Archive for May, 2011
Tuesday, May 31st, 2011
Many insolvency practitioners are familiar with the “high-asset” individual debtor – often a business owner or owner of rental property or other significant business and personal assets – whose financial problems are too large for standard “individual debtor” treatment.
Such debtors are a prominent feature of commercial insolvency practice in California and other western states. These individuals typically have obligations matching the size of their assets: Their restructuring needs are too large for treatment through an “individual” Chapter 13 reorganization, and must instead be handled through the “business” reorganization provisions of a Chapter 11.
When Congress amended the Bankruptcy Code in 2005, it recognized the need of some individuals to use the reorganization provisions of Chapter 11. It provided certain amendments to Chapter 11 which parallel the “individual” reorganzation provisions of Chapter 13.
But certain “individual” reorganization concepts do not translate clearly into Chapter 11’s “business” provisions. Among the most troublesome of these is the question of whether an individual debtor can reorganize by paying objecting unsecured creditors less than 100% while continuing to retain existing property or assets for him- or herself.
In Chapter 13, the answer to this question is “yes.” But in Chapter 11 – at least until 2005 – the answer has historically been “no.” This is because Chapter 11, oriented as it is toward business reorganization, prohibits a reorganizing debtor from retaining any property while an objecting class of unsecured creditors is paid something less than the entirety of its claims. Known as the “absolute priority rule,” this prohibition has been a mainstay of Chapter 11 business practice for decades.
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In 2005, Congress amended Chapter 11’s “absolute priority rule” provisions to provide that despite the “absolute priority” rule, individual Chapter 11 debtors could nevertheless retain certain types of property, even when objecting unsecured creditors are paid less than 100%. For instance, an individual debtor may retain certain wages and earnings earned after the commencement of the debtor’s case. But can the individual debtor retain other types of property (for example, a rental property or closely held stock in a business), while paying objecting creditors less than 100%?
Congress’ “absolute priority rule” amendments for individual debtors are ambiguous – as is the language of a section which expands the definition of “property” included within the individual Chapter 11 debtor’s estate (paralleling similar treatment of individual Chapter 13 debtors). As a result, Bankruptcy Courts are split on the question of whether or not the “absolute priority rule” applies to individual Chapter 11 debtors.
Until very recently, the Central District of California – one of the nation’s largest, and a frequent filing destination for individual Chapter 11 cases – had been silent on the issue. This month, however, Judge Theodor Albert of Santa Ana joined a growing number of courts which conclude that Congress’ 2005 “absolute priority rule” amendments apply only to individual wages and earnings, and that individuals cannot retain other types of property where objecting creditors are paid less than 100%.
In a careful, 13-page decision issued for publication, Judge Albert collected and examined cases on both sides of this question and concluded:
After BAPCPA, the debtor facing opposition of any one unsecured creditor must devote 5 years worth of “projected disposable income,” at a minimum (or longer if the plan is longer). But [the] debtor is not compelled to give also his additional earnings or after-acquired property net of living expenses beyond five years unless the plan is proposed for a period longer than five years. But there is no compelling reason to also conclude that prepetition property need not be pledged under the plan as the price for cram down, just as it has always been.
Judge Albert’s decision joins several other very recent ones going the same direction, including In re Walsh, 2011 WL 867046 (Bkrtcy.D.Mass., Judge Hillman); In re Stephens, 2011 WL 719485 (Bkrtcy.S.D.Tex., Judge Paul); and In re Draiman, 2011 WL 1486128 (Bkrtcy.N.D.Ill., Judge Squires).
Monday, May 16th, 2011
When a retailer becomes insolvent, suppliers or vendors who have recently provided goods on credit typically have the ability to assert “reclamation” rights for the return of those goods. Retailers may respond to these rights by seeking the protection the federal bankruptcy laws – and, in particular, the automatic stay.
When a retailer files for bankruptcy while holding goods which are subject to creditors’ “reclamation” rights, what should “reclamation” creditors do?
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The Bankruptcy Code itself provides some protection for “reclamation” creditors by providing such creditors additional time in which to assert their claims, and by affording administrative priority for a certain portion for such claims even when they are not formally asserted.
But is merely asserting a reclamation claim under the Bankruptcy Code sufficient to protect a supplier once a retailer is in bankruptcy? A recent appellate decision from Virginia’s Eastern District serves as a reminder that merely speaking up about a reclamation claim isn’t enough.
When Circuit City sought bankruptcy protection in 2009, Paramount Home Entertainment was stuck with the tab for more than $11 million in goods. Though it didn’t object to blanket liens on Circuit City’s merchandise which came with the retailer’s debtor-in-possession financing, and stood by quietly while Circuit City later liquidated its merchandise throug a going-out-of-business sale, Paramount did file a timely reclamation demand as required by the Bankruptcy Code. It also complied with what it understood to be the Bankruptcy Court’s orders regarding administrative procedures for processing its reclamation claims in Circuit City’s case. It was therefore unpleasantly surprised when Circuit City objected to Paramount’s reclamation claim – and when the Bankruptcy Court sustained that objection – on the grounds that Paramount hadn’t done enough to establish or preserve its reclamation rights.
Paramount appealed the Bankruptcy Court’s ruling, claiming that it complied with what it understood to have been the Bankruptcy Court’s administrative procedures for processing reclamation claims. Paramount argued that to have done more (i.e., to have sought relief from the automatic stay to take back its goods or commenced litigation to preserve its rights to the proceeds of such goods) would have disrupted Circuit City’s bankruptcy case.
In affirming the Bankruptcy Court, US District Judge James Spencer held that the Bankruptcy Code, while protecting a creditor’s reclamation rights, doesn’t impose them on the debtor. Instead, a reclaiming creditor must take further steps consistent with the Bankruptcy Code and state law to preserve the remedies which reclamation claims afford. Merely asserting a reclamation claim under the Bankruptcy Code – or under a Bankruptcy Court’s administrative procedure – isn’t enough:
“Filing a demand, but then doing little else in the end likely creates more litigation and pressure on the Bankruptcy Court than seeking relief from the automatic stay. . . or seeking a [temporary restraining order] or initiating an adversary proceeding. In this case, Paramount filed its reclamation demand, but then failed to seek court intervention to perfect that right. As the Bankruptcy Court held, the Bankruptcy Code is not self-executing. Although [the Bankruptcy Code] does not explicitly state that a reclaiming seller must seek judicial intervention, that statute does not exist in a vacuum. The mandatory stay as well as the other sections of the Bankruptcy Code that protect and enforce the hierarchy of creditors create a statutory scheme that cannot be overlooked. Once Paramount learned that Circuit City planned to use the goods in connection with the post-petition [debtor-in-possession financing], it should have objected. It didn’t. To make matters worse, Paramount then failed to object to Circuit City’s liquidation of its entire inventory as part of the closing [going-out-of-business] [s]ales.”
Let the seller beware.
Tuesday, May 10th, 2011
Most insolvency practitioners are familiar with the fighting which often ensues when creditors jockey for position over a troubled firm’s capital structure. From Kansas, a recent decision issued in February highlights the standards which apply to claims that a senior creditor’s claim ought to be “subordinated” to those of more junior creditors or equity-holders.
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QuVIS, Inc. (“QuVIS”), a provider of digital motion imaging technology solutions in a number of industries, found itself the target of an involuntary Chapter 7 filing in 2oo9. The company converted its case to one under Chapter 11 and thereafter sought to reorganize its affairs.
QuVIS ’ debt was structured in an unusual way. When presented with some growth opportunities in the early 2000’s, the company issued secured notes under a credit agreement that capped its lending at $30,000,000. “Investors” acquired these notes for cash and received a security interest, evidenced by a UCC-1 recorded in 2002. One of QuVIS’ “investors” was Seacoast Capital Partners II, L.P. (“Seacoast”), a Small Business Investment Company (“SBIC”) licensed by the United States Small Business Administration. Between 2005 and 2007, Seacoast lent approximately $4.25 million through a series of three separate promissory notes issued by QuVIS. In 2006, and consistent with the purposes of the Small Business Investment Act of 1958, under which licensed SBICs are expected to provide management support to the small business ventures in which they invest, Seacoast’s Managing Director, Eben S. Moulton (“Moulton”), was designated as an outside director to QuVIS’ board.
In 2007, it came to Seacoast’s attention that, despite its belief to the contrary, a UCC-1 had never been filed on Seacoast’s behalf regarding its loans to QuVIS. Nor had the earlier (and now lapsed) UCC-1 filed regarding QuVIS’ other “investors” ever been modified to reflect Seacoast’s participation in the company’s loan structure. Seacoast immediately filed a UCC-1 on its own behalf in order to protect its position. Some time after QuVIS found itself in Chapter 11 in 2009, the Committee of Unsecured Creditors (and other, less alert “investors”) sought to subordinate Seacoast’s position.
The Committee’s argument was based exclusively on 11 U.S.C. § 510(c), which provides, in pertinent part:
Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may— (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim …
“Equitable” subordination is based on the idea of “inequitable” conduct – such as fraud, illegality, or breach of fiduciary duties. Where an “insider” or a fiduciary of the debtor is the target of a subordination claim, however, the party seeking subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider.
Seacoast sought summary judgment denying the subordination claim. In granting Seacoast’s request, Judge Nugent of the Kansas Bankruptcy Court distinguished Seacoast’s Managing Director from Seacoast, finding that though Moulton was indeed an “insider,” Seacoast was not. Therefore, Seacoast’s claim was not subject to subordination for any “unfair conduct” which might be attributable to Moulton. To that end, Judge Nugent also appeared to go to some lengths to demostrate that Mr. Moulton’s conduct was not in any way “unfair” or detrimental to the interests of other creditors.
Subordination claims are highly fact-specific. With this in mind, the facts of the QuVIS decision afford instructive reading for lenders whose lending arrangements may entitle them to designate one of the debtor’s directors.
Monday, May 2nd, 2011
From Florida’s Northern District comes a cautionary tale of what can go wrong when distressed real estate requires restructuring. A copy of the decision is available here.
Davis Heritage GP Holdings, LLC (“Debtor”) was a family-owned LLC formed in 2002 to “hold, develop, and sell condominium development properties in Mississippi and Louisiana.” Its sole assets were membership interests in a series of single-member “middle-tier” LLC’s, which themselves held no assets except for interests in a series of single-member “lower-tier” LLC’s – each formed to hold separate parcels of real property.
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In December 2010, the Debtor sought protection under Chapter 11, ostensibly to deal with the adverse effects of a judgment entered against it. None of the “middle-tier” or “lower-tier” LLC’s had sought bankruptcy protection. Despite their separate, three-tier structure, the Debtor’s management adminstered them as if they were a single business enterprise. Until very shortly before the Debtor’s Chapter 11 filing, the expenses and income of the enterprise were processed through the Debtor’s bank account. In fact, none of the “lower tier” LLCs held bank accounts in their names until after meeting with the Debtor’s bankruptcy counsel. From at least January 2007 through August 2010, the Debtor’s bank accounts contained several millions of dollars, at one time exceeding $22 million. The Debtor’s principals have used the Debtor’s accounts freely, to receive and disburse money to and from whomever the principals chose at any given time. Despite this fact, the Debtor only disclosed one bank account in its Schedule B and did not disclose, but rather affirmatively denied, making any transfers to insiders within one year pre-petition.
Finally, the Debtor never disclosed the properties owned by the “lower tier” LLCs (or their income and expenses) in its Schedules or any other papers filed with the Court. Nevertheless, the Debtor’s Plan is based entirely upon the liquidation of some of those very properties.
The Debtor’s difficulties arose out of the purchase of land and subsequent construction of the 21-story “Beau View” luxury condominium tower in Biloxi, Mississippi. In exchange for the land, the Debtor had executed two junior-priority promissory notes to the seller, and obtained a senior-priority acquisition loan from Wells Fargo. The Debtor then financed construction with a separate loan – also from Wells Fargo – and completed the tower.
Though it made considerable progress selling condominium units and repaying Wells Fargo’s construction loan, the Debtor made only sporadic payments on its purchase notes to the seller. Eventually, the seller obtained a judgment on the note in Mississippi, then domesticated that note in Florida and sought to foreclose on all of the debtor’s membership interests in the “middle tier” LLC’s.
To avoid foreclosure on its “middle tier” LLC interests, the Debtor made a $200,000 payment in exchange for 60 days’ forbearance – then, promptly, sought Chapter 11 protection. At the time of filing, the Wells Fargo construction loan and acquisition loans were current. The Debtor had permitted two mortgage loan actions filed against two of the “lower tier” LLC’s by Sun Trust Bank to go to default judgment.
Very shortly after filing, the seller of the Biloxi property sought relief from stay to continue its foreclosure on the “middle tier” LLC interests – or, in the alternative, dismissal of the Debtor’s Chapter 11 case. The Debtor countered with an emergency motion for the sale of certain assets – and, a day prior to the hearing on the stay relief motion, a Chapter 11 Plan.
In reviewing the evidence and determining that dismissal of the Debtor’s case was appropriate, the court observed:
[W]hen determining whether to grant stay relief for cause or dismiss a chapter 11 case, . . . a number of factors may evidence an “intent to abuse the judicial process and the purposes of the reorganizationprovisions” . . . . . Those factors include:
a. the debtor has only one asset, the property;
b. the debtor has few unsecured creditors whose claims are small in relation to the claims of the secured creditors;
c. the debtor has few employees;
d. the property is the subject of a foreclosure action as a result of arrearages of the debt;
e. the debtor’s financial problems involve essentially a dispute between the debtor and the secured creditors which can be resolved in the pending state court action; and
f. the timing of the debtor’s filing evidences an intent to delay or frustrate the legitimate efforts of the debtor’s secured creditors to enforce their rights . . . . Once a court finds that the above factors are present, “[t]he possibility of a successful reorganization cannot transform a bad faith filing into one undertaken in good faith.” All of the [above-referenced] bad faith factors are present in this case, as are additional factors indicating bad faith. . . . The Debtor’s financial problems involve a two-party dispute between it and [the judgment creditor] that can be resolved in state court. Also, the timing of this petition shows an intent to delay or frustrate the legitimate collections efforts of [the judgment creditor]—who is the only real direct creditor of the Debtor . . . .
The court then went on to explain why the essence of the Debtor’s Chapter 11 plan – essentially, an effort to pay Wells Fargo and Sun Trust at the expense of the seller of the Biloxi property – was a “sort of reverse marshalling” inappropriate for Chapter 11 under the facts of this case:
Unlike the traditional single asset case where a main creditor is stayed from collecting out of the debtor’s only asset, this case involves a three-tier corporate structure created by the Debtor and its principals whereby [the Biloxi land seller and judgment creditor] is the only creditor that is adversely affected by the automatic stay. See 11 U.S.C. § 362(a). All other creditors of the Debtor with claims to the properties owned by the “lower tier” LLCs are free to pursue those claims through foreclosure on those real properties, thereby diminishing the value of the Debtor’s only asset (membership in the “middle tier” LLCs), beyond the control of [the judgment creditor]. This fact is illustrated by Sun Trust’s pursuit of its post-petition mortgage foreclosure litigation against [two “lower-tier” LLC] properties, which has been unopposed by the Debtor and its principals. Similarly, [the Debtor’s] testimony states that in spite of the bankruptcy, and the way the enterprise has historically been managed, all of the “lower tier” LLCs are doing business as usual, renting units, offering units for sale, selling property, signing contracts for sale, and paying their bills. After a history of treating all the entities as a single corporate enterprise, the Debtor now takes the position that it lacks control of its wholly-owned subsidiaries and only it, the Debtor, is subject to the rules and constraints of Chapter 11.
In reviewing Chapter 11 cases alleged to have been filed in bad faith, courts may look to all of the evidence and the totality of the circumstances to determine what is really happening, and the true intent and purpose behind the filing. . . . Here, the true intent and effect of this case and the Debtor’s Plan are plain: the Debtor’s insiders seek to donate assets subject to [the judgment creditor’s] judgment lien to Sun Trust and Wells Fargo in order to shield their own assets and money from those creditors. This scheme, memorialized in the Debtor’s Chapter 11 Plan, amounts to a kind of reverse marshaling. The Plan takes the only assets available to [the judgment creditor] (and subject to its levy), property owned not by the Debtor but by the “lower tier” LLCs, and shifts that property to Sun Trust and Wells Fargo, creditors with claims [are] secured by other assets owned by the insiders. This Plan reduces the amount that [the judgment creditor] may collect and simultaneously reduces the guarantors’/insiders’ liability to Sun Trust and Wells Fargo.
The court’s discussion of what constitutes “bad faith” in filing a Chapter 11 case is instructive, as is its analysis of how “bankruptcy remote” entities can be treated in the absence of related Chapter 11 filings.