Business Bankruptcy Issues

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.

Chapter 11 of the Bankruptcy Code trusts a debtor in possession to operate its business.  In general, a debtor in possession “is free to use, sell[,] or lease property of the . . . estate in the operation of the debtor’s business.”1  This discretion is “at the heart” of the powers of a debtor in possession, 2  and courts are reluctant “to interfere, or to permit other parties in interest to interfere, in the making of routine, day-to-day business decisions.” 3  Therefore, a court will not disturb a transaction if

  1. the transaction is in the ordinary course of business and
  2. the debtor in possession articulates a business purpose for the transaction.4

Not all transactions are in the ordinary course or free from scrutiny, however.

The “Sound Business Purpose” Standard

Section 363(b)(1) of the Bankruptcy Code permits a debtor in possession, “after notice and a hearing, [to] use, sell, or lease . . . property of the estate” outside “the ordinary course of business.”5  Section 363(b)(1) does not empower a debtor in possession: Section 363(b)(1)  limits its power.  Section 363(b)(1) requires “notice and a hearing,”but not approval of a court,8  before a debtor in possession transacts outside the ordinary course.  That is, Section 363(b)(1), which does not contain a standard by which a court could evaluate a transaction,simply ensures that parties in interest receive due process.10 

That said, courts, including U.S. Courts of Appeals, have inferred such a standard from the Bankruptcy Code.11  The standard is “flexible”:12 in evaluating a transaction, a court has “considerable,”13 though not unfettered,14 discretion.  Under the standard, a court should approve a transaction only if

  1. the debtor in possession articulates a “sound business purpose” for the transaction and
  2. that purpose justifies the transaction.15 

In general, the purpose of a transaction is to benefit the estate,16 but a court does not assume that every transaction does so;17 instead, a debtor in possession must show that its transaction would benefit the estate.18  Then, in determining whether the shown benefits of a transaction justify it, a court, after considering all relevant facts,19 must find that

  1. the consideration that the estate would receive is “fair and reasonable” and
  2. the counterparty is proceeding in good faith.20 

If a court finds that a “sound business purpose” justifies a transaction and “notice and a hearing” was provided to parties in interest, then the court should defer to the business judgment of the debtor in possession21 and approve the transaction.

A New Standard?

Courts have applied this standard for decades.

But in 2005, Congress amended the Bankruptcy Code by adding Section 503(c)(3), 22 which provides:

(c)  Notwithstanding [Section 503(b)], there shall neither be allowed, nor paid—

(3)    other transfers or obligations that are outside the ordinary course of business and not justified by the facts and circumstances of the case, including transfers made to, or obligations incurred for the benefit of, officers, managers, or consultants hired after the date of the filing of the petition.23

Like Section 363(b)(1), Section 503(c)(3) limits the power of a debtor in possession; however, unlike Section 363(b)(1), Section 503(c)(3) contains a standard by which a court could evaluate a transaction.  Section 503(c)(3) prohibits a transaction if it is

  1. “outside the ordinary course of business” and
  2. “not justified by the facts and circumstances of the case.”24 

This raises an interesting question: does this new standard differ from the one that courts inferred from the Bankruptcy Code?

Conflicts Between the Courts

Simply put, courts disagree on the answer.

Some courts, including the U.S. Bankruptcy Court for the Southern District of New York, have held that Section 503(c)(3) codifies the old standard.26  In In re Dana Corp.,25  Judge Lifland approved two transactions under Section 503(c)(3) because the debtors in possession “presented him with uncon[tro]verted evidence that” the transactions were

  1. “fair and reasonable” and
  2. “well within the[] business judgment [of the debtors in possession].”27  Then, in In re Dewey & LeBoeuf LLP,28 Judge Glenn, citing In re Dana Corp., explained that “[t]he requirement that a transaction be ‘justified by the facts and circumstances of the case” is the same as the business judgment standard under [S]ection 363(b).”29  At least one other court has joined Judges Lifland and Glenn: in In re Patriot Coal Corp.,30 the U.S. Bankruptcy Court for the Eastern District of Missouri, also citing In re Dana Corp., stated:

Any transfer made outside the ordinary course of business for the benefit of officers, managers[,] or consultants hired after the date of the filing of the petition must be justified by the facts and circumstances of the case, which ordinarily means that the business judgment standard of Section 363(b) applies. 31 

As Judge Glenn often writes: “[c]ourts have held that the ‘facts and circumstances’ language of [S]ection 503(c)(3) creates a standard no different than the business judgment standard under [S]ection 363(b).”32

But other courts, including the U.S. Bankruptcy Court for the Northern District of Texas, have held otherwise.33  In In re Pilgrim’s Pride Corp.,34 Judge Lynn held that Section 503(c)(3) does more than simply codify the old standard.35  She read Section 503(c)(3) as imposing a tougher standard because

  1. “read[ing] [S]ection 503(c)(3) as requiring nothing not already required by [S]ection 363(b)(1) would violate th[e] principle of construction” that “Congress is presumed to intend that independent sections of the [Bankruptcy] Code will have independent, differing impacts” and
  2. “Congress intended . . . court[s] to play a more critical role in assessing transactions . . . that fall within the ambit of [S]ection 503(c)(3).”36  

The U.S. District Court for the District of New Hampshire, the only appellate court to construe Section 503(c)(3), has agreed with Judge Lynn.37  In GT Advanced Techs. Inc. v. Harrington, 38  Judge McCafferty, citing In re Pilgrim’s Pride Corp., held that Section 503(c)(3) “directs courts to give more scrutiny to the business judgment of debtors than is permitted under the . . . business judgment test [under Section 363(b)(1)].”39  In short, courts have held that Section 503(c)(3) imposes a more demanding standard than the one that courts have applied for decades.

Finally, the U.S. Bankruptcy Court for the District of Delaware has joined both sides.  Judge Walrath has ruled that Section 503(c)(3) simply reiterates the standard that courts applied before Congress added the provision to the Bankruptcy Code:

[Section 503](c)(3) was meant to provide a standard, albeit not as clear, for any other transfers or obligations outside the ordinary course of business.

I agree that the including transfers made to officers, managers[,] or consultants hired after the petition date is not exclusive.  That’s clear from other provisions in the Bankruptcy Code.

So I do read [Section 503](c)(3) to be the catch-all and the standard under [Section 503](c)(3) for any transfers or obligations made outside the ordinary course of business are those that are justified by the facts and circumstances of the case.  Nothing more – no further guidance being provided to the Court by Congress, I find it quite frankly nothing more than a reiteration of the standard under [Section] 363 and – well, [Section] 363 under which courts had previously authorized transfers outside the ordinary course of business and[,] that is, based on the business judgment of the debtor, the court always considered the facts and circumstances of the case to determine whether it was justified.  And I’ll do the same in this case.40

In contrast, Judge Carey has construed Section 503(c)(3) as requiring “something” more than would otherwise be required:

Well, [Section 503(c)(3)] says something different and I’ve – I will say [that] I’ve interpreted it to mean something above the business judgment standard but maybe not much farther above it.  I mean, I don’t know how else to describe it.

And I guess someday if I get a chance to write on it or read the wisdom of others on the topic, you know, I may form a firmer view in my mind about precisely what it means.  But you know, that language was used and that’s what Congress chose.41 

Judges Shannon42 and Sontchi43 have avoided the fray.  Thus, in Delaware, as well as elsewhere, what Section 503(c)(3) requires is unclear.

Conclusion

In sum:

  1. Courts disagree on whether Section 503(c)(3) simply reiterates the standard that courts applied before Congress added Section 503(c)(3) to the Bankruptcy Code.
  2. The U.S. Bankruptcy Court for the District of Delaware has not decided whether the standards are identical, and two judges have expressed conflicting views in oral rulings.
  3. In the future, a “sound business purpose” could be insufficient to justify a transaction if Section 503(c)(3) controls.

Full document with citations

1              First Fid. Bank, N.A. v. Jason Realty, L.P. (In re Jason Realty, L.P.), 59 F.3d 423, 426 (3d Cir. 1995).

            In re DeLuca Distrib. Co., 38 B.R. 588, 592 (Bankr. N.D. Ohio 1984).

3               7 Collier on Bankruptcy ¶ 1108.07[1] (Alan N. Resnick & Henry J. Sommer eds., 16th ed. rev. 2009) (citing Cent. States Se. & Sw. Areas Health & Welfare & Pension Funds v. Columbia Motor Express, Inc. (In re Columbia Motor Express, Inc.), 33 B.R. 389, 393 (M.D. Tenn. 1983)).

4               See In re Nellson Nutraceutical, Inc., 369 B.R. 787, 797 (Bankr. D. Del. 2007) (“[I]f the Court determines that a transaction is in the ordinary course of a debtor’s business, the Court will not entertain an objection to the transaction, provided that the conduct involves a business judgment made in good faith[,] upon a reasonable basis[,] and within the scope of authority under the Bankruptcy Code.  Put another way, the Court will not disturb a transaction within the ordinary course of business if ‘the trustee can articulate reasons for his conduct (as distinct from a decision made arbitrarily or capriciously).’”  (quoting In re Curlew Valley Assocs., 14 B.R. 506, 513, 513 n.11a (Bankr. D. Utah 1981)) (citation omitted)).

5               11 U.S.C. § 363(b)(1).

6               See Calvert v. Bongards Creameries (In re Schauer), 835 F.2d 1222, 1225 (8th Cir. 1987) (describing 11 U.S.C. §§ 363(b)(1) and 704 as “enabling statutes that give the trustee the authority to sell or dispose of property if the debtors would have had the same right under state law”).

7               Section 102(1) of the Bankruptcy Code defines “notice and a hearing.”

8             See In re Robert L. Hallamore Corp., 40 B.R. 181, 183 (Bankr. D. Mass. 1984) (“In the absence of objections or counter-offers, a sale in accordance with [11 U.S.C. §] 363, [Fed. R. Bankr. P.] 2002, and [Fed. R. Bankr. P.] 6004 does not require court approval. . . . Pursuant to [11 U.S.C. §] 102(1), absent a request for a hearing[,] [a] sale will take place without court order.”  (citation omitted)).

9               See Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063, 1069 (2d Cir. 1983) (“[11 U.S.C. § 363(b)] seems on its face to confer upon the bankruptcy judge virtually unfettered discretion to authorize the use, sale[,] or lease, other than in the ordinary course of business, of property of the estate.”).

10                See Marcus Hook Dev. Park, Inc. v. T.A. Title Ins. Co. (In re Marcus Hook Dev. Park, Inc.), 143 B.R. 648, 660 (Bankr. W.D. Pa. 1992) (“The obvious purpose of th[e] mandatory prior notice [that 11 U.S.C. § 363(b)(1) requires] is to satisfy constitutional requirements where one’s interest in property will be adversely affected as a result of judicial action.”).

11              See, e.g., Institutional Creditors of Cont’l Air Lines, Inc. v. Cont’l Air Lines, Inc. (In re Cont’l Air Lines, Inc.), 780 F.2d 1223, 1226 (5th Cir. 1986) (stating that “the . . . requirement of justifying a proposed transaction” is “implicit in [11 U.S.C.] § 363(b)”).

12               ASARCO, Inc. v. Elliot Mgmt. (In re ASARCO, L.L.C.), 650 F.3d 593, 601 (5th Cir. 2011).

13               Dai-Ichi Kangyo Bank, Ltd. v. Montgomery Ward Holding Corp. (In re Montgomery Ward Holding Corp.), 242 B.R. 147, 152-53 (D. Del. 1999).

14                See In re Lionel Corp., 722 F.2d at 1071 (“As we shall see, the new Bankruptcy Code no longer requires such strict limitations on a bankruptcy judge’s authority to order disposition of the estate’s property; nevertheless, it does not go so far as to eliminate all constraints on that judge’s discretion.”).

15                In re Montgomery Ward Holding Corp., 242 B.R. at 153.

16             See In re Trans World Airlines, Inc., 2001 WL 1820326, at *11 (Bankr. D. Del. Apr. 2, 2001) (“[A] sale under [11 U.S.C.] 363(b) is intended to benefit the estate by minimizing loss of value to the estate.”).

17             See In re MF Global Inc., 467 B.R. 726, 730 (Bankr. S.D.N.Y. 2012) (“If a valid business justification exists, then a strong presumption follows that the agreement,” or transaction, “was negotiated in good faith and is in the best interests of the estate . . . .”  (emphasis added)).

18               See In re Montgomery Ward Holding Corp., 242 B.R. 147, 155 (D. Del. 1999) (“As this Court . . . ha[s] recognized, the debtor [in possession] carries the burden of demonstrating that a use, sale[,] or lease will assist the debtor’s reorganization . . . .”).

 19                See In re Lionel Corp., 722 F.2d at 1071 (“In fashioning its findings [that a sound business reason for a transaction], a bankruptcy judge . . . should consider all salient factors pertaining to the proceeding and, accordingly, act to further the diverse interests of the debtor, creditors[,] and equity holders, alike.”).

20               See In re Del. & Hudson Ry. Co., 124 B.R. 169, 176 (D. Del. 1991) (“Once a court is satisfied that there is a sound business reason or an emergency justifying [a] pre-confirmation sale, the court must also determine that the trustee has provided the interested parties with adequate and reasonable notice, that the sale price is fair and reasonable, and that the purchaser is proceeding in good faith.”).

21               See Myers v. Martin (In re Martin), 91 F.3d 389, 395 (3d Cir. 1996) (“Indeed, under normal circumstances, the court would defer to the trustee’s judgment so long as there is a legitimate business justification.”  (citing Fulton State Bank v. Schipper (In re Schipper), 933 F.2d 513, 515 (7th Cir. 1991))).

22               See Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, Pub. L. No. 109-8, § 331, 119 Stat. 23, 102 (2005) (adding subsection (c) to                     11 U.S.C. § 503).

23                 11 U.S.C. § 503(b)(3).

24              11 U.S.C. § 503(c)(3).

25               See In re Borders Grp., Inc., 453 B.R. 459, 473-74 (Bankr. S.D.N.Y. 2011) (“Courts have held that the ‘facts and circumstances’ language of [11 U.S.C. §] 503(c)(3) creates a standard no different than the business judgment standard under [11 U.S.C. §] 363(b).”).

26              358 B.R. 667 (Bankr. S.D.N.Y. 2006).

27              Id. at 584.

28              2012 WL 3065275 (Bankr. S.D.N.Y. July 30, 2012).

29             Id. at *4.

30              492 B.R. 518 (Bankr. E.D. Mo. 2013).

31              Id. at 530-31.

32              E.g., In re Borders Grp., Inc., 453 B.R. at 473-74.

33              See, e.g., In re Pilgrim’s Pride Corp., 401 B.R. 229, 236 (Bankr. N.D. Tex. 2009) (“The court agrees with the conclusion reached in this latter group of cases that the test of [11 U.S.C. §] 503(c)(3) should not be equated to the business judgment rule as applied under [11 U.S.C. §] 363(b)(1).”).

34              401 B.R. 229 (Bankr. N.D. Tex. 2009).

35              See Id. at 236 (“The court agrees . . . that the test of [11 U.S.C. §] 503(c)(3) should not be equated to the business judgment rule as applied under [11 U.S.C. §] 363(b)(1).”).

36               Id. at 236-37.

37               See GT Advanced Techs. Inc. v. Harrington, 2015 WL 4459502, at *7 (D.N.H. July 21, 2015) (“This court is persuaded by [In re Pilgrim’s Pride Corp., 401 B.R. 229] that 11 U.S.C. § 503(c)(3) directs courts to give more scrutiny to the business judgment of debtors than is permitted under the . . . business judgment test [of 11 U.S.C. § 363(b)(1)].”).

38               2015 WL 4459502 (D.N.H. July 21, 2015).

39              Id. at *7.

40                 Hr’g Tr. at 86:11-87:4, In re Nobex Corp., Case No. 05-20050 (CSS) (Bankr. D. Del. Jan. 30, 2006), ECF No. 194.

41              Hr’g Tr. at 40:20-41:2, In re Dura Auto. Sys., Inc., Case No. 06-11202 (KJC) (Bankr. D. Del. Apr. 25, 2007), ECF No. 1170.

42             See Hr’g Tr. at 114:9-14, In re Longview Power, LLC, Case No. 13-12211 (BLS) (Bankr. D. Del. Dec. 18, 2013), ECF No. 684 (“So the one question that remains is what is the appropriate standard?  And I, I think that there is no answer in this jurisdiction, at least in terms of, of a published decision, and it will remain that way.  I’ve said [that] I’ve previously ducked this question, and I’m ducking it today.”).

43              See In re Foothills Tex., Inc., 408 B.R. 573, 579 n. 25 (Bankr. D. Del. 2009) (“[11 U.S.C. § 503(c)] provides that the standard under [11 U.S.C. §] 503(c)(3) governing a payment that . . . is made to managers and consultants, who are not necessarily insiders, is different on its face from that which applies to payments made to directors and control persons, who are insiders.  The former must be ‘justified by the facts and circumstances of the case’ while the latter must satisfy the business judgment test under [11 U.S.C. §] 363 (provided [11 U.S.C. §§] 503(c)(1) and (2) are not applicable).  Whether there is any substantive difference between the two standards and, if so, what constitutes ‘justified by the facts and circumstances of the case’ is an issue for another day.”).

 

The Delaware Supreme Court recently held that creditors lack standing to bring a derivative suit on behalf of an insolvent Delaware limited liability company (an “LLC”) under the Delaware Limited Liability Company Act (the “LLC Act”).  CML V, LLC v. Bax, No. 735, 2011 WL 3863132 (Del. Sept. 2, 2011, corrected Sept. 6, 2011).  In an opinion written by Chief Justice Steele, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of claims brought by a junior secured creditor against the LLC’s present and former officers directly and derivatively for breaching their fiduciary duties.  The Delaware Supreme Court’s holding was based on a plain reading of 6 Del. C. § 18-1002 which requires that a plaintiff be a “member” or an “assignee” of a limited liability company interest to bring a derivative action on behalf of an LLC. 

Facts and Procedural History

Defendant JetDirect Aviation Holdings, LLC (“JetDirect”), a Delaware limited liability company, was a private jet management and charter company.  In 2005, JetDirect began a series of transactions to acquire small and midsized competitor and charter service companies which left the company heavily leveraged.  Between 2006 and 2007, JetDirect’s officers and board of managers learned of “serious deficiencies” in the company’s accounting system and internal controls.  Nevertheless, the board continued its aggressive acquisition strategy.  In April 2007, on the basis of outdated information, CML V, LLC (“CML”) made a loan to JetDirect of approximately $26 million, which later increased to approximately $34 million.  Shortly thereafter, in June 2007, JetDirect defaulted on its loan obligations to CML, and by January 2008, JetDirect was insolvent and began to liquidate its assets.

CML filed a complaint in the Delaware Court of Chancery asserting derivative claims against JetDirect’s present and former managers for: (1) breach of the duty of care for their approval of transactions without informing themselves of JetDirect’s financial condition; (2) bad faith for consciously failing to implement adequate internal controls; and (3) breach of the duty of loyalty for benefitting from self-interested asset sales.  CML also brought a direct claim for money damages against JetDirect for breach of the loan agreement, but the parties agreed that the Court of Chancery would only have jurisdiction over the direct claim if any of the derivative claims survived a motion to dismiss.  The Court of Chancery granted JetDirect and the individual defendants’ motion to dismiss the claims on the basis that “CML, as a creditor, lacks standing to pursue derivative claims on behalf of JetDirect.”  CML appealed to the Delaware Supreme Court.

Delaware Supreme Court Ruling

CML advanced the following arguments on appeal: (1) the LLC Act does not deny creditors standing to bring derivative actions on behalf of insolvent LLCs and (2) if the LLC Act denies the Court of Chancery jurisdiction over such derivative actions, it places an unconstitutional limit on the Court of Chancery’s equitable powers.  The Delaware Supreme Court rejected both arguments.

The Delaware Supreme Court first addressed the plain language of § 18-1002 of the LLC Act, which provides:

In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:

(1)  At the time of the transaction of which the plaintiff complains; or

(2)  The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transactions.

6 Del. C. § 18-1002.

The court reasoned that this provision is clear and unambiguous—only a member or an assignee of an LLC interest can bring a derivative action.  The court found it significant that § 18-1002 uses the term “must” be a member or assignee rather than “may”, and applies to “a derivative action” rather than “the derivative action.”  Although a different section of the LLC Act, § 18-1001, provides that a member or assignee “may” bring “the derivative action”, the court reasoned that § 18-1001 created the right to file a derivative action by members and assignees while § 18-1002 explicitly limited that right to members and assignees.  The court rejected CML’s argument that the General Assembly intended to take the corporate rule of derivative standing (which allows creditors of an insolvent corporation to sue derivatively) and apply it to the LLC context.  The court reasoned that the General Assembly is well suited to make a policy choice to deny derivative standing to creditors of an LLC, but allow such standing for creditors of a corporation, to promote business entity diversity.  The court further acknowledged the freedom of contract provided under the LLC Act.

The Delaware Supreme Court next rejected CML’s argument that limiting the Court of Chancery’s jurisdiction over derivative standing to members or assignees violates Article IV, Section 10 of the Delaware Constitution.  Under Delaware law, the General Assembly cannot limit the equity jurisdiction of the Court of Chancery to less than the general equity jurisdiction of the High Court of Chancery of Great Britain when Delaware first ratified its constitution.  The court observed that, unlike a corporation, an LLC as an entity did not exist at the time of enactment of the Delaware Constitution.  Accordingly, the Delaware Constitution does not prevent the General Assembly from limiting the Court of Chancery’s jurisdiction over derivative claims to members and assignees of LLC interests.  Moreover, the LLC is a creature of statute and the LLC Act was passed “in derogation of the common law.”  Accordingly, common law may supplement, but cannot override, the LLC Act’s express provisions, including § 18-1002.  Finally, the court reasoned that CML had an ample remedy at law, as it could have negotiated remedies by contract.

Conclusion

In structuring a finance transaction, lenders should be mindful of the differences in lending to a corporation, LLC or other Delaware business entity.  The Delaware Supreme Court emphasized the flexibility of an LLC as a business entity, and the freedom of contract available to its creditors.  The court suggested adding provisions that would, in the event of insolvency, convert the creditor’s interests to that of an “assignee” or give the creditor control of the LLC’s governing body.  Such provisions, however, place a creditor at risk of being viewed as an “insider”, or having its debt recharacterized as equity if the borrower becomes insolvent and files for bankruptcy.  An alternative solution not mentioned by the court would be to include a contractual fiduciary duty to creditors in the LLC agreement (to the extent permitted by law), and provide that creditors are third-party beneficiaries of such provision with a right of enforcement.  The lender could also enter into an agreement directly with the managers of the LLC, outlining the managers’ duties and providing a mechanism for enforcement.  Time will tell whether creditors are able, by these or other measures, to create enforceable protections against LLC managers’ misdeeds.

 

Pursuant to section 104(a) of the Bankruptcy Code (11 U.S.C. § 104(a)), starting April 1, 1998, and at each three year interval ending on April 1 thereafter, the dollar amounts in effect under various sections of the Bankruptcy Code are subject to adjustment. The adjustments are based upon the consumer price index, and a rounding to the nearest $25 amount that represents such change, with such adjusted amounts to be published in the Federal Register by the Judicial Conference of the United States not later than March 1 of each three year interval. Such adjustments apply only with respect to cases commenced after the effective date of such adjustments. On or about February 25, 2010, the Judicial Conference published the adjustments that will take affect as of April 1, 2010 (see Federal Register/Vol. 75, No. 37/Thursday, February 25, 2010/Notices, Page 8747-8749.)

The following are a few of the increases that would be relevant to business bankruptcy cases:

a.  Under the 28 U.S.C. § 1409(b), venue of proceedings arising under or related to cases under Title 11 to recover a debt against a non-insider of less than $11,725.00, may be brought only in the district court for the district in which the defendant resides. This is an increase from $10,950.

b.  In the definition of “small business debtor” under 11 U.S.C. § 101(51D)(A) and (B), the aggregate non-contingent liquidated secured and unsecured debts as of the date of the petition or the date of the order for relief has been increased from $2,190,000 to the amount of $2,343,300, each time it appears in such sections (note, these amounts exclude debts owed to one or more affiliates or insiders).

c.  The minimum aggregate amount of claims needed under 11 U.S.C. § 303(b) for the commencement of an involuntary Chapter 7 or Chapter 11 bankruptcy case has been increased from $13,475.00 to $14,425.00.

d.  Priority expenses and claims under 11 U.S.C. § 507(a) have been increased as follows:

  1. priority expenses and claims under 11 U.S.C. § 507(a)(4) for wages, salaries, or commissions, including vacation, severance and sick leave pay, or for sales commissions have been increased from $10,950.00 to $11,725.00;
  2. priority expenses and claims under 11 U.S.C § 507(a)(5) for allowed unsecured claims for contributions to an employee benefit plan have been increased from $10,950.00 to $11,725.00;
  3. priority expenses and claims under 11 U.S.C. § 507(a)(7) for pre-petition deposits have been increased from $2,425.00 to $2,600.00.

e.  The minimum amount that a trustee may seek to recover as a preferential transfer in a case filed by a debtor whose debts are not primarily consumer debts has been increased from $5,475.00 to $5,850.00.

f.  Again, the foregoing amounts apply only to cases commenced after April 1, 2010.