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The Jevic Files Continue: Pioneer-ing the Post-Jevic Era, and Wondering if Jevic Altered Critical Vendor Theory After All?

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Editors’ Note:  The Supreme Court’s Jevic ruling last spring remains a treasure trove of bankruptcy theory, suitable for the novice bankruptcy student and highly instructional for those of us who have practiced in chapter 11 for years.  We at The Bankruptcy Cave like it so much that we will be offering a few more posts in upcoming weeks on the lower courts’ interpretation of Jevic since the spring, the continued efforts in Delaware to sidestep Jevic, and other important learning from the case.  Here, our co-editor Justin Morgan, practicing law just a few short blocks from the court that gave us the resounding critical vendor opinion in KMart, points out that while Jevic provides dicta in support of critical vendor motions, subsequent caselaw continues to put debtors through their paces when seeking to use this theory. 

In Pioneer Health Services, Inc., Chief Judge Neil Olack of the Bankruptcy Court for the Southern District of Mississippi had one of the first opportunities to apply the Supreme Court’s recent decision on critical vendor payments structured dismissals in Czyzewski v. Jevic Holding Corp.  As we discussed here at the Bankruptcy Cave after Jevic first came out, Jevic’s holding—rejecting a structured dismissal that distributed assets contrary to the Bankruptcy Code’s priority scheme—was not particularly surprising.  But Jevic went out of its way to distinguish priority-skipping structured dismissals from other priority-skipping distributions such as critical vendor payments.  We wondered how strongly courts would read Jevic’s dicta to support critical vendor theory and other so-called “doctrine of necessity” theories.  If Pioneer is any indication, not much has changed—and courts remain (rightly) critical of critical vendors.

If anything, the Pioneer opinion was less of a resounding approval of critical vendor theory than Jevic as the bankruptcy court denied the debtor’s motion.  The bankruptcy court cited established tests for critical vendor treatment while expressing general disapproval for the whole judicially-fashioned theory.  “The Fifth Circuit, at best, takes a dim view of critical vendor orders,” according to Pioneer, so apparently Jevic did nothing to brighten the picture.  Judging by the single data-point of Pioneer, then, critical vendor theory appears to be where it was before Jevic was handed down.

A chapter 11 debtor seeks to pay prepetition claims of so-called critical vendors outside the priority scheme set forth in the Bankruptcy Code because the vendor would otherwise end its relationship with the debtor causing a disproportionate impact to the debtor’s business (or so the debtor may argue). Motions to approve critical vendor payments are usually sought early in a chapter 11 reorganization.  In exchange for accepting early payment of its prepetition claim, the critical creditor usually must enter into a new contract with the debtor-in-possession, agreeing to supply product (sometimes on credit) for the balance of the case, to ensure that it can’t simply pocket the money and run.

But the facts in Pioneer, as explained by the bankruptcy court, differed significantly from the typical critical vendor situation.  On the petition date, Pioneer owed wages to three emergency department doctors at two of its hospitals.  All three doctors had executed employment agreements with Pioneer.  According to Pioneer, all three doctors had concerns about continuing to work for a hospital that owed them money, and the hospitals would struggle or close if the doctors actually quit.  Accordingly, some ten months (?!?) after the petition date, Pioneer sought approval to pay the prepetition claims of the three doctors by treating them as critical vendors.

The bankruptcy court explained that payments to critical vendors are not explicitly authorized by the Bankruptcy Code and that the standards for approving payments of critical vendors’ prebankruptcy claims are strict.  The rule set out in CoServ (an opinion representing the low-water mark in the history of critical vendor theory, in our view) requires a showing that critical vendor payments preserve the estate:

First, it must be critical that the debtor deal with the claimant. Second, unless it deals with the claimant the debtor risk the probability of harm, or, alternatively, loss of economic advantage to the estate or the debtor’s going concern value, which is disproportionate to the amount of the claimant’s prepetition claim. Third, there is no practical or legal alternative by which the debtor can deal with the claimant other than by payment of the claim.

In re CoServ, L.L.C., 273 B.R. 487, 498 (Bankr. N.D. Tex. 2002).

The Supreme Court in Jevic cited to a different rule from the Seventh Circuit, which requires “(1) the payments are necessary for a successful reorganization, (2) the disfavored unsecured creditors will be as well off with reorganization as with liquidation, and (3) the critical vendors would cease doing business with the debtor if the payments are not made.” Pioneer at 10 (citing In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004)).

As the bankruptcy court explained, “Jevic suggests that CoServ’s and Kmart’s restrictive view of critical vendor payments is the correct approach.”  Accordingly, critical vendor status was denied as to any of the doctors because the evidence submitted by the Debtor “was insufficient to show that the Affected Physicians fall within any definition of critical vendors.” Pioneer at 11.  Specifically, there was no evidence that the doctors were critical in the sense of being irreplaceable, there was no evidence the doctors would actually leave if the payments weren’t made, there were other ways to compel performance of the employment contracts, and the business purpose for paying the doctors was unsound because the Debtor had not required the doctors to execute a critical vendor agreement that would assure continued performance. Though not explicit, the bankruptcy court’s analysis in Pioneer appeared to track the CoServ factors and did not explicitly analyze the Kmart factors.

Overall, Pioneer didn’t appear to distill new law from Jevic.  The bankruptcy court would have likely followed the CoServ factors with or without Jevic, and the fact that Jevic cited Kmart was not read as a rejection of the more restrictive rule from CoServ.  Furthermore, Pioneer rested in part on facts “so far outside the norm” for critical vendor motions in chapter 11 cases that the bankruptcy court rested its decision at least in part on policy concerns. Pioneer at 13.

The Supreme Court may well have intended this exact result.  A narrow Jevic decision resting only on the lack of justification in the Bankruptcy Code for priority-skipping structured dismissals would have gotten the job done in that case.  But without explaining why critical vendor payments (or first-day wage orders or roll-ups) were different, a self-described narrow Jevic opinion could have invited more questions than answers. Cf. Stern v. Marshall, 564 U.S. 462, 502 (2011) (“[W]e agree with the United States that the question presented here is a ‘narrow’ one.”).  Many in the bankruptcy bar feared such an outcome.  By explaining that the priorities of the Bankruptcy Code can be violated for legitimate bankruptcy objectives and where supported by a significant bankruptcy-related justification, the Supreme Court may have limited such challenges.  But let’s not go overboard—Pioneer reels us all in and reminds us that a critical vendor motion remains a hard argument to win, requiring detailed facts and thorough justification.

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Sabine: The Next Episode

Sabine: The Next Episode

April 13, 2017

Authored by: Craig Schuenemann

Editor’s Note: On June 16, 2016, The Bankruptcy Cave gave you our previous summary of the controversial Sabine decision.  When Bankruptcy Judge Chapman determined there was no reason to expedite review of her decisions in the case, we brought you Sabine Lives On (and On) detailing the struggles of Sabine’s midstream adversaries.  Like Hollywood, Bankruptcy Cave knows that sequels sell (with some notable awful exceptions, such as here and here).  We now bring you the third installment of Sabine.  If it sounds like a horror film or slasher flick, it was for the midstream sector.

The bankruptcy court was right!  Judge Rakoff of the United States District Court for the Southern District of New York stated starkly: “[T]he bankruptcy court did not err in authorizing the rejection of the Agreements pursuant to 11 U.S.C. § 365(a).  Nordheim challenges the decision only on the ground that the Agreements are real covenants that run with the land, and, since the Court reaches the contrary conclusion; Nordheim’s argument in this regard has no merit.”[i]

Backing up almost a year, on March 9, 2016, Bankruptcy Judge Chapman of the Southern District of New York issued her decision on the Debtor’s motion to reject certain contracts in Sabine Oil & Gas Corporation’s Chapter 11 case.  The decision allowed Sabine to reject “gathering agreements” between it and two “midstream operators” [for more info on these technical terms see my prior blog post here] Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC, under Section 365(a) of the Bankruptcy Code.  In June, 2016, Judge Chapman refused to allow the midstream operators to appeal her decision to the Second Circuit Court of Appeals and rejected requests to stay her decision.[ii]  These decisions sent shockwaves through the midstream energy sector and leveled the playing field for bankrupt production companies.

Judge Rakoff’s opinion (full copy Here) turns immediately to the question of “whether the Agreements run with the land and therefore cannot be rejected pursuant to § 365(a).”[iii]  Relying on Texas law and citing Inwood N. Homeowner’s Ass’n v. Harris, the Court notes that

In Texas, a covenant runs with the land when it touches and concerns the land; relates to a thing in existence or specifically binds the parties and their assigns; is intended by the original parties run with the land; and when the successor to the burden has notice.[iv]

It is the first requirement, that a covenant touch and concern the land, which drew the Court’s attention.

Judge Rakoff rejected Nordheim’s argument that the dedication of gas and condensate “produced and saved” under the Sabine contract was an interest that touched and concerned the land.[v]  Instead, Judge Rakoff reasoned that the Sabine contract had not granted Nordheim a royalty interest or any other mineral rights or interests recognized by Texas law.  The Court also noted that the Agreements “did not decrease Sabine’s legal relation to its real property interests.”[vi]  In other words, Sabine did not convey real property interests to the appellants, only personal property interests in the oil and condensate after it was produced.

Judge Rakoff’s reasoning followed Judge Chapman’s previous decision very closely and directly rejected any contrary interpretation of Texas law.  Specifically, both rejected Nordheim’s argument that In re Energytec, Inc. applied to the circumstances of the case.[vii]

The latest Sabine ruling has three immediate impacts. First, the ruling expands the precedential value of the bankruptcy court’s decision.  While technically the District Court’s ruling is only binding in the Southern District of New York, its practical implications are far broader.  Sabine is no longer a rogue decision; it has been upheld on a de novo review by a very well-regarded Judge Rakoff.  Second, the District Court’s ruling places additional pressure on midstream operators to settle and renegotiate their gathering agreements with bankrupt producers, as has been the case in multiple cases with gathering agreements similar to those at issue in Sabine.[viii]  [Of course, this is exactly what Congress had in mind with Section 365 – forcing parties with above-market contracts to come to the table and negotiate with a debtor-in-possession.]  Finally, attorneys for midstream operators will need to devise new contract language if they want to protect their clients’ interests by attaching them to the land.  It is no longer enough for a gathering contract to simply say that it is a covenant running with the land; the language and reach of the contract must be broad enough to actually provide the midstream operator with a property right.

[i] HPIP v. Sabine, No. 16-04127(JSR) Docket No. 28 (S.D.N.Y. Mar. 10, 2017).

[ii] In re Sabine Oil & Gas Corp., No. 15-11835 (SCC), Docket. No. 1276 (Bankr. S.D.N.Y. June 15, 2016).

[iii] HPIP Supra. Note 1 at *7-*8.

[iv] 736 S.W. 2d 632, 635 (Tex. 1987).

[v] HPIP Supra. Note 1 at *9-*10.

[vi] Id, at *11.

[vii] 739 F.3d 215, 221 (5th Cir. 2013).

[viii] See, e.g., In re Quicksilver Resources Inc., Case No. 15-10585 (Bankr. D. Del.) (settlement reached); In re Penn Virginia Corp., Case No. 16-32395 (Bankr. E.D. Va.) (settlement reached); In re Emerald Oil, Inc., Case No. 16-10704 (Bankr. D. Del.) (settlement reached); In re Magnum Hunter Resources, Case No. 15-12533 (Bankr. D. Del.) (agreements assumed); In re SandRidge Energy, Inc., Case No. 16-32488 (Bankr. S.D. Tex.) (settlement reached).

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Bankruptcy Bulletin Blamed for Blabbing Bondholders; New York Court Appoints Itself Arbiter of Who is “Legitimate Media”

world_war_II-talking_poster_1942We are all very used to (and very bored of) the on-going debate of what actually constitutes “the media” or “legitimate news.”  In most instances, this sort of debate pits exclusive, Columbia-educated, “proper” journalists against those who have large on-line followings and eschew any association with a Dickensian-era newspaper.  Or, as one story recently summarized it, “Corporate Media Freaks Out at Possibility of Breitbart, Infowars Being Allowed to Ask Questions [in White House Press Conferences],” full story here.

This debate has now, surprisingly, found its way into our arcane little bankruptcy world, with Murray Energy Corporation v. Reorg Research, Inc., 2017 NY Slip Op. 27036 (N.Y. County Sup. Ct., Feb. 14, 2017) (Edmead, J.).  It started with a distressed company called Murray Energy establishing an on-line “data room” for bondholders and lenders to access confidential information posted by Murray Energy about its restructuring efforts and financial performance.  For one to obtain the information, it had to sign a confidentiality agreement with Murray Energy, agreeing not to share the information with others.  According to Murray Energy, the information in the data room contained “vital clues about Murray’s business strategy and overall financial condition.”  Murray Energy was worried that the information, if widely disseminated, could help “potential hostile investors considering a possible takeover of Murray Energy (which can conceivably be orchestrated through a massive purchase of public debt).”  Moreover, according to Murray Energy, dissemination of the secret data “would also give competitors in the coal industry an unfair advantage because it offers a detailed and concrete window into how Murray Energy is handling the ups-and-downs of the turbulent coal market.”

While Murray Energy was attempting to control its information flow, a company known as Reorg Research smelled a story.  Reorg Research is a subscription-only service, gathering hard-to-find information on restructuring matters for its paid subscribers (at a rate of $30k-$120k/year, which we tightwads at The Bankruptcy Cave think is a lot!).  Reorg Research touts itself as a media company, focusin on “market-moving intelligence, and independent analysis on the distressed debt and leveraged financed markets.”  Importantly, Reorg Research subscribers must also agree, in writing, not to disseminate information learned from Reorg Research.

Anyway, back to Murray Energy.  In August of 2016, Reorg Research published several in-depth stories about the distressed coalminer.  The stories allegedly contained information that Murray Energy thought could only come from those who leaked data from a lender presentation Murray Energy had posted to its confidential data room for lenders and investors.  Murray Energy sued Reorg Research, demanding to find out who was the canary.  In response, Reorg Research relied on New York’s “Shield Law” (N.Y. Civil Rights Law § 79-h), which protects journalists from having to disclose confidential sources.

Protection by the Shield Law, however, requires one to be a “professional journalist,” which is defined by the Shield Law as

one who, for gain or livelihood, is engaged in gathering, preparing, collecting, writing, editing filming, taping or photographing of news intended for a newspaper, magazine, news agency, press association or wire service or other professional medium or agency which has as one of its regular function the processing and researching of news intended for dissemination to the public . . .

Here, because Reorg Research did not disseminate its stories to the public – and indeed, prohibited such dissemination through agreements with its subscribers – it could not rely on the Shield Law.  Curiously, the Court took great pains to distinguish a ruling that the ratings agency Fitch would be covered by the Shield Law despite that Fitch stories / bond ratings required a subscription.  Apparently Fitch made such items free to the public “for a limited time” on its website.  There is no discussion of what this “limited time” is, and so we at the Bankruptcy Cave are left wondering what the real difference is between Fitch and other ratings agencies that require subscriptions, and Reorg Research, which appears to be identical (albeit perhaps more expensive).  We are also concerned that the Court seemed to dispute that there is any public purpose served by companies like Reorg Research.  Indeed, the Court’s characterization of Reorg Research’s customers as “vulture investors” (a low blow, to us) appears to the Bankruptcy Cave as an inappropriate pre-judging of who is “good media with good readers” and who is “illegitimate media with bogus readers.”  Does this sound familiar to anyone?  Courts, like candidates, really have no place judging what media is legitimate and what it not.

At the end of the day, we wish Murray Research would have simply issued a subpoena to the users of its data room.  If one of them was the leak, we could avoid this entire, unsettling argument of what is a “professional journalist.”



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Supreme Court Completely Endorses Critical Vendor Theory! Well, Not Completely. But Almost!

We at the Bankruptcy Cave are not very surprised by the ruling yesterday in Czyzewski v. Jevic Holding Corp.  The Supreme Court in Jevic reviewed a Bankruptcy Court’s decision to approve a settlement (with a distribution of proceeds that contravened the Bankruptcy Code’s priority scheme) in conjunction with dismissing the bankruptcy case of the Chapter 11 debtor Jevic Holding Corp. According to the Bankruptcy Court, because the distributions would occur pursuant to a “structured dismissal” rather than a confirmed plan, the failure to follow the creditor priority scheme did not bar approval.  In short, the Bankruptcy Court did not confirm a plan of reorganization for the Chapter 11 debtor, in which sufficient creditor support can re-order some of the Bankruptcy Code’s priority scheme.  Nor did the Bankruptcy Court convert Jevic’s Chapter 11 case to Chapter 7, in which the Code’s creditor priority scheme can never be changed. Instead, the Bankruptcy Court allowed a “structured dismissal,” a hybrid unrecognized by the Code (but oh so popular among the Delaware set).  In a “structured dismissal,” a case is dismissed and, through opaque deal making, cash proceeds of the estate are shifted to some creditors that Congress afforded lower priority (like general unsecured claims in Jevic’s bankruptcy case) despite nothing being paid to higher priority creditors (like unpaid wage claims of truck drivers in Jevic’s bankruptcy case).

Nothing in the Bankruptcy Code allows such re-ordering of creditor priorities as part of a dismissal.  Thus, in Jevic, the Supreme Court rejected the proposed “structured dismissal” and sent the case back to the Bankruptcy Court to distribute the money as the Code requires.  In summary, Orwell’s adage that “all animals are equal, but some animals are more equal than others” George Orwell, Animal Farm 112 (Signet 1962 edition) (1946) has no place in the Bankruptcy Code, according to the Supreme Court in Jevic.

But a truly astounding part of the Supreme Court’s opinion in Jevic provided (in dicta, we grudgingly admit) strong support for the oft-criticized “critical vendor” theory used in many large Chapter 11 cases to immediately pay seemingly important (i.e., “more equal”) unsecured creditors while other creditors sit and wait.

Specifically, the Supreme Court’s opinion in Jevic went to great lengths to mention the many valid circumstances in which a bankruptcy court “has approved interim distributions that violate ordinary priority rules.”  The Court specifically noted “‘first-day’ wage orders that allow payment of employees’ prepetition wages, ‘critical vendor’ orders that allow payment of essential suppliers’ prepetition invoices, and ‘roll-ups’ that allow lenders who continue financing the debtor to be paid first on their prepetition claims.”

The Court noted that such orders are based on findings that these priority-skipping payments “would ‘enable a successful reorganization and make even the disfavored creditors better off.’” (Jevic, citing, inter alia, In re Kmart Corp., 359 F.3d 866, 872 (7th Cir. 2004)).  Thus, such payments would (or could? or always? — it is hard to say how strong this dicta is) be allowed due to a “significant offsetting bankruptcy-related justification.”

This was a shocker.  Not because we think it is wrong – the Supreme Court is dead right that the exigencies of the initial days in Chapter 11 can permit certain limited payments to pre-petition, unsecured creditors – but because the Court did not have to delve into these theories to decide Jevic.  The Supreme Court could simply have stated that nothing in the Code’s “dismissal” provisions allow for priority skipping, and that would be that.  But instead, the Court’s expansive reasoning buttresses “critical vendor theory” and similar theories that allow for some creditors to be paid immediately upon a Chapter 11 – if there is a “significant offsetting bankruptcy-related justification.”

In conclusion, Jevic did not surprise us with its ruling, but surprised (and impressed) us with how far it went to provide added support for critical vendor theory.  Jevic is, as one may say, a critical case for those in the bankruptcy world.

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Fifth Circuit Rules for PACA Claimants, and Weakens PACA, All in One Curious Ruling

Set of colored vegetables for kids

Most restructuring practitioners are aware, either vaguely or through punishing experience, of the power of PACA creditors.  PACA (or the Perishable Agricultural Commodities Act, 7 U.S.C. § 499a et seq. for those who hate brevity) requires that buyers of produce hold such produce – and their proceeds – in trust for the benefit of produce sellers.  General creditors of the produce buyer receive nothing, even if they hold a lien on the buyer’s assets, until produce sellers are paid in full on any valid PACA claims (including their interest and attorneys’ fees in most instances).

But sometimes, or many times, the PACA trust assets needed to pay produce sellers are not present.  Accounts must be collected, by use of employees, lawyers, collection agents, or other parties.  Inventory must be preserved and then sold, incurring further costs.  In short, assets to pay PACA claims don’t magically appear, and if no one is paid to pound the pavement to sell that inventory and collect those funds, nothing will be collected, and nobody gets paid.

The Bankruptcy Code deals with the problem very simply.  If assets are being collected for the benefit of unsecured or priority creditors, the post-petition costs and expenses incurred to liquidate such assets are granted first priority of payment.  11 U.S.C. § 503(b)(1)(A).  Alternatively, if assets are being collected (or costs incurred) for the benefit of a secured creditor, the secured creditor’s collateral can (and should) be surcharged.  11 U.S.C. § 506(c).  If the secured creditor complains or balks, the trustee or DIP can (and should) abandon the collateral and force the secured creditor to pay its own costs to liquidate the collateral.

However, a recent Fifth Circuit opinion rejects this common sense approach when PACA is involved.  In Kingdom Fresh Produce, Inc. v. Stokes Law Office (In re Delta Produce), the Fifth Circuit held that the trust structure of PACA mandates that produce sellers be paid in full even prior to the costs of counsel which collected every single dollar needed to pay those very produce sellers’ claims.

The case has limited reasoning.  It borrows from cases holding that PACA creditors are ahead of secured creditors or other creditors, and expands that principal to cover everything.  A utility keeps the power on at the food warehouse so the inventory can be preserved and sold?  That is a foolish utility, unless it knows to a certainty the proceeds can pay PACA sellers in full, leaving funds left over to pay the utility bills.  Employees show up to make collection calls, or process payments?  Good luck getting paid for such efforts, if despite their work funds are insufficient to pay PACA claims in full.  In short, Kingdom Fresh turns a food business in wind-down into a charity for the benefit of PACA claimants, with everyone providing pro bono service to enhance the PACA trust.

Kingdom Fresh recognizes this “free rider problem“: why would anyone work even one iota for an insolvent produce buyer, if payment for their efforts comes behind all the PACA claimants?  But while the Kingdom Fresh Court notes this problem, its proposed solutions are, frankly, illusory.  The Court notes (remarkably, in the view of The Bankruptcy Cave) many professionals will be willing to work to collect assets for PACA creditors, and bear the risk of their fees being behind millions of dollars of such PACA creditors.[1]  Wow.  Second, the Fifth Circuit states that a court-appointed Special Master could do the collections work.  Yet this is not at all what Special Masters do under Federal Rule 53.  Third, the Kingdom Fresh Court notes that PACA allows recovery of attorneys’ fees – and so presumably attorneys working for the estate to collect A/R can get paid from the account debtors?  We guess so, but this is also speculative.  And who is to say the unpaid produce sellers cannot glom onto an attorneys’ fee award the same way they have a senior interest in an underlying claim or judgment owed by a third party to a debtor?  The opinion is silent.

Kingdom Fresh can be viewed as a victory for produce sellers and other beneficiaries of PACA – once again, such creditors are declared to be first among all other creditors.  But its slavish devotion to PACA renders every insolvency case involving the sale of produce much harder – things will grind to a halt until professionals employed to collect and liquidate assets negotiate with PACA creditors to be paid.  By depriving courts of the power to surcharge PACA trust assets, collection of those assets will be delayed or just won’t happen at all.  No one benefits, not even those which PACA is supposed to help.  Kingdom Fresh is, in fact, one of the most anti-PACA cases we at The Bankruptcy Cave have seen, despite its protestations to the contrary.

[1] This is an astounding and unsupported assumption. People taking on greater risk need greater compensation.  No one will take on risk of non-payment for free.

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For Whom the Bell Tolls: Obligations and Risks of Third-party Witnesses under Rule 2004 Examinations.

November 27, 2016


Two recent Bankruptcy Court cases both remind and illustrate the power and risks presented by discovery of facts and documents under Bankruptcy Rule 2004, showing that it can compel third parties to provide information to support later litigation against them or cause them to lose their 5th Amendment right against self-incrimination.

  • In re Great Lakes Comnet, Inc.[1]/ (a copy of the case is here: great-lakes-comnet-inc), the Bankruptcy Court for the Western District of Michigan held that the Committee of Unsecured Creditors was entitled to conduct a Rule 2004 examination of a third-party company while explicitly recognizing that the intent of the examination was to prepare for and inform the committee regarding later litigation against the third-party.
  • In re Mavashev[2]/ (a copy of the case is here: in-re-mavashev), the Bankruptcy Court for the Eastern District of New York held that a third-party witness would not be prejudiced by any self-incrimination in the act of producing a document central to what was very likely a criminal transaction in association with the debtor, and further that such witness had waived his privilege against self-incrimination by prior, limited testimony in the Rule 2004 examination.

Discovery of facts and documents in bankruptcy litigation takes place under three broad categories of Bankruptcy Rule practice: (1) a Meeting of Creditors under Section 341 and Rule 2003, (2) examination and production of documents under Rule 2004, and (3) mirror-image federal civil rules discovery under Rules 7026-7037 for adversary proceedings or contested matters.  For all such discovery, the compulsory participation and scope of inquiry is relatively contained and governed under statutes, rules, and case law, and it is the tendency of jurisprudence over the years to make the rights and obligations thereunder more and more clear.  However, the broad scope of subject matter and proper parties to discovery under Rule 2004 seems to yield a staying power against attempts to limit it on the basis of anything other than a facts-and-circumstance, case-by-case approach.

The amorphous, yet clearly large and powerful, scope of subject matter and parties for compulsion under Rule 2004 seems particularly consternating in the recurrent problem of third-party witnesses. These are persons or entities that are not debtors or creditors, yet find themselves under substantial obligations to appear, testify and produce documents under Rule 2004.  Most lawyers in this area of practice will be familiar with the scenario of a client who is understandably incredulous that she has to comply with a burdensome obligation of appearance and production pursuant to a subpoena served under Rule 2004.

Practice under Rule 2004 involves many substantive and procedural issues.[3]  For purposes of this limited treatment of the subject, the general background of Rule 2004 practice includes:

  • The Rule 2004 inquiry may be made by any person with a legitimate interest in the case (i.e., not limited to the Trustee, Debtor, etc.) and upon any person or entity that has the required information (i.e., not limited to a party to the bankruptcy proceeding).
  • The scope of Rule 2004 inquiry is very broad and relates to any “acts, conduct, or property or to the liabilities and financial condition of the debtor, or to any matter which may affect the administration of the debtor’s estate, or to the debtor’s right to discharge.”
  • In Chapter 11 and Chapter 13 cases, the permissible scope includes the above, plus: inquiry related to “the operation of any business and the desirability of its continuance, the source of any money or property acquired or to be acquired by the debtor for purposes of consummating a plan and the consideration given or offered therefore, and any other matter relevant to the case or to the formulation of a plan.”
  • Generally, the breadth of permissible subject matter and potential witnesses has been likened to a “fishing expedition.”  However, limits on Rule 2004 include that it cannot be used: to harass parties or witnesses, as a substitute for civil rule or adversary proceeding rule discovery where an action is pending (with limited exceptions), in a post-confirmation or closed case scenario where there is no property of the estate, or where the inquiry is upon a dispute that is barred by res judicata.
  • Protections of privileged or confidential subject matter apply in the same way they do to deposition or trial testimony.

One of the most common objections seen in response to Rule 2004 notices and subpoenas to third-party witnesses is that the inquiry appears to be preparation for later litigation and therefore inappropriately attempts to avoid the witness and party protections of discovery under rules of civil cases and adversary proceedings.  This was the nature of the objection raised by the witness in the Great Lakes Comnet case.  The case was before the Court as a Chapter 11 case, and so involved the broadest scope of Rule 2004 inquiry as set out above.  The Debtors in the case had become the subject of a regulatory complaint by the Federal Communications Commission and AT&T that implicated the Debtors and Local Exchange Carriers of Michigan, Inc., a/k/a (“LEC-MI”) as to improper payments under a revenue sharing agreement.

The Committee of Unsecured Creditors (“Committee”) undertook investigation of potential claims against various parties, including LEC-MI.  For its part, LEC-MI voluntarily cooperated with the investigation up to a point, and then declined further participation.  The Committee then filed a motion requesting authority to conduct a Rule 2004 examination of LEC-MI, and LEC-MI’s responsive objections included that the Committee motion was a “clandestine attempt” to “circumvent the discovery rules.”  The Court found that “good cause” for a Rule 2004 examination includes seeking additional information to determine whether the Debtor estate has causes of action against third parties, noting that the permissible scope of the inquiry can be a “fishing expedition”, “exploratory”, and even “groping”.  In granting the Committee motion, the Court discussed with approval that making an extensive preliminary inquiry under Rule 2004 in advance of intended litigation supports goals of civil and adversary proceedings litigation practice by narrowing the eventual causes of action, exploring the potential of defenses and affirmative defenses, and supports the ability of a plaintiff to meet federal pleading standards for “plausible” causes of action or the heightened pleading standard for fraud.[4]/

In re Mavashev was a converted Chapter 7 case and therefore dealt with the comparatively lesser scope set out above.  However, this case dealt with “property of the debtor” and so was squarely within the scope of permissible subject matter even though the inquiry was of a third-party business entity and individual who had done business with the debtor.  The Trustee was pursuing investigation stemming from several transactions wherein the Debtor had delivered a total of $300,000 worth of diamonds to a business called LA Diamonds, but never received payment for them.  The course of the investigation yielded the testimony of an informed witness that the Debtor had some manner of arrangement with a convicted felon wherein they would acquire diamonds for no consideration and sell them to pawn shops.  The investigation led the Trustee to a pawn shop called Elegant Jewelry and its principal Elie Hanono (“Hanono”).

Basically, Hanono was reasonably cooperative up to a point, and then tried to stop providing information.  His Rule 2004 testimony included raising 5th Amendment objections on a question-by-question basis, testifying in some detail regarding transactions with the debtor, but in the end refusing on 5th Amendment grounds to produce a pawn ticket document that was of particular interest to the Trustee.  Points of interest covered by the Court in its decision included:

  • The 5th Amendment privilege applies in Rule 2004 examinations.
  • Corporations and artificial entities do not have 5th Amendment privilege.
  • Neither the entity nor an individual custodian of entity records in such capacity has a 5th Amendment privilege against producing entity records, no matter how small the entity may be.
  • 5th Amendment protection under the “act of production” doctrine requires that the act be both testimonial and incriminating, and whoever raises the objection must prove that it is both.
  • A witness waives the 5th Amendment privilege regarding a transaction by testifying about that transaction.Under these principals, the Court compelled Hanono to produce the pawn ticket over his 5th Amendment objection because the corporate record had not privilege, Hanano had no privilege as its custodian, Hanano had not met his burden of proof that the act of production would be testimonial and incriminating, and had in any event waived any 5th Amendment privilege regarding the production of the pawn ticket by testifying about the transaction the ticket regarded.

Together, these recent cases illustrate the continuing vitality of disputes arising under Rule 2004.  In re Great Lakes Comnet, Inc. reminds us of the broad scope of the rule, its use to explore claims and defenses, and perhaps even a bankruptcy court’s preference that eventual adversary cases be well-informed and well-pleaded.  From the witness’ perspective, In re Mavashev illustrates the perils of self-incrimination that can evolve along the way in inquiry to a third-party regarding a questionable transaction with a debtor.

[1]/              In re Great Lakes Comnet, Inc., No. GL 16-00290-JTG, 2016 WL 6081100 (Bankr. W.D. Mich. Oct. 17, 2016).

[2]/              In re Mavashev, No. 14-46442-CEC, 2016 WL 5854204 (Bankr. E.D.N.Y. Oct. 5, 2016)

[3]               For a broader treatment of Rule 2004, see T. Horan and M. Busenkell, “Gone Fishing: The Fundamentals of Rule 2004”, ABI Journal, Vol. XXIX, No. 1, February 2010.

[4]/              This approving view of the exploration of claims and defenses is stated in the context of claims directly related to the interests of the unsecured creditors of the estate.  A Rule 2004 examination may not be used to explore claims that are unrelated to the bankruptcy estate.  In re Rosenberg, 303 B.R. 172, 176-77 (B.A.P. 8th Cir. 2004).

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Executive Compensation Under Section 503(c) – The Sports Authority Story

A recent, and highly publicized, decision from the case formerly known as Sports Authority, In re TSA WD Holdings, Inc. et al., Case No. 16-10527 (MFW), Bankr. D. Del. (Docket #2863, Aug. 31, 2016), allowed the defunct company to pay three unnamed senior executives $1.425 million in “incentive pay” to remain with the company and oversee its liquidation.[i]  Judge Mary Walrath granted Sports Authority’s[ii] Motion for Order (A) Approving Modified Executive Incentive Program and Authorizing Payments Thereunder and (B) Authorizing the Debtors to File the Unredacted Modified Key Employee Incentive Program Under Seal (Docket #2746) (the “EIP Motion,” a copy of which is here) over the strenuous objection of the U.S. Trustee (Docket #2809) (the “UST Objection,” a copy of which is here), and only after she had denied a similar from the Debtors request a month earlier.  More importantly, Judge Walrath authorized the incentive payments in a case where Sports Authority’s primary assets had already been liquidated, Debtors would almost certainly pay nothing to unsecured creditors, and the estate may or may not be administratively insolvent.  The Sports Authority example is informative for three reasons: 1) it demonstrates how a company that needs to keeps its top executives in place, post Chapter 11 filing, can structure an incentive package; 2) it reinforces the requirement to evaluate any incentive package that pays insiders under Section 503(c); and (3) it demonstrates that a debtor’s ability to push through an incentive package is not dependent on the solvency of the estate.

Background of the Case

On March 2, 2016, Sports Authority and its subsidiaries filed voluntary Chapter 11 cases in Delaware.[iii]  At the time of filing, Debtors filed a Sales Motion pursuant to Sections 105, 363, and 365 of the Bankruptcy Code.[iv]  Debtors then solicited interest in substantially all of their assets, including their leasehold interests, inventory, and FF&E.[v]  Debtors did not receive any going concern bids for their assets on an enterprise level.  Instead, Debtors were forced to accept a bid from a joint venture for their retail inventory.[vi]  On May 24, 2016, the Court issued a Sale Order approving the sale of substantially all of Debtors’ retail inventory.  Debtors had liquidated substantially all their assets by August 10, 2016.[vii]

On July 12, 2016, Debtors filed a Motion for Order Approving Executive Incentive Program (Docket #2478) (the “First EIP Motion,” a copy of which is here).  The Executive Incentive Program (“EIP”) would have paid four of Debtors’ top executives up to $2,825,000 “to continue to provide services required of their existing positions with the Debtors, fully support the liquidation process and Chapter 11 Cases, and execute a release of claims . . . .”[viii]  Payments under the EIP were to be funded by Debtors’ Term Loan Agreement.[ix]  As such, Debtors stated in the First EIP Motion that they were seeking the Court’s approval out of an abundance of caution, that there was sufficient business justification for the incentive payments, and that Section 503(c) was not applicable to the incentive payments because they were not “Administrative Expenses of the Estate.”[x]  The U.S. Trustee objected to Debtors’ First EIP Motion (Docket #2602, a copy of which is here).  The U.S. Trustee argued that the EIP was subject to Court approval, that Section 503(c) applied to the EIP, and that the EIP did not pass muster under Section 503(c).[xi]  On August 2, 2016, the Court held a hearing on the First Motion.  At the hearing, the Court sided with the U.S. Trustee, entering an order (Docket #2720, a copy of which is here) denying Debtors’ First EIP Motion.[xii]

Undeterred by the Court’s denial, the Debtors brought the next EIP Motion. Debtors drastically altered the EIP for the second go-around and, perhaps most crucially, analyzed the EIP under Section 503(c).[xiii]  “The metrics included in the Original Incentive Plan [were] replaced and . . . Participants will [now] only be entitled to incentive bonus payments if the Debtors are able to (a) trigger the sharing provisions provided for in the Agency Agreement, and (b) achieve a considerable cost-savings relative to the Controllable Costs included in the Wind-Down Budget.”[xiv]  Despite Debtors’ changes to the EIP, the U.S. Trustee filed an objection to the EIP Motion stating that the incentive payments were still “impermissible insider retention bonuses, and the motion should be denied.”[xv]  Debtors prevailed, in an order that is here.


The Court authorized Sports Authority’s modified EIP after denying its initial EIP program, and over the U.S. Trustee’s Objection, for two reasons. First, Debtors sought relief under the appropriate provisions of the Code.  Instead of offering the Court a cursory review of the Debtors’ justification as was done in the First EIP Motion, the EIP Motion carefully justified the modified EIP explaining why it could be approved under Section 503(c)(3).  The EIP Motion set forth the reasons why “the payments incentivize and reward achievement of performance based on specific goals and targets and to do not provide payment for retention or severance . . . .”[xvi]

Second, Debtors showed how the program conformed to the statute, setting hard metrics that delineated executive performance. While the original EIP offered incentive payments for rather amorphous accomplishments like “inventory shrinkage levels” and “controllable wind-down costs,” the modified EIP provided tangible metrics referencing inventory reduction levels to those set forth in the Agency Agreement and setting cost controls relative to the numbers in the Wind-Down Budget.[xvii]  Sports Authority convinced the Court that the modified EIP satisfied Section 503 because it fit neatly into Section 503(c)(3) and was not subject to the restriction of  Sections 503(c)(1&2).  Because the modified EIP fit into Section 503(c)(3), the Court could apply the business judgment standard of Section 363(b) to the modified EIP.  That standard allowed the Court to approve the modified EIP regardless of the financial condition of Debtors’ estate.  The modified EIP also did away with fixed payments for the “Participants remaining employed with the Debtors through certain agreed upon dates.”

Debtors’ attempts to circumvent Section 503(c)’s requirements and failure to conform the First EIP Motion to the statute cost them more time and two rounds of briefing. Ultimately, the Court granted the EIP Motion because Debtors provided the Court with a payment structure it could approve under Section 503.  The Sports Authority case provides a road map for how a debtor can keep its executives in place even though incentive payments to those executives may not be embraced by the debtor’s creditors or its former employees.

A Sidenote

Debtors also prevailed in their attempts to withhold the names of the executives benefitted by the EIP. Over the U.S. Trustee’s Objection, the Court allowed the Debtors to file the actual EIP under seal.  Neither the public nor Sports Authority’s former employees will know which of Debtors’ executives received incentive payments for their work winding down the company.


[i]           All docket references that follow refer to the docket in In re TSA WD Holdings, Inc. et al., Case No. 16-10527 (MFW), Bankr. D. Del.  Debtors in the consolidated Case No. 16-10527 (MFW) may hereafter be referred to as “Debtors” or “Sports Authority.”

[ii]           Sports Authority is controlled by TSA WD Holdings, Inc., which is currently the Debtor in Possession in Case No. 16-10527, the jointly administered case for all of Sports Authority’s entities currently in Chapter 11.

[iii]          EIP Motion (Docket #2746) at ¶ 8.

[iv]          Id. at ¶ 10.

[v]           Id. at ¶ 11.

[vi]          Id.

[vii]         Id. at ¶ 2.

[viii]         First EIP Motion (Docket #2478) at ¶ 14.

[ix]          Id. at ¶ 10.

[x]           Id.

[xi]          First UST Objection (Docket # 2602).

[xii]         Order on First EIP Motion (Docket # 2720).

[xiii]         EIP Motion (Docket #2746) at ¶¶ 20-29.

[xiv]         EIP Motion (Docket #2746) at ¶ 4.

[xv]          UST Objection (Docket #2809) at ¶ 1.

[xvi]         EIP Motion (Docket #2746) at ¶ 21.

[xvii]        The Agency Agreement and Wind-Down Budget were previously approved by the Court as part of the Sale Order (Docket #2081).

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Proposed New Local Rules for the Southern District of New York

The United States Bankruptcy Court for the Southern District of New York recently announced proposed amendments to its local rules.  The proposed amendments will not take effect until December 1, 2016, but we could not wait to take a peek at the future of practice in the Southern District.  (And for those of you who are rules junkies, here and here are prior posts on FRBP changes applying to all courts, from earlier this year.)

The future looks largely like the present—do not expect wholesale changes or many new rules.  The most significant changes clarify procedures such as motions to redact identifying or confidential information and reorder the rules governing notices of presentment.  Comments will be accepted until November 14, 2016, so it is possible additional changes could be made.  Here are some of the most significant changes:

L.R. 1002-1(b) will be added, which will require, if practicable, advance notice to the clerk’s office and the U.S. Trustee of impending chapter 11 or chapter 15 filings and first day motions requiring immediate relief.

L.R. 2002-2 will be repealed, but it isn’t going away. See the note accompanying L.R. 9074-1(c) below.

L.R. 3011-1 will be added.  It requires all future chapter 11 plans to provide for distribution of unclaimed property and specifies the treatment of confirmed plans that do not specify how distribution is to take place.  The new rule is intended to fill a gap in 11 U.S.C. § 347(b) as applied to liquidating plans.  Section 347(b) distributes unclaimed property to the debtor or entity acquiring the debtor under the plan, but in liquidating plans there could be no acquirer and the debtor may be wound up or only exist as an empty shell.  (If you need an idea for a residual beneficiary in the liquidating plan you are drafting, ABI board member Chris Ward with Polsinelli has a suggestion – check it out here.)

L.R. 8010-1 will be added.  It requires preliminary motions filed in appeals under Fed. R. Bankr. P. 8010(c), which governs motions filed before transmission of the record on appeal filed with an appellate court, to be filed on the bankruptcy court docket as well with notice.

L.R. 9018-1 will be added.  It sets forth requirements for filing a motion to file documents under seal.  The procedure contemplated involves two components: (1) the motion to seal filed publicly, to which is attached a redacted copy of the confidential document along with a proposed order authorizing filing under seal, and (2) the unredacted version of the confidential document hand delivered to the clerk’s office in the bankruptcy court with a conspicuous label.

L.R. 9018-1 Practice Note: The unredacted version of the confidential document to be hand delivered to the clerk’s office may indicate which material is redacted, such as by highlighting it.  Also, the comment to proposed L.R. 9018-1 includes a reminder that if the redacted document is a motion, the time to file and serve that motion should comply with applicable rules.  Presumably notice of the underlying motion would not include confidential information and could (and thus, should) be publicly filed contemporaneously with the motion to seal.

L.R. 9037-1 will be added. This new rule sets forth procedures for redaction of personal data identifiers, such as social security numbers or names of minors.  The rule governs several situations, including documents to be filed, documents already filed, documents filed in closed cases, and documents filed in multiple cases.  (And don’t forget to redact such information in proofs of claim, as this blog post here shows, courtesy of the consumer finance specialists at Smith Debnam.)

L.R. 9074-1 will be revised to include current L.R. 2002-1.  The provisions are reordered and relabeled to further clarify the scope of each.  This change should help clarify the options by which a party can obtain relief in the Southern District of New York when a hearing is unnecessary.  The new rule is clearly organized as follows: part (a) governs submission of a proposed order, judgment, or decree on court request; part (b) governs presentment of a specific list of motions on regular notice; part (c) includes current L.R. 2002-1 and governs presentment of orders when notice and a hearing are required, but a motion is not, with either twenty-one days’ notice or seven days’ notice; and part (d) governs notice of presentment of orders for which notice and a hearing are not required with three days’ notice.  Part (e) will require the attachment of a proposed order to any notice of presentment, and directs submission of a copy of the proposed order to chambers once the presentment date and time has passed with no objections.

L.R. 9074-1 Practice Note: Some Courtroom Deputies in the Southern District of New York prefer that proposed orders be submitted to them electronically when the notice of presentment is filed, not on or after the presentment date.

Certain other smaller changes are included as well and listed below. Be sure to read the rules yourself whenever filing, both before and after December 1.

  • L.R. 1007-1: diskettes no longer accepted by the clerk
  • L.R. 2015-1: trustee may convert non-electronic books and records to an electronic format for cost-effective storage
  • L.R. 3018-1: plan proponents must disclose uncounted ballots
  • L.R. 3021-1: liquidating plan must specify steps to “monitor and ensure the safety of the trusts’ assets”
  • L.R. 3022-1: estate representative may file closing report
  • L.R. 5075-1: new requirements for claims agents
  • L.R. 7052-1: proposed counter-findings and conclusions no longer permissible without court approval and proposed findings and conclusions now part of the record on appeal
  • L.R. 9006-1: reply papers due 3 days before the return date
  • L.R. 9078-1: clarifying deadline for proof of service
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Losing Both Ways: Debtor Diligence in the Identification of Claims

Two recent cases serve as reminders the devil is truly in the details. As to the front-end risks associated with an early § 363(f) sale, in In re Motors Liquidation Company[1](the “GM” case) we have seen a $10 billion reminder that identification and actual notice to persons with claims against the Debtor is an indispensable element to the “free and clear” result intended by such a sale.  On the back-end risks of a confirmed Chapter 11 Plan, In re AmCad Holdings, LLC[2]teaches that failing to specifically identify claims of the Debtor against others for retained jurisdiction under the Plan can defeat the intended jurisdiction of the Bankruptcy Court to adjudicate those omitted claims.

GM involves the ongoing troubles from the 2009 insolvency of the General Motors Corporation, the United States’ largest car manufacturer.  As opposed to the usual reorganization procedures of 11 U.S.C. §§ 1121?1129, which can take years to accomplish (if ever), the debtor opted for an expedited sale under § 363, which can close in a matter of weeks and did so even here.  The sale resulted in a split between “Old GM”, the seller who remained the debtor-in-possession with limited assets, and “New GM”, the purchaser of substantially all of the Old GM assets which would use the purchased assets to carry on the majority of the business of the prior Old GM.   The proposed sale, the hundreds of objections, and resulting Sale Order all anticipated that New GM would take these assets “free and clear” of liabilities under § 363(f) and that the Sale Order would therefore act as a liability shield to prevent individuals with claims against Old GM from suing New GM.  Among its findings in the GM case, the Second Circuit effectively held that New GM was not shielded from certain large categories of tort claims related to defects in its cars because the debtor had the ability to notify the owners of such cars of the bankruptcy filing and of the proposed § 363(f) sale, yet failed to do so.  (This was not the first ruling out of the GM case addressing snafus – for our prior coverage on the mistaken release of $1.5 billion in liens, see here.)

AmCad Holdings involved the more traditional route of reorganization and Plan confirmation. As part of the Plan, a liquidation trust was established and certain estate assets, including causes of action, were assigned to the liquidating trust. Five months after confirmation, the Trustee brought an adversary proceeding against some prior managers and officers of the debtor, including three counts asserting defendants breaches of fiduciary duty.  The defendants moved to dismiss the fiduciary claims for lack of subject matter jurisdiction.  The Trustee asserted the Court had jurisdiction over the fiduciary claims under the Plan’s provisions for retention of post-confirmation jurisdiction over “Causes of Action”, which were defined in a very broad and inclusive, but annoyingly general manner.  The Plan had no specific retention of claims for breach of fiduciary duty.  In dismissing the fiduciary claims, the Court noted that its post-confirmation jurisdiction over non-core but related matters was narrow and limited to matters that had a close nexus to the Plan.  The Court reasoned that while a Chapter 11 Plan that retains jurisdiction over a specific cause of action generally satisfies this nexus, a wholesale assignment of causes of action to the post-confirmation trust did not.

In both cases, we observe that the attention to detail in the identification of claims – and in the case of AmCad Holdings, a proper disclosure of those claims – is not only important, but can be dispositive. Setting aside the sheer scale of the GM case, it’s still illustrative of the very basic issues of fairness and notice present in any § 363(f) sale on the front-end of a bankruptcy.  AmCad Holdings is on a more common scale, yet illustrates the back-end, post-confirmation risk of relying on broad-brush treatment of retained jurisdiction and perfunctory, generic disclosures of claims to be brought in the future. But once you have processed the facial lessons: (1) give actual notice to potential claimants and creditors in § 363 sale, (2) specifically identify claims for retention of post-confirmation jurisdiction, there is still more to be observed.

If the specific identification of claims and claimants can prove dispositively important, then isn’t the indicated level of diligence in this area of practice of like import? We live in the Information Age and practice among colleagues and clients of high sophistication.  Both the law firms and the clients hold information now measured in gigabytes and terabytes.  It is not a good bet that Courts will accept the proposition that it was too hard to identify a debtor’s customers, or to be aware of potential claims, or to foresee the claims that might be brought by an estate or liquidating trust post-confirmation.  But we also practice in a commercial and legal environment that is increasingly demanding, competitive, fast-paced, specialized, and that inherently involves delegation of detail work—both within the organization of the client and in that of the attorney.  These two recent cases should remind attorneys and clients in this area that attention to the identification of claims and the indicated parties to claims are important enough to support the investment of time, information, and data management, adequate staffing, full communications between client and counsel, and both factual and strategic scrutiny.  We can all learn from these cases – and adjust our habits and practices accordingly.

[1]               In re Motors Liquidation Company, Case No. 15-2844 (2d Cir., July 13, 2016).

[2]               Gavin Solmonese, LLC v. Shyamsundar (In re AmCad Holdings, LLC), United States Bankruptcy Court for the District of Delaware, Adv. No. 15-51979 (June 15, 2016) (Walrath, J.).

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