Category Archives: Uncategorized

December 15, 2015

Court Finds That, Under the Equities of a Particular Case, Pre-Substantive Consolidation Transfers May Be Like “Gap Period” Transfers That Cannot Be Avoided

The Bankruptcy Code contains a safe harbor for transactions that a debtor enters into after an involuntary petition is filed against it, but before an order for relief on the petition is entered.  See 11 U.S.C. §§ 549(b) and 303(f).  This safe harbor protects post-petition transactions, which are otherwise subject to avoidance, from being unwound by the trustee in bankruptcy.  The policy for this safe harbor is that before an order for relief enters, the debtor must be able to operate its business; the mere filing of an involuntary petition shouldn’t be allowed to cripple the debtor’s affairs.

A bankruptcy court recently held that, under the equities of the particular case, the same policy may have broader application and prevent the trustee from avoiding other transfers.  Specifically, where a non-debtor sells personal property in an arms-length transaction for value, and the non-debtor is later retroactively placed into bankruptcy through substantive consolidation, the sale may not be an avoidable post-petition transfer. 

In In re Clark, Case No. 12-00649-TLM, 2015 WL 8603098 (Bankr. D. Idaho Dec. 11, 2015), Clark managed a ranch called Crystal Springs Ranch, LLC (the Ranch).  Clark filed a chapter 12 case under his own name with the Ranch listed as a d/b/a.  The Ranch was not put into bankruptcy.  While Clark’s bankruptcy case was pending, Kerslake bought a tractor from the Ranch in good faith, for value, without knowledge of Clark’s bankruptcy case.  Eventually a chapter 7 trustee was appointed for Clark’s bankruptcy case, and the trustee successfully moved to have the Ranch substantively consolidated with Clark’s bankruptcy estate.  Notably, though the trustee apparently anticipated that he would bring certain avoidance actions if the substantive consolidation was successful, he did not provide notice of the substantive consolidation action to the anticipated targets of those actions, including Kerslake. 

The court granted substantive consolidation “nunc pro tunc,” in other words, it was deemed to be effective as of Clark’s petition date.  Thus, Kerslake’s purchase of the tractor was technically a post-petition transfer because it occurred after the deemed effective date of the substantive consolidation.  The trustee moved to avoid the transfer as an unauthorized post-petition transfer under Bankruptcy Code § 549.

The court granted summary judgment to Kerslake and held that the trustee could not avoid the purchase of the tractor.  Though the transaction didn’t fit neatly within the language of the “gap period” safe harbor in § 549(b), similar policies applied.  Specifically, there was no dispute that Kerslake purchased the tractor in good faith from the Ranch at a time when the Ranch was not in bankruptcy.  Only later, when the trustee obtained retroactive bankruptcy relief relating to the Ranch, without notice to Kerslake, did the purchase become a “post”-petition transaction avoidable under § 549(b).  Moreover, the substantive consolidation ruling itself was a form of equitable relief to the trustee, and the trustee could not use equitable relief to work an unequitable result on Kerslake.  As a result, under its Bankruptcy Code § 105 equitable powers, the court held that Kerslake’s purchase of the tractor was not an avoidable post-petition transfer.

June 9, 2015

Seventh Circuit Holds that a Debt Created by Fraud may be Discharged if the Fraud was Perpetrated by the Debtor’s Agent, so long as the Debtor was not Complicit in the Fraud

In the case of Sullivan v. Glenn (In re Glenn), No 14-3213 (7th Cir. 2015), the Seventh Circuit Court of Appeals held that a debt which was incurred as a result of fraud perpetrated by the debtor’s agent is dischargeable, so long as the debtor was not complicit in the agent’s fraudulent conduct.  The facts involved a loan made by Brian Sullivan to the Glenns through the actions of a loan broker by the name of Karen Chung.  Chung and Sullivan knew each other.  In fact, Sullivan, an attorney, had represented Chung on more than one occasion.  In this transaction, however, Chung acted as the agent of the Glenns in seeking a bridge loan of $250,000 pending the closing of a bank loan for $1,000,000.  Chung convinced Sullivan to loan the Glenns $250,000 on a short-term basis at a high interest rate, representing to Sullivan that a bank had agreed to give the Glenns a loan of $1,000,000.  Chung represented to the Glenns that she had negotiated the bank loan and that it had been approved.  Based on Chung’s representations, Sullivan made the loan to the Glenns, and the Glenns signed promissory notes to Sullivan.  As it turned out, there was no bank loan at all.  After the Glenns filed bankruptcy, Sullivan filed an adversary proceeding seeking denial of the discharge of his loan based on fraud.

Sullivan raised two arguments to justify denial of the debtors’ discharge, both of which were rejected by the Seventh Circuit.  First, Sullivan argued that a debtor’s complete innocence in connection with the fraud should not be a defense to nondischargeability.  The court rejected this “debt not the debtor” theory for denying a discharge, even though it agreed the theory was consistent with the language of § 523, stating this argument “just illustrates the limitations of literal interpretation of statutory language.”  The court illustrated this limitation by taking Sullivan’s argument to its logical conclusion:  if Chung, who was jointly liable with the Glenns on the loan, had assigned the debt to an innocent third party who agreed to assume it, and that third party later filed bankruptcy, Sullivan under his theory could obtain a judgment denying the discharge of the debt in that innocent third party’s bankruptcy case.  The court concluded the intent of § 523 did not go that far, and rejected the “debt not the debtor” argument advanced by Sullivan.

The court then addressed Sullivan’s agency argument, contending that Chung’s fraud should be charged to the Glenns.  Sullivan contended that an agent’s fraudulent conduct must always be binding on his principal, even if the principal had not knowledge of the fraud.  The court rejected this argument, and agreed with the Eighth Circuit’s opinion in In re Walker, 726 F.2d 452, 454 (8th Cir. 1984) that denial of a discharge of a debt based on an agent’s fraudulent conduct requires “proof which demonstrates or justifies an inference that the debtor knew or should have known of the fraud.”  On the facts before it, the Seventh Circuit determined that, as between the Glenns and Sullivan, the Glenns were the more innocent party, and Sullivan was in the better position to protect himself.  As a result, the court affirmed the judgment in favor of the Glenns.

May 9, 2014

Montana Supreme Court Rules That Mortgage Company May be Liable in Tort on Homeowner Claims Arising from Modification Applications Under HAMP

On May 7, 2014, the Montana Supreme Court rendered its decision in Morrow v. Bank of America, ushering in what could be a new era of tort liability for lenders and servicers. 

The Morrows had retired to Montana in 2006 and built a home financed by Countrywide.  They lost their source of income in the downturn in 2009, and – while still current on their loan – reached out to their lender to discuss a modification of their loan.  First, the Morrows’ claim they were told by Bank of America to skip a loan payment so that they would be eligible for a modification.  Then, they were informed by a representative of Bank of America that “they were ‘locked’ for a modification with trial payments of $1,239.99” per month which the Morrows started paying in December 2009.  A few months later Bank of America sent the Morrows a notice of acceleration.  Another employee of Bank of America advised them that their account was “under review”.  They continued to make payments through February of 2011.  The Morrows were invited to apply for the Federal Home Affordable Modification Program or HAMP but the notices of acceleration continued.  On January 11, 2011, the Morrows were advised that modification of their loan under HAMP had been denied.  Their final payment was rejected by Bank of America, and a sale of the property was scheduled.

The Morrows then sued Bank of America in state district court, asserting claims of breach of contract, negligence, negligent misrepresentation, and fraud, among others.  The district court eventually granted the Bank’s motion for summary judgment on all counts.  The Morrows appealed to the Montana Supreme Court.  The Supreme Court has now held that the district court erred in granting summary judgment to the Bank on several of the claims.

  • The Court found that a bank that goes “beyond the ordinary role of lender of money and actively advises customers in the conduct of their affairs” may owe a fiduciary duty to a borrower.  Going “beyond the ordinary role of lender” might include activities like advising a borrower to stop making payments, or to make lower payments and ignore foreclosure notices. 
  • The Supreme Court held the Bank could be negligent for the way it handled the Morrows’ request for a modification of their loan.  The Court stated that Bank of America had no duty to avoid foreclosure or to actually grant the modification of the loan.  Instead, the Bank “owed a duty to manage the modification process in a manner that would not cause the Morrows to suffer loss or injury by reason of its negligence.”  A jury trial on this issue will be required.
  • The Court also held that summary judgment on the Morrows’ claim of negligent misrepresentation was granted in error.  The Morrows allege that Bank of America made several false statements regarding the servicing of their existing loan and the status of the application for modification.  The Court noted that “the allegations by the Morrows raise questions of fact regarding whether Bank of America ‘exercise[d] reasonable care or competence’ in obtaining or communicating the information” regarding their request for modification.  A jury trial on that issue will be required.
  • A jury trial will also be required on the Morrows’ claims of fraud, constructive fraud, and violation of the Montana Consumer Protection Act (a statute that provides for treble damages).
  • Bank of America pointed out to the Court that the Morrows have not been damaged – the mortgage has not yet been foreclosed.  The Court refused to visit that question leaving it, instead, to the trial court and, presumably, the jury.

The case includes a fairly detailed recitation of lender liability case law.  Many of the cases date to the 1980s and will cause some lenders to remember the days when lender liability was alleged by every disgruntled borrower.  In Morrow v. Bank of America, the Supreme Court did little to undercut the decisions that ended the so-called “bad faith” era.  Instead, it signaled to lenders and servicers that the way they service distressed loans will be scrutinized and may be the subject of negligence and fraud claims.

The opinion can be accessed through the following link: http://tinyurl.com/kfwgho6 or from Holland & Hart upon request.

March 14, 2014

Ninth Circuit B.A.P. Holds That Principal Can Discharge Debts Caused By His Agent’s Fraud

The BAP held that “more than a principal/agent relationship is required to establish a fraud exception to discharge . . . The creditor must show that the debtor knew, or should have known, of the agent’s fraud.”

A central purpose of bankruptcy is to grant debtors a fresh start – in bankruptcy terms, a “discharge” of existing debts.  But not all debts are dischargeable.  Bankruptcy Code § 523(a)(2)(A), for example, prevents the discharge of debts resulting from “false pretenses, a false representation, or actual fraud . . . .”  What if a principal incurs a large debt based not on his own fraud, but on the fraud of his agent?  Is that debt dischargeable?  That was the question addressed recently by the Ninth Circuit Bankruptcy Appellate Panel in In re Huh, BAP No. CC-12-1633, 2014 WL 936803 (9th Cir. B.A.P. March 11, 2014). Download In re Huh 2014 WL 936803 9th Cir BAP 2014.

Benjamin Huh was a real estate broker who ran a real estate and business brokerage business as a sole proprietor.  He hired an agent, Jay Kim, who did not hold a brokerage license of his own and so relied on Huh’s brokerage license.  Kim sold a shopping market (the “Market”) to an out-of-country investor looking for a profitable investment that required minimal personal involvement.  It turned out that the Market was quite unprofitable and required substantial personal involvement.  Its gross sales were significantly lower than Kim represented, and it was subject to so many code violations that its business license was revoked. 

The investor sued Kim for fraud in state court and prevailed.  The investor then successfully moved the state court to add Huh to the judgment.  Huh thereby became jointly and severally liable on the judgment of approximately $1 million, based upon his agent’s fraud.

Huh filed for chapter 7 bankruptcy relief.  The investor filed a complaint under Bankruptcy Code § 523(a)(2)(A), asking the court to except his state court judgment from discharge.  The investor argued that under basic agency principals, a principal is liable for the torts of his agents, and therefore Kim’s liability should be imputed to Huh for purpose of discharge.  Notably, the state court findings of fact were not binding on the bankruptcy court, which made its own findings.  It found that Huh had no involvement with Kim’s sale of the Market, and was totally unaware of the Market until after the sale closed.  In short, he had not personally engaged in any culpable conduct.  Thus, the judgment debt would be dischargeable in Huh’s bankruptcy unless Kim’s fraud was imputed to Huh for purposes of § 523(a)(2)(A). 

The bankruptcy court dismissed the investor’s nondischargeability complaint, and the BAP, sitting en banc, affirmed.  The BAP held that “more than a principal/agent relationship is required to establish a fraud exception to discharge . . .  The creditor must show that the debtor knew, or should have known, of the agent’s fraud.”  In reaching this result, the BAP examined various approaches taken by circuit courts, and a recent United States Supreme Court case that granted a discharge exception under another subsection only if the creditor could establish a debtor’s “culpable state of mind.”  See  Bullock v. BankChampaign, N.A., 133 S.Ct. 526 (2013). 

Because Huh was not aware of the Market sale or of his agent’s false representations until after the sale closed, Huh’s liability on the state court judgment was dischargeable in his chapter 7 case.

September 28, 2012

Seventh Circuit Rejects Lubrizol and Holds that Trademark Licensee Retains its Rights After Rejection

In 1985, the Fourth Circuit in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985) held that, when an intellectual property license is rejected in bankruptcy, the licensee loses the ability to use any license copyrights, trademarks and patents. Three years after Lubrizol, Congress amended the Bankruptcy Code to add § 365(n), which provides that intellectual property licensees to continue to use the IP after rejection on meeting certain conditions.  However, the term “intellectual property” is defined by the Bankruptcy Code to include patents, copyrights and trade secrets.  11 U.S.C. § 101(35A).  The definition does not mention trademarks. 

Recently, the Seventh Circuit in Sunbeam Products, Inc. v. Chicago American Manufacturing, LLC, 2012 WL 2689739 (7th Cir. 2012) directly addressed the issue of whether Congress intended to exclude trademarks from the protections given other IP licensees under § 365(n).  In Sunbeam Products, the debtor, which engaged in business as a manufacturer of box fans, licensed its patents to Chicago American Manufacturing (“CAM”) so that CAM could manufacture box fans for sale to the debtor’s customers.  The debtor also licensed CAM to put the debtor’s trademark on the fans.  The license agreement also authorized CAM to sell the fax manufactured in the year 2009 for its own account if the debtor did not purchase them.

Shortly after the license was entered into, the debtor was placed in involuntary bankruptcy and the bankruptcy trustee sold the debtor’s business, including the trademarks, to Sunbeam.  Because Sunbeam did not want CAM selling fans with the debtor’s trademark on them in competition with Sunbeam, the bankruptcy trustee as part of the sale rejected the trademark license under § 365.  When CAM continued to manufacture and sell fans with the debtor’s trademark on them, Sunbeam filed an adversary proceeding seeking to prevent CAM from using the debtor’s trademark. 

The Seventh Circuit noted that some bankruptcy courts have held that, by failing to include trademarks in the definition of intellectual property in § 101(35A), Congress intended to codify
Lubrizol and exclude trademark licensees from the benefits and protection of § 365(n).  The Seventh Circuit in Sunbeam came to a different conclusion—(1) that Congress did not intend to codify Lubrizol in § 101(35A) and § 365(n), (2) that Lubrizol was wrongly decided, and (3) that trademark licensees are entitled to continue to use their licensed trademarks under the provisions of the Bankruptcy Code.

The Seventh Circuit reached its decision using the following analysis.  Section 365(g) provides that rejection of an executor contract constitutes a breach of that contract.  Outside of bankruptcy, a licensors’ breach does not terminate a licensee’s right to use intellectual property.  Consequently, had the debtor not filed bankruptcy and had breached the trademark license, CAM had the option of
treating the breach as ending its own obligations under the license or could have continued to sell the box fans it manufactured in 2009 as allowed by the license.  The Circuit Court concluded that § 365(g), by classifying rejection as a breach, establishes that in bankruptcy, as outside of it, the non-breaching party’s rights remain in place.  Rejection, however, does not “vaporize” the non-breaching party’s rights.  The court concluded that rejection is not “the functional equivalent of rescission, rendering void the contract and requiring that the parties be put back in the positions they occupied before the contract was formed.”  It “merely frees the estate from the obligation to perform” and “has absolutely no effect upon the contract’s continued existence.”

March 27, 2012

9th Circuit BAP Rules that an Undersecured Creditor’s Right to Recover from a Non-Debtor Source is Grounds for Separate Classification of its Claim Under Section 1122

Section 1122 of the Bankruptcy Code provides that “a plan may place a claim or an interest in a particular class only if such claim or interest is substantially similar to other claims or interests of such class.”  In cases where the debtor’s bankruptcy proceedings are governed by the rules applicable to single asset real estate cases, a secured creditor’s deficiency claim—which often will be by far the largest unsecured claim in the case—is generally considered to be “substantially similar” to the debtor’s other unsecured claims and must be included in the same class.  This rule is designed to avoid gerrymandering classes in order to obtain an accepting impaired class. 

In the case of In re Loop 76, LLC (Bankr. D. Az. 09-16799), the debtor prosecuted a single asset real estate case.  Its secured creditor, Wells Fargo Bank, was owed over $23,000,000, and its debt was secured by the debtor’s real property having a stipulated value of $17,050,000.  Wells Fargo’s deficiency claim of $6,000,000 greatly exceeded the debtor’s other unsecured debt, which totaled less than $200,000.  Wells Fargo, however, also held three guarantees from the debtor’s principals and had filed suit against the principals to recover on their guarantee.  The debtor’s chapter 11 plan classified Wells Fargo’s deficiency claim in a separate class from its general unsecured creditors, asserting that the fact that Wells Fargo could look to its three guarantors for payment meant that its claim was not “substantially similar” within the meaning of section 1122 of the Bankruptcy Code.  Wells Fargo objected to its separate classification.  The Bankruptcy Court held that a creditor’s right to look to a third party source, such as a guarantor, for payment of its debt, meant that its claim was not substantially similar to the debtor’s other unsecured claims, and agreed that separate classification was appropriate.

On appeal, the Ninth Circuit BAP affirmed.  In its analysis, the BAP relied heavily on the Ninth Circuit’s opinion in Steelcase, Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th Cir. 1994).  First, the BAP noted that whether claims are substantially similar for purposes of classification is a question of fact which is reviewed for clear error.  Next, the court went to state that section 1122 requires that claims be placed in the same class only if they are substantially similar, and prohibits classifying dissimilar claims in the same class.  In determining similarity, the Ninth Circuit requires a bankruptcy judge to evaluate the nature of each claim, including the kind, species, or character of each category of claims.

In Johnston, the Ninth Circuit held that a creditor whose claim was partially secured by property owned by a non-debtor third party and whose claims were subject to potential offset based on litigation between it and the debtor, held a claim that was not substantially similar to other unsecured claims.  Using the Johnston analysis, the BAP determined that a bankruptcy court may consider whether a claimant has a non-debtor source for repayment of its claim in determining whether claims are or are not substantially similar.  Based on the facts of the case, the BAP determined that the bankruptcy court’s determination that Wells Fargo’s claim was not substantially similar to the debtor’s general unsecured claims was not clearly erroneous.

August 4, 2011

Ninth Circuit BAP Requires Proof of Assignment of Note in Order for Lender to Have the Right to Foreclose on Deed of Trust

There are many cases throughout the country where borrowers, both in and out of bankruptcy, dispute the right of the mortgage holder to foreclose a deed of trust against the borrower’s home.  Allegations abound that the “lender” seeking to foreclose actually has no right to foreclose, with borrowers demanding proof that the lender seeking to foreclose actually has received an assignment of the note and deed of trust.  The Ninth Circuit Bankruptcy Appellate Panel recently issued an opinion that supports this contention, highlighting the need for a mortgage holder to present sufficient evidence of its standing to foreclose a mortgage.  In Veal v. American Home Mortgage Servicing, Inc. (In re: Veal), (BAP Nos. AZ-10-1055 and AZ-10-1056, June 10, 2011), the Ninth Circuit BAP issued its opinion on requirements for a lienholder to establish standing to receive relief from stay to foreclose a home mortgage.  After the Veals filed bankruptcy, Wells Fargo Bank filed a motion for relief from stay seeking to foreclose a deed of trust against the Veal’s home.  However, the bank failed to attach as exhibits to its motion documents establishing that it actually had received an assignment of the note and deed of trust that it sought to foreclose.  After the debtors’ filed their objection to the motion for relief, the bank supplemented its filings with copies of the promissory note in question and a copy of an assignment of the deed of trust, neither of which was authenticated under the Rules of Evidence.  As it turned out, the promissory note was identical to a note attached to a proof of claim filed by American Home Mortgage Servicing, and the assignment of the deed of trust, while purporting to assign rights under the deed of trust to Wells Fargo, contained no language assigning the promissory note to the bank. 

In analyzing the bank’s standing to obtain relief from stay to foreclose the deed of trust, the Ninth Circuit BAP reviewed the standing issue under both constitutional standing prudential standing principles.  TheBAP noted that constitutional standing requires an “injury in fact, which his caused by or fairly traceable to some conduct or some statutory prohibition, and which the requested relief will likely redress.”  The BAP found that the bank had established constitutional standing as a result of its inability, due to the automatic stay, to exercise its alleged foreclosure rights and remedies.  However, the BAP ruled that the bank had to also establish prudential standing, which “embodies judicially self-imposed limits on the exercise of federal jurisdiction.”  The one component of prudential standing which the BAP found lacking was the failure of the bank to establish that it was asserting its own legal rights, rather than rights held by others.  In this case, the promissory note in question was apparently held by American Home Mortgage Servicing, which itself had filed a proof of claim based on the note, whereas the bank established only that it held an assignment of the deed of trust without any corresponding assignment of the promissory note.

The BAP also analyzed whether the bank could be considered a party with a right to enforce the note under Article 3 of the Uniform Commercial Code, even though it was not a holder of the note.  Because there was no indication that the note had been delivered to the bank, much less delivered for the purpose of giving the bank the right to enforce the note.  This factor, plus established case law holding that a transfer of a deed of trust without an accompanying transfer of the note which it secures leaves the deed of trust ineffective and unenforceable in the hands of the transferee.  As a result, the BAP held that the bankruptcy court erred in granting the bank’s motion for relief from stay.

The result of this opinion for creditors’ counsel is clear.  We must be diligent in working with the client to ensure that the appropriate documents underlying its right to foreclose are properly executed, delivered and presented to the bankruptcy court in connection with seeking relief from the stay.

May 27, 2011

In Pari Delicto—A Dying Defense?

In pari delicto stands for the proposition that in a case of mutual fault, the position of the defending party is the better one.  The doctrine is grounded on two premises: (1) courts should not lend their services to mediating disputes among wrongdoers and (2) denying judicial relief to an admitted wrongdoer is an effective means of deterring illegality.  As a result, in pari delicto may bar a plaintiff’s recovery because of his or her own wrongful conduct.

With the increasing amount of discovered Ponzi schemes, bankruptcy trustees and state court receivers are suing more and more third parties under either the Bankruptcy Code or state law.  Because trustees and receivers stand in the shoes of the corporation, defendants often argue that the doctrine of in pari delicto should apply to bar the trustee or receiver’s claims where the corporation is equally responsible for the claim.  The defendant’s success in asserting the defense, however, depends on the type of claim and the party asserting the claim.

It is well established that under circumstances in pari delicto may bar an action by a bankruptcy trustee against third parties who participate in, or received benefits from, the debtor corporation’s Ponzi scheme.   The defense has been used to bar such actions as: (1) tort claims; (2) claims of violations of state partnership law; and (3) claims of breach of fiduciary duty.

However, no bankruptcy case has held that in pari delicto may bar claims of fraudulent or preferential transfer asserted by a bankruptcy trustee.  In fact, a number of bankruptcy courts have expressly refused to apply the doctrine to fraudulent and preferential transfer actions.  These courts reason that the applicability of the in pari delicto defense depends upon the language of the particular Bankruptcy Code section at issue and hold that while the defense may apply to actions brought by the trustee as successor to the debtor’s interests under  11 U.S.C. § 541, it does not apply to avoidance actions under 11 U.S.C. § 544. 

Moreover, the vast majority of courts hold that the in pari delicto defense does not apply to state court receivers at all.  These courts reason that while a party may itself be denied a right or defense because of its misdeeds, there is little reason to impose the same punishment on a receiver or similar innocent entity that steps into the party’s shoes pursuant to court order or operation of law.  A few cases have applied in pari delicto to bar a receiver’s claims, however, theses cases did not involved claims of fraudulent transfer.  In addition, like the bankruptcy courts, several state and federal courts have expressly held that in pari delicto may not bar a receiver’s fraudulent transfer claims.

In sum, it is clear that the in pari delicto defense may be waning and its viability is highly dependent on the type of claim asserted and the party asserting the claim.  If the claim is an avoidance action under 11 U.S.C. § 544 or a fraudulent transfer action under state law, it is doubtful a defendant would be successful in barring the claims by the in pari delicto defense.   Moreover, if a receiver asserts the claim, the defendant may have an uphill battle convincing the court to apply the doctrine to bar any of the receiver’s claims.

May 2, 2011

Subrogation Clauses may Entitle the Subrogee to Vote the Subrogor’s Claim on a Chapter 11 Plan

by Pauline Lee

The extent to which one creditor has a contractual right to vote another creditor’s claim in connection with a plan of reorganization was recently analyzed b the United States District Court for the District of Arizona in Matter of Avondale Gateway Center Entitlement, LLC v. National Bank of Arizona, 2011 WL 1376997 (D. Ariz. 2011).

In Avondale, National Bank of Arizona (”NBA”) and MMA Realty Capital, LLC (“MMA”) both extended credit to the debtor secured by deeds of trust.  The two creditors entered into a Subordination and Intercreditor Agreement which not only provided for the subordination of MMA’s claim to NBA’s claim, but also contained a subrogation clause which provided that NBA was subrogated to MMA with respect to MMA’s claims against Avondale and MMA’s “rights, liens, and security interests, if any, in any of the Borrower’s assets and the proceeds thereof . . . until the Senior Debt shall have been paid in full.” 

Avondale submitted a plan of reorganization.  MMA cast a ballot accepting the plan.  NBA cast two ballots against the plan, one for its own claim and the other for MMA’s claim.  On appeal, the court analyzed to what extent the subrogation clause entitled NBA to vote MMA’s claim.  First, the court found that the concept of a “claim” in bankruptcy is a broad one, holding that the right to vote is not itself a claim but instead is a derivative right possessed by the holder of the claim.

The court next determined that assignment and subrogation are not identical legal principles under Arizona law.  Assignment of a right is a manifestation of the assignor’s intent to transfer the right to the assignee.  Subrogation, on the other hand, is the wholesale substitution of one party in the place of another with respect to a claim.  Consequently, the court held that the subrogation clause in the intercreditor agreement resulted in NBA “stepping into the shoes” of MMA with respect to the claim and all rights relating to the claim, including the right to vote the claim.

The court then determined that subordination and subrogation are also different concepts.  The court noted that subordination clauses do not entitle the holder of the senior debt to vote the claim of the subordinated debt-holder absent specific language granting such voting rights.  However, the court noted reasoned that subordination does not result in the senior debt holder’s “stepping into the shoes” of the subordinated debt holder, and that generally subordination agreements only determine order of payment.  The court held that subrogation is a broader transfer of rights, and that it therefore applies to voting rights.