The Hidden Chapter of the Financial Aid Handbook:Tuition Payments Subject to Fraudulent Transfer Liability

by Jason Angelo

By Jason D. Angelo

The cost of a college and professional education has, as most attorneys know all too well, skyrocketed over the course of the past few decades. Some students graduate with tens or even hundreds of thousands of dollars in student loan debt. Bankruptcy practitioners know the high hurdle of obtaining a discharge of student loan debt in a personal bankruptcy. But what happens when a student’s parents pay for their son’s or daughter’s tuition and then end up filing a chapter 7 or chapter 13 petition?

There is an emerging trend in bankruptcy cases across the country in which some trustees are attempting to recover pre-petition tuition payments made to educational institutions by debtors (parents) on behalf of their children (students). The Wall Street Journal reports that trustees have recovered over $276,000.00 from at least 25 educational institutions since 2014.1 The rationale is that the student, not the parents, received the reasonably equivalent value of the tuition payments – that is, the child, not the parents, received the actual benefit of the tuition payments, and so those payments are recoverable as fraudulent transfers. Some trustees have even attempted to recover payments made for private elementary and high school education, although with far less success.2

While educational institutions begin to battle these claims, many have opted to settle with trustees rather than see an adversary proceeding through to the end. Some students, however, have been hit with dire consequences: institutions, such as the University of Southern California – currently battling a lawsuit to recover nearly $200,000.00 in tuition payments – have threatened to withhold transcripts, refuse certification of a degree, recover the funds from the students themselves and bar them from registering for classes.3 Institutions also argue that allowing trustees to claw back such funds is inconsistent with the principles of federal financial aid and that, because the student will still owe the tuition to the institution (and the parents will still be on the hook for any loan they co-signed or guaranteed given the difficulty of discharging such loans), this is simply a windfall of funds to creditors – funds that they have no right to receive.

While some courts have agreed with the trustees’ position that the parents did not receive reasonably equivalent value, others have rejected the attempt to recover tuition, relying on a “moral obligation” of parents to pay for higher education. There is little consensus among bankruptcy courts on this issue. This post surveys some recent bankruptcy court decisions on this controversial tactic.

No Reasonably Equivalent Value Received?

The Michigan case of In re Leonard4 is significant because the Bankruptcy Court determined that the debtors did not receive reasonably equivalent value for the tuition payments made on behalf of their son. The Chapter 7 trustee sought to avoid and recover, as fraudulent transfers, four payments totaling $21,527.00 that the debtors made to Marquette University to pay for their 18–year old son’s tuition. The payments were made by checks from debtors’ joint checking account. However, the funds transferred were from a $35,000.00 private student loan from J.P. Morgan-Chase taken out by the student and his father. While the trustee argued that the transfers should be avoided, the University responded that the funds were never debtors’ property and instead had been held in trust for the education of their son. Relying on a theory that an express oral trust was created regarding the use of the loan proceeds, the University contended that debtors held legal, but not equitable, title in the funds, barring them from ever becoming property of the estate.

The Court determined that, because the check for the loan proceeds from J.P. Morgan-Chase was actually made payable to both the student and the father, no express oral trust could be created as to half of the funds. Further, the deposit of the funds into debtors’ joint checking account created a rebuttable presumption under state law that the money was debtors’ property, and cast further doubt upon the claim that an express trust was created given the commingling of the funds. The Court rejected the notion that a constructive trust had been created and hence was not property of the estate. Ultimately, the matter came down to who received reasonably equivalent value for the transfers: the debtors’ son, or the debtors who received value in the form of intangible benefits, such as: (1) the son’s education “bestowed peace of mind” on the debtors in that their son “will be afforded opportunities” in life that would not have come but for the education; and (2) debtors “anticipate that they will not remain financially responsible” for their son. The Court rejected Marquette’s argument and found that the debtors received no economic value in exchange for the transfers. However, the trustee’s summary judgment motion was ultimately denied because there was a still a genuine issue of material fact regarding the creation of an express oral trust and whether the loan proceeds were ever property of the estate.

Recovery of Federal Loan Proceeds

 In a case pending in the District of Connecticut5, the Chapter 7 trustee sought disgorgement of tuition payments from Johnson & Wales University. Slated for trial this year, the trustee seeks to claw back $46,909.00 in payments made from March 2011 to December 2013. According to the University and the amici curiae, the trustee’s argument essentially transforms federal loans into a government subsidy to pay off the debtors’ creditors, leaving educational institutions, which are not able to protect themselves from parents who apply for Federal Loans and later file a bankruptcy petition, incredibly vulnerable.

The key issue here is the source and control of the payments: while the tuition payments were federal dollars, they were never in the debtors’ possession or control. Rather, the government made payments directly to the university for restricted purposes. Thus, according to the University, the funds never were and never could have been property of the estate; the funds were not “fungible cash” that could actually have been utilized by the debtors to pay their creditors. Moreover, as the amici curiae point out, diversion of federal PLUS Loan funds to the debtors’ estate would be deemed “misuse” of the funds, causing the loans to be accelerated and made immediately due. The proper relief, according to the University, is to avoid the debtors’ obligations to repay the loans for which they are solely liable rather than claw back the funds from an educational institution.

In response, the trustee asserts that the debtors are liable as the sole obligor on the master promissory note related to the funds, thereby providing debtors a clear and unequivocal interest in the funds. Where there is a direct transfer to a third party resulting in an increase in a debtor’s liability and no increase in a debtor’s assets, the trustee argues that there has clearly been a transfer of the debtor’s interest in property. The trustee further claims that, had Congress intended to exempt federal loan proceeds as property of the estate, they would have done so when passing BAPCPA – in which they exempted Education IRAs (529 plans), and that this omission demonstrates an intent that proceeds of federal loans be available for recovery. See 11 U.S.C. § 541(b)(5) and (6). By incurring nearly $50,000 in new debt and receiving no corresponding benefit, the trustee believed the transfers to be fraudulent and thus recoverable. The Bankruptcy Court has not ruled yet on these issues, and the case is scheduled for trial later this year.

A “Moral Obligation” As Reasonably Equivalent value

In two separate cases6 in the Western District of Pennsylvania, the bankruptcy court determined that debtors did in fact receive reasonably equivalent value for tuition payments. Specifically, the courts held that undergraduate expenses fit within the definition of “necessities” under Pennsylvania’s Uniform Fraudulent Transfer Act.

In In re Cohen, the trustee challenged a total of $102,573.00 in tuition payments, including $46,059.97 for their son’s undergraduate education, $7,562 for their daughter’s undergraduate education, and $39,205 for their daughter’s graduate education. The Court refused to accept the trustee’s argument that because Pennsylvania law does not require parents to pay for post-secondary education, it is not a necessity and is therefore avoidable. The Court held that post-secondary educational expenses are reasonable and necessary for the maintenance of the debtor’s family for purposes of the fraudulent transfer statutes only. However, the ruling was limited to undergraduate expenses only, with the Court expressly noting that “children in graduate school are well into adulthood.” Similarly, in In re Oberdick, the trustee challenged $82,536.22 used to pay for the college education of debtors’ children at the University of Chicago and Robert Morris University. Citing to Cohen, the Court relied on debtors’ testimony that “they viewed college tuition and related educational expenses for the children as a family obligation” to deny the trustee’s claim.

Willing to Settle

Unlike Johnson and Wales, Marquette and the University of Chicago, other institutions have elected to settle these fraudulent transfer actions rather than incur the costs of litigation. The University of Hartford, Quinnipiac University7, the University of Bridgeport, Pace University, Post University, the University of Arizona and the University of Michigan8 each paid more to the trustee to avoid the risks of litigation.  According to the trustee’s attorney, many similar adversary proceedings have settled, and there are “about a dozen pending” in the Connecticut bankruptcy courts as of May 2, 2016.9

A Potential Solution?

In response to the willingness of some trustees to go after tuition dollars, Congressman Chris Collins (R-NY) introduced H.R. 2267 – PACT (Protecting All College Tuition) Act of 2015. The legislation would amend Section 548 of the Bankruptcy Code to explicitly provide that “payment of tuition by a parent to an institution of higher education . . . for the education of that parent’s child is not a transfer” that is recoverable as fraudulent. While seemingly supported by legislators on both sides of the aisle, including Rep. Blake Farenthold (R-Tex.) and Sen. Richard Blumenthal (D-Conn.), the legislation has been languishing in the House Judiciary Committee’s Subcommittee on Regulatory Reform, Commercial and Antitrust Law since June 1, 2015.10 In the meantime, as educational institutions continue to settle these fraudulent transfer actions, expect to see more filings from trustees across the country in an attempt to claw back tuition payments for distribution to creditors.          

Jason D. Angelo is an Associate in McElroy, Deutsch, Mulvaney & Carpenter, LLP’s Bankruptcy, Restructuring & Creditors’ Rights Practice Group and is admitted to practice in Delaware and New Jersey.

[1] http://www.ctlawtribune.com/id=1202756519162/Bankruptcy-Attorneys-Sue-Colleges-to-Demand-Return-of-Tuition-Payments?slreturn=20160418124233; http://www.wsj.com/articles/bankruptcy-trustees-claw-back-college-tuition-paid-for-filers-kids-1430869820.

[2]               See, e.g., In re Akanmu, 2013 WL 6283582 (Bankr. E.D.N.Y. Dec. 4, 2013) (Debtors legally obligated under New York Law to provide their minor children with an education, and the fact that they chose to do so by sending their children to private or parochial school, rather than public school, did not render the tuition payments avoidable. Debtors received reasonably equivalent value by satisfying their legal obligation to educate their children and because parents and children are viewed as a single economic unit for purposes of a constructive fraudulent conveyance analysis).

[3]                    http://blogs.wsj.com/bankruptcy/2015/11/17/usc-in-tuition-battle-former-students-will-face-consequences/

[4]               In re Leonard, 2011 WL 1344732 (Bankr. E.D. Mich. Apr. 8, 2011)

[5]               Roumeliotis v. Johnson & Wales Univ., No. 15-03011 (Bankr. D. Conn. Apr. 8, 2015)

[6]                  In re Cohen, 2012 WL 5360956, at *9-10 (Bankr. W.D. Pa. Oct. 31, 2012), aff’d in part, vacated in part, remanded sub nom. Cohen v. Sikirica, 487 B.R. 615 (W.D. Pa. 2013); In re Oberdick, 2013 WL 1289152 (Bankr. W.D. Pa. Mar. 27, 2013).

[7]              Roumeliotis v. Univ. of Hartford, No. 15-03006 (Bankr. D. Conn. Mar. 11, 2015); Roumeliotis v. Quinnipiac Univ., No. 15-03017 (Bankr. D. Conn. Apr. 15, 2015).

[8]                       http://www.wsj.com/articles/bankruptcy-trustees-claw-back-college-tuition-paid-for-filers-kids-1430869820.

[9]                       http://www.ctlawtribune.com/id=1202756519162/Bankruptcy-Attorneys-Sue-Colleges-to-Demand-Return-of-Tuition-Payments?slreturn=20160418124233

[10]             http://www.ctlawtribune.com/id=1202756519162/Bankruptcy-Attorneys-Sue-Colleges-to-Demand-Return-of-Tuition-Payments?slreturn=20160418124233; http://blogs.wsj.com/bankruptcy/2015/05/12/bill-proposes-ban-on-tuition-clawbacks-in-bankruptcy/.

Second Circuit: Despite 363 Sale, GM Cannot Avoid Liability for Faulty Ignition Switches

by John Stoelker

In re Motors Liquidation Company, Case No. 15-2844 (2d Cir., July 13, 2016)

By John Stoelker, Esq.

In a decision that may threaten the reliability and enforceability of future bankruptcy sales, the U.S. Court of Appeals for the Second Circuit ruled on Wednesday that, despite the “free and clear” acquisition of substantially all assets of General Motors Corporation, the purchaser could not avoid successor liability claims relating to faulty ignition switches.  The decision dealt a major blow to the surviving entity, General Motors LLC, which may now be required to defend against the claims, with as much as $10 billion at stake.

As early as 2002, General Motors Corporation (“Old GM”) began producing vehicles with an ignition switch that was known to be faulty.  Specifically, as customer complaints would soon confirm, the application of only a minimal amount of force could cause the key in the ignition to switch from the “on” to the “off” position.  While initially categorized by Old GM as a “non-safety issue,” a series of tragic accidents attributable to a sudden loss of power was determined by Old GM to have been most likely caused by a problem with the ignition switch.

 

After suffering major losses during the financial crisis of 2007 and 2008, President Obama announced that the solution to Old GM’s financial woes would be a “quick, surgical bankruptcy.”  On June 1, 2009, Old GM filed for Chapter 11 bankruptcy protection and, on the same date, filed a motion to sell substantially all of its assets to New GM free and clear of liens, claims, encumbrances, and other interests, including any successor or transferee liability.  Shortly thereafter, the bankruptcy court approved the proposed sale through the entry of an order pursuant to Section 363 of the Bankruptcy Code (the “Sale Order”).  On July 10, 2009, the transaction officially closed and New GM began operating its business.

It was not until February 2014 that New GM began recalling cars with ignition switch defects.  This quickly resulted in various class action lawsuits claiming that the faulty ignition had caused personal injuries and economic losses, both before and after the 363 sale.  In response, New GM asked the bankruptcy court to enforce the “free and clear” provisions of the Sale Order, claiming that this language shielded it from successor liability with respect to any and all damages resulting from Old GM cars.

The bankruptcy court agreed with New GM, and held that New GM could not be sued in connection with ignition switch claims that could have been asserted against Old GM prior to the 363 sale, unless the claims resulted from New GM’s own wrongful conduct.  Notably, the bankruptcy court acknowledged that because the ignition switch claims were known or could have been known to Old GM prior to the sale, plaintiffs were entitled to actual notice (as opposed to publication notice) of the sale.  However, the bankruptcy judge ruled that this lack of procedural due process did not prejudice the plaintiffs because he would have approved the sale anyway and, as such, could not prevent enforcement of the Sale Order.

On appeal, the Second Circuit considered the application of the Sale Order to four categories of claims:  (1) claims arising from accidents involving Old GM cars that occurred prior to the closing; (2) economic loss claims (such as loss of car value) arising from the ignition switch defect or other defects; (3) independent claims relating exclusively to the conduct of New GM; and (4) the claims of used car purchasers.

With respect to the third and fourth categories of claims, the Court held that these claims are outside the scope of the Sale Order and, thus, are not subject to its “free and clear” provisions.  Claims relating exclusively to the conduct of New GM (e.g., a misrepresentation by New GM about the quality of Old GM cars) and claims of used car purchasers who bought Old GM cars after the 363 sale cannot be enjoined by the Sale Order, because the claimants could not have possibly known that their claims existed prior to the 363 sale.

With respect to the first and second categories, however, the Court found both to be precluded by the Sale Order’s “free and clear” provisions, as both types of claims arose pre-closing.  With respect to pre-closing accidents involving Old GM cars, the existence of a claim against Old GM arising from such an accident fits squarely within the language of the Sale Order.  As for the economic loss claims which may not have been revealed to the claimants until several years after the closing, the Court nonetheless concluded that they existed as “contingent” claims prior to the closing, and are enjoined by the Sale Order.

However, despite holding that the first two categories of claims were enjoined by the Sale Order, the Second Circuit dealt another blow to New GM by disagreeing with the bankruptcy court’s procedural due process ruling.  Because Old GM knew or should have known about the ignition switch defect, all individuals with potential claims arising from the defect were entitled to actual notice of the 363 sale by direct mail or otherwise and not merely by publication of notices in general circulation newspapers.  The Court disagreed with the bankruptcy court’s finding that the lack of notice was not “prejudicial,” as these claimants would have had the opportunity to oppose the entry of the Sale Order had they been afforded due process through actual notice.  This, in turn, might have enabled them to negotiate a deal, as other constituencies had managed to do during the sale approval process.

This potentially catastrophic result for New GM, which now must defend itself against claims totaling nearly $10 billion, underscores the limitations of “free and clear” sale orders and the importance of providing actual notice to all potential claimants, even those with contingent claims.

And potential purchases, fearing possible attacks based on successor liability theories, would do well to consider the implications of this decision.  Many may be well served to anticipate such attacks when negotiating the asset purchase agreement to protect themselves if such claims are later asserted.  A typical provision could include escrowing an appropriate portion of the sale price to protect the  buyer from claims of people who were not, but should have been, given notice of the 363 sale.

Pain on the Way to the Pump: Rejection of Executory Contracts and the Midstream Sector: An analysis of Sabine Oil & Gas

by John Stoelker

In re Sabine Oil & Gas Corp., 2016 WL 890299, __ B.R. __ (Bankr. S.D.N.Y. Mar. 8, 2016)
By John Stoelker, Esq.

While the recent decline in oil prices has led to better value at the pump for consumers, it has also resulted in a wave of bankruptcy filings among U.S. oil and natural gas companies beginning in 2015. Until recently, it was unclear what impact, if any, this would have upon the “midstream sector” of the energy industry, including companies that transport and process the gas produced by these bankrupt entities. These midstream operators had been viewed as insulated from the effects of energy prices, particularly due to the nature of their contracts with energy companies. But in a recent decision, the Bankruptcy Court for the Southern District of New York dealt a major blow to the midstream industry by permitting the rejection of its contracts with energy producers.

Background

Sabine Oil & Gas LLC (“Old Sabine”) was formed in 2007 with a focus on shale oil and gas production. Forest Oil Corporation (“Forest”), formed in 1916, was known primarily for its invention of a technique known as “waterflooding,” which is designed to initiate the secondary recovery of oil from wells when pressure drops within the oil reservoir. In 2014, Old Sabine and Forest combined to form Sabine Oil & Gas Corporation (“Sabine”) and its various affiliated entities. As part of the combination, Sabine inherited certain contracts with Nordheim Eagle Ford Gathering, LLC (“Nordheim”) and HPIP Gonzales Holdings, LLC (“HPIP”).

Pursuant to its contracts with Nordheim (the “Nordheim Contracts”), Sabine was required to deliver to Nordheim all gas, liquid hydrocarbons and other liquids produced by Sabine from a designated area, which Nordheim would then gather, treat, dehydrate and return to Sabine. Nordheim also agreed to construct pipelines and treatment facilities in order to perform its contractual obligations. Under the Nordheim Contracts, which had ten-year terms beginning in 2014, Sabine was required to pay monthly gathering fees to Nordheim and to make deficiency payments to Nordheim if it did not deliver a certain minimum amount of its products on an annual basis. The Nordheim Contracts expressly provide that they constitute a “covenant running with the [land]” as to the designated area.

Sabine also had two contracts with HPIP (the “HPIP Contracts”), pursuant to which Sabine agreed to dedicate certain leases, as well as the oil, gas and water produced from the wells located on the leased premises, to its performance of the HPIP Contracts, such that it would deliver that oil, gas, and water to HPIP. In turn, HPIP agreed to construct gathering facilities and to perform certain services with respect to the products received from Sabine. HPIP was also required to construct disposal facilities and to perform certain disposal services for the water and acid gas produced by Sabine at the subject leases premises. As with the Nordheim Contracts, the HPIP Contracts provided that Sabine’s obligation to deliver products to HPIP was a covenant “running with the lands and leasehold interests.”

On July 15, 2015, Sabine and several of its affiliated entities (together, the “Debtors”) filed Chapter 11 bankruptcy petitions in the Bankruptcy Court for the Southern District of New York. On September 30, 2015, the Debtors filed a motion to reject the Nordheim Contracts and the HPIP Contracts (together, the “Contracts”) pursuant to section 365(a) of the Bankruptcy Code, which provides that a debtor in possession, “subject to the court’s approval, may assume or reject any executory contract…of the debtor.”

In support of the motion, the Debtors argued that the Contracts were “unnecessarily burdensome,” in that the Debtors no longer had the financial wherewithal to deliver the minimum quantities of gas and other products to Nordheim and HPIP required by the Contracts. This inability to satisfy the minimum delivery threshold would, in turn, result in the imposition of daunting deficiency fees under the Contracts. Therefore, according to the Debtors, it was in the best interests of their collective estates to shed themselves of the Contracts and enter into new contracts with other parties on more favorable terms.

Both Nordheim and HPIP filed objections to the motion, asserting that Sabine’s dedication of certain leases and products under the Contracts were covenants that run with the land. Therefore, such covenants should survive rejection of the Contracts under Texas property law. The two parties took slightly different positions with respect to rejection.

HPIP asserted that rejection of the HPIP Contracts in general was appropriate, but rejection of specific covenants that purportedly “run with the land” could not properly be rejected. Moreover, HPIP argued that the Bankruptcy Court could – and should – as part of its decision on the rejection motion, make a determination under Texas law as to whether the covenants in the Contracts do, in fact, survive rejection.

Nordheim took a harder stance on rejection. While agreeing with HPIP’s position that certain covenants “run with the land” and are not subject to rejection, Nordheim made the broader argument that if the Debtors remained bound by such covenants, rejection of the remainder of the Contracts “would provide little or no benefit to the Debtors’ estates.” Therefore, rejection of the Contracts should be denied entirely. As for the Bankruptcy Court’s ability to make an immediate ruling on the application of Texas law to the covenants, however, Nordheim cited to the Second Circuit’s opinion in Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.), 4 F.3d 1095 (2d Cir. 1993), which held that a disputed factual issue must not be decided in the context of a rejection motion. The Orion Court reasoned that “[a]t heart, a motion to assume should be considered a summary proceeding, intended to efficiently review the trustee’s or debtor’s decision to adhere to or reject a particular contract in the course of the swift administration of the bankruptcy estate. It is not the time or place for prolonged discovery or a lengthy trial with disputed issues.” Id. at 1098-99.

Analysis

Applying the standard for rejection of executory contracts under section 365 of the Code, which essentially requires a bankruptcy court to step into the shoes of the debtor and determine whether rejection would be a good business decision, the Court held that the Debtor’s proposed rejection of the Contracts was proper. In fact, the Court noted that neither Nordheim nor HPIP presented any legitimate challenge to the Debtors’ business decision. Accordingly, the rejection motion was granted.

However, the Bankruptcy Court grudgingly agreed with Nordheim’s analysis of the Orion decision and determined it could not make a substantive legal determination of whether certain covenants in the Contracts do, in fact, run with the land under Texas law and thus survive rejection under section 365 of the Bankruptcy Code. While noting that bifurcation of the rejection motion and the underlying legal issue as to the nature of the covenants would be procedurally inefficient, the Court determined that the bifurcation was required by Orion.

Although limited in its ability to render any immediate decision on the underlying legal issue, the Court was not inclined to direct the parties to blindly move forward with their dispute. Instead, the majority of the Court’s opinion was devoted to a “non-binding analysis” of whether the covenants at issue “run with the land” under Texas property law, either as real covenants or equitable servitudes.

Under Texas law, a contractual covenant “runs with the land” when (1) it “touches and concerns” the land; (2) it relates to a thing in existence or specifically binds the parties and their assigns; (3) it is intended by the original parties to run with the land; and (4) the successor to the burden has notice of its existence. Moreover, most Texas courts have required “horizontal privity of estate,” which is typically created where a property owner conveys its property while reserving an interest in the property by way of covenant.

First, the Court determined that horizontal privity was lacking, as the Contracts were essentially service contracts whereby Nordheim and HPIP were engaged to gather, treat, dehydrate and return the products produced by Sabine on certain tracts of land. The covenants did not grant or reserve a real property interest in favor of Nordheim or HPIP.

Second, the Court concluded that the covenants did not “touch and concern” the land, as they only concerned Sabine’s interests in the products produced from the land – gas, liquid hydrocarbons and other liquids. Because Texas law provides that minerals, once extracted from the ground, become personal property rather than real property, the covenants at issue only affected Sabine’s personal property rights.

Having concluded that the first of four requirements of a real covenant was not satisfied by the covenants at issue, and that horizontal privity was lacking, the Bankruptcy Court opined that the covenants do not run with the land, and that they may be rejected under section 365. Without making a final determination due to the Orion precedent, the Court offered a preview of what its eventual determination would look like. In order for the Court to render a decision on this issue, the parties would need to bring the issue back before the Bankruptcy Court in the context of an adversary or other contested proceeding.

Key Takeaways

It should be noted that the importance of the Sabine decision is muted since it is not a final determination, and the parties have been invited to put the issue back before the Court for such a determination. However, the writing is on the wall and the Court has previewed its likely conclusion that the covenants at issue do not run with the land.

A question left unanswered as a result of the bifurcation of the proceeding is how the parties should conduct themselves pending a determination of the anticipated adversary proceeding. Presumably, until the Bankruptcy Court ultimately decides (rather than suggests, as it has done in Sabine) whether the covenants at issue survive rejection, the Debtors will simply treat the Contracts as rejected and of no force or effect. The counterparties to the Contracts will likely seek, as part of their adversary proceeding, or through the proof of claim process, damages associated with the Debtors’ failure to perform after the rejection motion was granted.

Moreover, as opinions from the Bankruptcy Court for the Southern District of New York tend to influence other venues, the Sabine decision is likely to carry a great deal of weight around the country. Midstream operators should be aware that other bankrupt energy companies may follow suit by rejecting their executory contracts and seeking more favorable ones.

RECAP OF NOTABLE 2015 SUPREME COURT DECISIONS

by Nicole Leonard

1.  Wellness International Network Ltd. v. Sharif[1] –Bankruptcy Court Jurisdiction

To hear the principal dissent tell it, the world will end not in fire, or ice, but in a bankruptcy court.”[2]

In Wellness, the Supreme Court addressed whether parties may consent to bankruptcy court jurisdiction over Stern claims and whether such consent must be express. The majority opinion determined the issue in favor of bankruptcy court jurisdiction when there is consent, even if such consent is implied.[3]  In so finding, the Court[4] found that in permitting bankruptcy courts, which operate under the purview of and assist in the workload of the district courts, to adjudicate claims for which the litigants have a right to adjudication by an Article III judge, if such litigants consent, it does not offend the separation of powers.  The court was unafraid of the principal dissent’s dire predictions to the contrary regarding the encroachment on the judicial power of Article III courts.

Facts:  Wellness International Network, Ltd. and its owners (“Wellness”), manufacturers of health products, entered into a contract with Richard Sharif (“Sharif”) whereby he would distribute the Wellness products.  The relationship soured and Sharif sued Wellness.  However, due to Sharif’s failure to comply with discovery requests, Wellness obtained a default judgment and Sharif was eventually sanctioned through an award to Wellness for attorneys’ fees of $650,000.  Sharif then filed a chapter 7 petition in the Northern District of Illinois.  Sharif failed to respond to Wellness’ requests to disclose his assets which allegedly included a valuable trust – though Sharif claimed he administered the trust for his Mother for the benefit of his sister.  Wellness filed an adversary complaint alleging that Sharif’s debts should not be discharged because he concealed property and that the trust was Sharif’s alter-ego and should be considered property of the estate (the “Trust Claim”).  Sharif answered the complaint, admitting the proceeding was core under 28 U.S.C. § 157(b) thus permitting the bankruptcy court to enter a final judgment and he requested that judgment be entered in his favor.  Sharif again failed to fully comply with discovery.  His discharge was denied and a default judgment was entered against him.  The court further issued a declaratory judgment on the Trust Claim, finding the trust part of the bankruptcy estate.

Sharif appealed the bankruptcy court decision. Six weeks before the deadline to file opening briefs in the appeal, Stern v. Marshall,  131 S.Ct. 2594 (2011) (“Stern”)  was decided Stern held that Article III precludes bankruptcy courts from entering final judgment when claims only seek to “augment” the bankruptcy estate and would otherwise exist outside the context of a bankruptcy proceeding. Id. at 1941.

Although Sharif did not mention Stern, at the close of briefing he moved to provide supplemental briefing on the case which request was denied and the bankruptcy decision was affirmed.  Sharif appealed to the Seventh Circuit Court of Appeals.  The Seventh Circuit was concerned with the structural issues raised by Sharif and determined that, although his objection was untimely, the structural “separation –of-powers considerations provided that “a litigant may not waive” a Stern objection” and  the Trust Claim was a Stern Claim for which the bankruptcy court did not have the constitutional authority to enter final judgment.

Analysis:  There are two premises in play in the Wellness decision – that of the common practice of adjudication by consent and the ability of a litigant to waive personal rights (such as to a jury trial) on one hand and, on the other, the constitutional requirement that there be a separation of powers, the so-called “structural” concerns.   Thus, despite litigants’ waiver of a personal right and consent to a decision by a non-Article III judge (i.e. a bankruptcy or magistrate judge), such consent may not be sufficient if there is a constitutional defect in such court entering a final order in the matter.

Said another way, Congress cannot, through the bankruptcy statute or otherwise, set up courts that will perform the duties of, or usurp the power and authority of, district courts established pursuant to Article III of the Constitution.  Indeed, to do so would violate the separation of powers between the branches of government and its system of checks and balances.   Thus, even if the litigants consent to have a non-Article III judge adjudicate a matter, that consent does not cure a structural separation of powers defect, if such defect exists.  So the matter before the Court was whether litigants with the right to have their claim heard by an Article III judge in the case of a Stern claim could consent to waive such right and permit the bankruptcy court to enter a final order or whether doing so would give the bankruptcy court impermissible authority in violation of the Constitution.  Citing prior holdings, the court found the following:

The entitlement to an Article III adjudicator is “a personal right” and thus ordinarily “subject to waiver,” . Article III also serves a structural purpose, “barring congressional attempts ‘to transfer jurisdiction [to non-Article III tribunals] for the purpose of emasculating’ constitutional courts and thereby prevent [ing] ‘the encroachment or aggrandizement of one branch at the expense of the other.’ ” … But allowing Article I adjudicators to decide claims submitted to them by consent does not offend the separation of powers so long as Article III courts retain supervisory authority over the process.[5]

The Court found that the institutional integrity of the judicial branch was not violated because bankruptcy judges: act as part of the district court, can be appointed and removed by Article III judges and hear matters based on the district court’s reference which can be withdrawn sua sponte.[6] Further, the claims in question are narrow: the bankruptcy court’s “ability to resolve such matters is limited to “a narrow class of common law claims as an incident to the [bankruptcy courts’] primary, and unchallenged, adjudicative function.”[7] The Court found no insidious purpose in Congress giving bankruptcy courts the ability to decide Stern Claims. The Court noted that Stern was a case in which there was no consent to bankruptcy court adjudication, and therefore did not address whether consent was possible.[8]

The Court said that implied consent, i.e. through actions instead of words, was permissible.  But, the Court did encourage bankruptcy courts to obtain express consent as a best practice:

Even though the Constitution does not require that consent be express, it is good practice for courts to seek express statements of consent or nonconsent, both to ensure irrefutably that any waiver of the right to Article III adjudication is knowing and voluntary and to limit subsequent litigation over the consent issue. Statutes or judicial rules may require express consent where the Constitution does not. Indeed, the Federal Rules of Bankruptcy Procedure already require that pleadings in adversary proceedings before a bankruptcy court “contain a statement that the proceeding is core or non-core and, if non-core, that the pleader does or does not consent to entry of final orders or judgment by the bankruptcy judge.” Fed. Rule Bkrtcy. Proc. 7008 (opening pleadings); see Fed. Rule Bkrtcy. Proc. 7012 (responsive pleadings). [9]

  1. Bank of America, NA v. Caulkett[10] – Lien Stripping

In Bank of America v. Caulkett, the Supreme Court addressed whether a chapter 7 debtor could strip off a wholly unsecured second mortgage.  The Court held[11]  that the lien could not be voided just because there was no equity in the property to which it could attach, applying its holding in Dewsnup v. Timm (“Dewsnup”)[12].

Facts:  The cases addressed by the Court had a typical fact pattern: the chapter 7 debtors each owned houses encumbered by two mortgages.  Bank of America (“BOA”) held the secured mortgage on each house.  The current market value of each house was less than the debt owed for the first mortgage and therefore there was no equity left to secure BOA’s mortgage liens.  Both debtors moved to void the wholly underwater BOA liens under 11 U.S.C. §506(d).[13] The bankruptcy court granted the motion in both cases and the decision was affirmed by the district court and the Eleventh Circuit Court of Appeals.  The focus of the Court was not whether the junior lien claims of BOA were “allowed” under Section 502– the parties conceded they were – but rather whether the claims were “secured” under Section 502(d).

Analysis:  The Court acknowledged that based on the language of section 506(a) it would seem that underwater claims like those of BOA would not be secured under Section 506(d):

Section 506(a)(1) provides that “[a]n allowed claim of a creditor secured by a lien on property … is a secured claim to the extent of the value of such creditor’s interest in … such property,” and “an unsecured claim to the extent that the value of such creditor’s interest … is less than the amount of such allowed claim.”[14]

However, the Court determined that its prior interpretation of “secured claim” under Section 506(d) in Dewsnup precluded such interpretation.  In Dewsnup, the debtor sought to reduce a secured claim to the value of the collateral under Section 506(d).  The Court described Dewsnup as follows:

[T]he debtor could not strip down the creditors’ lien to the value of the property under § 506(d) “because [the creditors’] claim [wa]s secured by a lien and ha[d] been fully allowed pursuant to § 502.” . In other words, Dewsnup defined the term “secured claim” in § 506(d) to mean a claim supported by a security interest in property, regardless of whether the value of that property would be sufficient to cover the claim. Under this definition, § 506(d)’s function is reduced to “voiding a lien whenever a claim secured by the lien itself has not been allowed.”[15]

The debtors sought to restrict the Dewsnup holding only to circumstances when a lien is partially, rather than wholly, underwater. But the Court found that the Dewsnup definition was not dependent on whether there was some equity that could go to the junior lien-holder. The Court rejected an approach that could have a lien voided or not based on the difference of a dollar of market value:

Under the debtors’ approach, if a court valued the collateral at one dollar more than the amount of a senior lien, the debtor could not strip down a junior lien under Dewsnup, but if it valued the property at one dollar less, the debtor could strip off the entire junior lien. Given the constantly shifting value of real property, this reading could lead to arbitrary results. To be sure, the Code engages in line-drawing elsewhere, and sometimes a dollar’s difference will have a significant impact on bankruptcy proceedings. See, e.g., § 707(b)(2)(A)(i) (presumption of abuse of provisions of Chapter 7 triggered if debtor’s projected disposable income over the next five years is $12,475). But these lines were set by Congress, not this Court.[16]

  1. Bullard v. Blue Hills Bank[17] – Finality of Orders

            In Bullard v. Blue Hills Bank, the Supreme Court addressed the finality of a bankruptcy court’s denial of confirmation of a chapter 13 plan where leave was granted for the debtor to amend the plan.  The Court, by unanimous opinion[18], determined that an order denying confirmation where the debtor is permitted to amend the plan, unlike confirmation of the plan or dismissal of the case, is not a final order subject to appeal.

Facts:  Blue Hills Bank (the “Bank”) held a mortgage on debtor’s real property which property was worth less than the amount of the claim secured by the mortgage.  The debtor proposed a plan in which he would treat the bank’s claim as both partially secured and unsecured based on the market value of the property.  The debtor would maintain monthly mortgage payments and the secured claim would be paid in full long after the bankruptcy.  The unsecured portion would be treated the same as any other unsecured claims for which the debtor would pay a portion over the life of the plan and the remainder would be discharged.   The Bank objected and the bankruptcy court ordered debtor to file a new plan.  The debtor appealed to the Bankruptcy Appellate Panel of the First Circuit Court of Appeals (the “BAP”).  The BAP determined that the order in which plan confirmation was denied was not final because debtor could amend the plan.  However, the BAP still exercised jurisdiction under its ability to hear an interlocutory appeal with leave of court and determined the bankruptcy court was correct.   The debtor then appealed to the First Circuit Court of Appeals, which dismissed the appeal for lack of jurisdiction, finding that:

because the BAP had not certified the appeal under § 158(d)(2), the only possible source of Court of Appeals jurisdiction was § 158(d)(1), which allowed appeal of only a final order of the BAP. … And under First Circuit precedent “an order of the BAP cannot be final unless the underlying bankruptcy court order is final.”[19]

The First Circuit analyzed whether a bankruptcy court’s denial of plan confirmation constitutes a final order and found it did not “so long as the debtor remains free to propose another plan”.[20]

Analysis: The Supreme Court set up the issue by first acknowledging that in general most civil matters culminate in a final decision that can be appealed, and that permitting piecemeal prejudgment appeals goes against judicial efficiency.  But, the Court recognized bankruptcy cases and the rules that apply to them are different:

A bankruptcy case involves “an aggregation of individual controversies,” many of which would exist as stand-alone lawsuits but for the bankrupt status of the debtor. 1 Collier on Bankruptcy ¶ 5.08[1][b], p. 5–42 (16th ed. 2014). Accordingly, “Congress has long provided that orders in bankruptcy cases may be immediately appealed if they finally dispose of discrete disputes within the larger case.”… The current bankruptcy appeals statute reflects this approach: It authorizes appeals as of right not only from final judgments in cases but from “final judgments, orders, and decrees … in cases and proceedings.” § 158(a).[21]

The debtor argued that the relevant “proceeding” permitting appeal is each review by the court of a plan, such that every confirmation or denial of a plan is a separate proceeding that is final and appealable.   The Bank in contrast viewed the whole plan process resulting in the ultimate confirmation of the plan or the dismissal of the case upon failure of confirmation as the “proceeding”.   The Court agreed with the Bank, finding the following:

           The relevant proceeding is the process of attempting to arrive at an approved plan that would allow the bankruptcy to move forward. This is so, first and foremost, because only plan confirmation—or case dismissal—alters the status quo and fixes the rights and obligations of the parties. When the bankruptcy court confirms a plan, its terms become binding on debtor and creditor alike.[22]

In contrast to confirmation or case dismissal, the Court found that a denial of confirmation, when the debtor is permitted to amend the plan, did little to change the parties’ rights.    As a practical matter, the court also found that if the debtor’s view were accepted “each climb up the appellate ladder and slide down the chute can take more than a year. Avoiding such delays and inefficiencies is precisely the reason for a rule of finality.”[23]

             The court did acknowledge that its ruling could mean that if an order denying a plan is not final that there would then “be no effective means of obtaining appellate review of the denied proposal”. [24] However the Court determined that that risk is tolerable when compared to the burden of endless appeals:

[O]ur litigation system has long accepted that certain burdensome rulings will be “only imperfectly reparable” by the appellate process. … This prospect is made tolerable in part by our confidence that bankruptcy courts, like trial courts in ordinary litigation, rule correctly most of the time. And even when they slip, many of their errors—wrongly concluding, say, that a debtor should pay unsecured creditors $400 a month rather than $300—will not be of a sort that justifies the costs entailed by a system of universal immediate appeals.[25]

The Court further noted that there are avenues to appeal interlocutory orders that serve as a further safeguard.[26]

  1. Baker Botts L.L.P. v. ASARCO LLC[27] – Fees for defense of fee applications

In Baker Botts, the Supreme Court addressed whether a law firm can receive fees for the defense of its fee application.   The majority opinion ruled that it could not[28].  The Court focused primarily on two concepts – (1) the American Rule which provides that litigants pay for their own fees absent certain limited exceptions such as fee-shifting statutes and  (2) the language of 11 U.S.C. §330(a)(1)(A) permitting “reasonable compensation for actual, necessary services rendered”.  

Facts: ASARCO as debtor in possession (“ASARCO”) retained  Baker Botts L.L.P. and Jordan, Hyden, Womble, Culbreth & Holzer, P.C., to represent it during the bankruptcy pursuant to 11 U.S.C. §327(a).   These firms prosecuted fraudulent transfer claims against ASARCO’s parent company, resulting in a judgment in favor of the Debtor between $7 and $10 billion.   This result permitted all of ASARCO’s creditors to be paid in full, and ASARCO emerged from bankruptcy with cash and little debt.     The Debtor’s attorneys sought compensation for their efforts and filed fee applications which were objected to by ASARCO (under the control of its parent company.) Following “extensive discovery and a 6-day trial on fees”, the objections were overruled and Debtor’s attorneys were awarded “$120 million for their work in the bankruptcy proceeding plus a $4.1 million enhancement for exceptional performance” in addition to “over $5 million for time spent litigating in defense of their fee applications.”[29] ASARCO appealed and the district court affirmed the fees incurred in defending the objections to their fee applications.   However, on appeal to the Fifth Circuit, the award of fees in defense of the fee application was reversed. The Supreme Court affirmed the Fifth Circuit’s ruling.

Analysis: The Court noted that it has “recognized departures from the American Rule only in “specific and explicit provisions for the allowance of attorneys’ fees under selected statutes.”[30] The Court further acknowledged the following:

To be sure, the phrase “reasonable compensation for actual, necessary services rendered” permits courts to award fees to attorneys for work done to assist the administrator of the estate, as the Bankruptcy Court did here when it ordered ASARCO to pay roughly $120 million for the firms’ work in the bankruptcy proceeding. No one disputes that § 330(a)(1) authorizes an award of attorney’s fees for that kind of work. [31]

However it found that “the phrase ‘reasonable compensation for actual, necessary services rendered” neither specifically nor explicitly authorizes courts to shift the costs of adversarial litigation from one side to the other—in this case, from the attorneys seeking fees to the administrator of the estate—as most statutes that displace the American Rule do.”[32] The Court emphasized that Section 330 allows compensation for “work done in service of the estate administrator” which means work performed for another. [33] Thus, the Court reasoned that Section 330(a)(6) does not give courts the ability to award compensation for work that is not done in service of the estate administrator. [34] The Court distinguished fees for the preparation of a fee application for which compensation is permitted from fees in defense of such fee application through the following analogy:

it would be natural to describe a car mechanic’s preparation of an    itemized bill as part of his “services” to the customer because it allows a customer to understand—and, if necessary, dispute—his expenses. But it would be less natural to describe a subsequent court battle over the bill as part of the “services rendered” to the customer.[35]

________________________________________________

[1] 135 S.Ct. 1932 (2015).

[2] Id. at 1947.

[3] The opinion was delivered by Justice Sotomayor and joined by Justices Kennedy, Ginsburg, Breyer and Kagan.  Justice Alito joined in part and filed a concurring opinion in which he concurred in part and in the judgment.  Chief Justice Roberts filed a dissenting opinion in which Justice Scalia joined and Justice Thomas joined in part.  Justice Thomas also filed a dissenting opinion.  This summary only addresses the majority opinion.

[4] The “Court” shall refer to the justices comprising the majority opinion.

[5] Id. at 1944 (internal citations omitted).

[6] Id. at 1944-45.

[7] Id. at 1945.

[8] Id. at 1946.

[9] Id. at FN13.

[10] 135 S.Ct. 1995 (2015)

[11] The opinion was delivered by Justice Thomas and joined by Chief Justice Roberts and Justices Scalia, Ginsburg, Alito and Kagan.   Justices Kennedy, Breyer and Sotomayor joined the opinion except as to a footnote regarding Dewsnup.

[12] 502 U.S. 410 (1992)

[13] 11 U.S.C. §506(d) provides the following:

(d) To the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void, unless–

(1) such claim was disallowed only under section 502(b)(5) or 502(e) of this title; or

(2) such claim is not an allowed secured claim due only to the failure of any entity to file a proof of such claim under section 501 of this title.

[14] Id. at 1998-99.

[15] Id. at 1999 (citing Dewsnup, 502 US at 416-17).

[16] Id. at 2001.

[17] 135 S.Ct. 1686 (2015)

[18] Chief Just Roberts delivered the opinion.

[19] 135 S.Ct. at 1691(internal citations omitted).

[20] Id.

[21] Id. at 1692 (internal citations omitted).

[22] Id.

[23] Id. at 1693.

[24] Id. at 1695.

[25] Id. (internal citation omitted).

[26] Id. at 1695-96.

[27] 135 S.Ct. 2158 (2015)

[28] Justice Thomas delivered the opinion which was joined by Chief Justice Roberts and Justices Scalia, Kennedy and Alito.  Justice Sotomayor joined in all but Part III–B–2 and filed an opinion concurring in part and concurring in the judgment. Justice Breyer filed a dissenting opinion, in which Justices Ginsberg and Kagan joined.

[29] 135 S.Ct. at 2163.

[30] Id. at 2164.

[31] Id. at 2165.

[32] Id.

[33] Id.

[34] Id. at 2167.

[35] Id.

Third Circuit Approves Payment by Creditor/High Bidder to Unsecured Creditors and Bankruptcy Professionals – Leaving Government in the Cold

by Nicole Leonard

In In re ICL Holding Co., Inc.[i], the Third Circuit Court of Appeals (the “Court”) addressed whether a bankruptcy sale and related settlement that resulted in (1) paying some administrative claimants (i.e. the case professionals) and not others (i.e. the government) and (2) paying unsecured creditors, while not paying creditors higher on the priority scheme, violated the Bankruptcy Code’s distribution requirements.  The Court found that following the sale and related settlement (neither of which the government was successful in staying), the government’s arguments against distribution were neither constitutionally, statutorily nor equitably moot.  Nevertheless, the Court affirmed the decisions of the lower courts approving distributions to both administrative creditors at the same priority as the government and junior creditors–while not paying the government – because such transfers were not made from property of the bankruptcy estate and were thus not subject to the Code’s distribution scheme.

Facts:

Debtor LifeCare Holdings, Inc. (“LifeCare” or “Debtor”) was in the business of operating long term acute care hospitals.  Following devastation of some its facilities after Hurricane Katrina, a post-Katrina environment of increased regulation and a debt load that thwarted obtaining new capital, LifeCare explored a sale of its assets.  After LifeCare entered into an asset purchase agreement with its secured lenders (the “Lender Group”), LifeCare and its 34 subsidiaries filed for chapter 11 protection.  The asset purchase agreement involved a credit bid by the Lender Group of about 90% of the debt owed to it   for the transfer of all of the Debtor’s assets and cash.  The agreement further provided that the Lender Group would pay for the legal and accounting costs of the Debtor and the (to-be-formed) unsecured creditors’ committee  (the “Committee”) as well as Debtor’s wind down costs.  These funds were to be held in escrow and any remaining funds after the aforementioned payments were made would go back to the Lender Group.

Following initial sale approval and an auction, the Lender Group bid was determined best.  But, the Committee and the government objected.   The Committee argued that the transaction was really a “veiled foreclosure” that would leave the estate administratively insolvent.  The government argued that the sale improperly provided for payment to certain administrative creditors, namely the case professionals, but did not provide for payment of the government’s administrative claim – described as an approximately $24 million capital gains tax claim resulting from the sale.

The Lender Group and the Committee worked out a deal that would provide $3.5 million to unsecured creditors and the Committee would thus withdraw its objection.  But removal of the Committee’s objection added to the government’s objection since the settlement resulted in unsecured creditors junior in priority to the government’s tax claim being paid ahead of (and instead of) the tax claim.  Despite the government’s objections, the settlement and the sale were approved in separate hearings. The government appealed both decisions and sought a stay pending appeal which was denied.  The district court affirmed denial of the stay and dismissed the government appeal.  The Third Circuit affirmed.

The Lender Group credit bid $320 million which was 90% of its $355 million secured claim. Following the credit bid, the Lender Group had an approximately $35 million remaining secured claim against any property of the estate.  The Debtor and Committee argued that the government’s claim for a $24 million tax liability was moot.  However, the Court disagreed and found that (a) the government’s claim, though remote, was not impossible and therefore not constitutionally moot; (b) Section 363(m) did not bar review so the claim was not statutorily moot; and (c) since the matter was not being addressed in the plan context it was not equitably moot.  Having determined the government’s claims were not moot, the Court turned to whether the funds escrowed for case professionals and placed in trust for the unsecured creditors were paid from property of the Debtor’s estate.

Settlement Payment to Unsecured Creditors

The Court found that “the settlement sums paid by the purchaser [Lender Group] were not proceeds from its liens, did not at any time belong to LifeCare’s estate, and will not become part of its estate even as a pass-through.”[ii] Further, the Court was not persuaded that language in the motion seeking approval of the Committee settlement, which described the settlement as an allocation of the “proceeds of the sale”, was evidence that the settlement proceeds served as consideration for the purchased assets.[iii]

Payment to Case Professionals

The Court found more difficult the analysis of whether the funds set aside for payment to professionals were property of the estate.  The asset purchase agreement described the funds as part of the purchase price for the Debtor’s assets.  Despite that description, the Court found it could not “ignore the economic reality of what actually occurred.”[iv] The Court explained that in the sale the Lender Group took all of the Debtor’s assets, including their cash, “[t]hus, once the sale closed, there technically was no more estate property.”[v] Further, any residual funds in the escrow account set aside for professionals would be returned to the Lender Group. The Court acknowledged the following:

All that said, we recognize that, in the abstract, it may seem strange for a creditor to claim ownership of cash that it parted with in exchange for something. . But in this context it makes sense. Though the sale agreement gives the impression that the secured lender group agreed to pay the enumerated liabilities as partial consideration for LifeCare’s assets, it was really “to facilitate … a smooth … transfer of the assets from the debtors’ estates to [the secured lenders]” by resolving objections to that transfer. …. To assure that no funds reached LifeCare’s estate, the secured lenders agreed to pay cash for services and expenses through escrow arrangements.[vi]

The Court distinguished this arrangement from a standard carve-out from a secured creditor’s cash collateral because in that circumstance, the cash collateral used for the carve-out is property of the estate where, as here, the funds escrowed were property of the Lender Group.

Key Take Aways:

  • This sale involved the Lender Group credit bidding part of its claim for all of the Debtor’s assets, including cash. Thus, the sale effectively removed all property from the estate. An important distinction made by the Court was that the funds to be distributed to the case professionals and unsecured creditors were not “cash collateral” and arguably part of the Debtor’s estate, but were rather funds of the Lender Group.       If the sale did not go through, the funds would not go to the Debtor but back to the Lender group.       Thus – this opinion does not address the distribution scheme in a typical carve-out scenario. However, this case does give a very useful roadmap on how to provide value for professionals and unsecured creditors outside of the plan context – although such value may come at the expense of other creditors similarly situated or even superior to those receiving the value.
  • This Court read substance over form in terms of the language in the sale documents even though the funds in question were specifically described as part of the purchase price. But, attention should be paid to drafting motions and asset purchase agreements in case another court is less inclined to divine the substance from the form.
  • An issue raised but not determined by the Court is whether the priority requirements apply in the 363 sale context “even if textually most (save for § 507) are limited to the plan context.”[vii] The Court found that “ even assuming the rules forbidding equal-ranked creditors from receiving unequal payouts and lower-ranked creditors from being paid before higher ranking creditors apply in the § 363 context, neither was violated here.”[viii] Thus the issue as to whether the priority scheme applies in the 363 context is left open.

[i] In re ICL Holding Co., Inc., No. 14–2709,  2015 WL 5315604 (Sept. 14, 2015 3d Cir.)

[ii] Id. at *7.

[iii] Id.

[iv] Id. at *8.

[v] Id.

[vi] Id. (internal citation omitted).

[vii] Id. at *6.

[viii] Id. at *9.

Principals of General Contractors Should Be Aware: Trustee’s Release of Claims May Not Release Bankrupt GC’s Principals from Trust Fund Violations under NY Law

by David Primack

A subcontractor still retains its right to sue the principals of a bankrupt general contractor for diversion of trust funds under New York law even when a bankruptcy trustee settles and releases causes of action against these same individuals on behalf of the bankruptcy estate. Such is the recent decision by the Bankruptcy Court for the Southern District of New York in In re Lehr Construction Corp., Case No. 11-10723-shl (September 2, 2015 Bankr. S.D.N.Y.) and it provides clarity (at least with regard to New York law) to certain rights of subcontractors when their general contractor files for bankruptcy.

Background

Lehr Construction Corp. (“Lehr”) served as construction manager and general contractor for customers in the New York metropolitan area. Lehr subcontracted electrical work to Robert B. Samuels (“Samuels”) for certain properties. The customers paid Lehr for the construction work that both Lehr and Lehr’s subcontractors performed on these properties. However, Samuels and other subcontractors were never paid. As the Bankruptcy Court noted, under Article 3-A of New York’s Lien Law (“Article 3-A”), when a general contractor is hired to improve real property, it is obligated to hold funds paid by the real property owners in trust for the benefit of the subcontractors that worked to improve the real property (e.g. Samuels and other subcontractors). In this case, historically Lehr generally deposited the payments from customers into commingled bank accounts and paid subcontractors from such accounts. Leading up to the bankruptcy filing, subcontractors were not being paid from these commingled accounts.

In February of 2011, Lehr filed for bankruptcy protection under Chapter 11 and a trustee (the “Chapter 11 Trustee”) was appointed to wind down Lehr. Several months later, in June 2011, Samuels filed a state court complaint pursuant to Article 3-A against non-debtor principals alleging that Lehr knowingly and wrongfully diverted Article 3-A trust assets and that the non-debtor principals were personally liable under the statute. Samuels’ state court action was enjoined by agreement of the parties and approved by Court order so that the Chapter 11 Trustee could administer the bankruptcy estate which might have an impact on the state court litigation. The Chapter 11 Trustee was concerned that if the Samuels suit and another similar action brought in state court went forward, such actions could deplete assets otherwise available to the bankruptcy estate.

The matter came before the Court again based on Samuel’s request for relief from the injunction against continuing its state court action. One issue that remained open was whether claims brought under Article 3-A are considered generalized claims or are rather individual/particular (i.e. subcontractor only) claims. This is an important distinction as it determines who may pursue a claim. As the Court explained, general claims are claims with no particularized injury arising from them and if the claim could be brought by any creditor of the debtor, a trustee is the proper person to assert them, and all creditors are bound by the outcome of the trustee’s action. On the other hand, particular or personal claims are claims where there is injury to one specific creditor or a select group of specific creditors and other creditors have no interest in such action.

In 2013 and 2014, the Chapter 11 trustee reached settlement agreements with various principals of Lehr. The Chapter 11 Trustee’s first proposed settlement agreement contained a permanent injunction which would enjoin claims against the principal for violation Article 3-A. The Chapter 11 Trustee took the position that Article 3-A claims were “general” claims and belonged to the Chapter 11 Trustee. Samuels objected and the Court agreed with Samuels to leave the issue open to a ruling at a later date. The settlement agreements that were eventually approved by the Court contained language that enjoined any claim that was duplicative or derivative of claims that could have been brought by the Chapter 11 Trustee  – but did not bar any claim against a principal that was held solely by an individual creditor. This open issue – whether Article 3-A claims are general or particular – was finally addressed by the Lehr Court’s September 2, 2015 decision.

Analysis

The Court held that Article 3-A claims are particularized claims for subcontractors and therefore Samuels is not barred from pursuing its rights in state court even if the Chapter 11 Trustee settles and releases its causes of action. As the Court notes, claims based on a breach of fiduciary duty belong to a corporation and thus, after a bankruptcy, such claims belong to the trustee. In general, a claim that a corporation misused trust funds could be construed as a violation of a fiduciary duty.

However, pursuant to Article 3-A and applicable case law, subcontractors have their own unique breach of fiduciary duty cause of action against a company and its principals. The Court further ruled that just because trust funds may be unavailable and untraceable because of the contractor’s commingling and disbursement, a subcontractor’s Article 3-A cause of action remains viable and not otherwise rendered a generalized claim. The Court then allowed Samuels to prosecute in state court its claims against the principals of Lehr for violation of their duties pursuant to Article 3-A.

Key Takeaways

The Lehr decision clarifies that under New York law, Article 3-A claims of subcontractors are not property of the corporation and therefore not general claims that may be pursued or settled by the bankruptcy estate or any subsequent bankruptcy trustee. A subcontractor can seek to enforce its rights against the principals of a bankrupt company in state court (though the subcontractor may be forced to halt such proceedings while a bankruptcy case is pending).

Importantly, the subcontractor’s monitoring of the bankruptcy case and vigilance in objecting to the Chapter 11 Trustee’s settlement proposals made sure that an order of the court did not override the subcontractor’s rights. Because many other states have similar statutes for subcontractors, this decision may provide guidance in those jurisdictions. Finally, this decision may make settlements with principals of general contractors more difficult as the principals will have to negotiate with both the bankruptcy estate and each subcontractor for resolution of all claims.

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CONDOMINIUM ASSOCIATION CLAIMS NOT DISCHARGED BY CONFIRMED PLAN -DELAWARE DISTRICT COURT APPLIES FRENVILLE TEST

by Jason Angelo

In re WCI Communities, Inc., 2015 WL 4477696 (D. Del. July 22, 2015)
In the Third Circuit, the answer to when a claim “arises” for purposes of the discharge depends upon what law applied at the time of the discharge.
The Court in the WCI case looked at three Third Circuit Court of Appeals decisions that addressed when a claim “arises”: In re M. Frenville Co., Inc., 744 F.2d 332 (3d Cir. 1984), which used the widely criticized accrual test based on whether an entity has a right to payment and when such right arose under state law; In re Grossman’s Inc., 607 F.3d 114 (3d Cir. 2010), which overruled the accrual test and used a test based on when the claimant was exposed to the product or conduct that led to the injury and formed the basis for the claim to payment; and Wright v. Owens Corning, 679 F.3d 101 (3d Cir. 2012), which addressed the due process issues raised when a person who did not have a “claim” under the Frenville test applicable at the time of plan confirmation would have had a claim under the subsequent Grossman’s test, thereby retroactively denying due process. The result as set forth in WCI following the opinion in Wright is an approach that permits Frenville to apply in narrow circumstances when to do otherwise would deny due process.

Background
In WCI, following the entry of the confirmation order and the discharge, a condominium association sought inter alia to pursue claims in state court against the reorganized debtor/builder for construction defects and past due amounts owed to the condominium association. As discussed below, the District Court for the District of Delaware, following the Third Circuit Court of Appeals decision in Wright, affirmed the Bankruptcy Court decision that the claims in question did not “arise” until after the discharge and therefore were not barred by it.

WCI Communities, Inc., along with its 126 subsidiaries (the “Debtor”), filed a voluntary Chapter 11 petition on August 4, 2008. Prior to filing its petition, the Debtor constructed homes and operated residential communities throughout the country, including the Lesina at Hammock Bay Condominium in Florida. Debtor filed a Condominium Declaration in 2007, which included Articles of Incorporation and the By-Laws for the community’s Condominium Association (the “Association”), which administers and manages the property. The Articles of Incorporation provided that the Association would be managed by a three-person board of directors appointed by the Debtor until an event known as “Turnover” under Florida law, at which point the control of the Association would be ceded to a five-member board elected by the Condominium owners.

The Bankruptcy Court set the bar date for filing claims against the estate as February 2, 2009, and thereafter approved the restructuring plan in August 2009. The Bankruptcy Court’s confirmation order contained a general discharge of all claims against the Debtor and permanently enjoined any holders of claims from asserting their claims against the Debtor. Following entry of the confirmation order, “Turnover” occurred on December 4, 2009. After the “Turnover,” an independent audit revealed that Debtor owed the Association over $80,000 in payments pursuant to the Condominium Declaration. An inspection by an engineering firm also revealed construction defects at the property with a repair cost of approximately $500,000.

The Association, when it was still under Debtor control prior to the “Turnover,” had timely filed a broad proof of claim that included any claims for “any defect in workmanship” and “assessment funding of association dues for unsold units.” However, post-Turnover, the Association contended that the confirmation order did not discharge its claims and filed a motion for declaratory relief pursuant to 11 U.S.C. §105(a) seeking a determination that the Debtor’s obligations to it were not discharged through the Plan and that Debtor was unjustified in threatening sanctions if the Association commenced a state court action.

Before the Bankruptcy Court ruled on the motion, the Third Circuit issued its opinion in Wright and utilized the standard for determining when a claim arises that was set forth in Frenville rather than the standard articulated in the en banc decision in Grossman’s. Thus, in WCI Judge Kevin Carey of the Bankruptcy Court for the District of Delaware held that Wright compelled the determination that the Third Circuit’s Frenville test applied to the Association’s claims and, under that test, the claims did not “arise” until after the “Turnover” date. Since the “Turnover” date was after the confirmation of the Plan, the Association’s claims were not subject to discharge under the Bankruptcy Code. Judge Gregory Sleet of the District Court upheld the Bankruptcy Court decision.

Analysis
As the District Court noted, when determining when the claims arose, the “dispute hinges upon whether the Association’s asserted statutory claims ‘arose’ prior to the date of the debtor’s plan confirmation.” In re WCI Communities, Inc., 2015 WL 4477696 at *3. The standard in the Third Circuit has been particularly fluid in recent years following the overruling of the widely-criticized Frenville “accrual” test. Under Frenville, a claim did not ripen until a right to payment arises, which in turn was decided by reference to state law. In re M. Frenville, 744 F.2d at 337. The Third Circuit further expounded on this in In re Remington Rand Corp., 836 F.2d 825, 830 (3d Cir. 1988), holding that “the existence of a valid claim depends on: (1) whether the claimant possessed a right to payment; and (2) when that right arose” as determined by reference to relevant non-bankruptcy law.” The Third Circuit’s 2010 Grossman’s decision abrogated the Frenville test. There, the Court held that a “claim” arises when an individual is exposed pre-petition to a product or other conduct giving rise to an injury, which underlies a “right to payment.” In re Grossman’s, 607 F.3d at 125. According to the Grossman’s Court, Frenville’s emphasis on a “right to payment” failed to give sufficient weight to other words in the statutory definition that modified the term “claim,” such as “contingent,” “unmatured,” and “unliquidated.” Id. at 121.

Wright addressed the retroactive effect of the Grossman’s decision, carving out specific exceptions where a claimant’s due process rights would be affected by its application. Specifically, claimants operating under the Frenville test would not have realized that they held “claims” and would not have taken action to protect their interests prior to the bar date and plan confirmation. To ensure that such claimants were afforded due process, instead of allowing claimants operating under the Frenville test to have their claims discharged in an earlier bankruptcy without notice or an opportunity to be heard, the Third Circuit in Wright held that the Frenville test applies to plans proposed and confirmed prior to the Grossman’s decision on June 2, 2010. So those who all of the sudden had “claims” under Grossman’s were exempt from the new test.

Since the WCI Debtor’s plan was confirmed prior to the Grossman’s decision, the Bankruptcy Court applied the Frenville accrual test and determined that the Association’s right to payment did not accrue under Florida law until the “Turnover,” which occurred after confirmation, and thus that the claims did not fall within the scope of the discharge. In upholding the decision, the District Court recognized that Grossman’s is not retroactively applicable in all situations, but only when a claimant’s due process rights would not be violated as per Wright.

The Debtor in WCI argued that the Association had been permitted due process because the Association (prior to the “Turnover”) had actually filed a proof of claim and thus had the opportunity to participate in the bankruptcy proceedings. In Debtor’s view, the filing of a proof of claim alone, even if a claimant did not yet hold a “claim,” would allow such a claim to be discharged upon confirmation of a plan.

The District Court refused to adopt such a bright line rule and countered that the mere filing of a proof of claim does not, in and of itself, mean that a claimant was afforded full due process. The District Court stated that “[w]hether a party receives proper due process depends on the circumstances of a particular case.” In re WCI Communities, Inc., 2015 WL 4477696 at *6 (citing In re Grossman’s, 607 F.3d at 127). Here, the Association could not have asserted the claims against Debtor until “Turnover,” since its cause of action under Florida law did not accrue until the condo owners acquired control of the Association. Further, since it was controlled by a Board hand-picked by the Debtor itself up to that point, the Association was not independent from the Debtor, and under Florida law, its actions were attributable to the Debtor rather than the condo owners until post-“Turnover.”

Key Takeaways
While Grossman’s and Wright have complicated the ever-evolving issue of when a “claim” arises in the Third Circuit, the District of Delaware recognized that due process concerns override the formalistic approach advocated by the Debtor. Additionally, the court made clear that the mere filing of a proof of claim would not per se meet the standard for due process under Third Circuit precedent.

Jason D. Angelo is an Associate in MCELROY, DEUTSCH, MULVANEY & CARPENTER, LLP.’s Bankruptcy Practice Group and is admitted to practice in Delaware and New Jersey.

THIRD CIRCUIT APPROVES STRUCTURED DISMISSAL OF CHAPTER 11 DESPITE NONCOMPLIANCE WITH ABSOLUTE PRIORITY RULE

by Jason Angelo

In re Jevic Holding Corp., 2015 WL 2403443, __ F.3d __ (3d Cir. May 21, 2015)

Section 507’s Absolute Priority Rule always applies – or does it? After last month’s precedential opinion issued by the Third Circuit Court of Appeals, apparently that isn’t always the case. In a matter of first impression within the Third Circuit, the Court determined that the Absolute Priority Rule is not necessarily implicated outside the context of plan confirmations. At the same time, the court became the first circuit court to determine that bankruptcy courts have the discretion to approve structured dismissals in connection with a Rule 9019 settlement, so long as the ultimate result does not evade the safeguards of the plan confirmation or conversion process.

Background

Jevic, a former New Jersey trucking company, was acquired in a 2006 LBO by Sun Capital Partners (“Sun Cap”) and financed by a group of lenders headed by CIT Group. In May 2008, Jevic ceased operations, notified its employees of their imminent termination, and filed a voluntary Chapter 11 petition in the Bankruptcy Court for the District of Delaware.

In the meantime, a group of former Jevic employees (the “WARN claimants”) initiated a class action lawsuit against Jevic and Sun Cap, alleging violations of the federal Worker Adjustment and Retraining Notification (“WARN”) Act and its New Jersey analogue. At the same time, the Official Committee of Unsecured Creditors brought a fraudulent conveyance action against Sun Cap and CIT in connection with the LBO.

The key players soon reached a settlement that provided for a release of claims between and among the Committee, Jevic, CIT, and Sun Cap in exchange for dismissal of the fraudulent conveyance action; for CIT to pay $2 million into an account to pay legal fees and other administrative expenses; for Sun Cap to assign its lien on the bankruptcy estate’s cash to a trust to pay tax, administrative, and general unsecured creditors; and for dismissal of the Chapter 11 case. The WARN claimants, however, were left out of the settlement, as Sun Cap refused to pay them as long as they maintained their WARN action. The WARN claimants and the U.S. Trustee objected to the settlement, arguing that it called for distribution of property of the estate to lower priority creditors under section 507’s distribution scheme; that the Bankruptcy Code does not permit structured dismissals; and that the Committee breached its fiduciary duties to the estate by leaving the WARN claimants out of the settlement.

In an oral opinion, Chief Judge Brendan L. Shannon approved the settlement and dismissal, concluding that the “dire circumstances” of the case– specifically, the lack of any realistic prospect of a distribution to any unsecured creditors if the settlement was not approved –mandated approval. Moreover, the Bankruptcy Court determined that there was no chance of approval of a Chapter 11 plan, and that conversion to Chapter 7 was impracticable both in terms of cost and the settling parties’ willingness to participate in a settlement in that context. The Bankruptcy Court also concluded that no fiduciary duties had been violated, that the settlements under Rule 9019 need not comply with the Absolute Priority Rule, and that the settlement was fair and equitable under the factors established by In re Martin, 91 F.3d 389 (3d Cir. 1996).

The WARN claimants appealed to the District Court, which rejected their contentions, holding that the Bankruptcy Court had correctly applied the Martin factors and had correctly ruled regarding the fiduciary duties and absolute priority rule issues. The District Court noted that even had the Bankruptcy Court erred, however, the WARN claimants’ appeal was equitably moot because the settlement had been “substantially consummated.” See Jevic Holding Corp., 2014 WL 2688613, at *2 (D.Del. Jan. 24, 2014). The WARN claimants appealed to the Third Circuit, with the U.S. Trustee joining in the appeal as amicus curiae.

Analysis

In a 2-1 panel split, the Third Circuit upheld the District Court’s order and the panel rejected the WARN claimants’ contention that structured dismissals are never permissible and must always comply with Section 507’s priority scheme. See In re Jevic Holding Corp., 2015 WL 2403443 (3d Cir. May 21, 2015).

Noting that the Code does not explicitly permit structured dismissals and that the only statutory ways out of a Chapter 11 case are plan confirmation, conversion to Chapter 7, or reversion to the status quo ante via dismissal “with no strings attached,” the panel stated that “structured dismissals are simply dismissals that are preceded by other orders . . . that remain in effect after dismissal.” Further, the Code, per Section 349, explicitly authorizes Bankruptcy Courts “to alter the effect of dismissal ‘for cause,’” such that “a hard reset” as contemplated by the WARN claimants was unnecessary. At bottom, bankruptcy courts have discretion to approve structured dismissals unless they are effectively sub rosa plans – that is, they are “contrived to evade the procedural protections and safeguards of the plan confirmation or conversion process.”

The Court next discussed whether settlements approved in the context of structured dismissals may ever disregard the Absolute Priority Rule by skipping a class of objecting creditors in favor of less senior creditors. Agreeing with the Second Circuit’s opinion in In re Iridium Operating LLC, 478 F.3d 452 (2d Cir. 2007), the panel noted that in determining whether a proposed settlement is “fair and equitable,” compliance with the Absolute Priority Rule will “usually be dispositive” because the policy behind the rule, “evenhanded and predictable treatment of creditors,” applies with equal force to both settlements and plans. The panel gave bankruptcy courts some leeway, however, to exercise their discretion depending on the facts of each case, by holding that they may approve settlements that do not follow the Absolute Priority Rule “’only if they have specific and credible grounds to justify [the] deviation.’”

The panel went on to conclude that the Bankruptcy Court had “sufficient reason” to approve the settlement and dismissal in this case because it was the “least bad alternative” – that is, there was no prospect of a confirmable plan and conversion would have resulted in the secured creditors taking what was left in the Estate. Outside of the settlement, there was no chance of the unsecured creditors receiving a meaningful distribution. Faced with the Hobson’s choice of accepting a settlement that strayed from the Code’s priority scheme or allowing the WARN claimants’ lawsuit to deplete the Estate, the Bankruptcy Court made a judgment call within its discretion in approving the settlement and dismissal.

Key Takeaways

This decision is significant for a number of reasons, especially considering the relative dearth of case law from courts of all levels across the nation addressing the issues discussed. The Third Circuit is the first circuit court to explicitly acknowledge that structured dismissals are permitted in some cases. Of particular note is the panel’s refusal to adopt a hard and fast rule that such structured dismissals are disallowed per se.

In the rare case where the traditional routes out of a Chapter 11 are closed off and a settlement will best serve the interests of the estate and its creditors as a whole, structured dismissals that deviate from the Absolute Priority Rule are justifiable. The Third Circuit’s decision grants further discretion to bankruptcy courts to approve alternatives to plan confirmation, conversion, or plain dismissal when the unique circumstances of a case justify such a decision.

Jason D. Angelo is an Associate in McElroy, Deutsch, Mulvaney & Carpenter, LLP’s Bankruptcy Practice Group and is admitted to practice in Delaware and New Jersey.

Welcome!

by Nicole Leonard

MDM&C welcomes you to our Bankruptcy Blog where MDM&C’s Bankruptcy and Corporate Restructuring Group will highlight new and interesting cases and issues in the insolvency and restructuring world. Look forward to new posts every other Thursday.