§ 1.1. Supreme Court
City of Chicago vs. Fulton, 141 S. Ct. 585 (2021). In the case before the Court, the City of Chicago impounded the debtors’ vehicles for failure to pay fines. The debtors then filed chapter 13 bankruptcy cases. Following the filing of the cases, the debtors requested that the city return the vehicles. The city refused and the bankruptcy court held that those refusals each constituted a violation of the automatic stay. The Seventh Circuit affirmed and held that “by retaining possession of the debtors’ vehicles after they declared bankruptcy,” the city had violated section 362(a) of the Bankruptcy Code by exercising control over the debtors’ property. The Supreme Court granted certiorari “to resolve a split in the Courts of Appeals over whether an entity that retains possession of the property of a bankruptcy estate violates § 362(a)(3).”
The Court began its analysis by noting that the filing of a bankruptcy petition has certain immediate consequences. The first is that it is the creation of an estate that, with limited exceptions, includes all of the debtor’s legal or equitable interests and property as of the commencement of the case. The Court noted that a second automatic consequence of the filing of a bankruptcy petition, again with certain limited exceptions, is that the petition operates as a stay of all efforts to collect from the debtor outside of the bankruptcy case. Among the many efforts prohibited by the state is “any act in possession of property of the estate or of property from the estate or to exercise control over property of the estate.” Justice Alito, writing for the Court, concluded that the language used in section 362(a)(3) suggests that simply retaining possession of estate property does not violate the stay. The Court noted that the stay bars “any act” to exercise control over property of the estate. The Court concluded that the most natural reading of the statutory language was to prohibit affirmative acts that would disturb the status quo of estate property as of the time of the bankruptcy filing. The Court further concluded that any ambiguity in the language of the Bankruptcy Code would be resolved in the non-debtor’s favor because of section 542. That provision, entitled “Turnover of Property to the Estate,” provides for the delivery of estate property to the trustee. Interpreting the automatic stay to cover mere retention of property would, in the Court’s analysis, create two problems. First, it would render section 542 largely superfluous, which would be contrary to basic principles of statutory interpretation. Moreover, this alternative reading of the automatic stay would render the automatic stay and the turnover provisions contradictory. The Court reached this conclusion because section 542 has exceptions for, inter alia, the turnover of inconsequential property. Reading section 362 as the debtors urged would have the automatic stay commanding turnover of property, when the more specific turnover provision would not. Accordingly, the court held that the mere retention of estate property after the filing of a bankruptcy petition does not violate the automatic stay.
In a concurring opinion, Justice Sotomayor emphasized that the Court did not decide whether and when the automatic stay’s other provisions might require a creditor to return a debtor’s property. Justice Sotomayor also noted that the Court did not address how bankruptcy courts should go about enforcing the commands of section 542(a), and that the city’s conduct could very well violate one or both of these provisions. Justice Sotomayor concluded by noting that any gaps in the efficacy of the turnover process would be “best addressed by rule drafters and policy makers, not bankruptcy judges,” and urged the Advisory Committee on Rules of Bankruptcy Procedure “to consider amendments to the Rules to insure prompt resolution of debtors’ requests for turnover under [section] 542(a), especially where debtors’ vehicles are concerned.”
§ 1.2. First Circuit
Union de Trabajadores de la Industria Electrica y Riego v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 7 F.4th 31 (1st Cir. 2021). In one of the latest of many decisions stemming from the proceedings under Title III of the Puerto Rico Oversight Management and Economic Stability Act (“PROMESA”), the First Circuit recently affirmed the decision of the court overseeing the Title III proceedings (the “Title III Court”) that section 503(b)(1)(A) of the Bankruptcy Code applies to Title III proceedings, notwithstanding that there is no “estate” in Title III proceedings.
In July 2017, the Financial Oversight and Management Board for Puerto Rico (“FOMB”), established by PROMESA to oversee the restructuring proceedings of Puerto Rico and its various instrumentalities, commenced Title III proceedings for the Puerto Rico Electric Power Authority (“PREPA”) after the public power utility—one of the largest in the United States and the only electrical energy distributor in Puerto Rico—became unable to service its debt. Almost a year later, in June 2018, Puerto Rico passed an act to partially privatize PREPA. As a result, a competitive bidding process was undertaken to find a private entity to assume control over PREPA’s power transmission and distribution system (“T&D System”). Two years later, in June 2020, LUMA Energy (“LUMA”) won the bid and entered into a contract to gradually assume operations and management of PREPA (“T&D Contract”). Under the T&D Contract, LUMA would provide front-end transition services to PREPA that would facilitate LUMA’s operational takeover, for which PREPA would pay an estimated $136 million, plus any late fees that might become due as a result of untimely payments. In addition, PREPA agreed to file a motion with the Title III Court seeking administrative expense treatment for any accrued and unpaid amounts required to be paid by PREPA during the front-end transition period; if the court refused to grant the motion, LUMA reserved the right to terminate the T&D Contract. Various prepetition creditors of PREPA opposed the motion, arguing the fees and expenses due under the T&D Contract could not be given administrative expense priority under section 503(b)(1)(A), notwithstanding that PROMESA incorporates section 503 of the Bankruptcy Code in its entirety, because there is no “estate” to preserve in Title III proceedings. The Title III Court rejected this argument, and determined that both the text and structure of PROMESA made it clear that PREPA’s operating expenses were entitled to administrative expense priority, to the extent that they were to preserve the property of a debtor in Title III debt adjustment proceedings. Nonetheless, the Title III Court denied the motion in part, without prejudice, solely to the extent that the motion sought an allowed administrative expense claim for late payment fees that might be incurred in the future.
The First Circuit agreed with the Title III Court, holding that the creditors’ interpretation would render meaningless 48 U.S.C. § 2161(a), which incorporates various Bankruptcy Code provisions referring to an “estate” into Title III of PROMESA. In addition, the First Circuit rejected the creditors’ argument that 48 U.S.C. 2161(c)(5), which provides that “[t]he term ‘property of the estate,’ when used in a section of [the Bankruptcy Code] made applicable in a case under this subchapter by subsection (a), means property of the debtor,” does not apply to section 503(b)(1)(A) because section 503(b)(1)(A) uses the terminology “estate” rather than the terminology “property of the estate.” Relying on 48 U.S.C. § 2161(b), which states that “[a] term used in a section of [the Bankruptcy Code], made applicable in a case under this subchapter by subsection (a), has the meaning given to the term for the purpose of the applicable section, unless the term is otherwise defined in this subchapter,” the court held that “‘the meaning given to’ the term ‘estate’ for ‘the purposes’ of § 503(b)(1)(A) is the meaning given to it under § 541, which is ‘property of the estate.’” Because the term “property of the estate” is otherwise defined in 48 U.S.C. § 2161(c)(5) to mean “property of the debtor,” there was no reason to read section 503(b)(1)(A) out of PROMESA.
In addition, the First Circuit rejected challenges to the Title III Court’s finding that the T&D Contract fees (other than late fees) satisfied the requirements of section 503(b)(1)(A) and affirmed the Title III Court’s determination that the FOMB had sole jurisdiction to review a fiscal plan for compliance with 48 U.S.C. § 2141(b)(1).
Pinto-Lugo v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 987 F.3d 173 (1st Cir. 2021). In another decision arising from the PROMESA proceedings, the First Circuit applied the doctrine of equitable mootness to dismiss three consolidated appeals of the plan of adjustment for the Puerto Rico Sales Tax Financing Corporation (“COFINA”). In so doing, the First Circuit undertook an analysis of (i) the Supreme Court’s decision in Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019) and whether that decision rendered the doctrine of equitable mootness invalid, and (ii) whether the doctrine of equitable mootness could be applied to a Title III proceeding, or to municipal bankruptcy proceedings generally. On both issues, the First Circuit resolved that equitable mootness was applicable to the current cases in controversy.
Certain holders of COFINA bonds objected to a settlement between the Commonwealth of Puerto Rico and COFINA resolving which entity had the superior right in the Commonwealth’s sales and use tax revenues (the “SUT Revenues”). The settlement, which formed the basis of COFINA’s plan of adjustment, allocated 53.65% of the SUT Revenues to COFINA, while the Commonwealth kept the remainder. To implement the settlement, the Commonwealth was required to pass new bond legislation, reorganizing COFINA, allocating the SUT Revenues as agreed under the settlement, and authorizing COFINA to issue replacement bonds. During the legislative session when the new bond legislation was brought to the floor of the Puerto Rico House of Representatives, a minority party representative stood to oppose the bill, but was ignored by the president of the House. The bill was subsequently passed and signed into law by the governor on November 15, 2018.
One contingent of bondholders (the “Pinto-Lugo Group”) filed a complaint seeking declaratory judgment that the law was invalid, asserting that the treatment of the minority representative amounted to a violation of the Puerto Rico legislative rules and the Puerto Rico Constitution. The complaint also sought a ruling that the predecessor act was invalid because it violated limitations on Commonwealth borrowing under the Puerto Rico Constitution. The action was removed to the Title III Court in January 2019.
Also in January 2019, the Title III Court heard objections to the proposed COFINA plan of adjustment, incorporating the settlement. In addition to an objection by the Pinto-Lugo Group, on grounds similar to the complaint, the plan also drew objections from a separate contingent of COFINA bondholders (the “Elliot Group”) and a single bondholder seeking to assert his individual claim. The Title III Court overruled all objections to the plan and dismissed the individual’s proof of claim as duplicative of an omnibus proof of claim filed on behalf of all bondholders, including the individual. The Title III Court approved the plan on February 5, 2019, and the plan was implemented a week later on February 12, 2019. These appeals followed.
The FOMB and others opposed the appeals on grounds of equitable mootness. The First Circuit considered two arguments raised regarding the threshold applicability of the doctrine before examining the merits of dismissing on the basis of equitable mootness. First, the Elliot Group argued that Mission Product undermined the doctrine of equitable mootness. Examining that holding, the First Circuit determined that, in Mission Product, the Supreme Court addressed the jurisdictional ramifications of equitable mootness, whereas in these appeals, the issue was whether the parties’ inaction and the passage of time rendered the relief sought inequitable. Accordingly, Mission Product did not pose an obstacle to the applicability of equitable mootness in the instant action. Second, the Elliot Group contended that the doctrine of equitable mootness was inapplicable to a municipal bankruptcy, and especially to a Title III case under PROMESA. The First Circuit rejected this argument, noting that all circuits to have considered the applicability of equitable mootness to municipal bankruptcy proceedings had treated it as applicable, and that the reasons for making the doctrine applicable to chapter 11 reorganizations applied equally to adjustments under PROMESA.
On the merits, the First Circuit considered: (i) whether the objectors had pursued with diligence all available remedies to obtain a stay; (ii) whether the challenged plan had proceeded beyond practicable annulment; and (iii) whether providing the relief sought would harm innocent third parties. The court found that both the Elliot Group and the Pinto-Lugo Group had “sat on their hands,” since they did not (a) object to the Bankruptcy Rule 3020(e) waiver in the plan, which permitted the plan to be implemented immediately; (b) move for a stay either before the Title III Court or the First Circuit; or (c) seek to expedite the appeal, but rather sought extensions of the briefing schedules themselves. The Pinto-Lugo Group asserted that they did not need to seek a stay to vindicate “fundamental constitutional rights,” but the First Circuit disagreed, holding that “the presence of underlying constitutional claims does not act as a per se bar to the applicability of the doctrine [of equitable mootness].” The court also found, without difficulty, that there was “no practical way to undo” the implementation of the plan, when the replacement bonds had been traded on the open market for over a year, and that any efforts to unwind the plan would inevitably result in harm to “innocent third parties who, due to the . . . objectors’ lack of diligence, justifiably came to rely on the confirmation order.” Accordingly, the First Circuit dismissed the appeals as equitably moot.
Mayoral v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 998 F.3d 35 (1st Cir. 2021). A third decision from the PROMESA proceedings speaks to the ability of investors in a mutual fund that had invested in bonds issued by the Commonwealth of Puerto Rico to bring a claim against the Commonwealth in its Title III proceedings. Notwithstanding the broad construction of the definition of a “claim” under the Bankruptcy Code, the Title III Court found, and the First Circuit affirmed, that these investors did not have standing to recover their losses against the Commonwealth.
Two individual investors each filed proofs of claim against the Commonwealth for a total of approximately $328,400, asserting as the basis for such claim an “investment in mutual funds.” The FOMB objected to the claims on grounds that these individuals were not creditors of the Commonwealth, and thus did not have standing to assert claims against the Commonwealth. Although the individuals argued that they were “co-owners” of the bonds with the mutual funds, and therefore had standing, the Title III Court agreed with the FOMB and disallowed the claims. After two motions for reconsideration before the Title III Court, the individuals appealed to the First Circuit.
First considering the merits of the Title III Court’s initial order disallowing the claims, the First Circuit found that the individuals were not creditors of the Commonwealth under section 501(a) of the Bankruptcy Code, as applicable to Title III proceedings by virtue of 48 U.S.C. § 2161(a). The Bankruptcy Code defines a “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor.” 11 U.S.C. § 101(10)(A). A “claim” is defined as a “right to payment” or a “right to an equitable remedy for breach of performance if such breach gives rise to a right to payment.” 11 U.S.C. § 101(5). And a “‘right to payment’ . . . ‘is nothing more nor less than an enforceable obligation.’” Id. at 41 (quoting Cohen v. de la Cruz, 523 U.S. 213, 218 (1998)). Because the claimants did not provide any evidence of an enforceable obligation existing between themselves and the Commonwealth, the First Circuit held that they were not creditors of the Commonwealth. Furthermore, the court found no injury separate from any injury the mutual funds may have suffered, creating a further barrier for standing. Accordingly, the First Circuit found no error in the Title III Court’s original holding and no abuse of discretion in connection with the denials of reconsideration.
Kupperstein v. Schall (In re Kupperstein), 994 F.3d 673 (1st Cir. 2021). In a recent examination of the police power exception to the automatic stay as related to contempt proceedings, the First Circuit adopted a liberal approach, determining that the contempt proceedings were not pursued for a pecuniary purpose, but even if there was an element of the proceedings that served a pecuniary purpose, based on the “totality of the circumstances,” the predominant purpose related to enforcement of public policy such that the contempt proceedings fell within the police power exception.
Donald C. Kupperstein was leasing a property belonging to the estate of Fred Kuhn and collecting rents from its tenants. Because the Kuhn estate owed a debt to the Massachusetts Office of Health and Human Services (“MassHealth”), the estate, MassHealth, and Kupperstein ended up in Massachusetts Probate Court. Kupperstein disregarded the probate court’s order to pay “any and all” rents collected from the property to MassHealth, and continued to rent the property for his own gain, despite the court’s order voiding the original transfer of the property to Kupperstein. Between August 2017 and January 2018, the probate court twice held Kupperstein in contempt and set a contempt hearing for early January 2018. The day before his contempt hearing, Kupperstein filed for bankruptcy in the United States Bankruptcy Court for the District of Massachusetts, listing the Kuhn property as his own property. The following day, at his contempt hearing, despite Kupperstein’s argument that his bankruptcy filing automatically stayed the probate court proceedings against him, the probate court jailed Kupperstein for the day for previously violating the court’s orders four times. At the next court date, Kupperstein narrowly avoided a 30-day jail sentence by finally turning over the keys to the property and producing $5,400, which he had been ordered to pay to MassHealth in December 2017. Kupperstein then vanished, and the probate court held him in contempt twice more for missing three court dates and continuing to violate its previous orders. The probate court also ordered Kupperstein to pay over $50,000 in outstanding rents and over $10,000 in attorneys’ fees as sanctions for repeatedly flouting the court’s orders and issued a warrant for Kupperstein’s arrest.
The Kuhn estate and MassHealth both filed motions in the bankruptcy court to lift the automatic stay to permit the state court actions to proceed; Kupperstein (through his counsel, because he was still “at large”) opposed the motions and moved the bankruptcy court to hold MassHealth in contempt and impose monetary sanctions because MassHealth participated in the probate court’s various contempt proceedings in violation of the bankruptcy court’s automatic stay. The bankruptcy court found “good cause” to lift the stay and ordered that the state court actions could proceed, including the assessment by the courts against Kupperstein of any restitution and sanction amounts, but that the Kuhn estate and MassHealth could not seek to enforce against Kupperstein any judgment with respect to a nearly $200,000 MassHealth reimbursement claim or attempt to collect all or any of such amount from Kupperstein. The bankruptcy court also denied Kupperstein’s motion to hold MassHealth in contempt and to impose sanctions, noting that “[a] court’s imposition and enforcement of a monetary sanction for contemptuous conduct is an exercise of its police power and is excluded from the automatic stay by Bankruptcy Code § 362(b)(4).” After the district court affirmed the bankruptcy court’s rulings, Kupperstein appealed to the First Circuit.
The First Circuit, examining whether the police power exception to the automatic stay applied to the probate court’s contempt proceedings and resultant penalties, concluded that the police power exception applied and that the bankruptcy court did not abuse its discretion. Considering the full array of contempt orders issued by the probate court—which included not only monetary fines, but also orders instructing Kupperstein to turn over the keys to the Kuhn property, to cease leasing the property to tenants as the landlord and not to engage in any new leases, and to turn over any documents he had previously executed regarding renting the property—the First Circuit found that the probate court’s contempt orders were “plainly not an attempt to collect money and there [wa]s simply nothing in the ‘pecuniary interest’ test or the Bankruptcy Code, generally, forbidding a court from ordering that a debtor hand over the keys to a house that he does not own.” As to the monetary fines, the First Circuit rejected Kupperstein’s argument that orders involving money were automatically for a “pecuniary purpose,” since such a position elided the distinction between “a judgment prematurely awarding assets to creditors ahead of the process permitted by the bankruptcy court . . . and an order commanding disgorgement of ill-gotten gains accumulated in direct violation of a court order.” Because neither the Kuhn estate nor MassHealth would gain any priority as a result of the probate court’s order, due to the carveout for enforcement of judgments relating to the $200,000 amount, there was no pecuniary purpose to the probate court’s contempt orders. The First Circuit ventured further still, holding that, even if there was some pecuniary purpose to the financial aspects of the probate court’s orders, it would not affect the court’s determination: “Where the application of the police power exception contains various elements, some of which effectuate a public policy and others of which could involve pecuniary interests, we examine the totality of the circumstances and what the governmental action is designed primarily to [do].” (internal citations omitted). Because “Kupperstein’s own refusal of earlier orders that had no money at stake created this situation . . .,” he could not use the automatic stay to forestall the imposition of the probate court’s contempt orders, including the monetary fines.
Miranda v. Banco Popular de P.R. (In re Cancel), 7 F.4th 23 (1st Cir. 2021). The First Circuit implicitly re-affirmed the Butner principle in a recent decision arising out of an individual chapter 7 case when the chapter 7 trustee sought to avoid an unrecorded Puerto Rican mortgage.
After initially granting the chapter 7 trustee summary judgment based on Massachusetts law, the bankruptcy court reversed on reconsideration, granting summary judgment in favor of the bank on the basis that Puerto Rico law does not treat an unrecorded mortgage as a property interest.
On appeal, the First Circuit considered the nature of Puerto Rican property law. “Puerto Rico has a fundamentally different scheme of mortgage rights. It uses a Property Registry system. A deed is not ‘recorded’ until the Property Registry judges that the deed is valid.” Accordingly, “[u]nder Puerto Rican law, a mortgage must be recorded for it to confer any interest in the underlying real property.” In addition, the First Circuit considered precedent established by the Supreme Court of Puerto Rico, wherein the court held that “a mortgage-holder does not acquire property rights to the underlying real property until the mortgage is recorded, or at least until the mortgage-holder begins the registration process.”
As such, the First Circuit concluded that an unrecorded mortgage in Puerto Rico does not trigger the trustee’s avoidance powers under section 544 of the Bankruptcy Code.
Roy v. Canadian Pac. Ry. Co. (In re Lac-Megantic Train Derailment Litig.), 999 F.3d 72 (1st Cir. 2021). In a question of first impression for the First Circuit, the court held that the Federal Rules of Bankruptcy Procedure—not the Federal Rules of Civil Procedure—govern the procedures in cases that have come within the federal district courts’ jurisdiction as cases “related to” pending bankruptcy proceedings under 28 U.S.C. § 1334(b).
This case arose out of a tragic train derailment and explosion involving a transnational shipment of crude oil, which caused many deaths, extensive personal injuries, and large-scale property damage. Montreal, Main and Atlantic Railway (“MMA”) eventually assumed responsibility for the rail cars in which the oil was transported, and subsequently sought the protection of the bankruptcy court in the District of Maine. Many lawsuits ensued, which were eventually consolidated in the District of Maine pursuant to 28 U.S.C. § 157(b)(5), which allows a district court having jurisdiction over a bankruptcy proceeding to order the transfer to it of any “personal injury tort and wrongful death claims” related to the bankruptcy proceeding. Eventually, the plaintiffs settled with all of the named defendants except for Canadian Pacific Railway Company (“Canadian Pacific”).
Canadian Pacific moved to dismiss the plaintiffs’ consolidated complaint for, among other reasons, lack of in personam jurisdiction, insufficient service of process, and forum non conveniens. In opposition, the plaintiffs sought leave to file a second amended complaint. The district court granted Canadian Pacific’s motion to dismiss, denied the plaintiffs’ motion to amend, and denied all other pending motions as moot, entering final judgment in favor of Canadian Pacific. Twenty-eight days after final judgment was entered, the plaintiffs moved for reconsideration in the district court of the denial of their motion to file an amended complaint. Canadian Pacific opposed the motion on a number of grounds, including timeliness, arguing that the Bankruptcy Rules—which allow only a fourteen-day window for motions for reconsideration—controlled and that, therefore, the plaintiffs’ motion for reconsideration was untimely. After the district court denied reconsideration, the plaintiffs filed a notice of appeal, purporting to challenge the district court’s denial of their motion for leave to amend.
The threshold issue before the First Circuit was whether the plaintiffs’ appeal was timely, which inquiry was determined by the applicable procedural rules: if the Civil Rules applied, the appeal was timely; if the Bankruptcy Rules applied, the appeal was untimely. The First Circuit began by noting that precedent favored the Bankruptcy Rules: all three of the courts of appeals to have considered the issue concluded that the Bankruptcy Rules apply to non-core, “related to” cases pending in a federal forum and that the leading treatise in the bankruptcy field also endorsed this view. The First Circuit read the statutory text as supporting this view, and noted that a procedural scheme that required a district court adjudicating both core and non-core cases in any given bankruptcy proceeding to simultaneously apply two different sets of rules, or that required a district court reviewing a bankruptcy court’s proposed findings of fact and conclusions of law in a non-core case to apply the Civil Rules after the bankruptcy court had applied the Bankruptcy Rules, “would be in marked tension with the bankruptcy system’s goal of resolving claims efficiently.” The First Circuit thus held that “[t]he text of the Bankruptcy Rules, read in conjunction with Congress’ redesign of the bankruptcy system in 1984, makes pellucid that the Bankruptcy Rules apply to non-core, ‘related-to’ cases adjudicated in federal district courts under section 1334(b)’s ‘related to’ jurisdiction.” As a result of this holding, the plaintiffs’ attempted appeal in the case, which would have been timely under the Civil Rules but not timely under the Bankruptcy Rules, was found to be untimely and had to be dismissed for want of appellate jurisdiction.
§ 1.3. Second Circuit
Clinton Nurseries, Inc. v. Harrington (In re Clinton Nurseries, Inc.), 998 F.3d 56 (2d Cir. 2021). After a bankruptcy court rejected the debtors’ constitutional challenge to quarterly fees imposed during the pendency of the debtors’ bankruptcy proceeding, the Second Circuit reversed, finding that the fees assessed in judicial districts in which the United States Trustee Program oversees bankruptcy administration (“UST Districts”), which were higher than the fees assessed in judicial districts in which judicially appointed bankruptcy administrators perform the same function (“BA Districts”), violated the uniformity requirement of the Bankruptcy Clause of the United States Constitution.
In 2017, Congress passed an amendment (the “2017 Amendment”) to the statute setting forth quarterly fees in bankruptcy cases. The 2017 Amendment increased quarterly fees in UST Districts only, and BA Districts did not immediately adopt an equivalent fee increase. In 2020, Congress passed the Bankruptcy Administration Improvement Act of 2020 (the “2020 Act”), which mandated that UST Districts and BA Districts charge equal fees. The debtors, who filed for bankruptcy in a UST District in 2017, incurred fees in accordance with the increase set forth in the 2017 Amendment during the period after that amendment but before the effective date of the 2020 Act. Accordingly, although the 2020 Act ensured the uniform application of fees in UST Districts and BA Districts, the Second Circuit was left with the question of whether Clinton was charged unconstitutional fees before the BA Districts fully implemented the 2017 Act’s fee increase.
After addressing the debtor’s standing to bring the constitutional challenge, the Second Circuit turned to the merits of the argument, rejecting the U.S. Trustee’s position that the 2017 Amendment was “an administrative funding measure, not a substantive bankruptcy law,” and thus did not implicate the uniformity requirement of the Bankruptcy Clause. Noting that this argument “has been repeatedly rejected by other courts,” the Second Circuit held that “[t]he subject of the 2017 Amendment plainly fits within the Supreme Court’s broad definition of ‘bankruptcy’ as ‘the subject of the relations between an insolvent or nonpaying or fraudulent debtor and his creditors, extending to his and their relief.’” Because the 2017 Amendment “governs debtor-creditor relations and impacts the relief available, it is a bankruptcy law subject to the Bankruptcy Clause and is constitutional only if ‘uniform.’”
The Second Circuit next addressed the question of whether the 2017 Amendment violated the uniformity requirement of the Bankruptcy Clause. The Second Circuit held that the delayed and inconsistent implementation of the fee increase in BA Districts contravened facially uniform statutory language. The 2017 Amendment stated that designated fees “shall” be imposed on debtors in UST Districts, while stating, by contrast, that the Judicial Conference “may” impose the same fees in BA Districts. The Second Circuit refused to ignore the distinction between “shall” and “may,” finding that there was no ambiguity in the statute’s grant of permissive authority to the Judicial Conference to adjust fees and that the statute was thus unconstitutional.
The Second Circuit also rejected the Trustee’s secondary argument, that a narrowly defined exception to the uniformity requirement—the “geographically isolated problem” exception—justified the fee discrepancy. This “geographically isolated problem” exception was first recognized in Blanchette v. Connecticut Gen. Ins. Corp., 419 U.S. 102 (1974), when the Supreme Court addressed the constitutionality of the Rail Act, which set special laws for bankrupt railroads and expressly applied only to a particular geographic region. Stating that “the uniformity clause was not intended to hobble Congress by forcing it into nationwide enactments to deal with conditions calling for remedy only in certain regions,” the Supreme Court concluded that the Rail Act did not contravene the Bankruptcy Clause’s uniformity requirement because all of the country’s bankrupt railroads at that time were located in the designated region and, therefore, in targeting the national rail transportation crisis, the statute addressed a geographically isolated problem. Other courts have applied the “geographically isolated exception” to uphold the constitutionality of the 2017 Amendment. E.g., In re Buffets, L.L.C., 979 F.3d 366 (5th Cir. 2020); In re Circuit City Stores, Inc., 996 F.3d 156 (4th Cir. 2021). The Fifth Circuit in Buffets, for example, reasoned that “[j]ust as it did in addressing the failure of railroads in the industrial heartland, Congress confronted the problem of an underfunded Trustee Program where it found it: in the Trustee Districts.” 979 F.3d at 378. The Second Circuit split from the Fourth and Fifth Circuits, “concerned . . . that the bankruptcy courts and the Buffets and Circuit City opinions  overlooked a critical distinction” between the Rail Act in Blanchette and the 2017 Amendment at issue in Buffets, Circuit City, and here.
The Second Circuit acknowledged that, although the Blanchette court held that Congress may “take into account differences that exist between different parts of the country, and…fashion legislation to resolve geographically isolated problems,” 419 U.S. at 159, the Supreme Court later clarified that “[t]o survive scrutiny under the Bankruptcy Clause, a law must at least apply uniformly to a defined class of debtors.” Ry. Labor Execs.’ Ass’n v. Gibbons, 455 U.S. 457, 473 (1982). “In Blanchette, all members of the class of debtors impacted by the statute were confined to a sole geographic area: [t]he statute applied only to bankrupt railroad companies, and there were no bankrupt railroad companies located outside the statutorily designated region. Here, by contrast, the 2017 Amendment’s fee increase applies to the class of debtors whose disbursements exceed $1 million, and there has been no suggestion that members of that broad class are absent in BA Districts.” Clinton Nurseries, 998 F.3d at 68-69 (internal citations omitted). The Second Circuit thus viewed this case as presenting the exact problem avoided in Blanchette: “[t]wo debtors, identical in all respects save the geographic locations in which they filed for bankruptcy,  charged dramatically different fees.” Id. at 69. Because the distinction between UST Districts and BA Districts appears to exist only because Congress chose to create a dual bankruptcy system, and because the funding shortfall plaguing the UST system was not caused by a “geographically isolated problem” that would place the entire class of affected debtors only in UST Districts, the Second Circuit refused to apply the “geographically isolated problem” exception to the 2017 Amendment, instead finding that prior to the 2020 Act, the 2017 Amendment was unconstitutionally nonuniform on its face because it mandated a fee increase in UST Districts but only permitted a fee increase in BA Districts.
PHH Mortg. Corp. v. Sensenich (In re Gravel), 6 F.4th 503 (2d Cir. 2021). On appeal, the Second Circuit vacated the imposition of punitive sanctions on creditor PHH Mortgage Corporation by the United States Bankruptcy Court for the District of Vermont in three chapter 13 cases, holding that Bankruptcy Rule of Procedure 3002.1 does not authorize punitive monetary sanctions.
This appeal involves punitive sanctions in three chapter 13 cases in Vermont. Rule 3002.1, which governs installment payments on home mortgages in chapter 13 plans, mandates, among other things, that mortgage creditors must serve on the trustee a notice itemizing all fees “within 180 days after the date on which the fees, expenses, or charges are incurred.” Fed. R. Bankr. P. 3002.1(c). If a creditor fails to comply with the 180-day timeline, a bankruptcy court may preclude the creditor from presenting the claim or award the debtor other relief, including expenses and attorneys’ fees. Fed. R. Bankr. P. 3002.1(i). When the Gravels reached the end of their chapter 13 plan, the bankruptcy court issued an order confirming that the Gravels had cured all pre-petition arrearages or defaults existing when the case was filed and made all post-petition payments. Five days later, PHH issued a monthly mortgage statement with an old charge for “property inspection fees,” which had grown to $258.75 over at least 25 monthly statements. The chapter 13 trustee moved for a finding of contempt and sanctions on the ground that the charge violated the bankruptcy court’s order and that each of the 25 charges violated Rule 3002.1. PHH admitted that the fee was not properly noticed, removed it from the mortgage statement, and opposed the motion for sanctions. Around the time the chapter 13 trustee filed its motion in the Gravel case, the same trustee moved for a finding of contempt and sanctions in another chapter 13 proceeding, for the Beaulieus, on the same basis—for late-noticed fees in violation of Rule 3002.1 and the court’s order in that case. The same chapter 13 trustee also moved for sanctions under Rule 3002.1(i) for late-noticed fees in the Knisley case, but did not allege PHH to be in contempt, as no court order had yet been issued in that case. After a consolidated hearing, the bankruptcy court granted the trustee’s motion, finding that PHH had violated Rule 3002.1(c) 25 times in each of the three bankruptcy cases, sanctioning PHH $75,000 pursuant to Rule 3002.1(i), and sanctioning PHH $200,000 in the Gravel case and $100,000 in the Beaulieu case pursuant to its inherent power and section 105 of the Bankruptcy Code for violating the court orders in those cases.
The United States District Court for the District of Vermont vacated both sanctions, holding that the $75,000 and $300,000 sanctions exceeded the bankruptcy court’s statutory and inherent powers because it lacks power to impose serious punitive sanctions. The bankruptcy court then issued a second sanctions order, imposing the same $75,000 sanction for the Rule 3002.1 violation, but reducing the sanctions for violation of the court orders to $150,000 and $75,000, respectively. PHH appealed the second sanctions order to the district court, but the bankruptcy court granted the trustee’s request to certify the order for direct review by the Second Circuit, which then granted the trustee’s petition for direct review.
First addressing the $225,000 sanction for violation of the bankruptcy court’s orders, the Second Circuit held that, because the bankruptcy court relied on its contempt power, its review was limited to whether it abused its discretion in exercising that power. Holding that the court orders were not a clear and unambiguous prohibition on PHH’s sanctioned conduct, the Second Circuit found that the bankruptcy court’s orders thus lacked the requisite clarity that would allow that court to hold PHH in contempt.
The bankruptcy court invoked Rule 3002.1’s authorization to “award other appropriate relief” to impose the $75,000 sanction for PHH’s repeated violations of Rule 3002.1. Presenting an issue of first impression among the circuit courts, the Second Circuit held that Rule 3002.1’s authorization to “award other appropriate relief” does not authorize punitive sanctions. Rule 3002.1 ensures that debtors are informed of new post-petition obligations, such as fees, and ultimately serves to prevent lingering deficits from surfacing after their bankruptcy case ends. The last subdivision of the rule provides for an enforcement mechanism: if a creditor fails to give the requisite notice, the bankruptcy court may preclude the creditor from presenting evidence of its claim in the case, Fed. R. Bankr. P. 3002.1(i)(1), and the court may also “award other appropriate relief, including reasonable expenses and attorney’s fees caused by the [creditor’s] failure [to give the requisite notice].” Fed. R. Bankr. P. 3002.1(i)(2). Because “‘other appropriate relief’ is a general phrase amid specific examples,” the Second Circuit decided that “it is best ‘construed in a fashion that limits the general language to the same class of matters as the things illustrated.’” Sensenich, 6 F.4th at 514 (quoting Canada Life Assurance Co. v. Converium Ruckversicherung (Deutschland) AG, 335 F.3d 52, 58 (2d Cir. 2003)). Noting that reasonable expenses and attorneys’ fees are compensatory forms of relief that expressly remedy harms to the debtor, the Second Circuit interpreted this to suggest that “other appropriate relief” is limited to non-punitive sanctions. Further supporting the Second Circuit’s interpretation of the non-punitive nature of the sanctions authorized under Rule 3002.1, the court reasoned that the other sanction provided for in the enforcement mechanism of Rule 3002.1(i)—preventing a creditor from collecting an improperly noticed claim—makes an exception for harmless non-compliance, and thus prospectively serves the remedial goal of shielding debtors from unforeseen charges, rather than a punitive purpose. Finally, the court noted that other sections of the Bankruptcy Code explicitly authorize punitive damages, whereas Rule 3002.1 does not. On appeal, the chapter 13 trustee argued, in the alternative, that the $75,000 sanction was authorized under the bankruptcy court’s inherent power. However, because the bankruptcy court did not assess whether the sanction was authorized pursuant to its inherent power, the Second Circuit could not properly consider that argument: “[t]he sanction was imposed under Rule 3002.1(i), and [the Second Circuit’s] holding is that the sanction went beyond the relief authorized by that rule.”
§ 1.4. Third Circuit
In re Weinstein Co. Holdings LLC, 997 F.3d 497 (3d Cir. 2021). In a case arising out of the Weinstein Company bankruptcy proceedings, the Third Circuit examined the definition of “executory contracts” in the context of a work-for-hire contract to find that the non-executory contract had been properly sold by the debtors as a non-executory contract, and thus the purchaser was not required to cure existing defaults under the contract.
In June 2018, the Weinstein Company and its affiliates (“TWC”) filed bankruptcy petitions to facilitate the sale of substantially all of their assets to Spyglass Media Group, LLC (“Spyglass”) under section 363 of the Bankruptcy Code. Among the assets sold was TWC’s work-made-for-hire contract with Bruce Cohen (the “Cohen Agreement”) to produce the critically acclaimed 2012 film Silver Linings Playbook. In October 2018, Spyglass filed a declaratory judgment action against Cohen seeking a determination that the Cohen Agreement was not an executory contract. Under the Cohen Agreement, Cohen was entitled to approximately $400,000 in previously unpaid contingent compensation: if the Cohen Agreement was an executory contract, Spyglass would assume the liability as part of the cure amount; if the Cohen Agreement was not an executory contract, the liability remained with the TWC debtors and would be payable on par with other general unsecured creditors of the debtors’ estate for cents on the dollar. On a motion for summary judgment, the bankruptcy court found that the contract was not executory and was properly sold as part of the TWC asset sale to Spyglass. After the district court affirmed the bankruptcy court’s decision, Cohen timely appealed to the Third Circuit.
Applying the Countryman test to determine whether the Cohen Agreement was an executory contract, the Third Circuit analyzed “whether the [Cohen] Agreement ‘contained at least one obligation for both [TWC] and [Cohen] that would constitute a material breach under New York law if not performed.’” Because New York law incorporates the substantial performance doctrine, the court also analyzed whether Cohen had breached the Cohen Agreement such that it would have excused TWC from not paying the contingent compensation then outstanding (i.e., whether Cohen had failed to substantially perform). The Third Circuit held that, “[o]n TWC’s side, its obligation to pay contingent compensation to Cohen is clearly material,” but, on Cohen’s side, “he contributed almost all his value when he produced the movie.” Noting that “other courts agree that the employee in a work-made-for-hire contract usually does not have material obligations after the work is completed despite ancillary negative covenants or indemnification obligations,” the Third Circuit decided that “none of Cohen’s remaining obligations go to the ‘root of the contract’ or ‘defeat the purpose of the entire transaction’ if breached.”
Cohen argued that, because the Agreement stated that TWC must pay contingent compensation provided Cohen was “not otherwise in breach or default,” all of his obligations were material, as even a breach of a technical provision would excuse TWC’s obligation to pay contingent compensation. The Third Circuit acknowledged that parties can indeed contract around the default substantial performance rule but held that Cohen and TWC did not clearly and unambiguously avoid the substantial performance rule under New York law. Thus, the Third Circuit “agree[d] with the Bankruptcy and District Courts that Cohen’s remaining obligations are immaterial and ancillary to the purpose of the contract…[so] the Cohen Agreement is not executory.” Accordingly, Spyglass was not obligated to cure the existing defaults as part of its purchase of the Cohen Agreement.
In re Orexigen Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021). The Third Circuit held that section 553 of the Bankruptcy Code, which governs creditor setoffs, requires “strict bilateral mutuality.” In so holding, the Third Circuit decided that creditors cannot set off obligations owed to debtors in bankruptcy against obligations that the debtors owe to creditors’ affiliates, notwithstanding parties’ contracts to the contrary.
Orexigen Therapeutics Inc. (“Orexigen”) entered into a pharmaceutical distribution agreement (“distribution agreement”) with McKesson Corp. Inc. (McKesson), pursuant to which Orexigen sold pharmaceuticals to McKesson. The distribution agreement included broad setoff rights permitting “each of McKesson and its affiliates . . . to set-off, recoup and apply any amounts owed by it to [Orexigen’s] affiliates against any [and] all amounts owed by [Orexigen] or its affiliates to any of [McKesson] or its affiliates.” Orexigen also entered into a services agreement (“services agreement”) with a McKesson subsidiary, McKesson Patient Relationship Solutions (“MPRS”), pursuant to which MPRS advanced funds to certain pharmacies on Orexigen’s behalf. Less than two years after entering into these agreements, Orexigen filed for bankruptcy in the United States Bankruptcy Court for the District of Delaware. As of the petition date, McKesson owed Orexigen almost $7 million under the distribution agreement and Orexigen owed MPRS approximately $9 million under the services agreement, and McKesson sought to exercise its contractual right under the distribution agreement to set off the amount it owed to Orexigen against the amount Orexigen owed to MPRS. The Bankruptcy Court rejected McKesson’s attempt to enforce its setoff right, holding that section 553 of the Bankruptcy Code imposes a mutuality requirement that private parties cannot contract around. The United States District Court for the District of Delaware affirmed the bankruptcy court’s ruling and McKesson appealed.
The Third Circuit affirmed the bankruptcy court and the district court. A question of first impression for the Third Circuit, the Court definitively rejected the permissibility of triangular setoffs under section 553 of the Bankruptcy Code, strictly construing section 553’s mutuality requirement to mean that the debt and claim sought to be setoff must be between the same two parties. The Third Circuit based its decision, in part, on Congress’ “inten[t] for mutuality to mean only debts owing between two parties, specifically those owing from a creditor directly to the debtor and, in turn, owing from the debtor directly to that creditor” and the absence of congressional intent “to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.” Holding that triangular setoffs are prohibited and cannot be contracted around, the Third Circuit observed that McKesson could have enjoyed the mutuality contemplated by section 553 by signing the services agreement itself instead of through its subsidiary, MPRS. The Third Circuit also noted that MPRS’ contract with Orexigen could have provided MPRS with a security interest in Orexigen’s accounts receivable, which, once perfected, would have given MPRS a priority right to the amount that McKesson sought through setoff without running afoul of the Bankruptcy Code.
In re Energy Future Holdings Corp., 990 F.3d 728 (3d Cir. 2021). The United States Court of Appeals for the Third Circuit held that, pursuant to section 503(b)(1)(A) of the Bankruptcy Code, stalking horse bidders may assert administrative expense claims for costs incurred while attempting to close on unsuccessful transactions even if the stalking horse bidders are not entitled to any breakup or termination fees.
Chapter 11 debtors Energy Future Holdings Corp. and its affiliates terminated the merger agreement between them and a stalking horse bidder after the stalking horse bidder failed to obtain the regulatory approval necessary to consummate the agreement. After the Third Circuit affirmed the bankruptcy court’s denial of the stalking horse bidder’s application for payment of a termination fee, the stalking horse bidder then filed an administrative expense application for costs incurred in connection with its unsuccessful efforts to complete the merger. In response to the application for administrative expenses, various bondholders jointly filed a motion to dismiss and a motion for summary judgment. The bankruptcy court granted both motions, which the district court affirmed, and the stalking horse bidder appealed.
The Third Circuit reversed the bankruptcy and district courts. The Third Circuit held that the plain language of the merger agreement permitted recovery of expenses specified under section 503(b)(1)(A) of the Bankruptcy Code. In so holding, the Third Circuit determined that it was appropriate to consider what ultimately transpired in connection with the merger in determining whether the estate received an actual benefit from the expenses incurred by the stalking horse bidder. In other words, the court could evaluate the necessity of the expenses using the benefit of hindsight. Notwithstanding that the contemplated merger was not ultimately realized, the Third Circuit found that the stalking horse had plausibly alleged a benefit to the estate because, among other things, the stalking horse had provided valuable information and paved a path forward for a later, successful transaction. Although the benefit to the estate could not be monetized, the allegations provided a plausible factual basis such that the stalking horse bidder’s application for administrative expenses should not have been denied on a motion to dismiss.
Davis v. California (In re Venoco LLC), 998 F.3d 94 (3d Cir. 2021). Interpreting and extending Supreme Court precedent in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), the Third Circuit held that, where a liquidating trustee brought a bankruptcy adversary proceeding against the State of California and its Lands Commission asserting an inverse condemnation claim, neither the State nor its Lands Commission were entitled to sovereign immunity in the face of such claims.
Debtor Venoco LLC and its affiliates (collectively, “Venoco”) operated an oil drilling rig off the coast of Santa Barbara (the “Offshore Facility”). After being extracted at the Offshore Facility, the oil and gas would then be transported to an onshore processing and refining facility (the “Onshore Facility”). Venoco leased, and did not own, the Offshore Facility, but did own the Onshore Facility. After a pipeline rupture in 2015 and an unsuccessful reorganization attempt in 2016, Venoco filed a second chapter 11 proceeding on April 17, 2017. On the same day, Venoco abandoned its leases pertaining to the Offshore Facility, at which point the California State Lands Commission took over decommissioning the rig and plugging the abandoned wells. Initially, the Lands Commission agreed to pay Venoco approximately $1.1 million per month to continue operating both facilities. When a third-party contractor took over operations for Venoco, a new agreement was reached wherein the Lands Commission would pay Venoco approximately $100,000 per month for access to and use of the Onshore Facility. Eventually, however, the Lands Commission stopped paying and invoked its police powers to continue using the Onshore Facility without making further payments to Venoco.
In May 2018, the Bankruptcy Court confirmed the Venoco plan of liquidation, pursuant to which the estates’ assets, including the Onshore Facility, were transferred to a liquidation trust. Shortly after the plan became effective, the court-appointed trustee of the liquidation trust commenced an adversary proceeding against the Lands Commission and the State (together, the “California Parties”), asserting a claim for inverse condemnation: “a cause of action against a governmental defendant to recover the value of property which has been taken in fact by the government defendant.” Knick v. Twp. of Scott, 139 S. Ct. 2162 (2019). The California Parties filed motions to dismiss, arguing, among other things, that they were immune from suit as sovereigns. The Bankruptcy Court denied the motions. The District Court granted leave for an interlocutory appeal only on the sovereign immunity defense. The District Court then affirmed the Bankruptcy Court, rejecting the California Parties’ assertion of both Eleventh Amendment sovereign immunity and state law immunity from liability.
On appeal, the Third Circuit considered the applicability of the Supreme Court’s decision in Katz. The Third Circuit interpreted Katz to stand for the proposition that, “States cannot assert a defense of sovereign immunity in proceedings that further a bankruptcy court’s in rem jurisdiction no matter the technical classification of that proceeding.” Davis, 998 F.3d at 104. Then, adopting the Eleventh Circuit’s interpretation of Katz, the Third Circuit found that the following constitutes a bankruptcy court’s in rem jurisdiction: “ the exercise of exclusive jurisdiction over all of the debtor’s property,  the equitable distribution of that property among the debtor’s creditors, and  the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, her, or it from further liability for old debts.” Id. (quoting In re Diaz, 647 F.3d 1073, 1084 (11th Cir. 2011)). Based on this framework, the court then concluded that the adversary proceeding implicated two of the three Diaz examples of a bankruptcy court’s in rem jurisdiction. First, it implicated the bankruptcy court’s exclusive jurisdiction over the Venoco debtors’ property, because it sought a ruling on rights in the Onshore Facility. Although the suit was for money damages, the Third Circuit focused on the function of the suit—to decide rights in Venoco’s property—over the form of the relief sought. Second, the adversary proceeding facilitated distributions to creditors due to the significance of the Onshore Facility as an asset of the Venoco debtors’ estates. Accordingly, the court would not permit the California Parties to avoid liability using sovereign immunity. The Third Circuit further expanded Katz to apply to assertions of state-law substantive immunity from liability, in addition to Eleventh Amendment sovereign immunity.