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Avoidance and Recovery
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Avoidance and Recovery
Avoidance and Recovery
One of the fundamental functions of any bankruptcy proceeding is the establishment of an amount and priority for each creditor’s claim against the debtor. A short, 5-page decision issued late last month by the Nebraska Bankruptcy Court in two related Chapter 11 cases (Biovance and Julien) serves as a reminder that although creditors are not permitted a “double recovery” on their claims, they are nevertheless permitted to assert the full value of their claims until those claims are paid in full.
Can a senior secured lender require, through an inter-creditor agreement, that a junior lender relinquish the junior’s rights under the Bankruptcy Code vis á vis a common debtor?
Though the practice is a common one, the answer to this question is not clear-cut. Bankruptcy Courts addressing this issue have come down on both sides, some holding “yea,” and others “nay.” Late last year, the Massachusetts Bankruptcy Court sided with the “nays” in In re SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr. D. Mass. 2011).
The decision (available here) acknowledges and cites case law on either side of the issue. It further highlights the reality that lenders employing the protective practice of an inter-creditor agreement as a “hedge” against the debtor’s potential future bankruptcy may not be as well-protected as they might otherwise believe.
In light of this uncertainty, do lenders have other means of protection? One suggested (but, as yet, untested) method is to take the senior lender’s bankruptcy-related protections out of the agreement, and provide instead that in the event of the debtor’s filing, the junior’s claim will be automatically assigned to the senior creditor, re-vesting in the junior creditor once the senior’s claim has been paid in full.
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.”
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:
In re Riddle, 444 B.R. 681, 686 (Bankr. N.D. Ga. 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?
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:
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.
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:
“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.
Title II of the Dodd-Frank Act provides “the necessary authority to liquidate failing financial companies that pose a systemic risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.”
Under this authority, the government would have had the requisite authority to structure a resolution of Lehman Brothers Holdings Inc. – which, as readers are aware, was one of the marquis bankruptcy filings of the 2008 – 2009 financial crisis.
Readers are also aware that Dodd-Frank is an significant piece of legislation, designed to implement extensive reforms to the banking industry. But would it have done any better job of resolving Lehman’s difficulties than did Lehman’s Chapter 11?
Predictably, the FDIC is convinced that a government rescue would have been more beneficial – and in “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” (forthcoming in Vol. 5 of the FDIC Quarterly), FDIC staff explain why this is so.
The 19-page paper boils down to the following comparison between Chapter 11 and a hypothetical resolution under Dodd-Frank:
By contrast, under Dodd-Frank:
Convinced? You decide.