Delaware Judge Rejects Challenge to Payment of Fees for Indenture Trustee in Southeastern Grocers Chapter 11 Case

Southeastern Grocers (operator of the Winn-Dixie, Bi Lo and Harvey’s supermarket chains) recently completed a successful restructuring of its balance sheet through a “prepackaged” chapter 11 case in the District of Delaware. As part of the deal with the holders of its unsecured bonds, the company agreed that under the plan of reorganization it would pay in cash the fees and expenses of the trustee for the indenture under which the unsecured bonds were issued.  In an important ruling for indenture trustees, Judge Mary Walrath approved the plan and rejected a challenge to the payment, a decision that will help to blunt some of the uncertainty which has arisen around this issue.  (Kelley Drye & Warren LLP represented the indenture trustee in this matter).

Payment by a debtor of an indenture trustee’s fees and expenses in cash is a significant business point in cases such as Southeastern Grocers, where bonds typically are surrendered in exchange for new common stock. Otherwise, the indenture trustee must recover its fees and expenses out of the distribution to the bondholders under a priority provision in the indenture known as the “charging lien.”  Exercising the charging lien against newly-issued shares and then monetizing such shares can be a difficult and time consuming process, particularly where the new shares are not intended to be publicly traded.  This reduces the bondholders’ recovery and delays the debtor’s emergence from chapter 11.

Under the Southeastern Grocers plan, the unsecured bondholders were the only impaired creditor class, and voted unanimously in favor. The office of the United States Trustee (“UST”) in Delaware nevertheless filed an objection to plan confirmation.  It contended, among other issues, that payment of the indenture trustee’s fees and expenses contravened section 503(b) of the Bankruptcy Code.  The objection by the UST (a representative of the U.S. Department of Justice that serves a watchdog function in large bankruptcy cases) in Southeastern Grocers is consistent with the stance USTs have been taking against the payment of indenture trustees’ fees and expenses in districts across the country.

The UST’s objection was that section 503(b) provides the only basis upon which the fees and expenses of an indenture trustee and other parties in interest can be paid in a chapter 11 case. Under that section, payments are permissible only upon a showing of “substantial contribution” in the case, a difficult standard to meet.  Courts have held that the type of actions that satisfy the “substantial contribution” test is “exceedingly narrow,” and, among other things, the party seeking such payment must demonstrate that it was not merely protecting its own interests but that its actions were for the benefit of all parties.

Because the “substantial contribution” standard is so difficult to satisfy, the key issue is whether subsection 503(b)(3)(D) in fact provides the sole authority under the Bankruptcy Code for such payments.

In Southeastern Grocers, the debtor, the indenture trustee and the bondholders responded to the UST’s objection by arguing, as some courts have held, that subsection 503(b)(3)(D) is simply the means by which an indenture trustee or other party in interest can compel payment of its fees and expenses, and that there is nothing in that subsection which in any way prevents a debtor from agreeing to pay such fees and expenses as part of a settlement. Further, those courts have pointed out that section 1123(b)(6) of the Bankruptcy Code, which states that a plan of reorganization may include “any . . . appropriate provision not inconsistent with the applicable provisions of this title[,]” provides a bankruptcy court with a “broad grant of authority” to permit the payment of an indenture trustee’s reasonable fees and expenses without the need to find compliance with section 503(b).

Judge Walrath rejected the UST’s arguments. With respect to the payment of the indenture trustee’s fees and expenses, she expressly stated,

[Section] 503(b)(3)(D) is not the only way where such expenses can be approved and paid in a case. And I think it is perfectly appropriate to agree . . . to the payment of those expenses without the necessity of a court having to approve them after the fact in order to get the parties to come to the table and negotiate [a] successful reorganization . . . I think that the fact that [Southeastern Grocers] agreed to that . . . was perfectly appropriate, and that there is no necessity that I review those expenses or otherwise interfere with that agreement.

This is a favorable decision for indenture trustees and parties to negotiated settlements to cite in future cases as persuasive authority. Judge Walrath is a highly regarded jurist, and her summary rejection of the UST position and express statement that section 503(b)(3)(D) is not the only basis for payment of an indenture trustee’s fees and expenses should carry weight with other judges in Delaware and in other districts.

Supreme Court Displays More Pragmatic Approach to the Bankruptcy Code in Merit Management v. FTI Consulting

The Supreme Court’s recent decision in Merit Management Group, LP v. FTI Consulting, Inc. has appropriately drawn significant attention.  The Court, by narrowing the “safe harbor” provision of Section 546(e) of the Bankruptcy Code, has opened the door for representatives of bankruptcy estates to use the avoidance powers of the Bankruptcy Code to seek to unwind a wider range of pre-bankruptcy transactions and recover value for the benefit of creditors.  Most of the focus on the ruling has been on its anticipated impact on the administration of business bankruptcy cases.  However, it is worth noting that the Court in Merit Management has taken a more pragmatic approach to statutory interpretation in its reading of the Bankruptcy Code than in two of its other recent business bankruptcy decisions, Baker Botts v. Asarco and Czyzewski v. Jevic Holding Corp., and the result in Merit Management appears to be more consistent with the intent of Congress than in those earlier cases

The issue in Merit Management was straight forward.  Trustees in bankruptcy are authorized to set aside certain transfers made by a debtor prior to bankruptcy.  Among these, under Section 548 of the Bankruptcy Code, are so-called “constructive” fraudulent transfers, which (regardless of intent) are transfers of property made by a debtor at a time when it was insolvent and for which it received less than reasonably equivalent value.  Section 550 of the Bankruptcy Code provides that the recovery can be obtained either from the initial transferee of such property or “any immediate or mediate transferee of such initial transferee.”  A trustee’s avoidance powers are limited, however, by other sections of the Bankruptcy Code.  One of these is Section 546(e), which exempts from avoidance certain securities transactions “made by or to (or for the benefit of)” qualifying “financial institutions” or others securities entities.

Merit Management Group was a large shareholder of Bedford Downs Management Corp.. Bedford Downs’ stock was acquired by Valley View Downs LP, which borrowed $55 million to fund the transaction.  The $55 million was not paid by Valley View directly to the Bedford Downs shareholders; there were intermediate transfers.  Specifically, Valley View borrowed funds from its lender, Credit Suisse, which transferred the money to another financial institution, Citizens Bank of Pennsylvania, as escrow agent, which in turn paid the purchase price to the shareholders of Bedford Downs, including Merit Management, in exchange for the surrender of their stock certificates.

Valley View intended to develop a race track and casino in Pennsylvania, but the project never came to fruition and it eventually filed for relief under chapter 11 of the Bankruptcy Code. FTI Consulting was appointed as trustee to pursue certain causes of action on behalf of Valley View’s bankruptcy estate, and it sought to avoid the $16.5 million portion of the Bedford Downs purchase price that had been received by Merit Management.  FTI contended that Valley View was insolvent at the time it bought the Bedford Downs stock and that it did not receive reasonably equivalent value in exchange for the payment.  Among the defenses raised by Merit Management was that the transaction fell within the Section 546(e) “safe harbor” because it included transfers “to (or for the benefit of)” two “financial institutions.”   The lower court granted Merit Management’s motion to dismiss.  The Seventh Circuit Court of Appeals reversed, however, reasoning that Section 546(e) did not apply to transactions where the financial institutions involved serve as “mere conduits.”  The Supreme Court granted certiorari to resolve a split between circuits on this issue, and unanimously affirmed.

The question before the Court was whether, for purposes of applying Section 546(e), a court should consider only the challenged transaction itself (in this case, the payment from Valley View ultimately received by Merit Management), or all of the component transfers within such challenged transaction (in this case, the transfers involving two financial institutions). The Court, noting the “specific context” of the language of Section 546(e), rejected Merit Management’s argument that the statutory language “to (or for the benefit of) a . . . financial institution” required reversal, and held instead that “the [Section 546(e)] exception applies to the overarching transfer that the trustee seeks to avoid, not any component part of that transfer.”

The result in Merit Management reflects a common sense reading of the Bankruptcy Code.  The clear intent of Section 546(e) is to safeguard various types of securities transactions from being unwound in order to prevent market disruption.  Allowing an ultimate transferee such as Merit Management to benefit simply because the transferred funds passed through one or more financial institutions would not further the purpose of the safe harbor.

Unfortunately, the Court does not always temper its reading of the statutory language of the Bankruptcy Code with the “specific context” in which such language is used. Other recent Supreme Court business bankruptcy decisions have not been as pragmatic as Merit Management.

In Baker Botts v. Asarco a few years ago, the Court majority applied a narrow and literal reading to the language of Section 330(a) of the Bankruptcy Code.  The result was to deny a law firm the ability to recover the costs that it incurred in defending its application for fees in representing a debtor, even though the Bankruptcy Code requires that all such fees be approved by the bankruptcy court and that other parties receive specific notice and be given an opportunity to object.

Last year, in Czyzewski v. Jevic Holding Corp., the Court also took a narrow approach in its reading of the Bankruptcy Code.  It refused to permit an order of dismissal in a chapter 11 case to contain substantive provisions regarding the distribution of assets of a debtor’s bankruptcy estate that would contravene the Bankruptcy Code’s priority scheme.  The Court declined to allow for any flexibility on this issue, even though such “structured dismissals” had become relatively common, and the bankruptcy court in Czyzewski had expressly found that without such provisions there would have been no recovery to any parties other than the senior lenders.

A similar approach in Merit Management would likely have led to a reversal of the Seventh Circuit.  The plain language of Section 546(e) makes no distinction between transfers where a financial institutions is the actual party to a transaction and those where it simply acts as a conduit.

The Bankruptcy Code was intentionally drafted to be flexible. Jurists and practitioners must contend all the time with difficult issues which do not fit within its strict parameters.  Adherence to the plain meaning of the Bankruptcy Code’s language is important, but the language usually is not unambiguous, and the intent of Congress cannot be properly understood without reference to “specific context.” Baker Botts and Czyzewski both ignored the realities of large corporate bankruptcy cases and long-standing commercial practice. Merit Management may signal a different direction by the Court in its approach to business bankruptcy cases.

A Patent Law Dispute Before the Supreme Court This Term Could Have a Major Impact on U.S. Bankruptcy Courts

The Supreme Court recently heard arguments in a patent dispute case, Oil States Energy Services, LLC v. Greene’s Energy Group, LLC.  Although the case has nothing to do with bankruptcy law, its outcome could have a substantial impact on bankruptcy practice and litigation. Oil States Energy concerns the limits of Congress’s ability to create courts pursuant to Article I of the Constitution rather than under Article III, and therefore raises separation of power issues similar to those considered by the Court in Stern v. Marshall, its 2011 decision limiting the authority of U.S. bankruptcy courts.

The facts of Oil States are straight-forward.  Oil States Energy sued Greene’s Energy Group for patent infringement.  Greene’s Energy responded by commencing a procedure known as “inter partes review”, an administrative process that permits parties to seek review by the Patent and Trademark Office (PTO) of patent grants.  Under this process, an administrative board within the PTO can invalidate the issuance of a patent, subject to appeal and review by the U.S. Court of Appeals for the Federal Circuit.  When the PTO board found for Greene’s Energy in this instance and held the patent grant to Oils States Energy to be invalid, Oil States Energy challenged its constitutionality, contending, among other things, that Congress had impermissibly vested Article III “judicial power” in an Article I forum.

The Supreme Court has been wrestling with the limits of the constitutional authority of Article I courts off and on for well over a century. A line of 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 typically are “private rights” that must be heard by an Article III judge.

With respect to bankruptcy courts, the common understanding has been that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power” under Article I, Section 8, constitutes a type of “public right” which can be heard and decided by an Article I bankruptcy judge. The Court has never expressly held this, however, or handed down a clear ruling as to where the line between “public rights” and “private rights” should be drawn in bankruptcy proceedings.  Although in some recent cases involving non-bankruptcy Article I tribunals the Court has taken an expansive and pragmatic view of the “public rights” doctrine, in Stern the Court adopted a more constricted approach.  It ruled that although an Article I bankruptcy judge could appropriately enter a final order regarding a creditor’s claim against a bankruptcy estate, a common law tort claim held by the bankruptcy estate against the same creditor nevertheless constituted a “private right” if it was not related to the initial claim against the estate, and that it was therefore unconstitutional for Congress to have authorized a non-Article III court to render a final determination on it.

As the Court in Stern candidly noted, “the distinction between public and private rights – at least as framed by some of our recent cases – fails to provide concrete guidance[.]” Stern did nothing to clarify this problem, and bankruptcy practitioners and judges have struggled since the opinion was handed down to understand the limits it placed on bankruptcy court authority.

The question in Oil States – whether an Article I tribunal may invalidate a previously granted patent – raises many of the same issues regarding “private rights” and “public rights.”  Oil States Energy contends that its dispute with Greene’s Energy is purely a private dispute over patent infringement, over which an Article I forum has no greater authority to adjudicate than the tort claim at issue in Stern.  Greene’s Energy argues in response that the case involves a “public right,” in that it derives from Congress’s patent power under Article I, Section 8, and is therefore completely distinguishable from Stern’s common law tort action.  Oil States Energy points to the Court’s concern in Stern regarding the encroachment by Congress on the essential protections of Article III, asserting that “[i]f a patent dispute case – a dispute over a private property right – may be swept out of the [Article III] federal courts to an [Article I] administrative agency simply by deeming it part of some amorphous ‘public right,’ then anything can be, and Article III’s protections are mere ‘wishful thinking.’”  Greene’s Energy counters by pointing to the Court’s discussion in Stern of a “public right” as deriving from “a federal regulatory scheme,” and the suggestion there that “what makes a right a ‘public right’ rather than private is that the right is integrally related to particular Federal Government action.”

Both bankruptcy and patent law fall squarely within the scope of Congress’s power under Article I, Section 8, and in both instances Congress has created specialized forums in an effort to allow parties to address issues which are not susceptible to efficient disposition in Article III courts. Accordingly, any ruling that the Court makes in Oil States on the distinction between “public rights” and “private rights,” and on the limits of the authority of courts created under Article I, is almost certain to have a significant impact on U.S. bankruptcy courts.

Judge Silverstein’s Opinion in Millennium Lab Holdings Threatens to Bring Clarity and Common Sense to Debate Regarding Constitutional Power of Bankruptcy Courts

In December 2015, U.S. Bankruptcy Court Judge Laurie Silverstein of the District of Delaware confirmed a plan of reorganization in the Millennium Lab Holdings chapter 11 case that included the non-consensual release of certain claims against various non-debtor third parties.  Earlier this year, ruling on an appeal from that decision, U.S. District Court Judge Leonard Stark remanded the case to Judge Silverstein and directed her to consider whether the grant of the releases exceeded her constitutional power as an Article I judge, in view of the issues raised by the U.S. Supreme Court in its 2011 decision in Stern v. Marshall.

Judge Silverstein recently issued a comprehensive opinion in which she determined that her confirmation of the plan was constitutional and did not contravene Stern.  Her analysis brings much-needed clarity to what has been a muddled discussion.  Her unstated premise – that a viable specialized court system is necessary to address matters of bankruptcy, and that Congress unquestionably has the power under Article I to create such forums – offers a pathway out of the uncertainty created by Stern over the constitutional power of the U.S. bankruptcy courts.

Background

The Supreme Court in Stern raised long dormant separation of power concerns.  Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III.  Congress, however, established the U.S. bankruptcy courts in their current form in 1978 pursuant to its bankruptcy power under Article I.  A line of Supreme Court cases has limited the authority of courts created by Congress pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (i.e., 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.

The Court, in the 1982 Northern Pipeline case, invalidated the 1978 grant of jurisdiction to the bankruptcy courts, ruling that Congress had impermissibly vested Article III “judicial power” in Article I courts by allowing a bankruptcy court to hear and rule on a debtor’s breach of contract claim against another party, a “private rights” dispute.  It did, however, provide some guidance to Congress by suggesting that disputes pertaining to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constituted a type of “public right” which could be heard and decided by an Article I bankruptcy judge.  Congress responded with a new grant of jurisdictional power providing that bankruptcy courts could issue final orders with respect to a variety of enumerated “core” matters intended to implicate only such “public rights,” but that with respect to “non-core” matters affecting “private rights,” a bankruptcy court could only submit proposed findings of fact and conclusions of law, and requiring that a final order on such matters be entered by an Article III district court following a full review.

The constitutionality of the “core” – “non-core” dichotomy appeared to have been long-settled by 2011, as in cases involving other Article I tribunals the Court took an expansive view of the “public rights” doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters. So it took most bankruptcy practitioners and commentators by surprise when, in Stern, the Court held that Congress had again improperly granted authority to bankruptcy courts to make certain final rulings. Stern ruled that Congress could not designate a debtor’s counterclaim against a creditor as a “core” matter if the counterclaim would not be resolved as part of the same process whereby the creditor’s claim against the debtor’s bankruptcy estate was determined.  The Court in Stern ruled that it would be unconstitutional for the counterclaim in that case, a tort action under Texas state law, to be decided by an Article I bankruptcy judge.  In the Court’s view, 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 with this reasoning is that the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy are usually determined by state law.  State law issues accordingly are intertwined with most “core” matters.  Although the Court in Stern characterized its ruling as “narrow,” its formulation of the issue suggested that “core” matters could often implicate “private rights.”  By opening up issues of bankruptcy court power regarding “core” matters to constitutional challenge, the Court created ongoing confusion regarding the extent to which U.S. bankruptcy judges can issue final rulings, which in turn has caused uncertainty in the administration of bankruptcy cases.

Millennium Lab Holdings Chapter 11 Case  

In Millennium Lab Holdings, the debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests.  The plan confirmed by Judge Silverstein in 2015 embodied a compromise, whereby the equity holders were to pay $325 million in exchange for a release of all claims against them held either by the debtor’s estate or directly by third parties.  Certain of the debtor’s lenders commenced litigation against the equity holders in federal district court, and objected to the releases in the plan that would preclude their claims.  Judge Silverstein overruled the objections.  She held that the non-consensual releases met the required standards under Third Circuit precedents and could be approved in connection with the confirmation of a plan of reorganization.

The constitutional issues were raised for the first time on appeal. The lenders contended that under Stern the releases were tantamount to resolving a “private rights” dispute between two non-debtor parties, and that Judge Silverstein therefore lacked constitutional authority to enter a final order resolving it.  Judge Stark agreed that the lenders were entitled to Article III adjudication of their claims, but determined that the issue had not been properly presented to Judge Silverstein, and remanded the case so that she could make the determination in the first instance.

Judge Silverstein’s Ruling on Remand

In her ruling, Judge Silverstein noted first the Supreme Court’s own admonition in Stern that it was intended to be a narrow opinion, and that its actual outcome “tread little new ground” beyond Northern Pipeline.  She then looked closely at the interpretations applied to Stern by various courts since its issuance.  Some bankruptcy judges have applied what she characterized as a “Narrow Interpretation,” limiting Stern to similar circumstances involving state law counterclaims against creditors that are not resolvable in the process of ruling on the creditor’s claims against the debtor.  Other bankruptcy judges have put forward a “Broad Interpretation” of Stern, holding that it may apply to any state law or common law cause of action commenced by a debtor or trustee against a creditor or other party.  Under what she describes as the “Broadest Interpretation,” bankruptcy judges have questioned their ability to enter final orders in other enumerated “core” proceedings.

The lenders argued that Stern did not permit Judge Silverstein to enter a final order confirming a plan of reorganization that would interfere with their causes of action against the debtor’s equity holders.  She rejected the lenders’ argument as “inverse” and “backward” reasoning: “[I]t examines the legal consequence of the confirmation order to find fault with the entry of the order, rather than examining the propriety of issuing the confirmation order in the first instance.”  She determined instead that an Article I judge should not step aside from issuing a ruling on a “core” matter simply because third parties’ rights under state or common law would be affected.

Judge Silverstein demonstrated that even under the “Broadest Interpretation” of Stern, her entry of a final order confirming the plan was within her authority.  She approached the constitutional question by noting that confirming plans of reorganization are a fundamental aspect of federal bankruptcy power, and placing the critical focus squarely on the nature of the “core” proceeding that was before her.  Although the plan affected the “private rights” of third parties by releasing certain causes of action, she held that she was not ruling on the merits of those causes of action.  Her decision was only on whether the plan (and the releases) satisfied applicable standards under the Bankruptcy Code and Third Circuit precedent:

“[T]here is no state law equivalent to confirmation of a plan.  And, third party releases do not exist without regard to the bankruptcy proceeding.  Rather, a ruling approving third party releases is a determination that the plan at issue meets the federally created requisites for confirmation and third party releases.”

Adopting the interpretation of Stern urged by the lenders, she observed, would effectively  end the viability of the U.S. bankruptcy court system, and require substantially greater involvement by Article III district court judges in bankruptcy matters – an outcome directly at odds with the Supreme Court’s stated intention in Stern that its ruling would not “meaningfully change[] the division of labor” between bankruptcy and district courts.  She noted several types of orders commonly entered by bankruptcy judges which, under the lenders’ reading of Stern, would instead need to be entered by Article III judges due to their possible impact on the rights of non-debtors under state law.  These would include orders approving sales of assets free and clear of successor liability claims under Section 363 of the Bankruptcy Code, rulings on substantive consolidation, and determinations regarding the recharacterization or subordination of debts.

Judge Silverstein tangentially alluded to the real problem raised by Stern – that by failing to articulate clearly the importance of federal bankruptcy law and a specialized bankruptcy court system as “public rights,” the Court allowed Stern to become fodder for “gamesmanship by both debtors and creditors in the bankruptcy context.”  Citing a recent Third Circuit ruling, In re Linear Electric Company, Inc., she expressly held “core” matters under the Bankruptcy Code to be “public rights.”  As such, it fell directly within her power as an Article I bankruptcy judge to confirm the Millennium Lab Holdings plan.  In Judge Silverstein’s view, “[t]here is no question [that] if the proper standard is met, a bankruptcy judge may enter a final order in a core matter that impacts or even precludes a state law action between two non-debtors.”  The preclusive effect of a ruling on the “private rights” of a non-debtor party might be an argument for a bankruptcy court to consider in weighing the merits of the releases themselves, but it could not limit the constitutional authority of a U.S. bankruptcy judge to make such a ruling.

In articulating the limits of Stern under any of its plausible interpretations, Judge Silverstein has provided guidance that can and should be followed by other courts towards viewing “core” matters as “public rights” squarely within the constitutional authority of an Article I court.  The key factor in resolving questions of bankruptcy court constitutional authority should be the nexus of any particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights under state law are affected.  Placing the focus on the “public” side of the public/private rights dichotomy can provide a path away from the confusion engendered by Stern, and restore the proper balance of U.S. bankruptcy courts’ constitutional power.

Fees for Defending Fees – Recent Rulings Permit Contractual Circumvention of Supreme Court’s Baker Botts v. Asarco Decision

The Supreme Court two years ago ruled in Baker Botts v. Asarco that bankruptcy professionals entitled to compensation from a debtor’s bankruptcy estate had no statutory right to be compensated for time spent defending against objections to their fee applications.  Since then, “estate professionals,” i.e., those retained in a bankruptcy case by a trustee, debtor in possession or an official committee of creditors, have sought ways to limit the potentially harsh impact of that decision.  A subsequent opinion in a Delaware bankruptcy case, In re Boomerang Tube, declined to allow Baker Botts to be circumvented by contract.  However, decisions in another Delaware case, Nortel Networks, and more recently in a New Mexico case, Hungry Horse LLC, have distinguished Boomerang Tube and permitted contractual provisions that allow payment for the defense of fees.  The pragmatic approach taken in Hungry Horse in particular offers a template that other courts will likely be urged to adopt.

In every bankruptcy case, the retention of estate professionals must be approved by the bankruptcy court. Their fees and expenses are paid out of the debtor’s bankruptcy estate and are subject to review and approval by the bankruptcy court pursuant to Section 330 of the Bankruptcy Code.  Objections from other parties have always been a recognized hazard for such professionals.  Prior to Baker Botts a majority of courts permitted the recovery of fees incurred in defending against such challenges.

The Court’s analysis in Baker Botts 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[.]”  The Court ruled that the plain text of Section 330(a) does not support a deviation from the “American Rule” regarding attorneys’ fees.  The Court’s majority stated, “[t]he word ‘services’ ordinarily refers to ‘labor performed for another.’”  Since Baker Botts was litigating to defend its own fees, the Court reasoned that it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitled to compensation for such time.

Baker Botts makes clear that the Bankruptcy Code does not provide a statutory exception to the American Rule.  The question remaining is whether estate professionals can sidestep it by contract.

In Boomerang Tube, Judge Mary Walrath answered that question in the negative.  The law firm chosen in that case to represent the official committee of unsecured creditors, in its application to the bankruptcy court, asked for the approval order to include a provision that would entitle it to be compensated from Boomerang Tube’s bankruptcy estate for fees incurred in defending its fees against any challenges.  The firm pointed to Section 328 of the Bankruptcy Code, which allows for the retention of estate professionals “on any reasonable terms and conditions.”  It argued that the Supreme Court in Baker Botts had noted that parties could and regularly did contract around the American Rule.

Judge Walrath denied the request. She first held that Section 328 does not create a statutory exception to the American Rule, as it makes no mention of awarding fees or costs in the context of an adversarial proceeding. She observed in contrast that several discrete Bankruptcy Code provisions do contain express language providing for payment of fees to a prevailing party.  She next rejected the law firm’s argument that Section 328 permitted a contractual agreement for the payment of defense fees.  The retention agreement was between the law firm and the official creditors’ committee, but it would be Boomerang Tube’s bankruptcy estate, a non-party to such agreement, that would bear the costs.  Finally, she determined that the proposed fee shifting provisions were simply not “reasonable” terms of employment of professionals with the meaning of Section 328.

In view of the extent to which challenges to estate professionals’ fees (or at least the threat of doing so) are ingrained in chapter 11 practice, it was unlikely that Boomerang Tube would be the last word on this issue.  Recent decisions in two cases, Nortel Networks and Hungry Horse, have distinguished Boomerang Tube.

Judge Kevin Gross, a Delaware colleague of Judge Walrath, ruled in Nortel Networks that Baker Botts and Boomerang Tube did not apply to a fee dispute between an indenture trustee and certain bondholders, and permitted the trustee to recover its attorneys’ fees for defending against the challenge.  Although this case is not directly on point as it did not involve an estate professional, and Judge Gross was not opining on whether Section 328 would permit such an agreement, he held that the bond indenture qualified as a contractual exception to the American Rule, noting that, unlike the retention agreement in Boomerang Tube, it was an agreement directly between the debtor and the trustee.

In Hungry Horse New Mexico Bankruptcy Judge David Thuma looked to Nortel Networks for support in holding that a retention agreement in a chapter 11 case between proposed debtor’s counsel and the debtor could pass muster under Section 328, thereby permitting a contractual work-around to Baker Botts.  Judge Thuma first determined that nothing in Baker Botts prevented a bankruptcy court from finding a fee defense provision in a retention agreement to be “reasonable” within the meaning of Section 328.  In his reading of Baker Botts, the Court simply limited the compensation an estate professional could receive under Section 330 to fees for services to the client, rather than on its own behalf, and noted that Section 328 had no applicability to that issue.

He then considered various other provisions typical of retention agreements, and observed that several were “reasonable” under Section 328 even if they were intended to favor the professional, rather than the client. He pointed to provisions, among other things, setting out retainer requirements, permitting an attorney to withdraw under certain conditions, and granting a lien on certain recoveries.  “A typical employment agreement between a lawyer and a client has many terms; some benefit the client, while others benefit the lawyer.  Considered together, they may be reasonable.”  The overall effect, he noted, is that “the client obtains the services of needed, able professionals.”

Judge Thuma concluded that Section 328 therefore can permit contractual exceptions to the American Rule, and outlined the terms of a fee defense provision in a retention agreement that he believed was “reasonable” and “violat[ed] neither the letter nor spirit of [Baker Botts].”  He stated that, among other things, it needed to be agreed to by the bankruptcy estate, in order to avoid the issue highlighted by Judge Walrath in Boomerang Tube, and provided also that it extended to the creditors’ committee’s professionals, in order to “level the playing field.”  He suggested sample language that he believed could be acceptable under Section 328:

Fee Defense. The Client agrees to pay all reasonable legal fees and expenses incurred by the Firm, and also by any counsel retained by the unsecured creditors’ committee (if one is formed in the Client’s bankruptcy case) for successfully defending their respective fee applications. The bankruptcy court must approve all of such fees as reasonable. The Client will have no obligation to pay for any fees or expenses the Firm incurs defending fees that are not allowed.

Disputes over payment of estate professionals’ fees will invariably remain part of the bankruptcy landscape. Estate professionals in chapter 11 cases are likely to ask bankruptcy judges in other jurisdictions to follow the pragmatic approach of Judge Thuma in Hungry Horse in order to blunt the detrimental impact of Baker Botts.

Could Supreme Court Case on Debt Recharacterization Provide a Pathway Out of the Stern v. Marshall Maze?

The Supreme Court recently granted certiorari in PEM Entities LLC v. Levin, in which it will decide whether federal or a state law should apply when a debt claim held by a debtor’s insider is sought to be recharacterized in bankruptcy as a capital contribution and treated as equity.  The case raises important questions about the extent to which the commencement of a proceeding under the U.S. Bankruptcy Code can and should affect parties’ rights and interests as they exist under non-bankruptcy law.  For this reason alone, the impact of PEM Entities is likely to be significant.

It is also possible that it could lead the Court more broadly to consider the scope of Congress’s bankruptcy power. In such event, PEM Entities potentially could provide the Court with a coherent rationale to start resolving the uncertainty it created six years ago in Stern v. Marshall regarding the constitutional authority of bankruptcy courts.

The facts of PEM Entities are straightforward.  A group of investors created an investment vehicle, Province Grande Olde Liberty, LLC (“Province”), in order to acquire real estate in North Carolina for the purpose of developing a golf course and surrounding homes.  Province obtained a bank loan of approximately $6.5 million, secured by the real estate itself, and received a separate, unsecured loan in the amount of $188,000 from an investment fund, Lakebound Fixed Return Fund LLC (“Lakebound”).

When the secured loan went into default and the bank threatened to foreclose, certain of Province’s investors formed PEM Entities LLC, and purchased the secured loan from the bank for approximately $1.24 million. The development efforts ultimately failed, however, and Province filed for protection under chapter 11 of the Bankruptcy Code.  When PEM sought to enforce its rights as a secured creditor under the purchased bank loan, certain investors in Lakebound brought an action to have the claim recharacterized as equity, and thus subordinate to Lakebound’s unsecured claim.

The bankruptcy court ruled in favor of the Lakebound investors, applying a federal standard for recharacterization in bankruptcy cases that is broader than the test that would have applied had it looked to applicable (North Carolina) state law. Under North Carolina law, the form of the transaction would probably have determined the outcome and, since PEM had purchased a loan made by a third party, PEM would have been able to enforce its rights as a secured creditor.  Under the federal test, adapted from decisions in tax cases, courts look beyond the form of the transaction to consider whether, in essence, the money at issue was invested for the purpose of being repaid with interest at an established date, or instead was a bet on the ultimate success of the venture.  The bankruptcy court, among other things, determined that when PEM acquired the bank loan, Province would not have been able to obtain financing from a non-affiliated third party, and that the PEM investors were mainly motivated to salvage their initial investment in Province.

The bankruptcy court’s ruling was affirmed on appeal by both the district court and the U.S. Court of Appeals for the Fourth Circuit, both of which similarly applied the federal standard. The Supreme Court granted certiorari in order to resolve a split among circuits as to whether federal or state law governs debt recharacterization.

PEM will argue that debt recharacterization is essentially a form of claim disallowance and is therefore governed by the plain language of section 502(b) of the Bankruptcy Code.  That section provides that claims filed against a bankruptcy estate are allowed unless the “claim is unenforceable . . . under applicable law[.]”  Since under North Carolina state law, the “applicable law” in this circumstance, the debt would not be subject to recharacterization, PEM will contend that its secured claim must be allowed.  PEM will also point to the Court’s decision in Butner v. United States, in which the Court expressly held that property rights in bankruptcy are determined by applicable state law unless “some federal interest” requires otherwise.

The Lakebound investors will counter that the equitable power of bankruptcy courts allows for the rejection of form over substance, and that the majority of circuit courts which have considered the issue have found that bankruptcy courts have the authority to recharacterize debt under section 105(a) of the Bankruptcy Code, which provides that bankruptcy courts “may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.”  They will argue that recharacterization by bankruptcy courts is an essential part of maintaining the Bankruptcy Code’s priority scheme, and that using the federal test is well within the “appropriate” means of section 105(a).

In its petition for Supreme Court review, PEM described the question as a split among federal courts of appeal as to “whether (a) the doctrine [of recharacterization] is part of some general power of bankruptcy administration or (b) the existing obligations of the debtor based on the law of the [fifty] states.” (emphasis added).  This description could apply equally to numerous other provisions of the U.S. Bankruptcy Code, which in essence constitutes a federal law structure overlaying substantive rights between private parties which are governed by applicable state law.  Bankruptcy judges must often determine whether “some federal interest,” mandates a different outcome for the parties under the Bankruptcy Code than under state law.

The Court will probably rule on this question narrowly in PEM Entities and limit it to the issue of debt recharacterization.  However, it is intriguing to consider where a broader ruling on the extent of “some general power of bankruptcy administration” could lead.  In particular, it could provide the Court with a pathway out of the constitutional maze it created a few years ago in Stern v. Marshall regarding bankruptcy court authority.

In Stern, the Court disrupted a long standing delicate constitutional balance between the need for an effective system of specialized courts existing pursuant to Congress’s bankruptcy power under Article I, Section 8, and the vesting of the judicial power of the United States in the federal courts under Article III.  Since the Court in cases going back to the nineteenth century had limited the final decisional authority of Article I courts to cases involving “public” rights (e.g., cases involving claims of citizens against the government), the ability of bankruptcy courts to hear and determine cases under the Bankruptcy Code was predicated on the notion that “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted a type of “public” right which could be heard and decided by an Article I bankruptcy judge.

Bankruptcy courts accordingly have since 1984 been statutorily authorized under section 157 of the Judicial Code to issue final orders with respect to a variety of enumerated “core” bankruptcy matters, such as resolving claims against a debtor’s bankruptcy estate and confirming plans of reorganization, and required to issue findings of fact and conclusions of law for review and determination by an Article III district court judge for all “non-core” matters. Stern put this balance out of kilter by focusing on parties’ “private” rights, and ruling that even “core” matters would in some situations require adjudication by an Article III judge. Stern involved a challenge to a bankruptcy court’s authority to hear and determine a bankruptcy estate’s counterclaim against an estate claimant.  Even though such counterclaims are listed as “core” matters under section 157, the Court in Stern ruled that it would be unconstitutional for the counterclaim in that case to be decided by an Article I bankruptcy judge, on the basis that it involved a “private” right because the cause of action would exist under state law “without regard to any bankruptcy proceeding.”

Stern has created a constitutional quandary.  Since (per Butner) parties’ rights in bankruptcy are usually based on state law, “core” matters will often implicate “private” rights.  The ability of bankruptcy judges to rule on fundamental matters such as determining whether certain property belongs to a bankruptcy estate has been questioned because they are governed by state law.  Although Stern’s quandary has been narrowed somewhat by subsequent Court decisions, it continues to cause confusion and uncertainty in the adjudication of bankruptcy cases.

The constitutional authority questions arising from Stern and the decisional law question of PEM Entities are very different.  However, if the Court in PEM Entities were to issue a ruling broadly focused on the scope of “the general power of bankruptcy administration” as a “federal interest” requiring the application of federal law to the question of debt recharacterization, it could lead to a viable view of such power as a “public” right.  This in turn could allow courts to make the key constitutional factor in resolving questions of bankruptcy court authority to be the nexus of a particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights would separately exist under state law.  Such a focus on the “public” side of the public/private rights dichotomy could provide a path away from the confusion engendered by Stern, and restore the constitutional balance of bankruptcy court authority.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Judge Gross overruled most of the 7.875% noteholder objections.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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