Business Bankruptcy Issues

Undersecured creditors face unique challenges because they are neither fully secured nor fully unsecured.  Beyond the obviously undesirable issue of being upside-down on their deal, undersecured creditors often are exposed to preference liability for those payments they received in the 90 days prior to the debtor filing bankruptcy.  This is especially true where an aggressive trustee is looking to create value or where an opportunistic trustee sees a chance to make a quick buck.

Bankruptcy Code section 506 states that a creditor with a claim that is secured by property of the estate has a secured claim up to the value of their collateral and an unsecured claim for the remaining portion of their claim.  Thus, an undersecured creditor’s claim is split, or bifurcated, into secured and undersecured portions.  Fully secured creditors enjoy protection from preference claims by virtue of the fact that payments received in the preference period do not allow them to receive more than they would in a hypothetical chapter 7 liquidation because their fully secured status allows them to get paid in full.

Undersecured creditors face an additional challenge from the unsecured portion of their claim because payments they receive in the preference period may allow them to recover more than they would have in a hypothetical liquidation chapter 7 liquidation.  While undersecured creditors have the same preference defenses available to them as an unsecured creditor, such as receiving payments in the ordinary course or that they provided new value, those defenses may not give quite the same level of comfort as a fully secured claim.  In applying the language of the Bankruptcy Code, the Fifth Circuit in El Paso Refinery provided a two part test for undersecured creditors.

In Krafsur v. Scurlock Permian Corp. (In re El Paso Refinery), 171 F.3d 249 (5th Cir. 1999), the chapter 7 trustee sought to avoid payments made from the debtor to its supplier of crude oil.  The supplier of crude oil shared a floating lien on accounts receivable, inventory, contract rights, and proceeds with the debtor’s prepetition lender pursuant to an intercreditor agreement.  The bankruptcy court ruled that the intercreditor agreement worked as a partial assignment of approximately 55% of the prepetition lender’s interest in the collateral.  The bankruptcy court went on to rule that the same portion of the payments received in the preference period were proceeds from the oil supplier’s own collateral, and, therefore, 55% of the alleged preferential preference payments were unrecoverable.  The district court affirmed and both parties appealed.

The Fifth Circuit reversed and held that none of the payments the oil supplier received were preferential.  In reaching this conclusion, the Fifth Circuit utilized the “improvement in position” or the “greater percentage” test interpreting section 547(b)(5) of the Bankruptcy Code.  The goal of this test is to determine if, by virtue of the payments in the preference period, the creditor received a greater recovery on its debt than it would have otherwise received in a hypothetical chapter 7 liquidation.  While this test is well established for unsecured creditors, the Fifth Circuit conformed its application of the test for undersecured creditors.

The Fifth Circuit stated that for undersecured creditors, two issues need to be resolved: “(1) to what claim the payment is applied and (2) from what source the payment comes.”  The Fifth Circuit refers to these issues as the “Application Aspect” and the “Source Aspect,” respectively.  In order to satisfy the Application Aspect of the test, the payments must be applied to the secured portion of the undersecured creditors claim, and the undersecured creditor must correspondingly reduce the secured portion of its claim.  If the undersecured creditor does not correspondingly reduce the secured portion of its claim, the payment is considered a payment on the unsecured portion of the claim.  To satisfy the Source Aspect of the test, the payments the undersecured creditor receives must come from its own collateral.  The Fifth Circuit reasoned that a creditor which merely receives its own collateral cannot be receiving any more than it would have in a hypothetical liquidation, and creditors with an interest in accounts receivable or other cash equivalents are automatically receiving a payment from their own collateral.

As a result of the language referring to undersecured creditors generally, it was unclear whether this test was meant to replace or supplement the existing hypothetical liquidation analysis under section 547(b)(5) for undersecured creditors.  The Fifth Circuit addressed this ambiguity in Garner v. Knoll, Inc. (In re Tusa-Expo Holdings Inc.), 811 F.3d 786 (5th Cir. 2016).

In Tusa-Expo, a chapter 7 trustee brought an action to avoid payments made to an office furniture supplier by an office furniture dealer.  The office furniture supplier had first-priority lien on certain of the debtor’s accounts receivable and a second-priority lien on all other and after acquired property.  The bankruptcy court, in a belt and suspenders approach, punted on determining whether to conduct the analysis in El Paso Refinery or a section 547(b)(5) hypothetical chapter 7 liquidation analysis and conducted both.  The bankruptcy court subsequently found that under both analyses the payments received by the office furniture supplier in the preference period were not preferences.  The district court affirmed, albeit for different reasons.

The Fifth Circuit resolved the issue regarding the proper standard to apply by stating that  a court could alleviate the need to conduct a typical hypothetical liquidation analysis by conducting the analysis under El Paso Refinery first.  If under the El Paso Refinery analysis the payments are not found to be preferential, that analysis is dispositive of the preference issues.  In the event that the El Paso Refinery standard is not met, the trustee is still required to establish that the undersecured creditor received more than would have received in a hypothetical chapter 7 liquidation.  As a result, the Fifth Circuit made clear that the El Paso Refinery analysis is a threshold which is intended to aid a section 547(b)(5) analysis rather than replace it.  In so concluding, the Fifth Circuit affirmed the holdings of the bankruptcy and district courts.

Tusa-Expo addresses the issues left open by El Paso Refinery and makes clear that the analysis in El Paso Refinery is merely a shortcut to potentially avoid a hypothetical chapter 7 liquidation analysis.  While the test in El Paso Refinery and the clarifying holding in Tusa-Expo do not change the outcome for a hypothetical liquidation analysis under section 547(b)(5), they do provide an additional and valuable front on which to challenge a trustee’s preference claims.  For those undersecured creditors that do not have an interest in the debtor’s accounts receivable or other cash equivalents, Tusa-Expo makes clear that that they still have the same tools available as any other creditor accused of receiving preferential payments.  While this holding is not a boon for undersecured creditors without an interest in accounts receivable or the like, it does clear up any unnecessary confusion about the scope and applicability of the standard in El Paso Refinery.

Short Summary

In In re AE Liquidation, Inc., 866 F.3d 515 (3d Cir. 2017), the Third Circuit answered two important legal questions under the Worker Adjustment and Retraining Notification Act of 1988 (the WARN Act).  First, the Third Circuit held that when a corporation is sold as a going concern, there is a presumption that the sale involves the hiring of the seller’s employees, “regardless of whether the seller has expressly contracted for the retention of its employees.”  Id. at 526.  Second, the Third Circuit held that, under the WARN Act, in determining whether a mass layoff was caused by “unforeseeable business circumstances,” a mass layoff is “reasonably foreseeable” only if it is “probable.”  Id. at 528.  The Court’s holding is more thoroughly examined below.

The WARN Act

The WARN Act “was enacted by Congress in 1988 to provide limited protections to workers whose jobs are suddenly and permanently terminated [and] generally precludes an ‘employer’ from ordering a ‘plant closing or mass layoff’ until the expiration of a sixty-day period after giving written notice.”  Laura B. Bartell, Why Warn?-the Worker Adjustment and Retraining Notification Act in Bankruptcy, 18 Bankr. Dev. J. 243, 243 (2002).

The WARN Act contains three exceptions to the this sixty-day notice period, but only one—the “unforeseeable business circumstances” exception—was presented to the Court in AE Liquidation.  29 U.S.C. § 2102(b)(2)(A) sets forth the “unforeseeable business circumstances” exception to the WARN Act’s notice requirements, and simply states that “[a]n employer may order a plant closing or mass layoff before the conclusion of the 60-day period if the closing or mass layoff is caused by business circumstances that were not reasonably foreseeable as of the time that notice would have been required.”  As the Third Circuit explained, this “exception must be offered by the employer as an affirmative defense” and “the employer must demonstrate (1) that the business circumstances that caused the layoff were not reasonably foreseeable and (2) that those circumstances were the cause of the layoff.”  AE Liquidation, 866 F.3d at 523.

The Code of Federal Regulations, at 20 C.F.R. § 639.9(b), provides additional guidance on this exception, explaining that (1) “[a]n important indicator of a business circumstance that is not reasonably foreseeable is that the circumstance is caused by some sudden, dramatic, and unexpected action or condition outside the employer’s control” and (2) “[t]he test for determining when business circumstances are not reasonably foreseeable focuses on an employer’s business judgment.”  Id. at § 639.9(b)(1)-(2).

Factual Background

The plaintiffs-appellants were former employees of the Debtor, Eclipse Aviation Corporation (Eclipse), who were laid off when the Eclipse’s § 363 sale to its largest shareholder fell through.  That sale, which would have allowed the Eclipse’s operations to continue as a going concern, was contingent upon funding from Vnesheconomban (VEB), a state-owned Russian Bank.  As the Third Circuit explained, “[f]or a month, Eclipse waited for the deal to go through with almost daily assurances that the funding was imminent and the company could be saved, but eventually, as those assurances failed to bear fruit, the time came when it was forced to cease operations altogether.”  AE Liquidation, 866 F.3d at 518.  As a result, on February 24, 2009—nearly two weeks after Eclipse had become administratively insolvent—Eclipse’s board of directors instructed Eclipse’s attorneys to file a motion to convert the case to a Chapter 7 liquidation.  Id. at 522.  As soon as the motion was filed, Eclipse emailed all of its employees and informed them that Eclipse was being liquidating and all employees were being laid off.  Id.

The Third Circuit’s Holding

The Third Circuit addressed two important legal questions left unresolved by the Code of Federal Regulations.  The first was the question of causation—what proof is needed to show that the “allegedly unforeseeable event was, in fact, the cause of the layoff”?  Id. at 525.  The second was the question of foreseeability—“what makes a business circumstance ‘not reasonably foreseeable’”?  Id. at 528.

The Court’s first ruling was simple—when a business is being sold as a going concern, the Court presumes that “that the sale ‘involves the hiring of the seller’s employees unless something indicates otherwise,’ regardless of whether the seller has expressly contracted for the retention of its employees.”  Id. at 526.  More importantly, the Court held that although the terms of the purchase agreement “freed ETIRC from any binding obligation to retain Eclipse’s employees and prevented it from incurring liabilities were it not to retain them,” this fact did not rebut the presumption.  Id. at 527.  As the Third Circuit explained, “[w]hile such boilerplate language perhaps signifies that the sustained employment of Eclipse’s workforce was not a foregone conclusion, it does not rebut the presumption in favor of continued employment in a going concern sale.”  Id.   By applying this presumption, the Third Circuit aligned itself with the Eighth and Ninth Circuit, which made similar holdings in Wilson v. Airtherm Prod., Inc., 436 F.3d 906 (8th Cir. 2006) and Int’l All. of Theatrical & Stage Employees & Moving Picture Mach. Operators, AFL-CIO v. Compact Video Servs., Inc., 50 F.3d 1464, 1468 (9th Cir. 1995).

The Court’s ruling on foreseeability similarly brought the Third Circuit in line with other Circuits.  Citing to the Fifth Circuit’s holding in Halkias v. Gen. Dynamics Corp., 137 F.3d 333, 336 (5th Cir. 1998), the Third Circuit explained that “anything less than a probability would be ‘impracticable.’”  AE Liquidation, 866 F.3d at 529.  The Third Circuit examined this proposition, and agreed with the Fifth Circuit, explaining that “there are significant costs and consequences to requiring these struggling companies to send notice to their employees informing them of every possible ‘what if’ scenario and raising the specter that one such scenario is a doomsday… premature warning has the potential to accelerate a company’s demise and necessitate layoffs that otherwise may have been avoided.”  Id.  By so holding, the Third Circuit joined the Fifth, Sixth, Seventh, Eighth and Tenth Circuit in determining that “more probable than not” is the appropriate standard for foreseeability under the WARN Act.  See Halkias, 137 F.3d 333; Watson v. Michigan Indus. Holdings, Inc., 311 F.3d 760, 765 (6th Cir. 2002); Roquet v. Arthur Andersen LLP, 398 F.3d 589 (7th Cir. 2005); United Steel Workers of Am. Local 2660 v. U.S. Steel Corp., 683 F.3d 882 (8th Cir. 2012); Gross v. Hale-Halsell Co., 554 F.3d 870 (10th Cir. 2009).

Applying these holdings to the facts of the case, the Court found that Eclipse had met its burden of demonstrating the “unforeseeable business circumstances” exception to WARN Act liability.  As the Court explained, “[u]nder the circumstances, and taking account of the historical relationship between the [Eclipse and its majority shareholder], it was commercially reasonable for Eclipse to believe that the sale was still at least as likely to close as to fall through before February 24th, so that no WARN Act notice was required prior to that time.”  In re AE Liquidation, Inc., 866 F.3d 515, 533 (3d Cir. 2017).

Conclusion

WARN Act issues arise often during bankruptcy proceedings.  Although the facts of AE Liquidation present a rare scenario—where WARN Act liability arose as a result of a failed sale process—the Third Circuit’s holding in AE Liquidation addresses two fundamental issues in the “unforeseen business circumstances” exception to WARN Act liability—causation and foreseeability.  The Third Circuit’s holding brings needed certainty to these issues and therefore greater certainty to the bankruptcy process.

Court: “You know, every piece of information and fact out there is within six degrees of separation of the debtors’ assets and financial affairs. The question is where do you draw the line?”

4/20/17 Transcript of hearing in In Re SunEdison, Inc., et al, Case No. 16-10992-smb (hereinafter “TR”), page 30 lines 6-11.

The Issue.  An issue of first impression appears to have arisen recently in a case pending before United States Bankruptcy Judge Stuart Bernstein in the United States Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”). In the Chapter 11 Case, In re: SunEdison Inc., et al., 16-10922 (SMB) (the “Debtors”), the Bankruptcy Court directed supplemental briefing on the question of whether a debtor is entitled to Bankruptcy Rule 2004 discovery into non-debtor litigation, because the outcome of that litigation may have an effect on the value of a significant asset of the bankruptcy estate of the Debtor. At the hearing where the issue arose, the Bankruptcy Court noted that it had been unable to find a case directly on point, and at the hearing the parties to the matter were not able to identify any such cases.  Spoiler alert—as of the date this blog was prepared, the Bankruptcy Court had not yet ruled; an update will be provided when it does so. While we hold our breath waiting for the Bankruptcy Court’s ruling, here is the background and where the six degrees of separation fit in (further spoiler alert: here, the six degrees of separation have nothing to do with Kevin Bacon).

Background: The debtor, SunEdison, Inc. (“SunE”) commenced its chapter 11 case on April 21, 2016, together with twenty-five affiliated co-debtor entities, with additional affiliated co-debtors thereafter filing voluntary petitions  (collectively, the “Chapter 11 Cases”). The Chapter 11 Cases have been consolidated for procedural purposes only and are being jointly administered.  Notably absent from the Chapter 11 filings were two entities that are referred to in the Chapter 11 Cases as the non-debtor publicly traded “YieldCo” subsidiaries of SunE, TerraForm Power, Inc. (“TERP”), and TerraForm Global, Inc. (“GLBL,” and together with TERP, the “YieldCos”). According to SunE, SunE holds a majority equity stake in TERP and approximately 33% equity stake in GLBL.

In 2014, SunE and TERP, as buyers, had entered into a contract to purchase from D.E. Shaw Composite Holdings, L.L.C. (“DESCO”) and Madison Dearborn Capital Partners IV, L.P. (“MDP” and, together with DESCO, “Plaintiffs”) a company named First Wind, an energy company that owned and developed wind and solar energy. Thereafter a dispute arose and on April 3, 2016, prior to the commencement of the Chapter 11 Cases, Plaintiffs filed a lawsuit in New York Supreme Court against TERP seeking a declaratory judgment as to TERP’s obligations (the “First Wind Litigation”). The Debtors are not a party to that litigation.  Upon SunE declaring bankruptcy in April 2016, Plaintiffs asserted that an acceleration event had occurred, and Plaintiffs filed an amended complaint in State Court asserting a claim for breach of contract for TERP’s failure to make what Plaintiffs assert is a $231 million in the aggregate “Accelerated Earnout Payment” as one of the two buyers under the purchase agreement, and for TERP’s failure to comply with its obligations as guarantor.

The Rule 2004 Motion and the Debtors’ Position.  In a motion filed jointly by the Debtors and TERP ( the “Rule 2004 Motion”), they sought the entry of an order of the Bankruptcy Court pursuant to Bankruptcy Rule 2004 seeking the production of documents by Plaintiffs and reserving the right to seek depositions[ Docket No. 2692].

According to the Debtors, on March 6, 2017, TERP and Brookfield Asset Management Inc. and its affiliates (“Brookfield”) entered into a definitive agreement under which Brookfield agreed to acquire a controlling interest in TERP (the “Brookfield Acquisition”), with SunE retaining a minority equity interest.  Pursuant to this transaction, the Debtors asserted that the Debtors’ estates stood to realize in excess of $800 million in cash and TERP equity and that, accordingly, the disposition of TERP is “critically important” to the formulation of a plan of reorganization of the Debtors, as well as to the proceeds available for distribution to secured and unsecured creditors of the estates.  Although the Brookfield Acquisition is not contingent upon resolution of Plaintiff’s claim against TERP, any liability with respect to these claims would, said the Debtors, reduce the value of the equity in TERP retained by SunE after the Brookfield Acquisition. The Debtors further contend that (a) uncertainty about the nature or magnitude of these claims could therefore complicate the financing and implementation of the Debtors’ plan of reorganization, which is premised, in part, on the value of the Debtors’ retained TERP equity; and, in addition, (b) the Brookfield Acquisition is subject to approval by TERP’s public stockholders, and the strength of Plaintiff’s claims against TERP may potentially be important to them.

The discovery is necessary, said the Debtors and TERP, so that SunE and TERP would be able to mitigate any concerns that SunE’s financing sources and TERP’s stockholders may have about the claims of Plaintiffs.  Also, contended Debtors and TERP, the discovery would demonstrate that Plaintiff’s claims against TERP were not colorable, on the basis that the First Wind Action depended entirely on Plaintiff’s interpretation of an ambiguous clause of the 2014 purchase agreement that parol evidence would not support. According to the Debtors, without discovery, Plaintiffs would be in a position to interfere with the Brookfield Acquisition and its benefits to SunE and TERP stakeholders.

Plaintiffs’ Initial Objection.  In their initial objection to the Rule 2004 Motion, Plaintiffs argued that the Rule 2004 Motion should be denied as a flagrant violation of the “pending proceeding” rule prohibiting the use of Rule 2004 to obtain or circumvent discovery in pending litigation. There was, argued Plaintiffs, no uncertainty about the nature or magnitude of Plaintiffs’ claims as the 2004 Motion alleges, the claims for breach asserted in the First Wind Litigation were unambiguous, and TERP failed to take discovery in the First Wind Litigation in the State Court.  Furthermore, according to Plaintiffs, the requested Rule 2004 discovery should also be rejected as wholly unnecessary for plan confirmation in the bankruptcy or in support of the Brookfield Acquisition [Docket No. 2783].

While Plaintiffs acknowledged that generally under Bankruptcy Rule 2004 a Bankruptcy Court may, on a motion, “order the examination of any entity” into “the acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate,” Fed. R. Bankr. P. 2004(a)-(b), it argued that even Rule 2004 examinations have limits.  As argued by Plaintiffs, under the “Pending Proceedings” limitation, parties are precluded from obtaining discovery through Bankruptcy Rule 2004 when proceedings are pending in another forum, and under those circumstances courts have held that discovery should be pursued under the Federal Rules of Civil Procedure or equivalent procedures governing discovery in state court proceedings.

The Bankruptcy Court Hearing.   At the Bankruptcy Court hearing on the Rule 2004 Motion conducted on April 20, 2017, the Bankruptcy Court played devil’s advocate with both sides.  First, as to the Debtors, the Bankruptcy Court noted that in the Rule 2004 Motion, the Debtors did not really appear to seek discovery regarding the claims filed by the Plaintiffs in the Chapter 11 Cases, but, rather, the discovery was directed at non-debtor TERP’s liability to the Plaintiffs. On this point the Bankruptcy Court queried the Debtors’ counsel:

THE COURT: Let me ask you a question. Suppose that a debtor’s most important customer is involved in litigation outside of bankruptcy, and if it loses that litigation, the customer’s going to go out of business. Would a debtor have the right to get discovery from the other party in that litigation regarding the strength of that claim? Because that’s really what you’re saying.

TR page 26, lines 11-17.

The Court pressed the point by asking Debtors’ Counsel:

THE COURT: Let’s suppose you’re an individual Chapter 11 debtor and your most significant asset is Microsoft stock. Microsoft is involved in a patent litigation in Seattle with some third party, and the outcome of that action would affect the value of your stock. Do you think you could….
insist in bankruptcy court through [Rule] 2004 that that adversary has to turn over information so you can gauge the strength of its patent claim?….

TR page 27, lines 23-25; page 281-2, 8-10.

Six Degrees of Separation.  After colloquy with Debtors’ counsel regarding the propriety of a 2004 examination in connection with third party litigation (litigation to which the debtor was not a party) on the basis that the outcome of that litigation could have an effect on the value of the debtor’s assets, with counsel for the Debtors pressing that the examination is appropriate because it concerns the Debtors assets,  the Bankruptcy Court made the statement quoted at the beginning of this article: “You know, every piece of information and fact out there is within six degrees of separation of the debtors’ assets and financial affairs. The question is where do you draw the line?”

The Bankruptcy Court likewise played devil’s advocate with Plaintiffs’ counsel and queried why couldn’t the Debtors take Rule 2004 discovery to determine the value of its interest in TERP and on why the transaction with TERP should be approved.

Bankruptcy Court’s Preliminary Ruling and Request for Supplemental Briefing. Ultimately, the Bankruptcy Court denied the Rule 2004 Motion as to TERP on the basis of the Pending Proceeding Rule.  As to the Debtors, however, after the Bankruptcy Court noted that it had looked for but had not found any cases on point, the Bankruptcy Court provided the parties with additional time to respond to the Bankruptcy Court’s questions.

The Debtors’ Supplemental Response. In the Debtors’ supplemental response (the supplemental responses were filed simultaneously), they asserted that the broad examination of third parties concerning the value of a debtor’s assets, or to aid in discovery of assets, is permitted under Rule 2004.  In support, the Debtors cited several cases that permitted such discovery, including with respect to the value of a debtor’s stock in several third parties, and the value of a debtor’s interest in real property.  The Debtors further asserted that Plaintiffs qualified as potential examinees under Rule 2004, citing this language from In re Ionosphere Clubs, Inc., 156 B.R. 414, 432 (Bankr. S.D.N.Y. 1993): “Because the purpose of the Rule 2004 examination is to aid in the discovery of assets, any third party who can be shown to have a relationship with the debtor can be made subject to a Rule 2004 investigation.” The Debtors also pointed out that the Plaintiffs were not just any third parties, as they had filed proofs of claim that were the subject of the First Wind Litigation, and therefore the First Wind Litigation was related to the Chapter 11 Cases [Docket No. 2901].

The Plaintiffs’ Supplemental Response.   In the Plaintiffs’ supplemental response, the Plaintiffs contend that Rule 2004 does not support the broad application that the Debtors urge the Bankruptcy Court to adopt, that to the extent courts have permitted Rule 2004 examinations of third parties, the purpose of such examinations was not to assess the potential outcome of a third party litigation, and allowing a Rule 2004 examination in connection with the Third Wind Litigation would be an impermissible interference in a pending litigation to which the Debtors are not a party [Docket No. 2902].

Stay Tuned. Whether the Bankruptcy Court finds the supplemental responses were in fact responsive to the questions posed by the Bankruptcy Court, and were persuasive, remains to be seen.  We will follow up once a decision is rendered by the Bankruptcy Court.  Ideally, the decision will answer the question, at least in this Bankruptcy Court, of within how many degrees of separation does an issue need to be for it to be subject to examination pursuant to Bankruptcy Rule 2004.

On January 6, 2017, Judge Robert D. Drain of the Bankruptcy Court for the Southern District of New York orally approved a prepackaged plan of reorganization (a “Prepack”) in In re Roust Corporation, et al. (Case No. 16-23786), only seven days after Roust Corporation (“Roust Corp”) and two of its affiliates, CEDC Finance Corporation LLC (“CEDC Finco”) and CEDC Finance Corporation International, Inc. (together with Roust Corp, the “Debtors”), filed petitions for relief under Chapter 11.  By having a plan of reorganization confirmed in only seven days, In re Roust became the fourth shortest Chapter 11 reorganization in recent history, and the shortest in the Southern District of New York (Judge Drain noted that the average length of a true prepack in SDNY is thirty-five days).  This blog post examines the seven most important steps the Debtors took to achieve such a speedy confirmation, and, along the way, highlights several notable legal holdings made by Judge Drain at confirmation.

The Facts and Circumstances of In re Roust

The Debtors and the Debt

The Debtors, all holding companies, filed petitions for relief under Chapter 11 on December 30, 2016 (the “Petition Date”).  Roust Corp, the lead Debtor, wholly owned, directly or indirectly, the equity in several dozen non-Debtor affiliated entities (the “NDEs” and, together with the Debtors, the “Roust Group”).  Through its operating entities, the Roust Group comprised one of the largest vodka producers in the world and the largest integrated spirit beverages business in Central and Eastern Europe.  Roust Corp was ultimately wholly owned by a single individual—Roustam Tariko (“Tariko”), the founder and sole owner of the conglomerate known as the Russian Standard Group (“Russian Standard”), whose enterprises include Russian Standard Vodka (“RSV”), the largest domestic distiller and distributor of Vodka in Russia, and Russian Standard Bank, one of the largest Russian banks and leading consumer lender in Russia.  Tariko, through Russian Standard, wholly owned Roust Trading Limited (“RTL”), which itself owned 100% of the equity in Roust Corp and, therefore, 100% of the Roust Group.

Tariko and Russian Standard acquired the Roust Group through the Chapter 11 reorganization of Central European Distribution Corporation (“CEDC”), which filed for Chapter 11 relief in the District of Delaware in 2013 (Case No. 13-10738-CSS).  RTL had held a 19.5% equity stake in CEDC prior to its 2013 bankruptcy and, through a substantial capital contribution in CEDC’s Plan of Reorganization, acquired 100% of the equity in the reorganized CEDC, which was subsequently renamed Roust Corp.

As part of CDEC’s plan of reorganization in 2013, CEDC Finco was created and issued two set of notes: the Senior Secured Notes and the Senior Convertible PIK Notes (the “Convertible Notes” and, together with the Senior Secured Notes, the “Noteholders”), both due 2018.  At the time of the Debtors’ filing in 2016, approximately $488 million in principal of the Senior Secured Notes and $279 million in principal of the Convertible Notes were outstanding.  Although the NDE’s had various debts and credit facilities outstanding at the Petition Date, the Debtors did not propose to alter or impair any debts owed to non-Russian Standard third parties.

The Plan

Simultaneously with their petitions for relief, the Debtors filed their Amended and Restated Joint Prepackaged Plan of Reorganization (the “Plan”) [Docket No. 8].  On January 6, 2017, Judge Drain held a hearing at which he approved confirmation of the Debtors’ Plan [Docket No. 39] and on January 10, 2017, Judge Drain issued his Findings of Fact, Conclusions of Law and Order Approving Confirmation (the “Confirmation Order”) [Docket No. 41].  The Debtors provided two reasons for why it was necessary to have the Plan confirmed so quickly: (1) there was a severe stigma attached to bankruptcy in the Eastern European markets in which the NDEs operated and (2) the Roust Group was required to pay significant exist taxes in Russia in January, and the capital infusion provided for in the Plan was necessary for those taxes to be paid.  Confirmation Transcript [Docket No. 39] at p. 21, ln. 23 – p. 22, ln. 21.

The Plan impaired only three classes: the Senior Secured Notes, the Convertible Notes and Roust’s equity holder, RTL.  First, the Plan provided for the Senior Secured Notes to receive new senior secured notes in principal amount of $385 million at 10% interest, cash consideration of $20 million, the right to participate in a $55 million rights offering (the “Share Placement”) and a debt-to-equity conversion for 12.08% of the common stock in Reorganized Roust.  Second, the Plan provided for the Convertible Notes to receive 10.59% of the equity in Reorganized Roust through a debt-to-equity conversion, an additional 1.00% of equity contributed from Russian Standard and the right to participate in the Share Placement.  Finally, Russian Standard, through RTL, was to receive 57.04% of the equity in Reorganized Roust in exchange for contributing Russian Standard Vodka to Reorganized Roust and forgiving $116 million of debt owing from Roust and RSV to RTL and its non-Roust subsidiaries.  Additionally, $100 million owed to Roust by RTL and its non-Roust subsidiaries was deemed repaid.

The Plan also contained two broad categories of releases: (1) “Releases by the Debtors” [Art. 9(B)] and (2) “Releases by Holders of Claims” [Art. 9(C)].  Under Art. 9(B), the Debtors released all claims against the “Released Parties,” which included Noteholders, Notes Trustees, RSV, RTL, Russian Standard, the NDEs and all of the foregoing’s affiliates, subsidiaries, managers, etc.  Under Art. 9(C), the definition of “Holders of Claims” was all-encompassing; thus, every creditor and interest holder in the case was releasing the Released Parties.

Seven Steps to Confirmation in Seven Days

The long term significance of Roust is contingent on whether it provides clear guidelines for how, and under what circumstances, such a quick path to confirmation can be achieved.  The Seven Steps detailed below are an attempt to summarize the facts and legal issues Judge Drain focused on during the Confirmation Hearing, and, more importantly, the reasons Judge Drain found those facts and legal issues significant.  Some of these steps involve relatively unique features of In re Roust—but even the most unique features can be partially replicated in other cases.  For example, an extremely important feature in In re Roust was the fact that Tariko wholly owned the Russian Standard Group and therefore had the unilateral power to grant releases to the Debtors and NDEs.  While this fact was influential because it removed the need for Judge Drain to conduct an exhaustive analysis of the propriety of those releases, Judge Drain’s questions and comments during the Confirmation Hearing made clear that the more the Debtors accomplished through private contractual arrangements, and the less they invoked the coercive power of the Bankruptcy Court, the more comfortable he was with confirming the Plan in such a short period of time.  It is the lesson, not the fact, that might prove significant for prospective debtors attempting to secure a speedy confirmation of a prepackaged plan.  It goes without saying that following the seven steps below won’t guarantee confirmation in seven days; every Debtor and every Judge has different issues and concerns that must be addressed.

Step 1.  Secure Overwhelming—Preferably Unanimous—Support from All Impaired Classes under the Plan

First and foremost, Judge Drain made clear that such a quick confirmation would be all but impossible without the overwhelming support of creditors.  All parties impaired by the Plan—Russian Standard, the Senior Secured Noteholders and the Convertible Noteholders—unanimously supported the plan.  Not a single Noteholder voted against the Plan, with, by aggregate value, 90% of the Senior Notes and 93% of the Convertible Notes voting in favor of confirmation.  Confirmation Transcript at p. 8, ln. 24 – p. 9, ln. 6.  In contrast, only two parties objected to the Plan: the U.S. Trustee (the “Trustee”) and the IRS, and the latter’s objection was resolved consensually prior to the Confirmation Hearing.

The Trustee made numerous objections, but devoted most of its written objection to four issues: (1) insufficient notice; (2) unconfirmable non-Debtor releases; (3) inadequate evidence of feasibility; and (4) improper allowance of administrative claims for professionals retained by the Noteholders.  U.S. Trustee’s Objection, Docket No. 22, at p. 11-20.  And Judge Drain, in overruling the first three objections, repeatedly cited the impaired classes’ overwhelming support of the Plan as a basis for his rulings.  When considering whether notice was sufficiently given, Judge Drain twice noted the sheer size of the Plan’s support.  Confirmation Transcript at p. 40, ln. 3-5, p. 43, ln. 18-19.  When considering the accuracy of the Debtors valuation, he reasoned that the overwhelming support of the impaired classes implied an accurate valuation.  Confirmation Transcript at p. 72, ln. 8-14.  When determining the propriety of the Plan’s releases, he noted that “the parties affected by it, now, have voted unanimously in favor of the Plan” and that “the lack of any objecting party with an economic stake” implied “that such parties are not aware of any potentially valuable claims against any of the released parties.”  Confirmation Transcript at p. 85, ln. 17 – p. 86, ln. 2, p. 86, ln. 24 – p. 87, ln. 8.

Step 2.  Give Notice—Lots of Notice

Second, the Debtors went above and beyond the requirements of the Code in giving pre-petition notice to the interested parties of both the terms of the Plan and the accelerated timeline in which the Debtors were seeking to confirm the Plan.  First, nearly two months prior to filing, the Debtors sought and received a tentative date for their combined hearing on the Disclosure Statement and confirmation of the Plan.  Second, on December 1, 2016, the Debtors mailed notice of the combined hearing to all parties in interest, mailed their solicitation materials and ballots to all parties entitled to vote upon the Plan and posted all of these documents online with Epiq Bankruptcy Solutions, LLC (“Epiq”) the Debtors’ voting and noticing agent.  Third, the Debtors published notice of the hearing in the international edition of the Financial Times.

This, however, was not enough for the Trustee, who objected on the grounds that the Debtors had not met the notice requirements of Bankruptcy Rule 3017, which requires that holders and claims and interests be given at least 28 days notice of the hearing on approval of the DS, and Bankruptcy Rule 2002, which requires 28 days notice of the deadline for filing objections to approval of the DS.  U.S. Trustee’s Objection at pp. 11-14.  The Trustee also argued that the Debtors had failed to give “any party in interest any ability to object because the objection deadline passed even before the Petitions were actually filed.”  Id. at p. 14.

Judge Drain, however, disagreed, on the basis that “Bankruptcy Rule 2002 provides for twenty-eight days’ notice.  It doesn’t say twenty-eight days after the Petition Date.”  Confirmation Transcript at p. 36, ln. 11-13.  As he explained, the Bankruptcy Code clearly contemplates prepackaged plans of reorganization and neither Bankruptcy Rule 2002 nor Rule 3007 tie their required notice periods to the date of the petition.  Id. at p. 44-45.  Thus, so long as the notice was not deficient and twenty-eight days’ notice was given to the required parties, “you’ve complied with the rules.”  Id. at p. 37, ln. 11-16.  Judge Drain also rejected the Trustee’s contention that the parties in interest lacked the ability to object, noting that (1) the parties in interest were still given thirty days to object (by mailing an objection to the Debtors pre-petition) and (2) the Court would have given any objecting party more time if someone had requested additional time.  Id. at p. 42, ln.. 4-9.

This is perhaps the most significant legal ruling in In re Roust; as Judge Drain noted, the average duration of a prepack “is about thirty-five days.”  Id. at p. 45, ln. 13.  Although few prepacks might have the necessary characteristics that allow confirmation seven days after filing, many prepacks may have some of these characteristics, which may enable confirmation fifteen, twenty, or twenty five days after filing.  Although many prospective debtors will have substantial reasons not to publicly disclose their impending bankruptcy filing—most notably, publicly traded companies or debtors with significant confidentiality concerns—Judge Drain’s interpretation of Bankruptcy Rules 2002 and 3007 pave the way for debtors without need of confidentiality to significantly shorten the period of time they spend in Chapter 11.

Step 3.  Identify All of Your Unsecured Creditors

Perhaps the most unusual characteristic of In re Roust, in comparison to a typical corporate Chapter 11 case, was the unsecured creditor pool.  First, because all three Debtors were holding companies, they had only eleven unsecured creditors.  Id. at p. 26, ln. 10 – p. 27, ln. 5.  Second, all of these unsecured creditors were professionals, a fact that proves significant in Step Four.  Id. at p. 27, ln. 1-5.  Third, the Debtors had identified each unsecured creditor specifically and had given notice of the confirmation hearing to each unsecured creditor individually.  Id. at p. 33, ln. 19 – p. 34, ln. 16.  The de minimis number of unsecured creditors, the Debtors’ specific identification and noticing of each unsecured creditor, and the fact that the unsecured creditors were not being impaired, combined, seemed to play a significant role in minimizing any concerns Judge Drain may have had regarding the adequacy of notice by making it extremely reasonable for Judge Drain to infer that it was highly unlikely that any unsecured creditors had not been given notice and a chance to be heard.

Step 4.  Demonstrate that All Interested Parties, Especially Impaired Parties, Are Sophisticated and Capable of Protecting Their Own Interests

Fourth, the fact that all of the Debtors’ creditors were sophisticated parties clearly increased Judge Drain’s comfort with the notice given by the Debtors and with the speed of confirmation.  In responding to the Trustee’s assertion that it wasn’t clear whether the unsecured creditors were sophisticated enough to know if they should, or even how to, object to confirmation, Judge Drain immediately responded that “looking at who they are, I think they are.”  Confirmation Transcript at p. 39, ln. 20 – p. 40, ln. 11.  In overruling the Trustee’s objection that insufficient or inadequate notice had been given, Judge Drain specifically noted that “this is not a request to bless a notice to moms and pops or even dentists and doctors.”  Id. at p. 49, ln. 6-13.  Similarly, in approving the Disclosure Statement, Judge Drain found it important that “the people who are impaired here are all qualified institutional investors” and therefore the Disclosure Statement was sufficient “under the securities laws, too.”  Confirmation Transcript at p. 50, ln. 20 – p. 51, ln. 11.  Finally, in approving the releases under the Plan, Judge Drain noted that “with sophisticated advisors and they [the Noteholders] themselves being sophisticated,” the release language in the ballots and the Plan more than sufficiently “warned parties of their contents.”  Id. at p. 85, ln. 17-25.

In short, the sophistication of the parties in interest belied any concern Judge Drain may have had that seven days from filing to confirmation was too short a time for the affected parties to digest the terms of the Plan or to determine how their interests would be affected.  In combination with the overwhelming support of the Noteholders, and the miniscule number of unsecured creditors, it appears that Judge Drain concluded that elongating the case would serve no useful purpose.

Step 5.  Achieve as Much as Possible Through Contractual Arrangements and Minimize Usage of the Coercive Power of the Bankruptcy Court

In contrast to the Trustee’s objections, Judge Drain’s focus was on ensuring that the Plan distinguished between (1) what actions in the Plan Judge Drain was ordering under the authority of the Bankruptcy Code and (2) what actions in the Plan were occurring as the result of private negotiations by and among the Debtors, Noteholders and Russian Standard.  In determining that the third party releases in the Plan were appropriate, Judge Drain repeatedly sought clarification from the Debtors that the releases by Russian Standard entities of claims against the Debtors and the NDEs were not being foisted upon Russian Standard by Judge Drain, and instead were being released voluntarily by Russian Standard.  Confirmation Transcript at Transcript at p. 15, ln. 24 – p. 16, ln. 1., p. 40, ln. 24 – p. 41, ln. 4., p. 73, ln. 14 – p. 80, ln. 9.  Similarly, the Plan provided that intercompany claims would be reinstated, but “subject to the express contractual subordination to the new Senior Secured Notes” or “released, waived and discharged, treated as a dividend, or contributed to capital or exchanged for equity.”  Judge Drain noted that such treatment in a plan of reorganization clearly qualified as impairment.  The Debtors, in response, clarified that these intercompany claims were not being altered through the Plan, but through private contractual arrangements among the RSA parties—the language in the Plan merely memorialized these arrangements.  Id. at p. 78, ln. 6 – p. 80, ln. 5.  A similar exchange occurred over the treatment of executory contracts, Id. at p. 77, ln. 17 – p. 78, ln. 2.

Step 6.  Provide a Mechanism of Review for All Post-Petition Professional Fees and Expenses Being Paid under the Plan

The Trustee did, however, unequivocally win one of its objections, although not in the way the Trustee hoped.  Although the Debtors professional were to be compensated through the normal process of § 327 and § 330 of the Code, the Debtors proposed, under Article I(A)(64) and (110) of the Plan, to allow as administrative claims the professional fees and expenses of the RSA Parties and the Notes Trustees without any need for those professionals to apply to the Bankruptcy Court for compensation.  The Trustee argued that the Court’s previous holding in In re Lehman Bros. Holdings Inc., 487 B.R. 181 (Bankr. S.D.N.Y. 2013), vacated and remanded on other grounds, 508 B.R. 283 (S.D.N.Y. 2014) established that that Sections 1123(b)(6) and 1129(a)(4) of the Code could not serve as a basis for paying the professional fees and expenses of creditors without the necessity of filing an application and meeting their evidentiary burden for payment under Section 503(b) of the Code.  Trustee’s Objection at p. 17-20.

Judge Drain disagreed with the Trustee’s arguments, and held that Lehman Brothers should be read narrowly to apply to the professional fees and expenses of official creditors’ committee’s members, and not broadly to all creditors.  Confirmation Transcript at p. 67, ln. 24 – p. 70, ln. 4.  Nonetheless, the Court held that § 1129(a)(4) requires that any fees being paid under that provision be reasonable and be subject to court review” and therefore an objective third party was needed “to make the type of objection that objective third parties make.”  Id. at p. 70, ln. 17-22.  Thus, the Court simply required that Notes Trustees and RSA Parties submit a copy of their professional fees and expenses claims; if the Trustee objected, the Court would determine whether the claims were reasonable, but if the Trustee did not object, the professional claims would be allowed.  Id. at p. 67, ln. 17-19.

Step 7.  Be Flexible and Willing to Compromise

Finally, and perhaps most importantly, Roust demonstrates the importance of flexibility.  A prepack, by its nature, heightens a number of judicial concerns, and those concerns skyrocket when confirmation is sought only seven days after filing.  The Debtors in Roust succeeded in confirming precisely because they were willing to bend on every peripheral issue that was raised.  The Debtors added language to the Plan to resolve nascent objections from White & Case, the largest unsecured creditor, and the IRS.  Judge Drain required at least a dozen clarifications be made in the Plan, all of which the Debtors assented to.  And most notably, the Debtors, in response to Judge Drain’s concerns, volunteered to carve the unsecured creditors entirely out of the third-party releases in the Plan, in order to ensure that the unimpaired status of the unsecured creditors was clear.  Id. at p. 84, ln. 3-8.  Any practitioner wishing to confirm a plan in only seven days must know exactly what the core terms of her Plan are and being willing to concede on everything else.

Conclusions

Ultimately, every case is confirmed on its facts.  In re Roust presents a unique set of facts that may not be widely generalizable.  And although the vast majority of cases will not share the unique facts of In re Roust, those facts were important because they mitigated specific concerns the Court had in confirming a plan shortly after the Petition Date.  Those concerns will be important in any prepack that seeks a speedy confirmation, and the Seven Steps above merely illustrate how these Debtors met them.  It will be interesting to see what creative solutions other debtors craft in the future to address these concerns.

On November 28, 2016, the Supreme Court is scheduled to hear oral arguments in the appeal of Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.), 787 F.3d 173 (3d Cir. 2015), as amended (Aug. 18, 2015), cert. granted sub nom. Czyzewski v. Jevic Holding Corp., 136 S. Ct. 2541 (2016). The question before the Court is whether a bankruptcy court may authorize the distribution of settlement proceeds in derogation of the absolute priority rule; the issue is the subject of a circuit split. Notably, the parties to the case did not ask the Court to consider whether structured dismissals are an appropriate exit vehicle from bankruptcy in spite of the fact that that issue was also discussed by the Third Circuit.

In Jevic, the Third Circuit affirmed a bankruptcy court’s approval of a settlement agreement that skirted the Bankruptcy Code’s priority scheme and brought about the structured dismissal of the debtors’ cases.¹ Although the Third Circuit made apparent its reluctance to affirm Jevic’s class-skipping settlement agreement, it found that, unlike plans, settlement agreements are not required to comply with the absolute priority rule. Nevertheless, it opined that “[i]f the ‘fair and equitable’ standard is to have any teeth, it must mean that bankruptcy courts cannot approve settlements and structured dismissals devised by certain creditors in order to increase their shares of the estate at the expense of other creditors.” Accordingly, it held that the absolute priority rule may be circumvented in the context of a settlement agreement if a court has “specific and credible grounds to justify [the] deviation.” In Jevic, the Third Circuit found that the structured dismissal at issue did, in fact, justify a deviation from the absolute priority rule in light of the fact that the debtor was facing administrative insolvency and had no viable means to exit bankruptcy absent the structured dismissal route and, most importantly, the structured dismissal was not “contrived to evade the procedural protections and safeguards of the plan confirmation or conversion processes.”

While at odds with the Fifth Circuit’s decision in U.S. v. AWECO, Inc. (In re AWECO, Inc.), 725 F.2d 293 (5th Cir. 1984), the Third Circuit noted that its approach aligns with that of the Second Circuit, which has found that although compliance with the absolute priority rule is the most important factor in determining if a settlement is “fair and equitable,” a settlement that does not adhere to the priority scheme may be approved if other factors weigh heavily in its favor. Motorola, Inc. v. Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 478 F.3d 452 (2d Cir. 2007) (expressing approval for one deviation from the priority scheme but remanding for more information to justify a different deviation). But cf. AWECO, 725 F.2d 293 (a settlement is “fair and equitable” only if it complies with the Bankruptcy Code’s priority scheme).

The case has garnered significant interest from third parties. For example, numerous scholars have submitted amicus briefs in support of the Third Circuit’s decision, arguing that imposing the absolute priority rule’s requirements on settlement agreements would expand existing law and limit debtors’ chapter 11 exit strategies. See generally, Brief for Amici Curiae Law Professors David Gray Carlson et al. Supporting Respondents, Czyzewski v. Jevic Holding Corp. (No. 15-649); Brief for Amici Curiae Law Professors Jagdeep S. Bhandari et al. Supporting Respondents, Czyzewski v. Jevic Holding Corp. (No. 15-649). These scholars emphasize the importance of flexibility in the bankruptcy process and the longstanding tradition of allowing parties-in-interest to craft unique, if imperfect, solutions for the benefit of the greater good. They caution that rigid application of the absolute priority rule would hamper the efforts of bankruptcy courts and all of their constituencies in fashioning constructive solutions to complicated problems.

On the other hand, Acting Solicitor General Ian Heath Gershengorn filed an amicus brief advocating for Jevic’s reversal, arguing that the absolute priority rule does indeed apply to settlements. Brief for the United States as Amicus Curiae Supporting Petitioners, Czyzewski v. Jevic Holding Corp. (No. 15-649). The United States was motivated by a desire to prevent non-consenting creditors (such as the United States itself) from being denied the benefit of their priority claim status. A group of 35 states and the District of Columbia also submitted an amicus brief advocating for the reversal of the Third Circuit opinion, noting the effect that a disruption of the priority scheme could have on tax claims, domestic support obligations, certain pre-petition wage claims, and consumer deposits. Brief for Illinois et al. as Amici Curiae Supporting Petitioners, Czyzewski v. Jevic Holding Corp. (No. 15-649). The states argued that in the absence of a reversal such class-skipping settlements will “become the norm” as non-priority creditors, secured lenders, potential buyers, and debtors will increasingly enlist the bankruptcy system to augment their coffers at the expense of the interests of priority creditors.

Regardless of the outcome, the Court’s decision on this matter will significantly affect the trajectory of American bankruptcies for years to come. Stay tuned for more information on this momentous case!

¹ For a more detailed description of the underlying Third Circuit decision, see Jacob S. Frumkin, U.S. Supreme Court to Weigh in on Structured Dismissals and Settlements Circumventing the Bankruptcy Code’s Priority Scheme (July 12, 2016).

Last month, the United States Bankruptcy Court for the Southern District of New York published proposed amendments to its local rules effective December 1, 2016 (the “Proposed Amendments”).  Links to the Bankruptcy Court’s notice to the bar with respect to the Proposed Amendments and the full text of the Proposed Amendments are provided below.  The Proposed Amendments are currently open for public comment.  The comment deadline is November 14, 2016 by 5:00 p.m.

Below is summary of substantive changes effected by the Proposed Amendments which may be of interest to practitioners:

  • Local Rule 1002-1 (Filing of Petition): the amended rule will require, to the extent practicable, that when a prospective chapter 11 debtor or chapter 15 petitioner anticipates the need to seek orders for immediate relief, counsel must contact the United States Trustee’s office and the Clerk’s office prior to filing the petition to advise them of the anticipated filing and the matters on which the debtor or petitioner intend to seek immediate relief.
    • The proposed amendment aligns the SDNY with a similar local rule that is already in effect in Delaware.
  • Local Rule 2002-1 (Notice of Proposed Action or Order When Not Proceeding by Motion): the current rule – which provides a procedure for presenting orders to the court when the Bankruptcy Code requires “notice and a hearing” but a motion is not mandatory – will be moved and combined with current Local Rule 9074-1, discussed below.
  • Local Rule 3011-1 (Disposition of Unclaimed Funds Under a Confirmed Chapter 11 Plan): this will be a new rule.  In summary, it will require a chapter 11 plan to provide for the distribution of unclaimed property that cannot be distributed pursuant to 11 U.S.C. § 347(b) by either reallocating the property pursuant to the absolute priority rule, or pursuant to the plan’s distribution scheme, or donating it to a designated not-for-profit, non-religious organization.
    • Pursuant to section 347(b) of the Bankruptcy Code, unclaimed funds revert to the debtor or the entity acquiring assets to a plan. The proposed official comment to the rule explains that the rule is designed to address a seeming infirmity of § 347(b) in the context of liquidating chapter 11 plans in which no entity acquires most of the debtor’s assets and the debtor essentially ceases to exist.
  • Local Rule 3018-1 (Certification of Acceptance or Rejection of Plans in Chapter 9 and Chapter 11 Cases): The current rule requires the submission of certified ballot reports, certifying the amounts and numbers of accepting or rejecting classes to the court seven days in advance of a confirmation hearing.  The proposed amendment will require that the ballot report also certify as to the amount and number of any ballots not counted.
  • Local Rule 3021-1 (Post-Confirmation Requirements in Chapter 11 Cases): The proposed amendment will add a subsection to the existing rule, requiring that, “as a condition to serving as a liquidating trustee or a successor trustee to a post confirmation liquidating, or similar trust, the liquidating plan shall specify what steps the trustee shall take to monitor and ensure the safety of the trusts’ assets.”
  • Local Rule 5075-1 (Clerk’s Use of Outside Services and Agents; Claims and Noticing Agents): the current rule governs the use of claims agents.  In addition to the rule’s existing provisions, the proposed amendment will revise subsection (c) and add a new subsection (d) to provide, respectively, that:  (1) “Upon the request of the Clerk, the agent must provide public access to the Claims Registers, including complete proofs of claim with attachments, if any, without charge” and (2) the order providing for the retention of a claims agent must provide for “(i) the discharge of the agent at the conclusion of the case, or as otherwise provided by entry of an additional order by the Court; and (ii) the disposition of any records, documents and the like, that have been provided or delivered to such agent, whether in paper or electronic form in accordance with the Protocol for the Employment of Claims Agents.”
  • Local Rule 7052-1 (Proposed Findings of Facts and Conclusions of Law): the current rule governs the submission of proposed finding of fact and conclusions of law.  The proposed amendment effects two substantive changes:  (1) Whereas previously, parties were allowed by right to submit counter-findings and conclusions (unless the Court ordered simultaneous submissions), the amendment requires parties to request the Court’s permission to submit such counter-findings and conclusions.  (2) The amendment strikes the portion of the rule that prohibited proposed findings and conclusions from forming any part of the record on appeal (unless otherwise ordered by the Court).  Accordingly, the content of the record on appeal will no longer be limited by the rule.
  • Local Rule 8010-1 (Notice to the Bankruptcy Court of the Filing of Preliminary Motion with an Appellate Court): this will be a new rule.  It requires a party filing a preliminary motion (as defined in Bankruptcy Rule 8010(c)) in the district court or the court of appeals, to also file that motion and notice thereof on the bankruptcy court’s docket.
  • Local Rule 9006-1 (Time for Service and Filing of Motions and Answering Papers): the current rule addresses the notice period and objection deadline for motions for which the notice period is not otherwise prescribed in the Bankruptcy Rules.  The existing rule is silent as to the right to submit reply papers.  The proposed amendment addresses the silence by providing that:  “reply papers shall be served so as to ensure actual receipt not later than 4:00 p.m. three (3) days before the return date.”
    • The proposed amendment aligns the SDNY with the rule already in effect in EDNY.
  • Local Rule 9018-1 (Motions to Publicly File Redacted Documents and to File Unredacted Documents Under Seal): this will be a new rule.  It provides a uniform procedure for the submission of sealing motions, including the substantive content that must be asserted in and the documents which must be included with the sealing motion.
    • The submission of sealing motions is currently governed by each Judge’s individualized Chambers’ rules.
  • Local Rule 9037-1 (Redaction of Personal Identifiers): this will be a new rule.  The rule will provide guidance and procedure with respect to the redaction of personal data identifiers, placing that responsibility solely on counsel, parties in interest and non-parties (e., not the Clerk or claim agent if one has been appointed).  If a party seeks to redact personal data from a document or proof of claim already filed with the Court, such party must contact the Clerk’s office to request that the data be restricted from public view and file a motion and pay the associated fee.
  • Local Rule 9074-1 (Submission, Settlement or Presentment of Order, Judgment, or Decree): as noted above, current rule 2002-2 will be moved and combined, in toto, to this rule.  Aside from certain stylistic revisions and reformatting resulting from combining the two rules, the amendment adds two provisions:  (1) In the circumstances addressed by current Rule 2002-2 in which Bankruptcy Code requires “notice and hearing” but a motion is not mandatory and a party presents an order to the Court following the procedure outlined in the local rule, the amendment makes clear that no hearing will be held by the court unless timely objection is filed.  (2) The amendment makes clear that in the case of a motion, application or any pleading submitted by notice of presentment (as opposed to notice of hearing), such pleading must include a copy of the proposed order and the moving party must promptly submit a copy of the proposed order to chambers after the presentment date if there has been no objection or hearing date scheduled.
  • The Proposed Amendments also will repeal Local Rules 7008-1, 7012-1, 9027-1, and 9027-2 in light of the revisions to National Bankruptcy Rules 7008, 7012 and 9027 that were effected since their enactment in April of 2012. These local rules were all enacted to address issues raised by the Supreme Court’s decision in Stern v. Marshal.

Notice to the Bar Regarding Proposed Amendments to Local Bankruptcy Rules.

Proposed Amendments to the Local Bankruptcy Rules for the Southern District of New York.

Many creditors who have supplied goods to a debtor before a bankruptcy case begins think their only prospects for recovery will be pennies on the dollar.  While often times, pre-petition claims are relegated to receive small, if any, distributions, there is a unique carve-out in Section 503(b)(9) of the Bankruptcy Code that elevates “goods” supplied in the 20 days before a bankruptcy filing to administrative expense status.  Understanding what exactly is entitled to 503(b)(9) treatment, recent developments in setoff case law and typical blunders to avoid are paramount to ensure the greatest recovery for your claim with the least amount of litigation.

What Is… and Is Not… Part of a 503(b)(9) Claim.

Section 503(b)(9) unequivocally refers to “goods” …. not “services.”  The term “goods” is not defined in the Bankruptcy Code but many courts look to the UCC definition of “goods” – which includes essentially all things which are moveable at the time of identification to the contract for sale, other than money, including unborn young of animals and growing crops, and other identified things attached to realty (which are to be severed from realty).  The term “goods” presumptively includes gas and water, but creates a grey area for other commodities, like electricity.  See In re Great Atlantic & Pacific Tea Co., Inc., 538 B.R. 666 (S.D.N.Y. 2015) (electricity is not a good because it is not moveable at the time of metering because it was already used); In re NE Opco, Inc., 501 B.R. 233 (Bankr D. Del. 2013) (same); compare In re Erving Indus., Inc., 432 B.R. 354, 370 (Bankr. D. Mass. 2010) (electricity is a good because it is moveable at the time of contract for sale and identifiable at the time of metering).

As an initial matter, creditors must carefully consider what they actually supply to a debtor and whether it qualifies as a 503(b)(9) claim.  If a creditor supplies only a “service”, then the creditor will not be entitled to assert a 503(b)(9) claim for those services.  Many creditors provide a hybrid of goods and services (i.e. sale of a piece of equipment and maintenance services for the equipment sold).  Such creditors often question whether they can recoup all, or at least part, of what is supplied as a 503(b)(9) claim.  What is ultimately recoverable as a 503(b)(9) claim in those circumstances will depend on the jurisdiction.

Certain courts use the predominant purpose test for contracts that mix the sale of goods with services, taking an all or nothing approach.  Such courts consider that if the predominant purpose of the contract is services, a creditor loses the right to seek a 503(b)(9) claim for the secondary – or incidental – purpose of the contract – namely the goods supplied under the contract in question.  See, e.g., Princess Cruises, Inc. V. GE Co., 143 F.3d 828 (4th Cir.), cert. denied 525 U.S. 982 (1998) (employing the predominant purpose test).

Other courts have rejected the predominant purpose test finding no reason to exclude goods that were delivered under a contract where the primary purpose may have been services.  See, e.g., In re Pilgrim’s Pride Corp, supra.  Where the value of services can be segregated out from the value of goods supplied, some courts will permit a creditor to assert a 503(b)(9) claim for the portion attributable to goods; the remainder attributable to services would be treated as a general unsecured claim.  See, e.g., In re Plastech Engineered Prods., Inc., 397 B.R. 828, 837-38 (Bankr. E.D. Mich. 2009) (finding where the value of services vs. goods could be ascertained, allowing 503(b)(9) for goods).

Section 503(b)(9) refers to goods “received by the debtor” – and what “receipt” means is the subject of litigation in certain cases.  The term “received” is not defined in the Bankruptcy Code, and like the term “goods”, courts often look to the UCC definition of “receipt,” which focuses on “physical possession.”  Several courts have held that goods received directly by a debtor’s customers – drop shipped vs. being shipped first to the debtor – are not compensable under 503(b)(9) – despite invoices reflecting that the goods are sold to the debtor and billed to the debtor.  See, e.g., In re SRC Liquidation Co., No. 15-10541(BLS) (Bankr. D. Del. Oct. 15, 2015) (transcript of bench ruling) (“[W]hile it may be a business relationship developed of long practice and, frankly, for the benefit and at the direction of the Debtor, nevertheless, the circumstances of that business relationship and the way product was moved from one party to another is such that it takes it outside of the scope of Section 503(b)(9).”); In re Plastech Engineered Prods., Inc., No. 08-42417, 2008 WL 5233014, at *1 (Bankr. E.D. Mich. Oct. 7, 2008) (sustaining debtors’ objection to 503(b)(9) claim for goods delivered directly to debtor’s customer); Ningbo Chenglu Paper Prods. Manuf. Co., Ltd. v. Momenta, Inc. (In re Momenta, Inc.), No. 11-cv-479-SM, 2014 WL 3765171, at *7 (D.N.H. Aug. 29, 2012) (same); In re World Imports, 516 B.R. 296 (Bankr. E.D. Pa. 2014) (holding goods shipped directly to debtor’s customers were not “received” by the debtor as required by section 503(b)(9)).  In contrast, creditors often assert claims of unfairness given that in many instances, debtors ordered the goods, were billed for the goods and are contractually liable for the goods, relegating what is an otherwise administrative expense claim to a pre-petition general unsecured claim.  Developing case law has hampered such arguments.

Practical Pointers.  In preparing a 503(b)(9) claim, creditors (and their counsel) should be mindful of the following issues:

1st:       Whoever is preparing the claim must have a firm grasp on what the creditor actually does and how they do it.  For example, if the creditor ships goods directly to a customer – and not to the debtor – the debtor will likely dispute liability for a 503(b)(9) claim because the debtor has not “received” the goods as set forth in Section 503(b)(9).  While case law may not support a creditor’s arguments to the contrary, such arguments may be useful in the overall negotiation of the allowance of the creditor’s claims.

2nd:       A 503(b)(9) claim should have adequate support, including itemized invoices, to help a debtor identify what exactly was shipped and when it was received (note: the date of actual receipt, not shipment, is relevant to the 20-day calculation).  Some creditors supply bills of lading as proof of a debtor’s receipt.  Carefully analyze the invoices to parse out goods from any services, freight/shipping, labor, interest, taxes and late fees which are generally recognized as not being part of the value of “goods.”  See, e.g., In re Pilgrim’s Pride Corp., 421 B.R. 231, 237 (Bankr. N.D. Tex. 2009) (sustaining objection to 503(b)(9) claim for freight services); In re Plastech Engineered Prods., Inc., 397 B.R. 828, 839 (Bankr. E.D. Mich. 2008) (sustaining objection to a 503(b)(9) claim for the portion designated “labor”).  To the extent the client’s invoices do not typically have adequate specificity to identify goods vs. labor, fees or expenses, additional support should be prepared to avoid a likely objection to the 503(b)(9) claim.

3rd:       Be aware of any setoff claims a debtor may have against a creditor, in particular from outside the 20-day 503(b)(9) period.  Two courts have recently held that regardless of the age of a debtor’s setoff claim, a debtor can elect to first reduce a creditor’s 503(b)(9) claim before reducing a creditor’s general unsecured claim.  See In re Circuit City Stores, Inc., No. 08-35653, 2009 WL 4755253 (Bankr. E.D. Va. July 12, 2009); In re ADI Liquidation, Inc. (f/k/a AWI Del., Inc.), No. 14-12092 (KJC), 2015 WL 4638605 (Bankr. D. Del. May 5, 2015).  Creditors often oppose such attempts because the value of a 503(b)(9) claim, which will receive likely a 100 cent payment, usually far exceeds the value of any setoff claims (paid in bankruptcy dollars – or a percentage on the amount of claim) being asserted by a debtor that arise long before the 503(b)(9) claim.

A 503(b)(9) claim is a valuable asset, particularly in cases where the prospects for recovery are grim for pre-petition claims.  Being mindful of the above issues can improve a creditor’s chances of payment – and potentially save on legal fees that would otherwise be spent pursuing recovery on a 503(b)(9) claim.

Jill Bienstock was recently a featured panelist on an ABI Live Webinar 503(b)(9) Claims from the Trenches: Debtor and Creditor Perspectives, which can be accessed for replay and CLE credit through the following link.

On March 16, 2016, Judge Shannon of the U.S. Bankruptcy Court for the District of Delaware rejected a proposed fee structure for Baker Botts L.L.P., which was proposed counsel to the debtors in In re New Gulf Resources, LLC.  His ruling is the latest development from that court on the U.S. Supreme Court’s decision in Baker Botts L.L.P. v. ASARCO LLC, which held that (1) the American Rule, under which “[e]ach litigant pays [its] own attorney’s fees, win or lose, unless a statute or contract provides otherwise,” controls awards of attorney’s fees and (2) Section 330(a)(1) of the Bankruptcy Code, which does not permit a court to award fees and expenses that a professional incurs defending its own fee application, is not a statute that provides otherwise.  His decision also follows Judge Walrath’s recent opinion in In re Boomerang Tube, Inc.,¹ which held that Section 328(a) does not permit a court to approve terms and conditions of employment that require an estate to pay fees and expenses that are not for services to it or its fiduciaries.

In In re New Gulf Resources, LLC, while seeking authority to employ Baker Botts, the debtors also requested approval of the following fee arrangement: (1) fees that New Gulf Resources, LLC and its three affiliates incurred while they are debtors would be increased by ten percent, and (2) the firm would waive its right to this premium if it did not incur material fees and expenses defending its fee applications.

In response to the proposed fee structure, Judge Shannon issued a letter stating that he “ha[d] carefully considered the [Boomerang Tube] Opinion and agree[d] with its holding (including comments contained in Footnote 6 of the Opinion applying its rationale to the retention of debtors’ counsel).” Judge Shannon later invited Baker Botts to submit an additional brief in support of the debtors’ application, and the firm did so.

Baker Botts, who was also the petitioner in Baker Botts L.L.P. v. ASARCO LLC, responded to Judge Shannon’s letter by distinguishing the proposed fee premium from the indemnification at issue in In re Boomerang Tube, Inc.  Baker Botts also argued that barring it from discounting its services when its costs, including those incurred defending its fee applications, are less than expected would hurt all debtors.

Recently, in a letter dated March 16, 2016, Judge Shannon rejected those arguments:

Having reviewed the brief and the original application, I stand by my earlier determination that the structure proposed by Baker Botts runs afoul of the holdings in Asarco and Boomerang Tube.  While I acknowledge the creative approach to the issue, I do not find that there is a meaningful distinction between the Fee Premium proposed here and the matters considered and ruled upon in Boomerang Tube.

Judge Shannon effectively determined that the Court could not approve any provision that varies the fees and expenses to which a professional is entitled based on whether it has incurred fees and expenses defending its fee applications.

To date, courts have not allowed professionals to expressly shift the risk of objections to their fees and expenses to bankruptcy estates.  Simply put, contrary to Section 328(a) of the Bankruptcy Code, the U.S. Supreme Court has put lower courts in the business of policing the form of compensation and reimbursement.

We will continue to report on developments on Baker Botts L.L.P. v. ASARCO LLC as additional decisions are made.

¹This opinion was the subject of an earlier blog post on February 8, 2016.

When a business files for bankruptcy, it can be a confusing and frustrating time for the debtor’s creditors. If an investment firm reaches out with an offer to purchase a creditor’s claim against the debtor, it may appear to be a great opportunity to be paid at least some cash now. The sale of a bankruptcy claim may also be attractive because it allows the creditor to avoid the time and expense involved in protecting its rights in the bankruptcy case. While the sale of a claim may be the right decision for a creditor, before it jumps at the first opportunity presented, there are several simple steps that should be taken to ensure that it maximizes the amount received for the sale of its claim.

(1) Evaluate the claim

The first step a creditor should take after being approached by a bankruptcy claims trader is to evaluate what type of claim it has against the debtor. This is important because different types of bankruptcy claims can be treated vastly different from one another under the Bankruptcy Code. For instance, a secured claim is treated much more favorably with respect to repayment under the Bankruptcy Code than a general unsecured claim. First, a secured creditor may be able to enforce its rights against its collateral or seek payments from the debtor prior to the entry of an order confirming a plan. Also, a chapter 11 plan must provide for a secured creditor to retain its lien on its collateral and for the debtor to make cash payments over time to the creditor that are at least as much as the value of the creditor’s interest in its collateral, or in other words, payments of at least the lesser of (a) the total amount of the secured debt, or (b) the value of the collateral.

Several categories of unsecured bankruptcy claims are also given priority in repayment over other unsecured claims. A few examples of claims that are provided priority in repayment include (a) claims based on goods received by the debtor within 20 days before the filing of the bankruptcy case, (b) domestic support obligations, and (c) wages, salaries and commissions earned within 180 days before the filing of the bankruptcy case. In a chapter 11 case, all of these claims must be paid in full in order to confirm a plan.

Due to the different repayment requirements under the Bankruptcy Code, administrative claims or priority unsecured claims are much more valuable than general unsecured claims. Therefore, if a creditor can determine that it has an administrative claim or priority unsecured claim, it should communicate this to the bankruptcy claims trader, who may be unaware of this fact. A creditor that knows it has an administrative claim or priority claim is in a better negotiating position to demand a premium for the sale of its claim compared to general unsecured creditors.

(2) Evaluate the bankruptcy case

A creditor should learn as much as possible about the status of the bankruptcy case before it begins any negotiations with the bankruptcy claims trader. The more information a creditor has about a bankruptcy case, the better position it will be in to evaluate what exactly is being given up in the sale. While examining every word of every piece of paper received in a bankruptcy case may seem overwhelming, there are a few key documents that a creditor can focus on that will provide important information regarding what a creditor may receive if the creditor retains its claim in the bankruptcy case. First and foremost, a creditor should review the “Disclosure Statement” and “Plan” documents, if it has received them. These documents will specifically provide the terms of repayment of a creditor’s claim. In particular, within the Disclosure Statement, a creditor should review carefully (a) the description of the payments for the class that contains its claim and (b) what is often referred to as the “Best Interest of Creditors Analysis” or “Liquidation Analysis,” which may be located either within the Disclosure Statement or as an exhibit to the Disclosure Statement. One or both of these sections should provide the estimated percentage of recovery that a creditor should receive if it keeps its claim. Also, within the Plan, a creditor should review the treatment of the class that contains its claim, which will detail exactly how the claim will be repaid. Also, if a creditor has received any documents regarding the sale of substantially all of the debtor’s assets, this may or may not also contain information regarding the estimated distribution to creditors in the case.

Alternatively, if a creditor has a good relationship with the debtor, it may want to briefly discuss the status of the case with the debtor’s attorney, or if one has been appointed, the creditors’ committee’s attorney. From just a quick phone call, a creditor may learn that all creditors are expected to be paid in full quickly from the sale of assets or, on the other hand, that the case may continue for a significant period of time and the terms of repayment to creditors is still uncertain.

If a creditor can determine that its claim will receive a large estimated recovery in the bankruptcy case, it should share this information with the bankruptcy claims trader as it negotiates the sale price. If the claims trader understands that a creditor knows that it should receive a large recovery in the bankruptcy case, it may be willing to offer that creditor a higher price for its claim than if the claims trader thinks it’s negotiating against someone that does not have that information.

(3) Read the sale documents carefully

A creditor should very carefully read the sale documents it receives from a bankruptcy claims trader. Since “[o]ther than a few notice requirements, claims trading in bankruptcy is virtually unregulated,” Norton Journal of Bankruptcy Law and Practice, 18 J. Bankr. L. & Prac. 1, Art. 1 (Jan. 2009), there is really no such thing as “standard language.” A creditor should enter into negotiations with the claims trader with the mindset that everything within the sale documents is negotiable. A creditor should read each provision closely because some of the “fine print” can be just as important as the sale price. For instance, sale documents may require the seller to refund the sale price if an objection is filed against the claim. It may be possible to negotiate that the sale price only needs to be refunded if the objection is sustained by the court. Similarly, a creditor should be careful to look for any provisions that require it to pay interest with the refunded sale price, if the sale price needs to be returned. Obviously, a creditor should negotiate for the lowest interest rate possible. Also, sale documents may fail to include the specific date by which the purchaser must pay for the claim. A deadline for the bankruptcy claims trader to pay for the claim should always be negotiated into the sale agreement. These are just a few examples of the types of provisions that may significantly change the true value of a purchase offer.

(4) Solicit offers from other bankruptcy claims traders

A creditor should solicit offers from as many bankruptcy claims traders as possible. The bankruptcy claims trading market is very large with numerous claims purchasers. See Prof. Adam J. Levitin, Bankruptcy Markets: Making Sense of Claims Trading, 68 Brook J. Corp. Fin. & Com. L. 67, 77 (2010) (stating that “academic articles place the [claims trading] market at hundreds of billions” of dollars, but that there is no real data on the exact size of the market) (citations omitted). Therefore, finding other interested claims traders should not be difficult. In fact, a quick internet search will disclose numerous bankruptcy claims trading websites where a creditor can fill out a simple online form to receive an offer for the purchase of its claim. Reaching out to several different claims traders may start a bidding war that can significantly increase the ultimately accepted sale price.

(5) Contact an attorney

It may make good business sense for a creditor to hire an attorney to represent it with respect to the sale of its bankruptcy claim. A creditor may want to consider hiring an attorney if it finds it difficult trying to (a) determine the type of claim it has, (b) understand the papers filed in the bankruptcy case, or (c) understand the language in the proposed sale documents. Also, even if a creditor has a strong grasp of the relevant information, it may still be advisable to have an attorney, who is an experienced negotiator, advocate on its behalf. If a creditor has a significant claim, paying an attorney to review the necessary documents and negotiate the highest purchase price possible may pay off several times over in the increased sale price the creditor ultimately receives compared to what the creditor would be able to negotiate on its own.

Conclusion

The sale of a bankruptcy claim may seem like a great opportunity to receive quick cash and avoid the headaches involved in an often long, drawn out bankruptcy process. However, creditors should still take certain steps such as considering the type of claim they possess, reviewing bankruptcy pleadings they’ve received or discussing the case with an attorney involved in the case, reviewing the sale documents closely, seeking out other purchase offers and obtaining counsel to represent them, before accepting the first purchase offer they receive. Taking these steps will help a creditor maximize the price received for its claim.

Lenders and secured creditors often require that debtor-customers direct all receivable collections into a lockbox, hoping to wrangle any available proceeds to apply to their debtors’ outstanding debt. In requiring a debtor or its customer to remit payments to a lockbox, however, creditors may be overlooking a potential source of significant liability. A creditor using a lockbox may unwittingly expose itself to greater risk and liability than just a debtor’s default if it receives funds that were collected as sales tax on a debtor’s goods or services.

As a lender or secured creditor, how do you know if you are at risk? First and foremost, understand your debtor’s business and whether its goods or services are taxed. Second, know what the laws provide for in the jurisdiction where your debtor is conducting business – particularly with respect to third-parties that collect or receive sales tax.

By way of example, the State of Texas treats anyone who collects or receives money that is collected as a tax as a strict, statutory trustee, holding the collected tax for the benefit of the taxing authority. Recipients and holders of such proceeds may be liable for the full tax amount collected – plus any accrued interest and penalties. See Tex. Tax Code Ann. § 111.016 (2007).

A central issue in determining liability in your jurisdiction may be how your lockbox is structured, as is the case for Texas. If a debtor’s customers pay receipts with sales tax directly to a lockbox, in Texas such a creditor is a strict, statutory trustee. If, however, a debtor’s customers pay receipts with sales tax first to the debtor and then those funds are transferred to a lockbox, a creditor still risks being liable as a transferee if they have the requisite “knowledge.” In determining whether to impose liability on a third-party, Texas courts consider whether the recipient knew that it received sales tax funds.  Knowledge is not just whether you had actual notice that the receipts contained sales tax funds. Instead, it is an “inquiry notice” standard, which requires a court to consider whether there was sufficient information available to cause you to inquire whether the funds received contained tax receipts. Courts consider a third-party as being on “inquiry notice,” and thus having the requisite knowledge to be held liable, where, if you pursued an issue, you would or could have ascertained the truth.

Do you have enough information to be on “inquiry notice?” Lenders and secured creditors often require that debtors provide various periodic reports and/or copies of invoices to monitor the financial health of their operations. As a careful and proactive creditor, you may already have sufficient information to be on “inquiry notice” that you are holding commingled funds in your lockbox. The case In re Amber’s Stores, Inc., 205 B.R. 828 (Bankr. N.D. Tex. 1997), presents an interesting analysis of “knowledge” in the context of lender-liability for receipts commingled in a lockbox with collected sales tax.  There, the debtor-vendor in that case received money from its customers (which included collected sales tax) and the debtor then sent the money directly to its secured lender’s lockbox; the lender in turn applied the receipts to the debtor’s outstanding loan and extended the debtor additional credit. The taxing authority sued the debtor’s lender to recover unpaid sales tax that was part of the receipts directed to the lender’s lockbox. The court determined that since the debtor first had dominion and control over the funds, and only then transferred them to the lender, that the lender was not a strict statutory trustee. However, the court found the lender could be a trustee who held the tax proceeds for the benefit of the taxing authority. The central issue was whether the lender could assert a good faith transferee defense, which hinged on whether the lender had “inquiry notice” that the lockbox contained collected sales tax. “Inquiry notice” could be attributed even if additional work or due diligence was required to uncover the existence of sales tax in the lockbox. The case ended up before the bankruptcy court on a summary judgment motion and the court ultimately held that there remained an issue of fact as to whether the lender had knowledge about the nature of the funds.  Despite the lender’s Vice President testifying that he was not aware of whether the debtor had, prior to remittance, segregated out its sales tax and that the debtor had not asked the lender to create a separate account to segregate the funds, the court found that there remained a question as to whether the lender was on “inquiry notice” and thus knowledge could potentially be imputed to the lender.  Although that case was ultimately settled in advance of trial, it is instructive because of the court’s clear analysis of the potential pitfalls facing lenders and secured creditors that use lockboxes without considering their potential exposure. It also highlights the distinction between lenders who receive payments directly from a debtor’s customer, which are strict statutory trustees, versus lenders who receive funds from a debtor, after they were collected from a customer, which still risk being deemed transferees potentially liable for the return of funds.

Ultimately, if you receive collected tax directly from a customer, you may be strictly liable for the return of such funds, as is the case in Texas. Even if you receive the funds indirectly, you may have liability for the failed remittance of taxes unless you can establish a lack of knowledge. That may be challenging, however, because jurisdictions, like Texas, may require lenders and secured creditors to first segregate funds to remove trust funds (like taxes) from a mixed account before applying funds on hand to overdrafts or liabilities.  See State Bank v. Valley Wide Elec. Supply Co., Inc., 752 SW 2d 661, 665 (Tex. App. 1988); see also Alon USA, LP v. State, 222 SW 3d 19, 30 (Tex. App. 2005), rehearing denied (2007).  Notably, if a lender or creditor is aware that any of the funds it applies to offset an overdraft or prior debt are trust-funds, like taxes, the lender/creditor will lose any asserted immunity. The end result is that it will be treated as a party liable for the collected tax.  See Alon, supra at 30-31.

Many lenders and secured creditors conduct business with debtors located in states other than their own. Creditors should consider the varying statutory requirements and, to the extent they use a lockbox, they should consider how best to segregate out any collected tax to avoid potential exposure.