Millenium Lab Holdings – Ruling on Third Party Releases Highlights Continuing Constitutional Questions Regarding Power of Bankruptcy Courts

In Millenium Lab Holdings, Delaware District Court Judge Leonard Stark, on an appeal from a bankruptcy court order confirming a plan of reorganization, recently upheld a challenge to the bankruptcy court’s constitutional authority to release claims against non-debtor third parties under the plan.  Judge Stark’s opinion demonstrates the extent to which the constitutional questions raised by the Supreme Court six years ago in Stern v. Marshall continue to cast a shadow over the adjudication of bankruptcy cases.

In Stern, the Supreme Court raised separation of powers concerns regarding the authority of United States bankruptcy courts that had long been viewed as settled.  Congress established the U.S. bankruptcy courts pursuant to its power to establish uniform laws on bankruptcy under Article I of the Constitution, rather than under Article III.  A line of Supreme Court cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public” rights (e.g., cases involving claims of citizens against the government).  Although claims of citizens against one another typically are “private” rights that must be heard by an Article III judge, the common understanding regarding bankruptcy courts is that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constitute a type of “public” right which can be heard and decided by an Article I bankruptcy judge.

Prior to Stern, the statute passed by Congress in 1984 conferring jurisdiction on Article I bankruptcy courts was viewed as having established the appropriate constitutional limits of such courts.  Section 157 of title 28 of the United States Code provides that bankruptcy courts can issue final orders with respect to a variety of enumerated “core” matters, but that with respect to “non-core” matters, a bankruptcy court can only submit proposed findings of fact and conclusions of law, and that a final order on such matters must be entered by an Article III district court following a full, or “de novo,” review.  Although the Court never ruled on the constitutionality of the “core” and “non-core” bankruptcy jurisdictional construct, in other cases involving Article I tribunals the Court took an expansive and pragmatic view of the “public” rights doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters set forth in the statute.

In Stern, however, the Court adopted a more constricted view of “public” rights.  It held that a matter listed as “core” under the statute, a debtor’s counterclaim against a creditor, nevertheless constituted a “private” right if it was not related to the creditor’s claim against the bankruptcy estate.  The Court ruled that it was therefore unconstitutional for Congress, by designating such counterclaims as “core” matters, to authorize a non-Article III court to render a final determination on them.

Stern, by making clear that bankruptcy court rulings regarding “core” matters could be subject to constitutional challenge, has created continuing uncertainty regarding the extent to which bankruptcy courts can issue final rulings.  The problem engendered by the ruling in Stern is this: the Court described the query for constitutional purposes as “whether the action at issue stems from the bankruptcy itself [i.e., Congress’s bankruptcy power under Article I].”  If the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling. Stern’s conundrum is that although the list of matters under 28 U.S.C. Section 157, such as ruling on claims against the bankruptcy estate or on the turnover of property to the estate, go to the “core” of “restructuring debtor-creditor relations,” the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy, such as for breach of contract or regarding title to property, are based on state law.  State law issues accordingly are intertwined with most “core” matters.  For purposes of ascertaining a bankruptcy court’s constitutional authority, which aspect of such adjudications should control?

Two follow-up Supreme Court cases and numerous lower court opinions have failed to clarify the questions raised by Stern regarding the constitutional limits of bankruptcy court authority. Millenium Lab Holdings is the latest case to demonstrate the extent to which the ambiguity of Stern remains unresolved.

The facts of Millenium Lab Holdings are complicated, but the issues faced by Judge Stark on appeal were fairly straight-forward.  Among them was whether the plan of reorganization could release the debtor’s insiders from claims of third parties absent such parties’ consent.  The debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests, and were named by certain of the debtor’s lenders as defendants in an action brought outside of the bankruptcy court.  Under the plan, the equity holders were to pay $325 million in exchange for a release of all claims held either by the debtor’s estate or directly by third parties such as the lenders.

The question of whether a bankruptcy court has statutory authority and subject matter jurisdiction to enjoin and release claims non-consensually against non-debtors has long been unclear, and some courts have ruled that bankruptcy courts have no power at all to resolve disputes between non-debtor parties.  Other courts, however, relying on the general equitable power provided under section 105 of the Bankruptcy Code, and the jurisdictional authority to hear proceedings “related to” a debtor’s case, have granted such releases.  Judge Laurie Silverstein, the bankruptcy judge in Millenium Lab Holdings, determined that non-consensual third party releases could be approved if necessary in connection with the confirmation of a plan of reorganization and where basic standards of fairness were satisfied.

The lenders argued on appeal that, regardless of whether the bankruptcy court had statutory and jurisdictional power, under Stern the releases were tantamount to resolving a “private” rights dispute between two non-debtor parties, and that the bankruptcy court therefore lacked constitutional authority to enter a final order resolving it.  Judge Stark agreed that constitutional authority had to be shown.  He rejected the debtor’s response that the releases could resolved by the bankruptcy court because they were a key component of the confirmation of the debtor’s plan of reorganization, which in turn could be viewed as a “public” right.  “Appellants appear to be entitled to Article III adjudication of these claims, and Stern dictates that no final order could be entered on such claims by an Article I court barring consent of the parties (which has not been provided here).”  He concluded, however, that the issue had not been properly presented or considered by the bankruptcy court, and remanded the case to Judge Silverstein so that she could make the determination in the first instance.

Judge Stark’s opinion in Millenium Lab Holdings highlights the ongoing uncertainty created by Stern.  “Core” matters invariably implicate “private” rights of parties under state law.  The Supreme Court at some point will need to address directly how Article I bankruptcy courts can fit within the scope of the “public” rights doctrine.  Until the Court resolves this ambiguity, which may require a strict limitation or even overturning of Stern, challenges to bankruptcy courts’ constitutional authority will continue.

Nortel Judge Rejects Noteholders’ Challenge to Indenture Trustee’s Fees

Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware handed down an important ruling last week that turned aside most of an unusual challenge to the fees and expenses of an indenture trustee in the long-running Nortel chapter 11 case.  The dispute has been watched closely by financial institutions that serve as trustees on bond issuances.  (Kelley Drye & Warren LLP represented a large creditor in the Nortel case but took no part in the issues discussed here).

The Trust Indenture Act of 1939 requires that a qualified financial institution be appointed as a trustee to protect the interests of noteholders for most issuances of private bonds or notes.  The duties are mainly ministerial.  When a default occurs, however, such as when the issuer files for bankruptcy, an indenture trustee can find itself in a precarious situation.  Different groups of noteholders may have disparate views, for example, as to whether the indenture trustee should seek to exercise remedies under the bond indenture, or work to reach a consensual restructuring of the debt.  Most bond indentures have language that requires the indenture trustee to exercise its duties in the same manner as a “prudent person” would use in the conduct of his or her own affairs.  Bond indentures also contain substantial protections for indenture trustees, such as broad indemnification for actions undertaken in good faith.  In addition, and of no small importance in bankruptcy situations, bond indentures provide trustees with the right to be paid out of recoveries ahead of the repayment of the notes for the trustee’s “reasonable” fees and expenses, including any fees of outside counsel.  This priority right of payment is usually referred to as the “charging lien.”

The dispute that arose in Nortel between one of the indenture trustees and its noteholders stemmed from the extraordinary length and complexity of that case.  Nortel filed for bankruptcy in January 2009.  An official committee of unsecured creditors (the “Nortel Committee”) was named shortly afterwards.  It has long been deemed consistent with the “prudent person” standard for indenture trustees for unsecured notes to serve on official committees of unsecured creditors in chapter 11 cases, and the indenture trustee for Nortel’s 7.875% unsecured notes sought and obtained appointment.  By the time Nortel succeeded in obtaining confirmation of its plan of reorganization in January 2017, the indenture trustee had incurred fees and expenses of approximately $8 million.

The outstanding amount due on the 7.875% notes at the time the case commenced was approximately $150 million. Nortel’s plan provided for payment in full of the $150 million, but no postpetition interest.  It also provided for payment of up to $4.25 million of the indenture trustee’s fees and expenses, which meant that the indenture trustee would have the right to obtain payment of its remaining fees and expenses out of the $150 million payment under the plan.

At the plan confirmation hearing, the 7.875% noteholders requested that the indenture trustee not be permitted to exercise its charging lien with respect to the remaining $3.75 million of fees and expenses, pending a determination by Judge Gross of the reasonableness of such fees.  A substantial basis for the objection was that it was not “reasonable” for the indenture trustee to exercise its charging lien with respect to a portion of the fees incurred in serving on the Nortel Committee for the eight years of the case.  Judge Gross confirmed the plan and reserved the noteholders’ rights.

After settlement efforts failed, an evidentiary hearing was held in late February.  At the hearing, the 7.875% noteholders contended that they were not challenging the appropriateness of the indenture trustee sitting on the Nortel Committee per se, but noted that when an indenture trustee does sit on a committee, it is essentially carrying out two sets of duties – one to noteholders under the bond indenture, and one to all general unsecured creditors.  The 7.875% noteholders argued that the exercise by the indenture trustee of the charging lien for payment of fees and expenses must be limited to fees incurred on behalf of the noteholders only.

The indenture trustee argued that its obligation to act as a prudent person required it to be involved in many aspects of the case, even if they may not have directly benefited the noteholders. It noted that day to day involvement in a case of Nortel’s size and complexity was necessary, as it was not feasible “to parachute in and out” when necessary to protect the noteholders’ interests.  It further contended that the determination as to whether involvement was prudent had to be made at the time, and should not be subject to hindsight.

Judge Gross overruled most of the 7.875% noteholder objections.

In making his ruling, he looked closely at the language of the 7.875% bond indenture, noting that the indenture trustee “[is] authorized in performing its duties to ‘act through agents or attorneys,’ and to ‘consult with counsel of its selection.’” He also considered the “prudent person” standard under New York law (the governing law of the indenture), and stated that “prudence is not something the Court can readily review in hindsight.”  He framed the questions to be decided as “whether the Indenture Trustee acted prudently in assigning the Lawyers to their tasks, and whether the Lawyers’ work was reasonable.”  With a few exceptions, Judge Gross answered both questions in the affirmative.

In response to the objections, Judge Gross looked carefully at the work done by the indenture trustee’s lawyers in connection with the indenture trustee’s role as a member of the Nortel Committee. He went on to describe the 7.875% noteholders’ objection as a “hindsight exercise[,]” adding that “[i]t simply was implausible for the Indenture Trustee or the Lawyers to know whether at the time they were performing the work that the Noteholders’ interests did not need protection, or whether what they learned through the Committee would be of no benefit to the Noteholders.”  He concluded that “[t]he matters at hand were too important to leave to chance that the Committee Work would have no impact on or significance to the Notes.”

Judge Gross did reduce a portion of the fees based on certain other factors, including for times when the firms representing the indenture trustee had multiple lawyers participating on committee calls or attending meetings.

In the final part of his ruling, Judge Gross distinguished the recent Supreme Court case of Baker Botts v. Asarco, and determined that the indenture trustee’s counsel could also recover from the charging lien its fees for defending against the 7.875% noteholders’ objection.  The Supreme Court in Baker Botts ruled that Bankruptcy Code provisions governing the payment of professionals entitled to compensation from a debtor’s bankruptcy estate do not provide an exception to the so-called “American Rule”, which states that each side in a dispute pays its own costs.  In contrast, Judge Gross held that a bond indenture “is a contract which qualifies for an exception to the American Rule.”  He cited the language of the indenture that expressly called for the issuer to indemnify the trustee for “the costs and expenses of defending itself against any claim or liability in connection with the performance of any of its powers or duties hereunder[.]”

The importance of this last point should not be overlooked. Together with its strong recognition of the breadth of the “prudent person” standard, Judge Gross’s Nortel decision significantly strengthens the ability of financial institutions to get paid for undertaking the duties of a trustee under bond indentures.

Delaware Bankruptcy Judge: A Carve-Out for Fees Is Not a Cap

Judge Christopher Sontchi recently issued an important opinion in the Molycorp chapter 11 case.  He held that a standard carve-out in a financing order for the fees of counsel and other professionals for an official creditors’ committee will not later limit the ability of such professionals to be paid in full under a confirmed plan of reorganization.  As with many decisions which come out of the Delaware bankruptcy court, this ruling could have a broad impact on chapter 11 practice in courts across the country.

Molycorp was an unusually large, complex and contentious chapter 11 case, but in a number of respects it was no different than many business reorganization cases which get filed every day. The key one is that it had virtually no unencumbered assets with which to pay the debtor’s professionals and the professionals retained by the official committee of unsecured creditors.  This has become a common situation, particularly in large cases with complicated capital structures which often feature more than one tranche of secured debt.  The only payment source for professionals in these cases is a “carve-out” from proceeds of collateral agreed to by the secured lenders.

Counsel for official committees in chapter 11 cases of this nature take on a challenging role. Official creditors’ committees are tasked with numerous important duties and granted significant powers under the Bankruptcy Code.  In most instances, professionals for the debtor and the secured lenders have been planning the course and timing of the bankruptcy filing and negotiating important pleadings and documents (and the carve-out for the debtor’s professionals) for weeks or even months.  The official committee, however, is not formed and counsel is not engaged until after the case has commenced.  At that point, a tremendous amount of information must be digested and analyzed and there are numerous important motions to address, almost always on an expedited basis.  Counsel must also negotiate the carve-out during this period or else risk non-payment.

Secured lenders consent to carve-outs because they generally prefer chapter 11 cases, where the going concern value of collateral can be preserved and realized through a reorganization or a sale of the debtor’s business, instead of fast liquidations under chapter 7 of the Bankruptcy Code or exercising foreclosure remedies under state law. Official creditors’ committees are a key component of chapter 11 cases.  Even though secured lenders know that committees usually will seek to extract some value from a secured lender for the benefit of unsecured creditors, such as by challenging liens or contesting enterprise valuations, they know also that if there are no unencumbered assets, most bankruptcy judges will require lenders to “pay the freight,” i.e., cover the costs of the chapter 11 cases.

In almost all chapter 11 cases, therefore, secured lenders (grudgingly) agree to a carve-out that will ensure that professionals for a creditors’ committee get paid for at least some of their work. The agreement usually comes only after hard negotiations (typically after sabers have not only been rattled but also drawn), as part of an order that provides new financing and/or permits a debtor to use cash proceeds of collateral in order to operate during the pendency of the bankruptcy case.

The question before Judge Sontchi in Molycorp was whether the carve-out served as a hard cap on fees. Molycorp, following months of hostility between the official creditors’ committee and its secured lender, succeeded in confirming a plan of reorganization.  The secured lender early in the case had consented to a carve-out of no more than $250,000.  In the end, the committee sought payment of nearly $8 million in fees and expenses for its counsel.  The secured lender objected, arguing that the only source of funds were from its collateral, and that because the proceeds of its collateral could not be used without its consent, the fees of the committee’s professionals were capped.

The committee relied on Section 1129(a)(9) of the Bankruptcy Code.  Among the requirements which must be met when a plan of reorganization is confirmed is that all administrative claims (i.e., claims incurred during the bankruptcy case that were necessary for the administration of the debtor’s bankruptcy estate) must be paid in full.  Fees of a creditors’ committee’s professionals are administrative claims.  The committee argued that once Molycorp’s plan was confirmed, Section 1129(a)(9) controlled and that the carve-out in the financing order was no longer operative.

The secured lender responded by noting that Section 1129(a)(9) provides that the holder of an administrative claim may agree to accept less than full payment.  In its view, the carve-out had effectively served as such an agreement.

Judge Sontchi sided with the creditors’ committee. He determined that the carve-out in the financing order could not limit the payment of committee counsel’s fees as administrative expenses under a confirmed plan of reorganization.  The payment of administrative expenses under Section 1129(a)(9), he stated, is “a fundamental statutory requirement of the Bankruptcy Code[.]”

In Judge Sontchi’s view, the carve-out agreed to in Molycorp, which he referred to as “standard”, was only intended to be applicable if Molycorp’s reorganization had failed. If the case had been converted to chapter 7 or dismissed, and the collateral liquidated, the $250,000 would have been the maximum that the committee’s professionals could have received.  But he ruled that the carve-out could not limit payment of committee counsel’s fees pursuant to Section 1129(a)(9).  He acknowledged the secured lender’s argument that a carve-out provision might serve as an agreement to accept less than full payment under a later plan.  However, he determined that the language in the carve-out provision before him “does not contain any language that can compel an automatic disallowance of [committee counsel’s] fees.”  He also signaled, in a footnote that appears to be intended for secured lenders in future cases, that he might not be willing to approve a carve-out provision that were to contain such language.

The first few weeks of representing a creditors’ committee in a large, complex and fast-moving case have been likened by some practitioners as comparable to trying to slow down a freight train by stepping in front it. Judge Sontchi’s analysis, if followed by other courts, will provide committee counsel during these fraught periods with at least a bit more leverage in negotiations with secured lenders over carve-out provisions and payment of fees.

Punt, Pass or Kick? Supreme Court Struggles With Jevic at Oral Argument

The U.S. Supreme Court heard oral arguments this week in the case of Czyzewski v. Jevic Holding Corp.  Although veteran Court watchers caution about seeking to predict ultimate rulings based on justices’ questions and stated concerns, it is difficult to read the hearing transcript and not come away with the view that at least some of the Court’s members are not keen to rule on the merits here.  This would be a relief to many bankruptcy practitioners and commentators who have been concerned about a broad ruling in this case that could significantly limit the ability of parties in bankruptcy cases to craft solutions to difficult issues which do not fit within the strict parameters of the Bankruptcy Code.  A procedural disposition appears possible; alternatively, if a ruling on the merits does get handed down, it is likely to be narrowly crafted.

The complications of Jevic, and the difficult choices facing the Court here, stem from both the knottiness of the specific statutory issues which have been presented, and the complicated process of corporate bankruptcy proceedings in general.  The statutory issues are both broad and narrow: do bankruptcy courts have authority to approve a resolution of a Chapter 11 bankruptcy case in a manner different from the three options specified by the Bankruptcy Code – confirmed plan, conversion to a liquidation under Chapter 7, or dismissal?  Specifically, if the case is to be dismissed, can parties “structure” the dismissal to include substantive provisions regarding the distribution of assets of a debtor’s bankruptcy estate, instead of simply leaving parties to their remedies under applicable non-bankruptcy law?  If yes, then can such provisions effect a distribution of those assets in a manner that contravenes the Bankruptcy Code’s priority scheme?

At the hearing, the justices grappled with whether they were being asked to rule on the broader question of the permissibility of structured dismissals, or the narrower question of adherence to the priority rules.  Justice Kagan specifically pressed the petitioners’ counsel to articulate the holding that they were requesting.  Justice Alito also pushed on this point, and even suggested that the petitioners may have argued a different question than the one on which the Court granted certiorari:

“Something strange seems to have happened between the petition stage and the briefing stage in the case. The question that you asked us to take was whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme . . . And we took the case.  But then the question that you address in your brief refers to ‘structured dismissal.’  There is nothing about structured dismissal in the question that you asked us to take . . . .”

On the merits, several justices did express concern about permitting parties to reach settlements that allocate assets in a manner that diverges from the Bankruptcy Code’s priority rules without the consent of all affected parties.  At the same time, however, at least some of the Court members were aware of the “extraordinary” circumstances presented, and the possible implications of a broad ruling if all deviations from the priority rules were to be prohibited.  Justice Kagan acknowledged that the case could be “one of these extraordinary circumstances in which some people can be better off and nobody will be made worse off.  Still the question is, where is the authorization for that in the Bankruptcy Code?”  Chief Justice Roberts observed to respondents’ counsel that “the reasonableness of your position is directly related to how extraordinary the extraordinary circumstances have to be.”

The ambivalence may suggest that some of the justices prefer to avoid a ruling on the merits and are looking for another path. As Justice Alito noted, a clear conflict between circuits exists on the permissibility of asset distributions at variance with the Bankruptcy Code’s priority scheme, but not on the issue of structured dismissals.  His statement above about the possible change in the framing of the question presented could be a prelude to a procedural disposition of the case, such as a dismissal of the appeal based upon an improvident granting of certiorari.  In any event, even with a ruling on the merits it appears less likely that Jevic will be the seminal case that some have feared.

Jevic Could Be the Most Consequential Chapter 11 Decision in Many Years

The U.S. Supreme Court will hear the case of Czyzewski v. Jevic Holding Corp. during the new term that began last week.  The questions it presents are relatively simple.  First, can a bankruptcy court, in dismissing a case under the U.S. Bankruptcy Code, permit parties to “structure” the dismissal to include substantive provisions regarding the distribution of assets of a debtor’s bankruptcy estate, instead of simply dismissing the case and leaving parties to their remedies under applicable non-bankruptcy law?  If yes, then can such provisions effect a distribution of those assets in a manner that contravenes the Bankruptcy Code’s priority scheme?  Most observers anticipate that the Court will focus on solely on the second question, and issue a fairly narrow ruling.  A ruling on the first question, however, would be far broader and could have as significant an impact on Chapter 11 bankruptcy practice as any case that the Court has decided in decades.

The facts of Czyzewski are straight-forward.  Jevic was a New Jersey trucking company; it filed for bankruptcy under Chapter 11 of the Bankruptcy Code following a failed leveraged buyout.  Jevic never attempted to reorganize; it ceased operations immediately prior to its bankruptcy filing and terminated nearly all of its driver employees.  Its secured lender, CIT Group, held a lien on virtually all of its assets, which were worth far less than the amount owed on the loan.  The drivers filed WARN Act claims for unpaid wages against Jevic and Sun Capital, its private equity sponsor.  Sun also held a portion of the secured debt.  An official committee of unsecured creditors was appointed, which commenced fraudulent conveyance and equitable subordination litigation against CIT and Sun.

Three years later, the case was in a place that has become all too familiar to Chapter 11 practitioners. All of the assets had been sold off and the proceeds distributed to the secured lenders.  Nothing remained of the Jevic bankruptcy estate except $1.7 million in cash (which was subject to the secured lenders’ lien) and the litigation claims against CIT and Sun.  The case was effectively at an impasse.  A plan could not be confirmed, because there were insufficient funds to pay all of the expenses of administration of the Chapter 11 case, such as the fees of professionals for Jevic and the creditors’ committee.  The only other means specified by the Bankruptcy Code of resolving a Chapter 11 case are either a conversion to a liquidation under Chapter 7, or a dismissal of the case under Section 349 of the Bankruptcy Code.  Under either of those approaches, however, professional fees would not have been paid, and no recovery would have been received by any creditors other than CIT or Sun.

Another path was taken. The case was dismissed, but the dismissal was structured in such a way so as to incorporate a settlement among Jevic, CIT, Sun, and the creditors’ committee.  Such “structured dismissals” have become increasingly common over the past several years.  As a proliferation of secured financing has resulted in more cases lacking sufficient unencumbered assets to finance an exit from Chapter 11 through plans of reorganization or liquidation, structured dismissals have been utilized by creative practitioners to wind down what would otherwise be irresolvable morasses.  Under the Jevic structured dismissal, CIT and Sun agreed, in exchange for a release of the litigation, to allow the $1.7 million in cash plus another $2 million they contributed to be used to pay administrative expenses and to provide a small distribution for general unsecured creditors.

The drivers, however, were not part of the settlement, because they refused to release their WARN Act litigation against Sun. They therefore received nothing, even though their claims for unpaid wages against the Jevic bankruptcy estate were entitled to priority treatment ahead of general unsecured claims.  The bankruptcy court nevertheless approved the settlement and the structured dismissal, finding that there otherwise was “no realistic prospect” of a recovery to any parties but CIT and Sun.  The U.S. Court of Appeals for the Third Circuit affirmed.

The Supreme Court granted certiorari on the question of whether a structured dismissal in a chapter 11 case can incorporate a settlement that diverges from the Bankruptcy Code’s priority scheme. It is possible, however, that the Court may first look at the broader issue of whether a dismissal that is “structured” is even a permissible means of resolving a chapter 11 case.

These issues could lead the Court to resolve a basic question that has driven arguments on the Bankruptcy Code for decades. It’s a debate between lawyers and judges who take a pragmatic view of the Bankruptcy Code, versus those who adhere strongly to the “plain meaning” rule of statutory interpretation.  The first group believes that the Bankruptcy Code was intentionally designed by Congress to be as flexible as possible and, while unstated, also was intended to be built upon and carry forward any number of long-standing practices derived from decades, and in some instances centuries, of commercial law.  In this view, the Bankruptcy Code was specifically intended to allow parties to develop solutions to difficult issues which do not fit within the strict parameters of the statute.

Jurists and practitioners on the other side contend that bankruptcy judges must defer to the plain meaning of the Bankruptcy Code and are not at liberty to approve solutions to problematic situations, such as a structured dismissal for resolving a log-jammed chapter 11 case, which go beyond those specifically provided by Congress. In Czyzewski, the drivers contend that because there is no express authority for structured dismissals under the Bankruptcy Code, the proposed deal among the other parties must fail.  The Third Circuit acknowledged the lack of statutory authority; however, it affirmed the lower court decisions as the “least bad alternative”, and ruled that a dismissal under Section 349 of the Bankruptcy Code could be accompanied by other court orders giving effect to a settlement, providing releases, and disposing of loose ends which otherwise would require continued litigation in another forum.

The second issue delves even deeper into the heart of the Bankruptcy Code. The “absolute priority rule” means that in a plan of reorganization, creditors with claims which would be entitled to seniority in the event of a straight liquidation must get paid ahead of creditors whose claims would be junior in priority.  The Third Circuit was troubled by the fact that general unsecured creditors would receive some small payment while the drivers with higher priority claims would be paid nothing.  The Court nevertheless upheld the settlement.  It determined that under a settlement, parties could deviate from the Bankruptcy Code’s priority scheme if “specific and credible grounds” so justified.  The dispositive factor in this instance was that under the only realistic alternative, no parties other than CIT and Sun would have received anything.  Although the Jevic bankruptcy estate held litigation claims, there were no assets to fund them.  Under any viable scenario, the drivers were receiving $0.  The only real question was whether such non-payment should obviate the possibility of any other party receiving any funds.  The Third Circuit declined to find “that our national bankruptcy policy is quite so nihilistic[.]”

The Court, as demonstrated by its recent decision in Baker Botts v. Asarco, leans strongly toward the plain meaning rule of statutory interpretation in bankruptcy cases, which suggests that the Court will reverse the Third Circuit here.  The main suspense in the outcome of Czyzewski lies not in the outcome per se, but rather in whether the Court rules broadly or narrowly.  A narrow ruling addressing only the second question here, overturning the ruling below based on the proposed recovery to general unsecured creditors ahead of the drivers and their claims for unpaid wages, would be significant but not too remarkable.  The Court could go further, however, and altogether invalidate structured dismissals due to the lack of specific authority.  Such a ruling could markedly alter the chapter 11 landscape.  The Supreme Court, however, has evidenced little concern in recent times for the extent to which its rulings in bankruptcy cases conflict with established practices, such as when it invalidated a long-standing jurisdictional scheme a few years ago in Stern v. Marshall.

One of the hallmarks of Chapter 11 has been the consistent ability of practitioners and judges to adapt it to situations that lie well outside of the intentions of the drafters of the Bankruptcy Code, such as in asbestos and other mass tort cases, or mega-cases such as the GM and Chrysler bankruptcies, and which likely would otherwise defy resolution. For better or worse, a broad ruling by the Court in Czyzewski would limit creative uses of the Bankruptcy Code, and substantially affect the manner in which difficult Chapter 11 cases are approached and resolved.

Secured Creditors Can Chill a Bit Following Aeropostale Ruling

The ability of a secured creditor to credit bid its debt in connection with a sale of a debtor’s assets received a strong boost in a decision last month in the Chapter 11 case of Aeropostale from U.S. Bankruptcy Judge Sean Lane of the Southern District of New York.  Two recent decisions, Fisker Automotive and Free Lance-Star Publishing Co., had surprised many observers by narrowing the rights of secured creditors to credit bid, and resurrected uncertainty about a debtor’s ability to limit those rights (a dispute that had appeared to have been resolved in favor of secured creditors only a few years earlier by the Supreme Court’s decision in RadLax Gateway Hotel).  In particular, Fisker Automotive and Free Lance-Star Publishing Co. suggested that the potential of a credit bid to “chill” bidding by other prospective buyers could suffice to limit a secured creditor’s rights.  Judge Lane’s ruling in Aeropostale significantly walks back those decisions and narrows the grounds on which credit bidding rights can curtailed.  (Kelley Drye & Warren LLP represents parties in the Aeropostale case but took no part in the matters discussed here.)

Section 363(k) of the Bankruptcy Code provides that secured creditors may credit bid the full amount of their debt when their collateral is sold, “unless the court for cause orders otherwise . . . .” (emphasis added).  Credit bidding in bankruptcy protects the expectations of secured creditors under non-bankruptcy law to be able to look to their collateral in the event of a default.  The Bankruptcy Code does not define what constitutes “cause”, but for many years it was generally viewed as being narrow in scope, such as a creditor’s bad faith or misconduct.  A controversy arose a few years ago when the U.S. Court of Appeals for the Third Circuit unexpectedly limited a secured creditor’s right to credit bid in the absence of “cause” in the Philadelphia Newspapers case.  That decision was effectively overruled by the Supreme Court’s decision in RadLax.

Fisker Automotive and Free Lance-Star Publishing Co. put the issue of credit bidding back on the table, creating controversy over how broadly courts could define the meaning of “cause” under Section 363(k).  Specifically, although there was evidence in each case of inequitable creditor conduct and possible invalidity of security interests, both rulings suggested that “cause” could be based solely on the goal of fostering a competitive auction process, i.e., not “chilling” the bidding.  This aspect of the rulings in Fisker Automotive and Free Lance-Star Publishing Co. raised particular concern for secured creditors.  Credit bidding can nearly always be said to “chill” competing offers.  In one sense, that is its very purpose – to protect a secured creditor from being forced to accept a cash payment that is below the value the secured creditor believes the collateral possesses.

In Aeropostale, the debtors engaged in a sale of substantially all of their assets, and sought to limit the ability of its secured lenders to credit bid.  The lenders are affiliates of a private equity firm, Sycamore Partners, that through other affiliates also owned equity in in Aeropostale and held a controlling interest in one of its largest suppliers.  The debtors alleged a broad range of inequitable conduct against Sycamore Partners and its affiliates arising from the multi-faceted connections, in an effort to show that the “cause” standard under Section 363(k) was satisfied.  Relying on Fisker Automotive and Free Lance-Star Publishing Co., the debtors also contended that permitting the secured lenders to credit bid would deter other parties from putting forward offers and would “chill” the bidding.

Following a multi-day trial, Judge Lane rejected the allegations regarding inequitable conduct on the part of Sycamore Partners and its affiliates, finding that each of the Sycamore related entities had acted in accordance with its contractual rights and had taken reasonable steps to protect its financial interests.  This left the question of whether “cause” could be shown merely by the possible negative effect on the sale process of permitting the secured lenders to credit bid.

Judge Lane expressly declined to give Fisker Automotive and Free Lance-Star Publishing Co. the expansive readings requested by the debtors.  He acknowledged that “courts will sometimes refer to concerns about the chilling of bidding as a factor [in considering whether to limit the ability to credit bid].”  However, he observed that the court in each those cases found both evidence of inequitable conduct on the part of the secured creditor, and questions regarding the extent and validity of the security interests held.  In contrast, Judge Lane found no bad actions on the part of the Sycamore partners and its affiliates in Aeropostale.  He also noted that no party had challenged the extent and validity of the secured lenders’ liens and security interests.  Judge Lane made clear that absent those factors, “cause” could not be shown.  “[T]he Court is unaware of any cases where the chilling of bidding alone is sufficient to justify a limit on a credit bid.” (emphasis added).

He also referenced the recent comprehensive report published by the American Bankruptcy Institute Commission to Study the Reform of Chapter 11.  The report has been criticized by banking groups and associations for certain recommendations which have been viewed as contrary to the interests of secured creditors.  With respect to credit bidding, however, the report came down firmly on the side of such interests.  Judge Lane cited its finding regarding “the fundamental role of credit bidding under state law and section 363(k)”, and conclusion that “the chilling effect of credit bidding alone should [not] suffice as cause under section 363(k).”

Judge Lane’s comprehensive Aeropostale opinion squarely addresses the key question that arose from Fisker Automotive and Free Lance-Star Publishing Co.  If followed by other courts, it will resolve that credit bidding rights may not be limited “for cause” where a secured creditor exercises its rights in good faith, and in the absence of any malfeasance or issues regarding the extent or validity of liens.  Even if doing so would enhance the prospects of a competitive auction for a debtor’s assets, Aeropostale makes clear that limitations on credit bids should not be permitted.

Energy Future Holdings Chapter 11 Case – The Largest Game Ever of Texas Hold’em?

The chapter 11 case of Energy Future Holdings (“EFH” or “Debtors”) roared back to life this month. Certain key conditions for the plan of reorganization approved last December (the “First Plan”) to become effective were not met by a deadline of April 30, and one of the major parties to the support agreement that underlay the First Plan gave written notice of termination on May 1.  The Debtors followed up immediately by filing a new proposed plan and a motion seeking a confirmation hearing in early August.  (Kelley Drye & Warren LLP represents a creditor of certain Debtors, but has taken no part in the matters discussed here).

EFH entered bankruptcy in April 2014 with over $42 billion in claims, and for well over a year it looked to be among the most intractable cases ever filed. The Debtors’ business operations are divided into two distinct silos: a majority interest in a regulated electrical utility, Oncor, indirectly owned by EFH subsidiary Energy Future Intermediate Holding Company LLC (the so-called “E side” of EFH), and non-regulated electricity generation, mining, and commodity risk management and trading operations, indirectly owned by EFH subsidiary Texas Competitive Holdings Company LLC (the so-called “T side” of EFH).

At the outset, EFH had the support of its E side creditors, who stood to see a substantial recovery from a proposed sale of the Oncor interests, but was facing intense opposition from junior creditors on the T side, who appeared to be out of the money. In the summer of 2015, however, the T side creditors began to coalesce around a bold strategy to backstop a real estate investment trust (“REIT”) structure to take control of the Oncor assets.  A REIT is a hybrid tax entity that is able to reduce or eliminate substantially all of the entity-level federal income taxes otherwise imposed on corporations by distributing its taxable income to shareholders.  The junior T side creditors, who had been prepared to prosecute a campaign of scorched earth litigation against the Debtors, their private equity sponsors and the senior T side creditors, began instead to negotiate the terms under which they would agree to backstop the new REIT vehicle.

The junior T side creditors proposed to pair with Hunt Group, a long time Texas utility operator. When it became clear that a plan of reorganization based on the transfer of the Oncor assets to a REIT structure could (i) garner support from all levels of the T side capital structure, and (ii) generate sufficient value to pay all E side creditors in full, EFH agreed to move forward with it.  Under the First Plan, the Hunt Group committed to provide over $7 billion, and the junior T side creditors agreed to backstop a $5.2 billion rights offering.

The riskiness of the First Plan was acknowledged by all parties. It would require numerous state and federal approvals, including from the IRS and the Texas Public Utility Commission (the “PUC”).  As the quid pro quo for agreeing to pursue the REIT structure, the Debtors insisted that the junior T side creditors agree to a global settlement that would be binding regardless of whether the First Plan ever became effective.  If the REIT proposal failed to garner the necessary approvals, the global settlement was intended to allow the Debtors to focus on an alternative path to exit the chapter 11 cases.  The junior T side creditors agreed to waive any claims against the Debtors, their private equity sponsors and the senior T side creditors, and to accept under an alternative plan a payout of $550 million, a small fraction of their claims.

The PUC approved the deal in March, but with a crucial caveat. Responding to objections raised by municipalities and consumer groups, the PUC issued an approval order that expressly left open the possibility that the Oncor investors (i.e., the junior T side creditors) might not be given the full tax benefits of the REIT structure, but instead might have to share such benefits with ratepayers.  The Oncor investors refused to close the deal on that basis.

Under the First Plan and the related agreements, the Oncor investors were required to close by April 30. However, that date was subject to an extension to June 30 if the PUC approval order had been approved.  The Oncor investors and the Hunt Group evidently believed that they had the additional time, and had already requested a new hearing before the PUC.  The Debtors and the senior T side creditors took the position that the PUC’s order was insufficient, since it did not resolve the treatment of the REIT tax benefits.  The Oncor investors could have effectively bought additional time by agreeing to give up $50 million of the their alternative payout consideration of $550 million, but they declined.  The T side senior creditors sent a notice of termination of the plan support agreement, thus effectively rendering the First Plan “null and void”.

Where the case proceeds from here is anyone’s guess. The machinations of the past several weeks could all be an elaborately choreographed series of steps to place maximum pressure on both the PUC and the Oncor investors to reach a resolution that would lead the Oncor investors to proceed forward.  The Debtors could withdraw the proposed new plan and seek to revive the First Plan.  The Debtors’ new plan also leaves open the possibility of a new REIT structure deal.  It also leaves open virtually any other possible exit strategy, such as a new auction process for Oncor.  At least one earlier bidder for the Oncor assets, NextEra Energy, has already made clear its continued interest.

Confirming a new plan for the T side Debtors should be fairly straight forward at this point, given the agreement by the T side junior creditors to settle their litigation claims and accept $550 million. Formulating a confirmable plan for the E side Debtors without the substantial value created by the REIT transaction could be long and difficult.  At a hearing last week, Judge Christopher Sontchi effectively split up the cases.  Confirmation of a new plan for the T side Debtors is scheduled to take place in August.  Judge Sontchi tentatively scheduled a confirmation hearing for the E side Debtors to begin in late September, but he acknowledged that with so many unresolved issues, that timing is unlikely to hold.

Heightening the intrigue, as Judge Sontchi noted last week, is the fact that the 18 month period in which the Debtors had the exclusive right to propose a plan of reorganization has expired.  This means that any party now has the ability to put forward a plan for reorganizing or selling the E side Debtors’ interests in the Oncor assets.  NextEra Energy is strongly believed to be considering such a strategy.

Any exit path for the E side Debtors will likely take a minimum of several months. Several sophisticated parties with billions of dollars at stake are sitting around a table, each waiting to see who will reveal their hole cards first.

Landlords Beware: Lease Terminations May Be Voidable In Bankruptcy

The Seventh Circuit Court of Appeals recently handed down a decision with significant implications for landlords contemplating lease termination agreements with distressed tenants. Ruling on a direct appeal in the chapter 11 case In re Great Lakes Quick Lube LP, the court held that a lease termination agreement between a landlord and a financially distressed tenant can be voided as either a fraudulent conveyance or a preferential transfer in the tenant’s subsequent bankruptcy case.

The debtor-tenant owned and operated a chain of automotive maintenance stores in the Midwest.  Less than two months before its chapter 11 filing, the debtor agreed with one of its landlords to terminate leases at five locations; two were profitable and three were not.  After the bankruptcy filing, an official committee of unsecured creditors was formed and eventually granted standing to pursue an action against the landlord on behalf of the debtor-tenant’s bankruptcy estate to recover the alleged value of the leases for the two profitable locations.

The bankruptcy court ruled that the lease terminations were not “transfers” for purposes of the avoidance statutes and that, even if a transfer had occurred, they could not be avoided and recovered by the estate because Section 365(c)(3) of the Bankruptcy Code prevents the assumption or assignment of a lease that has been validly terminated prior to the bankruptcy filing. The bankruptcy court also found that the debtor’s estate had received a benefit from being relieved of the lease payments at the three unprofitable locations

The Seventh Circuit reversed. The court determined that a “transfer” did occur when the debtor’s rights under the lease were terminated, and disagreed with the bankruptcy court’s finding regarding the non-avoidability of the value of such transfer.  Judge Richard Posner, writing for the court, disregarded the effect of Section 365(c)(3) of the Bankruptcy Code because the creditors’ committee was only trying to recover the value of the leaseholds, and not the leaseholds themselves.  Judge Posner also focused solely on the potential value lost by the debtor’s bankruptcy estate from the leases for the two profitable locations, and remanded the case back to the bankruptcy court to determine such value.  The bankruptcy court’s finding regarding value from the release of lease obligations at the three unprofitable locations did not insulate the transactions from further scrutiny regarding the possible value lost by the debtor’s estate from the termination of the profitable leases.

This is an important decision for landlords, as it stands as an invitation to trustees and creditors’ committees at a minimum to investigate, and possibly commence similar actions, where leases have been validly terminated pre-petition.  Although the opinion is very short and scant in its reasoning, Judge Posner is a highly regarded jurist and for that reason alone the decision is likely to draw the attention of other judges.  Landlords contemplating terminating leases with distressed tenants, particularly in the Seventh Circuit states of Illinois, Wisconsin and Indiana, will need to focus closely on the potential value of any leasehold interests being recovered and any benefits such tenants will be realizing in connection with the release from obligations under such leases.

Ruling on Pipeline Agreements in Sabine Chapter 11 Case Indicates Battles That Lie Ahead in Energy Company Bankruptcy Cases

U.S. Bankruptcy Judge Shelley Chapman ruled last week in the chapter 11 case of Sabine Oil & Gas that Sabine could utilize the U.S. Bankruptcy Code to “reject” certain agreements with pipeline operators.  This decision will permit Sabine to walk away from its obligations under the agreements and leave the pipeline operators with nothing but a claim in the bankruptcy case for breach of contract damages (a claim that is likely to be virtually worthless).  It upends the generally held view regarding the nature of these types of agreements, which is that they create cognizable real property interests under applicable state law.  Such real property interests have far stronger protections in bankruptcy cases than contractual rights.

Sabine, an exploration and production (E&P) company, filed for bankruptcy under chapter 11 of the Bankruptcy Code back in July 2015 in the Southern District of New York. Similar to most E&P companies, it had arrangements with two midstream gathering and processing (G&P) companies that gathered, treated, transported and processed Sabine’s oil and gas productions.  As is typical with these arrangements (the “midstream agreements”), Sabine agreed to dedicate certain oil and gas production to the G&P companies, and they, in turn, committed at their own expense to construct, operate and maintain for Sabine a system of pipelines and facilities.  Sabine committed under the midstream agreements to deliver certain minimum amounts of oil and gas on an annual basis, or else to make deficiency payments and other fees over a term of ten years.  The midstream agreements specifically provided that they are covenants intended to “run with the land.”

After filing for bankruptcy, Sabine sought to reject the midstream agreements. Section 365 of the Bankruptcy Code permits debtors to walk away from unexpired contracts and leases if they can demonstrate that such agreements are burdensome to their bankruptcy estates and that doing so would be in the best interests of the debtor and all of its creditors.  This is a crucial power under the Bankruptcy Code for troubled companies that are seeking to reorganize.

The G&P companies objected, and asserted strongly that the rejection of the midstream agreements would be of little avail to Sabine, because Sabine had conveyed real property interests to the G&P. They contended that even if Sabine terminated its ongoing contractual obligations under the midstream agreements, the covenants that run with the land could not be affected.

Property rights in bankruptcy are determined by applicable non-bankruptcy (in this case Texas) law. Notwithstanding that the covenants in the midstream agreements purported to run with the land, Judge Chapman, lamenting the “arcane and anachronistic rules” governing real property covenants, observed that the parties’ intentions were not necessarily dispositive, and that a number of conditions were required to be met in order to establish the existence of real property rights in Texas.  Since there were no decisions on point by the Texas Supreme Court that controlled all aspects of the questions at issue, she undertook her own analysis of whether the covenants between Sabine and the G&P companies did in fact “run with the land.”  She concluded that no such real property rights were created under Texas law.  (For technical reasons under the Federal Rules of Bankruptcy Procedure, she did not make a “final” ruling, but instead provided a “non-binding analysis” that can be readily applied when the procedural deficiencies are remedied).

Under Judge Chapman’s reading of Texas law, for a covenant to run with the land and thereby create a real property interest, among other things it must “touch and concern” the land (i.e., affect the fee owner’s ownership rights in some way), and also result from a “horizontal privity” between the parties (i.e., result from some transactional relationship between the parties, such as the reservation of certain rights upon a conveyance of a tract of land). In Judge Chapman’s view, the midstream agreements did not satisfy either of those requirements.  Instead, she found that

[Sabine] simply engaged [the G&P companies] to perform certain services related to the hydrocarbon products produced by Sabine from its property. The covenants at issue are properly viewed as identifying and delineating the contractual rights and obligations with respect to the services to be provided, and not as reserving an interest in the subject real property.

The decision in Sabine clearly has significant potential ramifications for G&P companies which have made substantial investments in facilities and infrastructure for distressed E&P companies. If Judge Chapman’s analysis is followed by other courts, E&P companies in chapter 11 would have the ability effectively to wipe out those investments by rejecting the midstream agreements under Section 365 of the Bankruptcy Code.  Other aspects of the Bankruptcy Code are implicated as well.  For example, a debtor in bankruptcy may sell its assets under Section 363 of the Bankruptcy Code “free and clear” of most contractual rights.  It is far more difficult to strip away real property interests such as covenants that run with the land.  This precise issue has arisen in the chapter 11 proceedings of Quicksilver Resources, which is pending in the District of Delaware, and a decision in that case from U.S. Bankruptcy Judge Laurie Silverstein is expected very shortly.

A number of factors make clear, however, that Judge Chapman’s decision will not, in and of itself, lead to a cascade of E&P companies seeking to reject midstream agreements with G&P companies. First and foremost, as the opinion itself demonstrates, the resolution of these questions is highly dependent on the facts of each individual case.  For example, Judge Chapman noted that Sabine only granted rights to the G&P companies in hydrocarbons after they were extracted from the ground and were thus personal property under Texas law.  Had the G&P companies in Sabine been granted rights to minerals in the ground, they would have constituted an interest in real property, and the outcome could very well have been different under Judge Chapman’s analysis.

Next, while Judge Chapman’s opinion will undoubtedly be persuasive, it will not be binding on any other court, even in the Southern District of New York. Judge Silverstein will shortly be rendering her decision in Quicksilver, and bankruptcy courts in Texas will almost certainly soon be weighing in on this topic.  Some of these decisions are certain to be appealed, setting up a process that will take two or three years, at a minimum, to play out in full.  Ultimately, it is not unreasonable to expect that a federal court of appeals will certify this question to the Texas Supreme Court for resolution.  The laws of different states are certain to be implicated in other cases as well.

Many industry observers are justifiably concerned over the prospects of G&P companies in the wake of the severe economic distress facing E&P companies, and whether other troubled E&P enterprises will similarly seek to jettison pipeline arrangements and other types of midstream agreements in bankruptcy.  However, Judge Chapman’s opinion will not in and of itself be a game-changer regarding the rights of G&P companies.  It is, rather, the first salvo in what could be a protracted battle among E&P companies and G&P transporters, and ultimately probably downstream refiners as well (and their accompanying lenders, creditors and investors) regarding the allocation of the ongoing economic pain stemming from historically low prices for oil and gas.  Many similar encounters lie ahead.

Delaware Bankruptcy Judge Rejects Effort to Circumvent Supreme Court’s Asarco Decision

The Supreme Court’s decision last term in Baker Botts v. Asarco, in which the Court ruled that professionals that are paid from a debtor’s bankruptcy estate cannot be compensated for time spent defending their fee applications, continues to rankle bankruptcy practitioners.  Moreover, a recent decision in a Delaware bankruptcy case shows that the impact of Asarco will not be easily circumvented.

Attorneys and other advisors retained by a debtor, a trustee or an official creditors’ committee are known as “estate professionals,” because their retention in each case must be approved by the bankruptcy court, and their fees and expenses are paid out of the debtor’s bankruptcy estate and are subject to review and approval pursuant to Section 330 of the Bankruptcy Code.  Section 330(a)(1) of the Bankruptcy Code states, “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services . . . .”

In Asarco, the law firm of Baker Botts was retained to represent the debtor in its chapter 11 bankruptcy case. During the case, Baker Botts sued Asarco’s parent company to recover improperly transferred assets, and won a huge recovery for the benefit of Asarco’s creditors. At the end of the chapter 11 case Baker Botts applied to the bankruptcy court for final approval of $120 million in fees and expenses, plus a performance bonus of $4.1 million.  Asarco, which wound up back under the control of its parent company after all of its creditors were paid in full, objected to Baker Botts’ fee application.  Following a multi-day trial, the bankruptcy court approved Baker Botts’ requested fees and also awarded it over $5 million to cover the costs incurred in defense of those fees. The Fifth Circuit reversed the award of fees for defending fees, and the Supreme Court upheld that reversal.

The Court’s analysis was straight-forward: under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees, unless there is an applicable statute or agreement that provides otherwise.  In the Court’s view, the plain text of Section 330(a) does not support a deviation from the “American Rule” regarding attorneys’ fees.  Citing to Webster’s New International Dictionary, the Court’s majority stated, “The word ‘services’ ordinarily refers to ‘labor performed for another.’”  Since Baker Botts was litigating to defend its own fees, the Court reasoned, it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitle to compensation for such time.

As many commentators have noted, the implications of Asarco in chapter 11 cases going forward could be substantial.  The requirement of bankruptcy court approval for all fees paid to estate professionals helps to maintain the fairness and integrity of the bankruptcy process, and is accepted as an inconvenient but necessary requirement by law firms and other professional firms that undertake such work.  That fees may only be allowed after a “hearing” necessarily implicates a contested process, and challenges from other parties have always been a recognized hazard for such firms.  A prohibition on compensation for costs incurred in fee disputes places estate professionals at a clear disadvantage.

Two weeks ago, Judge Mary Walrath, a well-regarded jurist in the influential Delaware bankruptcy court, denied an effort in the Boomerang Tube chapter 11 case to work around Asarco contractually.  Judge Walrath, in a carefully considered decision, makes her view clear that Asarco imposes a broad prohibition on fee-shifting into the Bankruptcy Code, one that estate professionals may not sidestep by contract.

Boomerang Tube filed for bankruptcy under chapter 11 last June. A short time thereafter, and right after the Asarco decision was handed down, the U.S. Trustee for the District of Delaware (a representative of the U.S. Department of Justice) appointed an official committee of unsecured creditors (the “Committee”), and the Committee selected Brown Rudnick LLP to represent it.

Brown Rudnick’s effort to render Asarco inapplicable to its applications for payment in Boomerang Tube was straight-forward.  In its motion to Judge Walrath to be approved as Committee counsel, the firm asked for the approval order to include a provision that would entitle it to be compensated from Boomerang Tube’s bankruptcy estate for any fees, costs or expenses incurred in defending its fees against any challenges.  In support of this provision, Brown Rudnick contended that Section 328 of the Bankruptcy Code allows for the retention of estate professionals “on any reasonable terms and conditions.” It further argued that Asarco had ruled only that Section 330 did not create an exception to the American Rule against fee shifting, and that the Supreme Court had noted that parties could and regularly did contract around the American Rule.  The U.S. Trustee objected, and Judge Walrath approved Brown Rudnick’s retention while reserving judgment on the fee defense provision.

The U.S. Trustee took issue with Brown Rudnick’s narrow interpretation of Asarco, and argued that estate professionals could not use Section 328’s retention provisions to avoid Section 330’s prohibition on fee shifting.  He further argued that fee defense provisions are not “reasonable” and cannot be approved under Section 328.

After requesting further briefing, Judge Walrath carefully weighed the arguments before coming down unequivocally on the side of the U.S Trustee on each one.

Judge Walrath first determined that Section 328 did not by itself create an exception to the American Rule, as it makes no mention of awarding fees or costs in the context of an adversarial proceeding. She noted by contrast that several discrete Bankruptcy Code provisions do contain express language providing for payment of fees to a prevailing party, and concluded that the absence of such express language was evidence of Congressional intent not to create an exception to the American Rule in Section 328.

She next considered Brown Rudnick’s argument that nothing in Section 328 prevented the Committee and Brown Rudnick from agreeing contractually in Brown Rudnick’s retention agreement for the payment of defense fees. She agreed that Section 328 contained no such prohibition, but rejected the argument that the retention agreement could, by itself, effect an exception to the American Rule, because in the end it would be Boomerang Tube’s bankruptcy estate, a non-party to the retention agreement, that would bear the costs.

Finally, Judge Walrath agreed with the U.S. Trustee’s argument that fee shifting provisions are not “reasonable” within the meaning of Section 328. Brown Rudnick contended that such provisions should be viewed as similar to the type of exculpation and indemnification provisions that are typically approved under Section 328 in retention agreements for investment bankers and financial advisors.  Judge Walrath found the analogy unpersuasive.  She noted that indemnification provisions are routine for investment bankers outside of bankruptcy, whereas lawyers are not commonly entitled to reimbursement for the costs of defending their fees.

Judge Walrath concluded her opinion by expressly warning other professionals not to parse her decision to find other possible ways to avoid Asarco: “Such provisions are not statutory or contractual exceptions to the American Rule and are not reasonable terms of employment of professionals.”

Judge Walrath’s decision in Boomerang Tube will undoubtedly be cited and followed by many other judges, but it will not resolve the issue.  Threats to contest estate professionals’ fees are an ingrained part of the hard-nosed negotiating process that is the hallmark of chapter 11 practice.  It is therefore inevitable that law firms will be making similar attempts to protect themselves in other districts.  As her opinion shows, these are not easy questions, and the strong likelihood is that there will be some courts that come out the other way.  This issue will probably come before the Supreme Court again.

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