Friday, June 27th, 2014
In the confirmation of a Chapter 11 plan – as in life – it is often the little things that count.
Late last month, a Houston Bankruptcy Court provided helpful guidance on a very seldom-discussed, and often-overlooked, confirmation issue: Whether the reorganized debtor’s management make-up and structure is consistent with “public policy.” A copy of that decision is available here.
Barring an outright sale of assets, the confirmation of a plan of reorganization is typically the centerpiece of any Chapter 11 case. Chapter 11’s confirmation provisions – set forth in section 1129 – impose a broad variety of requirements on the debtor, all of which must be met or legitimately excused under recognized exceptions. Though many of these requirements have been extensively litigated and discussed by Bankruptcy Courts, several – including those pertaining to the governance and ownership structure of the reorganized debtor – have not enjoyed nearly as much review or discussion. Before the Bankruptcy Court in In re Digerati Technologies, Inc. was the issue of whether the debtor’s proposed management structure was appropriate in light of the Code’s requirement that post-confirmation management be appointed on terms “consistent . . . with public policy” under § 1129(a)(5)(A)(ii).
Digerati Technologies filed a Chapter 11 bankruptcy petition in May 2013. The plan submitted by Digerati proposed that the CEO and CFO of the company, who were also stockholders and creditors of Digerati, continue as the officers and directors of the reorganized debtor entity, positions which they had occupied within the two years prior to Digerati’s Chapter 11. Digerati was a publicly-traded holding company for an operational subsidiary. Thus, the plan’s proposed ongoing “officer and director” capacity also left Digerati’s CEO and CFO effectively in control of Digerati’s subsidiary.
Two Digerati stockholders objected to the plan on the grounds that Digerati’s pre-petition self-dealing established that continuation of Digerati’s pre-petition management was “not in the best interest of the estate, the creditors, the equity security holders and fail[ed] to satisfy public policy.” On the basis of the evidence adduced at the confirmation hearing, the Bankruptcy Court denied confirmation of Digerati’s plan for its inability to satisfy the requirements of section 1129(a)(5)(A)(ii). In the process, the Court formulated a nine-point checklist of essential factors relevant to determining whether appointment of an individual to serve as an officer of a reorganized debtor is consistent with public policy:
(1) Does the proposed plan, if confirmed, keep the debtor in existence as an ongoing company, or is the debtor extinguished?
(2) Is the debtor a publicly- or privately-held company?
(3) Does continued service of the individual(s) proposed for officers and directors perpetuate incompetence, lack of direction, inexperience, or affiliations with groups inimical to the best interests of the debtor?
(4) Does the continued service of the proposed individual(s) provide adequate representation of all creditors and equity security owners?
(5) Does the retention of the proposed individual(s) violate state law in any respect?
(6) Is each proposed individual a “disinterested person”?
(7) Is each proposed individual capable and competent to serve in the proposed capacity assigned to him or her?
(8) Are the salaries and benefits that the proposed individual(s) will receive reasonable based upon the size of the debtor’s operations, the complexity of these operations, and the revenues to be generated?
(9) Are there any new independent outside directors being appointed under the proposed plan?
Digerati Technologies‘ review of applicable case law further highlights the following:
- Such little case law as exists on section 1129(a)(5)(A)(ii) suggests that a consistent focus is on whether management and the board of directors is “disinterested.” Here, Digerati’s management was not.
- At least one decision reviewed by the Bankruptcy Court suggests that, where present management will continue, management’s track record is relevant: Though Bankruptcy Courts are often reluctant to “second-guess” a debtor’s management, they will not reward or perpetuate incompetence and gross mismanagement where it clearly exists.
- Still another decision reviewed by the Bankruptcy Court focused on management’s level of compensation, relative to its experience and the demands of managing the debtor.
- Finally, the Bankruptcy Court’s helpful list of summarized factors, digested from all of the decisions, offers practitioners a useful “road map” to consider in drafting a Chapter 11 plan.
The Digerati decision serves as a reminder that all of Chapter 11′s requirements, no matter how seemingly arcane, must be met prior to a plan’s confirmation. In hotly-contested matters, these requirements can often be a source of contention and – on occasion – tactical advantage. In addition to this important reminder, Digerati offers both debtors’ and creditors’ counsel a helpful checklist for assessing their relative positions on the question of the debtor’s proposed corporate governance.
Monday, July 1st, 2013
A very recent decision out of California’s Central District Bankruptcy Court highlights the boundaries of “commercial reason” and “diligence” where distressed asset sales are concerned.
In re 1617 Westcliff, LLC (Case No. 8:12-bk-19326-MW) involved the court-approved sale of the debtor’s real property under a purchase agreement in which the debtor and the purchaser agreed to use their “commercially reasonable and diligent efforts” to obtain the approval of the debtor’s mortgage lender for the assumption of the mortgage debt by the buyer. If the approval was not obtainable, the buyer had the right to terminate the transaction. The buyer also had the right to terminate the deal if the assumption required payment of more than a 1% assumption fee.
As is sometimes the case where due diligence remains while a deal is approved, things didn’t quite work out as planned. Unfortunately, the bank proved less cooperative than the parties had anticipated. More importantly, however, the buyer notified the debtor-seller 4 days prior to closing that it would not proceed with the transaction as structured, but might be willing to proceed if the transaction was framed as a tax deferred exchange.
The debtor was, understandably, somewhat less than receptive to restructuring the deal at the 11th hour. It insisted that the buyer proceed with the transaction as originally agreed and as approved by the court. In response, the buyer effectively walked away. The parties then made competing demands on the escrow company regarding the buyer’s $200,000 deposit, and filed cross-motions with Bankruptcy Judge Mark Wallace to enforce them.
In a brief, 11-page decision, Judge Wallace found that the buyer’s renunciation of the deal 4 days before closing was a material breach of the buyer’s obligation to use “commercially reasonable and diligent efforts” to obtain assumption consent:
The Purchase Agreement required [the buyer] to keep working in good faith for an assumption until the close of business on May 10, 2013, not to throw up its hands and to propose – at the eleventh hour – a wholesale restructuring of the purchase transaction in a manner completely foreign to the Purchase Agreement. On [the date of the proposal] there were still four days left to reach agreement with the Bank, but [the buyer] chose (five months into the deal) to abandon the assumption. It was not commercially reasonable nor was it diligent for [the buyer] to cease negotiations with the Bank relating to the assumption of the loan under these circumstances.
Judge Wallace found that due to this breach the debtor was entitled to retain the $200,000 deposit. He found further that the buyer, by offering to purchase the property in a restructured transaction, had failed to effectively terminate the deal. Instead, the buyer had indicated that it was “eager to keep the Purchase Agreement in force (on terms other than those agreed to).” Since the deal had not terminated, the buyer remained under a duty to continue to use reasonable efforts to obtain the bank’s consent. Its failure to do so caused the loss of its deposit.
Bill of sale sedan 1927 (Photo credit: dlofink)
The 1617 Westcliff decision (the unpublished slip copy is available here) serves as a reminder to buyer’s counsel of the unique nature of distressed asset purchases. The Bankruptcy Court which originally approved the purchase remains available and prepared to resolve any issues which may arise prior to closing, often at a fraction of what it would cost to get a Superior Court involved in connection with an unraveled private sale. And conditions and contingencies to the sale must be carefully drafted and observed. This applies even to common asset-purchase “boilerplate” such as “commercial reasonableness” and “diligence.”
Friday, June 14th, 2013
In a 23-page memorandum decision issued yesterday, New York Bankruptcy Judge Stewart Bernstein ruled that the debtor and a third party were parties to a master agreement that allowed the debtor to issue purchase orders that the counter-party was required to fill. Judge Bernstein held that the debtor could assume the master agreement but could reject individual purchase orders. The purchase orders were divisible from the master agreement.
English: Sketch of Richard Mentor Johnson freeing a man from debtors' prison. Johnson was an advocate of ending the practice of debt imprisonment throughout his political career. (Photo credit: Wikipedia)
The decision (available here) provides a thorough analysis of when – and under what circumstances – an executory agreement may be “divisible” into separate, individual agreements . . . which can then be selectively assumed or rejected by a debtor or trustee.
Monday, January 23rd, 2012
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Thanks to an active lobby in Congress, commercial landlords have historically enjoyed a number of lease protections under the Bankruptcy Code. Even so, those same landlords nevertheless face limits on the damages they can assert whenever a tenant elects to reject a commercial lease.
Section 502(b)(6) limits landlords’ lease rejection claims pursuant to a statutory formula, calculated as “the [non-accelerated] rent reserved by [the] lease . . . for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease . . . .”
This complicated and somewhat ambiguous language leaves some question as to whether or not the phrase “rent reserved for . . . 15 percent . . . of the remaining term of such lease” is a reference to time or to money: That is, does the specified 15 percent refer to the “rent reserved?” Or to the “remaining term?”
Many courts apply the formula with respect to the “rent reserved.” See. e.g., In re USinternetworking, Inc., 291 B.R. 378, 380 (Bankr.D.Md.2003) (citing In re Today’s Woman of Florida, Inc., 195 B.R. 506 (Bankr.M.D.Fl.1996); In re Gantos, 176 B.R. 793 (Bankr.W.D.Mich.1995); In re Financial News Network, Inc., 149 B.R. 348 (Bankr.S.D.N.Y.1993); In re Communicall Cent., Inc., 106 B.R. 540 (Bankr.N.D.Ill.1989); In re McLean Enter., Inc., 105 B.R. 928 (Bank.W.D.Mo.1989)). These courts calculate the amount of rent due over the remaining term of the lease and multiply that amount times 15%.
Other courts calculate lease rejection damages based on 15% of the “remaining term” of the lease. See, e.g., In re Iron–Oak Supply Corp., 169 B.R. 414, 419 n. 8 (Bankr.E.D.Cal.1994); In re Allegheny Intern., Inc., 145 B.R. 823 (W.D.Pa.1992); In re PPI Enterprises, Inc., 324 F.3d 197, 207 (3rd Cir.2003).
For more mathematically-minded readers, the differently-applied formulas appear as follows:
||Maximum Rejection Damages = (Rent x Remaining Term) x 0.15
||Maximum Rejection Damages = Rent x (Remaining Term x 0.15)
Earlier this month, a Colorado bankruptcy judge, addressing the issue for the first time in that state, sided with those courts who read the statutory 15% in terms of time:
“In practice, by reading the 15% limitation consistently with the remainder of § 502(b)(6)(A) as a reference to a period of time, any lease with a remaining term of 80 months or less is subject to a cap of one year of rent [i.e.,15% of 80 months equals 12 months] and any lease with a remaining term of 240 months or more will be subject to a cap of three years rent [i.e., 15% of 240 months equals 36 months]. Those in between are capped at the rent due for 15% of the remaining lease term.”
In re Shane Co., 2012 WL 12700 (Bkrtcy. D.Colo., January 4, 2012).
The decision also addresses a related question: To what “rent” should the formula apply – the contractual rent applicable for the term? Or the unpaid rent remaining after the landlord has mitigated its damages? Under the statute, “rents reserved” refers to contractual rents, and not to those remaining unpaid after the landlord has found a new tenant or otherwise mitigated.
Colorado Bankruptcy Judge Tallman’s decision, which cites a number of earlier cases on both sides of the formula, is available here.
Monday, December 19th, 2011
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Outside of bankruptcy, a creditor whose loan is secured by collateral typically has the right to payment in full when that collateral is sold – or, if the collateral is sold at an auction, to “credit bid” the face amount of the debt against the auction price of the collateral.
Inside bankruptcy, however, the right to “credit bid” is not always guaranteed.
In July, this blog predicted Supreme Court review of a Seventh Circuit case addressing the question of whether a bankruptcy court may confirm a plan of reorganization that proposes to sell substantially all of the debtor’s assets without permitting secured creditors to bid with credit. The courts of appeals are divided two to one over the question, with the Third and Fifth Circuits holding that creditors are not entitled to credit bid and the Seventh Circuit holding to the contrary (for a review of the more recent, Seventh Circuit decision, click here).
The question is one of great significance for commercial restructuring practice, with several bankruptcy law scholars suggesting the answer “holds billions of dollars in the balance.”
Apparently, the Supreme Court agrees. Last week, the justices granted review of the Seventh Circuit decision. For the petitioners’ brief, respondent’s opposition, and amicus briefs, click here.
Sunday, July 10th, 2011
One of the time-honored attractions of US bankruptcy practice is the set of tools provided for the purchase and sale of distressed firms, assets and real estate. In recent years, the so-called “363 sale” has been a favorite mechanism for such transactions – its popularity owing primarily to the speed with which they can be accomplished, as well as to the comparatively limited liability which follows the assets through such sales.
But “363 sales” have their limits: In such a sale, a secured creditor is permitted to “credit bid” against the assets securing its lien – often permitting that creditor to obtain a “blocking” position with respect to sale of the assets.
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Until very recently, many practitioners believed these “credit bid” protections also applied whenever assets were being sold through a Chapter 11 plan. In 2009 and again in 2010, however, the Fifth and Third Circuit Courts of Appeal held, respectively, that a sale through a Chapter 11 Plan didn’t require credit bidding and could be approved over the objection of a secured lender, so long as the lienholder received the “indubitable equivalent” of its interest in the assets (for more on the meaning of “indubitable equivalence,” see this recent post).
Lenders, understandably concerned about the implications of this rule for their bargaining positions vis a vis their collateral in bankruptcy, were relieved when, about 10 days ago, the Seventh Circuit Court of Appeals respectfully disagreed – and held that “credit bidding” protections still apply whenever a sale is proposed through a Chapter 11 Plan.
The Circuit’s decision in In re River Road Hotel Partners (available here) sets up a split in the circuits – and the possibility of Supreme Court review. In the meanwhile, lenders may rest a little easier, at least in the Seventh Circuit.
Or can they?
It has been observed that the Seventh Circuit’s River Road Hotel Partners decision and the Third Circuit’s earlier decision both involved competitive auctions – i.e., bidding – in which the only “bid” not permitted was the lender’s credit bid. The Fifth Circuit’s earlier decision, however, involved a sale following a judicial valuation of the collateral at issue.
Is it possible to accomplish a sale without credit bidding – even in the Seventh Circuit – so long as the sale does not involve an auction, and is instead preceded by a judicial valuation?
Wednesday, July 6th, 2011
Guest-blogger Ray Clark of Valcor (whose prior posts appear here, here, and here) has recently completed a succinct but helpful piece on the valuation of firms in Chapter 11.
Ray’s piece focuses on the supportability of assumptions underlying valuations. As he notes:
Over the last year, there have been a rash of bankruptcy cases and related lawsuits involving challenges to both debtor and creditor financial experts, wherein opposing parties successfully attacked the relevance and reliability of valuation evidence. In a number of cases, even traditional methodologies were disqualified for lack of supportable assumptions, which severely impacted recoveries for various stakeholders.
The piece is here.
Monday, June 20th, 2011
A prior post on this blog featured an article highlighting some of the basic principles from Shari’a law which apply to insolvent individuals and businesses.
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Another, more recent article explores the intriguing question of what happens when an investment structured according to Shari’a law needs to be restructured in a non-Shari’a forum – such as a United States Bankruptcy Court. The University of Pennsylvania’s Michael J.T. McMillen uses the recent Chapter 11 filing of In re East Cameron Partners, LP as a case study to highlight some of the issues.
According to McMillen:
The issues to be considered [in connection with efforts to introduce Shariah principles into secular bankruptcy and insolvency regimes throughout the world] are legion. Starting at the level of fundamental principle, will the contemplated regime provide for reorganization along the lines of Chapter 11 systems, or will liquidation be the essential thrust of the system? If, in line with international trends, the system will incorporate reorganization concepts and principles, what is the Sharīʿah basis for this regime? Even the fundamental questions are daunting. For example, consideration will need to be given to debt rescheduling concepts, debt forgiveness concepts, delayed debt payment concepts, equity conversion concepts, asset sale concepts, and differential equity conceptions. There will have to be consideration of whether voluntary bankruptcies can and will be permissible. And after agreement is reached on the basic nature and parameters of the system, the long road of discovery and elucidation of specific Sharīʿah principles will have to be addressed. That undertaking will wind through a great deal of new territory, from the Sharīʿah perspective, and will entail a comparative laws analyses, and a systemic comparison, unlike any in history.
The article is available here.
Tuesday, June 7th, 2011
Chapter 11 practice – like so many other professional service specialties – is regrettably jargon-laden. Businesses that need to get their financial affairs in order “enter restructuring.” Those that must re-negotiate their debt obligations attempt to “de-leverage.” And those facing resistance in doing so seek the aid of Bankruptcy Courts in “cramming down” their plans over creditor opposition.
Likewise, the Bankruptcy Code – and, consequently, Bankruptcy Courts – employ what can seem an entirely separate vocabulary for describing the means by which a successful “cram-down” is achieved. One such means involves providing the secured creditor with something which equals the value of its secured claim: If the secured creditor holds a security interest in the debtor’s apple, for example, the debtor may simply give the creditor the apple – or may even attempt to replace the creditor’s interest in the apple with a similar interest in the debtor’s orange (provided, of course, that the orange is worth as much as the original apple).
The concept of replacing something of value belonging to a secured creditor with something else of equivalent value is known in “bankruptcy-ese” as providing the creditor with the “indubitable equivalent” of its claim – and it is a concept employed perhaps most frequently in cases involving real estate assets (though “indubitable equivalence” is not limited to interests in real estate). For this reason, plans employing this concept in the real estate context are sometimes referred to as “dirt for debt” plans.
A recent bankruptcy decision out of Georgia’s Northern District issued earlier this year illustrates the challenges of “dirt for debt” reorganizations based on the concept of “indubitable equivalence.”
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Green Hobson Riddle, Jr., a Georgia businessman, farmer, and real estate investor, sought protection in Chapter 11 after economic difficulties left him embroiled in litigation and unable to service his obligations.
Mr. Riddle’s proposed plan of reorganization, initially opposed by a number of his creditors, went through five iterations until only one objecting creditor – Northside Bank – remained. Northside Bank held a first-priority secured claim worth approximately $907,000 secured by approximately 36 acres of real property generally referred to as the “Highway 411/Dodd Blvd Property,” and a second-priority claim secured by a condominium unit generally referred to as the “Heritage Square Property.” It also held a judgment lien recorded against Mr. Riddle in Floyd County, Georgia.
A key feature of Mr. Riddle’s plan involved freeing up the Heritage Square Property in order refinance one of his companies, thereby generating additional payments for his creditors. To do this, Mr. Riddle proposed to give Northside Bank his Highway 411/Dodd Blvd Property as the “indubitable equivalent,” and in satisfaction, of all of Northside’s claims.
Northside Bank objected to this treatment, respectfully disagreeing with Mr. Riddle’s idea of “indubitable equivalence.” Bankruptcy Judge Paul Bonapfel took evidence on the issue and – in a brief, 9-page decision – found that Mr. Riddle had the better end of the argument.
Judge Bonapfel’s decision highlights several key features of “indubitable equivalent” plans:
- The importance of valuation. The real challenge of an “indubitable equivalence” plan is not its vocabulary. It is valuing the property which will be given to the creditor so as to demonstrate that value is “too evident to be doubted.” As anyone familiar with valuation work is aware, this is far more easily said than done. Valuation becomes especially important where the debtor is proposing to give the creditor something less than all of the collateral securing the creditor’s claim, as Mr. Riddle did in his case. In such circumstances, the valuation must be very conservative – a consideration Judge Bonapfel and other courts recognized.
- The importance of evidentiary standards. Closely related to the idea of being “too evident to be doubted” is the question of what evidentiary standards apply to the valuation. Some courts have held that because the property’s value must be “too evident to be doubted,” the evidence of value must be “clear and convincing” (the civil equivalent of “beyond a reasonable doubt”). More recent cases, however, weigh the “preponderance of evidence” (i.e., does the evidence indicate something more than a 50% probability that the property is worth what it’s claimed to be?). As one court (confusingly) put it: “The level of proof to show ‘indubitably’ is not raised merely by the use of the word ‘indubitable.’” Rather than require more or better evidence, many courts seem to focus instead on the conservative nature of the valuation and its assumptions.
- The importance of a legitimate reorganization purpose. Again, where a creditor is receiving something less than the entirety of its collateral as the “indubitable equivalent” of its claim, it is up to the debtor to show that such treatment is for the good of all the creditors – and not merely to disadvantage the creditor in question. Judge Bonapfel put this issue front and center when he noted, in Mr. Riddle’s case:
[I]t is important to recognize that § 1129(b), the “cram-down” subsection, “provides only a minimum requirement for confirmation … so a court may decide that a plan is not fair and equitable even if it is in technical compliance with the Code’s requirements.” E.g., Atlanta Southern Business Park, 173 B.R. at 448. In this regard, it could be inequitable to conclude that a plan provision such as the one under consideration here is “fair and equitable,” if the provision serves no reorganization purpose. See Freymiller Trucking, 190 B.R. at 916. But in this case, the evidence shows that elimination of the Bank’s lien on other collateral is necessary for the reorganization of the Debtor and his ability to deal with all of the claims of other creditors who have accepted the Plan. No evidence demonstrates that the Plan is inequitable or unfair
In re Riddle, 444 B.R. 681, 686 (Bankr. N.D. Ga. 2011).