Please Release Me? Colorado Bankruptcy Court Answers “Perhaps” in Midway Gold Case

by Nicole Leonard and Jeffrey Bernstein

This article is  reprinted with the permission of the American Bankruptcy Institute. It originally appeared in Volume 17, Number 1 of the ABI Business Reorganization Committee Newsletter, May 2018.

The permanent release of a nondebtor from a debt owed to a third party in a chapter 11 plan is barred per se in some courts and must meet a high standard to be allowed in others. The U.S. Bankruptcy Court for the District of Colorado in In re Midway Gold US Inc. addressed this issue in connection with confirmation of the joint chapter 11 plan of 14 debtor entities in the gold mining and exploration business.[1]

As a threshold issue, the Midway court looked to whether third-party releases are ever allowed in the Tenth Circuit or whether they are barred per se as had been argued and applied in other cases. The court analyzed the Western Real Estate case and concluded a chapter 11 plan could not “bar litigation against nondebtors for the remainder of the discharged debt” and that the court’s authority under § 105(a) could not be used in a manner inconsistent with § 524(e). However, such finding did not translate into an absolute bar of all nondebtor releases in all circumstances.[2]

In connection with its analysis of the nondebtor release, the Midway court reviewed the treatment of nondebtor releases in other circuits and found that while the “Fifth and Ninth Circuits have held a bankruptcy court does not have authority to issue and enforce third-party non-debtor releases in a Chapter 11 plan,” these circuits are in the minority.[3] Rather, the Midway court sided with the majority, represented by the First, Second, Third, Fourth, Sixth, Seventh, Eighth and Eleventh Circuits, permitting third-party releases under certain narrow circumstances.

Section 524(e) of the Bankruptcy Code provides in pertinent part that “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” The majority of the circuits view this language as a “savings clause” that preserves post-confirmation rights (e.g., the right to pursue a nondebtor for a debt) rather than “an absolute bar to third-party releases.”[1]

Further, the court observed that, read together, §§ 105(a),[2] 1123(b)(3)(A)[3] and 1123(b)(6)[4] indicate that “enjoining a creditor’s claims against a nondebtor may be necessary, and within the bankruptcy court’s authority, to achieve a successful reorganization.”[5]

Before forging its own path, the court examined the standards used by the other circuits in determining whether nondebtor releases are acceptable, some of which overlap. The First and Eighth Circuits look generally to the following nonexclusive list of factors outlined in the case In re Master Mortg. Fund (the “Master Mortgage Factors”), including whether:

(1) there is an identity of interest between the debtor and the third party, usually an indemnity relationship, such that a suit against the nondebtor is, in essence, a suit against the debtor or will deplete assets of the estate;

(2) the nondebtor has contributed substantial assets to the reorganization;

(3) the injunction is essential to reorganization (i.e., without it, there is little likelihood of success);

(4) a substantial majority of the creditors agree to such injunction; specifically, the impacted class (or classes) has “overwhelmingly” voted to accept the proposed plan treatment; and

(5) the plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the injunction.[6]

The Midway court found that courts in the Third Circuit do not have a specific test, although a Delaware bankruptcy court has looked to the Master Mortgage Factors as a foundation along with “other relevant factors.”[7] Third-party nondebtor releases are allowed in the Second and Seventh Circuit only “when truly ‘unusual circumstances’ exist.”[8] The Sixth Circuit also restricts allowing such releases to “unusual circumstances” and further looks to a set of seven factors, certain of which are identical or substantially similar to the Master Mortgage Factors referred to as the “Dow Corning Factors.” The Midway court found that the U.S. Courts of Appeals for the Fourth and Eleventh Circuits have also looked to the Dow Corning Factors.[1]

After analyzing Western Real Estate and the other circuits, the Midway court determined that “while § 524(e) does not expressly provide for the release of a third party’s claims against a nondebtor, § 524(e) does not expressly preclude such releases.” However, such releases are not given “carte blanche” and are acceptable only “in certain, and very limited, circumstances if the release is “appropriate” and not inconsistent with any other provision of the Bankruptcy Code, including § 524(e).”[2]

For its own approach, the Midway court found that “the Court must parse out exactly who is releasing whom from what.”[3] In other words, the court stressed the importance of distinguishing “between the Debtors’ release of nondebtors and third parties’ release of nondebtors” and to “find the release to be necessary for the reorganization and appropriately tailored to apply only to claims arising out of or in connection with the reorganization itself, and not to matters which would have no effect upon the estate.”[4] If not, there is potential for a jurisdictional issue that would preclude the authority of the bankruptcy court to enter a final order.

The court further warned against the releases providing “nondebtors with ‘blanket immunity’ for all times, transgressions and omissions and may not include immunity from gross negligence or willful misconduct.”[5] As the Midway court summarized it, “[i]t is not the intention of the Court to permit nondebtors to purchase immunity from unrelated torts, no matter how substantial their contribution to a debtor’s reorganization.”[6]

In summary, most jurisdictions will allow third party releases of nondebtors — but only in certain narrow circumstances. Courts will determine the issue based on the facts and dynamics of each case and will require that such releases be fully justified. Plan proponents must walk the tightrope of providing for the releases necessary to have a plan accepted while avoiding overbroad language and staying within the lines of bankruptcy jurisdiction.

 

The Supreme Court Sets the Limits of Fee-Shifting for Bad Faith Conduct in Goodyear Tire & Rubber Co. v. Haeger

by Nicole Leonard and Jeffrey Bernstein

This article is  reprinted with the permission of the American Bankruptcy Institute. It originally appeared in Volume 15, Number 2 of the ABI Business Reorganization Committee’s Ethics & Professional Compensation Newsletter, June 2017.

[1]In a recent unanimous decision delivered by Justice Kagan,[2] the Supreme Court has made clear that federal courts, when awarding sanctions for bad faith conduct through the use of their inherent powers (not derived from rule or statute), must limit such sanctions to only compensatory damages that have a causal connection to the misconduct.

The underlying lawsuit involved a products liability action against Goodyear Tire & Rubber Co. (“Goodyear”) in which customers alleged a Goodyear G159 tire failed and caused their motor home to swerve off the road and flip over. The plaintiffs (the “Haegers”) theorized that the tire design could not withstand the level of heat generated by driving at highway speeds.

The Haegers repeatedly requested that Goodyear provide them with Goodyear’s internal test results regarding the tire. Goodyear’s responses to these requests were slow and less than forthcoming. Additional discovery battles ensued but the case eventually settled just before trial.

Months later, the plaintiff’s counsel became aware of a pertinent piece of information from an article in a newspaper on another lawsuit involving the exact same Goodyear tire. Apparently, Goodyear had supplied additional internal test results in the other matter that were not supplied to the Haegers despite the Haegers’ repeated requests. The test results, unsurprisingly, revealed that the tire became unusually hot at highway speeds. Goodyear later conceded that it withheld this information. The Haegers in turn requested sanctions against Goodyear which included attorneys’ fees and costs for Goodyear’s discovery fraud.

The District Court for the District of Arizona (the “District Court”) found that the conduct of Goodyear spanned years and was egregious. Based on the severity of the misconduct, the District Court determined that it was not confined to award only the legal fees incurred as a result of the conduct but, rather, could award all the legal fees incurred by the Haegers from the moment the misconduct occurred. The District Court recognized that typically it would have to establish a causal connection between the misconduct and the fee award but determined this case was not typical based on the pattern of abuse. However, as an apparent hedge, the District Court also entered a contingent award in a lower amount in the event the inclusion of legal fees lacking a causal connection in the award was rejected on appeal.

The Ninth Circuit Court of Appeals, in a departure from rulings in other Circuits, affirmed the District Court, though not without dissent.[3] The majority found that it was appropriate to award legal fees incurred by the Haegers during the period of time that Goodyear was misbehaving — as opposed to the legal fees incurred as a result of the misconduct. The Supreme Court disagreed.

First, the Supreme Court (the “Court”) recognized that apart from the authority derived from rule or statute, federal courts have inherent power to “manage their own affairs so as to achieve the orderly and expeditious disposition of cases” and “fashion an appropriate sanction for conduct which abuses the judicial process.”[4] However, if the sanction is awarded under civil, as opposed to criminal, procedures, the sanction is limited to compensating the aggrieved party for the loss and cannot contain a component based on punishment for the bad acts. Thus an award compensating an aggrieved party for legal bills caused by the misconduct would be appropriate, but including legal bills that would have been incurred regardless of the misconduct would not be appropriate. In other words, a “but for” test is used to determine the appropriate sanction.

Thus, it is clear that sanctions awarded through a federal court’s inherent power based on civil procedures may only compensate an aggrieved party and may not contain a punitive component. But how does the trial court determine what compensatory sanction is appropriate? The direction here is less precise. The Court acknowledged that ‘“[t]he essential goal” in shifting fees is “to do rough justice, not to achieve auditing perfection” and “[a]ccordingly, a district court “may take into account [its] overall sense of a suit, and may use estimates in calculating and allocating an attorney’s time.”’[5] Further, in certain circumstances, requiring a causal connection does not preclude an award of all of an aggrieved party’s fees if such fees would not have been incurred but for the misconduct. But, in the absence of that unusual circumstance, the trial court is tasked with scrutinizing fees and segregating “individual expense items.” However, substantial deference is afforded to the trial court to determine what fees were caused by the misconduct given the trial court’s “superior understanding of the litigation.”[6]

The Court found that the District Court’s award of all the fees incurred by the Haegers from the moment of the misconduct by Goodyear was not appropriate because the Haegers could not show that the litigation would have settled but for the bad faith withholding of discovery. In other words, if Goodyear had supplied all the requested internal test results, the case may not have settled as Goodyear had other defenses (which the Court noted Goodyear used in other litigation which proceeded to trial) that might have precluded settlement at that time. Thus, it is possible the fees would have been incurred even in the absence of the bad faith withholding of discovery by Goodyear.

The Haegers argued that Goodyear waived the ability to challenge the District Court’s contingent award which purportedly excluded the punitive component because the amount of such award was based on Goodyear’s own submission. The Court acknowledged that the District Court should address the waiver issue on an initial basis as it would end the matter if it found in favor of the Haegers. Otherwise, the analysis of the appropriate amount of the sanction would have to start anew under the correct standard.

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.

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.