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

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

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

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

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

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

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

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

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

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Supreme Court Weighs Granting Cert on Bankruptcy Issues Involving Surcharge and Voting Rights of Assignee of Insider Claim

The Supreme Court is considering whether to grant review of two bankruptcy cases.  On October 3, 2016, the Supreme Court invited the Solicitor General to file briefs expressing the views of the United States.  Because the Supreme Court’s justices normally give significant weight to the federal government’s recommendations regarding interpretations of federal statutes (here, the Bankruptcy Code), the Solicitor General’s forthcoming briefs could influence whether the Supreme Court grants cert. on the two notable bankruptcy cases.

Southwest Securities v. Segner

The first case under consideration is Southwest Securities v. Segner (In re Domistyle, Inc.)811 F.3d 691 (5th Cir. 2015).  At the commencement of this case, the trustee believed the debtor possessed equity in certain real property that could benefit unsecured creditors.  Id. at 693-94.  The property was encumbered by Southwest Securities’ lien.  After marketing the property for a year, the trustee was unable to sell the property and ultimately abandoned it to Southwest and moved to surcharge Southwest for the expenses paid in maintaining the property from the start of the case.  Id. at 694-95.  The Bankruptcy Court for the Eastern District of Texas approved the surcharge over Southwest’s objection that the expenses were incurred to benefit unsecured creditors, and not Southwest.

To surcharge a lender for expenses under 11 U.S.C. sec. 506(c), the trustee bears the burden of proving that: “(1) the expenditure was necessary, (2) the amounts expended were reasonable, and (3) the creditor benefitted from the expenses.”  Id. at 695 (quoting In re Delta Towers, Ltd., 924 F.2d 74, 76 (5th Cir.1991)).  Southwest argued the surcharge was improper because, among other things, the bankruptcy court incorrectly found that the expenses were incurred “primarily” for its benefit simply because it ended up being the only creditor who received any payment from the property.  Id. at 695-96.

Southwest relied on language in Delta Towers that “require[ed] that the claimant incur the expenses primarily for the benefit of the secured creditor.” 924 F.2d at 77 (emphasis added).  In rejecting Southwest’s arguments, the Fifth Circuit reasoned that the word “primarily” is absent from the statute and Section 506(c) did not include an express requirement that funds be spent with any particular beneficiary in mind.  811 F.3d at 696.  The Fifth Circuit affirmed the surcharge because there was a direct relationship between the expenses and the collateral, evidenced by the fact that all of the surcharged expenses related only to preserving the value of the property and preparing it for sale.  Id. at 696.  The Fifth Circuit also noted the equitable nature of the statute, and that there was no evidence that Southwest could have sold the property earlier and thereby avoided the ongoing property preservation and maintenance expenses for which it was surcharged.  Id. at 699.

Finally, in weighing whether to grant cert., the Supreme Court will consider whether a circuit split exists.  Southwest argues that the Fifth Circuit’s opinion conflicts with In re Trim-X, Inc., 695 F.2d 296 (7th Cir. 1982) (holding that “expenses incurred prior to the time the trustee determined [the estate] had no equity in the assets were not for the benefit” of the secured creditor) and split panels from at least two other courts of appeals.  See Loudoun Leasing Dev. Co. v. Ford Motor Credit Co. (In re K&L Lakeland, Inc.), 128 F.3d 203 (4th Cir. 1997); Brookfield Prod. Credit Ass’n v. Barron, 738 F.2d 951 (8th Cir. 1984).

The trustee argued that there is no circuit split because the surcharge was to reimburse for benefits to Southwest itself, not potential benefits to unsecured creditors.  Response of Milo H. Segner, Jr., Trustee, in Opposition to Petition for a Writ of Certiorari, at 18-19.

U.S. Bank v. Village at Lakeridge

In The Village at Lakeridge, a non-statutory insider acquired a $2.76 million claim against the debtor from an insider for $5,000.  In re The Village at Lakeridge, LLC, 814 F.3d 993, 997 (9th Cir. 2016).  The debtor attempted to confirm its plan (which included a cramdown of U.S. Bank’s claim) by arguing that the assignee of the insider claim provided the debtor an impaired, consenting class.  U.S. Bank moved to designate the assignee’s claim on the basis that he was both a statutory and non-statutory insider, and that the assignment was made in bad faith.  Id. at 997-98.  The bankruptcy court designated the claim and ruled that the assignee was not entitled to vote because, when the claim was assigned, he acquired the insider status of the assignor as a matter of law.  Id. at 998.  However, the bankruptcy court ruled that the assignee was not himself an insider and the assignment was not made in bad faith. Id.

The Bankruptcy Appellate Panel for the Ninth Circuit reversed the bankruptcy court’s ruling that the assignee acquired insider status by way of assignment and affirmed the bankruptcy court’s determinations that the assignee was not himself an insider and the assignment was not made in bad faith.  The Ninth Circuit then affirmed the BAP.  Id.

In its Petition for a Writ of Certiorari, U.S. Bank urged that review is warranted for three fundamental reasons.  First, U.S. Bank argued that the Ninth Circuit’s ruling allows an insider claim to be transferred to a third party for the purpose of circumventing the Bankruptcy Code’s statutory prohibition against insider voting under 11 U.S.C. § 1129(a)(10).  U.S. Bank’s Petition for a Writ of Certiorari, at 7-8.  U.S. Bank argued that the Ninth Circuit’s holding ignores the general law of assignment, which holds that an assignment transfers all disabilities of the assignor (here, insider status) to the assignee.  Id. at 8.  (By the way, we at The Bankruptcy Cave would absolutely love it if, assuming cert is granted, the opinion can also resolve whether as assignee of a claim take it subject to disallowance impediments under Section 502(d) of the Code, or if an assignee cannot have its claim disallowed due to prior fraudulent transfers or preferences paid to the assignee.  This split is discussed here, courtesy of a post by our friends at Andrews & Kurth.)

Second, U.S. Bank argues a circuit split exists on the standard of review that should be applied to a determination of insider status.  Id. at 19.  U.S. Bank alleged that the Ninth Circuit’s review of the bankruptcy court’s determination of non-statutory insider status for clear error directly conflicts with the standard of review employed by the majority of circuit courts in the Third, Seventh, Tenth and Eleventh Circuits, which hold that questions of insider status are mixed questions of law and fact to be reviewed de novo.  Id. at 19-20 (citing Schubert v. Lucent Tech. Inc. (In re Winstar Comm’ns., Inc.), 554 F.3d 382, 395 (3d Cir. 2009); In re Longview Aluminum, L.L.C., 657 F.3d 507, 509 (7th Cir. 2011); In re Krehl, 86 F.3d 737, 742 (7th Cir. 1996); Anstine v. Carl Zeiss Meditec AG (In re U.S. Med., Inc.), 531 F.3d 1272, 1275 (10th Cir. 2008); and Miami Police Relief & Pension Fund v. Tabas (In re The Florida Fund of Coral Gables, Ltd.), 144 Fed. Appx. 72, 74 (11th Cir. 2005)).

Third, U.S. Bank argued a circuit split also exists on the proper test for determining nonstatutory insider.  Id. at 24.  Specifically, U.S. Bank argued the Supreme Court should resolve whether courts are to conduct an “arm’s length” analysis as applied by the Third, Seventh and Tenth Circuit Courts of Appeal, or apply a “functional equivalent” test which looks to factors comparable to those enumerated for statutory insider classifications as applied by the Ninth Circuit in this action.  Id. at 24-27 (citations omitted).

The debtor disputes that any circuit split of authority exists, and alleges that the Ninth Circuit applied all appropriate standards for determining insider status.  The Village at Lakeridge, LLC Brief in Opposition, at 6-11.

Potential Ramifications

Denying cert. in Southwest could both increase the risk of a surcharge of a secured creditor and dissuade a trustee from promptly abandoning assets.

Denying cert. in Village at Lakeridge could increase efforts by debtors to confirm plans by assigning insider claims to friendly non-insiders who will vote for the plan.

Stay tuned for more developments on both cases.

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