Last week, President Trump unveiled his proposal to fix our nation’s aging infrastructure. While the proposal lauded $1.5 trillion in new spending, it only included $200 billion in federal funding. To bridge this sizable gap, the plan largely relies on public private partnerships (often referred to as P3s) that can use tax-exempt bond financing. In evaluating bankruptcy and default risk with P3s and similar quasi-governmental entities it is important to understand whether such entities are eligible debtors under the Bankruptcy Code, and, if so, whether they are Chapter 11 or Chapter 9 eligible.

Continue Reading Checking-In: Chapter 9, Chapter 11 or Ineligible?

In the recently decided case, Mission Product Holdings, Inc. v. Tempnology, LLC, the United States Court of Appeals for the First Circuit took a hardline position that trademark license rights are not protected in bankruptcy. Bankruptcy Code section 365(n) permits a licensee to continue to use intellectual property even if the debtor rejects the license agreement. However, the Bankruptcy Code definition of “intellectual property” does not include trademarks, leading a majority of courts to conclude that trademark rights fall outside the scope of licensee rights under section 365(n). The First Circuit’s decision marks a split from the Seventh Circuit’s decision in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 686 F.3d 382 (7th Cir. 2012), which held that a trademark licensee retains basic contractual rights to use a debtor’s trademarks post-rejection.

In Tempnology, Mission entered into a co-marketing and distribution agreement with Tempnology (the Debtor). Under the agreement, Mission was granted: (i) an exclusive right to distribute certain manufactured products; (ii) a non-exclusive perpetual license to use Tempnology’s intellectual property other than its trademarks; and (iii) a non-exclusive, non-transferable, limited license to use Tempnology’s trademark and logo. After filing its chapter 11 petition, Tempnology moved to reject the co-marketing and distribution agreement. Mission objected and, relying on section 365(n), asserted that it retained its rights under the agreement, including the use of the intellectual property license, its exclusive product distribution rights and its right under the trademark license.

The Bankruptcy Court held that section 365(n) only protected Mission’s non-exclusive intellectual property rights and did not preserve Mission’s exclusive distribution rights or the trademark license. Mission appealed.

The Bankruptcy Appellate Panel for the First Circuit (BAP) agreed that the exclusive distribution rights were not preserved under section 365(n). The BAP also agreed that section 365(n) does not apply to trademarks because the definition of “intellectual property” under the Bankruptcy Code does not include trademarks. However, the BAP did not find that rejection of the agreement extinguished all of Mission’s rights under the trademark license. Instead, the BAP followed the Seventh Circuit’s ruling in Sunbeam and found that “because section 365(g) deems the effect of the rejection to be a breach of contract, and a licensor’s breach of a trademark agreement outside the bankruptcy context does not necessarily terminate the licensee’s rights, rejection under section 365(g) likewise does not necessarily eliminate those rights.” Thus, the BAP held that Mission’s post-rejection rights were governed by the terms of the agreement and non-bankruptcy law.

The First Circuit agreed that neither exclusive distribution rights nor trademarks were considered “intellectual property” under the Bankruptcy Code and thus neither were covered by section 365(n). Accordingly, section 365(n) did not preserve Mission’s exclusive distribution rights or its right to use the trademarks.

The First Circuit went on to reject the BAP’s support of Sunbeam, finding that the Sunbeam approach would impose a burden on a debtor, as the trademark owner, to monitor the quality of the trademark despite having rejected the contract. The Court noted that Sunbeam rested on the notion that it is possible to free the debtor from any continuing performance obligations under a trademark license even while allowing the licensee to continue to use the trademark. The Court reasoned that trademarks, unlike patents, were public-facing messages that required monitoring and control to maintain the goodwill associated with the trademark. Sunbeam’s approach would allow Mission to retain the use of Tempnology’s “trademarks in a manner that would force the Debtor to choose between performing executory obligations arising from the continuance of the license or risking the permanent loss of its trademarks, thereby diminishing the value….” Such a restriction runs afoul of section 365(a) and invites further degradation of a debtor’s fresh start options. Accordingly, the First Circuit concluded that trademark licenses are unprotected from court-approved rejection, and Mission retained no rights post-rejection.

The First Circuit joins the majority of courts that have found a trademark licensee only has a claim for damages upon rejection of its license, despite a recent trend of cases protecting trademark licensee’s rights in bankruptcy. This decision marks a split among the circuits, which may ultimately be resolved by Congressional amendment to the definition of intellectual property in the Bankruptcy Code, or by the Supreme Court.

The Massachusetts Supreme Judicial Court recently held that the Massachusetts Wage Act does not impose personal liability on board members or investors acting in their normal capacities. In Segal v. Genitrix, LLC, the SJC found that former board members and investors who were not company officers and who had limited agency authority did not fall within the scope of the Wage Act, which imposes liability for unpaid wages on certain officers and agents having management authority over the company.

In 1997, H. Fisk Johnson, III agreed with Andrew Segal to form a biotechnology company, Genitrix, LLC. To launch this venture, Segal contributed his intellectual property and served as president and chief executive officer; Johnson contributed capital. Each had two seats on the board. Later, through subsequent equity advances, Johnson gained a third board seat.

As CEO and president, Segal managed Genitrix. He was responsible for all day-to-day operations. Segal had sole authority on payroll issues; however, he did need board approval for certain hiring and firing activities.

In 2006, Genitrix experienced financial difficulty. Johnson conditioned any future equity investments on specified uses, such as payroll and other operating expenses. In January 2007, Segal decided to stop taking his salary to permit the company to pay its last remaining key employee.  A few months later, Segal informed his board that he had not been getting paid.

After a long falling out, Segal sued Johnson and others under the Wage Act for his unpaid wages from 2007 to 2009.

Under the Wage Act, the president and treasurer of a corporation, and any officers or agents “having the management of the corporation,” are liable for nonpayment of wages to employees. With no allegation that the defendants in Genitrix were officers, the SJC considered for the first time whether the definition of “agents having the management of the corporation” should apply to board members or investors.

The SJC recognized that not all agents of a corporation have the same responsibility. Only those agents that have assumed and accepted as individuals significant management responsibilities over the corporation, similar to those performed by a corporate president or treasurer, particularly concerning the control of finances or payment of wages, should have personal liability for Wage Act violations. Individual directors or investors may be considered agents of the corporation if they are empowered to act as such, whether through express or implied consent. However, in such cases, any agency relationship would stem from their appointment as an agent, not from their position as a director or investor.

Here, there was no indication that any individual board member or investor had engaged in any activity that equated to being an agent having management of Genitrix. The board, like most, acted collectively, not individually, when it set policy and oversaw management – the role of a typical board of directors. The board did not perform the management function of the company. Similarly, when the investors exercised financial control over the company, they were acting as outsiders, not managers or agents of the corporation. When investors in Genitrix earmarked future investments for specific expenses, they were not managing the company so much as managing the risk of their investment. The SJC noted that exercising one’s rights and leverage as an investor over infusions of new money is acting in a manner separate and distinct from being an agent having the management of the corporation.

In short, the SJC found the board members and investors did not act as “agents having the management of the corporation” when they went about their normal functions as a board and investors, respectively.

The Genitrix decision is good news for boards and investors in distressed companies who often find themselves facing landmines and pitfalls as their company falls into insolvency. Board members and investors that act in their respective capacities but that do not seek to manage the company directly, especially with respect to payment of wages, should be safe from liability under the Wage Act. Nevertheless, it is a good idea to make sure that those running the company timely and properly pay wages to avoid the possibility of personal liability on this issue.

Refusing to rely on “equitable principles” when interpreting the Delaware Uniform Fraudulent Transfer Act (DUFTA), the Third Circuit (2-1 decision) in Crystallex Int’l Corp. v. Petroleos De Venezuela, S.A, et als. held that a transfer by a non-debtor cannot be a fraudulent transfer.

Lending credence to Mel Brooks’ immortal words: “It’s good to be the king,” or the president of Venezuela, Bolivarian Republic of Venezuela (Venezuela) expropriated Crystallex International Corp.’s (Crystallex) rights in a gold mine the company had spent approximately $650 million developing. Eventually, the Venezuelan Central Bank purchased a 40% stake in the seized mine for $9.5 billion.

Mineless, Crystallex filed for bankruptcy and commenced an arbitration before the World Bank, resulting in a $1.2 billion victory against Venezuela. Undaunted, Venezuela refused to pay the award and stated that it would actively eschew making the payment. Venezuela then monetized its interest in CITGO Petroleum, its largest asset located in the United States, through a series of debt offerings and upstream dividends among a succession of directly and indirectly owned companies. These funds passed first through a series of US entities and then were transferred to the Venezuela national oil company, a foreign corporation.

Under applicable treaties, Venezuela could not be sued to disgorge the repatriated the money. Unable to pursue Venezuela, Crystallex sued PDV Holding, Inc. (PDVH) a top-level US entity and indirect subsidiary of Venezuela’s national oil company on an actual fraudulent transfer theory. PDVH moved to dismiss the lawsuit because Crystallex had failed to alleged that the transfer was made “by a debtor” as required under DUFTA. The District Court denied the motion and found that indirect transfers by instrumentalities of a debtor (explicitly recognizing that only Venezuela, and perhaps its alter ego in the form of the national oil company, was the debtor of Crystallex by virtue of the arbitration award) are actionable under DUFTA. The District Court also noted that DUFTA broadly provides for the application of the principles of law and equity in these situations.

Reversing the lower court, the Third Circuit noted the three necessary elements of a properly pled claim under DUFTA: (i) a transfer, (ii) by a debtor, (iii) with actual intent to hinder, delay or defraud a creditor.

Crystallex did not allege PDVH to be a debtor or to have any liability for the arbitration award. The Court found that the Delaware Chancery Court has held that a non-debtor cannot commit a fraudulent transfer (the Delaware Supreme Court has not decided the issue). Giving a nod to a fundamental precept of Delaware corporate law that parent and subsidiary corporations are separate entities, the Third Circuit refused to read “by a debtor” broadly enough to bring a non-debtor within the scope of DUFTA. The Court also noted that Crystallex did not allege any basis for piercing the corporate veil between PDVH and either Venezuela or its national oil company. Thus, there was no legal or factual basis for holding the subsidiary responsible for its parent’s debt

The Court then addressed alternative theories of non-debtor transferor liability, such as indirect transfers, aiding and abetting and conspiracy to commit fraudulent transfers.  Again, citing Delaware Chancery Court law, the Third Circuit debunked these theories, noting, “Delaware courts have closed the door to non-debtor transferor liability under [DUFTA], and we are not free to open it.”

The dissent took issue with the majority’s statutory interpretation, believing that PDVH’s dividend to the national oil company at Venezuela’s request was an indirect transfer by a debtor. The dissent noted that a transfer includes “every mode, direct or indirect . . . of disposing of or parting with an asset or an interest in an asset.”   The dissent believed that “even though [PDVH] was not a debtor to Crystallex, it clearly facilitated the fraudulent transfer and is therefore a proper defendant in this case.” The dissent disagreed with the majority’s view that the Delaware Chancery Court decisions support no liability under DUFTA.

Recognizing that DUFTA is “firmly grounded in principles of equity,” the dissent was “hard pressed to conceive of a scenario more worthy of a trial court’s invocation of its broad equitable powers under [DUFTA] than this one.” “[I]t cannot be that [DUFTA] . . . leaves . . . the victim of a purposeful and complicated fraud without any remedy for [PDVH’s] role in transferring $2.8 billion out of the United States to avoid Venezuela’s creditors.” The dissent would have upheld the lower court’s dismissal of PDVH’s motion to dismiss and let the case move to trial.

The Third Circuit, as a court sitting in diversity, felt constrained to apply state law as interpreted by the courts sitting in that state. The Court could not “‘act as a judicial pioneer’ in a diversity case.” Therefore, non-debtors in Delaware are free to make transfers to debtors without concern for fraudulent transfer liability until the Delaware state courts say otherwise, or the Third Circuit has a change of heart.

Last week the Second Circuit issued its long-awaited opinion on the appeals of plan confirmation taken by the first lien, 1.5 lien and subordinated noteholders in In re MPM Silicones, LLC (“Momentive”).   With one exception, the Court determined that the plan confirmed by the bankruptcy court in September 2014 comports with Chapter 11 of the Bankruptcy Code.  The Court remanded to the bankruptcy court in order to address the process for determining the proper interest rate under the cramdown provision of Chapter 11.

The Bankruptcy Code allows debtors to issue replacement notes pursuant to which deferred cash payments are made to secured creditors, but ultimately these payments must amount to the full value of the secured creditors’ claims.  In order to ensure that the creditor receives the full present value of its claim, the payments must carry the appropriate rate of interest.  In this case, the bankruptcy court applied an interest rate based on the “formula” approach, and selected interest rates of 4.1% and 4.85% for the first lien and 1.5 lien notes, respectively.  It was undisputed that these rates were below market, but the debtors asserted that this method was required by the Supreme Court’s plurality opinion in the Chapter 13 case Till v. SCS Credit Corp., 541 U.S. 465 (2004).

The Second Circuit adopted the Sixth Circuit’s two-step approach in setting the cramdown interest rate on the replacement notes.  Under this approach, the bankruptcy court must (i) ascertain whether there exists an efficient market and if so, apply a market rate of interest to the replacement notes or (ii) if no such efficient market exists, the court should then employ the formula approach which begins with the national prime rate and takes into account other factors, which was endorsed by the Supreme Court in Till. 

Although the Second Circuit remanded the case to the bankruptcy court to determine which rate should be used, the Court noted that the senior noteholders presented expert testimony in the bankruptcy court that, if credited, would have established a market rate in the 5-6+% range.

In addition, the Second Circuit expressly rejected the analysis of the Third Circuit in the Energy Future Holdings case regarding the enforceability of “make-whole” premiums in bankruptcy.  As noted in a previous post, available here, the Third Circuit Court of Appeals held that the debtor could not use a voluntary Chapter 11 bankruptcy filing to escape liability for a “make-whole” premium if express contractual language required such payment when the borrower makes an optional redemption prior to a date certain.  The Second Circuit has taken the opposite position, finding that the petition date becomes the maturity date for outstanding notes, such that they were not repaid ahead of time and therefore not entitled to the make-whole premium.

The Second Circuit also rejected the subordinated noteholders’ arguments that they should have been repaid before a group of second-lien noteholders, determining that although the documentation was ambiguous, it did provide for the repayment of the second-lien holders ahead of the subordinated notes.  Further, the panel disagreed that the appeals should have been dismissed as equitably moot, finding that given the scale of the debtors’ reorganization, the possibility that the debtors may be required to provide, at most, $32 million of additional annual payments over the next seven years, depending upon the bankruptcy court’s analysis, would not unravel the plan or threaten the debtors’ emergence.

In In Re Lexington Hospitality Group, LLC, the United States Bankruptcy Court for the Eastern District of Kentucky thwarted a lender’s efforts to control whether its borrower could file bankruptcy. As a condition to the loan, the lender mandated that the borrower’s operating agreement have certain provisions that require the affirmative vote of an “Independent Manager” and 75% of the members to authorize a bankruptcy. The lender also included a failsafe veto provision that prohibited the borrower from filing for bankruptcy without the advance, written affirmative vote of the lender even if the borrower had obtained the vote of the Independent Manager and 75% of the members.

Janee Hotel Group formed Lexington Hospitality Group (LHG) and acted as its manager. Under LHG’s original operating agreement, Janee managed the business and affairs of LHG. The operating agreement did not address bankruptcy.

Janee acquired a hotel with acquisition financing provided by PCG Credit Partners (PCG). In connection with the loan, LHG amended its operating agreement to admit a 30% member, 5532 Athens, which PCG owned. LHG also admitted two additional members totaling 10%, thereby reducing Janee’s ownership interest to 60%.

PCG also required LHG to include certain “Bankruptcy Restrictions” in its operating agreement, to wit: LHG may declare bankruptcy only so long as an “Independent Manager” authorizes such action, and then only upon a 75% vote of the members. The Independent Manager’s role was restricted to participating in bankruptcy matters and, when considering such matters, was required to weigh the costs/benefits of the decision on LHG, LHG’s creditors and 5532 Athens. Additionally, the operating agreement prevented LHG from filing bankruptcy “without the advance, written affirmative vote of [PCG] and all members of [LHG].”

Eventually, LHG filed for bankruptcy without satisfying the above requirements. Instead, Janee, as the sole manager of LHG, signed the filing resolution, which contained no vote by the Independent Manager or the other members, nor had LHG obtained PCG’s “advance, written affirmative vote” for the filing.  PCG moved to dismiss the bankruptcy as unauthorized.

The court recognized that state law governs whether LHG is authorized to file for bankruptcy, but federal law governs whether the Bankruptcy Restrictions are enforceable as a matter of public policy. Generally, parties have the freedom to agree to the terms of an operating agreement; however, attempts to contract away the right to file for bankruptcy generally are unenforceable.

Here, the court found that Kentucky law authorized LHG to file bankruptcy, since filing bankruptcy is a business decision connected to the business affairs of a company and within the expansive decisional authority reserved to managers under the Kentucky limited liability company act. Turning to the Bankruptcy Restrictions, the court noted that LHG included these provisions in its operating agreement only because PCG required them as a condition to loan. The court found that the inclusion of an Independent Manager was “merely a pretense to suggest that the right to file bankruptcy is not unfairly restricted.” While “[a] requirement that an independent person consent to bankruptcy relief, property drafted, is not necessarily a concept that offends federal public policy,” limiting the independence of that manager is problematic. One such limitation was that the Independent Manager needed to consider the interest of creditors and 5532 Athens when deciding on bankruptcy, a restriction that abrogated the Independent Manager’s fiduciary duty to LHG. Another constraint on the  Independent Manager’s ability to act independently was that, notwithstanding the Independent Manager’s vote for bankruptcy, a properly authorized filing still required a 75% member vote that could not be achieved without the vote of 5532 Athens (which was controlled by PCG).  Moreover, the Independent Manager requirement ceased once LHG repaid the loan, clearly tying the Independent Manager to PCG and further eroding its “independence.” Thus, the court concluded that the Independent Manger provisions were not adequately drafted to preserve the Bankruptcy Restrictions.

The court also took issue with the requirement that PCG consent to any LHG bankruptcy. Most troubling was that “PCG [had] no restrictions and no fiduciary duties to LHG that might limit self-interested decisions that ignore the best interest of [LHG].” The court, therefore, held that the Bankruptcy Restrictions as a whole “serve[d] only one purpose: to frustrate LHG’s ability to file bankruptcy;” and accordingly, were unenforceable.

Bankruptcy is a risk of doing business. Courts will scrutinize documents that purport to limit a borrower’s ability to utilize bankruptcy as a business strategy. Such limitations are rarely, if ever, countenanced. Lenders must understand this risk and underwrite accordingly.

The Delaware bankruptcy court recently decided that a debtor could not assign a trademark license absent the consent of the licensor.  The court concluded that federal trademark law and the terms of the license precluded assignment without consent.  Because the debtor could not assign the license under any circumstances (consent was not forthcoming), the court held that cause existed to annul the automatic stay to permit the licensor to “move on with its trademark and its business.”

The debtors (Rupari) engaged in the manufacture, sale and distribution of frozen meat products.  The licensor (Roma) granted Rupari a trademark license to use the “Tony Roma” mark.  After claiming a breach by Rupari, Roma purported to terminate the license.  Rupari denied any breach, asserted that Roma’s efforts to terminate the license were ineffective, and eventually filed for bankruptcy.

Immediately after its bankruptcy filing, Rupari sought to sell substantially all of its assets.  The sale provided that the assignment of the Roma license was a closing condition.  Rupari also filed a declaratory judgment action seeking to have all license termination efforts declared void.  Roma objected to the sale on the grounds that it had terminated the license prepetition (and therefore Rupari had no license to assign), and alternatively, if the license was intact, Rupari could not assign the license because Roma would not consent.  While this skirmish was pending, Rupari revised its sale agreement to remove the assignment of the license as a closing condition and reduced the purchase price by $2 million.  Rupari then dismissed the lawsuit.

Shortly after dismissal of the lawsuit, Roma issued a press release announcing that it had entered into a new exclusive licensing arrangement for its Tony Roma mark.  Rupari reacted by filing a second lawsuit seeking a determination that Roma had willfully violated the automatic stay and renewing the declaratory judgment issues.  A few weeks later, the court approved the Rupari sale without assignment of the license.

In considering the second lawsuit, the court cited federal trademark law for the general position that a non-exclusive trademark license cannot be assigned absent express authorization from the licensor.  Rupari stressed that the license agreement modified this general rule since the parties previously had amended the Roma license to replace strict anti-assignment language with a provision that permitted assignment of the license (a) by operation of law or (b) in connection with a sale of all or substantially all assets but only with the other party’s consent, which could not be unreasonably withheld.

Focusing on the latter provision, Rupari argued that Roma’s refusal to consider “well-qualified prospective bidders” as assignees of the license breached the “consent not unreasonably withheld” requirement. While perhaps a meritorious position in some circumstances, the court found Rupari had effectively mooted the argument by closing the sale (without the license) before resolving the assignment issues. Because the license was not being assigned “in connection with a sale,” the consent issue was not implicated. Accordingly, citing Third Circuit precedent, the court held that because there were no circumstances under which Rupari could now assign the license, “cause” existed to annul the automatic stay to permit Roma to proceed with licensing its trademark to another licensee.

Exculpation provisions in operating agreements must be carefully crafted in order to protect members, managers, directors and officers for breaches of fiduciary duties. In In re Simplexity, LLC, the Chapter 7 trustee sued the former officers and directors (who were also members and/or managers) for failing to act to preserve going concern value and exposing the debtors to WARN Act claims.  The defendants argued the exculpation language in the operating agreements shielded against breach of fiduciary duty liability.  The Delaware bankruptcy court found that the plain language of the applicable operating agreement did not protect the defendants from liability for breach of fiduciary duty; therefore the members, officers and directors could be liable for damages.

Under Delaware law, charter documents, such as a limited liability company operating agreement, can reduce or eliminate fiduciary duty liability for managers and controlling members of limited liability companies. The intent to reduce or eliminate such liability, however, must be “plain and unambiguous.”  In the absence of plain and unambiguous intent, managers and controlling members owe fiduciary duties.  To ascertain whether such intent was present in the Simplexity case, the court began where it must, with the language of the operating agreements.

If you want exculpation, be explicit.

The relevant provisions of the Simplexity operating agreement (Simplexity Agreement) provided:

Limitation on Liability. No current or former Manager of [Simplexity] shall be personally liable to the Company or the Member for monetary damages for breach of fiduciary duty as a Manager of [Simplexity]…provided, however, that this provision shall not eliminate liability of a Manager (i) for any breach of the Manager’s duty of loyalty to the Company and the Member, (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law, or (iii) for any transaction from which the Manager derived an improper personal benefit…

Limitation of Duties; Conflict of Interest To the maximum extent permitted by applicable law, the Company and each Member, Manager, officer and employee of the Company hereby waives any claim or cause of action against any [Parent Company] Person for any breach of any fiduciary duty to the Company or its Members or any of the Company’s Affiliates by any such [Parent Company] Person, including, without limitation, as may result from a conflict of interest between the Company or its Members or any of the Company’s Affiliates and such [Parent Company]Person or otherwise. Each Member acknowledges and agrees that in the event of any such conflict of interest, each such [Parent Company]Person may, in the absence of bad faith, act in the best interests of such [Parent Company]Person, including without limitation its Affiliates, employees, agents and representatives…[S]uch waiver shall not apply to the extent the act or omission was attributable to the Manager’s gross negligence or knowing violation of law as determined by a final judgment, order or decree of a court of competent jurisdiction… .

The similar provisions of the operating agreement for Services, LLC, Simplexity’s subsidiary, provided (Services Agreement):

Exculpation.

(a) No Fiduciary Duties. To fullest extent permitted by law:

(i) notwithstanding any duty otherwise existing at law or in equity, and notwithstanding any other provision of this Agreement, no Indemnified Party shall owe any duty (including fiduciary duties) to the Company, the Member or any other Person that is a party to or is otherwise bound by this Agreement, in connection with any act or failure to act, whether hereunder, thereunder or otherwise; provided, however, that this clause (i) shall not eliminate the implied contractual covenant of good faith and fair dealing, and

(ii) No Indemnified Party shall have any personal liability to the Company, the Member, or any other Person that is a party to or is otherwise bound by this Agreement for monetary damages in connection with any act or failure to act, or breach, whether under this Agreement, the Act or otherwise; provided, however, that this clause (ii) shall not limit or eliminate liability for any act or omission that constitutes a bad faith violation of the implied contractual covenant of good faith and fair dealing.

(b) No Personal Lability. If any provision of [the above-cited sections] is held to be invalid, illegal or unenforceable, the duties and personal liability of any Indemnified Party to the Company, of the Member or any other Person that is a party to or is otherwise bound by this Agreement shall be eliminated to the greatest extent permitted under the Act.

The defendants argued that they had no liability for breaches as to Simplexity because most of the parties to the Services Agreement were also party to the Simplexity Agreements, and therefore, the broad language of the Services Agreement that any “Member or any other Person that is a party to or is otherwise bound by this Agreement” covered Simplexity’s managers in their management of Simplexity.  Thus, they argued that the broad exculpation provisions of the Services Agreement were applicable to the managers of Simplexity.

The court disagreed and concluded that the Simplexity Agreement controlled the question of liability for management of Simplexity. The plain language of the Simplexity Agreement did not contain a clear intention to exculpate members and managers from fiduciary duty liability (contrast the language in the Services Agreement).  In other words, the Simplexity Agreement did not mitigate fiduciary duties and associated liability to the fullest extent permissible under Delaware law.  Rather, it expressly preserved claims for the breach of the duty of loyalty, gross negligence, and knowing violations of law. Thus, the defendants owed fiduciary duties and therefore could be held liable for their breach.

The take away is clear: Delaware law permits a limited liability company’s top brass to be insulated from fiduciary duty liability, but any such protection requires “plain and unambiguous” language in the charter documents. In the absence of plain and unambiguous language, managers and controlling members owe fiduciary duties, and can be found liable if they breach those duties.  If you want exculpation, be explicit.

The Supreme Court has granted certiorari to decide the question of whether bankruptcy courts should apply state law or a federal rule of decision when determining whether to recharacterize a debt claim as a capital contribution.

Recharacterization presents a critical issue for lenders and investors in distressed companies. Under the bankruptcy priority scheme, secured creditors get top priority, while equity interests have the lowest priority and are often completely wiped out.  A federal rule of decision more often leads to recharacterization of debt to equity than application of underlying state law.

Most circuits follow the federal rule of decision and apply a variety of multi-factor tests when analyzing whether to recharacterize debt as equity pursuant to the equitable powers granted bankruptcy courts by section 105 of the Bankruptcy Code. The Third, Fourth, Sixth, Tenth and Eleventh Circuits hold this majority view, while only the Fifth and Ninth Circuits apply state law.

In the case at issue, PEM Entities v. Levin, the Fourth Circuit affirmed the lower courts’ use of a federal rule of decision in permitting an insider’s secured loan to be recharacterized as a capital contribution.  Had the courts instead applied North Carolina state law, the debt would not have been recharacterized as equity.

The United States Bankruptcy Court for the Eastern District of North Carolina did not consider the fixed maturity date, required payments, third-party nature of the loan and first-lien security given for the loan as controlling the analysis. Rather, the Court focused on the discounted price paid for the distressed loan, the lender’s failure to enforce the original loan terms prior to bankruptcy, the debtor’s poor financial position at the time of the loan purchase, the lender’s insider status, the fact that the insider made additional capital contributions to the debtor and the inability of the debtor to obtain outside financing at the time the insider purchased the loan.

We will be following the proceedings and blog the decision of the Supreme Court on this important issue.

UPDATE:  On August 10, 2017, SCOTUS dismissed the petition for writ of certiorari as “improvidently granted,” ensuring that this split in the circuits will continue for the foreseeable future.

It is very common for bankruptcy court orders to provide that the court retains jurisdiction to enforce such orders.  Similarly, chapter 11 confirmation orders routinely provide that the bankruptcy court retains jurisdiction over all orders previously entered in the case.  The enforceability of these “retention of jurisdiction” provisions, however, will not rest on the plain language in the order but on the bankruptcy court’s statutory jurisdiction.  Because no court can simply create its own jurisdiction, whether these provisions are enforceable hinges on whether the dispute in question “arises under”, “arises in” or “relates to” the bankruptcy case as set forth by statute at 28 U.S.C. §§ 1334 and 157.

Recently, the First Circuit opined that a dispute involving a provision in a chapter 11 sale order did not “arise in” the bankruptcy case merely because the sale was approved by the bankruptcy court and the sale order included a “retention of jurisdiction” provision.   Gupta v. Quincy Medical Center, 2017 WL 2389407, Case No. 15-1183 (1st Cir. June 2, 2017).  The First Circuit recognized that “retention of jurisdiction” provisions are not sufficient to establish “arising in” jurisdiction—instead the bankruptcy court must consider the nature of the proceeding to independently determine if the matter could arise only in the context of a bankruptcy case.

The facts underlying Gupta are relatively straightforward.  Quincy Medical Center (QMC) entered into an asset purchase agreement (APA) to sell substantially all of their assets to an entity created by Steward Health Care System (Steward).  The APA required Steward to offer new employment to all QMC employees that were employed immediately prior to the sale closing.  The APA also provided that if Steward terminated any employee after the sale closed, then Steward would be liable for severance pay.  Immediately after executing the APA, QMC filed for chapter 11 to consummate the sale and liquidate.    Both the sale order and the later order confirming the chapter 11 plan included provisions retaining the bankruptcy court’s jurisdiction to determine disputes arising under or relating to the APA.

Shortly after the sale closed, Steward terminated two senior executives.  When Steward failed to pay severance, the former executives sought enforcement of the APA in the bankruptcy court.  The bankruptcy court determined it had subject matter jurisdiction to hear the dispute pursuant to the retention of jurisdiction language in the sale order and found Steward liable for the severance pay.  On appeal, the district court reversed, finding that the bankruptcy court lacked subject matter jurisdiction over the dispute.  The district court reasoned that the breach of contract claim fell outside the bankruptcy court’s subject matter jurisdiction – a contract dispute between two non-debtor parties – which could not be established by mere provisions in orders.   The First Circuit affirmed.

The First Circuit explained that the “jurisdiction of the bankruptcy courts, like that of all other federal courts, is grounded in, and limited by, statute.”  The scope of bankruptcy court jurisdiction is found at 28 U.S.C. § 1334.  Bankruptcy courts, by reference from the district courts, have jurisdiction over “cases under title 11”, and “proceedings arising under title 11, or arising in or related to cases under title 11.”  The statute provides no clear definition of “arising under”, “arising in” or “related to” and the First Circuit “observed that the boundaries between these types of proceedings are not always easy to distinguish from each other.”

The former executives did not assert “arising under” or “related to” jurisdiction; rather, they only argued that their severance claims “arise in” the bankruptcy case “because the APA was approved by the bankruptcy court in the Sale Order pursuant to [the bankruptcy code], and . . . . [the sale order] may ‘only be issued by a bankruptcy court.’”  In essence, the former executives asserted a “but for” causation:  “but for Debtors’ Chapter 11 case and the Sale Order approving the sale of Debtors’ assets to Steward in the APA, their claims for severance pay would not exist.”

The First Circuit rejected the “but for” test, instead holding that to establish “arising in” jurisdiction, the relevant proceeding must have “no existence outside of the bankruptcy[;]” “‘arising in’ jurisdiction exists only if Appellants’ claims are the type of claims that can only exist in a bankruptcy case.”   Examples of “arising in” proceedings are typically administrative in nature – orders to turn over property, dischargeability of debts and assumption or rejection of contracts.  Because the former executives’ claims were in the nature of a state law breach of contract claim, the First Circuit determined that the claims did not “arise in” the bankruptcy case and, therefore, the bankruptcy court did not have subject matter jurisdiction to determine the dispute.

Going forward, parties seeking to have their issues heard by a bankruptcy court should note that “retention of jurisdiction” provisions are not determinative.  Bankruptcy courts must look beyond the “retention of jurisdiction” language and determine whether the proceeding meets the statutory test of “arising under”, “arising in” or “relating to” the bankruptcy case.