Earlier this month, the Supreme Court announced that it will review the scope of Bankruptcy Code section 546(e)’s safe harbor provision. Section 546(e) protects from avoidance those transfers that are made “by or to (or for the benefit of)” a financial institution, except where there is actual fraud.  The safe harbor is intended to ensure the stability of the securities market in the event of corporate restructurings.

Now the Supreme Court is poised to determine whether this safe harbor precludes avoidance of a transfer made by or to a financial institution, where the financial institution is merely a conduit with no beneficial interest in the property transferred.

In July 2016, the Seventh Circuit held that the safe harbor does not protect transfers that are “simply conducted through financial institutions (or other entities named in section 546(e)), where the entity is neither the debtor nor the transferee but only the conduit.” FTI Consulting v. Merit Management, 830 F.3d 690, 691(7th Cir. 2016).

In this case, Valley View Downs, LP acquired the shares of a competitor for approximately $55 million, in which Merit had a 30% ownership interest. Valley View’s business strategy failed, and it filed for bankruptcy protection.  Subsequently, the trustee sought to recover the $16.5 million paid to Merit for the purchase of the shares for the estate.  While neither Merit nor the debtor were qualifying financial entities subject to the safe harbor of 546(e), the payment passed through two banks prior to being transferred by the debtor to Merit.  The Seventh Circuit determined that the statutory language was vague, and that Congress intended to protect only qualifying financial entities from avoidance, but not to protect entities that are not qualifying financial entities simply because a transfer passed through a financial intermediary.

The Seventh Circuit joined the Eleventh Circuit in so holding, while the majority of circuits – the Second, Third, Sixth, Eighth and Tenth have held that the 546(e) safe harbor does shield transfers that pass through a financial institution as merely a conduit. The Supreme Court is now expected to resolve this circuit split.

In a similar dispute, involving the Tribune Company LBO and subsequent bankruptcy, the Supreme Court has not yet granted nor denied the petition for certiori. In that case, which Distressing Matters discussed here, the Second Circuit held that the safe harbor prevents creditors from recovering under state constructive fraud theories when shareholders receive distributions under securities contracts effectuated through financial institutions.  Although the Tribune noteholders sought Supreme Court review of the Second Circuit’s ruling in September 2016, it appears that the Court is holding off on review of that particular issue for now. Stay tuned!

As noted in a recent Distressing Matters post, the United States Supreme Court in In re Jevic Holding Corp. held that debtors cannot use structured dismissals to make payments to creditors in violation of ordinary bankruptcy distribution priority rules.  The Jevic dissent complained that the majority avoided the more general question presented—whether a bankruptcy settlement can violate the statutory priority scheme.  The bankruptcy court for the Eastern District of Tennessee has addressed that complaint, holding that priority-altering settlements must be “fair and equitable” and promote a significant Code-related objective.

In In re Fryar, the bankruptcy court reviewed a settlement involving the sale of the debtor’s equity interests in two private ventures.  The IRS had a lien on the debtor’s equity interests.  The settlement proposed using the sale proceeds to pay off a bank lien on certain real estate, rather than using the proceeds to satisfy the IRS.  In exchange for the sale proceeds, the bank would release its lien on the real estate and retain a subordinated deficiency claim.  The IRS would then receive a lien on the now unencumbered real estate.  The bank acknowledged that if the sale proceeds were distributed according to the statutory priorities and the bank merely foreclosed on the real estate, its recovery would be less than half of what it stood to receive under the settlement.

Three unsecured creditors and the United States Trustee objected to the settlement on the basis that it reordered distribution priorities for the benefit of the bank. The bankruptcy court agreed, noting that the settlement allowed the bank to jump “to the head of the line.”  Absent the settlement, the proceeds would have gone first to the IRS to satisfy its lien on the equity, then to the estate for distribution to priority unsecured creditors (e.g., other unpaid tax claims) and finally to general unsecured creditors on a pro rata basis.

The bankruptcy court cited dicta from Jevic while considering the merits of the proposed settlement:

We recognize that Iridium is not the only case in which a court has approved interim distributions that violate ordinary priority rules. But in such instances one can generally find significant Code-related objectives that the priority-violating distributions serve. . . .  In doing so, these courts have usually found that the distributions at issue would “enable a successful reorganization and make even the disfavored creditors better off.” [Citations omitted].

Applying such guidance, the bankruptcy court determined that the settlement was more of a preamble to a conversion or structured dismissal than an anticipated reorganization and that the debtor did not prove that the settlement promoted a significant Code-related objective. Accordingly, the bankruptcy court sustained the objections to the settlement.

The bankruptcy court’s holding essentially establishes a new requirement for acceptance of any priority-altering settlement—post-Jevic, debtors wishing to consummate such settlements must now prove not only that the settlements are “fair and equitable” but also that the settlements promote a significant Code-related objective.  It remains to be seen whether other courts will demand that debtors meet similar standards for priority-altering settlements.

In a recent American Law Journal article, “When Hiding Assets Doesn’t Work: How Mintz Levin Recovered $20M for Cheated Client,” Daniel Pascucci and Joe Dunn detail the extensive efforts used to hold a judgment creditor accountable — 10 years and $20 million later, the case exemplifies the old saying that you can run, but you can’t hide.

In 2015, Distressing Matters reported on the Third Circuit’s decision in In re Jevic Holding Corp., wherein that panel ruled that, in rare circumstances, bankruptcy courts may approve the distribution of settlement proceeds in a manner that violates the Bankruptcy Code’s statutory priority scheme. The Third Circuit’s opinion endorsed the Second Circuit’s “flexible approach” solution to that question and rejected the Fifth Circuit’s finding that settlements must be “fair and equitable,” and thus comply with the priority scheme, as “too rigid.” Last year, the Supreme Court agreed to hear the case and address the circuit split.

The Court reversed (6-2) the Third Circuit ruling and held that bankruptcy courts may not approve structured dismissals that provide for distributions that do not conform to the ordinary priority rules, even as a “rare case” exception.

To briefly revisit the facts, the debtor was a financially-troubled trucking company. A private equity firm acquired the company in a leveraged buy-out and refinanced the company’s debt. Shortly thereafter, the company defaulted on these obligations and filed a Chapter 11 bankruptcy petition.

The company terminated most of its employees, including its truck drivers, just one day before filing the petition, which gave rise to a multimillion dollar priority wage claim. Despite the truckers’ priority status, distributions to the company’s senior lenders would have drained the company’s limited coffers, leaving nothing for the truckers.

At the same time, the unsecured creditors’ committee pursued fraudulent transfer claims against the senior lenders. Eventually, the senior lenders and the committee entered into a settlement agreement that would shuffle a few million dollars to the general unsecured creditors, thus bypassing the truckers’ priority claims. The bankruptcy court approved the settlement over the truckers’ objection and the district court affirmed that decision.

In a “close call,” the Third Circuit upheld the lower courts’ decisions, but stressed that deviation from the statutory priority scheme should occur only in those rare circumstances when bankruptcy courts “have specific and credible grounds to justify deviation.” Much of the Third Circuit’s reasoning attached to the simple fact that – whether the settlement was allowed or disallowed – the truckers would, in the court’s estimation, walk away empty-handed.

The Supreme Court disagreed. As Justice Breyer explained for the majority, the bankruptcy court cannot disregard the statutory priority scheme, at least not in the context of a structured dismissal.

A distribution scheme ordered in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic rules that apply under the primary mechanisms the Code establishes for final distributions of estate value in business bankruptcies.”

In reaching its conclusion, the Court reinforced that the priority rules are “a basic underpinning of business bankruptcy law” and “fundamental.” Admittedly, the structured dismissal statute gives bankruptcy courts a limited authorization to alter the status quo ante “for cause.” The Court ruled that flexibility does not extend to non-consensual modifications of the priority rules. Indeed, the Court suggested, departures from the status quo should only be permitted insofar as they are designed to protect third parties who reasonably relied on any modifications made throughout the course of the bankruptcy proceedings.

A dissent (authored by Justice Thomas and joined by Justice Alito) did not take aim at the majority’s reasoning but, instead, took umbrage with a perceived bait-and-switch. In Justice Thomas’ view, the Court granting certiorari on a particular question – whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme – but that the truckers argued and the majority answered the related but narrower question of whether a Chapter 11 case may be terminated by a structured dismissal that distributes estate property in violation of the priority scheme.

The dissent underscores an important take-away. The Court’s determination that bankruptcy courts may not depart from the statutory priority scheme, even in rare circumstances, applies only to cases concluding with a structured dismissal. The practice of a secured creditor bypassing an intervening class and “gifting” proceeds to a lower class of creditors in other situations (e.g. plan confirmations, liquidations) remains a fair and fertile battleground.

The filing of a bankruptcy case puts in place an automatic injunction, or stay, that halts most actions by creditors against a debtor. But can a creditor violate the automatic stay by not acting? The Tenth Circuit recently addressed the issue in WD Equipment, LLC v. Cowen (In re Cowen), adding to the split of authority on the issue.

In WD Equipment, the debtor filed for bankruptcy just after creditors repossessed two of his vehicles. After the creditors refused to return the vehicles, the debtor sought to have the creditors held in contempt for willful violations of the automatic stay. The bankruptcy court agreed and ordered the creditors to immediately turn over the vehicles.  When the creditors failed to comply, the debtor commenced an adversary proceeding for violations of the automatic stay.  The bankruptcy court ruled that failing to return the vehicles violated the automatic stay and imposed actual and punitive damages. The district court affirmed the bankruptcy court’s stay ruling, which followed the majority rule (applicable in the Second, Seventh, Ninth and Eighth Circuits) that the act of passively holding onto an asset constitutes exercising control over it and thus violates the automatic stay.

The Tenth Circuit disagreed, viewing the majority rule as resting on “practical” or “policy” considerations rather than “faithful adherence to the text.” Reasoning that the language of the statute is “plain”, the Tenth Circuit found that the automatic stay enjoins an “act”, which means to “take action” or “do something” to obtain control of the estate property. It does not cover “the act of passively holding onto an asset.”

The Tenth Circuit noted that the best, albeit flawed, argument for the majority rule is to read Bankruptcy Code sections 362 and 542 together. Section 542, which requires any entity in possession of estate property to turn it over to the trustee, would likely be enforced through the automatic stay provision. However, the Tenth Circuit dismissed this argument, because there is no textual link between sections 542 and 362. Adopting the minority rule, the Tenth Circuit concluded that the automatic stay only bars affirmative acts to gain possession of estate property. Thus, the creditors’ failure to the turnover the trucks did not violate the automatic stay.

Given the plain language of the statute, it’s difficult to disagree with the Tenth Circuit’s reasoning that the automatic stay only prohibits actions, not inactions (“an act to obtain possession of property of the estate,” “an act to create, perfect or enforce a lien,” “an act to collect, assess, or recover a claim”). However, did the debtor even need to assert a stay violation to obtain possession of the vehicles? Section 542 places an affirmative duty on creditors to turn over estate property. Thus, the debtor could have commenced a turnover action to obtain possession of the vehicles, given that the redemption period had not expired. Nevertheless, the automatic stay can be a powerful tool for debtors, and creditors should be aware of what actions, or inactions, constitute a violation.

 

In Nortel Networks, Inc., Case No. 09-0138(KG), Doc. No. 18001 (March 8, 2017), the Delaware Bankruptcy Court ruled on the objections of two noteholders who asked the Court to disallow more than $4.4 million of the $8.1 million of the fees sought by counsel to their indenture trustee.  Given the detailed rulings announced by the Court, the decision may establish a number of guidelines by which future fee requests made by an indenture trustee’s professionals will be measured.

Matters Handled by the UCC

The noteholders’ objection asserted that the trustee had breached its fiduciary duties because it had permitted its counsel to rack up millions of dollars of unnecessary fees during litigation that was being adequately handled by the Unsecured Creditors Committee (UCC). As proof, the noteholders pointed to the fact that the litigation was ultimately settled by counsel to the UCC pursuant to a global settlement which resulted in a resolution of the entire bankruptcy case.  In response, the Court noted that the trustee’s fiduciary duties with respect to the direction of counsel are governed by the “prudent person” standard, but that that standard cannot be applied through the 20/20 lens of hindsight.  Instead, the trustee’s actions must be analyzed in the context of the facts known at the time of the direction.

The Court observed that Nortel was an unusually long, complex and contentious proceeding in which the trustee and its counsel were required to protect the noteholders’ rights during a number of hotly contested proceedings, any one of which might have significantly and adversely affected the noteholders’ recoveries.  Thus, during the case, it would not have been prudent for the trustee to rely solely upon counsel to the UCC to protect the interests of the noteholders.  The fact that the case was ultimately resolved by the efforts of the UCC was not dispositive since, at the time, the trustee could not have prudently assumed that result.  The Court did, however, contrast the litigation issues which might have directly affected noteholders with matters, e.g., attendance at regular meetings of the UCC, which only affected general unsecured creditors as a whole.  Those latter issues were in fact being adequately handled by counsel to the UCC, and fees for more than one counsel representing the trustee at regular meetings of the UCC would be disallowed.

Transition Fees

The noteholders objected to fees charged by the trustee’s predecessor counsel for time spent transitioning the representation to the trustee’s current counsel. The Court found, as an evidentiary matter, that predecessor counsel had been uncooperative during the transition process, thereby necessitating more work by successor trustee counsel.  Accordingly, it sustained the noteholders’ objection based upon predecessor counsel’s “nonfeasance.”

Fees for Defending Fees

The noteholders objected to fees incurred by the trustee in defending the fee objection, citing the U.S. Supreme Court’s recent ASARCO case which stands for the proposition that lawyers cannot recover fees for defending their own fees in a bankruptcy proceeding.  The Bankruptcy Court noted, however, that ASARCO allowed an exception where one party had contractually agreed to pay the fees of the other party.  The Bankruptcy Court ruled that the indenture was such a contract because it required the debtor to pay the fees of trustee’s counsel and, in any event, granted the trustee a charging lien on any recovery owed to the noteholders.

All told, of the $8.1 million in asserted fees, the Bankruptcy Court sustained the noteholder’s objections to the extent of $913,936.70. The Court specifically remarked that it was generally unsympathetic to the noteholders’ complaints in light of the fact that the noteholders had never objected to counsels’ fees until near the end of the case.

In general, Nortel is a favorable decision for indenture trustees and their counsel, which stands for the proposition that fees should not be second-guessed with hindsight so long as there is a reasonable need to protect the specific interests of the noteholders.

One of the most powerful and oft used devices in bankruptcy is the sale of assets “free and clear” of liens, claims and interests. One issue a buyer at a bankruptcy sale must consider, however, is whether due process has been met with respect to parties whose liens, claims and/or interests are released through such sale.  Indeed, a lack of due process could foil a “free and clear” sale, leaving a buyer with an encumbered purchase and nowhere to turn for recourse.

In In re Olsen, a Wisconsin bankruptcy court considered whether the failure to provide formal notice to a party with a right of first refusal (ROFR) on certain of the debtor’s real estate (Property) voided the court’s “free and clear” sale order. The court held that the sale process did violate due process and that the effective remedy was honoring the ROFR in a subsequent (post bankruptcy) sale of the Property.

In order to maximize the going concern value of its grain facility business, the debtor sought to sell substantially all of its assets in conjunction with its plan of reorganization. Archer-Daniels-Midland (Purchaser) purchased the assets, including the Property.  Subsequent to the conclusion of the bankruptcy case, the Purchaser sold the Property to a third party.  Country Visions Cooperative (Objector), the holder of the ROFR, sued the Purchaser in state court and asserted its ROFR.  The Purchaser countered by moving to reopen the bankruptcy case to enforce the confirmation order and bar the Objector’s state court proceeding.

In upholding the ROFR, the bankruptcy court found three important undisputed facts: (i) the Objector was not listed as a creditor of the debtor, and did not receive formal notice of the bankruptcy case, (ii) the Objector never received formal notice that the Property was to be sold free and clear of the ROFR, and (iii) the Objector never received the contractual notice that the Property was being sold as required by the ROFR.

Notably, the Objector did receive informal notice of the bankruptcy case and may have even learned about the sale shortly before closing. However, such notice was not “notice reasonably calculated, under all the circumstances, to apprise interested parties of the pendency of the action and afford them an opportunity to present their objections”—as due process requires.  Thus, the bankruptcy court concluded that the Objector did not receive sufficient notice before its ROFR was purportedly extinguished.

The Purchaser argued that notwithstanding the faulty notice, the court should enforce the confirmation order to strip the ROFR because the Purchaser was a bona fide purchaser that acquired the Property in good faith under section 363(m) of the Bankruptcy Code. The court rejected this argument, explaining that a bona fide purchaser cannot have notice of a prior adverse claim.

Here, the Purchaser did have prior notice of the ROFR (even if the notice was constructive) because the ROFR was properly recorded. The Purchaser also had received an email indicating that someone had a ROFR on the Property.  The court explained that the Purchaser easily could have commissioned a title report and ensured that all parties in interest received due notice.   The court acknowledged that the debtor should have properly noticed all parties in interest, including the Objector, but also found that the Purchaser could not “cloak itself with the mantle of a bona fide purchaser when it ignored information suggesting the [Objector’s] rights were not addressed in the sale.”  Thus, the court approved the Objector’s request to enforce its ROFR in the Purchaser’s post-bankruptcy sale of the Property.

In sum, a buyer in bankruptcy should consider independently ensuring that all parties with purported liens, claims or interests in the sale assets receive proper notice of the sale; hoping that the debtor provides proper notice may not be sufficient.  A little effort up front can save time, money and aggravation in the end.

There are numerous reasons why a company might use more than one entity for its operations or organization: to silo liabilities, for tax advantages, to accommodate a lender, or for general organizational purposes. Simply forming a separate entity, however, is not enough. Corporate formalities must be followed or a court could effectively collapse the separate entities into one. A recent opinion by the United States Bankruptcy Court for the District of Massachusetts, Lassman v. Cameron Construction LLC provides a cautionary tale for companies that ignore critical guidelines necessary to maintain separateness.

Substantive consolidation is an equitable remedy in bankruptcy that has the effect of consolidating the assets and liabilities of separate entities into a single entity. Substantive consolidation is a highly unpredictable area of law; courts have developed no fewer than five different tests. While the cases are inherently fact-specific, common factors have emerged to provide some guidance.

In Cameron Construction & Roofing Co., the debtor operated a roofing company. Its primary assets at the time of its Chapter 7 bankruptcy were vehicles and tools, which were not sufficient to pay its creditors. Twelve years before the bankruptcy, the debtor’s majority owner formed a separate limited liability company (“LLC”) to own the real estate where the debtor operated its business, a common and reasonable strategy considering the environmental concerns with the property. The debtor and LLC maintained some corporate formalities, including filing separate tax returns and annual statements, and issuing separate W-2 statements for employees.

Nevertheless, over time, the role of the LLC evolved into more than a simple real estate holding company. It leased the property to the debtor at above-market rates and employed and paid the salaries of workers that performed services exclusively for the debtor (allegedly to avoid the debtor paying higher workers’ compensation premiums). Neither the debtor nor the LLC documented their intercompany transactions. Moreover, the debtor and the LLC apparently did not provide any notice of their separateness to their respective creditors.

Ultimately, the court found consolidation of the debtor and the LLC (a non-debtor) to be appropriate. Key to the court’s decision was a finding that there was a “substantial identity” between the debtor and the LLC. The court highlighted several of the more common substantive consolidation factors: common ownership of the debtor and the LLC, a lack of corporate formalities, and the absence of formal agreements between the entities (of note, even if there had been a formal lease between the debtor and the LLC, the above-market rent would have been problematic since agreements between entities should be similar to those available on an arms-length basis with unaffiliated third parties). The court also considered the benefit and harm to creditors resulting from consolidation, finding that no creditor of the LLC would be harmed by consolidation while creditors of the estate would benefit.

There are dozens of steps that companies can take to maintain proper separateness, signal to their creditors that only a particular entity’s assets are available to satisfy its liabilities, and decrease the likelihood that a court disregards a chosen corporate structure. The debtor in Cameron Construction & Roofing Co. and its related LLC took some of these steps, but ignored many others. These steps must be followed as much as possible or else companies operating related entities may unwittingly fall into the substantive consolidation trap.

In a recent decision (“Energy Future Holdings”) poised to have wide-reaching implications, the Third Circuit Court of Appeals reversed the decisions of the Bankruptcy and the District Courts to hold that a debtor cannot use a voluntary Chapter 11 bankruptcy filing to escape liability for a “make-whole” premium if express contractual language requires such payment when the borrower makes an optional redemption prior to a date certain. In so doing, the Third Circuit expressly rejected the reasoning of the Southern District of New York in the Momentive decisions, which reviewed similar language and held that no “make-whole” was due. The Momentive decisions are under advisement by the Second Circuit Court of Appeals, setting the stage for a potential circuit split.

In Energy Future Holdings, the debtor (“EFIH”) filed for bankruptcy for the explicit purpose of refinancing the debt at favorable interest rates (saving over $13 million per month) and avoiding its obligation to pay the make-whole premiums to both its first and second lien noteholders.  Several weeks after the bankruptcy filing, EFIH executed this strategy and the noteholders objected.  Both lower courts approved of EFIH’s actions, finding that the section of the indenture that accelerated the debt upon bankruptcy did not mention the make-whole payment, therefore none was due.

The Third Circuit took a different view of the two relevant provisions in the indentures: Section 3.07, which provided that at any time before December 1, 2015 the notes could be redeemed for 100% of the principal amount plus, inter alia, the make whole payment, and Section 6.02, which provided that upon a bankruptcy filing, all outstanding notes are due and payable immediately.

The Third Circuit found that these two provisions are not at odds with each other, and that New York law requires that that both provisions be given effect. The concept of “redemption” (as opposed to prepayment), under both New York and federal law, is not limited to only repayments of debt that predate its maturity; rather, redemption includes both pre-and post-maturity repayments of debt.  The redemption by EFIH was optional, despite the automatic acceleration of the debt under Section 6.02, as (i) EFIH voluntarily filed for bankruptcy, (ii) EFIH could have reinstated the accelerated notes’ original maturity date, and (iii) EFIH redeemed the notes over the noteholders’ objections.  To the Third Circuit, after reviewing the relevant indentures and the facts of the payments, “Redemptions, not prepayments, occurred here, they were at the election of EFIH, and they occurred before the respective dates [in the indentures].”

It remains to be seen whether the Second Circuit will agree with the analysis of the Third Circuit concerning almost identical operative sections of the respective indenture agreements, or whether it will uphold the lower courts’ decisions in Momentive. Under the Third Circuit’s holding, however, borrowers in that jurisdiction seeking the ability to avoid payment of the make whole upon acceleration of the debt need to make that expressly clear in the governing contract.

A recent opinion issued by the United States District Court for the Northern District of Illinois reminds us that corporate veil-piercing liability is not exclusive to shareholders. Anyone who is in control of and misuses the corporate structure can be found liable for the obligations of the corporation.  The facts of this case, however, did not support personal liability for veil-piecing.

In Seamans v. Hoffman, et al., the court was asked to find a former owner (Tauriac) of a debt collection agency personally liable for a violation of the Fair Debt Collection Practice Act (FDCPA).  Tauriac had recently sold the business but remained in control of the business bank account in order to reconcile and appropriately allocate between the pre- and post-sale receivables—the pre-sale receivables were owed to Tauriac per the terms of the sale transaction.

During this reconciliation period, the company attempted to collect a debt from an individual who had gone through a bankruptcy proceeding in which the debt was discharged. The individual, alleging violations of the FDCPA, sued and obtained a default judgment against the company and Tauriac.  Tauriac got the default judgment overturned and pursued the merits of her defense.

As an initial matter, the court recognized that under normal circumstances, “officers and shareholders of a debt collection [company] generally cannot be held liable for violations of the FDCPA.” An exception exists, however, if there is a basis to pierce the corporate veil.  Thus, if an individual exerts sufficient control and dominance over the entity and misuses the corporate structure, personal liability may be found.

Here, apart from the control Tauriac had over the business bank account pursuant to the terms of the sale agreement, she did not exhibit any other indicia of control or dominance over the corporation: she did not manage employees, she did not manage collection efforts, she did not interact, post-sale, with the company (other than with respect to the bank account), there was no evidence that she comingled her assets with those of the company, or otherwise used corporate assets to pay her expenses. In short, she did not disregard the corporate entity to use it as a mere instrumentality for personal gain.  Absent these indicia of control or evidence of personal use, there can be no personal liability for corporate obligations under a veil-piercing theory.

The take-away from this case is that there could be situations where a non-shareholder is held liable under a veil-piercing theory, if control, dominance and misuse are present.