On October 11, 2016, the United States Supreme Court granted certiorari to a debt collection agency in its appeal from the Eleventh Circuit case Johnson v. Midland Funding, LLC.[1] In Johnson, the Eleventh Circuit affirmed its decision in Crawford v. LVNV Funding, LLC,[2] which held that a debt collector violates the Fair Debt Collection Practices Act (the “FDCPA”) when it files a proof of claim in a bankruptcy case on a debt that it knows to be time-barred. In view of the emerging circuit split, the Supreme Court agreed to hear the case in order to resolve two issues: (1) whether the filing of a time-barred proof of claim in a bankruptcy proceeding exposes a debt-collection creditor to liability under the FDCPA and (2) whether the Bankruptcy Code, which governs and permits the filing of proofs of claim in bankruptcy, precludes a cause of action under the FDCPA for the filing of a time-barred proof of claim in a bankruptcy proceeding.

In Johnson, which originated in the District Court for the Southern District of Alabama, plaintiff Aleida Johnson (“Johnson”) filed a Chapter 13 bankruptcy petition in March 2014. In May 2014, a debt collection agency—Midland Funding, LLC (“Midland”)—filed a proof of claim in Johnson’s bankruptcy proceeding for an amount of $1,879.71.[3] This debt accrued over ten years before Johnson filed for bankruptcy and its collection was time-barred by Alabama’s statute of limitations, which permits a creditor only six years to collect an overdue debt.[4] Johnson brought suit against Midland’s filing of the proof of claim under the FDCPA, which provides that “[a] debt collector may not use any false, deceptive, or misleading representation or means in connection with the collection of any debt.”[5] This prohibition encompasses an attempt to collect a debt that is not permitted by law.[6] Johnson argued that pursuant to the language of the statute, Midland’s time-barred proof of claim was “unfair, unconscionable, deceptive, and misleading in violation of the FDCPA.”[7]

Midland promptly moved to dismiss Johnson’s FDCPA suit. The District Court granted the motion to dismiss, finding that the Bankruptcy Code’s affirmative authorization for creditors to file a proof of claim—regardless of whether it is time-barred—was in direct conflict with the FDCPA’s prohibition on debt collectors filing a time-barred claim. Under the doctrine of implied repeal, the District Court found that the later-enacted Bankruptcy Code effectively repealed the conflicting provision under the FDCPA and precluded debtors from challenging that practice as a violation of the FDCPA in a bankruptcy proceeding.[8]

The Eleventh Circuit reversed the District Court’s decision, holding that “[t]he Bankruptcy Code does not preclude an FDCPA claim in the context of a Chapter 13 Bankruptcy when a debt collector files a proof of claim it knows to be time-barred. . . . [W]hen a particular type of creditor—a designated ‘debt collector’ under the FDCPA—files a knowingly time-barred proof of claim in a debtor’s Chapter 13 bankruptcy, that debt collector will be vulnerable to a claim under the FDCPA.”[9] Under the Eleventh Circuit’s analysis, the allegedly conflicting provisions of the Bankruptcy Code and the FDCPA could co-exist harmoniously, and the presence of a “positive repugnancy” between the statutes necessitating application of the un-favored doctrine of implied repeal was lacking.[10] Thus, although the Bankruptcy Code guarantees a creditor’s right to file a proof of claim they know to be time-barred by the statute of limitations, those creditors do not thereby gain immunity from the consequences of filing those claims.[11] The Court rejected Midland’s assertion that such an interpretation would effectively force a debt collector to “surrender[] its right to file a proof of claim.”[12] The court likened this scenario to filing a frivolous lawsuit, stating that “[i]f a debt collector chooses to file a time-barred claim, he is simply opening himself up to a potential lawsuit for an FDCPA violation. This result is comparable to a party choosing to file a frivolous lawsuit. There is nothing to stop the filing, but afterwards the filer may face sanctions.”[13] Accordingly, the Eleventh Circuit found that the FDCPA lays over the top of the Bankruptcy Code’s regime, so as to provide an additional layer of protection to debtors against a particular kind of creditor—debt collectors.[14]

The Court in Johnson makes clear that its holding is limited in scope and should not have far-reaching consequences for most creditors. Most importantly, the Court acknowledges that the FDCPA’s prohibitions do not reach all creditors—the statute only applies to “debt collectors,” which are a narrow subset of the universe of creditors that might file proofs of claim in a bankruptcy proceeding.[15]  Furthermore, the FDCPA provides a safe harbor for debt collectors who unintentionally or in good-faith file a time-barred proof of claim.[16] Thus, a debt collector who files a time-barred proof of claim may escape liability by showing that the violation was not intentional and resulted from a bona-fide error.[17] These two limitations ensure that regardless of how the Supreme Court resolves this circuit split, there will not be a chilling effect on the submission of proofs of claims by the vast majority of creditors.

Although the direct impact of the Johnson ruling may be restricted to a limited creditor base, recent Supreme Court rulings involving bankruptcy cases have had broader knock-on effects on bankruptcy jurisprudence (and jurisdiction), and a decision on preemption as it relates to the Bankruptcy Code has the potential for a significant impact on various aspects of procedural and substantive bankruptcy law outside of the limited issue of the interplay of the FDCPA and the Bankruptcy Code. Accordingly, visit HHR’s Bankruptcy Report for future updates on this case and its potentially broader impact.

[1].      Johnson v. Midland Funding, LLC , 823 F.3d 1334 (11th Cir. 2016).

[2].      Crawford v. LVNV Funding, LLC, 757 F.3d 1254, 1261 (11th Cir. 2014).

[3].      Johnson, 823 F.3d  at 1336.

[4].      Id.

[5].      15 U.S.C. § 1692e (2012).

[6].      15 U.S.C. § 1692f(1) (2012).

[7].      Johnson, 823 F.3d at 1337 (internal quotation marks omitted).

[8].      Id.

[9].      Id. at 1338.

[10].    Id. at 1340.

[11].    Id. at 1338.

[12].    Id. at 1341 (alteration in original).

[13].    Id.

[14].    Id.

[15].    Id. at 1339.

[16].    Id.

[17].    Id.

Bank of New York Mellon lost priority status for its claim of $312 million in the liquidation of Sentinel Management Group when the 7th Circuit held that it should have suspected Sentinel was misusing customer assets and conducted an investigation into the source of the collateral Sentinel had posted.  The 7th Circuit clarified the doctrine of “inquiry notice” in a bankruptcy proceeding in its decision, and the holding requires firms to be reasonably diligent in investigating any suspicions they have relating to their customers or risk the loss of their security interest in pledged collateral.

Sentinel, a trading firm, had (in violation of federal law) pledged its customers’ securities to Bank of New York Mellon and Bank of New York (“BNYM”) as collateral for $312 million of loans to support Sentinel’s proprietary trading.  Following the bankruptcy, BNYM asserted a senior secured claim against Sentinel based on these pre-petition loans. The bankruptcy trustee, Fredrick J. Grede asserted that the transfer of customer securities to the firm’s clearing account constituted a fraudulent transfer, and that BNYM had not accepted the securities “in good faith” because it was on ‘inquiry notice’ – it was aware of suspicious facts that should have prompted an investigation that would have uncovered Sentinel’s use of its customer’s assets.  The District Court originally ruled that no fraudulent transfer had occurred, and the 7th Circuit reversed that decision on appeal and ruled that Sentinel had made fraudulent transfers, and remanded for determination of if BNYM had been on inquiry notice. After the District Court held that BNYM had not been on inquiry notice, Sentinel’s trustee appealed again to the 7th Circuit.

At stake in a finding that BNYM had not received the securities “in good faith” was the priority of BNYM’s $312 million claim.  If BNYM had received the securities in good faith it was entitled to senior secured status and a full recovery, while if it had not received the securities in good faith it was entitled only to an unsecured claim.

The 7th Circuit held that a company or person is on inquiry notice if they have “knowledge that would lead a reasonable, law-abiding person to inquire further” or would make a reasonable person “suspicious enough to conduct a diligent search for possible dirt.”  It is not necessary that such search actually be done, and that the company did not know of fraud or other wrongdoing is not sufficient to avoid being on inquiry notice.

The 7th Circuit identified a specific email from a BNYM employee, asking how Sentinel was able to provide $300 million in collateral with less than $20 million in capital (and, as the 7th Circuit noted, the actual figure was closer to $2-3 million) as sufficient information for a reasonable person to have begun an investigation.  Furthermore, had BNYM conducted an investigation into how Sentinel was able to provide its collateral, it would have discovered Sentinel was pledging its customers assets based on documents already in the bank’s possession.  BNYM had never conducted such an investigation and had relied on Sentinel’s assurances, but the 7th Circuit held that given the apparent disconnect between Sentinel’s capital and Sentinel’s ability to supply collateral, a reasonable person would have investigated and discovered Sentinel was misrepresenting its rights in the collateral.

The Sentinel decision is a significant victory for the Sentinel trustee and offers significant support to future trustees of failed financial firms seeking to recover misused customer funds, and ultimately the customers whose funds or securities were misused.  To avoid similar results, companies must be diligent in investigating any suspicions with regard to collateral they have received.  Relying on assurances from the firm that all regulations have been followed will not be sufficient to protect a company if a court determines that more investigation was needed.

On June 1, 2015, the U.S. Supreme Court issued its decision in Bank of America v. Caulkett.[1] The Court’s unanimous opinion, which was written by Justice Thomas, established that junior mortgage lienholders maintain a “secured” claim against a bankrupt debtor even where the junior mortgage lien is completely underwater. Further, an underwater junior mortgage lien cannot be voided if the lien is an “allowed” claim within the meaning of the section 502(a) of the Bankruptcy Code.  In the wake of the foreclosure crisis, the decision constitutes a significant victory for the many banks that issued second mortgages on homes owned by individuals who filed for bankruptcy at a time when the amount owed on their first mortgage exceeded the actual value of their homes.

For background, in Bank of America v. Caulkett, the respondents, two individuals, each owned homes with junior liens held by Bank of America.[2] The amount each respondent owed on his primary mortgage was greater than the respective value of each home.[3] Accordingly, Bank of America’s junior lien was completely “underwater” in both instances.[4] Each respondent filed for bankruptcy and sought to void the junior lien held by Bank of America pursuant to Bankruptcy Code section 506(d), which voids liens that do not constitute “allowed secured claims” against a debtor.[5] The Bankruptcy Court permitted voiding of the liens.[6] Bank of America appealed, and both the District Court and the Eleventh Circuit affirmed the Bankruptcy Court’s ruling.[7] The Supreme Court then decided the case on certiorari.

Both parties agreed that Bank of America’s claim against the debtors was an “allowed” claim within the meaning of section 502. The major issue before the Court was whether Bank of America’s underwater junior lien constituted a “secured claim” within the meaning of section 506(d), thus preventing Bank of America’s claim from being voided.[8]

The respondents argued that the claim was unsecured, and therefore could be voided, relying on Bankruptcy Code section 506(a)(1) which states that “[a]n allowed claim of a creditor secured by a lien on property…is a secured claim to the extent of the value of the creditor’s interest…in such property” and “an unsecured claim to the extent that the value of such creditor’s interest…is less than the amount of such allowed claim.”[9] A plain reading of the text suggests that an underwater junior lien is unsecured and voidable.

Nevertheless, the Court relied on its previous decision in Dewsnup v. Timm[10] to find that an underwater junior lien is a secured claim. In Dewsnup, the Court held that if a claim “has been ‘allowed’ pursuant to § 502 of the Code and is secured by a lien with recourse to the underlying collateral, it does not come within the scope of 506(d).”[11] The Caulkett Court, therefore, found that under Dewnsup, a secured claim is “a claim supported by a security interest in property, regardless of whether the value of the property would be sufficient to cover the claim.”[12] Although the claim at issue in Dewsnup involved a partially underwater lien, the Caulkett Court held that the definition of “secured claim” includes claims involving liens that are wholly underwater—that is, where after taking into account the money owed on the first mortgage, the value of the junior lienholder’s interest in the property would be zero. The Court found no reason to limit its holding in Dewsnup to claims backed by collateral with some value, noting that imposing this proposed limitation could lead to “arbitrary results” in light of the “constantly shifting value of real property.”[13] Accordingly, the Court found that wholly underwater junior liens, such as those held by Bank of America were allowed secured claims that could not be voided under section 506(d).

Bank of America v. Caulkett’s implications for underwater junior lienholders is significant. By establishing that the issuer of a second mortgage can maintain a secured claim against a debtor that cannot be voided, Caulkett means that underwater junior lienholders may have a shot at recovery where they otherwise would not. However, the overall reach of Caulkett may be limited to the chapter 7 context. Lien allowance and avoidance in the chapter 11 context is determined by the application of other code sections including 111(b), 1123(b)(5) and the cram down provisions of the Bankruptcy Code. This, along with the fact that the Court did not discuss the broader application of its ruling, indicates that it is unlikely that Caulkett will have any impact on the treatment of underwater junior liens in the chapter 11 context.

[1] Bank of America v. Caulkett, 135 S.Ct. 1995 (2015).

[2] Id. at 1998.

[3] Id.

[4] Id.

[5] Id.

[6] Id.

[7] Id.

[8] Id.

[9] Id. at 1998-99.

[10] Dewsnup v. Timm, 112 S.Ct. 773 (1992).

[11] Id. at 777.

[12] Id. at 1999.

[13] Id. at 2000-01.

Companies struggling to address liquidity problems are often attracted to debt-for-debt exchanges because such exchanges accomplish many of the same purposes as refinancing without requiring upfront cash payments, except to cover transaction costs and professional fees.  By restructuring debt obligations, a financially distressed company may avoid default and escape bankruptcy.  Partaking in a debt exchange is advantageous for creditors because, among other things, the new debt is frequently more senior in a company’s capital structure than the existing debt.

To date, however, it has been unclear whether the unamortized interest – i.e. original issue discount (“OID”) – generated by these exchanges would be an allowable claim in bankruptcy.  A recent decision of the U.S. Bankruptcy Court for the Southern District of New York answered this question in the affirmative in Official Comm. of Unsecured Creditors v. UMB Bank, N.A. (In Re Residential Capital, LLC), 501 B.R. 549 (Bankr. S.D.N.Y. 2013), finding that original issue discount can serve as the basis of a valid claim.

Face Value Exchange v. Fair Market Value Exchange

There are two types of debt-for-debt exchanges: face value and fair market value.  In a face value exchange, a comparatively healthy organization with liquidity problems exchanges old debt for newly issued debt to obtain short-term relief while remaining fully accountable for the original amount of funds borrowed.  In a fair market value exchange, an issuer in severe financial distress seeks to reduce its overall debt obligations by exchanging an existing debt for a new debt with a reduced principal amount that is determined by the market value at which the old debt is trading.

The amount of interest creditors receive back when the debt in either exchange matures is OID.  OID is defined by the Internal Revenue Code (the “Tax Code”) as the “excess (if any) of the stated redemption price at maturity over the issue price.”  26 U.S.C. § 1273.  It further describes “stated redemption price at maturity” as “the amount fixed by the last modification of the purchase agreement and includes interest and other amounts payable at that time (other than any interest based on a fixed rate, and payable unconditionally at fixed periodic intervals of one year or less during the entire term of the debt instrument).” Id.  Usually the interest in a debt-for-debt exchange is paid out all at once when the debt matures but, for tax or accounting purposes, the interest is accounted for as if it were paid out over the life of the debt.  Thus, under the Tax Code, for purposes of determining taxable income, a debt-for-debt exchange generates new OID.

Because section 502(b)(2) of the Bankruptcy Code allows a bankruptcy claim except to the extent such a claim is for “unmatured interest,” it was unclear how unaccrued OID would be treated in the bankruptcy context.  11 U.S.C. § 502(b)(2).  With respect to face value exchanges, the Second Circuit has held that “OID on the new debt consists only of the discount carried over from the old debt, that is, the unamortized OID remaining on the old debt at the time of the exchange.”  LTV Corp. v. Valley Fid. Bank & Trust Co. (In re Chateaugay Corp.), 961 F.2d 378, 383 (2d Cir. 1992).  As such, the In re Chateaugay court held that OID in a face value debt exchange was not unmatured interest and thus was an allowable claim in bankruptcy. The Second Circuit reasoned that its decision comports with the legislative intent of encouraging debtors to avoid bankruptcy by cooperating with creditors and, in doing so, took into account the “strong bankruptcy policy in favor of the speedy, inexpensive, negotiated resolution of disputes, that is an out-of-court or common law composition.”  Id. at 382.

Left unanswered by the Second Circuit was whether the same logic applies to OID generated in a fair market value debt exchange, which was resolved in In re Residential Capital LLC.

In re Residential Capital LLC

On May 5, 2008, Residential Capital, LLC (“ResCap”) offered to exchange its prepetition debt of $6 billion in unsecured notes for about $4 billion in new junior secured notes, and $500 million in cash.  Because the issue price of the junior secured notes was established based on the approximated market value of the old notes, this was considered a fair market value exchange.  The official committee of unsecured creditors and ResCap sought a determination from the bankruptcy court that unaccrued OID in this fair market value debt exchange, totaling about $377 million, was not an allowable claim because it was “unmatured interest” under the Bankruptcy Code.

With the Chateaugay decision as guidance, the court determined that OID in a fair market value exchange was not disallowed by Section 502(b)(2).  He determined from the testimony of both the plaintiffs’ and defendants’ experts at trial that there was no basis for distinguishing OID generated by fair value exchanges from OID generated by face value exchanges.  Both “fair and face value exchanges offer companies the opportunity to restructure out-of-court, avoiding the time and costs – both direct and indirect – of a bankruptcy proceeding.”  In re Residential Capital, LLC, 501 B.R. at 578-79.

The court noted that Section 502(b)(2) was passed at a time when debt-for-debt exchanges did not create OID for tax purposes.  It was only after the 1990 amendments to the Tax Code that both distressed face value exchanges and fair value exchanges created taxable OID.  He further noted that the both the Second Circuit and the Fifth Circuit[1] have found that, notwithstanding the Tax Code, face value exchanges do not create disallowable unmatured interest.  “The tax treatment of debt-for-debt exchanges derives from the tax laws’ focus on realization events, and suggests that an exchange offer may represent a sensible time to tax the parties.  The same reasoning simply does not apply in the bankruptcy context.”  Id. at 587.

The court found that all the features that companies consider in connection with a debt-for-debt exchange can be used in either face value or fair value exchanges, including: granting of security in the issuer’s collateral; interest rate; maturity date; payment priorities; affiliate guarantees; other lending covenants; redemption features; adding or removing a sinking fund or conversion feature; and offering stock with the new debt.  The court thus concluded that there is “no commercial or business reason, or valid theory of corporate finance, to justify treating claims generated by face value and fair value exchanges differently in bankruptcy” and he held that the junior secured noteholders claim was not reduced by the unaccrued OID.  Id. at 588.

Practical Implications

Notably, the court placed greater weight on the fact that both types of debt exchanges offer distressed entities the opportunity to restructure out-of-court.  Both sides experts acknowledged that if the creditors knew that a portion of the OID created in a fair market value exchange would be disallowed, distressed companies would need to provide better inducements for participation, and it would likely lead to more bankruptcy filings as opposed to out-of-court workouts.  Such a result would frustrate the strong bankruptcy policy favoring speedy, inexpensive, negotiated resolution of disputes.

By finding that OID created in a fair market exchange is an allowable claim in bankruptcy, the ruling in In re Residential Capital LLC has reduced one uncertainty in the distressed debt market which should encourage highly-leveraged companies and their creditors to restructure distressed debt in an exchange regardless of whether it is a fair market or face value exchange.

[1] Texas Commerce Bank, N.A. v. Licht (In re Pengo Indus., Inc.), 962 F.2d 543 (5th Cir. 1992).

In a recent decision, the First Circuit used a “flexible” approach to value the collateral claimed by an oversecured creditor, and granted post-petition interest on the creditor’s claim.  In re SW Boston Hotel Venture, LLC, No. 12-9008, 2014 WL 1399418, — F.3d — (1st Cir. Apr. 11, 2014).  Oversecured creditors (i.e., creditors whose collateral is worth more than the value of their secured claim) are exceptions to the general rule that creditors in a bankruptcy cannot receive post-petition interest.  11 U.S.C. § 502(b)(2) (disallowing claims for unmatured interest); 11 U.S.C. § 506(b) (creating exception for oversecured creditors).  Considering the claim of a creditor who became oversecured during the bankruptcy proceeding, the First Circuit highlighted the extent of a court’s discretion to determine how, when, and at what rate post-petition interest accrues.  Choosing between two camps, the First Circuit adopted what is known as the “flexible” approach in establishing when the creditor became oversecured (the “valuation date”) of the creditor’s collateral, though the court noted that this approach might not be appropriate in other circumstances.  The court looked to a pre-petition agreement among the parties to determine the rate at which post-petition interest accrued but found that, even though the parties’ contract called for compounded interest, the creditor forfeited that particular right by not raising it in time.

Determining Secured Status:  Application of the Flexible Approach

The parties in SW Boston did not dispute that the creditor, Prudential Insurance Company of America (“Prudential”), became oversecured at some point during the bankruptcy proceeding, but they disagreed as to when this occurred.  Because Prudential’s claim decreased over the course of the proceeding while the value of its underlying collateral increased, the measuring date made “the difference between a finding of oversecurity or undersecurity.”  In re SW Boston Hotel Venture, LLC, No. 12-9008, 2014 WL 1399418, at *6 (1st Cir. Apr. 11, 2014).

The Bankruptcy Code does not indicate when a court should value secured collateral to determine a creditor’s secured status.  The case law has separated into two camps:  some courts have adopted a strict “single-valuation” approach, where creditors’ secured statuses are categorically determined on the same date, such as the filing date or plan confirmation date.  See, e.g., Orix Credit Alliance, Inc. v. Delta Res., Inc., 54 F.3d 722, 729 (11th Cir. 1995).  Other courts endorse a “flexible” approach, whereby the bankruptcy court chooses the valuation measuring date based on each case’s circumstances. See, e.g.In re T-H New Orleans Ltd. P’ship, 116 F.3d (5th Cir. 1997).

In SW Boston, the First Circuit applied the flexible approach, finding that section 506(b), the bankruptcy rules, and the legislative history’s silence on the matter “[suggest] flexibility.”  SW Boston, 2014 WL 1399418, at *8.  The measuring date expressly provided by Congress in section 506(a) implies that the valuation contemplated by section 506(b) was not limited to a particular date.[1]  The flexible approach also appealed to the Court’s consideration of fairness and equity, avoiding “an all-or-nothing result that hinges more on fortuity than reality” and seeming “more likely to produce fair outcomes.”  Id. at *9.  While under the single-valuation approach, a creditor who becomes oversecured a day after the chosen date is not entitled to receive post-petition interest and a creditor who becomes oversecured a day earlier is.  The court clarified that it did “not suggest that bankruptcy courts must, or even should, adopt the flexible approach whenever collateral values and/or claim amounts fluctuate,” but instead “simply recognize[s]” that a bankruptcy court may look to principles of equity and fairness in determining the best approach.  Id. at *10, n.13.

A Note on the Valuation of Collateral

The bankruptcy court considered several potential valuation dates, including the petition date.  Prudential asserted that it was oversecured on the petition date, pointing solely to the debtors’ asset schedules as proof.[2]  The bankruptcy court instead applied the property’s sale price and closing date to determine oversecurity.  In finding that the bankruptcy court did not err in this determination, the First Circuit held “that a valuation made for one purpose at one point in a bankruptcy proceeding has no binding effect on valuations performed for other purposes at other points in the proceeding.”  Id. at *11.

Simple Interest Accruing at a Contractually Determined Rate

Section 506(b) does not determine at what rate post-petition interest accrues and whether it does so as simple or compounded interest.  Courts generally agree that the appropriate interest rate is within the court’s discretion.  But where an interest rate has been contractually agreed upon by the parties, such terms “presumptively apply” if they are not invalid under state law or inequitable.  Id. at *13.  The First Circuit approved of the lower courts’ use of a default rate specified in the loan agreement between the debtor and Prudential.  It found that the debtor failed to show that the default rate exceeded the threshold established by applicable state law, that the default rate was lawful under state law, and that the rate did not violate federal equitable principles.

The court also considered and rejected Prudential’s argument that its post-petition interest compounded on a monthly basis.  Although the parties’ agreement expressly called for monthly compounding of interest, the Court found that the creditor forfeited its “entitlement to compounding where it . . . did not seek compound interest until after the bankruptcy court granted it post-petition interest . . . .”  Id. at *15.

Practical Implications

In lieu of clear guidelines, the First Circuit’s decision elevates flexibility and fairness over other potential factors.  Under SW Boston, potential creditors cannot anticipate which valuation approach will apply to their circumstances, or how the court will apply its discretion.  But potential creditors can take steps to protect themselves.  Parties should draft clear agreements with a view to potential bankruptcy, keeping in mind that the default rates they choose may be applied to post-petition interest.  Once proceedings have commenced, it is in a creditor’s best interest to seek oversecured status early on, to seek the valuation of underlying property in the proper context, and to support any related claims with ample evidence

[1].      The Court stated that “[t]he fact that Congress mandated particular measuring dates in the exception without mandating a particular measuring date in the general rule suggests that it intended flexibility . . . .”  Id. at *8.

[2].      The Debtors’ schedules of assets “indicated that the value of Prudential’s collateral, in the aggregate, was substantially more than its total pre-petition claim.”  Id. at *10.

There are known knowns; there are things we know that we know.  There are known unknowns; that is to say, there are things that we know we don’t know.  But there are also unknown unknowns – there are things we don’t know we don’t know.

-United States Secretary of Defense, Donald Rumsfeld, February 12, 2002

Though perhaps not on Secretary Rumsfeld’s mind at the time, in bankruptcy too there can be known creditors and unknown creditors.  Unknown creditors are creditors whose identity or claim is not reasonably known or ascertainable, and to whom the debtor cannot directly provide key information such as the claims bar date.

In a bankruptcy, in order to effectively reorganize or liquidate, a debtor must be able to prevent creditors from asserting prepetition claims after a specified bar date (save excusable neglect).  To do so in a manner that protects creditors’ due process rights, a debtor must provide notice of the claims bar date.  If the creditor is known, the debtor must provide actual notice, whereas if the creditor is unknown, notice by publication is sufficient.  Thus, a key issue for a debtor with unknown creditors is what constitutes adequate publication notice.

Publication notice satisfies due process concerns when it is “reasonably calculated to reach all interested parties, reasonably conveys all the required information, and permits a reasonable time for response.” Chemetron Corp. v. Jones, 72 F.3d 341, 346 (3d Cir. 1995).  As this language suggests, a determination of the constitutional sufficiency of published notice depends on the specific context and facts of a case.  Recently, in the case of In re New Century TRS Holdings, Inc., United States Bankruptcy Court Judge Kevin J. Carney (D. Delaware) upheld the constitutional sufficiency of the debtors’ bar date publication notice to unknown creditors.

In New Century the court established a bar date of August 31, 2007.  The debtors mailed a copy of the bar date notice to all known creditors, and, on July 23, 2007, published the bar date notice in the Wall Street Journal and the Orange County Register.  Over the next several years a chapter 11 liquidation plan was confirmed and implemented and a liquidating trustee was appointed to administer the estate.  In July 2011, an individual filed a proof of claim, which the trustee sought to disallow and expunge as late-filed.  After several motions and rulings on the matter, in April 2012 the trustee moved for an order confirming that New Century had adequately noticed all unknown creditors.

Late-filed claimants objected to the trustee’s motion on the grounds that the bar date publication was a “mere gesture” not reasonably calculated to inform potential claimants of the bar date, and—given the potential for a large number of claims by unknown creditors—in fact was designed to ensure that potential claimants would not receive adequate notice.  These claimants argued that the debtors (1) did not consider readership profiles of the newspaper used for national notice, (2) did not spend enough money on publishing notice given the size and complexity of the case, (3) did not provide sufficient time for claimants to file claims, and (4) did not ensure that the font size and placement of the notice was adequate.

The court rejected each of these arguments.  First, the court found the debtors’ publication in the Wall Street Journal to be reasonably calculated to notify potential claimants of the bar date, noting that this specific publication was selected in an effort to reach all types of unknown creditors nationwide.

Second, the court was sensitive to the cost of publication on a liquidating estate with limited resources, and held that the notice was constitutionally sufficient.  Citing the Fourth Circuit’s decision in Vancouver Women’s Health Collective Soc. V. A.H. Robins Co., the court highlighted the need to balance the needs of notification of potential claimants with the interests of existing creditors.  820 F.2d 1359, 1364 (4th Cir. 1987).  The court reasoned that while additional publication notice may have been desirable, there was no proof that it would have been availing, and in any event the debtors’ notice was constitutionally sufficient.

Third, the court found that publishing notice 39 days before the bar date was sufficient, noting that the bar date order had only required notice no less than 30 days prior to the bar date.  Finally, the court found the font size and placement of the publication notice to have been sufficient.

For these reasons, the court held that the debtors’ publication notice “passe[d] constitutional muster,” and granted the trustee’s motion.  The court stressed the “overriding principle” in bankruptcy of finality, and stated that applying the bar date order here to all unknown creditors furthered this principle.

In re New Century TRS Holdings, Inc., et al., No. 07-10416, 2013 WL 4671734 (Bankr. D. Del. Aug. 30, 2013).