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“Singular” Cases on Nondischarge and Dischargeability

Liar businessman with crossed fingers at back .

Two recent cases analyzed the misrepresentations of a debtor regarding a single asset and held a written misrepresented value of a single scheduled estate asset would result in nondischargeability under Section 727, and that a verbal misrepresentation of a pre-petition asset to a creditor did not result in an exception to discharge under Section 523.

In Worley v. Robinson,[1]/ the Fourth Circuit affirmed nondischarge where a financially sophisticated debtor’s Schedules substantially undervalued his estate’s only substantial asset.  In Appling v. Lamar, Archer Cofrin LLP,[2]/ the Eleventh Circuit reversed a district decision and held that a false oral statements to a creditor regarding one pre-petition asset would not render the associated debt nondishargeable because they were statements of “financial condition” that must be in writing to support denial of discharge of a debt.

Litigation seeking nondischarge under Section 727 or the dischargeability of a debt under the exceptions of Section 523 is a broad topic. In general terms:

  • Section 727 provides a broad scope of discharge for the debtor, but sets out certain misconduct that will result in nondischarge, which denies the remedy of discharge of any of the debtor’s obligations.  The scope of such misconduct is generally some manner of fraudulent representation or activity in the context of the bankruptcy case, though it can involve pre-petition conduct.  The issue of nondischarge is raised procedurally by an objection to discharge filed by a creditor, the Trustee, or the U.S. Trustee.
  • Section 523, on the other hand, provides for exceptions to the general discharge of the debtor. These exceptions can render a specific obligation nondischargeable. Many of the exceptions are based on legal policies surrounding the character of the indebtedness, like certain taxes, child support obligations, and student loans.  But the commonly litigated exceptions generally involve some manner of pre-petition fraud upon a specific creditor.  The offended creditor typically initiates an adversary proceeding to obtain such an exception to discharge.

The Worley and Appling cases offer illustrations of nondischarge and dischargeability from the most singular perspective where the debtor’s misrepresentation pertains to only one asset.  The very limited facts regarding the assets actually help to identify the very important governing principals and policies of these different Bankruptcy Code treatments of alleged debtor misconduct.

In Worley, the debtor suffered nondischarge where he used a capitalization of income method to value an investment at $2,500, but the Court found it to be worth at least $13,200 under different considerations.  While just those facts may make it seem the Court was slicing it pretty thin against this debtor, other facts leveraged the adverse holding.  The debtor was an MBA with 10 years of brokerage experience who assumedly knew that the valuation method he used would undervalue the basically non-income producing asset, and that the “no asset” appearance of his bankruptcy Schedules would tend to chill further investigation by creditors or the trustee or even lead to abandonment of the property.  The Court found no clear error in the bankruptcy court’s denial of discharge under Section 727(a)(4), for the making a false oath or account.

Appling also involved very simple facts: the debtor lied to his lawyers to obtain pre-petition legal services on credit, first saying that he expected a big tax refund that would enable him to pay his legal bills, then after getting the refund, using it in his business and telling his lawyers he didn’t get the refund.  But again, the simple facts regarding this asset assist the clarity of the legal issues involved.  Section 523(a)(2)(A) and (B) both provide for exceptions from a discharge a debt obtained by misrepresentations.  However, (B) governs any misrepresentation “respecting the debtor’s … financial condition”, and requires that the misrepresentation be in writing.  Misrepresentations regarding other topics are governed by (A), and may be oral statements.  So, the question in Appling turned to whether debtor’s oral statements about this one asset were statements “respecting the debtor’s … financial condition.”  If they were, then Section 523(a)(2)(B) controls, and if the creditor does not have a written statement, the creditor loses.  Here, the existence vel non of a tax refund did relate to financial condition, and lacking any writing by the debtor about it, the debt was dischargeable.[3](We at The Bankruptcy Cave found this confusing – what oral statements do not relate to financial condition, and thus could lead to nondiscahrgeability?  The opinion answers it – “false [oral] representations about job qualifications and lies about the purpose and recipient of a payment,” for example, are the stuff that can lead to nondischargeability.  But if the creditor is complaining about a falsehood regarding financial condition, it should have gotten it in writing, the Eleventh Circuit held.)

Together the Worley and Appling cases show the varied levels of legal scrutiny of debtor intent and creditor reliance, and variable levels of materiality in the landscapes of nondischarge and dischargeability.  (My colleague Mark Duedall from BC Atlanta also wrote recently on this, in the context of a lender’s failure to perform any real diligence on a debtor’s statements, rendering the lender’s reliance unreasonable and foiling another effort to deny a discharge, here.)  It is intuitively useful to first remember that discharge and a “fresh start” are basically the whole point of the Code, and that variance of that result would be relatively rare.  (See a nice collection of Supreme Court statements on this point here.)

In the context of Section 523 dischargeability and misrepresentations, there is, in practical effect, a relatively lower expectation of debtor intent and a higher scrutiny of creditor reliance. For example, the Appling case arguably weighs “fresh start” against a legally sophisticated creditor’s unsecured lending to a financially distressed guy based on his oral statement that he was going to get a tax refund.  Is that really the creditor due diligence or underwriting standard that the Courts are endeavoring to protect in the scheme of Code policy goals?  Is that the creditor we should break “fresh start” for?  Is it too much to ask for unsecured creditors to obtain written statements of the borrower’s financial condition?  Were the oral statements really material to any reliance upon which credit was extended?  The result in Appling would indicate a negative answer to each of those rhetorical questions.

However, in the context of Section 727 nondischarge and misrepresentations, there is, in practical effect, a relatively higher expectation of debtor intent and a lower scrutiny of creditor reliance.  For example, the Worley case arguably weighs the debtor’s “fresh start” against his own financially sophisticated methods of asset valuation without any consideration of whether reasonably diligent creditors or trustees would have, in fact, been fooled.  Section 727 is itself the “fresh start”, and so the expectations of debtor conduct in the proceeding are high.  Does a debtor have to be scrupulously honest in characterizing his financial condition?  Can a Court scrutinize errors in a debtor’s Court statements down to the level of a single asset and the debtor’s subjective experience and expertise?  In the right circumstances, can a single asset be so material as to support nondischarge?  The result in Worley would yield positive answers to all those questions.

While the Worley and Appling cases involve unusual matters in their analysis of single asset factual disputes, the cases do illustrate that disputes involving nondischarge and dischargeability do not tend to provide safe harbors, and rather always involve a facts-and-circumstances analysis and a result that will largely depend on issues of intent, reliance, and materiality.

 

[1]/          Worley v. Robinson (In re Worley), 15-2346 (4th Cir. Feb. 28, 2017).

[2]/          Appling v. Lamar, Archer Cofrin LLP (In re Appling), 16-11911 (11th Cir. Feb. 15, 2017).

[3]/          The Appling Court noted a substantial Circuit split on this issue.

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

Set of colored vegetables for kids

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

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

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

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

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

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

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

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

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A Debtor’s Allegedly False Financial Statement Doesn’t, At All, Excuse a Lack of Lender Diligence

A decision rendered during the sometimes peaceful interlude between Christmas and New Year’s is worth reading, and heeding.  Hurston v. Anzo (In re Hurston), Adv. Proc. No. 15-2026 (Bankr. N.D. Ga. Dec. 27, 2016) is a helpful reminder to anyone representing lenders or creditors which are hell-bent-for-leather to pursue a non-dischargeability claim against a debtor that submits a false written statement (e.g., a personal financial statement) to obtain credit.  Often, in the fervor of the start of a bankruptcy case, the creditor (and its lawyer) will make great hay from the fact that a debtor may have lied in a pre-petition credit application, or forbearance agreement, or other written medium.  However, the facts of Hurston show that a creditor (and its lawyer) should pause, take a breath, and critically evaluate whether the creditor actually relied on the pre-petition writing from the debtor, and whether that creditor’s reliance was also, in fact, reasonable.  If not, then the creditor deserves a serious challenge from its own counsel on the wisdom of pursuing a expensive, and likely unsuccessful, non-dischargeability claim.

We don’t need to go in detail on the debtor’s alleged falsehoods – that is not the point of Hurston.  Instead, Judge Sacca of the Bankruptcy Court for the Northern District of Georgia covered in great detail how the creditor didn’t not rely on the allegedly false statements, and even if it did, its reliance was not reasonable.  The key takeaways from the opinion – and helpful advice for any lawyer that is thinking about taking on a “false statement” non-dischargeability action under 11 U.S.C. sec. 523(a)(2)(B) – are what the creditor in Hurston did and didn’t do.

First, where the creditor does not perform any material diligence on the false statement (here, a personal financial statement), then the creditor will have a difficult or impossible time showing that it “reasonably relied” on the allegedly false financial statement.  The creditor should ask for bank statements, tax returns, information from accountants, or other, third party evidence to back up information form a debtor.  If the creditor didn’t perform any follow up diligence, you should advise the creditor (right at the outset) that its claim may fail.

Second, this is especially true where the creditor and debtor do not have a prior relationship.  A prior relationship might (we emphasize, might) provide indicia of reliability of the debtor and its financial wherewithal to overcome a lack of diligence.  But if there is no prior relationship, the creditor should be ready to show that it did more diligence.

Third, where a financial statement (or other writing on which the non-dischargeability claim is based) contains “red flags,” including matters a reasonable creditor would question or that the specific creditor should know to question, the creditor must show that it followed up on those “red flags.”

Fourth, a debtor with an alleged strong financial reputation, or that appears to be wealthy based on appearance and community activity, does not excuse the creditor’s obligation to perform diligence on any written statement or financial statement.  In short, an argument based on “the debtor was a pillar of the community” will not go to show reasonable reliance by the creditor on an otherwise questionable financial statement or other writing.

Fifth, the creditor should be able to show it had established criteria to evaluate the credit being extended – and that those criteria were used and evaluated as a critical part of making any decision to extend credit.  A lack of rules and procedures to evaluate financial statements or other written submissions, or a failure to follow those procedures, will be very harmful to the creditor’s claim.

When you read 11 U.S.C. sec. 523(a)(2)(B), and in particular its requirement that the creditor “reasonably relied” on any alleged false statement, the Hurston decision is not surprising.  But Hurston remains a very helpful reminder for any creditor’s lawyer to critically examine the creditor’s case at the start of the matter.  The lawyer must cross-examine the creditor to get past the allegations of the debtor’s falsehoods (which the creditor will trumpet as much as you let it), and spend a great deal more time on whether the creditor did any diligence on the allegedly false written statements.  This can be an awkward conversation with your client – and perhaps perceived as blaming the victim – but it will be far more awkward to later explain to your client why the non-dischargeability action did not succeed.

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Defending A Preference Action – Can You Setoff Post-Petition Amounts Owed by the Debtor Against Your Preference Liability?

All bankruptcy lawyers (and most long-suffering trade creditors) know that creditors who receive payments from a debtor within the “preference period” – 90 days before a voluntary bankruptcy case was filed, or 1 year if the creditor is an “insider” of the debtor – are at risk of lawsuit to return those payments to the bankruptcy estate. Pre-petition claims the creditor hold are no automatic defense.  However, the Bankruptcy Court for the District of Delaware recently ruled, as a matter of first impression in that Court, that an allowed post-petition claim of the creditor can be used to set off the creditor’s preference liability. See Official Comm. of Unsecured Creditors of Quantum Foods, LLC v. Tyson Foods, Inc. (In re Quantum Foods, LLC), 2016 WL 4011727 (Bankr. D. Del. Jul. 25, 2016).  Here is a copy of the case.

The background of the case is simple. The Unsecured Creditors Committee filed various preference actions.  In the Quantum Foods preference case, the Committee sought to avoid and recover over $13 million in pre-petition transfers to two related Defendants.  The Defendants claimed, among other defenses, a right to set off a previously allowed administrative expense claim for $2.6 million in food products they had supplied to the Debtors post-petition.[1]

The Committee asserted that the Defendants’ setoff argument was a guise for a “post-petition new value defense.”  This would be improper, the Committee asserted, as a creditor’s new value defense is determined as of the bankruptcy petition date.  [The seminal decision on this is from Bankruptcy Judge Lundin, holding that “the preference window of § 547 close[s] on the date of the filing of the bankruptcy petition and post-petition payments [cannot] be used to deplete pre-petition ‘new value.'”  See here.]  However, while that is the rule in Delaware too under Friedman’s, the Court was not persuaded that this had anything to do with the new value defense.  It reasoned that a new value defense exclusively involves pre-petition activity, whereas the Defendants’ setoff claim was purely based on post-petition activity.  In short, post-petition activity (such as delivery of goods) will not give rise to a preference defense under the strict confines of the Bankruptcy Code, but may give rise to a plain old setoff defense under common law.

Thus, the question became not a matter of the new value defense under Section 547 of the Bankruptcy Code, but rather, the well-established doctrine of setoff.  In deciding whether the Defendants had valid setoff rights, the Court relied on the long-cited authority that, “setoff is only available in bankruptcy when the opposing obligations arise on the same side of the . . . bankruptcy petition date.”  Accordingly, setoff would only be permissible if the opposing obligation, i.e. the preference claim, also arose post-petition.  A “claim” in bankruptcy is defined as a “right to payment.”  Thus, the Court ruled, a preference claim is a “right to payment” which necessarily can only arise post-petition because a preference cause of action does not exist until after a bankruptcy case is initiated.

This is an important decision, from an important court.  It provides comfort to creditors that supply goods post-petition – non-payment for those goods, while a stinging result, can at least be used to reduce preference liability.

[1] The opinion did not address issues of mutuality of obligor and obligee.  That is, if Defendant A holds the $2.6 million post-petition claim, then it will be hard (actually, impossible) for that claim to be used as an offset against Defendant B’s liability.  So we will have to watch how this shakes out once the actual facts and mutuality of the claims among multiple parties are determined during discovery.

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Non-Final Finality: Does One Interlocutory Issue Resolved in a Bankruptcy Court Order Render All Issues Addressed in the Order Non-Appealable?

appellate court concept with gavel. 3D rendering

As the Supreme Court recently reminded us in Bullard v. Blue Hills Bank, not all orders in bankruptcy cases are immediately appealable as a matter of right.  Only those orders deemed sufficiently “final” may be appealed without leave under 28 U.S.C. § 158(a).  In light of the numerous parties and controversies involved in a typical bankruptcy case, determining whether an order is “final” can be complicated affair.  Thus, finality in bankruptcy is a “flexible standard” applied to discrete disputes that arise within the larger case. See generally 14 Wright, Miller & Cooper, Federal Practice and Procedure § 3926.2 (collecting examples of final and non-final orders).  That flexibility, however, has led to disparate results.

In In re Wolff, B.A.P. No. CO-16-016 (B.A.P. 10th Cir. Jul. 18, 2016), the Tenth Circuit Bankruptcy Appellate Panel (the “BAP”) dismissed an appeal filed by debtors Deris and Cheryl Wolff (the “Debtors”) on the grounds that the appeal was taken from an order that was interlocutory, and thus, non-appealable absent leave.  That order resolved two issues, one of which was interlocutory and the other of which ordinarily would be entitled to immediate appellate review.  The Wolff decision is an interesting example of what can occur when a single bankruptcy-court order resolves a typically final matter in connection with a non-final one.

An Order Determining Property of the Estate Is Interlocutory?

In Wolff, the Debtors filed a voluntary chapter 13 case, but their case was later converted to chapter 7.  The Debtors’ schedules listed two parcels of real property as assets, but the Debtors failed to claim either property as exempt.  The chapter 7 trustee filed two separate motions seeking approval to retain real estate brokers to market the properties.  The Debtors objected to the motion as to the first property and filed a motion for reconsideration of the order granting retention of the broker as to the second property.  In both the objection and the motion to reconsider, the Debtors argued that the properties could not be sold because they were not property of the bankruptcy estate, and that any post-petition appreciation in value belonged to the Debtors rather than the estate.

The bankruptcy court entered an order overruling the objection, denying the motion for reconsideration, and approving the trustee’s retention of a real estate broker to market and sell both properties. The bankruptcy court rejected the Debtors’ arguments that the properties were not part of the estate because 11 U.S.C. § 348(f)(1) provides that when a case is converted from chapter 13 to chapter 7, “property of the estate in the converted case shall consist of property of the estate, as of the date of the filing of the petition, that remains in the possession of or is under the control of the debtor on the date of conversion.”  Because the two parcels of real property were scheduled as estate property on the date of filing, they remained estate property upon conversion.  Moreover, the Debtors’ failure to claim any exemptions relating to the properties was binding upon them, and was ultimately inapposite, as the court concluded that the trustee could sell the property even if the exemption had been claimed.  The Debtors appealed.

On appeal, the BAP considered whether the order was interlocutory because it involved the employment of a broker, or whether the bankruptcy court’s ruling on property of the estate rendered the entire order final for appeal purposes. The BAP reasoned that an interlocutory order is one that constitutes part of the “process” of a bankruptcy case but does not otherwise substantively alter the rights of the parties.

Despite the ruling regarding property of the estate, the BAP concluded that the order was not final and appealable as a matter of right. Sales of estate property in a chapter 7 case involve a two-step process, according to the BAP.  First, the trustee must retain a broker with court approval.  Second, only after that broker has marketed the property in question, the trustee must file a separate motion for approval of the sale.  In this case, the bankruptcy court’s order represented only the first step in the process.  The BAP concluded that the Debtors’ rights were not substantively affected by the order because any decision as to the sale of the properties would require a separate motion, notice, and hearing.  “As a result,” concluded the BAP, “Appellants’ rights in the Colorado and Nebraska Properties, and any equity associated therewith, are not yet altered.”  The BAP also indicated that the Debtors would be able to seek review of “prior intermediate orders” if an order approving a sale were eventually entered.

Analysis and Conclusion

The Wolff decision is puzzling.  It certainly did not help the Debtors that they failed to claim the real property as exempt, and that their substantive arguments on the property-of-the-estate issue appeared to be weak.  Still, it is difficult to conceive of an order more “final” than one determining that an asset is property of the estate within the meaning of section 541 of the Bankruptcy Code.  Under the Wolff decision, such a determination may be deemed non-final if it is tied to a matter (e.g., retention of a broker) typically the subject of interlocutory orders.  Crafty litigants could use such a rule to deprive affected parties of immediate appellate review, even with respect to key issues if they are included in an order resolving other, interlocutory matters.

Moreover, the BAP failed to consider the impact of its ruling on the value of the properties. No rational buyer will bid as much when they learn that their bid could be held up in litigation, and appeals, over whether the property can be sold at all.  Buyers will discount their price for the likely attendant risk, and the fact that they may be “on hold” for months or years of litigation and appeals over a threshold issue.  If that threshold issue had been resolved, much of the cloud would be lifted over the property, and buyers obviously tend to bid more for a certainty.

In Wolff, the BAP appears to have justified the inclusion of a section 541 finding in a broker’s retention order on the rationale that if an asset “is not property of the estate, generally there would be no reason for a trustee to retain a broker to sell the property and the bankruptcy court would not approve a sale.”  But that somewhat circular reasoning does not consider the procedurally proper (and arguably more orderly) possibility of resolving the threshold question—whether the real estate was property of the estate—in an adversary proceeding and deferring the motion to retain a broker until after resolution of that fundamental question.[1]  As a middle ground, the court perhaps could have approved the broker’s retention conditionally, pending a ruling on property of the estate.  In fairness, the Debtors do not appear to have raised these possibilities, nor did they insist that resolution of a section 541 issue requires a properly filed adversary proceeding.  Had they done so, the result may have been quite different.

As the Wolff decision demonstrates, litigants in bankruptcy cases would be wise to identify important issues that a debtor, trustee, or other adverse party might attempt to bootstrap into a non-final order.  In particular, litigants should identify and zealously guard those matters subject to adversary-proceeding requirements under Federal Rule of Bankruptcy Procedure 7001.  Absent resolution of “final” matters in separate proceedings and orders, litigants could find themselves forced to await appellate review on key issues until far later in a bankruptcy case, when subsequent events could weaken the relevance of their appeal or simply render the appeal moot.

[1]    Contested issues regarding property of the estate generally require an adversary proceeding and all of the procedural safeguards associated therewith. See Fed. R. Bankr. P. 7001(2).

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The Little Airline That Couldn’t

The Little Airline That Couldn’t

July 27, 2016

Authored by: Clif Burns

Editor’s Note:  Our colleagues at Bryan Cave’s Export Law Blog, your one stop shop for helping clients navigate export matters, customs, cross-border, and all the daily evolutions in those practices, allowed us to cross-post this piece on the intricacies of Article 4A of the UCC (it covers funds transfers – we at the Bankruptcy Cave had to look it up!).  Anyone dealing with funds transfers (which is just about everyone) should read this great post.  

[Copyright © 2016 Clif Burns. All Rights Reserved.]

sabena

Remember Sabena, the ill-fated Belgian airline that declared bankruptcy in 2001?  Well, to quote Ford Madox Ford, this is the saddest story I have ever heard.

One of the things that Sabena did, other than fly people back and forth to Brussels, was to provide repair and technical services to other airlines.  One of those was Sudan Airways, which originated a wire transfer of $360,500 to pay Sabena.  One day before the wire transfer, on November 3, 1997, President Clinton blocked the assets of the government of Sudan, including those of Sudan Airways.  So when the wire from Sudan Airway’s bank hit Bankers Trust in New York on November 4 on its way to Sabena’s bank in Belgium, Banker’s Trust blocked the transfer and put the funds in a blocked account where they sat for more than a decade.

In 2009 Sabena requested that OFAC unblock the funds. In 2012, OFAC issued a license to Banker’s Trust (by then Deutsche Bank) to release the funds. The receivers for Sabena were doing a happy dance over getting the license from OFAC when their celebration was abruptly cut short.  Deutsche Bank relied on the license Sabena obtained and sent the funds not to Sabena’s bank but to Sudan Airways bank.  It’s something like renting a hall and a band for a party and then not being allowed to attend but rather forced to watch through the windows as your guests eat all your food and drink all your champagne.

So the receivers for Sabena decided to get even: they sued Deutsche Bank for not sending the money to them. But poor Sabena just can’t get a break.  On July 14, a New York appeals court dismissed the Sabena complaint and upheld the return of the unblocked funds to Sudan Airways.

To get there, the appeals court relied on Article 4A of the Uniform Commercial Code that governs fund transfers.  Specifically the court relied on two provisions.  First, it relied on section 4A-212, which says that an intermediary bank, like Bankers Trust, has no liability to the beneficiary of the funds transfer.  Second, it relied on section 4A-402 which requires the intermediary bank to return to the sender any uncompleted funds transfer.  Once the funds were blocked, then the transfer order was cancelled under section 4A-211(d) five days after the intermediary bank received a transfer request and did not execute it.  And once cancelled, then section 4A-402(d) requires the funds to go back to the sender.

The moral of the story is this: intended recipients of blocked fund transfers should not waste their time trying to get an unblocking license.

Photo Credit: Sabena Airbus A321-211 by Aero Icarus [CC-BY-SA-2.0 (http://creativecommons.org/licenses/by-sa/2.0)], via Flickr https://flic.kr/p/8PJXJn [cropped and color processed]. Copyright 2010 Aero Icarus.

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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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From Across the Pond – An Unsecured Creditor, Even with Contractual Rights Against the Secured Creditor, Cannot Enforce Common Law Duties on the Manner of Enforcement Against the Collateral

Editor’s Note:  Our good London colleague Ed Marlow recently published this as a Bryan Cave client advisory.  When we Yanks saw it, we found it fascinating, not only based on the arcane facts, but also to realize that British tribunals struggle with the same things we do here in the States – whether (or how) to protect junior creditors which allege that a secured creditor did not maximize value in disposing of the collateral.  Different countries, same insolvency challenges!  Our sincere thanks to Ed for this analysis; for a introduction to how Bryan Cave can assist with your corporate trust matters in England, France, Germany, or other EU countries, please click here.

Summary and Holding:

Including an unsecured creditor in an agreed payments waterfall does not by itself confer on that unsecured creditor the benefit of a mortgagee’s usual duties on enforcement of security, or a direct claim against the sale proceeds.

Background, Facts, and Reasoning:

The English Court of Appeal in PK Airfinance v Alpstream had to address a mortgagee’s duties on the enforcement of security (in this case over a number of aircraft).  In a reassuring case for secured lenders, the Court’s judgment confirms existing English law both as to the time and manner of realisation of the secured assets and when a mortgagee might buy the secured assets. Interestingly, the Court also had to consider whether the position of an unsecured creditor as a party in the agreed payments waterfall (of the realisation proceeds of the security), resulted in an exception to the principle that a mortgagee’s duties on enforcement do not extend to unsecured creditors.

Overturning the judge at first instance, the Court held that a mortgagee only owes its duties on enforcement, such as the duty to take reasonable care to obtain a proper price, to persons with an interest in the value of the equity of redemption in the secured assets. Those persons are the mortgagor, a subsequent mortgagee and (because of a guarantor’s subrogation rights) any guarantor of the mortgage debt. This was so even though in this case the relevant unsecured creditor, Alpstream, appeared in the agreed payments waterfall (albeit at the bottom) and so had a contractual right to repayment out of the balance of the sale proceeds after the secured creditors had been repaid in full. Holding otherwise would involve a departure from established authority, which the Court did not believe to be justified. Alpstream had expressly agreed in the intercreditor arrangements that its debt would be subordinated to the mortgagee and that it would not take any security in respect of its debt.

Therefore unsecured creditors are not owed the mortgagee’s usual duties when the mortgagee realises the secured assets, even though it may be foreseeable that the unsecured creditors might be adversely affected by the outcome of the sale. Nor will an unsecured party’s contractual right to receive payment out of the balance at the end of the payments waterfall confer a direct claim against the secured assets or their proceeds.

The Court was also concerned to give effect to the transaction documents to which the parties had agreed. Equitable duties (a mortgagee’s duties arise in equity) can be amended by agreement. The Court’s decision was consistent with the transaction documents.

There is an increasing trend in Europe for secured financings to permit unsubordinated unsecured debt. This case is perhaps a timely reminder of exactly where unsecured creditors stand.

A final observation: the Court was satisfied that the proceeds in this case from the sale to the mortgagee were higher than anyone else would have been willing to pay in the circumstances. The mortgagor had therefore benefited (and potentially Alpstream as unsecured creditor). Would the court have taken a different view on any of the issues if this had not been the case?

 

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Will your claim in bankruptcy withstand the test?

Within the past year bankruptcy courts and federal courts adjudicating bankruptcy appeals have further developed the law governing claims in bankruptcy which are generally governed by Sections 501 and 502 of Title 11 of the United States Code (the “Bankruptcy Code”) and related Federal Rules of Bankruptcy Procedure. Below is a discussion regarding two distinct cases that discuss the validity and priority of claims in bankruptcy.

Consumer Debt Buyers Beware: Think Before Filing A Proof of Claim

The Eleventh Circuit Court of Appeals held that a Chapter 13 debtor could prosecute an adversary proceeding against a consumer debt buyer for violating the Fair Debt Collections Practices Act (“FDCPA”) based on the creditor filing a proof of claim on debt which was uncollectible under the Alabama statute of limitations. Crawford v. LVNV Funding, LLC, 758 F.3d 1254 (11th Cir. 2014).

It appears the Eleventh Circuit’s decision comes in response to a significant increase in the number of consumer debt buyers “armed with hundreds of delinquent accounts purchased from creditors” who are filing proofs of claims on debts which are unenforceable pursuant to state statutes of limitation.

Factual And Procedural Background

Stanley Crawford, the Chapter 13 debtor and plaintiff in the adversary proceeding (“Crawford”) owed a debt in excess of $2,000 to a furniture company (the “Debt”). In September 2001 the furniture company sold the Debt to an affiliate of LVNV Funding, LLC[1]. Crawford’s last transaction on the account related to the Debt occurred in October 2001. Pursuant to Alabama’s three-year statute of limitations the Debt became unenforceable in both state and federal court in October 2004. Ala. Code Section 6-2-37(1).

In 2008, Crawford sought Chapter 13 bankruptcy protection. LVNV filed a proof of claim in attempt to collect from Crawford’s bankruptcy estate even though the Debt had been unenforceable under the Alabama statute of limitations for over four years.

Neither Crawford nor the Chapter 13 bankruptcy trustee objected to LVNV’s proof of claim. The trustee paid LVNV on the Debt from Crawford’s bankruptcy estate. It was not until four years later, in May 2012, that Crawford objected to LVNV’s claim through an adversary proceeding pursuant to Federal Rule of Bankruptcy Procedure (“FRBP”) 3007(b). Crawford alleged that LVNV routinely filed stale claims and that LVNV violated the FDCPA by attempting to collect the time-barred Debt.

The bankruptcy court dismissed Crawford’s adversary proceeding in its entirety. This decision was affirmed by the district court on appeal and subsequently appealed to the Eleventh Circuit which reversed the lower court’s ruling.

 

Fair Debt Collections Practices Act And The Least Sophisticated Consumer Test

The FDCPA is a consumer protection statute which prohibits false, deceptive or unfair debt-collection practices. The FDCPA regulates debt-collectors’ conduct. Note that not all creditors are considered “debt-collectors”. The FDCPA defines a debt-collector as one who, “regularly collects . . . debts owed or due or asserted to be owed or due another.”

Congress provided consumer debtors with a private right of action to enforce the FDCPA’s prohibitions. Debt collectors who violate the FDCPA can be liable for actual damages, statutory damages up to $1,000 and reasonable attorney’s fees and costs.

Pursuant to Section 1692e of the FDCPA, “a debt collector may not use any false, deceptive, or misleading representation or means in connection with the collection of any debt.”

Under Section 1692f, “a debt collector may not use unfair or unconscionable means to collect or attempt to collect any debt.”

The FDCPA does not define “unfair” or “unconscionable”. The Eleventh Circuit has concluded that these terms are vague and ambiguous.  As a result of the ambiguity the Eleventh Circuit has adopted a “least-sophisticated consumer” standard to assess whether a debt collector’s conduct is deceptive, misleading, unconscionable or unfair. The test is not whether the particular consumer involved was deceived or mislead. Instead, the threshold is whether the “least sophisticated consumer” would have been.

Eleventh Circuit’s Analysis

The Eleventh Circuit readily concluded that LVNV maintained a practice of filing time-barred proofs of claims because, unless the debtor or trustee objects, the time-barred claim is automatically allowed under 11 U.S.C. Section 502(a)-(b) and FRBP 3001(f). This results in Chapter 13 debtors paying the debt from his or her future wages as part of the Chapter 13 repayment plan, even though the debt is time-barred and unenforceable.

The Eleventh Circuit opined that a debt-collector’s filing of a time-barred proof of claim creates a misleading impression to a bankrupt debtor that the debt collector can legally enforce the debt. On that basis, the “least sophisticated” debtor may fail to object to the claim. In considering the Bankruptcy Code’s automatic allowance provision, in a Chapter 13 case, an otherwise unenforceable and time-barred debt will be paid from the debtor’s future wages as part of the Chapter 13 repayment plan. This necessarily reduces the funds available for legitimate creditors to recover on enforceable claims. Moreover, requiring a debtor to object to time-barred claims consumes a debtor’s resources, similar to filing a limitations defense in state court.

Eleventh Circuit Holding

The Eleventh Circuit, therefore, held that under the “least sophisticated consumer standard”, LVNV’s filing of a proof of claim for a time-barred Debt was unfair, unconscionable, deceptive and misleading under Sections 1692e and 1692f of the FDCPA.

In reaching this conclusion, the Eleventh Circuit expressly avoided the pending circuit split as to whether the Bankruptcy Code preempts the FDCPA.[2] LVNV did not argue preemption. LVNV only argued that its conduct did not fall under the FDCPA, or, alternatively, did not offend the FDCPA’s prohibitions.

International Treaty Thwarts Administrative Claim

The Bankruptcy Court for the Eastern District of Pennsylvania ruled on an issue of first impression. The Bankruptcy Court held that trade creditors who supplied goods to a debtor prior to its bankruptcy filing were not entitled to administrative priority status of their claims under Bankruptcy Code Section 503(b)(9). The Court reasoned that the goods were “received by the debtor” at the time they were placed on the vessels at Chinese ports, which was more than 20 days before the debtor’s bankruptcy filing. As a result, the debts were general unsecured debts. In re World Imports, Ltd., 511 B.R. 738 (Bankr. E.D. Pa. 2014).

Under Bankruptcy Code Section 503(b)(9) trade creditors who supplied the debtor with goods during the 20-day period prior to the debtor’s bankruptcy filing have administrative priority claims. These creditors can assert an administrative claim for “the value of any goods received by the debtor within 20 days before the date of commencement of a case under this title in which the goods have been sold to the debtor in the ordinary course of such debtor’s business.”

Based on the language in Section 503(b)(9) the date in which the debtor “received” the trade creditor’s goods is imperative. If a debtor is found to have received the goods anytime outside of the 20-day prepetition period, the creditor is only entitled to collect pro rata with other general unsecured creditors.[3]

Factual And Procedural Background

In this case the goods were shipped FOB (Free On Board) to the debtor from Shanghai and Xiamen. The goods were loaded on the vessel at the port of shipment more than 20 days before the debtor’s bankruptcy filing, but the debtor took physical possession of the goods in the United States during this 20-day prepetition period.

The creditors argued before the Bankruptcy Court that, because the Bankruptcy Code does not define the word “receive,” the Court should apply the definition of the term “receipt” found in the Uniform Commercial Code (“UCC”) article regarding the sale of goods. Under the UCC, “receipt” is taking physical possession of the goods. Under this definition, the debtor would have “received” the goods within the 20-day pre-petition period and the trade creditors would have administrative priority claims for the outstanding amounts due and owing.

However, the debtor and the creditors’ committee argued that the UCC’s definition of “receipt” should not apply because the relevant law at issue was international commercial law. Under international law, in a FOB sale, the transfer of the property to the buyer occurred once the goods were put on the ship, not when the buyer subsequently took physical possession of the property. Accordingly, under this theory, the debtor would have “received” the goods when they were first put on the vessels at port in China, before the 20-day prepetition period.

Bankruptcy Court’s Holding and Analysis

The Bankruptcy Court agreed with the debtor and the creditors’ committee and concluded that the debtor “received” the goods when they were placed on the vessels in China. The Bankruptcy Court reasoned that the transactions were governed by the Convention on Contracts for the International Sale of Goods (CISG), not the UCC. Under the CISG the risk of loss or damage passes to the buyer at the time the goods are placed on the vessel at port.

Accordingly, in addressing this issue of first impression, the Bankruptcy Court held that with respect to goods shipped FOB from overseas, the date the debtor “received” the goods is the date when the goods are loaded onto the vessel at the port of shipment, not later when the debtor actually took possession of the goods.

 

[1] LVNV Funding, LLC is among a group of affiliates and defendants in the adversary proceeding referred to here as “LVNV”.

[2] See Simmons v. Roundup Funding, LLC, 622 F.3d 93, 96 (2d Cir. 2010) (bankruptcy Code preempts FDCPA); Walls v. Wells Fargo Bank, N.A. 276 F.3d 502, 510 (9th Cir. 2002) (same); Simon v. FIA Card Ser., N.A., 732 F.3d 259, 271-74 (3d Cir. 2013) (bankruptcy code does not preempt FDCPA); Randolph v. IMBS, Inc., 368 F.3d 726, 730-33 (7th Cir. 2004) (same).

[3] In re World Imports, Ltd. does not address the 45-day reclamation period under 11 U.S.C. § 546(c). However, this section is helpful for trade creditors to consider if their buyer files for bankruptcy protection. Under this section a seller may reclaim its goods from the bankruptcy debtor if: (1) the seller sold goods to the debtor in the ordinary course of the seller’s business; (2) the debtor received the goods while insolvent within 45 days before debtor’s bankruptcy case was commenced; and (3) the seller demands reclamation of the goods in writing (A) not later than 45 days after the date of the debtor received the goods or (B) not later than 20 days after the debtor’s bankruptcy was commenced, if the 45-day period expires after the debtor’s bankruptcy was commenced.

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