Tag: Bankruptcy

“Caveat Emptor”: New York Bankruptcy Court Disallows Bankruptcy Claims Purchased from Recipients of Avoidable Transfers; Is Enron Going, Going, . . . ?

A recent Bankruptcy Court decision, In re Firestar Diamond, Inc., out of the Southern District of New York (“SDNY”) by Bankruptcy Judge Sean H. Lane, disallowed creditors’ bankruptcy claims purchased from sellers who allegedly received (and had not repaid) avoidable preferences and fraudulent transfers from the debtors.1 Judge Lane provides a cogent warning to claims purchasers that they bear the risk of Bankruptcy Code section 502(d) disallowance.

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.  See KB 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 See Firestar 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).

14 Firestar Diamond, 2020 WL 1934896 at *9.

15 Id.

16 Id. at *13-14.

© Copyright 2020 Cadwalader, Wickersham & Taft LLP

Boy Scouts File for Bankruptcy Amidst Wave of Sexual Abuse Charges

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.

COPYRIGHT © 2020, STARK & STARK

See the National Law Review Bankruptcy & Restructuring Law section for more information.

HAVEN ACT Provides Military Veterans With Increased Income Protections In Bankruptcy

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.

Copyright © 2019 Womble Bond Dickinson (US) LLP All Rights Reserved.

For more on veteran’s affairs, see the Government Contracts, Maritime & Military Law page on the National Law Review.

When Your Customer is In Bankruptcy, There Are Two Major No-Nos That You Must Remember.

First, don’t violate the automatic stay, which prevents a creditor from attempting to collect a debt while the debtor is in bankruptcy unless the creditor gets prior court approval.  Second, don’t violate the discharge injunction, which absolves a debtor of liability for those debts covered by the bankruptcy court’s discharge order.  The automatic stay takes effect when the debtor files bankruptcy, while the discharge injunction typically comes at the end of the case.

The United States Supreme Court recently decided a case involving the discharge injunction.  In Taggart v. Lorenzen, the issue was the legal standard for holding a creditor in civil contempt when the creditor violates the bankruptcy discharge order.  In a unanimous decision, the Supreme Court held that a court may hold a creditor in civil contempt for violating a discharge order if there is no fair ground of doubt as to whether the order barred the creditor’s conduct. In other words, civil contempt may be appropriate if there is no objectively reasonable basis for concluding that the creditor’s conduct might be lawful.

Bradley Taggart was a part owner of an Oregon company called Sherwood Park Business Center.  He got into a dispute with some of the other owners, and they sued him in state court for breach of Sherwood’s operating agreement.  During the lawsuit, Taggart filed a Chapter 7 bankruptcy. In Chapter 7, a debtor discharges his debts by liquidating assets to pay creditors.   Taggart ultimately obtained a discharge.  After the bankruptcy court entered the discharge order, the parties returned to the state court lawsuit.  The parties who had sued Taggart before he filed bankruptcy obtained an order from the state court requiring him to pay post-bankruptcy attorneys’ fees of $45,000.00.  Taggart contended this debt had been discharged and the parties’ actions violated his bankruptcy discharge.

Multiple appellate courts reached different conclusions as to whether – and why or why not – the parties had violated the discharge order.  One issue the courts struggled with was the standard to apply to the parties’ conduct.  Should the courts apply an objective test based solely on their conduct or should they consider their subjective beliefs and motivations?  Should the courts impose strict liability for discharge violations or should they let creditors off the hook if they didn’t realize their conduct was improper?  The Supreme Court agreed to resolve these questions.

In adopting the “no fair ground of doubt” standard, the Supreme Court noted that civil contempt is a severe remedy and basic fairness requires those enjoined know what conduct is outlawed before being held in contempt.  The standard is generally an objective one.  A party’s subjective belief he was complying with an order ordinarily will not insulate him from civil contempt if that belief was objectively unreasonable.  Bad faith conduct, and repeated or persistent violations can warrant civil contempt.  Good faith can mitigate against contempt and factor into the appropriate remedy.

Although a discharge order often has little detail, the Supreme Court pointed out that, under the Bankruptcy Code, all debts are discharged unless they are a debt listed as exempt from discharge under Section 523.  A domestic support obligation, for instance, is exempt from discharge.  (This recent article discusses how debts involving intentional, fraud-like conduct may be exempted from discharge.)  In other words, ignorance of the bankruptcy law is no excuse.

In adopting the “no fair ground of doubt standard,” the Supreme Court rejected two other standards, one more lenient and one more harsh.  First, the Supreme Court rejected a pure “good faith” test – a creditor’s good faith belief that its actions did not violate the discharge would absolve it of contempt. Second, the Supreme Court rejected a strict liability test – if a creditor violated the discharge, he would be in contempt regardless of his subjective beliefs about the scope of the discharge order or whether there was a reasonable basis for concluding that his conduct did not violate the discharge order.

The discharge injunction is no joke, and creditors violate it at their peril.  A debtor can be compensated for damages resulting from a discharge violation.  In this case, the bankruptcy court initially awarded Taggart over $100,000 for attorneys’ fees, emotional distress, and punitive damages.  Creditors with customers in bankruptcy, or who have filed bankruptcy in the past, should consult counsel who can advise them on what debts they can pursue.  And if a creditor finds itself accused of violating the discharge injunction, it should contact counsel to assess its chances of passing or failing the “no fair ground of doubt” test.

© 2019 Ward and Smith, P.A.. All Rights Reserved.

Mission Products v. Tempnology: SCOTUS Holds that Rejection of Trademark License in Bankruptcy Does Not Terminate the Right to Use the Mark

On May 20, 2019, the U.S. Supreme Court held by a vote of 8-1 that a trademark licensor’s rejection in bankruptcy of a trademark license does not terminate the licensee’s right to use the licensed mark.Mission Products Holdings, Inc. v. Tempnology, LLC, No. 17-1657, 587 U.S. ___ (2019). In so holding, the Court resolved a circuit split on the issue. The Court reversed the decision of the First Circuit, which held that Tempnology’s rejection of a trademark license under the Bankruptcy Code had the effect of terminating Mission Products’ right to use the licensed marks. The Court expressly affirmed the reasoning of the Seventh Circuit in Sunbeam Products, Inc. v. Chicago Am. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012), and held that rejection of a trademark license constitutes a pre-petition breach of the license agreement but does not otherwise terminate the licensor’s and licensee’s rights and obligations under the license agreement.

The Court’s opinion, authored by Justice Kagan, considered section 365 of the Bankruptcy Code, 11 U.S.C. §365. Specifically, the Court considered section 365(a), which permits a debtor in bankruptcy to reject any executory contract 1, and section 365(g), which provides that the debtor’s rejection “constitutes a breach of such contract.” 11 U.S.C. §365(a), (g).

In this case, the licensor, Tempnology, manufactured clothing and accessories designed to stay cool when used in exercise. Tempnology sold those products under the name “Coolcore” with related logos and labels. Tempnology entered into a license agreement with Mission Products, which granted, among other things, a non-exclusive license to use the Coolcore trademark in the United States and elsewhere. In 2015, less than a year before the license was to expire, Tempnology filed a petition for bankruptcy under Chapter 11 of the Bankruptcy Code. Tempnology exercised its option under section 365(a) to reject the license agreement, as it was still executory, and the Bankruptcy Court approved the rejection. The parties agreed that the rejection had two effects. First, Tempnology could stop performing under the license agreement, and second, Mission Products could assert a pre-bankruptcy petition claim for damages 2. 

Tempnology argued that its rejection of the license agreement also terminated the rights it previously granted Mission Products to use the Coolcore marks. Tempnology based its argument on a negative inference it drew from the fact that, over the years, Congress had adopted provisions in section 365 that allowed the other party in a rejected contract to continue exercising its contractual rights. Of particular relevance was section 365(n), which provides that if the licensor of certain intellectual property rights, such as patents, rejects the license, the licensee can continue to use the patented technology as long as it makes the payments required under the license. 11 U.S.C. §365(n).  Section 365(n) specifically excluded trademark licenses. See 11 U.S.C. §365(n). Tempnology argued that, because section 365(n) excludes trademark licenses, a negative inference should be drawn that Congress intended for trademark licenses to terminate upon rejection.

The Court rejected Tempnology’s arguments. In so doing, the Court first relied on the language in section 365(g), which provides that a rejection constitutes a breach. While a breaching debtor can stop performing its remaining obligations under the license, it cannot rescind the license. The Court went on to note that the section 365(n) provision allowing a licensee to continue using licensed intellectual property other than trademarks was a reaction to a Fourth Circuit decision – Lubrizol Enterprises v. Richmond Metal Finishers, 756 F.2d 1043 (4th Cir. 1985) – which held that a patent licensee’s rejection of an executory contract had the effect of revoking the grant of a patent license. The Court in Mission Products explained that “Congress’s repudiation of Lubrizol for patent contracts does not show any intent to ratify that decision’s approach for almost all others. Which is to say that no negative inference arises.” (emphasis in original).

The Court also rejected Tempnology’s arguments based on a trademark licensor’s duty to monitor and exercise quality control over licensed goods and services. Tempnology argued that if rejection does not terminate the license, the debtor-licensor is forced to choose between expending scarce resources on quality control, or forgoing expending such resources and thereby risking the loss of a valuable asset, presumably because use without quality control would lead to a naked license. The Court observed that these concerns, while possibly serious, “would allow the tail to wag the Doberman.” The Court explained that the ability to reject a contract under section 365 allows a debtor to escape its future contract obligations, but it does not exempt the debtor from all burdens that generally-applicable law, in this case the law on trademarks, imposes on the owner of the trademark.

Tempnology also argued that the case is moot because, it claimed, Mission Products could not recover damages.3The Court held that the case is not moot, as Mission Products would be able to recover damages. 

The Mission Products decision is important for several reasons.  First, it resolves the split that had developed between those courts holding that rejection results in a breach and those holding that rejection terminates the right to use a licensed mark. Second, resolving the split removes uncertainty faced by trademark licensors and licensees who are forced to consider what might happen if a licensor declares bankruptcy. Moreover, resolving this uncertainty avoids the need to use expensive and complex steps, such as placing licensed marks in a bankruptcy-remote entity, in order to avoid the effect of a licensor’s bankruptcy. 

[1] An executory contract refers to a contract that neither party has finished performing.[2] In its opinion, the Court noted that pre-petition creditors often receive only cents on the dollar of their bankruptcy claims.

[3]The lone dissent, by Justice Gorsuch, also argued mootness on the ground that the license had already expired by the time the bankruptcy court confirmed the rejection and declared that Mission Products could not use the mark.

© 2019 Brinks Gilson Lione. All Rights Reserved.

This post was written by David S. Fleming and Emily Kappers of Brinks Gilson Lione.

The Real Estate Problem of Retail

The retail sky is falling.  At least that is how it appears from recent and unprecedented number of retailers filing for bankruptcy. From iconic stores such as Sears and Toys ‘R’ Us, to department stores such as Bon Ton, to mall stores including Brookstone, The Rockport Company, Nine West, among others.  The reasons given for such filings vary as much as their products but one theme seems to be constant — the inability of retailers to maintain “brick and mortar” operating expenses in the era of online shopping.  Accordingly, it appears that what some retailers actually have is a real estate problem.

Another troubling theme of many retail filings is the use of bankruptcy courts to achieve a quick liquidation of the company, rather than a reorganization.  Chapter 11 filings over the past several years have shown a dramatic shift away from a process originally focused on giving a company a “fresh start” to one where bankruptcy courts are used for business liquidation.  The significant increase in retail Chapter 11 cases and the speed at which assets are sold in such cases is disturbing and provides a cautionary tale for developers and landlords alike.  Indeed, such parties need to be extremely diligent in protecting their rights during initial negotiations as well as when these cases are filed, starting from day one, lest they discover that their rights have been extinguished by the lightning speed of the sale process.

Recent statics suggest that the average time to complete a bankruptcy sale is only 45 days from the petition date.  Moreover, under the Bankruptcy Code, and arguably, best practices, the sale will close shortly after court approval thereby rendering any appeal likely moot.  This leaves little time for parties to protect their rights.

Bankruptcy Code Section 363(f) permits a debtor to sell property free and clear of interests in the property if certain conditions are met.  Unlike a traditional reorganization, which requires a more engaging process, including a disclosure statement containing “adequate information,” a sale under Section 363 is achieved by mere motion, even though it results in property interests being entirely wiped out.  Not only are property rights altered by motion, rather than by an adversary proceeding or a plan process, but these sale motions are being filed in retail cases as “first day motions” and concluded in as short as a month and half.

Even more alarming is that the notice accompanying such motions can be ambiguous as to how it will impact parties such as developers who have multiple interests in retail/multi-use properties.  Often, the reference to the developer and its property is buried in a 20+ page attachment in 8 point font, listed in an order only the debtor (or its professionals) understands.  If that was not concerning enough, these notices are being served by a third-party agent who may not have access to the most updated contact information necessary to ensure that non-debtors are actually receiving the notices in time to properly protect their rights.  It is not uncommon for these notices to be inaccurately addressed and not be received until after an order is entered; an order which will undoubtedly contain a provision that notice was proper.

Notably, despite Section 363(f)’s reference solely to “interests” (the group of things that an asset may be sold free and clear of), these sales are commonly referred to as sales free and clear of “claims and interests.”  Lacking an actual definition, courts have expansively interpreted “interests” to include “claims.”  Indeed, it is now the norm for bankruptcy courts to enter extensive findings of fact and conclusions of law supporting 363 sales that extinguish every imaginable potential claim (rather than merely “interests”).  While consistent with the overall spirit of the Bankruptcy Code to promote maximization of value through the alienability of property, it comes at the expense of those holding an interest in that property, such as a mall or shopping center developer.

Fortunately, there are certain well-accepted exceptions to the courts’ expansive application of “interest.”  Courts generally limit a debtor’s attempt to use Section 363 to strip off traditional in rem interests that run with the land.  When faced with such attempts, courts routinely constrain the interpretation of the statute to block the sale free and clear of an in rem interest.

The majority of state laws have long treated covenants, easements, and other in rem interests that are said to “run with the land” as property interests.  Although clearly falling within the common definition of “interests,” courts routinely hold them not to be strippable interests for purposes of a Section 363(f), as being so ingrained in the property itself that they cannot be severed from it, or, alternatively, that the in rem interests are not included in Section 363(f)’s use of the term “interests.”

The protection afforded to in rem interests should provide forward-thinking transactional attorneys with a valuable opportunity to insulate many rights and remedies for their developer clients.  A hypothetical real estate transaction is illustrative — consider a transaction in which a developer sells two parcels to a large retailer as part of a retail/mixed use shopping center and takes back a long-term ground lease for one of the parcels. There are a number of methods available to document this deal: a sale-leaseback agreement; a separate contract to convey in the future secured by a lien; entry into a partnership, joint venture, or similar agreement. When analyzed with respect to the risk of a potential retailer bankruptcy, these mechanisms are inferior to the use of a reciprocal easement agreement (“REA”) or similar devise that creates an in rem property interest that runs with the land in favor of the developer.

If traditional contractual methods are used, the documents run the risk of being construed as executory contracts in the retailer’s subsequent bankruptcy case, subject to rejection, leaving the developer with only a prepetition claim.  A lien in favor of the developer would only marginally improve its position, as any lien will likely be subordinated to the retailer’s development financing and therefore of little value.  But, based on the current state of the law, a non-severable REA or similar document recorded against the retailer’s property will not be stripped off the property absent consent or a bona fide dispute. Thus, rights incorporated into a properly drafted and recorded REA provide the developer with a level of “bankruptcy-proofing” against a potential future retailer bankruptcy. Further, as REAs in mixed-use developments are the norm in the industry, they are likely to be accepted, if not embraced, by the retailer’s construction lender, making their adoption that much more likely.

The lesson is be forward thinking and be diligent.

© Copyright 2019 Squire Patton Boggs (US) LLP.

Are You Ready for the Next Downturn? Ninth Circuit “Cramdown” Cases Affecting Real Estate Lenders

Plan Approval in a Multi-Debtor, Single-Plan Context

In In re Transwest Resort Properties, Inc., the Ninth Circuit addressed the Chapter 11 reorganization plan approval process where a single plan was proposed for multiple affiliated debtor entities whose cases were being administered jointly. Generally, for “cramdown” plans, the Bankruptcy Code requires that at least one class of impaired creditors vote in favor of a plan for it to be approved. In Transwest, a mezzanine lender who was the sole creditor for two of the five debtor entities and whose loan would be extinguished under the single, jointly administered plan, argued that impaired class approval had to occur on a per debtor basis, and that since it was the only impaired class member for two of the debtors, its votes against the plan in those debtor cases barred confirmation (as there were no impaired classes of creditors in those cases voting in favor of the plan). The bankruptcy court, the district court, and the Ninth Circuit rejected that position, holding instead that impaired class approval applied on a per plan basis, and that the votes of the impaired class of creditors of the other three debtors established consent from an impaired class across all debtors, and supported plan confirmation. The Ninth Circuit is the first circuit-level court to address this issue, and the lower bankruptcy courts remain split on the issue.

Potential Impact

Lenders, particularly mezzanine lenders, who lend to one or more isolated borrowing entities within a corporate group of debtor entities may not have the voting control in the plan confirmation process they assume exists to block “cramdown”, and should factor that reality into their risk assessments.

“Cramdown” Value = Replacement Value (even if it’s less than foreclosure value)

In In re Sunnyslope Housing Limited Partnership, the Ninth Circuit, in an en banc opinion, addressed how a secured creditor’s interest should be valued in the context of a “cramdown,” i.e. where the debtor seeks to retain and use creditor’s collateral in the reorganization plan and the value of that collateral is to be determined based on the proposed use of the property. Valuation of the property in the “cramdown” context was critical to how much the secured creditor would recover under the proposed plan, given that amount of its secured claim would be determined by the value of the property. The Sunnyslope case presented a highly unusual circumstance where the foreclosure value of the apartment complex collateral was significantly higher than its replacement or use value due to the existence of low-income housing covenants that would be extinguished in a prospective foreclosure.

Despite the higher foreclosure value supported by the secured creditor, the Ninth Circuit affirmed application of the replacement value standard for determining the secured creditor’s present value of its claim under the plan. In doing so, the Ninth Circuit affirmed prior precedent holding that only a property’s replacement value – to be determined in light of its “proposed disposition or use” – could be utilized for determining the amount of a secured claim in the cramdown context. In applying its replacement value standard in Sunnyslope, the Ninth Circuit confirmed that the highest and best use of collateral may not dictate the value of a creditor’s secured claim, even where the replacement value, as determined by the collateral’s anticipated use or disposition, is lower than its foreclosure value.

Potential Impact

Lenders facing a potential “cramdown” of its secured claim, based on present value of its claim against real property, should carefully analyze the potential difference between a property’s foreclosure value and its replacement value and adjust expectations accordingly.

© 2010-2018 Allen Matkins Leck Gamble Mallory & Natsis LLP

This post was written by Michael R. Farrell of Allen Matkins Leck Gamble Mallory & Natsis LLP.

University Wins Important Tuition Claw-Back Case

A federal bankruptcy court in Connecticut recently ruled in favor of Johnson & Wales University in a tuition claw-back case. Roumeliotis v. Johnson & Wales University (In re DeMauro), 2018 WL 3064231 (Bankr. D. Conn. June 19, 2018). Wiggin and Dana attorneys Aaron Bayer, Benjamin Daniels, and Sharyn Zuch had filed an amicus curiae brief in support of the University on behalf of the Connecticut Conference of Independent Colleges, the Association of Independent Colleges & Universities of Massachusetts, and the Association of Independent Colleges & Universities of Rhode Island.

The federal bankruptcy trustee in Roumeliotis sought to force the University to disgorge tuition payments that the parent-debtors had paid on behalf of their daughter. The trustee claimed that the payments were fraudulent transfers because the parents were insolvent at the time, and because the trustee believed that parents do not receive value when they pay for their adult children’s education. The trustee argued that the tuition should be returned to the debtors’ estate and be available for distribution to the parents’ creditors – even though the University was unaware of the parents’ financial circumstances when it received the payments and had long since provided the educational services to the daughter.

The bankruptcy court granted summary judgment dismissing the claim, finding that the tuition was never part of the parents’ assets. The decision turned, in large part, on the precise nature of the tuition payments at issue. The parents had used federal Direct PLUS Loans to pay the tuition. However, under that program, the proceeds of the loan were paid directly to the University and never held by the parents. Therefore, the loans were never technically the parents’ assets and never were held by the parents. To hold otherwise, the court concluded, would conflict with and undermine the purposes of the Direct PLUS Loan program. The trustee has not taken an appeal.

You can find the Bankruptcy Court decision here.  You can find the amicus brief here.

We continue to await a decision by the First Circuit in another very significant tuition claw-back case, DeGiacomo v. Sacred Heart University (In re Palladino), No. 17-1334 (1st Cir.). In that case, the Court is expected to rule on the question whether parents received “reasonably equivalent value” for tuition payments they made on behalf of their child. The bankruptcy trustee claims that they did not, because the child and not the parents received the education, and seeks to recover the tuition payments from the University.

© 1998-2018 Wiggin and Dana LLP

This post was written by Aaron Bayer and Benjamin Daniels of Wiggin and Dana LLP.

The Tail of a Dog with Two Hats: Fifth Circuit Upholds “Golden Share” Held by Creditor Affiliate

On May 22, 2018, the United States Court of Appeals for the Fifth Circuit issued its decision in Franchise Services of North America v. United States Trustees (In re Franchise Services of North America), 2018 U.S. App. LEXIS 13332 (5th Cir. May 22, 2018). That decision affirms the lower court’s holding that a “golden share” is valid and necessary to filing when held by a true investor, even if such investor is controlled by a creditor.

The backdrop of mergers and acquisitions leading up to this case need not be retold in detail to understand the holding’s significance, but some context is helpful. Franchise Services of North America, Inc. (“FSNA”), one of North America’s largest car rental companies, filed for chapter 11 bankruptcy without the required consent of its sole holder of preferred stock, Boketo, LLC (“Boketo”). Boketo was a minority shareholder that had invested $15 million in FSNA  making it FSNA’s single largest investor. Boketo is a wholly-owned subsidiary of investment bank Macquarie Capital (U.S.A.) (“Macquarie”), an unsecured creditor of FSNA’s by virtue of an alleged $3 million claim for fees incurred in connection with the aforementioned transactions. When Boketo invested $15 million in FSNA, it required FSNA to re-incorporate in Delaware and add a “golden share” provision to its corporate documents, i.e. Boketo’s affirmative vote of its preferred share was required for certain corporate events, such as filing bankruptcy. Nonetheless, FSNA eventually filed for chapter 11 in the Southern District of Mississippi without seeking Boketo’s consent, fearing that shareholder Boketo—controlled by creditor Macquarie—would not consent to filing.

Macquarie and Boketo filed motions to dismiss the case for a lack of corporate authority under FSNA’s amended corporate charter. In doing so, Macquarie donned two hats—that of a shareholder through Boketo and that of an unsecured creditor with a $3 million claim. FSNA asserted that Macquarie used Boketo as a “wolf in a sheep’s clothing” to equip a creditor with shareholders’ blocking rights under an allegedly unenforceable “blocking provision” or “golden share.” FSNA implied the tail had been wagging the dog—that Macquarie made the $15 million investment through Boketo to avoid the cost and inconvenience of trying to collect some portion of its $3 million claim in FSNA’s bankruptcy. The bankruptcy court denied Macquarie’s motion because case law and public policy forbid a creditor from preventing a debtor’s bankruptcy filing. However, it granted Boketo’s motion, given its status as a voting shareholder. The Fifth Circuit affirmed, and found FSNA’s theory that Macquarie chased $3 million with $15 million “strain[ed] credulity.”

FSNA’s various legal arguments each fell flat. First, FSNA sought a ruling that “blocking provisions” or “golden shares” (similar, but not identical, concepts), in general, are unenforceable under Delaware law. The Fifth Circuit declined to offer such an advisory opinion. Second, FSNA contended that even if Delaware law allowed these types of provisions, federal policy forbids them. This, too, failed to move the court, since the corporate charter did not eliminate FSNA’s ability to file bankruptcy. Instead, it specified which parties’ consent was necessary to authorize a bankruptcy filing, placing the decision with shareholders. Third, because authority to file bankruptcy is a matter of state law, FSNA argued that Boketo could not exercise its blocking right under Delaware law, and that Boketo had owed a fiduciary duty to facilitate the filing. The Fifth Circuit held that Delaware law, flexible by nature, allows a corporate charter to assign rights to shareholders that would ordinarily be assigned to directors/management, but declined to go so far as to determine whether such provision was valid under Delaware law. In addition, the court refuted FSNA’s fiduciary duty argument because only controlling minority shareholders owe fiduciary duties, and here, Boketo was a non-controlling minority shareholder. The court explained that the standard for minority control is a “steep one,” and that courts focus on control of the board—i.e., whether the minority shareholder can exert actual control over the company. While Boketo made a sizeable investment in FSNA, it only had the right to appoint 2 out of 5 directors and therefore could not exert actual control over the board. FSNA pointed to Boketo’s hypothetical ability to prevent bankruptcy as evidence of actual control, but the court distinguished such theoretical control from actual exertion thereof. The court keenly noted that FSNA defeated its own control argument when it filed bankruptcy without Boketo’s consent—if Boketo was a controlling shareholder, then once again the tail must have been wagging the dog.

Franchise Services highlights the potential for a creditor to essentially step into a shareholder’s shoes and assert shareholder rights pursuant to a corporate charter’s blocking provision or “golden share” by virtue of wearing two hats through a parent and subsidiary.

© 2018 Bracewell LLP.

This post was written by Logan Kotler and Jason G. Cohen of Bracewell LLP.

Supreme Court Bars Structured Dismissals of Bankruptcy Cases That Violate the Code’s Priority Distribution Scheme – Could it Affect Your Creditor Position?

supreme court structured dismissalsOn March 22, 2017 the Supreme Court issued its long-awaited ruling regarding the legality of structured dismissals of Chapter 11 bankruptcy cases that would make final distributions of estate assets to creditors in a manner that deviates from the Bankruptcy Code’s statutory priority distribution scheme.1 In Czyzewski v. Jevic Holding Corp., the Court held that such a structured dismissal was forbidden, absent the consent of the negatively affected parties. However, the Court did not bar all distributions of estate assets which violate the priority distribution scheme, suggesting that interim distributions that serve a broader Code objective such as enhancing the chances of a successful reorganization might be allowed, meaning that important bankruptcy tools like critical vendor orders and first-day employee wage orders are still viable.

In Jevic, the debtor was taken over by an investor in a leveraged buy-out (“LBO”), with money borrowed from a bank. The LBO added a significant and ultimately unsustainable level of the debt to the company. Shortly before the bankruptcy, Jevic ceased operations and fired all of its employees. A group of those laid-off employees (the truck drivers) filed a lawsuit against Jevic and the investor for violations of the federal WARN Act.2 The employees prevailed in the WARN Act litigation against Jevic and obtained a $12.4 million judgment, $8.3 million of which was entitled to priority status in Jevic’s bankruptcy case because it was for wages. As the holders of a priority claim, the truck drivers were entitled to be paid before any of the general unsecured creditors in the Jevic bankruptcy. The employees also had a WARN Act claim pending against the investor, the acquirer in the LBO. During the bankruptcy, the unsecured creditors’ committee sued the investor and the bank for fraudulent transfer claims arising from the LBO. While those cases were pending, and during the bankruptcy, several constituencies attempted to negotiate a resolution to the case with a plan of reorganization, but that effort failed. Ultimately everyone but the truck drivers agreed to a settlement regarding the fraudulent transfer claims and distribution of estate property and a structured dismissal of the bankruptcy case.3 The settlement excluded the truck drivers from any recovery, but did provide some recovery to consenting lower-priority unsecured creditors.

The truck drivers and the United States Trustee objected to the structured dismissal since it deviated from the Code’s priority rules. However the Bankruptcy Court approved it, and was affirmed by both the District Court and the Third Circuit Court of Appeals. Those courts reasoned that under the settlement and structured dismissal, there would be at least some recovery to some priority and general unsecured creditors—even if not to the bypassed truck drivers—whereas otherwise no one but the secured creditor would get anything.. The truck drivers could not really complain, those courts concluded, because they would have gotten nothing regardless. Furthermore, those courts did not believe that the absolute priority rule applied to a dismissal.

The Supreme Court, however, reversed the Third Circuit Court of Appeals, and concluded that in a final distribution of estate assets, by whatever mechanism, the Code’s priority rules must be respected, absent the consent of adversely affected parties.

However, the Court narrowly tailored its ruling, stating that strict compliance with the priority rules is only required in a final distribution of estate assets upon the conclusion of the bankruptcy case, whether via liquidation, plan confirmation, sale of assets, or dismissal. The Court noted that during a reorganization case, bankruptcy courts routinely approve interim distributions of estate assets in ways that violate the priority distribution scheme. For example, in almost every chapter 11 case, debtors seek the ability to pay their employees for pre-petition wages that are accrued but unpaid on the petition date. In some cases, debtors also seek critical vendor orders that allow them to pay certain key suppliers the pre-petition amounts due so that those suppliers will continue to ship goods or provide services during the bankruptcy case. The Court distinguished these interim priority-violating distributions from the one at issue in Jevic because the interim distributions served the goal of the bankruptcy system: the rehabilitation of debtors. Priority-violating final distributions made pursuant to structured dismissals do not serve that goal.

Jevic’s ruling will drastically curtail the growing trend of structured dismissals, eliminating some wiggle room bankruptcy stakeholders had in fashioning a resolution to a case outside a plan of reorganization. No longer can recalcitrant groups of creditors be threatened with being squeezed out of any distribution if they won’t cave in and agree to play ball; they can insist on their priority rights. However, the ruling still preserves the flexibility that has developed in chapter 11 cases to allow debtors to attempt to reorganize their business and protect parties that are willing to work with debtors during the bankruptcy.

ARTICLE BY Tamar N. Dolcourt & Gjina Lucaj of Foley & Lardner LLP
© 2017 Foley & Lardner LLP

1 Czyzewski v. Jevic Holding Corp., 580 U.S. ___ (2017); 2017 WL 1066259.

2 The WARN Act is the Worker Adjustment and Retraining Notification Act. Among other things, the WARN Act requires companies to give workers facing a mass layoff at least 60 days’ notice of the layoff, or pay their wages for the 60 day period. 29 U.S.C. 2102.

3 The truck drivers were excluded because they would not agree to drop their WARN Act claims against the investor, who was a party to the settlement.