Corporate Restructuring

Delaware’s Bankruptcy Court has recently issued two insightful opinions that impact a creditor’s ability to establish the “receipt” element of a valuable 503(b)(9) administrative expense priority claim.

CASE 1: In re SRC Liquidation, LLC, Case No. 15-10541, 2017 WL 2992718 (Bankr. D. Del. July 13, 2017)

On July 13, 2017, Chief Judge Shannon of the United States Bankruptcy Court for the District of Delaware issued an opinion in the In re SRC Liquidation, LLC bankruptcy case regarding the ability of a creditor to assert a Section 503(b)(9) administrative claim for goods shipped by the vendor directly to a debtor’s customer in the 20 days before a debtor’s bankruptcy – referred to as “drop shipping.”

As discussed in prior posts on 503(b)(9) claims (Getting the Most Bang for Your 503(b)(9) Claims and Section 503(b)(9) Claims – What Does “Receipt” Really Mean?), to establish a 503(b)(9) claim, a creditor must demonstrate that:

  • goods were received by a debtor within 20 days before the petition date;
  • the goods were sold to the debtor; and
  • the goods were sold in the ordinary course of business.

The critical consideration in the SRC Liquidation decision was whether the creditor could establish that the debtor “received” the goods for purposes of establishing that its claim was entitled to administrative treatment pursuant to  Section 503(b)(9) of the Bankruptcy Code.  If not – the claim would be relegated to a non-priority, general unsecured claim (with little chance for recovery).  The creditor asserted that receipt occurred when the creditor-vendor delivered the product to a third-party shipper (UPS) for ultimate delivery to the debtors’ non-debtor customer.  By example, with most drop shipments, a debtor may directly place an order with a creditor-vendor, but the creditor-vendor may deliver the goods directly to a debtor’s customer, rather than the debtor itself.

In SRC Liquidation, the court’s analysis began with recognizing that “receipt” is not defined in the Bankruptcy Code and looking to the UCC for guidance.  Under the UCC, the term “receipt” can include physical possession (see § 2-103) or, in certain circumstances, constructive possession (i.e. § 2-705) when placed in the control of a bailee for the debtor.  The United States Court of Appeals for the Third Circuit in its recent opinion in In re World Imports, Inc., was also recently tasked with defining receipt for purposes of 503(b)(9) claims.  There, the Third Circuit, just days prior to Judge Shannon’s SRC Liquidation decision, held that receipt for purposes of 503(b)(9) claims required physical possession – and the Third Circuit looked to both its prior precedent in the case of Montello Oil Corp. v. Marin Motor Oil, Inc. (In re Marin Motor Oil, Inc.), 740 F.2d 220 (3d Cir. 1984) (where receipt for reclamation purposes was found to require physical possession) and the UCC.  The Third Circuit in In re World Imports, Inc. also noted that in analyzing shipping arrangements, placement of the goods into the possession of a common carrier (who was not the debtor’s bailee) did not establish “receipt” –instead observing it occurred when the debtor physically received the goods.

The creditor in In re SRC Liquidation argued that receipt for purposes of 503(b)(9) should be interpreted to include constructive receipt – including by a debtor’s customers.  The creditor argued that the court should interpret the term “received” differently when considering it under 503(b)(9) as opposed to reclamation because the commercial realities and the remedies are different.  The creditor argued that for reclamation, because the remedy is recovery of actual goods delivered, physical possession of the goods would understandably be a prerequisite, while in contrast for a 503(b)(9) claim, a creditor is asserting a claim for the value of the goods – not for the actual goods – and thus constructive possession should be permitted.  A focal point of the creditor’s argument was that “receipt” for 503(b)(9) purposes should be determined when title passed from the seller – i.e. when placed with the third-party shipper.

The bankruptcy court disagreed finding that the term “received” should mean the same for reclamation as for 503(b)(9) purposes because they arise in similar circumstances and concern related issues.  The court further held that the passing of title was not the only concern – particularly under the UCC – for establishing rights of buyers and sellers – noting that “possession is the key.”   Judge Shannon cited the Third Circuit’s decision just days in In re World Imports, Inc.   My recent prior post provides a more in-depth analysis of that decision, where the Third Circuit held that physical possession by the debtor was determinative of whether the debtor “received” goods for 503(b)(9) purposes, as opposed to the when title or of loss of product passed.    

Judge Shannon’s decision was not appealed and appears to follow the majority of other courts that have addressed the drop shipment issue (including Judge Shannon’s prior findings in the SRC case).  The majority of courts hold that unless the actual debtor-customer (as opposed to another party) received the goods, the claim for such goods is not entitled to administrative expense priority treatment under Section 503(b)(9) of the Bankruptcy Code.  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).  The ultimate implication of this ruling is best considered in the context of the In re ADI Liquidation, Inc., et al. decision issued in June 2017 and discussed below.

CASE 2: In re ADI Liquidation, Inc., et al., Case No. 14-12092, 2017 WL 2712287 (Bankr. D. Del. June 22, 2017)

Last month, on June 22, 2017, Judge Carey of the United States Bankruptcy Court for the District of Delaware issued an opinion in the In re ADI Liquidation, Inc., et al. cases addressing what “received” means in the context of a Section 503(b)(9)  claim derived from a wholesale arrangement – which he analogized to a drop shipment arrangement.   Wholesale/cooperative arrangements are prevalent in and outside of the grocery industry.  In cooperatives, typically member-participants collectively order through a centralized billing system and typically the orders are all made by and through one entity to vendors (and that entity also pays for the goods), but the shipments are often made directly to the member-participants (as opposed to the ordering party), who then pay the ordering party after the fact.  Cooperatives often arise where buyers, who purchase the same products or purchase from the same vendors, pool their buying power to negotiate more favorable rates.

In the ADI Liquidation case, creditor Bimbo Bakeries USA, Inc. (“BBU”) supplied baked goods to AWI (f/k/a Associated Wholesalers, Inc.) and to its cooperative members (which included non-debtor entities).  The ordered goods were delivered directly to AWI as well as directly to the non-debtor cooperative members.  AWI would typically pay vendors for all of the purchased goods (by both AWI and its cooperative members).  There was a separate purchase and supply agreement between the members and AWI, pursuant to which AWI acted as a wholesaler to the members.  BBU as a vendor was not a party to the purchase agreement.

When BBU asserted its Section 503(b)(9) claims, it included goods delivered directly to debtor AWI and goods that BBU delivered to the non-debtor AWI Members (that were ordered and paid for by AWI).  As discussed above and in my prior posts on 503(b)(9) claims, to establish a 503(b)(9) claim, a creditor must demonstrate, among other things, that the goods were received by a debtor within 20 days before the petition date.

The central focus of the court’s opinion in In re ADI Liquidation was whether or not BBU established that the AWI debtors “received” the goods that BBU delivered to the non-debtor cooperative members.  BBU argued that the goods in question were constructively received by debtor AWI (and thus entitled to administrative expense treatment under Section 503(b)(9) because debtor AWI and the non-debtor receiving members/customers were so related and indivisible, that the receipt by the customer was the equivalent of the debtor receiving it.  The court’s instant decision did not address BBU’s other claims – including administrative expense claims for goods delivered to other debtors, but ordered by AWI.

Recognizing (as referenced above) that the term “received” is not defined by the Bankruptcy Code, the court looked to the UCC for guidance and found that for constructive receipt to be established (often considered in the context of reclamation), the receiving party must be a bailee of the debtor.  The court held that the receiving members were not bailees of debtor AWI and notwithstanding that the UCC contemplates that constructive receipt can occur by a buyer-representative who is a “sub-purchaser” (like in a drop ship context), the court held that the “buyers” were the non-debtor members and not debtor AWI.  In so finding, the court determined that the claims for the goods that BBU delivered to the non-debtor members were non-priority, general unsecured claims (which would receive little, if any distribution).

On July 5, 2017, BBU appealed the Delaware Bankruptcy Court’s June 2017 decision to the District Court (assigned Case No. 17-903).   Given the prevalence of cooperative buying arrangements, in and outside of the grocery context, and the importance of “receipt” in establishing the very valuable 503(b)(9) claims, creditors and debtors alike will be carefully monitoring the developments of this case.

CONCLUSION

As discussed in prior posts, Section 503(b)(9) claims are very valuable to creditors (with the likelihood of providing a dollar for dollar return) as opposed to other general unsecured claims which often times provide speculative, if any, return.  These recent decisions on the receipt element for establishing a Section 503(b)(9) claim provide helpful guidance so that debtors, creditors and their respective professionals can better understand the prospects for establishing these administrative claims, and in particular for debtors, the cost of confirming a bankruptcy case – which requires payment in full for such claims.

In an era when goods or materials often originate from suppliers or manufacturers outside the United States, bankruptcy courts are grappling with when “receipt” of goods occurs for the purpose of 503(b)(9) claims.

While often times pre-petition claims receive only pennies on the dollar, Section 503(b)(b)(9) of the Bankruptcy Code provides creditors with an administrative expense claim for goods (not services) that a debtor receives in the 20 days before bankruptcy that often times results in a dollar-for-dollar recovery. Section 503(b)(9) is generally recognized as an alternative (and more desirable) remedy to reclamation rights – which are addressed under Section 546(c) of the Bankruptcy Code.

I previously addressed what steps to take to ensure that you are Getting the Most Bang for Your 503(b)(9) Bucks.  One of the pre-requisites to establishing entitlement to this valuable claim is demonstrating first that the debtor “received” the goods in question during the 20-day period.  An interesting issue arises in the context of “FOB” shipping arrangements.  “FOB” – or free on board – in the context of international shipping means that the buyer and seller agree at what point the risk of loss for the goods is shifted from the seller to the buyer – whether it is FOB destination (meaning it occurs upon delivery) or FOB shipping point/origin (meaning it occurs when the goods are placed on the ship in the port of origin).

Why does this matter? Because – as addressed in last week’s opinion by the United States Court of Appeals for the Third Circuit in In re World Imports, Ltd., et al., — F.3d —-, 2017 WL 2925429 (3d Cir. July 10, 2017), No. 16-1357, creditors may use FOB origin to ship to a debtor.  The goods may be placed on a ship outside the 20-day period, but the debtor receives the goods (i.e., in-hand physical possession) within the 20-days.  The question becomes when are the goods “received” for the purpose of establishing the very valuable Section 503(b)(9) claim:  if outside the 20-day period, there is often little, if any, potential for a meaningful recovery, but if within the 20-day period, and provided the other elements of Section 503(b)(9) are met, a creditor can obtain a dollar-for-dollar recovery for those goods.

“Receipt” is not defined by the Bankruptcy Code.  The Third Circuit and the 2 lower courts from which the Third Circuit appeal emanated addressed what “receipt” in the context of an FOB origin arrangement means for establishing a Section 503(b)(9) claim.

The Bankruptcy Court for the Eastern District of Pennsylvania held in favor of the debtor and its Official Committee of Unsecured Creditors, finding that in an FOB origin arrangement, “receipt” of goods occurs at the point of origin when the goods were placed on the ship (which was outside the 20-day period), and when title and risk of loss of goods shifted to the debtor.  See, In re World Imports, Ltd., 511 B.R. 738 (Bankr. E.D. Pa. 2014).  This determination was affirmed by the District Court.  See In re World Imports, Ltd., 549 B.R. 820 (E.D. Pa. 2016).  The lower courts each rejected the creditors’ arguments that the courts should look to state law, i.e., the UCC definition of “receipt” – which requires the customer’s physical possession of the goods, looking instead to an international treaty, the Convention on Contracts for the International Sale of Goods (as adopted by the United States) (“CISG”), finding it created an exception.  Although “receipt” is also not defined in the CISG, it recognizes international commercial terms – like FOB, which provide for the transfer of risk of loss/damage to goods at the time the goods are placed on the ship. The lower courts both found that this transfer of title and risk was determinative of “receipt” for purposes Section 503(b)(9).

On July 10, 2017, however, the Third Circuit in In re World Imports, Ltd. reversed the lower courts, finding that receipt did not occur until the goods were physically in the debtor’s possession, which occurred within the 20-day period, enabling the creditors to succeed in meeting the prerequisite element that the goods were “received” within the 20-day period as required by Section 503(b)(9).  The Third Circuit began its analysis with examining the definition of “receipt.”  The Third Circuit considered how the UCC defines “receipt” – as well as Black’s dictionary and how the Third Circuit previously interpreted the term in the context of Section 546(c) of the Bankruptcy Code – the provision governing reclamation – all of which required physical possession. See, e.g., In re Marin Motor Oil, 740 F.2d 220, 224-25 (3d Cir. 1984).

Given the relationship between Section 503(b)(9) and the reclamation scheme (noting that 503(b)(9) is an exemption to that scheme), and the Third Circuit’s standing precedent that “receipt” in the context of reclamation requires physical possession, the Court found that “receipt” for Section 503(b)(9) also required “taking physical possession.”  In so finding, the Third Circuit dismissed arguments that “constructive receipt” under the terms of FOB origin shipping should determine “receipt” for bankruptcy purposes.  A key element to this finding was the Third Circuit’s prior determination that a carrier (like the ship) does not serve as a debtor’s agent for purposes of “receipt.”  See In re Marin Motor Oil, 740 F.2d at 222.  Notably, the Third Circuit in its prior decision in In re Marin Motor Oil, supra, addressed “constructive receipt” finding that “constructive receipt” occurred when the debtor’s agent took physical possession of the goods from the common carrier – not (the day prior) when the seller placed the goods in the hands of the common carrier.  Id.

The Third Circuit also based its decision on the UCC’s explicit distinction of “receipt” and “delivery – observing that while a supplier may be contractually obligated to “deliver” goods, that does not necessarily mean a buyer receives them – and that delivery and receipt can occur at two separate times.  Moreover, given its recognition that Section 503(b)(9) and the reclamation scheme under the Bankruptcy Code have generally borrowed from the definitions of the UCC, the Court did not believe it appropriate to look to other federal law, e.g. the CISG, for contextual meaning, as there was no explicit connection in that definitional scheme to that of the Bankruptcy Code.

Ultimately, and notwithstanding that parties may, in fact, contract for title and risk of loss to pass to a debtor-buyer days prior and in another country – “receipt” for Section 503(b)(9) does not occur until the goods are physically in a debtor’s possession.  The Third Circuit reversed and remanded to the lower court for further proceedings to permit the claims to receive the favored administrative status.

This issue may arise in a number of contexts – including domestically.  Creditor-vendors are well-advised to carefully examine the underlying facts in preparing their claims.  While establishing “receipt” is just one facet of proving your Section 503(b)(9) claim, the Third Circuit’s recent decision adds color and context for creditors to better understand how to establish these valuable administrative claims. This recent decision may enable a larger number of creditors to assert administrative expense claims against a debtor’s estate.  This will also necessarily increase a debtor’s administrative expenses where the debtor relies on goods or materials shipped from overseas, which may negatively impact a debtor’s ability to successfully emerge from bankruptcy.

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

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

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

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

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

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

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

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

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

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

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

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

TR page 26, lines 11-17.

The Court pressed the point by asking Debtors’ Counsel:

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

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

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

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

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

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

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

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

On 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.

Prepetition, Millennium Lab Holdings II, LLC, Millennium Health, LLC, and RxAnte, LLC (the Debtors) reached a settlement with various government entities (the USA Settling Parties) relating to, among other things, claims against the Debtors for violations of the Stark law, Anti-Kickback Statute and False Claims Act (FCA). The Debtors also negotiated a restructuring support agreement with an ad hoc group of lenders (the Ad Hoc Group) holding debt under a 2014 existing credit agreement in the original principal amount of $1.825 billion (the Credit Agreement). In re Millennium Lab Holdings II, LLC, 543 B.R. 703, 705 (Bankr. D. Del. 2016).

The terms of the settlements included: 1) a $325 million payment from the equity holders to the Debtors; 2) conversion of the Credit Agreement into a $600 million new term loan; 3) transfer of the Debtors’ equity interests to the lenders under the Credit Agreement (the Lenders); 4) creation of two trusts; 5) a $206 million payment to the USA Settling Parties; 6) full recovery for all creditors except the Lenders; and 7) non-debtor third-party releases (the Releases) of the Debtors’ equity holders and their officers and directors. Id. at 706.

Since the Debtors did not receive sufficient votes from the Lenders for an out-of-court restructuring, on Nov. 10, 2015, the Debtors filed petitions for Chapter 11 relief together with a proposed prepackaged plan (the Plan) in the United States Bankruptcy Court for the District of Delaware (the bankruptcy court). The Plan incorporated all of the terms of the prepetition settlements with the USA Settling Parties and the Ad Hoc Group, including the Releases. Id.

The Debtors provided disclosure of the Releases as follows: 1) including all Plan release provisions verbatim in bold typeface as an exhibit to the notice of hearing on confirmation of the Plan. In re Millennium Lab Holdings II, LLC, Case No. 15-12284, Dkt. No. 91, Ex. 2 (Bankr. D. Del. Dec. 10, 2015); 2) including the release provisions in the Lenders’ class 2 ballots (the “Class 2 Ballots”), id., Dkt. No. 16, Ex. A; and 3) using fully capitalized typeface in the Plan itself. Id., Dkt. No. 182-1, at 66-67. The Lenders were the only class entitled to vote on the Plan, id. at 27, and the Class 2 Ballots did not include an option to opt-out of the Releases. Id., Dkt. No. 16, Ex. A.

Some of the Lenders with claims against the Debtors’ equity holders and directors and officers voted against the Plan and objected to the Releases (the Opt-Out Lenders). On Dec. 10, 2015, an evidentiary hearing was held by the bankruptcy court to consider confirmation of the Plan. Id., Dkt. No. 190. The next day, the bankruptcy court made a lengthy oral ruling from the bench confirming the Plan and overruling the objections of the Opt-Out Lenders and the United States Trustee. Id., Dkt. No. 206 (the Hearing).

Oral Ruling

During Judge Laurie Selber Silverstein’s oral ruling, she first addressed the Opt-Out Parties’ assertion that the bankruptcy court did not have jurisdiction to approve the Releases. Judge Silverstein stated that bankruptcy courts have at least related to jurisdiction over third-party claims that could have an impact on the estate. Id. at 13:1-15. Here, the released parties had contractual indemnification claims and litigation advancement rights against the Debtors, which was a sufficient nexus to the Debtors’ estates, for the bankruptcy court to have jurisdiction to consider the Releases.

Second, Judge Silverstein addressed whether the Releases were appropriate under the circumstances. The Judge cited to In re Continental Airlines, 203 F.3d 203 (3d Cir. 2000), which “set forth what it called the ‘hallmarks’ of permissible, non-consensual releases; namely: Fairness, necessity to the reorganization, and specific factual findings to support the conclusions.” Judge Silverstein considered the following factors in analyzing the Continental hallmarks:

[1] An identity of interest between the debtor and the third party, such that a … suit against the non-debtor is, in essence, a suit against the debtor, or will deplete assets of the estate. [2] Substantial contribution by the non-debtor of assets to the reorganization. [3] The essential nature of the injunction to the reorganization, to the extent that, without the injunction, there is little likelihood of success. [4] An agreement by a substantial majority of creditors to support the injunction; specifically, if the impacted class or classes overwhelmingly votes to accept the plan. And [5] a provision in the plan for payment of all or substantially all of the claims of the … class or classes affected by the injunction. Hearing Tr. at 17:14-18:4.

Here, Judge Silverstein found that: 1) there was an identity of interest between the Debtors and the released parties due to the indemnification and advancement obligations owed by the Debtors should a nondebtor pursue a claim against the released parties; 2) the equity interest holders made substantial contributions by paying $325 million to the Debtors and relinquishing their equity interests in the Debtors, and the directors’ and officers’ sweat equity from their prior and future work for the Debtors was also a substantial contribution under the circumstances; 3) the Releases were essential to the Plan; 4) the support of 93.02% in number and 93.74% in amount of Class 2 Lenders was a substantial majority of creditors supporting the injunction; and 5) the $600 million new term loan, all the equity in the Debtors and recoveries under two trusts was reasonable compensation for Class 2 Lenders in exchange for the Releases, which is all that needs to be shown to satisfy the final factor.

Judge Silverstein stated that she was “not rejecting the argument that sweat equity alone may not be sufficient to constitute a substantial contribution in a given case. But in this case, where the record is unrebutted that the efforts of management successfully resulted in a viable plan that garnered support from all parties other than [the Opt-Out Lenders], and results in 100 percent payment to all creditors other than the [Lenders]; and that management, in the [Lenders’] view, is critical to unlocking the reorganized debtors’ total enterprise value, I find that the directors and officers have made a substantial contribution.”

After reviewing the relevant factors, Judge Silverstein approved the Releases, stating that “[t]aking into consideration the facts of this case, I find the releases and injunctions to all parties to be fair and necessary to the reorganization … . It is clear that the releases are necessary to both obtaining the funding and consummating a plan. In these cases, the funding does not merely enhance creditor recoveries; it is necessary for the [Debtors] to confirm the plan.”

The United States Trustee argued that there must be an ability to optout of releases contained in the Plan. In response, Judge Silverstein stated:

Here, the notice of non-voting status was served on all known non-voting classes … . That notice contained the full text, in bold, of the plan releases; thus, nonvoting creditors, including unsecured creditors, were on notice of the releases being granted and chose not to object. [G]iven the 100 percent payment on claims in this case, I find that the nonvoting parties have consented. Hearing Tr. at 27:22-28:5.

While Judge Silverstein confirmed the Plan without an opt-out mechanism, she stated that she could reevaluate this issue in future cases. Id. at 27:20-22.

Certification to the Third Circuit

Judge Silverstein certified the Opt-Out Lenders’ direct appeal to the U.S. Court of Appeals for the Third Circuit on the issue of what standard of law governs approval of “a non-debtor’s direct claims against other non-debtors for fraud and other willful misconduct without the consent of the releasing non-debtor … .”Millennium Lab, 543 B.R. at 709, 717. This issue met the requirements of direct certification because Judge Silverstein’s holding conflicts with Washington Mutual, 442 B.R. 314 (Bankr. D. Del. 2011). Id. at 714.

Unlike Judge Silverstein’s holding in Millennium Lab, Judge Mary F. Walrath stated in Washington Mutualthat a bankruptcy court “does not have the power to grant a third party release of a non-debtor. Rather, any such release must be based on consent of the releasing party (by contract or the mechanism of voting in favor of the plan).” Millennium Lab, 543 B.R. at 714-15 (quoting Washington Mutual, 442 B.R. at 352). While both cases recognized Continental, Judge Silverstein’s “interpretation of what is meant by Continental’s hallmarks — fairness and necessity to the reorganization — differs from that of theWashington Mutual court.” Millennium Lab, 543 B.R. at 715. However, the Third Circuit denied the petition for permission to appeal. In re Millennium Lab Holdings, No. 16-8017, Doc. No. 003112215428 (3d Cir. Feb. 22, 2016). Therefore, the Opt-Out Lenders were forced to file their appeal with the United States District Court.

Appeal to the District Court

The Opt-Out Lenders raised numerous issues on appeal of confirmation of the Plan, which is still pending before the district court. In re Millennium Lab Holdings II, LLC, Case No. 1:16-cv-00110(LPS), Dkt. No. 13, at 27-42 (D. Del. April 15, 2016). One of the issues on appeal is that the bankruptcy court erred in approving the Releases based on the facts of the case. The OptOut Lenders argue that the Plan does not provide for payment of all or substantially all of the Lenders’ claims, there is no identity of interest between the released parties and the Debtors because the released parties have no right to seek indemnification against the Debtors for willful misconduct claims, and the released parties are not contributing substantial assets. Id. at 45-58.

It is uncertain whether the issues raised on appeal by the OptOut Lenders will be decided by the district court. The Debtors filed a motion to dismiss the appeal on the grounds that the appeal is equitably and constitutionally moot, which the Opt-Out Lenders have opposed. In re Millennium Lab Holdings II, LLC, Case No. 1:16-cv-00110(LPS), Dkt. No. 7, 28 (D. Del. 2016). The district court scheduled a hearing on the Motion to Dismiss for Oct. 7, 2016. Id., Dkt. No. 41.

Practical Pointers

Prior to Millennium Lab, Washington Mutual provided precedent within the Third Circuit that a nondebtor third-party release could only be granted by a bankruptcy court based upon the affirmative consent of the releasing party. See Washington Mutual, 442 B.R. at 352. Millennium Lab now provides some authority for the position that bankruptcy courts can approve non-consensual third-party releases. Millennium Lab also provides new precedent for the proposition that directors’ and officers’ sweat equity alone could be enough to meet the substantial contribution factor in support of a nondebtor third party release.

However, practitioners should be careful in citing Judge Silverstein’s oral ruling as precedent in future cases. In fact, Judge Silverstein stated that “this ruling is not to be cited back to me. It may not even be persuasive in other cases, we’ll see.” Hearing Tr. at 5:3-4. The oral ruling needs to be considered in light of the circumstances that the bankruptcy court was faced with to confirm a plan prior to the expiration of a settlement deadline.

Judge Silverstein made it clear that she could reevaluate many of the issues decided in Millennium Lab, such as whether creditors must be given the ability to opt-out of non-debtor third-party releases contained in a plan, and whether sweat equity alone by directors and officers could be enough to weigh in favor of releases. Therefore, practitioners should carefully consider whether providing a mechanism for opting out of non-debtor third party releases is necessary and what consideration must be provided by officers and directors to support such a release in future cases. If nothing else, Millennium Lab provides a good example to debtors’ counsel of the notice that should be provided to all creditors should a plan provide for a non-debtor third-party release.

Reprinted with permission from the Volume 33, Number 12: October 2016 edition of the The Bankruptcy Strategist© 2016 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.

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.

On June 15, 2015, the U.S. Supreme Court issued its opinion in the case of Baker Botts L.L.P. v. ASARCO LLC, 135 S. Ct. 2158 (2015), denying compensation to two law firms for the fees they incurred in defending objections to their fee applications.  Subsequent to confirmation of ASARCO’s plan of reorganization, the law firms of Baker Botts L.L.P. and Jordan, Hyden, Womble, Culbreth & Holczer, P.C. filed fee applications under section 330(a)(1) of the Bankruptcy Code.  Id. at 2163.  ASARCO, then controlled by a company the two law firms successfully sued during the course of the bankruptcy cases, objected.  Id.  The bankruptcy court overruled ASARCO’s objection and awarded the law firms, among other sums, approximately $5 million for time spent litigating in defense of their fee applications.  Id.   The Fifth Circuit reversed, holding that section 330(a)(1) does not authorize fees for defending fee applications, and the Supreme Court affirmed.  Id.

In ASARCO, the Supreme Court relied on the “American Rule” of attorney fee structure that each litigant pays for his or her own attorney’s fees, win or lose, unless a statute or contract provides otherwise.  135 S. Ct. at 2164.  Although the Court conceded that it had recognized departures from the American Rule in the past, it had only done so with instances of “specific and explicit provisions for the allowance of attorneys’ fees under selected statutes,”  Id. (quoting Alyeska Pipeline Serv. Co. v. Wilderness Soc’y, 95 S. Ct. 1612, 1623 (1975)), noting that such provisions generally authorize the award of “a reasonable attorney’s fee,” “fees,” or “litigation costs,” and usually refer to a “prevailing party” in the context of an adversarial “action.”  135 S. Ct. at 2164 (citing 28 U.S.C. § 2412(d)(1)(A); 42 U.S.C. §§ 1988(b), 2000e-5(k)).  Accordingly, the Court found that section 330(a)(1) of the Bankruptcy Code did not fall within this description “because it neither specifically nor explicitly authorizes courts to shift the costs of adversarial litigation from one side to the other . . . as most statues that displace the American Rule do.”  135 S. Ct. at 2165.

Subsequent to ASARCO, certain professionals in bankruptcy cases pending in the U.S. Bankruptcy Court for the District of Delaware have sought to gain prospective approval of fees that they may incur in connection with successfully defending fee applications by including an indemnification provision in their engagement agreements and/or the proposed order submitted with their retention application.  See, e.g., In re New Gulf Res., LLC, Case No. 15-12566 (BLS) (Bankr. D. Del.), Dkt. No. 54; In re Taylor-Wharton Int’l LLC, Case No. 15-12075 (BLS) (Bankr. D. Del.), Dkt. No. 194; In re Quiksilver, Inc., Case No. 15-11880 (BLS) (Bankr. D. Del.), Dkt. No. 36; In re Boomerang Tube, Inc. Case No. 15-11247 (MFW) (Bankr. D. Del.), Dkt. No. 271.  The U.S. Trustee for the District of Delaware, however, has objected to, or provided informal comments to, most if not all of these professionals’ retention applications, asserting that ASARCO precludes approval of such an indemnification provision.  See, e.g., New Gulf Res., Dkt. No. 116; Taylor-Wharton Int’l, Dkt. No. 278; Boomerang Tube, Dkt. No. 314.  Although retention of these professionals has ultimately been approved, the orders approving such retention contain a caveat that the applicable indemnification provision is subject to further order of the court.  See, e.g., Quicksilver, Dkt. No. 245; Boomerang Tube, Dkt. No. 391.  On January 29, 2016, in the case of Boomerang Tube, Case No. 15-11247, 2016 WL 385933 (Bankr. D. Del. Jan. 29, 2016), Judge Walrath issued an opinion on the approval of fee defense provisions under section 328(a) of the Bankruptcy Code.

In Boomerang Tube, professionals for the official committee of unsecured creditors sought to distinguish ASARCO by arguing, among other things, that because they were seeking approval of a fee defense provision under section 328(a) of the Bankruptcy Code, rather than section 330(a), ASARCO was not binding precedent.  2016 WL 385933, at *1-2.  The U.S. Trustee disagreed, asserting that although committee professionals were retained under section 328(a) of the Bankruptcy Code (as opposed to section 327(a) as discussed in ASARCO), they could only be paid pursuant to section 330(a) of the Bankruptcy Code and therefore ASARCO was directly on point.  Id., at *2.  The court agreed with the U.S. Trustee, stating that “[n]either section 330 nor section 328 contain similar express language awarding attorneys’ fees for successful prosecution of a defense to a fee objection.”  Id., at *3.  Consequently, the court held that “section 328, like section 330, does not provide an exception to the American Rule and cannot support the fee defense provisions at issue under the Supreme Court’s ruling in ASARCO.”  Id.

Moreover, committee counsel argued that ASARCO acknowledged a contractual exception to the American Rule and that their retention agreements with the committee fall within that exception.  2016 WL 385933, at *3.  The court agreed with committee counsel that a contract exception to the American Rule was not precluded by ASARCO; however, it stated that retention agreements are “ultimately subject to approval (and modification) by the Court” and are not exceptions to the American Rule because they are not the “typical contract modifying the American Rule,” which is “a contract between two parties providing that each will be responsible for the other’s legal fees if it loses a dispute between them.”  Id., at *4.  In support of this finding, the court also noted that a retention agreement between committee professionals and the committee could not bind the bankruptcy estate because it is not a party to the contract.  Id. at *4.

Importantly, the court also noted, albeit in a footnote, that it would reach the same conclusion if the fee defense provisions were in a retention agreement filed by any professional retained under section 328(a) of the Bankruptcy Code, including one retained by a debtor, noting that “[s]uch provisions are not statutory or contractual exceptions to the American Rule and are not reasonable terms of employment of professionals.”  2016 WL 385933, at *8 n.6.

It remains to be seen whether other judges will adopt the reasoning set forth in Boomerang Tube; however, the standard in Delaware is already spreading.  For example, Judge Shannon recently issued similar letters in the cases of In re Taylor-Wharton International, LLC and In re New Gulf Resources, LLC, stating in both that he had “carefully considered the [Boomerang Tube] Opinion and agree[s] with its holding (including comments contained in Footnote 6 of the Opinion applying its rationale to the retention of debtor’s counsel).”  Taylor-Wharton Int’l, Dkt. No. 405; New Gulf Res., Dkt. No. 228.  Consequently, unless Congress amends the Bankruptcy Code to specifically permit compensation for fees incurred by professionals in defending objections to their fee applications, at least in the District of Delaware fees incurred in connection therewith remain subject to attack without the ability to be paid for defending those attacks.