“Just enough” is an undeniable—if informal—legal precept.  The concept finds its way into canon from adequacy of pleading to application of equity.  See, e.g., K-Tech Telecommunications, Inc. v. Time Warner Cable, Inc., 714 F.3d 1277, 1284 (Fed. Cir. 2013) (A complaint “must give just enough factual detail to provide ‘fair notice of what the . . . claim is and the grounds upon which it rests.’”) (emphasis added); Highway Cruisers of Cal., Inc. v. Sec. Indus., Inc., 374 F.2d 875, 876 (9th Cir. 1967) (“Equity has many reeds. A characteristic of it is that one may not get all of the reeds. One may get just enough relief to stop the evil where it is apparent no great damage was done[.]”) (emphasis added).

Recent rulings from bankruptcy courts throughout the United States confirm that “just enough” has now found a home in the nascent jurisprudence of Subchapter V eligibility.  Among Subchapter V’s eligibility requirements, a debtor must be engaged in, and have more than 50% of its debts from, commercial or business activity.  In the case of a liquidating or non-operating debtor, courts find that minimal activity may be sufficient to meet the “just enough” test for commercial or business activity.

The Statutory Requirements for Subchapter V Eligibility

In 2019, Congress passed the Small Business Reorganization Act of 2019 (“SBRA”). Pub. L. No. 116-54, § 5, 133 Stat. 1079 (2019).  The addition of Subchapter V to the Bankruptcy Code is one of the principal features of the SBRA.  Generally, Subchapter V affords small business debtors a new avenue of chapter 11 relief with truncated procedures intended to decrease the time and expense of bankruptcy.

A debtor is eligible for relief under Subchapter V of the Bankruptcy Code if it satisfies the eligibility requirements under Section 1182(1)(A) of the Bankruptcy Code.  As temporarily modified by the Coronavirus Aid, Relief, and Economic Security Act, Pub. L. No. 116-136, 134 Stat. 281, 310-12 (2020), Subchapter V debtors must:

  1. must be a person, which includes a corporation;
  2. must be engaged in commercial or business activity;
  3. may not have more than $7.5 million in debt on the petition date; and
  4. must have more than 50% of its debt from commercial or business activities.

Section 1182(1)(B) of the Bankruptcy Code excludes a debtor that otherwise meets these requirements if the debtor is (i) one of a group of affiliated debtors that exceed the $7.5 million debt cap on the aggregate, (ii) subject to certain reporting requirements under the Securities Exchange Act of 1934, or (iii) considered an “issuer” under Section 3 of the same Act.

At least two of the eligibility requirements are as straightforward as drafters can hope of for a legal standard. “Person” and “corporation” are defined terms in Section 101 of the Bankruptcy Code and the aggregate cap for petition date noncontingent liquidated secured and unsecured debts presents a simple calculation.  By contrast, the terms “commercial or business activities” featured in the remaining two requirements afford greater room for interpretation.

“Commercial or Business Activity” Is Broad and Can Include Maintaining Bank Accounts, Administering Claims, and Selling Assets.

The debtor has the burden to establish eligibility to file under a particular chapter—or subchapter in this case—of the Bankruptcy Code if a party challenges the debtor’s election.  The debtor must establish eligibility as of the date it filed its bankruptcy case.

In In re Vertical Mac Construction, LLC, the United States Bankruptcy Court for the Middle District of Florida recently address the United States Trustee’s (the “UST”) objection to a non-operating debtor’s Subchapter V election.  See In re Vertical Mac Construction, LLC, Case No. 6:21-bk-01520-LVV, 2021 WL 3668037 (Bankr. M.D. Fla. July 23, 2021).  The debtor was a stucco installation contractor for residential property.  In 2017, homeowners began filing construction defect claims against the debtor for improper stucco installation.  Ultimately, in October 2020, the debtor ceased operations after being unable to obtain either renewal or replacement insurance coverage.

The debtor filed its Subchapter V case after it ceased operations and filed a motion to sell substantially all of its assets under section 363 of the Bankruptcy Code.  The UST objected to the sale and argued that the debtor was impermissibly using the case to liquidate its assets rather than reorganize—the debtor had no operations, did not pursue accounts receivables or litigation, and had no intention to resume operations.  The debtor focused on its prepetition activities and argued its former business operations satisfied the statute.

The court charted its own course and approved the sale after conducting a plain reading analysis of the terms “engaged” and “commercial or business activity” in section 1182(1)(B) of the Bankruptcy Code.  The court adopted the following definitions:

Engaged.  involved in activity: occupied, busy.

Commercial.  occupied with or engaged in commerce or work intended for commerce; of or relating to commerce; viewed with regard to profit.

Commerce.  the exchange or buying and selling of commodities on a large scale involving transportation from place to place.

Business.  a usually commercial or mercantile activity engaged in as a means of livelihood; dealings or transactions especially of an economic nature.

Activity.  the quality or state of being active: behavior or actions of a particular kind.

The court concluded that the phrase “commercial of business activity” is broad and not limited to “operations.”  As the Court explained, “‘[o]perations’ insinuates a fully functioning business, but ‘activities’ encompasses acts that are business or commercial in nature but fall short of an actual operating business.”

With this broad definition in mind, the court held that the debtor satisfied the “commercial or business activity” standard.  Although it was no longer operating, the debtor was still maintaining bank accounts, working with insurance adjusters and insurance defense counsel to resolve the construction defect claims, and preparing for the sale of its assets.  Each of these constituted “activities” that were commercial or business in nature.

Additional Cases Interpreting “Commercial or Business Activities” to Liquidating or Non-Operating Subchapter V Debtors

The Vertical Mac Construction, LLC case joins a growing chorus of bankruptcy court decisions interpreting “commercial or business activities.”  Other cases with similar holdings include:

  • In re Ikalowych, Case No. 20-17547 TMB, 2021 WL 1433241 (Bankr. D. Colo. Apr. 15, 2021) (individual debtor met eligibility requirements because he (i) was an insurance salesperson earning wages from his sales, (ii) personally guaranteed the debt of a repair business of which he was a part equity owner, (iii) was the direct or indirect owner of two active LLCs and the manager of both, (iv) continued to have corporate responsibility, and (v) performed limited services to wind down one business).
  • In re Offer Space, Case No. 20-27480, 2021 WL 1582625 (Bankr. D. Utah Apr. 22, 2021) (maintaining a bank account, holding accounts receivable, exploring claims against a third party, managing the stock of the seller, and “winding down its business and taking reasonable steps to pay its creditors and realize value for its assets” sufficient engagement in commercial or business activities).

Courts are less likely to find sufficient “commercial or business activities” where the debtor is an individual who owns a non-operating business, particularly where the business has been dissolved under applicable state law:

  • In re Thurmon, Case No. 20-41400-can11, 2020 WL 7249555 (Bankr. W.D. Mo. Dec. 8, 2020) (individual debtors who were retired and did not intend to return to business were not engaged in commercial or business activity where they merely owned the majority equity interest in the “empty shell of” a pharmacy business that sold its assets prepetition).
  • In re Johnson, Case No. 19-42063-ELM, 2021 WL 825156 (Bankr. N.D. Tex. Mar. 1, 2021) (individual debtor was not engaged in commercial or business activity where he was the president of an oil and gas company owned by his mother because he was “nothing more than an employee” and was not conducting his mother’s business for his own profit).
Key Takeaways for Liquidating and Non-Operating Subchapter V Debtors

Potential debtors should consider the evolving state of play as courts continue to delineate the boundary of “just enough” commercial or business activity to satisfy Subchapter V eligibility.  The considerations include whether the potential debtor is an individual or a corporation, whether the entity is active or dissolved under state law, whether the entity has sold substantially all of its assets prepetition, and the remaining activities in which a non-operating entity is involved.  The calculus becomes more complex for individual debtors, where courts have expressed a particularly divergent view of sufficient commercial or business activity that ranges from narrow interpretations to “virtually all private sector wage earners” with capital at risk or debts arising from their work.

By Michael L. Temin and Martha B. Chovanes

Introduction

The relationship for  which counsel for a committee could be disqualified was addressed in the recent case of Bingham Greenbaum Doll, LLP v. Glenview Health Care Facility, Inc., 620 B.R. 582 (6th Cir. B.A.P. 2020) (“Glenview”).  In Glenview, the debtor corporation was owned by two shareholders.  The Official Committee of Unsecured Creditors in the case filed an application to employ an attorney who previously had represented one of the debtor’s 50% shareholders in estate planning matters.   The representation concluded two years before the debtor filed for bankruptcy.  On objection by the Debtor, the bankruptcy court denied the application.  On appeal, the Sixth Circuit BAP vacated the disqualification order.

Employment of Attorney for Creditors Committee

The only restriction placed by the Bankruptcy Code on employment of an attorney for a creditors committee is that “an attorney . . . employed to represent a [creditors] committee . . . may not, while employed by such committee, represent any other entity having an adverse interest in connection with the case  11 U.S.C. § 1103(b).

In denying the employment application for the Committee, the Bankruptcy Court improperly relied, in part,  on § 328(c), which permits a court to deny compensation to a creditors committee attorney “if, at any time during the professional person’s employment under section  . . .1103  .  ., such professional person is not a disinterested person, . . .”

The BAP noted, however, that the Bankruptcy Court’s analysis was conflating § 1103 with § 327 and proceeding as if § 1103 contained the same “disinterested” requirement.

Disinterested As Applied to Attorneys for a Creditors Committee

A professional person is “disinterested” if the person is

  • not a creditor, an equity security holder, or an insider;
  • not and was not within 2 years before the date of the filing of the petition, a director, officer, or employee of the debtor; and
  • does not have an interest materially adverse to the interest of the estate or of any class of creditors or equity security holders, by reason of any direct or indirect relationship to, connection with, or interest in, the debtor, or for any other reason.

11 U.S.C. § 101(14).

In denying retention of the Committee’s requested counsel, the Bankruptcy Court relied on Section 328(c) which track the language of § 327(a) limiting the professional that a trustee may employ to professionals “that do not hold or represent an interest adverse to the estate, and that are disinterested persons.  By contrast, an attorney for a committee is not required to be “disinterested,” and the prohibition on other employment is limited to concurrent representation of adverse interests in connection with the case.

The inclusion in § 328(c) of the same prohibitions on compensation of debtor counsel and of committee counsel, a requirement of disinterestedness, is inconsistent with the different constituents being represented and the particular roles they play in a bankruptcy case.  Committee counsel is intended to be adverse to the debtor or to other classes of creditors and shareholders (other than those creditors represented by the committee).  Because the application of § 328(c) by a bankruptcy court to deny compensation is discretionary, it is very unlikely that a court would deny compensation to committee counsel for doing its job.

Rules of Professional Conduct

The BAP found that, in assessing whether counsel to the Committee could be retained under § 1103(b), the Bankruptcy Court properly reviewed the Kentucky Rules of Professional Conduct for guidance in exercising its discretion to approve the employment of proposed counsel for the committee after the debtor challenged its qualifications.  The Bankruptcy Court relied on the Sixth Circuit’s articulation of the test for disqualification when counsel’s employment is challenged because of its representation of a former client, which is covered by Rule of Professional Conduct 1.9.

  • a past attorney-client relationship existed between the party seeking disqualification and the attorney it seeks to disqualify,
  • the subject matter of those relationships was/is substantially related; and
  • the attorney acquired confidential information from the party seeking disqualification.

Analyzing the facts, the BAP held there also was no basis on which to disqualify counsel under the state ethics rules.

The Glenview decision should serve as an important reminder for bankruptcy attorneys that in addition to complying with the eligibility criteria for retention under the Bankruptcy Code, attorneys must also be mindful of state ethics rules.

 

 

 

 

In a recent post, our own Harriet Wallace observed a truism in a recent ruling by the United States Bankruptcy Court for the District of Delaware in the chapter 7 iteration of the infamous Jevic case—the wording of an order matters.  The Court saw fit to bold and underline that maxim in yet another recent holding in Insys Liquidation Trust v. MeKesson Corporation (In re Insys Therapeutics, Inc.), No. 21-50176 (JTD), 2021 WL 3083325 (Bankr. D. Del. July 21, 2021).  To the near certain chagrin of critical vendors everywhere, the Court held that the language of the relevant critical vendor order was insufficient to insulate certain critical vendors from preference claims.

The Insys Therapeutics Critical Vendor Order

Insys Therapeutics, Inc. and its affiliates (the “Debtors”) developed and commercialized drugs and novel drug delivery systems for targeted therapies.  After filing their bankruptcy cases in 2019, the Debtors filed certain typical “first day” motions, including the Motion Pursuant to 11 U.S.C. §§ 105(a) and 363(b) for Authority to (I) Maintain and Administer Prepetition Customer Programs, Promotions, and Practices and (II) Pay and Honor Related Prepetition Obligations (the “Critical Vendor Motion”).  The Critical Vendor Motion requested, among other things, authority to pay all prepetition amounts owed to certain customers to continue to receive necessary services postpetition.

The Court granted the Critical Vendor Motion.  The order (the “Critical Vendor Order”) granting the Critical Vendor Motion included the following common language authorizing payments to critical vendors: “The Debtors are authorized, but not directed . . . to maintain and administer the Customer Programs[.]”

On January 16, 2020, the Court entered an order confirming the Debtors’ chapter 11 plan of liquidation.  The plan provided for the establishment of a liquidating trust (the “Liquidating Trust”) and assigned certain causes of action, including avoidance claims, to the Liquidating Trust.

On February 23, 2021, the trustee of the Liquidating Trust (the “Trustee”) filed a complaint for avoidance and recovery of certain prepetition transfers to certain prepetition critical vendors (the “Defendants”) and objected to all claims filed by the Defendants in the bankruptcy case.  The Defendants moved to dismiss the preference claim asserted in the complaint, in part, based on the provisions of the Critical Vendor Order.  The Defendants argued that the prepetition transfers would have been authorized under the Critical Vendor Order had they not been made prepetition, and that the Critical Vendor Order that would have authorized such transfers was law of the case.

The Trustee countered with three arguments—each of which was adopted by the Court.  First, the Court held that preferential payments that occur before the entry of a critical vendor order cannot be protected by a subsequent authorization to pay outstanding prepetition claims.  The language of the Critical Vendor Order did not preclude recovery of preferential payments that were made prepetition.  The Court concluded that the plain language of the Critical Vendor Order did not specifically bring prepetition transfers within the ambit of critical vendor relief.

Second, the language of the Critical Vendor Order was permissive rather than mandatory.  The language authorizing, but not directing, the Debtors to make critical vendor payments undercut the Defendants’ argument that prepetition transfers would necessarily have been authorized by the Critical Vendor Order had they not been made prepetition.

Third, the Critical Vendor Order included express language making clear that avoidance claims were not waived.  The Critical Vendor Order specifically provided that “[n]othing contained . . . in this Final Order is intended to be or shall be construed as . . . (c) a waiver of any claims or causes of action that may exist against any creditor or interest holder.”

The Court further distinguished the facts of the case from the limited circumstances in which courts in the Third Circuit recognize a “critical vendor defense.”  The Court explained that a critical vendor defense only exists where: (i) the debtor is required to pay the prepetition claims, either by order, stipulation, agreement, or statute; or (ii) the creditor against whom the preference action is asserted holds a priority claim and would therefore have unquestionably been paid in full in a liquidation scenario.

Based on its review of the Critical Vendor Order, the Court concluded that the first prong was not satisfied.  The Court distinguished other instances in which the first prong was satisfied by: (i) an order authorizing assumption of the underlying agreement (and, thus, requiring a cure of outstanding amounts) under 11 U.S.C. § 365, (ii) a postpetition agreement specifically obligating payment of any prepetition claim; or (iii) a prepetition priority wage claim that was otherwise required to be paid under an employee wage and benefits order.

Further, whether the Defendants would have “unquestionably” received payment in a full liquidation scenario was a factual question not appropriate on a motion to dismiss.  The Court could not conclude at the pleading stage that the Defendants would have unquestionably been paid in full in a liquidation—the transfers were on account of general unsecured claims rather than priority claims.

The “Something More” Critical Vendors Should Request

The Court concluded that “the fact that a creditor was named in a court order as a ‘critical’ or otherwise important customer of a debtor is not in and of itself enough to bar a preference claim; something more is required.”  The most obvious among the potential cures is specific language in the critical vendor order requiring payment of prepetition claims, which would require debtors to abandon the ubiquitous “authorized, but not directed” language common to first day orders.  Mandatory prepetition claim payment may draw heavier scrutiny, particularly early in a case before the appointment of a committee; however, specific language in the order mandating payment of prepetition claims would clearly bring non-priority claims within the ambit of the “critical vendor defense.”  Additionally, depending on the vendor’s leverage and preference risk, negotiating an alternative postpetition agreement may prove effective.  One thing is certain: the “something more” will certainly be of importance to critical vendors hoping to avoid an unwelcomed preference battle.

The Snowball effect, the Domino effect, and even the Streisand effect all demonstrate the accretive impact of small changes.  Though without a catchy metaphor, the tendency of Circuit splits to attract new and deviating opinions fits the concept—particularly as applied to the deepening rift between Circuits over the constitutionality of United States Trustee fee increases in the Bankruptcy Judgeship Act of 2017 (the “2017 Amendment”).  A recent ruling from the United States Bankruptcy Court for the Southern District of Ohio brings the United States Court of Appeals for the Sixth Circuit a step closer to addressing the issue over a ninth month period in which quarterly fees differed among bankruptcy cases subject to the United States Trustee Program and the Bankruptcy Administrator Program.  The constitutionality of this brief disparity has already divided the Second, the Fourth, and the Fifth Circuits.

The Judgeship Act of 2017

The administration of bankruptcy cases within the United States is overseen by two programs: the United States Trustee Program and the United States Bankruptcy Administrator Program.  The United States Trustee Program, a branch of the United States Department of Justice, is, by far, the most common administration program and oversees bankruptcy cases in 88 of the 94 federal judicial districts.  The six holdouts—all districts in Alabama and North Carolina—remain under the purview of the Bankruptcy Administrator Program, which is ultimately supervised by the United States Judicial Conference (the “Judicial Conference”).

In 2000, after the Ninth Circuit Court of Appeals ruled unconstitutional the disparate funding sources for the United States Trustee Program and the United States Bankruptcy Administrator Program, Congress amended 28 U.S.C. § 1930(a) to provide for funding of both programs through the collection of quarterly fees.  However, the two provisions in § 1930(a) were slightly different.  Section 1930(a)(6) provided that “a quarterly fee shall be paid to the United States trustee . . . in each case under chapter 11 of title 11 . . . for each quarter (including any fraction thereof) until the case is converted or dismissed, whichever occurs first.” 28 U.S.C. § 1930(a)(6)(A) (emphasis added).  By contrast, section 1930(a)(7) provided that “[i]n districts that are not part of a United States trustee region [i.e. those subject to the Bankruptcy Administrator Program] . . . the Judicial Conference of the United States may require the debtor in a case under chapter 11 of title 11 to pay fees equal to those imposed by paragraph (6) of this subsection.” 28 U.S.C. § 1930(a)(7) (emphasis added).  The permissive language made little difference in practice as the Judicial Conference swiftly adopted the quarterly fee system.

The 2017 Amendment substantially increased quarterly fees in response to declining bankruptcy filings and the resultant decline in quarterly fee revenue.  The 2017 Amendment first became effective for cases pending as of January 1, 2018, regardless of whether they were previously filed.  However, the 2017 Amendment only modified the “quarterly fees payable under section 1930(a)(6) of title 28, United States Code” and did not alter the permissive language of 28 U.S.C. § 1930(a)(7) with respect to Judicial Conference’s authority in districts with the Bankruptcy Administrator Program.  See Bankruptcy Judgeship Act of 2017, Pub. L. No. 115-72, Div. B, § 1004(c), Oct. 26, 2017, 131 Stat. 1232.  The Judicial Conference ultimately adopted the fee increase; however, the increase became effective for Bankruptcy Administrator Program districts in October 1, 2018 and only for cases filed on or after that date.  See Report of the Proceedings of the Judicial Conference of the United States (Sept. 2018) at 11–12, www.uscourts.gov/sites/default/files/2018-09_proceedings.pdf) (accessed July 12, 2021).

Congress ultimately amended § 1930(a)(7) to close the “may” loophole in January 12, 2021.  However, the nine-month gap in quarterly fee costs between districts in the United States Trustee Program and Bankruptcy Administrator Program was wide enough to create a constitutional issue now winding its way through the Circuits.

The Circuit Split

So far, three Circuits have weighed-in on whether the difference in quarterly fees presents a constitutional problem.  In Clinton Nurseries, Inc. v. Harrington (In re Clinton Nurseries Inc.), 998 F.3d 56 (2d Cir. May 24, 2021), the Second Circuit found that the dissimilar cost of quarterly fees among the various districts violated the Bankruptcy Clause of the Constitution.  The Second Circuit held that the “geographical discrepancy” among enforcement—where the increase was required in United States Trustee Program districts and permissive in United States Bankruptcy Administrator districts—failed the constitutional requirement that Congress establish “uniform Laws on the subject of Bankruptcies throughout the United States.”

The Clinton Nurseries decision departed from prior rulings from the Fourth and Fifth Circuits holding that the non-uniform fee increase did not implicate constitutional concerns.  In Siegel v. Fitzgerald (In re Circuit City Stores Inc.), 996 F.3d 156 (4th Cir. 2021), and Hobbs v. Buffets LLC (In re Buffets LLC), 979 F.3d 366 (5th Cir. 2020), the Circuits held that the increase did not violate the Due Process Clause or the Bankruptcy Clause of the Constitution.  In Circuit City Stores, Inc., the Fourth Circuit held, in part, that the increase was not the result of arbitrary geographical distinctions based on a debtor’s residence; rather it was as a result of the two distinct bankruptcy administration programs in the United States only one of which (the United States Trustee Program) was experiencing budget shortfalls.  Notably, both decisions from the Fourth Circuit and Fifth Circuit were divided 2-1 with dissents aimed at the constitutionality of the dual administration programs themselves.

The ASPC Corp. Decision

In Pidcock v. United States (In re ASPC Corp.), — B.R. —, 2021 WL 2935845 (Bankr. S.D. Ohio July 13, 2021), the bankruptcy court sided with the Fourth and Fifth Circuits in a challenge the constitutionality of the fee increase.  In ASPC Corp., the debtor filed its bankruptcy case in the intervening period between the effective date of the 2017 Amendment and the Judicial Conference’s adoption of the fee increase.  The postconfirmation creditor trust claimed that the differential in payments violated the Tax Uniformity Clause, the Bankruptcy Clause, and the Takings Clause of the Constitution.  The court rejected each of the three arguments.

First, the court held that the Tax Uniformity Clause does not apply because quarterly fees are “user fees” only payable by those that “use the bankruptcy system.”  As such, quarterly fees do not constitute a tax “[n]or are they duties, imposts, or excises” subject to the Tax Uniformity Clause.

Second, the court found that the Bankruptcy Clause was not violated on two grounds.  The court first concluded that Congress may enact laws addressing geographically isolated problems without violating the Bankruptcy Clause.  The court held that the differences in the United States Trustee Program and the Bankruptcy Administrator Program fell under the category of geographically isolated problems because the underfunding issue the fee increase was intended to address was limited to the United States Trustee Program.  Additionally, the court held that fee increase was not a result of Congressional action.  Instead, the uneven implementation of the fee increase resulted from the Judicial Council’s delay in implementing the fee increase for districts in the Bankruptcy Administrator Program.

Third, the court found that the Takings Clause was not implicated because the statute imposes a mere monetary obligation without regard to an identifiable property interest.  Even if it was implicated, the court held that the fee increase was not so excessive to violate the Takings Clause because it amounted to a fair approximation of the costs of benefits supplied to debtors.

The Road Ahead

On July 27, 2021, the creditor trust filed a notice of appeal in ASPC Corp. and indicated its intention to seek certification for direct review by the United States Court of Appeals for the Sixth Circuit.  The Sixth Circuit’s decision—whether following direct appeal or not—is likely to join a growing body of diverging Circuit-level decisions.  In addition to the Second, the Fourth, and the Fifth Circuits, the Federal Circuit is currently considering a similar challenge in an appeal from Acadiana Management Group LLC v. U.S., 19-496, 151 Fed. Cl. 121 (Ct. Cl. Nov. 30, 2020).

By Michael L. Temin and Martha B. Chovanes

To give a reorganized debtor a “fresh start,” the Bankruptcy Code provides that the confirmation of a plan discharges the debtor from any debt that arose before the confirmation date.  However, if a potential claimant lacks sufficient notice of a bankruptcy proceeding, due process considerations dictate that his or her claim cannot be discharged by a confirmation order.

The most innovative approach to deal with this issue was adopted by the New York bankruptcy court as part of the Manville plan of reorganization.  See In re Johns Manville Corp., 68 B.R. 618 (Bankr. S.D.N.Y. 1986). The Manville Trust was the basis of Congress’ effort to deal with the problem of asbestos claims on a national basis by enacting Bankruptcy Code § 524(g). That section provides for the establishment of a trust to assume, and pay, present and future asbestos claims and a channeling injunction directing all future claims to the trust.

The Third Circuit has reviewed several bankruptcy cases addressing the issue of adequate notification of latent tort creditors of the debtor.

In 2000, the Third Circuit said.

[D]ue process considerations [of lack of sufficient notice of bankruptcy proceedings] are often addressed by the appointment of a representative to receive notice for and represent the interests of a group of unknown creditors.

Jones v. Chemetron Corp., 212 F.3d 199, 209 (3d Cir. 2000).

However, the court stated that it did not believe that a bankruptcy court was obligated to sua sponte appoint a representative to deal with future interests. Id. at 210.

Ten years later, in In re Grossman’s, 607 F.3d 114, 127 (3d Cir. 2010), the Third Circuit said that a § 524(g) trust was specifically tailored to protect the  due process rights of future claimants and was perhaps the best vehicle for addressing these concerns.

More recently, in In re Energy Future Holdings Corp, 949 F.3d 806, 825 (3d Cir. 2020), the Third Circuit concluded its opinion affirming the confirmation of a reorganization plan that did not provide for a trust or a representative for future claims, as follows:

Though we decline to upset the approach taken here, we share the Bankruptcy Court’s “regret” that “the debtors asked for [a bar date] in the first place,” both because the bar date might “adversely affect . . . [claimants] who have manifested injury . . . or will manifest injury based on prepetition exposure who have not filed proofs of claim” and because it “led to a lot of litigation and a lot of expense and a $2 million noticing program.”  Indeed, this case serves as a cautionary tale for debtors attempting to circumvent §524(g). The alternative route EFH has chosen for addressing its asbestos liability has produced a similar result as a §524(g) trust—reimbursement for latent claimants who either filed proofs of claim or did not receive proper notice of the bar date—but with added and unnecessary back-end litigation. Like the Bankruptcy Court, however, we have only “a limited role” in this case.  We are not charged with ensuring that EFH’s strategic choices were optimal or even advisable; we are merely asked to ensure that they satisfy the Bankruptcy Code and the Constitution. And in this limited role, we conclude that the post-confirmation process described above satisfies both.

Notwithstanding the Third Circuit’s “regret,” we think it unlikely that debtors with contingent liabilities to latent claimants will adopt the § 524(g) route for a number of reasons.

First, 524(g) is only available to deal with liabilities arising from exposure to asbestos or asbestos containing products. Second, the plan must be funded, at least in part, by securities of the reorganized debtor. Third, the trust must own, or be entitled to own, the majority of the voting shares of the debtor, its parent, or its subsidiary.  Fourth, the plan must be approved by a 75% vote of the claimants whose claims are to be addressed by the trust, that is, the present claimants (not the future claimants who are also beneficiaries of the trust). Fifth, the trust must pay present claims and future demands that involve similar claims in substantially the same manner.  Each of these requirements creates a disincentive for the entities affected to propose or vote in favor of a § 524(g) plan.

Pursuant to 28 U.S.C. § 1930(a)(6), chapter 11 debtors must pay a quarterly fee to the United States Trustee for deposit in the United States Treasury, until the case is converted or dismissed.  The fee is based on a formula tied to the amount of disbursements made by the debtor during each quarter of the pendency of its chapter 11 case, capped at $250,000 per quarter.

Chapter 11 plans often provide for the creation of post-confirmation litigation trusts to administer specified assets and/or prosecute and settle certain claims for the benefit of designated beneficiary classes (often unsecured creditors).  The assets and claims are typically assigned or transferred by the debtor to the trust free and clear pursuant to the plan and confirmation order.  Once the plan is effective, administration of the transferred assets and claims is no longer a function of the debtor, but within the purview of the trust and the appointed trustee, with disbursements to trust beneficiaries to be made directly from the trust.

Notwithstanding that the debtor is no longer administering assets and claims and making disbursements following the transition to a litigation trust, the United States Trustee has sought payment of statutory quarterly fees under 28 U.S.C. § 1930(a) for disbursements made by post-confirmation trusts.  This can make the administration of litigation trusts costly, and litigation trusts will often look for ways to administratively close bankruptcy cases, even with adversary proceedings pending, in order to avoid having to making ongoing payments to the United States Trustee.  However, circumstances may necessitate that cases remain open for prolonged periods, such as to facilitate claims administration or if the plan requires the bankruptcy court to approve asset sales or settlements entered into by the trust.

In a recent opinion in the Paragon Offshore, PLC (“Paragon”) case in the United States Bankruptcy Court for the District of Delaware, Chief Judge Christopher Sontchi made clear that he believes the payment of post-confirmation quarterly fees by a litigation trust was not only inappropriate, but “offensive.”[1]   In Paragon, the plan established a litigation trust into which the debtor transferred the right to pursue certain claims for the trust’s beneficiaries (creditors of the debtor).  The plan provided that quarterly fees owed to the United States Trustee shall be paid by the debtors and reorganized debtors until the debtors’ chapter 11 cases are closed.  The plan and litigation trust became effective on July 18, 2017.  For the quarter between July 1, 2017 and September 30, 2017, the period during which the claims were transferred by the debtor to the litigation trust, the debtors’ distributions exceeded $623 million and the debtors accordingly paid the maximum fee due to the United States Trustee for that period under 28 U.S.C. § 1930(a).

Certain of the claims transferred to the litigation trust were settled in early 2021 for $90,375,000 and were approved by the Bankruptcy Court on February 24, 2021.  The trust received all of the settlement proceeds on March 19, 2021.  On May 12, 2021, the United States Trustee filed a motion to compel the trust to file post-confirmation quarterly reports and pay quarterly fees pursuant to 28 U.S.C. § 1930(a)(6) in connection with the settlement.

Chief Judge Sontchi determined that the quarterly fee requirement of 28 U.S.C. § 1930(a)(6) is triggered only by “payments by or on behalf of the debtor.”  The litigation trust was not paying any expenses on behalf of the debtors, but for the beneficiaries of the trust.  All disbursements related to the debtors’ obligations occurred on the effective date when the debtor transferred the claims to the litigation trust.  Chief Judge Sontchi regarded that as the “ultimate payment” made by the debtors, following which, the debtor remitted the required quarterly fee to the United States Trustee.  He noted that the litigation trust’s distributions four years later are from the trust’s assets, which vested “free and clear” in the trust years earlier, for the benefit of the trust’s beneficiaries.  The debtors did not have any interest in or control over the money disbursed.

Further, Chief Judge Sontchi regarded any payment of quarterly fees by the litigation trust at this point as effectively a tax on creditors given that the debtors had previously paid the required quarterly fees to the United States Trustee when the claims were transferred to the trust.  Making his feelings clear, Chief Judge Sontchi stated:

“I cannot stress enough how offensive I find the [United States Trustee’s] attempt to double, or triple its ‘tax.’  It would be hypocritical for a person’s whose livelihood depends on the taxation of his fellow citizens to suggest that taxation is, in and of itself, reprehensible.  It is, of course, necessary.  What is reprehensible is attempting to take money out of the pockets of creditors, which are already receiving a small recovery on their claims, multiple times for the same distribution.”[2]

It will be interesting to see if other bankruptcy courts follow the Paragon decision.  The decision may also provide a blueprint for debtors to draft plans and trust documents with language to help post-confirmation trusts avoid payment of fees to the United Stats Trustee.  This in turn may facilitate easier administration of post-confirmation trusts, knowing that cases may remain open to address various matters without having to incur substantial quarterly fees.

 

[1] Paragon Offshore, PLC, Case No. 16-10386-CSS (June 28, 2021).

[2] Id. at 6 FN 31.

The Payroll Protection Program (“PPP”) was created by Congress through the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) to loan money to certain businesses for the primary purpose of providing money to fund payroll expenses, and other eligible expenses.  If the PPP loan funds are used for designated purposes, all or some of the PPP loan will be forgiven.  Loans which are not fully forgiven are guaranteed by the Small Business Administration (“SBA”), the governmental agency appointed by Congress to oversee and administer PPP loans.

PPP loans are made under the SBA 7(a) program, which was already in existence prior to the CARES Act.  SBA 7(a) loans are made by directly by lenders to qualified borrowers, but are fully or partially guaranteed by SBA.  Being guaranteed by SBA means that if there is a default on the loan, SBA will reimburse the lender for the remaining balance once certain conditions and requirements set forth in the SBA regulations have been as satisfied.

PPP loans are different than other SBA 7(a) loans in that the application process is much more streamlined, the loans are unsecured, and the principals of a business entity borrower are not required to execute a personal guaranty.  If the borrower uses the PPP loan proceeds for qualified purposes, in many cases, all or part of the PPP loan will be forgiven.  However, not all PPP loans will be forgiven, or at least will not be forgiven in full.  When this happens, the borrower will be required to repay the PPP loan to the lender.

Since other SBA 7(a) loans are secured by collateral, if a borrower defaults, the lender must make its best efforts to liquidate the collateral and/or collect from the guarantor.  However, because PPP loans are unsecured and do not have guarantors, a lender’s duties in the event of a default are less clear. Lenders under the SBA 7(a) program are required to make their best, reasonable efforts to collect on defaulted PPP loans, just like they would with any other SBA 7(a) loan or any other unsecured, non-SBA loan.

Lenders should consider taking the following actions if a borrower defaults under a PPP loan before requesting payment of the SBA guaranty or requesting that the PPP loan be charged off:

  • Workouts: Just like any other unsecured loan of the same size and type, if a borrower begins to miss loan payments, the SBA lender should attempt to work with the borrower to cure the default.
  • Research Borrower’s Assets: Lenders need to determine whether obtaining a judgment would likely result in any monetary recovery.
  • Site visits are not mandatory with PPP loans under the SBA 7(a) regulations because the loans are unsecured. However, depending on the loan amount and specifics of what the lender knows about the business, site visits may still be important to determine the assets of the business.
  • Performing asset searches at this stage are also important to determine whether it would be worthwhile to seek a judgment against the business to try to collect the debt.
  • Lenders should also identify any property or assets that the borrower has recently transferred out of its name or conveyed for less than fair market value because these are signs of fraudulent conveyances which may be able to be set aside and recovered.
  • Accelerate Loan: After prudent attempts to help the borrower cure the default are unsuccessful, if the loan remains unpaid for sixty (60) consecutive days, the lender should accelerate the loan, send a demand letter to the borrower, and inform SBA that the loan is in litigation status.
  • Litigation Plan: Once the PPP loan (or any SBA 7(a) loan) is placed in litigation status, the lender must submit a litigation plan to SBA.  The Litigation Plan template can be found on the SBA website at https://www.sba.gov/document/support–litigation-plan-7a-504-loans.  The placement of a PPP loan in litigation status” does not mean that the lender will be required to litigate the collection of the loan.  The elements to be considered are:
  • Site Visit findings
    • If the lender did not perform a site visit, the lender must provide an explanation regarding why it did not conduct a site visit. A t typical explanation may include, among other things, that (1) a site visit was not required because the loan is unsecured, or (2) the asset search did not reveal any collectable assets
  • Feasibility of workout with borrower
    • How likely is it that lender will be able to reach a settlement with the borrower, or that the borrower may be able to repay the loan if provided with a loan modification, etc.?
  • Expected recovery of unencumbered assets
    • The site visit findings and asset search will assist with this explanation
  • Disclosure of all other non-SBA loans borrower has with the lender
    • The lender is not allowed to collect on other loans it has with the same borrower to the detriment of the SBA loan.
    • This can sometimes lead to a conflict, and a clear understanding with SBA regarding how recovery from the borrower will be allocated between the loans must be determined.

SBA approval of the Litigation Plan is not required for (1) routine, uncontested litigation, (2) routine, uncontested foreclosures, and (3) routine, uncontested bankruptcies as long as the expected fees are under $10,000.  All other litigation plans must be approved by SBA.

  • Request Charge-off by SBA: The lender can request that the PPP loan be charged-off when:
    • All reasonable efforts have been exhausted to achieve recovery from:
      • Voluntary payments on the note;
      • Compromise with the Borrower;
      • Liquidation of the collateral; and
      • Enforced collections.
    • Estimated cost of further collection efforts will likely exceed the anticipated recovery;
    • The only remaining avenue of recovery is from borrowers who cannot be located or are unable to pay the remaining balance; or
    • The loan balance is uncollectible due to some legal reason, such as discharge in bankruptcy or expiration of statute of limitations.

The Charge-off Checklist can be found on the SBA website at https://www.sba.gov/document/sba-form–sba-charge-tabswrap-report-test.

  • Guaranty Purchase Package: A Guaranty Purchase Package can be sent to SBA to request the purchase of the guaranty prior to completing the liquidation and request for Charge-Off.  However, SBA specifically encourages all lenders to liquidate all available assets first.  The SBA website has a Guaranty Purchase Package template at https://www.sba.gov/sites/default/files/2020-03/7aPurchaseTabs-03062020.pdf.

Lenders and lenders’ counsel should be aware that lenders are required to represent SBA’s interest in the event a borrower files bankruptcy or files any action which could affect the ability to collect on the PPP loan before the SBA pays the guarantee and accepts responsibility for collection of the PPP loan.

Even though PPP loans are unsecured and not guaranteed by the borrower’s principals, and are 100% guaranteed by SBA, SBA still expects lenders to make every effort to collect on such PPP loans that have gone into default (if unforgiven) just like a lender would do on a non-SBA unsecured loan.  The requirements for payment of the SBA guaranty are the same as any other SBA 7(a) loan, and are outlined above.

On December 21, 2020, the United States Trustee Program (USTP) published a final rule in the Federal Register, entitled the “Procedures for Completing Uniform Periodic Reports in Non-Small Business Cases Filed Under Chapter 11 of Title 11” (the “Final Rule”). See 28 C.F.R. § 58.8.

Bankruptcy practitioners should be aware that the Final Rule becomes effective for all reports filed on or after June 21, 2021.

The Final Rule requires that the filing of pre-confirmation monthly operating reports (MORs) and quarterly post-confirmation reports (PCRs) be done by using “streamlined, data-embedded, uniform forms in every case in every judicial district where the USTP operates.” See Notice Regarding the United States Trustee Program’s New Chapter 11 Periodic Reports (28 C.F.R. § 58.8).  This Final Rule applies to all debtors, except for those small business debtors who have filed under subchapter V of chapter 11.

The new forms and updates regarding the Final Report and Implementation will be posted by the USTP.

Stephanie Slater is a Law Clerk, based in the firm’s Wilmington, DE office.

The Delaware Bankruptcy Court now has eight judges to manage its hectic caseload.  Judge Craig Goldblatt was sworn in as a United States Bankruptcy Judge for the District of Delaware on April 26, 2021.  Judge Goldblatt fills the seat of former Judge Kevin Gross, who retired in 2020.

Prior to joining the bench, Judge Goldblatt was a partner in the Bankruptcy and Financial Restructuring Group at Wilmer Cutler Pickering Hale and Dorr LLP.  According to an Announcement from Chief Judge Christopher S. Sontchi, Judge Goldblatt’s practice primarily focused on the representation of financial institutions and other commercial creditors in complex bankruptcy litigation and appeals.  Additionally, Judge Goldblatt is a Conferee in the National Bankruptcy Conference and a fellow in the American College of Bankruptcy, where he chairs the Education Committee.

April was a busy month for the Delaware Bankruptcy Court with the appointment of Judge J. Kate Stickles and Judge Craig Goldblatt within weeks of each other.  Since the 2019 retirement announcement of former Judges Kevin Carey and Kevin Gross, the Delaware Bankruptcy Court has welcomed four new judges: Judge John T. Dorsey, Judge Karen B. Owens, Judge J. Kate Stickles, and most recently, Judge Craig Goldblatt.

As the Delaware Bankruptcy Court has seen an uptick of cases since 2019, the eight-member bench is now fully equipped to handle the heavy caseload.

Stephanie Slater is a Law Clerk, based in the firm’s Wilmington, DE office.

Judge Harlin D. Hale of the United State Bankruptcy Court for the Northern District of Texas dismissed the chapter 11 bankruptcy case filed by the National Rifle Association (the “NRA”) for cause, finding that the case was not filed in good faith.1  In its 38-page opinion issued in connection with multiple motions to dismiss and a motion to appoint an examiner (and after 12 days of trial testimony from 23 witnesses) the Court found that there was cause to dismiss the case because “the NRA’s bankruptcy petition was not filed in good faith but instead was filed as an effort to gain an unfair litigation advantage” in a dissolution action brought by the State of New York “and as an effort to avoid a regulatory scheme.”

The Filing and Dismissal

In August 2020 the New York Attorney General filed a complaint seeking, among other things, dissolution of the NRA (the “NYAG Enforcement Action”).  The complaint also sought other relief such as restitution from officers and it named certain individuals, including the NRA’s Executive Vice President Wayne LaPierre, as defendants in the complaint.

The NRA filed its chapter 11 case on January 15, 2021.  Several parties in interest filed motions seeking dismissal for cause under section 1112(b) of the Bankruptcy Code or the appointment of a chapter 11 trustee or an examiner.  Relying on Fifth Circuit authority, the Bankruptcy Court noted that the term “cause” affords flexibility to the bankruptcy courts and can include a finding that the debtor’s filing for relief is not in good faith.  In re Little Creek Dev. Co., 779 F.2d 1068, 1072-73 (5th Cir. 1986); In re Humble Place Joint Venture, 936 F.2d 814, 816-17 (5th Cir. 1991).  Furthermore, courts have held that a chapter 11 petition is not filed in good faith unless it serves a valid bankruptcy purpose. Off. Comm. of Unsecured Creditors v. Nucor Corp. (In re SGL Carbon Corp.), 200 F.3d 154, 165 (3d Cir. 1999).

In examining whether the NRA’s Chapter 11 case was filed in good faith, the Court applied a “totality of the circumstances approach” to filing requirements and considered the following two inquiries particularly relevant to the question of good faith: (1) whether the petition serves a valid bankruptcy purpose and (2) whether the petition is filed merely to obtain a tactical litigation advantage.  In re 15375 Mem’l Corp., 589 F.3d 605, 618 (3d Cir. 2009).

The NRA’s stated purposes for filing for bankruptcy, with some variations in pleadings and public statements, ostensibly were to (1) centralize and streamline litigation and claims, (2) reduce costs and reorganize the corporate structure and (3) move its corporate domicile to Texas.  However, the Court noted that that the NRA or its representatives, through various statements and filings, heavily emphasized the move to Texas as having the effect of avoiding the NYAG Enforcement Action. This seemed to be the most consistently stressed reason for the filing.  Indeed, in its opening statement, the NRA attorneys said the NRA was seeking to avoid “the death penalty” by filing for bankruptcy.  As a result of the trial, and relying heavily on Mr. LaPierre’s testimony, the Court determined that the NRA’s purported reasons for filing were not genuine and that the evidence demonstrated the true reason for filing for bankruptcy was to escape the NYAG Enforcement Action.

In dismissing the bankruptcy case, the Court explained that if the NRA could escape the NYAG Enforcement Action through the bankruptcy process, this would clearly give the NRA an unfair litigation advantage and subvert the State of New York’s ability to regulate not-for-profit corporations under its laws.  The Court distinguished between debtors who seek relief from monetary judgments and those who seek to avoid state regulation: “Debtors commonly file bankruptcy when faced with a judgment that has, or will, render them insolvent, but the threat against the NRA differs from the classic scenario in that dissolution would not be a collateral effect of litigation but rather the intended relief sought in a state’s regulatory action. And in this instance, dissolution could only occur after judicial consideration of whether dissolution is in the best interest of the public.”  The Court noted that while “bankruptcy courts can apply regulatory law, a bankruptcy case filed for the purpose of avoiding a regulatory scheme is not filed in good faith and should be dismissed.”

The Court Relied on Mr. LaPierre’s Testimony

Shortly before the bankruptcy filing, the NRA’s board of directors held a meeting on January 7, 2021 to, among other things, approve a new employment agreement for Mr. LaPierre.  The new employment agreement contained language permitting him to “exercise corporate authority in furtherance of the mission and interests of the NRA, including without limitation to reorganize or restructure the affairs of the Association for the purposes of cost- minimization, regulatory compliance or otherwise.”  Through testimony at the trial, the Court learned that throughout the entirety of the board meeting, both in the general and executive sessions, no discussion of bankruptcy, chapter 11 or the possible reorganization of the NRA occurred.  The board of directors was not informed that the language cited above could authorize Mr. LaPierre to unilaterally authorize file a bankruptcy petition on behalf of the NRA.  In fact, the board of directors was not informed that the NRA was considering filing for bankruptcy at all.  Mr. LaPierre and only four other people in the NRA (excluding the Chief Financial Officer or the General Counsel) knew of the plan to file chapter 11.2

Because Mr. LaPierre was so central to the filing of the case, there was no need to resolve inconsistent or conflicting reasoning and motivations of individuals who all had an equal say in the decision.  Rather, the Court found that the ultimate decision to file for bankruptcy was made solely by Mr. LaPierre. Mr. LaPierre’s testimony as to the reasons for filing for bankruptcy demonstrated how important the move to Texas from New York was for the NRA.  Mr. LaPierre stated that the NRA sought a “fair legal playing field where the NRA could grow and prosper in a fair legal environment.”  The NRA’s public communications also stated that it commenced a Chapter 11 petition primarily because of “the unhinged and political attack against the NRA by the New York Attorney General.”  Mr. LaPierre confirmed that the NRA’s financial position did not necessitate the filing and that if the case was dismissed the NRA would be able to pay all of its debts.  The Court found the following exchange to be helpful:

Q: Okay. So it comes down to the reason you filed Chapter 11 is because you have this New York attorney general enforcement action which is asking for dissolution of the NRA; is that correct?

[Counsel for the NRA]: Objection; misstates his testimony.

[Counsel for the Movant]: Well –

THE COURT: Well, I’m going to go ahead and let him answer that. Try to give an answer to that, Mr. LaPierre.

THE WITNESS: Yes, Your Honor. Yes, we filed the Chapter 11 to — because the New York State attorney general is seeking dissolution of the NRA and [seizure of] its assets, and we believe it’s not a fair, level playing field.

. . . .

Q: So really what we’re down to is that it’s — the New York attorney general action is the reason you believe you need to be in bankruptcy, and, really, solvency and all your other litigation, those are not issues that would require you to be in bankruptcy; is that correct?

A: That’s correct.

The Court characterized the foregoing exchange as demonstrating that “but for the NYAG Enforcement Action, it would not have been necessary to file for bankruptcy.”  Therefore, based on Mr. LaPierre’s unique standing within the NRA and his recently granted authority under which he could unilaterally cause the NRA to file for bankruptcy, the NRA’s fortunes in the case were directly tied to his testimony evidencing that the NRA’s Chapter 11 filing was made for the purpose of escaping from the NYAG Enforcement Action.  As this showed a lack of good faith in filing, the NRA’s case was dismissed.

Takeaways

The NRA’s case, and its dismissal, should demonstrate that the bankruptcy courts will see through a debtor’s attempt to forum-shop its way out of a state regulatory action.  If presented with a motion to dismiss a chapter 11 case for cause, a court will look to determine the true purpose or purposes for filing for bankruptcy.  In the NRA case, the Court found that Mr. LaPierre’s testimony would be the most direct evidence of the purpose for filing because he had unilateral authority to file the bankruptcy.  Potential debtors should be prepared to provide credible evidence of a valid bankruptcy purpose for filing, which cannot be to avoid a state regulatory action, to help survive a motion to dismiss for cause.

Notes:

  1. The Court also found that the appointment of a chapter 11 trustee or examiner would not have been in the best interests of creditors and the estate.
  2. The Court expressed concern about the “surreptitious manner in which Mr. LaPierre obtained and exercised authority to file bankruptcy for the NRA.” It stated that excluding the board and important officers from the process was “nothing less than shocking.”