Litigation and Avoidance Actions
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Litigation and Avoidance Actions
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.
Bankruptcy and Insolvency News and Analysis – Week of June 16 – 20, 2014:
Secured Lending and Claims:
Executory Contracts and Intellectual Property:
Jurisdiction and Bellingham Analysis:
And Still More:
Some of the week’s top bankruptcy and restructuring headlines:
And Still More:
An old and well-known proverb warns: “It is better to remain silent and be thought a fool than to speak and remove all doubt.” Over against this timeless advice, however, a very recent Second Circuit offers more specific guidance for creditors of a bankrupt debtor:
“The squeaky wheel gets the grease.”
In Adelphia Recovery Trust v. Goldman, Sachs & Co., et al., a creditors’ trust established to recover transfers under Adelphia Communications’ confirmed Chapter 11 plan of reorganization sought unsuccessfully to recover “margin call” payments made to Goldman, Sachs & Co. The Second Circuit Court of Appeals agreed with the lower courts in determining that the commingled funds used to make the payments had been taken from a “concentration account” scheduled as property of one of Adelphia Communications’ subsidiaries; consequently the funds were not Adelphia Communications’ to recover, and the trust could not belatedly be re-characterized them as such. A copy of the decision is available here.
In 2002, Adelphia Communications Corporation and related subsidiaries entered Chapter 11 bankruptcy following the disclosure of fraudulently concealed, off-balance sheet debt on Adelphia Communications’ books. The companies were ultimately liquidated and their secured creditors paid in full. In addition, all of the unsecured debt of Adelphia Communications’ subsidiaries was paid in full, with interest, and Adelphia Communications’ general creditors were paid in part. Under Adelphia Communications’ Chapter 11 Plan (confirmed in early 2007 – about 2½ years after the company entered bankruptcy), those same unsecured creditors were to receive the proceeds of the Adelphia Recovery Trust. The Trust was charged with recovery of, among other things, fraudulent transfers made by Adelphia Communications prior to the commencement of the Adelphia cases.
It was not until 2009 that the Trust identified as funds belonging to Adelphia Communications certain commingled funds held in a “concentration account” of one of Adelphia Communications’ subsidiaries. Those funds, it was alleged, were used to cover “margin calls” made by Goldman Sachs & Co. in connection with margin loans previously made to Adelphia Communications’ founders and primary stockholders and collateralized by Adelphia Communications stock. Goldman Sachs had issued the margin calls as the value of Adelphia Commutations stock declined amidst revelations of Adelphia Communications’ off-balance sheet debt.
Goldman Sachs sought, and obtained, summary judgment in the District Court on the basis that the funds in question had been paid by Adelphia Communications’ subsidiary – and not by Adelphia Communications. The Recovery Trust appealed, arguing that the funds in question were, in fact, owned by Adelphia Communications. The Second Circuit Court of Appeals disagreed and affirmed the District Court’s ruling.
The Second Circuit explained that the commencement of a bankruptcy case triggers a number of requirements for a debtor. Among these is the mandatory requirement that the debtor must submit a schedule of all its interests in any property, wherever situated. Ultimately, the debtor must propose a plan which distributes this property within a defined priority scheme, and in the manner most advantageous for the greatest number of creditors.
The plan must also designate classes of claims and classes of interests and specify how the debtor will attend to these classes. Once the relevant parties, including the creditors, approve the debtor’s plan, the court confirms the plan and binds all parties. It is therefore crucial that all claims and interests must be settled before the plan is finalized and within the time frame allotted by the Bankruptcy Code.
The Second Circuit found that the commingled funds sought by the Adelphia Recovery Trust were claimed by one of Adelphia Communications’ subsidiaries during the bankruptcy proceeding. Those claims were asserted without objection from Adelphia Communications’ creditors. The Trust’s subsequent claim to those assets in a subsequent proceeding was therefore inconsistent with creditors’ earlier stance. Under the doctrine of judicial estoppel, parties (and their successors) cannot be allowed to change their positions at their convenience. Consistent with this doctrine, disturbing claims and distributions at such an advanced stage of the proceedings to address the creditors’ changed position would undermine the administration of Adelphia Communications’ and its subsidiaries’ related cases. It would also threaten the integrity and stability of the bankruptcy process by encouraging parties to alter their positions at their whim, as and whenever convenient.
Adelphia Recovery Trust highlights three important realities of bankruptcy practice:
- First, the filing of a debtor’s bankruptcy schedules is more than a merely a perfunctory act. It is a preliminary statement, made to the best of the debtor’s belief and under penalty of perjury, of the debtor’s assets (including all of its ownership interests in any property, anywhere) and its liabilities. Ultimately, creditors and other interested parties – and the court itself – rely upon those schedules in determining the debtor’s compliance with the reorganization requirements of Bankruptcy Code section 1129.
– Second, related debtors are commonly related in much more than name or ownership. In addition to inter-company transfers and claims between debtors, it is common for such enterprises to separate functional asset ownership from legal asset ownership. This distinction may be an important one for various groups of creditors seeking additional sources of recovery.
– Third (and finally), creditors – and the professionals who represent them – should thoroughly investigate any and all “control,” commingling, and other aspects of the relationships between related debtors which may give rise to indirect ownership of assets. Where doubt or conflicting claims exist as to specific assets, it is important for parties with competing claims to reserve their rights early and clearly – thereby making themselves the “squeaky wheel” in the event of any future “grease.”
It often happens that, upon commencement of a bankruptcy case, property which is part of the debtor’s bankruptcy estate is not held or controlled by the trustee (or debtor-in-possession). To recover that property, Bankruptcy Code section 542 permits the trustee to seek its turnover from the party holding it.
Until very recently, Ninth Circuit law left unanswered the question of whether a party who at one point may have held estate property could remain liable for its turnover even after that property had been transferred elsewhere. Shapiro v. Henson answers that question in the affirmative.
In a case of first impression, the Ninth Circuit Court of Appeals expanded the trustee’s ability to seek turnover of estate property. In its analysis, the Court took cues from Section 542’s language which suggests that possession of property may not necessarily be mandatory for turnover. To support its interpretation of S. 542(a), the Court also reviewed turnover practices before the Bankruptcy Code was promulgated. Among these, the Court noted that ‘plenary proceedings’ did not require the present possession of property. The pre-Code possibility of a turnover of property of the bankruptcy estate without possession strengthened the Court’s similar reading of the present statute.
The Ninth Circuit Court also examined Section 550(a), which empowers trustees to recover from initial and intermediate transferees. Under the Ninth Circuit’s analysis, this section would be redundant if “present possession” was always a requirement for such recovery. Further, if possession or property was a must for seeking the property’s turnover, merely transferring the property in question would be an easy way to avoid the trustee’s reach. Finally, the Court considered (but rejected) the analysis behind Eighth Circuit rulings, which designate possession as a pre-requisite to turnover recovery.
In a nutshell Shapiro v. Henson‘s result means:
Shapiro v. Henson protects bankruptcy trustees from having to “chase” estate property through multiple transferees. But it does so at the cost of an added level of risk imposed on those initial holders of estate property who may not have notice of the debtor’s bankruptcy – or may be unable to prevent transfer of the property.
This summer was a very busy one for the Ninth Circuit’s bankruptcy appellate docket:
In Quin v. County of Kauai Department of Transportation, the Ninth Circuit reviewed the effect of a debtor’s failure to list a pending lawsuit in its schedules. The rule in such cases is that claims not listed are lost: “Conceal your claims; get rid of your creditors on the cheap, and start over with a bundle of rights. This is a palpable fraud that the court will not tolerate, even passively.” As an application of the doctrine of “judicial estoppel” (the doctrine that litigants shouldn’t be able to switch positions when doing so would be prejudicial to another litigant), the rule is designed to ensure the integrity of the judicial process.
But what happens when the failure to list claims is accidental (i.e., due to simple “inadvertence” or “mistake”)? “Consider, for example, a litigant who is not represented by counsel or who speaks English as a second language and fails to include a claim on her bankruptcy schedule because she does not understand that she was required to do so.”
Other circuits have addressed this question with yet another simple rule: If the debtor knew of the existence of a claim, but didn’t list it, an intent to fraudulently conceal the claim is automatically inferred.
But a three-judge panel in Quin declined to follow this rule. Emphasizing the “discretionary” nature of judicial estoppel, the Ninth Circuit panel instead noted that while the circumstances indicating “inadvertence” or “mistake” have never, in fact, been delineated in this Circuit, “[a] key factor is that Plaintiff reopened her bankruptcy proceedings and filed amended bankruptcy schedules that properly listed this claim as an asset.”
A number of other decisions focused on non-dischargeability:
Willms v. Sanderson. A bankruptcy court erred by (i) sua sponte extending the time in which to file a non-dischargeability complaint after the deadline had already passed; and (ii) doing so without either a showing or a finding of cause. On appeal, the District Court affirmed the bankruptcy court. But the Ninth Circuit panel remanded with instructions to dismiss.
In re Perle. The Ninth Circuit panel affirmed the Bankruptcy Appellate Panel’s ruling that an arbitration debt was nondischargeable in bankruptcy under 11 U.S.C. §§ 523(a)(3) and 523(a)(6). The panel held that the creditor’s challenge to the dischargeability of the debt was not filed within 60 days of the first date set for the creditors meeting but nonetheless was timely because the chapter 7 debtor did not adequately identify the debt on his Schedule E, and the creditor did not have notice or actual knowledge of the bankruptcy. The panel held that the creditor’s lawyer’s knowledge could not be imputed to the creditor on an agency theory when the lawyer learned of the bankruptcy during his representation of another client and after the completion of his representation of the creditor in relation to the debt.
Carpenters Pension Trust Fund v. Moxley. Distinguishing Stern v. Marshall, 131 S. Ct. 2594 (2011), a Ninth Circuit panel held that the bankruptcy court had jurisdiction to adjudicate the dischargeability of the pension fund’s claim against the contractor because a dischargeability determination is central to federal bankruptcy proceedings and therefore constitutes a public rights dispute that a bankruptcy court may decide. The contractor was subject to withdrawal liability under the Employee Retirement Income Security Act because he continued doing work covered by the collective bargaining agreement after it expired. The panel held that this debt was dischargeable because it did not qualify as a debt created via defalcation by a fiduciary under 11 U.S.C. § 523(a)(4). The panel concluded that the contractor was not a fiduciary of the fund pursuant to ERISA because he had nothing to do with the fund’s administration or investment policy and did not exercise control respecting disposition of its assets. The panel held that the fund’s assets did not include the unpaid withdrawal liability. It reasoned that the withdrawal liability was a statutory obligation, and was different from unpaid contributions arising from contractual obligations under the collective bargaining agreement. The panel held that the contractor’s failure to challenge the withdrawal liability amount in arbitration did not act as a waiver of his right to discharge the debt.
Finally, a decision released today regarding post-confirmation jurisdiction over tax disputes:
In re Wilshire Courtyard. The Ninth Circuit panel held that the bankruptcy court had jurisdiction to reopen a bankruptcy proceeding to consider the tax consequences of the reorganization, pursuant to a chapter 11 plan, of the debtor, a general partnership that owned two commercial buildings in Los Angeles, into a limited liability company with a 1% ownership interest in the property. As part of the bankruptcy, over $200 million of partnership debt was forgiven, and the individual partners reported cancellation of debt income on their tax returns. The California Franchise Tax Board sought to assess $13 million in unpaid income taxes on the partners, characterizing the transaction as a disguised sale and the reported cancellation of debt income as capital gains. The reorganized LLC asked the bankruptcy court to reopen the case. The panel agreed with the BAP that the bankruptcy court had neither “arising under” nor “arising in” subject matter jurisdiction over the dispute. But it disagreed with the BAP’s holding that the bankruptcy court lacked post-confirmation “related to” jurisdiction. The panel reaffirmed that a “close nexus” exists between a post-confirmation matter and a closed bankruptcy proceeding sufficient to support jurisdiction when that matter affects the “interpretation, implementation, consummation, execution, or administration of the confirmed plan.” The panel concluded that the ultimate merits question of the sale/non-sale attributes of the transaction depended in part on interpretation of the confirmed plan and confirmation order. In addition, the parties disputed the distinctly federal question of whether 11 U.S.C. § 346 (preempting state tax law) applies to non-debtor general partners of a debtor partnership that was dissolved as part of the reorganization. The panel also concluded that post-confirmation jurisdiction was consistent with the equitable objectives of the Bankruptcy Code. Holding that the character of the core transaction of the debtor’s bankruptcy was an issue that the bankruptcy court had jurisdiction to decide, the panel remanded the case to the BAP to determine in the first instance whether the bankruptcy court’s answer to this question gave due consideration to the “economic realities” of the transaction as structured under the plan and confirmation order.
“The humorist Douglas Adams was fond of saying, ‘I love deadlines. I love the whooshing sound they make as they fly by.’ But the law more often follows Benjamin Franklin’s stern admonition: ‘You may delay, but time will not.’ To paraphrase Émile Zola, deadlines are often the terrible anvil on which a legal result is forged.”
With these words, Ninth Circuit Court of Appeals last week declined to retroactively extend Federal Rule of Bankruptcy Procedure 4007(c)’s deadline to file a non-dischargeability complaint. That deadline permits creditors only 60 days following an individual debtor’s initial meeting of creditors (otherwise known as the debtor’s “section 341(a) meeting”) to file a complaint to have certain types of debt determined non-dischargeable, unless a request for extension of the deadline is filed within the same, initial 60-day period.
The case before the 3-judge panel involved a creditor who had, in fact, previously obtained an extension to file a non-dischargeability complaint – but who, due to internal word-processing difficulties with conversion to the “Portable Document Format” (*.pdf) format now required for electronic filings with federal bankruptcy courts, missed the extended deadline by less than an hour.
The brief, 14-page decision (available here) upheld prior rulings in the same matter by both the Bankruptcy Court and the District Court. It raised, but did not answer, the question of what happens when a missed deadline is due to external problems (e.g., technical difficulties with the Bankruptcy Court’s filing system), rather than problems with counsel’s IT configuration or office procedures. But it also declined to recognize an “equitable exception” to the rule in the absence of a Supreme Court directive to the contrary:
We acknowledge that the U.S. Supreme Court has not expressly addressed whether FRBP 4007(c)’s filing deadline admits of any equitable exceptions and that lower courts are divided on the issue. See Kontrick v. Ryan, 540 U.S. 443, 457 & nn.11–12 (2004) (declining to decide question and noting circuit split). We need not, and do not, reach the question of whether external forces that prevented any filings—such as emergency situations, the loss of the court’s own electronic filing capacity, or the court’s affirmative misleading of a party—would warrant such an exception. See, e.g., In re Kennerley, 995 F.2d at 147–48; see also Ticknor v. Choice Hotels Intern., Inc., 275 F.3d 1164, 1165 (9th Cir. 2002). . . . In short, absent unique and exceptional circumstances not present here, we do not inquire into the reason a party failed to file on time in assessing whether she is entitled to an equitable exception from FRBP 4007(c)’s filing deadline; under the plain language of the rules and our controlling precedent, there is no such exception.
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.
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.”