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Posts Tagged ‘United States Court of Appeals for the Ninth Circuit’
Workouts and Restructuring
Claims and Creditors
Avoidance and Recovery
Avoidance and Recovery
Avoidance and Recovery
A recently-issued Ninth Circuit decision creates potentially new avenues of recovery for creditors of an insolvent debtor.
Fitness Holdings International, Inc. (FHI), a home fitness corporation, had received significant funding between 2003 and 2006 from two entities: Hancock Park, its sole shareholder, and Pacific Western Bank. Â FHIâs unsecured obligations to Hancock Park, totaling $24 million, were subordinated to $12 million in secured financing by Pacific Western Bank in the form of a $5 million term loan and a $7 million line of credit (all guaranteed by Hancock Park).
In 2007, after numerous amendments, FHI re-financed its remaining obligations to Pacific Western Bank and to Hancock Park with a new $17 million term loan and an $8 million line of credit. Â The payoff of Pacific Western Bankâs prior secured loan had the effect of releasing Hancock Park from its guarantee. Â FHIâs efforts to restructure were ultimately not successful, however, and in 2008, the company sought protection under Chapter 11.
A Committee of Unsecured Creditors in FHI’s case sued Hancock Park, seeking to recover the earlier pay-off of Hancock Parkâs debt and alleging that the debt ought, in fact, to be re-characterized as âequityâ (and that the ârepaymentâ of the âdebtâ ought therefore to be avoided as a constructively fraudulent transfer, since FHI allegedly received âless than equivalent valueâ in exchange for the payments).
The Committee’s complaint was dismissed; however, FHIâs case was subsequently converted from one under Chapter 11 to one under Chapter 7, and the trustee appealed the dismissal to the US District Court. Â The District Court affirmed the dismissal, finding that under longstanding precedent of the Ninth Circuit Bankruptcy Appellate Panel, Hancock Parkâs advances to Fitness Holdings were loans and, as a matter of law, it was barred from re-characterizing such loans as equity investments.
The trustee appealed to the Ninth Circuit, which vacated the District Courtâs decision and remanded for further findings. Â In doing so, the Ninth Circuit held that in an action to avoid a transfer as constructively fraudulent under Â§ 548(a)(1)(B), if any party claims that the transfer constituted the repayment of a debt (and thus was a transfer for âreasonably equivalent valueâ), the court must determine whether the purported âdebtâ constituted a right to payment under state law. Â If it did not, the court may re-characterize the debtorâs obligation to the transferee under state law principles.
The decision is worth noting because:
â˘ Prior case law in the Ninth Circuit held that re-characterization of âdebtâ as âequityâ was impermissible (see In re Pacific Express, 69 B.R. 112 (B.A.P. 9th Cir. 1986)). Â This decision overrules that earlier precedent.
â˘ The Ninth Circuit joined the Fifth Circuit (In re Lothian Oil, 650 F.3d 539, 542â43 (5th Cir. 2011)) in holding that state law â and state law alone â controls in determining when, and whether, alleged âdebtâ ought to be re-characterized as âequity.â
â˘ The 3-judge panel’s ruling suggests that it is “substance” – and not “form” – which ultimately determines whether an obligation is an equity investment (rather than debt) under applicable state law. Â The crucial question is “whether that obligation gives the holder of the obligation a ‘right to payment’ under state law.”
A copy of the decision is attached.
One of the most effective vehicles for the rescue and revitalization of troubled business and real estate to emerge in recent years of Chapter 11 practice has been the “363 sale.”
Named for the Bankruptcy Code section where it is found, the “363 sale” essentially provides for the sale to a proposed purchaser, free and clear of any liens, claims, and other interests, of distressed assets and land.
The section has been used widely in bankruptcy courts in several jurisdictions to authorize property sales for “fair market value” . . . even when that value is below the “face value” of the liens encumbering the property.
In the Ninth Circuit, however, such sales are not permitted – unless (pursuant to Section 363(f)(5)) the lien holder “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”
A recent decision issued early this year by the Ninth Circuit Bankruptcy Panel and available here)Â provides a glimpse of how California bankruptcy court areÂ employing this statutory exception to approve “363 sales.”
East Airport Development (EAD) was a residential development project inÂ San Luis Obispo which, due to the downturn of the housing market, never came completely to fruition.
Originally financed with a $9.7 million construction and development loan in 2006, EAD’s obligation was refinanced at $10.6 million in mid-2009.Â By February 2010, the project found itself in Chapter 11 in order to stave off foreclosure.
A mereÂ two weeks after its Chapter 11 filing, EAD’s management requested court authorization to sell 2 of the 26 lots in the project free and clear of the bank’s lien, then to use the excess proceeds of the sale as cash collateral.
In support of this request, EAD claimed the parties had previously negotiatedÂ a pre-petition release price agreement.Â EAD argued the release price agreement was a âbinding agreement that may be enforced by non-bankruptcy law, which would compel [the bank] to accept a money satisfaction,â and also that the bank had consented to the sale of the lots.Â A spreadsheet setting forth the release prices was appended to the motion.Â The motion stated EAD’s intention to use the proceeds of sale to pay the bank the release prices and use any surplus funds to pay other costs of the case (including, inter alia, completion of a sewer system).
The bank objected strenuously to the sale.Â It argued there was no such agreement – and EAD’s attachment of spreadsheets and e-mails from bank personnel referencing such release prices ought to be excluded on various evidentiary grounds.
The bankruptcy court approved the sale and cash collateral use over these objections.Â The bank appealed.
On review, the Ninth Circuit Bankruptcy Appellant Panel found, first,Â that the bankruptcy court was within the purview of its discretion to find that, in fact, a release price agreement did exist – and second, that such agreement was fully enforceable in California:
The Ninth Circuit Bankruptcy Appellate Panel‘s East Airport decision provides an example of how bankruptcy courts in the Ninth Circuit are creatively finding ways aroundÂ legal hurdles to getting “363 sales” approved in a very difficult California real estate market.Â It likewise demonstrates the level of care which lenders’ counsel must exercise in negotiating the work-out of troubled real estate projects.
Nortonâs recently-published 2010 Annual Survey of Bankruptcy Law offers an intriguing article focusing on an often-overlooked difference between âSection 363 salesâ and Chapter 11 Plans â and suggesting that, for certain liabilities, Section 363 may actually afford broader relief than a Chapter 11 discharge.
InÂ Classic Chapter 11 Reorganizations Versus Section 363 Sales And The Effects On Environmental Cleanup Obligations: The Choice After Apex Oil Co.Â And General Motors, authors Joel Gross and Christopher Anderson contend:
â[U]nless the law [surrounding Section 363 sales] changes, any debtor seeking to provide maximum protection to its surviving business from broad cleanup liabilities for divested properties would be best advised to utilize a Section 363 sale. Â The protection from successor liability that can be achieved through such a sale will very likely exceed the more narrow discharge from monetary claims that can be obtained if the property is transferred under a plan of reorganization.â
In support of their argument, Gross and Anderson compare the results of two recent decisions â In re Apex Oil and the 2009 In re General Motors Corp. decision.
In Apex Oil, the 7th Circuit held that, despite its prior discharge in Chapter 11, the reorganized debtor remained liable for environmental liabilities incurred years earlier on the grounds that such liabilities were not âclaimsâ subject to discharge under Chapter 11âs provisions.Â A prior post regarding Apex is available here.
In General Motors â by contrast â the the US Government supported, and the Bankruptcy Court accepted, the transfer of GMâs business assets to a newly-formed entity (âNew GMâ) under a sale âfree and clear of all . . . interests,â including successor liability claims.Â In reaching this decision, the Bankruptcy Court relied on the reasoning set forth in In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir.2003) – i.e., that Section 363 provides a basis for selling assets free and clear of successor liability claims.
Not every circuit permits an extension of Section 363âs âfree and clearâ language to successor liability claims.Â See Michael H. Reed, Successor Liability and Bankruptcy Sales RevisitedâA New Paradigm, 61 Bus. Law. 179, 208â211 (2005) (surveying the lower courts’ application of TWA).Â Though at least one District Court and the Ninth Circuit Bankruptcy Appellate Panel have followed the TWA decision, the Ninth Circuit has not explicitly ruled.
Consequently, â[i]n light of the split in circuit authority, it remains to be seen whether the view that successor liability claims can ultimately be cut off via a Section 363 sale will prevail. Â For the time being, however, the majority of appellate courts (including the Second and Third Circuits where so many major Chapter 11 cases are fled) have held that they can, and there seems to be a similar trend in the lower courts.â
That said, the use of Section 363 to avoid environmental liabilities isnât without its problems: âOne potentially important limitation, which appears not to have been addressed by any court to date, is Section 363(e)’s requirement that all sales approved under Section 363 provide adequate protection for the interest of any entity in the property sold.â
Other issues present themselves as well.Â For example:
– Is it possible to provide for liens against the sale proceeds for successor interests?Â Gross and Anderson donât think so â as they see it, doing so would provide otherwise-unsecured creditors with preferential treatment.
– How much are contingent successor claims truly worth?Â Even if it were possible to provide âadequate protectionâ for successor claims, doing so raises the question of what such claims are truly worth.
– Finally, the ability to shield assets from successor liability claims frequently implicates the Courtâs equitable power under Section 105, and the extent of its scope.
Problematic or not, these considerations likely wonât stop debtors from taking a shot at a sale: â[G]iven the certainty following Apex Oil that at least some injunctive claims will survive a traditional chapter 11 reorganization, it can be expected that debtors with significant environmental exposure will prefer to follow the roadmap laid out in GM.â
Last month, this blog featured a preliminary post onÂ Ahcom Ltd. v. Smeding (9th Cir. Oct. 21, 2010, Docket No. 09-16020), a decision restating and reemphasizing the Ninth Circuit’s position that a creditor of a corporation in bankruptcy has standing to assert a claim against the corporation’s sole shareholders on an alter ego theory.
More recently, the Insolvency Law CommitteeÂ of the California State Bar’sÂ Business Law Section released an insightful and helpful e-bulletin discussingÂ the Ahcom decision’s impact on commercial bankruptcy practice in California.
A hard copy of the Committee’s e-bulletin is available here.
Altered Egos – The Ninth Circuit Weighs in (Again) On Whether Individual Creditors Can Pursue Their Own “Alter Ego” Claims Against a Bankrupt Entity’s PrincipalsMonday, October 25th, 2010
Whenever a troubled business seeks bankruptcy protection, unsecured creditors are often left scrambling to find other sources of recoveries for their claims.
In addition to individual, contractually negotiatedÂ protections such as personal guarantees and letters of credit, alter ego claims against the debtor’s principals can provide such creditors with additional pockets from which to seek payment.Â To do so, however, such creditors must often address the objectionÂ that they are without standing to pursue such claims, becauseÂ alter ego claims are often “general” ones, by which all creditors were injured – and from which all creditors are entitled to benefit.Â As a result, goes the objection, only the trustee – and not individual creditors – may pursue alter ego claims against the debtor’s principals.
The idea that alter ego claims may be prosecuted only by the debtor’s bankruptcy trustee on behalf of all creditors has been endorsed by at least one Circuit Court of Appeals:Â The 11th Circuit has affirmed as much in Baille Lumber Company, LPÂ v. Thompson, 413 F.3d 1293 (11th Cir. 2005).
But this view is not universally held.Â In fact, the 9th Circuit has long held a contrary view, as has the 8th Circuit.Â See Williams v. California 1st Bank, 859 F.2d 664, 667 (9th Cir. 1988) (“[N]o trustee . . . has the power under . . . the [Bankruptcy] Code to assert general causes of action, such as [an] alter ego claim, on behalf of the bankrupt estate’s creditors.”).Â Â See alsoÂ In re Ozark Restaurant Equipment Co., Inc., 816 F.2d 1222, 1228 (8th Cir. 1987); Estate of Daily v. Title Guar. Escrow Services, Inc., 187 B.R. 837, 842-43 (D. Haw. 1995), aff’d. 81 F.3d 167 (9th Cir. 1996).
Despite the Ninth Circuit’s guidance, however, several lower courts in California have continued to permit bankruptcy trustees to “glom onto” alter ego claims.Â See, e.g., In re Advanced Packaging and Products Co., 2010 WL 234795 (C.D. Cal. 2010) (permitting a trustee in bankruptcy to settle an alter ego claim brought against the bankrupt corporation’s parent entity because the claim was “general” rather than “particularized”).
Last week – for what appears to be the third time in as many decades – theÂ Ninth Circuit revisited this issue in Ahcom, Ltd. v. Smeding.
Ahcom‘s facts are relatively straightforward:Â Ahcom, a UK-based corporation, contracted for almonds with California-based Nuttery Farms, Inc. (NFI).Â After NFI allegedly failed to deliver the almonds, Ahcom commenced arbitration in Europe, then sued in the US to collect on the arbitrator’s award – but not before NFI had filed for bankruptcy protection.Â Undeterred, Ahcom directly sued NFI’s non-debtor principals, Hendrik and Lettie Smeding, seeking to pierce NFI’s corporate veil.Â Â TheÂ SmedingsÂ removed the action to US District Court for the Northern District of California and successfully dismissed the action on the grounds that Ahcom’s alter ego claims were “general” in nature – and, therefore, property of NFI’s bankruptcy estate.
On appeal, the Ninth Circuit reversed, noting that in California, “there is no such thing as a substantive alter ego claim at all . . . .” (citing Hennessey’s Tavern, Inc. v. Am. Air Filter Co., 251 Cal.Rptr. 859, 863 (Ct. App. 1988)).Â The panel then went further to explain that California law on this issue has been misread by bankruptcy courts and by the Bankruptcy Appellate Panel for the Ninth Circuit.
As a result, “California law does not recognize an alter ego claim or case of action that will allow a corporation and its shareholders to be treated as alter egos for purposes of all the corporation’s debts.Â Just because NFI’s trustee could not bring such a claim against the Smedings under California law, there is no reason why Ahcom’s claims against the Smedings could not proceed.”
A circuit split worthy of resolution by the Supreme Court?Â Perhaps.Â An alternate means of recovery for unsecured creditors who can allege the right facts?Â Most definitely.