A recent decision by the Bankruptcy Court for the Western District of Texas in In re Palmaz Scientific, 2018 WL 1036780, at *5 (Bankr. W.D. Tex. Feb. 21, 2018) serves as a cautionary tale of the importance of monitoring the plan confirmation process. In Palmaz, the bankruptcy court held that a chapter 11 bankruptcy reorganization plan would not bar investors from pursuing direct claims against the directors and officers of debtor. However, this was a hollow victory for the plaintiffs as the bankruptcy court went on to hold that the terms of the confirmed plan of reorganization prevented the plaintiffs from satisfying their claims from the proceeds from director and officers’ insurance.

On March 4, 2016, Palmaz Scientific Inc., a biomedical company that developed implantable devices used in treating diseases, filed a chapter 11 bankruptcy petition. The court approved the debtor’s chapter 11 plan on July 15, 2016. Palmaz Scientific’s plan transferred some of the debtors’ assets, including D&O claims, to a litigation trust. The plan defined D&O claims to include claims against the debtor corporation, but not against former directors and officers.

Soon after the corporation filed for bankruptcy, one group of investors (Turnbull plaintiffs) filed a direct action against its founder, Dr. Julio Palmaz. Before the bankruptcy case, another group of investors (Ehrenberg plaintiffs) had filed suit against Palmaz Scientific, Dr. Palmaz, and the company’s CEO, Steven Solomon. To block these lawsuits, Dr. Palmaz and the corporation’s litigation trustee filed an injunction in the District Court for the Western District of Texas.

To determine if the injunction impacted the Turnbull and Ehrenberg plaintiffs, the bankruptcy court had to decide whether their suits included D&O claims. While the bankruptcy court found that the Turnbull plaintiffs could proceed with their direct claims, the Ehrenbergs’ derivative claims could not. In response to this ruling, the Ehrenberg plaintiffs amended their original demand and eliminated their derivative claims. This prompted Palmaz Scientific’s insurer and litigation trustee to jointly move for a declaratory judgment of whether the Ehrenberg plaintiffs’ amended complaint interfered with the trustee’s right to control D&O recoveries.

After closely reviewing Palmaz Scientific’s reorganization plan and the bankruptcy injunction, the court determined that the injunction only enjoined derivative claims, or those brought against the corporation. As the amended Ehrenberg demand only included direct claims against Dr. Palmaz and Mr. Solomon individually, the injunction did not apply. However, the court also found that the Ehrenberg demand violated the plan’s terms by interfering with the litigation trustee’s right to “control. . . all D&O Insurance Recoveries, including negotiations relating thereto and settlements” (ECF No. 356, Plan § 6.6(d)). According to the court, this clause gave the trustee a superior right over other creditors to all D&O insurance proceeds. As a result, the court found that the Ehrenberg plaintiffs lacked the legal ability to satisfy their demand.

The outcome in Palmaz is an example of winning the battle but losing the war. While creditor plaintiffs may be entitled to pursue claims against directors and officers of a debtor corporation, the terms of a chapter 11 reorganization plan may prevent them from satisfying their claims from the proceeds of a D&O insurance policy. This case demonstrates the importance to potential D&O claimants of monitoring the plan confirmation process to ensure that potential claims are not compromised.

              -Summer associate Maya Jacob assisted in drafting.

The District of Delaware Bankruptcy Court recently sustained the objection of the Litigation Trustee to the claims of three former employees (together, the “Claimants”), based on their participation in their employer’s two-year retention program created prepetition (the “Prepetition Retention Program”). Opinion, In re Old BPSUSH, Inc., No. 16-12373 (KJC) (Bankr. D. Del. June 1, 2018), D.I. 1635. Largely adopting the arguments of the Litigation Trustee, the court held that the Claimants had waived their right to receive payments under the Prepetition Retention Program due to their participation in the court-approved Key Employee Retention Plan (“KERP”), notwithstanding the Claimants’ arguments that such waivers were unenforceable.

The Claimants were formerly employed by the Debtors. Prior to the commencement of their chapter 11 cases on October 31, 2016, the Debtors implemented the Prepetition Retention Program. Id. at *2 n.4. The Claimants each executed individual agreements, documenting their participation in the Prepetition Retention Program. Id. Among other things, the agreements provided that the Claimants would be entitled to a cash bonus if they remained with the Debtors for two years. Id. Such bonuses would vest on June 1, 2018. Id. at *10. However, the agreements also provided that, if the participating employee was terminated without cause within twelve months of a “change in control” of the Debtors, the award may vest sooner, provided that the Debtors’ compensation committee approved the award. Id. at *10 & n.21.

On December 22, 2016, the Debtors moved for an order approving a Key Employee Incentive Plan and a KERP (the “KERP Motion”). Id. at *3. The court approved the KERP Motion on January 5, 2017. Id. Pursuant to the court’s order, the Debtors sent letter agreements to eligible employees explicitly stating (i) the amount of his or her potential KERP award, id., (ii) that such award was subject to the successful closing of a potential sale transaction for substantially all of the Debtors’ assets and the employee’s continued employment in good standing until the payout date, id., and (iii) that “payments received under the KERP will be in lieu of any payments [the eligible employee] may have been entitled to receive under the previous retention programs offered by the [Debtors] prior to commencement of their Chapter 11 . . . proceedings,” id. at *4. Each of the Claimants executed such a letter agreement. After the sale transaction closed on February 27, 2017, the Debtors paid the Claimants their respective KERP bonuses in full. Id. at *4.

Nonetheless, after accepting the KERP bonuses, the Claimants filed claims for payments under the Prepetition Retention Program. The Litigation Trustee, authorized to do so under the Debtors’ confirmed Plan, objected to the Claimants’ claims, on the grounds that the Claimants had waived their right to receive payments under the Prepetition Retention Program based on their participation in the KERP program. Id. at *2. In response, the Claimants argued that there was no waiver for two primary reasons: first, the KERP letter agreements were novations that were not supported by new consideration; and second, the KERP letter agreements violated section 206.5 of the California Labor Code because they required the eligible employees to provide a release in return for wages due to them. Id. at *5.

The court, speaking to the Claimants’ first argument, found that the Claimants had received new and valid consideration in exchange for the KERP payments. Id. at *7. Assuming that amounts were due under the Prepetition Retention Program, the court considered that such payments would have been payable as prepetition general unsecured claims, for which the payment amount would have been uncertain. Id. By signing the KERP letter agreements, the court found that the Claimants had exchanged their uncertain, prepetition, general unsecured claims for postpetition, administrative expense claims, which entitled the Claimants to payment well before general unsecured creditors. Id. Thus, the Claimants had received new value in both the certainty and timing of their payments, such that the KERP letter agreements constituted a valid novation of the individual agreements under the Prepetition Retention Program. Id.

Turning to the Claimants’ arguments under the California Labor Code, the court concluded that KERP letter agreements did not violate the California Labor Code because the Claimants’ right to payment under the Prepetition Retention Program had not vested at the time the Claimants signed the KERP letter agreements. Id. at *11. Because bonuses are considered “wages” under the applicable California Labor Code sections, the Claimants attempted to argue that the KERP letter agreements deprived them of their wages due under the Prepetition Retention Program. Id. at *9. The Litigation Trustee disputed that such “wages” were due, since payments under the Prepetition Retention Program did not become due until June 1, 2018. Id. at *9-10. The Claimants then resorted to the “change of control” provision in their individual agreements under the Prepetition Retention Program, which accelerated the vesting of their bonus awards to the date of the sale transaction, since such transaction constituted a “change of control.” Id. at *10. The Litigation Trustee argued that, even if the “change of control” provision accelerated vesting of the Claimants’ bonuses under the Prepetition Retention Program, such award was still contingent on the Debtors’ discretion, as outlined in the “change of control” provision. Id. at *10-11. Accordingly, such amounts could not be considered due. Id. at *11. Considering California case law, the court agreed that, since all conditions on the awards under the Prepetition Retention Program had not been satisfied, such amounts were not due. Id.

Lastly, the court agreed with the Litigation Trustee that, even if the KERP letter agreements violated the California Labor Code, the California Labor Code was preempted by federal Bankruptcy Law, as enforced by the order of the Bankruptcy Court granting the KERP Motion. Id. at *11, 13.

The United States Court of Appeals for the Second Circuit affirmed a Bankruptcy Court’s exercise of jurisdiction over a post-confirmation contractual dispute between Relativity Media, LLC and Netflix, Inc. as a core proceeding.[1]

The dispute between Relativity and Netflix centered around Netflix’s assertion that it had the right under a licensing agreement, as amended, to stream two of Relativity’s films, Masterminds and The Disappointments Room, before they were scheduled to be released in the theatres. Netflix’s proposed actions would have completely undercut Relativity’s recently confirmed chapter 11 plan of reorganization, the feasibility of which was premised on the significant proceeds that Relativity expected to receive from first theatrically releasing the films and then Netflix distributing them under the licensing agreement.

Finding that Netflix did not have the contractual right to do so, the Bankruptcy Court granted Relativity’s motion under section 1142(b) of the Bankruptcy Code to enforce the plan and enjoined Netflix from streaming the films before they were released in the theaters.[2] Netflix appealed, arguing that the Bankruptcy Court did not have jurisdiction over the post-confirmation dispute. Both the District Court and the Second Circuit affirmed.

Following its decisions in In re U.S. Lines[3] and In re Petrie Retail, Inc.,[4] which found core bankruptcy court jurisdiction over post-confirmation disputes concerning the parties’ rights to the proceeds of major insurance contracts and the interpretation of a lease assigned under a Bankruptcy Court-approved sale order, the Second Circuit reasoned that the dispute between Netflix and Relativity was a core proceeding because of the impact that Netflix’s threatened distribution of the films would have on Relativity’s confirmed plan of reorganization.

As recounted by the Second Circuit, during the confirmation proceedings, Netflix objected to Relativity’s proposed plan of reorganization, questioning whether Relativity could actually theatrically release the films on the schedule proposed in the plan, and arguing that theatrical release of the films before distribution by Netflix was a material requirement to the licensing agreement. Relativity’s confirmed plan of reorganization incorporated Netflix’s understanding of the importance of the film’s being theatrically released before being streamed on Netflix. Testimony from the hearing on Relativity’s motion established that Netflix’s pre-release streaming of the films would have eviscerated the revenue streams anticipated by Relativity’s plan. The Second Circuit thus concluded that Netflix’s change of position would significantly impact the administration of the estate and “undercut the creditor relief provided by the Plan,” thus rendering the dispute a core proceeding over which the Bankruptcy Court properly exercised jurisdiction.[5]

[1].     Netflix, Inc. v. Relativity Media, LLC (In re Relativity Fashion, LLC), 696 Fed. App’x 26 (2d Cir. 2017).

[2].     The Bankruptcy Court also found that the doctrines of judicial estoppel and res judicata barred Netflix from asserting it had the right to stream the unreleased films because of the order confirming Relativity’s plan of reorganization and the related proceedings before the Bankruptcy Court.

[3].     197 F.3d 631 (2d Cir. 1999).

[4].     304 F.3d 223 (2d Cir. 2002).

[5].     Indeed, the Bankruptcy Court did not believe that Netflix’s change in position was made in good faith. The Bankruptcy Court believed that Netflix had recently negotiated more advantageous licensing agreements and speculated that “Netflix waited until very late in the process to spring this new issue on the Debtors in the hopes that it could gain leverage to force a contract change or maybe even a contract cancellation.” In re Relativity Fashion, LLC, No. 15-11989 (MEW), 2016 WL 3212493, at *12 (Bankr. S.D.N.Y. Jun. 1, 2016).

In a recent decision, the United States Bankruptcy Court for the Southern District of New York found that a relatively small retainer placed in the trust account of the foreign liquidators’ U.S. counsel constituted “property” sufficient to satisfy the requirements of section 109(a) of the Bankruptcy Code in a chapter 15 proceeding.[1] The decision elucidates the parameters of the “property” requirement of section 109, which the Second Circuit has applied even in the chapter 15 context.[2]

In August 2014, B.C.I. Finances Pty Limited, Binqld Finances Pty Limited, E.G.L. Development (Canberra) Pty Limited, and Ligon 268 Pty Limited (the “Debtors”), a group of companies controlled and operated by the Binetter family, were placed into Australian liquidation proceedings after allegations of fraud and tax evasion arose.[3] John Sheahan and Ian Russell Lock were appointed as joint liquidators (the “Liquidators”).[4] Following their appointment, the Liquidators brought suit against the Debtors’ corporate directors, including Andrew and Michael Binetter, in Australia, alleging that the corporate directors had breached their fiduciary duties, and that their breaches caused “significant losses” to the Debtors.[5] The trial judge in Australia ultimately ruled in the Liquidators’ favor, but did not come to a determination on the issue of damages.[6]

In 2017, the Liquidators sought chapter 15 recognition of the Australian liquidation proceedings in order to conduct discovery of Andrew and Michael Binetter, who had moved to New York City during the pendency of the trial in Australia.[7] Andrew Binetter, along with another party (together, the “Objecting Parties”), opposed the Liquidators’ chapter 15 petition.

The Objecting Parties claimed that the Debtors were ineligible for chapter 15 relief because they did not have sufficient “property” in the United States to satisfy section 109(a) of the Bankruptcy Code. Section 109(a) states that “only a person that resides or has a domicile, a place of business, or property in the United States . . . may be a debtor under this title.”[8] The Second Circuit has held that this requirement must also be satisfied in the context of chapter 15 proceedings.[9] However, the Second Circuit did not specify a threshold for the amount of “property” sufficient to satisfy this requirement in the chapter 15 context.

In response, the Liquidators argued that (1) a $1,250 retainer placed in the trust account of the Liquidators’ counsel (the “Retainer”) and (2) the Debtors’ fiduciary duty claims against Andrew and Michael Binetter (the “Fiduciary Duty Claims”) constituted “property in the United States” sufficient for section 109(a) eligibility.[10]

The Bankruptcy Court held that the Retainer and the Fiduciary Duty Claims each independently satisfied the section 109(a) requirement.[11] Before concluding that even a $1,250 retainer may satisfy section 109(a), the Court noted that “it is well established that ‘[a] debtor’s funds held in a retainer account in the possession of counsel to a foreign representative constitute property of the debtor in the United States and satisfy the eligibility requirements of section 109.’”[12] Furthermore, the court emphasized that the “property” requirement in section 109(a) is satisfied even by a “minimal amount of property” in the United States.[13] The court then rejected the Objecting Parties’ argument that the Debtors’ deposit was made in order to “manufacture eligibility under Section 109.”[14]

The court next addressed whether the Fiduciary Duty Claims were located in the United States, since it was undisputed that the Fiduciary Duty Claims were property of the Debtors. Using a multi-step analysis, the court first applied New York’s “greatest interest test,” holding that the situs of the Fiduciary Duty Claims should be determined according to Australian law.[15] Then, after considering expert testimony on the issue, the court determined that, under Australian law, claims “are situated where they are properly recoverable and are properly recoverable where the debtor resides.”[16] Therefore, the court concluded that, because the Binetters lived in New York, the situs of the Fiduciary Duty Claims was New York and qualified as “property in the United States.”

Although the Barnet decision imposed an additional eligibility requirement for foreign representatives seeking chapter 15 protections,[17] the Bankruptcy Courts have consistently lowered the barrier, ensuring that foreign representatives are afforded easy access to the protections offered in chapter 15. With this low barrier, even a de minimis amount of funds deposited in a trust account for the purpose of retaining counsel may satisfy the eligibility requirement. In addition, claims that situated in the United States under applicable laws may also satisfy the requirement.

-Hillary McDonnell assisted with the preparation of this post.

 

[1] In re B.C.I. Finances Pty Limited, 583 B.R. 288 (Bankr. S.D.N.Y. 2018).

[2] See Drawbridge Special Opportunities Fund LP v. Barnet (In re Barnet), 737 F.3d 238 (2d Cir. 2013).

[3] Id. at 290.

[4] Id.

[5] Id. at 291.

[6] Id.

[7] Id.

[8] Id. at 292; 11 U.S.C. § 109(a).

[9] See Barnet, 737 F.3d at 247; see also In re Forge Grp. Power Pty Ltd., No. 17-CV-02045-PJH, 2018 WL 827913, at *9 (N.D. Cal. Feb. 12, 2018) (adopting the Second Circuit’s reasoning to hold that Section 109(a) applies to chapter 15 proceedings). But see Transcript of Hearing at 8-9, In re Bemarmara Consulting A.S., No. 13-13037 (KG) (Bankr. D. Del. Dec. 17, 2013) (holding that section 109(a) does not apply to chapter 15 proceedings).

[10] B.C.I. Finances, 583 B.R. at 291.

[11] Id. at 290.

[12] Id. at 293 (quoting In re Poymanov, 571 B.R. 24, 29 (Bankr. S.D.N.Y. 2017)).

[13] Id. at 294.

[14] Id. at 295.

[15] Id. at 297.

[16] Id. at 300.

[17] Barnet, 737 F.3d at 251 (holding that a debtor within a foreign proceeding seeking recognition under chapter 15 must satisfy the section 109(a) requirement of residing or having a domicile, place of business, or property in the United States).

On December 21, the Bankruptcy Court for the Southern District of New York recognized and agreed to enforce the unopposed foreign restructuring plan of oil exploration company C.G.G. S.A. (“C.G.G.,” or the “Company”) under Chapter 15 of the Bankruptcy Code.  C.G.G.’s restructuring marks one of the few times a U.S. bankruptcy court has been asked to enforce a French court-sanctioned bankruptcy plan.

C.G.G.’s French Bankruptcy

C.G.G. is a nearly 90-year-old French company specializing in geophysical services.  Its business comes predominantly from the Oil and Gas Exploration and Production (“E&P”) industry.  Like other companies in E&P, as oil and gas prices dropped, C.G.G.’s revenues dropped precipitously, from more than $3.4 billion in 2012 to $1.2 billion in 2016.  C.G.G. simultaneously faced nearly $3 billion in funded indebtedness. C.G.G. initially divested non-core assets and reduced its headcount to save money, but soon determined that those measures were insufficient, and that restructuring was necessary.  The Company initiated restructuring in France in February 2017.  Negotiations with stakeholders eventually resulted in a June 2017 Lock-Up agreement, through which the company’s shareholders agreed not to sell their shares. Negotiations also led to a restructuring support agreement that would swap nearly $2 billion in debt for most of the reorganized Company’s equity.

C.G.G. simultaneously commenced insolvency proceedings in French court through a sauvegarde, or Safeguard proceeding, which halted debt payments, acceleration, and enforcement of securities against the company.  C.G.G. then filed a Chapter 15 petition in the Southern District on June 14. Some of C.G.G.’s subsidiary companies also filed under Chapter 11.  In July 2017, the New York court recognized the French case as a “foreign main proceeding” – occurring in the country of the debtors’ “center of main interests,” as described in section 1520 of the Code, rather than a “nonmain proceeding,” taking place in a country where the debtor only has an “establishment.”

C.G.G. passed the restructuring agreement, called the Safeguard plan, with more than 90% of voting creditors approving.  The French court accepted the plan via a “Sanctioning Order” on December 1.

On December 6, C.G.G., through its Foreign Representative, filed a new motion in the Southern District, requesting the court (a) give full force and effect to the Sanctioning order; (b) permanently enjoin actions against the Safeguard Plan within the U.S.; (c) declare securities given to the creditors under the plan (the “Safeguard Securities”) exempt from Section 1145 registration; (d) authorize C.G.G.’s Foreign Representative to seek entry of a final decree to close the Chapter 15 case under Rule 5009(c); and (e) waive the 14-day stay of effectiveness for the order.

The Order

Bankruptcy Judge Martin Glenn granted the motion on all counts. The court first determined that the Sanctioning Order (the “Order”) fell within “any appropriate relief,” as required under section 1521(a)(7). The court cited the creditors’ overwhelmingly support for the Safeguard Plan and reasoned that the plan’s effectiveness, and the concurrent Chapter 11 cases, was conditioned on the court’s acceptance of the Order.

The court then found that, as required under Section 1522, the interests of creditors and all interested parties in the case were “sufficiently protected.”  The court reasoned that, without the court’s approval of the Order, the Plan might not be fully implemented. Further, the French court had already fully determined, after a hearing with interested parties, that the Safeguard plan gave sufficient protection.  The court also agreed to permanently enjoin actions against the Safeguarding Plan.

The court also determined the Safeguard Securities were exempt from federal and state registration requirements.  It found that section 1145, which allows exemptions from Securities laws, can be applied to Chapter 15 cases through sections 1507 and 1521 as long as the securities (a) were offered or sold under a plan; (b) were securities of the debtor or an affiliate in a joint plan; and (c) were sold in exchange for a claim against the debtor or affiliate, as per section 1145(a)(1).  The court found that all three requirements were satisfied.

Last, the court found that, upon its order becoming final, section 350(a)’s requirements for closing a case were satisfied, and thus the case could be closed following the procedures of rule 5009(c). The court also waived the 14-day stay of effectiveness, in order to allow the restructuring to begin immediately.

Conclusion

The Southern District has frequently recognized and enforced foreign court orders in approval of a foreign debtor’s restructuring plan – including recent plans from Hong Kong, Australia, Canada, the Caymans, and South Africa.  But as Judge Glenn remarks in his opinion, French Safeguard plans have rarely been brought to U.S. bankruptcy courts for recognition and enforcement.  The ruling suggests that French plans that are widely approved by creditors will receive a stamp of approval from the Southern District.  It suggests moreover that the court will defer to the findings of French courts that have fully heard all parties to the restructuring on issues like section 1522 sufficient protection.

On January 12, 2018, the U.S. Supreme Court granted certiorari over the Eleventh Circuit’s decision in R. Scott Appling v. Lamar, Archer & Cofrin, LLP, which held that a fraudulent statement regarding a single asset may constitute a statement concerning the debtor’s financial condition, thereby allowing a debt incurred in reliance on the false statement to be discharged through a bankruptcy. The Eleventh Circuit’s decision focused on the dichotomy established in sections 523(a)(2)(A) and (B) of the Bankruptcy Code between fraudulent statements regarding the debtor’s “financial condition,” which only prevent the discharge of a debt if the false statement is made in writing, and other fraudulent statements giving rise to a debt, which can prevent a discharge even if the statement is only made orally. R. Scott Appling v. Lamar, Archer & Cofrin, LLP will allow the Supreme Court to address a split between the Circuits on this issue, as the Eleventh Circuit’s ruling is consistent with the approach adopted by the Fourth Circuit,[1] but contrary to the standard adopted by the Fifth, Eighth, and Tenth Circuit’s approach, which holds that a statement about a single asset does not “respect” a debtor’s financial condition as required by 523(a)(2)(A).[2]

The case arises out of an adversary proceeding initiated by Lamar, Archer & Cofrin, LLP (“Lamar”) against one of its clients, R. Scott Appling. Appling incurred certain legal fees when Lamar represented him in lawsuits against the former owners of his business; however, Appling was unable to pay his legal bills when they became due. During a meeting with attorneys from Lamar, Appling conveyed that he was expecting a substantial tax refund, which he represented would be sufficient to pay his outstanding legal bill as well, as to pay any future fees incurred during the ongoing litigation. In reliance of this statement, Lamar continued its representation of Appling and did not take any steps to immediately collect its overdue fees. However, Appling’s statement was false as he only received a modest refund, which he put into his business rather than to satisfy the outstanding legal fees owed to Lamar. Lamar eventually filed suit against Appling to collect the outstanding fees, and Appling subsequently filed for bankruptcy. The central issue is whether Appling’s oral statements regarding his tax refund, which pertained to a single asset, respected his financial condition and is therefore dischargeable.

The Supreme Court’s decision could have ramifications on the discharge of debts in bankruptcy. The narrower interpretation of the statute favored by the majority of circuits will limit the scope of the “financial condition” exception contained in section 523(a)(2)(B). This “gives effect to the fundamental bankruptcy policy that the bankruptcy courts will not provide safe haven for the perpetuators of fraud.”[3] Indeed, the exception was originally conceived by Congress to address certain consumer-finance companies that were deliberately encouraging customers to submit false statements for the purpose of insulating the creditor’s claim from discharge.[4] However, application of the majority view is difficult in practice because it creates “substantial line-drawing problems and may cause unjustified differential treatment of functionally equivalent scenarios.”[5]

On the other hand, applying the broader interpretation put forth by the Eleventh Circuit could promote predictability and accuracy while protecting debtors from abusive credit practices.[6] It encourages creditors to rely on written statements, which are more reliable as evidence, if they later seek an exemption.[7] The office of U.S. Solicitor General advanced this position and filed a brief as Amici Curiae agreeing with the Eleventh Circuit’s ruling. The Solicitor General argued that the broader interpretation best served Congress’s policy goals because it “gives creditors an incentive to create writings before the fact,” which may reduce fraud in the first instance.[8] By creating reliable evidence for future litigation, “such writing helps both the honest debtor prove his honesty and the innocent creditor prove a debtor’s dishonesty.”[9] Nevertheless, the Eleventh Circuit’s interpretation could expand the exception’s reach beyond its intended scope because “virtually every statement by a debtor that induces the delivery of goods or services on credit relates to his ability to pay.”[10] With the “financial condition” exception taking center stage, this Supreme Court decision will certainly be one to watch.

 

 

* This post was prepared with assistance from Jiun-Wen Bob Teoh.

[1] See Engler v. Van Steinburn, 744 F.2d 1060, 1061 (4th Cir. 1984) (holding that “a debtor’s assertion that he owns certain property fees and clear of other liens is a statement respecting his financial condition”).

[2] See, e.g., In re Bandi, 683 F.3d 671, 676 (5th Cir. 2012); In re Lauer, 371 F.3d 406, 413-14 (8th Cir. 2004); In re Joelson, 427 F.3d 700, 706 (10th Cir. 2005).

[3] Brief for Petitioner at 20, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Apr. 11, 2017).

[4] Brief for Petitioner at 22, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Apr. 11, 2017).

[5] Brief of United States as Amici Curiae at 18, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Nov. 9, 2017).

[6] Brief for Respondent at 20, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (May 25, 2017).

[7] Brief for Respondent at 20, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (May 25, 2017).

[8] Brief of United States as Amici Curiae at 8, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Nov. 9, 2017).

[9] Brief of United States as Amici Curiae at 17-18, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Nov. 9, 2017).

[10] Brief for Petitioner at 22, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Apr. 11, 2017).

In its recent decision in In re Peregrine Financial Group, the Seventh Circuit became the first circuit to accept a definition of “customer property” which excludes retail foreign exchange contracts, or “forex contracts”, and spot metal contracts.[1]  The Court’s ruling highlights the risk parties that transact in foreign exchange transactions and OTC metal transactions may face in the event that a future commodities merchant is forced into liquidation.

Background:

Peregrine was a registered “Future Commission Merchant” (“FCM”) and a registered “Forex Dealer Member” of the National Futures Association. Peregrine, in addition to futures, dealt in retail foreign currency transactions and spot metal transactions. In 2012, it was discovered that over a twenty-year period Peregrine’s CEO, Russel L. Wasendorf, had embezzled nearly $200 million from Peregrine’s segregated customer future accounts.  In July 2012, as a result of this defalcation, Peregrine filed for bankruptcy and a trustee was appointed to administer the Peregrine estate.  Subchapter IV of Chapter 7 of the Bankruptcy Code, 11 U.S.C. §§ 761–767, governs the bankruptcy of a futures commissions merchant such as Peregrine, and provides for the distribution of “customer property” in priority to all other claims.  “Customer property” is defined as including funds received in connection with a commodity contract, 17 C.F.R. § 190.08(a)(1)(i)(A), which in turn is defined in § 761(4) of the Bankruptcy Code.

The Peregrine Trustee excluded certain former account holders of Peregrine from receiving priority distributions of customer property based on his determination that the forex and spot metal transactions they had conducted through Peregrine did not constitute “commodity contracts” as defined by the Bankruptcy Code.  In response to the Trustee’s determination, certain former account holders (the “Plaintiffs”) commenced an adversary and assert that their forex and spot metal contracts should be treated as commodity contracts, which would entitle them to priority distributions.[2]

Decision: Forex and Spot Metal Contracts are not “similar to” Commodities Contracts

The Seventh Circuit’s ruling turned on the definition of “commodity contract” contained in section 761 of the Bankruptcy Code. The Plaintiffs alleged that their forex and spot metal contracts should be treated as commodity contracts under the “similar to” clause in Chapter 7 of the Bankruptcy Code.[3]  The question of whether the forex and spot metal contracts are considered commodity contracts was vital to the Plaintiffs’ potential for recovery as Chapter 7 gives priority distribution to “customer property” which is defined as “property received, acquired, or held to margin, guarantee, secure, purchase, or sell a commodity contract.”[4]

As defined in section 761 of the Bankruptcy Code, a “commodity contract” includes futures contracts,[5] or a contract “similar to” a futures contract.[6]  In Peregrine, the Plaintiffs pointed to both the language of the statute and congressional intent that they suggested supported the finding that their retail forex contracts and spot metal contracts were “similar to” futures contracts and therefore fell within the definition of commodity contract contained in the Bankruptcy Code.  Based largely on its previous ruling in In re Zelener, 373 F.3d 861 (7th Cir. 2004), the Seventh Circuit disagreed.

In Zelener, the Seventh Circuit considered whether “[forex transactions] are contracts of sale of a commodity for future delivery regulated by the Commodity Futures Trading Commission.”[7]  The Seventh Circuit held that retail forex transactions were distinguishable from futures contracts because the “customer buys foreign currency immediately rather than as of a defined future date, and because the deals lack standard terms.  [The defendant] buys and sells as a principal; transactions differ in size, price, and settlement date.  The contracts are not fungible and thus could not be traded on an exchange.”[8]  The Court expanded on this reasoning to find that the retail forex transactions and spot metal transactions were also not “similar to” futures contracts because “Zelener illustrated these two types of transactions were not alike in substance or essentials.”[9]  As the Court explained, “[f]utures contracts are fungible instruments that allow parties to trade in the contract with a clearinghouse accepting the risk of any counterparty default.  Retail forex, in contrast, involves private transactions that bear no fungible features.”[10]  The Court also rejected the Plaintiff’s argument that the legislative history of section 761 indicates that Congress intended for retail forex transactions to be treated as commodities contractions, noting “Congress has had opportunities to include OTC metal and retail forex transactions in the definition of ‘commodity contract’ but has declined to do so.  For example, in 2010, as part of Dodd-Frank, Congress amended section 761(4) to include ‘cleared swap’ transactions, 11 U.S.C. § 761(4)(F)(ii), yet declined to include retail forex or OTC metals.”[11]  The Court noted that this reasoning was further strengthened by the overall goals of the commodity broker provisions of chapter 7, which are to promote market stability during events of insolvency; a concern that is not implicated with retail forex or OTC metals because they are uncleared transactions where the customer assumes the risk of default.

The decision provides an important warning to lesson to forex and spot metal traders. Namely, that forex and spot metal transactions are not protected under Chapter 7 of the Bankruptcy Code, and will not receive priority distribution in a liquidation.

* Olivia Bensinger assisted with the preparation of this post.

 

[1] In re Peregrine Fin. Grp, Inc., 866 F.3d 775 (7th Cir. 2017), adopting the opinion of Secure Leverage Grp., Inc. v. Bodenstein, 558 B.R. 226, 241 (N.D. Ill. 2016).

[2] 11 U.S.C. § 761(4)(F)(i) (2012).

[3] Id.

[4] Id. at § 761(10)(A)(i).

[5] Id. at § 761(4)(A).

[6] Id. at § 761(4)(F)(i).

[7] In re Zelener, 373 F.3d 861, 862 (7th Cir. 2004).

[8] Id. at 864.

[9] Secure Leverage Grp., 558 B.R. at 241.

[10] Id.

[11] Id. at 242.

What happens when property that a trustee wants to sell in a section 363 sale is subject to unexpired leases that the trustee is empowered to reject under section 365(h)? The Ninth Circuit faced this conundrum in a recent case involving a luxury real estate development in Montana, Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 892 F.3d 892 (9th Cir. 2017).  Wrestling with a split between its sister circuits, the Ninth Circuit ultimately concluded that, “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict,” and the trustee could properly proceed with the sale.

Spanish Peaks, a 5,700-acre resort in Big Sky, Montana, was financed by a $130 million loan secured by a mortgage and assignment of rents from Citigroup Global Markets Realty Corp. Citigroup assigned the note and mortgage to Spanish Peaks Acquisition Partners LLC (“SPAP”).

At issue on appeal were two leases at the resort. The first was a restaurant space that Spanish Peaks Holdings, LLC (“SPH”) leased for $1,000 per month to Spanish Peaks Development, LLC (“SPD”).  SPH and SPD later replaced the lease with a 99-year leasehold for $1,000 per year in rent.  SPD assigned its interest to The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”).  The second was a parcel of commercial real estate SPH leased to Montana Opticom, LLC (“Opticom”), for a term of 60 years and annual rent of $1,285.

SPH defaulted on its loan payments and filed, along with two related entities, Chapter 7 petitions in Delaware. SPAP, SPH’s largest creditor with a claim of $122 million secured by the mortgage, assigned its claim to CH SP Acquisitions, LLC (“CH SP”).  The trustee and SPAP agreed to a plan to liquidate “substantially” all of the debtors’ property through an auction with a minimum bid of $20 million.  The trustee sought approval for sale of the property “free and clear of all liens,” except for certain enumerated encumbrances and liens to be paid out of the sale proceeds or otherwise protected.

The Pinnacle and Opticom leases were mentioned neither on the list of surviving encumbrances nor on the list of protected liens.. Both entities thus objected to any sale “free and clear of [their] leasehold interests.” 872 F.3d at 895.  The bankruptcy court authorized the sale but did not rule on Pinnacle’s and Opticom’s objections.  The court instead deferred them until the hearing on the motion to approve the sale.

At the auction and approval hearing on June 3, 2013, CH SP won the auction with a bid of $26.1 million. Pinnacle and Opticom renewed their claim that their leases allowed them to retain possession and objected to the “free and clear” language in the proposed approval order.

The bankruptcy court approved the sale, holding that the sale was free and clear of any “Interests,” including any leases “except any right a lessee may have under 11 U.S.C. § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure.” Id. at 896.  After some procedural back-and-forth and another evidentiary hearing, the bankruptcy court found defects in Pinnacle’s and Opticom’s leases, and noted that they had neither requested adequate protection for their interests nor proven that they would suffer economic harm if their interests were terminated.  The bankruptcy court thus held the sale was free and clear of the Pinnacle and Opticom leases, and the district court affirmed.

On appeal, the Ninth Circuit considered whether the leases survived the sale to CH SP, which gave rise to an apparent conflict between the trustee’s ability to sell property of the estate under section 363 and authority to assume or reject unexpired leases under section 365(a) and (h). Section 365 gives a lessee in possession with two choices:  “treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights—including a right of continued possession—to the extent those rights are enforceable outside of bankruptcy.” Id. at 898.

Other circuits had taken one of two approaches to the apparent conflict. The majority held that section 365 outweighed section 363 “under the canon of statutory construction that ‘the specific prevails over the general.’” Id. (internal citation omitted).

In contrast, the Seventh Circuit had held that “the statutory provisions themselves do not suggest that one supersedes or limits the other.” Id. (quoting Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537, 547 (7th Cir. 2003)).  In other words, section 363 confers a right to sell property free and clear of “any interest” without exempting leases protected under section 365, while section 365(h) focuses on the specific event of the rejection of an executory contract without reference to sales of estate property under section 363.  The Seventh Circuit explained:

Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest—provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the [estate] remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property.  So understood, both provisions may be given full effect without coming into conflict with one another and without disregarding the rights of lessees.

327 F.3d at 548.

The Ninth Circuit agreed with the Seventh Circuit’s approach as the best way to reconcile the two statutes, noting that while “[a] sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, . . . it is not the same thing as the ‘rejection’ contemplated by section 365.” 872 F.3d at 899.

Here, then, the trustee had not rejected the Pinnacle and Opticom leases, so section 365 was not in play, and section 363(f)(1) authorized the sale of the property free and clear of the leases. The Ninth Circuit therefore affirmed the judgment of the district court.

An increasingly common aspect of Chapter 11 plans is non-consensual third party releases, which are often a vital tool required to obtain global peace among competing constituencies whose support is often needed for a debtor to obtain confirmation of a Chapter 11 plan. However, the parameters of a bankruptcy court’s Constitutional authority to approve such non-consensual releases has, to date, been unclear. Clarity, however, has been provided by the recent decision by the United States Bankruptcy Court for the District of Delaware In re Millennium Lab Holdings II, LLC,[1] where the Court concluded that it had constitutional authority to confirm a restructuring plan that released third parties from liability to certain creditors, even though those creditors had not consented to the releases.  The Bankruptcy Court’s ruling will be of interest to potential debtors and other potential releasees who may seek to employ or benefit from non-consensual third party releases as well as to lenders and other creditors who may find themselves bound by non-consensual release contained in a Chapter 11 plan.

Debtor Millennium Lab Holdings II, LLC and certain affiliates commenced their Chapter 11 Cases in 2015 following a settlement with the United States federal government and certain states relating to alleged violations of the Anti-Kickback Statute, the False Claims Act, and the Stark Act (which relates to physician referrals for Medicare and Medicaid services). In December 2015, the Bankruptcy Court confirmed a Plan of Reorganization which contained settlements with certain equity holders (the “Non-Debtor Equity Holders”), who contributed $325 million to the estate and received third party releases.  Immediately prior to the confirmation hearing, certain dissenting creditors (the “Opt-Out Lenders”) commenced a lawsuit asserting common law fraud and RICO claims against the Non-Debtor Equity Holders.  The Opt-Out Lenders also filed an objection to the non-consensual third party releases in the proposed Plan.  The Opt-Out Lenders argued that the Plan’s non-consensual releases went beyond the scope of the Bankruptcy Court’s authority.[2]

The Bankruptcy Court overruled the Opt-Out Lenders’ arguments and confirmed the Plan in a bench ruling on December 11, 2015. Thereafter, in a January 12, 2016 written opinion, the Bankruptcy Court certified an appeal directly to the Third Circuit on the following question: “Do Bankruptcy Courts have the authority to release a non-debtor’s direct claims against other non-debtors for fraud and other willful misconduct without the consent of the releasing non-debtor?”[3]  The Third Circuit denied the petition for permission to appeal, and the appeal was docketed with the Delaware District Court.[4]

In the District Court, the Opt-Out Lenders principally pursued an argument based on the Supreme Court’s decision in Stern v. Marshall.[5]  According to the Opt-Out Lenders, the Bankruptcy Court lacked constitutional authority to enter a final order releasing direct, non-bankruptcy claims against non-debtors.  The District Court remanded the case to the Bankruptcy Court to decide that issue.  In doing so, however, the District Court provided its own view of the merits and voiced agreement with the Opt-Out Lenders’ Stern argument.  The District Court stated that it was “persuaded by [the Opt-Out Lenders’] argument that the Plan’s release, which permanently extinguished [the Opt-Out Lenders’] claims, is tantamount to resolution of those claims on the merits” and that it believed that “[i]f Article III prevents the Bankruptcy Court from entering a final order disposing of a non-bankruptcy claim against a nondebtor outside of the proof of claim process, it follows that this prohibition should be applied regardless of the proceeding (i.e., adversary proceeding, contested matter, plan confirmation).”[6]

On remand, the Bankruptcy Court concluded that it did have the authority to grant the release of the Opt-Out Lenders’ claims via confirmation of the Plan.  In its analysis, the Bankruptcy Court laid out a continuum of interpretations of Stern.  On one end of the continuum, the narrow interpretation reads Stern only as prohibiting a bankruptcy court from entering a “final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.”[7] Next, a relatively broad interpretation of Stern would prohibit a bankruptcy court from entering a final judgment on “all state law claims, all common law causes of action or all causes of action under state law.”[8] Finally, the broadest view of Stern holds “that bankruptcy judges should examine their ability to enter final orders in all enumerated or unenumerated core proceedings.”[9]

The Bankruptcy Court held that it possessed constitutional authority to confirm the Plan under both the narrow and broad views of Stern because confirmation of a plan is neither a state law counterclaim nor a state law claim of any kind.[10] Furthermore, even under the broadest interpretation of Stern, the Bankruptcy Court maintained constitutional authority to confirm the plan because (1) confirmation is at the core of a bankruptcy judge’s power, (2) confirmation applies a “federal standard,” and (3) the confirmation of the Plan met the Third Circuit’s “standard of fairness and necessity to the reorganization.”[11]

The Bankruptcy Court also rejected the Opt-Out Lenders’ interpretation of Stern. The Opt-Out Lenders argued that confirmation would violate Stern’s statement that “the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” The Bankruptcy Court questioned whether that disjunctive test was the appropriate measure of the constitutionality of a restructuring plan, and further held that confirmation of the Plan was constitutional because the Plan stemmed from the Chapter 11 Cases and “the releases were integral to confirmation and thus integral to the restructuring of the debtor-creditor relationship.”[12]

The Bankruptcy Court also dismissed the Opt-Out Lenders’ functionalist argument that, because confirmation had the effect of extinguishing their RICO lawsuit, the confirmation constituted an “impermissible adjudication of the litigation being released.” Relying on pre-Stern Third Circuit precedent,[13] the Bankruptcy Court concluded that a confirmation order can permissibly impact and even extinguish lawsuits in non-core proceedings. The Bankruptcy Court went on to note that, if taken to its logical conclusion, the Opt-Out Lenders’ interpretation of Stern would apply to an eye-popping range of core bankruptcy matters, including substantive consolidation, recharacterization and subordination of debts, and practically every section 363 sale.

In short, the Bankruptcy Court held that, regardless of Stern, bankruptcy courts have constitutional authority to confirm restructuring plans that include non-consensual releases of claims against third parties. Furthermore, Stern does not extend to core proceedings concerning federal law that implicate state law rights.

Although Stern is now nearly eight years old, its meaning remains a source of controversy and litigation in bankruptcy courts. The range of possible interpretations of Stern described by the Bankruptcy Court—as well as the differing view offered by the District Court—show that courts have not yet settled how Stern affects even routine and fundamental bankruptcy court business. Perhaps not surprisingly in light of the long history of the dispute and the District Court’s decision, the Opt-Out Lenders have filed a notice of appeal of the Bankruptcy Court’s decision. Stay tuned to the HHR Bankruptcy Report to stay apprised of further developments.

* James Henseler assisted with the preparation of this post.

[1].      In re Millennium Lab Holdings II, LLC, No. 15-12284, 2017 WL 4417562 (Bankr. D. Del. October 3, 2017).

[2].      According to the Bankruptcy Court, the Opt-Out Lenders raised four objections to the releases: (i) the court lacked subject matter jurisdiction to grant nonconsensual third party releases, (ii) the releases were impermissible, (iii) the Plan impermissibly did not allow parties to opt-out of the releases, and (iv) the releases were inconsistent with the Third Circuit’s holding in Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000).

[3].      In re Millennium Lab Holdings II, LLC, 543 B.R. 703, 711 (Bankr. D. Del. 2016).

[4].      In re Millennium Lab Holdings II, LLC, 242 F. Supp. 3d 322, 335 (D. Del. 2017).

[5].      Stern v. Marshall, 564 U.S. 462 (2011).

[6].      In re Millennium Lab Holdings II, LLC, 242 F. Supp. 3d 322, 339 (D. Del. 2017).

[7].      2017 WL 4417562, at *12 (quoting Stern, 564 U.S. at 503).

[8].      Id.

[9].      Id. at *13 (emphasis removed).

[10].    Id. at *14 (internal quotation marks omitted).

[11].    Id. at *15 (citing In re Cont’l Airlines, 203 F.3d 203, 214 (3d Cir. 2000)).

[12].    2017 WL 4417562, at *18.

[13].    CoreStates Bank, N.A. v. Huls Am., Inc., 176 F.3d 187 (3d Cir. 1999).