HHR Bankruptcy Report

Does Stern v. Marshall Prohibit Non-Consensual Third Party Releases of Non-Bankruptcy Claims in Plans of Reorganization?

Posted in Delaware, Stern v. Marshall, Third party release

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).

Unresolved Questions Remain in Recharacterizing Insider Debt

Posted in Claims Subordination, Debt Recharacterization, SCOTUS

On August 10, 2017, the Supreme Court dismissed the writ of certiorari in PEM Entities LLC v. Levin as improvidently granted. See No. 16-492, 2017 WL 3429146, at *1 (U.S. Aug. 10, 2017).  This decision leaves the circuit courts split on the issue of whether to use federal or state law in recharacterizing insider debt as equity, a critical distinction that can be dispositive as to the treatment of debt claims made by insiders of debtors.

Case Background

In PEM Entities LLC, Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from Paragon Commercial Bank (the “Loan”).  The Debtor subsequently defaulted on the Loan, eventually resulting in foreclosure proceedings.  The Debtor, its principal, and other related entities entered into a settlement agreement with the lender.  Under the settlement, Paragon Commercial Bank sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for around $1.2 million.  Critically, PEM was owned by insiders of the Debtor, relied solely upon principals of the Debtor to negotiate the settlement agreement, and failed to set out formal interest rates and payment schedules with the Debtor after the settlement of the loan.  When the Debtor could not maintain liquidity despite PEM’s intervention, the Debtor filed this Chapter 11 case, wherein PEM filed a secured claim for $7 million.   The Debtor’s unsecured debtholders moved to recharacterize the secured claim as equity.

Using the 11 factor federal test for recharacterizing insider debt claims laid out in Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (N. Am.), Inc.), 453 F.3d 225, 231 (4th Cir. 2006), the United States Bankruptcy Court for the Eastern District of North Carolina held that PEM’s claim would be recharacterized as equity rather than debt, moving the claim to lower priority status than the unsecured debtholders.  Both the district and circuit courts affirmed on appeal, with the Fourth Circuit signaling that the federal, rather than state, test for recharacterization would be proper and that PEM’s actions, while arguably debt in name, was at its core a capital investment in the company’s success rather than the temporary borrowing of money.

The Unresolved Circuit Split

The Supreme Court’s decision to dismiss the writ of certiorari in PEM Entities LLC leaves in place a Circuit split on whether to use federal or state law standards to recharacterize debt.  The Sixth, Tenth, Third, and Fourth Circuits all use a multi-factor test similar to the one used in PEM Entities, LLC that looks beyond form and to the substance of the transaction to decide whether it should be categorized as debt or equity.[1]  Similarly, the Eleventh Circuit applies a two-prong federal standard that also attempts to reach the substance of the transaction.[2]  On the other hand, the Fifth and Ninth Circuits have applied an approach to recharacterization based on the state law of the forum.[3]  These state laws vary greatly from state to state, but they are often more friendly to debtor insiders who invest in debt and look to the form of the transaction rather than the substance.

Reason for Dismissal

The circumstances of the dismissal further dampen the hopes of a quick resolution to this circuit split.  On October 11, 2016, PEM petitioned the Supreme Court for a writ of certiorari to review the Fourth Circuit decision on the issue of whether federal or state law should be applied to recharacterize debt as equity.  On June 27, 2017, this writ was granted only to be dismissed as improvidently granted six weeks later, prior to merits briefing, on August 10, 2017.  The Supreme Court is not obligated to explain its reasoning for dismissing certiorari and did not here.  Usually, certiorari is dismissed as improvidently granted if a party attempts to change its argument in its merits brief, if the dispute seems overly fact determinative, or if the Justices believe that the case has secondary issues that may prevent the court from reaching the merits also known as “vehicle” problems.

Here, certiorari was dismissed shortly after the parties filed a joint motion to confirm party status on July 21, 2017.  The original respondents for this action had settled a state court action which caused them to cease having a stake in the outcome of this case.  Instead, the parties moved the court for the Debtor to step into the unsecured debtors shoes as the respondents in this action, as they had a continued interest in defending the judgment below. Given the short period of time between the filing of this motion and the dismissal of certiorari as improvidently granted, as well as the fact that merits briefing was never even completed, it is likely that the Court dismissed this case due to “vehicle” issues.  That is, the Court decided that, due to the complexity of the party’s status and procedural posture, the likelihood that the Court would not reach the merits of the action had risen and it was no longer worth the risk of using its limited resources to hear the case.  This issue may continue to hamper attempts to bring the issue of this circuit split to the Supreme Court, as the interconnected and complex nature of relationships between parties in cases dealing with recharacterizing insider debt as equity rarely make the best simple and clear-cut vehicles for Supreme Court rulings.

[1].      See Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 749-750 (6th Cir. 2001); Sender v. Bronze Grp., Ltd. (In re Hedged-Investments Assocs., Inc.), 380 F.3d 1292, 1298 (10th Cir. 2004); Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448, 455-456 (3d Cir. 2006); In re Dornier Aviation (N. Am.), Inc., 453 F.3d at  233-234.

[2].      In re N & D Properties, Inc., 799 F.2d 726, 733 (11th Cir. 1986) (two-pronged test, shareholder loans may be deemed capital contributions “where the trustee proves initial undercapitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit.”).

[3].      See Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539, 543 (5th Cir. 2011); Official Comm. of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings Int’l, Inc.), 714 F.3d 1141, 1148 (9th Cir. 2013).

Just Passing Through: Merit Management Group, LP v. FTI Consulting, Inc.

Posted in Safe Harbor Provisions, SCOTUS

Next week, the Supreme Court will hear oral argument in Merit Management Group v. FTI Consulting to decide the correct way to apply the safe harbor of section 546(e) of the Bankruptcy Code.  The Court will review the Seventh Circuit’s decision splitting from the Second, Third, Sixth, Eighth and Tenth Circuits and holding that section 546(e) does not protect a transfer that is conducted through a financial institution (or other qualifying entity) where that entity is neither the debtor nor the transferee but acts merely as the conduit for the transfer.[1] The Seventh Circuit’s decision is consistent with a two-decades-old decision of the Eleventh Circuit.

Under Chapter 5 of the Bankruptcy Code, bankruptcy trustees have the power to avoid certain types of transfers made by an insolvent debtor.  The safe harbor of Bankruptcy Code section 546(e) is one of a number of provisions in Chapter 5 that limit the trustee’s avoidance powers.  Section 546(e) prevents the bankruptcy trustee from avoiding a transfer that is a “margin payment” or a “settlement payment” “made by or to (or for the benefit of)” a financial institution or five other qualified entities.  It also protects transfers “made by or to (or for the benefit of)” the same types of entities “in connection with a securities contract.”[2]

The case arises out of a bankruptcy trustee’s action to avoid as a fraudulent transfer a $16.5 million payment by the debtor, Valley View Downs—an aspiring owner of a “racino” (a combination horse track and casino establishment), to Merit Management in exchange for Merit’s shares in Bedford  Downs, a racino industry competitor.  The transfer was effected through Citizens Bank, acting as escrow agent, and Credit Suisse, serving as lender.

The parties do not dispute that neither Valley View nor Merit Management is a financial institution or other qualified entity enumerated in section 546(e). Instead, Merit takes the position that the transfer sought to be avoided by the trustee (i.e., the transfer by Valley View to Merit) is protected by the safe harbor because it involved three transfers “made by or to” institutions qualifying for section 564(e) protection:  a transfer by Credit Suisse (the lender) to Citizens Bank (the escrow agent) and two transfers by Citizens Bank to Merit.[3]  On the other hand, the trustee takes the position that section 564(e) is an exception to the trustee’s avoidance power and, as such, the “transfer” that the trustee “may not avoid” under section 546(e) is the same transfer that the trustee seeks to avoid under the antecedent and textually cross-referenced avoidance powers.[4]  The trustee does not seek to avoid any of the component parts of the transfer by Valley View to Merit (i.e., any of the transfers Merit identifies as “made by or to” institutions qualifying for section 564(e) protection)—nor could it have, because the trustee’s avoidance power is limited to transfers by the debtor.[5]  Thus, according to the trustee, the safe harbor of section 564(e) does not protect the transfer by Valley View to Merit from avoidance.

Bankruptcy practitioners and scholars are watching this case with great interest.  The National Association of Bankruptcy Trustees filed a Brief as Amici Curiae in Support of Respondents in which it warns that Merit’s application of section 564(e) would prevent a trustee from attempting to unwind a failed leveraged buyout—even a purely private one, as most are—despite the unique hazard to unsecured creditors that these transactions pose.[6]  Several prominent bankruptcy law professors also filed a separate Amici Curiae Brief in Support of Respondents.  These law professors agree with the Seventh Circuit that the Bankruptcy Code’s system for avoiding transfers and safe harbor from avoidance are two sides of the same coin—the safe harbor applies to transfers that are eligible for avoidance in the first place.[7]  They view the contrary decisions of many Circuits as mistaken applications of the safe harbor to protect transactions that pose no threat to the integrity of the security settlement and clearance process—the purpose for which the safe harbor was enacted.[8]

The Court’s decision in this case may also materially affect former shareholders and unsecured creditors of the Tribune Company and the Lyondell Chemical Company, both of which went into bankruptcy following failed leveraged buyouts. The former shareholders currently are defendants in constructive fraudulent transfer actions seeking to avoid and recover settlement payments for their shares, effected through national securities clearance and settlement systems.  The Second Circuit Tribune decision holding that section 564(e) bars the avoidance and recovery of these payments is inconsistent with the Seventh Circuit’s decision, and a petition for certiorari review of the Second Circuit decision is pending.  The Tribune and Lyondell former shareholders submitted an Amici Curiae brief in support of Petitioners,[9] and the Tribune unsecured creditors submitted a brief in support of Respondent.[10]

Visit HHR’s Bankruptcy Report for future updates on this case.

*Jiun-Wen Bob Teoh assisted with the preparation of this post.

[1]       FTI Consulting Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).

[2]       11 U.S.C. § 546(e).

[3]       Brief for Petitioner at 2, Merit Management Group v. FTI Consulting, No. 16-784 (July 13, 2017).

[4]       Brief for Respondent at 2, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 11, 2017).

[5]       Id.

[6]       Brief of National Association of Bankruptcy Trustees as Amici Curiae Supporting  Respondent, at 3, 13-18, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

[7]       Brief of Bankruptcy Law Professors Ralph Brubaker, et al. as Amici Curiae Supporting Respondent, at 4, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

[8]       Id. at 1-2.

[9]       Brief of Various Former Tribune and Lyondell Shareholders as Amici Curiae Supporting Petitioners, Merit Management Group v. FTI Consulting, No. 16-784 (July 20, 2017).

[10]     Brief of Tribune Company Retirees and Noteholders as Amici Curiae Supporting Respondent, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).

Bankruptcy Court Exercises Jurisdiction Over Foreign Defendant Based on Consent to Jurisdiction Clauses in Loan Agreement and DIP Order.

Posted in Chapter 11, Debtor-in-Possession Financing

The United States Bankruptcy Court for the Southern District of New York recently held that it had personal jurisdiction over a foreign defendant that was paid funds pursuant to the Court’s order approving the debtors’ post-petition financing (the “DIP order”), denying defendant Immigon’s[1] motion to dismiss an adversary proceeding commenced by the Motors Liquidation Company Avoidance Action Trust seeking to clawback the funds.[2]

In 2006, General Motors entered into a $1.5 billion Term Loan Agreement under which JP Morgan Chase Bank, N.A. and several other large financial institutions committed to provide funding and had the right to sell interests in the loan in the secondary market. In 2008, in connection with terminating a completely separate transaction, JP Morgan mistakenly authorized the termination of the security interest in the General Motors’ assets securing the loan.

Under the debtors’ DIP order, the Court authorized the debtors’ to pay in full all of General Motors’ obligations under the Term Loan Agreement, subject to the Official Committee of Unsecured Creditors’ right to investigate and challenge the perfection of the liens securing the loan. Following entry of the order, GM paid approximately $1.4 billion to its lenders under the Term Loan Agreement, including approximately $9.8 million to defendant Immigon on account of its $10 million interest in the loan purchased on the secondary market from JP Morgan.

In denying Immigon’s motion to dismiss, including on the grounds that the Court lacked personal jurisdiction over Immigon, the Court found that under the Term Loan Agreement, Immigon had expressly consented to personal jurisdiction in New York and waived the right to object to any New York State or Federal Court as the forum for any disputes arising out of the Agreement. Moreover, the Court found that the consent to jurisdiction and forum selections clauses should be enforced because Immigon “enjoyed the benefits and protection of New York law” in connection with the Agreement.

As a separate basis for exercising jurisdiction, the Court also held that Immigon consented to jurisdiction under the DIP order, which provided that any party receiving funds under the order consented to the jurisdiction of the Bankruptcy Court. Relying on evidence showing that an employee of Immigon had actually received and viewed the DIP order before receiving payment, the Court found that Immigon had knowingly consented to the jurisdiction provision in the DIP order by accepting payment of the funds.

As a third distinct basis for exercising jurisdiction over Immigon, the Court held that even if Immigon had not consented to the Court’s jurisdiction, sufficient minimum contacts existed between the litigation, New York and Immigon for the Court to exercise specific personal jurisdiction over Immigon. Specifically, the Court noted that “the lending relationship under the Term Loan Agreement was centered in New York, governed by New York law, and allowed all of the parties, including [Immigon], to enjoy the benefits of the U.S. banking system and New York’s status as a financial capital.”  Immigon selected Bank of New York Mellon for its correspondent bank account and JP Morgan made the disputed payment to Immigon’s New York bank account.  The Court found these contacts, among others, sufficient to show that Immigon had purposefully availed itself of the privilege of doing business in New York.

Finally, the Court found that subjecting Immigon to personal jurisdiction on any of these three grounds would not offend due process because the Court has a strong interest in adjudicating claims that arise under the Bankruptcy Code and the Trust has a strong interest in obtaining convenient and effective relief in the Bankruptcy Court. Moreover, the Court found that Immigon’s burden in having to litigate in New York is mitigated by the convenience of modern communication and transportation.

Practical Implications

The outcome of this case suggests the need for parties to carefully review proposed Bankruptcy Court orders affecting their rights. Here, in finding that Immigon had knowingly consented to the Bankruptcy Court’s jurisdiction in the DIP order, the Bankruptcy Court relied on evidence showing that an employee of Immigon had received and viewed the DIP order, despite the fact that the consent to jurisdiction provision was on page 26 of the 30-page order.  The case also suggests the need for caution by parties purchasing interests in transactions governed by agreements with consent to jurisdiction clauses.

[1].      Immigon, or Immigon Portfolioabbau AG, is a wind-down company operating under Austrian law, and is the successor in interest to OEVAG, or Osterreichische Volksbanken Aktiengesellschaft, which was the central institute of the Austrian co-operative of banks named Volksbanken.

[2].      Motors Liquidation Co. Avoidance Action Trust v. J.P. Morgan Chase Bank, N.A. (In re Motors Liquidation Co.), (Bankr. S.D.N.Y. 2017).

Bankruptcy Court Limits Rule 2004 Requests

Posted in Rule 2004

The Southern District of New York Bankruptcy Court recently limited certain bankruptcy discovery requests pursuant to Federal Rule of Bankruptcy Procedure 2004 by applying the concept of proportionality contained in the 2015 amendments to Federal Rule of Civil Procedure 26 . In re SunEdison, Inc., Case No. 16-10992 (SMB), ECF No. 2280 (Jan. 18, 2017).  The court’s decision curtails the ability of non-debtors to conduct so-called “fishing expeditions,” which have become increasingly costly with the spread of requests for electronically stored information (often referred to as “ESI”).  The court’s decision will be of particular interest to debtors’ counsel and assist in their efforts to stave off disruptive, costly and distracting Rule 2004 requests.

In re SunEdision arises from the application of CSI Leasing, Inc. and CSI Leasing Malaysia Sdn. Bhd. (collectively, “CSI”) to conduct a Rule 2004 examination of the debtors.  CSI was a creditor of both the debtor-subsidiary SunEdison Products Singapore Pte. Ltd. (“SEPS”) and the non-debtor subsidiary SunEdison Kuching Sdn. Bhd. (“SEK”) in connection with a failed equipment lease, entered into by SEK and guaranteed by SEPS.  As a result of SEK’s default on the lease and SEPS’s default on the guarantee, CSI had a claim against each for approximately $2.5 million.  Notwithstanding the $2.5 million owed to CSI, when SEK received approximately $45 million for the sale of substantially all of its assets in March 2016, SEK transferred the money to the debtors, namely SunEdison, Inc. (“SUNE”), which is the ultimate parent company of both SEK and SEPS.

As part of its overall efforts to collect on its guarantee, CSI filed an application seeking Rule 2004 discovery in the chapter 11 proceedings. CSI requested, among other things, “all documents and communications” generally related to: (i) the transfer of the asset sale proceeds to the debtors; (ii) the debtors’ chapter 11 cases; and (iii) SEK, the Malaysian proceeding, and CSI’s recovery in that proceeding.  After initially providing over 1,200 pages of responsive information on a rolling basis, the debtors subsequently objected to CSI’s application and argued that discovery was unnecessary as to CSI’s chapter 11 claims, which had been allowed.  Beyond that, the debtors characterized CSI’s application as “premature, overly broad, speculative and unduly burdensome”.[1]

The court began by outlining the law governing Rule 2004 applications, noting that generally a party seeking Rule 2004 examination must demonstrate “good cause” for the examination. “Good cause,” in turn, is typically demonstrated by showing that the “proposed examination ‘is necessary to establish the claim of the party seeking the examination, or … denial of such request would cause the examiner undue hardship or injustice.’”[2]

However, the court noted that Rule 2004 examinations require a balance between the needs of the examiner and the burden imposed on the examinee.[3]  This balance is especially necessary when juxtaposed with the immense costs of modern discovery on the producing party.  If left unchecked, the court was concerned that a “fishing expedition” could impose astronomical discovery costs on the party being examined.

In weighing this balance between the examiner’s need for discovery and the burden imposed on the examinee, the court found a solution in the Federal Rules of Civil Procedure’s proportionality requirements under Rule 26.[4]  Despite the absence of a comparable amendment to Rule 2004, the court drew a parallel between the aims of Rule 2004 and Rule 26.[5]  The court used this parallel to support the holding that an when the applicant is seeking the examination in one proceeding for claims in another proceeding, as in this case, there was no good cause for such examination.[6]

The court’s opinion imposes an additional limitation on Rule 2004 examinations, which has often been recognized as allowing wider discovery than that available under the Federal Rules of Civil Procedure. Under Rule 2004, the subject matter open to discovery is broader, there are fewer procedural safeguards, and discovery can generally be wielded against any related entity.  Bankruptcy courts have imposed few restraints on this rule, most of which prevent parties from taking advantage of such open-ended discovery when there is an on-going civil action between the same parties.  However, by borrowing a constraint on Rule 2004 from the Federal Rules of Civil Procedure, the court has checked what is often a burdensome discovery mechanism.

[1]       Opinion at 7.

[2]       Opinion at 9.

[3]       Opinion at 9-10.

[4]       Opinion at 10-11

[5]       Opinion at 11.

[6]       Opinion at 12.

First Circuit Provides Clarity to Puerto Rico Creditors Seeking Relief

Posted in First Circuit, PROMESA, Puerto Rico

The First Circuit’s recent opinion on the Puerto Rico Oversight, Management, and Economic Stability Act (“PROMESA”, 48 U.S.C §§ 2101-2241) outlines initial guidelines for possible future actions against the Puerto Rican government as a result of the Commonwealth’s ongoing debt crisis. Peaje Investments LLC v. García–Padilla, 845 F.3d 505 (1st Cir. 2017).  Congress enacted PROMESA in June 2016 to create, among other things, a temporary stay of debt-related litigation against the government of Puerto Rico.  The temporary stay was set to expire automatically on February 17, 2017, but has been extended until May 1, 2017.  The First Circuit permitted one creditor to move immediately for relief from the stay, but blocked another creditor’s bid.  The decision serves as a template for how creditors may move against the Commonwealth when the PROMESA stay expires later this spring.

In Peaje Investments LLC v. Garcia-Padilla, the First Circuit considered the appeal of two creditors whose motions for relief from PROMESA’s stay had been denied by the District Court of Puerto Rico without a hearing.  The denied creditor, Peaje Investments LLC (“Peaje”), argued that the stay should be lifted so it could challenge the government’s diversion of toll revenues.  The successful creditors, the Altair movants, similarly sought relief based on their interest in certain employee contributions diverted by the Commonwealth.  The First Circuit applied the Bankruptcy Code’s “lack of adequate protection” standard to determine cause for lifting the stay.

In Peaje’s case, the creditor alleged that a bond resolution required the government to deposit toll revenues with a fiscal agent to serve as collateral for bonds issued by the Puerto Rico Highways and Transportation Authority. The First Circuit affirmed the District Court’s denial of Peaje’s motion because “toll revenues are ‘constantly replenished,’” allowing Peaje’s security interest to continue as a “stable, recurring source of income that will eventually provide funds for the repayment” of the bonds.[1]

The Altair movants similarly alleged that the Commonwealth had suspended transfers of employee retirement contributions, which served as collateral for their bonds, to the required fiscal agent. The Altair movants, crucially, included in their filings a statement by the Commonwealth’s Employees Retirement System that “uncertainty about future employee contributions could affect” repayment of the bonds held by the Altair movants.  The District Court characterized these contributions as “a perpetual revenue stream whose value is not decreased by the Commonwealth’s acts,” much like Peaje’s collateral, but the First Circuit reversed course.  It found that the Altair movants deserved a hearing to demonstrate the “alleged uncertainty” of the Commonwealth’s ability to repay the bonds.[2]

The stay will expire in May, at which point an influx of actions against the government of Puerto Rico relating to the debt crisis is expected. The First Circuit’s decision is limited in scope due to the PROMESA stay’s anticipated expiration, but creditors pursuing litigation against the government after the stay is lifted may choose to heed the opinion’s underlying guidance:  do not hold back in initial pleadings.

[1]       Peaje Investments LLC v. García–Padilla, 845 F.3d 505, 511 (1st Cir. 2017)

[2]       Id.

Bankruptcy Court Decision Illustrates Limits of Section 510(b) Subordination of Claims

Posted in Claims Subordination, Section 510(b)

A recent decision in the Bankruptcy Court for the District of Delaware explored the limits of mandatory subordination under section 510(b) of the Bankruptcy Code. In In re FAH Liquidating Corp., No. 13-13087(KG), 2017 WL 95115 (Bankr. D. Del. Jan. 10, 2017), Judge Kevin Gross ruled that membership units in special purpose vehicles that held securities of a debtor were outside the scope of section 510(b) because they were neither “securit[ies] of the debtor” nor securities of “an affiliate of the debtor.”  Because the claimants invested in special purpose vehicles that were insulated from the debtor, their securities law claims against the debtor were indirect and therefore not subject to mandatory subordination.

Prior to the Petition Date, the debtor’s predecessor, Fisker Automotive Holdings, Inc. (“Fisker”), issued preferred stock. Fisker engaged Advanced Equities, Inc. (“AEI”) to aid in raising private capital.  As memorialized in a Placement Agreement, AEI would receive, among other things, warrants that it could transfer to other broker-dealers that it designated as sub-agents.  One such sub-agent, Middlebury Securities LLC (“Middlebury Securities”), entered into a Sub-Placement Agreement with AEI.  Middlebury Securities solicited qualified investors for purchase of Membership Units in one or more[1] Special Purpose Vehicles, affiliated with Middlebury Securities, that themselves purchased or held Fisker’s preferred shares.  Notably, however, there was no direct contractual relationship between Fisker and Middlebury Securities; rather, each contracted separately with AEI.

Two sets of plaintiffs commenced securities lawsuits against controlling shareholders and current and former officers and directors of Fisker, and filed proofs of claim on account of securities law claims against Fisker. One set of plaintiffs had purchased Fisker’s preferred stock (the “Direct Purchasers”), while the other plaintiffs had purchased membership units in one or more of the Special Purpose Vehicles (the “Membership Unit Purchasers”).

The parties and the Bankruptcy Court agreed that the Direct Purchasers’ claims against Fisker were subject to mandatory subordination under section 510(b) of the Bankruptcy Code, which subordinates any “claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim.”[2]

The parties also agreed that the Membership Units were “securities” and that the plaintiffs’ claims arose from the purchase or sale of securities. However, the parties disputed the application of section 510(b) to the claims of the Membership Unit Purchasers.

Although the Membership Units did not represent direct interests in Fisker, the Liquidating Trustee argued that purchases of Fisker securities were “part of the causal link leading to” the alleged injuries, and thus the Membership Unit Purchasers’ claims arose from the purchase or sale of a debtor’s securities.  The Liquidating Trustee further argued that there was a “complete identity of economic interest” between the Membership Units and Fisker’s securities.

In the alternative, the Liquidating Trustee argued that the Membership Unit Purchasers’ claims arose from the purchase or sale of securities of “an affiliate of the debtor” because Middlebury Securities acted as an intermediary between Fisker and investors for purposes of raising capital for Fisker. In the Liquidating Trustee’s view, the Special Purpose Vehicles were “affiliates” of Fisker because they were operated under the Placement Agreement between Fisker and AEI, pursuant to which AEI designated Middlebury Securities as its sub-agent.

The Bankruptcy Court first rejected the Liquidating Trustee’s argument that the Membership Units were securities “of the debtor.” The Bankruptcy Court noted that the Membership Units were distanced and insulated from Fisker due to the Special Purpose Vehicles: the Special Purpose Vehicles were not debtors, the Membership Units were not part of Fisker’s capital structure, and the Membership Unit Purchasers did not have actual ownership interests in Fisker.

The Bankruptcy Court next addressed the Liquidating Trustee’s contention that the Membership Units were the securities of Fisker’s affiliates. Section 101(2) of the Bankruptcy Code defines an “affiliate” as, among other things, a “person whose business is operated under a lease or operating agreement by a debtor, or [a] person substantially all of whose property is operated under an operating agreement with the debtor.”[3]  Focusing on that definition, the Bankruptcy Court emphasized that there was no contract between Fisker and Middlebury Securities.  The Placement Agreement was between Fisker and AEI; AEI separately contracted with Middlebury Securities as sub-agent to sell Membership Units.  The Special Purpose Vehicles thus fell outside the scope of section 101(2)(C): they were not “operat[ing] under an operating agreement with the debtor” (emphasis added).

The Bankruptcy Court further noted that the Fifth Circuit has applied a more expansive view of section 101(2)(C) where a debtor is “in full control” of another entity. However, the Bankruptcy Court found that the Debtors did not exert sufficient control to make the Special Purpose Vehicle entities mere “shell conduit[s] between [the] debtor and [the] entity.”  AEI acted as an independent contractor, and it used its own authority to contract with Middlebury Securities.  In fact, Fisker’s agreement with AEI even prohibited Fisker from communicating directly with sub-agents (like Middlebury Securities) without AEI’s authority.

The Bankruptcy Court’s decision shows that even the broad terms of section 510(b) have limits. Where a special purpose entity is sufficiently insulated from the debtor whose securities it holds, an investor in the special purpose entity may be able to maintain unsubordinated claims against the debtor (or the debtors’ directors and officers).  Purchasers of securities should be aware that claims against debtors on account of purchases of membership interests in unaffiliated special purpose vehicles may potentially be due a higher priority than claims on account of direct purchases of the debtor’s securities.  For their part, debtors and trustees should be aware that they may not be able to rely on section 510(b) in defending against such claims.

[1].      The decision notes that only one Special Purpose Entity— Middlebury Ventures II— was identified by name on the record, although the term was used in the plural by the Plaintiffs. Id. at *5-6.  Thus, it was “unclear from the record whether [Middlebury Ventures II] is the only Special Purpose Vehicle that issued the Membership Units.” Id. at *7.

[2].      11 U.S.C. § 510(b).

[3].      11 U.S.C. § 101(2)(C).

The Gate Swings Shut: Second Circuit Ruling Narrows Restructuring Limitations.

Posted in Chapter 11, Second Circuit, Trust Indenture Act

After a 2014 decision in the Southern District of New York holding that section 316(b) of the Trust Indenture Act (“TIA”) barred any non-consensual restructuring that impaired a creditor’s actual ability to receive payment, issuers, creditors and the financial markets more generally have been uncertain as to the contours of permissible out-of-court restructurings.[1]   The recent decision by the Second Circuit Court of Appeals in Marblegate Asset Management, LLC v. Education Management Finance Corp., 2017 WL 164318 (2d. Cir 2017) reversed the 2014 ruling and held that section 316(b) only bars restructurings that that impact a creditor’s core payment right, which is different from the practical ability to demand payment.  The Second Circuit’s Marblegate ruling will help resolve the disquiet among practitioners and issuers and restore expectations as to the ability of companies to conduct out-of-court restructurings without being hamstrung by non-consenting creditors.

Background of the Marblegate Rulings:

The Second Circuit’s decision arose from the restructuring of the debt of Education Management Corporation (“EDMC”).  EDMC is a for-profit higher education company that had: (i) $1.3 billion in secured obligations that were collateralized by virtually all of EDMC’s assets, and (ii) $217 million of unsecured notes (the “Notes”) that were issued by a subsidiary of EDMC and governed by an indenture qualified under the TIA (the “Indenture”).  The Notes were guaranteed by EDMC, but the guarantee was basically worthless as it had been issued solely to satisfy EDMC’s reporting obligations and would be automatically released if any secured creditor provided a release of any separate guarantee of EDMC (a fact that was clearly disclosed to potential Noteholders in the offering circular for the Notes).

Cash-strapped EDMC entered into negotiations with its secured creditors that resulted in a restructuring proposal.[2]  Under the proposed restructuring, the secured lenders would exercise their rights under their credit agreement and Article 9 of the Uniform Commercial Code to foreclose on all of EDMC’s assets and release EDMC from their guarantee (thereby automatically releasing EDMC from the Note guarantee).  The secured lenders’ collateral agent would then transfer all of the foreclosed assets to a newly created subsidiary of EDMC that would then issue new secured debt and stock to the secured lenders and any unsecured lenders that consented to the restructuring.  Importantly, the restructuring did not change the actual payment terms of the Indenture or limit the Noteholders’ ability to sue the EDMC subsidiaries that issued the Notes to collect the payment due on the Notes (albeit a futile exercise, because the EMDC subsidiaries would have no assets after the restructuring).

All of EMDC’s creditors, representing 98 percent of the company’s debt, consented to the proposed restructuring. The sole holdout creditor was Marblegate Special Opportunity Master Fund (“Marblegate”), which sued to enjoin the restructuring on the grounds that it violated the TIA.

The District Court Decision

Noting that the TIA itself was ambiguous, the District Court agreed with Marblegate and held that the proposed restructuring violated Section 316(b) of the TIA,[3] which prohibits any restructuring that “impair[s] or affect[s]” the “right” of any security holder to receive payment due under a note.[4]  After reviewing the text and legislative history of Section 316(b), the District Court concluded that the TIA “protects the ability” of the Note holders “to receive payment in some circumstances.”[5] Even though the Indenture payment terms remained the same, the District Court held, Section 316(b) is violated whenever a transaction “effect[s] an involuntary debt restructuring.”

EDMC appealed and argued that the prohibition contained in section 316(b) of the TIA applies only to non-consensual amendments to an Indenture’s core payment terms (here the ability of Marblegate to commence suit to demand payment from the EDMC issuers).

The Second Circuit’s Ruling

The issue before the Second Circuit therefore was whether section 316(b)’s prohibition on any restructuring that “impair[s]” or “affect[s]” a “right . . . to receive payment” contained in Section 316(b) of the TIA should be read narrowly to bar only non-consensual amendments to an indenture’s core payment terms, or whether it should be read broadly to prohibit any restructuring that affects the ability of a noteholder to receive payment. After a review of the parties’ competing readings of the statute, the Second Circuit agreed that the text of Section 316(b) was ambiguous on this issue.[6]  The court noted that the use of “‘right’ to describe what it sought to protect from non-consensual amendment suggests a concern with the legally enforceable obligation to pay that is contained in the Indenture, not with a creditor’s practical ability to collect on payments.”[7] However, the Court also noted that the section of 316(b) stated that such a right “cannot be ‘impaired or affected,’” and Congress’ inclusion of these terms implied that a creditor’s payment right could not validly be reduced or “otherwise affect[ed] in an injurious manner.”[8]

To resolve these competing interpretations, the Second Circuit analyzed the legislative history of the TIA and ultimately concluded that Congress intended a limited application of the prohibition contained in Section 316(b).[9]  Based on its review, the court determined that Congress was well aware of “possible forms of reorganization available to issuers, up to and including foreclosures like the one that occurred in this case” and noted that “foreclosure-based reorganizations were widely used at the time the TIA was drafted.”[10] This fact, combined with the expert testimony submitted to Congress at the time of the TIA’s drafting on the limited purposes of the TIA, demonstrated that Congress intended section 316(b) of the TIA to be applied narrowly to bar revisions to the core payment terms of an indenture but did not intend to prohibit the type of foreclosure-based restructuring employed by EDMC.

In addition, the court noted that the broad reading of section 316(b) put forth by Marblegate and endorsed by the District Court raised a number of practical problems, as it would require courts in every case to divine “whether a challenged transaction constitutes an ‘out-of-court debt restructuring . . . designed to eliminate a non-consenting holder’s ability to receive payment.’”[11] The practical requirement of determining the subjective intent of the parties to the restructuring, as opposed to a review of the transaction itself, ran afoul of the Second Circuit’s “particular distaste for interpreting boilerplate indenture provisions based on the ‘relationship of particular borrowers and lenders’ or the ‘particularized intentions of the parties to an indenture,’ both of which undermine ‘uniformity in interpretation.’”[12]

Conclusion

The Second Circuit’s ruling provides a framework by which companies can achieve out-of-court restructurings even though they might deprive dissenting creditors of the value of their notes. The fact that core payment terms remain unchanged, though, may encourage companies to take a more aggressive stance with creditors. Nevertheless, creditors are not without remedies, as the preservation of core payment terms allows dissenting creditors to pursue judicial remedies. The ability of dissenting creditors to pursue successor liability or fraudulent conveyance claims may operate as a check against restructurings that are not conducted at arms’ length or with improper intentions to deprive certain credit groups of payment.

 

[1]       See Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 75 F.Supp.3d 592, 612-615 (S.D.N.Y. 2014); see also BOKF, N.A. v. Caesars Entm’t Corp., 144 F. Supp. 3d 459, 466-67 (S.D.N.Y. 2015); Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Corp., 111 F. Supp.3d 542 (S.D.N.Y. 2015).

[2]       EDMC was unable to commence a bankruptcy proceeding because such a filing would cause it to lose its eligibility for Tile IV funds pursuant to 20 U.S.C. § 1002(a)(4)(A).

[3]       15 U.S.C. § 77ppp(b).

[4]       Section 316(b) of the TIA, entitled “Prohibition of impairment of holder’s right to payment,” provides:

Notwithstanding any other provision of the indenture to be qualified, the right of any holder of any indenture security to receive payment of the principal of and interest on such indenture security, on or after the respective due dates expressed in such indenture security, or to institute suit for the enforcement of any such payment on or after such respective dates, shall not be impaired or affected without the consent of such holder, except as to a postponement of an interest payment consented to as provided in paragraph (2) of subsection (a) of this section, and except that such indenture may contain provisions limiting or denying the right of any such holder to institute any such suit, if and to the extent that the institution or prosecution thereof or the entry of judgment therein would, under applicable law, result in the surrender, impairment, waiver, or loss of the lien of such indenture upon any property subject to such lien.

[5]       Marblegate Asset Mgmt. v. Educ. Mgmt. Corp., 75 F.Supp.3d 592, 612-615 (S.D.N.Y. 2014).

[6]       Judge Straub dissented on this basis and believed that the text of the TIA was clear and unambiguous and supported the District Court’s ruling. Judge Straub noted that if Congress had “intended merely to protect against modification of an indenture’s payment terms, it could have so stated” and that “nothing in the text of the statute requires the narrow reading that Section 316(b) merely prohibits modification of an indenture’s core payment terms (amount and due date) by noteholder majority action without consent of the individual noteholder.” He recognized the practical difficulties and uncertainty that his interpretation of the TIA would cause, but noted that such concerns were insufficient to override what he reasoned was the correct reading of the statute.

[7]       Marblegate Asset Management, LLC v. Education Management Finance Corp., 2017 WL 164318 at *4 (2d. Cir 2017).

[8]       Id.

[9]       Starting in 1936, the Securities and Exchange Commission (SEC) published a comprehensive eight-part report examining the role of protective committees in reorganizations.5 Part VI of that report, published in 1936 and entitled “Trustees Under Indentures” (the “1936 SEC Report”), led to enactment of the TIA. Additionally, the Court reviewed subsequent congressional reports, testimony, and other statements by SEC officials in reaching its decision.

[10]     Marblegate Asset Management, LLC v. Education Management Finance Corp., 2017 WL 164318 at *7 (2d. Cir 2017).

[11]     Id. at *12.

[12]     Id. at *12 (citing to Sharon Steel corp. v. Chase Manhattan Bank. N.A., 691 F.2d 1039, 1048 (2d Cir. 1982)).