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Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Ordinary Course Preference Case Takes Extraordinary Turn: Ninth Circuit Strikes Down Local Bankruptcy Rule On Jury Trials

Preference lawsuits are filed all the time in bankruptcy cases and the ordinary course of business defense is frequently asserted. Still, it’s the rare case that ends up with a federal court of appeals decision addressing jury trial rights and invalidating a bankruptcy court’s local rule. This post is about just such a case.

The Bankruptcy Preference. As a quick refresher, preferences are payments or other transfers made in the 90 days prior to a bankruptcy filing, on account of antecedent or pre-existing debt, at a time when the debtor was insolvent, that allow the transferee (the preference defendant) to be "preferred" by recovering more than it would have had the transfer not been made and the defendant instead had simply filed a proof of claim for the amount involved. The 90-day reachback period is extended to a full year prior to the bankruptcy petition for insiders such as officers, directors, and affiliates.

Jury Trials In Bankruptcy Cases? Preference defendants who do not file proofs of claim in the main bankruptcy case have the option to demand a trial by jury in the preference lawsuit. This is a right protected by the Seventh Amendment to the Constitution. The parties in the lawsuit can consent to having the bankruptcy court conduct the jury trial but this doesn’t happen very often. Why would a preference defendant make a jury demand? Here are three common reasons:

  • The defendant believes a jury would be more inclined to find in its favor than a bankruptcy judge;
  • The defendant wants the case moved to federal district court from the bankruptcy court, which some defendants perceive as more debtor-friendly; and
  • Jury trials are more expensive and complex, a fact the preference defendant may hope will translate into settlement leverage.

The HealthCentral.com Case. In a recent case, Sigma Micro Corporation, a company sued for an alleged preference by debtor HealthCentral.com, made just such a jury trial demand. It then filed a motion for certification before the bankruptcy court seeking to have its case moved to the district court, in accordance with Local Rule 9015-2(b) of the United States Bankruptcy Court for the Northern District of California. That Local Rule, entitled "Certification to District Court," provides:

If the Bankruptcy Judge determines that [a] demand was timely made and the party has a right to a jury trial, and if all parties have not filed written consent to a jury trial before the Bankruptcy Judge, the Bankruptcy Judge shall certify to the District Court that the proceeding is to be tried by a jury and that the parties have not consented to a jury trial in the Bankruptcy Court. Upon such certification, [the jurisdictional] reference of the proceeding shall be automatically withdrawn, and the proceeding assigned to a Judge of the District . . . .

The Bankruptcy Court held that Sigma had a right to a jury trial but then stayed its order to retain jurisdiction for pre-trial matters. It later granted the debtor’s motion for summary judgment in the preference case, finding no genuine issue of material fact and rejecting Sigma’s ordinary course of business defense. On appeal, Sigma argued that the Bankruptcy Court did not have jurisdiction to enter summary judgment because it should have transferred the case to the District Court upon finding that Sigma was entitled to a jury trial. It also argued that it had raised genuine issues of material fact on its ordinary course of business defense, precluding summary judgment.

The Ninth Circuit’s Decision. On September 21, 2007, the Ninth Circuit issued its opinion in the case (available here).  In addressing the jurisdiction question, the Ninth Circuit confronted "an issue of first impression in this circuit, that is, the validity of Local Rule 9015-2(b)." After reviewing the right of courts to promulgate local rules, it came to the core of the issue:

Considering these rules we hold Local Rule 9015-2(b) to be invalid as it establishes a procedure for withdrawing the district court’s jurisdictional reference inconsistent with the Acts of  Congress and Federal Rules of Bankruptcy Procedure. Cf. Coffey v. Marina Management Servs. (In re Kool, Mann, Coffee), 23 F.3d 66, 67-69 (3rd Cir. 1994) (finding local rule invalid because of inconsistency with Bankruptcy Code); In re Morrissey, 717 F.2d 100, 104-05 (3rd Cir. 1983) (same).

The Ninth Circuit noted that 28 U.S.C. § 157(d) provides that a "district court" may withdraw the reference of all or a part of a case or proceeding and that Federal Rule of Bankruptcy Procedure 5011(a) expressly states that a "motion for withdrawal of a case or proceeding shall be heard by a district judge." Putting these two provisions together, the Court of Appeals held:

After careful review we find the procedure established by Local Rule 9105-2(b) cannot be squared with the procedure established by 28 U.S.C. § 157(d), an “Act of Congress,” and Rule 5011(a), a “Federal Rule of Bankruptcy Procedure.” Fed. R. Bankr. Proc. 9029. At least two inconsistencies bear mentioning. First, Local Rule 9015-2(b) allows for the bankruptcy court to “withdraw[ ]” the jurisdictional reference, whereas 28 U.S.C. § 157(d) and Rule 5011(a) make it explicit that only a district court may “withdraw” the jurisdictional reference. See FTC v. First Alliance Mortg. Co. (In re First Alliance Mortg. Co.), 282 B.R. 894, 901 (C.D. Cal. 2001) (holding that “a motion [to withdrawal] is heard by the district court”) (emphasis added). Second, Local Rule 9015-2(b) permits a party to obtain a withdrawal of the reference upon a “Motion for Certification,” while 28 U.S.C. § 157(d) and Rule 5011(a) make it clear that a party may only obtain a withdrawal of the reference upon a “Motion for Withdrawal.” See Hawaiian Airlines, Inc. v. Mesa Air Group, Inc., 355 B.R. 214, 218 (D. Hi. 2006) (holding that “a litigant who believes that a certain [action] or portion of a [action] pending in the bankruptcy court should be litigated in the district court may make a motion to withdraw the reference”) (emphasis added).

Having invalidated the Local Rule, the Ninth Circuit found no error in the Bankruptcy Court’s decision not to adhere to it or to withdraw the reference. The Court of Appeal then considered whether the Seventh Amendment jury trial right itself required immediate transfer to the District Court, even for pre-trial proceedings. The Ninth Circuit agreed with courts outside the circuit that, it stated, had universally agreed that a jury trial right "does not mean that the bankruptcy court must instantly give up jurisdiction and that the case must be transferred to the district court."

Concluding that the Bankruptcy Court properly retained the case for pre-trial matters, the Ninth Circuit did ultimately reverse its grant of summary judgment. It found that Sigma had raised genuine issues of material fact on its ordinary course of business defense under the version of Section 547(c)(2) of the Bankruptcy Code in force prior to the amendments made by the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.

What About Local Rules In Other Courts? It appears that the Northern District of California’s local bankruptcy rule on certification of a jury trial right and transfer to the District Court is unusual. Some bankruptcy courts, including the District of Delaware and the Southern District of New York, have no specific rule addressing withdrawal of the reference based on a jury demand. Others require a prompt motion for withdrawal of the reference to be filed with the District Court, as provided in Central District of California Local Bankruptcy Rule 9015-2(g). 

Conclusion. Although it appears that the decision’s direct impact is limited to the Northern District of California and its jury demand procedures, this case proves that even well-established local rules will be struck down if inconsistent with governing statutes. That’s a pretty extraordinary outcome for an ordinary course of business preference case. 

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 Recent Developments The Financially Troubled Company

S&P Warns A Big Increase In Debt Defaults Is Coming

In an article entitled "Defaults wave to hit corporate US," the Financial Times reports that Standard & Poor’s is predicting that $35 billion in corporate debt will go into default by the end of 2008. This is similar to the view taken by Moody’s, reported in a recent post.

According to the Financial Times, S&P believes that the slowing economy, together with liquidity issues caused by credit market problems, puts approximately 75 issuers of junk debt at a high risk of default. These companies are primarily in the media, healthcare, and consumer products industries. Not surprisingly, S&P believes that the default rate could go up significantly if the economy were to decline more than currently predicted.

Struggling companies that took on substantial debt during the recent favorable credit environment “are highly reliant on financial market access to support operational cash needs, but the plentiful liquidity for high-yield borrowers is almost surely a thing of the past,” according to S&P.

Of course, debt defaults frequently lead to Chapter 11 bankruptcy filings. With S&P joining Moody’s in predicting a rise in defaults, the ride could get bumpy from here.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

A UK Perspective On The Turmoil In The Credit Markets

On his Insolvency Blog, Chris Laughton, a recovery and insolvency partner at the UK’s Mercer & Hole firm of chartered accountants, gives a UK and European perspective on the recent gyrations in the credit markets. His new post is entitled "The boom-bust cycle: where are we now?" and it chronicles the progression of the credit crunch from the United States to the UK and beyond. 

After providing links to a number of recent articles from the UK press on the subject, Chris sums up his views:

So what does all this mean? Yes the capital markets are in turmoil, banks are lending much more cautiously and some high risk investment vehicles are failing, but essentially this is only a liquidity problem. Its effect though is that stressed businesses will no longer be able to borrow their way out of trouble as they have become hard-wired to do over the last 3 years.

Crisis cash management and operational and corporate restructuring will come back into vogue as refinancing becomes passé. Only if stressed businesses fail to seek appropriate and timely assistance will the business insolvency statistics really start to rise.

His informative post, and the UK articles highlighted, underscores the interconnected nature of today’s global credit markets. It makes for interesting reading — wherever you are.

Business Bankruptcy Issues The Financially Troubled Company

Are “Termination On Bankruptcy” Contract Clauses Enforceable?

Practically every contract has a provision that makes the bankruptcy or insolvency of one contracting party a trigger for the other party to terminate the contract. These are standard fare and rarely negotiated unless they also include a provision for the reversion back of ownership of property, often intellectual property, upon bankruptcy or insolvency. This post takes a look at these provisions and examines whether they are enforceable.

The Typical Ipso Facto Clause. Termination on bankruptcy provisions are often known as ipso facto clauses (the Latin phrase meaning "by the fact itself") because the language provides that the fact of bankruptcy itself is enough to trigger the termination of the agreement. Here’s a common provision:

This Agreement shall terminate, without notice, (i) upon the institution by or against either party of insolvency, receivership or bankruptcy proceedings or any other proceedings for the settlement of either party’s debts, (ii) upon either party making an assignment for the benefit of creditors, or (iii) upon either party’s dissolution or ceasing to do business.

Variants of this language are found in many types of contracts, including licenses, leases, and development agreements. Some provide that termination is automatic and others first require notice. Termination triggers may include:

  • Filing a voluntary bankruptcy;
  • Having an involuntary bankruptcy filed against a party;
  • Becoming insolvent (frequently the term is left undefined in the contract);
  • Admitting in writing that the party is insolvent;
  • Making a general assignment for the benefit of creditors (a liquidation alternative recognized under the laws of many states); or
  • Tripping a financial condition covenant.

The bankruptcy or insolvency of either party is frequently a termination trigger. However, when the financial condition of only one contracting party is in doubt, the more financially stable party may insist on a one-sided provision allowing it to get out of the agreement upon the weaker party’s insolvency or bankruptcy. 

Notso Fasto: The Bankruptcy Code Stops The Clause In Its Tracks. These termination provisions may be common, but are they enforceable? The short answer, which may be surprising to some, is generally "no." Two key provisions of the Bankruptcy Code lead to this result. First, Section 541(c) of the Bankruptcy Code provides that an interest of the debtor (the bankrupt company or person) in property becomes "property of the estate," meaning that the debtor does not lose the property or contract right, despite a provision in an agreement:

that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.

11 U.S.C. §541(c). Translated from bankruptcy-ese, this statute means that a clause that terminates a contract because of the "insolvency" or "financial condition" of the debtor, or due to the filing of a bankruptcy case, will be unenforceable once a bankruptcy case has been filed.

A second Bankruptcy Code provision, Section 365(e)(1), governs ipso facto clauses in executory contracts, which are agreements under which both sides still have important performance remaining (discussed in more detail in this earlier post). Section 365(e)(1) provides:

Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract or lease that is conditioned on—

(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
11 U.S.C. §365(e)(1). This statute generally makes ipso facto provisions in executory contracts and leases unenforceable.

Why Put Ipso Facto Clauses In Contracts In The First Place? If these termination provisions are generally unenforceable, why do parties seem to include them in almost every contract? There are three main reasons.

Force Of Habit. One reason is that under the old Bankruptcy Act of 1898, replaced by the Bankruptcy Code in 1979, these ipso facto clauses were enforceable. Over the years, lawyers and businesses got used to including them in their contract forms and they have continued to write them into many agreements. Since it’s always possible that the Bankruptcy Code could be changed to reinstate the old rule, lawyers often see little reason to take them out.

It Takes An Actual Bankruptcy. Another and perhaps more important reason is that the rule applies only if a bankruptcy is actually filed. If an ipso facto provision provides that the agreement terminates upon a party’s insolvency, and no bankruptcy case is ever filed, it’s possible that the solvent party could terminate the agreement using the ipso facto provision. But be forewarned: if a bankruptcy case is later filed, an insolvency-based termination made before the bankruptcy filing may not be enforced in the bankruptcy case. This means that the debtor may still have a chance to retain the rights under the contract, including assuming or assigning an executory contract during the bankruptcy case.

A Limited Exception In Bankruptcy. A third reason is that an important, albeit limited, exception to the rule applies even after a bankruptcy is filed. The exception stems less from the ipso facto clause itself and more from the rules governing assumption of certain types of executory contracts, including intellectual property licenses (at least in some circuits).

  • Section 365(e)(2) of the Bankruptcy Code, in conjunction with Section 365(c)(1), provides that an ipso facto clause can be enforceable if the debtor or trustee is not permitted by "applicable law" to assume or assign the executory contract. Simply put, if applicable law provides that an IP license or another executory contract cannot be assumed by the debtor or trustee without the other party’s consent, then the non-debtor contracting party can force rejection of the license or seek relief from the automatic stay to terminate the agreement based on the ipso facto clause.
  • Although an analysis of the law governing assumption and assignment of IP licenses and related agreements is beyond the scope of this post, you can find a detailed discussion in an earlier one entitled "Assumption of IP Licenses In Bankruptcy: Are Recent Cases Tilting Toward Debtors?" 

A Word To The Wise. Parties include "termination on bankruptcy" provisions in contracts all the time, despite the general rule making them unenforceable in bankruptcy. Unfortunately, some do so without realizing that the provision may be ineffective, and that can lead to trouble. If enforcing an ipso facto clause is important to one of your agreements, especially if you also seek the highly problematic reversion of intellectual property or other rights upon such a termination, be sure to get specific legal advice on your situation, including whether alternative approaches may exist to help achieve your objectives.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Is The Default Rate On High-Yield Debt About To Double?

According to Moody’s, the credit rating and investor service firm, the default rate on high-yield or junk bond debt is likely to increase substantially from the current level of 1.4%. Moody’s predicts that the default rate will rise to 4.1% by August 2008 and then to 5.1% by August 2009. 

  • As reported by Credit, Moody’s director of corporate default research believes that "higher spreads and diminished liquidity" have increased the default risk for distressed issuers.
  • Unless the U.S. economy falls into a recession, however, the default rate is predicted to stay below its long-term average of 5.0%, at least until 2009. Any real downturn in the economy could push the default rate higher.

The New York Times DealBook Blog has a similar story, pointing out that Moody’s predicted in another report that the U.S. industries likely to have the highest default rate are packaging, construction, consumer durables, and automotive. Also, companies that need new financing will be more at risk than firms that already obtained financing on the favorable terms available in the credit markets until recently.

As The DealBook Blog points out, a rising default rate will likely lead to an increase in Chapter 11 bankruptcy filings. Stay tuned. 

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Delaware Supreme Court Issues Long-Awaited Decision In Deepening Insolvency Case

On August 14, 2007, the Delaware Supreme Court, sitting en Banc and following oral argument, issued its decision in the Trenwick America Litigation Trust v. Billet deepening insolvency case. Rather than write its own opinion, the Delaware Supreme Court released a two-page order affirming Vice Chancellor Strine’s August 10, 2006 Chancery Court decision "on the basis of and for the reasons assigned by" the Chancery Court in its opinion. A copy of the Chancery Court opinion is available here. 

The End Of Deepening Insolvency In Delaware. By adopting the basis and reasoning of the lower court’s opinion, the Delaware Supreme Court ratified Vice Chancellor Strine’s decision that there is no cause of action for deepening insolvency under Delaware law. Apparently concluding that no opinion of its own was necessary given the Chancery Court’s clear opinion below, the Delaware Supreme Court has put to rest the cause of action for deepening insolvency under Delaware law. Prior to the lower court’s decision in Trenwick, some bankruptcy and other federal courts had incorrectly predicted that Delaware would recognize this cause of action.

A Second Look At Vice Chancellor Strine’s Trenwick Opinion. Now that the Delaware Supreme Court has affirmed the Chancery Court’s decision and its reasons, the lower court’s opinion merits further consideration. As discussed in this August 2006 post on the Chancery Court’s decision, Vice Chancellor Strine held, in unequivocal terms, that there is no cause of action for deepening insolvency under Delaware law. To give context to the opinion’s legal analysis, some of its more important sections are quoted below at length:

Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. Even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red. The fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery. By doing so, the directors do not become a guarantor of success.  Put simply, under Delaware law, ‘deepening insolvency’ is no more of a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’ would be when a firm is solvent. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.

Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure.  With the prospect of profit often comes the potential for defeat.

The general rule embraced by Delaware is the sound one.  So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders.  Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective.

Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.

If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.

The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility.  Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.  The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure.  If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.

Moreover, the fact of insolvency does not render the concept of “deepening insolvency” a more logical one than the concept of “shallowing profitability.”  That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one.  If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler.  No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.

In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor.  Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part.  None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

The Delaware Supreme Court’s adoption of the basis and reasoning of the Chancery Court’s strongly-worded opinion represents the end of the road for the deepening insolvency cause of action under Delaware law.

Hints In The Gheewalla Decision? Interestingly, in its brief order the Delaware Supreme Court dropped a footnote giving not only the citation for the Chancery Court’s decision, Trenwick America Litig, Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), but also an intriguing comment: "Accord North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1453705 (Del. Supr. 2007)." This was a reference to its own decision of May 18, 2007 (opinion available here) holding that creditors cannot bring a direct cause of action for breach of fiduciary duty against directors of corporations that are insolvent or in the zone of insolvency.

  • As discussed in an earlier post on the Gheewalla decision, the Delaware Supreme Court opinion cited the lower court decision in Trenwick favorably, as well as the earlier Chancery Court decision in Production Resources (opinion available here), discussed in another earlier post. 
  • The "Accord" reference in its Trenwick order suggests that the Delaware Supreme Court believed that its May 2007 Gheewalla decision foreshadowed this week’s affirmance of the Chancery Court’s Trenwick decision and reasoning.

More Clarity For Directors. With the adoption of the Chancery Court’s opinion in Trenwick, and its own opinion in Gheewalla, the Delaware Supreme Court has effectively endorsed the trend in recent Chancery Court decisions to limit certain efforts to expand the liability of directors of insolvent or nearly insolvent corporations. Nearly sixteen years have passed since the Chancery Court’s decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), introduced us to the terms "vicinity of insolvency" and "zone of insolvency." Although the Delaware Supreme Court has left some questions open, these new decisions help provide meaningful guidance on how directors of financially troubled Delaware corporations should discharge their fiduciary duties.