fraudulent transfer

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Business Bankruptcy Issues Recent Developments

Winter 2014 Edition Of Bankruptcy Resource Now Available

I hope you had a wonderful holiday season and Happy New Year everyone.

To start the new year off, the Winter 2014 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, of which I am a member, has 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. 

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

  • An Eleventh Circuit ruling that indirect benefits from a Subchapter S election can constitute reasonably equivalent value for fraudulent transfer purposes;
  • The Ninth Circuit’s decision permitting recharacterization claims; and
  • A recent Seventh Circuit decision on the validity of a cross-collateralized real estate lien.

It 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, and Underground Energy, among others. Recent debtor representations include Cylex (now Immunology Partners), IntraOp Medical (now MC Liquidation), and Nirvanix.

I hope you find the latest edition of Absolute Priority to be of interest. Please note that this will be the final issue in newsletter format, as soon our group will be providing future insights through a new Absolute Priority blog, in addition to this In The (Red) blog. Stay tuned for more details. 

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 The Financially Troubled Company

Summer 2012 Edition Of Bankruptcy Resource Now Available

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.

Business Bankruptcy Issues Recent Developments

Summer 2011 Edition Of Bankruptcy Resource Now Available

The Summer 2011 edition of the Absolute Priority newsletter, published by the Bankruptcy & Restructuring group at Cooley LLP, 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 the impact of a confirmed plan on a second bankruptcy filing by a successor to the original debtor;
  • The Second Circuit’s recent decision limiting "gifting" in a Chapter 11 plan;
  • The reach of the Section 546(e) securities transaction safe harbor defense in avoidance actions; and
  • An update on litigation by the Madoff trustee against feeder funds and its broader implications.

This edition also reports on some of our recent representations, including the Chapter 11 bankruptcy case for our client Metropark USA, Inc., and our work for official committees of unsecured creditors in Chapter 11 cases involving major retailers and others. Recent committee cases include Blockbuster, Orchard Brands, ArchBrook Laguna Holdings, Signature Styles, Claim Jumper Restaurants, OTC Holding Corp., 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.

Business Bankruptcy Issues Recent Developments

Fall 2009 Edition Of Absolute Priority Now Available

The Fall 2009 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:

  • Developments in the General Growth Chapter 11 cases;
  • Updates on the General Motors and Chrysler bankruptcies;
  • Efforts in Congress to repeal certain of BAPCPA’s business bankruptcy provisions; and
  • The "settlement payment" defense to fraudulent transfer claims against shareholders in leveraged buyouts.

This edition also reports on some of our recent representations, including debtors Pacific Ethanol Holding Co. and Crabtree & Evelyn, Ltd., and our work for official committees of unsecured creditors in Chapter 11 bankruptcy cases involving major retailers. Recent committee cases include Eddie Bauer, Ritz Camera, Filene’s Basement, BT Tires Group, Boscov’s, Gottschalk’s, KB Toys, BTWW Retail, and G.I. Joe’s, among others. Also discussed is our work for Levi Strauss & Co. in purchasing 73 outlet stores from the Anchor Blue Retail Group case and for Rackable Systems, Inc. (now known as Silicon Graphics International) in purchasing substantially all of the assets of Silicon Graphics, Inc. in its recent Chapter 11 case.

In addition, a note from my colleague, Jeffrey Cohen, the editor of Absolute Priority, discusses how Section 363 asset sales have become the chief means for companies to restructure in bankruptcy, and how the number of "going concern" sales has grown over the past few months compared to the period following the bankruptcy of Lehman Brothers in September 2008.

I hope you find this Fall’s edition of Absolute Priority to be of interest.

Business Bankruptcy Issues Recent Developments

If Madoff Investors Are Sued By The SIPA Trustee And Pay Money Back, Can They File Proofs Of Claim After The Bar Date?

Recently, I posted about SIPA liquidations of brokerage firms, prompted by the Securities Investor Protection Act (known as SIPA) liquidations of Lehman Brothers, Inc. and Bernard L. Madoff Investment Securities LLC. An interesting issue has come up in the Madoff case involving investors who redeemed their accounts before the Madoff bankruptcy was filed. In other alleged Ponzi scheme cases, trustees have sued such investors asserting fraudulent transfer or other claims. The investors in turn often raise defenses, including that they redeemed their accounts in good faith and without any knowledge of the alleged fraud, and lengthy and complex litigation usually results.

Resolution of such litigation can come long after the deadline set for filing proofs of claim (known as a "bar date"). This raises a question: if investors end up paying money back to the estate as a result of the trustee’s litigation, will they be able to file proofs of claim — after the bar date — for the amounts they have to return? Before turning to that question, let’s take a look at how such post-bar date claims are dealt with in non-SIPA bankruptcy cases.

Section 502(h) Of The Bankruptcy Code. Under the Bankruptcy Code, if a person or entity is sued by the bankruptcy estate (usually by a trustee, the debtor in possession, or a creditors’ committee) for receipt of an alleged preference or fraudulent transfer, they will be able to file a proof of claim if they end up paying money back to the bankruptcy estate in settlement or as a result of a judgment. Bankruptcy Code section 502(h) expressly covers this situation:

(h) A claim arising from the recovery of property under section 522, 550, or 553 of this title shall be determined, and shall be allowed under subsection (a), (b), or (c) of this section, or disallowed under subsection (d) or (e) of this section, the same as if such claim had arisen before the date of the filing of the petition.

Section 502(h) recognizes that resolution of avoidance actions may come long after the original bar date for filing proofs of claim has past and allows holders of these later-arising claims to share in the estate along with other creditors. The Bankruptcy Code treats these claims as having arisen at the time of the payment back to the bankruptcy estate and allows proofs of claim to be filed months or even years after the bar date. 

The Claims Bar Date In SIPA Liquidations. In a SIPA liquidation, there are generally two claims bar dates. The first bar date set is for customer claims, in which customers of the failed brokerage firm seek to recover the securities in their accounts (or more likely in the Madoff case, the securities that were supposed to have been in their accounts). The Securities Investor Protection Corporation insurance of up to $500,000 applies to customer claims. A second bar date, usually a few months later, is for general claims. General creditors may include customers with claims in excess of the $500,000 SIPC protection or those who have more traditional trade creditor or other claims. 

The Madoff Case. In the Madoff case, last month several investors filed a motion seeking to have the bar date order clarified with regard to their potential claims in the event that the Madoff trustee later sued them and they were forced to return funds under a fraudulent transfer or other avoidance (sometimes called a  "clawback") cause of action after the general claims bar date.

  • These investors had previously redeemed some or all of their investments, and were seeking an order holding that claims arising from avoidance actions could be filed within 30 days after the judgment giving rise to the claim became final, a provision common in non-SIPA bankruptcy bar date orders due to Bankruptcy Code section 502(h).
  • The moving parties were concerned that without this clarification, any such claims they filed after the bar date might be held to be barred. On the other hand, if they were forced to file a protective claim before the bar date, they would submit to the court’s equitable jurisdiction and may be held to have waived their right to a jury trial in any avoidance action brought against them.
  • The Madoff trustee filed an opposition to the motion (copy available at the prior link) arguing, among other things, that these investors were not creditors, had not been sued, and as a result did not present an actual case or controversy ripe for adjudication. In addition, the trustee argued that Section 502(h) of the Bankruptcy Code was inapplicable, contending that it was inconsistent with an absolute bar date provision under SIPA. (The SIPA statute provides that Bankruptcy Code provisions are generally applicable in SIPA cases to the extent consistent with SIPA.)
  • The SIPC also filed a response to the motion (copy available at the prior link) making arguments similar to those advanced by the trustee. In particular, the SIPC argued that Section 502(h) was inconsistent with what the SIPC called SIPA’s "immutable" bar date.

The Court’s Decision. In a five-page decision issued on February 24, 2009, U.S. Bankruptcy Judge Burton R. Lifland denied the motion, first holding that the Court did not have the discretion to extend the bar dates involved. (A copy of the decision is available by clicking on the link in the prior sentence.) The Court then stated that the motion essentially sought a determination of whether Section 502(h) of the Bankruptcy Code was applicable in SIPA liquidations. Because no avoidance action had yet been filed, the Court held that the requested relief, if granted, would amount to an improper advisory opinion.

  • As a result, the Court refused to decide whether Bankruptcy Code Section 502(h) applies in SIPA cases, commenting as follows: "Although section 78fff(b) of SIPA specifies that the provisions of the Bankruptcy Code shall apply in SIPA liquidation proceedings, to the extent that they are consistent with SIPA, it is unclear whether section 502(h) of the Code would apply. 15 U.S.C. § 78fff(b) (1981)."
  • The Court concluded by noting that the investors could file a protective proof of claim before the general claims bar date, although that would subject them to the Court’s equitable jurisdiction.

An Open Question. Although the Court denied the motion, it left open the ultimate issue involved — whether Section 502(h) of the Bankruptcy Code applies in SIPA liquidations and permits parties to file proofs of claim after the bar date if they are sued by a trustee and later have to return funds or other property. With the issue undecided for now, some investors may choose to file a protective proof of claim before the bar date passes.

Business Bankruptcy Issues Recent Developments

New Article Examines Whether Wire Transfers Can Immunize Payments To Shareholders In LBOs

Leveraged buyouts, known as LBOs, have frequently been the subject of fraudulent transfer challenges when the target company later files bankruptcy. As its name implies, the classic LBO involves the use of leverage — debt — to finance the acquisition of the target company’s stock. Often that new debt is secured by the assets of the target company. This post highlights a new article that addresses one of the hot issues in LBO fraudulent transfer litigation, but before doing that it may help to give some context to the discussion.

What Is A Fraudulent Transfer? There are two types of fraudulent transfers. The first is a transfer made with an actual intent to hinder, defraud, or delay creditors. However, transfers may be considered fraudulent, even in the absence of actual fraud, if the transfer has a similar effect on creditors. This second type of fraudulent transfer involves what is known as "constructive fraud." A court may find that a transfer involves constructive fraud if a company, at a time when it is already financially impaired or is made so by the transaction itself, does not receive "reasonably equivalent value" in return for the transfer in question. Section 548, the Bankruptcy Code’s fraudulent transfer statute, and state fraudulent transfer laws, cover both actual and constructive fraudulent transfers.

The LBO Fraudulent Transfer Lawsuit. When an LBO is followed sometime later by a bankruptcy, a fraudulent transfer lawsuit may be filed to challenge the LBO itself. Although actual fraud may be asserted, more often the case involves a constructive fraud claim.

  • The argument usually made is that the use of the target company’s assets to secure loans (the leverage), the proceeds of which were then paid to selling shareholders (the buyout), rendered the company insolvent, made it otherwise unable to pay its debts when they became due, or left it with an unreasonably small capital with which to conduct its business. Since the target company does not receive anything in exchange for the payment to the selling shareholders, the lack of reasonably equivalent value element is usually present.
  • The plaintiff in a fraudulent transfer lawsuit may be the company itself as Chapter 11 debtor in possession, the official committee of unsecured creditors, or a bankruptcy trustee or post-confirmation plan trustee.
  • The defendants may include the new shareholders, the lenders who obtained security interests in the target company’s assets, and the shareholders who sold their stock for cash to the acquirer.

The Settlement Payment Defense. When selling shareholders are sued, they often assert a defense based on the "settlement payment" exception to certain fraudulent transfer claims found in Section 546(e) of the Bankruptcy Code. This exception was added to the Bankruptcy Code to prevent disruptions to the functioning of capital markets that might occur if long-settled trades were able to be unraveled by a fraudulent transfer action years down the road. Some courts, interpreting the term "settlement payment" to include payments made from a financial institution, have held that payments to selling shareholders, made by means of wire transfers using a bank or other financial institution, qualify as just such a "settlement payment" protected from avoidance as a fraudulent transfer under Section 546(e). Those courts, in effect, hold that the fact that a bank made wire transfers rendered an otherwise potentially fraudulent transfer immune from challenge.

Two Recent Articles Tackle This Issue. Two articles, including one published last week, take a look at how courts have been addressing the reach of the Section 546(e) defense in the context of these wire transfer payments.

How Far Does The Defense Go? The new article discusses case law from outside of the Third Circuit. In particular, it examines a recent decision from a New York bankruptcy court that rejected the Section 546(e) defense in a situation involving an LBO of a private, rather than publicly traded, target company. The article sums up the differences this way:

The application of the settlement payment defense in the context of an LBO has been far from uniform. While courts in the 3d Circuit have utilized Section 546(e) to shield virtually all LBO payments from avoidance, even in the context of private transactions, a significant number of courts have limited the scope of this safe harbor provision.           

Accordingly, the extent to which wire transfers may insulate LBO payments from attack under fraudulent transfer laws will likely be determined as much by the venue of the bankruptcy proceedings as much as the facts of the transaction at issue.

Worth Reading. Anyone involved in LBOs, including acquirers, target company directors or management, selling shareholders, and of course their professionals, will find these articles very interesting reading.