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).

In In re Boomerang Tube, Inc.,[1] the United States Bankruptcy Court for the District of Delaware refused to approve a proposed retention application that would have required the bankruptcy estate to reimburse counsel for the committee of unsecured creditors for fees and expenses the counsel incurred in any successful defense of their fees in the case.  The Bankruptcy Court ruled that such an arrangement was impermissible under the Bankruptcy Code and in contravention of the Supreme Court’s 2015 ruling in Baker Botts L.L.P. v. ASARCO LLC.[2]  The Bankruptcy Court’s decision poses implications for professionals faced with the prospect of defending their fees in bankruptcy cases, who may now be compelled to shoulder the expenses of a potential fee defense even if they have negotiated contractual provisions for the reimbursement of such fees.

In Boomerang Tube, the Official Committee of Unsecured Creditors (the “Committee”) retained counsel (“Committee Counsel”) pursuant to a retention agreement, which provided that Committee Counsel would be indemnified for any fees and expenses incurred while successfully defending potential challenges to their fees.  The Committee sought approval of the retention agreement pursuant to section 328(a) of the Bankruptcy Code.

The U.S. Trustee (the “UST”) objected to the fee defense provisions on three principal grounds.  First, the UST argued that the provisions were barred by the ruling in ASARCO, in which the Supreme Court held that a law firm cannot recover fees from a bankruptcy estate for its defense against an objection to its fees.  Second, the UST argued that section 328(a) of the Bankruptcy Code did not create an exception to the “American Rule” that requires each litigant to pay its own attorney’s fees.  Third, the UST contended that the proposed fee defense provisions were impermissible under section 328(a) because they were unreasonable and sought to compensate Committee Counsel for work outside the scope of their employment.

In response, the Committee first argued that ASARCO was distinguishable because it held only that section 330(a) of the Bankruptcy Code did not contain an express exception to the American Rule, whereas the Committee sought approval of the proposed fee defense provisions pursuant to section 328(a).  Second, the Committee asserted that the Supreme Court’s ruling in ASARCO did not preclude a contractual exception to the American Rule.  Third, the Committee contended that the proposed fee defense provisions were permissible under section 328(a), citing numerous bankruptcy cases in which indemnification provisions for successfully defending fees were approved.

The Bankruptcy Court rejected each of the Committee’s arguments and denied the Committee’s request for approval of the fee defense provisions in Committee Counsel’s retention agreement.  First, the Bankruptcy Court found that although section 328(a) of the Bankruptcy Code provided an exception to section 330, it did not authorize the fee defense provisions at issue because section 328(a) did not contain the “specific and explicit” statutory exception to the American Rule required under the ASARCO ruling.

Second, the Bankruptcy Court acknowledged the possibility of a contractual exception to the American Rule, but concluded that the proposed fee defense provisions were nonetheless impermissible because they were inconsistent with the Bankruptcy Code.  The Bankruptcy Court observed that the retention agreement was a contract between the Committee and Committee Counsel that called for a third party—the bankruptcy estate—to pay the Committee Counsel’s defense costs.  Because the retention agreement could not bind a non-party to the agreement, the Bankruptcy Court held the proposed fee defense provisions to be unenforceable.  The Bankruptcy Court also noted that retention agreements in bankruptcy proceedings are not simply contractual matters, but are also subject to objections by other parties and ultimately require court approval in accordance with the provisions of the Bankruptcy Code, regardless of the terms of the agreement.

Third, the Bankruptcy Court considered whether, even if ASARCO did not preclude the proposed fee defense provisions, they could be approved under section 328(a).  The Court agreed with the UST that the provisions did not constitute “reasonable terms and conditions of employment” for Committee Counsel under section 328(a), because defending their own fees would be a service performed by Committee Counsel only for their own interests, not for the Committee itself.  The Bankruptcy Court was also unpersuaded by the Committee’s reference to similar indemnification provisions that were approved in other cases.  The cases the Committee relied upon predated the ASARCO decision, which expressly rejected the consideration of such market factors in determining whether defense fees can be recovered.

Boomerang Tube presents a warning for all professionals involved in bankruptcy cases—not solely committee counsel—in drafting fee defense provisions in a retention agreement.  The Bankruptcy Court noted that it would deny approval of a retention agreement “filed by any professional under section 328(a)—including one retained by the debtor” that shifted fees incurred by the professional in defending fee objections.[3]  Other courts may follow this reasoning, and bankruptcy professionals may attempt other methods of circumventing ASARCO’s restrictions; the HHR Bankruptcy Report will continue to provide updates on further developments in this regard.

[1]       In re Boomerang Tube, Inc., No. 15-11247, 2016 WL 385933 (Bankr. D. Del. Jan. 29, 2016).

[2]       Baker Botts L.L.P. v. ASARCO LLC, 135 S. Ct. 2158 (2015).

[3]       In re Boomerang Tube, 2016 WL 385933 at *8 n.6.

The Third Circuit has affirmed the Delaware Bankruptcy Court’s approval of a section 363 sale and related settlement agreement over IRS’s objection to provisions in the sale and settlement agreements that provide payments to unsecured creditors and other administrative creditors while leaving the IRS with no recovery. While the IRS argued that the sale and settlement violated the absolute priority rule by favoring creditors with an equal or lesser priority under the Bankruptcy Code’s distribution scheme, the Third Circuit found that neither the funds set aside to make payments to unsecured creditors nor the funds set aside to pay other administrative creditors constitutes property of the debtor’s estate. As the Bankruptcy Code’s creditor-payment hierarchy is applicable only to property of the debtor, therefore, it was not implicated by the provisions in the sale and settlement agreements.

Prior to the petition date, and after failing to attract purchase offers that exceeded its debt obligations, LifeCare Holdings, Inc. entered into an asset purchase agreement with an acquisition vehicle made up of its secured lenders—who were undersecured due to the falling value of the company—whereby the secured lenders credited $320 million of the $355 million debt they were then owed in return for the cash and assets of LifeCare. In addition, the lenders agreed to pay the legal and accounting fees of LifeCare and the Committee of Unsecured Creditors, as well as the company’s wind-down costs, and to deposit funds into separate escrow accounts for the purpose of paying those amounts. The day after entering into the asset purchase agreement, LifeCare and its subsidiaries filed for bankruptcy and asked for permission to sell substantially all of its assets through a section 363 auction. Ultimately, the secured creditors’ “credit bid” remained the most attractive offer. After an objection to the sale by the Committee, the secured lenders’ group entered into a settlement agreement with the Committee whereby the secured lenders agreed to deposit $3.5 million in trust for the benefit of the general unsecured creditors.

The US Government, representing the IRS, objected to the sale and the settlement and sought a stay on the distribution of funds to creditors, arguing that the sale would result in a large capital-gains tax liability, thereby giving them an administrative claim, and that the proposed sale and settlement agreements therefore violated the absolute priority rule by providing for payments to be made to equally situated administrative creditors—primarily bankruptcy professionals—and to unsecured creditors.

In determining that the sale and settlement were properly approved by the Bankruptcy Court, the Third Circuit described the central issue as “whether certain payments by a section 363 purchaser . . . in connection with acquiring the debtors’ assets should be distributed according to the Code’s creditor-payment hierarchy.” The court focused on its view of the substance of the sale over form and found that the money in question was not paid at the debtors’ direction, consisted of the purchaser’s own funds, and never entered the estate.

The Third Circuit’s ruling may provide incentive for undersecured lenders to make similar credit bids, and for debtors to accept such bids. While potential purchasers, debtors, and creditors may be tempted to use the decision as a map to altering the Bankruptcy Code’s distribution scheme and a avoiding the tax implications of section 363 sales, the adoption of this approach by other circuits is not certain. For now, creditors should be warned that they risk being bypassed by such sale arrangements.

On Tuesday, September 15, 2015, Judge Kevin J. Carey, United States Bankruptcy Judge for the District of Delaware, granted motions to dismiss Chapter 11 proceedings relating to the failed Baha Mar resort project filed by Baha Mar’s Bahamian creditors CCA Bahamas Ltd. and Export-Import Bank of China.  The Debtors include fourteen corporations based in the Bahamas, as well as Northshore Mainland Services, Inc., which is incorporated in Delaware.

In his Memorandum Opinion, Judge Carey dismissed the Chapter 11 cases filed by the Bahamas-based debtors under section 305(a) of the Bankruptcy Code.  While the court considered a numbers of factors before concluding that granting the motions to dismiss would serve the best interests of the Debtors and all creditors, Judge Carey’s decision rested primarily on the fact that: (i) CCA, Export-Import, and the Debtors are Bahamian entities and, (ii) given that the project was based in the Bahamas, the parties would expect any resolution of the proceedings to be most effectively accomplished in the Bahamas.  Judge Carey therefore concluded that there was “no greater good to be accomplished by exercising jurisdiction over these chapter 11 cases.”

However, Judge Carey denied the motion to dismiss with respect to Debtor Northshore, holding that as a Delaware corporation, the “[p]arties would expect Northshore’s financial difficulties to be addressed in a proceeding in the United States.”

The court’s ruling may serve as a warning to international creditors that U.S. Bankruptcy Courts will not extend their jurisdiction limitlessly, and creditors should seriously consider whether a proceeding would be more appropriately brought in their home countries.

The Third Circuit, in Official Committee of Unsecured Creditors v. CIT Group/Business Credit Inc. (In re Jevic Holding Corp.),[1] became the first court of appeals to approve the settlement and dismissal of a chapter 11 case. Structured dismissals, as understood by the Third Circuit, are “simply dismissals that are preceded by other orders of the bankruptcy court (e.g., orders approving settlements, granting releases, and so forth).” This decision may provide flexibility in future bankruptcy resolutions as structured dismissals may become a tool for parties and judges, and deviation from the Bankruptcy Code’s claim priority scheme can be permitted in rare situations.

In 2006 Jevic Transportation, Inc. (“Jevic”), a New Jersey trucking company, was acquired by a subsidiary of Sun Capital Partners (“Sun”) in a leveraged buyout led by CIT Group (“CIT”). Two years later, Jevic filed a voluntary chapter 11 petition in the United States Bankruptcy Court for the District of Delaware. During the bankruptcy proceedings, two lawsuits were filed against the debtor: (i) a group of Jevic’s terminated truck drivers (“Drivers”) filed a class action against Jevic and Sun alleging violations of federal and state Worker Adjustment and Retraining Notification Acts because the Drivers were not given 60 days written notice before termination;[2] and (ii) the Official Committee of Unsecured Creditors (“Committee”) brought a fraudulent conveyance action against CIT and Sun on the estate’s behalf.[3] In March 2012, three of the parties – the Committee, CIT and Sun – reached a settlement agreement, under which the the fraudulent conveyance and preference actions would be dismissed, CIT would contribute $2 million to pay legal fees and administrative expenses for Jevic and the Committee, Sun would transfer its lien on Jevic’s assets to a trust in order to fully pay administrative and tax creditors (but not other priority creditors) and to pay unsecured creditor on a pro rata basis, and finally the bankruptcy case would be dismissed. The settlement did not include the Drivers who, along with the U.S. Trustee, objected to the settlement on the grounds that structured dismissals were not authorized under the Bankruptcy Code and that the settlement violated the Bankruptcy Code’s priority scheme by excluding the Drivers priority wage claims.

The Third Circuit had to determine whether structured dismissals were allowed under the Bankruptcy Code and if so, whether strict compliance with the Code’s priority distribution scheme in § 507 was required. The majority found that “absent a showing that a structured dismissal has been contrived to evade the procedural protections and safeguards of the [chapter 11] plan confirmation or conversion processes, a bankruptcy court has discretion to order such disposition.” The Third Circuit then compared the outcome of cases in the Fifth and Second Circuits that discussed whether the priority scheme must be followed when settlement proceeds are distributed in chapter 11 cases, and found that in “rare” circumstances a structured dismissal that does not strictly adhere to the Code’s priority scheme is warranted. The Fifth Circuit, in Matter of AWECO, Inc., held that the “fair and equitable” standard required by Federal Rule of Bankruptcy Procedure 9019 applies to settlements and that “fair and equitable” means compliant with the priority system.[4] In In re Iridium Operating LLC the Second Circuit held that a settlement that did not comply with the priority scheme could be approved as long as the balance of other factors weighed heavily in favor of approving a settlement and that “specific and credible grounds to justify [the] deviation” existed.[5] The Third Circuit followed the more flexible Iridium approach. Admittedly unsatisfied by the exclusion of the Drivers, the Third Circuit conceded that, when compared with “no prospect” of a plan being confirmed or the secured creditors’ taking “all that remained” in a chapter 7 conversion, the settlement was the “least bad alternative.” The dissent did not find the special circumstances required by Iridium present in Jevic.

This decision is the first by a circuit court of appeals to approve the use of a structured dismissal as an alternative to converting a case to chapter 7 or returning the parties to status quo via dismissal. Future use of structured dismissals will help clarify and continue to refine the definition of “rare” circumstances. For now, debtors should note the possibility of utilizing a structured dismissal and secured creditors should be warned that they may now risk being frozen out of settlements to the benefit of unsecured creditors.

[1].      No. 14-1465 (3d Cir. May 21, 2015).

[2].      The Bankruptcy Court eventually granted summary judgment for Sun finding that it did not qualify as an employer of the Drivers, In re Jevic Holding Corp., 492 B.R. 416, 425 (Bankr. D. Del. 2013), and entered summary judgment against Jevic because it had violated the New Jersey Worker Adjustment and Retraining Notification Act, In re Jevic Corp., 496 B.R. 151, 165 (Bankr. D. Del. 2013).

[3].      CIT’s motion to dismiss was granted in part and denied in part. The Bankruptcy Court held that the Committee had adequately pleaded claims of fraudulent transfer and preferential transfer under 11 U.S.C. §§ 548 and 547, but dismissed without prejudice the Committee’s claims for fraudulent transfer under 11 U.S.C. § 544. In re Jevic Holding Corp., 2011 WL 4345204, at *10 (Bankr. D. Del. Sept. 15, 2011).

[4].      725 F.2d 293, 298 (1984).

[5]       In re Iridium Operating LLC, 478 F.3d 452, 464, 466 (2d Cir. 2007). The four factors, from In re Martin are (1) the probability of success in litigation; (2) the likely difficulties in collection; (3) the complexity of the litigation involved, and the expense, inconvenience and delay of necessarily attending it; and (4) the paramount interest of the creditors. 91 F.3d 389, 393 (3d. Cir. 1996).

In what may become a precedential analysis of the cardinal principles of Delaware corporate and bankruptcy law, the Delaware Court of Chancery recently issued a decision in Quadrant Structured Products Co., Ltd. v. Vertin, extensively discussing the rights of an insolvent company’s creditors to pursue derivative claims against the company’s directors and provided guidance to directors of distressed companies on the fiduciary duties they owe to the corporation and its stakeholders.

As a result of the financial crisis, Athilon Capital Corp, which guaranteed credit default swaps on collateralized debt obligations, suffered severe financial distress and became insolvent. A former note holder, EBF & Associates LP, subsequently acquired all of Athilon’s equity and as a result also gained control of Athilon’s board. Following this acquisition, Quadrant Structured Products Company, a creditor and note holder of Athilon, filed a derivative lawsuit in the Delaware Court of Chancery against Athilon’s directors alleging that they had breached their fiduciary duties by adopting a high risk investment strategy for the sole benefit of EBF at the expense of Athilon’s other creditors. After the filing, Athilon structured several financial transactions with EBF, which, according to the defendants, returned Athilon to balance-sheet solvency. The directors then moved for summary judgment and argued that Quadrant could only have standing to bring a derivative lawsuit if it could show that (i) Athilon was insolvent at the time the lawsuit was commenced and continuously thereafter, and (ii) Athilon was “irretrievably insolvent,” i.e., with no reasonable prospect of returning to solvency.

Noting that the question was one of first impression under Delaware law, the court rejected continuous insolvency as a requirement for creditor standing. The court explained that a continuous insolvency requirement was ill-advised because, during the course of litigation, “a troubled firm could move back and forth across the insolvency line such that a continuing insolvency requirement would cause creditor standing to arise, disappear, and reappear again.” Further, to require continuing insolvency for creditor standing would allow conflicted directors to prevent the corporation and its creditors from pursuing valid claims by restoring the corporation back to solvency and would result in a “failure of justice.” Therefore, to have standing to sue derivatively, a creditor need only establish that a corporation was insolvent at the time the creditor filed suit; whether the corporation was continuously insolvent thereafter is irrelevant.[1] The court also rejected the more onerous “irretrievable insolvency” requirement because the great weight of Delaware authority uses the traditional “balance sheet test,” which deems an entity insolvent when it has liabilities in excess of a reasonable market value of assets. The court noted that the balance sheet test was also consistent with both the test under the Bankruptcy Code for recovery of allegedly preferential or fraudulent transfers,[2] and Delaware’s statutory standard for determining whether a Delaware corporation has a cause of action against its directors for declaring an improper dividend or improperly repurchasing stock.[3]

The ruling in Quadrant Structured Products Co., Ltd. v. Vertin should be of interest for board members whose company is already, or faces the prospect of, insolvency. Although the Delaware Court of Chancery rejected the continuous insolvency and “irretrievable insolvency” requirements, the ruling does not significantly expand derivative plaintiffs’ rights—they still may not bring direct claims to enforce fiduciary duties against an insolvent corporation, do not have a “deepening insolvency” cause of action, may only gain standing to derivatively sue the board when the corporation is insolvent rather than in the “zone of insolvency” and enjoy the broad protections of the business judgment rule. Quadrant may have removed a single arrow from the quiver of a director defending against derivative suits, but the quiver still remains full.

[1]       In reaching these conclusions, Vice Chancellor Laster elaborated on the legal principles underpinning the regime for creditor-derivative litigation in light of the Delaware Supreme Court’s 2007 decision in North American Catholic Educational Programming Foundation v. Gheewalla, 930 A.2d 92 (Del. 2007), and its progeny, namely that:

  • Creditors do not gain derivative standing when a corporation operates in a “zone of insolvency.” The corporation’s “insolvency itself” is the only factor conferring standing to creditors.
  • Regardless of the corporation’s solvency or insolvency, creditors may only bring derivative claims – as opposed to direct claims – to enforce fiduciary duties.
  • The directors of an insolvent corporation do not owe any particular duties to creditors and continue to owe fiduciary duties to the corporation for the benefit of its residual claimants, which includes creditors. Therefore, the directors (a) may continue to operate the insolvent entity and refuse to transfer or distribute all of its assets to the creditors, and (b) may exercise their good faith judgment to favor non-insider creditors over other creditors of similar priority.
  • There is no theory of “deepening insolvency” in Delaware. Directors may continue to operate an insolvent entity in the good faith belief that they may achieve profitability even if their decisions ultimately lead to greater losses for creditors.

[2]       See 11 U.S.C. § 101(32)(A) (defining insolvency as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of–(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and (ii) property that may be exempted from property of the estate under section 522 of [the Bankruptcy Code].”).

[3]       See 8 Del. C. § 160(a)(1); SV Inv. P’rs, LLC v. ThoughtWorks, Inc., 7 A.3d 973, 982 (Del. Ch. 2010) (“[T]he [net assets] test operates roughly to prohibit distributions to stockholders that would render the company balance-sheet insolvent, but instead of using insolvency as the cut-off, the line is drawn at the amount of the corporation’s capital.”), aff’d, 37 A.3d 205 (Del. 2011).

In considering a Section 363 asset sale in In re Fisker Automotive Holdings, Inc., , the United States Bankruptcy Court for the District of Delaware used its “for cause” power under Section 363(k) to limit the proposed purchaser’s credit bid and trigger a competitive cash auction for the debtor’s assets.  2014 WL 210593 (Bankr. D. Del. Jan. 17, 2014).  The decision demonstrates that courts considering the limitation or denial of credit bidding will consider factors both intrinsic to the proposed credit bid (the validity of the secured status asserted had not yet been determined) and extrinsic (perceived unfair process by the proposed sale purchaser, and the potential benefits of a competitive auction).

Bankruptcy Code section 363(k) authorizes a creditor with a security interest in an asset being sold to discount its successful bid by the value of the lien.  So called “credit bidding” can give secured creditors a substantial advantage in section 363 asset sales, especially when the value of the lien approaches or exceeds the market value of the sale asset.  There is no absolute right to credit bid; section 363(k) provides that the court may, for good cause, limit or deny credit bidding.

The would-be purchaser in In re Fisker, Hybrid Tech Holdings, LLC, purchased its $168.5 million claim, the largest by far against Fisker, from the Department of Energy for $25 million.  Hybrid then offered to purchase substantially all of Fisker’s assets in a private sale for consideration including $75 million in the form of a credit bid.  The Official Committee of Unsecured Creditors objected to the private sale, arguing that a competitive auction would return more value to the estate, and objected to the size of the credit bid, arguing that Hybrid should be precluded from entering any credit bid, or at least, not greater than the $25 million Hybrid actually paid to obtain the claim.  The rival bidder, Wanxiang America Corporation, made clear that there should be no auction unless Hybrid’s credit bid were limited to $25 million.

Although it rejected Hybrid’s $75 million credit bid and limited it to a $25 million credit bid in the anticipated auction, the court did not hold that credit bidding by the purchaser of a claim should always be limited to the amount actually paid to obtain the claim.  Instead, the court imposed this limit because the extent to which Hybrid’s claim was secured by a perfected lien was still in dispute, and it appeared that Hybrid was trying to rush the sale, freeze out other buyers, and prevent an auction.  The amount of $25 million was the maximum possible without foreclosing the auction all together.

In re Fisker does not indicate whether each of these justifications would be independently sufficient to establish “good cause” under section 363(k).  What the court’s ruling does demonstrate is the scrutiny that proposed credit bids will face, particularly private sales premised on credit bidding, to ensure that they are in the best interest of the estate.