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Business Bankruptcy Issues Recent Developments

Spring 2009 Edition Of Bankruptcy Resource Is Now Available

The Spring 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:

  • Claim issues involving the Madoff SIPA proceeding;
  • How new Bankruptcy Code provisions involving swap agreements and swap participants are being interpreted;
  • The importance of the mutuality requirement in setoffs;
  • Post-petition rent and Section 503(b)(9) "20 day goods" claims; and
  • The use of a trademark after a bankruptcy petition is filed.

This edition also reports 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, Gottschalk’s, Lenox Sales, Goody’s, KB Toys, BTWW Retail, and Innovative Luggage, among others. In addition, a note from my colleague, Jeffrey Cohen, the editor of Absolute Priority, discusses the current economic climate and the impact it continues to have on how debtors and creditors have been approaching bankruptcies and restructurings.

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

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

The Best Of Both Worlds: Can A Secured Creditor Get A Section 503(b)(9) “20 Day Goods” Administrative Claim Too?

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.

Business Bankruptcy Issues

Selling A Bankruptcy Claim: Opportunity And Risk

At one time or another just about every creditor in a large corporate Chapter 11 bankruptcy case will receive an offer to purchase the creditor’s claim.  These offers typically come from professional claims traders, most of which are in the business of buying claims at a discount to what they believe will be the claims’ ultimate value.  Some claims buyers, including hedge funds and other distressed debt investors, may buy claims with the strategic objective of controlling the direction of the Chapter 11 case by owing a substantial percentage of one or more classes of creditors. 

How do claims buyers find out about your claim? Within the first few weeks after a bankruptcy is filed, the debtor must file schedules of its assets and liabilities.  Creditors holding secured claims are listed on Schedule D and those with unsecured claims are listed on Schedule F.  These schedules show the amount the debtor believes it owes each creditor and whether it thinks the claim is disputed, contingent, or unliquidated.  Claims buyers will often first contact creditors with claims listed as being undisputed, not contingent, and liquidated because those claims are less likely to be subject to litigation later in the bankruptcy case. 

If you express interest in selling your claim, you may be sent a "confirmation" document with key terms such the percentage on the dollar to be paid and the amount of the claim to be purchased.  The actual document that transfers the claim, however, is usually a separate "claim assignment agreement."  You should carefully review all of the documentation, including the claim assignment agreement, before committing to sell your claim.

Selling a claim can sometimes be beneficial, but there are also risks.  When evaluating whether to sell your claim, here are some of the key points to keep in mind:

  • Liquidity.  The main advantage of selling your claim is getting some cash for it now.  Although creditors often believe that selling their claim will also eliminate any further risk of loss, for the reasons discussed below claim assignment agreements usually keep you at risk even after you sell your claim.  If you’re willing to accept those risks, you can get immediate liquidity by selling your claim instead of having to wait months or years to receive whatever payment — which sometimes is in the form of stock or debt instead of cash — the bankruptcy estate ultimately distributes.
  • Price.  Given the claims buyer’s usual objective of buying at a discount, coupled with the time value of money, the price you are offered could end up being lower than the value you could recover if you held your claim and waited for distributions to be made later in the case. The price offered for claims can also rise or fall over time as more information about creditors’ likely recovery becomes available.  
  • Read the fine print.  Occasionally, claims buyers add detailed provisions and representations to the claim assignment agreement that operate to give the buyer an option to "put" or sell all, or the disputed part, of the claim back to you upon the mere filing of an objection or other challenge to the claim — even if the objection is ultimately defeated. Why? Well, if the price paid for your claim later turns out to have been too high, the claims buyer might use the filing of a claim challenge to get its money back, plus interest. Since commonplace events such as claim objections and preference actions may be classified as triggering "challenges," it’s important to watch out for these provisions.
  • Defending the claim.  Often the claims buyer will put a provision in the claim assignment agreement requiring you to defend the claim against any objection at your own expense, and to pay the claims buyer back for any portion of the claim that might be disallowed.  If a portion of your claim is disputed, however, you may well want the right to defend the claim so you can keep what you’ve been paid. Either way, you may incur costs in the bankruptcy case after you sell your claim.
  • Setoff or other special claims.  Claim assignment agreements may also include provisions limiting your right to assert a setoff or recoupment against the debtor (concepts discussed in an earlier post) or requiring you to pay back all or a portion of the purchase price if you do.  If you have significant setoff rights, be careful to preserve those rights if you sell your claim. Likewise, if you have an administrative claim or reclamation claim (which could be paid at 100 cents on the dollar), be sure it’s clear how those valuable rights will be treated.
  • Creditors’ committee.  If you’re serving on the official committee of unsecured creditors in a Chapter 11 case, you should get legal advice on whether, or under what conditions, you may sell your claim.  You likely will have received confidential information about the debtor while on the creditors’ committee, and this could restrict your ability to sell your claim.  Generally, you will also have to resign from the committee if you sell your claim.  
  • Court-ordered restrictions.  In some cases, bankruptcy courts may restrict creditors — especially those with very large claims — from selling their claims.  This is done to preserve the tax benefits of a debtor’s net operating losses or NOLs, which can be lost if ownership of a large amount of claims or equity interests changes.  As this example shows, these orders can be very complicated and you may want to consult with a bankruptcy attorney to determine whether any restrictions apply to you.

If you sell your claim, you will often be required to sign an additional document with a name such as "Evidence of Transfer of Claim," which does not mention the price paid and which will be filed with the bankruptcy court.  Thereafter, you may receive a notice from the bankruptcy court that the claims buyer has filed the Evidence of Transfer of Claim document and giving you 20 days to object to the transfer.  This notice is designed to prevent unscrupulous individuals from fraudulently assigning claims to themselves and is only a formality in a legitimate claims sale.

Claims buyers can provide creditors with a ready market for their claims, generating liquidity months or years before creditors otherwise would receive a distribution from the bankruptcy estate.  Selling a claim is not risk free, however, so be sure to consult with a bankruptcy attorney for specific advice on how best to protect your rights if you do choose to sell.

Business Bankruptcy Issues The Financially Troubled Company

Setoffs And Bankruptcy

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.