It’s no secret that Delaware, New York (Southern District), and Texas (at least since the oil and gas crisis) have become known as the “hotspots” for filing large chapter 11 bankruptcy cases.  Whether due to desirable precedent, well qualified judges, the responsiveness of the Courts to the need for prompt scheduling of hearings, or a sense of uniformity, most large companies have historically chosen to file in these venues. However, these popular venues appear to have a rival.  Recently, some large chapter 11 debtors— Gymboree and Toys “R” Us— have filed in the commonwealth that generally prides itself as being a place “for lovers.”  So, let’s explore why recent chapter 11 debtors have chosen to file in Virginia.

Venue in a bankruptcy case is governed by 28 U.S.C. § 1408, which provides that a debtor may file its bankruptcy case in any district where the debtor’s domicile, residence, principal place of business, or principal assets are located.  For the purposes of the statute, “domicile” indicates a corporation’s state of incorporation.  However, the debtor is not restricted to these locations.  Bankruptcy venue is also proper in a district where the debtor’s affiliate, general partner, or partnership already has a bankruptcy case pending, often times opening the door to a variety of venues.  In many cases, more than one venue will satisfy the statutory requirements, allowing the debtor to make a choice.

What is so appealing about the United States Bankruptcy Court, Eastern District of Virginia (Richmond Division)?  First, the two judges sitting in this district are well respected. Michael A. Condyles, a lawyer in the firm representing Gymboree as local counsel, was quoted in a recent article published in The Virginia Lawyers Weekly as saying, “I do think there is a definite trend.  I think it is a testament to the quality of the judges.”  “The attraction is the ‘quality and sophistication’ of the judges,” Condyles continued.  Judges Kevin R. Huennekens and Keith L. Phillips, who serve in Rich­mond, have a combined 15 years of experience on the bankruptcy bench.

However, this alone cannot answer the question of “why Virginia” in a particular case. Attorneys who have appeared before the bankruptcy courts in Delaware, New York, and Texas, are well aware of the proficiency of excellence and sophistication of the judges who sit there.  The judges’ experience and competency are driving factors that regularly motivate sophisticated attorneys to fly in from all over the country to present their cases in the sought after venues. Clearly, the skill-level of the judges cannot be the only draw to the recent filings in Virginia.

According to a recent article published in the New York Times, the Richmond bankruptcy court is also known to move cases along quickly. While this may be true, that is understandable due to the fact that Virginia courts are required to juggle only a small fraction of the large chapter 11 cases that some of the other venues regularly encounter. The overburdened dockets which many courts frequently face, especially those of the Southern District of New York and Delaware, are managed with ease. These judges commonly schedule multiple hearings in one day, and many of the hearings involve sophisticated, complex issues. Nonetheless, the overburdened dockets are defied by these Courts’ ability to handle the caseload in an efficient manner. Therefore, there still must be more behind this new trend.

The recent large-case filings in Virginia may also be due to another feature attractive to debtors’ counsel— the court is known for approving high professional fees. Nationally, professional fees for bankruptcies have been increasing about 9.5 percent a year, about four times the rate of inflation, according to Lynn LoPucki, a bankruptcy professor at the University of California, Los Angeles who was quoted in the New York Times. In 2014, The National Law Journal posted the results of an hourly billing survey from law firms. It showed the average hourly rate for partners was $604, and associates charged $307. Now, partners in the largest 50 firms charge a median hourly billing rate of $625 per hour, versus those in a second largest group who charge almost $180 less for every hour, coming in at $447. As law firm size increases, so does the median billing rate. Public company debtors typically are represented by the large firms with high billing rates.

Kirkland and Ellis, counsel to Toys “R” Us, disclosed to the bankruptcy judge in the Eastern District of Virginia that its lawyers were charging as much as $1,745 an hour in the case. According to an analysis by The New York Times, that is 25 percent more than the average highest rate in 10 of the largest bankruptcies this year. So far, the Richmond judges seem to accept that with the complexities of large chapter 11 cases, come high attorney rates.

This begs the question, now that the allure of filing in Virginia is known, will we see this trend continue to grow? Only time will tell.

 

 

In order to secure a real property owner’s payment obligation, contractors, mechanics, materialmen, and other workmen are often granted a lien referred to by a variety of names including, materialmen’s liens, workmen’s liens, and mechanic’s liens.  While the parlance varies by jurisdiction, they are generally referred to as mechanic’s liens in Texas—even in the context of real property.  Because a mechanic’s lien secures the real property owner’s obligation to the underlying real property, making sure that their mechanic’s lien is properly perfected should be in the forefront of all contractors’ minds.  The protection afforded by a mechanic’s lien becomes increasingly important for contractors if they encounter issues obtaining payment from the real property owner or if the real property owner files bankruptcy.

Texas has two types of mechanic’s liens for real property: constitutional and statutory.  Article XVI section 37 of the Texas Constitution expressly provides for a variety of mechanic’s liens, and states:

Mechanics, artisans and material men, of every class, shall have a lien upon the buildings and articles made or repaired by them for the value of their labor done thereon, or material furnished therefor; and the Legislature shall prove by law for the speedy and efficient enforcement of said liens.

Courts interpret this section of the Texas Constitution as providing for “self-executing” liens as between the lien claimant and the property owner; that is, these constitutional liens do not generally require a contractor to take any additional steps beyond furnishing materials or labor directly to the property owner in order to perfect their interest.  The ease with which protection is afforded is generally great news for contractors because they receive increased rights just by virtue of their labor.  There is also a second, and arguably superior, way to obtain a mechanic’s lien on real property.

The second way to create a mechanic’s lien on real property in Texas is by following the statutory procedures.  More particularly described in chapter 53 of the Texas Property Code, the statute generally requires the completion of an affidavit containing certain statutorily specified information including, among other information, the amount of the claim, the contact information of the claimant, and a description of the encumbered property.  The statute also requires recording the affidavit with the county clerk for the county in which the property is located within a statutory period, and then providing a copy of the notice to the property owner.

But why would anybody want to jump through all those additional hoops for a statutory lien when obtaining a constitutional lien is so easy?  The answer is simple: the statutory lien is more powerful, and in certain situations, including if the real property owner files bankruptcy, may mean the difference between getting paid in full and getting pennies on the dollar.  In the context of bankruptcy, the crucial difference between these statutory and constitutional liens is the type of notice each provides.

In Texas, a mechanic’s lien claimant must provide actual or constructive notice to third parties to be protected against the rights of those third parties.  Because they are not recorded, constitutional liens rely on actual notice and constructive notice via the third party’s knowledge.  On the other hand, properly perfected statutory liens provide constructive notice because they are recorded in the county’s real property records.

Section 544 of the Bankruptcy Code provides the so-called “strong arm powers” of the bankruptcy trustee, which may be used to avoid certain liens and interests in property of the bankruptcy estate.  More particularly, Bankruptcy Code section 544(a) provides that

The trustee shall have as of the commencement of the case, and without regard to any knowledge of the trustee or of any creditors, the rights and powers of, or may avoid any transfer of property of the debtor or any obligation incurred by the debtor that is voidable by . . .

(3) a bona fide purchaser of real property, other than fixtures, from the debtor, against whom applicable law permits such transfer to be perfected, that obtains the status of a bona fide purchaser and has perfected such transfer at the time of the commencement of the case, whether or not such a purchaser exists.

Section 544 causes major problems for the contractors that only have a constitutional lien because it makes actual knowledge or notice irrelevant.  Constitutional mechanic’s liens are not recorded and rely on actual notice or knowledge to be effective.  Without actual notice and knowledge, constitutional liens are ineffective and can be avoided by the trustee’s strong arm powers.  Absent another defense, section 544 leaves a contractor relying a constitutional mechanic’s lien no better off than another unsecured creditor.

The simple solution to the problems associated with constitutional liens in bankruptcy is for contractors to fulfill the requirements to obtain a statutory mechanic’s lien.  The constructive notice provided by recording a statutory mechanic’s lien with the county clerk’s office is not rendered ineffective by section 544.  As a result, contractors with properly perfected statutory mechanic’s liens generally cannot have their interest avoided by section 544.  While constitutional mechanic’s liens are of value in some contexts, a properly perfected statutory mechanic’s lien provides greater protection in the event the real property owner files bankruptcy.

History:  In a June 14, 2017, bankruptcy blog titled “Six Degrees of Separation: Use of Bankruptcy Rule 2004 Examination in Connection with Third-Party Litigation, we reported on what appeared to be a case of first impression that arose in a case pending before United States Bankruptcy Judge Stuart Bernstein in the United States Bankruptcy Court for the Southern District of New York.  In the Chapter 11 case of In Re: Sun Edison Inc., et al., 16-109292(SMB), a dispute had arisen as to whether a debtor (“Sun Edison” or “Debtors”) and a related but non- debtor entity, TerraForm LLC (“TERP”) were entitled to Bankruptcy Rule 2004 discovery with respect to a pending state court litigation between TERP and a non-debtor third party plaintiff (“Plaintiff”).   The Debtors and TERP argued that the outcome of that litigation may have an effect on the value of a significant asset of the bankruptcy estate of the Debtors, being the Debtors’ equity interests in TERP.  In that earlier blog we noted that the Court at oral argument had stated: “You know, every piece of information and fact out there is within six degrees of separation of a Debtors’ assets and financial affairs. The question is where do you draw the line?” 4/2017 Transcript of Hearing, In Re: Sun Edison Inc., et al., Case No. 16-10992-SMB, page 30, lines 6-11.

The Decision:  As of the date of our earlier blog, the question posed by the Court remained unanswered. On June 16, 2017, however, the Court ruled in its fairly lengthy 16 page “Memorandum Decision and Order Denying Motion for a Rule 2004 Examination”. In re Sunedison, Inc., 572 B.R. 482 (Bankr. S.D.N.Y. 2017) (the “Decision”).  First, Judge Bernstein reiterated his ruling from the bench at the hearing denying TERP’s request for Rule 2004 discovery based on the “pending proceeding” rule.  Decision at 490.  Under that rule, Judge Bernstein noted that once an adversary proceeding or contested matter is commenced, discovery should be pursued under the Federal Rules of Civil Procedure and not by Rule 2004, and that the principle also applies to pending state court litigation (in which the state court discovery rules would be applied).  Id.

Turning next to the Debtors, the Court noted that the pending proceeding rule did not apply because the Debtors were not a party to the state court litigation.  The Court then stated that the Debtors would be entitled to Rule 2004 discovery if they could establish cause.  Id.  But beyond this, Judge Bernstein noted, “[r]elevance, however, is not enough; the Debtors must show that they need the discovery for some appropriate purpose, or that the failure to get the discovery will result in hardship or injustice.”  Id.   Judge Bernstein ruled that the Debtors’ essential argument that that cause exists because the outcome of the state court action will have a material effect on the value of an important asset (the TERP shares) did not withstand scrutiny under the facts of this case.  Id. at 491.

Judge Bernstein noted that this was not a circumstance in which a debtor was seeking pre-litigation discovery for a legitimate and supportable basis, such as into claims that it owns, or examining into whether to take control of a subsidiary in order to sell or liquidate its assets.  Id.  The Court opined that “Rule 2004 does not reach so far as to allow a debtor to take discovery from participants in third-party litigation involving claims it does not own or defenses it will not assert simply because the outcome may affect the value of an asset the debtor does own.”  Id.    Judge Bernstein noted further that he had requested supplemental briefing on this point, but the Debtors were unable to cite any authority to support their use of Rule 2004 to discover the merits of claims asserted in third party litigation against a subsidiary in order to value its stock ownership.  Id.  Furthermore, Judge Bernstein stated that the Debtors failed to support their assertions that they needed the discovery to finalize a chapter 11 plan, ensure accurate disclosure, reassure lenders and secure exit financing, and confirm and implement a Plan.  Id.  [Note: With the benefit of the passage of time, it is now known that the Debtors were able, without the Rule 2004 discovery it sought, to procure replacement debtor in possession financing, obtain approval of their disclosure statement, confirm a plan and have the plan go effective.]

In addition, Judge Bernstein stated in his decision that the specific circumstances of the joint Rule 2004 request gave the Court pause.  More specifically, it appeared to Judge Bernstein that with the Debtors and TERP being “united in interest regarding the desired outcome of the [state court action between TERP and the Plaintiff], what was actually occurring was an effort by the Debtors to use Rule 2004 to help TERP get the discovery that should be sought by TERP in the [state court action].”  Id. at 492.

Judge Bernstein concluded that the Debtors “failed to show any necessity for the Rule 2004 discovery, or that they will suffer injustice or hardship if they don’t get it.”   Id.

So, while a Rule 2004 examination itself may be broad, designed to assist the trustee in revealing the nature and extent of the estate, ascertaining assets, and discovering whether any wrongdoing has occurred, there does not appear to be any clearly definable answer to the question of how many degrees of separation may exist before moving beyond examination pursuant to Bankruptcy Rule 2004.  It appears that the elements of “cause” that a debtor must satisfy will be guided by the specific facts underlying the discovery it seeks, and an unsupported general assertion of need, or of adverse effect in the absence of such examination, will be a degree too far.

 

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

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

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

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

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

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

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

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

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

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

Short Summary

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

The WARN Act

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

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

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

Factual Background

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

The Third Circuit’s Holding

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

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

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

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

Conclusion

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

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.

If your practice involves discovery, chances are you have been on the receiving end (and maybe the dispensing end) of prolix boilerplate general objections in response to interrogatories or document demands.  Whatever logic may have led to the development of a laundry list of blasé general objections, courts have made clear that they are ineffective for much more than wasting space and annoying judges and that lawyers should stop interjecting them.  See, e.g., Fischer v. Forrest, 2017 WL 773694 (S.D.N.Y. Feb. 28, 2017) (Peck, Mag.); Sagness v. Duplechin, 2017 WL 1183988, at *2 (D. Neb. Mar. 29, 2017) (Zwart, Mag.); Liguria Foods, Inc. v. Griffith Labs., Inc., 2017 WL 976626 (N.D. Iowa Mar. 13, 2017); Cafaro v. Zois, 2016 WL 903307, at *1 (S.D. Fla. Mar. 9, 2016) (“Boilerplate objections may also border on a frivolous response to discovery requests.” citing Steed v. Everhome Mortg. Co., 308 F. App’x 364, 371 (11th Cir. 2009)); Heller v. City of Dallas, 303 F.R.D. 466, 482-85 (N.D. Tex. 2014) (“Counsel should cease and desist from raising these free-standing and purportedly universally applicable ‘general objections’ in responding to discovery requests.”); Waldrop v. Discover Bank (In re Waldrop), 560 B.R. 806, 810 (Bankr. W.D. Okla. 2016).  Some state courts have reached the same level of frustration with general objections.  See, e.g., In re Oxbow Carbon LLC Unitholder Litig., 2017 WL 959396, at *2-3 (Del. Ch. Mar. 13, 2017).

The Federal Rules of Civil Procedure have long stated that “the grounds for objecting to an interrogatory must be stated with specificity” and since December 1, 2015 the Federal Rules also state that, with regard to document requests, “[f]or each item or category, the response must either state that inspection and related activities will be permitted as requested or state with specificity the grounds for objecting to the request, including the reasons.”  Fed. R. Civ. P. 33(b)(4) and 34(b)(2)(B).  The word “specificity” in both rules precludes generic “general” objections.  See, e.g., Sagness, 2017 WL 1183988, at *2 (“Objections to interrogatories and requests for production of documents must be stated with specificity…. General blanket objections do not meet these specificity requirements and will be disregarded by this court.”).  Yet many lawyers persist in lodging general objections.  See Fischer, 2017 WL 773694, at *1 (“Most lawyers who have not changed their ‘form file’ violate one or more (and often all three) of [the] changes” to Fed. R. Civ. P. 33(b)(2)(B)-(C)).

General objections can be lumped into three broad categories:

  • Objections “Preserving” Rights Already Preserved Under the Civil Rules. These objections typically assert a general ground for objection that would be preserved whether stated or not.  Some examples of these objections include:
    • Objections to the extent that a request or interrogatory implicates privileged material. Privileged material is already excluded from the scope of discovery under Civil Rule 26(b)(1) and a generic assertion of privilege is, in and of itself, useless under Civil Rule 26(b)(5)(A)(ii).  See Schultz v. Sentinel Ins. Co., Ltd., 2016 WL 3149686, at*7 (D. S.D. Jun. 3, 2016) (“boilerplate ‘general objections’ fail to preserve any valid objection at all because they are not specific to a particular discovery request and they fail to identify a specific privilege or to describe the information withheld pursuant to the privilege”); Liguria Foods, 2017 WL 976626, at *11 (failure to provide privilege log renders privilege objections ineffective).
    • Objections to the extent a document request purports to require a party to obtain information that is not within its possession, custody or control. If the request purports to impose such a burden, it does not comply with Civil Rule 34(a)(1) in the first instance.
    • Objections that reserve the “right” to supplement responses. Parties are required to supplement their responses under Civil Rule 26(e)(1).  See Heller, 303 F.R.D. at 484.  This “objection” is pointless.
    • Objections that the production of a document is not an admission of authenticity, relevance, materiality or admissibility. Given that the scope of discovery expressly includes inadmissible documents under Civil Rule 26(b)(1), there can be no waiver arising from the production of inadmissible documents.  And the Federal Rules of Evidence regarding admissibility exist for a reason.
  • Objections Contradicted by the Civil Rules or Other Authority. These objections contradict the Civil Rules or other authority.  Some examples include:
    • Objections to interrogatories to the extent that they call for legal conclusions. Civil Rule 33(a)(2) provides that an interrogatory is not objectionable simply because it “asks for an opinion or contention that relates to … the application of law to fact….”
    • Objections to interrogatories or document requests seeking information regarding settlement negotiations. Federal Rule of Evidence 408 is a rule of admissibility, not discoverability.  See Arcelormittal Ind. Harbor LLC v. Amex Nooter, LLC, 2016 WL 4077154 (N.D. Ind. Jul. 9, 2016) (holding that even after removal of “discovery of admissible evidence” language from Rule 26, settlement documents remain discoverable); see also R. Civ. P. 26(b)(1) (“Information within this scope of discovery need not be admissible in evidence to be discoverable.”).
    • Objections that interrogatories are not admissions. “[D]isavowing interrogatory responses as ‘admissions of any nature’ flies in the face of Rule 33(c)’s provision that ‘[a]n answer to an interrogatory may be used to the extent allowed by the Federal Rules of Evidence.’”  Heller, 303 F.R.D. at 484.
    • The “not reasonably calculated to lead to the discovery of admissible evidence” objection. Lawyers who continue to make this objection have not read Civil Rule 26(b)(1) since December 1, 2015 or the Advisory Committee Notes accompanying the 2015 amendments to the Federal Civil Rules.  This is no longer a valid objectionSee Fischer, 2017 WL 773694, at *3 (“The 2015 amendments deleted that language from Rule 26(b)(1), and lawyers need to remove it from their jargon.”); In re Bard IVC Filters Prods. Liability Litig., 317 F.R.D. 562, 564 (D. Ariz. 2016) (“The 2015 amendments … eliminated the ‘reasonably calculated’ phrase as a definition for the scope of permissible discovery.  Despite this clear change, many courts continue to use the phrase.  Old habits die hard.”).
  • Substantive Objections Improperly Generalized. This category comprises two very common objections that are just as commonly stated generally rather than specifically:
    • The “overly broad and unduly burdensome” objection. Absent more, this “objection” is useless.  See Fischer, 2017 WL 773694, at *3 (“[S]tating that the requests are ‘overly broad and unduly burdensome’ is meaningless boilerplate.  Why is it burdensome?  How is it overly broad?  This language tells the Court nothing.”); Heller, 303 F.R.D. at 490-91(“the party resisting discovery [must] show how the requested discovery was overly broad, unduly burdensome, or oppressive by submitting affidavits or offering evidence revaling the nature of the burden”).
    • The “vague, ambiguous or confusing” objection. Here again, absent more, this “objection” is useless.  The party objecting on these grounds “‘must explain the specific and particular way in which a request is vague.’”  Heller, 303 F.R.D. at 491 (quoting Consumer Elec. Ass’n. v. Compras & Buys Magazine, Inc., 2008 WL 4327253, at 2 (S.D. Fla. Sep. 18, 2008)).

The typical practice is to incorporate these general objections into responses to individual interrogatories and document requests.  Courts are consistently, and strenuously, admonishing against this.  See, e.g., Fischer, 2017 WL 773694, at *3 (“General objections should rarely be used after December 1, 2015 unless each such objection applies to each document request….”); Meggit (Orange Cnty.), Inc. v. Nie, 2015 WL 12743695, at *1 (C.D. Cal. Feb. 17, 2015) (“The practice of making boilerplate general objections couched in terms of ‘to the extent’ and then incorporating those general objections into each interrogatory response is improper.”).  In short, counsel must craft targeted responses and objections to each document request or interrogatory and cannot simply incorporate general objections into those responses.

This is not to say that general objections are always inappropriate.  For instance, because instructions and definitions in discovery requests apply generally to each request, objections to those instructions and definitions that are then incorporated into each response for the sake of efficiency may be appropriate.  Some examples include objections to directions that impose requirements for privilege logs well beyond those imposed under Civil Rule 26(b)(5)(A)(ii) or that require responding parties to describe lost or destroyed documents in levels of detail that are often impossible to provide for the very obvious reason that the document is lost or destroyed.

Counsel should consider jettisoning boilerplate general objections for several reasons, including:

  • General objections preserve nothing. See Liguria Foods, 2017 WL 976626, at *11 (“[T]he idea that … general or ‘boilerplate’ objections preserve any objections is an ‘urban legend.’” quoting Matthew L. Jarvey, Boilerplate Discovery Objections: How They Are Used, Why They Are Wrong, and What We Can Do About Them, 61 Drake L. Rev. 913, 926 (2013)).
  • Reliance upon general objections to the exclusion of specific, targeted objections to interrogatories or discovery requests constitutes a waiver of whatever objection the party was trying to make. See, e.g., St. Farm Fire & Cas. Co. v. Admiral Ins. Co., 2016 WL 8135417, at *7 (D. S.C. Feb. 4, 2016) (“Boilerplate, general objections standing alone waive any actual specific objections.” citing Mancia v. Mayflower Textile Servs. Co., 253 F.R.D. 354, 358-59 (D. Md. 2008)).
  • Courts are now highly attuned to, and annoyed by, improper general objections, which may be the best reason of all to stop using them. See, e.g., Jones v. Bank of Am., N.A., 2015 WL 1808916, at *5 (S.D. W. Va. Apr. 21, 2015) (Eifert, Mag.) (“Quite frankly, the undersigned is astounded and troubled that, even after appearing in many cases in this district and despite clear and established circuit case law holding that such objections are improper, counsel for Defendant persists in asserting a litany of insupportable general objections in response to discovery requests.”); Liguria Foods, 2017 WL 976626, at *2 (“it is clear to me that admonitions from the courts have not been enough to prevent such conduct and that, perhaps, only sanctions will stop this nonsense”).

Old habits and bad habits are the hardest to break, but interjecting and relying on boilerplate general objections is an old and bad habit worth breaking for all of the foregoing reasons, which are incorporated herein by reference.

Traditional DIP Order Carve Outs Do Not Cap the Administrative Claims of Committee Professionals

On January 5, 2017, Judge Sontchi of the Bankruptcy Court for the District of Delaware issued an opinion (the “Opinion”) in the pending Molycorp Chapter 11 case (Case No. 15-11357).  In re Molycorp, Inc., 562 B.R. 67 (Bankr. D. Del. 2017).  In the Opinion, the Court rejected a challenge by OCM MLYCo. Ltd. (“Oaktree”), one of Molycorp’s pre-petition secured lenders, Molycorp’s DIP Lender and, in combination with Molycorp’s other set of secured lenders, purchaser of Molycorp’s more profitable operating subsidiaries, to the fees & expenses of Paul Hastings LLP, lead counsel to the Official Committee of Unsecured Creditors (the “Committee”).

Background

Molycorp’s Chapter 11 has been extremely contentious and detailing its history would take many pages.  The facts relevant to the Opinion are quite simple.  The DIP Financing Order entered by the Court provided for a carve-out of $250,000 for the Committee to investigate pre-petition claims against Oaktree (the “Investigation Budget”).  D.I. 278, ¶ 4(b).  The Committee began investigating potential claims against Oaktree almost immediately and, on January 14, 2016, the Court entered an order granting the Committee standing to bring litigation on the estate’s behalf against Oaktree.  D.I. 1086.  After mediation with all major parties in the case before the Honorable Robert D. Drain (SDNY), the Debtors filed a notice of the execution of a global settlement agreement on February 22, 2016, including a settlement of the claims brought by the Committee (the “Settlement Agreement”).  D.I. 1302, Settlement Agreement at Ex. A.  In the Court’s own words, “[t]he Settlement Agreement paved the way for a consensual reorganization plan for certain of the Debtors.”  Molycorp, 562 B.R. at 72.  On April 8, 2016, the Court entered an Order confirming a plan of reorganization premised on the Settlement Agreement.  D.I. 1580.

After the Settlement Agreement was approved, Paul Hastings filed a Second Interim Fee Application, covering the period from September 1, 2015 to March 31, 2016, requesting Court approval of $8,491,064.75 in fees and $226,179.06 in expenses (the “Fee Application”).  Oaktree objected to Paul Hastings’ Fee Application on four grounds.  First, Oaktree argued that the DIP Financing Order established a dispositive cap of $250,000.00 (the “Cap”) on the fees and expenses of the Committee counsel in relation to the investigation of claims against Oaktree.  Id. at 73.  Second, Oaktree argued that the DIP Financing Order only authorized the compensation of the Committee’s professionals for the investigation of claims, not for the initiation and prosecution of such claims.  Id.  Third, Oaktree argued that even if the Cap was not dispositive, “any portion of Paul Hastings’ fees that exceeds the cap set by the DIP Financing Order is presumptively unreasonable.”  Id. at 73-74.  Finally, Oaktree argued that the descriptions of the work performed by Paul Hastings’ attorneys were excessively vague and should be disallowed.  Id. at 74.

The Opinion

The Court’s opinion was decisive but comprehensive.  As the Court explained, before confirmation of a plan, “absent equity in the [secured party’s] collateral, administrative claimants cannot look to encumbered property to provide a source of payment for their claims.”  Molycorp, 562 B.R. at 75.  Thus, there was no doubt that as the secured party, Oaktree’s consent was necessary for the payment of administrative expenses and Oaktree was within its rights to “impose[] a limit on the amount of its collateral which may be used to pay the attorneys employed by the Committee.”  Id. at 77.

11 U.S.C. § 1129(a)(9)(A), however, mandates that for a plan to be confirmed, each holder of an allowed administrative expense claim, unless agreed otherwise, must be paid in cash equal to the allowed amount of such claim on the effective date of the plan.  Molycorp, 562 B.R. at 77.  Therefore, “if the secured parties desire confirmation, the administration claims must be paid in full in cash even if it means invading their collateral.”  Id. at 78 (quoting In re Emons Industries, Inc., 76 B.R. 59, 60 (Bankr. S.D.N.Y. 1987)).  Therefore, “in the context of a plan confirmation, a cap on the amount to be paid towards administrative expenses may only be approved after obtaining the administrative claimants’ consent.”  Molycorp, 562 B.R. at 78.

The Court then held that the Investigation Budget in the DIP Order unambiguously “[did] not contain any language that can compel automatic disallowance of Paul Hastings’ fees.”  Id. at 79.  The Court saw nothing in the language of the DIP Order that differed from a standard carve-out provision.  Id.  The Court  also noted the difference between the language in the DIP Order and the language in the Confirmed Plan, which stated that “[a]ny amounts incurred by the Creditors’ Committee’s legal professionals on and after the Committee Settlement Effective Date with respect to the Creditors’ Committee Legal Fee Cap Matters in excess of the Creditors’ Committee Legal Fee Cap shall be disallowed.”  Id. at 80 (emphasis in original).  The Court noted that the difference in language spoke for itself and made absolutely clear that “the costs incurred by Paul Hastings are not affected by the DIP Financing Order.”  Id.  Finally, the Court concluded by allowing Paul Hastings’ fees and expenses as reasonable compensation for services rendered, noting that the “record demonstrates that the services rendered benefited the Debtor’s estate and advantaged the Committee’s constituents.”  Id. at 82.

The Unanswered Question—Can a DIP Order Ever Be Used to Cap The Committee’s Professionals’ Administrative Claims?

The Court declined to answer whether it would ever uphold a provision in a DIP Order capping the allowable administrative claims of the Committee’s professionals.  Id. at p. 80, n. 62.  Both the parties and the Court noted that other courts had approved such provisions in a DIP Order, most notably In re Granite Broadcasting Corp. (ALG) (Bankr. S.D.N.Y. Jan. 5, 2007).  The Court did, however, note that there was an ongoing debate “with regard to the term ‘agreed’ [in § 1129(a)(9)(A)]: whether this requires a creditor expressly or affirmatively consent to a different treatment, or whether consent may be implied from the creditor’s conduct.”  Molycorp, 562 B.R. at 78, n. 54.

The Court’s acknowledgement of this debate was not mere happenstance.  If consent to lesser treatment may be implied from a creditor’s conduct, a court could find that by accepting employment from the Committee after such a DIP Order has been entered, a Committee professional has impliedly consented to the hard cap in the DIP Order.  If, however, implied consent is insufficient, it seems unlikely that a Court could ever find a hard cap in a DIP Order binding.

The Court did, however, signal its position on this debate in a footnote.  In explaining the debate over the type of consent necessary under § 1129(a)(9)(A), the Court cited to In re Teligent, Inc., in which administrative creditors who had not returned a ballot were deemed to have agreed to lesser treatment (the case was administratively insolvent).  The Court viewed the holding in Telligent as a “questionable fiction.”  Molycorp, 562 B.R. at 78, n. 54.  It therefore appears questionable that Judge Sontchi will be well disposed to arguments that an administrative claimant has impliedly consented to lesser treatment and, by implication, to DIP Orders which attempt to place a hard cap on the administrative claims of Committee professionals.