Posts Tagged ‘debtor’
Tuesday, January 17th, 2012
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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.
Tuesday, June 7th, 2011
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).
Tuesday, May 31st, 2011
Many insolvency practitioners are familiar with the “high-asset” individual debtor – often a business owner or owner of rental property or other significant business and personal assets – whose financial problems are too large for standard “individual debtor” treatment.
Such debtors are a prominent feature of commercial insolvency practice in California and other western states. These individuals typically have obligations matching the size of their assets: Their restructuring needs are too large for treatment through an “individual” Chapter 13 reorganization, and must instead be handled through the “business” reorganization provisions of a Chapter 11.
When Congress amended the Bankruptcy Code in 2005, it recognized the need of some individuals to use the reorganization provisions of Chapter 11. It provided certain amendments to Chapter 11 which parallel the “individual” reorganzation provisions of Chapter 13.
But certain “individual” reorganization concepts do not translate clearly into Chapter 11′s “business” provisions. Among the most troublesome of these is the question of whether an individual debtor can reorganize by paying objecting unsecured creditors less than 100% while continuing to retain existing property or assets for him- or herself.
In Chapter 13, the answer to this question is “yes.” But in Chapter 11 – at least until 2005 – the answer has historically been “no.” This is because Chapter 11, oriented as it is toward business reorganization, prohibits a reorganizing debtor from retaining any property while an objecting class of unsecured creditors is paid something less than the entirety of its claims. Known as the “absolute priority rule,” this prohibition has been a mainstay of Chapter 11 business practice for decades.
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In 2005, Congress amended Chapter 11′s “absolute priority rule” provisions to provide that despite the “absolute priority” rule, individual Chapter 11 debtors could nevertheless retain certain types of property, even when objecting unsecured creditors are paid less than 100%. For instance, an individual debtor may retain certain wages and earnings earned after the commencement of the debtor’s case. But can the individual debtor retain other types of property (for example, a rental property or closely held stock in a business), while paying objecting creditors less than 100%?
Congress’ “absolute priority rule” amendments for individual debtors are ambiguous – as is the language of a section which expands the definition of “property” included within the individual Chapter 11 debtor’s estate (paralleling similar treatment of individual Chapter 13 debtors). As a result, Bankruptcy Courts are split on the question of whether or not the “absolute priority rule” applies to individual Chapter 11 debtors.
Until very recently, the Central District of California – one of the nation’s largest, and a frequent filing destination for individual Chapter 11 cases – had been silent on the issue. This month, however, Judge Theodor Albert of Santa Ana joined a growing number of courts which conclude that Congress’ 2005 “absolute priority rule” amendments apply only to individual wages and earnings, and that individuals cannot retain other types of property where objecting creditors are paid less than 100%.
In a careful, 13-page decision issued for publication, Judge Albert collected and examined cases on both sides of this question and concluded:
After BAPCPA, the debtor facing opposition of any one unsecured creditor must devote 5 years worth of “projected disposable income,” at a minimum (or longer if the plan is longer). But [the] debtor is not compelled to give also his additional earnings or after-acquired property net of living expenses beyond five years unless the plan is proposed for a period longer than five years. But there is no compelling reason to also conclude that prepetition property need not be pledged under the plan as the price for cram down, just as it has always been.
Judge Albert’s decision joins several other very recent ones going the same direction, including In re Walsh, 2011 WL 867046 (Bkrtcy.D.Mass., Judge Hillman); In re Stephens, 2011 WL 719485 (Bkrtcy.S.D.Tex., Judge Paul); and In re Draiman, 2011 WL 1486128 (Bkrtcy.N.D.Ill., Judge Squires).
Monday, May 16th, 2011
When a retailer becomes insolvent, suppliers or vendors who have recently provided goods on credit typically have the ability to assert “reclamation” rights for the return of those goods. Retailers may respond to these rights by seeking the protection the federal bankruptcy laws – and, in particular, the automatic stay.
When a retailer files for bankruptcy while holding goods which are subject to creditors’ “reclamation” rights, what should “reclamation” creditors do?
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The Bankruptcy Code itself provides some protection for “reclamation” creditors by providing such creditors additional time in which to assert their claims, and by affording administrative priority for a certain portion for such claims even when they are not formally asserted.
But is merely asserting a reclamation claim under the Bankruptcy Code sufficient to protect a supplier once a retailer is in bankruptcy? A recent appellate decision from Virginia’s Eastern District serves as a reminder that merely speaking up about a reclamation claim isn’t enough.
When Circuit City sought bankruptcy protection in 2009, Paramount Home Entertainment was stuck with the tab for more than $11 million in goods. Though it didn’t object to blanket liens on Circuit City’s merchandise which came with the retailer’s debtor-in-possession financing, and stood by quietly while Circuit City later liquidated its merchandise throug a going-out-of-business sale, Paramount did file a timely reclamation demand as required by the Bankruptcy Code. It also complied with what it understood to be the Bankruptcy Court’s orders regarding administrative procedures for processing its reclamation claims in Circuit City’s case. It was therefore unpleasantly surprised when Circuit City objected to Paramount’s reclamation claim – and when the Bankruptcy Court sustained that objection – on the grounds that Paramount hadn’t done enough to establish or preserve its reclamation rights.
Paramount appealed the Bankruptcy Court’s ruling, claiming that it complied with what it understood to have been the Bankruptcy Court’s administrative procedures for processing reclamation claims. Paramount argued that to have done more (i.e., to have sought relief from the automatic stay to take back its goods or commenced litigation to preserve its rights to the proceeds of such goods) would have disrupted Circuit City’s bankruptcy case.
In affirming the Bankruptcy Court, US District Judge James Spencer held that the Bankruptcy Code, while protecting a creditor’s reclamation rights, doesn’t impose them on the debtor. Instead, a reclaiming creditor must take further steps consistent with the Bankruptcy Code and state law to preserve the remedies which reclamation claims afford. Merely asserting a reclamation claim under the Bankruptcy Code – or under a Bankruptcy Court’s administrative procedure – isn’t enough:
“Filing a demand, but then doing little else in the end likely creates more litigation and pressure on the Bankruptcy Court than seeking relief from the automatic stay. . . or seeking a [temporary restraining order] or initiating an adversary proceeding. In this case, Paramount filed its reclamation demand, but then failed to seek court intervention to perfect that right. As the Bankruptcy Court held, the Bankruptcy Code is not self-executing. Although [the Bankruptcy Code] does not explicitly state that a reclaiming seller must seek judicial intervention, that statute does not exist in a vacuum. The mandatory stay as well as the other sections of the Bankruptcy Code that protect and enforce the hierarchy of creditors create a statutory scheme that cannot be overlooked. Once Paramount learned that Circuit City planned to use the goods in connection with the post-petition [debtor-in-possession financing], it should have objected. It didn’t. To make matters worse, Paramount then failed to object to Circuit City’s liquidation of its entire inventory as part of the closing [going-out-of-business] [s]ales.”
Let the seller beware.
Monday, May 2nd, 2011
From Florida’s Northern District comes a cautionary tale of what can go wrong when distressed real estate requires restructuring. A copy of the decision is available here.
Davis Heritage GP Holdings, LLC (“Debtor”) was a family-owned LLC formed in 2002 to “hold, develop, and sell condominium development properties in Mississippi and Louisiana.” Its sole assets were membership interests in a series of single-member “middle-tier” LLC’s, which themselves held no assets except for interests in a series of single-member “lower-tier” LLC’s – each formed to hold separate parcels of real property.
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In December 2010, the Debtor sought protection under Chapter 11, ostensibly to deal with the adverse effects of a judgment entered against it. None of the “middle-tier” or “lower-tier” LLC’s had sought bankruptcy protection. Despite their separate, three-tier structure, the Debtor’s management adminstered them as if they were a single business enterprise. Until very shortly before the Debtor’s Chapter 11 filing, the expenses and income of the enterprise were processed through the Debtor’s bank account. In fact, none of the “lower tier” LLCs held bank accounts in their names until after meeting with the Debtor’s bankruptcy counsel. From at least January 2007 through August 2010, the Debtor’s bank accounts contained several millions of dollars, at one time exceeding $22 million. The Debtor’s principals have used the Debtor’s accounts freely, to receive and disburse money to and from whomever the principals chose at any given time. Despite this fact, the Debtor only disclosed one bank account in its Schedule B and did not disclose, but rather affirmatively denied, making any transfers to insiders within one year pre-petition.
Finally, the Debtor never disclosed the properties owned by the “lower tier” LLCs (or their income and expenses) in its Schedules or any other papers filed with the Court. Nevertheless, the Debtor’s Plan is based entirely upon the liquidation of some of those very properties.
The Debtor’s difficulties arose out of the purchase of land and subsequent construction of the 21-story “Beau View” luxury condominium tower in Biloxi, Mississippi. In exchange for the land, the Debtor had executed two junior-priority promissory notes to the seller, and obtained a senior-priority acquisition loan from Wells Fargo. The Debtor then financed construction with a separate loan – also from Wells Fargo – and completed the tower.
Though it made considerable progress selling condominium units and repaying Wells Fargo’s construction loan, the Debtor made only sporadic payments on its purchase notes to the seller. Eventually, the seller obtained a judgment on the note in Mississippi, then domesticated that note in Florida and sought to foreclose on all of the debtor’s membership interests in the “middle tier” LLC’s.
To avoid foreclosure on its “middle tier” LLC interests, the Debtor made a $200,000 payment in exchange for 60 days’ forbearance – then, promptly, sought Chapter 11 protection. At the time of filing, the Wells Fargo construction loan and acquisition loans were current. The Debtor had permitted two mortgage loan actions filed against two of the “lower tier” LLC’s by Sun Trust Bank to go to default judgment.
Very shortly after filing, the seller of the Biloxi property sought relief from stay to continue its foreclosure on the “middle tier” LLC interests – or, in the alternative, dismissal of the Debtor’s Chapter 11 case. The Debtor countered with an emergency motion for the sale of certain assets – and, a day prior to the hearing on the stay relief motion, a Chapter 11 Plan.
In reviewing the evidence and determining that dismissal of the Debtor’s case was appropriate, the court observed:
[W]hen determining whether to grant stay relief for cause or dismiss a chapter 11 case, . . . a number of factors may evidence an “intent to abuse the judicial process and the purposes of the reorganizationprovisions” . . . . . Those factors include:
a. the debtor has only one asset, the property;
b. the debtor has few unsecured creditors whose claims are small in relation to the claims of the secured creditors;
c. the debtor has few employees;
d. the property is the subject of a foreclosure action as a result of arrearages of the debt;
e. the debtor’s financial problems involve essentially a dispute between the debtor and the secured creditors which can be resolved in the pending state court action; and
f. the timing of the debtor’s filing evidences an intent to delay or frustrate the legitimate efforts of the debtor’s secured creditors to enforce their rights . . . . Once a court finds that the above factors are present, “[t]he possibility of a successful reorganization cannot transform a bad faith filing into one undertaken in good faith.” All of the [above-referenced] bad faith factors are present in this case, as are additional factors indicating bad faith. . . . The Debtor’s financial problems involve a two-party dispute between it and [the judgment creditor] that can be resolved in state court. Also, the timing of this petition shows an intent to delay or frustrate the legitimate collections efforts of [the judgment creditor]—who is the only real direct creditor of the Debtor . . . .
The court then went on to explain why the essence of the Debtor’s Chapter 11 plan – essentially, an effort to pay Wells Fargo and Sun Trust at the expense of the seller of the Biloxi property – was a “sort of reverse marshalling” inappropriate for Chapter 11 under the facts of this case:
Unlike the traditional single asset case where a main creditor is stayed from collecting out of the debtor’s only asset, this case involves a three-tier corporate structure created by the Debtor and its principals whereby [the Biloxi land seller and judgment creditor] is the only creditor that is adversely affected by the automatic stay. See 11 U.S.C. § 362(a). All other creditors of the Debtor with claims to the properties owned by the “lower tier” LLCs are free to pursue those claims through foreclosure on those real properties, thereby diminishing the value of the Debtor’s only asset (membership in the “middle tier” LLCs), beyond the control of [the judgment creditor]. This fact is illustrated by Sun Trust’s pursuit of its post-petition mortgage foreclosure litigation against [two "lower-tier" LLC] properties, which has been unopposed by the Debtor and its principals. Similarly, [the Debtor's] testimony states that in spite of the bankruptcy, and the way the enterprise has historically been managed, all of the “lower tier” LLCs are doing business as usual, renting units, offering units for sale, selling property, signing contracts for sale, and paying their bills. After a history of treating all the entities as a single corporate enterprise, the Debtor now takes the position that it lacks control of its wholly-owned subsidiaries and only it, the Debtor, is subject to the rules and constraints of Chapter 11.
In reviewing Chapter 11 cases alleged to have been filed in bad faith, courts may look to all of the evidence and the totality of the circumstances to determine what is really happening, and the true intent and purpose behind the filing. . . . Here, the true intent and effect of this case and the Debtor’s Plan are plain: the Debtor’s insiders seek to donate assets subject to [the judgment creditor's] judgment lien to Sun Trust and Wells Fargo in order to shield their own assets and money from those creditors. This scheme, memorialized in the Debtor’s Chapter 11 Plan, amounts to a kind of reverse marshaling. The Plan takes the only assets available to [the judgment creditor] (and subject to its levy), property owned not by the Debtor but by the “lower tier” LLCs, and shifts that property to Sun Trust and Wells Fargo, creditors with claims [are] secured by other assets owned by the insiders. This Plan reduces the amount that [the judgment creditor] may collect and simultaneously reduces the guarantors’/insiders’ liability to Sun Trust and Wells Fargo.
The court’s discussion of what constitutes “bad faith” in filing a Chapter 11 case is instructive, as is its analysis of how “bankruptcy remote” entities can be treated in the absence of related Chapter 11 filings.
Saturday, March 26th, 2011
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.”
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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.”
In sum, although Debtors claim that their financial circumstances have changed substantially, it appears to the Court that, with minor exceptions, Debtors have the same debt, same business, same properties, and same financial circumstances as they did in their previous case. The Court finds that there has not been a substantial change in Debtors’ financial circumstances and therefore, a presumption arises under section 362(c)(3)(C)(i)(III) that Debtors’ case was not filed in good faith.
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.
Monday, October 18th, 2010
In a well-known quote, Depression-era author Thurmond Arnold once described the inside of a corporate reorganization as:
a combination of a municipal election, a historical pageant, an antivice crusade, a graduate school seminar, a judicial proceeding, and a series of horse trades, all rolled into one — thoroughly buttered with learning and frosted with distinguished names. Here the union of law and economics is celebrated by one of the wildest ideological orgies in intellectual history. Men work all night preparing endless documents in answer to other endless documents . . . . At the same time practical politicians utilize every resource of patronage, demagoguery, and coercion beneath the solemn smoke screen.
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:
Bankruptcy’s master narratives have always been closely intertwined with the underlying legal structures, which suggests that bankruptcy judges and bankruptcy law will determine the future of . . . current, competing narratives.
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.
Monday, October 11th, 2010
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.
Saturday, January 9th, 2010
When a foreign business entity commences a bankruptcy proceeding, US courts’ recognition of that proceeding depends on whether or not it is a “foreign main proceeding” under the meaning of US Bankruptcy Code. Whether or not a foreign bankruptcy is a recognized “foreign main proceeding” depends on the location of the debtor’s “center of main interests” (or “COMI”).
The concept of a debtor’s “COMI” has become a critical one – not only in the US, but in a number of foreign jurisdictions including the UK. Because the same legal concept arises in multiple jurisdictions, the manner in which the “COMI” concept is applied across international boundaries carries with it the potential for the same sort of duplication, jurisdictional confusion, and mischief that led to the development and implementation of UNCITRAL’s model cross-border insolvency law in the first place. Consequently, getting COMI right – and getting it consistent across jurisdictional borders – has become a matter of international concern.
The importance of COMI has come to light most recently in the Stanford matter (see prior posts here), where multiple courts have been asked to determine COMI for Stanford International Bank, Ltd. (SIB). In Texas, Judge David Godbey has taken extensive briefing from the parties in advance of a decision on recognition. In London, Mr. Justice Lewison’s original decision finding SIB’s COMI to be Antigua – rendered last July – saw approximately 5 days of appellate argument at the end of last year. The parties presently await a decision from the English Court of Appeal.
The Stanford matter highlights a fundamental question about COMI: Should it be a flexible concept, susceptible to broad judicial discretion? Or should COMI be based purely on objective factors, precisely and mechanically applied?
Mr. Justice Lewison’s prior decision in London (summarized and avaialable here) took an essentially mechanistic approach to determining COMI, focusing primarily – as the UK Regulation requires – on what creditors objectively perceived about the debtor. US law – which, like England’s, is based on the UNCITRAL model – likewise places similar emphasis on creditors’ perceptions in dealing with the debtor.
But did legislators in the UK or the US intend that the analysis should stop with what creditors knew or likely would have known about the debtor?
After all, Stanford’s operation was a sham. And where creditors’ perceptions of SIB were based on a sham, is it appropriate to perpetuate the sham in determining COMI?
While the English Court of Appeal deliberates Lewison J’s decision, Judge Godbey appears headed in a slightly different analytical direction. Specifically, the questions on which he’s requested briefing in the Texas proceeding appear to focus more specifically on the similarity of COMI to a debtor’s “principal place of business” as that concept is recognized under US law. Though not inconsistent with what creditors would have perceived about the debtor, it tends to focus more broadly on factors which, though objective, are not tied as closely to what the debtor held out to specific parties. Instead, the debtor’s “principal place of business” views the totality of the debtor’s operations – whether or not such operations were completely visible to creditors or other third parties – and, on the basis of these specific facts, determines the debtor’s principal place of business.
Whether a possible change in COMI analysis means a change in SIB’s COMI remains to be seen.
Monday, September 14th, 2009
Unfortunately, life is full of them . . . and so is the 2005 Bankruptcy Code. Today’s post will discuss just one: The expanded protection afforded trade creditors under Section 503(b)(9).
What does this section do? And just how much protection does it provide? As amended, Section 503(b)(9) was intended by Congress to protect vendors who supplied goods to a debtor within 20 days of a debtor’s bankruptcy filing by extending “administrative” (i.e., 100% payment) status to their claims. Along with amendments to Section 546(c), the idea was to protect vendors who extended credit to a debtor immediately before the debtor filed a case. But in fact, Section 503(b)(9)’s application may now be leaving many such vendors at greater risk.
How so? A recent Daily Deal piece by Natixis’ Christophe Razaire briefly outlines three general problem areas.
- Goods? Or services? Section 503(b)(9) protects suppliers of goods well enough, and understandably so: Along with Section 546(c), it is designed to preserve and augment the protections extended to the same vendors under the Uniform Commercial Code. But what about suppliers of services? Unfortunately, as a number of creative service providers have discovered, the Code offers no such similar protection. Moreover, where a company relies primarily on services for its activity, it appears doubtful that the Code’s amendment does anything to alleviate the risk of a debtor’s default and eventual bankruptcy.
- Payment? Or post-petition payables? Though Section 503(b)(9) provides administrative priority for “20-day” vendor claims and Section 546(c) likewise permits vendors to assert reclamation demands for goods supplied immediately prior to the debtor’s filing, in practice, vendors rarely see any early compensation in the case.
Instead, a bankruptcy court is far more likely to simply afford such claims their entitled administrative status, then require the vendors holding them to wait until the conclusion of the case for payment. Economically, this means that vendors who should be enjoying administrative protection and receiving cash are, in fact, merely exchanging one “IOU” for another – and, in the meantime, suffering as much liquidity distress as any other general unsecured creditor.
Needless to say, this liquidity distress has to be dealt with in some fashion. And it is often addressed through a refusal to further supply the debtor-in-possession except on “COD” or similarly restrictive terms. Alternatively, other customers of a cash-strapped vendor may feel the squeeze through tightened terms as the vendor struggles to compensate for large – but unsatisfied – administrative obligations owed by the debtor.
- Administrative protection? Or administrative insolvency? Perhaps the most unintended consequence of Section 503(b)(9)’s amendment is that business reorganizations involving large numbers of “20-day” claims may, in fact, be threatened by its application.
“20-day vendors” can, if they so choose, accept payments on their administrative claims at a discount – and, in fact, it is not uncommon for debtors to attempt to cut such deals. But where there are numerous “20-day” claimants, the debtor often faces very slow, arduous negotiations. Many vendors are reluctant to negotiate with the debtor for fear of “selling out” too low; others may try their hand at brinksmanship, betting that the debtor’s need to satisfy such claims prior to emerging from bankruptcy will reward their willingness to “hold out.”
Often, the “reward” for such bargaining is something less than creditors may have hoped for. The debtor concludes it cannot negotiate and must instead incur the [additional] administrative expense of contesting such claims directly in an effort to reduce their aggregate amount. If these claims disputes do not go the debtor’s way, or if the debtor is already struggling to emerge with sufficient cash, the debtor may be forced to liquidate – thereby leaving all creditors, from secured debt to general unsecured claims, with far less than might otherwise be the case.
How big can these problems get? A recent “Dealscape” blog post by Ben Fidler illustrates how the section is playing out in the troubled retail and auto parts sectors, where vendors of goods often play a significant role in a company’s operations. Fidler points to larger Chapter 11 filings, such as Empire Beef Co., Blackhawk Automotive Plastics, Inc., and Plastech Engineered Products, Inc., which have been left administratively insolvent or have been threatened with such insolvency, as a result of section 503(b)(9)’s amendments.
Though not every case is as large as the ones cited by Fidler – and not every case results in administrative insolvency – similar dynamics with similar results can just as easily arise in smaller Chapter 11′s.
In sum, this anecdotal data suggests that Congress’ well-intended efforts to afford some creditors with more options in a debtor’s reorganization may, in fact, have left all creditors with far less options.
Surely, this cannot have been Congress’ intended consequence.