California Creditor's Rights & Business Bankruptcy Lawyer & Attorney : Robert Eisenbach : Business Bankruptcy Blog

A Difficult Problem. Imagine that your company is facing a government investigation, requiring you to spend hundreds of thousands of dollars in legal fees and costs, while being threatened with substantially more legal expense. That financial burden is simultaneously starving the company of cash needed to grow the business, and cash balances are heading toward zero. Worse yet, the cloud over the company means it cannot raise additional investment or even find a buyer, as potential buyers fear being saddled with the government investigation and any underlying potential claims.

The Strategy. That was the trap confronting our client Cylex Inc., a Maryland-based life sciences company whose diagnostic test kit detects immune function in organ transplant patients, when they asked me for help. After considering alternatives, the strategy we crafted was to use Chapter 11 bankruptcy’s sale process to obtain a bankruptcy court order expressly permitting the buyer to purchase the company’s assets “free and clear” of the government investigation and underlying claims. 

The Stalking Horse Bidder. With the legal strategy in place, the next step was negotiating with a strategic buyer the company had identified.  Fortunately, Cylex recognized the need for a solution early enough that we had time to work through the challenges of implementing the strategy.

• Given that the sale would be under Bankruptcy Code Section 363 – which allows a bankruptcy court to authorize an asset sale free and clear of liens, interests, claims and encumbrances – the buyer knew that its asset purchase agreement would be subject to “higher and better bids.” In effect, as seller, Cylex would have a chance to “shop” the buyer’s purchase agreement to try and find a better deal.
• The buyer, known as a “stalking horse bidder” in bankruptcy parlance, wanted both a break-up fee (a percentage of the sale price) and an expense reimbursement (for legal and other direct expenses), in the event another bidder emerged and won the bidding. Those amounts also set the floor for a minimum “topping” or overbid price.
• As is common, the stalking horse bidder also insisted on a no-shop provision until the bankruptcy was filed, meaning that Cylex would have a chance to shop the deal but only for a relatively short period after the bankruptcy was filed.
• The pre-bankruptcy sale negotiations with the stalking horse bidder were challenging and took months. However, in November 2012, Cylex and the stalking horse bidder executed a formal asset purchase agreement calling for a $6 million purchase price, but also including a long list of closing conditions, an escrow holdback, and other non-economic terms unfavorable to Cylex.

The Bankruptcy Filing.  Cylex filed Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the District of Delaware on December 3, 2012. Among the motions we filed on the first day of the case was one to approve the break-up fee, expense reimbursement, and bidding procedures, and the Bankruptcy Court approved them two weeks later. Given the company’s dwindling cash, the bidding procedures set a deadline of January 18, 2013 for any overbids, an auction on January 22, 2013 (if any overbids were made), and a hearing on approval of the sale on January 23, 2013. The schedule was accelerated to be sure Cylex could get the transaction closed before it ran out of cash.

The Sale And Auction Process. The company and its advisors only had about six weeks to shop the stalking horse bid, including over the holidays, but they made the most of the limited time.

• On the day of the overbid deadline, two new strategic bidders submitted overbids, both in the $6.7 million minimum overbid amount. That set the stage for the auction four days later.
• The auction made all of the efforts worthwhile. After 16 rounds of bidding, spanning more than 12 hours, the winning bid (from one of the two overbidders) was a stunning $14.425 million, all cash at closing. Through the auction, Cylex had increased the sale proceeds by more than $8 million over the stalking horse bid.
• When faced with bidding competition at the auction, the stalking horse bidder and each of the overbidders made concession after concession on non-economic terms, dropping closing conditions and the escrow holdback, and agreeing to purchase price adjustments favorable to Cylex.
• The Bankruptcy Court approved the sale to the winning bidder on January 23, 2013, and entered an order expressly permitting the winning bidder to purchase Cylex’s assets “free and clear” of the government investigation and underlying claims. The sale closed in February.

Conclusion. Cylex, now known as Immunology Partners Inc., faced an extremely challenging set of problems caused by the government investigation, in turn triggered by a False Claims Act qui tam complaint. Although the government later declined to intervene in the qui tam case, that decision came too late for the company to have non-bankruptcy options.  As mentioned in the press release on the sale, despite the legal issues and financial distress it faced, the company was ultimately able to sell its assets for 2.6 times revenue, a multiple typically reserved for healthy companies in its industry. It never could have achieved that sale price, or perhaps any price, without a bankruptcy sale process given the cloud of the government investigation.  Chapter 11 bankruptcy may be considered a last resort, but there are times when it is simply the best way to address a company’s financial and legal problems.

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The Summer 2012 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has now been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

• Decisions from courts in Delaware and California interpreting the Supreme Court's 2011 Stern v. Marshall decision and its impact on the ability of bankruptcy courts to enter final judgments in fraudulent transfer and other cases;
• The Section 546(e) defense to fraudulent transfer claims; and
• Issues involving the recharacterization of a non-insider's loans as equity.

This edition also reports on some of our recent representations, including our work for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others. Recent committee cases include Ritz Camera & Image, Blockbuster, Orchard Brands, Wave 2 Wave Communications, Signature Styles, Urban Brands, and Mervyn's Holdings, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

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When a company is facing financial distress, the question often comes up whether creditors can "force" the company into bankruptcy. Although the answer is more complicated than it may seem, this post aims to sort out what being "forced into bankruptcy" really means (hint: there are two different ways this can happen) and why it matters to companies and creditors.

Forced But Voluntary Bankruptcy. When a company is "forced" into bankruptcy, often what actually has happened is that the company filed a voluntary bankruptcy petition under Chapter 11 (reorganization) or Chapter 7 (liquidation) of the U.S. Bankruptcy Code in response to creditor actions. For example, a secured lender may have declared a default under its loan documents and commenced foreclosure proceedings, or an unsecured creditor may have filed a lawsuit or obtained a judgment against the company. In response, the company filed bankruptcy.

While it may be fair to describe the company as having been "forced" into bankruptcy, technically the company's board of directors made a voluntary decision to file bankruptcy given the company's financial circumstances or creditor actions. The distinction is important because a voluntary bankruptcy filing puts the company in bankruptcy immediately, making it subject to the Bankruptcy Code's provisions and the bankruptcy court's supervision. In contrast, the other kind of bankruptcy -- an involuntary bankruptcy filing -- does not. 

A Truly Involuntary Bankruptcy. This begs the question: if the company does not consent, can creditors literally force a company into bankruptcy anyway? The answer is yes, under certain circumstances, and subject to meeting the requirements for filing an involuntary bankruptcy petition. The major requirements, discussed below, are found in Section 303 of the Bankruptcy Code.

• Required number of creditors. The Bankruptcy Code specifies the minimum number of creditors and amount of their claims: 
  • If a company has 12 or more creditors, an involuntary bankruptcy petition requires (a) three or more creditors whose claims are not contingent as to liability or subject to a bona fide dispute as to either liability or amount to file the petition, and (b) those qualifying claims must total, in the aggregate, at least $14,425 if unsecured or $14,425 more than the value of any liens securing those claims if any are secured.
  • If the company has fewer than 12 creditors, it only takes one qualifying creditor to file an involuntary petition.
  • Additional creditors can join the petition later, and if only one creditor files and it turns out that the company has more than 12 creditors, the bankruptcy court will give other creditors an opportunity to join.
  • The $14,425 amount is adjusted every three years, with the next adjustment due in April 2013.
• Generally Not Paying Debts. If the company timely objects to the involuntary filing, for the company to be placed in bankruptcy, the company also must: 
  • generally not be paying its debts as they become due unless those debts are subject to a bona fide dispute as to liability or amount, or
  • have had a custodian appointed within the past 120 days to take possession or control of substantially all of its assets.
• Choosing The Chapter. In the involuntary petition, the petitioning creditors must designate which bankruptcy chapter (Chapter 7 or 11) into which they seek to force the company.

How Is An Involuntary Different? When an involuntary petition is filed, the automatic stay of bankruptcy kicks in immediately to prevent creditor actions, but that's where the similarities with voluntary bankruptcy end.

• Unlike a voluntary bankruptcy filing, when an involuntary bankruptcy petition is filed, a company is not immediately placed into bankruptcy and the company may continue to operate its business and use, acquire, or dispose of its property as if an involuntary bankruptcy case had not been filed.
• Instead, an involuntary bankruptcy petition functions more like a complaint asking the court to declare that the company should be put into bankruptcy. Like a complaint, the involuntary petition must be served together with a summons.
• Although the bankruptcy court has the authority to appoint an interim trustee or order other restrictions on the company, those do not automatically apply, have to be sought by motion, and may be denied by the bankruptcy court.
• The company can consent to the involuntary bankruptcy filing. When an involuntary Chapter 7 filing is made, the company can also respond with its own voluntary Chapter 11 filing and take control over the case as a debtor in possession.
• To contest an involuntary petition, the company must do so within the time allotted by the Federal Rules of Bankruptcy Procedure, currently 21 days after service of the summons. Typically that involves filing an answer or a motion to dismiss.
• Litigation over whether the requirements discussed above have been met, and thus whether the company should be put in bankruptcy, can involve various pleadings, document and deposition discovery, status conferences, motions for summary judgment, and/or an evidentiary hearing or trial. 
• If the bankruptcy court ultimately rules in favor of the petitioning creditors, an "order for relief" is entered and the company is officially placed into bankruptcy. At that point, the company is subject to the Bankruptcy Code's provisions and supervision by the bankruptcy court.

What If The Involuntary Fails? Filing an involuntary bankruptcy petition against a company is, of course, serious business, and the consequences of failing are equally serious.

• Once filed, an involuntary petition cannot be dismissed without a notice and an opportunity for a hearing, even if the petitioning creditors and the company agree.
• If the involuntary petition is dismissed, the petitioning creditors can be liable for costs and attorney's fees of the company.
• If the bankruptcy court determines that the involuntary petition was filed in bad faith, the petitioning creditors can be liable as well for damages caused by the involuntary filing and even for punitive damages.

When Do Creditors Typically File An Involuntary? The prospect of creditor liability for costs, attorney's fees, damages, and possibly punitive damages makes involuntary petitions one of the lesser-used creditor tools. Involuntary bankruptcy is most often used when unsecured creditors suspect fraud on the part of a company, such as when a Ponzi scheme is discovered, or for some other extraordinary reason. Otherwise, creditors will typically pursue collection of their own claims directly, including through litigation in state or federal court. That might end up "forcing" the company into bankruptcy, but technically it would be a bankruptcy of the voluntary kind.

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Creditor Derivative Claims Against Fiduciaries Of Insolvent Corporate Entities. In a 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency." 

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation's directors. That led many to wonder whether the same ruling would be extended to managers of Delaware limited liability companies ("LLCs"), the LLC equivalent of a corporation's directors. 

The Chancery Court's Decision. In November 2010, the Delaware Chancery Court answered the question, somewhat surprisingly, with a decisive "no." In CML V, LLC v. Bax, 6 A.3d 238 (Del.Ch. 2010), the Chancery Court held that creditors could not bring derivative actions for breach of fiduciary duty against managers of insolvent LLCs, chiefly because the relevant Delaware LLC Act provision limited standing to bring such suits only to LLC members and their assignees. For a discussion of the Chancery Court decision, follow the link to a November 2010 post on the blog entitled "New Ruling Finds Important Protection For Managers Of Insolvent Delaware LLCs."

The Delaware Supreme Court Decision. The decision was appealed to the Delaware Supreme Court. On September 2, 2011, the Delaware Supreme Court issued an opinion analyzing the Delaware LLC Act and affirming the Chancery Court's decision. A copy of the Delaware Supreme Court's opinion is available through this link.

• The Delaware Supreme Court held that the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, limits standing to bring derivative claims only to LLC members and their assignees because the LLC Act provides that only they are "proper plaintiffs." The Delaware Supreme Court held that this statute was unambiguous and expressly limits standing only to LLC members and their assignees. The creditor plaintiff argued that it was "absurd" for the result to be different as between a corporation and LLC, but the Delaware Supreme Court held that the Delaware General Assembly "was well suited to make that policy choice and we must honor that choice." 
• The plaintiff also claimed that by limiting standing, the statute violated the Delaware Constitution's prohibition against curtailing the Chancery Court's jurisdiction to less than the general equity jurisdiction of the High Court of Chancery of Great Britain as it existed in 1792, when Delaware ratified its first constitution. The Delaware Supreme Court rejected the argument holding that, among other reasons, Delaware limited liability companies, unlike corporations, came into existence only in 1992 and therefore did not exist in 1792. In addition, the LLC statute was properly able to both grant and limit derivative standing.

Creditor Options. Recognizing that this standing provision could limit creditor remedies in the event of insolvency, the Delaware Supreme Court discussed one remedial option available to creditors. In footnote 20 of the opinion, the Court stated:

Admittedly, this approach is not the only option the General Assembly had, and we make no normative comment on the General Assembly's policy choice. Our only purpose here is to explain that limiting derivative standing to members and assignees in a contractual entity like an LLC is not absurd because other interest holders--like creditors--have other options--as, for example, negotiating automatic assignment of membership interests upon insolvency clauses into the credit agreement and requiring the members and governing board to amend the LLC agreement accordingly.

Key Observations. As the Delaware Supreme Court noted, certain creditors may require that the LLC agreement be amended to provide for automatic assignment of membership interests to the creditors upon insolvency. If so, those creditors would then have standing to bring derivative claims. However, absent such provisions, under the Delaware Supreme Court's decision:

• Managers of a Delaware LLC will not be subject to derivative claims by creditors if the entity becomes insolvent, although it is far less certain that the standing statute would preclude a bankruptcy trustee from bringing claims on behalf of the LLC itself;
• An insolvent LLC's creditors will not have derivative standing to bring potential D&O type claims; and
• These creditors will be limited to contractual remedies against the LLC to protect themselves. 

Although Delaware LLCs and corporations share many common features, this new Delaware Supreme Court decision makes clear that the automatic derivative standing of creditors upon insolvency is one important distinction.

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The Spring 2011 edition of the Absolute Priority newsletter, published by the Cooley LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy and insolvency topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

• Recent case law on third-party releases in bankruptcy plans;
• Treatment of make-whole and no-call provisions in bankruptcy;
• Breach of fiduciary duty claims against managers of insolvent Delaware LLCs; and
• Ordinary course of business defense to preferences.

This edition also reports on some of our recent representations, including the successful Chapter 11 reorganization of our client, retailer Crabtree & Evelyn, Ltd., and our work for official committees of unsecured creditors in Chapter 11 bankruptcy cases involving major retailers and others. Recent committee cases include Blockbuster, Orchard Brands, Ultimate Electronics, Claim Jumper Restaurants, OTC Holdings, Urban Brands, Mervyn's Holdings, Sierra Snowboard, Trade Secrets, Mt. Diablo YMCA, and Pacific Metro, among others.

I hope you find the latest edition of Absolute Priority to be of interest.

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Derivative Claims Against Directors Of An Insolvent Delaware Corporation. With its 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007), the Delaware Supreme Court held that directors of an insolvent Delaware corporation could be sued derivatively by creditors for breaches of fiduciary duty. To read that decision, click on the case name in the prior sentence. For a discussion of the case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

What About LLCs? The Gheewalla decision clarified that creditors of a Delaware corporation that is insolvent (but not one only in the "zone of insolvency") can assert derivative claims against the corporation's directors, but a question remained: Would that same ruling extend to managers of Delaware limited liability companies, the LLC equivalent of a corporation's directors. Although a number of commentators and some court decisions assumed that it would, a recent Delaware Chancery Court decision has answered the question, somewhat surprisingly, with a decisive "no."

New Chancery Court Ruling. In the new decision, CML V, LLC v. Bax, C.A. No. 5373-VCL (Del.Ch. Nov. 3, 2010), the Delaware Chancery Court undertook an extensive analysis of the Delaware LLC Act and also examined the issue more broadly.

• The Court held that under the literal terms of the Delaware LLC Act, specifically 6 Del. C. section 18-1002, only LLC members and their assignees have standing to bring derivative claims because the LLC Act provides that only they are "proper plaintiffs." The LLC Act does not give an insolvent LLC's creditors standing to bring derivative claims. The situation is different for creditors of insolvent corporations because the governing Delaware corporation statutes do not impose exclusive derivative standing provisions.
• Although the Chancery Court acknowledged that arguments could be made for allowing creditors to bring derivative actions against managers of an insolvent LLC, the Court saw no reason to set aside the literal reading of the LLC Act's standing provision. The Court also noted that the Delaware Limited Partnership Act has a similar exclusive standing provision.

For a full discussion of the decision, including a link to the opinion itself, be sure to read Francis G.X. Pileggi's excellent post entitled "Chancery Bars Derivative Claim of Creditor Against Insolvent LLC, Based on LLC Act."  

Impact On An Insolvent LLC's Creditors. So where does this new decision leave creditors of an insolvent Delaware LLC?

• Under the Chancery Court decision, unlike directors of a Delaware corporation, managers of a Delaware LLC are not be subject to derivative claims by creditors if the entity becomes insolvent. 
• If the decision is followed by other courts -- specifically including bankruptcy courts where claims involving managers of bankrupt LLCs may more often be litigated -- then an insolvent LLC's creditors will not have access to potential D&O type claims. Instead, those creditors will have to rely on contractual remedies against the LLC to protect themselves. 

Stay Tuned. As noted, the bankruptcy court is often the forum where insolvency-related matters are litigated. Should these claims be pursued outside of the Chancery Court, it will be interesting to see how other courts interpret the Delaware LLC Act's provisions. 

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As I have reported over the past several years, Delaware courts, including the Delaware Supreme Court, have addressed the nature of a director's fiduciary duties when a Delaware corporation is insolvent or in the "zone of insolvency," most notably with the 2007 decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 930 A.2d 92 (Del. 2007). To read that decision, click on the case name in the prior sentence. For a discussion of that case, you may find this earlier post of interest: "Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency."

California courts, however, did not have occasion to consider fiduciary duty issues involving directors of financially distressed California corporations until recently. In a decision called Berg & Berg Enterprises, LLC v. Boyle, the California Court of Appeal for the Sixth Appellate District has provided directors of California corporations facing potential insolvency with meaningful guidance on the scope of their fiduciary duties, including the application of California's "trust fund doctrine." 

• Click on the link in this sentence for a complete discussion of this California decision and the guidance it gives directors of distressed California corporations, which we recently published at the Bankruptcy & Restructuring group of Cooley Godward Kronish LLP.
• Follow the link this sentence for a copy of the Berg & Berg Enterprises decision itself.

It will be interesting to see whether other California courts, perhaps eventually including the California Supreme Court, will have opportunity in the months and years ahead to consider these important issues to directors and officers.

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With the economy suffering through the longest recession since the 1930s, it's little wonder that much of the merger and acquisition ("M&A") activity these days has been focused on distressed companies. The Chrysler and General Motors cases may be the best-known examples, but Chapter 11 bankruptcy is frequently used by companies large and small to sell assets through Section 363 sales. The important intersection between bankruptcy and M&A deals in today's business climate was recently made the focus of an article in the Wall Street Journal, aptly called "Barbarians in Bankruptcy Court."

Although Section 363 sales are quite common, some distressed companies are able to complete an asset sale outside of bankruptcy. The sale may be made directly by the company, or the seller may actually be a lender foreclosing on its collateral under the Uniform Commercial Code. In still other situations, the seller may be an assignee acting through a general assignment for the benefit of creditors under state law.

Regardless of the path chosen, the landscape of distressed asset purchases can be significantly different from that traversed by many traditional M&A lawyers and, most importantly, their clients. Fortunately, one of my M&A partners at Cooley Godward Kronish LLP with significant experience in distressed acquisitions, Jennifer Fonner DiNucci, has recently written an insightful article on the subject. Entitled "Balancing the Risks and Benefits of Transactions Involving Distressed Companies," the article discusses the unique challenges -- and opportunities -- posed by distressed asset acquisitions. It also highlights some of the major issues that potential asset buyers encounter when dealing with a distressed seller, and points out key differences between distressed transactions and more traditional M&A deals with solvent companies.

The article makes for interesting -- and timely -- reading for anyone considering a purchase of assets from a distressed company.

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The Fall 2008 edition of the Absolute Priority newsletter, published by the Cooley Godward Kronish LLP Bankruptcy & Restructuring group, of which I am a member, has just been released. The newsletter gives updates on current developments and trends in the bankruptcy and workout area. Follow the links in this sentence to access a copy of the newsletter or to register to receive future editions. You can also subscribe to the blog to learn when future editions of the Absolute Priority newsletter are published, as well as to get updates on other bankruptcy topics.

The latest edition of Absolute Priority covers a range of cutting edge topics, including:

• Claims and defenses under the WARN Act;
• The Supreme Court's decision on transfer taxes and bankruptcy sales;
• Section 363 "free and clear" sales in bankruptcy; and
• The interplay between claim objections and the Section 503(b)(9) "20 day goods" administrative claim.

This edition also has information on some of our recent representations of official committees of unsecured creditors in Chapter 11 bankruptcy cases involving major retailers. These include Mervyn's, Boscov's, Hancock Fabrics, Steve & Barry's, Goody's, Sharper Image, The Bombay Company, and Shoe Pavilion, among others. In addition, a note from my partner Adam Rogoff, the editor of Absolute Priority, discusses how the current economic problems will require lenders, unsecured creditors, and others to consider the impact of Chapter 11 bankruptcy on their rights.

I hope you find this latest edition of Absolute Priority to be a helpful resource.

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In many Chapter 11 bankruptcy cases, unsecured creditors investigate whether a basis exists to recharacterize existing secured debt as equity. The reason? A successful challenge can turn first or second lien secured debt into "back-of-the-line" capital contributions, enabling unsecured creditors to realize a much greater recovery. A recent article by two of my Bankruptcy & Restructuring Group colleagues at Cooley Godward Kronish LLP, Ronald R. Sussman and Michael A. Klein, digs deeper into the complex issues behind these claims.

Appearing in the October 2008 edition of The Journal of Corporate Renewal published by the Turnaround Management Association, the article is entitled "Recharacterization Battles Likely in Next Round of Bankruptcies." You can access a copy of the article, reprinted with permission of The Journal of Corporate Renewal (© 2008, The Journal of Corporate Renewal), by clicking on its title in the prior sentence. It first discusses the concept of recharacterization itself, including the key factors courts typically apply. Next, the article compares recharacterization to the doctrine of equitable subordination under Section 510(c) of the Bankruptcy Code and examines some of the key differences between the two.

After setting the stage, the article then looks ahead to what appears to be a coming wave of bankruptcy cases. It focuses on how future efforts by unsecured creditors to challenge second lien loans -- a type of financing that has become a major part of corporate capital structures over the past several years -- may fare:

The next wave of bankruptcies undoubtedly will include attempts by unsecured creditors to recharacterize second lien debt as equity, especially when the second lien holder is an insider of the debtor. However, the current framework established by Bankruptcy Courts presents significant obstacles to unsecured creditors seeking to knock out the second lien claims of lenders that provided capital on a purportedly secured basis to a struggling debtor that was unable to find capital from alternative sources.

The article observes that, given the present state of the law, courts will have to embrace a more flexible legal standard if unsecured creditors are to have success in recharacterizing second lien debt as equity. It concludes by offering a different approach for addressing recharacterization with this new landscape in mind. Unsecured creditors, lenders, insolvency professionals and others confronting these issues will find the article to be a helpful and interesting read.

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When insolvent companies are unable to make payroll or to pay accrued vacation or other amounts owed employees, the question often arises whether directors, officers, or shareholders face personal liability for these unpaid amounts. The California Court of Appeal recently addressed that issue, examining whether particular sections of the California Labor Code, as well as section 17200 of the Business and Professions Code (California's unfair competition law), impose personal liability.

The Court of Appeal Decision. In its April 2008 decision in Bradstreet v. Wong, the Court of Appeal for the First Appellate District held that owners, officers, and managers of an insolvent company, which later filed bankruptcy, were not personally liable for unpaid wages, overtime, vacation pay, and other amounts based on a series of alleged California Labor Code violations. The Court also ruled that these individuals were not liable to pay restitution under Business and Professions Code section 17200. A copy of the Court of Appeal's opinion is available here.

Risks Remain. Although the decision is a favorable one for officers and directors, risks remain. Be sure to read the informative discussion written by my colleagues in the Employment & Labor Group at Cooley Godward Kronish LLP for a careful analysis of the decision. As they explain, despite this new decision, and the California Supreme Court's 2005 decision on similar issues in the Reynolds v. Bement case, it's possible that directors and officers may still face a risk of individual liability under other California Labor Code sections or based on different legal theories. Depending on the facts and statutes involved, there may also be individual liability under federal law or the laws of other states.

Get Advice. The issues presented when an insolvent company is, or might be, unable to pay wages are complicated. Directors and officers of a company facing this situation should be sure to get both insolvency and employment law advice to help guide them, and the company, through these difficult straits.

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David Feinlieb of Mohr Davidow Ventures has an interesting post on his Tech, Startups, Capital, Ideas blog entitled "Why Startups Fail." David highlights four main reasons around his general theme of "they run out of money":

• They spend too much on sales and marketing before they're ready.
• The market outpaces the startup's ability to execute.
• There is no entrepreneur.
• The market takes too long to develop.

David's explanations behind each of these headlines are incisive and thought-provoking, and they underscore the challenging road startups must travel. I would add to the list the impact an industry or general economic slowdown can have on a particular startup, including when it comes to raising additional capital. (For more on the topic, you may find interesting an earlier post discussing the views of another VC on why early stage businesses fail and another one examining how a recession may affect investment decisions of VCs.)

On a similar theme is a post by Brad Feld of Foundry Ventures entitled "Do VCs Fund Entrepreneurs Who Have Failed At Previous Ventures?" over at the Ask The VC blog. Thanks to Brad as well for first blogging on David Feinlieb's post on startups, where Brad observes that "we are heading for another wave of failure as companies run out of gas after their Series B / Series C rounds and their investors lose patience with them."

Brad sums up his views this way on the topic of funding entrepreneurs with a prior failed business:

My favorite entrepreneurs to fund are those that have had at least one success and one failure.  While it is a cliche, failure teaches the big lessons.  Most importantly, entrepreneurs that have some failure under their belt have humility and perspective that I think is deeply useful in the creation of the company.

Startups are inherently risky, even in a strong economic climate. As the potentially recessionary economy produces more failed startups, it's especially valuable to have insights and perspectives like these from experienced VCs.

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Companies in financial trouble are often forced to liquidate their assets to pay creditors. While a Chapter 11 bankruptcy sometimes makes the most sense, other times a Chapter 7 bankruptcy is required, and in still other situations a corporate dissolution may be best. This post examines another of the options, the assignment for the benefit of creditors, commonly known as an "ABC."

A Few Caveats. It's important to remember that determining which path an insolvent company should take depends on the specific facts and circumstances involved. As in many areas of the law, one size most definitely does not fit all for financially troubled companies. With those caveats in mind, let's consider one scenario sometimes seen when a venture-backed or other investor-funded company runs out of money.

One Scenario. After a number of rounds of investment, the investors of a privately held corporation have decided not to put in more money to fund the company's operations. The company will be out of cash within a few months and borrowing from the company's lender is no longer an option. The accounts payable list is growing (and aging) and some creditors have started to demand payment. A sale of the business may be possible, however, and a term sheet from a potential buyer is anticipated soon. The company's real property lease will expire in nine months, but it's possible that a buyer might want to take over the lease.

• A Chapter 11 bankruptcy filing is problematic because there is insufficient cash to fund operations going forward, no significant revenues are being generated, and debtor in possession financing seems highly unlikely unless the buyer itself would make a loan. 
• The board prefers to avoid a Chapter 7 bankruptcy because it's concerned that a bankruptcy trustee, unfamiliar with the company's technology, would not be able to generate the best recovery for creditors.

The ABC Option. In many states, another option that may be available to companies in financial trouble is an assignment for the benefit of creditors (or "general assignment for the benefit of creditors" as it is sometimes called). The ABC is an insolvency proceeding governed by state law rather than federal bankruptcy law.

California ABCs. In California, where ABCs have been done for years, the primary governing law is found in California Code of Civil Procedure sections 493.010 to 493.060 and sections 1800 to 1802, among other provisions of California law. California Code of Civil Procedure section 1802 sets forth, in remarkably brief terms, the main procedural requirements for a company (or individual) making, and an assignee accepting, a general assignment for the benefit of creditors:

1802.  (a) In any general assignment for the benefit of creditors, as defined in Section 493.010, the assignee shall, within 30 days after the assignment has been accepted in writing, give written notice of the assignment to the assignor's creditors, equityholders, and other parties in interest as set forth on the list provided by the assignor pursuant to subdivision (c).
   (b) In the notice given pursuant to subdivision (a), the assignee shall establish a date by which creditors must file their claims to be able to share in the distribution of proceeds of the liquidation of the assignor's assets.  That date shall be not less than 150 days and not greater than 180 days after the date of the first giving of the written notice to creditors and parties in interest.
   (c) The assignor shall provide to the assignee at the time of the making of the assignment a list of creditors, equityholders, and other parties in interest, signed under penalty of  perjury, which shall include the names, addresses, cities, states, and ZIP Codes for each person together with the amount of that person's anticipated claim in the assignment proceedings.

In California, the company and the assignee enter into a formal "Assignment Agreement." The company must also provide the assignee with a list of creditors, equityholders, and other interested parties (names, addresses, and claim amounts). The assignee is required to give notice to creditors of the assignment, setting a bar date for filing claims with the assignee that is between five to six months later.

ABCs In Other States. Many other states have ABC statutes although in practice they have been used to varying degrees. For example, ABCs have been more common in California than in states on the East Coast, but important exceptions exist. Delaware corporations can generally avail themselves of Delaware's voluntary assignment statutes, and its procedures have both similarities and important differences from the approach taken in California. Scott Riddle of the Georgia Bankruptcy Law Blog has an interesting post discussing ABC's under Georgia law. Florida is another state in which ABCs are done under specific statutory procedures. For an excellent book that has information on how ABCs are conducted in various states, see Geoffrey Berman's General Assignments for the Benefit of Creditors: The ABCs of ABCs, published by the American Bankruptcy Institute.

Important Features Of ABCs. A full analysis of how ABCs function in a particular state and how one might affect a specific company requires legal advice from insolvency counsel. The following highlights some (but by no means all) of the key features of ABCs:

• Court Filing Issue. In California, making an ABC does not require a public court filing. Some other states, however, do require a court filing to initiate or complete an ABC.
• Select The Assignee. Unlike a Chapter 7 bankruptcy trustee, who is randomly appointed from those on an approved panel, a corporation making an assignment is generally able to choose the assignee.
• Shareholder Approval. Most corporations require both board and shareholder approval for an ABC because it involves the transfer to the assignee of substantially all of the corporation's assets. This makes ABCs impractical for most publicly held corporations.
• Liquidator As Fiduciary. The assignee is a fiduciary to the creditors and is typically a professional liquidator.
• Assignee Fees. The fees charged by assignees often involve an upfront payment and a percentage based on the assets liquidated.
• No Automatic Stay. In many states, including California, an ABC does not give rise to an automatic stay like bankruptcy, although an assignee can often block judgment creditors from attaching assets.
• Event Of Default. The making of a general assignment for the benefit of creditors is typically a default under most contracts. As a result, contracts may be terminated upon the assignment under an ipso facto clause.
• Proof Of Claim. For creditors, an ABC process generally involves the submission to the assignee of a proof of claim by a stated deadline or bar date, similar to bankruptcy. (Click on the link for an example of an ABC proof of claim form.)
• Employee Priority. Employee and other claim priorities are governed by state law and may involve different amounts than apply under the Bankruptcy Code. In California, for example, the employee wage and salary priority is $4,300, not the $10,950 amount currently in force under the Bankruptcy Code.
• 20 Day Goods. Generally, ABC statutes do not have a provision similar to that under Bankruptcy Code Section 503(b)(9), which gives an administrative claim priority to vendors who sold goods in the ordinary course of business to a debtor during the 20 days before a bankruptcy filing. As a result, these vendors may recover less in an ABC than in a bankruptcy case, subject to assertion of their reclamation rights.
• Landlord Claim. Unlike bankruptcy, there generally is no cap imposed on a landlord's claim for breach of a real property lease in an ABC.
• Sale Of Assets. In many states, including California, sales by the assignee of the company's assets are completed as a private transaction without approval of a court. However, unlike a bankruptcy Section 363 sale, there is usually no ability to sell assets "free and clear" of liens and security interests without the consent or full payoff of lienholders. Likewise, leases or executory contracts cannot be assigned without required consents from the other contracting party.
• Avoidance Actions. Most states allow assignees to pursue preferences and fraudulent transfers. However, the U.S. Court of Appeals for the Ninth Circuit has held that the Bankruptcy Code pre-empts California's preference statute, California Code of Civil Procedure section 1800. Nevertheless, to date the California state courts have refused to follow the Ninth Circuit's decision and still permit assignees to sue for preferences in California state court. In February 2008, a Delaware state court followed the California state court decisions, refusing either to follow the Ninth Circuit position or to hold that the California preference statute was pre-empted by the Bankruptcy Code. The Delaware court was required to apply California's ABC preference statute because the avoidance action arose out of an earlier California ABC.

The Scenario Revisited. With this overview in mind, let's return to our company in distress.

• The prospect of a term sheet from a potential buyer may influence whether our hypothetical company should choose an ABC or another approach. Some buyers will refuse to purchase assets outside of a Chapter 11 bankruptcy or a Chapter 7 case. Others are comfortable with the ABC process and believe it provides an added level of protection from fraudulent transfer claims compared to purchasing the assets directly from the insolvent company. Depending on the value to be generated by a sale, these considerations may lead the company to select one approach over the other available options.
• In states like California where no court approval is required for a sale, the ABC can also mean a much faster closing -- often within a day or two of the ABC itself provided that the assignee has had time to perform due diligence on the sale and any alternatives -- instead of the more typical 30-60 days required for bankruptcy court approval of a Section 363 sale. Given the speed at which they can be done, in the right situation an ABC can permit a "going concern" sale to be achieved.
• Secured creditors with liens against the assets to be sold will either need to be paid off through the sale or will have to consent to release their liens; forced "free and clear" sales generally are not possible in an ABC.
• If the buyer decides to take the real property lease, the landlord will need to consent to the lease assignment. Unlike bankruptcy, the ABC process generally cannot force a landlord or other third party to accept assignment of a lease or executory contract.
• If the buyer decides not to take the lease, or no sale occurs, the fact that only nine months remains on the lease means that this company would not benefit from bankruptcy's cap on landlord claims. If the company's lease had years remaining, and if the landlord were unwilling to agree to a lease termination approximating the result under bankruptcy's landlord claim cap, the company would need to consider whether a bankruptcy filing was necessary to avoid substantial dilution to other unsecured creditor claims that a large, uncapped landlord claim would produce in an ABC.
• If the potential buyer walks away, the assignee would be responsible for determining whether a sale of all or a part of the assets was still possible. In any event, assets would be liquidated by the assignee to the extent feasible and any proceeds would be distributed to creditors in order of their priority through the ABC's claims process.
• While other options are available and should be explored, an ABC may make sense for this company depending upon the buyer's views, the value to creditors and other constituencies that a sale would produce, and a clear-eyed assessment of alternative insolvency methods. 

Conclusion. When weighing all of the relevant issues, an insolvent company's management and board would be well-served to seek the advice of counsel and other insolvency professionals as early as possible in the process. The old song may say that ABC is as "easy as 1-2-3," but assessing whether an assignment for the benefit of creditors is best for an insolvent company involves the analysis of a myriad of complex factors.

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For a number of years, the concept of deepening insolvency has been one of the more hotly debated issues in the insolvency arena. Two of my colleagues in the Bankruptcy & Restructuring group at Cooley Godward Kronish LLP, Michael Klein and Ronald Sussman, have written an interesting article entitled "Tide Has Turned On Deepening Insolvency - Courts Now Rejecting Theory As Cause Of Action," published in the February 2008 issue of the Journal of Corporate Renewal by the Turnaround Management Association. You can read the article by clicking on its title above.

The article gives a succinct overview of the impact of last year's Delaware Supreme Court decisions in the North American Catholic Educational Programming, Inc. v. Gheewalla and Trenwick America cases (as well as the Chancery Court's Trenwick decision that was adopted by the Supreme Court). In particular, the article describes how the Gheewalla decision altered the "zone of insolvency" analysis and how Trenwick's rejection of deepening insolvency as a cause of action in Delaware has led courts in other jurisdictions to follow suit. Directors of financially troubled companies and their counsel will find the article an informative read.

For more information on the Gheewalla decision, including a copy of the Delaware Supreme Court's opinion, click here. For more on the Trenwick decision, including copies of the Delaware Supreme Court order and Chancery Court opinion, click here.

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This post examines a new decision from the Bankruptcy Court for the Southern District of Florida involving the enforceability of a pre-bankruptcy waiver of the automatic stay. Let's first set the stage by taking a look at a not so uncommon fact pattern involving a real estate project in financial trouble.

The Real Estate Workout: Forbearance With A Price. The owner of a troubled real estate development is about to default on a loan secured by the real property. On the eve of foreclosure, the lender agrees to forbear from foreclosing for two months to give the developer time to refinance and save the project.  However, in exchange the lender insists that the developer agree that, in the event of bankruptcy, the lender would have relief from the automatic stay to foreclose. The developer agrees and the forbearance agreement is executed.

The Bankruptcy Aftermath. Unfortunately, the hoped-for financing falls through and the developer files a Chapter 11 bankruptcy for the project just before the rescheduled foreclosure sale. The lender quickly files a motion for relief from stay, asking the bankruptcy court to enforce the pre-bankruptcy relief from stay waiver included in the forbearance agreement. The motion is opposed by the developer, now a Chapter 11 debtor in possession, as well as the official committee of unsecured creditors and junior lienholders.

Is The Waiver Of The Automatic Stay Enforceable? This was the question answered by Bankruptcy Judge John K. Olson in an 18-page decision, issued on February 12, 2008, in the In re Bryan Road, LLC Chapter 11 bankruptcy case. The facts were essentially as described above, but a few additional details help put the issue in context.

• The real estate project involved a 210 unit "dry stack" boat storage facility in Dania Beach, Florida.
• The lender, which commenced a judicial foreclosure proceeding against the 191 units still owned by the debtor, had been awarded final judgment setting a foreclosure sale.
• On the morning of the foreclosure sale, the debtor and the lender entered into a forbearance agreement that was approved by the court in the foreclosure proceeding. The forbearance agreement provided for a two-month continuance of the foreclosure sale in exchange for the debtor's agreement that the lender would have relief from the automatic stay to foreclose in the event of a bankruptcy.
• The day before the continued foreclosure sale was to take place, the debtor filed its bankruptcy petition.

The Bankruptcy Court's Analysis. In his decision on the lender's stay relief motion, Judge Olson first noted that prepetition waivers of the stay will be given "no particular effect as part of initial loan documents" but the "greatest effect if entered into during the course of prior (and subsequently aborted) chapter 11 proceedings." After concluding that a confirmed chapter 11 plan was not required, the Bankruptcy Court looked to four non-exclusive factors, drawn from In re Desai, 282 B.R. 527 (Bankr. S.D. Ga. 2002), in considering whether stay relief should be granted based on the prepetition waiver:

(1) the sophistication of the party making the waiver; (2) the consideration for the waiver, including the creditor's risk and the length of time the waiver covers; (3) whether other parties are affected including unsecured creditors and junior lienholders; and (4) the feasibility of the debtor's plan.

As to the first two factors, the Bankruptcy Court found that the debtor's counsel was very sophisticated and, although the forbearance period was short, it was sufficient consideration. On the third and fourth factors, the Bankruptcy Court first noted the existence of junior lienholders and approximately $1 million of disputed unsecured claims. However, the Bankruptcy Court then engaged in a detailed analysis leading to the conclusion that the debtor's plan simply was not feasible. As such, there likely was no value for unsecured creditors in the boat storage project beyond the secured debt and the junior lienholders could protect their own interests under state law. Putting these factors together, the Bankruptcy Court concluded that the forbearance agreement -- including the waiver of the automatic stay -- should be enforced and the stay was lifted.

A Few Key Take-Aways. With economic conditions continuing to strain a variety of real estate developments, workouts in the shadow of foreclosure may become more common. The In re Bryan Road, LLC decision highlights that in the right case a bankruptcy court may be willing to enforce prepetition stay relief agreements if a bankruptcy is later filed.

• This is particularly true when the debtor is a single asset real estate entity, it signs an agreement on the eve of foreclosure, and it has few unsecured creditors. In fact, the more the bankruptcy appears to be just a two-party dispute between the debtor and lender, the more likely the prepetition automatic stay waiver will be enforced.
• On the other hand, when a troubled real estate project has a real chance of reorganizing, and substantial unsecured creditor claims are involved, these agreements more likely will be rejected in favor of traditional relief from stay analysis under Section 362 of the Bankruptcy Code.

Conclusion. Prepetition stay relief agreements involve complex issues. As with most bankruptcy questions, real estate owners and lenders should get advice from bankruptcy counsel on their specific situation when considering whether to include such a waiver of the automatic stay in any forbearance agreement.

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Many technology companies are based in Israel and license intellectual property to companies in the United States and around the world. This raises an interesting question: what happens if the Israeli company, as licensor, goes into bankruptcy or liquidation in Israel? The latest edition of Cross Border Commentary, a publication by the International Business Practice of my firm, Cooley Godward Kronish LLP, has just addressed that very question.

The U.S. Law Answer.  Before turning to Israeli law, let's look at how this issue plays out under the United States Bankruptcy Code. A licensor in bankruptcy or its bankruptcy trustee has the option of assuming (keeping) or rejecting (breaching) a license. Generally, a debtor licensor can assume a license if it meets the same tests (cures defaults and provides adequate assurance of future performance) required to assume other executory contracts.  Many licensees will not have a problem with assumption of their license as long as the debtor can actually continue to perform. Instead, the real concern for licensees is the fear of losing their rights to the licensed IP, which often can be mission critical technology, if the license is rejected.

• Special protections. Recognizing this concern, the United States Bankruptcy Code, in Section 365(n), provides licensees with special protections.  If the debtor or trustee rejects a license, under Section 365(n) a licensee can elect to retain its rights to the licensed intellectual property, including even a right to enforce an exclusivity provision. In return, the licensee must continue to make any required royalty payments. The licensee also can retain rights under any agreement supplementary to the license, which includes source code or other forms of technology escrow agreements.  Taken together, these provisions protect a licensee from being stripped of its rights to continue to use the licensed intellectual property.
• Watch out for trademarks. While many people would expect intellectual property to include trademarks, the Bankruptcy Code has its own limited definition of "intellectual property." The bankruptcy definition includes trade secrets, patents and patent applications, copyrights, and mask works.  Importantly, however, it does not include trademarks. This distinction means that trademark licensees enjoy none of Section 365(n)'s special protections and those licensees are at risk of losing their trademark rights in a bankruptcy. 

For more on these subjects, you may find these earlier posts, "Intellectual Property Licenses: What Happens In Bankruptcy?" and "Trademark Licensor In Bankruptcy: Special Risk For Licensees" of interest.

The Israeli Perspective. An article in Cooley's Cross Border Commentary, prepared by Einat Meisel of the Israeli law firm of Gross, Kleinhendler, Hodak, Berkman and Co., discusses a Tel-Aviv District Court decision involving these issues. When an Israeli company known as Commodio Ltd. entered liquidation, two of its intellectual property licensees sought to retain rights under their license agreements with Commodio. In ruling on the effort, the Israeli court made several important holdings:

• The licensees could continue to use the IP as long as they made required any royalty payments and complied with the terms of use in the agreements, with payments to be made to the liquidator.
• The licensees could gain access to the underlying source code behind the object code covered by their licenses provided this did not impose substantial expense on the company in liquidation.
• No transfer of ownership in the IP could occur due to the liquidation, as this would be contrary to Israeli bankruptcy law.
• A right of first refusal covering certain of the intellectual property would be enforceable in the bankruptcy.

Comparison To A U.S. Bankruptcy. With a few key differences, the outcome in the Commodio case is similar to the treatment under U.S. law. Under Section 365(n)'s provisions, licensees would have the ability to retain their rights to the IP, with any royalty payments being made to the bankruptcy estate. If an agreement contained a source code license, the licensees could also access the source code under Section 365(n). However, absent a license grant to the source code, the outcome would likely be different in a U.S. bankruptcy.  Provisions purporting to transfer ownership of the IP upon a bankruptcy or liquidation would not be enforceable in a U.S. bankruptcy. Finally, the right of first refusal enforced in the Israeli case might not be enforced in a U.S. bankruptcy if the agreement were rejected but could if the license were assumed. 

Get Advice. Licensing intellectual property from a foreign corporation raises a number of issues, including what happens if the foreign licensor goes bankrupt or becomes insolvent. Potential licensees should be sure to get expert advice on the applicable foreign law, including the implications of bankruptcy, when licensing IP from a foreign company. Although licensees from Israeli companies can find some comfort in the Commodio decision, it remains important to get advice on Israeli law specific to your situation. 

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Recent posts from two thought-leading venture capitalists give insights into how VCs approach the impact of a possible recession. The first is from Will Price, a managing director at venture capital firm Hummer Winblad. In his post, titled "Downturn - Now What?" (hat tip: Ask The VC blog), Will offers some very interesting observations, including this one:

If I take the last downturn as my guide, I can say with confidence that venture investors would be well suited to continue to invest right through the downturn - in 2002 and 2003 terrific companies were formed and funded at very reasonable valuations and with business models that reflected the demand for capital efficiency and economic viability.

The second post comes from Jason Mendelson who, together with fellow Foundry Group managing director Brad Feld, publish the Ask The VC blog. This new post, titled "What Is The Effect Of The 'Pending' Recession On Venture Capital Financings Of Private Companies?," examines similar issues. Jason makes a number of thoughtful comments, including:

Now how does this all affect VC financings?  Well, history would tell us that VCs will put less money into funding companies, converse cash and wait until the acquisition and public markets open up a bit.  With a lack of good exits, why would a VC want to invest in a company?  However, that's never made much sense to me, especially if we limit investments to early-staged companies.  I've always thought the best time to invest in young startups is when things are choppy.  You usually can invest at lower prices, hire folks for less than you normally would, etc.  Also, I'd never expect an investment to exit in the near future (1-3 years, for sure) and therefore the company will be well positioned to exit at the end of the recession.  If you wait until the recession is over, you are already paying too much.

For anyone interested in how a recession could impact venture-backed companies, including insolvency professionals who work with the ones that fail, these new posts from two leading venture capitalists make for very informative reading.

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Fred Wilson, a managing director at New York-based venture capital firm Union Square Ventures, has an insightful post entitled "Why Early Stage Venture Investments Fail." It's a rare opportunity to get a venture capital investor's perspective on the reasons startup companies go bust. Fred cites two main reasons:

1) It was a dumb idea and we realized it early on and killed the investment. I've only been involved in one investment in this category personally although I've lived through a bunch like this over the years in the partnerships I've been in.
2) It was a decent idea but directionally incorrect, it was hugely overfunded, the burn rate was taken to levels way beyond reason, and it became impossible to adapt the business in a financially viable manner.

He notes that it's the second reason -- a failure to adapt the business in a way that makes financial sense -- that predominates. Fred highlights the danger caused by allowing companies to run with high burn rates, something my own experience teaches is a common affliction of distressed companies, particularly those in the early, developmental stages before they have substantial revenues to offset the burn.

This post followed another in which Fred discussed his overall early stage failure rate. Both make for interesting reading for anyone looking to understand why businesses fail -- and how to help them succeed.

(Hat tip to Erick Schonfeld for his post on the subject at TechCrunch.)

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A commercial real estate lease often represents the largest single liability of many debtors. For retailers, which typically have scores or even hundreds of store leases, the liability involved is orders of magnitude larger. It's fair to say that the management of lease obligations can be of enormous consequence to debtors, landlords, and other creditors in Chapter 11 bankruptcy cases.

Rejected Leases And The Capped Claim. As explained in an earlier post on how commercial real estate leases are treated in bankruptcy, one of a debtor's options in a Chapter 11 case is to reject uneconomic or otherwise burdensome leases, terminating the debtor's obligation to pay rent and turning the landlord's claim for termination of the lease into a prepetition claim. Section 502(b)(6) of the Bankruptcy Code goes further and caps the landlord's prepetition rejection claim at an amount equal to the greater of (1) one year's rent or (2) fifteen percent of the remaining lease term, up to a maximum of three years' worth of rent. The starting date for calculating the claim is the earlier of the date when the bankruptcy petition was filed or when the landlord recovered possession of, or the tenant surrendered, the premises. A landlord with six years left on a rejected lease, for example, would have its claim capped at one year's worth of rent.

What's Covered By The Cap? This ability to cap a landlord's claim in bankruptcy can be a major benefit to debtor tenants. Ever since a 1995 decision by the Bankruptcy Appellate Panel (BAP) of the Ninth Circuit in In re McSheridan, 184 B.R. 91 (B.A.P. 9th Cir. 1995), debtors have been successful in many cases in capping a variety of claims by landlords. In McSheridan, the BAP held that the cap applied to all damages for the lessee's nonperformance of the lease, not just to claims based on future rent. Landlords have challenged that analysis but, at least in the Ninth Circuit, have had little success -- until this week.

The Ninth Circuit's El Toro Decision. In an eight-page opinion (available here) issued on October 1, 2007 in the In re El Toro Materials Company, Inc. Chapter 11 case,, the U.S. Court of Appeals for the Ninth Circuit took a very different view of the landlord cap under Section 502(b)(6). In the El Toro case, the debtor was a mining company that leased property from the Saddleback Community Church, paying $28,000 per month in rent. After the lease was rejected, Saddleback brought an adversary proceeding against El Toro for $23 million in damages alleging that El Toro left a million tons of wet clay "goo," mining equipment, and other materials on the property.

• The bankruptcy court held that Saddleback's claim, which asserted waste, nuisance, and other tort theories, would not be limited by the Section 502(b)(6) cap. 
• Following its McSheridan precedent, the BAP reversed and held that any damages would be subject to the cap. 
• Interestingly, two of the three judges on the BAP panel filed concurring opinions, voicing doubts about the wisdom of the McSheridan case. A copy of the BAP's unpublished El Toro decision from July 2005 is available here.

Judge Kozinski's Analysis. On appeal, the Ninth Circuit reversed the BAP's decision, holding that the cap did not apply to the landlord's tort claims. Judge Alex Kozinski authored the opinion and analyzed the key issues this way:

The structure of the cap—measured as a fraction of the remaining term—suggests that damages other than those based on a loss of future rental income are not subject to the cap. It makes sense to cap damages for lost rental income based on the amount of expected rent: Landlords may have the ability to mitigate their damages by re-leasing or selling the premises, but will suffer injury in proportion to the value of their lost rent in the meantime. In contrast, collateral damages are likely to bear only a weak correlation to the amount of rent: A tenant may cause a lot of damage to a premises leased cheaply, or cause little damage to premises underlying an expensive leasehold.

One major purpose of bankruptcy law is to allow creditors to receive an aliquot share of the estate to settle their debts. Metering these collateral damages by the amount of the rent would be inconsistent with the goal of providing compensation to each creditor in proportion with what it is owed. Landlords in future cases may have significant claims for both lost rental income and for breach of other provisions of the lease. To limit their recovery for collateral damages only to a portion of their lost rent would leave landlords in a materially worse position than other creditors. In contrast, capping rent claims but allowing uncapped claims for collateral damage to the rented premises will follow congressional intent by preventing a potentially overwhelming claim for lost rent from draining the estate, while putting landlords on equal footing with other creditors for their collateral claims.

The statutory language supports this interpretation. The cap applies to damages “resulting from” the rejection of the lease. 11 U.S.C. § 502(b)(6). Saddleback’s claims for waste, nuisance and trespass do not result from the rejection of the lease—they result from the pile of dirt allegedly left on the property. Rejection of the lease may or may not have triggered Saddleback’s ability to sue for the alleged damages.But the harm to Saddleback’s property existed whether or not the lease was rejected. A simple test reveals whether the damages result from the rejection of the lease: Assuming all other conditions remain constant, would the landlord have the same claim against the tenant if the tenant were to assume the lease rather than rejecting it? Here, Saddleback would still have the same claim it brings today had El Toro accepted the lease and committed to finish its term: The pile of dirt would still be allegedly trespassing on Saddleback’s land and Saddleback still would have the same basis for its theories of nuisance, waste and breach of contract. The million-ton heap of dirt was not put there by the rejection of the lease—it was put there by the actions and inactions of El Toro in preparing to turn over the site.

(Footnotes omitted.)

McSheridan Holding Overruled. The Ninth Circuit opinion noted the two concurrences from the BAP decision questioning McSheridan and suggested that the BAP consider adopting an en banc procedure to reconsider such doubtful precedents. Given the Ninth Circuit's holding, it will come as no surprise that the Court of Appeals also explicitly overruled McSheridan:

To the extent that McSheridan holds section 502(b)(6) to be a limit on tort claims other than those based on lost rent, rent-like payments or other damages directly arising from a tenant’s failure to complete a lease term, it is overruled.

The Ninth Circuit noted that McSheridan also holds that "damages flowing from the failure of a party that has rejected a lease to perform future routine repairs or pay utility bills are capped," but declined to address -- or overrule -- that holding.

Post-El Toro Ramifications.  At least in the Ninth Circuit, with McSheridan overruled landlords will work hard to characterize their damage claims as arising from tort theories or otherwise not being based on "lost rent, rent-like payments or other damages directly arising from a tenant's failure to complete the lease term." At the negotiation stage, when the market permits landlords may demand larger security deposits and letters of credit on the view that the Section 502(b)(6) cap no longer limits every type of damage recoverable against such security. They may also structure leases to separate claims for items such as clean-up costs, hazardous waste removal, property damage, and even tenant improvement repayments from rent claims, in an attempt to bolster the argument that these claims fall outside of the cap.

Conclusion. Like a bull charging a matador, the El Toro decision has ripped a hole in the Section 502(b)(6) cape previously used to turn away cap-busting landlord claims. Time will tell just how significant the decision turns out to be, but at first blush it seems that debtors and non-landlord creditors may be the ones who end up seeing red. 

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Preference lawsuits are filed all the time in bankruptcy cases and the ordinary course of business defense is frequently asserted. Still, it's the rare case that ends up with a federal court of appeals decision addressing jury trial rights and invalidating a bankruptcy court's local rule. This post is about just such a case.

The Bankruptcy Preference. As a quick refresher, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

Jury Trials In Bankruptcy Cases? Preference defendants who do not file proofs of claim in the main bankruptcy case have the option to demand a trial by jury in the preference lawsuit. This is a right protected by the Seventh Amendment to the Constitution. The parties in the lawsuit can consent to having the bankruptcy court conduct the jury trial but this doesn't happen very often. Why would a preference defendant make a jury demand? Here are three common reasons:

• The defendant believes a jury would be more inclined to find in its favor than a bankruptcy judge;
• The defendant wants the case moved to federal district court from the bankruptcy court, which some defendants perceive as more debtor-friendly; and
• Jury trials are more expensive and complex, a fact the preference defendant may hope will translate into settlement leverage.

The HealthCentral.com Case. In a recent case, Sigma Micro Corporation, a company sued for an alleged preference by debtor HealthCentral.com, made just such a jury trial demand. It then filed a motion for certification before the bankruptcy court seeking to have its case moved to the district court, in accordance with Local Rule 9015-2(b) of the United States Bankruptcy Court for the Northern District of California. That Local Rule, entitled "Certification to District Court," provides:

If the Bankruptcy Judge determines that [a] demand was timely made and the party has a right to a jury trial, and if all parties have not filed written consent to a jury trial before the Bankruptcy Judge, the Bankruptcy Judge shall certify to the District Court that the proceeding is to be tried by a jury and that the parties have not consented to a jury trial in the Bankruptcy Court. Upon such certification, [the jurisdictional] reference of the proceeding shall be automatically withdrawn, and the proceeding assigned to a Judge of the District . . . .

The Bankruptcy Court held that Sigma had a right to a jury trial but then stayed its order to retain jurisdiction for pre-trial matters. It later granted the debtor's motion for summary judgment in the preference case, finding no genuine issue of material fact and rejecting Sigma's ordinary course of business defense. On appeal, Sigma argued that the Bankruptcy Court did not have jurisdiction to enter summary judgment because it should have transferred the case to the District Court upon finding that Sigma was entitled to a jury trial. It also argued that it had raised genuine issues of material fact on its ordinary course of business defense, precluding summary judgment.

The Ninth Circuit's Decision. On September 21, 2007, the Ninth Circuit issued its opinion in the case (available here).  In addressing the jurisdiction question, the Ninth Circuit confronted "an issue of first impression in this circuit, that is, the validity of Local Rule 9015-2(b)." After reviewing the right of courts to promulgate local rules, it came to the core of the issue:

Considering these rules we hold Local Rule 9015-2(b) to be invalid as it establishes a procedure for withdrawing the district court’s jurisdictional reference inconsistent with the Acts of  Congress and Federal Rules of Bankruptcy Procedure. Cf. Coffey v. Marina Management Servs. (In re Kool, Mann, Coffee), 23 F.3d 66, 67-69 (3rd Cir. 1994) (finding local rule invalid because of inconsistency with Bankruptcy Code); In re Morrissey, 717 F.2d 100, 104-05 (3rd Cir. 1983) (same).

The Ninth Circuit noted that 28 U.S.C. § 157(d) provides that a "district court" may withdraw the reference of all or a part of a case or proceeding and that Federal Rule of Bankruptcy Procedure 5011(a) expressly states that a "motion for withdrawal of a case or proceeding shall be heard by a district judge." Putting these two provisions together, the Court of Appeals held:

After careful review we find the procedure established by Local Rule 9105-2(b) cannot be squared with the procedure established by 28 U.S.C. § 157(d), an “Act of Congress,” and Rule 5011(a), a “Federal Rule of Bankruptcy Procedure.” Fed. R. Bankr. Proc. 9029. At least two inconsistencies bear mentioning. First, Local Rule 9015-2(b) allows for the bankruptcy court to “withdraw[ ]” the jurisdictional reference, whereas 28 U.S.C. § 157(d) and Rule 5011(a) make it explicit that only a district court may “withdraw” the jurisdictional reference. See FTC v. First Alliance Mortg. Co. (In re First Alliance Mortg. Co.), 282 B.R. 894, 901 (C.D. Cal. 2001) (holding that “a motion [to withdrawal] is heard by the district court”) (emphasis added). Second, Local Rule 9015-2(b) permits a party to obtain a withdrawal of the reference upon a “Motion for Certification,” while 28 U.S.C. § 157(d) and Rule 5011(a) make it clear that a party may only obtain a withdrawal of the reference upon a “Motion for Withdrawal.” See Hawaiian Airlines, Inc. v. Mesa Air Group, Inc., 355 B.R. 214, 218 (D. Hi. 2006) (holding that “a litigant who believes that a certain [action] or portion of a [action] pending in the bankruptcy court should be litigated in the district court may make a motion to withdraw the reference”) (emphasis added).

Having invalidated the Local Rule, the Ninth Circuit found no error in the Bankruptcy Court's decision not to adhere to it or to withdraw the reference. The Court of Appeal then considered whether the Seventh Amendment jury trial right itself required immediate transfer to the District Court, even for pre-trial proceedings. The Ninth Circuit agreed with courts outside the circuit that, it stated, had universally agreed that a jury trial right "does not mean that the bankruptcy court must instantly give up jurisdiction and that the case must be transferred to the district court."

Concluding that the Bankruptcy Court properly retained the case for pre-trial matters, the Ninth Circuit did ultimately reverse its grant of summary judgment. It found that Sigma had raised genuine issues of material fact on its ordinary course of business defense under the version of Section 547(c)(2) of the Bankruptcy Code in force prior to the amendments made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

What About Local Rules In Other Courts? It appears that the Northern District of California's local bankruptcy rule on certification of a jury trial right and transfer to the District Court is unusual. Some bankruptcy courts, including the District of Delaware and the Southern District of New York, have no specific rule addressing withdrawal of the reference based on a jury demand. Others require a prompt motion for withdrawal of the reference to be filed with the District Court, as provided in Central District of California Local Bankruptcy Rule 9015-2(g). 

Conclusion. Although it appears that the decision's direct impact is limited to the Northern District of California and its jury demand procedures, this case proves that even well-established local rules will be struck down if inconsistent with governing statutes. That's a pretty extraordinary outcome for an ordinary course of business preference case. 

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In a decision from August 17, 2007, just released for publication, the Ninth Circuit's Bankruptcy Appellate Panel (BAP) faced a previously unanswered question under Section 503(b)(9) of the Bankruptcy Code, the section enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA).  Is a Section 503(b)(9) administrative claim available to secured creditors or only to unsecured creditors? You may find the BAP's answer surprising.

A Section 503(b)(9) Refresher. For those who haven't dealt with this relatively new section, here are the highlights. Section 503(b)(9) gives vendors an important right beyond the expanded reclamation claim also enacted as part of BAPCPA. Vendors are entitled to an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor's business." 

• In most cases, particularly Chapter 11 cases in which a plan of reorganization is confirmed, administrative claims are paid in full on the effective date of the plan. General unsecured claims, by contrast, often receive only cents on the dollar, and even secured creditors can be "crammed down" and forced to accept payments over a period of time. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing. It's available even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim. 
• For a more detailed analysis of Section 503(b)(9), you may find this earlier post entitled "20 Day Goods: New Administrative Claim For Goods Sold Just Before Bankruptcy" useful, as well as a later post giving an update on a few early court decisions on the section. 
• For more on the changes BAPCPA made to reclamation, you may want to read an earlier post entitled "Reclamation: Can A Vendor "Get The Goods" From An Insolvent Customer" and this post on some of the limitations of reclamation.

The Brown & Cole Stores Case. It was against this backdrop that the BAP analyzed the question before it in the In re Brown & Cole Stores, LLC case. Brown & Cole is a privately held grocery chain operating in Washington state. Its principal supplier and wholesaler, Associated Grocers, Incorporated (AGI), is a cooperative whose largest shareholder is Brown & Cole itself. In Brown & Cole's Chapter 11 case, AGI asserted a "20 day goods" claim of more than $6 million, and also asserted that it was a secured creditor with a pledge of AGI's own stock owned by Brown & Cole. Brown & Cole alleged a number of claims against AGI and argued that it had a right of setoff on those claims against any "20 day goods" claim.

When AGI moved for allowance of a Section 503(b)(9) claim, Brown & Cole argued that AGI was not eligible for that administrative claim because it was a secured creditor. The bankruptcy court rejected that argument and granted AGI's motion. It also denied Brown & Cole's request for a setoff of its own prepetition claims against the administrative claim, among other reasons because of what the bankruptcy court found to be Brown & Cole's inequitable conduct in ordering goods just prior to its bankruptcy filing.

The BAP's Decision. After hearing the appeal, the BAP issued its opinion and identified the first question presented as "Is a secured claim entitled to an administrative priority pursuant to section 503(b)(9)?" The opinion's introduction shows that the BAP was aware of the interest creditors would have in its decision:

This case presents us with an issue of first impression regarding new section 503(b)(9) (“§  503(b)(9)”) of the Bankruptcy Code, as amended in 2005. We expect that the issue is of great importance to many sellers of goods to troubled companies. The new provision gives expense-of-administration priority (“administrative priority”) to a claim for the value of goods received by a debtor within 20 days before the commencement of the case and sold in the ordinary course of business (“twenty-day sales”). The bankruptcy court granted administrative priority to a claim that may also be secured and denied the debtor’s claim of setoff. We AFFIRM the grant of administrative priority; we REVERSE the denial of setoff.

(Footnotes omitted.)

Secured Creditors Are Entitled To Section 503(b)(9) Claims. In reaching its holding, the BAP majority rejected Brown & Cole's primary argument that the Court should interpret Section 503(b)(9) as applying only to unsecured claims. Brown & Cole argued that at the same time as it added Section 503(b)(9), BAPCPA amended another subsection of Section 503 dealing with tax claims, specifically Section 503(b)(1)(B)(i), to clarify that it was available to "secured or unsecured" creditors.  In contrast, Congress did not include the words "secured claim" in Section 503(b)(9). This difference, Brown & Cole argued, should lead the BAP to hold that the "20 day goods" administrative claim is not available to secured creditors. The BAP's response was clear:

We reject that invitation. The provision is not ambiguous; as such, we must enforce it according to its terms and should not inquire beyond its plain language. Lamie, 540 U.S. at 534. Apart from finding no ambiguity in § 503(b)(9), we note that Congress also declined to put the word  “unsecured” into the same statute. The obvious conclusion, therefore, is that all claims arising  from twenty-day sales are entitled to administrative priority.

(Footnote omitted). The BAP majority also rejected a policy argument advanced by Brown & Cole (B&C), and adopted by Judge Alan Jaroslovsky in his dissent:

We can do nothing about B&C’s contention that giving priority to a secured creditor may be inequitable to other creditors. First, it is up to Congress to decide which creditors have leverage and which do not. More importantly, if AGI’s twenty-day sales claim is fully secured, then payment of it by B&C will free the value of the security for that claim for the benefit of other  creditors. If AGI’s claim proves to be undersecured or unsecured, then to deny administrative priority would be to ignore the statute, something we cannot do.

In a footnoted response to the dissenting opinion, Judge Dennis Montali, writing for himself and Judge Randall L. Dunn, expanded on the point:

The dissent is concerned that we are ignoring bankruptcy policy that permits a Chapter 11 debtor to “cramdown” a secured claim in full over time. Congress gave tremendous leverage to a twenty-day sales claimant such as AGI by permitting it to demand full payment as of confirmation, and in doing so, perhaps dramatically affecting the outcome of the case. The fact that the claim is also secured represents less leverage (albeit more than held by non-priority general unsecured claims) than having administrative priority. It is not our place to reallocate that leverage. In any event, if the dissent’s view were the law, the holder of a twenty-day sales claim could simply waive its security, obtain administrative priority, and have equally powerful influence over the outcome of the case.

Setoff May Be Proper. The BAP (the dissent joined in this part of the majority opinion) also reversed the denial of Brown & Cole's setoff request, holding that although prepetition unsecured claims (the kind Brown & Cole asserted against AGI) cannot generally be set off against administrative claims because of a lack of mutuality, here the administrative claim itself arose prepetition, specifically in the 20 days before the bankruptcy filing. On the finding of inequitable conduct in ordering goods and receiving just prior to bankruptcy, the BAP held that there was insufficient evidence of inequitable conduct and that a "debtor contemplating reorganization is under no legal obligation to inform suppliers that it is contemplating a bankruptcy filing." The BAP reversed and remanded that issue to the bankruptcy court.

A Dissenting Voice. Judge Jaroslovsky dissented from what he described as the majority's "overly-sterile conclusion that a fully secured creditor can also have rights under § 503(b)(9)," stating that "[n]ot only is my statutory analysis different, but I see compelling policy reasons for a different result." He found that the plain language of Section 503(b)(9) did not resolve the question of whether secured creditors could be entitled to the administrative priority in light of the change made to Section 503(b)(1)(B)(i). He then turned to the policy issues:

Moreover, some fundamental policy considerations are at stake in this case. While allowing a priority claim to a secured creditor may not have a big impact in most Chapter 7 cases, it can  make a huge difference in a Chapter 11 case like this one. If AGI’s $6 million claim is entitled to priority status, § 1129(a)(9)(A) requires that it must be paid in full in cash upon confirmation. If  it is treated as a secured claim, it still must be paid in full but is subject to cramdown pursuant to § 1129(b)(2)(A). If we incorporate by implication the “secured or unsecured” language into § 503(b)(9), we may be in effect giving a secured creditor veto power over a plan of reorganization when § 1129(b)(2)(A) and sound bankruptcy policy dictate that a secured creditor can be forced  to accept a plan which is fair and equitable to it, honors its secured status and pays its secured claim in full over time.

I would weave the new § 503(b)(9) into the tapestry of American bankruptcy law, preserving the clear intent of Congress to protect recent suppliers of goods to debtors without unraveling other provisions of the Code meant to facilitate reorganization. I prefer this result to the crazy quilt patched together by my brethren.

In his footnote to the prior paragraph, Judge Jaroslovsky stated: "Specifically, I would hold that a creditor would not be entitled to priority status for its twenty-day sales claim to the extent the claim is indubitably secured, applying any security first to claims other than the twenty-day sales claim. I note that AGI might well end up with an allowed priority twenty-day sales claim under this rule."

More Leverage For Secured Vendors. As both the majority and dissent discussed, a secured creditor who has the benefit of a Section 503(b)(9) administrative claim will have considerable leverage in getting paid in full upon confirmation of a Chapter 11 plan. Most secured creditors lend money instead of supplying goods, but a number of vendors do hold collateral for their claims. Even though BAP decisions (in contrast to Court of Appeals decisions) generally are not binding precedent, other courts may find this decision persuasive. If followed widely, secured creditors entitled to assert a Section 503(b)(9) claim will have a noticeable advantage in getting paid. In addition, as the dissent noted, this decision may also make it more difficult for debtors to confirm Chapter 11 plans unless they have the cash to pay all "20 day goods" administrative claims upon their exit from bankruptcy.

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In an article entitled "Defaults wave to hit corporate US," the Financial Times reports that Standard & Poor's is predicting that $35 billion in corporate debt will go into default by the end of 2008. This is similar to the view taken by Moody's, reported in a recent post.

According to the Financial Times, S&P believes that the slowing economy, together with liquidity issues caused by credit market problems, puts approximately 75 issuers of junk debt at a high risk of default. These companies are primarily in the media, healthcare, and consumer products industries. Not surprisingly, S&P believes that the default rate could go up significantly if the economy were to decline more than currently predicted.

Struggling companies that took on substantial debt during the recent favorable credit environment “are highly reliant on financial market access to support operational cash needs, but the plentiful liquidity for high-yield borrowers is almost surely a thing of the past,” according to S&P.

Of course, debt defaults frequently lead to Chapter 11 bankruptcy filings. With S&P joining Moody's in predicting a rise in defaults, the ride could get bumpy from here.

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On his Insolvency Blog, Chris Laughton, a recovery and insolvency partner at the UK's Mercer & Hole firm of chartered accountants, gives a UK and European perspective on the recent gyrations in the credit markets. His new post is entitled "The boom-bust cycle: where are we now?" and it chronicles the progression of the credit crunch from the United States to the UK and beyond. 

After providing links to a number of recent articles from the UK press on the subject, Chris sums up his views:

So what does all this mean? Yes the capital markets are in turmoil, banks are lending much more cautiously and some high risk investment vehicles are failing, but essentially this is only a liquidity problem. Its effect though is that stressed businesses will no longer be able to borrow their way out of trouble as they have become hard-wired to do over the last 3 years.

Crisis cash management and operational and corporate restructuring will come back into vogue as refinancing becomes passé. Only if stressed businesses fail to seek appropriate and timely assistance will the business insolvency statistics really start to rise.

His informative post, and the UK articles highlighted, underscores the interconnected nature of today's global credit markets. It makes for interesting reading -- wherever you are.

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Practically every contract has a provision that makes the bankruptcy or insolvency of one contracting party a trigger for the other party to terminate the contract. These are standard fare and rarely negotiated unless they also include a provision for the reversion back of ownership of property, often intellectual property, upon bankruptcy or insolvency. This post takes a look at these provisions and examines whether they are enforceable.

The Typical Ipso Facto Clause. Termination on bankruptcy provisions are often known as ipso facto clauses (the Latin phrase meaning "by the fact itself") because the language provides that the fact of bankruptcy itself is enough to trigger the termination of the agreement. Here's a common provision:

This Agreement shall terminate, without notice, (i) upon the institution by or against either party of insolvency, receivership or bankruptcy proceedings or any other proceedings for the settlement of either party's debts, (ii) upon either party making an assignment for the benefit of creditors, or (iii) upon either party's dissolution or ceasing to do business.

Variants of this language are found in many types of contracts, including licenses, leases, and development agreements. Some provide that termination is automatic and others first require notice. Termination triggers may include:

• Filing a voluntary bankruptcy;
• Having an involuntary bankruptcy filed against a party;
• Becoming insolvent (frequently the term is left undefined in the contract);
• Admitting in writing that the party is insolvent;
• Making a general assignment for the benefit of creditors (a liquidation alternative recognized under the laws of many states); or
• Tripping a financial condition covenant.

The bankruptcy or insolvency of either party is frequently a termination trigger. However, when the financial condition of only one contracting party is in doubt, the more financially stable party may insist on a one-sided provision allowing it to get out of the agreement upon the weaker party's insolvency or bankruptcy. 

Notso Fasto: The Bankruptcy Code Stops The Clause In Its Tracks. These termination provisions may be common, but are they enforceable? The short answer, which may be surprising to some, is generally "no." Two key provisions of the Bankruptcy Code lead to this result. First, Section 541(c) of the Bankruptcy Code provides that an interest of the debtor (the bankrupt company or person) in property becomes "property of the estate," meaning that the debtor does not lose the property or contract right, despite a provision in an agreement:

that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.

11 U.S.C. §541(c). Translated from bankruptcy-ese, this statute means that a clause that terminates a contract because of the "insolvency" or "financial condition" of the debtor, or due to the filing of a bankruptcy case, will be unenforceable once a bankruptcy case has been filed.

A second Bankruptcy Code provision, Section 365(e)(1), governs ipso facto clauses in executory contracts, which are agreements under which both sides still have important performance remaining (discussed in more detail in this earlier post). Section 365(e)(1) provides:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;

(B) the commencement of a case under this title; or

(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.

Why Put Ipso Facto Clauses In Contracts In The First Place? If these termination provisions are generally unenforceable, why do parties seem to include them in almost every contract? There are three main reasons.

Force Of Habit. One reason is that under the old Bankruptcy Act of 1898, replaced by the Bankruptcy Code in 1979, these ipso facto clauses were enforceable. Over the years, lawyers and businesses got used to including them in their contract forms and they have continued to write them into many agreements. Since it's always possible that the Bankruptcy Code could be changed to reinstate the old rule, lawyers often see little reason to take them out.

It Takes An Actual Bankruptcy. Another and perhaps more important reason is that the rule applies only if a bankruptcy is actually filed. If an ipso facto provision provides that the agreement terminates upon a party's insolvency, and no bankruptcy case is ever filed, it's possible that the solvent party could terminate the agreement using the ipso facto provision. But be forewarned: if a bankruptcy case is later filed, an insolvency-based termination made before the bankruptcy filing may not be enforced in the bankruptcy case. This means that the debtor may still have a chance to retain the rights under the contract, including assuming or assigning an executory contract during the bankruptcy case.

A Limited Exception In Bankruptcy. A third reason is that an important, albeit limited, exception to the rule applies even after a bankruptcy is filed. The exception stems less from the ipso facto clause itself and more from the rules governing assumption of certain types of executory contracts, including intellectual property licenses (at least in some circuits).

• Section 365(e)(2) of the Bankruptcy Code, in conjunction with Section 365(c)(1), provides that an ipso facto clause can be enforceable if the debtor or trustee is not permitted by "applicable law" to assume or assign the executory contract. Simply put, if applicable law provides that an IP license or another executory contract cannot be assumed by the debtor or trustee without the other party's consent, then the non-debtor contracting party can force rejection of the license or seek relief from the automatic stay to terminate the agreement based on the ipso facto clause.
• Although an analysis of the law governing assumption and assignment of IP licenses and related agreements is beyond the scope of this post, you can find a detailed discussion in an earlier one entitled "Assumption of IP Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?" 

A Word To The Wise. Parties include "termination on bankruptcy" provisions in contracts all the time, despite the general rule making them unenforceable in bankruptcy. Unfortunately, some do so without realizing that the provision may be ineffective, and that can lead to trouble. If enforcing an ipso facto clause is important to one of your agreements, especially if you also seek the highly problematic reversion of intellectual property or other rights upon such a termination, be sure to get specific legal advice on your situation, including whether alternative approaches may exist to help achieve your objectives.

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According to Moody's, the credit rating and investor service firm, the default rate on high-yield or junk bond debt is likely to increase substantially from the current level of 1.4%. Moody's predicts that the default rate will rise to 4.1% by August 2008 and then to 5.1% by August 2009. 

• As reported by Credit, Moody's director of corporate default research believes that "higher spreads and diminished liquidity" have increased the default risk for distressed issuers.
• Unless the U.S. economy falls into a recession, however, the default rate is predicted to stay below its long-term average of 5.0%, at least until 2009. Any real downturn in the economy could push the default rate higher.

The New York Times DealBook Blog has a similar story, pointing out that Moody's predicted in another report that the U.S. industries likely to have the highest default rate are packaging, construction, consumer durables, and automotive. Also, companies that need new financing will be more at risk than firms that already obtained financing on the favorable terms available in the credit markets until recently.

As The DealBook Blog points out, a rising default rate will likely lead to an increase in Chapter 11 bankruptcy filings. Stay tuned. 

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On August 14, 2007, the Delaware Supreme Court, sitting en Banc and following oral argument, issued its decision in the Trenwick America Litigation Trust v. Billet deepening insolvency case. Rather than write its own opinion, the Delaware Supreme Court released a two-page order affirming Vice Chancellor Strine's August 10, 2006 Chancery Court decision "on the basis of and for the reasons assigned by" the Chancery Court in its opinion. A copy of the Chancery Court opinion is available here. 

The End Of Deepening Insolvency In Delaware. By adopting the basis and reasoning of the lower court's opinion, the Delaware Supreme Court ratified Vice Chancellor Strine's decision that there is no cause of action for deepening insolvency under Delaware law. Apparently concluding that no opinion of its own was necessary given the Chancery Court's clear opinion below, the Delaware Supreme Court has put to rest the cause of action for deepening insolvency under Delaware law. Prior to the lower court's decision in Trenwick, some bankruptcy and other federal courts had incorrectly predicted that Delaware would recognize this cause of action.

A Second Look At Vice Chancellor Strine's Trenwick Opinion. Now that the Delaware Supreme Court has affirmed the Chancery Court's decision and its reasons, the lower court's opinion merits further consideration. As discussed in this August 2006 post on the Chancery Court's decision, Vice Chancellor Strine held, in unequivocal terms, that there is no cause of action for deepening insolvency under Delaware law. To give context to the opinion's legal analysis, some of its more important sections are quoted below at length:

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure.  With the prospect of profit often comes the potential for defeat.

The general rule embraced by Delaware is the sound one.  So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.

If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.

The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility.  Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.  The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure.  If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.

Moreover, the fact of insolvency does not render the concept of “deepening insolvency” a more logical one than the concept of “shallowing profitability.”  That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one.  If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler.  No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.

In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor.  Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part.  None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

The Delaware Supreme Court's adoption of the basis and reasoning of the Chancery Court's strongly-worded opinion represents the end of the road for the deepening insolvency cause of action under Delaware law.

Hints In The Gheewalla Decision? Interestingly, in its brief order the Delaware Supreme Court dropped a footnote giving not only the citation for the Chancery Court's decision, Trenwick America Litig, Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), but also an intriguing comment: "Accord North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1453705 (Del. Supr. 2007)." This was a reference to its own decision of May 18, 2007 (opinion available here) holding that creditors cannot bring a direct cause of action for breach of fiduciary duty against directors of corporations that are insolvent or in the zone of insolvency.

• As discussed in an earlier post on the Gheewalla decision, the Delaware Supreme Court opinion cited the lower court decision in Trenwick favorably, as well as the earlier Chancery Court decision in Production Resources (opinion available here), discussed in another earlier post. 
• The "Accord" reference in its Trenwick order suggests that the Delaware Supreme Court believed that its May 2007 Gheewalla decision foreshadowed this week's affirmance of the Chancery Court's Trenwick decision and reasoning.

More Clarity For Directors. With the adoption of the Chancery Court's opinion in Trenwick, and its own opinion in Gheewalla, the Delaware Supreme Court has effectively endorsed the trend in recent Chancery Court decisions to limit certain efforts to expand the liability of directors of insolvent or nearly insolvent corporations. Nearly sixteen years have passed since the Chancery Court's decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), introduced us to the terms "vicinity of insolvency" and "zone of insolvency." Although the Delaware Supreme Court has left some questions open, these new decisions help provide meaningful guidance on how directors of financially troubled Delaware corporations should discharge their fiduciary duties.  

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David Powlen, Managing Director and Partner at Western Reserve Partners LLC, has an interesting article on the Turnaround Management Association website entitled "Bargains Await Buyers Skilled At Navigating Section 363 Minefields." It gives a good overview of the range of issues that arise in the context of a sale under Bankruptcy Code Section 363. Among the article's observations:

• Unlike traditional private company M&A deals, Section 363 sales take place in the "fishbowl" of a bankruptcy proceeding;
• Although the bankruptcy process generally leads the debtor to seek an auction, some typical M&A bidders may not participate in a bankruptcy sale, potentially reducing the competition to a stalking horse bidder;
• Compensating for the usual lack of representations and warranties in an asset purchase agreement with a bankrupt company is the court's sale approval order, which generally approves a sale free and clear of liens, claims, and interests; and
• A Section 363 sale may not be free of every claim or interest, however, as certain environmental and product liability claims may nevertheless pass to the buyer. 

The article also includes a helpful chart giving a graphic presentation of the relative risks and benefits of an out-of-court sale, a Section 363 sale, and the less common sale through a Chapter 11 plan of reorganization. For more on these issues, you may also be interested in this earlier post and linked article on buying assets from a financially distressed company.

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Almost every financially troubled company will face a layoff at some point. Knowing how to implement one with sensitivity to all employees (including those not part of the layoff) and with the needs of the business squarely in mind can best preserve the ability for future success.

Will Herman, an entrepreneur and former CEO of several successful companies, has a very interesting post on his 2-Speed blog entitled "How To Manage A Layoff."  In it, Will offers up nine key guidelines for effectively managing a layoff. Among his well-put suggestions:

• Do it quickly -- Nothing will drain the life out of an organization faster than mass fear of job loss.
• Do it once -- Not completing a layoff in one pass will kill the productivity of those who remain.  
• Plan ahead -- Decide how you’re going to handle the termination details - have any severance, benefits, insurance, outplacement service offerings or reference policy well documented ahead of time (can you afford any of these?). 
• Communicate -- Make it clear to everyone (those being laid off and those remaining) why it happened and what has been done or is being done to make sure it doesn't t happen again.  Emphasize that the layoff as just witnessed is OVER and that no one else will be laid off because of the current situation (new situations may, of course, come up). 

Getting a layoff right can be a make-or-break event in a successful turnaround. Will's range of business experience makes his post essential reading for anyone interested in this important, if unpleasant, topic.

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Last week saw what may prove to be early signs of a turn in the robust market for the debt that finances private equity buyouts. In just a week's time, The New York Times reported on a possible cooldown in the buyout market, and the Financial Times published a commentary on signs of a possible "bondholder revolt" against issuer-favorable debt terms (including low debt coverage ratios mentioned in an earlier post) that have prevailed for the past several years. In addition, the DealBook Blog's post entitled "Buyout Boom Could Slow As Investors Push Back" discussed how several buyout debt offerings were recently curtailed or modified, a first in this previously strong debt market.

Then, in a separate but interesting move, the former co-head of investment banking at UBS, Jeff McDermott, left last week to start a new private equity firm, Stony Lane Partners. Stony Lane's focus? Buying and turning around distressed businesses. When asked by the Financial News why he's making the move, McDermott answered:

I think a credit crunch will play out over time, and it will be like a slow rolling wave. It’s won’t be a one-day cataclysmic event. I think there will be double leverage in the system. I think CDOs are buying margin leverage and are buying corporate credits, which are priced like there’s no end to economic growth in the future. Of course, there are economic cycles.

If he's right, a rise in defaults, restructurings, and Chapter 11 bankruptcy filings may be coming down the road.

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When a debtor grants a security interest in a patent issued by the U.S. Patent and Trademark Office (PTO), the creditor must take steps to perfect that security interest. Given that the PTO issues patents but the Uniform Commercial Code (UCC) generally governs perfection of security interests, creditors have often filed both a UCC-1 financing statement and made a filing in the PTO to cover all the bases.

Perfection By UCC Filing. In 2001, the Ninth Circuit held that a creditor who filed a UCC-1 financing statement properly perfected a security interest in a patent even if it did not also make a filing with the PTO. The decision in the In re Cybernetic Services, Inc. case, officially Moldo v. Matsco, Inc., 252 F.3d 1039 (9th Cir. 2001), rested on the Ninth Circuit's determination that the federal Patent Act does not cover liens on patents and does not preempt the UCC with respect to perfection of security interests. This seemed to settle the question of whether a UCC filing alone was enough to perfect a security interest in a patent, at least in the Ninth Circuit.

Does A PTO Filing Alone Perfect? Judge William C. Hillman of the U.S. Bankruptcy Court for the District of Massachusetts faced the opposite question in the In re Coldwave Systems, LLC case. There the creditor sought to rely on a PTO filing alone to perfect its security interest in a patent because the Bankruptcy Court avoided as a preference a tardy UCC filing made long after the security interest was granted but within 90 days of the bankruptcy petition. The creditor's much earlier PTO filing of a Recordation Form Cover Sheet, recording the conveyance of the security agreement between the debtor and the creditor, was not subject to avoidance as a preference. The creditor argued that the PTO filing was sufficient to perfect its security interest, even in the absence of a UCC filing.

UCC Perfection Or Bust. In his 14-page decision issued on May 15, 2007, Judge Hillman held that the PTO filing was insufficient to perfect the creditor's security interest because the Patent Act (specifically Section 261 of Title 35), did not create a system for the perfection of security interests in patents. After first concluding that "[t]he Federal statute does not protect holders of security interests," Judge Hillman held as follows:

There is nothing in §261 that addresses in any way the conflict between one who is not a holder of an interest by way of assignment, grant, or conveyance and a bankruptcy trustee. We must look to other law for the answer. 

That other law was the UCC. Holding that a patent is a general intangible, the Court ruled that nothing in the UCC excepts general intangibles from the rule requiring perfection by a UCC filing. Since no valid UCC filing perfected the creditor's security interest, it was unperfected and the Chapter 7 trustee prevailed.

The Bottom Line. The Coldwave Systems decision is consistent with the Ninth Circuit's earlier Cybernetic Services ruling. Together they teach creditors that the only way to perfect a security interest in a patent is by an unavoidable and proper UCC filing. Any creditor relying on a PTO filing alone will end up unperfected and unsecured. While there may be other reasons for a creditor to make a PTO filing, such as potentially protecting against an improper assignment of the patent, perfection of a security interest is not one of them.

Want More? For more on the Coldwave Systems and Cybernetic Services decisions, be sure to read Warren Agin's excellent post on the Tech Bankruptcy blog, entitled "An Expert Builds On Cybernetic Services." Warren also gets special thanks for first posting on Judge Hillman's interesting decision.

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On June 7, 2007, the U.S. Court of Appeals for the Third Circuit issued a decision in the In re Hechinger Investment Company case holding that the "contemporaneous exchange for new value" defense to preference claims can apply even if the payments were made in the context of a credit arrangement. The key is whether the parties intended the payments involved to be contemporaneous exchanges for new value, the linchpin of this particular preference defense. A copy of the Third Circuit's decision is available here.

Bankruptcy Preferences. As a reminder, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

The Contemporaneous Exchange Defense. This defense, found in Section 547(c)(1) of the Bankruptcy Code, is short and to the point:

(c) The trustee may not avoid under this section a transfer--

(1) to the extent that such transfer was--

(A) intended by the debtor and the creditor to or for whose benefit such transfer was made to be a contemporaneous exchange for new value given to the debtor; and

(B) in fact a substantially contemporaneous exchange.

In interpreting this language, the Bankruptcy Court held that a "credit relationship is inconsistent with the intent required in order to sustain" the defense. Essentially, under its view the defense would presumably be limited to situations in which no credit was allowed to remain outstanding but instead a C.O.D. purchase or other similarly immediate "goods for cash" swap was involved.

The Third Circuit's Focus On Intent. The Third Circuit reversed the Bankruptcy Court's ruling, explaining its reasoning as follows:

The Bankruptcy Court found that the disputed transfers were not intended by the parties to be contemporaneous exchanges because the transfers were credit transactions. In reaching this result, the Court relied upon several factually distinguishable cases, none of which stand for the proposition that parties can never intend credit transactions to be contemporaneous exchanges under § 547(c)(1)(A). We disagree with the Bankruptcy Court’s conclusion. Indeed, it would appear that § 547(c)(1) covers little other than credit transactions. The § 547(c)(1) defense applies only to transfers that the debtor has shown are payments on an “antecedent debt” under § 547(b). See 11 U.S.C. § 547(b)(2) (definition of avoidable transfers). If there is no delay between when the debt arises and payment of the obligation, then the transfer is outside the scope of § 547(b), and § 547(c)(1) is not implicated. The existence of a delay between the creation of a debt and its payment is a hallmark of a credit relationship, which is, by definition, a relationship in which the creditor entrusts the debtor with goods without present payment. OXFORD ENGLISH DICTIONARY (2d ed. 1989) (defining “credit” as “[t]rust or confidence in a buyer’s ability and intention to pay at some future time, exhibited by entrusting him with goods, etc. without present payment.”).

We do not think that the District Court’s interpretation of the Bankruptcy Court’s order – namely, as concluding that the parties intended to have a credit relationship – necessarily resolves the question. The inquiry still remains: even if a credit relationship was intended, was it nonetheless their intent that the ongoing payments would be contemporaneous exchanges for new value? A court may find the parties intended a contemporaneous exchange for new value even when the transaction is styled as a “credit” transaction. See In re Payless Cashways, Inc., 306 B.R. 243 (8th Cir. BAP 2004), aff’d, 394 F.3d 1082 (8th Cir. 2005). The question is one of intent, and although a delay between the incurrence of the debt and its payment can evidence that the exchange was not intended to be contemporaneous, the passage of time does not necessarily negate intent.

(Footnotes omitted.)

The Bottom Line. Under this decision, a contemporaneous exchange defense to a preference is available even if the defendant has extended credit to the debtor. Nevertheless, to prevail the defendant will have to prove that it and the debtor actually intended the payments to be contemporaneous exchanges for new value and they were, in fact, substantially contemporaneous with the exchange of goods or services.

A Final Note. The Third Circuit decision covered other issues as well, including the ordinary course of business defense and whether prejudgment interest is available for preference claims. For more on those issues, plus a copy of the Bankruptcy Court's decision below, be sure to read the detailed post on the case by the Delaware Business Bankruptcy Report.

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On June 8, 2007, Delaware Bankruptcy Judge Kevin Gross issued a decision in the World Health Alternatives, Inc. bankruptcy case that corporate directors, officers, attorneys, and bankruptcy professionals alike will find of interest. A copy of the Court's 13-page decision and short order is available here.

The Three-Sided D&O Policy. The issue in the case was whether a Chapter 7 bankruptcy trustee could get an injunction to prevent directors and officers from using the proceeds of a Director and Officer (D&O) liability policy to settle a shareholder lawsuit pending in another court (known as the Consolidated Action). The underlying question centered on who owns the proceeds of a D&O policy when the policy provides:

• Side A coverage for directors and officers;
• Side B coverage for the corporation's expenses in indemnifying directors and officers; and
• Side C coverage for the corporation's own exposure for securities litigation claims.  

As is true with many D&O policies, the policy involved in this case also had a "Priority of Payments" endorsement that gave payments under the Side A coverage for the directors and officers priority over both the Side B and Side C coverages.

Does The Automatic Stay Stop Use Of A D&O Policy's Proceeds? The Chapter 7 trustee sought to block the use of the D&O policy's limited proceeds to settle the shareholder lawsuit, arguing that they were property of the bankruptcy estate and that the effort to use them to settle this Consolidated Action violated the automatic stay of bankruptcy.  The Chapter 7 trustee had his own lawsuit pending against the directors and officers and he wanted to keep the "wasting" D&O policy (called "wasting" because the policy proceeds also had to cover defense costs) available to cover his claims. The debtor corporation had been dismissed from the shareholder litigation so no Side C coverage was implicated, and because no indemnification had been or was likely to be paid, the Side B coverage had not been triggered.

In denying the Chapter 7 trustee an injunction, the Delaware Bankruptcy Court held that although the policy was property of the bankruptcy estate since the debtor corporation had purchased it, the policy's proceeds were not. Although acknowledging that some other courts had ruled differently, Judge Gross followed an earlier Delaware Bankruptcy Court decision in In re Allied Digital Technologies Corp., 306 B.R. 505 (Bankr. D.Del. 2004), and held as follows:

Applying the rulings in the cases cited above to the case at hand, it appears that the proceeds of the Debtor’s insurance policy are not property of the estate. The Court arrives at this conclusion from its review of the ‘language and scope of the [P]olicy at issue.’ Allied Digital, 306 B.R. at 509. The Policy proceeds which are being used to fund the Settlement and are being held in escrow by Lead Counsel are from the Policy’s Coverage A. World Health, and now the Trustee as successor, has no right to any Coverage A proceeds, which insures only World Health’s officers and directors. World Health must look to Coverage B which insures it for indemnification claims. There are no such claims against World Health. If the Trustee is seeking to recover for the wrongs of the defendants in the Trustee’s Action pending in this Court, it is not entitled to preference over the settlement of the Consolidated Action. As the Court held in Allied Digital:

The Trustee’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from The D&O Policy rather than as a potential defendant seeking to be protected by the D&O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.

Id. at 512.

Judge Gross ruled that the automatic stay did not apply to the policy proceeds at issue and, as a result, the Chapter 7 trustee was not entitled to an injunction to stop them from being used to settle the other litigation. 

The Take-Aways. When D&O policy proceeds are being used by insured directors and officers to fund a defense or settlement of a covered claim, a bankruptcy trustee generally will not be able to interfere if none of the other coverages -- specifically the Side B and C coverages -- has been invoked.

• If claims have been made against the Side B or Side C coverages, the outcome could very well be different.
• A Priority of Payments endorsement, which gives priority to the Side A coverage for directors and officers, is one tool to consider to help ensure that the D&O policy is available for directors and officers first. However, the law is not clear whether that endorsement would trump the automatic stay if the other coverages were invoked.
• These issues are complicated and those with a stake in these questions should be sure to get legal advice on both the bankruptcy and insurance coverage issues involved.

For more discussion of the decision and the insurance issues raised, be sure to read Kevin M. LaCroix's excellent post at The D&O Diary. Special thanks to Francis G.X. Pileggi of the Delaware Corporate and Commercial Litigation Blog for highlighting Kevin's post.

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The Globe And Mail has a story on its Report On Business.com site entitled "Private equity's high-wire act: Can leveraged buyout artists build firm foundations on soft money?" The article discusses the current low default rate on the debt that has been financing private equity buyouts and considers who will get hurt when the default rate rises.

The article makes a number of interesting observations about the risks in the current buyout market, including the following:

• Banks hold a smaller percentage of leveraged debt, having sold off debt to hedge funds and others though pooling vehicles such as collateralized loan obligations, known as CLOs.
• This trend has put some banks in something of a loan broker role, making the initial acquisition loan but later selling the position.
• The free cash flow to interest expense ratios are now in the 1.7 range, a noticeable reduction from the 2.6 average three years ago.
• Toggle bonds, which allow borrowers to issue new bonds, often at higher rates, to finance interest costs on the existing bonds, have become more common.

The article concludes with a discussion of what might bring this private equity cycle to an end, a question on many people's minds these days. For more on this issue, you may find interesting three past posts on the general subject, available here, here, and here.

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On June 4, 2007, the U.S. Court of Appeals for the Ninth Circuit brought some additional clarity to the earmarking defense to preference claims in its decision in Metcalf v. Golden, an adversary proceeding within the In re Adbox, Inc. Chapter 7 case. In this post, I'll give a little background on preferences and the earmarking defense and then discuss how the defense works in the Ninth Circuit.

Preferences And Earmarking. Before reaching its decision on the earmarking issues, the Court set the legal context by discussing what preferences are and how earmarking can sometimes be a defense to a preference claim.

Under 11 U.S.C. § 547 the bankruptcy trustee may recover certain transfers made by the debtor within 90 days before filing for bankruptcy, if the trustee proves:

(1) a transfer of an interest of the debtor in property;

(2) to or for the benefit of a creditor;

(3) for or on account of an antecedent debt;

(4) made while the debtor was insolvent;

(5) made on or within 90 days before the date of the filing of the petition; and

(6) one that enables the creditor to receive more than such creditor would receive in a Chapter 7 liquidation of the estate.

In re Superior Stamp & Coin Co., Inc., 223 F.3d 1004, 1007 (9th Cir. 2000) (citing 11 U.S.C. § 547(b)). Such a transfer is known as an 'avoidable preference' or a 'preferential transfer.' Id. at 1007-09. The 'earmarking doctrine' is a courtmade exception to this rule that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor. Id.; In re Sierra Steel, Inc., 96 B.R. 271, 274 (B.A.P. 9th Cir. 1989). In such circumstances, the funds are deemed 'earmarked' and are not considered part the debtor’s estate. Sierra Steel, 96 B.R. at 274.

For more information on preferences, and some tips on how creditors can protect themselves when dealing with a financially troubled customer, you may find this post of interest.

Is Earmarking An Affirmative Defense? One previously unresolved issue involving the earmarking defense was whether it is a true "affirmative defense," which would mean that to assert it a preference defendant would have to include it in its answer to the preference complaint. In Metcalf, the Ninth Circuit said no:

Earmarking is not one of the affirmative defenses enumerated in Rule 8, and we decline to construe it as such under Rule 8’s residuary clause for 'any other matter constituting an avoidance or affirmative defense.' Properly understood, the earmarking doctrine is not an affirmative defense under Rule 8, but rather a challenge to the trustee’s claim that particular funds are part of the bankruptcy estate under 11 U.S.C. § 547. See Libby Int’l., 247 B.R. at 467 [In re Libby Int’l., Inc., 247 B.R. 463 (B.A.P. 8th Cir. 2000)]. Thus, the Metcalfs did not waive their earmarking defense by failing to plead it in their answer in the preference action.

Who Has The Burden Of Proof? With the affirmative defense issue out of the way, the Ninth Circuit then tackled the even more important question of whether the trustee or the defendant has the burden of proof on the earmarking defense. The Court held that although the trustee has the burden to prove that the funds at issue came from the debtor's account, the real burden of proof to establish the actual earmarking defense shifts back to the defendant:

As the district court noted, there is 'substantial confusion' over who bears the burden of proof on an earmarking defense. The Ninth Circuit Bankruptcy Appellate Panel addressed this question in Sierra Steel, where it denied an earmarking defense because the defendant 'ha[d] not traced the funds to money received by the debtor from [the lender].' 96 B.R. at 275. While the Sierra Steel court started from the general principal that the trustee has the burden of establishing that property is part of the bankruptcy estate, it also noted that the funds in question were disbursed from the defendant’s general account. Id. at 274 n.5. The source of the funds raised the presumption that the funds were property of the bankruptcy estate and the burden of proof accordingly shifted from the trustee—to establish that the funds were part of the estate —to the defendant—to show that they were not. Id. (citing In re Bullion Reserve of N. Am., 836 F.2d 1214, 1217 n.3 (9^th Cir. 1988)).

We follow well-established law in holding that the trustee bears the initial burden of establishing that a transfer is an avoidable preference under § 547. See Sierra Steel, 96 B.R. at 274. If, however, the trustee establishes that the transfer of the disputed funds was from one of the debtor’s accounts over which the debtor ordinarily exercised total control, we follow the approach of Sierra Steel and find that the trustee makes a preliminary showing of an avoidable transfer “of an interest of the debtor” under § 547(b). The burden then shifts to the defendant in the preference action to show that the funds were earmarked.

In the Metcalf case, the Court ultimately held that the defense was not established. The defendants could not prove the existence of an agreement between the debtor and the lender that had advanced the funds requiring them to be paid to the defendants. Since the debtor could have used those funds for another purpose, the payment to the defendants was a preferential transfer from the debtor's estate.

Where Does This Leave The Earmarking Defense? The Ninth Circuit's decision reaffirmed the existence of the earmarking defense and resolved two important procedural questions about how the defense may be asserted. The decision also highlighted the level of proof needed to make a successful earmarking defense. If a creditor is getting paid with loaned funds and hopes to use the defense, it should make sure that there is an actual agreement requiring the debtor to use the newly loaned funds to pay that creditor. Without proof of such an actual agreement, the earmarking defense will fail. 

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One of the significant changes made by the Bankruptcy Code amendments that took effect in October 2005 was the imposition of severe restrictions on "key employee retention plans," known in the bankruptcy world as KERPs.  In this post I'll discuss how several courts have handled these issues in the year and a half since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA, became effective. The most recent decision, issued late last week by the Delaware Bankruptcy Court in the Nellson Nutraceutical case, gives debtors added flexibility when trying to craft plans consistent with these new restrictions.

Changes Aimed At Curbing KERPs. Prior to BAPCPA, KERPs were a very popular way of making sure that a company could retain its most important officers and employees to guide it through bankruptcy. Citing perceived abuses, however, Congress added language in BAPCPA that requires debtors to satisfy nearly impossible standards before courts would be permitted to approve payment of retention bonuses (or severance payments) as administrative claims to officers and other insiders of a bankrupt company. The restrictions apply only to insiders; no similar limitations have been placed on payment of retention bonuses and severance to non-insiders.

The New Law's High Hurdles. To give you a flavor of the restrictions BAPCPA added to Section 503(c) of the Bankruptcy Code, a debtor company must now prove the following before it can gain approval for payment of a retention bonus to an insider:

• the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;
• the services provided by the person are essential to the survival of the business; and

• either

• the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or
• if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred.

The requirement of a bona fide job offer in particular has led some to observe that if an officer of a company in Chapter 11 really had such an offer he or she would probably just take it, mooting the entire retention issue. In any event, these provisions have had their desired effect. It is now rare to find a debtor proposing a KERP that seeks to make retention payments to officers or other insiders.

Debtors Opt For Plan B. Despite these restrictions, debtors still usually want to keep their key officers and may worry that they will leave for more stable companies absent some incentives to remain with the debtor. So what are debtors doing? Since October 2005, they have shifted gears and are proposing not retention plans but incentive plans instead. To date, only a few decisions, discussed below, have addressed what is necessary for an incentive plan to pass muster. In other instances, incentive plans have been approved with little or no opposition. Perhaps the earliest such approval came in May 2006 when Judge Burton R. Lifland approved one in the Calpine Corporation Chapter 11 case.

The Dana Corporation Case. The first significant contested plan motion came shortly after the Calpine incentive plan's approval. Dana Corporation, whose Chapter 11 case was also pending before Judge Lifland, filed a motion seeking approval of a plan similar to that approved in the Calpine case. After considering objections filed by various creditors and others, however, in September 2006 Judge Lifland refused to approve Dana Corporation's proposed plan, finding that it was a prohibited retention plan. For an excellent and entertaining discussion of the circumstances leading to denial of that first effort in the Dana Corporation case, including why the Calpine plan was approved while the first Dana plan was not, be sure to read Steve Jakubowski's detailed post on the Bankruptcy Litigation Blog.

A few months later, on Dana Corporation's second try, Judge Lifland approved the revised incentive plan. In his second ruling, he found that with certain modifications the debtor's revised proposals met the sound business judgment test required for approval. In addition, he ruled that the new plan incentivized the key officers "to produce and increase the value of the estate" and, because the benchmarks in the plan were difficult targets to reach and not easy "lay-ups," the proposal was an actual incentive plan and not a retention plan in disguise.

Evaluating Incentive Plans. In evaluating whether the Dana plan represented the exercise of sound business judgment, Judge Lifland considered the following factors:

• Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes for the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance? (emphasis added)
• Is the cost of the plan reasonable in the context of the debtor's assets, liabilities and earning potential?
• Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
• Is the plan or proposal consistent with industry standards?
• What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry?
• Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?

These factors provide useful guidance not only to bankruptcy courts but also to boards of directors of financially troubled companies, whether in or out of bankruptcy, when considering proposals for retention or incentive plans.

The Global Home Products Decision. In March 2007, Judge Kevin Gross of the Delaware Bankruptcy Court approved two incentive plans in the Global Home Products case. In that decision, as the Delaware Business Bankruptcy Report described here, the court followed the analysis Judge Lifland used in the Dana Corporation case and approved the two incentive plans. Specifically, Judge Gross found that the plans were true incentive plans, which he called "pay for value" plans and were not KERPs, or "pay to stay" plans. For this reason, Judge Gross evaluated the plans under the business judgment standard of Section 363 of the Bankruptcy Code, holding that the strict Section 503(c) limitations simply did not apply.

The Nellson Nutraceutical Decision. On May 24, 2007, Judge Christopher S. Sontchi of the Delaware Bankruptcy Court issued a decision in the Nellson Nutraceutical Chapter 11 case approving revisions to a previously-approved incentive plan. There, the debtors' first incentive plan provided for certain performance milestones based on target levels of EBITDA, or earnings before interest, taxes, depreciation, and amortization. Unfortunately, the debtors did not achieve those EBITDA milestones and sought to lower them to align with what they considered to be more realistic performance goals. After receiving testimony that the debtors had made similar reductions in bonus targets in the past, Judge Sontchi concluded that the debtors' current proposal was in the ordinary course of business and involved a good faith business judgment.

On the issue of whether Section 503(c)'s retention payment restrictions applied, Judge Sontchi found that the lowering of the incentive plan milestones did not turn the plans into retention plans. He held that if the primary purpose of a plan is to incentivize insiders and other employees, rather than merely retain them, it remains an incentive plan:

Under the facts of this case, although the modification of the 2006 bonus program has some retentive effect, it is for the primary purpose of motivating employees and, thus, the limitations of section 503(c)(1) are not applicable.

*     *    *

The [United States Trustee] argues with some force that if an incentive plan is based on achievement of EBITDA targets and those targets are not achieved, yet the bonus is still received, that the plan cannot be an incentive plan but must, in fact, be solely a retention plan.

*   *    *

While the Court agrees that the payment of bonuses under the modified 2006 [plan] has some retentive effect, the Court disagrees with the [United States Trustee's] argument that its sole or primary purpose is retention. Consistent with the Debtors’ pre-petition practice, the 2006 [plan] must be considered as a whole. It consists of two parts: the establishment of 'aspirational goals' in the early part of the year; and a review at the end of the year to consider whether those goals have been met and, if not, why. In this case, the Debtors did just that and determined that the 2006 [plan] served its purpose by motivating the employees to do a 'great job' in connection with the matters that those employees could reasonably be expected to influence. As such, the Debtors seek to award bonuses at a reduced level to compensate the employees for their success (albeit somewhat limited) in 2006 and to motivate the employees in 2007.

Finally, Judge Sontchi held that Section 503(c)(3)'s additional limitations, which among other things prohibit transfers to insiders that are "outside of the ordinary course of business and not justified by the facts and circumstances of the case," by its terms apply only to payments outside of the ordinary course of business. Given his earlier holding that the debtors' plans and their modifications were made in the ordinary course of business, Judge Sontchi concluded that Section 503(c)(3)'s requirements did not apply at all.

Conclusion. BAPCPA has effectively ended the use of KERPs for officers and other insiders of a debtor. However, more than a year and a half after BAPCPA became effective, bankruptcy courts in New York and Delaware, and perhaps elsewhere, are willing to approve incentive plans for insiders. The Nellson Nutraceutical decision goes further and, in the right circumstances, will allow the incentive plan's performance milestones themselves to be lowered without jeopardizing the "incentive" character of the plan. This area of the law is plainly evolving, so stay tuned for more developments.

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Almost sixteen years ago, the Delaware Chancery Court's decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), helped introduce the terms "vicinity of insolvency" and "zone of insolvency" into the legal and business lexicon. Since then, the Chancery Court issued a number of decisions on the question of whether creditors can sue directors of insolvent corporations, or those in the zone of insolvency, for breach of fiduciary duty. In the intervening years, however, the Delaware Supreme Court had never spoken on the issue.

The Chancery Court Limits Direct Creditor Claims. As reported in this earlier post, last September the Chancery Court issued a decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 2006 WL 2588971 (Del. Ch. Sept. 1, 2006) (Chancery Court opinion available here), holding that creditors could not bring a direct action for breach of fiduciary duty against directors of a corporation in the zone of insolvency. This case gave the Delaware Supreme Court the opportunity to issue a definitive ruling on the subject.

The Delaware Supreme Court Affirms. On Friday, May 18, 2007, the Delaware Supreme Court finally ruled on this important question. The Court's 24-page opinion in North American Catholic Educational Programming, Inc. v. Gheewalla, et al. affirmed the Chancery Court's decision and made three key rulings:

• When the corporation is in the zone of insolvency, creditors may not bring a direct action against the directors for breach of fiduciary duty;
• When the corporation is in fact insolvent, creditors have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties; and
• Even when the corporation is insolvent, creditors have no right to assert direct claims for breach of fiduciary duty against the directors.

The Supreme Court's Zone Of Insolvency Analysis. The Delaware Supreme Court first rejected the creditor's argument that it should be permitted to bring a direct claim for breach of fiduciary duty against the directors when the corporation was in the zone of insolvency:

It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders. While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights. Delaware courts have traditionally been reluctant to expand existing fiduciary duties. Accordingly, ‘the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.’

(Footnotes omitted.)

The Supreme Court next commented that although it had never addressed the issue of whether creditors have the right to sue directors in the zone of insolvency, the subject had been discussed in several Chancery Court decisions and in many scholarly articles. Among the Chancery Court decisions cited were the Production Resources decision (see earlier post on that decision), which the Supreme Court quoted at length, and the Trenwick America decision (discussed here and here), currently on appeal to the Supreme Court.

Concluding that the creditor could not state a direct claim for breach of fiduciary duty, the Supreme Court held:

In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.

(Footnotes omitted.)

The Supreme Court's Views When The Corporation Is Insolvent. The Delaware Supreme Court next tackled the issue of whether a direct claim for breach of fiduciary duty could be brought against directors when the corporation crossed from the zone of insolvency into actual insolvency:

It is well settled that directors owe fiduciary duties to the corporation. When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.

(Footnotes omitted; emphasis in original.) Later, the Court stated both its holding on this issue and the reasons for it:

Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. Accordingly, we hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim, as discussed earlier in this opinion, that may be available for individual creditors.

(Footnotes omitted; emphasis in original.) 

Fellow Bloggers Weigh In. Given the decision's importance, several legal bloggers reported on it almost immediately. These include Scott Riddle at the Georgia Bankruptcy Law Blog, Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog, and three law professors whose articles the Delaware Supreme Court cited in the opinion: Professor Stephen Bainbridge at ProfessorBainbridge.com, Professor Larry Ribstein at Ideoblog, and Professor Fred Tung at Conglomerate.

The Next Big Insolvency Case. The next major decision in the insolvency area should be the Delaware Supreme Court's decision in the Trenwick America case. In the Chancery Court, Vice Chancellor Strine held that no cause of action for deepening insolvency exists under Delaware law. The appeal was argued before the Delaware Supreme Court on March 14, 2007, and a decision could be handed down in the next month or two. The North American Catholic decision, with its approving quotes from and citations to other recent Chancery Court decisions in this area, raises the question whether the Delaware Supreme Court will again affirm the Chancery Court, this time in the Trenwick America case. Although it's hard to tell, we may not have to wait much longer to find out. 

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In a decision issued on April 3, 2007 in the In re: Ahaza Systems, Inc. case, the Ninth Circuit held that even first time transactions can qualify for the "ordinary course of business" defense to preferences. A copy of the Court of Appeal's decision is available here.

The Bankruptcy Preference. As a quick refresher, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

Pre-BAPCPA Statute. The ordinary course of business defense, designed to protect parties who engage in normal transactions with a financially troubled business, is one of the most common defenses available to preference recipients. The Ninth Circuit examined it under the version of the preference statute, Section 547 of the Bankruptcy Code, as it existed before the 2005 amendments made in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA). This pre-BAPCPA statute, specifically Section 547(c)(2), provided that a trustee could not avoid a transfer as a preference

to the extent that such transfer was —

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and

(C) made according to ordinary business terms.

The Court's focus was on subsection (A), the "debt" issue. Usually, parties have a series of contracts or purchase orders, as well as a payment history, that gives context to the ordinary course of business between them. In this case, however, the transaction that led to the allegedly preferential payments was their first one. The Court faced the question of whether a debt can be considered as having been incurred in the ordinary course of business of the debtor and the preference defendant when there had been no other past transactions to which it could be compared.

Court Looks To Past Practices With Other Similar Parties. The Court's answer was yes, holding that a preference defendant can indeed assert the ordinary course of business defense involving a debt created by the first contract or transaction between the parties. However, the Ninth Circuit articulated a special rule when a "first time" debt is involved:

[W]hen we have no past debt between the parties with which to compare the challenged one, the instant debt should be compared to the debt agreements into which we would expect the debtor and creditor to enter as part of their ordinary business operations. Consistent with Food Catering [971 F.2d 396 (9th Cir. 1982)], however, this analysis should be as specific to the actual parties as possible. Thus, we hold that to fulfill § 547(c)(2)(A), a first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties. Only if a party has never engaged in similar transactions would we consider more generally whether the debt is similar to what we would expect of similarly situated parties, where the debtor is not sliding into bankruptcy.

Both Original And Restructured Agreements Are Relevant. On a related point, since the first transaction here was an agreement that was later restructured to give the debtor more time to pay, the Ninth Circuit also held that both the original and revised agreement should be evaluated for ordinariness.

Ruling Still Important Under BAPCPA. BAPCPA revised the ordinary course of business defense so that Section 547(c)(2) now provides that a payment or other transfer cannot be avoided

to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

Although different, the current statute still makes the issue decided in the In re: Ahaza Systems case, whether the debt was incurred in the ordinary course of business, a requirement. The major change is that the statute now allows the defense to be established by additionally showing that payments were made either (A) in the ordinary course of business of the parties or (B) according to ordinary business terms, rather than both as under the pre-BAPCPA version.

How Hard To Meet? Having established the new test, the Court then reversed the granting of summary judgment to the defendant because it found the proof presented was inadequate. This suggests that although the Ninth Circuit will permit preference defendants to assert the ordinary course of business defense on first time transactions, some defendants may face a challenge in meeting that standard.

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One of the most important recent decisions by the Delaware Court of Chancery in the insolvency area was the August 10, 2006 opinion in the Trenwick America Litigation Trust case. As discussed at length in an earlier post, the Trenwick America decision by Vice Chancellor Strine (available here) squarely held that there was no cause of action for "deepening insolvency" under Delaware law. The Chancery Court's opinion rejected it as a cause of action in no uncertain terms:

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Delaware Supreme Court Hears Appeal. The significance of the Chancery Court decision makes it particularly interesting to follow the appeal in the case, now before the Delaware Supreme Court. The oral argument on the appeal, held on March 14, 2007 at the Widener University School of Law campus in Wilmington, may shed some light on how the Delaware Supreme Court will ultimately rule. Frank Reynolds of Andrews Publications prepared this news story on the oral argument, and the law school's website also has an article, complete with slideshow, on the oral argument in Trenwick America and in a second case that day. To hear the Trenwick America oral argument for yourself, follow this link and download the audio recording from the Delaware Supreme Court's website.

Focus At Oral Argument. Having listened to the recording (an entertaining addition to my iPod), it's interesting to note that the deepening insolvency issue received only a few mentions during oral argument. Those came mainly during a discussion of the business judgment rule and whether existing contractual and statutory remedies sufficiently protect creditors. Instead, the parties and the Justices focused on the following issues during oral argument:

• Whether the complaint sufficiently pled that the corporation was insolvent or in the zone of insolvency;
• Whether the business judgment rule protected the directors in permitting the subsidiary corporation to incur guaranty and other obligations;
• What fiduciary duty was owed and how it was allegedly breached;
• Whether the zone of insolvency issue was critical to the plaintiff's case; and
• Whether the directors breached any fiduciary duties when following the parent corporation's business plan for the subsidiary and the corporate group.

Reading The Tea Leaves. With the range of issues discussed at oral argument, it's possible that the Delaware Supreme Court will render its decision in the Trenwick America case without considering the Chancery's Court's ruling that deepening insolvency does not exist as a cause of action under Delaware law. Plaintiff's counsel argued that the Delaware Supreme Court could rule for his client without reaching the issue. Likewise, counsel for the defendants urged affirmance based on what Vice Chancellor Strine found to be insufficient pleading of insolvency, a lack of any fiduciary duty owed given the complaint's allegations, and the application of the business judgment rule. Although not directly involving deepening insolvency, in response to a specific question from one of the Justices, defense counsel also argued that the Delaware Supreme Court should consider holding that directors do not owe fiduciary duties to creditors upon insolvency, leaving creditors to the existing protections and remedies otherwise available to them.

After an interesting oral argument, stay tuned.

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A couple of months ago I posted on the new "20 day goods" administrative claim enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"). BAPCPA, which took effect in October 2005, added Section 503(b)(9) to the Bankruptcy Code giving vendors an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date the bankruptcy petition was filed, as long as "the goods have been sold to the debtor in the ordinary course of such debtor's business." 

In my earlier post, I posed a number of unresolved questions about this new section and predicted that courts would soon start to address those issues. Well, in the past couple of months we have in fact seen decisions answering at least a few of the questions raised by Section 503(b)(9).

The First Court Decisions. In late December 2006, bankruptcy courts in the District of Delaware and the Eastern District of Pennsylvania issued what appear to be the first two decisions on when and under what circumstances Section 503(b)(9) administrative claims must or should be paid. As explained below, in both decisions the bankruptcy court held that the administrative claimant was not necessarily entitled to payment prior to, in a Chapter 11 case, confirmation of a plan of reorganization.

• In the first decision, issued December 21, 2006, Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware denied a creditor's motion for payment of a Section 503(b)(9) administrative claim in the In re Global Home Products, LLC Chapter 11 bankruptcy case. The court held that the timing of payment of administrative claims is left to the discretion of the court. In so doing the court quoted with approval from an article that described Section 503(b)(9) as a "rule of priority, rather than payment." The court relied on a non-Section 503(b)(9) decision for the three factors to assess when considering when an administrative claim should be paid, chiefly, (a) the prejudice to the debtor, (b) hardship to the claimant, and (c) potential detriment to other creditors. The court applied those factors and denied the creditor's request for immediate payment.
• In the second decision, issued a week later on December 28, 2006, Judge Eric Frank of the U.S. Bankruptcy Court for the Eastern District of Pennsylvania denied a motion for immediate payment of Section 503(b)(9) claims filed by several creditors in the In re Bookbinders' Restaurant, Inc. Chapter 11 bankruptcy case. Although the debtor agreed that the creditors were entitled to allowance of a "20 day goods" administrative claim, it opposed the immediate payment of those claims. The court held that the timing of payment was a matter of the court's discretion but agreed to hold an evidentiary hearing to consider evidence to guide the exercise of that discretion.

A Few Early Take-Aways. In both of these decisions, the courts held that they have discretion to defer payment until the end of a Chapter 11 bankruptcy case, when a plan of reorganization is confirmed.

• Creditors who can establish that failing to pay their Section 503(b)(9) claim would cause them hardship, but not prejudice the debtor or other creditors, may still be able to obtain immediate payment. As these cases show, however, creditors will find it challenging to meet that standard.
• Interestingly, the Bookbinders court rejected what it called an "equal protection" argument by the creditors, who asserted that they should be paid immediately because vendors delivering goods to the debtor post-petition were being paid on their administrative claims. The court drew a distinction between the two claims, explaining that the creditors delivering goods post-petition were paid not under Section 503(b) but instead under Section 363(c)(1) of the Bankruptcy Code. That latter section allows a debtor in possession or trustee to enter into post-petition ordinary course of business transactions, and to pay for them, without court approval.
• Finally, DIP financing orders can impact the timing of paying Section 503(b)(9) claims. In some cases the DIP budget may not include funds to pay these claims and in others the DIP order may expressly prohibit their payment. Section 503(b)(9) creditors may want to review proposed DIP financing motions carefully with this in mind.

What Debtors Have Been Doing. In an attempt to exert a degree of control over Section 503(b)(9) claims, some debtors have filed motions seeking to establish procedures to handle these claims, not unlike the procedures used in past cases for reclamation claims. In the Seattle case of In re Brown & Cole Stores, LLC, for example, the debtor filed a motion for an order establishing procedures for Section 503(b)(9) claims. The court granted the motion and entered a Section 503(b)(9) procedures order which, among other things:

• Required creditors to file Section 503(b)(9) claims by a special bar date;
• Required the debtor to file a report evaluating such claims 21 days after the special bar date;
• Gave creditors 15 days thereafter to file a reply to the debtor's position;
• Made the debtor's position binding in the event a creditor did not timely respond; and 
• Reserved to the court the right to resolve any disputes. 

The order effectively reserved the issue of when valid Section 503(b)(9) claims would be paid but made the procedures the exclusive method for determining the validity and amount of such claims. I expect that other debtors will pursue similar procedures for handling these "20 day goods" claims.

Don't Touch That Dial. These early decisions are the first in what should be many future rulings on the questions posed by Section 503(b)(9). I'll continue to update you on how courts are interpreting this new administrative claim and, over time, we should begin to see more clarity on how debtors, vendors, and courts will address this new BAPCPA provision.

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Will Price, a principal with venture capital firm Hummer Winblad, has a very interesting post called Isolating Causality: Bad Market or Bad Company. Will identifies a series of factors that can help start-up companies and their investors tease out whether a company's financial and performance problems are company-centric or instead the result of not having a viable market for its products or services. 

Being able to tell the difference is crucial. As Will points out, when the problem is the absence of a market, neither additional investment nor new management will solve the problem. Instead, these companies are likely to be sold, wound down, or have to file for bankruptcy. 

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In a recent post about a vendor's reclamation rights, I discussed how the 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), extended a vendor's right to reclaim goods once a bankruptcy petition has been filed. This post focuses on another of BAPCPA's important changes affecting vendors, specifically, the new provision giving vendors an administrative claim for certain pre-petition goods sold.

Expanded Reclamation Right. As mentioned in my earlier post, a new 45 day bankruptcy reclamation right was added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the Uniform Commercial Code's 10-day reclamation period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing. However, in some cases a vendor may not be able to reclaim its goods. The reasons can include a failure to make a timely reclamation demand, the existence of a secured lender with a lien on the goods in question, or the debtor's prior sale of the goods. 

A Brand New Administrative Claim For Vendors, Even If Reclamation Fails. If a vendor's reclamation claim fails, another new Bankruptcy Code section, Section 503(b)(9), gives vendors an important additional right: an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date a bankruptcy petition was filed "in which the goods have been sold to the debtor in the ordinary course of such debtor's business." 

In most cases, administrative claims are paid in full instead of only cents on the dollar as with general unsecured claims. This new administrative claim is therefore a significant benefit, in effect putting vendors selling goods to a debtor in the 20 days before the bankruptcy filing on par with vendors selling goods after the bankruptcy filing.

• Section 546(c)(2) of the Bankruptcy Code expressly provides that even if a seller of goods fails to provide the required notice to have a post-bankruptcy reclamation claim, the vendor may still assert this special Section 503(b)(9) administrative claim. 
• This administrative claim applies in all types of bankruptcy cases, including Chapter 11 reorganization cases, Chapter 7 liquidation cases, and Chapter 13 cases.
• Vendors who sold goods during the 21 to 45 day period before the bankruptcy filing will have to rely on reclamation alone as to those goods.
• In either case, vendors and debtors should keep good records of shipments and deliveries of all goods received during the 45 days before the bankruptcy filing.

Unresolved Issues. This provision has been in effect for only a year and there are still a number of unanswered questions about how it will actually work in bankruptcy cases. Reviewing these questions may give you a sense of some of the issues to keep in mind when considering whether you (if you're a vendor) or your vendors (if you're a debtor) will have an administrative claim for "20 day goods." These issues include:

• Since the vendor is entitled to an administrative claim for the "value of any goods received by the debtor," does that mean the invoice price or some other amount?
• Does the term "goods" include services bundled with the goods?
• Does the term "goods" include intellectual property-based products, such as boxed software or other similar items, which the debtor resells or sublicenses?
• Does the "received by the debtor" requirement exclude goods that have been drop-shipped to a debtor's customer at the debtor's direction?
• What does the requirement that the goods have been "sold to the debtor in the ordinary course of such debtor's business" really mean?
• Does the vendor have to file a pleading to be paid on this administrative claim, given that this new section requires "notice and a hearing"?
• Can the debtor pay for the goods at the beginning of the case, much as it would for goods purchased after the bankruptcy filing, as a way of treating qualifying vendors as "critical vendors"?
• Can the debtor wait to pay for these "20 day goods" until a plan of reorganization goes effective, as it can for certain other administrative claims?
• If a Chapter 11 case converts to a Chapter 7 case, will this "20 day goods" administrative claim be treated as a Chapter 7 administrative claim, ahead of all unpaid Chapter 11 administrative claims, including those for goods sold during the Chapter 11 case?
• Will the existence of this administrative claim provision give vendors who actually got paid before the bankruptcy for "20 day goods" a new defense to a claim that the payment was preferential? 

Get Good Advice. These issues, and the potential for a valuable administrative claim, are yet another reason for vendors to get good legal advice as soon as they learn of a bankruptcy filing. Debtors also need to get good advice, both legal and financial, so they can factor in how the requirement to pay for these pre-petition goods as an administrative claim will impact their cash needs.

Stay Tuned. This provision has been in effect for only one year, and applies only to cases filed after BAPCPA took effect on October 17, 2005. No formal court decisions have addressed, much less answered, these open questions. I expect bankruptcy courts will start to answer some of these questions in the coming months, and I'll keep you updated on those developments. 

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Although vendors sell goods to get paid, it doesn't always work out that way. If the customer is insolvent or files bankruptcy, the vendor may be stuck with an unpaid account. To make matters worse, some customers (especially those with limited prospects for financing) may even "load up" on inventory and then file bankruptcy without paying. Regardless of why it happens, no one wants to ship goods and not get paid.

Some vendors, however, may be able to take advantage of a special, although limited, right to get back or "reclaim" certain of the goods. This reclamation right is part of both the Uniform Commercial Code and the Bankruptcy Code. The recent 2005 amendments to the bankruptcy laws, known as the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (called "BAPCPA"), made some significant changes that have enhanced a vendor's rights in a bankruptcy. This post discusses how reclamation rights play out both before and after bankruptcy.

Reclamation before bankruptcy. If the customer has not filed for bankruptcy, a vendor's reclamation rights are governed by the Uniform Commercial Code (known as the "UCC"). UCC Section 2-702 is the UCC"s reclamation statute. It provides a seller with the right to reclaim goods that a customer received on credit "while insolvent" if the seller makes a demand within ten days after the customer received the goods. This 10-day period means that, absent a bankruptcy, a vendor's reclamation right will be limited to reclaiming only those goods received by the customer in the ten days prior to the demand.

• Under the UCC, "insolvent" means (A) having generally ceased to pay debts in the ordinary course of business other than as a result of good faith dispute; (B) being unable to pay debts as they become due; or (C) being insolvent within the meaning of federal bankruptcy law.
• Under the federal Bankruptcy Code, insolvent means that the entity's debts exceed the value of its assets at a fair valuation. This is essentially a balance sheet test but, importantly, one using market value and not financial reporting standards such as GAAP. Because they are prepared for a different purpose, GAAP balance sheets tend to overstate asset values and understate actual liabilities compared to the bankruptcy balance sheet test. Companies that might seem solvent under GAAP could be insolvent under the UCC or the Bankruptcy Code.
• If the customer misrepresented its solvency in writing during the three months before the delivery of the goods in question, then the 10-day limitation does not apply.

The UCC reclamation demand. To exercise a reclamation right before bankruptcy, the vendor must make a demand. The demand should be in writing, directed to the customer, identify which goods are being reclaimed to the extent that information is available, include a general statement reclaiming all goods received by the customer from the vendor during the applicable time period, and demand that the goods be segregated. Vendors should consult with counsel to be sure the demand adequately protects their reclamation rights.

Reclamation after bankruptcy. Because of changes made in the 2005 amendments to the Bankruptcy Code, applicable to all bankruptcy cases filed on or after October 17, 2005, the filing of a bankruptcy now actually expands a vendor's reclamation rights. These new provisions apply in both Chapter 11 reorganization cases and Chapter 7 liquidation cases. Some of the key changes include:

• A new, 45-day bankruptcy reclamation right has been added to Section 546(c) of the Bankruptcy Code. Prior to this change, the Bankruptcy Code had merely incorporated the UCC's 10-day period. Now, once a bankruptcy is filed, a vendor can assert a reclamation demand for goods received within 45 days of the bankruptcy filing.
• The goods must have been sold in the "ordinary course" of the vendor's business and the debtor must have received the goods while insolvent (using the Bankruptcy Code's definition of insolvent discussed above).
• The reclamation demand must be in writing and made within 45 days of the receipt of the goods by the customer (now the debtor in bankruptcy).
• If the 45-day period expires after the bankruptcy case is filed, the vendor must make the reclamation demand within 20 days after the bankruptcy filing.
• As with pre-bankruptcy demands under the UCC, the demand should identify the goods being reclaimed, include a general statement reclaiming all goods received by the debtor from the vendor during the 45-day period, and demand that the goods be segregated. Vendors may also want to file a notice of reclamation with the bankruptcy court.

Sold goods and other issues. Whether before or after a bankruptcy filing, a vendor will lose its right to reclaim any goods that the customer sells before or after receiving the vendor's reclamation demand. 

• Absent an agreement with the customer or a reclamation program approved by the bankruptcy court (see this example from the Delphi case, which was filed before the new BAPCPA rules took effect), a vendor may be forced to seek and obtain a court order preventing further sales of goods while its reclamation claim is pending. 
• This "sold goods" problem has probably become more important because BAPCPA removed language from the prior version of Section 546(c) that had allowed a bankruptcy court to give a reclaiming vendor an administrative claim (with priority over unsecured claims and certain other claims) in lieu of a return of the goods.
• Both the UCC and the Bankruptcy Code require that the debtor itself must have received the goods for them to be reclaimed. Thus, goods that are drop shipped or otherwise delivered first to the debtor's own customer likely will not be able to be reclaimed.
• If the debtor made a misrepresentation of its solvency and then filed bankruptcy, it's unclear whether the 45-day rule in bankruptcy will govern or whether, like under the UCC, no time limit will apply. Keep in mind, however, that often goods shipped as far back as 45 days or longer, and sometimes even as few as 10 days for debtors with fast inventory turns, may already have been sold and thus will not be subject to reclamation. 

Rights of secured creditors. A vendor's reclamation right is further limited by the possibility that the debtor may have granted a bank or other creditor a security interest in the goods, which will be senior to the reclamation right.  As amended in 2005, Section 546(c) now expressly makes reclamation rights subject to the prior rights of a secured creditor with a security interest in goods or their proceeds.

New administrative claim for 20-day goods. Even if a vendor fails to make a reclamation demand, all may not be lost. A new Bankruptcy Code section, Section 503(b)(9), added by BAPCPA, gives vendors an administrative priority claim for the value of any goods received by the debtor within 20 days prior to the bankruptcy filing if the goods were sold in the ordinary course of the debtor's business. (I intend to discuss this new provision in a future post.) For now, note that it may be an important "fall back" right for vendors who fail to make a reclamation demand or who are unable to reclaim goods for other reasons.

Impact of new reclamation right on debtors and other creditors. With every new right also comes new burdens. Vendors certainly have greeted as good news the ability to reclaim goods received by a debtor as far back as 45 days. The impact of these changes on debtors, however, remains unclear. Some bankruptcy attorneys wonder whether this expanded reclamation right, together with the administrative claim for 20-day goods and certain other changes made by BAPCPA, will make it more difficult for debtors to reorganize or otherwise to pay unsecured creditors.

As always, get good legal advice. Reclamation can involve a number of twists and turns. Vendors who think they may have reclamation rights should be sure to get legal advice immediately upon learning of a customer's insolvency or bankruptcy to protect their interests, just as debtors should to know their own rights in response to reclamation demands.

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The Delaware Court of Chancery has issued another decision involving creditor claims against directors of a financially troubled corporation. In North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 2006 WL 2588971 (Del. Ch. Sept. 1, 2006), Vice Chancellor Noble made two important holdings:

• First, although derivative claims can be brought, creditors may not assert direct claims against directors of a Delaware corporation for alleged breaches of fiduciary duty that occur while the corporation is in the "zone of insolvency." 
• Second, assuming Delaware law would allow any creditor to bring a direct, non-derivative claim against directors of an actually insolvent corporation (still an unresolved question), the suing creditor's right to payment would have to be "clearly and immediately due." Thus, creditors with disputed or contingent claims likely will not be able to assert a direct claim for breach of fiduciary duty, even if the corporation is in fact insolvent.

A copy of the decision is available here. Thanks to the Delaware Business Litigation Report blog for reporting on it first. 

No direct claim in the "zone of insolvency." The court's refusal to permit a creditor to assert a direct claim -- as opposed to a derivative claim -- against corporate directors for breach of fiduciary duty in the zone or vicinity of insolvency was based on its careful analysis of the arguments for and against such claims. The court summed up its reasoning:

Indeed, it would appear that creditors’ existing protections—among which are the protections afforded by their negotiated agreements, their security instruments, the implied covenant of good faith and fair dealing, fraudulent conveyance law, and bankruptcy law—render the imposition of an additional, unique layer of protection through direct claims for breach of fiduciary duty unnecessary. Moreover, any benefit to be derived by the recognition of such additional direct claims appears minimal, at best, and significantly outweighed by the costs to economic efficiency. One might argue that an otherwise solvent corporation operating in the 'zone of insolvency' is one in most need of effective and proactive leadership—as well as the ability to negotiate in good faith with its creditors—goals which would likely be significantly undermined by the prospect of individual liability arising from the pursuit of direct claims by creditors.

Unclear if direct claims can be brought at all, even in a case of actual insolvency. The court engaged in a different analysis, focused more on the deficiency of the actual allegations in the complaint, in dismissing direct claims against the directors during the corporation's alleged actual insolvency. However, the court commented that, to the extent Delaware law would permit a creditor to have a direct claim against directors of an insolvent corporation for breach of fiduciary duty, the claim would have to involve invidious conduct directed at that creditor. In so holding, the court relied heavily on two earlier decisions of the Court of Chancery, one by Vice Chancellor Strine in Production Resources Group v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004) (discussed in an earlier post) and the other by Vice Chancellor Lamb in Big Lot Stores, Inc. v. Bain Capital Fund VII LLC, et al., 2006 WL 846121 (Del. Ch. March 28, 2006) (available here). These decisions, taken together, suggest that most if not all creditor claims for breach of fiduciary duty against directors of insolvent Delaware corporations will be characterized as derivative and not direct claims.

Developing trend against expanding a director's exposure to creditor claims. The Production Resources, Big Lot Stores, and now North American Catholic Educational Programming decisions, together with the recent Trenwick America Litigation Trust case refusing to recognize a cause of action for deepening insolvency (discussed in an earlier post), reflect the Delaware Court of Chancery's resistance to attempts by creditors to expand the liability of directors when a corporation is insolvent or in the zone of insolvency. Although well-stated derivative claims by creditors for breach of fiduciary duty may be recognized by the courts in some cases, a direct claim by a creditor -- if such a claim exists at all under Delaware law -- seems to be limited to the rare circumstance in which that particular creditor was the only creditor harmed by an alleged breach of fiduciary duty. The Delaware Supreme Court has yet to weigh in, but these four decisions from three different Vice Chancellors indicate that the Court of Chancery is developing a consistent view on these issues.

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Over the past few years, a number of bankruptcy and other federal courts have held that plaintiffs, often bankruptcy trustees or other bankruptcy estate representatives, could pursue a cause of action against a corporation's directors and others for "deepening insolvency."  What has made a deepening insolvency claim so attractive to plaintiffs and troubling to defendants is the lack of clarity about what conduct might give rise to such a claim, how damages for it might be calculated, and whether it would allow for expanded recoveries under other causes of action. 

What is deepening insolvency? Courts have described deepening insolvency as the "fraudulent prolongation of a corporation's life beyond insolvency," resulting in "damage to the corporation caused by increased debt" and similarly as the “fraudulent expansion of corporate debt and prolongation of corporate life.”  A more colorful way of putting it might be, under some circumstances, "better dead than (deeper in the) red." 

A question of state law. Since federal courts apply state law to many substantive issues, those federal courts that have recognized a deepening insolvency cause of action have done so by predicting how state courts would rule on the question.  With so many companies incorporated there, Delaware's view on deepening insolvency may be the most important.  For that reason, many attorneys took note when in the past few years bankruptcy courts in Delaware allowed deepening insolvency claims to go forward, based on their prediction that Delaware state courts would also recognize the cause of action.

The new Delaware decision.  Although federal courts had issued rulings, no Delaware state court had decided whether a cause of action for deepening insolvency exists under Delaware law.  Well, that changed on August 10, 2006, when Delaware's corporate law court, the Court of Chancery, issued a decision in a case called Trenwick America Litigation Trust v. Ernst & Young LLP, et al.  Click here to read the court's decision.

In Trenwick America, Vice Chancellor Strine squarely held, in unusually strong language, that no cause of action for deepening insolvency exists under Delaware law. The court also elaborated on how the business judgment rule can protect directors when a corporation is insolvent or in the zone of insolvency. Since the decision is almost 90 pages long, I've quoted below from the key deepening insolvency discussion (although I left out the extensive footnotes). It makes for interesting reading -- even if you're not a lawyer. 

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, 'deepening insolvency' is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure.  With the prospect of profit often comes the potential for defeat.

The general rule embraced by Delaware is the sound one.  So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.

If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.

The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility.  Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.  The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure.  If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.

Moreover, the fact of insolvency does not render the concept of “deepening insolvency” a more logical one than the concept of “shallowing profitability.”  That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one.  If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler.  No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.

In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor.  Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part.  None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

You might find Professor Larry Ribstein's discussion of the new decision interesting, as well as the comments made by Francis Pileggi, who publishes the Delaware Corporate and Commercial Litigation Blog.  They also discuss another aspect of the decision, the holding that directors of a wholly owned subsidiary corporation did not breach their fiduciary duties by taking on debt for the benefit of the parent corporation, even though both the parent and subsidiary ended up in bankruptcy.

Echoes of Production Resources. Some of you may recall that Vice Chancellor Strine was also the author of the November 2004 Production Resources decision, which interpreted Delaware law more favorably for directors of corporations that are insolvent or in the "zone of insolvency." The Production Resources decision was the subject of an earlier post. 

This new decision builds on Production Resources and, in so doing, follows an approach similar to one recently taken by a bankruptcy court in New York in In re Verestar, Inc.  The June 2006 Verestar decision cited to Production Resources and predicted that Delaware courts would reject deepening insolvency as a cause of action. Click here for a copy of the Verestar decision; its deepening insolvency discussion starts at page 41. 

Conclusion. With a clear voice from the Delaware Court of Chancery, the Trenwick America decision reinforces a recent trend among some federal courts to step away from recognizing deepening insolvency as a separate cause of action.  As with any new decision, however, the real test of its influence will be the extent to which other courts, including Delaware's highest court, the Delaware Supreme Court, follow its holding and reasoning. 

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The fiduciary duties that directors owe a Delaware corporation and its shareholders are generally held to expand to include the interests of creditors when the company is insolvent or in the "zone of insolvency."  A hot topic among directors, particularly those serving on boards of troubled companies, is how best to meet their fiduciary duties and avoid the potential for personal liability in these situations. 

One of the most important decisions in recent years on this issue came from the Delaware Court of Chancery, the corporate law court, in November 2004 in a case called Production Resources. Why is the case important?  In short, the Production Resources court interpreted the law in a way that gives directors more protection when they make business judgments for a troubled company. 

First, the Production Resources court rejected a trend among some courts and commentators that had sought to impose on directors of insolvent or potentially insolvent corporations a new set of fiduciary duties, beyond those owed to the corporation, in favor of creditors. That trend started back in 1991 with the Court of Chancery decision in the Credit Lyonnais case -- the decision that helped coin the phrase “vicinity” or “zone” of insolvency.  

Second, it held that the common exculpatory provision found in the corporate charter of most Delaware corporations, protecting directors from liability for monetary damages for a breach of the fiduciary duty of care, applies to claims made by creditors as well as by shareholders or the corporation itself.

This analysis discusses the Production Resources decision in more detail. (A pdf of the analysis is available as well.)  A "zone of insolvency" conference last November also produced an interesting discussion reported by Professor Larry Ribstein.  If you want to read the 54-page Production Resources decision itself, click here.

The decision's ultimate impact will depend on whether other courts (including bankruptcy courts where these issues are often litigated) decide to follow its approach -- so stay tuned.

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Many businesses not only sell products or services to another company, they also buy products and services from that company.  If you do business with a customer or vendor and you each end up owing the other money, you may have the right to "set off" the amount the other company owes you against the amount you owe it.  

Setoff. When a complete setoff is made, no cash changes hands but each side's debt to the other is canceled. In some business relationships, including in the telecommunications industry, these kinds of cross-debts occur frequently and setoffs can be an important part of the payment structure. In others, setoffs only come up if one side fails to pay what it owes.  The term is also used to describe a bank's right to sweep or set off the amounts owed on a loan against amounts the borrower has on deposit at the bank. 

Recoupment. A related concept called "recoupment" is similar to a setoff but it applies only when the offsetting amount or other defense to payment arises from the same contract or transaction that gives rise to your debt to the other company.

Impact of bankruptcy. The U.S. Bankruptcy Code does not create any setoff rights, but with certain limitations it does recognize the rights that exist under other applicable law.  However, with a bankruptcy filing comes a new risk that is similar to the preference risk that arises when you receive a direct payment before a bankruptcy.

• If you made a setoff within 90 days before the bankruptcy filing, the debtor company (or its bankruptcy trustee, if one has been appointed) may have a right to sue you to recover the amount of that pre-bankruptcy setoff.  
• Be sure to maintain detailed records of any setoffs made, along with the amounts each side owed the other during the business relationship. These records can be very helpful to your defense if such a claim is ever brought.

Setoff after bankruptcy. Making a setoff after a bankruptcy is filed -- also known as a "post-petition" setoff -- is allowed only in narrow circumstances.  Among other technical requirements, the debts have to be mutual between you and the actual debtor (not with one of its subsidiaries, for example) and they have to have arisen before the bankruptcy was filed.  Another very important point to remember is that you cannot make a setoff unless the bankruptcy court first grants you relief from the automatic stay that arises as soon as a company files for bankruptcy.

Get legal advice. This is a complex area of bankruptcy law and neither setoffs nor recoupments should be attempted after a bankruptcy has been filed without the advice of a bankruptcy attorney.  The old adage “Don’t try this at home” definitely applies. 

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Insolvent or nearly insolvent companies can present an attractive opportunity to purchase assets on the cheap, or at least at a significantly reduced cost.  Of course, a buyer purchasing assets from a troubled company wants to be as sure as possible that it is buying only the target's assets – and not also taking on all of the troubled company’s liabilities. This kind of specialized M&A deal raises issues that usually don't come up when acquiring a solvent company and that aren't always obvious at first. 

Several different strategies exist for balancing these risks with the potentially substantial rewards of a distressed asset acquisition.  Here is an overview of these issues.  A more extensive discussion focusing in particular on intellectual property assets, written by Cooley Godward intellectual property partner Gary Moore, can be found here.

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It's bad enough when you can't collect everything you are owed because of a customer's financial problems.  We've all faced that situation at one time or another.  Unfortunately, the U.S. Bankruptcy Code can add an entirely different wrinkle to the problem called a "preference."  (The word comes from the idea that your successful collection efforts enabled you to get preferred treatment over your customer's other creditors that didn't get paid.)  

Without some planning, an unhappy scenario can develop even if you aggressively move to collect the account.  If the customer files for bankruptcy, the customer's bankruptcy trustee -- or even the customer itself -- may sue you to recover those payments you were lucky enough to collect, calling them preferences. 

There are defenses and, with some careful planning, you can act to protect yourself.  These range from waiting to ship new goods or provide new services until after you've received a payment to putting the customer on C.O.D. or other payment in advance arrangement.  Here are some pointers on minimizing the bankruptcy preference risk. 

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