This survey reports annually on judicial decisions that we believe are of the greatest significance to those who practice in business finance and restructuring and in other areas impacted by Chapter 11 of the Bankruptcy Code (the “Code”). This year’s survey begins with a discussion of U.S. Supreme Court decisions involving bankruptcy law. It then surveys, by subject matter, other important decisions pertaining to business bankruptcy cases issued by the federal appellate courts.
In Lac du Flambeau Band of Lake Superior Chippewa Indians v. Coughlin, the U.S. Supreme Court addressed whether Indian tribes, and the lenders that they operate, benefit from sovereign immunity from the Bankruptcy Code’s requirements, specifically the automatic stay of Section 362(a). In an opinion by Justice Jackson and joined by Chief Justice Roberts and Justices Alito, Sotomayor, Kagan, Kavanaugh and Barrett, the Court held that the answer is “no,” pursuant to the Code’s abrogation of sovereign immunity in Section 106. Justice Thomas concurred in the judgment and Justice Gorsuch dissented.
The underlying dispute involved an $1,100 payday loan to Brian Coughlin by Lendgreen, which was owned by the Lac du Flambeau Band of Lake Superior Chippewa Indians (the Band). While the loan was outstanding, Coughlin filed a Chapter 13 bankruptcy petition, but the lender allegedly continued its aggressive attempts to collect, even after being reminded of the pending bankruptcy petition and the automatic stay. In the bankruptcy court, the debtor filed a motion seeking to have the stay enforced against the lender, its parent corporations, and the Band (collectively, the petitioners), and he sought damages for emotional distress, costs, and attorney’s fees, all pursuant to Section 362(k). The petitioners contested the motion and assertion of damages based on sovereign immunity, and the bankruptcy court ruled in their favor. On appeal, the U.S. Court of Appeals for the First Circuit reversed, ruling that Congress had abrogated the petitioners’ sovereign immunity. The First Circuit ruling deepened an existing split among the circuits.
Justice Jackson’s majority opinion centered on an interpretation of Section 106—which is titled “Waiver of Sovereign Immunity”—and its key term “governmental unit.” Section 106 provides that sovereign immunity is “abrogated,” including with respect to Section 362(a), “as to” a “governmental unit,” which is defined in Section 101(27) as follows:
The term “governmental unit” means United States; State; Commonwealth; District; Territory; municipality; foreign state; department, agency, or instrumentality of the United States (but not a United States trustee while serving as a trustee in a case under this title), a State, a Commonwealth, a District, a Territory, a municipality, or a foreign state; or other foreign or domestic government.
The interpretation had both textualist and purposive aspects, carried out in the context of precedent requiring congressional intentions to abrogate sovereign immunity to be “unmistakably clear in the language of the statute.” The Court pointed out, though, that this “clear statement rule” is not a “magic-words requirement”—“Congress need not state its intent in any particular way” or even in a “single [statutory] section.”
Textually, the definition was held to “exude[] comprehensiveness from beginning to end.” And the definition’s closing catch-all phrase, “or other foreign or domestic government,” was treated with particular detail and élan:
Few phrases in the English language express all-inclusiveness more than the pairing of two extremes. “Rain or shine” is a classic example: If an event is scheduled to occur rain or shine, it will take place whatever the weather that day might be. Same with the phrase “near and far”: If people are traveling from near and far, they are coming from all over the map, regardless of the particular distance from point A to point B.
The pairing of “foreign” with “domestic” is of a piece with those other common expressions.
Moreover, it would be “far-fetched” to construe the catch-all phrase as excluding governmental entities that are “not purely foreign or purely domestic—like tribes or the International Monetary Fund,” particularly in light of Section 102(5)’s rule of construction that “‘or’ is not exclusive.”
Purposively, the foregoing interpretations of Sections 106 and 101(27) were held to accord with other aspects of the Bankruptcy Code. The opinion calls out the Code’s fresh start policy in general and the automatic stay in particular, which keeps creditors from “dismember[ing]” the estate during the bankruptcy proceeding. The opinion similarly calls out Section 524(a)’s discharge provision and the plan confirmation procedures of, as relevant in this case, Section 1327(a). These provisions “sweep broadly, by their own terms,” to facilitate the Code’s “‘orderly and centralized’ debt-resolution process.” This purposive approach, so natural and compelling in construing a code, is a refreshing departure from some other recent Supreme Court bankruptcy opinions, such as City of Chicago v. Fulton.
Justice Thomas’s concurring opinion did not interpret Section 106 because, “to the extent that tribes possess sovereign immunity at all,” it does not extend to “suits arising out of a tribe’s commercial activities conducted beyond its territory.” Justice Gorsuch’s dissenting opinion found the majority’s reading of Section 106 to be plausible but not unequivocal, and thus inadequate under the sovereign immunity precedents.
Resolving a split among the circuits, the Supreme Court ruled, in MOAC Mall Holdings LLC v. Transform Holdco LLC, that Section 363(m), the Bankruptcy Code’s provision that renders moot appeals of sale orders, is not a “jurisdictional provision,” but rather just “a statutory limitation.” Justice Jackson delivered the opinion for a unanimous Court.
The distinction between a jurisdictional rule and a mere statutory limitation can be significant. As Justice Jackson explained, an unmet jurisdictional precondition deprives the court of the power to hear the case and requires immediate dismissal; but if a statute is not jurisdictional, courts are free to apply doctrines like waiver or forfeiture, where appropriate. Jurisdictional lapses are “impervious” to those doctrines, and courts must raise and enforce jurisdictional rules sua sponte.
The issue arose in the Chapter 11 proceedings of Sears, Roebuck and Co. (“Sears”), where Sears, as debtor-in-possession, sold most of its assets to respondent, Transform, including the right to designate the assignee of a lease between Sears and a landlord. After the bankruptcy court approved the sale, Transform designated that Sears’s lease with petitioner MOAC Mall Holdings LLC (“MOAC”) at the Mall of America should be assigned to a Transform subsidiary. MOAC objected on the ground that Sears had failed to provide adequate assurance of future performance by the assignee, as required by Section 365(f)(2)(B). The bankruptcy court approved the assignment to Transform’s subsidiary over MOAC’s objection (the “Assignment Order”).
MOAC sought to obtain a stay of the Assignment Order pending appeal to prevent Transform from using Section 363(m) to prevent the reversal of the assignment on appeal. The bankruptcy court denied MOAC’s request for a stay, reasoning that Section 363(m) did not cover authorizations like those in the Assignment Order, and further, Transform had explicitly represented that it would not use Section 363(m) to moot MOAC’s appeal.
On appeal, the district court disagreed with the bankruptcy court and vacated the Assignment Order. In response, Transform sought a rehearing and—contrary to its representations to the bankruptcy court—raised the Section 363(m) argument that the district court lacked the jurisdiction to overturn the Assignment Order. Although the district court was “appalled” by Transform’s last-minute reversal, it felt constrained by Second Circuit precedent that Section 363(m) was jurisdictional and dismissed the appeal. The Second Circuit, constrained by the same precedent, affirmed the district court decision, and the Supreme Court granted certiorari.
The Supreme Court began its analysis by recognizing that “we only treat a provision as jurisdictional if Congress ‘clearly states’ as much.” Then, with a phrase that she would later employ in her majority opinion in Lac du Flambeau, Justice Jackson stated that there are no particular “magic words” that Congress must employ to convey its clear statement that a statutory limitation be treated as jurisdictional. Nonetheless, the Court found nothing in the text of Section 363(m) to indicate Congress’s “clear … intent.” Rather, it found that Section 363(m) reads more like a “‘statutory limitation’ . . . that is tied in some instances to the need for a party to take ‘certain procedural steps at certain specified times.’” Then, the Court considered the statutory context of Section 363(m) and found that “clinche[d] the case.” The subsection is separated from the Code sections governing jurisdiction over bankruptcy matters. Nor does that section contain any “clear tie” to the Code’s jurisdictional provisions. Thus, the Court held that Section 363(m) is not jurisdictional, and remanded the case to the Second Circuit for a decision consistent with the Court’s opinion.
On remand, the Second Circuit ruled that, because the Supreme Court held that Section 363(m) is not jurisdictional, it could address the merits of the dispute. It ruled that Transform had not given adequate assurance of future performance under the lease, as required by Section 363(b)(3)(A). It therefore vacated the judgment of the district court and remanded the case for further proceedings. The district court in turn reinstated the order vacating the assumption and assignment. It also ordered that the lease be returned to the possession of the liquidating trustee of the Sears bankruptcy estate. And finally, it dismissed MOAC’s appeal as moot for lack of any further remedy.
In Tyler v. Hennepin County, the Court unanimously determined that a real estate tax foreclosure proceeding, which permitted the taxing authority to retain the surplus realized from the sale, violated the Takings Clause of the Fifth Amendment.
The petitioner, Geraldine Tyler, was a 94-year-old woman who owned a condominium in Minneapolis. After she moved into a senior community, neither she nor anyone else paid the taxes on the condo, and, within a few years, the $2,300 tax debt had ballooned to $15,000, including interest and penalties. Acting under Minnesota’s foreclosure procedures, the county seized the condo, sold it for $40,000 to satisfy the $15,000 tax debt, and retained the remaining $25,000. Tyler sued the county, asserting that its retention of the surplus was an illegal taking of her property without just compensation in violation of the Takings Clause of the Fifth Amendment. The Court found that the county’s retention of the surplus was an unconstitutional taking.
To determine if the excess value that the county retained was a property interest protected from uncompensated taking, the Court considered historical precedent and observed that “[t]he principle that a government may not take more from a taxpayer than she owes” has historical origins in English law, dating as far back as the Magna Carta. The Court also rejected the county’s arguments that Tyler had abandoned her home by failing to pay her taxes.
Though the opinion squarely addressed only the Takings Clause, it might also offer insight regarding the question of whether a tax foreclosure sale may be avoided as a fraudulent transfer. The Tyler opinion does not mention the Court’s earlier ruling in BFP v. Resolution Trust Corp., where, in a 5-4 decision authored by Justice Scalia, the Court ruled that any price obtained in a non-collusive, regularly-conducted mortgage foreclosure sale was, by definition, “reasonably equivalent value” for purposes of Section 548. The BFP Court specifically cabined its opinion to the facts of the case in its now famous footnote 3, which stated, “We emphasize that our opinion today covers only mortgage foreclosures of real estate. The considerations bearing upon other foreclosures and forced sales (to satisfy tax liens, for example) may be different.” Whether the avoidability of a tax foreclosure sale as a fraudulent transfer is limited by BFP is a question that has engendered disagreement among the federal courts of appeal.
Tyler recognized a Takings Clause claim to undo a tax foreclosure sale. However, because courts generally do not rule on constitutional grounds when a nonconstitutional basis is available, it is worthwhile to consider the broader application of the Tyler opinion and its impact, if any, on the reach of BFP. Perhaps the Court’s unanimous ruling that the surplus value of the delinquent taxpayer’s home is a constitutionally protected property interest invites recognition of the limited reach of BFP. Whether Tyler impacts BFP remains to be seen. Arguably, nothing in BFP affects the availability of preference law to avoid tax foreclosure sales.
In the context of bankruptcy proceedings involving individual debtors, Section 523(a)(2)(A) of the Code bars discharge of “any debt . . . to the extent obtained by . . . false pretenses, a false representation, or actual fraud.” Resolving a circuit split, the U.S. Supreme Court, in Bartenwerfer v. Buckley, held that Section 523(a)(2)(A) bars an honest and innocent individual debtor from obtaining a discharge for a debt arising from another’s fraud that is imputed to the debtor—“for example, deceit practiced by a partner or an agent.”
Bartenwerfer involved a married couple that co-owned a second home as “partners” in a “partnership” that they planned to renovate and sell (the “House Sale”). The Bartenwerfers agreed that Mr. Bartenwerfer would have the sole responsibility of managing and overseeing the House Sale. Following the renovation process, the Bartenwerfers located a buyer for the house. As part of the sale process, the Bartenwerfers signed a commonly used disclosure form, indicating that the house did not contain any defects. Mr. Bartenwefer, however, fraudulently signed the disclosure form, as he knew the house contained serious defects and he failed to disclose them. Mrs. Bartenwerfer, however, did not know of any such defects, as she did not have any involvement in the House Sale. Those defects soon manifested themselves. The buyer sued the Bartenwerfers in California state court for, inter alia, fraudulent “nondisclosure of material facts,” and successfully obtained a judgement against them (the “Imputed Fraud Debt”). The Bartenwerfers then filed a Chapter 7 bankruptcy petition. The buyer objected to Mrs. Bartenwerfer’s ability to discharge the Imputed Fraud Debt.
The U.S. Supreme Court ultimately held that Section 523(a)(2)(A) prevented Mrs. Bartenwerfer from obtaining a discharge with respect to the Imputed Fraud Debt, even though she lacked either knowledge (or inquiry notice) regarding the fraud her husband had committed in connection with the House Sale. In reaching this conclusion, the Court employed a textualist approach in interpreting Section 523(a)(2)(A). The Court ultimately concluded that Congress’s express use of the passive voice in Section 523(a)(2)(A) indicated that Congress intended that section to apply not only to frauds based on the debtor’s actions, but also to fraud-based debts of another party for which the debtor is jointly (or jointly and severally) liable.
In Purdue Pharma, L.P. v. City of Grand Prairie (In re Pharma L.P.), the Second Circuit affirmed the bankruptcy court’s order confirming a plan of reorganization that released the Sacklers—the non-debtor officers and directors and owners of Purdue—from liability to other non-debtors. The legitimacy of these so-called “third-party releases” has been the subject of dispute among the circuits, and the Supreme Court granted certiorari to hear an appeal from this ruling. (As the editorial process for this survey was nearing completion, the Supreme Court issued a decision that reversed the Second Circuit. In the 5-4 decision, the majority held that “the bankruptcy code does not authorize a release and injunction that, as part of a plan of reorganization under Chapter 11, effectively seeks to discharge claims against a non-debtor without the consent of affected claimants.” A full discussion of the Supreme Court decision will be the subject of our 2024 survey but, in light of the importance of the issue, we include a discussion of the Second Circuit’s decision.)
The Second Circuit began its opinion by recognizing a Solomonic truth about bankruptcy: It is “inherently a creature of competing interests, compromises, and less-than-perfect outcomes. Because of these defining characteristics, total satisfaction of all that is owed—whether in money or in justice—rarely occurs.” Moreover, in the mass tort context, those “complexities are magnified.” The court then recognized that, although the parties raised questions about fairness and accountability—especially where the plan released parties from liability for actions that caused great societal harm, its role in the appeal was to resolve two questions. First, “does the Bankruptcy Code permit nonconsensual third-party releases of direct claims against nondebtors”? And second, “if so, were such releases proper here in light of all equitable considerations and the facts of the case”? The court answered “yes” to both questions.
The court found statutory authority in Sections 105(a) and 1123(b)(6). Section 105(a) states that “[t]he court may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of [the Bankruptcy Code].” While this section grants broad power, that power must “be tied to another Bankruptcy Code section and not merely to a general bankruptcy concept or objective.” The court tied Section 105(a) to Section 1123(b)(6), which states that “a plan may . . . include any other appropriate provisions not inconsistent with the applicable provisions of this title.” This combination of the two provisions grants to bankruptcy courts what the Supreme Court has called a “residual authority” that is “consistent with ‘the traditional understanding that bankruptcy courts, as courts of equity, have broad authority to modify creditor-debtor relationships.’” Appellees argued that Section 1123(b)(6) does not permit third-party releases because they are not specifically authorized by the Code. However, the court pointed out that Section 1123(b)(6) “is limited only by what the Code expressly forbids, not what the Code expressly allows.”
The court also rejected the reasoning of those circuit courts that have not supported the imposition of nonconsensual third-party releases. Those courts relied upon provisions limiting the discharge of debt under Section 524(e), which states that “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” But the Second Circuit read Section 524(e) more narrowly—it only “assures that an entity also liable with a bankruptcy debtor for ‘such debt’ remains liable notwithstanding the debtor’s discharge of its obligation.” It does not limit the bankruptcy court’s powers to release a non-debtor from a creditor’s claims. Moreover, the court observed that, where Congress has limited the powers of the bankruptcy court, “it has done so clearly.”
Having outlined this statutory framework, the court proceeded to find that third-party releases are also consistent with Second Circuit precedent. It articulated a seven-factor test that delineates the circumstances under which releases may be approved. Courts should consider:
The court further noted that, “as with any term in a bankruptcy plan, a provision imposing releases of claims . . . must be imposed against a backdrop of equity.” Applying each of these factors to the Purdue plan, the court found that the releases were proper.
Large companies facing mass tort liability associated with products that they manufactured or distributed have historically sought Chapter 11 protection to contain and limit the tort liability associated with such mass tort claims. This is generally accomplished by the confirmation of a Chapter 11 plan that provides for a channeling injunction (a “Channeling Injunction”), which essentially stays any continued mass tort litigation against the debtor and requires all mass tort claimants to assert their claims against an established and funded trust (a “Mass Tort Claims Trust”). Mass tort cases generally involve latent claims (“Latent Claims”), meaning that, at the time of a debtor’s bankruptcy filing, the number and identity of future claimants, as well as the value of their claims, is not known. In such cases, the debtor generally attempts to estimate the value of current and Latent Claims associated with the mass tort. Of course, the amount of funds contained in the Mass Tort Claims Trust may be insufficient to ultimately satisfy all such claims.
Recently, based on a unique Texas statute, a new technique known as the “Texas Two-Step” enables companies to limit mass tort liability through the Chapter 11 process. Texas law defines a “merger” as: (i) the merger of two (or more) entities into one entity, or (ii) a division of one entity into two (or more) entities (the latter, a “Divisive Merger”). The Texas Two-Step or Divisive Merger works as follows. A company that is facing potential mass tort claims goes through a Divisive Merger through which it separates its assets and liabilities between two new corporate entities: (i) an entity that contains mostly all of the predecessor corporation’s current and future tort liabilities (“Old Corp.”), and (ii) an entity that contains mostly all of the predecessor corporation’s valuable assets (“New Corp.”).
In this scenario, Old Corp. is (i) basically a shell company tasked with defending and settling the mass tort claims, and (ii) staffed mostly with employees from either New Corp. or another affiliate. After the Divisive Merger, Old Corp. files for Chapter 11 protection, which halts all litigation against Old Corp. Old Corp. then seeks to confirm a Chapter 11 plan that contains a Channeling Injunction, a Mass Tort Claims Trust, and third-party releases favoring New Corp. The Divisive Merger strategy raises, inter alia, issues related to: (i) whether Old Corp.’s Chapter 11 filing (following the Divisive Merger) constitutes a “bad faith” bankruptcy filing, and (ii) a bankruptcy court’s jurisdiction to issue a Channeling Injunction, which generally restrains a creditor’s right to pursue claims against a business entity that is not in bankruptcy proceedings.
Although the Code requires that a debtor file its bankruptcy petition in good faith, the Code does not expressly define the precise meaning of “good faith” in this context. In LTL, the Third Circuit held that “good faith” in this context requires a Chapter 11 debtor to objectively be in immediate financial distress at the time of its Chapter 11 filing. The Third Circuit ordered the dismissal of the debtor’s petition (reversing the bankruptcy court), noting that the debtor did not meet this standard. As the Third Circuit noted, its definition of “good faith” in the context of a Chapter 11 filing was narrower than the definition of “good faith” applicable in the Fourth Circuit, which requires a party seeking dismissal to show the debtor’s “subjective bad faith” in filing its Chapter 11 petition and “the objective futility of any possible reorganization.”
LTL involved the massive wave of mass tort lawsuits against certain Johnson & Johnson (“J&J”) entities, including Johnson & Johnson Consumer Inc. (“J&J Predecessor”), based on allegations that its baby powder contained asbestos, which caused (or likely could cause) cancer. On October 12, 2021, J&J Predecessor underwent a Divisive Merger, pursuant to which it split into two entities: (i) LTL Management LLC (“LTL Management”), which would function as Old Corp., essentially holding J&J Predecessor’s current and future mass tort liabilities, and (ii) a “new” entity named Johnson & Johnson Consumer, Inc. (“New J&J”) that would function as the New Corp., essentially holding J&J’s valuable assets. Under the Divisive Merger, LTL Management became a beneficiary of a Litigation Funding Agreement, pursuant to which J&J and New J&J were jointly and severally liable to pay LTL Management (or a trust created under LTL Management’s Chapter 11 plan) $61.5 billion for the benefit of current and future mass tort claimants. Two days later, on October 14, 2021, LTL Management filed a Chapter 11 petition and sought, in essence: (i) a Channeling Injunction regarding claims against non-debtor affiliates, such as J&J and New J&J, and (ii) the establishment of a Mass Tort Claims Trust to pay current and future mass tort claims. A group of mass tort claimants moved to dismiss LTL Management’s Chapter 11 petition as a bad-faith filing.
Reversing the bankruptcy court, the Third Circuit held that LTL Management did not act in good faith when filing its Chapter 11 petition. In doing so, the Third Circuit noted that: (i) an objective standard of good faith applies in the Third Circuit, and (ii) a debtor bears the burden of demonstrating good faith by showing: (a) “a valid bankruptcy purpose,” and (b) that it did not file the petition “merely to obtain a tactical litigation advantage.” The Third Circuit held that, although a valid bankruptcy purpose does not require a debtor to be insolvent, it includes the requirement that the debtor be in immediate “financial distress.”
In finding that LTL Management was not in immediate financial distress, the Third Circuit concluded that, at the time of its Chapter 11 filing, LTL Management “was highly solvent with access to cash to meet comfortably its liabilities as they came due for the foreseeable future.” In reaching this conclusion, the Third Circuit focused on: (i) LTL Management’s assets, which included its rights under the Litigation Funding Agreement, and (ii) LTL Management’s projected future mass tort liabilities, taking into account J&J Predecessor’s success, during approximately five years prior its bankruptcy filing, in defending and settling mass tort claims.
In Bestwall, the Fourth Circuit held that the bankruptcy court had “related to” jurisdiction to enter a Channeling Injunction in the context of a Divisive Merger strategy because “related to” jurisdiction arises if “the outcome of [a civil] proceeding [against a non-debtor entity] could conceivably have any effect on the [bankruptcy] estate.”
Bestwall involved a massive wave of mass tort lawsuits brought against Georgia-Pacific LLC (“Old GP”), based on allegations that Old GP manufactured and sold products that contained asbestos, which caused (or likely could cause) mesothelioma. In 2017, Old GP undertook a Divisive Merger by which Old GP no longer existed, and its assets and liabilities were split between two new entities: (i) Bestwall LLC, which functioned as the Old Corp.; and (ii) Georgia-Pacific LLC (“New GP”) which functioned as the New Corp., holding most of Old GP’s valuable assets. Pursuant to this Divisive Merger, Bestwall LLC received assets that included $32 million in cash and the right to funding under a Litigation Funding Agreement with New GP.
After undergoing the Divisive Merger, Bestwall LLC filed for Chapter 11 protection and obtained a Channeling Injunction that: (i) required any and all mass tort claimants to assert any and all of their claims related to any Georgia-Pacific entity only against Bestwall LLC (or the Mass Tort Claims Trust established pursuant to Bestwall LLC’s later-confirmed Chapter 11 plan), and (ii) prevented the assertion of any such mass tort claims against New GP. A committee of mass tort claimants (the “Tort Claimant Committee”) appealed the bankruptcy court’s order, arguing that: (i) the bankruptcy court lacked “related to” jurisdiction to grant the Channeling Injunction, which enjoined tort claims against solvent non-debtor entities such as New GP; and (ii) Old GP improperly “manufacture[d] jurisdiction.” The district court and the Fourth Circuit, in a split decision, affirmed, rejecting the Tort Claimant Committee’s arguments.
The Fourth Circuit held that the bankruptcy court had “related to” jurisdiction to enter the Channeling Injunction because “related to” jurisdiction arises if “the outcome of [a civil] proceeding [against a non-debtor entity] could conceivably have any effect on the [bankruptcy] estate.” This test does not require the effect to be “certain or likely.” Instead, the mere “possibility” of such an effect suffices to confer “related to” jurisdiction, authorizing the bankruptcy court to issue a Channeling Injunction. The Fourth Circuit reasoned that any mass tort claims brought against New GP would be duplicative of the claims asserted against Bestwall LLC’s estate, which could: (i) result in unnecessary litigation costs associated with thousands of identical claims brought against both a debtor and a non-debtor affiliate, and (ii) affect the amount of distributions to other creditors of Bestwall LLC’s estate.
Similarly, the Fourth Circuit reasoned that Bestwall LLC did not improperly manufacture jurisdiction because, if Old GP did not undergo the Divisive Merger, the liability asserted by the Tort Claimant Committee “would have remained with Old GP.” If, as a result, Old GP would have then filed a Chapter 11 petition, “the bankruptcy court would have had jurisdiction over the same claims” involved in this case. The Fourth Circuit also noted that, to meet the “likely to succeed on the merits” test required to obtain a Channeling Injunction, Bestwall LLC only had to show a “realistic possibility” that it could successfully reorganize if it were to obtain the Channeling Injunction and did not have to make a “clear showing” that the Channeling Injunction was necessary for it to be able to successfully confirm a Chapter 11 plan.
Judge Robert B. King dissented, opining that New GP, a solvent company that was financially able to defend and pay for its asbestos-related liabilities, had artificially manufactured bankruptcy jurisdiction to “obtain shelter from its substantial asbestos liabilities without ever having to file for bankruptcy.” According to the dissent, it “border[ed] on the absurd” for the bankruptcy court to have found that the mass tort claims subject to the Channeling Injunction arose in Bestwall LLC’s bankruptcy case. Judge King cautioned that the majority’s holding could lead to a trend of solvent companies using “dubious readings of the Bankruptcy Code” to avoid mass tort liabilities.
Miller v. United States addressed the abrogation of sovereign immunity in the context of a fraudulent conveyance action pursuant to Section 544(b). Widening a circuit split on this issue, the Tenth Circuit ruled that sovereign immunity was abrogated.
The Bankruptcy Code provides a broad abrogation of sovereign immunity in Section 106(a), which provides that “sovereign immunity is abrogated as to a governmental unit . . . with respect to Section[] … 544 [among other provisions].” Although Section 106(a) expressly abrogates sovereign immunity as to Section 544(b), the cause for disagreement among the circuits arises from the unique means by which Section 544 empowers the trustee in bankruptcy to avoid transfers. Specifically, the trustee is granted the power to avoid “any transfer . . . that is voidable under applicable law by a creditor.” Those courts that have ruled that Section 106(a) does not abrogate sovereign immunity in this context have relied on the so-called “actual creditor” requirement: the requirement that there be an actual creditor in existence at the time of the transfer who could have avoided the transfer under applicable law in order to establish the trustee’s power to avoid. Because the actual creditor’s action against the government would have been barred by sovereign immunity outside of bankruptcy, the argument goes, the transfer would not be “voidable under applicable law by a creditor” and therefore, the trustee’s power to avoid the transfer under Section 544(b) is not established.
It would seem that, pursuant to this line of thought, sovereign immunity would never be abrogated as to Section 544(b)(1) without some other explicit congressional waiver. So, other courts have ruled that Section 106’s broad abrogation of sovereign immunity encompasses all of Section 544(b)(1).
In Miller, after the debtor’s Chapter 11 case was converted to Chapter 7, the trustee sued the IRS to recover payments made by the debtor to satisfy its principals’ personal tax liabilities. The trustee brought suit under Section 544(b)(1) and Utah’s fraudulent transfer statute, and the actual-creditor requirement was asserted to be satisfied by a creditor with an employment discrimination claim against the debtor. The IRS acknowledged that: (i) the debtor made the transfers; (ii) an actual creditor had an unsecured claim against the debtor arising before the transfers; (iii) the debtor did not receive reasonably equivalent value in exchange for the transfers; and (iv) the debtor was insolvent at the time of the transfers. Instead, the IRS argued that the actual-creditor requirement was not satisfied because sovereign immunity would have barred the actual creditor from suing the IRS outside of bankruptcy, and therefore, the trustee’s avoidance power never arose.
The bankruptcy court, the district court, and the Tenth Circuit each rejected the IRS’s argument, finding that the broad abrogation of sovereign immunity in Section 106(a) “reaches the underlying state law cause of action that [Section] 544(b)(1) authorizes the Trustee to rely on in seeking to avoid the transfers as issue.” The Tenth Circuit found the language in Section 106(a) that abrogates sovereign immunity “with respect to . . . Section[] . . . 544” to have a broadening effect, “cover[ing] not only its subject but also matters relating to the subject.” It also rejected the Seventh Circuit’s narrow interpretation of Section 106(a), finding that a narrow interpretation “effectively accomplishes … a total ban on actions under [Section] 544(b)(1) to set aside avoidable transfers against a ‘governmental entity’ … absent a second waiver of sovereign immunity by way of Congress or a state legislature as to the underlying state law cause of action.”
In considering an action to recover an intentionally fraudulent transfer, the Tenth Circuit ruled that the bankruptcy court appropriately considered facts both before and after the transfer at issue to determine “actual intent.”
The facts involved a forbearance negotiation between the debtor and a creditor that soured, prompting a subsequent sale of the debtor’s assets without the knowledge of the creditor. An entity called CML Metals Inc. (“CML”) fell behind on its rental payment obligations for equipment consisting of 540 railcars and 4 locomotives that it leased from Wells Fargo to haul iron ore. After Wells Fargo declared a default, CML requested that Wells Fargo forbear from exercising its remedies, and Wells Fargo agreed to enter forbearance negotiations with CML. While the forbearance negotiations with Wells Fargo were ongoing, but unbeknownst to Wells Fargo, CML began discussions with Gilbert Development Corporations (“GDC”) to purchase all of CML’s assets. The principal of GDC happened to be the father of CML’s president. CML and GDC entered into an Asset Purchase Agreement pursuant to which CML’s assets were transferred to Black Iron, an LLC formed to receive the assets purchased by GDC. After the transaction closed, the proceeds of the sale were disbursed to various creditors but not to Wells Fargo. CML sued Wells Fargo in state court on various breach of contract claims and Wells Fargo counterclaimed and ultimately filed suit against Black Iron and GDC, alleging that the transfer of assets was an actual fraudulent transfer. Black Iron, the recipient of the assets, ultimately filed Chapter 11 (and also later changed its name to Utah Iron).
The bankruptcy court in Black Iron’s Chapter 11 case held a trial on the fraudulent transfer claim and entered an order finding Black Iron and GDC liable under Utah’s fraudulent transfer statute. On appeal, both the district court and the Tenth Circuit upheld the bankruptcy court’s order. The bankruptcy court relied on “three key facts in finding intent: (1) CML started forbearance negotiations with Wells Fargo before the [t]ransfer; (2) the parties never finalized the forbearance agreement; and (3) [there was evidence that] CML discussed that Wells Fargo would receive no proceeds from [the] sale.” The Tenth Circuit rejected as too narrow Black Iron’s argument that, in an assessment of “actual intent,” the court’s focus should be on the intent related to the transfer rather than on what happened before or after the transfer. It held first that “there is no requirement that the intent to hinder, delay, or defraud be the sole or even primary motive of the defendant.” It also held that, under Utah law, in examining factors to determine whether “actual intent” exists, the court may consider facts both before and after the transfer at issue.
In In re George Washington Bridge Bus Station Development Venture LLC, the court considered whether a creditor who was not a party to a lease that the debtor sought to assume could assert a claim for “cure” under Section 365(b)(1)(A), and the court held that it could not. The debtor, a redeveloper, entered into a ground lease with the Port Authority of New York and New Jersey to redevelop the bus station. The lease provided that the debtor would hire a general contractor and subcontractors, and would “pay all claims lawfully made against it.” Tutor Perini Building Corp. (“Tutor Perini”), the general contractor the debtor hired for the project, asserted a general unsecured claim against the debtor pursuant to the separate contract it had entered into with the debtor. But when the debtor sought to assume the ground lease with the Port Authority, Tutor Perini objected, asserting that the debtor’s failure to pay its claims constituted a default under the ground lease which Section 365(b)(1)(A) required the debtor to cure before the lease could be assumed. Tutor Perini was not a party to the lease, but it argued that Section 365 does not require that one must be a contracting party to identify a default and seek priority of payment.
The court rejected Tutor Perini’s argument and held, “to receive priority under Section 365(b)(1)(A), a creditor asserting a default must have some right to pursue a breach of contract claim under the executory contract or unexpired lease a debtor assumes under Section 365(a).” In reaching its ruling, the court first noted “a well-established rule of Bankruptcy Code construction that . . . ‘statutory priorities are narrowly construed.’” It also relied upon Section 365’s purpose—to provide the contracting party the benefit of its bargain before requiring it to perform under the contract for the debtor’s benefit. The court rejected Tutor Perini’s argument that disallowing a non-party to a contract to assert a cure claim would afford the debtor a windfall. Rather, it reasoned, the non-party seeking payment is the one who would receive the windfall—a non-party who has no relevant bargain with the debtor and owes the debtor no performance under the contract. Finally, the court also rejected Tutor Perini’s argument that it was a third-party beneficiary under the lease.
The case involves interpretation of a plan provision specifying that the debtor would assume “all intellectual property contracts, licenses, royalties, or other similar agreements to which the Debtors have any rights or obligations in effect as of the date of the Confirmation Order.” The debtor, Fusion PM Holdings, Inc., acquired substantial intellectual property assets from IQMax, Inc., the plaintiff/appellant, pursuant to an asset purchase agreement, which called for the debtor to pay for those assets using an earnout arrangement based on royalties to be received from downstream sales of the assets purchased. The plaintiff contended that this payment arrangement brought the underlying asset purchase agreement within the group of contracts that were to be assumed. The bankruptcy court, district court, and Second Circuit all rejected this contention. All three courts agreed that the plan was best read as assuming ongoing intellectual property arrangements on which the business depended, and that “‘[t]he mere use of the term royalty fee . . . to characterize one aspect of the consideration for an outright purchase’ did not ‘transform IQMax’s entitlement into the sort of licensing or intellectual property ongoing arrangement that’ Fusion’s assumption encompassed.”
No mention is made in the reported opinions whether the underlying asset purchase agreement was in fact executory at all.
In this case, the Ninth Circuit considered the effect of the automatic stay on the entry of a judgment by the district court, ruling that the entry of the judgment was not stayed and was therefore entitled to preclusive effect.
The debtor acquired real property that was subject to a number of complex background disputes among prior owners and creditors and sought a determination from the bankruptcy court that the property then in the debtor’s hands was not subject to a mortgage. Separately, the district court determined (during the pendency of the bankruptcy case) that the mortgage was valid as against the party from whom the debtor had acquired the property. The debtor argued in the bankruptcy court that that ruling was not entitled to preclusive effect because it had violated the automatic stay.
Each of the bankruptcy court, the Bankruptcy Appellate Panel (“BAP”), and the Ninth Circuit rejected this argument. The Ninth Circuit first rejected the assertion that the district court’s order violated Section 362(a)(1), which stays judicial action “against the debtor” during the pendency of the bankruptcy case. The district court’s order had been issued in resolution of a counterclaim brought by one of the defendants in the quiet title action against the prior owner of the property and therefore was not an action “against the debtor.” Next, the Ninth Circuit rejected the debtor’s argument that Section 362(a)(3) was violated by the district court’s decision that the predecessor owner of the property took title subject to the mortgage. That subsection of the Code bars “any act to obtain possession . . . or to exercise control over property of the estate.” The Ninth Circuit relied upon the Supreme Court’s decision in City of Chicago v. Fulton to find that the district court’s decision did not “disturb the status quo of estate property as of the time when the bankruptcy petition was filed.” The Ninth Circuit then rejected the debtor’s final contention that the district court’s ruling violated Section 362(a)(4), which prohibits “any act to create, perfect, or enforce any lien against property of the estate.” The debtor argued that the district court’s order “perfected” the creditor’s lien, but the Ninth Circuit found that the lien was created and recorded pre-petition.
Many Chapter 11 cases are precipitated by a rental payment dispute between landlord and tenant, with the result that bankruptcy courts often grapple with these disputes in the context of a lift-stay motion. In re Howard Ave. Station, LLC provides a good example.
The opinion addresses the rental payment responsibilities of a debtor/tenant both while the leased premises were uninhabitable and after the tenant reoccupied the premises following repair. The debtor/tenant filed Chapter 11 after the landlord commenced eviction proceedings for nonpayment of rent. The landlord responded to the filing with a motion to lift the automatic stay to pursue its state law remedies and, alternatively, to compel the debtor to pay all post-petition rent and make monthly adequate protection payments. The bankruptcy court granted the alternative motion.
Subsequently, the debtor moved the bankruptcy court, pursuant to a Florida statute, to abate the rental payments while the premises were uninhabitable and in need of repair by the landlord. The bankruptcy court granted this motion but also ruled that the debtor was required to resume rental payments upon reoccupying the premises after repair. The debtor asked that the order be modified to relieve the debtor of the obligation to pay any back rent upon reoccupying the premises, and the bankruptcy court denied that request.
The debtor appealed that decision to the district court, which reversed the bankruptcy court’s ruling. The district court observed that, upon reoccupying the premises, the debtor will have a claim against the landlord for damages it sustained while it was deprived of the use of the premises and that to require the debtor to pay the back rent in advance of a determination of such damages “would be inequitable.” The landlord appealed the district court’s ruling, and the Eleventh Circuit affirmed the district court’s ruling, which, “in the interests of equity . . . [was] just and reasonable.” Though unstated by the Eleventh Circuit, to hold otherwise would also seem to defeat the compensatory purpose of the state law.
In the context of preference and fraudulent transfer actions, the Tenth Circuit applied the earmarking doctrine and the contemporaneous exchange exception to find the transfers unavoidable.
In an effort to keep the debtor, Chuza Oil Co., afloat, both Bobby Goldstein—the controlling shareholder, CEO, and director of the debtor—and BGPI—another company that Goldstein controlled—transferred to the debtor approximately $500,000. Contrary to the debtor’s Chapter 11 plan, the debtor then transferred $46,885 of the money it received to Goldstein’s mother, Paula, to pay the interest on a promissory note she held for an earlier loan to the debtor. Goldstein was also the guarantor of that promissory note. According to Goldstein, Chuza was loaned the funds provided that a portion thereof was used to pay Paula.
After an involuntary Chapter 7 petition was filed against the debtor and then granted by the bankruptcy court, the Chapter 7 trustee sought to recover the amount transferred to Paula. Pursuing alternative theories, the trustee sought to recover only certain funds as preferential transfers and all of the funds as fraudulently conveyed. The bankruptcy court refused to avoid the transfers because it found that the debtor never had an interest in the funds it transferred because they had been earmarked for Paula’s benefit. The bankruptcy court also found that the transfers were excepted from preference avoidance because they constituted contemporaneous exchanges for new value under Section 547(c)(1), and that they were also unavoidable as constructive fraudulent conveyances because they had been made in exchange for reasonably equivalent value.
On appeal, the BAP reversed. It found that the debtor did have an interest in the funds transferred because the estate had been diminished by replacing subordinated debt (which was owed to Paula) with new unsubordinated debt (which was owed to Goldstein and BGPI).
The Tenth Circuit affirmed the bankruptcy court. It first explained earmarking as the judicially created doctrine that permits a debtor to borrow money to pay a particular existing creditor without the payments being avoided and the borrowed funds becoming part of the estate, “but only if the borrowed money was ‘earmarked’ for that purpose.” “To earmark funds, the lender must condition the funds on payment to a specific creditor, and the debtor must abide by that condition.” The facts of this case are like those in which the earmarking doctrine usually arises—“co-debtor situations, where ‘the lender who provides the funds to the debtor to pay off the creditor was also obligated to the creditor either as a guarantor or surety.’” The doctrine prevents the funds from being put into the estate while still keeping the guarantor on the hook for the original debt.
The Tenth Circuit then explained its two-pronged test to determine whether the debtor has retained an interest in the funds transferred to it. First, the court must determine if the debtor exercised dominion and control over the funds. Second, the debtor’s transfer of the funds must have diminished the estate. Applying the test to the facts of this case, the Tenth Circuit first found that the debtor never exercised control over the funds. It relied upon Goldberg’s “uncontradicted and plausible” testimony that he and BGPI made the loans with the specific condition that part of the funds be used to pay Paula. That the condition was unwritten was also “of no moment.” As to the second element of the test, the Tenth Circuit rejected the trustee’s argument that the transfers diminished the estate because the transfers replaced a subordinated creditor with unsubordinated creditors. The court noted that, because of the promised transfers to Paula, the debtor received much more money than it paid out. Goldstein and BGPI infused the debtor with a total of $442,548.09, of which only $46,885 was paid to Paula. The payments from Goldstein and BGPI kept the debtor “afloat so that it could pay at least something to the non-insider creditors.” Thus, because the debtor never controlled the earmarked funds and the transfers did not diminish the estate, the earmarking doctrine was an available defense.
The Tenth Circuit also found that statutory defenses prevented avoidance. Under Section 547(c)(1), the trustee may not avoid, as a preference, a transfer that was “(A) intended by the debtor … to be a contemporaneous exchange for new value given to the debtor; and (B) in fact a substantially contemporaneous exchange.” Agreeing with the bankruptcy court, the Tenth Circuit found that both prongs were met, even though debtor received the funds from Goldstein and BGPI, rather than from Paula. The Tenth Circuit found that there was an “exchange” because the payments to the debtor were always contemporaneous with the payments to Paula—“this course of conduct suggests that … [the loans were] conditioned on [the debtor’s] use of a portion to pay Paula.” This contemporaneity was also consistent with Goldstein’s testimony that he agreed to make the loans to the debtor only if it paid some of the advance to Paula. As for the fraudulent transfer action, the Tenth Circuit, interpreting Section 548, found such a transfer would be unavoidable if the debtor “received . . . reasonably equivalent value in exchange for such transfer.” Because the debtor received more from the defendants than it had paid to Paula, the debtor did not receive less than equivalent value, dooming the fraud claim. The Tenth Circuit applied the same findings of exchange to both the preference and constructive fraudulent transfer actions making neither avoidable.
In the context of a preference action, the Ninth Circuit determined that a transaction denominated an “assignment” was a loan secured by certain aircraft parts, rather than an outright purchase of those aircraft parts. Accordingly, a later payment by the debtor was a partial repayment of the secured loan, and not attributable to some different and presumably non-avoidable transaction.
The Chapter 11 trustee sought to avoid, as a preference, a $400,000 pre-petition payment by the debtor, Hawaii Island Air, Inc., to Island Leasing, LLC. Island Leasing argued that it purchased aircraft parts from the debtor for $800,000—that it held no security interest in these parts and denominated the transaction an “assignment” and therefore the later $400,000 payment was not a transfer on account of antecedent debt. The bankruptcy court rejected this argument, finding the transaction involving the aircraft parts was a loan, rather than a sale, and the later $400,000 transfer was a partial repayment of that loan. The district court and the Ninth Circuit agreed with the bankruptcy court.
The Ninth Circuit first recognized that, in determining whether a transaction is a true sale or a loan, the “substance” of the transaction controls and not “the form by which the parties denominated their transaction.” Thus, the court found that, although the parties’ denomination of the transaction was an “assignment,” the substance of the transaction, when viewed in its entirety, was a loan. In particular, the Ninth Circuit noted the bankruptcy court’s findings that: (1) Island Leasing was a shareholder of the debtor; (2) the debtor needed $800,000 to meet payroll; (3) the debtor agreed to “assign” the aircraft parts to Island Leasing at the same time that payroll was due; (4) after the “assignment,” the debtor continued to keep the parts and sought a purchaser for them so that Island Leasing could recoup the $800,000; and (5) after the parties found a third-party buyer for the parts, the debtor would retain all of the proceeds in excess of the $800,000, which was to be returned to Island Leasing.
The Ninth Circuit’s opinion does not refer to the value of the aircraft parts that seemed to serve as the “collateral” for, in the court’s language, an “informal loan between related parties,” but presumably the loan was under-secured so as to justify the recovery of the $400,000 repayment as a preference.
The Third Circuit ruled in this case that, under Colorado law, the unpaid mineral royalty payments constituted the property of the royalty claimants, rather than an unsecured non-priority claim against the estate.
The debtor, Ursa Operating Co., LLC, an extractor and seller of natural gas, operated wells on leased property owned by the plaintiff-appellants (the “Royalty Claimants”). The Royalty Claimants contended that Ursa withheld royalty payments of approximately $24 million owed to them under the leases. In Ursa’s bankruptcy case, the Royalty Claimants asserted a real property interest in the royalties generated by the leased properties and sought the imposition of a constructive trust under Colorado law. The bankruptcy court concluded that the Royalty Claimants’ underpayment claims were more properly characterized as unsecured non-priority claims because the unpaid royalties retained by Ursa were property of the estate. The district court affirmed, and the Royalty Claimants appealed.
The Third Circuit reversed, holding that, under Colorado law, the royalties due to the Royalty Claimants constituted a property interest and never became property of the bankruptcy estate. The Third Circuit also noted that the Bankruptcy Code recognizes that, when a debtor holds only legal title to (but not an equitable interest in) property, that property will not become property of the estate. The Third Circuit read Section 541(d) together with Colorado law that recognizes that a reservation of a royalty interest in minerals or geothermal resources creates a property interest in the designated share of royalties, and found that the royalties at issue were not property of the estate.
The Third Circuit also held that Colorado law provides a constructive trust remedy if Ursa was unjustly enriched at the expense of the Royalty Claimants. The court found that because the debtor failed to pay the Royalty Claimants their percentage share of the natural gas proceeds, and then retained those proceeds to its benefit, the debtor “would be unjustly enriched if it were permitted to retain the benefit of the property that belongs to the Royalty Claimants.” Therefore, it held, a constructive trust may be imposed.
The Third Circuit remanded to the bankruptcy court to allow the Royalty Claimants to “identif[y] the funds that they assert to be equitably theirs.”
In this involuntary Chapter 7 case, the Eighth Circuit held that avoidance actions may be sold as property of the estate.
After the trustee determined that the estate lacked sufficient funds to pursue certain avoidance actions that it held against creditor Pitman Farms (“Pitman”), it solicited bids to compromise and sell the actions. Pitman and another creditor, ARKK Food Company, LLC (“AARK”), submitted bids, and the trustee determined that AARK’s bid was superior, so it filed a motion in the bankruptcy court to approve a compromise and sale of the actions, which the bankruptcy court granted. Pitman appealed directly to the Eighth Circuit, which affirmed the bankruptcy court’s ruling.
The Eighth Circuit rejected Pitman’s argument that avoidance actions belong to the trustee and are not property of the estate. The court began by embracing the Supreme Court’s broad interpretation of “property of the estate” in Whiting Pools. It then held that “property of the estate” includes inchoate or contingent interests held by the debtor pre-petition and that such inchoate interests include avoidance actions. Thus, avoidance actions are property of the estate pursuant to Section 541(a)(1). The court further held that, even if the debtor did not have an interest in the actions as of the commencement of the case, they would nonetheless be property of the estate pursuant to Section 541(a)(7), which includes “[a]ny interest in property that the estate acquires after the commencement of the case.” The court also made short shrift of Pitman’s arguments that reading Section 541(a)(1) and (7) to include avoidance actions as property would render other provisions in Section 541(a) as surplusage. It stated that the surplusage canon of statutory interpretation “is not an absolute rule,” and explained, “[i]t is not unreasonable that Congress would repeat itself in order to ensure the results it intended were followed.”
This case concerned whether the debtor’s cause of action against a seller of real property was property of the estate, and a divided panel held that it was not. The debtor sued the seller for malicious prosecution regarding an underlying dispute that pre-dated the bankruptcy proceeding by many years. Under applicable state law, success in a malicious prosecution suit requires a judgment in favor of the defendant in the underlying dispute, which the debtor did obtain, after its Chapter 11 proceeding was underway. The debtor did not list the cause of action as an asset in the schedules it filed with its bankruptcy petition, even in its contingent or nascent status. The plan of reorganization that was eventually confirmed expressly preserved “all claims of 10K [the plaintiff in the underlying suit] against the Debtor . . . [and vice versa] brought in the State Court Litigation.”
Ruling on the malicious prosecution action after the sellers/defendants removed it from state court, the bankruptcy court granted their motion to dismiss because maintenance of the suit “flouted [the] confirmed plan” of reorganization. Specifically, although the plan preserved certain causes of action, the debtor’s failure to list the cause of action in its schedules caused the debtor to waive it. The fact that the debtor had not yet secured the necessary judgment in its favor in the underlying dispute did not save the debtor, because the other facts relevant to the malicious prosecution cause of action were sufficiently well developed that the cause of action could and should have been scheduled.
The dissent emphasized that the malicious prosecution action could not have been brought until after the bankruptcy proceeding was already underway, because the claim did not accrue until there was a judgment in the underlying suit in the debtor/defendant’s favor, which was an element of the state law claim. Accordingly, in the dissent’s view, the cause of action “did not exist” and could not have been lost based on failure to schedule it.
Both opinions invoked Butner v. United States for its general deference to state law in determining property rights—but neither opinion referred to Butner’s own crucial limitation on that proposition where “some federal interest requires a different result.” As applied to this case, invocation of that limitation would have strengthened the majority opinion.
Section 546(e) is one of the Code’s “Safe Harbors,” and provides that a trustee cannot bring a preference action or a constructive fraudulent transfer action (a “CFTA”) seeking to avoid (or clawback) a “margin payment … or settlement payment … made by or to (or for the benefit of) a … financial institution … in connection with a securities contract.” Section 101(22)(A), in turn, defines a “financial institution” as a “bank” and a “customer” of such a bank when the bank “is acting as agent or custodian for a customer … in connection with a securities contract.”
In the context of a leveraged buyout (“LBO”), in 2019, the Second Circuit held that a target company (the “Target”) acquired through an LBO could itself qualify as a “financial institution” as defined in the Code by virtue of being a “customer” (the “Customer Defense”) of an intermediary bank used in an LBO to transmit the funds from the Target to the shareholders that redeemed their shares of the Target (the “Redeeming Shareholders”). In such a scenario, the Second Circuit held that Section 546(e) would insulate Redeeming Shareholders from liability in any CFTA.
Nine West involved the failed LBO of Nine West Holdings, Inc. (“NWHI”). Unlike many other LBOs, where a financial institution (purportedly) acted as the Target’s “agent” in making all payments to the Target’s Redeeming Shareholders, in the LBO of NWHI, a bank did not act as the Target’s “agent” with respect to all of the payments made to all of the Redeeming Shareholders. In Nine West’s LBO, payments were made to three separate types of Redeeming Shareholders through three separate transfers.
Specifically, the Target (i) deposited approximately $4 million with a bank so that shareholders holding paper stock certificates (the “Certificate Redeeming Shareholders”) could receive payment for their cancelled shares (the “Certificate Transfers”), (ii) deposited approximately $1.101 billion into an account at the bank, which the bank agreed to transmit to the DTCC (the “DTCC Transfers”), that in turn, would cause those funds to eventually be paid to Redeeming Shareholders that held their shares in the Target in brokerage accounts with registered broker-dealers (the “DTCC Redeeming Shareholders”), and (iii) paid $78 million to insider and employee shareholders of the Target (the “Payroll Redeeming Shareholders”) through NWHI’s payroll system (the “Payroll Transfers”).
The trustee of Nine West (the “Nine West Trustee”) later brought a CFTA against all of Nine West’s Redeeming Shareholders seeking to avoid (or claw-back) all of the payments they had received through the LBO. The Redeeming Shareholders sought to dismiss the Nine West Trustee’s lawsuit, arguing that the Customer Defense (and Section 546(e)) insulated them from clawback liability. Given the manner in which Nine West’s LBO was structured, the following two key issues arose: (i) whether the Customer Defense applied: (a) only to specific transfers in which a financial institution acted as the Target’s agent in an LBO, that is, only to specific transactions in which the bank, pursuant to the applicable transaction documents associated with the LBO, made payments to Redeeming Shareholders (the “transfer-by-transfer” approach), or (b) to all transfers made in connection with an LBO, so long as the bank, at some point, acted as the Target’s agent in connection with any transfer made to any Redeeming Shareholders pursuant to the applicable transaction documents (the “contract-by-contract” approach); and (ii) did the bank involved in Nine West’s LBO act as the Target’s “agent” in the disputed transactions.
The district court applied the contract-by-contract approach and held that the Customer Defense applied to shield all of the Redeeming Shareholders from fraudulent transfer liability. The Second Circuit, on the other hand, in a split decision, partially reversed the district court, and held that the transfer-by-transfer approach should apply when interpreting the Customer Defense. Under the majority’s interpretation, the Customer Defense would apply only if a financial institution acted as the Target’s agent with respect to the transfers a trustee was seeking to avoid (presumably by having agreed to transmit the redemption funds from the Target to the Redeeming Shareholders that the trustee was suing). In doing so, the Second Circuit affirmed the portion of the district court’s holding that Section 546(e) insulated both the Certificate Transfers and the DTCC Transfers from avoidance, but reversed the portion of the district court’s holding that the section insulated the Payroll Transfers from avoidance.
In reaching this conclusion, the Second Circuit pointed to its earlier holding in Tribune II, which held that the Customer Defense applies to situations where a “financial institution” acts as the Target’s “agent” in an LBO. The Second Circuit pointed to the reasoning in Tribune II, stating that, in situations where a Target uses a bank as an agent to transmit funds to Redeeming Shareholders in an LBO, the Customer Defense transforms the Target into a “financial institution,” which directly transferred the stock redemption payments to the Redeeming Shareholders. The Second Circuit reasoned that, because the Target hired a bank to act as intermediary between itself and the Certificate and DTCC Redeeming Shareholders, the Customer Defense applied and Section 546(e) insulated them from liability under CFTA. However, the Second Circuit held that the Customer Defense did not apply to insulate the Payroll Transfers made to the Payroll Redeeming Shareholders. The Second Circuit reasoned that, although the bank acted as the Target’s agent with respect to the redemption payments the Target made to the Certificate Shareholders and to the DTCC Shareholders, it did not act as the Target’s agent with respect to the payments the Target made to the Payroll Shareholders, because it played no meaningful role with respect to the Payroll Transfers.
In determining the bank’s role as the debtor’s “agent” in the LBO, the Second Circuit focused on the bank’s role in transmitting redemption funds to Redeeming Shareholders under the relevant transaction documents. The court reasoned that bank’s role in the LBO with respect to the Payroll Transfers was “purely ministerial,” as it merely “cancelled” the shares of all of the Redeeming Shareholders in the Target, and did not transfer any funds to the Payroll Redeeming Shareholders. Instead, the Target made the Payroll Transfers to the Payroll Redeeming Shareholders directly through the Target’s payroll system. The Second Circuit highlighted that the contract-by-contract approach to the Customer Defense would: (i) lead to an “absurd result” by “insulating every transfer made in connection with an LBO, as long as a bank served as [an] agent [of the Target] for at least one transfer,” (ii) “limit [a trustee’s] avoidance power even where it would not threaten [systemic risk to] the financial system,” and (iii) “incentivize ‘large banks to aid and abet corporate looters . . . by collecting large structuring fees’” while performing “little-to-no action on behalf of the debtor.”
Judge Sullivan dissented in part, asserting that the district court’s opinion should have been affirmed in all aspects. The dissent favored the district court’s contract-by-contract approach over the majority’s transfer-by-transfer approach. The dissent looked to the plain meaning of the language used in Section 546(e), focusing on the linkage between the terms “financial institution,” “customer,” “acting as agent” and “in connection with a securities contract.” Judge Sullivan reasoned that Section 546(e) should be interpreted broadly to insulate “each and every” transfer (from liability for CFTA) that a Target makes to its Redeeming Shareholders in an LBO once a bank acts as a Target’s “agent … in connection with a securities contract.” The dissent claimed that the majority seemed to be driven more by “policy concerns” than by “a textual reading” of the Code.
In the wake of Nine West, advisors that structure LBOs should advise Targets to use a bank (or similar intermediary) to transmit all redemption funds to all Redeeming Shareholders, so that all Redeeming Shareholders may avail themselves of the Customer Defense.
In Kirschner, the Second Circuit held that notes issued pursuant to a syndicated loan transaction did not qualify as “securities.”
In March 2014, a group of banks, led by JP Morgan Chase as agent, made a syndicated loan of approximately $1.7 billion to Millennium Health, which was secured by substantially all of its assets. As is typical in syndicated loans, different banks and investment funds purchased the notes issued under the syndicated loan arrangement. These notes could then be traded in the secondary market, subject to certain transfer restrictions (the “Note Transfer Provisions”) that limited the potential universe of transferees to certain financial market participants, such as large banks and investment funds.
In October 2015, Millenium Health paid $256 million to settle litigation initiated by the U.S. Department of Justice related to the company’s billing practices. Shortly thereafter, on November 10, 2015, Millennium Health filed a Chapter 11 petition. The bankruptcy court later confirmed Millenium Health’s Chapter 11 plan, which appointed Marc S. Kirschner as the trustee (the “Millenium Trustee”) to pursue claims on behalf of lenders that purchased notes issued in the syndicated loan transaction and to assert claims in Millenium Health’s bankruptcy proceedings. The Millenium Trustee filed a state court lawsuit that, inter alia, alleged securities law violations against JP Morgan Chase in connection with the notes issued under the syndicated loan transaction. The lawsuit was eventually removed to the U.S. District Court for the Southern District of New York, which dismissed the state-law securities claims, holding that the notes did not qualify as “securities” under Reves v. Ernst & Young.
The Second Circuit affirmed and applied Reves to conclude that the notes issued pursuant to the syndicated loan transaction did not qualify as “securities” subject to regulation, because those notes were issued in a commercial context, not an investment context. The court noted the Reves test requires the examination of four factors: “[f]irst, … the motivations that would prompt a reasonable seller and buyer to enter into [the transaction, s]econd, … the ‘plan of distribution’ of the instrument[, t]hird, … the reasonable expectations of the investing public[, and f]inally, whether . . . the existence of another regulatory scheme significantly reduces the risk of the instrument, . . . rendering application of [the securities laws] unnecessary.” The Second Circuit applied each factor in turn.
Regarding the first factor, the court found that the motivations of the buyers and the seller of the notes, although mixed, weighed in favor of the notes qualifying as securities because the note purchasers sought a “valuable return” from purchasing the notes. The court concluded, however, that the remaining three factors weighed against the notes qualifying as securities. The court reasoned that the notes would not qualify as securities under the second factor of the test because the notes were not “offered and sold to a broad segment of the public.” Indeed, the Note Transfer Provisions limited the universe of potential transferees of the notes to sophisticated financial market participants, preventing the transfer of the notes to members of the general public.
The court reasoned that reasonable members of the investing public would not view the notes as securities. JP Morgan Chase provided ample notice to the note purchasers that the notes were not securities. The note purchasers were sophisticated financial market participants that: (i) had significant experience in the asset-backed syndicated loan market, and (ii) had conducted due diligence regarding the notes by independently investigating Millennium Health’s creditworthiness. Finally, the court determined other risk-reducing factors were present, rendering the application of the securities laws unnecessary. The notes were “secured by a perfected first priority security interest in all of [Millennium Health’s] … assets,” reducing the risk of lending. Furthermore, the court noted that federal banking law addressed the syndicated loans, rendering unnecessary application of state securities law.
In Chesapeake, the Fifth Circuit held that a bankruptcy court lacked jurisdiction to approve the settlement of pre-petition claims after the effective date of a confirmed Chapter 11 plan. In doing so, the Fifth Circuit vacated and remanded the decisions of the U.S. Bankruptcy Court and U.S. District Court for the Southern District of Texas that approved, after the effective date of Chesapeake Energy Corp.’s (“Chesapeake Energy”) confirmed Chapter 11 plan, the settlement of pre-petition claims related to two class action lawsuits (collectively, the “Class Action Claims”). Prior to Chesapeake Energy’s bankruptcy filing, it had entered into leases with various lessors. Pursuant to those leases, Chesapeake Energy agreed to pay royalties to the lessors. In turn, the lessors permitted Chesapeake Energy to search the lessors’ real estate for (and, if discovered, extract) shale gas.
Later, thousands of lessors brought two class action lawsuits against Chesapeake Energy, alleging that Chesapeake Energy breached the leases by underpaying the royalties due thereunder. Chesapeake Energy and the lessors agreed to a preliminary settlement of the Class Action Claims. As part of the preliminary settlement agreements, Chesapeake Energy would pay royalties pursuant to formulae more favorable to the lessors.
On June 28, 2020, before obtaining necessary approvals related to those preliminary settlement agreements, Chesapeake Energy filed its Chapter 11 petition, which stayed the class action litigation. The bankruptcy court set a bar date of October 30, 2020 (the “Bar Date”) for filing proofs of claim against Chesapeake Energy’s bankruptcy estate. Neither of the named plaintiffs of the Class Action Claims filed a timely proof of claim, nor did “the vast majority” of the thousands of class members. On January 16, 2021, the bankruptcy court confirmed Chesapeake’s Chapter 11 plan (“Chesapeake’s Plan”), and the effective date of Chesapeake’s Plan was February 9, 2021 (“Effective Date”).
Chesapeake’s Plan and the associated disclosure statement provided that any and all proofs of claim filed after the Bar Date would “be deemed disallowed and expunged as of the Effective Date. The disclosure statement also provided that lessor’s “liquidated royalty claims” would be included in a class of “other general unsecured claims,” whose allowed claims would receive an estimated distribution of 0.1 percent of their allowed amounts. Furthermore, Chesapeake’s Plan expressly: (i) rejected, as executory contracts, the pre-petition preliminary settlement agreements that purported to settle the Class Action Claims, and (ii) provided that the leases would not be amended as proposed in those pre-petition preliminary settlement agreements.
One month after the Effective Date of Chesapeake’s Plan, Chesapeake Energy filed a motion seeking the bankruptcy court’s approval to enter into settlement agreements regarding the Class Action Claims, despite failures to timely file proofs of claim. These settlement agreements sought to resolve those Class Action Claims against Chesapeake Energy in exchange for: (i) the payment of a total of $6.25 million to the class members, and (ii) the amendment of future royalty calculation formulae contained the leases. Certain lessors that timely filed proofs of claim objected to the debtor’s motion.
The bankruptcy court overruled the objection and approved the settlement agreements. The bankruptcy court stated that it had “core” jurisdiction over the settlements pursuant to Section 1334(a), and that the settlements were “in the best interests of … [Chesapeake’s] estates, their creditors, and other parties in interest.” The district court affirmed the bankruptcy court’s decision. The lessors appealed. The Fifth Circuit vacated the decisions of the bankruptcy court and the district court and remanded with instructions to dismss the settlement proceedings, holding that those courts did not have either “core” or “related to” jurisdiction to approve the settlement agreements pertaining to the Class Action Claims after the Effective Date.
In reaching its decision, the Fifth Circuit discussed the “core” jurisdiction and “related to” jurisdiction that apply to bankruptcy courts after the confirmation of Chesapeake’s Plan. The court noted that, after the confirmation of the plan, the bankruptcy court’s “core” jurisdiction is confined to matters “pertaining to the implementation or execution of [a Chapter 11] plan,” such as claims reconciliation, avoidance actions, and administrative claims. For a bankruptcy court to have “related to” jurisdiction during that time period, the court pointed to the circuit’s three-prong test set forth in In re Craig’s Stores of Texas, Inc.: (i) Did the relevant claims deal with “post-confirmation relations between the parties?;” (ii) Was there “antagonism or [a] claim pending between the parties as of the date of the reorganization?;” and (3) Are there any “facts or law deriving from the reorganization or the plan necessary to the claim?”
The court reasoned that the bankruptcy court did not have jurisdiction to approve the settlement agreements regarding the Class Action Claims after the confirmation of Chesapeake’s Plan because those agreements were not in any way related to the implementation of a Chapter 11 plan. The factors of In re Craig’s Stores of Texas, Inc., were not satisfied. Indeed, the court reasoned that the bankruptcy court’s approval of those settlement agreements would completely upend the ordinary process of claims resolution, the concept of paying similarly situated unsecured creditors similarly, and the voting process regarding the Chapter 11 plan, which are all central to the reorganization process. The vast majority of the Class Action Claimants had notice of the Bar Date yet failed to file proofs of claim.
Furthermore, if the Class Action Claimants had timely filed proofs of claim, they would have recovered much less under Chesapeake’s Plan (i.e., 0.1 percent of the allowed amounts of their claims) than they would have recovered under the disputed settlement agreements. The court also noted that the disputed settlement agreements conflicted with the express provisions of Chesapeake’s Plan, because those settlement agreements effectively amended provisions of the leases relating to royalty calculations, while Chesapeake’s Plan provided that those “leases would ride through the reorganization unaffected.” Thus, if approved, the disputed settlement agreements would have given the Class Action Claimants an unfair advantage over other creditors who relied on Chesapeake’s Plan and associated disclosure statement when deciding whether to vote for (or against) Chesapeake’s Plan.
In In re America-CV Station Group, Inc., the Eleventh Circuit held that a modification to a Chapter 11 plan that materially and adversely changed the treatment of a creditor or an interest holder requires the plan proponent to provide any such creditor or interest holder with a new disclosure statement and a new opportunity to vote on the modified plan.
In re America-CV Station involved the Chapter 11 filing of holding companies that operated Spanish-language television networks. Initially, the debtors filed a proposed Chapter 11 plan (the “America-CV Station Plan”), which provided that, in return for an infusion of $500,000 and the execution of a post-confirmation $1.6 million line of credit in favor of the reorganized debtors (the “Exit Financing”), new equity interests in the reorganized debtors would be issued as follows: (i) 65.8 percent to three individuals collectively known as the Pegaso Group, and (ii) 44.2 percent to the Vassallo TV Group, LLC, which was owned and controlled by Carlos Vasallo, the debtors’ CEO.
Approximately two weeks before the scheduled confirmation hearing date for the America-CV Station Plan, which was also the voting deadline for the plan, the debtors informed the Pegaso Group that the Exit Financing deadline was being shortened from a date occurring after the plan’s confirmation date to three days before the confirmation hearing. The Pegaso Group missed this new deadline and were unable to participate in the Exit Financing. Vassallo then exploited this opportunity for his own benefit, by: (i) providing all of the Exit Financing, and (ii) seeking, through an emergency motion, to modify the America-CV Station Plan to give him all of the equity in the reorganized debtors. The modified plan stripped the Pegaso Group of its ability to participate in the Exit Financing and receipt of 65.8 percent of the equity in the reorganized debtors, as provided in the America-CV Station Plan and accompanying disclosure statement.
The Pegaso Group challenged this modification, claiming that they were entitled to a revised disclosure statement and another opportunity to vote on the modified plan (the “Amended America-CV Station Plan”), which materially and adversely changed their treatment as interest holders without their consent. The bankruptcy court confirmed the Amended America-CV Station Plan, and the district court affirmed. The Eleventh Circuit reversed.
In reversing the bankruptcy court, the Eleventh Circuit held that, when a plan modification materially and adversely changes the treatment of a creditor of the debtor or of an interest holder in the debtor, the debtor must provide such creditor or interest holder with a new disclosure statement and a new opportunity to vote for (or against) the modified plan. In this case, the proposed modification materially and adversely changed the Pegaso Group’s interest(s) in the debtors because it stripped the Pegaso Group of its right to participate in the Exit Financing and its right to receive its 65.8 percent equity interest in the reorganized debtors, without the Pegaso Group’s consent.
In Highland Capital Management, the Fifth Circuit held that a post-confirmation motion to establish an Indemnity Sub-Trust under a confirmed Chapter 11 plan did not qualify a “plan modification” requiring new solicitation and voting, because the Chapter 11 plan provided a mechanism (through a D&O Policy) to indemnify the reorganized debtor’s managers, which became infeasible during the plan implementation process. The creation of the Indemnity Sub-Trust during the post-confirmation period, as opposed to a D&O Policy or reserve fund expressly contained in the debtor’s plan, did not “alter the parties’ rights, obligations, and expectations under the [confirmed] plan.”
Highland Capital Management involved the Chapter 11 filing of Highland Capital Management, L.P. (“Highland Capital”), which was a global investment advisor of various asset portfolios. In February 2021, after contentious pre-confirmation plan litigation principally initiated by James Dondero, an insider and co-founder of the debtor, the U.S. Bankruptcy Court for the Northern District of Texas confirmed Highland Capital’s fifth amended Chapter 11 plan (the “Highland Plan”). The Highland Plan: (i) created the Claimant Trust to wind down the debtor’s estate and distribute the net proceeds to certain classes of unsecured creditors, (ii) recognized HCMLP GP LLC as the reorganized debtor’s sole general partner, (iii) reorganized the debtor to continue the management of certain investment portfolios, and (iv) created the Litigation Sub-Trust to resolve pending claims against the debtor. The Claimant Trust, which had a maximum duration of three years from Highland Plan’s effective date, owned the Litigation Sub-Trust and the limited partnership interests in HCMLP GP LLC.
Highland’s Plan, however, included a condition precedent to its implementation that, as one alternative to indemnifying the reorganized debtor’s managers, Highland Capital could obtain a D&O Policy agreed to by Highland Capital, a committee of unsecured creditors, the board overseeing the Claimant Trust, the Claimant Trust Trustee, and the Litigation Sub-Trust Trustee. The bankruptcy court reasoned that, without a D&O Policy, the directors and officers of the reorganized debtor would face “unacceptable risk” because of: (i) the threat to the managers’ personal assets due to lawsuits arising from routine actions undertaken by managers, and (ii) “Dondero’s continued litigiousness.”
For reasons unrelated to this decision, Dondero appealed the confirmation order directly to the Fifth Circuit, which, in September 2022, affirmed the bankruptcy court’s confirmation order. Between the time of Highland Plan’s effective date and September 2022, Highland Capital struggled to obtain an acceptable D&O Policy, in part due to Dondero’s appeal of the confirmation plan. As a result, after exploring other alternatives, Highland Capital moved the bankruptcy court to create an Indemnity Sub-Trust to “secure the indemnity obligations of the Claimant Trust, the Litigation [Sub-]Trust, and Reorganized Debtor … in the event that one of [those] entities did not pay such claims.” Dondero objected, arguing that the creation of a new trust constituted a modification of the Chapter 11 plan, which would require a new solicitation, voting, and confirmation process under Section 1127(b) of the Code. The bankruptcy court overruled Dondero’s objection and granted the motion.
In affirming the bankruptcy court, the Fifth Circuit held that the creation of a new trust did not qualify as a modification to the Highland Plan. Instead, the Fifth Circuit agreed with the bankruptcy court’s reasoning that the establishment of the Indemnity Sub-Trust was a method necessary to carry out the implementation of the Highland Plan and was “within [its] bounds,” because the plan, along with the “Claimant Trust Agreement, the Litigation Trust Agreement, and Limited Partnership Agreement for the Reorganized Debtor contemplated” that some form of indemnity would be provided to the directors and officers of the reorganized debtors. Thus, the Fifth Circuit held that the creation of the Indemnity Sub-Trust, instead of Highland Capital’s obtaining a D&O Policy, did not “alter any party’s rights, obligations, or expectations under the [Highland] Plan,” even though the approval of that motion could potentially result in the reduction of the payments to the estate’s creditors by approximately $25 million.
In Chapter 11 cases, the bankruptcy court generally must approve any “breakup fee” payable to a stalking horse bidder involved in a sale of assets pursuant to Section 363. Some courts have applied the more stringent standard contained in Section 503(b), applicable to the approval of administrative fees, which requires the fees at issue to be “actual [and] necessary costs” that benefit the debtor’s estate. Other courts, however, have applied the laxer standard contained in Section 363(b), which essentially is a business judgement rule (“BJR”) standard, and merely requires the debtor to have used its sound business judgement in agreeing to pay the breakup fee to a stalking horse bidder for that fee to be enforceable.
In Bouchard, the Fifth Circuit held that a stalking horse bidder was entitled to bid protections that included a breakup fee (which was three percent of the purchase price) and expense reimbursement under each of Sections 503(b) and 363(b). Bouchard Transportation Company, Inc. and its affiliates (collectively “Bouchard Transportation”) filed for Chapter 11 and sold some of its principal assets—shipping vessels—through a bankruptcy court-approved Section 363 sale. The approved bidding procedures permitted Bouchard Transportation to select a stalking horse bidder, so long as any breakup fee did not exceed three percent of the purchase price and so long as the bidder’s reimbursable expenses were capped. After struggling to generate interest in its vessels and after multiple extensions of the deadline to submit bids, Bouchard Transportation accepted a stalking horse bid of $110 million for specified assets (“Hartree’s Bid”) by Hartree Partners, LP (“Hartree”), but Bouchard Transportation could accept another offer, so long as that offer exceeded Hartree’s Bid by at least $500,000 and Hartree received a breakup fee of $3.3 million and an expense reimbursement of $1.5 million (collectively, the “Bid Protection Fees”). JMB Capital Partners Lending, LLC (“JMB”) won the ensuing auction with a bid of $115.3 million, which was the lowest permissible bid: (i) matching Hartree’s Bid of $110 million, (ii) besting that bid by the minimum incremental amount of $500,000, and (iii) covering the $4.8 million in Bid Protection Fees payable to Hartree.
Three days after the auction, a committee of unsecured creditors objected to the debtor’s payment of the Bid Protection Fees to Hartree, arguing that those fees: (i) qualified as administrative expenses under Section 503(b), and (ii) did not meet that section’s “strict necessity standard” because they were not “actual, necessary costs … of preserving the estate.” In response, Bouchard Transportation argued that Section 363(b) applied to the Bid Protection Fees, not Section 503(b). The bankruptcy court ruled that the Bid Protection Fees were permissible under both Section 503(b) and Section 363(b). Both the district court and the Fifth Circuit affirmed.
The Fifth Circuit reasoned that the Bid Protection Fees were enforceable under Section 503(b). First, the court noted that the purchase agreement between the debtor and Hartree arose during the post-petition period, thus satisfying 503(b)’s requirement that an allowable administrative expense must arise during the post-petition period as a result of the debtor’s actions. Next, the court reasoned that the fees were “actual” because they “provided numerous benefits to the estate.” Hartree was the only qualified stalking horse bidder that surfaced “on the eve of the auction” after the debtor actively marketed the auction to more than 150 potential bidders. Absent Hartree’s Bid, Bouchard Transportation lacked any “assurance that anyone would bid on its assets.” Likewise, the court noted that Hartree’s Bid benefitted the debtor’s estate by setting a “floor price” for the debtor’s assets, thus permitting the debtor to avoid a “naked auction,” which could result in the assets being sold for less than their market value, producing a lower recovery for the bankruptcy estate. Furthermore, the court noted that, beyond providing a benefit to the debtor’s estate, the Bid Protection Fees qualified as “necessary costs and expenses of preserving the estate,” because: (i) without them, Hartree would not have agreed to be the stalking horse bidder, and (ii) those fees compelled JMB to pay more for the debtor’s assets than it otherwise would have, which, in turn, resulted in the debtor’s estate receiving $1 million more than it would have recovered under Hartree’s Bid.
Finally, the court noted that, if the Bid Protection Fees were allowable under Section 503(b)’s more stringent test, then they would “easily satisfy” the more lenient test set forth in Section 363(b), which merely requires that a debtor exercise its reasonable business judgment when agreeing to pay Bid Protection Fees to a stalking horse bidder. The court noted that Bouchard Transportation exercised reasonable business judgment in considering Hartree’s Bid by diligently informing itself of the pros and cons associated with Hartree’s Bid and the Bid Protection Fees.
In the case of In re Kimball Hill, Inc., the Seventh Circuit affirmed the bankruptcy court’s order to: (i) enforce the confirmation order (the “Kimball Hill Confirmation Order”) of debtor Kimball Hill, Inc.’s (“Kimball Hill”) Chapter 11 plan (the “Kimball Hill Plan”), and (ii) impose contempt sanctions of $9.5 million against Fidelity and Deposit Company (“Fidelity” or the “Surety”), which pursued an indemnification claim that the Kimball Hill Confirmation Order extinguished and barred.
In the early 2000s, Kimball Hill was engaged in construction and real estate development and entered into real estate development contracts with different municipalities (collectively, the “Municipalities”) in Illinois. As is common in public construction projects, the applicable contracts (the “Construction Contracts”) required Kimball Hill, as the developer, to obtain surety bonds from a surety company that would essentially insure Kimball Hill’s performance obligations to the Municipalities under the Construction Contracts (the “Surety Obligations”). Separately, as is common in surety agreements, Kimball Hill agreed to indemnify Fidelity for any losses Fidelity suffered as a result of insuring Kimball Hill’s default under one or more of the Construction Contracts (“Kimball’s Pre-petition Indemnification Obligation”).
Kimball Hill defaulted on the Construction Contracts, and later, on April 23, 2008, filed for Chapter 11. Fidelity voted in favor of the Kimball Hill Plan. The injunction (the “Plan Injunction”) associated with the Kimball Hill Confirmation Order extinguished, outside of the bankruptcy proceeding, any claims that Fidelity may have had against Kimball Hill, including any claims related to Kimball’s Pre-petition Indemnification Obligation. Later, in 2010, the Kimball Hill Plan Trust sold Kimball Hill’s assets, including its rights under the Construction Contracts, to TRG Venture Two LLC (“TRG”).
After the asset sale to TRG, the Municipalities successfully sued Fidelity, compelling it to pay the Municipalities pursuant to its Surety Obligations. Fidelity, in turn, commenced litigation against TRG to recover the amounts it had paid the Municipalities under its Surety Obligations, arguing that TRG assumed Kimball Hill’s Pre-petition Indemnity Obligation when it purchased the assets from the Kimball Hill Plan Trust. TRG, in response, argued that: (i) Fidelity violated the Kimball Hill Confirmation Order because it expressly extinguished and barred Fidelity’s claims against TRG based on the Pre-petition Indemnification Obligation; and (ii) the court should impose sanctions against Fidelity. The bankruptcy court agreed with TRG, and the Seventh Circuit affirmed.
In affirming the bankruptcy court’s order for sanctions against Fidelity, the Seventh Circuit first noted that the bankruptcy court had jurisdiction to impose sanctions against Fidelity because the Kimball Hill Confirmation Order expressly provided for the bankruptcy court’s retention of jurisdiction over matters related to the interpretation and enforcement of that order and the Kimball Hill Plan. Next, the Seventh Circuit concluded that the bankruptcy court properly complied with standards set forth by the U.S. Supreme Court in Taggart when it imposed sanctions because TRG met its burden of demonstrating that Fidelity lacked any “objectively reasonable basis” to commence litigation against TRG under the Kimball Hill Confirmation Order. Likewise, the Seventh Circuit agreed with the bankruptcy court’s holding that Fidelity clearly and without “doubt” blatantly violated the Plan Injunction.
In support of these conclusions, the Seventh Circuit noted that Fidelity pursued its litigation claims against TRG based on the Pre-petition Indemnification Obligation, while simultaneously seeking to collect a distribution based on an unsecured indemnification claim it had filed against Kimball Hill’s bankruptcy estate. Likewise, the Seventh Circuit noted that Fidelity was well aware of the clear terms of the Kimball Hill Confirmation Order, which provided that all of Kimball Hill’s assets would be transferred to TRG “free and clear” of any claims. Indeed, Fidelity voted in favor of the Kimball Hill Plan, after receiving notice of its terms and the terms of the Plan Injunction. The Seventh Circuit noted that to hold otherwise could have a chilling effect on Chapter 11 plan sales, because potential purchasers may be reluctant to bid on a debtor’s assets if those purchasers could be subject to successor liability for claims associated with those assets that arose during the pre-petition period.
In In re Asset Enhancement, the Eleventh Circuit held that “a contempt order that contemplates imposing attorneys’ fees as a sanction for contempt but does not specify the amount of any such award is not a final, appealable order.” Instead, in that scenario, the final, appealable order, “is the later order that awards the specific amount of fees.”
In In re Décor Holdings, Inc., the Second Circuit held that a district court’s order that set aside a default judgment against a creditor based on due process grounds (here, insufficiency of service of process) and remanded the case to the bankruptcy court for further proceedings did not qualify as a final, appealable order. Instead, the final, appealable order will be the one eventually issued in those future proceedings—i.e., after the merits of the relevant issues (including the sufficiency of the service of process) have “been fully litigated” in the bankruptcy court.
In the case of In re California Palms Addiction Recovery Campus, Inc., the Sixth Circuit held that the bankruptcy court’s decision to convert a Chapter 11 case to a Chapter 7 case: (i) qualified as an appealable final decision, and (ii) was not an abuse of discretion because “cause” existed for conversion. The Sixth Circuit reasoned that the conversion order was a “final … order” because it resulted in the termination of a Chapter 11 proceeding, which was a “discrete dispute.” Similarly, the court reasoned that cause existed for conversion because the debtor’s estate faced a “substantial or continuing loss” of value and lacked “a reasonable likelihood of rehabilitation.”
In the case of In re East Coast Foods, Inc., the Ninth Circuit held that a creditor lacked standing to object to a bankruptcy court’s order approving a Chapter 11 trustee’s fee application, which sought “a 65% enhancement for exceptional services” (the “Fee Award”), because the creditor did not qualify as a “party aggrieved.” In rejecting the creditor’s arguments, the Ninth Circuit held that the creditor was not a “party aggrieved” because, although the Fee Award may have delayed the payment of the creditor’s claim, it did not jeopardize the likelihood that the creditor’s claim would be paid in full, according to the confirmed plan, for which the creditor voted. In reaching this conclusion, the Ninth Circuit reasoned that the debtor’s plan essentially guaranteed that the creditor’s claim would be paid in full.
Similarly, in NexPoint Advisors, the Fifth Circuit held that, to qualify as a “party aggrieved” by a bankruptcy court order, the party must demonstrate that the bankruptcy court order “directly and adversely affected pecuniarily” that party. The bankruptcy court overruled NexPoint’s objections to certain fee applications filed by the estate’s professionals. NexPoint argued that it had standing to appeal because it filed an administrative expense claim and was a defendant in an adversary proceeding brought by the debtor’s estate. In rejecting NexPoint’s arguments, the Fifth Circuit ruled that any potential harm to NexPoint resulting from the debtor’s payment of the professional fees to which NexPoint had objected was “speculative,” “remote,” and “far from a direct, adverse, pecuniary hit.”
The Third Circuit determined that a creditor’s state court judgment against the debtor may be setoff against the debtor’s judgment against it for damages under Section 303(i)(1).
This case represents the most recent round in a ten-plus-year dispute likened to the Jarndyce litigation of Charles Dickens’ Bleak House. U.S. Bank and others filed involuntary bankruptcy petitions against National Medical Imaging and its related company (collectively, “NMI”), which the bankruptcy court dismissed. After their dismissal, NMI sued U.S. Bank for costs and attorneys’ fees under Section 303(i)(1) and for proximate and punitive damages under Section 303(i)(2) for alleged bad faith in filing the involuntary petition.
While the debtor’s Section 303(i) suit was pending, U.S. Bank obtained a judgment against NMI for $12 million and thereafter sought to execute on that judgment by moving a state court to force NMI to sell its Section 303(i)(2) causes of action, which U.S. Bank would likely acquire and then dismiss. Soon thereafter, NMI filed its own voluntary bankruptcy, declaring its Section 303(i) claims as its only significant assets. It then sought a declaration from the bankruptcy court that U.S. Bank may not setoff its money judgment against NMI’s Section 303(i) award. The bankruptcy court granted NMI’s request, reasoning that, “‘as a matter of public policy,’ Section 303(i)(1) remedies are not subject to setoff.”
U.S. Bank appealed to the Third Circuit, which disagreed with the bankruptcy court. The Third Circuit ruled that “public policy cannot displace a statute that is directly on point,” emphasizing the language of Section 553(a). While that Code section does not create a right of setoff, it preserves whatever right of setoff exists. The court expressed concerns about displacing state law in bankruptcy without clear direction from Congress. The Third Circuit vacated the bankruptcy court’s judgment and remanded for it to consider whether U.S. Bank could obtain setoff under state law and Section 553(a).
The Ninth Circuit considered the effectiveness of a mechanic’s lien in connection with Section 546(b)(2). Philmont Management, Inc. (“Philmont”), the purported holder of a mechanic’s lien against real property of the debtor, sought a determination in the bankruptcy court of the validity, priority and extent of its lien. The bankruptcy court dismissed Philmont’s complaint for failure to state a claim. The bankruptcy court concluded that Philmont’s mechanic’s lien was invalid because it had not been recorded within the time required under California law, and that Philmont failed to allege sufficient facts to support its theory that the debtor was equitably estopped from challenging the timeliness of Philmont’s lien. The BAP affirmed the bankruptcy court’s order and Philmont appealed to the Ninth Circuit, which vacated and remanded.
First, the Ninth Circuit noted that the bankruptcy court was required to accept the allegations in Philmont’s complaint as true and to construe them in the light most favorable to Philmont. Philmont’s complaint recounted the detailed negotiations between the debtor and Philmont, beginning with debtor’s failure to pay Philmont’s $1.8 million bill for improvements to the debtor’s property, Philmont’s recording of its mechanic’s lien, the debtor’s repeated assurances that it would pay and repeated requests that Philmont not file a suit to perfect its lien while the debtor was negotiating a refinancing of the property, Philmont’s reliance on the debtor’s representations and promises, and finally the debtor’s filing its Chapter 11 petition. Based on those facts, the Ninth Circuit held that Philmont had alleged facts sufficient to support a reasonable inference of equitable estoppel.
As to the second basis for the bankruptcy court’s dismissal—that Philmont failed to file a timely notice of perfection under Section 546(b)(2)—the Ninth Circuit disagreed, finding that Philmont was not required to give notice under that statute. It found that the California statute on which the bankruptcy court relied governed lien enforcement, rather than lien perfection, rendering inapplicable the notice provision of Section 546(b)(2). If the holder of a mechanic’s lien is required, under that California statute, to commence an action to enforce the lien while the automatic stay is in effect, then Section 108(c) tolls the deadline to commence the action.
In USA Sales, Inc. v. Office of the U.S. Trustee, the Ninth Circuit held that a Chapter 11 debtor that paid administrative fees in the amount of $595,849 (the “Excess Fee Amount”) to the U.S. Trustee’s Office that were later held to be unconstitutional was entitled to a refund of the Excess Fee Amount from the U.S. government. The U.S. Trustee’s Office filed a petition for certiorari, which the Supreme Court granted—vacating the judgment and remanding the case for further consideration in light of Office of the U.S. Trustee v. John Q. Hammons Fall 2006, LLC, which held that Congress favored “prospective parity, and that remedy is sufficient to address the small, short-lived disparity caused by the constitutional violation.”
The authors are members of the ABA Business Law Section’s Business Bankruptcy Committee (the “Committee”) and thank the Committee for supporting this survey. Likewise, the authors thank: (i) law students Noah Morabito and Nicole Sammon for their excellent research and editing assistance; and (ii) Norman M. Powell, Editor-in-Chief, Steven John Cleveland, Professor of Law at the University of Oklahoma College of Law, Diane Babal, Production Manager, and the other members of The Business Lawyer Editorial Board for their excellent work editing and coordinating the publication of this survey.
