Supreme Court Watch 2016-2017 – Part I: Structured Dismissals and Insider Claims

Rick Antonoff and Adam Sansweet

The Supreme Court’s 2016–2017 term began last week with attention to two bankruptcy issues: Structured dismissals and insider claims.

Structured Dismissals:

Structured dismissals occur when a company’s assets in chapter 11 will not generate enough cash to pay priority claims in full and permit
confirmation of a plan. In Czyzewski v. Jevic Holding Corp., the official unsecured creditors’ committee sued the secured lender and negotiated a settlement whereby the lender agreed to set aside money for distribution to unsecured creditors following an agreed (i.e., “structured”) dismissal of the chapter 11 case. The distribution scheme did not follow priorities in the Bankruptcy Code because priority wage claimants received nothing from the lender while lower-ranked general unsecured creditors did. The bankruptcy court approved the settlement and dismissed the chapter 11 case over the wage claimant’s objection and that ruling was upheld in the district court and the Third Circuit.

The Supreme Court granted certiorari to review the Third Circuit’s ruling in Jevic on whether bankruptcy courts can dismiss chapter 11 cases when property is distributed in a settlement that does not comply with priorities contained in Section 507 of the Bankruptcy Code. The Court’s granting of certiorari in this case was not surprising because there has been a long-standing split in the circuits on the issue of structured dismissals. In Jevic, the Third Circuit approved a structured dismissal, following the Second Circuit on this issue. In contrast, the Fifth Circuit barred structured dismissals in a 1984 decision.

The Solicitor General recommended that the Supreme Court review and reverse the Third Circuit, arguing that “bankruptcy is not a free-for-all in which parties or bankruptcy courts may dispose of claims and distribute assets as they see fit” and that “nothing in the Code authorizes a court to approve a disposition that is essentially a substitute for a plan but does not comply with the priority scheme set forth in Section 507.”


Insider Claims:

On October 3, the first day of the new term, the Supreme Court invited the Acting Solicitor General to file a brief expressing the views of the United States on U.S. Bank NA v. The Village at Lakeridge LLC, which usually indicates a higher probability that the Court will grant certiorari. In Lakeridge, the Ninth Circuit held that a person does not become a statutory insider solely by acquiring a claim from a statutory insider. This issue is important when insiders hold the only unsecured claims because insider claims are not counted for purposes of confirming a cram-down plan over the objection of secured creditors.

In Lakeridge, the corporate debtor had only two creditors: a bank with a $10 million secured claim and the debtor’s general partner, which had a $2.8 million unsecured claim. In order to confirm a plan over the bank’s objection the holder of the unsecured claim would have to vote to accept the plan. But because the general partner was an insider, its vote would not be counted. To solve the cram-down problem, the general partner sold its claim for $5,000 to a close friend of one of the owners of the general partner and the plan called for $30,000 distribution on the unsecured claim. The bankruptcy judge ruled that although the buyer was not itself a statutory insider, it became an insider upon purchasing the claim. On appeal, the Bankruptcy Appellate Panel (“BAP”) agreed that the purchaser was not a statutory insider but reversed the bankruptcy court’s ruling that the purchaser became an insider by purchasing the insider claim. On further appeal, the Ninth Circuit upheld the BAP’s decision, although one judge filed a dissenting opinion on whether the purchaser was, in fact, a non-statutory insider based on the circumstances surrounding its claim purchase.

In the principal holding of the Ninth Circuit’s opinion, the majority in the Ninth Circuit agreed that a person does not become a statutory insider solely by acquiring a claim in good faith from a statutory insider. The opinion noted that the Code distinguishes between the status of a claim and the status of a creditor and that insider status pertains only to the claimant and not the claim. Therefore, the Ninth Circuit stated that status as an insider entails a factual inquiry to be conducted on a case-by-case basis and that to become an insider, a claim buyer must have a close relationship with the debtor and negotiate the relevant transaction at less than arm’s length. The bankruptcy judge had previously determined that the buyer was not an insider based on his conduct and relationship with the debtor and a majority of the Ninth Circuit panel did not find that conclusion to be clearly erroneous. It therefore affirmed the appellate panel.

The dissenting judge agreed that insider status depends on the circumstances of the case but believed that there were enough facts in this case about the relationship between the insider and the purchaser and the purchaser’s rationale for buying the claim to conclude that the purchaser should be treated as a non-statutory insider.

Bankruptcy 2016: Views from the Bench

Michael Schaedle

Michael B. SchaedleFriday, October 7, 2016

Georgetown University Law Center, Washington, D.C.

Join Partner Michael B. Schaedle at Bankruptcy 2016: Views from the Bench. This conference offers a unique opportunity for bankruptcy practitioners to hear from 18 bankruptcy judges during a full day of high-quality CLE and networking opportunities. This year’s program will examine the systematic and existential “threats” to the historical way in which the bankruptcy system has functioned, including structured dismissals, equitable mootness, gifting, successor liability, RSAs, and costs and legal fees. Is there a “shadow” bankruptcy system, prompted in part by hedge funds and equity funds that seeks ways to dominate and expedite the process, perhaps in the name of greater efficiency? Are clients, especially in the middle market, reluctant to use the bankruptcy system because it is too expensive, with no way to appeal bad results? Should judges be using the Chapter 11 Commission Report as an agent for change by adopting its recommendations or admonishing the bar to implement the changes?

The conference will also feature small group lunchtime breakout sessions with the morning topics’ judges and speakers, creating an interactive learning environment. Register and learn more at

To view this year’s agenda, please click here.

Madden v. Midland Funding: Supreme Court Leaves Non-Bank Loan Assignees Exposed to State Usury Laws

Rick Antonoff, Ritika Kapadia, and Marianne Caulfield

Rick Antonoff Ritika Kapadia Marianne T. CaulfieldOn June 27, 2016, the Supreme Court of the United States (the “Court”) denied Midland Funding LLC’s petition for certiorari in Madden v. Midland Funding, thereby letting stand a ruling by the Court of Appeals for the Second Circuit (the “Second Circuit”) that the National Bank Act (“NBA”), which preempts state usury laws for national banks, is not applicable to debt a bank transfers to a third party that is not a national bank or acting on behalf of a national bank.  The Second Circuit also raised (without deciding) the issue of whether an interest rate that is valid in a state identified in a debt instrument’s choice-of-law provision applies to assignees that are not national banks.

Although Madden involved consumer credit card debt, the proposition that third-party assignees are not entitled to charge and collect contractual interest rates for debt acquired from national banks may have broader implications.  First, the Second Circuit ignored a long-standing principle that if an interest rate is valid when the loan is made, it remains valid even when the loan is sold or transferred to a third party. (See Nichols v Fearson, 32 U.S. 103, 108 (1833)). The ruling may thereby weaken the secondary market for loans originated by national banks, at least within the Second Circuit, which includes New York, a major financial center.  Second, the Second Circuit concluded that enforcing state usury law against a non-bank assignee does not significantly interfere with an assignor national bank’s rights notwithstanding the potential effect on its sale of the loan to investors.

Section 85 of the NBA

Section 85 of the NBA permits national banks to “charge on any loan . . . interest at the rate allowed by the laws of the State, Territory, or District where the bank is located.”  For example, as in Madden, a national bank located in Delaware may collect an interest rate that is valid in Delaware, even though it may be usurious in the state where the borrower is located.  As a federal law, Section 85 preempts state usury law.

In Madden, the Second Circuit addressed whether Section 85 of the NBA continues to preempt the borrower’s state usury law after a national bank lender sold the loan to a third party that is not a national bank.  Midland Funding, a non-bank that acquired the loan from a national bank, argued that a loan, which is valid when made, cannot become usurious by virtue of a subsequent transaction.  Midland relied on a principle known as “valid-when-made” which, it argued, has been firmly established in common law long before the NBA was enacted and was therefore incorporated into Section 85 of the NBA. See Nichols v Fearson, 32 U.S. 103, 108-09 (1833) (confirming the “cardinal rule” that the determination of whether a loan is usurious occurs at the time of origination).  Midland prevailed in the District Court but the Second Circuit reversed on appeal and remanded the case to the District Court.

The Second Circuit held that in order “[t]o apply National Bank Act preemption to an action taken by a non-national bank entity, application of state law to that action must significantly interfere with a national bank’s ability to exercise its power under the National Bank Act.” In so holding, the Second Circuit reasoned that it would be an overly broad application of the National Bank Act to extend its protections to non-national bank entities that are not acting on behalf of a national bank.

Implications of the Supreme Court’s Decision Not to Review the Second Circuit

Courts of Appeals for the Fifth, Seventh and Eighth Circuits, have upheld the valid-when-made principle.  The Second Circuit in Madden did not address the principle at all and instead based its ruling on the absence of significant interference with the assignor bank’s powers under the NBA.  It remains to be seen whether the Supreme Court’s decision to decline review of Madden will result in loans to borrowers located in states within the Second Circuit (Connecticut, New York and Vermont) being more difficult for lenders to sell or securitize, and thereby tightening the availability of consumer credit in those states.  It also remains to be seen whether Madden’s impact will extend beyond consumer loans.

Going forward, non-bank debt purchasers acquiring loans to borrowers in the Second Circuit must ensure that the loans do not exceed applicable state usury laws. Alternatively, such non-bank debt purchasers could restructure financial transactions so that originating national banks retain material economic interests in, or contractual obligations with respect to, all loans once they are assigned or sold.

Finally, the Second Circuit in Madden remanded the case to the District Court to determine whether a contractual choice-of-law provision in the loan documents requires application of Delaware law, in which case the higher interest rate permitted in Delaware may be enforceable.  The Second Circuit noted that the District Court should decide the choice-of-law question “in the first instance,” suggesting that regardless of the District Court decision, the choice-of-law question would be ripe for appeal.

Lender Beware: The Pitfalls of Narrowly Defined Secured Obligations

Jonathan M. Schalit

schalit, jonathan M. (2)A recent decision by the United States Court of Appeals for the Seventh Circuit underscores the substantial risks secured lenders take when they narrowly define the obligations intended to be secured by their borrowers’ assets.  State Bank of Toulon v. Covey (In re Duckworth), 2014 U.S. App. LEXIS 22054 (7th Cir. Ill. Nov. 21, 2014)

Duckworth involved a farmer (the “Borrower”) who borrowed $1,100,000 (the “Loan”) from the State Bank of Toulon (the “Bank”) on December 15, 2008. The Borrower pledged his crops and farm equipment as collateral (collectively, the “Collateral”) to secure his obligation to repay the Loan and executed two documents: (1) a promissory note dated December 15, 2008 (the “Note”), and (2) an Agricultural Security Agreement dated December 13, 2008 (the “Security Agreement”).

The Security Agreement adequately described the Collateral as required under Section 9-108(b)(2) of the Uniform Commercial Code (the “UCC”) and the Bank filed a UCC-1 Financing Statement (the “Financing Statement”) with the Illinois Secretary of State in accordance with Sections 9-301 and 9-501 of the UCC.  The Financing Statement correctly identified the collateral, as required under Section 9-502(a)(3) of the UCC, however, the Security Agreement incorrectly described the Borrower’s obligation as arising under a note dated December 13, 2008 rather than the correct date of the Note, December 15, 2008.

In 2010, the Borrower defaulted on the Loan and filed a petition for bankruptcy protection under Chapter 7 of the Bankruptcy Code. Addressing two separate appeals brought by the bankruptcy trustee appointed in the Borrower’s bankruptcy case (the “Trustee”), the Court of Appeals reversed the bankruptcy court and the district court and held that the Security Agreement did not give the Bank a security interest in the Collateral that could be enforced against the Trustee. Consistent with this holding, the court found that the Trustee was able to exercise his “strong-arm power” under Section 544(a) of the Bankruptcy Code to invalidate the purported grant of a security interest in the Collateral, and the Bank was therefore left with an unsecured claim in the Borrower’s chapter 7 case. In sum, the court concluded that by mistakenly identifying a promissory note with a different date than the actual date of the Note, the Security Agreement referred to an obligation that did not exist and, therefore, the Collateral described in the Security Agreement did not secure the Loan evidenced by the Note because the Security Agreement referenced a note with a different date.

The Bank argued that it held a valid and enforceable lien on the Collateral because (1) the Financing Statement put the Trustee on notice of the Bank’s asserted lien on the Collateral, (2) the Borrower had no grounds to object to the validity of the lien, and (3) the Note and relevant testimony proved that the mutual intent of the Bank and the Borrower was that the Collateral secured the Note.

The  court, however, ruled that the Note and testimony were inadmissible parole evidence, affirming its prior holding in In re Martin Grinding & Machine Works, Inc., 793 F.2d 592, 595 (7th Cir. 1986) (holding that a secured lender cannot use parol evidence against a bankruptcy trustee to correct a mistaken description of collateral in a security agreement).  In so holding, the Seventh Circuit also aligned itself with the First Circuit in Safe Deposit Bank & Trust Co. v. Berman, 393 F.2d 401, 402–03 (1st Cir. 1968) (holding that a lender cannot use parol evidence against a bankruptcy trustee to change or add to the debts secured by the security agreement).

In light of Duckworth and Berman, secured lenders should draft security agreements to cover all obligations of their borrowers, whether such obligations then exist or thereafter arise, and regardless of what documents or instruments may evidence such obligations from time to time.  Otherwise, a seemingly minor mistake, like having one digit wrong in the identification of a borrower’s obligation, may leave a would-be secured creditor with an unsecured claim.

Appointment Of Independent Directors On The Eve Of Bankruptcy: Why The Growing Trend?

Regina Stango Kelbon, Michael DeBaecke, and Jonathan Cooper

The following is a summary of a paper prepared for the American Bar Association and later submitted to the Pennsylvania Bar Institute. The full article can be found at the link below.

Regina Stango KelbonMichael D. DeBaeckeJonathan CooperIn recent years, companies in financial distress have found “independent” directors to be useful to achieve protections for their board members. An independent director is a director – usually with no prior affiliation to the company – who has no personal interest or relationship that would render him or her incapable of acting solely in the best interests of the business. These individuals, typically selected on the basis of their business acumen and/or restructuring experience, bring not only expertise, but a desirable level of impartiality and objectivity to the corporate management scheme.

The appointment of an independent director can benefit a company in a number of ways, particularly when the business is struggling. From a practical standpoint, independent directors may be used for investigative purposes or to negotiate transactions involving insiders. The role of the independent director can mirror that of a bankruptcy examiner, a chief restructuring officer, or both, depending on the circumstances and strategic purposes.

Some companies have used independent directors in bankruptcy to stave off the appointment of an examiner or to derail a committee’s derivative standing to pursue litigation against corporate insiders.

Additionally, the presence of properly functioning independent directors can make it more difficult for a plaintiff shareholder to establish breach of fiduciary duty claims against the company and the board members. Under the typical business judgment rule, a board’s decisions are presumed reasonable and the burden to prove a breach of duty rests with the plaintiffs. In “conflict” situations, such as when a director or controlling shareholder stands on both sides of a deal, a more onerous standard (entire fairness review) may be triggered.

The presence of independent directors may afford the directors the business judgment presumption and/or allow the ultimate burden of proof to remain with the plaintiffs.

This article examines the fiduciary duties of directors and how independent directors have been used in certain bankruptcies.

“Appointment Of Independent Directors On The Eve Of Bankruptcy: Why The Growing Trend?” was formerly prepared and published in connection with the American Bar Association Business Law Section Spring Meeting held in Los Angeles, California, April 10-12, 2014. To read the full article, please click here.

River Road: A Cautionary Tale for Chapter 11 Financial Advisors

Leon Barson and Brandon Shemtob

6A471D42F6C801AD8D54571B3981426Dshemtobb1 (2)The United States Bankruptcy Court for the Northern District of Illinois recently handed down an opinion, In re River Road Hotel Partners LLC, 2014 WL 5488259 (Bankr. N.D. Ill. 2014), dealing with the issue of a financial advisory firm’s entitlement to a $2.6 million “restructuring fee” following confirmation of a Chapter 11 plan of reorganization proffered by the Debtors’ secured creditor. The opinion sheds light on the importance of clear drafting in engagement letters as well as the need to closely monitor a debtor’s proposed retention application for its financial advisor.

This Chapter 11 case concerned River Road Hotel Partners LLC and its affiliates in connection with their ownership of the Intercontinental Hotel at Chicago’s O’Hare Airport. After filing for bankruptcy in 2009, the Debtors sought to retain FBR Capital Markets & Co. to perform financial advisory services in connection with the reorganization effort. The parties negotiated an engagement letter, which provided for, among other things, a “restructuring fee” that compensated FBR in the event of a successful reorganization of the Debtors. The term “restructuring” was broadly defined in the engagement letter in order to encompass “any restructuring, reorganization and/or recapitalization…that involves all or a significant portion of the [Debtors’] outstanding obligations….”

After entering into the engagement letter, the Debtors filed a retention application with the Court seeking authorization to employ FBR. The initial application provided that FBR’s compensation would be determined based upon the terms of the engagement letter. However, the proposed form of order approving the retention application was modified prior to its approval by the Court to address an issue raised by the creditor’s committee. The revised order stated: “the ‘restructuring fee’ described…in the application is expressly contingent upon the consummation of a restructuring contemplated by the engagement letter.” The Court approved the modified form of order.

The Debtors were ultimately unsuccessful in their attempts to confirm a plan of reorganization. The secured lender, however, proposed and obtained confirmation of its own plan of reorganization. Following confirmation, FBR sought payment of the restructuring fee. The plan transferee (successor to the Debtors) objected, claiming that when read together, the engagement letter and retention order were ambiguous and parol evidence proved that FBR was only entitled to a restructuring fee if a debtor-sponsored plan was confirmed.

FBR filed a motion for summary judgment in which it argued that the engagement letter and the retention order were unambiguous and therefore created a clear entitlement to payment of the restructuring fee. The Bankruptcy Court, relying in large part on the declaration of Debtors’ counsel,[1] denied FBR’s motion and instead granted summary judgment sua sponte for the plan transferee. FBR appealed the decision to the District Court, which affirmed in part, reversed in part and remanded the matter for trial.

On remand, the Bankruptcy Court was tasked with determining whether FBR was entitled to the restructuring fee despite the fact that the confirmed plan was sponsored by a third party. The Court’s first hurdle was to determine whether consideration of parol evidence was appropriate in the matter sub judice. The Court concluded that while the engagement letter was unambiguous on its face, the language of the retention order created a latent ambiguity that necessitated consideration of parol evidence. Specifically, the Court found that this latent ambiguity arose when trying to square the engagement letter with the modified language in the retention order. Because the retention order made the restructuring fee “contingent upon the consummation of a restructuring contemplated by the Engagement Letter,” the Court concluded that it was entirely possible that a form of restructuring existed which would fall outside the purview of the engagement letter.

In considering parol evidence, the Bankruptcy Court next sought to ascertain the intent of the parties. After taking into account the evidence presented, the Court found that there was no evidence indicating the Debtors had ever advised FBR that the modification to the retention order was intended to change the definition of a restructuring from what was negotiated in the engagement letter (indeed, the financial advisor’s position was that the modification effected no substantive change to the terms of its engagement letter). Ultimately, the Court concluded that no credible evidence existed to show that the retention order materially changed FBR’s right to receive a restructuring fee. In view of this, the Court upheld FBR’s entitlement to a restructuring fee, notwithstanding the fact that the confirmed plan was sponsored by a third party.

The takeaway from FBR’s battle to recover its multi-million dollar restructuring fee is two-fold. First, it is imperative that financial advisors’ engagement letters are carefully drafted so as to avoid any potential ambiguity in terms of the entitlement to any form of compensation. Second, advisory firms must take care to monitor the debtor’s proposed retention order to ensure that it reflects, and is consistent with, the terms of their engagement. To be sure, a heightened attention to detail may serve to prevent post hoc disagreements as to the proper interpretation of what otherwise should have been viewed as a customary provision in a professional’s engagement letter.

Leon Barson is a partner in Blank Rome’s Finance, Business Restructuring & Bankruptcy group in Philadelphia, Pennsylvania.

Brandon Shemtob is an associate in Blank Rome’s Finance, Business Restructuring & Bankruptcy group in Philadelphia, Pennsylvania.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for general informational purposes and is not intended to be and should not be taken as legal advice.

[1] Interestingly, counsel for the Debtors (who drafted the modified retention order) testified that it was his understanding that FBR would only be entitled to a restructuring fee if the Debtors’ plan was confirmed.