and Stepanian could raise it in future appeals.
A “State of Flux” Leads to a Stay
The bankruptcy court concluded that the debtors’ counterclaims were integral to the resolution of HSP’s claims against the debtors’ estates because the counterclaims involved interrelated and common issues of
counterclaims. The bankruptcy court recognized that a broad interpretation of Stern would deny it authority to enter judgment on the attorneys’ fees claims because they arose from a separate set of facts than the other counterclaims.
The bankruptcy court found that the Fifth Circuit’s In re Frazin17 decision suggested that it had authority to make factual findings on debtors’ counterclaims because the debtors’ counterclaims had to be resolved to determine
HSP’s claims against their estates. The lack of a clear test in Frazin, in which three Fifth Circuit judges expressed three different rationales, however, left doubt as to the bankruptcy court’s authority. The bankruptcy court also expressed surprise that the Supreme Court’s recent decision in Executive Benefits Insurance Agency v.
Arkison, which we previously discussed on June 9,18 did
not resolve whether party consent is sufficient to overcome a lack of constitutional authority when the consent question was “squarely presented” to the Court, although it did confirm that the court’s findings could be treated as proposed findings of fact and conclusions of law. The bankruptcy court granted a stay pending appeal observing Frazin, Arkison, and other post-Stern cases led to a “serious state of flux” in the law and created the potential for a “waste of significant judicial resources” when a party such as HSP could grab a “second bite of the apple” by changing its position regarding bankruptcy court authority after an unsatisfactory result at trial.
Using the bankruptcy court’s reasoning, it is hard to see how a court could ever deny a stay pending appeal for a case involving state law counterclaims. The bankruptcy court several times in its opinion expressed confidence that the resolution of the debtors’ counterclaims was necessary to resolve HSP’s claims against the estate, which it could have relied on in order to bolster its claim for authority. The movants even had withdrawn their Stern objection. That a stay was granted in this case demonstrates just how uncertain the law is regarding consent and other Stern issues following Arkison and the
fact and law arising out of the management agreement
between HSP and the debtors. The bankruptcy court also found that it has authority to enter judgment on HSP’s counterclaims for attorneys’ fees and costs in the copyright action because HSP remained a potential creditor of the debtors’ estates until resolution of those
17 732 F.3d 313 (5th Cir. 2013).
18 See Breaking News: Unanimous Supreme Court Closes Statutory Gap, Leaves Other “Core” Stern Questions For Another Day (Executive Benefits Insurance Agency v. Arkison) dated June 9, 2014 on the Weil Bankruptcy Blog.
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reluctance by bankruptcy courts to tread in such issues for fear of getting the answer wrong.
There is hope, though. Now that the Supreme Court seems likely to determine the effect of consent on a bankruptcy court’s power to determine Article III questions, perhaps these uncertainties will be reduced. Until the Supreme Court decides Sharif, the debtors and others like them may have to keep waiting.
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In this section:
￭ Got Milk? Apparently Not Enough for This Dairy Producer. Court Denies Confirmation Because Plan Not Feasible, dated January 16, 2014
￭UnreasonablySmallCapital,dated January 28, 2014
￭MassTortBankruptciesand Valuation Considerations in the Claims Estimation Process, dated February 12, 2014
￭ Always Sunny In Adelphia – Bankruptcy Court Rejects DCF with Unreliable Projections, Drops Some Valuation Knowledge, dated May 28, 2014
Slice of the Pie
When dealing with valuation questions in bankruptcy, demands by creditors such as “Show me the money!” may quickly deteriorate into plaintive questions such as “Where did the money go?” In the first half of 2014, our Slice of the Pie series analyzed how courts have grappled with the key concept of valuation at various stages of a bankruptcy case, including in the context of avoidance action litigation, asset sales, secured lender foreclosure, claims estimation, and plan confirmation. Although each case presented its own unique facts and challenges, the courts continued to emphasize the importance of analyses of valuation and projections, rather than simply the advice of testifying experts. In fact, courts reminded parties that, just because a method or argument is generally acceptable does not mean that it’s always reliable, particularly when it is based on inputs or assumptions (such as management projections or anticipated revenues) that are may be flawed or uncertain (or, dare we say … pie in the sky?).
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Got Milk? Apparently Not Enough for This Dairy Producer. Court Denies Confirmation Because Plan Not Feasible
When are projections so optimistic that a chapter 11 plan cannot be confirmed? As the debtor in In re Friendship Dairies1 found out the hard way, when the projections start faltering right out of the gate. In our continuing
series on valuation issues, we examine the perils of highly optimistic projections in business plans.
In Friendship Dairies, the debtor was a dairy producer whose chapter 11 plan was premised on a complete revamping of its dairy operations. During the chapter 11 case, the debtor started moving its operations to a more intensive milking and complementary farming operation, with the hopes that the more modernized operations would generate sufficient income to pay its creditors in full over a period of several years and at rates that accorded its creditors the present value of their respective claims. The proposed chapter 11 plan sought to pay the many classes of secured and priority claims in installments, with certain classes receiving balloon payments at the end of the installment period. All but one of the impaired classes accepted the plan. The debtor’s largest secured creditor, AgStar, rejected the plan. (Apparently, the debtor’s relationship with AgStar was the topic of much of the litigation during the chapter 11 case as well. AgStar sought liquidation of the debtor and did not have any interest in agreeing to a plan that contemplated an ongoing relationship with the debtor.) The debtor’s second largest secured creditor thought the plan would work, as evidenced by its purchase of some of AgStar’s liens and its agreement to purchase (at a discount) claims of willing unsecured creditors under the plan.
In re Friendship Dairies, No. 12-20405, 2014 WL 29081 (Bankr.
N.D. Tex. Jan. 3, 2014).
AgStar objected to confirmation of the plan on multiple grounds. Although the court noted that some of AgStar’s objections (which included a conspiracy theory) were not “without some tilting at windmills,” the court held that two of the objections had merit and each on its own justified denial of confirmation.
Applicable Statutory Standard
A chapter 11 plan may be confirmed only if the requirements set forth in section 1129 of the Bankruptcy Code are met. Among the numerous confirmation requirements is section 1129(a)(11), which requires that confirmation of the plan not likely be followed by the liquidation, or the need for further financial reorganization, of the debtor (also referred to as the feasibility standard). In addition, section 1129(a)(8) requires that each impaired class of claims or interests accept the plan. If an impaired class of claims rejects the plan, section 1129(b)(1) provides that the plan may nevertheless be confirmed if it does not discriminate unfairly, and is fair and equitable, with respect to such class (also referred to as cramdown). With respect to an impaired class of secured claims that rejects a plan, section 1129(b)(2)(A)(i) provides that a plan is fair and equitable if it allows holders of such claims to retain their liens and receive payments on account of such claims in deferred cash payments totaling at least the allowed amount of such claims, of a value, as of the effective date of the plan, of at least the value of such holders’ interests in the estate’s interest in the property subject to the liens.
The court’s primary ground for denying confirmation of the plan was feasibility. The debtor’s expert performed an analysis of the debtor’s operations going forward and prepared projections that were included in the plan. The first year of the projections commenced during the chapter 11 case and ended after the anticipated effective date of the plan. The projections did not factor in the required payments to creditors under the plan, but showed that available cash existed for plan payments and to fund reserve accounts for future contingencies. Unfortunately for the debtor, as of the confirmation hearing, the debtor already had failed to meet the projections. In addition, shortly before the confirmation hearing, the debtor failed to pay two required adequate protection payments to one of its non-objecting secured
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creditors. Due to a shortfall resulting from operations, the debtor also did not have any reserves left.
In determining whether the plan was feasible, the court looked at whether the debtor had shown, by a preponderance of the evidence, the existence of a reasonable possibility that a successful rehabilitation could be accomplished within a reasonable period of time. A reorganization plan is successful when it is not likely to be followed by liquidation, or the need for further financial reorganization. As the court noted, the success of a debtor’s plan need not be guaranteed, but it should have a reasonable assurance of commercial viability. As the court noted, courts should closely scrutinize plans that are more visionary than realistic, pragmatic approaches to the debtor’s financial problems. Even under a “visionary” plan, though, if secured creditors are fully protected in the event of the plan’s failure, the court still may confirm the plan so long as it has at least a marginal prospect of success.
The court then outlined various factors that may be considered in determining whether a plan is feasible (any of which could be weighed, or even ignored, in a court’s discretion): the debtor’s capital structure, the earning power of the business, economic conditions, the ability of debtor’s management, the probability of continuation of management, and any other related matter. As to a debtor’s capital structure, the court pointed out that courts should be wary of any plan that provides for virtually all of the income of the reorganized debtor to go to making plan payments, without a sufficient buffer to weather economic storms. As to earning power of the business, the court noted that projections should be concrete and not speculative and that failure to meet projections during a test-run (absent a legitimate, fixable excuse) is an indication of the unreliability and lack of soundness of a debtor’s projections. The court also noted that when a plan provides for balloon payments, the court will have to be satisfied that the balloon payments themselves are feasible, which likely means a showing of a successful sale of the business to a likely or known buyer or the ability to refinance the debt from a likely or known refinancer before the balloon payments become due.
Having analyzed each of these factors with respect to the debtor, the court determined that the debtor’s plan was not feasible. As the court stated, the problem is that the
debtor stumbled at the starting line by failing to meet its own projections. In fact, it did not even have enough cash on hand to pay administrative expenses on the effective date. The debtor tried to argue, unsuccessfully, that it either had or would get agreements from administrative claimants to defer effective date payments and that the unavoidable delays in resolving claims would allow the debtor essentially to put off plan payments until a time at which its operations generated sufficient revenues. The court found that failure to prove that the debtor could make the initial round of payments under the plan signaled an impending crisis. Moreover, the debtor failed to provide evidence of how the balloon payments under the plan (which were significant) would be paid, and in the court’s words, was asking the court to “take yet another leap of faith” that such payments would be satisfied through deferrals or refinancings. Thus, in light of the debtor’s struggles during the case, its crushing debt load, and lack of capital or cushion of any sort, the court concluded that the plan would not work.
Fairness & Equitableness
The court held that the chapter 11 plan was not confirmable for one additional, independent reason. Section 506(b) of the Bankruptcy Code provides that oversecured creditors may add reasonable and necessary attorneys’ fees to their claims as long as such fees do not exceed the excess collateral value, and such fees are provided for under the agreement or the state statute under which the claim arose. The debtor’s plan, however, allowed attorneys’ fees of secured creditors to be paid without interest through installment payments, which would commence only after the underlying secured claim was paid off. In AgStar’s case, this would mean that its attorneys’ fees (if otherwise allowed) would only start to be paid in installments after the balloon payment on the underlying secured claim in 2028. The court held that the failure to capitalize the attorneys’ fees in such circumstance meant that AgStar would receive much less than the present value of its claim under the plan, making the plan not fair and equitable under section 1129(b) of the Bankruptcy Code.
Aside from highlighting the obvious perils of missing projections out of the gate, Friendship Dairies demonstrates the difficulties debtors may face when making drastic changes to their operations during the
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chapter 11 case in an effort to rehabilitate themselves and premising their chapter 11 plan on the success of such operational changes. With more and more chapter “22”s and even chapter “33”s being filed, it is not surprising that courts may scrutinize feasibility of chapter 11 plans more closely.
Unreasonably Small Capital
In other posts in our Slice of the Pie series, we have examined the statutory definition of insolvency as applicable to corporate and municipal debtors, exploring the differences between balance sheet insolvency versus that of equitable, or cash flow, insolvency. We also observed that, in the context of fraudulent transfer litigation involving corporate debtors, financial distress can also be established pursuant to the capital adequacy standard set forth in section 548(a)(1)(B)(ii)(II) of the Bankruptcy Code. We now turn our attention to an analysis of this provision, which is often referred to as the “unreasonably small capital” test of financial distress.
What Constitutes Unreasonably Small Capital?
Section 548(a)(1)(B)(ii)(II) provides that a transfer may be avoided if the debtor received less than reasonably equivalent value in exchange for such transfer and “was engaged in business or a transaction, or was about to engage in a business or transaction, for which any property remaining with the debtor was an unreasonably small capital.” The Bankruptcy Code does not provide further guidance as to what constitutes “unreasonably small capital.” Courts, however, have said that inadequate capitalization applies where, post-transfer, the corporate debtor is left technically solvent, but doomed to fail. The issue of inadequate capitalization is often litigated in the bankruptcy cases of corporate debtors that seek reorganization after a failed leveraged buyout, as
demonstrated by the classic decision2 of the Third Circuit
Court of Appeals.
How Is Unreasonably Small Capital Different from Balance Sheet or Equitable Insolvency?
Interestingly, some courts apply a “balance sheet-like” test to determine capital adequacy. Others at times equate capital inadequacy with equitable insolvency (i.e., an inability to pay debts as they become due). The majority of courts, though, have concluded that capital adequacy is different from either of the foregoing standards. Indeed, courts frequently describe unreasonably small capital as a financial condition short of equitable insolvency, focusing on the existence — or lack thereof — of an adequate capital cushion post- transfer that enables the debtor to weather reasonably foreseeable business risks (including downturns). In other words, unreasonably small capitalization encompasses difficulties that are “short of insolvency in any sense, but are likely to lead to insolvency at some time in the
How Do Courts Measure Unreasonably Small Capital?
Determining capital adequacy is a question of fact, and the burden of proof is on the debtor in possession or trustee to prove by a preponderance of the evidence that the corporate debtor had unreasonably small capital during the period in which the transfer(s) occurred.
In undertaking an analysis of unreasonably small capital, courts will look to such factors as the company’s debt to equity ratio, its historical capital cushion, and the need for working capital in the specific industry at issue. In addition, courts will compare a company’s projected cash inflows (also referred to as working capital or operating funds) with the company’s capital needs through a reasonable period of time after the transfer. Courts evaluate the reasonableness of a company’s cash flow projections objectively so as to balance what might be considered management’s optimism with the company’s actual performance. Only those cash inflows that are reasonable for a company to have expected to receive — whether through new equity, cash from operations, or available credit (whether secured or unsecured) — are considered in this analysis. Although a company does not need resources sufficient to withstand any and all
Moody v. Security Pac. Bus. Credit, Inc., 971 F.2d 1056 (3d Cir. 1992).
In re Vadnais Lumber Supply, Inc., 100 B.R. 127, 138 (Bankr. D.
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setbacks, projections are not reasonable unless they include a sufficient working capital cushion. Mere survival post-transfer is not enough.
In determining whether a company has a sufficient working capital cushion, courts look not only at the company’s capital needs on the date of the transfer, but also at the company’s capital needs through a reasonable period of time thereafter. The rationale behind this extended review period is to avoid the risk of ascribing “undue weight to the state of a company’s balance sheet on a particular day” and to allow “the court to make a realistic assessment of the impact of a transfer on a
company’s ability to conduct its affairs.”4 What
constitutes a reasonable period of time after the transfer is a business-specific inquiry, and courts have used periods of approximately one year to as long as seven years. This aspect is different from balance sheet analysis, which is focused on the specific time at which a transfer occurred. Accordingly, in a capital adequacy analysis, it is not unusual for the court to look at post- transfer events to determine the reasonability of pre- transfer projections.
Why Does It Matter?
It is important for both legal and financial practitioners to understand the differences and similarities between the two separate, objective tests of financial distress that can be at issue in federal fraudulent transfer analysis. Depending upon the facts and circumstances of any particular case, one standard may be more applicable than the other, and one may be more readily established than another. Accordingly, in developing (or defending) a fraudulent transfer case, understanding the nuances of each test is essential to create a cogent story of financial distress (or financial stability), whether at the time of the contested transfer or thereafter.
Mass Tort Bankruptcies and Valuation Considerations in the Claims Estimation Process
In our previous entries5 in the Slice of the Pie series, we explored the art of valuation and the role of the artist, or valuation expert, in assisting a court’s determination of a debtor’s solvency and/or capitalization at a particular point in the past or as of the petition date. Questions of future value also can come into play in bankruptcy. Perhaps one of the more challenging valuation exercises arises in the context of a mass tort bankruptcy, where the claims estimation process can be highly litigious and is often shaped by a debtor’s prepetition experience in a less than perfect tort system. Mass tort claims estimations often involve numerous experts testifying about the estimated liability of the debtor not only for cognizable personal injury or wrongful death claims, but also for the future claims of individuals whose injuries are not yet manifest despite their alleged prepetition exposure to the debtor’s products.
Likely the classic example of such cases stems from the asbestos-related filings of the early 1990s. As the W.R. Grace Company marks its exit this month from a more than decade-long chapter 11 case, we take a look at the recent asbestos-related claims estimation decision of the United States Bankruptcy Court for the Western District of North Carolina in the chapter 11 case of In re Garlock
Sealing Technologies, LLC.6
What Is Claims Estimation?
Claims estimation, in simplest terms, is just that — a debtor’s estimation of the value of those claims filed against it that may be contingent, unliquidated, or otherwise contested. Specifically, section 502(c) of the Bankruptcy Code authorizes the estimation of any contingent or unliquidated claim if fixing or liquidating the claim otherwise would cause undue delay. Notably, although the estimation of personal injury or wrongful death claims “for purposes of distribution” in a chapter 11
Barrett v. Cont’l Illinois Nat’l Bank & Trust Co., 882 F.2d 1, 4 (1st Cir. 1989), cert. denied, 494 U.S. 1028 (1990).
See In Assessing Solvency, Beware the Unknown Unknowns
dated August 7, 2014 on the Weil Bankruptcy Blog.
In re Garlock Sealing Technologies, LLC., 504 B.R. 71 (Bankr.
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case are not “core proceedings,”7 courts have concluded that bankruptcy courts may conduct such estimations for large groups of claims where no single claim is capped for distribution purposes, and such estimation is being done in connection with a chapter 11 plan. As the Garlock court observed, though, the Bankruptcy Code does not explain how a court is supposed to estimate such claims when their value — or even existence — is contested.
How Have Courts Estimated Mass Tort Liabilities in Chapter 11 Cases?
Despite this lack of explicit statutory guidance, the Garlock court found useful precedent in the various estimation decisions of other large chapter 11 cases involving asbestos liabilities, specifically those of Eagle- Picher Industries, USG Corporation, G-1 Holdings, Owens Corning, Federal-Mogul, W.R. Grace, Armstrong
Industries, and Specialty Products.8 In fact, the court
boiled these asbestos-related claims estimation proceedings down to four general principles.
First, the court observed that each court endeavored to reach a fair estimate based on the particular facts and circumstances of the case before it, recognizing the validity of the competing concerns of the various litigants in attempting to reach a proper resolution. Indeed, even when valuation is not in dispute, the Garlock court recognized the general prudence of reaching its “own estimates of liability.”
Second, the court noted that the debtor’s role in estimation can vary from case to case. At times, litigants reach a consensual resolution in order to propose a plan of reorganization. At other times, the debtor is agnostic to the value of the claims because it has no financial exposure. In other cases, the debtor, like Garlock, hotly contested claimants’ liability estimates. The level of a debtor’s participation can also inform the court as to its acknowledgement of — or challenge to — liability.
“Core proceedings include … estimation of claims for purposes of confirming a plan … but not the … estimation of contingent or unliquidated personal injury tort or wrongful death claims against the estate for purposes of distribution in a case under title 11.” See 28 U.S.C. § 157(b)(2)(B). The decision of the United States Bankruptcy Court for the District of Delaware in the Specialty Products chapter 11 cases was appealed to the District Court for the District of Delaware. An appellate decision has not yet been rendered.
Third, the court observed that the type of asbestos product at issue can be relevant in determining the extent of a particular debtor’s liability. Garlock argued that its products produced a small dose of a less potent form of asbestos in contrast to the products of comparable debtors, and the claimants failed to produce persuasive evidence to the contrary. Accordingly, the court concluded that historical asbestos estimations from those other cases were inapplicable to Garlock.
Fourth, the court recognized that a debtor’s claims resolution history (i.e., its prepetition litigation settlements) could be a useful — if not even the best — data point in estimating a debtor’s acknowledged liability. However, it is neither the exclusive nor controlling means to estimate liability, particularly where a bankruptcy court has discretion to determine the appropriate method of estimation in light of the particular facts and circumstances of the case before it.
The Garlock Conclusion
Noting that it had conducted a seventeen-day plus trial, with 29 witnesses and hundreds of exhibits, the Garlock court reached its estimation of present and future mesothelioma claims with these principles in mind. The present and future claimants’ representatives argued for a “settlement” based approach to estimation by way of statistical extrapolation from Garlock’s history of resolution of mesothelioma claims, a methodology employed in other asbestos-related bankruptcy cases. In contrast, the debtors argued for a “legal liability” approach that focused on the merits of the claims, reduced further by claimants’ prospects for recovery from other sources, to develop a projected estimate of value.
Recognizing that the settlement approach was generally useful in an estimation analysis because a defendant’s “own history of valuing claims in the tort system” may serve as a reliable benchmark of acknowledged liability, the court concluded that its application to Garlock was of limited use where (1) there was evidence of substantial malfeasance by plaintiffs’ attorneys in the underlying litigations (including, among other things, withholding exposure evidence and purporting to not have filed claims in other debtors’ chapter 11 cases so they could inflate their clients’ claims against Garlock), and (2) significant evidence suggested that Garlock’s settlement data represented a strategy of “cost avoidance” rather than actual liability. Accordingly, the court rejected the
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entirety of the claimants’ experts’ estimation data and relied entirely on the “reasonable and reliable estimate” of Garlock and the work of its experts.
Garlock’s estimate was “based on econometric analysis of current data produced in discovery by the representatives of a sizeable sample of the current claimants,” with “applied parameters based on observation and accepted measures.” Specifically, Garlock had created an analytical database from questionnaires that it had sent to the current claimants’ law firms as part of its discovery efforts. The data produced included job histories, asbestos exposure information relating to Garlock’s and third-parties’ products, claims and recoveries made in the tort system, and claims made to other asbestos plaintiffs’ trusts. The court observed that Garlock’s efforts resulted in the “most extensive database about asbestos claims and claimants” that had been “produced to date” and, unlike historical information, was the “only data” that accurately reflected the pool of claims against Garlock.
From this “reasonable and representative” sample, Garlock’s experts extrapolated estimates of Garlock’s liability for current claimants ($25 million) and for future claimants ($100 million). Although the estimate was a “‘projection,’” the court concluded that it was accurate and reliable. As a result, the court held that Garlock’s aggregate liability for present and future mesothelioma claims was $125 million — in contrast to the claimants’ estimation of $1-1.3 billion.
Claims estimation can be important for many reasons when it arises in the context of plan confirmation, particularly as a court examines feasibility and fairness. Accordingly, practitioners and experts alike should be aware of its potential impact on total enterprise value at exit and ensure that their presentation is both reasonable and reliable in order to win claims estimation litigation.
Always Sunny in Adelphia – Bankruptcy Court Rejects DCF With Unreliable Projections, Drops Some Valuation Knowledge
As we’ve noted on several occasions,9 parties in interest in a bankruptcy case generally hope for “big money – no whammies” (“Think of Thanksgiving. Everyone wants the biggest turkey possible (except, perhaps, the chef) but all bets are off when it’s time to wrestle over who gets a
leg.”).10 Putting aside those with short positions and those
who would like to exercise control at the fulcrum position, certain other parties want to show that they have but a small turkey – plaintiffs asserting actions to recover constructively fraudulent transfers. In such a situation, the plaintiff must prove, among other things, that the transfers (i) were made while the debtor was insolvent or rendered the debtor insolvent; (ii) left the debtor with unreasonably small capital; or (iii) were made with the belief that the debtor would incur debts beyond its ability to satisfy those debts as they matured.
Such was the case in a recent dispute between the Adelphia Recovery Trust and FPL Group.11 In attempting to collect any available assets for the Adelphia estate’s remaining beneficiaries, the recovery trust commenced an
action seeking to recover $150 million that Adelphia paid FPL Group and one of its affiliates in connection with Adelphia’s repurchase in January 1999 of its own stock from FPL. One of the central issues before the bankruptcy court was whether Adelphia was insolvent at the time of the challenged transfer. Even though the district court had ruled that the bankruptcy court lacked final adjudicatory authority over the matter, the bankruptcy court’s proposed decision is a prime example of an exercise in complex valuation, especially in the context of major corporate fraud and inaccurate or unreliable contemporaneous information.
See Picking at the Carcass: Thanksgiving Thoughts dated November 23, 2011 and see March Madness: Weil’s Elite Eight dated March 19, 2014 on the Weil Bankruptcy Blog. In re Leslie Controls, Inc., 437 B.R. 493 (Bankr. D. Del. 2010).
In re Adelphia Comm., 512 B.R. 447 (Bankr. S.D.N.Y. 2014).
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The facts of the underlying transaction are interesting in their own right, but time and space constraints prevent them from being fully repeated here. For purposes of our analysis of this particular aspect of the bankruptcy court’s decision, suffice it to say that if Adelphia was solvent in January 1999, the recovery trust’s action to recover the
$150 million paid to FPL would fail.12 Among other topics,
Judge Gerber touched on the following aspects of the parties’ arguments in support of their respective valuations.
Discounted Cash Flow Analysis Is Not Persuasive in the Absence of Accurate Projections or in the Presence of Fraud
Perhaps the most important aspect of the valuation dispute and the court’s decision is the treatment of the Discounted Cash Flow (“DCF”) method of valuing Adelphia as of January 1999. The DCF method is a common one in bankruptcy valuations and estimates an enterprise’s net present value by adding together (i) the projected unlevered cash flows for a certain number of upcoming years, discounted to present value based on the company’s weighted average cost of capital (“WACC”) and
the company’s projected cash flows for the period thereafter in perpetuity (the “terminal” or “exit” value). Using this methodology, the recovery trust’s expert reached a total enterprise value of $2.538 billion before any adjustments – far less than the company’s liabilities, which the experts had valued between $3 billion and $3.9 billion.
The problem with DCF, however, is that it almost always relies upon management projections. In Adelphia’s case, however, management projections were unavailable. In any event, Judge Gerber found that any such projections would have been unreliable because they would have been generated by unreliable management, many of whom were subsequently convicted on multiple counts of fraud in connection with their management of the company. Accordingly, the recovery trust’s expert generated his own cash flow projections for the company, based on contemporaneous reports from two third-party analysts.
Yes, we know this is a tremendous oversimplification of complex issues. As always, the decision itself is the best source for a complete understanding of the issues discussed here.
Because of these deficiencies in management’s own projections, FPL’s expert declined to use a DCF analysis. The bankruptcy court agreed with that decision, observing that “[a]s a matter of common sense, DCF works best (and, arguably, only) [i] when a company has accurate projections of future cash flows, [ii] when projections are not tainted by fraud, and [iii] when at least some of the cash flows are positive.” Arguably, there is some overlap between the first two of these premises (i.e., where projections are tainted by fraud, they will likely be inaccurate – or at least unreliable). But in any event, because the fraud at Adelphia made historical financials and forward projections unreliable, the court concluded that the dispute before it was a “poster child” for a situation in which “the propriety of any use of DCF (and the weight DCF conclusions should be given)” becomes “debatable at best.”
In light of that conclusion, the bankruptcy court was “surprised” by the recovery trust’s expert’s use of DCF alone, based only roughly on third-party projections for a “typical cable company.” Moreover, the court questioned the recovery trust’s expert’s decisions to use certain assumptions from one third-party analyst selectively, while using different assumptions from another. And even though the recovery trust’s expert made these choices out of necessity (rather than data manipulation), those choices “underscore[d] the excessively arbitrary, and ultimately speculative, nature” of the analysis. Consequently, the court concluded that, because of the fraud at Adelphia, “use of alternative established metrics would be superior to reliance on DCF – and especially to sole reliance on DCF.”
Comparable Companies and Precedent Transactions
Having dismissed DCF as a reasonable form of valuation methodology in the context of the fraud at Adelphia, Judge Gerber looked to the two methodologies employed by FPL’s expert – namely, “Comparable Companies” and “Precedent Transactions.” The first methodology examines the value of comparable firms and then uses those firms’ metrics to project a value for the subject company. In this case, FPL’s expert looked to the “Value per Subscriber” – a common valuation metric in the cable industry – of six comparable companies. In light of the data for those peer companies, FPL’s expert selected a Value Per Subscriber for Adelphia at $3,024 per
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subscriber – which reflected a valuation in the lowest quartile of the comparable companies’ multiples – resulting in a valuation of Adelphia’s cable assets at
$4.472 billion. That value, plus a control premium of
$376.4 million and cash of $156.1 million, amounted to a total unadjusted enterprise value of $5.004 billion.
The Precedent Transactions methodology similarly derives an enterprise’s value from comparable companies, but derives its data from the purchase prices for comparable companies in connection with their mergers and acquisitions. Those comparable transactions led FPL’s expert to assign a Value per Subscriber to Adelphia of $3,277, plus $156.1 million in cash, yielding a total unadjusted enterprise value of $5.001 billion.
Notably, the bankruptcy court did not simply accept either of these valuations. Instead, it observed that all methodologies introduced in the dispute were “speculative” (though perhaps there was no alternative to some degree of speculation) and that both experts’ valuations were questionable, at least in certain respects. Indeed, the court noted that Adelphia’s market capitalization in January 1999, based on the market value of the company’s equity, was approximately $3.14 billion, before Adelphia’s fraud was disclosed (which, in all likelihood, would mean that Adelphia’s “true” market price would be materially lower than that amount). In any event, the court reasoned that this $3.14 billion market cap demonstrated problems with both experts’ analyses. In the first instance, the court observed that the recovery trust’s expert had not demonstrated how the undisclosed fraud would have eliminated the entire $3.14 billion market cap, plus another $1 billion in asserted negative equity. On the other hand, the court was perhaps more troubled by the valuation of FPL’s expert, which yielded a 19% premium over Adelphia’s market cap. The court therefore had “some difficulty” understanding how Adelphia’s value could ever exceed its market cap – particularly given that the as-yet-undisclosed fraud likely artificially increased Adelphia’s market cap beyond its true value at the time of the stock buyback.
Based on this observation regarding Adelphia’s Market Cap, the court reached its own independent conclusions regarding Adelphia’s enterprise value and concluded that Adelphia’s enterprise value exceeded its liabilities a(even with other important adjustments described in detail in
the court’s decision). Accordingly, the court concluded that Adelphia was still solvent at the time of the challenged transaction.
The Court’s Data
Lastly (at least for now), we note that the court provided a chart as a guide to understanding its valuation as of the time of the challenged transfer. Though it is not the first time a court has provided a similar demonstrative aid, it is a useful example of the calculations that are taken into account in a comprehensive valuation and may help parties in interest to understand certain courts’ decision- making processes in connection with resolving valuation disputes.
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In this section:
￭ You Thought Your Deal Was Set in Stone? Maybe Not, Says Bankruptcy Court More Than a Decade After Plan Confirmation, dated June 3, 2014
￭ Recent Bankruptcy Court Decision Renews Debate over Artificial Impairment, dated June 4, 2014
Making — and Confirming — a Plan
We had to wait five months for some heady cases on plan-related issues, but it was worth the wait. These cases are primarily cautionary tales. The Litigation Trust for the Trust Beneficiaries of SNTL Corp. v. JP Morgan Chase serves as a warning that a bargained-for deal may be attacked long after confirmation of a chapter 11 plan and that a chapter 11 plan is a contract, which is subject to remedies such as reformation and restitution. RAMZ Real Estate Co., LLC, a single asset real estate case, reminded us that secured creditors should proceed carefully and keep in mind the dangers associated with artificial impairment. We hope the second half of this year brings another round of exciting cases on plan-related issues.
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You Thought Your Deal Was Set in Stone? Maybe Not, Says Bankruptcy Court More Than a Decade After Plan Confirmation
As one bankruptcy court has said, “[b]ecause deals are the heart and soul of the [c]hapter 11 process, bankruptcy courts enforce them as cut by the parties.”1 Unfortunately, however, deals do not always turn out as
the parties expected and there is sometimes litigation to determine what exactly was bargained for in a chapter 11 plan. The parties learned this in The Litig. Trust for the Trust Beneficiaries of SNTL Corp. v. JP Morgan Chase (In
re Superior Nat’l Ins.).2 In Superior National, the United
States Bankruptcy Court for the Central District of California granted in part and denied in part a motion to dismiss filed in an adversary proceeding commenced against the chapter 11 plan sponsor, a lender who purchased all of equity in the parent debtor to benefit from the debtors’ net operating loss carryforwards, or NOLs, but had not made any payments to the trust that was established to receive payment from the plan sponsor and distribute funds to the debtors’ stakeholders. The plan sponsor firmly believed that the bargain struck through the chapter 11 plan, and specifically the formula used to calculate the plan sponsor’s obligations thereunder, did not require any payment to the trust created for the benefit of the debtors’ stakeholders. The bankruptcy court’s decision, however, allowed the trust’s claims for equitable remedies of unjust enrichment and reformation to survive the motion to dismiss stage, leaving the plan sponsor to defend matters that it believed were resolved by confirmation of the chapter 11 plan.
Fourteen years ago, a parent holding company and several of its subsidiaries filed for relief under chapter 11 of the
1 In re Kendall, No. 04-85449, 2005 WL 2293573, at *3 (Bankr.
C.D. Ill. Sept. 19, 2005) (collecting cases).
2 Adv. No. 13-ap-01099-GM, 2014 WL 1873300 (Bankr. C.D. Cal. May 8, 2014).
Bankruptcy Code. Unsuccessful in their business endeavors, the debtors’ primary assets were more than $1 billion of NOLs. To realize value on the NOLs, the debtors structured a chapter 11 plan that transferred 100% of the common stock of the holding company to a plan sponsor, a lender that held $19 million of the debtors’ $100 million senior debt. As consideration, the plan sponsor issued an earn-out note to a trust that was created for the benefit of the debtors’ stakeholders. The note provided that the plan sponsor would make payments to the trust under a
formula set forth in the plan – this “NOL Utilization Value”3
was allegedly meant to capture most of the value of the plan sponsor’s tax savings as a result of obtaining the NOLs.
More than a decade after confirmation of the plan, the trust commenced an adversary proceeding against the plan sponsor by filing a complaint asserting, among other things, claims of unjust enrichment and reformation of the plan alleging that the plan sponsor had the benefit of over
$2.2 billion of NOLs, which resulted in a tax savings to the plan sponsor of over $775 million, but that the plan sponsor had not satisfied its obligations under the note, as the plan sponsor had not paid anything to the trust. Specifically, the trust alleged, among other things, that (a) the plan sponsor falsely inflated components of the NOL Utilization Value formula to reduce its payments under the note, (b) the plan sponsor received the advantage of NOLs that were based on prepetition operations, but were not
3 The NOL Utilization Value was defined as: The excess of (a) the amount of the holding company’s and its subsidiaries’ NOLs in existence and available immediately after the effective date of the plan (after taking into account adjustments required by reason of consummation of the plan, including reductions required pursuant to Sections 108(b) and 382(l)(5) of the Internal Revenue Code) and subsequently utilized in the plan sponsor’s federal income tax return multiplied by the applicable federal income tax rate or rates with respect to the tax year or years in which such NOLs are utilized, over (b) the Turnaround Amount. The Turnaround Amount was in turn defined as: The amount determined by the plan sponsor in its reasonable discretion, based on advice from an accounting firm, which is equivalent to the estimated future tax liability of, or arising from the ownership of, the holding company and its subsidiaries, excluding (i) taxes attributable to operating earnings of the business of the reorganized debtors and their non-debtor subsidiaries and (ii) taxes attributable to the pre-tax economic profit from a sale or other disposition of the stock of the reorganized debtors or their businesses.
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known to exist when plan negotiations were on-going (the “Later-Recognized NOLs”), and were thus not included in the NOL Utilization Value formula, and (c) the plan did not require the plan sponsor to pay interest on the millions of dollars of time benefit on NOLs that were utilized by the plan sponsor but later subject to turnaround (the “Turn- Around NOLs”), and thus not included in the NOL Utilization Value formula. Believing that it had acted within the confines of the bargained for and confirmed chapter 11 plan, the plan sponsor moved to dismiss the trust’s claims.
Despite the confirmed chapter 11 plan, the trust asserted that, through its use of the Later Recognized NOLs and the time value of the Turn-Around NOLs, neither of which were contemplated by the plan, the plan sponsor was unjustly enriched at the expense of the trust and the debtors’ stakeholders. Thus, the trust sought restitution for the benefits gained by plan sponsor.
The plan sponsor argued that restitution on the unjust enrichment claim is barred by the existence of the plan, which was a contract that covered the subject matter of the claim for restitution. To support this argument, the plan sponsor further argued that the subject matter should be interpreted broadly as referring to the general subject matter of the contract, rather than any specific term. Specifically, the plan unambiguously excluded the Later-Recognized NOLs by covering only NOLs “in existence and available immediately after the Effective Date” of the plan, and the plan provided that the trust was to be paid interest only on the NOL Utilization Value that was distributable to the trust.
The bankruptcy court acknowledged that a claim for restitution is barred if there is a valid contract between the parties governing the same subject matter, and that the plan and the note needed not specifically address the Later-Recognized NOLs or the interest on the Turn- Around NOLs for these items to be within the subject matter of the plan and the note. That said, the bankruptcy court determined that it was improper to dismiss the restitution claim at the pleading stage because the Later- Recognized NOLs and the interest on the Turn-Around NOLs were not “specifically and unequivocally” covered by the plan and the note. Additionally, the court stated that at least one provision of the note concerning interest was vague and that the plan sponsor was ignoring the fact
that there is a difference between “interest” and the benefit of “time value.”
Reformation of the Plan
The trust also asserted a claim for reformation of the plan, which was founded upon an allegation that the plan was based on either a mutual mistake or a unilateral mistake because the parties contemplated that the plan would require the plan sponsor to make payment to the trust for the benefit of the debtors’ stakeholders. Thus, the trust believed that the plan should be reformed to properly express the parties’ intent.
In support of its motion to dismiss, the plan sponsor argued that reformation would be a modification of the plan under section 1127 of the Bankruptcy Code, and, because the plan had been substantially consummated, the plan could not be modified under section 1127. The plan sponsor argued that section 1101(2)(A) of the Bankruptcy Code focuses on the transfer of property to and from the debtor, and that all such transfers contemplated under the plan had been completed, i.e., the transfer from the plan sponsor to the trust was not a transfer that was required for substantial consummation of the plan. Moreover, the plan sponsor argued that distributions to creditors under the plan had commenced by way of distribution of the trust certificates to the debtors’ creditors and the payment of administrative claims. Finally, the plan sponsor pointed out that the plan specifically stated that amendments to the plan were not allowed without the plan sponsor’s consent.
The bankruptcy court rejected the plan sponsor’s arguments. First, the bankruptcy court noted that section 1101(2)(A) is not restricted to transfers of “property of the estate” or transfers “to or from the debtor.” Thus, because the plan sponsor had not made the requisite transfers to the trust, the plan had not been substantially consummated.
Even if the plan had been substantially consummated, the court determined that the reformation claim could not be dismissed because reformation of the plan is different from plan modification. Although the plan sponsor’s consent would be needed to amend or modify the plan, such consent was not required for the reformation of the plan because reformation is an equitable remedy that merely determines parties’ intent and the legal effect of any given contract.
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Debtors, their stakeholders, and plan sponsors should be aware of cases like Superior National and the risk that a bargained-for deal may be attacked long after confirmation of a chapter 11 plan. Superior National highlights the great care and critical thinking that counsel must undertake when structuring a chapter 11 plan, and serves as a reminder that a chapter 11 plan is a contract that can be subject to typical contractual remedies like reformation and restitution. This is especially true when a chapter 11 plan involves complicated formulas like that at issue in Superior National and the plan does not turn out to benefit debtors and/or their stakeholders as expected. Parties that value certainty should be sure to clarify any ambiguities and be as specific as possible in drafting a chapter 11 plan to address any foreseeable contingencies.
Recent Bankruptcy Court Decision Renews Debate Over Artificial Impairment
Real estate lenders should be aware of a recent decision,4 In re RAMZ Real Estate Co., LLC, in which the United States Bankruptcy Court for the Southern District of New York held that a class of claims consisting solely of a secured tax claim was impaired for purposes of voting on a debtor’s chapter 11 plan where the plan provided for the full payment of the tax claim but allowed for the payment of postpetition interest at less than the statutorily provided interest rate, and that such impairment was not artificial for purposes of satisfying the requirements of section 1129(b) of the Bankruptcy Code.
In RAMZ Real Estate, the debtor owned two pieces of commercial real property in upstate New York. One of the properties, a mixed-use building located in Kingston, New York, was encumbered by a first mortgage in favor of Community Preservation Corporation in the amount of
$744,000. The debtor commenced its chapter 11 case after Community Preservation brought a foreclosure action in state court. Approximately eight months after the commencement of the chapter 11 case, the court
4 510 B.R. 712 (Bankr. S.D.N.Y. 2014).
entered an order valuing the Kingston property at
$485,000, significantly less than the outstanding mortgage debt.
When the debtor eventually filed its chapter 11 plan, the plan provided for the treatment of seven classes of claims
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Class 7, which was unimpaired under the plan, contained the interests of the Debtor’s sole existing equity holder. Pursuant to the plan, the debtor’s existing equity holder was to retain 100% of his ownership interest although he would not receive any dividends or payments under the plan. The other classes of claims treated under the debtor’s plan consisted of claims that were either paid in full and expunged by prior order or unimpaired and, thus, not entitled to vote under the plan.
Community Preservation voted to reject the debtor’s plan both for its Class 3 secured claim and its Class 6 unsecured claim. As Community Preservation controlled the vote of Class 3 and Class 6, both of those classes rejected the plan leaving Class 4, comprised of Ulster County’s tax claim, as the only impaired class of creditors voting to accept the debtor’s plan.
Community Preservation filed an objection to confirmation of the debtor’s plan arguing, among other things, that the plan contained classes that were artificially impaired and the plan violated the absolute priority rule.
For a chapter 11 plan to be confirmable it must meet the requirements of section 1129 of the Bankruptcy Code. Section 1129(a)(8) requires that each impaired class of claims accept the plan. If this is not possible, section 1129(a)(10) permits a plan to be “crammed down” over the objection of every other class of creditors pursuant to section 1129(b) so long as at least one class of impaired
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claims held by non-insider creditors has accepted the plan. In order to cram down a chapter 11 plan, the plan must meet all of the statutory requirements provided in section 1129(b) of the Bankruptcy Code, in addition to those provided in section 1129(a).
Community Preservation first argued that the debtor’s chapter 11 plan could not be confirmed because Ulster County’s claim was not impaired for purposes of section 1129 where it was receiving payment in full over five years at 9% interest. Community Preservation further argued that any impairment of Ulster’s claim was “artificial” and manufactured solely to obtain approval by at least one impaired class of creditors.
Section 1124 of the Bankruptcy Code provides, in relevant part, that a claim is impaired unless the plan “leaves unaltered the legal, equitable, and contractual rights to which such claim or interest entitles the holder of such claim or interest….” Where a section of the Bankruptcy Code alters a creditor’s claim, that claim is not considered “impaired” by the plan, as it is not the plan, but instead the Bankruptcy Code, that alters its treatment. Section 1129(a)(9)(C)(iii) and (D) permit unsecured and secured tax priority claims, respectively, to be paid regular installment payments “of a total value, as of the effective date of the plan, equal to the allowed amount of such claim.” Section 511 of the Bankruptcy Code provides that the rate of interest to be paid on tax claims is to be determined under applicable nonbankruptcy law.
The bankruptcy court held that because Ulster was receiving only 9% interest instead of the 12% interest that it was entitled to receive under New York Real Property Tax Law, the claim was impaired for purposes of voting on the debtor’s chapter 11 plan. In so holding, the court distinguished the treatment of Ulster’s claim from the treatment of a similar tax claim at issue in In re Bryson
Properties, XCIII,5 where the Fourth Circuit noted that
priority tax claimants, which receive preferential treatment under the Code, were generally not an impaired class that could accept a plan and bind other truly impaired creditors to a cram down. Unlike the tax claim in Bryson Properties, which was paid what it was entitled
5 961 F.2d 496, 501 (4th Cir. 1992).
under the Bankruptcy Code, the court found that Ulster was not receiving the full rate of interest as provided by applicable nonbankruptcy law and, accordingly, its claim was impaired.
The court went on to find that the debtor had legitimate business purposes for impairing Ulster’s claim and, therefore, its claim was not “artificially impaired.” The court agreed with the debtor that the lowering of the interest rate from 12% to 9%, which reduced the debtor’s monthly payments and allowed the debtor to remain within its budget, constituted a legitimate business purpose. Interestingly, the court found that the difference in the interest rates of 3% was not de minimis, especially “in light of the current financial situations that many government entities have faced in the last several years.” The court further noted that Ulster could have demanded to be paid the full 12% interest and yet, it chose to accept the plan. Although the court did not weigh too far into a discussion of the debtor’s possible motivations for impairing Ulster’s claim, the court appeared to indicate that such an examination may be irrelevant when it stated that “nothing in the Code prevents a debtor from negotiating a plan in order to gain acceptance and nothing requires a debtor to employ effort in creating unimpaired classes.”
The New Value Exception and the Absolute Priority Rule
Community Preservation next argued that the debtor’s plan could not be confirmed because the plan violated the absolute priority rule, as the holders of unsecured claims in Class 6, including Community Preservation’s deficiency claim, were not receiving payment in full while existing equity in Class 7 was retaining 100% ownership of the debtor.
Pursuant to section 1129(b)(1) of the Bankruptcy Code, the objection of a rejecting creditor may be overridden only “if the plan does not discriminate unfairly, and is fair and equitable, with respect to each class of claims or interests that is impaired under, and has not accepted, the plan.” As to a dissenting class of impaired unsecured creditors, a plan may be found to be “fair and equitable” under section 1129(b)(2)(B) only if the allowed value of the claim is paid in full or, in the alternative, if “the holder of any claim or interest that is junior to the claims of such [impaired unsecured] class will not receive or retain under the plan on account of such junior claim or interest any property.” This is known as the absolute priority rule.
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Despite previously ruling that Ulster’s claim was not artificially impaired, the court found that the plan violated the absolute priority rule and, therefore, could not be confirmed under section 1129. In so holding, the court rejected the debtor’s assertion that the absolute priority rule had been satisfied where existing equity was providing new value to the debtor in the form of a $15,000 contribution. A debtor relying on the so-called “new value exception” must show that the capital contribution by old equity is: (i) new; (ii) substantial; (iii) money or money’s worth; (iv) necessary for a successful reorganization; and
(v) reasonably equivalent to the property that old equity is retaining or receiving.
Following the precedent established by the Supreme Court in Bank of Am. Nat’l Trust & Sav. Assoc. v. 203 N. La Salle St. P’ship, the RAMZ court found that there was no possibility but to deny confirmation of the debtor’s plan. As the debtor had not provided for a competing plan nor was there any evidence that any other parties were given the opportunity to bid on the equity interests, the debtor had failed to demonstrate that the new money contribution of existing equity was “necessary for a successful reorganization.” Although the court was sympathetic to the debtor, the court stated that it would not “substitute its judgment for that of the creditors, which are entitled to vote on a plan.”
Even though the RAMZ court, ultimately, did not find artificial impairment, it does not mean that every other chapter 11 plan is out of the woods. In light of this decision, as well as the Fifth Circuit’s decision last year in
In re Village at Camp Bowie I, L.P.,6 secured creditors
should proceed with caution and understand that a plan that artificially impairs creditors may ultimately not be confirmed.
6 See The Battle for Camp Bowie: A Fifth-Circuit Story of Artificial Impairment, Cramdown, and the Risks of Secured Creditors dated April 3, 2013 on the Weil Bankruptcy Blog.
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In this section:
￭ Draft Wisely or Pay Dearly: The Fifth Circuit Weighs in on the Enforceability of Prepayment Premiums (Absent Prepayment), dated February 3, 2014
￭ What Rights Do You Have If Specific Performance Is Your Only Remedy Under a Rejected Contract? Possibly None., dated February 13, 2014
￭ 363(f) Versus 365(h): A Victory for 363(f), At Least in this Case, dated April 1, 2014
￭ The [Un]Interesting Side of Prepayment Premiums: Delaware Court Rules that Make-Whole Provision Gives Rise to Liquidated Damages, Not Interest Payments, dated May 18, 2011
￭ Are You Not Entertained? The SDNY Weighs In On the Battle Between Sections 363(f) and 365(h) of the Bankruptcy Code, dated June 19, 2014
￭ The Eighth Circuit Reverses Course and Concludes that a License Agreement that Is Part of a Completed Sale Transaction Is Not an Executory Contract, dated June 26, 2014
Promises and Predictability: The Ever-Changing Law of Contracts Contracts are supposed to make parties secure that they may rely on the
performance of their counterparties. All too often, however, insolvency turns
normal expectations upside down, and not just because it may interfere with a party’s ability to perform. A number of contract law questions in bankruptcy law overlay state laws on contracts, which have their own complexities, inconsistencies and open issues, creating a never-ending supply of important and novel contract issues in bankruptcy. The Weil Bankruptcy Blog monitors new cases that shed light on contract rights in the restructuring context, bringing its readers insights on new developments in this area. The Blog’s reporting and commentary helps readers understand potential outcomes for the treatment of contract rights in bankruptcy, but also provides insight useful to parties drafting new contracts. Highlights from the first half of 2014 cover a diverse range of topics, including the interpretation and treatment of prepayment premiums, rejection of trademark license agreements, the pitfalls in bankruptcy for contracts that limit remedies to specific performance, and reconciling a debtor’s 363(f) rights with other Bankruptcy Code provisions that protect the rights of parties leasing property from a debtor.
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Draft Wisely or Pay Dearly: The Fifth Circuit Weighs in on the Enforceability of Prepayment Premiums (Absent Prepayment)
Prepayment premium litigation is all the rage these days. Lenders’ degree of success enforcing payment of such premiums – also commonly referred to as “make-whole” premiums – in the bankruptcy context has generally been dependent on state law contract interpretation and courts’ legal determinations of whether such premiums should be properly characterized as disallowable “unmatured interest” under section 502(b)(2) of the Bankruptcy Code or, alternatively, as liquidated damages. The United States Court of Appeals for the Fifth Circuit recently weighed in with an opinion denying a lender’s claim for a prepayment premium because (i) no payment was actually made prior to the accelerated maturity date of the applicable note and (ii) the note did not expressly provide for payment of the prepayment premium in the event of acceleration alone. The Fifth Circuit’s decision in
In re Denver Merchandise Mart, Inc.1 is the latest in a
string of notable decisions on prepayment premium- related issues, including decisions issued by the Second Circuit in In re AMR Corporation2 this past September (holding that the governing indenture in that case precluded the indenture trustee’s recovery on its claim for
a make-whole premium) and the United States Bankruptcy Court for the District of Delaware in In re School Specialty3 this past April (allowing a lender’s claim for a make-whole premium after finding that the credit
agreement clearly provided for payment of the premium). We’ve also previously discussed a number of other, older decisions.4
In re Denver Merchandise Mart, Inc., 740 F.3d 1052 (5th Cir. 2014). In re AMR Corporation, 730 F.3d 88 (2d Cir. 2013).
In re School Specialty, No. 13-10125-KJC, 2014 WL 1838513,
slip op. (Bankr. D. Del. Apr. 22, 2013).
See Solvent Debtors Beware – Noteholders May Be Entitled to an Unsecured Claim for Expectation Damages Resulting From a
If you haven’t been tracking this issue, you may be asking yourself – “what, exactly, is a prepayment premium anyway?” Although the precise terms of prepayment premiums vary greatly (part of the reason for all the recent sturm und drang), prepayment premium provisions (usually included in an indenture, note, or credit agreement) generally provide that in the event a borrower pays the loan or note balance, in whole or in part, in advance of the date on which payment is due, the borrower is required to pay the lender an additional amount to compensate the lender for its anticipated interest on the prepaid amounts. Lenders reason that such provisions protect them in the event that a borrower refinances to a lower interest rate and the lender, likely facing less favorable market conditions, is unable to re- lend funds at the same interest rate and obtain the benefit of its bargain. The word “prepayment” can be somewhat misleading, however, as in some cases the premium may become payable even in the absence of a payment prior to the maturity date. For instance, in Denver Merchandise, the lender and borrower both agreed that no prepayment had actually occurred. Rather, the lender argued that the note provided for payment of a premium in the event of acceleration of the note, regardless of whether or not the borrower actually made payment prior to the accelerated maturity date.
In Denver Merchandise, the borrower defaulted on a note and, following the lender’s acceleration of the outstanding amounts owed under the note, the borrower commenced a chapter 11 case. The prepayment premium dispute in that case centered on two key note provisions. The first provision, contained in Article 6 (“Prepayment”), provided as follows:
Borrower shall pay the Prepayment Consideration due hereunder whether the prepayment is voluntary or involuntary (including without
No-Call Provision in Indenture dated December 21, 2010, see also Noteholders in the Southern District of New York Not Entitled to an Unsecured Claim for Expectation Damages Resulting From a No-Call Provision in an Indenture dated January 11, 2011, see also In re Chemtura Corporation: An Analysis of the Enforceability of Make-Whole and No-Call Provisions in the Southern District of New York dated May 15, 2011, and see The [Un]Interesting Side of Prepayment Premiums: Delaware Court Rules that Make-Whole Provision Gives Rise to Liquidated Damages, Not Interest Payments dated May 18, 2011 on the Weil Bankruptcy Blog.
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limitation in connection with Lender’s acceleration of the unpaid principal balance of the Note) ….
The second provision, contained in Article 4 (“Default and Acceleration”), provided as follows:
The whole of the principal sum of this Note, (b) interest, default interest, late charges and other sums, as provided in this Note … [and] (c) all other moneys agreed or provided to be paid by Borrower in this Note … shall without notice become immediately due and payable at the option of Lender if any payment required in this
Note is not paid prior to the tenth (10th) day after
the date when due or on the Maturity Date or on the happening of any other default ….
The lender in Denver Merchandise included the prepayment premium amount (approximately $1.8 million) in its proof of claim filed in the debtor-borrower’s chapter 11 case. The debtor objected to the lender’s claim and the lender responded, arguing that it was entitled to payment of the premium because the language in Articles 6 and 4, taken collectively, provided for payment of the premium in the event of acceleration. The debtor argued, on the other hand, that Article 6 dealt only with voluntary or involuntary “prepayments” and that the language pertaining to acceleration merely provided an example of a situation in which an involuntary prepayment might be made. Similarly, Article 4 did not explicitly provide for payment of a premium in the event of acceleration, but rather just permitted the lender to accelerate “all other moneys agreed or provided to be paid” by the debtor pursuant to the note. Because neither provision explicitly provided the lender with a right to the prepayment premium in the absence of an actual prepayment, the lender was not entitled to a claim for the asserted premium amount. The United States Bankruptcy Court for the Northern District of Texas agreed with the debtor and issued a short order granting the debtor’s claim objection. The United States District Court for the Northern District of Texas affirmed, and, on de novo review (Colorado law provides that interpretation of a contract is a matter of law and is reviewed de novo), the Fifth Circuit affirmed the District Court’s ruling.
The Fifth Circuit noted as an initial matter that, absent a clear contractual provision to the contrary or evidence of a borrower’s bad faith in defaulting to avoid a penalty, a lender’s decision to accelerate acts as a waiver of a prepayment penalty. Other courts have stated this differently, noting that because acceleration necessarily “accelerates” the maturity date, any subsequent payment is, per se, not a “pre”-payment. Regardless of whether you look at the issue as one of mechanics or one of waiver, the Denver Merchandise court was clear that absent express language providing for payment of a premium in the event of acceleration alone, a prepayment premium would not be enforceable absent prepayment.
The court determined that there was no language in the note at issue that “would deem the prepayment to have been made in the event of acceleration” and that although “[t]here are several conditions that might trigger the obligation to pay the Prepayment Consideration … none requires the Borrower to pay the Prepayment Consideration absent an actual prepayment.” The court also noted that if the lender had desired to ensure payment of the premium in the event of acceleration, it could have easily achieved that result by including unambiguous language in the note to that effect. As an example of the type of unambiguous language that would have supported enforcement of the premium, the Fifth Circuit cited to a case in the United States District Court
for the Western District of Missouri,5 in which the note
provided, in part, that “[t]he [borrower] agrees that if the holder of this Note accelerates the whole or any part of the principal sum … the undersigned waives any right to prepay said principal sum in whole or in part without premium and agrees to pay a prepayment premium.”
Because the Fifth Circuit determined that no premium was due and owing under the terms of the note, the court did not need to determine the issue of whether the premium was properly characterized as unmatured interest or liquidated damages; an issue that a number of other courts, including the School Specialty court, have wrestled with. The Fifth Circuit stated, in dicta, and in contrast to the majority opinion on this issue, that a “prepayment penalty is not liquidated damages and is not subject to the rules of reasonableness for liquidated damages.” The court, however, also appears to have
5 332 B.R. 380 (W.D. Mo. 2005).
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assumed that the prepayment premium did not constitute disallowable unmatured interest under section 502(b)(2) of the Bankruptcy Code because the court’s opinion suggests that the premium would have been allowed if it had been properly provided for in the note. The Fifth Circuit’s opinion implies that, at least in the Fifth Circuit, prepayment premiums do not constitute liquidated damages or unmatured interest.
As with the AMR Corporation and School Specialty decisions, the outcome in Denver Merchandise hinged on the governing language in the note. Although the law regarding enforceability of prepayment premiums is still rapidly developing, one thing is clear – if a lender intends to obtain a prepayment premium in the event of acceleration and regardless of any actual prepayment, the lender should be sure to include tight, unambiguous language to that effect in the governing documents.
What Rights Do You Have If Specific Performance Is Your Only Remedy Under a Rejected Contract? Possibly None
David G. Litvack
In a recent, must-read decision,6 the United States Bankruptcy Court for the Southern District of Florida ruled that a claimant could not obtain specific performance or money damages under a rejected contract because the contract limited the remedies for breach to specific performance, and specific performance is generally unavailable to a non-debtor counterparty to a contract rejected under section 365 of the Bankruptcy Code.
Prior to its chapter 11 filing, homebuilder TOUSA, Inc. (and its affiliates) entered into two contracts that required TOUSA to build and then sell homes to another homebuilder. After filing for chapter 11 protection, TOUSA received bankruptcy court approval to reject certain executory contracts, including the two contracts at issue. As a result of these contract rejections, the counterparty-claimant to the rejected contracts filed a proof of claim seeking rejection damages. The debtors objected to the claim and asserted that both contracts
In re Tousa, Inc., 503 B.R. 499 (Bankr. S.D. Fla. 2014).
clearly provided that, in the event of a default, the claimant could only seek a return of certain deposits or equitable relief, such as specific performance. Importantly, the contracts expressly provided that the claimant waived “any right it may now or in the future have, at law, in equity or otherwise, to seek or obtain money damages from Seller.” Notwithstanding this unequivocal language, the claimant asserted that it was entitled to money damages.
Under section 365(g) of the Bankruptcy Code, rejection of an executory contract constitutes a prepetition breach of such contract. Section 365, however, does not state what this means. As a result, courts are left to address issues such as whether the non-defaulting party is limited to asserting a claim for damages or whether it retains a right to specific performance. Section 101(5)(B) of the Bankruptcy Code converts certain rights to specific performance to claims, and section 502(c)(2) of the Bankruptcy Code permits a court to estimate, for purposes of claim allowance, “any right to payment arising from a right to an equitable remedy for breach of performance.” Nothing in the Bankruptcy Code, however, expressly ties these concepts together in the context of a rejected contract.
In TOUSA, the bankruptcy court started with the principle adopted by some courts that rejection of an executory contract typically deprives the non-defaulting party of its rights to specific performance. The bankruptcy court noted that, although section 502(c)(2) contemplates estimation of equitable remedies, this section of the Bankruptcy Code only allows for estimation if a claim “involves a right to payment” in the first instance. Put differently, section 502(c)(2) presupposes that a “right to payment” exists for breach of specific performance before estimation. Accordingly, the bankruptcy court characterized the central dispute between the parties as whether the counterparty had a right to payment, either under the contract or under state law.
Notwithstanding the express waiver in the contracts with respect to money damages, the claimant argued that Florida law creates an exception to this contractual waiver where the remedy of specific performance is impossible. Under this exception, where a seller intentionally breaches a contract in order to sell property at a higher price to a third party, the buyer may be entitled to recover the difference between the original buyer’s
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offer and the higher price paid by the third party notwithstanding a contractual waiver of money damages. The bankruptcy court, however, rejected this argument and found that TOUSA did not profit from the property at issue to the detriment of the claimant, deeming the exception to be inapplicable. The bankruptcy court held that because the rejected contracts expressly waived the claimant’s right to any money damages claim, and rejection foreclosed any possibility of specific performance, the only remaining remedy for the claimant under the contract was to seek a return of deposits.
It is worth noting that, in this particular case, specific performance was actually impossible because TOUSA,
are the ability of the lessee to retain its rights under the lease such as the right of possession. The conflict between these two sections is apparent: does free and clear really mean free and clear, even of rights granted under the Bankruptcy Code? Or can another provision of the Bankruptcy Code, for example section 365(h), limit a sale under section 363(f)? What happens to a tenant (or a licensee of intellectual property with rights post-rejection under section 365(n) of the Bankruptcy Code) when a debtor sells substantially all of its assets, including assets subject to a lease or license during a bankruptcy case? The United States Bankruptcy Court for the District of Montana weighed in on this issue in In re Spanish Peaks
after notice and a hearing, sold the property that was the subject of the two rejected contracts. Specifically, the bankruptcy court noted that the claimant “waived its specific performance entitlement when it was put on notice of the [m]otion to approve the [sale of the properties at issue] and did not object.” It is unclear, however, why this mattered to the bankruptcy court because it held that, as a general matter, rejection of a contract deprives a non-defaulting party of its specific performance remedy. Other courts, however, have held that the notable exception to this rule is where the remedy of specific performance cannot be reduced to monetary damages.
Although the ultimate result is not surprising, attorneys drafting similar contracts are wise to think twice about limiting remedies in a contract solely to specific performance. In the event of a bankruptcy filing, that remedy may prove to be illusory. As the old saying goes, “cash is king,” which holds especially true in the bankruptcy arena.
363(f) Versus 365(h): A Victory for 363(f), At Least in This Case
Section 363(f) of the Bankruptcy Code allows a trustee to sell property of the estate free and clear of any interest of an entity other than the estate. Section 365(h) of the Bankruptcy Code, on the other hand, protects the interests of a lessee in the event the trustee rejects an unexpired lease of real property where the debtor was the lessor. Among the protections afforded by section 365(h)
Holdings II, LLC.
Spanish Peaks Holdings II, LLC and its affiliated debtors sought to develop a private high-end residential ski and golf resort in Big Sky, Montana. To that end, in November 2006, the debtor entered into a loan agreement secured by its real property. Subsequently, Spanish Peaks entered into a lease, as lessor, with one of its non-debtor affiliates for The Pinnacle at Big Sky Restaurant. The Pinnacle lease was for a term of 99 years at a rental rate that was significantly below market. Spanish Peaks also entered into a lease, known as the Opticom lease, with a separate affiliate, covering real property in Gallatin and Madison Counties, Montana, under which Spanish Peaks was the lessor. The lease was for a term of 60 years and was never recorded.
In October 2011, the debtors filed a petition under chapter 7 of the Bankruptcy Code. The chapter 7 trustee sought to sell substantially all of the debtors’ assets to the debtors’ prepetition lender pursuant to section 363. The trustee’s proposed sale order provided that the sale would be free and clear of all liens, claims, interests and encumbrances under section 363(f) with the exception of certain permitted encumbrances. The Pinnacle and Opticom leases were never listed as permitted encumbrances.
Section 363(f) vs. Section 365(h)
At the sale procedures hearing, the affiliates that were lessees under the Pinnacle and Opticom leases opposed
In re Spanish Peaks Holdings II, LLC, Case No. 12-60041, 2014 WL 929701 (Bankr. D. Mont. Mar. 10, 2014).
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the sale and stated that if the leases were rejected, the affiliates would elect to retain all of their rights under section 365(h). The parties agreed to postpone a decision on the nature of the affiliates’ rights until the sale hearing. Subsequently, the trustee filed a motion to reject the Pinnacle and Opticom leases. No timely objection was received, and the court granted the trustee’s motion.
At the sale hearing, the lender sought a determination that the sale was free and clear of the Pinnacle and Opticom leases under section 363, and that section 365(h) did not apply to preserve the affiliates’ subordinate and/or voidable leasehold interests following the sale. The affiliates objected.
In making its decision, the bankruptcy court examined a split in the case law between courts holding that section 365(h) rights may be terminated in a section 363 sale, and courts holding that a tenant’s rights under section 365(h) may not be ended by a sale free and clear.
The bankruptcy court noted that courts holding that section 363(f) trumps generally rely on two canons of statutory construction: (i) statutes should be given their plain meaning; and (ii) courts should interpret statutes so as to “avoid conflicts between them if such construction is possible and reasonable.” The main case holding that section 365(h) rights may be terminated by a section 363(f) sale is the Seventh Circuit’s decision in Precision Industries, Inc. v. Qualitech Steel SBQ, LLC. In Precision Industries, the Seventh Circuit concluded that:
Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest — provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the debtor remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property.
327 F.3d at 548. Under Precision Industries, any lessee could have its possessory interest ended, subject to receiving adequate protection, if requested.
In contrast, the cases holding that section 365(h) trumps have noted that “specific legislation governs general legislation” and that section 365(h) “evinces a clear intent” that a “tenant will not be deprived of his estate for the term for which he bargained.” These cases further
conclude that “since Congress decided [with the enactment of section 365(h)] that lessees have the option to remain in possession, it would make little sense to permit a general provision, such as section 363(f), to override its purpose.” In re Churchill Props. III, L.P. Thus, according to these cases, “the lessee’s leasehold estate cannot be diminished, changes or modified due to bankruptcy’s intervention …. In short, §365(h) seeks to prevent forcible evictions whenever possible.” In re Lee Road Partners, Ltd. These cases all agree that section 365(h) is intended to protect the terms for which a lessee has bargained, including the rights of possession and quiet enjoyment.
The bankruptcy court in Spanish Peaks adopted neither of these two approaches. Instead, it found that a “case-by- case, fact-intensive, totality of the circumstances, approach, rather than a bright line rule” should guide whether section 363(f) or section 365(h) governs in any situation. In the case before it the bankruptcy court held that the property could be sold free and clear of the affiliates’ section 365(h) possessory rights, based on findings that (i) the leases between the debtors and the affiliates were entered into at a time when all parties were controlled by the same individual, (ii) the Pinnacle lease provided for lease rates that were far below fair market rental rates, (iii) the Opticom lease was never recorded, and (iv) the affiliates neither sought nor obtained a nondisturbance agreement from the prepetition lender to protect their rights.
Moreover, notwithstanding section 363(e) of the Bankruptcy Code, which generally provides that a party with an interest in property being sold by the trustee/debtor is entitled to adequate protection, the court found that the affiliates were not entitled to adequate protection in the case before it. This is because they had not requested adequate protection and they provided no evidence that they would suffer any economic harm if their possessory interests were terminated.
Relevance for Section 365(n)
Just as section 365(h) protects the rights of lessees, section 365(n) protects the rights of licensees of intellectual property in the event the trustee rejects an executory contract under which the debtor is a licensor. Section 365(n), in part, allows a licensee to retain certain rights under any such contract for the duration of the agreement. The outcome of any 363(f)/365(n) dispute
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would likely turn on the approach adopted by the bankruptcy court. A court following Precision Industries would likely hold that a section 363(f) sale terminated the licensee’s section 365(n) rights, although the licensee would still be entitled to adequate protection to the extent damages were established. Courts following the Churchill Properties/Lee Road Partners line of cases would likely hold that the licensee’s section 365(n) rights are preserved in any sale under section 363(f). Finally, courts using a fact-intensive approach, similar to the one here, would conduct the requisite inquiry and allow a totality of the circumstances guide them.
Although here the court appeared to side with the cases holding that section 363(f) trumps, the facts before the court were unique enough that most courts applying a similar fact-intensive framework might decide that a lessee’s 365(h) rights should be preserved. The leases in this case were between insiders and were well under- market, and the lessees did not take any actions to protect themselves either by seeking a nondisturbance agreement with the lender or by establishing a case for adequate protection. Moreover, in most cases where courts hold that section 363(f) trumps, lessees would likely seek, and be granted, adequate protection. We here at the blog will continue to monitor the battle of section 363(f) versus 365(h)/365(n) and we will be sure (of course) to keep you informed of any future developments.
The [Un]Interesting Side of Prepayment Premiums: Delaware Court Rules That Make-Whole Provision Gives Rise to Liquidated Damages, Not Interest Payments
whether a debtor may repay debt prior to its maturity where the debt instrument prohibits such prepayment and whether prepayment penalties pursuant to “make-whole” provisions entitle the lenders to a claim over and above principal and accrued interest. Yet the question still remains: what is a “make-whole” provision? Yes, a make- whole provision may provide for a prepayment premium – a charge for prepaying debt, designed to compensate lenders or noteholders for the loss of future interest that would have been earned had the debt not been paid down early. But what is that payment? Is it interest? A penalty? Neither? Both?
Though the answers to those questions are not necessarily fully settled in all jurisdictions, Judge Shannon of the United States Bankruptcy Court for the District of Delaware recently provided further guidance in construing the fundamental nature of prepayment penalties pursuant to make-whole provisions, holding that make-whole payments are not payments of unmatured interest, but should, instead, be construed as liquidated damages.
In In re Trico Marine Servs., Inc.,11 the debtor, Trico Marine International, Inc. issued approximately $18.9 million in notes to finance the construction of two supply vessels. The indenture for those notes provided that payments thereunder were subject to an optional redemption premium (i.e., a make-whole premium) that would mature if and when the debtor elected to redeem the notes “in whole or in part, at any time, at the redemption prices.”
The notes were not secured by any of the debtor’s property, but to induce the extension of this facility to the debtor, the United States Secretary of Transportation guaranteed the notes on behalf of the Maritime Administration, which administers a financial program to develop and promote the U.S. Maritime Service and other
In our previous posts, we have devoted8 extensive9 discussion10 to “make-whole” provisions. We have asked
8 See Solvent Debtors Beware – Noteholders May Be Entitled to an Unsecured Claim for Expectation Damages Resulting From a No-Call Provision in Indenture dated December 21, 2010 on the Weil Bankruptcy Blog.
See Noteholders in the Southern District of New York Not
Entitled to an Unsecured Claim for Expectation Damages Resulting From a No-Call Provision in an Indenture dated January 11, 2011 on the Weil Bankruptcy Blog.
See In re Chemtura Corporation: An Analysis of the Enforceability of Make-Whole and No-Call Provisions in the Southern District of New York dated March 15, 2011 on the Weil Bankruptcy Blog. In re Trico Marine Servs., Inc., 450 B.R. 474 (Bankr. D. Del. 2011).
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programs in furtherance of national maritime defense. Specifically, the Maritime Administration guaranteed payment of any unpaid interest or principal on the Trico notes. In exchange, the debtor granted the Maritime Administration a promissory note secured by a first priority lien on the vessels.
After commencing its chapter 11 case, the debtor sold the vessels. In exchange for its consents to the sale, the Maritime Administration demanded that the debtor use the proceeds to repay the outstanding notes (so as to ensure that the guarantee would not be called). Following the sale, the debtor paid the indenture trustee’s claims for outstanding principal and accrued interest under the indenture, but disputed the indenture trustee’s claim for make-whole premiums relating to the payoff. The debtor argued, among other things, that the make-whole premium should be disallowed as unmatured interest pursuant to section 502(b)(2) of the Bankruptcy Code, or, in the alternative, that the make-whole premium was a general unsecured claim that was not covered by the guarantee. Implicitly conceding that the make-whole premium was unmatured interest, the indenture trustee argued that the make-whole premium was covered by the guarantee and that it could, therefore, look to the Maritime Administration for payment of the make-whole premium. Not surprisingly, the Maritime Administration contended that the make-whole premium was not “interest” and thus, not covered by its guarantee.
Judge Shannon observed that courts have disagreed on the proper understanding of make-whole provisions and whether payments pursuant to those provisions should be characterized as unmatured interest or as liquidated damages. Judge Shannon agreed with the apparent majority view that prepayment premiums should more properly be construed as liquidated damages, noting that a majority of courts to have faced the issue have held similarly. Although Judge Shannon did not devote extensive discussion to the issue, the cases cited in Trico had reached that conclusion largely because make-whole payments constitute fully matured obligations pursuant to a contract and are not unmatured obligations that simply would have been incurred had the loan not been prepaid. In other words, because the obligation itself comes due at the time of prepayment, any such prepayment penalties are not deemed to be “interest” simply because the amounts of such payments are based on calculations of future interest obligations that would have been incurred.
A significant implication of the Trico decision is that, according to that holding, make-whole premiums cannot be disallowed pursuant to section 502(b)(2) of the Bankruptcy Code because they are not unmatured interest. What is a make-whole payment? The answer may not yet be fully clear for all purposes, but, at least under Trico, it is not unmatured interest.
Are You Not Entertained? The SDNY Weighs in on the Battle Between Sections 363(f) and 365(h) of the Bankruptcy Code
The conflict between sections 363(f) and 365(h) of the Bankruptcy Code involves the question of whether a debtor-lessor — through a free and clear sale pursuant to section 363(f) — can extinguish a lessee’s appurtenant rights in a lease despite the protections afforded such rights by section 365(h). Many courts have grappled with this question, often with diverging results. Some courts find that section 363(f)’s provision for sales free and clear of “any interest” includes a lessee’s appurtenant rights otherwise protected by section 365(h). Other courts reach the opposite conclusion, holding that 365(h)’s specific protections cannot be overcome by 363(f)’s broad language. We recently discussed a decision where the court held that the dispute should be resolved on a “case- by-case, fact intensive, totality of the circumstances approach, rather than a bright line rule.” Despite the diversity in authority, however, one thing most courts agree on is that the two sections seem to be irreconcilable.
The District Court for the Southern District of New York, in its recent decision in Dishi & Sons v. Bay Condos LLC,12 disagreed with the majority view and concluded that when read properly, section 363(f) and 365(h) do not conflict. The Bay Condos decision attempts to harmonize the language and resolve the tension between sections 363(f)
and 365(h), advancing the prospect of a resolution to the current discord in the courts.
12 510 B.R. 696 (S.D.N.Y. 2014).
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Section 363(f) authorizes the debtor to sell estate property free and clear of any interest, provided that one of five enumerated conditions is met. Section 365(h), on the other hand, provides a lessee with a seemingly unqualified right to retain its appurtenant rights to the lease if the lease is rejected. The conflict between these sections arises when a debtor seeks to sell a property free and clear of a leasehold interest. In other words, does section 363(f)’s “any interest” language trump the specific protections afforded to lessees under section 365(h)?
Most courts have concluded that the sections are irreconcilable and that 365(h) trumps 363(f). Courts adopting this view typically make three arguments in support of this result: (i) principles of statutory construction provide that the specific governs the general, and, therefore, section 365(h)’s specific protections trump 363(f)’s general language; (ii) the legislative history of section 365(h) evinces a congressional intent to protect lessees when the lessor files for bankruptcy; and (iii) the protections provided by section 365(h) would be nugatory if they could be defeated by section 363(f).
In contrast, a minority of courts have held that 365(h) only applies in the context of lease rejections, not property sales. Courts adopting this view reason that the protections of 365(h) only apply in the context of a lease rejection pursuant to section 365 — the protections are irrelevant in the context of an asset sale under 363(f). These courts often note, however, that a lessee’s appurtenant rights are nonetheless protected by the adequate protection requirements of section 363(e) despite the inapplicability of section 365(h).
In Bay Condos, the court adopted a novel approach for resolving the apparent conflict between sections 363(f) and 365(h) after the debtor sought to sell certain real property free and clear of a leasehold interest under its plan pursuant to section 363(f). The bankruptcy court’s order confirming the debtor’s plan approved the sale, but provided that the lessee had a right to elect to remain in possession of the property under section 365(h), or, in the alternative, as adequate protection of its interest under section 363(e).
Following the purchaser’s appeal, the District Court analyzed the “seemingly conflicting” provisions of 363(f)
and 365(h) and rejected both the majority and minority approaches discussed above. The court found that the supposed conflict between the sections could be resolved by first considering the role of section 365(h) in isolation. The court reasoned that section 365(h) simply codifies the principle that a debtor’s power to reject a lease under section 365 does not affect the lessee’s appurtenant rights. Accordingly, whether the debtor assumes, rejects, or does nothing with the lease, the lessee retains such rights. Further, the court noted that “nothing in § 365(h) precludes the trustee from terminating the lessee’s appurtenant rights if so empowered under another provision of the Code.” The court reconciled the apparent conflict between section 365(h) and 363(f) by concluding that because section 365(h) does not grant the lessee any special rights — it merely protects what rights the lessee already has in the event of rejection — section 363(f) may allow a debtor to sell property free and clear of the lessee’s appurtenant rights. Because the debtor failed to show that any of section 363(f)’s grounds for extinguishment were met, however, the court held that the lessee’s appurtenant rights could not be set aside and the lessee had the right to remain in possession of the property.
Thus, although section 365(h) did not prevent the sale free and clear of the lessee’s interest, it did require the debtor to take the lessee’s rights into account before selling the property free and clear of the leasehold interest under section 363(f). The court’s holding appears to reconcile the apparent conflict between these provisions by observing that the purpose of 365(h) is limited to the context of lease rejections — it does not grant lessees rights that may never be avoided by some other means. The ruling also strikes a balance between the majority and minority views discussed above by avoiding a categorical rule that either section 363(f) or 365(h) controls. Instead, the court puts lessees’ appurtenant rights on par with any other interest subject to extinguishment under section 363(f). Because the court ultimately held that a seller can extinguish a lessee’s appurtenant rights through a 363(f) sale — provided that one of section 363(f)’s five grounds for extinguishment is met — Bay Condos appears to be a defeat for section 365(h).
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The court’s ruling on the applicability of section 365(h) did not entirely resolve the issue of whether the lessee was entitled to retain possession of the property. The court continued its analysis to note that, even if the lessee’s appurtenant rights could be extinguished under section 363(f), section 363(e) requires the court to “prohibit or condition such use, sale, or lease as is necessary to provide adequate protection of such interest.” Adequate protection is defined in section 361, which states that adequate protection may be provided by, among other things, the “indubitable equivalent” of the entity’s interest.
In Bay Condos, the court held that even if the lessee’s appurtenant rights — including the right to maintain possession of the property — could be extinguished in a sale pursuant to 363(f), the lessee would nonetheless be entitled to remain in possession as adequate protection of its interest. The court reasoned that adequate protection could only be achieved through the lessee’s continued possession because the lessee’s interest was difficult to value and the lessee was unlikely to receive any compensation for its interest under the terms of the sale. Accordingly, at least in certain circumstances, a lessee may be entitled to continued possession under section 363(e) regardless of whether a sale free and clear of the lessee’s appurtenant rights is permissible. Further, sellers should realize that extinguishing a lessee’s appurtenant rights through a 363(f) sale may be a pyrrhic victory if the lessee is entitled to remain in possession as adequate protection of its interest.
Bay Condos adds another branch to the split of authority surrounding the conflict between sections 363(f) and 365(h) of the Bankruptcy Code. By declining to adopt the majority or the minority approach, Bay Condos charts a “middle way,” giving effect to what the court believed to be the underlying purposes of both sections. Although it remains to be seen whether other courts will adopt this new approach, Bay Condos also suggests that the outcome of this dispute is not always determinative of whether a lessee may retain possession of a property sold pursuant to section 363(f). Even if section 365(h) is not an absolute protection of a lessee’s appurtenant rights in a free and clear sale, the lessee may, in certain
circumstances, retain possession of the leased premises
Condos does not declare a clear winner in the battle between section 363(f) and 365(h), it does suggest that lessee’s seeking to remain in possession following a free and clear sale have another dog in the fight in the adequate protection provisions of section 363(e).
The Eighth Circuit Reverses Course and Concludes That a License Agreement That Is Part of a Completed Sale Transaction Is Not an Executory Contract
In 1988, Congress added section 365(n) to the Bankruptcy Code to provide special protections for licensees of intellectual property upon a debtor’s rejection of an intellectual property license agreement. Whether trademarks are within the ambit of section 365(n) protection, though, is open to question. Accordingly, one way that licensees of trademarks have sought to protect their trademark licenses is to challenge the ability of a debtor to reject license agreements on the ground that the agreement is not an executory contract. The United States Court of Appeals for the Third Circuit has already addressed this issue in In re Exide Techs., 607 F.3d 957
(3rd Cir. 2010), concluding that a license agreement
granting a perpetual, royalty-free, and exclusive trademark license in connection with a completed sale transaction should not be treated as an executory contract. Now the Eighth Circuit has weighed in on a similar issue with Lewis Brothers Bakeries Inc. v.
Interstate Brands Corp. (In re Interstate Bakeries Corp.).13
In Interstate Bakeries Corp., the United States Court of Appeals for the Eighth Circuit, sitting en banc, reversed a divided panel decision14 and concluded, among other things, that the debtor could not reject a perpetual, royalty-free, and exclusive trademark license agreement
because the license agreement was part of a larger, integrated agreement that had been substantially
13 751 F.3d 955 (8th Cir. 2014) (en banc).
Lewis Bros. Bakeries Inc. v. Interstate Brands Corp. (In re
as adequate protection of its interest. Although Bay
Interstate Bakeries Corp.), 690 F.3d 1069 (8
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performed by the debtor, and, thus, was not an executory contract.
As part of a divestiture required by an antitrust decree, Interstate Brands entered into an agreement with Lewis Brothers Bakeries to sell certain of its bread operations and assets located in territories in Illinois. This agreement was effectuated by the execution of two agreements, an Asset Purchase Agreement and a License Agreement. The Asset Purchase Agreement provided for the transfer to Lewis Brothers certain of Interstate Brands’ tangible assets and the grant of a “perpetual, royalty-free, assignable, transferable exclusive license to the trademarks … pursuant to the License Agreement.” The License Agreement provided Lewis Brothers a fully paid- up, perpetual license to use certain of Interstate Brands’ trademarks. Of the $20 million purchase price paid by Lewis Brothers, the parties allocated $8.12 million to the intangible assets, including the trademarks.
Nearly eight years after the completion of the sale to Lewis Brothers, Interstate Brands filed for chapter 11
contract and subject to assumption and rejection under section 365 of the Bankruptcy Code. Such obligations included, among others, (i) Interstate Brands’ duties to maintain and defend the trademarks, control the quality of goods produced under the trademarks, provide certain notice to Lewis Brothers, and refrain from using the trademarks in certain territories, and (ii) Lewis Brothers’ obligations to refrain from sublicensing the trademarks, limit its use of the trademarks to certain territories and products, maintain the character and quality of all goods sold under the trademarks, and assist Interstate Brands in any infringement litigation.
On appeal, the district court affirmed the bankruptcy court’s decision, again only looking to the License Agreement. Specifically, the district court reasoned that Lewis Brothers’ “failure to maintain the character and quality of goods sold under the [t]rademarks would constitute a material breach of the License Agreement, thus a material obligation remains under the License Agreement, and it is an executory contract.”
On appeal to the Eighth Circuit, a divided panel affirmed
protection. Interestingly, Interstate Brands proposed in its
the district court.
In a lengthy dissent, though, Judge
plan of reorganization to assume the License Agreement. Although the opinion does not discuss why Lewis Brothers should have been content with such decision (perhaps filing a reservation of rights with respect to the characterization of the License Agreement as executory in the event the debtor were to change its mind and seek rejection), Lewis Brothers required more clarity and sought to cure its uncertainties by commencing an adversary proceeding seeking a declaratory judgment that the License Agreement was not an executory contract and was therefore not subject to assumption or rejection.
The Prior Decisions
Looking solely to the License Agreement and relying on the lower courts’ decisions15 in In re Exide Techs. which was later vacated and remanded by the Third Circuit in In re Exide Techs., 607 F.3d 957 (3rd Cir. 2010), the bankruptcy court concluded that both Interstate Brands and Lewis Brothers had material, outstanding obligations that caused the License Agreement to be an executory
In re Exide Techs., 340 B.R. 222 (Bankr. D. Del. 2006), appeal denied, judgment aff’d, No. 06-302 SLR, 2008 WL 522516 (D. Del. Feb. 27, 2008).
Colloton argued that the Asset Purchase Agreement and
the License Agreement should be reviewed as an integrated asset sale agreement and that the parties’ ongoing obligations were not substantial.
Citing to the Third Circuit’s recent decision in Exide Technologies and Judge Colloton’s dissent, Lewis Brothers petitioned for rehearing en banc. After soliciting views from the Antitrust Division of the Department of Justice and the Federal Trade Commission, which opposed the termination of a license that was granted following an antitrust decree, the Eighth Circuit granted Lewis Brothers’ petition.
The En Banc Decision
Judge Colloton wrote the Eighth Circuit’s en banc decision, which started its inquiry by identifying the precise agreement that was at issue. Noting that the lower courts had focused on the License Agreement standing alone, the Eighth Circuit stated that proper analysis must consider the integrated agreement that includes both the Asset Purchase Agreement and the License Agreement. In reaching this conclusion, the
In re Interstate Bakeries Corp., 690 F.3d 1069 (8th Cir. 2012).
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Eighth Circuit turned to Illinois state contract law and its “general rule” that “in the absence of evidence of a contrary intention, where two or more instruments are executed by the same contracting parties in the course of the same transaction, the instruments will be considered together … because they are, in the eyes of the law, one contract.” Additionally, the Eighth Circuit pointed out that treating the License Agreement as a separate agreement would run counter to the plain language of both the Asset Purchase Agreement and the License Agreement.
Turning then to the fundamental question, whether the integrated agreement is an executory contract under the Bankruptcy Code, the Eighth Circuit implemented Professor Countryman’s well-known definition of an executory contract: “a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing the performance of the other.” Additionally, the Eighth Circuit stated that the doctrine of substantial performance, under which the nonbreaching party’s performance is not excused if the breaching party has “substantially performed,” is “inherent in the Countryman definition of executory contract” and that substantial performance and material breach are “interrelated concepts” as substantial performance is the “antithesis” of material breach.
Ultimately, the Eighth Circuit concluded that the integrated contract was not executory in nature because Interstate Brands substantially performed its obligations under the Asset Purchase Agreement and the License Agreement, and its failure to perform any of the remaining obligations would not be a material breach of the integrated agreement. The Eighth Circuit reasoned that the “root or essence” of the integrated agreement was the sale of certain of Interstate Brands’ bread operations in specific territories, not the mere licensing of any trademarks, and that the full purchase price had been paid, the tangible assets had been transferred, and the License Agreement had been executed. Because the only remaining obligations (such as obligations of notice and forbearance with regard to the trademarks, obligations relating to maintenance and defense of the marks, and other infringement-related obligations) of Interstate Brands arose under the License Agreement and were “relatively minor and do not relate to the central purpose” of the integrated agreement to sell certain of Interstate
Brands’ bread operations, the Eighth Circuit concluded that Interstate Brands had substantially performed its obligations.
The Eighth Circuit’s en banc decision was not without dissent, which was written by Judge Bye and joined by Judges Smith and Kelly. In the dissent’s view, the trademark license was of primary importance to the integrated agreement, as were the ongoing obligations under the License Agreement, and, accordingly, it was not appropriate to tally the various assets transferred through the integrated agreement and conclude that the license played a minor role in the transaction. This was especially true, in the dissent’s opinion, given the “central character” of the trademark license to the antitrust decree. To support its position, the dissent compared the language of the agreements and, specifically, the severability provisions of the Asset Purchase Agreement, which indicated that if a provision would be declared invalid, the provision was severable and the remaining provisions were valid, and the License Agreement, which indicated that if any provision of the License Agreement were determined to be invalid, either party could request a renegotiation of the License Agreement. Thus, the dissent reasoned that Interstate Brands had not substantially performed its obligations under the integrated agreement, and a breach of those obligations would be material.
Parties considering trademark license agreements in connection with larger asset sales should be made aware of decisions such as the Eighth Circuit’s en banc decision in Interstate Bakeries. Interstate Bakeries may provide some assurance to licensees in such deals, especially in conjunction with the Third Circuit’s recent decision in Exide Technologies, that there are at least some courts willing to examine license agreements in the context of larger, related transactions such that it is more difficult for a debtor to escape its obligations under a license agreement via rejection pursuant to section 365 of the Bankruptcy Code. In addition, licensees of trademarks facing possible rejection of such licenses should consider the Seventh Circuit’s approach in Sunbeam, which upheld rejection of a license agreement, but nevertheless found that the licensee was not limited to a claim for money damages, but was instead entitled to retain its trademark licensing rights post-rejection.
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In this section:
￭ 363 Asset Sales: Going Once, Going Twice, Sold! … Subject to Court Approval, dated March 14, 2014
￭ Free and Clear. Not So Fast.
Bankruptcy Court Claws Back Ability to Sell Distressed Assets Free and Clear of Claims and Interests, dated April 9, 2014
￭ Peanut Butter Maker Takes More Bread in 363 Sale, Leaves Winning Bidder in a Jam, dated April 11, 2014
Going Once, Going Twice, SOLD! … and Re-Opening the Bidding
An auction typically ends when an auctioneer determines that it has received the highest and/or best offer and declares a winning bidder. Auctions under section 363 of the Bankruptcy Code end with the bankruptcy judge’s gavel, not the auctioneer’s. The delay between concluding a 363 auction and obtaining court approval leaves open the possibility of post-auction bids, which belies a fundamental tension in 363 auctions: the estate’s primary interest in any 363 auction is obtaining the highest and/or best offer for the assets being sold vs. preserving the integrity of the auction process in order to maximize value effectively. In a number of recent bankruptcy court decisions, bankruptcy courts have appeared willing to re-open an auction if a bidder is willing to make a higher and/or better offer than the “winning bid,” even in the absence of procedural irregularities. In 363 Asset Sales: Going Once, Going Twice, Sold! … Subject to Court Approval and Peanut Butter Maker Takes More Bread in 363 Sale, Leaves Winning Bidder in a Jam, the Weil Bankruptcy Blog examined decisions that have allowed higher post-auction bids, apparently favoring the estate’s interest in obtaining the highest offer over the interest in preserving the integrity of the auction process. Additionally, in Free and Clear. Not So Fast. Bankruptcy Court Claws Back Ability to Sell Distressed Assets Free and Clear of Claims and Interests, the Weil Bankruptcy Blog examined a recent bankruptcy court decision in which the court held that a debtor could not sell an asset that was co-owned with a non-debtor free and clear of claims asserted by a prior purchaser with whom the debtor had refused to close before commencing its case under chapter 7 of the Bankruptcy Code.
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363 Asset Sales: Going Once, Going Twice, Sold! … Subject to Court Approval
We previously reported that a completed auction under section 363(b) of the Bankruptcy Code does not necessarily result in the sale of the property to the winning bidder. Even if the debtor conducts an auction pursuant to bid procedures previously approved by the court, the debtor must still be prepared to prove the business justifications and defend the terms of the
proposed sale. In In re Gregg,1 the Bankruptcy Court for
the District of South Carolina echoed these principles and stressed that a 363 sale must be in the best interests of the estate and the estate’s creditors, regardless of the completion of auction procedures and the emergence of a winning bidder.
On February 1, 2013, William Maxwell Gregg, II filed a voluntary chapter 11 petition with the United States Bankruptcy Court for the District of South Carolina. The debtor’s primary assets consisted of various pieces of real property, including 38.6 acres in Mount Pleasant, South Carolina. The debtor valued the “Mount Pleasant Tract” at $30 million.
The debtor owed Jupiter Capital, LLC between $8.2 million and $9.4 million, and such debt was secured by a lien on the Mount Pleasant Tract. The debtor, looking to realize more value from the Mount Pleasant Tract than the amount owed to Jupiter, entered into an agreement with CK Multifamily Acquisitions pursuant to which CK agreed to act as the stalking horse bidder with an opening bid of $11.5 million. The court entered a bid procedures order setting forth the auction’s deadlines, hearing date, and other details.
At several hearings prior to the date of the auction, the debtor expressed optimism that there would be competing bidders on the Mount Pleasant Tract.
1 In re Gregg, No. 13-00665-DD, 2014 WL 793126 (Bankr D. S.C. Feb. 25, 2014).
Moreover, although CK’s contract was subject to a number of conditions, the debtor also expressed confidence that some of those conditions would be eliminated through the competitive bidding process.
Despite the debtor’s optimism, the debtor did not receive any competing bids for the Mount Pleasant Tract. As a result, the debtor requested court approval of the sale to the stalking horse bidder, CK, for $11.5 million, upon the terms and conditions contained in the contract with CK.
The CK Contract
The CK contract was subject to the satisfaction of various terms and conditions, including the following:
￭ CK acquiring four additional parcels, each of which was owned by a person other than the debtor, that were adjacent to the Mount Pleasant Tract; and
￭ receipt of necessary approvals, upon terms and conditions acceptable to CK, to remove a pond and redirect storm water.
CK also had the right to terminate the contract and receive a refund of its deposit if CK determined that any of the conditions were not going to be satisfied on or before the closing date.
At the sale hearing, the debtor was unable to respond to several creditors’ questions relating to the CK contract. For example, prepetition, the debtor had agreed to sell the Mount Pleasant Tract to a developer, but the developer failed to obtain the zoning approval that was required under the contract. That contract was substantially similar to the CK contract, particularly with respect to zoning approvals, yet, at the hearing, the debtor could not describe the resistance to or reason behind the failure of the developer to obtain the zoning approval.
The Court’s Opinion
The court applied the “sound business test” in determining whether to approve an asset sale prior to plan confirmation and considered whether the sale would be in the best interests of the estate and its creditors. Under the sound business test, the debtor must show (i) a sound business reason or emergency justifies a pre-confirmation sale; (ii) the sale has been proposed in good faith; (iii) adequate and reasonable notice of the sale has been provided to interested parties; and (iv) the purchase price
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is fair and reasonable. In re Gregg, Case No. 13-00665, at 6 (internal citations omitted). The court held that the debtor had not met his burden of passing the sound business test and that the sale would not be in the best interests of the estate and the estate’s creditors.
In the decision, the court explained, first, that the debtor could not answer several questions at the hearing, and the debtor lacked sufficient knowledge of the terms of the contract with CK; this was, as the court put it, “not indicative of a debtor-in-possession who takes his fiduciary duties to his creditors seriously.” Second, because the debtor was unable to testify as to the developer’s previous attempted rezoning efforts and the opposition that the developer had faced, the current acquisition of zoning and permit approvals was suspect. Third, the sale was contingent on CK’s purchase of four additional parcels, each of which was subject to the “whims” of four different owners. Fourth, at the time of the decision, the debtor had not filed a viable disclosure statement or plan of reorganization, and the debtor’s second-most valuable asset (i.e., the Mount Pleasant Tract) would be tied up for the remainder of the year under a contract that might never close; given the number of directions the debtor’s case could go, the court did not wish to tie up the property under such uncertain circumstances.
As was evident in In re Gregg, a sale pursuant to section 363(b) is always subject to final court approval. This fact is crucial and must be taken seriously by any debtor looking to auction off property of the estate. While auctions can, and often do, maximize value for the estate and produce purchasers that are ready, willing, and able to close, the auction itself does not necessarily equate to a sale of the property to the highest (or only) bidder. The debtor must, among other things, be able to defend and justify the business reasons for and the terms of the sale.
Free and Clear. Not So Fast. Bankruptcy Court Claws Back Ability to Sell Distressed Assets Free and Clear of Claims and Interests
Distressed asset purchasers should be aware of a recent decision, In re Marko,2 in which the bankruptcy court for the Western District of North Carolina called into question a trustee’s ability to sell estate assets free and clear of certain claims and interests, including claims and
interests held against co-owners of the target assets.
The dispute in that case centered on a lake house property that was co-owned by the debtors, Bruce and Elizabeth Marko, and Mr. Marko’s parents by joint tenancy. At the petition date, the property was subject to a secured mortgage debt of approximately $1.4 million.
Prior to the commencement of the bankruptcy case, the property was offered for sale through a South Carolina auction house. It was unclear whether the sale was authorized by all of the owners and whether an absolute sale was authorized. The auction, however, proceeded, and a successful bidder was selected with a winning bid of
$650,000, significantly less than the outstanding mortgage debt. When the owners failed to appear at the closing to convey title, the putative purchaser commenced a suit against the co-owners, the auctioneer, and the mortgage lender in South Carolina state court seeking a variety of relief, including specific performance of his auction contract. To complicate matters, a short time later, the mortgage lender commenced a foreclosure action against the property.
The debtors, thereafter, commenced their chapter 7 bankruptcy case, staying both the foreclosure and the putative purchaser’s state court action. All parties agreed that there was no equity in the property to benefit creditors or the debtors.
After a number of previous attempts failed to recognize any value for the estate on account of the property, the trustee filed a motion seeking authority, pursuant to
2 In re Marko, No. 11-31287-JCW, 2014 WL 948492, slip op.
(Bankr. W.D.N.C. Mar. 11, 2014).
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sections 363(b), (f), and (h), to sell the property to a third party for $1.0 million, free and clear of all liens and interests, including the putative purchaser’s specific performance and equitable lien claims. In addition, the secured lender that now held the mortgage debt agreed to carve out $75,000 from the closing proceeds for the benefit of the estate. As an alternative to the sale, the trustee also filed a motion seeking authority to abandon the estate’s interest in the property on the basis of a lack of equity and a desire to avoid continuing expense and liability for the same.
In the sale motion, the trustee proposed to sell not just the debtors’ one-half interest in the property but also the interests of the parents, pursuant to sections 363(f)(2) and 363(h) of the Bankruptcy Code, both of whom had consented to the sale. With respect to other claim or lien holders, the trustee had the consent of the secured lender as required by section 363(f)(2). With respect to the putative purchaser, however, the trustee asserted that his interests in the property were in “bona fide dispute” and, therefore, the trustee was permitted, pursuant to section 363(f)(4), to sell the property, including the non-debtors’ ownership interests, free and clear of the putative purchaser’s alleged interests. The putative purchaser objected arguing, among other things, that the sale would deny him the relief he was seeking in the South Carolina state court action, namely the right to have the property deeded to him by specific performance.
Section 363(b) permits a trustee, after notice and a hearing, to use, sell, or lease property of the estate outside the ordinary course of the debtor’s business. Section 363(f)(4) provides that the trustee may sell property “free and clear of any interest in such property” if “such interest is in bona fide dispute. …” Section 363(h) allows a trustee, in certain circumstances, to sell both the estate’s interests and “the interests of any co-owner in property in which the debtor had, at the time of the commencement of the case, an undivided interests as a tenant in common, joint tenant, or tenant by the entirety.
Although the court conceded that the putative purchaser’s interests were in bona fide dispute, the court ultimately denied the sale motion, focusing instead on, and calling into question, the trustee’s ability to use section 363(f)(4)
the non-debtor, co-owners’ interests free and clear of the putative purchaser’s claims.
After briefly examining the limited and conflicting case authority on point, the court, citing the Eighth Circuit opinion in Missouri v. Bankr. E.D. Ark.3 held that courts should “use the free and clear power with caution —
meaning they should carefully consider their jurisdictional limitations — when the bona fide dispute concerns only the rights of third parties vis à vis one another and is not a dispute with the debtor.”
The court held that because the parent co-owners could not have effectuated a sale free and clear of the putative purchaser’s claims under state law, a ruling in favor of the trustee would, effectively, extend bankruptcy relief to those non-debtor parties. Accordingly, the court found the trustee’s ability to use section 363(f)(4) in conjunction with section 363(h) to sell property free of disputed liens on co-owners’ interests questionable.
The court then went on to state that, even if such a power did exist, it should not be exercised based on the facts presented. In support of its decision to deny the trustee’s motion, the court first took note of the fact that there was no equity in the property and the Bankruptcy Code generally contemplates that over encumbered property should not be sold. The court also dismissed the argument that the sale proponents had manufactured
$75,000 of equity via the carve-out in light of the legal
quandaries and the parties’ demonstrated propensities to litigate. The court then went on to state that a ruling in favor of the trustee would interfere with and change the course of the South Carolina state court action and, with no equity and multiple non-debtor parties, the state court action had the greater interest. The court further noted that a sale would eliminate the putative purchaser’s prospective remedy of specific performance and limit his potential recovery in that action. Finally, the court held that judicial economy dictated that it deny the sale motion and defer to the state court action. Accordingly, the court denied the sale motion and granted the trustee’s abandonment motion.
Although the outcome may have been different if there had been equity in the property for creditors, the decision does cloud the ability of parties to purchase distressed
in connection with the provisions of section 363(h) to sell
3 647 F.2d 768, 778 (8th Cir. 1981).
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assets in bankruptcy free and clear of all interests, including claims and interests against co-owners. Potential purchasers of distressed assets should take care to identify all potential claims that may impact their target assets, including those held against non-debtor co- owners, before proceeding with any distressed asset sale.
Peanut Butter Maker Takes More Bread in 363 Sale, Leaves Winning Bidder in a Jam
Gabriel A. Morgan
As we have noted in number of previous posts,4 auctions under section 363(b) of the Bankruptcy Code end with the bankruptcy judge’s gavel, not the auctioneer’s. To the dismay of many readers,5 the delay between concluding an auction and obtaining court approval allows for the
possibility of post-auction bids, which may force the debtor/trustee to choose between accepting a higher and/or better offer and preserving the integrity of its
auction process. In a recent decision,6 the United States
Bankruptcy Court for the District of New Mexico allowed a higher post-auction bid and re-opened the auction, reasoning that the winning bid at auction could not be approved because the court could not make a finding that a sale pursuant to that bid was in the best interests of the estate.
Prior to commencing a voluntary case under chapter 7 of the Bankruptcy Code, Sunland, Inc. was a leading producer of organic peanut butter, operating a processing plant in Portales, New Mexico. In the months after the bankruptcy filing, the trustee marketed Sunland’s assets
See 363 Asset Sales: Delaware Bankruptcy Court Agrees That “It ain’t over ’til it’s over” (And there’s still time to participate in our poll!) dated September 13, 2013, see also 363 Asset Sales: Recent Decision Says “It ain’t over ‘til it’s over” dated September 9, 2013, and see 363 Asset Sales: Going Once, Going Twice, Sold! … Subject to Court Approval dated March 14, 2014 on the Weil Bankruptcy Blog. See The Results Are In: Readers Split, But Advantage Process!
dated November 1, 2013 on the Weil Bankruptcy Blog.
In re Sunland Inc., 507 B.R. 753 (Bankr. D.N.M. 2014).
and ultimately filed a bid procedures/sale motion that proposed to sell the assets to Ready Roast Nut Company, LLC or, if a competing bid was received, the successful bidder at an auction. Hampton Farms, LLC submitted a competing bid and, shortly thereafter, the bankruptcy court entered an order that authorized the sale of Sunland’s assets and adopted the bidding procedures proposed in the trustee’s motion.
Roughly two weeks after Hampton Farms submitted its competing bid, the trustee conducted an auction at which Hampton Farms and Ready Roast were the only participants. At the conclusion of the auction, Hampton Farms was the winning bidder with an offer of
$20,050,000; Ready Roast was designated as the back-up bidder with an offer of $20,000,000.
The following day, the bankruptcy court held a hearing on whether to approve the sale to Hampton Farms. Shortly before that hearing, a representative of Golden Boy Foods, Ltd. called the trustee and offered $25,000,000 for Sunland’s assets. The bankruptcy court heard the arguments of counsel at the scheduled hearing, but ultimately continued the hearing to a date three days later.
At the continued sale hearing, representatives of Golden Boy testified that their interest in the Sunland assets arose shortly after the bankruptcy filing, and that they had visited the processing plant to conduct due diligence when the trustee was marketing the assets. At that time, however, Golden Boy’s parent corporation was in the process of selling its subsidiary and did not wish to pursue the Sunland assets. Four days after Golden Boy had been acquired by its new owner, the trustee provided notice of the Sunland asset sale to the president and CEO of Golden Boy’s new owner (who had been the president and CEO of Golden Boy prior to its acquisition). The notice stated that parties had approximately one month to bid on the Sunland assets. “[T]hings were rather chaotic at Golden Boy” following its acquisition and the notice was overlooked. Additionally, the Golden Boy representative incorrectly believed that the Sunland assets had already been sold. By the time the representative learned that the assets were still for sale and obtained authority to bid on them, the auction was over, therefore, Golden Boy submitted its bid just before the sale hearing.
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The bankruptcy court noted the lack of Tenth Circuit precedent on the issue of whether, and under what circumstances, a bankruptcy court may disapprove a section 363 sale pursuant to a properly conducted auction and re-open bidding because of a late upset bid. Accordingly, the bankruptcy court looked to the analysis used by other circuits, observing that courts generally weigh the competing considerations of the best interests of creditors and the integrity of the auction process. Citing
a Tenth Circuit decision,7 the bankruptcy court reiterated
the process integrity concern that “[r]efusing to confirm a sale to a high bidder merely because an intervening higher bid has been received is the surest way to destroy confidence in judicial sales.” The bankruptcy court, however, believed it could address this concern by acting consistently with the bidding procedures and complying with the reasonable expectation of bidders.
To that end, the bankruptcy court found that the language in the bidding procedures and the bidding procedures order placed Hampton Farms on reasonable notice that the court could reject the auction results. The bankruptcy court also found that the bidding procedures and the bidding procedures order required the bankruptcy court to determine whether “consummation of the sale contemplated by the successful bid will provide the highest or otherwise best value for the [Sunland assets] and is in the best interests of the estate.” The bankruptcy court next considered (1) the amount of Golden Boy’s overbid (approximately 25%), (2) the effect such bid would have on creditors (most of the overbid proceeds would be distributed to unsecured creditors), (3) Golden Boy’s good faith in making its bid, and (4) the lack of a previous order approving the sale to Hampton Farms, and determined that it could not make a finding that the sale to Hampton Farms was in the best interests of the estate. Accordingly, the bankruptcy court denied the sale to the winning bidder and re-opened the auction, starting with Golden Boy’s $25,000,000 bid.
The Sunland opinion is relevant to would-be purchasers insofar as the bankruptcy court’s reasoning relies on a
7 J.J. Sugarman Co. v. Davis, 203 F.2d 931, 932 (10th Cir. 1953).
premise that would permit almost any winning bid to be trumped by a higher post-auction bid.
Specifically, the bankruptcy court’s opinion was based on the premise that a sale to the winning bidder at a properly conducted auction could not be in the best interests of the estate because the court was aware of a materially higher good-faith bid. Although a court must find that a sale is in the best interests of the estate (generally as a component of the seller’s sound business judgment) to approve the sale under section 363, that is not the standard by which a court typically evaluates the appropriateness of a late bid. Under a best interests standard, arguably any higher post- auction bid could be allowed because it would increase the value realized by the estate. The fact that the bidding procedures and bidding procedures order in Sunland required a best interests finding before approval of the sale to the winning bidder does not justify the use of that standard in allowing late bids; the bankruptcy court would have been required to make such a determination regardless of the language in the bidding procedures and bidding procedures order. By conflating the two standards, the bankruptcy court may have established a precedent for the use of a more permissive standard to evaluate late upset bids. That precedent is troubling as it could lead to courts “[r]efusing to confirm a sale to a high bidder merely because an intervening higher bid has been received,” which, as the bankruptcy court acknowledged, “is the surest way to destroy confidence in judicial sales.” Alternatively, the bankruptcy court could have reached the same outcome by finding that the winning bid at auction was grossly inadequate in light of the higher post- auction bid. By applying a more restrictive standard, such a decision would be easier to reconcile with the bankruptcy policy of promoting finality and preserving the integrity of the auction process.
Golden Boy won the re-opened auction with an offer to purchase the Sunland assets for $26,000,000 (topping Hampton Farm’s bid of $25,100,000).
Hampton Farms subsequently filed an emergency motion for (1) reconsideration of the bankruptcy court’s order denying its bid and re-opening the auction, (2) stay pending appeal, (3) leave to file an interlocutory appeal, and (4) “equitable relief” in the form of a $500,000 award from the proceeds of the Golden Boy sale. The bankruptcy court promptly denied the request for
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reconsideration, denied the request for a stay pending appeal, declined to grant leave to file an interlocutory appeal, as such a request must be directed to the District Court or the Tenth Circuit Bankruptcy Appellate Panel, and declined to grant the requested equitable relief, instructing Hampton Farms to file an application for an administrative expense.
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In this section:
￭ Distributions to Cash Out Shareholders of Target Company in an LBO are Subject to Fraudulent Transfer Lawsuits in State Court, dated March 6, 2014
￭ I Didn’t Know, I Swear! Section 548(c)’s Good-Faith Defense to Fraudulent Transfer Actions, dated March 18, 2014
￭ Whose Value is It Anyway? When it Comes to Three-Party Relationships and Preference Liability, It May Not Matter, dated April 17, 2014
￭ How Safe Is the Section 546(e) Safe Harbor? Part I: Quebecor, dated August 28, 2013
￭ How Safe Is the Section 546(e) Safe Harbor? Part II: Financial Intermediaries and Financial Institutions, dated May 5, 2014
￭ How Safe Is the Section 546(e) Safe Harbor? Part III: Risk to the Financial Markets, dated June 11, 2014
Into the Fray: Analysis of Developments in Preference and Fraudulent Transfer
We had no shortage of important decisions involving fraudulent transfers and preferences over the first six months of the year, and the Weil Bankruptcy Blog was in the thick of the action covering these cases. Although a complete depository of such decisions is available on the Weil Bankruptcy Blog’s website, this semiannual review contains the heavy hitters of the bunch. The Eighth Circuit’s decision in In re LGI Energy confirmed that three is not a crowd when it comes to the new value defense to preference actions under section 547(c)(4), finding that the requisite “new value” need not necessarily come from the creditor against which the preference action is brought. In the fraudulent transfer arena, the Fourth Circuit’s decision in In re Taneja broke new ground in defining the requisite good faith required for a transferee to avail itself of section 548(c)’s good faith defense. Departing from other circuit courts that apply a strictly objective test for determining whether such transferees possess the requisite good faith, the Fourth Circuit injected a measure of subjectivity into its good faith analysis by focusing solely on whether the circumstances surrounding the transfer should have alerted the transferee to the fraudulent purpose of the transfer.
Other posts in this category concern the avoidance safe harbor of section 546(e), which protects certain margin and settlement payments related to securities contracts from many of the Bankruptcy Code’s avoidance provisions. In Weisfelner v. Fund 1 (In re Lyondell Chemical Co.), the United States Bankruptcy Court for the Southern District of New York held that 546(e) did not apply to state law fraudulent transfer claims brought by individual creditors against shareholders who received distributions in connection with the debtor’s failed LBO. Finally, the Weil Bankruptcy Blog published parts II and III of our miniseries “How Safe Is the Section 546(e) Safe Harbor?” rounding out our three-part series on the topic. All three parts are included in this review.
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Distributions to Cash Out Shareholders of Target Company in an LBO Are Subject to Fraudulent Transfer Lawsuits in State Court
S.D.N.Y. Holds that Section 546(e) Safe Harbor Provision Does Not Preempt State Law Constructive Fraudulent Transfer Claims Brought on Behalf of Individual Creditors
On January 14, 2014, the United States Bankruptcy Court for the Southern District of New York held in Weisfelner v. Fund 1 (In re Lyondell Chemical Co.)1 that the safe harbor provision contained in section 546(e) of the Bankruptcy Code offers no protection against state law constructive
fraudulent transfer claims brought on behalf of individual creditors against shareholders of the target company in a leveraged buyout. As a consequence, former shareholders who received distributions under a failed LBO may be subject to certain fraudulent conveyance claims that a debtor would otherwise be precluded from pursuing under section 546(e).
In December 2007, Basell AF S.C.A. bought Lyondell Chemical Company through an LBO entirely financed by debt that was secured by the target company’s assets. As a result of the merger, Lyondell’s balance sheet became encumbered with approximately $21 billion of additional secured debt. $12.5 billion of the loan proceeds were used to cash out Lyondell’s shareholders.
When Lyondell filed for chapter 11 in the Southern District of New York just less than thirteen months later, its unsecured creditors’ claims stood behind the colossal $21 billion secured loan. Lyondell’s assets, however, had previously been depleted by the $12.5 billion payment of loan proceeds to stockholders, “who, under the most basic
Weisfelner v. Fund 1 (In re Lyondell Chemical Co.), 503 B.R. 348
(Bankr. S.D.N.Y. 2014).
principles of U.S. insolvency law, are junior to creditors in right of payment.”2
As part of its plan of reorganization, Lyondell created numerous litigation trusts, each of which received the right to assert specific legal claims that arose as a result of the LBO and its related transactions for the benefit of Lyondell’s unsecured creditors. Pursuant to Lyondell’s plan, once the Lyondell estate abandoned its rights under section 544 of the Bankruptcy Code to bring fraudulent transfer actions under state law, the unsecured creditors assigned their claims to the LB Creditor Trust. Certain creditors holding unsecured trade claims, funded debt claims, and senior and subordinated secured deficiency claims assigned their rights to pursue state law fraudulent transfer suits to the LB creditor trust. The LB Creditor Trust then brought constructive fraudulent transfer actions in state court, pursuant to which it sought to recover approximately $6.3 billion of the $12.5 billion in payments made to the former stockholders of Lyondell who received the largest distributions in connection with the LBO.
A group of primarily institutional stockholder defendants removed the state proceeding to the bankruptcy court and filed a motion to dismiss the state law claims. They advocated that the safe harbor provisions contained in section 546(e) immunized stockholder recipients of LBO proceeds from constructive fraudulent transfer claims — even where such claims were brought by individual creditors under state law, by a trustee under the Bankruptcy Code. Section 546(e) of the Bankruptcy Code provides a safe harbor for certain transfers relating the purchase and sale of securities. At issue was whether section 546(e) applied to fraudulent transfer claims brought by, or on behalf of, creditors under state law and whether it preempts state law fraudulent transfer claims.
Relying heavily on its recent decision in In re Tribune,3 the court held that the section 546(e) safe harbor provision neither protects against nor preempts state law
Weisfelner v. Fund 1 (In re Lyondell Chemical Co.), 503 B.R. 348, *1 (Bankr. S.D.N.Y. 2014). In re Tribune Co. Fraudulent Conveyance Litigation, 499 B.R. 310 (S.D.N.Y. 2013).
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constructive fraudulent transfer claims brought on behalf of individual creditors.
concern, the court noted, has been that of protecting market intermediaries and protecting the markets — in
Noting that the provision provides only that “the trustee
each case to avoid “falling dominos.”
Thus, even ignoring
may not avoid a transfer”4 the court held that Congress did not intend to make section 546(e) applicable to claims brought by or on behalf of individual creditors and dismissed the argument that section 546(e) might apply to individual creditors’ state law claims.
The court next turned to the creditors’ preemption arguments. Whereas the defendants argued that section
546(e) reflected Congress’s intent to protect securities-
all other bankruptcy policy and focusing solely on
Congress’s desire to protect against “ripple effects” that caused section 546(e) to come into existence, in the context of an action against cashed-out beneficial stockholders at the end of the asset dissipation chain, the court held that state law fraudulent transfer laws would not frustrate Congress’s objectives.
The court distinguished the case at bar from Whyte v.
contract transfers, thereby favoring preemption, the court
Barclays Bank PLC,
a district court decision in which the
held that this narrow interpretation of section 546(e)’s objectives was false and misleading, for several reasons. To begin, it held5 that “Congress pursues a host of other aims through the Bankruptcy Code, not least making
whole the creditors of a bankruptcy estate. It is not at all clear that Section 546(e)’s purpose with respect to securities transactions trumps all of bankruptcy’s other purposes.”
The court paid further tribute to the Tribune court’s decision in noting that by enacting section 544(b)(2), Congress expressly preempted state fraudulent transfer laws that would permit individual creditors to recover with respect to charitable contributions so long as the contribution did not exceed a Congressionally-prescribed amount. As such, the court concluded that it is safe to assume that Congress could have elected to preempt individual creditors’ state law claims but purposefully opted against doing so with respect to section 546(e).
Finally, the court noted that Congress’s intent in drafting section 546(e) was to guard the financial markets against a “ripple effect” caused by the insolvency of one commodity or security firm. In interpreting this objective,
the court emphasized6 that “[p]rotecting the financial
markets is not necessarily the same thing as protecting investors in the public markets, even if they happen to be stockholders who are major investment banks.” The
court held that the section 546(g) safe harbor impliedly
preempted state law fraudulent conveyance actions seeking to avoid swap transactions. In Whyte, the court reasoned that avoiding the swap transactions would create disruption in the markets.
The bankruptcy court distinguished Whyte along the same lines as it did in its Tribune decision, noting that the plan of reorganization in Whyte had provided for a single trust to serve in the capacity of both the trustee and the representative of outside creditors, thereby permitting the trust to pursue causes of action on the estate’s behalf that section 546(g) prevented the trustee from pursuing. The bankruptcy court also questioned the court’s rationale in Whyte, stating that the Whyte court incorrectly declined to apply the presumption against implied preemption and that Whyte failed to consider the purposes and objectives of Congress beyond protection of the financial markets, including “longstanding and fundamental principles that insolvent debtors cannot give away their assets to the
prejudice of their creditors.”9
Following this ruling, the Lyondell court dismissed several types of claims — namely, certain state law intentional fraudulent conveyance claims on the basis of inadequate pleadings, claims assigned to LB Creditor Trust by secured lenders of the LBO who had already ratified their loans and thus were barred from arguing that they were defrauded by the transactions in question, and claims
11 U.S.C. §546 (e) (emphasis added).
In re Tribune Co. Fraudulent Conveyance Litigation, 499 B.R. 310, 317 (S.D.N.Y. 2013) (quoting Kaiser Steel Corp. v. Charles Schwab & Co., 913 F.2d 846, 848 (10th Cir. 1990).
Weisfelner v. Fund 1 (In re Lyondell Chemical Co.), 503 B.R. 348, *34 (Bankr. S.D.N.Y. 2014).
Weisfelner v. Fund 1 (In re Lyondell Chemical Co.), 503 B.R. 348, *33 (Bankr. S.D.N.Y. 2014). Whyte v. Barclays Bank PLC, 494 B.R. 196 (S.D.N.Y. 2013).
Weisfelner v. Fund 1 (In re Lyondell Chemical Co.), 503 B.R. 348, *41 (Bankr. S.D.N.Y. 2014).
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asserted against entities that behaved as conduits by passing payments to others as these entities did not qualify as beneficial owners and thus could not be held liable as recipients of fraudulent transfers.
“Good Faith” Pre-Taneja
Neither the Bankruptcy Code nor its legislative history provides the parameters for determining the “good faith” required of transferee’s raising an affirmative defense under section 548(c). Instead, courts have constructed
By tracing back the legislative history of section 546(e)
the applicable framework
for assessing whether a
and taking into account the varied objectives that the Bankruptcy Code seeks to promote, the court found no support for the argument that state law constructive fraudulent transfer claims are preempted by federal law. Whether section 546 safe harbors protect shareholders against state law avoidance actions brought by creditors following the confirmation of a plan of reorganization remains a murky issue. Nevertheless, as a result of the court’s rulings in Lyondell and Tribune, former shareholders who received distributions under a failed LBO may be subject to certain fraudulent conveyance claims brought by or on behalf of individual creditors that a debtor would otherwise be precluded from pursuing under section 546(e).
I Didn’t Know, I Swear! Section 548(c)’s Good Faith Defense to Fraudulent Transfer Actions
Section 548(c) of the Bankruptcy Code provides transferees subject to fraudulent conveyance actions with an affirmative defense if they received the transfer for value and in good faith. As with any affirmative defense, the transferee bears the burden of proof. In cases where the trustee attempts to avoid a debtor’s repayment of a monetary obligation — such as a repayment of a loan or a return of an investor’s cash investment — the “for value” component is rarely at issue because the property transferred — cash — has a readily ascertainable value. But the question of what constitutes “good faith” under section 548(c) is not so easily determined. Complicating matters, the Fourth Circuit’s recent decision in In re
Taneja10 adds to the uncertainty by departing, at least in
part, from the good-faith standard applied in other circuits.
In re Taneja, 743 F.3d 423 (4th Cir. 2014).
transferee received the transfer in good faith. As a
general matter, courts will ask whether the transferee knew or reasonably should have known that the transfer was made either (i) when the transferor was insolvent or
(ii) with a fraudulent purpose. If the transferee can prove that it did not know and that it should not have reasonably known of the transfer’s fraudulent purpose, then its burden of proof is met.
In cases where the trustee alleges that the transferee “should have known” of a transferor’s fraudulent purpose, the analysis consists of two components. Initially, courts will consider whether the transferee knew or reasonably should have known of certain facts — often referred to as “red flags” — that would have alerted a reasonably prudent transferee to the fraud. If the court determines that there were sufficient red flags surrounding the transfer to provide such “inquiry notice” of potential fraud, the transferee can still avail itself of section 548(c)’s affirmative defense by showing that a reasonably diligent inquiry would not have discovered the fraud. Both the inquiry notice and diligent inquiry components are objective tests. Accordingly, the court considers what a similarly situated, reasonably prudent transferee either should have known, or, if there are sufficient red flags such that a transferee would have inquiry notice of the potential fraud, should have discovered after a reasonably diligent inquiry.
The Good Faith Standard in Taneja
The Fourth Circuit’s split decision in Taneja introduces a measure of subjectivity into the standard of “good faith” required by section 548(c). In Taneja, the court held that the appropriate standard of good faith in the section 548(c) context is whether the “transferee actually was aware or should have been aware, at the time of the transfers and in accordance with routine business practices, that the transferor-debtor intended to hinder,
See Christian Bros. High School Endowment v. Bayou No Leverage Fund, LLC (In re Bayou Group, LLC), 439 B.R. 284 (2d Cir. 2010).
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delay, or defraud any entity to which the debtor was or became … indebted.” At first glance, this good-faith standard seems to comport with the generally accepted standard discussed above. It is in the application of this standard, however, that the Fourth Circuit appears to break new ground.
The transfers at issue in Taneja involved certain payments Financial Mortgage, Inc., a mortgage originator, made to First Tennessee National Bank, N.A., one of FMI’s mortgage warehouse lenders. Leading up the financial crisis of 2007–08, FMI was engaged in a fraudulent scheme that had started as early as 1999. As the financial crisis deepened, FMI’s operations crumbled. By the time the dust settled, First Tennessee had suffered nearly $5.6 million in losses. FMI filed for bankruptcy protection in June 2008, and a trustee was appointed to oversee the estate. Shortly thereafter, the trustee sought to avoid certain payments First Tennessee received from FMI as fraudulent transfers under section 548(a) of the Bankruptcy Code. In response, First Tennessee raised an affirmative defense under section 548(c).
During a three-day trial before the United States Bankruptcy Court for the Eastern District of Virginia, First Tennessee relied on the testimony of two of its employees to establish that it had received the transfers in good faith. Neither witness provided expert testimony. Based on the witnesses’ testimony, the bankruptcy court concluded that First Tennessee had proved that it acted with the requisite good faith when it accepted the transfers from FMI. Accordingly, because the trustee conceded that the transfers were received for value, the court held that the transfers could not be avoided under section 548(a). The United States District Court for the Eastern District of Virginia affirmed the bankruptcy court’s decision, and the trustee appealed.
On appeal, the trustee argued that (i) the bankruptcy court had misapplied the objective good-faith standard required by section 548(c), and (ii) First Tennessee failed to present sufficient evidence to prove it accepted the payments in good faith. The Fourth Circuit rejected these arguments and affirmed the district court’s decision. The court held that First Tennessee’s two lay witnesses had adequately demonstrated that the bank had received the transfers in good faith and without knowledge that should have alerted First Tennessee that the transfers were fraudulent. Notably, First Tennessee’s evidence did not
seem to address whether a reasonably prudent warehouse lender would have been alerted to the fraud. The dissent noted that if the Fourth Circuit was truly applying an objective good-faith test, the proper inquiry should have been whether the facts would have alerted a reasonably prudent warehouse lender to the fraud. Although First Tennessee’s witnesses may have been able to explain why FMI’s conduct did not raise suspicions of fraud at First Tennessee, the dissent stated that a truly objective inquiry would have required First Tennessee to present evidence showing that its conduct followed routine industry practices and that its response to the various “red flags” at FMI would not have alerted a reasonably prudent mortgage warehouse lender to the fraud.
Taneja introduces a measure of subjectivity into the court’s analysis of a transferee’s good faith under section 548(c) of the Bankruptcy Code. By focusing on whether First Tennessee acted reasonably, instead of whether a reasonably prudent warehouse lender would have been alerted to the fraud, the Fourth Circuit departed from the objective analysis typically applied in the section 548(c) context. Further, it alleviated First Tennessee’s burden of presenting expert evidence concerning the warehouse lending industry. Whether other circuits will introduce a subjective analysis when assessing good faith in the section 548(c) context remains to be seen.
Whose Value Is It Anyway? When It Comes to Three-Party Relationships and Preference Liability, It May Not Matter
Does the creditor asserting a “subsequent new value” exception to preference liability have to be the creditor that provided the value directly to the debtor? In In re LGI Energy Solutions, Inc.,12 the Eighth Circuit became the first court of appeals to interpret section 547(c)(4) of the
Bankruptcy Code under such facts.
In re LGI Energy Solutions, Inc., 746 F.3d 350 (8th Cir. 2014).
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Before its bankruptcy, the debtor provided bill payment services to its clients, large utility customers such as restaurant and fast food chains. During the 90 days prior to bankruptcy, the debtor made transfers totaling approximately $259,000 to two utilities to pay outstanding invoices for services provided to the debtor’s clients. The debtor’s chapter 7 trustee sought to recover the payments from the utilities as avoidable preferences under section 547(b) of the Bankruptcy Code. In response, the utilities asserted the subsequent new value defense under section 547(c)(4).
The utilities continued to provide services to the debtor’s clients after the preferential transfers were made. The debtor also continued to send invoices to its clients, who then sent checks totaling some $297,000 to the debtor for payment of the invoices. Having found itself in financial distress, the debtor never passed any of the new money on to the utilities. Those post-preference customer payments were the “subsequent new value” at issue in this case.
The subsequent new value exception in section 547(c)(4) provides that a trustee may not avoid a transfer “to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor.”
It’s safe to say the court found the trustee’s attempt to circumvent this exception pretty transparent. The trustee sued the utilities instead of the debtor’s clients because the trustee knew that the clients would assert the section 547(c)(4) exception for their post-preference transfers. None too pleased with this tactic, the court noted that “this approach does fundamental violence to the ‘prime bankruptcy policy of equality of distribution among creditors.’” If the utilities had been required to return the transfers to the bankruptcy estate, the estate would have been doubly replenished — and entirely at the expense of two of its creditor clients. Neither client received any benefit for its subsequent new value, and each client also remained on the hook for its unpaid utilities invoices.
You may be asking yourself, what in the preference statute could mandate such an inequitable result? According to the trustee, two little words.
benefit of the debtor, only subsequent new value given by the utilities, and not by the clients, could offset the utilities’ preference exposure. The bankruptcy court accepted this interpretation, but the Eighth Circuit Bankruptcy Appellate Panel disagreed. Attempting to refute the BAP’s interpretation on appeal, the trustee
relied primarily on In re Musicland Holding Corp.13 to
support his argument that “such creditor” must in all circumstances be construed as limiting new value to that personally provided by the creditor that the trustee is suing on account of the preferential transfer. Although not binding precedent, the Eighth Circuit distinguished Musicland, noting that the bankruptcy court denied the defendant’s claim of an offset for subsequent new value provided by another creditor who neither received nor benefitted from the preferential transfer. The court therefore interpreted Musicland to stand only for the proposition that a preferred creditor cannot offset subsequent new value provided by a non-preferred creditor.
But, as you’ve seen, in this case, both the clients and the utilities benefitted from the debtor’s preferential transfers.
Like the BAP, the Eighth Circuit relied on its decision in Jones Truck Lines14 to reject the trustee’s interpretation of section 547(c)(4). In Jones Truck Lines, the debtor sued to recover as avoidable preferences weekly employee benefit contributions paid to third-party benefit
funds. In that case, the defendant funds claimed the protection of two exceptions found in sections 547(c)(1) and (c)(4). The Eighth Circuit held that, in certain circumstances, a transfer of new value by a third party to the debtor may satisfy the new value requirement of the contemporaneous new value exception. The court also addressed the subsequent new value issue and noted that, even if the debtor had not received contemporaneous new value for the weekly payments, it necessarily received subsequent new value for each payment because its employees had continued working. Put differently, Jones Truck Lines concluded that transfers the debtor made to the benefit funds to satisfy obligations to pay employee benefits, if otherwise preferential, were excepted from preference liability to the extent the
The crux of the trustee’s argument was that, because
section 547(c)(4) limits the subsequent new value exception to new value “such creditor” gave to or for the
13 462 B.R. 66 (Bankr. S.D.N.Y. 2011).
14 130 F.3d. 323 (8th Cir. 1997).
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employees provided the debtor with post-transfer new value by continuing to work.
This case is closely analogous to Jones Truck Lines. The debtor’s preferential transfers to the utilities were based upon the debtor’s contractual obligations to its clients, who benefitted from those transfers by having their invoices paid. Accordingly, the Eighth Circuit held that, in three-party relationships where the debtor’s preferential transfer to a third party benefits the debtor’s primary creditor, new value (either contemporaneous or subsequent) can come from the primary creditor, even if the third party is a creditor in its own right and is the only defendant against whom the debtor has asserted a claim of preference liability. The utilities were therefore permitted to offset all new value the clients transferred to the debtor subsequent to the preferential transfers if those transfers of new value satisfied the conditions in section 547(c)(4)(A)-(B).
repurchase or reverse repurchase transaction on any such security.”
In Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.),15 the Second Circuit noted the existence of a split of authority regarding what role a
financial institution must play in a transaction for it to qualify for the section 546(e) safe harbor. Holding that “transfer[s] made … in connection with a securities contract” may qualify for the safe harbor even if the financial institution at issue is merely a conduit, the Second Circuit reiterated its agreement with the Third
Circuit,16 Sixth Circuit,17 and Eighth Circuit,18 as it set forth
in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.),19 that “the absence of a financial intermediary that takes title to the transacted securities during the course of the transaction is [not] a
proper basis on which to deny safe-harbor protection.”
In this case, it didn’t really matter which creditor provided
This contrasts with the holding of Eleventh Circuit
the new value, because the bankruptcy estate couldn’t have its cake and eat it too.
How Safe Is the Section 546(e) Safe Harbor? Part I: Quebecor
Lee Jason Goldberg
Section 546(e) Safe Harbor Jurisprudence in the Second Circuit
Section 547(b) of the Bankruptcy Code enables a debtor in possession to avoid a transfer made on or within 90 days of a debtor’s bankruptcy filing if the transfer meets certain enumerated statutory conditions. Even if those conditions are met, however, section 546(e) of the Bankruptcy Code provides a “safe harbor” that exempts the transfer from avoidance if, among other things, the transfer is a “settlement payment” or a “transfer … in connection with a securities contract,” in each case “made by or to (or for the benefit of) a … financial institution.”
According to the Second Circuit, a “settlement payment” is a “transfer of cash made to complete a securities transaction,” and, according to section 741(7) of the Bankruptcy Code a “securities contract” is a “contract for the purchase, sale, or loan of a security … including any
financial institution must acquire a beneficial interest in
the transferred funds or securities for safe harbor to apply.
This entry, on the Second Circuit’s decision in Quebecor, continues our examination of the development of section 546(e) safe harbor jurisprudence in Second Circuit courts, where Enron represents a turning point:
￭ In our first entry on the section 546(e) safe harbor, we reported21 on Geltzer v. Mooney (In re MacMenamin’s
15 719 F.3d 94.
Lowenschuss v. Resorts Int’l, Inc. (In re Resorts Int’l, Inc.), 181 F.3d 505 (3d Cir. 1999).
QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545 (6th Cir. 2009).
Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009). Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329 (2d Cir. 2011).
Munford v. Valuation Research Corp. (In re Munford, Inc.), 98 F.3d 604 (11th Cir. 1996) (per curiam).
See New York and Delaware Are Now at Odds over Application of Section 546(e)’s “Safe Harbor” to Private Stock Transactions dated May 11, 2011 on the Weil Bankruptcy Blog.
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Grill, Inc.),22 where the Southern District of New York bankruptcy court refused to interpret section 546(e) to apply to a private stock transaction.
The Dispute in Quebecor
Quebecor involved a multi-party transaction among the Canadian printing company Quebecor World, Inc.
￭ A few months later, we discussed
the Enron decision,
which provided Second Circuit courts with fresh guidance for analyzing the section 546(e) safe harbor.
(“Quebecor World”), its subsidiaries Quebecor World
(USA) Inc. (“Quebecor USA”) and Quebecor World Capital
Picard v. Katz,25
Corp. (“Quebecor Capital”), and holders of private
placement notes with a face value of $371 million issued
Southern District of New York district court held that
section 546(e) protected payments received by a customer from a stockbroker, except in cases of actual fraud.
by Quebecor Capital.
As Quebecor World’s financial difficulties gave rise to concerns about a potential debt-to-capitalization ratio
￭ Post-Enron, we also looked at
AP Services LLP v.
default under the private placement notes and a
Silva,27 where the Southern District of New York district court held that the section 546(e) safe harbor for settlement payments may apply regardless of whether the unwinding of the transaction in question would have an adverse effect on financial markets. An appeal of the district court’s decision is pending before the Second Circuit.
consequent cross-default under Quebecor World’s separate $1 billion credit facility, Quebecor World sought to redeem the notes from the noteholders. To avoid adverse Canadian tax consequences, however, Quebecor World structured the transaction so that Quebecor USA would purchase the notes from the noteholders for cash
and then Quebecor Capital would redeem the notes from
the Quebecor case, from the
Quebecor USA in exchange for forgiveness of debt that
Southern District of New York bankruptcy court29 (during which proceedings Enron was decided), through30 the Southern District of New York district court,31 and, now, on to the Second Circuit.
Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.), 450 B.R. 414 (Bankr. S.D.N.Y. 2011). See Second Circuit Affords Safe Harbor Protections to Redemption of Commercial Paper dated July 27, 2011 on the Weil Bankruptcy Blog. See District Court’s Dismissal of Madoff Trustee’s Constructively Fraudulent Claims Against Customers Reaffirms a “Settled” Principle dated October 7, 2011 on the Weil Bankruptcy Blog.
25 Picard v. Katz, 462 B.R. 447 (S.D.N.Y. 2011).
See Under Construction: Further Broadening the Securities Settlement Payment Safe Harbor Under Section 546(e) of the Bankruptcy Code date January 10, 2013 on the Weil Bankruptcy Blog. AP Services LLP v. Silva, 483 B.R. 63 (S.D.N.Y. 2012).
See It’s Settled — the Securities Safe Harbor Has Been Expanded dated September 1, 2011 on the Weil Bankruptcy Blog. Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.), 453 B.R. 201 (Bankr. S.D.N.Y. 2011). See Southern District Affirms Judge Peck’s Quebecor Decision, Broadly Interpreting “Settlement Payments” as
Quebecor USA owed to Quebecor Capital.
Fewer than 90 days before Quebecor USA filed for chapter 11 protection, it transferred approximately $376 million to the noteholders’ trustee, CIBC Mellon Trust Co. CIBC Mellon distributed the funds to the noteholders, and the noteholders eventually surrendered the notes directly to Quebecor World. Debtor Quebecor USA’s creditors’ committee sought to avoid and recover the transfer pursuant to section 547 of the Bankruptcy Code. The noteholders moved for summary judgment, arguing that the transfer was exempt from avoidance under section 546(e).
The Lower Courts’ Decisions
Before the bankruptcy court decided the summary judgment motion, the Second Circuit decided Enron, where it held that payments made to redeem commercial paper before its maturity date were “settlement payments,” within the meaning of section 546(e), because they were “transfer[s] of cash made to complete a securities transaction.”
Including Payments to Redeem Outstanding Notes dated October 24, 2012 on the Weil Bankruptcy Blog.
Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.), 480 B.R. 468 (S.D.N.Y. 2012).
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The bankruptcy court conducted additional briefing and granted the noteholders’ summary judgment motion, holding primarily that Quebecor USA’s payment fit the Enron court’s definition of “settlement payment.” The bankruptcy court held that the payment also qualified as a “transfer made … in connection with a securities contract” because Enron had made clear that the section 546(e) safe harbor applied to redemptions of commercial paper.
The district court affirmed the bankruptcy court’s decision, agreeing that Quebecor USA’s payment was a “settlement payment” under Enron. The district court did not agree that a transfer to “redeem” securities could qualify as a “transfer made … in connection with a securities contract” because section 741(7)(A)(i) of the Bankruptcy Code defines a “securities contract” as one “for the purchase, sale, or loan of a security.” The district court nonetheless affirmed the bankruptcy court’s alternative holding on the basis that the transaction was a “purchase” and not a “redemption.”
The Second Circuit’s Analysis
The Second Circuit decided that it did not need to reach the “settlement payment” prong of the section 546(e) safe harbor because the payment by Quebecor USA fit squarely within the plain wording of the “securities contract” prong of the safe harbor, as it was a “transfer made by or to (or for the benefit of) a … financial institution … in connection with a securities contract.” The payment was made to CIBC Mellon, a financial institution, in the amount and manner prescribed by note purchase agreements, which provided for both the original purchase and “repurchase” of the notes. Thus, the transfer was exempt from avoidance under the “securities contract” prong of the safe harbor. (This prong of the safe harbor — which was added to the statute after Enron filed for bankruptcy and the applicable adversary proceeding was commenced — was not at issue in Enron.)
The court also declined to decide whether the transfer would still be exempt if Quebecor USA had “redeemed” its own securities because the Second Circuit agreed with the district court that Quebecor USA made the transfer to “purchase” the notes, which had been issued by another corporation, Quebecor Capital. While the note purchase agreements gave only Quebecor Capital the right to “pre- pay” or redeem the notes, the agreements gave Quebecor Capital’s affiliates only the right to “purchase” the notes if
the affiliates complied with the note purchase agreements’ pre-payment provisions.
The Second Circuit rejected the creditors’ committee’s arguments that the transfer was a redemption and not a purchase. First, the court found that certain noteholders’ subjective understanding at the time of the transaction of its being a redemption was not dispositive because, from the noteholders’ perspective, the note purchase agreements treated redemptions and purchases the same way, and the noteholders received the same “pre- payment” price. Second, the court found that a cooperation agreement entered into among the noteholders both explicitly allowed for sale of the notes to certain Quebecor entities and failed to prohibit the noteholders as a group from selling (or Quebecor USA from purchasing) all of the notes in a single transaction. Moreover, none of the Quebecor entities was a party to the cooperation agreement, so any breach of that agreement would only create liability among the noteholders and not affect the validity of the transaction.
Most importantly, the court rejected the creditors’ committee’s argument that even if Quebecor USA “purchased” the notes, not all of the transfers were exempt because CIBC Mellon was merely a conduit and some of the noteholders were not financial institutions. The court noted that Enron rejected a similar argument, holding that the financial intermediary need not have a beneficial interest in the transfer. The Second Circuit concluded that “to the extent Enron left any ambiguity in this regard, we expressly follow the Third, Sixth, and Eighth Circuits in holding that a transfer may qualify for the section 546(e) safe harbor even if the financial intermediary is merely a conduit.”
The Second Circuit’s “Conduit” Rationale
To reach its conclusion, the court looked to the plain language of section 546(e), which refers to transfers made “by or to (or for the benefit of)” a financial institution, and found that a transfer may be either “for the benefit of” a financial institution or “to” a financial institution, but need not be both. (The court speculated that the phrase “(or for the benefit of),” which was added to section 546(e) after the circuit split arose, may have been intended to resolve the split, but the court refused to rely on the legislative history, as it found the words of the statute unambiguous.)
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Quoting the Enron court’s analysis of the “settlement payment” prong of the section 546(e) safe harbor, the Second Circuit also noted that its construction furthered the purpose behind the exemption. The Enron court explained that Congress enacted section 546(e) to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries. If a firm were required to repay amounts received in settled securities transactions, it could have insufficient capital or liquidity to meet its current securities trading obligations, placing other market participants and the securities markets themselves at risk. Thus, the Quebecor court found, a transaction involving one of these financial intermediaries, even as a conduit, necessarily touches upon these at-risk markets.
The Second Circuit also observed that the enumerated intermediaries are typically facilitators of, rather than participants with a beneficial interest in, the underlying transfers: “A clear safe harbor for transactions made through these financial intermediaries promotes stability in their respective markets and ensures that otherwise avoidable transfers are made out in the open, reducing the risk that they were made to defraud creditors.” In a footnote, the court cautioned that the “securities contract” safe harbor is not without limitation and, for example, mere structuring of a transfer as a “securities transaction” may not be sufficient to preclude avoidance, such as in the case of actual fraudulent transfers under section 548(a)(1)(A).
What Are the Potential Limitations on the Section 546(e) Safe Harbor in the Second Circuit?
In our next entry, on the decision of the Western District of New York bankruptcy court in Cyganowski v. Lapides (In re Batavia Nursing Home, LLC),32 we will explore the
potential limitations that Second Circuit courts may be
How Safe Is the Section 546(e) Safe Harbor? Part II: Financial Intermediaries and Financial Institutions
Lee Jason Goldberg
In Part I of this entry, we examined developing jurisprudence in Second Circuit courts regarding the safe harbor in section 546(e) of the Bankruptcy Code by discussing Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et
al. (In re Quebecor World (USA) Inc.).33 In Quebecor, the
Second Circuit held that transfers in connection with a securities contract made by or to (or for the benefit of) a financial institution/intermediary (terms which the court used interchangeably) may qualify for the section 546(e) safe harbor even if the financial institution/intermediary is merely a conduit.
In Parts II and III of this entry, we explore two issues: first, whether a “financial intermediary” is required for the safe harbor to apply, and second, whether undoing a transaction must pose a risk to the financial markets for the transaction to receive the protection of the section 546(e) safe harbor. Although the Second Circuit has suggested its views on these issues, its decisions arguably are not clear, and we need more guidance. For the second issue, guidance is particularly necessary in the context of small transactions.
In Quebecor, the Second Circuit shielded a transfer of approximately $376 million from avoidance. Subsequently, two New York bankruptcy courts shielded, under section 546(e), transfers from avoidance that were a mere fraction of the amount of the transfer in Quebecor: the Western District of New York bankruptcy court in Cyganowski v. Lapides (In re Batavia Nursing Home, LLC,
willing to impose on the section 546(e) safe harbor,
and the Northern District of New York bankruptcy
beyond the express statutory exclusion of actual fraudulent transfers.
court in Woodard v. PSEG Energy Technologies Asset
Mgmt. Co., LLC, et al. (In re Tougher Industries, Inc., et
Cyganowski v. Lapides (In re Batavia Nursing Home, LLC, et al.), Adv. No. 12-1145 (MJK), 2013 WL 3934237 (Bankr. W.D.N.Y. July 29, 2013).
33 719 F.3d 94.
Cyganowski v. Lapides (In re Batavia Nursing Home, LLC, et al.), Adv. No. 12-1145 (MJK), 2013 WL 3934237 (Bankr. W.D.N.Y. July 29, 2013).
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al.).35 (After Batavia and Tougher were decided, the Supreme Court denied the petition for writ for certiorari36 filed by Quebecor USA’s creditors’ committee.)
We explore the two issues above through these cases, but before doing so, we examine the role of Congressional intent in the interpretation of the section 546(e) safe harbor.
A Question of Congressional Intent?
Prior to the Second Circuit’s decisions in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.)37 and Quebecor, the Southern District of New York bankruptcy court in Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.)38 refused to interpret section 546(e) to apply to a small private stock sale (representing transfers totaling just over $1.1 million) made through “financial institutions,” notwithstanding the “apparent” plain meaning of the statute.
Despite expressing trepidation about “line drawing based on presumed Congressional intent,” the MacMenamin’s court found that it was “quite easy to find that the transaction at issue here would have absolutely no impact on the financial markets.” The court acknowledged, however, that it was somewhat difficult to articulate a clear standard to distinguish the transaction before it from the facts of QSI Holdings, Inc. v. Alford (In re QSI Holdings,
Inc.),39 (a “large private LBO transaction … with a $208
million purchase price and hundreds of selling shareholders, where at least some of the sales went through a financial intermediary that was arguably involved in the securities markets”), where the Sixth
Woodard v. PSEG Energy Technologies Asset Mgmt. Co., LLC, et al. (In re Tougher Industries, Inc., et al.), Adv. No. 08-90161 (REL), 2013 WL 5592902 (Bankr. N.D.N.Y. 2013). Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.), 134 S.Ct. 1278 (2014) (mem.). Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329 (2d Cir. 2011). Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.), 450 B.R. 414 (Bankr. S.D.N.Y. 2011).
QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545 (6th Cir. 2009).
Circuit held that the section 546(e) safe harbor applied, or “any number of hypothetical transactions in between.”
In the case before it, though, the MacMenamin’s court found that the defendants had not “provided any evidence that the avoidance of the transactions at issue involved any entity in its capacity as a participant in any securities market, or that the avoidance of the transactions at issue poses any danger to the functioning of any securities market.” The court viewed its conclusion as required by the Congressional intent behind the section 546(e) safe harbor.
Enron and Quebecor
As we noted in Part I of this entry, after MacMenamin’s was decided, the Enron court explained that Congress enacted section 546(e) to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries. The Second Circuit noted that if a firm were required to repay amounts received in settled securities transactions, it could have insufficient capital or liquidity to meet its current securities trading obligations, placing other market participants and the securities markets themselves at risk. The Quebecor court later quoted this language and found that a “transaction involving one of these financial intermediaries, even as a conduit, necessarily touches upon these at-risk markets.”
Courts in the Second Circuit, including the Second Circuit itself in Enron, frequently reference the purpose of section 546(e), including the “risks” to, and “stability” of, the “financial markets” and the “securities markets,” even though no such language appears in the statute. At the same time, they purport to rely on the plain language or meaning of section 546(e) in applying the safe harbor. Thus, in Enron, the Second Circuit, despite its discussion of the purpose of the statute earlier in its decision, stated that it reached its conclusion by looking to the statute’s plain language and declined to address Enron’s arguments regarding legislative history, “which, in any event, would not lead to a different result.” In Quebecor, the Second Circuit similarly purported to reach its conclusion based on the “plain language” of the statute but still discussed the statutory purpose to bolster its conclusion.
But, what if a party’s arguments regarding legislative history did lead to a different result, such as in
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MacMenamin’s? In refusing to protect a transaction from avoidance under the section 546(e) safe harbor despite the statute’s “apparent” plain meaning, the court in MacMenamin’s found that the statute’s legislative history “makes it clear that Congress intended section 546(e) to address risks that the movants have failed to show conclusively are implicated by the avoidance of the transaction at issue here.” In light of Enron and Quebecor, may a Second Circuit court likewise refuse to apply the section 546(e) safe harbor if a party claiming its protection cannot show that undoing a transaction would pose a risk to the financial markets?
After the Second Circuit’s decision in Enron (but prior to its decision in Quebecor), the District Court for the Southern District of New York in AP Services LLP v. Silva40 held that the section 546(e) safe harbor extended to a leveraged buyout in which five shareholders received
$106 million – transferred by wire directly into their bank accounts – in exchange for their privately held stock. Among other things, the court in Silva made two key holdings regarding application of the section 546(e) safe harbor. First, the court held that a “financial intermediary” was not required, only a “financial institution” (defined in section 101(22) of the Bankruptcy Code), such as the defendants’ banks. Second, the court refused to require a factual determination as to whether upsetting a concluded LBO would have an adverse effect on the financial markets.
This entry explores the Silva holdings, on which the courts in Batavia and Tougher relied for their analyses, in the context of small transactions.
Two Small LBO Cases
In Batavia, the chapter 11 trustee sought to avoid a $1.179 million transfer made to one of the debtors’ former owners to buy out his interests in the debtors and several other entities. The debtors had issued bonds to fund the buyout and for other financing needs. Bank of New York Mellon, the indenture trustee for the bonds, wired $1.179
million of the bonds’ proceeds to the bank account of the former owner’s law firm to buy out his interests.41
In Tougher, the chapter 11 trustee sought to avoid transfers totaling approximately $3.6 million made to the debtor’s former shareholder to buy out all of the debtor’s stock. The relevant transfers were wired from the debtor’s bank account directly to the shareholder’s bank account, with the majority of such payments funded through the debtor’s bank loans.
The buyouts in Batavia and Tougher were, therefore, very similar, except for their funding: the Batavia LBO was funded by the issuance of bonds, and the Tougher LBO was funded primarily by bank loans. In the remainder of this entry, we examine the application of the first Silva holding in the Tougher case, while in Part III, we will examine how the Batavia and Tougher courts relied on the second Silva holding to analyze the much smaller LBOs at issue in their cases.
Is a “Financial Intermediary” Required for Application of the Safe Harbor?
In Tougher, the court rejected the trustee’s argument that the section 546(e) safe harbor was inapplicable because the settlement payments did not pass from the debtor through a financial intermediary to the defendant. The court relied on Silva’s holding that “nothing in the language of the statute or the post-Enron case law indicates that an intermediary is necessary to trigger the safe harbor.” According to the court in Tougher, “[i]n addressing the legislative purpose of § 546(e), the [Silva] court found the reasoning of Enron applicable and stated that the negative effects of undoing long-settled LBOs would be ‘equally true regardless of whether a payment passed through a financial intermediary.’”
Although the Silva and Tougher courts applied the Second Circuit’s reasoning about undoing long-settled LBOs to payments made to “financial institutions” rather than only payments passed through “financial intermediaries,” neither court elaborated on how the negative effects would be equally true in both situations. Nonetheless, if the Second Circuit is confronted with the question of whether a “financial institution” or a “financial
QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545 (6th Cir. 2009).
See Supplementary Declaration in Support of Motion to Dismiss Complaint, Batavia, No. 12-1145 (MJK) (Bankr. W.D.N.Y. July 11, 2013) [ECF No. 34].
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intermediary” is required for the protection of the section 546(e) safe harbor, it may reach the same conclusion as that reached by the courts in Silva and Tougher – that only a “financial institution” is required. Even though the Second Circuit may reach this conclusion notwithstanding certain distinguishing factors in Enron and Quebecor, it is at least worth considering those distinguishing factors.
First, in each of Enron and Quebecor, the transaction involved a traditional “financial intermediary,” the Depository Trust Company in Enron and CIBC Mellon (the noteholders’ trustee) in Quebecor. The issue was whether the section 546(e) safe harbor applied to a transaction even if a financial intermediary did not have a beneficial interest in the transfer or was merely a conduit. This is different from the lack of a traditional financial intermediary altogether in Silva and Tougher, where only banks (“financial institutions”) participated in the transactions.
Second, in Enron, the Second Circuit was rejecting the argument that the absence of a financial intermediary taking a beneficial interest in the securities during the course of the transaction failed to implicate the systemic risks that motivated Congress’s enactment of the section 546(e) safe harbor. The Second Circuit cited reasoning from the Third Circuit (Brandt v. B.A. Capital Co. LP (In re
Plassein Int’l Corp.)),42 the Sixth Circuit (QSI), and the
Eighth Circuit (Contemporary Indus. Corp. v. Frost),43 that “undoing long-settled leveraged buyouts would have a substantial impact on the stability of the financial markets, even though only private securities were involved and no financial intermediary took a beneficial interest in the exchanged securities during the course of the transaction.”
According to the Second Circuit, there was “no reason to think that undoing Enron’s redemption payments, which involved over a billion dollars and approximately two hundred noteholders, would not also have a substantial and similarly negative effect on the financial markets.” Furthermore, as we noted in Part I, the Quebecor court observed that financial intermediaries are typically facilitators of, rather than participants with a beneficial
Brandt v. B.A. Capital Co. LP (In re Plassein Int’l Corp.), 590 F.3d 252 (3d Cir. 2009). Contemporary Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009).
interest in, the underlying transfers, and that “[a] clear safe harbor for transactions made through these financial intermediaries promotes stability in their respective markets and ensures that otherwise avoidable transfers are made out in the open, reducing the risk that they were made to defraud creditors.” (Actual fraudulent transfers under section 548(a)(1)(A) are excluded from the section 546(e) safe harbor.)
Thus, the context in which the Quebecor and Enron cases arose – transactions representing hundreds of millions and over one billion dollars, respectively, conducted through traditional financial intermediaries – may have informed the Second Circuit’s analysis of the section 546(e) safe harbor. This analysis does not foreclose the result reached in Silva and Tougher, though.
The Silva and Tougher courts relied on the Third Circuit’s decision in Plassein, which the Enron court cited with approval. Plassein involved LBO payments made not through financial intermediaries but directly to shareholders’ private bank accounts via wire transfer. In that case, the Third Circuit rejected the argument that settlement payments must travel through the settlement system (i.e., the system of intermediaries and guarantees usually employed in securities transactions) and found that “financial institutions” were implicated in the transfers: the debtor’s bank transferred the buyout funds to the shareholders’ banks.
Moreover, the Silva and Tougher courts correctly pointed out that “financial institution” is the term actually used in the statute, with the Tougher court observing that the plain language of section 546(e) does not contain a requirement that a financial intermediary act as a conduit or take a beneficial interest in the transfer. The court in Tougher further remarked that if Congress had intended that the safe harbor only be applied to transactions involving financial intermediaries, it would have explicitly included that language in the statute.
Although the Second Circuit’s repeated references to the purpose of section 546(e) may leave room to argue that the safe harbor should only apply to transactions involving financial intermediaries, the Second Circuit may find it dispositive that the plain language of the statute (i.e., “financial institution”) does not require a financial intermediary for application of the safe harbor.
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For Safe Harbor Protection, Must Undoing a Transaction Pose a Risk to the Financial Markets?
In our next entry, we explore, through the Batavia and Tougher cases, whether a party must show that undoing a transaction would pose a risk to the financial markets for the transaction to receive the protection of the section 546(e) safe harbor.
How Safe Is the Section 546(e) Safe Harbor? Part III:
that undoing a transaction would pose a risk to the financial markets. Some courts have considered this question by looking at, among other things, the dollar amount of the transaction at issue, as avoidance plaintiffs have continued to argue that the safe harbor should not be applied to small transactions.
In upholding the application of the safe harbor to a $106 million transaction, the court in Silva rejected any requirement that a party show that undoing a transaction would have a negative effect on the financial markets, relying on, inter alia, the Third Circuit (Brandt v. B.A.
Risk to the Financial Markets
Capital Co. LP (In re Plassein Int’l Corp.)),
Lee Jason Goldberg
In Part II of this three-part entry, we mentioned that the District Court for the Southern District of New York in AP Services LLP v. Silva44 made two key holdings regarding application of the safe harbor in section 546(e) of the Bankruptcy Code. First, the Silva court held that a “financial intermediary” was not required, only a “financial
institution.” Second, the court refused to require a factual determination as to whether upsetting a concluded LBO would have an adverse effect on the financial markets.
We examined the first holding in Part II, and in this part of the entry, we discuss how the Western District of New York bankruptcy court in Cyganowski v. Lapides (In re Batavia Nursing Home, LLC)45 and the Northern District of New York bankruptcy court in Woodard v. PSEG Energy Technologies Asset Mgmt. Co., LLC, et al. (In re Tougher Industries, Inc.)46 relied on the second Silva holding to analyze the much smaller LBOs – $1.179 million and $3.6 million, respectively – at issue in the cases before them.
Is the Dollar Amount of a Transaction Analogous to the Commonness of a Transaction?
Even assuming that a financial intermediary is not required for application of the section 546(e) safe harbor, the question remains as to whether a party must show
Circuit (QSI Holdings, Inc. v. Alford (In re QSI Holdings,
Inc.)),48 and the Eighth Circuit (Contemporary Indus. Corp.
v. Frost)49 (where the court suggested that undoing a transaction with “so much money at stake” – $26.5 million
The Batavia court acknowledged that the $1.179 million at issue seemed to be “far more remote from the ‘financial markets’” than the $106 million involved in Silva but noted that the Silva court, as to that “much higher amount,” rejected any argument that “would require a factual determination in each case as to whether upsetting a concluded LBO would have an adverse effect on the financial markets, thus casting all or at least many such transactions into uncertainty. In view of the Second Circuit’s reasoning in Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery
Corp.),50 that course is not properly open to this Court.”
As discussed below, however, the Second Circuit’s reasoning entailed refusing to require a factual determination as to a transaction’s “commonness” for application of the section 546(e) safe harbor.
The Tougher court similarly agreed with Silva and rejected the trustee’s argument that the section 546(e) safe harbor should not be applied because, given the
AP Services LLP v. Silva, 483 B.R. 63 (S.D.N.Y. 2012).
Cyganowski v. Lapides (In re Batavia Nursing Home, LLC, et al.), Adv. No. 12-145 (MJK), 2013 WL 3934237 (Bankr. W.D.N.Y. July 29, 2013). Woodard v. PSEG Energy Technologies Asset Mgmet. Co., LLC, et al. (In re Tougher Industries, Inc. et al.), Adv. No. 08- 90161 (REL), 2013 WL 5592902 (Bankr. N.D.N.Y. 2013).
Brandt v. B.A. Capital Co. LP (In re Plassein Int’l Corp.), 590 F.3d 252 (3d Cir. 2009).
QSI Holdings, Inc. v. Alford (In re QSI Holdings, Inc.), 571 F.3d 545 (6th Cir. 2009).
49 564 F.3d 981 (8th Cir. 2009).
Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V. (In re Enron Creditors Recovery Corp.), 651 F.3d 329 (2d Cir. 2011).
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relatively small amount of money involved in the transaction, avoidance of the transfers would not have a substantial impact on the financial markets. The court found that the plain language of section 546(e) does not provide a threshold amount below which the safe harbor is not available and noted that the trustee’s position would add a requirement that a “factual determination” be made as to whether the dollar amount of a transaction would have an impact on the financial markets.
The court in Tougher noted that the Second Circuit rejected a “similar argument” in Enron. As one of its three proposed limitations on the definition of “settlement payment” in section 741(8) of the Bankruptcy Code, Enron argued that the final phrase of the definition – “commonly used in the securities trade” – excluded all payments (including the redemption payments at issue in Enron) that are not common in the securities industry from the safe harbor for settlement payments in section 546(e). The Second Circuit rejected this argument, finding that it would make application of the safe harbor in every case depend on a factual determination regarding the “commonness” of a given transaction. Further, as the Tougher court remarked, the Second Circuit indicated that such a reading of the statute “would result in commercial uncertainty and unpredictability at odds with the safe harbor’s purpose and in an area of law where certainty and predictability are at a premium.”
Holding that the Second Circuit’s rationale as to
equally applicable to requiring a factual determination based on dollar amount.
Indeed, a hypothetical dollar threshold for application of the safe harbor, e.g., $5 million, shows that the analogy between commonness of a transaction and dollar amount of a transaction is imperfect. Notwithstanding the arbitrary nature of setting a specific dollar amount for application of the safe harbor, the simplicity of a dollar threshold contrasts with the array of potential factors cited by the Enron court that may bear on the commonness of a transaction, and, therefore, a dollar threshold may present a more certain and predictable means of determining whether the safe harbor applies.
Must Undoing a Transaction Pose a Risk to the Financial Markets for the Safe Harbor to Apply?
The purpose of pointing out the imperfect analogy between commonness and dollar amount drawn by the courts in Silva, Batavia, and Tougher is that those courts used the Enron rationale to reject plaintiffs’ arguments that undoing the transactions at issue would not have a negative effect on the financial markets. Plaintiffs’ continued use of this argument, which relies on the extra- textual purpose of the statute expressed by the Second Circuit and other courts (generally, that of protecting the financial markets from risks to their stability) – despite the fact that in Enron and Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life
“commonness” was “equally applicable here” (with “here”
Ins. Co., et al. (In re Quebecor World (USA) Inc.)
referring to the dollar amount of the transaction), the court in Tougher, like the courts in Silva and Batavia, thereby effectively equated a transaction’s size to its “commonness” without acknowledging that it was doing so. Yet, none of those courts included the Enron court’s illustration of the challenges presented by a “factual determination as to commonness,” i.e., whether such determination would “depend on the economic rationality of the transaction, its frequency in the marketplace, signs of an intent to favor certain creditors … such as the alleged coercion by Enron’s commercial paper noteholders … or some other factor.” Importantly, it was only after offering such an illustration that the Second Circuit sounded its cautionary note about resulting “commercial uncertainty and unpredictability.” The courts in Silva, Batavia, and Tougher, however, failed to explain why the rationale militating against requiring a factual determination as to the commonness of a transaction is
Second Circuit professed to reach its conclusions
regarding section 546(e) based on the statute’s plain language – attests to the need for the Second Circuit to clarify whether undoing a transaction must pose a risk to the financial markets for the transaction to receive the protection of the section 546(e) safe harbor.
The court’s decision in Batavia also evidences the need for such clarity. The court reasoned that “were any bankruptcy court to decide to conduct an evidentiary hearing into whether a small LBO might be so small as to fail to ‘disrupt the financial markets’ (which was, of course, the stated focus of Congress in enacting the ‘safe harbor,’ [sic]) then every LBO in an amount beneath some indeterminate dollar amount that everyone would agree
Official Comm. of Unsecured Creditors of Quebecor World (USA) Inc. v. Am. United Life Ins. Co., et al. (In re Quebecor World (USA) Inc.), 719 F.3d 94 (2d Cir. 2013).
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would ‘disrupt the financial markets’ per se would be suspect” (i.e., not susceptible to protection of the safe harbor).
In attempting to align safe harbor protection of small LBOs with the statutory purpose, the Batavia court observed that the very act of conducting an evidentiary hearing into whether “undoing an LBO might possibly disrupt the financial markets” could cause the disruption that the safe harbor statute sought to avoid. Although the Batavia court’s observation appears to dovetail with the Enron court’s concerns about “certainty and predictability,” the Batavia court was not referring to the markets that would be disrupted by the ultimate recovery of LBO funds in an avoidance action. Instead, the Batavia court was referring to the market for bonds (or other securities) funding “smaller” LBOs that would be disrupted; however, such funding sources are not the recipients of “transfers” subject to avoidance action clawbacks, so section 546(e) does not apply to them.
Thus, the Batavia rationale does not answer the question implied by the court in Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.)52 prior to Enron that some argue remains outstanding subsequent to Enron – whether protecting a small transaction from avoidance is so demonstrably at odds with the Congressional purpose of
section 546(e) that a dollar threshold for application of the safe harbor must be inferred. The imperfect analogy between commonness and dollar amount drawn by the courts in Silva, Batavia, and Tougher does not answer this question, either. The Second Circuit, therefore, arguably has left unanswered the question of whether a lower court may, as in MacMenamin’s, refuse to apply the section 546(e) safe harbor if a party claiming its protection cannot show that avoiding the transaction would pose a risk to the financial markets.
Until the Second Circuit expressly overrules MacMenamin’s, there remains room for plaintiffs to argue that, like in that case, a transaction is not protected by the safe harbor because “Congress intended section 546(e) to address risks that the [defendants] have failed to show conclusively are implicated by the avoidance of the transaction at issue here.” Indeed, the Second Circuit may have left this door open itself. In Part II of this entry, we
indicated that the Second Circuit reached its conclusion in Enron by looking to statute’s plain language and declined to address Enron’s arguments regarding legislative history, “which, in any event, would not lead to a different result.” In support of this comment, the Second Circuit cited the canon of statutory construction that “[i]t is well- established that when the statute’s language is plain, the sole function of the courts – at least where the disposition required by the text is not absurd – is to enforce it according to its terms.”
In Part II, we asked, what if a party’s arguments regarding legislative history did lead to a different result? In other words, would the Second Circuit extend the protection of the section 546(e) safe harbor to the small transactions at issue in Batavia and Tougher, or would it find such a result to be absurd or contrary to the Congressional purpose of the statute? Appeals of the decisions in Batavia and Tougher may have provided an opportunity for the Second Circuit to clarify the scope of section 546(e), but, before the district courts rendered their decisions in those cases, the trustees agreed to dismiss their respective appeals.
What Is Next for the Section 546(e) Safe Harbor?
Even a decision from the Second Circuit purporting to clarify the scope of the section 546(e) safe harbor as it is currently drafted may not forestall litigation over the statute, given the conflict between its seemingly broadly worded language and its apparently narrower purpose. Accordingly, it may be in the hands of Congress to refashion a safe harbor that more precisely protects the financial markets from risks to their stability. Without Congressional action, it is likely that parties will continue battling over the contours of the section 546(e) safe harbor in its current form.
Geltzer v. Mooney (In re MacMenamin’s Grill, Inc.), 450 B.R. 414 (Bankr. S.D.N.Y. 2011).
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In this section:
￭ Whose Claim Is It Anyway?, dated February 19, 2014
￭ “Moo”-ving Away from Omegas: Seventh Circuit Opens the Barn Door for Use of Constructive Trusts as a Preference Defense, dated April 7, 2014
Following the Circuits
The Weil Bankruptcy Blog pays particularly close attention when a circuit court issues a decision addressing bankruptcy issues. Over the first half of the year, many circuit court decisions have graced the pages of our Blog, and most are covered elsewhere in this semiannual review. This category represents the “Island of Misfit Toys” for circuit court decisions that, though notable for their holdings, do not fit neatly within a particular category covered by this review. Like a train with square wheels or a cowboy that rides an ostrich, these decisions are worthy of inclusion in our semiannual review even though they concern unique bankruptcy topics.
In In re Emoral, the Third Circuit considered whether successor liability claims against a purchaser of the debtor’s assets constituted property of the estate when the plaintiffs sought to impose liability on the purchaser for personal injury claims. Because the successor liability claim, if successful, would render the purchaser liable for all of the debtor’s liabilities, the court concluded that such claims belong to the estate and may only be asserted by the trustee or debtor in possession despite the personal nature of the plaintiffs’ injuries. In In re Mississippi Valley Livestock, Inc., the Seventh Circuit breathed new life into the applicability of the constructive trust doctrine in bankruptcy cases, breaking away from the Sixth Circuit’s often-cited decision In re Omegas Group, Inc., where the Sixth Circuit found the constructive trust doctrine to be fundamentally at odds with the Bankruptcy Code. The Seventh Circuit held that, in limited circumstances, the constructive trust doctrine may be used in bankruptcy where the debtor was merely holding property for the benefit of another such that the debtor’s estate – not the debtor itself – would be unjustly enriched. Although In re Emoral and In re Mississippi Valley Livestock, Inc. may not fit neatly within a topic covered by this review, these circuit court decisions nonetheless represent important precedents that warrant inclusion in this semiannual review.
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Whose Claim Is It Anyway?
In In re Emoral, Inc.,1 the Third Circuit addressed whether personal injury claims alleging harms caused by a debtor’s products could be asserted against a prepetition purchaser of the debtor’s assets under a “mere continuation” theory of successor liability. The court ultimately concluded that the claimants lacked standing to pursue the claims because any successor liability claim against the purchaser constituted property of the bankrupt estate.
As a general matter, after a company files for bankruptcy, creditors lack standing to file claims that constitute property of the estate. A claim constitutes property of the estate if it (i) arose prepetition, (ii) is general, meaning no particularized injury arose from it, and (iii) could have been asserted by the debtor on its own behalf under state law.
Vesting sole authority to pursue such claims in the trustee (or debtor in possession) promotes the orderly distribution of estate assets and advances the “fundamental bankruptcy policy of equitable distribution to all creditors.” Permitting individual creditors to pursue such claims against non-debtor third parties outside of bankruptcy would create the proverbial “rush to the courthouse” the Bankruptcy Code endeavors to avoid. Creditors that would otherwise have a general unsecured claim against the debtor’s estate could “jump the line” by obtaining a recovery from a non-debtor third party in a separate proceeding. In this scenario, claims that would otherwise inure to the benefit of all of the debtor’s creditors if pursued by the trustee would be diminished by any recovery obtained by an individual creditor outside of the bankruptcy case. Vesting sole authority to pursue such claims with the trustee, however, avoids this result and ensures that the estate’s assets will be maximized for the benefit of all the debtor’s creditors.
Although it is axiomatic that once a claim is determined to be property of the estate only the trustee may prosecute or defend the claim, it is not always clear from the outset whether a particular claim will qualify as property of the
In re Emoral, Inc., 740 F. 3d 875 (3rd Cir. 2014).
estate. Whether a claim constitutes property of the estate affects not only the debtor and its creditors, but also purported plaintiffs and potential defendants in such claims. The Third Circuit’s decision in In re Emoral demonstrates how this determination can affect third parties, as well as the value of a release from the claims of a debtor’s estate.
In re Emoral, Inc.
In August 2010, Aaroma Holdings LLC purchased certain assets and assumed certain liabilities of Emoral, Inc., a manufacturer of the chemical diacetyl. Both parties knew at the time of the sale that Emoral was facing potential liabilities related to various personal injury claims alleging injuries caused by the claimants’ exposure to diacetyl. The asset purchase agreement, however, expressly provided that Aaroma was not assuming any of Emoral’s diacetyl-related liabilities.
Within a year of the asset sale, Emoral filed for bankruptcy under chapter 7. A number of disputes arose postpetition between the chapter 7 trustee and Aaroma, including the trustee’s claim that Emoral’s asset sale constituted a fraudulent transfer. Aaroma entered into a settlement agreement with the trustee to resolve these claims, which provided, among other things, that Aaroma would pay $500,000 to Emoral’s estate in exchange for a release from any “causes of action … that are property of the Debtor’s Estate.”
Once the United States Bankruptcy Court for the District of New Jersey entered an order approving the settlement agreement, a number of plaintiffs brought diacetyl-related personal injury claims against Aaroma under a “mere continuation” theory of successor liability. In response, Aaroma filed a motion to enforce the bankruptcy court’s order approving the settlement agreement, arguing that the diacetyl plaintiffs’ claims were released by the trustee under the settlement agreement. The diacetyl plaintiffs countered that the claims were not general claims constituting property of the debtor’s estate because of the personal nature of their injuries, and therefore could not have been released by the settlement agreement.
The bankruptcy court agreed with the diacetyl plaintiffs and denied Aaroma’s motion, holding that the underlying injury asserted by the diacetyl plaintiffs — the personal injuries resulting from diacetyl exposure — were personal harms individual to the plaintiffs, but the United States
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District Court for the District of New Jersey reversed. On appeal, the Third Circuit affirmed in a 2"1 decision, agreeing with the district court that the diacetyl plaintiffs’ emphasis on the personal nature of their injuries was misplaced. The Third Circuit reasoned that the only theory of liability advanced against Aaroma, a third party that was not alleged to have caused the diacetyl plaintiffs any direct harm, was that “Aaroma constitutes the ‘mere continuation’ of Emoral such that it also succeeded to all of Emoral’s liabilities.” To prove such a theory under applicable state law, the diacetyl plaintiffs would have to “establish that there is continuity in management, shareholders, personnel, physical location, assets, and general business operation between selling and purchasing corporations following the asset acquisition.” Although the court acknowledged that the injuries sustained by the diacetyl plaintiffs were indeed personal, the facts underlying the “mere continuation” theory of liability against Aaroma would be common to all of Emoral’s creditors. Further, if the diacetyl plaintiffs were successful in advancing their theory, Aaroma would become liable for all of Emoral’s liabilities, and therefore the claim must constitute property of the estate.
Although the dissent agreed that the successor liability theory asserted by the diacetyl plaintiffs was “inextricably tied to” their claims, the dissent noted that no other creditor could assert the diacetyl plaintiffs specific successor liability claims. The dissent reasoned that because none of Emoral’s other creditors could assert successor liability claims against Aaroma alleging liability for injuries suffered as a result of diacetyl exposure, the claims must be considered individual claims belonging to the diacetyl plaintiffs.
Both the majority and the dissent recognized that the diacetyl plaintiffs’ underlying personal injury claims and theory of successor liability could not be viewed in isolation. Instead, viewing the diacetyl plaintiffs’ claims as being comprised of two inseparable components, the deciding factor in the court’s analysis appears to be whether the court emphasizes the claimant’s underlying cause of action or the legal theory employed to extend liability to the non-debtor third party. Although the majority’s approach in focusing on the latter results in an admittedly harsh result for the diacetyl plaintiffs, it ensures that the benefits of such claims are preserved for the entire bankrupt estate and promotes the equitable and orderly distribution of estate assets.
The Third Circuit’s Emoral decision clarifies the analysis a court must perform when determining whether a particular claim constitutes property of the estate. Rather than analyzing whether the alleged injury was particular to the creditor, the Third Circuit looked to the legal theory the claimants relied upon to extend liability to the non- debtor third party. Where the factual circumstances supporting that theory — whether it be a “mere continuation” theory of successor liability or otherwise — are generally available to the creditors as a whole, the court will deny the claimants standing to assert the claim. Accordingly, even where a creditor can allege a particularized injury, if the ultimate theory relied upon to assert liability against the non-debtor third party is generally available to all of the debtor’s creditors, the claim will most likely constitute property of the estate.
As the court’s split decision demonstrates, however, it can often be a “close call” as to how the court will classify any particular claim. Further, the extent to which other circuits will adopt the Third Circuit’s Emoral holding remains to be seen.
“Moo”-ving Away from Omegas: Seventh Circuit Opens the Barn Door for Use of Constructive Trusts as a Preference Defense
Distinguishing itself from the Sixth Circuit’s holding in In re Omegas Group, Inc.,2 in In re Mississippi Valley Livestock, Inc.,3 the Seventh Circuit recently held that, under some circumstances, the bankruptcy court may impose a constructive trust to find that prepetition funds transferred by the debtor never constituted property of
In re Omegas Group, Inc., 16 F.3d 1443 (6th Cir. 1994).
In re Mississippi Valley Livestock, Inc., 745 F.3d 299 (7th Cir. 2014).
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Background and Issues
The debtor, Mississippi Valley Livestock, housed — but did not own or retain the option to buy — cattle from multiple ranchers, including J&R Farms. The debtor acted as the middleman in cattle sales; it housed ranchers’ cattle that were ready for sale, sold the cattle into the market, collected the proceeds from the sale, deposited those proceeds into its general operating account, and then paid the various ranchers the respective amounts owed to them from funds on deposit in its operating account.
In early March through early April of 2007, Mississippi Valley sent J&R Farms nearly $900,000 representing completed sales. In May 2007, several creditors filed an involuntary petition for relief against Mississippi Valley under chapter 7 of the Bankruptcy Code. The trustee sought to recover the funds Mississippi Valley transferred to J&R Farms as preferences under section 547(b) of the Bankruptcy Code.
J&R Farms, however, argued that the payments could not constitute preferential transfers because the debtor essentially acted as a conduit, and, therefore, the transferred funds did not constitute “an interest of the debtor in property” as required under section 547(b). The issue came down to whether a constructive trust might be imposed on the transferred funds, thereby qualifying them as property of J&R Farms. The court focused its analysis on three questions:
Did Mississippi Valley hold J&R Farms’ cattle in bailment?
Is it possible to impose a constructive trust in bankruptcy?
Can the payments made during the preference period be traced to the proceeds of the sales of J&R Farms’ cattle?
The Seventh Circuit answered each question in turn.
Bailment May Exist Where a Seller Acts as a Supplier’s Agent
In arguing that the debtor had the requisite property interest in the funds, the trustee contended that Mississippi Valley’s estate had an interest in the transferred funds because they were commingled with the company’s general operating account. In contrast, J&R Farms maintained that Mississippi Valley held the
cattle sale proceeds in bailment, and hence, the proceeds were never part of the debtor’s estate.
The Seventh Circuit turned to its 1903 decision, In re Galt,4 in finding that the key distinguishing feature of a bailment is that the sender (here, J&R Farms) has a right to compel a return of the goods sent, and that the receiver (here, Mississippi Valley) does not have the option to pay for the goods in money. Mississippi Valley never had an ownership interest in, nor a right to purchase, the supplier’s cattle, agreed to pay J&R Farms immediately following the sales, and disposed of the cattle as J&R Farms directed. Based on these facts, the Seventh Circuit found that Mississippi Valley behaved as J&R Farms’ agent and, therefore, a prepetition bailment existed between J&R Farms and Mississippi Valley.
In the Seventh Circuit, Courts May Sparingly Use Constructive Trusts as Remedies in Bankruptcy
Although the court found that a bailment existed, its analysis was not complete. Mississippi Valley’s transfer of money, a fungible asset, as opposed to cattle, complicated matters. To hold that J&R had an interest in the funds transferred, the court had to find a link between J&R’s cattle and the funds that Mississippi Valley transferred to J&R — and the only way to do so was to impose a constructive trust over the funds in favor of J&R. If the remedy of a constructive trust were feasible, J&R would triumph over the trustee because “[j]ust as the assets of a conventional trust do not enter the bankruptcy estate when the bankrupt person is the trustee, … the assets of a constructive trust do not either.”
The Seventh Circuit acknowledged that other courts have rejected the view that constructive trusts may properly exist in bankruptcy. Specifically, the Sixth Circuit held in its much-cited Omegas case that the constructive trust, in privileging some creditors over others, is fundamentally at odds with the Bankruptcy Code’s objectives, and, therefore, bankruptcy courts could not impose constructive trusts except in very narrow circumstances. Though the Seventh Circuit in Mississippi Valley recognized that the remedy of a constructive trust could subvert the Bankruptcy Code’s distribution scheme, it held that the constructive trust has a place in bankruptcy —
4 In re Galt, 120 F. 64, 68 (7th Cir. 1903).
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provided that courts use it sparingly and that state law polices any abuses of the remedy.
In deciding whether the estate would be unjustly enriched by retaining the claimant’s property, the court emphasized that the debtor’s creditors — in other words, the bankruptcy estate — could feasibly gain an equitable interest even though the debtor itself had no such interest. This is because the issue is not whether the debtor had a legitimate ownership interest in the disputed property; instead, it is whether the debtor was holding the property for the benefit of another. This distinction is crucial, for if the court restricted its analysis to the statutory scope of the debtor’s property, the debtor’s creditors would always yield to a claimant who had a valid restitution claim against the debtor. Viewing the constructive trust as a remedy for a restitution claim against the estate allows the estate to invoke certain defenses that are unavailable to the debtor.
More Information Needed to Apply the Lowest Intermediate Balance Rule in Tracing the Proceeds
In bankruptcy, a restitution claimant seeking the remedy of a constructive trust must, at a minimum, prove its interest in specific property presently in the estate’s possession. In Mississippi Valley, the funds were drawn from a commingled account. As a result, the court held that the lowest-intermediate balance rule would determine the extent of J&R’s interest in the account. Pursuant to this rule, if the amount on deposit in the commingled fund has at all times equaled or exceeded the amount of the trust, the trust’s funds will be returned to their full amount. To the extent that the lowest intermediate balance dips below the amount of the proceeds deposited pursuant to the trust, however, the claimant’s claim will be abated accordingly.
Absent information about the lowest intermediate balance of Mississippi Valley’s comingled account, the court could not determine whether the transferred funds in their entirety were properly impressed with the trust. As a result, J&R had not demonstrated that the transferred funds were its property, and the court could not determine whether they were “an interest of the debtor in property” as required to support the trustee’s preference action under section 547(b). Hence, the court remanded the case for further proceedings.
In departing from the Sixth Circuit’s holding in Omegas, the court in Mississippi Valley Livestock gave creditors in the Seventh Circuit slightly more flexibility in seeking the remedy of a constructive trust. The court refused to endorse the Sixth Circuit’s more severe restrictions on the availability of the constructive trust in bankruptcy; however, by cautioning lower courts to exercise the remedy sparingly and remanding the case to ensure that the funds were traceable, the Seventh Circuit reinforced the Sixth Circuit’s view that this remedy is only to be used with care. Seventh Circuit creditors seeking restitution in the bankruptcy context will not be as strictly limited in bringing forward arguments supporting the imposition of a constructive trust as those in the Sixth Circuit; as a result, they may have more opportunity to gain priority access to property of the estate and a better defense to preference actions. Nevertheless, they continue to face an uphill battle in meeting all the requirements of a constructive trust.
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In this section:
￭DespiteLackofValue,Seventh Circuit Permits Nonrecourse Secured Lender to Assert Deficiency Claim, dated January 7, 2014
￭ How a Single Asset Real Estate Bankruptcy in Georgia Led to One of the Code’s Most Misunderstood Provisions — the Pine Gate Case Revisited, dated May 15, 2014
￭ How a Real Estate Bankruptcy in Georgia Led to One of the Code’s Most Misunderstood Provisions — the Pine Gate Case Revisited, Part Two, dated May 22, 2014
The Most Misunderstood Provision
Many sections of the Bankruptcy Code are subject to inconsistent interpretations, labyrinthine analysis, and general practitioner malaise, but perhaps no Bankruptcy Code provision is more misunderstood and maligned than section 1111(b). The confusing, seemingly incongruent provision has been called “one of the most difficult sections of the Code” whose plain language was criticized before it even took effect. As part of our Throwback Thursday series, we explored How a Single Asset Real Estate Bankruptcy in Georgia Led to One of the Code’s Most Misunderstood Provisions — the Pine Gate Case Revisited. As the articles discuss, greater understanding of section 1111(b) begins with a consideration of the provision’s historical origins — specifically In re Pine Gate Associates, Ltd., a pre-Code bankruptcy case from the Northern District of Georgia that exposed a major flaw in the Bankruptcy Act. The severity of the “Pine Gate problem” and the decision’s unfortunate timing required quick and decisive action from Congress — action that resulted in the last-minute, backroom drafting of a powerful, vital, but unquestionably enigmatic Bankruptcy Code provision. Another post considers a contemporary interpretation of section 1111(b).
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Despite Lack of Value, Seventh Circuit Permits Nonrecourse Secured Lender to Assert Deficiency Claim
In an issue of first impression before it, the Seventh Circuit Court of Appeals held1 in In re B.R. Brookfield Commons No. 1, LLC that the plain language of section 1111(b) of the Bankruptcy Code permits election by a nonrecourse undersecured lender of the deficiency portion of its claim as recourse against the debtors. Further, even though the
collateral property at issue had no value, the court held that the claim could not be disallowed. In issuing its decision, the Seventh Circuit distinguished previous precedent of other bankruptcy courts as improperly decided.
The facts of Brookfield Commons are not unusual to those familiar with single asset real estate bankruptcies. Prior to its bankruptcy, the debtor placed two mortgages on its principal asset, a commercial shopping center. The second mortgage was nonrecourse, which simply meant that, outside bankruptcy, the second mortgagee’s recovery in a foreclosure or sale scenario would be limited solely to the proceeds of the pledged collateral. In other words, if any debt were left outstanding after disposition of the collateral, the lender would be barred from pursuing a deficiency claim against the debtor for such amounts.
As part of its chapter 11 plan of reorganization, the debtor proposed to retain ownership of the shopping center. The judicial valuation of the property established that its appraisal value would be less than the amount of the first mortgage. Accordingly, the second mortgagee’s claim was “totally unsecured by any equity” in the real property. The debtor argued that because the claim was unsecured by any value in the real property, it should be disallowed. The second mortgagee’s assignee, however, argued that section 1111(b)(1)(A) of the Bankruptcy Code permitted it to treat its nonrecourse claim as if it had recourse,
requiring allowance of an unsecured deficiency claim for the full amount of the debt.
The court began its analysis with the language of section 1111(b)(1)(A), which provides, in relevant part, that a claim “secured by a lien on property of the estate” shall be allowed or disallowed “as if the holder of such claim had recourse against the debtor on account of such claim, whether or not such holder has such recourse.” The court found that the “only precondition to the statute’s application” is that the claim at issue be secured by a lien on property of the estate. Because the statute does not state that the claim must be secured by property of any value (or that the creditor has to have an allowed secured claim as determined by section 506(a) of the Bankruptcy Code), the Seventh Circuit determined that the “value of the collateral” was “immaterial”, and the second mortgagee could assert its deficiency claim.
While the court found the statutory language to be clear, because there were some differing interpretations of its provisions by lower courts, the Seventh Circuit also looked to the legislative history on section 1111(b). While the legislative history did not provide definitive guidance on the issue, the court reasoned that it supported the conclusion that permitting nonrecourse secured lenders a right of recourse in bankruptcy, particularly where the debtor intends to retain its property as part of its reorganization plan, struck an appropriate balance between “debtor protections and equitable treatment of creditors.” Indeed, the court noted that, prior to the adoption of section 1111(b), a debtor could have enjoyed a “windfall” at the undersecured creditor’s expense because it could retain the property, but leave the creditor without full payment of the loan or the right to foreclose. Lastly, the court made clear that any prior precedent on the issue contrary to its Brookfield Commons holding was neither persuasive nor controlling.
Accordingly, through Brookfield Commons, the Seventh Circuit has made clear that the plain meaning of section 1111(b) permits recourse election for nonrecourse undersecured creditors in bankruptcy, regardless of the value of their secured claim under section 506(a). Bad news for debtors, but good news for secured lenders.
1 In re B.R. Brookfield Commons No. 1, LLC, 735 F.3d 596 (7th Cir. 2013).
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How a Single Asset Real Estate Bankruptcy in Georgia Led to One of the Code’s Most Misunderstood Provisions — the Pine Gate Case Revisited
Part One: The Pine Gate Problem
Since the inception of the Bankruptcy Code, certain “celebrated” cases have come to be so significant that their holdings are practically part of the Code itself. For instance, the Fifth Circuit’s In re Greystone III opinion shapes section 1122(b) so significantly (“thou shalt not classify similar claims differently in order to gerrymander
an affirmative vote on a reorganization plan”)2 that almost
25 years later it essentially remains a required citation in any brief challenging classification. Likewise, a bankruptcy practitioner would be foolish to write a brief about the duty to maximize value without at least a tip of the hat to Commodity Futures Trading Comm’n v.
Weintraub.3 These types of cases serve an important role
by filling in the gaps inevitably left in the Code.
On the contrary, In re Pine Gate Assocs., Ltd.4 didn’t so much fill a gap in the bankruptcy law as it exposed a crater — one so large that Congress was forced to quickly piece together legislation it hoped would solve what quickly became known as “the Pine Gate problem.” Decided on the eve of the Bankruptcy Act’s replacement in favor of the modern Bankruptcy Code, the result of Pine Gate was the last-minute addition of Bankruptcy Code section 1111(b) — a provision so confusing that courts have admitted to “struggling” with the provision’s “apparent confusion in language” and have called it “one
of the most difficult sections of the Code.”5 Nonetheless,
section 1111(b) is essentially unchanged since its creation, a testament to the severity of the Pine Gate problem and the provision’s ability to protect the rights of
2 995 F.2d 1274, 1276 (5th Cir. 1991).
3 471 U.S. 343 (1985).
4 Case No. B75-4345A, 1976 U.S. Dist. LEXIS 17366 (N.D. Ga. Oct. 14, 1976).
In re Realty Invest., Ltd. V, 72 B.R. 143, 145 (Bankr. C.D. Cal. 1987).
undersecured creditors effectively — especially where the debtor seeks to continue using the collateral of an undersecured nonrecourse creditor after reorganization. Without the context of Pine Gate, however, section 1111(b) is not just confusing, but also appears almost unnecessarily overprotective of the undersecured creditor. Considered in the context of Pine Gate, however, this difficult provision reveals its true merits and intended purpose.
A Problem Exposed
Pine Gate was a Chapter XII single asset real estate bankruptcy filed at a time when real estate prices were depressed throughout the United States. The Pine Gate debtor was a limited partnership that owned and operated apartments outside of Atlanta — apartments that were apparently too far outside of Atlanta. In violating the three golden rules of real estate (location, location, location), the debtors never brought in enough tenants to stay afloat, forcing the Chapter XII filing in December 1975.
Chapter XII had found limited use since its creation in 1938, until new bankruptcy rules in August 1975 did away with requirements that a Chapter XII debtor must both file its plan with its petition and immediately surrender
corporate control to a trustee.6 These new rules, coupled
with a depressed economy, high interest rates, and the advantage of the so-called “cramdown” provisions particular to Chapter XII caused an explosion of Chapter XII filings in 1975 and 1976, especially among owners of
distressed real property.7
Recognizing an opportunity to take advantage of these new rules, Chapter XII’s “cram down” provisions, and the temporarily depressed value of its sole asset, the Pine Gate debtor secured exit financing from a third party willing to lend an amount that matched the value of the apartments’ most recent appraisal — $1.2 million. With this financing assured, the debtor proposed a plan that
In re Pine Gate, 1976 U.S. Dist. LEXIS 17366 at *9-10.
The Northern District of Georgia had one Chapter XII case from 1938 to 1974, but 35 such cases filed between 1975-76. At the time of the Pine Gate decision, over one-third of all Chapter XII cases ever filed in the United States had been filed between 1975 and June 30, 1976, including 22 percent of all such cases in the first half of 1976 alone. In re Pine Gate, 1976 U.S. Dist. LEXIS 17366 at *10 fn. 12.
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paid its nonrecourse mortgage creditors the $1.2 million, an amount well below both the lenders’ original $1.45 million lien and the asset’s expected future value. The plan contemplated that the undersecured creditors would get their $1.2 million, but as nonrecourse creditors, the Bankruptcy Act didn’t allow them a deficiency claim for the remaining $250,000 they were owed. Most importantly, with their lien extinguished, the lenders would be unable to enjoy the asset’s expected post- confirmation upswing in value.
Unsurprisingly, the lenders opposed the debtor’s tactic and voted against the plan, but the small class of unsecured creditors entitled to vote (who otherwise would have been swamped by a $250,000 deficiency claim) voted in favor of the plan. Facing a cram down, the secured lenders argued that the plan could only be confirmed over their objection if they were paid the full amount of their debt, or in the alternative, if the debtor
surrendered the property.8 Surrender of the property, the
lenders argued, was the most accurate approximation of the rights they would be afforded outside of bankruptcy — where they could have foreclosed on the apartments, bought the asset at auction, and held onto the asset as property values rose.
After considering the arguments, Judge William L. Norton, Jr.9 held as follows:
When the dissenting secured creditors have, by contractual agreement, exculpated the Debtor and all persons associated with it from personal liability for any part of the debt, Section 461(11)(c) may be constitutionally applied to extinguish the debt of the dissenting secured creditors, and a Plan of Arrangement confirmed in spite of such dissenting class, so long as the dissenting class of creditors is compensated by the payment in cash of the value of the debt; i.e. the value of the
As Judge Norton recognized, the Bankruptcy Act was clear — there was nothing that required undersecured nonrecourse creditors be given an opportunity to reclaim their collateral or assert a deficiency claim. The debtor could “hold and keep the property to use in the debtor’s business enterprise … provided the plan offer[ed] ‘adequate protection’ to the nonassenting secured
creditor;”11 receiving the appraised value of their collateral
in cash constituted adequate protection under the prevailing law. With no dissenting class of unsecureds and the secured creditors crammed down, the Pine Gate court confirmed the plan, effectively permitting the debtor to retain ownership of the property while making
$250,000 worth of the lenders’ principal disappear.
The Bankruptcy Act’s shortcomings had been laid bare for all to see, and the immediate threat to nonrecourse lenders nationwide was apparent:
As a result of the Pine Gate decision, it became clear that (under the former Bankruptcy Act) a debtor could file bankruptcy proceedings during a period when real property values were depressed, propose to repay secured indebtedness only to the extent of the then appraised value of the property, “cramdown” the secured lender class and thereby preserve all potential future
appreciation for the debtor.12
The decision threatened to destroy the viability of nonrecourse loans entirely. The year was 1977, and lenders nationwide turned to Congress for relief. There they found the legislature hard at work, preparing to reconcile disparate versions of a piece of legislation Congress had been working on for half a decade — the Bankruptcy Code.
Id. at *3.
Judge Norton is famous among bankruptcy practitioners as the editor-in-chief and namesake of the Norton Bankruptcy Law Adviser, the Norton Annual Survey of Bankruptcy Law, the Norton Journal of Bankruptcy Law and Practice, and various other bankruptcy-related publications. In re Pine Gate, 1976 U.S. Dist. LEXIS 17366 at *56-57.
Id. at *19.
In re DRW Property Co. 82, 57 B.R. 987, 990 (Bankr. N.D. Tex.
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How a Real Estate Bankruptcy in Georgia Led to One of the Code’s Most Misunderstood Provisions — the Pine Gate Case Revisited, Part Two
Part Two: The Aftermath of Pine Gate
When we left off in a previous Throwback13 Thursday entry, the year was 1977, and lenders across the country were in an uproar over a single asset real estate bankruptcy case from the Northern District of Georgia —
In re Pine Gate Assocs., Ltd.14 The case had exposed a
means by which debtors could “cash out” nonrecourse mortgage lenders under Chapter XII of the former Bankruptcy Act: (1) wait for a decline in property values and file a Chapter XII petition; (2) obtain sufficient exit financing to pay your nonrecourse lenders cash equal to the appraised (a.k.a. currently depressed) value of the property subject to their lien; (3) identify an accepting class of creditors to effectuate a cramdown over your lenders’ dissenting vote; and (4) smile broadly as the portion of your principal balance greater than the appraised value of the property disappears. In short, the Pine Gate case demonstrated that the savvy debtor could use the Bankruptcy Act as a sword to cause a mortgage lender’s principal to evaporate whenever real estate prices were depressed. This became known as “the Pine Gate problem.”
But the strategy employed by the Pine Gate debtor did more than simply wipe the nonrecourse lenders out — “[b]y only repaying the undersecured, non-recourse creditor the appraised value of the property rather than returning the property to the lender or allowing him to foreclose, the Debtor received all future appreciation and the lender did not receive full payment of his debt or possession of the property (i.e. the benefit of its
See How a Single Asset Real Estate Bankruptcy in Georgia Led to One of the Code’s Most Misunderstood Provisions—the Pine Gate Case Revisited dated May 15, 2014 on the Weil Bankruptcy Blog. In re Pine Gate Assocs., Ltd., Case No. B75-4345A, 1976 U.S. Dist. LEXIS 17366 (N.D. Ga. Oct. 14, 1976).
bargain).”15 Outside of bankruptcy, the Pine Gate lenders would have had the right to seize their temporarily undervalued collateral and hold a foreclosure auction, thereby realizing the true, market value of the collateral. If the foreclosure auction didn’t bring the results the lenders expected, they had two choices: (i) credit bid for their collateral and hold the property while its value rebounded or (ii) take the money and run.
Most troubling to lenders, there was little or nothing they could do about the Pine Gate problem once a Chapter XII proceeding had begun. Unlike the undersecured recourse lender, the undersecured nonrecourse lender had no right to an unsecured deficiency claim under the Bankruptcy Act. The undersecured nonrecourse creditor could still vote to reject the plan on the basis of its secured claim, but the Pine Gate debtor had just drafted the blueprint for rendering such a vote meaningless. With little chance of overturning Judge Norton’s well-reasoned (and legally correct) Pine Gate opinion on appeal, and recognizing the circumstances underlying the case were ubiquitous amidst the American economic slump that served as Pine Gate’s backdrop, lenders lobbied Congress for relief.
Pine Gate Is Handed Down Late in the Game
By the 1970s, the Pine Gate problem was hardly the only problem with the Bankruptcy Act. “[T]he law governing reorganizations in the United States was largely dysfunctional. Old Chapter X was slow, expensive, and unwieldy. Old Chapter XI did not allow for the
restructuring of secured debt.”16
To address these issues and many more, Congress was already hard at work on the Bankruptcy Reform Act,17 an enormous piece of legislation18 that contained more than 300 sections and amended more than half of the titles of the United States Code. Indeed, Congress had been hard at work on this new Bankruptcy Code for nearly a decade,
beginning with debates as early as 1968. By 1970, it
In re DRW Property Co. 82, 57 B.R. 987, 990 (Bankr. N.D. Tex.
Douglas G. Baird, Remembering Pine Gate, 38 J. MARSHALL L. REV. 5 (2004).
17 Act of Nov. 6, 1978, Pub. L. No. 95-598, 92 Stat. 2549.
Frank R. Kennedy, Foreward: A Brief History of the Bankruptcy Reform Act, 58 N.C. L. REV. 667, 668 (1979-80).
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created the Commission on Bankruptcy Laws19 to “study, analyze, evaluate, and recommend changes” in the bankruptcy laws in light of the “technical, financial, and commercial” changes of the previous 20 years.20 This Committee’s 1973 report, along with the
recommendations of the National Conference of Bankruptcy Judges21 and other academics, formed the backbone of what would be the most comprehensive revision to our nation’s bankruptcy laws in decades. Just
as Pine Gate was turning the stomachs of nonrecourse lenders everywhere in 1977, the House and Senate finally introduced their competing versions of title 1122 — the perfect statutory vehicle to address the Pine Gate problem. Unfortunately for the lenders, the time for additions essentially had passed.
Consequently, as lenders mobilized their lobbyists in late 1977 and early 1978 to descend on Capitol Hill, it
the Pine Gate problem probably required significant debate in the legislature, artful and thoughtful drafting that ensured the provision wouldn’t overreach, and perhaps even consultation with a committee similar to the long-since disbanded Commission on Bankruptcy Laws.
An Answer From Behind Closed Doors — the Creation of Section 1111(b)
Unfortunately, there wasn’t time24 for such luxuries. Both the House and the Senate were already under considerable pressure to present a reconciled version of the legislation to President Carter before the end of the Congressional session — in part for fear the already decade-old legislative effort would lose momentum over the break and in part because the consumer credit industry, the SEC, and even Chief Justice Warren Burger were reportedly mounting an effort to convince Carter to
appeared they had already missed the boat on getting the
veto the bill.
Because of the need for expediency and the
Pine Gate problem addressed in the new Bankruptcy
difficult compromises necessary to reconcile the over 300
Code. The House debated and passed its version of the
differences between the bills,
Bankruptcy Reform Act23 — H.R. 8200 — on February 1,
procedure of utilizing a conference committee was not
1978 without addressing the Pine Gate problem. The
From September 7 to October 6, 1978, “under
Senate’s version of the legislation — S. 2266 — passed on
Representatives Don Edwards
September 7, 1978, and contained only a token attempt to remedy the Pine Gate problem by allowing nonrecourse
creditors a deficiency claim. From the lenders’
and Caldwell Butler and Senators Dennis DeConcini and
Malcolm Wallop, along with Congressional staffers Kenneth Klee and Richard Levin, “hammered out a
perspective, the Senate’s quick fix was an improvement
resolution of the differences”
between each chamber’s
over the current state of affairs, but it really didn’t guarantee them much more than a chance to vote against a plan twice. It seemed clear that an issue as complex as
The Bankruptcy Commission was a nine-member group consisting of academics, financiers, federal judges, and members of the House and Senate Judiciary committees. REPORT OF THE COMMISSION ON THE BANKRUPTCY LAWS OF THE UNITED STATES, July 1973, H.R. Doc. No. 93-137 at 1-2,
93rd Cong., 1st Sess. (1973).
20 Act of July 24, 1970, 1978, Pub. L. No. 91-354, 84 Stat. 468.
The National Conference of Bankruptcy Judges was a voluntary nonprofit organization consisting of leading referees of courts of bankruptcy and district court judges acting in lieu of referees. See generally, Kenneth N. Klee, Legislative History of the New Bankruptcy Law, 28 DEPAUL L. REV. 941 (1979) (providing a detailed history timeline of the legislative debates surrounding the Bankruptcy Code).
23 Act of Nov. 6, 1978, Pub. L. No. 95-598, 92 Stat. 2549.
version of the Bankruptcy Code.
Further, it’s doubtful that nonrecourse lenders wanted to wait several years for Congress to agree on a better answer to the Pine Gate problem while their borrowers were entering Chapter XII at dizzying rates, anyway. Kennedy, Foreward: A Brief History of the Bankruptcy Reform Act, 58 N.C. L. REV. at 677-8. The differences between the bills were hardly cosmetic. The two chambers disagreed about whether bankruptcy court judges should be Article III judges, how the reorganization process for publically-held companies should work, and numerous other highly fundamental issues. Kennedy, Foreward: A Brief History of the Bankruptcy Reform Act, 58 N.C. L. REV. at 679; see also Klee Legislative History of the New Bankruptcy Law, 28 DEPAUL L. REV. at 954. Id.
Id. at 676.
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This abridged reconciliation process permitted the Congressmen more than just an opportunity to synthesize the two bills; it permitted the drafters one final chance to consider issues that had not been adequately addressed in either the House or Senate versions of the Bankruptcy
Reform Act.30 Taking full advantage, “the legislation
underwent a number of important changes that could not be described as reconciliation of the diverse provisions of the bills that passed the House and Senate.”31 Chief among these changes was the decision to address Pine Gate by drafting section 1111(b).32
The resulting provision attempted to solve the Pine Gate problem in two ways. First, in a nod to the Senate bill, section 1111(b)(1) treated all undersecured debt as recourse debt for the purposes of chapter 11, giving undersecured nonrecourse lenders an unsecured deficiency claim they could use to vote. Second, section 1111(b)(2) afforded both undersecured recourse and nonrecourse creditors a choice: (i) bifurcate their claims into a secured claim and an unsecured deficiency claim or
(ii) elect to have their whole claim treated as a secured claim. By introducing this novel “1111(b) election,” the group tasked with reconciling the bills had addressed the other issue exposed by the Pine Gate decision — the ability of the savvy debtor to secure for itself the benefits of a
post-confirmation increase in the value of the collateral.33
30 Act of Nov. 6, 1978, Pub. L. No. 95-598, 92 Stat. 2549.
Id. at 677; see also Dale C. Schian, Section 1111(b)(2): Preserving the In Rem Claim, 67 AM. BANKR. L.J. 479, 480 (1993) (“Unlike most of the Bankruptcy Code, § 1111(b)(2) did not emanate from the Bankruptcy Commission.”). The last-minute addition of section 1111(b) might also explain the noticeable disconnect between sections 1111(a) and 1111(b), as section 1111(a) had been part of the debated House and Senate versions of the Code before the reconciliation process. Section 1111(b)(2) does this by working in tandem with Bankruptcy Code section 1129(b)(2)(A)(i), which says that to “cram down” a secured creditor, a plan must provide that the secured creditor retains its liens on the collateral and receives deferred cash payments equal to the present value of the collateral. If the reorganized debtor then realizes an increase in the value of the collateral at a later date, it must then make the secured creditor whole. Put simply, a creditor making the 1111(b) election will at least receive payments equal to the current appraised value of its collateral, plus receive the benefit of any post-confirmation sale of the collateral up to the value of the original lien.
After just a few short weeks of round-the-clock work, primary architects Congressman Edwards and Senator DeConcini each stood before their respective chambers of Congress and announced the results of the backroom
reconciliation process.34 Memorialized in the
Congressional Record of September 28 and October 6, 1978, the two referenced the single asset real estate case from Georgia as they described the purpose and intent behind the previously unconsidered section 1111(b). Pine Gate had created law.
The Aftermath of the Addition of Section 1111(b)
At least due in part to its rapid, unconventional path from case law to statutory law, section 1111(b) suffers from enigmatic language considered so unwieldy that the
provision was criticized before it even took effect.35 To
this day, modern bankruptcy courts lament that “[a] literal reading of the statute, without reviewing the legislative history or carefully analyzing those decisions dealing with nonrecourse creditors, can result in a
misunderstanding of the statute.”36 It also turned out to
be almost too effective, as Congress was forced to draft an entire new chapter of the Bankruptcy Code less than a decade later in part to eliminate its burdensome effects on farmers.37
These problems and criticisms, however, should be viewed less as a testament to Congress’ drafting abilities and more as a testament to the severity of the Pine Gate
Statement of Congressman Edwards, 124 Cong. Rec. H 11,104 (Sept. 28, 1978); Statement of Senator DeConcini, 124 Cong. Rec. S 17,420 (Oct. 6, 1978). See Michael J. Kaplan, Nonrecourse Undersecured Creditors under New Chapter 11—The Section 1111(b) Election: Already a Need for Change, 53 AM. BANKR. L.J. 269, 270 (1979) (“It is the purpose of this article to call attention … to some problems in the Code language that deserve consideration and resolution before the Code becomes effective on October 1, 1979.”); see also Jeffrey A. Stein, Section 1111(b): Providing Undersecured Creditors with Postconfirmation Appreciation in Value of the Collateral, 56 AM. BANKR. L.J. 195, 207, 211 (1982) (suggesting possible revisions to section 1111(b) intended to clarify Congress’ intent). In re Waterways Barge P’ship, 104 B.R. 776, 782 (Bank. N.D.
See In re Quintana, 107 B.R. 234, 246 (B.A.P. 9th Cir. 1989) (discussing the historical interplay between chapter 12 and section 1111(b)).
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problem and the speed with which it had to be addressed. Considered in this light, we hope the readers of this blog approach section 1111(b) with a newfound appreciation for its purpose, as well as a newfound appreciation for In re Pine Gate — the little case that nearly blew the Bankruptcy Act wide open.
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In this section:
￭ Foreign Bitcoin Exchanges and Chapter 15, dated March 11, 2014
￭ Would a U.S.-Based Bitcoin Exchange Be Eligible for Bankruptcy?, dated April 10, 2014
Early 2014 saw the first major intersection of bankruptcy law and virtual currency in the failure of Japanese Bitcoin exchange Mt. Gox. Bitcoin is a new financial product. It has no clear legal framework, defies conventional restructuring techniques, and implicates difficult cross-border questions. In other words, it is exactly the kind of thing we get excited about. The Weil Bankruptcy Blog is proud to have introduced the Bitcoin Bankruptcy series to examine these issues. We are currently analyzing what the filing of a hypothetical U.S.-based Bitcoin exchange would look like, and we have many more posts in store that will address a wide variety of virtual-currency-related restructuring topics.
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Foreign Bitcoin Exchanges and Chapter 15
The Japanese insolvency and chapter 15 bankruptcy filing of bitcoin exchange Mt. Gox raise a host of questions about parties’ rights to bitcoins — assets that defy neat analysis under existing legal frameworks. How would a bitcoin exchange be restructured or liquidated? What assets does it have, and where are they situated? And what are those assets in the first place?
The Weil Bankruptcy Blog is pleased to announce a new series titled “Bitcoin Bankruptcy.” We will explore the legal questions that a hypothetical bankruptcy of a bitcoin exchange might pose under the Bankruptcy Code. We will also consider the implications of such a bankruptcy on the debtor exchange, its customers, its creditors, the bitcoin market and its infrastructure, and regulatory authorities. We first provide some background on Bitcoin and consider some of the questions raised by Mt. Gox’s chapter 15 filing.
What Is Bitcoin and How Does It Work?
Bitcoin is a digital payment system that functions as money among those who attribute value to it. To finance professionals, Bitcoin is a hybrid form of asset that straddles the line between currency and commodity. For example, the following are some of Bitcoin’s currency-like properties:
￭ Bitcoin is a medium of exchange used to purchase goods and services.
￭ Bitcoin has exchange rates against government- sponsored currencies.
￭ Bitcoins can be taken offline and converted to tangible form.
￭ A searchable record of all Bitcoin transactions (called the “block chain”) is maintained.
￭ Bitcoins appear to have no nonmonetary value (unlike things like oil, wheat, or gold).
Yet Bitcoin also has the following commodity-like properties:
￭ Bitcoin is not backed by a government and has no centralized regulatory authority.
￭ Bitcoins are scarce: a maximum of only 21 million bitcoins will ever exist.
￭ Bitcoins are released into circulation gradually (through a process known as “mining”).
￭ Bitcoin prices are extremely volatile and may not be susceptible to stabilization by a government.
At a high level, transacting in Bitcoin is similar to transacting in any other currency. A prospective Bitcoin market participant opens an account with a Bitcoin “wallet” service — an Internet company that holds one’s bitcoins in what is essentially a deposit account. The participant visits a Bitcoin exchange, which works like any other type of currency exchange, selling bitcoins for other currencies at various exchange rates that fluctuate over time. The exchange matches a buyer with a seller and earns the bid-ask spread on the transaction. The participant pays for the Bitcoins using PayPal, wire transfer, or another payment system and deposits those bitcoins in his or her wallet.
The market participant might be a consumer. A consumer can spend his or her bitcoins wherever bitcoins are accepted, such as the websites for Overstock.com or the Sacramento Kings basketball team. But the market participant might instead be an investor. An investor might buy bitcoins at one price and sell them at a higher price; use them to hedge transactions in other currencies; or use them for other types of financial transactions.
Bitcoins can also be converted from digital form into physical form. Market participants can perform these conversions at bitcoin ATMs and store physical bitcoins in wallets. A number of market participants have in fact converted their bitcoins into physical form and stored them in safe-deposit boxes at banks.
Most governments and companies do not presently accept Bitcoin as a medium of exchange, but Bitcoin’s acceptance has been growing in most parts of the world since Bitcoin’s introduction in 2009. Bitcoin prices are extremely volatile, though. Bitcoins traded around $5 in March 2012; over $1,200 in November 2013; and between
$600 and $700 on most major exchanges over the past week.
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Transaction Mechanics and Market Infrastructure
At a more granular level, Bitcoin’s transaction mechanics differ markedly from other forms of payment. These differences may raise significant questions regarding how bitcoin-based transactions should be analyzed under the Bankruptcy Code and other restructuring frameworks.
For a frame of reference, suppose a buyer purchases goods from a seller via PayPal. PayPal serves as a third party escrow-type agent that both parties trust will clear the transaction properly. As an intermediary, PayPal is also a means by which a buyer can initiate a chargeback — i.e., reverse the transmission of funds where the buyer disputes the transaction. For most purposes, this is a typical online payment structure.
Bitcoin transactions are fundamentally different. A Bitcoin transaction occurs between a buyer and a seller, each of which is identified only by a unique publicly available code called an “address.” The transaction occurs on a peer-to-peer basis, and that is Bitcoin’s most significant innovation: it does not require a bank or other trusted third party to clear transactions. Instead, Bitcoin relies on what one might call “crowdsourced market infrastructure.”
When a Bitcoin transaction takes place, a signal announcing the transaction is sent out to the Bitcoin market. The signal is received by thousands of computers with specialized hardware called “miners.” Miners perform calculations (called “mining”) that verify that the transaction they have received is, in fact, a valid transaction involving unique bitcoins. When a critical percentage of miners have verified the transaction, the transaction is considered valid and is recorded in the block chain, a public ledger. No third party clears transactions, and so transaction costs are generally low. Chargebacks are difficult or impossible for buyers to perform.
A word about miners: Miners’ incentive to verify transactions is that they receive bitcoins for doing so. The more effective a miner is at mining, the more bitcoins it receives. The bitcoins are distributed to miners by the Bitcoin network, and mining gets more difficult as more bitcoins are mined. The Bitcoin network will stop distributing bitcoins once 21 million bitcoins have been distributed.
This is just an overview of Bitcoin, but much more writing is available online for those interested in more detail.
The Mt. Gox Crisis
Mt. Gox is a bitcoin exchange headquartered in Tokyo, Japan. It was once the world’s largest bitcoin exchange. Mt. Gox operated two related businesses — an exchange and a wallet system — for both its own accounts and its customers’ accounts. It managed both hot wallets and cold wallets. A “hot” wallet is a bitcoin wallet that is maintained on a computer connected to the Internet. A “cold” wallet is maintained on an offline computer.
Mt. Gox has asserted that, in early February 2014, unidentified hackers may have broken into its wallet system — apparently both hot and cold, and both its own accounts and its customers’ accounts — and stolen approximately 850,000 bitcoins. Following its discovery of the bitcoin losses, Mt. Gox stopped permitting customers to make withdrawals from their wallets. On February 28, 2014, Mt. Gox commenced a bankruptcy-like civil rehabilitation proceeding in Tokyo. Yesterday, Mt. Gox petitioned the United States Bankruptcy Court for the Northern District of Texas for chapter 15 relief.
Chapter 15 for a Non-U.S. Bitcoin Exchange
Generally, a debtor’s decision whether to file under chapter 15 is a strategic or practical one. Chapter 15 facilitates the debtor’s foreign proceeding (i.e., its proceeding outside of the United States) by granting judicial recognition of that proceeding in the United States. A debtor in a foreign proceeding can use chapter 15 to protect assets situated in the United States; to establish
U.S. procedures for filing claims in the foreign proceeding; to facilitate asset sales approved in the foreign proceeding; and for certain other purposes. In its case, Mt. Gox asserts that it has sought chapter 15 relief to avoid “expend[ing] substantial monetary and personnel resources” to defend itself in litigation pending in the United States.
Mt. Gox may be the next debtor to raise the question whether section 109(a) of the Bankruptcy Code applies to debtors seeking chapter 15 relief. Section 109(a) requires, among other things, that a debtor in a bankruptcy case have “a domicile, a place of business, or property in the United States.” The United States Court of Appeals for the Second Circuit recently held that section 109(a) applies to debtors in foreign proceedings seeking relief under chapter 15. By contrast, the United States Bankruptcy Court for the District of Delaware recently
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held in an oral ruling that section 109(a) does not apply to a debtor in a foreign proceeding. In Mt. Gox’s case, no one seems to know what, if any, property Mt. Gox has in the United States. And for that matter, it is unclear what kind of property a foreign-based bitcoin exchange would be expected to have in the United States.
Where in the World Is Property of the Estate? (And What Is That Property?)
In general, the kinds of property a foreign bitcoin exchange could have in the United States might include a website, servers, data, bitcoins, and other intellectual property, among other things. Yet there may not be clear answers on where certain of these intangible assets are situated. For example: where is data situated? Is it on a physical server; in the owner’s principal place of business; in the owner’s jurisdiction of incorporation; or somewhere else? Does it depend on what kind of data is at issue? Do bitcoins in digital form constitute data or some other kind of property?
Further, it is unclear whether customers’ bitcoins constitute property of the debtor’s estate or custodial property held in trust for the debtor’s customers. (In other words, do customers constitute creditors?) In the context of a typical (fiat) currency, a deposit of funds into a bank account generally creates a debtor-creditor relationship between the bank and the depositor. Yet it is unclear whether the same would be true for the deposit of a bitcoin into a wallet. The commodity-like property of bitcoins may weigh in favor of considering the bitcoin- wallet relationship one of custody rather than of debt.
Notice and Service Procedures May Be Antiquated
Bitcoin exchange bankruptcies also raise the question whether currently applicable service and notice procedures are obsolete. For example, when a typical debtor commences a bankruptcy case, it generally provides notice of the case to known creditors by mail and to unknown creditors by newspaper publication. But these methods may not work for a bitcoin exchange. Parties transacting in bitcoin are identifiable only by their public pseudonyms, and they may be located anywhere in the world. Their mailing addresses likely are all unknown, and there may be no way to determine which newspaper would most effectively reach creditors. Thus, traditional methods of giving notice — and, for similar reasons, of serving process — may not apply in the bankruptcy of a
bitcoin exchange. It may be that the bitcoin exchange’s website itself constitutes the most effective forum for providing notice and serving process in the case. Moreover, the involvement in bitcoin exchanges by parties located all over the world may implicate novel questions of the statutory and constitutional reach of bankruptcy courts’ in personam jurisdiction.
More to Come
These issues are just the tip of the Bitcoin Bankruptcy iceberg. In other posts, we will explore the issues that may arise in a hypothetical bankruptcy of a U.S.-based bitcoin exchange. We are excited to discuss what may be the next new frontier of restructuring law.
Would a U.S.-Based Bitcoin Exchange Be Eligible for Bankruptcy?
In our last Bitcoin Bankruptcy post, we discussed some of the questions that Mt. Gox’s chapter 15 filing raises. In this post, we begin to consider what a bankruptcy of a hypothetical U.S.-based bitcoin exchange might look like.
The U.S.-Based Bitcoin Exchange and Its Filing
Hypothetical debtor: Our hypothetical debtor is a Delaware corporation having its headquarters office in New York, New York. It operates a website with a “.com” top-level domain, which it has registered through a U.S.- based domain name registrar. The website offers two services to its users: (i) bitcoin wallet services and (ii) a bitcoin exchange. Like Mt. Gox our hypothetical U.S. bitcoin exchange maintains both customer and proprietary bitcoin wallets. Assume that our debtor has deposit accounts at banks within New York State. And to keep matters simple, assume that all of our debtor’s obligations were issued in U.S. dollars.
Hypothetical distress event: Now, assume that our hypothetical debtor experiences the same distress event that Mt. Gox experienced. One day, the company suddenly discovers that most or all of its customers’ and its own bitcoins have gone missing. The bitcoins’ disappearance has put the company in default of its obligations, and customers have commenced a class action against the company. Unable to find the bitcoins and cure its defaults,
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and in the midst of a crisis of confidence, the company voluntarily seeks the protection of the U.S. bankruptcy laws.
Bitcoin Exchanges and Eligibility
First, our debtor must determine whether it is eligible for relief under the Bankruptcy Code. This question has two parts:
￭ Does it satisfy the requirements of section 109(a) of the Bankruptcy Code?
￭ Even if so, does another part of section 109 expressly render it ineligible for bankruptcy?
Section 109(a) of the Bankruptcy Code requires that a corporate debtor in a U.S. bankruptcy case “resid[e] or ha[ve] a domicile, a place of business, or property in the United States.” Here, our hypothetical bitcoin exchange has, among other things, a domicile in Delaware, a place of business in New York, deposit accounts in New York, and a domain name situated in the United States. Our debtor easily meets the requirements of section 109(a) to be a debtor in bankruptcy.
The next question is whether another part of section 109 of the Bankruptcy Code expressly excludes the debtor from eligibility for relief under certain chapters of the Bankruptcy Code. The answer largely depends on the debtor’s business model.
Bitcoin Exchanges: Four Sample Business Models
Bitcoin exchanges operate under several different business models. Based on our research, the following four business models appear to be the most common among bitcoin exchanges currently in operation:
The “Dealer” Model
The “Dealer” exchange is a classic market maker. In every exchange of bitcoins for real currency, the “Dealer” exchange faces the customer. Customers who buy bitcoins purchase directly from the exchange. Customers who sell bitcoins sell them directly to the exchange. This sort of exchange may earn revenue through fees collected upon the customer’s registration, upon each exchange transaction, or in other ways.
The “Order Book” Model
The “Order Book” exchange never faces customers. Instead, it manages an order book. It matches third-party buyers and sellers, provides a digital platform on which
the parties can make the exchange, and earns a commission on each transaction.
The “Margin Trading” Model
Some bitcoin exchanges provide a margin-trading and bitcoin-lending platform in addition to one of the exchange services described above. Like a traditional broker-dealer, the “Margin Trading” bitcoin company facilitates customers’ trading of bitcoins by establishing trading accounts in which they can deposit bitcoins as margin collateral. Based on the amount of margin collateral they maintain in their accounts, customers are able to borrow bitcoins (either from the exchange itself or from other customers) to take leveraged positions in trades directly against other customers. Customers’ trades may be based in bitcoins themselves or in bitcoin derivatives.
The “Escrow” Model
A fourth type of bitcoin “exchange” is not truly an exchange but rather an escrow service. It is similar to the “Order Book” model, except that the seller’s bitcoins pass through the exchange before going to the buyer. The “Escrow” exchange maintains an order book. When it matches a buy order with a sell order, it notifies the parties and provides the buyer with a bank account number of the seller. The seller transfers the requisite bitcoins to the exchange, and the buyer deposits cash into the seller’s bank account at a local branch. The buyer then provides the exchange with proof of the deposit (such as a copy of the receipt). When the seller confirms that it has received the deposit, the exchange releases the bitcoins from escrow to the buyer.
Chapter 11 May Not Be Available for All Bitcoin Exchanges
Not all of these bitcoin exchanges may be eligible to file a chapter 11 case. Section 109(d) of the Bankruptcy Code provides that only the following types of entities are eligible for chapter 11 relief:
￭ Certain banks that operate multilateral clearing organization businesses under section 409 of the Federal Deposit Insurance Corporation Improvement Act of 1991; and
￭ Persons that may be debtors under chapter 7, except stockbrokers and commodity brokers. In general,
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companies that are not railroads, insurers, or most types of banks may be debtors under chapter 7.
So what types of entity is a bitcoin exchange? There are a few types that we can rule out at a glance. First, a bitcoin exchange obviously is not a railroad. Second, a bitcoin exchange does not appear to be an insurance company. Although the Bankruptcy Code does not define “insurance company,” the Supreme Court of the United States has explained that “[t]he primary elements of an insurance contract are the spreading and underwriting of a policyholder’s risk.” Bitcoin exchanges generally are not in the business of underwriting risk, so they probably do not constitute insurance companies.
As such, it appears that a bitcoin exchange would be eligible for chapter 11 unless it is a stockbroker, a commodity broker, or a bank that is not a multilateral clearing organization. Could a bitcoin exchange be a stockbroker or a commodity broker? Based on its wallet business, could it be a bank? If it’s a bank, could it constitute a clearing organization?
Our hypothetical bitcoin exchange facilitates the trading (at least in some sense) of bitcoins, and it also maintains wallets in which it holds customers’ bitcoins. Depending on the exchange’s business model, and despite the fact that bitcoin transfers are peer-to-peer transactions, there may be an argument that a bitcoin exchange performs a kind of clearing function. Accordingly, we must consider whether any of the bitcoin exchange business models described above constitutes a stockbroker, a commodity broker, a type of bank, or a clearing organization. Future Bitcoin Bankruptcy posts will look at eligibility under each of these categories in detail.
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The Weil Bankruptcy Blog is published by Weil’s Business Finance & Restructuring (BFR) department. The editorial board consists of BFR partners Debra Dandeneau and Ronit Berkovich and counsel Elisa Lemmer. Partners and associates from across the firm contribute to the blog, and Weil’s clients and fellow restructuring professionals are also welcome to contribute. If you would like to contribute to the blog, or have any questions or comments, please contact us.
Weil is regarded as having the world’s premier restructuring practice and is “the first name you think of,” according to Chambers Global. Weil has been involved in virtually every major chapter 11 reorganization case in the U.S. and in major international out-of-court debt restructurings. The BFR department has a market leading chapter 11 bankruptcy practice, advising debtors, creditors, bondholders, debtor in possession lenders and committees. The BFR department advises regularly on out-of-court restructurings, distressed mergers and acquisitions, and cross-border insolvencies, and provides crisis management counseling to major corporations around the world.
This article was originally posted on Weil’s Bankruptcy Blog. For more information, please visit the blog at: http://business-finance-restructuring.weil.com/