Business Bankruptcy Issues

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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.

Business Bankruptcy Issues Recent Developments

Official Bankruptcy Forms Revised To Reflect April 1, 2013 Dollar Amount Adjustments

As discussed in an earlier post called "Going Up: Bankruptcy Dollar Amounts Will Increase On April 1, 2013," various dollar amounts in the Bankruptcy Code and related statutory provisions were increased for cases filed on or after today, April 1, 2013. Now several official bankruptcy forms have been revised to reflect these new dollar amounts.

Remember, the increased dollar amounts reflected on these forms apply only to cases filed on or after April 1, 2013.

Business Bankruptcy Issues The Financially Troubled Company

Using Chapter 11 Bankruptcy’s Sale Process To Achieve An Exceptional Sale Price

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.