Avoidance and Recovery
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Posts Tagged ‘United States Court of Appeals for the Second Circuit’
Avoidance and Recovery
An old and well-known proverb warns: “It is better to remain silent and be thought a fool than to speak and remove all doubt.” Over against this timeless advice, however, a very recent Second Circuit offers more specific guidance for creditors of a bankrupt debtor:
“The squeaky wheel gets the grease.”
In Adelphia Recovery Trust v. Goldman, Sachs & Co., et al., a creditors’ trust established to recover transfers under Adelphia Communications’ confirmed Chapter 11 plan of reorganization sought unsuccessfully to recover “margin call” payments made to Goldman, Sachs & Co. The Second Circuit Court of Appeals agreed with the lower courts in determining that the commingled funds used to make the payments had been taken from a “concentration account” scheduled as property of one of Adelphia Communications’ subsidiaries; consequently the funds were not Adelphia Communications’ to recover, and the trust could not belatedly be re-characterized them as such. A copy of the decision is available here.
In 2002, Adelphia Communications Corporation and related subsidiaries entered Chapter 11 bankruptcy following the disclosure of fraudulently concealed, off-balance sheet debt on Adelphia Communications’ books. The companies were ultimately liquidated and their secured creditors paid in full. In addition, all of the unsecured debt of Adelphia Communications’ subsidiaries was paid in full, with interest, and Adelphia Communications’ general creditors were paid in part. Under Adelphia Communications’ Chapter 11 Plan (confirmed in early 2007 – about 2½ years after the company entered bankruptcy), those same unsecured creditors were to receive the proceeds of the Adelphia Recovery Trust. The Trust was charged with recovery of, among other things, fraudulent transfers made by Adelphia Communications prior to the commencement of the Adelphia cases.
It was not until 2009 that the Trust identified as funds belonging to Adelphia Communications certain commingled funds held in a “concentration account” of one of Adelphia Communications’ subsidiaries. Those funds, it was alleged, were used to cover “margin calls” made by Goldman Sachs & Co. in connection with margin loans previously made to Adelphia Communications’ founders and primary stockholders and collateralized by Adelphia Communications stock. Goldman Sachs had issued the margin calls as the value of Adelphia Commutations stock declined amidst revelations of Adelphia Communications’ off-balance sheet debt.
Goldman Sachs sought, and obtained, summary judgment in the District Court on the basis that the funds in question had been paid by Adelphia Communications’ subsidiary – and not by Adelphia Communications. The Recovery Trust appealed, arguing that the funds in question were, in fact, owned by Adelphia Communications. The Second Circuit Court of Appeals disagreed and affirmed the District Court’s ruling.
The Second Circuit explained that the commencement of a bankruptcy case triggers a number of requirements for a debtor. Among these is the mandatory requirement that the debtor must submit a schedule of all its interests in any property, wherever situated. Ultimately, the debtor must propose a plan which distributes this property within a defined priority scheme, and in the manner most advantageous for the greatest number of creditors.
The plan must also designate classes of claims and classes of interests and specify how the debtor will attend to these classes. Once the relevant parties, including the creditors, approve the debtor’s plan, the court confirms the plan and binds all parties. It is therefore crucial that all claims and interests must be settled before the plan is finalized and within the time frame allotted by the Bankruptcy Code.
The Second Circuit found that the commingled funds sought by the Adelphia Recovery Trust were claimed by one of Adelphia Communications’ subsidiaries during the bankruptcy proceeding. Those claims were asserted without objection from Adelphia Communications’ creditors. The Trust’s subsequent claim to those assets in a subsequent proceeding was therefore inconsistent with creditors’ earlier stance. Under the doctrine of judicial estoppel, parties (and their successors) cannot be allowed to change their positions at their convenience. Consistent with this doctrine, disturbing claims and distributions at such an advanced stage of the proceedings to address the creditors’ changed position would undermine the administration of Adelphia Communications’ and its subsidiaries’ related cases. It would also threaten the integrity and stability of the bankruptcy process by encouraging parties to alter their positions at their whim, as and whenever convenient.
Adelphia Recovery Trust highlights three important realities of bankruptcy practice:
- First, the filing of a debtor’s bankruptcy schedules is more than a merely a perfunctory act. It is a preliminary statement, made to the best of the debtor’s belief and under penalty of perjury, of the debtor’s assets (including all of its ownership interests in any property, anywhere) and its liabilities. Ultimately, creditors and other interested parties – and the court itself – rely upon those schedules in determining the debtor’s compliance with the reorganization requirements of Bankruptcy Code section 1129.
- Second, related debtors are commonly related in much more than name or ownership. In addition to inter-company transfers and claims between debtors, it is common for such enterprises to separate functional asset ownership from legal asset ownership. This distinction may be an important one for various groups of creditors seeking additional sources of recovery.
- Third (and finally), creditors – and the professionals who represent them – should thoroughly investigate any and all “control,” commingling, and other aspects of the relationships between related debtors which may give rise to indirect ownership of assets. Where doubt or conflicting claims exist as to specific assets, it is important for parties with competing claims to reserve their rights early and clearly – thereby making themselves the “squeaky wheel” in the event of any future “grease.”
Ever since the first corporate reorganizations in the US, business owners have been looking for ways to retain ownership of their restructured companies while reducing debt. And ever since owners have been trying to retain ownership, courts have been resisting them.
Today, it is commonly understood that the equity holders of a reorganizing business cannot retain their ownership unless other, senior creditors are paid in full. This principle, known as the “absolute priority rule,” has been developed and refined through various decisions which date back to the 1860′s – before the concept of “corporate reorganization” was formally recognized as such.
Despite the pedigree of the “absolute priority rule,” equity owners nevertheless have continued undaunted in creative efforts to retain some piece of the (reorganized) pie even though creditors senior to them receive less than full payment. And courts, though stopping short of prohibiting it outright, nevertheless keep raising the bar for such ownership.
Yesterday, the Second Circuit Court of Appeals raised the bar another notch with its decision in In re DBSD Incorporated.
The basic economic scenario in DBSD is a relatively common one for business reorganizations: DBSD was an over-leveraged “development stage” start-up company with reorganizable technology and spectrum licensing assets, but no operations – and therefore, no revenue. It was essentially wholly owned by ICO Global, which sought to de-leverage DBSD through Chapter 11 – but who also sought to retain an equity interest in DBSD.
To accomplish these goals, ICO Global negotiated a Chapter 11 Plan which (i) paid its first lien-holders in full; (ii) paid its second lien-holders in stock in the reorganized entity worth an estimated 51% – 73% of their original debt; and (iii) paid general unsecured creditors in stock worth an estimated 4% - 46%. The Plan further provided that ICO Global would receive equity (i.e., shares and warrants) in the newly organized entity.
One of the larger unsecured creditors objected, claiming that DBSD’s Plan violated the “absolute priority rule.” Both the Bankruptcy Court and the District Court found that that the holders of the second lien debt, who were senior to the unsecured creditors and whom the bankruptcy court found to be undersecured, were entitled to the full residual value of the debtor and were therefore free to “gift” some of that value to the existing shareholder if they chose to.
The Second Circuit disagreed. In a lengthy decision (available here), the Court of Appeals held, essentially, that merely calling a Plan distribution a “gift” doesn’t make it one. As a result, the Plan’s distribution of stock and warrants to ICO Global under the Plan was impermissible.
Nevertheless, the Second Circuit didn’t slam the door altogether on the “gifting” of stock from senior creditors to equity. Equity holders looking to de-leverage with the assistance of senior creditors may still consider the following approaches:
- A separate agreement for distributions outside the Plan. Though the DBSD decision notes that the “absolute priority rule” preceded the present Bankruptcy Code, and further devotes some discussion to the general policy reasons behind it, the Second Circuit stopped short of precluding such gifts altogether:
This analysis suggests it may be possible to negotiate outside a Chapter 11 plan for the same economic result as that originally proposed (but rejected) in DBSD.
- A “consensual” foreclosure by a senior secured creditor. Along the way to its conclusion, the Second Circuit distinguished DBSD from another “gifting” case - In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993).
In SPM, a secured creditor and the general unsecured creditors agreed to seek liquidation of the debtor and to share the proceeds from the liquidation. 984 F.2d at 1307-08. The bankruptcy court granted relief from the automatic stay and converted the case from Chapter 11 to a Chapter 7 liquidation. Id. at 1309. The bankruptcy court refused, however, to allow the unsecured creditors to receive their share under the agreement with the secured creditor, ordering instead that the unsecured creditors’ share go to a priority creditor in between those two classes. Id. at 1310. The district court affirmed, but the First Circuit reversed, holding that nothing in the Code barred the secured creditors from sharing their proceeds in a Chapter 7 liquidation with unsecured creditors, even at the expense of a creditor who would otherwise take priority over those unsecured creditors.
The Second Circuit held that DBSD‘s result should be different from SPM‘s because (i) SPM involved a Chapter 7 (where the “absolute priority rule” doesn’t apply); and (ii) the creditor had obtained relief from stay to proceed directly against its collateral – and therefore, the collateral was no longer part of the bankruptcy estate.
This distinction suggests that, under appropriate circumstances, a stipulated modification of the automatic stay and “consensual foreclosure” by a friendly secured creditor might likewise facilitate the transfer of property to equity holders outside the strictures of a Chapter 11 Plan.
DBSD offers interesting reading – both for its coverage of reorganization history, and for its implicit suggestions about the future of “creative reorganizations.”