After a brief hiatus, we’re back – and just in time to discuss a recent decision of some import to trademark owners and licensors.

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For many years, insolvency practitioners have recognized the value of the Bankruptcy Code in permitting a reorganizing firm to assign contractual rights to a third party, even where the contract itself prohibits assignment.  That power is limited, however, where “applicable [non-bankruptcy] law” prohibits the assignment without the non-bankrupt party’s consent.

In recent years, the “anti-assignment” provisions of federal copyright and patent law have limited the transfer of patent and copyright licenses through bankruptcy.   Whether the transfer of trademark licenses is likewise limited has been an open question, at least amongst the Circuit Courts of Appeal.

Until now.

In late July, the Seventh Circuit Court of Appeals found in In re XMH Corp. that trademarks were not assignable.

XMH Corp. involved the former Hartmarx clothing company’s Chapter 11, along with the related filings of several subsidiaries.  XMH ultimately sold its assets and assigned contracts to a group of third-party purchasers.  Those assets included certain trademark licenses for jeans held by one of the XMH subsidiaries.  The trademarks were owned by a Canadian firm.

The Canadian firm objected to the trademark assignment, and the bankruptcy court agreed.  The District Court reversed, and the licensor appealed to the Seventh Circuit.

In a succinct, 15-page decision, Judge Posner found that where “applicable law” prohibits the assignment of a trademark, it cannot be assigned through a bankruptcy proceeding absent the trademark owner’s consent.

Judge Posner apparently reached this decision despite a lack of either party to articulate which “applicable law” actually prohibited the assignment:

Unfortunately the parties haven’t told us whether the applicable trademark law is federal or state, or if the latter which state’s law is applicable (the contract does not contain a choice of law provision)—or for that matter which nation’s, since [the licensor] is a Canadian firm. ([The licensee's] headquarters are in the State of Washington.)  None of this matters, though, because as far as we’ve been able to determine, the universal rule is that trademark licenses are not assignable in the absence of a clause expressly authorizing assignment. Miller v. Glenn Miller Productions, Inc., 454 F.3d 975, 988 (9th Cir. 2006) (per curiam); In re N.C.P. Marketing Group, Inc., 337 B.R. 230, 235-36 (D. Nev. 2005); 3 McCarthy on Trademarks § 18:43, pp. 18-92 to 18-93 (4th ed. 2010).

But the Seventh Circuit then turned to the question of whether the contract actually contained a valid trademark license - and found that though the agreement appeared to provide a relatively short-term license of the trademark, what remained at the time of the proposed assignment was merely a contract for services.

Despite its brevity, XMH Corp. is instructive in two respects:

• Trademarks cannot be assigned – at least not in the 7th Circuit.
• Contract drafters and negotiators must be careful to identify and preserve the trademark rights at issue.

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?

Stay tuned.

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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.

On Thursday, the US Supreme Court released its second decision in the long-runing battle between the estate of Vickie Lynn Marshall (aka Anna Nicole Smith) and her erstwhile son-in-law, Pierce Marshall.

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The 63-page slip opinion, available here, illustrates how the result of a high-profile celebrity bankruptcy can ultimately turn on arcane, esoteric matters of jurisdiction – and how such esoterica can be potentially ground-shifting for the US Bankruptcy Court system which has been in effect since its first constitutional challenge in 1984.

A small portion of the already considerable commentary evolving in conventional media and in the blogosphere appears below.

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• Anna Nicole Smith estate loses big at Supreme Court (news-briefs.ew.com)
• Ruling Against Anna Nicole Smith’s Heirs, Chief Justice Quotes Dickens [The Supremes] (jezebel.com)
• SCOTUS Decision in Stern v. Marshall (lawprofessors.typepad.com)

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.

Personal liability for corporate debt has been all the rage in the Ninth Circuit.  Within the last year, at least two appellate decisions (discussed here and here) have clarified the doctrine of alter ego liability – the idea that a corporate entity and its principals ought to be treated as one and the same, and therefore equally liable for corporate obligations.

It is easy to see why interest in alter ego liability has become so fashionable: When a business slips into insolvency and cannot pay its creditors in full, those creditors naturally go looking for other pockets from which to satisfy their claims.

Cover of Flushed Away (Widescreen Edition)

If creditors can show that the business’ officers effectively ran the business for personal economic purposes rather than as a separate and distinct corporate entity, the doctrine of alter ego permits creditors to hold the officers responsible for the business’ obligations.  This is especially the case where it appears the officers used the business to perpetrate a fraud or some other inequity on creditors.  One California court noted that “[t]he general purpose of the doctrine of alter ego is to look through the fiction of the corporation and to hold the individuals doing business in the name of the corporation liable for its debts in those cases where it should be so held in order to avoid fraud or injustice.”

Earlier this year, Judge Clarkson of California’s Central District followed this fashion trend by offering his view on a non-dischargeability claim based on alter ego liability.

The facts of In re Munson are relatively straightforward.  Robert and Kimberly Munson were the owners – and corporate officers – of Munson Plumbing, Inc. (“MPI”), a plumbing subcontractor on several public works projects in the Los Angeles metropolitan area.  As is typically required of public works contractors, MPI’s work was backed by surety bonds issued by SureTec Insurance Company (“SureTec”).  As part of the consideration for the issuance of the surety bonds, the Munsons and MPI signed a General Agreement of Indemnity (“SureTec Indemnity Agreement”), in which the Munsons agreed to jointly and severally indemnify SureTec and to deposit collateral with SureTec upon its demand.  The SureTec Indemnity Agreement contained language that all project funds received by MPI would be held in trust for the benefit of SureTec.

Eventually, MPI encountered financial difficulties and could not pay its own subcontractors – thereby requiring SureTec to make payments under the bonds and finish MPI’s work.

Concurrent with MPI’s demise, the Munsons commenced individual Chapter 7 proceedings.  SureTec, which had been left with over $436,000 in losses related to various MPI projects, asserted claims against the Munsons individually.  It also sought to have at least a portion of those losses deemed non-dischargeable in the Munsons’ Chapter 7 case.  Specifically, it claimed:

- The SureTec Indemnity Agreement created an express trust which placed fiduciary duties upon the Munsons.

- Further, because the Munsons had allegedly defrauded SureTec by diverting at least $95,000 in progress payments on the projects to non-bonded expenses, including their own personal expenses, applicable fiduciary duties upon the Munsons arose by California statutes (including Business & Professions Code §7108 and Penal Code §§§ 484b, 484c and 506.)

- The Munsons were alter egos of MPI, and therefore were liable for MPI’s obligations under the surety bonds.

- The Munsons’ obligations were non-dischargeable because they arose as a result of the Munsons’ breach of their fiduciary duties.

The Debtors sought dismissal of SureTec’s lawsuit.  In a brief, 9-page decision, Judge Clarkson found that:

-  The SureTec Indemnity Agreement did not impose fiduciary duties upon the Munsons.  “If a trust was created, it imposed the fiduciary duty obligations on the corporation, the receiver and disburser of the project funds. The [Munsons,] [in] signing the [SureTec Indemnity Agreement] were creating only a creditor-debtor relationship (and a contingent one at that) between SureTec and the [Munsons]. They were “indemnifying” SureTec, as SureTec accurately indicates  . . . .”

- Any alleged trust relationship created on a constructive, resulting, or implied basis (i.e., arising legally as a result of the Munsons’ allegedly bad acts) is not the sort of trust relationship which gives rise to a non-dischargeable debt.  “The core requirements [for asserting non-dischargeability based on breach of a fiduciary duty] are that the [fiduciary] relationship exhibit characteristics of the traditional trust relationship, and that the fiduciary duties be created before the act of wrongdoing and not as a result of the act of wrongdoing.”

- SureTec’s allegations of alter ego liability were likewise insufficient to tag the Munsons with the sort of fiduciary obligations that would give rise to a non-dischargeable claim.  “If a finding of alter ego were to be considered as imposing fiduciary duties, any such imposition would be ex maleficio, i.e., trusts that arose by operation of law upon a wrongful act.”

Judge Clarkson also found that SureTec’s separate non-dischargeability claim for fraud had not been pleaded with the requisite particularity, and dismissed it with leave to amend.

The Munson decision is important in several respects:

- It emphasizes the relatively narrow scope of non-dischargeability claims based on breaches of fiduciary duty in the Ninth Circuit.

- It also emphasizes the similarly narrow scope of liability derived from alter ego status.

- It highlights the importance of the alter ego doctrine as a strategic tool for both creditors and trustees in bankruptcy litigation – as well as litigants’ varying success in using it.  As detailed in other posts, alter ego liability has been employed (i) unsuccessfully as a “blocking device” in an attempt to capture recoveries for the corporation’s bankruptcy estate; and (ii) successfully to preserve recoveries from self-settled trusts to which the debtors attempted to convey assets out of the reach of creditors.  Here, alter ego was employed (again, without success) to “bootstrap” a creditor’s claim into “non-dischargeable” status.

Related articles

• Article on Contractual Relationships and Fiduciary Duty (lawprofessors.typepad.com)

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).

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).

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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.

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.