Bryan Cave’s restructuring attorneys are on the leading edge of complex Chapter 11 matters, workouts, distressed M&A, creditors’ rights and insolvency-related litigation. Our Bankruptcy Cave blog provides real-time analysis of critical issues for those involved in the world of insolvency, and we bring these same skills to bear in all client engagements the harder, the better.
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.
Pictured: Reno Nevada’s The Villages at Lakeridge, a great investment for non-statutory insiders, or for anyone else!!
Last April, we updated you that the Supreme Court had granted review of In re The Village at Lakeridge, LLC, 814 F.3d 993 (9th Cir. 2016). Our most recent post is here.
On March 5, 2018, the Supreme Court held a clear-error standard of review should apply to a review of a determination of non-statutory insider status. U.S. Bank Nat. Ass’n v. Vill. at Lakeridge, LLC, No. 15-1509, ___ S. Ct. ___2018 WL 1143822, at *2 (U.S. Mar. 5, 2018).
As a refresher, in Village at Lakeridge, in exchange for $5,000, an insider (Bartlett) transferred a $2.76 million claim against the debtor to an individual (Rabkin) who was not a statutory insider. 814 F.3d at 997. The debtor argued that the assignee of the insider claim (who voted in favor of the debtor’s plan) provided the debtor an impaired, consenting class for purposes of cramdown under 11 U.S.C. § 1129(b). U.S. Bank moved to designate the assignee’s claim on the basis that he was both a statutory and non-statutory insider (including because Rabkin and Bartlett were, or had been, romantically involved), and that the assignment was made in bad faith. Id. at 997-98. The bankruptcy court designated the claim and ruled that the assignee was not entitled to vote because, when the claim was assigned, the assignee acquired the insider status of the assignor as a matter of law. Id. at 998. However, the bankruptcy court ruled that the assignee was not himself an insider and the assignment was not made in bad faith. Id.
The United States Bankruptcy Appellate Panel for the Ninth Circuit reversed the bankruptcy court’s ruling that the assignee acquired insider status by way of assignment and affirmed the bankruptcy court’s determinations that the assignee was not himself an insider and the assignment was not made in bad faith. Id.
In the Ninth Circuit, a creditor qualifies as a non-statutory insider if two conditions are met: “(1) the closeness of its relationship with the debtor is comparable to that of the enumerated insider classifications in [Section 101(31) of the Bankruptcy Code], and (2) the relevant transaction is negotiated at less than arm’s length.” In re Village at Lakeridge, LLC, 814 F. 3d 993, 1001 (9th Cir. 2016). The Bankruptcy Court, as affirmed by the Ninth Circuit, determined that because the transaction was found to be at arm’s length, the creditor was not an insider under the Ninth Circuit test. Id. at 1002-1003.
As we advised you last year, the Supreme Court granted review on only one issue, framed by U.S. Bank as follows: “Whether the appropriate standard of review for determining non-statutory insider status is the de novo standard of review applied by the Third, Seventh and Tenth Circuit Courts of Appeal, or the clearly erroneous standard of review adopted for the first time by the Ninth Circuit Court of Appeal in this action.” U.S. Bank’s Petition for a Writ of Certiorari, at i.
Writing for a unanimous Supreme Court, Justice Kagan was careful to note that they were not reviewing the Ninth Circuit’s test for determining non-statutory insider status. Village at Lakeridge, Slip Op. at 6 (“We do not address the correctness of the Ninth Circuit’s legal test; indeed, we specifically rejected U. S. Bank’s request to include that question in our grant of certiorari. . . . We simply take that test as a given in deciding the standard-of-review issue we chose to resolve.).”
Justice Kagan then stated the all parties – and the Supreme Court – were in agreement that the “historical facts” were reviewed deferentially. Id. These facts included the Bankruptcy Court’s findings about Rabkin’s relationship with Bartlett (e.g., that they did not “cohabitate” or pay each other’s “bills or living expenses”) and his motives for purchasing the insider’s claim (e.g., to make a “speculative investment”). Id. at 6-7.
When a legal standard is applied to historical facts, a “mixed question” of law and fact arises. “[W]hen applying the law involves developing auxiliary legal principles of use in other cases—appellate courts should typically review a decision de novo.” Id. at 8 (citing Salve Regina College v. Russell, 499 U. S. 225, 231–233 (1991)).
However, a deferential, clear error standard is appropriate where case-specific factual issues prevail—“compelling them [appellate courts] to marshal and weigh evidence, make credibility judgments, and otherwise address what we have (emphatically if a tad redundantly) called ‘multifarious, fleeting, special, narrow facts that utterly resist generalization.’” Id. (citing Pierce v. Underwood, 487 U. S. 552, 561–562 (1988) (internal quotation marks omitted)).
Justice Kagan boiled down the issue before the court to a single question: “Given all the basic facts found, was Rabkin’s purchase of MBP’s claim conducted as if the two were strangers to each other?” Id. at 10. The Supreme Court concluded: “That is about as factual sounding as any mixed question gets[,]” and held the clear-error standard of review applied. Id. at 10-11.
But the fun doesn’t end with Justice Kagan’s opinion. Justice Kennedy wrote a short, concurring opinion that stressed the court was only ruling on the standard of review, and should not be read to approve of the test used by the Ninth Circuit. Id. (Kennedy, J., concurring).
Justice Sotomayor wrote a lengthier concurrence in which Justices Kennedy, Thomas, and Gorsuch joined. Justice Sotomayor affirmatively questioned whether the Ninth Circuit applied the correct test, but acknowledged that the Supreme Court declined to grant certiorari on that issue. Id. at 2 (Sotomayor, J. concurring).
Because the Ninth Circuit’s test is phrased in the conjunctive, a creditor would not be an insider under such test if the transaction was at arm’s length even if the closeness of the creditor’s relationship with the debtor is comparable to that of the statutory insiders. Id. This troubled Justice Sotomayor, who noted that the Code presumes lack of arm’s length to statutory insiders. A creditor who is substantially similar to a statutory insider (e.g., a romantic partner of an insider who in all respects acts like a spouse) can nevertheless conclusively foreclose a finding of insider status (at least in the Ninth Circuit) by showing the transaction was at arm’s length. Id. at 3-4 (Sotomayor, J. concurring).
Justice Sotomayor then states she can conceive of “at least two possible legal standards that are consistent with the understanding that insider status inherently presumes that transactions are not conducted at arm’s length.” They are:
First, it could be that the inquiry should focus solely on a comparison between the characteristics of the alleged non-statutory insider and the enumerated insiders, and if they share sufficient commonalities, the alleged person or entity should be deemed an insider regardless of the apparent arm’s-length nature of any transaction.” Cf. In re Longview Aluminum, LLC, 657 F. 3d 507, 510–511 (7th Cir. 2011) (considering only whether a manager of a debtor corporation was comparable to the enumerated insiders, regardless of whether any transaction was conducted at less-than-arm’s length).
Second, it could be that the test should focus on a broader comparison that includes consideration of the circumstances surrounding any relevant transaction. If a transaction is determined to have been conducted at less-than arm’s length, it may provide strong evidence in the context of the relationship as a whole that the alleged non-statutory insider should indeed be considered an insider. Relatedly, if the transaction does appear to have been undertaken at arm’s length, that may be evidence, considered together with other aspects of the parties’ relationship, that the alleged non-statutory insider should not, in fact, be deemed an insider.
Id. at 4-5 (Sotomayor, J. concurring). Justice Sotomayor then noted that if the appropriate test for determining non-statutory insider status were different from the one articulated by the Ninth Circuit, then “the applicable standard of review would be different as well.” Id. at 5 (Sotomayor, J. concurring).
For now, the clear error standard applies to a review of a determination of non-statutory insider status. But practitioners should be mindful that several Supreme Court justices openly question the Ninth Circuit test, and appear willing to changing the standard of review should a different test arise.
Any first-year law student could attest that understanding what the law is can be a difficult task, in part because the law is not always applied consistently by courts. This problem gives rise to a maxim law professors often invoke (sometimes citing Justice Oliver Wendell Holmes, a proponent of this maxim) when questioned about the law’s occasional incoherence: “hard cases make bad law.” The idea is that courts are sometimes tempted to skirt the proper application of the law when the result seems harsh or unfair. Typically, this happens when a court is faced with a particularly sympathetic party who happens to be on the wrong side of the dispute. Although the court’s desire to avoid a harsh outcome is laudable, if the court allows this desire to distort its interpretation of the law it allows other (often less sympathetic) parties to avoid proper application of the law as well. At a minimum, when the law is applied inconsistently it creates confusion and ambiguity, for which future parties will need to spend time and money litigating simply to figure out their legal rights .
In the recent case of In re Kunkel, 17-5781-SWD, 2018 WL 735929 (W.D. Mich. Feb. 5, 2018), one bankruptcy court prudently upheld the integrity of the judicial system by faithfully applying the letter of the law in an important legal area (contractual setoff rights), even though doing so may have deprived two young children of their life savings. Ms. Kunkel was a member of the Michigan State University Federal Credit Union (the “Credit Union”), with whom she maintained a VISA credit card account. Ms. Kunkel’s two minor children were also members of the Credit Union, having opened “Lil’ Sweet Pea” savings accounts in 2006. The Credit Union’s decision to offer such accounts to children under the age of five was undertaken to teach children a lesson about saving for the future. (As the kids aged, they could move up to the Credit Union’s “Dollar Dog” accounts, and then as teenagers, could enroll in “Cha-Ching” accounts – we are not kidding, check out these promos here.) Sadly, the lesson learned by Ms. Kunkel’s children in this case was not a positive one.
On December 20, 2017, Ms. Kunkel and her husband found themselves in financial trouble, and filed chapter 13 bankruptcy cases. Before doing so, Ms. Kunkel had racked up $11,068 in credit card debt using her Credit Union VISA account. Unfortunately for the Kunkel children, who were less than five years old when their accounts were first opened, their mother was named as a joint owner on their Lil’ Sweet Pea savings accounts. By the time of their mother’s bankruptcy, the children were between the ages of ten and sixteen, and had saved about $11,000 between their accounts. Because their mother was a joint owner, the Credit Union sought to apply the children’s money against their mother’s credit card debt, citing a provision in Ms. Kunkel’s membership agreement which gave the Credit Union a setoff right against any account in which Kunkel was a joint owner, notwithstanding the source of the funds in that account.
When the Credit Union moved the bankruptcy court for relief from the automatic stay to apply its setoff right, the law was clearly on the Credit Union’s side. Ms. Kunkel’s failure to timely pay her credit card bills and the Credit Union’s contractual rights were legally sufficient to establish “cause” to lift the stay. Even assuming that the money represented eleven years’ worth of birthday card money and lemonade stand revenue, because it was held in a joint account, the law treats the children as non-recourse guarantors, having in effect pledged their interest in that money as collateral for their mother’s debt.
Despite its recognition that the law required it to rule in favor of the Credit Union, the court made no effort to hide its views of the “unseemliness of shucking the ‘Lil’ Sweet Pea’ accounts to pay the debts of the Children’s mother.” The court emphasized that it would not rule on the merits “or advisability” of the proposed setoff, requiring the parties to “pursue their state court rights, or not, as they see fit.” The court also hinted its apparent preference that Ms. Kunkel and the Credit Union instead negotiate a new chapter 13 plan “to accommodate the needs of all interested parties, including the Children.” With its final expression of disapproval, the court refused to make its decision effective immediately, allowing the stay to remain effective for 14 additional days under Bankruptcy Rule 4001(a)(3) despite having little basis to believe that Ms. Kunkel could justifiably seek post-judgment relief from the court’s order. In the end, however, the court commendably recognized its duty to “be guided by statute and case law, rather than any visceral reaction to the harshness of a creditor’s proposed action.” Despite the tremendous sympathy that one must feel for the children in this case, the court’s steadfast adherence to the law gives reassurance to financial institutions (and their lawyers) that they can depend on well-settled legal principles to determine their legal rights when offering credit or other financial services to consumers.
 Northern Securities Co. v. United States, 193U.S.197, 400 (1904) (Holmes, J. dissenting)
Pictured above: “Here’s your adequate protection.”
Happy 2018! We at The Bankruptcy Cave have been itching to write about the Cherry Growers Chapter 11 case – which really is ground-breaking – but the holidays, life, and yes, work for clients too, all just got in the way. But with each passing week, the case stayed on our minds. So now that time permits, here is the writeup – and see below for the remarkable significance of the case.
In re Cherry Growers (now reported at 576 B.R. 569, Bankr. W.D. Mich. 2017), is a garden-variety produce-related bankruptcy case. (Ha ha, “garden-variety” produce, get it?) The Debtor bought produce and sold it to others, in addition to conducting other food distribution activities. When the Debtor filed for bankruptcy, there was the typical push-and-pull between a lender secured by the Debtor’s inventory and a/r, and a supplier claiming a trust interest in those same assets, protected by the Perishable Agricultural Commodities Act (“PACA”). This was litigated in the context of the Debtor’s motion to use cash collateral, and the PACA supplier’s objection, asserting that the Debtor cannot use PACA trust assets absent immediate payment of the claims protected by the PACA trust.
The opinion provides some in-depth analysis of how courts should approach this issue when a debtor obtains some assets from PACA-protected produce, and obtains other assets from non-produce business activities, like sub-letting its warehouse space. But that is not what makes the case interesting. There was also a big fight in the pleadings over whether $450,000 worth of frozen cherries sitting in awarehouse since 2014 (!!!) could serve as adequate protection for $350,000 in asserted PACA claims (yes, that’s right, monstrous blocks of frozen fruit lying dormant in a refrigerated warehouse for three+ years can be “adequate protection” – amazing). And we got a kick out of Judge Dales’ wry reference to the “voracious PACA trust” that seeks to gobble all estate assets. But that is not why the case is interesting either.
Judge Dales’ conducted a thorough and scholarly analysis of the interplay of Section 541 (property of the estate) and the common law of trusts, which PACA incorporates. He concluded that PACA, when filtered through Section 541, does not require the immediate payment of PACA claims, or the immediate segregation of assets to pay PACA claims – all that is required is “adequate protection” of the PACA trust interests under Section 361 of the Bankruptcy Code. And because the Debtor showed it had several million dollars of assets, it could adequately protect a $350,000 PACA claim. Hence, the Debtor could use its cash, A/R, and inventory to continue to operate, as opposed to writing an immediate check for $350,000 to the PACA claimant (which likely would have been impossible, as most of the Debtor’s assets were real property, equipment, and the like, not liquid or susceptible to immediate conversion to cash). In short, the case could go on, the Debtor would not have to shut down immediately for lack of $350,000 in cash, and it can try to reorganize under Section 1129 of the Code.
And so, we get to the real fascinating part of the case. At the end of the ruling, the Court reminds us that it sometimes makes sense to actually read the Bankruptcy Code. In this case, the definition of a lien under Section 101(37) of the Bankruptcy Code: “a charge against or interest in property to secure payment of a debt or performance of an obligation.” Judge Dales then remarks that this definition of a lien “embraces both a secured creditor’s and a PACA claimant’s interest in particular items in the nature of property.”
Wow – can we all grasp the consequence of that? A PACA trust interest is really just a “lien,” by the Bankruptcy Code’s definition. And that would make a PACA trust right just another secured claim under Section 506(a) of the Bankruptcy Code. As we all know, weird things can happen to secured claims – they can be crammed down under Section 1129(b)(2)(A), and paid out over years. They can be surcharged under Section 506(c) of the Bankruptcy Code. So picture this – a Chapter 11 debtor fights off the PACA creditors in a cash collateral fight. The Chapter 11 debtor then seeks to cramdown the PACA creditors, paying them over 20 years (or more!). And a really smart Chapter 11 debtor adds a third party release to its plan, providing that the PACA creditors cannot pursue officers and directors (which they normally can under PACA) based on some miscellaneous new consideration provided by the Ds and Os to the reorganized debtor. Let’s all watch how Cherry Growers is used – it could have a real impact on how PACA claims are addressed in Chapter 11.
Of course, as additional protection of the PACA creditors, there is always the $450,000 worth of frozen cherries that have been sitting in the back of the freezer since 2014 . . .
Arthur C. Clarke famously observed: “Any sufficiently advanced technology is indistinguishable from magic.” Our regulatory, legislative, and judicial systems illustrate this principle whenever new technology exceeds the limits of our existing legal framework and collective legal imagination. Cryptocurrency, such as bitcoin, has proven particularly “magical” in the existing framework of bankruptcy law, which has not yet determined quite what bitcoin is—a currency, an intangible asset, a commodity contract, or something else entirely.
The answer to that question matters, because capturing the value of highly-volatile cryptocurrency often determines winners and losers in bankruptcy cases where cryptocurrency is a significant asset. The recently-publicized revelation that the bankruptcy trustee of failed bitcoin exchange Mt. Gox is holding more than $1.9 billion worth of previously lost or stolen bitcoins highlights the issue.
The Mt. Gox Case: Timing is Everything
In 2013, Mt. Gox was the world’s largest bitcoin exchange. By some estimates, it accounted for more than 80% of all bitcoin exchange activity. By February 2014, Mt. Gox had shut down its website, frozen customer accounts, and ceased trading. A leaked internal document indicated that hackers had gained access to Mt. Gox’s online wallets and stolen nearly 850,000 bitcoins, each then worth approximately $550 (that’s an estimated $467.5 million in lost value, as of when Mt. Gox froze its operations in early 2014). That same month, Mt. Gox commenced insolvency proceedings in Japan, and thereafter filed a corresponding chapter 15 bankruptcy in the United States. Mt. Gox eventually “found” approximately 200,000 bitcoins previously believed to be among those lost or stolen, but 650,000 were (and are) still missing.
When it became clear that Mt. Gox could not reorganize and would proceed with liquidation, the Japanese court appointed a trustee over Mt. Gox’s assets. A former Mt. Gox exchange customer then filed a lawsuit against the trustee seeking the return of the customer’s purchased bitcoins. The Japanese court, however, ruled that the bitcoins at issue were not capable of ownership under Japanese law and dismissed the lawsuit. Article 85 of the Civil Code of Japan provides that an object of ownership must be a tangible “thing,” in contrast to intangible rights (like contract or tort claims) or natural forces (like sunlight or electricity). Bitcoin, the court ruled, does not meet the definition of a “thing” under the statute and, therefore, does not qualify for private ownership.
The ruling effectively left Mt. Gox’s customers with claims for damages in the insolvency proceeding rather than ownership claims for the return of their bitcoins. Accordingly, the value of each claim was fixed at an exchange rate of one bitcoin to ¥50,058.12 (approximately $483), the value of bitcoin shortly before Mt. Gox filed its insolvency proceeding in Japan.
At the time of this post, bitcoin is now longer trading at $550 – it is now trading at more than $9,500. That constitutes more than a 17x increase over the April 2014 exchange rate fixed in the Mt. Gox bankruptcy. The Mt. Gox bankruptcy estate is holding 202,185 recovered bitcoins, currently worth approximately $1.9 billion. The value of the estate’s bitcoins exceeds the total claims against Mt. Gox by several hundred million dollars. That excess value is creating controversy.
Millions for Mismanagement: An Insolvency Sleight of Hand?
In bankruptcy, once all creditor claims are paid in full, surplus assets flow to the owners. In the Mt. Gox case, the owners of Mt. Gox— not the customers who purchased bitcoin and still await repayment—stand to benefit from the dramatic increase in the value of bitcoin over the last three years. The single largest potential beneficiary is Mark Karpelès, Mt. Gox’s former CEO and majority shareholder, who currently is on trial in Japan for embezzlement.
Customers have repeatedly accused Mr. Karpelès of mismanagement, breach of duties, and outright fraud. Unsurprisingly, the prospect of Mr. Karpelès’ enrichment through the bankruptcy process has galled Mt. Gox’s still unpaid customers, many of whom insist that the rise in bitcoin value should be paid to them rather than the owners of the failed exchange. To date, however, those customers have not articulated a recognized legal basis for their desired result, particularly in light of the Japanese court’s ruling that bitcoin is not legally susceptible of private ownership.
As Karpelès himself has noted, “Creditors, when filing with the bankruptcy, had to convert any amount to JPY – which makes sense in a purely legal term, as it’d be impossible for anyone to proceed with a bankruptcy if debts had to be re-calculated all the time and could change over time. . . . Nobody in this whole process could have predicted the way the price went, especially as its initial trend was downward, not upward.”
Although Karpelès may be technically correct, bankruptcy is fundamentally an equitable proceeding, and it seems patently unfair to award a windfall to the owners of a failed bitcoin exchange to the detriment of its customers, who have endured the freezing of their accounts and years of uncertainty in multi-national bankruptcy proceedings. It also makes little sense that bitcoin cannot be legally owned in the same way stocks, gold, Japanese yen, or U.S. dollars are privately owned under applicable civil law. Unfortunately, such results appear to be a reality in the Mt. Gox case, and they stem from the current legal framework’s shortcomings in addressing this revolutionary technology.
Cryptocurrencies are not going away. Absent an expansion of our existing legal doctrines to account for their unique nature and often volatile trading value, we likely will continue to see results at odds with the spirit and intent of existing bankruptcy law. The Mt. Gox case hopefully will spur discussion about the need to amend our bankruptcy statutes to account for crypto-assets and how the judiciary may need to expand the existing decisional framework to achieve the policies of insolvency law in cases involving such technologies.
 In a notable thematic coincidence, Mt. Gox is an acronym for “Magic: The Gathering Online eXchange.”
 In the Mt. Gox case, some creditors urged the trustee to provide them the option of receiving crypto-tokens, “Goxcoins,” representing the customer’s pro-rata share of the estate’s distributable bitcoins, rather than reducing their claim amounts to yen. The customers who chose this option would assume the risk of fluctuation of bitcoin exchange rates and ultimately receive bitcoins back, albeit fewer bitcoins than they purchased on the Mt. Gox exchange. Essentially, they would agree to take a pro rata share of a smaller pie, betting that each slice of that pie would increase in value. As it turns out, they were correct. The trustee did not adopt that approach in the Japanese insolvency proceeding, but in fairness, the court had ruled that customers did not own the bitcoins, and bitcoin’s value appeared to be on the decline in mid-2014. Although it may be difficult to impose such a structure in a U.S. chapter 7 bankruptcy case, it may be viable under a chapter 11 liquidating plan in certain cases.
Courts and professionals have wrestled for years with the appropriate approach to use in setting the interest rate when a debtor imposes a chapter 11 plan on a secured creditor and pays the creditor the value of its collateral through deferred payments under section 1129(b)(2)(A)(i)(II) of the Bankruptcy Code. Secured lenders gained a major victory on October 20, 2017, when the Second Circuit Court of Appeals concluded that a market rate of interest is preferred to a so-called “formula approach” in chapter 11, when an efficient market exists. In re MPM Silicones (Momentive), LLC, 2017 WL 4700314 (2d Cir. Oct. 20, 2017).
In Momentive, the bankruptcy court categorically dismissed expert testimony presented by the lenders to demonstrate a market rate of 5-6+%. Because the debtor had offered to cash out the lenders (and prepared to borrow the funds necessary to do it), there was direct evidence of the economic terms on which an arm’s-length lender would have been willing to make a loan similar to the obligation held by the lenders after confirmation of the plan. The bankruptcy court declined to consider this evidence, instead relying on a formula approach offered by the debtor, which started with a risk-free rate and built to a rate of 4.1-4.85%. The economic difference was large, and justified multiple appeals, since the difference between the two rates translated to approximately $150 million over the term of the plan according to the lenders.
Since the Supreme Court addressed cramdown interest in the very different context of a chapter 13 case involving an automobile in Till v. SCS Credit Corp., 124 S.Ct. 1951 (2004), there has been an ongoing debate about whether building an interest rate through a formula approach or allowing the market to determine cramdown interest is more appropriate in chapter 11. (For an in-depth discussion of the odd Till plurality, and the very different approaches among the Supreme Court justices, see here, co-authored by our dearly departed colleague Mark Stingley, as well as Leah Fiorenza of our Atlanta office.)
In Momentive, the debtor argued that the Till decision required an application of the formula method. The Second Circuit reversed the bankruptcy and district court decisions, both of which found in favor of the debtor’s formula-driven interest rates. Addressing this issue for the first time in the chapter 11 context, the Second Circuit adopted the Sixth Circuit’s two-step process for selecting an interest rate. Specifically, when an efficient market exists in a chapter 11 case, a bankruptcy court should apply the market rate. Only when no efficient market exists should a bankruptcy court employ the formula approach. Momentive, pp.8-11.
The Second Circuit remanded the case to the bankruptcy court for further proceedings to determine whether there was an efficient market for the replacement notes being crammed down on the senior lenders. In so doing, the Second Circuit added certainty to this issue in an important venue for chapter 11 cases and raised the possibility that the Supreme Court may intervene.
Significantly, the Second Circuit also rejected the debtor’s argument that this issue was equitably moot. Because the secured lenders repeatedly tried to obtain a stay and given the sheer size of this case, the Second Circuit ruled that the additional annual payments that would be required at a higher interest rate over seven years would not unravel the confirmed plan or threaten the debtor’s emergence from bankruptcy.
There are several practical implications of Momentive. We expect more litigation in the future over what constitutes an “efficient market” for purposes of secured creditor cramdown, particularly in larger cases. In smaller chapter 11s, it may remain difficult for a creditor to demonstrate that the market is efficient, and it will be the rare case in which a debtor lays the groundwork by undertaking refinancing efforts that result in relevant and comparable interest rate proposals. (Indeed, could this create the perverse incentive whereby debtors don’t even seek exit financing for fear of creating a discoverable paper trail, and move directly to cramdown instead?) But even when the evidence is less comprehensive than in Momentive, courts may become more comfortable using market-driven analysis for the value indications it can provide, rather than relying solely on the “build-an-interest-rate” formula approach. Unless and until the Supreme Court addresses this issue in the chapter 11 context, however, this issue will likely remain the subject of further debate and litigation.
Editor’s Note from The Bankruptcy Cave: Our good colleagues Robert Dougans and Tatyana Talyanskaya from BC’s London office published this earlier in the summer, and we could not wait to add it to your autumn reading list. The lesson here is powerful – England, the birthplace of the common law, comes through again to right an injustice where traditional legal principles might otherwise fall short. Many of you readers have often dealt with defendants playing a shell game with their assets. The Marex decision provides a powerful response – an independent tort against the individuals who perpetrated the asset stripping, instead of a pursuing a daisy-chain of subsidiaries and affiliates, all bereft of assets. We at The Bankruptcy Cave applaud this decision – for every right, there shall be a remedy!
There is a joke that freezing injunctions are dangerous to heath. They appear to be carcinogenic, as people subject to them often tell the Court they are too ill to engage with proceedings. (Observation of such defendants may provide heartwarming evidence for miracle cures.) They also appear to cause amnesia, as defendants somehow forget to disclose the existence of very substantial assets.
In a similar way adverse judgments can be a boon for corporate finance professionals. A large judgment against a corporate defendant may well provoke a flurry of M&A activity as the unsuccessful corporate defendant’s asset are rapidly re-allocated to other group companies, or to the defendant’s beneficial owner
The background to the decision of Mr. Justice Knowles in Marex Financial Ltd v Garcia  EWHC 918 (Comm) dealt with a familiar situation. A claimant obtains a judgment against the company which (according to pre-litigation due diligence) has substantial assets. When enforcement proceedings begin the claimant learns that the management/owners of the defendant company have immediately emptied the cupboard as soon as judgment was obtained, leaving them with a worthless decision.
What can be done? Insolvency law may provide remedies but a claimant is then in the hands to some extent of insolvency practitioners, and clawing back assets from some jurisdictions may be difficult in practice. Mr. Justice Knowles’ decision suggests a claimant should explore making the persons responsible for the asset-stripping liable in tort.
The Marex case involved the claimant, a foreign exchange broker, obtaining judgment for $5m against two BVI companies (the “Companies”) owned by Mr. Sevilleja. As soon as the draft judgment was circulated, Mr. Sevilleja embarks upon a thorough asset-stripping of the Companies, transferring over $9m from the Companies to himself. When they commenced enforcement proceedings Marex found that the Companies’ position had deteriorated and they had just over $4,500 between them. Marex brought proceedings against Mr. Sevilleja, saying he had induced/caused the Companies to dissipate assets to frustrate the earlier judgment. Marex relied upon the following causes of action.
knowingly inducing and procuring the Company’s to act in wrongful violation of the Claimants rights under the judgments;
committing the tort of intentionally causing loss by unlawful means; and/or unlawful interference with the Claimants economic interests (some of the so-called “economic torts”).
The defendant argued that no tort of unlawful violation of rights under a judgment existed. He accepted that the relevant “economic torts” did exist (they are well-established under English law), but argued that they did not cover frustrating the enforcement of a judgment in this way.
Mr. Justice Knowles found for the claimant on both points: He recognised the existence of a tort violation of rights under a judgment, and also recognised that doing so could count as an economic tort.
Of particular note is that the reasoning for his judgment was based on the well-known proposition that an award of damages by a court of competent jurisdiction (even a foreign court with whom there is no enforcement convention) is recognised in England as a debt which can be enforced at common law. This judgment does not, therefore, simply cover frustrating enforcement of an English court judgment. Asset-stripping a company to frustrate enforcement of a foreign court judgment could also create an actionable wrong under English law.
There are powerful lessons to be learned from this case. Defendants who try to avoid paying judgment debts must tread very carefully to avoid risking personal liability. Claimants who are the victim of post-judgement assets stripping can, however, take heart – they may be able to pin the blame upon persons/entities with assets.
But trust us, faithful reader, and you can, in about three short minutes, become a whiz on last week’s latest change to ObamaCare, which we think will lead to a lot more healthcare-related restructuring activity. So here is the 411 on last week’s termination of ObamaCare’s so-called “CSR Subsidies,” and its impact on our precarious, bankruptcy-prone, healthcare marketplace. All presented to you in easy-to-follow FAQs!
What is a CSR Subsidy?
The federal government calls them “Cost-Sharing Reduction Subsidies.” In short, a key part of ObamaCare had the federal government give cash to insurers. In turn, insurers used that money – the CSR Subsidy – to lower all ObamaCare premiums, and also reduce out-of-pockets and deductibles for low-income ObamaCare enrollees.
How much were these CSR Subsidies?
The CSR Subsidies cost the federal government about $7-$9 billion annually.
How much did the CSR Subsidies help?
A lot. The Kaiser Foundation – which has great coverage of this and other healthcare issues – estimates that the CSR Subsidies to insurance companies prevented certain rate hikes that would be borne by all ObamaCare enrollees. Also, each low-income ObamaCare enrollee’s annual medical and prescription deductibles decreased by over $3,000 and annual out-of-pocket maximums were lowered by over $5,500. We’re not making this up, click here to see the Kaiser Foundation study for yourself.
But I thought Congress didn’t “Repeal or Replace” ObamaCare – So how did this change happen?
The CSR Subsidies were required under ObamaCare – but Congress never actually appropriated any money to make the CSR Subsidies to insurance companies. The prior administration paid the insurers anyway, leading to a very weird lawsuit by Congress against President Obama. Last week, President Trump simply decided to no longer send funding to insurance companies, and since the funding had never been appropriated by Congress, no congressional action was needed to end the federal government’s CSR Subsidies.
Here is the scenario: You are a creditor. You hold clear evidence of a debt that is not disputed by the borrower, an individual. That evidence of debt could be in the form of a note, credit agreement or simply an invoice. You originated the debt, or perhaps instead it was transferred to you — it does not matter for this scenario. At some point the borrower fails to pay on the debt when due. For whatever reason, months or even years pass before you initiate collection efforts.
Finally, you seek to collect on the unpaid debt. Those collection efforts include letters and phone calls, and maybe even personal contact, all of which are ignored. Then you employ an investigator and an attorney. You eventually obtain a default judgment from a state court, which the borrower (unsurprisingly) refuses to pay. You then garnish the borrower’s wages to pay the debt. You collect a few payments before the borrower informs you that the debt was discharged in bankruptcy. Wait . . . how could that be? You never received notice of the bankruptcy, you didn’t have an opportunity to file a proof of claim, until now you never saw the discharge order. Indeed, you come to find out that the borrower never listed you on his bankruptcy schedules and you never received notice that there was a bankruptcy.
The way the borrower informs you of the bankruptcy is even more disturbing. The borrower serves a Motion for Sanctions that he filed in the bankruptcy court. He is asking the bankruptcy court to set aside your state court judgment, for the return of his garnished wages, for emotional distress damages, and for a whole bunch of attorney’s fees that he incurred to reopen the case and file the Motion for Sanctions.[i]
You say to yourself, “No way!” Surely, the bankruptcy court cannot punish you for a case you knew nothing about. After all, isn’t it the Debtor’s burden to list all of his creditors. There was no way that your debt was discharged. Think again, you could be in trouble!
Here’s why. Due to the complicated interaction of multiple sections of the bankruptcy code and the way in which courts have interpreted that interaction in no-asset Chapter 7 Bankruptcy cases, your debt was discharged and your collection efforts were in violation of the discharge injunction despite the fact that you lacked knowledge of the bankruptcy. In a Chapter 7 case, § 727(b) discharges a debtor “from all debts that arose before the date of the order for relief” except as provided in § 523. Section 524, also known as the discharge injunction, applies to any “debt discharged under section 727” and operates as an injunction against the commencement or continuation of an action, or an act, to collect, recover or offset any personal liability of a debtor. Generally speaking, Debtors receive a discharge under § 727(a), and the scope of that discharge is set forth by § 727(b). Pursuant to § 727(b), a prepetition debt is discharged as a matter of law, unless it is nondischargeable under § 523.
Ahah-your debt must fall under § 523, or so you think. After all, § 523(a)(3)(A) states “A discharge under section 727 . . . does not discharge an individual debtor from any debt neither listed nor scheduled under section 521(a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit . . . timely filing of a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing.” You never had notice, did not to get to file that proof of claim, and you knew nothing about the case until that sanctions motion arrived on your doorstep. Sure you are protected by § 523, right?
Not so fast. Section 523 does not apply to all Chapter 7 cases. It is “well accepted that the failure to give notice to a creditor will be disregarded in a Chapter 7 no asset case and that in such cases failure to schedule a prepetition debt will not preclude the discharge of that debt.”[ii] When a debtor’s case is administered as a no-asset case with no set claims bar date and, therefore, has no cut off for the “timely filing of a proof of claim,” an unlisted creditor is not deprived the opportunity to file a timely proof of claim.[iii] Because the time to file a proof of claim never passes, it matters not that the debtor failed to list a creditor in the first place. Nor does it matter why the debt was not listed. The 10th Circuit, for example, says that “equitable considerations,” such as the Debtors’ reasons for failing to schedule the debt or the creditor, “do not impact the dischargeability” of the prepetition debt under § 523(a)(3)(A).[iv]
All this bouncing around the Bankruptcy Code takes us back to § 524 for an explanation of why no notice is actually required. Section 524(a)(2) of the Bankruptcy Code, which creates the discharge injunction, is unambiguous and makes no distinction between debts which are discharged following notice to a creditor and those that are discharged despite a lack of notice. Section 524 provides:
(1) discharge in a case under this title–
(2) operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived[v]
Thus, a lack of knowledge of the discharge does not provide a defense for a creditor who attempts to collect in violation of the discharge injunction.
All is not lost. Despite the mandate of § 524, not all bankruptcy courts (which are still courts of equity) have divorced themselves from equitable principals. The court in In re Wilcox refused to sanction an unlisted creditor for violation of the discharge injunction despite the creditor’s prosecution of a state-court collections case. The Wilcox Court stated that it:
cannot blame the Creditors for their confusion which, after all, proceeds in large measure from the Debtor’s incomplete disclosure in Schedule F and the mailing matrix. Under the circumstances, and up to this point in time, their filing and prosecution of the [state court] lawsuit is not contemptuous. If, however, they continue to pursue their claims against the Debtor without also seeking a declaration . . . that their claims are excepted from discharge under § 523(a)(3), they run the risk of violating the Discharge, especially now that they have a better understanding of their rights.[vi]
The ultimate lesson to be learned is that creditors need to exercise the utmost caution in their pursuit of borrowers, especially if there is reason to believe that borrower filed bankruptcy. A search of public bankruptcy filings before collection efforts are begun, may be the ounce of prevention that is worth a pound of cure. If the borrower produces a bankruptcy discharge, a creditor should retain counsel to review the case and determine whether § 523 applies to the case. Lack of notice is not enough to prevent liability.
[i] The scenario is based on the recent case out of the District of Utah, In re Slater, No. 09-21947, 2017 WL 2656119, at *1 (Bankr. D. Utah June 20, 2017), where the Court concluded that creditor “should be placed in civil contempt for violation of the discharge injunction of 11 U.S.C. § 524. The Default Judgment in the State Action is void pursuant to § 524(a).” The court also found the creditor liable to Debtors for actual damages for all wages garnished, as well as costs and reasonable attorney fees incurred by the Debtors in bringing the motion to enforce the discharge order. Other cases in other jurisdictions have come to similar conclusion based on similar rational, although facts and the creditors level of knowledge of the bankruptcy tend to vary slightly. Cf. In re Greenberg, 526 B.R. 101 (Bankr. E.D.N.Y. 2015) and In re Haemmerle, 529 B.R. 17, 20 (Bankr. E.D.N.Y. 2015).
[ii]In re Delafied 246 Corp., No. 05-13634ALG, 2007 WL 2332527, at *2 (Bankr. S.D.N.Y. Aug. 14, 2007)); In re Herzig, 238 B.R. 5 (E.D.N.Y.1998).
[iii] It should be noted that there is currently a Circuit split on the issue of whether an unlisted debt in a no-asset bankruptcy is automatically discharged by operation of law. The Third, Sixth, Ninth, and Tenth Circuits follow the “mechanical approach” and hold that any such debt is discharged by operation of law; therefore, there is no need to reopen the case and determine dischargeability regardless of the debtor’s reason for failing to list the debt. See In re Parker, 264 B.R. 685, 694 (10th Cir. 2001); In re Madaj, 149 F.3d 467, 471 (6th Cir. 1998); In re Judd, 78 F.3d 110, 115 (3d Cir. 1996); In re Beezley, 994 F.2d 1433 (9th Cir. 1993); see also In re Cruz, 254 B.R. 801, 807 (Bankr. S.D.N.Y. 2000) (summarizing cases). In contrast, the First, Fifth, Seventh, and Eleventh Circuits have held that motions to reopen a no-asset Chapter 7 case should be granted to amend the list of creditors—thus subjecting the unlisted creditor to the bankruptcy discharge—unless the omission was the result of fraud or intention. See Colonial Surety Co. v. Weizman, 564 F.3d 526 (1st Cir. 2009); In re Faden, 96 F.3d 792, 797 (5th Cir. 1996); In re Baitcher, 781 F.2d 1529, 1534 (11th Cir. 1986); In re Stark, 717 F.2d 322 (7th Cir. 1983). In these jurisdictions, the Debtor’s basis for failing to list the Debt could be scrutinized as part of the process to reopen the case. While this doesn’t mean that the debt will not be discharged, it adds a level of scrutiny to the debtor’s failure to list the debt in the first place and provides a creditor additional notice of the bankruptcy.
[iv]In re Parker, 313 F.3d 1267, 1268 (10th Cir. 2002).
[v] See 11 U.S.C. § 524(a)(2). See Green v. Welsh, 956 F.2d 30, 32 (2d Cir.1992).
[vi]In re Wilcox, 529 B.R. 231, 238 (Bankr. W.D. Mich. 2015); see also In re Johnson, 521 B.R. 912, 916 (Bankr. W.D. Ark. 2014)(finding that the debtor failed to notify the creditor. Therefore the creditor was under no obligation to return the money it had collected from the debtor’s state tax return and the debtor’s motion for contempt was denied.)
Editors’ Note: The Supreme Court’s Jevic ruling last spring remains a treasure trove of bankruptcy theory, suitable for the novice bankruptcy student and highly instructional for those of us who have practiced in chapter 11 for years. We at The Bankruptcy Cave like it so much that we will be offering a few more posts in upcoming weeks on the lower courts’ interpretation of Jevic since the spring, the continued efforts in Delaware to sidestep Jevic, and other important learning from the case. Here, our co-editor Justin Morgan, practicing law just a few short blocks from the court that gave us the resounding critical vendor opinion in KMart, points out that while Jevic provides dicta in support of critical vendor motions, subsequent caselaw continues to put debtors through their paces when seeking to use this theory.
In Pioneer Health Services, Inc., Chief Judge Neil Olack of the Bankruptcy Court for the Southern District of Mississippi had one of the first opportunities to apply the Supreme Court’s recent decision on critical vendor payments structured dismissals in Czyzewski v. Jevic Holding Corp. As we discussed here at the Bankruptcy Cave after Jevic first came out, Jevic’s holding—rejecting a structured dismissal that distributed assets contrary to the Bankruptcy Code’s priority scheme—was not particularly surprising. But Jevic went out of its way to distinguish priority-skipping structured dismissals from other priority-skipping distributions such as critical vendor payments. We wondered how strongly courts would read Jevic’s dicta to support critical vendor theory and other so-called “doctrine of necessity” theories. If Pioneer is any indication, not much has changed—and courts remain (rightly) critical of critical vendors.
If anything, the Pioneer opinion was less of a resounding approval of critical vendor theory than Jevic as the bankruptcy court denied the debtor’s motion. The bankruptcy court cited established tests for critical vendor treatment while expressing general disapproval for the whole judicially-fashioned theory. “The Fifth Circuit, at best, takes a dim view of critical vendor orders,” according to Pioneer, so apparently Jevic did nothing to brighten the picture. Judging by the single data-point of Pioneer, then, critical vendor theory appears to be where it was before Jevic was handed down.
A chapter 11 debtor seeks to pay prepetition claims of so-called critical vendors outside the priority scheme set forth in the Bankruptcy Code because the vendor would otherwise end its relationship with the debtor causing a disproportionate impact to the debtor’s business (or so the debtor may argue). Motions to approve critical vendor payments are usually sought early in a chapter 11 reorganization. In exchange for accepting early payment of its prepetition claim, the critical creditor usually must enter into a new contract with the debtor-in-possession, agreeing to supply product (sometimes on credit) for the balance of the case, to ensure that it can’t simply pocket the money and run.
But the facts in Pioneer, as explained by the bankruptcy court, differed significantly from the typical critical vendor situation. On the petition date, Pioneer owed wages to three emergency department doctors at two of its hospitals. All three doctors had executed employment agreements with Pioneer. According to Pioneer, all three doctors had concerns about continuing to work for a hospital that owed them money, and the hospitals would struggle or close if the doctors actually quit. Accordingly, some ten months (?!?) after the petition date, Pioneer sought approval to pay the prepetition claims of the three doctors by treating them as critical vendors.
The bankruptcy court explained that payments to critical vendors are not explicitly authorized by the Bankruptcy Code and that the standards for approving payments of critical vendors’ prebankruptcy claims are strict. The rule set out in CoServ (an opinion representing the low-water mark in the history of critical vendor theory, in our view) requires a showing that critical vendor payments preserve the estate:
First, it must be critical that the debtor deal with the claimant. Second, unless it deals with the claimant the debtor risk the probability of harm, or, alternatively, loss of economic advantage to the estate or the debtor’s going concern value, which is disproportionate to the amount of the claimant’s prepetition claim. Third, there is no practical or legal alternative by which the debtor can deal with the claimant other than by payment of the claim.
In re CoServ, L.L.C., 273 B.R. 487, 498 (Bankr. N.D. Tex. 2002).
The Supreme Court in Jevic cited to a different rule from the Seventh Circuit, which requires “(1) the payments are necessary for a successful reorganization, (2) the disfavored unsecured creditors will be as well off with reorganization as with liquidation, and (3) the critical vendors would cease doing business with the debtor if the payments are not made.” Pioneer at 10 (citing In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004)).
As the bankruptcy court explained, “Jevic suggests that CoServ’s and Kmart’s restrictive view of critical vendor payments is the correct approach.” Accordingly, critical vendor status was denied as to any of the doctors because the evidence submitted by the Debtor “was insufficient to show that the Affected Physicians fall within any definition of critical vendors.” Pioneer at 11. Specifically, there was no evidence that the doctors were critical in the sense of being irreplaceable, there was no evidence the doctors would actually leave if the payments weren’t made, there were other ways to compel performance of the employment contracts, and the business purpose for paying the doctors was unsound because the Debtor had not required the doctors to execute a critical vendor agreement that would assure continued performance. Though not explicit, the bankruptcy court’s analysis in Pioneer appeared to track the CoServ factors and did not explicitly analyze the Kmart factors.
Overall, Pioneer didn’t appear to distill new law from Jevic. The bankruptcy court would have likely followed the CoServ factors with or without Jevic, and the fact that Jevic cited Kmart was not read as a rejection of the more restrictive rule from CoServ. Furthermore, Pioneer rested in part on facts “so far outside the norm” for critical vendor motions in chapter 11 cases that the bankruptcy court rested its decision at least in part on policy concerns. Pioneer at 13.
The Supreme Court may well have intended this exact result. A narrow Jevic decision resting only on the lack of justification in the Bankruptcy Code for priority-skipping structured dismissals would have gotten the job done in that case. But without explaining why critical vendor payments (or first-day wage orders or roll-ups) were different, a self-described narrow Jevic opinion could have invited more questions than answers. Cf.Stern v. Marshall, 564 U.S. 462, 502 (2011) (“[W]e agree with the United States that the question presented here is a ‘narrow’ one.”). Many in the bankruptcy bar feared such an outcome. By explaining that the priorities of the Bankruptcy Code can be violated for legitimate bankruptcy objectives and where supported by a significant bankruptcy-related justification, the Supreme Court may have limited such challenges. But let’s not go overboard—Pioneer reels us all in and reminds us that a critical vendor motion remains a hard argument to win, requiring detailed facts and thorough justification.
Read Full Article
Read for later
Articles marked as Favorite are saved for later viewing.
Scroll to Top
Separate tags by commas
To access this feature, please upgrade your account.