Month: September, 2015

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.