Bankruptcy & Restructuring Law Monitor : Bankruptcy Lawyer & Attorney : Cole Schotz Meisel Forman & Leonard Law Firm : NJ, Mid-Atlantic Restructuring & Chapter 11

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.

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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.

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Pursuant to section 104(a) of the Bankruptcy Code (11 U.S.C. § 104(a)), starting April 1, 1998, and at each three year interval ending on April 1 thereafter, the dollar amounts in effect under various sections of the Bankruptcy Code are subject to adjustment. The adjustments are based upon the consumer price index, and a rounding to the nearest $25 amount that represents such change, with such adjusted amounts to be published in the Federal Register by the Judicial Conference of the United States not later than March 1 of each three year interval. Such adjustments apply only with respect to cases commenced after the effective date of such adjustments. On or about February 25, 2010, the Judicial Conference published the adjustments that will take affect as of April 1, 2010 (see Federal Register/Vol. 75, No. 37/Thursday, February 25, 2010/Notices, Page 8747-8749.)

The following are a few of the increases that would be relevant to business bankruptcy cases:

a.  Under the 28 U.S.C. § 1409(b), venue of proceedings arising under or related to cases under Title 11 to recover a debt against a non-insider of less than $11,725.00, may be brought only in the district court for the district in which the defendant resides. This is an increase from $10,950.

b.  In the definition of “small business debtor” under 11 U.S.C. § 101(51D)(A) and (B), the aggregate non-contingent liquidated secured and unsecured debts as of the date of the petition or the date of the order for relief has been increased from $2,190,000 to the amount of $2,343,300, each time it appears in such sections (note, these amounts exclude debts owed to one or more affiliates or insiders).

c.  The minimum aggregate amount of claims needed under 11 U.S.C. § 303(b) for the commencement of an involuntary Chapter 7 or Chapter 11 bankruptcy case has been increased from $13,475.00 to $14,425.00.

d.  Priority expenses and claims under 11 U.S.C. § 507(a) have been increased as follows:

1. priority expenses and claims under 11 U.S.C. § 507(a)(4) for wages, salaries, or commissions, including vacation, severance and sick leave pay, or for sales commissions have been increased from $10,950.00 to $11,725.00;
2. priority expenses and claims under 11 U.S.C § 507(a)(5) for allowed unsecured claims for contributions to an employee benefit plan have been increased from $10,950.00 to $11,725.00;
3. priority expenses and claims under 11 U.S.C. § 507(a)(7) for pre-petition deposits have been increased from $2,425.00 to $2,600.00.

e.  The minimum amount that a trustee may seek to recover as a preferential transfer in a case filed by a debtor whose debts are not primarily consumer debts has been increased from $5,475.00 to $5,850.00.

f.  Again, the foregoing amounts apply only to cases commenced after April 1, 2010.
 

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In a recent decision, the United States Court of Appeals for the Third Circuit further defined its standard for awarding a break-up fee to an unsuccessful “stalking horse” bidder for a debtor’s assets. In In re Reliant Energy Channelview LP, ___ F.3d ___, 2010 WL 143678 (C.A. 3 (Del.) 2010), the debtors sought to sell their largest asset, a power plant, pursuant to Section 363 of the Bankruptcy Code. Following a comprehensive marketing process, the debtors accepted a $468 million bid of Kelson Channelview LLC (Kelson). The contract with Kelson simply required the debtors to seek an order approving certain bid protections and procedures, including the payment of a $15 million break-up fee to Kelson, if the bankruptcy court were to require the debtors to hold an auction, which it subsequently did.

In response to the debtors’ request to approve the proposed break-up fee, a potential competing bidder, Fortistar, LLC (Fortistar), argued that it was discouraged from submitting a higher bid by the proposed break-up fee. After the bankruptcy court refused to allow the break-up fee, Kelson withdrew its offer on the ground that it was no longer valid and did not participate in the auction process. The debtors accepted Fortistar’s bid, which exceeded Kelson’s original bid by $32 million, and the bankruptcy court approved the sale of the power plant to Fortistar. Kelson appealed the bankruptcy court’s denial of a break-up fee to the district court, which affirmed the bankruptcy court’s ruling. Kelson then appealed to the Third Circuit.

The court in Reliant noted its decision in Calpine Corp. v. O’Brien Environmental Energy, Inc. (In re O’Brien Environmental Energy, Inc.), 181 F.3d 527 (3d Cir. 1999), where it held that the allowance of a break-up fee was subject to the standard for allowance of an administrative priority claim under Section 503(b) of the Bankruptcy Code; that is, the fees had to be necessary to preserve the value of the bankruptcy estate. In O’Brien, the court ruled that a break-up fee did not meet that standard where the unsuccessful bidder would have bid even without the assurance of a break-up fee (which, in that case, it did).

The court in Reliant further defined the O’Brien standard by ruling that to preserve the value of the estate, the break-up fee must have either induced or preserved a bidder’s bid. The court held that because Kelson did not condition its bid on the provision of a break-up fee, but only required the debtors’ agreement to seek a break-up fee, the fee was not necessary to induce Kelson’s bid. Additionally, the court held that the break-up fee was not necessary to preserve Kelson’s bid because, among other things, it was reasonable to assume that Kelson would not have abandoned its contract with the debtors if no other bidders materialized.

Reliant teaches that buyers of assets in Section 363 sales who seek maximum bid protections, including a break-up fee, should make allowance of those protections a material condition of their contract with a debtor, and specifically provide that failure to obtain court approval of such protections will constitute an event of default under the contract.

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Over the last several years, there have been a series of decisions rendered by the federal courts of appeals that grappled with the application of §510(b) to a claim that does not readily fall within the statute’s language.  Click here to read about the continuing expansion of §510(b).

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Bankruptcy practitioners should be aware of the U.S. Supreme Court’s recent decision in Ashcroft v. Iqbal, 129 S. Ct. 1937, (2009), which confirmed a new, more subjective standard for evaluating whether a complaint complies with Federal Rule of Civil Procedure 8(a)(2). That Rule, which applies to adversary proceedings pursuant to Federal Rule of Bankruptcy Procedure 7008(a)(2), states that a pleading must contain a “short and plain statement of the claim showing that the pleader is entitled to relief.” Since 1957, motions to dismiss for failure to state a claim have been assessed under Conley v. Gibson, 355 U.S. 41, in which the Supreme Court held that “a complaint should not be dismissed unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.” The Conley approach made motions to dismiss a complaint for failure to state a claim very difficult to win. Two years ago, in Bell Atlantic Corp. v. Twombly, 550 U.S. 544 (2007), the Supreme Court held that Conley’s ‘no set of facts’ standard should be retired, and opted instead for a “plausibility standard.” The pleader now had to amplify a claim with sufficient factual statements so as to render the claim “plausible.” In order to survive a motion to dismiss, a plaintiff must provide “more than labels and conclusions, and a formulaic recitation of the elements of a cause of action will not do.” Because of apparent doubt among reviewing courts whether Twombly applies in all cases, or just anti-trust cases such as Twombly, the Supreme Court in Iqbal confirmed that the Conley standard no longer applies in any civil case.

Under Twombly/Iqbal, the court embarks on a two-part analysis in determining whether to dismiss a complaint for failure to state a claim. First, the court must accept as true all allegations contained in the complaint, although that tenet does not apply to legal conclusions. Second, the court should consider whether a complaint states a “facially plausible” claim for relief. In turn, determining if a complaint states a plausible claim for relief will be a “context-specific” task that requires the court to “draw on its judicial experience and common sense.” Notably, if the “well-pleaded facts do not permit the court to infer more than the mere possibility of misconduct, the complaint has alleged – but it has not “show[n] – “that the pleader is entitled to relief.” Clearly, this new standard gives trial judges considerable discretion in determining whether a complaint satisfies Rule 8(a).

Bankruptcy courts already have dismissed preference and fraudulent conveyance complaints under the new Rule 8(a) standard. See, e.g., In re Caremerica, Inc., 2009 WL 2227212 (July 23, 2009) (“Caremerica I”), and 409 B.R. 346 (July 28, 2009) (“Caremerica II”). In Caremerica I, after addressing each of the elements of a complaint under Section 547(b) of the Bankruptcy Code, the court found the Trustee’s complaint did not plead sufficient factual allegations to establish a claim for relief that is plausible. Among other things, the trustee did not indicate which of the consolidated debtors initiated the transfers at issue, the complaint did not assert facts supporting the existence of an antecedent debt owed by the debtors to the defendants, the trustee did not allege sufficient facts that insolvency was plausible on the dates transfers to alleged insiders were made outside of the presumed 90-day insolvency period, and the allegations did not establish a reasonable inference of insider status. In Caremerica II the court dismissed the trustee’s constructive fraudulent transfer complaint against a separate defendant under Section 548(a)(1)(B) for not describing the consideration received by each transferor or the debtors’ insolvency at the time of the transfer. Without such factual content, the trustee could not show that his constructive fraud theory was plausible.

This new, more stringent pleadings standard suggests that motions to dismiss undoubtedly will become more prevalent and, to avoid the success of such motions, the factual allegations of a complaint should be drafted carefully and exactingly so as to make a claim for relief plausible.
 

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On April 8, 2009, the United States Court of Appeals for the Second Circuit, reversing a ruling by the United States Bankruptcy Court for the Southern District of New York, concluded that certain “termination premiums” due to the Pension Benefit Guaranty Corporation (“PBGC”) are not contingent pre-petition claims subject to discharge in a Chapter 11 reorganization. The Second Circuit’s decision is of great import because debtors that terminate their pension plans after filing for bankruptcy may no longer be able to escape paying significant claims to the PBGC.

Background

On February 28, 2006, the Deficit Reduction Act of 2005 (“DRA”) was enacted. The DRA requires employers that terminate qualified pension plans to pay annual “termination premiums” to the PBGC equal to $1,250 per beneficiary for three years after the termination. A “Special Rule,” however, applies to termination of pension plans in bankruptcy proceedings. That “Special Rule” provides that termination premiums begin to accrue on the date of the discharge or dismissal of the employer’s bankruptcy case.

Flatware manufacturer Oneida Ltd. commenced a Chapter 11 case in 2006. At the outset of its case, Oneida moved to terminate its three underfunded pension plans. After confirming its plan of reorganization, Oneida sought a declaratory judgment that the PBGC’s claims for termination premiums were contingent pre-petition claims that were discharged by Oneida’s plan of reorganization. The Bankruptcy Court for the Southern District of New York agreed with Oneida. The PBGC appealed the Bankruptcy Court’s ruling and the Second Circuit granted the parties’ joint request to hear the appeal directly under 28 U.S.C. § 158(d)(2).

The Second Circuit’s Decision

The Second Circuit reversed the lower court’s ruling. The Second Circuit stated that in order to have a valid bankruptcy claim, a party must have a right to payment that arose pre-petition, which right must be determined in accordance with non-bankruptcy law. The Second Circuit, relying on the “Specific Rule,” found that the PBGC’s right to payment of termination premiums does not arise until after the employer is discharged from bankruptcy. As such, the Second Circuit held that the PBGC’s termination premium claim is not a pre-petition claim subject to discharge in Chapter 11. The Second Circuit remanded the case to the Bankruptcy Court for further proceedings consistent with its ruling.

Conclusion

The Oneida ruling is the first published decision on the issue. Companies seeking to use the bankruptcy process to terminate their pension obligations must now squarely address whether termination should occur before the bankruptcy filing in view of the Oneida ruling. This decision cannot be taken lightly as pre-petition pension plan termination might adversely impact a company’s relationship with its employees.
 

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