Business Bankruptcy Issues

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Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Defending A Preference: Ninth Circuit Holds That Even First Time Transactions Can Be In The “Ordinary Course”

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.

Business Bankruptcy Issues Recent Developments

New Article On How Distressed Debt Investors Are Preparing For The Next Economic Downturn

The DealBook blog from the New York Times has an interesting post entitled "Stocking Up For A Storm." It describes how certain investment banks have been expanding their distressed debt businesses, believing that the length of the current "good times" period may actually lead to an increase in the level of distress when the economy finally turns. 

The DealBook post points readers to a new article in The Economist on so-called vulture investors. Entitled "The Vultures Take Wing," the article discusses the view of many investors and insolvency professionals that, after a drought of restructurings, a new wave of bankruptcies and defaults may not be too far off. When the problems come, they will likely be even more complex than in past cycles. Not only have very active hedge funds taken a much greater role in recent years, but many companies now have an additional tranche of secured debt in the form of the increasingly popular second lien loans.

While corporate restructurings and Chapter 11 bankruptcy cases have always been complex, when the next surge in defaults hits these trends are likely to present even more challenges — and perhaps opportunities — for both debtors and creditors.

Business Bankruptcy Issues Recent Developments

Northwest Airlines Ad Hoc Committee Files Second Appeal On Disclosure Of Trading Details

As reported last week, the Ad Hoc Committee of Equity Security Holders in the Northwest Airlines case, a group made up chiefly of hedge funds, recently complied with the Bankruptcy Court’s earlier orders and filed a Rule 2019 statement disclosing details of their trades. Having made the filing, it wasn’t clear whether the Ad Hoc Committee would continue to appeal from the Bankruptcy Court’s decisions compelling the disclosure. An answer to that question came late in the day on Monday, March 26.

New Appeal Filed. Late Monday, the remaining membership of the Ad Hoc Committee of Equity Security Holders filed a second notice of appeal, this time from the Bankruptcy Court’s original February 26, 2007 decision requiring the detailed statement to be filed. A copy of the new notice of appeal is available here. An earlier notice of appeal was filed from the Bankruptcy Court’s March 9, 2007 order denying a motion to file the Rule 2019 statement under seal. It appears that the earlier appeal will be pursued as well.

No Stay Pending Appeal. As previously reported, at a March 15, 2007 hearing the Bankruptcy Court also denied the Ad Hoc Committee’s motion for a stay pending appeal. However, the Ad Hoc Committee got until March 25, 2007 to seek a stay from the United States District Court for the Southern District of New York. (Here’s the Bankruptcy Court’s order on the stay issue, which was filed only last Friday.) Despite the temporary reprieve, the Ad Hoc Committee apparently decided against seeking a stay pending appeal and instead went ahead and filed the updated Rule 2019 statement and then a new appeal.

The Disclosure Issue Moves To Another Court. With the new appeal filed Monday, this issue should be headed to the District Court for briefing and argument in the coming months. It’ll be interesting to see whether the District Court, sitting as an appellate court, has any different reaction to the disclosure issue. Stay tuned for future developments.

Business Bankruptcy Issues Recent Developments

A Smaller Ad Hoc Committee Of Hedge Funds Discloses Trading Information In Northwest Airlines

As reported last week, the Bankruptcy Court in the Northwest Airlines Chapter 11 bankruptcy case ordered the Ad Hoc Committee of Equity Security Holders to make public detailed information about the claims and stock they own and the amounts they paid for them. For those who missed it, here’s the Bankruptcy Court’s first decision on the Rule 2019 disclosure issue back on February 26, 2007. If you want the full story on the hedge fund disclosure issue, check out these two earlier posts, which you can find here and here.

Ad Hoc Committee Discloses Trades. After failing to persuade the Bankruptcy Court to reconsider its decision or to allow the disclosure to be filed under seal, a noticeably smaller Ad Hoc Committee filed this Rule 2019 disclosure on Wednesday, March 21, 2007, providing details on the amounts of claims or stock held, the dates purchased, and the amounts paid. The Ad Hoc Committee’s membership appears to have been reduced by at least four, currently standing at nine, although the Rule 2019 statement does not explain the change in membership or include any disclosure by the former members.

Although Smaller, Ad Hoc Committee Is Still Intact. The filing answers at least one question — whether the hedge funds involved would decide to disband the ad hoc committee to avoid disclosing their trading information. While four dropped out, it seems that the nine remaining Ad Hoc Committee members concluded that the benefits of collective action outweighed the burdens of making the required disclosure.

Appeal Status Unclear. The Ad Hoc Committee had previously filed a notice of appeal from the Bankruptcy Court’s decision, seeking review by the United States District Court for the Southern District of New York. With the disclosure actually filed, it’s not clear whether the Ad Hoc Committee plans to drop the appeal and an accompanying motion for leave to appeal, which it had originally filed in the Bankruptcy Court, and whether the appeal would be moot if continued. Should the Ad Hoc Committee or its former members pursue the appeal effort, I’ll post updates as developments warrant. 

Business Bankruptcy Issues

The U.S. Supreme Court Rejects The Fobian Rule Barring Unsecured Creditors From Recovering Attorney’s Fees In Bankruptcy Cases

Attorney’s Fees And Unsecured Claims. For more than 15 years, creditors in the Ninth Circuit who sought to include in unsecured claims amounts for attorney’s fees incurred post-petition litigating bankruptcy issues have had that portion of their claims disallowed. The reason? A decision by the United States Court of Appeals for the Ninth Circuit in a 1991 case called In re Fobian, 951 F.2d 1149 (9th Cir. 1991).  

The Fobian Rule. In In re Fobian, the Ninth Circuit held that even if the parties’ underlying contract provided for the prevailing party to recover attorney’s fees, "where the litigated issues involve not basic contract enforcement questions, but issues peculiar to federal bankruptcy law, attorney’s fees will not be awarded absent bad faith or harassment by the losing party." 

The Supreme Court Overrules Fobian. That all changed on Tuesday, March 20, 2007, with the U.S. Supreme Court’s unanimous decision in Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co. (click here for the decision). Neither Travelers nor PG&E sought to defend the Fobian rule, and the Supreme Court had little problem disposing of it:

The Fobian rule finds no support in the Bankruptcy Code, either in §502 or elsewhere. In Fobian, the court did not identify any provision of the Bankruptcy Code as providing support for the new rule. See 951 F. 2d, at 1153. Instead, the court cited three of its own prior decisions, In re Johnson, 756 F. 2d 738 (1985); In re Coast Trading Co., 744 F.2d 686 (1984); and In re Fulwiler, 624 F. 2d 908 (1980) (per curium). Significantly, in none of those cases did the court identify any basis for disallowing a contractual claim for attorney’s fees incurred litigating issues of federal bankruptcy law. Nor did the court have occasion to do so; in each of those cases, the claim for attorney’s fees failed as a matter of state law. See Johnson, supra, at 741–742; Coast Trading, supra, at 693; Fulwiler, supra, at 910. [footnote omitted]

The absence of textual support is fatal for the Fobian rule. Consistent with our prior statements regarding creditors’ entitlements in bankruptcy, see, e.g., Raleigh, 530 U.S., at 20, we generally presume that claims enforceable under applicable state law will be allowed in bankruptcy unless they are expressly disallowed. See 11 U. S. C. §502(b). Neither the court below nor PG&E has offered any reason why the fact that the attorney’s fees in this case were incurred litigating issues of federal bankruptcy law overcomes that presumption.

An Important But Undecided Question. Although the Supreme Court dispatched the Fobian rule, it remanded the case without deciding whether Travelers, an unsecured creditor, could actually recover its attorney’s fees. Instead, the Supreme Court held that the remaining arguments had not been raised below. Still to be resolved is whether Section 506(b) of the Bankruptcy Code, which expressly allows attorney’s fees to oversecured creditors, means that creditors cannot recover attorney’s fees as part of an unsecured claim. For a flavor of the Supreme Court’s reactions to this open issue, you may find the transcript of the oral argument, held in January 2007, interesting .

Thanks to the Supreme Court of the United States Blog and the Georgia Bankruptcy Law Blog for first reporting on the decision.

Business Bankruptcy Issues Recent Developments

No Fooling: Bankruptcy Code Dollar Amounts Will Increase On April 1st

Although it hasn’t gotten much publicity, certain dollar amounts in the Bankruptcy Code will be increased for cases filed on or after April 1, 2007. You can find a chart listing all of the changes on this Federal Register page, which printed last month’s official notice from the Judicial Conference of the United States. 

Among the most meaningful for business bankruptcy cases:

  • The total amount of claims required to file an involuntary petition increases to $13,475 from $12,300;
  • The employee compensation priority under Section 507(a)(4) increases to $10,950 from the $10,000 level established by the Bankruptcy Abuse Prevention and Consumer Protection Act (known as BAPCPA);
  • The consumer deposit priority under Section 507(a)(7) increases to $2,425 from $2,225;
  • The dollar amount in the bankruptcy venue provision, 28 U.S.C. Section 1409(b), that requires actions for non-consumer, non-insider debt to be brought against defendants in the district in which they reside, has increased to $10,950 from $10,000.

Other adjustments will affect consumers more than business debtors. For example, the debt limit for an individual to qualify to file a Chapter 13 bankruptcy case will top $1,000,000 of secured debt for the first time, and certain exemption amounts will also rise. 

Although the changes aren’t large, be sure to keep them in mind when evaluating cases after April 1st. 

Business Bankruptcy Issues Recent Developments

The Latest On Northwest Airlines And The Hedge Fund Disclosure Issue

The Rule 2019 Decisions. As I reported in a post earlier this week, after first ruling that members of an Ad Hoc Committee of Equity Security Holders were required to disclose detailed information about the claims or stock they own and the amounts they paid for them, on March 9, 2007, the Bankruptcy Court in the Northwest Airlines case issued a second decision holding that this Rule 2019 information must be filed publicly.

The Motion for Reconsideration. Three hedge funds that are members of the Ad Hoc Committee filed a motion for reconsideration of the Bankruptcy Court’s first decision. In addition, the Loan Syndications and Trading Association (LSTA) and the Securities Industry and Financial Markets Association (SIFMA) filed an amicus curiae brief in support of the motion for reconsideration, arguing as follows:

LSTA and SIFMA are very concerned that the Rule 2019 Decision will have a serious detrimental impact on the willingness and ability of many stakeholders to participate in future chapter 11 cases. Although the Debtors and certain equity holders are at odds in these cases, there are countless examples in other cases where groups of stakeholders have cooperated, many times in the guise of ‘ad hoc’ committees to create imaginative and strikingly successful solutions. The Rule 2019 Decision, by requiring the disclosure of proprietary and highly confidential information, will in all likelihood erect a substantial obstacle to the participation of many stakeholders – in particular, those sophisticated stakeholders that are the most likely to have the means and the experience to make a positive contribution toward reorganization.

The Court Rules On The Motion For Reconsideration. The hearing on the motion for reconsideration took place on March 15, 2007. As reported by the Associated Press here, the Bankruptcy Court denied the reconsideration motion, describing it as "totally frivolous" and observing that it did not advance any new arguments.

Motion for Leave To Appeal. Given that the Ad Hoc Committee had filed a notice of appeal of the Bankruptcy Court’s decision on March 14, 2007, at the March 15, 2007 hearing the Bankruptcy Court apparently agreed to stay its ruling for ten days. The stay is designed to permit the Ad Hoc Committee the opportunity to pursue a motion for leave to appeal, which it had also filed on March 14, 2007, in the United States District Court for the Southern District of New York. The motion seeks leave to appeal on the following basis:

[T]he bankruptcy court ordered the Ad Hoc Committee to disclose to the world detailed trading data, including all individual purchases and sales of any interest in the Debtors (whether it be stock, bonds, claims or any other interest), including purchase and sales prices. The Ad Hoc Committee hereby seeks to appeal the decision refusing to allow the filing to be made under seal. As an initial matter, the order at issue is a final order within the meaning of 28 U.S.C. § 158(a)(1). Likewise, the order satisfies the collateral order doctrine also making the decision appealable now. Nevertheless, the cases vacillate between characterizing such an appeal under the collateral order doctrine as one of right or one requiring leave. Accordingly, and so as to avoid any doubt as to the validity of the appeal, the Ad Hoc Committee also seeks leave in addition to having filed its notice of appeal as of right.

More Action Ahead. With Bankruptcy Judge Gropper’s latest decision and the motion for leave to appeal, it looks like the disclosure issue will now shift to the District Court. The Bankruptcy Court reportedly has also deferred decision on the Ad Hoc Committee’s motion for appointment of an examiner, apparently until the Rule 2019 statement is filed or the appeal is resolved. I’ll plan to provide additional updates as developments warrant.