Avoidance and Recovery
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Posts Tagged ‘debtor’
Avoidance and Recovery
Leases and Executory Contracts
Intellectual Property and Social Media
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).
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.
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:
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).
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.
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.
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:
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:
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.
A South Carolina bankruptcy court decision issued earlier this month highlights and illustrates the perils facing individual sole proprietors who struggle to reorganize their financial affairs through the Chapter 11 process.
The debtors – a husband and wife who owned a business and several pieces of rental property – filed a Chapter 11 in November 2009, but the case was dismissed approximately 10 months later. In February this year, while their appeal of that dismissal was pending, they filed a second Chapter 11.
When an individual debtor seeks bankruptcy protection for a second time within 12 months, Section 362(c)(3) (added in connection with the 2005 BAPCPA amendments) terminates the automatic stay by default unless, within 30 days, the debtor can demonstrate that their second attempt is in “good faith.”
Put another way, an individual debtor’s second attempt at bankruptcy protection is presumptively in “bad faith” – and the automatic stay will self-terminate – unless the debtor can demonstrate otherwise.
Demonstrating otherwise is what the debtors attempted to do in In re Washington.
So what does it take for an individual to establish “clear and convincing” evidence of “good faith” in these circumstances?
Apparently, a good deal of personal organization – and evidence of consistent, clearly documented efforts to reorganize, with clearly documented results to show for it.
In Washington, the debtors produced evidence regarding their business income and rental receipts which the Court characterized as “inconsistent and confusing.” The Court took issue with the debtors’ estimates of present income, found holes in their testimony regarding decreased expenses, and found the debtors’ revenue projections to be “unjustifiably rosy.”
The Court found that the same result applied under section 362(c)(3)(i)(III)(bb). That subsection imposes a presumption that a debtor’s second case was not filed in good faith if the court finds reason to conclude that the current case will not be concluded “with a confirmed plan that will be fully performed.”
But if Washington provides a cautionary tale for individual debtors who are struggling through the bankruptcy process, it also emphasizes the touchstone for every successful reorganization, no matter how small: A viable business strategy.
In a well-known quote, Depression-era author Thurmond Arnold once described the inside of a corporate reorganization as:
Most litigators understand the compelling power of story as a means to rationalize and persuade. In bankruptcy, a debtor’s “first day motions” are the initial means by which counsel has to weave the “wild orgy” of corporate restructuring into a cohesive narrative that will serve the client’s interests.
Because business insolvency and its resolution typically follow a well-understood process with a predictable set of possible outcomes, the “first day” narratives describing a debtor’s demise – and setting forth its “exit strategy” – likewise often follow familiar patterns. These patterns have been adapted over the decades to suit the capital structure of distressed firms and the economic conditions they face. But in the end, they remain . . . familiar patterns.
Penn Law Professor David Skeel, Jr. has recently taken up an engaging, non-empirical analysis of these patterns as they have appeared in US bankruptcy law. In Competing Narratives in Corporate Bankruptcy: Debtor in Control vs. No Time To Spare (published most recently as Research Paper No. 10-20 under the auspices of Penn Law’s Institute for Law and Economics and previously in the Winter 2009 issue of Michigan State Law Review) Skeel argues that such narratives have been utilized historically to justify and obtain judicial sanction for what, at the time, may be innovative, even controversial, reorganization techniques attempted within the strictures of a fixed bankruptcy legal structure. In bankruptcy, he suggests, the power of narrative grows out of the innovation employed to restructure a firm, and is then used to strengthen and further extend the innovation.
Skeel – who earlier authored Debt’s Dominion: A History Of Bankruptcy Law In America – traces this narrative and its variations from the early “equity receiverships” utilized to reorganize railroads through the early cases filed in the wake of the 1978 Bankruptcy Code, and to the more recent 2008-09 “headline” cases of Lehman Brothers, Chrysler, and General Motors. Observing that reorganizations proposed over the last 30 years have been explained using one of two predominant narratives – “Debtor in Control” (used most commonly to justify the debtor’s further prosecution of an ongoing reorganization) or “No Time to Spare” (often used to justify the sale of the debtor’s business assets) – he then circles back to ask whether the “innovations” proposed are justifiable under either narrative.
Skeel’s treatment of narrative – particularly, in questioning whether there was truly “no time to spare” in the Lehman, Chrysler, and GM bankruptcies – is insightful. As he sees it:
Though his work covers narrative in the domestic bankruptcy context, the same complexity and requests for emergency, interim relief that require narrative explanation also arise in cross-border insolvencies.
As these “master narratives” become intertwined with multiple (and potentially conflicting) “legal structures,” their continued evolution bears close watching.
Most readers of this blog are aware that, under the Bankruptcy Code, a Chapter 11 debtor (or the trustee appointed in the debtor’s case) is entitled to seek “avoidance” of a limited set of pre-bankruptcy “preference” payments, provided it can establish the payments were made:
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt . . . ;
(3) . . . while the debtor was insolvent;
(4) . . . on or within 90 days before the date of the filing of the [bankruptcy] petition; . . . and
(5) that enables [the] creditor to receive more than [its anticipated pro rata distribution in Chapter 7].
Even if all these elements are met, however, the Bankruptcy Code provides creditors with an affirmative “ordinary course of business” defense.
Though articulated slightly differently by different courts, 11 U.S.C. §547(c)(2) essentially provides that the “ordinary course of business exception” permits a creditor to retain transfers made by a debtor to a creditor during the ninety days before the petition date if: (1) such transfers were made for a debt incurred in the “ordinary course of business” of the parties; and either (2) the transfers were made in the “ordinary course of business” of the parties; or (3) the transfers were made in accordance with “ordinary business terms.”
Once an “ordinary course” relationship is established between the debtor and the creditor who received allegedly preferential payments, the focus shifts to showing whether or not the payments at issue complied with “ordinary course” timing and terms.
To show this, the preference defendant must demonstrate that the relevant payments did not differ from past payments in “amount” or “form,” were not the result of “unusual collection or payment activit[ies],” or did not come as a result of the “creditor [taking] advantage of the debtor’s deteriorating financial condition.”
Importantly, the emphasis is on the payments themselves – rather than on what the debtor and creditor may have otherwise considered or discussed. This distinction is illustrated in a recent decision issued by Judge Christopher Sontchi in Burtch v. Detroit Forming, Inc. (In re Archway Cookies) (available here).
In Burtch v. Detroit Forming, the Trustee in a Chapter 7 case (converted from one under Chapter 11) commenced an adversary proceeding against Detroit Forming, Inc. (“DFI”) seeking to avoid as preferential six (6) transfers totaling $180,648.17. DFI asserted the “ordinary course” defense, arguing it had a two-year suppplier relationship with the debtors and that it had received the payments in question under the same timing and terms as those extant throughout this relationship.
DFI’s defense is typical of that offered under the “ordinary course” defense: It established a specific range of days-to-payment from invoicing, then showed that the payments in question were timed substantially similar to the days-to-payment average and under similar terms (i.e., by check rather than by wire transfer or COD).
Notably, the Court was not troubled by a letter sent by DFI’s CFO/Controller notifying the Debtors that no product would be shipped unless the accounts were current. For purposes of establishing “ordinary course,” it was the subjective relationship that existed between the debtor and the preference defendant which mattered – rather than the debtor’s relations with all its creditors.
Burtch v. Detroit Forming is instructive on what it takes to mount a successful “ordinary course” defense, as is the Ninth Circuit’s earlier decision in Sigma Micro v. Healthcentral.com (In re Healthcentral.com) (availabe here) – a similar case where the defendant’s “ordinary course” analysis was deemed sufficient to withstand a motion for summary judgment, and where the Ninth Circuit placed little stock in the debtor’s evidence of pre-petition “old school” cash management practices whereby the debtor’s management determined each week which creditors would be paid, and how much.