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Kaitlin Walsh is an Associate in the firm’s New York office. Her bankruptcy practice focuses on corporate restructurings and insolvencies. She represents debtors, creditors, purchasers, lenders, and other parties-in-interest in Chapter 11 reorganizations, out-of-court restructurings, and bankruptcy litigation.

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.

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!

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.

In a recent New York Law Journal article, “The Evolution of Fiduciary Duties Under Delaware Law”, John Bae and Kaitlin Walsh describe the ongoing development of Delaware law regarding directors’ duties and provide guidance to directors of corporations facing insolvency.  The article explores the duties of a director of a solvent company, the shift of these duties upon insolvency and the nature of related creditor claims.  The authors provide practical considerations for directors when weighing options in the face of financial distress.