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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.

Takeaways

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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Internet Service a Utility in Bankruptcy? It Might Be Now.

HTTP on a Computer Monitor

Editor’s Note:  One of the many fascinating things about restructuring work is its willingness to evolve by borrowing from other areas of the law.  Just as business practices change, new financing techniques evolve, and transactions become more complex, the bankruptcy world must adapt as well, to allow for a well functioning insolvency system and not a stilted, out of date process.  To that end, we at The Bankruptcy Cave love finding curious decisions in tangential fields of the law, and thinking about how they may change bankruptcy practice, or how bankruptcy practice may change them (for instance, click here for a neat post last year about “Obamacare” and bankruptcy, or here for the most recent edition of The Guarantor Chronicles).  Anyway, here is our latest curious find – “net neutrality” and its effect on Section 366 “utility providers.”

On June 14, 2016, the Court of Appeals for the District of Columbia Circuit affirmed the legality of the Federal Communications Commission’s new “net neutrality” rules.[1]  In part, the rules determined that broadband Internet service is a telecommunications service under the Telecommunications Act of 1996 (the “Act”).[2]  The determination reclassified broadband Internet service providers as telecommunications carriers, which are common carriers under the Act.[3]

The reclassification imposed new obligations on broadband providers under Title II of the Act, though the FCC forbore from enforcing some requirements.[4]  “Among other things, Title II requires that carriers ‘furnish . . . communication service upon reasonable request,’ 47 U.S.C. § 201(a), engage in no ‘unjust or unreasonable discrimination in charges, practices, classifications, regulations, facilities, or services,’ id. § 202(a), and charge ‘just and reasonable’ rates, id. § 201(b).”[5]

However, the reclassification could affect broadband providers’ Bankruptcy Code duties as well.  The Bankruptcy Code forbids utility providers from discontinuing service to customers who file for bankruptcy.[6]  Previously, courts did not treat cable television and Internet services as utilities, essentially concluding that they were “luxuries.”[7]  (Despite that one study shows that 34% of Americans think broadband internet is a necessity, and 23% think cable TV is a necessity as well.)  Oppositely, telephone services are utilities.[8]  Courts base this distinction partly on the “special governmental regulation[s]” that apply to telephone companies,[9] including Title II common carrier requirements.[10]

The Bankruptcy Code does not define “utility.”  Accordingly, judges will likely continue employing the same standards used when classifying telephone services as utilities.  As the FCC increasingly treats broadband like basic telephone services, bankruptcy judges may eventually do the same.  If the FCC’s net neutrality rules stand, broadband providers should anticipate the possibility that their Title II obligations may trigger Bankruptcy Code obligations as well.

[1] U.S. Telecom Ass’n v. Fed. Commc’ns Comm’n, No. 15-1063, slip op. at 8 (D.C. Cir. June 14, 2016).

[2] Id. at 24.

[3] 47 U.S.C. § 153(51) (“The term “telecommunications carrier” means any provider of telecommunications services, except that such term does not include aggregators of telecommunications services (as defined in section 226 ).  A telecommunications carrier shall be treated as a common carrier under this Act only to the extent that it is engaged in providing telecommunications services . . . .”).

[4] Id. at 21 (citing 2015 Open Internet order, 30 FCC Rcd. At 5804–05 ¶ 434, 5849–51 ¶ 513).

[5] U.S. Telecom Ass’n, slip op. at 11.

[6] 11 U.S.C. § 366(a) (“[A] utility may not alter, refuse, or discontinue service to, or discriminate against, the trustee or the debtor solely on the basis of the commencement of a case under this title or that a debt owed by the debtor to such utility for service rendered before the order for relief was not paid when due.”).

[7] Carlson v. U.S. Bank Home Mortg., 2012 WL 6861333, at *11 (D. Minn. 2012) (quotations omitted) (cable television and internet services are not utilities within the meaning of 11 U.S.C. § 366); In re Moorefield, 218 B.R. 795, 796 (Bankr. M.D.N.C. 1997) (“[C]able television does not rise to the level of other utilizes listed under legislative history . . . . Cable television is not a necessity as millions of Americans continue to exist without such service.”)

[8] One Stop Realtour Place, Inc. v. Allegiance Telecom, Inc., 268 B.R. 430, 436 (Bankr. E.D. Penn. 2001) (“[A telephone company] is a “utility” within the ordinary meaning of that term, since it provides telephone service to the public and is subject to regulation by the FCC and the Pennsylvania PUC.”).

[9] Id. at 435 (quoting Public Utility, Merriam-Webster’s Collegiate Dictionary (10th ed.)).

[10] Nat’l Cable & Telecomms. Ass’n v. Brand X Internet Servs., 545 U.S. 967, 976 (2005) (noting that the FCC treats telephone services as a “basic service,” subjecting it to Title II common carrier regulation).

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Some Much Needed Transparency Required on Liquidating Trustees, Liquidating Trusts, Plan Documents, and Other Post-Confirmation Matters

We at The Bankruptcy Cave applaud the recent ruling by Judge Whipple of the Bankruptcy Court for the Northern District of Ohio, seeking to make the post-confirmation parties, processes, and procedures far more transparent. In In re Affordable Med Scrubs, LLC,[1] Judge Whipple declined to approve a disclosure statement for a secured creditor’s liquidating plan.  The key deficiencies were as follows:

 

  1. Disclosure Must be Provided about the Liquidating Trustee: While the secured creditor’s disclosure statement did state who the liquidating trustee would be, it provided no disclosures about the putative trustee’s connections to key creditors and other parties in interest. We applaud this effort to require disclosures about a proposed liquidating trustee or plan administrator. The selection of a liquidating trustee or plan administrator is a murky process – at best, it is based on some vague (and undisclosed) considerations of pricing and experience of the individual or company that will serve in this role.  At worst, selection of a liquidating trustee or plan administrator may reek of “payola,” favors being returned, or other completely inappropriate (and also undisclosed) factors.  It is not much to ask, at all, for any proposed post-confirmation parties to make a full disclosure under Bankruptcy Rules 2014 and 2016.

 

  1. The Same Disclosure Must be Made About any “Plan Oversight Committee”: See above – the same rules apply to Oversight Committees or other parties involved in supervising post-confirmation actions.

 

  1. Better Disclosure of Litigation Claims Against Key Parties: The Affordable Med Scrubs disclosure statement also did not clearly deal with potential claims against the largest creditor (which is not very surprising, as the largest creditor was the party submitting the disclosure statement).  References, cross-references, and unclear descriptions of claims don’t help anyone – plan proponents should carefully and plainly describe in one place in the disclosure statement what they know about various claims, and whether they plan on pursuing them or recommending that the liquidating trustee pursue them (or not pursue them).  No one should be surprised later that a claim is brought, or that a claim against a key party is not brought by the Liquidating Trustee (see above, in relation to the risk that side-deals may be involved in selection of Liquidating Trustees or Oversight Committees).[2]

 

  1. The Liquidating Trust Agreement and Other Key Documents Should be Filed with the Disclosure Statement: We at The Bankruptcy Cave are increasingly annoyed with the massive dump of “plan documents” being filed 5-10 days before confirmation.  The Affordable Med Scrubs court was not pleased with the failure of the parties to file the proposed Liquidating Trust agreement with the disclosure statement.  This is particularly important as such agreement often has key terms on the authority of the liquidating trustee, fees paid to the liquidating trustee and his or her professionals, and other items about which creditors should be aware (some or all of which, such as post-confirmation professional fees, may be shielded from future court or creditor scrutiny altogether).

 

This is an important case on issues that are not typically addressed. We look forward to a raising of the bar in our collective practices to require more disclosure of post-confirmation parties, how they came to be chosen and their connections with creditors and other parties in interest, and expected post-confirmation events and claims.

[1]           Case No. 15-33448, Bankr. N.D. Ohio, Order Disapproving Disclosure Statement, Docket No. 267 (July 5, 2016).

 

[2]           We don’t intend to imply, at all, that anything improper was going on among the parties in the Affordable Med Scrubs case – many of the deficiencies the court notes with the disclosure statement could simply be oversight, or a desire for expediency.  The Affordable Med Scrubs court does not even hint at any impropriety, and we didn’t see any in the facts at all – just a lack of disclosure.  But we have seen other cases in which substantial litigation claims are not brought, or settled for small amounts, as to creditors that had a major role in selecting the parties that will control those very same post-confirmation events.

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Bankruptcy Courts Closing In – Will An Agreement Requiring Unanimous Consent To File For Bankruptcy Be Effective?

Magnifying Glass and document close up

We’ve all seen it.  The business opportunity looks enticing but is laced with risk about a potential bankruptcy filing down the road.  As bankruptcy lawyers we are often asked how deals can be structured to prevent a potential bankruptcy filing.  One approach (really, about the only approach, and it has its own risks) has been to structure the deal requiring unanimous member/manager/director consent to place the entity into bankruptcy but meanwhile adding a member/manager/director who may vote against taking the entity into bankruptcy in the future, or who may have interests and motives other than those of insiders.

Two recent bankruptcy court decisions have called this practice into question, especially when this corporate structure is implemented when the company is in distress.  The Bankruptcy Court for the District of Delaware ruled in an opinion you can read here that a provision requiring unanimous consent of a company’s equityholders to seek bankruptcy protection was void as against public policy.  Meanwhile, the Bankruptcy Court for the Northern District of Illinois (here is that opinion) did not find that this that type of provision would be void against public policy but did rule that fiduciary duties owed to a company cannot be obviated.  These cases provide insight into (i) the enforceability of unanimous consent provisions in differing jurisdictions and (ii) how such provisions may be drafted (or not) to enhance the likelihood of enforceability if subsequently called into question. 

In re Intervention Energy Holdings, LLC

In re Intervention Energy Holdings, LLC filed its bankruptcy case in the Delaware Bankruptcy Court.  A creditor holding a single “common unit” of the LLC filed a motion to dismiss the case, stating that it did not consent to the bankruptcy filing.  The creditor claimed that the bankruptcy filing was unauthorized because a unanimous vote in favor of bankruptcy was required under the Debtor’s LLC agreement.  The court ruled that this unanimous consent provision was void as against well-established federal public policy because a debtor may not waive its right to seek bankruptcy protection.  The court extended this protection to business entities including LLCs.

Notably, the creditor in question, EIG Energy Fund XV-A, L.P. (“EIG”), had purchased a single common unit of Intervention Energy Holdings, LLC (“Intervention”) during negotiations of a forbearance agreement.  While EIG held one common unit, Intervention’s parent company owned the remaining 22 million common units.  EIG filed a motion to dismiss Intervention’s bankruptcy case.  EIG argued that Intervention needed EIG’s consent to seek bankruptcy protection because by owning its one common unit EIG was able to veto a bankruptcy filing, per the specific terms of Intervention’s corporate documents.

The court overruled EIG’s motion to dismiss.  The court held that a provision in Intervention’s prepetition operating agreement which allowed EIG to veto any voluntary bankruptcy filing by Intervention contravened public policy.  In reaching this decision the court relied on many prior rulings which found parties’ prepetition agreements to waive future bankruptcy protections to be unenforceable.

In re Lake Michigan Beach Pottawatamie Resort LLC

The Bankruptcy Court for the Northern District of Illinois took a more narrow approach in In re Lake Michigan Beach Pottawatamie Resort LLC.  There, the court considered the balance between unenforceable blanket bankruptcy prohibitions in agreements versus permissible “blocking director” provisions which allow directors to vote against putting the entity into bankruptcy but still require the blocking director to uphold its fiduciary duties to the entity.  (The latter are very common in structured finance matters.) The court found that public policy and fiduciary duty concerns involving “blocking director” provisions for corporations also extended to LLCs.

In the Lake Michigan case, before filing its bankruptcy case the debtor defaulted on its obligations to its lender, BCL-Bridge Funding LLC (“BCL”), which resulted in a forbearance agreement between the parties.  As part of the forbearance agreement, the debtor agreed to amend its operating agreement to add BCL as a “special member” of the debtor.  As a special member BCL had a right to approve or disapprove any “material action” by the debtor which included filing a bankruptcy case.  However, the amended operating agreement also provided that in acting as a special member BCL was only required to consider its own interests, rather than the interests of the debtor.

Ultimately, the debtor filed for bankruptcy protection.  All of the debtor’s members, except BCL, supported the bankruptcy filing.  BCL moved to dismiss the bankruptcy case asserting that the debtor did not have authority to file because BCL, as a special member, did not consent.  The debtor argued that the amended operating agreement requiring BCL’s consent to bankruptcy was void against public policy as a prohibition on a party’s right to seek bankruptcy protection.  The court did not find this provision void as against public policy.  Instead, the court held that the blocking member provision in the amended operating agreement contravened the fiduciary duties that BCL owed to the debtor under Michigan law.  Thus, the amended operating agreement provision which only required BCL to consider its own interests, not the debtor’s, was void.  This rendered the remaining directors’ votes in favor of the bankruptcy filing sufficient corporate authority.

Conclusion

These cases emphasize that unanimous consent provisions will not always be enforceable.  The language and structure of such provisions are crucial, as is the timing of when the provision is added to any organic documents.  Agreements limiting the fiduciary duties of a member/manager/director or limiting the ability of an entity to seek bankruptcy protection should be scrutinized – or rejected outright, frankly – to avoid future enforceability concerns.

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Sabine Lives On (and On): Bankruptcy Court Rejects Immediate Appeal to Second Circuit and Motion for Stay

Editor’s Note:  On June 16, 2016, The Bankruptcy Cave gave you our summary of the controversial Sabine decision.  At that time, post-hearing motions were pending.  As luck would have it (we at The Bankruptcy Cave should start wagering on college football, or who will win JoJo’s heart, with this luck!), just a few days later the drama continued with some important rulings on the timing of any final resolution of these important issues.  Here’s the skinny:

On June 15, 2016, Bankruptcy Judge Shelley Chapman of the Southern District of New York issued a follow on decision concerning rejection of certain midstream contracts in Sabine Oil & Gas Corporation’s (“Sabine”) Chapter 11 case.[i]  In its decision, the Court rejected Nordheim Eagle Ford Gathering, LLC’s (“Nordheim”) request for an immediate appeal to the Second Circuit Court of Appeals.  The Court also refused to stay enforcement of either its decision to allow Sabine to reject Nordheim’s gathering agreements with the Debtor or its final adversary decision where it found that Nordheim did not have an “interest running with the land.”

The Court rejected Nordheim’s argument that an immediate appeal was warranted under 28 U.S.C. § 158(d)(2)(A) because “the Rejection Decision addressed legal issues of first impression under Texas law which neither the Second Circuit nor the United States Supreme Court has previously addressed.”[ii]  The Court also determined that its previous orders did not “involve a matter of public importance” under 28 U.S.C. § 158(d)(2)(A)(i).[iii]  In both instances, Judge Chapman took the position that her rulings on Nordheim’s gathering agreements were limited.  The Court viewed its previous decisions as based on the facts of the case and established bankruptcy law, not the novel issues of Texas property law.[iv]  Finally, Judge Chapman premised her decision not to stay the case pending appeal on the basis that Nordheim would not suffer “irreparable harm” were the case to proceed, but Sabine would be harmed by a stay.[v]

Judge Chapman’s June 15th decision means that her previous rulings will not be on appellate review any time soon. While the June 15th decision attempts to downplay the influential value of those decisions, they will no doubt be cited by other producers in their attempts to shed onerous midstream arrangements. Sabine lives on.

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

[ii] Id. at *7-*9.

[iii] Id. at *11.

[iv] Id. at *7-*9.

[v] Id. at *13-*14.

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Sabine – A New York Bankruptcy Judge’s Interpretation of Texas Property Law Encourages Compromise and Leaves an Industry in Limbo

On March 9, 2016, Bankruptcy Judge Shelley 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.[i]  The decision, which allowed Sabine to reject “gathering agreements”[ii] between it and two “midstream operators,”[iii] Nordheim Eagle Ford Gathering, LLC and HPIP Gonzales Holdings, LLC, under Section 365(a) of the Bankruptcy Code, sent shockwaves through the midstream energy sector and leveled the playing field for bankrupt production companies.  Yet, the case leaves undecided the ultimate question – what midstream contracts are protected as real covenants running with the land?  That question may be months, or even years, away from any resolution.[iv]  In the interim, energy companies are left with Sabine, which implies producers can renegotiate midstream contracts in a slumping energy market, using the threat of bankruptcy and rejection as a powerful bargaining chip to bring midstream operators to the table.

The Decision

By its Motion, Sabine sought to reject four contracts under Section 365, two with Nordheim and two with HPIP. Under all four agreements, Sabine agreed to “dedicate” to the “performance” of the agreement certain leases owned by Sabine and the hydrocarbons from the wells located on the land subject to those leases.  For their part, Nordheim and HPIP agreed to construct, operate, and maintain gathering facilities for the respective leases.

When it addressed the Motion, the Court undertook a two part analysis to determine whether Sabine could reject the contracts. First, the Court deferred to Sabine’s business judgment and found “that the Debtors have properly and adequately considered the business and legal risks associated with rejection of the Nordheim Agreements and the HPIP Agreements.”[v]  There was little question that rejection would benefit the estate as Sabine indicated that rejection could save it up to $200,000 a month.

The second part of the Court’s analysis was more involved. There the Court was forced to determine whether any of the contracts were real covenants or equitable servitudes that ran with the land.  Both Nordheim and HPIP argued that Sabine could not reject the contracts because they were real property interests that cannot be rejected under Section 365.  While Judge Chapman acknowledged her inability to decide substantive legal issues under Orion Pictures Corp. v. Showtime Networks (In re Orion Pictures Corp.), and In re The Great Atlantic & Pacific Tea Co.[vi] without an accompanying adversary proceeding, she dove into an analysis of what constituted a covenant running with the land under Texas law.

After applying Texas’ four-part test for determining whether a covenant runs with the land, the Court rejected HPIP and Nordheim’s contention that their contracts were real property interests. The Court found that the covenants in Nordheim’s and HPIP’s contracts did not satisfy the “touch and concern” prong of Texas’ test for a covenant running with the land.  Instead, the interest in the extracted minerals was a personal property interest.  The Court also determined that the covenants “do not readily fit into the traditional paradigm for horizontal privity of estate.”[vii]  Consequently, the Court made a “preliminary” determination that the contracts between Sabine and the two gathering companies could be rejected.

The Fallout

Despite Judge Chapman’s later statement that “this was not a broad sweeping pronouncement,”[viii] the ruling may significantly impact the energy industry. Moreover, the case and its progeny could shape jurisprudence on the rejection of similar contracts in several energy sector bankruptcy cases while an appeal works its way up the chain.  Until Sabine, agreements between producers and midstream companies were generally treated as constants, not subject to renegotiation upon insolvency.  That paradigm may now be realigned.

Upstream producers, many of whom are suffering under today’s low energy prices, can now seek concessions from their midstream partners. This places the parties on more equal footing and could actually be a catalyst for negotiated resolution.  In fact, courts dealing with the issue may actually prefer the parties resolve the issue through compromise. Sabine has already had an impact in this respect.  In In re Magnum Hunter Resources Corp., Bankruptcy Judge Kevin Gross encouraged the parties to resolve a similar dispute before the Court had to weigh in on the motion to reject.[ix]  Likewise, in In re Quicksilver Resources Inc., the purchaser of the debtor’s assets was able to reach a compromise with its midstream operator before the Court had to rule on a Section 365 motion.[x]  Both cases are examples of how producers have greater power to negotiate terms with midstream companies in the wake of Sabine.

Finally, Sabine is not over.  Nordheim’s and HPIP’s adversary case was decided on May 3, 2016.[xi]  Once again, in a decision located here, Judge Chapman found “that the covenants at issue in the Nordheim Agreements and the HPIP Agreements do not run with the land either as real covenants or as equitable servitudes.”[xii]  On June 1, 2016, Nordheim and HPIP sought Judge Chapman’s consent to appeal that decision.  The midstream operators argued that an appeal to the Second Circuit and a subsequent reference to the Texas Supreme Court to decide the state property law issues were appropriate.  The Court has not yet ruled on the request, but no one believes that this will be the end of the debate.  Upstream producers will continue to pursue rejection of midstream contracts that are overly burdensome and midstream operators will continue to argue that rejection is improper until more concrete guidance is issued by District and Circuit Courts.

[i]            In re Sabine Oil & Gas Corp., 547 B.R. 66, 69 (Bankr. S.D.N.Y. 2016).

[ii]           Gathering Agreement means an agreement by which one party agrees to collect oil, gas or other hydrocarbons at the wellhead and transport such oil, gas or other hydrocarbons through a network of pipelines to a central point, often a processing system or an inlet to a larger transportation pipeline.

[iii]           Midstream Operator means a company that gathers, transports and processes oil, gas or other hydrocarbons by pipeline, rail, trucks or otherwise.

[iv]          On June 1, 2016, Judge Chapman declined to rule on Nordheim’s request for an immediate appeal her decision to the Second Circuit Court of Appeals.  While the Court determined that the contracts at issue in the case do not run with the land, in both its preliminary decision and in a later adversary opinion, it left open the question of what type of midstream contract would run with the land such that it constituted a real property interest.

[v]           Sabine Oil, 547 B.R. at 74.

[vi]          4 F.3d 1095, 1098 (2d Cir. 1993) and 544 B.R. 43 (Bankr. S.D.N.Y. 2016).

[vii]          Sabine Oil, 547 B.R. at 79.

[viii]         See Judge Skeptical of Quick Appeal in Sabine Midstream Dispute located at http://www.law360.com/articles/802504/judge-skeptical-of-quick-appeal-in-sabine-midstream-dispute.

[ix]          In re: Magnum Hunter Resources Corp. et al., No. 15-12533, in the U.S. Bankruptcy Court for the District of Delaware.

[x]           See Jones Day’s advisory, Quicksilver Drops Motion to Reject Midstream Agreements in Connection with Closing of Sale to Bluestone Natural Resourcesfor a more in depth discussion.

[xi]          Following the Court’s decision to grant Sabine’s Motion to Reject, Nordheim and HPIP filed an adversary proceeding in which they sought a declaration that the their respective leases were “covenants running with the land.”  The Court, once again, rejected the midstream operators’ argument and issued a final ruling that the leases did not convey a real property interest to the midstream operators.

[xii]          In re Sabine Oil & Gas Corp., No. 15-11835 (SCC), 2016 WL 2603203, at *8 (Bankr. S.D.N.Y. May 3, 2016).

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When Going “All In” Pays Off: The Third Circuit Upholds The Decision of the Bankruptcy Court in In re Trump Entertainment Resorts, Inc.

In an appeal certified directly from the Bankruptcy Court for the District of Delaware (the “Bankruptcy Court”) to the Court of Appeals, the Third Circuit issued a ruling upholding Judge Kevin Gross’s decision that a chapter 11 debtor-employer may reject the continuing terms and conditions of a collective bargaining agreement (“CBA”) under 11 U.S.C. § 1113, despite that the CBA expired post-petition.

The Bankruptcy Court’s Decision

In December 2014, the Bankruptcy Cave first reported on the Bankruptcy Court’s decision in In re Trump Entertainment Resorts, Inc. (the “Bankruptcy Opinion”).  The controversy centered around whether provisions of the National Labor Relations Act (“NLRA”) that maintain the status quo of an expired CBA during negotiations for a new CBA mean that the expired CBA still exists as a contract that can be “rejected” under section 1113 of the Bankruptcy Code.  The Bankruptcy Opinion held in the affirmative – the Debtors could reject the expired CBA because section 1113 failed to distinguish between expired and unexpired CBAs.  The Bankruptcy Opinion was largely driven by practical factual considerations – the Union had engaged in “stiff-arm” negotiation tactics that left the Debtors with few choices, and absent the rejection of the expired CBA, the Debtors faced a complete shut-down, the loss of thousands of jobs, and the shuttering of the business.  The Debtors went “all in” on this poker hand, it was rejection or bust; the Bankruptcy Court agreed with the Debtors.

The Appeal

On appeal, In re Trump Entertainment Resorts, Case No. 14-4807 (3d Cir. Jan. 15, 2016), the Union centered its argument on a parallel to section 365, arguing that because a debtor may not assume or reject an expired executory contract under section 365, it also may not reject an expired CBA under section 1113.  However, the Third Circuit noted that due to the NLRA, the obligations of the expired CBA continue to burden the debtor (unlike that of a traditional executory contract).  In addition, Congress failed to include in section 1113 a distinction between expired or unexpired CBAs, and otherwise failed to address the continuing effect such agreements may have upon a debtor.  To that end, the court opined that Congress must have considered the overlapping impact of these federal statutory regimes.  The interpretation that permits a debtor to reject an expired CBA, held the Third Circuit, best balances a debtor’s ability to proceed through the protracted NLRA process with some speed, while still protecting workers by obligating the estate to honor the CBA’s provisions until there is a rejection.

The Third Circuit also noted the “exigencies” the Trump Debtors faced, which were significant factors in the Bankruptcy Opinion.  The Third Circuit noted that as a policy matter, it is preferable to preserve jobs through rejection rather than face the permanent loss of positions, and an entire business, by requiring debtors to continue to abide by the terms of an onerous CBA.

Analysis and Conclusion

Following the appeal, our initial analysis of the implications of this case appears to hold true.  The Third Circuit’s interpretation of section 1113 may be a boon to a would-be debtor that is laden with burdensome labor obligations, and is nearing the expiration of a CBA.  While outside bankruptcy a company would normally be required to bargain to impasse (a very time consuming endeavor), in bankruptcy court a company may be able to short-circuit this process and obtain rejection of the CBA, even where it expired post-petition.  As explained by the Bankruptcy Court and the Third Circuit, the ability of debtors to reorganize and emerge as operating companies, which is arguably the primary purpose of chapter 11, supports this interpretation of section 1113.

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