Bankruptcy and Restructuring Blog

New Change To Required Language For Foreclosure Notices Under California Civil Code § 2924c

Effective as of January 1, 2011, the language prescribed for all notices of default recorded pursuant to Section 2924 et seq. of the California Civil Code has changed. Despite the fact that this change became effective as of the beginning of this year, some foreclosure trustees are still using old forms that do not comply with current California law. Accordingly, lenders should be diligent in reviewing their foreclosure notices to ensure compliance with current requirements.

]]> Under Section 2924c(b)(1) of the California Civil Code, the text of such notices of default must begin with the following statement:

"IMPORTANT NOTICE [14-point boldface type if printed or in capital letters if typed]

IF YOUR PROPERTY IS IN FORECLOSURE BECAUSE YOU ARE BEHIND IN YOUR PAYMENTS, IT MAY BE SOLD WITHOUT ANY COURT ACTION, [14-point boldface type if printed or in capital letters if typed] and you may have the legal right to bring your account in good standing by paying all of your past due payments plus permitted costs and expenses within the time permitted by law for reinstatement of your account, which is normally five business days prior to the date set for the sale of your property. No sale date may be set until approximately 90 days from the date this notice of default may be recorded (which date of recordation appears on this notice).

This amount is __________ as of __________ (Date) and will increase until your account becomes current.

While your property is in foreclosure, you still must pay other obligations (such as insurance and taxes) required by your note and deed of trust or mortgage. If you fail to make future payments on the loan, pay taxes on the property, provide insurance on the property, or pay other obligations as required in the note and deed of trust or mortgage, the beneficiary or mortgagee may insist that you do so in order to reinstate your account in good standing. In addition, the beneficiary or mortgagee may require as a condition to reinstatement that you provide reliable written evidence that you paid all senior liens, property taxes, and hazard insurance premiums.

Upon your written request, the beneficiary or mortgagee will give you a written itemization of the entire amount you must pay. You may not have to pay the entire unpaid portion of your account, even though full payment was demanded, but you must pay all amounts in default at the time payment is made. However, you and your beneficiary or mortgagee may mutually agree in writing prior to the time the notice of sale is posted (which may not be earlier than three months after this notice of default is recorded) to, among other things, (1) provide additional time in which to cure the default by transfer of the property or otherwise; or (2) establish a schedule of payments in order to cure your default; or both (1) and (2).

Following the expiration of the time period referred to in the first paragraph of this notice, unless the obligation being foreclosed upon or a separate written agreement between you and your creditor permits a longer period, you have only the legal right to stop the sale of your property by paying the entire amount demanded by your creditor.

To find out the amount you must pay, or to arrange for payment to stop the foreclosure, or if your property is in foreclosure for any other reason, contact:

_______________________________
(Name of beneficiary or mortgagee)

_______________________________
(Mailing address)

_______________________________
(Telephone)

If you have any questions, you should contact a lawyer or the governmental agency which may have insured your loan.

Notwithstanding the fact that your property is in foreclosure, you may offer your property for sale, provided the sale is concluded prior to the conclusion of the foreclosure.

Remember, YOU MAY LOSE LEGAL RIGHTS IF YOU DO NOT TAKE PROMPT ACTION. [14-point boldface type if printed or in capital letters if typed]"

The new changes are noted in bold in the above excerpt of the statute. The phrase "approximately 90 days" replaced the phrase "three months" in the first paragraph of the prior version of the statute. The phrase "three months after this notice of default is recorded" replaced the phrase "the end of the three-month period stated above" in the fourth paragraph of the prior version of the statute. Section 2924c(b)(1) also contains other requirements for such notices, including that such notices must appear in at least 12-point boldface type unless otherwise specified in the statute.

California has many other requirements for foreclosure of a deed of trust or mortgage on real property in California. Parties to a foreclosure should seek the counsel of an experienced foreclosure attorney to ensure compliance with all applicable requirements.

Authored By:

Jenny Park Garner

(415) 774-2949
jpark@sheppardmullin.com

A Chapter 11 Diaspora? House Judiciary Committee Considers Chapter 11 Venue Reform

The House Judiciary Committee recently held a hearing to consider an amendment to the venue provisions of the Bankruptcy Code proposed by the Committee’s Chairman that would require corporations to file voluntary chapter 11 petitions in the district where they maintain their principal place of business or have their principal assets. Under the current bankruptcy venue provisions of the U.S. Code, a debtor corporation can file its bankruptcy case in the state where it is incorporated, where it has its principal assets, or where it is headquartered. A corporation can also file a chapter 11 case in a venue where its corporate affiliate’s case is already pending. Utilizing these rules, many large chapter 11 cases are commenced in Delaware and New York, despite the fact that the corporate debtor has little ties to those states. For example, Enron – a Texas-based company – filed a bankruptcy for a small New York subsidiary in the Southern District of New York. Shortly thereafter, Enron commenced the bankruptcy case for the main company, and used the venue provisions to bootstrap this case with its New York case, which allowed it to heard along with the subsidiary's case in New York. A more recent example is the Fremont, CA-based Solyndra LLC, which filed a voluntary chapter 11 petition in Delaware, the state of its incorporation.

]]> H.R. 2533, the "Chapter 11 Bankruptcy Venue Reform Act of 2011," is designed to change the venue rules to prevent the type of forum-shopping that occurred in the Enron case. The bill would amend 28 U.S.C. § 1408 by including the following provisions:

(b) A case under chapter 11 of title 11 in which the person that is the subject of the case is a corporation may be commenced only in the district court for the district--

(1) in which the principal place of business in the United States, or principal assets in the United States, of such corporation have been located for 1 year immediately preceding such commencement, or for a longer portion of such 1-year period than the principal place of business in the United States, or principal assets in the United States, of such corporation were located in any other district; or

(2) in which there is pending a case under chapter 11 of title 11 concerning an affiliate of such corporation, if the affiliate in such pending case directly or indirectly owns, controls, or holds with power to vote more than 50 percent of the outstanding voting securities of such corporation.[1]

The amendment effectively prohibits forum-shopping by requiring a debtor to file the bankruptcy case in the district where its principal place of business or principal assets are located. Proponents of the bill argue that chapter 11 debtors should not be able to leave their home districts and shop for a forum whose judicial precedent on bankruptcy law may be the most favorable to them. They further contend that when a large case is filed far away from the debtor's principle place of business, employees, creditors, and the community in which the business operates feel out of touch with the reorganization process, and interested parties frequently have to travel long distances to present evidence to support their claims.

Conversely, opponents of the bill argue that the Delaware and New York bankruptcy courts are remarkably effective at handling complex chapter 11 filings. They also point out that approximately 90% of Chapter 11 cases are filed where the company has its principal place of business, so the vast majority are filed in the most convenient district.

This bill is currently in the House Committee on the Judiciary, which will continue to deliberate, investigate, and revise the bill prior to any general debate or vote by the House. Stay tuned to http://www.bankruptcylawblog.com/ for further updates on this pending legislation.

Authored by:

Stephanie M. Seidl
(213) 617-4177
sseidl@sheppardmullin.com

[1] The complete text of the bill is available at http://www.govtrack.us/congress/billtext.xpd?bill=h112-2533.

Fifth Circuit Rejects Per Se Rule That Recharacterization Applies Only To Insiders

In a recent ruling, the Fifth Circuit Court of Appeals rejected a per se rule that only corporate insiders can have their debt claims recharacterized as equity. Instead, in In re Lothian Oil Inc., 2011 WL 3473354 (5th Cir. Aug. 9, 2011), the Court of Appeals held that "recharacterization extends beyond insiders and is part of the bankruptcy courts' authority to allow and disallow claims under 11 U.S.C. § 502." Thus, all creditors, regardless of their insider status, are susceptible to having their claims recharacterized as equity.

]]> The Facts of the Case

While the case involved extensive litigation between the parties, the issue decided by the Court of Appeals – whether a bankruptcy court can recharacterize a claim as equity rather than debt – focused on two agreements between the debtor Lothian Oil Inc. ("Lothian") and a non-insider third-party, Israel Grossman ("Grossman"). Specifically, on each of April 27 and May 12, 2005, Grossman and Lothian signed documents pursuant to which Grossman "loaned" Lothian $200,000 and $150,000, respectively. Both agreements provided that Grossman would receive a royalty of one percent of Lothian's share of gross production of oil and gas on certain properties and that each of the loan amounts would be repaid from the proceeds of an equity placement made in Lothian.

Lothian filed for chapter 11 protection on June 13, 2007, and Grossman filed various claims in the case, including claims based on the two "loans". The Bankruptcy Court for the Western District of Texas rejected the claims, finding that they "assert[ed] common equity interests at best and that insufficient evidence of the value of the interests was presented." The District Court, however, reversed the recharacterization of the two claims as equity, "declin[ing] to extend the concept of debt recharacterization to a non-insider creditor."

Recharacterization of Debt Under Section 502 of the Bankruptcy Code

The Court of Appeals found that bankruptcy courts have the authority to recharacterize debt claims as equity as part of their authority to disallow claims under section 502 of the Bankruptcy Code. Specifically, section 502 provides that "the court, after notice and a hearing, shall determine the amount of such claim ... and shall allow such claim in such amount, except to the extent that—(1) such claim is unenforceable against the debtor and property of the debtor, under any agreement or applicable law . . ." 11 U.S.C. § 502(b). Applicable law is typically state law. See Butner v. United States, 440 U.S. 48, 54 (1979). Thus, the Court of Appeals found that "[i]f a claim asserts a debt that is contrary to state law, the bankruptcy court may not allow the claim. . . [W]here the reason for such disallowance is that state law classifies the interest as equity rather than debt, then implementing state law as envisioned in Butner requires different treatment than simply disallowing the claim. . . [R]echaracterizing the claim as an equity interest is the logical outcome of the reason for disallowing it as debt." 2011 WL 3473354 at *3.

Rejection of a Per Se Rule for Corporate Insiders

In affirming the Bankruptcy Court's decision to recharacterize Grossman's claims, the Court of Appeals explicitly rejected the District Court's finding that only the claims of insiders can be recharacterized as equity. Based on its analysis of section 502 of the Bankruptcy Code, the Court found that unless state law makes insider status relevant to characterizing a claim as equity or debt, that status is irrelevant in bankruptcy proceedings. The Court stated that "because insiders and non-insiders alike can mischaracterize their claims in contravention of state law, we decline to limit recharacterization to insider claims." Id. Thus, all creditors, regardless of their relationship to a debtor, can have their claims recharacterized as equity.

Factors Relevant to Characterization of Claim as Debt

To distinguish between debt and equity, bankruptcy courts have imported various multi-factor tests from federal tax law. In the Fifth Circuit, those factors include (1) name of the instrument memorializing the transaction; (2) definitiveness of maturity date; (3) source of payments; (4) right to enforce payment; (5) participation in management; (6) relationship of would-be "creditors" to general creditors; (7) intent of the parties; (8) adequacy of capitalization; (9) identity of ownership; (10) source of interest payments; and (11) ability of corporation to obtain loans elsewhere. See Jones v. United States, 659 F.2d 618, 622 n. 12 (5th Cir. 1981).

In finding that Grossman's claims were equity and not debt, the Bankruptcy Court focused on the fact that Grossman would be paid from royalties and "equity placements", which depended on the success of Lothian's business, instead of a prescribed interest rate, as well as the lack of a term for repayment and a maturity date. In affirming the Bankruptcy Court's ruling, the Court of Appeals found that because Texas law would not have recognized Grossman's claims as asserting a debt interest, the bankruptcy court correctly disallowed them as debt and recharacterized the claims as equity interests.

A Warning For Creditors: Non-Insider Status Does Not Offer Protection

The Fifth Circuit's holding is a warning for creditors that non-insider status is not enough to protect their claims from recharacterization as equity. All creditors, regardless of their relationship with a debtor, must ensure that their debts are properly documented as debts.

Authored By:

Blanka Wolfe
(212) 332-3822
bwolfe@sheppardmullin.com

A Shock to the Core: The Supreme Court Pries Jurisdiction Away from the Bankruptcy Courts on Counterclaims to Proofs of Claim, and Possibly More

On Thursday, the Supreme Court in a 5-4 decision ruled in Stern v. Marshall[1] that the congressional grant of jurisdiction to bankruptcy courts to issue final judgments on counterclaims to proofs of claim was unconstitutional. For the litigants, this decision brought an end to an expensive and drawn out litigation between the estates of former Playboy model Anna Nicole Smith and the son of her late husband, Pierce Marshall, which Justice Roberts writing for the majority analogized to the fictional litigation in Charles Dickens’ Bleak House. For bankruptcy practitioners, it is yet another chapter in an even more epic saga – that of the back-and-forth between Congress and the Supreme Court over the jurisdictional limits of the nation’s bankruptcy courts. Instead of offering finality, the decision only raises more questions about how far the Court’s reasoning will extend, and what the implications will be for practice under the Bankruptcy Code.

]]> Background: Broad Bankruptcy Court Jurisdiction in 1978 Reform Act Ruled Unconstitutional by Supreme Court in 1982; Congress Adopts “Emergency Rule” in Response in 1984

Few who practiced then can forget the effect of the Supreme Court’s 1982 decision in Northern Pipeline[2] on the statutory regime enacted by Congress in the still-nascent Bankruptcy Code, which had gone into effect in October of 1978. The Code was a sweeping reform of the nation’s bankruptcy laws which involved elevating the previous “referees” in bankruptcy to the title of judges, and granting them the power to exercise the United States District Court’s jurisdiction over “all civil proceedings arising under title 11 [i.e., the Bankruptcy Code] or arising in or related to cases under title 11.”[3] A plurality of the Supreme Court in Northern Pipeline declared this grant of jurisdiction to bankruptcy courts under the new Bankruptcy Code unconstitutional, leaving courts and practitioners to wonder whether the Code would be thrown out the window.

The Northern Pipeline Court reasoned that granting such broad jurisdiction to bankruptcy courts was unconstitutional because bankruptcy courts were not “Article III courts” – that is, courts whose authority derives from Article III of the Constitution. Article III courts come with two principal safeguards prescribed in Article III, Section 1 of the Constitution: lifetime appointment and the inability of Congress to reduce the judges’ salaries. These safeguards are intended to ensure the courts’ independence from the other branches of government, and are thus an implementation of the separation of powers principles underlying the Constitution in general. United States District Courts are Article III courts. Bankruptcy courts, on the other hand, are Article I courts. The Northern Pipeline Court held that assigning bankruptcy courts the jurisdiction of the district courts violated Article III of the Constitution because it removed “essential attributes of the judicial power” from the Article III courts.[4]

In response, Congress enacted a new statutory scheme, embodied in 28 U.S.C. §§ 157 and 1334, which was based on the so-called “Emergency Rule” developed by the district courts after Northern Pipeline. Under this scheme, United States District Courts have original jurisdiction over matters arising under, arising in or related to cases under the Bankruptcy Code, but district courts can refer these matters to the bankruptcy courts (a referral that is now automatic in all districts). Bankruptcy courts are given the power to issue final judgments in all “core proceedings” arising under the Bankruptcy Code, or arising in a case under the Bankruptcy Code. As to other, “non-core” matters related to a case under the Bankruptcy Code, bankruptcy courts can only issue proposed findings of fact and conclusions of law for de novo review by the district court, unless the parties otherwise consent. This statutory scheme went into effect in 1984.

History of Stern v. Marshall

Stern v. Marshall presented the Supreme Court with the opportunity to review the statutory scheme adopted by Congress in 1984. The model and actress Anna Nicole Smith had filed for bankruptcy in Los Angeles after the death of her billionaire husband, J. Howard Marshall, in 1995. Bitter litigation that had begun even before her husband’s death continued in the bankruptcy court between Smith and her late husband’s son, Pierce Marshall, over their competing claims to the Marshall estate.

In Smith’s bankruptcy case, Pierce filed both a proof of claim for defamation and an adversary complaint seeking a determination that his defamation claim was nondischargeable. Smith filed a compulsory counterclaim for tortious interference by Pierce with the gift she expected from her late husband. The bankruptcy court held a trial and granted judgment to Smith in the amount of $447 million.

Appeals and parallel litigation ensued, all of which cannot be described here, or in a manuscript of less than ten volumes. In short, after the entry of the bankruptcy court's extraordinary judgment Pierce prevailed in a separate trial on the merits in Texas state court. Thereafter, Smith prevailed in a de novo review of the bankruptcy court’s judgment in federal district court in Los Angeles, though her $447 million judgment was reduced to $44 million. In this second round before the Supreme Court, the issue was very simple - did the bankruptcy court have jurisdiction to enter a final judgment on Pierce's counterclaim? If so, that judgment would be the first final judgment in the matter and would thereby have a preclusive effect under principles of res judicata on the later Texas judgment in Pierce's favor. If not, the Texas judgment would be the first final judgment and preclude the later district court judgment in Smith's favor. In an earlier appeal, the Supreme Court had determined that the probate exception to federal jurisdiction did not apply in the case to render void the bankruptcy court judgment, sending the matter back to the Ninth Circuit to determine whether the bankruptcy court judgment had a preclusive effect on the Texas court contrary judgment based on other principles.

Supreme Court’s Holding

The Supreme Court held that while Smith’s compulsory counterclaim to Pierce's proof of claim was clearly a “core proceeding” under the language of 28 U.S.C. § 157(b)(2)(C), the statute itself was unconstitutional. The Court held that Congress cannot grant to the bankruptcy courts (as Article I courts) the power to issue final judgments on common law causes of action like Smith’s counterclaim that are not resolved in the process of ruling on the proof of claim. The Court reasoned that any suit that is “the stuff of the traditional actions at common law tried by the courts at Westminster in 1789, and is brought within the bounds of federal jurisdiction,” is within the exclusive jurisdiction of Article III courts. Permitting Congress to take such actions out of Article III courts’ jurisdiction would frustrate the separation of powers principles of Article III and render that Article ineffective.[5]

The Court rejected the argument put forward by Smith that the so-called “public rights” exception applied and permitted Congress to grant bankruptcy courts the authority to issue final decisions on counterclaims like Smith’s. The Court found that Smith’s counterclaim did not fall under any of the formulations of the public rights exception for several reasons, including: (i) Smith’s counterclaim did not flow from a federal statutory scheme, (ii) Smith’s counterclaim was not completely dependent upon adjudication of a claim created by federal law, (iii) Pierce did not truly consent to bankruptcy court jurisdiction, since he had nowhere else to go but bankruptcy court if he wished to recover from Smith’s bankruptcy estate; and (iv) the case did not involve a situation where a specialized subset of matters was assigned to a special administrative agency, but rather a situation where a common law action was sought to be determined by a court with broad substantive jurisdiction.[6]

Potential Implications of Stern v. Marshall

The Supreme Court’s holding was limited to one subsection of 28 U.S.C. § 157(b) – in particular subsection (b)(2)(C) which provides that counterclaims to proofs of claim are core proceedings. Indeed, the Court asserted that its holding does not “meaningfully change[] the division of labor in the current statute,”[7] though in the same breath it also stated that a statute’s efficiency or convenience will not save it if it is contrary to the Constitution.[8]

However, the Court’s reasoning is broad, and can potentially be applied to other subsections, such as section 157(b)(2)(H) pertaining to fraudulent conveyance actions, which the Supreme Court has previously held to be “quintessentially suits at common law,”[9] and/or section 157(b)(2)(K), pertaining to determinations of the validity, extent and priority of liens, which are generally determined by state law.

Also, even if limited to section 157(b)(2)(C), counterclaims by the estate are a common occurrence in bankruptcy. As the dissent noted, the Court’s ruling may lead to gamesmanship between creditors and debtors in litigation over proofs of claim, with the proof of claim being decided in the bankruptcy court and a parallel proceeding occurring in the district court. All of this would lead to increased costs and delay – neither of which a typical debtor or creditor can afford. Writing for the dissent, Justice Breyer referred to this as “a constitutionally required game of jurisdictional ping-pong” which will lead to “inefficiency, increased cost, delay and needless additional suffering among those faced with bankruptcy.”[10]

A Potential Fix: Bankruptcy Courts as Article III Courts

Historically, Congress has rewritten or substantially revised the nation’s bankruptcy laws approximately once every 40 years – witness the Bankruptcy Act of 1898, followed by the Bankruptcy Act of 1938, followed yet again by the Bankruptcy Reform Act of 1978. The Bankruptcy Code itself has been amended in significant respects on multiple occasions, including in 1984, 1994 and 2005. The potentially inefficient jurisdictional system following the Supreme Court’s ruling in Stern v. Marshall may be cause to take up the drafting pen yet again. This time, Congress may consider taking a step it deliberately refrained from taking in 1978 and 1984 – that is, providing for bankruptcy courts to be Article III courts by making bankruptcy judges appointed for life and immune to salary reductions by Congress. This would avoid the core/non-core mire altogether in favor of a system of clarity and efficiency that should benefit most debtors and creditors, and well as the bankruptcy courts and district courts.

Authored by:

Geraldine A. Freeman
(415) 774-2966
gfreeman@sheppardmullin.com

Michael M. Lauter
(415) 774-2978
mlauter@sheppardmullin.com

[1] See, Stern v. Marshall, __ U.S. __, No. 10-179 (June 23, 2011).

[2] See, Northern Pipeline Construction Co. v. Marathon PipeLine Co., 458 U.S. 50 (1982).

[3] See, 11 U.S.C. § 1471(c), repealed by Pub. L. No. 98-353 § 122 (1984).

[4] Northern Pipeline, 458 U.S. at 81. TEXT

[5] Stern v. Marshall, supra, slip op. at 18.

[6] Id., slip op. at 22-29.

[7] Id., slip op. at 37.

[8] Id., slip op. at 36.

[9] See, Granfinanciera, S.A. v. Nordberg, 492 U.S. 33, 56 (1989).

[10] Stern v. Marshall, slip op. at 17 (Breyer, J., dissenting)

Reinstatement of Debt: A Bankruptcy Court's Strict Interpretation and Application of Change-in-Control Provisions to Protect Senior Secured Lenders

In In re Young Broadcasting, Inc., et al., 430 B.R. 99 (Bankr. S.D.N.Y. 2010), a bankruptcy court strictly construed the change-in-control provisions of a pre-petition credit agreement and refused to confirm an unsecured creditors' committee's plan of reorganization, which had been premised on the reinstatement of the debtors' accelerated secured debt under Section 1124(2) of the Bankruptcy Code.

]]> "Reinstatement" refers to a chapter 11 plan proponent's ability to reinstate the pre-default terms of an accelerated debt by curing all defaults. This cure is typically accomplished by paying off all late payments and other arrearages and bringing the loan current. The bankruptcy court in Young Broadcasting rejected the committee's attempt to reinstate the debtors' senior secured debt because the committee's plan resulted in a default under the change-in-control provisions of the pre-petition credit agreement. In so holding, the bankruptcy court rejected the committee's arguments that certain provisions of the plan which "formalistically" complied with the change-in-control provisions were sufficient to avoid a default, finding the plan provisions to violate the plain terms and clearly expressed purpose of the change-in-control provisions.

Factual Background

Young Broadcasting, Inc. ("YBI") and certain affiliates (collectively, the "Debtors") owned and operated various television stations across the country and a national television sales representation firm. Prior to the bankruptcy filing, YBI had obtained senior secured financing of $350 million (the "Senior Secured Debt"). In addition, YBI had issued senior subordinated notes in the amount of $640 million.

After filing for chapter 11, competing plans of reorganization were filed in the Debtors' jointly-administered cases by the Debtors and the Official Committee of Unsecured Creditors (the "Committee"). Under the Debtors' proposed plan, holders of the Senior Secured Debt would receive equity in a new company formed to hold all of the common stock of the reorganized Debtors and the senior subordinated noteholders would receive equity warrants in the new company. As a result, the Debtors would be completely deleveraged.

By contrast, the Committee's proposed plan would reinstate $338 million of the Senior Secured Debt. The Committee's plan would also provide the senior subordinated noteholders with a pro rata share of 10% of the reorganized Debtors' common stock and options to purchase preferred stock and additional common stock. In connection with the proposed reinstatement, and in an attempt to remain in compliance with the change-in-control provisions of the credit agreement (described below), the Committee's plan provided that Vincent Young, one of the Debtors' founders ("Mr. Young"), would receive all of the Class B shares of common stock of the reorganized Debtors and certain accompanying voting rights described further below. Upon full repayment of the Senior Secured Debt in November 2012 (the original maturity date), such stock would convert to 10% of the Class A common stock.

Holders of the Senior Secured Debt objected to confirmation of the Committee's plan on the grounds that the proposed reinstatement was impermissible as it would violate certain change-in-control provisions in the credit agreement and that the plan was not feasible and violated the absolute priority rule.

Analysis

Section 1124 of the Bankruptcy Code defines when a creditor's claim is deemed "impaired", thereby entitling the creditor to vote on a plan of reorganization. A creditor whose claim is "unimpaired" is not entitled to vote. Pursuant to Section 1124(2), a plan of reorganization may render a claim unimpaired by providing for the reinstatement of the original terms of the prepetition obligation as it existed before default. This Section requires (i) that the plan provides for the cure of any payment or performance defaults (other than an ipso facto default), (ii) that the plan provides for compensation for any damages caused by the creditor's reasonable reliance on the right of acceleration, (iii) that the plan provides for compensation for any actual pecuniary losses incurred as a result of a failure to perform a nonmonetary obligation, (iv) that the plan provides for the affirmation of the original terms, including maturity, and (v) that the plan not otherwise alter the legal, equitable or contractual rights of the creditor. Because an obligation that is so reinstated is deemed to be unimpaired, the reinstated creditor is deemed to have accepted the plan of reorganization and will have no right to vote. In effect, by meeting the requirements set forth under Section 1124(2), the plan proponent will have the ability to reverse a lender's exercise of its contractual or legal right of acceleration and reinstate the original terms of the obligation. This can be a powerful tool for debtors and creditors when formulating plans under chapter 11 of the Bankruptcy Code. It is typically used with respect to obligations that had been accelerated pre-petition. Fully matured obligations must be paid in full in order to be reinstated.

In Young Broadcasting, the holders of the Senior Secured Debt argued that reinstatement was improper because the terms of the plan violated the change-in-control provisions in the credit agreement, resulting in uncured defaults. Both sides cited to In re Charter Communications, 419 B.R. 221 (Bankr. S.D.N.Y. 2009), where the bankruptcy court found no default under a change-in-control provision when a plan of reorganization provided the relevant principal with the necessary voting rights and voting power, but divorced those rights from the underlying economic interest in the company (i.e., the principal's voting power was out of proportion to his underlying equity interest in the reorganized debtor).

The pertinent provisions of the Senior Secured Debt holder's credit agreement provided that a change-in-control default would occur if Mr. Young, his immediate family members, certain persons controlled by Mr. Young and members of management ceased to hold over 40% of the Voting Stock (which stock granted the holder general voting power to elect the board of directors). The credit agreement also required that if any person or group were to own more than 30% of the total outstanding Voting Stock, then the Young group must own more than 30% or, alternatively, have the right or ability to elect a majority of the Debtors' board of directors.

The Committee's plan provided for two classes of directors and two classes of stock with different voting rights. There would be six Class A directors and one Class B director. The stock was likewise split between Classes A and B, with Mr. Young receiving all of the Class B shares of common stock of the reorganized Debtor. Each Class A share of common stock (5,000,000 of which were to be issued) would have 20 votes for Class A directors and 1 vote for the Class B director. Each Class B share of common stock (500,000 of which were to be issued) would have 1 vote for Class A directors and 1,000 votes for the Class B director. Under this structure, the Committee argued that the terms of its plan complied with the change-in-control provisions of the credit agreement because Mr. Young, who would be given all of the Class B stock, would have over 82% of the vote – far in excess of the 40% requirement. The Committee arrived at this figure by comparing the total number of votes Mr. Young would be entitled to vote (i.e. 500,500,000) to the total number of votes all Class A shareholders would be entitled to vote (i.e. 105,000,000). Thus, the Committee relied on the idea that Mr. Young's retention of 82% of the absolute number of votes would suffice to avoid a default under the change-in-control provisions, even though, as a result of the two tiers of directors and stock, Mr. Young retained much less than the required 40% of the actual voting power.

Disagreeing with the Committee's contentions, the bankruptcy court, applying New York law to interpret the credit agreement, found that the plain meaning of the change-in-control provisions required that the Young group retain the power to elect over 40% of the entire board of directors and not just over 40% of the votes. Under the Committee's proposed terms, Mr. Young would have the ability to control less than 15% of the entire board. The bankruptcy court found that the clear intent of the change-in-control provisions was to preclude third parties from obtaining more control than the Young group and management. Accordingly, the bankruptcy court held that reinstatement of the Senior Secured Debt pursuant to the Committee's plan was impermissible since the plan resulted in defaults under the change-in-control provisions of the pre-petition credit agreement that were not cured.

The bankruptcy court also denied confirmation of the Committee's Plan for failure to meet the requirement under Bankruptcy Code Section 1129(a)(11) that the plan be feasible. Applying the "reasonable likelihood of success" standard for feasibility and looking at expert valuations and projections, the bankruptcy court found that the Committee's plan was not feasible because the Committee failed to establish that the reorganized Debtors could satisfy the Senior Secured Debt upon maturity in November 2012 through either a sale or a refinancing.

Lastly, the bankruptcy court found that the Committee's Plan violated the absolute priority rule because the Committee failed to produce sufficient evidence showing that the distribution of equity to Mr. Young, while general unsecured creditors were not paid in full, was outweighed by the value of the benefits conferred by reinstatement of the Senior Secured Debt. Thus, ultimately, the Committee in Young Broadcasting was unable to establish that reinstatement was a beneficial bargain for the estate.

Lessons Learned

Young Broadcasting has lessons for both lenders and debtors. For lenders, it highlights the importance of clearly drafted change-in-control provisions which can be used as a weapon to guard against an unfavorable reinstatement in a chapter 11 bankruptcy case. For debtors and other plan proponents, Young Broadcasting establishes some clear limits on the gamesmanship that can be played with change-in-control provisions in a reinstatement under Bankruptcy Code Section 1124(2). Though the Charter Communications case indicates that it may be possible to separate the economic interest from the voting interest, Young Broadcasting shows that it may not be possible to separate the actual number of votes from the underlying voting power and avoid a change-in-control default. The equitable considerations at play in Young Broadcasting also highlight the importance of clearly establishing the economic benefits to be obtained by the estate from the reinstatement.

Authored By:

Gina Giang
(213) 617-5484
ggiang@sheppardmullin.com

In Re TOUSA: District Court Reverses Bankruptcy Court's Order Requiring Lenders To Disgorge $480 Million As Fraudulent Transfer

On February 11, 2011, the Hon. Alan Gold of the United States District Court for the Southern District of Florida issued a 113 page opinion and order quashing the bankruptcy court's order requiring the lenders involved in TOUSA, Inc.'s Transeastern joint venture to disgorge, as fraudulent transfers under Section 548 of the Bankruptcy Code, settlement monies that they had received on July 31, 2007 in repayment of their existing debt and to pay prejudgment interest on such monies, for a total disgorgement in excess of $480 million.

]]> Judge Gold's decision signifies a victory for lenders who have criticized the bankruptcy court's order as unduly broadening the scope of fraudulent transfer risk and liability to lenders and for failing to recognize the commercial realities of financing provided to a corporate group. However, whether Judge Gold's decision will withstand the scrutiny of appeal to the Eleventh Circuit remains to be seen.

TOUSA and the July 31 Transaction

In June 2005, TOUSA, Inc. ("TOUSA")'s wholly-owned subsidiary Tousa Homes LP ("Homes LP") entered into a joint venture (the "Transeastern JV") with an unaffiliated entity for the purpose of acquiring certain homebuilding assets. The Transeastern JV was funded primarily by $675 million of financing from various lenders (the "Transeastern Lenders"). TOUSA and Homes LP were obligated as guarantors under multiple completion and carve-out guarantees in favor of the Transeastern Lenders.

In or about September 2006, the TOUSA obligors went into default under the Transeastern credit agreements. In late 2006, litigation ensued between TOUSA and Homes LP and the Transeastern Lenders. The Transeastern Lenders alleged more than $600 million was advanced under the Transeastern credit agreements and that liability under the completion guarantees exceed the full amounts owing under the credit agreements several times over.

In June 2007, TOUSA and its Transeastern JV subsidiaries entered into a settlement with the Transeastern Lenders, pursuant to which the Transeastern Lenders would be paid approximately $420 million. To fund the settlement, TOUSA obtained and caused certain of its subsidiaries not involved in the Transeastern JV (the "Conveying Subsidiaries") to obtain new loans from lenders referred to as the "First and Second Lien Term Lenders." The new loan agreements named the Conveying Subsidiaries as "Subsidiary Borrowers," and they were required to pledge their assets as security for the new loans. The new loan documents directed that the loan proceeds be used to satisfy the Transeastern settlement.

On July 31, 2007, there occurred an exchange of property interests and funds broken down into three parts (the "July 31 Transaction"). First, TOUSA and the Conveying Subsidiaries pledged their assets as security to the First and Second Lien Term Lenders, which placed liens on those assets. Second, in exchange for those liens, the First and Second Lien Term Lenders disbursed $500 million in funds to TOUSA, the parent. The net funds were wired to Universal Land Title, Inc. ("ULT"), a wholly-owned subsidiary of TOUSA. Third, ULT then wired approximately $426 million to the agent for the Transeastern Lenders.

The Bankruptcy Litigation

Six months after the July 31 Transaction, TOUSA and most of its subsidiaries filed for bankruptcy. The Official Committee of Unsecured Creditors brought an adversary proceeding on behalf of the Conveying Subsidiaries seeking recovery of the settlement funds received by the Transeastern Lenders in the July 31 Transaction. The Committee argued that the July 31 Transaction rendered the Conveying Subsidiaries insolvent and that the Conveying Subsidiaries did not receive "reasonably equivalent value" for the new loans because TOUSA used the loan proceeds to finance the settlement of the Transeastern litigation, in which the Conveying Subsidiaries held no stake because they were not defendants.

On October 30, 2009, the bankruptcy court issued its order holding in the Committee's favor on all of its claims. It held that (1) the obligations incurred by the Conveying Subsidiaries to the First and Second Lien Term Lenders, and the liens transferred to secure those obligations, could be avoided pursuant to 11 U.S.C. §§ 544 and 548; (2) the Transeastern Lenders were entities "for whose benefit" the improper transfer was made; and (3) the transfer of more than $421 million to the Transeastern Lenders could also be avoided pursuant to Sections 544 and 548. The bankruptcy court further found that the First and Second Lien Term Lenders and the Transeastern Lenders did not act in good faith and were grossly negligent when they engaged in the July 31 Transaction on the basis that there was "overwhelming evidence that TOUSA was financially distressed."

The First and Second Lien Term Lenders and the Transeastern Lenders filed separate appeals of the bankruptcy court's order. The First and Second Lien Term Lenders' appeals were assigned to Judge Jordan, and the Transeastern Lenders' appeal was assigned to Judge Gold.

District Court's Reversal as to Transeastern Lenders

With respect to liability, the Transeastern Lenders raised the following issues on appeal to the district court: (1) whether the Transeastern Lenders can be compelled to disgorge to the Conveying Subsidiaries funds paid by TOUSA to satisfy a legitimate, uncontested debt, where the Conveying Subsidiaries did not control the transferred funds; and (2) whether the Transeastern Lenders are liable for disgorgement as the entities "for whose benefit" the Conveying Subsidiaries transferred the liens to the new lenders, where the Transeastern Lenders received no direct and immediate benefit from the lien transfer.

Judge Gold ruled in favor of the Transeastern Lenders in an opinion severely rebuking the bankruptcy court and reversing the bankruptcy court on both theories of liability at issue. Of note, he criticized the bankruptcy court for lumping all the appellees together for purposes of the fraudulent transfer analysis when "this case actually involved different transfers involving different parties with different legal implications."

(1) Direct Transferee Theory

As to the first theory of liability, Judge Gold held that the Transeastern Lenders could not be compelled to return the new loan proceeds to the Conveying Subsidiaries because the Conveying Subsidiaries did not have a legally cognizable property interest in such proceeds. Under the law of the Eleventh Circuit, a transfer is avoidable under Section 548 only if the debtor exercised actual control over the property transferred, including the power to designate the payee and the power to disburse the funds at issue to the payee. The rationale is that, without the requisite control, the subject property could not have been used by the debtor to pay another creditor, and the transfer thus did not decrease the value of the debtor's estate. Here, the Conveying Subsidiaries did not receive the loan proceeds and did not have the power to direct or disburse the loan proceeds. Since the Conveying Subsidiaries had no right to receive and use the loan proceeds under the loan documents in the first place, the Conveying Subsidiaries and their creditors have no right to seize the loan proceeds from the Transeastern Lenders. Such disgorgement would result in a windfall to the Conveying Subsidiaries and their creditors.

Judge Gold further held that even assuming the Conveying Subsidiaries had a "minimal" property interest in the new loan proceeds as found by the bankruptcy court, there is still no Section 548 liability because the bankruptcy court erred as a matter of law and fact in refusing to recognize as reasonably equivalent value the indirect benefits to the Conveying Subsidiaries from the July 31 Transaction. As stated by Judge Gold, "indirect, intangible, economic benefits, including the opportunity to avoid default, to facilitate the enterprise's rehabilitation, and to avoid bankruptcy, even if it provided to be short lived, may be considered in determining reasonable equivalent value. . . . The touchstone is whether the transaction conferred reasonable commercial value on the debtor." Due to the Transeastern settlement, the Conveying Subsidiaries were able to avoid imminent default on significant bond and revolving credit obligations owing by the TOUSA enterprise and to preserve their net worth. Whether a debtor received reasonably equivalent value must be evaluated as of the date of the transaction and not in hindsight.

(2) "For Whose Benefit" Theory

As to the second theory of liability, Judge Gold held that the Conveying Subsidiaries cannot recover from the Transeastern Lenders under Section 550 of the Bankruptcy Code as entities "for whose benefit" the Conveying Subsidiaries transferred the liens to the First and Second Lien Term Lenders. There are three types of entities from whom or from which a trustee may recover an avoidable transfer under Section 550(a): (1) an initial transferee, (2) an entity for whose benefit the initial transfer was made, or (3) a subsequent transferee. The liability of the initial transferee or the entity for whose benefit the initial transfer was made is absolute, whereas the liability of the subsequent transferee is not strict but subject to the "good faith purchaser for value" defense contained in Section 550(b).

The initial transfer for purposes of this inquiry was the transfer of liens from TOUSA and the Conveying Subsidiaries to the First and Second Lien Term Lenders, who remain the sole holders of such liens. Since the liens remained at all times with the First and Second Lien Term Lenders and were never transferred to the Transeastern Lenders, the Transeastern Lenders could not qualify as either the "initial transferees" or "subsequent transferees." Further, the Transeastern Lenders did not qualify as entities "for whose benefit" the initial transfer was made because the benefit must derive directly from the initial transfer, not from the use to which it is put by the transferee. The paradigm "entity for whose benefit such transfer was made" is a guarantor of the debtor. As explained by Judge Gold, "[s]omeone who receives the money later on is not an 'entity for whose benefit such transfer was made.'"

Judge Gold went further to reverse the bankruptcy court's finding the Transeastern Lenders to have acted in bad faith. As summarized by the district court, the bankruptcy court held that it is "bad faith" for a creditor of someone other than the debtor to accept payment of a valid, tendered debt outside of any preference period, through settlement or otherwise, if the creditor does not first investigate the debtor's internal re-financing structure and ensure that the debtor's subsidiaries had received fair value as part of the repayment, or that the debtor and its subsidiaries, in an enterprise, were not insolvent or precariously close to being insolvent. The bankruptcy court's standard was "patently unreasonable and unworkable."

Concluding Thoughts

Judge Gold's decision represents a victory for lenders who have criticized the bankruptcy court's order as unduly broadening the scope of fraudulent transfer risk and liability to lenders and for failing to recognize the commercial realities of financing provided to a corporate group. Given the high stakes, it came as no surprise when the Committee appealed the district court's order to the U.S. Court of Appeals for the Eleventh Circuit on March 8, 2011. Whether the district court's opinion will withstand the scrutiny of the Eleventh Circuit remains to be seen.

With respect to the separate appeals of the bankruptcy court's order by the First and Second Lien Term Lenders pending in the district court, on March 28, 2011, Judge Jordan issued an order staying these bankruptcy appeals pending the appeal of Judge Gold's opinion to the Eleventh Circuit. The order noted that Judge Gold's opinion, if upheld by the Eleventh Circuit, would be dispositive in these appeals.

Authored By:

Jenny Park Garner
(415) 774-2949
jpark@sheppardmullin.com

The opinions expressed herein are those of the author and do not necessarily reflect the views of the firm or its clients. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

Court to Lenders: Strict Compliance with Local Recording Requirements Necessary

A decision out of the District Court for the Middle District of North Carolina (the “District Court”), now being appealed to the Fourth Circuit Court of Appeals, highlights just how critical it is for lenders to strictly comply with local recording requirements when recording their liens. In SunTrust Bank N.A. v. Northen, 433 B.R. 532 (M.D.N.C. Aug. 6, 2010), the District Court affirmed the Bankruptcy Court’s decision to grant summary judgment in favor of the chapter 7 trustee (the "Trustee") seeking to avoid the deed of trust of lender SunTrust Bank N.A. (“SunTrust”), which had been properly recorded pre-petition by SunTrust’s predecessor-in-interest in one indexing system, but improperly in another. In finding that the Trustee’s actual or constructive knowledge of the lien was irrelevant to its avoiding power and that only the official real property index was relevant in determining whether a deed is properly recorded, the District Court has sent a telling message to lenders – strictly comply with local recording requirements or face avoidance of your security interest in your borrower's property in bankruptcy.

]]> The Facts of the Case

Orange County, North Carolina has a unique method of recording land transactions, pursuant to which every tract of land in the county is assigned a unique parcel identifier number ("PIN") and all land transactions relating to a particular tract of land are indexed under that tract's PIN. While the county also maintains a traditional grantor/grantee indexing system in which instruments are indexed alphabetically by the names of the parties, the PIN Index is the county's official real property index.

John Gregory McCormick (the "Debtor") owned two tracts of land ("Tract I" and "Tract II") in Orange County, North Carolina, on which he granted a deed of trust in 1999 to Central Carolina Bank and Trust Company, the predecessor-in-interest to SunTrust. The deed of trust was a single document that described and applied to both tracts of land. However, the deed of trust only contained the PIN for Tract II (the PIN for Tract I was not written on it). When the deed of trust was recorded by SunTrust's predecessor, it was correctly indexed in the grantor/grantee index, but was indexed only under the Tract II PIN in the PIN index. In 2004, the Debtor granted a deed of trust on a portion of Tract I to Marc and Maryann Macky, which was correctly recorded in both the PIN and grantor/grantee indexes. The SunTrust deed of trust was finally correctly indexed under Tract I on August 25, 2008.

An involuntary bankruptcy proceeding was initiated against the Debtor on August 7, 2006 (Bankr. M.D.N.C. Case No. 06-80976C-7D). The Trustee sold all of Tract I and the Court transferred all liens on Tract I to the proceeds of the sale. Thereafter, on October 6, 2008, the Trustee commenced an adversary proceeding (Adv. Proc. 08-09028) against SunTrust, seeking to avoid SunTrust's deed of trust on Tract I under section 544 of the Bankruptcy Code.

Avoidance Powers Under the Bankruptcy Code and the Bankruptcy Court's Decision

Section 544 of the Bankruptcy Code provides, among other things, that a chapter 7 trustee may, regardless of its or any creditor's knowledge, avoid any obligation incurred by the debtor that would be voidable under applicable nonbankruptcy law by a bona fide purchaser of real property at the commencement of the bankruptcy case, whether or not such a purchaser exists. See 11 U.S.C. § 544(a)(3). Thus, a trustee can avoid a lien on a debtor's real property if a hypothetical bona fide purchaser could avoid such lien under nonbankruptcy law. Once the lien is avoided, such lienholder loses its security interest in the property and is left with an unsecured claim.

The Bankruptcy Court evaluated whether SunTrust's deed of trust was properly recorded against Tract I prior to the bankruptcy filing under North Carolina law, even though it was not recorded in the PIN Index. The Bankruptcy Court concluded that it was not, and therefore SunTrust did not have a valid interest in the property that was enforceable against a bona fide purchaser. The Bankruptcy Court granted summary judgment in favor of the Trustee and the Mackys, concluding that the Mackys had first priority on their portion of Tract I and the Trustee could avoid the SunTrust deed of trust.

The District Court Decision: No Constructive Knowledge

The District Court affirmed the Bankruptcy Court's decision, and held that, as a matter of law, "the SunTrust deed of trust was not properly indexed ahead of the Macky deed of trust on Tract I and is not effective against [the Trustee], standing in the shoes of a hypothetical bona fide purchaser, under 11 U.S.C. § 544." Id. at 535.

SunTrust had argued that the Trustee had constructive notice of the SunTrust deed of trust on Tract I, and thus could not avoid the lien. In rejecting this argument, the District Court explained that, by the plain language of the statute, the Trustee's actual or constructive knowledge of SunTrust's lien on Tract I was irrelevant. Additionally, as to the Trustee's knowledge in his role as the hypothetical bona fide purchaser, the District Court found that a bona fide purchaser would not have been on notice pre-petition of the deed of trust. Because the deed of trust did not include the PIN for Tract I, it would not have appeared in any bona fide purchaser's search for Tract I in the PIN Index. Requiring a bona fide purchaser to search the grantor/grantee index in addition to the PIN index would render the PIN Index superfluous and the North Carolina law adopting it meaningless. Finally, the District Court found that it was not improper for SunTrust to bear the risk of loss where its predecessor failed to ensure that the deed was properly recorded.

The Lesson for Lenders: Follow Local Recording Requirements to the Letter

The District Court's holding was explicitly limited by its conclusion that a separate search of the grantor/grantee index in Orange County, North Carolina was not required as a matter of law because the PIN Index was the official index for the relevant time period. But the decision has broader implications for lenders across all jurisdictions. Even though a search in the grantor/grantee index would give a bona fide purchaser constructive knowledge in almost every jurisdiction in the U.S., such constructive knowledge was insufficient where the grantor/grantee index was not the official index. Therefore, lenders and their attorneys need to ensure that they know and strictly comply with the peculiarities of recording or other lien perfection requirements in each jurisdiction. Assuming that the "typical rules apply" can imperil a lien and endanger a lender's ability to recover in a bankruptcy.

Authored By:

Blanka Wolfe
(212) 332-3822
bwolfe@sheppardmullin.com

Altered Ego: New Ninth Circuit Opinion Overrules Previously Well-Settled Law Regarding Exclusive Standing Of Bankruptcy Trustees To Pursue General Claims On Behalf Of The Estate

On October 21, 2010, the Ninth Circuit overruled what many thought to be well-settled law, and held that a bankruptcy trustee does not have standing to pursue alter ego claims, at least in cases governed by California law. The court first held that California state law does not recognize a general alter-ego cause of action that allows an entity and its equity holders to be treated as alter egos for purposes of all of the entity’s debts. As a result, the court found that bankruptcy trustees (or debtors-in-possession) do not have standing to bring such a claim on behalf of a bankruptcy estate, even if the claim affects all of the bankrupt entity's creditors.

]]> The opinion, Ahcom, Ltd. v. Smeding, 2010 WL 4117736 (9th Cir. 2010), overruled at least two other opinions, one entered in California Central District Bankruptcy Court and another entered by a Ninth Circuit Bankruptcy Appellate Panel, both of which held that trustees had the right – and the exclusive right – to bring general alter-ego claims on behalf of the estate when no particular injury was shown to a specific creditor. Both of the overruled opinions relied on a California state court case, Stodd v. Goldberger, 73 Cal. App. 3d 827 (1977), for the proposition that California recognized a general alter-ego claim.

The Ninth Circuit decision found that the other courts had misread Stodd, which the Smeding panel interpreted to mean that a trustee can only bring certain causes of action that directly injure the bankrupt entity, such as fraudulent transfer, conversion and theft, while it cannot bring others because a trustee is not an appropriate general representative of all creditors.

The relatively brief opinion in Smeding may have consequences in bankruptcy cases.

First, the decision may lead to an increase in alter-ego claims by creditors dissatisfied with the progress of, or their treatment in, a Chapter 11 case. These creditors may bring these types of claims against the debtor's principals to gain leverage in their attempts to alter the course of a bankruptcy proceeding or their treatment in it. Debtors may be able to delay such tactics with a Section 105 injunction, but that will only temporarily solve the problem, at least in the Ninth Circuit.

Second, the Smeding decision may mean that it is no longer possible to eliminate alter-ego claims through a release contained in a reorganization plan or in a settlement agreement between the estate and the principals (or other alter ego targets), since the estate is not the holder of the claims. Parties wishing to resolve alter-ego claims in the context of a Chapter 11 plan may be forced to resort to more creative solutions, such as the filing of a class-action alter-ego lawsuit by a creditor, which is then settled in the class action pursuant to class action rules concurrently with plan confirmation.

Third, bankruptcy trustees (and debtors-in-possession) in the Ninth Circuit may be limited to only three categories of claims they can pursue: (1) claims that the debtor could have brought outside of a bankruptcy proceeding and which are therefore property of the bankruptcy estate, (2) avoidance claims of creditors under applicable non-bankruptcy law, which the trustee may pursue under Section 544 of the Bankruptcy Code, and (3) claims specifically created by the Bankruptcy Code, such as preference actions (Section 547), fraudulent transfers (under Section 548) and unauthorized post-petition transfers (Section 549).

Authored By:

M. Reed Mercado
(213) 617-5410
rmercado@sheppardmullin.com

Reversal Of Decision In Bayou Group Bankruptcy Offers Little Guidance For The Institutional Investor Wishing To Redeem From A Fraudulent Ponzi Scheme

In a partial reversal of a decision from Bayou Group LLC's bankruptcy case, the U.S. District Court for the Southern District of New York reconsidered a controversial ruling that sent shivers down the spines of institutional investors in 2008. See In re Bayou Group , LLC, No. 09 Civ. 02577 (S.D.N.Y. Sept. 17, 2010). Specifically, the District Court found the Bankruptcy Court's legal reasoning faulty in deciding that, as a matter of law, all money paid out to redeeming investors within the reachback period could be avoided as a fraudulent conveyance, even though many of these investors had been defrauded themselves. The District Court's recent ruling may do little, however, to help clarify a murky area for institutional investors, leaving them confused as to how they can not only guard against investment risk in unforeseen fraudulent endeavors, but protect themselves from disgorgement of any return they may have innocently received therefrom once a bankruptcy is filed.

]]> The Bayou Bankruptcy

In 1996, Sam Israel, Daniel Marino and James Marquez created the Bayou Fund, a hedge fund aimed at attracting large, institutional investors. Although the Fund began losing money from the outset, and never actually turned a profit thereafter, the Fund's managers manufactured the illusion of profitability by issuing fraudulent financial reports claiming extraordinary annual profits. Israel and Marino misappropriated new investor money for their own personal gain, and created a fictional accounting firm to act as an "independent" auditor verifying their financial statements. Additionally, to avoid detection of their fraud, as well as to lend credence to their financial claims, the Fund regularly honored requests from individual investors who wished to redeem their investments. In so doing, the Fund managed to evade investigation, and therefore, legal inquiry. In sum, the Fund had amassed over $450 million in investments by the time it announced its voluntary liquidation in July 2005.

The Bankruptcy Code provides that, upon a showing of actual or constructive fraud, a trustee in bankruptcy may avoid certain transfers made up to two years prior to the initiation of the bankruptcy case (or up to four years under the law of most states, and six years under New York law), whether or not the recipient was complicit in the fraudulent activity. Accordingly, the trustee in Bayou’s bankruptcy case sought to exercise those avoidance powers as to all Bayou investors who had redeemed their investments prior to the bankruptcy filing, recovering both the principal investment as well as the fictional profits received. In siding with the trustee, the Bankruptcy Court noted that all dividends paid out to investors within the framework of this type of investment scheme – i.e., a "Ponzi" scheme – necessarily constituted actual fraud as a matter of law and had to be returned to the estate for equitable redistribution for the benefit of all creditors. The Court went even further in announcing that any "red flag" that puts an investor on notice "of some potential infirmity in the investment" defeats any possible assertion of a good faith defense. Accordingly, the Court's broad standard, in effect, precluded redeeming investors from raising any defense whatsoever, regardless of the fact that the recipients were themselves victims of the Ponzi scheme.

Bayou Revisited

In September 2010, the U.S. District Court for the Southern District of New York reviewed the Bankruptcy Court's decision. Although the earlier decision was largely affirmed, the District Court ordered a new trial allowing the redeeming investors to rebut the presumption of actual fraud. Specifically, the District Court held that the earlier decision employed the wrong standard in assessing what level of suspicion should prompt a reasonable investor to conduct further investigation.

Although the District Court recognized the difficulty in "attempting to apply absolute rules in this area," Judge Gardephe nevertheless noted that the Bankruptcy Court's reasoning on this point cited no legal authority. Judge Gardephe stated further that the Bankruptcy Court "committed legal error" by substantially broadening the well-established legal threshold at which an investor should be required, at the risk of being deemed complicit in the fraud, to conduct a diligent investigation. In so finding, the District Court Judge opined that before imposing such an onerous burden, bankruptcy courts have required the existence of some objective information indicating either that the investment entity was insolvent or that there was a fraudulent purpose in making a transfer, such that the investor is put on "inquiry notice" of a fraudulent scheme – by contrast, the Bankruptcy Court's lower threshold would preclude an investor from asserting their innocence upon the trustee's mere showing of some "infirmity" in the fund.

Under the Bankruptcy Court's ruling, individual investors, who likely lack the means to conduct a meaningful investigation, inherited an affirmative obligation to personally monitor each entity in which they entrust their money. As a consequence, any showing of a "red flag" or "infirmity" in the investment would leave an investor with the Hobson's Choice of either expending significant personal resources to expose a potentially fraudulent scheme (and therefore prohibiting itself from redeeming upon discovery of a fraud), or immediately trying to redeem its investment (and thus subjecting itself to the avoidance powers of the bankruptcy trustee). In reviewing that decision, the District Court presented a litany of "infirmities" which could potentially fall under the Bankruptcy Court's new umbrella, including "resume puffing, lying to employees or any other act of dishonesty, a failure to pay personal taxes, an unjustified refusal to pay a vendor, sexual harassment or sexual affairs," which might constitute sufficient notice requiring an investor to conduct an independent investigation and, as a matter of law, risk liability for receiving a fraudulent conveyance.

Instead, the District Court held that the appropriate inquiry is not whether there was reason to doubt the financial integrity of Bayou, but rather, whether a reasonably prudent institutional investor would suspect either that Bayou might be insolvent or that a transfer from Bayou might be made with a fraudulent purpose. Because the Bankruptcy Court had not considered these issues and potential inquiries, the District Court believed that the Court's decision was premature. Accordingly, Judge Gardephe ordered a new trial on the issue of whether the investors had sufficient information to put them on inquiry notice. The District Court further instructed that, if a factual finding reveals that the investors were on inquiry notice, two additional queries must then be resolved: first, did the investors conduct a diligent investigation under the circumstances; and second, would a diligent investigation have uncovered Bayou's fraud. However, despite the District Court's admonitions against troubling scenarios under the Bankruptcy Court's standard, Judge Gardephe did not offer any specific guidance as to what should prompt a diligent inquiry. On the contrary, Judge Gardephe recognized that the investigation requirement is largely illusory, stating that upon discovery of a "red flag", the "sensible" investor will redeem rather than spend "more time and money on further inquiry."

The Aftermath

Unfortunately, the Bankruptcy Code does not define "good faith", and courts have been wary of assigning any concrete parameters to the term. In the aftermath of the District Court's reversal of the Bayou decision, while an investor has gained a greater chance of asserting a good faith defense, an open question remains as to what, if anything, might rise to the level of inquiry notice as a matter of law. The District Court observed that the lack of clarity affords a necessary flexibility, particularly in negotiating the underlying tension between protecting creditors on the one hand, and promoting the ease of commercial transactions on the other. That flexibility, however, is not likely to provide much comfort to the institutional investor faced with the dilemma of retrieving invested money from an enterprise in which they have a colorable suspicion of fraudulent activity vs. conducting an independent investigation and awaiting the distribution procedures of a bankruptcy proceeding.

Authored by:

Jeffrey N. Shah
212-634-3086
jshah@sheppardmullin.com

Supreme Court To Decide Whether To Review Seventh Circuit Decision Holding That Bankruptcy Does Not Discharge Environmental Clean-Up Liability Under The Resource Conservation And Recovery Act

In a decision that may create a significant roadblock for companies saddled with environmental clean-up liability to continue as a going concern, the Seventh Circuit in U.S. v. Apex Oil Company, Inc., 579 F.3d 734 (7th Cir. 2009) affirmed a district court injunction requiring the clean-up of a contaminated site in Illinois under section 7003 of the Resource Conservation and Recovery Act (RCRA) despite the company's bankruptcy. On September 27, 2010, the Supreme Court is scheduled to discuss whether to grant review of the Apex decision.

]]> In Apex, the district court held that an oil refinery owned by Apex's predecessor created a plume of millions of gallons of oil that is contaminating groundwater and emitting surface fumes that pose a hazard to the environment and to the health of the citizens of Hartford, Illinois. The district court held that RCRA imposes liability on Apex to "abate this nuisance." The principal question on appeal to the Seventh Circuit was whether the United States' claim for a mandatory injunction under RCRA was discharged in Apex's bankruptcy and, therefore, could not be renewed in a subsequent lawsuit.

Bankruptcy cases interpreting pre-petition liability under various environmental laws, including Apex, have found that certain equitable claims are not dischargeable. To begin with, confirmation of a plan of reorganization under Chapter 11 of the Bankruptcy Code allows a debtor to obtain a discharge of "any debt that arose before the date of such confirmation." 11 U.S.C. § 1141(d)(1)(A). This allows the debtor a fresh start coming out of bankruptcy. The Bankruptcy Code defines "debt" as "liability on a claim." 11 U.S.C. § 101(12). A "claim" is defined as, among other things, a "right to an equitable remedy for breach of performance if such breach gives rise to a right to payment, whether or not such right to an equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed, undisputed, secured, or unsecured." 11 U.S.C. § 101(5)(B) (emphasis added). Thus, as explained by the Seventh Circuit in Apex, the crucial question in determining whether an equitable remedy is discharged in bankruptcy is whether that remedy gives rise to a right to payment. If it does, the claim is discharged in bankruptcy.

The Seventh Circuit held that RCRA entitles the government to require a defendant to clean up a contaminated site at the defendant's expense. However, RCRA does not entitle the government to demand payment of the clean-up costs from the defendant. Apex argued that the cost of complying with an equitable decree under RCRA should be deemed a monetary claim and, thus, be dischargeable in bankruptcy. Citing cases in the Seventh, Third and Second Circuits, the Apex court held that the cost to Apex of complying with the injunction is not a "right to payment" as used in the Bankruptcy Code. The court reasoned that because every equitable decree imposes a cost on the defendant, under Apex's argument, every equitable claim would be dischargeable in bankruptcy unless there was an exception in the Bankruptcy Code. The court held this was inconsistent with the spirit and framework of the Bankruptcy Code. In sum, the Seventh Circuit held that the government's equitable claim was not discharged in bankruptcy and it upheld the injunction requiring Apex to clean-up the contaminated site in Illinois.

Of note, in deciding Apex, the Seventh Circuit expressly distinguished Ohio v. Kovacs, 469 U.S. 274 (1985), a case in which the Supreme Court held that an equitable obligation to clean up a contaminated site by the debtor was discharged in the debtor's bankruptcy. In Kovacs, the debtor failed to comply with its clean-up obligation post-bankruptcy. A receiver was appointed to take possession of the debtor's assets and obtain from the debtor money to pay for cleaning the contaminated site. The Seventh Circuit in Apex held that, because the receiver in Kovacs was seeking money, as opposed to an order mandating the clean up, this was a "right to payment" and therefore a "claim" that could be discharged under the Bankruptcy Code. By contrast, in Apex, the government was not seeking the payment of money and the underlying statute did not entitle it to payment. Accordingly, the Seventh Circuit held that the Supreme Court's decision in Kovacs did not mandate a different result.

As Apex no longer had the capacity to perform the clean-up itself, Apex estimated that it would cost $150 million to hire another company to complete the job, minus any recovery Apex could obtain from other contributors of the contamination. Apex argued that had it known that the government's equitable claim was not dischargeable in bankruptcy, it would have had to liquidate, rather than reorganize.

The Apex ruling may erode the ability of a company with environmental contamination liability to continue as a going concern. To the extent courts follow the reasoning of Apex and hold that equitable claims for environmental clean-up costs are nondischargeable, a chapter 11 bankruptcy may have marginal to no benefit to companies saddled with such liability. In that instance, a chapter 7 liquidation may be the company's only option. Further, the Apex ruling may guide lawmakers on how to draft future environmental legislation to prevent companies from shedding their contamination liability. That is, if an environmental law confers no right to payment on the plaintiff and only imposes an obligation on the defendant to take some affirmation action (such as cleaning up contamination), then courts following Apex will hold that the plaintiff's equitable claim is not dischargeable in bankruptcy.

Authored by:

Theresa W. Bangert
213-617-5596
tbangert@sheppardmullin.com

Dead Zone? Direct Claims by Creditors of a California Corporation May Not Lie Against Management Based on Management's Allegedly Shifting Duties When Corporation Is in the Zone of Insolvency or Even Insolvent

The California Court of Appeal recently rejected the argument that directors and officers owe fiduciary duties to the company's creditors when the company is in the so-called "zone of insolvency," or is even clearly insolvent. In Berg & Berg Enterprises, LLC v. John Boyle, et al., 100 Cal. Rptr. 3d 875 (Cal. Ct. App. 6th Dist. Oct. 29, 2009), the California court expounded that "there is no broad, paramount fiduciary duty of due care or loyalty that directors of an insolvent corporation owe the corporation's creditors solely because of a state of insolvency." Id. at 893-94. The court was even much less inclined to find that directors owed such duties when the corporation is not clearly insolvent but on the brink of insolvency, and held that "there is no fiduciary duty prescribed under California law that is owed to creditors by directors of a corporation solely by virtue of its operating in the 'zone' or 'vicinity' of insolvency." Id. at 893.

]]> It is well settled that directors and officers of a solvent company owe fiduciary duties to act with honesty, loyalty and good faith to the company's shareholders, since the shareholders are the owners of the company and its residual risk bearers. So long as the company remains solvent, the company's obligations to its creditors are governed simply by their contractual arrangement.

When the company becomes insolvent, some courts outside of California have held that management's duties shift to the company's creditors. See, e.g., Geyer v. Ingersoll Publ’ns Comp., 621 A.2d 784, 787 (Del. Ch. 1992) ("When the insolvency exception does arise, it creates fiduciary duties for directors for the benefit of creditors."). The rationale for this shift in the fiduciary duties is that when a company is insolvent, creditors' contract claims are affected by management's decisions in a way they are not outside of insolvency. At the same time, shareholders' interests become essentially worthless. While there are no California cases specifically recognizing this shift, some courts have found it to be an application of the "trust fund doctrine" recognized by the California courts. Under that doctrine, which is typically limited to situations where officers or directors divert, dissipate, or unduly risk corporate assets, an insolvent company's assets are said to be managed as though held in trust for the benefit of its creditors.

Beginning in the 1990's, courts outside of California began to suggest that management's fiduciary duties are owed to creditors not only when insolvency ensues, but also when the company is still technically solvent but within what has been termed as the "zone" or "vicinity" of insolvency. The catalyst for this trend was Chancellor Allen's statement in an unpublished decision in Delaware in 1991. See Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., No. 12150, 1991 Del. Ch. LEXIS 215, *108 (Del. Ch. Dec. 30, 1991) ("At least where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the residue risk bearers, but owes its duty to the corporate enterprise."). Chancellor Allen expanded on this statement in his now-famous footnote 55, outlining a hypothetical situation in which a board of directors' best course of action would be one that neither stockholders, creditors nor any particular group would prefer, but rather one that would best serve the "community of interests" represented by the corporation. Id. at *108 n.55. Chancellor Allen noted that "the possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors." Id. The proponents of expanding the zone-of-insolvency theory have relied on this footnote to argue that, once the company teeters on the brink of insolvency, the pool of those to whom directors owe their fiduciary duties expands to include the company's creditors.

This concept of a "zone of insolvency" has caused no small amount of consternation among practitioners, judges and commentators alike. For example, how does a company know when it is in the dreaded "zone"? See Prod. Res. Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772, 790 (Del. Ch. 2004) ("[I]t is not always easy to determine whether a company even meets the test for solvency.").

In 2007, the Delaware Supreme Court brought much-needed clarity to this issue, and significantly limited creditors' ability to bring zone-of-insolvency-type claims against the management of Delaware companies, when it announced that "no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency." North American Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).

In California, until the decision in Berg, no published opinion had addressed the issue of whether California law recognizes claims for breach of management's fiduciary duties to creditors either when the company is insolvent or in the zone of insolvency. In Berg, the California Court of Appeal made it clear that such claims cannot lie against the management of a California company.

The Berg Decision

Berg, the largest creditor of a California corporation based in Cupertino, Pluris, Inc. (“Pluris”), sued the directors of Pluris after Pluris had experienced financial difficulties and entered into an assignment for the benefit of its creditors ("ABC") under sections 493.010 and 1802 of the California Code of Civil Procedure.

Berg alleged that prior to the ABC, Pluris and a Berg-related entity were involved in a litigation regarding a lease repudiated by Pluris. The litigation was later settled when Pluris, which was experiencing financial distress, informed Berg that it was in the process of securing outside financing to continue operations and that such financing was conditioned on the settlement of its dispute with Berg. Pluris and the Berg-related entity agreed to a settlement of the litigation that assigned the claim of the Berg-related entity to Berg, making him Pluris' largest creditor. Berg allegedly informed Pluris at the time that, in case Pluris was unable to obtain the financing, Berg had a plan to derive value from Pluris’ net operating losses by reorganizing under the Bankruptcy Code or exploring other alternatives.

Eventually, Pluris could not secure sufficient outside financing, and its directors entered into the ABC instead of pursuing Berg’s plan.

The Trial Court

After several amendments to his complaint, the essence of Berg's claim was that the Pluris directors owed their fiduciary duty to Berg and the other creditors because the company was either insolvent or operating in the "zone of insolvency" at the time the ABC was accomplished. Berg alleged that Pluris' directors breached this duty when they approved the ABC transaction and did not pursue Berg's plan or alternative options that may have preserved the value of Pluris' $50 million net operating loss.

The directors demurred, and the trial court ultimately sustained the demurrer without leave to amend. In its dismissal of Berg's complaint, the trial court relied on a decision by the United States District Court for the Northern District of California interpreting California law. CarrAmerica Realty Corp. v. nVIDIA Corp., Case No. 05-00428, 2006 U.S. Dist. LEXIS 75399 (N.D. Cal. September 29, 2006). The CarrAmerica court had concluded that the trust fund doctrine governs the duties of management of an insolvent corporation in California. The court stated that the scope of this doctrine is limited to cases where directors or officers have "diverted, dissipated, or unduly risked the insolvent corporation's assets" necessary to satisfy' creditors' claims. Such conduct involves self-dealing or prohibited preferential treatment of certain creditors. As such, since Berg failed to point to such misconduct by Pluris' directors, Berg's allegations failed to state a cognizable claim under California law.

On Appeal

The Court of Appeal affirmed the trial court's decision and approved the lower court's reliance on CarrAmerica. In effect, according to the Berg court, under California law, the company's insolvency does not create new duties on part of the directors who continue to be bound by their obligation to refrain from engaging in misconduct, self-dealing or preferential transfers to creditors.

According to the court, there was no misconduct on the part of Pluris' directors when they approved the ABC, which the court described as "a recognized statutory alternative to liquidation through bankruptcy," instead of "investigating, exploring or pursuing a bankruptcy reorganization." Such other alternatives described by Berg were "inherently speculative," the costs and risks of which "would not have been eliminated by discussions with Carl Berg or anyone else."

Further, the court held that even assuming that Berg's complaint pled a cognizable claim, the Pluris' directors would not be liable on alternative grounds. The Court found that the directors would be insulated from liability pursuant to the business judgment rule that immunizes directors when they acted in good faith in what they believed to be the company's best interest and without the presence of conflict of interest. According to the court, Berg made merely conclusory allegations that, without more, failed to rebut the presumption afforded by the business judgment rule.

Closing Thoughts

While the Berg decision is very favorable to directors of California corporations, the Supreme Court of California is yet to opine on the issue, and other appellate courts may hold differently in the future. In addition, a different set of circumstances facing directors charting the troubled waters of insolvency may yield a different result. Lastly, while there have been no California cases holding that directors owed their fiduciary duties to the company's creditors, directors of California companies have been found liable for breaches of fiduciary duties owed to the corporation and its shareholders when their decision to file bankruptcy harmed the value of the company's shares and when they did not consider other alternatives to bankruptcy. See, e.g., Davis v. Yageo Corporation, 481 F.3d 661 (9th Cir. 2007) (directors liable as the bankruptcy filing was a breach of fiduciary duty designed to enable the majority shareholder to acquire the corporation’s assets at less than fair value). Therefore, it remains important for California directors to continue to exercise diligence in weighing the options available to them when their company is insolvent and in considering the impact of these alternatives on all the company's constituencies, including its shareholders and creditors.

Authored By:

Robert Sahyan
(415) 774-3146
rsahyan@sheppardmullin.com

When Are Goods Received For The Purpose Of Asserting Administrative Priority Status Under Section 503(b)(9) Of The Bankruptcy Code?

A bankruptcy court recently held that in order for a supplier of goods on credit to establish an administrative claim under Bankruptcy Code section 503(b)(9) in the bankruptcy case of its buyer, the supplier will need to show that its buyer "physically" received the goods within 20 days prior to the buyer's bankruptcy filing, regardless of when title to the goods passed. In Re Circuit City Stores, Inc., et al., Case No. 08-35653, No. 7149 (Bankr. E.D. VA April 8, 2010).

]]> Section 503(b)(9) was added to the Bankruptcy Code in 2005, which, along with the expanded reclamation rights in section 546(c), was intended to provide suppliers of goods on credit with additional protections upon the bankruptcy filing of their customers. Pursuant to section 503(b)(9), vendors can claim administrative priority status for the value of the goods supplied within 20 days prior to a customer's bankruptcy filing. As a result, the claims of vendors who supply product to the debtor within this time period (and who have not received payment) are placed above, and paid before, those of the general unsecured creditors.

The relevant part of Section 503(b)(9) reads:

"After notice and a hearing, there shall be allowed administrative expenses, . . . including—

….

(9) the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor's business."

11 U.S.C. § 503(b)(9). At first blush, the section appears simple enough, in that it requires: (a) a vendor to sell goods to a debtor in the ordinary course of business (and not receive payment for the goods); and (b) such goods to be "received" by the debtor within 20 days prior to filing bankruptcy.

However, since the adoption of section 503(b)(9), courts have had to grapple with the meaning of the various requirements of 503(b)(9) in order to define its limits, such as defining the term "goods." See In re Circuit City Stores, Inc., 416 B.R. 531, 537 (Bankr. D. Va. 2009) (adopting the UCC definition of "goods"); accord In re Goody's Family Clothing, Inc., 401 B.R. 131, 134 (Bankr. D. Del. 2009); In re Plastech Engineered Prods., Inc. (Plastech II), 397 B.R. 828, 836 (Bankr. E.D. Mich. 2008). Most recently in the Circuit City case, the word "received" became the center of a dispute between the debtor and one of its vendors asserting administrative status under section 503(b)(9).

Circuit City was a national retailer that had a somewhat distinct business arrangement with one of its vendors. That vendor supplied goods to Circuit City pursuant to a consignment agreement. The agreement provided that, although the goods were physically delivered to Circuit City’s warehouses and stores and remained in the physical possession of Circuit City after delivery up to the time of their sale to Circuit City's customers, the vendor retained title to the goods until the time that Circuit City sold these goods to its customers. Under this "consignee/consignor and buyer/seller relationship," title to the particular goods passed first to Circuit City and then to the customer at the time of the sale to the customers as part of a simultaneous transaction.

As of the time of Circuit City's bankruptcy filing, Circuit City owed the vendor more than $9 million for goods that were sold by Circuit City during the 20 day prior to the bankruptcy filing, but were physically delivered to it before this 20-day period. The vendor sought administrative status for these amounts and asserted that section 503(b)(9) requirements were all satisfied, including the requirement of having the "goods received by the debtor within 20 days before the date of [the bankruptcy filing]." The vendor took the position that the relevant date for determining when the goods were "received" for the purposes of section 503(b)(9) is the date when Circuit City sold the goods to its customers, since title to the goods could not pass to Circuit City before then. Circuit City argued that the critical date is instead when the goods were "physically delivered," which was prior to the 20-day window, regardless of when title to the goods passed.

The bankruptcy court agreed with Circuit City and rejected the vendor's interpretation of the word "received." Reaching this conclusion, the court partly relied on judicial interpretations of the word "receipt" as used in section 546(c). The word "receipt" in section 546(c) is likewise not defined in the Bankruptcy Code. However, courts interpreting 546(c) have generally adopted the definition set forth in Article 2 of the UCC, which provides that "receipt" means "taking physical possession.” The court in Circuit City concluded that the words “received” in section 503(b)(9) and “receipt” in section 546(c) are "similar words and concern related issues," and therefore adopted that same definition from the UCC.

While the court's decision in Circuit City is not binding on other courts, it may be followed if it is found to be well reasoned. If nothing else, it serves as a caution to vendors who may be relying on similar consignment/sale arrangements to increase their 503(b)(9) claims and therefore lessen their risk exposure in the event their customers file bankruptcy. Such vendors concerned about the creditworthiness of their customers may wish to consult counsel and explore alternative mechanisms to improve their positions.

Authored By:

Robert Sahyan
(415) 774-3146
rsahyan@sheppardmullin.com

Top 10 Best Practices For Lenders On Problem Loans

Since the start of the financial crisis, the number of problem loans has increased as real estate values declined, credit markets tightened, and various companies struggled to survive and stay in business during this recession. For lenders who made loans secured by real estate or personal property collateral during better economic conditions, these lenders are now being faced with loan defaults and having to decide whether to workout the loan (e.g., by giving an extension of maturity date, or restructuring the interest rate or other loan terms, or waiving certain defaults) or to exercise its rights and remedies (e.g., by foreclosure, appointment of a receiver, action against the guarantor, etc.). The following identifies ten best practices and issues for consideration by lenders when dealing with a problem loan.

]]> Top Ten Tips for Lenders

1. Centralize Lines of Communication.To avoid the "end-run" around asset management, the lender should speak with "one voice." Whether the lender representative is an officer in the special assets department or an asset manager responsible for the loan, the lender should avoid assurances to the borrower that a workout will be possible. At the early stages, the lender may be unaware of facts that will make a consensual workout impractical. At the same time, the lender will want to assemble its team comprised of the asset manager, counsel, appraisers and other outside experts.

2. Review Your Collateral. The lender will want to update its evaluation of repayment sources, including available collateral for the loan. In evaluating the value of collateral, the lender should consider the following, as may be applicable: (a) appraisal, (b) updated title report and UCC searches, (c) environmental review, (d) development status of the project (e.g., entitlements, construction, obligations to contractors), (e) engineering review, and (f) confirm that required insurance coverages are in place.

3. Review Your Loan Documents. After identifying a problem loan, one of the first steps for the lender is to retain counsel to prepare a document review report identifying any problems with the loan documents and determining whether there are any major issues with the loan documents that would make the exercise of remedies problematic. For example, for a California real estate secured loan, if the deed of trust is missing the customary "power of sale" language, then the lender may not have the option to pursue a non-judicial foreclosure sale of the real property collateral. In such case, the lender may be limited to a judicial foreclosure sale, which is generally more time-intensive and costly, unless the lender enters into a consensual loan workout to cure this deficiency in the loan documents.

4. Check for Suretyship Waivers. Depending on the applicable governing law, a guarantor of a loan may be entitled to numerous statutory and judge-made rights and defenses, which may undermine the purpose of the guaranty unless such rights and defenses are effectively waived. Guaranties typically include suretyship waivers. However, such waivers are often missing in other loan documents when the loan involves co-borrowers or third-party pledgors of collateral. Suretyship rights and defenses also may arise indirectly if one loan is cross-defaulted and cross-collateralized with another loan, and the loans are made to distinct entities. As part of its document review, the lender's counsel should carefully review the inclusion and adequacy of suretyship waivers in the loan documents.

5. Correct Any Deficiencies in UCC-1 Financing Statements. A common mistake on a UCC-1 financing statement is including the wrong debtor name! The lender should verify the formal legal name of the borrower. If the borrower is an entity, the UCC-1 should have the name shown on the Articles of Incorporation, Certificate of Formation, or Certificate of Partnership, as may be applicable, on file with the appropriate filing office designated by the state of the borrower's organization. For example, if the name of a corporation organized in California is "ABC Corporation", the UCC-1 should not state the name of the debtor as "ABC Corporation, a California corporation". Depending on the search parameters of the filing office, a UCC search of a debtor by its correct legal name may not turn up financing statements with mistakes in the debtor's name. Moreover, the lender should always obtain a certified post-filing UCC search to confirm that its UCC-1 financing statement is shown on record.

6. Review the Administration of the Loan. The asset manager handling the problem loan should confer with any relationship manager or prior asset managers to flush out potential lender liability claims. For example, is there any evidence of oral agreements modifying the written loan documents, or course of conduct that may suggest implied waiver of the terms of the written loan documents? Any complaints by the borrower that the lender has not performed? Any evidence of inappropriate conduct such as inordinate involvement in management?

7. Review Your Borrower and Guarantors. The lender also may want to update its review of the borrower and any guarantors of the loan, including taking one or more of the following steps: (a) obtain current financial information on the borrower and guarantors, (b) evaluate the current management (i.e., competence, motivation, honesty, and intentions), (c) evaluate current operations (i.e., financial controls and position in market), (d) evaluate external factors (i.e., general economic conditions, market conditions for particular product type, etc.), (e) identify the causes of the borrower's problems (Extraordinary event or ongoing issues? Fundamental problem in the market or borrower's business plan? Is borrower diverting rents or other income?), and (f) determine if borrower has sources if additional cash is needed.

8. Determine Your Strategic Position. The lender should identify defaults and potential defaults under the loan documents, checking notice and/or cure requirements and possible waiver issues. Then, the lender should evaluate the materiality of the defaults. Is there a material breach of a material obligation? Evidence of a material deterioration in the borrower's financial condition, in the value of collateral, and in prospects for repayment? Once the lender has determined that one or more material defaults exist under the loan, the lender can consider its available rights and remedies under the loan documents and applicable law (e.g., demand the curing of defaults, cease funding, impose default rates of interest, accelerate principal balance, etc.) and determine if any documentation or collateral deficiencies might impair the lender's ability to take any specific action. Finally, the lender should consider the likely reaction of the borrower and its other creditors to any action to be taken (e.g., bankruptcy of the borrower).

9. Select a Strategy. Subject to the loan structure and any documentation or collateral limitations, the lender may have various options in dealing with a problem loan, such as the following:

(a) Do nothing.

(b) Gather more information.

(d) Extend time to cure defaults.

(e) Encourage the borrower to address its problems, including getting advice from consultants. (To avoid potential lender liability, the lender may offer suggested consultants, but the lender should not mandate any particular consultant or make the borrower's selection subject to lender's approval.)

(f) Restructure the terms of the loan (i.e., commence a workout).

(g) Accelerate the loan and demand payment.

(h) Request a deed-in-lieu of foreclosure.

(i) Commence non-judicial foreclosure sale.

(j) Exercise judicial rights and remedies, including non-judicial and/or judicial foreclosure, appointment of a receiver, and action against any guarantors.

10. Consider a Pre-Negotiation Agreement. If the lender is considering a consensual workout, the lender should consider entering into a pre-negotiation agreement with the borrower, the guarantors or joinder parties, and any third-party pledgors or indemnitors before starting negotiations. The basic elements of the pre-negotiation agreement are to clarify among the parties that there is no deal until it is in the final documents, that there are no oral agreements, that discussions will not be discoverable, and that the parties are not foregoing alternatives. The lender may want to strengthen the pre-negotiation agreement in its favor if the borrower has made threats or if the lender's negotiating position will allow (e.g., acknowledge loan is in default, no defenses to payment, etc.) However, the lender should beware of getting bogged down in negotiating the pre-negotiation agreement, since the primary purpose is to ensure that neither party gives up any rights or incurs any obligations during the discussions unless a final written agreement is signed by the parties.

Conclusion

The handling of a problem loan presents pitfalls for the unwary lender. A lender should review the issues described above before rushing to workout a problem loan or exercise its remedies. A careful review of the loan documents and collateral may often reveal deficiencies that can be corrected easily prior to any action on the loan, and may shape the lender's approach to dealing with the problem loan.

Authored By:

Jenny Park Garner
(415) 774-2949
jpark@sheppardmullin.com

and

Geraldine A. Freeman
(415) 774-2966
gfreeman@sheppardmullin.com

One's Crisis is Another's Opportunity: Section 363 Sales

With the increasing numbers of companies which were once thought to be giants of industry filing for bankruptcy, more opportunities to purchase major assets are becoming available to savvy buyers looking to expand their business or asset base. The Bankruptcy Code provides debtors with the ability to liquidate all or a part of their assets through court-supervised sales and buyers with the ability to obtain those assets at more favorable prices than they would pay if the sale were consummated outside of a bankruptcy.

]]> One of the most advantageous provisions of the Bankruptcy Code is that a deal can be approved and consummated relatively quickly, providing for approval on as little as 40 days notice (or less in exigent circumstances). For example, in the Chrysler case, the sale of substantially all of Chrysler's assets to New CarCo (and Fiat) was approved and closed within approximately 40 days after the bankruptcy filing, while in the Lehman case, the time frame was even more expedited – with entry of an order approving the sale to Barclays only 3 days after the filing of the sale motion.

Basic Procedures for Purchasing Assets From a Debtor

The purchase and sale of assets in a bankruptcy case often begins with a "stalking horse" bidder who has agreed to buy the target assets pursuant to a negotiated asset purchase agreement. The stalking horse bidder is often the bidder who, after some general solicitation of bids outside of bankruptcy, makes the highest bid for the most assets and is the most able to complete the purchase and/or requires the least amount of time, if any, to undertake a due diligence review.

Once an agreement has been reached and finalized with the stalking horse bidder, the debtor will begin the process of seeking bankruptcy court approval of the asset sale. Section 363 of the Bankruptcy Code provides debtors with two options for asset sales: private sales or public auctions. In both private sales and public auctions, a debtor seeking to sell property will be required to provide public notice of the sale and time for parties to object.

In a private sale, the debtor will make a motion to the bankruptcy court for approval of the sale transaction, setting forth the basis for the sale, the terms of the sale, a proposed hearing date for approval of the sale and a deadline by which any objections to the sale must be filed. Although no auction process is contemplated in a private sale, interested parties may submit competing bids for the target assets by "objecting" or otherwise responding to the sale by the objection deadline creating, in essence, in a de facto auction for the assets. Typically, however, debtors and bankruptcy courts prefer public auctions to private sales because, among other things, public auctions provide better protection against subsequent claims that the debtor failed to maximize value for the benefit of its creditors.

The sale of Lehman's assets to Barclay's provides a good example of how private sales are utilized in certain circumstances, but are not necessarily favored by the courts. In that case, although the sale was not actually called a private sale, the sale of Lehman's assets to Barclays was undertaken without an auction process being proposed by the debtors or implemented by the court. In approving the sale on an extremely expedited time frame without any competitive bidding procedure, the bankruptcy court noted that the sale had been approved under a unique set of extraordinary circumstances, in an emergency situation, and because it was clear that Barclays was the only interested buyer. Accordingly, the court made clear that the process implemented in that case would not have precedential value.

In a public auction, a debtor will make a motion or motions to the bankruptcy court describing the basis for the sale, the terms of the sale, the procedures for accepting "higher and better" offers and a proposed time and place for the auction of the assets, requiring two separate orders from the bankruptcy court. The first order will be a "procedures order" approving the form of the purchase agreement and the procedures for competing offers and the auction, including break-up fees, bid increments, competitive bid qualification requirements, the auction date and the sale approval hearing date. The second order will be the "sale approval order", which will be entered after the auction has been conducted, and will authorize the sale of the assets to the bidder making the "highest and best offer" for the assets. Each order will be subject to separate objection deadlines and hearing dates.

In the context of a public auction, it is generally advantageous to be the stalking horse bidder, as opposed to a subsequent competing bidder. The stalking horse bidder will have some control over the terms of the auction and will negotiate the form of the purchase agreement upon which any future bidders will be required to base their bids. However, competing bidders who are able to work within the terms of the stalking horse's agreement can end up as the successful buyer of the assets at the auction, thereby reaping the rewards of a stalking horse bidder's labors. To offset the risk to the stalking horse bidder that another bidder may win the assets at the auction, and to induce a stalking horse bidder to negotiate and create a competitive market for the debtor's assets despite the potential "loss" of the assets in an auction, the stalking horse bidder's purchase agreement often includes "break-up" fee and/or expense reimbursement provisions, which are intended to cover the stalking horse bidder's costs and, in order to be approved, must be reasonable. In most cases, courts have agreed to approve break-up fees equal to anywhere from 2% to 4% of the overall purchase price, or which are based on the actual, reasonable expenses incurred by the stalking horse bidder.

In some cases, bidding at an auction can be very lively, often taking hours and, in rare cases, days, and increasing the price ultimately paid for the assets by millions of dollars over the original price proposed by the stalking horse bidder. For example, in the case of Riverstone Networks, two bidders emerged – Lucent Technologies and Ericsson. At the auction, held over two days and through numerous rounds of bidding, the purchase price for the assets was increased by $47 million, with Lucent, the stalking horse bidder, ultimately winning the assets with a final bid of $217 million in cash and cash equivalents. In others, there may be no bidding at all, with the auction, if not canceled, lasting no more than 10 minutes so as to create a complete record stating that no competing bidders came forward, and that the stalking horse bidder is the winning bidder. Accordingly, each auction is different depending on the type of assets and the market for the assets – no two are exactly the same.

The Purchase Agreements in the Bankruptcy Context

In addition to providing for a break-up fee and/or expense reimbursement, a purchase agreement in a bankruptcy case differs in certain material respects from a purchase agreement outside of the bankruptcy context. First, a bankruptcy purchase agreement will provide that its effectiveness is conditioned upon the entry of the sale approval order. In addition, the sale of a debtor's assets is usually made on an "as is, where is" basis, with the representations and warranties that a debtor is willing or able to provide being fairly limited and surviving only until closing of the sale. Indemnification by a debtor is rare. The principal reasons for these differences are that: (1) the debtor is generally not an economically viable entity and its representations and warranties are of limited value; (2) the debtor will ultimately be discharged from most of its liabilities as part of the bankruptcy case, including claims under the purchase agreement; and (3) the creditors of the debtor desire finality and do not wish to have ongoing exposure that may diminish the assets of the debtor available for distribution.

A potential buyer of assets should not, however, let these differences and limitations deter it. The fact is that a properly drafted sale order will provide a buyer of distressed assets with essentially the same or better protection as a buyer outside of bankruptcy, by providing that the assets are being sold free and clear of any liens, claims, encumbrances or other interests therein (resulting in what is referred to as a "cleansing" of the assets) and that the buyer is a "good faith" purchaser. This language alone generally protects a buyer from, and is generally enforceable against, any claims of a third party or the debtor in or to the assets and releases any liens or other encumbrances on the assets, with such liens, claims, interests or other encumbrances attaching to the proceeds from the sale of that asset.

Closing Thoughts

Each sale of assets by a debtor in bankruptcy is unique. The fundamental principle in all sales is that the sale be conducted in a manner that is reasonably calculated to maximize value for the debtor's creditors and estate, and that each sale be negotiated and conducted on an arms' length basis in "good faith" by the debtor and purchaser. These general rules apply equally to all bidders providing all potential buyers with the same protections, but also submitting all buyers to the jurisdiction of the bankruptcy court.

In addition, the scope of the assets that can be sold through these section 363 sales is extremely broad – the assets can be in the U.S. or outside the U.S., and they can be tangible assets like inventory, equipment, real property, fixtures etc. and they can also include intangibles such as stock, leases, mortgages, loan portfolios and intellectual property. Consequently, they can be an effective tool to expanding a company's business and, in many cases, represent tremendous opportunities to a savvy purchaser.

Authored By:

Malani J. Cademartori
(212) 634-3085
mcademartori@sheppardmullin.com

Equitable Subordination of a Creditor's Secured Claim when such Secured Creditor is, itself, in Bankruptcy

In a majority opinion dated December 15, 2009, the Ninth Circuit Bankruptcy Appellate Panel held that a chapter 11 debtor may not equitably subordinate a creditor's claim and transfer the lien securing that claim, when such creditor is, itself, in bankruptcy, before first obtaining relief from the automatic stay under section 362 of the U.S. Bankruptcy Code in such creditor's bankruptcy case. Lehman Commercial Paper v. Palmdale Hills Prop. (In re Palmdale Hills Prop., LLC), 2009 Bankr. LEXIS 4294 (B.A.P. 9th Cir. Dec. 15, 2009).

]]> It is well established that a bankruptcy court has the power to reorder the priority of allowed claims based on equitable grounds. Indeed, under section 510(c) of the Bankruptcy Code, if the principles of equity so dictate and after appropriate notice and a hearing, the bankruptcy court may subordinate all or part of an allowed claim, and transfer any lien securing such subordinated claim to the bankruptcy estate. The decision in the Palmdale Hills case adds a wrinkle to this process when the creditor is in bankruptcy. According to Palmdale Hills, if the subject creditor happens to be in bankruptcy, relief from the automatic stay applied in such creditor's case upon filing must first be obtained before such creditor's secured claim can be equitably subordinated.

The debtors in the Palmdale Hills case were integrated companies formed as part of a joint venture to develop residential real estate projects with affiliates of Lehman Brothers, Inc. Lehman and its affiliates, including Lehman ALI, Inc. ("Lehman ALI") and Lehman Commercial Paper Inc. ("Lehman Commercial"), provided the financing for the projects through a series of loan agreements and equity arrangements on the debtors' projects. The debtors contended that the structure of these financing arrangements constituted manipulative lending practices and fraudulent conveyances, and that Lehman's complete control over the use of the funds created their significant debt burdens and eventually forced them to file bankruptcy.

Soon after filing bankruptcy in California, the debtors sought blanket relief from the automatic stay in Lehman Commercial's bankruptcy case pending in New York. The purpose of this relief was to allow the Palmdale Hills debtors to administer their California bankruptcy cases without the need to file repeated motions for relief from the automatic stay in Lehman Commercial's New York bankruptcy cases. However, the New York bankruptcy court denied the broad relief requested by the debtors without prejudice to the debtors' rights to refile specific requests for stay relief.

Eventually, the debtors proposed a chapter 11 plan based principally on equitably subordinating the claims of Lehman ALI (an entity not in bankruptcy) and Lehman Commercial (who is in bankruptcy, together with Lehman ALI, the "Lehman Lenders"). The debtors also filed an adversary proceeding against Lehman ALI to equitably subordinate its claim, which they later proposed to amend to include a request to equitably subordinate Lehman Commercial's claim and transfer its lien to the estate if the California bankruptcy court determined that such action would not violate the automatic stay applicable in Lehman Commercial's bankruptcy case.

The Lehman Lenders filed a motion for relief from stay in the debtors' California case arguing that they were owed more than $649 million on their loans to the debtors, and that the properties securing these loans lacked equity and were declining in value. The Lehman Lenders also argued that the debtors' reorganization would fail because it was based on equitably subordinating Lehman Commercial's claim, which Lehman Commercial argued violated the automatic stay applicable in its bankruptcy case.

The California bankruptcy court did not, however, grant the Lehman Lenders' stay relief motion, and instead treated it as an informal proof of claim. The court also ruled that the debtors could pursue equitable subordination, through either an adversary proceeding or a plan, as a defense to Lehman Commercial's stay relief motion without violating the automatic stay imposed in Lehman Commercial's bankruptcy case. Lehman Commercial appealed, challenging the California bankruptcy court's decision regarding the scope and application of Lehman Commercial's automatic stay.

The BAP reversed, holding that the California bankruptcy court erred in finding that the debtors could pursue equitable subordination of the Lehman Commercial's claim and transfer its lien to the estate without first obtaining relief from the automatic stay in Lehman Commercial's New York bankruptcy case. While the BAP agreed that equitable subordination could be asserted as a defense to a motion seeking relief from the automatic stay without the necessity for seeking relief from the automatic stay, the BAP concluded that, under the facts of the case, equitable subordination was not merely a defense to the relief from stay motion. According to the BAP, when the California bankruptcy court permitted the debtors to pursue equitable subordination of Lehman Commercial's claim, it conflated equitable subordination as a defense to a relief from stay motion with equitable subordination as an objection to a claim. Because the adjudication of the debtors' equitable subordination of Lehman Commercial's claim sought affirmative relief and was not merely a defense, it rose to the level of violating Lehman Commercial's stay.

The BAP also rejected the debtors' contention that, because a complete disallowance of a claim through a claim objection could be achieved without a stay violation, their "lesser defensive remedy" of claim subordination could not possibly violate the automatic stay. The BAP noted that when a claim is disallowed, the creditor effectively never had the right to payment under that claim and the debtor did not recover any property from the creditor; whereas under equitable subordination, the creditor has a right to payment, but that right is modified based on equitable grounds and, if the claim is secured by a lien, that lien is transferred to the estate. According to the BAP, it was this key difference that transformed the debtors' claim of equitable subordination from a proper defense to Lehman Commercial's stay relief motion into an offensive action against Lehman Commercial's estate.

Finally, the BAP also noted that if the debtors were allowed to subordinate Lehman Commercial's claim in the California bankruptcy court without first moving for a stay relief in Lehman Commercial's New York bankruptcy case, Lehman Commercial's creditors would be deprived of notice and the chance to challenge the subordination action even though their rights would be affected.

One judge dissented in the Palmdale Hills case and disagreed with the majority's principal holding (as characterized by the dissent) that a debtor may not, in its own bankruptcy, unilaterally defend against a lender's inequitable claim if that lender is also a bankruptcy debtor. According to the dissent, the majority's distinction between claim disallowance and claim subordination is a distinction without a difference and does not constitute a good reason to require a debtor to seek permission of its creditor's bankruptcy court to avoid an equitable result in its own case. Alternatively, according to the dissent, Lehman Commercial waived its right to raise automatic stay issues once it filed its proof of claim.

Ultimately, the Palmdale Hills decision represents a warning sign for a debtor in bankruptcy to tread carefully when dealing with claims filed in its own case. In light of the large number of bankruptcy filings in recent months, it may behoove such a debtor intending to equitably subordinate a creditor's claim, to first check the bankruptcy status, if any, of such creditor and avoid violating the creditor's automatic stay if it happens to be in bankruptcy itself.

Authored By:

Robert Sahyan
(415) 774-3146
rsahyan@sheppardmullin.com