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The recent decision from the United States Supreme Court in Lamar, Archer & Cofrin, LLP v. Appling (“Lamar”), further restricts a creditor’s ability to pursue future recovery on its debt through a nondischargeability action in a debtor’s bankruptcy. On June 4, 2018, the Court ruled in Lamar that a debtor’s false statement about a single asset must be in writing before the creditor’s debt can be excepted as nondischargeable in bankruptcy.
The Supreme Court’s full opinion can be viewed here: Lamar Opinion 2018 . The Court’s decision in Lamar resolved a circuit split and provides for consistent interpretation of the Bankruptcy Code which did not previously exist. The issue before the Court was whether a false oral statement about a single asset can render a specific obligation nondischargeable, or whether such a statement must be in writing.
Nondischargeability in Bankruptcy
A brief review of the concept of “nondischargeabilty” is helpful. A public policy underlying U.S. bankruptcy law is that an honest debtor should receive a fresh start after seeking bankruptcy protection. This “fresh start” is implemented by a bankruptcy “discharge” which generally protects debtors against creditors pursuing them for recovery of their debts after the bankruptcy case.
However, there are exceptions to this discharge, and some of them arise by reason of misrepresentations by the debtor. Remember, the underlying public policy is for honest debtors to receive a discharge. A creditor can sue a debtor within the bankruptcy case (aka an adversary proceeding) to except the creditor’s specific debt from the debtor’s discharge because of misrepresentations made by the debtor. If the creditor prevails, that particular creditor’s debt is “nondischargeable”. (Note this is different from objecting to the debtor’s discharge entirely—see the Bankruptcy Cave’s prior blog post discussing this distinction: BCLP singular-cases-nondischarge-and-dischargeability). If a creditor’s debt is determined to be “nondischargeable” then the individual debtor remains responsible for repayment of that debt despite filing for bankruptcy protection and receiving a discharge.
A creditor can seek to except its debt from a debtor’s discharge if the creditor extended credit to the debtor and that credit was obtained by a false representation. See 11 U.S.C. § 523(a)(2)(A). However, there is a limitation. If the false representation is a statement “respecting” the debtor’s financial condition, the statement must be in writing for the debt to be nondischargeable. See 11 U.S.C. § 523(a)(2)(B).
Facts in Lamar
Bankruptcy debtor R. Scott Appling (“Appling”) was a former client of the law firm Lamar, Archer & Cofrin, LLP (the “Law Firm”). The Law Firm represented Appling in litigation. When Appling was unable to pay his legal bills Appling told the Law Firm that he was expecting a substantial tax refund which would cover his outstanding legal bills and be enough to pay future legal fees incurred in ongoing litigation. In reliance on this statement, the Law Firm continued to represent Appling and did not take action to immediately collect on Appling’s overdue legal bills.
However, Appling’s statement to the Law Firm attorneys was false. He only received a modest tax refund and he spent that money on his business instead of paying the Law Firm. The Law Firm eventually sued Appling and obtained a judgment for the unpaid legal fees. Appling subsequently filed for bankruptcy protection.
Lower Courts’ Interpretation of 11 U.S.C. § 523 and Corresponding Circuit Split
The bankruptcy court, as the original trial court, ruled in favor of the Law Firm finding its debt to be nondischargeable in Appling’s bankruptcy case. The district court, on appeal, affirmed the bankruptcy court’s ruling. However, on further appeal at the Eleventh Circuit, the court overturned the lower courts’ decisions finding that a debtor’s fraudulent statement regarding a single asset may constitute a statement “respecting” the debtor’s financial condition and, thus, must be in writing to be considered a nondischargeable debt.
The Eleventh Circuit’s ruling was consistent with the Fourth Circuit’s interpretation of 11 U.S.C. § 523(a)(2). However, the Fifth, Eighth and Tenth Circuits have held that a statement about a single asset is not “respecting” a debtor’s financial condition and thus need not be in writing for the debt to be dischargeable.
Issue on Appeal
The central issue on appeal was whether Appling’s oral statement regarding his tax refund, a single asset, was “respecting” his financial condition and thus dischargeable under 11 U.S.C. § 523(a)(2)(A) or whether Appling’s statement regarding his tax refund needed to be in writing to be dischargeable under 11 U.S.C. § 523(a)(2)(B).
Supreme Court’s Decision
The Court’s decision turned on the meaning of the word “respecting” in the application of § 523(a)(2)(A). The Court determined that because the Bankruptcy Code does not define the term “respecting”, the Court looks to the plain meaning of the word. The Court consulted multiple dictionaries and interpreted the term’s plain meaning expansively. Accordingly, the Court held that an individual debtor’s statement about a single asset was a statement respecting the debtor’s financial condition and had to be in writing to be nondischargeable.
As a general matter the Bankruptcy Code prohibits individual debtors from canceling their debts that were incurred from dishonest or fraudulent conduct of the individual debtor. However, the exception to this general rule can be found in 11 U.S.C. § 523(a)(2)(B) where statements respecting the debtor’s financial condition must be in writing to be nondischargeable. Congress enacted this statute to protect individual debtors from abusive creditors in the consumer credit industry who would historically induce debtors to sign incomplete or inaccurate financial statements to render the debts nondischargeable in bankruptcy. In this decision, the Court has reemphasized the underlying public policy dedicated to an individual’s fresh start after emerging from bankruptcy.
As a result of the Court’s ruling a creditor’s reliance on statements made by a debtor need to be in writing now more than ever before and will result in more reliable evidence for the underlying trial court. Ultimately, the Court’s broad interpretation of this statute will likely result in more uniform application of the Bankruptcy Code nationwide.
Editors’ Note: While this post is not a per se bankruptcy issue, matters on consumer financial services are always in the curtilage of bankruptcy and the U.S. Bankruptcy Code. Our BCLP consumer financial services colleague Cathy Welker is an expert in this area, advising banks, servicers, and other financial institutions on the Byzantine regulatory world they face, not only in New York where she practices but also at the federal level. Likewise, BCLP’s Dallas office enjoys the benefits of Greg Sachnik, a former senior banking executive deep in the front lines of TILA, RESPA, deceptive trade practices, wrongful foreclosure, and fair debt collection. We appreciate seeing this update from them, especially as reverse mortgage issues grow exponentially – according to one study, reverse mortgage foreclosures increased by over 600 percent in recent years. So we are pleased to re-publish it here, and for you to read it.
New York has signed into law an amendment redefining a reverse mortgage as a “home loan.” With this amendment (see link at the bottom of this post), statutory pre-foreclosure ninety day notices (RPAPL 1304) and a “certificate of merit” (CPLR 3012-b) will be required in all New York reverse mortgage foreclosures. Additionally, New York’s foreclosure settlement conference law (CPLR 3408) now incorporates by reference the new “home loan” definition. The legislation was signed by Gov. Andrew Cuomo on April 12, 2018 but “shall be deemed to have been in full force and effect on and after April 20, 2017.” However, the pre-foreclosure notice requirement specific to reverse mortgages has an effective date of May 12, 2018.
Under the new legislation, for actions commenced after May 12, 2018, lenders, assignees, or servicers are required to provide a pre-foreclosure notice at least 90 days before commencing legal action against the borrower or borrowers at the property address and any other addresses of record. The language of the notice is set by statute. Although the 90-day waiting period does not apply, or ceases to apply under certain circumstances (i.e. where a borrower no longer occupies the residence as a principal dwelling),the 90 Day Notice is a condition precedent which, if not strictly complied with, may subject a foreclosure action to dismissal. Further, the foreclosing party is required by statute to deliver the notices by first class and certified mail. Relevant case law makes clear that evidencing the proof of mailing may require tracking documentation for first class mail and certified receipts for notices sent by certified mail.
The inclusion of reverse mortgages in the definition of “home loan” also means that lenders seeking to foreclose on a reverse mortgage must file a “certificate of merit” with the complaint. The certificate requires that the attorney filing the complaint certifies that he or she has reviewed the relevant loan documents (note, mortgage, assignments and any other instruments of indebtedness) and has consulted “about the facts” of the case with a representative of the lender. Based on this review and consultation, the attorney must certify that “there is a reasonable basis for the commencement of this action, and that plaintiff is the creditor entitled to enforce rights under these documents.”
Finally, because New York’s foreclosure settlement conference law incorporates the new “home loan” definition, the amendment removes any lingering doubt that foreclosure settlement conferences are mandated in most reverse mortgage cases. There are some exceptions for reverse mortgage defaults, but as a practical matter, courts likely will schedule settlement conferences in all reverse mortgage cases before it can be determined whether the matter falls within an exception.
The text of the omnibus legislation that includes the changes to RPAPL § 1304 can be found here (It is a huge bill, but use the search function to get to part HH and it is right there.) Or contact Cathy or Greg through the links above and they would be happy to send it to you.
Just last month, the Bankruptcy Cave reported upon a Southern District of Texas case in which a debtor was denied discharge of a debt owed to an old (and likely former!?!) friend from church who had been required to pay off a student loan made to the debtor which the friend had guaranteed. Today we report another case involving friends and family and non-dischargeable student debt from the U.S. Bankruptcy Court for the Eastern District of Michigan.
The case, Ramani v. Romo (In Re Romo), Ad. Pro. No. 17-2107-dob (link for you here), was recently resolved by way of summary judgment for the plaintiffs, the debtor’s former in-laws. As set forth in the May 14, 2018 opinion of Judge Daniel S. Opperman, the debtor entered her marriage to the plaintiffs’ son with considerable student debt. The U.S. Department of Education offered to forgive a significant amount of the debt in return for an immediate payment of $105,000.
The plaintiffs were able to provide the funds necessary to retire the debt and did so in 2012 by way of a scarcely documented loan which the debtor was to repay at the rate of $400 every two weeks. Over several years, the debtor repaid $21,550. Also, during that time, the debtor’s marriage to the plaintiffs’ son ended as did her twice-monthly payments to the plaintiffs. The plaintiffs sued in state court and took an $84,312 judgment against the defendant in April 2017. In July 2017, the debtor filed for relief under Chapter 7.
Importantly, as it turned out, the plaintiffs’ complaint included a detailed description of the purpose of the loan, reciting that the original debt was owed to the Department of Education and that the loan was made by way of a check from the plaintiffs, payable to the department. The complaint also described the history of payments made by the debtor and her refusal to pay the balance of the loan. The debtor did not answer the complaint and a default judgment was entered for the plaintiffs. The debtor did not appeal.
The plaintiffs filed an adversary proceeding in the bankruptcy, challenging the dischargeability of the debt owed to them. In his opinion granting summary judgment to the plaintiffs, Judge Opperman held that the debtor was collaterally estopped by the state court judgment from challenging the existence or enforceability of the loan or the plaintiffs’ assertion that the loan was for educational purposes. “While she makes excellent arguments supporting her position, the (state court judgment) answers all these questions and closes the door to her because of collateral estoppel.”
Utilizing the facts set forth in the state court complaint, Judge Opperman concluded that the loan was a “qualified education loan” as defined by 26 U.S.C. § 221(d)(1), which specifically includes loans made to refinance student debt, and therefore excepted from discharge under 11 U.S.C. §523(a)(8)(B), which exempts student loans that are neither made nor guaranteed by a governmental agency.
Finally, Judge Opperman notes that while 26 U.S.C. §221(d)(1) excludes debts owed to a “related person,” the term, as defined by 26 U.S.C. 267 (b) and (c), limits the exclusion to debts owed to one’s “brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants.” Notably excluded from the exclusion are a debtor’s former mother-in-law and father-in-law.
So, for a practitioner representing a lender seeking to collect a debt which may be non-dischargeable in the event of the defendant’s subsequent bankruptcy, it is important to allege facts in the collection action that will support a later determination of non-dischargeability.
On the other hand, for a practitioner representing a borrower with hopes of obtaining a discharge, you can’t let a creditor take a judgment in state court and only seek bankruptcy protection in response to collection activity without being stuck with the facts as established in the collection suit.
And for over-extended student loan borrowers, if you’re going to hit someone up to refinance your debt, get it from your own parents or well-to-do sister, not your in-laws.
Garrison Keillor once said, “Sometimes I look reality straight in the eye and deny it.” Being that the case arose in Minnesota, perhaps Circuit Judge Michael Melloy channeled Keillor, one of that state’s great humorists, when he authored the opinion in The Official Committee of Unsecured Creditors v. The Archdiocese of Saint Paul and Minneapolis et al. (In re: The Archdiocese of Saint Paul and Minneapolis) Case No. 17-1079 2018 WL 1954482 (8th Cir. April 26, 2018) [a link to the opinion is here]. Regardless, the quote must sum up the Appellant’s view of the outcome. The unsecured creditors that make up the Committee, most of whom were victims of clergy sexual abuse, will not obtain access to the value of over 200 non-profit entities affiliated with the Archdiocese of Saint Paul and Minneapolis to pay their claims.
In a concise opinion, the 8th Circuit held that a bankruptcy court’s authority to issue “necessary or appropriate” orders did not give it the power to substantively consolidate a Chapter 11 estate of a bankrupt nonprofit entity, the Archdiocese, with the estates of non-debtor parishes and parish schools that also qualified as nonprofit entities under Minnesota law. Despite the breadth 11 U.S.C. § 105(a), the Court looked past weighty equitable interests and instead relied on to state law, and on the plain language of the Section 303(a) of the Bankruptcy Code (which prohibits an involuntary filing against “a corporation that is not a moneyed, business, or commercial corporation”).
The case arose from the 2013 passage of Minnesota’s Child Victims Act, which allowed previously time-barred sexual abuse claims to be brought. Hundreds of claims of clergy sexual abuse were filed against the Archdiocese. In 2015 the Archdiocese filed Chapter 11 bankruptcy. In May 2016, the Committee, representing more than 400 clergy sexual abuse claimants, filed a motion in the bankruptcy case to substantively consolidate Debtor with over 200 affiliated non-profit entities. The bankruptcy court applied Rule 7012 of the Federal Rules of Bankruptcy Procedure to the Committee’s motion, converting the motion to an adversary proceeding and allowing the responding parties to file motions to dismiss, which many did. The Bankruptcy Court dismissed the Committee’s Complaint and the District Court upheld that decision.
The 8th Circuit’s Decision
As the Court recognized, “[s]ubstantive consolidation allows the court, in appropriate situations, to expand the definition of the debtor’s bankruptcy estate to include assets also within debtor’s possession and control.” Section 105 (a) of the Bankruptcy Code forms the basis for substantive consolidation; it provides the option in equity to “issue any order, process, or judgment that is necessary or appropriate to carry out the provisions.”
What could be a more valid equitable consideration than providing relief to victims of sexual abuse? After all, Minnesota certainly wanted to provide relief when it passed legislation to overturn its own statute of limitations. Why would a bankruptcy court stand in the way of the victims’ recovery?
The answer, as stated by the 8th Circuit Panel, is simple. The Bankruptcy Code will not allow substantive consolidation?permissible only under the general powers of Section 105?given the more specific mandate of Section 303(a). In the words of the Panel, “the broad, catch-all equitable powers conferred under 11 U.S.C. § 105(a) do not allow a bankruptcy court to override explicit mandates of other sections of the Bankruptcy Code.” Section 303(a) details the parties who may (and may not) be subject to an involuntary bankruptcy petition. It states:
An involuntary case may be commenced only under chapter 7 or 11 of this title, and only against a person, except a farmer, family farmer, or a corporation that is not a moneyed, business, or commercial corporation, that may be a debtor under the chapter under which such case is commenced. (emphasis added).
Per the Panel’s determination, “not a moneyed . . . corporation” is equivalent to the modern-day terms “not-for-profit” or “non-profit.” Further supporting this definition was Minn. Stat. Ann. § 315, under which the institutions in question were chartered. With this distinction, the Panel specifically found that the Bankruptcy Court did not have the legal authority to substantively consolidate Debtor and the “Targeted Entities,” all of which were non-profits under state law.
III. A Deeper Look While the Panel’s reliance on Section 303’s prohibition seems straight forward, the quickness with which it reaches that legal conclusion may short change the circumstances of the case. The Committee’s motion detailed the centralized nature of the Archdiocese relationship with the Targeted Entities. According to the motion, the Bishop who heads the Archdiocese sits on the board of every Targeted Entity and wields control over almost every major decision. The Archdiocese requires prior approval before, among other financial transactions, the parishes:
[p]urchase any interest in real property; [t]ransfer or rezone any interest in real property; [e]nter into any loan; [g]rant any mortgage; [e]stablish any line of credit; [c]onsolidate or refinance any existing loan; [m]odify any existing mortgage, loan, or line of credit; [p]urchase personal property of $25,000 or more; [e]nter a lease of any kind for a term of longer than one year; … [g]rant contracts for deed; [b]uild any new structure on parish property; [r]enovate or restore any existing parish improvements; … [a]pprove construction change orders that increase costs by $5,000 or more; … [i]nitiate a capital fund campaign in which the total projected annual expenses exceed $25,000; [e]stablish any endowment.
The decision also quotes a priest that says,
In my time as priest and a Parish Administrator, I never felt or believed that the parishes had control over their own assets and operations. The Bishop and Archbishop always maintained direct and ultimate control. It was as if the parishes were merely departments in the Diocese or Archdiocese organization….
One wonders whether this variety of corporate control and centralized structure would doom a for profit entity in a similar situation. Would the Court have more closely followed its own ruling in In re Giller, 962 F.2d 796, 799 (8th Cir. 1992), where it affirmed a bankruptcy court’s decision to substantively consolidate six Chapter 11 debtors because that was the “only hope” of recovery for the unsecured creditors?
Or perhaps, the Giller example is not entirely applicable. After all, in Giller, all the parties that needed to be substantively combined were already in bankruptcy making it far less of a stretch to force them into a single case. As the Panel recognized, only the Ninth Circuit has directly addressed the substantive consolidation of debtors with non-debtors. Even the Panel itself recognized the limitations of its decision, leaving for another day the issue of whether a non-debtor that is the alter ego, the agent of a non-debtor principal, or that is part of a Ponzi scheme, can be consolidated. (Editor’s Note: Indeed, while second-guessing is never appreciated, The Bankruptcy Cave does wonder why instead of a motion for substantive consolidation was chosen as the procedural vehicle for such an important matter, the Committee didn’t instead file a complaint (or obtain standing and then file a complaint) seeking all of these other traditional state law remedies that debtors have against their affiliates?)
Three take-aways seem evident from the Case: 1) a bankruptcy court will not be afforded the opportunity to use its equitable powers to right a wrong where language in the Bankruptcy Code limits that power; 2) the corporate form offers protection, even in Bankruptcy, and 3) think carefully about how procedurally and substantively to go forward, and if in doubt, go with the more traditional approaches that allow for formal pleading and more relief.
In short, creditors beware. While the decision may not set the boundaries for substantive consolidation in every case, it provides needed insight into the level of scrutiny an appellate court will give efforts to bring non-bankrupt entities into a Chapter 11 case to serve as a means of recovery.
 Quote of Garrison Keillor found at: https://www.brainyquote.com/authors/garrison_keillor.
 Multiple references in the article are made to The Official Committee of Unsecured Creditors v. The Archdiocese of Saint Paul and Minneapolis et al. (In re The Archdiocese of Saint Paul and Minneapolis) Case No. 17-1079, 2018 WL 1954482 (8th Cir. April 26, 2018).
Some years ago, a judge in New York wrote that “the reported cases for replevin of a pet dog are few, in part because of the legal expense involved in maintaining such an action.” Webb v. Papaspiridakos, 889 N.Y.S.2d 884 (Sup. Ct. 2009). That statement was not entirely accurate then, for courts have dealt with canine replevin from time to time for decades. But in the years since Webb was decided—all nine of them—the court’s statement has come to seem remarkably naïve. A wave of replevin cases involving man’s best friend is upon us. What has changed during this relatively short period? Many people are saying that millennials own a lot more dogs today than they did in 2009. Disputing that theory would require a lot of research in a real library. [Editors’ Note: The Bankruptcy Cave does not subscribe to the theory that anything unpleasant may be blamed on millennials. For example, when a member of the Greatest Generation married a Gen Xer, their sole offspring was Stern v. Marshall, and it doesn’t get much worse than that.]
So let’s move on to the real point here. What useful lessons can we learn from the rich jurisprudence of canine replevin?
1. Contract language matters. A West Publishing syllabus that begins with “Alleged owner of dog brought action…” is a good indication that you’re headed into the world of canine replevin. The recent case of Patterson v Rough Road Rescue Inc, 529 S.W.3d 887 (Mo. App. 2017), demonstrates some of the pitfalls of this type of litigation, and many other types as well. Patterson involved a dispute between a dog-rescue organization and the family with which they placed a mutt named Jack, or maybe Mack. The parties signed an adoption agreement that had been prepared by the rescue group, apparently without a lawyer. The Pattersons didn’t read it before they signed it, and they didn’t keep a copy. Among other things, the agreement provided that the Pattersons would “provide a fenced yard” and that noncompliance with any terms of the contract “may void this contract … [a]nd could immediately give a representative of Rough Road Rescue, Inc. the authority to take possession of said animal.” Not surprisingly, litigation ensued when Mack escaped from the Pattersons’ yard, the rescue organization offered a reward for his return, and someone turned Mack in to the rescue group.
The trial court construed the contract as providing for the sale of Mack—a dog being a good (or a good dog, so to speak) under the Uniform Commercial Code—and concluded that the Pattersons had not breached the contract. It issued a writ of replevin, which the rescue group doggedly resisted, to the point that its principal was jailed for contempt of court. The court of appeals affirmed, remarking that “This Court admires the rescue group’s meritorious mission. But we do not admire their confusing contract.” Id. at 894. The court construed a number of ambiguities against the rescue group, including “may” and “could” in the operative provisions quoted above, and concluded that Mack should be returned to the Pattersons.
2. A good lawyer knows the law. A great lawyer knows geography. Marcia Graham’s dog, Harlee, ran away from her home in Spokane County. Someone found him along 44th Avenue and brought him to the Spokane animal shelter. James Notti adopted Harlee before Graham was able to track him down. Graham sued for replevin when Notti refused to turn over the dog to her. But 44th Avenue is the boundary between the city of Spokane and Spokane County, each of which has its own animal shelter and regulations governing the disposition of found animals. In Graham v Notti, 196 P.3d 1070, 1074 (Wash. App. 2008), the court determined that whether Harlee was found on the city side or the county side of the street was a disputed issue of material fact, because the city shelter could not have transferred valid title to a dog found outside the city limits.
3. Pay attention to the rules of pleading. The court in Vantreese v McGee, 60 N.E. 318 (Ind. App. 1901), had to wrestle with a difficult question: is the body of a dead dog subject to replevin? The court concluded that it is, but only after carefully distinguishing an Arkansas case standing for the proposition that salt cannot be replevied if it has been destroyed before suit is filed. The plaintiffs in Vantreese were awarded the body of their deceased family pet so that they might give it a proper burial on their farm. But it seems to have been important that they pleaded that “the hide is of the value of $1; [and] the carcass, exclusive of the hide, is of the value of $1 for fertilizing purposes.” Having “duly averred” the value of the property they sought, the plaintiffs defeated the defendants’ demurrer. Id. at 319.
4. An interlocutory order isn’t immediately appealable. Not even if a dog is involved. Well, maybe sometimes. Plaintiffs in Covatch v Cent Ohio Sheltie Rescue Inc, 61 N.E.3d 859 (Ohio App. 2016), sought replevin of their dog, Legacies Pipe Dream, from a rescue group. (And a full-fledged internet war commenced – here’s a sample of the serious blogging about this mad tale, including a picture of the dog at issue.) The litigation escalated quickly, with the rescue group accusing Covatch of burglarizing the home of the group’s principal, among many other torts. The trial court issued an order requiring the group to turn over the dog to Covatch immediately and suggesting that the other claims would be addressed separately. The rescue group appealed the replevin order, but the court of appeals dismissed for lack of a final judgment. The court suggested, however, that “deprivation of an animal’s companionship for a protracted period of time may lessen the effectiveness of an appeal following judgment,” in which case perhaps an interlocutory appeal would be permissible. Id. at 863. Because the rescue group acknowledged that it wasn’t seeking the immediate return of Legacies Pipe Dream, the answer to that question must await another day in Ohio.
5. Don’t forget about equitable principles.Gerhart v City of St Louis, 270 S.W. 680 (Mo. 1925), involved a plaintiff who didn’t seek replevin. Gerhart apparently wanted to test the validity of a city ordinance authorizing the marshal to deliver dogs from the city pound to local medical schools upon request. The poundmaster, who also was an officer of the Humane Society, was no fan of the ordinance either. And so it came to pass that a dog that may or may not have belonged to Gerhart was picked up, and the poundmaster refused to release him to Gerhart because of a pending request for dogs by a medical school. Gerhart filed suit, seeking to enjoin enforcement of the ordinance, but he didn’t ask the court to order the return of his dog. The dog wasn’t sent to the medical school, but it appears to have been euthanized in accordance with the pound’s regular procedures.
The appellate court noted wryly that “plaintiff preferred to try out a bill in equity with a dead dog as the moving cause, rather than take a simple legal remedy to recover the same.” The plaintiff’s failure to pursue his adequate remedies at law thus doomed his suit in equity.
6. If at first you don’t succeed, try again. But don’t try again in another state, because your initial loss may be given full faith and credit. Webb, the case discussed at the beginning of this post, represented the plaintiff’s third lawsuit to recover her dog, and she was finally successful after four years of litigation. Webb, 889 N.Y.S.2d 884; see also J.K.G. v. S.G., 922 N.Y.S.2d 742 (Civ. Ct. 2011) (describing plaintiff’s three suits to recover Macho on the basis that plaintiff lacked donative intent when he gave the dog to a friend while intoxicated and at his wit’s end). The facts of Herren v Dishman, 1 N.E.3d 697 (Ind. App. 2013), are more complex. The two parties lived in Indiana for a time with their dog, Sofie; then they all lived in North Carolina for less than two months, until the couple broke up; and then Dishman and Sofie returned to Indiana. Dishman threatened both Herren and Sofie with violence, so Herren obtained a protective order from a North Carolina court that included language granting her custody of any animal owned or held as a pet by either party. The police in Muncie enforced the order by removing Sofie from Dishman’s apartment, and Herren took her back to North Carolina. Unwilling to give up, Dishman filed a replevin action in Indiana, which Herren defended, pro se, largely on the basis of the North Carolina protective order. The small-claims court refused to consider the North Carolina papers, but the court of appeals held that the Full Faith and Credit Clause required the Indiana courts to enforce the order to the same extent that the North Carolina courts would have. Id. at 707.
7. Equity abhors a forfeiture, but sometimes the legislature loves one. Dogs have, “from time immemorial, been considered as holding their lives at the will of the legislature, and properly falling within the police powers of the several states.” Sentell v New Orleans And CR Co, 166 U.S. 698, 702 (1897). The cases discussed above demonstrate that lost dogs and self-help by rescue organizations can present tricky questions in replevin cases. But when regulatory agencies remove dogs from their owners, the issues may be very simple. For example, in Gonzalez v Royalton Equine Veterinary Services PC, 7 N.Y.S.3d 756 (A.D. 2015), the police, acting under a warrant, and the local SPCA removed a horse and three dogs from Gonzalez’s premises. The SPCA placed them for adoption after the plaintiff’s five-day redemption period under a state statute expired. When Gonzalez sued the new owners for replevin, the court rejected her argument that the SPCA was required to take judicial action to divest her of ownership, holding that the statute was self-executing. See id. at 757. The result was similar in In re Hoffman, Adv. No. 16-03222, 2017 WL 727543 (Bankr. S.D. Tex. Feb. 23, 2017). But Texas law is somewhat different and requires a hearing and a judicial determination of cruelty before an owner’s interest in an animal is terminated. Hoffman lost at his hearing and his horses were transferred by the court to the SPCA. He then sought relief under Chapter 12, but it was too late. The Rooker-Feldman doctrine limited him to jurisdictional attacks on the state-court proceedings, which were unsuccessful, and the bankruptcy court rejected his fraudulent-transfer claim, reasoning that he had no remaining interest in the horses when they were transferred to the SPCA. See Hoffman, 2017 WL 727543, at *5.
8. Never sell a dog on credit on a Sunday in New Jersey. The plaintiff in Foster v Behre, 146 A. 672 (N.J. 1929), sought to reclaim a dog named Red Bounce that he had sold to the defendant on credit, because the defendant didn’t pay. The court’s opinion doesn’t mention whether the plaintiff properly reserved a chattel mortgage in Red Bounce. That was irrelevant, because “if a sale occurred, it occurred on a Sunday.” Id. at 672. The effect of the blue laws on a contract made on a Sunday was so obvious to readers in 1929 that the court found it unnecessary to explain precisely why the law will not assist the parties to an illegal transaction.
The blue laws are not what they once were. But before you pursue a claim to recover a dog, be sure that your client hasn’t traded the dog for a sawed-off shotgun or lost him in an illegal poker game.
 Many issues are beyond the scope of this post. They include whether a defendant may invoke his Fifth Amendment right to counsel by saying, “I know that I didn’t do it so why don’t you just give me a lawyer dog.” See State v. Demesme, 228 So. 3d 1206 (La. 2017) (a real case – he may not; read here). There is the difficult question whether joint custody of a pet can be awarded in divorce proceedings. See Travis v. Murray, 977 N.Y.S.2d 621, 631 (Sup. Ct. 2013) (no; that would be “an invitation for endless post-divorce litigation”). And any litigator should be familiar with the “dog that didn’t bark” canon of statutory interpretation, derived from a Sherlock Holmes story. Church of Scientology v. IRS, 484 U.S. 9, 17-18 (1987).
 The court of appeals helpfully noted that all evidence favorable to the prevailing party in a bench-tried case must be accepted as true on appeal. Id. at 889 n.2. Because the trial court used the Pattersons’ preferred name, Mack, the appellate court did the same.
 Gerhart also includes the authoring judge’s aside that he has “kept in touch with dog law” since he began his career by recovering $50 from a defendant who shot his client’s dog. Id. at 682. Lest the reader think that this was the result of 19th-century jackpot justice, the judge notes that the dog was a “pure-bred Collie.” Id.
 At this point, the court of appeals seems to have been thrown off the scent, holding that Dishman should nevertheless prevail because the order did not apply to Sofie by its terms. The court reasoned that by the time Herren obtained the protective order, long after Dishman and Sofie had returned to Indiana, Sofie was not owned or held as a pet by Herren. See id. at 708. Why the court thought this was important is unclear, because the order plainly applied to pets owned or held by either party. See id. at 701.
 Hoffman involved many horses and no dogs, but the distinction is immaterial. But see Sentell, 166 U.S. at 701 (dogs “are not considered as being upon the same plane with horses, cattle, sheep, and other domesticated animals, but rather in the category of cats, monkeys, parrots, singing birds, and similar animals, kept for pleasure, curiosity, or caprice”).
 When I began my career in private practice, a distinguished senior partner in the firm distributed to new associates a list of rules. Most of them related to the practice of law, but we also were advised that “It is a sin to sell a dog.” The reader should consult his or her spiritual adviser for further guidance on this point.
 See http://www.nj.com/bergen/index.ssf/2017/06/countys_confusing_law_on_sunday_shopping_made_jeopardy.html
In In re Palmaz Scientific Inc., the bankruptcy court for the Western District of Texas determined that a confirmed plan of reorganization would not stop a group of investors from pursuing direct (non-derivative) claims against directors and officers of the debtor companies because plan injunction language only covered claims against the debtors. 2018 WL 1036780, at *5 (Bankr. W.D. Tex. Feb. 21, 2018) (slip op. at 11). Unfortunately for the investor plaintiffs, this proved to be a success without victory because the court went on to hold that the plan precluded the investors from using the D&O insurance proceeds to satisfy their claims. Id. at *7 (slip op. at 14). This case is both a cautionary tale for claimants and a potential boon for post-confirmation trustees.
When (and why) do D&O Insurance Proceeds become the coveted prize?
When D&O claims are asserted against a distressed company and/or its directors and officers, all parties look to the D&O insurance proceeds to satisfy their claims and/or fund their defenses. If the business seeks chapter 11 bankruptcy protection, the bankruptcy court must determine which parties are entitled to access and utilize such proceeds. Usually, the issue is framed for the court as a question of whether the D&O insurance proceeds constitute property of the bankruptcy estate, but, ultimately, the real question is whether the proceeds are available to satisfy claims against a debtor and/or its directors and officers. Post-confirmation (after a bankruptcy plan has been approved by the court), investors and equity holders of a failed business may find themselves fighting with a post-confirmation trustee for access to D&O insurance proceeds. In this scenario, the post-confirmation trustee will almost always claim that the policy and its proceeds belong to the post-confirmation trust because D&O insurance policies are often wasting policies (and one of the most valuable assets available to post-confirmation trusts). Of course, D&O claimants, as well as directors and officers, will disagree. To them, D&O insurance policies are the very source of proceeds that was purchased in order to protect and benefit directors and officers and D&O claimants.
How do courts typically determine who the prize winner is?
To resolve the “proceeds” dispute, bankruptcy courts look to the language of the confirmed plan, the confirmation order, and any trust agreement (that transfers assets from the bankruptcy estate to the post-confirmation trust). The analysis usually consists of determining whether the D&O claims belong to the post-confirmation trustee (as opposed to investors, equity holders or any other potential plaintiffs). Thus, depending on the types of claims asserted (for example, direct versus derivative) and the language of the governing documents, bankruptcy courts may prevent or enjoin “would be” plaintiffs from proceeding with their claims against debtors and/or former directors and officers. Indeed, in relatively recent years, post-confirmation trustees have been losing the battle over insurance proceeds when the claims asserted are direct rather than derivative. See, e.g., In re SemCrude, L.P., 2011 WL 4711891 (Bankr. D. Del. Oct. 7, 2011) (“Sem Crude I”) (claims were derivative, and, thus, property of the estate that had been transferred to the post-confirmation trustee, because the plaintiffs’ alleged injury was the same as the harm the debtor suffered), and subsequently aff’d, 796 F.3d 310 (3d Cir. 2015) (“Sem Crude II”); see alsoIn re Palmaz Scientific Inc., 562 B.R. 331, 63 Bankr. Ct. Dec. (CRR) 99 (Bankr. W.D. Tex. 2016) (direct claims were not covered by the plan injunction but other claims that were common to all investors, and therefore derivative, were subject to the injunction and could only be asserted by the trustee).
Can the prize winner be the loser?
Based on Palmaz, a claimant may be entitled to pursue D&O claims but unable to access D&O insurance proceeds. See In re Palmaz Scientific Inc., 2018 WL 1036780, at *5-*7 (Bankr. W.D. Tex. Feb. 21, 2018) (slip op. at 11-14). Of course, this is like saying “you can have the car, but not the keys.” So, how can this happen? In short, the holding in Palmaz was based on a particular plan provision that was quite possibly initially understood by all parties to mean one thing but later interpreted by the court to mean another.
Before the bankruptcies were filed, a group of investors sued the debtors and two directors and officers. The action was stayed (temporarily put on hold) when the bankruptcy petitions were filed, but came back to life after the bankruptcy court approved the debtors’ joint plan. As is often the case, the debtors’ confirmed plan created a litigation trust and transferred certain of the debtors’ assets, including D&O claims, to the litigation trust. The plan defined D&O Claims to include claims against Debtors but not former directors and officers, so the investor plaintiffs amended their state court complaint to drop claims against the debtors (presumably because these claims were understood to belong to the post-confirmation trust). With their live complaint against only the directors and officers, the investor plaintiffs made a demand on their D&O claims against the debtors’ D&O insurance policy. The insurance company sought a declaratory judgment from the bankruptcy court to determine whether the demand violated the confirmed plan’s bankruptcy injunction, and the litigation trustee joined in the motion. None of this is unusual; however, the litigation trustee argued that the post-confirmation trust controlled all of the D&O insurance recoveries. This argument probably came as a surprise to the investor plaintiffs.
Specifically, the litigation trustee argued that the investors’ demand for insurance coverage (i) violated the plan’s bankruptcy injunction; and (ii) interfered with the litigation trustee’s right to control D&O insurance recoveries. In response, the investor plaintiffs relied on a line of cases that hold “even where insurance policies themselves are property of the estate, non-debtor insureds have a right equal to the debtor to the benefits provided by such policies.” Id. at *7 (citations omitted) (slip op. at 14). The bankruptcy court found these cases were inapplicable because “none of those cases involve[d] plan provisions similar to those [that were] before the Court,” and ultimately, ruled in favor of the post-confirmation trustee. Id. Ultimately, the court rejected the post-confirmation trustee’s first argument and accepted the second because the plan gave the litigation trustee the right to control D&O claims “and all D&O Insurance Recoveries.” Id. at *6 (slip op. at 13). The language actually used in the plan was as follows:
“The right to control the D&O Claims and all D&O Insurance Recoveries, including negotiations relating thereto and settlements thereof, shall be vested in the Litigation Trust on and after the Effective Date.”
Id. at *7 (slip op. at 13). Significant to the court’s decision was the plan’s broad definition of D&O Insurance Recoveries, which included “the right to pursue and receive the benefits and/or proceeds of the D&O Insurance Policies.” Id. According to the express plan provisions, the post-confirmation trustee did not have the exclusive right to assert claims against former directors and officers but had all rights with respect to any and all D&O insurance proceeds. Practically speaking, then, the investor plaintiffs’ legal ability to pursue their claims was of little value to them because the proceeds were not available to them.
Is there any real prospective power behind the punch in Palmaz?
Palmaz suggests that post-confirmation trustees may be able to control D&O insurance proceeds, keeping the proceeds all to themselves, by negotiating for a simple plan provision. Of course, this would benefit all post-confirmation trustees because they are responsible for maximizing the value of trust assets in order to increase distributions to trust beneficiaries. However, Palmaz puts potential claimants on notice that plan provisions may – intentionally or unintentionally – give post-confirmation trustees any and all rights over any and all proceeds of D&O insurance policies (regardless of the types of claims asserted). Based on mere speculation, the parties in Palmaz likely intended for the post-confirmation trustee to have control over all D&O Insurance Recoveries with respect to D&O Claims belonging to the post-confirmation trust. In other words, the parties probably did not expect for the post-confirmation trustee to have control over proceeds that related to direct claims against directors and officers. Going forward, in light of Palmaz, claimants and other parties in interest will likely pay closer attention to plan provisions that relate, even tangentially, to D&O claims, policies, proceeds, and recoveries.
On top of providing a cautionary tale and a potential tool (or trick) to be used by post-confirmation trustees, does Palmaz permit post-confirmation trustees to control insurance proceeds without showing that the proceeds – as opposed to the policies – were property of the debtors’ estates (and, therefore, property of post-confirmation trusts)? Maybe, but the clear takeaway is that in cases where debtors have D&O insurance policies, parties should carefully review all relevant plan provisions to make sure they are – or are not – similar to the one used in Palmaz. At a minimum, Palmaz is a reminder that the pen is powerful.
Pictured: Forget about the pounds; think about corporate governance.
Editor’s Note: The April 1, 2018 merger of US-based Bryan Cave and UK-based Berwin Leighton Paisner provides us with far greater insight into cross-border insolvencies, an expertise to handle any restructuring, workout, or dissolution matters in the US, UK, Europe, Russia, UAE, Israel, China, and other points in the Far East. For more information, contact Tessa or Sophie (the authors of this post), or visit here.
Following a number of corporate governance failures in situations of insolvency, the Government has published a consultation paper (located here) aimed at cracking down on directors and employers behaving irresponsibly. “These reforms will give the regulatory authorities much stronger powers to come down hard on abuse and to make irresponsible directors bear the consequences of their actions.” Greg Clark
Responses are required by 11 June 2018.
Sale of Businesses in Distress
Although directors of an insolvent company must act in the best interests of that company’s creditors, there is no wider duty in a group context.
To encourage directors selling an insolvent subsidiary within a corporate group to consider subsidiary stakeholder interests, the Government proposes that holding company directors should be held to account if they conduct a sale which harms the subsidiary’s employees/creditors and that harm was reasonably foreseeable at the time of sale.
Directors would only suffer penalties (disqualification and personal liability) in exceptional situations ie. where the group subsidiary was in financial difficulty; the directors could not reasonably have believed that the sale was in the interests of creditors; the group subsidiary subsequently entered into administration or liquidation; and the harm that should have been foreseen has occurred with creditors suffering losses. However, liability would cease two years from the date of sale.
Value extraction schemes
The Government is seeking views on extending the antecedent recovery powers of insolvency office-holders by allowing them to apply to court to reverse a connected party transaction which unfairly strips value from an ailing company. These powers would only apply where the company (i) had received an investment; (ii) had value extracted in a transaction(s) designed for the benefit of the investor (eg. excessive interest on loans or management fees) without adding value to the company; and (iii) subsequently enters liquidation/administration.
Investigation into the actions of directors of dissolved companies
This section explores Government proposals to extend existing investigative powers into the conduct of directors to cover situations where directors avoid accountability by allowing their companies to be dissolved instead of putting them into a formal insolvency process. The proposals envisage the scope of the current investigation and enforcement regime being extended to include former directors of dissolved companies. This will avoid the need to first restore a company to the Register of Companies.
Strengthening corporate governance in pre-insolvency situations
The Government considers a number of areas of corporate governance law including:
Group structures – are stronger corporate governance and transparency measures required in relation to the oversight and control of complex group structures?
Shareholder responsibilities – bearing in mind recent corporate failures, should large institutional shareholders be more actively engaged with long term company strategies?
Payment of dividends – does the definition of ‘distributable profits’ remain fit for purpose to avoid situations where companies can pay out large dividends just before they become insolvent?
Directors duties – are directors commissioning professional advice without being fully aware of their duties as directors?
Protection of companies in the supply chain – should more be done to help protect payments to SMEs in a supply chain in the event of insolvency of a customer?
This consultation paper is a good opportunity to get an advanced view of hot corporate governance topics for UK companies in or approaching insolvency; we recommend it highly to those regularly in the insolvency field, and even more highly to those who find themselves in the insolvency field unexpectedly.
Providing an exception to the axiom that no good deed goes unpunished (a wonderful phrase courtesy of Clare Booth Luce, author, Ambassador, speaker, and a model for our times even thirty years after her death), a Texas bankruptcy court recently declared nondischargeable a debt owed to a guarantor who had been forced to pay the debtor’s defaulted student loan.
The case, De La Rosa v. Kelly (Adv. Pro. No. 17-03320 (In re Kelly, Case No. 17-32295)) was resolved by the U.S. Bankruptcy Court for the Southern District of Texas by way of summary judgment on March 23, 2018. The debtor, Tabitha Renee Kelly, borrowed $6,292 from the Texas Higher Education Coordinating Board in 2002 to pay educational expenses. The plaintiff in the adversary proceeding, Mary A.V. De La Rosa, a longtime acquaintance of Kelly who attended the same church, agreed to guaranty the loan.
Kelly defaulted on the loan and the lender sued De La Rosa, as guarantor, in 2016. De La Rosa resolved the suit by paying the loan in full, $12,136.80. Kelly and her husband filed a Chapter 13 bankruptcy case in 2017. De La Rosa filed an adversary proceeding seeking to have the debt declared a nondischargeable student loan debt under Bankruptcy Code § 523(a)(8)(ii), which expanded nondischargeability of student loans to non-governmental obligees.
In granting summary judgment to De La Rosa, the court noted that in order to prevail, De La Rosa was required to prove that Kelly was obligated to repay the funds, that the funds had been received for an educational purpose, and that De La Rosa had standing to sue. Even in the face of such proof, the debt could still be discharged if Kelly could prove repayment would constitute an undue hardship. The court stated that there was no dispute as to the obligation to repay the loan and its receipt for educational purposes and that Kelly never alleged undue hardship.
The only issue to be resolved by the court was De La Rosa’s role in the loan and whether it conferred standing to enforce the nondischargeability provisions of Bankruptcy Code § 523(a)(8)(ii). Kelly argued that De La Rosa was, in fact, a co-maker or co-borrower and not entitled to seek nondischarge under the student loan provisions of the Bankruptcy Code. The court concluded that De La Rosa was an accommodation party under Texas law, in part because she had received no direct benefit in return for guarantying the loan. As an accommodation party, the court concluded that De La Rosa was and entitled to bring the nondischarge action.
The court noted that there was no binding precedent regarding accommodation parties, but found two earlier cases addressing the issue to be persuasive. The cases, Benson v. Corbin (In re Corbin), 506 B.R. 287 (Bankr. W.D. Wash. 2014) and Brown v. Rust (In re Rust), 510 B.R. 562 (Bankr. E.D. Ky. 2014), both involved co-signers who had received no consideration for co-signing for a student loan and who had had to pay the loan in full when the borrower defaulted. In both cases, the debt to the co-signors was declared nondischargeable.
The court rejected as unpersuasive an opinion that had found a co-signer to be a co-borrower who could not invoke the non-discharge provision of Bankruptcy Code § 523(a)(8)(ii). The opinion, Gorosh v. Posner (In re Posner), 434 B.R. 800 (Bankr. E.D. Mich. 2010), was deemed unpersuasive because it relied on two other cases, Resurrection Medical Center v. Lakemaker (In re Lakemaker), 241 B.R. 577 (Bankr. N.D. Ill. 1999) and Santa Fe Medical Services, Inc. v. Segal (In re Segal), (57 F.3d 342 (3rd Cir. 1995), both of which involved employers who had assumed physicians’ educational debt as part of an employment compensation package rather than co-signers or guarantors who derived no direct benefit from the student loan. The Posner opinion, the court also stated, failed to take into account the Congressional intent to broaden the protections provided by Bankruptcy Code § 523(a)(8)(ii) to include accommodation parties.
As a practical matter, to increase the likelihood that a debt arising from a third party’s student loan would be declared non-dischargeable, it is probably advisable to assume the role of guarantor rather than co-signer, so as to discourage an argument that the guarantor is a co-borrower. It is also advisable to include recitations in the guaranty that the loan is for educational purposes and that the guarantor is receiving no direct benefit from the loan.
Editors’ Note: The upcoming merger between Berwin Leighton Paisner and Bryan Cave will create a 1500 lawyer, fully integrated firm with best-in-class offices in the US, UK, Europe, Russia, Hong Kong, and the UAE. The combined Firm, to be known as Bryan Cave Leighton Paisner LLP, will have particular strengths in real estate, financial services, litigation, and corporate practices. Most importantly for followers of The Bankruptcy Cave, this merger will result in a cadre of restructuring professionals able to handle insolvencies matters around the globe, with proven expertise in cross-border workouts, restructurings, and any other insolvency featuring international flavors. We look forward to speaking with you any time on any insolvency matter that includes any cross-border implications.
In Wright (and another) (as joint liquidators of SHB Realisations Ltd (formerly BHS Ltd) (in liquidation)) v Prudential Assurance Company Ltd, the court held that, when the BHS CVA terminated, the landlord was entitled to claim the full rent due under its lease. With more recent retail CVAs seeking to push the envelope even further, is the continued compromise of landlord creditors post-CVA the next issue to be tested in the courts?
On 6 March 2018 the court heard an application for directions from the joint liquidators of SHB Realisations Limited (in liquidation) (formerly BHS Limited and referred to in this article as “BHS”). BHS was the principal trading company of the BHS group. BHS had entered into a company voluntary arrangement (“CVA”) with its creditors under which certain landlords agreed to accept lower rents. The CVA was terminated, on its terms, for non-payment of the compromised rent to landlords, following BHS moving from administration to liquidation. The question before the court was whether landlords were entitled to claim the full amount of rent due under their leases or only the compromised rent agreed under the CVA.
4 March 2016
BHS proposes a CVA.
23 March 2016
The CVA is approved by the members and creditors of BHS.
25 April 2016
BHS goes into administration with the CVA continuing to run in parallel.
3 August 2016
The joint administrators vacate the relevant properties.
2 December 2016
BHS moves from administration into creditors’ voluntary liquidation.
16 December 2016
Following the service of notices under the CVA in connection with non-payment to landlords, the CVA is terminated.
What was the dispute?
The BHS CVA provided that certain landlords would receive less than the full amount of rent due under their respective leases. On termination of the CVA:
“…the compromises and releases effected under the terms of the CVA shall be deemed never to have happened, such that all Landlords and other compromised CVA Creditors shall have the claims against [BHS] that they would have had if the CVA Proposal had never been approved (less any payments made during the course of the CVA)”.
As a result of the CVA terminating on 16 December 2016, the landlord claimed that:
it was entitled to recover the full amount of outstanding rent payable under the relevant leases (less any amounts received during the CVA) and not just the compromised rent permitted by the CVA;
where the rent had accrued during the joint administrators’ occupation of the relevant property (from 25 April to 3 August 2016), that should be paid as an administration expense;
where the rent had accrued when the joint administrators’ were not in occupation, that should rank as an unsecured claim.
The subsequently appointed joint liquidators of BHS sought the court’s direction on the issue.
What was the decision?
The court agreed with the landlord.
It held that, following termination, the landlord was entitled to claim the full amount of outstanding rent (less any amounts received under the CVA), not just the compromised rent. The amount attributable to the period when the joint administrators were in occupation of the premises should be paid as an administration expense, with the remainder to rank as an unsecured claim.
Why is this case interesting?
The decision itself was made largely on the facts of the case and the wording of the termination clause. However, it provides a very timely reminder of the fact that “…a variation of a lease granted by deed has to be by deed”. A CVA is not a deed; it is, or operates as, a contract (albeit a hypothetical one) and is not a variation of the lease itself.
Starting with Toys “R” Us in December 2017, 2018 looks set to be the year of the CVA, especially in the retail and casual dining sectors. Unlike BHS, a number of the CVAs we have seen in 2018 so far expressly purport to extend the landlord compromise beyond any termination of the CVA. This seems somewhat inconsistent with the bargain between a debtor and its creditors which sits at the core of CVAs, which is that the creditor accepts a compromise to help the debtor avoid an insolvency, not to worsen its position in an insolvency (which is textbook unfair prejudice). It can also lead to absurd results which cannot have been intended. For instance, imagine the scenario where a CVA is approved, but then successfully challenged on unfair prejudice grounds. Can it be right that a creditor continues to be compromised even though unfair prejudice has been demonstrated?
With Toys “R” Us now also in administration, we look ahead with interest to see how the administrators and creditors will navigate the CVA.
The Restructuring & Insolvency team at BLP have had significant roles for landlords and other creditors on all the recent retail and casual dining CVAs. If you would like to know more about CVAs or Restructuring & Insolvency generally, please contact Ben Jones at email@example.com.
In the typical day-to-day experience in bankruptcy proceedings, the debtor’s ability to assume or reject executory contracts and leases under Section 365 of the Bankruptcy Code is seen from the sometimes-unfortunate perspective of the creditor. To the creditor’s perspective, the prohibitions of the automatic stay, periods of time during which treatment of the contract is uncertain, struggling to acquire adequate protection, a loss of control over who the contract may be assumed and assigned to, and the alternative of being rejected and left with a deemed prepetition claim, all combine to an undesirable scenario.
As misery loves company, two recent cases have illustrated that the requirements and operations of Section 365 can also result in disappointment to a debtor estate seeking contract damages and to a civil action plaintiff seeking compensation for appropriation of its intellectual property.
In Lauter v CITGO Petroleum Corp.,  a United States District Court dismissed a claim based upon a post-petition breach of contract because the debtor’s rejection of such contract also ended the debtor’s ability to bring claims for post-petition breach. In Stanley Jacobs Production, Ltd. v. 9472541 Canada, Inc.,  a Delaware Bankruptcy Court determined that a defendant who had utilized the plaintiff production company’s infomercials after purchasing assets of a debtor could not be liable to plaintiff for royalties under the debtor’s contract because the debtor had not assumed and assigned the agreement, nor could there be an implied assumption and assignment of a debtor’s executory contract.
Treatment of executory contracts and leases under Section 365 is a broad topic. In general terms:
Section 365 allows the bankruptcy estate, through the trustee or debtor in possession, to do three things with an executory contract: (i) reject it, (ii) assume it or (iii) assume and assign it.
If the estate rejects the contract, the rejection is deemed to constitute a material breach of the contract occurring the day before the filing of the bankruptcy petition, Section 365(g)(1), and the non-debtor party receives pre-petition claim for damages arising from such breach. So, rejection converts the non-debtor contract party into an unsecured creditor. Sections 365(g), 502(g).
If the estate assumes the contract, the estate is required to cure all defaults or to provide “adequate assurance” that such defaults will be promptly cured, and is committed to perform on a going-forward basis. Section 365(b)(1)(A).
Assumption of the contract is a prerequisite to the estate’s ability to assign the contract. Section 365(f)(2)(a).
Procedurally, a party must submit a motion for court approval to properly assume or reject an executory contract. Fed. R. Bankr. P. 6006, 9014 (procedures for filing a motion to approve or reject an executory contract).
Because the essential purposes of the Bankruptcy Code include giving the debtor “breathing room,” and a “fresh start” or opportunity to reorganize its debts, it should come as no surprise that the above-stated factors of Section 365 are all unpleasant for creditors. Creditors can end up compelled to perform an agreement that is later rejected in exchange for an unsecured claim of dubious value, or having to perform under an assumed contract with dubious “adequate assurance,” or having their contract assigned to a party they would not have chosen to do business with.
But the recent Lauter and Stanley Jacobs cases illustrate that Section 365 is truly a gift that keeps on giving, and the same substantive and procedural factors can also reach out to work to the detriment of legal parties other than typical creditors of the estate.
The Lauter case involved a corporate Chapter 11 debtor that operated a service station and a contract with the debtor’s petroleum supplier. In the underlying bankruptcy case, the debtor sold substantially all its assets, rejected many executory contracts including the supplier’s agreement, then confirmed a Chapter 11 Plan that specifically preserved and transferred claims for breach of contract against the supplier to the post-confirmation trust. In due course, the post-confirmation trust sued the supplier on claims including material post-petition breaches of the supply contract.
However, the trust’s claim for post-petition breaches of the supply contract were dismissed by the court because the debtor’s rejection of the supply contract effectively divested the debtor and the trust from standing to sue for post-petition breach. The Court reasoned that the debtor’s rejection of the supply contract constituted a material breach entitling the supplier to a dischargeable, unsecured, pre-petition claim and “relieved both the [debtor] and [supplier] from post-petition performance.” Therefore, the rejection “not only relieved the estate of its post-petition performance obligations, but also relieved the estate of its ability to assert claims for post-petition breaches thereof.”
The Stanley Jacobs case involved a corporate Chapter 15 debtor that used television ads in that sale of consumer products and a “Production Agreement” contract with a producer that created infomercials for such products. The contract included an obligation of the debtor to pay royalties for use of the infomercials. In the course of the bankruptcy case, the debtor sold substantially all of its assets. While the debtor had the explicit right to assign the contract, the debtor did not include the contract as one being assumed and assigned in the sale. The debtor also did not advise the producer of the sale, and the producer was unaware of the bankruptcy until after the sale.
However, the sale purchaser did use one of the infomercials, and the producer responded by filing a district court lawsuit to recover royalties from the purchaser under the contract. The district case was transferred from its California venue and referred to the Delaware bankruptcy court. The plaintiff producer asserted that the contract royalties were binding upon the purchaser because the purchaser’s course of conduct and continued actual use of the infomercial yielded an implied assumption of this executory contract.
The Delaware court addressed the proposition of implied assumption with significant criticism and authority. While acknowledging the existence of cases supporting the doctrine of implied assumption, the court characterized the issue as “unsettled” and “hazy” and one that would “force courts to meddle in the fact-laden intricacies of transactions.” The court expressed the concern that the use of implied assumption brings undesirable uncertainty to the parties, and relied on authorities treating Section 365 and Fed. R. Bankr. P. 6006 as (i) requiring the formalities of assumption and rejection, and (ii) effectively overruling cases that may have recognized implied assumption and rejection. The Court specifically held that “continued use does not obviate the need for a formal motion to assume,” further stating, “there simply cannot be an assumption without providing the necessary cure or adequate assurance of one.”
There are two postscripts of note regarding these cases. The loss of standing via rejection set out in the Lauter case is not plenary, and clearly would not apply to any prepetition breach. As for the plaintiff in Stanley Jacobs, beyond the contract royalties claim here discussed, there are other theories of recovery that do not require contractual privity available against a person is unjustly enriched by appropriation of another’s property without compensation.