Bankruptcy Law Insights

Bankruptcy Law Insights

Commentary & Analysis on Current Events & Issues in Large & Mid-Market Chapter 11 Cases

Loan to Moan? Judge Limits Right to Credit Bid in Chapter 11 Case of Free Lance-Star Publishing Co.

Posted in Distressed M&A

A few months ago, a ruling in the Chapter 11 case of Fisker Automotive narrowed a secured creditor’s right to credit bid its debt in connection with a sale of the debtor’s assets.  The decision surprised many observers and resurrected uncertainty about a debtor’s ability to limit a secured lender’s credit bidding rights (a dispute that appeared to have been firmly resolved in favor of secured creditors only two years ago by the Supreme Court’s decision in RadLax Gateway Hotel).  Fisker Automotive put the issue of credit bidding back on the table, particularly in so-called “loan to own” situations where secured debt is purchased at a substantial discount for the purpose of effecting the acquisition of a distressed borrower.  An opinion issued last week in the Chapter 11 case of Free Lance-Star Publishing Co. is certain to further the uncertainty.  

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 . . . .”  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 it has generally been 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 ruling in RadLax

The new dispute over credit bidding arising from Fisker Automotive and Free Lance-Star Publishing Co. turns on how broadly courts can define the meaning of “for cause” under Section 363(k).  Specifically, can “cause” be based solely on the goal of fostering a competitive auction process?  Moreover, could the credit bidding rights of purchasers of debt for less than face value be different from those of original lenders?  

In Fisker Automotive, Judge Kevin Gross granted a motion to cap the right to credit bid “for cause” of Hybrid Tech Holdings, a secured creditor that purchased a $165 million loan at a substantial discount.  There was a genuine dispute as to the extent of Hybrid’s security interests on Fisker’s assets (at least a portion of the assets that were to be sold did not appear to be encumbered by Hybrid’s liens, and therefore could not be the subject of a credit bid), and  Judge Gross also excoriated Hybrid’s actions during the case, thus inferring inequitable conduct.  A ruling that “cause” existed to limit credit bidding for these reasons would not have been particularly remarkable. 

However, the decision also suggested a much broader reading of the term “for cause”.  Judge Gross ruled that Hybrid’s right to credit bid could be limited to $25 million (the amount it paid to acquire the loan) on the basis that it would improve the ability of other bidders to compete at an auction.  He wrote, “bidding will not only be chilled without the cap; bidding will be frozen.”  This last statement raised numerous eyebrows, suggesting as it did that credit bidding could be limited even in the absence of any malfeasance by the holder of the debt. 

The first shoe following Fisker Automotive has now dropped.  The facts of Free Lance-Star Publishing Co. are in many ways similar to Fisker Automotive.  A secured creditor, DSP, acquired the secured debt of Free Lance-Star Publishing at a discount, intending to use the full face amount of $38 million to credit bid for the debtor’s assets.  The debtor and the creditors’ committee objected to the credit bid, contending that the lender from which DSP acquired its secured debt did not hold valid and perfected liens over certain of the debtor’s key assets, including FCC licenses and the real property on which the debtor’s radio transmission towers sit, and alleging various forms of “inequitable conduct” on the part of DSP.  Unsurprisingly, the debtor and the creditors’ committee also cited Judge Gross’s statement in Fisker Automotive, arguing that “cause” existed to limit DSP’s right to credit bid in order to avoid chilling the bidding process and to “restore enthusiasm” for the sale. 

Judge Kevin Huennekens held that DSP’s credit bid will be limited to $13.9 million.  His opinion noted the three separate arguments advanced by the debtors and the creditors’ committee against permitting DSP to credit bid its full debt.  He determined that DSP’s liens did not extend to the transmission towers or to the proceeds from the sale of FCC licenses, and also found inequitable conduct on the part of DSP, stating that he was “troubled by DSP’s efforts to frustrate the competitive bidding process.”  As in Fisker Automotive, a ruling to limit credit bidding based on these findings alone would have been narrow and un-noteworthy.  But, just as Judge Gross did in Fisker Automotive, Judge Huennekens went further, and also found that “it is necessary to limit DSP from bidding the full amount of its claim against all of the Debtors’ assets in order to foster a fair and robust sale.” 

This last statement of Judge Huennekens (if the decision stands on appeal), will be the focus of attention.  In Free Lance-Star Publishing Co., as in Fisker Automotive, credit bidding could have been limited based solely on the basis of the asserted inequitable conduct.  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 that value the secured creditor believes the collateral possesses.  Given the extent to which Chapter 11 is used these days to effect sales of distressed businesses under Section 363 rather than reorganizations, and the common “loan to own” practice of purchasing secured debt at a discount for purposes of credit bidding, Judge Huennekens’ language is going to be cited in many objections to Section 363 sales.  

Of course, the full impact of Fisker Automotive and Free Lance-Star Publishing Co. remains to be seen.  The key question now is whether other courts will limit credit bidding rights “for cause” in the absence of any inequitable conduct, but instead solely on the basis that it is necessary to “restore enthusiasm” among other potential bidders so as to improve the chances of a competitive auction.  If a “loan to own” secured creditor acquired the debt and exercised its rights in good faith, will a court still limit its ability to credit bid?  

If so, then these cases will have a broad effect on both Chapter 11 and commercial law practice, and could significantly alter the secondary trading market for distressed debt.  Another credit bidding case is likely to make its way to the Supreme Court.

Sbarro and Quiznos Serve Up Prepackaged “Cramdown” Plans

Posted in Uncategorized

The chapter 11 filings this month of Sbarro and Quiznos share many similarities.  Both companies are looking to survive in a difficult sector of a tough industry.  Both were forced to seek bankruptcy despite recent successful efforts to reduce debt – an out-of-court restructuring for Quiznos and a 2011 chapter 11 case for Sbarro.  In addition, both cases also continued a strong trend of corporate bankruptcies that look to minimize the duration of the case.  

Each proceeding is a true “prepackaged” case – a phrase that is often used to describe any number of negotiated arrangements between a debtor and its major creditors, but that is in fact a term of art that properly refers to cases where the requisite votes for approval of the plan of reorganization are solicited and obtained prior to the filing of the bankruptcy petition.  The approach works well for effecting balance sheet restructurings, such as where the debtor and its lenders agree to swap out existing debt in exchange for equity in the reorganized enterprise.

Because the entire purpose of a “prepackaged” plan is to allow the debtor to spend as little time in bankruptcy as possible, the debtor and the supporting lenders usually attempt to avoid delays and objections.  Such plans therefore will often provide for payment in full to general unsecured creditors.  By treating such creditors as “unimpaired” under the plan, their acceptance of the plan can be assumed, the time and expense of soliciting their votes can be forgone, and objections to the plan are minimized. 

Sbarro and Quiznos, however, are both deviating from this approach.  The plans in both cases are “cramdown” plans.  Quiznos’s plan provides a minimal recovery, and Sbarro’s provides nothing, for general unsecured creditors.  The time and expense of solicitation can still be forgone, because the assumption here is that such creditors are rejecting the plan.  Sbarro and Quiznos intend to ask the bankruptcy judges in their respective cases to approve their plans notwithstanding the presumed rejections (i.e., “cram down” the plan).  Both companies will contend that recent severe declines in revenues have reduced the value of their respective enterprises by so much that senior creditors are receiving far less than what they are owed, and no value can flow down to general unsecured creditors.

Unsecured creditors in both cases, unsurprisingly, can be expected to object vehemently.  Opponents of the Sbarro and Quiznos plans will use all arguments at their disposal to derail confirmation of the plans.  The valuation assumptions will be challenged, as will Sbarro’s and Quiznos’s assertions that they have satisfied the numerous requirements for plan confirmation under Section 1129 of the Bankruptcy Code.            

Plan confirmation can be difficult and time-consuming even where consensus exists among creditor constituencies.  Therefore, in recent years most chapter 11 cases of so-called “melting ice cube” companies such as Sbarro and Quiznos have involved quick sales under Section 363 of the Bankruptcy Code in order to preserve a debtor’s going concern value.  For the lenders who wind up taking control of these business enterprises, however, there can be numerous advantages obtained from confirming a plan of reorganization (for example, valuable tax attributes can often be preserved).  In seeking quick confirmation of a non-consensual plan, lenders are effectively making a bet that Sbarro and Quiznos are at this point in such poor shape that there will be no way for unsecured creditors to argue successfully for a share of enterprise value, and that there will be no other valid arguments against plan confirmation that can be asserted.

Detroit’s Proposed Plan of Adjustment – Two Crucial Questions

Posted in Chapter 9

The chapter 9 bankruptcy case of the City of Detroit has been as complex and litigious as anticipated.  Nevertheless, Emergency Manager Kevyn Orr has kept plodding forward, and last week filed a proposed plan of adjustment, the road map for the Motor City to emerge from bankruptcy.  There are two key components to the plan.  The first is that it will seek to inflict somewhat less pain on retired employees than on bondholders.  The second is that it will direct approximately $1.5 billion towards Detroit’s future rather than to the payment of creditors.    

 While the plan raises numerous issues on top of the thorny disputes with which Detroit and its creditors are already grappling, these components of the plan raise two fundamental questions that go to the heart of what municipal bankruptcy may be able to accomplish: how much disparate treatment of different creditor classes can be tolerated, and to what extent can the city invest in its own future, rather than pay back creditors?  The plan will be the subject of intense negotiations over the next few months, and is almost certain to be revised substantially.  However, if Mr. Orr cannot reach deals with the City’s retirees and bondholders, these questions will be at the forefront of the issues that Judge Steven Rhodes will need to adjudicate.        

 The Bankruptcy Code provides that a plan may not “unfairly discriminate” among classes of creditors holding claims of equal priority.  So what level of discrimination is fair?  The Detroit plan proposes to pay police and fire retirees approximately 90% and general retirees approximately 70% of their earned pensions (in both cases after elimination of cost of living allowances).  The holders of general obligation bonds, on the other hand, are slated to receive approximately a 20% recovery.  Emergency Manager Orr will contend that such discriminatory treatment is not “unfair”, given the competing equities between the retirees and the bondholders arising from the probable hardships that retirees will face from pension reductions.  The bondholders are likely to have a different view

 The plan must also be “in the best interests of creditors”.  In a corporate bankruptcy, satisfying this requirement is fairly straight-forward: creditors must receive more under a reorganization than if the debtor were to be liquidated.  A municipal debtor, however, cannot be liquidated, so the determination of what constitutes the “best interests of creditors” in a chapter 9 case is much more nebulous.  The Detroit plan contemplates spending $1.5 billion over ten years on essential infrastructure spending and on fostering growth and redevelopment.  Detroit has seen impressive private sector growth over the last several years, but its ability to once again be a thriving municipality (albeit on a far smaller scale than in its heyday) depends on its ability to emerge from the chapter 9 process with a debt structure that fits its reduced size, and with sufficient free cash to support at least a minimum threshold of functionality.  It’s a noble vision; however, it may not be one that can be deemed to be “in the best interests of creditors”, who will argue that the City’s future should not be funded on their backs. 

 There are numerous other hurdles for the Detroit plan.  A deal on the termination of certain interest rate swap obligations that would free up crucial casino revenues must be reached. Bondholders will additionally argue against the proposal that seeks to monetize the collection of the Detroit Institute of Art and use the proceeds to shore up the City’s pension funds.  The retirees, notwithstanding their proposed favorable treatment, have not yet agreed to any reductions in their pensions, and are appealing the ruling of Judge Rhodes late last year that not only found Detroit eligible for chapter 9 protection, but also held that the City’s pension obligations could be impaired in a federal bankruptcy proceeding.     

 These are fascinating and complex issues in their own right.  However, it is the resolution of the two overarching questions that will largely determine the extent to which Detroit’s chapter 9 case can ultimately provide a model for future municipal bankruptcy cases. 

Fisker Automotive Chapter 11 Case: a Two-Headed Stalking Horse and a New Credit Bidding Controversy

Posted in Distressed M&A

Fisker Automotive’s chapter 11 case began in what has become a depressingly familiar fashion – a fast-tracked sale to a secured lender.  However, two rulings by Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware have made this a fascinating case to follow.  Judge Gross has directed  Fisker to proceed with an auction in which two bidders have been granted “stalking horse” status on the same assets.  He is also limiting the ability of one of the bidders to credit bid its secured debt, a determination that could give rise to a new controversy on an issue that appeared to have been resolved two years ago with the Supreme Court’s RadLax decision

Back in 2010, Fisker obtained capital from the U.S. Department of Energy (“DOE”) in the form of secured debt to support its development of electric automobiles.  In October 2013, Hybrid Tech Holdings LLC (“Hybrid”) bought the outstanding DOE debt, paying only $25 million for DOE’s position of $165 million.  In late November, Fisker filed its chapter 11 case for the purpose of effecting a quick sale of its assets to Hybrid in exchange for a credit bid of Hybrid’s recently-acquired secured debt.  Fisker’s creditors’ committee objected to the sale and located another potential bidder, Wanxiang America Corporation (“Wanxiang”).  The committee also objected to Hybrid’s right to credit bid. 

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 has always permitted courts to limit the right to credit bid “for cause”, a term not defined but 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 creditors right to credit bid in the absence of “cause” in the Philadelphia Newspapers case.  That decision was effectively overruled by the Supreme Court’s ruling in RadLax.    

In Fisker, Judge Gross agreed with the committee’s contention that “cause” exists to limit Hybrid’s credit bid to the $25 million that it paid for the DOE secured debt.  However, the basis for his ruling is not entirely clear.  There appears to be a bona fide dispute as to the extent of Hybrid’s liens on Fisker’s assets; at least a portion of the assets that will be sold may not be encumbered by Hybrid’s liens.  If that is the case, then Hybrid should not be able to use its debt to pay for such unencumbered assets, and Judge Gross’s decision would be unremarkable. 

But Judge Gross also stated that he found “cause” to limit Hybrid’s right to credit bid because “bidding will not only be chilled without the cap; bidding will be frozen.”  Finding “cause” to limit credit bidding on that basis would be a much broader reading of the term.  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 that value the secured creditor believes the collateral has.  Forcing a secured creditor to pay cash for an asset on which it already has a valid lien is a somewhat superfluous exercise, since if the secured creditor wins the auction it would be writing a check to itself.    

In another unusual decision, Judge Gross has ruled that both Hybrid, which has changed its bid to $30 million in cash in addition to its $25 million credit bid, and Wanxiang, which is offering $35 million in cash plus 20% of the equity in the reorganized debtor, are entitled to have stalking horse status.  This means that they will each receive a break-up fee of $750,000 if a third party comes in with a topping bid. 

Even as Hybrid is participating in the auction with its revised offer, it is seeking an immediate appeal of Judge Gross’s decision that “cause” exists to limit its right to credit bid.  What makes this case all the more interesting is the possibility that Hybrid’s appeal will at some point be heard by the Third Circuit Court of Appeals, the same court that issued the Philadelphia Newspapers decision.

Judge Slams Bankruptcy Trustee’s Suit to Recover Parochial School Tuition Payments

Posted in Bankruptcy

A parochial elementary school and high school were recently sued in the U.S. Bankruptcy Court for the Eastern District of New York by Robert Geltzer, a bankruptcy trustee.  The suits, Geltzer v. Our Lady of Mt. Carmel-St. Benedicta School and Geltzer v. Xavarian High School, were brought in an effort to recover tuition payments made by a student’s parents who had later filed for bankruptcy. (Kelley Drye & Warren LLP represented Our Lady of Mt. Carmel-St. Benedicta School on a pro bono basis).  Judge Carla Craig, the U.S. Bankruptcy Judge before whom the cases were argued, wrote an opinion granting motions to dismiss that appropriately rejected the trustee’s legal arguments and that should deter other such cases from being brought.

Geltzer sought to have the payments avoided as “fraudulent conveyances”.  Transactions undertaken by people or companies when they are insolvent, and for which they received less than “reasonably equivalent value”, can later be unwound by a bankruptcy court, which can require the funds or assets transferred by the debtor to be paid over to a bankruptcy trustee.  Geltzer’s theory in the Mt. Carmel-St. Benedicta and Xavarian cases was straight forward – the tuition paid by the parents before they filed for bankruptcy were “fraudulent conveyances” because the parents received no benefit from the payments; only the debtors’ children received any actual “value”, in the form of the education that they, and not the parents, received. Geltzer therefore claimed the right to sue the schools and recover the payments.

The lawsuits appeared at first glance to be frivolous to the point of warranting sanctions.  Surprisingly, however, there were no precedent cases explicitly against Geltzer’s position.  Moreover, he was able to cite to two similar cases involving college tuition payments, made by parents on behalf of adult children, that provided at least a veneer of support for his argument.

In their motions to dismiss, Mt. Carmel-St. Benedicta and Xavarian both made similar contentions.  The implications of Geltzer’s position were disturbing.  If his theory were correct, then virtually any expenditures on behalf of a minor son or daughter, made by parents who were later to file for bankruptcy, could subsequently be challenged and recovered by a bankruptcy trustee.

The troubling potential ramifications of Geltzer’s argument aside, the schools strongly attacked his arguments that no “value” was received by the parents for paying school tuition for their children.  The Second Circuit Court of Appeals ruled in a tax case many years ago that a parent could not claim a charitable tax deduction for parochial school tuition “because the [parent] expects, and in fact receives, a definite economic benefit” for the payments.  In another highly analogous case, a bankruptcy trustee sought to recover residential mortgage payments made by a man who voluntarily paid the mortgage for the house in which his acknowledged minor son and the boy’s mother lived.  The bankruptcy court in that case rejected the trustee’s argument that the man could only have received “value” for the mortgage payments if he were legally obligated to make them, noting that the debtor received “reasonably equivalent value” from the “psychic and other intangible benefits that he received from payments that he . . . made for the benefit of [his] child.”

At the hearing, Judge Craig made no secret about how she viewed the lawsuit, at various points characterizing Geltzer’s positions as “ridiculous” and “absurd”.  Her opinion, while slightly more measured than her comments during oral argument, dismissed Geltzer’s claims as “based on a fundamentally flawed legal theory that is . . . at odds with common sense.” There could be no parsing out the value received for the tuition payments, “because the Debtors and their minor children must be viewed as a single economic unit for these purposes.” She then went even further, noting that parents are legally obligated to provide their children with life’s necessities, and their choices cannot be subjected to later review by bankruptcy trustees.  “The fact that they chose [to send] their children to private or parochial school . . . does not render the payments subject to scrutiny by the Trustee for avoidance, any more than the Trustee would be entitled to second-guess other choices made by debtors pre-petition in providing clothing, food [or] shelter . . . to their minor children.”

Before Judge Craig’s ruling, Geltzer had sent letters to several other parochial and private schools in the New York area, demanding the return of tuition payments.  While Geltzer’s legal argument against Mt. Carmel-St. Benedicta and Xavarian perhaps may have fallen just short of frivolous in narrow legal terms, it was, as Judge Craig made clear, “at odds with common sense”.  Her opinion disposed of it appropriately and should prevent similar cases from being commenced.

Heard About Detroit? The First Word on Treatment of Public Employee Pension Benefits in Chapter 9 (And Absolutely Not the Last)

Posted in Chapter 9

Last week’s ruling by Judge Stephen Rhodes finding the City of Detroit eligible for protection under Chapter 9 of the U.S. Bankruptcy Code has rightly received considerable attention. The determination that Detroit has met the standards under Section 109(c) of the Bankruptcy Code to be a debtor under Chapter 9 was widely expected. The surprising part of the opinion lies in Judge Rhodes’s express ruling that the pension rights of Detroit’s current and former public employees are simple contractual obligations that may be subject to impairment in bankruptcy. Uncertainty regarding the appropriate legal treatment of pension obligations, and the Tenth Amendment implications in connection therewith, has been a crucial overhanging issue in Chapter 9 municipal bankruptcy cases for several years, and Judge Rhodes’s opinion is the first opinion directly to address it.

In Judge Rhode’s view, Michigan’s public pension rights are not vested property interests, but instead are contractual rights.

The [Michigan] constitution could have given pensions protection from impairment in bankruptcy in several ways. It could have created a property interest that bankruptcy would be required to respect . . . Or, it could have established some sort of a secured interest in the municipality’s property. It could even have explicitly required the State to guaranty pension benefits. But it did none of these.

Instead, both the history . . . and the language of the pension provision . . . make it clear that the only remedy for impairment of pensions is a claim for breach of contract.

As such, Judge Rhodes held that public pension rights may be impaired in bankruptcy, similar to rights arising under any other contract. Judge Rhodes saw no abrogation of the Tenth Amendment, which reserves to states rights not granted to the federal government under the Constitution, because the State of Michigan had expressly authorized municipalities to seek protection under Chapter 9.

Impairing contracts is what the bankruptcy process does. . . For Tenth Amendment and state sovereignty purposes, nothing distinguishes pension debt in a municipal bankruptcy case from any other debt.

The importance of Judge Rhodes’s opinion should not be understated, but at the same time it should not be overstated. His analysis is detailed and well-reasoned. However, the extent to which it will affect or apply to pension obligations in other cities and states, particularly in the California cases where similar issues have been playing out, remains very much an uncertainty. Judge Rhodes’s opinion relied on a detailed parsing of the Michigan statutes and the provisions in the Michigan state constitution, which by itself could limit its applicability.

Other courts are going to weigh in, beginning with the U.S. Court of Appeals for the Sixth Circuit, which will probably hear a direct appeal of Judge Rhodes’s decision. It is likely that at least one court will come to a different conclusion, either due to different underlying facts or a good faith disagreement with Judge Rhodes’s analysis. It is a near certainty that this issue will ultimately wind up before the Supreme Court.

Interesting ResCap FactOID – Court Rejects Effort to Disallow Portion of Bond Claims Based on “Original Issue Discount”

Posted in Chapter 11

In an opinion that will have a significant impact on the viability of debt for debt exchanges and out of court restructurings, Judge Martin Glenn of the U.S. Bankruptcy Court for the Southern District of New York has refused in the Chapter 11 case of Residential Capital LLC (“ResCap”) to disallow a portion of the claims of a class of junior secured noteholders (the “JSNs”) that constituted unamortized “original issue discount” arising from a fair market value exchange of notes several years earlier.  (Kelley Drye & Warren LLP represents the indenture trustee for the JSNs).  A contrary ruling would have cast a shadow over such exchanges and would make out of court restructurings far more difficult to achieve.  Judge Glenn’s opinion resolves a long-standing question left from the landmark Second Circuit Court of Appeals decision over twenty years ago in LTV Corp. v. Valley Fidelity Bank & Trust Company (In re Chateaugay Corp.).

“Original issue discount”, or “OID, typically arises when a bond is issued in a face amount that exceeds the amount actually paid by the purchaser.  The difference represents the interest on the bond.  Such notes are often referred to as “zero coupon bonds” because although the OID amortizes over the life of the bond, the interest does not get paid to the holder of the note until the date the note matures and becomes due.  Since Section 502(b) of the Bankruptcy Code disallows claims for “unmatured interest”, bankruptcy courts have disallowed claims arising from unamortized OID.

The IRS has determined that OID also arises for tax purposes in debt exchanges in which the old notes given up are worth less than the new notes issued.  Financially distressed companies often solicit such exchanges in the hope of obtaining financial relief and thereby avoiding the costs and disruptions of a Chapter 11 case.  Some exchanges are for notes in the same face amount (usually with reduced interest rates or extended maturities) and are referred to as “face value” exchanges.  Other debt exchanges involve the issuance of new notes with a principal amount that more closely reflects the market value of the old notes, thereby lessening the amount of debt on the issuer’s balance sheet.  These are referred to as “fair market value” exchanges.

In Chateaugay, the Second Circuit declined to reduce the claims of noteholders who had exchanged their notes in a face value exchange, ruling that in such situations unamortized OID should not be disallowed as “unmatured interest” under Section 502(b).  The court held that disallowing unamortized OID as unmatured interest would discourage out of court debt exchanges, and “would likely result in fewer out-of-court debt exchanges and more Chapter 11 filings.”  However, the Second Circuit expressly declined to extend its holding to fair market value exchanges, stating that it “might make sense” to treat unamortized OID as unmatured interest “where the corporation’s overall debt obligations are reduced.”

ResCap presented this precise situation.  In 2008, ResCap and its affiliates were reeling from the mortgage crisis.  In an effort to stave off bankruptcy and wishing to reduce the debt on its balance sheet, ResCap solicited a fair market value exchange in which it exchanged $6 billion in old notes for approximately $4 billion of new JSNs.

Over five years later, ResCap and its official committee of unsecured creditors (the “Committee”) were locked in a confirmation battle over the recovery to which the JSNs are entitled under ResCap’s plan of reorganization (the “Plan”).  In addition to battling over the value of the collateral securing the JSNs, the Committee commenced an adversary proceeding, raising the issue left unanswered by Chateaugay and seeking a determination that the JSNs’ claims should be reduced, arguing that the unamortized OID arising from the 2008 fair market value exchange should be disallowed as unmatured interest.

Judge Glenn, however, rejected the Committee’s effort to draw a distinction between face value exchanges and fair market value exchanges, and ruled that the Second Circuit’s holding in Chateaugay should apply equally to unamortized OID arising from both.  Judge Glenn noted that the only feature of a note that cannot be modified in a face value exchange is the principal amount of the debt.  Otherwise, in both face value exchanges and fair market value exchanges, the new notes offered may, among other things, be secured by new or additional collateral, have modified interest rates and maturity dates, be granted seniority of payment over other obligations, and enhanced by affiliate guaranties.  Accordingly, Judge Glenn determined “that there is no meaningful basis upon which to distinguish between the two types of exchanges.”

The Second Circuit stated in Chateaugay that if claims for unamortized OID arising out of face value exchanges were disallowed, “then creditors will be disinclined to cooperate in a consensual workout that might otherwise have rescued a borrower from the precipice of bankruptcy.”  A ruling that unamortized OID arising from fair market value exchanges should be treated differently would similarly have made successful out of court workouts much harder to achieve.  Judge Glenn’s extension of Chateaugay’s logic to apply with equal force to fair market value exchanges will make out of court workouts and restructurings easier for distressed companies to undertake.

Stockton Bankruptcy Settlement Preserves Pensions

Posted in Chapter 9

The Chapter 9 bankruptcy case of Stockton, California has come to an unexpectedly quick and consensual resolution. The outcome here, which will see the city’s pension obligations maintained, is particularly surprising given the vehement opposition of Stockton’s bond insurers at the outset of the case. The bond insurers, who backstopped approximately $240 million of the city’s debt, contested Stockton’s eligibility for Chapter 9 protection. They claimed that the city’s failure to engage in negotiations with Calpers, the California public employee pension system, prior to filing its petition demonstrated a lack of “good faith” that required the dismissal of Stockton’s bankruptcy case. Although they lost that battle, comments made at the time by Judge Christopher Klein suggested that Stockton would have difficulty obtaining approval of a plan of adjustment unless it directly confronted its pension obligations.

Uncertainty regarding the proper appropriate legal treatment of pension obligations has become a crucial overhanging issue in Chapter 9 municipal bankruptcy cases. Plans of adjustment for municipal debtors, similar to plans of reorganization for corporate debtors, prohibit “unfair” discrimination among classes of similarly situated creditors. The Stockton case looked to be an excellent opportunity for the bond insurers to show that any preferential treatment afforded Calpers in a Chapter 9 case is precisely the type of “unfair” discrimination that the Bankruptcy Code forbids. Calpers has been equally eager for this battle in order to establish that such discrimination is not “unfair”, as the protections for public employee pension obligations under California law mandate such different treatment. The bondholders argue that this type of state law preferential treatment is trumped by federal law under the Bankruptcy Code, while Calpers contends that the preference under California law for public employee pension obligations is protected under the Tenth Amendment.

The anticipated bare-knuckled courtroom brawl has given way, however, to a settlement that will keep in place the current pension benefits while terminating health insurance for most of Stockton’s retirees. Stockton’s bond insurers are accepting reduced recoveries on the bonds. The key to the settlement is an increase in the sales tax in Stockton from 8.25 percent to 9 percent that is intended to raise about $300 million over 10 years, and will allow the city to rehire police officers and public safety workers. The tax increase was approved by Stockton voters last week.

The showdown between the bond insurers and Calpers has been averted for the time being. However, similar issues are brewing in the Chapter 9 bankruptcy of San Bernadino, California, and other California cities may also seek Chapter 9 protection in order to challenge Calpers. After that looms Detroit, whose unions are claiming similar pension protections under Michigan law. The good news for aficionados of legal contretemps is that it remains highly probable that battle will be joined on this front sooner rather than later.

As Madoff Five Year Anniversary Approaches, Investors Denied Time-Based Damages

Posted in Bankruptcy

Two months from now will bring the five year anniversary of the unraveling of Bernie Madoff’s Ponzi scheme, one of the bookends, along with the collapse of Lehman Brothers., of the extraordinary Fall of 2008. To date, Trustee Irving Picard has recovered over $9.5 billion through litigation and settlements and distributed over $4.7 billion to former Madoff customers. 

Since its commencement, the Securities Investor Protection Act (SIPA) proceeding for Bernard L. Madoff Investment Securities LLC (BLMIS) has seen a vast array of legal battles, ranging from the Trustee’s aggressive pursuit of the owners of the New York Mets to disputes testing the international reach of the U.S. Bankruptcy Courts. At its heart, however, the BLMIS case, as with all SIPA proceedings, has been about the recovery of “customer property” for the satisfaction of “net equity claims of customers.” To that end, the Trustee has had to address three crucial questions under SIPA:

·          how to determine customer “net equity claim” amounts, which are supposed to be based on the liquidation value of the securities positions of each customer as of the filing date, when such securities never existed;

·          exactly who is a “customer”; and

·          whether “net equity claims” include damages based on the time value of money. 

Judge Burton Lifland resolved the first two questions in the Trustee’s favor earlier in the case. In the absence of securities whose liquidation value could have been determined, the Trustee put forward, and Judge Lifland approved, the “Net Investment Method” for determining “net equity claims”, subtracting amounts withdrawn from total amounts deposited for each customer and denying claims based on Madoff’s fabricated account statements.  Judge Lifland also ruled in favor of the Trustee’s determination to deny “customer” status to clients of so-called “feeder funds”, holding that only investors who maintained an account at BLMIS constituted “customers” under SIPA. Both rulings were subsequently upheld by the Second Circuit Court of Appeals. 

A few weeks ago, Judge Lifland handed down a decision on the final issue, holding that “net equity claims” do not include damages for interest, inflation adjustment, or otherwise based on the time value of money. In affirming the Trustee’s position (against which $1.4 billion has been reserved), Judge Lifland looked to both the plain language of SIPA and the Act’s underlying purposes. 

First, Judge Lifland noted the absence of any language in the applicable SIPA provisions that would support the inclusion of time-based damages, and contrasted such silence with language in other parts of SIPA and different statutes in which Congress expressly provided for interest payments or inflation adjustments. Next he looked at SIPA’s intent of satisfying “customer expectations”. In Judge Lifland’s view, BLMIS customers could not have had legitimate expectations of receiving any compensation for the period in which their money was invested with BLMIS: 

When they invested in Madoff, they bargained for a market-driven investment designed to fluctuate with the performance of the market; they did not bargain for a contractually guaranteed interest rate or inflation-protected investment vehicle.       

Finally, he looked to the statutory framework of SIPA. He noted that SIPA gives priority to claims based on the recovery of “customer property”, but does not provide specific protection for claims based on broker malfeasance or fraud: 

It was Madoff’s continuous fraudulent activity . . . that misled customers into leaving their investments with BLMIS for extended periods of time . . . Such claims do not constitute net equity claims to be paid out from the customer fund. 

As with the litigation over the Trustee’s Net Investment Method for calculating net equity claims and the denial of “customer” status to investors in feeder funds, Judge Lifland’s decision will go up to the Second Circuit. Judge Lifland even indicated that he would look favorably on a motion for certification of a direct appeal. A ruling by the Second Circuit will fully resolve the last of the three key questions under SIPA and, after five years, permit the case arising from the largest Ponzi scheme in history to follow Lehman Brothers toward its conclusion.

Auto-Hauler Allied Systems Holdings’ Car Wreck of a Chapter 11 Case May Finally Be at an End

Posted in Chapter 11

Many commentators have remarked that a “new normal” has evolved for Chapter 11 proceedings, wherein the major constituents negotiate the salient terms and exit strategy of the debtor’s restructuring prior to the filing of the bankruptcy petition, generally leading to shorter, less litigious cases. This dynamic, often evidenced by a plan support agreement, a proposed sale of assets under Section 363 of the Bankruptcy Code, or a pre-packaged plan of reorganization for which creditor approval has already been solicited and obtained, has led to expeditious resolutions in many recent large and complex corporate restructurings.   

Allied Systems Holdings clearly did not get the memo.   

Its Chapter 11 case, now in its sixteenth month, has been a scorched-earth battleground featuring internal fights among its first lien lenders, conflicts between its secured and unsecured creditors, and litigation brought by its creditors’ committee against its major shareholder. 

Allied Systems Holdings emerged from an earlier Chapter 11 case several years ago with a new senior credit facility and controlled by private equity firm Yucaipa. As Allied’s business was negatively affected by the downturn of the U.S. automobile industry, Yucaipa began buying up Allied’s first lien debt. This led to a pitched battle between Yucaipa and two of the first lien lenders, Black Diamond Capital Partners and Spectrum Investment Partners.  Those firms contended that the loan document terms had been specifically intended to prevent Yucaipa, as Allied’s controlling shareholder, from gaining control of the first lien debt as well. Yucaipa countered that the first lien loan documents had been properly amended to permit it to make the purchases. The dispute ultimately led to the filing of an involuntary bankruptcy petition against Allied by Black Diamond and Spectrum in May 2012.

The conflict continued to play out in both the bankruptcy court and New York state court, and was not resolved until late July of this year, when Judge Christopher Sontchi of the U.S. Bankruptcy Court for the District of Delaware ruled in favor of Black Diamond and Spectrum.          

In the meantime, Allied’s creditors’ committee also sued Yucaipa, alleging that Yucaipa sought to advance its own interests at the expense of Allied’s general unsecured creditors, and seeking the recharacterization or subordination of Yucaipa’s claims. Although a motion seeking approval of a proposed settlement has been filed, Black Diamond and Spectrum have objected to it and it remains pending. 

Mediation efforts aimed at resolving the numerous disputes appeared to succeed earlier this summer, with the approval of an auction process that was scheduled for mid-August. A $105 million bid (consisting of $40.5 million in cash and a credit bid of $64.5) from Black Diamond and Spectrum, now ensconced as the “requisite lenders” in control of the first lien debt, was declared the winning bid. 

Rather than leading to peace among the parties, however, a new round of hostilities broke out when the creditors’ committee objected and moved for a new auction, arguing that the auction failed to comply with the bidding procedures and that a competing all cash $100 million bid from a strategic bidder, Jack Cooper Transport Co., was actually a “higher and better” offer for Allied’s assets. When Jack Cooper thereafter submitted a new bid in the amount of $135 million, Allied effectively threw up its hands and joined in the committee’s request for the auction to be reopened. 

A new auction was held on September 11, at which Jack Cooper’s new bid, consisting of $125 million in cash and $10 million in notes, was determined to be the winning bid. The proposed sale to Jack Cooper bid was approved yesterday by Judge Sontchi.    

Allied’s Chapter 11 case has unquestionably been an outlier, bucking the recent trend towards prepackaged or pre-negotiated cases that are concluded in months, and sometimes weeks. It remains to be seen if the sale to Jack Cooper will finally bring about a consensual resolution to these long-running proceedings.

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