Peculiar Parting from Protocol: U.S. Trustee’s Objection to Debtors’ Application to Retain Management Consultants under Section 363(b) Shot Down in SDNY

by Bradley Lehman

A recent decision from the United States Bankruptcy Court for the Southern District of New York ratifies a procedure often used for the employment of financial consultants by corporate debtors and the applicability of the “Jay Alix Protocol” in connection therewith.

In the Chapter 11 case of In re Nine West Holdings, Inc., et al., the debtors filed an application to retain Alvarez & Marsal North America, LLC (“A&M”) to provide an interim CEO and other management personnel to the debtors. The debtors sought the retention of A&M pursuant to Section 363(b) of the Bankruptcy Code, which applies a business judgment standard in evaluating a debtor’s proposed use of its money.

The Office of the United States Trustee (the “UST”) filed an objection to the application, arguing that A&M and the interim CEO are “professional persons” within the meaning of the Bankruptcy Code, such that their retention must be considered only under Section 327(a). Section 327(a) applies a more stringent standard than the relatively permissive business judgment rule applicable under Section 363(b). The UST argued that because the interim CEO had previously served on some of the debtors’ subsidiaries’ boards of directors, he and (by extension) A&M could not meet the disinterestedness requirement of Section 327(a).

The debtors and A&M, supported by other significant stakeholders in the case, vehemently disagreed with the UST’s objection. They pointed out that distressed management consultants have been retained under Section 363(b) in many bankruptcy cases. A&M cited to 37 other cases in which A&M itself had been retained under Section 363(b), noting that the UST objected to A&M’s retention in only one of those cases. The debtors and A&M also argued that the UST was ignoring the “Jay Alix Protocol,” the UST’s own national policy which has been in place for some fourteen years and directs debtors to seek retention of consultants like A&M under Section 363(b).

In her July 2 opinion, Judge Shelley Chapman noted that the UST was “seemingly ignoring this mountain of precedent,” and that the UST’s attempt to distinguish cases involving a consultant CEO rather than a CRO was “nonsensical.” With respect to the Jay Alix Protocol, the Court found that the UST’s surprising departure from the Protocol “lacks intellectual honesty and consistency.” The Court ultimately found that A&M’s retention would not violate the Protocol and granted the debtors’ application. Judge Chapman was sensitive to the economic and operational realities of the case.  She noted that removing A&M personnel from management positions they had held for the past four years, three of which were pre-bankruptcy, would likely have a disastrous effect on the debtors’ efforts to reorganize.


Texas District Court Finds Unclaimed Oil and Gas Royalties Are Not Property of the Estate

by Bradley Lehman

By: Bradley Lehman, Esquire

McElroy, Deutsch, Mulvaney & Carpenter, LLP

A recent opinion from the U.S. District Court for the Southern District of Texas, on appeal from the bankruptcy court in the District, is likely to have broad applicability in pending and future energy producer bankruptcy cases. In Oklahoma State Treasurer v. Linn Operating, Inc., 6:17-CV-0066, 2018 WL 1535354 (S.D. Tex., March 29, 2018), the Chapter 11 plan filed by Linn Operating LLC, an Oklahoma-based oil and gas producer, provided that the claims of owners of the approximately $1 million in unclaimed royalties held by the debtor would be discharged upon confirmation of the plan and the debtor would retain the funds. The bankruptcy court confirmed the plan, and the State of Oklahoma filed an adversary action against the debtor seeking turnover of the unclaimed royalties to the state. The bankruptcy court dismissed the complaint, finding that the adversary case was merely a post-confirmation collateral attack on the debtor’s plan.

Oklahoma appealed the dismissal of its adversary case to the Southern District of Texas, and Judge Kenneth M. Hoyt entered an opinion reversing the bankruptcy court’s decision. The District Court found that, as a matter of state law, unclaimed oil and gas royalties are held in trust by the producer for the owners of the royalties. Therefore, the unclaimed royalties were never property of the debtor’s bankruptcy and were not subject to the bankruptcy court’s jurisdiction or to confirmation of the debtor’s Chapter 11 plan.

Supreme Court Finds Determination of Insider Status Rests with the Bankruptcy Court and “Clear Error” is the Appropriate Standard of Review

by Bradley Lehman

By: Bradley P. Lehman, Esquire

McElroy, Deutsch, Mulvaney & Carpenter, LLP

A recent decision by the United States Supreme Court in U. S. Bank N. A., Trustee, by and through CWCapital Asset Management LLC v. Village at Lakeridge, LLC, 138 S.Ct. 960  (2018) clarified the standard of review to be applied to bankruptcy court determinations of who counts as an “insider” of the debtor under the Bankruptcy Code.

When Village at Lakeridge declared bankruptcy, it had two primary creditors: U.S. Bank and MBP Equity Partners (“MBP”). MBP also owned Village at Lakeridge. Village at Lakeridge proposed a Chapter 11 plan pursuant to which both of its creditors were in separate impaired classes. U.S. Bank would not consent to the proposed plan, and MBP’s vote could not be counted because, being the owner of the debtor, it was the classic insider. MBP devised a plan to bypass this inconvenience by selling its claim to someone else who would vote in favor of the plan. Thus, an MBP board member approached the doctor whom she was dating about buying MBP’s claim, and he agreed to purchase the $2.76 million claim for $5,000.

U.S. Bank argued that the purchaser of MBP’s claim was still an insider, albeit a non-statutory insider, and therefore could not be counted as an affirmative vote in favor of the debtor’s plan. The bankruptcy court disagreed and found that he was not an insider because he purchased the claim as a speculative investment and did so in the context of an arms-length transaction. U.S. Bank appealed, and the Ninth Circuit held that there was no clear error in the lower court’s determination that the transaction was at arm’s length. U.S. Bank appealed to the United States Supreme Court, arguing that the Ninth Circuit should have reviewed the lower court’s determination de novo.

The Supreme Court disagreed in its unanimous opinion finding that the clear error standard utilized by the Ninth Circuit was appropriate because the answer to the mixed question of law and fact involved more factual work than legal work.   Thus, deference to the bankruptcy court on the appeal through use of the clear error, rather than de novo, standard of review was appropriate.


Court Orders Sanctions for Non-payment of Accountants

by Bradley Lehman

A recent opinion from the Bankruptcy Court for the District of Delaware, In re Washington Mutual, Inc., et al., Case No. 08-12229 (MFW), 2018 WL 704361 (Bankr. D. Del. February 2, 2018), illustrates the value of unambiguous contractual provisions and the importance of timely compliance with court orders.

This matter evolved out of the failure of Washington Mutual Bank in 2008 and the resulting chapter 11 bankruptcy filings.  In early 2008, prior to the bankruptcy, Washington Mutual sought to challenge the constitutionality of certain California tax policy regarding taxation of interest on federal bonds.  Washington Mutual retained the accounting firm Grant Thornton LLP to develop the theory that California was required to tax federal and state bonds similarly and assist Washington Mutual in getting tax refunds based on the theory. Although Washington Mutual and other similarly situated taxpayers stood to receive very substantial tax refunds from California if a court deemed California’s taxes on federal bond interest unconstitutional, Washington Mutual’s principal motivation was to leverage the Treasury bond interest issue against the California Franchise Tax Board (“FTB”) in order to offset Washington Mutual’s other California tax liabilities.

On September 25, 2008, Washington Mutual closed its doors and was turned over to the FDIC as receiver, whereupon the FDIC immediately sold all of Washington Mutual’s assets to JPMorgan Chase. Washington Mutual’s unceremonious farewell remains the largest bank failure in U.S. history by a very large margin. On the following day, Washington Mutual and its affiliates filed Chapter 11 bankruptcy in the District of Delaware

Washington Mutual and Grant Thornton entered into a post-petition retainer agreement pursuant to which Grant Thornton was to continue developing the Treasury bond interest issue and was to be paid its hourly fees, subject to a twenty percent discount, plus ten percent of any “Economic Value” that Washington Mutual received from the FTB, capped at $5 million. Throughout the bankruptcy proceeding, Grant Thornton assisted with the preparation of tax returns, technical memos, and letters to the FTB, as well as continuing negotiations with the FTB regarding Washington Mutual’s tax liability and objecting to the FTB’s $280.5 million proof of claim.

The Bankruptcy Court confirmed Washington Mutual’s Chapter 11 plan of reorganization in early 2012, and a liquidating trust (the “Liquidating Trust”) was set up to handle the distributions to creditors. In August 2012, the Bankruptcy Court entered the final Omnibus Fee Order which included Grant Thornton’s contingent fee. Grant Thornton later learned by browsing the docket that Washington Mutual had reached a settlement with the FTB. Pursuant to the settlement, the FTB obtained a full and complete release in exchange for an immediate tax refund to Washington Mutual in the amount of $225 million, in addition to other deferred refunds. Upon learning of the settlement, Grant Thornton requested that the Liquidating Trust pay Grant Thornton’s contingent fee. The Liquidating Trust refused to pay on the basis that the FTB had always rejected the Treasury bond interest issue and that none of the settlement funds were in consideration for the Treasury bond interest issue. Thus, the Liquidating Trust believed that Grant Thornton was not entitled to the contingent portion of its fees. Grant Thornton moved for the imposition of sanctions against the Liquidating Trust in April 2015.

In granting Grant Thornton’s motion, the Court found that the contingent fee language in the retainer agreement was broad and unambiguous, that the contingent fee was not improvident under Section 328(a) of the Bankruptcy Code, and that Grant Thornton was entitled to sanctions because the Litigation Trust was in civil contempt of the Omnibus Fee Order. The Liquidating Trust had argued that there was a “mutual mistake” regarding the post-petition retention agreement in that the agreement erroneously expanded Grant Thornton’s contingency fee to all recoveries from FTB rather than just those related to the Treasury bond interest issue.  However, the Court determined that the terms in the retainer agreement were clear and intentionally broad, containing no qualification that funds not directly attributable to the Treasury bond interest issue were excluded. The parties had anticipated all along that the FTB might reject Washington Mutual’s position on the Treasury bond interest issue but still agree on a settlement in order to keep a court from ruling on it.

The Court found that § 328(a) sets a high bar for a finding of improvidence. After approving the terms of a professional’s compensation under § 328, a court will only allow different compensation “if such terms and conditions prove to have been improvident in light of developments not capable of being anticipated at the time of” entry. In this case, the Court found that the parties could certainly have foreseen that the Court would enforce the agreement exactly as written. Further, the Court was not persuaded by the Liquidating Trust’s argument that there had been a mutual mistake regarding the contingent fee arrangement. The Court noted that even if “the Debtors were unilaterally mistaken,” such unilateral mistake would not be the basis for a finding of improvidence.

Finally, the Court found that the imposition of sanctions against the Liquidating Trust was appropriate where the Liquidating Trust continued to ignore the final fee order entered by the Court even despite Grant Thornton’s repeated requests for payment and despite the Court’s determination that the plain terms of the retainer agreement entitled Grant Thornton to the contingent fee. The Court found that the Liquidating Trust “demonstrated an inexcusable disregard for the Court’s order” that could not be “remedied by a pleading of good faith.” Thus, in addition to the recovery of its contingent fee, the Court concluded that Grant Thornton was also entitled to recover the costs associated with filing and prosecuting its motion as a sanction against the Liquidating Trust.

Although the Liquidating Trust may have had a legitimate disagreement as to the terms of the retention agreement with Grant Thornton, it appears that the repeated refusal to comply with the Court’s order based on the Liquidating Trust’s unilateral position that there was mutual mistake is what led to the ultimate imposition of the sanction.  The Court noted that the Liquidating Trust “could have either remitted the Contingency Fee or sought relief from the Court.” It did neither, and just refused to comply with the Court’s order which proved to be an expensive obstinacy.