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From Across the Pond – Dissipation of Assets May be Tort Under English Law: Marex Financial Limited v. Garcia [2017] EWHC918

Editor’s Note from The Bankruptcy Cave:  Our good colleagues Robert Dougans and Tatyana Talyanskaya from BC’s London office published this earlier in the summer, and we could not wait to add it to your autumn reading list.  The lesson here is powerful – England, the birthplace of the common law, comes through again to right an injustice where traditional legal principles might otherwise fall short.  Many of you readers have often dealt with defendants playing a shell game with their assets.  The Marex decision provides a powerful response – an independent tort against the individuals who perpetrated the asset stripping, instead of a pursuing a daisy-chain of subsidiaries and affiliates, all bereft of assets.  We at The Bankruptcy Cave applaud this decision – for every right, there shall be a remedy! 

There is a joke that freezing injunctions are dangerous to heath.  They appear to be carcinogenic, as people subject to them often tell the Court they are too ill to engage with proceedings.  (Observation of such defendants may provide heartwarming evidence for miracle cures.)  They also appear to cause amnesia, as defendants somehow forget to disclose the existence of very substantial assets.

In a similar way adverse judgments can be a boon for corporate finance professionals.  A large judgment against a corporate defendant may well provoke a flurry of M&A activity as the unsuccessful corporate defendant’s asset are rapidly re-allocated to other group companies, or to the defendant’s beneficial owner

The background to the decision of Mr. Justice Knowles in Marex Financial Ltd v Garcia [2017] EWHC 918 (Comm) dealt with a familiar situation.  A claimant obtains a judgment against the company which (according to pre-litigation due diligence) has substantial assets.  When enforcement proceedings begin the claimant learns that the management/owners of the defendant company have immediately emptied the cupboard as soon as judgment was obtained, leaving them with a worthless decision.

What can be done? Insolvency law may provide remedies but a claimant is then in the hands to some extent of insolvency practitioners, and clawing back assets from some jurisdictions may be difficult in practice.  Mr. Justice Knowles’ decision suggests a claimant should explore making the persons responsible for the asset-stripping liable in tort.

The Marex case involved the claimant, a foreign exchange broker, obtaining judgment for $5m against two BVI companies (the “Companies) owned by Mr. Sevilleja.  As soon as the draft judgment was circulated, Mr. Sevilleja embarks upon a thorough asset-stripping of the Companies, transferring over $9m from the Companies to himself.  When they commenced enforcement proceedings Marex found that the Companies’ position had deteriorated and they had just over $4,500 between them.  Marex brought proceedings against Mr. Sevilleja, saying he had induced/caused the Companies to dissipate assets to frustrate the earlier judgment.  Marex relied upon the following causes of action.

  • knowingly inducing and procuring the Company’s to act in wrongful violation of the Claimants rights under the judgments;
  • committing the tort of intentionally causing loss by unlawful means; and/or unlawful interference with the Claimants economic interests (some of the so-called “economic torts”).

The defendant argued that no tort of unlawful violation of rights under a judgment existed. He accepted that the relevant “economic torts” did exist (they are well-established under English law), but argued that they did not cover frustrating the enforcement of a judgment in this way.

Mr. Justice Knowles found for the claimant on both points: He recognised the existence of a tort violation of rights under a judgment, and also recognised that doing so could count as an economic tort.

Of particular note is that the reasoning for his judgment was based on the well-known proposition that an award of damages by a court of competent jurisdiction (even a foreign court with whom there is no enforcement convention) is recognised in England as a debt which can be enforced at common law. This judgment does not, therefore, simply cover frustrating enforcement of an English court judgment.  Asset-stripping a company to frustrate enforcement of a foreign court judgment could also create an actionable wrong under English law.

There are powerful lessons to be learned from this case.  Defendants who try to avoid paying judgment debts must tread very carefully to avoid risking personal liability.  Claimants who are the victim of post-judgement assets stripping can, however, take heart – they may be able to pin the blame upon persons/entities with assets.

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No Notice: How Unnotified Creditors Can Violate a Discharge Injunction

Here is the scenario: You are a creditor.  You hold clear evidence of a debt that is not disputed by the borrower, an individual.  That evidence of debt could be in the form of a note, credit agreement or simply an invoice.  You originated the debt, or perhaps instead it was transferred to you — it does not matter for this scenario.  At some point the borrower fails to pay on the debt when due.  For whatever reason, months or even years pass before you initiate collection efforts.

Finally, you seek to collect on the unpaid debt. Those collection efforts include letters and phone calls, and maybe even personal contact, all of which are ignored.  Then you employ an investigator and an attorney.  You eventually obtain a default judgment from a state court, which the borrower (unsurprisingly) refuses to pay.  You then garnish the borrower’s wages to pay the debt.  You collect a few payments before the borrower informs you that the debt was discharged in bankruptcy.  Wait . . . how could that be?  You never received notice of the bankruptcy, you didn’t have an opportunity to file a proof of claim, until now you never saw the discharge order.  Indeed, you come to find out that the borrower never listed you on his bankruptcy schedules and you never received notice that there was a bankruptcy.

The way the borrower informs you of the bankruptcy is even more disturbing. The borrower serves a Motion for Sanctions that he filed in the bankruptcy court.  He is asking the bankruptcy court to set aside your state court judgment, for the return of his garnished wages, for emotional distress damages, and for a whole bunch of attorney’s fees that he incurred to reopen the case and file the Motion for Sanctions.[i]

You say to yourself, “No way!” Surely, the bankruptcy court cannot punish you for a case you knew nothing about.  After all, isn’t it the Debtor’s burden to list all of his creditors.  There was no way that your debt was discharged.  Think again, you could be in trouble!

Here’s why. Due to the complicated interaction of multiple sections of the bankruptcy code and the way in which courts have interpreted that interaction in no-asset Chapter 7 Bankruptcy cases, your debt was discharged and your collection efforts were in violation of the discharge injunction despite the fact that you lacked knowledge of the bankruptcy.  In a Chapter 7 case, § 727(b) discharges a debtor “from all debts that arose before the date of the order for relief” except as provided in § 523.  Section 524, also known as the discharge injunction, applies to any “debt discharged under section 727” and operates as an injunction against the commencement or continuation of an action, or an act, to collect, recover or offset any personal liability of a debtor.  Generally speaking, Debtors receive a discharge under § 727(a), and the scope of that discharge is set forth by § 727(b).  Pursuant to § 727(b), a prepetition debt is discharged as a matter of law, unless it is nondischargeable under § 523.

Ahah-your debt must fall under § 523, or so you think. After all, § 523(a)(3)(A) states “A discharge under section 727 . . . does not discharge an individual debtor from any debt neither listed nor scheduled under section 521(a)(1) of this title, with the name, if known to the debtor, of the creditor to whom such debt is owed, in time to permit . . . timely filing of a proof of claim, unless such creditor had notice or actual knowledge of the case in time for such timely filing.”  You never had notice, did not to get to file that proof of claim, and you knew nothing about the case until that sanctions motion arrived on your doorstep.  Sure you are protected by § 523, right?

Not so fast. Section 523 does not apply to all Chapter 7 cases.  It is “well accepted that the failure to give notice to a creditor will be disregarded in a Chapter 7 no asset case and that in such cases failure to schedule a prepetition debt will not preclude the discharge of that debt.”[ii] When a debtor’s case is administered as a no-asset case with no set claims bar date and, therefore, has no cut off for the “timely filing of a proof of claim,” an unlisted creditor is not deprived the opportunity to file a timely proof of claim.[iii]  Because the time to file a proof of claim never passes, it matters not that the debtor failed to list a creditor in the first place.  Nor does it matter why the debt was not listed.  The 10th Circuit, for example, says that “equitable considerations,” such as the Debtors’ reasons for failing to schedule the debt or the creditor, “do not impact the dischargeability” of the prepetition debt under § 523(a)(3)(A).[iv]

All this bouncing around the Bankruptcy Code takes us back to § 524 for an explanation of why no notice is actually required. Section 524(a)(2) of the Bankruptcy Code, which creates the discharge injunction, is unambiguous and makes no distinction between debts which are discharged following notice to a creditor and those that are discharged despite a lack of notice. Section 524 provides:

(1)        discharge in a case under this title–

(2)        operates as an injunction against the commencement or continuation of an action, the employment of process, or an act, to collect, recover or offset any such debt as a personal liability of the debtor, whether or not discharge of such debt is waived[v]

Thus, a lack of knowledge of the discharge does not provide a defense for a creditor who attempts to collect in violation of the discharge injunction.

All is not lost. Despite the mandate of § 524, not all bankruptcy courts (which are still courts of equity) have divorced themselves from equitable principals. The court in In re Wilcox refused to sanction an unlisted creditor for violation of the discharge injunction despite the creditor’s prosecution of a state-court collections case. The Wilcox Court stated that it:

cannot blame the Creditors for their confusion which, after all, proceeds in large measure from the Debtor’s incomplete disclosure in Schedule F and the mailing matrix. Under the circumstances, and up to this point in time, their filing and prosecution of the [state court] lawsuit is not contemptuous. If, however, they continue to pursue their claims against the Debtor without also seeking a declaration . . . that their claims are excepted from discharge under § 523(a)(3), they run the risk of violating the Discharge, especially now that they have a better understanding of their rights.[vi]

The ultimate lesson to be learned is that creditors need to exercise the utmost caution in their pursuit of borrowers, especially if there is reason to believe that borrower filed bankruptcy. A search of public bankruptcy filings before collection efforts are begun, may be the ounce of prevention that is worth a pound of cure.  If the borrower produces a bankruptcy discharge, a creditor should retain counsel to review the case and determine whether § 523 applies to the case.  Lack of notice is not enough to prevent liability.

[i]  The scenario is based on the recent case out of the District of Utah, In re Slater, No. 09-21947, 2017 WL 2656119, at *1 (Bankr. D. Utah June 20, 2017), where the Court concluded that creditor “should be placed in civil contempt for violation of the discharge injunction of 11 U.S.C. § 524. The Default Judgment in the State Action is void pursuant to § 524(a).”  The court also found the creditor liable to Debtors for actual damages for all wages garnished, as well as costs and reasonable attorney fees incurred by the Debtors in bringing the motion to enforce the discharge order. Other cases in other jurisdictions have come to similar conclusion based on similar rational, although facts and the creditors level of knowledge of the bankruptcy tend to vary slightly. Cf. In re Greenberg, 526 B.R. 101 (Bankr. E.D.N.Y. 2015) and In re Haemmerle, 529 B.R. 17, 20 (Bankr. E.D.N.Y. 2015).

[ii]   In re Delafied 246 Corp., No. 05-13634ALG, 2007 WL 2332527, at *2 (Bankr. S.D.N.Y. Aug. 14, 2007)); In re Herzig, 238 B.R. 5 (E.D.N.Y.1998).

[iii] It should be noted that there is currently a Circuit split on the issue of whether an unlisted debt in a no-asset bankruptcy is automatically discharged by operation of law. The Third, Sixth, Ninth, and Tenth Circuits follow the “mechanical approach” and hold that any such debt is discharged by operation of law; therefore, there is no need to reopen the case and determine dischargeability regardless of the debtor’s reason for failing to list the debt. See In re Parker, 264 B.R. 685, 694 (10th Cir. 2001); In re Madaj, 149 F.3d 467, 471 (6th Cir. 1998); In re Judd, 78 F.3d 110, 115 (3d Cir. 1996); In re Beezley, 994 F.2d 1433 (9th Cir. 1993); see also In re Cruz, 254 B.R. 801, 807 (Bankr. S.D.N.Y. 2000) (summarizing cases).  In contrast, the First, Fifth, Seventh, and Eleventh Circuits have held that motions to reopen a no-asset Chapter 7 case should be granted to amend the list of creditors—thus subjecting the unlisted creditor to the bankruptcy discharge—unless the omission was the result of fraud or intention. See Colonial Surety Co. v. Weizman, 564 F.3d 526 (1st Cir. 2009); In re Faden, 96 F.3d 792, 797 (5th Cir. 1996); In re Baitcher, 781 F.2d 1529, 1534 (11th Cir. 1986); In re Stark, 717 F.2d 322 (7th Cir. 1983).  In these jurisdictions, the Debtor’s basis for failing to list the Debt could be scrutinized as part of the process to reopen the case.  While this doesn’t mean that the debt will not be discharged, it adds a level of scrutiny to the debtor’s failure to list the debt in the first place and provides a creditor additional notice of the bankruptcy.

[iv] In re Parker, 313 F.3d 1267, 1268 (10th Cir. 2002).

[v] See 11 U.S.C. § 524(a)(2). See Green v. Welsh, 956 F.2d 30, 32 (2d Cir.1992).

[vi] In re Wilcox, 529 B.R. 231, 238 (Bankr. W.D. Mich. 2015); see also In re Johnson, 521 B.R. 912, 916 (Bankr. W.D. Ark. 2014)(finding that the debtor failed to notify the creditor. Therefore the creditor was under no obligation to return the money it had collected from the debtor’s state tax return and the debtor’s motion for contempt was denied.)

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What’s Yours is Mine and What’s Mine is For the Benefit of My Creditors: Bankruptcy Courts Remain Reluctant to Impose Constructive Trusts on Debtor Property

There is an inherent tension between the goals of bankruptcy law and the state law doctrine of constructive trust.  A central tenet of bankruptcy policy is that similarly situated creditors should be treated equally: because an insolvent business or individual will not be able to pay all creditors in full, a proper bankruptcy system must provide as equitable a distribution to each of them as possible.  Constructive trust law, on the other hand, works to the advantage of a single creditor – which always means the detriment of the others when everyone is competing for limited funds.

Constructive trusts are imposed when “property has been acquired in such circumstances that the holder of the legal title may not in good conscience retain the beneficial interest.”  Beatty v Guggenheim_Exploration_Co, 225 N.Y. 380, 386 (1919) (Cardozo, J.).  When a creditor in a bankruptcy case alleges that the debtor is holding certain property in constructive trust, it is saying that the debtor does not really own the property; the debtor is simply holding on to it for the creditor.  Because only the debtor’s property can be used to pay its creditors, any property held in constructive trust for one creditor is removed from the asset pool for all other creditors, who can only fight over whatever is left.

Bankruptcy courts are wary of constructive trusts.  However, the constructive trust doctrine is governed by state law, which is not preempted by the Bankruptcy Code.  In New York for example, the elements of a constructive trust claim are: (1) a confidential relationship; (2) a promise; (3) reliance; and (4) unjust enrichment.  Sharp v. Kosmalski, 40 N.Y.2d 119, 121 (1976).  Under New York law, the unjust enrichment requirement, “does not require the performance of any wrongful act by the one enriched.”  Simonds v. Sismonds, 45 N.Y.2d 233, 242 (1978).  Constructive trust law notwithstanding, bankruptcy courts in the Second Circuit have demonstrated a marked reluctance to apply the doctrine when it can be avoided; the latest case in that trend is Fetman, No. 1-15-43716-nhl, 2017 WL 598476 (Bankr. E.D.N.Y. Feb. 14, 2017).

In Fetman, a pair of secured creditors attempted to prevent a § 363 sale by claiming that, for the past thirty years, they were the “true owners” of the properties to be sold.  Those creditors were Mr. and Mrs. Fetman, who also happened to be the debtor’s parents.  The debtor owned two parcels of real property, located at 4301 and 4305 Tenth Avenue in Brooklyn, which the chapter 7 trustee intended to sell to satisfy claims against the debtor.  The properties were subject to a $2.3 million judgment lien in favor of the debtor’s parents, and an additional $21.4 million judgment lien in favor of another creditor.  Both liens were to attach to the proceeds of the sale, but the Fetmans objected on the grounds that the properties were actually owned by them, not the debtor.

The Fetmans explained that they first purchased the 4305 property in the name of a corporation that Mr. Fetman owned when they first immigrated to the United States in the 80’s.  In 1992, the Fetmans purchased the 4301 property in their son’s name because they were not yet American citizens.  They later transferred the 4305 property from their corporation to their son so he could finance loans that the parents could then use to purchase other properties.  With respect to both properties, the Fetmans provided the purchase money, received all of the income generated, and paid all associated expenses.  For his part, the debtor joined in his parents’ objection to the § 363 sale.  He also acknowledged that he had promised to convey the properties to his parents at their request.

Taking the Fetman’s claims at face value, they appear to have easily satisfied the first three requirements for a constructive trust under New York law.  Family members are often deemed to entrust their confidence in one another; the debtor promised that he would own the property in name only, and formally convey it to his parents at their request; the Fetmans purchased the 4301 property, and conveyed the 4305 property to their son, in reliance on that understanding.  It was the fourth requirement – unjust enrichment – on which the Fetmans were ultimately tripped up.  Acknowledging the tension between constructive trust and bankruptcy law, the court pointed out that, in the Second Circuit, “a constructive trust has been imposed against a bankruptcy estate only where a court has found some pre-petition unjust conduct by the debtor relating to the subject property.”  The court rejected the Fetmans’ constructive trust claim, finding not only that they failed to demonstrate sufficient misconduct by the debtor to justify imposing a constructive trust, but they actually benefitted from the arrangement (at least until the trustee proposed selling it for the benefit of creditors who had nothing to do with the Fetmans).  Accordingly, the court granted the trustee’s motion to sell the properties.  To the extent the Fetmans believed themselves to be the owners of the properties, that order must have doubly stung because not only were they about to lose their property, but they were the ones who set the ball in motion by filing an involuntary bankruptcy petition against their son in the first place.

In refusing to impose a constructive trust, the court may have given somewhat short shrift to constructive trust law.  It is far from clear that “misconduct” is a requirement under New York law, particularly in light of the Court of Appeals’ Sismond decision, which suggests that a “wrongful act” is not necessary.  The Fetman court relied heavily on Second Circuit precedent involving bankruptcy proceedings, rather than state law decisions.  In fact, the only New York case that the court directly cites in support of a “misconduct” requirement ultimately refused to impose a constructive trust, not because there was no misconduct, but because there was no evidence of a promise to surrender the property.  See Plotnikoff v. Finkelstein, 105 A.D.2d 10, 14 (1st Dept. 1984).  It seems plausible to say that, outside of bankruptcy, the debtor in Fetman would have been “unjustly enriched” had he simply decided to sell his parents’ properties and use the proceeds to buy $21.4 million worth of Lay’s potato chips.  It is not entirely clear why the result should be different if he (or the chapter 7 trustee) used the proceeds to pay his creditors instead.  That is not to say that the Fetman court incorrectly applied New York law.  The constructive trust doctrine certainly has room for interpretation, and the issues are highly dependent on the equities of a given case.  However, the court was clearly concerned with balancing the goals of bankruptcy law against those of constructive trust law.  Its willingness to read a misconduct requirement into the elements of a constructive trust claim – with little to no discussion of the underlying state law basis – is indicative of the continuing trend in bankruptcy proceedings to tip the balance of those interests toward an equitable distribution to all creditors – and not allow the imposition of a constructive trust.

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Involuntary Bankruptcy Primer Part I: Understanding the Oft Ignored Involuntary Bankruptcy Petition (with Bankruptcy Cave Embedded Briefs for Your Use!)

Editor’s Note:  This is a new one for us at The Bankruptcy Cave.  We are starting a series of primers, covering a narrow range of law but with more depth than just “here’s a recent case.”  And also, we have our first edition of “The Bankruptcy Cave Embedded Briefs” – top quality briefs on a certain issue, feel free to download to your own form files or come back and grab ’em when you need ’em.  Let us know what you think – we are always trying to improve things around here for our readers.

 

Involuntary bankruptcy is an underused but potentially powerful tool in the Bankruptcy playbook.  Although the process to initiate an involuntary case is relatively straightforward (and has been largely unchanged for decades), the scarcity of involuntary petitions filed each year means few bankruptcy lawyers have any practical experience in this area of law.  In 2012 (the last year for which we have good data) just over 500 involuntary bankruptcy petitions were filed, representing but .04% of total bankruptcy filings.[1]

Initiating the Involuntary Case

An involuntary case is commenced by the filing of an involuntary bankruptcy petition under Chapter 7 or 11 of the Bankruptcy Code.[2]  With a few exceptions,[3] creditors holding “a claim … that is not contingent as to liability or the subject of a bona fide dispute as to liability or amount” have standing to file an involuntary bankruptcy petition.  A bona fide dispute must be to the debt’s existence and validity, and not merely the amount of the debt owed.[4]

An involuntary petition requires three or more creditors with an aggregate claim of at least $15,325.[5]  However, if the putative debtor has fewer than twelve total creditors (excluding employees and insiders), a single creditor may file an involuntary petition if its claim exceeds $15,325.

  • The Bankruptcy Cave Embedded Briefs: Can you have an involuntary case if the Debtor has just one creditor? Yes – so long as there is a “bankruptcy purpose” to the case – fraudulent transfers, the need for a trustee, or other relief that is somewhat unique to the Bankruptcy Code.  Check out this imbedded brief [Imbedded Brief 1] on the issue (which won), and use for future reference.  And see the posts cited below for more on the requirement that there be a “bankruptcy purpose” for an involuntary case, even where the statutory standards are met.

The requirements of Section 303 are determined at the moment the involuntary petition is filed; a putative debtor cannot defeat an involuntary petition by subsequently paying off the petitioning creditors to reduce their number or to generate a “bona fide dispute” as to a claim.[6]  Additionally, Section 303(c) permits other creditors to join a petition after it is filed to cure a deficiency in the original petition.[7]

Unlike a voluntary petition under Chapter 7 or 11, the filing of an involuntary petition does not constitute an order for relief under Section 301(b) and, therefore, most provisions of the Bankruptcy Code do not yet apply.  Until an order for relief is entered, a putative involuntary bankruptcy debtor may continue to operate under normal business conditions, as if the involuntary petition had never been filed.[8]

Challenging the Involuntary Bankruptcy Petition, Part I – The Statutory Standards

Filing an involuntary bankruptcy petition is akin to filing a lawsuit against the putative debtor.  Upon the petition filing, the bankruptcy court clerk will issue a summons to be served on the debtor,[9] and the debtor generally has twenty-one days from the date of service to respond.[10]  If contested, a bench trial on the petition will be held.  The petitioning creditors must prove that the threshold elements of Section 303(b) were met and either:

  1. the debtor is generally not paying its debts as they become due, unless such debts are the subject of a bona fide dispute; or
  2. within 120 days before the date of the filing of the petition, a custodian, other than a trustee, receiver, or agent appointed or authorized to take charge of less than substantially all of the property of the debtor for the purpose of enforcing a lien against such property, was appointed or took possession.[11]

The “generally not paying debts” standard looks to the totality of the circumstanced at the time the involuntary petition was filed, and takes into consideration the following, non-exclusive factors: (i) the number and amount of unpaid claims; (ii) the materiality of the nonpayment; (iii) duration of nonpayment; (iv) total amount of indebtedness and financial situation; and (v) any reduction in the debtor’s assets.[12]

If the petitioning creditors can establish that the putative debtor is generally not paying debts, or that a custodian has been appointed over substantially all of the putative debtor’s property, an order for relief will be entered and the case will proceed in the same course as a voluntary Chapter 7 or Chapter 11 case.

Challenging the Involuntary Bankruptcy Petition, Part II – An Independent Requirement of Good Faith?

Recent Delaware caselaw indicated that even an involuntary petition that satisfies the statutory requirements of Section 303 can be dismissed, if there is an ulterior motive to the filing separate from the collection of a debt.  In one case, the petitioners’ primary desire to effectuate a change in management, and not to collect their debts, rendered the filing in bad faith.  Check out the analysis (and a link to the opinion) here, courtesy of John Bird of Fox Rothschild.  In another recent case, the petitioning creditors were using the bankruptcy case to transfer venue of long-running litigation, resulting in another dismissal of the case due to bad faith.  Check out this additional analysis (and a link to the opinion) here, from Ben Keenan of Ashby and Geddes.  (By the way, Fox Rothschild’s Delaware Bankruptcy Litigation blog and Ashby and Geddes’s Delaware Bankruptcy Insider are really the two best Delaware-centric bankruptcy blogs out there – must-read stuff (in addition to The Bankruptcy Cave, of course) to stay abreast of DE happenings and DE’s influence in the restructuring world.)

We hope you liked Part I of this Involuntary tips and traps (with Bankruptcy Cave Embedded Briefs).  Stay tuned for Part II of this post in a few weeks, The Risks and Rewards of the Involuntary Bankruptcy Petition.

[1] See Table 7.2—U.S. Bankruptcy Courts Judicial Facts and Figures (September 30, 2012) at http://www.uscourts.gov/statistics/table/72/judicial-facts-and-figures/2012/09/30

[2] See 11 U.S.C. § 303(b).

[3] See 11 U.S.C. §§ 303(b)(3)-(4).

[4] See In re Busick, 831 F.2d 745, 747 (7th Cir. 1987); Efron v. Gutierrez, 226 B.R. 305, 312 (D. P.R. 1998); In re Food Gallery at Valleybrook, 222 B.R. 480, 487 (Bankr. W.D. Penn. 1998) (a dispute as to the proper interest rate and the method for amortization is not a bona fide dispute of the debt). See also Vortex Fishing, 277 F.3d at 1066-1067 (existence of litigation, or mere filing of answer to a claim, cannot, by itself, constitute a bona fide dispute, but affirmative defenses, including defense that petitioning creditor’s action made debtor’s performances impossible, raised a bona fide dispute to otherwise undisputed debt on open account.) (“So long as the petitioning creditor has established that there is no dispute regarding the debtor’s liability on the creditor’s claim, the creditor has standing.”).  That said, as noted in the Bankruptcy Insider blog post cited below, there remains an open issue as to whether a dispute as to part of a debt is enough to disqualify it for purposes of Section 303, if the undisputed part still is more than the statutory threshold.

[5] As of the time of this article. The dollar threshold for filing an involuntary petition is adjusted for inflation annually.

[6] In re All Media Prop., Inc., 5 B.R. 126, 137 (Bankr. S.D. Tex. 1980); Liberty Tool & Mfg. v. Vortex Fishing Systems, Inc. (In re Vortex Fishing Systems, Inc.), 277 F.3d 1057, 1063 (9th Cir. 2002). See also 11 U.S.C. § 549(b).

[7] See, e.g., Basin Elec. Power Co-op. v. Midwest Processing Co., 769 F.2d 483, 486, 87 (8th Cir. 1985).

[8] 11 U.S.C. § 301(b); 11 U.S.C. § 303(f). However, Section 303(g) permits a party in interest to request the appointment of an interim trustee under Section 701 “if necessary to preserve the property of the estate or to prevent loss to the estate.”

[9] Fed. R. Bankr. P. 1010.

[10] Fed. R. Bankr. P. 1011.

[11] 11 U.S.C. § 303(h).

[12] See Maverick Tube Corp., 853 F.2d at 1546; Vortex Fishing, 277 F.3d at 1064; In re Arriola Energy Corp., 74 B.R. 784, 789 (Bankr. S.D. Tex. 1987); In re Norris, 183 B.R. 437, 455 (Bankr. W.D. La. 1995).  We at The Bankruptcy Cave are also always pleased to find an opinion on point from the great jurist Judge Drake – founder of the SBLI, former president of the NCBJ, and skilled jurist of the highest caliber – see In re Smith, 243 B.R. 169 (Bankr. N.D. Ga. 1999) (debtor was current on day-to-day expenses, but was months past due with large creditors; held that the debtor was not paying its debts as they came due).

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PROMESA Shields Puerto Rico Behind a New Automatic Stay

On June 30, 2016, President Obama signed the Puerto Rico Oversight, Management, and Economic Stability Act (PROMESA)[1] into law.  A copy of the Act can be found here. The most significant portions of PROMESA are found in titles I and II, which establish an Oversight Board with budgetary and fiscal control over Puerto Rico, and title III, which creates of a debt adjustment procedure for Puerto Rico and other territories of the United States.  From a bankruptcy perspective, title III gives rise to a fascinating new procedure that, while it does not make U.S. territories eligible to commence cases under chapter 9 of the Bankruptcy Code, patterns itself after a chapter 9 case by adopting and incorporating substantial portions of chapters 1, 3, 5, 9, and 11 of the Bankruptcy Code to create an wholly new debt adjustment process for Puerto Rico and other U.S. territories.

Beyond all the social, political, and economic furor surrounding PROMESA, however, tucked at the end of the Act is a standalone provision that promises an immediate impact not merely on bondholders and other creditors seeking to enforce payment and remedies but on any person or entity seeking to enforce rights generally against the Government of Puerto Rico or any “territorial instrumentality,” a phrase only a Congressional staffer or bankruptcy professor could love.[2]  Section 405, which took effect immediately upon enactment of PROMESA and remains in effect through at least February 15, 2017,[3] operates as a stay identical to the automatic stay imposed under § 362(a)(1)-(7) of the Bankruptcy code.

Portions of the “PROMESA stay” are applicable only to a “Liability Claim,” defined broadly as a right to payment[4] on account of any financing indebtedness for borrowed money (e.g., bond, loan, letter of credit).  However, like the automatic stay imposed by Bankruptcy Code § 362(a) to protect a debtor in bankruptcy, § 405 of PROMESA also imposes a stay of such familiar acts as:

  • the commencement or continuation of any action or proceeding against the Government of Puerto Rico that was or could have been commenced prior to the enactment of PROMESA;
  • the enforcement of any judgment against the Government of Puerto Rico or its property;
  • any act to obtain possession of property of, or exercise control over, the Government of Puerto Rico or its property; and
  • any act to create, perfect, or enforce any lien against property of the Government of Puerto Rico.[5]

Exceptions to the PROMESA stay are limited: only actions pending on or before December 18, 2015 and actions pertaining to a governmental unit’s police and regulatory powers are excluded from the injunctive effect of the stay. Other exceptions to the automatic stay were not incorporated into § 405.  Thus, for example, there is no automatic exception from the PROMESA stay for the exercise by a commodity broker or forward contract merchant under any arrangement relating to a commodity contract, forward contract, or securities contract (Cf. 11 U.S.C. § 362(b)(6)), nor any exception for acts by a lessor of nonresidential real property to retake possession following the  following the natural expiration of the lease (Cf. 11 U.S.C. § 362(b)(10)).

Perhaps in recognition of the split among circuit courts as to whether violations of the automatic stay in bankruptcy cases are void ab initio or merely voidable, acts in violation of the PROMESA stay are void by statute.[6]  Moreover, whereas damages may be recovered only for a willful violation of the automatic stay under § 362 of the Bankruptcy Code, PROMESA requires no such showing of willfulness for a person found to violate the stay to be held liable for damages, costs, and attorneys’ fees.[7]

Relief from the PROMESA stay may be granted—as in the bankruptcy context—“for cause.”[8]  PROMESA does not define “cause” in this context, but the obvious derivation of § 405 from the provisions of Bankruptcy Code § 362 strongly suggests that courts would look to caselaw applying Bankruptcy Code § 362(d)(1) for guidance in deciding whether cause exists to grant relief from the PROMESA stay.  Stay relief similar to that afforded under § 362(d)(2)—i.e., where there is a lack of equity in property that is not otherwise necessary to an effective reorganization—is not available under PROMESA.

The timing of a hearing on a request for relief from the PROMESA stay also closely tracks the language of Bankruptcy Code § 362, except that the PROMESA statute allows the district court 45 days in which to order continuation of the stay as the result of a hearing or otherwise, whereas the corresponding provision of the Bankruptcy Code terminates the stay after only 30 days.[9]

Original and exclusive jurisdiction of any such civil action arising under or relating to PROMESA § 405 is vested solely in the federal district courts of Puerto Rico.[10]  Despite the strong similarities to the bankruptcy stay, the general order referring certain matters to the bankruptcy courts does not extend to civil proceedings arising outside of the Bankruptcy Code.[11]  Therefore, despite the similarity to lift stay proceedings in bankruptcy, litigants should not expect to see requests for relief from the PROMESA stay referred to bankruptcy judges for adjudication.

With PROMESA having just been signed into law, it is too early to tell precisely how § 405 will be received and applied by the federal judges in the District of Puerto Rico. Nevertheless, it is clear that PROMESA is not just for bondholders, and the new Act’s reach extends far beyond the realm of defaulting municipal bonds and quasi-chapter 9 debt adjustment proceedings.  Any pending or contemplated litigation against an instrumentality of the Government of Puerto Rico, or any act to assert control over the Government, or a property interest of the Government, may already be stayed by PROMESA § 405.  As when contemplating action against a debtor in bankruptcy, the well-advised litigant will carefully consider the implications of the PROMESA stay before moving ahead.

[1]           Promesa is Spanish for promise.

[2]           The term “territorial instrumentality” is construed broadly to include any political subdivision, public agency, instrumentality, or public corporation of a territory (e.g., Puerto Rico), including any instrumentality that is also a bank. PROMESA § 5(19).

[3]           The timing of certain other key events (e.g., the establishment of an Oversight Board for Puerto Rico) may extend that date.

[4]           Section 405(a)(2) incorporates the broad “right to payment, etc.” language that the Bankruptcy Code uses to define a claim” in the bankruptcy context. Cf. 11 U.S.C. § 101(5).

[5]           PROMESA § 405(b)(1)-(4).

[6]           PROMESA § 405(h).

[7]           PROMESA § 405(h).

[8]           Compare PROMESA § 405(e)(2) (permitting relief from the stay “for cause shown) with 11 U.S.C. § 362(d)(1) (permitting stay relief “for cause”).

[9]           PROMESA § 405(f). Cf. 11 U.S.C. § 362(e)(1).

[10]          PROMESA § 405(e)(1).

[11]          Resolution (D.P.R. July 19, 1984) (referring to the bankruptcy courts of the District of Puerto Rico “all cases under title 11 of the United States Code, 11 USC 101 et seq., and all proceedings arising under title 11 of the United States Code, supra., or arising in or relating to a case under title 11…”

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How Reporting a Crime May Subject You to Sanctions

You are a creditor and your loan is secured by personal property, let’s say equipment.  The borrower recently filed for bankruptcy protection.  You receive a phone call from a friend advising you that someone has a moving truck outside the borrower’s business location and it looks like they are stealing equipment.  You don’t know who is moving the equipment — but you do know it’s without your permission and in violation of the security agreement.  You are furious.  You think a crime is being committed and you want tell the appropriate authorities.  You call the police, file a police report and hope the police will recover the equipment so your collateral remains intact.  A few weeks later, the chapter 11 debtor files an action against you for willful violation of the automatic stay and requests sanctions again you under 11 U.S.C. 362(k)(1)!  Will you have to pay sanctions?

Believe it or not, the answer may be yes.

Most business professionals know about the automatic stay under 11 U.S.C. 362.  When a debtor files for bankruptcy protection, a creditor may not take any action to collect on its debt without a court order granting it relief from stay.  One exception to the automatic stay is the “commencement or continuation of a criminal action or proceeding against the debtor” but that exception is not absolute. 11 U.S.C. 362(b)(1).  Litigation over this exception generally arises over whether a particular proceeding is in fact a “criminal action or proceeding,” or is it really just a disguised attempt to collect a debt.

Courts have taken two positions on this issue.

  1. Prosecuting Authority Pursuing Criminal Charges: The first is that a criminal proceeding initiated by a prosecuting authority is excepted from the stay, regardless of whether the proceeding results from the debtor’s failure to pay a debt.
  2. Creditor Pursuing Criminal Charges: The courts are split on whether a creditor may pursue criminal charges after a bankruptcy has been filed. Some courts consider the creditor’s motivation for initiating the criminal prosecution: if the creditor did so to collect a debt rather than to benefit the public good, the action violates the stay.  Courts that consider the creditor’s motives generally apply a “stringent” test that finds a stay violation only when the creditor’s primary motive was to collect its debt.

 

  1. Prosecuting Authority: 

The 9th Circuit provides the leading authority on Section 362(b)(1), in County of Los Angeles v. Gruntz (In re Gruntz), 202 F.3d 1074 (9th Cir. 2000) (en banc).  Before Gruntz, a criminal proceeding did not fall under the 362(b)(1) exception if the purpose of a criminal proceeding was to collect upon a financial obligation. Hucke v. State of Oregon, 992 F.2d 950, 953 (9th Cir. 1993).  The Ninth Circuit in Gruntz overruled Hucke and held that Section 362(b)(1) applies to all criminal proceedings regardless of whether there is a financial element.  992 F.2d at 1085-86.  Several other courts around the country follow this ruling. See, e.g., Weary v. Potent (In re Poteat), 2015 WL 4747883, *4 (E.D. Tenn. 2015); In re Dunn, 2013 WL 1091737, *7 (Bankr. E.D. Tenn. 2013); Simonini v. Bell (In re Simonini), 69 F. App’x 169, 170-71 (4th Cir. 2003); In re Bartel, 404 B.R. 584, 590-91 (BAP 1st Cir. 2009).

While that long standing principle is clear enough, Gruntz did not address the issue of criminal proceedings vis-à-vis non-governmental actors. Rather, Section 362(b)(1) is limited to only governmental entities. Weary v. Poteat (In re Poteat), 2015 WL 4747883, *4 (E.D. Tenn. 2015); Bender Industrial Group, Inc. V. Herbert (In re Herbert), 2015 WL 1579575, *3 (Bankr. D. Or. 2015) see also Heath v. Alabama, 474 U.S. 82, 88 (1985) (“The dual sovereignty doctrine is founded on the common-law conception of crime as an offense against the sovereignty of the government”).  The Herbert bankruptcy court reviewed the Ninth Circuit’s opinion in Gruntz and several other authorities, observing that Gruntz refers to state sovereignty several times, and most importantly specifically states that the parties to a criminal proceeding are between the state and the accused. Herbert, at *3.

  1. Creditors:

In In re Byrd, 256 B.R. 246 (Bankr. E.D.N.C. 2000), the court addressed Section 362(b)(1) as it pertains to a creditor.  Byrd involved a violation of the discharge injunction (which is not materially different than a violation of the automatic stay).  In that case, the debtor negotiated two checks pre-petition. While the debtor’s civil liability was discharged, the debtor was subsequently arrested and required to repay the creditor in full to be released from custody. The bankruptcy court ruled that Section 362(b)(1) did not protect the creditor, but nonetheless concluded that the creditor did not violate the discharge injunction because the creditor did not take any affirmative action to collect on his debt.

Conversely, the bankruptcy court in Pearce v. E.L.W. Corp. (In re Pearce), 400 B.R. 126 (Bankr. N.D. Iowa 2009), sanctioned a creditor who filed a post-petition criminal complaint for non-payment of a pre-petition debt.  The court ruled that every creditor has a right under Section 523 to seek to except a debt from a debtor’s discharge or object to discharge under Section 727, but a creditor cannot utilize the criminal process to improve its position at the expense of other creditors. Pearce, 400 B.R. at 132.

The Nevada bankruptcy court reached a similar conclusion as the courts in Byrd and Pearce.  See Fidler v. Donahue (In re Fidler), 442 B.R. 763 (Bankr. D. Nev. 2010).  While the Court did not enjoin the criminal prosecution, it left the bankruptcy court open to determine whether the creditor violated the bankruptcy discharge.

There are courts that hold that a creditor does not violate the automatic stay when it reports a crime to the police or applies for a criminal warrant that would initiate a criminal complaint pursuant to state law.  In re Dunn, 2013 WL 1091737 at *2 (Bankr. E.D. Tenn. 2013).  In Dunn, the bankruptcy court recognized the split of authority among the courts.  While the Court believed the facts created a close question, it was ultimately persuaded that it should apply the unambiguous language of § 362(b) to except all criminal proceedings from the automatic stay regardless of who initiated the criminal proceeding or the purpose for which the proceeding was brought.  It noted that “Congress was capable of being very specific when it intended to be.” Id. at *7.  Interestingly, the District Court in Tennessee in Poteat (2015 WL 474883 *5) recognized the bankruptcy court’s reasoning in Dunn.  It accepted the Dunn holding but distinguished it by stating “to the extent that the criminal prosecution exception of subsection (b)(1) covers the actions of private parties, the scope of the exception is limited to conduct that fundamentally advances the important state interest at stake – the commencement or continuation of a criminal action or proceeding.” Poteat, *5.  However, the § 362(b) exception does not apply to an action beyond that purpose to include collecting a debt.

It appears that if a creditor is accused of violating the automatic stay (or discharge injunction) by initiating a criminal complaint or proceeding, then at least some bankruptcy courts will require the creditor to prove that it did not intend to collect on its debt when it initiated the criminal prosecution. Whether the creditor’s intent is ultimately exonerated, it will require the creditor to defend itself before a bankruptcy court, which will likely include an expenditure of attorney’s fees, cost, and attendant risk.

Word to the wise: if a creditor is truly concerned about its collateral, the safest avenue is to bring the issue to the attention of the bankruptcy court or bankruptcy trustee as soon as possible.

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Bitcoin after Brexit: Safe Haven or Harbinger of Future Distress?

Currency icons consept : Businessman touching the screen about currency icons

What a difference a week makes! On June 17, 2016, bitcoin was trading at more than $750. Five days later, as polls showed the Brexit vote leaning heavily to “remain,” bitcoin dropped as low as $585. After the vote to leave the European Union became final, the British Pound, the Euro, the Chinese Yuan, and global stocks dropped precipitously. Bitcoin, on the other hand, spiked to more than $676, and was trading in the $660s on Friday. Could this mean bitcoin is being perceived as a new safe-haven asset?

A Brief Background on Bitcoin Generally

Bitcoin often is described as a “digital currency.” On a more technical level, bitcoin is a digital asset within a peer-to-peer computer network payment system created in 2008 by an anonymous cryptographer going by the pseudonym Satoshi Nakamoto. Because the computer network uses open-source, peer-to-peer software, no truly central authority administers and oversees transactions, and no government controls or backs the digital “currency.” Instead, users or “nodes” on the network verify transactions by solving complex computer algorithms. The verified transactions are then recorded on a public ledger (called the blockchain) for all to see. Because transactions employ lengthy key codes rather than traditional personally-identifiable information, users can trade bitcoin quasi-anonymously.

Because bitcoin lacks government or centralized control, conceptually it is accessible to anyone with an internet connection and eliminates many of the transaction costs associated with traditional currency trading. For the same reasons, however, it can be highly volatile. At the inception of the network in 2009 and through 2012, a single bitcoin was worth mere pennies. In 2013, amid a financial crisis and the seizure of bank accounts in Cyprus, holders of Cypriot accounts began buying massive amounts of bitcoin, which drove the price of bitcoin to more than $260 for the first time. By November 2013, the value of bitcoin peaked at $1,242. The price of bitcoin declined thereafter amid hacking scandals, the insolvency proceeding of Mt. Gox (bitcoin’s then largest exchange), and negative perceptions created by the high-profile criminal case involving the elicit online marketplace known as Silk Road. Despite its volatility over the last seven years, however, bitcoin has endured and shows no signs of disappearing.

Bitcoin as a Safe Haven?

Bitcoin’s sharp rise after the Brexit vote appears to evidence a new confidence in bitcoin as a safe haven. Investment professionals, however, have been extremely reluctant to give bitcoin such status. One recent research note observed that calling bitcoin a safe haven “obfuscates the fact that bitcoin is a high-risk and volatile investment” and ignores that “bitcoin’s correlation to other traditional safe-haven assets has fluctuated significantly.” Instead, bitcoin can be viewed as “something entirely different that does not fit into the normal buckets that investments are typically bracketed into.”

The inability to categorize bitcoin into a traditional “bucket” is equally visible in the legal context, and perhaps particularly in the bankruptcy context. In a recent widely-circulated decision, for example, a bankruptcy judge concluded that bitcoin is not currency for purposes of a trustee’s recovery of avoidable transfers. See In re Hashfast Technologies LLC, No. 15-3011DM (Bankr. N.D. Cal. Feb. 19, 2016). The case involved a “bitcoin mining” computer company that paid 3,000 bitcoin to an individual to promote the company’s products. After the company’s bankruptcy filing, a trustee was appointed. The trustee sought the return of the value of the bitcoin paid to the promoter. The total value of the bitcoin in question had increased from $363,861 at the time of payment to nearly $1.3 million as of the Feb. 19, 2016 ruling.

The arguments on each side were predictable. The promoter argued that the company intended to use the bitcoin as currency and that the trustee should be able to recover only the value of the bitcoin at the time of the payment. The trustee, on the other hand, argued that the bankruptcy estate should be able to recover the fully appreciated value of the bitcoin as a commodity. The bankruptcy court did not fully resolve the issue. Rather, it concluded solely that “bitcoin are not United States dollars,” and left for another day the question of whether the trustee could recover the value of the bitcoin at the time of payment or the subsequent appreciated value.

As the Hashfast case demonstrates, the current legal framework is still deciding whether bitcoin fits into any familiar “buckets” or whether Congress or the judiciary will have to create new ones. Characterizing bitcoin as a commodity versus a currency, versus some other property right, is just one example of the many issues bitcoin presents in a financially distressed situation. In short, the legal outcomes, particularly in bankruptcy, currently lack any degree of predictability.

Conclusion

From a legal perspective, bitcoin does not appear to share the features of traditional safe-haven investments such as government bonds or stable fiat currency. Whether traders treat it as a safe haven, however, ultimately will be the true test. Over time, their collective decisions may give rise to bitcoin as an alternative safe haven, or those decisions may bring a wave of novel legal issues to our federal bankruptcy courts. In either case, insolvency professionals would do well to keep their eye on this growing and rapidly evolving field.

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Ninth Circuit Decides Issue of First Impression, Protects Insider Guarantor from Preference Liability

In a case of first impression for any district or appellate court, the Court of Appeals for the Ninth Circuit (the “Court”) held that “when an insider guarantor has a bona fide basis to waive his indemnification rights against the debtor in bankruptcy and takes no subsequent actions that would negate the economic impact of that waiver, he is absolved of any preference liability to which he might otherwise have been subjected.” As discussed below, the case provides a list of factors for courts to consider in determining whether an indemnification waiver should be considered valid for purposes of exempting an insider guarantor’s preference liability.

In Stahl v. Simon (In re Adamson Apparel, Inc.), the Court decided whether a personal guarantor of corporate debt may be liable for preferences where that guarantor is an insider of the debtor but validly waived his rights to indemnification against the debtor. The debtor Adamson Apparel, Inc. (the “Company”) was the borrower under a multi-million dollar loan. The Company’s President and CEO Arnold H. Simon (“Simon”) personally guaranteed the Company’s obligations under the loan. At the same time, Simon waived his rights against the Company for indemnification, for reimbursement of any amounts Simon paid against the loan.

Prior to filing bankruptcy, the Company executed a large sale of its merchandise to a third party for approximately $5 million. The Company instructed the merchandise purchaser to transfer the purchase price directly to the Company’s lender, in partial satisfaction of the debt. A few months thereafter, Simon personally paid the balance of the loan, equal to approximately $3.5 million.

Six months after Simon paid off the loan, the Company filed for Chapter 11 bankruptcy, and the Committee of Unsecured Creditors (“Committee”) filed a lawsuit against Simon claiming he was liable for preferential payments. The Committee’s lawsuit theorized that the $5 million debt payment by the Company (via the merchandise sale) amounted to a preference in favor of Simon, because it reduced Simon’s debt under the loan by the same amount.

The key question was whether Simon was a “creditor” of the Company. Bankruptcy Code Section 547(b) sets the parameters of preference liability, and those parameters state that a preference exists only if, among other things, the debtor transfers property “to or for the benefit of a creditor.” Bankruptcy Code Section 101(10) defines “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief,” and a “claim” includes a contingent right to payment. The plaintiff carries the burden of proof to establish that the defendant is, in fact, a creditor.

Under Levitt v. Ingersoll Rand Fin. Corp. (In re Deprizio), 874 F.2d 1186 (7th Cir. 1989) and Section 547(b), insider guarantors may be liable for transfers made by the debtor on the guaranteed debt up to one year before the petition date.   In the wake of Deprizio, an increasing number of guarantors executed indemnification waivers like the one executed by Simon. The bankruptcy courts have been split on whether such waivers are valid. One line of bankruptcy cases concludes that such waivers are valid and excuse the guarantor from preference liability. E.g., O’Neil v. Orix Credit Alliance, Inc. (In re Ne. Contracting Co.), 187 B.R. 420 (Bankr. D. Conn. 1995). However, another line of bankruptcy cases, most notably In re Telesphere Commc’ns, Inc., 229 B.R. 173 (Bankr. N.D. Ill. 1993), concludes that such waivers are invalid, because they lack economic impact—

if the principal debtor pays the note, the insider guarantor would escape preference liability, but if the principal debtor does not pay the note, the insider could still obtain a claim against the debtor, simply by purchasing the lender’s note rather than paying on the guarantee. . . . The attempted waiver of subordination rights was thus held to be a sham provision, unenforceable as a matter of public policy.

Telesphere, 229 B.R. at 176 n.3.

At a bench trial before the bankruptcy court, Simon argued that he had fully waived his indemnification rights against the Company and did not file a proof of claim against the Company, and therefore he was not a “creditor” of the Company and not subject to preference liability. The bankruptcy court agreed and entered judgment in favor of Simon. The district court affirmed the bankruptcy court’s judgment, and the lawsuit was then appealed up to the Ninth Circuit, which reviewed the bankruptcy court’s findings of fact for clear error and its conclusions of law de novo.

After concluding that the bankruptcy court did not make clear error in finding that Simon fully waived his indemnification rights, the Court addressed Telesphere’s concern regarding “sham” waivers. The Court stated that, rather than negating a waiver because it hypothetically could be a sham, “courts should instead examine the totality of the facts before them for evidence of ‘sham’ conduct.” In this case, the Court considered four factors to be relevant to the examination:

  1. Available Collateral—The loan in question was secured by a lien on the Company inventory and accounts receivable and, therefore, the loan could have been satisfied by those assets, without Simon’s guarantee.
  2. No Act as Creditor—Simon never filed a proof of claim against the Company and did not purchase the loan from the lender.
  3. No Unilateral Right to Purchase Loan—Simon did not have a unilateral right to purchase the loan.
  4. Other Guaranteed Debts—The plaintiff presented no evidence that the loan in question was the only Company debt that Simon guaranteed. If the loan was the only Company debt that Simon guaranteed, then perhaps Simon would have an incentive to satisfy this lender’s debt instead the Company’s other debts. But plaintiff presented no such evidence to support its burden.

All of these facts led the Court to conclude that Simon’s indemnification waiver was valid and not a sham, and therefore Simon was not a “creditor” of the Company under the Bankruptcy Code.

As the only appellate or district court decision to decide the issue, Adamson presents the strongest case to date that, in the event a borrower files bankruptcy, any insider guarantors who have truly waived their indemnification rights will not be liable for preferences related to the borrower’s pre-petition payoff of the debt.

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