Business Bankruptcy Issues

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Business Bankruptcy Issues The Financially Troubled Company

The Privilege Is All Mine: What Happens To A Corporation’s Attorney-Client Privilege In Bankruptcy?

It’s well-established that a corporation has an attorney-client privilege and can assert it to keep communications between the corporation and its attorneys confidential. When a corporation is solvent, its officers and directors maintain the right to assert — or waive — the attorney-client privilege on behalf of the corporation, and control who has access to privileged communications.

The Attorney-Client Privilege In Bankruptcy. This raises a question: what happens if the corporation files bankruptcy? The answer depends on the type of bankruptcy filed and whether a bankruptcy trustee is appointed.

  • Chapter 11 Case. In a Chapter 11 reorganization bankruptcy, the corporation generally remains as a "debtor in possession," unless a trustee is appointed. As a debtor in possession, the corporation’s board of directors and management remain in control — literally "in possession" — of the company’s assets. Courts have held that this control extends to the continued right to assert, or waive, the corporation’s attorney-client privilege.
  • Chapter 7 Bankruptcy. In a Chapter 7 liquidation bankruptcy, a Chapter 7 trustee is appointed and the debtor corporation’s board and management is removed from control. The U.S. Supreme Court held in CFTC v. Weintraub, 471 U.S. 373 (1985), that it’s the Chapter 7 trustee alone who controls the ability to assert, or waive, the corporation’s attorney-client privilege. This means that the Chapter 7 trustee is given access to all of the corporation’s attorney-client privileged communications prior to bankruptcy.
  • Chapter 11 Trustee. The answer is less clear in the relatively few Chapter 11 cases in which the court appoints a Chapter 11 trustee. Several courts, however, have extended the Supreme Court’s decision in Weintraub and held that the appointed Chapter 11 trustee, like a Chapter 7 trustee, takes control of the debtor’s assets and therefore has authority to assert or waive the corporation’s attorney-client privilege and to access privileged communications.

Access To Attorney-Client Privileged Communications. It’s important for officers, directors, and attorneys for corporations to remember that the attorney-client privilege belongs to the corporation. Anyone who later gains control of the corporation will have access to its attorney-client privileged communications.

  • While nothing new, for solvent companies this means that, for example, future officers and directors will have access to attorney-client communications that took place in the past between corporate counsel and former officers and directors. The same is true when a corporation is acquired through a merger; the new ownership and management takes control of the corporation — and also of its past and present attorney-client privileged communications.
  • Likewise, when a corporation files bankruptcy, a bankruptcy trustee, certainly a Chapter 7  trustee and probably a Chapter 11 trustee, will be given similar access to the corporation’s attorney-client communications. This is true even if the trustee wants access to use previously privileged communications, as they sometimes will do, to bring causes of action against former officers and directors or others.

Conclusion. The attorney-client privilege is an essential part of the attorney-client relationship, fostering the ability of a corporation to get the full benefit of its counsel’s legal advice. While not always obvious, the privilege is held by the corporation, not specific officers or directors. Companies that file Chapter 11 bankruptcy and remain as a debtor in possession generally do not turn over the corporation’s attorney-client privilege to a third party. However, if the corporation files or ends up in a Chapter 7 bankruptcy, or perhaps has a Chapter 11 trustee appointed, control of the corporation, and its attorney-client privileged communications, may well end up in the hands of the bankruptcy trustee. 

Business Bankruptcy Issues Recent Developments

Video Of Testimony Before ABI Commission To Study Reform Of Chapter 11

As mentioned in a recent blog post, the American Bankruptcy Institute has established a Commission to Study the Reform of Chapter 11. A video of testimony before the Commission’s June 4, 2013 field hearing in New York is available below.

  • At that hearing, I testified on the second panel, discussing intellectual property licenses, their treatment in bankruptcy cases, and potential reforms to address several key issues. My testimony begins at the 01:14:14 mark.
  • Lawrence Gottlieb, my colleague at Cooley LLP in our Corporate Restructuring and Bankruptcy group, testified as part of the first panel, focusing on real property lease issues, how they impact Chapter 11 cases (especially those involving retailers), and suggested reforms. His testimony begins at the 00:08:12 mark.

More information on the Commission and its work, together with access to the video and written testimony of all panelists at the Commission’s hearings, is available at the Commission’s website.

 

Business Bankruptcy Issues Recent Developments

ABI Commission To Study The Reform Of Chapter 11

The American Bankruptcy Institute has established a Commission to Study the Reform of Chapter 11.

  • This afternoon, June 4, 2013, I will be testifying before the Commission about intellectual property licenses, their treatment in bankruptcy cases, and potential reforms to address several key issues. 
  • Lawrence Gottlieb, my colleague at Cooley LLP in our Corporate Restructuring and Bankruptcy group, will also be testifying before the Commission today, focusing on real property lease issues, how they impact Chapter 11 cases (especially those involving retailers), and suggested reforms.

More information on the Commission and its work, together with access to the testimony of all panelists at the Commission’s hearings, is available at the Commission’s website.

A copy of my testimony is also available by following the link in this sentence.

Business Bankruptcy Issues Recent Developments

Do Trademark Licensees Have Reason For Hope? New Article Discusses Recent Decisions On Trademark Licenses And Bankruptcy

I have written a number of times on the blog about the impact of bankruptcy on trademark licenses, in particular what happens to trademark licensees whose licensors file bankruptcy. Trademark licensees face a real risk of losing their license rights in bankruptcy since they have no protection under Section 365(n) of the Bankruptcy Code. However, recent decisions, including an important decision last summer from the U.S. Court of Appeals for the Seventh Circuit, may give licensees reason for hope.

An article I wrote discussing these recent developments was just published by the American Bar Association’s Business Law Section in its online publication, Business Law Today. The article, titled "There’s Something Happening Here: Recent Bankruptcy Developments May Given Trademark Licensees Reason to Hope" is available by following the link. You can also download a PDF of the article.  

I hope you find the article of interest. 

Business Bankruptcy Issues Recent Developments

Ninth Circuit Opens The Door To Recharacterization Of Debt As Equity

In bankruptcy, prepetition loans made by insiders are often investigated, and sometimes challenged, by debtors, creditors’ committees, or trustees. The two most frequent challenges brought are that (1) the loans in question are not really debt and should be recharacterized as equity, and (2) the debt should be equitably subordinated below the claims of all or some other creditors. Recharacterization focuses on the intent of the parties (e.g., did the parties intend for the debt to be repaid or treated like equity) and the characteristics of the alleged debt instrument. Equitable subordination, on the other hand, generally requires, among other facts, a showing of inequitable conduct on the insider’s part. A successful challenge on either basis usually means the insider receives nothing on its claim since most debtors cannot pay all creditors in full. 

The Ninth Circuit BAP Had Rejected Recharacterization Claims. For the past 27 years, although recharacterization challenges have been advanced in cases elsewhere around the country, lower courts in the Ninth Circuit have largely rejected them. Instead, they have tended to follow the holding of a 1986 decision by the Ninth Circuit Bankruptcy Appellate Panel, In re Pacific Express, Inc., 69 B.R. 112 (B.A.P. 9th Cir. 1986), which shut the door on recharacterization claims.

  • In Pacific Express, the Bankruptcy Appellate Panel held that the characterization of claims as equity or debt was governed exclusively by equitable subordination principles under Section 510(c) of the Bankruptcy Code.
  • This meant that no separate challenge based only on recharacterization of debt as equity could be pursued. 

The Ninth Circuit Opens The Door.  With a decision issued last week by the U.S. Court of Appeals for the Ninth Circuit, made at the Circuit level and not by the lower BAP court, those days are over. In its April 30, 2013 opinion in In the Matter of: Fitness Holdings Int’l, the Ninth Circuit held that recharacterization and equitable subordination address distinct concerns, and a recharacterization challenge separate from equitable subordination is permissible. (Follow the link in the prior sentence to read the opinion.) The Fitness Holdings court stated that recharacterization determines whether there is a claim to be paid at all while equitable subordination considers whether an allowed claim should be subordinated to other claims. The Ninth Circuit held that the Pacific Express court erred in holding that the characterization of claims as equity or debt is governed solely by Bankruptcy Code Section 510(c).

  • The case arose in the context of a fraudulent transfer claim originally brought on behalf of the bankruptcy estate by the creditors’ committee. The committee alleged that the debtor’s pre-bankruptcy repayment of a loan made by its sole shareholder was a constructively fraudulent transfer, a transfer made at a time when the debtor was insolvent or otherwise financially impaired and for which it did not receive "reasonably equivalent value."
  • Normally, repayment of a loan provides a debtor with reasonably equivalent value because it discharges an equal amount of debt owed by the debtor. However, the complaint sought to recharacterize the loan itself as an equity interest.  If recharacterized, the repayment would be treated as a distribution to equity for which the debtor received no value in return. 
  • In a footnote, the Ninth Circuit also called out the district court for erroneously holding that it, an Article III court, was bound by a decision of the Bankruptcy Appellate Panel.

State Law Applies To Recharacterization Claims. Having opened the door, the Ninth Circuit then determined how recharacterization claims should be considered. Specifically, the Court ruled that bankruptcy courts should look to state law to determine whether a challenged debt claim should be characterized as debt or equity. The Ninth Circuit followed the Fifth Circuit’s decision in In re Lothian Oil Inc., 650 F.3d 539 (5th Cir. 2011), which applied state law, rejecting the approach used in the Third and Sixth Circuits, which have developed their own set of factors based on a bankruptcy court’s general equitable authority under Section 105(a) of the Bankruptcy Code. This widened a split among the circuits but the Ninth Circuit held that Supreme Court authority, including Travelers Cas. & Sur. Co. of Am. v. Pac. Gas & Elec. Co., 549 U.S. 443 (2007), requires state law to govern the substance of claims and, as a result, also the characterization of a claim as debt or equity. (Read this prior post for more information on the Travelers case.)  In Fitness Holdings, the Ninth Circuit did not reach the issue of whether the loan should actually be recharacterized, instead sending the case back to the lower courts for further proceedings.

Conclusion. The Fitness Holdings decision aligns the Ninth Circuit with most other courts around the country in permitting a claim to be challenged on grounds that it should be recharacterized as equity instead of a true debt. Although the case arose in the context of a fraudulent transfer claim, the holding that recharacterization claims may be made separately from equitable subordination claims seems likely to be applied outside of that context. That said, a recharacterization claim is not easy to establish, and not every insider loan will be susceptible to such a challenge. Also, recharacterization claims have not typically been brought in state court. It remains to be seen how application of state law, as opposed to the well-developed factors used by bankruptcy courts in other circuits, will impact the viability of recharacterization claims. Nevertheless, given Fitness Holdings, recharacterization is now an issue that major shareholders and other insiders, as well as debtors, creditors’ committees, and trustees, will need to keep in mind in bankruptcy cases in the Ninth Circuit.

Business Bankruptcy Issues Recent Developments

Spring 2013 Edition Of Bankruptcy Resource Now Available

The Spring 2013 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:

  • The U.S. Supreme Court’s decision upholding a secured creditor’s right to credit bid;
  • Determining when a claim arises under the Bankruptcy Code;
  • How the assumption of an executory contract can protect a party from a preference claim; and
  • A recent Seventh Circuit decision applying the absolute priority rule in a Chapter 11 plan context.

This edition also reports on some of our recent representations, including for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others, and our work for Chapter 11 debtors. Recent committee cases include Mervyn’s Holdings, Appleseed’s Intermediate Holdings, Atari, Vertis Holdings, United Retail, and Urban Brands, among others.

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

Business Bankruptcy Issues Recent Developments

Seventh Circuit Decision Gives Support To Protecting Buyers In Bankruptcy Sales From Successor Liability

Last week, the U.S. Court of Appeals for the Seventh Circuit addressed whether a buyer of assets outside of bankruptcy (in this case, from a receivership), takes on successor liability for federal Fair Labor Standards Act ("FLSA") claims made by the employees of the company whose assets it purchases. Although the case arose in a receivership, the Seventh Circuit’s opinion provides important insights into how these issues play out in bankruptcy sales of substantially all assets of a debtor.

Successor Liability Imposed. In Teed v. Thomas & Betts Power Solutions, L.L.C., the Seventh Circuit held that the buyer took on successor liability for the FLSA claims, even though the sale was made "free and clear" of all liabilities generally and of the FLSA claims in particular. The Seventh Circuit ruled that although those provisions would have protected the buyer, Thomas & Betts, under applicable Wisconsin state law, the FLSA is a federal statute and under federal common law, the buyer had successor liability for the FLSA claims. You can read a copy of the Seventh Circuit’s opinion, issued March 26, 2013, by clicking on the link in this sentence.

Contrast With Section 363 Bankruptcy Sales. As discussed in a recent post, when a debtor is facing major potential liabilities, the ability of a bankruptcy court to order the sale to the buyer "free and clear" of liabilities, including successor liability, can lead to a much higher price in a Section 363 sale. Cases discussing successor liability in bankruptcy therefore get the attention of those involved in distressed asset sales.

  • At first glance, the Seventh Circuit’s opinion seems to be troubling news for buyers of assets from distressed companies because the buyer in the Teed case was held to have successor liability for the FLSA claims at issue.
  • However, there appears to be more to the Seventh Circuit’s thinking. In its opinion, written by Judge Richard A. Posner, the Seventh Circuit concluded that "successor liability is appropriate in suits to enforce federal labor or employment laws–even where the successor disclaimed liability when it accepted the assets in question–unless there are good reasons to withhold such liability."  It was in examining possible "good reasons" not to impose successor liability that the Seventh Circuit specifically highlighted bankruptcy sales.

Seventh Circuit’s Analysis. Given that most bankrupt companies are insolvent, the Seventh Circuit noted that imposing successor liability on a buyer might allow unsecured FLSA claims against the seller (debtor) to become, effectively, senior to a secured creditor’s claim against the debtor if the buyer lowered its purchase price to account for such claims:

That is a good reason not to apply successor liability after an insolvent debtor’s default, whether its assets were sold in bankruptcy or outside (by a receiver, for example, as in this case): to apply the doctrine in such a case might upend the priorities of competing creditors. See In re Trans World Airlines, 322 F.3d 283, 290, 292-93 (3d Cir. 2003); Douglas G. Baird, The Elements of Bankruptcy 227-28 (5th ed. 2010). It’s an example of a good reason not mentioned in conventional formulations of the federal standard for not imposing successor liability. But it doesn’t figure in this appeal. Thomas & Betts has not urged it. It says that it didn’t discount its bid for Packard because of the workers’ claims; this both suggests that it didn’t anticipate successor liability and may explain why the bank has not complained about the imposition of that liability.

                                                *          *          *

Thomas & Betts argues finally, with support in Musikiwamba v. ESSI, Inc., supra, 760 F.2d at 751, that allowing the workers to enforce their FLSA claims against the successor, in a case such as this in which the predecessor cannot pay them, complicates the reorganization of a bankrupt. Seeing the handwriting on the wall and wanting to minimize the impact of the reorganization on them (in loss of employment or benefits), the workers might decide to file a flurry of lawsuits, whether or not well grounded, hoping to substitute a solvent acquirer for their employer as a defendant in the suits. The prospect thus created of increased liability might scare off prospective buyers of the assets. But there is no suggestion of such a tactic by workers in this case; if there were, it would be another good reason for denying successor liability. Still another concern is that an insolvent company, seeking to maximize its value, might decide not to sell itself as a going concern but instead to sell off its assets piecemeal, even if the company would be worth more as a going concern than as a pile of dismembered assets. In the latter case there would be as we said no successor liability, and successor liability depresses the going concern value of the predecessor, so the insolvent company might be better off even though it was destroying value by not selling itself as a going concern. Once a firm is in Chapter 7 bankruptcy (or in a Chapter 11 bankruptcy in which a trustee is appointed), or receivership, it is “owned” by the trustee (or receiver), whose sole concern is with maximizing the net value of the debtor’s estate to creditors (and maybe to other claimants—including shareholders, if the estate is flush enough to enable all the creditors’ claims to be satisfied in full). In re Taxman Clothing Co., 49 F.3d 310, 315 (7th Cir. 1995); In re Central Ice Cream Co., 836 F.2d 1068, 1072 (7th Cir. 1987). With immaterial exceptions, the trustee in a Chapter 7 bankruptcy (or, we assume, a receiver) must sell the debtor’s assets for the highest price he can get. 11 U.S.C. § 704(a)(1); In re Moore, 608 F.3d 253, 263 (5th Cir. 2010); In re Atlanta Packaging Products, Inc., 99 B.R. 124 (Bankr. N.D. Ga. 1988). He may not cut the price so that some junior creditor can enforce a claim not against the debtor’s assets but against a third party, the successor, in this case Thomas & Betts. The trustee would be required to sell the assets piecemeal if that would yield more money for the creditors as a whole (to be allocated among them according to their priorities) than sale as a going concern would, even if some creditors would be harmed because successor liability would have been extinguished, and even if economic value would have been destroyed.

But this is a theoretical rather than a practical objection. Since most firms’ assets are worth much more as a going concern than dispersed, successor liability will affect the choice between the two forms of sale in only a small fraction of cases. Lynn M. LoPucki & Joseph W. Doherty, “Bankruptcy Fire Sales,” 106 Mich. L. Rev. 1, 5 (2007).

Conclusion. Although the Court of Appeals did not find any of the potential "good reasons" applicable in the Teed case, its discussion of the problems with imposing successor liability in a bankruptcy sale is helpful.  Despite the holding, the decision’s analysis provides support for buyers seeking protection from successor liability in bankruptcy sales, even from liability under federal labor and employment statutes that might otherwise trump state law, and likewise for bankruptcy courts issuing orders granting buyers that protection. For that reason, it is an interesting and important opinion for buyers and sellers of distressed assets and the professionals that work with them.