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Bankruptcy and Restructuring Law Monitor

Providing Commentary and the Latest Updates on Bankruptcy & Restructuring Law

Latest Trends in the Enforceability of Make-Whole Premiums

By Ryan T. Jareck on Posted in Bankruptcy Litigation

A lender’s entitlement to a make-whole premium, that is, a prepayment penalty designed to compensate the lender for the loss of interest payments it would have received had the borrower continued to service the debt through the maturity date of the loan, depends principally on the plain language of the bond indenture or credit agreement.  See, e.g., HSBC Bank USA, N.A. v. Calpine Corp. (In re Calpine Corp.), No. 07 Civ 3088 (GBD), 2010 WL 3835200, at *4 (S.D.N.Y. Sept. 15, 2010) (after reviewing the debt instruments, the district court agreed with the bankruptcy court insofar as it held that the lenders were not entitled to make-whole premiums because the plain language of the debt instruments did not provide for the payment of premiums in the event of payment pursuant to acceleration); In re Solutia, Inc., 379 B.R. 473, 485 n.7 (Bankr. S.D.N.Y. 2007) (where the indenture provided for automatic acceleration upon the filing of a chapter 11 petition but was silent as to whether any make-whole amount would or would not be payable in connection with such an acceleration, the court refused to “read into agreements between sophisticated parties provisions that are not there,” and held that no make-whole amount was due); Premier Entm’t Biloxi, LLC v. U.S. Bank N.A. (In re Premier Entm’t Biloxi LLC), 445 B.R. 582, 625-27 (Bankr. S.D. Miss. 2010) (trust indenture that provided for automatic acceleration of notes upon default arising from debtors’ bankruptcy filing rendered the notes mature at time of their repayment as part of consummation of debtors’ confirmed chapter 11 plan, such that noteholders had no contractual right to prepayment premium).

Consistent with those cases, on January 17, 2013, the United States Bankruptcy Court for the Southern District of New York ruled that American Airlines (“American”) was not obligated to pay make-whole premiums at the time American refinanced a series of loans.  See U.S. Bank Trust National Association v. American Airlines Inc. (In re AMR Corp.), Bankr. No. 11-15463 (SHL), Adv. Nos. 12-01932 (SHL), 12-01946 (SHL), 2013 WL 209643 (Bankr. S.D.N.Y. Jan. 17, 2013).

Facts

Prior to its bankruptcy filing, American entered into three separate financing transactions.  One transaction involved the issuance of notes secured by certain aircrafts (the “Secured Notes Financing”).  The remaining two transactions were structured as enhanced equipment trust certificate (“EETC”) financings, which involved the issuance of equipment notes secured by certain aircrafts (the “EETC Financing” and, together with the Secured Notes Financing, referred to collectively as the “Prepetition Financing”).  During its bankruptcy case, American sought approval to enter into a new $1.5 billion EETC facility (at a lower interest rate than the Prepetition Financing) to refinance the Prepetition Financing.  As part of the request, American sought to avoid paying the make-whole premiums contained in the Prepetition Financing loan documents.

American’s bankruptcy filing constituted an event of default under each of the indentures.  The indentures provided that a bankruptcy filing automatically accelerated the Prepetition Financing without any further action by U.S. Bank Trust National Association, as the loan trustee and security agent (“U.S. Bank”).  Under those circumstances, the indentures expressly provided that the Prepetition Financing was payable in full without having to pay the make-whole premium that was due in other cases of repayment of the Prepetition Financing.  Specifically, the indentures provided that upon an event of default due to American’s bankruptcy filing: “the unpaid principal amount of the [Prepetition Financing] then outstanding, together with accrued but unpaid interest thereon and all other amounts due thereunder (but for the avoidance of doubt, without Make-Whole Amount), shall immediately and without further act become due and payable…” (emphasis added).

The Court’s Holding and Rationale

Relying on this express contractual provision, the court held that a make-whole premium was not due upon American’s repayment of the Prepetition Financing after the automatic acceleration that occurred as a result of its bankruptcy filing.  In so ruling, the court rejected several arguments advanced by U.S. Bank.  First, U.S. Bank argued that the automatic acceleration clause was not enforceable under New York law because the lenders did not choose to invoke that clause.  The court found that the indentures provided U.S. Bank the option to pursue remedies following certain events of default.  Where a default was premised upon a bankruptcy filing, however, the indentures explicitly state that all amounts due, other than the “Make-Whole Amount,” were immediately due and payable.  In addition, U.S. Bank unsuccessfully argued that the automatic acceleration clause constituted an invalid ipso facto clause under the Bankruptcy Code.  Because the parties conceded the indentures were not executory contracts, the court relied on the cases that hold that ipso facto clauses are not per se invalid except where contained in executory contracts.  U.S. Bank further argued that it could decelerate the Prepetition Financing, either by contractual right or the lifting of the automatic stay in American’s bankruptcy.  The court held that the automatic stay prohibited U.S. Bank from decelerating the Prepetition Financing.

Finally, U.S. Bank contended, to no avail, that American’s attempt to refinance the Prepetition Financing without satisfying the make-whole provision was inconsistent with American’s previous exercise of its rights under section 1110 of the Bankruptcy Code.  Section 1110 of the Bankruptcy Code provides certain special rights to parties involved in aircraft financing.  More specifically, the provision allows a party with a security interest in aircraft and related equipment to take possession of its collateral pursuant to the terms of the contract, notwithstanding the automatic stay normally imposed by Section 362 upon the filing of the bankruptcy, unless the debtor meets certain conditions.  These conditions include that, within the first 60 days of the case, the debtor must agree to perform its contractual obligations as they become due and that the debtor must also cure certain contractual defaults, other than a default of a kind specified in section 365(b)(2) of the Bankruptcy Code.  The kinds specified in section 365(b)(2) include a default that is a breach of a provision relating to– (A) the insolvency or financial condition of the debtor at any time before the closing of the case; (B) the commencement of a case under this title; (C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement; or (D) the satisfaction of any penalty rate or penalty provision relating to a default arising from any failure by the debtor to perform nonmonetary obligations under the executory contract or unexpired lease.

The court held that section 1110(a) requires only that a debtor continue performing its contractual obligations and cure any non-bankruptcy defaults.  The court held that section 1110(a), however, does not require the curing of a bankruptcy default.  Because it was the commencement of the case that triggered a bankruptcy default, acceleration and the language that provides for no payment of a make-whole premium, American was not required to cure the bankruptcy default and pay the make-whole premium.

In conclusion, the plain meaning of the relevant indenture terms prevailed.  Notwithstanding all of U.S. Bank’s reasonable arguments, the court held no make-whole premium would be due upon repayment by American of the Prepetition Financing after the automatic acceleration that occurred as a result of American’s bankruptcy filing.

U.S. Bank will presumably appeal the decision.  If an appeal is filed, a key issue at the District Court level likely will be whether Judge Lane’s interpretation of section 1110(a) of the Bankruptcy Code was accurate.

Emergency Contact Information: Attorneys’ Cell Phone Numbers

By Joe Koshar on Posted in Uncategorized

We apologize, but our New Jersey telecommunication systems remain adversely affected and are currently not functioning.  This includes phone, voicemail and fax communication.  Thus, if you need to contact anyone at our NJ office, please click here for an attachment containing all of our attorneys’ mobile phone numbers. 

You may also access our attorneys’ phones numbers on our website.

Alternatively, you may also dial 212-752-8000 for our New York main line, where our Client Service Representative will direct your call accordingly.

All of our offices are open and operational.

Again, and most importantly, we truly wish our best to everyone.

Perhaps We Can Help During These Difficult Times

By Joe Koshar on Posted in Uncategorized
Dear clients, friends and neighbors,

We realize that in this difficult aftermath of the storm, many of our clients, friends and neighbors are dealing with issues where we may be able to present some relief.

We are very fortunate to have power and Internet in our New Jersey, New York, Delaware and Maryland offices.  For anyone who needs it, we would like to offer you the ability to use our conference rooms to charge your devices, check email or other important areas of your life that you are unable to access.

We very much realize that these are tumultuous times.  It is our utmost hope that we may be able to help alleviate some of the pain and trouble experienced by the people and families we care about.  Please do not hesitate to contact Gayle Englert, Director of Human Resources, at genglert@coleschotz.com or 201-320-2766, if you would like to make use of our facilities.  We will do our very best to accommodate everyone we possibly can.

Also, we hope that you may find the below list of important numbers and services to be helpful.

Lastly, we realize that many of you may have been trying unsuccessfully to contact us over the previous several days.  We deeply apologize for this as our systems were adversely affected and were not restored until today.

Again, we wish our absolute best to everyone affected.  During these times, we are reminded of the paramount importance of health, safety and family and hope that all are as strong for you as possible.  We hope you know that you are in our thoughts and we hope to help you as we surmount the obstacles ahead of us.

Cole Schotz Alert Due to Hurricane Sandy – Contact Information Update for All Offices

By Joe Koshar on Posted in Uncategorized

All of our offices are open, however, we are experiencing problems with telephone communication in New Jersey.  If you need to contact anyone in our New Jersey office via telephone, please dial our New York main line at 212-752-8000. Our Client Service Representative will then direct your call accordingly.  You may also reach our attorneys on their cell phones.

Communication to our New York, Delaware, Maryland and Texas offices remains functional.

We wholeheartedly offer our best wishes to everyone affected by Hurricane Sandy.

Lenders Beware: Delaware Supreme Court Holds Creditors of Insolvent LLC Lack Derivative Standing

By Therese A. Scheuer on Posted in Bankruptcy Litigation, Business Bankruptcy Issues, Recent Developments

The Delaware Supreme Court recently held that creditors lack standing to bring a derivative suit on behalf of an insolvent Delaware limited liability company (an “LLC”) under the Delaware Limited Liability Company Act (the “LLC Act”).  CML V, LLC v. Bax, No. 735, 2011 WL 3863132 (Del. Sept. 2, 2011, corrected Sept. 6, 2011).  In an opinion written by Chief Justice Steele, the Delaware Supreme Court affirmed the Court of Chancery’s dismissal of claims brought by a junior secured creditor against the LLC’s present and former officers directly and derivatively for breaching their fiduciary duties.  The Delaware Supreme Court’s holding was based on a plain reading of 6 Del. C. § 18-1002 which requires that a plaintiff be a “member” or an “assignee” of a limited liability company interest to bring a derivative action on behalf of an LLC. 

Facts and Procedural History

Defendant JetDirect Aviation Holdings, LLC (“JetDirect”), a Delaware limited liability company, was a private jet management and charter company.  In 2005, JetDirect began a series of transactions to acquire small and midsized competitor and charter service companies which left the company heavily leveraged.  Between 2006 and 2007, JetDirect’s officers and board of managers learned of “serious deficiencies” in the company’s accounting system and internal controls.  Nevertheless, the board continued its aggressive acquisition strategy.  In April 2007, on the basis of outdated information, CML V, LLC (“CML”) made a loan to JetDirect of approximately $26 million, which later increased to approximately $34 million.  Shortly thereafter, in June 2007, JetDirect defaulted on its loan obligations to CML, and by January 2008, JetDirect was insolvent and began to liquidate its assets.

CML filed a complaint in the Delaware Court of Chancery asserting derivative claims against JetDirect’s present and former managers for: (1) breach of the duty of care for their approval of transactions without informing themselves of JetDirect’s financial condition; (2) bad faith for consciously failing to implement adequate internal controls; and (3) breach of the duty of loyalty for benefitting from self-interested asset sales.  CML also brought a direct claim for money damages against JetDirect for breach of the loan agreement, but the parties agreed that the Court of Chancery would only have jurisdiction over the direct claim if any of the derivative claims survived a motion to dismiss.  The Court of Chancery granted JetDirect and the individual defendants’ motion to dismiss the claims on the basis that “CML, as a creditor, lacks standing to pursue derivative claims on behalf of JetDirect.”  CML appealed to the Delaware Supreme Court.

Delaware Supreme Court Ruling

CML advanced the following arguments on appeal: (1) the LLC Act does not deny creditors standing to bring derivative actions on behalf of insolvent LLCs and (2) if the LLC Act denies the Court of Chancery jurisdiction over such derivative actions, it places an unconstitutional limit on the Court of Chancery’s equitable powers.  The Delaware Supreme Court rejected both arguments.

The Delaware Supreme Court first addressed the plain language of § 18-1002 of the LLC Act, which provides:

In a derivative action, the plaintiff must be a member or an assignee of a limited liability company interest at the time of bringing the action and:

(1)  At the time of the transaction of which the plaintiff complains; or

(2)  The plaintiff’s status as a member or an assignee of a limited liability company interest had devolved upon the plaintiff by operation of law or pursuant to the terms of a limited liability company agreement from a person who was a member or an assignee of a limited liability company interest at the time of the transactions.

6 Del. C. § 18-1002.

The court reasoned that this provision is clear and unambiguous—only a member or an assignee of an LLC interest can bring a derivative action.  The court found it significant that § 18-1002 uses the term “must” be a member or assignee rather than “may”, and applies to “a derivative action” rather than “the derivative action.”  Although a different section of the LLC Act, § 18-1001, provides that a member or assignee “may” bring “the derivative action”, the court reasoned that § 18-1001 created the right to file a derivative action by members and assignees while § 18-1002 explicitly limited that right to members and assignees.  The court rejected CML’s argument that the General Assembly intended to take the corporate rule of derivative standing (which allows creditors of an insolvent corporation to sue derivatively) and apply it to the LLC context.  The court reasoned that the General Assembly is well suited to make a policy choice to deny derivative standing to creditors of an LLC, but allow such standing for creditors of a corporation, to promote business entity diversity.  The court further acknowledged the freedom of contract provided under the LLC Act.

The Delaware Supreme Court next rejected CML’s argument that limiting the Court of Chancery’s jurisdiction over derivative standing to members or assignees violates Article IV, Section 10 of the Delaware Constitution.  Under Delaware law, the General Assembly cannot limit the equity jurisdiction of the Court of Chancery to less than the general equity jurisdiction of the High Court of Chancery of Great Britain when Delaware first ratified its constitution.  The court observed that, unlike a corporation, an LLC as an entity did not exist at the time of enactment of the Delaware Constitution.  Accordingly, the Delaware Constitution does not prevent the General Assembly from limiting the Court of Chancery’s jurisdiction over derivative claims to members and assignees of LLC interests.  Moreover, the LLC is a creature of statute and the LLC Act was passed “in derogation of the common law.”  Accordingly, common law may supplement, but cannot override, the LLC Act’s express provisions, including § 18-1002.  Finally, the court reasoned that CML had an ample remedy at law, as it could have negotiated remedies by contract.

Conclusion

In structuring a finance transaction, lenders should be mindful of the differences in lending to a corporation, LLC or other Delaware business entity.  The Delaware Supreme Court emphasized the flexibility of an LLC as a business entity, and the freedom of contract available to its creditors.  The court suggested adding provisions that would, in the event of insolvency, convert the creditor’s interests to that of an “assignee” or give the creditor control of the LLC’s governing body.  Such provisions, however, place a creditor at risk of being viewed as an “insider”, or having its debt recharacterized as equity if the borrower becomes insolvent and files for bankruptcy.  An alternative solution not mentioned by the court would be to include a contractual fiduciary duty to creditors in the LLC agreement (to the extent permitted by law), and provide that creditors are third-party beneficiaries of such provision with a right of enforcement.  The lender could also enter into an agreement directly with the managers of the LLC, outlining the managers’ duties and providing a mechanism for enforcement.  Time will tell whether creditors are able, by these or other measures, to create enforceable protections against LLC managers’ misdeeds.

 

Jason Realty’s Restrictions on Use of Rents as Cash Collateral Do Not Apply to a Debtor’s Use of Hotel Revenues

By Jason R. Finkelstein on Posted in Bankruptcy Litigation, Recent Developments

The Bankruptcy Court for the District of New Jersey (Kaplan, J.) recently held that hotel revenues (including revenues generated from room occupancy, food and beverage sales, catering, gift shop purchases, spa, and related hotel services) do not constitute “rent” within the meaning of the Third Circuit decision of In re Jason Realty, L.P., 59 F.3d 423 (3d Cir. 1995).  Therefore, even if they are absolutely assigned to the secured lender, hotel revenues can be used by the debtor as cash collateral to pay its ordinary and necessary operating expenses and to reorganize.  In re Ocean Place Dev., LLC, No. 11-14295 (Bankr. D.N.J. Mar. 31, 2011).

Ocean Place Development, LLC (“Debtor”) owned a 254-room beachfront resort in Long Branch, New Jersey, which included a large conference center, three restaurants, a bar/lounge, a full-service spa, and numerous other amenities.  Ocean Place owed approximately $58 million pursuant to the terms of its loan agreement with AFP 104 Corp., as successor to Barclays Capital Real Estate Inc. (“AFP”).  Repayment of the loan was secured by, among other things, a Mortgage and an Assignment of Rents and Leases (the “Assignment of Rents”).  Both the Mortgage and Assignment of Rents defined the term “rents” broadly, to include all “… revenues and credit card receipts collected from guest rooms, restaurants, bars, meeting rooms, banquet rooms and recreation facilities, all receivables, customer obligations, installment payment obligations and other obligations now existing or hereafter arising or created out of the sale, lease, sublease, license, concession or other grant of the right of the use and occupancy of the property or rendering of services by Borrower [Debtor] or any operator or manager of the hotel . . . .”

Following the Debtor’s default under the loan, AFP obtained a foreclosure judgment.  The Debtor filed a Chapter 11 petition before the scheduled foreclosure sale, and sought authority to use cash collateral consisting of hotel revenues.  AFP objected, and cross-moved for an order dismissing the Debtor’s case as a bad faith filing or, alternatively, for relief from the automatic stay to proceed with the foreclosure sale.  The Bankruptcy Court granted the Debtor’s request to use cash collateral, and denied AFP’s motion.

In a case of first impression, the Bankruptcy Court commenced its opinion with an analysis of whether hotel room revenues constitute property of the estate within the meaning of Section 541 of the Bankruptcy Code.  The Court framed its task as two-fold: (i) first, it had to decide whether a security interest in hotel room revenues constitutes an interest in realty or an interest in personalty that must be perfected and enforced under Article 9 of New Jersey’s version of the Uniform Commercial Code (“UCC”); and (ii) second, even if such interest was deemed personalty, whether the Debtor’s use of hotel revenues was consistent with Jason Realty. 

Article 9 governs transactions which create security interests in personal property or fixtures.  The Court found that the loan transaction in this case clearly was a “secured” transaction, as the loan documents granted the lender a security interest in the rents and leases and further stated that “Borrower [Debtor] intends for the security instrument to be a ‘security agreement’ within the meaning of the UCC.”  Additionally, the loan documents provided other indications of a secured transaction as they allowed: (i) the Debtor to collect rents as long as it was not in default of the mortgage; (ii) AFP to use post-default rents only to reduce the Debtor’s obligations to AFP; and (iii) for automatic termination of the Assignment of Rents after repayment of the loan. 

The Court then noted that Article 9 does not extend to interests in or liens on real property, including a lease or rents thereunder.  However, based on a case from the Bankruptcy Court for the Southern District of New York, In re Kearney Hotel Partners v. Richardson, 92 B.R. 95 (Bankr. S.D.N.Y. 1988), the Official Comments to the UCC and an examination of New Jersey statutes, the Bankruptcy Court concluded that hotel room revenues are “accounts” or “payment intangibles,” and not “rents.”  In so ruling, the Court adopted the distinction from those authorities between guests in hotel rooms, who are simply licensees, and tenants under a lease.  Thus, Judge Kaplan held that despite the definition of “rents” in the loan documents, hotel revenues are personal property included in the definition of property of the estate.

The Court then examined whether classifying hotel room revenue as personal property conflicts with the Third Circuit’s precedent in Jason Realty.  After discussing the background of Jason Realty, Judge Kaplan noted that case involved an absolute assignment of rents due from tenants of a two-story retail and office building, and not the assignment of receipts from a debtor’s operation of a hotel, restaurant or spa.  Additionally, the Court distinguished Jason Realty on the basis that the Third Circuit was tasked with assessing the “treatment of an assignment under New Jersey property law and the ensuing rights of an assignee arising under an absolute assignment of rents.”  Judge Kaplan, to the contrary, had to determine whether hotel room revenues should be treated as real property interests.  Because he determined that interests in hotel revenues should be treated as personalty under Article 9, he was not required to address whether “the assignment of rents absolutely vested title in AFP.”  Indeed, Judge Kaplan did not even necessarily dispute that the loan transaction evidenced both a security agreement and an absolute assignment of rents.  Based on his distinction of Jason Realty from the case before it in Ocean Place, Judge Kaplan declined to extend Jason Realty to personal property security interests, and allowed the Debtor to use its hotel room revenues as cash collateral so long as AFP remained adequately protected.

 

Third Circuit Holds a Plan Administrator in Debtor’s Second Bankruptcy was Not in Privy of Debtor in the First Bankruptcy for Res Judicata Purposes and 11 U.S.C. § 1111(b) Permits Non-Recourse Claims to Become Recourse for Distribution Purposes Only

By Grant L. Cartwright on Posted in Recent Developments

In In re Montgomery Ward, LLC, 634 F.3d 732 (3d. Cir. 2011), the Court of Appeals for the Third Circuit clarified the principles of res judicata in the context of a bankruptcy proceeding and further defined the scope of 11 U.S.C. § 1111(b). The decision is significant because it is the first appellate decision to determine what constitutes privity for res judicata purposes in the context of a bankruptcy proceeding and also because it held that section 1111(b) transforms non-recourse claims into recourse claims only for distribution purposes.

Facts and Procedural History

Montgomery Ward, LLC (“Montgomery Ward”) contracted with Jolward Associates Limited Partnership (“Jolward”) to construct a department store, on land Montgomery Ward owned in Illinois that was the planned site to develop a mall. The parties entered into a ground lease and Montgomery Ward transferred a leasehold interest in the land upon which the department store was to be constructed to Jolward.

The parties also entered into a lease and sublease agreement (the “Lease and Sublease Agreement”) whereby Jolward subleased the land underlying the department store back to Montgomery Ward, and also leased the department store back to Montgomery Ward, for a period of thirty years. Jolward obtained construction financing by executing a mortgage (the “Mortgage”) in favor of State Farm Life Insurance Co. (“State Farm”). Montgomery Ward joined in the execution of the Mortgage, but assumed no personal liability. Thus, the Mortgage was without recourse to Montgomery Ward.

Some twenty years later, in 1997 and again in 2000, Montgomery Ward filed chapter 11 bankruptcy petitions. In the first bankruptcy proceeding (“Ward I”), State Farm filed a proof of claim for the outstanding balance of the Mortgage. The confirmed plan (“Ward I Plan”) provided for no distribution to State Farm on account of the Mortgage. However, State Farm retained its security interest. In addition, Montgomery Ward assumed the Lease and Sublease Agreement.

In the second bankruptcy proceeding (“Ward II”), a liquidating chapter 11, Dika-Ward, LLC (“Dika-Ward”), as assignee of the State Farm and Jolward bankruptcy claims, filed a proofs of claim for the full amount of the Mortgage and lease rejection damages based on the Lease and Sublease Agreement. Dika-Ward asserted that the Mortgage, although initially nonrecourse, had become recourse in Ward I under section 1111(b) of the Bankruptcy Code.

The Plan Administrator objected to both claims. Specifically, the Plan Administrator argued that the Lease and Sublease Agreement was merely a structured financing agreement and not a true lease. Dika-Ward argued that the confirmed Ward I Plan precluded the Plan Administrator from challenging the Lease and Sublease Agreement on principles of res judicata. The Delaware Bankruptcy Court granted summary judgment for Dika-Ward on the res judicata issue and summary judgment for the Plan Administrator on the Dika-Ward Mortgage claim. Both Dika-Ward and the Plan Administrator appealed.

The Appellate Ruling

The Third Circuit vacated the summary judgment for Dika-Ward regarding res judicata and remanded the issue to the Bankruptcy Court for a determination as to whether the Lease and Sublease agreement was a true lease or a structured financing. The Third Circuit observed that res judicata bars relitigation of a claim if there has been a final judgment on the merits in a prior suit involving the same claim and the same parties or their privies. Here, the Court focused on “whether the Ward II Plan Administrator, as successor in interest to the Ward II Estate, was the same party as, or privy of, the Ward I Debtor.” The Court found that the Plan Administrator in Ward II was not in privity with the debtor in Ward I and, therefore, was not barred by the doctrine of res judicata from contending that the arrangement was a structured financing agreement and not a true lease. The Court reasoned that the Ward I debtor was a party to the Ward I confirmation proceeding, and that upon confirmation, the Ward I debtor ceased to exist, and the reorganized Montgomery Ward succeeded to the Ward I estate. When the Ward II bankruptcy was filed, the Ward II debtor became the trustee of the new bankruptcy estate.

Moreover, the Court found that as trustee, the Ward II debtor was not the same party as the debtor in the first instance because it did not have the same incentives as the Ward I debtor had in the first proceeding. In Ward I, the debtor had an incentive not to bring the cause of action because it wanted Montgomery Ward to continue operating the store; however, in Ward II, the Plan Administrator had an incentive to challenge the lease because Montgomery Ward was liquidating, and a successful challenge would increase returns to the general unsecured creditors. Accordingly, the Court held that because the Plan Administrator was not in privy with the Ward I debtor, res judicata did not preclude the Plan Administrator from challenging the Lease and Sublease Agreement.

The Third Circuit next addressed Dika-Ward’s argument that the Mortgage had become recourse under section 1111(b) as a result of the first bankruptcy proceeding. Section 1111(b) provides that if a debtor elects to continue using encumbered property in its reorganization, the bankruptcy court will grant the nonrecourse creditor, whose claim is secured by an interest in that property, an allowed claim under section 502 as if its security interest had recourse. The Court found that “[s]ection 1111(b)’s language and purpose indicate that the recourse transformation is for distribution purposes only.” In affirming the Bankruptcy Court, the Third Circuit held that Dika-Ward possessed no claim against the Ward II debtor on account of the Mortgage because the security interest remained nonrecourse as to Montgomery Ward.

Conclusion

This case represents one of the first appellate decisions determining who constitutes a “party in privity” for res judicata purposes in a bankruptcy proceeding and establishes that in the Third Circuit for res judicata to bar relitigation of a claim in a bankruptcy proceeding the parties at issue must have aligned incentives.

In light of the Montgomery Ward decision, a trustee appointed in bankruptcy would not be barred by res judicata from challenging the actions taken by a debtor-in-possession prior to the trustee’s appointment as long the trustee can prove different incentives.

This case also represents one of the first appellate decisions finding that section 1111(b) transforms non-recourse claims into recourse claims only for distribution purposes. Affirming the Bankruptcy Court, the Third Circuit emphasized that while section 1111(b) provides recourse status to non-recourse claimants in bankruptcy, it does not alter the creditor’s legal and contractual rights outside of bankruptcy.

Application of the Common Interest Doctrine in Bankruptcy Proceedings

By Gerald H. Gline on Posted in Bankruptcy Litigation, Recent Developments

The U.S. Bankruptcy Court for the District of Delaware recently extended the common-interest doctrine to pre-petition communications between the debtor and an informal committee of claimants in In re Leslie Controls Inc.  Gerald Gline and David Kohane, Members of Cole Schotz, and Jason Finkelstein, an associate at Cole Schotz, recently wrote an article for the American Bankruptcy Institute Journal about the common-interest doctrine’s role in bankruptcy proceedings.  Click here to read the article.

What Does “Commercially Reasonable Determinants of Value” Mean Under Section 562 of the Bankruptcy Code?

By Ryan T. Jareck on Posted in Recent Developments

As part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”), Congress added Section 562 to the Bankruptcy Code. Section 562 governs the timing of damage measurements with respect to swap agreements, securities contracts, forward contracts, commodity contracts, repurchase agreements, and master netting agreements that are rejected or terminated in connection with a bankruptcy case.  Section 562 provides, in relevant part, that:

(a) If the trustee rejects a…repurchase agreement,…or if a…repo participant… liquidates, terminates, or accelerates such contract or agreement, damages shall be measured as of the earlier of –

(1) the date of such rejection; or

(2) the date or dates of such liquidation, termination, or acceleration

(b) If there are not any commercially reasonable determinants of value as of any date referred to in paragraph (1) or (2) of subsection (a), damages shall be measured as of the earliest subsequent date or dates on which there are commercially reasonable determinants of value.

Accordingly, damages are measured as of the earlier of the date of the debtor’s rejection of the contract or the date of the eligible party’s liquidation, termination, or acceleration of the contract. See In re Enron Corp., 354 B.R. 652 (S.D.N.Y. 2006). If commercially reasonable valuation data is not available as of that date, then Section 562(b) of the Bankruptcy Code requires that damages be measured as of the earliest subsequent date for which data is available. Realizing that such a valuation system could lead to parties attempting to improve their position by valuing the qualified contract in the future, Congress added a deterrent – if the damages are not measured as of the dates provided in Section 562(a), and either the trustee or the protected party objects to the timing of the measurement of damages, the burden falls on the non-objecting party to prove that there was no commercially reasonable method of calculating the value of the derivative as of the dates specified in subparts (1) or (2). See 11 U.S.C. § 562(c).

In conjunction with adding Section 562, Congress also added Section 502(g)(2) to the Bankruptcy Code, which provides that any claim for damages arising from the post-petition rejection, liquidation, termination or acceleration of a qualified contract under Section 562 shall be treated as a prepetition claim.  See 11 U.S.C. §§ 502(g)(2) and 562.

In the approximately 5 years since BAPCPA, there has been very little case law interpreting Sections 562 and 502(g)(2) of the Bankruptcy Code. Recently, a Delaware bankruptcy court delivered the first decision applying Section 562 to a claim based on the termination of a repurchase agreement.  See In re American Home Mortgage Corp., 411 B.R. 181 (Bankr. D. Del. 2009). In that case, certain American Home entities and Calyon New York Branch (“Calyon”) entered into a repurchase agreement pursuant to which Calyon purchased certain mortgage loans from American Home.  Following American Home’s default, Calyon accelerated the repurchase agreement in accordance with its terms, thereby requiring American Home to repurchase the loans immediately for a price of approximately $1.14 billion (the “Repurchase Price”).  Shortly thereafter, American Home filed for Chapter 11 bankruptcy protection. Calyon submitted a claim slightly in excess of the Repurchase Price. Calyon contended that it could not have obtained a “commercially reasonable price” for the loan portfolio on the acceleration date because, among other things, the market was distressed and, therefore, the only proper valuation methodology for its claim was the market or sale value. Therefore, Calyon measured its claim based on a subsequent market valuation. American Home argued, in turn, that Calyon could not prove that no “commercially reasonable determinants of value” existed on the acceleration date. Rather, Calyon’s claim should be measured based on a discounted cash flow valuation as of the acceleration date.

The Bankruptcy Court found that the phrase “commercially reasonable determinants of value” in Section 562 was ambiguous, and looked to legislative history for guidance. The Court remarked that the legislative history contains “an acknowledgement that the size of the portfolio or a dysfunctional market would make reliance upon the market price on a specific day unreasonable. . .   Thus, where the market is dysfunctional it may be difficult or impossible to use a market price to assign value to an entire asset or asset pool on a single date – either because the nature of the market mandates that the asset be broken up and sold off in multiple pieces on multiple dates (thereby making it impossible to measure damages on a single date) or because the nature of the market at given time would result in having to sell or liquidate the asset in a commercially unreasonable manner.”

The Court then analyzed the purpose and intent of Section 562 and noted that the common thread for repurchase agreements in the Bankruptcy Code is liquidity: “the primary purpose of the Code provisions relating to repurchase agreements is to preserve the liquidity in the relevant assets, including mortgage loans and interests in mortgage loans. Section 562 serves to align the risk and rewards associated with an investment in those assets.”

The Court ultimately did not find significant assistance from the legislative history or purpose of Section 562, and returned to the fundamental inquiry of assessing an asset’s value. The Court agreed with Calyon that “commercially reasonable determinants of value” means evidence regarding what an asset could be bought or sold for in the marketplace. The Court disagreed, however, that the only pertinent determinants of value are “those that provide evidence of the asset’s actual market price.” Such a reading of Section 562, the Court concluded, was too narrow. The Court reasoned that nothing in Section 562 suggests a limitation on any particular methodology used to determine value, as long as it is commercially reasonable. Furthermore, waiting for the asset to become saleable and/or the market to correct itself might take a long time. In fact, in the case at issue, Calyon took more than a year before selling the asset. The Court opined that “[t]his creates exactly the moral hazard that section 562 was designed to prevent. In such an instance, the repo participant can sit back and monitor market conditions while being protected, at least in part, from market losses by its potential deficiency claim against the debtor.”

In sum, the Court held that the phrase “commercially reasonable determinants of value” is not circumscribed to the actual sale or market value of an asset, and that a discounted cash flow valuation is a valid method for determining the value of the loan portfolio at issue, which was an income-producing asset. Therefore, Calyon suffered no damages from the termination of the repurchase agreement.

Third Circuit Holds Section 1129(b)(2)(A) of the Bankruptcy Code Does Not Provide Secured Lenders With a Legal Entitlement to Credit Bid at an Auction Sale Pursuant to a Plan of Reorganization

By Ryan T. Jareck on Posted in Recent Developments

Does a secured creditor have an absolute right to acquire its collateral, which is sold pursuant to a plan of reorganization, by credit bidding its debt? The Third Circuit Court of Appeals, in a strict constructionist opinion, has just answered this question in the negative.

The Court of Appeals in In re Philadelphia Newspapers, LLC, No. 09-4266 (3d Cir. March 22, 2010) upheld the decision of the United States District Court for the Eastern District of Pennsylvania (which reversed the Bankruptcy Court’s ruling) that barred the prepetition secured lenders from credit-bidding their secured claim to purchase the assets of Philadelphia Newspapers L.L.C. (the “Debtor”) pursuant to the Debtor’s plan of reorganization. The Debtor and other related affiliate-debtors own and operate The Philadelphia Inquirer, Philadelphia Daily News, and philly.com (the “Assets”), which they acquired for $515 million in July 2006 with the proceeds of a $295 million loan from a syndicate of lenders (the “Lenders”). The Lenders hold a first priority lien on substantially all of the Debtor’s Assets, and are owed approximately $319 million. The Debtor proposed a Chapter 11 plan of reorganization (the “Plan”) providing for the sale of the Assets at a public auction free and clear of all liens, claims and encumbrances. Simultaneously, the Debtor entered into a stalking horse purchase agreement with Philly Papers, LLC, an insider of the Debtor, and sought, through its proposed bidding procedures, to preclude the Lenders from credit bidding at the public auction (i.e., all bids had to be in the form of cash).

The Third Circuit was asked to decide whether the District Court correctly held that Section 1129(b)(2)(A) of the Bankruptcy Code does not provide secured lenders with a legal entitlement to credit bid at an auction sale pursuant to a plan of reorganization. The Third Circuit, as did the District Court, relied on the plain language of the statute, which “provides three distinct routes to plan confirmation – retention of liens and deferred cash payments under subsection (i), a free and clear sale of assets subject to credit bidding under subsection (ii), or provision of the “indubitable equivalent” of the secured interest under subsection (iii).” These three alternatives were independent and, therefore, proceeding under either of them was sufficient for confirmation of a plan as “fair and equitable” under the Bankruptcy Code. Because subsection (iii), unlike subsection (ii), does not incorporate the right to credit bid, a debtor who seeks confirmation under the third alternative is not required to allow credit bidding.

In so ruling, the Third Circuit agreed with the Fifth Circuit’s decision in In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009), and distinguished its holding in In re SubMicron Systems Corp., 432 F.3d 448 (3d Cir. 2006). The Court found that SubMicron, which holds that a lender in a Section 363(b) sale could bid up to the full value of its loan and the credit bid sets the value of the lender’s secured interest in collateral, does not equate to a holding that a credit bid must be the successful bid at a public auction. Rather, a court is called at the plan confirmation stage to determine whether a lender has received the “indubitable equivalent” of its secured interest in the collateral. In other words, it is the plan of reorganization, and not the auction itself, that must generate the “indubitable equivalent.” The Third Circuit noted that, notwithstanding its ruling, secured lenders still retain their rights to argue at confirmation that the absence of a credit bid fails to provide them with the “indubitable equivalent” of their collateral.

Judge Thomas Ambro, a former bankruptcy judge, dissented. Judge Ambro reasoned that to read subsection (iii) to accomplish a sale free of liens, but without following the specific procedures prescribed by subsection (ii), undoubtedly places the two clauses in conflict. He expressed serious concern that the majority’s ruling effectively eviscerated the rights afforded to and expectations of secured lenders, and forecasted the adverse impact the ruling would have on the availability and pricing of future credit. Given the prevalence of credit bidding in Chapter 11 cases today, the Third Circuit’s opinion will have a significant ripple effect.