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.

Were the Energy Future Holdings and Caesars Chapter 11 Cases Just Saved by K Street Lobbyists?

Bankruptcy and restructuring professionals usually do not need to be political junkies. Amendments to the Bankruptcy Code, and the accompanying machinations of the Congressional legislative process, typically occur at a glacial pace, and such changes nearly always affect future rather than current chapter 11 cases.  However, the federal tax and spending bill approved by Congress earlier this month, passed in the usual whirlwind of year-end activity and horse trading, nearly derailed the pending reorganizations of two of the largest chapter 11 cases ever filed, Energy Future Holdings Corp. (“EFH”) and Caesars Entertainment Operating Company (“Caesars”).  (Kelley Drye & Warren LLP represents creditors of both EFH and Caesars, but has had no involvement in the matters discussed here.)

The bill initially contained language intended to eliminate certain tax advantages of real estate investment trusts (“REITs”).  Such structures are central components of the chapter 11 plans for both enterprises.  Had the bill passed with the language unmodified, it could have been devastating for both companies.  The blow would have been particularly keen for EFH, which only a few days earlier had succeeded in getting its plan of reorganization confirmed, following months of work by an army of bankruptcy professionals and a multi-day hearing.  The proposed REIT limitation language could have prevented the plan from ever becoming effective.

REITs are entities designed to hold real estate assets and provide investors with numerous tax breaks.  The EFH plan is centered around an unusual strategy of permitting certain creditors to invest in a new REIT structure to take control of EFH’s public utility assets, an approach projected to attract enough new capital to pay most of EFH’s remaining creditors in full immediately upon the effectiveness of the Plan.  Although the Caesars case remains mired in contentiousness and is at best several months away from having a plan confirmed, all plans proposed to date in Caesars have similarly been centered on transferring various hotel and casino properties to a REIT structure.

In recent years, a number of companies with substantial real estate assets, such as Sears and Darden Restaurants (owner of the Olive Garden chain), have transferred those assets into REITs and then leased them back, moves that have resulted in aggregate tax savings of over $21 billion. Certain members of Congress view these types of transactions as an abuse of the REIT structure, and inserted provisions in the tax and spending bill designed to curb them.

The REIT limitation language was contained in the initial version of the tax and spending bill that was released on December 7. It is unlikely that more than a handful, if any, of the bankruptcy professionals in the EFH and Caesars cases were aware of the threat posed by the tax and spending bill (and a review of bankruptcy-related news services turns up no mention of the REIT limitation proposal), but business persons at both EFH and Caesars spotted the danger.  Lobbyists for both companies immediately began pressing the case that any changes to the tax benefits of REITs should be prospective only, as it would have a huge negative impact on several companies to disrupt deals that had already been announced.  A crucial ally was found in Sen. Harry Reid of Nevada, a state heavily reliant on the strength of the gaming industry and therefore the continued viability of Caesars.

Sen. Reid also sought unsuccessfully to help Caesars by adding language to the tax and spending bill which would have amended another federal statute, the Trust Indenture Act (“TIA”).  The proposed TIA change was intended to defuse a litigation threat to Caesars, but it drew significant opposition from numerous financial institutions, hedge funds and academics, and was removed.  Withdrawing the proposed TIA amendment language may have given Sen. Reid a bargaining chip to push through the necessary protective fix with respect to the REIT proposal.  In any event, by the time the bill made it to President Obama’s desk for signature on December 18, an additional fifty-four words that insulated EFH and Caesars had been inserted to the language governing the REIT changes:

The amendments made by this section shall apply to distributions on or after December 7, 2015, but shall not apply to any distribution pursuant to a transaction described in a ruling request initially submitted to the Internal Revenue Service on or before such date, which request has not been withdrawn and with respect to which a ruling has not been issued or denied in its entirety as of such date.

The threat to the REIT transactions for EFH and Caesars was averted and, for EFH creditors especially, it remained a merry Christmas.

GM Judge Nuances His Earlier Rulings and Sets Out Permissible Ignition Switch Lawsuits

At a hearing in late August, Judge Robert Gerber expressed his annoyance with both sides in the ongoing battle to determine whether General Motors LLC (“New GM”), the entity formed in 2009 to acquire the assets of General Motors Corporation (“Old GM”), is shielded from lawsuits based on ignition switch defects in cars manufactured prior to New GM’s acquisition of the assets of Old GM in 2009. He chastised the parties for being “insufficiently nuanced” in their interpretations of his decisions earlier this year on the extent to which New GM could face liability for economic damages stemming from the defects, which allegedly caused numerous deaths and injuries, and which were known by employees of Old GM but were not properly reported (or may have been deliberately covered up).

Not surprisingly, a lengthy opinion issued by Judge Gerber last week on two crucial ancillary issues – could knowledge of Old GM regarding the scope of the ignition switch defects be attributed to New GM, and, relatedly, whether New GM is liable for punitive as well as compensatory damages – was an exemplar of nuance.  Judge Gerber finely parsed those questions and made subtle but meaningful distinctions between Old GM actions, which cannot be a basis for New GM liability, and knowledge of Old GM that became knowledge of New GM under principles of imputation and for which New GM could be liable.  (Kelley Drye & Warren LLP represents certain major creditors of Old GM but has had no role in these proceedings.)

As widely reported, Judge Gerber previously ruled that most of the lawsuits against New GM are barred by the provisions of the Sale Order he entered at that time, which transferred the assets to New GM “free and clear” of claims against Old GM (other than a narrow range of expressly assumed liabilities) and protected New GM from any claims based on theories of successor liability.  However, he also held that New GM could not claim protection under the Sale Order against liabilities based solely on its own post-sale conduct, and said that he would permit lawsuits in other courts based on such allegations against New GM to move forward.  The August hearing was held to determine which of the pending actions satisfied Judge Gerber’s requirement of being independent claims against New GM.

At the end of that hearing, Judge Gerber directed counsel for New GM to submit to him marked copies of the complaints in the pending lawsuits, showing specifically which causes of action New GM believes are grounded in the behavior of Old GM and should be barred by the Sale Order. He also requested briefs with regard to the issues of imputation of knowledge and punitive damages.  Judge Gerber was determined, as he put it at a subsequent hearing in October, to fulfill the role of “gatekeeper” in terms of construing the Sale Order and his opinions from earlier this year, and to decide once and for all (albeit subject to appeals) the types of claims which could get past the “bankruptcy gate” and proceed in other courts.

Judge Gerber made clear during the October hearing just how narrow a needle’s eye he intended to thread.  He stated that he would have no tolerance for causes of action based on theories of successor liability, no matter how they might be “dressed up” to resemble something different.  On the other hand, he also said that independent claims against New GM could be based on “inherited” knowledge.  The distinction would depend on the specificity of the allegations of knowledge and the rules governing imputation under the state law governing each specific action.

Thus, for example, Judge Gerber ruled in last week’s opinion that any causes of actions referring to New GM as a “mere continuation” of Old GM, or that elided the distinctions between Old GM and New GM, would be barred as grounded in successor liability.  Claims stating that “New GM knew,” however, would be permitted to go forward and satisfy a high but by no means impossible standard:

[P]laintiffs will have to prove the New GM knowledge they allege, on the part of identified human beings, and by identified documents to the satisfaction of . . . any . . . court hearing those claims – and by competent proof, not on theories that New GM was a “successor” to Old GM.

Judge Gerber applied a similar analysis to the issue of punitive damages. While making clear that punitive damages could not be based on the knowledge or conduct of Old GM, “or anything else that took place at Old GM[,]” and had to be based on “New GM knowledge and conduct alone[,]” he nevertheless also ruled that “New GM might have acquired relevant knowledge when former Old GM employees came over to New GM or New GM took custody of what previously were Old GM records.”  But the plaintiffs would need to show that such knowledge was “acquired in fact, and not by operation of law (such as any kind of successorship theory).”

Judge Gerber emphasized that imputation and punitive damages were ultimately matters to be determined under applicable nonbankruptcy law, and that he was not making any substantive rulings on these issues:

[The Court] has ruled simply that allegations of imputation to New GM premised on the knowledge of New GM employees, or documents in New GM’s files, get through the bankruptcy gate. After that, issues as to the propriety of imputation in particular contexts in particular cases are up to the judges hearing those cases.

It was clear from Judge Gerber’s earlier rulings that New GM would be required to defend itself in lawsuits that seek damages based solely on New GM’s post-sale actions and conduct, and the fact that such claims would possibly involve automobiles or parts manufactured by Old GM would not provide New GM with a shield under the Sale Order. Last week’s decision splits innumerable hairs, but delineates the extent to which the Sale Order protects New GM and the hurdles that the plaintiffs will need to clear to the satisfaction of other judges in order to get their claims past the bankruptcy “gate.”

Energy Future Holdings – Kicking a Very Large Can Down the Road

Energy Future Holdings (“EFH” or “Debtors”) has cleared all of the preliminary hurdles in its path as it moves towards the confirmation of its plan of reorganization (the “Plan”). Last week Judge Christopher Sontchi of the United States Bankruptcy Court for the District of Delaware approved the Debtors’ disclosure statement in support of the Plan, authorized the Plan to be distributed to creditors for voting purposes, and scheduled the hearing on Plan confirmation to begin on November 3. In view of the complexity and contentiousness of these cases, bringing them to the verge of completion in less than eighteen months is a notable achievement for EFH and its professionals.

The final step, however, will be by far the toughest. EFH has reached this point mainly by successfully deferring the battle on certain crucial issues. In order to gain Judge Sontchi’s approval of the Plan and overcome the strong objections of key parties, EFH will need to show, among other things, that the Plan is “feasible,” and that under its terms many of its largest creditors will be “unimpaired.” These requirements will be the focal point of a proceeding that, absent an unexpected settlement, is expected to take several weeks. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but will not be taking any position on the issues discussed here.)

EFH entered bankruptcy in April 2014 with over $42 billion in claims, and for most of the time since then these cases have looked to be among the most intractable 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). For the first year of these cases, 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.

Over the past summer, 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, an approach projected to attract enough new capital to pay all E side creditors in full in cash immediately upon the effectiveness of the Plan. Such treatment of the E side creditors would render them “unimpaired” under section 1124 of the Bankruptcy Code, meaning that the Plan would not alter their “legal, equitable and contractual rights.” Unimpaired creditors are presumed to support a plan of reorganization and are not entitled to vote to approve or reject it.

The E side creditors, however, are attacking such characterization of their treatment. They contend that the Plan will not in fact pay all of their claims in full, and therefore that they are “impaired” creditors and entitled to vote. The E side creditors also believe that the Oncor sale process, which they view as a far more certain path towards getting repaid, was abandoned too soon, and have asserted that the REIT structure contemplated by the Plan has too many contingencies to succeed. This is another fundamental objection, as under the Bankruptcy Code Judge Sontchi must expressly determine that the Plan is “feasible.” In view of the numerous approvals which must be obtained from regulators and the IRS, and the billions of dollars of new capital which needs to be raised in a volatile financial environment, the E side creditors intend to show during the Plan confirmation hearing that the Debtors cannot demonstrate a sufficient likelihood that the Plan will ever become effective, and that it is the E side creditors who will bear all the economic risk if the REIT structure does not succeed.

Judge Sontchi has so far been supportive of EFH’s approach, and has approved the disclosure statement and other key agreements while deferring the major substantive objections to the Plan. He has made clear, however, that when the time comes he will be holding the Debtors’ feet to the fire. One argument made by the E side creditors against their supposed non-impairment under the Plan, for example, has been that it does not pay interest accrued on their billions of dollars in claims at the rates set forth in the underlying contracts or indentures, but instead proposes to pay at the much lower federal funds rate. Judge Sontchi has noted the importance of this issue, observing that EFH has placed “all of its eggs in the ‘unimpairment’ basket,” and has expressly warned EFH not to “get cute.”

In a similar vein, earlier this week he turned aside a request from certain E side creditors to postpone the start of the confirmation hearing until after Thanksgiving. This stemmed from a change in the Plan made immediately prior to the disclosure statement hearing, in which EFH suggested that, rather than paying certain E side unsecured note claims in cash, it instead may “reinstate” those claims under the Plan, with the note obligations being assumed by the reorganized T side companies. Technically, reinstatement can be one way to treat claims as “unimpaired,” and the Debtors contend that it is expressly permitted under the indenture governing the notes. However, while Judge Sontchi denied the requested delay, he appeared to agree that such reinstatement raises substantial questions about the future financial condition of the reorganized companies that payment in cash would not, and suggested that the Debtors were being somewhat “disingenuous” in trying to equate the two.

EFH has come this far in large part by convincing Judge Sontchi to push off several contentious and complex issues. Those issues must now finally be confronted. Although it is possible that the Debtors will manage to settle with the objecting E side creditors and avoid a lengthy and adversarial confirmation hearing, the one certainty here is that there is no more road down which the Debtors can kick what has become a very large can.

Energy Future Holdings – Another Major Success for Chapter 11 Mediation?

Mediation has become an invaluable tool in large chapter 11 cases. Traditionally viewed as a means for resolving discrete disputes between a debtor’s estate and an adversary party, in recent years mediation in certain complex cases has evolved into a multi-party undertaking involving claimants from all levels of a debtor’s capital structure, with the ambitious goal of resolving the entire case through a consensual plan of reorganization.

Recent examples include Residential Capital, LLC and Cengage Learning, Inc. These cases illuminate the primary benefits of mediation: the potential to expedite the plan process through a mediator’s assistance which can save both the estate and creditors from incurring enormous fees related to litigation, and a mediator’s ability to help parties craft unique solutions which would not be available through litigation. This year, over the past few months, mediation has led to a possible exit path in Energy Future Holdings Corp. (“EFH”), one of the most seemingly intractable chapter 11 cases ever filed. Although numerous hurdles remain for EFH and opposition from certain key parties remains, the mediation process in that case has led to a structure that could permit a consensual plan of reorganization to be confirmed by the end of 2015. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but has had no role in the mediation process.)

EFH arose out of one of the largest leveraged buyouts ever undertaken. Falling natural gas prices upended all of the financial assumptions on which its capital structure was based, and when it filed for chapter 11 in spring 2014 its total debt exceeded $42 billion. Its 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). A sale process earlier in the case that was being undertaken for the Oncor interest suggested that the E side creditors would see substantial recoveries; however, it was clear from the outset that there would be insufficient value on the T side to provide recoveries to any but the most senior creditors.

The array of disputes complicating the cases has been substantial. Junior creditors on the T side have sought standing to commence litigation against the senior T side lenders arising from the leveraged buyout and subsequent refinancings. There has been extensive litigation over make-whole premiums. Conflicts of interest between the T side and the E side have necessitated detailed corporate governance protocols and the retention of numerous other professional advisors. In addition, there are difficult and highly technical issues arising from the EFH’s tax structure and the potential disposition of its subsidiaries’ assets, which threaten to impose multi-billion dollar tax liabilities on the EFH estates.

A mediation process was initiated earlier this year in an effort to resolve the intercreditor T side disputes. After several weeks, however, it became clear by statements being made in open court that the process had overrun its boundaries and had led to much more comprehensive discussions regarding overall case resolution. A seemingly pie-in-the-sky idea to create a real estate investment trust (“REIT”) structure to take control of the Oncor assets began to appear viable, and the junior T side creditors who had been prepared to prosecute a campaign of scorched earth litigation began instead to negotiate the terms under which they would agree to backstop it. When it became clear that a plan of reorganization based on the 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 discontinue the Oncor sale process and to put forward a plan based on the terms reached with and among the T side creditors during the course of the mediation.

The REIT-based plan will not be easy to implement. Approvals must be obtained from Texas state regulators and the IRS, and billions of dollars of new capital need to be raised in a volatile financial environment. The E side creditors’ committee and other major E side creditors are opposed, believing that the Oncor sale process was abandoned too soon, that the REIT plan is not feasible, and that it will be the E side creditors who will bear all the economic risk if the REIT plan does not succeed.

Notwithstanding, the fact that the EFH chapter 11 cases have moved in a relatively short period of time from being poised for months (if not years) of contentious litigation, to being on the verge of a consensual plan that can obviate opposition by being able to pay the claims of non-consenting creditors in full, stands as a strong testament to the broad possibilities of bankruptcy mediation. If ultimately successful, the resolution achieved in EFH will likely cement the role of mediation in virtually all “mega” chapter 11 cases going forward.

Energy Future Holdings – More Bad News for Bondholders on Make-Whole Premiums

For the second time in the past few months, Judge Christopher Sontchi has dashed the hopes of certain creditors in the Energy Future Holdings (“EFH”) chapter 11 case that they would be paid a make-whole premium worth over $400 million.

Make-whole premiums are often used in connection with the issuance of debt in order to protect noteholders with long term investment horizons from being repaid early. At the time of the bankruptcy filing of EFH in April 2014, certain of the EFH debtors were obligated under a series of 10% First Lien Notes (the “Notes”) issued by EFH subsidiary Energy Future Intermediate Holding Company (“EFIH”). Under the indenture governing the Notes (the “Indenture”), EFIH’s bankruptcy filing caused the automatic acceleration of the Notes. Shortly after the filing, EFIH sought approval of debtor-in-possession financing, in part to repay all principal and accrued interest under the Notes with less expensive debt. The indenture trustee for the noteholders (the “Trustee”) objected, contending that the repayment by EFIH constituted an “Optional Redemption” under the Indenture, and that such a redemption gave rise to a secured claim under the Indenture for the make-whole premium. EFIH argued in response that no Optional Redemption had occurred because of the automatic acceleration under the Indenture. Once the acceleration occurred the Notes were due and owing, such that the repayment of the Notes could not constitute an Optional Redemption. Judge Sontchi overruled the Trustee’s objection without prejudice and permitted EFIH to make the repayment in June 2014, while reserving the Trustee’s right to continue to seek the make-whole premium. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but has had no role in these proceedings.)

In March of this year, Judge Sontchi, following the reasoning of a similar decision involving a make-whole premium in the Southern District of New York case of MPM Silicones, LLC, et al. (“Momentive”), agreed with EFH and EFIH, holding that due to the automatic acceleration, the repayment of the Notes in June 2014 did not constitute an Optional Redemption, and that EFIH therefore had no obligation to pay a make-whole premium.

This did not fully resolve the issue, however. The Trustee contended that even if the automatic acceleration could eliminate the EFIH’s obligation to pay the make-whole premium, under the Indenture the Trustee had the right to deliver, and in June 2014 in fact did deliver, a notice that rescinded the automatic acceleration (the “Rescission Notice”). The EFH and EFIH responded that the Rescission Notice was null and void by virtue of the automatic stay under section 362 of the Bankruptcy Code. (Upon the commencement of a bankruptcy case, section 362(a) expressly stays, among other things, “any act to collect, assess, or recover a claim against the debtor . . . .”) In his March opinion, Judge Sontchi noted that under section 362(d) of the Bankruptcy Code, the automatic stay can be lifted for “cause”, and he further ruled that the Trustee was entitled to a separate hearing in order to seek to show that “cause” existed to lift the automatic stay retroactively. Judge Sontchi acknowledged that if “cause” existed to lift the automatic stay effective as of June 2014, it would effectively resuscitate the Rescission Notice and thereby trigger the right to payment of the make-whole premium.

Although Judge Sontchi left a door open for the Trustee and the noteholders in March, it has now been slammed shut. After holding an evidentiary hearing in April, Judge Sontchi, again following a similar ruling in Momentive, has now ruled that the Trustee failed to make its showing. In an opinion issued last week, Judge Sontchi rejected the Trustee’s arguments for lifting the automatic stay.

Under applicable Third Circuit precedents, the factors for assessing whether “cause” exists to lift the automatic stay in any particular case are: (1) whether any great prejudice would result to the debtor; (2) whether the hardship to the creditor seeking relief from the automatic stay “considerably outweighs” the hardship to the debtor; and (3) the probability of the creditor prevailing on the merits.

Judge Sontchi first rejected the Trustee’s argument that “cause” existed because EFIH was presumed for purposes of these proceedings to be solvent, and therefore no prejudice would result to the debtor or its bankruptcy estate. In what will probably be the most commented on portion of the opinion, he held that in determining harm to a debtor’s estate from lifting the automatic stay, the interests of equity holders must be considered. “While equity lies at the bottom of the waterfall of priorities under the Bankruptcy Code, its interests cannot and should not be ignored. Equity may be structurally subordinate to the creditors but it is not a second class citizen in a debtor’s capital structure.” Judge Sontchi noted that the impact of the make-whole premium would be $431 million, and found “great prejudice” to EFIH “[r]egardless of those amounts are going to creditors, equity or creditors of equity[.]”

He then examined whether the harm to the noteholders from maintaining the automatic stay would “considerably outweigh” the harm to the debtors from lifting the stay. Observing that the harm that would result to either side was effectively the same – the estimated $431 million make-whole premium, he held that “the harms . . . are, in the best case for the Trustee, in equipoise[.]” Because in this instance the harm to both sides would be equal (i.e., the harm to either side would be either the payment or non-payment of the amount of the make-whole premium), Judge Sontchi held that the Trustee could not meet its burden of showing that the harm of maintaining the automatic stay would “considerably outweigh” the harm to EFIH.

Judge Sontchi did find that the final prong favored the Trustee, as the lifting of the stay to permit the delivery of the Rescission Notice would mean that the payment by EFIH constituted an Optional Redemption and give rise to the noteholders’ right to receive the make-whole premium. That was not enough, however, based on his analysis of the other two factors for weighing the existence of “cause,” to warrant the lifting of the automatic stay.

Disputes over the payment of make-whole premiums have loomed large in major chapter 11 cases the past few years, as debtors have looked to take advantage of the current low interest rate environment to reduce or eliminate more expensive debt. Judge Sontchi’s decisions in March and last week, together with the rulings in Momentive, make clear that only clear and express language in the applicable debt documents will serve to support a claim for such payments, and that the automatic acceleration of debt due to bankruptcy cannot be undone for purposes of imposing make-whole premium liability on debtors.

Baker Botts v. Asarco: The Supreme Court Shows Again That It Really Doesn’t Understand Corporate Bankruptcy Cases

The Supreme Court has not handled its recent major bankruptcy decisions well. The jurisdictional confusion engendered by its 2011 decision in Stern v. Marshall was only partially clarified by this term’s opinion in Wellness International Network v. Sharif. The Court’s ruling this week in Baker Botts v. Asarco, while narrower, stands as another example of obtuse judicial reasoning that will create unnecessary problems for practitioners and bankruptcy court judges.

The law firm of Baker Botts was retained to represent Asarco 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, as the Bankruptcy Code requires for all professional firms that represent debtors or official committees, 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. 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 the Court’s view, the plain text of the statute 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.

The problem with this analysis is that the statutory language of Section 330(a) of the Bankruptcy Code is nowhere near as unambiguous as the majority read it. Unsurprisingly, the dissent offered an equally plausible alternative reading, focusing on the words “reasonable compensation.” Although the work undertaken by a law firm defending its fees may not be a “service,” in the dissent’s view, “[t]he statute permits compensation for fee-defense work as a part of compensation for the underlying services in a bankruptcy proceeding” – not for the “service” of defending the fee application. The dissent noted that Section 330(a)(6) expressly contemplates that compensation should be awarded for preparing a fee application. It reasoned that if compensation should be awarded for the preparation of a fee application, then time spent in defending the application should also be compensable.

While this may all seem to be an academic debate, the implications in chapter 11 cases could be substantial. The requirement of bankruptcy court approval for all fees paid by the bankruptcy estate to professionals employed by a debtor, a trustee or an official committee 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. Indeed, threats to contest professionals’ fees are an ingrained part of the hard-nosed negotiating process that is the hallmark of corporate restructuring practice. The common view, reflected in the vast proportion of lower court decisions, has long been that “reasonable compensation” should be provided for responding to such challenges. In other words, the dissent’s reading of Section 330(a) is more consistent with both the understanding of most bankruptcy practitioners and basic fairness.

The majority opinion needlessly ignores the realities of large corporate bankruptcy cases and long-standing commercial practice. By determining that compensation cannot be given for defending fee applications, the Court’s ruling in Baker Botts v. Asarco will invariably encourage more litigation challenges to the allowance of professional fees, and increase the costs and time necessary to wind down chapter 11 bankruptcy estates.

Supreme Court Decides to Maintain the Viability of the U.S. Bankruptcy Courts, But a Key Question Remains Unresolved

Four years ago, in Stern v. Marshall, the Supreme Court stunned many observers by re-visiting separation of powers issues regarding the jurisdiction of the United States bankruptcy courts that most legal scholars had viewed as long settled. Stern significantly reduced the authority of bankruptcy courts, and bankruptcy judges and practitioners both have since been grappling with the ramifications of that decision. It quickly became clear, notwithstanding the Court’s characterization of its holding in Stern as “narrow,” that the Court would need to address and clarify two key questions regarding the power of judges and courts created under Article I, rather than Article III, of the Constitution: the scope of what constitutes a “public right” in the context of bankruptcy that can be decided by an Article I judge, and whether the right to have a dispute determined by an Article III judge may be waived by consent

The Supreme Court this week, in Wellness International Network v. Sharif, answered one of those questions, and in doing so escaped somewhat from the formalistic straitjacket of Stern. The Court ruled that Article I bankruptcy judges can, with the knowing consent of the parties, issue final decisions on matters that would otherwise necessitate a ruling by an Article III judge. If the narrow view of the authority of bankruptcy judges articulated in Stern had prevailed in Wellness International, bankruptcy judges would no longer be able to make final rulings on issues as integral to the bankruptcy process as determinations regarding what constitutes property of the bankruptcy estate. If bankruptcy judges’ powers were so severely circumscribed, there would be little purpose served by having separate specialized bankruptcy courts. Simply put, in ruling as it did, the Court effectively preserved, for the time being, the viability of the United States bankruptcy courts. However, by leaving the other key question unanswered, the Court ensured that some uncertainty will continue to hover over issues of bankruptcy court jurisdiction.

To recap how the Supreme Court got itself to this point:

Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III. Among other things, judges of Article III courts have lifetime tenure in order to ensure judicial independence. 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. U.S. bankruptcy judges are appointed for 14 year terms. 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). Claims of citizens against one another under state law, such as for breach of contract or common torts, are “private rights” that must be heard by an Article III judge. It had long been believed since the Supreme Court last invalidated the grant of jurisdiction to the bankruptcy courts in 1982 and Congress responded with the Bankruptcy Reform Act of 1984, that disputes pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted a type of “public rights” that could be heard and decided by an Article I bankruptcy judge.

The Supreme Court surprised the commercial legal community in Stern by reopening the question of the constitutionality of the U.S. bankruptcy courts. The Court’s holding in Stern showed that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge is far narrower than previously understood. The Court in Stern 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.

The problem created by the Supreme Court’s ruling in Stern is this: the Bankruptcy Code gives the bankruptcy courts power over all property of a debtor’s estate under Section 541(a). Determining what constitutes property of a debtor’s bankruptcy estate is indisputably fundamental to “the restructuring of debtor-creditor relations.” But the Supreme Court has expressly stated in other cases that property rights in bankruptcy are based on state law. State-law issues are an inseparable part of virtually every bankruptcy case. For purposes of determining “public” and “private” rights, which aspect of such adjudications should control?

Wellness International highlighted the ramifications of Stern’s cramped view of bankruptcy court authority. The case stems from Sharif’s personal bankruptcy case, which he filed after Wellness International obtained a substantial judgment against him. Wellness International brought an action before the bankruptcy court, challenging Sharif’s claim that certain assets were property of a separate trust and thus excludable from his bankruptcy estate under Section 541(a) of the Bankruptcy Code. The bankruptcy court found in favor of Wellness International, and Sharif appealed. He claimed, among other things, that in the wake of Stern, the bankruptcy court lacked the constitutional authority to enter a final judgment, because the question of ownership of the supposed trust assets was purely an issue of state law, independent of federal bankruptcy law. He also argued that the right to a determination of this issue by an Article III court was not a right that could be waived, not even by a debtor that had expressly sought the jurisdiction of an Article I bankruptcy court by filing a bankruptcy petition. The Seventh Circuit agreed with Sharif on these points and reversed the bankruptcy court ruling.

The Court ruled yesterday that the right to have a dispute determined by an Article III judge may be waived by consent. Justice Sotomayor, writing for the majority, clearly recognized the implications of a ruling against Wellness International, not only for the bankruptcy courts but also for other Article I judges, such as the U.S. magistrates. She noted that Congress has authorized 534 U.S. magistrates and 349 bankruptcy judges, a combined total of 883 Article I judges that far exceeds the 677 Article III district court judges. In the one year period between October 1, 2013 and September 30, 2014, over 960,000 cases were filed in the bankruptcy courts, more than double the number of cases filed in U.S. district and circuit courts. Magistrates handle large numbers of federal misdemeanor cases and significant pretrial work in civil and felony criminal cases. In short, without the bankruptcy judges and magistrates, Justice Sotomayor observed, “the work of the federal court system would grind nearly to a halt.”

The Court did not, however, make a decision as to whether Sharif had, by voluntarily filing his bankruptcy case and invoking the authority of an Article I bankruptcy court, “knowingly and voluntarily consent[ed] to the adjudication by a bankruptcy judge.” The Court instead remanded the case to the Seventh Circuit to make that determination. If the Seventh Circuit decides that the act of filing of a bankruptcy petition in and of itself evinces consent, it would eliminate the power of any bankruptcy debtor to challenge bankruptcy court jurisdiction. If, however, the Seventh Circuit were to rule that simply commencing a bankruptcy case is not sufficient in and of itself, then the import of this case could be significantly limited.

More importantly, the Court avoided completely the crucial question as to the scope of what constitutes a “public right” in the context of bankruptcy; i.e., whether the dispute between Sharif and Wellness International regarding whether certain assets constituted property of Sharif’s bankruptcy estate “stem[med] from the bankruptcy itself.” There invariably will be cases going forward where the consent of a party to allow bankruptcy court adjudication will not exist. The question as to the types of matters that can be decided by an Article I judge will then need to be squarely addressed. Until the Supreme Court confronts and clearly delineates the extent of bankruptcy judges’ authority, some uncertainty will continue to hover over issues of bankruptcy court jurisdiction.

Law360 Selects Kelly Drye Special Counsel Jason R. Adams As One of its 2015 ‘Rising Stars’

Kelley Drye is pleased to announce that special counsel Jason R. Adams has been honored by Law360 as one of the “Rising Stars” in bankruptcy law for 2015, which recognizes top legal talent across the United States under the age of 40.

As one of the nine honorees in the bankruptcy category, Mr. Adams was selected for having a hand in some of the most high profile bankruptcies in the country in recent years, including GT Advanced Technologies, Caesers Entertainment Operating Co. Inc. and Residential Capital LLC.  He was noted as being a key part of the expansion of Kelley Drye’s creditor committee practice and has earned a reputation as an innovative practitioner with a diverse skill set.

As far as advice to other young lawyers looking to have a successful career in restructuring work, Mr. Adams said, “In addition to finding good mentors, diverse experience is the name of the game.  That means going out to different practice areas in your firm and seeking the opportunity to do something that you know will be beneficial to your practice.”  He encourages young attorneys to work on as many varied projects as possible.

This year, 144 attorneys made the Law360 Rising Stars Under 40 list out of a pool of a record 1,200 nominees. The annual series recognizes attorneys under 40 based on their career accomplishments in their respective practice areas.  To read Jason’s Law360 article, please click here.

Judge Protects GM Against Most, But Not All, Ignition Switch Claims

Judge Robert Gerber ruled last week that General Motors LLC (“New GM”), the entity formed in 2009 to acquire the assets of General Motors Corporation (“Old GM”), is shielded from a substantial portion of the lawsuits based on ignition switch defects in cars manufactured prior to New GM’s acquisition of the assets of Old GM in 2009. Judge Gerber determined that the lawsuits are barred by the provisions of the Sale Order he entered at that time, which transferred the assets to New GM “free and clear” of claims against Old GM (other than a narrow range of expressly assumed liabilities) and protected New GM from any claims based on theories of successor liability.

The ignition switch plaintiffs argued that they should not now be bound by the Sale Order because they were never given proper notice of the sale in 2009 and were therefore denied due process. Although Judge Gerber agreed with the ignition switch plaintiffs’ contentions that the publication notice given at the time of the sale had failed to satisfy the requirements of due process, he determined that the plaintiffs mostly had not suffered prejudice as a result. Judge Gerber held that the lack of required notice did not constitute a due process violation without some showing of prejudice, and that there was no prejudice because most of the plaintiffs’ arguments regarding New GM’s post-sale liability had been made at the time by other parties and rejected.

However, he noted that one argument now being pressed by the ignition switch plaintiffs, regarding the extent to which New GM could claim protection under the Sale Order against liabilities based solely on its post-sale conduct, had not been raised by any party in 2009, and that in such respect the plaintiffs had in fact suffered prejudice from the lack of direct notice. Judge Gerber stated that because he likely would have agreed in 2009 that utilizing the Sale Order protections to cover liabilities stemming solely from post-sale actions of New GM was overbroad and impermissible, he will permit lawsuits based on such allegations against New GM to move forward.

Background

As has been widely reported, ignition switch defects in cars manufactured prior to 2009 that allegedly caused numerous deaths and injuries were known by employees of Old GM but were not properly reported (or perhaps were deliberately covered up).  Vehicle owners have sued New GM, seeking compensation for economic damages caused by the defects.  These cases have mostly been consolidated into a single class action proceeding before Judge Jesse Furman in the Southern District of New York.  New GM responded by bringing a motion in the Old GM bankruptcy case to enforce the Sale Order injunction with respect to all litigation seeking compensation for economic damages. (New GM agreed under the Sale Order to assume liability for death and personal injury claims against Old GM, and has structured a non-judicial compensation arrangement to address such claims arising from ignition switch defects.)

Judge Gerber and lawyers for New GM, the creditor trust that is the successor-in-interest to Old GM, and the vehicle owner plaintiffs spent several months last year identifying the “threshold” legal issues that would need to be addressed. At a mid-February hearing, the parties focused on whether there had been a violation of the due process rights of the ignition switch plaintiffs due to the lack of direct notice and, if so, what the appropriate remedy should be. (Kelley Drye & Warren LLP represents certain major creditors of Old GM but has had no role in these proceedings.)

Judge Gerber’s Ruling

In his opinion, Judge Gerber first considered whether the publication notice given at the time satisfied the requirements of due process. He noted that publication notice sufficed under most circumstances with respect to “unknown” claimants. As to the owners of vehicles with ignition switch defects, however, he agreed with the plaintiffs’ contention that there had been sufficient knowledge of the potential problems on the part of certain employees and officers of Old GM in 2009 to impute such knowledge to Old GM. Given the requirements to maintain data bases regarding accidents under the National Traffic and Motor Vehicle Safety Act, the plaintiffs argued, and Judge Gerber concurred, that the claimants should have been “known” in 2009 based on what Old GM was charged with knowing under federal law.  Since there had been no direct notice given to the vehicle owners, the requirements of due process with respect to “known” creditors was not satisfied.

He made clear, however, that the sufficiency of the notice given in 2009 was only part of the inquiry, and strongly disagreed with the plaintiffs’ contention that the lack of proper notice meant that they should not be bound by the Sale Order. He ruled that the plaintiffs were entitled only to “the full and fair hearing [they were] initially denied, with the Court then focusing on the extent to which prejudice actually resulted[.]” In addition, he held that he needed to consider both the appropriate remedy, and the extent to which the Sale Order could be modified.

New GM, in its briefs and during the hearing, contended that regardless of whether proper notice had been given, there was no prejudice to the plaintiffs. New GM pointed out that extensive arguments had been made by numerous parties in 2009 against the Sale Order, and rejected then by Judge Gerber, to the effect that New GM should not be able leave behind potential liabilities of Old GM nearly identical to those held by the ignition switch plaintiffs. Judge Gerber agreed. The plaintiffs, he stated, “[have not] advanced any arguments on successor liability that were not previously made, and made exceedingly well before.”

But he went on to note that the plaintiffs were making one important argument that was not based on theories of successor liability, and that had not been advanced by any other party in 2009. The Sale Order protects New GM from any liabilities (other than a few narrow categories expressly assumed) involving vehicles and parts involving Old GM. The plaintiffs contended that the breadth of this exclusion was so broad that it would effectively shield New GM from defective ignition switch lawsuits even if the only wrongful conduct alleged were on the part of New GM subsequent to the sale. Judge Gerber observed that he had in fact agreed with a similar argument that was made in 2009 with respect to environmental liabilities, and therefore would likely have agreed with the plaintiffs if they had been given the chance to make the same argument at that time. He held that the plaintiffs, by not having had the chance to make such argument, had thus shown prejudice from the lack of proper notice.

Judge Gerber then considered the appropriate remedy for the plaintiffs. He noted his agreement with New GM regarding the importance of finality in bankruptcy sales, and of protecting the expectations of purchasers of assets in bankruptcy cases that they are acquiring assets “free and clear” of any claims against the bankrupt seller or claims based on successor liability. But he then noted that due process considerations are constitutional in nature, and determined that “[a] doctrine that would bar modification of the Sale Order under less extreme circumstances has to give way to constitutional concerns.” He also disagreed with New GM’s assertion that because the provisions of the Sale Order were non-severable, the Sale Order had to be either enforced or voided in full. He held that if an order could be voided in full, then the non-severability provisions of such order could be voided, so that a court could uphold the order while simultaneously denying the enforcement of “cherry-picked components . . . that have been entered with denials of due process.”

He emphasized that New GM remained protected against all liabilities of Old GM and any claims based on theories of successor liability. But New GM will now be required to defend itself in lawsuits that seek damages based solely on New GM’s post-sale actions and conduct. The fact that such claims may happen to involve automobiles or parts manufactured by Old GM will no longer provide New GM with a shield under the Sale Order.

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