The In re Jevic Holding Corp. chapter 11 case continues to make news.  The case is likely best remembered for the 2017 Supreme Court decision holding that the distribution scheme in a structured dismissal of a Chapter 11 case cannot violate the absolute priority rule.  The case has since been converted to Chapter 7, and in its most recent development, the Bankruptcy Court in Delaware barred the Chapter 7 trustee from stepping into the shoes of either the former unsecured creditors’ committee or the debtor due to the language in the Final Debtor In Possession Order.

Chapter 7 trustees have the power to pursue claims in the name of debtors, but such power does not apply if the debtor bars itself and its successors from asserting such claims.  However, a trustee does not have a right to take over an avoidance claim brought by a creditors’ committee unless the action being pursued is derivative of the debtor’s rights.

In Jevic, the Chapter 7 trustee filed a motion to be substituted as plaintiff for the Creditors’ Committee that had been appointed in the Chapter 11 case, and which filed an adversary action against certain creditors of the debtor known as the “Lender Group,” before the case converted to Chapter 7 and the Creditors’ Committee was dissolved.  As the Court noted, the “terms of the financing order are paramount in [the] analysis” as to the trustee’s rights.  08-11006-BLS, Doc. 1914, May 5, 2021, at 14.  In Jevic, the Court found that the language of the Final DIP Order prevented the trustee from being substituted as plaintiff in place of the Creditors’ Committee and from exercising its avoidance powers against the Lender Group based on the Debtor’s rights.

The language of the Final DIP Order was specific regarding who could assert a challenge and the timeframe in which a challenge could be asserted.  While any party could assert a challenge no later than 75 days of the Petition Date, only the Creditors’ Committee could assert an action no later than 75 days after the appointment of the Committee.  By the time the Chapter 7 trustee was appointed, it was well past 75 days from the Petition Date, and the Final DIP Order did not provide that a Chapter 7 Trustee could succeed to the rights of the Creditors’ Committee.  Most importantly, the Order stated that “[t]he stipulations and admissions contained in this Final Order shall be binding upon the Debtors and any successor thereto (including without limitation any Chapter 7 or Chapter 11 trustee appointed or elected for any of the Debtors) in all circumstances.”  08-11006-BLS, Doc. 1914, May 5, 2021, at 11.  Based on this language the Debtor waived not only its rights, but also waived the right to challenges by any successor, specifically including a Chapter 7 trustee.  The Bankruptcy Court therefore ruled that the Chapter 7 trustee was unable to step into the shoes of the Debtor to pursue an adversary action against the Lender Group referenced in the Final DIP Order.

It is noted that the language at issue in this Final DIP Order is fairly standard language in financing orders.  Therefore, parties wishing to avoid this result in future cases should consider using alternative language which will allow a Chapter 7 Trustee to succeed in the place of a Creditors’ Committee and/or the debtor.  Absent language preserving the rights of potential successors, such as a Chapter 7 Trustee, the estate may lose the ability to pursue certain claims.

By Michael L. Temin and Martha B. Chovanes


In an issue of first impression, in In re Energy Future Holdings Corp., 2021 U.S. App. LEXIS 7400 (3d Cir. Mar. 15, 2021), the Third Circuit addressed the question whether an initial bidder whose break-up fee was disallowed could receive a portion of its costs as an administrative expense claim even if the ultimate sale price was below the amount of the initial bid?  The Third Circuit answered this question in the affirmative.

In Calpine Corp. v. O’Brien Env’t Energy, Inc. (In re O’Brien Env’t Energy, Inc.), 181 F.3d 527 (3d Cir. 1999), the Third Circuit concluded that break-up fees could be authorized under Bankruptcy Code § 503(b), which permits payment of post-petition administrative expenses, for “actual, necessary costs and expenses of preserving the estate,” to induce an initial bid.

The Facts:

NextEra entered into an agreement (the “Merger Agreement”) with the Debtors to purchase the Debtors’ interest in Oncor, a large electric and power distribution company, subject to PUCT approval.  The Merger Agreement provided for a termination fee of $275 million to be paid to NextEra if the Merger Agreement was terminated.  Ultimately, the Bankruptcy Court disallowed the payment of a termination fee if the  PUCT did not approve the merger as contemplated.

Eventually, the Debtors sold their interest in Oncor for $ 350 million less than the amount NextEra had agreed to pay. NextEra filed an administrative expense application pursuant to 503(b)(1)(A) to recover its out-of-pocket expenses and other costs incurred in its efforts to complete the transaction and obtain the requisite PUCT approval, for the period from execution of the Merger Agreement until notice of termination of the Merger Agreement.  The Bankruptcy Court and the District Court denied NextEra’s administrative expense application.

The Court’s Opinion:

On appeal, the Third Circuit found that the terms of the Merger Agreement did not preclude NextEra’s application for administrative expenses. The Court noted:

An administrative expense claim is entitled to priority under Section 503(b)(1)(A) if (1) there was a “post-petition transaction between the claimant and the estate,” and (2) those expenses yielded a “benefit to the estate.”

The Merger Agreement was a post-petition transaction. As noted by the Court,

“The word benefit’ . . . functions as ‘merely a way of testing whether a particular expense was truly ‘necessary’ to the estate:  If it was of no ‘benefit,’ it cannot have been ‘necessary’ within the meaning of § 503(b)(1)(A). ”

* * *

In O’Brien, we elucidated the concept of “benefit” under Section 503(b)(1)(A) in describing a framework for evaluating the possible beneficial acts that could justify a termination fee, e.g., (1) “promot[ing] more competitive bidding” by “inducing an initial bid” or “inducing a bid that otherwise would not have been made and without which bidding would have been limited”; and (2) “encourage[ing] a prospective bidder to do the due diligence” to “research the value of the debtor and convert that value to a dollar figure on which other bidders can rely . . . [which] increase[es] the likelihood that the price at which the debtor is sold will reflect its true worth.”

NextEra argued  that by (i) negotiating the Merger Agreement, (ii) settling objections with creditors and (iii) providing further due diligence, it created guideposts that directly facilitated the merger that ultimately took place.

The Court concluded,

With respect to the motion  to dismiss the question before us is not whether NextEra actually benefitted the estate, but whether it plausibly alleged that it did so.

On this basis, the Court reversed the lower courts’ dismissal of the motion for administrative expenses and remanded to give NextEra the opportunity to present facts relevant to its request for an administrative expense claim in its attempt to recoup some of its costs in the failed acquisition.

On April 6, 2021, J. Kate Stickles was sworn in as a United States Bankruptcy Judge for the District of Delaware. According to an Announcement issued by the Delaware Bankruptcy Court, Judge Stickles fills the seat vacated by former Judge Kevin J. Carey, who retired in 2019. With Judge Stickles’ appointment, the Delaware Bankruptcy Court now has seven total members on its bench. Judge Stickles has practiced in Wilmington, Delaware for 30 years and has been recognized as a leading bankruptcy practitioner in Chambers USA since 2010, Best Lawyers in America, and Best Lawyers Business Edition, 2017-2020.

The Delaware Bankruptcy Court is one of the busiest bankruptcy courts in the nation. In 2020, the Delaware Bankruptcy Court recorded 1,666 chapter 11 filings, surpassing all other bankruptcy courts’ chapter 11 totals. This high number of cases is due in large part to the impact of the Covid-19 pandemic. This historic number of cases before the then six-member Delaware bankruptcy bench added more to the judges’ case load who already handled the most cases per judge prior to the pandemic.   For comparison, in 2019, the Delaware Bankruptcy Court recorded only 611 chapter 11 filings.

With the addition of J. Kate Stickles, the Delaware Bankruptcy Court now has a seventh member to assist in managing its hectic caseload.

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

Secured creditors have many choices when it comes to how to file a proof of claim in bankruptcies. Those choices should be weighed carefully, however, because certain choices can have important unexpected consequences that outlive the bankruptcy and affect a secured creditor’s subsequent rights in state court actions.

When a debtor files a bankruptcy in which proof of claims are allowed, secured creditors have four options. They can (1) disregard the bankruptcy proceedings and just rely on their security; (2) file a secured proof of claim with the bankruptcy court; (3) waive their security interest and declare their claim as unsecured through a proof of claim in the bankruptcy court; or (4) file a proof of claim declaring their security interest but also availing themselves on the general assets of the bankruptcy estate as to the unsecured balance.

Once a creditor elects one of these options, especially electing to share in distributions from the general assets of the bankruptcy estate as a wholly unsecured creditor, it may not necessarily change its position and later ask to be treated as a secured creditor. This is especially true when a secured creditor files an unsecured proof of claim in the bankruptcy and then attempts to recover as a secured creditor in a subsequent state court action or to receive insurance proceeds if the collateral is destroyed. In re Bailey, 664 F.3d 1026 (6th Cir. 2011); In re Taylor, 280 B.R. 711 (Bankr. S.D. Ala. 2001).

For example, in In Re Taylor, a mortgage lien holder filed an unsecured non-priority proof of claim in a Chapter 13 bankruptcy. When the Plan was completed, there was still a balloon payment due. Had the creditor filed the proof of claim as a secured claim, the lien would have survived the plan and discharge of the debtors. Because the creditor filed an unsecured proof of claim, it waived its secured status and the lien ceased to exist upon the completion of the plan payments, which essentially released the mortgage in state court.

Filing unsecured proof of claims will also effect a secured creditor’s lien priority in a state-court foreclosure action. Even though title searches do not always check for the treatment of secured claims in bankruptcy cases, secured creditors involved in state foreclosure actions should pay attention to how other secured creditors filed their proof of claims because it is possible that some state court liens are still on record with the Register of Deeds Office which were actually waived and/or released in a prior bankruptcy case.

This was the issue in a recent South Carolina state foreclosure action. In South State Bank v. Greer et. al, Civil Action Number 2019-CP-23-00720 (Mar. 25, 2021), the foreclosure sale of commercial property resulted in surplus funds. American Express National Bank (“AMEX”) had previously filed a state court judgment against the landowner, which was first in line in the state records office after the mortgage that was foreclosed. Clayton Tile Distributing Co., Inc. (“Clayton Tile”) had filed a judgment against the landowner, which was technically filed after AMEX’s judgment. During the landowner’s Chapter 7 bankruptcy, assets were declared. AMEX filed an unsecured proof of claim while Clayton Tile filed a secured proof of claim. The Master in Equity for Greenville County held that:

[T]his Court finds that any claim by AMEX to the surplus funds has been waived or abandoned. AMEX had notice of the existence of the foreclosure action through the schedules filed in the Bankruptcy by Cameron H. Greer in July of 2019. AMEX did not assert a lien claim against the subject property in its Proof of Claim filed in the Bankruptcy. Accordingly, AMEX waived any claim to the surplus funds by filing its claim in the Bankruptcy as unsecured. See In re Devey, 590 B.R. 706 (Bankr. D.S.C. 2018); see also In re Workman, 373 B.R. 460 (Bankr. D.S.C. 2007).

The courts have reasoned that when a secured creditor makes a deliberate choice to make a claim as an unsecured creditor in hopes of participating in the distributions of a bankruptcy estate, it waives its right to also seek collection from the collateral.  Therefore, the creditor cannot change its position from unsecured to secured when it discovers an unforeseen benefit in the collateral.

For these reasons, secured creditors should be thoughtful and deliberate when deciding whether how to file proofs of claims in bankruptcies.  And, in state court actions, competing (and seemingly junior creditors) should pay close attention to how competing secured creditors filed claims in intervening bankruptcies because priorities may have shifted.

Fox Rothschild Washington D.C. associate, Diana Lyn Curtis McGraw, published an article in TMA’s Journal of Corporate Renewal (April 2021) entitled “The Role of the Trustee in Chapter V Cases.  This article outlines some of the most important duties of a Subchapter V trustee and the trustee’s ability to retain counsel and other restructuring professionals.

Role of the Trustee in Subchapter V Cases (Journal of Corporate Renewal, April 2021)

The “COVID-19 Bankruptcy Relief Extension Act of 2021” was signed into law by President Biden on March 27, 2021, extending the key provisions of the COVID-19 Bankruptcy Relief Act which was enacted in the CARES Act for another year.

Section 1113 of the CARES Act, which temporarily amended bankruptcy law to assist individuals and businesses affected by the coronavirus pandemic on March 27, 2020, has been extended by the COVID-19 Bankruptcy Relief Extension Act of 2021 and includes the following provisions:

  • The business debt limit under subchapter V of the Small Business Reorganization Act (SBRA) is increased from $2,725,625 to $7.5 million for another year – until March 27, 2022. This allows small businesses with debts under a certain debt limit to file bankruptcy and reorganize more quickly and less expensively.

Subchapter V was enacted under the SBRA on February 19, 2020, just prior to the COVID-19 pandemic, as a subchapter to Chapter 11.  The purpose was to assist small business debtors in reorganization by reducing expenses and making it faster and easier to file bankruptcy.  Subchapter V is available to a person or entity engaged in commercial business activity with non-contingent liquidated secured and unsecured debts as of the date of the petition filing of originally not more than $2,725,625, in which the majority of such debts have arisen from commercial or business activities of the debtor.

  • The definition of “income” under section 1325(b)(2) for purposes of filing bankruptcy is temporarily amended to exclude coronavirus-related payments received from the federal government until March 27, 2022.
  • The definition of “income” under section 1325(b)(2) for purposes of filing bankruptcy is temporarily amended to exclude coronavirus-related payments received from the federal government until March 27, 2022.
  • In a chapter 13 plan, disposable income shall not include coronavirus-related payments.
  • In a chapter 13, individuals and families who are experiencing material hardships due to the coronavirus pandemic may seek modifications to their plans, including seeking to extend the plan for up to seven years from date of the initial plan payment.

These provisions will sunset, or expire, on March 26, 2022, unless extended again.

When the Bankruptcy Code was first enacted in 1978, student loan debt could be discharged either after the passage of five years since the repayment obligation began, or if repayment would impose an undue hardship on the debtor or his/her dependents.  In 1990, the five-year waiting period was extended to seven years, and then in 1998, the Bankruptcy Code was amended to eliminate the waiting period altogether, leaving establishing undue hardship as the only means to discharge student loan debt as set forth in section 523(a)(8) of the Bankruptcy Code.

In assessing whether student loan debt may be discharged as an “undue hardship” under section 523(a)(8), the majority of courts follow the three-part test created by the Second Circuit in Brunner v. N.Y. State Higher Educ. Servs. Corp., 831 F.2d 395 (2d Cir. 1987).  The “Brunner Test” provides that student loan debt can be discharged if the debtor establishes by a preponderance of the evidence that:

  1. She cannot maintain, based on current income and expenses, a minimal standard of living for herself and her dependents if forced to repay the loans;
  2. Additional circumstances exist indicating that this state of affairs is likely to persist for a significant portion of the repayment period; and
  3. She has made good faith efforts to repay the loans.

In application, the Brunner Test has largely proven to be a difficult burden for debtors to overcome, with discharge of student loan debt often granted only to debtors who have demonstrated dire circumstances impeding their ability to repay the debt in both the present and for the foreseeable future.  Some have termed this a “certainty of hopelessness” standard.

In recent years, however, some courts have more flexibly applied the Brunner Test to at least allow for partial discharge of student loan debt.  For instance, in 2018, a bankruptcy court opinion in New Jersey determined that based on the debtor’s monthly surplus income, it was appropriate to discharge the debtor’s student loan obligations maturing before June 2037, while preserving obligations maturing after that date.  As a result, the debtor’s monthly student loan bill decreased from $2,609.24 to $414.26.  See Hunter v. New Jersey Higher Educ. Student Assistance Auth., adv. pro, no. 15-02052-JKS (Bankr. D.N.J. April 27, 2018).  In a similar decision a few months later, a Wisconsin bankruptcy court allowed for a partial student loan debt discharge reducing the debtor’s monthly student loan repayment obligation from $694 to $208.  See Manion v. Modeen, adv. pro. no. 17-00071-cjf (Bankr. W.D. Wis. June 8, 2018).

In a January 2020 opinion authored by Chief Bankruptcy Judge Cecelia Morris of the Southern District of New York, a debtor’s $221,385 student loan debt was entirely discharged as an undue hardship.  Chief Judge Morris opined that the Brunner Test had been warped over time, subsuming the “certainty of hopelessness” standard that was more punitive than the original design of the Brunner Test.  See Rosenberg v. N.Y. State Higher Educ. Servs. Corp., 610 B.R. 454 (Bankr. S.D.N.Y. 2020).  This decision, occurring within the Second Circuit and the high profile Southern District of New York, coupled with other recent decisions allowing for partial discharge of student loan debt, as well as the economic hardships resulting from the COVID-19 pandemic, fueled speculation that debtors may increasingly bring adversary proceedings to discharge student loan debt in the hope of finding an emerging trend of judicial flexibility in applying the Brunner Test.

For those hoping for potential daylight in discharging student loan debt, the Second Circuit, however, demonstrated earlier this month that it is not inclined to revisit the form of the Brunner Test at this time.  See In re Tingling, 2021 WL 922448 (2d Cir. March 11, 2021).  In particular, the debtor, aligning with Chief Judge Morris’ view, argued that the Brunner Test had become too onerous a burden for debtors to satisfy.  The Second Circuit, however, reaffirmed the elements of the Brunner Test that it adopted nearly 25 years earlier, noting that it “reflects the Section 523(a)(8) statutory scheme exhibiting ‘clear congressional intent … to make the discharge of student loans more difficult than that of other nonexcepted debt…”  The Second Circuit then affirmed the lower courts’ findings that the debtor failed to establish undue hardship.

The Second Circuit’s recent pronouncement has made clear that any large scale relief in bankruptcy for student loan debt will likely be contingent on Congressional action.

Interplay Between Subordination Agreements and Chapter 11 Cramdown Plans

The Bankruptcy Code provides that subordination agreements are enforceable in bankruptcy to the same extent that such agreements are enforceable under non-bankruptcy law.  11 U.S.C. § 510(a).  However, Section 1129(b)(1) of the Bankruptcy Code permits a Chapter 11 plan to be confirmed subject to certain requirements “notwithstanding” Section 510(a).

Until recently, there was no Circuit-level guidance on whether bankruptcy courts had authority to disregard a valid subordination agreement in the context of a non-consensual “cramdown” plan when enforcement of the subordination agreement would jeopardize a plan proponent’s ability to confirm an otherwise enforceable Chapter 11 plan.

In re Tribune Co., 972 F.3d 228 (3d Cir. 2020)

In a case of first impression, the Third Circuit Court of Appeals in In re Tribune Co., 972 F.3d 228 (3d Cir. 2020) affirmed the Bankruptcy Court’s order confirming Tribune Company’s Chapter 11 plan over the objections of certain creditors who sought to enforce a subordination agreement entered into prior to the bankruptcy filing.   The Third Circuit found that the Bankruptcy Code’s cramdown provision set forth in Section 1129(b)(1) “supplants strict enforcement of subordination agreements” and held that “when cramdown plans play with subordinated sums, the comparison of similarly situated creditors is tested through a more flexible unfair-discrimination standard.”  The Third Circuit determined that the plain meaning of the word, “notwithstanding,” as used in Section 1129(b)(1) means that despite the rights conferred by Section 510(a) to subordination agreements, bankruptcy courts must confirm the plan over the objection of a non-consenting class of creditors if all of the applicable requirements of Section 1129(a) are satisfied so long as the plan does not discriminate unfairly, and is fair and equitable, for each impaired class that does not accept the plan.

            Eight-Factor Test to Determine Unfair Discrimination

The Third Circuit established eight “principles” to assess unfair discrimination in this context:  (1) subordination agreements need not be strictly enforced in the case of a cramdown, and creditors holding claims with the same priority can be treated differently so long as such discrimination is not unfair. “There is, as is typical in reorganizations, a need for flexibility over precision. The test becomes one of reason circumscribed so as not to run rampant over creditors’ rights.”; (2) unfair discrimination applies only to classes of dissenting creditors rather than individual creditors; (3) unfair discrimination is determined from the perspective of the dissenting class; (4) classes must be aligned correctly to enable bankruptcy courts to assess whether a cramdown plan discriminates unfairly; (5) bankruptcy courts should resolve how a plan proposes to pay each creditor’s recovery measured in terms of the net present value of all payments or the allocation of materially greater risk in connection with its proposed distribution; (6) bankruptcy courts should first determine the pro rata baseline for the recovery of creditors sharing the same priority and then compare such baseline against the percentage distribution that claimants in the dissenting class would have otherwise been entitled to receive under full enforcement of their subordination agreements under Section 510(a), but did not get under the plan; (7) there is a presumption of unfair discrimination where there is a materially lower percentage recovery for the dissenting class or a materially greater risk to the dissenting class in connection with the proposed distribution; and (8) the presumption of unfair discrimination may be rebutted (as determined by the bankruptcy courts in the first instance).

Pragmatic Approach to Assessing Unfair Discrimination

Applying the above principles, the Third Circuit agreed with the Bankruptcy Court’s finding that the difference between the senior noteholder’s desired and actual recovery is not material. The subordinated sums allocated to the retirees and trade creditors comprised 11.7% toward their 33.6% recovery, but only reduced the senior noteholders recovery by less than 1%.

According to the Third Circuit, its interpretation and application of Section 1129(b)(1) to override Section 510(a) supports the Bankruptcy Code’s purpose to allow confirmation of a cramdown plan provided that it protects the interests of the dissenting class of creditors. As the Third Circuit noted:

Both § 510(a) and the cramdown provision’s unfair-discrimination test are concerned with distributions among creditors. The first is by agreement, while the second tests, among other things, whether involuntary reallocations of subordinated sums under a plan unfairly discriminate against the dissenting class. Only one can supersede, and that is the cramdown provision. It provides the flexibility to negotiate a confirmable plan even when decades of accumulated debt and private ordering of payment priority have led to a complex web of intercreditor rights. It also attempts to ensure that debtors and courts do not have carte blanche to disregard pre- bankruptcy contractual arrangements, while leaving play in the joints.

In the alternative, the Third Circuit held that the allocation of the subordinated amounts to the class of non-consenting claimants did not result in unfair discrimination.  The Third Circuit noted that the prohibition against unfair discrimination “ensures that a dissenting class will receive relative value equal to the value given to all other similarly situated classes.”  In determining a plan’s differing treatment, the Third Circuit found that the best approach requires bankruptcy courts to compare the recovery of the preferred class and the dissenting class.  However, where a class-to-class comparison is difficult, such as in Tribune where the “Swap claims” were entitled to benefit from the subordination of various notes while the trade creditors and retirees were not, “a court may opt to be pragmatic and look to the discrepancy between the dissenting class’s desired and actual recovery to gauge the degree of its different treatment.”  Although this approach “is not the preferred way to test whether the allocation of subordinated amounts under a plan to initially non-benefitted creditors unfairly discriminates, . . . [t]here is, as is typical in reorganizations, a need for flexibility over precision.”  Due to the perceived importance of flexibility over precision, the Third Circuit upheld the Bankruptcy Court’s unfair discrimination analysis which compared the Senior Noteholders’ recovery under the Plan to its recovery if strict enforcement of the Subordination Agreements were enforced, and found that a 0.9% loss in recovery was immaterial.

Unfair Discrimination Test Only Applies to Classes of Creditors, Not Individual Creditors

In a recent unpublished decision, the Third Circuit expanded its holding in Tribune to dismiss an appeal of a Chapter 11 plan confirmation order as equitably moot, holding that the unfair discrimination test only applied to classes of dissenting creditors rather than individual creditors. See In re Nuverra Envt’l Sol., Inc., 834 Fed.Appx. 729, 2021 WL 50160 (3d Cir. Jan. 6, 2021), amended, Feb. 2, 2021 (unpublished).  In Nuverra, a creditor objected to the debtor’s plan of reorganization on the basis that the plan unfairly discriminated between classes of creditors.  The District Court dismissed the appeal as equitably moot, which was subsequently appealed to the Third Circuit.  The Third Circuit affirmed the dismissal, noting “’that unfair discrimination applies only to classes of creditors (not the individual creditors that comprise them), and then only to classes that dissent. Thus, a disapproving creditor within a class that approves a plan cannot claim unfair discrimination, and the standard does not ‘apply directly with respect to other classes unless they too have dissented.””  Id. at *4 (quoting Tribune, 972 F.3d at 242).  Although the Third Circuit held that the creditor was free to object to the plan on unfair discrimination grounds, he could “propose that the appropriate remedy is to pay only him and no one else in his class. He never asked for individualized relief before the Bankruptcy Court. Nor could he have at the confirmation hearing, because § 1123(a)(4) bars individualized treatment. . . .”  Id.  Because the only way to give the objecting creditor redress was to give all creditors in the same class a 100% refund on their unsecured notes in the amount of $40.4 million “which would fatally scramble the Plan and significantly harm third parties,” the Third Circuit found that his appeal was properly dismissed as equitably moot.  Id.  Therefore, creditors who challenge a plan based on unfair discrimination can only seek relief on behalf of the class.  Although this decision is not precedential, the Third Circuit’s rationale is instructive.

Takeaways from Tribune

Tribune provides valuable guidance regarding the interplay between subordination agreements and non-consensual cramdown plans.  Courts and parties will need to grapple with the competing policies of freedom of contract to negotiate subordination agreements which are recognized under Section 510(a) and the hammer granted by Congress to plan proponents under Section 1129(b)(1) to cram down a plan over the objection of non-consenting creditors.  Notably, Tribune’s flexible “unfair-discrimination” standard enables bankruptcy courts to disregard the rigid enforcement of subordination provisions when courts determine that it would be inequitable to do so by denying confirmation of an otherwise equitable plan of reorganization.

Somewhere in our rough memories of high school science, we should recall the general principle that a gas will always expand to fill a given void.  Although the Bankruptcy Code diverges markedly from scientific principles, newly enacted provisions in Subchapter V of Chapter 11 of the Bankruptcy Code suggest some similarity.  In In re Dani Transport Service, Inc., the United States Bankruptcy Court for the Central District of California found that Sections 1183 and 1185 of the Bankruptcy Code can be read together to remove a Subchapter V debtor’s misbehaving management and expand the Subchapter V trustee’s management duties to fill the void.  Aside from an example of these provisions in action, the case offers insight into the circumstances under which parties and the bankruptcy court may find management substitution preferable to chapter 7.

The Debtor’s Principals Fraudulently Apply for and Mismanage PPP Loan Proceeds

Dani Transport Service, Inc. (the “Debtor”) was a family business owned and operated by Abraham and Daniela Gutierrez that transports cars from manufacturers and delivers them to dealerships throughout California.  The Debtor expanded its services in mid-2019, but soon found that the contracts yielded substantially lower profit that did not offset the company’s costs of expansion.  On February 19, 2020, the Debtor filed a voluntary petition under Subchapter V.

In a sign of the times, two months after the Petition Date, the Debtor submitted a borrower application to the Small Business Administration for a loan (a “PPP Loan”) under the Paycheck Protection Program.  However, the Debtor’s principals did not disclose the bankruptcy case in the PPP Loan application where required, and did not disclose the PPP loan application to the Bankruptcy Court.

On April 30, 2020, the SBA approved the application and authorized the lender to disburse $170,000 to the Debtor.  The Debtor’s principals deposited $169,500 of the proceeds into a prepetition bank account and then transferred the funds to their son’s separate business account.  Ultimately, the Debtor’s principals used $100,000 of the funds to repay personal expenses and could not account for the remaining $70,000.

The Bankruptcy Court Removes Management and Expands the Subchapter V Trustee’s Duties

The scheme unraveled in February 2021, when the United States Trustee, Subchapter V trustee, and Debtor’s counsel learned of the PPP Loan from a filing in the bankruptcy case.  Although the Debtor’s principals agreed to repay the PPP Loan proceeds, the United States Trustee filed a motion to remove the principals from management of the Debtor and expand the responsibilities of the Subchapter V Trustee to fill management.

The United States Trustee’s motion relied on two sections of the newly enacted Subchapter V—11 U.S.C. §§ 1183 and 1185.  Section 1185(a) provides:

On request of a party in interest, and after notice and a hearing, the court shall order that the debtor shall not be a debtor in possession for cause, including fraud, dishonesty, incompetence, or gross mismanagement of the affairs of the debtor, either before or after the date of commencement of the case, or for failure to perform the obligations of the debtor under a plan confirmed under this subchapter.

Section 1183(b)(1) sets forth the initial duties of a Subchapter V Trustee.  However, following the request of a party in interest, the court can expand of those duties “for cause,” under § 1183(b)(2).  The Bankruptcy Code specifically provides that, if the debtor ceases to be a debtor in possession, the Bankruptcy Court can order that a Subchapter V Trustee

perform the duties specified in section 704(a)(8) and paragraphs (1), (2), and (6) of section 1106(a) of this title, including operating the business of the debtor[.]

11 U.S.C. § 1183(b)(5).  The United States Trustee argued that the principals’ dishonesty and misconduct—fraudulently applying for the PPP Loan, diverting the PPP Loan proceeds, and failing to disclose the PPP Loan to the Bankruptcy Court by motion or in monthly operating reports—demonstrated sufficient cause to remove the principals from management and expand the scope of the Subchapter V trustee’s duties under these provisions.

For its part, the Debtor joined in the United States Trustee’s motion and offered insight into the rationale against conversion to chapter 7.  The Debtor had filed a disclosure statement and reorganization plan in December 2020.  The Debtor contended that plan confirmation would provide a 27% return to holders of allowed unsecured claims, which could not be achieved in a chapter 7 case.

On February 23, 2021, the Bankruptcy Court granted the motion, removed the principals from management of the Debtor, and expanded the Subchapter V trustee’s duties to include management under Section 1183(b)(2) of the Bankruptcy Code.  The Bankruptcy Court separately continued upcoming hearings on approval of the disclosure statement and related matters “to give the trustee additional time to evaluate the case.”

The Upshot

Subchapter V cases contemplate a unique and balanced relationship—similar to chapter 12 cases—between the Subchapter V trustee and the debtor in possession.  Section 1112, governing conversion or dismissal, still applies in Subchapter V cases, but Sections 1183 and 1185 offer parties in interest a more nuanced approach to misbehaving management by simply expanding the Subchapter V Trustee’s role.  Dani Transport sheds some light on at least one circumstance, a pending plan with purported benefit to unsecured creditors, in which the United States Trustee and Bankruptcy Court may prefer application of Sections 1183 and 1185 to maintain the debtor’s operations.

In many chapter 11 cases, a committee of unsecured creditors is formed early in the case to represent the overall interests of unsecured creditors. See 11 U.S.C. § 1102. Members of the committee hold a “fiduciary” obligation to the entire general unsecured creditors’ class. Notably, each member of an unsecured creditors committee is duty-bound to act in the interests of all general unsecured creditors above the committee member’s singular and particular interests in the case. This fiduciary obligation carries great responsibility, and as recently seen in connection with the Neiman Marcus bankruptcy, great consequences if not honored.

Daniel Kamensky, a hedge fund founder, was the co-chair of the Official Committee of the Unsecured Creditors in the Neiman Marcus bankruptcy case. Earlier this month, Kamensky pled guilty to one count of bankruptcy fraud in a criminal action against him in the United States District Court for the Southern District of New York. Kamensky’s guilty plea was the result of his scheme to pressure a rival bidder to abandon its higher bid for securities in Neiman Marcus’ bankruptcy case so that his own hedge fund could acquire the assets at a lower price. Kamensky was made aware of a diversified financial services company’s interest in bidding on the securities involved at a price which was potentially twice as much as what Kamensky’s hedge fund was offering. After learning of the competing bid, Kamensky sent messages to employees at the financial services company telling them not to bid and threatened to use his position as co-chair of the Committee to prevent the financial services company from acquiring the securities. Further, Kamensky stated that if the financial services company moved forward with the bid, Kamensky’s hedge fund would cease doing business with them in the future. As a result, the financial services company decided to not make the bid to purchase the securities.

This scheme violated Kamensky’s fiduciary duty to the unsecured creditors in the Neiman Marcus bankruptcy as the higher bid from the financial services company would have resulted in a greater recovery for the unsecured creditors. Additionally, Kamensky is a former bankruptcy attorney, and therefore should have been well aware of his fiduciary obligations that come with the position of a committee member. Instead, Kamensky exploited his position on the committee to favor his own hedge fund at the expense of the general unsecured creditors he was supposed to represent.

U.S. Attorney Audrey Strauss recognized Kamensky’s abuse of his committee position in attempting to corrupt the asset distribution process and take profits for himself and his hedge fund. Strauss goes on to say that Kamensky “predicted in his own words to a colleague: ‘Do you understand…I can go to jail?’… ‘this is going to the U.S. Attorney’s Office.’ His fraud has indeed come to the U.S. Attorney’s Office and now has been revealed in open court.” Indeed, it has. Kamensky has acknowledged his “lapse of judgment” and “terrible mistake.” The extent of the consequences will be known when Kamensky is sentenced on May 7, 2021.

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