In a recent decision, Heritage Home Group LLC, et al., Case No. 18-11736-KG, 2018 WL 4684802 (Bankr. D. Del. Sept. 27, 2018), Judge Kevin Gross, U.S. Bankruptcy Judge for the District of Delaware, held that a consultant tasked with liquidating the debtors’ assets under a store closing and asset disposition agreement (“Disposition Agreement”) is not a professional, and consequently, not required to be retained under Section 327(a) of the Bankruptcy Code.

The Debtors, Heritage Home Group LLC, et al. (“Debtors”), sought to retain SB360 Capital Partners, LLC (“SB360” or “Consultant”), pursuant to the Disposition Agreement, as their consultant to sell the Debtors’ “Non-Luxury Group” assets.  Heritage Home Group, 2018 WL 4684802 at *1.  In exchange, Debtors agreed to pay SB360 commissions from the sales of assets and furniture, fixtures and equipment.  Id. at *2.  Bankruptcy court approval of the retention was sought under Sections 105(a) and 363 of the Bankruptcy Code, pursuant to a motion for authority to, inter alia, enter into the Disposition Agreement and conduct store closing or similar themed sales.  Id. at *1; see also Case No. 18-11736-KG, Docket No. 219.

The U.S. (“Trustee”) objected to SB360’s retention on the bases that the engagement was subject to Section 327(a) of the Bankruptcy Code, not Section 363.  More specifically, the Trustee argued that the Consultant was a “professional like an auctioneer” and should be required to file a declaration of disinterestedness and have its fees reviewed under applicable professional compensation standards, in compliance with Section 327(a) of the Bankruptcy Code and Federal Rule of Bankruptcy Procedure 2014.  Id. at *2; see also Case No. 18-11736-KG, Docket No. 265.

The Debtors disputed that the engagement required approval under Section 327(a), arguing that Section 363 was the proper standard and the engagement was a valid exercise of the Debtors’ business judgment.  See Case No. 18-11736-KG, Docket No. 305 at 2-3.  SB360 argued it was not a “professional” as defined in Section 327(a), and the services provided under the Disposition Agreement did not require Section 327 retention because the services did not assist the Debtors in administering the chapter 11 cases.  See Case No. 18-11736-KG, Docket No. 300 at 2.

Following an evidentiary hearing and argument, the Delaware Bankruptcy Court rejected the notion that SB360 was an auctioneer.  Heritage Home Group, 2018 WL 4684802 at *3.  Noting the term “auctioneer” is not defined in case law or the Bankruptcy Code; the Court reviewed the Black’s Law Dictionary definition of an auctioneer and determined that SB360 was not an auctioneer because it was not in charge of selling at an auction and there was no public auction.  Id.

The Court, citing In re First Merchants Acceptance Corp., 1997 WL 873551 (D. Del. Dec. 15, 1997), observed that “a ‘professional’ is limited to those occupations which control, purchase or sell assets that are important to reorganization, is negotiating the terms of a plan of reorganization, has discretion to exercise his or her own personal judgment, and whether he or she contributes ‘some degree of special knowledge or skill.’”  Id. at *3.  The Court noted that SB360 was not at the center of Debtors’ reorganization and the terms of the Disposition Agreement nullified SB360’s control.  Id.

The Court then looked to the bankruptcy court decisions in In re Nine West Holdings, Inc., 2018 WL 3238695 (Bankr. S.D.N.Y. July 2, 2018), and In re hhgregg, Inc., Case No. 17-01302-RLM-1 (Bankr. S.D. Ind. May 8, 2017).  Id. at *4.  In Nine West Holdings, the Bankruptcy Court for the Southern District of New York rejected the argument that Alvarez and Marsal and its employee serving as Nine West’s CEO should be retained under Section 327(a), as opposed to Section 363(b).  That court reiterated that “a ‘professional’ for purposes of Section 327(a) is intimately involved in the reorganization process.”  Id.  Judge Gross noted that SB360 was not so involved.  Id.  Similarly, in hhgregg, the Bankruptcy Court for the Southern District of Indiana did not require Section 327(a) retention because the consultant at issue “(1) carried out debtor’s judgment, (2) did not play a central role in the reorganization, (3) did not have broad discretion and (4) had no control over sale prices.”  Id.

Considering the language of the Disposition Agreement which required SB360 to, among other things, “‘recommend appropriate discounting,’ ‘provide qualified supervision,’ ‘maintain focused and constant communication,’ …,” the Court concluded that the Consultants’ responsibilities were “clearly advisory” and did not “constitute an intimate role in the Debtors’ plans.”  Id.

In overruling the Trustee’s objection, the Court observed that the Bankruptcy Code provides clearly that certain professionals must be retained formally pursuant to Section 327(a) but that retention of the Consultant did not require such treatment.  Id.

The ruling in Heritage Home Group provides certainty to practitioners, as well as consultants seeking to be retained by a debtor to liquidate assets, that such consultants are not “professionals” requiring retention under Section 327(a) in the Delaware bankruptcy court.

Postscript

Subsequent to Judge Gross’ decision in Heritage Home Corp., Judge Brendan Linehan Shannon, U.S. Bankruptcy Judge for the District of Delaware, held, in Brookstone Holdings Corp., Case No. 18-11780-BLS, 2018 WL 4801890 (Bankr. D. Del. Oct. 1, 2018), that Gordon Brothers Retail Partners, LLC and Hilco Merchant Resources, LLC (collectively, “Hilco”), performing services related to debtor’s going-out-of-business (“GOB”) sales (and acting in a role similar to SB360 in Heritage Home Corp.), was not a “professional” within the meaning of Section 327(a).  Judge Shannon looked to the common usage of the term “auctioneer” and concluded that the sale process was not an auction and Hilco was not hired to conduct an auction.  As such, Hilco was not engaged as an “auctioneer” for purposes of Section 327(a). Brookstone Holdings Corp., 2018 WL 4801890 at *6.  The Court also considered whether Hilco was an “other professional” as the term is used in Section 327(a) and decided it was not.  Id. at *10.  The Court reviewed the factors developed in First Merchants for determining whether an employee is a “professional” within the meaning of Section 327(a), and concluded Hilco’s services were “not sufficiently central to the development and implementation of the Debtor’s reorganization.”  Id. at *1.  Based on the record, the debtor remained in “complete control of all aspects of the GOB sales” and Hilco did not control or manage the sale process, was not involved in negotiating the terms of a plan, did not exercise discretion “in the administration of the debtor’s estate” and it’s role in store closures did not “constitute meaningful participation in the ‘administration of debtors’ estate.’”  Id. at *7-9.

Bankruptcy remote structures have become common in recent years to attempt to prevent a borrower from filing for Chapter 11.  One such structure is commonly referred to as a “golden share.”  The “golden share” typically refers to a noneconomic membership interest provided to a lender whose vote would be necessary for the borrower to file Chapter 11.

The Fifth Circuit in In re FranchiseServs. of N. Am., Inc., 891 F.3d 198, 209

(5th Cir. 2018), as revised (June 14, 2018), recently considered the enforceability of blocking “golden share” provisions and whether a creditor or shareholder could use such a provision to prevent a company from filing for bankruptcy.

In re Franchise Services

Prior to the petition date, the debtor obtained a $15 million investment from an investor, Boketo, LLC (“Boketo”), to finance an acquisition.  Id. at 203.  Boketo was a fully-owned subsidiary of Macquarie Capital Inc. (“Macquarie”), which created Boketo to finance the transaction.  Id.  The debtor agreed to pay Macquarie a $3 million fee for arranging the financing.  Id.  Boketo was given 100% of preferred stock in the form of a convertible preferred equity instrument.  Id.  Boketo was the largest single investor in the debtor and its stake in the debtor  amounted to a 49.76% equity interest if converted.  Id.  As a condition of the investment, the debtor reincorporated in Delaware and adopted a new certificate of incorporation that provided, in part, the majority of all equity classes, voting separately, must approve a bankruptcy filing.  Id.

The debtor filed a chapter 11 petition without requesting or securing the consent of  Boketo and the common shareholders.  Id. at 204.  Boketo and Macquarie moved to dismiss the bankruptcy case claiming the debtor failed to seek shareholder authorization.   Id.  In response, the debtor argued that the consent provision was an invalid restriction on its right to file a bankruptcy petition.  Id.

Following an evidentiary hearing, the bankruptcy court granted the motion to dismiss finding that, because Boketo was an owner, rather than a creditor, conditioning the debtor’s right to file a voluntary petition on the investor’s consent was not contrary to federal bankruptcy policy.  Id.

Thereafter, the bankruptcy court certified three questions for direct appeal to the Fifth Circuit:

(i)  Is a provision, typically called a blocking provision or a golden share, which gives a party (whether a creditor or an equity holder) the ability to prevent a corporation from filing bankruptcy valid and enforceable or is the provision contrary to federal public policy?

(ii)  If a party is both a creditor and an equity holder of the debtor and holds a blocking provision or a golden share, is the blocking provision or golden share valid and enforceable or is the provision contrary to federal public policy?

(iii)  Under Delaware law, may a certificate of incorporation contain a blocking provision/golden share? If the answer to that question is yes, does Delaware law impose on the holder of the provision a fiduciary duty to exercise such provision in the best interests of the corporation?  Id.

The Fifth Circuit observed as an initial matter that a “blocking provision” and “golden share” are not synonymous.  Id.  The term “‘blocking provision’ is a catch-all to refer to various contractual provisions through which a creditor reserves a right to provide debtor from filing for bankruptcy.”  Id.  A “golden share” is a “share that controls more than half of the corporation voting rights and given the shareholder veto power over changes to the company’s charter.”  Id.  The facts at issue did not fit into either definition and would narrow the certified questions.  Specifically, the bankruptcy court requested the Fifth Circuit opine on the legality of “blocking provisions” and “golden shares”, but to do so would result in an advisory opinion.  Id.  Instead, the Fifth Circuit confined its analysis to whether federal and Delaware law permit parties to “amend a corporate charter to allow a non-fiduciary shareholder fully controlled by an unsecured creditor to prevent a voluntary bankruptcy petition.”  Id. at 206.

On appeal, the debtor argued that federal law precluded enforcement of the corporate charter because it violated a “federal public policy against waiving the protections of the Bankruptcy Code.”  Id. at 207.  The debtor also asserted that the case involved “a creditor masquerading as a bona fide equity owner.”  Id. at 207.  The Fifth Circuit, however, found no evidence that the arrangement was merely a ruse to ensure that the investor would pay the affiliate’s bill.  Id. at 207.  Based on the facts presented, the Fifth Circuit held that “federal bankruptcy law does not prevent a bona fide equity holder from exercising its voting right to prevent the corporation from filing a voluntary bankruptcy petition just because it also holds a debt owed by the corporation and owes no fiduciary duty to the corporation or its fellow shareholders.”  Id. at 209.

The Fifth Circuit next addressed, in two parts, whether Delaware law allows the investor to exercise the block right: (i) “whether Delaware law allows parties to provide in the certificate of incorporation that the consent of both classes of shareholders is required to file a voluntary petition” and (ii) “whether Delaware law would impose a fiduciary duty on a minority shareholder with the ability to prevent a voluntary bankruptcy petition.”  Id.

As to the first inquiry, the Fifth Circuit noted the debtor had waived such argument on appeal, and, having found no Delaware cases on point, the Fifth Circuit assumed that Delaware law would tolerate a provision in a certification of incorporation conditioning a corporation’s right to file a petition on shareholder consent.  Id. at 210-211.  As to the second question involving consent, the Fifth Circuit noted that an investor could only owe a fiduciary duty if it qualifies as a controlling minority shareholder.  Id.  The Fifth Circuit stated the standard for minority control is high and “potential control is not enough.”  Id. at 212Rather, the debtor must prove “Boketo actually dominated the [debtor’s] corporate conduct.  Id. 213 (emphasis included).  The board’s willingness to act without Boketo’s consent undercut the case for control according to the Fifth Circuit.  Id.  Accordingly, the Fifth Circuit found that the record before it did not establish that Boketo was a controlling shareholder.  The Court also observed a fundamental defect in the debtor’s argument.  Id. at 214.  Assuming Boketo was a controlling shareholder and breached its fiduciary duty, the proper remedy was not to “deny an otherwise meritorious motion to dismiss the bankruptcy petition.”   Id.  The debtor must seek “its remedy under state law.”  Id.

The Franchise Services decision touches on difficult questions regarding whether a creditor or shareholder can block a bankruptcy filing pursuant to a corporate charter’s “golden share” or other blocking provisions.  The decision may be viewed as somewhat favorable to creditor’s ability to block a bankruptcy; however, the Fifth Circuit’s decision is limited to the unique set of facts involved in the case.

 

 

On April 17, 2018, the U.S. Bankruptcy Court for the Southern District of New York (the “Court”) issued a decision requiring CohnReznick LLP (“CohnReznick”) to produce documents requested by the foreign representatives (the “Foreign Representatives”) in the chapter 15 case of Platinum Partners Venture Arbitrage Fund (International) Limited (in Official Liquidation) (the “International Fund”).  In re Platinum Partners Value Arbitrage Fund L.P. (in Official Liquidation), No. 16-12925, 2018 WL 1864931 (Bankr. S.D.N.Y. Apr. 17, 2018).  In doing so, the Bankruptcy Court rejected CohnReznick’s arguments that it did not need to comply with the requests because (i) Cayman Islands law precludes the production of the requested documents; and (ii) the underlying subpoena impermissibly sought “pre-suit discovery” regarding potential claims that fell within the scope of the arbitration provision of CohnReznick’s engagement agreement.

Procedural History

In August 2016 the International Fund, Platinum Partners Value Arbitrage Fund L.P. (in Official Liquidation) (the “Master Fund”), and Platinum Partners Value Arbitrage Intermediate Fund L.P. (in Official Liquidation) (the “Intermediate Fund” and, together with the International Fund and the Master Fund, the “Funds”) were placed into liquidation by order of the Grand Court of the Cayman Islands.  Platinum Partners, 2018 WL 1864931, at *2.  In a Cayman liquidation proceeding, liquidators are appointed to “collect, realise, and distribute” the liquidating entity’s assets and are empowered to investigate the “promotion, business, dealings and affairs” of such entity, including the causes of its failure.  Id., at *3.  Prior to the liquidators’ appointment, the Funds were managed by Platinum Management (NY) LLC, which is headquartered in New York.

On October 18, 2016, the joint liquidators of the International Fund and the Master Fund filed petitions under chapter 15 of title 11 of the United States Code (the “Bankruptcy Code”) seeking recognition of the Cayman liquidation proceedings as “foreign main proceedings.”  Platinum Partners, 2018 WL 1864931, at *3.  On November 22, 2016, the Court entered an order (the “Recognition Order”) recognizing the Cayman proceedings as foreign main proceedings.  Id.  The Recognition Order authorized the Foreign Representatives to conduct discovery “within the territorial jurisdiction of the United States concerning the assets, affairs, rights, obligations or liabilities of the Funds, the Funds affiliates and the Funds,” including “upon written request, obtaining turnover of any and all documents . . . that are property of, concern or were made or issued on behalf of the Funds . . . .”  Id.  A chapter 15 petition subsequently was filed by the Intermediate Fund, and on October 12, 2017, the Court entered an order recognizing the Intermediate Fund’s liquidation proceeding as a foreign main proceeding.  The Funds’ chapter 15 cases are being jointly administered for procedural purposes only.  Id.

In connection with their investigation of the Funds, the Foreign Representatives informally sought certain documentation from CohnReznick, which had been retained by the Funds to provide audit services for calendar years 2014 and 2015.  Platinum Partners, 2018 WL 1864931, at *4.  Although CohnReznick produced copies of certain original documents that it maintained were property of the Funds, it did not provide other documentation in its audit file, including work papers, engagement documents and invoices, on the basis that such documents were not the Funds’ property.  Id.  As a result, on August 31, 2017, the Foreign Representatives served a subpoena on CohnResnick relating to its “auditing, accounting, or other services for, on behalf of or in relation to any Fund,” to which CohnReznick served written objections.  Id.  After the parties were unable to consensually resolve the objections, the parties both filed letters with the Court and, ultimately, the Foreign Representatives filed a motion to compel production pursuant to Rule 2004 of the Federal Rules of Bankruptcy Procedure (the “2004 Motion”).  Id.

The Court’s Decision

Prior to addressing CohnReznick’s argument, the Court reviewed Chapter 15 generally and other provisions of the Bankruptcy Code pertaining to discovery.  First, the Court noted that upon recognition of a foreign main proceeding, at the request of a foreign representative, a bankruptcy court can authorize discovery “concerning the debtor’s assets, affairs, rights, obligations or liabilities.”  Platinum Partners, 2018 WL 1864931, at *5; see also 11 U.S.C. § 1521(a)(4) and (a)(7).  Second, the Court observed that, consistent with the principles of comity, chapter 15 provides bankruptcy courts with “broad, flexible, and pragmatic rules” to fashion relief that is largely discretionary.  Platinum Partners, 2018 WL 1864931, at *5.  Finally, the Court discussed section 542(e) of the Bankruptcy Code, which allows a court to order an accountant to turn over documentation relating to the debtor’s property or financial affairs, and Bankruptcy Rule 2004, which allows a party in interest, such as a foreign representative, to subpoena documents relating to the “acts, conduct, or property or to the liabilities and financial conduction of the debtor.”  Id. at *6.

CohnReznick’s first main argument was that Cayman law does not permit the discovery of audit work papers or materials that are not a debtor’s property and, if the Court were to grant the 2004 Motion, its interests and the interests of comity would not be protected.  Platinum Partners, 2018 WL 1864931, at *7.  The Court dismissed this argument somewhat summarily, agreeing with the Foreign Representatives that the Cayman law was “unsettled” because Cayman courts have not clearly defined what portions of audit work papers constitute a debtor’s property.  Id. at *8.  Moreover, the Court noted that “it is well-established that comity does not require that the relief available in the United States be identical to the relief sought in the foreign bankruptcy proceeding; it is sufficient if the result is comparable and that the foreign laws are not repugnant to our laws and policies.”  Id.  at *10.  In limiting CohnReznick’s reliance on comity principles, the Court cautioned that “requiring this Court to ensure compliance with foreign law prior to granting relief sought pursuant to chapter 15 would require the Court to engage in a full-blown analysis of foreign law each and every time a foreign representative seeks additional relief in the United States, which may result in differing interpretations of U.S. law depending on where the foreign main proceeding was pending.”  Id. at *11.  Accordingly, the Court found that it was specifically authorized to order the requested discovery under section 1521 of the Bankruptcy Code.  Id. at *11-*12.

CohnReznick’s second main argument was that the arbitration clause in its engagement agreement precluded the Foreign Representatives from seeking pre-litigation discovery because the pending discovery dispute was a “dispute, controversy, or claim” relating to CohnReznick’s accounting services that was required to by resolved by arbitration and not by a court of law.  Platinum Partners, 2018 WL 1864931, at *13.  The Foreign Representatives disagreed, arguing that they were merely seeking information essential to their investigation and that, in the absence of a pending “proceeding,” CohnReznick had no contractual right to limit the relief available under the Bankruptcy Code.  Id. at *14.  The Court agreed with the Foreign Representatives, stating that interpreting the arbitration clause so broadly that it eliminated the Foreign Representative’s right to seek discovery under section 1521 would run counter to one of the significant objectives of chapter 15 – “provid[ing] judicial assistance to foreign representatives in gathering information which will enable them to comply with their duties.”  Id.  Indeed, the Court noted that “chapter 15 proceedings cannot be held hostage by an arbitration clause when there is no dispute pending.”  Id.

Conclusion

Although CohnReznick’s reliance on Cayman law had some support in its submissions, the Court declined to deviate from the “broad, flexible, and pragmatic rules” governing the relief available to foreign representatives in chapter 15 cases.  Accordingly, parties seeking to thwart efforts by a foreign representative to carry out his or her duties on the basis of conflicting foreign law should be cognizant that such efforts may be unsuccessful unless the requested relief truly is contrary to the public policy of the foreign jurisdiction or does not sufficiently protect the debtor’s creditors and other parties in interest.  See 11 U.S.C. §§ 1521 (a) and (b), 1522.

The Bankruptcy Code gives a bankruptcy trustee, or the debtor in possession, the power to “avoid” certain transfers made by the debtor at various times before filing for bankruptcy relief.  Congress provided a number of limits on these significant avoidance powers, whether within the sections granting the powers themselves (e.g., in Section 547(c), which sets forth a number of transfers that a trustee or debtor may not avoid, and Section 547(b)’s statutory limitation with respect to potentially preferential transfers to non-insiders made beyond the 90 days preceding the bankruptcy filing) or in other sections of the Bankruptcy Code, such as Section 546, which is aptly entitled “Limitations on Avoiding Powers.”  Subsection “(e)” of Section 546, which limits a trustee’s avoiding powers with regard to certain securities related transactions, has been the subject of noteworthy debate.

The implementation of Section 546(e)’s “safe harbor” provision was the central issue in Merit Management Group, LP v. FTI Consulting, Inc.  In Merit, a racetrack casino, Valley View Downs, acquired another racetrack casino in Pennsylvania through a stock purchase transaction.  In order to complete the transaction, Valley View arranged for a portion of the purchase price to be wired into the account of a third party escrow agent.  Following closing, the third party escrow agent distributed funds as provided for by the parties’ purchase agreement, including to one of the seller’s shareholders, Merit Management Group.  However, despite the foregoing stock acquisition, Valley View and its parent company ultimately filed a Chapter 11 bankruptcy.

Following confirmation of the plan of reorganization in Valley View and its parent’s bankruptcy, FTI Consulting, as trustee of the litigation trust, attempted to avoid those payments made to Merit by the third party escrow agent.  FTI argued that such payments were constructively fraudulent.  In response to FTI, Merit argued that because the payment it received was transferred to it from a financial institution, acting as an intermediary escrow agent, the payment was protected under the safe harbor in Section 546(e).

Courts have interpreted the safe harbor’s reach differently, with a majority of Circuit Courts of Appeal—the Second, Third, Sixth, Eighth, and Tenth Circuits—holding that the presence of a qualifying financial institution in a securities related transaction, even if acting as an intermediary or a conduit, is sufficient to trigger the protections of Section 546(e) for the entire transaction.  A minority of Circuits that have addressed this issue—the Seventh and Eleventh Circuits—have held the opposite: that the mere presence of a qualifying financial institution in a securities related transaction, if only acting as a conduit or intermediary, is insufficient to trigger the safe harbor of Section 546(e).  The Supreme Court granted certiorari from the Seventh Circuit in Merit and resolved this split of authority.

The Supreme Court sided with the minority of Circuits and affirmed the Seventh Circuit.  In a unanimous decision, the Supreme Court held “that the only relevant transfer for the purposes of the [Section 546(e)] safe harbor is the transfer that the trustee seeks to avoid.”  Said differently, the relevant transfer for the purposes of Section 546(e)’s safe harbor is the overarching transfer a trustee identifies for avoidance, rather than the intervening pass-through transfers that are part and parcel of that overarching transfer.

In reaching this conclusion, the Supreme Court began its analysis by looking at the statutory scheme of a trustee’s avoidance powers and the statutory history of Section 546, before turning to a textual analysis of the section.  There, the Court emphasized that the text of Section 546(e) creates an exception to a transfer that would otherwise be avoidable.  It reasoned that the “notwithstanding” clause, which lists each of the sections containing a trustee’s avoiding powers wholesale, signals that the safe harbor is intended to apply to the entirety of a trustee’s avoiding powers under such sections.  Thus, the Court concluded, the starting point for determining the scope of the safe harbor is the trustee’s substantive avoiding powers and, “consequently, the transfer a trustee seeks to avoid as an exercise of those powers.”

The Supreme Court went on to identify other portions of the text that supported its analysis, such as the exception contained within the safe harbor which prevents its application to actually fraudulent transfers.  The Court concluded that such an exception further signals Congress’ intent that the safe harbor applies to the overarching transfer, rather than a mere component part, by explicitly identifying an entire type of transfer that is outside the scope of the safe harbor.  Memorably, the Supreme Court concluded its textual interpretation of Section 546(e) by stating, “Not a transfer that involves.  Not at transfer that comprises.  But a transfer that is a securities transaction covered under §546(e).”

The opinion concludes by discussing the role of Section 546(e) within the statutory structure of the Bankruptcy Code as a whole and then addressing and dismissing Merit’s counter arguments.

To be sure, given that the Supreme Court sided with the minority of Courts, those circuits which were abrogated by Merit will have to adjust their case law going forward.  However, legal scholars are already speculating on the effect of the holding in Merit on leveraged-buyout transactions in bankruptcy and suggesting work-arounds.  Accordingly, the long term effects of Merit remain to be seen.

Section 365 of the Bankruptcy Code provides that a debtor “subject to the court’s approval, may assume or reject any executory contract or unexpired lease of the debtor.”  11 U.S.C. § 365.  This provision is a powerful tool because it allows a chapter 11 debtor to assume agreements that will be beneficial to restructuring efforts while rejecting agreements that are burdensome.  Given its importance, the application of section 365 is not without challenge and subject to interpretation.

Two recent bankruptcy court decisions, In re Cho, 581 B.R. 452 (Bankr. D. Md. 2018) and In re Thane International, Inc., No. 15-12186-KG, 2018 WL 1027658 (Bankr. D. Del. Feb. 21, 2018), examine the fundamentals of executory contracts — when a contract is “executory” and whether there can be an “implied” assumption and assignment of an executory contract.

In re Cho

Considering whether a prepetition settlement agreement was an executory contract that could be rejected, the Maryland bankruptcy court, in Cho, observed: “whether a contract is executory depends on the facts of the particular matter, the language of the subject agreement, and the consequences under applicable nonbankruptcy law of either party ceasing to perform any ongoing or remaining obligations under the contract.”  Cho, 581 B.R. at 454.

In Cho, the debtors were defendants in state court litigation prior to filing bankruptcy.  Id.  The parties to the state court litigation agreed to a settlement that was reduced to writing, but the defendants refused to sign and maintained that the plaintiffs violated a certain non-disparagement provision in the settlement.  Id.  The state court ruled that there was a valid agreement and compelled the parties to execute the agreement.  Id.  Thereafter, the defendants filed for chapter 11 relief and moved to reject the settlement agreement as an executory contract under section 365 of the Bankruptcy Code.  Id.

Based on the facts and state court ruling, the bankruptcy court initially determined that there was a valid and enforceable contract under Maryland law.  Id. at 460.  Then, the court considered whether the contract was an “executory contract” for purposes of rejection under section 365 of the Bankruptcy Code.  Id. at 461.  Applying the Countryman test, the court evaluated whether both parties had unperformed obligations under the contract, which if not performed would result in a material breach of the contract.  Id.  Under the settlement agreement, the debtors were required to, in part, transfer a dry-cleaning business to the plaintiffs and make a cash payment.  Id. at 462-463.  The plaintiffs were required to dismiss litigation and note a certain judgment was satisfied.   Id. at 463.  In addition, both parties had non-disparagement obligations.  Id.

The main issue for the court was whether the obligations, and in particular the plaintiff’s obligations, were material under Maryland law.  Id. at 462.  The court noted this question depended on the primary purpose of the contract, which the court found to be settling the litigation and providing finality and certainty to the parties, and the non-disparagement provision bolstered and served this purpose.  Id. at 463-464.  Accordingly, the court held that the agreement could be rejected as an executory contract and the record supported the debtors’ business judgment and request to reject.  Id. at 466.  The court also observed that rejection generally does not eviscerate the non-breach party’s state law rights under the contract but any nonbankruptcy rights that the plaintiffs retain do not include the right to request specific performance of the agreement.  Id. at 467-68 citing Newman Grill Sys., LLC v. Ducane Gas Grills, Inc., 320 B.R. 324, 337 (Bankr. D. S.C. 2004).

In re Thane International

 In Thane, Delaware bankruptcy court considered “whether an executory contract that was neither affirmatively assumed nor rejected was included and assigned in a sale transaction.”  Thane, 2018 WL 1027658 at *1.  In Thane, the court had approved a sale of substantially all of the debtor’s assets under section 363 of the Bankruptcy Code.  Id.  A contract with a producer of informercials was not included as a contract to be assumed and assigned as part of the sale.  Id. Several months after the sale closed, the producer filed suit against the purchaser alleging it was owed royalties under a production agreement with the debtor.  Id.  The producer argued that the purchaser’s post-closing conduct and use of the contract effectuated a valid assumption and assignment of the contract.  Id. at *4.  The purchaser moved to dismiss the action on the basis that the producer failed to “distinguish pre- and post-closing royalties” and argued, in part, that an assumption and assignment did not occur because the “strictures” were not met, and “course of conduct cannot substitute.”  Id. at *1 and 2.

The bankruptcy court rejected the producer’s argument that the purchaser’s course of conduct constituted an implied or tacit assumption.  Id. at *6.  The court held that “there is no assumption” of an executory contract “absent a motion” as required under section 365 of the Bankruptcy Code.  Id.  In so ruling, the court observed that “there simply cannot be an assumption without providing the necessary cure and adequate assurance of one”, which the producer did not receive.  Id. at *7 citing 11 U.S.C. § 365(b)(1)(A)-(C).  As summarized by the court, section 365 allows a debtor “to do three things with an executory contract: (i) reject it, (ii) assume it or (iii) assume and assign it.”  Thane at *10.

The Cho and Thane decisions provide helpful guidance in determining whether an agreement is executory and a debtor’s options under section 365.  Cho is a reminder of the power of section 365 to a debtor while Thane is a reminder to adhere to the Code’s procedural requirements to obtain the benefits of section 365.

In JPMCC 2007-C1 Grasslawn Lodging, LLC v. Transwest Resort Props. Inc., et al. (In re Transwest Resort Props. Inc.), Case No. 16-16221, 2018 U.S. App. LEXIS 1947 (9th Cir. Jan. 25, 2018), the Ninth Circuit was the first Circuit court to decide a significant split in the lower courts between the “per plan” or “per debtor” impaired accepting class requirement to confirmation.  The decision is significant if adopted by other Circuit courts because it means that multiple debtors with a joint plan may cram their plan down on all creditors based on a single impaired accepting class, even where the impaired accepting class has claims against different debtors than the class that is crammed down.

The case involved five (5) debtors.  The corporate structure involved a holding company that was the sole equity owner of two mezzanine debtors, which in turn were the sole equity owners of the two operating debtors, which owned and operated two resorts.  The resorts were encumbered by a $209 million loan to the operating debtors (the “Operating Loan”).  In addition, there was a $21.5 million loan secured by the mezzanine debtors’ equity interests in the operating debtors (the “Mezzanine Loan”).

The debtors’ plan provided for (a) a sale of the operating debtors for $30 million, thereby extinguishing the mezzanine debtors’ ownership interest in the operating debtors, (b) a restructuring of the Operating Loan to a 21- year note with a principal amount of $247 million, with interest payments due each month, and (c) no recovery on account of the Mezzanine Loan claims.  Despite objection to confirmation by the holders of the Mezzanine Loan claims, the plan was confirmed because there were other impaired, accepting creditor classes holding claims against the operating debtors.  The bankruptcy court, adopting the “per plan” approach, held that the plan could be confirmed even though there was no impaired accepting creditor class for the mezzanine debtors.  On appeal, the district court applied the “per plan” approach and affirmed the bankruptcy court.

On appeal, the Ninth Circuit first analyzed the plain language of section 1129(a)(10), which requires that at least one impaired creditor class has accepted the plan.  The Court found that the plain language of the statute supports the “per plan” approach.  Section 1129(a)(10) requires that one impaired class “under the plan” approve “the plan.”  It makes no distinction concerning the creditors of different debtors under “the plan,” nor does it distinguish between single-debtor and multi-debtor plans.

In addition, the Court rejected the mezzanine lender’s argument that section 102(7) required that section 1129(a)(10) apply on a “per debtor” basis.  Section 102(7), a rule of statutory construction, provides that “the singular includes the plural.”  Section 102(7), the Court found, effectively amends section 1129(a)(10) to read: “at least one class of claims that is impaired under the plans has accepted the plans.” The “per plan” approach is still consistent with this reading.  Moreover, the Court found that the other subsections in section 1129(a) do not support a “per debtor” approach.  Most importantly, the Court found no support for the position that all subsections must uniformly apply on a “per debtor” basis, especially when the Bankruptcy Code phrases each subsection differently.

Lastly, the Court addressed the mezzanine lender’s argument that although the plan was presented as a jointly administered plan, it was in fact a substantively consolidated plan based on the application of the “per-plan” approach.  The Court identified two hurdles with this argument.  First, the issue was not raised before the bankruptcy court and thus not properly before the Ninth Circuit.  Second, to “the extent the Lender argues that the ‘per plan’ approach would result in a parade of horribles for mezzanine lenders, such hypothetical concerns are policy considerations best left for Congress to resolve.”

For these reasons, the Ninth Circuit adopted the “per plan” approach to confirmation.  The opinion is significant because it is the first Circuit ruling on the “per plan” versus “per debtor” debate.

Interestingly, it is questionable whether the “per plan” approach is a form of substantive consolidation that is inappropriate and unfair in certain circumstances.  In a concurrence authored by Judge Friedland, she argues that the problem in her view is not the interpretation of section 1129(a)(10); rather, the plan in Transwest Resort Props. effectively merged the debtors without an assessment of whether substantive consolidation was appropriate.  Such an assessment would have required the bankruptcy court to evaluate whether it was fair to proceed on a consolidated basis.  According to Judge Friedland, if a creditor believes that a reorganization plan inappropriately combines different estates, the creditor should object to the plan on a substantive consolidation basis rather than the requirements for confirming the plan under section 1129(a)(10).

On November 28, 2017, Tidewater Inc. and its affiliated debtors (collectively, the “Tidewater Debtors”) withdrew their motion objecting to final allowance of rejection damage claims of Fifth Third Equipment Finance Company (“Fifth Third”).  The notice of withdrawal indicated that Fifth Third, the sole remaining non-settling vessel lessor, resolved its dispute with the Tidewater Debtors pursuant to which Fifth Third’s “Sale Leaseback Claim” was allowed in the amount of $67,500,000.

The Tidewater Debtors (and their non-debtor affiliates) own and operate Offshore Support Vessels (OSVs) that support offshore energy exploration and production activities worldwide.  The Tidewater Debtors commenced Chapter 11 proceedings on May 17, 2017 to implement a fully negotiated and consensual restructuring under a prepackaged plan of reorganization filed on the same day.

Before the bankruptcy filings, the Tidewater Debtors and Fifth Third (as well as the other vessel lessors, the “Lessors”) entered into sale-leaseback transactions pursuant to which some of the Tidewater Debtors (collectively, the “Charterers”) sold vessels to the Lessors, which then leased the vessels back to the Charterers under bareboat charter agreements (the “Bareboat Charter Agreements”).  The Bareboat Charter Agreements each provided that upon an Event of Default (as defined therein, but including the Tidewater Debtors’ insolvency and bankruptcy filings, confirmation of a plan and rejection), Lessors were entitled to recover a stipulated loss value (“SLV”) as liquidated damages.  Tidewater Inc. absolutely and unconditionally guaranteed the payment and performance of the Charterers’ obligations under the Bareboat Charter Agreements.

A bareboat charter agreement is one type of charter agreement that governs the terms and conditions for the lease of a vessel. A bareboat charter is an executory contract that can be assumed or rejected under Section 365(a) of the Bankruptcy Code.  Rejection allows a debtor to disavow contracts that are burdensome or no longer advantageous to its ongoing business operations.

On the petition date, the Tidewater Debtors filed a motion to reject the Bareboat Charter Agreements.  They asserted that rejecting the Bareboat Charter Agreements would save them approximately $171 million over the next seven years.  In the motion, the Tidewater Debtors preemptively also sought to disallow the Lessors’ rejection damage claims in the amount of the SLV stated in the respective Bareboat Charter Agreements as an “unreasonable and unenforceable liquidated damages provision.”  The Tidewater Debtors argued the claims should be limited to “the reasonable expectation damages incurred by the Lessors.”  They proposed the final damages claims to equal the total maximum amount owing under each Bareboat Charter Agreement discounted to present value.  With respect to Fifth Third, the difference in the parties’ positions was astronomical.  Fifth Third argued for an SLV claim of approximately $94 million, while the Debtors posited it should be $34 million.

Relying on two Third Circuit decisions (In re Transworld Airlines, Inc., 145 F.3d 123 (3d Cir. 1998) and In re Montgomery Ward Holding Corp., 326 F.3d 383 (3d. Cir. 2003)), on August 31, 2017, Judge Brendan Shannon of the U.S. Bankruptcy Court for the District of Delaware ruled that the SLV provision was an unenforceable penalty.  He scheduled an evidentiary hearing in late September to determine Fifth Third’s “actual and appropriate damages” from rejection of the Bareboat Charter Agreement.

As parties oftentimes do in bankruptcy proceedings, the Tidewater Debtors and Fifth Third sagaciously resolved their dispute.  Given the settlement of Fifth Third’s claim, Judge Shannon did not have to rule on Fifth Third’s argument that even if the SLV is an unenforceable penalty against the direct contract counterparty, under New York law, it is entitled to the SLV amount pursuant to Tidewater Inc.’s guaranty.  That was an argument with respect to which he reserved opinion at the August hearing. It is clear, however, that vessel lessors may not be able to enforce their contractual SLV provisions if the actual damages they incur from rejection of the charter agreement is less than the SLV.

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.