Category Archives: Bankruptcy

March 1, 2016

Tenth Circuit Holds Default Judgments for Violations of Securities Laws Must be Given Preclusive Effect in Non-dischargeability Actions Under Section 523(a)(19)

The Tenth Circuit has in the past refused to give preclusive effect in bankruptcy non-dischargeability actions brought under § 523(a)(2) to pre-petition default judgments arising from claims of actual fraud. In re Jordana, 216 F.3d 1087 (10th Cir. 2000). However, the Tenth Circuit recently held that this refusal does not extend to pre-petition default judgments based on violations of securities laws where the claim for non-dischargeability is brought under § 523(a)(19), and that such judgments must be given preclusive effect for purposes of denying the dischargeability of the debt. Tripoldi v. Welch et al, 810 F.3d 761 (10th Cir. 2016).

Robert Tripoldi brought an action in the U.S. District Court for the District of Utah against Nathan Welch and others alleging violations of state and federal securities laws. Welch answered the complaint, but during the course of the litigation, his attorneys withdrew and Welch never retained new counsel. Eventually, the trial court issued a default judgment against Welch. Welch subsequently filed a chapter 7 bankruptcy petition, and then filed motions with the district court to set aside the default judgment and grant judgment on the pleadings in Welch’s favor. Tripoldi filed a motion with the district court to declare the pre-petition default judgment non-dischargeable under § 523(a)(19). The district court denied Welch’s motions and granted Tripoldi’s.

On appeal, after determining the district court did not abuse its discretion in entering the default judgment or in denying the motion to vacate it, the Tenth Circuit then turned to the issue of whether the default judgment could be the basis for a denial of discharge under § 523(a)(19). Welch argued that a default judgment should not be the basis for the denial of a discharge, relying on the Tenth Circuit’s prior opinion in Jordana. The Tenth Circuit disagreed, and noted what it considered to be significant differences between § 523(a)(2) and § 523(a)(19). The court stated that it declined to extend its reasoning in Jordana to default judgments based on violations of securities laws because § 523(a)(2) and § 523(a)(19) “have different requirements and different purposes.” The court placed great importance on the fact that § 523(a)(19) contains the specific requirement that the debt be memorialized in a “judgment, order, decree or settlement agreement” stemming from a violation of securities laws, whereas § 523(a)(2) contains no such requirement. The court also that Congress, in enacting § 523(a)(19) to include the requirement of a judgment, intended to close what it perceived to be a “loophole in the law.” The noted its decision was consistent with those of two other courts to rule on the issue: In re Pujdak, 462 B.R. 560 (Bankr. D. S.C. 2011) and Meyer v. Rigdon, 36 F.3d 1375 (7th Cir. 1994) (interpreting § 523(a)(11) which contained a similar requirement).

February 25, 2016

“Structured Dismissals” within the Tenth Circuit

  1. Introduction

The United States Bankruptcy Court for the District of Utah has published the first opinion within the Tenth Circuit analyzing and authorizing the “structured dismissal” of a chapter 11 case. See In re Naartjie Custom Kinds, Inc., 534 B.R. 416 (Bankr. D. Utah 2015) (Thurman, J.)  In Naartjie, Judge Thurman addressed two issues: first, whether the bankruptcy court has statutory authority to grant a “structured dismissal,” and second, whether the debtor met its burden of establishing cause for the court to grant such a relief.  Answering both of these questions in the affirmative, the court joined a growing number of jurisdictions, including the Third Circuit, where structured dismissals are now a viable alternative to traditional exit strategies from chapter 11 cases.  This article introduces the debate about the propriety of structured dismissals by comparing Naartjie to the Third Circuit’s decision in Jevic Holding Corp., 787 F.3d 173 (3rd Cir. 2015) decision – an opinion from the highest court to have weighed in on the debate.  It concludes with  ten “practice pointers” to consider when seeking or opposing an order authorizing a structured dismissal in the Tenth Circuit.

  1. Structured Dismissals Generally

Generally, “structured dismissals are simply dismissals that are preceded by other orders of the bankruptcy court (e.g., orders approving settlements, granting releases, and so forth) that remain in effect after dismissal.” Jevic Holding, 787 F.3d at 181.   “Unlike old-fashioned one sentence dismissals order – ‘this case is hereby dismissed’ – structured dismissal orders often include some or all of the following additional provisions: ‘releases’ (some more limited than others), protocols for reconciling an paying claims, ‘gifting’ of funds to unsecured creditors and provisions providing for the bankruptcy court’s continued retention of jurisdiction over certain post-dismissal matters.’” In re Strategic Labor, Inc., 467 B.R. 11, 18 (Bankr. D. Mass. 2012) (quoting Norman L. Pernick & G. David Dean, Structured Chapter 11 Dismissals: a Viable and Growing Alternative After Asset Sales, 29 Am. Bankr.Inst. J. 1, 56 (June 2010)).  The most contentious features of some structured dismissals are provisions that authorize distribution of funds outside the priority scheme prescribed by § 507 of the Bankruptcy Code. 

III.       Structured Dismissals in Practice: Jevic and Naarjie

The recent decisions of the Third Circuit in Jevic and the Utah Bankruptcy Court in Naartjie illustrate the nature of and issues surrounding structured dismissals.

  1. Jevic and Structured Dismissals that Deviate from Section 507’s Priority Scheme

As of December of 2015, the Third Circuit was the highest court to have opined on the propriety of “structured dismissals” under the Code. In Jevic, the Third Circuit upheld the bankruptcy court’s order authorizing a dismissal of a Chapter 11 case pursuant to a settlement agreement that, among other things, included broad exculpatory clauses and authorized the distribution of estate assets outside the priority scheme of § 507 of the Code.

Jevic was a typical case with an atypical outcome.  In 2006, CIT Group financed Sun Capital Partners’ leveraged buyout of Jevic Transportation, Inc. See Jevic, 787 F.3d at 175.  Jevic was a trucking company in decline, and as part of the acquisition, CIT advanced an $85 million revolving credit facility to Jevic secured by substantially all of Jevic’s assets. Id. The acquisition did not alter Jevic’s fate, and by May of 2008, the company had been forced to enter into a forbearance agreement with CIT, which also required a $2 million guarantee from Sun. See id. On May 19, 2008, Jevic ceased business operations and notified employees that they would be terminated.   See id. at 175-176.  The next day, the company filed a petition for protection under Chapter 11 of the Code in Delaware. See id. at 176.  As of the petition date, Jevic owed $53 million to CIT and Sun.   See id. It owed also over  $20 million in tax and general unsecured claims. See id.

The court appointed a committee of unsecured creditors, which filed an adversary proceeding asserting fraudulent and preferential transfer claims against CIT and Sun. See Jevic, 787 F.3d at 176.  In essence, the committee alleged that “Sun, with CIT’s assistance, acquired Jevic with virtually none of its own money based on baseless projections of almost immediate growth and increasing profitability.” Id. Meanwhile, a group of truck drivers filed a class action against Jevic and Sun, alleging that the defendants had violated the Worker Adjustment and Retraining Notification (“WARN”) Act by failing to give the workers 60 days’ written notice of their layoffs. See id.

By March of 2012, the estate’s sole remaining assets consisted of $1.7 million in cash and the committee’s action against CIT and Sun. See Jevic, 787 F.3d at 176.  The $1.7 million were subject to Sun’s lien, and although the committee had partially succeeded in defeating a motion to dismiss the fraudulent and preferential transfer claims, it had concluded that the estate lacked sufficient funds to finance prosecution of its action.  Accordingly, the committee, Sun, Jevic, CIT and Sun reached a settlement agreement whereby: (1) all parties would exchange releases, (2) the committee’s fraudulent and preferential transfer action would be dismissed with prejudice, (3) CIT would deposit $2 million into an account earmarked to pay the estate’s administrative expenses, including the fees of the committee’s and the debtor’s professionals, (4) Sun would assign its lien in the remaining $1.7 million to a trust for the payment of tax and administrative creditors first, and the remainder to unsecured creditors on a pro rata basis, and (5) the chapter 11 case would be dismissed. See id. at 177.  Although the truck drivers participated in the settlement discussions, the parties could not agree on a settlement of the WARN Act claims, which the drivers valued at $12.4 million, inclusive of 8.3 million entitled to priority under § 507(a)(4) of the Code. See id. Consequently, the drivers were not included in the settlement presumably because Sun, who remained a defendant in their WARN Act lawsuit, did not want to fund litigation against itself. See id. The effect of the drivers’ exclusion from the settlement would be that the drivers would receive nothing from the estate, even on the $8.3 million wage claim, but all other general unsecured would receive about four percent of their claims. See id. at 177, 177 n.1.

The truck drivers and the United States Trustee objected to the proposed settlement, arguing, in part, that the proposed distribution violated the priority scheme prescribed by § 507 of the Code. See Jevic, 787 F.3d at 178.[1]   The drivers argued that the Code does not authorize “structured dismissals,” but rather only three ways for the debtor to exit chapter 11: (1) confirmation of a plan, (2) conversion to chapter 7, or (3) “plain dismissal with no strings attached.” See id. at 180.  The Third Circuit addressed these objections in reverse.

First, the Third Circuit affirmed the district court and bankruptcy court’s conclusion that while structured dismissals are not expressly authorized by the Code, they are not prohibited by the Code either. See Jevic, 787 F.3d at 181.  Specifically, the Third Circuit held that “though § 349 of the Code contemplates that dismissal will typically reinstate the pre-petition state of affairs by revesting property in the debtor and vacating orders and judgments of the bankruptcy court, it also explicitly authorizes the bankruptcy court to alter the effect of dismissal ‘for cause’ – in other words, the Code does not strictly require dismissal of a Chapter 11 case to be a hard reset.” Id.

Second, the Third Circuit rejected the argument that “even if structured dismissals are allowed, they cannot be approved if they distribute estate assets in derogation of the priority scheme of § 507 of the Code.” See Jevic, 787 F.3d at 182.  In essence, the drivers argued that § 103(a) required settlements in Chapter 11 cases to comply with § 507’s priority scheme. See id.[2] Although the Third Circuit acknowledged “some tacit support in the caselaw for the [d]river’s position,” it concluded that “neither Congress nor the Supreme Court has ever said that the [absolute priority rule] applies to settlements in bankruptcy.” Id. at 182-83.  The Third Circuit noted that the Fifth and Second Circuits “had grappled with whether the priority scheme of § 507 must be followed when settlement proceeds are distributed in Chapter 11 cases.” Id. (citing Matter of AWECO, Inc., 725 F.2d 293, 295-96 (4th Cir. 1984) (declining to approve a settlement agreement because unsecured creditor would be paid ahead of senior claims); In re Iridium Operating LLC, 478 F.3d 452, 463-64 (2nd Cir. 2007) (rejecting the AWECO ruling as too rigid because and finding that the absolute priority rule is not necessarily implicated in settlements outside of plans of reorganization)).  The Third Circuit agreed with the Second Circuit’s approach, and held that “bankruptcy courts may approve settlements that deviate from the priority scheme of § 507 of the Bankruptcy Code only if they have specific and credible grounds to justify the deviation.”   Id. at 184 (citation and quotation omitted). 

Having concluded that the bankruptcy court had authority to grant structured dismissals, and that the “structure” could include distributions outside the priority scheme of § 507, the Second Circuit found that although it was a “close call,” the bankruptcy court had “sufficient reasons” to approve the settlement in Jevic and overrule the Trustee’s and the truck drivers’ objections. See Jevic, 787 F.3d at 184-85.  The court emphasized that there was “no evidence calling into question the Bankruptcy Court’s conclusion that there was ‘no realistic prospect’ of a meaningful distribution to Jevic’s unsecured creditors apart from the settlement under review.”   Id. at 185.  Instead, it was apparent that if the court did not approve the proposed settlement, the unsecured creditors would not receive anything at all because the estate lacked sufficient funds to prosecute the fraudulent claims against Sun and CIT, both of which claimed they would not enter into the same settlement with a trustee were the case converted to chapter 7.  Thus, the court concluded, the movants had shown cause for approval of a structured dismissal that deviated from § 507, “[a]lthough this result is likely to be justified only rarely.”   Id. at 186.[3]

  1. Naartjie – a Simple Structure

Naartjie was a much narrower decision than Jevic. See Naartjie, 534 B.R. 416. 

Naartjie was a children clothing retailer that filed Chapter 11 intending to reorganized using pre-arranged financing. See id. at 418.  The financing fell through shortly after the petition date, and the debtor shifted to an orderly liquidation. Id. Over the next six months, the court approved multiple orders authorizing the debtor to sell significantly all of its assets pursuant to § 363 of the Code. See id. Following the proof of claim deadline, four principal creditor constituencies emerged: (1) a group of secured noteholders claimed a senior lien against virtually all of the debtor’s assets in the amount of $8.8 million; (2) a trade creditor of the debtor – Target Ease – asserted a $7 million claim, of which $2.1 was entitled to administrative priority and $2.6 million consisted of a reclamation claim;(3) a shipping company asserted a claim secured by a maritime line in the amount of $339,923.47; and (4) general unsecured creditors. See 418-19.

The parties sought and obtained approval of a settlement agreement to distribute the estates’ assets as follows: (1) payment of all allowed administrative claims subject to a negotiated budget, and priority claims up to $382,000; (2) payment of $140,000 to the shipping company in satisfaction of its claim; (3) all remaining funds to be distributed among the secured creditors (45%), the trade creditor Target Ease (30.5%), and the unsecured creditors excluding Target Ease (24.5%). All parties agreed to mutual releases and to seek dismissal of the case or confirmation of a plan. See id. at 419. No one objected to the settlement proposal, and the court approved it pursuant to Rule 9019 and the factors set out in In re Kopexa Realty Venture Co., 213 B.R. 1020 (BAP 10th Cir. 1997).

After liquidating all assets, and consummating much of the settlement agreement, the debtor moved for approval of a structured dismissal under §§ 305(a) and 349 of the Code, whereby (1) all of the court’s orders would remain in full force; (2) the court would retain jurisdiction over the approval of professional fees and any disputes arising from the interpretation and implementation of an order approving the dismissal; (3) the court’s dismissal order would incorporate the exculpation clauses and releases negotiated through the settlement agreement; and (4) the debtor and committee of unsecured creditors would distribute all funds pursuant to the terms of the settlement agreement. See Naartjie, 534 B.R. at 420. 

No party with an economic interest in the estate objected, and the senior secured creditors, the committee and Target Ease supported the motion for approval of the structured dismissal. See Naartjie, 534 B.R. at 521.  The U.S. Trustee objected, however, arguing that the Code does not authorize the approval of “structured dismissals” because “there are only three ways to exit a Chapter 11 case: (1) by  confirmation of a plan pursuant to § 1129; (2) by dismissal of the case pursuant to § 1112(b); or (3) by conversion of the case pursuant to §1112(b).” See id.  

The court granted the debtor’s motion, holding that §305(a) authorized dismissals of any case if the interest of creditors and the debtor would be better served by such dismissal or suspension. Naartjie, 534 B.R. at 422.  The court then turned to the determinative question: “may the Court alter the effect of dismissal?”  Id.  Quoting § 349(b), the court held that “[t]his subsection describes the effect of dismissal, but it qualifies the effect by providing that the Court may, for cause, order otherwise.  It follows that, if cause is shown, a bankruptcy court may alter the effect of dismissal.  The statute is clear and unambiguous on this point.” Id. at 422-23.  Furthermore, analyzing § 349’s legislative history, the court concluded that “[t]he effect of dismissal is to put the parties, as much as practicable, back in the positions they occupied pre-bankruptcy.” Id. at 423.  “But, if cause is shown, such as when a structured dismissal will better serve the interests of the creditors and the debtor, the bankruptcy court may order otherwise and alter the effect of dismissal.” Id.

Having concluded that it had statutory authority to authorize a structured dismissal, the court found that the debtor had shown cause for dismissal under § 305(a) because (1) “it [was] clear that the proposed structured dismissal [was] the most efficient and economic[cal] way to administer” the case; (2) the parties’ rights were protected and preserved since the court’s orders would remain in full force and effect; (3) the parties would have access to a forum where they could enforce those orders (i.e, the bankruptcy court); and (4) the settlement agreement was an out-of-court workout that equitably distributed the assets of the estate. See Naartjie, 534 B.R. at 426 (applying factors adopted in In re Zapas, 530 B.R. 560, 572 (Bankr.E.D.N.Y. 2015), In re AMC Investors, LLC, 406 B.R. 478, 488 (Bankr.D.Del. 2009), In re RCM Global Long Term Capital Appreciation Fund, Ltd., 2000 B.R. 514, 525 (Bankr.S.D.N.Y. 1996), In re Picacho Hills Util. Co., No. 11-13-10742 TL, 2013 WL 1788298, at *9 (Bankr.D.N.M. Apr. 26, 2013)). 

The court found that the debtor had also met the standard for altering the effect of dismissal under § 349. Naartjie, 534 B.R. at 426.  In addition to the bases discussed above, it found that despite receiving notice of both the settlement motion and the motion for approval of a structured dismissal, “no economic stakeholder [] objected.”  Moreover, there was little for the debtor to do in the case, other than distributing the assets.  The court concluded that the motion was “not an attempt to work around the protections of § 1129; it is simply the rare case where cause is shown to alter the effect of dismissal.” Id. Thus, the court concluded, the movants had shown cause for alternating the effect of dismissal under § 349.

  1. Ten Factors to Consider When Proposing or Opposing a Structured Dismissal

As Judge Thurman noted in Naartjie, that case was part of a “growing trend of structured dismissals.” Naartjie, 534 B.R. at 421.  Given their perceived or actual benefits, including speed and lower cost, structured dismissals are likely to become more common over the next few months or, at least, are highly likely to be litigated more frequently.  In seeking approval of or opposing structured dismissals, practitioners should consider the following:

  1. Statutory Relief: Consider whether dismissal should be or is sought under §§ 305(a) or 1112(b). As Judge Thurman noted in Naartjie, “[s]ection 305(a)(1) is a narrower provision for dismissing a Chapter 11 case than § 1112(b).” Naartjie, 534 B.R. at 422. Under § 305(a), a court may dismiss a case if “the interests of creditors and the debtor would be better served by” the dismissal. 11 U.S.C. § 305(a)(1). By contrast, under § 1112(b), the court may appoint a trustee, convert or dismiss a chapter 11 case, “whichever is in the best interest of creditors and the estate.” 11 U.S.C. § 1112(b). Courts are less likely to grant relief under § 305(a) than 1112(b) particularly because the court’s decision under § 305(a) is not subject to appellate review pursuant to § 305(c) of the Code. Nevertheless, movants may be tempted to seek relief under § 305(a) over § 1112(b) to limit the range of potential relief – i.e., to avoid the possibility that the court may appoint a trustee or convert the case rather than dismiss it. Section 305(a) is particularly attractive where all parties with an economic interest in the outcome of the case have reached a settlement.
  2. Focus on “Cause” Under § 349: At this point, the debate on whether the court has statutory authority to grant a structured dismissal is largely academic. Even the courts that have denied motions for approval of structured dismissals have recognized that they have the statutory authority to alter the effect of dismissal under § 349(b) of the Code. Although “cause” for altering the effect of § 349 is a developing concept, the Naartjie opinion provides some guidance on factors that may be considered when determining whether the movant has met this burden. See Naartjie, 534 B.R. at 426 (considering the notice provided to the parties, objections filed, and whether movant was attempting “work around the protections of the Bankruptcy Code”).
  3. Anticipate the U.S. Trustee’s Objection: In virtually every reported opinion, the U.S. Trustee has objected to motions seeking approval of structured dismissals. The reasons for the U.S. Trustee’s distaste for structured dismissals are articulated in an article by the Associate General Counsel for Chapter 11 Practice at the Executive Office for the U.S. Trustee titled Structured Dismissals, or Cases Dismissed Outside of the Code’s Structure, 30 Am. Bankr. Inst. J. 20 (March 2011). Practitioners proposing or opposing structured dismissals can anticipate the U.S. Trustee’s position and address, to the extent possible, the concerns raised in this article.
  4. Timing: Movants should seek relief under § 349(b) as soon as it becomes significantly likely that confirmation of a plan is not a viable option, but after resolution of as many preliminary matters as possible. Correspondingly, opponents should highlight loose ends that may affect negatively the rights of creditors or other stakeholders. For example, the court may reject a structured dismissal motion where claim disputes are outstanding.
  5. Consider sub rosa Jurisprudence: Strictly speaking, a proposal constitutes a sub rosa plan where it dictates the terms of a reorganization plan. See Jevic, 787 F.3d at 188 (Scirica, J., dissenting); see also, In re Shubh Hotels Pittsburgh, LLC, 439 B.R. 637, 644-45 (Bankr. W.D. Penn. 2010) (“a transaction would amount to a sub rosa plan or reorganization if it: (1) specifies the terms of any future reorganization plan; (2) restructures creditors’ rights; and (3) requires that all parties release claims against the Debtor, its offices and directors, and its secured creditors”). Structured dismissals, by definition, do not implicate the confirmation of a plan, and thus are distinguishable from sub rosa plans. Structured dismissals, however, implicate the same policy concerns as sub rosa plans. Accordingly, practitioners should consult case law analyzing sub rosa plans and may rely on it by analogy particularly when opposing structured dismissals motions.
  6. 9019 Settlements and Asset Sales: Most successful structured dismissals follow approval of a settlement under Rule 9019, the sale of substantially all assets of the debtor under § 363, or both. The practical reason for this sequence is that by the time the court has to determine whether there is cause for altering the effect of § 349, all other major disputes in the case have been resolved. This is particularly true in cases like Naartjie, where all constituents with an economic interest in the case reach a settlement (or, at least, are represented during settlement discussions). Thus, in seeking structured dismissals, movants increase the likelihood of succeeding if they first obtain relief, were applicable, under § 363 and seek consensus from stakeholders in the form of a settlement under Rule 9019.
  7. But if no Consensus, Invoke Jevic: Failure to obtain consensus from all stakeholders with an economic interest in the case, however, is not a dispositive post Jevic. The effect of that opinion appears to be that so long as objecting creditors like the truck drivers in Jevic can vindicate their rights elsewhere or against another party, the court may approve a structured dismissal that violates the absolute priority rule. In other words, movants should seek consensus, but if they must, then they should abandon only creditors who can fend for themselves.
  8. Remain Vigilant: Opponents of structured dismissal motions should object to any Rule 9019 or §363 motion that sets up the dismissal motion. For example, in Naartjie, the Rule 9019 Motion that predated the structured dismissal motion contemplated a filing of the latter. In dismissing the case, the court noted that no party had objected to the earlier motion. See Naartjie, 534 B.R. at 426.
  9. Prove Efficiency: One of the primary justifications for granting a structured dismissal motion is the movant’s ubiquitous proffer that the structured dismissal will save the estate significant resources over an expensive plan confirmation process. Typically, however, the estate is not fully administered as of the date the court enters an order approving a structured dismissal. Thus, part of the “structure” will likely include process for wrapping up the case. Practitioners should be careful not to surprise the court with professional fees or administrative expenses incurred post-approval of a structured dismissal that disprove its professed efficiency.

10.       Equitable Mootness: The Jevic dissent points out that the doctrine of equitable mootness was not applicable to a court’s order approving a structured dismissal because that doctrine applies only where a plan of reorganization is confirmed. See Jevic, 787 F.3d at 186 (Scirica, J., dissenting) (citing In re Semcrude, L.P., 728 F.3d 314 (3d. Cir. 2013). It is unclear, however, whether Judge Scirica’s rationale holds true in the Tenth Circuit, specially when the structured dismissal is approved pursuant to a rule 9019 motion, or where the court dismisses the case under § 305(a). See e.g., Rindlebach v. Jones, 532 B.R. 850, 856-58 (Bankr. D. Utah 2015) (appeal from order approving settlement equitably moot).  Opponents of structured dismissal motions should therefore consider whether and when to ask a court to stay an order pending post-ruling motions.


[1] The drivers also claimed that the committee of unsecured creditors violated its fiduciary duties to the estate because the settlement it negotiated excluded the drivers. See Jevic, 787 F.3d at 178.

[2]               Section 103(a) provides, “[e]xcept as provided in section 1161 of this title, chapters 1, 3, and 5 of this title apply in a case under chapter 7, 11, 12, or 13 of this title, and this chapter, sections 307, 362(0), 554 through 557, and 559 through 562 apply in an case under chapter 15.” 11 U.S.C. § 103(a).

[3] Judge Scirica dissented, arguing that it was not clear that the only alternative to the settlement was a chapter 7 liquidation. See Jevic, 787 F.3d at 186. He emphasized that the settlement at bar was not substantially distinguishable from sub rosa plans, and emphasized that this was not a “gifting” case because the assets to be distributed were assets of the estate since the settlement resolved the estate’s fraudulent transfer claims. See id. at 187-88.

February 16, 2016

Seventh Circuit Finds Suspicion, Negligence and Ineptitude Sufficient to Defeat a Claim that a Transferee Received a Fraudulent Transfer in Good Faith, but Insufficient to Equitably Subordinate the Transferee’s Claim

Section 548(c) of the Bankruptcy Code entitles the recipient of a fraudulent transfer in certain circumstances to retain a lien on the property received through the debtor’s fraud if the transferee took the property in good faith and for value. The Seventh Circuit recently, In addressing a case where the bankruptcy trustee asserted the recipient of a fraudulent lien did not take in good faith and its claim should be equitably subordinated to unsecured claims, held suspicion, negligence and ineptitude on the part of the claimant to be sufficient to defeat the recipient’s claim that it acted in good faith but insufficient to equitably subordinate the claim. Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 809 F.3d 958 (7th Cir. 2016).

In Sentinel, the debtor was a cash management firm which borrowed money from BNYM to funds its operations. Sentinel received money from its customers, which it used to purchase securities for its customers and which it was required by law to maintain in segregated accounts separate from the accts which Sentinel used for its own trading. Sentinel had a capitalization of less than $3 million, but also had securities it had purchased for its customers’ accounts which exceeded $300 million. When securities markets became shaky in the summer of 2007, Sentinel found itself unable to meet both its collateral levels with the bank and its customers’ requests to redeem their securities. Sentinel embarked on a scheme under which it borrowed on its line of credit with the bank to meet its customers’ redemption demands, and transferred its customers’ securities from their segregated accounts into Sentinel’s personal accounts on which the bank held a lien. By transferring customer securities to accounts on which the bank held a lien, Sentinel violated federal law. When Sentinel filed bankruptcy, a dispute arose between the bank and the trustee over whether the bank received its lien in good faith or whether the trustee could avoid the lien under § 548. The district court ruled in favor of the bank, finding the bank’s actual belief that Sentinel had not pledged the securities in question without its customers’ consent, was sufficient to establish it acted in good faith. The Seventh Circuit reversed.

The Seventh Circuit stated the district court’s conclusion was wrong. The court held that inquiry notice, which it defined as “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing,” prevents the recipient of a fraudulent transfer from the protections afforded a good faith transferee. The court further stated “inquiry notice is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further—would make him in other words suspicious enough to conduct a diligent search for possible dirt.” As a result, an actual belief that the transfer is not fraudulent is insufficient if the recipient has knowledge of facts which place him on notice that further investigation is warranted. In this instance, the fact that the debtor’s capital was less than $3 million yet it had the ability to post $300 million of collateral to secure its debt to the bank, were sufficient to place the bank on notice that the debtor was using someone else’s property to collateralize the loan. A memo from a bank employee who worked on the Sentinel account to the bank evidencing “puzzlement” at the source of the collateral and a suspicion that the collateral was owned by parties other than the debtor, was sufficient to require additional investigation on the bank’s part. As a result, the court held the bank did not qualify as a good faith transferee with respect to its lien on securities owned by the debtor’s customers.

The next question before the court was whether the bank’s conduct was sufficient to warrant equitable subordination of its unsecured claim to claims of general unsecured creditors. The trustee argued that the same conduct which prevented the bank from being considered a good faith transferee was sufficient to warrant equitable subordination of its claim. The court disagreed, stating that, while mere negligence or ineptitude may be sufficient to place a transferee on inquiry notice for purposes of a good faith defense, they are insufficient to warrant equitable subordination under § 510(c)(1). In order to warrant equitable subordination, the court held the transferee’s conduct must not only be inequitable but “seriously so,” using the words “egregious,” “tantamount to fraud” and “willful” as the type of conduct required. The bank should have suspected something was amiss, and that was sufficient to eliminate its good faith defense, but because the trustee did not establish the bank knew Sentinel had pledged its customers’ securities without their consent, the court found there was insufficient evidence to equitably subordinate the bank’s unsecured claim.

January 12, 2016

Ninth Circuit BAP Holds That a Wholly Unsecured Junior Lien, Discharged in Chapter 7, is not Included in Calculating Chapter 13 Eligibility Under Sec. 109(e)

Section 109(e) of the Bankruptcy Code limits eligibility for chapter 13 relief to those individual debtors whose noncontingent, liquidated unsecured debts do not exceed statutory limits. In calculating eligibility to file chapter 13, should a court consider debts which have been discharged in a prior chapter 7 case and which are “out of the money” because, while secured by a trust deed against the debtor’s residence, the value of the debtor’s residence is insufficient to cover the debt relating to the first trust deed? The Ninth Circuit Bankruptcy Appellate Panel answered this question in the negative, holding in Free v. Malaier (In re Free), 2015 WL 9252592 (9th Cir. BAP 2015) that such debts are not to be included in determining eligibility for chapter 13 relief.

In Free the debtors owned a home which they valued in their chapter 7 schedules at $425,000. The home secured three debts totaling over $900,000, with the first lien holder owed more than the value of the home. The debtors received a chapter 7 discharge and shortly thereafter commenced a chapter 13 case in which they sought to strip off the two subordinate liens. The chapter 13 trustee filed a motion to dismiss the case, arguing that these two wholly unsecured subordinate liens should be included in determining eligibility, and doing so rendered the debtors ineligible for chapter 13 relief. While noting that there was no Ninth Circuit controlling case directly on point, the bankruptcy court relied on several opinions in the Ninth Circuit in chapter 12 cases to conclude the subordinate liens should be included in the calculation and finding the debtors were not eligible for chapter 13 relief.

The BAP reversed, concluding that the discharged debts reflected by the wholly unsecured subordinate liens, should not be considered in determining chapter 13 eligibility. The court began its analysis with the definitions of “debt” and “claim” in section 101 of the Code. Because “claim” is defined as a right to payment and “debt” is defined as liability on a claim, the court held “there is no ‘unsecured debt’ unless the creditor has a ‘right to payment’ on an unsecured basis.” The court next concluded that the result of the debtors’ chapter 7 discharge resulted in their having no personal liability to pay the debts relating to the subordinate liens.

Because the bankruptcy court based its ruling in part on the U.S. Supreme Court’s decision in Johnson v. Home State Bank, 501 U.S. 78 (1991), the BAP addressed its perceived distinctions between the facts in Johnson and the facts in the present case.   In Johnson, the debtor obtained a chapter 7 discharge of a judgment in a foreclosure action and then filed a chapter 13 case with the intent to pay the in rem judgment through his chapter 13 plan. In addressing the question of whether an in rem claim for which personal liability has been discharged can properly be included in a chapter 13 plan, the Supreme Court held that such a claim can be treated in a chapter 13 plan because the claim was enforceable against the debtor’s property even though it was not enforceable against the debtor himself.

The BAP also distinguished the decision of the Ninth Circuit in Quintana v. Commissioner, 915 F.2d 513 (9th Cir. 1990) and the Ninth Circuit BAP in Davis v. Bank of America (In re Davis), 2012 WL 3205431 (9th Cir. BAP 2012), both of which involved chapter 12 proceedings. In Quintana, a judgment creditor agreed to waive any deficiency judgment following the sale of the debtor’s real property securing the judgment. Because the real property had not yet been sold, making a determination of the relative amounts of the secured and unsecured debts uncertain, the Ninth Circuit held it appropriate to include the full amount of the judgment debt in determining the debtor’s eligibility for chapter 12 relief. The BAP also noted the differences between § 109(e), which segregates secured and unsecured debts in determining eligibility, and § 101(18), which determines who is a family farmer by looking to the individual’s aggregate debts. The BAP distinguished its prior decision in Davis on similar grounds.

The BAP then distinguished the Ninth Circuit’s decision in Scovis v. Henrichsen (In re Scovis), 249 F.3d 975 (9th Cir. 2001) and the Ninth Circuit BAP’s decision in Smith v. Rojas (In re Smith), 435 B.R. 637 (9th Cir. BAP 2010) both of which held that the unsecured portion of partially secured debts are to be included in determining chapter 13 eligibility on the grounds that both Scovis and Smith dealt with cases where the chapter 13 proceeding was not preceded by a chapter 7 discharge of the debtor’s personal liability on the debt in question.

Finally, the BAP addressed the U.S. Supreme Courts’ decisions in Dewsnup v. Timm, 502 U.S. 410 (1992) and Bank of America v. Caulkett, 135 S. Ct. 1995 (2015) in connection with lien stripping efforts by chapter 13 debtors. The Court in Dewsnup held that a chapter 7 debtor cannot strip down a partially unsecured lien under § 506(d) to the value of the collateral. Subsequently in Caulkett the Court extended its holding in Dewsnup to situations involving wholly unsecured junior liens. The BAP noted that, following Dewsnup and Caulkett, litigants have argued that debtors who first file a chapter 7 case and obtain a personal discharge and then file a chapter 13 case seeking to strip the remaining in rem claim are acting in bad faith. The BAP refused to reach this issue as it had not been brought forward in the appeal but did state that this argument must be raised by filing a motion to dismiss the chapter 13 case as a bad faith filing and not in the context of whether the debtor is eligible under § 109(e) to file a chapter 13 case.

December 29, 2015

Tenth Circuit Refuses to Allow Guarantors to Shirk Their Guaranty Liability by Relying on Primary Obligor’s Confirmed Plan

May a chapter 11 debtor who is a guarantor require a creditor to look solely to the provisions of the primary obligor’s confirmed plan for repayment? The Tenth Circuit recently held that, in many cases, guarantors will not be able to restrict creditors’ rights in this fashion.

In FB Acquisition Property I, LLC v. Larry Gentry et al, 2015 WL 8117969 (10th Cir. 2015), Larry and Susan Gentry personally guaranteed a loan made by FirstTier Bank to their company, Ball Four, Inc. Their guaranty provided they would pay “all of the principal amount” of the “Indebtedness” of Ball Four to the bank, whether that amount was barred or unenforceable against Ball Four for any reason. In addition, their guaranty contained a waiver of any defenses arising because of the “cessation of Borrower’s liability from any cause whatsoever.” Third, the Genrtrys agreed not to assert “any deductions to the amount guaranteed under this Guaranty” through setoff, counterclaim, counter demand or other method.

Ball Four defaulted on the loan and filed a chapter 11 proceeding. Ball Four filed an adversary proceeding against FirstTier Bank, asserting various breaches of the loan agreement entitling Ball F our to setoffs and reductions of amounts it owed the bank. Ball Four obtained confirmation of a plan that provided payment of the bank’s claim at interest, amortized over twenty-five years with a five year call. During the course of Ball Four’s bankruptcy proceedings, the Colorado Division of Banking closed FirstTier Bank and the FDIC was appointed receiver. Eventually the Ball Four loan was transferred to FB Acquisition.

After Ball Four filed bankruptcy, FirstTier sued the Gentrys on their guaranties. The Gentrys filed a personal chapter 11 petition. The creditor filed a proof of claim in the Gentry bankruptcy case based on the guaranties of the loan, with the amount of the claim exceeding the amount of the proof of claim filed in the Ball Four bankruptcy case by the amount of default interest accruing on the debt between the two petition dates. The Gentrys took the position that their liability under their guaranties was co-extensive with Ball Four’s liability on the debt, and that they would enjoy any reduction of the debt through the adversary proceeding in the Ball Four bankruptcy case. The Gentrys proposed a plan which provided the debt owed on the FirstTier loan would be paid by Ball Four pursuant to its confirmed plan, with the Gentrys not paying any amounts to the creditor unless and until Ball Four defaulted on its plan obligations on the debt.

FB Acquisition appealed the confirmation of the Gentry plan, arguing the bankruptcy court erred in two regards: (1) basing its analysis of the feasibility of the Gentry plan on the feasibility of the Ball Four plan and (2) confirming the Gentry plan which treated the Gentrys’ liability under their personal guaranties as co-extensive with the liability of Ball Four under its confirmed plan.

The Tenth Circuit affirmed the feasibility findings. The court rejected FB Acquisition’s argument that the bankruptcy court relied solely on the Ball Four plan’s feasibility in determining the feasibility of the Gentry plan. The Tenth Circuit held that the bankruptcy court properly determined feasibility of the Gentry plan because the Gentrys had sufficient financial wherewithal to pay the debt if Ball Four defaulted under its plan and because the Gentrys would not receive a discharge in their case until the debt was paid in full.

However, the Tenth Circuit held that the bankruptcy court erred in confirming the Gentrys’ plan, which provided their guarantor liability on the debt was co-extensive with Ball Four’s liability. First, while Colorado law provides that a guarantor’s liability is co-extensive with that of the primary obligor, the Tenth Circuit held that “this rule of equivalent liability is inapplicable in the bankruptcy context. The court noted the majority rule that the Bankruptcy Code’s discharge provisions do not affect a guarantor’s liability. The court pointed to the specific language of § 524(e), which states the “discharge of a debt of the debtor does not affect the liability of any other entity on, or the property of any other entity for, such debt.” The Tenth Circuit stated that “Holding otherwise would impair a guaranty. Guaranties act as a safeguard, assuring performance of a guarantor even if the borrower defaults,” and further stated “Extending this rule of equivalent liability into the bankruptcy context would destroy the value of a guaranty.”

Second, the Tenth Circuit held that the specific terms of the guaranties themselves precluded the Gentrys from asserting their liability was co-extensive with Ball Four’s. The guaranties provided contained the Gentrys’ promise to pay “all of the principle amount outstanding” whether “barred or unenforceable against Borrower for any reason whatsoever.” The guaranties also contained waivers of defenses arising from the cessation of Ball Four’s liability from any cause whatsoever.” In addition, the Gentrys in their guaranties agreed not to assert any deductions to the amount guaranteed by way of setoff or counterclaim. The Gentrys contended that, since the guaranties provided they guaranteed the “Indebtedness” of Ball Four, they were entitled to any reductions in that indebtedness which might arise from a judgment in the adversary proceeding brought by Ball Four in its case. The Tenth Circuit disagreed, concluding that while a bankruptcy court may grant a discharge, “a discharge does not extinguish the underlying debt, rather it changes a debtor’s liability for that debt.” Therefore, although the confirmation of the Ball Four plan modified Ball Four’s liability for its debt, it did not modify the indebtedness itself. Because the indebtedness remained unchanged, the Gentrys’ liability also remained unchanged.

December 26, 2015

Eleventh Circuit Holds That An Assignee for the Benefit of Creditors has no Authority to File a Bankruptcy Petition for the Assignor

In analyzing the parameters surrounding a state law assignment for benefit of creditors, as well as the extent and limits of the powers of the assignee, the Eleventh Circuit in Ullrich v. Welt (In re NICA Holdings, Inc.), 2015 WL 9241140 (11th Cir. 2015) held that an assignee for the benefit of creditors lacks the authority to file a bankruptcy petition on behalf of the assignee.

In NICA Holdings, the debtor owned stock in a company a company commonly called “Nicanor” which owned and operated a fish farm in Nicaragua. Peter Ullrich and a company called Biotec Holdings owned the remaining shares in Nicanor. When NICA Holdings experienced financial difficulties, it executed an Assignment for the Benefit of Creditors, pursuant to the applicable Florida statute. Under the Florida ABC statute, an assignment for the benefit of creditors serves as an alternative to bankruptcy, with the statute providing for the irrevocable assignment by the assignor of its assets to the assignee, with the assignee charged with disposing of the assets in accordance with state law. In this instance NICA Holdings assigned its assets to Kenneth Welt. When his efforts to sell NICA Holdings’ stock in Nicanor came to naught, Nicanor ceased business operations, and Ullrich instituted litigation against him, Welt filed a bankruptcy petition on behalf of NICA Holdings. Welt believed he had authority to cause NICA Holdings to file bankruptcy under the terms of the Assignment which NICA Holdings had signed in his favor. Ullrich disagreed and filed a motion to dismiss the bankruptcy case on the argument that Welt, as an assignee of NICA Holdings, lacked authority to file a bankruptcy petition on its behalf. The bankruptcy court denied Ullrich’s motion to dismiss, but the Eleventh Circuit agreed with Ullrich and reversed and remanded the case to the bankruptcy court with instructions to dismiss it.

The Eleventh Circuit began its analysis of the authority issue by notice that Florida’s Assignment for Benefit of Creditors (“ABC”) statute is designed to provide a simpler and cheaper process to the more complex procedures provided by the Bankruptcy Code. The ABC process may, in certain instances, be preferable because it is more flexible, faster, more private and less supervised than bankruptcy proceedings. In addition, the Eleventh Circuit noted that Florida courts had described the ABC statute as “an alternative to bankruptcy [that] allows a debtor to voluntarily assign its assets to a third party in order to liquidate the assets.” Hillsborough Cty. V. Lanier, 898 So. 2d 141, 143 (Fla. 2d DCA 2005). The Eleventh Circuit held that ABCs and bankruptcy proceedings are alternative proceedings—a debtor chooses to pursue one to the exclusion of the other. The ABC statute lacked any provision empowering an assignee to file a bankruptcy petition on behalf of the assignor, and the Eleventh Circuit refused to read any such power into the statute. Furthermore, the Assignment Agreement itself under which NICA Holdings assigned its assets to Welt did not contain any language specifically authorizing Welt to file a bankruptcy petition on NICA Holdings’ behalf. The court noted that the language of the agreement, while granting Welt broad powers, authorized him to exercise those powers only in furtherance of the ABC.

Could an assignee for the benefit of creditors file a bankruptcy on behalf of the assignor if the assignor grants specific authority to the assignee to do so? The Eleventh Circuit did not reach this question. I did note, however, that the Florida ABC statute requires all ABC agreements to “substantially” adopt the language in the proposed forms accompanying the statute, an indication that, in Florida at least, an assignee for the benefit of creditors could not be granted authority to file a bankruptcy petition on behalf of the assignor.

December 15, 2015

Tenth Circuit Hits Debtor’s Counsel With a Double Whammy—Denying Fees Incurred Prior to Formal Appointment and After Confirmation of Plan

In its decision in Lazzo v. Bank (In re Schupach Investments, L.L.C.), 2015 WL 6685416 (10th Cir. 2015), the Tenth Circuit sent a clear message to attorneys representing debtors-in-possession: make sure you have authority to represent the debtor if you want to be compensated from the estate.

In this case, Mark Lazzo, debtor’s counsel, failed to file an application seeking appointment as counsel for the debtor-in-possession until about one month after the case was filed. Lazzo stated that his application “got lost in the shuffle” of other first day motions which he had filed. In addition, Lazzo did not specifically request post facto approval of his appointment when he did get around to filing the application. He claimed his failure to timely file the application was the result of excusable neglect.

Several of the debtor’s secured creditors filed a plan of liquidation which provided for the transfer of the debtor’s secured property to the secured creditors, the cancellation of members’ interests, the dissolution of the debtor, and the transfer of the debtor’s unencumbered assets to a liquidating trust. The plan also required the debtor to cooperate post-confirmation in effecting various administrative tasks required by the plan. The debtor consented to the creditors’ plan, and the bankruptcy court confirmed it. Although the plan empowered the liquidating trustee to retain counsel, and the liquidating trustee did not retain Lazzo, Lazzo continued to perform services for the debtor after confirmation. Lazzo filed fee applications seeking payment of his fees, including fees incurred before the bankruptcy court approved his appointment as and after confirmation of the creditors’ plan of liquidation. The bankruptcy court allowed these fees, but the Bankruptcy Appellate Panel reversed. The Tenth Circuit affirmed the decision of the BAP, agreeing that Lazzo was not entitled to fees for services performed before his appointment was approved or after the plan was confirmed.

In connection with the issue of entitlement to fees for services performed before Lazzo’s retention as debtor’s counsel was approved by the bankruptcy court, the Tenth Circuit revisited its prior decision in Land v. First Nat’l Bank of Alamosa (In re Land), 943 F.2d 1265 (10th Cir. 1991). In Land the court assumed that a bankruptcy court may approve an attorney’s employment post facto, thereby entitling him to seek fees for work performed prior to approval. In Land, the court held that retroactive approval of an attorney’s employment “is only appropriate in the most extraordinary circumstances” and that “[s]imple neglect will not justify pro tunc approval.” Land 943 F.2d at 1267-68. Lazzo argued that this language in Land was dicta and that the appropriate standard for post facto approval of employment applications should be excusable neglect. The Tenth Circuit noted the minority view, as set out in the Seventh Circuit’s opinion in Matter of Singson, 41 F.3d 316, 319 (7th Cir. 1994), that excusable neglect is the proper standard. The Tenth Circuit panel, however, reaffirmed its language in Land, stating that it was not dicta and further represented the prevailing approach among the circuits. The court went on to state that the reasons provided by Lazzo for failing to timely seek appointment as debtor’s counsel did not rise to the “extraordinary circumstances” required to support post facto approval.

In connection with the issues of entitlement to fees for services performed post-confirmation, the court looked to both the provisions of the Bankruptcy Code and the provisions of the confirmed plan. As the court noted, because termination of a debtor’s status as a debtor-in-possession also terminates debtor’s counsel’s authorization under § 327 to provide service as an attorney for the debtor-in-possession, Lamie v. U.S. Tr., 540 U.S. 526, 532 (2004), the Tenth Circuit framed the question as “whether the Debtor retained its status as debtor-in-possession after confirmation of the Creditors’ Plan.” The court held that § 1101(1) of the Bankruptcy Code eliminates the debtor-in-possession’s ability to perform the functions and duties of a trustee where a qualified trustee has been appointed and is serving those functions. The court stated that § 1101(1) “serves the salutary purpose of avoiding the logistical difficulties inherent in having two different and possibly conflicting trustees serving simultaneously.” Although the plan trustee in the case was not qualified under § 322 of the code, the court found that § 1101(1) does not entitle permanent debtor-in-possession status in those instances where a trustee is appointed pursuant to a plan. In addition, the court noted well-settled case law holding that debtor-in-possession status terminates on confirmation of a plan. In the present case, the plan provided that all of the debtor’s unencumbered assets vested on confirmation in the liquidating trust, and vested the trustee of the liquidating trust with all rights and powers of a trustee under the Bankruptcy Code. Further, the plan dissolved the debtor as of the confirmation date. The court believed the plan’s provisions obligating the debtor to cooperate with the plan trustee in connection with various ministerial and administrative aspects of the plan “fell far short of encompassing the responsibilities of a debtor-in-possession.” Because the debtor lost its debtor-in-possession status when the plan was confirmed, Lazzo had no authority to seek compensation from the post-confirmation trust for services he performed post-petition.

December 1, 2015

Non-Compete Agreements and Fraudulent Transfer Law–How Doing Nothing can be Reasonably Equivalent Value in the Tenth Circuit

How can a recipient of a transfer of money do nothing in return, and by such inaction provide reasonably equivalent value in exchange for the transfer? The Tenth Circuit in its decision in Weinman v. Walker (In re Adam Aircraft Industries, Inc.), 2015 WL 5973397 (10th Cir. 2015) held that a former employee’s compliance with a severance agreement containing a non-compete provision, provided reasonably equivalent value in exchange for the payments made to him under the agreement.

Joseph Walker served as president and a member of the board of directors of the debtor. Throughout his tenure, he never had an employment agreement, a non-compete agreement or a severance agreement, with the company. About one year before the company filed bankruptcy, its board concluded that it needed to replace Walker as president of the company and to remove him from the board. This conclusion was not known to Walker until after the board had hired his replacement. At the time, the company was in the final stages in its negotiations for a substantial debt financing with Morgan Stanley. In communicating the board’s decision to Walker, the Chairman and CEO told Walker that it was important to the company’s financing negotiations that Walker’s separation be treated as a resignation rather than a firing. Shortly after this discussion, Walker went to his office, retrieved his personal belongings and left the company’s premises never to return. The minutes of the board meeting for Feb. 7, 2007 reflected Walker had resigned effective Feb. 2, 2007. His replacement commenced his duties as president of the debtor on Feb. 2, 2007.

Over the next several days, Walker and the company negotiated a separation agreement that contained several essential elements: (1) the company retained Walker as a consultant for 18 months at a salary of $250,000 per year, contingent on his helping the debtor to maintain its sales backlog at a certain level, (2) Walker would not compete with the company during this time frame, (3) the company would refund Walker’s deposit he had placed for the purchase of an aircraft, and (4) the company would repurchase stock Walker owned in the company for the same price he paid for it several months earlier. The separation agreement, along with a subsequent modification of it, both stated that Walker’s employment with the company terminated March 1, 2007, about one month after Walker’s resignation.

The company’s bankruptcy trustee sued Walker seeking to recover, among other things, the severance payments made to him under the agreement as fraudulent under §548. The questions addressed by the Tenth Circuit included (1) whether Walker was a statutory insider for purposes of § 548, (2) whether Walker was a non-statutory insider, and (3) whether Walker gave reasonably equivalent value in exchange for the severance payments he received.

With regard to its determination whether Walker was a statutory insider, the court first looked to the definition of the term “insider” in the Bankruptcy Code. That definition states that an “insider” is an officer, director or a person in control of the debtor.   In this instance, although the two separation agreements stated that Walker’s employment terminated on March 1, the Tenth Circuit held that the bankruptcy court’s finding that his employment actually ended on February 1 was not clearly erroneous. Walker had submitted his resignation, emptied his office, had performed no duties, and his replacement took office, all on February 1 and 2. Finding these facts supported a conclusion that Walker had made a “clean break” with the company in early February, the Tenth Circuit affirmed the finding that Walker was not a statutory insider on the dates he received his severance payments. With regard to the question of whether Walker qualified as a non-statutory insider, the Tenth Circuit considered the only evidence produced by the trustee—that Walker had presented the initial terms for his separation—to be an insufficient basis for a finding of insider status.

In addressing the trustee’s arguments that Walker did not provide reasonably equivalent value in exchange for his severance payments, the Tenth Circuit noted the bankruptcy court’s findings of fact on the dispute. The bankruptcy court found that (1) Walker agreed to refrain from taking a position with a competing company, (2) Walker could have easily found a position with the competitor because of his high reputation in the industry, (3) Walker agreed to be supportive of the debtor in its efforts to obtain its financing package from Morgan Stanley, and (4) waived his potential claims for wrongful termination. In short, the company was willing to pay Walker money in exchange for his noncompetition, goodwill and waiver of claims. The members of the board were sophisticated business people, and the majority of them were outside directors who were more intent on making a profit than in reaching an agreement with Walker merely to placate him. The evidence established that several members of the board were concerned that firing Walker could imperil the company’s negotiations for financing, and reaching an agreement with Walker that paid him several hundred thousand dollars while at the same time preserving the company’s ability to receive $80,000,000 in financing, was a good deal for the company.

In reaching its conclusion, the Tenth Circuit refused to accept the trustee’s argument that non-compete agreements have no value as a matter of law. The court distinguished the holdings of two cases on which the trustee relied—In re Joy Recovery Tech. Corp., 286 B.R. 54 (Bankr. N.D. Ill. 2002) and In re Vadnais Lumber Supply, Inc.), 100 B.R. 127 (Bankr. D. Mass. 1989)—because the individuals involved in both cases already owed a fiduciary duty to their employers not to compete, a duty which Walker did not owe until after he entered into the separation agreements following his resignation as president.

November 10, 2015

The Tenth Circuit Joins the Sixth, Seventh and Ninth Circuits in Holding that a First-Time Transaction May Qualify for the Ordinary Course Defense under 11 U.S.C. sec. 547(c)

In issuing its decision in Jubber v. SMC Electrical Products, Inc. (In re C.W. Mining Company), 2015 WL 4717709 (10th Cir. 2015), the Tenth Circuit joined the Sixth, Seventh and Ninth Circuits in holding that a first-time transaction between the debtor and a creditor may qualify for the ordinary course defense of § 547(c). [1]  In C.W. Mining the debtor purchased equipment from SMC with the intent of changing its mining operation from continuous mining to longwall mining.  The debtor and SMC had never conducted business with each other before.  The debtor paid SMC $200,000 on for the equipment within ninety days before filing bankruptcy.  The bankruptcy trustee asserted the payment was a preference, but SMC contended the payment was made in the ordinary course.  While noting that it construes preference defenses narrowly, the court reiterated that the ordinary course defense is “intended to leave undisturbed normal financial relations,” and a payment will be within the defense if it is in the ordinary course of both the debtor and the transferee.  The court noted that several bankruptcy courts have held that first-time transactions cannot qualify for the defense, interpreting the statute as requiring the transaction to be in the ordinary course of business between the debtor and the transferee.  The Tenth Circuit declined to follow these decisions and instead agreed with its sister circuits to decide the issue that a first-time transaction can qualify for the defense.

In reaching its conclusion, the Tenth Circuit looked to the language of the statute itself, and noted that it stated the defense refers to ordinary course of business or financial affairs of the debtor and the transferee, not to the business or financial affairs between the debtor and the transferee.  The Tenth Circuit agreed with the Seventh Circuit’s analysis in Kleven  that “the court can imagine little (short of the certain knowledge that its debt will not be paid) that would discourage a potential creditor from extending credit to a new customer in questionable financial circumstances more than the knowledge that it would not even be able to raise the ordinary course of business defense, if it is subsequently sued to recover an alleged preference.”  Kleven, 334 F.3d at 643). 

The court stated that it had previously defined “ordinary business terms” to mean “those used in ‘normal financing relations’: the kinds of terms that creditors and debtors use in ordinary circumstances, when debtors are healthy.”  In re Meredith Hoffman Partners, 12 F. 3d. at 1553.  As a result, the court said that determination of what is ordinary contemplate an examination of what is ordinary in the relevant industry, not what is ordinary in each party’s respective practices.  Agreeing with the Ninth Circuit in Ahaza, the Tenth Circuit concluded that a “first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties.”  In re Ahaza Sys., Inc., 482 F.3d at 1126. 

The Tenth Circuit’s decision reached a balance between the justification for allowing an ordinary course defense for a first-time transaction and the general policy of the preference statute to discourage unusual action by either the debtor or its creditors during the debtor’s slide into bankruptcy.

[1] The sister circuit opinions are:  (1) Gosch v. Burns (In re Finn), 909 F.2d 903 (6th Cir. 1990); (2) Kleven v. Household Bank F.S.B., 334 F.3d 638 (7th Cir. 2003) and (3) Wood v. Stratos Prod. Dev., LLC (In re Ahaza Sys. Inc.), 482 F.3d 1118 (9th Cir. 2007).

October 27, 2015

Creditors May Collect Debts From Funds Distributed to a Debtor From His/Her Exempt Retirement Account Under Tenth Circuit Ruling that Distributed Funds are not Exempt

In a case of first impression, the Tenth Circuit has held that a resident of Colorado may not assert an exemption under Colo. Rev. Stat. § 13-54-102(1)(s) for funds distributed from an exempt pension or retirement plan.  In re Gordon, 791 F.3d 1182 (10th Cir. 2015).  In Gordon the debtors received a lump sum distribution of $16,700 from an exempt 401(k) plan prior to filing bankruptcy.  They deposited the funds into a savings account, where the funds remained segregated from all other funds the debtors had received from other sources.  The debtors used these funds to pay their living expenses prior to filing bankruptcy, and on the petition date had $2,051 remaining.  They asserted an exemption in these remaining funds.  The trustee objected to the claim of exemption, contending the exemption does not apply to funds after their distribution from the exempt retirement account.  The bankruptcy denied the exemption, and the Tenth Circuit agreed with the bankruptcy court’s holding.

The court concluded the language of the statute was clear in allowing an exemption only for funds that are within the exempt retirement account, noting the statute provides an exemption for “property, including funds, held in or payable from any pension or retirement plan or deferred compensation plan.”  Colo. Rev. Stat. § 13-54-102(1)(s).  Noting that Colorado courts have not addressed the question whether the exemption applies to funds which have been distributed, the Tenth Circuit stated that it “must ascertain and give effect to the intent of the legislature, and that task begins with the language of the statute itself.”  The court concluded that the statutory exemption applies only to funds that are actually in the exempt plan.  Although the court agreed with the debtors that Colorado liberally interprets statutes granting exemptions, the court stated that “even a liberal construction must find support in the statutory text,” and determined that such support was lacking in the statute at hand.  The fact that the Colorado legislature had provided an exemption in other statutes for distributed funds but did not do so in the pension and retirement account statute also supported its reasoning.  For example, the court noted that Colorado law provides for an exemption for proceeds of life insurance policies, Colo. Rev. Stat. § 13-54-102(1)(l)(I)(B), as well as for all money received as a pension arising out of service as a member of the armed forces of the U.S., Colo. Rev. Stat. § 13-54-102(h). 

The court concluded that creditors are prohibited by the statute from going after the plan itself, but once the funds in the plan are distributed to the debtor, the creditor is free to execute.