The lesson from the case was that the bankruptcy court cannot sanction a creditor if there is an objectively reasonable basis for concluding that the creditor’s conduct is lawful.
The moral was that a creditor can avoid the time, expense, and risk associated with litigating contempt and sanctions issues by taking basic steps to ensure that confirmed Chapter 11 plans are clear and precise. The moral is even more glaring now because a recent decision from the Fourth Circuit Court of Appeals reveals that the parties continue to fight in court over the easily-avoidable sanctions order. The decision also clarifies when and why a bankruptcy court can sanction a creditor.
Factual Background
In 2009, the Beckharts filed Chapter 11. At the time, they were almost a year behind on a loan secured by the property at Kure Beach. The loan servicer objected to planning confirmation because it did not specify how post-petition mortgage payments would be applied to principal and interest. The bankruptcy court confirmed the plan without clarifying the issue, but the servicer did not ask the court to reconsider its order, nor did it appeal.
The Beckharts paid for five years. Shellpoint acquired the loan from the original servicer and treated it as in default based on unpaid accrued arrearages. Periodically, Shellpoint sent default letters to the Beckharts, who disputed the default. Counsel for Shellpoint advised that the confirmation order had not changed the loan contract terms and that the loan remained in default. The matter escalated with the Beckharts filing complaints with the Consumer Financial Protection Bureau. Shellpoint commenced foreclosure, then represented to the Beckharts that it was ceasing foreclosure, but then posted a foreclosure hearing notice on the Beckharts’ door (allegedly due to error).
Litigation
In January 2020, the Beckharts moved the bankruptcy court to find Shellpoint in contempt and award them monetary sanctions. The court held a hearing in June and, in September 2020, found Shellpoint in contempt. The court tagged Shellpoint with $115,000 in sanctions for lost wages, “loss of a fresh start,” attorney’s fees, and travel expenses.
Bankruptcy courts have the power to hold a party in civil contempt and to impose sanctions for violation of a confirmed plan. The test for liability is based on a recent United States Supreme Court decision — Taggart v. Lorenzen. The Taggart test prohibits sanctions if there was an “objectively reasonable basis for concluding that the creditor’s conduct might be lawful.” There can be contempt for violating the discharge injunction only “if there is no fair ground of doubt as to whether the order barred the creditor’s conduct.”
In reversing the bankruptcy court, the district court noted that the plan and confirmation order did not state how much the debtors would owe on confirmation, did not say how the $23,000 in arrears would be paid, and did not set the amount of the first payment. Confusingly, the confirmation order also said that the original loan terms would remain in effect, except as modified. Finally, the district court pointed out that Shellpoint was repeatedly advised by counsel that their behavior was authorized, and reliance on the advice of outside counsel is a sufficient defense to civil sanctions. Based on all these facts, the district court found that Shellpoint acted in good faith and interpreted the confirmation order in a manner consistent with the contractual terms of the loan, and that was objectively reasonable.
Taggart was a Chapter 7 case involving a discharge violation, but the Fourth Circuit held that the “no fair ground of doubt” test applied broadly in bankruptcy – including in Chapter 11 cases.
But the Fourth Circuit disagreed with the district court’s decision to reverse the bankruptcy court because the creditor had requested and received legal advice from outside counsel. The Fourth Circuit held that advice of counsel is not an absolute defense in civil contempt. The Court suggested that, under the Taggart test, advice of counsel “may still be considered in appropriate circumstances as a relevant factor” and “a party’s reliance on guidance from outside counsel may be instructive, at least in part, when determining whether that party’s belief that she was complying with the order was objectively unreasonable.”
The Fourth Circuit held that both lower courts had made mistakes and sent the case back to the bankruptcy court to “reconsider the contempt motion under the correct legal standard, including any additional fact-finding that may be necessary.”
Creditors can take some comfort in the “no fair ground of doubt” test, which is more forgiving than a strict liability standard. But creditors can’t blame their lawyer for perilous conduct and expect the court to exonerate them.
But the most important takeaway hasn’t changed: Creditors should insist on clear and specific plan terms. After over two years of litigation, Shellpoint remains in peril of sanctions. All of this could have been avoided had the loan servicer insisted the plan specify how the Beckharts’ payments would be applied to satisfy the arrearage.
In March 2020, in response to the COVID-19 pandemic, Congress passed the CARES Act, which raised the Subchapter V debt ceiling to $7.5 million for one year. Congress extended it to March 27, 2022. A bipartisan Senate bill would make the Subchapter V debt limit permanent at $7.5 million and index it to inflation. But Congress has not yet passed the legislation or sent it to President Biden for signature. So, for now, the debt ceiling has shrunk to the original $2,725,625.
Subchapter V has proven popular, with over 3,100 cases filed in the last two years (78 in North Carolina). Many of those cases could not have proceeded under Subchapter V but for the higher debt limits. The American Bankruptcy Institute has reported that Subchapter V cases are experiencing higher plan-confirmation rates, speedier plan confirmation, more consensual plans, and improved cost-effectiveness than if those cases had been filed as a traditional Chapter 11. Anecdotally, most debtors in North Carolina are filing under Subchapter V if they are eligible.
We will continue to monitor legislative activity and report if Congress passes a law to reinstate the $7.5 million debt ceiling.
The facts of Indian Hills Holdings, LLC v. Frye are relatively straightforward. Plaintiff Indian Hills Holdings (“IHH”), Construction & Design Professional Corp. (“CDP”) and its principal Christopher Frye (“Frye” and, together with CDP, the “Defendants”) entered into a contract whereby IHH paid Defendants to purchase Cultivation “Adult” Extreme Cubes (the “Cubes”). Defendants in turn contracted with ICT Centurion Investments, LLC (“ICT”) to purchase the Cubes. The Cubes were marketed as a “fully integrated growing container system” used in indoor cannabis cultivation. When ICT sold the Cubes to another party, Defendants were unable to deliver the Cubes to IHH. Defendants refused to return the money, and IHH sued, asserting breach of contract, unjust enrichment and fraud claims.
A default judgment was entered against CDP for failing to respond to IHH’s complaint. Frye, however, filed a motion to dismiss the complaint, arguing in part that IHH did not have standing to bring its claims. Noting that Frye only “cursorily” raised the standing issue and that the “issue is a complex one”, the court reframed Frye’s argument as follows:
The contract is illegal under the Controlled Substances Act, 21 U.S.C. §§ 801, et seq.(the “CSA”);
Federal district courts will not enforce contracts that violate federal law;
Because federal district courts will not enforce contracts that violate federal law, IHH lacks an “actionable injury”; and
Because IHH lacks an actionable injury, the district court does not have subject matter jurisdiction.
Legal Analysis
The court began its analysis by considering whether the parties’ contract violated the CSA. Section 863(a) of the CSA makes it unlawful to sell or offer for sale “drug paraphernalia,” which is defined to include “any equipment, product, or material of any kind which is primarily intended or designed for use in manufacturing … a controlled substance.” Because the Cubes are used to grow cannabis, and because cannabis is a controlled substance, the sale of the Cubes would seemingly violate section 863(a) of the CSA. However, the CSA contains an exemption, whereby section 863 does not apply to any person authorized by state law to manufacture, possess or distribute drug paraphernalia. California allows the manufacturing of drug paraphernalia, which would include the Cubes. As a result, the court wrote that the contract “may fall within the CSA exemption.” Additionally, the court noted that the U.S. Department of Justice has declined to enforce the CSA’s prohibition on the sale of marijuana when the marijuana is bought or sold in accordance with state law. For these reasons, the court concluded that enforcing the parties’ contract would likely neither violate the CSA nor public policy.
While the contract may be legal, the court still had to consider whether assuming jurisdiction over the dispute would result in a violation of federal law. After all, federal courts will not assume jurisdiction over a dispute where the court will be required to order a legal violation. The question therefore became whether a plausible remedy existed for IHH that would not require the court to order such a legal violation. The court held that it could fashion a remedy without violating the law by simply awarding IHH monetary damages. A judgment for money damages, unlike an award of specific performance, would not result in IHH obtaining the Cubes and growing cannabis. Instead, the result would be a return of the monies paid by IHH to Defendants for the Cubes. The court’s ruling was consistent with prior cases involving state-legalized cannabis business, where the courts found ways to provide relief without violating the CSA. E.g., Polk v. Gontmakher, 2021 U.S. Dist. LEXIS 53569 (W.D. Wash. Mar. 22, 2021) (noting that “recent case law involving cannabis-related business contracts does not espouse an absolute bar to the enforcement of such contracts”); Mann v. Gullickson, 2016 U.S. Dist. LEXIS 152125 (N.D. Cal. Nov. 2, 2016) (court may consider breach of contract claim arising from sale of cannabis business when “it is possible for the court to enforce [the] contract in a way that does not require illegal conduct”).
Takeaways
As the legalized cannabis industry continues to grow and develop, market participants will undoubtedly need access to courts. The bankruptcy courts remain off-limit, thus requiring distressed cannabis businesses and their creditors to turn to state-law insolvency proceedings (e.g., assignments for the benefit of creditors; receiverships). To those in the industry, it may be a welcome relief to know that at least some federal district courts have made themselves available to these parties and that these courts thus far have shown a willingness to adjudicate disputes arising from the cannabis industry. However, any party seeking their day in federal court needs to ensure that they are not asking the court to grant relief that would violate federal law, including the CSA. This means that while money damages should be available, specific performance of the contract is likely off the table.
The Court agreed to hear issues involving: 1) the grounds for relief from a final judgment under Federal Rule of Civil Procedure 60(b)(1), 2) the limits on Congress’ authority to apply different bankruptcy rules to different parts of the country, and 3) the scope of states’ authority to apply their workers’ compensation laws to federal facilities.
Such issues are not the most high-profile the Court will address this term, as underscored by the absence of cert-stage amicus briefs in all three of the cases (though this is less uncommon than one might think; by our calculations, about 40 percent of the cert. petitions granted for plenary review last term lacked cert-stage amicus briefs). For governmental entities, bankruptcy practitioners, and federal court civil litigators, however, the cases are worth noting and following.
Rule 60(b) Motions for Relief from Final Judgment
In Kemp v. United States, the Court finally agreed to resolve what the cert. petition characterizes as a 50-year circuit split on whether the “mistake” prong of Rule 60(b)(1) authorizes relief based on a district court’s legal error. Rule 60(b) sets out six categories of reasons why a district court may relieve a party from a final judgment, including “mistake, inadvertence, surprise, or excusable neglect” under 60(b)(1) and “any other reason that justifies relief” under 60(b)(6). The lower courts agree that 60(b)(1) and 60(b)(6) authorize relief for at least some legal errors, but disagree about which of those provisions does so.
And that seemingly picayune distinction can matter. The Federal Rules require all 60(b) motions to be made “within a reasonable time” but set a hard one-year time limit for relief sought on 60(b)(1) grounds. This means that if Rule 60(b)(1) does not encompass legal errors, motions alleging legal errors would fall under Rule 60(b)(6) and would not need to meet the bright-line one-year rule – though such motions would then be subject to the Supreme Court’s additional requirement that 60(b)(6) motions establish “extraordinary circumstances” justifying relief. Accordingly, the question in this case can mean the difference between a timely and untimely 60(b) motion, and civil litigators should be on the lookout for the Court’s answer.
Congress’ Authority to Adopt “Uniform” Bankruptcy Rules
The Court will also take up Siegel v. Fitzgerald, where it will consider the meaning of the Constitution’s Bankruptcy Clause, which authorizes Congress to establish “uniform Laws on the subject of Bankruptcies throughout the United States.” The petitioner in this case contends that Congress violated this “uniformity” requirement by dividing the nation’s bankruptcy courts into two slightly different categories. Most operate under the U.S. Trustee program, while six (all in North Carolina and Alabama) operate under the Bankruptcy Administrator program.
In 2017, Congress increased the quarterly fees paid by debtors in large Chapter 11 bankruptcies from $30,000 to $250,000, and while this increase was immediately applicable to all pending and future cases in Trustee districts, it was imposed in Administrator districts nine months later, and then only to future cases. In Siegel the Court will decide whether this difference renders the 2017 statute unconstitutionally “non-uniform” (and, if the Court concludes it is unconstitutional, there will be a further difficult question to tackle concerning how such a defect should be remedied). Notably, even the respondent (who is represented by the U.S. Solicitor General) urged the Court to take this case, observing that though Congress eliminated the difference in 2020, the question presented in this case could affect the status of approximately $324 million in quarterly fees imposed nationwide under the 2017 statute.
In light of such figures, bankruptcy professionals across the country – especially those with cases subject to the 2017 statute – will likely have a strong interest in what the Court will say.
Limits on States’ Application of Workers’ Compensation Laws to Federal Facilities
In United States v. Washington, the Court agreed to hear the federal government’s challenge to a Washington workers’ compensation law that applies exclusively to contractors at a federally owned nuclear-waste cleanup site. Under longstanding principles of intergovernmental immunity, state regulation of federal facilities is generally permissible only where such regulation is clearly authorized by Congress. And the federal government contends that the relevant statute here – which allows states to regulate workers’ compensation at federal facilities “in the same way and to the same extent as if the premises were under the exclusive jurisdiction of the State” – does not permit states to single out federal facilities for unique treatment. The state of Washington, meanwhile, counters that states routinely apply different rules to different employers, and it argues that the federal statute simply authorizes such context-sensitive regulation at private and federal facilities alike.
The dispute accordingly consists of competing interpretations of a narrow federal statute (40 U.S.C. § 3172(a)), and it is therefore difficult to see how the case could have much broader significance outside the workers’ compensation context. Contractors working at federal facilities, however, may be interested to see whether the Supreme Court opens the door for future challenges to state workers’ compensation laws.
To be eligible for a Paycheck Protection Program (“PPP”) loan, the applicant must certify on the borrower application that the applicant and any owner of 20% or more of the applicant are not “presently involved in any bankruptcy.” This eligibility requirement spawned numerous lawsuits between debtors and the United States Small Business Administration (“SBA”) in the year since the SBA took this position. In every case under the first round of funding under the CARES Act, the SBA argued that entities in bankruptcy were not eligible for PPP loans. And with the second round of funding arriving in 2021, the SBA did not change its position.
Now, with the May 31 deadline for PPP loan applications looming, the SBA has published additional guidance, which provides that entities that have concluded a bankruptcy proceeding are not, for PPP eligibility, considered “presently involved in any bankruptcy.”
In its answer to Frequently Asked Question Number 67 about the PPP loan program, the SBA states that, for PPP eligibility purposes, a party is no longer involved in bankruptcy under these circumstances:
Chapter 7 – The Bankruptcy Court has entered a discharge order.
Chapters 11, 12 and 13 – The Bankruptcy Court has entered an order confirming the plan.
Any Chapter – The Bankruptcy Court has entered an order dismissing the case.
For an entity to be eligible for a PPP loan, the above orders must be entered before the date of the PPP loan application. If an entity is permanently closed, through bankruptcy or otherwise, it is not eligible for a PPP loan.
The Small Business Administration’s (SBA) rules and regulations concerning the eligibility of businesses for Paycheck Protection Program (PPP) loans when the business is involved in bankruptcy have recently been a source of substantial uncertainty, with the nationwide split of authority in bankruptcy courts. While these cases deal with a very small minority of PPP recipients and are a relative novelty in that regard, these decisions could foretell future issues for companies who have received PPP loans but are later forced to file Chapter 11, specifically regarding their eligibility for loan forgiveness.
The SBA is enabled with emergency rulemaking authority to adopt rules and regulations to manage application and qualifications for PPP loans under the CARES Act. Pursuant to this authority, the SBA publishes Interim Final Rules (IFR). The SBA’s April 28, 2020 IFR expressly disqualified applicants who are debtors in a bankruptcy proceeding at any time between the date of application and when the loan is disbursed.[1] Several companies in bankruptcy proceedings, whose loans have been denied, have challenged the SBA’s rulemaking authority in this regard, leading to a nationwide split on this issue in bankruptcy courts.
Specifically, these courts have rendered opinions to decide whether the SBA can impose a policy disqualifying a business in bankruptcy proceedings from participating in the PPP and whether the SBA violates other laws for doing so.[2] More than a dozen cases have been decided in the last two months, with the recent decisions highlighting the confusion that bankruptcy courts face in discerning the intent of Congress and the purpose of the CARES Act.
In decisions amounting to a majority of court decisions to date, bankruptcy courts have ruled in favor of the debtor on the merits or a request for injunctive relief.[3] One decision in favor of the debtor, with detailed analysis, has been rendered in the In re Gateway Radiology Consultants, P.A. bankruptcy case. In that case, the bankruptcy court concluded that excluding Chapter 11 debtors conflicts with the intent of Congress and the purpose of the CARES Act. The bankruptcy court determined that collectability was not a criterion for a qualification which Congress intended to focus on and rejected the SBA’s argument that debtors had a higher risk of misusing PPP funds for non-covered expenses.[4]
On the other hand, in a minority stance are bankruptcy courts that have found that the IFR is not in violation of the CARES Act, and that the SBA has not exceeded its statutory authority under the APA. Some of these courts point to the extreme urgency with which the CARES Act was enacted, which they say necessitated clarifying rulemaking, as well as the historical broad authority granted by Congress to the SBA which allows for such rulemaking in areas where the CARES Act is silent.[5]
Given the large number of PPP recipients and the potential for a dramatic increase in the number of companies forced to file for bankruptcy protection in the near future, the ultimate resolution of this issue may have significant implications for the future. Varnum will continue to follow the current case split, as well as their possible implications for other debtors that may have received a PPP loan pre-filing and will seek to have the loans forgiven as part of the Chapter 11 process.
[1] See Interim Final Rule, 13 C.F.R. Parts 120-21, Business Loan Program Temporary Changes; Paycheck Protection Program – Requirements – Promissory Notes, Authorizations, Affiliation, and Eligibility (RIN 3245-AH37), at p. 8-9. [2] The laws invoked are under the Administrative Procedures Act (the “APA”) 5 U.S.C. § 706(2)(C), APA 5 U.S.C. § 706(2)(A), and under the Bankruptcy Code’s antidiscrimination provision, 11 U.S.C. § 525. [3] In re Skefos, No. 19-29718-L, 2020 WL 2893413 (Bankr. W.D. Tenn. June 2, 2020) (order granting the Debtor’s motion for PI); In re Gateway Radiology Consultants, P.A., No. 8:19-BK-04971-MGW, 2020 WL 3048197 (Bankr. M.D. Fla. June 8, 2020) (enjoining the SBA from disqualifying the Debtor and finding that the decision-making of the SBA was not reasoned); Diocese of Rochester v U.S. Small Bus. Admin., No. 6:20-CV-06243 EAW, 2020 WL 3071603 (W.D.N.Y. June 10, 2020). [4] In re Gateway Radiology Consultants, P.A., No. 8:19-BK-04971-MGW, 2020 WL 3048197, at *15-17. [5] Schuessler v United States Small Bus. Admin., No. AP 20-02065-BHL, 2020 WL 2621186 (Bankr. E.D. Wis. May 22, 2020) (denying declaratory and injunctive relief and dismissing the complaints in three consolidated Chapter 12 cases); In re iThrive Health, LLC, Adv. Pro. No. 20-00151 (Bankr. D. Md. June 8, 2020) (finding Debtor would not prevail on the merits and denying preliminary injunction; but granting Debtor’s motion to dismiss the bankruptcy without disclosing if Debtor intends to move to reinstate the bankruptcy after PPP funding is approved as contemplated by Debtors in Arizona and S.D. Florida); In re Henry Anesthesia Assoc., 2020 WL 3002124 (Bankr. N.D. Ga. June 4, 2020).
While the world has been hunkered down at home, participating in Zoom calls and getting jobs done from kitchen tables and home offices across the country, the legal industry has continued to innovate, respond and move forward, even during these troubled times.
Read on for a sampling of legal industry changes from May 2020.
Hiring and Law Firm Moves
Last week, Perkins Coie announced that Jill Louis joined the Corporate & Securities practice as a partner in the Dallas office, in a move that further augments their capabilities in the Lone Star state. Randy Bridgeman, the co-chair of Perkins Coie’s Corporate & Securities practice praised Louis’s entrepreneurial spirit and her in house and leadership experience. He says, “Jill’s background in M&A and representing private equity-backed healthcare, infrastructure, and technology companies will be highly valuable to our clients across Texas and beyond.”
Jill B. Louis Perkins Coie
Louis has experience working with public and private companies in mergers and acquisitions, franchise transactions, corporate governance matters and working in industries including retail, technology and healthcare. She has worked with large and small companies, from startups to Fortune 50 corporations, and has worked both in house and in private practice during her career. Dean Harvey, the Dallas office managing partner, says, “Jill’s arrival aligns with our ongoing strategy of expanding our corporate offering in Dallas to support our growing technology and privacy capabilities.”
Up in the northeast, Pierce Atwoodadded bankruptcy and creditors’ rights attorney Alex F. Mattera to the firm’s Boston office. Mattera focuses his practice on creditor and debtor rights, commercial bankruptcy, bankruptcy litigation and insolvency. He represents secured creditors, focusing on the collection and workouts of defaulted and troubled loans, creditors’ committees, debtors, trustees and other parties involved in bankruptcy.
“Alex’s expertise in bankruptcy and creditors’ rights matters, particularly his loan workout experience, will really help us serve our lending and business clients. This is the third major recession Alex has been through,” said Pierce Atwood Business Practice Group Chair Keith J. Cunningham. “That kind of experience is so valuable in times like these. We couldn’t be happier to welcome him to the firm.”
Mattera has presented and sat on panels for the American Bankruptcy Institute, as well as Massachusetts Continuing Education and the Boston Bar Association.
“Alex’s expertise in workouts and collections will provide the firm even greater depth on the backend of loan transactions as we continue to provide a comprehensive suite of services to creditors and banks,” said Bruce I. Miller, Pierce Atwood’s real estate lending partner.
Devon Williams Ward and Smith
With an eye to the future and succession planning, North Carolina firm Ward and Smithelected labor and employment attorney Devon Williams as the firm’s co-managing director elect. Williams will assume the new role at the end of 2020. She will serve alongside Brad Evans, who has served as the Ward and Smith’s managing director since 2017. Williams is preceded in the co-managing director position by Ken Wooten, who is retiring from Ward and Smith at the end of this year.
“Succession planning is essential to all businesses, including our own, and choosing a strong leader enables seamless continuity in client service, and maintains stability within the firm,” Wooten said. “I think it says a lot about our firm that we’re selecting a millennial leader to take us into the next decade. Devon will bring a unique, and much needed perspective to the perennial concerns of a fully-engaged law firm.”
Since joining Ward and Smith in 2012, Williams has led the firm’s Labor and Employment Section and co-chaired the Raleigh Geographic Team.
“I’m grateful for and enthusiastic about the opportunity to build upon the legacy the firm has experienced under Ken’s leadership while working in tandem with Brad to continue our efforts to innovate efficient legal solutions for our clients, and attract and retain top-tier talent,” Williams said.
As co-managing director of Ward and Smith, Williams will maintain her labor and employment practice, where she advises employers on wage and hour issues, federal contractor compliance, prevention of employment discrimination, employee discipline and retaliation and harassment claims.
Life sciences attorney Frank Rahmani joined Sidley Austin as a partner in the firm’s Palo Alto, Calif., corporate practice, and will be a member of the Global Life Sciences practice. Ramani counsels CEOs, boards of directors, founders and investors on financings and public offerings, strategic collaborations, licensing matters, technology acquisition and spin-off transactions.
“Frank has a well-earned reputation as a trusted adviser, which is built on enduring relationships and breadth of experience representing high-growth, cutting edge life sciences and technology companies and investors at all stages,” said Martin Wellington, managing partner of Sidley Austin’s Palo Alto office. “He has great energy, a high-quality practice and a clear vision for growth that aligns with ours. Frank’s arrival signifies our strategy to build out Sidley’s presence in Northern California.”
Gitter joined Womble Bond Dickinson in 1962, when Womble had about a dozen attorneys. Gitter was the lead attorney in over one thousand cases filed in North Carolina state and federal courts between 1964 and 2009. Many lawyers who are now partners with the firm tried their first cases with Gitter, including Gemma Saluta, Murray Greason, Rachel Keen, Jim Morgan, Rick Rice, Bill Raper, Ellen Gregg, Alison Bost, Brad Wood and Chris Geis.
Gitter was inducted as a fellow in the American College of Trial Lawyers in 1982, and served as an Advocate in the American Board of Trial Advocates. He loved legal research and the law, but his interests also included coaching the Tiny Demons Pop Warner football team and his work at the Children’s Center, a facility devoted to the education and care of children with chronic health issues. He put himself through law school in part with his work as a night radio deejay on the campus radio station, employing his trademark sign-off at the end of the night: “Remember never to buy bad dreams.”
Gitter is survived by his wife of 32 years, Sandy; three children, Alison, Kent, and Ryne; two step-children, Wendy and Rob; multiple grandchildren and one great-grandchild.
Law Firm Innovation, Awards and Accomplishments
Redgrave LLP, a law firm focused on information governance and eDiscovery law, formed a Restructuring Discovery Team, working closely with law firms and advisors on litigation readiness and discovery for all types of restructurings. The Redgrave team handles data collection, preservation and review efforts during pre-petition and after a bankruptcy has been filed.
“We are proud to be the nation’s leading eDiscovery law firm, and we are very excited to formalize our experience in restructuring discovery,” said Redgrave partner Christine Payne, head of the firm’s restructuring team. “Many people do not realize how different discovery can be in the restructuring and bankruptcy contexts, as opposed to typical civil litigation. There is significant client need in this area, and we want to support that.”
IP Stars covers IP practice areas in over 70 jurisdictions, making it one of the most comprehensive guides in the industry.
In a decision that could provide a roadmap for local Marijuana dispensaries, A Kutak Rock team including litigation partners Andrew King and Fred Davis, and intellectual property counsel Sara Gillette representing Conway, Arkansas-based Harvest Cannabis Dispensary (“Harvest”) secured a preliminary injunction in a trademark dispute. Natural State Wellness Dispensary, LLC (“NSW”), and Natural State Enterprises, LLC, were using the name “Harvest” in for cannabis facilities across Arkansas, something the preliminary injunction now prohibits.
After an evidentiary hearing conducted over Zoom, Circuit judge Susan Weaver rejected the argument that The NSW Entities were authorized to use the name “Harvest” through their connection with Arizona-based Harvest Health & Recreation, Inc, a company using the Harvest mark in Arizona, Pennsylvania and Florida prior to the opening of the Arkansas Harvest dispensary. The court looked at precedent set by the USPTO and other federal courts, indicating products containing more than 0.3% THC are illegal under the Controlled Substances Act and therefore do not enjoy Trademark rights under the Lanham Act. Furthermore, Harvest adopted its name in 2017 and opened its facility in October of 2019, providing the dispensary with state-law trademark rights in Arkansas.
Kutak Rock partner Andrew King: “The Faulkner County outcome is the first of its kind, where a local cannabis dispensary prevailed under state trademark law against a multi-state operator for which federal trademark protection is unavailable. This outcome could provide a road map for local cannabis companies in states where cannabis has been legalized.”
Law Firm and Legal industry Response to COVID-19: A Sampling
COVID-19 has upended business as usual across the country; injecting terms like “flatten the curve”; “PPE” and “Contract Tracing” into everyday conversation. The National Law Review has covered some of the steps firms and other legal industry groups have taken to have a positive impact during these challenging times. For example, DLA Piper has signed on to the Ascend’s Five Point Action program, demonstrating a dedication to mitigating the disparate impact of COVID-19 on minority communities. Additionally, to broaden the reach of Coronavirus information and regulatory developments, Cornerstone Research worked with Stanford University to provide a database of legal articles and memos. Below are some more instances of law firms and other legal industry groups taking steps to mitigate the negative impact of COVID-19.
Mintz Law Firm provided pro bono counsel to Partners in Health (“PIH”), a Boston global health nonprofit, helping with the development of the Massachusetts COVID-19 Community Tracing Collaborative (“CTC”). The CTC is an initiative that works with PIH, the Massachusetts COVID-19 Command Center, Commonwealth Health Insurance Connector Authority and Massachusetts Department of Public Health to train, hire and deploy workers who will work with individuals exposed to Coronavirus. This veritable army of “contact tracers” will provide individuals with information about the virus, social support to facilitate self-isolation or quarantine, and provide appropriate next steps so individuals can stay healthy and protect their families; ultimately enhancing the Commonwealth’s ability to respond to COVID-19. Dr. Joia Mukherjee, PIH’s chief medical officer, says on contact tracing:
Access to this information helps contacts to know how to protect their loved ones, and to get tested or cared for themselves,” she said. “Without knowing our own status, without being able to specifically protect our loved ones, we are all living in the dark. (And) we know that there is significant anxiety in this darkness.
An interdisciplinary group of Mintz attorneys worked with PIH to facilitate this partnership on a pro-bono basis, helping this critical work get off the ground. Attorneys involved were Dianne Bourque and Ellen Janos, Members in Mintz’s Health Practice, Elissa Flynn-Poppey, Chair of the Government Law Practice, Julie Korostoff Chair of the firm’s IT Transactions & Outsourcing Practice, Andrew Matzkin, a Member in the firm’s Employment practice, and Corporate Associate Daniel Marden.
“Mintz is pleased to have been able to assist PIH in its efforts to change the course of COVID-19 in the Commonwealth,” said Mintz Member Ellen Janos. “It has been deeply rewarding to work on such a critically important project.”
Another group working to mitigate the negative impact of COVID-19 is the Diverse Attorney Pipeline Program(“DAPP”), a group with a mission to diversify the legal profession by expanding opportunities for women of color law students to secure summer positions at law firms and corporations following their first year of law school, an activity that greatly increases the likelihood of an offer of paid employment after graduation. DAPP was founded by Tiffany Harper and Chastity Boyce, both women of color who graduated from law school during the previous recession, and are passionate about mitigating the negative effects on women attorneys of color.
Recognizing the disruption that COVID-19 has had on everyone, and specifically law firm internships, DAPP is launching a fund and fellowship for students who are unable to complete their law firm internships this year. Started with seed money from the organization, DAPP has a goal of 100,000 to fund this program, and is requesting support from law firms, corporations, bar associations, and other nonprofit organizations in the form of earmarked donations.
“As law firms and businesses are forced to cut their summer internship programs, we hope they’ll consider contributing to this fund to support our work of infusing the pipeline to the legal profession with talented, highly qualified women of color in order to address the dismal statistics surrounding the number of women of color who are hired, retained and promoted at large law firms across the nation,” said Harper.
Students who receive the stipend will receive financial support as well as intensive professional development; involving volunteer legal work to facilitate skill development and meaningful training for participants. Additionally, the awardees will be matched with lawyer mentors, be provided with professional development and coaching.
“This is not a time to give up on diversity and inclusion efforts; it’s a time to refocus our efforts on preparing the next generation of lawyers for the challenges they’ll face in a diverse, global marketplace,” added Boyce.
Judge Lane based the Firestar Diamond decision on Bankruptcy Code section 502(d), which mandates disallowance of claims of an entity that has received property that the estate may recover (e.g., avoidable transfers) unless that entity or its transferee has repaid the avoidable or recoverable amount.2 Further, in so ruling, Judge Lane aligned his Court with the view of the Third Circuit Court of Appeals in In re KB Toys Inc.3 There, when faced with the same issue, the Third Circuit held that the taint of section 502(d) disallowance risk travels with the claim itself and the taint cannot be cleansed through a subsequent transfer of the claim to a third-party transferee.
Notably, in reaching its holding in Firestar Diamond, Judge Lane rejected a holding by a District Court in its own district. Thirteen years ago, in the aftermath of the Enron bankruptcy, District Court Judge Shira Scheindlin held that Bankruptcy Code section 502(d) is a “personal disability and does not travel with the ‘claim,’ but with the ‘claimant.’” In a decision that was regarded as a boon to the secondary bankruptcy claims trading market, Judge Scheindlin ruled that purchasers of claims (not mere assignees) would take free from the risk of section 502(d) disallowance.4 The District Court vacated the Bankruptcy Court’s order disallowing claims and remanded to determine the nature of the transfer. If the transfer were a sale, rather than an assignment, it would not be disallowed under section 502(d).5 But the Enron decision found few adherents. Firestar Diamond joins a lengthening line of decisions criticizing or declining to follow it.
Some risk mitigation suggestions are set forth in the “Implications” section below.
Background:
In Firestar Diamond, the Debtors were three wholesalers of jewelry – Firestar Diamond, Inc., Fantasy, Inc., and A. Jaffee, Inc. (collectively, “Firestar” or the “Debtors”) – who sold mainly to department stores and specialty chain stores in the United States. Firestar filed for Chapter 11 protection in February of 2018 in the SDNY in the “shadows of an alleged massive fraud” conducted by Firestar’s owner, Nirav Modi, who allegedly used a number of shadow entities (“Non-debtor Entities”) to pose as independent third parties in sham transactions in order to obtain billions of dollars in bank financing.
The SDNY Bankruptcy Court appointed an examiner to look into these allegations. The examiner found “substantial evidence” of the Debtors’ “knowledge and involvement” in the alleged criminal conduct. As a result, the court appointed a Chapter 11 trustee to administer the Debtors’ estates.6
A number of banks filed proofs of claims in the Chapter 11 case. The banks’ claims were not based on their dealings with the Debtors. Instead, the banks’ claims were based on amounts that the Debtors owed to the Non-debtor Entities, which had pledged their receivables or sold their invoices to the banks at a discounted price for amounts the Debtors owed.7
The Chapter 11 trustee objected to the banks’ claims under section 502(d) because the claims had been acquired from claim sellers who had received fraudulent transfers and preferences from the Debtors. The banks opposed the trustee’s argument based on Enron, arguing instead that “disallowance under Section 502(d) is a personal disability and does not travel with the ‘claim,’ but with the ‘claimant’” and that the banks had “acquired rights to payment from the Debtors through a ‘sale’ rather than an ‘assignment’.” Therefore, the claims had been washed clean.8
In contrast, the trustee argued that “sale” or “assignment” was of no import and urged the Court to reject Enron and follow rulings by other courts, including the Third Circuit’s decision in KB Toys. In the trustee’s view, the banks’ claims should be treated the same as if they had been filed by the Non-debtor Entities and disallowed.
Ultimately, Judge Lane agreed with the trustee and held that the banks’ claims should be disallowed because section 502(d) focuses on the claims themselves rather than who holds them. The original claims were disallowable and, therefore, remained disallowable even after their sale to the banks.
Enron and KB Toys:
Enron and KB Toys represent opposing views interpreting section 502(d). Generally, Enron attributed disallowance under section 502(d) to the claimant rather than a feature that transfers with a claim. On the other hand, KB Toys viewed section 502(d) disallowance as an attribute of the claim and therefore a feature that travels with the claim upon transfer.
In Enron, the court also held that when a claim is transferred, the “nature of that transfer” will dictate whether there may be a disallowance under section 502(d). Indeed, a transfer of a claim by assignment would allow the personal disability to transfer with the claim because an assignee “stands in the shoes of the assignor” and would, therefore, take on the transferred property with “whatever limitations it had in the hands of the assignor[.]” Meanwhile, a transfer by a sale would allow the purchaser only to receive the claim, washing the claim of the disability. Judge Scheindlin reasoned that recovery of property under the threat of section 502(d) disallowance would not be achieved if the claim was held by a creditor who had not received the preference.9
KB Toys rejected the distinction between “assignment” and “sale,” noting that there is no support for this distinction in the Bankruptcy Code. The Third Circuit concluded that “claims that are disallowable under [section] 502(d) must be disallowed no matter who holds them.”10 The Third Circuit reasoned that allowing a claim originally held by the recipient of a fraudulent or preferential transfer to be washed clean of section 502(d) disabilities would “contravene” the purpose of section 502(d), “which is to ensure equality of distribution of estate assets.”11 If the original claimant could rid the claim of its disabilities by selling the claim to a transferee, trustees would be “deprive[d] . . . of one of the tools the Bankruptcy Code gives trustees to collect assets—asking the bankruptcy court to disallow problematic claims.”12
A number of other courts and scholars alike have agreed with the Third Circuit, thereby concluding that section 502 follows the claim rather than the claimant.13
In re Firestar Diamond:
Judge Lane’s recent decision in Firestar Diamond continues that trend. Indeed, Firestar Diamond adopted KB Toys’ reasoning and rejected the banks’ position and reliance on Enron.14 Judge Lane, focusing on the claims rather than the claimants, granted the trustee’s section 502(d) claim objections. The banks’ claims were tainted by fraudulent and preferential transfers received by participants in Firestar’s bank fraud scheme. Those Non-debtor Entities could not cleanse their other claims against the debtor by selling them to third parties, unless they repaid the avoidable transfers.
In addition, Judge Lane rebuffed the banks’ argument that disallowance of their claims would “wreak havoc in the claims trading market or unfairly punish good faith transferees.” Rather, the Court explained that it would be “inequitable” to favor the banks over other creditors.15
Following KB Toys, Judge Lane thus concluded that claims purchasers should bear that risk because (i) they voluntarily chose to participate in the bankruptcy and were aware of the risks of doing so, and (ii) they are able to mitigate that risk through due diligence and including an indemnity clause in the transfer agreement. On the other hand, other creditors in a bankruptcy “have no way to protect themselves against the risk that claims with otherwise avoidable transfers will be washed clean by a sale or assignment.”16
Implications
Firestar Diamond continues the trend of disallowing creditor claims acquired from sellers who received avoidable or preferential transfers from the debtor. In light of yet another decision coming out this way, claims purchasers need to transact with eyes wide open and be mindful of potential consequences pursuant to section 502(d) of the Bankruptcy Code.
Duly informed claims purchasers may mitigate some risk by, among other things, considering the following measures:
Conduct due diligence with the goal of aiming to minimize disallowance risk under section 502(d) by investigating and inquiring into the seller’s relationship and transactions with the debtor.
Consider including protections in claim transfer agreements, such as indemnification language in the event of a claim objection based on section 502(d).
Consider documenting transfers as “sales” rather than assignments to take advantage of whatever protection or benefit the Enron rationale may still bestow and provide.
1 In re Firestar Diamond, Inc., et al., No. 18-10509 (SHL), 2020 WL 1934896 (Bankr. S.D.N.Y. Apr. 22, 2020) (“Firestar Diamond”).
2 Section 502(d) provides, in part, “[T]he court shall disallow any claim of an entity from which property is recoverable under section 542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable under section 522(f), 522(h), 544, 545, 547, 548, 549, or 724(a) of this title, unless such entity or transferee has paid the amount, or turned over any such property, for which such entity or transferee is liable under section 522(i), 542, 543, 550, or 553 or this title.”
3 736 F.3d 247 (3d Cir. 2013) (“KB Toys”).
4 Judge Scheindlin limited protection from section 502(d) disallowance to claims held by creditors who acquired their claims by “sale” rather than “assignment.” The District Court reasoned that a transfer by assignment will not grant the assignee more rights than possessed by the assignor – an assignee “stands in the shoes of the assignor” and takes with the assignor’s limitations. 379 B.R. at 435. But a claim that is “sold” is not subject to the personal disabilities of the transferor. Id. at 436.
5 In re Enron Corp., 379 B.R. 425, 445-46 (S.D.N.Y. 2007) (“Enron”) (“the nature of the transfer will determine whether [the] claims can be subject to . . . disallowance based on [Debtor]’s conduct”). The Third Circuit, other courts, and bankruptcy commentators have questioned the distinction between “sale and “assignment,” finding it “problematic” and unsupported by state law. SeeKB Toys, 736 F.3d at 254; Firestar Diamond, 2020 WL 1934896 at *9-12.
6 Firestar Diamond, 2020 WL 1934896 at *2-3.
7 Id. at *4 n.3.
8 Id. at *4-6.
9 Enron, 379 B.R. at 443 (The purpose of section 502(d) is to “coerce the return of assets obtained by preferential transfer. That purpose would not be served if a claim in the hands of a claimant could be disallowed even where that claimant had never received the preference to begin with, and as a result, could not be coerced to return it. It seems implausible that Congress would have intended such a result.”).
10 KB Toys, 736 F.3d at 252.
11 Id. at 252.
12 Id.
13 SeeFirestar Diamond, 2020 WL 1934896 at *10-11 (collecting cases and scholarly articles); In re Motors Liquidation Co., 529 B.R. 520 (Bankr. S.D.N.Y. 2015); In re Wash. Mut., Inc., 461 B.R. 200 (Bankr. D. Del. 2011), vacated in part on other grounds, 2012 WL 1563880 (Bankr. D. Del. Feb. 24, 2012); Adam J. Levitin, Bankruptcy Markets: Making Sense of Claims Trading, 4 Brook. J. Corp. Fin. & Com. L. 67, 92 (2009); Jennifer W. Crastz, Can a Claims Purchaser Receive Better Rights (Or Worse Rights) Than Its Transferor in a Bankruptcy?, 29 Cal. Bankr. J. 365, 637 (2007); Roger G. Jones & William L. Norton, III, Norton Creditor’s Rights Handbook § 8:8 (2008).
In the face of approximately 300 sexual abuse lawsuits from former Boy Scouts, the Boy Scouts of America has filed for bankruptcy protection under Chapter 11 of the Bankruptcy Code. The Boy Scouts of America is the nation’s largest scouting organization and one of the largest youth organizations. Because Chapter 11 allows an organization to continue operations, scouting programs are expected to proceed at this time.
Officials with the organization said in a statement on Tuesday, February 19, “Our plan is to use this Chapter 11 process to create a Trust that would provide equitable compensation to these individuals.”
The national landscape has shifted significantly in recent years as large, influential organizations like the Catholic Church and USA Gymnastics have become the subject of sexual abuse scandals. One of the most important ways laws have changed has been the extension of the statute of limitations. Many states, including New Jersey and Pennsylvania, have chosen to grant sexual abuse victims longer timeframes to seek damages in sexual abuse and assault cases.
Military veterans often pay a heavy toll for their service from a physical, emotional and even financial standpoint. A new federal law— the Honoring American Veterans in Extreme Need Act of 2019 or the HAVEN Act— aims to address the latter hardship, providing disabled military veterans with greater protections in bankruptcy proceedings.
Prior to the passage of the HAVEN Act, federal Department of Veterans Affairs (VA) and Department of Defense disability payments were included when calculating a debtor’s disposable income when in bankruptcy. In other words, this income is subject to the reach of creditors.
By contrast, Social Security disability benefits are exempt from calculating a debtor’s disposable income. The HAVEN Act places military disability benefits in the same protected category as Social Security disability.
The actual language of the new exception reads as follows:
“(IV) any monthly compensation, pension, pay, annuity, or allowance paid under title 10, 37, or 38 in connection with a disability, combat-related injury or disability, or death of a member of the uniformed services, except that any retired pay excluded under this subclause shall include retired pay paid under chapter 61 of title 10 only to the extent that such retired pay exceeds the amount of retired pay to which the debtor would otherwise be entitled if retired under any provision of title 10 other than chapter 61 of that title.”
The HAVEN Act received strong bipartisan support in both the House and Senate, and was endorsed by both the American Bankruptcy Institute and a host of veterans’ advocacy organizations, including the American Legion and VFW. Reps. Lucy McBath (D-GA) and Greg Steube (R-FL) co-sponsored the legislation in the House, while Sen. Tammy Baldwin (D-WI) and John Cornyn (R-TX) co-sponsored the Senate legislation. President Donald Trump signed the HAVEN Act into law August 23, 2019 and it became effective immediately.
Specific benefits protected under the Haven Act are:
Permanent Disability Retired Pay
Temporary Disability Retired Pay
Retired or Disability Severance Pay for Pre-Existing Conditions
Disability Severance Pay
Combat Related Special Compensation
Survivor Benefit Plan for Chapter 61 Retirees
Special Survivor Indemnity Allowance
Special Compensation for Assistance with Activities of Daily Living
VA Veterans Disability Compensation
VA Dependency and Indemnity Compensation, and
VA Veterans Pension.
Veterans advocates pushed for the HAVEN Act following five recent Bankruptcy Court Decisions that held that under previous bankruptcy law, disabled veterans were required to include military disability in their disposable income in bankruptcy proceedings.
The new law also provides relief to a segment of the population that needs assistance. According to the 2018 VA Annual Benefits Report, 4.74 million US veterans—or 25 percent of the total veteran population—receive VA disability benefits.
Veterans also make up a disproportionate share of bankruptcy filers. Nearly 15 percent of both Chapter 7 and Chapter 13 bankruptcy filers are veterans, who make up approximately 10 percent of the overall population. Approximately 125,000 veterans filed for bankruptcy in 2017 alone.
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