The Financially Troubled Company

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Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Ninth Circuit Clarifies Earmarking Defense To Preference Claims

On June 4, 2007, the U.S. Court of Appeals for the Ninth Circuit brought some additional clarity to the earmarking defense to preference claims in its decision in Metcalf v. Golden, an adversary proceeding within the In re Adbox, Inc. Chapter 7 case. In this post, I’ll give a little background on preferences and the earmarking defense and then discuss how the defense works in the Ninth Circuit.

Preferences And Earmarking. Before reaching its decision on the earmarking issues, the Court set the legal context by discussing what preferences are and how earmarking can sometimes be a defense to a preference claim.

Under 11 U.S.C. § 547 the bankruptcy trustee may recover certain transfers made by the debtor within 90 days before filing for bankruptcy, if the trustee proves:

(1) a transfer of an interest of the debtor in property;

(2) to or for the benefit of a creditor;

(3) for or on account of an antecedent debt;

(4) made while the debtor was insolvent;

(5) made on or within 90 days before the date of the filing of the petition; and

(6) one that enables the creditor to receive more than such creditor would receive in a Chapter 7 liquidation of the estate.

In re Superior Stamp & Coin Co., Inc., 223 F.3d 1004, 1007 (9th Cir. 2000) (citing 11 U.S.C. § 547(b)). Such a transfer is known as an ‘avoidable preference’ or a ‘preferential transfer.’ Id. at 1007-09. The ‘earmarking doctrine’ is a courtmade exception to this rule that applies when a third party advances funds to the debtor subject to an agreement requiring the debtor to use the funds to pay off another creditor. Id.; In re Sierra Steel, Inc., 96 B.R. 271, 274 (B.A.P. 9th Cir. 1989). In such circumstances, the funds are deemed ‘earmarked’ and are not considered part the debtor’s estate. Sierra Steel, 96 B.R. at 274.

For more information on preferences, and some tips on how creditors can protect themselves when dealing with a financially troubled customer, you may find this post of interest.

Is Earmarking An Affirmative Defense? One previously unresolved issue involving the earmarking defense was whether it is a true "affirmative defense," which would mean that to assert it a preference defendant would have to include it in its answer to the preference complaint. In Metcalf, the Ninth Circuit said no:

Earmarking is not one of the affirmative defenses enumerated in Rule 8, and we decline to construe it as such under Rule 8’s residuary clause for ‘any other matter constituting an avoidance or affirmative defense.’ Properly understood, the earmarking doctrine is not an affirmative defense under Rule 8, but rather a challenge to the trustee’s claim that particular funds are part of the bankruptcy estate under 11 U.S.C. § 547. See Libby Int’l., 247 B.R. at 467 [In re Libby Int’l., Inc., 247 B.R. 463 (B.A.P. 8th Cir. 2000)]. Thus, the Metcalfs did not waive their earmarking defense by failing to plead it in their answer in the preference action.

Who Has The Burden Of Proof? With the affirmative defense issue out of the way, the Ninth Circuit then tackled the even more important question of whether the trustee or the defendant has the burden of proof on the earmarking defense. The Court held that although the trustee has the burden to prove that the funds at issue came from the debtor’s account, the real burden of proof to establish the actual earmarking defense shifts back to the defendant:

As the district court noted, there is ‘substantial confusion’ over who bears the burden of proof on an earmarking defense. The Ninth Circuit Bankruptcy Appellate Panel addressed this question in Sierra Steel, where it denied an earmarking defense because the defendant ‘ha[d] not traced the funds to money received by the debtor from [the lender].’ 96 B.R. at 275. While the Sierra Steel court started from the general principal that the trustee has the burden of establishing that property is part of the bankruptcy estate, it also noted that the funds in question were disbursed from the defendant’s general account. Id. at 274 n.5. The source of the funds raised the presumption that the funds were property of the bankruptcy estate and the burden of proof accordingly shifted from the trustee—to establish that the funds were part of the estate —to the defendant—to show that they were not. Id. (citing In re Bullion Reserve of N. Am., 836 F.2d 1214, 1217 n.3 (9th Cir. 1988)).

We follow well-established law in holding that the trustee bears the initial burden of establishing that a transfer is an avoidable preference under § 547. See Sierra Steel, 96 B.R. at 274. If, however, the trustee establishes that the transfer of the disputed funds was from one of the debtor’s accounts over which the debtor ordinarily exercised total control, we follow the approach of Sierra Steel and find that the trustee makes a preliminary showing of an avoidable transfer “of an interest of the debtor” under § 547(b). The burden then shifts to the defendant in the preference action to show that the funds were earmarked.

In the Metcalf case, the Court ultimately held that the defense was not established. The defendants could not prove the existence of an agreement between the debtor and the lender that had advanced the funds requiring them to be paid to the defendants. Since the debtor could have used those funds for another purpose, the payment to the defendants was a preferential transfer from the debtor’s estate.

Where Does This Leave The Earmarking Defense? The Ninth Circuit’s decision reaffirmed the existence of the earmarking defense and resolved two important procedural questions about how the defense may be asserted. The decision also highlighted the level of proof needed to make a successful earmarking defense. If a creditor is getting paid with loaned funds and hopes to use the defense, it should make sure that there is an actual agreement requiring the debtor to use the newly loaned funds to pay that creditor. Without proof of such an actual agreement, the earmarking defense will fail. 

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Delaware Bankruptcy Court Considers Whether Key Employee Incentive Plan Milestones Can Be Lowered Without Triggering The Restrictions On Retention Plans

One of the significant changes made by the Bankruptcy Code amendments that took effect in October 2005 was the imposition of severe restrictions on "key employee retention plans," known in the bankruptcy world as KERPs.  In this post I’ll discuss how several courts have handled these issues in the year and a half since the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, known as BAPCPA, became effective. The most recent decision, issued late last week by the Delaware Bankruptcy Court in the Nellson Nutraceutical case, gives debtors added flexibility when trying to craft plans consistent with these new restrictions.

Changes Aimed At Curbing KERPs. Prior to BAPCPA, KERPs were a very popular way of making sure that a company could retain its most important officers and employees to guide it through bankruptcy. Citing perceived abuses, however, Congress added language in BAPCPA that requires debtors to satisfy nearly impossible standards before courts would be permitted to approve payment of retention bonuses (or severance payments) as administrative claims to officers and other insiders of a bankrupt company. The restrictions apply only to insiders; no similar limitations have been placed on payment of retention bonuses and severance to non-insiders.

The New Law’s High Hurdles. To give you a flavor of the restrictions BAPCPA added to Section 503(c) of the Bankruptcy Code, a debtor company must now prove the following before it can gain approval for payment of a retention bonus to an insider:

  • the transfer or obligation is essential to retention of the person because the individual has a bona fide job offer from another business at the same or greater rate of compensation;
  • the services provided by the person are essential to the survival of the business; and

  • either

  • the amount of the transfer made to, or obligation incurred for the benefit of, the person is not greater than an amount equal to 10 times the amount of the mean transfer or obligation of a similar kind given to nonmanagement employees for any purpose during the calendar year in which the transfer is made or the obligation is incurred; or
  • if no such similar transfers were made to, or obligations were incurred for the benefit of, such nonmanagement employees during such calendar year, the amount of the transfer or obligation is not greater than an amount equal to 25 percent of the amount of any similar transfer or obligation made to or incurred for the benefit of such insider for any purpose during the calendar year before the year in which such transfer is made or obligation is incurred.

The requirement of a bona fide job offer in particular has led some to observe that if an officer of a company in Chapter 11 really had such an offer he or she would probably just take it, mooting the entire retention issue. In any event, these provisions have had their desired effect. It is now rare to find a debtor proposing a KERP that seeks to make retention payments to officers or other insiders.

Debtors Opt For Plan B. Despite these restrictions, debtors still usually want to keep their key officers and may worry that they will leave for more stable companies absent some incentives to remain with the debtor. So what are debtors doing? Since October 2005, they have shifted gears and are proposing not retention plans but incentive plans instead. To date, only a few decisions, discussed below, have addressed what is necessary for an incentive plan to pass muster. In other instances, incentive plans have been approved with little or no opposition. Perhaps the earliest such approval came in May 2006 when Judge Burton R. Lifland approved one in the Calpine Corporation Chapter 11 case.

The Dana Corporation Case. The first significant contested plan motion came shortly after the Calpine incentive plan’s approval. Dana Corporation, whose Chapter 11 case was also pending before Judge Lifland, filed a motion seeking approval of a plan similar to that approved in the Calpine case. After considering objections filed by various creditors and others, however, in September 2006 Judge Lifland refused to approve Dana Corporation’s proposed plan, finding that it was a prohibited retention plan. For an excellent and entertaining discussion of the circumstances leading to denial of that first effort in the Dana Corporation case, including why the Calpine plan was approved while the first Dana plan was not, be sure to read Steve Jakubowski’s detailed post on the Bankruptcy Litigation Blog.

A few months later, on Dana Corporation’s second try, Judge Lifland approved the revised incentive plan. In his second ruling, he found that with certain modifications the debtor’s revised proposals met the sound business judgment test required for approval. In addition, he ruled that the new plan incentivized the key officers "to produce and increase the value of the estate" and, because the benchmarks in the plan were difficult targets to reach and not easy "lay-ups," the proposal was an actual incentive plan and not a retention plan in disguise.

Evaluating Incentive Plans. In evaluating whether the Dana plan represented the exercise of sound business judgment, Judge Lifland considered the following factors:

  • Is there a reasonable relationship between the plan proposed and the results to be obtained, i.e., will the key employee stay for as long as it takes for the debtor to reorganize or market its assets, or, in the case of a performance incentive, is the plan calculated to achieve the desired performance? (emphasis added)
  • Is the cost of the plan reasonable in the context of the debtor’s assets, liabilities and earning potential?
  • Is the scope of the plan fair and reasonable; does it apply to all employees; does it discriminate unfairly?
  • Is the plan or proposal consistent with industry standards?
  • What were the due diligence efforts of the debtor in investigating the need for a plan; analyzing which key employees need to be incentivized; what is available; what is generally applicable in a particular industry?
  • Did the debtor receive independent counsel in performing due diligence and in creating and authorizing the incentive compensation?

These factors provide useful guidance not only to bankruptcy courts but also to boards of directors of financially troubled companies, whether in or out of bankruptcy, when considering proposals for retention or incentive plans.

The Global Home Products Decision. In March 2007, Judge Kevin Gross of the Delaware Bankruptcy Court approved two incentive plans in the Global Home Products case. In that decision, as the Delaware Business Bankruptcy Report described here, the court followed the analysis Judge Lifland used in the Dana Corporation case and approved the two incentive plans. Specifically, Judge Gross found that the plans were true incentive plans, which he called "pay for value" plans and were not KERPs, or "pay to stay" plans. For this reason, Judge Gross evaluated the plans under the business judgment standard of Section 363 of the Bankruptcy Code, holding that the strict Section 503(c) limitations simply did not apply.

The Nellson Nutraceutical Decision. On May 24, 2007, Judge Christopher S. Sontchi of the Delaware Bankruptcy Court issued a decision in the Nellson Nutraceutical Chapter 11 case approving revisions to a previously-approved incentive plan. There, the debtors’ first incentive plan provided for certain performance milestones based on target levels of EBITDA, or earnings before interest, taxes, depreciation, and amortization. Unfortunately, the debtors did not achieve those EBITDA milestones and sought to lower them to align with what they considered to be more realistic performance goals. After receiving testimony that the debtors had made similar reductions in bonus targets in the past, Judge Sontchi concluded that the debtors’ current proposal was in the ordinary course of business and involved a good faith business judgment.

On the issue of whether Section 503(c)’s retention payment restrictions applied, Judge Sontchi found that the lowering of the incentive plan milestones did not turn the plans into retention plans. He held that if the primary purpose of a plan is to incentivize insiders and other employees, rather than merely retain them, it remains an incentive plan:

Under the facts of this case, although the modification of the 2006 bonus program has some retentive effect, it is for the primary purpose of motivating employees and, thus, the limitations of section 503(c)(1) are not applicable.

*     *    *

The [United States Trustee] argues with some force that if an incentive plan is based on achievement of EBITDA targets and those targets are not achieved, yet the bonus is still received, that the plan cannot be an incentive plan but must, in fact, be solely a retention plan.

*   *    *

While the Court agrees that the payment of bonuses under the modified 2006 [plan] has some retentive effect, the Court disagrees with the [United States Trustee’s] argument that its sole or primary purpose is retention. Consistent with the Debtors’ pre-petition practice, the 2006 [plan] must be considered as a whole. It consists of two parts: the establishment of ‘aspirational goals’ in the early part of the year; and a review at the end of the year to consider whether those goals have been met and, if not, why. In this case, the Debtors did just that and determined that the 2006 [plan] served its purpose by motivating the employees to do a ‘great job’ in connection with the matters that those employees could reasonably be expected to influence. As such, the Debtors seek to award bonuses at a reduced level to compensate the employees for their success (albeit somewhat limited) in 2006 and to motivate the employees in 2007.

Finally, Judge Sontchi held that Section 503(c)(3)’s additional limitations, which among other things prohibit transfers to insiders that are "outside of the ordinary course of business and not justified by the facts and circumstances of the case," by its terms apply only to payments outside of the ordinary course of business. Given his earlier holding that the debtors’ plans and their modifications were made in the ordinary course of business, Judge Sontchi concluded that Section 503(c)(3)’s requirements did not apply at all.

Conclusion. BAPCPA has effectively ended the use of KERPs for officers and other insiders of a debtor. However, more than a year and a half after BAPCPA became effective, bankruptcy courts in New York and Delaware, and perhaps elsewhere, are willing to approve incentive plans for insiders. The Nellson Nutraceutical decision goes further and, in the right circumstances, will allow the incentive plan’s performance milestones themselves to be lowered without jeopardizing the "incentive" character of the plan. This area of the law is plainly evolving, so stay tuned for more developments.

Recent Developments The Financially Troubled Company

Delaware Supreme Court Addresses, For The First Time, Whether Creditors Can Sue Directors For Breach Of Fiduciary Duty When The Corporation Is Insolvent Or In The Zone Of Insolvency

Almost sixteen years ago, the Delaware Chancery Court’s decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), helped introduce the terms "vicinity of insolvency" and "zone of insolvency" into the legal and business lexicon. Since then, the Chancery Court issued a number of decisions on the question of whether creditors can sue directors of insolvent corporations, or those in the zone of insolvency, for breach of fiduciary duty. In the intervening years, however, the Delaware Supreme Court had never spoken on the issue.

The Chancery Court Limits Direct Creditor Claims. As reported in this earlier post, last September the Chancery Court issued a decision in North American Catholic Educational Programming, Inc. v. Gheewalla, et al., 2006 WL 2588971 (Del. Ch. Sept. 1, 2006) (Chancery Court opinion available here), holding that creditors could not bring a direct action for breach of fiduciary duty against directors of a corporation in the zone of insolvency. This case gave the Delaware Supreme Court the opportunity to issue a definitive ruling on the subject.

The Delaware Supreme Court Affirms. On Friday, May 18, 2007, the Delaware Supreme Court finally ruled on this important question. The Court’s 24-page opinion in North American Catholic Educational Programming, Inc. v. Gheewalla, et al. affirmed the Chancery Court’s decision and made three key rulings:

  • When the corporation is in the zone of insolvency, creditors may not bring a direct action against the directors for breach of fiduciary duty;
  • When the corporation is in fact insolvent, creditors have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties; and
  • Even when the corporation is insolvent, creditors have no right to assert direct claims for breach of fiduciary duty against the directors.

The Supreme Court’s Zone Of Insolvency Analysis. The Delaware Supreme Court first rejected the creditor’s argument that it should be permitted to bring a direct claim for breach of fiduciary duty against the directors when the corporation was in the zone of insolvency:

It is well established that the directors owe their fiduciary obligations to the corporation and its shareholders. While shareholders rely on directors acting as fiduciaries to protect their interests, creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights. Delaware courts have traditionally been reluctant to expand existing fiduciary duties. Accordingly, ‘the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.’

(Footnotes omitted.)

The Supreme Court next commented that although it had never addressed the issue of whether creditors have the right to sue directors in the zone of insolvency, the subject had been discussed in several Chancery Court decisions and in many scholarly articles. Among the Chancery Court decisions cited were the Production Resources decision (see earlier post on that decision), which the Supreme Court quoted at length, and the Trenwick America decision (discussed here and here), currently on appeal to the Supreme Court.

Concluding that the creditor could not state a direct claim for breach of fiduciary duty, the Supreme Court held:

In this case, the need for providing directors with definitive guidance compels us to hold that no direct claim for breach of fiduciary duties may be asserted by the creditors of a solvent corporation that is operating in the zone of insolvency. When a solvent corporation is navigating in the zone of insolvency, the focus for Delaware directors does not change: directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.

(Footnotes omitted.)

The Supreme Court’s Views When The Corporation Is Insolvent. The Delaware Supreme Court next tackled the issue of whether a direct claim for breach of fiduciary duty could be brought against directors when the corporation crossed from the zone of insolvency into actual insolvency:

It is well settled that directors owe fiduciary duties to the corporation. When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation’s growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation’s insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm’s value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.

(Footnotes omitted; emphasis in original.) Later, the Court stated both its holding on this issue and the reasons for it:

Recognizing that directors of an insolvent corporation owe direct fiduciary duties to creditors, would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation. To recognize a new right for creditors to bring direct fiduciary claims against those directors would create a conflict between those directors’ duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors. Directors of insolvent corporations must retain the freedom to engage in vigorous, good faith negotiations with individual creditors for the benefit of the corporation. Accordingly, we hold that individual creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors. Creditors may nonetheless protect their interest by bringing derivative claims on behalf of the insolvent corporation or any other direct nonfiduciary claim, as discussed earlier in this opinion, that may be available for individual creditors.

(Footnotes omitted; emphasis in original.) 

Fellow Bloggers Weigh In. Given the decision’s importance, several legal bloggers reported on it almost immediately. These include Scott Riddle at the Georgia Bankruptcy Law Blog, Francis Pileggi at the Delaware Corporate and Commercial Litigation Blog, and three law professors whose articles the Delaware Supreme Court cited in the opinion: Professor Stephen Bainbridge at ProfessorBainbridge.com, Professor Larry Ribstein at Ideoblog, and Professor Fred Tung at Conglomerate.

The Next Big Insolvency Case. The next major decision in the insolvency area should be the Delaware Supreme Court’s decision in the Trenwick America case. In the Chancery Court, Vice Chancellor Strine held that no cause of action for deepening insolvency exists under Delaware law. The appeal was argued before the Delaware Supreme Court on March 14, 2007, and a decision could be handed down in the next month or two. The North American Catholic decision, with its approving quotes from and citations to other recent Chancery Court decisions in this area, raises the question whether the Delaware Supreme Court will again affirm the Chancery Court, this time in the Trenwick America case. Although it’s hard to tell, we may not have to wait much longer to find out. 

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

Defending A Preference: Ninth Circuit Holds That Even First Time Transactions Can Be In The “Ordinary Course”

In a decision issued on April 3, 2007 in the In re: Ahaza Systems, Inc. case, the Ninth Circuit held that even first time transactions can qualify for the "ordinary course of business" defense to preferences. A copy of the Court of Appeal’s decision is available here.

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.

Pre-BAPCPA Statute. The ordinary course of business defense, designed to protect parties who engage in normal transactions with a financially troubled business, is one of the most common defenses available to preference recipients. The Ninth Circuit examined it under the version of the preference statute, Section 547 of the Bankruptcy Code, as it existed before the 2005 amendments made in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (known as BAPCPA). This pre-BAPCPA statute, specifically Section 547(c)(2), provided that a trustee could not avoid a transfer as a preference

to the extent that such transfer was —

(A) in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee;

(B) made in the ordinary course of business or financial affairs of the debtor and the transferee; and

(C) made according to ordinary business terms.

The Court’s focus was on subsection (A), the "debt" issue. Usually, parties have a series of contracts or purchase orders, as well as a payment history, that gives context to the ordinary course of business between them. In this case, however, the transaction that led to the allegedly preferential payments was their first one. The Court faced the question of whether a debt can be considered as having been incurred in the ordinary course of business of the debtor and the preference defendant when there had been no other past transactions to which it could be compared.

Court Looks To Past Practices With Other Similar Parties. The Court’s answer was yes, holding that a preference defendant can indeed assert the ordinary course of business defense involving a debt created by the first contract or transaction between the parties. However, the Ninth Circuit articulated a special rule when a "first time" debt is involved:

[W]hen we have no past debt between the parties with which to compare the challenged one, the instant debt should be compared to the debt agreements into which we would expect the debtor and creditor to enter as part of their ordinary business operations. Consistent with Food Catering [971 F.2d 396 (9th Cir. 1982)], however, this analysis should be as specific to the actual parties as possible. Thus, we hold that to fulfill § 547(c)(2)(A), a first-time debt must be ordinary in relation to this debtor’s and this creditor’s past practices when dealing with other, similarly situated parties. Only if a party has never engaged in similar transactions would we consider more generally whether the debt is similar to what we would expect of similarly situated parties, where the debtor is not sliding into bankruptcy.

Both Original And Restructured Agreements Are Relevant. On a related point, since the first transaction here was an agreement that was later restructured to give the debtor more time to pay, the Ninth Circuit also held that both the original and revised agreement should be evaluated for ordinariness.

Ruling Still Important Under BAPCPA. BAPCPA revised the ordinary course of business defense so that Section 547(c)(2) now provides that a payment or other transfer cannot be avoided

to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—

(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or

(B) made according to ordinary business terms.

Although different, the current statute still makes the issue decided in the In re: Ahaza Systems case, whether the debt was incurred in the ordinary course of business, a requirement. The major change is that the statute now allows the defense to be established by additionally showing that payments were made either (A) in the ordinary course of business of the parties or (B) according to ordinary business terms, rather than both as under the pre-BAPCPA version.

How Hard To Meet? Having established the new test, the Court then reversed the granting of summary judgment to the defendant because it found the proof presented was inadequate. This suggests that although the Ninth Circuit will permit preference defendants to assert the ordinary course of business defense on first time transactions, some defendants may face a challenge in meeting that standard.

Recent Developments The Financially Troubled Company

Report On The Delaware Supreme Court’s Recent Oral Argument In The Trenwick America Deepening Insolvency Case

One of the most important recent decisions by the Delaware Court of Chancery in the insolvency area was the August 10, 2006 opinion in the Trenwick America Litigation Trust case. As discussed at length in an earlier post, the Trenwick America decision by Vice Chancellor Strine (available here) squarely held that there was no cause of action for "deepening insolvency" under Delaware law. The Chancery Court’s opinion rejected it as a cause of action in no uncertain terms:

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.

Delaware Supreme Court Hears Appeal. The significance of the Chancery Court decision makes it particularly interesting to follow the appeal in the case, now before the Delaware Supreme Court. The oral argument on the appeal, held on March 14, 2007 at the Widener University School of Law campus in Wilmington, may shed some light on how the Delaware Supreme Court will ultimately rule. Frank Reynolds of Andrews Publications prepared this news story on the oral argument, and the law school’s website also has an article, complete with slideshow, on the oral argument in Trenwick America and in a second case that day. To hear the Trenwick America oral argument for yourself, follow this link and download the audio recording from the Delaware Supreme Court’s website.

Focus At Oral Argument. Having listened to the recording (an entertaining addition to my iPod), it’s interesting to note that the deepening insolvency issue received only a few mentions during oral argument. Those came mainly during a discussion of the business judgment rule and whether existing contractual and statutory remedies sufficiently protect creditors. Instead, the parties and the Justices focused on the following issues during oral argument:

  • Whether the complaint sufficiently pled that the corporation was insolvent or in the zone of insolvency;
  • Whether the business judgment rule protected the directors in permitting the subsidiary corporation to incur guaranty and other obligations;
  • What fiduciary duty was owed and how it was allegedly breached;
  • Whether the zone of insolvency issue was critical to the plaintiff’s case; and
  • Whether the directors breached any fiduciary duties when following the parent corporation’s business plan for the subsidiary and the corporate group.

Reading The Tea Leaves. With the range of issues discussed at oral argument, it’s possible that the Delaware Supreme Court will render its decision in the Trenwick America case without considering the Chancery’s Court’s ruling that deepening insolvency does not exist as a cause of action under Delaware law. Plaintiff’s counsel argued that the Delaware Supreme Court could rule for his client without reaching the issue. Likewise, counsel for the defendants urged affirmance based on what Vice Chancellor Strine found to be insufficient pleading of insolvency, a lack of any fiduciary duty owed given the complaint’s allegations, and the application of the business judgment rule. Although not directly involving deepening insolvency, in response to a specific question from one of the Justices, defense counsel also argued that the Delaware Supreme Court should consider holding that directors do not owe fiduciary duties to creditors upon insolvency, leaving creditors to the existing protections and remedies otherwise available to them.

After an interesting oral argument, stay tuned.

Business Bankruptcy Issues Recent Developments The Financially Troubled Company

The New Section 503(b)(9) Administrative Claim: The Latest On What Courts And Debtors Have Been Doing

A couple of months ago I posted on the new "20 day goods" administrative claim enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ("BAPCPA"). BAPCPA, which took effect in October 2005, added Section 503(b)(9) to the Bankruptcy Code giving vendors an administrative priority claim for "the value of any goods received by the debtor within 20 days before" the date the bankruptcy petition was filed, as long as "the goods have been sold to the debtor in the ordinary course of such debtor’s business." 

In my earlier post, I posed a number of unresolved questions about this new section and predicted that courts would soon start to address those issues. Well, in the past couple of months we have in fact seen decisions answering at least a few of the questions raised by Section 503(b)(9).

The First Court Decisions. In late December 2006, bankruptcy courts in the District of Delaware and the Eastern District of Pennsylvania issued what appear to be the first two decisions on when and under what circumstances Section 503(b)(9) administrative claims must or should be paid. As explained below, in both decisions the bankruptcy court held that the administrative claimant was not necessarily entitled to payment prior to, in a Chapter 11 case, confirmation of a plan of reorganization.

  • In the first decision, issued December 21, 2006, Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware denied a creditor’s motion for payment of a Section 503(b)(9) administrative claim in the In re Global Home Products, LLC Chapter 11 bankruptcy case. The court held that the timing of payment of administrative claims is left to the discretion of the court. In so doing the court quoted with approval from an article that described Section 503(b)(9) as a "rule of priority, rather than payment." The court relied on a non-Section 503(b)(9) decision for the three factors to assess when considering when an administrative claim should be paid, chiefly, (a) the prejudice to the debtor, (b) hardship to the claimant, and (c) potential detriment to other creditors. The court applied those factors and denied the creditor’s request for immediate payment.
  • In the second decision, issued a week later on December 28, 2006, Judge Eric Frank of the U.S. Bankruptcy Court for the Eastern District of Pennsylvania denied a motion for immediate payment of Section 503(b)(9) claims filed by several creditors in the In re Bookbinders’ Restaurant, Inc. Chapter 11 bankruptcy case. Although the debtor agreed that the creditors were entitled to allowance of a "20 day goods" administrative claim, it opposed the immediate payment of those claims. The court held that the timing of payment was a matter of the court’s discretion but agreed to hold an evidentiary hearing to consider evidence to guide the exercise of that discretion.

A Few Early Take-Aways. In both of these decisions, the courts held that they have discretion to defer payment until the end of a Chapter 11 bankruptcy case, when a plan of reorganization is confirmed.

  • Creditors who can establish that failing to pay their Section 503(b)(9) claim would cause them hardship, but not prejudice the debtor or other creditors, may still be able to obtain immediate payment. As these cases show, however, creditors will find it challenging to meet that standard.
  • Interestingly, the Bookbinders court rejected what it called an "equal protection" argument by the creditors, who asserted that they should be paid immediately because vendors delivering goods to the debtor post-petition were being paid on their administrative claims. The court drew a distinction between the two claims, explaining that the creditors delivering goods post-petition were paid not under Section 503(b) but instead under Section 363(c)(1) of the Bankruptcy Code. That latter section allows a debtor in possession or trustee to enter into post-petition ordinary course of business transactions, and to pay for them, without court approval.
  • Finally, DIP financing orders can impact the timing of paying Section 503(b)(9) claims. In some cases the DIP budget may not include funds to pay these claims and in others the DIP order may expressly prohibit their payment. Section 503(b)(9) creditors may want to review proposed DIP financing motions carefully with this in mind.

What Debtors Have Been Doing. In an attempt to exert a degree of control over Section 503(b)(9) claims, some debtors have filed motions seeking to establish procedures to handle these claims, not unlike the procedures used in past cases for reclamation claims. In the Seattle case of In re Brown & Cole Stores, LLC, for example, the debtor filed a motion for an order establishing procedures for Section 503(b)(9) claims. The court granted the motion and entered a Section 503(b)(9) procedures order which, among other things:

  • Required creditors to file Section 503(b)(9) claims by a special bar date;
  • Required the debtor to file a report evaluating such claims 21 days after the special bar date;
  • Gave creditors 15 days thereafter to file a reply to the debtor’s position;
  • Made the debtor’s position binding in the event a creditor did not timely respond; and 
  • Reserved to the court the right to resolve any disputes. 

The order effectively reserved the issue of when valid Section 503(b)(9) claims would be paid but made the procedures the exclusive method for determining the validity and amount of such claims. I expect that other debtors will pursue similar procedures for handling these "20 day goods" claims.

Don’t Touch That Dial. These early decisions are the first in what should be many future rulings on the questions posed by Section 503(b)(9). I’ll continue to update you on how courts are interpreting this new administrative claim and, over time, we should begin to see more clarity on how debtors, vendors, and courts will address this new BAPCPA provision.

The Financially Troubled Company

Assessing The Distressed Company: A Peek Inside The VC’s Toolbox

Will Price, a principal with venture capital firm Hummer Winblad, has a very interesting post called Isolating Causality: Bad Market or Bad Company. Will identifies a series of factors that can help start-up companies and their investors tease out whether a company’s financial and performance problems are company-centric or instead the result of not having a viable market for its products or services. 

Being able to tell the difference is crucial. As Will points out, when the problem is the absence of a market, neither additional investment nor new management will solve the problem. Instead, these companies are likely to be sold, wound down, or have to file for bankruptcy.