September 13, 2016

Delaware Bankruptcy Court Holds LLC Operating Agreement Provisions Placing Sole Power in the Company’s Lender to Prevent a Bankruptcy Filing are Void as Against Public Policy

In an important decision for debtors and creditors alike, the United States Bankruptcy Court for the District of Delaware has ruled that provisions in a limited liability company operating agreement, granting the company’s lender absolute power to prevent the company from filing a bankruptcy petition are unenforceable as against public policy. In re: Intervention Energy Holdings, LLC, 2016 WL 3185576 (Bankr. D. Del. 2016).

The facts involved in the case are straight-forward. The debtors—a parent limited liability company and its subsidiary—found themselves in financial straits compelling them to seek a forbearance agreement with their lender. The lender agreed to forbear, but only on the condition that the debtors amend their respective operating agreements to include a provision admitting the lender as a member of the parent and further requiring the unanimous consent of the members of the parent for any voluntary filing for bankruptcy by either the parent or the subsidiary. The debtors filed chapter 11 petitions without the consent of the lender, and the lender filed a motion to dismiss the petitions as filed without authority.

The bankruptcy court noted that the issue of whether debtors and creditors are free to contract away bankruptcy rights was one of first impression in Delaware. However, the court determined that it need not decide this issue, as it determined public policy considerations provided an alternate ground for its decision. The court concluded such a provision violates public policy and is unenforceable, stating its conclusion in the strongest of terms:

“A provision in a limited liability company governance document obtained by contract, the sole purpose and effect of which is to place into the hands of a single, minority equity holder the ultimate authority to eviscerate the right of that entity to seek federal bankruptcy relief, and the nature and substance of whose primary relationship with the debtor is that of creditor-not equity holder-and which owes no duty to anyone but itself in connection with an LLC’s decision to seek federal bankruptcy relief, is tantamount to an absolute waiver of that right, and, even if arguably permitted by state law, is void as contrary to federal public policy.”

The court relied on opinions from various courts to the effect that contractual provisions restricting the right to a bankruptcy discharge and the right to file bankruptcy are unenforceable as against public policy. Klingman v. Levinson, 831 F.2d 1291 (7th Cir. 1987) (“for public policy reasons, a debtor may not contract away the right to a discharge in bankruptcy.”). MBNA Am. Bank. N.A. v. Trans World Airlines, Inc. (In re Trans World Airlines, Inc.), 275 B.R. 712 (Bankr. D. Del. 2002) (“prepetition agreements purporting to interfere with a debtor’s rights under the Bankruptcy Code are not enforceable.”). In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996) (“the Bankruptcy Code pre-empts the private right to contract around its essential provision.”). The court believed such provisions would frustrate the object of the Bankruptcy Code and be repugnant to its purposes.

The concluded its opinion with the following strongly-worded language:

“Under the undisputed facts before me, to characterize the Consent Provision here as anything but an absolute waiver by the LLC of its right to seek federal bankruptcy relief would directly contradict the unequivocal intention of [the lender] to reserve for itself the decision of whether the LLC should seek federal bankruptcy relief. Federal courts have consistently refused to enforce waivers of federal bankruptcy rights.”

This decision, along with the recent decision of the U.S. Bankruptcy Court for the Northern District of Illinois in In re Lake Michigan Beach Pottawatamie Resort LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016), which found a similar provision violated applicable state corporate law, should be instructive to creditors’ counsel of the need to carefully craft these types of restrictive agreements in ways which comport with public policy and applicable state law.

August 30, 2016

Ninth Circuit Holds that the One-Year Period in Sec. 727(a)(2) is not Subject to Equitable Tolling

Ronald Neff was a dentist against whom his patient, Douglas DeNoce, obtained a judgment for malpractice. After he filed a chapter 13 petition, Neff recorded a quit-claim deed transferring a condominium from himself to a trust. This first chapter 13 case was dismissed, as was a second chapter 13 case filed by Neff. Neff then filed his third bankruptcy case, a chapter 7 proceeding, more than one year following the recording of the quit-claim deed. DeNoce filed an adversary proceeding, seeking the denial of Neff’s discharge under § 727(a)(2) of the Bankruptcy Code, asserting the transfer of the condominium was made with intent to hinder, delay or defraud creditors. Because § 727(a)(2) requires the transfer be made within one year before the bankruptcy filing, Neff contended the transfer of the condominium, which occurred more than a year before he filed his chapter 7 petition, did not bar his discharge.

The bankruptcy court granted Neff a summary judgment on the complaint, and DeNoce appealed, contending the one-year period in the statute is subject to equitable tolling based on Neff’s first two bankruptcy cases. The Ninth Circuit BAP affirmed, as did the Ninth Circuit. DeNoce v. Neff (In re Neff), 2016 WL 3201236 (9th Cir. 2016).

The sole question before the Ninth Circuit was whether the one-year time period contained in § 727(a)(2) can be subject to equitable tolling. The Ninth Circuit concluded it is not, in an straight-forward analysis. First, the court noted that equitable tolling “is fundamentally a equstion of statutory intent,” and that the Supreme Court presumes that Congress intended equitable tolling would be available “if the period in question is a statute of limitations.” Young v. United States, 535 U.S. 43 (2002). However, this presumption has only been applied to statutes of limitation and has not been applied to other statutes, such as statutes of repose. Lozano v. Montoya Alvarez, 134 S. Ct. 1224 (2014).

Consequently, the court determined the question before it was whether the time period in § 727(a)(2) is a statute of limitations. The court noted that a statute of limitations is generally “[a] law that bars claims after a specified period; specifically, a statute establishing a time limit for suing in a civil case, based on the date when the claim accrued.” CTS Corp. v. Waldburger, 134 S. Ct. 2175 (2014). The purpose of a statute of limitations is to encourage claimants to diligently pursue their claims. The court concluded that § 727(a)(2) was not a statute of limitations. Its purpose was not to encourage claimants to timely pursue claims against a debtor, but rather its purpose is to prevent dishonest debtors from abusing the bankruptcy process by evading the consequences of their misconduct. The court stated: “At the core of the Bankruptcy Code are the twin goals of ensuring an equitable distribution of the debtor’s assets to his creditors and giving the debtor a fresh start.” Sherman v. SEC (In re Sherman), 658 F.3d 1009 (9th Cir. 2011). The one-year is designed to set a date on transfers for which a debtor may be denied a discharge, and is not a statute of limitations by which a creditor must bring an action.

August 16, 2016

Buyer Beware: a Sale “Free and Clear” is not Free and Clear of Claims Whose Holders Were not Provided Notice of the Sale Hearing

The Second Circuit’s recent opinion in The Matter of: Motors Liquidation Company, 2016 WL 3766237 (2nd Cir. 2016) should give pause to all buyers of assets from bankruptcy estates. This decision comes in the bankruptcy proceedings of General Motors, in which the debtor’s assets were sold by “Old GM” to “New GM” free and clear of all liens, interests, claims and encumbrances, including claims of successor liability, within weeks after the petition was filed. The question in this particular situation was whether the sale was free and clear of claims purchased by consumers prior to the bankruptcy filing and which had a defective ignition switch. Several years after the bankruptcy sale closed, a group of vehicle owners filed an adversary proceeding against New GM in the bankruptcy court, asserting economic losses arising from the ignition switch defect and seeking liability against New GM on a theory of successor liability. New GM sought to enforce the sale order, arguing it acquired Old GM’s assets free and clear of these claims.

The bankruptcy found that GM had actual knowledge of the defect and of potential claims based on it, and that the holders of these claims were entitled to actual notice of the sale hearing. However, although finding that notice to the claimants had been inadequate under the Due Process Clause of the Fifth Amendment, the bankruptcy court nevertheless enforced the sale order, concluding the claimants had not been prejudiced by the sale order because the court would have entered the sale order over any objection the claimants might have raised. An appeal was certified directly to the Second Circuit.

The Second Circuit reversed and remanded the bankruptcy court’s finding as to these “ignition switch” claims. The court began its analysis by noting that several of its sister courts have held that § 363(f) may be used to bar a successor liability claims, concluding the use of the term “claim” in § 363(f) is to be read in harmony with the definition of the word in § 101. Since successor liability claims falls within the parameters of the term “claim” as defined in § 101(5), the court concluded that assets can be sold under § 363 free and clear of such claims. In short, the court held that the “free and clear” language of § 363(f) applies to claims that flow from the debtor’s ownership of the sold assets.

The Second Circuit agreed with the bankruptcy court that the debtors failed to comply with the Due Process Clause when they failed to give actual notice by mail of the proposed sale to the holders of ignition switch claims. The court also agreed with the bankruptcy court that Old GM could have easily identified the holders of these claims and could have provided them with actual notice of the proposed sale by mail. The court relied on the general rule that “notice by publication is not enough with respect to a person whose name and address are known or very easily ascertainable and whose legally protected interests are directly affected by the proceeding in question.” Schroeder v. City of New York, 371 U.S. 208, 212-13 (1962).

On the issue of prejudice, however, the Second Circuit came to a different conclusion than the bankruptcy court. The bankruptcy court held that prejudice is a requirement of the Due Process Clause, and that a party who has been denied due process may not be entitled to relief if he has suffered no prejudice. In this instance, the bankruptcy court found no prejudice, concluding it would have entered the sale order even if the claimants had been given notice. In analyzing this aspect of the bankruptcy court’s decision, the Second Circuit noted a split in authority, with the First Circuit concluding prejudice must be shown in asserting a due process violation, Perry v. Blum, 629 F.3d 1 (1st Cir. 2010), whereas the Eighth Circuit has held a showing of prejudice is not required, In re New Concept Hous., Inc., 951 F.2d 932 (8th Cir. 1991). The Second Circuit did not take either side, concluding instead that, even assuming the claimants had to demonstrate prejudice, they had in this specific case. Noting the significant negotiations among numerous parties which lead to the final sale order entered by the court, the Second Circuit believed the claimants, had they received notice of the sale, may have succeeded in negotiating more favorable treatment in the sale order.

This decision highlights the importance to purchasers of assets to make sure their debtor/seller provides appropriate notice to all holders of claims against which the buyer seeks protection from successor liability.

August 2, 2016

Eleventh Circuit Reaffirms its Prior Ruling that Debt Collectors who File Time-Barred Proofs of Claim are Subject to Liability Under the Fair Debt Collections Practices Act, and Further Concludes its Holding does not Place the FDCPA in Conflict with the B

In 2014 the Eleventh Circuit held that a debt collector violates the Fair Debt Collections Practices Act when it filed a proof of claim in a chapter 13 case on a debt that it knows to be time-barred. Crawford v. LVNV Funding, LLC, 758 F.3d 1254 (11th Circ. 2014). The United States District Court for the Southern District of Alabama subsequently held the Crawford decision as placing the FDCPA and the Bankruptcy Code in irreconcilable conflict. On appeal, the Eleventh Circuit found no such conflict, stating “Although the code certainly allows all creditors to file proofs of claim in bankruptcy cases, the Code does not at the same time protect those creditors from all liability,” and that a particular group of creditors—debt collectors—may be liable for damages for violating the FDCPA if they file claims in chapter 13 cases they know to be time-barred. Johnson v. Midland Funding, LLC, 2016 WL 2996372 (11th Cir. 2016).

The court reaffirmed its prior conclusion by looking to the language of the FDCPA, which prohibits a “false, deceptive or misleading representation,” 15. U.S.C. § 1692e, or “unfair or conconscionable means, 15 U.S.C. § 1692f, to collect a debt. Finding these terms to be ambiguous, the court adopted a “’least-sophisticated consumer’ standard” to determine whether a debt collector’s conduct is deceptive under the FDCPA. The court concluded in Crawford that filing a time-barred proof of claim is akin to filing a time-barred lawsuit, something which is prohibited by the FDCPA. As a result, in Crawford, the court held knowingly filing a time-barred proof of claim constituted misleading conduct under the FDCPA.

However, the court agreed it left unanswered in Crawford an additional question: whether the Bankruptcy Code preempts the FDCPA when creditors misbehave in bankruptcy. This specific question was not raised in Crawford but was raised in Johnson by the creditor, who argued the Bankruptcy Code, having been enacted subsequent to the FDCPA, preempted it as to claims for violation. The Eleventh Circuit disagreed and decided the two statutes could be read in harmony.

The court commenced its analysis by noting the Supreme Court interpreted the Bankruptcy Code’s definition of a “claim” in § 101(5)(A) as creating an entitlement for creditors to file a proof of claim where a right to payment exists. Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443 (2007). The court further noted that a “right to payment” under the Bankruptcy Code “is nothing more or less than an enforceable obligation.” Penn. Dept. of Pub. Welfare v. Davenport, 495 U.S. 552 (1990). The court continued its analysis by stating a the Bankruptcy Code contemplates that creditors may file unenforceable claims. In re McLean, 794 F.3d 1313 (11TH Cir. 2015). Further, the court noted that “having a claim is not the same as being entitled to a remedy,” and further noted that applicable state law provides the running of the statute of limitations does not extinguish a cause of action but rather makes the remedy unavailable. Consequently, the average creditor filing a time-barred claim will likely face a disallowance of its claim and will not receive a distribution from the bankruptcy estate.

However, the court noted that debt collectors are not the average creditor, as the FDCPA imposes requirements on debt collectors which don’t apply to other creditors. The FDCPA prohibits the use of unfair or unconscionable means to collect or attempt to collect a debt, as well as the use of any false, deceptive or misleading representation or means in connection with the collection of any debt. A debt collector who violates these proscriptions faces civil liability to the debtor. Debt collectors are a narrow subset of creditors who might file proofs of claim in chapter 13 cases. Contrary to the conclusion of the district court, the circuit court found no irreconcilable conflict between the Bankruptcy Code, which permits creditors to file time-barred proofs of claim, and the FDCPA which prohibits debt collectors from engaging in such conduct. The Eleventh Circuit reached this conclusion by noting first that repeals by implication are not favored and will not be presumed unless the intention of the legislature to repeal is clear and manifest. Nat’l Ass’n of Home Builders v. Defenders of Wildlife, 551 U.S. 644 (2007). The court noted the U.S. Supreme Court’s conclusion “[W]hen two statutes are capable of coextistence, it is the duty of the courts, absent a clearly expressed congressional intention to the contrary, to regard each as effective.” J.E.M. Ag Supply, Inc. v. Pioneer Hi-Bred Int’l, Inc., 534 U.S. 124 (2001). The court stated that, for an irreconcilable conflict to exist, there must usually be some sort of “positive repugnancy” between the statutes, not merely “different requirements and protections.” Statutory repeal cannot be inferred unless the later statute expressly contradicts the earlier statute or an inference of repeal is “absolutely necessary” in order for the latter statute to have “any meaning at all.”

The Eleventh Circuit concluded the Bankruptcy Code and the FDCPA can be construed in a way that allows both to exist. A conclusion that the Bankruptcy Code repealed the FDCPA was not “absolutely necessary” in order for § 501 of the Bankruptcy Code to have “any meaning at all.” The Bankruptcy Code allows all creditors to file claims, with the overlay from the FDCPA that a certain subgroup of creditors—debt collectors—may face liability by filing a time-barred proof of claim if they do so knowing it is time-barred. The court concluded the goals and purposes of both statutes can still be served with this construction. The purpose of the FDCPA is to punish debt collectors who engage in misleading or unconscionable conduct, not to punish debt collectors who file proofs of claim in chapter 13 cases. As a result, the court determined that the statutes were not in irreconcilable conflict and that the Bankruptcy Code did not effect a repeal of the FDCPA.

July 19, 2016

Eleventh Circuit Holds Bankruptcy Rules Applicable to Matters on Which the Reference has been Withdrawn to the U.S. District Court

When an adversary proceeding is transferred to the district court pursuant to a withdrawal of the reference, which rules—and deadlines—apply: those contained within the Federal Rules of Civil Procedure, or those contained within the Federal Rules of Bankruptcy Procedure? The Eleventh Circuit recently held the Federal Rules of Bankruptcy Procedure, not the Federal Rules of Civil Procedure, govern adversary proceedings before the district courts. Rosenberg v. DVI Receivables XIV, LLC, 2016 WL 1392642 (11th Cir. 2016). In so holding, the Eleventh Circuit agreed with the conclusions of two of its sister circuits, In re Celotex Corp., 124 F.3d 619 (4th Cir. 1997) and Diamond Mortgage Corp. v. Sugar, 913 F.2d 1233 (7th Cir. 1990).

The facts in Roxenberg arose from the dismissal of an involuntary bankruptcy petition, followed by the debtor’s filing an adversary proceeding against the petitioning creditors seeking compensatory and punitive damages as well as attorney’s fees incurred in defending the involuntary petition and in prosecuting the adversary proceeding. The adversary proceeding was bifurcated, with the district court withdrawing the reference on the debtor’s damages claims, and leaving resolution of the claims for attorney’s fees with the bankruptcy court. Following a jury verdict and judgment in the debtor’s favor, the petitioning creditors filed a motion for judgment as a matter of law pursuant to Rule 50(b) of the Federal Rules of Civil Procedure. The petitioning creditors filed the motion within the 28-day deadline in the Federal Rule, but after the 14-day deadline in the Bankruptcy Rule.

The Circuit Court held the motion was untimely. The based its conclusion on the plain language of the federal and bankruptcy rules, finding the plain language of Fed. R. Bankr. P. 1001 requires application of the Federal Bankruptcy Rules in cases under title 11 of the United States Code. The court noted that Rule 1001 was amended in 1987 “for the specific purpose of expanding the reach of the rules beyond the bankruptcy courts to all courts hearing bankruptcy matters.” Further, the advisory committee’s notes to the 1987 amendments stated the amendment “makes the Bankruptcy Rules applicable to cases and proceeding under title 11, whether before the district judges or the bankruptcy judges of the district.” The court could find no justification for treating a party to a bankruptcy proceeding differently based on whether the case or adversary proceeding was being handled by the district court as opposed to the bankruptcy court. In addition to concluding this holding was consistent with the Fourth Circuit’s decision in Celotex and the Seventh Circuit’s decision in Diamond Mortgage, the Eleventh Circuit also found support for its conclusion in the Third Circuit’s decision in Phar-Mor, Inc. v. Coopers & Lybrand, 22 F.3d 1228 (3d Cir. 1994), where the court stated “the Bankruptcy Rules govern non-core, ‘related to’ proceeding before a district court.”

As a result, the Eleventh Circuit held the petitioning creditors’ motion for judgment as a matter of law under Rule 50(b) was untimely because it was not filed within the fourteen day deadline contained in the Bankruptcy Rule.

July 5, 2016

Eighth Circuit Holds a Lender to a Special Purpose Entity is not a “Person Aggrieved” by an Order Substantively Consolidating the SPE’s Bankruptcy Estate with Another Estate

Lenders often go to great lengths to ensure their borrowers are Special Purpose Entities—entities whose assets will not be commingled with the assets of parent or affiliated companies—rendering bankruptcy filings by the SPE less likely. However, when a SPE does file bankruptcy and its trustee seeks to substantively consolidate its estate with the estate of its parent and affiliates, does the lender have standing to contest that motion and thereby be a “person aggrieved” from an adverse order? The Eighth Circuit recently answered this question in the negative, holding a lender to a special purpose entity is not a person aggrieved by an order of substantive consolidation and, therefore, lacks standing to appeal the order. Opportunity Finance, LLC et al v. Kelley, 2016 WL 2848587 (8th Cir. 2016).

In Opportunity Finance, the debtors were Petters Company, Inc. (“PCI”) and eight affiliated companies which were special purpose entities. All were controlled by Thomas Petters. Although the lenders presumably required the SPEs to maintain their assets separate and apart from PCI and the other affiliates and to not commingle their assets, just the opposite happened. In fact, Petters used PCI and the SPEs to operate a Ponzi scheme. The SPEs had no appreciable assets and held only illusory accounts. PCI and the SPEs were placed into receivership. The receiver caused them to file chapter 11 petitions, and soon after the petitions were filed, sought an order from the bankruptcy court substantively consolidating the bankruptcy estates. Each lender was a net winner of the Ponzi scheme and, therefore, not a creditor of the bankruptcy estate of its specific SPE when the bankruptcy filings occurred. The lenders opposed the receiver’s motion for substantive consolidation and then perfected an appeal from the order granting the motion.

The receiver contended the lenders were not persons aggrieved by the substantive consolidation order and, as a result, lacked standing to appeal it. The Eighth Circuit agreed. The lenders first argued that the “person aggrieved” standard for appellate standing did not survive the transition from the Bankruptcy Act to the Bankruptcy Code. The Eighth Circuit quickly rejected its argument, relying on its prior opinion in In re AFY, 734 F.3d 810 (8th Cir. 2013). The court then addressed the standing issue. First, the court stated that “standing in a bankruptcy appeal is narrower than Article III standing.” This is because bankruptcy proceedings typically involve a myriad of parties, making the need to limit collateral appeals more acute. The court held that the doctrine limits standing to “persons with a financial stake in the bankruptcy court’s order, meaning they were directly and adversely affected pecuniarily by the order.” To meet this standard, the order must diminish the person’s property, increase his burdens or impair his rights.

The court determined the lenders could not meet this standard. They were not creditors of the estates. The court held that, in order for the lenders to be affected by the substantive consolidation order, several steps had to occur: (1) the receiver had to prevail in the avoidance actions he had brought against them, (2) the affected lender had to pay the judgment in the adversary proceeding in full, (3) the lender then had to file a proof of claim against the estate. Since none of these steps had taken place at the time of the entry of the consolidation order, the court held none of the lenders was a party aggrieved. The fact that the consolidation order would likely affect defenses which the lenders might be able to raise in the adversary proceedings did not change the outcome. The court’s decision was consistent with the decision of the Eleventh Circuit in In re Ernie Haire Ford, Inc., 764 F.3d 1321 (11th Cir. 2014), on which the Eighth Circuit relied, and where the court held that an adversary defendant is not a person aggrieved, even if the bankruptcy court order strips the defendant of a defense in the adversary proceeding.

As a result, the lenders were not persons aggrieved by the substantive consolidation order, and the Eighth Circuit concluded they lacked standing to appeal it.

June 21, 2016

Supreme Court Expands Creditors’ by Allowing Denial of a Discharge Under Sec. 523(a)(2)(A) if Debtor Transfers Assets in Violation of State Fraudulent Transfer Statute

Section 523(a)(2)(A) of the Bankruptcy Code allows a creditor to obtain a judgment denying its debtor a discharge of debts incurred by false pretenses or actual fraud. However, if the debt itself was not incurred by actual fraud, but the debtor subsequently transfers his assets with the intent prevent its creditors from obtaining payment, may the creditor still obtain a judgment denying the debtor’s discharge under § 523(a)(2)(A)? The United States Supreme Court answered that question in the affirmative in its recent decision in Husky International Electronics, Inc. v. Ritz, 2016 WL 2842452 (2016).

Chrysalis Manufacturing Corp. incurred a debt to Husky International arising from Chrysalis’s purchase from Husky of components used in electronic devices. Over a period of four years, Chrysalis incurred a debt to Husky totaling over $160,000. There was no contention that this debt was incurred as the result of false representations or actual fraud. However, during the latter part of this same period, Daniel Ritz, a director and owner of Chrysalis, caused Chrysalis to transfer virtually all its assets to other companies Ritz also controlled. Husky sued Ritz under a Texas statute which allows creditors to hold shareholders responsible for corporate debts under circumstances involving actual fraud. After Ritz filed a personal bankruptcy petition under chapter 7, Husky brought an adversary proceeding against him seeking denial of the dischargeability of its debt under § 523(a)(2)(A). The District Court concluded the Ritz was liable under the Texas statute but also concluded that the debt was not obtained by actual fraud could be discharged. The Fifth Circuit affirmed, agreeing the debt could be discharged since it was not incurred by actual fraud as required by § 523(a)(2)(A).

The Supreme Court reversed, holding the term “actual fraud” in § 523(a)(2)(A) “encompasses forms of fraud, like fraudulent conveyance schemes, that can be effected without a false representation.”

The Court commenced its analysis by first looking to the prior Bankruptcy Act, which prohibiting debtors from discharging debts obtained by false pretenses or false representations, but contained no provisions relating to situations which might constitute “actual fraud” but not fall within the meaning of false pretenses or false representations. Congress added the term “actual fraud” when it enacted the Bankruptcy Code in 1978. The addition of the words “actual fraud” were presumed by the Court to have “real and substantial effect.” The Court believed the words “actual fraud” were intended to mean something other than “false representation.” The Court then analyzed the historical meaning of the terms “actual fraud” and concluded the words have long included the type of fraudulent transfer scheme in which Ritz engaged. First, the Court noted the word “actual” has a simple meaning in the common law, and denotes any fraud that “involves moral turpitude or intentional wrong,” and stands in contrast to implied fraud or fraud in law. The Court stated “Thus, anything that counts as ‘fraud’ and is done with wrongful intent is ‘actual fraud.’”

The Court found analyzing the history of the word “fraud” to be more challenging, and although it “connotes deception or trickery generally,” was more difficult to precisely define. However, the Court noted the term “fraud” had long been used by courts to describe a debtor’s transfer of assets which impairs a creditor’s ability to collect a debt. The Court further noted that fraudulent conveyances at common law did not require a misrepresentation by a debtor to his creditor. The fraudulent conduct was not in inducing the creditor to extend credit but rather was in the act of concealment and hindrance. As a result, the Court determined the actual fraud need not be present at the inception of a credit transaction.

June 7, 2016

Lenders Beware: Make Sure Your Borrower’s Organizational Documents’ Blocking Director Provisions Comply With State Law

Many lenders attempt to render their borrower bankruptcy remote by requiring the borrower to have on its board a director, known as a “blocking director,” whose consent is required for any bankruptcy filing. However, in doing so, the lender needs to make sure the organizational documents which impose this condition on the buyer comply with requirements of the law of the state in which the borrower is organized. If they don’t, a lack of the blocking director’s consent may not prevent the borrower from filing bankruptcy. This harsh lesson was learned by the lender in In re: Lake Michigan Beach Pottawattamie Resort, LLC, 547 B.R. 899 (Bankr. N.D. Ill. 2016).

In Lake Michigan Beach, the debtor was organized under the laws of the state of Michigan. It owed a loan to BCL-Bridge Funding, LLC secured by real property comprising a resort on Lake Michigan. When the borrower ran into financial trouble, the lender agreed to forbear, but required certain amendments to the borrower’s Operating Agreement under which the borrower added a fifth member (the “Special Member”). The amended Operating Agreement required the Special Member’s consent for the borrower to file bankruptcy. This Special Member had no right to distributions and was not required to make capital contributions. Essentially, the Special Member was kept separate from the borrower for all purposes other than to vote on filing bankruptcy. Further, the amended Operating Agreement provided that the Special Member, in voting on a bankruptcy filing, was not obligated to consider any interests or desires other than its own and had “no duty or obligation to give any consideration to any interest of or factors affecting the Company or the Members.”

After the borrower’s default and lender’s commencement of foreclosure proceedings, the borrower’s members—with the exception of the Special Member—voted to cause the borrower to file a chapter 11 petition. The lender filed a motion to dismiss, contending the filing was not authorized. The bankruptcy court denied the motion, finding the provisions in the amended Operating Agreement did not comply with applicable Michigan corporate governance law. The court stated that, under Michigan law, members of a limited liability company have a duty to consider the interests of the entity and only their own interests in the decisions they make for the company. Specifically, the Michigan statute relied on by the court stated: “A manager shall discharge the duties of manager in good faith, with the care an ordinarily prudent person in a like position would exercise under similar circumstances, and in a manner the manager reasonably believes to be in the best interests of the limited liability company.” As a result, the court held the Special Member provision unenforceable.

May 24, 2016

Default Interest Rates are Presumed Reasonable Under Sec. 506(b), and a Bankruptcy Court May Not Use the Fair and Equitable Language of Sec. 1129(b) to Conclude Otherwise

The Ninth Circuit BAP recently discussed on appeal the issue of whether a bankruptcy court may use the “fair and equitable” standard for confirmation in § 1129(b) to deny an oversecured creditor default interest on its claim to which it would otherwise be entitled under § 506(b). In Wells Fargo Bank, N.A. v. Beltway One Development Group, LLC (In re Beltway One Development Group, LLC), 547 B.R. 819 (9th Cir. BAP 2016), the Ninth Circuit BAP concluded that the fair and equitable standards for confirmation deal with treatment of an allowed claim post-confirmation, but that allowance of an oversecured claim is governed by § 506(b). The BAP held the bankruptcy court erred In using § 1129(b) to deny Wells Fargo default interest on its claim.

The facts in Beltway One were straightforward. The value of the bank’s collateral exceeded the amount the bank was owed. The debtor’s plan, however, provided that the bank would not be entitled to any default interest on its claim, and treated the claim by modifying its terms and providing for payment amortized over 30 years. The plan further provided that any pre-effective date defaults would be deemed to have been cured. The debtor’s argument was that the default was “cured” because it was paid with a new loan; therefore, under the Ninth Circuit’s decision in Great Western Bank & Trust v. Entz-White Lumber and Supply, Inc. (In re Entz-White Lumber and Supply, Inc.), 850 F.2d 1338 (9th Cir. 1988), the default had been cured and the bank was not entitled to default interest during the pendency of the case. Wells Fargo opposed confirmation, asserting the plan did not meet the “fair and equitable” test under § 1129(b)(1). The bankruptcy court agreed with the debtor, concluding the new loan under the plan “paid” the debt within the meaning of Entz-White, and confirmed the plan.

The BAP reversed. The BAP noted a major factual difference between the Beltway One plan and the Entz-White plan in that the debtor in Entz-White­ actually cured the defaults on its secured creditor’s debt by paying the debt in full on the effective date of the plan, whereas Beltway One merely restructured the terms of its secured debt with Wells Fargo. Consequently, the BAP concluded Entz-White was not applicable to the present case. The BAP stated that determining post-petition interest on an oversecured claim under § 506(b) “is an issue separate and distinct from the fair and equitable test for plan confirmation under § 1129(b). The BAP held that determination of interest on an oversecured debt is a claim issue, not a confirmation issue.

This holding did not end the inquiry, however. The BAP also concluded that entitlement to default interest during the pendency of the case “is not automatic but may be allowed upon demonstrating that it meets certain requirements.” The BAP stated that the determination is accompanied with a presumption that the contract’s default interest rate is reasonable unless the debtor introduces evidence that it is not. The BAP based its conclusion on the Ninth Circuit’s decision in Gen. Elec. Capital Corp. v. Future Media Prods., Inc. (In re Future Media), 536 F. 3d 969 (9th Cir.), amended 547 F.3d 956 (9th Cir. 2008), which held that, if Entz-White does not apply, then the bankruptcy court must evaluate the viability of the contractual default interest rate by using applicable “substantive law creating the debtor’s obligation, subject to any qualifying or contrary provisions of the Bankruptcy Code.” In other words, the bankruptcy court should apply a presumption of allowability for the contract default interest rate, provided the rate is not unenforceable under applicable non-bankruptcy law. The creditor enjoys a presumption that the contracted for rate is reasonable, and the debtor bears the burden of demonstrating it is not, or that the rate is not enforceable under applicable non-bankruptcy law.

March 15, 2016

Secured Creditors Beware: Ninth Circuit Holds a Chapter 13 Debtor may Avoid Liens Even if not Entitled to a Discharge

Congress enacted § 1328(f) of the Bankruptcy Code when its passed BAPCPA. This section prohibits the granting of a chapter 13 discharge if the debtor received a chapter 7 discharge within four years prior to the commencement of his chapter 13 case. The Ninth Circuit in In the Matter of Blendheim, 803 F.3d 477 (9th Cir. 2015) held a chapter 20 debtor may in his chapter 13 case avoid a lien under § 506(d) even if § 1328(f) precludes him from receiving a discharge.

The creditor in Blendheim was HSBC Bank, which held a deed of trust lien on the debtors’ home. The debtors filed a chapter 7 case and received a discharge. Soon thereafter, they filed a chapter 13 case, mainly to restructure debts relating to their primary residence. HSBC timely filed a secured proof of claim based on its deed of trust against the debtors’ residence. The debtors objected to the claim, substantively objecting on the grounds that the note which formed the basis for the claim bore a forged signature. For some unknown reason, HSBC never responded to the debtors’ objection, and the bankruptcy court entered an order disallowing HSBC’s secured claim. In fact, after receiving notice that its secured claim had been disallowed, HSBC withdrew its proof of claim and requested the court to no longer send it electronic notifications in the case.

Thereafter, the debtors filed an adversary proceeding against HSBC seeking to void HSBC’s lien under § 506(d) which provides “to the extent that a lien secures a claim against the debtor that is not an allowed secured claim, such lien is void.” The debtors contended they were entitled to avoid the lien because the plain language of the statute says a lien securing a debt which is not an allowed secured claim is void. HSBC defended, asserting the debtors were not entitled to avoid the bank’s lien because the debtors were precluded from receiving a discharge by § 1328(f), which provides that a debtor may not receive chapter 13 discharge if he has received a chapter 7 discharge within four years prior to the commencement of his chapter 13 case.

The Ninth Circuit agreed the debtors could avoid HSBC’s liens even though they could not receive a chapter 13 discharge. First, the court concluded the plain language of § 506(d) entitled the debtors to avoid HSBC’s lien. Because this section provides that a lien is void if it secured a debt which is not an allowed secured claim, the court concluded that Congress’ intent was manifest, and held the purpose of § 506(d) was to nullify a creditor’s legal rights in a debtor’s property if the creditor’s claim is disallowed. The court stated its belief that the Supreme Court’s decision in Dewsnup v. Timm, 502 U.S. 410 (1992) confirmed its interpretation. In Dewsnup, the debtors argued that the creditor’s claim was not an allowed secured claim because it was undersecured, and therefore they could avoid it under § 506(d). The Supreme Court rejected this argument, holding “§ 506(d) did not void the lien on his property because the creditor’s claim has been fully ‘allowed.’”

HSBC argued that such a conclusion would be inconsistent with decisions from the Eighth,[1] Fourth[2] and Seventh[3] Circuits, all of which held that avoiding liens for claims which were disallowed because they were untimely filed violated the long-standing principle that valid liens pass through bankruptcy unaffected. Viewing these decisions as holding that filing an untimely claim is akin to not filing a claim at all, the court determined the reasoning of these cases to be inapplicable since HSBC’s claim was disallowed on the merits. The court also noted that the Eleventh[4] and Fourth[5] Circuits have held that a chapter 13 debtor who cannot receive a discharge because of § 1328(f) may still void liens under § 506(d).

Finally, the court rejected HSBC’s argument that allowing avoidance of its lien in these circumstances would effectively grant the debtors on a de facto basis, the discharge to which they were not entitled. The court stated this argument ignored the difference between in personam and in rem liability. By enacting § 1328(f), Congress affected only the debtor’s in personam liability: “We take Congress at its word when it said in § 1328(f) that Chapter 20 debtors are ineligible for a discharge, and only a discharge.” The court further noted there is no language in the Bankruptcy Code which prevents Chapter 20 debtors from receiving the other benefits chapter 13 has to offer, and had Congress intended to prevent these debtors from avoiding liens, it would have included specific language when it enacted BAPCPA.


[1] In re Shelton, 735 F.3d 747 (8th Cir. 2013)

[2] In re Hamlett, 322 F.3d 342 (4th Cir. 2003)

[3] In re Tarnow, 749 F.2d 464 (7th Cir. 1984)

[4] In re Scantling, 754 F.3d 1323 (11th Cir. 2014)

[5] In re Davis, 716 F.3d 331 (4th Cir. 2013)