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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 . . .

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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[1] 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,[2] 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.

Conclusion

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.

[1]           In a notable thematic coincidence, Mt. Gox is an acronym for “Magic: The Gathering Online eXchange.”

[2]           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.

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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.

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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 [2017] 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.

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Ok, if your attention span is anything like ours, all this wonky stuff about the ins and outs of the Affordable Care Act (or “ObamaCare,” as most of us know it) causes your eyes to glaze over and makes your mind wander to simpler topics, like who will win Dancing with the Stars, whether the Will & Grace reboot can make it, or how Luke may soon be revealed as the most evil Jedi of all.

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.

So what will happen without the CSR Subsidies?

Actually, low-income ObamaCare enrollees are entitled to discounts from their insurers whether the federal government subsidizes / reimburses the insurers or not.  But that $7-$9 billion in lost government funding has to be made up somewhere – so insurers in the ObamaCare exchanges are expected to raise rates next year by 15-21% due to the loss of CSR Subsidies, according to the Kaiser Foundation study cited above.

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.

How does this relate to restructuring?

We’re lawyers, not economists. But even we can surmise that when the price of a good or service (here, ObamaCare) goes up 15-21% in one year, less people will buy it.  Indeed, our friends at The Motley Fool estimate that the loss of CSRs will result in 7 million more uninsured Americans.  So when folks said this was a real blow to ObamaCare, they weren’t kidding.

And of course, fewer patients with insurance means more unreimbursed care for hospitals and other healthcare providers. This precarious industry is getting ready for another terrific beating.  Sure enough, when news of the end of the CSR Subsidy program broke last Thursday night, October 12, the next day saw all major healthcare stocks – insurers, hospitals, ambulatory centers, even benefits administrators – take serious losses.  The strong ones will make it; as to the weak ones, get ready for more restructuring activity as more uninsured patients cause more losses.

So, is all lost when it comes to the CSR Subsidies?

People, Washington D.C. is a weird place.  Even as we were writing this Bankruptcy Cave Blog post last night, news broke that a bipartisan effort was underway in the Senate to reinstate the CSR Subsidies for two years, and President Trump said he would support it!  What??  But then, as we were editing this post today, President Trump tweeted that the CSR Subsidies were just a bailout for insurance companies – and he won’t support the new legislation.  Anyway, we give up trying to figure out what is next, folks.  Hey, is Will & Grace on?  Is T.O. dancing a salsa tonight?  And when is the next trailer for The Last Jedi going to drop?

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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.)

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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.

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Editor’s Note:  The Bankruptcy Cave is just about ready to return from summer vacation (which is our lame way of saying we got really busy with work for actual clients, and blogging just fell by the wayside).  But rest assured, we have a lot of great posts tee’d up for the next several weeks, and The Bankruptcy Cave looks forward to re-joining the cadre of practical, semi-academic, and occasionally critical commentators on restructuring and bankruptcy matters.  In the meantime, here is a great cross-post based on a Bryan Cave client advisory issued last week by our Bryan Cave Consumer Financial Services colleagues Eric Martin and Jonathan NicolSpokeo shows up a lot in consumer class actions, but this Supreme Court opinion is equally important to anyone dealing with FDCPA, FCRA, or other types of claims brought by a Chapter 7 debtor.   

On August 15, 2017, the Ninth Circuit Court of Appeals held once again (“Spokeo III”) that Thomas Robins had standing to assert a claim based upon the Fair Credit Reporting Act (“FCRA”) against Spokeo, Inc., the operator of a website that aggregates public information regarding individuals.  Robins alleged that Spokeo violated § 1681e(b) of the FCRA, which requires “reasonable procedures to assure maximum possible accuracy of the information,” because his Spokeo profile contained inaccuracies regarding his personal information.  Robins claimed that the inaccuracies harmed his employment prospects but did not identify the loss of any specific job opportunity.  Following the Ninth Circuit’s original decision in 2014 (“Spokeo I”) that reversed the lower court and found sufficient standing, the United States Supreme Court accepted certiorari and held that the Ninth Circuit had not properly analyzed the “injury-in-fact” requirement and remanded for further consideration (“Spokeo II” or “Spokeo”).  To establish an injury-in-fact, a plaintiff must show “an invasion of a legally protected interest” that is “concrete and particularized.”  The Supreme Court found that the Spokeo I decision satisfied the “particularized” requirement but did not sufficiently analyze the “concrete” requirement.

In determining whether an intangible harm arising from a statutory claim satisfies the injury-in-fact requirement, Spokeo II provides two considerations:  (1) whether the defendant is alleged to have violated a statute resulting in the plaintiff suffering the type of harm that Congress sought to prevent by enacting the statutory requirement allegedly violated; or (2) whether the plaintiff seeks relief for a type of harm that has a close relationship to one that provides a basis for a suit at common law.  Even then, the plaintiff must allege a “real” and not “abstract” injury.  As the Ninth Circuit summarized in Spokeo III, “[E]ven when a statute has allegedly been violated, Article III requires such violation to have caused some real – as opposed to purely legal – harm to the plaintiff.”

In Spokeo III, after examining the history and purpose of the FCRA, the Ninth Circuit agreed with Robins that the procedural FCRA provisions at issue were “real,” rather than purely legal.  Thus, even though Robins could not identify any specific lost job opportunity and, in some respects, the inaccurate information reported by Spokeo was arguably more favorable for Robins in terms of estimated wealth and educational credentials, the Ninth Circuit concluded that consumers had a “concrete interest in accurate credit reporting about themselves.”

Having found a concrete interest for Robins in accurate credit reporting, the Ninth Circuit examined a second hurdle to his claim; namely, whether Robins alleged FCRA violations that actually harmed or created a material risk of harm to his concrete interest. Because Robins alleged that Spokeo prepared an inaccurate report and published it online, Robins’s claim implicated the concrete interest.  But the Ninth Circuit disagreed with Robins that any inaccuracy in the report would satisfy the harm element. Borrowing an example from the Supreme Court, Spokeo III noted that reporting an incorrect zip code would be inaccurate but would not cause concrete harm.  Here, however, because the nature of the reporting inaccuracies (wealth, education level, etc.) is the “type that may be important to employers” in matters such as making hiring decisions, Robins sufficiently established harm to his concrete interest in accurate credit reporting.

The Ninth Circuit’s decision is the latest and most notable entry into the injury-in-fact standing jurisprudence that has developed in the fifteen months since the Supreme Court’s decision.  Courts of Appeals and District Courts have applied Spokeo with varying results:  some courts have viewed Spokeo as strengthening standing requirements while others view it as simply restating them.  The Spokeo III decision seems to fall into the latter category.

Below is a summary of notable factors considered in the standing analysis in post-Spokeo decisions under two frequent sources of procedural statutory claims:  the FCRA and the Telephone Consumer Protection Act (“TCPA”).

FCRA

Given that Spokeo involved a claim under the FCRA, the opinion has been used by parties on both sides of such disputes.  Courts are split when faced with questions of standing under this statute.

A number of courts have applied Spokeo and determined that there was no standing under the FCRA in certain situations.  The following allegations were found to be insufficient for standing purposes:

  • A putative class action alleging violations by a credit reporting agency for listing a defunct credit card company, rather than the name of the company’s servicer, as the source of information on the plaintiffs’ credit reports.
  • A class action alleging failure to comply with the FCRA requirements for an employer to provide a disclosure for obtaining a consumer report on prospective employees.
  • Where the consumer report disclosure was not given in the correct form.
  • Where the plaintiff failed to support a claim for the statutory award of punitive damages without any further showing of a concrete injury.
  • Where the plaintiffs claimed defendants willfully and/or negligently violated the FCRA by maintaining and disseminating allegedly incomplete information in a database containing information on commercial truck drivers’ safety records.

Other courts have found standing under Spokeo in FCRA suits.  These cases include ones where the plaintiff alleged an identifiable taking (intentional theft of personal information) and did not have to wait to suffer an adverse impact resulting from the taking.  Similarly, allegations showing unauthorized disclosure of a proposed class’ private information satisfies standing.  Standing was also established where a job applicant sought relief from a prospective employer for failing to disclose its intent to procure the job applicant’s credit report.  Other cases include where the plaintiff alleged that the defendant actually disseminated inaccurate information about the consumer, and where the defendant failed to disclose to the consumer the source of inaccurate information.  Other cases determined there was Article III standing when the allegations supported a material risk of real harm including denial of credit.  Still other cases held there was standing based on an invasion of privacy for claims related to pulling credit reports without proper disclosures or authorization. Another decision found that standing was established when the plaintiff alleged the defendant procured a consumer report without following the FCRA’s disclosure and authorization requirements.

TCPA

For the TCPA, there are Spokeo-guided decisions on both sides of the standing issue, but the majority of courts favor standing.

Courts hold there is standing when a plaintiff alleges receiving unsolicited telemarketing or text messages prohibited by the TCPA. These courts hold that the TCPA codifies the application of a long-recognized common law tort of invasion of privacy and the interests of peace and quiet that Congress intended to protect.  Finding the right to be substantive, the courts also cite to the wasted time suffered by a plaintiff in answering or otherwise addressing robocalls.  That being said, some of these same courts hold that calls made to a neglected phone that go unnoticed or calls that are dropped before they connect may violate the TCPA, but may not cause any concrete injury.

As to TCPA cases where the courts found there was no standing under Spokeo, the reasons have been more case-specific.  One court granted a motion to dismiss in a junk fax case based on a single line included in a solicited four-page fax, where the plaintiff merely identified its injury as the alleged statutory infraction.  Another court dismissed the suit when the plaintiff could not allege that the use of an autodialer system to dial his number caused him to incur a charge that he would not have incurred had defendants manually dialed his number, which would not have violated the TCPA.  Other courts have found no standing when there was no “connection” between the use of an autodialer and the claimed concrete harm.  Still another dismissed for lack of standing where the complaint alleged only that the plaintiff suffered “statutory damages, in addition to actual damages, including but not limited to those contemplated by Congress and the [Federal Communications Commission]”).

Conclusion

The Supreme Court’s Spokeo decision affirmed that plaintiffs cannot satisfy the injury-in-fact test for standing by alleging bare procedural violations. Instead, plaintiffs’ allegations must satisfy both a particularity and concreteness analysis. Whether Spokeo enhanced the standing requirements or merely restated them will continue to play out in federal court decisions. Regardless, Spokeo III demonstrates the rigorous analysis that courts are employing in analyzing the concrete injury requirement for claims based on statutory violations. As the Spokeo III decision shows, even intangible harms arising from alleged procedural statutory violations can rise to the level of concrete injuries if the harm is one that Congress sought to address and the violations caused or created a material risk of harm to the plaintiff.

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Last December, we updated you that the Supreme Court was considering whether to grant review of In re The Village at Lakeridge, LLC, 814 F.3d 993 (9th Cir. 2016). Our original post is here.  On March 27, 2017, the Supreme Court granted review of Village at Lakeridge, but only as to one question presented, the most boring one in our view.  (Seems like after giving us bankruptcy professionals a thrill with a deep, insightful, and important ruling like Jevic, the Supreme Court is going back to bankruptcy matters that range from the esoteric to the downright irrelevant; oh well.)

In The Village at Lakeridge, a non-statutory insider acquired a $2.76 million claim against the debtor from an insider for $5,000.  Id. at 997.  The debtor attempted to confirm its plan (which included a cramdown of U.S. Bank’s claim) by arguing that the assignee of the insider claim provided the debtor an impaired consenting class.  U.S. Bank moved to designate the assignee’s claim on the basis that he was both a statutory and non-statutory insider, 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, he 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.  Three years later (!!), the Ninth Circuit affirmed.

As we advised you in December, U.S. Bank presented three questions that it urged merited review.  Its second question was:  “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.

U.S. Bank argued a circuit split exists on the standard of review that should be applied to a determination of insider status.  Id. at 19.  U.S. Bank alleged that the Ninth Circuit’s review of the bankruptcy court’s determination of non-statutory insider status for clear error directly conflicts with the standard of review employed by the majority of circuit courts in the Third, Seventh, Tenth, and Eleventh Circuits, which hold that questions of insider status are mixed questions of law and fact to be reviewed de novo.  Id. at 19-20 (citing Schubert v. Lucent Tech. Inc. (In re Winstar Comm’ns., Inc.), 554 F.3d 382, 395 (3d Cir. 2009); In re Longview Aluminum, L.L.C., 657 F.3d 507, 509 (7th Cir. 2011); In re Krehl, 86 F.3d 737, 742 (7th Cir. 1996); Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.), 531 F.3d 1272, 1275 (10th Cir. 2008); Miami Police Relief & Pension Fund v. Tabas (In re The Florida Fund of Coral Gables, Ltd.), 144 Fed. Appx. 72, 74 (11th Cir. 2005).

On March 27, 2017, the United States Supreme Court granted U.S. Bank’s petition for writ of certiorari, but only as to the question of the proper standard of review.  Case updates for In re The Village at Lakeridge, LLC are available here.

Potential Ramifications

Affirming the appellate rulings in Village at Lakeridge could increase efforts by debtors to confirm plans by assigning insider claims to friendly non-insiders who will vote for the plan.

On the other hand, a ruling in this case could add some clarity to the other little circuit split on whether an assignee of a claim (such as a claims buyer) takes a claim subject to impediments such as potential disallowance due to the claim seller’s receipt of a preference, or whether the assignment frees the claim of such impediments (which is a huge windfall to the claimant, we think).   A great summary of this split – which is far more interesting, in the view of the Bankruptcy Cave – can be found here in an very good article by Simon Fraser of Cozen O’Connor and Benjamin Klehr of Cohen Pollock.

Stay tuned for more developments on this case.

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Editor’s Note: On June 16, 2016, The Bankruptcy Cave gave you our previous summary of the controversial Sabine decision.  When Bankruptcy Judge Chapman determined there was no reason to expedite review of her decisions in the case, we brought you Sabine Lives On (and On) detailing the struggles of Sabine’s midstream adversaries.  Like Hollywood, Bankruptcy Cave knows that sequels sell (with some notable awful exceptions, such as here and here).  We now bring you the third installment of Sabine.  If it sounds like a horror film or slasher flick, it was for the midstream sector.

The bankruptcy court was right!  Judge Rakoff of the United States District Court for the Southern District of New York stated starkly: “[T]he bankruptcy court did not err in authorizing the rejection of the Agreements pursuant to 11 U.S.C. § 365(a).  Nordheim challenges the decision only on the ground that the Agreements are real covenants that run with the land, and, since the Court reaches the contrary conclusion; Nordheim’s argument in this regard has no merit.”[i]

Backing up almost a year, on March 9, 2016, Bankruptcy Judge Chapman of the Southern District of New York issued her decision on the Debtor’s motion to reject certain contracts in Sabine Oil & Gas Corporation’s Chapter 11 case.  The decision allowed Sabine to reject “gathering agreements” between it and two “midstream operators” [for more info on these technical terms see my prior blog post here] Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC, under Section 365(a) of the Bankruptcy Code.  In June, 2016, Judge Chapman refused to allow the midstream operators to appeal her decision to the Second Circuit Court of Appeals and rejected requests to stay her decision.[ii]  These decisions sent shockwaves through the midstream energy sector and leveled the playing field for bankrupt production companies.

Judge Rakoff’s opinion (full copy Here) turns immediately to the question of “whether the Agreements run with the land and therefore cannot be rejected pursuant to § 365(a).”[iii]  Relying on Texas law and citing Inwood N. Homeowner’s Ass’n v. Harris, the Court notes that

In Texas, a covenant runs with the land when it touches and concerns the land; relates to a thing in existence or specifically binds the parties and their assigns; is intended by the original parties run with the land; and when the successor to the burden has notice.[iv]

It is the first requirement, that a covenant touch and concern the land, which drew the Court’s attention.

Judge Rakoff rejected Nordheim’s argument that the dedication of gas and condensate “produced and saved” under the Sabine contract was an interest that touched and concerned the land.[v]  Instead, Judge Rakoff reasoned that the Sabine contract had not granted Nordheim a royalty interest or any other mineral rights or interests recognized by Texas law.  The Court also noted that the Agreements “did not decrease Sabine’s legal relation to its real property interests.”[vi]  In other words, Sabine did not convey real property interests to the appellants, only personal property interests in the oil and condensate after it was produced.

Judge Rakoff’s reasoning followed Judge Chapman’s previous decision very closely and directly rejected any contrary interpretation of Texas law.  Specifically, both rejected Nordheim’s argument that In re Energytec, Inc. applied to the circumstances of the case.[vii]

The latest Sabine ruling has three immediate impacts. First, the ruling expands the precedential value of the bankruptcy court’s decision.  While technically the District Court’s ruling is only binding in the Southern District of New York, its practical implications are far broader.  Sabine is no longer a rogue decision; it has been upheld on a de novo review by a very well-regarded Judge Rakoff.  Second, the District Court’s ruling places additional pressure on midstream operators to settle and renegotiate their gathering agreements with bankrupt producers, as has been the case in multiple cases with gathering agreements similar to those at issue in Sabine.[viii]  [Of course, this is exactly what Congress had in mind with Section 365 – forcing parties with above-market contracts to come to the table and negotiate with a debtor-in-possession.]  Finally, attorneys for midstream operators will need to devise new contract language if they want to protect their clients’ interests by attaching them to the land.  It is no longer enough for a gathering contract to simply say that it is a covenant running with the land; the language and reach of the contract must be broad enough to actually provide the midstream operator with a property right.

[i] HPIP v. Sabine, No. 16-04127(JSR) Docket No. 28 (S.D.N.Y. Mar. 10, 2017).

[ii] In re Sabine Oil & Gas Corp., No. 15-11835 (SCC), Docket. No. 1276 (Bankr. S.D.N.Y. June 15, 2016).

[iii] HPIP Supra. Note 1 at *7-*8.

[iv] 736 S.W. 2d 632, 635 (Tex. 1987).

[v] HPIP Supra. Note 1 at *9-*10.

[vi] Id, at *11.

[vii] 739 F.3d 215, 221 (5th Cir. 2013).

[viii] See, e.g., In re Quicksilver Resources Inc., Case No. 15-10585 (Bankr. D. Del.) (settlement reached); In re Penn Virginia Corp., Case No. 16-32395 (Bankr. E.D. Va.) (settlement reached); In re Emerald Oil, Inc., Case No. 16-10704 (Bankr. D. Del.) (settlement reached); In re Magnum Hunter Resources, Case No. 15-12533 (Bankr. D. Del.) (agreements assumed); In re SandRidge Energy, Inc., Case No. 16-32488 (Bankr. S.D. Tex.) (settlement reached).

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