South Florida Chapter 11 Bankruptcy Blog

The "Minimum Essential Coverage Provision" Held Unconstitutional

2010-12-13T17:11:00.010-05:00

Not a bankruptcy case, but a good opportunity to review constitutional law.

As widely report in the media today, Judge Henry Hudson of the District Court for the Eastern District of Virginia issued his opinion in Commonwealth of Virginia ex rel. Kenneth T. Cuccinelli, II v. Kathleen Sebelius, Secretary of the Department of Health and Human Services and ruled that the "Minimum Essential Coverage Provision" (ie. Section 1501) of the Patient Protection and Affordable Care Act exceeds the constitutional boundaries of congressional power. In this case, the Commonwealth of Virginia, challenged the constitutionality of Section 1501 which requires that all U.S. citizens, with certain exceptions, maintain a minimum level of health insurance coverage for each month beginning in 2014. The failure to comply with Section 1501, results in a penalty reflected in the person's annual federal tax return.

Virginia sought declaratory and injunctive relief finding that the enactment of Section 1501 exceeded the power of Congress under the Commerce Clause and General Welfare Clause of the U.S. Constitution. In the alternative, Virginia argued that Section 1501 is in direct conflict with a certain Virginia statute, thereby implicating the 10th Amendment. The case came before the Court on motions for summary judgment.

The Court stated that Virginia's challenge includes the following three facets:

That Section 1501 and the affiliated penalty for failure to purchase the insurance, are "beyond the outer limits of the Commerce Clause and associated Necessary and Proper Clause"
That Section 1501 is not a "legitimate exercise of the congressional power of taxation under the General Welfare Clause" and mischaracterizes the penalty as a "tax"
That Section 1501 is in direct conflict with the Virginia Health Care Freedom Act and thereby "encroaches on the sovereignty of the Commonwealth, and offends the Tenth Amendment to the U.S. Constitution."

In support of the provision, the Secretary of the Department of Health and Human Services argued this provision is a proper exercise of Congressional power under the Commerce Clause or the Necessary and Proper Clause, urged the Court to reject Virginia's contention that Section 1501 violates state sovereignty or the Tenth Amendment, and argued that Section 1501 is a valid exercise of Congress's "independent authority to lay taxes and provide for the general welfare."

The Court stated that the Secretary's assertion that the standard for facial challenges establishes a high hurdle and requires Virginia to demonstrate that the provision "cannot operate constitutional under any circumstance" is weak. The Court made the distinction that this lawsuit focuses not on the impact or effect of the enactment, but rather the authority of Congress to enact the legislation ie. the power to act ab initio.

The Court noted that Section 1501 "appears to forge new ground and extends the Commerce Clause powers beyond its current high water mark." The Court stated that the "accepted contours of Article I Commerce Clause power were restated by the Supreme Court" in its 1971 decision in Perez v. United States which "divided traditional Commerce Clause powers into three distinct strands" - ie. 1. that Congress can regulate the channels of interstate commerce, 2. that Congress can regulate and protect the instrumentalities of interstate commerce and persons and things in interstate commerce, and 3. that Congress has the power to regulate activities that substantially affect interstate commerce. The Court stated that this case appeared to only present the third category of Commerce Clause power - the power to regulate activities that substantially affect interstate commerce.

The Court concluded that "Congress lacked the power under the Commerce Clause, or associate Necessary and Proper Clause, to compel an individual to involuntarily engage in a private commercial transaction as contemplated by" Section 1501. The Court also held that the "absence of a constitutionally viable exercise of this enumerated power is fatal to the accompanying sanction for noncompliance," ie. the penalty for noncompliance. The Court noted that its review of the "pertinent constitutional case law has yield no reported decisions from any federal appellate courts extending the Commerce Clause or General Welfare Clause to encompass regulation of a person's decision not to purchase a product, notwithstanding its effect on interstate commerce or role in a global regulatory scheme."

The Court also rejected the argument that Section 1501 was a bona fide revenue raising measure enacted under the taxing power of Congress under the General Welfare Clause. The Court concluded that in enacting this provision, Congress did not intend to exercise it power of taxation under the General Welfare Clause and stated that the assertion of the objective to generate revenue was only a "transparent afterthought" and that the resulting revenue is "extraneous to any tax need." Instead, the Court found that the "legislative purpose underlying this provision was purely regulation of what Congress misperceived to be economic activity."

The Court cited the Supreme Court's decision in La Franca and further held that the "[t]he two words [tax vs. penalty] are not interchangeable.." and a that a penalty cannot be "converted into a tax by the simple expedient of calling it such." The Court noted that the provision specifically "referred to the exaction as a penalty" and that previous versions of the bill in Congress used the "toxic term 'tax'". The Court also found it significant that other sections specifically used the word "tax" instead of "penalty." The Court was also not persuaded by the argument that the provision's placement in the Internal Revenue Code as a "miscellaneous excise tax" held the level of significance argued by the Secretary.

The Court concludes that as Section 1501 "is in form and substance, a penalty as opposed to a tax, it must be linked to an enumerated power other than the General Welfare Clause. The Court found it clear "from the text of Section 1501 that the underlying regulatory scheme was conceived as an exercise of Commerce Clause powers" and that for the provision to survive constitutional challenge, it must serve to effectuate a valid exercise of an enumerated power - here the Commerce Clause."

The Court found that the invalid Section 1501 was severable from the balance of the enactment and rejected Virginia's argument to invalidate the entire enactment. The Court held to the "time-honored rule to severe with circumspection, servering 'problematic portions while leaving the remainder intact.'"

The Court also rejected Virginia request for injunctive relief and found that declaratory relief was adequate.

New Rules of Bankruptcy Procedures

2010-12-02T18:34:00.003-05:00

On December 1, 2010, certain amendments to the Bankruptcy Rules of Procedure went into effect. They are outlined in Weils Gotshal's "Bankruptcy Blog". Many of the new rules related to procedure in chapter 15 cases. Certain changes were also made to certain official forms.

New Book

2010-09-16T10:12:00.004-04:00

Supreme Court Justice Stephen Breyer appeared on the "Daily Show" with John Stewart the other day and spoke about his new book "Making Our Democracy Work - A Judge's View". Looks like a interesting book.

Federal Income Taxation of Individual in Chapter 11

2010-09-12T16:39:00.003-04:00

The Internal Revenue Service Publication 908 reviews various aspects of the federal taxation of the individual in chapter 11 bankruptcy.

Bankruptcy Estate as Separate Taxable Entity - The bankruptcy estate of an individual in chapter 11 is a separate taxable entity. The debtor’s pre-petition income is included on his personal income tax return. The bankruptcy estate includes in its gross income all of the debtor’s income, including wages and income from the estate’s property, to which the estate is entitled. Any amounts not included in the bankruptcy estate's income are included in the individual's personal income. The debtor is to allocate his wages between the debtor and the bankruptcy estate. A simple percentage method may be used. Income from exempt and abandoned property, although initially part of the estate, are subsequently excluded from the estate. An individual (as debtor-in-possession) may be compensated by the bankruptcy estate for managing its business. Such payments are to be reported by the debtor on his individual returns as miscelleaneous income.

Tax Returns - The individual files a Form 1040 and the bankruptcy estate files a Form 1041 for the involved tax year. Form 1040 is to be attached to the Form 1041. In the case of a joint bankruptcy filing of a husband and wife, the bankruptcy estate is treated as two separate taxable entities and that two separate tax returns are filed for the bankruptcy estate. The bankruptcy estate must file the Form 1041 if its gross income exceeds the amount required for filing based on a statues of a married individual filing separately.

A “Notice 2006-83 Statement” is required to be attached to the individual and bankruptcy estate’s tax returns regarding the chapter 11 case. The statement should list the date of filing of the bankruptcy case, the case number, the location of the Bankruptcy Court, and the bankruptcy estate’s employment identification number. EIN. This statement is to reflect the allocations of income and withheld income taxes and describe the method used for such allocations. A model statement is included in Publication 908.

Election to End Tax Year - An individual may elect to close his tax year as of the day before the date the bankruptcy case is file. In such case, the tax year is divided into two short tax years (adding up to 12 months). Any tax liability for the first short year becomes an allowable claim against the bankruptcy estate. If such election is not made, the commencement of the bankruptcy estate does not affect the individual’s tax year and no part of the debtor’s income tax liability for such year can be collected from the bankruptcy estate.

Computation of Tax, Tax Attributes - The bankruptcy estate figures its taxable income and takes deductions and credits in the same manner that the debtor would have on his individual tax return. The bankruptcy estate uses the rates for a married individual filing separately and can take one personal exemption and either itemize deductions or take the standard deduction for a married individual filing a separate tax return.

The bankruptcy estate figures its tax attributes the same way the debtor would have. These amounts are figured on the date the bankruptcy is filed. The tax attributes the bankruptcy estate takes from the debtor include the following: NOL carryovers, basis, holding period, and character of assets, method of accounting, etc. Certain tax attributes of the estate must be reduced by an excluded income from cancellation of debt occurring during the bankruptcy case.

Debt Cancellation – Cancelled or forgiven debt is generally income for tax purposes, with certain exceptions such as if the debt is cancelled during a bankruptcy case or while the debtor is insolvent. Certain tax attributes (such as certain losses, credits, and basis of property) though may be reduced by the amount of the excluded income. Cancellation during bankruptcy takes precedence over the insolvency exclusion. Bankruptcy cancellation would be as a result of a plan confirmed by the Bankruptcy Court. A person is generally insolvent when and to the extent liabilities exceed the fair market value of the assets just before the cancellation of the debt.

Administrative Expenses – the bankruptcy estate is allowed a deduction for administrative expenses and fees or charges assessed. These are generally deductible as itemized deductions. Administrative expenses attributable to the conduct of a trade or business by the bankruptcy estate are deducted at arriving as adjusted gross income.

Employer identification Number (“EIN”) – a chapter 11 individual debtor needs to obtain an employer identification number for the estate to use on any tax returns filed for the estate. Such number should be provided as soon as reasonably possible to those persons that are required to file information returns for the bankruptcy estate’s gross income, gross proceeds, or other types of reportable payments. The payors should report such amounts using the bankruptcy estate’s name and EIN. One may obtain an EIN at www.irs.gov/businesses/small, by calling (800) 829-4933, or by mailing a Form SS-4.

Form W-2 – An individual chapter 11 debtor does not need to provide his EIN to his employer for use with on his W-2. The employer should continue to report all wage income and tax withholdings, whether pre-or post-petition, on the Form W-2 issued under the debtor’s individual social security number. Determination of income tax withholding, FICA, FUTA are not changed.

Closing of Bankruptcy Estate – the bankruptcy estate ends as a taxable entity when the chapter 11 case is closed, dismissed, or converted to chapter 13. If the case is converted to chapter 7, the bankruptcy estate will continue to exist as a separate taxable entity. Generally, once the bankruptcy estate is ended, gross income realized thereafter is reported to the debtor not the estate. The debtor should send notice of such closing to all persons previously notified of the bankruptcy case to ensure that items are reported to the debtor social security number or EIN instead of to the bankruptcy estate.

Dismissal of Bankruptcy Case – the Bankruptcy Code provides that the taxing authority may request a dismissal of your case if you fail to file the required tax return or pay taxes owed after the bankruptcy case is filed. If the chapter 11 case is dismissed, the debtor is treated as is the bankruptcy petition was never filed. Amended returns on Form 1040X are to be filed to replace the returns filed by the bankruptcy estate. The amended returns are to include the items of income, deductions, and creditor that were included on the bankruptcy estate’s tax return that were not reported on the individual’s tax return.

Justice Souter on Constitutional Judging – on Understanding the "Meaning of Facts"

2010-06-12T16:44:00.009-04:00

Former Supreme Court Justice David H. Souter's recent speech at the Harvard Commencement exercises on the subject of constitutional judging has been termed an "extraordinary gift." In the preface to his speech, Justice Souter stated that he desired to address “in detail” the conceptions of the Constitution and constitutional judging that underlie the critical rhetoric” and to compare them to the “notions that lie behind our own intuitive responses” that this critical rhetoric “tends to miss..." Justice Souter noted that he sought to address the "criticism that the court is making up the law, that the court is announcing constitutional rules that cannot be found in the Constitution, and that the court is engaging in activism to extend civil liberties."

Columnist Andrew Cohen described the speech as a "firm answer" to both the one who decries "judicial activism" and the "originalist" who "see[s] the Constitution as a contract that must be interpreted only in light of what its original drafters wrote and .... [it is] known to have meant at the time." Cohen suggests that Souter's criticism of the "fair reading model" of constitutional interpretation, may be in the spirit of Oliver Wendell Holmes' "Co mmon Law" ("The life of the law has not been logic; it has been experience"). Cohen notes a previous occasion that Justice Souter addressed this topic. Columnist E.J. Dionne, Jr. of the Washington Post described the speech as a "philosophical shot heard 'round the country'". Matthew J. Franck wrote a stinging critique in the National Review Online.

In his address, Justice Souter suggested that the “charges of [judicial] lawmaking and constitutional novelty seem to be based on an impression of the Constitution, and on a template for deciding constitutional claims” based on the “fair reading model” which would suggest that deciding constitutional cases is a “straightforward exercise of reading fairly and viewing facts objectively” and that a claim made in court asserting a constitutional power or right can be decided by the Court based on “some particular provision of the Constitution.” Justice Souter concedes that there are some constitutional claims that can “decided just about the way this fair reading model would have it,” and gives example in a hypothetical claim based on the constitutional age of candidicy restriction for a United States Senate seat ("No Person shall be a Senator who shall not have attained to the Age of thirty Years...", Article One, Section 3, Clause 3)

But Justice Souter observes that the “fair reading model” only has a “tenuous connection to [the] reality” of the cases that tend to come before the Supreme Court and that it would be “unrealistic” to expect otherwise as the “Constitution has a good share of deliberately open-ended guarantees like right to due process of law, equal protection of the law and freedom from unreasonable searches…” Souter noted that such provisions cannot be simply applied as in the Constitutional provision relating to the Senate seat age restriction, as they “call for more elaborate reasoning to show why [their] very general language applies in some specific cases but not in others..." Justice Souter also notes that the Constitution “contains values that may well exist in tension with each other, not in harmony.”

Justice Souter offers another reason that constitutional judging is not a “mere combination of fair reading and simple facts” in the explanation that the “facts that determine whether a constitutional provision applies” may not be as simple as a “person’s age or the amount of the grocery bill” but may require judges to “understand the meaning that the facts may bear before the judges can figure out what to make of them.” In illustration of this point, Souter offers two examples of “what can really happen, two stories of two great cases” – New York Times Co. v. United States (the "Pentagon Papers" case) and Brown v. Board of Education.

The Pentagon Papers case (per curiam decision, 1971) involved the government’s assertion for the “prior restraint” on the First Amendment’s provision that “no law” should abridge "the freedom of speech, or of the press." The United States sought a “prior restraint” on publication by the New York Times and the Washington Post on the grounds of national security. The case made its way quickly through the lower courts and arrived before the Supreme Court. Justice Souter noted the “colloquy” between Solicitor General Dean Erwin Griswold on behalf of the United States and Justice Black in which Dean Griswold retorted to Justice’s Black construction that the First Amendment’s provision that “no law” means “no law“ and left no room for exceptions. Justice Griswold responded that that to him it is “equally obvious that ‘no law’ does not mean ‘no law.’” Souter remarked that this was “one of those instances of a grain of sand that reveals a universe.” Souter remarked that Dean Griswold “pointed out that the First Amendment was not the whole Constitution” and that the Constitution also granted the government authority to provide for the security of the nation. In this manner, the “explicit terms” of the Constitution create a “conflict of approved values” but “do not resolve that conflict when it arises” and places the Court in a position that a “choice may have to be made” on the basis of “which of our approved desires has the better claim, right here, right now…”

Justice Souter also pointed to the 1954 case of Brown v. Board of Education, which reversed the 1896 decision in Plessy v. Ferguson, to support his position that the “exclusive norm” for constitutional judging is not “merely [the] fair reading of language applied to facts objectively viewed…” Souter suggests that as the wording of the First Amendment did not change between 1896 and 1954, it is the “meaning” and “judicial perception” of the facts in these cases, which present little difference in substance (separate railroad cars and separate schools), that changed. Justice Souter writes that the meaning of “old facts may…change [ ] in the changing world.” In closing, Justice Souter concludes that the “fair reading model fails to account for what the Constitution actually says, and it fails just as badly to understand what judges have no choice but to do” in choosing between “good things that the Constitution approves.” Souter suggests that behind the “dreams of a simpler Constitution there lies a basic human hunger for the certainty and control that the fair reading model seems to promise.” Souter writes that he believes that in our “indeterminate world I cannot control, it is still possible to live fully in the trust that a way will be found leading through the uncertain future.”

Some legal scholars may assert that Justice Souter's speech is accordance with the "historicist view" of the Constitution which posits that the Constitution must be interpreted in "light of a Progressive understanding of society in which the historically situated, contingent nature of the state, the individual, and society and constitutionalism itself determines the meaning of our fundamental law." Bradley Watson asserts that the historicist approach has a certain background in social Darwinism and the pragmatism of John Dewey and William James. Justice Souter's speech may be in the spirit of Justice William J. Brennan who wrote that "the genius of the Constitution rests not in any static meaning it might have had in a world that is dead and gone, but in the adaptability of its great principles to cope with current problems and current needs." Watson further notes Brennan's assertion that the "demands of human dignity will never cease to evolve." Watson refers to Oliver Wendel Holmes as the Supreme Court's "first social Darwinist" who wrote in condemnation of laws whose grounds "have vanished long since" and against "blind imitation of the past." ("The Path of the Law", 1897).

Bradley Watson though would apparently not view Justice Souter as an unmitigated progressive. Watson notes that Souter in his concurring judgment in Washington v. Glucksberg (1997) prefers the "experimentation of the legislative process" over judicially imposed standards - but "only for the present time." Justice Souter wrote that "The Court should accordingly stay its hand to allow reasonable legislative consideration. While I do not decide for all time that respondents' claim should not be recognized"..."I acknowledge the legislative institutional competence as the better one to deal with that claim at this time." Watson asserts that for Souter, "judicial intervention is not called for until it is called for."

Justice Souter's apparent support for judicial restraint is may be reflected in Washington v. Glucksberg where he wrote that

"The best that can be said is that through the course of this Court's decisions it has represented the balance which our Nation, built upon postulates of respect for the liberty of the individual, has struck between that liberty and the demands of organized society. If the supplying of content to this Constitutional concept has of necessity been a rational process, it certainly has not been one where judges have felt free to roam where unguided speculation might take them. The balance of which I speak is the balance struck by this country, having regard to what history teaches are the traditions from which it developed as well as the traditions from which it broke. That tradition is a living thing. A decision of this Court which radically departs from it could not long survive, while a decision which builds on what has survived is likely to be sound. No formula could serve as a substitute, in this area, for judgment and restraint."

Avoidance of Unauthorized Transfer of Cash Collateral, No Statutory Defenses

2010-03-27T17:39:00.001-04:00

On March 16, 2010, the 11th Circuit Court of Appeals issued its opinion in the case of In re
Marathon Petroleum co., LLC v. Cohen (In re Delco Oil, Inc.), 2010 WL 918058 (11th Cir. 2010) and upheld the Bankruptcy Court's summary judgment allowing the bankruptcy trustee to avoid post-petition payments made by a debtor as unauthorized transfers of cash collateral. The Court also found sections 549(a) and 550(a) do not include exceptions based on harmless error, ordinary course or for an innocent vendor to prevent the avoidance of these transfers.

The Court reviewed that "[s]ection 549(a) of the Bankruptcy Code authorizes a trustee to recover unauthorized post-petition transfers of estate property." Pursuant to this provision, the trustee need only show that the post-petition transfer of estate property was not authorized by the Bankruptcy Code or court. Upon this showing, the transferee bears the burden of proving that the transfer was valid.

The Court found that the fact the the secured lender did not have a security interest under Florida law in the funds after they were transferred was "beside the point" and that the basis for the avoidance and recovery of the transfer was that the debtor did not have the authority to transfer the funds to anyone post-petition.

The Court explained that in order to determine whether the funds constituted cash collateral prior to the transfer was based on their status prior to the disputed transfer and not thereafter. The status as cash collateral is also not restricted to the status of the funds on the petition date.

The Court rejected the transferree's argument that the transferred funds did not constitute cash collateral as there was no filed deposit control agreement to establish "control" under Florida Statute section 679.3141(1). The Court found that Florida Statute sections 679.3151 (1)(b) and (3) provide that a security interest attaches to any identifiable proceeds of collateral and that a security interest in proceeds is a perfected security interest if the security interest in the original collateral was perfected.

The Court also rejected the transferee's argument that a genuine issue of fact existed as to whether the funds it received were "identifiable proceeds" of the secured creditor's collateral. The Bankruptcy Court had based its summary judgment ruling that the transferred funds were so identifiable proceeds on the unrebuted affidavit of an officer of the debtor. The Court of Appeals noted that there was nothing in the record that creates a genuine issue of material fact as to whether the funds were anything but the secured creditor's cash collateral.

The Court further rejected the transferee's argument that the transfer of fund caused the debtor no harm to the secured creditor or debtor in that it gave equivalent value of new inventory in exchange for the transferred funds. The Court held that there is no "harmless error exception" to the trustee's section 549 (a) avoiding powers.

The Court was also not persuaded by the transferee's argument that it held an "implicit defense" under section 549 for ordinary course transfers and for innocent vendors who deal with a debtor-in-possession. The Court held that section 363(c)(2) restriction on the use of cash collateral without consent or court order is a specific limitation on section 363(c)(1)'s express ability for a debtor-in-possession to use estate property in the ordinary course of business. The Court also held that the provisions of sections 549 and 550 do not contain any reference to transferee defense based on its status as a vendor or on its state of mind.

Tousa, Inc. Set to File Preferential Transfer Cases

2010-03-20T21:05:00.000-04:00

By its order dated January 15, 2010, the Bankruptcy Court of the Southern District of Florida granted Tousa, Inc., et al.'s motion to establish uniform procedures and deadlines for certain adversary proceedings Tousa intends to file to avoid and recover alleged preferential transfers. In its motion to the Court, Tousa advised the court that it expected to file as many as 1,200 adversary proceedings to avoid and recover preferences made within the 90 days prior to the filing of its bankruptcy petition on January 29, 2008.

Preferential Transfers
The Bankruptcy Code provides a power to avoid and recover certain pre-bankruptcy transfers, including preferential and fraudulent transfers. The elements of a preferential transfer include proof that the transfer was made 1. to or for the benefit of a creditor, 2. on account of an antecedent debt, 3. at a time the debtor was insolvent, 4. within 90 days prior to the filing of the case (or 1 year to an insider), and 5. which resulted in the creditor receiving more than it would have received in a chapter 7 case. Certain exceptions to a preference action include, i. a "contemporaneous exchange" for new value or ii. if made in the "ordinary course of business."

Four Tracks
The Tousa order divides the adversary proceedings into 4 "tracks" and set several "omnibus" or mass hearings over a period of from May 4, 2010 to March 24, 2011. Track I includes cases to recover between $25,000 to $50,000, Track II cases to recover between $50,001 to $100,000, Track III cases to recover from $100,001 to $250,000, and Track IV cases to recover in excess of $250,000.

Events
Tousa's prior motion proposed to set deadlines in each Track for various events, including initial disclosures, amendments to pleadings, expert reports, discovery, motions, and completion of mediation. The motions were proposed to be heard at various omnibus hearings.

Mediation
The Tousa order states that mediation will be mandatory in these cases with Tousa, Inc. to pay the mediator's fees. Tousa's motion proposed that each party is to receive fourteen days' advance written notice of its mediation conference which are to take place in Ft. Lauderdale, Florida unless otherwise agreed. Within seven days after the mediation conference, the mediator is to file his report. In the event of an impasse, cases are to be set for trial.

Preference Actions - Ordinary Course of Business and New Value Defenses

2010-03-14T11:45:00.000-04:00

On February 10, 2010, the Bankruptcy Court for the Southern District of Florida issued its opinion in the case of Deborah C. Menotte, Trustee v. Oxyde Chemicals, Inc., __ B.R. ___, 2010 WL 554900 (Bkrtcy.S.D.Fla.). The case involved a attempt to avoid and recover an alleged preferential transfer and the creditor's alleged a defense of "ordinary course of business" or "new value." The transfer in issue was a check dated within 90 days before the filing for payment of an invoice dated a few months earlier.

Elements of Preference Avoidance

The Court noted that the U.S. Supreme Court has explained that the purpose for the trustee's power to avoid preferences is to "discourage creditors from 'racing to the courthouse to dismember the debtor during bankruptcy,' and to facilitate an equality of distribution among creditors. The Court reviewed that section 547 (b) sets forth five elements to allow an avoidance of a preference.

Payment was to or for the benefit of a creditor
On account of an antecedent debt
Made while the debtor was insolvent
Made within 90 days before the bankruptcy petition date (one year for insider)
Effective in allowing the creditor to receive more than it would have received in a chapter 7 distribution

Ordinary Course of Business Defense

The Court found that the five elements of a preference were met and that the payment could avoided unless one of the exceptions set forth in section 547 (c) applied. The creditor argued that the section 547 (c)(2)(A) "ordinary course of business" exception applied. The elements of this exception are that the (i) debt was incurred in the ordinary course of business or financial affairs of the debtor and creditor and (ii) the payment was made in the ordinary course of business of the debtor and creditor. The trustee argued that this exception did not apply as the payment was made later than payments made during the pre-ninety day period and was made in response to unusual collection activity.

The Court cited the 11th Circuit case of In re Globe Mfg. Corp., 567 F.3d 1291 (11th Cir. 2009) and explained that the "ordinary course inquiry is subjective" and requires the court to consider whether the transfer was ordinary in relation to other business dealings between the creditor and debtor. It further stated that courts consider the following in making this determination:

Prior course of dealings between the parties during the pre-preference period - Transactions during the pre-preference are examined to determine the parties' ordinary course of business and then transactions occurring during the preference period are compared to the parties' pre-preference transaction to determine if they were made in a similar manner. Although courts have various mathematical tools available to make these analyses, there is no single formula the court must use and most tend to use the "range of terms that define the transaction, rather than considering only averages." The payment need not be rigidly similar to each past transaction, but need only demonstrate "some consistency with other business transaction."

Amount of the payments

Timing of the Payments - Untimely payments are more likely to be considered outside the ordinary course of business. The operative date is the date of delivery of the check and not the date the check is issued, but dishonored checks are considered delivered on the date the check is actually honored by the drawee bank.

Circumstances surrounding the payments - Otherwise "normal" payments which result from "unusual debt collection or payment practices" are not protected. Marathon Oil Co. v. Flatau (In re Craig Oil Co.), 785 F.2d 1563, 1566 (11th Cir. 1986). In making this determination (as with aging of payments), courts "normally conduct a comparative analysis between the preference and pre-preference periods." The analysis in on a case by case basis and legal action or coercion is not required.

Although the Court found that the payment was within the range of the debtor's ordinary course of late payments, it found that the circumstances surrounding the payment indicated "unusual debt collection" and therefore took it outside of the ordinary course of business. In making this finding, the Court compared the emails between the parties during the preference and pre-preference periods and found that warning of imposition of prepaid credit status/request for next day payment and a placement of a "credit hold"(which triggered the payment herein) were substantively different types of collection activity.

New Value Defense

The Court also rejected the creditor's attempt to use the section 547 (c)(4) "new value" exception as the other credit that was extended was before and not after the challenged preference payment. The section 547 (c)(4) new value defense requires that (1) the creditor extend new value after receiving the challenged payments, 2. the new value must be unsecured, and 3. the new value must remain unpaid.

Prejudgment Interest

The Court found that pursuant to the 11th Circuit's decision in In re Globe Mfg. Corp., courts have the discretion to award prejudgment interest as a matter of federal common law, but that its award must be "equitable." As the Court found that the creditor's ordinary course of business defense was colorable although ultimately unpersuasive and that the creditor did not otherwise delay the proceedings, it declined to exercise its discretion to award prejudgment interest.

US Supreme Court: Corporation's "Nerve Center" is its "Principal Place of Business"

2010-02-28T15:08:00.001-05:00

On February 23, 2010, the U.S. Supreme Court decided the case of Hertz Corp. v. Friend, et al., 559 U.S. ____ (2010) in which the issue was whether there was federal diversity jurisdiction under 28 U.S.C. § 1332. Hertz Corp. removed the case from state court to federal court and the respondents argued that diversity jurisdiction was lacking on their contention that Hertz Corp's "principal place of business" was in California not New Jersey. Hertz argued that its "principal place of business" was in New Jersey where it carried out its main executive and administrative functions.

The District Court, based on Ninth Circuit precedent, found that Hertz Corp. was a California citizen by looking to the amount of the corporation's business activity State by State and also found that the amount of its activity in California predominated. The Ninth Circuit Court of Appeals affirmed. The Supreme Court granted Hertz Corp.'s writ for certiorari. The Supreme Court vacated the Ninth Circuit's judgment and remanded the case for further proceedings. The Court explained its decision as follows.

Under the federal diversity jurisdiction statute, a corporation is deemed to be a citizen of any State in which it has been incorporated and where is has its principal place of business 28 U.S.C. § 1332 (c)(1)

The Constitution provides that "judicial Power shall extend" to "Controversies...between Citizens of different States." Art. III, § 2.

Pursuant to such Constitutional power, Congress conferred diversity jurisdiction upon the federal courts and set the scope of the federal courts' jurisdiction within constitutional limits.

The Supreme Court's approach to the determination of citizenship of corporations for purposes of diversity jurisdiction has been varied in the last two hundred years.

In 1958, Congress enacted legislation whereby a corporation was to be deemed a citizen of any State in which it was incorporated and in the State where it has its principal place of business.

"The phrase 'principal place of business' has proved more difficult to apply than its originators likely expected."

The various Circuits have followed various rules, applying different tests, and highlighted different factors, including the "nerve center" test, a general "business activities" approach, a "center of gravity" approach, "locus of operations", and "center of corporate activities"

The effort of the courts to apply the phrase "principal place of business" "in light of the general purpose of diversity jurisdiction, ie. an effort to find the State where a corporation is least likely to suffer out-of-state prejudice when it is sued in a local court".... "seems doomed to failure. After all, the relevant purposive concern - prejudice against an out-of-state party - will often depend upon factors that courts cannot easily measure, for example, a corporation's image, its history, and its advertising, while the factors that courts can more easily measure, for example, its office or plant location, its sales, it employment, or the nature of the goods or services it supplies, will sometimes bear no more than a distant relation to the likelihood of prejudice."

In order to achieve a "more uniform interpretation of the statutory phrase," the Court concluded that "'principal place of business' is best read as referring to the place where a corporation's officers direct, control, and coordinate the corporation's activities. It is the place that Court's of Appeals have called the corporation's 'nerve center'"

"[I]n practice it should normally be the place where the corporation maintains its headquarters - provided that the headquarters is the actual center of direction, control, and coordination, ie., the 'nerve center'"

The Court recognizes that this approach may be "imperfect", but that it "is superior to other possibilities."

The word "place"as used in the statute "of the State where it has its principal place of business" means the place within a State, not the State itself. "The word 'place' is in the singular, not the plural....A corporation's 'nerve center,' usually its main headquarters, is a single place."

"[A]dministrative simplicity is a major virtue in a jurisdictional statute....Complex jurisdictional tests complicate a case, eating up time and money as the parties litigate, not the merits of their claims, but which court is the right court to decide those claims."

"Simple jurisdictional rules also promote greater predictability" which is "valuable to corporations making business and investment decisions."

The Court recognized that "under the 'nerve center' test...there will be hard cases" and that it may in some cases "produce results that seem to cut against the basic rationale" for diversity jurisdiction.

"The burden of persuasion for establishing diversity jurisdiction...remains on the party asserting it."

Dismissal of Tousa Cash Collateral Appeal

2010-02-07T12:45:00.001-05:00

On February 5, 2009, the District Court of the Southern District of Florida issued its decision in the case of Aurelius Capital Master, Ltd., et al. vs. TOUSA, Inc., et al., Case No. 08-61317-CIV-GOLD. affirming the bankruptcy court's order dated June 20, 2008 granting the motion to use cash collateral. The District Court dismissed the appeals for mootness, lack of standing, that the cash collateral order is not a final order, and that in any event the appeals would fail on their merits. In its decision, the District Court made the following conclusions.

Standard for Review

The Court may review the cash collateral order under an abuse of discretion standard.

Standing for Appeal

In the bankruptcy context, a person has standing to appeal if he is a "person aggrieved" by the order. An aggrieved party in the bankruptcy context are "those parties having a direct and substantial interest in the question being appealed." The "person aggrieved" doctrine is more restrictive than traditional Article III standing, as it allows a person to appeal a bankruptcy order only when they are "directly and adversely affected pecuniarily by the order." Mere appearance in a bankruptcy proceeding does not give a party standing to appeal an order of the bankruptcy court.
An appellant lacked standing as it was deemed to have consented to the cash collateral order as pursuant to the intercreditor agreement, it had bargained away its right to object

Equitable Mootness Doctrine

The equitable mootness doctrine permits the courts to dismiss an appeal based on its lack of power to rescind certain transaction. "In bankruptcy, the mootness doctrine recognizes that at some point the case has progressed so far that it is impossible to unwind all that has been done."
There is a narrow exception to the equitable mootness doctrine that applies only in exceptional situations when the action being challenged is capable of being repeated and evading review.

Final Order

A final order is "one which ends the litigation on the merits and leaves nothing for the court to do but execute the judgment." "Finality is given a more flexible interpretation in the bankruptcy context..." As bankruptcy is an aggregation of controversies and suits, "it is generally the particular adversary proceeding or controversy that must have been finally resolved rather than the entire bankruptcy."
Although cash collateral orders may be regarded as final under certain circumstances, broadly speaking a "conditional order approving the use of cash collateral is not appealable as a final order."
Courts have found disgorgement provisions of cash collateral order to render the order interlocutory in nature.
The aspect of the order as to the use of cash collateral to fund an award of interim professional fees is also non-final as such award is interlocutory in nature
"Court have found bankruptcy ruling to be interlocutory where they are open to reexamination and open to subsequent challenge."
Even with the lack of finality, appeal jurisdiction may be proper if it is a proper interlocutory appeal
In the absence of a motion for leave to file an interlocutory appeal, the Court has the discretion to consider a timely filed Notice of Appeal as a motion for leave to file an interlocutory appeal
Interlocutory review is generally disfavored for its piecemeal effect on cases, but district courts have discretion to grant interlocutory review of bankruptcy court orders if the bankruptcy court involves 1. a controlling question of law 2. to which there is a substantial ground for difference of opinion and 3. is such that an immediate appeal would advance the ultimate termination of the litigation. This three-part standard is analogous to that set forth in 28 U.S.C. section 1292 (b) as to appeals from the district court to the circuit court of appeals.

Standards for Approval of Consensual Cash Collateral Order

Significant case law supports the use of the "business judgment standard" in approving a consensual cash collateral order
Even with the factual support for the satisfaction of the business judgment standard, the bankruptcy court cannot permit parties to consent around the requirements of the bankruptcy code
The "best interest of the estate standard" for the approval of consensual cash collateral order is more stringent and requires that the settlement be "fair and equitable"
The court found persuasive the Second Circuit's decision in In re Blackwood Associates, L.P, 153 F.3d 61,67 (2nd Cir 1998), that where there is consent to the use of the cash collateral, its use its not conditioned on the provision of adequate protection of security interests under section 363(e), section 361 is not triggered, and there is no requirement that the debtor demonstrate diminution of value.
Oversecured creditors may not be entitled to cash payments or postpetition liens because they are adequatley protected through the existence of a value cushion. Whether a value cushion is sufficient to provide adequate protection must be determined by the facts in each case.

Citizens United vs. Federal Election Commission - Chief Justice Robert's Concurring Opinion

2010-01-30T13:40:00.000-05:00

Last week, the Supreme Court issued its decision in Citizens United v. Federal Election Commission, 558 U.S. ___ (2010) dealing with an issue of federal campaign finance law. The majority opinion written by Justice Kennedy overruled two prior Supreme Court decisions and held that the First Amendment permits corporations and unions to use their general funds to produce their own independent political campaign advertisements. Chief Justice Roberts stated that he wrote a separate concurring opinion to "address the important principles of judicial restraint and stare decisis implicated in this case."

Chief Justice Roberts noted that in this case, that "[f]idelity to precedent - the policy of stare decisis - is vital to the proper exercise of the judicial function." He wrote that stare decisis "promotes the evenhanded, predictable, and consistent development of legal principles, fosters reliances on judicial decisions, and contributes to the actual and perceived integrity of the judicial process." (quoting, Payne v. Tennessee, 501 U.S. 808, 827 (1999)) and that "departures from precedent are inappropriate in the absence of a 'special justification.'" (quoting, Arizona v. Rumsey, 467 U.S. 203, 212 (1984)).

Chief Justice Roberts further stated that [w]hen considering whether to reexamine a prior erroneous holding, we must balance the importance of having constitutional questions decided against the importance of having them decided right." He quoted Justice Jackson, who explained that this requires a "sober appraisal of the disadvantages of the innovation as well as those of the questioned case, a weighing of practical effects of one against the other." He further wrote "stare decisis in not an end in itself" but is instead "the means by which we ensure that the law will not merely change erratically, but will develop in a principled and intelligible fashion." (quoting, Vasquez v. Hillery, 474 U.S. 254, 265 (1986)).

On the situation where "the precedent under consideration itself departed from the Court's jurisprudence," Justice Roberts wrote that "returning to the 'intrinsically sounder' doctrine established in prior cases" may "better serv[e] the values of stare decisis than would following [the] more recently decided case inconsistent with the decisions that came before it." (quoting, Adarand Constructors, Inc. v. Pena, 515 U.S. 200, 231 (1995). He further wrote that "[a]brogating the errant precedent, rather than reaffirming or extending it, might better preserve the law's coherence and curtail the precedent's disruptive effects."

2009-12-15T15:51:00.000-05:00

The Bankruptcy Court's decision in In re Miller Engineering, Inc., 398 B.R. 473 (Bkrtcy.S.D.Fla. 2008), involved a discussion of various issues, including that of the priority of a Florida landlord's lien over a security interest on personal property. The resolution of the issue involved a determination of whether the lease was a continuing over eight years or whether based on the circumstances a new lease agreement arose.

The Court noted that the "creation and perfection of liens are fundamentally questions of state law" and that "Florida Statute section 83.08 governs the creation of a landlord's lien for rent due and owing." Section 83.08 generally provides, inter alia, for a lien in favor of every person to whom rent is due upon the property found upon or off the premises rented and in the possession of any person that belongs to the lessee and that is usually kept on the premises. The lien is superior to any lien acquired subsequent to the bringing of the property onto the leased premises. This statutory lien of the landlord does not need to be filed or recorded to be perfected and it attaches at the commencement of the tenancy or as soon as the chattel is brought onto the premises.

Florida Statutory Landlord's Lien

But the Bankruptcy Court reviewed that a landlord's lien is not permanent and that "[n]owhere in the statute does it indicate that the superiority of a landlord's lien over a subsequent lienholder continues after the lease period has ended, the lease's terms and conditions fulfilled, and a new lease is entered into between the same landlord and the same tenant..." (citing, Flowers v. Centrust Savings Bank, 556 So.2d 1123, 1125 (Fla. 3d DCA 1989). The Bankruptcy Court stated that Florida case law provides guidance into the facts which would constitute a legal termination of a lease, whether a new lease was entered into, and whether continued occupancy legally constitutes "arising under the same transaction."

In this case, the Bankruptcy Court founds that whether the lessee debtor elected to use its option to continue occupancy or whether it continued under a "more informal month-to-month arrangement is irrelevant" and that therefore the landlord's lien that arose under the original lease continued unbroken.

Waiver

The Court also noted that under Florida law that a landlord's lien may be waived. A waiver is "generally characterized as the 'intentional relinquishment of a known right'". (citing, Dooley v. Weil (In re Garfinkel), 672 F.2d 1340, 1347 (11th Cir. 1982)). The waiver may be express or implied. In this case, the Court found that the landlord's lien had been waived.

Marshaling

The Court next reviewed the priority of the various competing lien claims and the elements of the doctrine of marshaling. The Court stated that the equitable doctrine of marshaling "rests upon the principle that a creditor having two funds to satisfy his debt, may not by his application of them to his demand, defeat another creditor, who may resort to only one of the funds." (citing, Meyer v. United States, 375 U.S. 233 1963)). The Court noted that "[b]ankruptcy courts have the equitable power to order the marshaling of assets in a bankruptcy case." The Court further reviewed that in the absence of a contrary court order or statute, that as a general principle, a party with inferior interests to a junior lienholder, cannot object to marshaling.

Recharacterization of Claims as Equity

2009-10-24T17:07:00.000-04:00

"Recharacterization" refers to the equitable power exercised by bankruptcy courts to recast a purported claim or transaction according to its true economic nature and substance, regardless of its form or label. In bankruptcy, the two major types of recharacterization is of loans to be in actuality equity contributions and the recharacterization of sales as secured loans.

In the case of First NLC Financial Services, LLC, 396 B.R. 562 (Bkrtcy. S.D. Fla., 2008), a chapter 7 trustee brought an adversary proceeding against purported lenders and asserted that their claims based on loans should, inter alia, be recharacterized instead as equity. The bankruptcy court stated that at least five Circuit Courts of Appeal, including the Eleventh Circuit, recognize the power of bankruptcy courts to recharacterize debt as equity. The bankruptcy court further states that the purpose of recharacterization is to prevent equity investors from labeling their contributions as loans and thereby circumventing the Bankruptcy Code's priority system by obtaining a larger recovery and higher priority in the event of a bankruptcy. The court further distinguished recharacterization from equitable subordination in that recharacterization rests on the substance of the transaction while equitable subordination is based on the assessment of the creditor's behavior. The Bankruptcy Court noted that the determination of recharacterization is generally based on a number of factors, including the issue of undercapitalization, the names given to the certificates evidencing the debt, the presence of a fixed maturity date, the source of the payments, the right to enforce payments, participation in management, the status of the contribution in relation to regular corporate creditors, the intent of the parties, identity of interest between the creditor and stockholder, source of the interest payments, the ability of the corporation to obtain loans from outside lending institutions, the extent to which the advance was used to acquire capital assets, and the failure of the debtor to repay on the due date or seek a postponement.

Yellowstone Mountain Club, LLC

2009-08-16T16:22:00.000-04:00

On June 29, 2009, the Bankruptcy Court of Montana issued its order vacating its prior order dated May 12, 2009 wherein it entered a judgment against Credit Suisse and equitably subordinated its $232 million secured claim as to certain other claims, including unsecured creditors.

In its May 12, 2009 decision, the Court explained that pursuant to 11 U.S.C. Section 510(c), a court may subordinate for purposes of distribution all or a part of a claim or interest to all or part of another. The Court noted that per the Ninth Circuit's decision in In re First Alliance Mortg. Co., 3497 F.3d 977, 1006 (9th Cir. 2006) equitable subordination of claims generally requires three findings: "1. that the claimant engaged in some type of inequitable conduct, 2. that the misconduct injured creditors or conferred unfair advantage on the claimant, and 3. that subordination would not be inconsistent with the Bankruptcy Code" and that when equitable subordination involves a non-insider, non-fiduciary, "the level of pleading and proof is elevated: gross and egregious conduct will be required before a court [can] equitably subordinate a claim." The Court reviewed case law that "equitable subordination is seldom used in a non-insider, non-fiduciary scenario..."

The Court found that Credit Suisse's conduct met this high threshold as it was "so far overreaching and self-serving that they shocked the conscience of the Court." The Court found that in 2005, "Credit Suisse was offering a new financial product for sale" in which it real estate developers "to take their profits up front by mortgaging their development projects to the hilt." Pursuant to this program, Credit Suissed lent the funds on a non-recourse basis, earned a substantial fee, and sold off most of the debt to loan participants. The loan enabled the real estate developers to take most of the loan out as a "profit dividend, leaving the developments saddled with enormous debt." The Court found that Credit Suisse and the individual owners of development would benefit, "while their developments-and especially the creditors of their developments-bore all the risk of loss" as the developments were left "too thinly capitalized to survive." The Court found that Credit Suisse turned a "blind eye to Debtor's financial statements" and that its "due diligence with respect to the $375 million loan was almost all but non-existent." The Court also found fault with Credit Suisse's "newly devised valuation methodology...even though such projections bore no relation to the Debtor's historical or present reality." The Court noted that Credit Suisse "could not have believed under any set of circumstances that the Debtors could service such increased debt load."

The Court found that Credit Suisse's actions were "simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may." The Court stated that the "naked greed in this case combined with Credit Suisse's complete disregard for the Debtors or any other person or entity who was subordinated to Credit Suisse's first lien position, shocks the conscience of this Court. While Credit Suisse's new loan product resulted in enormous fees to Credit Suisse in 2005, it resulted in financial ruin for several residential resort communities. Credit Suisse lined its pockets on the backs of the unsecured creditors." Based on this conduct, the Court subordinated Credit Suisse's first lien to that of the superpriority dip financing and to the unsecured creditors. The Court did not subordinate the claim to the membership claims.

General Growth Decision: Good Faith May Include Consideration of Interests of Group, But No Implication of "Substantive Consolidation"

2009-08-12T11:16:00.001-04:00

In April, 2009, the nation's second largest shopping center owner, General Growth Properties, Inc. and 166 of its subsidiaries filed for relief under chapter 11 in the Bankruptcy Court of the Southern District of New York. These filings raised the concerns of investors in commercial mortgage-backed securities (CMBS) as certain of the General Growth Properties subsidiaries were intended to be "bankruptcy remote" special purpose entities ("SPEs").

On August 11, 2009, Judge Allan L. Gropper issued his opinion in General Growth Properties, Inc., et al.. ___ B.R. ___, 2009 WL 2448423 (Bkrtcy.S.D.N.Y.) on the secured creditors' motions to dismiss the subject chapter 11 cases for alleged bad faith. The secured creditors argued that the subject debtors were not yet in need of bankruptcy relief although others in the corporate group were in financial distress. The Court denied the motions to dismiss and held that "a judgment on an issue as sensitive and fact-specific as whether to file a Chapter 11 petition can be based in good faith on consideration of the interests of the group as well as the interests of the individual debtors." The Court further held that the special purpose entity structure of the various debtors was still in place and that the Court's opinion on this issue does not imply that substantive consolidation would be appropriate.

Some of the subject debtors which owed mortgages on their properties were set up to function as SPEs. SPE's are intended to protect the interests of the mortgagee secured lenders by isolating the operations of the borrower from the borrower's affiliates and parent. To advance that purpose, there are typically limitations on the SPE, including certain prohibitions on consolidation and liquidation, merger and assets sales, etc. Often SPE documentation requires the entity to retain one or more independent directors or managers. In this instance, although the mortgage loans were typically secured by a separate property owned by an individual debtor, many of the loans were guaranteed by other affiliate debtors. The involved mortgage loans typically were of a three to seven-year term with low amortization and a large balloon payment due at the end. Many of the involved mortgage loans were financed in the commercial mortgage-backed securities ("CMBS") market. In a typical CMBS transactions, mortgages are sold to a tax qualified REMIC trust which in turn sells certificates to investors. The REMIC is managed by a master servicer or a special servicer in the event of defaults.

The Court explained that the principle that a chapter 11 reorganization case can be dismissed as having been filed in bad faith is a "judge-made doctrine." The court set forth Second Circuit precedent that grounds for dismissal exist if it is clear on the filing date that "there was no reasonable likelihood that the debtor intended to reorganize and no reasonable probability that it would eventually emerge from bankruptcy proceedings" and further cited Chief Judge Brozman that "the standard in this Circuit is that a bankruptcy petition will be dismissed if both objective futility of the reorganization process and subjective bad faith in filing the petition are found." No one factor is determinative and the Court "must examine the facts and circumstances of each case in light of several established guidelines or indicia..."

Argument of Premature Filing

The secured creditors contended that the subject chapter 11 cases were filed prematurely arguing that the various debtors were not yet in financial distress as none of the involved mortgages had a maturity date earlier than March 2010. The Court stated that in effect, the secured creditors argued that the issue of financial distress should not be examined from the perspective of the group but only on an individual-entity basis.

The Court held that the various debtors were justified in filing the chapter 11 petitions when they did. The Court found that the individual debtors were indeed in varying degrees of financial distress at the time of filing of the chapter 11 cases. Some of the loans had cross-defaulted to the defaults of affiliates or would as the result of the other debtors' bankruptcy filings. Also some of the loans had gone into "hyper-amortization" in 2008. The Court noted that there was no evidence to counter the debtors' showing that the CMBS market on which they relied was "dead" as of the petition date with no prospects for improvement.

The Court noted that although Chapter X of the former Bankruptcy Act required that a petition be filed in good faith, neither Chapter XI nor XII of the former Bankruptcy Act contained such requirement and that Congress did not include the good faith requirement in chapter 11 as enacted by the Bankruptcy Reform Act of 1978. The Court further noted that even the 2005 BAPCPA amendments which strengthened section 1112 relating to dismissal or conversion of an abusive chapter 11 case, did not provide for dismissal for a bad faith filing.

The Court also stated that it is "well established that the Bankruptcy Code does not require that a debtor be insolvent prior to filing." The Court also noted a corollary that there is no particular degree of financial distress required as a condition to filing for bankruptcy relief.

SPE Structure Does Not Restrict Group Analysis

The Court also rejected the secured creditors' argument that the SPE or bankruptcy-remote structure of the project-level debtors' financial distress be analyzed only an individual basis. The Court recognized that there is "no question that this [SPE] structure was designed to make each Subject Debtor 'bankruptcy remote.'" The Court found that the secured lenders did not contend "they were unaware that they were extending credit to a company that was part of a much larger group, and that there were benefits as well as possible detriments from this structure." The Court looked to supporting precedent which held that it was sound business practice for a parent business to seek chapter 11 relief also for its wholly-owned subsidiaries when those subsidiaries were crucial for it own reorganization plan. The Court found that the parent Debtor was faced with the "unprecedented collapse of the real estate markets, and serious uncertainty as to when or if they would be able to refinance the project-level debt, the Debtors' management had to reorganize the Group's capital structure."

Fiduciary Duty of "Independent Managers"

The Court noted that the operating agreements of many of the project-level debtors required the appointment of two "independent managers" who are to consider only the interests of the individual company and its creditors in acting or voting as to filing for bankruptcy relief. But the Court further noted that the operating agreements also provided that the independent managers have the fiduciary duty of loyalty of care similar to that of a director of a Delaware corporation.

The Court held that although the operating agreements "may have attempted to create impediments to a bankruptcy filing" by directing the independent managers to only consider the interests of the individual company and its creditors, it also appropriately provided that the independent managers can only act as permitted by applicable Delaware law which provides or "indeed, required" that the directors of a solvent corporation are to consider the interest of their shareholders in exercising their fiduciary duties. The Court cited North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) where the Delaware Supreme Court held that the directors of an solvent corporation navigating in the zone of insolvency "must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owner." The Court held that Delaware law does not support the secured creditors' contention that the independent managers "should have considered only the interests of the secured creditors when they made their decision to file Chapter 11 petitions, or that there was a breach of fiduciary duty" on their part by voting to file chapter 11 based on the interest of the group. Judge Gropper stated that the secured creditors were mistaken if they believed that an independent manager can serve on a board "solely for the purpose of voting 'no' to a bankruptcy filing" as under the applicable Delaware law they owe their duties to the corporation and ordinarily to the shareholders.

No Finding of Objective or Subjective Bad Faith

The Court also rejected the secured creditors' argument that "objective futility" has been established because the debtors will not be able to confirm a plan over their opposition. The Court held that there "is no requirement in the Bankruptcy Code that a debtor must prove that a plan is confirmable in order to file a petition" and that courts have "consistently refused to dismiss on this ground before a plan has been proposed."

The Court further reject the secured creditors' arguments that the subject debtors lacked subjective good faith in their filings by failing to negotiate prior to filing and that several of the independent managers of the SPE's were fired and replaced shortly prior to the filing. The Court held that the "Bankruptcy Code does not require that a borrower negotiate with its lender before filing a Chapter 11 petition." The Court cited two consumer provisions added by BAPCPA to emphasize that "Congress knows how to impose a filing requirement when it wants to do so." Furthermore, the Court noted that "there is no evidence that pre-filing talks would have been adequate to deal with the extent of the problem." The Court also held that the record did not support the assertion that the firing of the independent managers constituted sufficient bad faith to require dismissal and in any event the fired independent managers did not have a duty to keep any of the debtors from filing from bankruptcy under Delaware fiduciary duty law.

No Implication of Substantive Consolidation

The Court noted that fundamental protections negotiated for with SPE structures "are still in place and will remain in place during the Chapter 11 cases. This includes protection against substantive consolidation of the project level Debtors with any other entities." The Court stated that "the question of substantive consolidation is entirely different from the issue" whether a board of a debtor that is part of a corporate group "can consider the interests of the group along with the interest of the individual debtor when making a decision to file a bankruptcy case." The Court also stated that [n]othing in this Opinion implies that the assets and liabilities of any of the Subject Debtors could properly be substantively consolidate with those of any other entity."

The Court also found that the involved Illinois land trust was eligible to be a debtor as it satisfied the Bankruptcy Code's definition of a "business trust" as it conducted business activities.

Bankruptcy Court Approves GM's Section 363 Sale of Assets

2009-07-06T17:04:00.000-04:00

On July 5, 2009, the U.S. Bankruptcy Court for the Southern District of New York issued its decision in the General Motors Corporation chapter 11 case and approved the motion for approval of sale of the bulk of its assets in a 363 sale pursuant to the "Master Sale and Purchase Agreement" to the Vehicle Acquisitions Holdings, LLC, which is a purchaser sponsored by the U.S. Department of Treasury.

GM's motion was supported by the U.S. Government which is GM's largest pre-and post-petition creditor as well as by the Government of Canada and Ontario, the UAW, and other bond holders. The objectors argued that GM's assets can only be sold under a chapter 11 plan and that the proposed 363 sale amounts to an impermissible "sub rosa" plan. Other issues included the limitations on successor liability and well as retiree claims.

The Court agreed with GM's assertion that "this is exactly the kind of case where a section 363 sale is appropriate and indeed essential..." and that "GM cannot survive with its continuing losses and associated loss of liquidity, and without the governmental funding that will expire in a matter of days." The Court added "there are no options to this sale...." and that "the only alternative to an immediate sale is liquidation." The Court stated that the Bankruptcy Code and caselaw do not require waiting for a plan confirmation process when the inevitable consquence would be liquidation.

The Court also rejected the various objectors' arguments that this is amounts to a sub rosa plan as the proceeds of the sale GM's assets will be distributed according to statutory priorities under a subsequent plan. The Court stated that the arrangements that will be made by the purchaser "do not affect the distribution of the Debtor's property."

The Court stated that the issues regarding successor liability were the only truly debatable issues in this case and that while the caselaw on a nationwide basis is not uniform, the Court will follow the caselaw in the Second Circuit and the Southern District of New York in holding that "to the extent the Purchaser has not voluntarily agreed to accept successor liability, GM's property - like that of Chrysler, just a few weeks ago - may be sold free and clear of claims."

The Court found that "section 363 has no carveouts from its grant of authority when applied in cases under chapter 11" and that it does not provide a limitation from its use "for dispositions of property exceeding any particular size..." The Court added the "neither section 363 nor section 1123(b)(4) 4 provides that resort to 1123(b)(4) is the only way by which all or substantially all of the assets can be sold in a chapter 11 case." In short, the Court stated that the plain meaning of section 363 "permits what GM proposes here to do."

The Court also stated that Second Circuit and Southern District of New York case law supports its decision, including those in Chrysler, Lionel, LTV, Financial News Network, Gucci, and Iridium. The Court noted the standards for pre-confirmation section 363 sales were set by the Second Circuit's decision in In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983). In Lionel, the Court rejected "the requirement that only an emergency permits use of section 363(b)" but it also rejected "the view that seciton 363 grants the bankruptcy judge carte blanche." The Court in Lionel established a balancing test for lower courts, including factors of an "articulated business justification" and a "good business reason" with a consideration of the "salient factors of the proceeding" and to "act to further the diverse interests of the debtor, creditor and equity holders."

The Court stated that caselaw "recognizes the impropriety of sub rosa plans in instances where they genuinely exist." The Court noted the idea underlying the prohibition against sub rosa plan appears in Braniff where the Fifth Circuit Court of appeals held that "the debtor and the Bankruptcy Court should not be able to short circuit the requirements of Chapter 11 for confirmation of a reorganization plan by establishing the terms of the plan sub rosa in connection with a sale of assets." The Court stated that a 363 sale may be objectionable when it "dictate[s] the terms of the ensuing plan or contrains parties in exercising their confirmational rights" or "if the sale itself seeks to allocate or dictate the distribution of sale proceeds among the different classes of creditors." The Court held that none of these factors were present in this case. The GM sale brings in value that the creditor will share in pursuant to a chapter 11 plan that is subject to confirmation by the Court.

Potentially Subordinated Creditors Qualify to Petition for Involuntary Bankruptcy

2009-06-25T15:56:00.000-04:00

The Bankruptcy Court of the Southern District of Florida recently issued it order denying the motion to dismiss the involuntary chapter 7 bankruptcy petition filed against Flamingo Enterprises, Inc.. In re Flamingo Enterprises, Inc., ___ B.R. ___, (Bkrtcy.S.D.Fla.)(Ray, J.).

The motion to dismiss by Flamingo Enterprises, Inc. alleged that the petitioners were not qualified to petition for the involuntary relief in that their claims were the subject of a bona fide dispute as to whether they were subordinated to a bank credit facility. that therefore they were not qualified creditors.

The Court noted that per the case of In re Euro-American Lodging Corp., 357 B.R. 700, 712 (Bankr. S.D.N.Y. 2007) that there is a five part test for a contested involuntary petition: 1. whether the claims are not contingent as to liability, 2. whether the claims are not subject to a bona fide dispute as to liability or amount, 3. whether the claims total in the aggregate at least $13,475.00, 4. whether three or more entities commenced the petition, and 5. whether the alleged debtor is generally not paying its debts as they come due. The Court further noted that the only item in issue was whether the petitioners' claims are the subject to a bona fide dispute as to liability or amount.

The Court rejected Flamingo Enterprises, Inc.'s argument that the question of of subordination introduced a "bona fide dispute". The Court stated that whether or not the claims of the petitioners are subordinated, they represent a liability or "financial obligation." The Court distinguished the case of IMI Acquisition of Boca Raton Corp., 221 B.R. 35, 37 (Bankr. S.D. Fla. 1998) due to the intervening amendments of BAPCPA to sections 303(b)(1) and 303(h)(1) which narrowed the scope of "bona fide dispute" by adding "as to liability or amount."

The "Empty Creditors" of General Motors

2009-05-14T15:58:00.000-04:00

An article in a major international business newspaper today is headlined: "Credit Insurance Hampers GM Restructuring." The article submits that hedge funds and other investors "stand to make billions of dollars on credit insurance contracts if General Motors declares bankruptcy" and that this is making it more difficult to reach a restructuring plan for General Motors.

It is reported that the prospects have "diminished" that holders of $27 billion in General Motors bonds will agreed to swap their debt for a 10 percent equity stake in General Motors by the June 1 deadline due to the involvement of credit default swaps. (Other parts of the agreement will give the U.S. government a 50 percent equity share, the United Auto Workers union healthcare fund 39 percent and existing shareholders 1 percent. ) Pursuant to the provisions of the credit default swaps, creditors will receive more in the event of a General Motors default than if they agree to a restructuring of General Motors' debt. According to the article, the Depository Trust & Clearing Corporation submits that creditors which hold $34 billion in credit default swaps will "make a net profit of $2.4bn if GM were to default."

The behavior of these General Motors' creditors would appear to be accordance with that of the "empty creditor" explored in the recently reviewed writings of University of Texas Law School Professor Henry T.C. Hu. Professor Hu asserts that the empty creditor is one that exhibits puzzling creditor behavior towards troubled debtors when credit default swaps and other products are involved. Professor Hu suggests that due to the use of credit default swaps and the like, the empty creditor may have a perverse incentive to fail to cooperate and cause the troubled firm's value to fall. Professor Hu explains that traditionally, the law assumes that creditors would seek to "keep solvent firms out of bankruptcy and to maximize their value."

Professor Hu's work on the "empty creditor" has been reviewed in the Wall Street Journal and Newsweek, and Business Week.

Freeze Order in SEC Action in Alleged $550 Million "Hedge Fund" Fraud

2009-05-13T16:06:00.000-04:00

On May 7th, 2009, Judge John E. Steele of the U.S. District Court of the Middle District of Florida issued an order in the case of "Securities and Exchange Commission, Plaintiff vs. Founding Partners Capital Management, and William L. Gunlicks Defendants, et al." This case involves a five-count securities fraud complaint filed by the SEC against Gunlicks, Founding Partners Capital Management Company ("Founding Partners") which is described as a management company registered as an investment advisor as well as six other "relief defendants".

The SEC alleges in its complaint that Gunlicks and Founding Partners operate three "hedge funds" and one mutual fund all of which made loans to two other relief defendant entities (Sun Capital, Inc. and Sun Capital Healthcare, Inc.) which in turn purchased commercial and healthcare accounts receivables at a discount. The SEC alleges in the complaint that Stable-Value", one of the four named "relief defendants" was the "primary fund". Interest was paid to "Stable-Value" at approximately 1.3% per month and Founding Partners charged the lender "Stable-Value" a 1.75% annualized management fee.

The SEC alleged that Gunlicks and Founding Partners solicited funds from investors upon the representation that the Stable-Value loans to the two Sun Capital entities constituted a "safe investment opportunity." It is alleged that Gunlicks and Founding Partners represented that receivable purchased by the two Sun Capital entities were short-term and highly liquid and that they fully secured the loans made to it by Stable-Value. The SEC further alleged that despite these representations to investors, Gunlicks and Founding Partners permitted the two Sun Capital entities to purchase less liquid and riskier longer-term receivables such as workers' compensation receivables, "Disproportionate Share (DSH) receivables", and loans to financially troubled hospitals. Gunlicks and Founding Partners were alleged to have continued to solicit investors without disclosing the changes in lending and the increased risks presented. It is further alleged that the two Sun Capital entities owe $550 million on the Stable-Value loans of which only 32% were invested in less risky, short-term receivables as described to investors by Gunlicks and Founding Partners. The SEC also alleged that Gunlicks and Founding Partners had failed to honor most of the recent significant number of redemption requests, that they falsely represented that the 2007 financial statements were audited, and failed to disclose a certain consent order, and that there was use of fund assets for personal expenses.

The case came before the court on its order to show cause as the continuation of the freeze order as to Gunlicks, Founding Partners and four of the six relief defendants. Gunlicks also moved to challenge the validity and scope of the "freeze order" and requested exemptions from the freeze order for asset preservation and living expenses and attorney fees.

The court found that it did have the authority to issue the freeze order as the SEC sought the equitable relief of disgorgment in its complaint. The court held that although it does not have the authority to issue an asset freeze order when the SEC only seeks money damages, it can enter a freeze order where equitable relief such as disgorgement is sought even if it is coupled with requests for money damages and civil penalty. The purpose of a freeze order is to ensure the adequacy of a disgorgement remedy.

The court also rejected Gunlicks' contention that the freeze order should be lifted on a questioning of the likelihood of success on the merits. The court found that the SEC satisfied its burden of establishing a likelihood of success on the merits and that it established a prima facie case. The court ordered that its ex parte temporary "freeze order" should remain in effect as to defendant Williams L Gunlicks until further order and denied Gunlicks' motion to amend or modify the "freeze order."

The court also disagreed with Gunlicks' challenge to the scope of the asset freeze order to his personal assets that were obtained prior to the alleged fraudulent conduct. The court held that a district court may enter an "order freezing all of a defendant's assets, even though the assets are not related to the alleged fraud and it is not certain whether disgorgement will be ordered or the amount of such disgorgement." The court further held that the freeze order may remain in effect until it can make a further informed determination. The court stated that although the SEC has the burden of showing the amount of assets subject to disgorgement, that its burden is light and that "[e]xactitude is not a requirement" in the SEC's demonstration of a "reasonable approximation of a defendant's illgotten gains..."

Due to a lack of a provision of a factual basis, the court also denied Gunlicks' request to modify the freeze order as to his personal assets to exempt payment related to the preservation of assets, living expenses, and attorneys' fees.

Professor Hu on the "Empty Creditor"

2009-05-01T16:55:00.000-04:00

Professor Henry T.C. Hu wrote recently in the Wall Street Journal of the concept of the "empty creditor." Professor Hu coined the term "empty creditor" to help explain "otherwise-puzzling creditor behavior toward troubled debtors" when credit default swaps and other products are used.

Professor Hu explains that traditionally the law assumes that the package of economic, contractual, and legal rights flowing from debt ownership are bundled together. Another assumption would be that creditors generally would seek to "keep solvent firms out of bankruptcy and to maximize their value." Hu submits that these assumptions cannot be relied upon when credit default swaps and other like products are used to allow a creditor "avoid any actual exposure to financial risk" from a debt default while at the same time still maintaining his formal contractual rights under the agreement and its legal rights in bankruptcy. Hu states that the creditor may "simultaneously have control rights" and at the same time incentives to cause the debtor firm's value to fall, ie. a "decoupling." Professor Hu suggest that an "empty creditor" may have less incentive to cooperate with troubled businesses and may cause "substantive and disclosure complexities in bankruptcy."

Among his writings, Professor Hu reviews the concepts of the "empty creditor" in his jointly authored article Abolition of the Corporate Duty to Creditor, 1324 COLUMBIA LAW REVIEW 1321 (2007).

Madoff May Face Involuntary Bankruptcy

2009-04-15T16:04:00.000-04:00

Judge Louis L. Stanton of the District Court of the Southern District of New York granted a motion for partial relief from injunction to allow certain alleged creditors to file an involuntary bankruptcy against Bernard L. Madoff in the case 08-Civ-10791 of Securities and Exchange Commission vs. Bernard L. Madoff and Bernard L. Madoff Investment Securities LLC.

The movants argued that although Bernard L. Madoff Investment Securities LLC ("BLMIS") is presently being liquidated under SIPA in case 08-1789 in the Bankruptcy Court of the Southern District of New York, no bankruptcy case has yet been commenced against Madoff individually nor has a receiver apparently been appointed for Madoff's individual property. The movants further argued that a bankruptcy proceeding against Madoff individually could be coordinated with the present SIPA case pending in Bankruptcy Court against BLMIS.

The motion was opposed by the SEC, the U.S. Attorney, and the Trustee of Bernard L. Madoff Investment Securities LLC ("BLMIS") under SIPA. These parties questioned the utility of a bankruptcy proceeding as to Madoff's individual assets that are not criminally forfeitable. The SIPA Trustee claimed that he alone could "deliver maximum relief to victims." The U.S. Attorney emphasized that the criminal forfeiture is an independent system of recovery and distribution in which Madoff's general unsecured creditors would not have standing and that the criminal forfeiture processes are not subject to bankruptcy's automatic stay. A criminal forfeiture order divests the defendant of forfeited property and the property does not become part of the defendant's bankruptcy estate. United States v. Pelullo, 178 F.3d 196, 203 (3rd Cir. 1999).

The Court noted that although Madoff's assets have been frozen, they are not subject presently to any form of receivership. The Court further noted the distinction that a distribution under SIPA would be to those who invested in the BLMIS's "customers" rather than to those "whose losses stemmed from investments made through intermediaries."

The Court stated the opponents to the motion did not offer "as familiar, comprehensive, and experienced a regime as does the Bankruptcy Code for staying the proliferation of individual lawsuits against Mr. Madoff individually, marshaling his personal assets other than those criminally forfeitable, and distributing those assets among his creditor according to an established hierarchy of claims." The Court found that the concerns of increased administrative costs or delay were merely speculative and outweighed by a Bankruptcy Trustee's ability for orderly and equitable administration of assets.

The Court ruled that the moving parties should be able to pursue an involuntary bankruptcy against Madoff as to property that is neither criminally forfeitable nor subject to liquidation of BLMIS under SIPA. The Court suggested in a footnote that the Attorney General "might consider delegating forfeited property to the bankruptcy estate."

Yale Professor Robert Shiller Speaks on "Irrational Exuberance"

2009-03-22T16:57:00.000-04:00

Superstar Yale economics Professor Robert Shiller speaks on "irrational exuberance" - the human side of speculative economic bubbles.

City of Vallejo Files for Chapter 9 Bankruptcy

2008-05-25T16:32:00.000-04:00

On May 23, 2008, the City of Vallejo filed for chapter 9 municipal bankruptcy relief in the Eastern District of California, Sacramento Division in case #08-26813. Vallejo, a city of about 120,000 people, is located about 30 miles northeast of San Francisco. Vallejo is the largest California city to file for bankruptcy relief.

Vallejo's bankruptcy filing was widely anticipated in the media since February as tax revenues fell and employee labor costs remained high. The LA Times reports that "eighty percent of the city's budget goes to police and firefighters, far above the norm for most California cities." The largest creditor listed is the California Public Employees Retirement System for retirement health benefits for about $135 million and unfunded pension plan benefits for about $84 million. The City requested the court to set June 9, 2008 as the deadline for objections to its bankruptcy filing.

The city has set up a website to provide information on its bankruptcy filing.

Servicer of Mortgages Held by Securitized Trusts Gets the Chapter 11 Vote - Not the Trusts' Certificate Holders

2007-12-06T19:14:00.000-05:00

The 2002 decision in In re Shilo Inn, Diamond Bar, LLC, 285 B.R. 726 (Bankr.D.Or.2002)(Perris, J.) addressed the issue of whether the servicer of mortgage loan pools held by securitized mortgage trusts possessed the power to vote the trusts' claims with respect to the debtors' proposed chapter 11 plan of reorganization or whether the claims could only be voted by the trusts' certificate holders. The court concluded that the servicer held the power to vote under the provisions of the parties' pooling and servicing agreements ("PSAs"). The court's decision is quite timely due to the current subprime mortgage crisis facing the United States and the various proposals being expounded to modify the terms of subprime mortgages held by securitized mortgage trusts. Although the court's decision may have turned in part on the terms of the involved PSAs, many PSAs may contain similar provisions and the court's decision illustrates the typical nature of the relationship between the servicer of the trust's pool of mortgages, the trust, and the trust's certificate holders.

In this case, the chapter 11 debtors were the mortgagors on mortgage loans totaling $159,000,000.00 which became part of pools of loans held in three securitized trusts. As is typical, the trusts sold beneficial interests in the trust which held the pools of mortgages, including the mortgages of the debtors, to investors who received certificates evidencing their interests. The certificates were divided into different classes or tranches, each of which held different rights with regards to amounts collected by the trust on the pooled loans.

The debtors asserted that the provisions of the PSAs restricted the servicer from voting on the proposed chapter 11 plan of reorganization and that the certificate holders as the beneficial holders of the trusts' loans must be allowed to vote. It should be noted that the debtors did not dispute the servicers' authority to act on behalf of the trust aside from the power to vote. They argued the certificate holders should be allowed to vote just as is the bondholder in his relationship with an indentured trustees. The debtors also argued that in its favor that as a practical matter, the PSAs require the servicer to oppose the plan on behalf of the trusts as the PSAs limit the servicer's discretion in the servicing of the loans.

The servicer of the mortgage loans argued that pursuant to the PSAs that it was entitled to vote on behalf of the trusts. They pointed to the provisions of the PSAs that limit the rights of certificate holders to control the actions of the servicer on behalf of the trust.

The court noted that section 1129(a) provides that the holder of a claim allowed under section 502 may accept or reject a plan and that claims are deemed allowed unless a party in interest objects. In this case the trusts filed proofs of claims and that since no objections were filed, they were deemed allowed.
The court concluded that the claims belonged to the trusts and not to the individual certificate holders and that therefore the servicer as agent for the trusts may vote the trusts' claims. The court reasoned that the certificate holders merely held certificates evidencing a beneficial interest in the trusts' funds and that the chapter 11 debtors were obligated to the trusts and not to the certificate holders. That is, the certificate holders do not hold a direct interest in the obligations of the debtors, but hold an interest in the assets of the trusts.

The court noted the distinction between corporate bond issuance and securitized financing of assets. The court noted that in corporate bond issuance, a third party is often retained to administer a bond issue and act as the "indenture trustee". The court pointed out that although Bankruptcy Rule 3003(c)(5) authorizes an indenture trustee to file a proof of claim on behalf of all the bond holders, that the indenture trustee is not the holder of the claim and is not entitled to vote.

The court explained that in contrast to the bondholder-indenture trustee relationship, the trust, which is a special purpose entity, issues the securities and has the relationship with the investors and not the company that generated the loan, such as the chapter 11 debtor mortgagor in this case. The court furthermore pointed out that it would be unwieldy for each of the numerous certificate holders to have individual rights against each of the various obligors on the hundreds of loans held by the trusts. The court noted that the PSAs provide for the collective collection efforts on behalf of the certificate holders. In footnote seven, the court pointed out that the different classes of certificate holders hold different economic interests and would vote accordingly and it was unclear how the votes of the certificate holders would be calculated or weighed between the trust classes in determining the vote of the single plan class for each mortgage.

The court further noted that the PSAs in this case do not provide the certificate holder a right to vote on the chapter 11 plan of an obligor on the loans that constitute the asset pools in which the certificate holders hold an interest. The PSAs only provide the certificate holders certain limited voting rights, including relating to the termination of the servicer, the waiver of servicer defaults, the removal of trustees, etc. The representative of the controlling class of certificate holders were allowed to advise the servicer with regard to certain actions and the servicer was not allowed to take certain actions without the approval of the controlling class representative. This included the action to modify a term of a mortgage loan other than the extension of the maturity date for less than one year. It is interesting to note that the court pointed out that the certificate holder may have the right to enforce the pooled mortgage loans on their own if the trustee refused to pursue enforcement. The court stated that this was not the case herein.
The court also ruled that even if the PSAs restrictions precluded the servicers from voting in favor of the proposed chapter 11 plan, that this would not lead to the conclusion that the certificate holders must therefore be allowed to vote on the trusts' claims as the parties by contract have set out the rights and obligations of the servicers.

The court summarized its decision stating that "in a corporate bond issuance, the investor is a creditor of the corporation that issued the bonds or debentures, and has a right to payment from the corporation. In contrast, in an asset securitization, the investors' relationship is with the special purpose vehicle to which the originator of the assets...has transferred those assets, and the investors' right to payment come from the cash generated by the transferred assets, not from the originator of the assets itself.

Another Court Holds that Absolute Priority Rule Does Not Apply to Individual Chapter 11 Case Post-BAPCPA

2007-08-25T18:51:00.000-04:00

I previously reviewed the case of In re Tegeder, 349 B.R. 477, (Bkrtcy.D.Neb. 2007) which held that per BAPCPA's amendments, the absolute priority rule no longer applies to the retention of property by individual chapter 11 debtors. The court in the recent case of In re Roedemeier, ___ B.R. ___, 2007 WL 2350184 (Bkrtcy.D.Kan.)(Somers,J.) reached the same conclusion. In this case, the Chapter 11 Debtor, who was a dentist, proposed a Chapter 11 plan that would, inter alia, allow him to retain ownership of his interest in his LLC which operated his dental practice and proposed to pay $30,000 on general unsecured claims totaling about $875,000.

The court noted that prior to the enactment of BAPCPA in 2005, the absolute priority rule applied to all Chapter 11 debtors, but that BAPCPA added the "except" clause to section 1129(b)(2)(B)(ii) with the addition of the phrase "except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115..." The court stated that the "except" clause created an exception for individual Chapter 11 debtors to the absolute priority rule. The court construed this exception and section 1115 broadly to allow a debtor to exempt both pre- and postpetition property under a plan even though a class of unsecured creditors are not paid in full.

The court stated that a various changes were made to Chapter 11, including the exception to the absolute priority rule, so that it could function for individual Chapter 11 debtors much like Chapter 13. These include section 1115 which bring postpetition property into the estate, section 1123(a)(8) which calls for the debtor's plan to provide for payment to creditors from the debtor's postpetition earning from services or other future income, section 1129(b)(2)(B)(ii)'s allowance to the debtor to keep property included in the estate under section 1115 without paying in full a class of rejecting unsecured creditors, section 1129(a)(15) which authorizes the debtor to overcome an objection by an unsecured creditor by meeting the projected income test, section 1141(d)(5) which generally delays entry of the discharge until completion of all payments under the plan, and section 1127(e) which permits post-confirmation plan modification.The court also made some other interesting conclusions in the case.

The court found that section 1129(a)(15), which was added by BAPCPA, only applies if a holder of an allowed unsecured claim objects to confirmation. As the involved creditor did not so object, the Debtor was not required to meet the requirements of section 1129(a)(15)(A) or (B). Section 1129(a)(15)(A) would have required the claim to have been paid in full and section 1129(a)(15)(B) would have imposed a disposable income test. But the court found that the requirements of the section 1129(a)(15)(B) disposable income test were met in any event. The court concluded that the disposable income test should be performed with the expenses side judicially determined for this above-median income debtor (as per Form 22B) and not by the use of the I.R.S. standards as per section 707(b)(2).

In approving the debtor's disclosure statement, the court concluded that disclosure statements for smaller businesses are not required to be as extensive as those of a medium to large reorganization which often involve the issuance of securities. The court referred to the list for smaller businesses in 7 Collier on Bankruptcy, para. 1125.02[2] at pp. 1125-12 to 1125-13 (citing In re Malek, 35 B.R. 443 (Bankr.E.D.Mich.1983)). The court stated that the minimum information should include a description of the business, its history, financial information, description of the plan, facts respecting its execution, a liquidation analysis, identification of management and its compensation, transaction with insiders, and tax consequences of the plan.

11th Circuit on the Single Satisfaction Rule

2007-08-01T17:09:00.000-04:00

The 11th Circuit Court of Appeals recently issued a decision in the case of In re Prudential of Florida Leasing, Inc., ___ F.3d ___, 2007 WL 445368 (11th Cir. (Fla.)) involving the "single satisfaction rule". In general, the single satisfaction rule prevents one from recovering twice for the same damages. See, e.g. Fla. Stat. Section 46.015 (2).

The 11th Circuit held that federal rule of common law would be used in interpreting the "single satisfaction" rule of avoided transfers. It reversed the decisions of the bankruptcy court and the district court and held that the federal rule of common law, rather than state law, would be used in interpreting 11 USC 550(d) which bars a trustee from taking more than a "single satisfaction" on account of the same avoided transfer.

The Court reasoned that a uniform rule of federal law was preferable because the rule of single satisfaction concerned the judicial process as opposed to a substantive matter and that state law ordinarily does not govern the procedures of federal courts. Furthermore, applying state law -here Florida which erred on the side of preventing a single satisfaction - had the potential to frustrate the purposes of the Bankruptcy Code. The Court also reasoned that applying a uniform rule of federal law would not disturb any pre-existing commercial expectations predicated on state law, and was supported by a textual analysis of the Code

Absolute Priority Rule No Longer Applies in Individual in Chapter 11 per BAPCPA

2007-07-11T18:58:00.001-04:00

The pre-BAPCPA Gosman decision held that the retention of exempt property by an individual debtor in a chapter 11 plan violates the absolute priority rule unless unsecured creditors are paid in full. In re Gosman, 282 B.R. 45 (Bankr. S.D. Fla. 2002). Some courts disagree with the Gosman decision and hold that a chapter 11 debtor's retention of his exempt property is not subject to the absolute priority rule. See e.g. In re Bullard, 358 B.R. 541 (Bankr. D.Conn. 2007)(the retention of exempt property is not on account of the debtor's junior interest in property).

Since the passage of BAPCPA and its amendments to 11 U.S.C. section 1129(b)(2)(B)(ii), there has been some commentary (Hon. Norton, Hon. Drake, etc.) that the absolute priority rule is no longer applicable to an individual chapter 11 debtor's retention of property. The case of In re Tegeder, 369 B.R. 477 (Bkrtcy.D.Neb. 2007)(Saladino, J.) is one of the the first decisions to address this issue.

The court in Tegeder held that the new amendments to 1129(b)(2)(B)(ii) provide an exception to the absolute priority rule for the retention of property by individual chapter 11 debtors and that the "absolute priority requirements imposed by Code 1129(b)(2)(B)(ii) were waived by permitting a debtor to retain property included in the estate under 1115". BAPCPA added the following to 1129(b)(2)(B)(ii) "except that in a case in which the debtor is an individual, the debtor may retain property included in the estate under section 1115, subject to the requirements of subsection (a)(14) of this section". New section 1115 defines property of the estate to include property specified in section 541 as well as property acquired post-petition and earnings from services performed post-petition. The court stated that interpreting new 1129(b)(2)(B)(ii) any narrower would cause the amendment to have little effect.

It should be noted the Tegeder decision is broader than the Bullard decision as it holds that the absolute priority rule is inapplicable to the retention of all types of property by the chapter 11 debtor. The Bullard case was limited to the retention of exempt property by the chapter 11 debtor.

Retention of Exempt Property Does Not Violate Absolute Priority Rule

2007-05-13T19:08:00.000-04:00

Judge Weil recently issued her decision in the Bullard case on the issue of the absolute priority rule and the retention of exempt property in the context of the confirmation of a chapter 11 plan for an individual debtor. In re Bullard, 358 B.R. 541 (Bankrtcy.D.Conn 2007).

The Court noted that there was a disagreement among the courts concerning whether a chapter 11 debtor may retain his exempt property and still comply with the absolute priority rule. Cases such as In re Gosman, 282 B.R. 45 (Bankr.S.D.Fla.2002) by one Bankruptcy Court Judge from the Southern District of Florida, held that the retention of exempt property violates the absolute priority rule. Judge Weil held that the better line of authority holds that the debtor's retention of his exempt property does not violate the absolute priority rule as such retention is not "on account of...[the debtor's] junior interest..." The court explained that "[o]nce the exemptions are allowed the properties are no longer part of the Debtor's estate, and the Debtor does not retain property on account of such interest because he retains it as a matter of right by virtue of recognition of his right to exemptions..."

The Bullard court did not base its decision on an argument that the BAPCPA amendments to 1129(b)(2)(B)(ii) effected a waiver of the absolute priority rule as to individual chapter 11 debtors as the debtor abandoned the argument.

11th Circuit Rules on Section 1146(c) Stamp-Tax Exemption

2007-04-19T17:26:00.000-04:00

On April 18, 2007, the 11th Circuit Court of Appeals issued its decision in In re Piccadilly Cafeterias, Inc., 484 F.3d 1299 (11th Cir. 2007), which was on appeal from the U.S. District Court and the U.S. Bankruptcy Court for the Southern District of Florida. The issue presented was whether the Section 1146(c) stamp-tax exemption may apply to asset transfers made before a Chapter 11 bankruptcy reorganization plan is confirmed.

In this case, the debtor executed an asset purchase agreement before the Chapter 11 bankruptcy case was filed. Subsequently the debtor filed a section 363 motion requesting authorization to sell substantially all of its assets outside of the ordinary course of business and also requested that the bankruptcy court conduct an auction through which the highest bidder would be entitled to purchase the involved assets. As part of the proceedings, the debtor requested an exemption from stamp taxes on the asset sale. The Florida Department of Revenue ("DOR") objected. The Bankruptcy Court held that the sale was exempt from stamp taxes pursuant to section 1146(c). Subsequently, the debtor filed its Chapter 11 Plan. The bankruptcy court confirmed the debtor's Amended Plan.

The DOR filed an adversary proceeding seeking a declaration that the transaction was not exempt from stamp taxes under section 1146(c). The bankruptcy court granted summary judgment in favor of the debtor. The bankruptcy court reasoned that the sale of substantially all of the debtor's assets was a transfer "under" its confirmed plan because the sale was necessary to consummate the plan. The district court affirmed the bankruptcy court.

Section 1146(c) (per BAPCPA re-designated as section 1146(a))exempts from stamp or similar taxes any asset transfer "under a plan confirmed under" section 1129. The 11th Circuit Court of Appeals noted that the Third and Fourth Circuit had previously held that the 1146(c) exemption may not apply to pre-confirmation transfers. The Court noted that although it had yet to squarely address the issue, it addressed a somewhat similar issue involving section 1146(c) in In re T.H. Orlando Ltd., 391 F.3d 1287, 1291 (11th Cir. 2004). That case involved a transaction between two non-debtors that was specifically contemplated by the confirmed chapter 11 plan. The court concluded that "[a] transfer 'under a plan' refers to a transfer authorized by a confirmed Chapter 11 plan." Accordingly the court in T.H. Orlando Ltd. held that the phrase "under a plan refers to a transfer that is necessary to the consummation of a confirmed Chapter 11 plan".

The court followed the T.H. Orlando Ltd. construction that the phrase "under a plan confirmed" looks not to the timing of the transfer but to the necessity of the transfer to the consummation of a confirmed Chapter 11 plan. The court reasoned that the plain language of section 1146(c) is ambiguous as the statute can plausibly be read to describe eligible transfers to include transfers regardless of when the plan is confirmed or as the DOR argued, to impose a temporal restriction on when the confirmation of the plan must occur. Furthermore, the court reasoned that when Congress wanted to place a temporal restriction in the Bankruptcy Code, it did so expressly--which it did not do in section 1146(c). The Court also reasoned that a strict temporal construction of section 1146(c) would ignore the practical realities of Chapter 11 reorganization cases.

In short, the court held that "section 1146(c)'s tax exemption may apply to those pre-confirmation transfers that are necessary to the consummation of a confirmed plan of reorganization, which at the very least, requires that there be some nexus between the pre-confirmation sale and the confirmed plan." The court emphasized that the issue of whether the section 1146(c) tax exemption properly applied to the asset sale in this case was not properly before the court and it did not decide the issue. The court left "for another day an attempt to set forth a framework for determining the circumstances under which section 1146(c)'s tax exemption may apply to pre-confirmation transfers".

US Supreme Court Rules in Allocation of Attorney's Fees Case

2007-04-04T17:31:00.000-04:00

On March 20, 2007, the US Supreme Court issued its decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., ___ US ___ (2007) which was before the Court on a writ of certiorari from the 9th Circuit Court of Appeals. The issue before the Court was "whether federal bankruptcy law precludes an unsecured creditor from recovering attorney's fees authorized by a prepetition contract and incurred in postpetition litigation." The 9th Circuit Court of Appeals had held that such fees are categorically prohibited to the extent the litigation involves issues of federal bankruptcy law. The US Supreme Court disagreed and vacated the lower Court's decision.

In the bankruptcy case, Traveler's filed a proof of claim that included an amount to recover its attorney's fees incurred in connection with PG&E's bankruptcy proceedings. The Bankruptcy Court agreed with PG&E, that Traveler's was not entitled to recover attorney's fees incurred while litigating issues of bankruptcy law. The District Court agreed relying on In re Fobian, 951 F.2d 1149 (9th Cir. 1991) which held that "where the litigated issues involve not basic contract enforcement questions, but issues peculiar to federal bankruptcy law, attorney's fees will not be awarded absent bad faith or harassment by the losing party." The 9th Circuit Court of Appeals affirmed.

The US Supreme Court explained that under the American Rule, the prevailing litigant is ordinarily not entitled to collect attorney's fees from the loser, unless this rule is overcome by statute or by an enforceable contract allocating attorney's fees. The Court held that an otherwise enforceable contract is allowable in bankruptcy except where the Bankruptcy Code provides otherwise. The Court further held that the Bankruptcy Code does not disallow a contract-based claim for attorney's fees based solely on the fact that the fees in issue were incurred litigating issues of bankruptcy law. The Court stated that the Fobian rule has no support in the Bankruptcy Code either in section 502 (which is the section dealing with the allowance and disallowance of claims) or in any other code section.

The Court expressed no opinion whether following the demise of the Fobian Rule, other principles of bankruptcy law may provide an independent basis for disallowing the involved attorney's fees claim. One such argument not addressed by the Court as it was not raised in the Courts below was whether section 506(b) by explicit negation disallows unsecured claims for contractual attorney's fees. In short, the Court's holding was a narrow repudiation of the Fobian rule, leaving open the broader question of whether unsecured creditors can collect post-petition attorney's fees.

Choice of Law in the Context of Claims Allowance

2007-03-18T19:21:00.000-04:00

In the case of In re Hionas, ___ B.R. ___, 2006 WL 3913760 (Bkrtcy.S.D.Fla.)(Isicoff J.) the Court denied a casino's motion for summary judgment in its adversary proceeding to determine an alleged gambling debt nondischargeable. The decision also provides a review of the rules of choice of law in the 11th Circuit in the context of the allowance of a claim in a bankruptcy case.
The Court noted that normally a federal court hearing a matter pursuant to diversity jurisdiction must apply the law of the state in which the court sits, Erie Railroad v. Tompkins, 304 U.S. 64 (1938), including the conflict of law rules of the state in which the federal court sits. However, a federal court with jurisdiction over a matter by virtue of its bankruptcy jurisdiction, when considering the allowance of claims, is not sitting as a court of diversity and the court does not apply the law of the state where it sits. Bankruptcy courts must determine how and what claims should be allowed under equitable principles.

The Court stated that there is apparently a split among the courts as to whether a bankruptcy court should apply the conflicts of law provisions of the state in which it sits or whether it should apply federal law to determine which law should apply. But the Court stated that there does not appear to be a conflict when a bankruptcy court is considering allowance of claims, which is a matter subject to the bankruptcy court's core jurisdiction. The Court reviewed the Supreme Court's decision of Vanston Bondholders Protective Comm. v. Green, 329 U.S. 156 (1946) and stated that it held that the determination by a bankruptcy court of which state law should apply in adjudicating the allowability of a claim should not be dictated by the happenstance of where the bankruptcy case is filed, but rather which law more logically relates to the claim and is most consistent with the dictates of the court's equitable jurisdiction. Furthermore this determination requires the exercise of an informed judgment in the balancing of all the interests of the states with the most significant contacts in order best to accomodate the equities among the parties to the policies of those states.

The Court further found that each of the cases that have followed Vanston in the context of the allowance of a claim have been consistent in recognizing the inapplicability of Erie and Klaxon Co. v. Stentor Electric Mfg. Co., 313 U.S. 487 (1941) and apply a federal analysis to the choice of law issue in the claims allownace context. The Court noted that in the 11th Circuit, in order to determine which law should apply in making a decision regarding choice of law, the court must apply the "significant relationship" test although, depending on the nature of the dispute, more specific factors may have a bearing on the court's determination. See Dresdner Bank A.G v. M/V Olympia Voyager, 446 F.3d 1377 (11th Cir.2006).

The Court concluded by pointing out that whether Nevada law applies to the involved decision would be based on the significant relationships test and not solely on the language in the involved contracts.

Avoided Preference Repaid Prepetition Not Recoverable

2007-03-10T17:13:00.000-05:00

Judge Hyman's recent decision in In re Sawran, __ B.R. ___, 2007 WL 101841 (Bkrtcy. S.D. Fla.) presents an analysis of the common fact pattern. If a debtor made a prepetition preferential payment to an initial transferee, but the initial transferee or immediate transferee repays the involved amount to the debtor prepetition, may the trustee in bankruptcy still recover the preference?

The Sawran case presented a situation where the trustee obtained a judgment to avoid a preferential transfer under section 547. The trustee then filed an action under section 550 to recover the amount of the avoided transfer from an immediate transferee of the initial transferee.

The Court began its analysis with a review of section 550(d) which provides that a trustee is only entitled to a single recovery under 550(a)--the single satisfaction rule. That is, the trustee cannot recover from the various transferees more than the actual amount avoided. The Court further pointed out that the avoidance of a voidable transfer and the recovery from the transferee are distinct from one another.

The Court held that a trustee is prohibited under section 550(d) from recovering the amount avoided from a transferee who has already returned to the estate that which was avoided. To allow the trustee to collect the amount would result in a windfall to the trustee that violates the single satisfaction rule of section 550(d).

The Court found an alternative basis for its holding pursuant to the use of the Court's equitable powers under section 105(a) by finding that it had the power to grant the initial transferees an "equitable credit" even if there was no defense available under the provisions of the Code. The initial transferees were innocent of wrongdoing and deserved protection to the extent that they repaid the involved amount. The equitable credit prevented the estate from receiving a windfall.
The Court noted that the Court's equitable powers under section 105(a) are also used in other contexts to prevent a trustee from being able to recover from a party who is innocent of wrongdoing and deserves protection, such as when the initial recipient is a "mere conduit" of funds and therefore not an "initial transferee" under section 550(a)(1).

Federal Income Taxation of Individual Chapter 11 Debtor

2007-02-17T14:09:00.000-05:00

The IRS released Internal Revenue Bulletin 2006-40, Notice 2006-83 on October 2, 2006 to provide guidance to individuals filing bankruptcy under Chapter 11 on or after October 17, 2005. It further provides guidance for the employers of these individuals, persons filing Forms W-2, 1099 or other information returns that report payment to these individuals, and Chapter 11 trustees in cases filed by an individual.

The bankruptcy estate of an individual who files under Chapter 11 is a separate taxable entity under section 1398 of the Internal Revenue Code. In general, the estate, rather than the individual, must include in its gross income all of the debtor's income to which the estate is entitled under the Bankruptcy Code. As a result of the enactment of section 1115 of the Bankruptcy Code by BAPCPA, the bankruptcy estate rather than the individual must include in its gross income both 1. the debtor's gross earnings from post-petition services and 2. the gross income from post-petition acquired property. IRC Section 1398(e)(1).

Because the bankruptcy estate is a separate taxable entity, the trustee or debtor in possession must obtain an employer identification number for the estate and use it on any tax returns filed for the estate.

The individual must continue to file his own individual tax returns during the bankruptcy proceedings. IRC Section 6012(a)(1). The trustee or debtor in possession must prepare and file the income tax returns of the bankruptcy estate if required under IRC Section 6012(a)(9).
Although post-petition wages earned by a debtor are generally treated for income tax purposes as gross income of the estate rather than the individual, the reporting and withholding obligations of a debtor's employer however have not changed as a result of the enactment of section 1115 of the Bankruptcy Code. Section 1115 has no effect on the determination of wages under FICA, FUTA, or for income tax withholding purposes. See IRC Section 3306(b) and 3401(a). An employer should continue to reflect such wages and accompanying tax withholding on a Form W-2 issued to the debtor under the debtor's name and social security number.