Recent developments regarding claims in bankruptcy

RECENT DEVELOPMENTS
REGARDING
CLAIMS IN BANKRUPTCY
ABA SECTION OF BUSINESS LAW
SPRING MEETING
APRIL 15, 2011
BOSTON MASSACHUSETTS
Kay Standridge Kress
Pepper Hamilton LLP
100 Renaissance Center, 36th Floor
Detroit, Michigan 48243
(313) 393-7365
kressk@pepperlaw.com

Table of Contents
Page
I. OVERVIEW OF THE CLAIMS PROCESS IN BANKRUPTCY .......................................... 2
II. FILING CLAIMS AND THE CLAIMS OBJECTION PROCESS.......................................... 7
A. Implications and Consequences of Filing a Claim ............................................................. 7
B. Withdrawal of a Proof of Claim.......................................................................................... 7
C. Informal Proofs of Claim.................................................................................................... 7
D. Evidentiary Issues ............................................................................................................... 8
1. Proofs of Claim............................................................................................................. 8
2. Objections to Proofs of Claim..................................................................................... 11
E. Untimely Proofs of Claims ............................................................................................... 13
1. Chapter 9 and 11 Cases............................................................................................... 13
2. Chapter 7, 12 and 13 Cases......................................................................................... 15
F. Amending Proofs of Claim ............................................................................................... 16
G. Transferring Claims .......................................................................................................... 18
H. Claims Reconsideration .................................................................................................... 18
III. STATUTORY LIMITATIONS ON THE ALLOWANCE OF CLAIMS.............................. 20
A. The Scope of 11 U.S.C. § 502 .......................................................................................... 20
B. Claims Not Enforceable in Bankruptcy ............................................................................ 20
C. Claims For Unmatured Interest......................................................................................... 21
D. Claims for Services of an Insider or Attorney for the Debtor........................................... 22
E. Lease Rejection Claims..................................................................................................... 23
F. Estimation of Claims......................................................................................................... 24
G. Claims of Entities From Which Property is Recoverable................................................. 25
H. Reimbursement and Contribution Claims......................................................................... 26
IV. SUBORDINATION................................................................................................................ 27
A. Subordination Agreements................................................................................................ 27
B. Sale of Stock ..................................................................................................................... 27
C. Equitable Subordination.................................................................................................... 28
INTRODUCTION
This material is intended as an overview of certain trends and significant
decisions in recent case law relating to claims in bankruptcy. It deals primarily with unsecured

claims and does not include all recently decided cases or address all areas of law relating to
bankruptcy claims. Rather, this material is intended as a “survey” of certain recurring themes in
cases decided in the last year.
I. OVERVIEW OF THE CLAIMS PROCESS IN BANKRUPTCY
11 U.S.C. §§ 501 and 502 and the Federal Rules of Bankruptcy Procedure
(“FRBP” or “Bankruptcy Rules”) 3001, 3002, 3003, 3005, 3006, 3007 and 3008 govern the way
in which creditors and equity security holders present their claims or interests to the bankruptcy
court, and provide the guidelines within which such claims are allowed or disallowed in the
bankruptcy proceeding. There are different rules for filing and allowing claims in cases under
Chapters 9 and 11 than for filing and allowing claims in cases under Chapters 7, 12 and 13.
11 U.S.C. § 501 and FRBP 3001 generally governs the filing of proof of claim. A
proof of claim is a “written statement setting forth a creditor’s claim” which must conform
substantially to the appropriate Official Form. FRBP 3001(a). In re Gulfport Pilots Association,
Inc., 434 B.R. 380 (Bankr. S.D. Miss. 2010); In re Marchfirst, Inc., 431 B.R. 436, 442 (Bankr.
N.D. Ill. 2010); In re Curry, 425 B.R. 841, 843 (Bankr. D. Kansas 2010). In addition, the proof
of claim must be executed by the “creditor or the creditor’s authorized agent.” FRBP 3001(b).
In re Circuit City Stores, Inc., 426 B.R. 560 (Bankr. E.D. Va. 2010)(class representative does not
have the authority to file a class proof of claim without authorization of each claimant, or
certification of the class); In re Tarragon Corporation, 2010 WL 3842409 (Bankr. D.N.J.
2010)(class claim may be filed but the claimant must move for class certification without undue
delay; claimant cannot merely wait for an objection to be filed to the claim before seeking
certification); In re Hernandez, 2009 WL 4639645 (servicer is required to provide evidence of its
authority to file on behalf of the debtholder); In re Penaran, 424 B.R. 868, 875 (Bankr. D. Kansas
2010). If a claim is based on a writing, “the original or a duplicate shall be filed with the proof
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of claim.” FBRP 3001(c). In re O’Brien, 440 B.R. 654 (Bankr. E.D. Pa. 2010)(if an assignee
files a proof of claim, it must provide a writing evidencing the assignment); In re Chaney, 2010
WL 2925083 (Bankr. N.D. Ohio 2010); In re Abbott, 2010 WL 1780059 at *5 (Bankr.S.D.N.Y.
2010); In re Curry, 425 B.R. at 846 (“when filing a proof of claim, a credit card creditor whose
claim is listed on the schedules must provide supporting documentation, or at least an
explanation why such documentation is not provided”); In re Minbatiwalla, 424 B.R. 104, 111
(Bankr. S.D.N.Y. 2010). In addition, if the claimant is asserting a security interest, “the proof of
claim shall be accompanied by evidence that the security interest has been perfected.” FRBP
3001(d), Id.
Pursuant to FRBP 3001(c), a creditor asserting a claim based upon a writing has
the procedural burden of producing and attaching to the proof of claim the documentary proof to
support the claim. Most courts have held that the lack of such documentation, however, will not
constitute the basis for the disallowance of the claim, particularly if the creditor’s claim is similar
to the amount listed by the debtor for such creditor in its Schedules. In re Willis, 2010 WL
5463066 (Bankr. N.D. Ga. 2010)(failure to comply with FRBP 3001(c) is not grounds for
disallowance of the claim, but rather the claim loses the presumption of its prima facie validity);
In re O’Brien, 440 B.R. 654 (Bankr. E.D. Pa. 2010); In re Chaney, 2010 WL 2925083 (Bankr.
N.D. Ohio 2010)(failure of a creditor to comply with the writing requirements of FRBP 3001(c)
is not grounds for disallowance if the amount is similar to the amounts scheduled by the Debtor
in a chapter 13 case); In re Minbatiwalla, 424 B.R. 104 (Bankr. S.D.N.Y. 2010)(failure to attach
the required documentation to the proof of claim will result in the loss of the prima facie validity
of the claim). In In re Wingerter, 594 F.3rd 931 (6 th Cir. 2010) the Court of Appeals for the
Sixth Circuit reversed the bankruptcy court which held that a creditor was to be sanctioned for
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violating FRBP 3001 by (a) not providing copies of the originating documents or an explanation
of why copies of such documents were unavailable, and (b) not properly making a reasonable
pre-filing inquiry as to the validity and amount of the claim before filing it in violation of FRBP
9011.
The Bankruptcy Rules govern the form and substance of the proof of claim. In
cases under Chapters 7, 12 and 13, except for certain specifically defined exceptions, a proof of
claim must be filed within ninety (90) days after the first date set for the first meeting of creditors
under 11 U.S.C. § 341. FRBP 3002; 11 U.S.C. § 502(b)(9). In re Stewart, 2010 WL 34090976
(Bankr. E.D. La. 2010)(a claimant must file a proof of claim in a chapter 13 case to receive
payments under the plan, even a secured creditor); In re Ginzl, 430 B.R. 702 (Bankr. M.D. Fla.
2010)(in a chapter 7 case, a creditor must file a claim to share in any distribution from the
estate); In re Sikes, 2010 WL 1251645 (Bankr. W.D. La. 2010)(in a chapter 13 case a pre-
petition claim must be filed before the expiration of the bar date or the claim is discharged under
the plan); In re Myrick, 2010 WL 749792 (Bankr. E.D.N.C. 2010)(if a creditor does not timely
file a proof of claim in a chapter 13 case, it cannot participate in reorganization process,
including having the automatic stay lifted to continue an action in civil court); In re Eberwein,
2010 WL 1337346 (Bankr. N.D. Cal. 2010). See In re Trapp, 2010 WL 2465536 (Bankr. D.
Neb. 2010)(the 180-day limitation for a governmental entity to file a claim in a chapter 13 case
applies only to pre-petition claims, not post-petition claims); In re Morris, 430 B.R. 824 (Bankr.
W.D. Tenn. 2010)(a personal injury claimant was not required to file a proof of claim in a no
asset chapter 7 case and it will still have the right to pursue the debtor’s insurance company).
See also In re Yan, 2010 WL 4791839 (Bankr. N.D. Cal., 2010)(if there is a surplus in a chapter
7, it is within the discretion of the court to allow late-filed claims).
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In cases under Chapters 9 and 11, however, a proof of claim must be filed only if
(i) the claim is listed in the debtor’s Schedules of Liabilities (the “Schedules”) as disputed,
contingent and/or unliquidated, In re Fickes, 2010 WL 4388076 (W.D. Pa. 2010); In re JNL
Funding Corp., 438 B.R. 356 (Bankr. E.D.N.Y 2010), or (ii) the creditor disagrees with the
amount of the claim as listed in the Schedules. FRBP 3003(c)(2). In re Yelverton, 2010 WL
3245525 (Bankr. D. Dist. Col. 2010); In re Sportsstuff, Inc., 2009 WL 6338615 (Bankr. D. Neb.
2009). If a proof of claim is filed, it supercedes the amount scheduled by the debtor. If,
however, the proof of claim is subsequently disallowed because it was not timely filed, the
scheduled claim will be reinstated for purposes of distribution.
Neither the Bankruptcy Code (the “Code”) nor the Bankruptcy Rules provide a
time by which creditors asserting claims in cases under Chapters 9 and 11 must file proofs of
claim. Rather, the time is set either by local rule, or by order of the Court upon motion of the
debtor or another party in interest. FRBP 3003(c)(3). In re JNL Funding Corp., 438 B.R. at 364.
If a creditor relies on the debtor’s Schedules filed in a case under Chapter 11 (and
does not file a proof of claim), and the case is subsequently converted to a case under Chapter 7,
the creditor cannot continue to rely on the Chapter 11 Schedules. All unsecured creditors in a
case under Chapter 7 that did not file proofs of claim in the case under Chapter 11 must file
proofs of claim once the case is converted. FRBP 1019(6).
If a creditor fails to file a proof of claim within the prescribed time period, the
debtor or trustee may file a claim on behalf of the creditor within thirty (30) days after the
applicable time period. FRBP 3004. In re Turnbull, 2010 WL 3927240 (Bankr. D. Mass.
2010)(debtor may file a proof of claim on behalf of a creditor that did not file a claim by the
claims bar date and if the creditor does not agree with the claim so filed, it must file an objection
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to the claim); In re Hight, 434 B.R. 505 (W.D. Mich. 2010)(upheld bankruptcy court decision
that a chapter 13 debtor was entitled to file a proof of claim on behalf of the State even though
the State’s claim arose post-petition when the return was filed rather than pre-petition at the
conclusion of the tax year); In re Senczyszyn, 426 B.R. 250 (Bankr. E.D. Mich. 2010); In re
Hatley, 2010 WL 200825 (Bankr. E.D. Tenn. 2010)(debtor may file a proof of claim on behalf of
a creditor that did not receive notice of the bankruptcy prior to the expiration of claims bar date
and the debt will be discharged). Courts are split, however, on whether the time in which the
creditor or trustee has to file the claim under FRBP 3004 may be enlarged. See In re Cox, 2010
WL 2083257 (Bankr. M.D. Tenn 2010)(the time in which a debtor has to file a proof of claim on
behalf of a creditor may be enlarged under FRBP 9006(b)(1) under the “excusable neglect”
standard of Pioneer 1 ); In re Schuster, ___ B.R. ___, 2010 WL 1891252 (Bankr. E.D. Wis.
2010)(FRBP 3004 allowing a debtor to file a claim on behalf of a creditor may be enlarged in a
chapter 13 case if excusable neglect under the Pioneer standard is established). But see, In re
Stewart, 2010 WL 5372782 (Bankr. C.D. Ill. 2010)(a chapter 13 debtor inherited money after
confirmation of its plan and the trustee requested permission to file untimely proofs of claim on
behalf of creditors which did not file proofs of claim and the court denied the trustee’s motion,
allowing the excess to be paid back to the debtor).
Any entity liable with the debtor to a creditor may file a proof of claim on behalf
of that creditor if the creditor fails to file its own proof of claim within thirty (30) days after the
expiration of the operative claims bar date. FRBP 3005. In re Currency Management Co. Ltd.,
(1993).
1 Pioneer Inv. Servs. Co. V. Brunswick Assocs. Ltd. P’Ship, 507 U.S. 380, 113 S.Ct. 1489, 123 L.Ed.2d
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2010 WL 3523086 (Bankr. N.D. Ill. 2010)(a creditor may file a proof of claim on behalf of a co-
liable creditor after the expiration of the claims bar date and does not need authorization from the
co-liable creditor).
II. FILING CLAIMS AND THE CLAIMS OBJECTION PROCESS
A. Implications and Consequences of Filing a Claim
The filing of a proof of claim triggers the claims allowance and disallowance
process, and, accordingly, the bankruptcy court’s core jurisdiction under 28 U.S.C.
§157(b)(2)(B). 2 In re Louis Jones Enterprises, Inc., 2010 WL 1726820 (Bankr. N.D. Ill.
2010)(the Internal Revenue Service waived its sovereign immunity when it filed a proof of claim
in a chapter 11 case).
B. Withdrawal of a Proof of Claim
Generally, a creditor may withdraw a proof of claim as of right, unless (i) an
objection to the claim has been filed, (ii) a complaint was filed against the creditor in an
adversary proceeding, (iii) the creditor accepted or rejected the plan, or (iv) the creditor
otherwise participated significantly in the case, at which time the creditor must have an order of
the court to withdraw its claim. FRBP 3006.
C. Informal Proofs of Claim
Although FRBP 3001(a) provides that a proof of claim conform substantially to
the appropriate Official Form, under certain circumstances, courts allow “informal” proofs of
claim. For an informal proof of claim to be recognized in the Second Circuit, the creditor must
establish that there is a document that was (1) timely filed with the bankruptcy court and became
2 The bankruptcy court’s core jurisdiction under 28 U.S.C. §157(b)(2)(B) does not extend to the
liquidation or estimation of contingent or unliquidated personal injury tort or wrongful death claims.
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part of the judicial record; (2) state the existence and nature of the debt; (3) state the amount of
the claim against the estate, and (4) evidence the creditor’s intent to hold the debtor liable for the
debt. In re Mechanical, Inc., 434 B.R. 54 (Bankr. E.D.N.Y. 2010)(the notice of appointment
filed by the Office of the United States Trustee does not constitute an informal proof of claim);
In re Enterlife Ambulance Corporation, 2010 WL 1508296 (Bankr. D. Puerto Rico
2010)(unaudited balance sheets filed in the case did not constitute an informal proof of claim).
A different variation on the test to establish an informal proof of claim is that the
creditor must establish that the (a) the informal proof of claim must be in writing, (b) the writing
must contain a demand by the creditor on the debtor’s estate, (c) the writing must express an
intent to hold the estate liable for the debt, (d) the writing must be filed with the Bankruptcy
Court, and (d) based upon the facts of the case, it must be equitable to allow the claim. In re
Woodhollow Loft, Inc., ___ B.R. ___, 2010 WL 2088978 (N.D. Ill 2010)(motion for relief from
stay was not an informal proof of claim as it did not contain a demand of the intent to hold the
estate liable).
D. Evidentiary Issues
1. Proofs of Claim
A Chapter 11 debtor’s Schedules (filed pursuant to 11 U.S.C. § 521(1)) constitute
prima facie evidence of the validity and amount of the claims of creditors. FRBP 3003(b)(1). In
re South Canaan Cellular Investments, Inc. & South Canaan Cellular Equity, LLC, 427 B.R. 44,
n.3 (Bankr. E.D. Pa. 2010)(pursuant to FRBP 3003(b)(1) the debtor’s schedules constitute proofs
of claim on behalf of creditors who did not file proofs of claim). If the claim is scheduled as
unliquidated, disputed and/or contingent, the creditor must file a proof of claim. FBRP
3003(c)(2). In re Fickes, 2010 WL 4388076 (W.D. Pa. 2010).
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If a creditor or interest holder subsequently files a timely and properly executed
proof of claim, such claim supersedes the debtor’s Schedules. FRBP 3003(c)(4) and FRBP
3001(f).
A properly filed equity interest scheduled pursuant to Rule 3003(b)(2) and
1007(a)(3) also constitutes prima facie evidence of the validity and amount of the interest and is
deemed allowed even without the filing of a proof of claim.
A properly filed proof of claim constitutes prima facie evidence of the validity
and amount of the claim, and the claim is deemed allowed unless an objection is filed to the
claim. FRBP 3001(f); 11 U.S.C. § 502(a). An objecting party is then required to produce
evidence to rebut the claimant’s prima facie evidence, and if such evidence is sufficient, the
burden shifts back to the claimant to demonstrate the validity of the claim. In re Altheimer &
Gray, 601 F.3d 740 (7 th Cir. 2010); In re Jacobsen, 362 Fed. Appx. 413 (5 th Cir. 2010); In re
Level Propane Gases, Inc., 438 B.R. 354 (B.A.P. 6 th Cir. 2010); In re Ellzey, 2010 WL 3924011
(E.D. La. 2010); In re Moye, 2010 WL 3259386 (S.D. Tex. 2010); In re Affinity Group, Inc.,
424 B.R. 251 (N.D. Ohio 2010); In re Ausilio, 2010 WL 55507 (E.D. Mich. 2010); In re Tinnell,
2009 WL 4827445 (D. Neb. 2009); In re Capco Energy, Inc., 2011 WL 13508 (Bankr. S.D. Tex.
2011); In re Willis, 2010 WL 5463066 at *2-4; In re Probulk Inc., 2010 WL 5376284 (Bankr.
S.D.N.Y. 2010); In re Travers, 2010 WL 5288691 (Bankr. D. Md. 2010); In re Vincent, 2010
WL 5137739 (Bankr. D. Or. 2010); In re Smith, 2010 WL 5018379 (Bankr. W.D. Wash. 2010)(a
properly filed claim is deemed allowed unless an objection is filed, even a late-filed claim in a
chapter 13 case); In re Cadiz, 2010 WL 4916575 (Bankr. D. Hawaii 2010); In re Wolff, 2010
WL 4959949 (Bankr. E.D. Tenn. 2010); In re Johnson, 2010 WL 4809104 (Bankr. D.S.C. 2010);
In re Lampe, 2010 WL 4811798 (Bankr. E.D. Pa. 2010); In re Watson, 2010 WL 4496837
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(Bankr. N.D. W.Va. 2010); In re JNL Funding Corp, 438 B.R. at 364; In re King, 2010 WL
4290527 (Bankr. E.D.N.Y. 2010); In re Condere Corporation, 2010 WL 3946310 (Bankr. S.D.
Miss. 2010); In re O’Brien, 440 B.R. 654 (Bankr. E.D. Pa. 2010); In re Edwards, 2010 WL
3807161 at *2; In re Brownell, 2010 WL 3718893 (Bankr. W.D. La. 2010); In re Meyer, 2010
WL 370297 (Bankr. N.D. Ill. 2010); In re Bateman, 435 B.R. 600 (E.D. Ark. 2010); In re Reid,
2010 WL 3447571 (Bankr. D. Idaho 2010); In re Canton, 2010 WL 3396852 (Bankr. D. Mont.
2010); In re Viva Vista Ventures, Inc., 2010 WL 3366408 (Bankr. N.D. Ohio 2010); In re
Stewart, 2010 WL 3490976 at *5; In re Polo Builders, Inc., 433 B.R. 700 (Bankr. N.D. Ill.
2010); In re Bareford, 2010 WL 3528604 (Bankr. S.D. Ga. 2010); In re Market Center East
Retail Property, Inc., 433 BR. 335 (Bankr. D. N.M. 2010); In re Robaszkiewicz, 2010 WL
2901884 (Bankr. S.D. Tex. 2010); In re Soares, 2010 WL 2942692 (Bankr. N.D. Cal. 2010); In
re Kipling, 2010 WL 2584191 (Bankr. E.D. Ky. 2010); In re Trapp, 2010 WL 2465536 at *3; In
re Share Building Products, Inc., 2010 WL 2402882 (Bankr. E.D. Wis. 2010); In re Fenn, 428
B.R. 494, (Bankr. N.D. Ill. 2010); In re Moe, 2010 WL 1904830 (Bankr. D. N.D. 2010); In re
Abbott, 2010 WL 1780059 at *5; In re Weese, 428 B.R. 380 (Bankr. W.D. Mich. 2010); In re
Innovative Communication Corporation, 2010 WL 1728536 (Bankr. Virgin Islands)(if a claimant
fails to comply with the requirements of FRBP 3001 in filing its proof of claim, the claim does
not have the prima facie effect of FBRP 3001(f)); In re Lopez, 2010 WL 1636040 (Bankr. D.
Ariz. 2010); In re Starks, 2010 WL 1538848 (Bankr. N.D. Miss. 2010); In re Gulfport Pilots
Association, Inc., 434 B.R. 380 (Bankr. S.D. Miss. 2010); In re Schackner, 2010 WL 1418083
(Bankr. E.D.N.Y. 2010); In re Cam Recycling & Materials, Inc., 2010 WL 1416858 (Bankr. E.D.
Wis. 2010); In re Usgen New England, Inc., 429 B.R. 437, 2010 WL 1416537 (Bankr. D. Md.
2010); In re McLemore, 426 B.R. 728 (Bankr. S.D. Ohio 2010); In re GTI Capital Holdings,
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, 2010 WL 1254879 (Bankr. D. Ariz. 2010)(section 502(a) applies only to pre-petition
claims); In re Bentley, 2010 WL 2036952 (Bankr. N.D. Ga. 2010); In re Prayer Apostolic
Church, Inc., 2010 WL 1235949 (Bankr. D. Mass. 2010); In re Voss, 426 B.R. 326 (Bankr. D.
Mont. 2010); In re Vanhook, 426 B.R. 296 (Bankr. N.D. Ill. 2010); In re Curry, 425 B.R. at 843;
In re Yellowstone Club World, Inc., 2010 WL 989050 (Bankr. D. Mont. 2010); In re Rogel, 425
B.R. 231 (Bankr. W.D. Pa. 2010); In re Alvo Grain and Feed, Inc., 2010 WL 1430782 (Bankr. D.
Neb. 2010); In re Appling, 2010 WL 2036793 (Bankr. N.D. Ga. 2010); In re Circuit City
Stores,Inc., 441 B.R. 496 (Bankr. E.D. Va. 2010); In re Machne Menachem, Inc., 425 B.R. 749
(Bankr. M.D. Pa. 2010); In re Rushing, 424 B.R. 747 (Bankr. M.D. La. 2010); In re Hodder,
2010 WL 729009 (Bankr. D. Ariz. 2010); In re McVey, 2010 WL 724366 (Bankr. D. Kan.
2010); In re Kaisha, Y.K.F., 423 B.R. 888 (Bankr. N.D. Cal. 2010); In re Penaran, 424 B.R. at
875; In re Eastern Towers, Inc., 2010 WL 346914 (Bankr. D. Mass. 2010); In re Daily, 2010 WL
148414 (Bankr. M.D. Tenn. 2010); In re Mobley, 2010 WL 2293457 (Bankr D. Dist. Col. 2010);
In re Ryan, 431 B.R. 1 (Bankr. D. Mass. 2010)(although proof of claim filed pursuant to FRBP
3001(f) is prima facie valid, a chapter 13 plan will determine the amount of a claim unless the
creditor objects to the claim); In re Wilson, 2009 WL 4894803 (Bankr. D. Ariz. 2009); In re
Boudinot, 2009 WL 4884462 (Bankr. E.D. Okla. 2009); In re Hernandez, 2009 WL 4639645
(Bankr. S.D. Tex. 2009).
2. Objections to Proofs of Claim
In order to contest a proof of claim or interest, FRBP 3007 requires that the
objection be in writing, be filed and served on the creditor thirty (30) days prior to the hearing
date set for such objection. In re Ausilio, 2010 WL 55507 at *5. See also In re Shekerjian, 2010
WL 1417782 (E.D. Mich. 2010)(section 502 procedures for which the estate can object to a
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proof of claim is not analogous to the procedures by which a creditor would object to the
debtor’s discharge in a chapter 7 case).
Claims objections are contested matters which are governed by FRBP 9014. If
the objection, however, if joined with a demand for relief, then the objection must be included in
an adversary proceeding. In re Brownell, 2010 WL 3718893 at *1, n.1 (a party shall not include
a demand for relief specified in FRBP 7001 in an objection to claim, but may include an
objection to claim in an adversary proceeding); In re Donson, 434 B.R. 471 (Bankr. S.D. Tex.
2010)(demand under Rule 7001 must be brought by adversary proceeding, not as part of a claims
objection); In re Angulo, 2010 WL 1727999 (Bankr. E.D. Pa. 2010)(an objection to claim may
be included in an adversary proceeding); In re Bencharsky, 2010 WL 309145 (Bankr. N.D. Cal.
2010)(an objection to claim coupled with affirmative relief is to be brought by an adversary
proceeding); In re Kund, LLC, 2010 WL 173831 (Bankr. N.D. Ala. 2010); In re Hardaway, 421
B.R. 226 (Bankr. N.D. Miss. 2010); In re Wilson, 2009 WL 4894803 at *2 (in order to invalidate
a lien, the debtor must file an adversary proceeding); In re Sportsstuff, Inc., 2009 WL 6338615 at
*2 (an adversary proceeding must be filed to determine the validity and priority of a secured
claim). But see In re R&B Construction, 2010 WL 3397418 (Bankr. N.D. Ga. 2010)(a claim
objection combined with the challenge to the validity, priority and extent of a lien should be
brought by an adversary proceeding, but the court may resolve issues of lien validity outside of
an adversary proceeding when the parties have sufficient notice and opportunity to be heard); In
re Circuit City Stores, Inc., 2009 WL 4755253 (Bankr. E.D. Va. 2009)(debtor is not required to
file an adversary proceeding to assert an affirmative defense to a claim in an objection to claim).
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Neither the Bankruptcy Code nor the Bankruptcy Rules provide a bar date or
deadline for filing objections to claims. In re Innovative Communication Corporation, 2010 WL
1728536 at *12.
Generally, all parties in interest have standing to object to the filed claims. The
majority of courts have held that the only basis for an objection to claim must be found in 11
U.S.C. § 502(b). In re Fenn, 428 B.R. 494 (Bankr. N.D. Ill. 2010); In re McLemore, 426 B.R.
728 (Bankr. S.D .Ohio 2010); In re Bentley, 2010 WL 2036952 (Bankr. N.D. Ga. 2010)(nothing
in § 502(b) permits disallowance of a secured claim because the secured creditor has the
collateral or the debtor has abandoned the collateral); In re Maple, 434 B.R. 363 (Bankr. E.D.
Va. 2010)(section 502(b) is the sole basis for disallowing a claim and the procedural violation of
a creditors failure to redact information in the attachment to its proof of claim is not an
independent grounds for disallowance); In re Davis, 430 B.R. 902 (Bankr. D. Colo.
2010)(creditor filing proof of claim that includes the debtor’s social security number, date of
birth and driver’s license cannot be disallowed under § 502(b)); In re Appling, 2010 WL
2036793 (Bankr. N.D. Ga. 2010)(there is no basis in § 502(b) to disallow the claim of a secured
creditor because it has its collateral); In re Terrell, 2009 WL 6499214 (Bankr. N.D. Ga.
2010)(the creditor’s failure to respond to the request for verification is not a basis for objecting to
a claim under § 502(b)).
E. Untimely Proofs of Claims
1. Chapter 9 and 11 Cases
As a general rule in cases under Chapters 9 and 11, claims that are not filed timely
are disallowed, and any creditor who files a late claim is prohibited from participating in the case
and receiving any payment with respect to its claim. FRBP 3003. There is, however, one
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exception to this rule. FRBP 9006 (b)(1) allows the court to enlarge the time for filing a proof of
claim, if the claimant establishes that the delay in filing is due to “excusable neglect.”
In Pioneer Investment Services Company v. Brunswick Associates Limited
Partnership, 507 U.S. 380, 113 S. Ct. 1489, 1498 (1993), the United States Supreme Court
articulated a non-exclusive balancing test which examined the following factors to determine
whether a claimant’s neglect in filing a timely proof of claim was excusable:
1. The danger of prejudice to the debtor if the untimely filing is allowed;
2. The length of the delay and its potential impact on the judicial
proceedings;
3. The reason for the delay, including whether the delay was beyond the
reasonable control of the person whose duty it was to perform; and
4. Whether the creditor acted in good faith.
As with the application of any “balancing test,” the courts, using the Pioneer
standard, have great discretion in deciding whether to allow an untimely-filed proof of claim.
Accordingly, all of the published decisions discussing the Pioneer balancing test are very fact
specific. For examples of cases in which the courts apply the Pioneer standard, see In re DPH
Holdings Corp., 434 B.R. 77 (S.D.N.Y 2010)(the bankruptcy court did not abuse its discretion in
denying the request of the State of Michigan workers’ compensation fund to file a late claim,
even though the State relied upon the fact that the self-insured employer debtor proposed under
its plan to continue paying workers’ compensation claims, because it could have anticipated the
possibility that the debtor might change its plan and have protected itself in filing a contingent
proof of claim); In re Victory Memorial Hospital, 435 B.R. 1 (Bankr. E.D.N.Y. 2010)(an
unknown creditor is only entitled to constructive notice of the bankruptcy case and there is no
excusable neglect if the claimant’s attorney was on medical leave); In re St. James Mechanical,
Inc., 434 B.R. at 62 (the Pioneer excusable neglect standard cannot be used to file post-
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confirmation late claims); In re TALT, 2010 WL 2771841 (Bankr. S.D.N.Y. 2010)(a claimant
whose claim arose out of a plan confirmation rejection of a contract under which there was no
amounts owing at the time of the claims bar date would not be allowed to file a late claim
because of the “hardline approach” taken in the Second Circuit and the prejudice to the estate);
In re Caritas Health Care, Inc., 435 B.R. 111 (an error on the part of an attorney representing the
creditor in a jointly administered chapter 11 case, in not effectively communicating with his
creditor client to determine who would file the proof of claim, was not “excusable neglect”); In
re Lehman Brothers Holdings Inc., ____ B.R. at ____, 2010 WL 2000326 at *5
(miscommunication between a creditor and its investment advisor that allegedly led to its failure
to timely file a proof of claim was entirely within the creditor’s control and did not constitute
“excusable neglect); In re Enterprise Ambulance Corporation, 2010 WL 1508296 at *3 (there is
a potential danger of prejudice to the debtors in allowing a late claim after confirmation of a plan
and there was nothing in the record to explain why the claimant delayed in filing its proof of
claim); In re 2715 N. Milwaukee LLC, 422 B.R. 675 (Bankr. N.D. Ill. 2010)(creditor that failed
to file a forwarding address and did not return to his former address for three-and-a-half months
to obtain mail lacks the good faith for excusable neglect).
2. Chapter 7, 12 and 13 Cases
In Chapter 7, 12 and 13 cases, FRBP 3002(c) provides six exceptions to the
general rule that claims must be filed within ninety (90) days of the first meeting of creditors.
Most courts have taken the position that these specifically enumerated exceptions are the only
reasons for a creditor not filing a proof of claim in a timely manner, and that the Pioneer
“excusable neglect” standard does not apply. In re Dozier, 2010 WL 4810829 (Bankr. E.D.
Tenn. 2010)(in a chapter 13 case, the court has no discretion to allow late-filed claims, even if
they did not receive notice of the filing of the case); In re McMillan, 2010 WL 4062506 (Bankr.
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D. Mont. 2010); In re Toriello, 2010 WL 3943737 at *3 (Bankr. D.N.Y. 2010)(“where a late
proof of claim in a chapter 13 case does not fit within one of the narrow exceptions outlined in
Rule 3002(c), the claim is barred”); In re Edwards, 2010 WL 3807161 (Bankr. M.D. Ala. 2010)(
a late-filed claim in a chapter 13 case must disallowed in a chapter 13, unless it fits into one of
the statutory exceptions); In re DV8, Inc., 435 B.R. 738 (Bankr. S.D. Fla. 2010)(in a case
converted from a chapter 11 to a chapter 7, the court has no discretion to allow the filing of late
claims); In re Idacrest Frams, Inc., 2010 WL 2926145 (Bankr. D. Idaho 2010)(the court has no
discretion to enlarge the time for a creditor to file a claim in a chapter 7 case); In re Chaney,
2010 WL 2925083 at *3 (Bankr. N.D. Ohio 2010)(a late claim cannot be allowed in a chapter 13
case); In re Arnold, 2010 WL 2926153 (Bankr. N.D. Iowa 2010)(in a chapter 13 case, there is
nothing that permits a court to allow a late-filed claim because of “excusable neglect”); In re
Thul-Theis, 431 B.R. 828 (Bankr. W.D. Wisc. 2010)(a claimant in a chapter 13 case will not be
allowed to file a late claim when the claimant had actual notice of the chapter 13 case). Contra,
In re Russo, 2009 WL 4672669 (D.N.J. 2009)(district court upheld the bankruptcy court’s
decision to allow a late filed claim in a chapter 13 case because the creditor did not receive
notice of the filing of the bankruptcy case); In re Winter Manufacturing, Inc., 2010 WL 737326
(Bankr. D. Vt. 2010)(court allowed a creditor in a chapter 7 case without actual notice of the
bankruptcy to file a untimely proof of claim and share in the distribution despite the prohibition
in 11 U.S.C § 502(b)(9) and FRBP 3002). See also In re Davis, 430 B.R. 62 (Bankr. W.D.N.Y.
2010)(tardily filed claims by a chapter 7 trustee under FBRP 3004 in a surplus chapter 7 case is
not covered by 11 U.S.C § 726 and the claim must be disallowed as untimely).
F. Amending Proofs of Claim
Amendments to timely filed proofs of claim are generally allowed when the
purpose is to cure a defect in the claim as originally filed, to describe the claim with greater
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particularity or to plead a new theory of recovery on the facts set forth in the original claim. In
re Rodriguez, 2010 WL 1838286 (M.D. Fla. 2010)(bankruptcy court did not abuse its discretion
in not allowing the creditor to amend its claim because the amended claim did not describe its
claim with greater particularity, but rather increased the amount of the claim by more than
double without providing any substantiation at all); In re Yellowstone Club World, LLC, 2010
WL 989050 (Bankr. D. Mont. 2010)(an amended proof of claim filed after the claims bar date
must relate back to the original proof of claim and give fair notice of the conduct, transaction or
occurrence that forms the basis of the claim asserted in the amendment); In re Xehcem
International, Inc., 424 B.R. 836 (Bankr. N.D. Ill 2010)(because the amended claims arise from
the same conduct, transaction, or occurrence as the originally filed proof of claim, the claims
asserted in the amended proof of claim will be found to relate back).
The Bankruptcy Court for the Middle District of Florida, in In re George, 426
B.R. 895, 900 (Bankr. M.D. Fla. 2010) detailed the following five equitable factors to be
considered when determining whether a late-filed claim will “relate back” as an amendment to a
timely filed claim:
1. Whether the debtor and creditors relied on the earlier proof of claim or had
reason to know that a subsequent proof of claim would be filed;
2. Whether other creditors would receive a windfall if the court refused to
allow amendment;
3. Whether the claimant intentionally or negligently delayed in filing the
amendment;
4. The justification for the failure to file for an extension to the bar date; and
5. Whether other equitable considerations exist that compel amendment.
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G. Transferring Claims
Claims may be transferred, both before and after a proof of claim is filed. FRBP
3001(e). In re Dewberry, 2010 WL 4882016 (Bankr. N.D. Ga. 2010)( FRBP allows post-petition
assignment of a claim). The notice of the transfer is filed with the Court and noticed by the
Clerk of the Court. If no objection is filed by the transferee, the claim is transferred and the
transferor is substituted as the claimant by operation of law. In re Samuels, 2010 WL 2651909
(Bankr. D. Mass. 2010).
H. Claims Reconsideration
The Bankruptcy Code allows a court to reconsider an allowed or disallowed claim
“for cause” according to the equities of the case. 11 U.S.C. § 502(j) and FRBP 3008. In re
Nathanson, 2010 WL 1850185 (D.N.J. 2010)(the bankruptcy court correctly held that § 502(j)
allows a court to reconsider a claim if equity so demands); In re Kara Homes, Inc., 2010 WL
2546018 (Bankr. D. N.J. 2010)(some “cause” for reconsideration must be articulated before
FRBP 3008 is to be invoked); In re Morningstar, 433 B.R. 714 (Bankr. N.D. Ind. 2010)(although
Rule 60(b) standards are appropriate for determining whether to reconsider a claim, before the
court can consider the equities of the case, it must determine whether there is cause to
reconsider); In re Yelverton, 2010 WL 1487850 (Bankr. D. Dist. Col. 2010)(there are no hard
and fast rules for determining whether cause exists to reconsider a claim, rather the court should
consider the totality of the circumstances to determine whether there is cause).
The standard for determining cause under Rule 60(b)(1) is an “excusable neglect”
analysis. In re Journal Register Company, 2010 WL 5376278 (Bankr. S.D.N.Y. 2010)(excusable
neglect exists in the context of a Rule 60(b) motion, and the factors to be considered are (a)
whether the failure to respond was willful, (b) the existence of a meritorious defense, and (c) the
degree of prejudice that the movant would suffer if the court granted the motion); In re Coxeter,
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2009 WL 4893170 (Bankr. N.D.N.Y 2009)(the excusable neglect standard is slightly different
than that articulated by the Supreme Court in Pioneer).
While there is no time limit within which a motion for reconsideration under §
502(j) must be filed, the timing of the request usually determines the standard employed by the
court. When a motion to reconsider is filed within ten days of the original decision, the “for
cause standard” of FBRP 9023 is employed. When the motion to reconsider, however, is filed
more than ten days after the order is entered, courts generally decide the motion under FRBP
9024, which incorporates Rule 60(b) of the Fed. R. Civ. P. and employs an “excusable neglect”
standard for determining “cause.” In re Mouzon Enterprises, Inc., 610 F.3d 1329 (11 th Cir.
2010)(reversing the bankruptcy court and the district court, the Court held that an order allowing
or disallowing any claim to which an objection has been filed is not “entered with contest,” and
the party seeking relief from the order on the basis of an alleged mistake must file a motion for
relief within one-year period specified in Rule 60, even in cases where the claims objection is
settled before being considered on the merits by a bankruptcy court); In re Universal Service
Administrative Company, 437 B.R. 766 (E.D.N.Y. 2010)(the creditor’s motion for
reconsideration was untimely as it was filed more than a year after the date of the entry of the
order settling the claim because, pursuant to Rule 60(b)(1), the motion is timely if it is made
within a reasonable time, not to exceed one year after entry of the claims order).
Secured creditors in Chapter 13 cases may ask to have their claim reconsidered
under Section 502(j) even after confirmation of the Chapter 13 Plan. In re Coffia, 2010 WL
1872878 (Bankr. S.D. Ga. 2010)(section 502(j) may be used by a secured creditor to determine
its deficiency claim in a chapter 13 case after the collateral is surrendered by the debtor to the
secured creditor); In re Brown, 431 B.R. 309 (Bankr. D. Mass. 2010)(secured creditor allowed to
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amend its claim after the bar date to correct deficiencies in the initial proof of claim). See also In
re Stewart, 2010 WL 3490976 at *9 (a secured creditor’s claim that was filed three and one-half
years late and was allowed as it was not objected to, under § 502(j), may be examined as to the
validity and amount of such claim).
The bankruptcy case must be open for the court to reconsider a claim under §
502(j) and FRBP 3008. In re Kline, 2010 WL 2206404 (Bankr. D.N.M. 2010)(Rule 3008
contemplates reconsideration before the bankruptcy case is closed or after the case is reopened
under 11 U.S.C. § 350(b)).
III. STATUTORY LIMITATIONS ON THE ALLOWANCE OF CLAIMS
A. The Scope of 11 U.S.C. § 502
Section 502(b) requires that the court determine the amount of the claim in lawful
currency in the United States as of the date of the filing of the bankruptcy petition. If the
claimant is asserting a claim based upon foreign currency, the exchange rate in effect on the
petition date will be used to convert the claim to U.S. dollars. If future payments are due as part
of the claim, the court must value present claims and reduce the claims for future payment to the
present value; discounting to the petition date is required. In re US Gen New England, Inc., 429
B.R. 437 (Bankr. D. Md. 2010).
B. Claims Not Enforceable in Bankruptcy
11 U.S.C. §502(b)(1) disallows claims against the debtor that would not be
enforceable against the debtor under an agreement or applicable law at the time of the
bankruptcy petition. In re Jadczak, 2011 WL 13612 (Bankr. E.D. Pa. 2011)(whether an entity
holds a claim against the debtor is generally determined by relevant non-bankruptcy law, usually
state law). In other words, this section disallows claims that would not be enforceable if the
bankruptcy had not been filed. See In re Travers, 2010 WL 5288691 at *2 (debtor’s objection to
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claim is based statute of limitations and an evidentiary hearing is required as to the application of
the statute of limitations); In re Kemp, 440 B.R. 624 (Bankr. D.N.J. 2010)(under New Jersey
law, a bank cannot enforce a note as the holder of a note if it did not have possession of the
note); In re Ricks, 2010 WL 4257598 (Bankr. D. Idaho 2010)(state law analyzed to determine
whether the deficiency portion of the claim of a secured creditor was to be allowed); In re Bath,
___ B.R. ___, 2010 WL 4118109 (Bankr. E.D. Pa. 2010)(whether the creditor has a claim
against the debtor is determined by state law); In re Bateman, 435 B.R. at 611 (under Arkansas
law, the creditor breached the promissory note and deed of trust by miscalculating late charges,
compounding interest and misapplying payments rendering the claim unenforceable in part); In
re Market Center East Retail Property, Inc., 433 B.R. at 354 (section 502(b)(1) is used to
determine the secured creditors claim at the time of the petition regarding late fees, default
interest and related fees and expenses authorized in the loan documents); In re Share Building
Products, Inc., 2010 WL 2402882 at *3 (claim will be disallowed in bankruptcy if unenforceable
under non-bankruptcy law); In re Fenn, 2010 WL 2293419 (Bankr. N.D. Ill 2010)(chapter 13
case discharged the personal liability of the debtors for the junior lien on their home, but there is
no basis under § 502(b)(1) to discharge the in rem claim); In re Dinan, 425 B.R. 583 (Bankr. D.
Nev 2010)(the existence and enforceability of a debt to a creditor in a chapter 7 case is governed
by state law).
C. Claims For Unmatured Interest
11 U.S.C. § 502(b)(2) disallows the payment of unmatured interest (or post-
petition interest) on unsecured claims. In re HSBC Bank USA, National Association, 2010 WL
3835200 (S.D.N.Y. 2010)(indenture trustee’s request for expectation damages is nothing more
than unmatured interest and cannot be allowed under § 502(b)(2)); In re Washington Group
International, Inc., 2010 WL 1257636 (D. Nev. 2010)(the bankruptcy code prohibits claims for
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post-petition interest on unsecured claims); In re Washburn, 432 B.R. 282 (Bankr. D. Kan.
2010)(in an individual’s chapter 11 case, post-petition tax interest is disallowed under §
502(b)(2), but it continues to accrue and is excepted from discharge); In re Robaszkiewica 2010
WL 2901884 at *4 (unsecured creditors are not entitled to unmatured interest on their claims); In
re Gulfport Pilots Association, Inc., 2010 WL 1459723 at *4 (section 502(b)(2) prohibits the
payment of post petition interest to unsecured creditors); In re Reeder, 2010 WL 925849 (Bankr.
D. Dist. Col 2010)(the discharge of a chapter 13 debtor extended to post-petition interest and
penalties as unmatured interest or interest that accrued after the petition date is disallowed under
§ 502(b)(2)). See also Educational Credit Mgmt. v. Kirkland, 600 F.3d 310 (4 th Cir. 2010)(post-
petition interest for a chapter 13 discharged student loan debt is not within the subject matter
jurisdiction of the bankruptcy court).
D. Claims for Services of an Insider or Attorney for the Debtor
11 U.S.C. §502(b)(4) provides that a claim “for services of an insider or attorney
for the debtor” shall be disallowed if the claim “exceeds the reasonable value of such services.”
See In re Boulder Crossroads, LLC, 2010 WL 4924745 (Bankr. W.D. Tex. 2010)(the contract
rate billed by an attorney before the petition date does not determine the value of the claim once
the debtor is in bankruptcy; at that point the claim is disallowed to the extent it exceeds the
reasonable value of those services); In re Siller, 427 B.R. 872 (Bankr. E.D. Cal. 2010)(section
502(b)(4) preempts state law to the extent that state law permits claims on account of prepetition
legal services and debtor’s former attorneys were estopped from arguing that the confirmed
arbitration awarding fees to such attorneys established that the fees were reasonable); In re Delta
Air Lines, Inc., 2010 WL 423279 (Bankr. S.D.N.Y. 2010)(the determination of whether the
claimant is an insider is determined at the time that the contact on which the claim is based was
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executed; termination of breach of a consulting contract pre-petition does not change the analysis
of insider).
E. Lease Rejection Claims
11 U.S.C. § 502(b)(6) 3 limits the claim of a landlord whose lease is rejected by a
debtor during a bankruptcy proceeding. Section 502(b)(6) is designed to compensate a landlord
for the loss suffered by termination of a lease, while not permitting large claims for breaches of
long-term leases, which would prevent other general unsecured creditors from recovering from
the estate.
The Bankruptcy Code clearly provides that a claim for damages based upon the
termination of a real property lease is limited by § 502(b)(6). Section 502(b)(6) is the cap on a
claim after the mitigation of damages by a landlord as required under applicable state law. In re
EDM Corporation, 2009 WL 6338012 (Bankr. D. Neb. 2009)(landlord had a duty to mitigate its
damages and the amount of mitigation is deducted from the total damages before the cap is
3 11 U.S.C. § 502(b)(6) provides, in pertinent part, that:
(b) [T]he court . . . shall allow [a] claim . . ., except to the extent that --
(6) if such claim is the claim of the lessor for damages resulting from the termination of a lease of real
property, such claim exceeds--
(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to
exceed three years, of the remaining term of such lease, following the earlier of --
(i) the date of the filing of the petition; and
(ii) the date on which such lessor repossessed, or the lessee surrendered the leased property; plus
(B) any unpaid rent due under such lease, without acceleration, on the earlier of such dates.
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applied; taxes, insurance and maintenance are included in the “rent reserves” under the
McSheridan test 4 , while utilities are not).
Section 502(b)(6), however, applies only after a claim is filed and to which an
objection is filed. In re Mohr, 436 B.R. 504 (S.D. Ohio 2010)(section 502(b)(6) is not used at
the time that the petition is filed to determine eligibility for a chapter 7 petition; eligibility is
determined by the amounts scheduled by the debtor when no proof of claim has yet been filed);
In re Staddon, 425 B.R. 457 (Bankr. S.D. Ohio 2010)(section 502(b)(6) does not apply to the
threshold inquiry of eligibility of a chapter 7 debtor under 11 U.S.C. § 707(b)).
F. Estimation of Claims
11 U.S.C. § 502(c) 5 allows the bankruptcy court to estimate, for purposes of
allowance, any contingent or unliquidated claim, if the liquidation of such claim would unduly
delay the administration of the bankruptcy case. The Bankruptcy Code is silent as to the
particular kind of procedure that must be employed in estimating a claim; therefore, a bankruptcy
judge may use whatever method is best suited to the particular issues of the case. In re Texans
Cuso Insurance Group, LLC, 426 B.R. 194 (Bankr. N.D. Tex. 2010); In re Perry, 425 B.R. 323
(Bankr. S.D. Tex. 2010).
4 In re McSheridan, 184 B.R. 91 (B.A.P. 9 th Cir. 1995).
5 11 U.S.C. §502(c) provides that:
(c) There shall be estimated for purpose of allowance under this section --
(1) any contingent or unliquidated claim, the fixing or liquidation of which, as the case may be, would
unduly delay the administration of the case; or
(2) any right to payment arising from a right to an equitable remedy for beach of performance.
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G. Claims of Entities From Which Property is Recoverable
11 U.S.C. § 502(d) disallows the claim of any entity from whom property is
recoverable. In re Amelung, 2010 WL 1417742 (Bankr. S.D. Fla. 2010)(once there is a
determination that the transfer is a fraudulent conveyance, the proof of claim of the creditor
receiving the transfer must be disallowed until the funds are repaid to the estate); In re Jackson,
426 B.R. 701 (Bankr. E.D. Mich. 2010)(because the defendants are liable under 11 U.S.C. § 550,
the claims of the defendants are disallowed under §502(d)); In re Valley Petroleum, LLC, 2010
WL 2746989 (Bankr. E.D. Wis. 2010)(claim of the creditor disallowed under § 502(d) because a
judgment under 11 U.S.C. § 547 was entered).
In order for §502(d) to apply, the party must have filed a proof of claim in the
bankruptcy case. In re S.W. Bach & Company, 425 B.R. 78 (Bankr. S.D.N.Y. 2010); In re DHP
Holdings II Corp., 435 B.R. 220 (Bankr. D. Del 2010)(debtor’s request to disallow a claim under
§ 502(d) is premature because the creditor has not yet even filed a proof of claim).
The courts are also unsettled as to whether a judicial order is required to object to
a claim using § 502(d). All of the recently decided cases, however, have held that there must be
judicial order entered for the section to apply. In re DHP Holdings II Corp., 435 B.R. 264
(Bankr. D. Del. 2010)(section 502(d) is not triggered until an order is entered requiring the
turnover of estate property); In re DHP Holdings II Corp., 435 B.R. at 226 (the debtor’s request
to disallow a claim under § 502(d) is premature because the debtors do not yet have a judgment
against the creditor); In re Global Technovations, Inc., 431 B.R. 739 (Bankr. E.D. Mich.
2010)(under § 502(d) the claims of creditors against which a judgment under 11 U.S.C. § 548
has been entered are disallowed until the judgment is paid in full). See also In re Patriot Seeds,
Inc., 2010 WL 381612 (Bankr. C.D. Ill. 2010)(although the creditors received a preference
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payment, its claim would not be immediately disallowed under § 502(d) to allow the creditor
time to pay the judgment).
Some courts allow a debtor to use § 502(d) to disallow administrative claims
under 11 U.S.C. § 503(b)(9). In re Circuit City Stores, Inc., 426 B.R. 560 (Bankr. E.D. Va.
2010).
H. Reimbursement and Contribution Claims
11 U.S.C. § 502(e)(1)(B) requires disallowance of any claim for reimbursement or
contribution of a co-debtor, surety, or guarantor of any obligation of the debtor that is contingent
as of the time of allowance or disallowance of the claim. In order for a claim to be disallowed
under this section, the objecting party must establish that (i) the claim is contingent; (ii) the claim
is for reimbursement or contribution, and (iii) the claimant is co-liable with the debtor with
respect to the claim. In re Wolverine, Proctor & Schwartz, LLC, 436 B.R. 253 (D. Mass.
2010)(the PBGC is not liable with the debtor, therefore, § 502(e)(1)(B) cannot be used to
disallow the claim of the PBGC).
Judge Gerber, sitting in the Southern District of New York, rendered several
recent opinions dealing with the application of § 502(e)(1)(B). See, In re Lyondell Chemical
Company, 442 B.R. 236 (Bankr. S.D.N.Y. 2011)(future environmental costs asserted by third
party potential responsible parties are contingent, even if consent decrees have been entered
relating to the future cleanup costs, so the claims must be disallowed; the contingency
contemplated by § 502(e)(1)(B) relates to both payment and liability, therefore a claimant’s
claim is contingent until its liability is established and the co-debtor has paid the creditor); In re
Chemtura Corporation, 436 B.R. 286, 295-296 (Bankr. S.D.N.Y. 2010)(“Congress clearly meant
to include all situations wherein indemnitors and contributors could be liable with the debtor,
even with respect to tort claims”).
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IV. SUBORDINATION
A. Subordination Agreements
11 U.S.C. § 510(a) provides that a subordination agreement “is enforceable in a
case under this title to the same extent that such agreement is enforceable under applicable
nonbankruptcy law.” In re Bank of New England Corp., 426 B.R. 1 (D. Mass 2010). The party
asserting the rights under the subordination agreement has the burden of proof by the
preponderance of evidence. 11 U.S.C. §1129(a) can, however, override contractual
subordination. In re TCI 2 Holdings, LLC, 428 B.R. 117 (Bankr. D. N.J. 2010). But see In re
Lehman Brothers Holdings Inc., 422 B.R. 407 (Bankr. S.D.N.Y. 2010)(the shift in payment
priority upon the commencement of a bankruptcy case renders unenforceable that aspect of the
subordination agreement).
B. Sale of Stock
11 U.S.C. § 510(b) subordinates claims arising from the purchase or sale of stock 6
to the claims of general unsecured creditors. Therefore, the claims of a security holder based
upon alleged fraud, rescission, or other tort in the sale of the security cannot and will not be
elevated to the status of general unsecured claims. In re Northfield Laboratories Inc., ___
B.R.___, 2010 WL 3417229 (Bankr. D. Del 2010)(claims that arise out of the purchase of the
debtor’s common stock are assigned the same priority as the stock); In re Marchfirst, Inc., 431
B.R. at 442 (fraud claims asserted for inducement to purchase debtors stock is within the
6 11 U.S.C. § 510(b) provides that:
For purposes of distribution under this title, a claim arising from rescission of a purchase or sale of a
security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a
security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be
subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security,
except that if such security is common stock, such claim has the same priority as common stock.
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purview of § 510(b)). But see In re Swift Instruments, Inc., 2010 WL 5156118 (Bankr. N.D.
Cal. 2010)(section 510(b) does not apply to promissory notes generated by a stock sale); In re
Semcrude, L.P., 436 B.R. 317 (Bankr. D. Del. 2010)(section 510(b) does not apply to a stock
purchase that does not relate to the debtor of an affiliate of the debtor).
Section 510((b) does not strip creditors of their rights to file proofs of claim or
automatically convert the claims to equity interests. In re Bayou Group, LLC, 439 B.R. 284
(S.D.N.Y. 2010).
C. Equitable Subordination
11 U.S.C. § 510(c) allows claims to be subordinated under certain other
circumstances. 7 It does not, however, allow the subordination of claims to equity interests. In re
Champion Enterprises, Inc., 2010 WL 3522132 (Bankr. D. Del. 2010).
Equitable subordination is remedial rather than penal; therefore, a claim should be
equitably subordinated only to the extent necessary to offset the harm suffered by the debtor and
its creditor as a result of the inequitable conduct. In re Montagne, 2010 WL 271347 (Bankr. D.
Vt. 2010); In re Sunshine Three Real Estate Corporation, 426 B.R. 6 (Bankr. D. Mass.
2010)(since there are no creditors in the case to which subordination would have any relevance,
the motion to dismiss the complaint was granted); In re Elrod Holdings Corp., 421 B.R. 700
(Bankr. D. Del 2010). It may be used to subordinate payment, but not to disallow claims. In re
7 11 U.S.C. §510(c) provides that:
(c) Notwithstanding subsections (a) and (b) of this section, after notice and hearing the court may --
(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an
allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another
allowed interest; or
(2) order that any lien securing such a subordinated claim be transferred to the estate.
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, 2010 WL 4286344 (Bankr. M.D. Fla. 2010). Most courts hold that equitable
subordination cannot be used unless there is an allowed claim. In re Tronox Incorporated, 429
B.R. 73 (Bankr. S.D.N.Y 2010).
An equitable subordination claim or cause of action is within the core jurisdiction
of the bankruptcy court, and must be asserted through an adversary proceeding. In re Keenan,
2010 WL 780098 (Bankr. D. N.M. 2010). Some courts have held that a court may raise
equitable subordination sua sponte. See In re Lockwood Auto Group, Inc., 428 B.R. 629 (Bankr
W.D. Pa. 2010).
The seminal case on equitable subordination is Benjamin v. Diamond (In re
Mobile Steel Co.), 563 F.2d 692, 699-700 (5th Cir. 1977), wherein the United States Court of
Appeals for the Fifth Circuit established three requirements for the application of the doctrine of
equitable subordination:
1. the claimant must have engaged in some type of inequitable conduct;
2. the misconduct must have resulted in injury to the creditors of the debtor
or conferred an unfair advantage on the claimant; and
3. equitable subordination of the claim must not be inconsistent with the
provisions of the Bankruptcy Code.
When reviewing the first prong of the Mobile Steel test, courts frequently look to
the following three non-exclusive categories of inequitable conduct, enunciated in Wilson v.
Huffman (In re Missionary Baptist Foundation, Inc.), 712 F.2d 206 (5th Cir. 1983), rev’d on
other grounds, 818 F.3d 1135 (8th Cir. 1997):
1. fraud, illegality, or breach of fiduciary duty;
2. undercapitalization; or
3. claimant’s use of the debtor as an instrumentality or alter ego.
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In examining a claim for equitable subordination, and in evaluating the first
requirement articulated in Mobile Steel, (whether the claimant engaged in some sort of
inequitable conduct), special scrutiny is given to the conduct of insiders, and the allocation of the
burden of proof is adjusted accordingly. In re Alma Energy, LLC, 2010 WL 4736905 (E.D. Ky.
2010)(case remanded to the bankruptcy court because the bankruptcy court order failed to reflect
the rigorous scrutiny to the claims against insiders); In re Sunbelt Grain WKS, LLC, 427 B.R.
896 (D. Kan. 2010)(the level of scrutiny employed in determining whether the defendant has
engaged in conduct sufficient to subordinate its claim is based upon whether the defendant is an
insider or fiduciary of the debtor); In re Rich Capital, LLC, 436 B.R. 224, 232 (Bankr. S.D. Fla.
2010)(where the claimant is an insider or fiduciary, the evidence must show unfair conduct); In
re Hydrogen, L.L.C., 431 B.R. 337, 2010 WL 1609536 (Bankr. S.D.N.Y. 2010)(the scrutiny for
presence of inequitable conduct is more stringent with respect to creditors who are insiders of the
debtor); In re Elrod Holdings Corp., 421 B.R. at 720; In re Lockwood Group, Inc., 428 B.R.
629, 2010 WL 1931986 (Bankr. W.D. Pa. 2010)(if the creditor is not an insider, the evidence
must show more egregious conduct such as fraud, spoliation or overreaching).
There are several factors to be examined to determine whether the creditor is an
“insider” and subject to a higher scrutiny. In re Broadstripe, LLC, ___ B.R. ___, 2010 WL
3768003 (Bankr. D. Del. 2010)(courts have looked at various factors in determining a creditor’s
insider status, including whether the creditor (i) attempted to influence decisions made by the
debtor, (ii) selected new management of the debtor, (iii) had special access to the debtor’s
premises and personnel, (iv) was the debtor’s sole source of financial support, (v) generally acted
as a joint venture or prospective partner with the debtor rather than an arm’s-length creditors, (vi)
control over the debtor’s voting stock, (vii) managerial control, and (viii) whether the
-30-

elationship between the debtors and the creditor was the result of an arm’s-length transaction);
In re Champion Enterprises, Inc., 2010 WL 3522132 at *7 (to determine whether a creditor is an
insider, it must be determined whether there is a close relationship between the debtor and the
creditor and anything else to suggest that any transaction was not conducted at arm’s length).
Most courts have held that all three requirements of the Mobile Steel test must be
present, in order for equitable subordination to be appropriate. See In re Airadigm
Communications, Inc., 616 F. 3d 642 (7 th Cir. 2010)(section 510(c) focuses on the behavior of a
creditor, knocking down the status of the claim where a creditor engaged in inequitable conduct);
In re Shields, 2010 WL 4813585 (E.D. Cal. 2010)(upheld the bankruptcy court’s decision that
equitable subordination is appropriate when a creditor’s conduct had a negative effect on
creditors because those creditors would have been paid had the sale been consummated); In re
Grede, 441 B.R. 864 (N.D. Ill. 2010)(while the bank at which the futures commission merchant
maintained both segregated and non-segregated may have exhibited a lack of diligence in failing
to verify which property had been pledged as security for the loans the bank’s conduct did not
rise to the level of “egregious misconduct” of the kind required to equitably subordinate its
claim); In re Vargas Realty Enterprises, Inc., 440 B.R. 224 (S.D.N.Y. 2010)(because an ordinary
mortgagee does not owe a fiduciary duty to the debtor, it is rare for a court to subordinate claims
arising out of arms-length transactions); Dottore v. National Staffing Service, LLC, 2010 WL
2106223 (N.D. Ohio 2010)(when there are genuine issues of fact as to whether a creditor
engaged in inequitable conduct and whether such action caused harm to the debtor’s estate or the
creditors, the matter must be determined after a trial); In re Sunbelt Grain WKS, LLC, 427 B.R.
at 909 (the alleged conduct in which the creditor engaged was a sharp business practice and that
is not a sufficient basis for equitably subordinating a claim made against a party that is neither an
-31-

insider or a fiduciary); In re Rich Capitol, LLC, 436 B.R. at 233 (a financial institution conduct,
after being named in a lawsuit by the debtor, in refusing to convert a construction loan, in
accelerating obligations owed by the debtor based upon an alleged default, in freezing the
debtor’s bank accounts, and in seeking to foreclose its interests did not provide the basis for
equitable subordination because there is no allegation that the financial institution exercised
dominion or control over the management of the debtor such that it became a fiduciary of the
debtor); In re Champion Enterprises, Inc., 2010 WL 3522132 at *10 (equitable subordination
must be based on the claimant’s own acts); In re Yablonsky, 2010 WL 3219529 (Bankr. D. N.J.
2010)(bidders failure to close the sale does not result in equitable subordination of its claim); In
re M&S Grading, Inc., 2010 WL 2860096 (Bankr. D. Neb. 2010)(the failure of the IRS to collect
taxes pursuant to an agreement with the debtor did not give rise to equitable subordination as the
pension plans were not a third-party beneficiary to the agreement and there was no duty on the
part of the IRS); In re American Consolidated Transportation Companies, Inc., 433 B.R. 242
(Bankr. N.D. Ill. 2010)(actions by a bank to enforce its rights under the loan documents did not
constitute inequitable conduct, even where the bank insisted on the debtor retaining a chief
restructuring officer).
#13970264 v2
-32-

__________________________________________
UPDATES ON SELECTED ISSUES
REGARDING BANKRUPTCIES OF
INDIVIDUALS
(INCLUDING EXEMPTIONS LAW)
__________________________________________
Current Developments Task Force
of the Business Bankruptcy Committee of the ABA Section of Business Law 1
Spring 2011 Meeting
(in conjunction with meeting of the ABA Section of Business Law)
Boston, Massachusetts Christopher Combest
April 15, 2011 Quarles & Brady LLP
300 N. LaSalle Street, Suite 4000
Chicago, Illinois 60654
(312) 715-5091 (direct phone)
(312) 632-1727 (direct FAX)
Christopher.Combest@quarles.com
© 2011 Christopher Combest. All rights reserved.
1 If you would like additional copies of these or the author's previous materials, you may obtain them
by contacting the author by phone at (312) 715-5091, by fax at (312) 632-1727, or by e-mail at
.

I. May a State Constitutionally Legislate a Set of Exemptions That Applies Only to
Debtors in Bankruptcy?
A. Background:
1. The Code 2 permits debtors to elect to exempt from property of their estates
(and, therefore, from distribution to their creditors) either (1) property
provided for by the Code itself (Code §522(d)) or (2) property provided
for by the applicable state's exemption law. However, the Code also
allows each state to "opt out" of the Code's exemption scheme: a state may
require debtors to whom the state's exemptions apply to claim only those
state-law exemptions, thereby eliminating any right to elect the federal
exemptions.
2. Mich. Comp. Laws §600.5451 creates a set of exemptions for use
exclusively by debtors in bankruptcy, separate from the set of exemptions
otherwise available to other judgment debtors in Michigan.
3. California (Cal. Civ. Proc. Code §703.140) and West Virginia (W. Va.
Code §38-10-4) have similar sets of exemptions applicable only to debtors
in bankruptcy.
B. Issue: May a state constitutionally create a set of exemptions for use solely by
debtors in cases under the Code, that is, that are not generally applicable to parties
both within and outside of bankruptcy?
Current Answer: Still developing, but we've got a circuit-split a-brewing. The
only current federal circuit court decision on the issue of which the author is
aware is from the Fourth Circuit, finding West Virginia debtor-only exemption
laws constitutional; however, the Eighth Circuit Bankruptcy Appellate Panel
recently found the Michigan debtor-only exemption law unconstitutional in:
a. In re Schafer (consolidated with In re Jones), –– B.R. ––, Case
Nos. 10-8030 and 10-8031, 2011 WL 650545 (B.A.P. 6th Cir.
Feb. 24, 2011)
FACTS:
(1) Michigan permits its debtor-residents to choose between
federal Bankruptcy Code exemptions (Code §522(d)) and
Michigan state exemptions, but provides two sets of state
law exemptions, one of which may be selected only by
debtors under the Code, and not by other judgment debtors
in Michigan.
2 The United States Bankruptcy Code, 11 U.S.C. §§101-1532, as amended.

(2) The bankruptcy-only exemptions are much more generous
than the Michigan state exemptions available to nonbankruptcy-debtors
and are somewhat more generous than
the federal exemptions.
(3) The Bankruptcy Clause: Article I, Section 8, Clause 4 of
the United States Constitution empowers Congress to
"establish . . . uniform Laws on the subject of Bankruptcies
throughout the United States."
HOLDING: Michigan's bankruptcy-debtor-only exemption statutes are
unconstitutional.
(1) Violation of Bankruptcy Clause – Uniformity Principle:
The BAP discussed the intent and purpose of the
Bankruptcy Clause, including: (a) a review of the historical
treatment of debtors and insolvents by the various states;
(b) a discussion of the Federalist Papers on the topic of
bankruptcies; (c) observations regarding the push-and-pull
between the states and the federal government as uniform
federal bankruptcy laws were passed, repealed, replaced,
and repealed again over 178 years, and, (d) the reasons for,
and meaning of, the opt-out provisions of the current Code.
Intent of Bankruptcy Clause: The BAP concluded
that the Bankruptcy Clause is intended to grant exclusive
jurisdiction to Congress to enact uniform bankruptcy laws
and that the purpose of the clause was to eliminate the
conflicts among the patchwork of state insolvency laws that
had arisen in the absence of a uniform national bankruptcy
law; in the words of the BAP (at *9):
It was hoped that a uniform system would resolve
the chaos caused by state-to-state variations in
bankruptcy laws and to prevent states from enacting
laws that apply only to debtors in bankruptcy. The
Bankruptcy Clause exists to restrict the power of
the states to legislate in the area of bankruptcy.
"Plan of the Convention": The BAP held that the
states, in adopting the Constitution, had consented to cede
their authority to legislate in the area of bankruptcy – at
least, so long as a national bankruptcy law was in effect –
and, just as that consent abrogated the states' sovereign
immunity to suit under various Code provisions (see Code
§106(a)), it has also restricted their power to legislate for
themselves in the area of bankruptcy.
2

What about the Opt-Out Provisions of the Code's
Exemption Scheme – Doesn't That Allow State Legislation
in Bankruptcy Matters?: The BAP answered "yes, but…"
– states have only as much "concurrent jurisdiction" as
Congress permitted under the Code; that jurisdiction
extends to permitting states to preclude their residents from
using the federal exemptions under Code §522(d), but does
not allow states to affirmatively enact bankruptcy-debtoronly
exemptions that are not generally available to other
residents of the state – that is, "[a]lthough Congress allows
states to choose whether or not to opt-out of the federal
exemptions, it does not follow that states may enact their
own bankruptcy laws" (at *12).
Geographical Uniformity: The reason for the
distinction described above is that the United States
Supreme Court has held that the "uniformity" required by
the Bankruptcy Clause is geographical, not personal,
uniformity. The opt-out provisions mean that the Code will
not affect each individual debtor in the country the same as
each other individual debtor, but that is not required – what
is required is that, "within a state, bankruptcy and nonbankruptcy
(judgment) debtors and judgment creditors be
treated the same" (at *14).
Michigan's laws violate the requirement of
geographical uniformity, because Michigan provided better
rights to a state-law judgment creditor – who, for example,
may attach a judgment debtor's homestead property to the
extent the value of that interest exceeds $3,500 – than to a
bankruptcy trustee – the analogous bankruptcy-debtor-only
Michigan homestead exemption is $34,500.
(2) What about the Supremacy Clause?: The BAP did not
deem it necessary to determine if the Michigan statutes
violate the Supremacy Clause of the U.S. Constitution.
But, here's the looming circuit split –
b. Sheehan v. Peveich, 574 F.3d 248 (4th Cir. 2009) – West Virginia
bankruptcy-debtor-only exemption law is constitutional. (Collects
cases for and against constitutionality of such state statutes at
footnote 2) Currently the only circuit-level decision on such
bankruptcy-debtor-only exemption laws.
3

If Schafer (above) is appealed to, and affirmed by, the 8th
Circuit, there will be a split between the 4th and 8th Circuits
on this issue.
c. In re Sassak, 426 B.R. 680 (E.D. Mich. 2010) – Michigan statute
constitutional (but finding it so, by finding that state legislature had
not intended to bar bankruptcy debtors from using the general
exemptions; therefore, law was not an attempt to write different
federal exemptions, but only to give more alternatives to debtors)
(inconsistent with Schafer)
d. In re Jones, 428 B.R. 720 (Bankr. W.D. Mich. 2010) – Michigan
statute constitutional – overruled by In re Schafer (see above).
e. In re Pontius, 421 B.R. 814 (Bankr. W.D. Mich. 2009) – Michigan
statute unconstitutional (consistent with Schafer)
f. In re Wallace, 347 B.R. 626 (Bankr. W.D. Mich. 2006) – Michigan
statute unconstitutional (consistent with Schafer)
g. In re Applebaum, 422 B.R. 684 (B.A.P. 9th Cir. 2009) – California
statute constitutional. (See Regevig, below.)
h. In re Regevig, 389 B.R. 736 (Bankr. D. Ariz. 2008) – Arizona
bankruptcy court (Haines, J.) finding unconstitutional the same
California statute that the Ninth Circuit BAP found constitutional
in Applebaum.
II. Revisiting the Reality-Based Community: Ransom v. FIA Card Services, N.A., 562
U.S. ––, 131 S. Ct. 716 (2011)
"The epic battle between the use of the 'mechanical approach' versus the
'forward-looking approach' for determining projected disposable income has
been waged in what seems an infinite number of bankruptcy and appellate courts
for at least four years now, no doubt generating much weeping, and wailing, and
gnashing of teeth."
– In re Liehr, 439 B.R. 179, 183 n.22
(B.A.P. 10th Cir. 2010) (opinion written by
Bankruptcy Judge Terrence L. Michael of the
Northern District of Oklahoma)
A. Background:
1. Chapter 13 allows individuals with regular income and whose debts do not
exceed certain maximums to propose a plan for the repayment of creditors
over time, in exchange for which the debtor is permitted to retain property
he or she might otherwise have forfeited under chapter 7.
4

2. If the standing chapter 13 trustee or an unsecured creditor objects to a
chapter 13 debtor's proposed plan, the court may approve the plan anyway,
if the debtor has committed all of his or her "projected disposable income"
to the plan for 3-5 years from the date payments are to commence (the
time period varies depending upon how the annual income of the debtor,
calculated under the relevant Code provisions, compares with the median
income in the debtor's state for households of the debtor's household's
size).
3. The term "projected disposable income" is not defined in the Code, but the
term "disposable income" is defined formulaically, as a result of changes
to chapters 7 and 13 made by the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005 ("BAPCPA"):
a. The calculation starts with the debtor's "current monthly income"
– as defined in Code §101(10A), that term refers to the debtor's
average monthly income from all sources for the six months before
the debtor's bankruptcy filing – the debtor submits this information
on Official Form 22C.
b. "Disposable income" (Code §1325(b)(2)) is calculated based on
current monthly income, less certain permitted expenses.
c. If the chapter 13 debtor's current monthly income, multiplied by 12
(basically, her annual income), exceeds the median family income
for the state where the case is filed (as calculated and published by
the Bureau of the Census), then, the debtor must calculate her
permitted expenses as required by Code §707(b)(2)(A) and (B).
(1) Often referred to as the "means test", Code §707(b)(2)(A)
and (B) is also used to determine whether a debtor is
eligible to file for relief under chapter 7; it (arguably)
creates some bright-line rules for determining a debtor's
income available to pay creditors, after expenses.
(2) Expenses that may be deducted from "current monthly
income" to arrive at "disposable income" are determined, in
part, by reference to schedules created by the Internal
Revenue Service ("IRS") for use in evaluating requests by
taxpayers for negotiated payment of delinquent taxes.
(a) These schedules are referred to in the Ransom
opinion as the "Standards" – they comprise the
National Standards (covering six categories of
expense, including food and clothing); the Local
Standards (covering housing and utilities expenses,
5

and transportation expenses), and the Other
Necessary Expenses.
(b) The IRS also issues the "Collection Financial
Standards", which describe how to use the National
and Local Standards tables and what the amounts
and categories set forth in those Standards mean.
NOTE that the Code did not enact, nor does the
Code refer to, the Collection Financial
Standards.
B. Some Context – Shading the Bright-Line Rules: The U.S. Supreme Court's earlier
decision in Hamilton v. Lanning, 560 U.S. ––, 130 S. Ct. 2464 (2010):
1. At issue in Hamilton v. Lanning was how to calculate the "projected
disposable income" of the debtor – Lanning – and what facts, if any,
courts have discretion to consider to vary the operation of the Code's
formulaic provisions for calculating a chapter 13 debtor's "disposable
income":
2. As noted above, the calculation starts with the debtor's "current monthly
income" – i.e., her average monthly income from all sources for the six
months before the debtor's bankruptcy filing.
3. Lanning had received a buy-out from her employer during the six months
before her bankruptcy filing, and so, she contended, her income, as shown
on Form 22C, was artificially inflated for that period.
a. The debtor argued that the bankruptcy court should recognize the
actual fact that her real income going forward is not accurately
predicted by her inflated prior-six-months income and should use
that "forward-looking approach" in calculating her projected
disposable income; Lanning argued that she should be required to
commit just $144 per month to her plan payments.
b. Hamilton, the standing Chapter 13 trustee, argued that the
bankruptcy court had no discretion to abandon the "mechanical
approach" required by the Code. Under that approach, Lanning's
Form 22C calculations must be honored, notwithstanding the onetime
infusion of cash from the buy-out. The trustee argued that
Lanning should have to commit $756 per month to her plan
payments – over five times what Lanning said she could pay.
4. The Supreme Court held for the debtor, finding that, in calculating a
debtor's projected disposable income in Chapter 13, a bankruptcy court
may take account of changes in the debtor's income or expenses that
are known or are virtually certain to occur; in this instance, it was
certain that Lanning's one-time buy-out windfall would not recur.
6

Two moves – one unremarkable; one questionable – are critical to the
Court's analysis in Hamilton, and they recur in Ransom:
a. First, the Court observed – as it has many times – that words that
are not given a defined meaning in the Code should be given their
ordinary meanings as commonly used (often, this means taking
refuge in an unabridged dictionary). The word at issue in
Hamilton was "projected" – the Court found that, in ordinary
usage, a "projection" takes into account historical facts but allows
for adjustment for anticipated events that may change past trends.
b. Second, the Court held that BAPCPA, which established the means
test and provided for its application in chapters 7 and 13, did not
eliminate the traditional discretion of the court to project
disposable income based on known or virtually certain changes.
This seems a more questionable assertion, given that one of the
themes that emerges from the BAPCPA amendment as a group is
the attempt to restrain or eliminate the discretion of individual
bankruptcy judges in various ways, particularly in connection with
the cases of individual debtors.
C. The Facts and Arguments of Ransom:
1. John Ransom was a Nevada chapter 13 debtor with:
a. above-median income for his state and family size; and
b. a car that he owned free and clear of any debt.
2. As an above-median-income debtor, his disposable income – the amount
available to pay his creditors under his chapter 13 plan – was calculated as
"current monthly income", less the expenses allowed under the means test
of Code §707(b)(2).
a. The critical statutory language: From the means-test provisions
of Code §707(b)(2)(A): a "debtor's monthly expenses shall be the
debtor's applicable monthly expense amounts specified under the
[Standards]". (Emphasis, of course, added.)
b. The Local Standards permit the deduction of two separate vehiclerelated
expenses from "current monthly income" for the purpose of
calculating "disposable income": for Ransom, these monthly
amounts were "Ownership Costs" of $471 and "Vehicle Operating
Costs" of $338.
7

c. Ransom deducted both such expenses, because they were set out in
the Local Standards chart "applicable" to him as a resident of
Nevada with a single car.
3. At issue was Ransom's deduction of the vehicle "Ownership Costs" (no
one disputed his taking of the "Operating Costs" deduction):
a. Without that expense, Ransom would pay his creditors over the
five-year term of his chapter 13 plan $28,000 more than he would
if he could take the "Ownership Cost" deduction to reduce his
disposable income.
b. The question, then, was whether the vehicle Ownership Cost
deduction was "applicable" to Ransom.
D. HOLDING OF SUPREME COURT: Against Debtor (affirming all lower
courts): a chapter 13 debtor who incurs no present expense in a particular
category under the Standards may not deduct the amount for that expense set
forth in the Standards.
The steps of the argument are:
1. Because the word "applicable" is not defined in the Code, it must be given
its ordinary, common meaning.
2. The dictionary definition of applicable is "appropriate, relevant, suitable,
or fit".
3. Using that definition, an expense is applicable if it corresponds to an
individual debtor's financial circumstances. A debtor may claim a
deduction under the Standards if it is appropriate to him, and such an
expense deduction is appropriate to a debtor only if the debtor incurs
expenses in that category.
4. So, did Ransom incur expenses in the category of vehicle "Ownership
Costs"?
a. The Court surmised that "Ownership Costs must refer to something
other than "Operating Costs" (gas, insurance, etc.)
b. Absent guidance from the Code, the Court deemed it proper and
permissible to refer to the IRS "Collection Financial Standards" for
an explanation:
(1) The Court takes pains to emphasize (as the dissent also
points out) that Congress did not, and the Court does not
intend to, incorporate or import into the Code the IRS
Collection Financial Standards.
8

(2) However, since the IRS created the Collection Financial
Standards specifically to elaborate and explain the National
and Local Standards, revises all of the Standards regularly,
and uses them daily, its views – like those of any agency
interpreting its own rules and regulations – have some
persuasive power, especially when they do not conflict with
any Code provisions (as the majority found they did not).
c. The Collection Financial Standards limit "Ownership Costs" to the
costs associated with leasing or financing a vehicle, and
specifically provide that "Ownership Costs will be $0" for a
taxpayer who has "no lease or car loan payment".
d. Debtor Ransom had no such obligations, and, therefore, was not
entitled to the "Ownership Costs" expense deduction from "current
monthly income," for the purpose of determining his "projected
disposable income".
E. Dissent: As in Hamilton v. Lanning, Justice Scalia was the sole dissenting justice
in Ransom, in the dissent's view:
1. The Court should apply the Code's means-test scheme mechanically.
2. Congress should be deemed to have known that application of a brightline
mechanical test will result in the "occasional peculiarity" and to have
been willing to accept those occasional odd results, in exchange for
certainty in the application of the formulaic test.
3. The word "applicable" simply points the debtor to the correct schedule of
deductions to use under the Standards – for example, Ransom had one car,
so he picked the expense deduction applicable to debtors in his
geographical region who have one car, because the expense deduction
allowed listed for debtors with two cars would not have been applicable to
him.
4. Underlying Justice Scalia's dissent in both Hamilton and Ransom seems to
be a fundamental disagreement on the overriding purpose of the BAPCPA
amendments, and, especially, the means test:
a. The Court's majorities see BAPCPA as a device intended to better
align the privilege of bankruptcy relief with a debtor's actual
ability to pay creditors; in Hamilton, the mechanical application of
the BAPCPA amendments would have resulted in, effectively,
denying a debtor chapter 13 relief, because the mechanical tests
would have required Lanning to pay her creditors far more than
she actually could; in Ransom, the mechanical or formulaic
approach would have denied to creditors payments that the debtor
was well able to make.
9

Underlying the Court's view, however, is the notion that BAPCPA
was not intended to withdraw a court's discretionary power to
make adjustments to the formulaic results, when such adjustments
are necessary to carry out what the majorities see as BAPCPA's
purpose.
b. Justice Scalia may or may not agree that BAPCPA was intended to
extract more money from debtors than the system required before
BAPCPA. But, in any event, Scalia would leave the mechanics
erected by BAPCPA to do their work as they may, whether well or
poorly – if they are unsuccessful in too many cases, it is up to
Congress to fix the mechanics.
Justice Scalia appears to view the most important aspect of
BAPCPA to be exactly the opposite of the assumption underlying
the opinions of the Court: that BAPCPA is intended to eliminate
court discretion in matters addressed by the provisions at issue in
Hamilton and Ransom.
F. Author's Comments: As did Hamilton v. Lanning, the Ransom opinion
addresses a real confusion on how to perform the "projected disposable income"
calculation. But, problems appear to persist:
a. How broad is a court's power to "project"?: The debtor in Ransom
had no current expense for "ownership cost" (as the Court viewed
the scope of that term) for a vehicle, and, so, was denied the
deduction from his current monthly income.
However, the Court in Hamilton stressed that the term "projected"
is intended to permit courts to take into account the possibility of
changes in a debtor's financial situation from what it was
prepetition. What about a chapter 13 debtor who has no vehicle at
the petition date, but asserts that she plans to obtain a car loan and
buy a vehicle postpetition? Is that debtor – in theory, at least –
entitled to an expense deduction for "ownership costs", because the
projection of her disposable income needs to include that
anticipated change? If so, what's the standard of proof for "virtual
certainty"?
b. The Court raised – but refused to decide – whether a debtor who
has expenses in a particular category covered by the Standards, but
whose actual such expenses are less than the amount specified in
the Standards, should be allowed to take the whole amount listed in
the Standards. The United States, as amicus in Ransom, indicated
in its briefs that such a debtor should be able to take the full
expense deduction, so long as he or she incurs some expense
relating to the deduction category in the Standards.
10

2. The same argument over "flexible" or "actual" calculations vs.
"mechanical" approaches arises in calculating a debtor's current monthly
income under Code §707(b)(2)(A), for the purposes of determining if the
debtor qualifies for chapter 7 relief. As of this writing (March 2011), the
author has found no cases applying Ransom and Hamilton to that issue,
but interested practitioners should watch for them.
III. Re-revisiting the BAPCPA Homestead Exemption Cap and Entireties Property: Is a
Homestead Acquired Within 1,215 Days Prepetition, But Held in Tenancy by the
Entireties, Subject to the Exemption Cap of Code §522(p)(1)?
A. Background:
1. Limitations on Homestead Exemptions
a. The Code permits debtors to elect to exempt from property of their
estates (and, therefore, from distribution to their creditors) either
(1) property provided for by the Code itself (Code §522(d)) or (2)
property provided for by the applicable state's exemption law.
However, the Code also allows each state to "opt out" of the
Code's exemption scheme: a state may require debtors to whom the
state's exemptions apply to claim only those state-law exemptions,
thereby eliminating any right to elect the federal exemptions.
b. The Bankruptcy Abuse Prevention and Consumer Protection Act
of 2005 ("BAPCPA") added Code §522(p)(1), which limits the
dollar amount of the homestead exemption that a debtor may
claim under state law, by disallowing any amount above
$146,450, 3 if that amount was added to the homestead (in the
statutory language, if it was an "interest acquired") within 1,215
days (about 3 years, 4 months) prepetition, unless the amount was
transferred from a homestead in the same state or the debtor is a
"family farmer" (as defined by Code §101(18)).
c. BAPCPA also enacted a separate homestead limitation in Code
§522(o), which requires that the value of the debtor's permissible
homestead exemption be reduced – even below the $146,450 cap,
if the cap applies – by the value of any property (a) that would not
have been exempt under Code §522(b) had the debtor owned it on
the petition date and (b) that the debtor transferred, during the 10
years before the petition date, with the intent to hinder, delay, or
defraud a creditor.
3 For cases commenced before April 1, 2007, but on or after the effective date of BAPCPA (October 17, 2005), that
amount was $125,000; for cases commenced on or after April 1, 2007, but before April 1, 2010, that amount was
$136,875.
11

d. But, Code §§522(p) and 522(o) both begin with the phrase "[f]or
purposes of [Code §522] (b)(3)(A) (emphasis added), and . . .
e. . . . entireties property is exempt under Code §522(b)(3)(B), to the
extent it would be exempt from process under applicable nonbankruptcy
law.
2. Domicile Requirements for Use of a Particular State's Exemptions
a. Before BAPCPA, a debtor's state-law exemptions were based on
the law that was applicable on the date of the filing of the
bankruptcy petition in the state where the debtor had been
domiciled for 180 days before the date of the filing of the petition,
or for the greater part of that 180-day period than in any other
state.
b. Today, under BAPCPA, a debtor's exemptions are based on the
state law applicable on the petition date in the place where the
debtor has been domiciled (a) for 730 days (2 years) prior to the
date of the filing of the petition; or, (b), if, as of the petition date,
the debtor's domicile has not been located in a single state for 730
days, then, for (I) the 180 days immediately preceding that 730day
period, or (II) for the greater part of that 180-day period
than in any other state.
3. Lien Avoidance: Code §522(f) permits a debtor to avoid (i.e., invalidate
or nullify) a secured creditor’s lien on property that is exempt under Code
§522(b) (to the extent of a dollar amount arrived at through an arithmetic
calculation set forth in Code §522(f)(2)).
B. Issues: If the homestead property is entireties property:
1. Is the state-law exemption for such property limited by either (a) Code
§522(p)(1), regarding property acquired 1,215 days before the
commencement of the bankruptcy case or (b) Code §522(o), regarding
actually fraudulent transfers of otherwise non-exempt assets into
homestead property?
2. Must the debtor have been domiciled in the state upon whose entireties
exemption law the debtor is relying for 730 days before the petition date?
Continuing Answer: No as to all of items 1(a), 1(b), and 2 – but, with a wrinkle
as to item 2 (See paragraph i, below).
The cases below hold that the "plain language" – and policy – of the
BAPCPA amendments support either (or both) of the holdings that an entireties
homestead is not subject to either (i) the $146,450 cap or (ii) the fraudulent
12

transfer limitation (the cases in boldface type below have been added for these
Spring 2011 materials).
a. In re Aranda, Case No. 08-26059, 2010 WL 5018320 (Bankr.
S.D. Fla. Dec. 3, 2010) – same holding as Davis (see below) –
cites Davis, Hinton, and Buonopane (all mentioned below) (Issues
1(a) and 1(b))
b. In re Allan, 431 B.R. 580 (Bankr. M.D. Pa. 2010) – Because
Pennsylvania state law (which Debtor elected to use) provides for
an exemption for entireties property as to claims solely against one
spouse, Code §522(b)(3)(B) exempts the whole interest of the
debtor-spouse, and, the bank’s lien on the debtor’s interest may be
completely avoided as impairing the debtor’s exemption under
Code §522(f)(1). (The entireties exemption itself under Code
§522(b)(3)(B) was not disputed; the dispute in Allan focused on (i)
whether the property could be reached on account of a debt owed
solely by the debtor-spouse and (ii) lien avoidance.)
c. In re Champalanne, 425 B.R. 707 (Bankr. S.D. Fla. 2010) –
neither Code §522(p) nor §522(o) affects property exempted under
the tenancy-by-the-entireties exemption of Code §522(b)(3)(B).
(Issues 1(a) and (b)) (Trustee did not argue applicability of Code
§§522(p) and 522(o), so this is statement is, arguably, dicta.)
d. In re Davis, 403 B.R. 914 (Bankr. M.D. Fla. 2009) – adopts
holding of Hinton (below) re inapplicability of Code §522(o) to
property held in a tenancy by the entireties. (Issue 1(b))
Moreover, a Florida state court had previously found that funds
used to buy the exempt homestead had been withdrawn from a
bank account held in a tenancy-by-the-entireties, a bank account
into which the funds had been fraudulently transferred;
nonetheless, the exemption stood. The court held that Florida
fraudulent transfer law provides an election of remedies –
avoidance and pursuit of the asset itself, or a money judgment for
the asset's value or the creditor's claim (whichever is less) – and
the plaintiff in state court had received a money judgment rather
than avoidance of the transfer. The transfer into the homestead
was unavoidable under the Florida state constitutional homestead
exemption. Absent avoidance of one of those transfers, the
transfer of assets into the homestead had to stand.
e. In re Buonopane, 359 B.R. 346 (Bankr. M.D. Fla. 2007) – policy
of Code §522(p)(1) is to close the "mansion loophole", not to alter
or attack Florida common law on tenancy by the entireties. (Issue
1(a))
13

f. In re Schwarz, 362 B.R. 532 (Bankr. S.D. Fla. 2007) – same
holding. (Issue 1(a))
g. In re Hinton, 378 B.R. 371 (Bankr. M.D. Fla. 2007) – same
holding as to Code §522(o). (Issue 1(b))
h. In re Zolnierowicz, 380 B.R. 84 (M.D. Fla. 2007) – in dicta, the
court indicated that it agreed with the cases above (and,
specifically, Schwarz) as to Code §§522(p)(1) and 522(o); the
actual holding of the court, however, added a new benefit to
ownership by the entireties: BAPCPA's 730-day domiciliary
requirement does not apply to property exempted as entireties
property under Code §522(b)(3)(B). (Issues 1(a), (b) and 2)
However, there is no residual 180-day – or, indeed, any other –
domiciliary requirement in Code §522. Therefore, by the holding
of the Zolnierowicz court, not only does the mansion loophole
continue, so long as a husband and wife slip through it together,
but the loophole opens up as soon as the spouses cross the Florida
border and can obtain a homestead by the entireties.
But, here's the wrinkle –
i. In re Garrett, 435 B.R. 434 (Bankr. S.D. Tex. 2010) – Joint
husband-and-wife debtors filed a chapter 7 case in Texas, after
having moved there from North Carolina. The domiciliary rules
set forth above (see Section III.A.2) required them to use North
Carolina exemption law, which recognizes the tenancy-by-theentireties
form of ownership. The debtors therefore sought to
exempt $268,618 worth of the value of their interest in their Texassituated
residence under North Carolina entireties exemption law,
even though Texas does not recognize tenancies-by-the-entireties.
Held: Exemption denied as to asserted entireties property. The
court found that, while North Carolina exemption law applied
otherwise under Code §522(b)(3)(A), the "applicable
nonbankruptcy law" that must provide for the exemption of
entireties property in order for Code §522(b)(3)(B) to apply is the
law applicable to the situs of the property at issue – here, Texas
law.
14

RECENT DEVELOPMENTS REGARDING
PRIORITIES IN BANKRUPTCY
ABA
BUSINESS BANKRUPTCY COMMITTEE
Boston
April, 2011
Michael R. Enright
Robinson & Cole LLP
Hartford, Connecticut
(860) 275-8290
menright@rc.com

1. More on administrative rent claims
Nine years ago, the Third Circuit decided Centerpoint Properties v. Montgomery
Ward Holding Corp. (Montgomery Ward Holding Corp.), 268 F.3d 205 (3d Cir. 2001),
which gave us the “billing date” approach to the analysis of whether lease obligations are
to be paid under §363(d)(3). Unfortunately, this left open the question of whether the
claim for stub rent (the rent due from the petition date up to the first rental due date that
occurs post-petition) is payable as an administrative claim under §503(b), or is to be paid
at all. We now have clarity on the stub rent issue, at least in the Third Circuit, with the
opinion in In re Goody’s Family Clothing, Inc., 2010 U.S. App. LEXIS 13209 (3d Cir.
June 29, 2010).
In Goody’s, the debtor filed its petition on June 9, 2008, and immediately engaged in
going out of business sales at the locations in question. It was undisputed that the debtor
reaped substantial benefits from the use of the leased locations to conduct the sales. Also,
the debtor received from the liquidator an amount equal to the per diem rent on the
properties for the “stub rent” period, which started on June 9 and ended on June 30, 2008,
but did not pay any rent whatsoever to the landlord for that period.
The landlord moved for allowance of an administrative claim for use and occupancy
for the stub rent period, pursuant to §503(b)(1), asserting that the use and occupancy of the
premises benefitted the estate and that the claim was an actual and necessary cost. The
debtor objected, asserting that §365(d)(3) supplanted §503(b)(1) and did not provide for
the payment of any rent for the stub rent period. The bankruptcy court sided with the
landlord, the district court affirmed, and the Third Circuit agreed.
The court first analyzed whether §365(d)(3) preempts §503(b)(1). Holding that it did
not, the court explained that §365(d)(3) imposes a special duty on trustees with respect to
unexpired leases of nonresidential real property, requiring the timely performance by the
trustee of obligations arising after the petition date. As the court had held in Montgomery
Ward, an obligation arises under a lease when the duty to perform arises. The court
dismissed the debtor’s argument that the Montgomery Ward holding ended the argument.
Contrary to the debtor’s position that since the rent was due before the petition date, and
because §365(d)(3) only mandates payments arising after the petition date, the debtor
simply is not obligated to pay rent for the stub rent period, the court concluded that
Montgomery Ward simply did not address this issue.
The court, in a footnote, also turned away the debtor’s argument that §365 provides
the exclusive means for payment of rent. First, stub rent may not be connected to a lease at
all, being in the nature of use and occupancy. Second, other Bankruptcy Code provisions
address leases, so there is no exclusivity to §365 in this regard. Third, the debtor’s
construction would permit residential tenants to avoid lease payments altogether, because
§365(d)(3) simply never addresses them. Fourth, the debtor’s argument that expressio
unius should apply failed on its face, because §365(d)(3) on its face expressly reserved
other rights under the Bankruptcy Code.
2

Section 365(d)(3) imposes special duties on the trustee “notwithstanding section
503(b)(1).” The use of “notwithstanding” means “in spite of” or “without prevention or
obstruction from or by” (citing Webster’s). Therefore, §365(d)(3) is an exception to the
generally applicable procedures under §503(b)(1), relieving a landlord of the burden of
those procedures. “Put simply, §365(d)(3) does not supplant or preempt §503(b)(1).” The
court noted that this reading was consistent with the legislative history of the section.
Having concluded that the landlord was not barred from a §503(b)(1) recovery for the
stub rent period, the court then turned its analysis to the requirements for proving a claim
for an administrative use and occupancy expense under that section. Of course, the
landlord needed to prove an actual and necessary benefit to the DIP in the operation of its
business. Looking to the Mammoth Mart test, the court noted that the debtor had
continued to occupy the premises without providing any benefit to the landlord. Citing to
the analogous situation in its prior decision in Zagata Fabricators v. Superior Air Prods.,
893 F.2d 624 (3d Cir. 1990), which concerned an expired lease, the court concluded that
maintaining post-petition possession, thereby inducing post-petition services from the
landlords, was sufficient to justify administrative priority. Here, it was particularly clear
that the use and occupancy benefitted the estate, because of the success of the going-outof-business
sales at the premises.
On the other hand, in In re GCP CT School Acquisition, LLC, 2010 Bankr. LEXIS
3839 (Bankr. D. Mass. Oct. 28, 2010), the Bankruptcy Court chose to follow the “accrual
approach” to the obligation to pay rent under §365(d)(3), holding that “pro-rating postpetition,
pre-rejection obligations serves the legislative interest of providing landlords with
a ‘current payment’ for ‘current services’ without producing results that are inconsistent
with the Bankruptcy Code.”
2. More from the Third Circuit on break-up fees.
The Third Circuit once again weighed in on the topic of break-up fees in In re Reliant
Energy Channelview LP, 594 F.3d 200 (3d Cir. 2010).
The Debtor decided to sell its power plant and went through a marketing process to
identify a stalking horse bidder. Kelson was the winning bidder, in part because its bid
was not contingent on financing the proposed $468 million deal. The Debtor and Kelson
entered into an Asset Purchase Agreement, subject to Bankruptcy Court approval. The
Debtor first requested that the Court approve the deal without an auction process, in light
of the extensive marketing undertaken at that point. The Court would not approve the deal
without an auction.
The Debtor then requested that the Court enter an order providing Kelson with bid
protections, including a break-up fee of $15 million. One of the other bidders, which had a
contingency in its losing bid, objected, asserting that imposition of a break-up fee would
chill the bidding at the auction. The Court then conducted a hearing on the proposed
bidding protections.
3

The Bankruptcy Court’s analysis of the request for approval of the bidding procedures
turned on whether it could conclude that the proposals would benefit the estate. In this
regard, the Court noted the presence of other active bidders, and that in similar
circumstances the Court had denied a break-up fee request. Ultimately, the Court denied
the requested break-up fee, but approved an expense reimbursement feature for Kelson
(capped at $2 million), and some other bid procedures.
Kelson did not participate further in the sale proceedings, the other bidder topped the
Kelson bid by $32 million, and no break-up fee was paid to Kelson (Kelson did get its
expenses reimbursed for about $1.2 million). Kelson appealed the order denying the
break-up fee, but the District Court affirmed. Kelson then went to the Third Circuit.
The Third Circuit referred back to its decision in Calpine Corp. v. O’Brien Ev’t
Energy, Inc. (In re O’Brien Env’t Energy, Inc.), 181 F.3d 537 (3d Cir. 1999), in which it
had determined that the applicable standards for consideration of a break-up fee were to be
found in §503(b), which is the general administrative claim provision. In that case, the
Court had decided that it was permissible to offer a break-up fee to induce an initial bid, so
long as granting the break-up fee did not give an advantage to a favored purchaser by
increasing the cost of other bidders. Also, the Court noted in that case that a break-up fee is
not necessary if the bidder would have bid even without the break-up fee.
Applying O’Brien to the case now before it, the Court examined whether a break-up
fee was needed to induce Kelson’s initial bid. Examining carefully the language of the
APA entered into between the Debtor and Kelson, the Court concluded that the break-up
fee was not necessary to induce the bid, because it was clear beyond doubt that Kelson did
not condition its bid on the presence of a break-up fee. Rather, the condition in the APA
was that the Debtor would seek authority to pay the break-up fee, not that it would be
successful in obtaining the approval. This fact destroyed Kelson’s argument that the fee
was needed to induce its bid.
The Court went on to consider whether the break-up fee was needed to preserve
Kelson’s bid. This seemed particularly appropriate given that Kelson abandoned its bid
after the fee was not approved. In this regard, the Court noted that the Bankruptcy Court
had a difficult choice, because if it did not approve the break-up fee, Kelson might walk
away. But the Court held that the decision to deny the fee was justified by the other
bidder’s assertion that it was going to continue to bid, the language of the APA and the
logical belief that Kelson would not abandon its bid.
The bottom line is that the stalking horse bidder lost here, and careful attention needs
to be paid to the exact wording of the conditions in the APA regarding approval of the
break-up fee. It is not clear that the decision would have been different if the condition had
been stated in a manner that required the approval of the break-up fee, but it probably
would have increased Kelson’s chances, and may have been some comfort to Kelson when
it decided to abandon its bid regarding whatever risks it may have faced for its decision to
abandon, assuming that same may have been a breach of the APA.
4

3. More from the Sixth Circuit on Deductible Loss Reimbursements
In its per curiam decision in In re HNRC Dissolution Co., 536 F.3d 683 (6 th Cir.
2009), cert. denied, 129 S.Ct. 2866 (2009), the Sixth Circuit rejected the assertion of
entitlement to administrative priority by a workers’ compensation insurer regarding a postconfirmation
loss projection arising from future deductible loss reimbursements under a
workers’ compensation policy. The loser there was Zurich. Following on HNRC, the
Sixth Circuit recently held in National Union Fire Ins. Co. v. VP Buildings, Inc., 606 F.3d
835 (6 th Cir. June 4, 2010), that Zurich’s competitor National Union Fire Insurance
Company would fare no better.
National Union provided LTV with workers’ compensation insurance post-petition.
With workers’ compensation insurance, the insurer is on the hook to the injured employee
not only for the year in which the injury occurred, but sometimes for years to come. The
insurance contract required National Union to make these payments, and required LTV to
reimburse National Union for them after they are made. LTV’s reimbursement obligations
are called “deductible loss reimbursements.”
National Union sought administrative expense priority for the payments that would
not be due until after closure of the bankruptcy estate. It obtained an arbitrator’s ruling
valuing the claim. The bankruptcy court denied priority for this claim, concluding that it
was not an actual expense and would not benefit the estate. The district court affirmed, as
did the Sixth Circuit.
The court determined that it was bound by its prior decision in HNRC, and that HNRC
could not be distinguished. National Union argued that it had successfully determined the
claim through arbitration, whereas the insurer in HNRC had only an actuary’s estimate of
the claim. This, asserted National Union, transformed the claim into an “actual” expense.
The court disagreed, pointing out that however certain the future liability might be, the
reimbursement obligation did not arise until payments were actually made by the insurer,
and was not “actual” until then.
National Union also argued that HNRC was wrongly decided and conflicted with the
Supreme Court’s decision in Reading. However, pending an en banc ruling to the
contrary, the panel was required to follow the HNRC panel’s holding.
In a separate concurrence, two of the panel members argued that en banc
consideration was warranted. The concurring judges concluded that framing the issue in
terms of when the payment was to be made dictated the outcome unfairly. The correct
analysis should involve reviewing the purpose of the expense in question. If the debtor’s
survival depends on obtaining workers’ compensation coverage during the Ch. 11 case,
then the costs associated with obtaining that policy for that period should be allowed as an
expense of administration, regardless of when payment obligations fall due.
5

4. Two decisions in Chrysler regarding termination damages for dealer contracts.
Judge Gonzalez entered two decisions on January 5 in the Chrysler case determining
the extent and nature of the claims of dealers under prepetition contracts with Chrysler.
The dealers lost in both decisions in their attempts to impose administrative expense
claims on the estate for termination damages that arose from prepetition contracts.
First, in In re Old Carco LLC, 424 B.R. 650 (Bankr. SDNY 2010), the Court was
faced with the claim of a dealer which had voluntarily terminated its agreement with
Chrysler in accordance with the express terms of the agreement, and then asserted an
administrative expense claim for termination damages. As it happened, the termination
was effective on the date that Chrysler filed its Ch. 11 petition.
The dealer sought an administrative expense claim under traditional standards, arguing
that it had bestowed a benefit on the estate by voluntarily terminating and sparing the
estate the costs of having to reject the contract. The dealer also argued that the vehicles
(subject to a repurchase requirement in the agreement upon termination) were property of
the estate, which the dealer preserved, thus benefitting the estate.
In considering the traditional administrative expense standards, the Court noted that
the claim arose out of the prepetition contract, and not from a transaction with the estate.
Furthermore, the dealer did not provide any benefit to the estate. The dealer’s activities all
related to its existing obligations under the prepetition contract, and the dealer benefitted
from those activities. Whatever claim arose out of that contract was a prepetition claim.
Also, nothing in these facts implicated the Reading line of cases. That line of cases is
limited to situations involving a debtor’s negligence, intentional misconduct, or injury to
an innocent third party. The Court also rejected an argument based on 28 U.S.C. §959(b),
which requires a debtor to operate its business in accordance with the requirements of state
law.
The District Court affirmed this thinking later in 2010 (In re Old Carco, LLC, 2010
U.S. Dist. LEXIS 118174 (SDNY Nov. 2, 2010). The District Court concluded that the
Reading exception did not apply to the claim, because it was a claim that arose under a
prepetition contract, rather than a purely postpetition damage claim, and because the
debtor had ceased operating upon filing the petition. The claimant’s efforts to portray the
hiring of lawyers and consultants for the bankruptcy process as a continuation of the
business was unavailing. The Court also concluded that the rationale of the 28 U.S.C.
§959(b) decisions did not apply. Because the debtor was not operating, it could not
possibly have attained an unfair advantage over competing businesses by failing to comply
with the state law in question.
The Bankruptcy Court also dealt with the 28 U.S.C. §959(b) issue in the companion
case decided on January 5, 2010, In re Old Carco LLC, 424 B.R. 633 (Bankr. SDNY
2010). The facts were a bit different in this second decision. Here, the Court was dealing
with the claims of dealers whose prepetition dealer agreements had not been voluntarily
terminated prepetition, but had been rejected during the Ch. 11 case. The dealers argued
6

that special considerations merited administrative priority for their termination claims, and
relied particularly on 28 U.S.C. §959(b) and state laws enacted to protect dealers in
support of this position.
The Court held that although state law determined the consequences of a rejectioninduced
breach, the Bankruptcy Code determined the priority of the claim for breach, and
that the determination of the claim’s priority was the exclusive province of the Bankruptcy
Code, thus preempting the state dealer laws in regard to priority. Also, the Court held that
the state dealer laws were not intended to protect the health and safety of the general
public, and did not implicate the Reading line of cases.
In construing the application of 28 U.S.C. §959(b), the Court noted the intent of the
law, which is to prevent a bankruptcy estate from having an unfair advantage over
nonbankrupt competitors. Several courts have held that the statute does not apply to a
liquidating company, which is not competing with others, and the Court took note that
Chrysler was no longer operating and had gone into immediate liquidation.
5. Two cases exploring the impact of §503(b)(9) on preference recoveries.
In In re Circuit City Stores, Inc., 426 B.R. 560 (Bankr. E.D. Va. 2010), the Court
grappled with the issue of whether §502(d) could be used to temporarily disallow the
§503(b)(9) claims of creditors who had received allegedly preferential transfers.
Creditors who had delivered goods within the 20 day period prior to the Ch. 11 filing
submitted claims under §503(b)(9), to receive administrative priority for the value of those
goods. The Debtor filed omnibus objections to those claims, seeking to disallow them
under §502(d) up to the value of potentially avoidable prepetition transfers.
The Court noted the split of authority on whether §502(d) applies to administrative
expense claims, particularly In re Plastech Engineered Prods., Inc., 394 B.R. 147 (Bankr.
E.D. Mich. 2008), which held that §502(d) could not be used in the context of a §503(b)(9)
claim, and noting that the majority line of cases did not permit the use of §502(d) to
disallow administrative expense claims. Furthermore, the Court held that this majority line
of cases was more consistent with established Fourth Circuit precedent.
However, the Court distinguished the majority line of cases that construed the
application of §502(d) to administrative claims generally from the proposed application of
§502(d) to §503(b)(9) claims specifically. The distinguishing factor regarding a
§503(b)(9) claim is that unlike other administrative claims, it by definition would have
arisen prepetition, not postpetition. Because they had prepetition claims, holders of
§503(b)(9) claims were creditors within the meaning of §101(10)(A). As such, they were
required to file a proof of claim under §501(a) in accordance with Rules 3002 and 3003.
Claims filed under those rules were subject to disallowance under §502(d), like any other
prepetition claim.
7

In a follow up to this decision, in In re Circuit City Stores, Inc., 2010 Bankr. LEXIS
4398 (Bankr. E.D. Va. Dec. 1, 2010), the Bankruptcy Court directly addressed the issue of
whether shipments of goods made in the twenty day period prior to the filing of the
petition (eligible for §503(b)(9) administrative priority) could be used as “subsequent new
value” for the purpose of diminishing preference exposure stemming from payments
received prior to those shipments by the vendor. The Court concluded that these
shipments could not be used as new value, because doing so would constitute doublecounting.
The Court’s rationale was based on E.D. Va. and 4 th Circuit precedent
concerning whether new value must remain unpaid in order to qualify as a preference
defense. The applicable case law explains that the correct analysis is “whether the new
value has been paid for by an otherwise unavoidable transfer.”
The Court considered the available avoidance statutes, and concluded that none of
them could apply to avoid the ultimate postpetition payment of the administrative claim
available under §503(b)(9). The Court also concluded that the stipulation entered by the
Court which resolved temporarily the §503(b)(9) claim by establishing a reserve for the
amount of the claim was a “transfer” for purposes of the new value analysis. Having
concluded that the twenty-day goods obligation was an otherwise unavoidable transfer, the
Court determined that the new value defense could not apply for this amount. It is clear
from the Court’s opinion that its view of the combination of the allowance of the
administrative claim and the new value defense as a double dip drove this decision.
Reaching a different conclusion, the Court in In re Commissary Operations, Inc., 2010
Bankr. LEXIS 62 (Bankr. M.D. Tenn. 2010), dealt with the same issue: Whether the fact
that goods delivered by the creditor to the Debtor within the 20 day prepetition period
qualified for treatment under §503(b)(9) excluded the value of those goods from eligibility
as “subsequent new value” under §547(c)(4) in defense of a preference claim.
The Debtor was a food wholesaler to chain restaurants. Over 200 creditors filed
§503(b)(9) claims for goods delivered in the 20 days prior to the bankruptcy filing. The
Debtor initiated adversary proceedings seeking to recover preferences paid to some of
those 200 creditors. The Court invited the parties to assert their contrary arguments about
whether the creditor defendants could reduce potential preference exposure by the amount
of new value delivered during the 20 day period if they also sought repayment on an
administrative expense priority basis for those amounts. This was a case of first
impression for the Court.
The Court looked to a prior decision where reclaimed goods had formed part of the
basis for the new value defense. In that decision, the conclusion reached was that the
creditor “essentially kept strings on those goods,” and they did not qualify for new value
treatment. But the Court concluded that the rationale of that earlier decision was not
applicable. First, the ability to assert a §503(b)(9) claim only arises after a bankruptcy is
filed, and also does not provide a lien right, so there is no “string” on the goods. In
general, the rights of a reclaiming creditor are quite different than those of a creditor
seeking a 20 day goods claim.
8

Instead, §503(b)(9) claims are analogous to the claims of critical vendors, and the
Court examined precedent concerning whether creditors who had received critical vendor
treatment could use prepetition deliveries as subsequent new value. In one such case, the
holding was that the value of such goods was eligible for new value treatment.
The Court noted that to force a creditor to choose between asserting §503(b)(9) and
preserving its administrative claim or not doing so in order to preserve its new value
defense would work a disservice on the policy goals Congress intended when enacting the
statute. Requiring creditors to make that choice would chill their willingness to do
business with troubled entities, and deprive sellers of protections Congress wanted them to
have. If Congress did not intend such a “double use,” it could have easily amended the
statutes to eliminate the possibility, but did not do so. The Court held that the value of the
goods could be used as new value despite the assertion and allowance of the 20 day goods
claim.
6. Recent substantial contribution award cases.
In In re SONICblue, Inc., 422 B.R. 204, (N.D. Cal. 2009), the Court lays out the
unpleasant factual history of the professional fee and disgorgement issues in the case, and
considers a further award under §503(b)(4) for substantial contribution by the holder of a
claim (purchased from the creditor) who played a central role in the case. Although it does
not break any apparent new legal ground, it is certainly interesting reading, and a lesson
for all bankruptcy professionals of the risks we run when employed on behalf of the
bankruptcy estate. The Court held that the claimant had benefitted the estate through its
extensive activities in uncovering problematic conduct, and awarded it another $300,000
(on top of a prior award of almost $700,000), bringing its total recovery to nearly a million
dollars.
In In re Yellowstone Mountain Club, LLC, 2009 Bankr. LEXIS 3654 (Bankr. D.
Mont. 2009), the Court rejected the proposed settlement of a request for a substantial
contribution award pursuant to §503(b)(4). Although the claimant and the Debtor reached
agreement to allow the claim in the amount of $50,000 (the application requested
$400,000), the Committee objected and the Court concluded that it could not approve the
settlement because the result would be contrary to the law.
The Court noted that the claimant bore the burden of proving the benefit to the estate,
and had failed to carry that burden. Although in Celotex the Eleventh Circuit held that the
motive of the applicant (meaning that it acted out of self-interest) was not a factor in
determining substantial contribution, Celotex was distinguishable. The claimant was not
able to prove that the information it provided to the Debtor was not otherwise available to
the Debtor, or that its participation even benefitted the estate.
As if Philadelphia Newspapers could not get more interesting, we have a substantial
contribution claim decision from that case. In In re Philadelphia Newspapers, LLC, 2010
Bankr. LEXIS 3718 (Bankr. E.D. Pa. October 21, 2010), the Court was faced with a
substantial contribution claim by an insider who offered to make a DIP loan to the debtors,
9

and also sought to be the stalking horse bidder for a cash bid. The offer of the DIP loan
was valuable to the debtors, because it was made at a time when the debtors were anxious
to provide some alternative to the lenders’ proposed DIP loan, which would have given the
lenders veto power over any plan, preventing the pursuit of any plan that would restrict the
lenders’ right to credit bid. Ultimately, the debtors were able to negotiate a DIP loan with
the existing lenders free of such a restriction, and credited the insider’s offer as important
to this result.
The Court considered and compared an administrative expense award it had approved
to another alternative DIP lender in making a DIP loan proposal in the case, and concluded
that the insider was not entitled to as much, because the insider had much of the necessary
due diligence information already at its fingertips, and also had a significant interest in
protecting its own equity stake in the debtors. Nonetheless, the Court found that the
insider was entitled to an award in a reduced amount.
The Court in In re Brooke Corporation, 2011 Bankr. LEXIS 19 (Bankr. D. Kan. Jan. 5,
2011) was less generous. An indenture trustee, which had initiated receivership litigation
prepetition and obtained the appointment of a receiver, who later became Ch. 11 trustee
after filing a bankruptcy petition for the debtor, sought recovery of fees for its prepetition
efforts, asserting that it created benefit for the estate, and citing to similar circumstances in
the Bayou Group cases, where an award was made. However, the Court distinguished the
facts and circumstances of Bayou, where the creditors had come together for the purpose
of orchestrating a Ch. 11 filing and the appointment of a trustee, from this case, where the
indenture trustee had acted to prevent a Ch. 11 filing. The Court found that the indenture
trustee was interested in protecting its own position, and that any benefit to the estate was
incidental, and so not the basis for an award under 10 th Circuit precedent.
7. Two cases about standing to object to allowance of an administrative expense.
The Court in In re Central Illinois Energy Cooperative, 2009 Bankr. LEXIS 3804
(Bankr. C.D. Ill. 2009) considered the administrative expense request of a petitioning
creditor in a case initiated as an involuntary, pursuant to §503(b)(3)(A) and §503(b)(4).
The case had been filed as a Ch. 11 and later converted to a Ch. 7. A putative creditor
filed an objection to the request, and the petitioning creditor challenged the standing of the
putative creditor to object.
The Court determined that the putative creditor most likely had no claim whatsoever
remaining against the estate (its claim arose pursuant to a lien which had been foreclosed),
and that if it did have a claim that remained, it was grossly oversecured. In either instance,
the putative creditor’s interest would not be impaired or affected by allowance of the
administrative expense claim. Therefore, the Court held that the putative creditor lacked
standing to object.
Similarly, in In re Runnels Broadcasting Systems, LLC, 2009 Bankr. LEXIS 3946
(Bankr. D.N.M. 2009), the Court had to consider whether the party objecting to allowance
of an administrative expense claim had standing to pursue the objection. In this case, the
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Ch. 7 trustee sought approval of his final report, including his compensation as trustee.
The case had been converted from a Ch. 11, and one of the holders of a Ch. 11
administrative claim objected to the final report, including the allowance of the maximum
compensation to the trustee.
The Court noted that although the objecting party held an administrative claim in the
Ch. 11 case by virtue of its unsatisfied administrative claim, the trustee’s final report
concerned only the Ch. 7 phase of the case. The Court’s focus was on whether the
objecting party had any pecuniary interest in the outcome. Here, the objecting party had
no pecuniary interest, because it would not receive a distribution on its Ch. 11
administrative expense claim even if the trustee’s compensation was reduced to zero.
8. Another critical vendor request passes the Coserv test.
On appeal from the Bankruptcy Court, the District Court affirmed a critical vendor
order in J.M. Blanco, Inc. v. PMC Marketing Corp., 2009 U.S. Dist. LEXIS 119063
(D.P.R. 2009).
The debtor operated a chain of drugstores and had three primary distributors that
provided it with merchandise. These three held the largest claims against the estate. Postpetition,
the debtor conducted negotiations with these three suppliers for terms of ongoing
credit extensions to stock the shelves. Only one of the three agreed to terms, and the debtor
moved for approval of those terms pursuant to a critical vendor request.
The terms included: 1) the supplier would be paid between 30 and 40 days after
purchase; 2) the supplier’s $7.78 million prepetition claim would be paid in installments,
in full; 3) the supplier would extend credit up to a maximum of $7 million; and 4) the
supplier would waive any 20 day goods or reclamation claim or lien. The Bankruptcy
Court considered this request and applied the standards of In re Coserv, LLC, 273 B.R.
487 (Bankr. N.D. Tex. 2002).
Although the Bankruptcy Court approved the request, it initially limited the term to 30
days and the amount to $1.5 million of credit, and ordered the debtor to conduct further
negotiations with the other two primary suppliers, offering them similar terms, and
requested some other clarifications and refinements. In accordance with this order, the
debtor came back with an extension request, indicating that the other suppliers had no
interest, and clarifying that the proposed critical vendor had conditioned its proposal on
elevation of its prepetition unsecured claim to administrative expense priority. The debtor
also requested that the credit limit be increased to $7 million, as originally requested. The
committee and a competing supplier objected.
The Bankruptcy Court entered an order permitting the credit limit to be increased to
$5.8 million. It also granted the supplier an administrative claim equivalent to the amount
of the post-petition credit it granted to the debtor and allowed the debtor to pay up to $5.8
millon of the supplier’s prepetition claim. The competing supplier, also one of the largest
unsecured creditors, which had objected, appealed.
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The District Court reviewed the record and noted that the Bankruptcy Court had found
facts that supported a conclusion that the debtor’s request complied with the Coserv
requirements, which are: 1. That it is critical that the debtor deal with that particular
vendor; 2. Evidence must be provided that unless the debtor deals with that vendor, the
debtor risks harm or loss of economic advantage which is disproportionate to the amount
of the vendor’s prepetition claim; and 3. That there is no practical or legal alternative by
which the debtor can deal with the vendor other than payment. The District Court was
unwilling to set aside those findings because they were adequately supported by the
record.
The Court also considered the argument that the doctrine of necessity was limited in
its application to railroad reorganization cases. Although it is true that cases cited in
support of critical vendor treatment stem from such cases, the Court did not feel limited in
applying the rationale to cases outside of that context. Furthermore, the Court noted that
Coserv based its analysis on §105(a), and that a debtor-in-possession has a duty under
§1107(a) to protect and preserve the estate, including the going concern value. Using its
equitable powers to grant the critical vendor status to the supplier accomplished this
objective.
9. A handful of employee-related priority cases.
In Trucking Employees of North Jersey Welfare Fund, Inc. v. Marcal Paper Mills,
Inc., 2009 U.S. Dist. LEXIS 101695 (D.N.J. 2009), the pension fund challenged the
Bankruptcy Court’s ruling that no portion of its withdrawal liability claim was entitled to
administrative expense priority. The pension fund had sought the entire amount of the
withdrawal liability as an administrative claim based on the postpetition withdrawal from
the plan, but later adjusted its request to seek only that portion attributable to post-petition
services.
Finding no Third Circuit precedent, the Bankruptcy Court, in its opinion below,
followed the recent case of In re HNRC Dissolution Co., Inc., 396 B.R. 461 (B.A.P. 6 th
Cir. 2008), holding that the determination of withdrawal liability is dependent on so many
factors unrelated to the services rendered to the debtor post-petition that no portion of the
withdrawal liability directly related to post-petition labor and could not be considered to
confer a benefit on the debtor’s estate.
The District Court reversed. It first noted that withdrawal liability consists of the
employer’s proportionate share of a multiemployer plan’s unfunded vested benefits
calculated as the difference between the present value of the vested benefits and the current
value of the plan’s assets. Withdrawal liability is calculated based on methods specified
by the statute.
The post-petition labor of plan participants was clearly necessary to the continued
operation of the debtor during the bankruptcy case, so there was clearly a transaction with
the estate and a benefit to the estate. Under the circumstances, to “the extent the debt to
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the pension fund for benefits payable at a later date is based on services rendered to [the
debtor] after it had filed for bankruptcy protection, the debt was incurred for the benefit of
the estate.” Courts have understood withdrawal liability to represent an accelerated
obligation to pay deferred compensation, and contemplated that the claim could be split
into pre- and post-petition components.
The Court concluded that HNRC missed the mark by focusing on the manner in which
the assessment is computed, rather than the nature of the underlying obligation. Because
there was no settled method of apportionment, the District Court remanded to the
Bankruptcy Court to figure that out.
The Court in In re Circuit City Stores, Inc., 2009 Bankr. LEXIS 3158 (Bankr. E.D.
Va. 2009), decided the priority of employee claims for unused paid time off in the context
of a liquidating Ch. 11 case. The debtor changed its policies regarding unused paid time
off just prior to filing its bankruptcy petition. Because the policy change was explained in
a confusing manner, and actually caused a fair amount of confusion (including causing
employees who might have utilized accumulated paid time off during the postpetition
period to not use it), the Court held that it would be unfair to deny priority to the claims of
employees who had accrued unpaid time off at the time of their termination.
In In re Arclin Us Holdings, Inc., 416 B.R. 117 (Bankr. D. Del. 2009), the Court held
that medical benefits provided to a terminated employee could not be modified postpetition,
except in accordance with the restrictions of §1114. The employee in question
had been employed by the debtor for 41 years at the time of his involuntary prepetition
termination. Also, the termination letter characterized his benefits as “an early retirement
package.” Part of the package was the provision of 29 months of health insurance
premiums under the debtor’s “Retiree Benefit Plan.”
The debtor argued that despite all these references to retirement benefits in the
package, the benefits offered were not “retiree benefits” under ERISA, and that as such
they should not be considered benefits covered by §1114. The Court, citing to the Howard
Delivery decision, concluded that it is not always appropriate to rely on ERISA definitions
in construing Bankruptcy Code provisions, especially when there was no specific reference
incorporating them. Nonetheless, the debtor argued that the agreement in question was
similar to other (non-retirement) severance agreements, was offered to the employee in
conjunction with an overall RIF, and there was no intention to treat him as a retiree.
The Court concluded to the contrary, holding that the expressed intention was to offer
the employee an early retirement package in recognition of 41 years of service, and as
further evidenced by his inclusion in the retiree medical plan. Accordingly, the premiums
were protected by §1114(a).
In In re The Albert Lindley Lee Memorial Hospital, 428 B.R. 283 (Bankr. N.D.N.Y
2010), the court was faced with determining whether the reimbursement obligation owed
by a nonprofit to a state fund for payments-in-lieu under an unemployment insurance
program was entitled to §507(a)(8) priority as an employment or an excise tax. The court
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applied both the Lorber analysis and the Suburban II analysis (as it was unclear whether
the 2d Circuit would go so far as Suburban II) and concluded that the reimbursement
obligation was a tax. However, the court also concluded that this tax was not an
employment tax, following the reasoning of In re Boston Regional Medical Center, 256
B.R. 212 (Bankr. D. Mass. 2000). The court went on, though, to conclude that the tax was
an excise tax, and so was entitled to priority.
Class members unsuccessfully pressed for priority under §507(a)(4) for unpaid “off
the clock” overtime compensation pursuant to a purported prepetition settlement
agreement in In re Idearc, Inc., 2010 Bankr. LEXIS 4633 (Bankr. N.D. Tex. Dec. 14,
2010). After concluding that the settlement agreement was not binding in any event, the
Court went on to deal with the priority issue. The claimants asserted that the obligations
were “earned” when the settlement was reached, within the 180 day window permitted by
the statute. The Court disagreed, noting that while the Bankruptcy Code does not define
“earned,” Black’s Law Dictionary defines it as “[t]o acquire by labor, service or
performance … [t]o do something that entitles one to a reward or result, whether it is
received or not.” Citing to well-known treatises, the Court held that the wages were
earned, if at all, when the work was performed, not on the purported settlement date.
The Court in In re Corcoran, 2010 Bankr. LEXIS 4721 (Bankr. D. Hawaii December
16, 2010) held that court reporters who were independent contractors and had not been
paid by the debtor were entitled to §507(a)(4) priority even though they were not
employees, because the plain language of the statute does not restrict priority to the claims
of employees.
In a case that is hopefully an oddity, in In re Louis Jones Enterprises, Inc., 2010
Bankr. LEXIS 4598 (Bankr. N.D. Ill. Dec. 22, 2010), the debtor apparently had not
properly segregated funds withheld from employees for the payment of health insurance
premiums. Prior to the petition date, a creditor setoff against the debtor’s bank accounts,
with the result that the health insurance premiums were not paid and the insurance was
cancelled. Nonetheless, the deductions continued, and an employee who incurred health
care expenses in the meantime sought allowance of administrative and §507(a)(5) claims
for reimbursement. Noting that the debtor had an obligation under ERISA to segregate the
funds, which duty it had breached, the Court held that the employee had a valid claim
against the debtor, and given the timing of the events, it should be accorded both pre and
postpetition priorities accordingly.
10. Tax-related Issues.
Of some interest to those contending with IRS priority claims is In re G-I Holdings,
Inc., 2009 U.S. Dist. LEXIS 108339 (D.N.J. 2009), regarding the confirmation of the
debtor’s plan. The IRS objected to confirmation on several grounds regarding the
treatment of its asserted priority claims. There was serious disagreement with the IRS over
its claims, which were pending in tax litigation in another court. The plan provided that
once the tax litigation was resolved, the IRS would be in position to assess the contested
taxes. So, it was only at that point that the six year period for calculating the deferred cash
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payments would begin. The debtor’s proposal, which was to issue a note payable six years
after this delayed assessment, was approved by the Court, which held that this treatment
satisfied §1129(a)(9)(C). Furthermore, the interest rate proposed under the plan for the IRS
priority claim (LIBOR plus 1) satisfied the standard set by the Supreme Court in Till. The
Court also determined that the IRS could not pursue collection of the taxes in the
meantime from non-debtor affiliates.
The Court in In re Probulk, Inc., 2010 Bankr. LEXIS 4961 (Bankr. SDNY Dec. 23,
2010) dealt with the pressing question of whether annual tonnage and other taxes due to
the Republic of Liberia were entitled to §507(a)(8) priority. The Court noted that
“governmental unit” is defined to include an agency of a foreign state and that the
assessments in question were in fact claims for property taxes, based on the tonnage of
Liberian-flagged vessels owned by the debtor. Otherwise, to the extent that the timing was
right on the claims, they were entitled either to eighth priority or administrative priority.
The Court in In re J.H. Investment Services, Inc., 2010 U.S. Dist. LEXIS 119128
(M.D. Fla. Oct. 7, 2010) basically held that the IRS is like anyone else and has to assert an
unsecured claim if it wants to recover on one, and cannot just rely on its filed secured
claim. The IRS contended that it was not required to bifurcate, that bifurcation worked by
operation of law, and that the unsecured claim generated by bifurcation was automatically
entitled to eighth priority, without the need for the IRS to file a proof of claim in that
regard. The Court rejected this argument, and noted that the IRS had lost on this one
before in the same District.
In re Resource Technology Corp., 2011 U.S. Dist. LEXIS 15334 (N.D. Ill. Feb. 10,
2011) affirmed the Bankruptcy Court’s determination that the State of Illinois was entitled
to administrative priority for its claim for reimbursement of tax credits issued to electricity
suppliers as part of a state statutory scheme to promote alternative sources of energy. The
debtor was the owner/operator of several generation facilities, and obtained “QSWEF”
status for certain facilities, obligating the major electric utilities to purchase power from
them at higher rates than would otherwise prevail. Because the utility was required to pay
this higher rate, it was entitled to a tax credit for the difference in rates. The statute also
provided that if certain things happened, the owner/operator would be required to
reimburse the state for the tax credit granted to the utility. One of those things, the
cessation of business by the owner/operator, occurred after conversion of the case to Ch. 7
The state sought an administrative claim for the reimbursement obligation relating to
the tax credits, which became due when the debtor ceased operations. The Court held that
the tax credit scheme brought value to the debtor’s Ch. 11 estate, because the debtor was
able to charge more for electricity purchases by the utility prior to conversion of the case
as a direct result of this scheme. Therefore, the reimbursement claim was entitled to
administrative priority.
11. Electricity Eligible for §503(b)(9).
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In In re Grede Foundries, Inc., 2010 Bankr. LEXIS 1823 (Bankr. W.D. Wisc. June 1,
2010), the court held that electricity supplied by utilities to the debtor’s foundry prepetition
qualified for treatment as “goods” under §503(b)(9). Oddly, the opinion references a 90
day prepetition period, but one would assume this is an error, and the court intended to
reference the 20 day period. The court construed the definition of goods in the UCC, and
noted a split in authority on the issue of whether electricity can be considered goods. The
parties argued about whether electricity is moveable, which is one of the criteria for goods,
but the court concluded that whether it moved slowly or at the speed of light, it still
moved, and so electricity can be considered to fall within the definition of “goods.”
This decision was affirmed by the District Court. GFI Wisconsin, Inc. v. Reedsburg
Utility Commission, 440 B.R. 791 (W.D. Wis. November 12, 2010). The Court concluded
that it was reasonable to look to the UCC definition of “goods” in the absence of a
definition in the Bankruptcy Code. After an interesting discussion of the properties of
electricity, the Court held that “the meaning of ‘goods’ under the UCC should not depend
upon quantum physics,” which is a proposition that is hard to disagree with. Ultimately,
the Court agreed “with those courts concluding that electricity is movable, tangible and
consumable, that it has physical properties, that it is bought and sold in the marketplace
and thus, that it qualifies as a good for purposes of the UCC and the Bankruptcy Code.”
12. Use of Trademark by Franchisee Supports Administrative Claim.
A hotel chain franchisor is entitled to administrative priority for its franchisee’s
continued post-petition use of its trademarks, trade names, service marks, national
reservation system and other benefits provided by the franchise system. The debtor in In
re Shreyas Hospitality, LLC, 2010 Bankr. LEXIS 2074 (Bankr. C.D. Ill. July 15, 2010)
objected to Super 8 Worldwide, Inc.’s administrative claim for unpaid franchise
obligations owed for the postpetition period. The debtor operated a 122 room Super 8
motel in Springfield pursuant to a franchise agreement. It was not disputed that during the
bankruptcy case, the debtor continued to operate as a Super 8, participated in the national
reservation system, and received the other benefits offered by franchise membership. The
debtor asserted that postpetition administrative claim liability for use of a trademark was
limited to situations where trademarked goods were distributed by the debtor (as no goods
were distributed in operating the hotel). The court did not agree. The debtor also
challenged the amounts under the contract, but the court held that the franchise agreement
was arms-length and the amounts therein were the measure of the benefits received. The
court also held that the claimant did not need to demonstrate that the debtor profited from
the use of the franchise agreement, and that “benefit” in the administrative claim context is
“akin to ‘use’ not ‘profit’”, citing In re Patient Education Media, Inc., 221 B.R. 97 (Bankr.
S.D.N.Y. 1998).
13. Decisions of Particular Interest to Bankruptcy Lawyers (Other Fee Issues).
Perhaps it would have been wiser to leave a 20 year old bankruptcy case alone. In In
re Wolff, 2010 Bankr. LEXIS 4367 (Bankr. E.D. Tenn. Nov. 30, 2010), counsel got burned
16

for performing services in such a case, with no recovery for its efforts. Back in 1984, the
debtors filed a Ch. 7 case in Florida, and Fowler White represented them. The case was
closed in 1987. It was reopened in 2008 when some money was found, and an adversary
proceeding was initiated there to determine who should get the money. Fowler White
appeared for the debtor. Fowler White then negotiated a settlement, which was approved
by the Bankruptcy Court in Florida. In the meanwhile, the debtors filed a new Ch. 7 case
in Tennessee, and the net settlement funds from Florida were sent to the Tennessee Ch. 7
trustee. Fowler White then filed a claim in the Tennessee Ch. 7 proceeding, seeking
recovery for its fees in connection with filing the answer and negotiating the settlement,
which, after all, resulted in a recovery for the Tennessee trustee. The trustee objected, on
the basis of Lamie, arguing that Fowler White worked for a Ch. 7 debtor, and could not be
awarded compensation in the case. The Court determined that the services performed by
Fowler White were almost all performed after the filing of the Ch. 7 case in Tennessee,
and therefore could only be compensated if they fell into one of the administrative priority
categories. However, because the Tennessee trustee never employed Fowler White, and
Fowler White worked only for the debtor, no recovery was available, despite the fact that
Fowler White’s services clearly benefitted the estate.
If you need another decision that requires disgorgement of attorneys’ fees paid to
debtor’s counsel during a Ch. 11 case after the case is converted to a Ch. 7 and determined
to be administratively insolvent, check out In re Cryptek, Inc., 2010 Bankr. LEXIS 4830
(Bankr. E.D. Va. Dec. 21, 2010). The wrinkle in the case was that the attorneys had been
paid out of retainer, which would typically work against disgorgement efforts. However,
the retainer had been paid post-petition, and had never been approved by the Court,
although it had been disclosed. But disclosure was no substitute for approval, and the
Court ordered counsel to choke up $35,000.
Finally, in In re Nashville Senior Living, LLC, 2010 Bankr. LEXIS 3749 (Bankr.
M.D. Tenn. Oct. 25, 2010), the proposed counsel for the committee was not approved by
the Court, because of a disclosure issue. Replacement counsel was approved, and they
sought, among other things, to have the Court reconsider the disqualification of the
lawyers they had replaced. When replacement counsel applied for fees, this part of their
efforts went uncompensated. The Court determined that replacement counsel “was on
notice at the time it undertook representation that [original committee counsel] had been
disqualified” and therefore “knew, or should have known, that it was working at its own
peril with regard to compensation as it related” to the reconsideration effort. That portion
of the fee application was denied.
14. The Truly Miscellaneous.
No Reading Claim – Failed to Prove Causation: In In re Resource Technology
Corp., 2010 U.S. Dist. LEXIS 132171 (N.D. Ill. Dec. 10, 2010), the owner of a hotel next
to a landfill (sounds like a destination resort) sought allowance of an administrative claim
for damage to his business caused by failure of the methane gas collection system for the
landfill, resulting in malodorous vapors infiltrating the hotel property. The Ch. 7 trustee
took over the property on September 21, and the gas problems overwhelmed the hotel
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within about ten days afterwards. The Court concluded that the trustee could not be
responsible for the failure of the gas collection system, which undoubtedly had been
malfunctioning to some degree and was destined for failure long before the Ch. 7 trustee
was appointed. The fact that it happened on his watch, shortly after his appointment, did
not give rise to a claim based on Reading, because the hotel owner could not demonstrate
that the failure was due to the Ch. 7 trustee’s negligence.
No §364(a) Claim – Insider DIP Lender Not Ordinary Course: The Court in In re
Keystone Surplus Metals, Inc., 2010 Bankr. LEXIS 4545 (Bankr. E.D. Pa. Dec. 7, 2010)
rejected the administrative claim requested by an insider of the debtor for unsecured DIP
loans advanced to the debtor without disclosure or approval. The Court made note of the
fact that these advances had not been disclosed on the MORs filed in the case, or in any
other way. Also, there was no documentation for the loans, just cancelled checks. In its
plan and disclosure statement filed with the Court, the loans were never mentioned. With
this background, the Court analyzed whether the loans could be characterized as having
been incurred in the ordinary course, and concluded that they could not be.
Club “Membership Deposits” Were Not Deposits After All: The debtor in In re
Palmas Del Mar Country Club, Inc., 2010 Bankr. LEXIS 4981 (Bankr. D. P.R. Dec. 29,
2010) operated a golf, tennis and beach club. Those wishing to join executed Membership
Agreements, and made an upfront payment, termed a “Membership Deposit.” These were
refundable to members who resigned upon resale of the membership to a new member, or
after 30 years had passed. The members sought allowance of their claims for return of this
upfront payment as a priority for a deposit under §507(a)(7), analogizing them to gym
membership deposits. The Court disagreed, concluding that the upfront payments were not
within the meaning of deposits as used in the priority section. The members had no
expectation that the funds would be held in escrow or that any trust relationship was
formed.
Homeowners Association Assessments Entitled to Priority: In In re Vista Ridge
Development, LLC, 2010 Bankr. LEXIS 4492 (10 th Cir. BAP Dec. 20, 2010), the
developer of a subdivision filed a Ch. 11 petition. In its plan, it proposed to pay the
Homeowners Association for the development the amount owed for assessments on each
lot as the lots were sold off. The Homeowners Association had other ideas, and filed a
motion requesting that the postpetition assessments be given administrative priority, so
that they would have to be paid in full at confirmation of the plan. The debtor objected,
arguing that the assessments were not on account of any benefit to the estate. Apparently,
the great majority of the assessments were to fund a recreation center operated by the
Homeowners Association for the subdivision. The BAP, reviewing the Bankruptcy
Court’s ruling in favor of the Homeowners Association, noted the Bankruptcy Court’s
reliance on the uncontroverted affidavit of the director of the Homeowners Association
describing the funding and operation of the recreation center and preservation of the
common areas, and noted that the debtor had not submitted any other evidence, or
challenged the sufficiency of the affidavit to support the administrative claim in the
proceedings before the Bankruptcy Court. The BAP treated this as a failure to raise the
issue below, foreclosing that issue from review on appeal. Ultimately, the BAP was
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“skeptical, as was the Bankruptcy Court, that the $55 per month for amenities such as fully
staffed recreation and fitness centers, pools, and running/walking trails does not provide a
benefit of at least that amount to each lot.” The BAP affirmed.
Risk Hedging Agreement Did Not Benefit Estate: Post-petition contracts entered
into by the debtor in connection with its farming operations for the delivery of grain did
not provide any benefit to the estate and therefore could not sustain a claim for
administrative priority. The debtor in In re Eckberg, 2011 Bankr. LEXIS 303 (Bankr. C.D.
Ill. Jan. 27, 2011) regularly entered into various hedge contracts in connection with its
production of crops. The contracts required the debtor to deliver and sell specified
quantities of harvested crops to the counter-party, specifying a time for delivery (and the
time of delivery in some cases could be rolled forward). Prior to the debtor’s rejection of
these contracts, no cash or anything else of value was provided by the counter-party to the
debtor. The only consideration that would be paid would be paid upon delivery. The
counter-party asserted that it was entitled to an administrative claim for the benefit the
debtor received by having a ready market for its crops upon harvesting. However, the
Bankruptcy Court saw no consideration in this. As the Court noted, the contracts “are
either price risk avoidance or price speculation devices that provided no quantifiable
benefit to the estate of the kind required for administrative claim status.” Although there
may have been a future benefit, realizable upon delivery/payment, this possibility was
eliminated upon rejection. The Court did not appear to see any benefit to the elimination
of the price risk for the crop producer.
Section 365(d)(5) – Truck Leases: In In re Double G Trucking of the Arlatex, Inc.,
2010 Bankr. LEXIS 4926 (Bankr. W.D. Ark. Dec. 20, 2010), the debtor leased trucks for
use in its business. The debtor stopped paying and filed Ch. 11. The lessor sought to
require assumption or rejection of the truck lease. The debtor countered that the
arrangement was actually a secured transaction, and the debtor was ordered to pay
adequate protection, which was in an amount less than the monthly lease payments.
Ultimately, the Court determined that the transaction was a true lease, and required the
debtor to assume it or reject it. The debtor rejected the lease and surrendered the trucks.
Of the three vehicles, one was in a state of disrepair prior to filing of the petition, and was
not used postpetition.
The lessor sought an administrative claim for the use of the trucks postpetition, both
under the general administrative claim rubric for the first 59 days of the case, and then
pursuant to §365(d)(5) for the balance of the term pre-rejection. The Court noted that the
presumption is that the lease payment is the reasonable rental value in the absence of
evidence to the contrary from the debtor, and that the debtor’s only argument was that the
adequate protection payment amount should be used instead of the lease payment set forth
in the lease. The Court rejected the debtor’s argument, and did not find it at all persuasive.
On that basis, the Court awarded an administrative claim for the two trucks used in the first
59 days of the case at the rental stipulated in the lease. Regarding the balance of the claim,
the debtor argued that it should be excused from paying anything for the period of time
during which the parties disputed whether the transaction was a lease or a disguised
19

secured transaction. Again, the Court rejected this argument, holding that there “is nothing
inequitable about holding the debtor to its bargain during this ‘challenge period.’”
What Do You Do With an 8 Foot Tall Teddy Bear?: For an interesting diversion,
read Alley v. Giannini, 2010 Bankr. LEXIS 4292 (Bankr. N.D. Ill. Dec. 2, 2010), which is
about, among other things, an eight foot tall teddy bear. The debtor operated a retail
furniture store selling log furniture and rustic art. He vacated the premises, told the
landlord he would file bankruptcy, and then filed a Ch. 7 case. The landlord almost
immediately rented the space to a bicycle shop, despite the fact that the inventory was still
in the space. He had the bicycle shop employees move the goods to the basement, a loft,
and a garage, for safekeeping. Along the way, and unbeknownst to the landlord, some of
the bicycle shop employees saw fit to “store” some of the “rustic artwork” in the dumpster,
and it was hauled away. The Ch. 7 trustee sought a turnover of the goods, and the landlord
initially told him to go pound sand. He came around to the trustee’s way of thinking when
the trustee moved for contempt and after consultation with an attorney. But the trustee
could not see fit to remove the goods, because they were of questionable value and hard to
move. The landlord warned the trustee that some of the goods, including the eight foot
teddy bear, were in less than ideal locations, and could be damaged by weather, leakage,
etc. Indeed, the poor bear was overrun with mice before the case was over, and ruined. At
the end of the day, the landlord’s claim for administrative priority for storage space was
denied (he could not establish either any true rental value for the storage space, which was
not normally let out for that purpose, or that the goods stored actually had any meaningful
value, so arguably the storage preserved no value), and damages were assessed against him
for being a neglectful bailee of the goods, and contemptuous to boot.
20

RECENT DEVELOPMENTS REGARDING
THE INTERFACE BETWEEN INSURANCE AND BANKRUPTCY
ABA SECTION OF BUSINESS LAW
BUSINESS BANKRUPTCY COMMITTEE
SPRING MEETING
APRIL 15, 2011
BOSTON, MASSACHUSETTS
Robert B. Millner
SNR Denton US LLP
233 S. Wacker Drive
Suite 7800
Chicago, Illinois 60606
312.876.8000

1. Chapter 11 Tort Settlement Trust Requiring Claim Liquidation
By Arbitrator Violates Insurer’s Rights and Vitiates Coverage
In Berger v. Catholic Mutual Relief Society of America, Adv. No. F08-90019 (DMO)
(Bankr.D. Alaska, 12/13/2010) [Dkt. No. 224], the trustee of a settlement trust sought to
determine the scope of its insurance coverage for abuse claims. The action was related to the
chapter 11 case of the Catholic Bishop of Northern Alaska (“Debtor”), which confirmed its plan
on February 13, 2010. Under the plan an abuse claimant could elect to be a Settlement Tort
Claim (as 253 out of 255 claimants did), and the claim would then be allowed and paid by the
settlement trust as determined by an arbitrator who could consider facts bearing on liability and
damage. The insurer, Catholic Mutual, claims that this arbitration provision breached the
corporation clause and its policies:
Catholic Mutual says it has been prejudiced because, under the
terms of the confirmed plan, the abuse claims are to be liquidated
under a binding arbitration procedure. These plan provisions
violate CBNA’s duty to cooperate under the occurrence based
policies and prejudice Catholic Mutual because they preclude
Catholic Mutual’s right to conduct suits regarding the abuse
claims. (Opinion at 56, ¶ 30.)
The Court ruled that the Debtor had breached the cooperation clause, and that the breach
was prejudicial to the insurer (Opinion at 57, ¶¶ 36-37.) It also ruled that the plan could not be
modified to eliminate the arbitration provision because it has been substantially consummated.
Id.
Further, the court considered whether the Debtor’s breach of the cooperation claims
might be excused by insurer misconduct -- which the trustee alleged to be the insurer’s refusal to
respond to a reasonable settlement offer regarding claims the insurer had agreed to defend. This,
asserted the trustee, breached a duty of good faith and fair dealing under the policies. The court
rejected that there was any such breach by the insurer because, at the time of the settlement offer
at issue, there were significant issues as to scope and amount of coverage, and the automatic stay
limited the insurer’s ability to investigate the claims and particularly the viability of a statute of
limitations defense. (Opinion at 59-60.)
In a final coup de grace, the bankruptcy judge ruled that it would enforce the arbitration
clause in a separate policy (a claims made policy) also at issue and require the trustee to submit
all disputes as to that policy to arbitration in accordance with that policy. (Opinion at 71.)
The bankruptcy court’s rulings were proposed findings and conclusions to the district
court, pursuant to 28 U.S.C. § 157(c)(1). The matter is now before the District Court.
2. Insurer Cannot Condition Settlement with Debtor
on Bar Order Releasing Non-Debtor Co-Insureds
In re GunnAllen Financial, Inc., 2011 WL 379778 (Bankr.M.D. Fla. Feb. 4, 2011).
In the Debtor’s main bankruptcy case, the Liquidating Agent under the Debtor’s
confirmed plan moved for approval of a settlement agreement (the “Motion to Approve”) one of

the Debtor’s liability insurers, American International Specialty Lines Insurance Co (“AISLIC”)
to settle claims made by certain of the Debtor’s customers arising out of securities transactions
(“Securities Claimants” and “Securities Claims”). Per the settlement agreement, AISLIC would
pay the remaining proceeds under the policies, which would be used to make partial distributions
to the Securities Claimants (less than 25% of their claims), general unsecured creditors, and the
claims arbitrator who determined the allowed amount of the Securities Claims.
The Securities Claimants asserted claims against not only the Debtor, but its
representatives, officers, and directors, and these non-debtor parties were also insureds under the
policies. The projected allowed amount of the Securities Claims exceeded the policy limits of
defense coverage for non-debtor parties (litigation against the Debtor was stayed) and indemnity
coverage against the Debtor.
The settlement agreement provided that the insurer would pay the full remaining amount
of remaining proceeds to the Liquidating Agent only if the Court entered a bar order permanently
enjoining the Securities Claimants from continuing pending arbitration and litigation against the
non-Debtor co-insureds. The settlement was opposed by the SEC.
First, the court satisfied itself as to its jurisdiction over the Motion to Approve, holding
that the policy was property of the bankruptcy estate, that the Court retained jurisdiction over the
matter post-confirmation, that the pending Securities Claims were “related to” the bankruptcy
proceeding, and that the Securities Claimants submitted to the Court’s jurisdiction by filing
proofs of claim. Slip op. at *4.
Next, the court cited Eleventh Circuit law holding that a settlement incorporating a third
party release or bar order should not be approved unless it is fair, adequate, and reasonable. The
Court noted that it was the Liquidating Agent’s claim for indemnity coverage under the policy
that was resolved by the settlement agreement, and that the settlement provided the estate with
the maximum recovery possible (the full remaining value of the proceeds) without compromising
any of the estate’s rights. Id.
The bar order, however, burdened the Securities Claimants, who were not parties to the
settlement agreement and did not have a right to opt out of the agreement, by settling their claims
with non-debtor co-insureds. The bar order forced the Securities Claimants to accept a
distribution of less than 25 percent on their claims, whereas the non-debtor co-insureds were
relieved of all personal liability in exchange for no payment whatsoever. The Court noted that
the payment of meaningful consideration, absent here, is a “key consideration” by courts in
considering whether to approve bar orders. Slip op. at *5. Finally, the Court found that the
settlement agreement was not necessary to settle the Debtor’s indemnity claims under the policy.
Although an insurer has a duty to try to settle as many claims against multiple insureds as
possible when the policy has insufficient funds to cover all claims, an insurer cannot expend
remaining policy proceeds on behalf of one insured only when all other insureds are released.
To the contrary, an insurer could be held to have acted in bad faith if it refuses to settle because
all other insureds are not released under a settlement. The Court held that the insurer does not
act in bad faith so long as it attempts to obtain releases for claims against non-debtor insureds,
even if it is unsuccessful, as it was here, because the Court deemed the settlement not fair and
equitable and would not impose it over the objections of the Securities Claimants. Slip op. at *6.
2

3. Automatic Stay and Discharge Injunction Do Not Protect
Third-Party Insurer; Circumstances In Which Court Will
Pierce the Corporate Veil between Insurer and Subsidiary
Tucker v. American International Insurance Group, Inc., 2010 WL 3925254 (D.Conn.
Sept. 30, 2010).
Plaintiff sought damages from her employer’s insurers, American International Group,
Inc. (“AIG”) and National Union Fire Insurance Company of Pittsburgh, PA (“National Union”),
arising out of her unlawful discharge, specifically to collect from the insurers her $4 million
judgment rendered in the district court in her favor against her employer Journal Register East
(the “Employer”), a debtor in bankruptcy. The insurers moved to dismiss.
First, the Court addressed the insurers’ argument that Plaintiff lacked standing under
Connecticut’s Direct Action Statute because she had not yet obtained a final judgment against
the insurers. Here, the Employer had filed post-judgment motions challenging the $4 million
judgment that were denied without prejudice because the Employer filed for bankruptcy. The
insurers asserted that, absent bankruptcy, it was likely the verdict would have been overturned or
the judgment reduced. Following the bankruptcy proceeding, Plaintiff and the Employer moved
to reopen the $4 million judgment and sought approval for a stipulation that reduced the
judgment amount and assigned all of the Employer’s rights in its coverage claim against the
insurers to Plaintiff. The insurers sought to intervene, opposing the stipulation sought by the
Employer and the Plaintiff. Given the “rather convoluted circumstances,” the Court denied
without prejudice the motion to dismiss with respect to the argument that Plaintiff has no final
judgment, pending the district court’s ruling on Plaintiff/Employer’s motion to reopen. Slip op.
at *6.
The Court next addressed and rejected the insurers’ argument that Plaintiff’s complaint
must include the Employer to avoid violating the automatic stay. The bankruptcy court had
expressly lifted the stay for the purpose of allowing Plaintiff to “proceed against the Insurer to
establish insurance coverage” and “to pursue the Claims against National Union and the [policy
at issue] to the limits of the [policy].” Slip op. at *7. The bankruptcy court had not granted
relief to the insurers to contest the underlying $4 million judgment because the insurers had
disclaimed coverage and the existence coverage had not yet been determined. The bankruptcy
court also noted (and the district court expressly agreed) that Plaintiff’s action against the
insurers would have been proper absent stay relief because the “stay does not ordinarily protect
third parties” such as the insurers. Id.
Similarly, the permanent discharge injunction of § 524(a) is designed to protect only the
debtor and not other parties, citing Second and Eleventh Circuit caselaw. In particular, the Court
found persuasive the Eleventh Circuit’s opinion in In re Jet Florida Systems, Inc., 883 F.2d 970
(11 th Cir. 1989), which held that “the insurance company should not be entitled to gain a benefit
[discharge] that was not intended or in any way computed within the rate charged for its policy.”
883 F.2d at 975. It also relied on Green v. Welsh, 956 F.2d 30, 33 (2d Cir. 1992). The court held
that Plaintiff may establish liability against the insurers “through whatever means are required”
and dismissed the insurers’ argument for dismissal on the point. Slip op. at *8.
Finally, the Court addressed the insurers’ argument that Plaintiff’s complaint failed to set
forth a claim against AIG because, as the parent company to National Union, it was not a party to
3

the policy at issue and may not be sued because the requisite facts to justify piercing the
corporate veil were lacking. The court examined the language of the policy and concluded that,
as a matter of law, AIG was not a party to the policy. The policy listed and specified only
National Union as the “insurer.” Plaintiff contended that because the name AIG appeared on the
policy, the policy was entitled “AIG Executive Liability”, and the cover letter was written by an
AIG vice president, but the Court noted that the policy made clear it was provided by an AIG
member company, i.e. the subsidiary National Union, and not AIG. Slip op. at *10-11.
However, the court held that Plaintiff pled sufficient facts to pierce the corporate veil and
include AIG as a defendant under the “instrumentality test” under Connecticut law, which
requires plaintiff to prove: 1) control by the parent of the finances and policies relating to the
transaction in question such that the subsidiary had no separate existence of its own; 2) that the
parent exercised control over the subsidiary in order to commit a fraudulent or unlawful act; and
3) the control and breach of duty proximately caused plaintiff’s injury. Slip op. at *12 (citing
Angelo Tomasso, Inc. v. Armor Construction & Paving, Inc., 447 A.2d 406, 410 (Conn. 1982).
Plaintiff’s allegations that AIG, together with National Union, sold the policy to the Employer,
wrote the accompanying cover letter, administered the policy by accepting notice of the claim
and assigning a case number, and eventually rejected the claim, led the Court to conclude it was
plausible that AIG stepped into the role of insurer under the policy such that National Union
appeared to have no separate will of its own with respect to the policy’s administration. Slip op.
at *13. Furthermore, because it was AIG that allegedly committed the act that proximately
caused Plaintiff’s damages by wrongfully and unilaterally closing the claim file and rejecting
Plaintiff’s claim. Id. Under these “exceptional circumstances” the Court concluded that, at this
early pleading stage of the proceedings, “it would be inequitable” to allow AIG to hide behind
National Union merely on the basis of National Union’s signature on the policy. Id. The Court
denied the motion to dismiss with prejudice with respect to claims that AIG was an improper
party.
4. No Sovereign Immunity for State Workers’ Comp
Agencies in Dispute Over Debtor’s Insurance Coverage
In re DPH Holdings Corp., 437 B.R. 88 (S.D.N.Y. 2010).
On October 8, 2005, Delphi filed for Chapter 11 protection. Shortly thereafter, it filed a
motion to assume certain insurance contracts with Ace American Insurance Company and
Pacific Employers Insurance Company, including retention policies providing excess workers’
compensation coverage (the “Retention Policies”) and deductible policies (the “Deductible
Policies”), which insured certain of Delphi’s affiliates not authorized as self-insurers under the
Michigan Worker’s Disability Compensation Act. Pursuant to the bankruptcy court’s order
granting this motion, obligations owing to Ace and Pacific from Delphi under the Policies were
accorded administrative expense priority.
In July 2009, the State of Michigan Workers’ Compensation Insurance Agency (the
“Agency”) sent the insurers notice of certain workers’ compensation claims filed by former
Delphi employees injured during the time that the insureres had filed notices of issuance of
policy with the Agency.
On October 26, 2009, the insurers filed an adversary complaint against Delphi, the
Agency and Funds Administration (the “Funds,” together with the Agency, the “Michigan
4

Defendants”) seeking a declaration that the Deductible Policies do not provide coverage for the
injured workers’ claims and that the Retention Policies provide only excess coverage of the
claims. In the alternative, the insurers asked the bankruptcy court to reform the Policies to
reflect the parties’ shared understanding that Delphi’s workers’ compensation obligations were
self-insured.
On November 10, 2009, the Michigan Defendants moved to dismiss the adversary
proceeding for lack of subject matter jurisdiction, sovereign immunity, and failure to state a
claim. In the alternative, the Michigan Defendants requested that the bankruptcy court abstain to
allow the Michigan courts and administrative bodies to resolve the dispute. Subsequently, on
January 26, 2010, the bankruptcy court entered an order finding that it had jurisdiction over the
adversary proceeding and that the Michigan Defendants were not entitled to sovereign immunity.
The Michigan Defendants then appealed the bankruptcy court’s January 26 order with regards to
the bankruptcy court’s sovereign immunity and subject matter jurisdiction determinations.
The district court first addressed the Michigan Defendants’ arguments related to the
bankruptcy court’s lack of subject matter jurisdiction, including that that the adversary
proceeding did not arise under or in title 11 of the United States Code and is not related to a case
under title 11 and that the bankruptcy court lacked post-confirmation jurisdiction. In its analysis,
the district court differentiated between core and non-core bankruptcy proceedings. A
bankruptcy court may hear and determine all cases under title 11 and all core proceedings arising
under title 11 or arising in a case under title 11. In contrast, in non-core proceedings, in which a
proceeding is “related to” cases under title 11, the bankruptcy court may only enter proposed
findings of fact and conclusions of law that are subject to de no review by the district courts.
The district court relied on the Second Circuit’s analysis in In re U.S. Lines to determine
whether the adversary proceeding was a core proceeding. In that case the Second Circuit
examined the following factors to determine whether a proceeding involving a contract was a
core proceeding: “(1) whether the contract is antecedent to the reorganization petition; and (2)
the degree to which the proceeding is independent of the reorganization.” Id. at 95 (citing U.S.
,United States Lines, Inc. v. American S.S. Owners Mut. Prot. & Indemn. Ass’n, Inc. (In re U.S.
Lines, Inc.), 197 F.3d 631, 637 (2d Cir. 1999)). The Second Circuit held that “proceedings can
be core by virtue of their nature if either (1) the type of proceeding is unique to or uniquely
affected by the bankruptcy court proceedings, or (2) the proceedings directly affect a core
bankruptcy function.” Id.
In applying the U.S. Lines factors to the adversary proceeding, the district court noted
that the adversary proceeding involved the determination of the allowance or disallowance of the
claims filed by the Michigan Funds as well as whether the insurers would be entitled to
administrative expenses. The district found that such determinations have an impact on the
distribution of Delphi’s estate to its creditors. Thus, the district court concurred with the
bankruptcy court’s conclusion that a declaratory judgment proceeding that provides for a
determination under title 11 of the operation of the Bankruptcy Court’s core functions, such as
allowance or disallowance of claims or the administration of the estate, is a core proceeding. Id.
at 96.
The district court also affirmed the bankruptcy court’s holding that it also had postconfirmation
jurisdiction over the adversary proceeding. In order for a bankruptcy to exercise
5

post-confirmation jurisdiction over a matter, the bankruptcy court must find that “(1) the matter
has a close nexus to the bankruptcy plan or proceeding, as when a matter affects the
interpretation, implementation, consummation, execution, or administration of the confirmed
plan and (2) that the plan provides for the retention of jurisdiction over the dispute.” Id. at 97
(citations omitted). Because the adversary proceeding related to “the core post-confirmation
bankruptcy function of dealing with claims against the estate and the estate’s remaining assets
for distribution.,” the bankruptcy court had jurisdiction over the bankruptcy proceeding. Id. at
98.
Next, the district court addressed the Michigan Defendants’ argument that they were
entitled to sovereign immunity and, therefore, should not be subject to the adversary proceeding.
Specifically, the Michigan Defendants argued that: (1) Congress did not abrogate the Michigan
Defendants’ sovereign immunity under 11 U.S.C. § 106; (2) the bankruptcy court erroneously
interpreted § 106(a); (3) the bankruptcy court’s decision was contrary to the automatic stay
provision; and (4) § 106(a), as applied in the case, was not enacted pursuant to valid
constitutional authorities. Id. at 98.
The district court found that because the bankruptcy court’s jurisdiction over the
adversary proceeding is required in order for it to effectuate its in rem jurisdiction over the
estate, the application of § 106 to the Michigan Defendants was within constitutional limits. Id.
Citing the Supreme Court’s decision in Central Virginia Community College v. Katz, 546 U.S.
365 (2006), the district court noted that sovereign immunity is abrogated with respect to
proceedings necessary to effectuate, or ancillary to, the bankruptcy court’s in rem jurisdiction.
Id. at 99 (citing In re Katz, 546 U.S. at 378). Because of its impact on the allowance and
disallowance of claims, the adversary proceeding represents an exercise of the bankruptcy
court’s in rem jurisdiction. Further, in the adversary proceeding, the insurers seek the
bankruptcy court’s determination of their liabilities under the Policies, which are assets of
Delphi’s estate. Such a determination is necessary to effectuate the bankruptcy court’s
jurisdiction over the estate and its equitable distribution.
The district court further disagreed with the Michigan Defendants’ argument that the
bankruptcy court failed to correctly interpret § 106(a)(2) to permit the exercise of jurisdiction
over the Michigan Defendants without regard to state sovereign immunity in connection with
Sections 502 and 503 of the Bankruptcy Code. Sections 502 and 503 pertain to the allowance of
claims or interest and the allowance of administrative expenses, respectively. The district court
agreed with the bankruptcy court’s holding that § 106(a) does not require that the governmental
units themselves must file a claim or that a claim made by a governmental unit must be affected
by the outcome of the bankruptcy proceeding in order for § 106(a)(2) to apply §§ 502 and 503 to
the Michigan Defendants.
The Michigan Defendants also argued that Congress violated its constitutional authority
under Article I of the Constitution when it enacted § 106. Once again citing to the Supreme
Court’s decision in Katz, the district court found that the Michigan Defendants incorrectly
viewed abrogation in the context of bankruptcy law as an exercise of Congress’s power pursuant
to Article I. Rather, the source of abrogation of state sovereign immunity in the context of
bankruptcy law is the states’ ratification of the Constitution.
6

Lastly, the district court rejected the Michigan Defendants’ argument that the bankruptcy
court misinterpreted § 106 in a contrary manner to the goals and rational of § 362(b)(4). Noting
that § 362(b)(4) makes no reference to state sovereign immunity, the court found that the
provision supports a broad reading of § 106, permitting the bankruptcy court to preside over all
disputes concerning the debtor’s estate, including those involving governmental units. Id. at 102.
5. Cause Exists for Permissive Withdrawal of the Reference, but
Bankruptcy Court Can and Should Retain Jurisdiction over all Pretrial Matters
GunnAllen Financial, Inc. v. U.S. Specialty Insurance Company (In re GunnAllen
Financial, Inc.), 2011 WL 398054 (M.D. Fla. Feb 3, 2011).
Defendant U.S. Specialty Insurance Company (“USSIC”) issued D&O policies to
Plaintiffs broker-dealer GunnAllen Financial, Inc. (“GAF”) and GAF’s parent company
GunnAllen Holdings, Inc. (”GAH”) prior to GAF filing for bankruptcy. USSIC denied coverage
for GAF, GAH, and certain directors and officers of GAF. Post-confirmation, Plaintiffs filed an
adversary proceeding asserting a claim for declaratory relief for coverage under the policies,
breach of contract due to the denial of coverage, and attorneys’ fees. USSIC moved to withdraw
the reference, asserting that the adversary proceeding was non-core, GAF lacked standing to
bring the adversary complaint, and that USSIC’s request for a jury trial required withdrawal.
The policies at issue provided A-side coverage for directors and officers, and B-side
coverage for GAF and GAH. The policies provided that the insurer would first pay any loss
payable under A-side coverage, and if the insurer concluded that the amount of loss was likely to
exceed $5,000,000, the insurer could withhold some or all of the loss payable under B-side
coverage to ensure that as much of the $5,000,000 as possible was available for A-side coverage.
Considering whether “cause” existed to warrant permissive withdrawal of the reference,
the district court did not decide whether the adversary proceeding was core or non-core, because
the bankruptcy court had made no ruling on that issue. It further noted that the confirmation
order did not weigh in favor or against withdrawal because, although it indicated an intent for the
bankruptcy court to retain jurisdiction over disputes surrounding the insurance policies “to the
greatest extent permitted by applicable law,” it also stated that the insurance companies had the
right to challenge that bankruptcy court jurisdiction. Slip op. at *3.
USSIC argued that GAF (the debtor) did not have standing to bring the adversary
proceeding because GAF and GAH’s interest in B-side coverage was subordinate to the
directors’ and officers’ interest in A-side coverage. The district court held that, although the
directors and officers (under A-side coverage) had a superior interest in the policies, GAF (the
debtor) could recover under the policies if the loss were less than $5,000,000, which was
possible given the limited facts before the Court. As such, GAF had standing to assert a
coverage claim. Slip op. at *4.
USSIC also argued that its demand for a jury trial alone required withdrawal of the
reference. The parties agreed that USSIC was entitled to a jury trial on the breach of contract
claim and that the reference had to be withdrawn for the jury trial. However, the district court
ruled that the bankruptcy court would retain jurisdiction over all pretrial matters, citing cases
holding that the bankruptcy court can retain jurisdiction from discovery through dispositive
7

motions and that judicial resources (and resources of the parties) would be conserved by having
the bankruptcy court address all preliminary matters. Id.
In sum, the court found that USSIC established cause for permissive withdrawal but
granted the motion to withdraw only as to the jury trial and jury selection; all pretrial matters
were left to the bankruptcy court. The district court directed USSIC to move to reopen the case
after the bankruptcy court addressed all pretrial matters.
14941804\V-1
8

Recent Developments Affecting Chapter 11 Cases
"…The Commission charged with reviewing the bankruptcy laws
in the lead-up to the enactment of the Bankruptcy Code
suggested loosening the absolute priority rule to allow greater
participation by equity owners. See Bruce A. Markell, Owners,
Auctions, and Absolute Priority in Bankruptcy Reorganizations,
44 Stan. L. Rev. 70, 87-89 & n.117 (1991). Yet, although
Congress did soften the absolute priority rule in some ways, it
did not create any exception for 'gifts' like the one at issue here.
See also H.R. Rep. 95-595, 1978 U.S.C.C.A.N. 5963, 6372
(1977) (noting that absolute priority rule was “designed to
prevent a senior class from giving up consideration to a junior
class unless every intermediate class consents, is paid in full, or
is unimpaired”). We therefore hold that the bankruptcy court
erred in confirming the plan of reorganization."
Prepared for Task Force on Current
Developments of Business Bankruptcy
Subcommittee of the Section of
Business Law of the American Bar
Association
Spring Meeting: April 2011
DISH Network Corp. v. DBSD North
America, Inc. (In re DBSD North
America, Inc.), ___ F.3d ___ (2d
Cir., filed Feb. 7, 2011)(2-1) (Slip
Op. at 37)(footnotes omitted).
Martin J. Bienenstock
DEWEY & LEBOEUF LLP

Table of Contents
RECENT DEVELOPMENTS AFFECTING CHAPTER 11 CASES .......................................0
TABLE OF CONTENTS.................................................................................................................I
1. SECTION 363 SALES FREE AND CLEAR V. SUB ROSA CHAPTER 11
PLANS ...............................................................................................................................1
A. INDIANA STATE POLICE PENSION TRUST V. CHRYSLER LLC (IN RE CHRYSLER
LLC), 592 F.3D 370 (2D CIR., AUGUST 5, 2009), CERT. GRANTED, JUDGMENT
VACATED WITH INSTRUCTIONS TO DISMISS APPEAL AS MOOT, 558 U.S. ___, ORDER
09-285 (DECEMBER 14, 2009).............................................................................................1
i. Facts........................................................................................................................1
ii. Issues ......................................................................................................................1
iii. Holdings..................................................................................................................2
iv. Rationale.................................................................................................................3
v. Analysis ..................................................................................................................3
2. “THE FRENVILLE ACCRUAL TEST SHOULD BE AND NOW IS
OVERRULED.” THAT SIMPLE? ..................................................................................5
A. JELD-WEN, INC. V. BRUNT (IN RE GROSSMAN’S INC.), 607 F.3D 114, 121 (3D
CIR. 2010)..........................................................................................................................5
i. Facts ......................................................................................................................5
ii. Issues.....................................................................................................................6
iii. Holding...................................................................................................................6
iv. Analysis .................................................................................................................7
3. THE BANKRUPTCY CODE DOES NOT PER SE DISALLOW PREPETITION
CLAIMS FOR ATTORNEYS’ FEES INCURRED LITIGATING
POSTPETITION BANKRUPTCY ISSUES ....................................................................10
A. TRAVELERS CASUALTY & SURETY CO. OF AMERICA V. PACIFIC GAS & ELECTRIC
CO., 549 U.S. 443 (2007) ..................................................................................................10
i. Facts......................................................................................................................10
ii. Issue......................................................................................................................10
iii. Holding .................................................................................................................10
iv. Rationale...............................................................................................................11
B. VIOLATION OF TRAVELERS? – NATIONAL ENERGY & GAS TRANSMISSION, INC. V.
LIBERTY ELECTRIC POWER, LLC (IN RE NATIONAL ENERGY & GAS
TRANSMISSION, INC.), 492 F.3D 297 (4TH CIR. 2007), REHEARING DENIED (AUGUST
6, 2007).............................................................................................................................11
i. Facts......................................................................................................................12
ii. Issues ....................................................................................................................12
iii. Judgments .............................................................................................................12
iv. Rationale...............................................................................................................13
v. Analysis and Implications.....................................................................................13
1. The Judgment’s Reliance on “principles of equity” Does Not Identify the Equity
Accomplished because There is None..................................................................................13
2. The Judgment Yields Illogical and Absurd Consequences Demonstrating its Fallacy 15
3. The Judgment Resulted from Arbitrary Sequencing....................................................16
4. The Judgment Undermines Public Policy ....................................................................16
i

C. TRAVELERS AND 11 U.S.C. § 1123(D) SUPPORT DEFAULT RATE INTEREST IN
GENERAL ELECTRIC CAPITAL CORP. V. FUTURE MEDIA PRODUCTIONS INC., 536
F.3D 969 (9 TH CIR. 2008) ...................................................................................................16
i. Facts......................................................................................................................16
ii. Issues ....................................................................................................................17
iii. Holdings................................................................................................................17
iv. Rationale...............................................................................................................18
v. Analysis ................................................................................................................18
4. NON-DEBTORS CAN NOT DEPRIVE DEBTORS POSTPETITION OF THE
OPTION TO ASSUME OR REJECT EXECUTORY CONTRACTS.............................18
A. COR ROUTE 5 CO. V. PENN TRAFFIC CO. (IN RE PENN TRAFFIC CO.), 524 F.3D 373
(2D CIR. 2008)...................................................................................................................18
i. Facts......................................................................................................................18
ii. Issues ....................................................................................................................19
iii. Holding .................................................................................................................19
iv. Rationale...............................................................................................................19
v. Analysis ................................................................................................................20
B. SPECIFIC PERFORMANCE ...................................................................................................22
i. Specific Performance under the UCC...................................................................22
ii. Specific Performance of Real Property Sales Granted by the Bankruptcy
Code......................................................................................................................24
iii. Rights to Specific Performance Are Often Nondischargeable..............................32
5. WHAT ARE THE STANDARDS FOR DESIGNATING VOTES
PURSUANT TO BANKRUPTCY CODE SECTION 1126(E)?.................................40
A. BANKRUPTCY CODE SECTION 1126(E) PROVIDES: .........................................................40
B. BACKGROUND...................................................................................................................40
C. IN RE DBSD NORTH AMERICA, INC., 421 B.R. 133 (BANKR. S.D.N.Y.
2009); IN RE DBSD NORTH AMERICA, INC., 419 B.R. 179 (BANKR.
S.D.N.Y. 2009), AFF'D, 2010 U.S. DIST. LEXIS 33253 (S.D.N.Y., MARCH
24, 2010), REVERSED BASED ON VIOLATION OF ABSOLUTE
PRIORITY RULE AND AFFIRMED AS TO VOTE DESIGNATION, DISH
NETWORK CORP. V. DBSD NORTH AMERICA, INC. (IN RE DBSD
NORTH AMERICA, INC.), 627 F.3D 496 (2D CIR. 2010)(SUMMARY
ORDER) AND DOCKET NOS. 10-1175, 1201, 1352 (2D CIR., FILED
FEB. 7, 2011)(“SLIP OP.”)............................................................................................47
i. Facts......................................................................................................................47
i. Valuation Issue...................................................................................................51
ii. Holding.................................................................................................................51
ii. Rationale .............................................................................................................51
iii. Designation of DISH' Rejection of First Lien Treatment...............................52
iv. Confirmation........................................................................................................67
v. Expected Aftermath of DBSD...........................................................................70
6. PERILS OF DISAPPROVED POSTPETITION LENDING. .....................................71
A. ALFS V. WIRUM (IN RE STRAIGHTLINE INVESTMENTS, INC.), 525 F.3D 870 (9 TH
CIR. 2008)........................................................................................................................71
i. Facts......................................................................................................................71
ii. Issues ....................................................................................................................71
iii. iii. Holdings ..........................................................................................................72
ii

iv. Rationale...............................................................................................................72
v. Punitive Damages? ...............................................................................................73
7. ARE TRIANGULAR SETOFF AGREEMENTS ENFORCEABLE IN TITLE 11
CASES?............................................................................................................................73
A. IN RE SEMGROUP, L.P., 399 B.R. 388 (BANKR. D. DEL. 2009) (BLS)...............................73
i. Facts......................................................................................................................73
ii. Issues ....................................................................................................................74
iii. Holdings................................................................................................................75
iv. Rationale...............................................................................................................75
v. Analysis ................................................................................................................78
8. MUCH DIMINISHED STATE SOVEREIGN IMMUNITY IN THE
BANKRUPTCY COURT.................................................................................................94
A. CENTRAL VIRGINIA COMMUNITY COLLEGE V. KATZ, 546 U.S. 356, 126 S. CT. 990
(2006) ...............................................................................................................................94
i. Facts......................................................................................................................94
ii. Issue......................................................................................................................95
iii. Holding .................................................................................................................95
iv. Rationale...............................................................................................................96
B. TENNESSEE STUDENT ASSISTANCE CORPORATION V. HOOD, 124 S. CT. 1905
(2004) ...............................................................................................................................98
i. Facts......................................................................................................................99
ii. Issue......................................................................................................................99
iii. Holding. ................................................................................................................99
iv. Rationale...............................................................................................................99
v. The Eleventh Amendment provides: ..................................................................100
C. SUPREME COURT PRECEDENTS GOVERNING ENFORCEMENT OF FEDERAL
BANKRUPTCY LAW AGAINST STATES..............................................................................100
i. The Discharge of a Debt by a Bankruptcy Court...............................................100
ii. States are Bound by Bankruptcy Discharges Whether They Participate or Not .100
iii. But, Bankruptcy Court Enforcement of a Bankruptcy Discharge against a
State is An Open Question..................................................................................100
iv. Sales Free and Clear ...........................................................................................101
D. HOOD’S UNANSWERED QUESTION: WHETHER CONGRESS CAN
CONSTITUTIONALLY ABROGATE STATES’ SOVEREIGN IMMUNITY FROM PRIVATE
SUITS UNDER THE BANKRUPTCY CODE ...........................................................................101
7. STATE LAW CAN NOT OUST FEDERAL BANKRUPTCY COURTS OF
SUBJECT MATTER JURISDICTION GRANTED BY 28 U.S.C. § 1334 ...................105
A. MARSHALL V. MARSHALL, 126 S. CT. 1735 (2006).........................................................105
i. Facts....................................................................................................................105
ii. Issue....................................................................................................................106
iii. Holding. ..............................................................................................................106
B. BUT, BANKRUPTCY JURISDICTION BY AMBUSH IS NOT EASY IN THE NINTH
CIRCUIT (MARSHALL V. STERN (IN RE MARSHALL), 600 F.3D 1037 (9 TH
CIR.
2010), CERT. GRANTED, STERN V. MARSHALL, 177 L. ED. 2D 1152; 2010 U.S.
LEXIS 5746; 79 U.S.L.W. 3194 (SEPT. 28, 2010).....................................................106
i. 28 U.S.C. § 157(b)(2)(C) provides a core proceeding includes:...............106
ii. Prior Jurisprudence Underlying Jurisdiction by Ambush............................107
iii

iii. Ninth Circuit Rejects Jurisdiction by Ambush ..............................................111
iv. Analysis .............................................................................................................113
8. WHEN MUST VALID CLAIMS UNDER STATE LAW BE DISCOUNTED TO
BE ALLOWABLE UNDER BANKRUPTCY LAW?...................................................114
A. IN RE OAKWOOD HOMES CORPORATION, 449 F.3D 588 (3D CIR. 2006)(2-1) ..................114
i. Facts....................................................................................................................114
ii. Issue....................................................................................................................115
iii. Holding ...............................................................................................................115
iv. Rationale.............................................................................................................115
v. An Easier Way....................................................................................................116
B. WHEN DEBT IS RESTRUCTURED BY EXCHANGING DEBT, FOR DEBT IN THE SAME
FACE AMOUNT WITH DIFFERENT COVENANTS, THE DIFFERENCE BETWEEN THE
NEW DEBT’S TRADING VALUE AND PAR IS NOT UNALLOWABLE ORIGINAL ISSUE
DISCOUNT .......................................................................................................................116
i. Facts....................................................................................................................117
ii. History ................................................................................................................117
iii. Analysis ..............................................................................................................117
iv. In re Chateaugay Corp., 961 F.2d 378 (2d Cir. 1992); In re Pengo Industries,
Inc., 962 F.2d 543 (5th Cir. 1992). .....................................................................117
v. The Constant Interest Method Measures Original Issue Discount.....................117
9. LIMITS AND EXTENSIONS OF OFFICIAL UNSECURED CREDITORS'
COMMITTEE V. STERN (IN RE SPM MANUFACTURING CORP.), 984 F.2D
1305 (1ST CIR. 1993) ....................................................................................................118
A. OFFICIAL UNSECURED CREDITORS' COMMITTEE V. STERN (IN RE SPM
MANUFACTURING CORP.), 984 F.2D 1305 (1ST CIR. 1993) .............................................118
i. Facts....................................................................................................................118
ii. Issue....................................................................................................................119
iii. Holding ...............................................................................................................119
iv. Rationale.............................................................................................................120
v. Implications ........................................................................................................120
B. IN RE ARMSTRONG WORLD INDUSTRIES, 432 F.3D 507 (3D CIR. 2005) ...................................121
v. Facts....................................................................................................................121
vi. Issues ..................................................................................................................122
vii. Holdings..............................................................................................................122
iv. Analysis ..............................................................................................................123
C. LIMITS AND EXTENSIONS OF SPM............................................................................................123
i. After Armstrong, Secured Claimholders Can Still Voluntarily Cede Collateral
Proceeds to General Creditors, Skipping Priority Creditors (In re World
Health Alternatives, Case No. 06-10166 (Bankr. D. Del., July 7, 2006))...........123
ii. Transferring Property Outside a Chapter 11 Plan May Be Permissible when The
Same Transfers Inside a Plan May be Barred .....................................................125
iii. Some Courts Allow Senior and Secured Creditors to Use Chapter 11 Plans to
Reallocate Their Distributions to Other Creditors Not Otherwise Entitled to
Them...................................................................................................................126
10. WHAT ARE THE STANDARDS FOR SUBSTANTIVE CONSOLIDATION?..........126
A. CREDIT SUISSE FIRST BOSTON V. OWENS CORNING (IN RE OWENS CORNING), 419
F.3D 195 (3D CIR. 2005), AMENDED, 2005 U.S. APP. LEXIS 18043 (3D CIR.,
AUGUST 23, 2005), CERT. DEN. 2006 U.S. LEXIS 3492, 3493 (U.S., MAY 1, 2006)........126
iv

i. Facts....................................................................................................................127
ii. History ................................................................................................................127
iii. Holding ...............................................................................................................127
iv. Rationale.............................................................................................................129
B. PRINCIPLES UNDERLYING SUBSTANTIVE CONSOLIDATION..............................................130
i. Authority for Substantive Consolidation ............................................................130
ii. Reasons Why All Appellate Courts Rule Substantive Consolidation Must Be
Used Only Sparingly...........................................................................................131
iii. Substantive Consolidation is Not Based on a Scoring System of
Miscellaneous Indicia of Corporate Overlap ......................................................132
iv. Use of a Subsidiary to Benefit the Parent Company Does Not Justify
Piercing the Subsidiary’s Corporate Form..........................................................133
v. Use of a Subsidiary to Benefit the Parent Directly or Indirectly Does Not
Justify Avoidance of Intercompany Debt ...........................................................135
vi. Use of Subsidiaries to Minimize Taxes Does Not Render Their Corporate
Form Illegitimate ................................................................................................136
vii. Substantive Consolidation Can Not Be Ordered Based on a Balancing of
Benefits and Burdens..........................................................................................136
viii. When Substantive Consolidation is Ordered, Creditors Who Relied on the
Separateness of an Entity Being Consolidated Are Entitled to Priority Claims
against the Entity ................................................................................................139
11. HOW DO ‘X-CLAUSES’ WORK? ...............................................................................140
A. DEUTSCHE BANK, AG V. METROMEDIA FIBER NETWORK, INC. (IN RE METROMEDIA
FIBER NETWORK, INC.), 416 F.3D 136 (2D CIR. 2005).....................................................140
i. Facts....................................................................................................................140
ii. Issue....................................................................................................................141
iii. Holding. ..............................................................................................................141
iv. Rationale.............................................................................................................141
v. Analysis. .............................................................................................................141
12. WHEN DO LEASE ASSIGNMENTS RENDER APPEALS MOOT PURSUANT
TO 11 U.S.C. § 363(M)? ................................................................................................142
A. WEINGARTEN NOSTAT, INC. V. SERVICE MERCHANDISE COMPANY, INC., 396 F.3D 737
(6 TH CIR. 2005) ................................................................................................................142
i. Facts....................................................................................................................142
ii. Issue....................................................................................................................142
iii. Holding. ..............................................................................................................142
iv. Rationale.............................................................................................................143
B. MADE IN DETROIT, INC. V. OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF MADE
IN DETROIT, INC. (IN RE MADE IN DETROIT, INC.), 414 F.3D 576 (6 TH CIR., 2005) ..........143
i. Facts....................................................................................................................143
ii. Issue....................................................................................................................143
iii. Holding. ..............................................................................................................143
iv. Rationale.............................................................................................................143
13. DOES 11 U.S.C. § 363(F) AUTHORIZE A SALE FREE OF A LESSEE’S
POSSESSORY INTERESTS PRESERVED ON LEASE REJECTION BY 11
U.S.C. § 365(H)? ............................................................................................................144
A. PRECISION INDUSTRIES, INC. V. QUALITECH STEEL SBQ, LLC (IN RE QUALITECH STEEL
CORP.), 327 F.3D 537 (7 TH CIR. 2003)..............................................................................144
i. Facts....................................................................................................................144
v

ii. Holding ...............................................................................................................145
iii. Rationale.............................................................................................................145
iv. Precision Industries Is Right for the Wrong Reasons: Section 365(h) Does
Not Elevate a Lessee’s Possessory Right Above a Prior Mortgagee’s
Undersecured Lien; But Sections 363(f), 363(l), and 365(h), Can Not
Correctly be Interpreted to Empower a Court to Divest a Lessee of Its
Possessory Rights under Section 365(h).............................................................146
a) The Lease’s Susceptibility to Extinguishment in a Mortgage Foreclosure Is
Dispositive .........................................................................................................................146
b) The Plain Meaning of Sections 363(l) and 365(h)(1)(A)(ii) Was Disregarded..........147
c) The Seventh Circuit’s Interpretation Yields Absurd Results Contrary to the United
States Supreme Court’s Rule that Statutory Interpretation Should Avoid Absurd Results 151
14. CRAM DOWN INTEREST RATES NEED NOT RENDER THE LENDER
SUBJECTIVELY INDIFFERENT BETWEEN PRESENT FORECLOSURE
AND FUTURE PAYMENTS.........................................................................................157
A. TILL V. SCS CREDIT CORP., 124 S. CT. 1951 (2004)(CHAPTER 13)..........................................157
i. Facts....................................................................................................................157
ii. Issue....................................................................................................................158
iii. Holding. ..............................................................................................................158
iv. Rationale.............................................................................................................159
v. A New Twist on Statutory Interpretation............................................................160
B. BANK OF MONTREAL V. OFFICIAL COMMITTEE OF UNSECURED CREDITORS (IN RE
AMERICAN HOMEPATIENT, INC.), 420 F.3D 559 (6 TH CIR. 2005)......................................161
i. Facts....................................................................................................................161
ii. Issue....................................................................................................................161
iii. Holding. ..............................................................................................................161
iv. Rationale.............................................................................................................161
v. Other Cramdown Interest Rate Decisions Since Till ..........................................161
C. OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. DOW CORNING CORP., 456
F.3D 668 (6 TH CIR. 2006) .................................................................................................162
i. Facts....................................................................................................................162
ii. Issues ..................................................................................................................162
iii. Holdings..............................................................................................................162
iv. Rationale.............................................................................................................163
15. BARTON V. BARBOUR, 104 U.S. 126 (1881), IS ALIVE AND WELL. ...................164
A. BECK V. FORT JAMES CORP. (IN RE CROWN VANTAGE, INC.), 421 F.3D 963 (9 TH
CIR. 2005) .......................................................................................................................164
i. Facts....................................................................................................................164
ii. Issues. .................................................................................................................166
iii. Holdings..............................................................................................................166
iv. Rationale.............................................................................................................167
16. ONLY THE DEBTOR IN POSSESSION/TRUSTEE CAN INVOKE 11 U.S.C. §
506(C).............................................................................................................................168
A. HARTFORD UNDERWRITERS INSURANCE CO. V. UNION PLANTERS BANK, 120 S.
CT. 1942 (2000) (SCALIA, J.)...........................................................................................168
i. Facts....................................................................................................................168
ii. Holding ...............................................................................................................169
iii. Unanswered Questions .......................................................................................169
iv. Lessons Learned. ................................................................................................170
vi

17. CAN COURTS GRANT DERIVATIVE STANDING TO PARTIES IN
INTEREST TO BRING AVOIDANCE ACTIONS? .....................................................170
A. OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF CYBERGENICS CORP., ON
BEHALF OF CYBERGENICS CORP., DEBTOR IN POSSESSION V. CHINERY,330 F.3D 548
(3D CIR. 2003), REPLACING 304 F.3D 316(3D CIR. 2002)(3-0), VACATED AND
REHEARING EN BANC GRANTED, 310 F.2D 785 (3D CIR., 2002) .......................................171
i. Facts....................................................................................................................171
ii. Issue....................................................................................................................171
iii. Holding. ..............................................................................................................171
iv. Bankruptcy Code Sections 506(c) and 544(b). ...................................................171
v. Rationale.............................................................................................................172
vi. Reasons Cybergenics En Banc is Correct...........................................................172
1. Defining “the trustee may” in section 544(b)(1) as “only the trustee/debtor in
possession may” does not resolve the question whether the trustee/debtor in possession may
avoid a transfer by authorizing a creditors’ committee to sue in the debtor in possession’s
name .................................................................................................................172
2. Interpreting Section 544(b)(1) to Bar Derivative Actions, Renders Section
503(b)(3)(B) a Practical Absurdity ...................................................................................176
3. 11 U.S.C. § 1123(b)(3) Does Not Support Barring Derivative Actions.....................178
4. The Panel Decision in Cybergenics Violated the Rule of Statutory Construction in
Midlantic National Bank v. New Jersey Department of Environmental Protection, 474 U.S.
494 (1986), to Continue Pre-Code Law Absent a Showing of Congressional Intent to
Change It . ................................................................................................................180
5. The Panel Decision in Cybergenics Undermined Two Vital Congressional Policies
. 182
6. Barring Derivative Actions Would Violate the Rule of Construction in Dewsnup v.
Timm, 502 U.S. 410 (1992), Under Which The Same Statutory Language Must Be
Interpreted Differently In Two Provisions To Continue Pre-Code Law Unless Congress
Evidences An Intent To Change It . ..................................................................................184
B. SMART WORLD TECHNOLOGIES, LLC V. JUNO ONLINE SERVICES, INC. (IN RE
SMART WORLD TECHNOLOGIES, LLC), 423 F.3D 166 (2D CIR. 2005).............................186
i. Facts....................................................................................................................186
ii. Issue....................................................................................................................187
iii. Holding ...............................................................................................................187
iv. Rationale.............................................................................................................187
C. ACC BONDHOLDER GROUP V. ADELPHIA COMMUNICATIONS CORP. (IN RE
ADELPHIA COMMUNICATIONS CORP.), 361 B.R. 337 (S.D.N.Y. 2007) ...........................187
i. Facts....................................................................................................................188
ii. Issue....................................................................................................................188
iii. Holding ...............................................................................................................188
iv. Rationale.............................................................................................................188
v. Subsequent History.............................................................................................189
vi. A Recent Strike against Equitable Mootness: Schroeder v. New Century
Liquidating Trust (In re New Century TRS Holdings, Inc.), ___ B.R. ___ (D.
Del. 2009) ...........................................................................................................190
(a) Facts .........................................................................................................................190
(b) Issue .........................................................................................................................191
(c) Holding.....................................................................................................................191
(d) Rationale ..................................................................................................................191
18. DOES A STATUTORY COMMITTEE REQUIRE COURT APPROVAL OR
DEBTOR/TRUSTEE CONSENT TO COMMENCE AN ADVERSARY
PROCEEDING THE BANKRUPTCY CODE DOES NOT ASSIGN
EXCLUSIVELY TO THE TRUSTEE? .......................................................................192
vii

A. OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. HALIFAX FUND, L.P. (IN RE
APPLIED THEORY CORP.), 493 F.3D 82 (2D CIR. 2007)..............................................192
i. Facts....................................................................................................................192
ii. Holding ...............................................................................................................192
iii. Rationale.............................................................................................................192
iv. Analysis ..............................................................................................................193
19. CAN CREDITORS COMMENCE DERIVATIVE ACTIONS WITHOUT
CONSENT OR COURT APPROVAL? .........................................................................197
A. PW ENTERPRISES, INC. V. NORTH DAKOTA RACING COMMISSION (IN RE RACING
SERVICES, INC.), 540 F.3D 892 (8 TH CIR. 2008)................................................................197
i. Facts....................................................................................................................197
ii. Issues ..................................................................................................................198
iii. Holdings..............................................................................................................198
iv. Analysis ..............................................................................................................199
B. AFTER DERIVATIVE STANDING IS GRANTED, IT CAN BE TAKEN AWAY..........................200
i. Official Committee of Equity Security Holders v. Official Committee of
Unsecured Creditors (In re Adelphia Communications Corp.), 544 F.3d 420
(2d Cir. 2008) .....................................................................................................200
a) Facts...........................................................................................................................200
b) Issues.........................................................................................................................200
c) Holding......................................................................................................................200
d) Analysis.....................................................................................................................201
C. DOES THE TRANSFER OF A CLAIM RENDER THE TRANSFEREE VULNERABLE TO
DEFENSES PERSONAL TO THE TRANSFEROR? ..................................................................201
1. Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R.
425 (S.D.N.Y. 2007), motion for certification of interlocutory appeal denied,
2007 Dist. LEXIS 70731 (S.D.N.Y., Sept. 2, 2007). ..........................................201
i. Facts ...........................................................................................................................201
ii. Issue...........................................................................................................................202
iii. Holding.....................................................................................................................202
iv. Rationale...................................................................................................................203
v. Analysis .....................................................................................................................204
20. MUST A CHAPTER 11 PETITION BE FILED WITH A “VALID
REORGANIZATIONAL PURPOSE? ...........................................................................207
A. OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. NUCOR CORP. (IN RE SGL
CARBON CORPORATION), 200 F.3D 154 (3D CIR. 1999) ..................................................207
i. Facts....................................................................................................................207
ii. Holding. ..............................................................................................................208
iii. Analysis. .............................................................................................................208
B. SOLOW V. PPI ENTERPRISES (U.S.), INC. (IN RE PPI ENTERPRISES (U.S.), INC.) 324
F.3D 197 (3D CIR. 2003)..................................................................................................209
i. Facts....................................................................................................................209
ii. Issues ..................................................................................................................211
iii. Holdings..............................................................................................................212
iv. Rationale and Evaluation....................................................................................213
C. NMSBPCSLDHB, L.P. V. INTEGRATED TELECOM EXPRESS, INC. (IN RE
INTEGRATED TELECOM EXPRESS, INC.), 384 F.3D 108 (3D CIR. 2004), REHEARING
DENIED, 389 F.3D 423 (3D CIR. 2004) .............................................................................216
i. Facts....................................................................................................................216
viii

ii. Issue....................................................................................................................217
iii. Holding. ..............................................................................................................217
iv. Rationale.............................................................................................................218
v. Analysis. .............................................................................................................219
D. SANTA FE MINERALS, INC. V. BEPCO, L.P. (IN RE 15375 MEMORIAL CORP.), 589 F.3D
605 (3D CIR. 2009)..........................................................................................................220
i. Facts ...........................................................................................................................220
ii. Issue....................................................................................................................222
iii. Holding ...............................................................................................................222
iv. Rationale.............................................................................................................222
E. IN RE GENERAL GROWTH PROPERTIES, INC., 409 B.R. 43 (BANKR. S.D.N.Y. 2009).......222
i. Facts....................................................................................................................223
ii. Issue............................................................................................................................224
iii. Holding ...............................................................................................................224
iv. Rationale.............................................................................................................224
21. THE INTERFACE OF STATE LAW CORPORATE GOVERNANCE AND
BANKRUPTCY LAW ...................................................................................................226
A. ESOPUS CREEK VALUE LP V. MARKS, 913 A.2D 593 (DEL. CH. 2006).....................................226
i. Facts 226
ii. Issue....................................................................................................................227
iii. Holding ...............................................................................................................227
iv. Rationale.............................................................................................................228
v. Analysis ..............................................................................................................228
B. NO FIDUCIARY DUTIES TO CREDITORS: NORTH AMERICAN CATHOLIC
EDUCATIONAL PROGRAMMING FOUNDATION, INC. V. GHEEWALLA, 930 A.2D 92
(DEL. 2007).....................................................................................................................230
i. Facts....................................................................................................................230
ii. Issue....................................................................................................................231
iii. Holding ...............................................................................................................231
iv. Rationale.............................................................................................................231
v. Aftermath............................................................................................................233
vi. What of the Trust Fund Doctrine? ......................................................................233
C. DEEPENING INSOLVENCY: TRENWICK AMERICA LITIGATION TRUST V. ERNST &
YOUNG, L.L.P., 906 A.2D 168 (DEL. CH. 2006), AFF’D TRENWICK AMERICA
LITIGATION TRUST V. BILLETT, 2007 DEL LEXIS 357 (DEL., AUG. 14, 2007)................235
i. Facts....................................................................................................................235
ii. Issues ..................................................................................................................236
iii. Holding ...............................................................................................................236
iv. Rationale.............................................................................................................238
v. But, Is Deepening Insolvency a Valid Damage Measure for Breach of a
Director's Fiduciary Duties of Care, Loyalty, or Good Faith? See Miller v.
McCown DeLeeuw & Co. (In re The Brown Schools), 386 B.R. 37 (Bankr.
D. Del. 2008). .....................................................................................................240
1. Facts...........................................................................................................................240
2. Issues .........................................................................................................................242
3. Holdings ....................................................................................................................242
4. Analysis .....................................................................................................................243
D. LOAN TO OWN: OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF RADNOR
HOLDINGS CORP. V. TENENBAUM CAPITAL PARTNERS (IN RE RADNOR HOLDINGS
CORP.), 353 B.R. 820 (BANKR. D. DEL. 2006) ................................................................251
ix

i. Facts....................................................................................................................251
ii. Issues ..................................................................................................................251
iii. Holdings..............................................................................................................252
iv. Rationale.............................................................................................................252
22. CRITICAL VENDOR PAYMENTS OF PREPETITION CLAIMS: IN RE KMART
CORP., 359 F.3D 866 (7 TH CIR. 2004), REHEARING DENIED, 2004 U.S. APP.
LEXIS 9050, (7 TH CIR. MAY 6, 2004), CERT. DENIED, 2004 U.S. LEXIS 2649
(U.S., NOV. 15, 2004).....................................................................................................255
A. FACTS..............................................................................................................................255
B. ISSUES.......................................................................................................................................256
C. HOLDINGS. ......................................................................................................................256
D. RATIONALE: ....................................................................................................................257
E. ANALYSIS........................................................................................................................257
(i) No Per Se Rule Barring Payment of Prepetition Debt with Court Approval.............258
1. (ii) Acts to Collect Prepetition Debts May Be Automatic Stay Violations ................258
(iii) Foreign Vendors Having No Minimum Contacts with United States .....................259
(iv) Procedure ................................................................................................................259
(v) No Authority to Pay Unallowable Prepetition Claims..............................................259
(vi) No Authority to Pay Prepetition Claims without Offsetting Benefit to Estate ........260
(vii) No Authority to Cross Collateralize Prepetition Debt with Postpetition Collateral
without Offsetting Benefit to Estate...................................................................................260
(viii) Paying Prepetition Debt Does Not Violate Equitable Subordination Rules if the
Unpaid Prepetition Debt Benefits ......................................................................................261
(ix) The Bankruptcy Code Allows Payment of Prepetition Debt in Numerous Instances..261
(x). Prepetition Debt Can Not Be Paid without Court Approval ........................................261
(xi) The Bankruptcy Code’s Priority Scheme Includes Substantial Flexibility..............262
23. TO WHAT EXTENT CAN A DEBTOR IN POSSESSION INDEMNIFY ITS
FINANCIAL ADVISOR? ..............................................................................................263
A. IN RE UNITED ARTISTS THEATRE CO., 315 F.3D 217 (3D CIR. 2003) .......................................263
i. Facts....................................................................................................................263
ii. Issue....................................................................................................................263
iii. Holding ...............................................................................................................263
iv. Rationale.............................................................................................................265
v. Consequences .............................................................................................................265
24. THE STAMP TAX EXEMPTION REQUIRES A PREVIOUSLY CONFIRMED
CHAPTER 11 PLAN......................................................................................................265
A. FLORIDA DEPARTMENT OF REVENUE V. PICCADILLY CAFETERIAS, INC., 554 U.S. ___
(2008) .............................................................................................................................265
i. Facts....................................................................................................................266
ii. ii. Issue................................................................................................................266
iii. Holding ...............................................................................................................266
iv. Rationale.............................................................................................................266
v. The Dissent .........................................................................................................267
vi. Analysis ..............................................................................................................267
vii. Consequences .....................................................................................................268
viii. Prior Law ............................................................................................................268
25. CAN CONFIRMATION NEGATE STAY RELIEF?....................................................269
A. ATALANTA CORP. V. ALLEN (IN RE ALLEN), 300 F.3D 1055 (9 TH CIR. 2002)...................269
i. Facts....................................................................................................................269
x

ii. Holding ...............................................................................................................269
iii. Rationale.............................................................................................................270
iv. Analysis ..............................................................................................................270
26. CAN UNMATURED INTEREST BE ALLOWED AS DAMAGES UNDER AN
INTEREST RATE SWAP? ............................................................................................270
A. THRIFTY OIL CO. V. BANK OF AMERICA, 310 F.3D 1188 (9 TH CIR. 2002) ........................270
i. Facts....................................................................................................................270
ii. Issue....................................................................................................................271
iii. Holding ...............................................................................................................271
iv. Rationale.............................................................................................................271
27. IS GOOD FAITH TOO AMBIGUOUS A STANDARD?.............................................272
A. IN RE CORAM HEALTHCARE CORP., 271 B.R. 228 (BANKR. D. DEL. 2001). .............................272
i. Facts....................................................................................................................272
ii. Holding ...............................................................................................................274
iii. Rationale.............................................................................................................274
iv. A Proper Application of Good Faith under Section 1129(a)(3)? ........................275
B. IN RE BIDERMANN INDUSTRIES U.S.A., INC., 203 B.R. 547 (BANKR. S.D.N.Y. 1997)..............276
i. Facts....................................................................................................................276
ii. Holdings..............................................................................................................277
iii. Should the Committee Have Broken Its Word?..................................................277
28. NATIONAL GYPSUM REVISITED: NEW NATIONAL GYPSUM
COMPANY V. NATIONAL GYPSUM COMPANY SETTLEMENT TRUST
(IN RE NATIONAL GYPSUM COMPANY), 219 F.3D 478 (5 TH CIR. 2000)(2
TO 1) ..............................................................................................................................277
A. FACTS..............................................................................................................................277
B. HOLDINGS .......................................................................................................................279
C. LESSONS LEARNED..........................................................................................................279
29. AVOIDANCE ACTIONS ARE PROPERTY OF NEITHER THE DEBTOR, NOR
THE DEBTOR IN POSSESSION, NOR THE ESTATE; BUT HOW ABOUT
THEIR PROCEEDS? .....................................................................................................280
A. OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. CHINERY (IN RE
CYBERGENICS CORP.), 226 F.3D 237 (3D CIR. 2000).......................................................280
i. Facts....................................................................................................................280
ii. Holding ...............................................................................................................280
iii. What About Bankruptcy Code Section 541(a)(3)? .............................................281
B. AVOIDANCE ACTIONS CAN ONLY BE BROUGHT TO BENEFIT CREDITORS.......................281
30. RELEASES OF NON-DEBTORS .................................................................................282
A. THE GENERAL RULE........................................................................................................282
B. RES JUDICATA. ................................................................................................................284
C. IN RE INGERSOLL, INC., 562 F.3D 856 (7 TH CIR. 2009) .....................................................285
i. Facts....................................................................................................................285
ii. Issues ..................................................................................................................286
iii. Holdings..............................................................................................................286
iv. Rationale.............................................................................................................287
v. Analysis ..............................................................................................................287
xi

D. AIRADIGM COMMUNICATIONS, INC. V. FEDERAL COMMUNICATIONS COMMISSION
(IN RE AIRADIGM COMMUNICATIONS, INC.), 519 F.3D 640 (7 TH CIR. 2008).....................288
i. Facts....................................................................................................................288
ii. Issues ..................................................................................................................289
iii. Holdings..............................................................................................................289
iv. Rationale.............................................................................................................289
v. Analysis ..............................................................................................................291
E. TRAVELERS INDEMNITY CO. V. BAILEY, 129 S. CT. 2195 (2009) ....................................291
i. Facts....................................................................................................................291
ii. Issues ..................................................................................................................292
iii. Holdings..............................................................................................................292
iv. Rationale.............................................................................................................293
v. Does Travelers Implicitly Overrule Metromedia and Drexel Burnham?............295
vi. Johns-Manville Corp. v. Chubb Indemnity Insurance Co. (In re Johns-
Manville Corp.), 600 F.3d 135 (2d Cir. 2010)....................................................296
F. DEUTSCHE BANK, AG V. METROMEDIA FIBER NETWORK, INC. (IN RE
METROMEDIA FIBER NETWORK, INC.), 416 F.3D 136 (2D CIR. 2005)..............................297
i. Facts....................................................................................................................298
ii. Issue....................................................................................................................298
iii. Holding. ..............................................................................................................298
iv. Rationale.............................................................................................................298
G. LACY V. DOW CORNING CORP. (IN RE DOW CORNING CORP.), 280 F.3D 648 (6TH
CIR. 2002) .......................................................................................................................299
i. Facts....................................................................................................................299
ii. Issue....................................................................................................................299
iii. Holding ...............................................................................................................299
iv. Rationale.............................................................................................................299
H. GILMAN V. CONTINENTAL AIRLINES (IN RE CONTINENTAL AIRLINES), 203 F.3D
203 (3D CIR. 2000)..........................................................................................................300
i. Facts....................................................................................................................300
ii. Holding ...............................................................................................................300
iii. Rationale.............................................................................................................300
I. BRUNO’S, INC. V. W.R. HUFF ASSET MANAGEMENT CO. (IN RE PWS HOLDING
CORP.), 228 F.3D 224 (3D CIR. 2000) ..............................................................................301
i. Facts....................................................................................................................301
ii. Holding ...............................................................................................................301
iii. Rationale.............................................................................................................302
J. MONARCH LIFE INSURANCE CO. V. ROPES & GRAY, 65 F.3D 973 (1ST CIR. 1995). ........302
i. Facts....................................................................................................................302
ii. Holding. The confirmation order has collateral estoppel effect barring suits
against Ropes & Gray. Its ambiguity could have been litigated at
confirmation........................................................................................................303
K. RESORTS INTERNATIONAL, INC. V. LOWENSCHUSS (IN RE LOWENSCHUSS), 67 F.3D
1394 (9TH CIR. 1995). .....................................................................................................303
L. W.R. GRACE & CO. V. CHAKARIAN (IN RE W.R. GRACE & CO.), 591 F.3D 164 (3D
CIR. 2009) ......................................................................................................................303
i. Facts....................................................................................................................303
ii. Issue....................................................................................................................304
xii

iii. Holding ...............................................................................................................304
iv. Rationale.............................................................................................................304
v. Analysis ..............................................................................................................305
31. SUPERPRIORITY CLAIMS UNDER BANKRUPTCY CODE SECTION
507(B) HAVE MET RESISTANCE; BUT HOW ABOUT NON-SUPER
ADMINISTRATIVE CLAIMS? – LNC INVESTMENTS, INC. V. FIRST
FIDELITY BANK, 247 B.R. 38 (S.D.N.Y. 2000) .........................................................307
A. FACTS..............................................................................................................................307
B. ISSUE...............................................................................................................................307
C. HOLDING .........................................................................................................................308
D. RATIONALE .....................................................................................................................308
E. RATIONALE OR IRRATIONALE..........................................................................................309
F. SUBSEQUENT HISTORY: LNC INVESTMENTS, INC. V. NATIONAL WESTMINSTER
BANK, 308 F.3D 169 (2D CIR. 2002), CERT. DENIED, 2003 U.S. LEXIS 3729 (2003) ......311
i. Facts....................................................................................................................311
ii. Issue....................................................................................................................311
iii. Holding ...............................................................................................................312
32. AT ELECTROMAGNETIC LICENSE AUCTIONS, WHAT’S FOR SALE?..............312
A. FEDERAL COMMUNICATIONS COMMISSION V. NEXTWAVE PERSONAL
COMMUNICATIONS, INC. (IN RE NEXTWAVE PERSONAL COMMUNICATIONS, INC.),
200 F.3D 43 (2D CIR. 1999), CERT. DENIED, 121 S.CT. 298 (2000) ..................................312
i. Facts....................................................................................................................312
ii. Holding ...............................................................................................................313
iii. Rationale.............................................................................................................313
iv. Consequences of Holding ...................................................................................314
B. IN RE GWI PCS 1 INC., 230 F.3D 788 (5 TH CIR. 2000)......................................................314
i. Facts....................................................................................................................314
ii. Holding ...............................................................................................................315
iii. Rationale.............................................................................................................315
C. FEDERAL COMMUNICATIONS COMMISSION V. NEXTWAVE PERSONAL
COMMUNICATIONS INC., 537 U.S. 293, 123 S. CT. 832 (2003)(8-1), AFFIRMING, 254
F.3D 130 (D.C. CIR. 2001)...............................................................................................315
i. Bankruptcy Code section 525(a) provides:.........................................................315
ii. History Subsequent to 200 F.3d 43 (2d Cir. 1999), cert. denied, 121 S.Ct.
298 (2000)...........................................................................................................316
iii. Holding ...............................................................................................................316
33. PURCHASING DISTRESSED DEBT CLAIMS WITH INTENT TO
PROSECUTE THEM IS STILL LEGAL –ELLIOTT ASSOCIATES, L.P. V.
BANCO DE LA NACION, 194 F.3D 363 (2D CIR. 1999) ...........................................318
A. FACTS..............................................................................................................................318
B. ISSUE...............................................................................................................................318
C. HOLDING .........................................................................................................................319
D. RATIONALE .....................................................................................................................319
34. LESSONS FROM A FAILED LIMITED FUND SETTLEMENT CLASS
ACTION – ORTIZ V. FIBREBOARD CORP., 119 S. CT. 2295 (1999).........................320
xiii

(A) FACTS..............................................................................................................................320
(B) HOLDING .........................................................................................................................322
(C) RATIONALE .....................................................................................................................322
(a) Historical Limited Fund Mandatory Class Actions ............................................322
(b) Criteria for Limited Fund Class Actions under Fed. R. Civ. P. 23(b)(1)(B).......322
(c) Potential Constitutional Impediments to Application of Fed. R. Civ. P. 23
(b)(1) to Mass Torts............................................................................................323
(d) Causes of Reversal..............................................................................................323
(e) Certain Unanswered Questions...........................................................................327
(D) POTENTIAL APPLICATIONS OF FIBREBOARD....................................................................327
i. Companies for which Chapter 11 Is Not a Solution or Is Too Dangerous..........327
ii. Use of Fed. R. Civ. P. 23(b)(1)(B) in place of Chapter 11?................................328
35. CAN SINGLE ASSET CASES BE CONFIRMED OVER AN
UNDERSECURED LENDER'S REJECTION, OR NOT? ............................................328
A. IMPACT OF BANKRUPTCY ABUSE PREVENTION AND CONSUMER PROTECTION ACT
OF 2005 FOR CASES COMMENCED ON AND AFTER OCTOBER 17, 2005.............................328
i. 11 U.S.C. § 362(d)(3) provides:..........................................................................328
ii. Consequences of 11 U.S.C. § 362(d)(3) .............................................................329
B. WHICH CASES CANNOT BE CONFIRMED?........................................................................330
i. Potential Treatments of Secured Claims.............................................................330
ii. Potential Treatments of Unsecured Claims.........................................................330
C. CAN THE MORTGAGEE'S UNSECURED DEFICIENCY CLAIM BE SEPARATELY
CLASSIFIED?....................................................................................................................331
D. WHEN SEPARATE CLASSIFICATION IS ALLOWED, UNFAIR DISCRIMINATION IS NOT.......334
E. WHEN THE OBSTACLES OF SEPARATE CLASSIFICATION AND UNFAIR
DISCRIMINATION ARE OVERCOME, THE NEW VALUE OBSTACLE REMAINS. ...................334
F. HAVE YOU THOUGHT ABOUT BANKRUPTCY CODE SECTION 1111(B)(1)(A)(II)
LATELY? CRAMDOWN ATTORNEYS HAVE......................................................................338
i. Bankruptcy Code Section 1111(b)(1)(A)(ii) provides:.......................................338
ii. The Issue.............................................................................................................338
1. ........................................................................................................................................338
2. Background................................................................................................................338
3. Sword and Shield Uses of § 1111(b)(1)(A)(ii)...........................................................338
iii. Mortgagor Cannot Gamble with Mortgagee's Collateral....................................339
1. The Mortgagee Can Credit Bid its Deficiency Claim. ...............................................340
iv. No Credit Bidding after Electing § 1111(b)(2)...................................................341
1. ........................................................................................................................................341
G. BANK OF AMERICA V. 203 NORTH LASALLE STREET PARTNERSHIP, 119 S. CT.
1411 (1999).....................................................................................................................342
i. Facts....................................................................................................................342
ii. Issue....................................................................................................................343
iii. Holding ...............................................................................................................343
iii. Rationale.............................................................................................................344
iv. How Does North LaSalle Work? ........................................................................345
v. Aftermath In North LaSalle ................................................................................345
H. THE ANSWER...................................................................................................................346
xiv

36. PREJUDGMENT ATTACHMENT, AS AN EQUITABLE REMEDY, IS
BEYOND THE FEDERAL COURTS’ POWER ...........................................................347
A. GRUPO MEXICANO V. ALLIANCE BOND FUND, 527 U.S. 308 (1999) (5-4) ......................347
i. Facts....................................................................................................................347
ii. Holding. ..............................................................................................................347
iii. Rationale.............................................................................................................347
iv. Consequences .....................................................................................................348
37. CAN A CHAPTER 11 DEBTOR IN POSSESSION ASSUME AN
EXECUTORY CONTRACT IF IT CANNOT ASSIGN IT? .........................................348
A. BANKRUPTCY CODE SECTION 365(C)(1) PROVIDES: ........................................................348
B. BANKRUPTCY CODE SECTION 365(F)(1) PROVIDES:.........................................................349
C. PERLMAN V. CATAPULT ENTERTAINMENT, INC. (IN RE CATAPULT
ENTERTAINMENT, INC.), 165 F.3D 747 (9 TH CIR. 1999)....................................................349
i. Facts....................................................................................................................349
ii. Holding ...............................................................................................................349
iii. Rationale and Irrationale.....................................................................................350
D. IN RE FOOTSTAR, INC., 323 B.R. 566 (BANKR. S.D.N.Y. 2005)................................................351
i. Facts....................................................................................................................351
ii. Issue....................................................................................................................351
iii. Holding. ..............................................................................................................351
iv. Rationale.............................................................................................................351
E. BONNEVILLE POWER ADMINISTRATION V. MIRANT CORP. (IN RE MIRANT CORP.), 440
F.3D 238 (5TH CIR. 2006)................................................................................................352
i. Facts....................................................................................................................352
ii. Issue....................................................................................................................352
iii. Holding ...............................................................................................................353
iv. Rationale.............................................................................................................353
F. WHEN FAILURE OF ADEQUATE ASSURANCE VALIDLY DEFEATS ASSIGNMENT: IN RE
FLEMING COMPANIES, INC.), 499 F.3D 300 (3D CIR. 2007) .............................................353
i. Facts....................................................................................................................354
ii. Issues ..................................................................................................................354
iii. Holdings..............................................................................................................354
iv. Implications ........................................................................................................355
38. DEVAN V. SIMON DEBARTOLO GROUP, 180 F.3D 149 (4 TH CIR. 1999)..............355
i. Facts....................................................................................................................355
ii. Holding. ..............................................................................................................355
iii. Dangerous Dictum about Rejection ....................................................................356
xv

1. Section 363 Sales Free and Clear v. Sub Rosa Chapter 11 Plans
A. Indiana State Police Pension Trust v. Chrysler LLC (In re Chrysler LLC), 592
F.3d 370 (2d Cir., August 5, 2009), cert. granted, judgment vacated with
instructions to dismiss appeal as moot, 558 U.S. ___, Order 09-285
(December 14, 2009).
i. Facts
Chrysler commenced its chapter 11 case on April 30, 2009 with a proposal
to sell, pursuant to Bankruptcy Code section 363, substantially all its operating
assets (including manufacturing plants, brand names, certain dealer and supplier
relationships, etc.) to New Chrysler in exchange for New Chrysler’s assumption
of certain liabilities and $2 billion cash. Slip op. at 7-8. The bankruptcy court
approved the sale by order dated June 1, 2009. Slip op. at 9.
The United States Court of Appeals for the Second Circuit affirmed on
June 5, 2009, but entered a short stay pending Supreme Court review. The
Supreme Court extended the stay, but declined a further extension and the sale
closed on June 10, 2009. Slip op. at 9.
Under the sale, “’[n]ot one penny of value of the Debtors’ assets is going
to anyone other than the First Lien Lenders.’” Slip op. at 25. “[A]ll the equity
stakes in New Chrysler were entirely attributable to new value – including
governmental loans, new technology, and new management – which were not
assets of the debtor’s estate.” Slip op. at 25. “The linchpin of [the bankruptcy
court’s] analysis was that the only possible alternative to the Sale was an
immediate liquidation that would yield far less for the estate – and for the
objectors.” Slip op. at 25-26.
New Chrysler’s membership interests were 55% to an employee benefit
entity created by the United Auto Workers union, 8% to the United States
Treasury, and 2% to Export Development Canada. Slip op. at 8. “Fiat, for its
contributions, would immediately own 20% of the equity with rights to acquire
more (up to 51%), contingent on payment in full of the debts owed to the United
States Treasury and Export Development Canada.” Slip op. at 8-9. “Fiat had
conditioned its commitment on the Sale being completed by June 15, 2009.
While this deadline was tight and seemingly arbitrary, there was little leverage to
force an extension.” Slip op. at 27. The union employees would be working
under new union contracts containing a six-year no-strike provision. Slip op. at
28.
ii. Issues
1. Is the sale an impermissible sub rosa plan, unapprovable under
Bankruptcy Code section 363?

2. Does the sale conform to Bankruptcy Code section 363(f)? Does the
“Sale impermissibly [subordinate the Indiana Pensioners’] interests as
secured lenders and [allow] assets on which they have a lien to pass
free of liens to other creditors and parties, in violation of § 363(f)?” Slip
op. at 10.
3. Is it constitutional to use TARP funds to finance the sale?
4. Can the sale be made free and clear of present and future tort and
asbestos claims?
iii. Holdings
1. No. “On this record, and in light of the arguments made by the parties,
the bankruptcy court’s approval of the Sale was no abuse of discretion.
With its revenues sinking, its factories dark, and its massive debts
growing, Chrysler fit the paradigm of the melting ice cube. Going
concern value was being reduced each passing day that it produced
no cars, yet was obliged to pay rents, overhead, and salaries.
Consistent with an underlying purpose of the Bankruptcy Code –
maximizing the value of the bankrupt estate – it was no abuse of
discretion to determine that the Sale prevented further, unnecessary
losses. See Toibb v. Radloff, 501 U.S. 157,163 (1991) (Chapter 11
‘embodies the general [Bankruptcy] Code policy of maximizing the
value of the bankruptcy estate.’).” Slip op. at 27-28.
2. “[T]he secured lenders have consented to the Sale, as per § 363(f)(2).”
Slip op. at 10.
3. “We conclude that the Indiana Pensioners lack standing to raise this
challenge” to the use of TARP funds. Slip op. at 10.
4. The sale was legally approved free and clear of tort claims. “Because
appellants’ claims arose from Old Chrysler’s property, § 363(f)
permitted the bankruptcy court to authorize the Sale free and clear of
appellants’ interest in the property.” Slip op. at 49-50. This includes
present asbestos claims. Bankruptcy Code section 524(g) only applies
to a chapter 11 plan, and the sale order did not violate it. Slip op. at
51. In respect of whether the sale order legally approved the transfer
of assets free of future asbestos claims: “We affirm this aspect of the
bankruptcy court’s decision insofar as it constituted a valid exercise of
authority under the Bankruptcy Code. However, we decline to
delineate the scope of the bankruptcy court’s authority to extinguish
future claims, until such time as we are presented with an actual claim
for an injury that is caused by Old Chrysler, that occurs after the Sale,
2

and that is cognizable under state successor liability law.” Slip op. at
52.
iv. Rationale
“…Thus a § 363(b) sale may well be a reorganization in effect without
being the kind of plan rejected in Braniff. See, e.g., Fla. Dep’t of Revenue v.
Piccadilly Cafeterias, Inc., 128 S. Ct. at 2330 n.2….” Slip op. at 23-24. “Braniff
rejected a proposed transfer agreement in large part because the terms of the
agreement specifically attempted to dictat[e] some of the terms of any future
reorganization plan. The [subsequent] reorganization plan would have to
allocate the [proceeds of the sale] according to the terms of the [transfer]
agreement or forfeit a valuable asset….” Slip op. at 22 (brackets in original).
“Braniff’s holding did not support the argument that a § 363(b) asset sale must be
rejected simply because it is a sale of all or substantially all of a debtor’s assets.
Thus a § 363(b) sale may well be a reorganization in effect without being the kind
of plan rejected in Braniff. 9 ” Slip op. at 9 & n.9 (n9: ”The transaction at hand is
as good an illustration as any. ‘Old Chrysler’ will simply transfer the $2 billion in
proceeds to the first lien lenders, and then liquidate. The first lien lenders
themselves will suffer a deficiency of some $4.9 billion, and everyone else will
likely receive nothing from the liquidation. Thus the Sale has inevitable and
enormous influence on any eventual plan of reorganization or liquidation. But it
is not a ‘sub rosa plan’ in the Braniff sense because it does not specifically
‘dictate,’ or ‘arrange’ ex ante, by contract, the terms of any subsequent plan.”).
Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722
F.2d 1063, 1069 (2d Cir. 1983), “’reject[ed] the requirement that only an
emergency permits the use of § 363(b).’” Slip op. at 14. “…Lionel required a
‘good business reason’ for a § 363(b) transaction.” Slip op. at 15.
“As § 363(b) sales proliferate, the competing concerns identified in Lionel
have become harder to manage. Debtors need flexibility and speed to preserve
going concern value; yet one or more classes of creditors should not be able to
nullify Chapter 11’s requirements. A balance is not easy to achieve, and is not
aided by rigid rules and prescriptions. Lionel’s multi-factor analysis remains the
proper, most comprehensive framework for judging the validity of § 363(b)
transactions.” Slip op. at 21.
v. Analysis
The term ‘sub rosa plan’ has taken on two meanings. The original
meaning was shown in Pension Benefit Guaranty Corp. v. Braniff Airways, Inc.
(In re Braniff Airways, Inc.), 700 F.2d 935 (5 th Cir. 1983), to be a sale transaction
that also included distributions of sale proceeds which would otherwise be
distributed in a chapter 11 plan. In Braniff, the appellate court held the
transaction was illegal because it included at least three elements outside the
scope of section 363, which would otherwise be subject to the Bankruptcy
3

Code’s confirmation requirements. They were the requirements that: (a) Braniff
pay $2.5 million to the buyer for travel scrip which had to be distributed to former
Braniff employees or shareholders, (b) the secured lenders vote a portion of their
deficiency claim in favor of any future plan secured approved by a majority of the
creditors’ committee, and (c) all parties release Braniff, its secured lenders, and
its officers and directors. Braniff, 700 F.2d at 939-940. In Motorola, Inc. v.
Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 478
F.3d 452 (2d Cir. 2007), a settlement between the debtor and the secured
lenders provided for left over funds for litigation, if any, to be distributed to
unsecured claimholders, rather than be available for unpaid administrative
claims. 478 F.3d at 459-460. At the time of the settlement, however, it was still
unclear whether there would be unpaid, allowed administrative claims. 478 F.3d
at 464. Therefore, the court declined to hold the bankruptcy court cannot
approve a settlement outside a plan, which settlement may violate the
Bankruptcy Code’s distribution scheme. 478 F.3d at 464. Rather, the court
ruled: “In the Chapter 11 context, whether a settlement’s distribution plan
complies with the Bankruptcy Code’s priority scheme will often be the dispositive
factor. However, where the remaining factors weigh heavily in favor of approving
a settlement, the bankruptcy court, in its discretion, could endorse a settlement
that does not comply in some minor respects with the priority rule if the parties to
the settlement justify, and the reviewing court clearly articulates the reasons for
approving, a settlement that deviates from the priority rule.” 478 F.3d at 465.
The second meaning of sub rosa plan has been a transaction that does
not distribute proceeds in lieu of a chapter 11 plan distribution, but disposes of a
crown jewel asset that may restrict the type of chapter 11 plan that must result.
See, e.g., Richmond Leasing co. v. Capital Bank, N.A., 762 F.2d 1303, 1312-
1313 (5 th Cir. 1985)(affirmed assumption of amended lease creating large
administrative claims based on valid exercise of debtor’s business judgment,
while cautioning that assumption and other factors could sometimes create sub
rosa plan) ; Inst. Creditors of Continental Air Lines, Inc. v. Continental Air Lines,
Inc. (In re Continental Air Lines, Inc.), 780 F.2d 1223 (5 th Cir. 1986). In
Continental, the appellate court reversed the bankruptcy court’s approval of the
debtor entering into leases of two large aircraft because the court had not
considered whether the objecting creditors would have been able to block the
leases if proposed in a chapter 11 plan. 780 F.2d at 1227-1228.
In Chrysler, the section 363 transaction included (a) the distribution of
sale proceeds to the first lien holders, rather than simply have the liens attach to
the proceeds, which distribution clearly eliminated the estate’s use of the funds
(subject to adequate protection requirements) for reorganization, and (b) the
payment of prepetition, unsecured trade debt. The objectors to the Chrysler
transaction did not raise either of these features in their objections, but they
clearly rendered the transaction a partial sub rosa plan.
4

The appellate court’s deferral of its review of the enforceability of the sale
order’s provision that the sale was free of successor liability for future claims,
sets up an interesting dynamic. When and if a claimant asserts a future claim
against the buyer, the buyer may attempt to enforce the sale order in the
bankruptcy court which issued it by suing the claimant for contempt of the
injunction in the sale order. Alternatively, the claimant may start out by
requesting relief from the injunction in the bankruptcy court. The bankruptcy
court will presumably have little choice but to enforce the order. The district court
and Second Circuit will then determine whether the order can be collaterally
attacked and, if so, whether it was valid. Travelers Indemnity Co. v. Bailey, 129
S. Ct. 2195 (2009), certainly creates a question as to whether the order can be
collaterally attacked.
2. “The Frenville Accrual Test Should Be and Now Is Overruled.” That
Simple?
A. JELD-WEN, Inc. v. Brunt (In re Grossman’s Inc.), 607 F.3d 114, 121
(3d Cir. 2010)
i. Facts
In 1977, Brunt purchased products allegedly containing asbestos from
Grossman’s, a home improvement and lumber retailer. 607 F.3d at 117. In
1997, Grossman’s commenced a chapter 11 case. Id. Grossman’s knew it had
sold products containing asbestos and knew about their adverse health risks. Id.
Grossman’s was unaware of any product liability lawsuits against it based on
asbestos-containing products. Id. Grossman’s gave notice by publication of the
deadline for filing proofs of claim and there was no suggestion in the notice that
Grossman’s might have future asbestos liability. Id. Grossman’s chapter 11 plan
was confirmed in 1997 and purported to discharge all claims arising before its
effective date. Id. The plan did include a channeling injunction pursuant to
Bankruptcy Code section 524(g) and could not because Grossman's had not
been sued prepetition for asbestos damages. Id. at 127n.13.
Brunt did not file a proof of claim before plan confirmation because she
was unaware of any claim since she had not manifested any symptoms related to
asbestos exposure. Id. In 2006, Brunt began to manifest symptoms of
mesothelioma, a cancer linked to asbestos exposure. Id. She was diagnosed
with mesothelioma in 2007 and shortly thereafter filed an action for tort and
breach of warranty in New York state court against JELD-WEN, as successor to
Grossman’s, and 57 other companies who allegedly manufactured the products
Brunt bought from Grossman’s in 1977. Id.
JELD-WEN moved to reopen Grossman’s chapter 11 case seeking a
determination that Brunt’s claim was discharged. Id. at 118. Brunt died in 2008.
Id. Relying on Avellino & Bienes v. M. Frenville Co. (In re M. Frennville Co.), 744
F.2d. 332 (3d Cir. 1984), the bankruptcy court held Grossman’s chapter 11 plan
5

had not discharged Brunt’s claim because under New York law Brunt’s cause of
action did not accrue until the injury manifested itself in 2006. Id. (JELD-WEN
became the only remaining defendant in the New York action because other
defendants settled with Brunt for $305,850. Id. at n.3). The district court affirmed
the bankruptcy court’s ruling that Brunt’s tort claim had not been discharged, but
reversed its ruling that the breach of warranty claim had not been discharged
because that claim accrued when the product was delivered in 1977 and was
discharged. Id. at 118.
ii. Issues
Was Brunt’s tort claim a claim within the meaning of Bankruptcy Code
section 101(5) before the effective date of Grossman’s chapter 11 plan?
If Brunt's tort claim was a claim within the meaning of Bankruptcy Code
section 101(5) before the plan became effective, is its discharge consistent with
fundamental due process?
iii. Holding
" Irrespective of the title used, there seems to be something
approaching a consensus among the courts that a prerequisite for
recognizing a "claim" is that the claimant's exposure to a product
giving rise to the "claim" occurred pre-petition, even though the
injury manifested after the reorganization. We agree and hold that a
"claim" arises when an individual is exposed pre-petition to a
product or other conduct giving rise to an injury, which underlies a
"right to payment" under the Bankruptcy Code. See 11 U.S.C. §
101(5). Applied to the Van Brunts, it means that their claims arose
sometime in 1977, the date Mary Van Brunt alleged that
Grossman's product exposed her to asbestos."
Id. at 125 (emphasis supplied).
" The due process safeguards in § 524(g) are of no help to the
Van Brunts as Grossman's Plan of Reorganization did not provide
for a channeling injunction or trust under that provision. 13 A court
therefore must decide whether discharge of the Van Brunts' claims
would comport with due process, which may invite inquiry into the
adequacy of the notice of the claims bar date. The only open matter
before the District Court is JELD-WEN's request for a declaration
that the Van Brunts' claims had been discharged.
13 Nor could it have done so, as § 524(g) applies only to
companies that have been sued for damages before the date of the
bankruptcy petition. See 11 U.S.C. § 524 (g)(2)(B)(i)(I).
6

Whether a particular claim has been discharged by a plan of
reorganization depends on factors applicable to the particular case
and is best determined by the appropriate bankruptcy court or the
district court. In determining whether an asbestos claim has been
discharged, the court may wish to consider, inter alia, the
circumstances of the initial exposure to asbestos, whether and/or
when the claimants were aware of their vulnerability to asbestos,
whether the notice of the claims bar date came to their attention,
whether the claimants were known or unknown creditors, whether
the claimants had a colorable claim at the time of the bar date, and
other circumstances specific to the parties, including whether it
was reasonable or possible for the debtor to establish a trust for
future claimants as provided by § 524(g).
These are not factors for consideration in the first instance by
this court sitting en banc. Both the Bankruptcy Court and the
District Court held that the Van Brunts' state law claims survived
under Frenville. Neither had any reason to consider whether the
Van Brunts' claims were discharged.
Id. at 127-128.
iv. Analysis
By holding that Brunt held a claim due to her exposure to asbestos, rather
than a demand within the meaning of Bankruptcy Code section 524(g)(5), 1 the
Third Circuit largely, but not entirely, eliminated demands and the function of the
legal representative included in Bankruptcy Code section 524(g)(4)(B). 2
1 Bankruptcy Code section 524(g)(5) provides:
(5) In this subsection, the term “demand” means a demand for payment, present
or future, that—
(A) was not a claim during the proceedings leading to the confirmation of a plan
of reorganization;
(B) arises out of the same or similar conduct or events that gave rise to the
claims addressed by the injunction issued under paragraph (1); and
(C) pursuant to the plan, is to be paid by a trust described in paragraph (2)(B)(i).
2 Bankruptcy Code section 524(g)(4)(B) provides:
"(B) Subject to subsection (h), if, under a plan of reorganization, a kind of
demand described in such plan is to be paid in whole or in part by a trust
described in paragraph (2)(B)(i) in connection with which an injunction described
in paragraph (1) is to be implemented, then such injunction shall be valid and
enforceable with respect to a demand of such kind made, after such plan is
confirmed, against the debtor or debtors involved, or against a third party
described in subparagraph (A)(ii), if—
7

Because the Third Circuit based Brunt's claim on her prepetition exposure to
asbestos, the decision does not cover those persons first exposed to asbestos
after the bankruptcy of the entity at least partially responsible for the exposure.
For instance, a person may be exposed to asbestos in the person's attic, after
the bankruptcy of the manufacturer or seller of the asbestos. But, those are rare
cases. The bulk of the legal representative's constituency has been persons
exposed prepetition to asbestos, but who manifest injury post-effective date.
Notably, a trial court in the Third Circuit had previously counted as
liabilities for purposes of determining solvency in a fraudulent transfer action
under state law, the 'claims' of people exposed to asbestos before they knew
they had claims. 3
(i) as part of the proceedings leading to issuance of such injunction, the court
appoints a legal representative for the purpose of protecting the rights of persons
that might subsequently assert demands of such kind, and
(ii) the court determines, before entering the order confirming such plan, that
identifying such debtor or debtors, or such third party (by name or as part of an
identifiable group), in such injunction with respect to such demands for purposes
of this subparagraph is fair and equitable with respect to the persons that might
subsequently assert such demands, in light of the benefits provided, or to be
provided, to such trust on behalf of such debtor or debtors or such third party."
3
Official Committee of Asbestos Personal Injury Claimants v. Sealed Air Corporation (In re W.R.
Grace & Co.), 281 B.R. 852, 862 (D. Del. 2002).
To continue in rendering this in limine opinion, the Court must engage in
some reasonable assumptions ahead of the proven facts. It is reasonable to
conclude that of the tens of thousands of persons making claims for asbestos
personal injury against W.R. Grace after the 1998 transfer date, substantial
numbers of them had viable claims against the company prior to that time.
Asbestos had not been manufactured or employed in industry for many years
prior to 1998 and any person with a post-1998 claim must have been exposed
long before the transfer date. That such exposure would lead to long-term,
serious, health effects with long latency periods has been common knowledge for
twenty to perhaps thirty years.
It may be, under some states' law, that this exposure is enough. See, e.g.,
Ayers, 106 N.J. 557, 525 A.2d 287. However, it must also follow that many, and
no doubt a substantial majority, of these persons had some physical
manifestation of their exposure, whether they knew it at that time or not.
Exposure and physical manifestation doubtless gave the affected person a claim
under the laws of most states. See Schweitzer, 758 F.2d at 942 (quoting W.
Prosser & P. Keeton, Prosser & Keeton on Torts 165 (5th ed. 1984)).
Therefore, and for the reasons stated thus far, these persons had a "right to
payment" and thus a claim for purposes of the solvency analysis of the UFTA on
the transfer date. To recognize this does not contradict the rule defendants
reiterate that solvency must be determined as of the transaction date. Mellon
Bank v. Metro Communications, 945 F.2d 635, 648 (3d Cir. 1991). It cannot
matter that the claimants themselves may have been unaware of their own claim
in 1998. The assumption of Schweitzer, 758 F.2d at 942, quoted supra at p. 861,
is intuitively correct--a cause of action may exist before its owner is aware of it.
8

Finally, in Frenville, the indemnity and contribution claim against the
debtor was raised during the bankruptcy case when the banks sued the
accounting firm for issuing negligent and reckless financial statements and the
accounting firm attempted to implead the debtor. Avellino & Bienes v. M.
Frenville Co. (In re M. Frenville Co.), 744 F.2d 332, 333-334 (3d Cir. 1984). In
contrast, in In re Penn Central Transportation Co., 71 F.3d 1113 (3d Cir. 1995),
the reorganized debtor, Penn Central, was sued after consummation of its
reorganization plan under the Bankruptcy Act of 1898, as amended, for
contribution to USX Corporation and Bessemer and Lake Erie Railroad Co. who
had been found liable postconsummation for antitrust damages arising out of a
prepetition ratemaking agreement with Penn Central's predecessor who was
alleged to be the instigator, enforcer and primary beneficiary of the conspiracy.
71 F.3d at 1114. Penn Central had been dismissed from the lawsuit on the
ground the direct claim against it had been discharged. 71 F.3d at 1114. The
Third Circuit explained that notwithstanding that Penn Central's conduct occurred
prepetition, it would be wholly unworkable to have required the filing of proofs of
claim:
"Our holding makes for sound policy. Appellants could not
have been expected to file a contingent claim pre-consummation
based on the speculative possibility that their conduct, which began
in the 1950s, might have extended beyond the bounds of its
statutory antitrust immunity and that they might successfully be
sued years later. If the Bessemer were required to act with such
clairvoyance, then countless other entities that did business with
the Penn Central and its predecessors, would also have been
required to file contingent claims. Affixing value to these claims,
both individually and in the aggregate, would be impossible, and
the uncertainty thus created would render any reorganization plan
unworkable."
Penn Central, 71 F.3d at 1117-1118. The Third Circuit did opine that Frenville
was unnecessary to its decision in Penn Central. 71 F.3d at 1117.
Nevertheless, under Grossman's, Penn Central had both prepetition legal
relationships with USX Corp. and Bessemer, and engaged in what turned out to
be the wrongful conduct. Accordingly, Penn Central would likely be decided
differently after Grossman's. But, if so, then the Third Circuit's warning in Penn
Central may materialize, namely that everyone who does business with a debtor
may have to file protective, contingent claims just in case they are later sued and
are entitled to contribution. Of course, this has been the law outside the Third
Circuit for decades and the horrible imaginings have not come to be.
Id. ("a cause of action may 'exist' before it has 'accrued' [under the discovery rule
of the statute of limitations]").
The trial judge who rendered the decision was later recused. In re Kensington Int'l Ltd., 368 F.3d
289 (3d Cir. 2004).
9

3. The Bankruptcy Code Does Not Per Se Disallow Prepetition Claims for Attorneys’
Fees Incurred Litigating Postpetition Bankruptcy Issues
A. Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co.,
549 U.S. 443 (2007)
i. Facts.
Prepetition, PG&E had indemnified Travelers for the surety bonds
Travelers issued guaranteeing PG&E’s payment of state workers’ compensation.
Pursuant to the indemnity agreements, PG&E was liable for any loss Travelers
incurs in connection with the bonds, including attorneys’ fees incurred in
pursuing, protecting, or litigating Traveler’s rights in connection with those bonds.
Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 127 S.
Ct. 1199, 1202 (2007).
With bankruptcy court approval, PG&E agreed to include in its chapter 11
plan language protecting Travelers’ rights to indemnity and subrogation in the
event of a default by PG&E. But, PG&E and Travelers ended up litigating the
protective language and then settling the litigation in a bankruptcy court approved
stipulation. Id. at 1202-1203.
Travelers filed an amended proof of claim seeking to recover the
attorneys’ fees it incurred in connection with PG&E’s chapter 11 case. PG&E
objected arguing on the basis of In re Fobian, 951 F.2d 1149 (9th Cir. 1991), that
Travelers can not recover attorneys’ fees incurred litigating issues of bankruptcy
law. Id. at 1203. The bankruptcy court, district court, and Ninth Circuit Court of
Appeals agreed those fees were not allowable claims in bankruptcy. Id.
Fobian was in conflict with the Fourth Circuit’s decision in In re Shangra-
La, Inc., 167 F.3d 843, 848-849 (4th Cir. 1999).
ii. Issue
“We are asked to consider whether federal bankruptcy law precludes an
unsecured creditor from recovering attorney’s fees authorized by a prepetition
contract and incurred in postpetition litigation.” Id. at 1202.
“This case requires us to consider whether the Bankruptcy Code disallows
contract-based claims for attorney’s fees based solely on the fact that the fees at
issue were incurred litigating issues of bankruptcy law.” Id. at 1204.
iii. Holding
“…We conclude that it does not.” Id.
10

“Accordingly, we express no opinion with regard to whether, following the
demise of the Fobian rule, other principles of bankruptcy law might provide an
independent basis for disallowing Travelers’ claim for attorney’s fees. We
conclude only that the Court of Appeals erred in disallowing that claim based on
the fact that the fees at issue were incurred litigating issues of bankruptcy law.
Id. at 1207-1208.
iv. Rationale
Pursuant to 11 U.S.C. § 502(b), when a party in interest objects to a claim,
the court “’shall allow’ the claim ‘except to the extent that’ the claim implicates
any of the nine exceptions enumerated in § 502(b).” Id. at 1204 (quoting from 11
U.S.C. § 502(b)).
Section 502(b)(1) “is most naturally understood to provide that, with limited
exceptions, any defense to a claim that is available outside of the bankruptcy
context is also available in bankruptcy….” Id. at 1204. “This reading of §
502(b)((1) is consistent not only with the plain statutory text, but also with the
settled principle that ‘[c]reditors’ entitlements in bankruptcy arise in the first
instance from the underlying substantive law creating the debtor’s obligation,
subject to any qualifying or contrary provisions of the Bankruptcy Code.’ Raleigh
v. Illinois Dept. of Revenue, 530 U.S. 15, 20 (2000). Id. at 1205
“Indeed, we have long recognized that the ‘ ‘basic federal rule’ in
bankruptcy is that state law governs the substance of claims, Congress having
‘generally left the determination of property rights in the assets of a bankrupt’s
estate to state law.’’ Ibid. (quoting Butner v. United States, 440 U.S. 48, 57, 54
(1979); citation omitted). Accordingly, when the Bankruptcy Code uses the word
‘claim’ – which the Code itself defines as a ‘right to payment,’ 11 U.S.C. §
101(5)(A)—it is usually referring to a right to payment recognized under state
law. As we stated in Butner, ‘[p]roperty interests are created and defined by
state law,’ and ‘[u]less some federal interest requires a different result, there is no
reason why such interests should be analyzed differently simply because an
interested party is involved in a bankruptcy proceeding.’ 440 U.S., at 55; …” Id.
at 1205.
In Travelers, the lower courts did not conclude Travelers’ claim was
rendered unenforceable by any Bankruptcy Code provision. Id. at 1205.
11 U.S.C. § 502(b)(4) disallows a particular category of attorneys’ fees,
which suggests that other categories are allowed. Id. at 1206.
B. Violation of Travelers? – National Energy & Gas Transmission, Inc. v.
Liberty Electric Power, LLC (In re National Energy & Gas Transmission,
Inc.), 492 F.3d 297 (4th Cir. 2007), rehearing denied (August 6, 2007)
11

i. Facts
Liberty had a prepetition energy contract (the “Agreement”) with National
Energy & Gas Transmission Energy Trading Power, L.P. (“ET Power”).
To back up ET Power’s financial obligations under the Agreement, Liberty
also procured guaranties from ET Power’s corporate parent, National Energy
& Gas Transmission, Inc. (“NEGT”) and from an NEGT subsidiary, Gas
Transmission Northwest Corporation (“GTN”). The guaranties guaranteed
payment of “all amounts payable by [ET Power] under the Agreement…,”
subject to a cap of $140 million. 492 F.3d at 299.
ET Power and NEGT commenced chapter 11 cases and ET Power
rejected the Agreement. Liberty received an arbitral award of $140 million
plus, among other things, interest from the date of rejection. The postpetition
interest approximated $17 million. NEGT sold GTN during the arbitration
proceedings. To facilitate the closing, $140 million was first escrowed and
then paid to Liberty to satisfy the GTN guaranty and to stop interest from
further accruing. Id. at 300.
Liberty allocated the $140 million first to interest and then to principal,
thereby leaving unpaid approximately $17 million of principal. Then, Liberty
asserted against ET Power a claim of $140 million, subject to the limitation
that it could not collect more than the $17 million of principal to make it whole.
As a practical matter, Liberty made this allocation because it knew that
Bankruptcy Code section 502(b)(2) bars Liberty from having an allowable
claim against ET Power for the $17 million of postpetition interest. Id. at 300.
Therefore, by collecting the postpetition interest from GTN, it left principal
unpaid.
ii. Issues
“We initially consider the debtors’ contention that the value of Liberty’s
claim must be reduced by the $140 million it received from GTN in order to reflect
accurately the amount currently owed to Liberty. Because Liberty is currently
owed only approximately $17 million, the debtors argue its claim should be
limited to this amount.” Id. at 300-301.
“We next turn to the more fundamental question presented by this appeal:
whether the Bankruptcy Code bars Liberty from collecting the $17 million it now
seeks….” Id. at 301.
iii. Judgments
“The debtors’ argument is foreclosed by the combination of Ivanhoe
Building & Loan Ass’n of Newark v. Orr, 295 U.S. 243 (1935), and New York law,
which governs pursuant to the Agreement. In Ivanhoe, the Supreme Court held
that a creditor need not deduct from his claim in bankruptcy an amount received
12

from a non-debtor third party in partial satisfaction of an obligation. Thus, as a
matter of bankruptcy law, ET Power’s debt to Liberty is not reduced by the
amount which Liberty received from GTN.” Id. at 301. Under N.Y. Gen. Oblig. L.
§ 15-103, GTN was a surety for ET Power’s obligations to Liberty.
“…Accordingly, the value of ET Power’s debt to Liberty under state law is not
reduced by the $140 million received from GTN.” Id. at 301.
The Primary Decision (Circuit Judge Shedd’s opinion) agrees that Liberty
can classify GTN’s payment as interest. (“Liberty is free to classify GTN’s
payment as interest…” Id. at 303n.5). But, the Primary Decision holds that
Liberty’s classification of the GTN payment as interest is not binding on ET
Power. (“…We merely hold that Liberty may not affect the rights of a party in
bankruptcy by its classification of a payment received from a non-debtor
guarantor.” Id. at 303n.5).
“…[W]e conclude that § 502(b)(2) prevents Liberty from collecting the
additional $17 million which it seeks from the estate.” Id. at 303.
Judge Duncan dissented. Id. 304-306. It is uncontested, he stressed, that
Section 502(b)(2) “has no impact on the accrual of unmatured interest against . .
. non-debtor guarantors.” Id. at 304. The lead opinion’s construction of this
provision, however, limited the non-debtor guarantor’s liability for interest: “the
majority would have the bar to recovery of interest from the debtor swallow the
accrual of interest on the debt across all parties liable for it.” Id. 305. Not only is
there no provision in the Bankruptcy Code demanding this result, the dissent
observed, but it is contradicted by Section 524(e) of the Code, which provides
that the “discharge of a debt of the debtor does not affect the liability of any other
entity on . . . such debt.” 11 U.S.C. § 524(e).
iv. Rationale
The Primary Decision reasons that “principles of equity,” id. at 302, require
it to apply Bankruptcy Code section 502(b)(2) by disregarding Liberty’s
classification of GTN’s payment: “The § 502(b)(2) bar to collection of interest is
not overcome by Liberty’s classification of the $17 million it now seeks as
principal….Because ET Power’s debt was capped at $140 million by the filing of
the bankruptcy petition and because the debt was increased only by the accrual
of interest pursuant to the arbitration award, we view Liberty’s claim for an
additional $17 million as disallowed post-petition interest no matter how Liberty
chooses to classify it.” Id. at 302-303.
Notably, no decision contends the bankruptcy court was clearly erroneous
in characterizing Liberty’s claim as a claim for principal.
v. Analysis and Implications
1. The Judgment’s Reliance on “principles of equity”
13

Does Not Identify the Equity Accomplished because
There is None
Vanston Bondholders Protective Committee v. Green, 329 U.S. 156, 158
(1946)(cited in the Primary Decision), made clear it was disallowing a claim for
interest on interest because the claim’s allowance would leave less assets for
other creditors. Here, no such equity exists and the decisions identify none.
Rather, the judgment creates a windfall for GTN based on no identified policy or
purpose. Indeed, it appears the decisions here do not even recognize that they
have no impact on the debtor, but simply injure Liberty to bestow a windfall on
GTN.
1. Liberty undisputably held a $140 million allowable claim for principal
against ET Power and a claim for postpetition interest unallowable
pursuant to 11 U.S.C. § 502(b)(2).
2. ET Power was liable to make a ratable distribution to Liberty on the $140
million principal claim.
3. Because Liberty was already paid $140 million by GTN, GTN inherited the
right to procure reimbursement from ET Power by way of indemnity or
subrogation. See 11 U.S.C. §§ 502(e) and 509.
4. If GTN’s payment to Liberty is characterized as $140 million of principal,
then GTN has an allowable indemnity or subrogation claim against ET
Power for $140 million.
5. If GTN’s payment to Liberty is characterized as $123 million of principal
and $17 million of postpetition interest, then:
a. Liberty has a $140 million claim against ET Power; but
b. By way of indemnity or subrogation, GTN inherits from Liberty, all
distributions it receives from ET Power in excess of $17 million.
6. Under both number 4 and 5 above, ET Power makes the same distribution
in respect of a $140 million claim for principal. Therefore, neither ET
Power nor its creditors are burdened with any distribution for postpetition
interest. Thus, there is no equity that compels number 4 over number 5
because there is NO impact whatsoever on the ET Power estate.
7. The difference between numbers 4 and 5 only impacts GTN and Liberty.
a. Under number 4, GTN obtains reimbursement (through indemnity
or subrogation) equal to ET Power’s ratable distribution on a claim
for $140 million.
b. Under number 5, GTN obtains reimbursement equal to ET Power’s
ratable distribution on a claim for $140 million LESS $17 million
that goes to Liberty.
8. Accordingly, the judgment makes ET Powers and its creditors, no better
off and no worse off. Rather, it makes GTN, as guarantor, $17 million
better off while depriving Liberty of $17 million of postpetition interest that
GTN guaranteed.
9. The judgment does no equity. Instead, it impairs commercial credit
enhancement by depriving Liberty of one of the two benefits it bargained
14

for by having a guaranty of all obligations whether allowable against ET
Power or not. The judgment is simply a windfall to GTN. It guaranteed
postpetition interest, but can get reimbursement from ET Power as if it did
not.
Significantly, the decisions at bar identify neither any equity served nor
which factors to take into account. The most important equity would presumably
be the impact on the debtor’s estate. But, there is no impact. Are we to take into
account how well Liberty does on its guaranties? If so, why? Liberty is not in the
same position as creditors without guaranties. Are we to take into account the
amount of reimbursement of a nondebtor (GTN)? If so, why? The imposition of
unidentified equity here renders the judgment a cloud over the enforcement of
commercial guaranties because there is no logic that can give rise to predictable
results. Put differently, every panel looking at the issue could come out
differently due to the absence of any articulated principles on which to apply
“equity.”
2. The Judgment Yields Illogical and Absurd
Consequences Demonstrating its Fallacy
Liberty’s guaranty from GTN was of “all amounts payable” by ET Power
under the Agreement. It is undisputed this included principal and interest. The
judgment, however, deems Liberty to have collected all principal from GTN even
though Liberty exercised its contract right to allocate some of GTN’s payment to
interest.
Let’s consider a slightly different guaranty. Let’s assume Liberty did
business with ET Power and with XYZ Corp, and GTN guaranteed their
respective obligations to Liberty up to a maximum of $140 million in the
aggregate. When ET Power commenced its bankruptcy case, ET Power owed
Liberty $140 million and XYZ Corp. owed Liberty $140 million. GTN paid Liberty
$140 million and Liberty allocated the amount to XYZ Corp.’s obligation. Next,
Liberty asserts its $140 million claim against ET Power. Is there any basis to tell
Liberty it must allocate GTN’s payment to ET Power’s obligation and not to XYZ
Corp.’s obligation? Of course not.
When Liberty has the right to allocate GTN’s payment to interest there is
no basis to eliminate that contract right, especially without compensation.
Now, let’s assume Liberty’s guaranty from GTN were SOLELY for interest.
In that situation, neither Judge Shedd nor Judge Wilson could argue Liberty was
endrunning section 502(b)(2) by asserting a principal claim against ET Power.
Thus, Liberty would be allowed to assert a $140 million principal claim against ET
Power if its guaranty from GTN were solely for interest. But, according to the
judgment, the instant guaranty of principal AND interest deprives Liberty of its
right to assert any principal claim against ET Power. How can a better guaranty
(guaranty of principal and interest) from a nondebtor give Liberty lesser rights
15

against its primary obligor than it would have with an inferior guaranty (guaranty
of interest only)?
3. The Judgment Resulted from Arbitrary Sequencing.
Yet another means to show the illogic of the judgment is to consider its
dependence on Liberty’s sequencing of its claim collections. As conceded by all
the decisions, Liberty had an allowable claim against ET Power in the amount of
$140 million as of the first day of ET Power’s chapter 11 case. All the decisions
also concede Liberty has the right to assert its full $140 million claim against ET
Power and each guarantor, so long as it does not collect in the aggregate more
than the full amount of its claim.
If Liberty had proceeded against ET Power before collecting from GTN,
there would be no basis to hold that ET Power did not have to provide Liberty
with a ratable distribution on its $140 million claim. Then, Liberty would be free
to collect from GTN all principal it did not receive from ET Power (i.e,, ET Power
may distribute less than 100 cents on the dollar) and all postpetition interest.
But, according to the judgment at bar, Liberty’s rights to collect full principal and
interest change if Liberty collects $140 million first from GTN. Manifestly,
Liberty’s rights of collection can not rationally or validly be impacted based on
whether it collects first from ET Power or first from GTN. But, the judgment is
totally dependent on the sequencing.
4. The Judgment Undermines Public Policy
Guaranties are a standard form of credit enhancement in the world of
commercial finance. Entities that are not themselves creditworthy, frequently
obtain credit when the lender can obtain a guaranty. Similarly, guaranties reduce
the cost of credit because they reduce the risk of loss. Equally obvious is that
interest is an essential component of credit because no lender can afford to lend
money for no return.
C. Travelers and 11 U.S.C. § 1123(d) Support Default Rate Interest in General
Electric Capital Corp. v. Future Media Productions Inc., 536 F.3d 969 (9 th
Cir. 2008)
i. Facts
When the debtor commenced its chapter 11 case, GECC was an
oversecured creditor and its credit agreement provided that contract interest
would increase by 2 percentage points after default. 536 F. 3d at 971. The
debtor sold the collateral pursuant to 11 U.S.C. § 363 prior to any chapter 11
plan. The proceeds inclusive of default interest and all fees were paid to GECC,
subject to the statutory creditors' committee's rights to litigate GECC's entitlement
to default interest and attorneys' fees. 536 F.3d at 972.
16

The bankruptcy court disallowed default interest based on In re Entz-
White Lumber and Supply, Inc., 850 F.2d 1338 (9 th Cir. 1988), and disallowed
attorneys' fees because GECC lost the litigation. 536 F.3d at 972.
ii. Issues
Does the Entz-White rule disallowing default interest on obligations reinstated
under a chapter 11 plan with defaults cured, apply to preplan sales, and if not,
should default rate interest be allowable?
iii. Holdings
Entz-White does not apply to preplan sales, and its continued validity for
sales under a plan is questionable due to the enactment of 11 U.S.C. § 1123(d). 4
536 F.3d at 974, 974n.2.
"…We read Travelers to mean the default rate should be enforced, subject
only to the substantive law governing the loan agreement, unless a provision of
the Bankruptcy Code provides otherwise...." 536 F.3d at 973.
"Because the Bankruptcy Code does not provide a 'qualifying or contrary
provision' to the underlying substantive law here, the bankruptcy court's
extension of Entz-White to the loan agreement's default rate was error.
Consistent with the Supreme Court's holding in Travelers, we hold that the
parties' arms length bargain, governed by New York law, controls." 536 F.3d at
974.
"[W]e remand to allow the bankruptcy court to decide whether the default
rate should apply under the rule adopted by the majority of federal courts. That
rule simply stated is: the bankruptcy court should apply a presumption of
allowability for the contracted for default rate, 'provided that the rate is not
unenforceable under applicable nonbankruptcy law.' 4 Collier on Bankruptcy, ¶
506.04[2][b][ii] (15 th Ed. 1996)…" 536 F.3d at 974. Therefore, default rate
interest should be allowed if it is enforceable under New York law.
"…We reject the creation of a bright line rule that would accept 2% as an
allowable default rate differential…." 536 F.3d at 975.
4 11 U.S.C. § 1123(d) provides:
Notwithstanding subsection (a) of this section and sections 506(b),
1129(a)(7), and 1129(b) of this title, if it is proposed in a plan to
cure a default the amount necessary to cure the default shall be
determined in accordance with the underlying agreement and
applicable nonbankruptcy law.
17

iv. Rationale
Entz-White disallowed default rate interest under a chapter 11 plan where
the default was cured under 11 U.S.C. § 1124(2)(A). But, there is no cure that
would nullify defaults in a section 363 sale.
v. Analysis
Although the Ninth Circuit's decision makes the default rate issue a
function of its enforceability under state law, the Ninth Circuit cites two decisions
for the proposition that there is a presumption in favor of allowing default rate
interest subject to rebuttal based on equitable considerations. 536 F.3d at 974
(citing In re Layman, 958 F.2d 72, 75 (5 th Cir. 1992) and In re Terry Ltd. P'ship,
27 F.3d 241, 243 (7 th Cir. 1994). The question that jumps off the page is whether
default rate interest provisions are preempted by the Bankruptcy Code's priority
scheme.
4. Non-Debtors Can Not Deprive Debtors Postpetition of the Option to Assume or
Reject Executory Contracts
A. COR Route 5 Co. v. Penn Traffic Co. (In re Penn Traffic Co.), 524 F.3d 373
(2d Cir. 2008)
i. Facts
Penn Traffic operated supermarkets and COR was a real estate
development company. 524 F.3d at 376. They had entered into a project
agreement under which Penn Traffic would convey certain land to COR and
lease back the land and a supermarket constructed on it, in exchange for COR
reimbursing $3.5 million of the construction cost and conveying certain parcels to
Penn Traffic. 524 F.3d at 376-377. When Penn Traffic commenced its chapter
11 case, COR had performed all its obligations under the project agreement
except for reimbursing the $3.5 million and tendering the lease back to Penn
Traffic. 524 F.3d at 377. Penn Traffic had not conveyed the supermarket parcel
to COR. 524 F.3d at 377.
Several months after commencement of Penn Traffic’s chapter 11 case,
COR tendered reimbursement of the $3.5 million as well as a signed lease. 524
F.3d at 377. Penn Traffic declined to accept the tender, and several months later
moved to reject the project agreement. 524 F.3d at 377.
Initially, the bankruptcy court ruled the project agreement was executory
on the petition date, but that COR’s tender rendered it nonexecutory and
therefore not subject to rejection. 524 F.3d at 377. The bankruptcy court
observed the debtor’s motion to reject the agreement, had it been executory,
appeared to satisfy the low threshold for rejecting the agreement of the business
judgment test because the supermarket parcel had been appraised at $9.8
18

million and the triggering event for the debtor’s conveyance of the parcel to COR
was the reimbursement payment of $3.5 million. 524 F.3d at 377. The district
court reversed, holding postpetition performance cannot alter the executoriness
of a contract, and remanded. 524 F.3d at 377. COR appealed, but the circuit
appellate court dismissed the appeal for lack of appellate jurisdiction due to the
further proceedings on remand. 524 F.3d at 377. The bankruptcy court entered
an order approving the rejection and providing COR was not waiving its position
that the contract was not executory. 524 F.3d at 378. On appeal to the district
court, that court reinstated its first decision and affirmed the subsequent rejection
order, and COR appealed to the Second Circuit. 524 F.3d at 378.
ii. Issues
“The principal issue presented on this appeal is whether the non-debtor
party to a contract that is executory at the time a bankruptcy case is commenced
can, by post-petition tender or performance of its own outstanding obligations
under the contract, deprive the debtor party of the ability to exercise its statutory
right to reject the contract as disadvantageous to the estate.” 524 F.3d at 378.
Does COR have rights to specific performance or rights under 11 U.S.C. §
365(i)-(j)?
iii. Holding
“We hold that it cannot.” 524 F.3d at 378.
“…Because these arguments anticipate issues that may arise in claimsadjudication
proceedings that have not yet commenced, we think it best to
permit the Bankruptcy Court to consider these arguments in the first
instance.” 524 F.3d at 383n.5.
iv. Rationale
“Sympathy for the non-debtor that may, through no fault of its own,
bear some significant burden from the debtor’s rejection of an executory
contract due to the happenstance of an unforeseen bankruptcy
proceeding is understandable. The notion that a non-debtor could prevent
the exercise of § 365 rights with regards to an executory contract through
post-petition performance of the non-debtor’s contractual obligations is,
however, inconsistent with both the plain language and the policy of the
Code….The Code does not condition the right to assume or reject on lack
of prejudice to the non-debtor party, and the satisfaction of claims at less
than their full non-bankruptcy value is common in bankruptcy proceedings,
as is the disruption of non-debtors’ expectations of profitable business
arrangements.” 524 F.3d at 382.
“However long this process may take, however onerous the
dilemmas faced by the non-debtor party to an executory contract may be
while the non-debtor awaits the debtor’s decision, and whether or not the
19

ankruptcy judge grants a motion by the non-debtor party to accelerate
the debtor’s timetable for making its election to assume or reject, the
power to make that election is, as we made clear in In re Chateaugay
Corp., that of the debtor alone. 10 F.3d at 955 (“Section 365 does not
confer any power of election upon the other contracting party.”);…” 524
F.3d at 382-383.
v. Analysis
Consistent with bankruptcy policy and precedent, it is hornbook law that,
subject to equitable principles, 5 the debtor in possession has the option to
assume or reject executory contracts in accordance with which alternative is
better for its estate. 6
If the nondebtor party could proffer performance postpetition and thereby
compel the debtor to perform contracts for which it has superior alternatives, the
equity policy would be turned upside down. Rather than the nondebtor contract
party sharing losses with other creditors, the nondebtor would be paid in full while
causing other creditors to take greater losses.
Just imagine a debtor having an executory contract to purchase 100
widgets at $10 per widget when the market price is $7 per widget. The debtor
should reject the contract and purchase widgets in the market for $7 per widget
to save $300. The nondebtor party can file a prepetition damage claim of $300.
But, if the estate pays claims at less than 100 cents on the dollar, the estate and
its other creditors will be better off. The notion that the nondebtor widget seller
can prevent rejection of the contract by tendering 100 widgets and eliminating its
executoriness, would gut the estate’s right and power to make economically
rational decisions.
Thus, the fundamental issue determined in Penn Traffic, that the
nondebtor contract party can not eliminate executoriness by postpetition activity,
5 See, e.g., Brotherhood of Railway, Airline and Steamship clerks v. REA Express,
Inc. (In re REA Express, Inc.), 523 F.2d 164 (2d Cir. 1975), cert. denied, sub nom.
International Assoc. of Machinists & Aerospace Workers, AFL-CIO v. REA
Express, Inc., 423 U.S. 1073 (1976); Control Data Corp. v. Zelman (In re Minges),
602 F.2d 38, 44 (2d Cir. 1979 ); In re Penn Central Transp. Co., 458 F.Supp. 1346,
1356 (E.D. Pa. 1978); Software Customizer, Inc. v. Bullet Jet Charter, Inc. (In re
Bullet Jet Charter, Inc.), 177 B.R. 593, 603 (Bankr. N.D. Ill. 1995) (denying debtor’s
motion to reject a contract for sale of an aircraft, in part, because such motion was
“just another device to pressure [the buyer] to pay more money, not an effort to sell
[the aircraft] for more to another likely purchaser”).
6 American Anthracite & Bituminous Coal Corp. v. Leonardo Arrivabene, S.A.,
280 F.2d 119, 126 (2d Cir. 1960).
20

was obviously corrected determined. The decision, however, fails to deal with
two other issues embedded in the decision, one it mentions and one
unmentioned.
The unmentioned issue is whether the nondebtor party would be better off
as a consequence of the contract not being executory. Clearly, COR believes it
would be better off and would presumably have the right to the conveyance of
the supermarket parcel in exchange for the $3.5 million and the lease. But, that
is hardly clear. When a contract is not assumed and the nondebtor party tenders
performance, the debtor is, by definition, not bound by the terms of the contract.
The contract provides a rebuttable presumption of what the debtor is obligated to
provide, but the presumption is rebuttable by the market value and the debtor
may have to provide more or less than what the contract would require. 7
Therefore, COR’s tender of the $3.5 million and the lease, would not entitle it to
the conveyance of land worth $9.8 million absent the debtor’s assumption of the
project agreement which did not occur.
The issue the court acknowledged, but did not determine, was whether
upon rejection of the project agreement COR would be entitled to specific
performance of the conveyance of real property (the supermarket parcel), which
issue is discussed below. 524 F.3d at 383n.5. It does not appear, however, that
the court could properly determine the appeal of the project agreement’s
rejection without knowing the answer to the specific performance issue. If the
debtor’s rejection of the project agreement would entitle COR to conveyance of
the supermarket parcel, then it does not appear the debtor’s estate can satisfy
the business judgment test for rejection because the estate would not be better
off. Indeed, the estate may be worse off because in addition to having to convey
the parcel, the estate would be liable for breach (rejection) of contract and that
could add other damages such as attorneys’ fees and the like. It could even put
into question whether COR would have to pay $3.5 million once Penn Traffic
breaches the contract by rejecting it.
7 NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984); In re Thompson, 788 F.2d 560 (9th Cir. 1986)
(the fair and reasonable value of the benefits on the open market controls, not the value to the debtor);
Peoples Gas Sys., Inc. v. Thatcher Glass Corp. (In re Thatcher Glass Corp.), 59 B.R. 797 (Bankr. D. Conn.
1986) (same), but see American Anthracite & Bituminous Coal Corp. v. Leonardo Arrivabene, S.A., 280
F.2d 119, 126 (2d Cir. 1960); GATX Leasing Corp. v. Airlift Int'l, Inc. (In re Airlift Int'l, Inc., 761 F.2d
1503, 1508 (11th Cir. 1985); Philadelphia Co. v. Dipple, 312 U.S. 168, 174 (1941); Quincy M&PR Co. v.
Humphreys, 145 U.S. 82 (1892); Palmer v. Palmer, 104 F.2d 161, 163 (2d Cir. 1939); In re United Cigar
Stores Co., 69 F.2d 513 (2d Cir.), cert. denied sub nom. Reisenwebers, Inc. v. Irving Trust Co., 293 U.S.
566 (1934); In re Lane Foods, Inc., 213 F. Supp. 133, 166 (S.D.N.Y. 1963); In re O.P.M. Leasing Servs.,
Inc., 14 B.C.D. 83, 86 (Bankr. S.D.N.Y. 1986); In re Bohack, 1 B.C.D. 287 (Bankr. E.D.N.Y. 1974). One
court holds that even a postpetition lease entered into in the ordinary course of business without requiring
court approval gives rise to administrative expense claims only in the amount the court determines is the
fair market value of the debtor's use of the leased premises. Burlington N.R.R. Co. v. Dant & Russell, Inc.
(In re Dant & Russell, Inc.), 853 F.2d 700 (9th Cir. 1988).
21

Finally, if the consequences of rejection have to be known before the court
can determine whether the business judgment test supports rejection, then the
matter before the circuit court may not have been a final order over which it had
appellate jurisdiction. Rather, because the rejection determination would have to
await a bankruptcy court determination as to whether COR would be entitled to
specific performance, the order on appeal may not amount to a final order.
B. Specific Performance
i. Specific Performance under the UCC
Pursuant to section 2-716 of the Uniform Commercial Code, a buyer may
be entitled to specific performance where the goods are “unique or in other
proper circumstances,” and the Official Comment makes crystal clear that supply
contracts for unique parts are the prototypical proper circumstances. Sections
2-716(1)-(2) of the Uniform Commercial Code provide:
(1) Specific performance may be decreed where
the goods are unique or in other proper circumstances.
(2) The decree for specific performance may
include such terms and conditions as to payment of the price,
damages, or other relief as the court may deem just.
Official Comment 2 to section 2-716 provides:
In view of this Article’s emphasis on the commercial
feasibility of replacement, a new concept of what
are ‘unique’ goods is introduced under this section.
Specific performance is no longer limited to goods
which are already specific or ascertained at the
time of contracting. The test of uniqueness under
this section must be made in terms of the total
situation which characterizes the contract. Output
and requirements contracts involving a particular or
peculiarly available source or market present today
the typical commercial specific performance
situation, as contrasted with contracts for the sale
of heirlooms or priceless works of art which were
usually involved in the older cases. However,
uniqueness is not the sole basis of the remedy
under this section for the relief may also be granted
“in other proper circumstances” and inability to
cover is strong evidence of “other proper
circumstances.”
22

Consistent with the Official Comment, specific performance is granted when the
buyer has an inability to cover. 8
Courts consistently rule specific performance is available to prevent
irreparable harm where the remedy at law is inadequate. 9 Courts grant buyers
specific performance of purchase contracts when monetary damages are deemed
inadequate and the buyers would be irreparably harmed 10 by termination of the
purchase contracts. 11
In DaimlerChrysler Corp. v. Lear Corp. 12 DaimlerChrysler Corporation
(“DCC”) filed a complaint against Lear Corporation (“Lear”), a sole source supplier
of seats and other parts for Chrysler vehicles, on the ground that Lear’s threats to
8 See International Casings Group, Inc. v. Premium Standard Farms, Inc., 358 F.
Supp. 2d 863, 876 (W.D. Mo. 2005) (holding that a buyer of hog casings could
not find cover goods to replace the casings manufactured by the seller because
those casings were not fungible and were not readily available on the spot
market); Software Customizer, Inc. v. Bullet Jet Charter, Inc. (In re Bullet Jet
Charter, Inc.), 177 B.R. 593, 599 (Bankr. N.D. Ill. 1995) (specific performance
granted where buyer of an aircraft was unable to cover, “if at all, without
considerable inconvenience, expense, and delay.”).
9 Edidin v. Detroit Econ. Growth Corp., 352 N.W.2d 288, 291 (Mich. Ct. App.
1984); see also Shell Oil Co. v. AMPM Enters., Inc., No. 95-CV-75117-DT, 1996
U.S. Dist. LEXIS 4667, *14 (E.D. Mich. Mar. 18, 1996); Wirth v. United States,
No. 2:91-CV-099, 1991 U.S. Dist. LEXIS 16038, *9 (W.D. Mich. June 26, 1991).
10 See , Zurn Constructors, Inc. v. The B.F. Goodrich Co., 685 F. Supp. 1172,
1181 (D. Kan. 1988) (“[n]umerous cases support the conclusion that loss of
customers, loss of goodwill, and threats to a business’ viability can constitute
irreparable harm.”).
11 See, e.g., Laclede Gas Co. v. Amoco Oil Co., 522 F.2d 33, 39 (8th Cir. 1975)
(decreeing specific performance of a long-term contract to supply propane gas to
a distributor for distribution to a specific subdivision even though propane gas
was readily available on the market and the distributor had propane gas
immediately available to it under other contracts with other suppliers because the
distributor probably would not have been able to enter into a similar long-term
contract with anyone else and monetary damages for the considerable expense
and trouble of rearranging distribution from other sources to the subdivision
supplied by the defendant would have been difficult to estimate); Zurn
Constructors, Inc. v. The B.F. Goodrich Co., 685 F. Supp. 1172, 1187 (D. Kan.
1988) (granting specific performance to a buyer of polyvinylchloride (“PVC”) pipe
grade resin, an essential raw material used by buyer to manufacture PVC pipes,
because the buyer was not able to purchase a sufficient amount of PVC pipe
grade resin from other sources due to a shortage, and the buyer would have
been irreparably harmed by the termination of the supply contract because the
inability to buy the raw material for its products would potentially have put it out of
business, and money damages would thus have been inadequate).
12 No. 05-70865, slip op. (Mich. Cir. Ct. Dec. 1, 2005).
23

cease production of certain parts to DCC unless DCC would agree to Lear’s
demanded price increases constituted anticipatory reputation by Lear of the supply
contract and entitled DCC to specific performance. The Michigan Circuit Court
issued a temporary restraining order restraining Lear from repudiating or
threatening to breach its purchase contracts with DCC for a certain term or
refusing to fulfill any of its supply obligations to DCC. 13 The court found DCC
would suffer “irreparable harm [to its] customer goodwill, business reputation, and
existence” if Lear ceased delivery of parts and DCC would not have an adequate
remedy at law. 14
ii. Specific Performance of Real Property Sales Granted by the
Bankruptcy Code
California.To obtain specific performance for breach of contract under California
law, a plaintiff must show “(1) the inadequacy of his legal remedy; (2) an
underlying contract that is both reasonable and supported by adequate
consideration; (3) the existence of a mutuality of remedies; (4) contractual terms
which are sufficiently definite to enable the court to know what it is to enforce;
and (5) a substantial similarity of the requested performance to that promised in
the contract.” Real Estate Analytics, LLC v. Vallas, 160 Cal. App. 4th 463, 472
(Cal. Ct. App. 2008). The party seeking specific performance cannot be in
material breach of the contract. See Cal. Civ. Code § 3392; Galvez v. Yoo, No.
B193913, 2007 WL 4465139, at *2 (Cal. Ct. App. Dec. 21, 2007) (plaintiff must
plead and prove he is ready, willing and able to specifically perform contract).
Moreover, courts will not specifically enforce a contract against a party if that
party’s assent “was obtained by misrepresentation, concealment, circumvention,
or unfair practices” by the party seeking specific performance, or if the party’s
asset “was given under the influence of mistake, misapprehension, or surprise.”
Cal. Civ. Code § 3391. Ultimately, “the specific performance of a contract is not
a matter of course, but rests in the sound discretion of the Court, upon a view of
all the circumstances.” See, e.g., Cooper v. Pena, 21 Ca. 403, 411 (1863).
The California legislature has enacted a statute specifically prescribing
that “[i]t is to be presumed that the breach of an agreement to transfer real
property cannot be adequately relieved by pecuniary compensation.” Cal. Civ.
Code. § 3387. Where the real property at issue is a single-family dwelling in
which the party seeking performance intends to live, the presumption is
conclusive; for all other real property, the presumption is rebuttable and shifts the
burden of proof to the party opposing enforcement to prove that damages would
be adequate. Id.; Real Estate Analytics, 160 Cal. App. 4th at 474. By shifting the
burden, “the Legislature intended that a damages remedy for a nonbreaching
party to a commercial real estate contract is the exception rather than the rule.”
Real Estate Analytics, 160 Cal. App. 4th at 474. The question of what evidence
suffices to rebut the presumption of inadequacy of damages is an open one, but
it is clear that the mere fact that the party seeking specific enforcement seeks the
13 Id. at *2.
14 Id. (emphasis added).
24

property for investment purposes, as opposed to dwelling or commercial
purposes, is insufficient standing alone. Id. (that plaintiff was motivated “solely to
make a profit from the purchase of the property does not overcome the strong
statutory presumption that all land is unique”; noting that the property at issue
was unique in physical attributes and location, as well as in its investment
potential and the reasonableness of the contract price).
With respect to the third element (the “mutuality of remedy” requirement),
California courts will not enforce a contract where the party seeking enforcement
“cannot himself be compelled to perform it,” unless (a) specific performance is
otherwise an appropriate remedy, and (b) the agreed counter-performance has
been substantially performed, is assured, or can be secured to the satisfaction of
the court. See, e.g., Cooper, 21 Ca. at 410; Cal. Civ. Code § 3386. To that end,
obligations to render personal services or to employ another in personal service
cannot generally be specifically enforced. See, e.g., Cal. Civ. Code § 3390;
Cooper, 21 Ca. at 410; but see Ellis v. Mihelis, 60 Cal. 2d 206, 215 (1963)
(“Where a party commences an action to compel the specific enforcement of an
agreement for the sale of property, the requirement of mutuality is satisfied, the
theory being that by bringing the action the plaintiff has submitted himself to the
jurisdiction of equity and thereby enables the court to assure performance of
him.”).
Nevada. Under Nevada law, specific performance is available when (1) the
terms of the contract are definite and certain, (2) the remedy at law is
inadequate, (3) the plaintiff has tendered performance or is ready, willing, and
able to perform, and (4) the court is willing to order it. Carcione v. Clark, 96 Nev.
808, 810 (1980) (internal citations omitted). In Nevada, as in California, the
remedy at law is generally deemed inadequate when the contract at issue is for
real property, on the theory that each parcel of land is unique. Id.; see also Stoltz
v. Grimm, 100 Nev. 529, 533 (1984). Thus, in Nevada, as in California, specific
enforcement is generally granted in cases where the contract at issue calls for
the transfer of real property, provided the foregoing requirements are satisfied.
That said, in Nevada – as in California – the decision whether to award specific
performance is committed to the sound discretion of the court, see, e.g., Cohen
v. Rasner, 97 Nev. 118, 120 (1981), and the decision “will not be disturbed on
appeal unless an abuse of discretion is shown,” McCann v. Paul, 90 Nev. 102,
103-04 (1974).
Florida. Under Florida law, “the decision whether to decree specific performance
of a contract is a matter that lies within the sound judicial discretion of the trial
court and it will not be disturbed on appeal unless it is clearly erroneous.” Free v.
Free, 936 So.2d 699, 702 (Fla. App. 2006); Bird Lakes Dev. Corp. v. Muruelo,
626 So.2d 234, 238 (Fla. App. 1993) (affirming denial of specific enforcement
where the party seeking enforcement of a contract for the sale of real property
could be adequately compensated by money damages). “The exercise of that
discretion is governed by consideration of all of the facts and circumstances of
25

the case and application of well-settled legal and equitable principles.” Free, 936
So.2d at 702. “[T]he ultimate goals to be achieved by invocation of specific
performance” are “justice and fairness,” and if these goals would be contravened
by a grant of specific enforcement, the court will not grant the remedy. Id.15
Florida courts have held that specific performance is “uniquely capable” of
rectifying breaches of contract involving the sale of real estate. See Bell v. Alsip,
435 So.2d 840, 842 (Fla. App. 1983). This is because real estate is unique and
“[m]oney damages upon breach of a purchase and sale agreement adequately
compensates neither a seller, burdened with ownership, nor a buyer, deprived of
ownership and possession.” Id.; see also Bermont Lakes LLC v. Rooney, No.
2D07-3138, 2008 WL 1883980, at *4 (Fla. App. Apr. 30, 2008) (“[M]oney
damages are considered an inadequate remedy at law to a purchaser of land
because all land is considered unique.”); Henry v. Ecker, 415 So.2d 137, 140
(Fla. App. 1982) (“Since all land is considered unique, money damages to a
contract purchaser of lands is an inadequate remedy at law.”).
Arizona. Under Arizona law, “specific performance is ordinarily available to
enforce contracts for the sale of real property because land is viewed as unique
and an award of damages is usually considered an inadequate remedy.”
Queiroz v. Harvey, No. 1 CA-CV 07-0309, 2008 WL 2058233, at *7 (Ariz. App.
Div. May 15, 2008) (quoting Woliansky v. Miller, 135 Ariz. 444, 446 (App. 1983)).
There is, however, a potential exception to this general rule. Specifically, the
Arizona Court of Appeals has held that “[i]n case where the purchaser does not
desire the real property for personal use but instead wants to acquire the land
merely for the profit to be gained upon resale, damages would theoretically be an
adequate remedy.” Woliansky, 135 Ariz. at 446 (remanding case to trial court to
determine the appropriate remedy for breach of contract to sell parcel of real
property).
Ultimately, the decision to grant specific performance is “never a matter of
absolute right”, and the trial court is afforded “wide discretion” to determine
whether or not damages would be an adequate remedy in contracts concerning
the sale of real property. Queiroz, 2008 WL 2058233, at *7.16
15 Under Florida law, when parties have contracted for specified remedies in the event of breach,
their agreement will generally control, “provided the remedy is mutual, unequivocal and reasonable.” See
Seaside Cmty Dev. Corp. v. Edwards, 573 So.2d 142, 147 (Fla. App. 1991) (granting money damages for
breach of real estate contract despite the fact that the contract provided that the available remedies for
breach by the seller were specific performance or refund of earnest money; statute of limitations for
specific enforcement had expired, and the return of earnest money deposit was neither reasonable or
mutual).
16 Note that “once a contract is rejected [in bankruptcy], the equitable remedy of specific
performance is no longer available.” TPG of Scottsdale, LLC v. Scott Desert Shadows, LLC, Bankr. Adv.
P. No. 06-00003, 2006 WL 1775828, at *4 (Bankr. D. Ariz. Apr. 14, 2006).
26

Utah. Under Utah law, specific performance “is the presumed remedy for the
breach of an agreement to sell real property.” Knighton v. Bowers, No.
20030170-CA, 2004 WL 797560, at *1 (Utah Ct. App. Apr. 15, 2004).17 Indeed,
specific performance is generally available when the contract involves property
which is unique or possesses special value, and real property is assumed to be
unique. Id. That said, “[s]pecific performance is an equitable remedy, and
accordingly, the trial court is granted wide discretion in applying and formulating
it.” Id. The remedy is not, in other words, a matter of “absolute right” and the trial
court “after evaluating equitable considerations” may properly deny it. Id.
(affirming denial of specific performance of contract involving real property where
party seeking specific performance delayed nearly four years in bringing suit);
see also Morris v. Sykes, 624 P.2d 681, 684 (Utah 1981) (affirming denial of
specific performance involving real property where plaintiff was delinquent in
payments and defendant had sold the property to another entity); Prop.
Assistance Corp. v. Roberts, 768 P.2d 976, 979 (Utah Ct. App. 1989) (“Specific
performance is a remedy of equity which his addressed to the sense of justice
and good conscience of the court, and accordingly, considerable latitude of
discretion is allowed in [the trial court’s] determination as to whether it shall be
granted and what judgment should be entered.”)
Colorado. Under Colorado law, specific performance may be granted when the
party seeking enforcement of the contract cannot be fully compensated at law
because of the nature of the property or its speculative value; the property at
issue need not be real property to warrant specific enforcement. See Bernhardt
v. Hemphill, 878 P.2d 107, 113 (Colo. Ct. App. 1994) (holding that time-share
contracts, although not creating interests in real property, may be specifically
enforced).
Generally, real property is deemed unique and legal remedies are,
therefore, inadequate to compensate for a breach. See Prosser v. Schmidt, 197
P.2d 318, 319 (Colo. 1948) (legal remedies for breach of a contract conveying
real estate are presumed inadequate; “different tracts of land are not of equal
type and value like bushels of wheat from the same bin.”); White v. Greenamyre,
234 P. 164, 165 (Colo. 1925) (“The general rule is that specific performance of a
contract for the sale of land will be granted, even thought he plaintiff might be
fully compensated in damages for any injury resulting from a failure of the
defendant to convey.”). However, “[e]quity will not decree specific performance
of a contract to convey land if there is an adequate remedy at law.” Schreck v. T
& C Sanderson Farms, Inc., 37 P.3d 510, 514 (Colo. Ct. App. 2001). Thus, at
17 In fact, specific performance may be granted even where the contract at issue does not identify
specific performance as a possible remedy, provided the remedies identified in the contract are not properly
deemed exclusive remedies. See Kelley v. Leucadia Fin. Corp., 846 P.2d 1238, 1241-42 (Utah 1993)
(holding buyer was entitled to specific performance where the contractual remedies were not properly
deemed exclusive and did not “in any way limit the traditional common law or equitable remedies available
to” the plaintiff). Further, “when specific performance is in order, the buyer may be entitled to an award of
lost rents or profits, while the seller may be entitled to interest on the purchase money withheld by the
purchaser.” Saunders v. Sharp, 840 P.2d 796, 808 (Utah Ct. App. 1992).
27

least one court has held that a party seeking specific performance of a contract
involving real property must demonstrate that the property at issue has unique
qualities that are important to the party. Id. In addition, another court has implied
that specific performance of a contract concerning real property may not be
specifically enforced where the party seeking enforcement is interested in the
property for “primarily financial and not personal” reasons. See Hornick v.
Boyce, Civ. No. 03-cv-02504-REB-CBS, 2007 WL 8392, at *11 (D. Colo. Jan. 2,
2007) (specific performance was impracticable due to disposition of the property
to a third party; in any event, the remedy may not have been warranted where
the plaintiff’s interest in the property was primarily financial and not personal, and
where the agreement at issue demonstrated that the plaintiff was not interested
in specific, unique property but rather in a membership interest in a LLC).
Minnesota. Under Minnesota law, “[s]pecific performance is an equitable remedy
addressed to the discretion of the court.” Saliterman v. Bigos, 352 N.W.2d 494,
496 (Minn. Ct. App. 1984). It is not an absolute right and “if enforcement would
be unconscionable or inequitable, performance will not be decreed.” See Giles
Props., Inc. v. Kukacka, No. A06-1275, 2007 WL 1191801, at *2 (Minn. Ct. App.
Apr. 24, 2007) (quotations omitted).
Courts applying Minnesota law consider several factors when determining
whether to grant specific performance of a contract involving real property.
Namely, courts analyze the following factors:
(a) the contract must be established by clear, positive, and
convincing evidence; (b) it must have been made for adequate
consideration and upon such terms which are otherwise fair and
reasonable; (c) it must have induced without sharp practice,
misrepresentation, or mistake; (d) its enforcement must not cause
unreasonable or disproportionate hardship or loss to the
defendants or to third persons; and (e) it must have been
performed in such a manner and by the rendering of services of
such a nature and under such circumstances that the beneficiary
cannot be properly compensated in damages.
Saliterman, 352 N.W.2d at 496; see also Giles Props., 2007 WL 1191801, at *3.
In addition, the party seeking enforcement “shall have been prompt, ready, and
eager to perform upon his part and have exercised good faith and been diligent.”
See Boulevard Plaza Corp. v. Campbell, 94 N.W.2d 273, 283 (Minn. 1959).
Finally, although not determinative, courts will consider whether the contract
allows for mutuality of remedy. Saliterman, 352 N.W.2d at 496.
Land is generally deemed to be unique; “[w]hile the remedy of specific
performance of enforceable real estate purchase/sale agreements is not
automatic, the remedy will ordinarily lie where performance is feasible.” Giles,
2007 WL 1191801, at *4 (quoting In re Kreger, 296 B.R. 202, 209 (Bankr. D.
28

Minn. 2003)); cf. Schumacher v. Ihrke, 469 N.W.2d 329, 335 (Minn. Ct. App.
1991) (“If real property is involved, specific performance is a proper remedy,
even if the other remedies would be adequate.”) Where, however, the evidence
demonstrates that land is purchased for investment purposes, the general
principle that specific performance should be granted because the land is unique
is less persuasive. See Hilton v. Nelsen, 283 N.W.2d 877, 881 (Minn. 1979)
(denying specific performance to purchaser where contract provided that, upon
seller’s default, purchaser would be entitled to seek specific performance or
damages; reasoning, in part, that the purchaser purchased the property for
investment purposes). That is not to say that a claim for specific performance is
automatically defeated by the fact that the party seeking performance intends to
purchase the land for investment purposes; rather, it is simply one of several
factors courts will consider when making a determination of whether to grant
specific performance. See Hilton, 283 N.W.2d at 883; Giles, 2007 WL 1191801,
at *4.
Texas (3%)
Texas. It is well-settled that, under Texas law, “specific performance is
more readily available as a remedy for the sale of real estate than for the sale of
personal property.” Rus-Ann Dev., Inc. v. ECGC, Inc., 222 S.W.3d 921, 927
(Tex. App. 2007).18 “This is because damages are generally believed to be
inadequate in connection with real property.” Rus-Ann Dev., 222 S.W.3d at 927.
There is arguably conflicting authority regarding whether, when
appropriately invoked, specific performance is a right or simply one possible
remedy. In Graves, the court suggested that the remedy is a right, holding that,
“[a] purchaser of real estate is entitled to specific performance of a contract for
sale of land.” 132 S.W.3d at 17-18 (quoting Abraham Inv. Co. v. Payne Ranch,
Inc., 968 S.W.2d 518, 527 (Tex. App. 1998)); see also, e.g., Hubler, 700 S.W.2d
at 698 (“It is as much a matter of course for a court to decree specific
performance of a contract to sell real estate as it is to give damages for its
breach.”); Claflin, 645 S.W.2d at 633 (“[A] contract for the sale of land will be
enforced as a matter of right, regardless of its wisdom or folly, if fairly and
understandingly made . . . [C]ourts cannot arbitrarily refuse specific performance
of a contract, because they deem it unwise, or because subsequent events
disclose that it will result in a loss to defendant; but to justify the refusal of this
relief it must appear that the defendant had been misled and overreached to
such an extent that the contract is unconscionable.” (quoting Bennett v.
Copeland, 235 S.W.2d 605, 609 (Tex. 1951)).
Other authorities have held, however, that specific performance is “not a
matter of right,” but merely often granted when the party seeking enforcement of
a contract for real estate makes the requisite showings. See, e.g., Scott v.
18 As a general rule, Texas courts will not grant specific performance of a contract relating to
personal property. See Nash v. Conatser, 410 S.W.2d 512, 520 (Tex. Civ. App. 1966).
29

Sebree, 986 S.W.2d 364, 369 (Tex. App. 1999) (“Although specific performance
is not a matter of right, it is often granted where a valid contract to purchase real
property is breached by the seller.”); Magram v. Lewis, 618 S.W.2d 420, 422
(Tex. App. 1981) (“Specific performance of a contract for the sale of [l]and is
ordinarily granted where the action is based upon a valid contract, but the relief is
not a matter of right.”); Fisher v. Wilson, 185 S.W.2d 186, 190 (Tex. Civ. App.
1945) (specific performance is not an absolute right, and that “[g]enerally
speaking, it may be said that specific performance, where permissible under the
terms of contract, will be granted when it is apparent from a view of all the
circumstances that it will serve the ends of justice, and it will be withheld when,
from a like view, it is apparent that performance will result in hardship or injustice
to either of the parties.”). At least one court has noted (albeit in dicta) that Texas
law provides damages as an alternative remedy to specific performance for
breach of contract for the transfer of real property; as such, even in cases where
specific performance is available, damages may be awarded in its stead. See
Swinehart v. Stubbeman, McRae, Sealy, Laughlin & Browder, Inc., 48 S.W.3d
865, 885 (Tex. App. 2001) (specific performance was not available because the
contract failed to satisfy the statute of frauds, but stating that, even if specific
performance were available, money damages are an alternative remedy for
breach of contract for the transfer of real property; as a result, the contract gave
right to a “claim” for bankruptcy purposes). The resolution to this apparent
conflict may depend upon the remedies the parties identify in their contract.
Indeed, in a case with particularly strong language favoring the theory that
specific performance is a right, the contract specifically provided that the seller
was entitled to elect as remedies either specific enforcement or termination of the
contract and liquidated damages; the court emphasized the agreed-upon
remedies in affirming the trial court’s award of specific performance to the seller.
See Claflin, 645 S.W.2d at 632.
Maryland. Under Maryland law, specific performance is an extraordinary
equitable remedy; it may be granted where traditional remedies, such as
damages, are “either unavailable or inadequate.” Archway Motors, Inc. v.
Herman, 27 Md. App. 674, 681 (Md. Ct. Spec. App. 1977). Courts have held that
this remedy is particularly appropriate in the context of contracts for the sale of
land, “because of the presumed uniqueness of land itself, no parcel being exactly
like another.” Archway, 27 Md. App. at 681 (citing Restatement of Contracts §
360 (1932)). In other words, when a contract is for the sale of land, traditional
remedies are generally presumed to be uncertain and inadequate. Id. at 683-84.
Under Maryland law, where all criteria are satisfied, “it is as much a matter
of course for a court of equity to decree its specific performance as it is for a
court of law to give damages for its breach.” Archway, 37 Md. App. at 684, 686
(noting that specific performance under these circumstances has been held to be
a “matter of course” or “duty”).19 The decree of special enforcement “need not
19 In addition to specific performance, the party seeking enforcement may be entitled to ancillary
money damages to compensate that party for losses caused by the defending party’s breach of the contract.
30

e identical with that promised in the contract. Such a decree may be drawn so
as best to effectuate the purposes for which the contract was made, and it may
be granted on such terms and conditions as justice requires.” Boyd, 28 Md. App.
at 23.
Virginia. Under Virginia law, suits for specific performance of contracts relating to
land are “appropriately addressed to the discretion of a court sitting in equity
because of the unique nature of such a contract.” In such cases, the court may
grant specific performance if: (1) there is a valid, certain, and definite contract
between the parties that is itself not inequitable; (2) specific performance is a
practical form of relief in the circumstances; (3) there are mutual performance
obligations, such that each party may comply with obligations under the contract;
and (4) there are no legal or equitable defenses to enforcement of the
agreement.” Adams v. Doughtie, No. 03-0484, 2003 WL 23140076, at *11 (Va.
Cir. Ct. Dec. 31, 2003); see also City of Manassas v. Bd. of County Supervisors
of Prince William County, 250 Va. 126, 134 (1995) (“[T]he terms of the contract
sought to be specifically enforced must be definite.”); Firebaugh v. Hanback, 247
Va. 519, 526 (1994) (noting that the court has denied specific performance of
contracts executed under a mutual mistake of fact and further holding that “he
who asks equity must do equity, and he who comes into equity must come with
clean hands.”);20 Duke v. Tobin, 198 Va. 758, 760 (1957) (“It is an elementary
principle that a court of equity will not specifically enforce a contract unless it be
complete and certain. All the essential terms of the contract must be finally and
definitely settled.”). In addition, the party seeking enforcement must demonstrate
that “he has been able, ready, prompt, eager and willing to perform the contract
on his part.” Alaragy v. Dengler, No. 181411, 2004 WL 1662279, at *3 (Va. Cir.
Ct. June 9, 2004).
As a general matter, “where a contract respecting real property is in its
nature and circumstances unobjectionable, it is as much a matter of course for
courts of equity to decree specific performance of it, as it is for a court of law to
give damages for a breach of it.” Bond v. Crawford, 193 Va. 437, 444 (1952)
(quotations omitted). “Specific performance of a contract is not a matter of
absolute right but rests in a sound judicial discretion.” Alaragy, 2004 WL
1662279, at *3; Chesapeake Builders, Inc. v. Lee, 254 Va. 294, 300 (1997)
(“Specific performance of a contract does not lie as a matter of right, but rests in
the discretion of the chancellor, and may be granted or refused under established
equitable principles and the facts of a particular case.”). That discretion “must be
Archway, 37 Md. App. at 687-88. Further, specific performance may be granted even though not identified
as a remedy in the contract at issue, unless the contract clearly indicates that the identified remedies are
exclusive. See Miller v. United States Naval Inst., 47 Md. App. 426, 435-36 (Md. Ct. Spec. App. 1980)
20 Although one seeking equity must have clean hands, “the clean hands maxim does not operate to
bar a sinner forever from a court of equity.” Bond v. Crawford, 193 Va. 437, 447 (1952). To defeat a
claim for specific performance, “[t]he misconduct relied on must relate directly to the matter in litigation.
It is not sufficient that the wrongdoing is remotely or indirectly connected with the subject of the suit.” Id.
31

exercised with a view to the substantial justice of the case.” Chesapeake
Builders, 254 Va. at 300.
iii. Rights to Specific Performance Are Often Nondischargeable
Significantly, the Bankruptcy Code itself grants certain federal rights of
specific performance regardless of whether they exist under state law. For
instance, entities holding executory contracts to purchase real property from the
debtor, who are in possession of the property, have rights to specific performance
if the debtor in possession or trustee rejects the contract. 21 Licensees of
intellectual property are also granted rights to continue to use a rejected license.22
Rejection of an executory contract breaches it, but does not terminate it or
avoid it. 23 For example, “[c]onsistent with bankruptcy law’s general deference to
21 Bankruptcy Code section 365(i) provides:
(1) If the trustee rejects an executory contract of the debtor for the
sale of real property or for the sale of a timeshare interest under a
timeshare plan, under which the purchaser is in possession, such
purchaser may treat such contract as terminated, or, in the
alternative, may remain in possession of such real property or
timeshare interest.
(2) If such purchaser remains in possession—
(A) such purchaser shall continue to make all payments due under
such contract, but may, offset against such payments any damages
occurring after the date of the rejection of such contract caused by
the nonperformance of any obligation of the debtor after such date,
but such purchaser does not have any rights against the estate on
account of any damages arising after such date from such
rejection, other than such offset; and
(B) the trustee shall deliver title to such purchaser in accordance
with the provisions of such contract, but is relieved of all other
obligations to perform under such contract.
22 11 U.S.C. § 365(n).
23 Medical Malpractice Ins. Ass’n v. Hirsch (In re Lavigne), 114 F.3d 379, 386-
387 (2d Cir. 1997), aff’g, 183 B.R. 65, 72 (Bankr. S.D.N.Y. 1995) (“Rejection . . .
does not extinguish all rights under an executory contract. . . . State-law rights
embodied within executory contracts survive rejection.”); Eastover Bank for
Savings v. Sowashee Venture (In re Austin Development Co.), 19 F.3d 1077,
1081-1084 (5 th Cir. 1994); In re Modern Textile, Inc., 900 F.2d 1184, 1191 (8 th
Cir. 1990); Leasing Service Corp. v. First Tennessee Bank, Nat'l Ass'n, 826 F.2d
434, 436-37 (6 th Cir. 1987); Michael T. Andrew, Executory Contracts in
Bankruptcy: Understanding Rejection, 59 U. Colo. L. Rev. 845, 931 (1988)
(quoted approvingly by Second Circuit in Lavigne at 114 F.3d at 387); Creator’s
Way Associated Labels, Inc. v. Mitchell (In re Mitchell), 249 B.R. 55, 58 (Bankr.
32

state-law rights in or to specific property, rejection of a contract does not terminate
such rights that arise from rejected contracts.” 24 Accordingly, “[b]ecause rejection
constitutes only a breach, not a termination, an obligation in a rejected contract
continues to bind a debtor unless the obligation is discharged.” 25
Only liabilities on “claims” are discharged by confirmation of a chapter 11
plan. 26 Section 101(5) of the Bankruptcy Code defines “claim” as:
(A) right to payment, whether or not such right is reduced to
judgment, liquidated, unliquidated, fixed, contingent, matured,
unmatured, disputed, undisputed, legal, equitable, secured, or
unsecured; or
(B) right to an equitable remedy for breach of performance if such
breach gives rise to payment, whether or not such right to an
equitable remedy is reduced to judgment, fixed, contingent,
matured, unmatured, disputed, undisputed, secured, or
unsecured.27
Accordingly, a right to an equitable remedy for breach of performance that does
not give rise to payment is not a dischargeable claim. The issue becomes whether
the equitable remedy for the breach imposed by rejection gives rise to payment for
purposes of section 101(5)(B).
As the first step in the analysis, it is crystal clear a creditor’s right to
equitable remedies is not rendered dischargeable simply because the court is
empowered to grant equitable and monetary relief for the same breach. In Ohio v.
Kovacs, 28 the United States Supreme Court decided whether a prepetition
injunction ordering a debtor “to remove specified wastes from the property,” 29 was
dischargeable when the debtor had been dispossessed from the site by a receiver
S.D.N.Y. 2000); Cohen v. Drexel Burnham Lambert Group Inc. (In re Drexel
Burnham Lambert Group, Inc.), 138 B.R. 687, 709 (Bankr. S.D.N.Y. 1992).
24 Drexel Burnham, 138 B.R. at 709 (quotations omitted); see also Licensing by
Paolo, Inc. v. Sinatra (In re Gucci), 126 F.3d 380, 389 (2d. Cir. 1997) (non-debtor
party “has a reasonably strong argument that rejection of its licensing contract
[pursuant to which the non-debtor party had a right to license the prepetition
designs created by the debtor] does not eliminate the transfer of the property
right created under it”).
25 Abboud v. Ground Round, Inc. (In re Ground Round, Inc.), Case No. 05-039,
2005 Bankr. LEXIS 2595, *19 (1st Cir. B.A.P. Dec. 15, 2005).
26 11 U.S.C. § 1141(d)(1).
27 Id. § 101(5) (emphasis added).
28 469 U.S. 274 (1985).
29 Id. at 275.
33

and the state conceded “the only performance sought from Kovacs was the
payment of money.” 30
The Supreme Court held the injunction was a dischargeable claim precisely
because “the cleanup order had been converted into an obligation to pay
money.” 31 The court went out of its way to caution it was not addressing “what the
legal consequences would have been had Kovacs taken bankruptcy before a
receiver had been appointed and a trustee had been designated with the usual
duties of a bankruptcy trustee.” 32 Given that cleaning up and paying for cleanup
procure the identical result as occurred in Kovacs, the Supreme Court clearly did
not see the possibility of a money judgment as automatically rendering an
injunction dischargeable.
Notably, the Supreme Court rejected the argument that its analysis of what
a claim is under section 101(5)(B) should differ according to whether a civil statute
is being enforced or a contract is breached. 33 The Supreme Court also observed
that Congress had considered two versions of section 101(5)(B). 34 One version
only discharged rights to payment and the other version discharged rights to
payment and equitable remedies. Congress enacted a compromise version. 35
Significantly, the key question that the Supreme Court announced it did not
decide in Kovacs (i.e., whether the injunction against the debtor in possession to
clean up hazardous waste would have been dischargeable as ‘giving rise to a right
to payment’ if the debtor had remained in possession and had the ability to
remediate) was later decided in United States v. LTV Corp. (In re Chateaugay
Corp.). 36 There, LTV had deposited hazardous substances prepetition, which
substances continued to contribute to pollution postpetition. 37 The United States
Environmental Protection Agency (“EPA”) had ordered LTV to clean up the
affected sites. LTV, unlike Kovacs, remained in possession of its property during
its chapter 11 case.
The United States Court of Appeals for the Second Circuit conceded: “It is
true that, if in lieu of such an order, EPA had undertaken the removal itself and
sued for the response costs, its action would have both removed the accumulated
waste and prevented continued pollution.” 38 But, applying the definition of claim in
section 101(5)(B), the Second Circuit ruled the cleanup order was
30 Id. at 283.
31 Id.
32 Id. at 284.
33 Id. at 278-279.
34 Id. at 280.
35 Id.
36 944 F.2d 997 (2d Cir. 1991).
37 Id. at 999, 1008.
38 Id. at 1008.
34

nondischargeable because a portion of the cleanup order was not convertible to a
right to payment. 39
Under most or all state laws, specific performance is only given when
money damages do not suffice as shown above.
Significantly, the Second Circuit volunteered it could have decided
Chateaugay somewhat differently. 40 The other possibility would have been more
in line with the Bankruptcy Code’s fresh start policy because it would have relieved
the debtor of an ongoing liability to clean up prepetition hazardous releases. The
Court observed it could have placed “on the non-‘claim’ side only those injunctions
ordering a defendant to stop current activities that add to pollution (e.g., depositing
new hazardous substances), while leaving on the ‘claim’ side all other injunctions,
including those that direct the cleanup of sites from which hazardous substances,
previously deposited, are currently contributing to pollution.” 41 Previously,
however, the Second Circuit had warned:
Of course, the comprehensive nature of the bankruptcy statute
does not relieve us of the obligation to construe its terms, nor may
we resolve all issues of statutory construction in favor of the “fresh
start” objective, regardless of the terms Congress has chosen to
express its will. . . . But we are obliged to apply the bankruptcy
laws that Congress enacted, not to reformulate it as theorists
would prefer to see it. 42
Then, the Second Circuit rejected its alternate resolution, explaining:
We think we must endeavor to apply the ‘claim’ definition as
written, mindful of the purposes of bankruptcy law but without the
prerogative of rewriting it to maximize bankruptcy objectives that
Congress might not have fully achieved. 43
In sum and substance, the Second Circuit (now joined by other circuits) 44
logically determined that section 101(5)(B)’s provision that a breach must give rise
39 Id. (“Since there is no option to accept payment in lieu of continued pollution,
any order that to any extent ends or ameliorates continued pollution is not an
order for breach of an obligation that gives rise to a right of payment and is for
that reason not a ‘claim.’”).
40 Id. at 1009.
41 Id.
42 Id. at 1002, 1003.
43 Id. at 1007.
44 See In re: Udell, 18 F.3d 403, 406, 407-8 (7th Cir. 1994) (holding that the
ability of a party to obtain injunctive relief and liquidated damages gives rise to
non-dischargeable claim if, under state law, such remedies are cumulative, not
35

to payment to be a dischargeable claim, must refer to a payment that is an
adequate substitute for specific performance. Anything less would create an
exception that swallows the rule because courts can always order payment for
breach of performance.
Demonstrating that the right to payment under section 101(5)(B) must be an
adequate substitute for performance, the United States Court of Appeals for the
Seventh Circuit held the debtor’s contractual covenant not to compete gave rise to
alternative); Air Line Pilots Assoc. v. Continental Airlines (In re Continental
Airlines), 125 F.3d 120, 135, 136 (3d Cir. 1997), cert. denied, 522 U.S. 1114
(1998) (adopting same test for whether an equitable remedy is a dischargeable
claim: whether money damages are only “cumulative” or independently will
“suffice to remedy the alleged violation); In re Ben Franklin Hotel Ass., 186 F.3d
301 (3d Cir. 1999) (defrauded partner not barred from pursuing equitable
demand for reinstatement of its partnership interest because such ownership
interest was not a claim or debt, and since monetary payment was not a viable
remedy, it was not subject to bankruptcy discharge); Sheerin v. Davis (In re
Davis), 3 F.3d 113 (5th Cir. 1993) (holding section 101(5)(B) of the Bankruptcy
Code does not require creditors entitled to an equitable remedy to select a
suboptimal remedy of money damages); see also Abboud v. Ground Round, Inc.
(In re Ground Round, Inc.), Case No. 05-039, 2005 Bankr. LEXIS 2595 (1st Cir.
B.A.P. Dec 15, 2005) (holding non-debtor lessor entitled to specific performance
of a lease rejected under section 365 requiring debtor to transfer liquor license to
lessor because liquor license was a unique item and for which money damages
would be inadequate). But see Lubrizol Enterprises, Inc. v. Richmond Metal
Finishers, Inc., 756 F.2d 1043, 1048 (4th Cir. 1985) (Although the Lubrizol court
concluded that rejection eliminates specific performance, it reached that result by
erroneously drawing an inference from legislative history of a proposed version of
the Bankruptcy Code later changed before enactment. Lubrizol inferred from
House Report No. 95-595, 95th Cong., 2d Sess. (1977) at 349, that section
365(g) provides “only a damages remedy” for the nondebtor. Id. at 1048. That
legislative history provides: “The purpose [of section 365(g)] is to treat rejection
claim [sic] as prepetition claims.” When the House Report was issued in 1977,
the House version of the Bankruptcy Code (H.R. 8200) defined “claim” to include
all legal and equitable rights including specific performance, by providing “claim”
means a “right to payment . . .” or a “right to an equitable remedy for breach of
performance if such breach does not give rise to a right to payment . . .”
(emphasis added). As finally enacted and as the Supreme Court acknowledged
in Kovacs, 469 U.S. at 280, “claim” means “right to payment…” or a “right to an
equitable remedy for breach of performance if such breach gives rise to a right to
payment . . .” (emphasis added). In short, the legislative history relied on by
Lubrizol refers to “claims,” and the meaning of “claims” changed from including to
excluding specific performance after the legislative history was written. By
carving out of the universe of claims, rights to equitable remedies that do not give
rise to rights of payment, Congress excluded specific performance from
discharge when a right to payment is not an adequate substitute for it, as here.)
36

a nondischargeable claim in In re Udell, 45 even though the contract at issue
included a liquidated damages clause.
Udell commenced its analysis by stating the issue as “whether § 101(5)(B)
requires any connection between the equitable and the legal remedies beyond the
fact that both remedies arise from the same breach of performance.” 46 Based on
Kovacs, Johnson v. Home State Bank, 47 Chateaugay, and In re CMC Heartland
Partners, 48 the Seventh Circuit found it easy to rule out the notion that if a breach
gives rise to an equitable remedy and money damages, the breach automatically
creates only a dischargeable claim. 49 Rather, the court ruled the right to
performance and the right to payment must be substitutes for one another or
related in a manner that the debtor is entitled to stop the performance remedy,
such as foreclosure, by paying money:
[W]e hold that a right to an equitable remedy for breach of
performance is a “claim” if the same breach also gives rise to a
right to payment “with respect to” the equitable remedy. If the right
to payment is an “alternative” to the right to an equitable remedy,
the necessary relationship clearly exists, for the two remedies
would be substitutes for one another. . . . As the Supreme Court’s
decision in Home State Bank implies, relationships other than
outright substitution may also suffice. For example, the right to
foreclose on a mortgage, though not strictly an ‘alternative’ to the
right to the proceeds from the sale of the debtor’s property,
nonetheless gives rise to a corollary right to payment (and may in
fact be considered an alternative to money in the sense that the
debtor can stop the foreclosure by paying the full debt). The two
remedies are sufficiently related that the Supreme Court classified
the right to foreclose as a “claim.” 50
Udell’s application of its holding to its facts is instructive. The court ruled
that state law allows an injunction in addition to liquidated damages, and thus, the
remedies are cumulative, unless the parties intended them to be substitutes at the
election of the party by whom the money is to be paid. 51 Because the remedies
were cumulative and not alternative, the court ruled the right to an injunction was
not a dischargeable claim. Indeed, based on Kovacs, the court reasoned: “the fact
that both remedies are triggered by a single act does not mean that the right to an
injunction gives rise to a right to liquidated damages. . . Lacking is the derivative
relationship between the two remedies exemplified by Home State Bank, supra,
45 18 F.3d 403 (7th Cir. 1994).
46 Id. at 406.
47 501 U.S. 78 (1991).
48 966 F.2d 1143 (7th Cir. 1992).
49 Udell, 18 F.3d at 407-08.
50 Id. at 408 (emphasis added) (footnote omitted).
51 Id.
37

where the equitable remedy of foreclosure was the means for realizing the right to
the proceeds from the sale of the debtor’s property.” 52
The concurrence in Udell utilizes a different, but equally persuasive analysis
concluding the covenant not to compete was a nondischargeable claim. Circuit
Judge Flaum reasons that any other result would create a patently absurd
interpretation of the statute. 53
One court has provided guidance as to how to determine whether money
damages are adequate. In Creator’s Way Associated Labels, Inc. v. Mitchell (In re
Mitchell), 54 the individual chapter 7 debtor contended his contract to provide
recordings exclusively for Creator’s Way was dischargeable. Chief Bankruptcy
Judge Bernstein articulated the test as follows:
As noted, the determinative question is whether the unperformed
obligation gives rise to a right to payment under state law, which
right is an adequate alternative to equitable relief. 55
Judge Bernstein recognized that breach of the recording contract “ordinarily gives
rise to a damage claim for lost profits.” 56 But, “[t]he availability of the monetary
remedy, however, does not automatically mean that damages are an adequate
alternative under state law.” 57 Judge Bernstein ruled that to prove
nondischargeability, there would have to be proof the debtor’s services “are
extraordinary or unique, or can not be replaced, or that damages are
inadequate.” 58
Notably, the equities compelling state courts to grant specific performance
must be fairly vindicated and not simply subordinated to other creditors’ desire to
maximize value no matter what the consequence to the injured contract party.
Public Auditorium Authority of Pittsburgh v. HBRM, LLC (In re Pittsburgh Sports
Associates Holding Co.), 59 held an injunction against a debtor based on a lease
covenant nondischargeable, and explained:
Even if we assume, however, that claim holders and equity
interest holders would fare less well if a permanent injunction is
52 Id. at 409, 410; accord Kennedy v. Medicap Pharmacies, Inc., 267 F.3d 493
(6th Cir. 2001) (equitable remedy of an injunction for breach of covenant not to
compete was not dischargeable claim because the requested injunction was not
an alternative to the right of payment).
53 Id. at 412.
54 249 B.R. 55 (Bankr. S.D.N.Y. 2000).
55 Id. at 60 (emphasis added).
56 Id.
57 Id.
58 Id.
59 1999 Bankr. LEXIS 1870, *23-24, 33 (Bankr. W.D. Pa. 1999).
38

issued, the irreparable harm suffered by [the arena owners], and
the community at large in the absence of a permanent injunction
outweighs that experienced by claim holders and interest holders
in the presence of one. . . . It is not sufficient for purposes of §
101(5)(B) that the equitable remedy and the right to money
damages are related only to the extent that both happen to be
disjunctively available in the event of a breach.
Bankruptcy courts across the country adjudicate whether an equitable remedy is
dischargeable by determining whether money damages are an alternative remedy
as opposed to being an additional or cumulative remedy. 60 That specific
performance under state law is often discretionary with the trial judge, does not
mean money damages are always an alternative. It is axiomatic that discretionary
decisions are reversible for abuse of discretion. Therefore, if it would be an abuse
of discretion to fail to grant specific performance, money damages would not be a
substitute.
As explained in In re Walnut Assocs.: 61
[U]nless specific performance is available to the nondebtor party
under applicable state law, the debtor cannot be compelled to
60 See, e.g., In re Indian River Estates, Inc., 293 B.R. 429, 434 (Bankr. N.D. Ohio
2003) (the dischargeability test is: “could a monetary award substitute for the
equitable remedy. . . . §101(5)(B) does not require that a party accept a monetary
alternative if it is not in proportion to the equitable remedy.” (citations omitted);
(breach of contract remedy to convey 8 lots held nondischargeable); In re Willets,
262 B.R. 552, 556 (Bankr. N.D. Fla. 2001) (order to remove pool and concrete
deck and to replace wooden deck nondischargeable because money damages not
an alternative); In re Bush, 273 B.R. 625, 628-629 (Bankr. S.D. Cal. 2002)
(contract to convey residence nondischargeable because state law provides it can
not be adequately relieved by pecuniary compensation); cf. In re Nickels Midway
Pier, LLC, 332 B.R. 262, 275-276 (Bankr. D.N.J. 2005) (“An equitable remedy can
be a claim in bankruptcy under § 101(5) provided that it can be reduced to
monetary damages.”) (when the nondebtor’s right to specific performance for
breach of contract is already protected by the Bankruptcy Code’s grant of specific
performance in sections 365(i) or (j), the Bankruptcy Code’s specific performance
provisions control); In re Alongi, 272 B.R. 148, 155-156 (Bankr. D.Md. 2001)
(covenant to employer by individual debtor-doctor not to compete and covenant to
pay tail insurance held nondischargeable because debtor triggered those
provisions by postpetition termination of contract); Stone StreetCapital, Inc. v.
Granati (In re Granati), 270 B.R. 575, 586-587 (Bankr. E.D. Va. 2001) (debtor’s
specifically enforceable obligation to turn over annuity payments to entity that paid
debtor lump sum for such payments held nondischargeable based on
Chateaugay).
61 145 B.R. 489 (Bankr. E.D. Pa. 1992).
39

ender its performances required under the contract. However, if
state law does authorize specific performance under the rejected
executory contract, it means that the non-debtor should be able to
enforce the contract against the Debtor, irrespective of his rejection
of it. 62
5. What are the Standards for Designating Votes pursuant to Bankruptcy
Code section 1126(e)?
A. Bankruptcy Code section 1126(e) provides:
(e) On request of a party in interest, and after notice and a
hearing, the court may designate any entity whose acceptance or
rejection of such plan was not in good faith, or was not solicited or
procured in good faith or in accordance with the provisions of this
title.
B. Background
The bankruptcy court may nullify the vote of any entity whose acceptance or
rejection is not in good faith or was not solicited in good faith. 63 Thus, an
improperly solicited rejection may be stricken, although if the rejection appears
independent of the wrongful solicitation it should not be stricken because doing
so would unfairly penalize the voter. 64 Generally, votes cast as part of wrongful
schemes to enable the voter to do better than other claims in its class in violation
of Bankruptcy Code section 1123(a)(4), and votes cast as part of wrongful
conduct such as blackmail, shakedowns, and the like are clearly subject to
designation. As shown below, the appellate courts appear to restrict designation
to these relatively clear categories. But, some trial courts sometimes make
subjective decisions about good faith that are hard to predict and not doctrinal,
usually to facilitate plan confirmation.
The concept of nullifying votes cast or solicited without good faith is an
equitable and statutory doctrine necessary to prevent abuses of the system and
dates back to section 203 of Chapter X of the Bankruptcy Act. 65 The United
62 Id. at 494 (emphasis added); see also Fellerman & Cohen Realty Corp. v.
Clinical Plus Inc. (In re Hirschhorn), 156 B.R. 379, 381-82 (Bankr. E.D.N.Y. 1993)
(“Section 365(g) is intended to affect only the monetary rights of creditors. . . .
Section 365(g) does not disturb the equitable non-monetary rights arising from
the breach of contract.”).
63 Bankruptcy Code section 1126(e).
64.Texas Extrusion Corp. v. Lockheed Corp. (In re Texas Extrusion Corp.), 844 F.2d 1142, 1163-
64 (5th Cir. 1988).
65 See Bankruptcy Act section 203 (former 11 U.S.C. § 603). The power to nullify votes was
granted to courts of bankruptcy to prevent situations that arose in cases such as Texas Hotel
40

States Supreme Court has extrapolated the good faith voting requirement to
prevent abuses even when not directly related to voting. 66 When two members of
a shareholders' committee resigned from the committee, appealed a confirmation
order on the ground a creditor was paid too much, and then sold their stock and
their appeal to the creditor, the Supreme Court used the good faith voting
requirement and its underlying purpose as the basis for holding that the
shareholders were not entitled to keep the settlement funds to themselves, but
must share them with all shareholders. 67 This is consistent with the recurring
theme that lack of good faith revolves around an entity attempting to obtain better
treatment for itself than other members of its class.
The Supreme Court summarized the history of Chapter X section 203 as
follows:
“A year before the House Committee on the Judiciary held its
extensive hearings on the Chandler Act a Circuit Court of Appeals
held that a creditor could not be denied the privilege of voting on a
reorganization plan under Sec. 77B, although he bought the votes for
the purpose of preventing confirmation unless certain demands of his
Sec. Corp. v. Waco Dev. Co., 87 F.2d 395 (5th Cir. 1936), cert. denied, 300 U.S. 679 (1937), and
Security First Nat'l Bank v. Rindge Land & Navigation Co., 85 F.2d 557 (9th Cir.), cert. denied,
299 U.S. 613 (1937). In Waco Dev. Co., a tenant that had lost its lease with the debtor-landlord
bought up the debtor's first mortgage bonds with the intent of preventing any reorganization that
did not give the former tenant compensation for losing the lease on which it defaulted in addition
to a payment on the bonds. In the then absence of Bankruptcy Act section 203, the tenant's vote
was held valid. In Rindge Land the purchaser of 98% of the debtor's first mortgage bonds
consummated its purchase pursuant to a fraudulent scheme whereby it paid forty cents on the
dollar and the expenses of both the bondholder protective committee and the indenture trustee,
for bonds worth well in excess of their price. "Here the appellants first formulated a scheme the
effect of which was not only to deprive the legitimate bondholders or original owners from
receiving the actual value of their bonds, but particulrly [sic] to defeat the approval by the court of
any plan whereby the debtor might satisfy all of his creditors and have something left." 85 F.2d
567, 564-68 (facts taken from dissent).
66 Young v. Higbee Co., 324 U.S. 204, 211 (1945). Cf. In re P-R Holding Corp., 147 F.2d 895 (2d
Cir. 1945) (plan proponent held unable to vote claims it purchased for better consideration than it
was offering generally to other creditors).
67 In Young v. Higbee Co., 324 U.S. 204, 211 n. 10 (1945) the Supreme Court ruled that
Bankruptcy Act section 203 applied to
stockholders whose selfish purpose was to obstruct a fair and feasible
reorganization in the hope that someone would pay them more than the ratable
equivalent of their proportionate part of the bankrupt assets. . . . Its purpose was to
prevent creditors from participating who "by the use of obstructive tactics and holdup
techniques exact for themselves undue advantages from the other stockholders
who are cooperating." Bad faith was to be attributed to claimants who opposed a
plan for a time until they were "bought off"; those who "refused to vote in favor of a
plan unless . . . given some particular preferential advantage." Hearings on
Revisions of the Bankruptcy Act before the Committee on the Judiciary of the
House of Representatives, 75th Cong., 1st Sess., on H.R. 6439, Serial 9, pp. 180-
182.
41

should be met. Texas Hotel Corporation v. Waco Development Co., 5
Cir., 87 F.2d 395. The hearings make clear the purpose of the
Committee to pass legislation which would bar creditors from a vote
who were prompted by such a purpose. To this end they adopted the
'good faith' provisions of Sec. 203. Its purpose was to prevent
creditors from participating who 'by the use of obstructive tactics and
hold-up techniques exact for themselves undue advantages from the
other stockholders who are cooperating. Bad faith was to be
attributed to claimants who opposed a plan for a time until they were
'bought off'; those who 'refused to vote in favor of a plan unless . . . .
given some particular preferential advantage.' Hearings on Revision
of the Bankruptcy Act before the Committee on the Judiciary of the
House of Representatives, 75th Cong., 1st Sess. on H.R. 6439, Serial
9, pp. 180-182.” 68
In In re P-R Holding Corp., 147 F.2d 895 (2d Cir. 1945), the proposed
Chapter X plan provided for a 50% payout consisting of one-third cash and twothirds
in 10-year mortgage notes. After voting had commenced, the two plan
proponents purchased claims (mostly for 50% cash, but some for 40% cash),
including claims that had been voted to reject the plan. They purchased the
claims for the avowed purpose of assuring the success of the plan and the votes
were changed to accepting votes, which caused the plan to be accepted. After
the SEC contended that the claims purchases discriminated against claimants
who did not sell their claims because they provided the sellers all cash, the plan
proponents revised the plan so the cash they would receive for the purchased
claims would instead be distributed to other creditors and the proponents would
not receive mortgage notes on behalf of the claims they purchased. The district
court confirmed the revised plan and certain creditors appealed. On appeal, the
circuit court agreed “there is ‘bad faith’ when those purchases result in a
discrimination in favor of the creditors selling their interests.” 147 F.2d at 897.
But, because the original offer of the plan proponents was the best available, and
because they improved that offer by distributing the cash they would take to other
creditors, the court affirmed confirmation.
A vote constituting part of a scheme to enable the holder of a claim or
interest in a particular class to do better than the other claim or interestholders of
that class in contravention of Bankruptcy Code section 1123(a)(4), generally
indicates bad faith. 69 For instance, a vote motivated by receipt of an extra
payment from a debtor's parent corporation may be in bad faith if undisclosed or
surreptitious. 70 Significantly, the notion that votes cast with an "ulterior motive"
68 Young v. Higbee Co., 324 U.S. 204, 211n.10 (1945).
69 See Young v. Higbee Co., 324 U.S. 204, 211 (1945); 6A COLLIER, BANKRUPTCY ¶ 9.21, at 1676
(14th ed. 1977).
70 See In re Featherworks Corp., 25 B.R. 634 (Bankr. E.D.N.Y. 1982), aff'd, 36 B.R. 460
(E.D.N.Y. 1984); In re P-R Holding Corp., 147 F.2d 895, 897-98 (2d Cir. 1945). Rejections by
former employees of the debtor who formed a competing business while working for the debtor
may be disregarded if interposed solely for the ulterior purpose of destroying the debtor's
42

must be designated, is too short handed. Rather, "pure malice, 'strikes' and
blackmail, and the purpose to destroy an enterprise in order to advance the
interests of a competing business, all plainly constituting bad faith, are motives
which may be accurately described as ulterior." 71 " If a selfish motive were
sufficient to condemn reorganization policies of interested parties, very few, if
any, would pass muster." 72
For instance in Figter, 73 the mortgagee was confronted with a plan that
would enable the reorganized debtor to sell condominium units and obtain a
release of the mortgagee's lien against each unit as it were sold. That exposed
the mortgagee to the possibility that it would end up having a lien against unsold
condominium units that would be rented, which scenario it did not like.
Therefore, the mortgagee offered to purchase all the unsecured claims for 100
cents on the dollar so that it would be able to cause the class of unsecured
claims to reject, thereby preventing confirmation due to the absence of an
impaired accepting class required by Bankruptcy Code section 1129(a)(10). The
appellate court affirmed the bankruptcy court's holding that the mortgagee's
votes of its unsecured claims did not lack good faith.
Conversely, in Dune Deck, 74 when an entity purchased the approximately
$3 million first mortgage and approximately half the unsecured claim amount of
approximately $100,000 and indicated it would reject the plan, the court ruled it
would have to look further into the entity’s motivations over and above the fact
that the proposed plan suddenly doubled the debtor’s assessment of property
value and proposed a mortgage at a 1:1 loan to value ratio at 8% interest. The
entity had arrangements with another party motivating it to get control of the
property and terminate its inhabitants rights to use adjacent amenities in a resort
area. Outside bankruptcy a party could have acquired the property and
terminated its rights to use adjacent property. Absent any unequal treatment of
creditors or wrongful act, the designation of the votes would not have been
supported by the jurisprudence or any policy to be served.
Creditors are expected to vote according to their economic self interests, 75
and a vote motivated by a claimholder's tax situation or its intent to hold out for a
better plan does not lack good faith. 76 Neither does a negative vote cast by a
business and furthering the competitor. In re McLeod Co., 63 B.R. 654 (Bankr. S.D. Ohio 1986);
In re Pine Hill Collieries Co., 46 F. Supp. 669 (E.D. Pa. 1942).
71
Figter Limited v. Teachers Insurance and Annuity Association of America (In re Figter Limited),
118 F.3d 635, 639 (9 th Cir. 1997); Insinger Mach. Co. v. Federal Support Co. (In re Federal
Support Co.), 859 F.2d 17 (4th Cir. 1988).
72
Figter Limited v. Teachers Insurance and Annuity Association of America (In re Figter Limited),
118 F.3d 635, 639 (9 th Cir. 1997).
73
Id.
74
In re Dune Deck Owners Corp., 175 B.R. 839, 844 (Bankr. S.D.N.Y. 1995).
75
In re 500 Fifth Avenue Associates, 148 B.R. 1010, 1020 (Bankr. S.D.N.Y. 1993); In re Dune
Deck Owners Corp., 175 B.R. 839, 844 (Bankr. S.D.N.Y. 1995).
76
. In re Landau Boat Co., 7 B.C.D. 214 (Bankr. W.D. Mo. 1981); 5 COLLIER, BANKRUPTCY ¶
1126.05, at 1126-17 (15th ed. 1985).
43

creditor that the debtor is suing, even if the lawsuit is the debtor's only asset and
the creditor believes that the suit will not be prosecuted as vigorously absent the
plan. 77
Bankruptcy Code section 1126(e), as originally proposed by the House of
Representatives, provided the vote of an "entity that has, with respect to such
class, a conflict of interest that is of such a nature as would justify exclusion of
such entity's claim or interest" may be designated. H.R. 8200, 95 th Cong., 1 st
Sess. (1977). The legislative history explained:
Subsection (e) permits the court to designate for any class of
claims or interests any person that has, with respect to that class, a
conflict of interest that is of such nature as would justify exclusion of
that person's claim or interest from the amounts and number
specified in subsection (c) or (d). A person might have such a
conflict, for example, where he held a claim or interest in more than
one class. Exclusion from one class for voting purposes would not
require his exclusion from the other class as well…."
House Report No. 95-595, 95 th Cong., 1 st Sess. (1977), at 411. Section 1126(e),
as enacted, however, refers to designating votes cast without good faith, but
does not specify that a conflict of interest is one example of a lack of good faith.
The legislative history provided subsequent to enactment by representatives of
both the House and the Senate, however, explains that a conflict of interest
remains a ground to designate a vote.
"Section 1126 of the House amendment deletes section 1126(e) as
contained in the House bill. Section 105 of the bill constitutes
sufficient power in the court to designate exclusion of a creditor's
claim on the basis of a conflict of interest…." 78
Significantly, both the representative of the House of Representatives
whose proposed bankruptcy bill included the express language about
designating votes for conflicts of interest, and the representative of the Senate
whose proposed bankruptcy bill did not include such language, agreed the
statute as enacted included authority to designate votes for conflicts of interest. 79
77 Insinger Mach. Co. v. Federal Support Co. (In re Federal Support Co.), 859 F.2d 17 (4th Cir.
1988). See Young v. Higbee Co., 324 U.S. 204, 211 (1945); 6A COLLIER, BANKRUPTCY ¶ 9.21, at 1676 (14th
ed. 1977).
78 Statement by the Hon. Don Edwards, Chairman of the Subcommittee on Civil and
Constitutional Rights of the House Committee on the Judiciary, upon introducing the House
amendment to the Senate Amendment to H.R. 8200. Sept. 28, 1978 Congressional record H
11089; Statement by the Hon. Dennis DeConcini, Chairman of the Subcommittee on
Improvements in Judicial Machinery of the Senate Committee on the Judiciary, upon introducing
the Senate Amendment to the House Amendment to H.R. 8200. October 6, 1978, 124
Congressional Record S 17406.
79 Id.
44

Thus, the court "can designate the vote of a creditor who has a conflict of interest
with the class in which it votes." 80
Notwithstanding this legislative history and the jurisprudence applying it, 81
when confronted with a motion to designate votes accepting a plan, which motion
was propounded on the ground that certain creditors voted for that debtor’s plan
because the plan included a settlement that would harm that debtor and benefit
an affiliated debtor against which the creditors had larger claims, 82 one court
denied the motion on the ground “we have come to place great reliance on what
statutes actually say (notwithstanding statements in legislative history that might
lead to a contrary result)…” 83 The court declined to designate the votes
explaining the right to vote on a chapter 11 plan is a “sacred entitlement,” opining
designation is a “draconian measure” requiring egregious conduct principally
seeking to advance interests apart from recovery under the plan. 84 The
explanation was ironic because, in fact, the designation motion’s main thrust was
that the claimant was voting for one plan to cause the debtor to be saddled with a
bad settlement that benefitted an affiliated debtor against whose estate the
creditor held a larger claim and would benefit under its chapter 11 plan. 85 The
court also wrote that if a similar motion against the moving creditors had not been
withdrawn, it would have applied the same principles to that motion. 86
80 In re Dune Deck Owners Corp., 175 B.R. 839, 845 (Bankr. S.D.N.Y. 1995).
81 In re Dune Deck Owners Corp., 175 B.R. 839, 845 (Bankr. S.D.N.Y. 1995).
82 In re Adelphia Communications Corp., 359 B.R. 54, 58 (Bankr. S.D.N.Y. 1996)(“In nearly all
respects, an increase in any recovery on the Arahova Notes results in a decrease in recovery on
the ACC senior notes, and vice versa.”).
83 In re Adelphia Communications Corp., 359 B.R. 54, 56, 65 (Bankr. S.D.N.Y. 1996)(“Since the
time the Code was enacted, we have come to place great reliance on what statutes actually say
(notwithstanding statements in legislative history that might lead to a contrary result), and I think I
must find some significance in the fact that at one time, Congress considered a provision that
would impose the requirement sought here, and that it did not enact it. In light of that, I'm
reluctant to enact it by judicial fiat. And while I fully recognize that Senator DeConcini regarded
section 105 as a means to achieve vote designation notwithstanding the absence of statutory
language that would explicitly provide for it, recent section 105 jurisprudence has displayed a
marked reluctance to use section 105 to achieve results that are not authorized under the Code
or substantial caselaw precedent.”)(footnote omitted).
84 The court opined:
“…The ability to vote on a reorganization plan is one of the most sacred
entitlements that a creditor has in a chapter 11 case. And in my view, it should
not be denied except for highly egregious conduct--principally, seeking to
advance interests apart from recovery under the Plan, or seeking to extract plan
treatment that is not available for others in the same class.”
In re Adelphia Communications Corp., 359 B.R. 54, 56-57 (Bankr. S.D.N.Y. 1996).
85 In re Adelphia Communications Corp., 359 B.R. 54, 56, 65 (Bankr. S.D.N.Y. 1996).
86 In re Adelphia Communications Corp., 359 B.R. 54, 57n.6 (Bankr. S.D.N.Y. 1996)(“If it is any
consolation to the movants here, I'd regard these same principles to be applicable if the nowwithdrawn
motion in the other direction had been pressed.”).
45

Approximately 3 years later when the same court was requested to
designate votes rejecting a plan in another case (the DBSD case), the court
determined to designate the votes and apparently felt compelled to explain why
its earlier opinion providing the right to vote is a “sacred entitlement,” was no bar.
It observed that in the earlier Adelphia case, it would have, if necessary,
designated other votes rejecting the plan “in a heartbeat” because the votes were
held by creditors who held long positions against one Adelphia debtor and short
positions against an affiliated Adelphia debtor, and the creditors not only wanted
one debtor to win, but also wanted its affiliated debtor “to lose.” 87
The two positions taken by the court -- on the motion it decided and the
motion that was withdrawn for which the court volunteered its decision -- had
both a consistency and an inconsistency. The consistency was that each
decision it made or would have made, would facilitate confirmation of the chapter
11 plans for all the affiliated debtors by preserving votes to accept the plans and
designating (eliminating) votes to reject the plans.
The inconsistency was that accepting one debtor’s plan to lock in a bad
settlement for it because the settlement benefitted an affiliated debtor against
which the creditor held larger claims, is substantively no different than rejecting a
debtor’s plan to prevent it from settling on terms that favor an affiliated debtor
against which the creditor had shorted claims. In both instances, the creditor’s
vote is motivated by a desire to cause one debtor to obtain more and another
affiliated debtor to obtain less when the two debtors are engaged in a zero sum
exercise of settling interdebtor disputes. The court had already found that “[i]n
nearly all respects, an increase in any recovery on the Arahova Notes results in a
87 In re DBSD North America, Inc., 421 B.R. 133, 143n.44 (Bankr. S.D.N.Y. 2009)(“There was a
second designation motion in Adelphia, directed at distressed debt investor creditors of ACC, one
of the Adelphia debtors, who had admitted, to another distressed debt investor in an ad hoc
committee of ACC bondholders, that they held short positions in the bonds of Arahova
Communications, another of the Adelphia debtors. There was evidence that they opposed the
settlement of interdebtor disputes under the plan (under which debtor Arahova would give up
some value to debtor ACC, but not as much as those distressed debt investors desired) as they
would profit more from losses of value by Arahova, the debtor in which they held their short
positions, than they would by gains in value by the debtor, ACC, where they were long. "[T]hese
different incentives led [the two distressed debt investors] to care not only about the total
distribution that ACC Creditors would receive but also that the consideration to be received come
from the Arahova estate. In other words, over time, I formed the view that, for [the two distressed
debt investors], it was not enough for ACC Creditors to 'win' but at the same time Arahova had to
'lose.'" Decl. of [a distressed debt investor officer], dated Dec. 4, 2006. *** This second
designation motion was withdrawn, when it turned out that those two distressed debt investors'
votes against the plan did not make a difference. If the motion had not been withdrawn, and if the
evidence the Court heard was not refuted, the Court would have designated their votes in a
heartbeat. Profiting from another constituency's pain or from losses to everybody from delay in
the case would be a classic example of an unprotected ulterior motive.”)(emphasis in original).
46

decrease in recovery on the ACC senior notes, and vice versa.” 88 Therefore, to
say pejoratively that the creditors wanted one debtor “to lose,” 89 is actually to say
that creditors wanted interdebtor disputes settled differently. The court’s
reasoning on the first designation motion in the Adelphia case that the legislative
history could not be used to support designation of votes cast by creditors with
conflicts of interest between two debtors’ estates was clearly at odds with its later
statement that it would have designated votes in a heartbeat on the withdrawn
designation motion because the votes were cast with the motivation to help one
estate while hurting another. Indeed, the court itself had initially volunteered that
it would apply the same principles to the motion that was withdrawn as it applied
to the motion that it decided. 90
Subsequently, in ruling on applications in the Adelphia case for
reimbursement of creditors’ attorneys’ fees, the court labeled as “offensive
behavior,” for which it would approve no reimbursement, “[s]horting the Arahova
bonds, and thereby making a financial bet on reduced recoveries by the Arahova
bondholders, and on delay in the case.” 91 In the worlds of finance and
economics, investors take long positions on securities they think are undervalued
and take short positions on securities they think are overvalued. Long positions
are no more ethical than short positions. They are driven by dispassionate
economic and financial analysis. What the court labeled as ‘offensive behavior,’
investors label as ‘capitalism and freedom.’
C. In re DBSD North America, Inc., 421 B.R. 133 (Bankr.
S.D.N.Y. 2009); In re DBSD North America, Inc., 419 B.R. 179
(Bankr. S.D.N.Y. 2009), aff'd, 2010 U.S. Dist. LEXIS 33253
(S.D.N.Y., March 24, 2010), reversed based on violation of
absolute priority rule and affirmed as to vote designation,
DISH Network Corp. v. DBSD North America, Inc. (In re DBSD
North America, Inc.), 627 F.3d 496 (2d Cir. 2010)(summary
order) and Docket Nos. 10-1175, 1201, 1352 (2d Cir., filed Feb.
7, 2011)(“Slip Op.”)
i. Facts
The opinion of the United States Court of Appeals for the Second Circuit
refers to the “full facts” in the bankruptcy court and district court decisions and
only recites the most pertinent facts to the appeals. Slip Op. at 4-5. The debtors
88 In re Adelphia Communications Corp., 359 B.R. 54, 58 (Bankr. S.D.N.Y. 1996)(“In nearly all
respects, an increase in any recovery on the Arahova Notes results in a decrease in recovery on
the ACC senior notes, and vice versa.”).
89 In re DBSD North America, Inc., 421 B.R. 133, 143n.44 (Bankr. S.D.N.Y. 2009).
90 In re Adelphia Communications Corp., 359 B.R. 54, 57n.6 (Bankr. S.D.N.Y. 1996)(“If it is any
consolation to the movants here, I'd regard these same principles to be applicable if the nowwithdrawn
motion in the other direction had been pressed.”).
91 In re Adelphia Communications Corp., 441 B.R. 6, 20-21 (Bankr. S.D.N.Y. 2010) (footnote
omitted). Notably, it is unlikely the taking of short positions created any attorneys’ fees for which
reimbursement would be denied pursuant to the opinion.
47

were developing a satellite communication system having terrestrial components
to avoid the problem of pure satellite systems having signal blockages from
buildings and other terrain. The debt structure included $51 million of fully
secured debt encumbering most all assets including auction rate securities, $752
million of undersecured second lien debt, and unsecured debt in excess of $211
million. The first lien debt originally had a 13 month maturity to occur before
maturity of the second lien debt, and was to be amortized from sale proceeds of
any collateral.
Overall, the "Plan provides for the Debtors to continue to operate as a prerevenue
enterprise, implementing cost saving initiatives until the Debtors obtain
strategic partnerships with entities that are able to complement the Debtors'
satellite offerings or obtain additional capital to continue funding the enterprise."
419 B.R. at 187.
The debtors proposed a chapter 11 plan contemplating an exit facility of
$57.25 million carrying a 20% interest rate, 2% commitment fee, and 2% closing
fee, with warrants to acquire 20% of the common stock and a lien junior to the
first lien debt. 419 B.R. at 188. The first lien debt would receive a new debt
instrument for the principal and interest accrued through the effective date and
would lose its lien against the equity in the debtors and the auction rate
securities. Its affirmative and negative covenants would be eliminated or
loosened and its cross default provisions would be less restrictive than they were
prepetition. 419 B.R. at 189. Its 12.5% interest would be payable in kind (PIK)
for 4 years, and all principal and interest would be payable in cash in 48 months.
The default rate had been 14.5% and the rate during the chapter 11 case was
16%. Id. The second lien debt would be converted into 95% of the common
stock not issued to the exit facility lender or other unsecured claimholders.
Unsecured claims of $50,000 or less would receive 40% of their allowed claims
in cash. The equity would receive 5% of the common stock plus warrants.
Distributions to the unsecured claimholders and equity were made from a ‘gift’ by
the second lien debt holders who were undersecured because the class of
general unsecured claims rejected the plan. 419 B.R. at 204, 210. Sprint had an
allowed claim for voting purposes of $2 million claim against one of the debtor
entities, and no party to the appeal argued that it mattered as to which debtor
entity it was. Slip Op. at 6n.1.
“Meanwhile, DISH, although not a creditor of DBSD before its filing, had
purchased the claims of various creditors with an eye toward DBSD’s spectrum
rights. As a provider of satellite television, DISH has launched a number of its
own satellites, and it also has a significant investment in TerreStar Corporation, a
direct competitor of DSDB’s in the developing field of hybrid satellite/terrestrial
mobile communications. DISH desired to ‘reach some sort of transaction with
[DBSD] in the future if [DBSD’s] spectrum could be useful in our business.’” Slip
Op. at 8.
48

DISH had purchased the debt at par after the chapter 11 plan was
proposed, “with an agreement that the sellers would make objections to the plan
that DISH could adopt after the sale,” Slip Op. at 8, and it then rejected the plan,
but the DISH’ vote was designated pursuant to 11 U.S.C. § 1126(e), so the vote
was not counted pursuant to 11 U.S.C. § 1126(d). In re DBSD North America,
Inc., 421 B.R. 133, 135 (Bankr. S.D.N.Y. 2009). “As DISH admitted, it bought the
First Lien Debt not just to acquire a ‘market piece of paper’ but also to ‘be in a
position to take advantage of [its claim] if things didn’t go well in a restructuring.’”
Slip Op. at 8.
DISH, the holder of the first lien debt, had internal documents, in pertinent
part providing:
"DISH has invested [$32.9M] for [$111.6M] of Face Value 2 nd
Priority Convertible Notes at an average dollar price of [29.5].
The Company is attempting to negotiate a proposal to
equitize Bondholders in return for 95% of the restructured ICO N.A.
(subject to certain earnouts based on valuation).
We believe there is a strategic opportunity to obtain a
blocking position in the 2 nd Priority Convertible Notes and control
the bankruptcy process for this potentially strategic asset.
We are seeking Board approval to invest up to an
incremental [$ 100M] to purchase securities necessary to gain
control of the Unsecured (impaired) Class."
421 B.R. at 136 (emphasis supplied by court).
Another DISH document in pertinent part provided:
The Company is attempting to negotiate a proposal to
equitize Bondholders in return for 95% of a restructured ICO N.A.
(subject to certain earnouts based on valuation).
We believe there is a strategic opportunity to obtain the
remaining convertible bonds outstanding in an attempt to convert to
equity and acquire control of ICO North America.
We are seeking board approval for up to [$200M] to acquire
the remaining convertible bonds outstanding and establish control
of this strategic asset."
421 B.R. at 136 (emphasis supplied by court).
49

“In the end, DISH (through a subsidiary) purchased only $111 million of
the Second Lien Debt – not nearly enough to control that class – with the small
size of its stake due in part to DISH’s unwillingness to buy any claims whose
prior owners had already entered into an agreement to support the plan.” Slip
Op. at 9. Thus, DISH did not cause the class of second lien debt to reject
DBSD's proposed chapter 11 plan. 421 B.R. at 137n.12. “Separately, DISH
proposed to enter into a strategic transaction with DBSD, and requested
permission to propose its own competing plan (a request it later withdrew).” Slip
Op. at 9.
The class of second lien debt accepted the plan by 85% in number and
78% in amount. 419 B.R. at 184n.3. DISH also held some second lien debt and
opposed confirmation.
Sprint held an unsecured claim against one debtor and also opposed
confirmation on the ground the class of second lien debt was not allowed to
transfer property to an equity class when Sprint’s class of unsecured claims had
rejected the plan. Slip Op. at 7.
The reorganized debtor held commitments for financing of $52.75 million
for the first two of the four years before the first lien debt would be repayable.
Confirmation would eliminate $600 million of debt, so the reorganized debtor
would start with $81 million debt on the effective date and subsequently have
$260 million debt when the first lien debt becomes due in the amount of $82.6
million. 419 B.R. at 189-190. The reorganized debtors’ two competitors each
have $900 million debt or more.
Both DISH and the debtors’ respective valuation experts used Trading
Comparables Analysis, Spectrum Transactions Analysis, and Discounted Cash
Flow, but weighted them differently. The debtors assigned a 90% weight to the
Trading Comparables Analysis (and a 5% weight to each of the other two
measures), while DISH assigned it a 20% weight while weighting the other two
measures 40% apiece.
Based on two public company competitors, the debtors’ expert calculated
the Trading Comparables Valuation using total enterprise value per megahertzpopulation,
then weighted book and market values, and concluded the Trading
Comparables Analysis produced a valuation of the debtors between $380 million
and $650 million. DISH’ expert only used the market values and calculated a
valuation range of $530 million to $590 million.
To compute the Spectrum Transaction Valuation, the debtors’ expert
determined the mean and median transaction price paid per MHz population for
spectrum auction transactions he considered most comparable. Then, he
deducted the cost of a new satellite the debtors would have to produce. The
debtors’ expert concluded this method produced a valuation range of $850
50

million to $3.1 billion. DISH’ expert used one auction from which he deduced the
price per MHz population; then he reduced the price by 85% because the stock
prices of the debtors’ competitors fell by 85% since the auction, and he deducted
the cost of producing another satellite and additional funding requirements, to
conclude the valuation range was $140 million to $215 million.
To compute the discounted cash flow value the debtors’ expert used a
business plan contemplating the production of another satellite, and to compute
the terminal value at the end of the forecasted period he used an EBITDA
multiple between 6 and 6.5 (the midpoint between the median 2009 and 2010
Total Enterprise Value/EBITDA of wireless, satellite, and competitive local
exchange industries). He used discount rates of 22% and 24%, and concluded
the dcf method produced a valuation range of $570 million to $900 million. DISH’
expert used the debtors’ financial projections in its disclosure statement from
2010 to 2013, and for the terminal value used the average TEV/MHz POP
derived in the trading comparables and precedent spectrum transactions
analyses. He applied a 25% discount rate to the terminal value and discounted
the projected cash flows at the risk free rate in one scenario and 25% in a
second scenario. His conclusion was a valuation range of $70 million to $100
million.
i. Valuation Issue
What is the correct valuation and valuation method?
ii. Holding
The bankruptcy court adopted the debtors’ expert’s valuation,
supplemented to omit any weighting of the dcf method. It yielded a valuation
range of $492 million to $692 million. The valuation was not appealed.
Only the debtors’ expert provided a liquidation value analysis, and the
court adopted its range of $113 million to $152 million. 419 B.R. at 200-201.
ii. Rationale
The bankruptcy court opined it had serious problems with the dcf method
because the debtor’s expert used projections assuming major capital
expenditures of $1.5 billion, while DISH’ expert used a stream of largely negative
cash flows, which the court observed would mean the buyer would have a reason
other than cash flow for buying the company.
The bankruptcy court found the Trading Comparables Analysis resulted in
the most reliable valuation of the debtors’ business because it was based on two
companies with directly comparable assets operating in the same segment of the
industry. The experts also differed the least using this methodology. The court
sided with the debtors’ expert’s use of both the book values and market values
51

“because the stock of the comparable companies was trading at a significant
discount at the time of the valuation, and because of the uncertainty in the
markets, it was prudent to weight the book and market value equally.” 419 B.R.
at 198.
The bankruptcy court found the Spectrum Transactions Analysis less
reliable than the Trading Comparables Analysis. To the extent it is considered,
the court sided with the debtors’ expert’s analysis “because the relatively large
range of values reached by Mr. Henkin [debtors’ expert] was tempered by his low
weighting of this method…” 419 B.R. at 198. The court observed that DISH’
expert’s finding that there was only one comparable transaction necessitates
placing less than a 40% weighting on that figure.
Using only the Trading Comparables Analysis and Spectrum Transactions
Analysis, weighted 94.7% and 5.3%, the debtors’ expert’s range became $492
million to $692 million. DISH’ expert’s new weighting would be 33.3% and
66.7%, yielding a range of $270 million to $340 million.
iii. Designation of DISH' Rejection of First Lien Treatment
The bankruptcy court designated DISH' rejection ballot in respect of the
class of first lienholders based largely on its interpretations of In re P-R Holding
Corp., 147 F.2d 895 (2d Cir. 1945), and what it called the "Allegheny doctrine,"
alluding to In re Allegheny International, Inc., 118 B.R. 282 (Bankr. W.D. Pa.
1990). 421 B.R. at 138, 139-140.
The bankruptcy court concentrated on the language in P-R Holding
providing when a claim "purchase is in aid of an interest other than an interest of
a creditor, such purchases may amount of 'bad faith…'" P-R Holding, 147 F.2d
at 897 (emphasis supplied). DBSD, 421 B.R. at 138n.16.
The Second Circuit affirmed the vote designation. Slip Op. at 4.
Initially, the Second Circuit espoused the general rules in the designation
jurisprudence.
“We start with general principles that neither side disputes.
Bankruptcy courts should employ § 1126(e) designation sparingly,
as ‘the exception, not the rule.’ In re Adelphia Commc’ns Corp., 359
B.R. 54, 61 (Bankr. S.D.N.Y. 2006). For this reason, a party
seeking to designate another’s vote bears the burden of proving
that it was not cast in good faith. See id. Merely purchasing claims
in bankruptcy ‘for the purpose of securing the approval or rejection
of a plan does not of itself amount to ‘bad faith.’ In re P-R Holding,
147 F.2d at 897; see In re 255 Park Plaza Assocs. Ltd. P’ship, 100
F.3d 1214, 1219 (6th Cir. 1996). Nor will selfishness alone defeat a
creditor’s good faith; the Code assumes that parties will act in their
52

own self interest and allows them to do so. See In re Figter, 118
F.3d at 639.”
Slip Op. at 39.
Next, the Second Circuit carves out the background of the exception to the
general rules:
“’[T]he section [1126(e)] was intended to apply to those who
were not attempting to protect their own proper interests, but who
were, instead, attempting to obtain some benefit to which they were
not entitled.’ In re Figter, 118 F.3d at 638. A bankruptcy court may,
therefore, designate the vote of a party who votes ‘in the hope that
someone would pay them more than the ratable equivalent of their
proportionate part of the bankrupt assets,’ Young, 324 U.S. at 211,
or one who votes with an ‘ulterior motive,’ 1937 Hearing, supra, at
180 (statement of SEC Commissioner William O. Douglas), that is,
with ‘an interest other than an interest as a creditor,’ In re P-R
Holding, 147 F.2d at 897.”
Slip Op. at 40.
“Clearly, not just any ulterior motive constitutes the sort of
improper motive that will support a finding of bad faith. After all,
most creditors have interests beyond their claim against a particular
debtor, and those other interests will inevitably affect how they vote
the claim. For instance, trade creditors who do regular business
with a debtor may vote in the way most likely to allow them to
continue to do business with the debtor after reorganization. See
John Hancock Mut. Life Ins. Co. v. Route 37 Bus. Park Assocs.,
987 F.2d 154, 161-62 (3d Cir. 1993). And, as interest rates change,
a fully secured creditor may seek liquidation to allow money once
invested at unfavorable rates to be invested more favorably
elsewhere. See In re Landing Assocs., Ltd., 157 B.R. 791, 807
(Bankr. W.D. Tex. 1993). We do not purport to decide here the
propriety of either of these motives, but they at least demonstrate
that allowing the disqualification of votes on account of any ulterior
motive could have far-reaching consequences and might leave few
votes upheld. The sort of ulterior motive that § 1126(e) targets is
illustrated by the case that motivated the creation of the “good faith”
rule in the first place, Texas Hotel Securities Corp. v. Waco
Development Co., 87 F.2d 395 (5th Cir. 1936). In that case, Conrad
Hilton purchased claims of a debtor to block a plan of
reorganization that would have given a lease on the debtor’s
property – once held by Hilton’s company, later cancelled – to a
third party. Id. at 397-99. Hilton and his partners sought, by buying
and voting the claims, to ‘force [a plan] that would give them again
53

the operation of the hotel or otherwise reestablish an interest that
they felt they justly had in the property.’ Id. at 398. The district
court refused to count Hilton’s vote, but the court of appeals
reversed, seeing no authority in the Bankruptcy Act for looking into
the motives of creditors voting against a plan. Id. at 400.”
Slip Op. at 41.
The Second Circuit attributes the development of section 1126(e) and its
predecessor (section 203) under the Bankruptcy Act of 1898, as amended, to
Congress’ and then SEC Chairman William Douglas' desires to overturn
legislatively Texas Hotel Securities Corp. v. Waco Development Co., 87 F.2d 395
(5th Cir. 1936):
“That case spurred Congress to require good faith in voting
claims. As the Supreme Court has noted, the legislative history of
the predecessor to § 1126(e) “make[s] clear the purpose of the
[House] Committee [on the Judiciary] to pass legislation which
would bar creditors from a vote who were prompted by such a
purpose” as Hilton’s. Young, 324 U.S. at 211 n.10. As then-SEC
Commissioner Douglas explained to the House Committee:
‘We envisage that “good faith” clause to enable the
courts to affirm a plan over the opposition of a minority
attempting to block the adoption of a plan merely for selfish
purposes. The Waco case . . . was such a situation. If my
memory does not serve me wrong it was a case where a
minority group of security holders refused to vote in favor of
the plan unless that group were given some particular
preferential treatment, such as the management of the
company. That is, there were ulterior reasons for their
actions.’ 1937 Hearing, supra, at 181-82. 10
[Second Circuit Footnote 10: "Commissioner Douglas also
described the Hilton claim-holders telling the other parties, in effect,
'For a price you can have our vote.' 1937 Hearing, supra, at 182. In
this respect, Douglas’s memory may have served him wrong, since
at least the opinion of the court of appeals records nothing along
these lines, unless one interprets 'a price' broadly to include
reinstatement of a lease or reassignment of management rights."]
"One year after Commissioner Douglas’s testimony, and two years
after the Waco case, Congress enacted the proposed good faith
clause as part of the Chandler Act of 1938. Pub. L. 75-575, § 203,
52 Stat. 840, 894. The Bankruptcy Code of 1978 preserved this
54

good faith requirement, with some rewording, as 11 U.S.C. §
1126(e).”
Slip Op. at 42-43.
Next, the Second Circuit observes the bankruptcy court’s heavy
reliance on Allegheny:
“…In perhaps the most famous case, and one on which the
bankruptcy court in our case relied heavily, a court found bad faith
because a party bought a blocking position in several classes after
the debtor proposed a plan of reorganization, and then sought to
defeat that plan and to promote its own plan that would have given
it control over the debtor. See In re Allegheny Int’l, Inc., 118 B.R.
282, 289-90 (Bankr. W.D. Pa. 1990)….”
Slip Op. at 43.
Finally, the Second Circuit explains why it affirms the designation:
“Although we express no view on the correctness of the
specific findings of bad faith of the parties in those specific cases,
we think that this case fits in the general constellation they form. As
the bankruptcy court found, DISH, as an indirect competitor of
DBSD and part-owner of a direct competitor, bought a blocking
position in (and in fact the entirety of) a class of claims, after a plan
had been proposed, with the intention not to maximize its return on
the debt but to enter a strategic transaction with DBSD and 'to use
status as a creditor to provide advantages over proposing a plan as
an outsider, or making a traditional bid for the company or its
assets.' DBSD II, 421 B.R. at 139-40. In effect, DISH purchased the
claims as votes it could use as levers to bend the bankruptcy
process toward its own strategic objective of acquiring DBSD’s
spectrum rights, not toward protecting its claim.”
“We conclude that the bankruptcy court permissibly
designated DISH’s vote based on the facts above. This case
echoes the Waco case that motivated Congress to impose the
good faith requirement in the first place. In that case, a competitor
bought claims with the intent of voting against any plan that did not
give it a lease in or management of the debtor’s property. 87 F.2d
at 397-99. In this case, a competitor bought claims with the intent of
voting against any plan that did not give it a strategic interest in the
reorganized company. The purchasing party in both cases was less
interested in maximizing the return on its claim than in diverting the
progress of the proceedings to achieve an outside benefit. In 1936,
55

no authority allowed disregarding votes in such a situation, but
Congress created that authority two years later with cases like
Waco in mind.”
“We also find that, just as the law supports the bankruptcy
court’s legal conclusion, so the evidence supports its relevant
factual findings. DISH’s motive – the most controversial finding – is
evinced by DISH’s own admissions in court, by its position as a
competitor to DBSD, 12 "
[footnote 12: "Courts have been especially wary of the good
faith of parties who purchase claims against their competitors. See
In re MacLeod, 63 B.R. at 655; see also In re Figter, 118 F.3d at
640 (finding no bad faith in part because party was not competitor);
In re 255 Park Plaza Assocs., 100 F.3d at 1219 (same); In re Pine
Hill Collieries Co., 46 F. Supp. 669, 672 (E.D. Pa. 1942) (finding no
bad faith even for a competitor, but only because competitor had a
prior interest in the debtor)."],
"by its willingness to overpay for the claims it bought, 13 "
[footnote 13: "The fact that DISH bought the First Lien Debt
at par is circumstantial evidence of its intent, though we do not put
as much weight on the price as the bankruptcy court did. See
DBSD II, 421 B.R. at 140. It is certainly true, as the Loan
Syndications and Trading Association points out in an amicus brief,
that purchasers may have many good business reasons for buying
debt at par, especially when, as in this case, the debt is well
secured and interest rates dropped between the original issuance
of the debt and its purchase. Buying claims at or above par
therefore could not provide the sole basis for designating a
creditor’s vote. Nevertheless, a willingness to pay high prices may
tend to show that the purchaser is interested in more than the claim
for its own sake. The weight to be given to such evidence is
primarily an issue for the finder of fact, and we see no clear error in
the bankruptcy court’s reliance on the factor in this case."],
"by its attempt to propose its own plan, and especially by its
internal communications, which, although addressing the Second
Lien Debt rather than the First Lien Debt at issue here,
nevertheless showed a desire to ‘to obtain a blocking position’ and
‘control the bankruptcy process for this potentially strategic asset.’
We therefore hold that a court may designate a creditor’s vote in
these circumstances.”
56

“The Loan Syndications and Trading Association (LSTA), as
amicus curiae, argues that courts should encourage acquisitions
and other strategic transactions because such transactions can
benefit all parties in bankruptcy. We agree. But our holding does
not 'shut[ the door to strategic transactions,' as the LSTA suggests.
Rather, it simply limits the methods by which parties may pursue
them. DISH had every right to propose for consideration whatever
strategic transaction it wanted – a right it took advantage of here –
and DISH still retained this right even after it purchased its claims.
All that the bankruptcy court stopped DISH from doing here was
using the votes it had bought to secure an advantage in pursuing
that strategic transaction.”
Slip Op. at 46.
"DISH argues that, if we uphold the decision below, “future
creditors looking for potential strategic transactions with chapter 11
debtors will be deterred from exploring such deals for fear of
forfeiting their rights as creditors.” But our ruling today should deter
only attempts to “obtain a blocking position” and thereby “control
the bankruptcy process for [a] potentially strategic asset” (as
DISH’s own internal documents stated)…."
Slip Op. at 46 (emphasis in original).
Significantly, the Second Circuit attempts to open the door to strategic
acquisitions and claims purchases in other unspecified circumstances without
triggering vote designation:
“We leave for another day the situation in which a preexisting
creditor votes with strategic intentions. Cf. In re Pine Hill Collieries
Co., 46 F. Supp. 669, 672 (E.D. Pa. 1942). We emphasize,
moreover, that our opinion imposes no categorical prohibition on
purchasing claims with acquisitive or other strategic intentions. On
other facts, such purchases may be appropriate. Whether a vote
has been properly designated is a fact-intensive question that must
be based on the totality of the circumstances, according
considerable deference to the expertise of bankruptcy judges.
Having reviewed the careful and fact-specific decision of the
bankruptcy court here, we find no error in its decision to designate
DISH’s vote as not having been cast in good faith.”
Slip Op. at 47.
As explained below, the Second Circuit appears to have erred by:
57

(a) not citing and failing to follow controlling Second Circuit precedent,
Mokava Corp. v. Dolan, 147 F.2d 340 (2d Cir. 1945), holding a vote cannot be
designated for lack of good faith when the creditor purchased its claim (i) after
the plan was proposed, (ii) by paying the claimholders full principal and interest,
and (iii) for the purpose of rejecting an improper plan (in Mokava Corp. the plan
was improper because it classified two secured claims secured by different
collateral in the same class, whereas in DBSD the plan provided the first
lienholder a 4-year nonperforming note, which treatment would have been
objected to by any claimholder and had never previously been approved as the
indubitable equivalent by any court), 92
(b) overlooking a critical difference between Texas Hotel and Allegheny on
one hand, and DBSD on the other, namely that DISH’ rejection would neither
cause the failure of DBSD’s reorganization nor the special treatment of DISH, but
rather only cause DBSD to repair the patently offensive first lien treatment its
plan proposed (a 4-year nonperforming loan never before approved as the
indubitable equivalent),
(c) overlooking that Texas Hotel Securities Corp. v. Waco Development
Co., 87 F.2d 395 (5th Cir. 1936), involved a rejection that would make
confirmation impossible unless the debtor gave special treatment to the rejecting
creditor and not to other creditors in its class,
(d) overlooking that P-R Holding and Allegheny actually enabled the
creditors whose votes were challenged to obtain control, and were only
concerned with unequal treatment of creditors of equal rank, and
(e) substituting “will” for “may” in P-R Holding by concluding the motive to
control is alone sufficient to designate a vote.
92 Mokava Corp. v. Dolan, 147 F.2d 340, 344 (2d Cir. 1945), in pertinent part, provides:
“The court below, however, seemed to believe that Meyer acted with
grave impropriety in buying the Annex mortgage, because Meyer's purpose in so
doing was obviously to frustrate acceptance of the plan. On the facts here we
see no such impropriety. In any event, there can be no such impropriety sufficient
to amount to lack of good faith under § 203 of the Bankruptcy Act, 11 U.S.C.A. §
603. For there can be no bad faith in buying up claims in order to frustrate the
obtaining of acceptances from members of a class invalidly constituted.
Moreover, the court could find lack of good faith under § 203 only after a 'hearing
upon notice,' and no such hearing was held.
Here Meyer, in frustrating the acceptances by the certificateholders,
other than Dolan, was doing them no harm: Through his purchase of the
mortgage they obtained full payment in cash of principal and accrued interest,
whereas under the plan they would have received substantially less cash (i. e.,
for one-half their accrued interest they would have received only preferred stock).
As the lower court itself said, the struggle over the plan was merely a contest
between Meyer and Dolan for 'control of the hotel.'”
58

Significantly, DBSD does not cite (perhaps because the litigants did not
cite) the Second Circuit decision whose rationale and holding show there was no
basis to designate DISH’ vote. In Mokava Corp. v. Dolan, 147 F.2d 340 (2d Cir.
1945), the debtor owned a hotel and annex, with separate first mortgages on
each property. Although the two first mortgages were classified in the same
class under the proposed Chapter X plan, they were each given different
treatment. Dolan had purchased the first mortgage during the Chapter X case
and his proposed plan gave him a controlling amount of the reorganized debtor’s
stock in exchange for the accrued interest on the first mortgage. The principal
amount of the first mortgage would remain a first mortgage note. After the
Chapter X plan was proposed, the controlling shareholder of the debtor, Meyer,
purchased the entire first mortgage against the annex, because its amount was
greater than one-third of the total first mortgage claims in the class, and therefore
Meyer’s rejection of the plan would frustrate its acceptance. The bankruptcy
court, however, pursuant to Bankruptcy Act section 203 (former 11 U.S.C. § 603)
did not count Meyer’s rejection vote on the ground Meyer’s purpose for
purchasing the mortgage was to frustrate acceptance of the plan, which the court
regarded as an impropriety.
Mokava’s reasoning contradicts DBSD on many fronts. First, because the
classification in one class of two mortgages receiving different treatment was
wrong, the Second Circuit ruled “there can be no bad faith in buying up claims in
order to frustrate the obtaining of acceptances from members of a class invalidly
constituted.” 147 F.2d at 344. Similarly, in DBSD, DISH cannot be faulted for
frustrating acceptance of a class being crammed down with a 4-year
nonperforming note. Given that no reported decision had previously approved a
4-year nonperforming note as the indubitable equivalent, DISH could have no
bad faith in opposing it. In Mokava, Meyer could not have known for sure that it
would prevail on its classification argument when it cast its vote to reject, but it
had good grounds to think it would, just as DISH had good grounds.
Second, and more critically, the Second Circuit ruled that rejecting a plan
to gain control is not a ground to disenfranchise the creditor’s vote to reject the
plan:
“Here, Meyer, in frustrating the acceptances by the
certificateholders, other than Dolan, was doing them no harm:
Through his purchase of the mortgage they obtained full payment in
cash of principal and accrued interest, whereas under the plan they
would have received substantially less cash (i.e., for one-half their
accrued interest they would have received only preferred stock).
As the lower court itself said, the struggle over the plan was merely
a contest between Meyer and Dolan for ‘control of the hotel.’ The
plan’s treatment of the first mortgage on the Main Building would
have given Dolan that control. There was nothing wrong in the fact
that Meyer’s purchase of the Annex mortgage (which gave Dolan
59

cash in full for his certificates) prevented Dolan from getting control
through an erroneous classification order.”
147 F.2d at 344 (emphasis supplied). Third, as shown by Mokava’s ruling,
paying in full in cash for a claim that would be paid partially in debt and stock
under a proposed plan, is “doing them no harm.” Id. It’s not a bad thing. It’s a
good thing!
In P-R Holding, the appellate court explained the plan proponents'
purchase of claims was in bad faith because "those purchases result in a
discrimination in favor of the creditors selling their interests." In re P-R Holding
Corp., 147 F.2d 895, 897 (2d Cir. 1945). P-R Holdings did not determine the
claims purchases were in bad faith simply because the purchaser wanted to
acquire the debtor’s property. Indeed, after finding the claims purchase was in
bad faith, the court did not designate the purchased votes. Rather, it ruled the
purchaser’s plan and acquisition of control should be confirmed. The facts in P-R
Holding were that the plan provided for payment of one half the prepetition
mortgage debt, 1/6 in cash and 2/6 in new 10-year mortgage debt at 4% interest.
147 F.2d at 896. The plan proponents who were funding the plan purchased
claims for cash at 40% and 50% on the dollar because the claims had rejected
the plan and they wanted to vote them to accept the plan. 147 F.2d at 896.
Thus, the purchased claims received better treatment than the other claims
would receive under the plan. ("We agree that the purchases by Bisgeier and
Cohen resulted in an inequity among the creditors, since those who sold to
Bisgeier and Cohen received 50 cents in cash, while the plan provided for
payment of 50 cents on the dollar, partly in cash and largely in mortgage
securities…. 147 F.2d at 897.). Notably, the appellate court ruled it would not
disqualify or designate the votes purchased because the plan still represented
the best offer available and was made somewhat more attractive by some
concessions from the plan proponents. 147 F.2d at 898.
Thus, P-R Holding follows the black letter jurisprudence a few months
later embraced by the Supreme Court in Young v Higbee Co., 324 U.S. 204
(1945), finding bad faith when a party in interest treats some creditors better than
others in the same class, P-R Holding adheres to the principle that purchasing
claims to cause a plan to be accepted or rejected does not by itself warrant
disqualification, 147 F.2d at 897, and also demonstrates that purchasing claims
as part of a strategy to control the debtor's only asset is not bad faith as long as
the purchases do not discriminate against creditors. In DBSD, DISH purchased
all the claims in the first lien class at par. Thus, there was no discrimination
there. Moreover, DISH never did purchase a blocking position in the second lien
debt. Had it done so for a price not exceeding the amount DISH would offer
other second lien debt holders in a plan, that also would not show per se bad
faith even if DISH does want to control DBSD's business.
60

In In re Allegheny International, Inc., 118 B.R. 282, 286 (Bankr. W.D. Pa.
1990), an entity called Japonica proposed a plan to acquire the reorganized
debtor under which Japonica would purchase the shares issued under the plan
for $6.42 per share, subject to holdbacks based on future resolutions of disputed
claims. The debtor's proposed plan offered $7 per share. 118 B.R. at 286. To
cause the debtor's plan to be rejected, Japonica purchased 33.87% of the claims
in one class for prices ranging from 95% to 82% of face. Japonica purchased
less than 1/3 of the claims in another class for 66% of face and caused that class
to reject as well. 118 B.R. at 287. The debtor requested the designation of
Japonica's votes pursuant to Bankruptcy Code section 1126(e) because the plan
was not confirmable over those classes' rejections. 118 B.R. at 290. Japonica
purchased claims for $7 per share when it was offering those claims only $6.42
per share in its proposed plan. 118 B.R. at 294. Additionally, Japonica launched
a tender offer and thereby acquired 62% of the claim amount in one class and
36% in another. 118 B.R. at 295. The tender offer expired while voting on
Japonica's plan was in process and resulted in Japonica treating the purchased
claims differently than claims were treated under the plan in that the purchased
claims received immediate cash with no holdback. 118 B.R. at 295-296.
Japonica paid between 6% and 23% more to purchase certain claims than it
offered under its proposed plan. 118 B.R. at 297. Japonica revised its own
proposed plan to increase the distribution to 94.86% to a class in which Japonica
had purchased claims for 66% of their amounts. The court wrote: "This is
chutzpah with a vengeance. It is also bad faith." 118 B.R. at 297.
The Allegheny court summed up Japonica's motive as follows:
"Japonica's actions and statements make abundantly clear that it is 'control' and
'control profit' that they seek. This control profit will not be shared through a
reorganization plan with all creditors and all interest holders. A control profit will
be shared by only Japonica and their affiliates. Japonica intends to use its newly
acquired control to extract economic profit for itself, not to maximize the results
for all creditors. *** Acquiring claims with the clear purpose of achieving control of
the debtor, thereby earning a control profit, does not maximize the result for all
creditors. Such action manipulates the process." 118 B.R. at 299, 300.
The foregoing observations of the Allegheny court together with the
remedy it ordered, sheds much light on what a 'motive to acquire control' has to
do with vote designation. In short, the Allegheny court made control available to
Japonica in a manner that virtually guaranteed Japonica would obtain control for
many reasons. The court ordered that Japonica had 45 days to show it had the
ability to buy all the reorganized debtor's shares for $7 per share and warrants for
$1.53 per warrant, and that if it did, the debtor and Japonica were to facilitate the
purchase and an orderly change in control. 93 The court also ordered that if
93 In re Allegheny International, Inc., 118 B.R. 282, 303 (Bankr. W.D. Pa. 1990) (“Shares to be
distributed to Japonica or their affiliates shall be held in trust by the debtor and shall not be
entitled to vote on any matter while in trust or owned by Japonica. Japonica, however, may enjoy
the other benefits of ownership, such as dividends and proceeds from sale. If, within 45 days from
61

Japonica did not acquire control or sell its shares, then its shares would be held
in trust by the reorganized debtor for 3 years. 118 B.R. at 303-304. Because
Japonica was already a substantial shareholder, it would have been very
negative for Japonica and for other shareholders to have a material portion of the
company's stock in limbo for 3 years. Major capital transactions would be
stymied by the inability of a major shareholder to vote its shares. Thus,
Allegheny's holding virtually compelled Japonica to take control, which totally
repudiates the notion that taking control is considered bad.
The court's remedy makes clear that the motive to acquire control is not
per se evil or a ground to designate votes under section 1126(e). Indeed,
Allegheny expressly holds: “Simply stated, the court should designate the votes
of only those creditors or interest holders who were engaged in wrongdoing.” 94
The policy to be served is to stop a claimholder from using its claims purchases
and votes to prevent other claimholders from sharing in the 'control profit.' The
Allegheny court made sure Japonica would pay to all creditors the top end of
what the court found was the share value. 118 B.R. at 305 ("The resultant values
of the reorganization shares were $6.33 to $7 per share of the new common
stock and zero to $1.53 for the warrants.").
The DBSD bankruptcy court espouses a principle it asserts it takes from
Allegheny, but is actually unsubstantiated by Allegheny and flatly contradicted by
Mokava, namely that the motive to take control alone warrants the designation of
votes: "Lastly, the purpose to acquire debt in this case, and to use voting to
advance the effort to take control, is as plain in this case as it was in
Allegheny….421 B.R. at 140. DBSD overlooks the absence of any fact showing
that DISH caused itself to be favored, or different creditors in the same class to
be treated differently or to be deprived of the maximum return they could obtain.
Moreover, even if a motive to control, alone were actionable, DBSD overlooks
DISH' ultimate failure to buy a blocking or controlling position in the second lien
debt, notwithstanding its documents showing one DISH employee wanted to do
so.
Notably, the same bankruptcy judge who wrote DBSD, had recently
decided a vote designation motion in In re Adelphia Communications Corp., 359
B.R. 54 (Bankr. S.D.N.Y. 2006). There, the judge cited Allegheny and described
it altogether differently, never mentioning control. The court's opinion capsulized
Allegheny's holding as follows: "holding that the court should designate the votes
of only those creditors or interest holders who were engaged in wrongdoing,"
consistent with Allegheny’s actual ruling (“Simply stated, the court should
designate the votes of only those creditors or interest holders who were engaged
the date of this order, and subject to approval by this court, Japonica establishes with the debtor
that it has the ability to respond to puts from all other shareholders and warrant holders at $7 per
share and $1.53 per warrant, then the debtor and Japonica are to facilitate the purchase
transaction and an orderly change in control….”)
94 In re Allegheny International, Inc., 118 B.R. 282, 293 (Bankr. W.D. Pa. 1990).
62

in wrongdoing.” 95 ). In re Adelphia Communications Corp., 359 B.R. 54, 60n.27
(Bankr. S.D.N.Y. 2006).
While the lesson of Allegheny is that a creditor aiming to control the
reorganized debtor must share the control profit or value ratably with all other
creditors if it uses the voting process to take control, DBSD (a) extracts from
Allegheny its remarks about Japonica wanting control, while (b) overlooking
Allegheny’s methodical listing of all Japonica’s actions designed to treat
differently creditors in the same class and depriving many of them of the control
profit Japonica would reap from being a creditor in such classes, and (c)
overlooking that Allegheny’s remedy was to facilitate Japonica’s taking of control
as long as it paid each creditor its ratable share of the control profit.
As a result, DBSD actually criticizes DISH for paying each first lien creditor
the full amount of its claim, when that would prevent DISH from profiting at their
expense and having them treated differently. Obtaining top dollar for creditors
and preventing unequal treatment is exactly what Allegheny attempted to
accomplish, not discourage. But, DBSD propounds the accusation that: "First,
as the Court has found, and even more egregiously than Japonica did in
Allegheny –where Japonica made its purchases at a maximum of 95[cent] on the
dollar – DISH purchased all of the First Lien Debt at par, knowing that the Plan
proposed replacing the First Lien Debt with an Amended Facility that DISH did
not want…." 421 B.R. at 140 (emphasis supplied by court). What DBSD points
to as egregious, is exactly what Mokava, Allegheny and all other courts want to
foster, namely maximum and equal payment to all claimholders in the class.
DBSD overlooks that Allegheny highlighted Japonica’s purchase of certain debt
for 95 cents on the dollar, because Japonica paid other debt in the same class
only 82 cents on the dollar, Allegheny, 118 B.R. at 287, not because Allegheny
was against creditors being treated well or because Japonica wanted to
purchase control. It was the uneven manner in which Japonica proceeded that
Allegheny highlights. The Second Circuit tones down the DBSD bankruptcy
court’s characterization. 96
95 In re Allegheny International, Inc., 118 B.R. 282, 293 (Bankr. W.D. Pa. 1990).
96 Slip Op. at 45n.13 provides:
"The fact that DISH bought the First Lien Debt at par is circumstantial evidence of
its intent, though we do not put as much weight on the price as the bankruptcy
court did. See DBSD II, 421 B.R. at 140. It is certainly true, as the Loan
Syndications and Trading Association points out in an amicus brief, that
purchasers may have many good business reasons for buying debt at par,
especially when, as in this case, the debt is well secured and interest rates
dropped between the original issuance of the debt and its purchase. Buying
claims at or above par therefore could not provide the sole basis for designating
a creditor’s vote. Nevertheless, a willingness to pay high prices may tend to show
that the purchaser is interested in more than the claim for its own sake. The
weight to be given to such evidence is primarily an issue for the finder of fact,
and we see no clear error in the bankruptcy court’s reliance on the factor in this
case."
63

The DBSD bankruptcy court's premise that a motive to control is alone a
wrongful motive, also caused it to regard as a strike against DISH that DISH
requested permission to propose a chapter 11 plan after having earlier asserted
it was not proposing a plan. 97 Clearly, creditors cannot maximize their returns
when there is no competition to acquire the reorganized debtor. Allegheny used
the competition to maximize creditors’ returns, while DBSD leaves the second
lienholders with stock in a reorganized debtor lacking committed funding for the
last two years before it projects revenues, and no competing bidders. Notably,
the filing of a competing plan cannot be bad for a debtor’s constituents because
(a) the court is the final arbiter as to whether to confirm the debtor’s plan or the
investor’s plan after considering creditor and shareholder preferences, 98 and (b)
the investor’s plan must satisfy all the same requirements as the debtor’s plan
including the requirement that it must be proposed in good faith. 99
DBSD also treats negatively that a potential acquirer such as DISH has a
“strategic investment interest,” and not just a motive to maximize its recovery on
a claim. 100 Why? Whether a claims purchaser purchases the claim because it
believes the market undervalues it, or because it believes it can cause the debtor
to engage in activities more profitable than its current business plan, the claims
purchaser is trying to make a profit. There is no explanation in DBSD or any
other decision on vote designation as to why a strategic investment interest
makes a difference. Rather, the jurisprudence cited above consistently looks to
whether the entity voting a claim either treated other creditors differently, or
committed some type of tort such as blackmail. 101
Accordingly, while the DBSD bankruptcy court asserts it is applying the
"Allegheny doctrine," 421 B.R. at 139, it is actually excising the portion of
Allegheny that explains Japonica was attempting to gain control, from the
balance of Allegheny showing it was Japonica’s acts to treat creditors in the
same class differently and to deprive them of the control profit that Japonica
would obtain as a creditor in numerous classes, that were the wrongful acts.
Allegheny simply applies prior law designating votes when the claimant is
creating unequal treatment of creditors in the same class and favoring itself. In
fact, a computer search shows no other court has ever referred to the " Allegheny
doctrine," most likely because Allegheny does not create a new doctrine
designating votes solely because a creditor seeks control; rather it adheres to the
97 DBSD, 421 B.R. at 141 (“But the Court cannot agree that DISH has acted as a "model citizen,"
or that by not engaging in the acts it mentioned, DISH should be immune from application of the
Allegheny doctrine. That is especially true here, since within days of saying what it said in its
pleading, DISH did seek to terminate exclusivity, to propose a competing plan.”).
98 Bankruptcy Code section 1129(c).
99 Bankruptcy Code section 1129(a)(3).
100 DBSD, 421 B.R. at 141-142 (“Here, by contrast, DISH has acted to advance strategic
investment interests wholly apart from maximizing recoveries on a long position in debt it holds.”).
101 See footnotes 66-68, supra.
64

jurisprudence designating votes of a creditor attempting to attain ownership and
control by attempting to have creditors in the same class treated differently with
the acquiring creditor treated the best.
DBSD also dismisses the fact that the holders of first lien debt who sold
their claims to DISH would, like DISH, likely have objected to and rejected the
plan's treatment. 421 B.R. at 140. As explained above, there would be no
interest or principal payments for 4 years, and the note would lose some
collateral, covenants, and cross defaults. Indeed, what claimholder would not
reject a plan proposing a nonperforming 4-year note from a startup operation
uncertain to have sufficient funds for 4 years of operations? Based on DBSD,
claims purchasers have to worry they lose their rights to vote and to oppose
cramdown treatment if they pay 100 cents for a claim. That frustrates the public
policy to try to maximize creditor recoveries and minimize their losses. 102
In Texas Hotel Securities Corp. v. Waco Development Co., 87 F.2d 395
(5th Cir. 1936), the Waco-Hilton Hotel Company had lost to Waco Development
Co. a 99-year lease of a hotel in the depression, after it had built and furnished
the hotel and then sold it and leased it back. The Waco Development Co.
commenced a section 77B case under the Bankruptcy Act of 1898 and proposed
a plan that would extend the maturity and lower the interest rate on the mortgage
bonds that had been issued to finance the hotel development. Waco Hilton's
owner, Texas Hotel Securities Corp., purchased more than one third of the bonds
three days before bankruptcy to prevent confirmation of any plan that did not
make the Waco-Hilton Hotel Company the operator of the hotel. The rejection of
the plan by Waco-Hilton would cause the class of mortgage bonds to reject the
plan, and that rejection would prevent confirmation of the plan because: "The
provision here important, paragraph (e) (1), § 77B (11 U.S.C.A. § 207 (e) (1), is:
'A plan of reorganization shall not be confirmed until it has been accepted in
writing * * * by or on behalf of creditors holding two thirds in amount of the claims
of each class whose claims have been allowed and would be affected by the
plan.'" 87 F.2d at 399. Thus, Waco-Hilton was demanding that in addition to the
treatment provided to all mortgage bondholders, it had to receive a contract to
operate the hotel.
In contrast, DISH did not demand any extra consideration. Moreover, any
holder of the first lien claim would reject a plan providing a 4-year nonperforming
note. In Texas Hotel Securities, Waco-Hilton's vote prevented confirmation of the
plan. But, DISH' vote had no such effect for two reasons. First, unlike former
section 77B, Bankruptcy Code section 1129(a)(10) only requires one class of
impaired claims to accept the plan and the class of second lienholders did
102 Grayson-Robinson Stores, Inc. v. SEC, 320 F.2d 940,949 (2d Cir. 1963)(decision on whether
reorganization should proceed under Chapter X or Chapter XI) (“The prime objective of the
Bankruptcy Act remains the simple one of getting creditors paid, and people engaged in trade are
still the best judges of their own self-interest in that regard.”).
65

accept. Second, Bankruptcy Code section 1129(b)(2)(A) allows the DBSD plan
to be confirmed over DISH' rejection if any of 3 requirements are satisfied.
DBSD was attempting to use the requirement in section 1129(b)(2)(A)(iii) to
provide DISH the "indubitable equivalent" of its secured claim. To conform the
plan's treatment to other cases where courts have found plans provided the
indubitable equivalent, DBSD only had to improve the nonperforming nature of
the note so that some interest would be paid before the ultimate maturity four
years after the effective date. 103
103 See, e.g., Sandy Ridge Development Corp. v. Louisiana National Bank (In re Sandy Ridge
Development Corp.), 881 F.2d 1346, 1350 (5 th Cir. 1989)(court explained that plan turning over
collateral security to the secured claimholder provides the indubitable equivalent, but not a plan
that pays interest and no principal for 10 years, ruling: "In Murel, the reorganization plan
proposed to pay the secured creditor interest on the collateral for ten years, with full payment of
the principal due at the end of that time. However, the plan made no provision for amortization of
principal or for maintenance of the collateral (an apartment building) over the ten-year term. Id.
The court refused to confirm this 'wholly speculative' plan, since the creditor would receive neither
money nor property, nor would he receive an equivalent substitute. Id. In the present case, LNB
will receive the actual property underlying its secured claim and, therefore, it is clear that it will
receive the indubitable equivalent of its secured claim."); Brite v. Sun Country Development, Inc.
(In re Sun Country Development, Inc.), 764 F.2d 406 (5 th Cir. 1985)(granting secured claimholder
twenty separate notes secured by portions of collateral was indubitable equivalent); Travelers
Insurance Company v. Pikes Peak Water Company (In re Pikes Peak Water Company), 779 F.2d
1456, 1461 (10 th Cir. 1985)(court approves plan providing indubitable equivalent in form of note
on which no regular payments of principal and interest need be paid, but within 3 years note must
be paid in full or brought current); In re James Wilson Associates, 965 F.2d 160, 172 (7 th Cir.
1992)(Plan provided current interest payments and amortization payments on 25-year schedule
for 7-year mortgage and court ruled it was the indubitable equivalent because: "Even more
clearly than such questions as negligence and possession, moreover, the question whether the
interest received by a secured creditor under a plan of reorganization is the indubitable equivalent
of his lien is one of fact, In re Snowshoe Co., 789 F.2d 1085, 1088 (4th Cir. 1986), and our review
is therefore deferential. Since Metropolitan is in the business of making loans, it can hardly
complain that its loan was extended, provided not only that the security is adequate (as it is) but
also that the interest rate compensates it for the opportunity cost of its money and the risk of
default. The bankruptcy judge thought that the seven-year Treasury bill rate plus 2.5 percent
would do this, given the adequacy of the first mortgage as security for Metropolitan's loan. It
might appear that if the security is worth much more than the loan (almost twice as much here),
the risk of default will be negligible and the interest bonus was therefore superfluous. But the
appearance is misleading. The risk of default may be great. The borrower may use the difference
between the value of the security and the loan secured by it to secure other loans. Nor is the risk
of default a costless one to the secured creditor merely because his lien is oversecured. More
important than the expenses of foreclosure (should there be a default) is the possibility that the
security will decline in value over the life of the loan, here seven years, to the point where it is no
longer adequate. Nevertheless the testimony of experts that the judge was authorized to credit
confirmed that the value of the building is far in excess of Metropolitan's lien, giving Metropolitan
a considerable cushion against the impact of a default."); Koopmans v. Farm Credit Services of
Mid-America, 102 F.3d 874 (7 th Cir. 1996)(secured claimholder granted interest payments at
prime rate plus a risk factor and court approved same as indubitable equivalent, ruling: "In such
a cramdown the secured creditor is entitled to the "indubitable equivalence" ( In re Murel Holding
Corp., 75 F.2d 941, 942 (2d Cir. 1935) (L. Hand, J.)) of its property interest, 11 U.S.C. §
1225(a)(5)(B)(ii), which means a stream of payments including interest that adds up to the
present value of its claim. Cf. In re Fortney, 36 F.3d 701 (7th Cir. 1994). At what rate of interest
will Farm Credit Services be as well off in the reorganization as if it had been allowed to foreclose
on and sell the farm?").
66

iv. Confirmation
The bankruptcy court held that although there was no accepting vote in
the first lienholder class, it would be deemed an accepting class because the
sole voter was designated and there was authority under Heins v. Ruti-
Sweetwater, Inc. (In re Ruti-Sweetwater), 836 F.2d 1263 (10 th Cir. 1988), to do
so. Notably, in Sweetwater, the court emphasized there was no objection to
deeming the class to accept, 104 as there is in DBSD. Nevertheless, the Second
Circuit affirmed. Slip Op. at 47-49.
The bankruptcy court ruled, however, that even if the first lien class were
deemed to reject the plan, the plan’s treatment of the first lien debt satisfied the
indubitable equivalent treatment required for cramdown under 11 U.S.C. §
1129(b)(2)(a)(iii). (The Second Circuit expressly provided it was not opining on
the indubitable equivalent issue, but did conclude the bankruptcy court’s
feasibility finding was not clear error. Slip Op. at 49-53). The bankruptcy court’s
rationale was that the claim is sufficiently oversecured by at least 6 times,
comparing the first lien debt of $82.6 million in 4 years to the lowest going
concern valuation of $492 million. The court did not discuss two things.
First, if the first lienholder had to resort to enforcement, the liquidation
value of $113 million may be more relevant. Moreover, by rendering the first lien
debt nonpayable in cash for interest or principal for 4 years, the bankruptcy court
effectively subordinated it to the exit facility, deprived it of the collateral coverage
of the auction rate securities, and deprived it of the original strength of the loan
covenants and cross defaults. Additionally, nothing would prevent the
reorganized debtor from refiling a new chapter 11 case in four years and
repeating the process.
Second, just as the court focused on the DISH memo recommending
further investment to acquire the reorganized debtor and not the fact that DISH
did not make any further investment, the court focused on the then value of the
spectrum licenses and not the fact that it was dealing with the inherently volatile
telecom industry where the value of spectrum licenses is subject to quick
turnarounds. Indeed, two of the most famous decisions in bankruptcy and
corporate governance illustrate the case. In Federal Communications
Commission v. NextWave Personal Communications, Inc. (In re NextWave
Personal Communications, Inc.), 200 F.3d 43, 47 (2d Cir. 1999), cert. denied,
121 S.Ct. 298 (2000), NextWave filed bankruptcy in the first place because the
spectrum licenses it purchased lost more than three-quarters of their value in
approximately a year.
104 Heins v. Ruti-Sweetwater, Inc. (In re Ruti-Sweetwater), 836 F.2d 1263, 1267-1268 (10 th Cir.
1988)("Since the Heins did not object to the Plan at any time prior to its confirmation and because
the Heins unilaterally opted not to vote on the confirmation of the Plan, the bankruptcy court did
not err in presuming their acceptance of the Plan for purposes of § 1129(b).").
67

In North American Catholic Education Programming Foundation, Inc. v.
Gheewalla, 105 the Delaware Supreme Court rendered its landmark decision that
there are no direct fiduciary duties of directors to creditors of an insolvent
corporation, in the context of a lawsuit that arose because a deal in 2001 to sell
spectrum licenses to the corporation turned into a bad deal when the value of
spectrum licenses suddenly plummeted: “In June 2002, the market for wireless
spectrum collapsed when WorldCom announced its accounting problems. It
appeared that there was or soon would be a surplus of spectrum available from
WorldCom.” 106
In short, none of the decisions cited by DBSD bankruptcy court impose a
nonperforming loan for 4 years without any protection against a refiling by the
reorganized debtor which makes repayment even more remote. This pushes the
meaning of indubitable equivalent to an onerous, burdensome treatment unlikely
within the contemplation of Congress when it drafted the Bankruptcy Code and
certainly unsupported by all jurisprudence to date.
The bankruptcy court held that the equity going to unsecured claimholders
and old equity from the class of second lien debt was not a violation of the
absolute priority rule, on the authority of Official Unsecured Creditors Comm. v.
Stern (In re SPM Mfg. Corp.), 984 F.2d 1305 (1st Cir. 1993), and its progeny
(e.g., In re Journal Register Co., 407 B.R. 520, 533 (Bankr. S.D.N.Y. 2009); In re
World Health Alternatives, Inc., 344 B.R. 291, 298-299 (Bankr. D. Del. 2006)). It
reasoned that “the gifting here does not injure any junior creditor. In fact, the
only class that receives less than its entitlement is the one agreeing to provide
the gift.” DBSD, 421 B.R. at 214. But, that is the fatal flaw here. The class did
not vote unanimously to make the gift. DBSD, 419 B.R. at 184n.3. Therefore, a
portion of the gift is coming from class members who either voted to reject or who
did not vote. There is no known authority to support that exception to the
absolute priority rule and one circuit court expressly held it is illegal:
“…In turn, Class 7 automatically waived the warrants in favor of
Class 12, without any means for dissenting members of Class 7 to
protest. Allowing this particular type of transfer would encourage
parties to impermissibly sidestep the carefully crafted strictures of
the Bankruptcy Code, and would undermine Congress’s intention to
give unsecured creditors bargaining power in this context. See
H.R. Rep. No. 95-595, at 416, reprinted in 1978 U.S.C.C.A.N. 5963,
6372 (‘ [Section 1129(b)(2)(B)(ii)] gives intermediate creditors a
great deal of leverage in negotiating with senior or secured
creditors who wish to have a plan that gives value to equity.’).”
105
930 A.2d 92 (Del. 2007).
106
North American Catholic Education Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92,
95 (Del. 2007).
68

In re Armstrong World Industries, 432 F.3d 507, 514-515 (3d Cir. 2005).
The Second Circuit reversed, Slip Op. at 4, It did not deploy the rationale
of Armstrong quoted above. Rather, it ruled the plan violated the absolute
priority rule because the plan provided property to shareholders on account of
their equity interests when the class of unsecured claims rejected and was not
paid in full. Slip Op. at 25-26.
What the Second Circuit expressly determined it need not decide is
significant: "We need not decide whether the Code would allow the existing
shareholder and Senior Noteholders to agree to transfer shares outside of the
plan, for, on the present record, the existing shareholder clearly receives these
shares and warrants under the plan.” Slip Op. at 26.
Notably, the Second Circuit considered and rejected the view that 'gifting'
should be allowed to facilitate reorganizations and foster creative restructurings:
"We recognize the policy arguments against the absolute
priority rule. Gifting may be a “powerful tool in accelerating an
efficient and non-adversarial . . . chapter proceeding,” Leah M.
Eisenberg, Gifting and Asset Reallocation in Chapter 11
Proceedings: A Synthesized Approach, 29 Am. Bankr. Inst. J. 50,
50 (2010), and no doubt the parties intended the gift to have such
an effect here. See DBSD I, 419 B.R. at 214. As one witness
testified below, “where . . . the equity sponsor is out of the money,. .
. a tip is common to [e]nsure a consensual bankruptcy rather than a
contested one.” Enforcing the absolute priority rule, by contrast,
“may encourage hold-out behavior by objecting creditors . . . even
though the transfer has no direct effect on the value to be received
by the objecting creditors.” Harvey R. Miller & Ronit J. Berkovich,
The Implications of the Third Circuit’s Armstrong Decision on
Creative Corporate Restructuring: Will Strict Construction of the
Absolute Priority Rule Make Chapter 11 Consensus Less Likely?,
55 Am. U. L. Rev. 1345, 1349 (2006)."
Slip Op. at 35. Critically, the Second Circuit explained the harms
emanating from a gifting law providing shareholders the power to file a
plan favoring the class that agrees to make the biggest gift to
shareholders:
"It deserves noting, however, that there are substantial policy
arguments in favor of the rule. Shareholders retain substantial
control over the Chapter 11 process, and with that control comes
significant opportunity for self-enrichment at the expense of
creditors. See, e.g., 11 U.S.C. § 1121(b) (giving debtor, which is
usually controlled by old shareholders, exclusive 120-day period in
69

which to propose plan). This case provides a nice example.
Although no one alleges any untoward conduct here, it is noticeable
how much larger a distribution the existing shareholder will receive
under this plan (4.99% of all equity in the reorganized entity) than
the general unsecured creditors put together (0.15% of all equity),
despite the latter’s technical seniority. Indeed, based on the
debtor’s estimate that the reorganized entity would be worth
approximately $572 million, the existing shareholder will receive
approximately $28.5 million worth of equity under the plan while the
unsecured creditors must share only $850,000. And if the parties
here were less scrupulous or the bankruptcy court less vigilant, a
weakened absolute priority rule could allow for serious mischief
between senior creditors and existing shareholders."
Slip Op. at 36.
Additionally, to empower gifting would put a cloud of uncertainty over the
enforceability of the absolute priority rule. In turn, this would render
unpredictable the distributions to different classes in many chapter 11 cases.
Uncertainty and unpredictability are great for generating attorneys' fees, but
terrible for commerce and fair and efficient reorganizations.
v. Expected Aftermath of DBSD
The Second Circuit's reversal of the gifting allowed in DBSD is beneficial
to the entire world of chapter 11 reorganization. Absent such reversal, chapter
11 plans would be hostage to which class agrees to make the largest gift to
shareholders. The enforceability of the absolute priority rule would be clouded,
thereby generating immense litigation expense. Reorganizations would neither
be fair nor appear fair.
Because the Second Circuit left open the issue of whether a gift may be
made outside a chapter 11 plan, one can expect new attempts at gifting where
the gift is disclosed, but not made part of the plan. The doctrine of substance
over form should prevent gifting outside a plan, but it is sure to be litigated.
Conversely, the Second Circuit's affirmance of the designation of DISH'
vote on the ground it was looking for a strategic transaction, will likely harm
creditors and reorganizations until the Second Circuit recants or narrows its
holding. To be sure, the holding can already be narrowed to apply to competitors
purchasing claims after a plan has been proposed. But, even that narrow holding
will deprive an estate's creditors of the ability to sell claims for the highest dollar
in some cases.
Interestingly, the Second Circuit neither cited nor overruled Mokava Corp.
v. Dolan, 147 F.2d 340 (2d Cir. 1945). Thus, it is possible that trial courts will
70

continue to restrict their designations of votes to situations in which (a) the
claimant is not rejecting a plan due to a patently offensive plan provision affecting
its claim, and (b) the claimant has already provided or will provide better
treatment for certain similarly situated claims or its own claim, and not for all
similarly situated claims in the class.
6. Perils of Disapproved Postpetition Lending.
A. Alfs v. Wirum (In re Straightline Investments, Inc.), 525 F.3d 870
(9 th Cir. 2008)
i. Facts
The debtor, Straightline, operated a sawmill and did custom lumber milling
when it commenced its chapter 11 case. 525 F.3d at 875. Straightline requested
bankruptcy court approval to borrow up to $500,000 from Aalfs. 525 F.3d at
875. Straightline’s president personally guaranteed Aalfs against all losses Aalfs
may incur from any lending to Straightline. 525 F.3d at 875. The bankruptcy
court authorized Straightline to borrow up to $100,000 from Aalfs secured by a
junior lien against equipment and a senior lien against inventory. But, the court
specifically denied requests to authorize any further borrowing, including loans
secured by accounts receivable. 525 F.3d at 876. Despite the order, from
September 30, 1997 through March 9, 1998 Aalfs advanced money to
Straightline in exchange for accounts receivable. 525 F.3d at 876. Aalfs paid
$186,455 for accounts having a face value of $200,600, and Aalfs collected
$163,007 from the accounts. 525 F.3d at 876. Aalfs referred to the transaction
as a “factoring transaction.” The Ninth Circuit notes that factoring is a sale of
accounts receivable at a discounted price that gives the seller the benefit of
immediate cash and the benefit that the factor assumes the risk of loss. 525
F.3d at 876n.1.
In April 1998, a chapter 11 trustee was appointed and then the case was
converted to chapter 7. The trustee commenced an action to avoid the factoring
transactions. The bankruptcy court ordered that the transfers of the accounts
receivable should be avoided which meant that Aalfs should return to the estate
the $163,007 it collected, the remaining accounts receivable it had not collected,
interest, and costs. 525 F.3d at 876. The Bankruptcy Appellate panel affirmed.
525 F.3d at 876.
ii. Issues
Are the transfers of accounts receivable avoidable pursuant to 11 U.S.C. §
549?
Were the transfers of accounts receivable conducted in the ordinary
course of business?
71

Was the bankruptcy court’s remedy under 11 U.S.C. § 550 an abuse of
discretion?
iii. Holdings
. iii
Yes. The transfers were avoidable pursuant to 11 U.S.C. § 549(a) and
“the bankruptcy court’s finding that the transaction was a disguised loan in
contravention of its earlier order was not clearly erroneous.” 525 F.3d at 885.
The defenses of earmarking and recoupment were not established. 525 F.3d at
885.
The transfers were not conducted in the ordinary course of business. 525
F.3d at 885.
The recovery under 11 U.S.C. § 550 was an appropriate equitable
remedy. 525 F.3d at 885.
iv. Rationale
Bankruptcy Code section 549(a) provides:
“Except as provided in subsection (b) or (c) of this section, the
trustee may avoid a transfer of property of the estate—
(1) That occurs after the commencement of the case; and
(2) (A) that is authorized only under section 303(f) or 542(c)
of this title; or
(B) that is not authorized under this title or by the court.”
The Ninth Circuit reasoned that regardless of whether the transaction was
a sale or a loan, it was a transfer after commencement of the case. In response
to Aalfs’ argument that section 549(a) does not apply when the transfer does not
deplete the estate, the Ninth Circuit ruled: “We decline to expand the diminution
of estate doctrine, from its established application in § 547 and § 548 cases, to
this § 549 case. Although the primary purpose of 11 U.S.C. § 549 is to allow the
trustee to avoid post-petition transfers of property which deplete the estate, see 5
Lawrence P. King, Collier on Bankruptcy § 549.02 (15 th ed. 2005), the plaintiff’s
failure to demonstrate a measurable depletion of the estate is not enough to
allow a transfer to stand when it is otherwise avoidable under § 549 because it
satisfies all of the explicit requirements of an avoidable postpetition transfer.”
525 F.3d at 878 (footnote omitted).
Aalf argued that the transfer was authorized by 11 U.S.C. § 363(c)
because it was in the ordinary course. First applying the creditor expectation
test, see Burlington N. R.R. Co. v. Dant & Russell, Inc. (In re Dant & Russell,
Inc.), 853 F.2d 700, 704 (9 th Cir. 1988), the court agreed with the bankruptcy
court that creditors would have expected notice and hearing after the court
72

disapproved the loan based on the accounts receivable. Second, the court ruled
similar businesses would not engage in the sale in the ordinary course based on
the evidentiary record. 525 F.3d at 881.
Earmarking requires that a third party lend money to a debtor for the
specific purpose of paying a selected creditor. Here there was no selected
creditor. 525 F.3d at 881-882.
Recoupment will not allow Aalf to collect back the amount he paid for the
accounts receivable because it is an equitable remedy and Aalf engaged in
inequitable conduct. 525 F.3d at 882.
11 U.S.C. § 550(a) only allows the transferee to set off the amount it paid
in circumstances not relevant here. 525 F.3d at 884-885.
v. Punitive Damages?
Plainly, the lender who may have been doing the debtor a favor, ended up
being tagged with compensatory and punitive damages. He lost the accounts
receivable he purchased and lost his purchase price, while the estate obtained a
windfall. As a matter of fairness, this appears only justifiable if the transaction is
viewed as an intentional circumvention of the bankruptcy court’s order. That
characterization, however, is unlikely because the court did not order the debtor
not to use the collections from its accounts receivable. Thus, if the account
debtors had paid quickly, the debtor could have used the money to continue its
business. What the decision demonstrates, however, is that a dispassionate
application of 11 U.S.C. §§ 363(c), 549(a), and 550(a) yields an exceptionally
harsh result because no credit is given for the amount paid for the accounts
receivable.
Finally, who was in the wrong? Bankruptcy Code section 364(a) controls
what debt the debtor may incur, and the bankruptcy court ordered the debtor not
to incur more debt or to borrow against its accounts receivable. The debtor
violated the statute and the court’s direction. But, the court punished the lender,
while the debtor and its creditors obtained a windfall benefit for the debtor’s
wrongful conduct.
7. Are Triangular Setoff Agreements Enforceable in Title 11 Cases?
i. Facts
A. In re SemGroup, L.P., 399 B.R. 388 (Bankr. D. Del. 2009) (BLS)
Chevron entered into prepetition derivative transactions with three
affiliated debtors. As credit enhancement, Chevron held the guaranty of
SemGroup, L.P. for all its transactions with SemGroup’s affiliates, and all the
73

parties entered into agreements containing triangular setoff authorizations which
provided:
“in the event either party fails to make a timely payment of monies
due and owing to the other party, or in the event either party fails to
make timely delivery of product or crude oil due and owing to the
other party, the other party may offset any deliveries or payments
due under this or any other Agreement between the parties and
their affiliates.”
399 B.R. at 391.
Upon commencement of the chapter 11 cases of SemGroup and its
affiliates, Chevron owed SemCrude $1,405,878.40, while Chevron was owed
$10,228,439.34 by SemFuel, and an additional $3,302,806.03 by SemStream.
399 B.R. at 392. Accordingly, Chevron requested relief from the automatic stay
(11 U.S.C. § 362(a)(7)) to effectuate a setoff against what it owed SemCrude of
amounts it was owed by SemFuel or SemStream.
ii. Issues
As a result of the triangular setoff provision, do Chevron and SemCrude
owe each other mutual debts for purposes of setoff under 11 U.S.C. § 553(a)? 107
107 11 U.S.C. § 553(a) provides:
Setoff
(a) Except as otherwise provided in this section and in sections 362
and 363 of this title, this title does not affect any right of a creditor to
offset a mutual debt owing by such creditor to the debtor that arose
before the commencement of the case under this title against a
claim of such creditor against the debtor that arose before the
commencement of the case, except to the extent that--
(1) the claim of such creditor against the debtor is disallowed;
(2) such claim was transferred, by an entity other than the debtor,
to such creditor--
(A) after the commencement of the case; or
(B)
(i) after 90 days before the date of the filing of the petition; and
(ii) while the debtor was insolvent (except for a setoff of a kind
described in section 362(b)(6), 362(b)(7), 362(b)(17), 362(b)(27),
555, 556, 559, 560, or 561); or
(3) the debt owed to the debtor by such creditor was incurred by
such creditor--
74

“…[M]ay debts owing among different parties be considered ‘mutual’ when there
are contractual netting provisions governing all parties’ business relationship
(sic)? 399 B.R. at 396.
Are triangular setoff arrangements permitted exceptions to the mutual debt
requirement in 11 U.S.C. § 553(a)? 399 B.R. at 396.
iii. Holdings
“Chevron asserts that the terms of its contracts with the Debtors permit it to setoff
[sic] the debt it owes to one corporation, SemCrude, against the debt owed to it
by two other corporations, SemFuel and SemStream, thus effecting a triangular
setoff. The Court does not need to determine whether the specific terms of these
various contracts grant SemCrude this right, however. Instead, the Court holds
that Chevron is not permitted to effect such a setoff against the Debtors in this
case because section 553 of the Code prohibits a triangular setoff of debts
against one or more debtors in bankruptcy as a matter of law due to lack of
mutuality." 399 B.R. at 392-393.
“Accordingly, the Court holds that non-mutual debts cannot be
transformed into a “mutual debt” under section 553 simply because a multi-party
agreement allows for setoff of non-mutual debts between the parties to the
agreement.” 399 B.R. at 398.
“The Court finds nothing in the language of the Code upon which to base a
conclusion that there is a contractual exception to the “mutual debt” requirement.
Absent a clear indication from the text of the Code that such an exception exists,
the Court deems it improper to recognize one.” 399 B.R. at 399 (footnote
omitted).
“For these reasons, the Court holds that no exception to the “mutual debt”
requirement in section 553 can be created by private agreement.” 399 B.R. at
399.
iv. Rationale
”…In order to effect a setoff in bankruptcy, courts construing the Code
have long held that the debts to be offset must be mutual, prepetition debts. See,
e.g., Scherling v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181
B.R. 730, 738-39 (Bankr. S.D. N.Y. 1995).”
(A) after 90 days before the date of the filing of the petition;
(B) while the debtor was insolvent; and
(C) for the purpose of obtaining a right of setoff against the debtor
(except for a setoff of a kind described in section 362(b)(6),
362(b)(7), 362(b)(17), 362(b)(27), 555, 556, 559, 560, or 561).
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“The authorities are also clear that debts are considered ‘mutual’ only
when ‘they are due to and from the same persons in the same capacity.’
Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 149 (2d Cir. 2002)(citing
Westchester, 181 B.R. at 740). Put another way, mutuality requires that ‘each
party must own his claim in his own right severally, with the right to collect in his
own name against the debtor in his own right and severally.’ Garden Ridge, 338
B.R. at 633-34 (quoting Braniff Airways, Inc. v. Exxon Co., U.S.A., 814 F.2d
1030, 1036 (5th Cir. 1987)). Because of the mutuality requirement in section
553(a), courts have routinely held that triangular setoffs are impermissible in
bankruptcy. See, e.g., Matter of United Sciences of America, Inc., 893 F.2d 720,
723 (5th Cir. 1990) (‘The mutuality requirement is designed to protect against
‘triangular’ set-off; for example, where the creditor attempts to set off its debt to
the debtor with the latter’s debt to a third party.’); Elcona Homes Corp. v. Green
Tree Acceptance, Inc., 863 F.2d 483, 486 (7th Cir. 1988) (holding that the Code
speaks of a ‘mutual debt’ and ‘therefore precludes ‘triangular’ set offs’).
Moreover, because each corporation is a separate entity from its sister
corporations absent a piercing of the corporate veil, ‘a subsidiary’s debt may not
be set off against the credit of a parent or other subsidiary, or vice versa,
because no mutuality exists under the circumstances.’ Sentinel Products Corp.,
192 B.R. at 46 (citing MNC Commercial Corp. v. Joseph T. Ryerson & Son, Inc.,
882 F.2d 615, 618 n. 2 (2d Cir. 1989)). Allowing a creditor to offset a debt it
owes to one corporation against funds owed to it by another corporation – even a
wholly-owned subsidiary – would thus constitute an improper triangular setoff
under the Code.” 399 B.R. at 393-394 (footnotes omitted).
Most triangular setoff decisions trace back to In re Berger Steel Co., 327
F.2d 401 (7th Cir. 1964). There, the court denied a triangular setoff due to its
finding that no such agreement existed, but the court cited certain decisions
allowing triangular setoffs under state law and in equity receiverships. 108 399
B.R. at 395.
Having determined that mutual debts must exist, the SemGroup court
determined debts created by a tripartite agreement can not be mutual:
“The court finds the definition of ‘mutuality’ embraced by other
courts to be instructive in this matter. The overwhelming majority of
courts to consider the issue have held that debts are mutual only if
‘they are due to and from the same persons in the same capacity.’
See, e.g., Westinghouse, 278 F.3d at 149; Garden Ridge, 338 B.R.
at 633; Westchester, 181 B.R. at 740. It is also widely accepted that
‘mutuality is strictly construed against the party seeking setoff.’ In re
Bennett Funding Group, Inc., 212 B.R. 206, 212 (2d Cir. BAP
1997). See also Garden Ridge, 338 B.R. at 634; In re Clemens,
261 B.R. 602, 606 (Bankr. M.D. Pa. 2001). The effect of this narrow
108 Piedmont Print Works v. Receivers of People’s State Bank, 68 F.2d 110 (4th
Cir. 1934), and Bromfield v. Trinidad Nat. Inv. Co., 36 F.2d 646 (10 th Cir. 1929).
76

construction is that ‘each party must own his claim in his own right
severally, with the right to collect in his own name against the
debtor in his own right and severally.’ Garden Ridge, 338 B.R. at
633-34 (quoting Braniff Airways, Inc., 814 F.2d at 1036).”
“Construing the generally accepted definition of mutuality
narrowly, as it is obliged to do, the Court concludes that mutuality
cannot be supplied by a multi-party agreement contemplating a
triangular setoff. Unlike a guarantee of debt, where the guarantor is
liable for making a payment on the debt it has guaranteed payment
of, an agreement to setoff funds does not create an indebtedness
from one party to another. 109 An agreement to setoff funds, such as
the one claimed by Chevron in this case, does not give rise to a
debt that is ‘due to’ Chevron and ‘due from’ SemCrude. A party
such as SemCrude does not have to actually pay anything to a
creditor such as Chevron under a tripartite setoff agreement; rather,
it only sees one of its receivables reduced in size or eliminated.
SemCrude does not owe anything to Chevron, thus there are no
debts in this dispute owed between the ‘same persons in the same
capacity.’”
“Likewise, Chevron does not have a “right to collect” against
SemCrude under the agreement in this case. At most, the
agreement of the parties would give Chevron a “right to offset” – a
right to pay less than it would otherwise have to pay to the extent of
the setoff. The agreement does not call for SemCrude to make a
payment to Chevron, however. Consequently, the agreement does
not call for Chevron to ‘collect’ anything from SemCrude. Chevron
is thus without a “right to collect” from SemCrude. At bottom,
Chevron may enjoy privity of contract with each of the relevant
Debtors, but it lacks the mutuality required by the plain language of
section 553.”
399 B.R. at 396-397.
Ultimately, the SemGroup court determines that Chevron can not have
mutual debts between it and SemCrude because Chevron does not even have a
claim against SemCrude:
109 “This is not to say that setoff would necessarily be appropriate against
SemCrude if it were a guarantor of SemStream or SemFuel’s debt, however. The
Court notes that a split of authority exists regarding the issue of whether an
unpaid guarantee can create mutuality for purposes of section 553. Compare
Ingersoll, 90 B.R. at 172, with Bloor, 32 B.R. at 1001- 02. The Court does not
reach this issue in this case because the only guarantor in this matter is
SemGroup, an entity that is not owed a debt by Chevron.” 399 B.R. at 397n.7.
77

“…Regardless of whatever contractual right to setoff these debts
against each other it might have under state law, the fact remains
that Chevron only owes a debt to one debtor, SemCrude, and
SemCrude owes nothing to Chevron. Chevron does not even have
a ‘claim’ against SemCrude because to have a claim it must have a
‘right to payment’ from SemCrude. See 11 U.S.C. § 101(5). 110 As
noted above, a right to effect a setoff can never impose a ‘right to
payment,’ it only can yield a right to pay less than one would
otherwise have to pay. Therefore, the setoff advocated by Chevron
falls outside the express terms of section 553, and is
impermissible.”
399 R. at 397-398.
v. Analysis
Significantly, while SemCrude ruled with a broad brush, it did not and
could not rule that parties are not allowed to convert non-mutual debts into
mutual debts. For instance, if A owes B, and a subsidiary of B owes A, there is
no law barring B from assuming or becoming jointly and severally liable for the
debt its subsidiary owes A, thereby creating mutual debts between A and B.
Such a debt assumption would only be voidable if B's incurrence of the debt
would be a fraudulent transfer. SemCrude did hold, however, that triangular
setoff agreements will not convert non-mutual debts into mutual debts. 111
SemCrude raises, but leaves unanswered whether B's guaranty of its
subsidiary's debt will transform the non-mutual debts into mutual debts. 112
Chevron's second argument raised the pivotal question, namely whether a
private agreement requiring triangular setoffs can transform non-mutual debts
into mutual debts. SemCrude says no. The crux of SemCrude's reasoning is
that granting A the right to reduce the amount A owes B, by the amount C owes
110 “Section 101(5) of the Code defines a ‘claim’ as a ‘right to payment, whether or
not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent,
matured, unmatured, disputed, undisputed, legal, equitable, secured, or
unsecured’ or a ‘right to an equitable remedy for breach of performance if such
breach gives rise to a right to payment, whether or not such right to an equitable
remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed,
undisputed, secured, or unsecured.’ Although Chevron may be able to assert a
state law right to the equitable remedy of setoff, this right is not based on a
breach of performance that gives rise to a ‘right to payment,’ as noted above. A
setoff agreement such as the one in this case only creates a right to pay less or
nothing, not a right to receive a payment.” 399 B.R. at 398n.8.
111 “Accordingly, the Court holds that non-mutual debts cannot be transformed into a “mutual debt”
under section 553 simply because a multi-party agreement allows for setoff of non-mutual debts
between the parties to the agreement.” 399 B.R. at 398.
112 399 B.R. at 397n.7.
78

A, does not grant A the right to collect money from B. From the absence of A's
right to payment from B, SemCrude concludes A has no claim against B, and A
can not have a debt from B that is mutual with A's debt to B. 113 This logic may
seem valid from the Bankruptcy Code's definition of claim in section 101(5) as a
"right to payment," and its definition of a debt in section 101(12) as a liability on a
claim. But, it is not valid for two reasons. The first reason is that Bankruptcy
Code section 102(2) eliminates the need for a right to payment. The second
reason is that section 101(5)(A) was misapplied.
SemCrudes logic is as follows:
“…Regardless of whatever contractual right to setoff these debts
against each other it might have under state law, the fact remains
that Chevron only owes a debt to one debtor, SemCrude, and
SemCrude owes nothing to Chevron. Chevron does not even have
a ‘claim’ against SemCrude because to have a claim it must have a
‘right to payment’ from SemCrude. See 11 U.S.C. § 101(5). 114 As
noted above, a right to effect a setoff can never impose a ‘right to
payment,’ it only can yield a right to pay less than one would
otherwise have to pay. Therefore, the setoff advocated by Chevron
falls outside the express terms of section 553, and is
impermissible.” 115
Chevron Held a Claim against SemCrude
Bankruptcy Code section 553(a) safeguards the offset of a mutual debt
owing by a creditor to the debtor against "a claim of such creditor against the
debtor…" Section 102(2) provides: "'claim against the debtor' includes claim
against property of the debtor."
Simply put, the triangular setoff agreement grants Chevron a claim against
property of the debtor, namely SemCrude's receivable from Chevron. Therefore,
pursuant to the plain language of the Bankruptcy Code section 102(2), the
triangular setoff agreement grants Chevron a claim against the debtor
(SemCrude) because it grants Chevron a claim against property of the debtor.
Accordingly, SemCrude's conclusion that Chevron has no claim against
113 399 B.R. at 396-398.
114 “Section 101(5) of the Code defines a ‘claim’ as a ‘right to payment, whether or not such right
is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed,
undisputed, legal, equitable, secured, or unsecured’ or a ‘right to an equitable remedy for breach
of performance if such breach gives rise to a right to payment, whether or not such right to an
equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed,
undisputed, secured, or unsecured.’ Although Chevron may be able to assert a state law right to
the equitable remedy of setoff, this right is not based on a breach of performance that gives rise
to a ‘right to payment,’ as noted above. A setoff agreement such as the one in this case only
creates a right to pay less or nothing, not a right to receive a payment.” 399 B.R. at 398n.8.
115 S399 B.R. at 397-398.
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SemCrude is unequivocally wrong. The SemCrude court may not have
considered and discussed section 102(2) because it does not appear Chevron
made this contention.
Bankruptcy Code section 102(2) is normally associated with nonrecourse
claims against the debtor's property. 116 Significantly, Congress could have
provided that a secured claim against the debtor includes a claim against
property, as opposed to a claim against the debtor includes a claim against
property. It did not do so. Additionally, Congress provided in Bankruptcy Code
section 506(a)(1) that an allowed claim subject to setoff will be a secured claim to
the extent of such setoff amount and an unsecured claim for the balance, if any.
Therefore, it appears Congress intentionally wrote section 102(2) broadly to
incorporate secured and unsecured claims against property of the debtor to
capture setoff claims. In any event, “[w]hen ‘the statute’s language is plain,*the
sole function of the courts*’ – at least where the disposition required by the text is
not absurd -- *’is to enforce it according to its terms.*’” 117
That a right to payment is not a required element of a claim is
independently corroborated by section 1111(b)(1)(A) of the Bankruptcy Code.
There, the Bankruptcy Code refers to an entity holding a nonrecourse lien
against property of the estate as holding a claim. 118
116 The legislative history of 11 U.S.C. § 102(2) provides:
"Paragraph (2) specifies that 'claim against the debtor' includes claim
against property of the debtor. This paragraph is intended to cover nonrecourse
loan agreements where the creditor's only rights are against property of the
debtor, and not against the debtor personally. Thus, such an agreement would
give rise to a claim that would be treated as a claim against the debtor
personally, for the purposes of the bankruptcy code. However, it would not
entitle the holders of the claim to distribution other than from the property in
which the holder had an interest."
Senate Report No. 95-989, 95 th Cong., 2d Sess. (1978) at 315. After the Senate Report was
issued and during the House-Senate conference to reconcile their respective bankruptcy bills, 11
U.S.C. § 1111(b)(1)(A) was added, see 124 Congressional Record H 11089 (September
28,1978)(statement of Congressman Don Edwards), which actually does entitle holders of
nonrecourse claims to distributions from property in which they do not have an interest in some
circumstances. See footnote 71 below.
117 Hartford Underwriters Insurance Co. v. Union Planters Bank, 530 U.S. 1, 6 (2000)(quoting
United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241(1989), quoting Caminetti v. United
States, 242 U.S. 470, 485 (1917)).
118 11 U.S.C. § 1111(b)(1)(A) provides:
A claim secured by a lien on property of the estate shall be allowed or disallowed
under section 502 of this title the same as if the holder of such claim had
recourse against the debtor on account of such claim, whether or not such holder
has such recourse, unless—
(i) the class of which such claim is a part elects, by at least two-thirds in amount
and more than half in number of allowed claims of such class, application of
paragraph (2) of this subsection; or
80

Next, Bankruptcy Code section 101(12) provides that "debt" means
"liability on a claim." Given that Chevron holds a claim against SemCrude's
account receivable, and thus, SemCrude pursuant to section 102(2), Chevron
also holds a debt from SemCrude which is SemCrude's liability on Chevron's
claim. SemCrude's liabilities under the triangular setoff agreement include its
obligation to reduce its account receivable from Chevron to the extent of
Chevron's accounts receivable from SemFuel and SemStream. Conversely,
Chevron's liabilities to SemCrude are to reduce its account receivable from
SemCrude by the amounts of SemCrude's accounts receivable from Chevron's
affiliates.
Although section 102(2) shows a right to payment is an unnecessary
component of a claim (and a debt) if the creditor has a claim against the debtor’s
property, Chevron also has a right to payment that SemCrude overlooked. The
second reason SemCrude erroneously determined Chevron did not hold a claim
against SemCrude is that SemCrude misapplied Bankruptcy Code section
101(5). SemCrude tested whether Chevron had a right to payment from
SemCrude by looking to see whether the triangular setoff contract expressly
granted Chevron a right to payment. SemCrude reasoned that “a right to effect a
setoff can never impose a ‘right to payment,’ it only can yield a right to pay less
than one would otherwise have to pay.” 119
But, to determine whether a contractual right is a claim, section 101(5)
makes clear you must look at the remedy for breach, not just whether the
contract requires the debtor to pay money. In pertinent part, section 101(5)
provides a claim is a “right to payment, whether or not such right is reduced to
judgment…,” or a “right to an equitable remedy for breach of performance if such
breach gives rise to a right to payment…” The Bankruptcy Code's references to
“reduced to judgment” and “remedy for breach” make clear that the inquiry goes
to what type of judgment the nonbreaching contract party can procure if the
debtor breaches the contract. Here, if SemCrude were to breach the triangular
setoff agreement and require that Chevron pay SemCrude without setting off,
there is no question Chevron could obtain a money judgment for the amount it
was wrongfully required to pay. Conceptually, it is also clear that the remedy for
the breach of a financial contract such as a triangular setoff agreement would be
money damages.
That the court must look to the remedy for breach and not to whether the
contract requires the debtor to pay money under the express terms of the
contract, is critical. For instance, if A has a contract with B under which A agrees
not to compete with B in a certain geographical area, and A commences a
(ii) such holder does not have such recourse and such property is sold under
section 363 of this title or is to be sold under the plan.
119 399 B.R. at 398.
81

chapter 11 case and rejects the contract, SemCrude would preclude B from filing
an allowable damage claim against A because B has no right to payment from A
under the contract, notwithstanding that under state law B would certainly be
entitled to a money judgment for damages.
Similarly, if A has a contract to sell widgets to B for $1 per widget, and A
commences a chapter 11 case and rejects the contract because widgets are
selling for $3 per widget, SemCrude’s holding would bar B from filing an
allowable claim against A for damages because under the contract B does not
have a right to payment from A. B only has a right to widgets from A. Indeed,
Bankruptcy Code section 502(b) provides that except to the extent a claim is not
allowable, the court “shall determine the amount of such claim in lawful currency
of the United States as of the date of the filing of the petition, and shall allow the
claim in such amount…” It would be unnecessary for the statute to require the
allowance of claims in U.S. dollars if the failure of a contract to require payment
of U.S. dollars would render unallowable any claim under it.
Manifestly, the right to payment is determined on breach. Otherwise, the
entire policy underlying the Bankruptcy Code to provide debtors fresh starts
would be frustrated because multiple contracts would not give rise to claims. If
contracts requiring performance not involving the payment of money do not
create claims, those contract rights will not be dischargeable because
Bankruptcy Code sections 727(b), 1141(d)(1)(A), 1228(a), and 1328(a) only
discharge claims. Thus, the consequences of SemCrude’s reasoning undermine
the key purpose of the definition of "claim" in the Bankruptcy Code to permit "the
broadest possible relief in the bankruptcy court." 120 It is beyond doubt that these
consequences were unintended by the SemCrude court. The consequences
leave no doubt that SemCrude's test for determining whether a claim exists is
erroneous.
Based on the foregoing analysis of Bankruptcy Code sections 101(5),
101(12), and 102(2), the triangular setoff agreement grants Chevron a prepetition
claim and debt against SemCrude recognized by the Bankruptcy Code because:
(a) the triangular setoff agreement grants Chevron a claim against
SemCrude's property which is its account receivable from Chevron,
(b) section 102(2) renders Chevron's claim against SemCrude's property a
claim against SemCrude, and Chevron's contract rights independently provide
Chevron a claim against SemCrude because Chevron would be entitled to a
money judgment on breach of the setoff agreement, and
(c) section 101(12) defines SemCrude's liability on Chevron's claim as a
debt.
Chevron and SemCrude had Mutual Debts
120 Senate Report No. 95-989, 95 th Cong., 2d Sess. (1978) at 309.
82

A given fact in the decision is that SemCrude has a prepetition claim and
debt against Chevron. 121 Therefore, the remaining requirement for purposes of
setoff under Bankruptcy Code section 553(a) is whether Chevron and
SemCrude's respective debts are mutual debts.
SemCrude concluded mutual debts can not be created by a triangular
setoff agreement based on its reasoning that Chevron lacked any rights to
payment, claims, and debts against SemCrude. At the outset of its analysis of
the mutual debt question, however, SemCrude recited the accepted formula
defining mutual debts for setoff purposes, as follows:
"…The overwhelming majority of courts to consider the issue have
held that debts are mutual only if 'they are due to and from the
same persons in the same capacity.' See, e.g., Westinghouse, 278
F.3d at 149; Garden Ridge, 338 B.R. at 633; Westchester, 181 B.R.
at 740. It is also widely accepted that 'mutuality is strictly construed
against the party seeking setoff.' In re Bennett Funding Group, Inc.,
212 B.R. 206, 212 (2d Cir. BAP 1997). See also Garden Ridge, 338
B.R. at 634; In re Clemens, 261 B.R. 602, 606 (Bankr. M.D. Pa.
2001). The effect of this narrow construction is that 'each party
must own his claim in his own right severally, with the right to
collect in his own name against the debtor in his own right and
severally.' Garden Ridge, 338 B.R. at 633-34 (quoting Braniff
Airways, Inc., 814 F.2d at 1036)." 122
The first test is whether Chevron and SemCrude have debts "due to and
from the same persons in the same capacity." 123 Here, a given fact is that
SemCrude holds a claim against and debt from Chevron of approximately $1.4
million. 124 Based on the analysis above, pursuant to the triangular setoff
agreement, Chevron holds a claim against and debt from SemCrude. In each
instance, SemCrude and Chevron hold their respective debts in their corporate
capacities, and not as an agent, trustee, or other capacity. Thus, the first test is
satisfied.
The second test is that "each party must own his claim in his own right
severally, with the right to collect in his own name against the debtor in his own
right and severally." In re Garden Ridge Corp., 338 B.R. 627, 633-634 (Bankr. D.
Del. 2006). Here, there is no dispute that SemCrude owned its claim with the
right to collect in its name against Chevron. Based on the triangular setoff
agreement, Chevron owns a prepetition claim against SemCrude. Indeed, it was
entered into precisely to enable Chevron to collect from SemCrude by reducing
Chevron's account payable to SemCrude. If SemCrude were to breach and
121 399 B.R. at 392.
122 S399 B.R. at 396.
123 Washington Credit Corp., v. D'Urso, 278 F.3d 138, 149 (2d Cir. 2002).
124 399 B.R. at 392.
83

disallow setoff, Chevron has a valid state law claim entitling it to collect money
damages from SemCrude. In each instance, Chevron and SemCrude hold the
claims in the same capacities and can collect against each other severally.
Accordingly, the second test for mutual debts is also passed.
Another way to determine whether Chevron and SemCrude owe each
other mutual debts is to look at the substance of the triangular setoff transaction.
Assume that after Chevron trades with SemCrude and SemStream for one day,
Chevron owes SemCrude $1.4 million and SemFuel owes Chevron $10.2 million.
Further assume the three parties have entered into a master agreement
providing that on each payment or settlement date, SemCrude must assume joint
and several liability for SemFuel's debt in the amount, if any, that Chevron would
otherwise have to pay SemCrude on that date. Once SemCrude assumes joint
and several liability for a SemFuel debt to Chevron, there can be no question that
SemCrude and Chevron owe each other mutual debts for purposes of
Bankruptcy Code section 553(a). While this would enable Chevron to sue
SemCrude severally to collect the amount of debt SemCrude assumed, Chevron
would not have to go to the trouble of doing so because, in or out of bankruptcy,
it would be able to set off its debt to SemCrude against the SemCrude debt to
Chevron that SemCrude assumed from SemFuel.
Rather than going to the trouble of having SemCrude assume SemFuel's
debt to Chevron on each payment date, the triangular setoff agreement
eliminates the formal assumption step by authorizing the setoff which grants
Chevron the right to collect from SemCrude by setting off, or suing severally for
the money if SemCrude breaches and does not allow a setoff. 125 Thus, the
master agreement and the triangular setoff agreement put the parties in the exact
same place. Substantively they are equivalent.
Therefore, whatever test is used, Chevron and SemCrude have mutual
debts for purposes of Bankruptcy Code section 553(a). Here, the terms of the
triangular setoff agreement expressly grant the right of setoff only upon the
failure of a counterparty to timely pay what it owes. That does not appear to
125 See, e.g., In re Lang Machinery Corporation (Equibank v. Lang Machinery Co.), 1988 WL
110429 (Bankr.W.D.Pa.1988)(“For a valid ‘ triangular’ setoff to exist, Debtor must have formally
agreed to permit” aggregation of debts by two creditors), cited with approval in U.S. Bank v.
Custom Coals Laurel (In re Custom Coals Laurel), 258 B.R. 597, 607 (Bankr. W.D. Pa. 2001); In
re Virginia Block Co., 16 B.R. 560, 562 (Bankr. W.D. Va. 1981) (citing Inland Steel Co. v. Berger
Steel Co., Inc., 327 F.2d 401, 403-04 (7th Cir. 1964)) ("The Berger court found that a setoff
arrangement accommodating a parent corporation and its subsidiary would be allowable only in
those unique situations in which the parties to the transaction had, at the outset of their
relationship, entered into a separate agreement clearly establishing the intention of the parties to
treat the parent and subsidiary as one entity. Given this strict construction, it is clear in this
proceeding that the debts are not mutual debts within the meaning of s 553."); In re Balducci Oil
Co., Inc., 33 B.R. 847, 853 (Bankr. D. Colo. 1983) (mutuality found between three parties, as a
matter of contract law, where there was an express contractual agreement clearly evincing the
intent of the parties to treat the parent and subsidiary as one entity).
84

impact any of the mutual debt tests, and SemCrude does not rely on it to
conclude the debts are not mutual.
Public Policy
SemCrude attempts to corroborate its conclusions that Chevron and
SemCrude do not hold mutual debts, and setoff is unauthorized, by looking to
policy:
"One of the primary goals – if not the primary goal – of the Code is
to ensure that similarly-situated creditors are treated fairly and
enjoy an equality of distribution from a debtor absent a compelling
reason to depart from this principle. By allowing parties to contract
around the mutuality requirement of section 553, one creditor or a
handful of creditors could unfairly obtain payment from a debtor at
the expense of the debtor’s other creditors, thereby upsetting the
priority scheme of the Code and reducing the amount available for
distribution to all creditors." 126
SemCrude's policy argument is circular. The policy that similarly situated
creditors should be treated alike, does not help determine whether creditors
having triangular setoff agreements are similarly situated to creditors not having
them. It certainly appears, they are not similarly situated. More importantly,
SemCrude distorts the policy that similarly situated creditors should be treated
alike, into a destructive policy that courts should strive to treat creditors as if they
are similarly situated. There is no virtue or benefit in the latter. As Judge
Friendly bluntly explained: “Equality among creditors who have lawfully
bargained for different treatment is not equity but its opposite.” 127
Notably, the Bankruptcy Code freely allows debtors and creditors to
contract for special treatment. The statute expressly acknowledges that creditors
can bargain to be secured, and the statute treats secured claims better than
unsecured claims. This is critical because often a debtor can not raise money
without granting collateral security. Similarly, debtors and creditors are allowed
to transact business with one another in a fashion that allows for setoff and
recoupment. In commodity trading, logic and common sense tell us that Chevron
would be willing to do more trading with SemGroup if each of the SemGroup
entities took responsibility for each other's debts by allowing Chevron to set off
against one entity amounts that were originally owed by another. SemCrude
retards public policy by hampering commerce and chilling Chevron's willingness
to trade with SemGroup entities absent the credit enhancement provided by
triangular setoff.
126 399 B.R. at 399 (footnote omitted).
127 Chem. Bank N.Y. Trust Co. v. Kheel (In re Seatrade Corp.), 369 F.2d 845, 848 (2d Cir. 1966).
85

Allowance and Avoidance of Setoff Rights
Once a setoff right is established, however, the question remains whether
it is disallowable or avoidable. There appear to be four areas of inquiry.
First, the setoff right must pass muster under state law, except as modified
or preempted by the Bankruptcy Code. Bankruptcy Code section 502(b)(1)
provides a claim shall be allowed except to the extent that:
“such claim is unenforceable against the debtor and property of the
debtor, under any agreement or applicable law for a reason other
than because such claim is contingent or unmatured…”
Pursuant to some states' laws, mutual debts may be set off when
liquidated and calculable, even if not matured. 128 Here, the triangular setoff
agreement provided Chevron could set off when and if an affiliate of SemCrude
did not timely pay monies due and owing. Thus, while perhaps unnecessary
given the wording of 11 U.S.C. § 502(b)(1), the monies Chevron was owed were
both uncontingent and matured. Likewise, the amount was liquidated and does
not even appear to have been in dispute. Whether Chevron’s setoff claim is
conceptualized as its claim against SemCrude’s receivable as interpreted by
Bankruptcy Code section 102(2), or as its claim for damages for breach by
SemCrude of its triangular setoff agreement under Bankruptcy Code section
101(5), the amount of the claim appears fully liquidated.
Second, is Chevron’s setoff right disallowed by 11 U.S.C. § 553(a)(3)? 129
To be disallowable under section 553(a)(3), Chevron’s claim against SemCrude
would have had to have been outside the Bankruptcy Code's safe harbors
(discussed below) and incurred by Chevron within 90 days before SemCrude’s
bankruptcy, while SemCrude was insolvent, and for the purpose of obtaining a
right of setoff against SemCrude (except for certain setoffs within the Bankruptcy
Code’s safe harbors for derivative transactions). For argument’s sake, let us
assume Chevron’s claim was incurred within 90 days prior to SemCrude’s
chapter 11 petition and that SemCrude was insolvent. The question becomes
whether it was incurred to obtain a right of setoff. This is a question of intent.
The decision does not tell us whether Chevron incurred its claim before or after
its affiliates incurred their respective claims. The existence of the triangular
setoff agreement shows both Chevron and SemCrude wanted their respective
net exposures to equal the net amount that would be owing if neither of them had
128 The triangular setoff agreement is governed by Texas law. Texas law recognizes the right of
setoff so long as such amounts are liquidated and calculable. See e.g., Alley v. Bessemer Gas
Engine Co., 228 S.W. 963, 966 (Tex. Civ. App. Amarillo 1991), writ dismissed (June 15, 1921);
Commercial State Bank v. Van Hutton, 208 S.W. 363 (Tex. Civ. App. San Antonio 1919); see also
In re Williams, 61 B.R. 567, (Bankr. N.D. Tex. 1986) (Under Texas law, debtor's bank that issued
a promissory demand note had a valid right of offset on date petition was filed, even though the
note had not matured by its terms.)
129 See footnote 7, supra.
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any affiliates. Thus, it is not possible from the SemCrude decision to determine
the intent issue. The jurisprudence, of necessity, is case specific, but logically
shows, for instance, that an assignment of a judgment claim between affiliates for
no apparent reason other than to create a right of setoff, implies an intent to incur
a right of setoff. 130
Conversely, SemCrude did, in fact, incur SemFuel or SemStream’s debt to
Chevron for the purpose of providing Chevron a right of setoff. This was required
by the triangular setoff agreement. This would not satisfy the literal terms of
section 553(a)(3), which requires the nondebtor to incur the debt. Even if the
statute were read to encompass the debtor’s incurrence of a debt to allow the
creditor a right of setoff, there is still a question as to timing. SemCrude’s
incurrence of the debt was pursuant to the triangular setoff agreement
presumably entered into when the two parties started trading. Thus, even if
SemFuel and/or SemStream’s trades occurred within 90 days before
SemCrude’s bankruptcy, incurrence of their debts to Chevron may be traced
back to when SemCrude entered into the triangular setoff agreement. Whether
to place the incurrence of debt on the triangular setoff agreement date, the trade
date, or the settlement date is not yet addressed in the jurisprudence, but, as
seen below, is immaterial for trades falling within the safe harbors for derivatives
and expressly insulated from the operation of this avoidance power by
Bankruptcy Code sections 546 and 553.
To address this uncertainty, however, it appears trading parties desiring to
enforce triangular setoff should enter into mutual guaranties of their respective
affiliates’ debts at the outset of the trading relationship, which guaranties should
expressly provide for each affiliate to assume its affiliate's debt for purposes of
allowing setoffs on settlement dates. Here, that would have rendered SemCrude
liable in the first place for SemStream and SemFuel’s debts to Chevron so that
Chevron would have had a setoff right without the triangular setoff agreement
and section 553(a)(3) would be inapplicable. 131 The guaranties could provide that
130
Equibank v. Lang Machinery Co. (In re Lang Machinery Corp.), 1988 WL110429*3 (Bankr.
W.D. Pa. 1988).
131
In In re Ingersoll, 90 B.R. 168, 171 (Bankr. W.D. N.C. 1987), a corporation (Rosdon) owed a
husband and wife over $440,000, which debt was guaranteed by Rosdon's owner. The note
provided Rosdon could set off against its note, any amounts the husband or wife owed Rosdon.
Subsequently, the husband and wife became indebted to Rosdon's owner for $22,000, and the
husband orally advised the owner he could offset the $22,000 against Rosdon's note if the
$22,000 were not paid. When the wife commenced a chapter 13 case, the owner requested
leave to set off the $22,000 against the $440,000. The court denied the owner's request, ruling
"[a]ny comments [husband] may have made regarding [owner's] right to set off Rosdon's debt do
not constitute a contractual right for offset. Those statements lack the formality of a binding
contract and amount at most to a statement of opinion...." Id. In respect of the owner's
contention that his guaranty of Rosdon's note rendered the two debts mutual, the court ruled:
"While that may be the effect of his guaranty, it does not change the fact that the debts are
between different parties in different capacities, and, thus, not subject to offset. Id. The latter
ruling may be justified on the facts because there was no cross default and therefore the $22,000
debt was matured due to bankruptcy, while the $440,000 was unmatured. "An unmatured claim
may not be offset against a matured claim unless the indemnitor is insolvent. Collum v.
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they should be enforced only to the extent of available setoffs on settlement
dates, if the parties want to replicate the effects of a triangular setoff agreement.
Of course, the uncertainty may also be addressed by having the affiliates
assume joint and several liability for each other's trades, but that could create
liability beyond the setoffs contemplated by triangular setoff agreements, unless
the affiliates assume joint and several liability only up to the amount available for
setoff which is substantively what happens under triangular setoff agreements.
Third, if the right of setoff is not otherwise allowable under section 553, is
it nevertheless rendered allowable by one of the safe harbors in the Bankruptcy
Code or in that section? Chevron is not reported to have asserted its setoff right
is enforceable due to a safe harbor, but it may well have that protection. For
example, if the contracts were qualifying 132 forward contracts, the triangular setoff
agreement, which provides credit enhancement, would come within the portion of
the definition of forward contracts in Bankruptcy Code section 101(25)(E), 133
which includes any “other credit enhancement related to” qualifying forward
contracts. Chevron could then invoke the safe harbor in Bankruptcy Code
section 556, 134 which safeguards Chevron’s ability to liquidate, terminate, or
Commercial Credit Co., 134 S.W.2d 826, 827 (Tex.Civ.App.-Amarillo 1939, writ dism'd w.o.j.)." In
re The Charter Co., 63 B.R. 568, 571 (Bankr. M.D. Fla. 1986). Otherwise, Ingersoll is contrary to
Bloor v. Shapiro, 32 B.R. 993, 1002 (S.D.N.Y. 1983)(Bankruptcy Act Chapter X case), where the
court ruled: "If the guarantee agreements entitled the [guarantors] to assert the [primary obligors']
claims, which were closely related to the guarantees, then the trustee's liability under such claims
would be debts owed to the [guarantors], to the extent of the [guarantors'] liability under the
guarantees. Such claims could thus be asserted by the [guarantors] as set-offs…." Accordingly,
as belt and suspenders, trading parties will better position themselves to avoid attacks on
triangular setoffs if they utilize guarantees containing express triangular setoff language. The
master agreements and termination provisions should assure the parties will be setting off
matured debts against matured debts.
132 References to “qualifying” contracts in this article are to contracts (a) held by one of the entities
listed in Bankruptcy Code sections 555, 556, 559, 560, or 561, and (b) constituting one of the
types of contracts whose liquidation, termination, and enforcement are protected by such sections
when held by one of such entities.
133 11 U.S.C. § 101(25)(E) provides:
The term “forward contract” means—
(E) any security agreement or arrangement, or other credit enhancement related
to any agreement or transaction referred to in subparagraph (A), (B), (C), or (D),
including any guarantee or reimbursement obligation by or to a forward contract
merchant or financial participant in connection with any agreement or transaction
referred to in any such subparagraph, but not to exceed the damages in
connection with any such agreement or transaction, measured in accordance
with section 562.
134 11 U.S.C. § 556 provides:
The contractual right of a commodity broker, financial participant, or forward
contract merchant to cause the liquidation, termination, or acceleration of a
commodity contract, as defined in section 761 of this title, or forward contract
because of a condition of the kind specified in section 365 (e)(1) of this title, and
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accelerate qualifying forward contracts by providing they “ shall not be stayed,
avoided, or otherwise limited by operation of any provision of this title or by the
order of a court in any proceeding under this title.” Notably, given that section
556 overrides any provision of title 11, even provisions of section 553 must give
way to their enforceability under section 556. This is partially recognized in
section 553(a)(2) and (3) by those subsections’ express carveouts of safe
harbors including section 556. Significantly, however, section 556 and the other
similar safe harbors in the Bankruptcy Code provide the contractual rights to
liquidate, terminate, or accelerate a qualifying contract, which includes credit
enhancements, shall not be limited by operation of any provision of title 11. In
addition, “contractual right” is broadly defined to include a right, whether or not
evidenced in writing, arising under common law, under law merchant or by
reason of normal business practice, suggesting that even dealings in the ordinary
course of the derivatives business gives rise to contractual rights. Therefore, it
appears the plain language of the safe harbor provisions bars the limitation of
setoffs of debts whether mutual or not, if effective under state law.
The same analysis applies to any qualifying commodity contract because
its definition also includes credit enhancements related to them. 135 Similarly,
securities contracts are defined to include credit enhancements, 136 and are
protected by the safe harbor in Bankruptcy Code section 555. The same
analysis applies to qualifying repurchase agreements, swap agreements, and
master netting agreements. 137
In addition to safeguarding contractual rights to liquidate, terminate, and
accelerate qualifying derivative contracts and their credit enhancements, the
Bankruptcy Code also insulates the holders of those contracts from most
avoidance powers such as preferences and fraudulent transfers, other than
fraudulent transfers with actual intent to hinder, delay, or defraud creditors. 138
the right to a variation or maintenance margin payment received from a trustee
with respect to open commodity contracts or forward contracts, shall not be
stayed, avoided, or otherwise limited by operation of any provision of this title or
by the order of a court in any proceeding under this title. As used in this section,
the term “contractual right” includes a right set forth in a rule or bylaw of a
derivatives clearing organization (as defined in the Commodity Exchange Act), a
multilateral clearing organization (as defined in the Federal Deposit Insurance
Corporation Improvement Act of 1991), a national securities exchange, a national
securities association, a securities clearing agency, a contract market designated
under the Commodity Exchange Act, a derivatives transaction execution facility
registered under the Commodity Exchange Act, or a board of trade (as defined in
the Commodity Exchange Act) or in a resolution of the governing board thereof
and a right, whether or not evidenced in writing, arising under common law,
under law merchant or by reason of normal business practice.
135 11 U.S.C. § 761(4)(J).
136 11 U.S.C. § 741(7)(A)(ix).
137 11 U.S.C. §§ 101(38A)(A)(master netting agreement), 101(47)(A)(v)(repurchase agreement),
101(53B)(A)(vi)(swap agreement), 559, 560, 561.
138 11 U.S.C. §§ 546(e-g) provide:
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Thus, the liquidation of qualifying derivative contracts and the exercise of the
triangular setoff should not be voidable as a preference or constructively
fraudulent transfer (a fraudulent transfer not based on actual intent to hinder,
delay, or defraud creditors).
The entering into of the triangular setoff agreement, however, is not within
the safe harbor which only protects transfers under qualifying derivative
contracts. Therefore, the entering into of the triangular setoff agreement may be
avoided as a constructively fraudulent transfer if, for instance, it is entered into
after the derivative trading has begun and its effect is to cause a debtor to
assume affiliate debt without any corresponding, reasonably equivalent benefit to
the debtor and while the debtor is insolvent or rendered insolvent. If the
agreement itself is avoided, transactions under it may be avoided.
The Bankruptcy Code also excludes from the operation of the automatic
stay, setoffs of mutual debts under or in connection with qualifying commodity
contracts, forward contracts, securities contracts, repurchase agreements, swap
agreements, and master netting agreements. 139
Fourth, if Chevron’s right of setoff against SemCrude’s account receivable
from Chevron is conceptualized as Chevron having a security interest in that
account receivable, then should the security interest be avoided pursuant to
Bankruptcy Code section 544(a)(1) 140 and preserved for the benefit of the
(e) Notwithstanding sections 544, 545, 547, 548 (a)(1)(B), and 548 (b) of this title,
the trustee may not avoid a transfer that is a margin payment, as defined in
section 101, 741, or 761 of this title, or settlement payment, as defined in section
101 or 741 of this title, made by or to (or for the benefit of) a commodity broker,
forward contract merchant, stockbroker, financial institution, financial participant,
or securities clearing agency, or that is a transfer made by or to (or for the benefit
of) a commodity broker, forward contract merchant, stockbroker, financial
institution, financial participant, or securities clearing agency, in connection with a
securities contract, as defined in section 741 (7), commodity contract, as defined
in section 761 (4), or forward contract, that is made before the commencement of
the case, except under section 548 (a)(1)(A) of this title.
(f) Notwithstanding sections 544, 545, 547, 548 (a)(1)(B), and 548 (b) of this title,
the trustee may not avoid a transfer made by or to (or for the benefit of) a repo
participant or financial participant, in connection with a repurchase agreement
and that is made before the commencement of the case, except under section
548 (a)(1)(A) of this title.
(g) Notwithstanding sections 544, 545, 547, 548 (a)(1)(B) and 548 (b) of this title,
the trustee may not avoid a transfer, made by or to (or for the benefit of) a swap
participant or financial participant, under or in connection with any swap
agreement and that is made before the commencement of the case, except
under section 548 (a)(1)(A) of this title.
139 11 U.S.C. §§ 362(b)(6), 362(b)(7), 363(b)(17), and 362(b)(27).
140 11 U.S.C. § 544(a)(1) provides:
90

debtor’s estate pursuant to Bankruptcy Code section 551, 141 thereby stripping
Chevron of its right to set off? If Chevron’s setoff right were an unperfected
security interest and unprotected by a safe harbor, it would be subject to
avoidance by the trustee or debtor in possession’s hypothetical status as a
judicial lien creditor. If the triangular setoff agreement, however, is a qualified
derivative contract for which a safe harbor exists, the safe harbor would insulate
Chevron from attacks by a trustee or debtor in possession pursuant to
Bankruptcy Code section 544. 142 The safe harbor would not, however, insulate
Chevron from an attack by an entity holding a perfected security interest in
SemCrude’s account receivable from Chevron because the Uniform Commercial
Code’s priority scheme gives the perfected security interest priority over the
unperfected security interest. 143
“(a) The trustee shall have, as of the commencement of the case, and without
regard to any knowledge of the trustee or of any creditor, the rights and powers
of, or may avoid any transfer of property of the debtor or any obligation incurred
by the debtor that is voidable by—
(1) a creditor that extends credit to the debtor at the time of the commencement
of the case, and that obtains, at such time and with respect to such credit, a
judicial lien on all property on which a creditor on a simple contract could have
obtained such a judicial lien, whether or not such a creditor exists…”
141 11 U.S.C. § 551 provides:
Any transfer avoided under section 522, 544, 545, 547, 548, 549, or 724 (a) of
this title, or any lien void under section 506 (d) of this title, is preserved for the
benefit of the estate but only with respect to property of the estate.
142 See 11 U.S.C. § 546(e-g) at footnote 32, supra.
143 U.C.C. § 9-322(a) provides:
(a) [General priority rules.]
Except as otherwise provided in this section, priority among conflicting security
interests and agricultural liens in the same collateral is determined according to
the following rules:
(1) Conflicting perfected security interests and agricultural liens rank according to
priority in time of filing or perfection. Priority dates from the earlier of the time a
filing covering the collateral is first made or the security interest or agricultural
lien is first perfected, if there is no period thereafter when there is neither filing
nor perfection.
(2) A perfected security interest or agricultural lien has priority over a
conflicting unperfected security interest or agricultural lien.
(3) The first security interest or agricultural lien to attach or become effective
has priority if conflicting security interests and agricultural liens are unperfected.
91

Because Bankruptcy Code section 102(2) provides a claim includes a
claim against property, and does not require a secured claim against property,
the Bankruptcy Code clearly does not require that the setoff right be considered a
perfected or unperfected secured claim as a condition of qualifying as a claim.
Therefore, it is consistent with the Bankruptcy Code that Chevron’s setoff right be
characterized as an unsecured claim against property of SemCrude pursuant to
section 102(2), namely a simple unsecured claim under the triangular setoff
agreement. The allowability of the claim is further corroborated by Bankruptcy
Code section 506(a)(1) which renders the setoff claim a secured claim to the
extent it is subject to setoff under section 553.
If Chevron’s setoff claim is considered a contract claim or defense, 144 then
Uniform Commercial Code subsections 9-404 (a) and (b) 145 govern. 146 In short, if
Chevron obtained the setoff right against SemCrude’s account receivable from
Chevron, prior to Chevron’s receiving notification 147 of a security interest in the
144 U.S. Aeroteam, Inc. v. Delphi Automotive Systems LLC (In re U.S. Aeroteam, Inc.), 327 B.R.
852, 863 (Bankr. S.D. Ohio 2005)(triangular setoff right treated and referred to as contractual
right).
145 U.C.C. section 9-404(a)-(b) provide:
(a) [Assignee's rights subject to terms, claims, and defenses; exceptions.]
Unless an account debtor has made an enforceable agreement not to assert
defenses or claims, and subject to subsections (b) through (e), the rights of an
assignee are subject to:
(1) all terms of the agreement between the account debtor and assignor and any
defense or claim in recoupment arising from the transaction that gave rise to the
contract; and
(2) any other defense or claim of the account debtor against the assignor which
accrues before the account debtor receives a notification of the assignment
authenticated by the assignor or the assignee.
(b) [Account debtor's claim reduces amount owed to assignee.]
Subject to subsection (c) and except as otherwise provided in subsection (d), the
claim of an account debtor against an assignor may be asserted against an
assignee under subsection (a) only to reduce the amount the account debtor
owes.
146 Pursuant to U.C.C. § 9-109(d)(10)(B), article 9 of the U.C.C. does not apply to recoupments
and setoffs, except section 9-404 applies to defenses or claims of an account debtor.
147 U.C.C. § 1-202 provides:
§ 1-202. Notice; Knowledge.
92

account receivable, such as the debtor in possession’s hypothetical lien, then
Chevron’s setoff right takes precedence and can be enforced.
Conclusions:
1. A dispassionate reading of sections 101(5), 101(12), and 102(2) of the
Bankruptcy Code shows triangular setoff agreements can create mutual debts
for purposes of setoff pursuant to Bankruptcy Code section 553(a).
2. There is no valid public policy encouraging a court to treat creditors with
triangular setoff agreements like creditors without them. Indeed, such similar
treatment of different creditors would chill and distort commerce by
discouraging creditors from extending additional credit to debtors that provide
credit enhancement through triangular setoff agreements.
(a) Subject to subsection (f), a person has "notice" of a fact if the person: (1) has
actual knowledge of it; (2) has received a notice or notification of it; or (3) from all
the facts and circumstances known to the person at the time in question, has
reason to know that it exists.
(b) "Knowledge" means actual knowledge. "Knows" has a corresponding
meaning.
(c) "Discover", "learn", or words of similar import refer to knowledge rather than
to reason to know.
(d) A person "notifies" or "gives" a notice or notification to another person by
taking such steps as may be reasonably required to inform the other person in
ordinary course, whether or not the other person actually comes to know of it.
(e) Subject to subsection (f), a person "receives" a notice or notification when:
(1) it comes to that person's attention; or (2) it is duly delivered in a form
reasonable under the circumstances at the place of business through which the
contract was made or at another location held out by that person as the place for
receipt of such communications.
(f) Notice, knowledge, or a notice or notification received by an organization is
effective for a particular transaction from the time it is brought to the attention of
the individual conducting that transaction and, in any event, from the time it
would have been brought to the individual's attention if the organization had
exercised due diligence. An organization exercises due diligence if it maintains
reasonable routines for communicating significant information to the person
conducting the transaction and there is reasonable compliance with the routines.
Due diligence does not require an individual acting for the organization to
communicate information unless the communication is part of the individual's
regular duties or the individual has reason to know of the transaction and that the
transaction would be materially affected by the information.
Notification is not satisfied by the filing of a security interest; it requires actual notice. Iowa Oil
Co. v. Citgo Petroleum Corp (In re Iowa Oil Co.) , 2004 U.S. Dist. LEXIS 20734, 2004 WL
2326377, *6 , 55 U.C.C. Rep. Serv. 2d (Callaghan) 48 (N.D. Iowa, September 30, 2004).
93

3. When a triangular setoff agreement is entered into in connection with
qualifying derivative contracts, the safe harbors in the Bankruptcy Code
should protect setoff rights arising under them as credit enhancements,
although they do not protect the entering into of the triangular setoff
agreement. Therefore, if the agreement is entered into after trading has
commenced and only has the effect of causing an insolvent entity to incur
additional debt, the agreement may be avoided. Otherwise, the triangular
setoffs should neither be avoided as preferences, constructively fraudulent
transfers, or unperfected security interests.
4. If, however, the setoffs are deemed unperfected security interests, they will
be subject to any perfected security interests in the account to be set off.
5. Finally, if the triangular setoffs are more properly deemed contract rights or
defenses, they should be enforceable against any party holding a perfected
security interest in the account to be set off, including a bankruptcy trustee,
who obtains the security interest after the setoff right is created, but not
against parties obtaining perfected security interests beforehand and causing
the nondebtor party to be notified of same beforehand.
6. To mitigate the possibilities that the setoff right will not be considered a setoff
of mutual debts, or that the setoff may be avoided under Bankruptcy Code
section 553 or treated as an unperfected security interest, the parties may
enter into mutual guarantees of their respective affiliates’ debts at the
inception of trading, and the guarantees should provide that they shall be
enforced by setoffs on settlement dates if the parties desire to replicate the
rights and remedies of the triangular setoff agreement. The master
agreements and their termination provisions should expressly provide that
affiliates assume their affiliates' debt for purposes of enabling the parties to
set off on settlement dates.
8. Much Diminished State Sovereign Immunity in the Bankruptcy Court
A. Central Virginia Community College v. Katz, 546 U.S. 356, 126 S. Ct. 990
(2006)
i. Facts.
A bankruptcy court appointed liquidating supervisor of Wallace
Bookstores, Inc. commenced an action in the bankruptcy court against Virginia
educational institutions entitled to sovereign immunity to recover preferences
under 11 U.S.C. §§ 547(b) and 550(a) and to collect accounts receivable. 126 S.
Ct. at 994. The supervisor filed a letter with the Supreme Court indicating his
intent not to pursue the accounts receivable claims. 126 S. Ct. at 996. Based on
Hood v. Tennessee Student Assistance Corporation (In re Hood), 319 F.3d 755
(6 th Cir. 2003), the district court and United States Court of appeals for the Sixth
Circuit affirmed the bankruptcy court’s denial of the governmental units’ motions
to dismiss grounded in sovereign immunity.
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ii. Issue.
The Supreme Court granted certiorari to consider the question left open by
Tennessee Student Assistance Corporation v. Hood, 541 U.S. 440 (2005),
namely whether Congress’ attempt to abrogate state sovereign immunity in the
amendment of 11 U.S.C. § 106(a) is valid. But, the Supreme Court ultimately
decided the case based on the more dramatic issue of whether the United States
Constitution itself abrogates sovereign immunity in the bankruptcy court,
rendering 11 U.S.C. § 106(a) unnecessary.
iii. Holding
“…The relevant question is not whether Congress has ‘abrogated’ States’
immunity in proceedings to recover preferential transfers. See 11 U.S.C. §
106(a). (footnote omitted). The question, rather, is whether Congress’
determination that States should be amenable to such proceedings is within the
scope of its power to enact ‘Laws on the subject of Bankruptcies.’ We think it
beyond peradventure that it is.” 126 S. Ct. at 1005.
“Congress may, at its option, either treat States in the same way as other
creditors insofar as concerns ‘Laws on the subject of Bankruptcies’ or exempt
them from operation of such laws. Its power to do so arises from the Bankruptcy
Clause itself; the relevant ‘abrogation’ is the one effected in the plan of the
Convention, not by statute.” 126 S. Ct. at 1005.
“[T]he ratification of the Bankruptcy Clause does represent a surrender by
the States of their sovereign immunity in certain federal proceedings….” 126 S.
Ct. at 1000n.9. *** “As we explain in Part IV, infra, it is not necessary to decide
whether actions to recover preferential transfers pursuant to § 550(a) are
themselves properly characterized as in rem. (footnote omitted). Whatever the
appropriate appellation, those who crafted the Bankruptcy Clause would have
understood it to give Congress the power to authorize courts to avoid preferential
transfers and to recover the transferred property.” 126 S.Ct. at 1001-1002.
“Insofar as orders ancillary to the bankruptcy courts’ in rem jurisdiction,
like orders directing turnover of preferential transfers, implicate States’ sovereign
immunity from suit, the States agreed in the plan of the Convention not to assert
that immunity….” 126 S.Ct. at 960. *** “[T]ext aside, the Framers, in adopting
the Bankruptcy Clause, plainly intended to give Congress the power to redress
the rampant injustice resulting from States’ refusal to respect one another’s
discharge orders. As demonstrated by the First Congress’ immediate
consideration and the Sixth Congress’ enactment of a provision granting federal
courts the authority to release debtors from state prisons, the power to enact
bankruptcy legislation was understood to carry with it the power to subordinate
state sovereignty, albeit within a limited sphere.” 126 S.Ct. at 1004.
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“The ineluctable conclusion, then, is that States agreed in the plan of the
Convention not to assert any sovereign immunity defense they might have had in
proceedings brought pursuant to ‘Laws on the subject of Bankruptcies.” *** The
scope of this consent was limited; the jurisdiction exercised in bankruptcy
proceedings was chiefly in rem – a narrow jurisdiction that does not implicate
state sovereignty to nearly the same degree as other kinds of jurisdiction. But
while the principal focus of the bankruptcy proceedings is and was always the
res, some exercises of bankruptcy courts’ powers – issuance of writs of habeas
corpus included – unquestionably involved more than mere adjudication of rights
in a res. In ratifying the Bankruptcy Clause, the States acquiesced in a
subordination of whatever sovereign immunity they might otherwise have
asserted in proceedings necessary to effectuate the in rem jurisdiction of the
bankruptcy courts. (footnote 15)” 126 S.Ct. at 1004-1005.
To be sure, footnote 15 will provoke further litigation. It provides: “We do
not mean to suggest that every law labeled a ‘bankruptcy’ law could, consistent
with the Bankruptcy Clause, properly impinge upon state sovereign immunity.”
126 S.Ct. at 1005n.15.
iv. Rationale
The Supreme Court had agreed in Seminole Tribe of Fla. v. Florida, 517
U.S. 44 (1966), that Congress unequivocally expressed its intent to abrogate
state immunity, 517 U.S. at 56, but ruled the abrogation applicable there was not
pursuant to a valid exercise of power. Both the majority and dissent in Seminole
signaled the bankruptcy, antitrust, and copyright laws ought to correspondingly
fail to abrogate validly the states’ sovereign immunity. Seminole, 517 U.S. at 73
(majority) and 93-94 (Justice Stephens’ dissent). Accordingly, the Supreme
Court first dealt with whether its prior observations were binding.
The majority reasoned based on Cohens v. Virginia, 6 Wheat. 264 (1821),
that the court was “not bound to follow our dicta in a prior case in which the point
now at issue was not fully debated. See id., at 399-400 (‘It is a maxim not to be
disregarded, that general expressions, in every opinion, are to be taken in
connection with the case in which those expressions are used. If they go beyond
the case, they may be respected, but ought not to control the judgment in a
subsequent suit when the very point is presented for decision.’).” 126 S.Ct. at
996.
The Supreme Court reasoned based on Gardner v. New Jersey, 329 U.S.
565, 574 (1947), that bankruptcy jurisdiction, at its core, is in rem, and includes
power to issue compulsory orders to facilitate administration and distribution of
the res. 126 S.Ct. at 995. Then, the court explains based on the history of the
Bankruptcy Clause, the reasons it was inserted in the Constitution, and the
legislation enacted under its auspices immediately after the Constitution’s
ratification, the Bankruptcy Clause was not just a grant of legislative authority to
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Congress, but also authorized a limited subordination of state sovereign
immunity in bankruptcy. 126 S.Ct. at 996.
To demonstrate the delegates to the Constitutional Convention
understood the bankruptcy clause must subordinate sovereign immunity to
enforcement of federal bankruptcy laws, the Supreme Court demonstrates
England and the 13 American colonies had widely divergent laws governing
debtors. Discharges referred to discharge from debtors’ prison and discharge
from debt. Until 1705, the English Parliament did not discharge debtors from
debt, but only from prison, and in 1705 it only started to discharge traders and
merchants from debt. 126 S.Ct. at 997.
In the some States, debtors fared worse than common criminals in prison,
in that they had to provide their own food, fuel, and clothing. 126 S.Ct. at 997.
The State laws governing discharge varied widely. Some discharged debtors
from prison upon surrender of their property and some included a discharge of
debts. Some States required indentured servitude for a release from prison.
Some States provided no relief to debtors at all. 126 S.Ct. at 997-998 .
The Supreme Court found one delegate to the Constitutional Convention,
Jared Ingersoll, had been the attorney in two separate actions involving
nonuniform state insolvency laws. In the first action, James v. Allen, 1 Dall. 199
(C.P. Phila. Cty. 1786), Ingersoll successfully represented a creditor who caused
a debtor to be arrested and imprisoned for nonpayment of debt in Pennsylvania
after the debtor had received a discharge from prison in New Jersey. 126 S.Ct.
at 998. In the second action, Miller v. Hall, 1 Dall. 229 (Pa. 1788), Ingersoll
successfully argued against the principle of James saying “’the discharge of the
Defendant in one state ought to be sufficient to discharge [a debtor] in every
state.’” 126 S.Ct. at 999. The Committee of Detail at the Constitutional
Convention was charged with preparing a draft of the Constitution based on
delegates’ proposals and considered inclusion of insolvency laws within the
coverage of the Full Faith and Credit Clause. A few days later, the Committee of
Detail reported it recommended adding the power ‘to establish uniform laws upon
the subject of bankruptcies’ to the Naturalization Clause of what later became
Article I. 126 S.Ct. at 999. Thus, the Supreme Court concluded: “The absence
of extensive debate over the text of the Bankruptcy Clause or its insertion
indicates that there was general agreement on the importance of authorizing a
uniform federal response to the problems presented in cases like James and
Millar.” 126 S.Ct. at 999-1000.
“The text of Article I, § 8, cl. 4, of the Constitution, however, provides that
Congress shall have the power to establish ‘uniform Laws on the subject of
Bankruptcies throughout the United States.’ Although the interest in avoiding
unjust imprisonment for debt and making federal discharges in bankruptcy
enforceable in every State was a primary motivation for the adoption of that
provision, its coverage encompasses the entire ‘subject of Bankruptcies.’ The
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power granted to Congress by that Clause is a unitary concept rather than an
amalgam of discrete segments.” 126 S.Ct. at 1000.
That the Bankruptcy Clause was understood to authorize Congress to
pass laws enforceable against the States is also demonstrated by Congress’
early grant to federal courts of the power to issue in personam writs of habeas
corpus directing States to release debtors from state prisons. 126 S.Ct. at 1001.
The nation’s first bankruptcy act, the Bankruptcy Act of 1800, provided for federal
courts to issue writs of habeas corpus effective to release debtors from state
prisons. 126 S.Ct. at 1001. It took 67 years before the writ of habeas corpus
would be generally available to state prisoners. Id. At the time, the nation was
quite aware of the sovereign immunity issue as teed up by Chisholm v. Georgia,
2 Dall. 419 (1793), yet there was no record of any objection to the bankruptcy
legislation or the grant of habeas corpus power to federal courts based on
infringement of sovereign immunity. 126 S.Ct. at 1003. The notion that a writ of
habeas corpus is against a state official rather than the state is not a meritorious
reason to argue the bankruptcy laws did not subordinate state sovereignty
because the notion was adopted in Ex parte Young, 209 U.S. 123, 159-160
(1908), over a century after enactment of the first bankruptcy act. 126 S.Ct. at
1005n.14.
In dissent, Justice Thomas argues the majority opinion can not be squared
with the Supreme Court’s state sovereign immunity jurisprudence and can not be
reached without overruling Hoffman v. Connecticut Dept. of Income
Maintenance, 492 U.S. 96 (1989). 126 S.Ct. at 1006.
As explained in the majority decision, the Supreme Court never confronted
the issue as to whether the Bankruptcy Clause abrogates state sovereign
immunity in bankruptcy cases.
The second point is especially easy to refute. Hoffman was a plurality
decision in which a fifth justice joined in the judgment. Justice Thomas claims a
majority of justices agreed (1) a preference action in bankruptcy against a state
agency is barred by sovereign immunity, and (2) absent the State’s consent,
overcoming that immunity requires a clearer abrogation than Congress had
provided. 126 S.Ct. at 1007. Both points are wrong. Four justices agreed the
preference action was barred by sovereign immunity because Congress had not
evidenced a clear intention to abrogate it. Hoffman at 104. Only two justices,
Justices O’Connor and Scalia, claimed Congress did not have the power to
abrogate it. Hoffman at 105. After Hoffman was decided, Congress amended 11
U.S.C. § 106 to make clear its intention to abrogate the immunity. Thus,
Hoffman nowhere deals with the amended statute, has only 2 justices opining
Congress can not waive the States’ sovereign immunity, and offers no opinion on
whether the Constitution already waives State immunity in bankruptcy.
B. Tennessee Student Assistance Corporation v. Hood, 124 S. Ct. 1905 (2004)
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i. Facts.
When Hood commenced her no-asset chapter 7 case, she had an
educational loan guaranteed by a governmental unit. Accordingly, the general
discharge she obtained did not discharge her student loan. Hood did not list her
student loan in her chapter 7 case. Later, Hood procured the reopening of her
chapter 7 case requesting a determination that her student loans were
dischargeable as an “undue hardship” pursuant to 11 U.S.C. § 523(a)(8). Hood
requested that determination by filing a complaint naming the governmental unit
as a defendant.
ii. Issue.
The governmental unit moved to dismiss Hood’s complaint for lack of
jurisdiction based on its Eleventh Amendment sovereign immunity. The
bankruptcy court, bankruptcy appellate panel, and United States Court of
Appeals for the Sixth Circuit agreed the motion should be denied. The circuit
appellate court ruled Art. 1, § 8, cl. 4 of the U.S. Constitution provided Congress
with the necessary authority to abrogate state sovereign immunity on the theory
Congress can only pass “uniform laws” on the subject of bankruptcy if it can
impose the laws against the states. But, the Supreme Court ultimately decided
Hood without determining whether Congress validly abrogated the states’
sovereign immunity in 11 U.S.C. § 106(a).
iii. Holding.
The United States Supreme Court affirmed on the ground the “undue
hardship determination sought by Hood in this case is not a suit against a State
for purposes of the Eleventh Amendment. 124 S. Ct. at 1913. “This is not to
say, ‘a bankruptcy court’s in rem jurisdiction overrides sovereign immunity,’
United States v. Nordic Village, Inc., 503 U.S. 30, 38 (1992), … but rather that
the court’s exercise of its in rem jurisdiction to discharge a student loan debt is
not an affront to the sovereignty of the State. Nor do we hold that every exercise
of a bankruptcy court’s in rem jurisdiction will not offend the sovereignty of the
State. No such concerns are present here, and we do not address them.” 124
S. Ct. at 1913 n. 5.
The fact that the discharge proceeding had to be commenced by service
of a summons and complaint on the State did not violate the State’s sovereign
immunity based on the indignity of having to submit itself to personal jurisdiction
of the bankruptcy court because it doesn’t have that effect in that only a
discharge is requested. 124 S. Ct. at 1913-1916.
iv. Rationale.
The discharge of a debt in bankruptcy is an in rem proceeding, and the
bankruptcy court can provide a debtor a fresh start despite lack of participation
by all creditors because its “jurisdiction is premised on the debtor and his estate,
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and not on his creditors.” 124 S. Ct. at 1910. “A bankruptcy court’s in rem
jurisdiction permits it to ‘‘determin[e] all claims that anyone, whether named in the
action or not, has to the property or thing in question. The proceeding is ‘one
against the world.’’ 16 J. Moore, et al., Moore’s Federal Practice § 108.70[1], p.
108-106 (3d ed. 2004). Because the court’s jurisdiction is premised on the res,
however, a nonparticipating creditor cannot be subjected to personal liability.
See Freeman v. Alderson, 119 U.S. 185, 188-189 (1886)…” 124 S. Ct. at 1911.
To make the service of the summons and complaint a violation of
sovereign immunity would effectively cause the Bankruptcy Rule requiring the
complaint to have an impermissible effect under 28 U.S.C. § 2075 of rendering a
dischargeable debt nondischargeable. 124 S. Ct. at 1914.
v. The Eleventh Amendment provides:
“The Judicial power of the United States shall not be construed to
extend to any suit in law or equity, commenced or prosecuted
against one of the United States by Citizens of another State, or by
Citizens or Subjects of any Foreign State.”
C. Supreme Court Precedents Governing Enforcement of Federal Bankruptcy
Law against States
i. The Discharge of a Debt by a Bankruptcy Court
is an in rem proceeding. Gardner v. New Jersey, 329 U.S. 565, 574 (1947);
Straton v. New, 283 U.S. 318, 320-321 (1931); Hanover Nat. Bank v. Moyses,
186 U.S. 181, 192 (1902); New Lamp Chimney Co. v. Ansonia Brass & Copper
Co., 91 U.S. 656, 662 (1876).
ii. States are Bound by Bankruptcy Discharges Whether They
Participate or Not
When a state does not timely file its tax claim, the bankruptcy court can
bar the State’s claim because if the State wants to participate it must submit to
appropriate requirements. New York, v. Irving Trust Co., 288 U.S. 329
(1933)(state sovereign immunity held inapplicable). Exercise of in rem
jurisdiction to discharge a debt does not infringe on state sovereignty. Cf.
Hoffman v. Connecticut Dept. of Income Maintenance, 492 U.S. 96, 102 (1989).
iii. But, Bankruptcy Court Enforcement of a Bankruptcy
Discharge against a State is An Open Question
Hood did not rule on whether the bankruptcy court can enforce a
discharge injunction against a state without violating its sovereign immunity. 124
S. Ct. at 1911 n. 4. But, based on Missouri v. Fiske, 290 U.S. 18, 29
(1933)(federal court has no power to order State to subject itself to federal court’s
determination of stock ownership for probate purposes), the court noted the
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State might still be bound by a federal court’s adjudication even if the federal
court can not issue an injunction against the State to carry out its adjudication.
Id.
Notably, International Shoe Company v. Pinkus, 278 U.S. 261 (1929),
reversed a judgment of the Supreme Court of Arkansas affirming the dismissal of
a creditor’s enforcement action against a state court receiver on the ground “[t]he
enforcement of state insolvency systems, whether held to be in pursuance of
statutory provisions or otherwise, would necessarily conflict with the national
purpose to have uniform laws on the subject of bankruptcies throughout the
United States.” 278 U.S. at 268. There, a debtor commenced a receivership
action the same day a creditor obtained a judgment against the debtor. Under
the state’s insolvency law, creditors granting releases to the debtor had a right to
distributions on their claims prior to rights of creditors not granting releases. The
debtor had been a bankrupt under federal law in the last six years, thereby
precluding him from obtaining a discharge in a new bankruptcy case. Thus, the
state insolvency law would have granted the debtor relief unavailable under the
federal statute.
The United States Supreme Court ruled that even in the absence of
pending proceedings under the Bankruptcy Act, the operation of the state
insolvency law was unconstitutional because states are without power to make or
enforce any law governing bankruptcies that impairs the contracts of persons
outside their jurisdiction or conflicts with the national bankruptcy laws. 278 U.S.
at 263-264; Sturges v. Crowninshield, 4 Wheat. 122; Ogden v. Saunders, 12
Wheat. 213, 369; Baldwin v. Hale, 1 Wall. 223,228; Denny v. Bennett, 128 U.S.
489, 497-498; Brown v. Smart, 145 U.S. 454, 457; Stellwagen v. Clum, 245 U.S.
605, 613.
Significantly, the complaining creditor in Pinkus was not the federal
government; it was International Shoe Company. The United States Supreme
Court had no problem ruling the state courts could not enforce their insolvency
laws. That ruling implicitly suggests the states’ sovereign immunity against
enforcement of the federal bankruptcy laws is abrogated.
iv. Sales Free and Clear
The bankruptcy court has authority to sell a debtor’s property free and
clear of a State’s tax lien. Van Huffel v. Harkelrode, 284 U.S. 225, 228-229
(1931).
D. Hood’s Unanswered Question: Whether Congress Can Constitutionally
Abrogate States’ Sovereign Immunity from Private Suits under the Bankruptcy
Code
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The key question answered affirmatively by the lower court’s decision, but
left unanswered by the Supreme Court’s affirmance in Hood, was whether at the
Constitutional Convention the states granted Congress the power to abrogate
their sovereign immunity under Article I, section 8 of the United States
Constitution. The lower court concluded that when the states granted Congress
in the Constitution the power to make uniform bankruptcy laws, they intended to
grant exclusive legislative power to the federal government on the subject of
bankruptcies and to cede their immunity to suit. Hood v. Tennessee Student
Assistance Corp., 319 F.3d 755, 767-768 (6th Cir. 2003), aff’d judgment on other
ground, 124 S. Ct. 1905 (2004). 148
The states’ sovereign immunity from suit in federal court presents perhaps
the grandest question of statutory interpretation in federal jurisprudence.
Moreover, those justices known for ruling the plain meaning of the statute ends
the inquiry unless the result is absurd, are in the position of arguing it is absurd to
interpret the Constitution to deprive states of the English monarchy’s traditional
insulation from suit based on the myth the king can do no wrong, when the
Constitution by its express terms provides subject matter jurisdiction over actions
between States and citizens of States and the Eleventh Amendment only bars
such actions when they involve judicial power and are between a State and
citizens of another State. See generally, Metromedia Fiber Network, Inc. v.
Various State and Local Taxing Authorities (In re Metromedia Fiber Network,
Inc.), 299 B.R. 251, 257-258 (Bankr. S.D.N.Y. 2003).
The United States Constitution provides plainly in Article III, section 2 that:
The Judicial Power shall extend, … (5) To controversies between two or more
States; between a State and citizens of another State; between citizens of
different States…” How then can there even be a question as to the
susceptibility of states to suit in federal court?
The first time this question was presented to the Supreme Court, it
determined almost unanimously that a citizen of South Carolina could sue the
State of Georgia in federal court for assumpsit to recover money. Chisolm v.
State of Georgia, 2 U.S. 419 (1793). Justice Iredell, in dissent, looked to the
Judiciary Act of 1789 under which Congress carried out the Constitution’s grant
of power to create federal courts and noted that section 13 provided:
“That the Supreme Court shall have exclusive jurisdiction of all
controversies of a civil nature; where a State is a party, except
148 Five courts of appeal have ruled suits against states under the Bankruptcy Code in the bankruptcy court
are barred by sovereign immunity. Schlossberg v. State of Maryland (In re Creative Goldsmiths of
Washington, D.C., Inc.), 119 F.3d 1140 (4th Cir. 1997), cert. denied, 523 U.S. 1075 (1998); Dep’t of
Transp. & Dev. , State of Louisiana v. PNL Asset Mgmt. Co., LLC (In re Fernandez), 123 F.3d 241,
corrected, rehearing denied, 130 F.3d 1138 (5th Cir. 1997); Sacred Heart Hosp. of Norristown v.
Pennsylvania (In re Sacred Heart Hospital of Norristown), 133 F.3d 237 (3d Cir. 1998); Mitchell v.
Franchise Tax Bd., State of California (In re Mitchell), 209 F.3d 1111 (9th Cir. 2000); Nelson v. Lacrosse
County Dist. Attorney (State of Wisconsin) (In re Nelson), 301 F.3d 820 (7th Cir. 2002).
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etween a State and its citizens; and except also, between a State
and citizens of other States, or aliens, in which latter case it shall
have original, but not exclusive jurisdiction….”
From section 13’s grant of original, but not exclusive jurisdiction, Justice Iredell
deduced that Congress only granted the federal courts the same power the state
courts had and he opined they did not have power to sue the sovereign for
assumpsit. 2 U.S. at 431-438. Notably, Justice Iredell expressly left open the
possibility Congress may have the constitutional power to grant federal courts
power against states. 2 U.S. at 434; Seminole, infra, at 79 (Justice Stephens’
dissent).
Chisolm was a very unpopular decision and Congress and the states
speedily passed the Eleventh Amendment in reaction to it.
A hundred years later, the Supreme Court was faced with the question
whether a state can be sued by one of its own citizens in federal court. The
wording of the Eleventh Amendment only bars suits in federal court against
states by citizens of other states. Based on Alexander Hamilton’s remarks in The
Federalist No. 81 where he announced state sovereignty would be preserved
except for surrenders of immunity in the plan of the convention, the court ruled a
state can not be sued in federal court by its own citizens. Hans v. Louisiana, 134
U.S. 1 (1890).
The portion of Alexander Hamilton’s remarks in The Federalist No. 81 that
might convince a court of the absurdity of interpreting the Constitution to
abrogate states’ sovereign immunity provides:
“…The contracts between a nation and individuals are only binding
on the conscience of the sovereign, and have no pretension to a
compulsive force. They confer no right of action independent of the
sovereign will. To what purpose would it be to authorize suits
against States for the debts they owe? How could recoveries be
enforced? It is evident that it could not be done without waging war
against the contracting State; and to ascribe to the federal courts by
mere implication, and in destruction of a pre-existing right of the
state governments, a power which would involve such a
consequence, would be altogether forced and unwarrantable.”
Over the years, states’ sovereign immunity has been rendered even
broader. For instance, in Federal Maritime Commission v. South Carolina, 535
U.S. 743 (2002), the Supreme Court held state sovereign immunity also bars a
federal agency (Federal Maritime Commission) from adjudicating a private
party’s complaint against the state for violation of the Shipping Act of 1984, 46
U.S.C. § 1701, even though judicial power was not being exercised and the
Eleventh Amendment only bars use of judicial power.
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In Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996)(5 to 4), the
Supreme Court held the Indian Commerce Clause of the Constitution does not
grant Congress the power to allow a tribe to sue a state to enforce a federal
statute passed under that clause if the state does not consent to be sued, and
the Ex Parte Young doctrine (209 U.S. 123 (1908)) whereby a tribe may have
sued an official of the state for prospective injunctive relief was inapplicable
because Congress had legislated a remedial scheme. 517 U.S. at 47.
Interestingly, the statutory scheme ultimately provided for the Secretary of
the Interior to prescribe procedures under which gaming may be conducted on
Indian lands if mediation did not result in consensus, and the lower court granted
the Indians immediate recourse to the Secretary because it dismissed the
Indians’ suit due to sovereign immunity. Thus, the Indians obtained the ultimate
relief they sought and the State’s enforcement of its sovereign immunity was a
pyrrhic victory..
Although the Eleventh Amendment, by its terms, only bars use of judicial
power against a State in a diversity jurisdiction case and Seminole involved a
federal question case, the Supreme Court reaffirmed its prior rulings that the
Eleventh Amendment stands “’not so much for what is says, but for the
presupposition…which it confirms.’ Blatchford v. Native Village of Noatak, 501
U.S. 775, 779…(1991). That presupposition, first observed over a century ago in
Hans v. Louisiana, 134 U.S. 1…(1890), has two parts: first, that each State is a
sovereign entity in our federal system; and second, that ‘it is inherent in the
nature of sovereignty not to be amenable to the suit of an individual without its
consent…’” Seminole, 517 U.S. at 54.
The Supreme Court agreed in Seminole that Congress unequivocally
expressed its intent to abrogate state immunity, 517 U.S. at 56, but ruled the
abrogation was not pursuant to a valid exercise of power. The Supreme Court
had recognized only two sources of a valid power, the Fourteenth Amendment
(inapplicable here) and the Interstate Commerce Clause (Art. I, § 8, cl. 3). The
Supreme Court overruled the plurality of Pennsylvania v. Union Gas Co., 491
U.S. 1 (1989), that held the Interstate Commerce Clause was a valid source of
power. Seminole, 517 U.S. at 66.
Based on the latter holding, both the majority and dissent in Seminole
signaled the bankruptcy, antitrust, and copyright laws might also fail to abrogate
validly the states’ sovereign immunity. Seminole, 517 U.S. at 73 (majority) and
93-94 (Justice Stephens’ dissent).
In the aftermath of Seminole, the Supreme Court also ruled nothing in
Article I of the United States Constitution authorizes Congress to subject
nonconsenting states to private suits for damages under federal statutes (the Fair
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Labor Standards Act of 1938, as amended, 29 U.S.C. § 201 et seq.) in state
courts. Alden v. Maine, 527 U.S. 706 (1999).
7. State Law Can Not Oust Federal Bankruptcy Courts of Subject Matter Jurisdiction
Granted by 28 U.S.C. § 1334
A. Marshall v. Marshall, 126 S. Ct. 1735 (2006)
i. Facts.
Vickie Lynn Marshall (a/k/a Anna Nicole Smith) commenced a chapter 7
case in the Central District of California. She is the widow of J. Howard Marshall
who left her nothing in his will. After one of Mr. Marshall’s son’s filed a proof of
claim for defamation, accusing the debtor of having wrongly accused him of
forgery, fraud, and overreaching to gain control of his father’s assets, the debtor
counterclaimed that the son had tortiously interfered with a gift she expected.
126 S. Ct. at 1742.
The bankruptcy court granted summary judgment against Mr. Marshall on
his proof of claim, ruled the claim and counterclaim were core proceedings, and
issued a judgment in favor of the debtor on her counterclaim in the amount of
$449 million compensatory damages and $25 million punitive damages. 126 S.
Ct. at 1742. The bankruptcy court also ruled Mr. Marshall waived the probate
exception to the court’s subject matter jurisdiction and waived mandatory
abstention by untimely raising those issues. 126 S. Ct. at 1742, 1746 n.3. On
appeal, the district court determined the counterclaim was not a core proceeding
and treated the bankruptcy court’s judgment as proposed rather than final. 126
S. Ct. at 1743.
The district court determined Mr. Marshall had tortiously interfered with the
debtor’s expectancy evidenced by her husband’s having instructed his lawyers to
prepare a trust to provide her with half the appreciation of his assets from the
date of his marriage. The district court found the son conspired to suppress or
destroy the trust document and to strip his father of assets by backdating,
altering, and falsifying documents, arranging for surveillance of his father and the
debtor, and presenting documents to his father under false pretenses. 126 S. Ct.
at 1744. The district court awarded the debtor $44.3 million of compensatory
damages and $44.3 million of punitive damages. Id.
The United States Court of Appeals for the Ninth Circuit reversed, ruling
the probate exception bars federal jurisdiction as did the State of Texas’ grant of
exclusive jurisdiction to the state probate court. 126 S. Ct. at 1744.
In the meantime, after the bankruptcy court ruled in the debtor’s favor, the
debtor dismissed her claims in the Texas probate court that her husband’s will
was invalid and that Mr. Marshall had tortiously interfered. 126 S. Ct. at 1743.
After a jury trial, the Texas probate court declared the living trust and the debtor’s
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husband’s will were valid. 126 S. Ct. at 1743. The state court’s ruling became
final after the bankruptcy court issued its ruling that the district court treated as a
proposal and approximately one month before the district court issued its
judgment in favor of the debtor. 126 S. Ct. at 1750. The Ninth Circuit did not
address whether the debtor’s claim was core and whether Mr. Marshall’s
arguments about claim and issue preclusion were valid. 126 S. Ct. at 1750.
ii. Issue.
Does the judicially created probate exception to federal subject matter
jurisdiction apply not only to direct challenges to a will or trust, but also to
questions which would ordinarily be decided by a probate court in determining
the validity of the decedent’s estate planning instrument? 126 S. Ct. at 1741.
iii. Holding.
“We hold that the Ninth Circuit had no warrant from Congress, or from
decisions of this Court, for its sweeping extension of the probate exception.” 126
S. Ct. at 1741.
“…It is also clear, however, that Texas may not reserve to its probate
courts the exclusive right to adjudicate a transitory tort. We have long
recognized that ‘a State cannot create a transitory cause of action and at the
same time destroy the right to sue on that transitory cause of action in any court
having jurisdiction.’ Tennessee Coal, Iron & R. Co. v. George, 233 U.S. 354,
360, 34 S. Ct. 587, 58 L. Ed. 997 (1914)…Directly on point, we have held that the
jurisdiction of the federal courts, ‘having existed from the beginning of the
Federal government, [can] not be impaired by subsequent state legislation
creating courts of probate.’ McClellan v. Carland, 217 U.S. 268, 281, 30 S. Ct.
501, 54 L. Ed. 762 (1910)…” 126 S. Ct. at 1749.
On remand, the lower court can consider whether the debtor’s claim was a
core proceeding and whether claim and issue preclusion apply in respect of the
probate court’s rulings. 126 S. Ct. at 1750.
B. But, Bankruptcy Jurisdiction by Ambush Is Not Easy in the Ninth
Circuit (Marshall v. Stern (In re Marshall), 600 F.3d 1037 (9 th Cir.
2010), cert. granted, Stern v. Marshall, 177 L. Ed. 2d 1152; 2010
U.S. LEXIS 5746; 79 U.S.L.W. 3194 (Sept. 28, 2010).
i. 28 U.S.C. § 157(b)(2)(C) provides a core proceeding
includes:
“(C) counterclaims by the estate against persons filing claims
against the estate…”
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This is what bankruptcy lawyers refer to as jurisdiction by ambush, namely
that claimants lose their article III rights when debtors sue them, if they file proofs
of claim against the debtors’ estates, which they must do to obtain any
distribution if the debtor has not listed their claim as liquidated, uncontingent, and
undisputed. 149 The loss of article III rights stems from the Congressional grant to
non-article III bankruptcy judges to adjudicate core proceedings by themselves,
without an article III judge or a jury. 150
ii. Prior Jurisprudence Underlying Jurisdiction by Ambush
In Katchen v. Landy, 382 U.S. 323, 325 (1966), after the creditor filed a
proof of claim, the bankruptcy trustee counterclaimed that the creditor received
an avoidable preference and requested its disgorgement. Pursuant to
Bankruptcy Act section 57g (former 11 U.S.C. § 93g), 151 a claim could not be
allowed until the claimant disgorged any voidable transfers it received.
(Bankruptcy Code section 502(d) 152 is the analog of former section 57(g). This
149 Bankruptcy Code section 1111(a) provides:
(a) A proof of claim or interest is deemed filed under section 501 of this title for
any claim or interest that appears in the schedules filed under section 521 (1) or
1106 (a)(2) of this title, except a claim or interest that is scheduled as disputed,
contingent, or unliquidated.
Bankruptcy Rule 3003(c)(2) provides:
“(2) Who must file.
Any creditor or equity security holder whose claim or interest is not scheduled or
scheduled as disputed, contingent, or unliquidated shall file a proof of claim or
interest within the time prescribed by subdivision (c)(3) of this rule; any creditor
who fails to do so shall not be treated as a creditor with respect to such claim for
the purposes of voting and distribution.”
150 28 U.S.C. § 157(b)(1) provides:
(b)
(1) Bankruptcy judges may hear and determine all cases under title 11 and all core
proceedings arising under title 11, or arising in a case under title 11, referred under
subsection (a) of this section, and may enter appropriate orders and judgments, subject to
review under section 158 of this title.
151 Former 11 U. S. C. § 93(g) provides:
"(g) The claims of creditors who have received or acquired preferences, liens,
conveyances, transfers, assignments or encumbrances, void or voidable under
this title, shall not be allowed unless such creditors shall surrender such
preferences, liens, conveyances, transfers, assignments, or encumbrances."
152 Bankruptcy Code section 502(d) provides:
“(d) Notwithstanding subsections (a) and (b) of this section, the court shall
disallow any claim of any entity from which property is recoverable under section
542, 543, 550, or 553 of this title or that is a transferee of a transfer avoidable
107

meant the bankruptcy court would have to determine the existence and amount
of the voidable preference before it could determine whether to allow the claim
and how much the creditor would have to disgorge before the claim could be
allowed. The technical question was whether the bankruptcy court had summary
jurisdiction under the Bankruptcy Act of 1898, as amended, to order
disgorgement of the preference, after having found all the facts establishing the
existence and amount of the voidable preference for purposes of determining the
claim could not be allowed. Id. To answer the question, however, the Supreme
Court had to consider whether a disgorgement order entered by a non-article III
court would unconstitutionally deprive the creditor of a jury trial in violation of the
Seventh Amendment:
“Petitioner contends, however, that this reading of the statute
violates his Seventh Amendment right to a jury trial. But although
petitioner might be entitled to a jury trial on the issue of preference
if he presented no claim in the bankruptcy proceeding and awaited
a federal plenary action by the trustee, Schoenthal v. Irving Trust
Co., 287 U.S. 92, when the same issue arises as part of the
process of allowance and disallowance of claims, it is triable in
equity. The Bankruptcy Act, passed pursuant to the power given to
Congress by Art. I, § 8, of the Constitution to establish uniform laws
on the subject of bankruptcy, converts the creditor's legal claim into
an equitable claim to a pro rata share of the res, Gardner v. New
Jersey, 329 U.S. 565, 573-574, a share which can neither be
determined nor allowed until the creditor disgorges the alleged
voidable preference he has already received. See Alexander v.
Hillman, 296 U.S. 222, 242.”
Katchen, 382 U.S. at 336. Thus, facts that must be found as part of the claims
allowance process can be determined by a non-article III court within its equity
jurisdiction to allocate the estate among creditors. 153 The Supreme Court also
reasoned that since the non-article III bankruptcy court’s findings and
conclusions in respect of the preference were entitled to res judicata effects in a
under section 522 (f), 522 (h), 544, 545, 547, 548, 549, or 724 (a) of this title,
unless such entity or transferee has paid the amount, or turned over any such
property, for which such entity or transferee is liable under section 522 (i), 542,
543, 550, or 553 of this title.”
153 Katchen provides (at 382 U.S. at 330-331):
“Unavoidably and by the very terms of the Act, when a bankruptcy trustee
presents a § 57g objection to a claim, the claim can neither be allowed nor
disallowed until the preference matter is adjudicated. The objection under § 57g
is, like other objections, part and parcel of the allowance process and is subject
to summary adjudication by a bankruptcy court. This is the plain import of § 57
and finds support in the same policy of expedition that underlies the necessity for
summary action in many other proceedings under the Act.”
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subsequent action to recover the preference, there was no reason why the
bankruptcy court could not simply order the preference disgorged:
“…Thus, once a bankruptcy court has dealt with the preference
issue nothing remains for adjudication in a plenary suit. The normal
rules of res judicata and collateral estoppel apply to the decisions of
bankruptcy courts. Chicot County Drainage District v. Baxter State
Bank, 308 U.S. 371, 376-377; Stoll v. Gottlieb, 305 U.S. 165. More
specifically, a creditor who offers a proof of claim and demands its
allowance is bound by what is judicially determined, Wiswall v.
Campbell, 93 U.S. 347, 351; and if his claim is rejected, its validity
may not be relitigated in another proceeding on the claim. Sampsell
v. Imperial Paper Corp., 313 U.S. 215, 218-219; Lesser v. Gray,
236 U.S. 70, 75….”
Katchen, 382 U.S. at 334. Notably, Wiswall, which only involved the filing of a
proof of claim and not any counterclaim by the estate, contained very broad
language:
“…Hence the necessity for as "quick and summary" a disposal of
the questions arising under this part of the case as is consistent
with a reasonable protection of the rights of the parties in interest.
Every person submitting himself to the jurisdiction of the bankrupt
court in the progress of the cause, for the purpose of having his
rights in the estate determined, makes himself a party to the suit,
and is bound by what is judicially determined in the legitimate
course of the proceeding. A creditor who offers proof of his claim,
and demands its allowance, subjects himself to the dominion of the
court, and must abide the consequences. His remedies for the
purpose of this proof are prescribed by the law….” 154
Katchen expressly provided it was not ruling on whether the non-article III
bankruptcy court could determine an estate counterclaim to a proof of claim
whose facts would not be determined in the claims allowance process:
“Rather, our decision is governed by the "traditional
bankruptcy law that he who invokes the aid of the bankruptcy court
by offering a proof of claim and demanding its allowance must
abide the consequences of that procedure. Wiswall v. Campbell, 93
U.S. 347, 351." Gardner v. New Jersey, 329 U.S. 565, 573. As this
is the basis of our decision, we obviously intimate no opinion
concerning whether the referee has summary jurisdiction to
adjudicate a demand by the trustee for affirmative relief, all of the
substantial factual and legal bases for which have not been
disposed of in passing on objections to the claim.”
154 Wiswall v. Campbell, 93 U.S. 347, 351 (1876).
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Katchen, 382 U.S. at 333.
In Piombo Corp. v. Castlerock Properties (In re Castlerock Properties),
781 F.2d 159, 160 (9th Cir. 1986), a creditor requested stay relief to continue its
state court action against the debtor, and the debtor answered the stay relief
motion by asserting its state court counterclaims against the debtor. The creditor
objected to the bankruptcy court’s determination of the counterclaims in its stay
relief proceeding, but the court denied the motion. The creditor then answered
the counterclaims and filed a proof of secured claim. Id. The creditor requested
reference withdrawal on the ground the bankruptcy court’s determination of the
estate’s counterclaims would be unconstitutional and that motion was denied. Id.
Then, the bankruptcy court tried the counterclaims and rendered judgment for the
debtor. Id. But on appeal, the district court determined the bankruptcy court
lacked jurisdiction to determine the counterclaims and it vacated the automatic
stay. Id.
On appeal to the United States Court of Appeals for the Ninth Circuit, the
district court’s judgment was affirmed. Id. at 163. The appellate court dealt with
28 U.S.C. § 157(b)(2)(C), by reasoning:
“…However, it seems unfair under the facts of this case to
categorize the counterclaims as falling within this provision. The
counterclaims were asserted before the Proof of Claim was filed.
Piombo would not have filed the Proof of Claim if the bankruptcy
court had declined jurisdiction over the counterclaims…”
“Further, we are persuaded that a court should avoid
characterizing a proceeding as ‘core’ if to do so would raise
constitutional problems…”
Id. at 161-162. The court held:
Id. at 162.
“…Accordingly, we hold that state law contract claims that do not
specifically fall within the categories of core proceedings
enumerated in 28 U.S.C. § 157(b)(2)(B)-(N) are related
proceedings under 157(c) even if they arguably fit within the literal
wording of the two catch-all provisions, sections § 157(b)(2)(A) and
(O)….”
110

In Langenkamp v. Culp, 498 U.S. 42 (1990), 155 the Supreme Court held
creditors who filed proofs of claim were not entitled to jury trials on the estate’s
preference actions against them because the preference claim became part of
the claims allowance process which is subject to the court’s equitable (non-article
III) jurisdiction. 156
Langenkamp relied on Katchen and Granfinanciera, S. A. v. Nordberg,
492 U.S. 33 (1989)(preference and fraudulent transfer defendant entitled to jury
trial when they had not filed proofs of claim), and did not break new ground.
In First Fidelity Bank v. L.J. Hooker Investments, Inc. (In re L.J. Hooker
Investments, Inc.), 937 F.2d 833 (2d Cir. 1991), the bank claimant requested an
extension of the bar date so its filing of its proof of claim would not convert the
estate’s preference action into a core proceeding determinable by the non-article
III bankruptcy court. On appeal, because of a lack of appellate jurisdiction, the
court treated the appeal as a request for a writ of mandamus and denied the writ:
The Bank offers no basis, however, for disregarding the general
rule of Langenkamp and Granfinanciera that a creditor who invokes
the bankruptcy court's equitable jurisdiction to establish a claim
against a debtor's estate is also subject to the procedures of equity
in the determination of preference actions brought on behalf of the
estate.
The Court ruled that effectuating the equitable purposes of
bankruptcy adjudication was the type of circumstance contemplated
by Dairy Queen, Inc. and Beacon Theatres, Inc., in which the
bankruptcy court could proceed to resolve the equitable claims
presented to it, even if their determination would be dispositive of
what would otherwise be a legal claim. Katchen, 382 U.S. at 339-
40.
L.J. Hooker Investments, 937 F.2d at 838, 839.
iii. Ninth Circuit Rejects Jurisdiction by Ambush
In Marshall v. Stern (In re Marshall), 600 F.3d 1037 (9 th Cir. 2010),
Marshall’s son filed a nondischargeability complaint in Vickie Lynn Marshall’s
155 “This case presents the question whether creditors who submit a claim against a bankruptcy
estate and are then sued by the trustee in bankruptcy to recover allegedly preferential monetary
transfers are entitled to jury trial under the Seventh Amendment.” Langenkamp, 498 U.S. at 42-
43.
156 “In other words, the creditor's claim and the ensuing preference action by the trustee become
integral to the restructuring of the debtor-creditor relationship through the bankruptcy court's
equity jurisdiction. Granfinanciera, supra, at 57-58. As such, there is no Seventh Amendment
right to a jury trial.” Langenkamp, 498 U.S. at 44-45.
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(Anna Nicole Smith’s) chapter 11 case, alleging his claim for defamation was
nondischargeable, and also filed a proof of claim. Vickie Lynn Marshall
counterclaimed for tortious interference with her husband’s intent to give her an
inter-vivos gift. Id. at 1039. First, the bankruptcy court determined Vickie Lynn
Marshall’s counterclaim in her favor. Next, Vickie Lynn Marshall nonsuited her
claims in the Texas Probate Court. Id. at 1046. Next, the Texas probate court
determined J. Howard Marshall effected his estate plan without tortious
interference and did not intend to make a gift to Vickie Lynn Marshall. Finally, on
appeal, the district court held the bankruptcy court lacked power to enter a
judgment, but after taking additional evidence, the district court entered a
judgment in favor of Vickie Lynn Marshall for over $88 million in compensatory
and punitive damages. Id. at 1039-1040, 1048. Initially, the Ninth Circuit
reversed on the ground of the probate exception. But, the Supreme Court
reversed and remanded for a determination whether Vickie Lynn Marshall’s
counterclaim was a core proceeding.
The Ninth Circuit appellate court held:
“We conclude that the findings of the Texas probate court
should be afforded preclusive effect because it is the earliest final
judgment on matters relevant to this proceeding. The bankruptcy
court exceeded its statutory grant of power and the constitutional
limitations on that power when it purported to enter a final judgment
in favor of Vickie Lynn Marshall on her counterclaim. The
bankruptcy court is empowered by 28 U.S.C. § 157(b)(1) to hear
and finally determine ‘core proceedings arising under title 11, or
arising in a case under title 11.’ Vickie Lynn Marshall's counterclaim
for tortious interference is not such a ‘core proceeding’ because its
resolution was not a necessary precursor to the resolution of Pierce
Marshall's claim against the bankruptcy estate for defamation. In
other words, her counterclaim was not so closely related to his
claim that they essentially merged, with her counterclaim becoming
part and parcel of the bankruptcy court's claims determination and
allowance process. Thus, the bankruptcy court could, at most, enter
proposed findings of fact and conclusions of law on Vickie Lynn
Marshall's counterclaim for tortious interference. See 28 U.S.C. §
157(c).”
Id. at 1039-1040.
Interestingly, the Ninth Circuit explains that days after marrying Anna
Nicole Smith, J. Howard Marshall made his living trust irrevocable, thereby
making it impossible for him to make the gifts at issue, although Vickie Lynn
Marshall alleged in the Texas Probate Court that Pierce Marshall used fraud and
undue influence to cause J. Howard Marshall to make the trust irrevocable. Id. at
1042.
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According to the Ninth Circuit court of appeals, a counterclaim is only a
core proceeding if it must be determined to determine the allowability of the
creditor’s claim:
“Our review of the evolution of the Bankruptcy Code, the Supreme
Court's opinions in Katchen and Marathon, as well as our own
jurisprudence cautioning against creating constitutional problems
through an overly broad construction of what is a ‘core proceeding,’
Piombo Corp. v. Castlerock Props. (In re Castlerock Props.), 781
F.2d 159, 162 (9th Cir. 1986), leads us to agree with the amici curie
professors that ‘a counterclaim under § 157(b)(2)(C) is properly a
'core' proceeding 'arising in a case under' the [Bankruptcy] Code
only if the counterclaim is so closely related to the proof of claim
that the resolution of the counterclaim is necessary to resolve the
allowance or disallowance of the claim itself.’ Professors' Amicus
Br. at 11. Such a construction of § 157(b)(2)(C) takes into account
the whole of the statute, avoids rendering any terms superfluous,
follows Katchen, and comports with the principles of Marathon and
Congress' desire to revise the Bankruptcy Code in a manner
consistent with the Constitution.
Id. at 1058-1059.
iv. Analysis
Marshall v. Stern (In re Marshall), supra, answers the question left open in
Katchen, 382 U.S. at 333, namely whether the bankruptcy court can determine a
counterclaim unnecessary to determine the allowance of a proof of claim. From
the perspective of the debtor’s estate’s ability to make distributions and to
determine the creditor’s share of the estate, the counterclaim must be
determined. From the perspective of whether the moneys the creditor may
have to pay to satisfy a judgment on the counterclaim are property of the estate
the bankruptcy court is allocating, the moneys are not property of the estate until
paid. 157 Because the underpinning of Katchen is that the allocation of the estate
renders the proof of claim an equitable proceeding, it is possible the Supreme
Court will agree with the Ninth Circuit.
Conversely, the foregoing analysis would elevate form over substance. Just
as the preference action had to be determined in Katchen before the bankruptcy
court could determine the allowability of the creditor’s proof of claim, Vickie Lynn
Marshall’s counterclaim against Pierce Marshall has to be determined before the
bankruptcy court determines what share, if any, of Vickie Marshall’s estate is
allocated to Pierce Marshall. Procedurally, Pierce Marshall’s proof of claim could
157 See, e.g., Rushton v. Traub (In re Nell), 71 B.R. 305 (D. Utah 1987); Fisher v. Insurance Co. of Pa. (In
re Pied Piper Casuals, Inc.), 65 B.R. 780 (S.D.N.Y. 1986).
113

e allowed without a prior determination of Vickie Marshall’s counterclaim, but
how much of the estate Pierce Marshall is entitled to receive and keep, must
await determination of his liability, if any, to the estate on the counterclaim.
Therefore, there is no principled basis on which to distinguish between the
bankruptcy court’s need to determine the estate’s preference action and its need
to determine the estates’ counterclaims. Both have the same impact, namely
they offset the estate’s liability to the creditor who filed a proof of claim. Katchen
made clear the policy to be served is to make the distribution of the estate
efficient and inexpensive:
“When Congress enacted general revisions of the bankruptcy
laws in 1898 and 1938, it gave "special attention to the subject of
making [the bankruptcy laws] inexpensive in [their] administration. "
H. R. Rep. No. 1228, 54th Cong., 1st Sess., p. 2; H. R. Rep. No.
1409, 75th Cong., 1st Sess., p. 2; S. Rep. No. 1916, 75th Cong., 3d
Sess., p. 2. Moreover, this Court has long recognized that a chief
purpose of the bankruptcy laws is "to secure a prompt and effectual
administration and settlement of the estate of all bankrupts within a
limited period," Ex parte Christy, 3 How. 292, 312, and that
provision for summary disposition, "without regard to usual modes
of trial attended by some necessary delay," is one of the means
chosen by Congress to effectuate that purpose, Bailey v. Glover, 21
Wall. 342, 346. See generally Wiswall v. Campbell, 93 U.S. 347,
350-351; U.S. Fidelity Co. v. Bray, 225 U.S. 205, 218.”
Katchen, 382 U.S. at 328-329.
8. When Must Valid Claims under State Law be Discounted to be Allowable under
Bankruptcy Law?
A. In re Oakwood Homes Corporation, 449 F.3d 588 (3d Cir. 2006)(2-1)
i. Facts
The debtor was in the business of manufacturing prefabricated homes and
selling them to customers in exchange for purchase money mortgages. The
debtor then securitized the mortgages by selling them to a trust which paid for
them by selling certificates having different priorities of payment. 449 F.3d at
589-590. The debtor guaranteed repayment of the certificates. 449 F.3d at 590.
Repayment of the principal amount of the certificates stretched out to 2030.
On behalf of the B-2 certificate holders, a $400 million claim was filed
against the debtor’s estate. The $400 million consisted of $116 million of
principal, $1 million of prepetition interest, and the balance was unmatured
interest. The claim for unmatured interest was disallowed under 11 U.S.C. §
502(b)(2). That was not appealed to the Third Circuit and the Third Circuit
114

expressly stated it was expressing no view. 449 F.3d at 595. Because the $116
million claim for principal represented principal payments over time through 2030,
the bankruptcy court reduced the principal claim to present value using a 7.74%
discount rate and allowed the claim in the amount of $30.49 million. 449 F.3d at
591. The district court affirmed.
ii. Issue
“[W]hether the Bankruptcy Court erred by ‘double disounting’ when it
discounted the principal component of the claims to present value after also
having disallowed the post-petition interest portion of the claims.” 449 F.3d at
592.
iii. Holding
“We conclude that the language used in § 502(b) does not clearly and
unambiguously require discounting an interest-bearing obligation to present
value in light of the words’ plain meanings and the language used elsewhere in
the Bankruptcy Code. The Bankruptcy Court erred: Interest-bearing debt should
not be discounted to present value after unmatured interest has been disallowed
pursuant to § 502(b)(2).” 449 F.3d at 603. “We do not hold here that 11 U.S.C. §
502(b) never authorizes discounting a claim to present value, but instead that the
statute does not clearly and unambiguously require it for all claims evalueated
under § 502.” 449 F.3d at 598. “Once the Bankruptcy Court disallowed postpetition
interest pursuant to § 502(b)(2), the legislative history of the provision,
the economic reality of the transaction, and fundamental tenets of bankruptcy law
do not permit further discounting of the principal.” 449 F.3d at 599.
iv. Rationale
The preamble of 11 U.S.C. § 502(b) requires the court to “determine the
amount of such claim…as of the date of the filing of the petition.” This raises the
question whether after unmatured interest is disallowed under 11 U.S.C. §
502(b)(2), the court must present value the stream of principal payments, and
section 502(b) is “far from clear and unambiguous.” 449 F.3d at 593. The
remainder of the Bankruptcy Code refers to “’value, as of’ to signify discounting
to present value and ‘amount’ and ‘value’ are not synonymous.” 449 F.3d at 595.
The legislative history of section 502(b)(2) provides:
“’Section 502(b) thus contains two principles of present law. First,
interest stops accruing at the date of the filing of the petition, because
any claim for unmatured interest is disallowed under this paragraph.
Second, bankruptcy operates as the acceleration of the principal
amount of all claims against the debtor. One unarticulated reason for
this is that the discounting factor for claims after the commencement
of the case is equivalent to [the] contractual interest rate on the claim.
Thus, this paragraph does not cause disallowance of claims that have
not been discounted to a present value because of the irrebutable
115

presumption that the discounting rate and the contractual interest rate
(even a zero interest rate) are equivalent.’”
449 F.3d at 600 (quoting H.R. Rep. No. 95-595, at 352-54 (1977), same as S.
Rep. No. 95-989, at 62-65 (1978)). From this legislative history, the Third Circuit
concludes: “To the extent that the Code in any way contemplates discounting to
present value, such discounting is not permitted where the claim is for principal
plus interest, and the interest has already been disallowed pursuant to §
502(b)(2).” 449 F.3d at 600.
v. An Easier Way
The Third Circuit struggled with the notion of when a stream of principal
payments needs to be present valued, especially after the unmatured interest is
disallowed pursuant to 11 U.S.C. § 502(b)(2). Significantly, the legislative history
quoted above provides section 502(b) does not cause disallowance of claims that
have not been present valued because of the irrebutable presumption the
discounting rate and the contract interest rate are equivalent even if the contract
rate is zero. This does not mean that a note providing for payment of its principal
amount in 10 years in a balloon payment with no interest, is not present valued if
the note was issued at a discount because the original issue discount is treated
as unmatured interest.
The Third Circuit would have had an easier time if it invoked 11 U.S.C. §
502(b)(1) which disallows a claim to the extent “such claim is unenforceable
against the debtor and property of the debtor, under any agreement or applicable
law for a reason other than because such claim is contingent or unmatured.”
Thus, when nonbankruptcy law requires that a claim be present valued, it can
only be allowed in the amount of its value as of the petition date. For example, if
A lends $1,000 to B, to be repaid in 10 years in a balloon payment, but with
interest payable at 6% per year, nonbankruptcy law would allow A to obtain a
judgment for at least $1,000 if B defaults on the first interest payment. Similarly,
if the note did not carry interest, but provided for acceleration on bankruptcy,
state law would allow a judgment for at least $1,000 if B commences a
bankruptcy case.
Another guidepost the Third Circuit could have used is the practicality of
the law providing an allowed claim for less than an entity loans a moment after it
makes the loan. In other words, if A lends $1,000 to B at 8% interest for 20
years, and B commences a bankruptcy case the next day, what is A’s claim. We
know the unmatured interest is disallowed by 11 U.S.C. § 502(b)(2). If the
$1,000 has to be present valued because it is not repayable for 20 years, then a
moment after making the loan for $1,000, A could have an allowed claim of only
about $200. If that were the law, then B should obtain that loan and go into
bankruptcy immediately to repay the $1,000 loan with $200. Clearly, the law is
not designed to produce that result.
B. When Debt is Restructured by Exchanging Debt, for Debt in the Same
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Face Amount with Different Covenants, the Difference between the New
Debt’s Trading Value and Par is not Unallowable Original Issue Discount
i. Facts.
Outside bankruptcy a distressed company issued new debentures and
stock in exchange for its old debentures in the same face amount, but with
amended provisions for interest rates, sinking funds, and maturities.
ii. History
The bankruptcy court held the amount of the new debentures would be
disallowed as unmatured interest under Bankruptcy Code section 502(b)(2) to
the extent the value of the stock and face amount of the new debentures
exceeded the market value of the old debentures when exchanged. In re
Chateaugay Corp., 109 B.R. 51 (Bankr. S.D.N.Y. 1990), aff'd without analysis,
130 B.R. 403 (S.D.N.Y. 1991).
iii. Analysis
Chateaugay Corp. was wrong for numerous reasons. Primarily, no
"original issue discount" is created when new debt is exchanged for old debt of
the same amount.
Chateaugay Corp. caused immense damage to large and small
companies and their creditors attempting to restructure public and private debt
outside bankruptcy. Holders of public debentures were deterred from
exchanging debentures because the new debentures would not be allowable
claims in their full amounts, even when the old debentures would be. Holders of
private debt, such as banks and insurance companies, ran the risk that amending
old notes to change interest rates, amortization schedules, and maturities would
render the new or amended notes subject to partial disallowance. Indeed,
Chateaugay Corp. would have compelled that result.
iv. In re Chateaugay Corp., 961 F.2d 378 (2d Cir. 1992); In re
Pengo Industries, Inc., 962 F.2d 543 (5th Cir. 1992).
The United States Courts of Appeal for the Second and Fifth Circuits have
repudiated the lower courts' decisions and held that debt for debt exchanges do
not create new original issue discount disallowable in bankruptcy cases.
Neither appellate court ruled on whether a debt for equity exchange as
was consummated in In re Allegheny Int'l, Inc., 100 B.R. 247 (Bankr. W.D. Pa.
1989) (debt exchanged for preferred stock), could result in original issue discount
disallowable in bankruptcy. Indeed, there is no reason why it should not if the
face amount of the debt exceeds the market value of the capital stock being
exchanged.
v. The Constant Interest Method Measures Original Issue
Discount
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Finally, the Second Circuit affirmed that portion of Chateaugay Corp. (and
thereby disapproved that portion of Allegheny Int'l) which determined how original
issue discount is amortized. In Chateaugay Corp., the old debt had been issued
at a discount, thereby creating actual original issue discount, the unamortized
part of which is disallowable under Bankruptcy Code section 502(b)(2). The
dispute was whether the original issue discount is amortized by an equal amount
each day (the straight line method), or whether by a slightly greater amount each
day to take into account the compounding of a constant interest rate (the
constant interest method or yield to maturity method). Because the constant
interest method better describes economic reality, the Second Circuit adopted
that method.
9. Limits and Extensions of Official Unsecured Creditors' Committee v. Stern (In re
SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993)
A. Official Unsecured Creditors' Committee v. Stern (In re SPM
Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993)
i. Facts
The statutory creditors' committee representing creditors owed $5.5 million
determined a reorganization under existing management was unfeasible and a
liquidation would leave nothing for any creditor other than the secured
claimholder. 984 F.2d at 1307-1308. The committee agreed with the creditor
holding a $9 million claim secured by all estate assets except certain
encumbered real estate that the two entities would cooperate to (i) take all
actions reasonably necessary to replace the debtor's chief executive officer, (ii)
formulate a joint chapter 11 plan, and (iii) negotiate in good faith to reach
mutually acceptable agreements with respect to a number of details of the plan.
984 F.2d at 1307n.2, 1308. The secured creditor agreed to allocate the net
proceeds it obtains in reorganization or liquidation between itself and the
committee according to a schedule under which the committee obtains 10% of
the first $3 million, 20% of the next $3 million, 30% of the next $3 million, $40%
of the next $3 million, and 100% of any further proceeds the secured creditor
obtains. 984 F.2d at 1308.
The Internal Revenue Service held a $750,000 unsecured priority tax
claim for unpaid withholding taxes certain insiders would be responsible for if not
paid by the debtor. 984 F.2d at 1307. The IRS is not a party to the appeal and
appears not to have participated in the bankruptcy court. The insiders who were
the owners and served as the president and chairperson of the board did appear
as appellees in opposition to the committee’s agreement. 984 F.2d at 1307.
The committee filed the agreement as an exhibit to a motion, and the court
expressed concern and characterized the agreement as a ‘tax-avoidance’
scheme. 984 F.2d at 1308. At no time did any creditor or insider object to the
agreement and it was never formally approved or disapproved until a chapter 7
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trustee requested that the secured claimholder turn over to the estate the funds
allocable to unsecured claimholders under the agreement. Id.
The agreement expressly stated the committee was making the
agreement on behalf of general unsecured creditors "exclusive of the Internal
Revenue Service and potential 'insider' creditors." 984 F.2d at 1308.
When the case was converted to chapter 7, the chapter 7 trustee opposed
a joint motion of the secured claimholder and the committee to distribute the
secured claimholder's net proceeds in accordance with the agreement. The
bankruptcy court ruled the proceeds allocable to the committee should go to the
estate for distribution in accordance with chapter 7 priorities including the Internal
Revenue Service. 984 F.2d at 1309. The bankruptcy court treated the joint
motion as a motion to approve the agreement and refused to grant it. 974 F.2d
at 1309n.5. The district court affirmed. 974 F.2d at 1310.
ii. Issue
Did the bankruptcy court err as a matter of law in ordering the secured
claimholder to pay a portion of its secured interest to the chapter 7 estate as
opposed to the unsecured claimholders under the agreement? 974 F.2d at 1310.
iii. Holding
The court of appeals reversed and vacated the bankruptcy court's award
of the committee's allocation to the estate.
“…While a creditors’ committee and its members must act in accordance
with the provisions of the Bankruptcy Code and with proper regard for the
bankruptcy court, the committee is a fiduciary for those it represents, not for the
debtor or the estate generally.” 974 F.2d at 1315.
“The creditors’ committee is not merely a conduit through whom the debtor
speaks to and negotiates with creditors generally. On the contrary, it is
purposely intended to represent the necessarily different interests and concerns
of the creditors it represents. It must necessarily be adversarial in a sense, tough
its relation with the debtor may be supportive and friendly. There is simply no
other entity established by the Code to guard those interests. The committee as
the sum of its members is not intended to be merely an arbiter but a partisan
which will aid, assist, and monitor the debtor pursuant to its own self-interest.”
974 F.2d at 1316.
“…We conclude, therefore, that the bankruptcy court erred as a matter of
law insofar as it felt that the Committee was under a particular duty to negotiate
the sharing provision of the Agreement for the benefit of the estate as a whole.”
974 F.2d at 1316.
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The appellate court noted the secured lender was willing to abide by its
agreement, and that the issue of the agreement's enforceability was not before it.
974 F.2d at 1318.
Additionally, the court of appeals ruled the committee's allocable portion of
the proceeds was not estate property once the automatic stay terminated and the
court ordered the sale proceeds distributed to the creditor, and therefore the
bankruptcy court had no jurisdiction to order its return to the estate. 974 F.2d at
1313. Therefore, the matter was remanded for the bankruptcy court to determine
whether the estate or the secured lender should be responsible for distributing
the committee's allocation, with the appeals court warning that appellant had not
pointed to any basis in the Bankruptcy Code for authorizing, let alone requiring,
the bankruptcy court or trustee to administer a distribution of nonestate funds
pursuant to a private agreement. 974 F.2d at 1319.
iv. Rationale.
The court of appeals explained the committee is not a fiduciary for the
debtor or estate as a whole. Rather, it is a fiduciary only for those whom it
represents. "It is charged with pursuing whatever lawful course best serves the
interests of the class of creditors represented....It must necessarily be adversarial
in a sense, though its relation with the debtor may be supportive and
friendly....The committee as the sum of its members is not intended to be merely
an arbiter but a partisan which will aid, assist, and monitor the debtor pursuant to
its own self-interest." 974 F.2d at 1315-1316. Because the committee was only
obtaining a share of whatever would be distributed to the secured lender, the
court did not believe any other creditor, such as the IRS, was unfairly hurt.
In response to arguments that such agreements conflict with bankruptcy
policies, the court of appeals noted the bankruptcy court's power to disqualify
votes cast in bad faith and to reconstitute creditors' committees failing to be
properly representative enable it to control the tenor of proceedings. The court
noted the good faith requirement bars creditors from casting votes for ulterior
motives, such as coercing a higher payment from the estate, pure malice, and
advancing the interests of a competing business. 974 F.2d at 1317.
v. Implications
Prior to bankruptcy there is no law against intercreditor agreements
allocating future distributions from a bankruptcy case. Indeed, subordination
agreements do that everyday. The question becomes whether something
changes the innocuous nature of such agreements when consummated
postpetition, especially by a statutory committee.
In SPM, the agreement itself was somewhat defensive. It was drafted as
an agreement to join in a reorganization plan, when its bottom line purpose was
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to evade the requirements of a plan in 11 U.S.C. § 1129(a)(9)(C) that the priority
tax claim be paid in full. Thus, the agreement actually contemplated a liquidation
in chapter 7.
The agreement entered into in SPM diminished the committee's incentive
to avoid the secured lender's lien, albeit there is nothing in the decision to
suggest that was possible. Moreover, it flat out committed the committee to try to
replace management. If the committee entered into that commitment to obtain
compensation for creditors rather than because it believed management was
subpar, Bankruptcy Rule 9011 would be implicated if the committee filed motions
to replace management without good grounds therefor. There is nothing to
suggest it did.
Notably, the decision shows that creditors not represented by a statutory
committee can not count on the committee to police the case. The creditors will
have to do so themselves, usually at their own expense. Additionally, the
bankruptcy court was never asked to approve the agreement until the time came
to disburse the funds. Therefore, whether the committee had a good basis to join
forces with the secured lender and perhaps not vigorously attack the security
interests was never tested. Other creditors may not have known about the
agreement.
Finally, it is not clear the committee had the capacity to enter into the
agreement, to be held to it, or to bind its constituency to it. But, the committee
was able to fulfill the agreement’s requirements to the creditor. The agreement
also provided no mechanism to resolve any disputed creditors’ claims before
distributions of the amount obtained from the secured claimholder. The appellate
court suggested strongly that the bankruptcy court should not be used to
implement a private agreement to distribute nonestate funds. Had the funds
been deemed estate funds, then they would have to be paid to the IRS instead to
general unsecured claimholders. Accordingly, where should the committee
litigate disputed unsecured claims? What funds are to be used to compensate
committee attorneys for resolving the claims?
B. In re Armstrong World Industries, 432 F.3d 507 (3d Cir. 2005)
v.Facts
The debtor, Armstrong, negotiated a chapter 11 plan in its mass tort
asbestos case. Pursuant to the proposed plan, general nonasbestos creditors
would recover approximately 59.5% of their $1.651 billion of claims, while the
asbestos claims and demands would initially recover 20% of their claims from a
fund of $1.8 billion, and shareholders would receive warrants worth $35 million to
$40 million. 432 F.3d at 509. The proposed plan provided that if the
nonasbestos claimants rejected the plan the warrants would be distributed to the
asbestos claimants; provided further, that the asbestos claimants would
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automatically waive receipt of the warrants which would then be issued to the
shareholders. Id.
Although the commercial creditors’ committee initially approved of the
proposed plan, it later withdrew support largely because Armstrong would have
to pay only up to $805 million (instead of $1.8 billion) for asbestos claims if
Congress passed asbestos legislation. The class of commercial creditors then
rejected the plan and the commercial creditors’ committee objected to
confirmation on the ground it violated the absolute priority rule and because
commercial creditors would have a greater return if the legislation passed. 432
F.3d at 510.
The bankruptcy court recommended confirmation of the proposed plan on
the ground the waiver by the class of asbestos claimants did not violate the
absolute priority rule, and because the commercial creditors’ committee waived
its right to object to the plan when it entered into a consensual plan providing for
the waiver. 432 F.3d at 510. The district court denied confirmation on the
ground it violated the absolute priority rule and because no equitable exception to
the absolute priority rule applied. In re Armstrong World Indus., Inc., 320 B.R.
523 (D. Del. 2005).
vi. Issues
Does the absolute priority rule apply when the rejecting class is not an
intervening class between the class yielding value to a junior class and the junior
class?
Is the absolute priority rule violated when an accepting class of claims
having dissenting members (Class 7) agrees to transfer a portion of its
distribution to an equity class (Class 12) when a co-equal class of claims (Class
6) rejects the plan?
Is there a basis to create an equitable exception to the absolute priority
rule when (a) the creditors’ committee negotiates, endorses, and then withdraws
support for the plan, (b) the transfer to the junior class does not come at the
expense of the rejecting class, (c) the transfer to the junior class is of a relatively
small value, (d) the rejecting class has a majority in number (though not in
amount) accepting the plan, and (e) the rejecting class caused delay?
vii. Holdings
“…The plain language of the statute makes it clear that a plan cannot give
property to junior claimants over the objection of a more senior class that is
impaired, but does not indicate that the objecting class must be an intervening
class.” 432 F.3d at 513.
“…In turn, Class 7 automatically waived the warrants in favor of Class 12,
without any means for dissenting members of Class 7 to protest. Allowing this
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particular type of transfer would encourage parties to impermissibly sidestep the
carefully crafted strictures of the Bankruptcy Code, and would undermine
Congress’s intention to give unsecured creditors bargaining power in this context.
See H.R. Rep. No. 95-595, at 416, reprinted in 1978 U.S.C.C.A.N. 5963, 6372 (‘
[Section 1129(b)(2)(B)(ii)] gives intermediate creditors a great deal of leverage in
negotiating with senior or secured creditors who wish to have a plan that gives
value to equity.’).” 432 F.3d at 514-515.
“In addition, our application of equitable considerations in Penn Central
[596 F.2d 1127, 1142 (3d Cir. 1979)] did not mean that the absolute priority rule
was abandoned. Rather, we held firm to the idea that the rule still ‘required…that
provision be made for satisfaction of senior claims prior to satisfaction of junior
claims.’ Id. at 1153.” 432 F.3d at 517.
iv. Analysis
Armstrong, at its core, bars the expansion of SPM to enable an accepting
class with dissenting members or an accepting class having less than a
unanimous vote, to cause a portion of its distribution to be transferred to a junior
class when a class senior to the junior class rejects and is not paid in full.
Armstrong also answers the question as to whether the absolute priority
rule should be modified, as a matter of policy, to allow a class to transfer value to
a junior class when a senior class rejects. Armstrong explains, using legislative
history, that such a modification would deprive creditors of the negotiating
leverage Congress gave them with the absolute priority rule. One can easily
conjure up scenarios in which debtors or equity classes could use such a
modification to condition their proposal of a chapter 11 plan on a creditors’ class
agreement to transfer value to equity. This possibility would, in turn, cause
uncertainty in the capital markets as to how to value the creditor claims and
result in inefficient asset allocation.
C. Limits and Extensions of SPM
i. After Armstrong, Secured Claimholders Can Still Voluntarily Cede
Collateral Proceeds to General Creditors, Skipping Priority Creditors (In
re World Health Alternatives, Case No. 06-10166 (Bankr. D. Del., July 7,
2006))
In In re World Health Alternatives, Case No. 06-10166 (Bankr. D. Del.,
July 7, 2006), the prepetition secured lender granted a postpetition loan subject
to the right of creditors to challenge the allowability of its prepetition claim within
certain time limits. The rights of all creditors other than the statutory creditors’
committee to challenge the claim expired. Meanwhile, the debtor moved to sell
substantially all the estate’s assets and the prepetition lender attempted to be the
stalking horse bidder.
Subject to bankruptcy court approval, the committee agreed to withdraw
its objection to the sale and to some of the prepetition lender’s liens and to
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elease certain claims, in exchange for $1.625 million from the lender, which the
committee could use to prosecute actions to benefit all creditors of the estate or
to distribute to the general prepetition creditors, skipping the IRS tax claim in
excess of $4 million. Prior to an uncontested conversion of the case to chapter
7, the debtors and the committee requested approval of the agreement over the
United States trustee’s objection. The IRS did not object.
The crux of the United States trustee’s objection was that the committee
“isnot authorized to borrow and/or compromise estate claims and causes of
action at the expense of priority creditors in chapter 11.” Slip Op. at 12. The
bankruptcy court overruled the objection, holding:
“Although the general unsecured creditors will receive money
before the priority creditors, that money does not belong to the
estate – it belongs to CapSource. See Official Comm. of
Unsecured Creditors v. Stern (In re SPM Mfg. Corp.), 984 F.2d
1305, 1313 (1st Cir. 1993). In other words, the payout to the
general unsecured creditors is a carve out of the secured creditor’s
lien and not estate property. I believe the Bankruptcy Code does
not prohibit this arrangement and reported cases so hold. Id. at
1313.”
Slip. op. at 12-13. The bankruptcy court explained Armstrong did not apply
because the settlement World Health was not arising in a chapter 11 plan
implicating the absolute priority rule, the secured lender could distribute its own
proceeds, and the distribution was a carve out from the lien. Slip. op. at 15-16.
Notably, parties should not and can not be allowed to evade the absolute
priority rule by doing something in a court approved settlement as opposed to a
plan. But, the bankruptcy court’s other rationales for approving the settlement
are valid because unlike Armstrong where creditors were being compelled to part
with a portion of their entitlements, in World Health the secured lender was doing
it voluntarily.
The United States trustee’s most potent argument was that the estate’s
defenses and causes of action should not be used to benefit general creditors
before priority creditors. Significantly, the IRS could have prevented that result
by itself objecting to the lender’s liens and thereby placing itself in the way of a
deal between the lender and the committee. It allowed its rights to expire. The
bankruptcy court did not take sides on the issue of whether the committee owed
fiduciary duties to priority creditors contrary to substantial authority,158 but did
opine that refusal to approve the settlement would only help the secured lender.
158 In re SPM, 984 F.2d 1305 ,1316 (1st Cir. 1993); Official Dalkon Shield
Claimants’ Comm. v. Mabey (In re A.H. Robins Co.), 880 F.2d 769, 771 (4th Cir.
1989); In re Int’l Swimming Pool Corp., 186 F.Supp. 63, 64 (S.D.N.Y. 1960);
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ii. Transferring Property Outside a Chapter 11 Plan May Be Permissible
when The Same Transfers Inside a Plan May be Barred
In SPM, the secured claimholder transferred a portion of its collateral
proceeds in chapter 7 and the appeals court approved it while questioning
whether the bankruptcy court could be further involved in the actual distribution of
funds and determination of claims of the unsecured claimant recipients. 974
F.2d at 1319.
In In re Sentry Operating Co. of Texas, 264 B.R. 850 (Bankr. S.D. Tex.
2001), the secured claimholder allowed a portion of its collateral to be paid to one
of two classes of unsecured claims pursuant to a proposed chapter 11 plan. The
recipient class would receive 100% recovery while the other class would receive
a 1% recovery. 264 B.R. at 855. The debtor’s rationale for the different
treatment was that the class being paid 100% contained local trade creditors and
the funeral home operations would terminate or suffer if they were not paid. The
court found the debtor’s president’s testimony to that effect credible and true.
264 B.R. at 856.
The court ruled the rationale for separate classification was valid, but the
actual classification was invalid under 11 U.S.C. § 1122 because the class being
paid 100% contained many national creditors whose payment was not tied to
maximizing the value of estate assets. 264 B.R. at 861. The court also held the
different treatment of the two classes of unsecured claims constituted unfair
discrimination under 11 U.S.C. § 1129(b) because a secured creditor can not
decide which creditors get paid without reference to fairness. 264 B.R. at 865.
Accordingly, while no law prevents the secured creditor from paying
certain local trade creditors outside a chapter 11 plan, putting their payment into
the plan made a difference. The dilemma faced by the debtor was likely that
without a separate classification in the plan, it would not obtain an impaired
accepting class of unsecured claims for purposes of 11 U.S.C. § 1129(a)(10).
But, the plan could easily have impaired the secured claimholder who could
provide the impaired accepting class.
Similarly, in In re Snyders Drug Stores, Inc., 307 B.R. 889 (Bankr. N.D.
Ohio 2004), the chapter 11 plan proposed by the debtor and creditors’ committee
contained 3 classes of unsecured claims: one for reclamation claimants, one for
trade creditors, and one for landlord claims. The reclamation claimants would
receive 27% distributions, the trade creditors 6-7%, and the landlords 0%. 307
B.R. at 892. The plan proponents argued against an unfair discrimination
objection that the return to the unsecured claims was not property of the estate.
The court ruled it was and sustained the objection, reasoning SPM did not apply
Creditors’ Comm. of Trantex Corp. v. Baybank Valley Trust Co., (In re Trantex
Corp.), 10 B.R. 235, 238 (Bankr. D. Mass. 1981).
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ecause its distribution was outside a plan and was not from property of the
estate. 307 B.R. at 896.
iii. Some Courts Allow Senior and Secured Creditors to Use Chapter 11
Plans to Reallocate Their Distributions to Other Creditors Not Otherwise
Entitled to Them
By contrast, in In re Parke Imperial Canton, Ltd., 1994 Bankr. LEXIS 2274
(Bankr. N.D. Ohio 1994), two secured claimholders proposed a chapter 11 plan
under which the estate’s hotel leasehold would be sold with the proceeds
allocated to the secured claimholders, except for amounts a secured claimholder
may use to satisfy its guaranty to one class of unsecured claimholders that it
would receive at least a 10% return. The court did not sustain an objection that
the plan discriminated unfairly by providing one class of claims a 10% guarantee,
reasoning that the guarantee would not be paid from estate assets and was
allowed under SPM. 1994 Bankr. LEXIS 2274 at *32-33.
Similarly, in In re MCorp Financial, Inc., 160 B.R. 941 (S.D. Tex. 1993),
the court confirmed a chapter 11 plan under which the FDIC received a
distribution of $33.054 million in settlement of its claims against the estate and
the estate’s counterclaims, 160 B.R. at 948, based on the rationale that the FDIC
could receive a higher distribution than the estate’s subordinated bondholders
who were subordinate to senior bondholders, but not to the FDIC, based on
SPM. 160 B.R. at 960. Because the senior bondholders accepted the plan
under which the FDIC received a distribution that would otherwise have
increased only the senior bondholders’ distribution, the court confirmed the plan,
reasoning: “That the creditor [in SPM] was secured is not relevant; it was the
creditor’s status as prior to the IRS that allowed it to share with those under the
IRS, just as the seniors’ priority over the juniors allows them to fund the FDIC
settlement.” 160 B.R. at 960.
Citing MCorp and SPM, In re Genesis Health Ventures, Inc., 266 B.R. 591
(Bankr. D. Del. 2001), overruled an objection to classification under a chapter 11
plan that separately classified punitive damage claims from other unsecured
claims and provided no distribution to the punitive damage claims (except from
insurance proceeds) while providing a 7.34% dividend in stock to other
unsecured claims, because the secured claimholders held liens against all estate
assets and were not being paid in full. 266 B.R. at 598, 601-602.
Notably, while the foregoing decisions allow secured and senior
claimholders to use a chapter 11 plan to distribute distributions of theirs to other
creditors, they do not explicitly hold such distributions are exempt from
classification and unfair discrimination restrictions.
10. What are the Standards for Substantive Consolidation?
A. Credit Suisse First Boston v. Owens Corning (In re Owens Corning), 419
F.3d 195 (3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., August
126

23, 2005), cert. den. 2006 U.S. LEXIS 3492, 3493 (U.S., May 1, 2006)
i. Facts.
Owens Corning (“OC”) and its subsidiaries and limited liability companies
comprised a multinational corporate group. Members of the group existed for
different reasons such as to limit liability concerns, to gain tax benefits, or for
regulatory reasons. Each entity observed corporate formalities, maintained its
own business records, and documented intercompany transactions. There may
have been some sloppy bookkeeping. But, two officers testified the financial
statements of all subsidiaries were accurate in all material respects. Credit
Suisse First Boston v. Owens Corning (In re Owens Corning), 419 F.3d 195, 200-
201 (3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., August 23,
2005)
In 1997, OC needed a loan to acquire Fibreboard Corporation and had a
poor credit rating due to its growing asbestos liability. The banks made a loan
proposal which from the outset required guarantees from subsidiaries as credit
enhancements. The banks loaned $2 billion pursuant to a credit agreement that
had many covenants recognizing the guarantees. The credit agreement also
contained numerous covenants requiring each subsidiary to remain separate,
maintain books and records, and deal with OC without incurring losses. Id. at
201.
After OC commenced its chapter 11 case, it proposed a chapter 11 plan
premised on a “deemed consolidation” of OC with its subsidiaries, whereby there
would be no actual merger, but all the guarantees of the bank debt would be
deemed eliminated. Id. at 202.
ii. History
After the district judge tried the substantive consolidation motion, he was
recused. In re Kensington Int’l Ltd., 368 F.3d 289 (3d Cir. 2004). The new
district judge reviewed the trial record and granted substantive consolidation, but
reserved for the confirmation hearing a determination of whether the banks are
entitled to a priority or secured claim for the guarantees they would lose in the
deemed consolidation. In re Owens Corning, 316 B.R. 168 (Bankr. D. Del.
2004). The banks appealed and the appellate court denied a motion to dismiss
the appeal as interlocutory. Credit Suisse First Boston v. Owens Corning (In re
Owens Corning), 419 F.3d 195, 202-204 (3d Cir. 2005), amended, 2005 U.S.
App. LEXIS 18043 (3d Cir., August 23, 2005).
iii. Holding
Reversed. Id. at 216. Substantive consolidation must be based on the
following principles:
“(1) Limiting the cross-creep of liability by respecting entity separateness
is a ‘fundamental ground rule[].’ Kors, supra, at 410. As a result, the general
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expectation of state law and of the Bankruptcy Code, and thus of commercial
markets, is that courts respect entity separateness absent compelling
circumstances calling equity (and even then only possibly substantive
consolidation) into play.
(2) The harms substantive consolidation addresses are nearly always
those caused by debtors (entities they control) who disregard separateness. n 18
Harms caused by creditors typically are remedied by provisions found in the
Bankruptcy Code (e.g., fraudulent transfers, §§ 548 and 544(b)(1), and equitable
subordination, § 510 (c)).
(3) Mere benefit to the administration of the case (for example, allowing a
court to simplify a case by avoiding other issues or to make postpetition
accounting more convenient) is hardly a harm calling substantive consolidation
into play.
(4) Indeed, because substantive consolidation is extreme (it may
profoundly creditors’ rights and recoveries) and imprecise, this ‘rough justice’
remedy should be rare and, in any event, one of last resort after considering and
rejecting other remedies (for example, the possibility of more precise remedies
conferred by the Bankruptcy Code).
(5) While substantive consolidation may be used defensively to remedy
the identifiable harms caused by entangled affairs, it may not be used offensively
(for example, having a primary purpose to disadvantage tactically a group of
creditors in the plan process or to alter creditor rights).” Id. at 211.
“The upshot is this. In our Court what must be proven (absent consent)
concerning the entities for whom substantive consolidation is sought is that (i)
prepetition they disregarded separateness so significantly their creditors relied on
the breakdown of entity borders and treated them as one legal entity, or (ii)
postpetition their assets and liabilities are so scrambled that separating them is
prohibitive and hurts all creditors.” Id at 211.
“Proponents of substantive consolidation have the burden of showing one
or the other rationale for consolidation. The second rationale needs no
explanation. The first, however, is more nuanced. A prima facie case for it
typically exists when, based on the parties’ prepetition dealings, a proponent
proves corporate disregard creating contractual expectations of creditors that
they were dealing with debtors as one indistinguishable entity. Kors, supra, at
417-18; Christopher W. Frost, Organizational Form, Misappropriation Risk and
the Substantive Consolidation of Corporate Groups, 44 Hastings, L.J. 449, 457
(1993). Proponents who are creditors must also show that, in their prepetition
course of dealing, they actually and reasonably relied on debtors’ supposed
unity. Kors, supra, at 418-19. Creditor opponents of consolidation can
nonetheless defeat a prima facie showing under the first rationale if they can
prove they are adversely affected and actually relied on debtors’ separate
existence. n22 (n22 As noted already, supra n. 16, we do not decide here
whether such a showing by an opposing creditor defeats totally the quest for
consolidation or merely consolidation as to that creditor.)” Id. at 212.
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iv. Rationale
To protect prepetition expectations of creditors, the first test for
substantive consolidation allows consolidation when the debtor intentionally or
inadvertently misleads creditors into believing multiple entities are one entity. Id.
at 211 n. 19.
Owens Corning’s first test conforms to widespread jurisprudence. The
judge-made rule of substantial identity has as its most critical element that it must
connote that creditors of the various entities consider them as one entity to which
they are extending credit and the determination of substantial identity must be
based on evidence that creditors believed they were dealing with one entity and
not several different entities. See, e.g., Flora Mir Candy Corp. v. R.S. Dickson &
Co., 432 F.2d 1060, 1062 (2d Cir. 1970); In re Bonham, 229 F.3d 750, 766 (9th
Cir. 2000); Olshan v. Southern Motel Assoc., 935 F.2d 245, 249 (11th Cir. 1991).
The second test is based on the practicality that all creditors are better off
with consolidation if the value to all of them is greater than it will be if the assets
and liabilities can not be separated at an expense leaving greater value for each
creditor. Id. at 211 n. 20. “…Moreover, the benefit to creditors should be from
cost savings that make assets available rather than from the shifting of assets to
benefit one group of creditors at the expense of another. Mere benefit to some
creditors, or administrative benefit to the Court, falls far short.” Id. at 214.
There was no meaningful evidence of hopeless commingling in Owens
Corning. There was no question which entity owns which principal assets and
has which material liabilities. Id. at 214. “Neither the impossibility of perfection in
untangling the affairs of the entities nor the likelihood of some inaccuracies in
efforts to do so is sufficient to justify consolidation.” Id. at 214.
In Owens Corning, the banks “did the ‘deal world’ equivalent of ‘Lending
101’,” and undoing that bargain is a demanding task. Id. at 212. While the banks
actually did have considerable information about the subsidiary guarantors, even
if disregard of the debtors’ corporate form were proven, “we cannot conceive of a
justification for imposing the rule that a creditor must obtain financial statements
from a debtor in order to rely reasonably on the separateness of that debtor.
Creditors are free to employ whatever metrics they believe appropriate in
deciding whether to extend credit free of court oversight. We agree with the
Banks that ‘the reliance inquiry is not an inquiry into lenders’ internal credit
metrics. Rather, it is about the fact that the credit decision was made in reliance
on the existence of separate entities…” Id. at 213-214. Thus, even if Owens
Corning had made a prima facie case that creditors treated it as one entity, the
banks overcame that case with their separate guarantees and credit agreement.
Substantive consolidation was also inappropriate because (a) Owens
Corning was using it offensively to deprive the banks of voting rights in each
subsidiary and (b) Owens Corning was using it to eliminate the guarantees of the
129

ank debt rather than satisfy the Bankruptcy Code requirements of fraudulent
transfer law to avoid the guarantees. Id. at 215. “But perhaps the flaw most fatal
to … the consolidation sought was ‘deemed’ (i.e., a pretend consolidation for all
but the Banks). If Debtors’ corporate and financial structure was such a sham
before the filing of the motion to consolidate, then how is it that post the Plan’s
effective date this structure stays largely undisturbed, with the Debtors reaping all
the liability-limiting, tax and regulatory benefits achieved by forming subsidiaries
in the first place? In effect, the Plan Proponents seek to remake substantive
consolidation not as a remedy, but rather a stratagem to ‘deem’ separate
resources reallocated to OCD to strip the Banks of rights under the Bankruptcy
Code, favor other creditors, and yet trump possible Plan objections by the Banks.
Such ‘deemed’ schemes we deem not Hoyle.” Id. at 216.
“…No principled, or even plausible, reason exists to undo OCD’s and the
Banks’ arms-length negotiation and lending arrangement, especially when to do
so punishes the very parties that conferred the prepetition benefit – a $2 billion
loan unsecured by OCD and guaranteed by others only in part. To overturn this
bargain, set in place by OCD’s own pre-loan choices of organization form, would
cause chaos in the marketplace, as it would make this case the Banquo’s ghost
of bankruptcy.” Id. at 216.
B. Principles underlying Substantive Consolidation
i. Authority for Substantive Consolidation
In enacting section 302(b), Congress made clear substantive
consolidation should not be used to change creditors’ rights under the
Bankruptcy Code. As stated in In re Lewellyn, 26 B.R. 246, 250 (Bankr. S.D.
Iowa 1982):
“The section, of course, ‘is not license to consolidate in
order to avoid other provisions of the title’ to the detriment of either
the debtors or their creditors. It is designed mainly for ease of
administration. (Emphasis added). H.R.Rep. No. 595, 95th Cong.,
1st Sess. (1977), U.S.Code Cong. & Admin. News 1978, p. 5787;
S.Rep. No. 989, 95th Cong., 2d Sess. (1978),
U.S.Code Cong. & Admin. News 1978, p. 5787.”
Congress’ authorization of substantive consolidation in chapter 11
of spouses’ estates, certainly implies it chose not to authorize consolidation of
corporate estates. The only possible source of power to consolidate corporate
estates is 11 U.S.C. § 105(a), providing the “court may issue any order, process,
or judgment that is necessary or appropriate to carry out the provisions of this
title….” Union Savings Bank v. Augie/Restivo Baking Co. (In re Augie/Restivo
130

Banking Co.), 860 F.2d 515, 518 (2d Cir. 1988); FDIC v. Colonial Realty Co., 966
F.2d 57, 59 (2d Cir. 1992).
Because section 105(a) only authorizes orders carrying out the
Bankruptcy Code, orders undermining it are beyond the court’s subject matter
jurisdiction. For example, this Court recently held Congress’ enactment of 11
U.S.C. § 524(g) protecting debtors under certain circumstances from future
asbestos claims negates any section 105(a) power to protect nondebtors from
nonderivative asbestos claims. The Court ruled:
“The general grant of equitable power contained in § 105(a)
cannot trump specific provisions of the Bankruptcy Code, and must
be exercised within the parameters of the Code itself. See
generally Norwest Bank Worthington v. Ahlers, 485 U.S. 197,206
(1988) (‘Whatever equitable powers remain in the bankruptcy
courts must and can only be exercised within the confines of the
Bankruptcy Code.’) When the Bankruptcy Code provides a
specified means for a debtor to obtain a specific form of equitable
relief, those standards and procedures must be observed. See In
re Fesco Plastics Corp., 996 F.2d 152, 154-55 (7 th Cir.
1993)(‘[W]hen a specific Code section addresses an issue, a court
may not employ its equitable powers to achieve a result not
contemplated by the Code.’); Resorts Int’l v. Lowenschuss (In re
Lowenschuss), 67 F.3d 1394, 1402 (9 th Cir. 1995)(‘Section 105
does not authorize relief inconsistent with more specific law’); In re
Zale Corp., 62 F.3d at 760 (5 th Cir. 1995) (‘A § 105 injunction
cannot alter another provision of the [C]ode’).”
In re Combustion Engineering, Inc., 391 F.3d 190, 236 (3d Cir. 2004).
ii. Reasons Why All Appellate Courts Rule
Substantive Consolidation Must Be Used Only
Sparingly
Based on the wholesale frustrations of fundamental rights, statutory
rights, and commercial expectations wrought by substantive consolidation, it is
not surprising that all courts of appeal addressing the issue emphasize
substantive consolidation must be used sparingly or as a last resort. See, e.g.,
Credit Suisse First Boston v. Owens Corning (In re Owens Corning), 419 F.3d
195, 211 (3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., Aug.
23, 2005); Augie/Restivo, 860 F.2d at 518; Flora Mir, 432 F.2d at 1062; Kheel,
369 F.2d at 847; Alexander v. Compton (In re Bonham), 229 F.3d 750, 767 (9th
Cir. 2000); Reider v. FDIC (In re Reider), 31 F.3d 1102, 1109 (11th Cir. 1994).
Constitutional Right to Fair Share of Debtor’s Assets. As a threshold
matter, substantive consolidation destroys the constitutional right of a creditor to
the “equitable distribution of the debtor’s assets among his creditors,” Kuehner v.
131

Irving Trust Co., 299 U.S. 445, 451 (1937), in favor of a distribution from a
hodgepodge of multiple debtors’ assets to their aggregate liabilities “[B]ecause
every entity is likely to have a different debt-to-asset ratio, consolidation almost
invariably redistributes wealth among the creditors of the various entities. This
problem is compounded by the fact that liabilities of consolidated entities inter se
are extinguished by the consolidation.” Drabkin v. Midland-Ross Corp. (In re
Auto-Train Corp.), 810 F.2d 270 at 276 (D.C. Cir. 1987).
Right to Enforce Corporate Separateness. Likewise, substantive
consolidation destroys creditors’ rights to enforce corporate separateness absent
fraud. United States v. Bestfoods, 524 U.S. 51, 62 (1998).
Right to Enforce Intercompany Claims Regardless of Reliance.
Additionally, absent substantive consolidation, creditors can enforce claims valid
under state law regardless of whether they relied on them at all, let alone to the
trial judge’s satisfaction. Gould v. Levin (In re Credit Indus. Corp.), 366 F.2d 402,
410 (2d Cir. 1966) (“a senior creditor can enforce in bankruptcy a subordination
agreement which was executed for his benefit without alleging or proving that he
advanced funds in reliance thereon”); Kira v. Holiday Mart, Inc. (In re Holiday
Mart, Inc.), 715 F.2d 430 (9th Cir. 1983); First Nat’l Bank v. Am. Foam Rubber
Corp., 530 F.2d 450 (2d Cir. 1976).
Right to Enforce Creditor’s Claim and Intercompany Claims Absent
Wrongful Conduct. Absent substantive consolidation, any claim including a
guaranty claim can not be subordinated, let alone eliminated, unless the claimant
engaged in wrongful conduct. United States v. Noland, 517 U.S. 535 (1996);
Citicorp Venture Capital, Ltd. v. Comm. of Creditors, 160 F.3d 982 (3d Cir. 1998).
Because substantive consolidation frustrates these rights, it is reserved for
unavoidable situations involving either a hopeless commingling of several entities
assets and liabilities, or a substantial identity among several entities causing
creditors to believe they were extending credit to a group as opposed to one
entity.
iii. Substantive Consolidation is Not Based on a
Scoring System of Miscellaneous Indicia of
Corporate Overlap
Many decisions determine hopeless commingling or substantial identity
based on the number of incidences of overlap between entities, such as common
officers and directors, common headquarters, central cash management, etc.
See, e.g. In re Vecco Constr. Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va.
1980). The problem with this is that items having no real significance as to
whether the assets and liabilities can be separated or whether creditors were
misled into believing there was only one entity, are counted as meaningful.
“Too often the factors in a check list fail to separate the unimportant from
the important, or even to set out a standard to make the attempt….This often
132

esults in rote following of a form containing factors where courts tally up and spit
out a score without an eye on the principles that give the rationale for substantive
consolidation (and why, as a result, it should so seldom be in play)….” Credit
Suisse First Boston v. Owens Corning (In re Owens Corning), 419 F.3d 195, 210
(3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., Aug. 23, 2005).
iv. Use of a Subsidiary to Benefit the Parent Company
Does Not Justify Piercing the Subsidiary’s
Corporate Form
Some litigants believe that if a subsidiary does not operate to maximize its
own profit, then its corporate form need not be observed because it is not acting
like a real corporation. This contention is based on a fundamentally erroneous
premise that any ‘legitimate’ corporation must operate for its own benefit. To the
contrary, as shown below, a corporation is supposed to operate for the benefit of
its shareholder(s). In reversing substantive consolidation, Owens Corning
acknowledges that many subsidiaries were used for liability-limiting, tax, and
regulatory benefits, id. at 200, 216, all of which benefits benefited only the parent
company and not the individual subsidiaries.
“[I]n a parent and wholly-owned subsidary context, the
directors of the subsidiary are obligated only to manage the affairs
of the subsidiary in the best interests of the parent and its
shareholders.”
Anadarko Petroleum Corp. v. Panhandle Eastern Corp., 545 A.2d 1171, 1174
(Del. 1988).
“A wholly-owned subsidiary is to be operated for the benefit of
its parent. A subsidiary board is entitled to support a parent's
business strategy unless it believes pursuit of that strategy will
cause the subsidiary to violate its legal obligations. Nor does a
subsidiary board have to replicate the deliberative process of its
parent's board when taking action in aid of its parent's acquisition
strategies.”
Trenwick America Litigation Trust v. Ernst & Young, 906 A.2d 168, 174
(Del. Ch. 2006).
The foregoing rule applies except when the subsidiary is not wholly owned
and the parent is causing the subsidiary to enter into a transaction that is
beneficial to the parent at the expense of the minority shareholders of the
subsidiary. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)(business
judgment rule applies to parent’s transactions with subsidiary unless “the parent,
by virtue of its domination of the subsidiary, causes the subsidiary to act in such
133

a way that the parent receives something from the subsidiary to the exclusion of,
and detriment to, the minority stockholders of the subsidiary.”).
In Anardarko, Panhandle had spun off to its shareholders its subsidiary,
Anardarko. Anardarko sued its former directors and former parent claiming they
breached their fidicuciary duties before the spinoff by modifying various
agreements between Panhandle and Anardarko after the spinoff dividend was
declared but before it was made. The court affirmed summary judgment
dismissing the claim because prior to the spinoff, the subsidiary’s directors were
supposed to manage it in the best interests of its corporate parent.
The duty of a subsidiary to act for the best interests of its parent is so clear
and strong that the directors of the parent have a duty to stop the subsidiary from
acting in its own interests if the subsidiary’s action would be adverse to the
parent corporation and its shareholders. Grace Brothers v. UniHolding Corp.,
C.A. No. 17612, 2000 Del Ch. LEXIS 101 (Del. Ch. July 12, 2000).
“It is by no means a novel concept of corporate law that a whollyowned
subsidiary functions to benefit its parent. n. 31 (n 31 E.g.,
Stenberg v. O’Neil, Del. Supr., 550 A.2d 1105, 1124 (1988);
Anadarko Petroleum Corp. v. Panhandle Eastern Corp., Del. Supr.,
545 A.2d 1171, 1174 (1988)). To the extent that members of the
parent board are on the subsidiary board or have knowledge of
propsosed action at the subsidiary level that is detrimental to the
parent, they have a fiduciary duty, as part of their management
responsibilities, to act in the best interests of the parent and its
stockholders.”
Grace Brothers v. UniHolding Corp., C.A. No. 17612, 2000 Del Ch. LEXIS 101 at
*40 (Del. Ch. July 12, 2000).
It is considered settled law that:
“(1) ‘a parent does not owe a fiduciary duty to its wholly owned
subsidiary,’ and (2) ‘in a parent and wholly-owned subsidiary
context, the directors of the subsidiary are obligated only to
manage the affairs of the subsidiary in the best interests of the
parent and its shareholders.’”
Shaev v. Wyty, C.A. No. 15559, 1998 Del. Ch. LEXIS 2, at *7 (Del. Ch. Jan. 6,
1998)(quoting Anadarko Petroleum Corp. v. Panhandle Eastern Corp., Del.
Supr., 545 A.2d 1171, 1174 (1988)).
134

v. Use of a Subsidiary to Benefit the Parent Directly or
Indirectly Does Not Justify Avoidance of
Intercompany Debt
Based on the foregoing principle that a subsidiary has a duty to act to
benefit its parent corporation, directly or indirectly, when a parent corporation
sells assets to its subsidiaries in exchange for intercompany debt, creditors of the
subsidiaries are not entitled to avoidance of the intercompany debt as would
occur in a substantive consolidation unless the incurrence of the debt is actually
avoided in a fraudulent transfer action. Creditors are not entitled to avoidance of
the debt on the ground they would have preferred that the parent have made a
capital contribution to the subsidiary.
The jurisprudence shows clearly that a parent company has no duty to a
subsidiary’s creditors to make capital contributions of assets rather than sell
assets to a subsidiary. That directors of each subsidiary owe duties to its
shareholder and not its creditors is well ingrained in the jurisprudence cited
above.
For instance, Revlon tried to defeat a hostile tender offer by granting a
“white knight” a lock up option on certain of Revlon’s businesses. Revlon Inc. v.
MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 175-176, 182 (Del. 1986).
In exchange, Revlon obtained the white knight’s commitment to support the par
value of certain of Revlon’s debt securities issued in an early phase of Revlon’s
takeover defense. Id. at 182-184. The Delaware Supreme Court invalidated the
lock up option on the ground that once Revlon’s takeover was inevitable, the
directors breached their duty of loyalty to shareholders by preferring the interests
of debtholders over obtaining the highest price for shareholders. Id. at 182;
accord Pittelman v. Pearce, 8 Cal. Rptr. 2d 359 (1992); C-T of Virginia, Inc. v.
Barrett, 124 B.R. 689, 692-293 (W.D. Va. 1990) (holding that directors owed no
fiduciary duties to creditors in connection with leveraged buyout since one
directors “determined that the best way to serve shareholder interests was to
place the firm on the market….the directors’ duties were limited … to gain[ing]
the highest price for its shareholders. [This] duty cannot extend to the interests
of current or future unsecured creditors of the company.”).
Similarly, following the sale of Federated Department Stores, a debtholder
sued the company for causing the downgrading of its debt in violation of its duty
of good faith and fair dealing. The debtholder lost on the ground it was entitled to
no greater protection than that provided in its indenture. Hartford Fire Ins. Co. v.
Federated Dep’t Stores, 723 F. Supp. 976, 992 (S.D.N.Y. 1989); accord
Metropolitan Life Ins. v. RJR Nabisco Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989);
Harff v. Kerkorian, 324 A.2d 215 (Del. Ch. 1974).
Owens Corning tried to use substantive consolidation to eliminate its
subsidiaries’ guarantees of the bank debt rather than satisfy the Bankruptcy
135

Code requirements of fraudulent transfer law to avoid the guarantees, id. at 215,
and the court rejected the tactic because substantive consolidation was being
deployed as a sword and not as a shield. Id. at 216.
Similarly, Owens Corning’s effort to have the intercompany debt
eliminated in substantive consolidation on the ground the accounting was
imperfect was rejected, with the appellate court ruling the trial court could
oversee an accounting process that would sufficiently account for the claims. Id.
at 215.
It has long been the law that when one subsidiary has a claim against
another, the creditors of the first subsidiary can block a substantive consolidation
of the subsidiaries to protect their rights to their subsidiary’s intercompany claim.
Flora Mir Candy Corp. v. R. S. Dickson & Co. (In re Flora Mir Candy Corp.), 432
F.2d 1060, 1062-1063 (2d Cir. 1970).
vi. Use of Subsidiaries to Minimize Taxes Does Not
Render Their Corporate Form Illegitimate
Organizing a corporate group to legally minimize the group’s tax
burden is consistent with the directors’ fiduciary duties. It is well settled that
directors are required to act on behalf of the corporation as would “ordinarily
prudent and diligent men . . . under similar circumstances. . . .” Briggs v.
Spaulding, 141 U.S. 132, 152 (1891). In furtherance of this fiduciary duty of care,
“Delaware law imposes on a board of directors the duty to manage the business
and affairs of the corporation. 8 Del.C. § 141(a). This broad mandate includes a
conferred authority to set a corporate course of action, including time frame,
designed to enhance corporate profitability.” Paramount Communications, Inc. v.
Time Inc., 571 A.2d 1140, 1150 (Del.1989) (emphasis added). It is self evident
that a principal way to “enhance corporate profitability” is to reduce expenses,
including the payment of unnecessary taxes.
“There is nothing sinister in arranging one’s affairs so as to
minimize taxes.” Sullivan v. United States of America, 618 F.2d 1001, 1007 (3d
Cir. 1980) (citing Comm’r v. Newman, 159 F.2d 848, 850 (2d Cir. 1947) (Hand,
J., dissenting) (“[O]ver and over again courts have said that there is nothing
sinister in so arranging one’s affairs as to keep taxes as low as possible.
Everybody does so, rich or poor; and all do right, for nobody owes any public
duty to pay more than the law demands: taxes are enforced exactions, not
voluntary contributions. To demand more in the name of morals is mere cant.”);
Gregory v. Helvering, 293 U.S. 465, 469 (1935) (“The legal right of a taxpayer to
decrease the amount of what otherwise would be his taxes, or altogether avoid
them, by means which the law permits, cannot be doubted.”); Comm’r v. First
Sec. Bank of Utah, 405 U.S. 394, 398 n.4 (1972) (“Taxpayers are, of course,
generally free to structure their business affairs as they consider to be in their
best interests, including lawful structuring (which may include holding companies)
to minimize taxes.”).
vii. Substantive Consolidation Can Not Be Ordered
136

Based on a Balancing of Benefits and Burdens
As Nesbit v. Gears Unlimited, Inc., 347 F.3d 72, 86 n. 7 (3d Cir.
2003), observes, some courts apply a 7-factor test from In re Vecco Constr.
Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980). Vecco suffers from two
defects: 1. it involved no controversy, and 2. it cited no authority for its “liberal
trend.”
In 1979, with the effectiveness of the Bankruptcy Code, the West
Reporter first published bankruptcy court decisions. Some bankruptcy judges,
therefore, wrote decisions without pending disputes. Vecco is an example. With
no opposition, no one being harmed, everyone benefiting, and creditors having
done business with the group and not with an individual debtor, Vecco, 4 B.R. at
411, the debtors wanted to consolidate because the parent had already acquired
all the assets and assumed the liabilities of the subsidiaries, and no records of
intercompany transfers had been kept for over a year. All the assets had been
scrambled for over a year and there was no way to track the intercompany
accounts.
The facts of Vecco satisfied the stringent tests for consolidation
described above (and there was no harm and no objection), and Vecco cited the
same Second Circuit authority cited above. Instead of simply granting the
consolidation motion, the court wrote a decision without a controversy to decide.
The decision announced a “liberal trend” allowing consolidation in recent
jurisprudence it did not cite, Id. at 409, and proffered a 7-factor test. Id. at 410.
Then, Murray Industries, infra, cited Vecco and Eastgroup, infra, cited Murray
Industries and Vecco as they followed the liberal trend. Most recently, Vecco’s
purported trend has been criticized. See, e.g., World Access, 301 B.R. at 257,
n.57 (“Although certain courts have observed a ‘modern’ trend toward more
‘liberal’ application of the doctrine, see, e.g., Murray Indus., Inc., 119 B.R. at 828,
this Court is skeptical of the ‘liberal’ approach…”).
Owens Corning (419 F.3d at 209n. 15) unabashedly declares “we
disagree with the assertion of a ‘liberal trend’ toward increased use of
substantive consolidation…,” citing as examples of decisions asserting it:
Eastgroup Props. v. S. Motel Assocs., Ltd., 935 F.2d 245 (11 th Cir. 1991); In re
Murray Industries, Inc., 119 B.R. 820, 828 (Bankr. M.D. FLa. 1990), and Vecco.
Id
The problem with the so-called trend is it renders substantive
consolidation an unpredictable coin toss violating parties’ fundamental rights
which are not trendy. This is best illustrated in Eastgroup. Notably, virtually all
consolidation opinions cite the Second Circuit authorities, but some pay lip
service and some actually follow them. Eastgroup is in the former category.
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In Eastgroup, common owners set up two partnerships, SMA and
GPH. SMA procured motels by purchasing or leasing them, and then leased or
subleased the motels to GPA which operated them. Eastgroup, 935 F.2d at 246-
247. SMA charged GPH the same amount SMA had to pay in rent or mortgage
payments for its motels. Id. at 247. Their common chapter 7 trustee requested
their substantive consolidation when SMA had $861,205 and GPH had $283,917.
Id. SMA was liable for $600,000 of chapter 7 expenses and $800,000 of chapter
11 expenses. GPH was liable for $1 million of chapter 11 expenses. Its chapter
7 expenses were unknown. The upshot of this is that consolidation would make
available from SMA another $261,205 for administrative expenses generated by
GPH. Absent consolidation, the $261,205 would be available to pay accrued
chapter 11 expenses of SMA such as rent and mortgage payments owed to the
persons objecting to consolidation.
Towards the end of SMA’s tenure in chapter 11, GPH failed to pay
rent to SMA for three or four months. The treasurer testified it was likely GPH
paid some of SMA’s unsecured obligations, but she couldn’t recall any specific
instance and testified each entity had claims against the other. Eastgroup, 935
F.2d at 247 n. 8. The employees of each partnership were the same and they
didn’t allocate expenses to SMA although most of the work was for GPH. Id. at
247. SMA and GPH did hold themselves out to creditors as separate
corporations. Id. at 248. At one point, GPH represented to a contractor that
GPH owned a motel that SMA actually owned and the contractor did work for
GPH on that property. Id. Although $12 million of total claims against SMA
would have to be reduced to less than $861,205 before a distribution to equity
would be possible, the trustee who wanted consolidation testified a distribution to
SMA’s equity holders was possible depending on objections to claims. Id. at
251.
Alluding to the “‘modern’ or ‘liberal’ trend,” Eastgroup ruled “the
basic criterion by which to evaluate a proposed substantive consolidation is
whether ‘the economic prejudice of continued debtor separateness’ outweighs
‘the economic prejudice of consolidation.’” Eastgroup, 935 F.2d at 249 (quoting
In re Snider Bros., Inc., 18 B.R. 230, 234 (Bankr. D. Mass. 1982)). Then,
Eastgroup nominally adopted the Auto-Train standard, Drabkin v. Midland-Ross
Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987), which is different
than the balancing test Eastgroup sets out. Finally, Eastgroup suggests the 7factor
test from Vecco may be used to establish a prima facie case under Auto-
Train. Id. Ultimately, Eastgroup finds the parties conceded to the substantial
identity component and the court had to determine whether there were benefits
to be realized or harms to be avoided from consolidation, and whether the
objectors relied on the entities’ separate credit. Id. at 251.
Here is Eastgroup’s analysis. First, Eastgroup refers to the
testimony that GPH likely paid some SMA expenses and reasons consolidation is
beneficial because it will lessen the harm to GPH’s creditors done by GPH’s
138

payments. Eastgroup, 935 F.2d at 251. What principled rule caused the court to
focus on GPH’s possible payment of some SMA expenses, and to ignore the
certainty that GPH failed to pay SMA rent for 3 to 4 months during its chapter 11
case? What principle caused the court to ignore the fact that GPH and SMA had
claims against one another? What good will consolidation do for GPH creditors,
given that money flows first to chapter 7 administrative claims? In short,
Eastgroup’s selective benefit is wholly arbitrary and completely unprincipled and
unpredictable.
Eastgroup’s second determination is that consolidation will benefit
creditors such as the contractor who rendered services to SMA’s motel because
GPH misrepresented that GPH owned it. Eastgroup, 935 F.2d at 251.
Eastgroup says such creditors must have relied on the combined credit of both
partnerships. Id. If GPH misrepresented the facts, why should SMA’s creditors
suffer? What is the benefit of consolidation?!
Significantly, in Reider v. FDIC (In re Rieder), 31 F.3d 1102 (11 th
Cir. 1994), the Eleventh Circuit revisited the issue of substantive consolidation
and debtor misrepresentations and took a different position. There, a request
was made to consolidate a wife’s assets and liabilities with her debtor-husband’s
estate. To get credit, the husband had represented he owned property that was
actually owned by his wife. The court reversed the granting of substantive
consolidation. Reider, 31 F.3d at 1109.
Eastgroup’s third determination is that consolidation is beneficial
because it will benefit GPH’s administrative and priority creditors. Id. And
exactly why is their benefit at SMA’s creditors’ expense a net benefit of
consolidation? How does one make that judgment?
Simply put, each of Eastgroup’s reasons for consolidation is so
arbitrary and unpredictable, it shows substantive consolidation is reduced to legal
mush when reduced to a weighing test of any factors that come to mind and
disregard of the fundamental rights being violated.
viii. When Substantive Consolidation is Ordered,
Creditors Who Relied on the Separateness of an
Entity Being Consolidated Are Entitled to Priority
Claims against the Entity
In Sampsell v. Imperial Paper & Colorcorp., 313 U.S. 215, (1941),
an individual’s estate was substantively consolidated into the estate of the
corporation where he had placed his assets to hinder creditors. A creditor of the
corporation requested a priority claim to the corporation’s assets. The Supreme
Court denied it because the creditor had aided the fraudulent transfer of the
individual’s assets into the corporation, but announced the general rule:
139

“All questions of fraudulent conveyance aside, creditors of the
corporation normally would be entitled to satisfy their claims out of
the corporate assets prior to any participation by the creditors of the
stockholder.”
313 U.S. at 218 (citing Withers v. White (In re Foley), 4 F.2d 154 (9 th Cir. 1925)
and Miller v. Ehrlich (In re Smith), 16 F.2d 697 (2d Cir. 1929)).
In re Lewellyn, 26 B.R. 246, 251 (Bankr. S.D. Iowa 1982), states the rule
as follows: “There is also a rule that a creditor who relies on the sole credit of
one entity is entitled to have its claim satisfied out of that entity's assets even if
the entity is no more than a corporate pocket of a parent entity. Commerce Trust
Co. v. Woodbury, 77 F.2d 478 (8th Cir. 1935), cert. denied, 296 U.S. 614, 80 L.
Ed. 435, 56 S. Ct. 134 (1935). “
The granting of priority claims to those creditors proving they relied on
separate entities is required. See Stone v. Eacho (In re Tip Top Tailors, Inc.),
127 F.2d 284, 290 (4 th Cir. 1942), rehearing denied and priority reaffirmed, 128
F.2d 16 (4 th Cir. 1942); FDIC v. Hogan (In re Gulfco Investment Corp.), 593 F.2d
921, 929 (10 th Cir. 1979).
11. How Do ‘X-Clauses’ Work?
A. Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re Metromedia
Fiber Network, Inc.), 416 F.3d 136 (2d Cir. 2005)
i. Facts.
Subordinated noteholders of the debtor, MFN, were bound by a
subordinated indenture containing the following provisions concerning the
respective rights of the senior and junior noteholders:
“Upon the payment or distribution of the assets of [MFN n1]
of any kind or character…to creditors upon any dissolution,
winding-up, liquidation or reorganization of [MFN]…any payment or
distribution of assets of [MFN] of any kind or character…to which
the Holders [of the Notes] or the Trustee on behalf of the Holders
would be entitled…shall be paid or delivered…to the holders of the
Senior Indebtedness…”
But, the indenture exempted from subordination:
“securities of [MFN] as reorganized or readjusted, or securities of
[MFN] or any other Person provided for by a plan of reorganization
or readjustment, junior, or the payment of which is otherwise
subordinate, at least to the extent provided in this Article 12, with
respect to the Notes, to the payment of all Senior Indebtedness.”
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416 F.3d at 139.
In the MFN chapter 11 case, the senior noteholders were given a
combination of cash, common stock, and warrants (identical to the warrants
given to the subordinated noteholders), all of which together did not amount to
full payment. Id. at 140. The chapter 11 plan provided for the warrants allocated
to the junior noteholders to be channeled to the senior noteholders under the
foregoing provisions. Id.
ii. Issue.
Under the foregoing facts, are the subordinated noteholders allowed to
retain their warrants pursuant to the x-clause without impairing the priority
assured to the senior noteholders?
iii. Holding.
No. 416 F.3d at 140-141.
iv. Rationale.
“If appellants can keep their warrants, they would be able to buy the same
class of common stock allocated to the Senior Indebtedness giving appellants
and the Senior Indebtedness equal priority to any future distributions. Therefore,
allowing appellants to retain the warrants would effect an impairment of
seniority.” Id. at 140-141. Based on the American Bar Foundation’s
Commentaries on Model Debenture Indenture Provisions
(1971)(“Commentaries”), the court reasoned that “when subordinated and senior
note holders are given securities under a plan of reorganization, an X-Clause
allows the subordinated note holder to retain its securities only if the securities
given to the senior note holder have higher priority to future distributions and
dividends (up to the full amount of the senior notes). This provides for full
payment of the senior notes before any payment of the subordinated notes is
made. In such a case, the senior note holder enjoys unimpaired the priority to
payment that it had under its notes, i.e., payment on the subordinated note
holder’s securities are ‘subordinate…to the payment of all Senior Indebtedness.’”
Id. at 140 (quoting Commentaries, § 14-5 at 570).
The MFN court’s reasoning is consistent with In re Envirodyne Indus., 29
F.3d 301, 306 (7 th Cir. 1994).
v. Analysis.
The theme of the X-Clause analysis is that subordinated notes can obtain
securities allowing them cash from the debtor on a basis junior to the securities
distributed to the senior noteholders if the senior noteholders receive securities
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entitling them to distributions constituting payment in full. Otherwise, the
subordinated noteholders would have a right to a distribution when the senior
noteholders will not have been paid in full. Significantly, however, the junior
security itself may nevertheless have value that the junior noteholder can sell
immediately on receipt and thereby obtain cash before the senior noteholders are
paid in full. But, the cash the junior noteholder receives for its subordinated
security will not be cash from the debtor.
12. When Do Lease Assignments Render Appeals Moot pursuant to 11 U.S.C. §
363(m)?
A. Weingarten Nostat, Inc. v. Service Merchandise Company, Inc., 396 F.3d 737
(6 th Cir. 2005)
i. Facts.
The bankruptcy court approved the assumption and assignment of a
shopping center lease over the landlord’s objections that it was not provided
adequate assurance of future performance and the assignee was subletting
space to a store that competes directly with an existing tenant in the mall.
Weingarten Nostat, Inc. v. Service Merchandise Company, Inc., 396 F.3d 737,
739 (6 th Cir. 2005). The existing tenant’s lease allowed the tenant to reduce its
rent by a third or to terminate the lease if another tenant selling competing goods
moved into the mall. Id. The landlord had objected to the assignment under 11
U.S.C. §§ 365(b)(3)(A), 365(b)(3)(C), and 365(b)(3)(D).
The landlord vigorously sought a stay pending appeal and even a writ of
mandamus from the United States Court of Appeals for the Sixth Circuit, all of
which was denied due to the absence of probability of success on the merits
even though irreparable harm was assumed. Id. at 740.
Two days after the district court denied th e stay, the assignment
was made and a week later the sublease was executed. Then, the district court
affirmed and the landlord appealed. The assignor then moved to dismiss the
appeal under 11 U.S.C. § 363(m).
ii. Issue.
Was the appeal moot under 11 U.S.C. § 363(m) which provides:
“The reversal or modification on appeal of an authorization…of a
sale or lease of property [under § 363(b)] does not affect the validity
of a sale or lease under such authorization to an entity that
purchased or leased such property in good faith, whether or not
such entity knew of the pendency of the appeal, unless such
authorization and such sale or lease were stayed pending appeal.”
iii. Holding.
Yes. Id. at 742.
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iv. Rationale.
Even though the assumption and assignment of a lease is governed by 11
U.S.C. § 365, the assignment for a valuable consideration is a sale of property to
which section 363(m) applies. Id. at 742; Dev. Co. of America, Inc. v. Adamson
Co., Inc. (In re Adamson Co., Inc.), 159 F.3d 896, 898 (4 th Cir. 1998); LRSC Co.
v. Rickel Home centers, Inc. (In re Rickel Home Centers), 209 F.3d 291, 295 (3d
Cir. 2000).
The policy underlying section 363(m) is “to afford finality to the orders and
judgments of the bankruptcy court relied on by third parties in ordering their
affairs.” Id. at 303-304.
Some circuits apply a per se rule that the absence of a stay pending
appeal moots the appeal under section 363(m). See, e.g., Pittsburgh Food &
Beverage, Inc. v. Ranallo, 112 F.3d 645, 650-51 (3d Cir. 1997)(citing decisions in
the 1 st , 2d, 5 th , 7 th , and 11 th circuits as adopting a per se rule). The Third Circuit
holds that even if section 363(m) applies, failure to obtain a stay does not
dispose of the appeal if some remedy can be fashioned that does not disturb the
validity of the sale at issue. Krebs Chrysler-Plymouth, Inc. v. Valley Motors, Inc.,
141 F.3d 490, 499-500 (3d Cir. 1998).
B. Made In Detroit, Inc. v. Official Committee of Unsecured Creditors of Made in
Detroit, Inc. (In re Made In Detroit, Inc.), 414 F.3d 576 (6 th Cir., 2005)
i. Facts
The debtor and its creditors’ committee proposed competing chapter 11
plans. The debtor’s plan was premised on obtaining a loan to develop the
property, while the committee’s plan provided for an immediate liquidation. Made
In Detroit, Inc. v. Official Committee of Unsecured Creditors of Made in Detroit,
Inc. (In re Made In Detroit, Inc.), 414 F.3d 576, 579 (6 th Cir. 2005). The court
confirmed the committee’s plan. After every court addressing the debtor’s
request for a stay pending appeal (including the Sixth Circuit) denied the stay,
the committee closed the sale of its land and the land was subsequently resold.
Id. at 580.
ii. Issue
On appeal to the Sixth Circuit, the appeal was limited to the issue of
whether the purchaser was a good faith purchaser.
iii. Holding.
583.
The purchaser was a good faith purchaser and the appeal is moot. Id. at
iv. Rationale.
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“’Section 363(m) protects the reasonable expectations of good faith thirdparty
purchasers by preventing the overturning of a completed sale, absent a
stay, and it safeguards the finality of the bankruptcy sale.’ Official Comm. of
Unsecured Creditors v. Trism, Inc. (In re Trism, Inc.), 328 F.3d 1003, 1006 (8 th
Cir. 2003).” As a result, ‘section 363(m) maximizes the purchase price of assets
because without this assurance of finality, purchasers could demand a large
discount for investing in a property that is laden with the risk of endless litigation
as to who has rights to estate property.’” Made In Detroit, Inc. v. Official
committee of Unsecured Creditors (In re Made In Detroit, Inc.), 414 F.3d 576,
581 (6 th Cir. 2005) (quoting In re Gucci, 126 F.3d 380, 387 (2d Cir. 1997)).
A good faith purchaser is “’one who purchases the assets for value, in
good faith and without notice of adverse claims.’ In re Rock Indus. Mach. Corp.,
572 F.2d 1195, 1197 (7 th Cir. 1978).” Id. at 581. Thus, good faith and value
must be proved. In re Abbotts Dairies of Pennsylvania, Inc., 788 F.2d 143, 147
(3d Cir. 1986). “[T]o show lack of good faith, the debtor must demonstrate that
there was fraud or collusion between the purchaser and the seller or the other
bidders, or that the purchaser’s actions constituted an attempt to take grossly
unfair advantage of other bidders.” 255 Park Plaza Assocs. Ltd. P’ship v. Conn.
Gen. Life Ins. Co. (In re 255 Park Plaza Assocs. Ltd. P’ship), 100 F.3d 1214,
1218 (6 th Cir. 1996); . Made In Detroit, Inc. v. Official committee of Unsecured
Creditors (In re Made In Detroit, Inc.), 414 F.3d 576, 581 (6 th Cir. 2005).
13. Does 11 U.S.C. § 363(f) Authorize a Sale Free of a Lessee’s Possessory
Interests Preserved on Lease Rejection by 11 U.S.C. § 365(h)?
A. Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech
Steel Corp.), 327 F.3d 537 (7 th Cir. 2003)
i. Facts.
Precision had 2 prepetition agreements with the debtor, Qualitech. One
agreement was a supply agreement under which Precision would construct a
supply warehouse on Qualitech’s property and operate it for 10 years while
providing supply services. The other agreement was a 10-year land lease
providing for rent of $1 per year. It provided Precision exclusive possession of
the warehouse with a right to remove all improvements and fixtures on early
termination of the lease. At the normal maturity of the lease, Qualitech had the
right to purchase the warehouse and fixtures and other improvements for $1.
The lease was not recorded. 327 F.3d at 540.
During Qualitech’s chapter 11 case substantially all the estate assets were
sold to the secured claimholders’ for their credit bid of $180 million. Their
outstanding mortgage claim was more than $263 million. The order approving
the sale directed Qualitech to convey the assets “free and clear of all liens,
claims, encumbrances, and interests….” 327 F.3d at 541. Precision had notice
and did not object to the sale order. Id. Neither did it request adequate
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protection of its interest. 327 F.3d at 548. The sale order reserved for the
purchaser the debtor’s right to assume and assign executory contracts pursuant
to 11 U.S.C. § 365. The sale closed before assumption of either agreement, but
the parties extended the deadline for assumption on 4 occasions while
negotiating. Ultimately, the lease and supply agreement were de facto rejected.
327 F.3d at 541
Although Precision padlocked its warehouse, New Qualitech hired a
locksmith and took possession. Then, Precision filed an action with the District
Court for wrongful eviction and other relief and New Qualitech asked that it be
referred to the bankruptcy court, which it was. The bankruptcy court ruled the
sale order provided New Qualitech the assets free of Precision’s possessory
rights. 327 F.3d at 541-542. But, the District Court reversed holding 11 U.S.C. §
365(h) prevails over 11 U.S.C. § 363(f). 327 F.3d at 542. Neither party asserted
the requirements of section 363(f) were unsatisfied. 327 F.3d at 546.
ii. Holding
“With these points in mind, it is apparent that the two statutory provisions
can be construed in a way that does not disable section 363(f) vis a vis leasehold
interests. Where estate property under lease is to be sold, section 363 permits
the sale to occur free and clear of a lessee’s possessory interest – provided that
the lessee (upon request) is granted adequate protection for its interest. Where
the property is not sold, and the debtor remains in possession thereof but
chooses to reject the lease, section 365(h) comes into play and the lessee
retains the right to possess the property. So understood, both provisions may be
given full effect without coming into conflict with one another and without
disregarding the rights of lessees.” 327 F.3d at 548.
iii. Rationale
The appellate court first observed neither section 363(f) nor section 365(h)
limits the other by their terms. Second, section 365(h), by its terms, has a limited
scope insofar as it pertains to rights arising on rejection of leases. Third, section
363 provides a mechanism to protect parties whose interests may be adversely
affected by the sale of estate property. Namely, section 363(e) directs the
bankruptcy court, on request, to prohibit or condition the sale as necessary to
provide adequate protection. 327 F.3d at 547. In turn, adequate protection
does not guarantee continued possession, but does demand “the lessee be
compensated for the value of its leasehold – typically from the proceeds of the
sale.” 327 F.3d at 548. The Seventh Circuit reasoned adequate protection will
“protect the rights of parties whose interests may be adversely affected by the
sale of estate property.” 327 F.3d at 547.
As shown below, sections 363(l) and 365(h)(1)(A)(ii) do limit section 363(f)
by their terms and adequate protection protects the value of the lease when the
lease rent is less than market rent, but does not protect the lessee’s investments
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in the location such as marketing expense, employee training, nearby distribution
centers, and the like.
Significantly, the Seventh Circuit Court of Appeals adopted the following
statutory interpretation principles from decisions of the United States Supreme
Court:
“We ‘are not at liberty to pick and choose among
congressional enactments, and when two statutes are capable of
co-existence, it is the duty of the courts, absent a clearly expressed
congressional intention to the contrary, to regard each as effective.’
Morton v. Mancari, 417 U.S. 535, 551, 94 S. Ct. 2474, 2483, 41 L.
Ed. 2d 290 (1974). We should read federal statutes ‘to give effect
to each if we can do so while preserving their sense and purpose.’
Watt v. Alaska, 451 U.S. 259, 267, 101 S. Ct. 1673, 1678, 68 L. Ed.
2d 80 (1981); see also United States v. Fausto, 484 U.S. 439, 453,
108 S. Ct. 668-77, 98 L. Ed. 2d 830 (1988).”
327 F.3d at 544.
iv. Precision Industries Is Right for the Wrong Reasons:
Section 365(h) Does Not Elevate a Lessee’s Possessory Right
Above a Prior Mortgagee’s Undersecured Lien; But Sections
363(f), 363(l), and 365(h), Can Not Correctly be Interpreted to
Empower a Court to Divest a Lessee of Its Possessory Rights
under Section 365(h)
a) The Lease’s Susceptibility to Extinguishment in a
Mortgage Foreclosure Is Dispositive
Outside bankruptcy, absent a nondisturbance agreement, a lease
(including its possessory rights) can be extinguished by foreclosure of a prior
undersecured mortgage lien. Nothing in 11 U.S.C. § 365(h) grants lessees rights
to stymie senior mortgages. Indeed, the bankruptcy jurisprudence has
recognized for a long time that the lessee’s rights can be extinguished in
bankruptcy by prior undersecured mortgage liens. In re Hotel Governor Clinton,
96 F.2d 50 (2d Cir.), cert. denied, 305 U.S. 613 (1938). Any congressional effort
to subordinate senior mortgage liens to lessee rights would have created quite a
furor in commercial finance.
Therefore, Precision Industries could and should have been decided,
consistent with Hotel Governor Clinton, on the simple and narrow ground that the
lease was subject to extinguishment in foreclosure because it was subordinate to
a mortgage lien of over $263 million secured by property worth no more than
$180 million. The lease was not even recorded.
The problem with Precision Industries is its holding rested instead on an
exercise in statutory interpretation concluding broadly (and unhinged to whether
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the lease is susceptible to extinguishment in a foreclosure) that possessory rights
preserved by 11 U.S.C. § 365(h) can be extinguished by a sale of the property
under 11 U.S.C. § 363(f) as long as the lessee’s rights are provided adequate
protection under 11 U.S.C. § 363(e). Accordingly, the correctness of that
statutory interpretation is the issue.
b) The Plain Meaning of Sections 363(l) and
365(h)(1)(A)(ii) Was Disregarded
As step 1, the Seventh Circuit adopted the United States Supreme Court’s
rule that statutory interpretation begins with the words of the statute and “courts
must presume that a legislature says in a statute what it means and means in a
statute what it says there….When the words of a statute are unambiguous, then,
this first canon is also the last: ‘judicial inquiry is complete.’” Precision
Industries, 327 F.3d at 544, quoting Connecticut Nat’l Bank v. Germain, 503 U.S.
249, 253-254 (1992) (quoting Rubin v. United States, 449 U.S. 424, 430 (1981)).
It is difficult to quarrel with the Seventh Circuit’s conclusion that the literal
terms of 11 U.S.C. § 363(f) 159 authorize the sale of estate property free of the
possessory interest preserved by 11 U.S.C. § 365(h) if one only reads section
363(f) and not sections 363(l) and 365(h).
But, failure to consider the entire statutory scheme, runs afoul of hornbook
law set forth in Bank of America National Trust and Savings Association v. 203
North LaSalle Street Partnership, 526 U.S. 434, 452 (1999), that there is an
“interpretive obligation to try to give meaning to all the statutory language.” 160
This also runs afoul of the rule in United Savings Association of Texas v.
Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365 (1988), that one section
159 11 U.S.C. § 363(f) provides:
“The trustee may sell property under subsection (b) or (c) of this section
free and clear of any interest in such property of an entity other than the estate,
only if –
(1) applicable nonbankruptcy law permits sale of such property free and
clear of such interest;
(2) such entity consents;
(3) such interest is a lien and the price at which such property is to be sold
is greater than the aggregate value of all liens on such property;
(4) such interest is in bona fide dispute; or
(5) such entity could be compelled, in a legal or equitable proceeding
proceeding, to accept a money satisfaction of such interest.
160 In 203 North LaSalle, the Supreme Court rejected an interpretation of § 1129(b)(2)(B)(ii) that
would have made the words “on account of” a redundancy. Bank of America National Trust and
Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 452 (1999)
147

of a statute should not be interpreted to make another section a nullity or an
absurdity. 161
Here, Precision Industries’ interpretation of section 363(f) contradicts the
plain language of section 365(h)(1)(A)(ii) and renders sections 363(l) and 365(h),
(i), and (n) nullities and absurdities.
Section 365(h)(1)(A)(ii) provides:
(h)(1)(A) If the trustee rejects an unexpired lease of real property
under which the debtor is the lessor and –
(ii) if the term of such lease has commenced, the lessee may retain
its rights under such lease (including rights such as those relating
to the amount and timing of payment of rent and other amounts
payable by the lessee and any right of use, possession, quiet
enjoyment, subletting, assignment, or hypothecation) that are in or
appurtenant to the real property for the balance of the term of such
lease and for any renewal or extension of such rights to the extent
that such rights are enforceable under applicable nonbankruptcy
law.
161 There, an undersecured creditor contended it was entitled to relief from the automatic stay
because the debtor’s failure to pay it monthly use or interest payments on the secured portion of
its claim deprived it of adequate protection for purposes of section 362(d)(1). 484 U.S. at 368-
369. 11 U.S.C. §§ 362(d)(1)-(2) provide:
“On request of a party in interest and after notice and a hearing, the
court shall grant relief from the stay provided under subsection (a) of
this section, such as by terminating, annulling, modifying, or
conditioning such stay –
(1) for cause, including the lack of adequate protection of an interest in
property of such party in interest; or
(2) with respect to a stay of an act against property under subsection
(a) of this section, if --
(A) the debtor does not have an equity in such property; and
(B) such property is not necessary to an effective reorganization.”
The Supreme Court remarked that statutory construction is a “holistic endeavor” often
clarified by the remainder of the statutory scheme. 484 U.S. at 371. Then, it interpreted section
362(d)(1) by reference to section 362(d)(2). If an undersecured creditor not receiving use or
interest payments would be entitled to stay relief for lack of adequate protection under section
362(d)(1), then why would any creditor resort to section 363(d)(2) for stay relief which requires
both that (a) the creditor be undersecured (which assures the debtor has no equity in the
property), and (b) the property not be necessary to an effective reorganization. The Supreme
Court ruled “petitioner’s interpretation of § 362(d)(1) makes nonsense of § 362(d)(2)…..This
renders § 362(d)(2) a practical nullity and a theoretical absurdity.” 484 U.S. at 374, 375.
148

Section 365(h) makes clear that notwithstanding the debtor-lessor’s
rejection of a lease, the lessee retains is rights under the lease, including rights
of use, possession, quiet enjoyment, subletting, assignment, and hypothecation,
to the extent enforceable under nonbankruptcy law. Nonbankruptcy law is clear
that the covenant of quiet enjoyment “insulates the tenant against any act or
omission on the part of the landlord, or anyone claiming under him, which
interferes with a tenant’s right to use and enjoy the premises for the purposes
contemplated by the tenancy.” Petroleum Collections Incorporated v. Swords, 48
Cal. App. 3d 841 (1975); Friedman, Friedman on Leases, § 29.201 (“The
covenant [of quiet enjoyment] is to the effect that the tenant shall have quiet and
peaceful possession, as against the lessor or anybody claiming through or under
the lessor or anybody with a title superior to the lessor.” ) at pp. 1462-1471
(collects authorities) (3d ed. 1990). Significantly, leases lacking express
covenants of quiet enjoyment have the best covenants of quiet enjoyment
because the best covenant is implied. Friedman, Friedman on Leases, § 29.202
at p. 1468 (3d ed. 1990).
Thus, in section 365(h)(1)(A)(ii), Congress provided lessees retain their
rights to have quiet and peaceful possession against their lessors after their
leases are rejected. Congress’ choice of the word “retain” shows Congress
never intended that the nondebtor-tenant ever be deprived of the covenant of
quiet enjoyment before or after rejection of the lease. By itself, the
Congressional edict that the nondebtor-tenant retains the lessor’s covenant of
quiet enjoyment, bars lessors from invoking section 363(f) to nullify the quiet
enjoyment Congress safeguarded for them. .162 Moreover, when Congress wants
to override nonbankruptcy law, it knows how to say so. See, e.g., 11 U.S.C. §§
1123(a) and 1142(a). While it certainly appears there is nothing unclear or
ambiguous about this, at the very least this meaning of section 365(h)(1)(A)(ii)
prevents any rote determination that section 365(f) does not impinge on section
365(h) before its implications are fully analyzed.
Thus, even if the foregoing meaning of section 365(h)(1)(A)(ii) is somehow
deemed less than fully dispositive of the issue the Seventh Circuit decided in
Precision Industries, it definitely raises sufficient doubt about the Seventh
Circuit’s interpretation of sections 363(f) and 365(h) to require consideration of
the statutory scheme and whether the Seventh Circuit’s interpretation yields
absurd results.
162 Under the facts of Precision Industries, the determination to assume or reject the lease was
left for after the closing of the sale under sections 363(b) and (f). 327 F.3d at 541. Even if
section 365(h)(1)(A)(ii) is interpreted to reimpose (rather than retain or safeguard) the debtorlessor’s
covenant of quiet enjoyment, nothing in the facts suggests either party agreed to waive
the consequences of assumption or rejection. Significantly, the Seventh Circuit’s decision
squarely deals with the court’s power to order property sold free of possessory rights under
section 365(h)(1)(A)(ii) and does not turn on entry of the sale order prior to the actual rejection of
the lease.
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Notably, section 363(f) allows for sales under section 363(b) and (c) to be
free and clear of any interests in the property sold. But, section 363(l) 163 renders
all sales under section 363(b) and (c) subject to 11 U.S.C. § 365(h). While the
Seventh Circuit, whose decision does not mention section 363(l), takes comfort
from its own reading of section 365(h) that its preservation of possessory rights
only occurs on rejection of a lease, 327 F.3d at 547, every sale of property
subject to a lease is preceded by or results in the assumption or rejection of the
lease. Thus, section 363(l) is more than plausibly read to render section 363(f)
sales subject to section 365(h), even when section 365(h) is interpreted as the
Seventh Circuit interprets it to be effective only when a lease is rejected as
opposed to showing the nondebtor tenant has the benefit of the debtor-lessor’s
covenant of quiet enjoyment at all times.
Significantly, the Seventh Circuit buttresses its interpretation by observing
that while sections 363(d) and 365(a) contain cross references making certain of
their provisions subject to other statutory mandates, neither section 363(f) nor
section 365(h) contains a cross reference indicating the broad right to sell estate
property free of any interest is subordinate to the section 365(h) protections for
lessees. 327 F.3d at 547. As explained above, section 365(h) doesn’t need a
cross reference because its language declaring the lessee retains its rights to
possession and quiet enjoyment stops a debtor-lessor from exercising section
363(f). But, the Seventh Circuit’s observation is also incomplete. Not only does
it fail to mention the cross reference in section 365(l), the Seventh Circuit doesn’t
mention that in other Bankruptcy Code sections (i.e., sections 303(f), 303(k),
363(e), 363(h), 365(b)(4), 502(d), 505(c), 510(c), 522(f)(1), 522(g), 522(j), 546(e),
546(f), 546(g), 1107(b), 1112(f), 1123(d), 1125(f), 1126(f), 1126(g), 1129(b)(1),
1129(c), and 1129(d)) Congress uses the terminology ‘notwithstanding section x
of this title,’ when it wants to show that one section trumps another. Section
363(f) has no such ‘notwithstanding section 365(h)’ language to indicate
Congress wanted it to trump section 365(h).
Because Congress has used various linguistic techniques to cause one
section to curtail another, it would be incorrect to argue that because section
363(f) does not contain the language ‘notwithstanding section 365(h),’ section
363(f) can not override section 365(h). Rather, the point is that the Seventh
Circuit’s observation that sections 363f) and 365(h) do not cross reference each
163 11 U.S.C. § 363(l) provides:
Subject to the provisions of section 365, the trustee may use, sell, or lease
property under subsection (b) or (c) of this section, or a plan under chapter 11,
12, or 13 of this title may provide for the use, sale, or lease of property,
notwithstanding any provision in a contract, a lease, or applicable law that is
conditioned on the insolvency or financial condition of the debtor, on the
commencement of a case under this title concerning the debtor, or on the
appointment of or the taking possession by a trustee in a case under this title or a
custodian, and that effects, or gives an option to effect, a forfeiture, modification,
or termination of the debtor’s interest in such property.
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other is no more support for arguing section 363(f) is not curtailed by section
365(h), than section 363(f)’s lack of ‘notwithstanding section 365(h)’ language is
support for arguing section 363(f) does curtail section 365(h).
c) The Seventh Circuit’s Interpretation Yields Absurd
Results Contrary to the United States Supreme Court’s
Rule that Statutory Interpretation Should Avoid Absurd
Results
The Seventh Circuit recognized its mandate to “read federal statutes ‘to
give effect to each if we can do so while preserving their sense and purpose.’”
327 F.3d at 544, quoting Watt v. Alaska, 451 U.S. 259, 267 (1981). To that end,
the Seventh Circuit first explained section 365(h) strikes a balance between the
debtor-lessor and lessee by enabling the debtor to reject burdensome obligations
under the lease while allowing the tenant to retain possession for the term of the
lease. 327 F.3d at 546. Then, the Seventh Circuit explained that when estate
property is sold, the lessee’s possessory interest is entitled to adequate
protection, while the ability to sell free of the possessory interest is “consistent
with the process of marshaling the estate’s assets for the twin purposes of
maximizing creditor recovery and rehabilitating the debtor, which are central to
the Bankruptcy Code.” 327 F.3d at 548.
To be sure, the Seventh Circuit believed it did not reach an absurd result.
Based on the foregoing analysis, the Seventh Circuit concluded it was both
reasonable and correct to interpret and to reconcile sections 363(f) and 365(h) to
enable 365(h) to operate only on rejection while allowing the preserved
possessory interest to be extinguished in exchange for adequate protection on a
sale.
Let’s examine that analysis.
Pursuant to the Seventh Circuit’s ruling, if a debtor in possession desires
to retain property while ousting its tenant of possession, it need only reject the
lease and then propose a plan that sells the property to a new entity pursuant to
section 363(f). This can be easily manufactured. Instead of distributing to
creditors the new stock of the reorganized debtor, the plan can provide for
creation of a new entity that will purchase the property from the estate and its
stock will be distributed to the estate’s creditors.
This raises the question why Congress would preserve a lessee’s
possessory rights when its lease is rejected by the debtor-lessor, but not
preserve those rights when the debtor-lessor sells the property. The Seventh
Circuit opines the sale free and clear of the possessory rights serves the twin
bankruptcy policies of maximizing creditor recovery and rehabilitating the debtor.
This explanation does not hold up. First, a sale under which the estate must pay
the lessee the value of its leasehold may not yield more for the estate than a sale
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subject to the lessee’s possessory rights and rental obligations. Second, the sale
may occur when the debtor is not rehabilitating as was the case in Precision
Industries, 327 F.3d at 540. In fact, sections 363(f) and 365(h) apply in chapter 7
liquidation cases. Third, if those bankruptcy policies are the policies to be
served, why would they be any less applicable when the debtor does not sell the
property? It is far more likely a debtor is rehabilitating when it retains its property.
Its rehabilitation may well be enhanced if the debtor can eliminate a lessee’s
possessory rights when it has a better use for the property.
Significantly, the consequence of the Seventh Circuit’s ruling is not limited
to the fact that it will almost always enable the debtor to defeat the lessee’s
section 365(h) possessory rights by proposing a plan that transfers the
underlying property. Contrary to the comfort the Seventh Circuit took from the
adequate protection requirement in 11 U.S.C. § 363(e), the transfer of the
property will frequently result in no payment to the lessee notwithstanding that it
sustains material economic harm.
The measure of the value of a lease is the present value of the positive
difference, if any, between the market rent and the lease rent. See Connecticut
Ry. & Lighting Co. v. Palmer, 305 U.S. 493 (1939), after remand, 311 U.S. 544
(1941), reh’g denied, 312 U.S. 713 (1941). The lessee’s claim for loss of its
lease will be zero when the lease rent and market rent are equivalent. Even
when the lease rent is less than the market rent, the lessee’s damage claim does
not include components for the lessee’s economic injury by being dispossessed.
For instance, a tenant operating a retail store advertises its location, develops a
clientele in the vicinity, has trained employees whose families live in the vicinity,
and so forth. If the tenant has to move, none of these items figure in the value of
the lost leasehold. Adequate protection is designed by the terms of 11 U.S.C. §
361 to compensate for loss of the value of an interest in property. The market
value is based on a comparison of lease rent to market rent, not on the original
lessee’s individual investment in advertising, clientele, employee training, and the
like.
Thus, the value Congress preserved for lessees in section 365(h), is not
reimbursed to them under section 363(e). But, under the Seventh Circuit’s
holding, lessees retain this value if the debtor’s estate does not sell the property,
but do not retain it if it does sell. As a practical matter, if Congress had only
intended to preserve for lessees the value of their leaseholds, Congress could
quite simply have provided them administrative claims for the values of their
leases when rejected, regardless of whether the estate sells the property.
Congress did not have to give them the right to retain possession if Congress
was only concerned about furnishing them their leasehold values. Clearly,
Congress gave lessees a possessory remedy in section 365(h) that protects
certain lessee investments independently of what is covered by adequate
protection under section 363(e). Why would Congress do that in a manner the
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estate can so easily circumvent under the Seventh Circuit’s interpretation of
section 363(f)?
Why would Congress create uncertainty in the real estate finance industry
for lenders, lessees, and title insurers? Based on the holding in Precision
Industries, imagine the dilemma of a leasehold lender when an entity leases land
for 100 years and wants financing to build an office building on the land. How is
the lender supposed to evaluate the risk the lessor will sell the property free of
the land lease during bad economic times under section 363(f), and a judge will
determine how much value out of the sale price goes to the lessee? Who would
write title insurance for the lessee and its financer? The mere possibility of an
undervaluation will make the initial financing more expensive or unavailable. If
the financing is done and the lessor ultimately commences a chapter 11 case,
the mere prospect of a section 363(f) sale and an undervaluation by the judge
will provide the debtor-lessor enormous leverage over the leasehold financers.
Significantly, Congress knew before the Bankruptcy Code became
effective on October 1, 1979, that the uncertainty about a lessee’s possessory
rights in bankruptcy was a material issue and the court in charge of the
reorganization of Penn Central Transportation Company had ruled it would be
inequitable to deprive lessees of their possessory rights, even in the context of
the railroad’s reorganization. See In re Penn Cent. Transp. Co., 458 F. Supp.
1346 (E.D. Pa. 1978).
Finally, other subsections of section 365 show the Seventh Circuit’s
statutory interpretation is at odds with the statutory regimen. Just as possessory
interests are preserved on rejection for lessees by section 365(h)(1), sections
365(h)(2) and 365(i) preserve leased and sold time share interests and rights to
acquire real property by purchasers in possession of it, and section 365(n)
preserves licensed intellectual property rights. Just as upon rejection section
365(h)(1)(A)(ii) preserves for the lessee its right to quiet enjoyment of the
premises for the duration of the lease inclusive of renewals, section 365(i)(2)(B)
requires that the time share or real property purchaser be granted title in
accordance with the purchase contract, and section 365(n)(3) requires that the
intellectual property licensee be granted continued use of the license and that the
debtor-licensor not interfere with the licensee’s rights in the license. In each
situation, the debtor’s estate’s sale of the time share property, real property, or
intellectual property free of the purchaser’s interests would violate these
subsections of section 365.
Indeed, section 365(n) was enacted to protect licensees against the
financial nightmare of building a $100 million factory to make use of a license,
and then losing the license when the licensor rejects it in the licensor’s title 11
case. The Intellectual Property Bankruptcy Protection Act, Pub. L. No. 100-506,
102 Stat. 2538-2540 (1988), thereby overturned Lubrizol Enterprises, Inc. v.
Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), cert. denied, 106
153

S. Ct. 1285 (1986), which allowed the rejection of a license to deprive the
licensee of its use. There is no assurance whatsoever that if the licensor sells its
intellectual property free of the license, the sale proceeds allocable to the license
will compensate the licensee for the factory as well as continued exploitation of
the license would. 164
Accordingly, the Seventh Circuit’s statutory interpretation produces,
among others, the following absurd results:
1. The Bankruptcy Code and Bankruptcy Rules provide for a lessee
to obtain a determination for cause (11 U.S.C. § 365(d),
Bankruptcy Rule 6006(b)) whether the debtor in possession will
assume or reject a lease; while there is no provision entitling the
lessee, for any reason, to obtain a determination whether the
lessee will be allowed to retain possession;
2. if a debtor-lessor wants to use the property it can not dispossess
the lessee (except by manufacturing a transfer to a new entity); but
if it does not want to use the property it can dispossess the lessee;
3. a lessee’s right to retain possession turns on whether the debtor
transfers the property or gives creditors ownership rights in the
debtor-entity;
4. a lessee’s noncompensable investments are preserved for it if the
debtor retains the property, but not if the debtor transfers the
property;
5. the debtor’s ability to deprive the lessee of possession creates
uncertainty throughout leasehold financing;
6. the lessee’s possessory rights under section 365(h) are illusory
due to the ease with which the debtor can eliminate them by
transferring a lease to a new entity its creditors control.
164 Notably, in FutureSourceLLC v. Reuters Limited, 312 F.3d 281 (7 th Cir. 2002), cert. denied,
155 L. Ed. 513 (2003), without citing section 365(n), in dicta the court observed a debtor can sell
assets free of a license-interest in intellectual property under section 363(f), at least when the
interest holder consents by not objecting. 312 F.3d at 285-286. There, a debtor had sold free and
clear of liens, claims, encumbrances, and interests, its assets with which it provided reformatted
financial markets data. A party holding a prepetition contract from the debtor for such data, sued
the purchaser to supply the data. The United States Court of Appeals for the Seventh Circuit
ruled the contract party had no claim against the purchaser because the sale was free and clear,
the purchaser did not inherit the prepetition contract, and, in any event, the contract party was
demanding reformatted data that did not yet exist. The court was right. The legislative history of
section 365(n) provides: “…The benefits of the bill are intended to extend to such license
agreements, consistent with the limitation that the licensee’s rights are only in the underlying
intellectual property as it existed at the time of the filing.” S. Rep. No. 100-505, 100th Cong.., 2d
Sess. (1988) at p. 8.
154

The United States Supreme Court consistently articulates an age old
principle of statutory interpretation that while plain statutes should be enforced
according to their terms, they should not be interpreted to produce absurd
results. Hartford Underwriters Insurance Co. v. Union PlantersBank, 530 U.S. 1,
6 (2000)(“[w]hen ‘the statute’s language is plain,*the sole function of the courts*’
– at least where the disposition required by the text is not absurd -- *’is to enforce
it according to its terms.*’”)(quoting United States v. Ron Pair Enterprises, Inc.,
489 U.S. 235, 241(1989), quoting Caminetti v. United States, 242 U.S. 470, 485
(1917)). Significantly, the United States Court of Appeals for the Seventh Circuit
agrees. .165
“But ascertainment of the meaning apparent on the face of a single
statute need not end the inquiry. Train v. Colorado Public Interest Research
Group, 426 U.S. 1, 10 (1076); United States v. American Trucking Assns., Inc.,
310 U.S. 534, 543-544 (1940). This is because the plain-meaning rule is ‘rather
an axiom of experience than a rule of law, and does not preclude consideration
of persuasive evidence if it exists.’ Boston Sand Co. v. United States, 278 U.S.
41, 48 (1928)(Holmes, J.). The circumstances of the enactment of a particular
legislation may persuade a court that Congress did not intend words of common
meaning to have their literal effect. E.g., Church of the Holy Trinity v. United
States, 143 U.S. 457, 459 (1892); United States v. Ryan, 284 U.S. 167, 175
(1931).” Watt v. Alaska, 451 U.S. 259, 266 (1981).
In Watt v. Alaska, Congress had amended a statute (16 U.S.C. § 715s(c))
in 1964 to provide for the government to obtain 75% of royalties from minerals on
public lands acquired or reserved for conservation and protection of certain fish
and wildlife. Congress did not amend a prior statute in the Mineral Leasing Act of
1920 (30 U.S.C. § 191) which allocated to the State of Alaska 90% of such
royalties. Even though on its face the newer statute applied, the Supreme Court
determined from the absence of legislative history showing a Congressional
intent to alter the prior formula for distribution of substantial funds that the newer
statute only applied to mineral revenues from acquired lands. 451 U.S. at 272-
273.
Watt cites Church of the Holy Trinity. In Holy Trinity a religious society
had contracted to employ a rector and pastor who would immigrate to the United
States from England. The United States government contended the contract was
illegal under a federal statute rendering it unlawful to “encourage the
importation… of any alien…into the United States…under contract…made
previous to the importation…to perform any labor or service of any kind….”
Notwithstanding the plain meaning of the statute, the Supreme Court ruled
165 “Nonsensical interpretations of contracts, as of statutes, are disfavored….Not because of a
judicial aversion to non-sense as such, but because people are unlikely to make contracts, or
legislators statutes, that they believe will have absurd consequences.” FutureSourceLLC v.
Reuters Limited, 312 F.3d 281, 284-285 (7 th Cir. 2002) (Posner, C.J.).
155

“however broad the language of the statute may be, the act, although within the
letter, is not within the intention of the legislature, and therefore cannot be within
the statute.” 143 U.S. at 472.
In deriving its ruling, the United States Supreme Court tracked examples
of statutes that can not be interpreted in accordance with their plain meaning due
to the absurd results such interpretations would yield:
“…’If a literal construction of the words of a statute be absurd, the
act must be so construed as to avoid the absurdity. The court must
restrain the words. The object designed to be reached by the act
must limit and control the literal import of the terms and phrases
employed.’ [quoting Margate Pier Co. v. Hannam, 3 B. & Ald. 266,
270]. ’All laws should receive a sensible construction. General
terms should be so limited in their application as not to lead to
injustice, oppression or an absurd consequence. It will always,
therefore, be presumed that the legislature intended exceptions to
its language which would avoid results of this character. The
reason of the law in such cases should prevail over its letter. The
common sense of man approves the judgment mentioned by
Puffendorf, that the Bolognian law which enacted ‘that whoever
drew blood in the streets should be punished with the utmost
severity.’ Did not extend to the surgeon who opened the vein of a
person that fell down in the street in a fit. The same common
sense accepts the ruling, cited by Plowden, that the statute of 1 st
Edward II., which enacts that a prisoner who breaks prison shall be
guilty of felony, does not extend to a prisoner who breaks out when
the prison is on fire, ‘for he is not to be hanged because he would
not stay to be burnt.’ And we think that a like common sense will
sanction the ruling we make, that the act of Congress which
punishes the obstruction or retarding of the passage of the mail, or
of its carrier, does not apply to a case of temporary detention of the
mail caused by the arrest of the carrier upon an indictment for
murder.’” [Quoting United States v. Kirby, 7 Wall. 482, 486].
Church of the Holy Trinity, 143 U.S. at 460. Significantly, the Supreme
Court’s examples of absurd results requiring statutes to be interpreted
differently than their overt plain meanings are frequently not accompanied
by legislative history showing Congress did not intend a certain result.
Rather, the fact Congress did not intend an absurd result is inferred.
An example of the need to avoid an absurd result in the bankruptcy
context was identified in a concurrence, where the issue was whether an
entity’s right to an injunction enforcing a non-compete covenant would be
made dischargeable because the entity was entitled to money damages in
addition to the injunction and not in place of it:
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“To appreciate the patent absurdity of implementing the plain
text of Section 101(5)(B) one must keep in mind that this is a
bankruptcy statute. If, following the plain language, an injunction
may be stayed in bankruptcy anytime the underlying breach of
contract or law also happens to give rise to money damages, the
real-world results would be ludicrous. If we were to apply the plain
text of § 101(5)(B) to individuals restrained by court orders – e.g.
trespassers, polluters, stalkers, batterers – theoretically, simply by
filing bankruptcy, the violator could escape from any restraining
order prompted by a breach that also gave rise to an award of
money damages. Certainly the parade of horribles is extensive,
and I need not belabor it further. Since the text of § 101(5)(B)
presents one of those extremely unique circumstances of patent
absurdity, we may turn to the purpose, context and policy of §
101(5)(B) to supplement its plain language.”
In re Udell, 18 F.3d 403, 412 (7th Cir. 1994) (C.J. Flaum concurring) (footnotes
omitted).
Here, the plain meaning of the statute appears to be the opposite of the
Seventh Circuit’s interpretation for the reasons set forth above. But, if the plain
meaning conforms to the Seventh Circuit’s interpretation, that meaning should be
set aside because it yields the absurd results described above that Congress can
be safely assumed not to have intended. As the Seventh Circuit ruled in In re
Handy Andy home Improvement Centers, Inc., 144 F.3d 1125, 1128 (7 th Cir.
1998): “Statutory language like other language should be read in
context….When context is disregarded, silliness results….”
14. Cram Down Interest Rates Need Not Render the Lender Subjectively Indifferent
between Present Foreclosure and Future Payments
A. Till v. SCS Credit Corp., 124 S. Ct. 1951 (2004)(Chapter 13)
i. Facts.
The chapter 13 debtors owed their lender $4,894.89 secured by a truck
purchased with the loan which had a value of $4,000 in bankruptcy. They
proposed a chapter 13 plan under which they would assign $740 of their wages
each month to repay debt including the $4,000 at an interest rate of 9.5% derived
by taking the 8% risk free rate and adding 1.5% to reflect borrowers of similar
risk. The lender objected claiming it was entitled to a 21% interest rate because
it could foreclose and use the money to lend out at 21% interest which is the
prepetition rate charged to the debtors. 124 S. Ct. at 1956-1957.
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The district court and United States Court of Appeals for the Seventh
Circuit reversed the bankruptcy court’s adoption of the 9.5% interest rate and
ruled a coerced loan approach should be used. 124 S. Ct. at 1957-1958.
ii. Issue.
Should the cram down interest rate under 11 U.S.C. § 1325(a)(5)(B)(ii) be
determined in accordance with the coerced loan approach, presumptive contract
rate approach, cost of lender’s funds approach, or the formula approach?
iii. Holding.
A plurality joined by Justice Thomas’ concurrence ruled in chapter 13, the
court should use the formula approach. “[T]he approach begins by looking to the
national prime rate, reported daily in the press, which reflects the financial
market’s estimate of the amount a commercial bank should charge a creditworthy
commercial borrower to compensate for the opportunity costs of the loan, the risk
of inflation and the relatively slight risk of default. Because bankrupt debtors
typically pose a greater risk of nonpayment than solvent commercial borrowers,
the approach then requires a bankruptcy court to adjust the prime rate
accordingly. The appropriate size of that risk adjustment depends, of course, on
such factors as the circumstances of the estate, the nature of the security, and
the duration and feasibility of the reorganization plan. The court must therefore
hold a hearing at which the debtor and any creditors may present evidence about
the appropriate risk adjustment. Some of this evidence will be included in the
debtor’s bankruptcy filings, however, so the debtor and creditors may not incur
significant additional expense. Moreover, starting from a concededly low
estimate and adjusting upward places the evidentiary burden squarely on the
creditors, who are likely to have readier access to any information absent from
the debtor’s filing (such as evidence about the ‘liquidity of the collateral market,’
post, at 1973 (SCALIA, J., dissenting)). Finally, many of the factors relevant to
the adjustment fall squarely within the bankruptcy court’s area of expertise.” 124
S. Ct. at 1961 (emphasis in original, footnote omitted). If the court is certain a
debtor would complete his plan, the prime rate would be adequate. 124 S. Ct. at
1961 n. 18.
“…It is sufficient for our purposes to note that, under 11 U.S.C. §
1325(a)(6), a court may not approve a plan unless, after considering all creditors’
objections and receiving the advice of the trustee, the judge is persuaded that
‘the debtor will be able to make all payments under the plan and to comply with
the plan.’ Ibid. Together with the cram down provision, this requirement
obligates the court to select a rate high enough to compensate the creditor for its
risk but no so high as to doom the plan. If the court determines that the
likelihood of default is so high as to necessitate an ‘eye-popping’ interest rate,
301 F.3d at 593 (Rovner, J., dissenting), the plan probably should not be
confirmed.” 124 S. Ct. at 1962.
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Because numerous lenders advertise financing for chapter 11 debtors in
possession, in chapter 11 cases “it might make sense to ask what rate an
efficient market would produce.” 124 S. Ct. at 1960 n. 14.
Notably, the dissent described its disagreement with the plurality narrowly,
saying: “…The plurality would use the prime lending rate – a rate we know is too
low – and require the judge in every case to determine an amount by which to
increase it. I believe that, in practice, this approach will systematically
undercompensate secured creditors for the true risks of default. I would instead
adopt the contract rate – i.e., the rate at which the creditor actually loaned funds
to the debtor – as a presumption that the bankruptcy judge could revise on
motion of either party….” 124 S. Ct. at 1968 (emphasis in original).
iv. Rationale
The language of section 1325(a)(5)(B)(ii) requires that when the secured
claimholder does not accept the plan, the plan should be confirmed only if “the
value, as of the effective date of the plan, of property to be distributed under the
plan on account of such claim is not less than the allowed amount of such claim.”
The Supreme Court reasoned that the determination of value must be an
objective one, as opposed to a subjective determination of what would make the
secured claimholder indifferent between the plan and immediate foreclosure:
“…That is, although § 1325(a)(5)(B) entitles the creditor to property whose
present value objectively equals or exceeds the value of the collateral, it does not
require that the terms of the cram down loan match the terms to which the debtor
and creditor agreed prebankruptcy, nor does it require that the cram down terms
make the creditor subjectively indifferent between present foreclosure and future
payment. Indeed, the very idea of a ‘cram down’ loan precludes the latter result:
By definition, a creditor forced to accept such a loan would prefer instead to
foreclose. Thus, a court choosing a cram down interest rate need not consider
the creditor’s individual circumstances, such as its prebankruptcy dealings with
the debtor or the alternative loans it could make if permitted to foreclose. Rather,
the court should aim to treat similarly situated creditors similarly, and to ensure
that an objective economic analysis would suggest the debtor’s interest
payments will adequately compensate all such creditors for the time value of their
money and the risk of default.” 124 S. Ct. at 1959-1960 (emphasis in original,
footnote omitted).
The plurality discarded arguments that the interest rate should reflect the
lender’s costs and opportunities (the coerced loan approach) because it would
(a) produce the absurd result of granting higher rates to inefficient, poorly
managed lenders, (b) require debtors to gather information about each lender,
and (c) overcompensate creditors because the market lending rate must be high
enough to cover factors like lenders’ transactions costs and overall profits that
are no longer relevant in a court administered and supervised cram down loan.
124 S. Ct. at 1960.
159

v. A New Twist on Statutory Interpretation
Significantly, in his concurrence, Justice Thomas points to the plain
meaning of the statute as barring a debtor-specific risk adjustment:
“I agree that a ‘promise of future payments is worth less than
an immediate payment’ of the same amount, in part because of the
risk of nonpayment. But this fact is irrelevant. The statute does not
require that the value of the promise to distribute property under the
plan be no less than the allowed amount of the secured creditor’s
claim. It requires only that ‘the value … of property to be distributed
under the plan,’ at the time of the effective date of the plan, be no
less than the amount of the secured creditor’s claim. 11 U.S.C. §
1325(a)(5)(B)(ii) (emphasis added). Both the plurality and the
dissent ignore the clear text of the statute in an apparent rush to
ensure that secured creditors are not undercompensated in
bankruptcy proceedings. But the statute that Congress enacted
does not require a debtor-specific risk adjustment that would put
secured creditors in the same position as if they had made another
loan….” 124 S. Ct. at 1965.
***
“Respondent argues, and the plurality and the dissent agree,
that the proper interest rate must also reflect the risk of
nonpayment. But the statute contains no such requirement. The
statute only requires the valuation of the “property to be
distributed,” not the valuation of the plan (i.e., the promise to make
the payments itself). Thus, in order for a plan to satisfy §
1325(a)(5)(B)(ii), the plan need only propose an interest rate that
will compensate a creditor for the fact that if he had received the
property immediately rather than at a future date, he could have
immediately made use of the property. In most, if not all, cases,
where the plan proposes simply a stream of cash payments, the
appropriate risk-free rate should suffice.” 124 S. Ct. at 1966.
Significantly, the plurality agrees Justice Thomas demonstrated section
1325(a)(5)(B)(ii) “may be read to support the conclusion that Congress did not
intend the cram down rate to include any compensation for the risk of default.”
124 S. Ct. at 1963. As the plurality notes, the United States, as Amicus Curiae,
makes the same point, but advocates the formula approach the plurality adopted.
124 S. Ct. at 1964 n. 25.
To overcome that reading, the plurality reasons that “because so many
judges who have considered the issue (including the authors of the four earlier
opinions in this case) have rejected the risk-free approach, we think it is too late
in the day to endorse that approach now. Of course, if the text of the statute
required such an approach, that would be the end of the matter. We think,
however, that § 1325(a)(5)(B)(ii)’s reference to ‘value, as of the effective date of
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the plan, of property to be distributed under the plan’ is better read to incorporate
all of the commonly understood components of ‘present value,’ including any risk
of nonpayment….” 124 S. Ct. at 1964.
B. Bank of Montreal v. Official Committee of Unsecured Creditors (In re
American Homepatient, Inc.), 420 F.3d 559 (6 th Cir. 2005)
i. Facts.
At a contested confirmation hearing, the bankruptcy court valued the bank
lenders’ collateral at $250 million and fixed the interest rate at 6.785% which
equaled 3.5% above the risk free rate for a 6-year treasury note. The banks had
requested a valuation of between $300 million and $320 million and an interest
rate of 12.16%.
ii. Issue.
How should the cramdown interest rate for a secured loan be computed in
chapter 11 cases?
iii. Holding.
“…This means that the market rate should be applied in Chapter 11 cases
where there exists an efficient market. But where no efficient market exists for
a Chapter 11 debtor, then the bankruptcy court should employ the formula
approach endorsed by the Till plurality. This nuanced approach should obviate
the concern of commentators who argue that, even in the Chapter 11 context,
there are instances where no efficient market exists.” 420 F.3d at 568.
iv. Rationale.
“…Although the lenders argue that the rate chosen by the bankruptcy court was
not the rate produced by an efficient market, this is a question that was fully
considered by that court. Its conclusion that the appropriate market rate
would be 6.785% was reached only after carefully evaluating the testimony of
various expert witnesses. The fact that the bankruptcy court utilized the rubric
of the "coerced loan theory" that was criticized in Till provides no basis to
reverse the bankruptcy court's decision because Till pointed out that, if
anything, the coerced loan theory "overcompensates creditors . . . ." Till , 542
U.S. at 477 (emphasis added). We therefore concur in the result reached by
both the bankruptcy court and the district court on this issue.” 420 F.3d at 569.
v. Other Cramdown Interest Rate Decisions Since Till
“At least one court that has examined cramdown interest rates post- Till
has concluded that Till does not apply in a Chapter 11 context. See In re
Prussia Assocs., 322 B.R. 572, 585, 589 (Bankr .E.D. Pa. 2005) (holding that
" Till is instructive, but it is not controlling, insofar as mandating the use
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of the 'formula' approach described in Till in every Chapter 11 case," and
noting that "[ Till 's] dicta implies that the Bankruptcy Court in such
circumstances (i.e., efficient markets) should exercise discretion in evaluating
an appropriate cramdown interest rate by considering the availability of market
financing").
Several outside commentators, however, have argued that Till 's formula
approach should apply to Chapter 11 cases as well as to Chapter 13 cases,
noting that the two are not all that dissimilar. See 7 Collier on Bankruptcy P
1129.06[1][c][i] ("The relevant market for involuntary loans in chapter 11 may
be just as illusory as[**20] in chapter 13."); Ronald F. Greenspan & Cynthia
Nelson, 'Un Till ' We Meet Again: Why the Till Decision Might Not Be the Last
Word on CramdownInterest Rates, Am. Bankr. Inst. J., Dec.-Jan. 2004, at 48
("So we are left to wonder if footnote 14 nullifies Till in a chapter 11 context
(or at least where efficient markets exist), modifies its application or is
merely an irrelevant musing."); Thomas J. Yerbich, How Do You Count the
Votes--or Did Till Tilt the Game?, Am. Bankr. Inst. J., July-Aug. 2004, at 10
("There is no more of a 'free market of willing cramdown lenders' in a chapter
11 (or a chapter 12, for that matter) than in a chapter 13."). And at least one
court has concluded that Till does apply in a Chapter 11 context. See
Official Unsecured Creditor's Comm. of LWD, Inc. v. K&B Capital, LLC (In re
LWD, Inc.), -- B.R. --, 2005 Bankr. LEXIS 384, 2005 WL 567460 (Bankr. W.D.
Ky. Feb. 10, 2005) . American Homepatient, 420 F.3d at 567-568.
C. Official Committee of Unsecured Creditors v. Dow Corning Corp.,
456 F.3d 668 (6 th Cir. 2006)
i. Facts
Class 4 rejected Dow Corning’s chapter 11 plan. The class consisted of
approximately $1 billion of unsecured commercial debt The estate was solvent.
456 F.3d at 671-672. The bankruptcy court had interpreted the plan to provide
the class with interest at the nondefault contract rate on the debtor’s petition
date, and denied requests for default interest, attorneys’ fees, costs, and
expenses because none of them were incurred in the litigation of the validity of
their claims. The district court affirmed. 456 F.3d at 673-674.
ii. Issues
Did the bankruptcy court abuse its discretion in interpreting the plan not to
require default interest in a solvent case for unsecured claimholders entitled to
interest at the default rates in their contracts if that interpretation would cause the
plan to violate 11 U.S.C. § 1129(b), 456 F.3d at 677, and are they entitled to their
attorneys’ fees, costs, and expenses incurred in enforcing their claims (and not
for litigating the validity of their contracts) if they have valid claims under state
law?
iii. Holdings
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“…Despite the equitable nature of bankruptcy proceedings, the bankruptcy
judge does not have ‘free-floating discretion to redistribute rights in accordance
with his personal views of justice and fairness,’ Id. at 528 [quoting In re Chicago,
791 F.2d 524 (7 th Cir. 1986)]. Rather, absent compelling equitable
considerations, when a debtor is solvent, it is the role of the bankruptcy court to
enforce the creditors’ contractual rights. See Chicago, 791 F.2d at 528(‘[I]f the
bankrupt is solvent the task for the bankruptcy court is simply to enforce creditors
rights according to the tenor of the contracts that created those rights.’).” 456
F.3d at 679. “We conclude like the other courts to have considered this issue,
that there is a presumption that default interest should be paid to unsecured
claim holders in a solvent debtor case.” 456 F.3d at 680.
“In this circuit, an unsecured creditor may recover those costs to which it
has a state-law based right against a solvent debtor, regardless of the nature of
the federal proceedings. State law may, of course, require an examination of the
nature of the proceedings in federal court, but absent such state law concerns,
the federal law of this circuit does not limit contractual awards of attorneys’ fees
to situations where the issue of contract enforceability was litigated in bankruptcy
court. [footnote omitted]. Although arguably in tension with the Ninth Circuit, our
decision is consistent with that of other courts that have awarded attorneys’ fees
to which a party was contractually entitled, despite the fact that the litigation did
not involve enforcement of the contract itself.” 456 F.3d at 686.
Both issues were remanded for determination by the bankruptcy court as
to whether there are compelling equitable considerations that overcome default
interest and whether state law enforces claims for attorneys’ fees, costs, and
expense of enforcement of contract claims.
iv. Rationale
When a class of unsecured claims rejects a plan in a solvent case, it
would violate the absolute priority rule for equity to participate before creditors’
claims are paid in full. Therefore, if they have valid claims for default interest,
they must be paid absent compelling equitable circumstances. “’Whether a
company is solvent or insolvent in either the equity or the bankruptcy sense, ‘any
arrangement of the parties by which the subordinate rights and interests of the
stockholders are attempted to be secured at the expense of the prior rights of
credtiors ‘comes within judicial denunciation.’’” (quoting Consolidated Rock
Prods. Co. v. Du Bois, 312 U.S. 510, 527 (1941)).
11 U.S.C. § 506(b) expressly allows postpetition interest for secured
claims to the extent the collateral value can pay it; but that is necessary because
section 502(b)(2) disallows unmatured interest. Because there is no general
prohibition against claims for attorneys’ fees, costs, and expenses, there is no
need for an express allowance of such claims against solvent debtors. 456 F.3d
at 682. The Sixth Circuit does not follow Thrifty Oil Co. v. Bank of Am., 322 F.3d
1039, 1040-1042 (9 th Cir. 2003), which held that even if provided for by
163

contractual provisions valid under state law, creditors may never be awarded
attorneys’ fees expended litigating issues solely of federal bankruptcy law. 456
F.3d at
15. Barton v. Barbour, 104 U.S. 126 (1881), Is Alive and Well.
A. Beck v. Fort James Corp. (In re Crown Vantage, Inc.), 421 F.3d 963 (9 th
Cir. 2005)
i. Facts.
In 1995, James River spun off assets related to its communications
papers and packaging business by transferring the assets to subsidiaries (the
“Crown Entities”) and dividending their stock. Prior to the spinoff, James River
entered into a contribution agreement with the Crown entities. That agreement
led to various disputes, all of which were settled in 1998. The settlement
agreement provided each side with releases and provided the sole forum to
litigate disputes arising out of it would be the state and federal courts in
Delaware. 421 F.3d at 967.
In 2000, the Crown Entities commenced chapter 11 cases in the Northern
District of California. During the chapter 11 cases, the creditors’ committee
requested authority to investigate whether an action should be commenced
against Fort James (successor by merger to James River) relating to the spinoff.
Fort James commenced an adversary proceeding for a declaration that the
spinoff was not a fraudulent transfer and that, in any event, the settlement
agreement released Fort James. 421 F.3d at 967-968. The debtors in
possession commenced an adversary proceeding against Fort James asserting
the settlement agreement release was a fraudulent transfer. 421 F.3d at 968. All
the actions were consolidated into one action, 421 F.3d at 968, and the reference
was withdrawn to the district court in the Northern District of California. 421 F.3d
at 969.
Ultimately, the bankruptcy court confirmed a chapter 11 plan providing for
all assets to be transferred to a liquidating trust, whose trustee would liquidate
the assets and bring authorized causes of action including a fraudulent transfer
action against Fort James. The trustee would be substituted as the debtors’
successor in all actions. 421 F.3d at 968. The confirmation order provided the
court retained “;exclusive jurisdiction over all matters arising out of, and related
to, the Chapter 11 cases and the Plan to the fullest extent permitted by law,
including but not limited to, the matters set forth in Article XII of the Plan.’” 421
F.3d at 968.
Article XII of the plan provided the bankruptcy court would, “as legally
permissible,” retain exclusive jurisdiction over all matters arising out of or relating
to the chapter 11 cases including jurisdiction to hear and determine all adversary
proceedings and contested matters. 421 F.3d at 968.
164

The chapter 11 plan also provided the bankruptcy court would retain
jurisdiction over the liquidating trust and the agreement establishing it, including
the agreement’s interpretation and enforcement. 421 F.3d at 969.
After confirmation, the liquidating trust commenced an action in California
state court against the law firm (McGuire Woods) that represented James River
in the spinoff and other entities. The defendants removed the action to federal
court and the district court refused to remand because of substantial overlap
with the consolidated action. 421 F.3d at 969.
Next, Fort James and McGuire Woods commenced an action in
Delaware Chancery Court for a declaration that the (a) California actions were
barred by the settlement agreement and (b) liquidating trustee breached the
settlement agreement by prosecuting the California actions. The Delaware
action requests damages from the liquidating trustee, costs, and attorneys’ fees.
421 F.3d at 969. The liquidating trustee removed the Delaware action to the
district court in Delaware and moved to dismiss, or alternatively transfer it to
California. The district court granted the Fort James entities’ motion to remand
and denied the motion to dismiss or transfer as moot. 421 F.3d at 969. Then,
the liquidating trustee moved to dismiss the action or stay it pending resolution of
the California actions. 421 F.3d at 969.
The Fort James entities requested an order in the California district court
that their Delaware action did not violate the automatic stay or the Barton
doctrine. That doctrine derives from Barton v. Barbour, 104 U.S. 126 (1881),
where the Supreme Court “ruled that the common law barred suits against
receivers in courts other than the court charged with the administration of the
estate…The Supreme Court held in Barton that, before suit is brought against
such a receiver, leave of the court by which the trustee was appointed must be
obtained.” 421 F.3d at 970n.4. The Fort James entities asserted Barton was
inapplicable; the Delaware action was against the liquidating trustee as the legal
representative of the Crown entities and not in his personal capacity; and there
was a presumptively valid forum selection clause. 421 F.3d at 970.
The California district court ruled the bankruptcy court should determine
the Fort James entities’ issues in the first instance. 421 F.3d at 970. The
liquidating trustee commenced an adversary proceeding in the California
bankruptcy court requesting an order enjoining the Fort James entities from
prosecuting the Delaware action. The Delaware Chancery Court stayed a ruling
on the liquidating trustee’s motion to dismiss pending resolution of the adversary
proceeding. 421 F.3d at 970.
Next, the bankruptcy court enjoined prosecution of the Delaware action on
the ground it violated Barton, and the court ruled the settlement agreement’s
forum selection clause did not control. 421 F.3d at 970. On appeal to the district
court, the district court ruled the liquidating trustee would likely prevail that the
165

Delaware action violated Barton, but vacated the preliminary injunction enjoining
the Delaware action because the liquidating trustee had not proven irreparable
harm. 421 F.3d at 970.
ii. Issues.
Does the Barton doctrine apply to liquidating trustees under chapter 11
plans?
To enforce Barton with an injunction, must the movant prove irreparable
harm?
iii. Holdings.
“We join our sister circuits in holding that a party must first obtain leave of
the bankruptcy court before it initiates an action in another forum against a
bankruptcy trustee or other officer appointed by the bankruptcy court for acts
done in the officer’s official capacity. See Muratore v. Darr, 375 F.3d 140, 147
(1 st Cir. 2004); Carter v. Rodgers, 220 F.3d 1249, 1252 (11 th Cir. 2000); In re
Linton, 136 F.3d 544, 546 (7 th Cir. 1998); Lebovits v. Scheffel (In re Lehal Realty
Assocs.), 101 F.3d 272, 276 (2d Cir. 1996); Allard v. Weitzman (In re DeLorean
Motor Co.), 991 F.2d 1236, 1240 (6 th Cir. 1993). In our circuit, the doctrine was
recognized by our Bankruptcy Appellate Panel in Kashani v. Fulton (In re
Kashani), 190 B.R. 875, 883-85 (9 th Cir. BAP 1995).” 421 F.3d at 970.
“Further, the fact that the officer involved is not a bankruptcy trustee, but
rather a liquidating trustee, is of no moment. As the Sixth Circuit has observed,
under the Barton doctrine, ‘court appointed officers who represent the estate are
the functional equivalent of a trustee…’ Delorean, 991 F.2d at 1241. Here, as
part of a liquidating Chapter 11 reorganization proceeding, the bankruptcy court
chose the mechanism of a liquidating trust to liquidate and distribute the assets
of the estate. The bankruptcy court retained jurisdiction over the case. In this
context, the Liquidating Trustee is the ‘functional equivalent’ of the bankruptcy
trustee and is entitled to Barton protection. Id.” 421 F.3d at 973.
Pursuant to 11 U.S.C. § 105(a), injunctions can be issued to prevent
impairment of the bankruptcy court’s jurisdiction without regard to irreparable
harm. “It would thwart the purpose of the Barton doctrine to add an additional
requirement that the party show irreparable harm before being able to obtain
relief. The essence of the Barton doctrine is that parties may not commence or
maintain unauthorized litigation. The only appropriate remedy, therefore, is to
order cessation of the improper action. There is no requirement in Barton or any
of its progeny that the aggrieved party bear the additional burden of showing
irreparable harm, nor does such a requirement make any sense in the Barton
context. Indeed, even in the non-bankruptcy context, we have held that courts
appointing a receiver are invested with broad power to issue orders barring
166

actions which would interfere with its administration of that estate. Diners Club,
Inc. v. Bumb, 421 F.2d 396, 398 (9 th Cir. 1970).” 421 F.3d at 976.
iv. Rationale.
Barton held “that if leave of court were not obtained, then the other forum
lacked subject matter jurisdiction over the suit. Barton, 104 U.S. at 127. Part of
the rationale underlying Barton is that the court appointing the receiver has in
rem subject matter jurisdiction over the receivership property. Id. at 136. As the
Supreme Court explained, allowing the unauthorized suit to proceed ‘would have
been a usurpation of the powers and duties which belonged exclusively to
another court.’ Id. n5.” 421 F.3d at 971.
This explains why the forum selection clause has no effect. The Delaware
forum lacked subject matter jurisdiction over the action commenced by the Fort
James entities.
“…Thus, ‘the district court in which the bankruptcy case is commenced
obtains exclusive in rem jurisdiction over all of the property in the estate.’ Hong
Kong and Shanghai Banking Corp., Ltd. V. Simon (In re Simon), 153 F.3d 991,
996 (9 th Cir. 1998). The court’s exercise of in rem bankruptcy jurisdiction
‘essentially creates a fiction that the property – regardless of actual location – is
legally located within the jurisdictional boundaries of the district in which the court
sits.’ Id. (citations omitted). Thus, the jurisdiction of the bankruptcy court
exceeds that of any other court-appointed receiver. The requirement of uniform
application of bankruptcy law dictates that all legal proceedings that affect the
administration of the bankruptcy estate be brought either in bankruptcy court or
with leave of the bankruptcy court.” 421 F.3d at 971.
Crown Vantage acknowledges that 28 U.S.C. § 959(a) 166 is a limited
statutory exception to Barton. 421 F.3d at 971. But, section 959(a) had no
application because it only applies to actions related to pursuing the business as
an operating enterprise and does not apply to actions taken in the mere
continuous administration of property. 421 F.3d at 972.
The public policies underlying the Barton doctrine were articulated by
Circuit Judge Posner:
166 28 U.S.C. § 959(a) provides:
“Trustees, receivers or managers of any property including debtorin-possession,
may be sued, without leave of the court appointing
them, with respect to any of their acts or transactions in carrying on
business connected with such property. Such actions shall be
subject to the general equity power of such court so far as the
same may be necessary to the ends of justice, but this shall not
deprive a litigant of his right to trial by jury.”
167

“Just like an equity receiver, a trustee in bankruptcy is working in
effect for the court that appointed or approved him, administering
property that has come under the court’s control by virtue of the
Bankruptcy Code. If he is burdened with having to defend against
suits by litigants disappointed by his actions on the court’s behalf,
his work for the court will be impeded. This concern is most acute
when suit is brought against the trustee while the bankruptcy
proceeding is still going on. The threat of his being distracted or
intimidated is then very great…”
“…Without the [Barton] requirement, trusteeship will become a
more irksome duty, and so it will be harder for courts to find
competent people to appoint as trustees. Trustees will have to pay
higher malpractice premiums, and this will make the administration
of the bankruptcy laws more expensive (and the expense of
bankruptcy is already a source of considerable concern).
Furthermore, requiring that leave to sue be sought enables
bankruptcy judges to monitor the work of the trustees more
effectively. It does this by compelling suits growing out of that work
to be as it were prefiled before the bankruptcy judge that made the
appointment; this helps the judge decide whether to approve this
trustee in a subsequent case.”
In re Linton, 136 F.3d 544, 545 (7 th Cir. 1998).
Bankruptcy courts can enjoin proceedings in other courts when satisfied
they would defeat or impair the bankruptcy court’s jurisdiction over the case
before it and does not need a showing of an inadequate remedy at law or
irreparable harm. Crown Vantage, 421 F.3d at 975; In re L&S Industries, Inc.,
989 F.2d 929, 932 (7 th Cir. 1993); Allard v. Weitzman (In re DeLorean Motor Co.),
991 F.2d 1236, 1242 (6 th Cir. 1993); Manville Corp. v. Equity Security Holders
Comm. (In re Johns-Mannville Corp.), 801 F.2d 60, 63 (2d Cir. 1986).
16. Only the Debtor in Possession/Trustee Can Invoke 11 U.S.C. § 506(c).
A. Hartford Underwriters Insurance Co. v. Union Planters Bank, 120 S. Ct.
1942 (2000) (Scalia, J.)
i. Facts.
The chapter 11 debtor’s prepetition lender was owed approximately $4
million secured by a lien against substantially all the debtor’s real and personal
property. Once the chapter 11 case commenced, the bankruptcy court approved
the lender’s advance of another $300,000 and the use of the new money and the
cash collateral to pay expenses including workers’ compensation insurance.
168

After the chapter 11 case was converted to chapter 7, the insurer first
learned of the bankruptcy and was owed $50,000 in unpaid premiums the debtor
failed to make during its chapter 11 case.
The insurer requested a payment of its administrative claim pursuant to 11
U.S.C. § 506(c). The bankruptcy court granted the request and was affirmed by
the district and circuit courts. Then, the circuit court, en banc, reversed and the
Supreme Court agreed to review it.
11 U.S.C. § 506(c) provides:
“The trustee may recover from property securing an
allowed secured claim the reasonable, necessary costs and
expenses of preserving, or disposing of, such property to the
extent of any benefit to the holder of such claim.”
ii. Holding
“We conclude that 11 U.S.C. § 506(c) does not provide an administrative
claimant an independent right to use the section to seek payment of its claim.”
120 S. Ct. at 1951.
“…The class of cases in which 506(c) would lie dormant without
nontrustee use is limited by the fact that the trustee is obliged to seek recovery
under the section whenever his fiduciary duties so require….” 120 S. Ct. at 1950.
Even if this issue had arisen during the chapter 11 case, “we do not read
1109(b)’s general provision of a right to be heard as broadly allowing a creditor to
pursue substantive remedies that other Code provisions make available only to
other specific parties….” 120 S. Ct. at 1948.
iii. Unanswered Questions
“We do not address whether a bankruptcy court can allow other interested
parties to act in the trustee’s stead in pursuing recovery under § 506(c).” 120 S.
Ct. at 1951n.5.
Also identified, but not addressed, is whether the trustee’s recovery under
section 506(c) goes into the estate to be distributed in accordance with the
Bankruptcy Code’s priority provisions or whether it goes to the administrative
claimant who benefited the collateral. Likewise, whether the trustee may use
section 506(c) prior to paying the expense for which reimbursement is sought is
an open question. 120 S. Ct. at 1950n.4.
The latter questions raise perplexing issues. For instance, assume the
trustee repairs the lender’s collateral at a cost of $1,000 paid from
169

unencumbered funds. The trustee can then recoup from the collateral the
$1,000. This may be by having the secured claimant pay the estate $1,000 or by
simply reducing the amount of the secured claim by $1,000. Notably, the
wording of section 506(c) creates only a nonrecourse claim of the trustee. It
provides the trustee may recover “from property…,” not from the claim holder.
Therefore, if after repairing the collateral, it is or becomes worth less than $1,000,
the trustee cannot collect more than its value.
Now, assume the trustee repairs the lender’s collateral, but does not pay
the repairperson the $1,000. When the trustee asserts rights under section
506(c) against the property, the secured claimant agrees to reduce its secured
claim by $1,000, theoretically increasing the trustee’s equity in the property by
$1,000. Does the repairperson obtain the exclusive benefit of that $1,000?
It appears this will turn on whether section 506(c) is intended to protect
unsecured claimholders against the depletion of unencumbered funds to improve
a lender’s collateral, or whether section 506(c) is intended to protect the
administrative claimant. Logically, if it were to protect the administrative
claimant, one would think the administrative claimant would have standing to
enforce section 506(c) by itself, which the Supreme Court held it does not have.
iv. Lessons Learned.
Administrative claimants who can not protect themselves with liens or
other credit support should advise the debtor’s responsible officers or trustee at
the outset that their fiduciary duties require them to take necessary steps to
ensure payment of their claims, including the enforcement of rights under section
506(c). As a tactical matter, the trustee and the claimant have more leverage at
the outset. They can advise the secured lender that they will not preserve the
collateral absent consent in advance to reimbursement of the necessary cost of
doing so. Of course, the secured claimant may respond that if the trustee opts
not to protect the collateral, stay relief should be granted. In many cases,
however, the secured claimholder does not want to foreclose because its
collateral is worth more as part of the debtor’s business than it is worth as
standalone property.
Additionally, as the Supreme Court opined, such claimants should protect
themselves “by paying attention to the status of their accounts.” 120 S. Ct. at
1950.
17. Can Courts Grant Derivative Standing to Parties in Interest to bring
Avoidance Actions?
170

i. Facts.
A. Official Committee of Unsecured Creditors of Cybergenics
Corp., on behalf of Cybergenics Corp., debtor in
possession v. Chinery,330 F.3d 548 (3d Cir. 2003),
replacing 304 F.3d 316(3d Cir. 2002)(3-0), vacated and
rehearing en banc granted, 310 F.2d 785 (3d Cir., 2002)
The statutory creditors’ committee requested the debtor in possession to
prosecute fraudulent transfer actions under 11 U.S.C. § 544(b), which claims
arose out of a leveraged buyout. The debtor in possession refused, and the
committee obtained bankruptcy court authorization to bring the claims
derivatively on behalf of the debtor in possession. 330 F.3d at 554. After the
committee filed its complaint, the reference of the adversary proceeding was
withdrawn on consent and defendants moved to dismiss on the ground the estate
had previously sold its avoidance actions. The district court granted the motion
and the appellate court reversed. In re Cybergenics Corp., 226 F.3d 245 (3d Cir.
2000). Then, defendants moved to dismiss on the ground, among others, the
committee lacked standing. The district court granted the motion finding the
Bankruptcy Code does not authorize a committee to bring a fraudulent transfer
avoidance action derivatively. That decision was affirmed on appeal, then
vacated and reversed en banc. 330 F.3d at 555.
ii. Issue.
“The question on appeal is whether the decision of the United States
Supreme Court in Hartford Underwriters Ins. Co. v. Union Planters Bank, 530
U.S. 1…(2000), a Chapter 7 case which interpreted the text of 11 U.S.C. § 506(c)
to foreclose anyone other than a trustee from seeking to recover administrative
costs on its own behalf, operates to prevent the Bankruptcy Court from
authorizing” a creditors’ committee to sue on the estate’s behalf to avoid a
fraudulent transfer in a chapter 11 case. 330 F.3d at 552.
iii. Holding.
“[B]ankruptcy courts can authorize creditors’ committees to sue
derivatively to avoid fraudulent transfers for the benefit of the estate.” 330 F.3d
at 580.
iv. Bankruptcy Code Sections 506(c) and 544(b).
Section 506(c) provides:
The trustee may recover from property securing an allowed
secured claim the reasonable, necessary costs and
expenses of preserving, or disposing of, such property to
the extent of any benefit to the holder of such claim.
171

Section 544(b)(1) provides:
Except as provided in paragraph (2), the trustee may avoid
any transfer of an interest of the debtor in property or any
obligation incurred by the debtor that is voidable under
applicable law by a creditor holding an unsecured claim
that is allowable under section 502 of this title or that is not
allowable only under section 502(e) of this title.
v. Rationale.
“We believe that Sections 1109(b), 1103(c)(5), and 503(b)(3)(B) of the
Bankruptcy Code evince Congress’s approval of derivative avoidance actions by
creditors’ committees, and that bankruptcy courts’ equitable powers enable them
to authorize such suits as a remedy in cases where a debtor-in-possession
unreasonably refuses to pursue an avoidance claim.” 330 F.3d at 553.
vi. Reasons Cybergenics En Banc is Correct.
The interpretation of Bankruptcy Code section 544(b)(1) to bar derivative
actions is not compelled by any plain language or meaning, creates absurd
results, is contradicted by another Third Circuit decision rendered three days
after the Cybergenics (now vacated) panel decision, is contradicted by a prior
Second Circuit decision, and conflicts with (i) Bankruptcy Code section
503(b)(3)(B), (ii) pre-Code law, (iii) express Congressional intent underlying
Bankruptcy Code chapter 11, and (iv) rules of statutory construction deployed by
the Supreme Court when interpreting the Bankruptcy Code.
1. Defining “the trustee may” in section 544(b)(1) as “only
the trustee/debtor in possession may” does not resolve the
question whether the trustee/debtor in possession may
avoid a transfer by authorizing a creditors’ committee to
sue in the debtor in possession’s name
.
Defining the words “the trustee may” in section 544(b) to mean “only the
trustee/debtor in possession may,” 167 because Hartford Underwriters uses that
definition in section 506(c), does not yield the result the vacated Cybergenics
decision reached, namely that committees can not sue derivatively under section
544(b). Indeed, the Supreme Court noted it was not addressing a creditor’s right
to sue derivatively under section 506(c), and added that “whatever the validity of
that [derivative action] practice [under section 544(b)], it has no analogous
application here, since petitioner did not ask the trustee to pursue payment…”
Hartford Underwriters, 530 U.S. at 13.
167 Based on 11 U.S.C. § 1107(a) as confirmed by Hartford Underwriters
(530 U.S. at 6n.3) and the Third Circuit’s earlier decision in In re Cybergenics
172

Put differently, by defining “the trustee may” in both sections 506(c) and
544(b) to mean “only the trustee/debtor in possession may,” neither section
grants other entities the causes of action embodied in those sections. But, that
definition does not answer the question as to how the trustee/debtor in
possession can prosecute its actions. Thus, the holding in Hartford Underwriters
that section 506(c) grants the trustee, but not a creditor, the right to share in
another creditor’s collateral, does not help determine Cybergenics where the
question is whether a trustee/debtor in possession can avoid transfers for the
estate under section 544(b)(1) only by itself or by using a creditors’ committee.
Most likely because transplanting to section 544(b)(1) the definition of “the
trustee may” in section 506(c) does not determine whether section 544(b)(1) bars
derivative standing, three days after Cybergenics was rendered, another panel of
the Third Circuit rendered a conflicting decision with no reference to Hartford
Underwriters. In In re Pillowtex, 304 F.3d 246 (3d Cir., September 23, 2002), the
appellate court held that whether the debtor’s attorneys received a preference
required resolution before approval of the retention of the debtor’s attorneys
could be assessed. In suggesting who had standing to bring the preference
action, the appellate court noted:
“There was some confusion at oral argument about
whether the U.S. Trustee has standing to pursue the
preference action below. Although we leave the question
to the District Court on remand in the first instance, we call
to its attention our discussion in U.S. Trustee v. Columbia
Gas Sys. Inc. (In re Columbia Gas Sys. Inc.), 33 F.3d 294
(3d Cir. 1994), where we observed of section 307 of the
Code, ‘it is difficult to conceive of a statute that more clearly
signifies Congress’s intent to confer standing.’ Id. at 296.”
304 F.3d at 321n.7. Significantly, 11 U.S.C. § 307 grants U.S. trustees standing
the same as section 1109(b) grants creditors’ committees standing. (U.S.
Trustee v. Columbia Gas Sys. Inc. (In re Columbia Gas Sys. Inc.), 33 F.3d 294
(3d Cir. 1994), held the U.S. trustee has standing to enforce section 345 of the
Bankruptcy Code against the debtor in possession.).
The preference action referred to by Pillowtex arises from Bankruptcy
Code section 547(b) which includes the identical language Hartford Underwriters
Corp., 226 F.3d 237, 243 (3d Cir. 2000)(“[t]he terms ‘trustee’ and ‘debtor in
possession,’ as used in the Bankruptcy Code, are thus essentially
interchangeable.”), Cybergenics agrees that when section 544(b)(1) authorizes
the trustee to avoid any transfer the debtor in possession may do so as well. 304
F.3d at 318n.1.
173

and Cybergenics rely on, namely “the trustee may.” 11 U.S.C. § 547(b), in
pertinent part provides:
“Except as provided in subsection (c) of this section, the
trustee may avoid any transfer of an interest of the debtor
in property—“
(Emphasis supplied). Accordingly, when Pillowtex suggested the U.S. trustee
could bring a preference action based on its standing under 11 U.S.C. § 307 168 ,
the circuit court was clearly opining Hartford Underwriters does not apply to suits
brought on behalf of the estate.
Prior to Pillowtex, but after Hartford Underwriters, a creditors’ committee’s
standing to prosecute the estate’s avoidance actions was upheld by the Second
Circuit in Commodore International Limited, by and through the Official
Committee of Unsecured Creditors v. Gould, 262 F.3d 96 (2d Cir. 2001), without
any reference to Hartford Underwriters. In Commodore, bankruptcy cases for the
debtors were pending in the Bahamas and under the Bankruptcy Code. The
Bahamian liquidators of the debtors consented to the creditors’ committee
appointed under the Bankruptcy Code prosecuting the estate’s claims for fraud,
mismanagement, and waste. 262 F.3d at 98. The lower court’s decisions show
these claims included claims for preferences and fraudulent transfers, thereby
invoking Bankruptcy Code sections 544(b)(1) and 547. In re Commodore
International Limited, 231 B.R. 175, 176 (Bankr. S.D.N.Y. 1999); see also In re
Commodore International, Limited, 242 B.R. 243, 247 (Bankr. S.D.N.Y. 1999).
The committee commenced its action, and subsequently the liquidators
brought identical claims in a separate action because defendants moved to
dismiss the committee’s action. 262 F.3d at 98. The committee’s action was
dismissed for lack of standing and the committee appealed to the Second Circuit
raising 2 issues: whether it validly obtained standing by consent and whether the
standing can be unilaterally revoked. 262 F.3d at 98-99. The Second Circuit
reviewed numerous decisions allowing creditors or committees to sue in the
name of the debtor in possession under section 544(b) and otherwise, and held a
committee can obtain standing if the trustee or debtor in possession unjustifiably
refuses to bring an action or if the trustee/debtor in possession consents and the
committee’s action is necessary and beneficial to resolution of the bankruptcy.
262 F.3d at 99-100. Because the liquidators had commenced their own action
and the Bahamian court ruled they should not have consented, the Second
168 11 U.S.C. § 307 provides:
“The United States trustee may raise and may appear and
be heard on any issue in any case or proceeding under this
title, but may not file a plan pursuant to section 1121(c) of
this title.”
174

Circuit upheld the dismissal of the committee’s action because it was no longer
necessary and beneficial. 262 F.3d at 100.
Significantly, appellant and appellee in Commodore were represented by
Stroock & Stroock & Lavan, LLP and Cahill Gordon & Reindel, respectively. 262
F.3d at 96. The Second Circuit judges on the Commodore panel were Chief
Circuit Judge Walker and Circuit Judges Cabranes and Straub, with the opinion
written by Chief Judge Walker. Id. at 96-97. It is impossible that these eminent
judges and law firms were unaware of Hartford Underwriters. The only possible
explanation is they did not mention Hartford Underwriters because they didn’t
view it as having any application to derivative standing.
In section 506(c), Congress grants the trustee/debtor in possession a
cause of action to collect from a creditor’s collateral security under certain
circumstances. In general, section 506(c) provides that if the trustee or debtor in
possession uses estate resources to preserve a creditor’s collateral, the trustee
or debtor in possession may obtain reimbursement from the collateral. In
Hartford Underwriters an unpaid insurer claimed the trustee benefited a creditor’s
collateral by procuring the insurance, but did not pay for the insurance with estate
resources or otherwise. Therefore, the unpaid insurer wanted to collect from the
creditor’s collateral under section 506(c).
In Hartford Underwriters the Supreme Court did not need to decide
whether the trustee’s recovery under section 506(c) would go into the estate for
pro rata distribution or would go to the estate for ultimate distribution to the
secured claimholder. 530 U.S. at 12n.4. Rather, it could easily answer the
question as to whether section 506(c) grants entities other than the trustee a
cause of action against a secured claimholder’s collateral by determining that by
granting the trustee a cause of action in section 506(c), Congress was not
granting the secured claimholder or anyone else a cause of action. Since the
creditor in Hartford Underwriters was suing for its own account and not for the
estate, it was simple to conclude section 506(c) does not grant private causes of
action.
In section 544(b)(1), Congress grants the trustee/debtor in possession the
power to avoid transfers for the benefit of the estate. We know it’s for the benefit
of the estate because sections 541(a)(3) and (4) 169 render the recoveries
169 11 U.S.C. § 541(a)(3)-(4) include the following in property of the estate:
(3) Any interest in property that the trustee recovers
under section 329(b), 363(n), 543, 550, 553, or 723 of this
title.
(4) Any interest in property preserved for the benefit of or
ordered transferred to the estate under section 510(c) or
551 of this title.
175

property of the estate. Therefore, the question presented by the meaning of the
words “the trustee may” in section 544(b)(1) is not whether section 544(b)(1)
grants entities other than the trustee causes of action to avoid transfers. Rather,
the question is whether the trustee or debtor in possession can use other entities
to exercise the trustee’s power to avoid transfers for the estate’s benefit.
Interpreting section 544(b)(1) to mean “only” the trustee/debtor in possession
may avoid any transfer, does not answer the question as to how the trustee may
do it. When a creditors’ committee acts for a trustee or debtor in possession it
sues in the name of the debtor in possession or trustee on behalf of the estate as
the caption of Cybergenics shows. Therefore, the prosecution of an avoidance
action by a committee acting derivatively is simply a method for the trustee or
debtor in possession to exercise its avoiding power.
Most recently, in In re Housecraft Industries USA, Inc., 310 F.3d 64, 67
(2d Cir. 2002), the defendant “moved to dismiss for lack of standing, arguing that
[Bankruptcy Code] §§ 548 and 549 only authorize trustees or debtors-inpossession
– not creditors – to bring avoidance actions.” The Second Circuit
rejected the argument, noting: “While some courts require individual creditors to
satisfy a more stringent standard than creditors’ committees in order to obtain
standing, such a requirement is unnecessary in our circuit because under
Commodore, we only grant standing to creditors – either individuals or
committees – when doing so is in the best interest of the estate.” 310 F.3d at
71n.7.
2. Interpreting Section 544(b)(1) to Bar Derivative Actions,
Renders Section 503(b)(3)(B) a Practical Absurdity
.
Interpreting section 544(b)(1) to bar a creditor and a committee from
bringing suit derivatively to recover property under section 544(b)(1) renders
section 503(b)(3)(B) a practical absurdity. 11 U.S.C. § 503(b)(3)(B) provides:
(b) After notice and a hearing, there shall be
allowed administrative expenses, other
than claims allowed under section 502(f)
of this title, including—
(3) the actual, necessary expenses, other than
compensation and reimbursement
specified in paragraph (4) of this
subsection, incurred by—
(B) a creditor that recovers, after the court’s
approval, for the benefit of the estate any
property transferred or concealed by the
debtor;
(emphasis supplied).
176

Section 503(b)(3)(B) expressly provides for creditors to obtain allowed
administrative claims to reimburse them for recovering property if they recover it
after procuring court approval. The wording of section 503(b)(3)(B) shows clearly
it is referring to avoidance actions to retrieve property the debtor fraudulently or
preferentially transferred. If under section 544(b)(1) the courts cannot grant
approval to a creditor to recover property for the estate, then section 503(b)(3)(B)
serves no purpose. Put differently, section 503(b)(3)(B) shows Congress did not
intend that section 544(b)(1) be interpreted to bar derivative actions.
There is no application for the words “after the court’s approval” in section
503(b)(3)(B) if section 544(b)(1) is interpreted to mean the court can not approve
a creditor pursuing recovery of property transferred by a debtor. This runs afoul
of hornbook law set forth in Bank of America National Trust and Savings
Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 452 (1999),
that there is an “interpretive obligation to try to give meaning to all the statutory
language.” (In 203 North LaSalle, the Supreme Court rejected an interpretation
of 1129(b)(2)(B)(ii) that would have made the words “on account of” a
redundancy. Id.).
The foregoing analysis is consistent with and required by the Supreme
Court’s statutory interpretation of 11 U.S.C. § 362(d)(1) in United Savings
Association of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365
(1988). There, an undersecured creditor contended it was entitled to relief from
the automatic stay because the debtor’s failure to pay it monthly use or interest
payments on the secured portion of its claim deprived it of adequate protection
for purposes of section 362(d)(1). 484 U.S. at 368-369. 11 U.S.C. §§ 362(d)(1)-
(2) provide:
“On request of a party in interest and after notice and a
hearing, the court shall grant relief from the stay provided
under subsection (a) of this section, such as by terminating,
annulling, modifying, or conditioning such stay –
(1) for cause, including the lack of adequate protection of
an interest in property of such party in interest; or
(2) with respect to a stay of an act against property under
subsection (a) of this section, if --
(A) the debtor does not have an equity in such property;
and
(B) such property is not necessary to an effective
reorganization.”
177

The Supreme Court remarked that statutory construction is a “holistic
endeavor” often clarified by the remainder of the statutory scheme. 484 U.S. at
371. Then, it interpreted section 362(d)(1) by reference to section 362(d)(2). If
an undersecured creditor not receiving use or interest payments would be
entitled to stay relief for lack of adequate protection under section 362(d)(1), then
why would any creditor resort to section 363(d)(2) for stay relief which requires
both that (a) the creditor be undersecured (which assures the debtor has no
equity in the property), and (b) the property not be necessary to an effective
reorganization. The Supreme Court ruled “petitioner’s interpretation of §
362(d)(1) makes nonsense of § 362(d)(2)…..This renders § 362(d)(2) a practical
nullity and a theoretical absurdity.” 484 U.S. at 374, 375.
Here, the interpretation of section 544(b)(1) to bar derivative actions would
render section 503(b)(3)(B) nonsense, a practical nullity, and a theoretical
absurdity. Section 503(b)(3)(B)’s grant of reimbursement to a creditor who
recovers property “after the court’s approval,” is all of those things if the court
can’t give approval.
Significantly, the Supreme Court strained to find a possible application of
section 362(d)(2), if section 362(d)(1) were interpreted to require stay relief if
monthly payments are not made to an undersecured creditor. It found one. If the
debtor does make monthly payments to an undersecured creditor, thereby
furnishing adequate protection, then, conceivably, the creditor could still request
stay relief under section 362(d)(2) on the ground the property is unnecessary to
reorganization. Notwithstanding that section 363(d)(2) could still serve a
purpose, the Supreme Court maintained its ruling that the creditor’s interpretation
of section 362(d)(1) rendered section 362(d)(2) absurd. It observed the creditor
“offers no reason why Congress would want to provide relief for such an
obstreperous and thoroughly unharmed creditor.” 484 U.S. at 375.
Accordingly, even if some conceivable application of section 503(b)(3)(B)
could be imagined, notwithstanding a repudiation of its language that the court
can approve a creditor’s recovery of property the debtor transferred, the abstract
application of section 503(b)(3)(B) would not save the section from being
rendered a practical nullity.
In re Blount, 276 B.R. 753, 754, 759 (Bankr. M.D. La. 2002)(chapter 7
case), holds section 503(b)(3)(B) is statutory authority to confer derivative
standing on creditors to act for the estate. 170
3. 11 U.S.C. § 1123(b)(3) Does Not Support Barring
Derivative Actions
170 In reTogether Development Corp., 262 B.R. 586, 589 (Bankr. D.Mass. 2001),
also finds statutory authority to grant derivative standing to a committee in 11
U.S.C. §§ 1103(c)(5) and 1109(b).
178

Bankruptcy Code section 1123(b)(3) provides:
“(b) Subject to subsection (a) of this section, a plan may –
(3) provide for –
(A) the settlement or adjustment of any claim or interest
belonging to the debtor or to the estate; or
(B) the retention and enforcement by the debtor, by the
trustee, or by a representative of the estate appointed for
such purpose, of any such claim or interest.
The panel decision in Cybergenics treated this section as supporting its position:
“…Furthermore, § 1123(b)(3)(B) suggests that Congress
was aware of the issue of proper estate representation and
could have incorporated language allowing a non-trustee
estate representative to bring claims under § 544.
Congress did not do so, just as it did not allow for the
prosecution of a case under § 506(c) by a party that is not
a trustee.”
304 F.3d at 324n.11. Section 1123(b)(3)(B) supports the opposite
conclusion.
First, section 1123(b)(3)(B) lists provisions that may be included in chapter
11 plans. But, its reference to a representative of the estate could be a
representative of the estate granted derivative standing prior to any chapter 11
plan. It would be completely consistent with pre-Code practice for a
representative of the estate to commence an action prior to confirmation, and the
chapter 11 plan would provide for the representative to continue it. Cybergenics’
assumption that the representative referred to would first come into existence on
confirmation of the plan has no basis.
Second, let’s analyze the logic or illogic of Congress authorizing derivative
standing under a plan, but not prior to a plan. A statutory creditors’ committee is
appointed by a United States trustee and can only retain professionals without
certain conflicts and connections, approved by the court, and paid with court
approval. 11 U.S.C. §§ 328(a), 328(c), 330, 1102(a)(1), and 1103(b). Does it
make any sense that Congress would not want that committee to prosecute
estate avoidance actions, but would then allow the debtor, trustee, or an estate
representative to pursue the action after plan confirmation? Does it make any
sense that the Congress that granted every creditor and creditors’ committee
standing to raise, appear, and be heard on every issue in the case under 11
179

U.S.C. § 1109(b) 171 would not allow the committee to commence an avoidance
action? There is no rational reason for Congress to make that distinction.
Section 1123(b)(3)(B) makes far more sense if its reference to an estate
representative includes a representative granted derivative standing prior to
confirmation who has not yet completed its avoidance action. In view of section
503(b)(3)(B) which expressly refers to court approval of creditors bringing
avoidance actions, there can be little doubt that the panel decision in
Cybergenics wrongly interpreted sections 544(b) and 1123(b)(3)(B).
4. The Panel Decision in Cybergenics Violated the
Rule of Statutory Construction in Midlantic National Bank
v. New Jersey Department of Environmental Protection,
474 U.S. 494 (1986), to Continue Pre-Code Law Absent a
Showing of Congressional Intent to Change It
.
.
In Midlantic, the bankruptcy trustee requested authority to abandon
contaminated waste oil in leaky containers, 474 U.S. at 497, pursuant to 11
U.S.C. § 554(a) which provides:
After notice and a hearing, the trustee may abandon any
property of the estate that is burdensome to the estate or
that is of inconsequential value and benefit to the estate.”
There was no question the literal requirements of section 554(a) were
satisfied in that the waste oil and the property it was on were burdens to the
estate. Id. Nevertheless, the City and State of New York objected on the ground
the abandonment would violate local laws.
The Supreme Court held “a trustee may not abandon property in
contravention of a state statute or regulation that is reasonably designed to
protect the public health or safety from identified hazards.” 474 U.S. at 507.
The Supreme Court explained its rationale for interpreting section 554(a)
to add on conditions to abandonment undisputedly not included in section 554’s
language:
171 11 U.S.C. § 1109(b) provides:
A party in interest, including the debtor, the trustee, a
creditors’ committee, an equity security holders’ committee,
a creditor, an equity security holder, or any indenture
trustee, may raise and may appear and be heard on any
issue in a case under this chapter.
180

“Thus, when Congress enacted § 554, there were wellrecognized
restrictions on a trustee’s abandonment power. In
codifying the judicially developed rule of abandonment,
Congress also presumably included the established corollary
that a trustee could not exercise his abandonment power in
violation of certain state and federal laws. The normal rule of
statutory construction is that if Congress intends for legislation
to change the interpretation of a judicially created concept, it
makes that intent specific. Edmonds v. Compagnie Generale
Transatlantique, 443 U.S. 256, 266-267 (1979). The Court has
followed this rule with particular care in construing the scope of
bankruptcy codifications….”
474 U.S. at 501. Based on three pre-Code decisions, the Supreme Court
determined that under pre-Code practice abandonment could not be done in
violation of local laws reasonably designed to protect the public health or safety.
474 U.S. at 500-501.
Similarly, in Kelly v. Robinson, 479 U.S. 36, 50 (1986), the Supreme Court
interpreted 11 U.S.C. § 523(a)(7) to render restitution obligations
nondischargeable when part of a state court’s criminal sentence, based on pre-
Code practice.
It is acknowledged that pre-Code law was even more clear in allowing
creditors and committees to sue derivatively for a bankruptcy trustee. See, e.g.,
Trimble v. Woodhead, 102 U.S. 647 (1881); Moyer v. Dewey, 103 U.S. 301
(1881); Gochenour v. Cleveland Terminals Bldg. Co., 118 F.2d 89 (6th Cir.
1941). Even the panel decision in Cybergenics acknowledged the existence of
the pre-Code practice. 304 F.3d at 331 (court admits pre-Code practice of
derivative actions on fraudulent transfers is “more compelling” than the practice
on section 506(c)).
In United States v. Ron Pair Enterprises, Inc., 489 U.S. 235 (1989), the
Supreme Court interpreted section 506(b) of the Bankruptcy Code to grant
holders of involuntary oversecured liens postpetition interest, notwithstanding
that the debtor asserted the result was contrary to pre-Code law. 489 U.S. at
243. Referring to Midlantic and Kelly, the Supreme Court explained it preserved
pre-Code law or practice in those decisions, but was not doing so in Ron Pair
because “this natural interpretation of the statutory language does not conflict
with any significant state or federal interest, nor with any other aspect of the
Code.” 489 U.S. at 245.
In Cybergenics, there is no ‘natural interpretation’ of the statute that bans
derivative standing.
181

5. The Panel Decision in Cybergenics Undermined Two Vital
Congressional Policies
.
At the conclusion of the panel decision, Cybergenics announced its
holding leaves a creditor or committee several options when a debtor in
possession refuses to sue. Specifically, the court ruled:
304 F.3d at 333.
“…Section 1103(c)(4) expressly authorizes a
creditors’ committee to move for the appointment of a
trustee under § 1104. In addition, as ‘a party in interest,’
the Committee could have moved to dismiss the
bankruptcy petition under § 1112 so that it could pursue its
state law avoidance claims in state court….”
It is an understatement to say there are deeply embedded Congressional
policies against trustees or dismissal, for the sake of bringing an avoidance
action the debtor in possession is not best suited to bring.
First, the statute shows the steep standard required by Congress for a
trustee’s appointment. In pertinent part, 11 U.S.C. §§ 1104(a)(1)-(2) provide for
the appointment of a trustee:
(1) “for cause, including fraud, dishonesty, incompetence,
or gross mismanagement of the affairs of the debtor by
current management, either before or after the
commencement of the case, or similar cause, but not
including the number of holders of securities of the
debtor or the amount of assets or liabilities of the
debtor; or
(2) if such appointment is in the interest of creditors, any
equity security holders, and other interests of the estate,
without regard to the number of holders of securities of
the debtor or the amount of assets or liabilities of the
debtor.”
Frequently, a debtor in possession will not want to sue vendors or other
entities to recover preferences or fraudulent transfers based on business
judgment. These entities may be ongoing vendors or financers for the business.
Similarly, appearances may render it inappropriate, or certainly less than optimal,
for a debtor in possession to sue former management. Some creditors or equity
security holders may not believe the debtor in possession will sue as vigorously
as a creditors’ committee would. According to Cybergenics, the appointment of a
trustee is the answer.
182

That answer conflicts with section 1104(a) for several reasons. First,
section 1104 makes clear that business judgment and appearances fall far short
of the standard for a trustee. They do not approach the fraud or dishonesty
required. Indeed, one of the statute’s leading indicators of the ultra high standard
required for a trustee’s appointment is the requirement of proof of “gross
mismanagement.” ‘Mismanagement’ alone is not enough!
Second, a trustee must be in the best interests of equity security holders if
the trustee appointment is under section 1104(a)(2), and absent dishonesty of
current management, equity security holders rarely ever believe their interests
will fare as well with a trustee who does not answer to directors as with a chief
executive officer who does answer to directors having fiduciary duties to
shareholders.
In addition to the statute itself, the Bankruptcy Code’s legislative history
speaks volumes. First, the United States Senate passed a proposed bankruptcy
code rendering trustees mandatory for any company having at least $5 million of
non-trade debt and 1000 security holders. S.2266, 94 th Cong., 1 st Sess. (1977)
at section 1101(3) and 1104(a). The Senate’s trustee provisions were rejected in
favor of the House version quoted above. The House of Representatives
recognized debtors would wait too long before seeking chapter 11 relief if a
trustee would automatically be appointed. House Report No. 95-595, 95 th Cong.,
1 st Sess. (1977) at 233-234. It is so common for debtors in possession and
creditors’ committees to want the committees to prosecute avoidance actions
that is that need is now ground for a trustee, the panel decision in Cybergenics
creates the very deterrent to the use of chapter 11 that Congress went to great
lengths to avoid.
Moreover, by deterring management from seeking chapter 11 relief until
there is no alternative and the business can not be saved, the panel decision in
Cybergenics eliminates the benefits Congress targeted for reorganizations: “By
permitting reorganization, Congress anticipated that the business could continue
to provide jobs, to satisfy creditors’ claims, and to produce a return for its
owners.” H.R. Rep. No. 95-595, 95 th Cong., 1 st Sess. (1977) at 220.
Notably, creditors frequently do not want chapter 11 trustees. It is more
and more common for creditors to prevail on a debtor to retain a new turnaround
manager, satisfactory to the creditors, in the capacity of a chief restructuring
officer or chief executive officer. In either case, the creditors do not want their
nominee displaced by a trustee appointed by the United States trustee.
The panel decision in Cybergenics other solution when a debtor in
possession does not bring an avoidance action is for creditors to move for
dismissal of the case under 11 U.S.C. § 1112(b). It’s probably a blessing that
failure to bring an avoidance action is not a ground for dismissal under section
183

1112(b). Pursuant to 11 U.S.C. § 362(c)(2)(B), the automatic stay terminates on
dismissal of a chapter 11 case. That means every creditor is free to enforce its
rights against the debtor and its property as soon as the case is dismissed. That
means dismissal begins the race to the courthouse by each creditor and the
onslaught of ‘grab law.’ Reorganization becomes impossible. Thus, under
Cybergenics’ panel decision, if a debtor in possession fails to bring an avoidance
action, creditors have a choice if they don’t want a trustee: forfeit the avoidance
action or forfeit the reorganization and resort to grab law.
The panel in Cybergenics acknowledged that on dismissal of a chapter 11
case, the avoidance actions under state law may yield smaller recoveries than
under the Bankruptcy Code’s avoidance provisions. 304 F.3d at 333n.17.
Indeed, unless the court orders otherwise, 11 U.S.C. § 349(b) reinstates voidable
transfers and recoveries as they existed at the commencement of the case.
6. Barring Derivative Actions Would Violate the Rule of
Construction in Dewsnup v. Timm, 502 U.S. 410 (1992),
Under Which The Same Statutory Language Must Be
Interpreted Differently In Two Provisions To Continue Pre-
Code Law Unless Congress Evidences An Intent To
Change It .
As explained above, interpreting the phrase “the trustee may” in both
sections 506(c) and 544(b)(1) to mean “only the trustee/debtor in possession
may” does not resolve the issue in Cybergenics as to whether the debtor in
possession can proceed derivatively through a committee. But, if that is wrong
and the definition does cause section 544(b)(1) to ban derivative actions, that
statutory construction violates the Supreme Court’s ruling in Dewsnup where it
showed the same words in different sections of the Bankruptcy Code should be
interpreted differently when necessary to preserve pre-Code law unless
Congress indicated an intent to change it which is not the case here.
In Dewsnup, two undersecured creditors held a $120,000 recourse claim
against property valued at $39,000. 502 U.S. at 414. Thus, pursuant to 11
U.S.C. § 506(a), the creditors had a secured claim of $39,000 and an unsecured
claim of $81,000. Section 506(a) provides:
An allowed claim of a creditor secured by a lien on
property in which the estate has an interest, or that is
subject to setoff under section 553 of this title, is a secured
claim to the extent of the value of such creditor’s interest in
the estate’s interest in such property, or to the extent of the
amount subject to setoff, as the case may be, and is an
unsecured claim to the extent that the value of such
creditor’s interest or the amount so subject to setoff is less
than the amount of such allowed claim. Such value shall
be determined in light of the purpose of the valuation and of
184

the proposed disposition or use of such property, and in
conjunction with any hearing on such disposition or use or
on a plan affecting such creditor’s interest.
The chapter 7 debtor commenced an adversary proceeding to avoid the
portion of the creditors’ lien securing anything more than $39,000 pursuant to 11
U.S.C. § 506(d), which provides:
To the extent that a lien secures a claim against the debtor
that is not an allowed secured claim, such lien is void,
unless –
(1) such claim was disallowed only under section 502(b)(5)
or 502(e) of this title; or
(2) such claim is not an allowed secured claim due only to
the failure of any entity to file a proof of such claim
under section 501 of this title.
The debtor contended the phrase “allowed secured claim” must have the
same meaning in sections 506(a) and 506(d), thereby requiring that the lien
securing anything over $39,000 be void pursuant to section 506(d). That would
enable the debtor to obtain any appreciation in the property over $39,000.
Conversely, the creditors contended the phrase “allowed secured claim” in
section 506(d) is not used as in section 506(a), but rather means a claim that is
allowed first, and is secured by a lien, second. Since the creditors’ claim was
allowed and was secured by a lien, it would not be void under section 502(d).
The Supreme Court held:
“…Therefore, we hold that § 506(d) does not allow
petitioner to ‘strip down’ respondents’ lien, because
respondents’ claim is secured by a lien and has been fully
allowed pursuant to § 502. Were we writing on a clean
slate, we might be inclined to agree with petitioner that the
words ‘allowed secured claim’ must take the same meaning
in § 506(d) as in § 506(a). But, given the ambiguity in the
text, we are not convinced that Congress intended to
depart from the pre-Code rule that liens pass through
bankruptcy unaffected.”
502 U.S. at 417 (footnote deleted).
Defining “the trustee may” in section 544(b)(1) to mean “only the
trustee/debtor in possession may” leaves an ambiguity far more material than
any ambiguity in section 506(d) because “only the trustee/debtor in possession
185

may” does not answer the question as to whether the trustee may avoid a
transfer by authorizing a creditors’ committee to prosecute the action in the
debtor in possession’s name. The existence of prior law allowing committees to
do so and the absence of any indication Congress wanted to change it should
invoke the same rule of construction used in Dewsnup, which would preserve
pre-Code law. Indeed, the dissent of two justices in Dewsnup considered section
502(d) “seemingly clear.” 502 U.S. at 435.
B. Smart World Technologies, LLC v. Juno Online Services, Inc. (In re
Smart World Technologies, LLC), 423 F.3d 166 (2d Cir. 2005)
i. Facts
The chapter 11 debtor in possession, Smart World Technologies, LLC
(“Smart World”), was prosecuting in the bankruptcy court its claim against the
postpetition purchaser of its internet service business for failure to pay the full
purchase price. Under the sale contract, the purchaser was supposed to pay a
price that increased with the number of qualified subscribers of Smart World that
used the purchaser’s services. Smart World claimed the purchaser circumvented
the process for tracking subscribers by causing a database dump. 423 F.3d at
169.
For three years, the bankruptcy court allowed Smart World’s adversary
proceeding to stall based on the purchaser’s representations that settlement was
imminent. In the first year, the purchaser negotiated with Smart World’s creditors
and represented a settlement was reached, which caused the bankruptcy court
to terminate discovery. The purchaser had negotiated with one creditor,
Worldcom, that admitted it was not motivated by the merits of Smart World’s
claims, but rather by the need to quickly resolve a deteriorating situation. 423
F.3d at 171.
Ultimately, the purchaser and Smart World’s creditors filed a motion for
approval of a settlement of Smart World’s claims under Bankruptcy Rule 9019.
Pursuant to the proposed settlement, Juno would pay $5.5 million to Worldcom in
satisfaction of its disputed secured claim and an ancillary dispute between
Worldcom and the purchaser, and $1.8 million to the creditors’ committee for its
expenses. 423 F.3d at 172n.9. Smart World objected to the settlement on the
grounds (a) it did not require the purchaser to pay its admitted liability to Smart
World, (b) the settlement paid a highly suspect and overstated secured claim to
Worldcom, (c) the settlement was premature because Smart World was not
granted meaningful discovery, (d) Smart World was actively pursuing its claims
and the creditors should not be allowed to settle them, and (e) the creditors
lacked standing to settle over Smart Worlds’ objection. 423 F.3d at 172.
At the settlement hearing, the bankruptcy court displayed hostility towards
Smart World for trying to argue the merits of its claims rather than the
186

easonableness of the settlement. The bankruptcy court announced its intention
to approve the settlement unless Smart World satisfied a condition it could not
meet, namely that it post a supersedeas bond securing the amount of the
settlement. 423 F.3d at 173.
The bankruptcy court approved the settlement finding Smart World’s
refusal to join the settlement was unreasonable in view of the risks, expense, and
delay, and because Smart World was gambling with a recovery that otherwise
would go to creditors. It found creditors had a right to intervene and determined
the bankruptcy court had equitable powers to approve the settlement. The
district court affirmed finding the bankruptcy court had equitable power to allow
Worldcom and the statutory creditors’ committee to settle. 423 F.3d at 173.
ii. Issue
Did the bankruptcy court “err in granting Smart World’s creditors standing
to settle the adversary proceeding between Smart World and Juno, without
Smart World’s participation and over Smart World’s objections? 423 F.3d at 174.
iii. Holding
“[W]hile authority to pursue a Rule 9019 motion may, in certain limited
circumstances, be vested in parties to the bankruptcy proceeding other than the
debtor-in-possession, those circumstances are not present here.” 423 F.3d at
174. “We do not rule out that in certain, rare cases, unjustifiable behavior by the
debtor-in-possession may warrant a settlement over the debtor’s objection, but
this is not such a case.” 423 F.3d at 177.
iv. Rationale
Bankruptcy Rule 9019 and Bankruptcy Code section 323 show that only
the trustee and debtor in possession are authorized to bring a settlement motion
and be the estate representative. 423 F.3d at 174. Bankruptcy Code section
1106(a) holds the debtor in possession accountable to maximize value. 423 F.3d
at 175. Derivative standing is available when the debtor in possession
unjustifiably fails to bring suit, In re STN Enterprises, 779 F.2d 901 (2d Cir.
1985), or the debtor consents, Commodore Int’l Ltd. v. Gould (In re Commodore
Int’l Ltd.), 262 F.3d 96, 100 (2d Cir. 2001). Bankruptcy Code section 1109(b)
allows creditors to intervene in adversary proceedings, not to take ownership of
the debtor’s claims. 423 F.3d at 182. “[T]he bankruptcy court’s power to act
pursuant to § 105(a) does not provide an independent basis upon which to grant
appellees standing.” 423 F.3d at 184.
C. ACC Bondholder Group v. Adelphia Communications Corp. (In re
Adelphia Communications Corp.), 361 B.R. 337 (S.D.N.Y. 2007)
187

i. Facts
The bankruptcy court established a process to resolve disputes between
the affiliated debtors. The debtors and statutory creditors’ committee were
ordered to remain neutral. Several unofficial creditors’ committees were
deputized to litigate on behalf of the different debtors. While a right was reserved
for the debtors to compromise one or more of the issues, the authorized litigants
had the right to object to the compromise and to assert the debtors had no
authority to compromise those issues. Then, the bankruptcy court authorized the
debtors to propose a chapter 11 plan that included a proposed settlement, but
conditioned that right on offering creditors the option of voting for the plan without
the intercreditor settlement. Ultimately, the debtors entered into a settlement with
all the committees except the committee for the parent debtor. That committee
had 23 members and two (later 3 more) signed the settlement in their individual
capacities.
The plan was accepted by all classes. At the confirmation hearing, the
court treated the proposed settlement as a settlement entitled to be assessed
under Protective Committee for Independent Stockholders of TMT Trailer Ferry,
Inc. v. Anderson, 390 U.S. 414, 424 (1968), and In re W.T. Grant Co., 699 F.2d
599, 608 (2d Cir. 1972), whereby the settlement is approved if it reaches the
lowest level of the range of reasonableness. The court confirmed the plan and
the ACC Bondholder Group requested a stay pending appeal on many grounds.
The bankruptcy court denied the stay, reasoning the issues were not even close
questions: "Here I do not believe that an appeal would have a likelihood of
success. Sometimes I decide matters of first impression or where the issue is
close, but this is not one of them." In re Adelphia Communications Corp., 368
B.R. 140, 283 (Bankr. S.D.N.Y. 2007).
ii. Issue
Did the ACC Bondholder Group have a substantial possibility of success
in prevailing on its confirmation objection that there was no settlement or that it
was improperly approved?
iii. Holding
Yes. “…It must be remembered that it was the ACC Noteholders
Committee – not each individual member of that Committee – that was
authorized to act on behalf of the ACC Debtor. Thus, in the absence of the
approval of that Committee, the authorized litigant for ACC had not agreed to the
Settlement. “ 361 B.R. at 356. The appellate court found a substantial possibility
of success on 3 other issues as well.
iv. Rationale
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“The non-consenting members of the ACC Noteholders Committee raised these
very objections at the Confirmation Hearing. In addressing these objections, the
Bankruptcy Court first declared that the Committee was ‘dysfuncion[al]’
apparently because only two (later five) of its members supported the settlement,
while the majority of the others did not. Relying on Smart World, the court then
found that the objections were meritless, because the Debtor always retains the
authority to settle an estate’s claims. This literal reading of Smart World,
however, ignores the facts of both that case and this bankruptcy proceeding. In
Smart World, the settling creditors had no authority to act on behalf of the Debtor.
Here, the ACC Noteholders committee (of which the objecting creditors were
members) had been given the authority to settle claims, thus acting as a proxy
for the Debtor. By contrast, the Debtor here had retained only limited authority to
propose a settlement under clearly articulated conditions. Thus, just as the two
creditors in Smart World could not settle the claims out from under the Debtor,
two individual creditors (acting without court authority) could not settle the claims
out from under the ACC Noteholders Committee, acting on behalf of and in place
of the Debtor.” 361 B.R. at 356-357.
v. Subsequent History
While the district court ruled there were at least 4 independent grounds on
which there was a substantial possibility of reversal, the court required a $1.3
billion bond. Later, the court considered lowering the bond to $250 million, but
appellants’ maximum upside was not more than $250 million and it made no
sense for appellants to post a bond to protect all debtors’ estates when
appellants’ claims were only against one debtor. When the court determined to
require the bond even though Bankruptcy Rule 8005 does not render it
mandatory, appellants did not post it and the appeal was dismissed as equitably
moot. ACC Bondholder Group v. Adelphia Communications Corp. (Inn re
Adelphia Communications Corp.), 367 B.R. 84, 99 (S.D.N.Y. 2007). Notably, the
extreme result was not necessarily required. "[W]hen a court can fashion 'some
form of meaningful relief,' even if it only partially redresses the grievances of the
prevailing party, the appeal is not moot." Resolution Trust Corp. v. Swedeland
Development Group, Inc. (In re Swedeland Development Group, Inc.), 16 F.3d
552, 560 (3d Cir. 1994)(in banc) (quoting Church of Scientology v. United States,
113 S. Ct. 447, 450 (1992)). Significantly, Swedeland also points out in the
context of an appeal from an order approving a borrowing secured by a priming
lien under 11 U.S.C. § 364(d), that there is a "practical consideration that it may
be impossible for a pre-petition creditor with a meritorious appeal to obtain a stay
of a section 364(d) order." Resolution Trust Corp. v. Swedeland Development
Group, Inc. (In re Swedeland Development Group, Inc.), 16 F.3d 552, 561 (3d
Cir. 1994). Swedeland reasons that this practical consideration justifies and
makes fair its determination to affirm the granting of some relief on appeal rather
than dismissing the appeal for mootness. The reasoning is even more
compelling in the context of a confirmation order when a few creditors who are
wronged are told they must post a bond in an amount creating a risk that no
prudent investor should take.
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The latter decision demonstrates that confirmation orders riddled with
reversible error can avoid article III review and any review if courts do not
expedite appeals rapidly while not requiring a bond. Notably, district courts can
revoke the reference of confirmation, while allowing the bankruptcy court to try
confirmation and propose findings of fact and conclusions of law to the district
court. Using that procedure, the district court is able to review the bankruptcy
court’s proposals before an order is entered and before any bond could be
required.
vi. A Recent Strike against Equitable Mootness: Schroeder v.
New Century Liquidating Trust (In re New Century TRS
Holdings, Inc.), ___ B.R. ___ (D. Del. 2009)
(a) Facts
In July 2008, the bankruptcy court confirmed a liquidating chapter 11 plan
for New Century TRS Holdings, Inc. over objections. The company had formerly
originated, serviced, and purchased mortgage loans with 7,200 employees and
$17.4 billion of credit facilities.
The confirmed plan grouped 16 debtors into 3 groups and aggregated the
assets of each group for distribution to its aggregate creditors after payment of
the group’s aggregate administrative, priority, and secured claims. Certain
protocols adjusted the distributions to general creditors so that, for instance,
creditors having claims for which two debtors in a group were jointly and/or
severally liable would receive 130% of their claims against one debtor and 0% of
their claims from the other.
Certain employees of the debtors were beneficiaries of a trust to which n
they had contributed funds under deferred compensation plans. They sued for a
determination that their money was not part of the debtors’ estates (i.e., that the
deferred compensation plans were not unfunded “top hat” plans under ERISA, 29
U.S.C. § 1051(2)).
The employees’ class rejected the plan and objected to confirmation on
the grounds that (a) it was an illegal substantive consolidation and (b) the
protocol caused creditors in the same class to be treated differently in violation of
Bankruptcy Code section 1123(a)(4). The bankruptcy court confirmed the plan
and denied the objectors a stay pending appeal, but required the liquidating trust
created under the plan to provide appellants 30 days’ written notice of its intent to
distribute any funds to certain classes.
The plan’s effective date occurred. The creditors’ committee dissolved. A
plan advisory committee was formed. The debtors’ officers and directors were
replaced. The estates’ assets were distributed to the liquidating trust. All the
debtors’ outstanding notes and stock were cancelled. 127,000 entities received
notice of the effective date of the plans. The liquidating trust entered into
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contracts with a temporary legal staffing agency and an information technology
contractor, extended a short term lease, and spent $1.3 million on those
contracts. The trust spent $142,720 on a premium for a one-year bond covering
its assets and $311,400 on a premium for a 3 year errors and omissions policy
for the trust. The liquidating trust also spent $5.65 million on post-effective date
professional fees. Certain claims were settled and allowed. In one settlement
the trust paid $1.84 million, and paid lesser amounts to settle administrative
claims. The trust also paid $2.6 million to employees to settle WARN Act claims
and other claims arising from their termination.
(b) Issue
Should the appeal be dismissed for equitable mootness?
No.
(c) Holding
(d) Rationale
An appeal should be dismissed as equitably moot if affording appellants
relief “’would be inequitable.’” Slip op. at 13 (quoting In re PW Holding Corp.,
228 F.3d 224, 236 (3d Cir. 2000).
“It is reasonable to question whether the equitable mootness doctrine, as
articulated by the Third Circuit, even applies in the liquidation context,” although
“the court is not aware of any reason why it should be concerned with inequitable
appellate relief in a reorganization context but not in a liquidation context.” Slip
op. at 14 n. 27 (citing In re Continental Airlines, 93 F.3d 553, 560 (3d Cir. 1996);
Nordhoff Investments, Inc. v. Zenith Electronics Corp., 258 F.3d 180, 185 (3d Cir.
2001)).
“…Thus, in a reorganization context, it makes sense to treat the
unraveling of the plan as a significant fact weighing in favor of finding the appeal
equitably moot. See generally id. However, it makes less sense to treat the
unraveling of the plan with such significance in a liquidation context, since (in that
context) the plan transactions tend to be discrete and relatively simple
transactions aimed at disposing of the debtor’s assets in the short term (sale or
disposal of assets, services contracts to sustain the debtor through liquidation,
etc.) and the non-adverse third parties transacting with the debtor are not doing
so with any particular interest in debtor’s future condition, let alone relying on
debtor’s future condition as contemplated by the particulars of any chapter 11
plan.” Slip op. at 15.
“Two countervailing considerations inform the court’s exercise of
discretion. On the one hand, public policy is ser ved by encouraging nonadverse
third parties to rely on the finality of bankruptcy confirmation orders.
Continental, 91 F.3d at 565. Since applying the doctrine brings finality, this
suggests that there should be a low bar for applying the doctrine and that the
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ocurt should construe facts accordingly. On the other hand, however, even while
encouraging reliance on finality, the court must preserve a meaningful right of
appeal. If the equitable mootness bar is too low, that is if equitable mootness
factors swing too easily in favor equitable mootness, the right of appeal becomes
meaningless and the instruction to apply the doctrine ‘cautiously’ and on a
‘limited’ scope, PWS Holding, 228 F.3d at 236, is contravened.” Slip op. at 16.
While no stay was obtained, no creditor class has received distributions.
The plan components that went forward were not components on which nonadverse
third parties detrimentally relied. Slip op. at 18.
“Where parties have not relied to their detriment on finality, which is often
the case in the liquidation context, this factor does not weigh in favor of equitable
mootness.” Slip op. at 19-20.
The plan effected an unwarranted substantive consolidation and treated
claims in the same class differently without consent in violation of Bankruptcy
Code section 1123(a)(4). Slip op. at 23-24.
18. Does a Statutory Committee Require Court Approval or Debtor/Trustee
Consent to Commence an Adversary Proceeding the Bankruptcy Code
Does Not Assign Exclusively to the Trustee?
A. Official Committee of Unsecured Creditors v. Halifax Fund, L.P. (In re
Applied Theory Corp.), 493 F.3d 82 (2d Cir. 2007)
i. Facts
The bankruptcy court denied authority to the statutory creditors’ committee
to sue to equitably subordinate a creditor’s claim to all other creditors’ claims or
to recharacterize it as equity. 493 F.3d at 84. The committee’s theory was that
the creditor had acted unfairly prepetition in obtaining collateral security for $30
million of preexisting unsecured debt in exchange for providing $4 million of new
secured debt. 493 F.3d at84. The chapter 11 trustee had investigated the claim
and determined it lacked merit. 493 F.3d at 85. The district court affirmed the
bankruptcy court’s denial. Official Committee of Unsecured Creditors v. Halifax
Fund, L.P. (In re Applied Theory Corp.), 345 B.R. 56 (S.D.N.Y. 2006).
ii. Holding
The circuit appellate court affirmed the district court’s judgment.
iii. Rationale
“…While the Bankruptcy Code authorizes a creditors’ committee to “raise
and . . . appear and be heard on any issue in a case under” Chapter 11, 11
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U.S.C. § 1109(b), this provision does not allow the committee “to usurp the
trustee’s role as a representative of the estate with respect to the initiation of
certain types of litigation that belong exclusively to the estate,” Hartford
Underwriters Ins. Co. v. Union Planters Bank, N.A., 503 U.S. 1, 8-9 (2000)
(quoting 7 Collier on Bankruptcy ¶ 1109.05 (Lawrence P. King et al. eds., rev.
15th ed. 1999)). Moreover, the Bankruptcy Code “contains no explicit authority
for creditors’ committees to initiate adversary proceedings.” STN, 779 F.2d at
904.” 493 F.3d at 85.
“Nevertheless, the Committee argues that STN and Commodore [In re
STN Enterprises, 779 F.2d 90 (2d Cir. 1985) and Commodore Int’l Ltd. v. Gould
(In re Commodore Int’l Ltd.), 262 F.3d 96 (2d Cir. 2001)] are inapplicable
because they involved “derivative” claims brought on behalf of a trustee or
debtor-in-possession, whereas its claim for equitable subordination is “direct.”
According to the Committee, section 510(c) indicates that an equitable
subordination claim is a direct claim that can be commenced by parties in interest
other than the trustee without first seeking court approval. Unlike other sections
of the code, § 510(c), the Committee contends, does not provide that only the
trustee may bring equitable subordination claims. See, e.g., 11 U.S.C. §§ 547,
548 (preference and fraudulent conveyance claims). Citing only out-of-circuit
authority – In re Vitreous Steel Prods. Co., 911 F.2d 1223 (7th Cir. 1990) – the
Committee urges us to adopt a bright-line rule, under which equitable
subordination claims “may be brought directly by a creditor, creditors, or a
creditors’ committee, without Bankruptcy Court approval.” We are not
persuaded.” 493 F.3d at 86.
“In any event, regardless of how the Committee characterizes it, any
equitable subordination claim brought by the Committee would allege harm to the
Debtor generally and would seek to subordinate the Lenders to other creditors.
Since the Committee is not itself a creditor, it does not have any rights held by
any creditor to assert such a claim against another creditor. In other words, the
Committee has not sustained an injury for which a “direct” claim might otherwise
be available.” 493 F.3d at 87.
iv. Analysis
Applied Theory erroneously holds a statutory committee requires court
approval to bring an equitable subordination claim for three independently
sufficient reasons. It overlooks (a) 11 U.S.C. § 502(a) which expressly grants the
committee authority to object to any claim, (b) the basis of a claim for equitable
subordination as adopted by the Supreme Court, 172 which requires inequitable
conduct which injures, not the debtor, but rather, other creditors, and (c) Term
Loan Holder Committee v. Ozer Group, L.L.C., (In re Caldor Corp.), 303 F.3d
161, 162 (2d Cir. 2002), which holds a party in interest’s right to raise any issue
in a case applies equally in adversary proceedings and contested matters.
172 United States v. Noland, 517 U.S. 535, 538 (1996).
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11 U.S.C. § 502(a) provides:
(a) A claim or interest, proof of which is filed under section 501 of
this title, is deemed allowed, unless a party in interest, including a
creditor of a general partner in a partnership that is a debtor in a
case under chapter 7 of this title, objects.
In turn, 11 U.S.C. § 1109(b) 173 provides a creditors’ committee is a party in
interest. Thus, a creditors’ committee is expressly authorized to object to any
proof of claim. Bankruptcy Rule 3001(a) requires a proof of claim to conform
substantially to the Official Forms. Official Form 10 governs proofs of claim and
requires the claimant to list its amount, security, and priority. A party objecting to
a claim, may object to any part of it, including its priority. Section 502(a) should
have begun and ended this dispute. Inexplicably, it is not mentioned in the
district court and Second Circuit’s opinions. There is no indication the parties
brought it to the courts’ attention.
Separately, Applied Theory is premised on the notion that the debtor in
possession or trustee starts out owning the interest in equitably subordinating a
claim and the committee has no such interest. 174 In fact, the trustee and estate
do not gain or lose anything if one creditor is paid ahead of another. Conversely,
the committee represents all general unsecured claimholders who do gain if the
committee prevails on subordinating a $34 million secured claimholder to the
unsecured claimholders. Thus, Applied Theory assumes the estate owns the
objection to the priority of a secured claim, for which objection the estate receives
no remedy for itself.
To try to make its case that an action for equitable subordination belongs
to the trustee or debtor in possession, Applied Theory assumes that equitable
subordination must allege harm to the debtor generally. 175 That is both wrong
173 11 U.S.C. § 1109(b) provides:
(b) A party in interest, including the debtor, the trustee, a creditors’
committee, an equity security holders’ committee, a creditor, an equity
security holder, or any indenture trustee, may raise and may appear and
be heard on any issue in a case under this chapter.
174 “The Committee has demonstrated no interest of its own in subordination separate and apart
from the interests of the estate as a whole, and has failed to demonstrate why it should be
permitted to step into the shoes of the trustee. Cf. St. Paul Fire & Marine Ins. Co. v. PepsiCo,
Inc., 884 F.2d 688, 700-03 (2d Cir. 1989).” Slip Op. at 7.
175 “In any event, regardless of how the Committee characterizes it, any equitable
subordination claim brought by the Committee would allege harm to the Debtor generally and
would seek to subordinate the Lenders to other creditors. Since the Committee is not itself a
creditor, it does not have any rights held by any creditor to assert such a claim against another
194

and irrelevant. It is wrong because there is no such requirement. It is irrelevant
because the relief requested does not compensate the estate in any way
whatsoever. Rather, eligibility for such relief depends on showing unfairness to
other creditors.
When the United States Supreme Court compiled the grounds for
equitable subordination it did not require that inequitable conduct harm the
debtor, but did recite the need for injury to creditors:
The judge-made doctrine of equitable subordination
predates Congress's revision of the Code in 1978. Relying in part
on our earlier cases, see, e. g., Comstock v. Group of Institutional
Investors, 335 U.S. 211, 92 L. Ed. 1911, 68 S. Ct. 1454 (1948);
Pepper v. Litton, 308 U.S. 295, 84 L. Ed. 281, 60 S. Ct. 238 (1939);
Taylor v. Standard Gas & Elec. Co., 306 U.S. 307, 83 L. Ed. 669,
59 S. Ct. 543 (1939), the Fifth Circuit, in its influential opinion in In
re Mobile Steel Co., 563 F.2d 692, 700 (CA5 1977), observed that
the application of the doctrine was generally triggered by a showing
that the creditor had engaged in "some type of inequitable
conduct." Mobile Steel discussed two further conditions relating to
the application of the doctrine: that the misconduct have "resulted in
injury to the creditors of the bankrupt or conferred an unfair
advantage on the claimant," and that the subordination "not be
inconsistent with the provisions of the Bankruptcy Act." Ibid. 176
The fact that the remedy for equitable subordination only benefits
some creditors against another creditor and provides no benefit to the
debtor or estate, shows that the trustee or debtor in possession have little
or no interest in a claim for equitable subordination.
Applied Theory also reasons the committee had no direct claim for
equitable subordination of a secured claim. 177 That is technically true. It
is the committee’s constituency, general unsecured claimholders, who
held the direct claim. Applied Theory, however, in attempting to show the
trustee owned the equitable subordination action appears to overlook that
the debtor in possession or trustee are not allowed to bring creditors’
claims other than avoidance actions. Caplin v. Marine Midland Grace
Trust Co., 406 U.S. 416 (1972); Shearson Lehman Hutton Inc. v.
Wagoner, 944 F.2d 114, 118 (2d Cir. 1991)(“ It is well settled that a
bankruptcy trustee has no standing generally to sue third parties on behalf
of the estate's creditors, but may only assert claims held by the bankrupt
creditor. In other words, the Committee has not sustained an injury for which a “direct” claim
might otherwise be available.” Slip Op. at 7‐8.
176 United States v. Noland, 517 U.S. 535, 538-539 (1996).
177 Slip Op. at 8.
195

corporation itself. Caplin, 406 U.S. at 434 (trustee in Chapter 10
reorganization has no standing to sue indenture trustee, who allegedly
permitted corporation to violate indenture, on behalf of holders of
debentures issued by the corporation).” Of course, debtors in possession
and trustees, as parties in interest, are authorized by section 502(a) to
object to claims, including their priorities. In sum, the trustee is authorized
by statute to object to the claim, as is every party in interest such as the
creditors’ committee. But, the trustee is barred by lack of statutory
authorization and the jurisprudence from suing a creditor on behalf of
other creditors for money damages except for avoidance actions whose
proceeds are made property of the estate by 11 U.S.C. § 541(a)(3).
Bankruptcy Rule 7001(7) and (8) provide a proceeding for equitable relief
or to subordinate a claim is an adversary proceeding. Applied Theory appears to
give weight to the notion that because under the Bankruptcy Rules, equitable
subordination requires an adversary proceeding, the committee needs court
approval to commence it. Applied Theory asserts the Bankruptcy Code contains
no explicit authority for creditors’ committees to initiate adversary proceedings. 178
But, in Term Loan Holder Committee v. Ozer Group, L.L.C., (In re Caldor Corp.),
303 F.3d 161, 168-171 (2d Cir. 2002), the Second Circuit exhaustively showed
that when pursuant to 11 U.S.C. § 1109(b) the Bankruptcy Code grants a right to
a party in interest such as a creditors’ committee, to raise any issue in a case,
that right applies to adversary proceedings: “We hold, therefore, that the phrase
‘any issue in a case’ plainly grants a right to raise, appear and be heard on any
issue regardless whether it arises in a contested matter or an adversary
proceeding…Any other construction given to the statute would be contrary to the
accepted principles of statutory interpretation.” Id. at 169-170.
The Bankruptcy Rules cannot deprive litigants of rights granted by the
statute. In re Smart World Techs., LLC, 423 F.3d 166, 181 (2d Cir. 2005)
("where a conflict between a Rule and a statutory provision exists . . . the Rules
Enabling Act requires that [the Court] apply the statutory provision." ).
Finally, on the facts of Applied Theory, the holding did no substantive
harm to creditors because their theory underlying equitable subordination was
doomed from the start. In 11 U.S.C. § 547(b), Congress showed it would avoid a
transfer collateralizing unsecured debt within 90 days of bankruptcy if certain
other conditions are satisfied, but would not avoid the transfer if made more than
178 “…While the Bankruptcy Code authorizes a creditors’ committee to “raise and . . . appear and
be heard on any issue in a case under” Chapter 11, 11 U.S.C. § 1109(b), this provision does not
allow the committee “to usurp the trustee’s role as a representative of the estate with respect to
the initiation of certain types of litigation that belong exclusively to the estate,” Hartford
Underwriters Ins. Co. v. Union Planters Bank, N.A., 503 U.S. 1, 8-9 (2000) (quoting 7 Collier on
Bankruptcy ¶ 1109.05 (Lawrence P. King et al. eds., rev. 15th ed. 1999)). Moreover, the
Bankruptcy Code “contains no explicit authority for creditors’ committees to initiate adversary
proceedings.” STN, 779 F.2d at 904.” Slip Op. at 4.
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90 days before bankruptcy. Indeed, if the debtor had repaid the debt, instead of
securing it, more than 90 days before bankruptcy, there would be no avoidance
action against the creditor. If repayment is unavoidable, than surely something
less such as collaterizing debt is not voidable. In Applied Theory the transfer had
to have occurred more than 90 days before bankruptcy because otherwise the
creditors would simply have avoided the transfer as a preference. But, when
Congress creates a bright line test of 90 days, it would be completely incongruent
for a court to grant relief when the collateral was granted more than 90 days
before bankruptcy. Moreover, the creditor provided $4 million of new money on a
secured basis. While the creditors’ committee claims the new money was safe,
the facts that the debtor commenced a bankruptcy case which would initially stop
debt service, and that the committee would try to subordinate the entire $34
million shows the new loan was not commercially safe.
Thus, the harm of Applied Theory is its potential application in future
cases to block committees from pursuing relief in the interest of their creditor
constituencies when the debtor has no incentive to request the relief. Hopefully,
this harm can be avoided by timely citing of 11 U.S.C. § 502(a) and the other
authorities listed above.
19. Can Creditors Commence Derivative Actions without Consent or Court
Approval?
A. PW Enterprises, Inc. v. North Dakota Racing Commission
(In re Racing Services, Inc.), 540 F.3d 892 (8 th Cir. 2008)
i. Facts
Three days before the statute of limitations would expire, a creditor owed
$2 million filed a preference and fraudulent transfer complaint against a
governmental entity holding a $6 million tax priority claim. 540 F.3d at 896. The
creditor contended the government had received a payment improperly classified
as a tax payment. Before the filing, the creditor showed its draft complaint to the
chapter 7 trustee who declined to bring the action. 540 F.3d at 896. Two months
later, the creditor requested bankruptcy court permission to pursue the claims.
The trustee did not oppose the request, but obtained a clarification that the
creditor was bringing it for the estate’s benefit and was advancing the fees and
costs. 540 F.3d at 897.
The bankruptcy court denied the creditor’s request for derivative standing
on the ground it had not shown the trustee abused his discretion or acted
unjustifiably by failing to pursue the avoidance claims. 540 F.3d at 897. The
court did not address the consent issue. The bankruptcy appellate panel
affirmed. 540 F.3d at 897. On appeal to the circuit appellate court, the state
argued the bankruptcy court’s denial of derivative standing was correct because
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the creditor waited till after filing the complaint to request permission. 540 F.3d at
897.
ii. Issues
What are the requirements for obtaining derivative standing?
“…In this case, we must decide whether the bankruptcy court erred in
holding that, as a matter of law, a creditor may never obtain derivative standing
to pursue avoidance claims absent a showing that the trustee was ‘unable or
unwilling’ to do so.” 540 F.3d at
Can a creditor be granted derivative standing when the trustee does not
oppose it or consents?
Can a creditor be granted derivative standing when it files the complaint
before seeking permission from the bankruptcy court?
iii. Holdings
“[T]o establish derivative standing, a creditors must show: (1) it petitioned
the trustee to bring the claims and the trustee refused; (2) its claims are
colorable; (3) it sought permission from the bankruptcy court to initiate an
adversary proceeding; and (4) the trustee unjustifiably refused to pursue the
claims….To satisfy its burden, the creditor, at a minimum, must provide the
bankruptcy court with specific reasons why it believes the trustee’s refusal is
unjustified….*** At bottom, the determination of whether the trustee unjustifiably
refuses to bring a creditor’s proposed claims will require bankruptcy courts to
perform a cost-benefit analysis….” 540 F.3d at 900, 901 (Emphasis in original;
footnotes omitted).
“Like the Second Circuit, we are persuaded by the reasoning of In re
Spaulding Composites, and hold that a creditor may proceed derivatively when
the trustee (or debtor-in-possession) consents (or does not formally oppose) the
creditor’s suit….*** We also adopt the Second Circuit’s standard for establishing
derivative standing when the trustee (or debtor-in-possession) consents:
‘A creditor[]…may acquire standing to pursue the debtor’s
claims if (1) the [creditor] has the consent of the debtor in
possession or trustee, and (2) the [bankruptcy] court finds that suit
by the [creditor] is (a) in the best interest of the bankruptcy estate,
and (b) is necessary and beneficial to the fair and efficient
resolution of the bankruptcy proceedings.’”
540 F.3d at 902.
“…We therefore make plain that a trustee’s consent is a necessary, but
not sufficient condition for granting a creditor derivative standing in this
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context. Regardless of whether a creditor seeks derivative standing
because the trustee ‘unjustifiably’ refuses to pursue its claims or consents
to the creditor’s complaint, the bankruptcy court has the same obligation -
- to carefully scrutinize the request and satisfy itself that derivative
standing is proper under the circumstances.” 540 F.3d at 903.
“Our rejection of a per se rule forbidding retroactive grants of derivative
standing should not be understood as limiting the bankruptcy courts’
authority to deny such requests in the appropriate circumstances. But
bankruptcy courts should not, as a matter of course, either reject or grant
motions for retroactive authorization. Rather, they must evaluate each
request independently. We caution bankruptcy courts, however, from
exclusively relying on the fact that a creditor filed its motion after its
complaint as a basis for denying meritorious derivative actions.” 540 F.3d
at 904 (emphasis in original).
“We conclude that a creditor (or creditor’s committee may obtain
derivative standing to pursue avoidance actions under circumstances in
which the trustee (or debtor-in-possession) either unjustifiably refuses to
bring the creditor’s proposed claims or consents to the creditor pursuing
such claims in his stead. We also hold that the bankruptcy courts may
retroactively grant a creditor derivative standing. We emphasize,
however, that under no circumstances may a creditor prosecute its
derivative complaint without the bankruptcy court’s permission.” 540 F.3d
at 904-905 (emphasis in original).
iv. Analysis
As the Eighth Circuit acknowledges, it largely adopts the Second Circuit’s
standards for the grant of derivative standing, with one exception. Namely, the
Eighth Circuit expressly allows a creditor to commence a derivative action before
obtaining bankruptcy court approval. While the facts here were that there was
little or no time to obtain approval before the statute of limitations expired, that
portion of the ruling is troublesome for two reasons.
First, commencing an action that the trustee controls is a violation of the
automatic stay under 11 U.S.C. § 362(d)(3). The stay was not discussed in the
decision.
Second, once creditors and committees know they can commence
derivative actions before obtaining court approval, the case dynamics and game
theory change. Debtors in possession will not want to risk losing control of
actions to third parties. Therefore, this decision motivates them to be more
trigger happy to eliminate the risk that a third party may take control. In the
future, debtors may attempt to obtain declaratory judgments that derivative
standing should not be granted, to eliminate the risk of a third party grabbing
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control of a cause of action and becoming a factor in negotiations with the party
being sued.
B. After Derivative Standing is Granted, It Can be Taken
Away
i. Official Committee of Equity Security Holders v. Official
Committee of Unsecured Creditors (In re Adelphia Communications
Corp.), 544 F.3d 420 (2d Cir. 2008)
a) Facts
In the Adelphia chapter 11 case, a statutory equity committee was
appointed when there existed a possibility of residual value for equity holders.
544 F.3d at 422. After the debtor rejected a demand to bring certain claims
against its bank lenders and investment banks, the court granted the equity
committee derivative standing to do so, and the debtor neither objected nor
supported the equity committee’s request to do so. 544 F.3d at 422-423.
Subsequently, the bankruptcy court confirmed Adelphia’s chapter 11 plan
under which the action controlled by the equity committee would be transferred to
a litigation trust managed by 5 trustees appointed by the creditors’ committee.
544 F.3d at 423. The bankruptcy court determined creditors would have to
recover $6.5 billion before there would be money to flow to shareholders, and
that rendered the equityholders “hopelessly out of the money.” In re Adelphia
Communications Corp., 368 B.R. 140, 272 (Bankr. S.D.N.Y. 2007), quoted at .
544 F.3d at 423. The class of equityholders accepted the plan. 544 F.3d at
426n.7. The equity committee appealed and the district court dismissed the
appeal as equitably moot. In re Adelphia Communications Corp., 371 B.R. 660
(S.D.N.Y. 2007).
b) Issues
After granting the equity committee derivative standing, could the
bankruptcy court retract the derivative standing without the equity committee’s
consent? If so, did the bankruptcy court abuse its discretion in doing so?
c) Holding
Yes. “We hold that, to the contrary, a court may withdraw a committee’s
derivative standing and transfer the management of its claims, even in the
absence of that committee’s consent, if the court concludes that such a transfer
is in the best interests of the bankruptcy estate.” 544 F.3d at 423.
“We do not mean to trivialize, but only to place in context, the role of the
derivative plaintiff. It serves ‘with the approval and supervision of a bankruptcy
court’ and shares the ‘labor’ of litigation with the debtor-in-possession.
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Commodore, 262 F.3d at 100. Contrary to the Equity Committee’s arguments,
however, it does not usurp the central role of the court or debtor in overseeing
and managing the estate’s legal claims.” In re Adelphia Communications Corp.,
544 F.3d 420, 427 (2d Cir. 2008).
The bankruptcy court did not abuse its discretion in transferring the equity
committee’s derivative standing to the litigation trust because the trustees of the
litigation trust were required by the plan to “’maximize the value of the transferred
Causes of Action, whether by litigation, settlement or otherwise,’ and the trustees
are liable for deliberately intending to injure, or recklessly disregarding the best
interests of, interest holders in the litigation trust (including equity holders),” and
“the bankruptcy court conducted a reasonable analysis of the costs and benefits
of the Equity Committee’s continued management of the claims.” 544 F.3d at
425.
d) Analysis
It is always dangerous for litigation to be controlled by a party having no
interest in it unless it results in a grand slam homerun, as was the case here. As
a practical matter, a party given derivative standing can not prosecute or settle a
claim effectively if the debtor retains the right to settle. Therefore, it becomes an
important part of case management for the bankruptcy court to make clear that a
party given derivative standing is the only party who can prosecute or settle until
such time as the bankruptcy court transfers the derivative standing after notice
and hearing and after determining the transfer is in the best interests of the
estate.
C. Does the Transfer of a Claim Render the Transferee Vulnerable to Defenses
Personal to the Transferor?
i. Facts
1. Enron Corp. v. Springfield Associates, LLC
(In re Enron Corp.), 379 B.R. 425
(S.D.N.Y. 2007), motion for certification of
interlocutory appeal denied, 2007 Dist.
LEXIS 70731 (S.D.N.Y., Sept. 2, 2007).
When Enron commenced its chapter 11 case on December 2, 2001,
pursuant to a short term credit agreement it owed Citibank over $1.7 billion.
During Enron’s chapter 11 case, approximately $5 million of Citibank’s claim was
transferred first to Deutsche Bank and then to Springfield Associates. Each
transfer included sales and assignment agreements and each one indemnified
the buyer against equitable subordination and disallowance of the transferred
claim. Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R.
425, 428-429 (S.D.N.Y. 2007). Enron commenced an adversary proceeding
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against Citibank seeking equitable subordination of its claims, disallowance of its
claims pursuant to 11 U.S.C. § 502(d), and compensatory and punitive damages
for aiding and abetting fraud and breach of fiduciary duty. 379 B.R. at 429.
Subsequently, Enron commenced adversary proceedings against Springfield and
other transferees, alleging their claims should be equitably subordinated and
disallowed pursuant to 11 U.S.C. § 502(d), all based on facts relating to Citibank.
379 B.R. at 429.
The district court granted leave to Springfield to prosecute interlocutory
appeals of the bankruptcy court’s denials of Springfield’s motions to dismiss the
adversary proceedings. 379 B.R. at 430.
The bankruptcy court had reasoned: “[B]ased on the Court's previous
policy analysis, no legal and policy basis supports the premise that transferees of
bonds or notes should be treated differently than those holding the transferred
loan claims. All the post-petition transferees assume the risk that their claims
may be subject to subordination." Enron Corp. v. Springfield Assocs., L.L.C. (In
re Enron Corp.), Nos. 01-16034, 05-01025, slip op. (Bankr. S.D.N.Y. Nov. 28,
2005) (emphasis added)); Enron Corp. v. Avenue Special Situations Fund II, LP
(In re Enron Corp.), 340 B.R. 180, 201 n. 23 (Bankr. S.D.N.Y. 2006) (stating the
same, but substituting "disallowed" for "subordinated" and "section 502(d)
disallowance" for "subordination").
ii. Issue
“The question presented, as the Court stated in its January 30, 2007 Opinion
granting leave to file this interlocutory appeal, is ‘whether equitable subordination
under 510(c) and disallowance under 502(d) can be applied, as a matter of law,
to claims held by a transferee to the same extent they would be applied to the
claims if they were still held by the transferor based on alleged acts or omissions
on the part of the transferor.’" 379 B.R. at 427-28. (quoting Enron Corp. v.
Springfield Assocs., L.L.C. (In re Enron Corp.), No. M47, 2007 U.S. Dist. LEXIS
9151, 2007 WL 313470, at *1 (S.D.N.Y. Feb. 1, 2007).
iii. Holding
“…I conclude that equitable subordination under section 510(c) and
disallowance under section 502(d) are personal disabilities that are not fixed as
of the petition date and do not inhere in the claim. Nevertheless, Springfield may
be subject to equitable subordination and disallowance based solely on the
conduct of the transferor if the claims were transferred to Springfield by way of an
assignment. Accordingly, the Bankruptcy Court's Subordination Order and
Disallowance Order are VACATED, and the matter is REMANDED to the
Bankruptcy Court to decide the motion to dismiss consistent with this Opinion.”
379 B.R. at 448-449. (emphasis in original).
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iv. Rationale
Initially, the court rejected Enron’s contention that based on Sexton v.
Dreyfus, 219 U.S. 339 (1911), and United States v. Marxen, 307 U.S. 200
(1939), the priority and allowability of claims is fixed on the petition date. 379
B.R. at 438. The district court’s rationale was that equitable subordination can
not be determined on the petition date because it requires court action, is
discretionary, and is sometimes based on postpetition conduct, and disallowance
under 11 U.S.C. § 502(d) depends on whether the claimant returns voidable
transfers it received. 379 B.R. at 438-439.
Next, the court ruled that equitable subordination and disallowance
pursuant to 11 U.S.C. § 502(d) are personal disabilities that do not inhere in the
claim; therefore they are only transferred to the transferee if the claim is
assigned, as opposed to sold. 379 B.R. at 439-442.
The district court adopted the rule that the assignment of a claim puts the
transferee in the shoes of the transferor and thereby entitles the counterparty to
assert against the transferee whatever defenses it has against the transferor
even if they do not relate to the assigned claim, from Caribbean S.S. Co., S.A. v.
Sonmez Denizcilik Ve Ticaret A.S., 598 F.2d 1264, 1266-67 (2d Cir. 1979) and
29 Williston on Contracts § 74:47 (4th ed. 2003) (an assignee is "subject to all
defenses that the obligor may have against the assignor, including . . . defenses .
. . that relate to the assigned obligation itself, but also rights . . . [that] aris[e] out
of separate matters that the obligor might have asserted against its original
creditor, the assignor"). 379 B.R. at 436.
The district court acknowledged an exception to the rule exists if the
assignee is a holder in due course of a negotiable instrument. 379 B.R. at 436-
437. But, given that UCC § 3-302 provides that a holder cannot be a holder in
due course if it takes the debt with knowledge it is overdue, someone who
purchases debt after the debt’s maker is in bankruptcy cannot qualify as a holder
in due course. 379 B.R. at 437. (Additionally, debt from a credit agreement
would not qualify as a negotiable instrument in the first place because under
UCC § 3-314 it contains promises other than unconditional promises to pay.)
The district court also acknowledged that states following the third party
latent equities doctrine do not allow the assignee to be subject to personal
defenses of the maker of which it was unaware. 379 B.R. at 437.
Conversely, the district court reasoned a sale of a claim to a good faith
purchaser has a different result then an assignment based on UCC § 8-202(d):
“See, e.g., N.Y. U.C.C. § 8-202(d) (stating that all defenses of the
issuer of a security with enumerated exceptions, are ‘ineffective
against a purchaser for value who has taken the security without
notice of the particular defense’ (emphasis added)).”
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379 B.R. at 436 n. 58. The district court cites In re Latham Lithographic Corp.,
107 F.2d 749, 750 (2d Cir. 1939), to support its ruling that sale of debt does not
allow the borrower to assert personal defenses against the purchaser. Latham
Lithographic holds that if a claim is sold, the purchaser can vote the claim for or
against a reorganization plan even if the seller would have been unable to vote it.
Based on its reasoning that the outcome of the case turns on whether the
claim was transferred by assignment or sale, the district court rejects In re
Metiom, 301 B.R. 634 (Bankr. S.D.N.Y. 2003), because it assumes assignment
principles apply. Ironically, the district court also rejects In re Wood & Locker,
Inc., No. MO 88 CA 011, 1988 U.S. Dist. LEXIS 19501 (W.D. Tex. June 17,
1988), because, although it refused to attribute to the transferee the conduct of
the transferor, it focused on the conduct of the transferee instead of analyzing
whether the claim was transferred by sale or assignment. 379 B.R. at 444-445.
To determine whether a claim is transferred by sale or assignment, the
district court noted that the transfer documents will sometimes provide the
answer, but in other situations it will be obvious. Specifically, the court notes that
“sales of claims on the open markets are indisputably sales and subrogation of a
surety to the rights under a claim is indisputably an assignment.” 379 B.R. at
446 n. 104.
Finally, although the district court observes that its decision is driven by
the statutes and case law, and it will not make policy decisions reserved for the
legislature, the district court explains that its decision will only allow for claims
washing in “limited circumstances” (when the claim is sold to a bona fide
purchaser for value) and there the debtor can sue the claim-transferor, albeit the
timing and standard of proof may be longer and higher. 379 B.R. at 448.
v. Analysis
By seizing on the word “purchaser” in UCC § 8-202(d) to create a
distinction between sales and assignments, the district court overlooked the
Uniform Commercial Code’s definitions of purchase and purchaser. In short, a
purchaser takes by purchase and a purchase is not only a sale, but also “any
other voluntary transaction creating an interest in property. 179 Therefore, a
179 U.C.C. § 1-201(29-30) provides:
29) "Purchase" means taking by sale, lease, discount, negotiation,
mortgage, pledge, lien, security interest, issue or reissue, gift, or any
other voluntary transaction creating an interest in property.
(30) "Purchaser" means a person that takes by purchase.
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purchase is a sale and is also an assignment because an assignment is a
voluntary transaction creating an interest in property.
The district court also did not take into account section 13-105 of the New
York General Obligations law. There is no indication it was brought to the court’s
attention. Pursuant to section 13-105, when a claim is transferred, the debtor
can defend against the claim with “any defense or counter-claim, existing against
the transferrer, before notice of the transfer…” 180 A “transfer” includes both
sales and assignments as the district court acknowledges. 379 B.R. at 435 n.
52.
Likewise, the district court overlooked UCC § 9-404(a)(2) and (b) 181 which
provide an assignee of bank debt takes the claim subject to “any other defense
180 New York General Obligations Law § 13-105 provides:
Effect of transfer of claim or demand
Where a claim or demand can be transferred, the transfer thereof
passes an interest, which the transferee may enforce by an action or
special proceeding, or interpose as a defense or counter-claim, in his
own name, as the transferrer might have done; subject to any defense
or counter-claim, existing against the transferrer, before notice of the
transfer, or against the transferee. But this section does not apply,
where the rights or liabilities of a party to a claim or demand, which is
transferred, are regulated by special provision of law; nor does it vary
the rights or liabilities of a party to a negotiable instrument, which is
transferred.
181 UCC § 9-404 (a) and (b) provide:
RIGHTS ACQUIRED BY ASSIGNEE; CLAIMS AND DEFENSES AGAINST
ASSIGNEE.
(a) [Assignee's rights subject to terms, claims, and defenses; exceptions.]
Unless an account debtor has made an enforceable agreement not to assert
defenses or claims, and subject to subsections (b) through (e), the rights of an
assignee are subject to:
(1) all terms of the agreement between the account debtor and assignor and any
defense or claim in recoupment arising from the transaction that gave rise to the
contract; and
(2) any other defense or claim of the account debtor against the assignor which
accrues before the account debtor receives a notification of the assignment
authenticated by the assignor or the assignee.
(b) [Account debtor's claim reduces amount owed to assignee.]
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or claim of the account debtor…,” to reduce the amount the account debtor owes.
Equitable subordination is subsumed within reducing the amount the account
debtor owes because its effect is to lower the assigned claim’s priority which may
result in the account debtor paying the claim amount or a reduced amount.
The district court’s reliance on In re Latham Lithographic Corp., 107 F.2d
749, 750 (2d Cir. 1939), to support its thesis that the “purchase” of a claim
insulates it from being subordinated is based on a misunderstanding of
bankruptcy law and a misreading of Latham Lithographic. The Bankruptcy Code
and prior case law disallowed creditor votes for a trustee, not claims. Indeed, the
Latham Lithographic court explained the purpose of the statute was to prevent
entities owning interests in the bankrupt from voting to elect a trustee “too friendly
to the bankrupt.” 107 F.2d at 750. There is nothing in the decision to suggest
that the court would hold that once the claim is no longer held by an insider
creditor, it can not be voted if it were assigned, but can be voted if it were sold.
Rather, the court referred to “a creditor who would be disqualified to vote” who
“assigns it [the claim] in good faith to a purchaser who is not disqualified…” 107
F.2d at 750 (emphasis supplied). Thus, the court’s own language embraces
assignments and purchases (and purchases include sales and assignments),
and makes clear that once a claim is held by “a purchaser who is not
disqualified,” 107 F.2d at 750, it can be voted. After referring to the fact that part
of the claim was assigned, the court ultimately did not allow the claimholder to
vote the claim because the actual claim was held in trust and could be voted by a
trustee, and what was assigned was only a beneficial interest in the claim. 107
F.2d at 751.
Accordingly, while it appears the court’s ruling that when claims are
assigned they are assigned subject to defenses against the transferor (with
certain exceptions described above) is consistent with applicable statutes and
case law, the court’s different holding for sales of claims appears inconsistent
with applicable law.
Additionally, the court’s rejection of the principle that claims should be
adjudicated as of the petition date appears flawed. While it is not possible to
determine a claim’s allowability on the petition date, it can be done as of the
petition date. And, the fact that equitable subordination is discretionary is no bar.
Discretion must be exercised one way or the other and is reversible for abuse of
discretion. The reason for determining claims as of the petition date is to avoid
postpetition tactical behavior as explained in In re Brints Cotton, 737 F.2d 1338
(5 th Cir. 1984). The importance of this concept cannot be overemphasized. For
Subject to subsection (c) and except as otherwise provided in subsection (d), the
claim of an account debtor against an assignor may be asserted against an
assignee under subsection (a) only to reduce the amount the account debtor owes.
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instance, a debtor may propose a plan classifying a claim likely to be equitably
subordinated in a separate class because it would not be similar to
unsubordinated claims and therefore would be ineligible for classification with
them pursuant to 11 U.S.C. § 1122. On the eve of confirmation, the claimant
could wash its claim by selling it to a market buyer. The underpinning of the
whole plan could be upset. Put differently, the district court’s decision provides a
recipe for claim owners to wash their claims.
Finally, in many cases, the availability of an action to equitably
subordinate a claim does not mean the debtor has any valid action against the
creditor for affirmative damages. Equitable subordination requires conduct
inequitable to other creditors, United States v. Noland, 517 U.S. 535 (1996), and
may or may not include conduct for which the debtor has a cause of action.
For now, claim buyers will continue to want to make sure they have
indemnity against defenses applicable to the claim transferor. But, it will be in
the interests of the claim transferor and claim transferee to document the transfer
as a sale and to negate its transfer as an assignment. This is not necessarily
easily done when trading bank claims because the purchaser has to step into the
shoes of the transferor because it assumes the transferor’s obligations to the
bank agent, such as to make advances, pay agent fees, and the like.
20. Must A Chapter 11 Petition Be Filed with A “Valid Reorganizational Purpose?
A. Official Committee of Unsecured Creditors v. Nucor Corp. (In re SGL Carbon
Corporation), 200 F.3d 154 (3d Cir. 1999)
i. Facts.
SGL was an American subsidiary of a German company. It manufactured
and sold graphite electrodes used in steel production. The United States
government commenced a price-fixing investigation of SGL, which was followed
by class action and individual antitrust lawsuits by private parties. SGL took a
$240 million reserve for liability and filed its chapter 11 petition prior to the guilty
pleas of its chairman and its agreement to pay a $135 million criminal fine.
Upon filing, SGL issued press releases. One provided it filed “to protect
itself against excessive demands made by plaintiffs in civil antitrust litigation and
in order to achieve an expeditious resolution of the claims against it….
SGL CARBON Corporation is financially healthy.” 200 F.3d at 157. On a
conference call with security analysts, SGL’s chairman said its chapter 11
petition was “fairly innovative [and] creative” because “usually Chapter 11 is used
as protection against serious insolvency or credit problems, which is not the case
[with SGL Carbon’s petition.]” Id. at 158
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In deposition testimony, SGL’s vice president stated the chapter 11 case
would “change the negotiating platform” with plaintiffs and “increase the pressure
on …plaintiffs to settle.” Id. SGL officers “expressly and repeatedly
acknowledged Chapter 11 petition was filed solely to gain tactical litigation
advantages.” Id. at 167.
SGL also proposed a plan impairing only the plaintiffs. It provided the
plaintiffs could purchase SGL’s product at discounts for 30 months after
confirmation and barred plaintiffs from bringing any action against SGL’s affiliates
arising out of their claims against SGL. Id. at 157
The bankruptcy court found the antitrust litigation posed a serious threat to
SGL’s continued operations and a judgment could cause the company financial
and operational ruin. Id. at 158-159.
ii. Holding.
The Court of Appeals held the findings clearly erroneous because the
evidence showed the company was not losing customers and was meeting its
targets and because the officers were insisting the company was financially
healthy. Also, there was no evidence of the amount being sought by plaintiffs
and SGL’s records showed an estimate of $54 million. Id. at 163. Then, the
court ruled there is a requirement under Bankruptcy Code section 1112(b) that a
filing have a valid reorganizational purpose.
“The mere possibility of a future need to file, without more does not
establish that a petition was filed in ‘good faith.’” Id. at 164.
Significantly, the court conceded “the Bankruptcy Code encourages early
filing….It is well established that a debtor need not be insolvent before filing for
bankruptcy protection….It also is clear that the drafters of the Bankruptcy Code
understood the need for early access to bankruptcy relief to allow a debtor to
rehabilitate its business before it is faced with a hopeless situation….Such
encouragement, however, does not open the door to premature filing, nor does it
allow for the filing of a bankruptcy petition that lacks a valid reorganizational
purpose….” Id. at 163.
Although the proposed plan would be subject to a good faith
determination, “where a debtor attempts to abuse the bankruptcy process,
proceedings should end well before formal consideration of the plan." Id. at
167n.19.
iii. Analysis.
First, the appellate court’s overturning of the bankruptcy court’s findings
shows 2 things: the making of a poor record and a lack of reality. Empirically,
even the most financially strapped debtors make press releases boasting of
financial health after they file. The releases are true in the context of the debtor
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in possession that doesn’t have to worry about its prepetition debt. Any other
type of release is a recipe to lose all future business in a hurry! Can you imagine
a debtor issuing a press release that its operations are in jeopardy?! SGL should
have explained that in the record. Presumably, SGS did not take good attorneys’
advice to emphasize the need to quickly resolve the litigation to avoid a
downward spiral in the business.
SGL’s initial proposed plan was also suspect. Although it was a good idea
to file a proposed plan at the outset of the case to demonstrate the debtor wants
to reorganize its balance sheet and move on, the terms of the plan were
offensive. Clearly, the plaintiffs would reject a plan offering them nothing but
discounts. There does not appear to be any basis to discriminate against the
plaintiff class. To determine the value of the discounts as a percentage of
plaintiffs’ claims, the bankruptcy court by estimation or otherwise (or another
tribunal) would have to try the claims. In short, the plan was not well conceived.
Clearly, SGL should not have postured the case as a litigation tactic. It
should have postured it as a prudent method of preserving its assets for all
creditors while resolving its litigation in a responsible way without the threat of
judgments and levies that could destabilize its operations.
Second, chapter 11 is a process to cause a fair allocation of a company's
asset value. Notwithstanding SGL’s proposed chapter 11 plan, creditors may
have proposed competing plans and the court was not required to confirm SGL’s
plan because section 1129(a)(3) does require that plans be proposed in good
faith. There’s the rub. It was unnecessary for the court to impose a good faith
filing requirement. That requirement suffers from 2 major problems.
First, good faith filing turned on the mindset of the individuals determining
to file the petition. That makes no sense. The fair allocation of value should not
depend on the mindset of the control persons. The filing puts SGL at risk of
having a plan that will sell the company and pay off all claims leaving the
shareholders with nothing. The chapter 11 process may well not favor the
debtor!
Second, the holding will create much litigation over petitions due to its
carefully couched language on the one hand acknowledging the need to file
early, while on the other hand imposing a hard-to-define requirement for a valid
reorganizational purpose.
B. Solow v. PPI Enterprises (U.S.), Inc. (In re PPI Enterprises (U.S.), Inc.) 324
F.3d 197 (3d Cir. 2003)
i. Facts
Solow leased office space in 1989 to PPI Enterprises (“PPIE”) for 10
years. Annual rent was $620,000 per year for the first five years, then $650,000
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per year thereafter. Poly Peck, the indirect corporate parent of PPIE guaranteed
the lease and Sanwa Bank issued Solow a stand-by letter of credit for $650,000
which the lease required PPIE to replenish or replace with a security deposit to
the extent the letter of credit was used. 324 F.3d at 200. The lease required a
security deposit, but provided a letter of credit would satisfy the requirement. 324
F.3d at 210. About two years after the lease commenced, Polly Peck
commenced insolvency proceedings in Great Britain and PPIE faced defaults
exceeding $17 million. 324 F.3d at 200.
Solow contended PPIE engaged in transactions designed to reduce his
eventual damages claim. For instance, PPIE’s parent sold stock for $15 million
to a third party, transferred the $15 million to Sanwa Bank, and treated the
transfer as a loan to PPIE, even though PPIE owed no obligation to Sanwa Bank.
324 F.3d at 200n. 3. Also, PPIE acquired a 2% interest in Del Monte Food Co.
for $12.6 million, but transferred the interest to Polly Peck for an accounting
credit. Later, Polly Peck’s English administrators sold the stock back to PPIE for
$12. 6 million and PPIE’s vice president for finance reduced its balance sheet
value to $3.5 million. 324 F.3d at 200n.3. When during PPIE’s chapter 11 case
Del Monte agreed to repurchase the interest for $1.6 million subject to higher
offers, Solow objected and ultimately purchased the interest for $11 million and
resold it to Texas Pacific Group for $30 million. 324 F.3d at 201n. 5.
In 1991, PPIE abandoned the office space and ceased paying rent. After
liability was established and the parties negotiated, Solow asked the court to
schedule a damages hearing. On the eve of that hearing, PPIE commenced its
chapter 11 case in 1996. PPIE stated its chapter 11 case had 4 objectives: (a)
the Polly Peck wind down, (b) liquidating PPIE, (c) invoking provisions to reject
the restriction on the sale of the Del Monte stock, and (d) limiting Solow’s lease
termination damages under Bankruptcy Code section 502(b)(6). 324 F.3d at
201. Solow moved to dismiss the chapter 11 case for bad faith alleging it was
filed to create value for Polly Peck and its creditors at his expense and without
any intent to effectuate a corporate reorganization. The bankruptcy court denied
the motion without prejudice. 324 F.3d at 201.
PPIE proposed a chapter 11 plan in which Solow was in Class 2 (noninsider
general unsecured claims), which was to be paid 100 cents on the dollar
in “cash and other consideration as required.” 324 F.3d at 201n. 6. In Class 2,
PPIE solicited votes even though it contended the class was unimpaired. Solow
voted “no” and one creditor voted “yes.” Solow contends the class rejected the
plan. 324 F.3d at 202.
At confirmation, Solow renewed his motion to dismiss and contended his
claim was improperly classified as unimpaired. The bankruptcy court determined
Solow’s damage claim of $4,757,824.94 was subject to the statutory cap in
Bankruptcy Code section 502(b)(6) and had to be further reduced by the
$650,000 Solow had drawn on the letter of credit. The court also ruled the
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chapter 11 case was filed in good faith and that Solow was unimpaired and
therefore deemed to have accepted the plan. 324 F.3d at 202. The district court
affirmed without opinion.
ii. Issues
Does 11 U.S.C. § 502(b)(6) render Solow’s claim impaired under 11
U.S.C. § 1124 182 ?
Is a claim impaired under 11 U.S.C. § 1124 if it is paid in full in cash
without postpetition interest?
182 Bankruptcy Code section 1124 provides:
Impairment of claims or interests. Except as provided in section
1123(a)(4) of this title, a class of claims or interests is impaired
under a plan unless, with respect to each claim or interest of such
class, the plan—
(1) leaves unaltered the legal, equitable, and contractual
rights to which such claim or interest entitles the
holder of such claim or interest; or
(2) notwithstanding any contractual provision or
applicable law that entitles the holder of such claim or
interest to demand or receive accelerated payment of
such claim or interest after the occurrence of a
default—
(A) cures any such default that occurred before or
after the commencement of the case under this title,
other than a default of a kind specified in section
365(b)(2) of this title;
(B) reinstates the maturity of such claim or interest
as such maturity existed before such default;
(C) compensates the holder of such claim or
interest for any damages incurred as a result of any
reasonable reliance by such holder on such
contractual provision or such applicable law; and
(D) does not otherwise alter the legal, equitable, or
contractual rights to which such claim or interest
entitles the holder of such claim or interest.
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Does the amount of the letter of credit held by the lessor reduce the
lessor’s allowable claim under 11 U.S.C. § 502(b)(6) 183 ?
Is a chapter 11 petition filed in good faith for purposes of 11 U.S.C. §
1112(b) and a chapter 11 plan proposed in good faith for purposes of 11 U.S.C. §
1129(a)(3) if filed and proposed to avail the debtor of 11 U.S.C. § 502(b)(6)?
iii. Holdings
Impairment based on Statute. “…Accordingly, we hold that where §
502(b)(6) alters a creditor’s nonbankruptcy claim, there is no alteration of the
claimant’s legal, equitable, and contractual rights for the purposes of impairment
under § 1124(1). 324 F.3d at 204.
Impairment based on Lack of Postpetition Interest. “In other words, §
1124(1) and (3) were different exceptions to the presumption of impairment, and
the repeal of one should not affect the other. We agree with the Bankruptcy
Court’s analysis. Contrary to Solow’s representations, the legislative history
does not reflect a sweeping intent by Congress to give impaired status to
creditors more freely outside the postpetition interest context. Instead, as the
Bankruptcy Court noted, the legislative history accompanying the repeal of §
1124(3) indicated the ‘principal change’ in the repeal ‘relates to the award of post
petition interest.’ The congressional committee specifically referenced the New
Valley decision without referencing the text of § 1124(1) or the many cases
addressing its provisions, including Solar King. Therefore, the legislative history
supports our holding.” 324 F.3d at 207.
183 Bankruptcy Code section 502(b)(6) provides:
“If an objection to a claim is made, the court, after notice and a
hearing, shall determine the amount of such claim in lawful
currency of the United States as of the date of the filing of the
petition, and shall allow such claim in such amount, except to the
extent that if such claim is the claim of a lessor for damages
resulting from the termination of a lease of real property, such claim
exceeds –
(A) the rent reserved by such lease, without acceleration,
for the greater of one year, or fifteen percent, not to exceed three
years, of the remaining term of such lease, following the earlier of –
(i) the date of the filing of the petition; and (ii) the date on which
such lessor repossessed, or the lessee surrendered, the leased
property; plus
(B) any unpaid rent due under such lease, without
acceleration, on the earlier of such dates.”
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Application of Letter of Credit Proceeds towards Capped Claim.
“Nonetheless, we need not decide the underlying question because it is clear the
parties intended the letter of credit to operate as a security deposit….” 324 F.3d
at 210. In turn, the court affirmed the ruling that Solow’s allowable claim was
limited to the amount computed under the cap in section 502(b)(6) minus the
amount Solow drew on the letter of credit.
Good Faith. “A good faith determination must be a fact-intensive inquiry.
Here, the Bankruptcy Court analyzed the purpose of § 502(b)(6) and the totality
of the circumstances, and determined that PPIE’s bankruptcy filing did not
contravene the good faith requirement. Under the circumstances, we see no
abuse of discretion.” 324 F.3d at 211-212. In NMSBPCSLDHB, L.P. v. Integrated
Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), ___ F.3d ___, ___
(3d Cir. 2004), the court ruled “…PPI stands for the proposition that an insolvent
debtor can file under Chapter 11 in order to maximize the value of its sole asset
to satisfy its creditors, while at the same time availing itself of the landlord cap
under § 502(b)(6).”
iv. Rationale and Evaluation
No Impairment by Statute. “Generally, we agree with the Solar King [90
B.R. 808 (Bankr. W.D. Tex. 1988)] analysis. The relevant impairment language
requires bankruptcy plans to leave unaltered those rights to which the creditor’s
‘claim or interest entitles the holder of such claim or interest.’ 11 U.S.C. §
1124(1). This language in § 1124(1) does not address a creditor’s claim ‘under
nonbankruptcy law.’ The use of a present-tense verb suggests a creditor’s rights
must be ascertained with regard to applicable statutes, including the § 502(b)(6)
cap. In other words, a creditor’s claim outside of bankruptcy is not the relevant
barometer for impairment; we must examine whether the plan itself is a source of
limitation on a creditor’s legal, equitable, or contractual rights.” 324 F.3d at 204.
“In sum, PPIE’s Chapter 11 Plan intends to pay Solow his ‘legal
entitlement’ and provide him with ‘full and complete satisfaction’ of his claim on
the date the Plan becomes effective. Solow is only ‘entitled’ to his rights under
the Bankruptcy Code, including the § 502(b)(6) cap. Solow might have received
considerably more if he had recovered on his leasehold claims before PPIE filed
for bankruptcy. But once PPIE filed for Chapter 11 protection, that hypothetical
recovery became irrelevant. Solow is only entitled to his ‘legal, equitable, and
contractual rights,’ as they now exist. Because the Bankruptcy Code, not the
Plan, is the only source of limitation on those rights here, Solow’s claim is not
impaired under § 1124(1).” 324 F.3d at 205.
This result is virtually guaranteed by logic and common sense. If the
holder of a capped claim being paid in full in cash on the effective date is allowed
to reject a plan, what are the possible consequences? If the rejection causes the
class to reject, but the plan is still confirmable, then section 1129(b)(2)(B) is
triggered and the same plan can be confirmed as long as the rejecting class is
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paid in full before any junior class participates. In that scenario, the rejection
does not yield a different result than the deemed acceptance by an unimpaired
class. If, however, the rejection makes confirmation impossible because there is
no impaired accepting class without counting insider votes, then there are 2
potential consequences. One is that the case is converted to chapter 7 and the
rejecting capped claim receives the same or less than what is would receive
under the plan. This can not possibly be a result desired by Congress or the
rejecting landlord. The other potential consequence is that the case is
dismissed. This would mean that if a landlord doesn’t like the statutory cap on its
claim and has enough voting power, the landlord can prevent all parties in
interest from obtaining the benefits of chapter 11. Put differently, the statutory
cap imposed by Congress for fairness purposes, would be used to create
unfairness to all other parties. It is inconceivable Congress intended such a
result.
No Impairment Due to Lack of Postpetition Interest in Insolvent Estate.
The United States Court of Appeals for the Third Circuit opined based on
references to In re New Valley Corp., 168 B.R. 73 (Bankr. D.N.J. 1994), in the
legislative history accompanying Congress’ repeal of 11 U.S.C. § 1124(3) (a
class of claims is impaired unless the plan “(3) provides that, on the effective
date of the plan, the holder of such claim or interest receives, on account of such
claim or interest, cash equal to – (A) with respect to a claim, the allowed amount
of such claim….”) that Congress only intended to render fully paid claims
impaired when, as in New Valley, they were entitled to postpetition interest from
a solvent estate. 324 F.3d at 206-207.
Although some courts have held allowed claims against insolvent estates
that are fully paid in cash on the effective date are impaired due to the repeal of
section 1124(3), see, e.g., In re Seasons Apartments, L.P., 215 B.R. 953, 955-
956 (Bankr. W.D. La. 1997); In re Crosscreek Apartments, Ltd., 213 B.R. 521,
536 (Bankr. E.D. Tenn. 1997); Equitable Life Ins. Co. of Iowa v. Atlanta-Stewart
Partners, 193 B.R. 79, 80 (Bankr. N.D. Ga. 1996); In re David Green Property
Management, 1994 Bankr. LEXIS 206 (Bankr. W.D. Mo. 1994), the legislative
history and the wording of section 1124(1) convinced the appellate court that
denial of postpetition interest from insolvent estates is not a basis for impairment.
The jurisprudence has long entitled unsecured claimholders to postpetition
interest from solvent estates. See, e.g., Consol. Rock Prods. Co. v. Dubois, 312
U.S. 510 (1941); Debentureholders Protective Committee of Continental Inv.
Corp. v. Continental Inv. Corp., 679 F.2d 264, 269 (1st Cir. 1982).
Those courts that treat claims paid in full in cash as impaired, enable plan
proponents in certain cases to obtain an impaired accepting class for purposes of
11 U.S.C. § 1129(a)(10) and to deploy section 1129(b)(2) against rejecting
classes. The notion that a fully paid class should satisfy the ‘impaired accepting
class’ requirement is contrary to the democratic theme built into the Bankruptcy
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Code. That said, even prior to the elimination of section 1124(3), a class paid
99.9 cents on the dollar was indisputably impaired and its acceptance would
count for purposes of section 1129(a)(10).
The Claim Limited by Section 502(b)(6) is Reduced by Letter of
Credit Draws. It has long been the law that a landlord holding a security deposit
from its debtor-tenant must reduce its claim capped by the bankruptcy statutes
by the amount of the security deposit. Oldden v. Tonto Realty Corp., 143 F.2d
916, 921 (2d Cir. 1944). The issue here is whether proceeds from outside the
estate, namely from the letter of credit issuer, should also count to reduce the
landlord’s remaining allowable claim.
After explaining that under Solow’s view, Solow could keep the letter of
credit proceeds and claim the same amount again against the debtor’s estate
while the letter of credit issuer could also claim against the estate to recover that
amount, the court determined it did not need to determine the effect of the letter
of credit because the lease made clear “the parties intended the letter of credit to
operate as a security deposit.” 324 F.3d at 210. The lease provided the tenant
could provide a letter of credit in place of a security deposit.
That rationale is less than meritorious because it provides no rationale
why a lease providing for a security deposit or a letter of credit must yield the
same bankruptcy results regardless of which option is chosen. Put differently,
had the lease provided how the landlord’s claim would be treated in bankruptcy,
the court would clearly declare the parties are powerless to change the
bankruptcy law by contract. Moreover, it makes no more sense to limit the
landlord’s claim to its amount as if it had a security deposit when it really had a
letter of credit, than it makes sense to treat the landlord’s claim as if it had a letter
of credit when it really had a security deposit defined as a ‘letter of credit.’
Thus, the question remains whether the landlord’s claim under section
502(b)(6) is reduced by the landlord’s recovery on a letter of credit. In the
context of preferences, a creditor can not evade receipt of a voidable preference
by having the debtor provide collateral to a letter of credit issuer rather than
directly to the creditor. Kellogg v. Blue Quail Energy, Inc. (In re Compton Corp.),
831 F.2d 586, 595 (5th Cir. 1987). Thus, if the debtor provides collateral to a
letter of credit issuer instead of providing a security deposit directly to a landlord,
the debtor’s estate should not be reduced more simply because it passed the
security deposit through a middleman. If a debtor convinces the letter of credit
issuer to issue the letter of credit without first receiving collateral security for the
issuer’s reimbursement claim, the damage cap in section 502(b)(6) would be
circumvented if the estate could be liable both to the landlord and to the letter of
credit issuer for the same amount in the form of reimbursement. The language of
section 502(b)(6) which caps “the claim of a lessor for damages” appears broad
enough to enable the court to subtract what the lessor received from the letter of
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credit given that it enables the court to subtract what the lessor receives from a
security deposit under Oldden.
If, however, the debtor convinces a bank to issue to the debtor’s landlord a
letter of credit for an amount in excess of the landlord’s capped claim in the
debtor’s title 11 case, what happens? Under Oldden, if the debtor provides a
security deposit in excess of the capped damage claim, the landlord must return
the excess. If the debtor provides the letter of credit issuer with collateral for the
letter of credit, does the letter of credit issuer return the excess or does the
landlord return it? Because the monies the letter of credit issuer pays the
landlord are not property of the debtor’s estate, it appears the landlord may retain
them. But, must the letter of credit issuer return the collateral in excess of the
damage cap to the estate? If the letter of credit issuer’s reimbursement claim in
excess of the statutory cap is disallowed under section 502(e)(1)(A), then the
issuer must return the excess collateral. As a corollary, if the issuer determines
to pursue subrogation to the landlord’s claim rather than reimbursement, the
issuer will have to return the excess collateral because the landlord has been
paid its maximum claim. Finally, if the issuer’s reimbursement claim is not
disallowed under section 502(e)(1)(A) (i.e., if the issuer is not deemed “liable with
the debtor on” or to have “secured the claim of a creditor”), then the issuer may
be allowed to retain the collateral unless the transaction is collapsed and the
court determines it can not be enforced because it circumvents section 502(b)(6).
Notably, in EOP-Colonnade of Dallas Limited v. Faulkner (In re
Stonebridge Technologies, Inc.), 430 F.3d 260, 274 (5 th Cir. 2005), the court held
Ҥ 502(b)(6) does not apply to cap the proceeds that EOP [lessor] may claim
against the Letter of Credit because EOP never filed a claim for damages against
the Stonebridge estate.” Stonebridge explains that section 502(b)(6) allows only
one thing, namely disallowance of the filed claim to the extent it exceeds the cap.
430 F.3d at 270. It appears, therefore, that Stonebridge went an extra mile to
avoid ruling that PPI Enterprises is wrong. Stonebridge could more properly
have ruled that the section 502(b)(6) cap has no impact on a landlord’s right to
draw on a letter of credit, but that a landlord’s proof of claim is still subject to the
cap.
C. NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (In re Integrated
Telecom Express, Inc.), 384 F.3d 108 (3d Cir. 2004), rehearing denied, 389
F.3d 423 (3d Cir. 2004)
i. Facts.
The debtor, Integrated, was a supplier of software and equipment to the
broadband communications industry. In the summer of 2000, Integrated entered
into a 10- year lease in Silicon Valley at $200,000 per month increasing 5%
annually. 2001 was a very poor year for Integrated and it retained Lehman
Brothers to help evaluate its alternatives. Unable to find a third party willing to
enter into a merger and unable to identify an alternative business model,
Integrated’s board of directors prepared a plan of liquidation and dissolution. A
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securities class action arising out of Integrated’s initial public offering
commenced, requesting $93.24 million.
Integrated had $105 million in cash, a $20 million insurance policy for the
class action, and $1.5 million of other assets. Its liabilities consisted of the class
action claim which Integrated believed would be resolved inside its insurance
policy limits, its liability on the lease of approximately $26 million, and another
$430,000 of miscellaneous obligations. “[I]n a smoking gun resolution approved
by the Board, and notwithstanding its strong financial position, Integrated
authorized a letter to the Landlord threatening that if it did not enter into a
settlement of the lease in the amount of at least $8 million, Integrated would file
for bankruptcy so as to take advantage of § 502(b)(6), which sharply limits the
amount that a landlord can recover in bankruptcy for damages resulting from the
termination of a lease.” 384 F.3d at 129.
Integrated managed to sell its assets during its chapter 11 case for $1
million more than the sale price it negotiated outside bankruptcy. 384 F.3d at
126.
Integrated proposed a chapter 11 plan and the bankruptcy court confirmed
it. The plan provided for the securities class action claimants to receive up to the
insurance policy proceeds and another $5 million, and the claimants accepted
that treatment. The landlord’s allowable claim for rejection of its lease was set at
$4.3 million. Confirmation was stayed pending appeal.
ii. Issue
“The issue on appeal is whether, on the facts of this case, a Chapter 11
petition filed by a financially healthy debtor, with no intention of reorganizing or
liquidating as a going concern, with no reasonable expectation that Chapter 11
proceedings will maximize the value of the debtor’s estate for creditors, and
solely to take advantage of a provision in the Bankruptcy Code that limits claims
on long-term leases, complies with the requirements of the Bankruptcy Code.”
384 F.3d 112.
iii. Holding.
“To be filed in good faith, a petition must do more than merely invoke
some distributional mechanism in the Bankruptcy Code. It must seek to create or
preserve some value that would otherwise be lost – not merely distributed to a
different stakeholder – outside of bankruptcy. This threshold inquiry is
particularly sensitive where, as here, the petition seeks to distribute value directly
from a creditor to a company’s shareholders….Because Integrated was not in
financial distress, its Chapter 11 petition was not filed in good faith as it could not
– and did not – preserve any value for Integrated’s creditors that would have
been lost outside bankruptcy.” 384 F.3d at 129.
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The incremental $1 million of sale proceeds for Integrated’s assets does
not justify invoking chapter 11 under the circumstances in Integrated where the
assets were sold to insiders who had been willing to purchase them outside
bankruptcy and the price may have increased because the assets were not
adequately marketed. 384 F.3d at 126-127.
In respect of Integrated’s argument that invoking chapter 11 to deploy
section 502(b)(6) shows good faith, the court held: “The far more relevant
question is whether a desire to take advantage of a particular provision in the
Bankruptcy Code, standing alone, establishes good faith. We hold that it does
not.” 384 F.3d at 128.
The court also recognized that chapter 11 may be invoked to liquidate as
well as reorganize, but ruled “liquidation plans, no less than reorganization plans,
must serve a valid bankruptcy purpose. That is, they must either preserve some
going concern value, e.g., by liquidating a company as a whole or in such a way
as to preserve some of the company’s goodwill, or by maximizing the value of the
debtor’s estate.” 384 F.3d at 120.
“The law is clear that the burden is on the bankruptcy petitioner to
establish that its petition has been filed in good faith.” 384 F.3d at 128n.8, citing
Solow v. PPI Enters. (U.S.), Inc. (In re PPI Enters. (U.S.), Inc.), 324 F.3d 197,
211 (3d Cir. 2001), and Official Committee of Unsecured Creditors v. Nucor
Corp. (In re SGL Carbon Corporation), 200 F.3d 154 (3d Cir. 1999).
Notably, dissenting from the denial of a motion for rehearing, Circuit
Judges Ambro and Rendell offered the following caution about the limited scope
of the holding:
“We voted for rehearing en banc not because we believe
that the panel has necessarily reached the wrong result. The core
effect, as we perceive, it, of the panel’s holding – that equity
holders of a debtor may not file a chapter 11 bankruptcy petition
solely ‘to reap [for themselves] a substantial gain through
bankruptcy… at the expense of the [debtor’s] sole creditor.’ Op. n.4
– may pass muster with the unique facts this case presents. Our
problem is this: counsel in other cases may argue the panel’s
opinion to go further in requiring good faith than anyone on the
panel intended. We thus voted for rehearing en banc to allow the
full Court to dispel this argument, for we believe the panel’s opinion
is limited to its snow in August facts.”
NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (Integrated Telecom
Express, Inc.), 389 F.3d 423, 424 (3d Cir. 2004).
iv. Rationale.
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The court reasoned it could not identify any value of Integrated’s assets
that was threatened outside bankruptcy. 384 F.3d at 129. It explained that while
invoking 11 U.S.C. § 502(b)(6) does not establish bad faith, it also does not
establish good faith. 384 F.3d at 128, and that any rule that any tenant willing to
undergo chapter 11 can cap its landlord’s claim would obviate the need for a
good faith requirement. 384 F.3d at 129. The court also explained that unlike
the debtor in PPI, Integrated was solvent even with the securities action claim,
384 F.3d at 125n.6, and that Integrated had no inchoate claims that needed to be
liquidated or barred. 384 F.3d at 127.
v. Analysis.
The Third Circuit’s articulation of its holding provides it is limited to the
circumstances of Integrated. 384 F.3d at 129-130. Additionally, the court made
numerous observations about the facts that should help prevent the misuse of
the holding to prevent chapter 11 relief when it is not invoked solely to
redistribute value. Specifically, the court observes that the chapter 11 case was
not being used to: (a) maximize value of the company, 384 F.3d at 120, 125, (b)
realize any efficiencies in chapter 11 unavailable under state law, 384 F.3d at
126, (c) “’face such financial difficulty that, if it did not file at that time, it could
anticipate the need to file in the future,’” 384 F.3d at 121 (quoting from In re
Cohoes Indus. Terminal, Inc., 931 F.2d 222, 228 (2d Cir. 1991), (d) maximize the
value of an asset by selling it free of restrictions that would otherwise limit its
value, when, “critically,” the debtor is insolvent as in Solow v. PPI Enters. (U.S.),
Inc. (In re PPI Enters. (U.S.), Inc.), 324 F.3d 197 (3d Cir. 2001), 384 F.3d at 123,
(e) distribute value in the face of any financial distress, 384 F.3d at 129, (f) sell
property free of liens when the estate’s solvency was unclear and ultimately pay
the secured lienholder its default rate rather than the contract rate of interest, as
in Platinum Capital, Inc. v. Sylmar Plaza, L.P. (In re Sylmar Plaza, L.P.), 314
F.3d 1070 (9 th Cir. 2002), 384 F.3d at 123, (g) avoid any threat to value because
the securities class action did not threaten any value the debtor sought to
preserve, 384 F.3d at 125, (h) liquidate or bar inchoate claims, 384 F.3d at 127,
or (i) seek a chance for a financially troubled company to remain in business, 384
F.3d at 129.
Integrated presented no basis for chapter 11 relief other than wealth
redistribution from a landlord to shareholders. It is virtually impossible to argue
plausibly that Congress ever enacted a bankruptcy law to override state law
calculations of damages under a simple real estate lease to benefit shareholders.
Notably, however, if the court had simply overturned confirmation on the ground
the plan was not proposed in good faith under 11 U.S.C. § 1129(a)(3), the case
would have remained extant so that 11 U.S.C. § 502(b)(6) may still have been
applied. Thus, the decision strongly suggests that just as avoidance actions are
supposed to benefit creditors and not shareholders (“Although the Bankruptcy
Code contains many provisions that have the effect of redistributing value from
one interest group to another, these redistributions are not the Code’s purpose.
Instead, the purposes of the Code are to preserve going concerns and to
maximize the value of the debtor’s estate.” 384 F.3d at 128-129), the cap in 11
219

U.S.C. § 502(b)(6) should similarly be used only for creditors, at least when other
uses of chapter 11 are unnecessary.
D. Santa Fe Minerals, Inc. v. Bepco, L.P. (In re 15375 Memorial Corp.), 589
F.3d 605 (3d Cir. 2009)
i. Facts
The chapter 11 debtors were Santa Fe Minerals, Inc. ("Santa Fe") and its
owner, Memorial Corp. ("Memorial"). In turn, Memorial was owned by Global
Santa Fe Corp. ("GSF"), one of the world's largest offshore oil and gas drilling
contractors. Santa Fe had been an oil and gas exploration company until it filed
for dissolution under Wyoming law in December 2000. Under Wyoming law,
once a company publishes notice of dissolution, there is a 3-year limitations
period for creditors to file claims against the company. Santa Fe neglected to
publish notice until August 4, 2006. Santa Fe's assets had been upstreamed to
GSF entities and it was only allowed to act through its owner, Memorial, which
had dissolved, but then revoked the dissolution on advice of counsel. 589 F.3d
at 609-610.
David Faure was the vice president and assistant secretary of Memorial.
He was charged with marshalling the debtors' assets, dealing with their liabilities,
and working on their bankruptcies. Faure had other important responsibilities to
other GSF entities and took orders from GSF's senior vice president and general
counsel. Although Faure was also charged with recovering upstreamed funds
from the GSF entities, he testified that "'he [did] not think [the claims against the
GSF Entities] '[we]re very good claims,'" and he testified that filing a lawsuit
against [GSF] on behalf of the Debtors to facilitate the return of upstreamed
funds would jeopardize his job. 589 F.3d at 611.
In April 2005, Santa Fe and other defendants (including BEPCO) in the
chain of title in respect of a mineral lease were sued for $320 million (the “Tebow
Action”) for contaminating soil and ground water in Louisiana by disposing of
water produced from oil wells in unlined pits. Santa Fe learned from its own
expert and its adversaries’ expert that Santa Fe was most likely liable more liable
than the other defendants because the unlined pit probably came into existence
in 1965, the year after a major codefendant had assigned its interest in the lease.
Santa Fe also learned that the cost of eliminating the contamination would
approximate $189 million. 589 F.3d at 612.
The debtors were aware their bankruptcies would permit them to avoid
liability in the Tebow Action because the complaint stated plaintiffs would not
pursue claims against any party that “has or intends to file for bankruptcy
concerning any of the claims alleged…” Moreover, the debtors’ bankruptcies
could protect the GSF entities based on the debtors’ theories: “Indeed, the
Debtors continue to argue that any alter ego claims against the GSF Entities are
part of their estates and cannot be asserted by BEPCO, while simultaneously,
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and incongruously, stating that they believe that any such claims would have no
value…If the Debtors and the GSF Entities had their way, BEPCO would be left
without any opportunity to litigate its alter ego claims against the GSF Entities
and, conveniently for the GSF Entities, the Debtors would not bring the claims
because they do not believe the claims have value. Even if the Bankruptcy Court
later permits BEPCO to bring its alter ego claims against the GSF Entities in
Louisiana state court, BEPCO will have already been prejudiced ‘to the extent of
the lost time value of money for the settlement funds it has already paid out to
resolve its liability in the Tebow Action.’…’More critically, BEPCO [will be]
prejudiced by the lapse of time in terms of its ability to effectively prosecute its
claims’ because ‘[w]itnesses and documents may become unavailable.’” 589
F.3d at 626.
The trial in the Tebow Action was scheduled for October 11, 2006. On
August 16, 2006, the debtors commenced their chapter 11 cases. In June 2006,
BEPCO and the Tebow plaintiffs had advised Santa Fe they would pursue the
GSF entities under an alter ego theory. On August 8, 2006, the debtors entered
into a note agreement with a GSF entity agreeing that in exchange for a
$500,000 revolving credit line, Memorial accepted all liability for Santa Fe
activities, would indemnify the GSF entities, and agreed it was not a single
enterprise with GSF. 589 F.3d at 613.
On August 25, 2006, BEPCO filed a third party complaint against the GSF
entities asserting they were alter egos of Santa Fe. In response, the debtors
accused BEPCO of violating the automatic stay, BEPCO requested stay relief,
and the bankruptcy court denied BEPCO’s request. BEPCO settled with the
Tebow plaintiffs for $20 million, and filed a proof of claim in the bankruptcy court
against Santa Fe as well as the GSF entities on the theory they were alter egos
of Santa Fe. The bankruptcy court granted stay relief to BEPCO to pursue Santa
Fe and its insurers, but did not allow BEPCO to pursue GSF entities on an alter
ego theory, in part because the debtors asserted the alter ego claims were
property of their estates. 589 F.3d at 613-614.
Faure and GSF entities had conducted a review of insurance policies and
found certain policies of the Debtors that covered the Tebow Action and possibly
two other actions against the debtors. Aside from the insurance policies, the
debtors had the cash drawn on the revolving note. The litigation created $320
million of claims, whereas other liability amounted to just over $500,000. 589
F.3d at 615. The debtors filed their bankruptcy petitions because of the
piecemeal litigation and they feared alter ego liability for Memorial and the GSF
entities. 589 F.3d at 615-616.
On February 15, 2008, the bankruptcy court denied BEPCO’s motion to
dismiss the debtors’ chapter 11 petitions for lack of good faith and subsequently
denied a motion for reconsideration. The district court reversed on January 27,
2009, and the debtors appealed. 589 F.3d at 616.
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ii. Issue
Did the debtors file their chapter 11 petitions in good faith?
iii. Holding
“The Debtors have failed to show that their Chapter 11 bankruptcy
petitions served valid bankruptcy purposes because the bankruptcies did not
maximize the Debtors’ estates. Moreover, the timing of the Debtors’ filings, two
months prior to a trial in which they and the GSF Entities faced substantial
liability, show that the bankruptcy petitions were filed primarily as a litigation
tactic. Accordingly, we will affirm the District Court’s order to dismiss the
Debtors’ bankruptcy petitions for lack of good faith.” 589 F.3d at 626.
iv. Rationale
The burden is on the bankruptcy petitioner to establish good faith. 589
F.3d at 618. The court focuses on two inquiries: whether the petition serves a
valid bankruptcy purpose and whether the petition is filed merely to obtain a
tactical litigation advantage. Here, there was no valid purpose and the petitions
were filed as a litigation tactic. 589 F.3d at 618.
A central forum for litigation adds little value because the insurance
policies cannot be used for liabilities not covered. 589 F.3d at 621. And the
insurance policies will be available in or out of bankruptcy. 589 F.3d at 621. “In
short, the Debtors could have managed and searched for assets without filing for
bankruptcy and without incurring bankruptcy-related administrative expenses.”
589 F.3d at 624.
“[T]he Debtors’ representative was primarily concerned with protecting the
GSF Entities, not the Debtors.” 589 F.3d at 624 (emphasis in original). “Faure’s
mixed allegiances prevented him from adequately protecting the Debtors’
interests.” 589 F.3d at 624. “While this appeal does not involve a breach of
fiduciary duty claim against the debtor in possession, In re Insilco Tech., Inc., 480
F.3d 212, 215 n.3 (3d Cir. 2007) (noting that debtor in possession is ‘bound by all
of the fiduciary duties of a bankruptcy trustee’), similar concerns are relevant to
the good faith inquiry.” 589 F.3d at 625n. 14.
“In sum, the Debtors’ filing for bankruptcy did not maximize the value of
their estates. Indeed, it would be exceedingly difficult to do so where neither
Santa Fe nor Memorial had any real assets to preserve besides various
insurance policies….” 589 F.3d at 625.
E. In re General Growth Properties, Inc., 409 B.R. 43 (Bankr. S.D.N.Y.
2009)
222

i. Facts
Holders of 5 mortgage loans moved to dismiss chapter 11 cases of
debtors owned by General Growth Properties, Inc., chapter 11 debtor in
possession ("GGP"). GGP is a publicly-traded real estate investment trust
owning 387 other debtors and approximately 312 nondebtors (collectively, the
"GGP Group") owning over 200 shopping centers, several commercial office
buildings, and five master-planned communities. 409 B.R. at 47. GGP is the
general partner of GGP Limited Partnership ("GGP LP"), the company through
which most business is conducted. Id. GGP LP controls GGPlP, L.L.C., The
Rouse Company LP ("TRCLP"), and General Growth Management, Inc.
("GGMI").
The GGP Group reported $27.3 billion of liabilities, of which $18.27 billion
was project level debt secured by individual properties. The motions to dismiss
involved $1.83 billion of project debt. 409 B.R. at 48. Many projects were owned
by special purpose entities ("SPE's") structured to protect their secured lenders
from having their operations combined with the parent's and its other affiliates'
operations. Id. The typical SPE's required one or more independent directors or
managers. 409 B.R. at 50. The typical mortgage loan had a 3 to 7 year term
with most amortization at the end. Those that had longer nominal maturities had
an anticipated repayment date ("ARD") at which point the loan became
"hyperamortized" even if final maturity were 30 years in the future. Id. When the
ARD occurs, there is a steep increase in interest rate, a requirement that cash be
kept at the project with excess cash flow applied to amortize principal, and a
requirement that certain expenses be submitted to lenders for approval. Id.
Many of the mortgage loans were financed in the commercial mortgagebacked
securities ("CMBS") market. There, many mortgage loans are sold to a
trust qualified for tax purposes as a real estate mortgage conduit ("REMIC"). The
REMIC sells certificates entitling holders to payments of principal and interest on
the pool of mortgages. The holders have different interest rates, rights to the
payment stream, and control rights. The REMIC is managed by a master
servicer having no power to agree to an alteration of the material terms of
mortgage loan. On default, a special servicer takes over, but frequently needs
consent of holders to agree to modify the loan. 409 B.R. at 51.
In addition to the project debt, the GGP Group had $6.58 billion of
unsecured debt inclusive of senior debt, subordinated debt, and trade debt. Id.
The GGP Group historically financed itself with mortgage loans, but a crisis in the
credit markets spread in 2008, especially in the CMBS market, and the GGP
Group was unable to refinance. 409 B.R. at 54. After a foreclosure started, the
GGP Group commenced filing chapter 11 petitions, and did not dispute that its
shopping center business had a stable and generally positive cash flow and had
continued to perform well. 409 B.R. at 55.
223

Some of the SPE's had operating agreements requiring two independent
managers or directors and they were permitted to be supplied by Corporation
Service Company ("CSC"). The operating agreements provided: “To the extent
permitted by law…the Independent Managers shall consider only the interests of
the Company, including its respective creditors, in acting or otherwise voting on
the matters referred to in Article XIII (p).” That provision required unanimous
written consent of the managers before an SPE can file a chapter 11 petition.
409 B.R. at 63. GGP Group terminated the independents on March 4, 2009, but
did not notify the independents until it sent a letter on April 16, 2009 to CSC
notifying it of the terminations. 409 B.R. at 67-68. The corporate documents did
not prohibit the "admittedly surreptitious firing" of the independents, or GGP
Group's appointment of other independents. 409 B.R. at 68. The debtors
admitted the terminations of the independent managers “were not disclosed to
CSC or to the original managers themselves until after the bankruptcy filings due
to concern that such information ‘could subject the company to publicity about
potential restructuring strategies…’ and because the Debtors had no contractual
obligation to inform the managers.” 409 B.R. at 68.
Movants requested dismissal for lack of good faith on the grounds that (a)
the relevant chapter 11 petitions were filed prematurely, and (b) the relevant
debtors could not procure confirmed plans because the movant-lenders would
not consent. 409 B.R. at 56-57. Each of the relevant debtors was in some
degree of financial distress in that 4 would have been in default due to other
bankruptcy petitions, 1 had gone into hyper-amortization, 5 would mature or go
into ARD in 2010, 2 in 2011, and 1 in 2012. The remaining 7 debtors were either
guarantors on maturing loans, or their property was collateral for a maturing loan,
or had other indicia of distress such as a high loan-to-value ratio. 409 B.R. at 57-
58. The GGP board considered each project-level entity individually in
determining whether it should file a chapter 11 petition. 409 B.R. at 58-59.
ii. Issue
Did the debtors commence their chapter 11 cases in good faith?
Yes.
iii. Holding
iv. Rationale
The Bankruptcy Code's omission of a good faith hearing at the outset of a
chapter 11 case, in contrast to the former Bankruptcy Act's express requirement
that Chapter X petitions be filed in good faith, together with the omission of a
mandatory chapter 11 trustee, show "the goal of the 1978 Bankruptcy Code [was]
to incentivize a debtor to file earlier rather than later, so as to preserve the value
of the estate." 409 B.R. at 60 (footnote omitted). Additionally, the legislative
history provided "[p]roposed chapter 11 recognizes the need for the debtor to
remain in control to some degree, or else debtors will avoid the reorganization
provisions in the bill until it would be too late for them to be an effective remedy."
H.R. Rep. No. 595, at 233, 95 th Cong., 1 st Sess. (1977).
224

Although movants asserted the financial distress of each debtor should be
analyzed exclusively based on the debtor and independent of the financial
problems of GGP Group, the Fourth Circuit in In re U.I.P. Engineered Products
Corp., 831 F.2d 54 (4 th Cir. 1987), stated it was irrelevant whether the
subsidiaries could independently demonstrate good faith in their respective
filings. Rather, it was sound business practice for the parent to seek chapter 11
protection for its subsidiaries when they were crucial to its own reorganization
because the nature of a corporate family creates an identity of interest that
justifies the protection of the subsidiaries as well as the parent. The law was the
same under the Bankruptcy Act. Duggan v. Sansberry, 327 U.S. 499, 510-511
(1946)(it was Congress’ intent “ordinarily to allow parent and subsidiary to be
reorganized in a single proceeding, thereby effectuating its general policy that the
entire administration of an estate should be centralized in a single reorganization
court.”).
None of movants challenged the good faith of the parent companies
commencing chapter 11 cases. $1.1 billion of project debt had matured from
January through April 2009, and billions had reach hyper-amortization. 409 B.R.
at 62.
Although the operating agreements provided the independent managers
should consider the interests of creditors to the extent permitted by law, the law
(North American Catholic Educational Programming Foundation, Inc. v.
Gheewalla, 930 A.2d 92 (Del. 2007)) required the managers to consider the
interests of the shareholders in exercising their fiduciary duties. 409 B.R. at
64.184
184 GGP states Gheewalla “held for the first time that the directors of an insolvent corporation have
duties to creditors that may be enforceable in a derivative action on behalf of the corporation.”
409 B.R. at 64. Gheewalla actually held that when a corporation is insolvent, the creditors may
be given leave to sue on behalf of the corporation for breach of a director’s duty to the corporation
(not to creditors):
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.
FOOTNOTES
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
225

There is no requirement that a debtor show it can confirm a chapter 11
plan without creditors’ consent as a precondition to filing a chapter 11 petition.
409 B.R. at 65. In respect of subjective good faith, there is no requirement that a
debtor negotiate before commencing its chapter 11 case and in GGP there is no
evidence that pre-filing talks could have been adequate. 409 B.R. at 66.
The debtors were allowed to replace the independent managers and they
replaced them with seasoned individuals who voted to commence chapter 11
cases to preserve value for the debtors’ estates and creditors. 409 B.R. at 68-
69. “On this record it cannot be said that the admittedly surreptitious firing of the
two “independent Managers” constituted subjective bad faith on the part of the
Debtors sufficient to require dismissal of these cases.” 409 B.R. at 68.
21. The Interface of State Law Corporate Governance and Bankruptcy Law
A. Esopus Creek Value LP v. Marks, 913 A.2d 593 (Del. Ch. 2006)
i. Facts
A Delaware corporation, Metromedia International Group, Inc.
(“Metromedia”), had publicly traded preferred stock and common stock. Its
principal asset was a 50.1% equity interest in Magticom, the Republic of
Georgia’s leading mobile telephony provider. The equity interest generated
sizable free cash flow and EBITDA, and Metromedia’s stock had increased from
3 cents a share to more than $1.50 per share since February 2003. The
corporation had no substantial long term or secured debt.
Since March 2005, however, Metromedia had delayed filing its SEC
Forms 10K and 10 Q, blaming its auditor for not signing off on its audited
financials due to an issue involving only 2 cents a share.
In mid-2006, Metromedia received an offer for its Magticom stake that far
exceeded any previous offer and was an objectively fair valuation of the stake.
Pursuant to 8 Del. C. § 271(a), a majority vote of common shareholders was
required to approve the sale because it was a sale of all or substantially all
Metromedia’s assets. Metromedia was advised, however, that because its
shares were registered under section 12 of the Securities Exchange Act of 1934,
section 14c barred it from calling a shareholders meeting or soliciting proxies
while it was not current in its SEC filings. Metromedia had not considered
requesting an exemption from the SEC.
incentive to pursue valid derivative claims on its behalf that shareholders have when the
corporation is solvent.
Gheewalla, 930 A.2d at 101-102 (footnotes omitted).
226

Accordingly, Metromedia’s board negotiated a sale to be implemented in a
chapter 11 case and locked up approximately 80% of its preferred shares to vote
for it after providing their holders under a confidentiality agreement much nonpublic
information to value their interests. In a liquidation (which the sale did not
constitute under Metromedia’s certificate of designation) Metromedia’s preferred
shareholders were entitled to a liquidation preference of $50 per share plus all
accrued but unpaid dividends. Pursuant to the lockup for the $480 million offer,
the preferred shareholders would take a discount on their claims, but if the sale
price increased over the range of $506 million to $535 million, they would receive
more than the certificate of designation would provide them. Metromedia
planned to commence a chapter 11 case, request sale approval under 11 U.S.C.
§ 363, and then propose a chapter 11 plan. By locking up 80% of the preferred
shares, Metromedia assured itself that the class of preferred shares would
accept the plan under 11 U.S.C. § 1126(d). Metromedia’s proposed chapter 11
plan presumed the common shares would be unimpaired and that, in any event,
they would receive at least as much as they would in a liquidation in a chapter 7
case for purposes of 11 U.S.C. § 1129(a)(7).
Holders of 8.2% of the common shares commenced an action to
preliminarily enjoin Metromedia from executing an agreement with the buyer
absent an affirmative vote of a majority of Metromedia’s common shares. At oral
argument, the parties agreed (a) the sale would be subject to a common
shareholder vote under 8 Del. C. § 271(a), (b) the directors would make a
concerted effort to obtain exemptive relief from the SEC to solicit proxies and
provide robust financial information, (c) regardless of exemptive relief, the
company would distribute all information required under Delaware law to ensure
the section 271 vote is informed, (d) the company would encourage common
shareholders to attend the section 271 meeting, and (e) the Delaware court
would reserve jurisdiction over the dispute and to adjust any terms of the agreed
order. Notably, approximately 44% of the common shares were already known
to support the terms of the sale.
ii. Issue
Should the Delaware Chancery Court enjoin Metromedia’s board of
directors from binding Metromedia to a transaction to sell Magticom before first
complying with 8 Del. C. § 271?
iii. Holding
“In sum, the actions of Metromedia’s directors in structuring the proposed
transactions they did resulted in a theoretically legal, yet undeniably inequitable,
reallocation of control over the corporate enterprise. That reallocation does not
withstand close judicial scrutiny.” There is reason to believe the SEC will grant
exemptive relief to allow Metromedia to convene a common shareholders’
meeting to vote on the sale. But, if no meeting occurs, “the Court of Chancery
227

enjoys the ability to appoint a receiver when and if a corporation ‘refuse[s], fail[s],
or neglect[s] to obey any order or decree of any [Delaware court]…’”
“…These facts, when viewed in light of the underlying rehabilitative
purposes of the bankruptcy code, persuade the court that Metromedia’s
proposed transactional scheme, though technically within the letter of the law,
works a profound inequity upon the company’s common stockholders and is thus
prohibited by the teachings of Schnell v. Chris-Craft Industries, Inc. [285 A.2d
437 (1971)]. And while the defendants are correct that the Supremacy Clause of
the United States Constitution and federal preemption jurisprudence prevent this
court from issuing an order enjoining them from filing a bankruptcy petition, this
court unquestionably has the power to prevent the board of directors from
binding the company to a transaction to sell Magticom before first complying with
the mandates of 8 Del. C. § 271.” (footnotes omitted).
iv. Rationale
“Metromedia’s financial circumstances provide strong evidence of the
inequity of a bankruptcy sale….It therefore seems an abuse of the bankruptcy
process for a robust and healthy company, encumbered by virtually no debt, to
seek out the vast and extraordinary relief a bankruptcy court is capable of
providing.” While the Chancery Court did not presume to determine good faith
under the Bankruptcy Code, it ruled that “standard provide[s] ample support for
the notion that the board’s conduct here inequitably abridged the justified
expectations of the common stockholders.”
“In lieu of holding a statutory right as residual owners to approve the
proposed Magticom sale, the common stockholders find themselves relegated to
the status of sideline objectors in bankruptcy court.”
“…The primary interests protected by the bankruptcy process are those of
creditors. Because of this simple fact, the bankruptcy code does not contemplate
a freestanding right to vote by the holders of common equity. Were such a vote
available, the legal rights of the creditors to the remaining assets of the entity
would take a subsidiary position to the interests of the residual owners who, at
least where a company is insolvent, no longer have any cognizable financial
interest to protect.”
“…Nevertheless, it is important to note that a state law process is
available to deal with management’s inability to properly fulfill its duty to hold an
election – a process well capable of protecting the interests of all constituent
groups.”
v. Analysis
Did the Delaware Chancery Court overlook whether the bankruptcy court
would have subject matter jurisdiction over Metromedia’s chapter 11 case
brought to evade state law corporate governance?
228

Yes, although it strongly implied the case would be dismissed for lack of
good faith. All federal bankruptcy legislation emanates from the bankruptcy
power granted Congress by article I, section 8 of the United States Constitution.
The bankruptcy power encompasses discharges of debts, Hanover Nat’l Bank v.
Moyses, 186 U.S. 181 (1902), distributions of a debtor’s property, id., and
reorganizations, Continental Ill. Nat’l Bank & Trust Co. v. Chicago, Rock Island &
Pac. Ry., 294 U.S. 648 (1935), In re Reiman, 20 F. Cas. 490 (S.D.N.Y. 1874),
aff’d, 20 F. Cas. 500 (C.C.S.D.N.Y. 1875) (No. 11,675).
The bankruptcy power does not encompass the power to change a
company’s corporate governance when its debts do not need to be reorganized
or discharged. In In re Texaco, Inc., 81 B.R. 806, 809 (Bankr. S.D.N.Y. 1988),
the Icahn Group requested termination of Texaco’s exclusivity to enable the
group to propose a chapter 11 plan “substantially the same as” Texaco’s
proposed plan, “except that it includes certain proposed amendments to further
‘corporate democracy.’” The Icahn Group’s proposed corporate governance
provisions “do not address any bankruptcy issues that relate to an effective
Chapter 11 reorganization. The issues raised by the Icahn Group do not involve
the relationship between the debtors and their creditors, nor do the corporate
governance proposals involve the relationship between the debtors’ creditors and
their shareholders.” Id.
Therefore, the bankruptcy court held: “The Chapter 11 Reorganization
process is not the appropriate vehicle for introducing changes in Texaco’s
existing system of corporate governance. The changes proposed by the Icahn
Group should be dealt with in an appropriate state law forum, rather than the
Bankruptcy Court.” Id. at 813.
Similarly, Metromedia would be unable to show the need for any relief
within the bankruptcy power and its chapter 11 case would be vulnerable to
dismissal for lack of subject matter jurisdiction to grant its requested relief,
namely a change in corporate governance to accomplish the sale.
Is the Delaware Chancery Court’s injunction against Metromedia and its
directors barring a sale of its stake in Magticom absent a shareholder vote
enforceable in a Metromedia chapter 11 case?
Unless reorganization is threatened, the bankruptcy court lacks power to
alter a debtor’s corporate governance. Mannville Corp. v. Equity Sec. Holders
Comm. (In re Johns-Mannville Corp.), 801 F.2d 60, 64-69 (2d Cir. 1986).
Therefore, if the board is unauthorized to propose a sale without a shareholder
vote, it is not clear there is any federal bankruptcy statute that preempts that
restriction, unless failure to propose a sale under 11 U.S.C. § 363 would cause
Metromedia to breach its fiduciary duties under the Bankruptcy Code. In
practice, debtors do not seek shareholder approval when proposing chapter 11
plans disposing of all their assets, presumably because they can not carry out
229

their responsibilities under the Bankruptcy Code without doing so and therefore
any contrary state law restrictions would be preempted. But, shareholders can
police this by objecting at the confirmation hearing. The restriction on
Metromedia and its board, however, would not preclude other parties in interest
such as creditors or preferred shareholders or common shareholders from
requesting permission to propose chapter 11 plans providing for the sale.
Did the Delaware Chancery Court correctly reason that “the
bankruptcy code does not contemplate a freestanding right to vote by the holders
of common equity?”
To the extent common shares are impaired, such as when the preferred
shares obtain more than they are entitled to, the common shares do vote and are
protected by the best interests test in 11 U.S.C. § 1129(a)(7) and the cramdown
provisions in 11 U.S.C. § 1129(b)(2)(C) under which holders of common shares
are entitled to the shares’ value. To the extent common shares are unimpaired,
their “legal, equitable, and contractual rights” must be unaltered under 11 U.S.C.
§ 1124(1) or must be compensated pursuant to 11 U.S.C. § 1124(2)(C)-(D).
B. No Fiduciary Duties to Creditors: North American Catholic Educational
Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)
i. Facts
NACEPF owned radio wave spectrum licenses. It agreed to grant
Clearwire Holdings, Inc. rights in the licenses. NACEPF, as a creditor and not a
shareholder of Clearwire, sued the directors of Clearwire who served at the
behest of Goldman Sachs (a minority of the board) for breach of fiduciary duty.
According to their complaint, the directors induced NACEPF to enter into a
master agreement to transfer rights in its licenses by representing Clearwire’s
purpose was to create a national system of wireless connections to the internet.
The complaint alleges that in fact, Goldman Sachs did not intend to carry out that
business plan which would have required it to pay $23.4 million for licenses.
When the market for the licenses collapsed after WorldCom announced its
accounting problems, Clearwire started negotiating to pay small amounts to
extract itself from its payment obligations by threatening to file for bankruptcy.
NACEPF’s complaint alleged (a) the directors fraudulently induced
NACEPF to enter into the master agreement and to maintain its licenses
available for sale to Clearwire, (b) Clearwire was insolvent or in the zone of
insolvency and the directors owed fiduciary duties to NACEPF which they
breached by holding onto NACEPF’s license rights to help Goldman Sachs keep
its investment in play, and (c) the directors tortuously interfered with NACEPF’s
prospective business opportunity to sell its licenses to others by causing
Clearwire to wrongfully assert it had the right to acquire NACEPF’s wireless
spectrum.
230

ii. Issue
“…whether, as a matter of law, a corporation's creditors may assert direct
claims against directors for breach of fiduciary duties when the corporation is
either: first, insolvent or second, in the zone of insolvency.” 930 A.2d at 97.
iii. Holding
“In this opinion, we hold that the creditors of a Delaware corporation
that is either insolvent or in the zone of insolvency have no right, as
a matter of law, to assert direct claims for breach of fiduciary duty
against the corporation's directors.”
930 A.2d at 94, 103.
iv. Rationale
“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.’"
930 A.2d at 99 (footnotes omitted).
“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.
Therefore, we hold the Court of Chancery properly concluded that
Count II of the NACEPF Complaint fails to state a claim, as a
matter of Delaware law, to the extent that it attempts to assert a
231

direct claim for breach of fiduciary duty to a creditor while Clearwire
was operating in the zone of insolvency.”
930 A.2d at 101.
It is well settled that directors owe fiduciary duties to the
corporation. 36 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. 37
[**26] When a corporation is insolvent, however, its creditors take the
place of the shareholders as the residual beneficiaries of any
increase in value.
36 See, e.g., Guth v. Loft, Inc., 23 Del. Ch. 255, 5 A.2d 503, 510
(Del. 1939).
37 See, e.g., Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)
partially overruled on other grounds by Brehm v. Eisner, 746 A.2d
244 (Del. 2000).
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. 38 The corporation's
insolvency "makes the creditors the principal constituency injured by
any fiduciary breaches that diminish the firm's value." 39 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.
38 Agostino v. Hicks, 845 A.2d 1110, 1117 (Del. Ch. 2004); see
also Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d at 1036
("The derivative suit has been generally described as 'one of the
most interesting and ingenious of accountability mechanisms for
large formal organizations.'" (quoting Kramer v. W. Pac. Indus., Inc.,
546 A.2d 348, 351 (Del. 1988); Guttman v. Huang, 823 A.2d 492,
500 (Del. Ch. 2003) (noting the "deterrence effects of meritorious
derivative suits on faithless conduct.").
39 Production Resources Group, L.L.C. v. NCT Group, Inc., 863
A.2d at 794 n.67.
930 A.2d at 101-102.
232

“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. 46
46 Production Resources Group, L.L.C. v. NCT Group, Inc., 863
A.2d at 797.
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.
930 A.2d at 103.
v. Aftermath
The former Chief Justice of the Delaware Supreme Court, E. Norman
Veasey, summed up the law as follows:
"…So it is clear that creditors have no direct fiduciary duty
claims against directors of an insolvent corporation or a solvent
one, whether or not it is in the 'zone of insolvency.' If the
corporation is actually insolvent, they may have derivative claims to
make on behalf of the corporate entity, if the facts support such a
claim. Whether creditors may bring derivative claims against
directors of a corporation that is solvent but in the zone of
insolvency is unclear, but doubtful as a practical matter."
E. Norman Veasey, "Counseling the Board of Directors of a Delaware
Corporation in Distress," ABI Journal, Vol. XXVII, No. 5 (June 2008)
(emphasis in original).
vi. What of the Trust Fund Doctrine?
233

Curiously, Gheewalla reaches its holding that directors of insolvent
corporations owe no fiduciary duties to creditors, without mentioning the trust
fund doctrine. While this might have been oversight, it also appears the trust
fund doctrine would not change Gheewalla's holding.
The trust fund doctrine originated in Wood v. Dummer, 30 F. Cas. 435
(Cir. D. Me. 1824). There, a bank whose charter expired issued dividends of its
capital stock to the bank's shareholders. Then, the bank's noteholders sued to
be paid by the recipients of the dividends. The court reasoned that "the charters
of our banks make the capital stock a trust fund for the payment of all the debts
of the corporation…." 30 F. Cas. at 436. "The stockholders have no right to any
thing but the residuum of the capital stock, after payment of all the debts of the
bank. The funds in their hands, therefore, have an equity attached to them, in
favour of the creditors." 30 F. Cas. at 439.
Later, the United States Supreme Court was asked to rule in Hollins v.
Brierfield Coal and Iron Co., 150 U.S. 371 (1893), whether contract creditors of
an insolvent corporation have a lien against its property or whether its property is
charged with a direct trust for their benefit. The answer was no. 150 U.S. at
386-387. The Supreme Court canvassed the jurisprudence and ruled:
"While it is true language has been frequently used to the effect that
the assets of a corporation are a trust fund held by a corporation for
the benefit of creditors, this has not been to convey the idea that
there is a direct and express trust attached to the property. As said
in 2 Pomeroy's Equity Jurisprudence, § 1046, they 'are not in any
true and complete sense trusts, and can only be called so by way
of analogy or metaphor.'" 150 U.S. at 381-382.
"'…The property of a corporation is doubtless a trust fund for the
payment of its debts, in the sense, that when the corporation is
lawfully dissolved and all its debts paid out of the corporate
property before any distribution thereof among the stockholders. It
is also true, in the case of a corporation, as in that of a natural
person, that any conveyance of property of the debtor, without
authority of law, and in fraud of existing creditors, is void as against
them.'" 150 U.S. at 384 (quoting Wabash, St. Louis & Pacific
Railway v. Ham, 114 U.S. 587, 594 (1885)).
"These cases negative the idea of any direct trust or lien
attaching to the property of a corporation in favor of its creditors,
and at the same time are entirely consistent with those cases in
which the assets of a corporation are spoken of as a trust fund,
using the term in the sense that we have said it was used." 150
U.S. at 385.
234

Based on Brierfield, modern day courts conclude: "The doctrine doesnot,
in fact, involve the application of any actual 'trust' at all…American National Bank
of Austin v. Mortgageamerica Corp. (In re Mortgageamerica Corp.), 714 F.2d
1266, 1269 (5 th Cir. 1983).
The Delaware Chancery Court addressed the trust fund doctrine when a
judgment creditor sued an insolvent corporation claiming its directors could not
prefer some non-insider creditors over other non-insider creditors. Amussen v.
Quaker City Corp., 18 Del. Ch. 28 (Del. Ch. 1931). The court ruled:
"…as among creditors, no trust exists which prevents the directors
of an insolvent corporation from preferring some over others,
notwithstanding the corporation is in failing circumstances and
manifestly headed for disaster…." 18 Del. Ch. at 31.
"…So that any creditor, who is unwilling to entrust his chances of
fair treatment to the officers and directors of the corporation, has
recourse open to him to resort to the courts where he may ask that
the corporate assets be drawn under judicial administration upon a
basis of equality. The creditor is therefore not helpless. While it
may be said that to compel creditors to seek protection by
receivership proceedings casts upon them the burden of vigilance,
the reply is that such is a burden that creditors have always been
generally expected to assume…." 18 Del. Ch. at 34.
The Delaware Chancery Court again addressed the trust fund doctrine
when it was faced with the question whether an insolvent corporation can prefer
an insider (director) creditor over non-insider creditors:
"The principle upon which the rule rests that forbids a directorcreditor
to enjoy a preference over others in the circumstance of the
company's insolvency, is variously stated. By most of the
authorities it is posited on the so-called 'trust fund theory' by which
capital assets are said to constitute a trust fund for creditors. By
others it is said to be based on the inequity of allowing a director to
take advantage of the superior means of information which he
enjoys over other creditors, conjoined as it is with a power or
influence which enables the possessor to reap a personal
advantage over others whose claims are equally meritorious…."
Pennsylvania Company v. South Broad St. Theatre Co., 20 Del.
Ch. 220, 228 (Del. Ch. 1934).
C. Deepening Insolvency: Trenwick America Litigation Trust v. Ernst & Young,
L.L.P., 906 A.2d 168 (Del. Ch. 2006), aff’d Trenwick America Litigation
Trust v. Billett, 2007 Del LEXIS 357 (Del., Aug. 14, 2007)
i. Facts
235

On December 31, 1998, the Trenwick Group had assets of $1.4 billion,
stockholders’ equity of $348 million, and a stock price of $31.49 per share.
Trenwick, 906 A.2d at 176. The parent holding company embarked on a strategy
of growth by acquisition and acquired 3 insurance companies in 2 years. In
connection with two of the acquisitions, the holding company’s top U.S.
subsidiary assumed or guaranteed hundreds of millions of dollars of debt,
although its financial statement still showed a positive asset value over $200
million. The trust contends the book numbers were the product of creative
accounting and hid insolvency. Trenwick, 906 A.2d at 184. Five years after the
growth strategy started, the holding company and its U.S. subsidiary commenced
chapter 11 cases because the insurance companies acquired turned out to have
more liabilities than assets. The chapter 11 plan of the U.S. subsidiary created a
litigation trust holding the subsidiary’s claims. That trust brought an action
against the holding company’s directors (10 of 11 of which were independent
directors) and its advisors, as well as the subsidiary’s directors. The corporate
charter exculpated directors from breaches of their duty of care.
The action essentially alleges that the directors embarked, due to a lack of
diligence, on an imprudent strategy as shown by its result. The action seeks to
hold defendants liable for breach of duties of care and loyalty, deepening
insolvency, and aiding and abetting it. The advisors are accused of malpractice
and breach of their duties as advisors to the parent to protect the subsidiary from
harm. Trenwick, 906 A.2d at 188. The action attempts to capitalize on the
companies’ insolvencies. Trenwick, 906 A.2d at 172-173. Defendants moved to
dismiss the action for failure to state a claim.
ii. Issues
Can a litigation trust formed by a debtor’s chapter 11 plan bring actions belonging
to the debtor’s creditors if the creditors do not assign them to the trust?
Does Delaware law recognize a cause of action for deepening insolvency?
Does a parent corporation owe duties to its subsidiary or its creditors?
What must be shown to overcome a corporate charter’s exculpation of directors
from a duty of care?
What must be shown to state a claim for breach of duty of loyalty?
iii. Holding
No. Based on Caplin v. Marine Midland Grace Trust Co.,406 U.S. 416
(1972), a litigation trust is not allowed to bring its creditors’ claims. Trenwick, 906
A.2d at 191.
“What Delaware law does not do is to impose retroactive
fiduciary obligations on directors simply because their chosen
236

usiness strategy did not pan out. That is what the Litigation Trust
seeks here, to emerge from the wreckage wielding the club that the
holding company's own failed subsidiary can now accuse the
holding company's directors of a breach of fiduciary duty. To
sanction such a bizarre scenario would undermine the wealthcreating
utility of the business judgment rule.”
Trenwick, 906 A.2d at 173-174.
“Equally important, however, is that 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.”
Trenwick, 906 A.2d at 174.
“…Under settled principles of Delaware law, a parent corporation does not
owe fiduciary duties to its wholly-owned subsidiaries or their creditors. 66
66 E.g., Anadarko Petro. Corp. v. Panhandle Eastern Corp., 545 A.2d
1171, 1174 (Del. 1988). Although it is said in general terms that a parent
corporation owes a fiduciary obligation to its subsidiaries, this obligation
does not arise as such unless the subsidiary has minority stockholders.
See DAVID A. DREXLER, LEWIS S. BLACK, JR., & A. GILCHRIST
SPARKS, III, DELAWARE CORP. LAW AND PRACTICE § 15.11, at 15-72
(2002).”
Trenwick, 906 A.2d at 191-192.
“To state a claim for gross negligence, a complaint might allege,
by way of example, that a board undertook a major acquisition
without conducting due diligence, without retaining experienced
advisors, and after holding a single meeting at which management
237

made a cursory presentation. To state a claim of disloyalty, a
complaint might allege that a board undertook an acquisition of a
company controlled by one of its directors because that director
was having financial problems and the board, in bad faith, decided
to prefer his interests to that of the company. What a plaintiff may
not do, however, is simply allege that a majority independent board
undertook a business strategy that was "all consuming and
foolhardy" and that turned out badly and thereby seek to have the
court infer that the later failure resulted from a grossly deficient
level of effort or from disloyal motives.”
Trenwick, 906 A.2d at 194.
iv. Rationale
“…Wholly-owned subsidiary corporations are expected to
operate for the benefit of their parent corporations; that is why they
are created. Parent corporations do not owe such subsidiaries
fiduciary duties. That is established Delaware law.”
“That is not to say that Delaware law leaves the creditors of
subsidiaries without rights. That would be inaccurate. Delaware has
a potent fraudulent conveyance statute enabling creditors to
challenge actions by parent corporations siphoning assets from
subsidiaries. And Delaware public policy is strongly supportive of
freedom of contract, thereby supporting the primary means by
which creditors protect themselves - through the negotiations of
toothy contractual provisions securing their right to seize on the
assets of the borrowing subsidiary.”
Trenwick, 906 A.2d at 174.
“A wholly-owned subsidiary is to be operated for the benefit of
its parent. A subsidiary board is entitled to support a parent's
business strategy unless it believes pursuit of that strategy will
cause the subsidiary to violate its legal obligations. Nor does a
subsidiary board have to replicate the deliberative process of its
parent's board when taking action in aid of its parent's acquisition
strategies.”
Trenwick, 906 A.2d at 174.
“Finally, it is important to point out that my refusal to conclude
that a wholly- owned subsidiary may sue the directors of its parent
company on the premise that their improvident business strategies
ultimately led to the bankruptcy of the subsidiary does not leave
open a gap in the law. There is no chasm.”
238

“The laws of all states and the federal bankruptcy laws address
precisely the scenario the Litigation Trust contends occurred in the
reorganization but fails to plead. They do so through a body of law
that might be fairly called the "law of fraudulent transfer."
Trenwick, 906 A.2d at 198 (footnote omitted).
“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.”
Trenwick, 906 A.2d at 174-175.
“ 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….”
Trenwick, 906 A.2d at 204.
“But business failure is an ever-present risk. The business
judgment rule exists precisely to ensure that directors and
managers acting in good faith may pursue risky strategies that
seem to promise great profit. If the mere fact that a strategy turned
out poorly is in itself sufficient to create an inference that the
directors who approved it breached their fiduciary duties, the
business judgment rule will have been denuded of much of its
utility.”
Trenwick, 906 A.2d at 193 (footnote omitted).
“To this point, I also do not believe that Trenwick America is
permitted to do an end-run around Trenwick's exculpatory charter
provision. A judicial acknowledgement that, as a matter of the
common law of equity, directors of a public company protected by
239

an exculpatory charter provision may be exposed to negligencebased
liability claims made by the public company's wholly-owned
subsidiaries would undercut the important public policy reflected in
8 Del. C. § 102(b)(7). Out of nowhere independent directors of
parent corporations would face, in a litigation context in which firm
failure is a given, due care claims by entities to which our law has
said the parent itself does not owe any fiduciary duties. To sanction
such bizarre claims would discourage board service and create
uncertainty about the extent to which parent corporations could
deploy their organization's assets in a good faith effort to undertake
risky strategies that promise future profit. Put simply, even if one
were to conclude (as I do not) that Trenwick America can proceed
against the Trenwick directors directly, at the very least Trenwick
America would have to plead a claim not exculpated by the
Trenwick charter. It has failed to do so.”
Trenwick, 906 A.2d at 194.
“If simple failure gave rise to claims, the deterrent to healthy risk
taking by businesses would undermine the wealth-creating potential
of capitalist endeavors. For that reason, our law defines causes of
action that may be pled against business fiduciaries and advisors
with care, in order to balance society's interest in promoting goodfaith
risk-taking and in preventing fiduciary misconduct. The
Litigation Trust has failed to meet its burden to plead facts stating
claims of that kind against the defendants in this case.”
Trenwick, 906 A.2d at 218.
v. But, Is Deepening Insolvency a Valid Damage Measure for Breach
of a Director's Fiduciary Duties of Care, Loyalty, or Good Faith?
See Miller v. McCown DeLeeuw & Co. (In re The Brown Schools),
386 B.R. 37 (Bankr. D. Del. 2008).
1. Facts
Brown Schools is a decision on a motion to dismiss a complaint.
Accordingly, the 'facts' are the court's interpretation of the complaint's allegations
and not the court's findings. 386 B.R. at 41.
McCown De Leeuw & Co., Inc. ("MDC") acquired control of The Brown
Schools, Inc. ("TBS") in 1997 and 1998. Id. It acquired 65% of the stock for $63
million. Id. MDC also procured an advisory services agreement under which it
would be paid the greater of $400,000 or 0.3% of revenues. Id. TBS also
obtained a $100 million credit commitment from CSFB, secured by substantially
all TBS' assets. Id.
240

In 1999, TBS obtained a $15 million loan from TIAA, subordinated to the
CSFB loan, in exchange for interest payments at 18% per year and warrants to
purchase 40,000 shares. Id. at 42. In 2000, TBS obtained a $5 million loan from
MDC, subordinated to both the CSFB and TIAA debt, in exchange for interest
payments at 12% per year, but the interest was payable in kind. MDC also
obtained warrants to purchase 74,000 shares. Id.
Later in 2000, when the CSFB debt was in default, TBS restructured it by
agreeing to sell $32 million of assets, with the proceeds to be used to pay down
the CSFB debt. Id. CSFB also procured an increase in its interest rate and
required TBS to raise an additional $7.5 million by selling additional PIK notes to
MDC. Id.
By April 7, 2003, TBS owed approximately $47 million to CSFB, $18.4
million to TIAA, $12.5 million plus interest to MDC, and $22 million to other
creditors. Id. Additionally, TBS was a defendant in over 30 lawsuits. Id. During
April 2003, TBS sold all its residential treatment centers for $64 million. TBS
used the proceeds to repay CSFB in full, to pay $907,000 to TBS' financial
advisors, $578,000 to TBS' attorneys, $278,000 to CSFB' legal and financial
advisors, and $1.7 million to MDC. Id. (Plaintiff, the chapter 7 trustee of the
estate of TBS, contends the $1.7 million payment was a vehicle to unlawfully
prefer MDC over other creditors since MDC provided no compensable services
beyond those for which it was being paid by its advisory services agreement. Id.).
In May 2003, TBS retained the Winstead firm at MDC's direction. Id. In
July 2004, TBS restructured its debt again. It gave TIAA a first lien against
substantially all its assets and TIAA agreed to waive defaults. TIAA's debt of
$20.95 million was restructured into 4 tranches. TBS agreed to sell $7 million of
assets to reduce TIAA's debt. Subsequently, TIAA and MDC entered into an
intercreditor agreement under which MDC was entitled to receive up to $2.9
million from monies thereafter received by TIAA. Id. TBS granted TIAA and
MDC security interests and then liquidated more than $18 million of assets,
whose proceeds were paid to TIAA which shared them with MDC. Id.
In March 2005, TBS filed chapter 7 petitions. Id. The chapter 7 trustee
filed a complaint against MDC, the director MDC installed at TBS, and Winstead.
Defendants filed motions to dismiss which were granted in part with permission
to replead. Miller v. McCown DeLeeuw & Co. (In re The Brown Schools), 368
B.R. 394 (Bankr. D. Del. 2007). Although the complaint alleged creditors were
damaged, “the Trustee in every instance also asserts that the Debtors were
damaged.” 368 B.R. at 400. On that basis, the court denied the first motion to
dismiss on standing grounds because even though a trustee lacks standing to
assert claims on behalf of creditors, it can assert claims on behalf of the estate.
Id.
241

"The Trustee asserts that MDC wrongfully prolonged the existence of the
Debtors so that MDC could profit at the expense of the Debtors and their
creditors, in violation of its duties of good faith, honest governance, and loyalty
which required a prompt bankruptcy filing and liquidation of the Debtors. As an
example, the Trustee points to the April 2003 transaction where the Debtors sold
all of their residential treatment centers for $64 million and paid MDC $1.7
million. In addition, the Trustee asserts that MDC effectuated the July 2004
Restructuring in breach of its fiduciary duty to the Debtors' creditors in order to
prefer MDC over non-insider creditors. Therefore, the Trustee seeks to recover
$18 million in damages caused by the Debtors paying TIAA as part of the
restructuring…." Id. at 45.
The repleaded complaint, among other things, alleged (a) defendants
were liable for deepening insolvency, (b) MDC was liable, in the amount of the
$18 million paid to TIAA, for breach of fiduciary duties by wrongfully prolonging
TBS' existence and damaging TBS, so MDC could profit at the expense of TBS
and its creditors, such as by receiving the $1.7 million, (c) aiding and abetting
fraudulent transfers, (d) the MDC director was liable for the fraudulent transfers
received by MDC because he benefited based on his affiliation with MDC, (e) the
MDC director was liable for aiding and abetting fraudulent transfers, (f) the MDC
director was liable for civil conspiracy and aiding and abetting a civil conspiracy,
namely MDC and other defendants caused TBS to retain Winstead to devise a
strategy to prefer MDC over other creditors in breach of MDC's fiduciary duties to
other creditors, and (g) Winstead was liable for breach of fiduciary duty, aiding
and abetting breach of fiduciary duty, conspiracy, fraudulent transfers, and aiding
and abetting fraudulent transfers.
2. Issues
10. Is there a valid cause of action for deepening insolvency?
11. If a cause of action for breach of fiduciary duty to creditors and the debtor is
brought to recover damages measured by deepening insolvency, is the cause
of action a disguised action for deepening insolvency?
12. Is there a cause of action for aiding and abetting a fraudulent transfer?
13. If a defendant is neither an initial transferee, nor an immediate, nor a mediate
transferee of a fraudulent transfer, can it be liable for the fraudulent transfer
based on indirect benefits?
14. Is there a cause of action for civil conspiracy or aiding and abetting a civil
conspiracy to breach fiduciary duties to creditors or the debtor?
3. Holdings
1. No. Miller v. McCown DeLeeuw & Co. (In re The Brown Schools), 386 B.R.
37, 44 (Bankr. D. Del. 2008). There is no cognizable cause of action In
Delaware for deepening insolvency. Trenwick Am. Litig. Trust v. Billett, 2007
Del. LEXIS 357, at *1 (Del. 2007).
2. Deepening insolvency can be a valid theory of damages for breach of
fiduciary duties. Id. at 48.
242

3. Under Delaware law, there is no valid cause of action for aiding and abetting
a fraudulent transfer. Id. at 53.
4. Being an employee of a transferee of a fraudulent transfer, does not alone
establish that the employee was a transferee or benefited from the transfer.
Id. at 54.
5. The allegations that the MDC installed director conspired with Winstead to
have Winstead act to prefer MDC's interests over the interests of other
creditors and that the purpose was achieved through the restructuring in 2004
state claims against the director and Winstead for civil conspiracy and aiding
and abetting civil conspiracy (which is a confederation of two or more persons
to do an unlawful act in furtherance of the conspiracy which results in actual
damages to plaintiff). Id. at 55-56.
4. Analysis
Miller v. McCown DeLeeuw & Co. (In re The Brown Schools), 386 B.R. 37
(Bankr. D. Del. 2008), poses the ultimate predicament for investors in distressed
companies. Namely, once distress is recognized, what actions can the investor
take to try to recoup some of its investment without incurring personal liability to
the company in amounts equaling or exceeding other creditors' unpaid claims?
Here, the private equity investor that paid $63 million for its ownership stake, put
in another $12.5 million on a subordinated basis once trouble surfaced, but is
being sued for over $18 million because it allegedly breached fiduciary duties by
trying to prefer itself and by not earlier depositing the company into bankruptcy.
The chapter 7 trustee also complains of and demands disgorgement from the
investor of the $1.7 million it was paid when the first lien debt was reduced and
the $2.9 million it received from a paydown of the second institution's debt, but no
fraud or dishonesty is alleged.185
This predicament has serious implications. If working out a distressed
situation without fraud or dishonesty can carry personal liability if the workout is
unsuccessful, the availability of capital to start or to grow businesses will shrink
and become more expensive. For the same reasons, the market's ability and
willingness to undertake out-of-court restructurings would diminish materially.
Conversely, if the law does not enforce fiduciary duties of directors and senior
officers, capital availability will seriously diminish due to lack of confidence in the
system.
Thus, the question becomes whether in the absence of fraud and
dishonesty, controlling shareholders, directors, and senior management have
185 MDC is also accused of having taken collateral security for its $12.5 million.
But, it appears MDC never benefited from that collateral security and the
company commenced its chapter 7 case less than a year after the security was
granted, thereby likely rendering the collateral security a voidable preference to
an insider pursuant to 11 U.S.C. § 547(b)(4)(B).
243

fiduciary duty liability, independent of and beyond the liability imposed by the
preference and fraudulent transfer statutes, for deferring bankruptcy liquidation
while they try to enable the dominant shareholder to recoup a portion of its
investment and they hope for a change of fortune. 186
Starting with the basics, entities use corporations and limited liability
companies precisely to limit their liability. When the United States government
tried to hold a parent corporation liable for its subsidiary's environmental liability,
the Unites States Supreme Court articulated the black letter law:
“It is a general principle of corporate law deeply ‘ingrained in our
economic and legal systems’ that a parent corporation (so-called
because of control through ownership of another corporation’s
stock) is not liable for the acts of its subsidiaries.”
United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876, 1884 (1998) (quoting
Douglas & Shanks, Insulation from Liability Through Subsidiary Corporations, 39
Yale L.J. 193 (1929)(“Douglas”).
“Thus it is hornbook law that ‘the exercise of the control which stock
ownership gives to the stockholders…will not create liability beyond
the assets of the subsidiary. That control includes the election of
directors, the making of by-laws…and the doing of all other acts
incident to the legal status of stockholders. Nor will a duplication of
some or all of the directors or executive officers be fatal.”
United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876, 1884 (1998)(quoting
Douglas at 196, footnotes omitted).
“But there is an equally fundamental principle of corporate
law, applicable to the parent-subsidiary relationship as well as
generally, that the corporate veil may be pierced and the
shareholder held liable for the corporation’s conduct when, inter
alia, the corporate form would otherwise be misused to accomplish
certain wrongful purposes, most notably fraud, on the shareholder’s
behalf.”
United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876, 1885 (1998).
186 Bearing in mind that the decision arose in the context of a motion to dismiss
based on the face of the complaint, we have to analyze the allegations that MDC
kept TBS out of bankruptcy solely to prefer itself, without consideration of MDC’s
possible defenses at trial such as that it validly formed a business judgment that
it would maximize value by conducting sales outside bankruptcy or that a
turnaround could occur. Thus, the question is simply whether a controlling
shareholder would breach a fiduciary duty by avoiding bankruptcy solely to
improve its own position.
244

In the case of TBS, the chapter 7 trustee determined to proceed against
the shareholder by way of breach of fiduciary duty rather than piercing the
corporate veil, possibly because no fraud could be alleged in the complaint.
Insofar as fiduciary duties are concerned, the Delaware Supreme Court has
recently nullified two avenues of recovery for the trustee. First, the court made
clear that directors and officers owe no fiduciary duties to creditors even when
the debtor is in the zone of insolvency or insolvent. 187 Besides, a chapter 7
trustee is unauthorized to bring creditor claims 188 other than avoidance
actions. 189 Second, the court made clear Delaware does not recognize a cause
of action for deepening insolvency. 190
Therefore, the chapter 7 trustee is left with enforcing the directors'
fiduciary duties to the corporation. 191 As a former Chief Justice of the Delaware
Supreme Court sums it up: "Directors owe fiduciary duties of due care and
loyalty to the enterprise…." 192 While these are broad sounding terms, they
certainly do not mean that whenever a corporation loses money, the directors are
personally responsible. Obviously, such a rule would undermine the entire
purpose of using the corporate form and would deter most persons from serving
as director.
In the case of TBS, the trustee's contention that the directors violated their
duties of care and loyalty to the enterprise arises in the awkward scenario where
the trustee is contending the enterprise should have been killed earlier.
Prior to the bankruptcy court’s decision on PE’s motion to dismiss, the
Delaware Supreme Court held that (a) “creditors of a Delaware corporation that
is either insolvent or in the zone of insolvency have no right, as a matter of law,
to assert direct claims for breach of fiduciary duty against the corporation's
187 North American Catholic Educational Programming Foundation, Inc. v. Rob
Gheewalla, Gerry Cardinale and Jack Daly, 930 A.2d 92, 103 (Del. 2007)( “In this
opinion, we hold that the creditors of a Delaware corporation that is either
insolvent or in the zone of insolvency have no right, as a matter of law, to assert
direct claims for breach of fiduciary duty against the corporation's directors.”).
188 Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972).
189 11 U.S.C. § 544.
190 Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168
(Del. Ch. 2006), aff’d Trenwick America Litigation Trust v. Billett, 2007 Del LEXIS
357 (Del., Aug. 14, 2007).
191 “It is well established that the directors owe their fiduciary obligations to the
corporation and its shareholders…." North American Catholic Educational
Programming Foundation, Inc. v. Rob Gheewalla, Gerry Cardinale and Jack
Daly, 930 A.2d 92, 99 (Del. 2007).
192 E. Norman Veasey, "Counseling the Board of Directors of a Delaware
Corporation in Distress," ABI Journal, Vol. XXVII, No. 5 June 2008.
245

directors….,” 193 and (b) Delaware has no cognizable cause of action for
deepening insolvency. 194 “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.” 195
(Pennsylvania law does recognize a cause of action for deepening
insolvency). 196 The bankruptcy court explained that if the trustee were asserting
a claim for breach of the fiduciary duty of care, “claims alleging a duty of care
violation could be viewed as a deepening insolvency claim by another name.” 197
Additionally, the court observed that duty of care violations are indemnifiable
under Delaware law and can be defeated by proving the process of reaching the
final decision was not the result of gross negligence. 198 But, the bankruptcy court
denied PE’s motion to dismiss because “[f]or breach of loyalty claims, on the
other hand, the plaintiff need only prove that the defendant was on both sides of
the transaction…,” after which the defendant has the burden “to prove that the
transaction was entirely fair.” 199
Whether the trustee stated a claim for a breach of the fiduciary duty of
loyalty is quite significant. Our nation’s underlying public policy driving economic
growth is to “encourage others to assume entrepreneurial and risk-taking
activities by protecting them against personal liability when they have performed
in good faith and with due care, however unfortunate the consequence.” 200
Half of new businesses fail within their first five years. 201 Should their
creators be sued for the losses on the ground they allowed personal goals to
overshadow risks to their creditors?
A glance at recent economic history further illustrates the issue.
Routinely, American enterprise makes bets. A few years ago, Wall Street bet the
country needed stadium movie theaters and invested billions to build them, which
A. 193 North American Catholic Educational Programming Foundation, Inc., v.
Gheewalla, 930 A.2d 92, 103 (Del. Sup. Ct. 2007).
194 Trenwick America Litig. Trust v. Billet, 931 A.2d 438 (Del. 2007), aff’g Trenwick Am. Litig.
Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006).
195 Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174 (Del. Ch. 2006).
196 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir.
2001).
197 Miller v. McCown De Leeuw & Co. (In re The Brown Schools), 386 B.R. 37, 47 (Bankr. D.
Del. 2008).
198 Id.
199 Miller v. McCown De Leeuw & Co. (In re The Brown Schools), 386 B.R. 37, 47 (Bankr. D.
Del. 2008).
200 Continuing Creditors’ Committee of Star Telecomm., Inc. v. Edgecomb, 385 F.Supp.2d 449,
458 (D.Del. 2004) (quoting Duesenberg, The Business Judgment Rule and Shareholder
Derivative Suits: A View from Inside, 60 Wash. U.L.Qu. 311, 314 (1982)).
201
http://www.sba.gov/smallbusinessplanner/plan/getready/SERV_SBPLANNER_ISENTFORU.html.
246

were mostly lost. 202 Stadium theaters in the face of growing movie distribution
over the internet and in competition with pre-existing theaters was a high wire act
which went awry. If, using hindsight, the directors and officers were sued for
making that bet in breach of their duty of loyalty on the ground they approved use
of investors’ funds in a risky bet so they could collect directors’ fees,
compensation, and bonuses, should they have had to prove it was fair to bet the
funds and endanger creditors while they collected benefits regardless of the
outcome? Today, the public airlines are losing billions and are destined to fail if
oil prices do not subside dramatically in a relatively short time. Which way oil
prices will go is no more predictable than a roulette ball -- maybe less. If their
directors and officers are sued for not having placed the airlines in bankruptcy
now to avoid future losses, while instead preferring to continue their positions
and benefits, should they have to prove it is fair to bet the funds and endanger
creditors while they collect benefits? Should the directors and officers of our auto
manufacturers be sued for breach of loyalty and have to prove that they have not
put the auto companies into bankruptcy even though they are losing billions
because they are making a good bet that they can solve the auto companies
declining market shares, retiree expenses, uncompetitive wage structures, and
not because they want to maintain their jobs and benefits?
When the issue in TBS is replicated for the stadium theaters, airlines, and
auto manufacturers, a fundamental question occurs across each scenario.
Namely, why would bankruptcy produce a better result for shareholders or
creditors? In TBS, the trustee alleged that while PE kept TBS out of bankruptcy,
its insolvency deepened by over $22 million, leaving shareholders with zero and
creditors further in the red. But, the TBS trustee nowhere alleged that (a) an
earlier bankruptcy could have attained as much sale proceeds as TBS procured
outside bankruptcy to retire over $98 million in debt and (b) an earlier bankruptcy
would not have cost millions of dollars more while all the properties were
administered, operated, and sold in bankruptcy. Put differently, the trustee’s
complaint did not allege what it needed to allege to aver that TBS or its creditors
were worse off by not having an earlier bankruptcy. Without those allegations
which would be exceedingly difficult to prove, the complaint lacked a prima facie
case of any harm. But, it appears the bankruptcy court was not asked to dismiss
the breach of loyalty claim on that ground.
Additionally, in each of these hypotheticals, as well as in the case of TBS,
the duty of loyalty is owed initially to shareholders. By failing to put TBS or any of
the stadium theaters, airlines, or auto manufacturers into chapter 7 liquidation
cases, all shareholders’ prospects, however tenuous, are preserved. Therefore,
there does not appear to be any breach of a duty of loyalty to the shareholders.
To the extent the controlling shareholder or directors also owe their duty of
loyalty to the company, it is incongruous to assert the shareholder breached its
202 See, e.g., In re UA Theatre Co., Case No. 00-3514 (PJW) , 2004 Bankr. LEXIS 1258 (Bankr.
D.Del. August 25, 2004); In re Winstar Communications Inc., 378 B.R. 756 (Bankr. D.Del. 2007);
In re GC Companies, Inc., 274 B.R. 663 (Bankr. D.Del. 2002);
247

duty of loyalty to the company by not killing it earlier, terminating all jobs, hurting
customers, and eliminating it as a competitor in the economy.
To be sure, a control person breaches his or her fiduciary duty of loyalty
when she puts her own interests, whether financial or personal, ahead of the
company. 203 "[T]he central insight of the entire fairness test...is that when a
fiduciary self-deals he might unfairly advantage himself even if he is subjectively
attempting to avoid doing so." 204 This raises the question as to whether
controlling shareholders, directors, and officers can get bogged down in litigation
every time a party alleges they acted for personal motives in breach of their
fiduciary duty of loyalty.
To try to deter and avoid unwarranted attacks on controlling shareholders'
and directors' loyalties, there are safeguards to deploy. First and foremost, the
goal is to invoke the business judgment rule presumption that the directors were
disinterested, did not lack independence and acted in good faith. 205 To do so, the
controlling shareholder or interested directors need a board of directors having
two or more independent and disinterested directors who can objectively assess
transactions in which the controlling shareholder or interested directors have
personal interests. The jurisprudence provides other safeguards. For instance,
receipt of directors' fees 206 and ownership of the company's stock 207 are mostly
held not to be factors rendering directors interested, unless a single director
serves on multiple boards of companies controlled by the same investment
advisor. 208
From the complaint in TBS, it does not appear that PE created a board
having disinterested directors who could have assessed the transactions in which
PE received benefits that other creditors or shareholders did not. Had that been
done, the trustee's complaint may not have survived the pleading stage. To
survive a motion to dismiss, the trustee's complaint would have to "plead around
the business judgment rule." 209 The Delaware courts scrupulously require
particularized pleading showing why the business judgment rule presumption
does not apply, such as by identifying which directors approved a transaction and
alleging why they were not independent and disinterested. 210 Many private
203 See Venhill Limited Partnership v. Hillman, 2008 Del. Ch. LEXIS 67, *9 (Del. Ch. June 3,
2008)(not released for publication; subject to revision or withdrawal); In re RJR Nabisco, Inc.
S'holders Litig., 1989 WL 7036, at *15 (Del. Ch. Jan. 31, 1989).
204 Id. at *68.
205 See Block, Barton, Radin, The Business Judgment Rule (5 th ed. 1991) at 264.
206 Unitrin, Inc. v. American Gen. Corp., 651 A.2d 1361, 1380 (Del. 1995); Tabas v. Mullane, 608
F. Supp. 759, 766 (D.N.J. 1985).
207 OBerly v. Kirby, 592 A.2d 1268 (Del. 1991).
208 Strougo v. Scudder, Stevens & Clark, Inc., 964 F. Supp. 783, 794 (S.D.N.Y. 1997),
reargument denied, [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,533 (S.D.N.Y. Aug. 18,
1997).
209 Stanziale v. Nachtomi (In re Tower Air, Inc.), 416 F.3d 229, 238 (3d Cir. 2005).
210 See, e.g., Nelson v. Emerson, 2008 Del. Ch. LEXIS 56, *6 (Del. Ch. May 6, 2008)(Strine,
V.C.)(not released for publication and subject to revision and withdrawal).
248

equity firms find much value added from independent directors who can provide
objective views and industry insights. Having such directors provides both
valuable ideas and legal defenses.
The TBS complaint also raises the issue as to the correct remedy for
wrongful transfers. The complaint emphasizes that PE was paid $1.7 million for
a sales transaction yielding $64 million, notwithstanding that PE received
consulting fees of up to $800,000 per year. At face value, if PE did nothing extra
to earn the $1.7 million and TBS was insolvent, then the transfer was a
constructively fraudulent transfer and PE will have to disgorge the $1.7 million
plus interest. Similarly, if PE granted the second institutional lender a security
interest in TBS' assets solely to give it a priority in exchange for which the lender
would share $2.9 million of collateral proceeds with PE and not with TBS' other
creditors, Delaware law has a fraudulent transfer statute that would void the
transfer to PE if TBS were insolvent at the time and PE had reasonable cause to
believe TBS was insolvent. 211 The special treatment for the institutional lender is
not actionable as Delaware law allows insolvent debtors to prefer a non-insider
creditor over another and explains the 'trust fund' doctrine does not require a
different result. 212 Insider creditors, however, can not be preferred. 213 Notably,
when the Delaware Supreme Court ruled that directors of insolvent corporations
owe no direct fiduciary duties to creditors, it did not even mention the trust fund
doctrine. 214
Similarly, the grant of the junior lien to PE for its subordinated claim of
$12.5 million would likewise be a voidable preference if granted within a year of
TBS' bankruptcy while it was insolvent and if TBS benefited from it which is
unclear. 215 Notably, while Congress enacted a preference statute applicable to
insiders that recovers transfers to them up to a year before bankruptcy as
opposed to ninety days for non-insiders, Congress thereby knowingly allowed
insiders to keep repayments of debt received more than a year before
bankruptcy.
The trustee's complaint proceeds on the premise that the combination of
PE's failure to put TBS into chapter 7 earlier and PE's receipt of potentially
voidable transfers creates a larger damage award equal to the deepening
insolvency of TBS by more than $22 million. The larger damages are said to
arise from PE's breach of its duty of loyalty. As explained above, it is not clear
that the deepening insolvency was a harm to TBS or its creditor body because an
earlier liquidation in bankruptcy may have produced a much worse result.
211 6 Del.C. § 1305(b); Joseph v. Frank (In re Troll Communications, LLC), 385 B.R. 110, 122
(Bankr. D.Del. 2008).
212 Pennsylvania Co. v. South Broad St. Theatre Co., 20 Del. Ch. 220, 227, 229-230 (Del. Ch.
1934).
213 Amussen v. Quaker City Corp., 18 Del. Ch. 28 (Del. Ch. 1931).
214 See North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930
A.2d 92 (Del. Sup. Ct. 2007).
215 11 U.S.C. § 547(b)(4)(B).
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Notably, the use of deepening insolvency as a damage measure is rejected by
many courts. 216 The bankruptcy court in TBS did not reject it, but ironically relied
on a decision that refused to disclaim deepening insolvency as a damage
measure, 217 but expressly explains that the correct damage measure would
require the plaintiff to prove "that the defendants' actions forced the debtors to
dissipate corporate assets that would have been retained otherwise (and then
quantify the value of those assets)." 218 Applying that to TBS, the trustee would
have to prove that PE's operation of the business outside bankruptcy realized
less or cost more than what could have been realized in bankruptcy, which is not
pled in the complaint.
Finally, history also has some bearing on the trustee's complaint against
PE. The Bankruptcy Act of 1898, as amended, contained an indemnity
requirement. Bankruptcy courts were authorized to order debtors to post bonds
to indemnify the estate against subsequent loss or diminution. 219 Congress
discontinued that requirement under the Bankruptcy Code. Now, the remedy for
substantial or continuing losses is that a chapter 11 case may be converted to
chapter 7 or dismissed, but only if there is an absence of a reasonable likelihood
of rehabilitation. 220 Rehabilitation does not have to repay creditors in full or any
such thing. It only requires that the business survives. This was not raised by
PE in the context of its motion to dismiss, but this history clearly shows Congress
has quite a tolerance for investors attempting to continue their businesses in the
hope of rehabilitation, even at the expense of incurring losses to creditors who
will not be made whole for such losses. That tolerance may preempt
jurisprudence disallowing the continuation of businesses.
The world is still safe for capitalism for those who learn from history.
Whether starting a business or rescuing one, the control persons should bring
themselves under the umbrella of the business judgment rule by the use of
independent directors, expert opinions, or comparable methods. The preliminary
decision in TBS, does not mean private equity funds should not collect consulting
fees from their portfolio companies and should not collect additional fees for
arranging capital transactions. It means the services for such fees should be
carefully documented. Indeed, private equity firms can save their portfolio
companies small fortunes by providing treasury functions that few executives can
provide. It is only a matter of making that clear and having independent directors
objectively assess it. Private equity firms can also rescue their portfolio
companies and can do so with secured debt, so long as independent directors
216 See, e.g., Seitz v. Detweiler, Hershey and Associates (In re CITX Corp.), 448 F.3d 672, 678
(3d Cir. 2006); Wooley v. Faulkner (In re SI Restructuring, Inc.), 2008 U.S. App. LEXIS 13140 (5 th
Cir. 2008); Joseph v. Frank (In re Troll Communications, LLC), 385 B.R. 110, 122 (Bankr. D.Del.
2008).
217 Alberts v. Tuft (In re Greater Southeast Community Hospital Corp.), 353 B.R. 324, 338
(Bankr. D.D.C. 2006).
218 Id.
219 Former 11 U.S.C. §§ 326 (Chapter XI), 426 (Chapter XII).
220 11 U.S.C. § 1112(b)(4)(A).
250

are satisfied. Breaches of the fiduciary duty of loyalty can be avoided, with good
planning by experts who have seen what can go wrong. That is the lesson of
TBS.
D. Loan to Own: Official Committee of Unsecured Creditors of Radnor
Holdings Corp. v. Tenenbaum Capital Partners (In re Radnor Holdings
Corp.), 353 B.R. 820 (Bankr. D. Del. 2006)
i. Facts
After Radnor’s financial advisor (Lehman Brothers) had contacted 40
potential investors, Tenenbaum Capital Partners agreed to purchase $25 million
of preferred stock and $95 million of senior secured debt. 353 B.R. at 828.
Tenenbaum was granted the right to designate a board member and a person to
monitor board meetings, and had the right to name more board members if
certain financial targets were not met. 353 B.R. at 828. Tenenbaum also had
the right to veto certain employment agreements and transactions with affiliates.
The court found it would be irrational to believe Tenenbaum invested in stock
while believing the company was insolvent. 353 B.R. at 830. When Radnor
failed to meet its projections, Tenenbaum made an additional $23.5 million
secured loan. 353 B.R. at 832. The unsecured noteholders consented. 353
B.R. at 834. Tenenbaum refrained from declaring certain defaults such as a
failure to satisfy and ebitda covenant while the banks insisted on the debtor’s
retention of a turnaround consultant. 353 B.R. at 834. Radnor commenced its
bankruptcy case because its bank creditors determined they had overadvanced
against their collateral and they stopped lending. 353 B.R. at 834.
Tenenbaum did not want to be a stalking horse bidder for Radnor, but was
convinced by the board that without Tenenbaum as stalking horse, the case
could result in a chapter 7 liquidation. 353 B.R. at 834. The Tenenbaum
representative resigned from the board and the asset purchase agreement was
negotiated at arms’ length. Id.
As part of the order approving bidding procedures, the bankruptcy court
authorized the statutory creditors’ committee to sue Tenenbaum and others.
Tenenbaum would be allowed to credit bid at the sale, whatever amount of its
$128.8 million secured claim survived the committee’s complaint. 353 B.R. at
826-827.
ii. Issues
Should Tenenbaum’s claim be recharacterized as equity?
Should Tenenbaum’s claim be equitably subordinated to general
unsecured claims?
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Is Tenenbaum or the director it nominated liable for breach of fiduciary
duty or aiding and abetting breach of fiduciary duty?
iii. Holdings
Neither Tenenbaum nor the director it nominated have any liability on the
foregoing counts.
iv. Rationale
The overriding consideration in a recharacterization case is the intent of
the parties. Cohen v. KB Mezzanine Fund II (In re SubMicron Systems Corp.),
432 F.3d 448 (3d. Cir. 2006). Tenenbaum’s knowledge that Radnor was
experiencing a liquidity crisis when it made its $23.5 million loan, does not
change the loan into equity because it’s rational for an existing lender to protect
its debt with an additional loan. Id. at 457. Thus, the loan cannot be
recharacterized on the ground no prudent lender would make a loan in those
circumstances. 353 B.R. at 840. Here, the parties at all times treated the loan
as a loan and not equity. 353 B.R. at 839.
Tenenbaum engaged in no inequitable conduct that harmed other
creditors. Moreover, its access to inside information did not make it an insider or
put it in control for purposes of applying to it a more stringent standard. 353 B.R.
at 841.
Based on Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168
(Del. Ch. 2006) and Seitz v. Detweiler, Hershey & Assoc. (In re CitX Corp), 448
F.3d 672 (3d Cir. 2006), there is no breach of fiduciary duty simply because a
board attempts to rehabilitate an insolvent company while maintaining
operations:
“As I conclude below, the Trenwick opinion made quite clear
that under Delaware law, a board is not required to wind down
operations simply because a company is insolvent, but rather may
conclude to take on additional debt in the hopes of turning
operations around.”
353 B.R. at 842.
Delaware law allows a corporation’s certificate of incorporation to
exculpate directors from their duty of care: 8 DEL. CODE ANN. § 102(b)(7).
“Section 102(b)(7) provisions act as a complete bar to liability
even when creditors or a trustee, rather than stockholders, are
suing derivatively. Production Res. Group, L.L.C. v. NCT Group,
Inc., 863 A.2d 772, 793 (Del. Ch. 2004); Pereira v. Farace, 413
252

F.3d 330, 342 (2d Cir. 2005), cert. denied, 126 S. Ct. 2286, 2006
U.S. LEXIS 3965, 164 L. Ed. 2d 812.”
“However, the fact that the Committee has dropped its duty of
care claims does not render Article Seventh and § 102(b)(7)
meaningless to this case. To the contrary, much of the Committee's
case at trial at best would have implicated the duty of care, not the
duty of loyalty. By way of example only, if the Radnor board should
not have approved a $ 55 million EBITDA maintenance covenant
because that number was too high (and the Court need not and
does not make such a finding here), it did not do so in bad faith;
rather, the only potential breach would have been in not
understanding that the Company's projections were optimistic and
that the maintenance covenant, set at the $ 55 million level, ran too
high of a risk of causing a default. That is a quintessential duty of
care claim. Simply alleging that Mr. Kennedy desired funding at any
cost does not convert this claim into one implicating the duty of
loyalty. Thus, Article Seventh and § 102(b)(7) would have barred
any such claims against the board, and Tennenbaum and Mr.
Feliciano therefore could not have possibly been held liable for
aiding and abetting such claims.”
353 B.R. at 842-843.
Tenenbaum was also not liable for aiding or abetting a breach of fiduciary
duty and deepening insolvency is not a recognized cause of action in Delaware:
“TCP never aided and abetted a breach of fiduciary duty.
The elements for aiding and abetting a breach of fiduciary duty
under Delaware law are as follows: "(1) the existence of a fiduciary
relationship, (2) a breach of the fiduciary's duty and (3) a knowing
participation in the breach by the non-fiduciary defendant." Cantor
Fitzgerald, L.P. v. Cantor, 724 A.2d 571, 584 (Del. Ch. 1998). The
evidence does not support a finding that any of these elements
have been satisfied.”
.Even if the Debtors were insolvent at the time of the
Tranche A, B and C transactions, the Radnor [**50] Board's
actions would not have breached any fiduciary duties owed to the
Debtors' unsecured creditors. As the Court of Chancery
acknowledged in Trenwick, Delaware law does not impose an
absolute obligation on the board of an insolvent company to cease
operations and liquidate. See Trenwick, 906 A.2d at 204. Rather,
directors of an insolvent company may pursue strategies to
maximize the value of the company, including continuing to operate
in the hope of turning things around. See id.; Equity-Linked
253

Investors, L.P. v. Adams, 705 A.2d 1040 (Del. Ch. 1997) (permitting
board of company within days of a bankruptcy filing to incur new
secured debt in aid of funding risky but promising new products
over the objection of preferred stockholders with liquidation
preference).
353 B.R. at 843.
The business judgment rule protects the directors of solvent, barely
solvent, and insolvent corporations against claims of creditors and
shareholders. 353 B.R. at 843.
“The Court holds that Mr. Feliciano did not breach his duty of
loyalty. The Committee has failed to prove that Mr. Feliciano was
interested in any transaction and voted in favor of it due to his
outside financial interests rather than voting in the best interests of
Radnor. Cede & Co. v. Technicolor Inc., 634 A.2d 345, 363 (Del.
1993) ("to establish a breach of duty of loyalty, [plaintiff] must
present evidence that the director either was on both sides of the
transaction or 'derive[d] any personal financial benefit from it in the
sense of self-dealing, as opposed to a benefit which devolves upon
the corporation or all stockholders generally."') (emphasis in
original).”
353 B.R. at 844-845 (emphasis in original).
The Delaware doctrine of acquiescence also bars relief here:
“The Committee's equitable subordination and breach of
fiduciary duty Counts are causes of action sounding in equity. In
addition to holding that the Committee has failed to prove its casein-chief
on these Counts, I conclude that the Committee's claims
are barred by the equitable defense of acquiescence, as applied by
the Delaware courts.
It has long been the law of Delaware that where a transaction
cannot be accomplished without stockholder approval, a
stockholder who either votes in favor of the transaction or accepts
the consideration offered by the transaction is barred from asserting
[**65] claims in claims in connection with that transaction. See,
e.g., Kahn v. Household Acquisition Corp., 591 A.2d 166, 176-77
(Del. 1991); Bershad v. Curtiss-Wright Corp., 535 A.2d 840, 848
(Del. 1987); Elster v. Am. Airlines, 34 Del. Ch. 94, 100 A.2d 219,
254

220-221 (Del. Ch. 1953); Finch v. Warrior Cement Corp., 16 Del.
Ch. 44, 141 A. 54, 60 (Del. Ch. 1928). Here, 95% of the
noteholders, including a majority of the members of the Committee,
did both: they voted in favor of Tranche C and accepted $ 675,000
in exchange for their consent. Thus, they have acquiesced to the
Tranche C Loans. Having acquiesced to it, they cannot now be
heard to argue that Tranche C should be treated as equity, nor that
entering into Tranche C was a breach of fiduciary duty.
While the Committee is a separate legal entity from the
noteholders who approved Tranche C, the Delaware cases draw no
such distinction. They typically arise in a class action context,
where like the seven members of the Committee, a stockholder
attempts to bring claims not only on his or her own behalf, but on
behalf of all stockholders, including stockholders that [**66] did not
acquiesce. Nevertheless, the Delaware courts have barred the
stockholders who acquiesced from asserting such claims on behalf
of those who did not. See, e.g., Kahn, 591 A.2d at 176-77; In re
Lukens Inc. Shareholders Litig., 757 A.2d 720, 738 (Del. Ch. 1999),
aff'd sub. nom., Walker v. Lukens, Inc., 757 A.2d 1278 (Del. 2000)
(TABLE) (noting, because a "large majority of the putative plaintiff
class . . . both voted in favor of the merger and received the
benefits of it," that "plaintiffs would confront substantial obstacles in
continuing the action on behalf of those persons"). I find that the
noteholders who control the Committee are in the same position
and cannot maintain their equitable subordination and breach of
fiduciary duty claims.”
353 B.R. at 848.
22. Critical Vendor Payments of Prepetition Claims: In re KMART Corp., 359 F.3d
866 (7 th Cir. 2004), rehearing denied, 2004 U.S. App. LEXIS 9050, (7 th Cir. May 6,
2004), cert. denied, 2004 U.S. LEXIS 2649 (U.S., Nov. 15, 2004).
A. Facts.
On the first day of its chapter 11 case, KMART requested permission to
pay in full at its discretion the prepetition claims of all critical vendors who agreed
to furnish goods on customary trade terms for the next two years. The order
granting the request provided the relief was in the best interests of the debtors,
their estates, and creditors. No notice had been given to the non-critical vendors.
Kmart used its authority to pay 2,330 suppliers approximately $300 million from
$2 billion of new credit. The non-critical vendors ultimately received about 10
cents on the dollar, mostly in stock. 359 F.3d at 868-869
A creditor timely appealed the order and it was reversed 14 months later,
just before confirmation of Kmart’s chapter 11 plan. 359 F.3d at 869. Certain
255

critical vendor-appellants argued the reversal was too late to require
disgorgement of the funds, 359 F.3d at 869, and one appellant who intervened in
the circuit court appeal argued that its not having been named earlier in the
appeal meant the reversal couldn’t affect it, 359 F.3d at 870.
B. Issues.
Does the Bankruptcy Code grant the bankruptcy court authority to prefer
some vendors over others? 359 F.3d at 872.
Can the critical payments be recovered after confirmation? 359 F.3d at
869-870.
Does the failure to have named a critical vendor in the appeal of the
critical vendor order prevent the appellate decision from affecting the unnamed
vendor? 359 F.3d at 870.
C. Holdings.
Section 363(b) is a more promising underpinning than any other
Bankruptcy Code provision to authorize a critical vendor order because
satisfaction of a prepetition debt to keep critical supplies flowing is a use of
property other than in the ordinary course of administering an estate in
bankruptcy. 359 F.3d at 872. “Even if ¶ 363(b)(1) allows critical-vendors orders
in principle, preferential payments to a class of creditors are proper only if the
record shows the prospect of benefit to the other creditors.” 359 F.3d at 874.
What the Supreme Court’s holdings (United States v. Reorganized CF&I
Fabricators, of Utah, Inc., 518 U.S. 213 (1996) and United States v. Noland, 517
U.S. 535 (1996)) “principally say is that priorities do not change unless a statute
supports that step; and if 363(b)(1) is such a statute, then there is no
insuperable problem. If the language is too open-ended, that is a problem for the
legislature. Nonetheless, it is prudent to read, and use, 363(b)(1) to do the least
damage possible to priorities established by contract and by other parts of the
Bankruptcy Code. We need not decide whether 363(b)(1) could support
payment of some pre-prepetition debts, because this order was unsound no
matter how one reads 363(b)(1).” 359 F.3d at 872.
“[T]he bankruptcy court did not explore the possibility of using a letter of
credit to assure vendors of payment. The court did not find that any firm would
have ceased doing business with Kmart if not paid for pre-petition deliveries,….
The court did not find that discrimination among unsecured creditors was the only
way to facilitate a reorganization. It did not find that the disfavored creditors were
at least as well off as they would have been had the critical vendors order not
been entered.” 359 F.3d at 873-874.
256

The doctrine of necessity is just a fancy name for a power to depart from
the Bankruptcy Code and did not survive its passage. “Older doctrines may
survive as glosses on ambiguous language enacted in 1978 or later, but not as
freestanding entitlements to trump the text.” 359 F.3d at 871.
No provision of the Bankruptcy Code forbids revision of the critical vendor
order as the Bankruptcy Code does for certain other orders. 359 F.3d at 869.
“Judges do not invent missing language.” 359 F.3d at 869.
As a party to the appeal in the circuit court, the intervening appellant will
not be allowed to contest matters resolved there. 359 F.3d at 870-871.
Unnamed and nonintervening critical vendors will be subject to the precedential
effect of the appellate decision as opposed to the preclusive force of the
appellate decision. 359 F.3d at 871.
D. Rationale:
Bankruptcy Code section 105(a) empowers the bankruptcy court to
implement the Bankruptcy Code, not to override it. 359 F.3d at 871. “’The fact
that a [bankruptcy] proceeding is equitable does not give the judge a free-floating
discretion to redistribute rights in accordance with his personal views of justice
and fairness, however, enlightened those views may be.’” 359 F.3d at 871
(quoting In re Chicago, Milwaukee, St. Paul & Pacific R.R., 791 F.2d 524, 528
(7 th Cir. 1986)).
‘…If paying the critical vendors would enable a successful reorganization
and make even the disfavored creditors better off, then all creditors favor
payment whether or not they are designated as “critical.” This suggests a sue of
363(b)(1) similar to the theory underlying a plan crammed down the throats of an
impaired class of creditors: if the impaired class does at least as well as it would
have under a Chapter 7 liquidation, then it has no legitimate objection and cannot
block the reorganization….” 359 F.3d at 872-873.
E. Analysis.
While Kmart affirms the reversal of a critical vendor order, it also provides
a potential roadmap for using section 363(b)(1) to authorize critical vendor
orders. To do so, debtors must show their critical vendors really won’t supply
goods as long as they are assured of payment by the debtor having a line of
credit, posting a letter of credit, or other means, as well as showing the noncritical
vendors will not be worse off due to the payments.
The United States District Court for the Northern District of Illinois in
Capital Factors Inc. v. Kmart Corp., 291 B.R. 818 (N.D. Ill. 2003), corrected by
257

Capital Factors, Inc. v. Kmart Corp.,2003 U.S. Dist. LEXIS 17437 (N.D. Ill.,
Sept. 29, 2003), had reversed the order of the bankruptcy court in the Kmart
chapter 11 case authorizing payment of critical vendor prepetition claims. It
announced a per se rule that critical vendor payments “simply are not
authorized under the Bankruptcy Code.” 291 B.R. at 823 (“Nevertheless, it is
clear that however useful and practical these payments may appear to
bankruptcy courts, they simply are not authorized by the Bankruptcy Code.
Congress has not elected to codify the doctrine of necessity or otherwise
permit pre-plan payment of prepetition unsecured claims. Because we hold
that the bankruptcy court did not have either the statutory or equitable power to
authorize the pre-plan payment of prepetition unsecured claims, we need not
address the second and third issues Capital raises on appeal.”)(unchanged by
corrected opinion).
258
(i) No Per Se Rule Barring Payment
of Prepetition Debt with Court
Approval
Notably, the affirmance by the United States Court of Appeals for the
Seventh Circuit leaves the order in the Kmart case vacated, but effectively
undoes the district court’s announcement of the rule barring payment of critical
vendors’ prepetition claims based on the court’s purported lack of power to
authorize such payments.
From a policy and common sense perspective, there is no question the
bankruptcy court should be empowered to authorize a debtor in possession to
pay prepetition when the payment will create more value for the estate than the
amount of the payment. As observed in Kmart, 359 F.3d at 872, section 363(b)
may authorize such payments as it is very open ended. These situations can
arise in numerous scenarios. For instance, if the debtor’s operations depend on
receipt of certain goods or services not susceptible of timely replacement by
alternate vendors, and the vendor itself will fail if its prepetition debt is not paid,
then the debtor confronts the need to shut down or pay the vendor’s prepetition
claim. Normally, shutdown destroys far more value and jobs than the amount of
the prepetition claim. Sometimes, failure to pay prepetition materialmens’ claims
leave the unpaid vendor with a secured claim. In those situations, the debtor
loses nothing by paying the prepetition claim if it is fully secured. Alternatively, if
a vendor is operating at capacity, it may have the luxury of determining to
upgrade its customer list which may mean dropping the debtor. Unless alternate
supplies at comparable price and quality are available, the debtor may lose more
value by not paying the vendor’s prepetition claim than the amount of the claim.
1. (ii) Acts to Collect Prepetition
Debts May Be Automatic Stay
Violations

To be sure, a vendor who simply threatens a debtor that it will stop
supplying goods unless its prepetition debt is paid, may be violating the
automatic stay against taking acts to collect prepetition claims. 11 U.S.C. §
362(a); see Sportfame of Ohio, Inc. v. Wilson Sporting Goods (In re Sportfame
of Ohio, Inc.), 40 B.R. 47; (Bankr. N.D. Ohio 1984).
Moreover, most vendors are smart enough to know that refusing to sell
goods tomorrow at a profit to a debtor in possession having an adequate credit
line due to a prepetition debt existing is economically irrational. Kmart, 359
F.3d at 873.
259
(iii) Foreign Vendors
Having No Minimum
Contacts with United
States
Foreign vendors having no minimum contacts with the United States of
America and therefore not being subject to the bankruptcy court’s power to
enforce the automatic stay, frequently have the leverage to demand payment of
their prepetition claims and the debtor’s estate is better off paying the claims
when termination of supplies from the foreign vendors will destroy more estate
value than the amount of the claims to be paid.
While there are many situations where the issuance of critical vendor
orders is warranted, the courts need to guard against abuse. For instance, no
vendor should be paid simply because of its relationships with management.
(iv) Procedure
Significantly, debtors and their estates and creditors are better off not
naming the creditors who are critical. That eliminates the possibility of the debtor
convincing the vendor to supply new goods and services without having its
prepetition debt paid. Thus, the debtor’s showing might include evidence that the
estate can not take the risk of a cessation of supplies and must have the
authority to do the necessary to obtain supplies vital to maintaining their
operations as a going concern and to a successful reorganization. The court’s
power to revise its orders and the creditors’ committee’s later ability to review the
debtor’s basis for each critical vendor payment can provide sufficient restraint on
the debtor’s management not to abuse the authority it gets to make such
payments. Notably, by recognizing the critical vendor order was issued the first
day of the case and by verifying that payments made can be recovered if
wrongful, the Kmart decision does not prohibit the issuance of critical vendor
orders, if needed, on the first day of a case, but sets very rational parameters for
entry of such orders.
(v) No Authority to Pay Unallowable Prepetition Claims

The various authorities and theories used to reject critical vendor orders
as illegal on a per se basis, are each inapplicable to situations where the estate
gains more value than it loses by paying a critical vendor’s prepetition claim. For
example, in the A.H. Robins chapter 11 case resulting from injuries to women
using the Dalkon Shield, the debtor and examiner wanted to make $15 million
available to fund reconstructive surgery for women whose child bearing ability
might terminate prior to plan confirmation. Official Comm. of Equity Sec. Holders
v. Mabey, 832 F.2d 299 (4th Cir. 1987).
The United States Court of Appeals for the Fourth Circuit reversed the
district court order approving the emergency fund because the women’s claims
were not allowed claims and the payments would precede plan confirmation.
There was also no certainty the payments could be recovered from women who
later turned out not to have had allowed claims. In short, the A.H. Robins
situation was a sympathetic attempt to pay prepetition debt without any offsetting
benefit to the estate. Section 363(b), therefore, could not help and the decision
appears inapplicable to critical vendor payments that do create value or avoid
harm to a debtor’s estate.
260
(vi) No Authority to Pay
Prepetition Claims
without Offsetting
Benefit to Estate
In the chapter 11 case of Oxford Management Inc., over the debtor’s
objection, the bankruptcy court ordered the debtor to pay a prepetition claim for a
brokerage commission. Fortunately, the United States Court of Appeals for the
Fifth Circuit reversed. Chiasson v. J. Louis Matherne Assocs. (In re Oxford
Management Inc.), 4 F.3d 1329 (5th Cir. 1993). There was no showing that
paying the prepetition claim would add value to the estate or avoid any harm.
Instead, one creditor would benefit at the expense of other creditors of equal
rank. This is the opposite of the rationale for critical vendor payments under
which the payment is only justified if it avoids harm or adds value for other
creditors.
(vii) No Authority to Cross Collateralize Prepetition
Debt with Postpetition Collateral without Offsetting Benefit to
Estate
Cross collateralization of $24 million of prepetition debt was denied by the
United States Court of Appeals for the Eleventh Circuit in the chapter 11 case of
Saybrook Manufacturing Co. Shapiro v. Saybrook Mfg. Co. (In re Saybrook Mfg.
Co.), 963 F.2d 1490 (11th Cir. 1992). There, the debtor proposed to collateralize
$24 million of prepetition debt in exchange for a new loan of $3 million. That is
certainly consistent with the notion that payment of prepetition debt of critical

vendors should not be authorized unless it results in a benefit to the estate
exceeding the payment. Paying or securing $24 million in exchange for the
benefit of a $3 million loan doesn’t pass the section 363(b) test. Nowhere was
the $3 million loan shown to be worth $24 million in the Saybrook situation.
Thus, other unsecured claimholders would have been hurt, not helped.
(viii) Paying Prepetition Debt Does Not Violate Equitable
Subordination Rules if the Unpaid Prepetition Debt Benefits
The rationale for denying payment of prepetition debt in the chapter 11
case of FCX Inc. is also quite interesting. In re FCX Inc., 60 B.R. 405 (E.D.N.C.
1986). There, the United States district court ruled that in elevating certain
prepetition unsecured claims over the debtor’s other creditors, the bankruptcy
court subordinated the claims of the debtor’s remaining creditors without
satisfying the standards for equitable subordination. Those standards require
that a creditor act wrongfully to benefit itself and harm other creditors before its
claim should be equitably subordinated.
The unique aspect of equitable subordination, however, is that the
subordination of the creditor’s claim results in the creditor obtaining a smaller (or
zero) distribution from the estate. Conversely, in the context of critical vendor
payments, they should only be authorized when they result in the estate having
greater value than it would have if the payment were not made. Under these
circumstances, the other so-called ‘subordinated’ creditors who do not receive
payment of their prepetition debt do not obtain lesser distributions from the
estate. Rather, they obtain more.
(ix) The Bankruptcy Code Allows Payment of Prepetition Debt
in Numerous Instances
Moreover, in the numerous circumstances under the Bankruptcy
Code when prepetition debt must be paid prior to plan confirmation, such as
when a debtor assumes an executory contract or unexpired lease and pays the
cure cost, it is never a condition precedent that other creditors not having their
prepetition claims cured satisfy the requirements for equitable subordination of
their claims. Indeed, the test for assuming an executory contract is generally the
same as for invoking section 363(b) to pay a prepetition claim. Namely, the
value of the assumed contract to the estate should exceed the cure amount.
(x). Prepetition Debt Can Not Be Paid without Court
Approval
In the chapter 11 case of B&W Enterprises, Inc., the United States
Court of Appeals for the Ninth Circuit affirmed a decision of the district court
overturning critical vendor payments made without court approval. B&W
261

Enterprises Inc. v. Goodman Comp., 713 F.2d 534 (9th Cir. 1983). In dicta, the
court opined it was not convinced the “necessity of payment rule” should be
applied to a debtor in the trucking industry. Since the payments had not been
submitted for court approval before they were made and the case was converted
to a chapter 7 liquidation case, there was no record showing whether the estate
was better off for making them.
(xi) The Bankruptcy Code’s Priority Scheme Includes
Substantial Flexibility
Significantly, the most prevalent rationale of courts ruling the Bankruptcy
Code bars payment of prepetition debt prior to plan confirmation is that
payment would alter the distribution scheme imposed by Congress. To assess
this rationale, several factors must be considered. See, e.g., Capital Factors,
Inc. v. Kmart Corp.,2003 U.S. Dist. LEXIS 17437 at *8-*9 (N.D. Ill., Sept. 29,
2003) (“The Bankruptcy Code sets forth a priority scheme for the payment of
claims. See 11 U.S.C. §§ 503, 507. The Code does not carve out priority or
administrative expense status for prepetition general unsecured claims based
on the ‘critical ‘ or "integral" status of a creditor. But the effect of the
bankruptcy court's orders was to elevate the claims of the ‘critical’ vendors
over those of other unsecured creditors and to subordinate the claims of non-
‘critical’ unsecured creditors. The bankruptcy court altered the priority scheme
set forth in the Bankruptcy Code.”).
No provision of the Bankruptcy Code expressly bars such
payments. Several provisions such as section 363(b) appear to allow such
payments. Additionally, the distribution scheme Congress imposed in the context
of plan confirmation is rather flexible and allows for some creditors to be treated
better than similarly situated prepetition claimholders when valid business
reasons for separate classification exist. And, most importantly, when payment
of the prepetition debt results in every other creditor obtaining more than it would
otherwise receive because the payment increased the estate’s value or averted a
loss, it does not appear the flexible Congressional distribution scheme Congress
imposed for plan confirmation is altered. It also furthers the fundamental purpose
of a chapter 11 reorganization.
To avoid having to request court approval for payment of these
claims, the prudent debtor with sufficient resources will prepay critical vendors
prior to the chapter 11 case commencing in exchange for commitments to
continue shipping on customary terms. Most debtors, however, do not have the
resources to prepay these claims and therefore will have to request court
approval. Before filing a motion a debtor should verify that no other alternative
source of supply for the product exists. A debtor should also instruct vendors
that conditioning continued shipment of product on payment of a prepetition claim
is a violation of the automatic stay. Only after a debtor is convinced that no
alternative source of supply exists, and the estate will lose profits or value without
262

the vendor’s goods, in excess of the prepetition debt to be paid, should it seek
authority to pay the vendor’s prepetition debt.
23. To What Extent Can A Debtor in Possession Indemnify Its
Financial Advisor?
A. In re United Artists Theatre Co., 315 F.3d 217 (3d Cir. 2003)
i. Facts
United Artists, as chapter 11 debtor in possession (“UA”), requested an
order approving its retention of Houlihan, Lokey, Howard & Zukin Capital
(“HLHZ”) as its financial advisor. The proposed retention agreement provided
UA “would indemnify Houlihan Lokey’s reasonable attorneys’ fees and expenses,
as well as any losses incurred by Houlihan Lokey with respect to, inter alia, its
providing of services. The letter also contained an exception for ‘any Losses that
are finally judicially determined to have resulted from the gross negligence, bad
faith, willful misfeasance, or reckless disregard of its obligations or duties on the
part of Houlihan Lokey.” 315 F.3d at 222.
UA’s motion “supplemented the gross negligence and willful misconduct
carveouts for indemnity in subparagraph (d) above by providing that, in the case
of a judicial determination, it must be final and find that either the gross
negligence or willful misconduct is ‘solely’ the cause of any claim or expense of
Houlihan Lokey. The order approving the application contains the same
language.” 315 F.3d at 222.
ii. Issue
The United States trustee objected that the agreement exempted HLHZ
from its own negligence, violating the Bankruptcy Code, public policy, and “basic
tenets of professionalism.” The United States trustee contended the indemnity
was unreasonable under sections 327(a) and 328(a) because they undermine
the principal purpose of bankruptcy to conserve debtors’ assets to pay creditors.
315 F.3d at 224. The district court approved the retention and a chapter 11 plan
was subsequently confirmed containing certain exculpation provisions under
which, among other things, the debtors released HLHZ from all claims related in
any way to the chapter 11 case and each creditor accepting the plan released
HLHZ from all claims. 315 F.3d at 224. The plan also provided that the debtor’s
professionals shall not incur to any person any liability in respect of the plan,
provided that this provision would have no effect on any liability determined in a
final order to have been gross negligence or willful misconduct. 315 F.3d at 225.
iii. Holding
“The upshot for this case is that, to the extent that fiduciaries may obtain
indemnity for their negligence, financial advisors in bankruptcy (who may or may
not be fiduciaries) may do the same.***Delaware courts have resolved the
263

negligence conundrum in the corporate sphere by evaluating the process by
which boards reach decisions, rather than the final result of those decisions. A
board’s failure to inform itself of ‘all material information reasonably available’
results in a finding of gross negligence.*** Delaware has navigated the Scylla of
condoning directors’ misconduct and the Charybdis of stifling their business
decisions with a rule that stresses not the end result, but the path taken to reach
it. Under this approach, courts do not interfere with advice by financial advisors
when they (1) have no personal interest, (2) have a reasonable awareness of
available information after prudent consideration of alternative options, and (3)
provide that advice in good faith….In the corporate sphere this is known as the
‘business judgment rule.’ A creature of common law…it acknowledges a judicial
syllogism derived from five fundamental tenets….” 315 F.3d at 231, 232-233.
“Here, where a debtor’s financial affairs – the pith of a reorganization – are
shaped by its financial advisors, they lay out the economic choices and assess
their risks, and (though not sureties of success) can be held accountable for not
advising with the level of care or loyalty expected, transposing the business
judgment rule from its corporate ambit to bankruptcy appears well suited. For by
this transposition we have a means to distinguish gross from simple negligence,
and thus a benchmark for approving as reasonable an arrangement for indemnity
that includes common negligence.” 315 F.3d at 233.
“We reach this result with two caveats. The first is that Houlihan Lokey
attempted to supplement its retention agreement with a provision in the retention
application and approving order that in effect mandates indemnification to
Houlihan Lokey for even its gross negligence if that negligence is not judicially
determined to be ‘solely’ the cause of its damages. In other words, the Debtors
would be bound to indemnify Houlihan Lokey when its gross negligence
contributed only in part to its damages. This attempted end run goes out of
bounds for acceptable public policy….” 315 F.3d at 234.
“Secondly…Houlihan Lokey in the Plan sought indemnity only for actions in its
professional capacity. The retention agreement arguably goes further, for it
requires indemnification of Houlihan Lokey for contractual disputes with the
Debtors. To the extent Houlihan Lokey seeks indemnity for a contractual dispute
in which the Debtors allege the breach of Houlihan Lokey’s contractual
obligations, this is hardly an indemnity-eligible activity….” 315 F.3d at 234.
“Financial advisors are an essential part of reorganizations. Our decision today
recognizes the need for safeguards from the second-guessing of creditors and,
ultimately, the courts. At the same time, it assigns courts their accustomed task
of evaluating the process by which advice is given. If financial advisors take the
appropriate steps to arrive at a result, the substance of that result should not be
questioned. So understood, agreements to indemnify financial advisors for their
negligence are reasonable under section 328(a) of the Bankruptcy Code.” 315
F.3d at 234.
264

iv. Rationale
In re Busy Beaver Bldg. Ctrs., Inc., 19 F.3d 833 (3d Cir. 1994), shows that
reasonable compensation is based on a market driven approach. Indemnity
against negligence is becoming a common market occurrence. Although marketdriven
does not mean the market is determinative, the market should be
considered subject to the court’s special supervisory role. 315 F.3d at 229-230.
“Though directors and officers are fiduciaries of the corporations they
serve, we do not hold financial advisors like Houlihan Lokey to be fiduciaries.
Still, in the bankruptcy context they may owe a higher level of care than in
ordinary practice….” 315 F.3d at 231n.14.
“Courts are increasingly recognizing the awkwardness inherent in using
the terms ‘negligence’ and ‘gross negligence’ in the area of corporate
governance. The art of governing (it is emphatically not a science) is replete with
judgment calls and ‘bet the company’ decision (negligent) alternatives, but rather
face a range of options, each with its attendant mix of risk and reward. Too
coarse a filter, the traditional negligence construct does not allow these nuances
to emerge… 315 F.3d at 231.
v. Consequences
Although the concurring opinion of Judge Rendell, 315 F.3d at 235-239,
takes exception with the wide scope of the main opinion and identifies new
issues to arise in applying the gross negligence test it espouses, unquestionably,
the opinion will serve as a guidepost for assessing financial advisors’ liability and
may effectively cloak them with their own business judgment rule. More
importantly, the decision approves the terms of the indemnity which require
payment by the debtor in possession of the financial advisor’s defense costs and
losses until and unless the financial advisor is adjudged by final order to have
acted with gross negligence, bad faith, willful misfeasance, or reckless disregard
of its obligations or duties. Empirically, assertion of claims against postpetition
financial advisors is very rare. But, the ability to bring an action and create a
nuisance is relatively easy and current payment of defense costs as incurred is
critical to the financial advisor. Protections normally inserted into a plan, such as
requirements that any actions against the advisor be brought in the bankruptcy
court, should probably be included in the orders approving their retentions to
enable the bankruptcy court to control and supervise the case.
24. The Stamp Tax Exemption Requires a Previously Confirmed
Chapter 11 Plan
A. Florida Department of Revenue v. Piccadilly Cafeterias, Inc.,
554 U.S. ___ (2008)
265

i.
i. Facts
After commencing its chapter 11 case, Piccadilly requested a sale of
substantially all its assets as a going concern, and as a precondition to the sale,
entered into a global settlement with committees of its secured and unsecured
claimholders dictating the priority of distribution of the sale proceeds. The
bankruptcy court approved the proposed sale and settlement agreement, and
also ruled the transfer was exempt from stamp taxes under 11 U.S.C. §
1146(a). 221 Ten days after the sale closed, Piccadilly filed its proposed plan and
later amended it. The plan provided for distributions in a manner consistent with
the settlement agreement. Florida objected to the plan contending its stamp tax
assessment of $39,200 was outside the exemption because the transfer had not
been under a plan confirmed.
The bankruptcy court granted summary judgment for Piccadilly and the
district court affirmed. Then, the Eleventh Circuit affirmed, finding the statute
was ambiguous and should be interpreted consistent with the principle that a
remedial statute such as the Bankruptcy Code should be liberally construed. In
re Piccadilly Cafeterias, Inc., 484 F.3d 1299, 1304 (11 th Cir. 2007).
ii. ii. Issue
Does the 11 U.S.C. § 1146(a) stamp tax exemption apply to
preconfirmation transfers?
iii. Holding
“…In the context of § 1146(a), the decision whether to transfer a given asset
‘under a plan confirmed’ must be made prior to submitting the Chapter 11 plan to
the bankruptcy court, but the transfer itself cannot be ‘under a plan confirmed’
until the court confirms the plan in question. Only at that point does the transfer
become eligible for the stamp-tax exemption.” (Footnote omitted).
"…Because Piccadilly transferred its assets before its Chapter 11 plan
was confirmed by the Bankruptcy Court, it may not rely on § 1146(a) to avoid
Florida's stamp taxes…."
iv. Rationale
“While both sides present credible interpretations of § 1146(a), Florida has
the better one. To be sure, Congress could have used more precise language –
221 Bankruptcy Code section 1146(a) provides:
(c) The issuance, transfer, or exchange of a security, or the making
or delivery of an instrument of transfer under a plan confirmed
under section 1129 of this title, may not be taxed under any law
imposing a stamp tax or similar tax.
266

i.e., ‘under a plan that has been confirmed’—and thus removed all ambiguity.
But the two readings of the language that Congress chose are not equally
plausible: Of the two, Florida’s is clearly the more natural…. “(Emphasis in
original).
“…To read the statute as Piccadilly proposes would make § 1146’s
exemption turn on whether a debtor-in-possession’s actions are consistent with a
legal instrument that does not exist—and indeed may not even be conceived of—
at the time of the sale….”
“…We find it informative that Congress placed § 1146(a) in a subchapter
entitled, “POSTCONFIRMATION MATTERS.” To be sure, a subchapter heading
cannot substitute for the operative text of the statute…The placement of §
1146(a) within a subchapter expressly limited to postconfirmation matters
undermines Piccadilly’s view that § 1146(a) covers preconfirmation transfers.”
“’…To the contrary, this Court has rejected the notion that ‘Congress had
a single purpose in enacting Chapter 11.’ Toibb v. Radloff, 501 U.S. 157, 163
(1991). Rather, Chapter 11 strikes a balance between a debtor’s interest in
reorganizing and restructuring its debts and the creditors’ interest in maximizing
the value of the bankruptcy estate….The Code also accommodates the interests
of the States in regulating property transfers…”
“…[W]e see no absurdity in reading § 1146(a) as setting forth a simple,
bright-line rule instead of the complex, after-the-fact inquiry Piccadilly
envisions….”
v. The Dissent
"The statute's purpose is apparent on its face. It seeks to further Chapter
11's basic objectives: (1) 'preserving going concerns' and (2) 'maximizing
property available to satisfy creditors.' Bank of America Nat. Trust and Sav.
Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 453 (1999)."
"'Statutory interpretation is not a game of blind man's bluff. Judges are
free to consider statutory language in light of a statute's basic purposes.' Dole
Food Co. v. Patrickson, 538 U.S. 468, 484 (2003) (Breyer, J., concurring in part
and dissenting in part). It is the majority's failure to work with this important tool
of statutory interpretation that has led it to construe the present statute in a way
in my view, runs contrary to what Congress would have hoped for and expected."
vi. Analysis
The majority's interpretation of section 1146(a) is hard to quarrel with
because it is a plausible reading of the statute. While the Bankruptcy Code's
dominant purposes may well include maximizing property available to creditors,
Congress actually made it quite clear that other forces were also at work. The
fact is that there is no stamp tax exemption in chapter 7. That is inconsistent with
the notion that maximizing property available to creditors is always dominant.
267

Additionally, if the absence of the exemption in chapter 7 is rationalized by
positing that to get the exemption the debtor has to reorganize, Congress did not
implement that concept either because under a confirmed plan the exemption is
available whether it's a reorganization plan or liquidation plan.
The dissent's essential point is that no rational theory explains why
Congress would want to make the exemption available after confirmation, but not
before. But, Congress did not make the exemption available in chapters 7, 12, or
13 at any time.
Notably, while the majority wrote the placement of section 1146(a) in the
subchapter entitled "POSTCONFIRMATION MATTERS," "undermines
Piccadilly's view that § 1146(a) covers preconfirmation transfers," neither the
majority nor the dissent observed that section 1146(b) authorizes the bankruptcy
court to authorize a plan proponent to request an advance ruling on the tax
effects of a plan and to determine the debtor's state and local tax liability prior to
confirming a plan if there are any disputes. Senate Report No. 95-989, 95 th
Cong., 2d Sess. (1978) at p. 133. Thus, it is fairly clear that Congress placed in
the subchapter on postconfirmation matters, provisions that will affect
postconfirmation economics, but that contemplate actions and results prior to
confirmation.
vii. Consequences
The majority's determination that section 1146(a) sets forth "a simple,
bright-line rule," will likely be used to come within the stamp tax exemption.
Perhaps real property will be transferred into a wholly-owned subsidiary of a
debtor without recording a deed and incurring stamp taxes, and then the
subsidiary will transfer the property to the buyer pursuant to a simple confirmed
chapter 11 plan for the subsidiary. Such mechanisms are likely to flourish now
that the simple, bright-line rule is articulated.
viii. Prior Law
Under the Bankruptcy Act of 1898, as amended, section 267 222 of Chapter
X provided for the stamp tax exemption under confirmed plans, and the
222 Section 267 provided:
The issuance, transfer, or exchange of securities or the making or
delivery of instruments of transfer under any plan confirmed under
this chapter, shall be exempt from any stamp taxes now or
hereafter imposed under the laws of the United States or of any
State.
Prior to the enactment of section 267, section 77B(f) of the Bankruptcy Act
exempted “the issuance, transfers, exchanges of securities or making or delivery
of conveyances to make effective any plan of reorganization confirmed under the
268

legislative history of the Bankruptcy Code shows Congress’ intent to continue it.
S. Rep. No. 95-989, 95th Cong., 2d Sess. (1978) at p. 132; House Report No.
95-595, 95th Cong., 1st Sess. (1977) at p. 421.
25. Can Confirmation Negate Stay Relief?
i. Facts
A. Atalanta Corp. v. Allen (In re Allen), 300 F.3d 1055 (9 th
Cir. 2002)
Allen, a kiwi fruit farmer, had property encumbered by liens held by
Atalanta and Anatom securing $1,000,000 and $550,000, respectively. In his
chapter 11 case, Allen stipulated with the lien holders that the automatic stay
would terminate as to 5 parcels as of December 1, 1998, but that if by February
1, 1999 Allen paid $325,000 to Atalanta and $175,000 to Anacom, they would
release their liens on 4 of the 5 parcels. The stipulation also provided that on
March 1, 1999, Atalanta could foreclose liens against 3 other parcels, and that
Allen would harvest the 1998 crop and Atalanta would market it. The court
approved the stipulation which did not provide it would be incorporated into any
chapter 11 plan.
In April 1999, the bankruptcy court confirmed Allen’s chapter 11 plan that
did not incorporate the stipulation. Instead, it provided Atalanta and Anacom’s
debts would be paid in annual installments with the entire balance due in balloon
payments in May 2004 and May 2005 and did not allow their foreclosures to
continue. 300 F.3d at 1058. Another creditor had a stipulation that provided its
terms would be incorporated into a plan and they were incorporated.
Atalanta and Anacom appealed. The district court affirmed, but remanded
for specific findings as to the interest rates for the Atalanta and Anacom loans.
Then, they appealed to the circuit court.
In an earlier decision, the Ninth Circuit had held an order approving a
stipulation providing it would bind the debtors in any chapter 11 plan could only
be modified or reversed if the bankruptcy court found “special circumstances”
such as preventing forfeiture of a family farm, and the bankruptcy court must take
maximum steps reasonably practical to put the other party in a position close to
what the stipulation provided. In re Lenox, 902 F.2d 737 (9 th Cir. 1990).
ii. Holding
A preconfirmation stipulation and order modifying the automatic stay, but
not providing it will bind the debtor or the court in a chapter 11 plan does not do
so.
provisions of this section” from certain federal tax provisions. Thus, section 267
amplified the exemption.
269

iii. Rationale
The court reasoned the requirements for confirming a plan are not
complied with in connection with approving a stipulation affecting the automatic
stay and notice is not given all interested parties unless the stipulation provides it
will bind any plan. Therefore, the stipulation only lasts until confirmation and the
rule against overturning stipulations has no role to play. 300 F.3d at 1059.
iv. Analysis
This is a situation where the important thing is to know the rule, not so
much what the rule is. Now, we all know that if a stipulation regarding the
automatic stay does not provide it can not be changed in a chapter 11 plan, then
it can be. Because an order terminating the automatic stay only allows a
lienholder to foreclose, it is not necessarily inconsistent with such an order for a
chapter 11 plan to restructure the lien. Indeed, the chapter 11 plan can
restructure all debts of the estate and until a foreclosure is completed, the debt
and lien remain in existence. There is nothing inherent in stay relief that renders
the debt and lien immune to restructuring or to repayment pursuant to a plan.
Moreover, courts sometimes terminate the automatic stay to allow the lienholder
to foreclose up to but not including the foreclosure sale. That way, if the debtor
does not reorganize, no time is lost. But, if the debtor does reorganize, it can
retain the use of the encumbered property.
Significantly, the notion that approval of a stipulation regarding the
automatic stay will be noticed to all interested parties is an interesting issue.
Normally, requests for stay relief are served on a shortened service list that
includes the debtor, the statutory creditors’ committee, and all entities that
requested notice. Absent a settlement, the court will grant complete stay relief if
the requirements of section 362(d) are satisfied. That relief may well affect the
balance of the case.
26. Can Unmatured Interest Be Allowed as Damages
under an Interest Rate Swap?
A. Thrifty Oil Co. v. Bank of America, 310 F.3d 1188 (9 th Cir. 2002)
i. Facts
The borrower wanted a $75 million loan to refinance a $52.1 million
secured note and to finance capital improvements, at a fixed interest rate of 11%.
310 F.3d at 1192. The final loan proposal from the bank provided for a floating
rate term loan and required the borrower to enter into interest rate swaps to
hedge the interest rate fluctuation risk. The lender allowed the borrower to obtain
the swaps from any suitable swap dealer. Ultimately, the borrower took the loan
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and swaps from the same lender and they were cross defaulted and cross
collateralized. 310 F.3d at 1193.
Under the swaps, the borrower paid the lender a fixed rate on a notional
amount of $45 million and received a floating rate on the same notional amount.
Between the term loan and swaps, the borrower ended up paying 9.83% interest.
When the borrower commenced a chapter 11 case and a plan was
confirmed, the lender asserted a swap claim of $5.4285 million and the debtor
objected that it was unallowable unmatured interest and was alternately
disallowable under California’s Bucket Shop Law.
ii. Issue
“[I]n this case BofA provided both the loan and the three interest rate
swaps, an arrangement that creates a theoretical possibility that the periodic
swap payments form part of BofA’s compensation for the risk and delay
associated with the term loan. The question therefore becomes whether or
under what circumstances, BofA’s dual role as lender and swap dealer converts
GWR’s periodic swap payments from derivative cash flows into interest on the
term loan.” 310 F.3d at 1199.
iii. Holding
“[T]he price a borrower pays for an interest rate swap may contribute to
overall funding costs but does not necessarily comprise that element of the
borrower’s funding costs attributable to interest.” 310 F.3d at 1198.
“[T]he speculative possibility that a lender could use interest rate swaps to
evade Section 502(b)(2) does not overcome the strong Congressional policy of
encouraging the innovative use of interest rate swaps, or justify eschewing the
benefits available to counterparties who obtain swaps from their lenders. A case
where such abuse could occur would involve, for example, a lender that does not
maintain a swap portfolio, an unsophisticated borrower, non-standard swap
documentation or artificially inflated swap pricing. However, where the lender
provides a standard interest rate swap to a sophisticated borrower and the swap
serves a legitimate non-bankruptcy purpose, the lender’s claim for termination
damages is, for all purposes, indistinguishable from a claim filed by a non-lending
swap dealer. Allowing the lender to collect termination damages in such a case
offends none of the principles and policies of Section 502(b)(2).” 310 F.3d at
1201-1202.
The swap claim was neither unallowable unmatured interest under
Bankruptcy Code section 502(b)(2), nor unallowable under the Bucket Shop Law.
iv. Rationale
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Bankruptcy Code section 502(b)(2) provides a claim shall not be allowed if
“such claim is for unmatured interest.” It has 3 underlying reasons: (1) to avoid
penalizing a debtor by making it pay interest for delays due to the law’s
prohibition on its paying interest during a case; (2) to avoid the inconvenience of
forcing a debtor to constantly recalculate the amount owed each creditor; and (3)
to prevent each party from gaining or suffering due to “delays inherent in
liquidation and distribution of the estate.” 310 F.3d at 1195-1196.
“Payments made under an interest rate swap cannot possibly compensate
for the delay and risk associated with borrowed money because no loan has
taken place between the counter-parties.” 310 F.3d at 1197.
If the swap dealer had been an entity different from the lender, it would be
clear that the dealer’s interest rate swap claim is not for interest because no
money would have been borrowed between the dealer and the debtor. Notably,
swap agreements can have money being owed from the swap dealer to the
debtor. Therefore, interest rate swaps are not inherently unmatured interest
claims.
27. Is Good Faith Too Ambiguous a Standard?
A. In re Coram Healthcare Corp., 271 B.R. 228 (Bankr. D.
Del. 2001).
i. Facts.
In 1997, 3 investors purchased $250 million of the debtors’ unsecured
notes. The debtors, Coram, had become a leading provider of alternative site
infusion therapy services. From Junje 1998 through July 24, 2000, a
representative of one of the noteholders, Cerberus, served as one of Coram’s
directors. In 1998 or 1999, Crowley joined Cerberus’ “bench” of ceo consultants
available to work for Cerberus with troubled companies. Cerberus’ principal
orally agreed that Cerberus would pay Crowley $80,000 per month plus
expenses to serve as a consultant to distressed companies in which Cerberus
had a stake. In August 1999, at Cerberus’ suggestion, the debtors hired Crowley
as a consultant to their ceo. As a result of the debtors’ severe financial
difficulties, their ceo resigned in the fall of 1999 and the debtors agreed to hire
Crowley as ceo as a condition to a restructuring and forbearance agreement with
the noteholders. In November 1999, Crowley sent a personal and confidential
letter to Cerberus’ principal requesting additional compensation from Cerberus in
the form of incentive bonuses for consulting work he was doing on Cerberus’
behalf for other distressed companies. The additional compensation was to be
paid in consideration for Crowley signing an employment contract with the
debtors. 271 B.R. at 230-231.
On November 18, 1999, Crowley signed a 3-year employment agreement
with the debtors. The next day, Crowley signed a consulting agreement with
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Cerberus under which he would receive $80,000 per month and an increased
performance bonus based bonus for his work on another distressed company.
Such amounts would be paid by Cerberus, but reduced by amounts Crowley
receives from the companies to which he is assigned. Section 2.3 of the
agreement required Crowley to use his best efforts to promote the success of
Cerberus’ business or the business of companies to which he’s assigned.
Section 6.3 of the agreement entitles Cerberus to terminate Crowley for cause
including Crowley’s “’failure to follow the reasonable instructions of [Cerberus]…,
[Cerberus’ principal], or the Board of Directors of [the debtors]. 271 B.R. at 231.
Neither Crowley nor the Cerberus principal on the debtors’ board of
directors disclosed the terms of the consulting agreement to the debtors. 271
B.R. at 231.
By the end of 1999 the debtors faced enormous financial difficulties and
consulted bankruptcy attorneys. In June 2000, the debtors sold their pharmacy
business for net cash of $38 million and used some of it to pay down on secured
revolver debt that had been provided by the noteholders and, at Crowley’s
direction without prior notice to the board of directors or bankruptcy attorneys,
paid $6.3 million of interest on the unsecured notes that could have been paid in
kind by adding $6.3 million to the outstanding principal. 271 B.R. at 231.
A few days later, the noteholders’ representative resigned from the
debtors’ board and on August 8, 2000, the debtors commenced their chapter 11
cases. Crowley continues to serve as ceo. The debtors’ schedules show the
noteholders were owed more than $252 million and trade creditors were owed
$7.5 million. The statutory creditors’ committee was comprised of 2 noteholders
and one trade creditor. Additionally, the U.S. trustee appointed a statutory equity
committee.
The debtors’ first proposed chapter 11 plan extinguished the equity and
provided the new equity to the noteholders and $2 million cash to the trade
creditors. The bankruptcy court denied confirmation on the ground Crowley’s
consulting agreement with Cerberus created an actual conflict of interest that
tainted the restructuring of the debtors’ debt and operations, and its negotiations.
As a result, the court determined it was unable to find the plan was proposed in
good faith for purposes of Bankruptcy Code section 1129(a)(3).
On February 26, 2001, the bankruptcy court granted the debtors’ motion to
retain Goldin Associates, LLC to investigate the extent of Crowley’s conflict and
the damage, if any, that was done to the debtors as a result of the conflict.
Goldin was also directed to try to mediate a plan.
Goldin concluded that while Crowley and Cerberus should have disclosed
the full extent of their relationship to the debtors’ other directors and officers,
there was neither evidence Cerberus ever instructed Crowley to act contrary to
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the debtors’ interests, nor evidence Crowley or Cerberus expected Crowley wold
seek to advance Cerberus’ interests to the detriment of the debtors’. Goldin
found the $6.3 million payment did not affect the noteholders’ position vis-à-vis
other creditors or impact other creditors. The debtors were found to have
suffered damages from the undisclosed conflict comprised of the expense up to
$6 million of professional fees for the failed confirmation and possible business
losses of $7 million to $9 million resulting from the inability to obtain confirmation.
Goldin recommended that Crowley’s bonus be reduced by $7.5 million to $5.9
million.
The debtors proposed a second chapter 11 plan that treated Crowley as
Goldin recommended, gave the new equity to the noteholders, and offered $10
million to the equity holders if they accepted the plan and if the creditors do not
object on the basis of the absolute priority rule. The equity did not accept the
plan and the equity committee objected to confirmation again.
At the confirmation hearing on the second proposed plan, the court found
Goldin had not investigated the continuation after December 2000 of Crowley’s
conflict and whether he continued to get payments from Cerberus. Goldin
testified, however, that he assumed Crowley would do no harm to the debtors
after his arrangement with Cerberus was revealed because he had done no harm
beforehand. A member of the debtors’ board testified Goldin was hired “’to
sprinkle holy water on the situation’ and make everything all right.”
ii. Holding
The bankruptcy court denied confirmation again on the ground the
“continuous conflict of interest by the CEO of the Debtor precludes the Debtors
from proposing a plan in good faith under 1129(a)(3).
iii. Rationale
“Crowley cannot serve the interests of both the Debtors and a large
creditor, Cerberus. Under the Consulting Agreement, Cerberus has the
discretion to fire Crowley if he fails to follow its instructions, resulting in the loss of
$1 million per year in compensation to Crowley….” 271 B.R. at 236. Crowley
has a fiduciary duty to the estate which includes a duty of loyalty to avoid a
direct, actually conflict of interest. Id. For instance, Crowley did not cause the
debtors to sue to avoid the $6.3 million interest payment. Although that action is
preserved under the proposed plan, it will not likely be brought because the
noteholders would control the reorganized debtor. “…Crowley’s conflict of
interest is a violation of his fiduciary duty to the Debtors and the estate and is so
pervasive as to taint the “’Debtors’ restructuring of its debt, the Debtors’
negotiations towards a plan, even the Debtors’ restructuring of its
operations’…The Debtors’ hiring of Goldin to ‘ sprinkle holy water on the
situation’ does not cure the conflict or evidence good faith.” 271 B.R. at 240.
“Given the fact that Crowley had not disclosed the agreement in the first place,
the Debtors should have asked for full disclosure and required that Crowley
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sever all agreements with Cerberus as a condition of continued employment.
The ‘don’t’ ask, don’t tell’ approach adopted by the Debtors and their Special
Committee does not fulfill their fiduciary duty to these estates.” 271 B.R. at 238.
iv. A Proper Application of Good Faith under
Section 1129(a)(3)?
While the failure to disclose the consulting agreement to all creditors and
the director’s disrespectful (and apparently unprepared and unlawyered)
testimony that Goldin was retained to sprinkle holy water on the process create a
prima facie violation making denial of confirmation seem natural, the court’s
ruling creates potentially unjustified leverage for equity holders rather than any
potential remedy for any wrong committed. The decision contains no indication
the estate was anywhere near solvent, and the creditor litigants contend the
estate was at least $100 million insolvent.
In short, the question is why the court should not have confirmed the plan
while preserving for shareholders any actions they had against Crowley or
Cerberus.
Put differently, what if the noteholders had proposed the chapter 11 plan
instead of the debtors? Certainly, no one can contend the noteholders lack good
faith for proposing a plan that maximizes their benefit. Perhaps they would also
have been held to lack good faith for not disclosing Crowley’s consulting
agreement. The trade creditors, however, could propose the same plan without
being blameworthy for failure to disclose. No evidence suggests the equity could
have been in the money in any scenario. The failure of the Crowley to seek to
recover the $6.3 million interest payment from the noteholders, may have had no
impact because the money would simply go back to the company the
noteholders would own.
Notably, while Crowley and Cerberus were found not to have disclosed
their agreement, the court also found the debtors employed Crowley as a
condition to obtaining a forbearance agreement from Cerberus and the other
noteholders. Therefore, it was certainly disclosed and known that Crowley was
there because Cerberus and the other noteholders wanted him as the debtors’
ceo. Once that was known, there can be little doubt that anyone involved in the
case would assume Crowley had an incentive to try to please the entities that put
him there, namely the noteholders. The incremental allegiance that Crowley had
due to the consulting agreement appears marginal. Although the court makes
much of the fact that Cerberus could cancel its obligation to pay Crowley $1
million per year if he didn’t follow Cerberus’ instructions, Crowley was actually
getting more than $1 million from the debtors and therefore under the consulting
agreement, Cerberus would not have to pay Crowley. Moreover, it’s certainly
possible to interpret the consulting agreement as deferring to Crowley’s duties to
any company that employed him and not requiring him to obey Cerberus if that
meant violating duties to the debtors.
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B. In re Bidermann Industries U.S.A., Inc., 203 B.R. 547
(Bankr. S.D.N.Y. 1997)
i. Facts.
Prior to bankruptcy, the debtor had retained turnaround consultants, one
of whom served as ceo at $700,000 per year and one of whom was retained at
$350,000 per year. When the chapter 11 case commenced, the bankruptcy court
approved the arrangement.
The debtor requested the bankruptcy court to approve a letter agreement
setting up a process to accomplish a leveraged buy out of the debtor under which
the turnaround consultants and an investor they procured would acquire the
debtor. The turnaround consultant serving as ceo would remain ceo and the
amount of the equity investment would be probably $40 million and up to $60
million in the discretion of the buyers. The cooperation of the prepetition majority
shareholder was assured by providing him a 10-year option to acquire 2% of
the common stock at the same price as the buyers pay as well as numerous
other options to purchase stock and assets of the company. 203 B.R. at 549-50.
Additionally, the shareholder would receive a consulting agreement paying him
$300,000 per year for 5 years and $750,000 for his covenant not to compete.
Reimbursement, Topping Fee, No Shop Clause, etc Under the letter
agreement, the investor would be entitled to up to $2 million in expense
reimbursement, a topping fee of $2 million and up to $3.8 million, a broad
indemnification, no solicitation or competing bid encouragement by the debtor
except to the extent the debtor s fiduciary duties would be violated, the
prohibition of any insider filing an inconsistent plan, and the granting of an
administrative expense priority to the investor for the foregoing obligations.
The debtors agreed to the deal without retaining an investment banker or
testing the waters for a more favorable deal. The ceo admitted the business was
a different enterprise than it was two years earlier when it had an investment
banker. The ceo also admitted the debtors could reorganize without the buyout
and that a strategic buyer would pay more than a financial buyer like the investor
at issue. 203 B.R. at 551, 554.
Statutory Committee Support. The statutory creditors committee
supported the deal. Its constituency would be paid $13.5 million cash for $26
million in claims. The support was based on a prior arrangement agreed to by
the committee and the institutional note holders.
The letter agreement was objected to by 2 institutional noteholders who
were not part of the agreement. The debtors and the committee attacked the
objectors claiming they were only trying to earn a windfall on the claims they
purchased at a discount!
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ii. Holdings.
The court denied approval of the letter agreement and scheduled a
hearing to consider why an examiner with expanded powers should not be
appointed. 203 B.R. at 554.
Initially, the court observed the ceo had a clear conflict: he was trying to
acquire the debtor for the lowest possible price while he had a fiduciary obligation
to obtain the highest possible price for creditors and shareholders. 203 B.R. at
551. The failure to retain an investment banker and the no shop clause were
ruled “astounding” and “incomprehensible,” respectively. 203 B.R. at 551, 552.
The court ruled the business judgment test should not be applied to test
the letter agreement because it only applies when the directors are disinterested,
which the debtor’s directors were not. See Official Committee v. Integrated
Resources, Inc. (In re Integrated Resources, Inc.), 147 B.R. 650 (S.D.N.Y. 1992),
appeal dismissed, 3 F.3d 49 (2d Cir. 1993).
iii. Should the Committee Have Broken Its Word?
When the debtor argued that although management was not
disinterested, the committee participation saves the day, the court ruled:
“I understand how it is that the committee agreed to this proposal; it
agreed because the proposal satisfied the arrangement earlier
negotiated between the committee and the institutional note
holders. However, once it became apparent that the debtors were
amenable to a sale of the businesses, the committee should have
explored whether its constituency might fare better than they would
pursuant to the agreement with the note holders...”
203 B.R. at 553.
A. Facts.
28. National Gypsum Revisited: New National
Gypsum Company v. National Gypsum Company
Settlement Trust (In re National Gypsum
Company), 219 F.3d 478 (5 th Cir. 2000)(2 to 1)
In 1993, the bankruptcy court confirmed a chapter 11 plan for National
Gypsum Company. Pursuant to the plan, a new Delaware corporation, New
National Gypsum (“New NGC”), was formed to purchase the debtor’s operating
assets. The bankruptcy court found it was worth $350 million. The value of that
company was given to bond and trade creditors of the debtor owed
approximately $1.1 billion, thereby providing them less than 35 cents on the
dollar on average.
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The old company was left with an engineering firm worth approximately
$125 million, asbestos insurance worth between $300 million and $600 million,
and $10 million cash. That company and a trust created to hold some of its
assets were dedicated to the debtors’ then and future asbestos claims. Based
on the facts as then existed, it appeared likely, though not a certainty, that all
asbestos claims would be paid in full. As a backup in the event the Georgine
nationwide class action asbestos settlement were not approved (as it ultimately
was not, Amchem Products, Inc. v. Windsor, 521 U.S. 591 (1997)), the chapter
11 plan provided for an alternate claims facility to be used to pay each present
and future asbestos claimant an equivalent percent of its claim.
The plan proponents had included a permanent injunction in the chapter
11 plan, barring the assertion of asbestos claims against New NGC. The
bankruptcy court, at the urging of the legal representative for unknown claimants,
refused to confirm the plan with the permanent injunction, reasoning it did not
have jurisdiction to enjoin persons who did not yet hold claims. The court did
allow the plan to include a ‘channeling order’ under which asbestos claims would
have to be asserted against the trust until it is exhausted before any claimant
could attempt to assert them against New NGC. All then existing asbestos
claims were discharged. The bankruptcy court noted New NGC could defend
against the assertion of any future asbestos claims under non-bankruptcy law by
claiming it was not a successor to the debtor’s liability.
As confirmed, the plan provided that New NGC would not assume
asbestos liabilities of the debtor which shall be the sole responsibility of the trust.
Additionally, the bankruptcy court approved the agreement under which New
NGC purchased the debtor’s operating assets. That agreement provided New
NGC would not assume any asbestos liability including unknown claims. Then,
the plan was consummated and New NGC issued its securities which were
traded in the public markets.
In May 1996, the Georgine settlement was overturned. The trust created
under the plan returned to the bankruptcy court and requested a determination
that New NGC has liability for the future/unknown asbestos liability by reason of
the bankruptcy court’s having denied the permanent injunction. The bankruptcy
court ruled:
“[T]he plan as confirmed by order of this court implicitly
imposes or maintains liability on New NGC for asbestos
disease non-Bankruptcy Code claims not discharged by the
confirmation order and not satisfied by the Trust….By
implicitly addressing this asbestos liability, rather [than]
explicitly doing so, and by deferring the matter as
provided in the plan, the court enabled New NGC to
emerge in the marketplace post-confirmation as an
effective entity, poised, under the right market conditions
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to prosper, and thereby benefit all the constituencies.”
(Emphasis supplied).
The bankruptcy court admitted there are no express statements
in the plan or confirmation order that affirm New NGC’s liability for
unknown claims. In fact, the bankruptcy court opined at a February
1993 hearing: “…in the event that there’s anything to fight about, in the
event that some claims in the future…they can proceed with their rights,
and new NGC can defend and say we’re not a successor.”
The channeling portion of the confirmation order provided
nothing therein “shall preclude an Unknown Asbestos Disease
Claimant form pursuing his rights, if any, under applicable nonbankruptcy
law against any Person who may be liable to such Unknown
Claimant after exhausting the remedy or remedies provided by the
[Trust].” (Emphasis supplied).
The confirmation order also provided that New NGC was
purchasing assets “free and clear of all Liens, Claims, Interests and
other liabilities, obligations, charges or encumbrances thereon or there
against…to the maximum extent permitted by the Bankruptcy Code.”
The bankruptcy court did bar unknown claimants from asserting
punitive damage claims against New NGC.
B. Holdings
“Then, when subsequently it became apparent that the Trust would be
insufficient to fund Unknown Claims, the bankruptcy court unreasonably altered
the meaning of the Plan documents to hold that future asbestos claimants could
go after New-NGC. While this impulse may have been noble, and perhaps even
socially desirable, the bankruptcy court cannot now ignore the plain meaning of
the documents that created New-NGC as a separate operating company with no
liability as a reorganized debtor.” 219 F.3d at 492.
Once the bankruptcy court determined the unknown claims were not
claims within the meaning of 11 U.S.C. 101(5), it no longer retained jurisdiction
to limit punitive damages awards in favor of those claimants.
C. Lessons Learned
Imagine being the attorney for an underwriter of an initial public offering
and knowing the company has a potential mass tort liability, but intentionally not
disclosing it so the company ‘can emerge in the market place and prosper. ‘
That’s hard to imagine. Now, imagine a federal judge helps you do it. Next,
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imagine the victim must go unvindicated in the district court and is finally
vindicated in the circuit court of appeals by a two to one margin.
The only legal principle embodied in this decision is the principle that
express terms in the documents can not be overridden by “implicit” rulings
nowhere to be found.
This decision is here to show that confidence in our bankruptcy court
system can be easily shaken by decisions carrying out a yearning by a court to
do a certain type of unpredictable equity at the expense of third parties
purposefully kept ignorant of the risks they were incurring.
29. Avoidance Actions Are Property of Neither the Debtor, Nor the Debtor in
Possession, Nor the Estate; But How About Their Proceeds?
A. Official Committee of Unsecured Creditors v. Chinery (In re
Cybergenics Corp.), 226 F.3d 237 (3d Cir. 2000).
i. Facts.
At the outset of its chapter 11 case, the chapter 11 debtor in possession
sold “all of the rights, title, and interest of Cybergenics in and to all of the assets
and business as a going concern of Cybergenics,” according to its sale
agreement. 226 F.3d at 239. The bankruptcy court order authorizing and
directing the sale provided “it is acknowledged that all of the assets of the Debtor
[defined to include Cybergenics as debtor and debtor in possession] are being
conveyed to the Purchaser."” 226 F.3d at 241.
Subsequently, the statutory creditors’ committee was authorized to bring a
fraudulent transfer action against entities that had sold Cybegenics in a
leveraged buyout more than a year before the chapter 11 case commenced.
Those entities moved to dismiss the complaint on the ground the fraudulent
transfer action had been sold to the purchaser. The U.S. District Court granted
the motion. 226 F.3d at 240. The fraudulent transfer claim was not listed as an
asset on the debtor’s schedules and the purchaser of the assets did not appear
and did not take the position that it had purchased the claim. 226 F.3d at 245-
246.
ii. Holding
The United States Court of Appeals for the Third Circuit reversed. It
reasoned that the fraudulent transfer claims being brought under Bankruptcy
Code section 544(b) were initially creditors’ claims. 226 F.3d at 245. Although
the debtor in possession is empowered to pursue those claims for the benefit of
all creditors, “[t]he avoidance power itself, which we have analogized to the
power of a public official to carry out various responsibilities in a representative
capacity, was likewise not an asset of Cybergenics, just as this authority would
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not have been a personal asset of the trustee, had one been appointed.” 226
F.3d at 245. “Issues relating to property of the estate are simply not relevant to
the inquiry into whether the fraudulent transfer claims in the Committee’s
complaint were assets of Cybergenics as debtor or debtor in possession.” 226
F.3d at 246.
In a footnote, the appellate court explained that even if an analysis of
property of the estate were necessary, its analysis would not change because
“[s]ubject to a few specifically enumerated exceptions, the bankruptcy estate
contains only the interests of the debtor in property as of the time of the
bankruptcy filing, ‘no more, no less.’ In re Jones, 768 F.2d 923, 927 (7 th Cir.
1985) (citation omitted). As we already have explained, the fraudulent transfer
action belonged ot Cybergenics’ creditors as of the time of the bankruptcy filing.
It bears emphasis that we focus here on the cause of action to avoid the transfer,
not on any sort of ‘equitable interest’ that some courts have said may be retained
by a debtro in fraudulently-transferred property….” 226 F.3d at 247n.16.
iii. What About Bankruptcy Code Section 541(a)(3)?
Notably, the Bankruptcy Code does not render avoidance actions property
of the estate. But, pursuant to Bankruptcy Code section 541(a)(3), the estate
includes “[a]ny interest in property that the trustee recovers under section 329(b),
363(n), 543, 550, 553, or 723 of this title.” In turn section 550(a) provides for
recoveries of transfers avoided pursuant to section 544. Therefore, the
recoveries from the fraudulent transfer action were property of the estate.
Based on the facts, property of the estate was not sold. Therefore, the
court appears to have correctly determined that the purchasers did not purchase
the recoveries from the action. Additionally, the failure of the purchaser to lay
claim to the fraudulent transfer action or its proceeds suggests strongly it did not
intent to buy the action.
The court’s footnote 16, however, appears erroneous to the extent it
implies property of the estate would not include recoveries from the fraudulent
transfer action.
B. Avoidance Actions Can Only Be Brought to Benefit Creditors
To buttress its argument that the avoidance power is a power a debtor in
possession or trustee can use for creditors, but not an asset of the debtor in
possession, Cybergenics points to several interesting decisions barring
avoidance actions whose results will help the equity owner but not creditors. 226
F.3d at 244.
In Wellman v. Wellman, 933 F.2d 215 (4 th Cir. 1991), the chapter 11 plan
paid all administrative and general unsecured creditors in full. The secured
creditors were paid in cash, collateral, and a $600,000 interest in the avoidance
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action that the reorganized debtor was allowed to prosecute or not in his
discretion. 933 F.2d at 2116-217. After all those payments, the estate had a
cash surplus of $2,524,769 for the debtor. 933 F.2d at 219.
The appellate court ruled the reorganized debtor could not prosecute the
fraudulent transfer action which was against his brother for having paid him too
little for his stock in a family business years earlier. The surplus cash and the
reorganized debtor’s absolute right not to prosecute the action convinced the
court the action was unnecessary to get creditors paid. Id.
In Whiteford Plastics Co. v. Chase National Bank, 179 F.2d 582 (2d Cir.
1950) (Chapter XI case), the debtor proposed a chapter XI plan providing for
10% payments to unsecured creditors. Before the plan was confirmed, the debtor
brought an action to avoid liens against two steam generators on the ground the
creditor, due to inadvertence, failed to perfect the liens by recordation. The court
held the debtor never offered to contribute the lien value to the unsecured
creditors and can not obtain it for its own benefit. 179 F.2d 584.
Query: What if the lien had been avoided prior to any plan proposal and
the creditors had agreed the debtor’s shareholder could retain value in excess of
the value of the avoided liens? Should the avoidance be undone? What is the
test?
In Vintero Corp. v. Corporacion Venezolana de Fomento (In re Vintero
Corp.), 735 F.2d 740 (2d Cir. 1984), the debtor had contracted to sell two ships
for $17 million and granted the guarantor of the sales price a nonrecourse lien
against the ships. When the ships were moved, the guarantor failed to refile its
security interest and it became unperfected. The chapter XI debtor in possession
took the position that its adversary proceeding to avoid the lien together with the
nonrecourse nature of the claim would prevent the guarantor from making any
claim whatever against the estate. 735 F.2d at 741.
The appellate court reasoned the perfection requirements are for the
benefit of third parties, not the debtor. Accordingly, it held the lien could be
avoided, but the nonrecourse creditor could share in the proceeds of the ships on
a pro rata basis with all unsecured creditors. 735. F.2d at 743.
30. Releases of Non-Debtors
A. The General Rule.
For constitutional reasons, the bankruptcy court generally and often can
not discharge nondebtors. First, exercise of the bankruptcy power to discharge
debt can not be constitutionally accomplished absent a contemporaneous fair
allocation of the debtor's assets to the debtor’s creditors. Kuehner v. Irving Trust
Co., 299 U.S. 445, 450, 452, 455 (1937). Second, Bankruptcy Code section
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524(e) provides the debtor's discharge does not discharge nondebtors, as
follows:
“Except as provided in subsection (a)(3) of this section, discharge
of a debt of the debtor does not affect the liability of any other entity
on, or the property of any other entity for, such debt.” 223
See, e.g., American Hardwood, Inc. v. Deutsche Credit Corp. (In re American
Hardwoods Inc.), 885 F.2d 621, 626 (9th Cir. 1989); Landsing Diversified
Properties-II v. First Natl Bank & Trust Co. (In re Western Real Estate Fund,
Inc.), 922 F.2d 592 (10th Cir. 1990), modified on other grounds, 932 F.2d 898
(10th Cir. 1991); Underhill v. Royal, 769 F.2d 1426 (9th Cir. 1985); Consolidated
Motor Inns v. BVA Credit Corp. (In re Consolidated Motor Inns), 666 F.2d 189
(5th Cir. 1982) Union Carbide Corp. v. Newboles, 686 F.2d 593 (7th Cir. 1982).
As shown below, the circuit courts differ as to whether and under what
circumstances the bankruptcy court can discharge or release nondebtors. One
simple cause of the dispute is that some courts start the analysis by asking the
constitutional question, while other courts skip that step and start by looking at
the statutory jurisdictional grant to the bankruptcy court. Because 11 U.S.C. §
1334(b) broadly grants the bankruptcy court power over all civil proceedings
"related to cases under title 11," it is clear the court has the raw statutory power
to grant discharges to nondebtors.
The courts that start their analysis with section 1334(b) next wrestle with
the unfairness of a nondebtor obtaining a discharge or a release from certain
liability without subjecting its assets to the provisions of title 11. 11 U.S.C. §
105(a) empowers the court to “issue any order…necessary or appropriate to
carry out the provisions of” title 11. Given that title 11 prescribes an elaborate
set of requirements before any entity can receive a discharge, the question
becomes whether granting a nondebtor a discharge of one or more debts without
satisfying all title 11 requirements is consonant with section 105(a). Courts
granting such discharges or releases attempt to limit the unfairness by restricting
such discharges to situations where they are necessary for the reorganization
and are unlikely to harm creditors materially.
223 Bankruptcy Code section 547(d) purports to discharge a surety to the extent
the surety bonded an obligation and received collateral security for its
reimbursement right and the lien would have been avoidable.
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Bankruptcy Rule 3016(c) 224 requires the plan and disclosure statement, if
the plan enjoins conduct not otherwise enjoined by the Bankruptcy Code, to
disclose in bold, italic, or underlined text "all acts to be enjoined and identify the
entities that would be subject to the injunction." Normally, releases are
accompanied by injunctions against suing to enforce the released claims.
Bankruptcy Code section 524(a)(2) automatically imposes an injunction against
enforcing claims against the debtor or estate that are discharged pursuant to
section 1141(d)(1)(A).
B. Res Judicata.
Notwithstanding the illegalities of discharging nondebtors, when it does
occur on notice to an affected creditor and is not reversed, the discharge is
binding due to res judicata and may not be collaterally attacked except perhaps
in extraordinary circumstances. Travelers Indemnity Co. v. Bailey, 129 S. Ct.
2195 (2009); Stoll v. Gottlieb, 305 U.S. 165 (1938); Levy v. Cohen, 19 Cal. 3d
165 (Sup. Ct. 1977).
The foregoing creates an ethical dilemma for bankruptcy attorneys. In
carrying out the attorney’s duty to provide zealous representation, should the
attorney propose in a chapter 11 plan that nondebtors be discharged in
circumstances not warranting a discharge because the impacted creditor may
consent or fail to object, or should the attorney not propose such illegal relief? In
United Student Aid Funds, Inc., v. Espinosa, 130 S. Ct. 1367, 1382 (2010), the
Supreme Court ruled a creditor that failed to object to a chapter 13 plan that
wrongfully discharged a student loan without the debtor having complied with the
requirement that he commence an adversary proceeding and procure a judgment
establishing undue hardship, could not obtain an alteration of the discharge order
under Fed. R. Civ. P. 60(b)(4), but that sanctions against the attorney may be
available:
“We acknowledge the potential for bad-faith litigation tactics.
But expanding the availability of relief under Rule 60(b)(4) is not an
appropriate prophylaxis. As we stated in Taylor v. Freeland &
Kronz, 503 U.S. 638, 112 S. Ct. 1644, 118 L. Ed. 2d 280 (1992),
‘[d]ebtors and their attorneys face penalties under various
provisions for engaging in improper conduct in bankruptcy
proceedings,’ id., at 644, 112 S. Ct. 1644, 118 L. Ed. 2d 280; see
224 Bankruptcy Rule 3016(c) provides:
Injunction under a Plan. If a plan provides for an injunction against
conduct not otherwise enjoined under the Code, the plan and
disclosure statement shall describe in specific and conspicuous
language (bold, italic, or underlined text) all acts to be enjoined and
identify the entities that would be subject to the injunction.
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Fed. Rule Bkrtcy. Proc. 9011. The specter of such penalties should
deter bad-faith attempts to discharge student loan debt without the
undue hardship finding Congress required. And to the extent
existing sanctions prove inadequate to this task, Congress may
enact additional provisions to address the difficulties United
predicts will follow our decision.”
Significantly, notice of the discharge must pass constitutional muster and
the rules. In Century Indemnity Co. v. National Gypsum Company Settlement
Trust (In re National Gypsum Company), 208 F.3d 498 (5 th Cir. 2000), cert.
denied, 121 S.Ct. 172 (2000), the reorganized debtor asserted it discharged the
cure amount claim of the nondebtor party to one of its executory contracts by
providing in its chapter 11 plan that the contract to be assumed had a cure
amount of zero. The evidence on summary judgment did not show the
nondebtor party had notice other than a general notice of the pendency of the
chapter 11 case.
On appeal, the Fifth Circuit affirmed the district court’s affirmance of the
bankruptcy court and held Ҥ 1141(d) cannot be read to provide for discharge of
amounts in default under assumed contracts in a manner that would nullify the
cure requirement of section 365(b)(1).” 208 F.3d at 509.
But, the bankruptcy court had also held the nondebtor party was bound to
the zero cure amount based on res judicata. The district court reversed and the
Fifth Circuit affirmed the reversal. Notably, the appellate courts did not require
that the nondebtor party receive a standalone motion to assume listing the cure
amount as zero. Rather, the Fifth Circuit held “the debtor must demonstrate
delivery of the proposed plan of reorganization or some other court-ordered
notice that set forth National Gypsum’s intent to assume the Wellington
Agreement with a $0 cure amount.” 208 F.3d at 513. The court approved other
decisions holding the “motion to assume was ‘made’ when the non-debtor party
to the lease was served notice of the plan’s filing.” 208 F.3d at 513 (citing Riddle
v. Aneiro (In re Aneiro), 72 B.R. 424, 428 (Bankr. S.D. Cal. 1987); In re Hall, 202
B.R. 929, 932-933 (Bankr. W.D. Tenn. 1996).
C. In re Ingersoll, Inc., 562 F.3d 856 (7 th Cir. 2009)
i. Facts
Ingersoll Cutting Tool Company ("ICTC"), and its parent company,
Ingersoll International, Inc. ("Ingersoll") had been controlled by the Gaylords.
When the Gaylords learned that the outside ceo and directors were trying to
cause ICTC to be sold, the Gaylords retained a law firm to stop the sale, 562
F.3d at 859, which firm explained it would need help from an attorney at another
firm. 562 F3d at 859. The parties negotiated fee arrangements that led to
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multiple disputes down the road. Ultimately, ICTC was sold and Ingersoll ended
up in chapter 11.
Ultimately, Ingersoll's liquidation plan was confirmed and contained a
release of the Gaylords, providing the Gaylords:
"shall be released from any and all claims and causes of action by
all creditors, parties-in-interest, directors, officers, shareholders,
agents, affiliates, parent entities, successors, assigns,
predecessors, members, partners, managers, employees, insiders,
agents and representatives of the Debtors and their estates arising
from or relating to the Gaylord Actions, including, without limitation,
any claims causes of action, and counterclaims by any present or
former party to any of the Gaylord Actions."
562 F.3d at 862. One of the Gaylords' attorneys was served with a copy
of the confirmed chapter 11 plan, but nevertheless sued the Gaylords in state
court contending the Gaylords were breaching their arbitration agreement by
suing the attorney in state court. 562 F.3d at 862. The Gaylords requested the
bankruptcy court to enjoin the attorney from suing them and to hold the attorney
in contempt. The bankruptcy court held the attorney's suit was within the release
language in the chapter 11 plan and enjoined him from pursuing his claim, and
also held the plan's release of the (nondebtor) Gaylords from claims of the
(noncreditor) attorney was valid because it was central to the negotiation and
ultimate success of the plan. 562 F.3d at 862-863.
The district court remanded the attorney's appeal for the bankruptcy court
to determine if the attorney was a creditor of the debtor. 562 F.3d at 863. On
remand, the bankruptcy court ruled the attorney was not a creditor, but that the
release was needed to ensure the success of the bankruptcy plan and he did not
change his ruling that the release was proper. Then, the district court affirmed.
562 F.3d at 863.
ii. Issues
1. Was the release "by its terms broad enough to cover [the
attorney's] claim?
2. Was the release legally valid even though it released a nondebtor
from claims of entities who were not creditors of the debtor?
iii. Holdings
1. Yes. 562 F.3d at 864.
2. Yes. 562 F.3d at 863.
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3. "Yet, it is important to note in all this what we are not saying. We
are not saying that a bankruptcy plan purporting to release a claim
like Miller's is always – or even normally – valid. In the unique
circumstances of this case, however, we believe it is. We go no
further than to apply the rule we adopted in Airadigm to the facts at
hand. In most instances, releases like the one here will not pass
muster under that rule. Bankruptcy litigants should keep that in
mind when they sit down at the negotiating table." 562 F.3d at 865.
iv. Rationale
Section 105 of title 11 "authorizes a bankruptcy court to 'issue any order,
process, or judgment that is necessary or appropriate to carry out the provisions
of [the bankruptcy code]." 562 F.3d at 864. "This 'residual authority' is consistent
with a bankruptcy court's 'traditionally broad' equitable powers, In re Airadigm
Comm., Inc., 519 F.3d 640, 657 (7 th Cir. 2008)…" 562 F.3d at 864. The
equitable powers "also make an appearance within the context of reorganization
plans. Similar to § 105, 11 U.S.C. § 1123(b)(6) allows a court ot include in a plan
'any other appropriate provision not inconsistent with the applicable provisions of
[the bankruptcy code].'" 562 F.3d at 864.
"[T]he release does not provide blanket immunity. As in Airadigm – and in
contrast to Metromedia – it is narrowly tailored and critical to the plan as a whole.
The release only covers claims arising from or relating to two cases (the Gaylord
Actions), so it is far from a full-fledged 'bankruptcy discharge arranged without a
filing and without the safeguards of the Code.'…Just as importantly, the
bankruptcy court found that the release was an 'essential component' of the plan,
the fruit of 'long-term negotiations' and achieved by the exchange of 'good and
valuable consideration' by the Gaylords that 'will enable unsecured creditors to
realize distribution in this case.'" 562 F.3d at 865.
"When the plan was confirmed (following an objection period), the debtors
served copies of the plan on creditors and parties in interest. Miller received a
copy as a party-in-interest." 562 F.3d at 862.
v. Analysis
The appellate decision analyses the issue from the viewpoint of whether
the release of a nondebtor is authorized by sections 105 and 1123. The decision
skips right to the statute, and nowhere asks whether the bankruptcy power
granted in article I of the U.S. Constitution grants authority to Congress to pass
laws discharging nondebtors from any claims. While the court does observe that
the release of the Gaylords was not a blanket release, thereby not creating a
discharge without the Gaylords abiding by all the other provisions of title 11, the
court does not determine whether the power granted to Congress to discharge
debtors, can be applied to nondebtors. Indeed, in Kuehner v. Irving Trust Co.,
299 U.S. 445, 450, 452, 455 (1937), the Supreme Court ruled exercise of the
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ankruptcy power to discharge debt can not be constitutionally accomplished
absent a contemporaneous fair allocation of the debtor's assets to the debtor’s
creditors. Accord ACC Bondholder Group v. Adelphia Communications Corp. (In
re Adelphia Communications Corp.), 361 B.R. 337, 358n. 98 (S.D.N.Y. 2007)(" In
order for the implementation of the Bankruptcy law to be constitutional, it must
provide for a fair distribution of assets to a debtor's creditors. See Kuehner v.
Irving Trust Co., 299 U.S. 445, 451, 57 S. Ct. 298, 81 L. Ed. 340 (1937).).
Finally, the attorney who lost his claim against the nondebtors, received a
copy of the confirmed plan, but the facts do not show he received a copy in time
to object to confirmation. Conversely, the decision does not discuss that issue,
so the attorney presumably did not raise it on appeal. Perhaps the attorney did
not raise it because he was able to argue his objection to the bankruptcy court
when the issue arose after confirmation.
D. Airadigm Communications, Inc. v. Federal Communications Commission
(In re Airadigm Communications, Inc.), 519 F.3d 640 (7 th Cir. 2008)
i. Facts
During Airadigm's first chapter 11 case commenced in 1999, the FCC
cancelled Airadigm's personal communications services licenses which Airadigm
had purchased at a 1996 auction for cash and debt. Airadigm owed the FCC
$64.2 million when it commenced its chapter 11 case. That case resulted in a
confirmed chapter 11 plan that assumed the FCC had properly cancelled the
licenses. The chapter 11 plan was financed by Telephone and Data Systems
("TDS"), which would pay the FCC different amounts on its proof of claim
depending on whether the FCC would reinstate the licenses during two years
after confirmation.
Then, in 2003, the United States Supreme Court decided FCC v.
NextWave Personal Communications, Inc., 537 U.S. 292 (2003), where it
overturned the FCC's license cancellation in similar circumstances to Airadigm
and the FCC acknowledged its cancellation of the Airadigm licenses was
ineffective. Airadigm then commenced a second chapter 11 case in 2006 and
commenced an adversary proceeding against the FCC requesting a divesting of
the FCC of any further interest in the licenses. The bankruptcy court granted the
FCC summary judgment rejecting Airadigm's claims.
Later in 2006, the bankruptcy court confirmed Airadigm's chapter 11 plan.
Based on the licenses then being worth $33 million, the plan treated the FCC as
having a $33 million secured claim and a deficiency claim for the balance of the
$64.2 million. The FCC could take an immediate payout of $33 million and lose
its liens in the licenses, or it could make the section 1111(b)(2) election. If it
made the election, the debtor would purchase and hold $33 million of
government-backed or low risk securities having different maturities, such that
over time (no more than 30 years) the principal and interest from the securities
would pay the FCC $64.2 million. If the reorganized debtor were to sell the
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licenses, the FCC would receive the sale proceeds, and if less than $64.2 million,
would retain its lien against the licenses.
The FCC objected to its treatment. First, it objected that its lien was not
being preserved because its regulations provided that on a sale, the entire
balance becomes due. Second, the FCC objected to the plan's release of its
third party financer from "any act or omission arising out of or in connection with
the…confirmation of this Plan…except for willful misconduct." The bankruptcy
court determined that without the financer the debtor would have to finance $188
million and the financer would not go forward without the release.
ii. Issues
1. Airadigm asserts its first chapter 11 plan extinguished the FCC's
liens.
2. Airadigm also asserts the FCC's interests in the licenses were
avoidable by its strongarm powers.
3. The FCC challenged the interest rate being paid on its claim if it
made the section 1111(b)(2) election.
4. The FCC contended its liens were not being preserved due to the
absence of a 'due-on sale' sale clause in the plan.
iii. Holdings
1. Airadigm's first chapter 11 plan did not extinguish the FCC's liens.
2. Airadigm's strongarm powers can not avoid the FCC's liens.
3. The FCC waived its interest rate argument by not raising it in the
bankruptcy court.
4. The FCC's liens were preserved because the due-on sale clause is
not part of the lien.
“In light of these provisions, we hold that this 'residual authority' permits
the bankruptcy court to release third parties from liability to participating creditors
if the release is 'appropriate' and not inconsistent with any provision of the
bankruptcy code."
iv. Rationale
Bankruptcy Code section 1141(c) provides that "after confirmation of a
plan, the property dealt with by the plan is free and clear of all claims and
interests of creditors…" But for the plan to 'deal[ ] with' property for purposes of §
1141(c), the plan itself must give some indication that it has compensated the
creditor for or otherwise impliedly affected its interest…." Here, the plan
assumed the licenses were cancelled and did not deal with them.
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Bankruptcy Code section 544(a)(1) provides Airadigm the "rights and
powers of … a creditor that extends credit to the debtor at the time of the
commencement of the case, and that obtains, at such time and with respect to
such credit, a judicial lien" against the property. If a hypothetical creditor could
have obtained an interest superior to the FCC's at the time of Airadigm's filing,
the FCC would be an unsecured claimholder.
Here, "the property itself – the license – is a creature of federal law.
Accordingly, federal law also defines the FCC's retained interest in that
license….And as defined by federal law, the FCC does not have to perfect its
interest in a spectrum license because federal law prevents another creditor from
holding a superior interest. *** These statutory and regulatory provisions indicate
that federal law precludes a private party from obtaining a superior interest to the
FCC. *** But if the forced sale of the PCS licenses were to occur with the FCC as
merely an unperfected secured creditor, the sale would conflict with the statutes
and regulations covering the FCC's licensing scheme. This conflict gives rise to
a negative inference – controlling in this case – that federal law does not allow
private creditors to obtain an interest in PCS licenses superior to the FCC's…."
"The due-on-sale provisions contained in the FCC's regulations do not
constitute part of its lien that the bankruptcy court had to 'retain' in order to
approve the plan pursuant to § 1129. The bankruptcy code [sic] defines a 'lien'
as a 'charge against or interest in property to secure payment of a debt or
performance of an obligation.' 11 U.S.C. § 101(37). The due-on-sale provision
contained in the federal regulation is not a 'charge against or interest in property'
but is instead a regulation regarding the terms of payment for the debt…."
Section 524(e) is a savings clause and provides the "discharge of a debt
of the debtor does not affect the liability of another entity on, or the property of
any other entity for, such debt." If section 524(e) were meant to limit the
bankruptcy court's power to release a nondebtor it would have said the discharge
of a debtor shall not affect the liability of another entity. In contrast, section 34 of
the Bankruptcy Act of 1898, as amended, provided: "'[t]he liability of a person
who is a co-debtor with, or guarantor or in any manner a surety for, a bankrupt
shall not be altered by the discharge of such bankrupt." Thus, Union Carbide
Corp. v. Newboles, 686 F.2d 593 (7 th Cir. 1982)(all nondebtor releases were
prohibited under the prior version of the Bankruptcy Code), "is no longer
controlling on this point of view."
"…Section 1123(b)(6) permits a court to 'include any other provision not
inconsistent with the applicable provisions of this title.'…In light of these
provisions, we hold that this 'residual authority' permits the bankruptcy court to
release third parties from liability to participating creditors if the release is
'appropriate' and not inconsistent with any provision of the bankruptcy code."
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v. Analysis
Both section 524(e) and its predecessor, section 34, solely provide that
the debtor's discharge does not discharge liability of a third party. The distinction
the court makes between section 34 which uses the word "shall" and section
524(e) which does not, is a distinction without a difference because neither
section talks to the court's power to release third parties. Accordingly, by
bypassing the constitutional issue and by overlooking the big picture, namely that
the Bankruptcy Code has an elaborate set of requirements preceding the release
of liability which is not satisfied by the nondebtor, the court manages to conclude
the court is empowered to and can validly release a nondebtor.
As a practical matter, however, there is nothing in the facts indicating the
FCC or any creditor had any claim against the financer. The bankruptcy court
clearly could have ordered that any claims against the financer arising out of the
chapter 11 case be filed in its court by a date certain. Thus, the equivalence of
the release could likely have been achieved.
E. Travelers Indemnity Co. v. Bailey, 129 S. Ct. 2195 (2009)
i. Facts
As what was called the "cornerstone" of the reorganization, and as part of
Johns-Manville Corp.'s ("Manville") settlement with its insurers for $770 million,
Travelers, as Manville's primary insurer, paid nearly $80 million. 129 S. Ct. at
2199. "There would have been no such payment without the injunction"
providing "'all Persons are permanently restrained and enjoined from
commencing and/or continuing any suit, arbitration or other proceeding of any
type or nature for Policy Claims against any or all members of the Settling Insurer
Group.'" 129 S. Ct. at 2199. "'Policy Claims'" were defined as "'any and all
claims, demands, allegations, duties, liabilities and obligations (whether or not
presently known) which have been, or could have been, or might be asserted by
any Person against …any or all members of the Settling Insurer Group based
upon, arising our of or relating to any or all of the Policies.'" Id.
Various plaintiff groups subsequently filed direct action lawsuits against
Travelers and other insurers on a variety of legal theories falling into two broad
categories: violation of state consumer-protection statutes by conspiring with
other insurers and asbestos manufacturers to hide dangers of asbestos and to
raise a fraudulent 'state of the art' defense to personal injury claims; and violation
of common law duties by failing to warn the public about the dangers of asbestos
or by acting to keep its knowledge of those dangers from the public. 129 S. Ct.
at 2200.
Travelers requested the bankruptcy court to enjoin the lawsuits. 129 S.
Ct. at 2200. After a mediation, 3 classes of plaintiffs settled with Travelers
paying over $400 million. Id. The settlements were conditioned on entry of a
291

ankruptcy court order clarifying that the direct action lawsuits are and have
always been prohibited by the 1986 confirmation order and related orders. Id.
The bankruptcy court issued the order after finding that Travelers learned
virtually everything it knew about asbestos from its relationship with Manville and
that "'[t]he gravamen of [the] Direct Action Claims were acts or omissions by
Travelers arising from or relating to Travelers['] insurance relationship with
Manville.'" 129 S. Ct. at 2201. The bankruptcy court also reasoned that the
Second Circuit's earlier decision, MacArthur Co. v. Johns-Manville Corp., 837
F.2d 89, 93-94 (2d Cir. 1988), was controlling. 129 S. Ct. at 2202. That decision
rejected a claim that the provisions of the confirmation order and settlement order
exceeded the bankruptcy court's jurisdiction.
ii. Issues
1. After the bankruptcy court confirmed Manville's chapter 11 plan and
enjoined certain lawsuits against Manville's insurers including Travelers, does the
injunction bar "state-law actions against Travelers based on allegations either of
its own wrongdoing while acting as Manville's insurer or of its misuse of
information obtained from Manville as its insurer? 129 S. Ct. at 2198.
2. "…[W]hether the Bankruptcy Court had subject-matter jurisdiction
to enter the Clarifying Order." 129 S. Ct at 2205.
iii. Holdings
1. "We hold that the terms of the injunction bar the actions and that
the finality of the Bankruptcy Court's orders following the conclusion of direct
review generally stands in the way of challenging the enforceability of the
injunction." 129 S. Ct at 2198.
2. "…The answer is easy: as the Second Circuit recognized, and
respondents do not dispute, the Bankruptcy Court plainly had jurisdiction to
interpret and enforce its own prior orders. See Local Loan co. v. Hunt, 292 U.S.
234, 239, 54 S. Ct. 695, 78 L. Ed. 1230 (1934)…" 129 S. Ct. at 2205.
"Our holding is narrow. We do not resolve whether a bankruptcy court, in
1986 or today, could properly enjoin claims against nondebtor insurers that are
not derivative of the debtor's wrongdoing. As the Court of Appeals noted, in 1994
Congress explicitly authorized bankruptcy courts, in some circumstances, to
enjoin actions against a nondebtor 'alleged to be directly or indirectly liable for the
conduct of, claims against, or demands on the debtor to the extent such alleged
liability . . . arises by reason of . . . the third party's provision of insurance to the
debtor or a related party,' and to channel those claims to a trust for payments to
asbestos claimants. 11 U.S.C. § 524 (g)(4)(A)(ii). On direct review today, a
channeling injunction of the sort issued by the Bankruptcy Court in 1986 would
have to be measured against the requirements of § 524 (to begin with, at least).
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But owing to the posture of this litigation, we do not address the scope of an
injunction authorized by that section. 8
8 Section 524(h) provides that under some circumstances § 524(g)
operates retroactively to validate an injunction. We need not decide
whether those circumstances are present here.
Nor do we decide whether any particular respondent is bound by the 1986
Orders. We have assumed that respondents are bound, but the Court of Appeals
did not consider this question. Chubb, in fact, relying on Amchem Products, Inc.
v. Windsor, 521 U.S. 591, 117 S. Ct. 2231, 138 L. Ed. 2d 689 (1997), and Ortiz v.
Fibreboard Corp., 527 U.S. 815, 119 S. Ct. 2295, 144 L. Ed. 2d 715 (1999), has
maintained that it was not given constitutionally sufficient notice of the 1986
Orders, so that due process absolves it from following them, whatever their
scope. See 340 B. R., at 68. The District Court rejected this argument, id., at 68-
69, but the Court of Appeals did not reach it, 517 F.3d at 60, n. 17. On remand,
the Court of Appeals can take up this objection and any others that respondents
have preserved." 129 S. Ct. at 2207.
iv. Rationale
"Respondents seek further refuge in evidence that before entry of the
1986 Orders some parties to the Manville bankruptcy (including Travelers)
understood the proposed injunction to bar only claims derivative of Manville's
liability. They may well be right about that: we are in no position to engage in
factfinding on this point, but there certainly are statements in the record that
seem to support respondents' contention. See App. for Respondent Chubb 1a-
3a, 5a, 13a-14a. But be that as it may, where the plain terms of a court order
unambiguously apply, as they do here, they are entitled to their effect. See, e.g.,
Negron-Almeda v. Santiago, 528 F.3d 15, 23 (CA1 2008) ('[A] court must carry
out and enforce an order that is clear and unambiguous on its face'); United
States v. Spallone, 399 F.3d 415, 421 (CA2 2005) ('[I]f a judgment is clear and
unambiguous, a court must adopt, and give effect to, the plain meaning of the
judgment' (internal quotation marks omitted)). If it is black-letter law that the
terms of an unambiguous private contract must be enforced irrespective of the
parties' subjective intent, see 11 R. Lord, Williston on Contracts § 30:4 (4th ed.
1999), it is all the clearer that a court should enforce a court order, a public
governmental act, according to its unambiguous terms. This is all the Bankruptcy
Court did." 129 S. Ct. at 2204.
"Those orders are not any the less preclusive because the attack is on the
Bankruptcy Court's conformity with its subject-matter jurisdiction, for '[e]ven
subject-matter jurisdiction . . . may not be attacked collaterally.' Kontrick v. Ryan,
540 U.S. 443, 455, n. 9, 124 S. Ct. 906, 157 L. Ed. 2d 867 (2004). See also
Chicot County Drainage Dist. v. Baxter State Bank, 308 U.S. 371, 376, 60 S. Ct.
317, 84 L. Ed. 329 (1940) ('[Federal courts] are courts with authority, when
293

parties are brought before them in accordance with the requirements of due
process, to determine whether or not they have jurisdiction to entertain the cause
and for this purpose to construe and apply the statute under which they are
asked to act. Their determinations of such questions, while open to direct review,
may not be assailed collaterally'). So long as respondents or those in privity with
them were parties to the Manville bankruptcy proceeding, and were given a fair
chance to challenge the Bankruptcy Court's subject-matter jurisdiction, they
cannot challenge it now by resisting enforcement of the 1986 Orders. See
Insurance Corp. of Ireland v. Compagnie des Bauxites de Guinee, 456 U.S. 694,
702, n. 9, 102 S. Ct. 2099, 72 L. Ed. 2d 492 (1982) ('A party that has had an
opportunity to litigate the question of subject-matter jurisdiction may not . . .
reopen that question in a collateral attack upon an adverse judgment'); Chicot
County, supra, at 375, 60 S. Ct. 317, 84 L. Ed. 329 ('[T]hese bondholders, having
the opportunity to raise the question of invalidity, were not the less bound by the
decree because they failed to raise it'). 6
6 The rule is not absolute, and we have recognized rare situations in
which subject-matter jurisdiction is subject to collateral attack. See, e.g.,
United States v. United States Fidelity & Guaranty Co., 309 U.S. 506, 514,
60 S. Ct. 653, 84 L. Ed. 894 (1940) (a collateral attack on subject-matter
jurisdiction is permissible "where the issue is the waiver of [sovereign]
immunity"); Kalb v. Feuerstein, 308 U.S. 433, 439-440, 444, 60 S. Ct. 343,
84 L. Ed. 370 (1940) (where debtor's petition for relief was pending in
bankruptcy court and federal statute affirmatively divested other courts of
jurisdiction to continue foreclosure proceedings, state-court foreclosure
judgment was subject to collateral attack). More broadly, the Restatement
(Second) of Judgments § 12, p. 115 (1980), describes three exceptional
circumstances in which a collateral attack on subject-matter jurisdiction is
permitted:
'(1) The subject matter of the action was so plainly beyond the court's
jurisdiction that its entertaining the action was a manifest abuse of
authority; or
'(2) Allowing the judgment to stand would substantially infringe the
authority of another tribunal or agency of government; or
'(3) The judgment was rendered by a court lacking capability to make an
adequately informed determination of a question concerning its own
jurisdiction and as a matter of procedural fairness the party seeking to
avoid the judgment should have opportunity belatedly to attack the court's
subject matter jurisdiction.'
This is no occasion to address whether we adopt all of these
exceptions. Respondents do not claim any of them, and we do not see how
any would apply here. This is not a situation, for example, in which a
bankruptcy court decided to conduct a criminal trial, or to resolve a custody
dispute, matters "so plainly beyond the court's jurisdiction" that a different
result might be called for." 129 S. Ct. at 2205-2206.
294

v. Does Travelers Implicitly Overrule Metromedia and Drexel
Burnham?
Significantly, the Supreme Court reversed the Second Circuit's holding
that the bankruptcy court's injunction could be collaterally attacked. By doing so,
the Supreme Court had no occasion to opine on whether the Second Circuit's
underlying reasoning was correct that a bankruptcy court lacks subject matter
jurisdiction to release claims against a non-title 11 debtor which were not
derivative of the title 11 debtor's wrongdoing. Indeed, the Supreme Court
expressly announced it was not resolving that issue. 129 S. Ct. at 2207.
Therefore, it is possible that the Second Circuit has narrowed or changed its
previous jurisprudence allowing third party releases important to the
reorganization.
Previously, the Second Circuit has acknowledged the bankruptcy court's
subject matter jurisdiction to grant third party releases when they are important to
the reorganization. “[A] court may enjoin a creditor from suing a third party,
provided the injunction plays an important part in the debtor’s reorganization
plan.” Drexel Burnham Lambert Trading Corp. v. Drexel Burnham Lambert
Group, Inc. (In re Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 293 (2d
Cir. 1992).
Fundamentally, the words of the grant of subject matter jurisdiction to the
bankruptcy court encompass the granting of third party releases because they
are so broad. Pursuant to 28 U.S.C. § 1334(b), subject matter jurisdiction is
granted "of all civil proceedings arising under title 11, or arising in or related to
cases under title 11." At a minimum, the grant of a third party release to a
nondebtor that injects cash into the estate, is "related to" the case. As the United
States Supreme Court observed in Celotex Corp. v. Edwards, 514 U.S. 300,308
(1995), Congress' choice of the words "related to" "suggests a grant of some
breadth," and "must be read to give district courts…jurisdiction over more than
simply proceedings involving the property of the debtor or the estate." The court
noted the test of Pacor, Inc. v. Higgins, 743 F.2d 984, 994 (3d Cir. 1984) for
related to jurisdiction: "The usual articulation of the test for determining whether
a civil proceeding is related to bankruptcy is whether the outcome of that
proceeding could conceivably have any effect on the estate being administered
in bankruptcy….Thus the proceeding need not necessarily be against the debtor
or against the debtor's property. An action is related to bankruptcy if the outcome
could alter the debtor's rights, liabilities, options, or freedom of action (either
positively or negatively) and which in any way impacts upon the handling and
administration of the bankruptcy estate." (emphasis supplied by Pacor). But, the
impediments to third party releases are the constitutional concerns listed above
and the danger of abuse alluded to below in Metromedia.
The question at hand is whether the portion of the Second Circuit's
decision in Johns-Manville Corp. v. Chubb Indem. Ins. Co. (In re Johns-Manville
295

Corp.), 517 F.3d 52 (2d cir. 2008), rev'd, 129 S. Ct. 2195 (2009), that was not
reached by the Supreme Court eliminates the Second Circuit's holdings in Drexel
and Metromedia that releases of third parties from claims that are not paid from
estate assets are still available when "important" to the reorganization. In Drexel,
the Second Circuit affirmed approval of a class action settlement with the debtor
in possession under which one subclass was permanently enjoined from bringing
any future actions against Drexel's directors and officers and another subclass
was given the exclusive right to share in a portion of the settlement funds. Drexel
Burnham Lambert Trading Corp. v. Drexel Burnham Lambert Group, Inc. (In re
Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 288-89 (2d Cir. 1992). The
Second Circuit's decision reversed on jurisdictional grounds by Travelers, sub
silencio harkens back to the old subject matter jurisdictional regimen under the
Bankruptcy Act of 1898, as amended, which turned on property of the estate, the
res. The new statutory jurisdictional grant goes beyond limiting subject matter
jurisdiction to the res as conceded in Celotex, supra. To be sure, in a case
where insurance proceeds were very important as in Manville, had the issue
arisen at confirmation as to whether Travelers and the other insurers would have
entered into the settlement at the same amount if they had known their release
would not include a release of claims not payable from their insurance policies,
the answer would almost certainly have been no. Under the Drexel and
Metromedia standard, their releases would have been approved under the
'important to reorganization' standard. The Second Circuit's decision reversed on
jurisdictional grounds by Travelers makes it uncertain at best whether that
standard has survived.
vi. Johns-Manville Corp. v. Chubb Indemnity Insurance Co. (In re
Johns-Manville Corp.), 600 F.3d 135 (2d Cir. 2010)
On remand from the Supreme Court, the Second Circuit Court of Appeals
addressed the following issue:
"As the Bailey Court suggested, the primary current
contention is the argument of Chubb Indemnity Insurance Company
("Chubb") that "it was not given constitutionally sufficient notice of
the 1986 Orders, so that due process absolves it from following
them, whatever their scope." Id. In our view, Chubb is correct."
Chubb, 600 F.3d at 137. Interestingly, all objecting parties other than Chubb
failed to raise the due process issue. Therefore, the bankruptcy court's order
enforcing the release was affirmed as to each party other than Chubb. Chubb,
600 F.3d at 147.
The Second Circuit had earlier ruled that: "a bankruptcy court only has
jurisdiction to enjoin third-party non-debtor claims that directly affect the res of
the bankruptcy estate." In re Johns-Manville Corp. ("Manville III"), 517 F.3d 52,
66 (2d Cir. 2008). This is quite different than the "important" standard described
above.
296

The Second Circuit resolved the due process issue as follows:
In conclusion, we hold that MacArthur does not foreclose
Chubb's due process argument. We further hold that Chubb was
not adequately represented in the proceedings that lead to the
bankruptcy court's approval of the 1984 Insurance Settlement
Agreement and the Manville Plan, and that it did not receive
adequate notice of the 1986 Orders. Accordingly, both the
bankruptcy court and the district court erred by rejecting Chubb's
due process argument. Chubb is therefore not bound by the terms
of the 1986 Orders. Consequently, it may attack the Orders
collaterally as jurisdictionally void. And, as we held in Manville III,
that attack is meritorious.
600 F.3d at 158. The rationale that the notice to Chubb that its
contribution rights against Travelers were being released was inadequate
is:
"To the extent that the Notice document could be interpreted to
suggest that the 1984 Insurance Settlement Agreement would bar
non-derivative claims against non-debtors, the parties publicly
clarified their intentions by amending the agreement in a manner
that indicated that Chubb was not an interested party in Manville's
Chapter 11 proceedings. Specifically, when certain objectors to the
settlement argued that the terms of the proposed channeling
injunction exceeded the scope of the bankruptcy court's in rem
jurisdiction, Travelers signed a letter agreement indicating that the
objectors were wrong. The June 3, 1985 letter agreement stated
that it was intended to "clarif[y] the intent of the parties with respect
to certain provisions of the [1984 Insurance] Settlement
Agreement," and that it was an "amendment" to the Agreement.
One portion of the letter stated that "[t]he channeling order is
intended only to channel claims against the res to the Settlement
Fund and the injunction is intended only to restrain claims against
the res (i.e., the Policies) which are or may be asserted against the
Settling Insurers."
Following this amendment to the 1984 Insurance Settlement
Agreement, Chubb could not have known that it was an interested
party in Manville's bankruptcy proceedings or that the 1986 Orders
would bar its non-derivative in personam claims against Travelers."
600 F.3d at 157-158.
F. Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re Metromedia
Fiber Network, Inc.), 416 F.3d 136 (2d Cir. 2005)
297

i. Facts.
Pursuant to MFN’s chapter 11 plan, the Kluge Trust together with its
insiders would receive a release from all claimholders against MFN of all claims
arising out of any matter related to MFN or its affiliates through the effective date
of the plan. Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re
Metromedia Fiber Network, Inc.), 416 F.3d 136, 141 (2d Cir. 2005). In exchange
for the release, the Kluge Trust would forgive approximately $150 million of
claims, convert $15.7 million of senior secured claims to equity, invest $12.1
million in the reorganized debtors and purchase up to $25 million of common
stock in the reorganized debtors. Id.
Additionally, the chapter 11 plan released former and current MFN
personnel from claims related to the bankruptcy, except for claims based on
gross negligence or willful misconduct, and from claims related to MFN, the
debtors, or the chapter 11 plan. Id. at *141n. 5.
ii. Issue.
Were the releases authorized by the Bankruptcy Code on the findings
made by the bankruptcy court? Id. at 141.
iii. Holding.
No. Id. at 143. But, rather than remand to determine if findings can
support the releases, the appeal must be dismissed for equitable mootness
because reversal would be inequitable and appellants had neither sought a stay
of the confirmation order nor sought an expedited appeal. Id. at 144.
iv. Rationale.
In bankruptcy, “a court may enjoin a creditor from suing a third party,
provided the injunction plays an important part in the debtor’s reorganization
plan.” Drexel Burnham Lambert Trading Corp. v. Drexel Burnham Lambert
Group, Inc. (In re Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 293 (2d
Cir. 1992).
Two considerations create a judicial reluctance to approve nondebtor
releases. First, only section 524(g) of the Bankruptcy Code provides for
nondebtor releases and section 105(a) cannot be used to create substantive
rights. Id. at 142. Second, nondebtor releases lend themselves to abuse
because nondebtors thereby obtain a bankruptcy discharge without the other
safeguards of the Bankruptcy Code. Id.
Here, there was a finding below that the Kluge Trust made a material
contribution to the estate, id. at *143, but there was no finding the release itself
was important to the plan or necessary for the plan. Id. “A nondebtor release in
a plan of reorganization should not be approved absent the finding that truly
unusual circumstances render the release terms important to success of the
plan…” Id.
298

Because the Kluge transaction can not be undone without violence to the
overall agreement and the court can not predict what will happen if the settlement
is altered, the appeal is equitably moot. Id. at 145.
G. Lacy v. Dow Corning Corp. (In re Dow Corning Corp.), 280 F.3d 648 (6th
Cir. 2002)
i. Facts
Dow Corning proposed a chapter 11 plan under which Dow’s product
liability insurers, Dow’s shareholders, and Dow’s operating reserves provided
$2.35 billion for payment of personal injury claimants, government health care
payers, and other creditors asserting claims related to silicone-implant product
liability claims. As a quid pro quo, Dow’s insurers and shareholders would be
released from all further liability on claims arising out of settled personal injury
claims and claimants would be permanently enjoined from bringing related claims
against them. 280 F.3d at 255. The bankruptcy court interpreted the plan to
mean the release and injunction would only apply to consenting claimants. But,
the district court interpreted it to apply to all creditors and affirmed confirmation.
280 F.3d at 655-666.
ii. Issue
“Whether a bankruptcy court has the authority to enjoin a non-consenting
creditor’s claims against a non-debtor to facilitate a reorganization plan under
Chapter 11 of the Bankruptcy Code?” 280 F.3d at 656.
iii. Holding
“We hold that when the following seven factors are present, the
bankruptcy court may enjoin a non-consenting creditor’s claims against a nondebtor:
(1) There is an identity of interests between the debtor and the third
party, usually an indemnity relationship, such that a suit against the non-debtor
is, in essence, a suit against the debtor or will deplete the assets of the estate;
(2) The non-debtor has contributed substantial assets to the reorganization; (3)
The injunction is essential to reorganization, namely, the reorganization hinges
on the debtor being free from indirect suits against parties who would have
indemnity or contribution claims against the debtor; (4) The impacted class, or
classes, has overwhelmingly voted to accept the plan; (5) The plan provides a
mechanism to pay for all, or substantially all, of the class or classes affected by
the injunction; (6) The plan provides an opportunity for those claimants who
choose not to settle to recover in full and; (7) The bankruptcy court made a
record of specific factual findings that support its conclusions….” 280 F.3d at
658.
iv. Rationale
The Bankruptcy Code provides in section 105(a) that the bankruptcy court
can issue any order necessary or appropriate to carry out the provisions of the
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Bankruptcy Code. 280 F.3d at 658. The statutory grant of power in section
105(a) renders Grupo Mexicano v. Alliance Bond Fund Inc., 527 U.S. 308 (1999),
inapplicable to bar equitable relief, and brings the case within the realm of United
States v. First National City Bank, 379 U.S. 378 (1965), which upheld use of an
injunction granted pursuant to a statute (26 U.S.C. § 7402(a)(1964)) granting
courts power to issue injunctions “necessary or appropriate for the enforcement
of the internal revenue laws.” 280 F.3d at 657-658. Notably, the court did not
rely on the general jurisdictional grant in 28 U.S.C. § 1334.
H. Gilman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203
(3d Cir. 2000)
i. Facts
During its chapter 11 case, Continental Airlines, with court approval,
entered into a triparty agreement with its directors and officers insurers and
directors and officers. Under the settlement, the insurers paid $5 million to
Continental. Continental released the insurers and the directors and officers.
And, the directors and officers released Continental. Plaintiffs in then pending
securities fraud class action suits against the directors and officers did not object
to the settlement. Prior to the settlement, the bankruptcy court had temporarily
restrained plaintiffs from prosecuting the directors and officers. Then,
Continental’s chapter 11 plan released the directors and officers from plaintiffs’
claims and enjoined plaintiffs from pursuing them. Over plaintiffs’ objections the
plan was confirmed and the confirmation was affirmed in the district court 5 years
later.
ii. Holding
The United States Court of Appeals for the Third Circuit reversed the
district court, holding “[p]laintiffs, who have never had their day in court, have
been forced to forfeit their claims against non-debtors with no consideration in
return,” 203 F.3d at 211, and the release and injunction were “legally
unsupportable.” 203 F.3d at 218.
iii. Rationale
Without deciding whether non-debtor releases are never legal absent
consent, or are legal when fair to the claimants and necessary to the
reorganization, the court found there were no findings in the record to justify the
release in either situation. 203 F.3d at 214.
First, there was nothing in the record showing the released directors and
officers “provided a critical financial contribution to the Continental Debtors’ plan
that was necessary to make the plan feasible in exchange for receiving a release
of liability for Plaintiffs’ claims.” 203 F.3d at 215.
Second, the court questioned whether the reorganized debtor would really
have to indemnify the directors and officers given that federal courts disfavor
indemnity obligations for violating federal securities laws. 203 F.3d at 216.
300

Third, the court questioned the proposition that claims against the
directors and officers would implicate the debtors’ insurance policy because the
directors and officers may have direct rights to proceeds of the property. 203
F.3d at 216.
I. Bruno’s, Inc. v. W.R. Huff Asset Management Co. (In re
PWS Holding Corp.), 228 F.3d 224 (3d Cir. 2000)
i. Facts
Pursuant to the confirmed chapter 11 plan for Bruno’s, Inc., fraudulent
transfer claims against affiliates of the debtor’s shareholders and others were
released. Additionally, the confirmation order provided:
“[n]one of the Debtors, the Reorganized Debtors, New Bruno’s, the
Creditor Representative, the Committee or any of their respective
members, officers, directors, employees, advisors, professionals or agents
shall have or incur any liability to any holder of a Claim or Equity Interest
for any act or omission in connection with, related to, or arising out of, the
Chapter 11 Cases, the pursuit of confirmation of the Plan, the
consummation of the Plan or the property to be distributed under the Plan,
except for willful misconduct or gross negligence, and in all respects, the
Debtors, the Reorganized Debtors, New Bruno’s, the Creditor
Representative, the Committee and each of their respective members,
officers, directors, employees, advisors, professionals and agents shall be
entitled to rely upon the advice of counsel with respect to their duties and
responsibilities under the Plan.” 228 F.3d at 246.
A holder of $290 million of $421 million of subordinated debt appealed the
confirmation order on numerous grounds including (a) that the release of
fraudulent transfer defendants violated the absolute priority rule, and (b) that the
provision quoted above violates 11 U.S.C. 524(e) and the Third Circuit’s
decision in Gilman v. Continental Airlines (In re Continental Airlines), 203 F.3d
203 (3d Cir. 2000).
ii. Holding
The United States Court of Appeals for the Third Circuit affirmed the
confirmation order because, among other things, the releases of avoidance
claims were not on account of the shareholders’ equity interests in the debtor and
the protections afforded under the confirmation order are consistent with the
standard of liability under the Bankruptcy Code. 228 F.3d at 229-230.
“[w]e announce a narrow rule that, without direct evidence of causation,
releasing potential claims against junior equity does not violate the absolute
priority rule in the particular circumstance in which the estate’s claims are of only
marginal viability and could be costly for the reorganized entity to pursue.” 228
F.3d at 242.
301

iii. Rationale
The examiner in the chapter 11 case had concluded the avoidance claims
had little or no value. 228 F.3d at 242. Nevertheless, the objector had offered
$100,000 and sharing of proceeds in exchange for the claims. The appellate
court affirmed their release for no consideration, reasoning “the District Court did
not err in concluding that the potential cost of defending and paying
indemnification claims, cross claims, and counterclaims arising out of the
prosecution of the claims was high, and that the claims were extinguished not on
account of KKR’s interest in the Debtors, but because the Debtors determined
that they were unlikely to have any value.” 228 F.3d at 242. “[T]he claims were
extinguished because, in the judgment of the plan proponents, extinguishment
was the approach most likely to provide the greatest possible addition to the
bankruptcy estate.” Id.
The appellate court concluded the protections granted to the creditors’
committee and professionals who rendered services to the debtor do not violate
11 U.S.C. § 524(e) because they do not affect liability of another entity on a debt
of the debtor. Rather, the protections are consistent with the limited immunity
granted to committees and professionals who serve the debtors. See, e.g., Pan
Am Corp. v. Delta Air Lines, Inc., 175 B.R. 438, 5114 (S.D.N.Y. 1994); In re L.F.
Rothschild Holdings, Inc., 163 B.R. 45, 49 (S.D.N.Y. 1994); In re Drexel Burnham
Lambert Group, Inc., 138 B.R. 717, 722 (Bankr. S.D.N.Y. 1992), aff’d, 140 B.R.
347 (S.D.N.Y. 1992); In re Tucker Freight Lines, Inc., 62 B.R. 213, 216, 218
(Bankr. W.D. Mich. 1986).
J. Monarch Life Insurance Co. v. Ropes & Gray, 65 F.3d 973 (1st Cir.
1995).
i. Facts
In the context of a chapter 11 plan proposed for Monarch Capital by its
creditors and former subsidiary, Monarch Life, the court enjoined, among other
things:
“commencement or continuation of any action or proceeding
arising from or related to a claim against [Monarch Capital]
against or affecting or [sic]any property of [Monarch Capital],
or any direct or indirect transferee of any property of, or direct
or indirect successor in interest to, any of the foregoing...”
After confirmation, Monarch Life sued Ropes & Gray for allegedly having
represented simultaneously Monarch Life and Monarch Capital and having
deliberately concealed from Monarch Life the ongoing use by Monarch Capital of
Monarch Life's funds when there was no realistic prospect of repayment. The
logic of the release of Ropes & Gray and others was that although they were not
contributing to the funding of the plan, actions against them would lead to the
302

impleader of other parties who were contributing to the plan and who would not
contribute unless they were assured of no further exposure.
ii. Holding. The confirmation order has collateral estoppel
effect barring suits against Ropes & Gray. Its ambiguity
could have been litigated at confirmation.
K. Resorts International, Inc. v. Lowenschuss (In re Lowenschuss), 67 F.3d
1394 (9th Cir. 1995).
Here, Resorts International first filed a claim against Lowenschuss, but
then realized its claim was against the Lowenschuss pension plan for having
wrongfully tendered stock to Resorts International. Accordingly, Resorts
International requested leave to withdraw its claim without prejudice to
reinstatement if the pension plan were ultimately consolidated with Lowenschuss'
estate. The bankruptcy court, however, told Resorts International to litigate its
claim or withdraw it with prejudice even though the chapter 11 plan included a
global release releasing the pension plan from Resorts International's claims.
When Resorts International asked the bankruptcy court what the outcome would
be if the pension plan were later consolidated, the court responded: Thats just
tough. That's tough." 67 F.3d at 1400.
On appeal, the court ruled Resorts International should be allowed to
withdraw its claim without prejudice and affirmed the district court's vacation of
the global release.
L. W.R. Grace & Co. v. Chakarian (In re W.R. Grace & Co.), 591 F.3d 164
(3d Cir. 2009)
i. Facts
Grace operated a vermiculite mine ten miles north of Libby, Montana. The
mine yielded ore used to create zonolite which contains tremolite, alleged to be
an especially carcinogenic variety of asbestos. 591 F.3d at 167. When the mine
operated it created tremolite-laden dust allegedly causing injury to mine workers,
their families, and others in the community. Those claiming injury, the Libby
Claimants, sued Grace in state court and Grace commenced its chapter 11 case.
The bankruptcy court granted a preliminary injunction enjoining the litigation
against Grace’s nondebtor affiliates and its insurer (MCC) which Grace had
settled with and agreed to indemnify. The bankruptcy court denied a request to
enable plaintiffs to sue the insurer. The district court reversed, but the Third
Circuit affirmed the bankruptcy court. Gerard v. W.R. Grace & Co. (In re W.R.
Grace & Co.), 115 F. App’x 565 (3d Cir. 2004)(“Gerard”).
The Libby Claimants asserted the State of Montana had a duty to warn
them of the risks of asbestos from the Libby mine, and won a judgment against
the State of Montana from the Montana Supreme Court. It ruled Montana had a
303

duty to gather public health-related information and provide it to the people, and
remanded for a determination whether Montana breached its duty to the miners
and caused the damages they claimed. Montana then requested stay relief from
the bankruptcy court to enable it to implead Grace as a third party defendant.
Grace opposed and requested an expansion of the preliminary injunction to
include the action against Montana. 591 F.3d at 168. In response, the Libby
Claimants contended the bankruptcy court lacked jurisdiction to enjoin their
action against Montana. The bankruptcy court stayed the action pending its
decision. 591 F.3d at 169.
Ultimately, the bankruptcy court denied the motion and held it lacked
“related to” subject matter jurisdiction to stay the action against Montana
because the outcome of that action would not be binding on the debtor and even
if the Libby Claimants prevailed, Montana would then have to bring a separate
action against the debtors because Montana law prohibits Montana from litigating
against the debtors for contribution or indemnity during the Libby Claimants’
action. 591 F.3d at 169. After the bankruptcy court denied Montana and the
debtors’ reconsideration motion, the district court granted the debtors leave to
appeal, and then affirmed. 591 F.3d at 169.
ii. Issue
Did the bankruptcy court have subject matter jurisdiction to enjoin the
Libby Claimants’ action against Montana, and is it a prerequisite of such
jurisdiction that the bankruptcy court also have subject matter jurisdiction over
the Libby Claimants’ action?
iii. Holding
The bankruptcy court lacked jurisdiction to enjoin the Libby Claimants’
action against Montana. “[A] bankruptcy court may not enjoin proceedings
between third parties unless those proceedings arise in or under or are related to
the underlying bankruptcy.” 591 F.3d at 175 (footnote omitted).
iv. Rationale
11 U.S.C. § 105(a) does not provide an independent source of federal
subject matter jurisdiction. In re Combustion Eng’g, Inc., 391 F.3d 190, 225 (3d
Cir. 2004). 591 F.3d at 170. 28 U.S.C. § 1334(b) grants “arising under, “arising
in,” and “related to” jurisdiction, but only “related to” jurisdiction is at issue here.
Slip op. at 13. “Related to” jurisdiction is governed by the “any conceivable
effect” test in Pacor, Inc. v. Higgins, 743 F.2d 984, 994(3d Cir. 1984), which
provides a matter is related to a title 11 case if “the outcome of that proceeding
could conceivably have any effect on the estate being administered in
bankruptcy…An action is related to bankruptcy if the outcome could alter the
debtor’s rights, liabilities, options, or freedom of action (either positively or
negatively) and which in any way impacts upon the handling and administration
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of the bankrupt estate.” 591 F.3d at 171. In In re Federal-Mogul Global, Inc.,
300 F.3d 368, 382 (3d Cir. 2002), the court reaffirmed Pacor and stated “’[t]he
test articulated in Pacor for whether a lawsuit could ‘conceivably’ have an effect
on the bankruptcy proceeding inquires whether the allegedly related lawsuit
would affect the bankruptcy proceeding without the intervention of yet another
lawsuit.’” (Emphasis in Grace). 591 F.3d at 171-172. Similarly, in In re
Combustion Eng’g, Inc., 391 F.3d 190, 231-232 (3d Cir. 2004), the court
determined there was no “related to” jurisdiction when” the third party claim did
not directly result in liability of the debtor.” 591 F.3d at 172.
Here, the Libby Claimants’ action against Montana is based on an
independent duty of Montana to those claimants and is not binding on the
debtors and the debtors’ estates would not be impacted unless Montana could
bring a successful contribution or indemnity claim against the debtors’ estates.
591 F.3d at 173. A potential right of contribution is not a sufficient basis for a
kind of unity of interest that gives rise to related to jurisdiction. 591 F.3d at 173.
There is no indemnity contract between the debtors and Montana which would
create a more direct threat to the bankruptcy estate. But, “we do not mean to
imply that contractual indemnity rights are in themselves sufficient to bring a
dispute over that indemnity within the ambit of related-to jurisdiction. What will or
will not be sufficiently related to a bankruptcy to warrant the exercise of subject
matter jurisdiction is a matter that must be developed on a fact-specific case-bycase
basis.” 591 F.3d at 174 n. 9.
v. Analysis
Interestingly, nowhere in Grace does the court refer to Avellino & Bienes
v. M. Frenville Co. (In re M. Frenville Co.), 744 F.2d 332 (3d Cir. 1984) and its
progeny. 225 There, bank lenders to the debtor sued the debtor’s accounting firm
225 In In re Penn Central Transportation Company, 71 F.3d 1113 (3d Cir. 1995), the appellate
court held that a $600 million indemnity claim against the debtor for conduct that preceded its
bankruptcy was nevertheless a non-discharged postpetition claim because there was no
prepetition indemnity agreement and the law suit against certain steel companies that resulted in
their indemnity claim against Penn Central was not brought until 1980 and Penn Central had
commenced its reorganization case in 1970 and obtained a consummation order in 1978.
Similarly, in Schweitzer v. Consolidated Rail Corp., 758 F.2d 936, 944 (3d Cir. 1985), the
appellate court ruled that persons exposed to asbestos prior to bankruptcy, but who had
subclinical asbestos-related injuries and did not manifest injury until after consummation of the
reorganization plan, did not have claims under the Federal Employers’ Liability Act, 41 U.S.C. §
51 et seq. (1982), dischargeable under section 77(b) of the Bankruptcy Act of 1898, as amended,
when the consummation order was entered. The court reasoned:
Moreover, we are persuaded that a contrary rule would be undesirable as applied
in the asbestos-related tort context. If mere exposure to asbestos were sufficient
to give rise to a F.E.L.A. cause of action, countless seemingly healthy railroad
workers, workers who might never manifest injury, would have tort claims
cognizable in federal court. It is obvious that proof of damages in such cases
would be highly speculative, likely resulting in windfalls for those who never take
ill and insufficient compensation for those who do. Requiring manifest injury as a
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(A&B), and A&B requested stay relief to name the debtor and one of its principals
(also a title 11 debtor) as third party defendants so A&B could request indemnity
from them if it were found liable to the banks. The Third Circuit ruled stay relief
was unnecessary because the accounting firm’s claim against the debtor was not
stayed as a prepetition claim. Rather, the court determined it would be a
postpetition claim because A&B would not have a right to payment until after the
banks commenced their lawsuit. “In the case at bar, A&B had an unmatured,
unliquidated, disputed claim when the banks brought suit against it in New York
state court. Until the banks instituted suit, however, A&B did not have any claim
or cause of action based on indemnity or contribution against the Frenvilles.
Since the banks’ suit began some fourteen months after the filing of the
Frenvilles’ involuntary chapter 7 proceedings, A&B’s claim, as well as its cause of
action, arose post-petition. Although arguably A&B may have had some claim at
the time the Frenvilles gave it allegedly false information, it did not have a claim
for indemnification or contribution until the banks filed their suit.” 744 F.2d at
337.
Significantly, Frenville observed that: “The present case is different from
one involving an indemnity or surety contract. When parties agree in advance
that one party will indemnify the other party in the event of a certain occurrence,
there exists a right to payment, albeit contingent, upon the signing of the
agreement….” 744 F.2d at 336. The court added that although state law
normally determines when a right to payment arises, “[i]f there were some
overriding federal policy, we might have the power to develop federal law. See In
re Beck Indus., Inc., 725 F.2d 880, 891 (2d Cir. 1984); In re Johns-Manville
Corp., 36 Bankr. 743, 751 n.4 (S.D.N.Y.), appeal denied, 39 Bankr. 234
(S.D.N.Y. 1984). A bankruptcy proceeding stemming from a mass tort – such as
exposure to asbestos – may be a case in which the application of federal law is
indicated.” 744 F.2d at 337 n.8; see Killbarr Corp. v. General Services
Administration (In re Remington Rand Corp.), 836 F.2d 825, 830 (3d Cir. 1988).
To reconcile Frenville’s dicta that a prepetition indemnity agreement
would render the contingent indemnity claim a prepetition claim with Grace’s
dicta that the existence of a written indemnity agreement will not necessarily
render a contingent indemnity claim related to the bankruptcy even though Pacor
holds something that could alter the debtor’s liabilities is related to the title 11
necessary element of an asbestos-related tort action avoids these problems and
best serves the underlying purpose of tort law: the compensation of victims who
have suffered. Therefore we hold that, as a matter of federal law, F.E.L.A.
actions for asbestos-related injury do not exist before manifestation of injury.
Schweitzer, 758 F.2d at 942. Notably, the court did not consider that if all contingent claims had
been asserted by all persons exposed to asbestos, the distribution would not have had to overpay
those who would not have injury and underpay the others. Rather, the reorganization plan could
have provided a fund from which each claimant could draw when and if the claimant did manifest
injury.
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case, one could infer from Grace’s language alluding to the need to examine the
facts on a case-by-case basis, Grace, slip op. at 19-20 n.9, that the answer turns
on whether the prepetition indemnity agreement clearly encompasses an
indemnity obligation for a prepetition act.
31. Superpriority Claims under Bankruptcy Code Section 507(b) Have Met Resistance;
But How About Non-Super Administrative Claims? – LNC Investments, Inc. v. First
Fidelity Bank, 247 B.R. 38 (S.D.N.Y. 2000)
A. Facts
At the outset of the Eastern Airlines (“Eastern”) chapter 11 case, Eastern
had secured bonds outstanding in the amount of $453,765,000. 247 B.R. at 40.
The collateral consisted of 104 aircraft worth $681,100,000. The collateral value
eroded to an appraised value between $475 million and $590 million, and on
November 14, 1990, the indenture trustees filed a motion for adequate protection
or stay relief. Id. Eastern discontinued operations and on January 18, 1991
stipulated to return the aircraft to the trustees. 247 B.R. at 41. Ultimately, the
bondholders holding second and third liens against the aircraft were left with
insufficient collateral value and they sued the indenture trustees for breach of
fiduciary duty in waiting too long before propounding their motion. Id.
B. Issue
The bondholders undertook to show that if the indenture trustees had
earlier made their motion and it had been denied, the bondholders would have
been entitled to superpriority claims under Bankruptcy Code section 507(b).
Accordingly, the trial court needed to determine for purposes of giving jury
instructions “whether on a proper construction of the Code a secured creditor’s
claim is entitled to ‘superpriority’ status if the creditor files a motion with the
bankruptcy court for an order lifting the stay of proceedings against the debtor or,
in the alternative, for an order of adequate protection, the bankruptcy court
denies any relief, and the creditor’s collateral subsequently proves inadequate to
cover its claim.” 247 B.R. at 40.
Bankruptcy Code section 507(b) provides:
“If the trustee, under section 363, 363, or 364 of this title,
provides adequate protection of the interest of a holder of a claim
secured by a lien on property of the debtor and if,
notwithstanding such protection, such creditor has a claim
allowable under subsection (a)(1) of this section arising from the
stay of action against such property under section 362 of this
title, from the use, sale or lease of such property under section
363 of this title, or from the granting of a lien under section
364(d) of this title, then such creditor’s claim under such
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subsection shall have priority over every other claim allowable
under such subsection.”
C. Holding
While acknowledging the closeness of the question, and the fact that the
prior judge presiding over the case had rendered one decision holding section
507(b) superpriority claims are not triggered by denials of stay motions and then
another decision holding the opposite, 247 B.R. at 42n.4, the court held the
denial of a motion for adequate protection, or alternatively stay relief, does not
trigger the creditor’s superpriority claims under section 507(b). 247 B.R. at 50.
But, the court also held en route to its ultimate holding that the
bondholders have an allowable administrative claim for their deficiency.
“The parties differences arise out the first prerequisite to §
507(b) superpriority status, found in the subsection’s introductory
phrases. There are other prerequisites, § 507(b) requires that a
secured creditor’s claim be ‘allowable under subsection (a)(1) of
this section’ and ‘arising form’ conduct covered by §§ 362, 363,
or 364(d). The Bondholders’ claims satisfy these conditions. §
507(a)(1) cross-references § 503(b)(b), which provides that
administrative expenses include the ‘actual, necessary costs and
expenses of preserving the estate.’ The use of collateral to keep
a business operating qualifies as an administrative expense.
See In re J.F.K. Acquisitions Group, 166 B.R. 207, 212 (Bankr.
E.D.N.Y. 1994) (“Since the Debtor’s use of the Hotel and its
proceeds went to maintain the property and operate the
business, it was an essential aspect of its efforts to reorganize.
The use of the collateral was an actual and necessary cost of
preserving the estate. Therefore, the claim of Americana is
allowable as an administrative claim under Section 503(b)’).
One cannot imagine a more ‘essential aspect’ of an airline’s
efforts to reorganize than the use of its aircraft. Moreover, the
Bondholders’ claims arise from the automatic stay imposed by §
362(a)(1), which prevented the Trustee from foreclosing on the
collateralized aircraft.”
247 B.R. at 42n.4.
D. Rationale
First, the court reasons from the phrase “If the trustee, under section 363,
363, or 364 of this title, provides adequate protection,” that section 507(b) can
only be triggered by providing adequate protection after the petition date and that
an order denying an adequate protection or stay relief motion can’t satisfy the
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word “provides” in the statute. 247 B.R. at 46, 47. From that, the court rules the
creditors must show the literal application of section 507(b) is absurd (citing Holy
Trinity Church v. United States, 143 U.S. 457 (1892)) if they are to convince the
court not to interpret it literally. 247 B.R. at 46-47.
Second, the court reasons “the overhanging, intimidating presence of a
multimillion dollar superpriority claim may chill the willingness of others to do
business with a debtor-in-possession, dooming that resolution preferred by
Congress, a successful reorganization, and leading to a liquidation.” 247 B.R. at
48-49.
Third, the court applies a balancing test. “I think that the Code protects
secured creditors up to a point, but not beyond, and the point of demarcation is
reached when granting superpriority status would imperil other identifiable
objectives of the Code, which include a preference for economically feasible
reorganizations.” 247 B.R. at 49.
Fourth, the court acknowledges “it is anomalous for the grating and denial
of an adequate protection motion to have such disparate consequences, when
the bankruptcy court’s error in assessing adequacy and the consequent prejudice
to the secured creditor are the same. However, in view of the language
Congress used and the manner in which the Code’s sections cross-reference
each other, that is an anomaly that the Congress must remedy.” 247 B.R. at 50.
E. Rationale or Irrationale
It is unclear why the court believed the language of section 507(b) means
its superpriority claim is not triggered when an adequate protection or stay relief
motion is denied. Bankruptcy Code section 363(e) grants every secured
claimholder an unconditional, absolute right to adequate protection. It provides:
“Notwithstanding any other provision of this section, at
any time, on request of an entity that has an interest in property
used, sold, or leased, or proposed to be used, sold, or leased, by
the trustee, the court, with or without a hearing, shall prohibit or
condition such use, sale, or lease as is necessary to provide
adequate protection of such interest.” (emphasis supplied).
Likewise, Bankruptcy Code section 363(d)(1) mandates the court to
grant stay relief if the secured claim is not adequately protected. It
provides:
On request of a party I interest and after notice and a hearing,
the court shall grant relief from the stay provided under
subsection (a) of this section, such as by terminating,
annulling, modifying, or conditioning such stay --
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(1) For cause, including lack of adequate protection of an
interest in property of such party in interest; or… (emphasis
supplied).
Therefore, the only time a court can deny a motion for adequate
protection or for stay relief is when adequate protection is being provided
by the trustee or debtor in possession. Such protection can take multiple
or alternate forms such as equity cushions, procurement of insurance,
maintenance of the collateral, etc. But, it must always be provided. The
court appears to have been influenced by semantics, namely that an
order denying adequate protection would be an order than no adequate
protection is needed. The statute rebuts that interpretation by granting
an absolute right to adequate protection to every secured claimant.
Once it is recognized that such motions can only be denied when
adequate protection is being provided, the plain meaning of section
507(b) becomes the reverse of what the court inferred. Section 507(b)
then plainly means that whenever the stay is maintained in effect and it
turns out the creditor’s secured position erodes while the creditor is
restrained from possessing its collateral, the creditor’s loss from that
erosion qualifies as a superpriority claim.
The court’s second rationale does not comport with logic or
practice. The “overhanging, intimidating presence of a multimillion dollar
superpriority claim” will exist no matter which way the court decides the
issue. Thus, it is illogical for the court to deny the triggering of the
superpriority claim in the current instance. Entities doing business with
debtors in possession or trustees will still have to be concerned about
superpriority claims emanating from each court decision that grants
adequate protection.
In practice, trade creditors and others do not grant credit to
debtors in possession based on their analyses of the esoterics of section
507(b). Rather, they look at the credit available to the debtor in
possession and determine whether they want to take the risk of granting
unsecured or secured credit.
The court’s theory that it should interpret section 507(b) so as not
to trigger a superpriority claim because the contrary holding would
imperil reorganizations is both demonstrably wrong and contrary to the
Bankruptcy Code. It is demonstrably wrong because the court’s own
conclusion that the creditor, in any event, has an allowable, nonsuprepriority
administrative claim for its losses due to the automatic stay
and the debtor’s use of the collateral, makes the creditor’s claim for such
losses payable in full in cash on the effective date of the chapter 11 plan.
Once that is established, the fact that the creditor’s claim should be paid
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as a suprepriority before other administrative claims has no effect
whatsoever on the prospects for reorganization because all
administrative claims of whatever priority must be paid in full in cash on
the effective date of the plan unless the claimant consents otherwise.
Bankruptcy Code section 1129 (a)(9)(A).
It is contrary to the Bankruptcy Code because sections 362(d)(1)
and 363(e) expressly make clear that a secured claimholder’s right to
adequate protection is absolute and unconditional. There is no room to
deny adequate protection or stay relief if the claimholder is not
adequately protected regardless of its effect on the prospects for
reorganization. It is also illogical to conclude that the superpriority claim
granted under section 507(b) should be denied when the creditor’s
absolute and unconditional right to adequate protection or stay relief is
denied. That is the very instance when the creditor needs the
superpriority claim!
Finally, the court’s acknowledgment of the anomaly caused by its
decision satisfies the court’s own standard that its reading of section
507(b) must yield absurd results before the court will interpret it
differently. Based on the court’s reading of section 507(b), an adequate
protection order directing the debtor to provide one additional dollar of
collateral would yield a superpriority claim if it’s insufficient, while an
order denying adequate protection would yield no superpriority claim. By
any standard, that is absurd.
i. Facts
F. Subsequent History: LNC Investments, Inc. v. National
Westminster Bank, 308 F.3d 169 (2d Cir. 2002), cert.
denied, 2003 U.S. LEXIS 3729 (2003)
At the jury trial, the court instructed the jury that if the bankruptcy court
grants a motion for adequate protection or denies stay relief and the protection
proves insufficient, the creditor is entitled to a superpriority claim. But, if the
motion is denied, the creditor is not entitled to a superpriority claim. 308 F.3d at
174-175. The trial court denied the bondholders the right to claim imprudence by
the indenture trustees for not pursuing an ordinary administrative claim because
they raised it at the eleventh hour before trial. 308 F.3d at 175. The jury
returned a special verdict finding the indenture trustees did not act imprudently
and judgment was entered in their favor. 308 F.3d at 175. The bondholders
appealed claiming the trial court should have instructed the jury that the making
of an adequate protection or stay relief motion would have resulted in a
superpriority claim under section 507(b) regardless of whether the bankruptcy
court granted any additional protection or denied the motion. 308 F.3d at 175.
ii. Issue
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The appellate court ruled the issue of whether the bondholders were
correct in their interpretation of section 507(b) would only be relevant if the
hypothetical prudent indenture trustee must be presumed to know the “true” legal
effect of such a motion. 308 F.3d at 175.
iii. Holding
At the time the indenture trustees were supposed to have made a motion
for adequate protection or stay relief, the meaning of section 507(b) was
unsettled. Accordingly, the hypothetical prudent indenture trustee should not be
presumed to know the true legal effect of such a motion. Therefore, the jury’s
special verdict that the trustees did not act imprudently should not be overturned.
The true meaning of section 507(b) would go to the issue of causation of
damages, but is not reached if the indenture trustees did not act imprudently in
the first place, 308 F.3d at 175-176, and the court expressly concluded it would
not decide that issue, 308 F.3d at 171.
In a concurring opinion, Judge Parker ruled the interpretation of section
507(b) did need to be determined because if the bondholders were correct, the
indenture trustees’ failure to have made a motion would appear a clear decision
not to take steps that would surely protect the bondholders. 308 F.3d at 179.
Judge Parker concurred because he concluded the denial of a motion for stay
relief or adequate protection would not create a superpriority claim under section
507(b). 308 F.3d at 179-180.
32. At Electromagnetic License Auctions, What’s For Sale?
A. Federal Communications Commission v. NextWave Personal
Communications, Inc. (In re NextWave Personal Communications, Inc.), 200
F.3d 43 (2d Cir. 1999), cert. denied, 121 S.Ct. 298 (2000)
i. Facts
At the FCC auction in May and July 1996, NextWave made the winning
bid of $4.74 billion for 63 C-block licenses. On January 3, 1997, the FCC
conditionally granted the licenses to NextWave after NextWave submitted a plan
to bring its capital structure into compliance. On February 14, 1997, the FCC
granted NextWave the licenses conditioned on receiving the promissory notes.
On February 19, 1997, NextWave executed the notes in the amount of $4.27
billion for the unpaid portion of the purchase price. By then, the licenses were
worth less than a quarter of their purchase price. 200 F.3d at 47.
Three times, the FCC issued restructuring orders allowing winning bidders
to return their licenses in exchange for forgiveness of debt or to return some
licenses. The FCC determined not to allow bidders to retain licenses at reduced
prices. 200 F.3d at 48.
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NextWave commenced a chapter 11 case on June 11, 1998 after the FCC
denied its request for more time to consider its options. The bankruptcy court
determined in an adversary proceeding that NextWave incurred its debt on
February 19, 1997 when the licenses were worth $1,023,211,000 and it had
already paid $474,364,806. Accordingly, the bankruptcy court ruled NextWave’s
issuance of $4.27 billion of notes for licenses worth a little over $1 million was a
constructively fraudulent transfer, and avoided NextWave’s note debt down to a
level of $548,846,194 (which together with its down payments equaled the full
value of the licenses). The district court affirmed. 241 B.R. 311 (S.D.N.Y. 1999).
ii. Holding
“…We are merely holding that NextWave may not collaterally attack or
impair in the bankruptcy courts the license allocation scheme developed by the
FCC.” 200 F.3d at 55. “By holding that for a price of $1.023 billion NextWave
would retain licenses for which it had bid $4.74 billion, the bankruptcy and district
courts impaired the FCC’s method for selecting licensees by effectively awarding
the Licenses to an entity that the FCC determined was not entitled to them….”
200 F.3d at 55.
“…We limit ourselves here to finding that NextWave’s obligations were incurred
at the close of auction and that the transaction in which they were incurred was
therefore not constructively fraudulent….” 200 F.3d at 59.
iii. Rationale
The appellate court explained that licenses are not property. Additionally,
the FCC was simply using an auction to help perform its function of allocating
electromagnetic spectrum. “Congress therefore enacted 47 U.S.C. 309(j)
authorizing the FCC to develop a system for allocating spectrum through a
competitive bidding process.” 200 F.3d at 51. “…The fact that market forces are
the technique used to achieve that regulatory purpose does not turn the FCC into
a mere creditor, any more than it turns an FCC license won at auction into a
property estate in spectrum.” 200 F.3d at 54-55.
Accordingly, the court held the bankruptcy court had no authority to
allocate spectrum licenses in defiance of the FCC’s determination to take the
allocation away from NextWave. “If the conditions to which a license is subject
are not met, the FCC may revoke the license. It is beyond the jurisdiction of a
court in a collateral proceeding to mandate that a licensee be allowed to keep its
license despite its failure to meet the conditions to which the license is subject.”
200 F.3d at 54.
“The radio (or electromagnetic) spectrum belongs to no one. It is not
property that the federal government can buy or sell. It is no more governmentowned
than is the air in which Americans fly their airplanes or the territorial
waters in which they sail their boats.” 200 F.3d at 50. “Although not owned by
the federal government, the radio spectrum is subject to strict governmental
regulation.” 200 F.3d at 50. “A license does not convey a property right; it
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merely permits the licensee to use the portion of the spectrum covered by the
license in accordance with its terms.” 200 F.3d at 51 (quoting FCC v. Sanders
Bros. Radio Station, 309 U.S. 470 (1940) (“[N]o person is to have anything in the
nature of a property right as a result of the granting of a license.”)).
On the issue of the constructively fraudulent transfer, the appellate court
held the date NextWave incurred its debt for the full purchase price was the date
of the close of the auction because the FCC’s own interpretation of its own
regulations deserve a presumption of correctness. 200 F.3d at 58.
iv. Consequences of Holding
Significantly, the Second Circuit’s ruling that the licenses are not property
and do not create property rights changes the landscape for the fraudulent
transfer analysis. The underpinning of the court’s analysis was that if NextWave
became liable for the full amount of the winning bid at the auction, then the
incurrence of debt can not be voidable because it was by definition the amount of
the market tested value of the licenses NextWave was purchasing. Therefore,
NextWave must have been receiving reasonably equivalent value in exchange
for the debt. But, if NextWave is now deemed not to have received any property
at the auction or subsequently, then how could it have received fair value in
exchange for its debt?
B. In re GWI PCS 1 Inc., 230 F.3d 788 (5 th Cir. 2000)
i. Facts
On May 6, 1996, GWI was the high bidder for 14 PCS licenses. On
January 27, 1997, the FCC approved the granting of the licenses to GWI. On
March 10, 1997, GWI’s subsidiaries executed notes to the FCC for the unpaid
portion of the purchase price, $954 million. 230 F.3d at 792-793. On October
20, 1997, GWI’s subsidiaries commenced their chapter 11 cases and on October
29, 1997 they commenced an adversary proceeding to avoid the notes. 230
F.3d at 794.
At trial, the bankruptcy court found that although the licenses were worth
$1.06 billion when the auction closed, they had declined to $166 million by
January 27, 1997. 230 F.3d at 794. The court ruled the transfer would be
evaluated as of January 27, 1997, the date the licenses were issued. Therefore,
the transfer was constructively fraudulent because the debt incurred was $894
million in excess of the value of the licenses received.
Then, the bankruptcy court confirmed a chapter 11 plan with some
modifications it imposed to provide the FCC larger secured and unsecured
claims depending on what relief the FCC obtains on appeal.
Ultimately, the district court dismissed parts of the FCC’s appeal of the
adversary proceeding and the confirmation order on the ground of equitable
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mootness. 245 B.R. 59, 64 (N.D. Tex. 1999). The court affirmed the balance of
the judgments. 230 F.3d at 799.
ii. Holding
“…Although the bankruptcy court possibly erred in permitting avoidance
and enjoining the FCC from revoking the subsidiary debtors’ licenses for failing to
remit the full bid price, thereby taking onto itself a quasi-regulatory function held
by the FCC, the FCC’s challenge on this point and request that the avoidance
judgment, in its entirety, and the enjoinment order, be reversed are barred by
equitable mootness.” 200 F.3d at 804. “The Second Circuit’s decision, In re
Nextwave Personal Communications, Inc., 200 F.3d 43 (2d Cir. 1999)…although
casting doubt on the merits of the bankruptcy court’s assuming a quasiregulatory
role, does not dissuade us from ruling that the FCC’s challenge on this
issue is equitably moot.” 230 F.3d at 804.
“…Therefore, we conclude that the bankruptcy court properly determined
January 27, 1997 as the appropriate date to evaluate the avoidance motion.
With respect to this issue, the FCC’s challenge fails, and we affirm the avoidance
of the approximately $894 million of the obligation of the subsidiary debtors (and
of any such obligation of GWI PCS) to the FCC.” 230 F.3d at 810.
iii. Rationale
The Fifth Circuit cited substantial evidence that the FCC adopted its
interpretation of its regulations as to the date GWI incurred its liability to pay the
full purchase price in light of the actual litigation. 230 F.3d at 06-807.
Accordingly, it did not afford them deference. Rather, the court recognized the
FCC auction was not typical. “…Under the C-block auction rules, the winning
bidder is not entitled to the license until after receiving subsequent FCC approval
and does not become obligated for the full bid price until the notes securing the
full bid price are thereafter signed.” 230 F.3d at 810. The court deduced the
foregoing, in part, from regulations limiting the winning bidder’s liability to
expectation damages. 230 F.3d at 808. Query whether the limitation of liability
to expectation damages shows the winning bidder was liable for less than the full
bid as of the close of bidding?
C. Federal Communications Commission v. Nextwave Personal
Communications Inc., 537 U.S. 293, 123 S. Ct. 832 (2003)(8-1), affirming,
254 F.3d 130 (D.C. Cir. 2001)
i. Bankruptcy Code section 525(a) provides:
Except as provided in the Perishable Agricultural
Commodities Act, 1930, the Packers and Stockyards Act,
1921, and section 1 of the Act entitled ‘An Act making
appropriations for the Department of Agriculture for the fiscal
year ending June 30, 1944, and for other purposes,’ approved
July 12, 1943, a governmental unit may not deny, revoke,
suspend, or refuse to renew a license, permit, charter,
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franchise, or other similar grant to, condition such a grant
to, discriminate with respect to such a grant against deny
employment to, terminate the employment of, or
discriminate with respect to employment against, a
person that is or has been a debtor under this title or a
bankrupt or a debtor under the Bankruptcy Act, or
another person with whom such bankrupt or debtor has
been associated, solely because such bankrupt or debtor
is or has been a debtor under this title or a bankrupt or
debtor under the Bankruptcy Act, has been insolvent
before the commencement of the case under this title, or
during the case but before the debtor is granted or denied
a discharge, or has not paid a debt that is dischargeable
in the case under this title or that was discharged under
the Bankruptcy Act. (Emphasis supplied).
ii. History Subsequent to 200 F.3d 43 (2d Cir. 1999), cert. denied, 121
S.Ct. 298 (2000)
After the United States Court of Appeals for the Second Circuit reversed
the bankruptcy court’s holding that Nextwave’s incurrence of debt for its licenses
was voidable as a fraudulent transfer, Nextwave proposed a chapter 11 plan
under which it would pay in full for the licenses. The bankruptcy court declared
null and void the FCC’s cancellation of the licenses on the ground the FCC
violated the automatic stay, reasoning that the FCC had no regulatory interest in
the timely payment requirement of the license price. The Second Circuit
reversed holding “there can be little doubt that if full payment is a regulatory
condition, so too is timeliness.”. In re FCC, 217 F.3d 125, 136 (2d Cir. 2000).
Additionally, the appellate court ruled it was outside the jurisdiction of the
bankruptcy court to determine if the FCC was arbitrary: “…It is for the FCC to
state its conditions of licensure, and for a court with power to review the FCC’s
decisions to say if they are arbitrary or valid.” Id. at 137.
When Nextwave asked the FCC to reconsider its license cancellation, the
FCC ruled Nextwave was late because the cancellation was built into the original
transaction, and that the Second Circuit’s decision was res judicata on
Nextwave’s Bankruptcy Code arguments. 15 Fcc Rcd 17500, Fcc 00-335 P 10,
26.
iii. Holding
First, pursuant to the Administrative Procedure Act, the court must hold
unlawful agency action not in accordance with law, 5 U.S.C. § 706(2), which
means any law and not simply the laws the agency enforces. 123 S. Ct. at 838.
Notably, the FCC never denied that if Nextwave had made its payments timely, it
could have retained its licenses. 123 S. Ct. at 838. Similarly, the FCC did not
deny that Nextwave’s obligations to make its payments were enforceable debts.
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Second, Bankruptcy Code section 525 prohibits the FCC from revoking
licenses held by a debtor in bankruptcy upon the debtor’s failure to make timely
payments owed to the FCC for purchase of the licenses.
Third, “[t]he FCC has not denied that the proximate cause for its
cancellation of the licenses was NextWave’s failure to make the payments that
were due. It contends, however, that § 525 does not apply because the FCC had
a ‘valid regulatory motive’ for the cancellation….In our view, that factor is
irrelevant. When the statute refers to failure to pay a debt as the sole cause of
cancellation (‘solely because’), it cannot reasonably be understood to include,
among the other causes whose presence can preclude application of the
prohibition, the governmental unit’s motive in effecting the cancellation. Such a
reading would deprive § 525 of all force. It is hard to imagine a situation in which
a governmental unit would not have some further motive behind the cancellation
– assuring the financial solvency of the licensed entity,…” 123 S. Ct. at 838-839.
“Some may think (and the opponents of § 525 undoubtedly thought) that there
ought to be an exception for cancellations that have a valid regulatory purpose.
Besides the fact that such an exception would consume the rule, it flies in the
face of the fact that, where Congress has intended to provide regulatory
exceptions to provisions of the Bankruptcy Code, it has done so clearly and
expressly, rather than by a device so subtle as denominating a motive a
cause….” 123 S. Ct. at 839.
Fourth, the FCC contended NextWave’s license obligations are not debts
dischargeable in bankruptcy. “This is nothing more than a retooling of
petitioners’ recurrent theme that ‘regulatory conditions’ should be exempt from §
525. No matter how the FCC casts it, the argument loses. Under the Bankruptcy
Code, ‘debt’ means ‘liability on a claim,’…and ‘claim,’ in turn, includes any ‘right
to payment’…We have said that ‘claim’ has ‘the broadest available definition,’…
and have held that the ‘plain meaning of a right to payment is nothing more nor
less than an enforceable obligation, regardless of the objectives the State seeks
to serve in imposing the obligation…In short, a debt is a debt, even when the
obligation to pay it is also a regulatory condition.” 123 S. Ct. at 839. The
appellate court had rejected the FCC’s argument that timely payment of the
license obligation was a regulatory requirement and not a dischargeable debt.
The court reasoned the FCC was creating a “regulatory purpose exception” to
section 525. 254 F.3d at 152. The court pointed out that section 525 carves out
the regulatory purposes and statutes Congress wanted to carve out, showing
Congress did not intend a general regulatory purpose exception. 123 S. Ct. at
839.
Fifth, it is not beyond the bankruptcy court’s jurisdictional authority to
discharge a debt unless it falls within an express exception to discharge. The
appellate court had rejected the FCC’s argument that section 525 is inapplicable
because the U.S. Court of Appeals for the Second Circuit held the bankruptcy
court lacked jurisdiction to discharge Nextwave’s license obligation and section
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525 by its terms only applies to dischargeable debts. The D.C. Circuit Court of
Appeals reasoned the issue is whether the license obligation is dischargeable
under the Bankruptcy Code by a court of competent jurisdiction, not whether the
bankruptcy court can discharge or modify it. 254 F.3d at 152. The United States
Supreme Court agreed that except for the 9 kinds of debts saved from discharge
in 11 U.S.C. § 523(a), “a discharge in bankruptcy discharges the debtor from all
debts that arose before bankruptcy.” 123 S. Ct. at 840.
Notably, the U.S. Court of Appeals had also rejected the FCC’s argument
that section 525 does not bar actions not exempted from the automatic stay
under section 362(b)(4) as governmental regulatory actions. Such an
interpretation would be inconsistent with the plain language of section 525. 254
F.3d at 150. Moreover, section 362(b)(4) does not exempt any acts from the
automatic stay of actions to create, perfect, or enforce liens under section
362(a)(4). Therefore, the FCC is wrong that its actions were not automatically
stayed. 254 F.3d at 151.
33. Purchasing Distressed Debt Claims with Intent to Prosecute Them Is Still Legal –
Elliott Associates, L.P. v. Banco De La Nacion, 194 F.3d 363 (2d Cir. 1999)
A. Facts
In October 1995, an investment fund whose primary types of investment
included investments in distressed debtors purchased $28.75 million of
Panamanian sovereign debt for $17.5 million. In July 1996, it brought suit
against Panama for full payment. The fund was guided by a consultant and
attorney having previously purchased sovereign debt of several other countries
prior to filing lawsuits for full payment. 194 F.3d at 365-366. Panama was
finalizing its Brady Plan restructuring which is not binding on creditors unless
they consent. 194 F.3d at 366. Between January and March 1996, the fund
purchased for $11.4 million, $20.7 million of bank debt guaranteed by Peru. The
trial court found the fund timed its purchases with key events in litigation by
another fund to enforce its debt. 194 F.3d at 367.
When the fund sued to enforce its Peruvian debt claims, the district court
denied its motion for prejudgment attachment of U.S. Treasury bonds and
ultimately dismissed the fund’s complaint on the ground the fund violated Section
489 of the New York Judiciary Law because it “’purchased the Peruvian debt with
the intent and purpose to sue.’” 194 F.3d at 368 (quoting from 12 F. Supp. at
332).
B. Issue
“The pivotal issue…is whether, within the meaning of Section 489 of the
New York Judiciary Law, Elliott’s purchase of Peruvian sovereign debt was ‘with
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the intent and for the purpose of bringing an action or proceeding thereon,’
thereby rendering the purchase a violation of law.” 194 F.3d at 371.
Section 489 provides:
“No person or co-partnership, engaged directly or
indirectly in the business of collection and adjustment of claims,
and no corporation or association, directly or indirectly, itself or
by or through its officers, agents or employees, shall solicit, buy
or take an assignment of, or be in any manner interested in
buying or taking an assignment of a bond, promissory note, bill
of exchange, book debt, or other thing in action, or any claim or
demand, with the intent and for the purpose of bringing an action
or proceeding thereon; provided however, that bills receivable,
notes receivable, bills of exchange, judgments or other things in
action may be solicited, bought, or assignment thereof taken,
from any executor, administrator, assignee for the benefit of
creditors, trustee or receiver in bankruptcy, or any other person
or persons in charge of the administration, settlement or
compromise of any estate, through court actions, proceedings or
otherwise. Nothing herein contained shall affect any assignment
heretofore or hereafter taken by any moneyed corporation
authorized to do business in the state of New York or its
nominee pursuant to a subrogation agreement or a salvage
operation, or by any corporation organized for religious,
benevolent or charitable purposes. Any corporation or
association violating the provisions of this section, and any
officer, trustee, director, agent or employee of any person, copartnership,
corporation or association violating this seciton who,
directly or indirectly, engages or assists in such violation, is guilty
of a misdemeanor.”
C. Holding
“…[W]e are convinced that, if the New York Court of Appeals, not us, were
hearing this appeal, it would rule that the acquisition of a debt with intent to bring
suit against the debtor is not a violation of the statute where, as here, the primary
purpose of the suit is the collection of the debt acquired. Consequently, we must
reverse the judgment of the district court.” 194 F.3d at 372. “[W]e hold that
Seciton 489 is not violated when, as here, the accused party’s ‘primary goal’ is
found to be satisfaction of a valid debt and its intent is only to sue absent full
performance.” 194 F.3d at 381.
D. Rationale
New York cases show Section 489’s predecessor “was intended to curtail
the practice of attorneys filing suit merely to obtain costs, which at that time
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included attorney fees….” 194 F.3d at 373. To violate Section 489 the primary
purpose of the debt purchase must be to enable the attorney to commence a
suit, rather than to be paid and to commence suit only if payment is not
forthcoming.
As policy matters, the appellate court also recognized that a holding
rendering debt unenforceable when purchased with the intent to sue for full
payment would add to the risk of lending to developing nations and would disrupt
or destroy the secondary market for defaulted debt. 194 F.3d at 380. Such a
holding “sould also create ‘a perverse result’ because it ‘would permit defendants
to create a champerty defense by refusing to honor their loan obligations.’ 194
F.3d at 380 (quoting Banque de Gestion PriveeSib v. La Republica de Paraguay,
787 F. Supp. 53, 57 (S.D.N.Y. 1992)).
34. Lessons from a Failed Limited Fund Settlement Class Action – Ortiz v. Fibreboard
Corp., 119 S. Ct. 2295 (1999)
(a) Facts.
To try to settle all its present and future asbestos liability, Fibreboard
approached certain leading plaintiffs’ attorneys. The plaintiffs’ attorneys
represented plaintiffs holding then pending claims. But, they also negotiated on
behalf of potential future claimants. Fibreboard’s insurance companies had been
contesting coverage, but also agreed to join the settlement and to provide $1.535
billion. Fibreboard had a net worth of approximately $235 million (excluding
asbestos liability), and agreed to furnish $10 million to the settlement fund of
which all but $500,000 came from other insurance. Just prior to the proposed
class action settlement, one of the plaintiffs’ law firms procured a separate
settlement for its 45,000 pending claims. In that settlement, the settlement
amounts were higher than average with one-half due on closing and the
remainder contingent on either a global settlement or Fibreboard’s success in its
litigation against its insurers.
At the plaintiffs’ firms’ insistence, the insurers reached an additional
settlement under which they would provide $2 billion in coverage if the class
action settlement did not win approval.
Under the putative settlement, Fibreboard and the insurers would obtain
full releases from class members in exchange for setting up the settlement fund
in a trust. Claimants would be required to try to settle with the trust and had to
exhaust mediation, arbitration, and a mandatory settlement conference before
litigating. Once litigating, the claimants would be limited to no more than
$500,000 and would be unable to obtain prejudgment interest or punitive
damages. Claims resolved without litigation would be paid over 3 years. Claims
resolved with litigation would be paid over 5 to 10 years.
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When the class action settlement was fully documented, a group of
plaintiffs filed an action in the United District Court for the Eastern District of
Texas seeking certification for settlement purposes of a ‘mandatory’ class
pursuant to Fed. R. Civ. P. 23(b)(1). 226 The class excluded claimants with actions
pending against Fibreboard and claimants who had formerly sued Fibreboard
and dismissed their actions for consideration with right to sue again upon
226 Fed. R. Civ. P. 23(b) provides:
Class Actions Maintainable. An action may be maintained as a
class action if the prerequisites of subdivision (a) are satisfied,
and in addition:
(1) the prosecution of separate actions by or against
individual members of the class would create a risk of
(A) inconsistent or varying adjudications with respect to
individual members of the class which would establish
incompatible standards of conduct for the party
opposing the class, or
(B) adjudications with respect to individual members of the
class which would as a practical matter be dispositive
of the interests of the other members not parties to the
adjudications or substantially impair or impede their
ability to protect their interests; or
(2) the party opposing the class acted or refused to act on
grounds generally applicable to the class, thereby
making appropriate final injunctive relief or
corresponding declaratory relief with respect to the
class as a whole; or
(3) the court finds that the questions of law or fact
common to the members of the class predominate over
any questions affecting only individual members, and that
a class action is superior to other available methods for
the fair and efficient adjudication of the controversy. The
matters pertinent to the findings include: (A) the interest of
members of the class in individually controlling the
prosecution or defense of separate actions; (B) the extent
and nature of any litigation concerning the controversy
already commenced by or against members of the class;
(C) the desirability or undesirability of concentrating the
litigation of the claims in the particular forum; (D) the
difficulties likely to be encountered in the management of
a class action.
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development of an asbestos-related malignancy. The court appointed a guardian
ad litem to review the fairness of the settlement to class members.
The district court approved the mandatory class action settlement, the
United States Court of Appeals for the Fifth Circuit affirmed.
(b) Holding
The United States Supreme Court reversed. “We hold that applicants for
contested certification on this rationale [limited fund theory under Fed. R. Civ. P.
23(b)(1)(B)] must show that the fund is limited by more than the agreement of the
parties, and has been allocated to claimants belonging within the class by a
process addressing any conflicting interests of class members.” 119 S. Ct. at
2302.
(c) Rationale
(a) Historical Limited Fund Mandatory
Class Actions
In Dickinson v. Burnham, 197 F.2d 973 (2d Cir.), cert. denied, 344 U.S.
875 (1952), investors furnished $600,000 to save a failing company. The
monies were misused, but a pool remained of secret profits on the investment.
To allocate the fund, the court approved the class action.
In Guffanti v. National Surety Co., 196 N.Y. 452 (1909), the defendant
converted money furnished him for steamship tickets, but had posted a $15,000
bond before being adjudicated bankrupt. The appellate court sustained the
equitable class suit citing the limited fund subject to pro rata distribution.
In early creditors’ bills equity would order a master to call for all creditors
to prove their debts, to take account of the entire estate, and to apply the estate
in payment of the debts. See 1 J. Story, Commentaries on Equity Jurisprudence
§§ 547, 548 (I. Redfield 8 th rev. ed. 1861).
(b) Criteria for Limited Fund Class Actions
under Fed. R. Civ. P. 23(b)(1)(B).
There are 3 requirements. First, the fund must be insufficient to pay all
the claims when the maximum fund is compared to the maximum potential
claims. The limited fund creates the necessity for the class action.
Second, the whole of the inadequate fund must be devoted to the
overwhelming claims. Otherwise, the defendant may procure a deal better than
available to claimants in seriatim litigation.
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Third, all claimants must be treated equitably among themselves and it is
assumed the class includes all claimants. Pro rata distribution provides the
required fairness.
(c) Potential Constitutional Impediments to
Application of Fed. R. Civ. P. 23 (b)(1) to
Mass Torts
Fed. R. Civ. P. 23 requires no notice requirement beyond what’s required
under Fed. R. Civ. P. 23(e) 227 for settlement purposes. This may or may not be
curable by notice to the class of the fairness hearing and an opportunity to be
heard and to participate in the litigation. Next, the settlement implicates the class
members’ rights to jury trials under the Seventh Amendment. Here, class
members were limited to verdicts of $500,000 or less as compared to
multimillion-dollar verdicts in some asbestos jury trials. Next, with limited
exceptions, a person should not be bound by a judgment in litigation in which he
is not a party or has not been served. The exceptions include situations in which
the person’s interests are adequately represented by someone with the same
interests or where a special remedial scheme exists expressly foreclosing
successive litigation as in bankruptcy or probate.
(d) Causes of Reversal
The trial court “failed to demonstrate that the fund was limited except by
the agreement of the parties, and it showed exclusions from the class and
allocations of assets at odds with the concept of limited fund treatment and the
structural protections of Rule 23(a) explained in Amchem.” 228 119 S. Ct. at 2316
(footnote added).
In Amchem, the Supreme Court was asked to reverse the Third Circuit’s
reversal of the district court’s approval of an asbestos class action settlement
under Fed. R. Civ. P. 23(b)(3). To satisfy the requirements of Rule 23(b)(3), the
requirements of Rule 23(a) 229 must be satisfied and (1) common questions must
227 Fed. R. Civ. P. 23(e) provides:
Dismissal or Compromise. A class action shall not be dismissed
or compromised without the approval of the court, and notice of
the proposed dismissal or compromise shall be given to all
members of the class in such manner as the court directs.
228 Amchem Products, Inc. v. Windsor, 521 U.S. 591 (1997).
229 Fed. R. Civ. P. 23(a) provides:
Prerequisites To A Class Action. One or more members of a
class may sue or be sued as representative parties on behalf of
all only if (1) the class is so numerous that joinder of all members
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predominate over any questions affecting only individual members and (2) class
resolution must be superior to other available methods for the fair and efficient
adjudication of the controversy. Amchem, 521 U.S. at 615.
The Supreme Court ruled common questions did not predominate. For
instance, some claimants manifested injury from asbestos and some were simply
exposed. Some had cancer. Some had only asymptomatic pleural changes.
Moreover, the state law applicable to each varied. Amchem, 521 U.S. at 624.
The Supreme Court also ruled the settlement flunked the adequacy-ofrepresentation
requirement in Fed. R. Civ. P. 23(a)(4). This focuses on both the
plaintiffs and the competency and conflicts of class counsel. 521 U.S. at 625,
625n.20. The plaintiffs had diverse medical conditions, yet no subclasses were
established to deal with the conflicts between the currently injured who want
generous immediate payments and the exposure-only plaintiffs who want an
inflation protected fund for the future. 521 U.S. at 626. The settlement embodied
implicit allocation decisions. For instance, there would be no adjustments for
inflation. Only a few claimants a year could opt out. And, loss-of-consortium
claims were extinguished with no compensation. 521 U.S. at 627. There was no
assurance the named plaintiffs operated under a proper understanding of their
representational responsibilities. 521 U.S. at 628.
On the issue of whether constitutional notice could ever be given to
exposure-only claimants, the Supreme Court opined: “In accord with the Third
Circuit, however, see 83 F.3d at 633-634, we recognize the gravity of the
question whether class action notice sufficient under the Constitution and Rule
23 could ever be given to legions so unselfconscious and amorphous.” 521 U.S.
at 628. Notably, the limited fund situation makes this problem more soluble
because the appointment of a guardian ad litem to obtain for future claimants
what might otherwise cease to exist (i.e., their fair share of the fund) has no real
alternative.
The limited fund finding is comprised of two elements, namely, the
maximum claim amount and the maximum fund amount. Here, the fund assets
would be limited if the total of demonstrable claims would render the insurers
insolvent or if the policies had limits less than the total claims, in either case by
an amount more than Fibreboard’s value. 230 119 S. Ct. at 2317. To determine
is impracticable, (2) there are questions of law or fact common to
the class, (3) the claims or defenses of the representative parties
are typical of the claims or defenses of the class, and (4) the
representative parties will fairly and adequately protect the
interests of the class.
230 The Supreme Court observed the district court “at least” heard evidence and
made an independent finding of Fibreboard’s value, unlike its adoption of the
parties’ agreement as to the limited insurance funds. 119 S. Ct. at 2317n.28.
But, the Supreme Court also noted that while an investment banker testified to
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the amount of insurance available, the lower courts used the settlement values
($1.55 billion or $2 billion). The Supreme Court ruled:
“Settlement value is not always acceptable, however.
One may take a settlement amount as good evidence of the
maximum available if one can assume that parties of equal
knowledge and negotiating skill agreed upon the figure through
arms-length bargaining, unhindered by any considerations
tugging against the interests of the parties ostensibly
represented in the negotiation. But no such assumption may be
indulged in this case, or probably in any class action settlement
with the potential for gigantic fees. 30 (FN 30: In a strictly
rational world, plaintiffs’ counsel would always press for the limit
of what the defense would pay. But, with an already enormous
fee within counsel’s grasp, zeal for the client may relax sooner
than it would in a case brought on behalf of one claimant.) In
this case, certainly, any assumption that plaintiffs’ counsel could
be of a mind to do their simple best in bargaining for the benefit
of the settlement class is patently at odds with the fact that at
least some of the same lawyers representing plaintiffs and the
class had also negotiated the separate settlement of 45,000
pending claims, 90 F.3d at 969-970, 971, the full payment of
which was contingent on a successful global settlement
agreement or the successful resolution of the insurance
coverage dispute (either by litigation or by agreement, as
eventually occurred in the Trilateral Settlement
Agreement)…Class counsel thus had great incentive to reach
any agreement in the global settlement negotiations that they
thought might survive a rule 23(e) fairness hearing, rather than
the best possible arrangement for the substantially unidentified
global settlement class….The resulting incentive to favor the
known plaintiffs in the earlier settlement was, indeed, an
egregious example of the conflict noted in Amchem resulting
from divergent interests of the presently injured and future
claimants….”
119 S. Ct. at 2317-2318. The federal courts have used different methods to
determine whether a fund is limited in cases involving mass torts. Some courts
hold the proponents must demonstrate allowing the adjudication of individual
claims will inescapably compromise the claims of absent class members, while
others require a showing of only a substantial probability (less than a
preponderance, but more than a mere possibility) that claims will exceed fund
assets. 119 S. Ct. at 2316n.26.
Fibreboard’s $235 million value, the company was acquired in 1997 for $515
million plus $85 million in assumed debt. Id.
325

Thus, the Supreme Court demonstrated acute insights into the workings of
the industry of plaintiffs’ attorneys in the asbestos industry. In short, these
attorneys obtain percentages of all collections. They have obvious economic
motivations to collect sooner rather than later. Therefore, from any fund, they
would have an economic motivation to allocate more to the current claimants
than the future claimants because they would receive the money faster. This
conflict led the Supreme Court to reverse the approval of a settlement these
attorneys made between the present and future claimants, both represented, at
least in part, by the same attorneys.
Additionally, the Supreme Court ruled the settlement fell short in respect of
the inclusiveness of the class. The class excluded 45,000 pending claims as well
as claimants who had previously sued Fibreboard and withdrew their claims with
a right to reassert them on development of an asbestos related malignancy. The
Supreme Court observed the 45,000 excluded claims may be as much as a third
of the class and were represented by class counsel. 119 S. Ct. at 2319. The
Supreme Court left open the issue of how far a mandatory settlement class may
be depleted by prior dispositions of claims and still qualify as such a class. 119
S. Ct. at 2319. The Supreme Court also mentioned without deciding that it might
make a difference if the excluded claimants were receiving comparable benefits.
Id. Here, that was not the case.
The Supreme Court also overturned the settlement due to the lack of
fairness of distribution within the class. When it is not possible to do a straight
forward pro rata distribution, the settlement “must seek equity by providing for
procedures to resolve the difficult issues of treating such differently situated
claimants with fairness as among themselves.” 119 S. Ct. at 2319. First, there
were no homogenous subclasses of present claimants and future claimants with
separate attorneys for each. The named plaintiffs were not named until after the
settlement was reached. The adequacy of the named plaintiffs and counsel are
both important for fairness purposes. Id. Moreover, the class distribution
scheme did not differentiate between persons exposed to asbestos before and
after 1959 even though the insurance policies did not cover liability for exposure
after 1959. Therefore, claimants exposed before 1959 had more valuable
claims, but did not receive more under the settlement.
The Supreme Court rejected the argument that all claimants’ common
interests in a global settlement override the foregoing deficiencies. The court
ruled the settlement can not under Fed. R. Civ. P. 23(e) override Fed. R. Civ. P.
23(a) and 23(b). 119 S. Ct. at 2320-2321.
Without deciding whether the settlement’s failure to provide claimants with
all the assets available for payment of claims would itself be fatal, the Supreme
Court wrote it must identify the issue so its decision would not be misleading.
119 S. Ct. at 2321. Here, Fibreboard was left with virtually its entire net worth.
The Supreme Court noted:
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“We need not decide here how close to insolvency a limited fund
defendant must be brought as a condition of class certification.
While there is no inherent conflict between a limited fund class
action under Rule 23(b)(1)(B) and the Bankruptcy Code, cf., e.g.,
In re Drexel Burnham Lambert Group, Inc., 960 F.2d 285, 292
(CA2 1992), it is worth noting that if limited fund certification is
allowed in a situation where a company provides only a de
minimis contribution to the ultimate settlement fund, the
incentives such a resolution would provide to companies facing
tort liability to engineer settlements similar to the one negotiated
in this case would, in all likelihood, significantly undermine the
protections for creditors built into the Bankruptcy Code….”
119 S. Ct. at 2321n.34.
In response to the trial court’s contention that the enormous transaction
costs saved may justify Fibreboard’s retention of its net worth, the Supreme
Court wrote: “If a settlement thus saves transaction costs that would never have
gone into a class member’s pocket in the absence of settlement, may a credit for
some of the savings be recognized in a mandatory class action as an incentive to
settlement? It is at least a legitimate question, which we leave for another day.”
119 S. Ct. at 2321.
(e) Certain Unanswered Questions
The Supreme Court questioned without deciding whether Fed. R. Civ. P.
23 (b)(1)(B) is applicable to liquidate actual and potential tort claims. Also, the
court raised without deciding whether the class claims were nonjusticiable under
Article III based on the exposure-only claimants being without injury in fact and
hence without standing to sue.
On the first issue, the Supreme Court cautioned that use of the mandatory
settlement class for mass torts must at least be done without abridging Rule 23
or allowing the rules to abridge substantive law contrary to the Rules Enabling
Act, 28 U.S.C. § 2072(b); with any deviations from the historical paradigm of
limited fund settlements to be justified by the proponents. 119 S. Ct. at 2312,
2322-2323. On the second issue, the court did not provide guidance, but
expressly took into account the future claims when determining they deserved
separate attorneys and were prejudiced by having a settlement negotiated for
them by attorneys hoping to be paid on present claims. 119 S. Ct. at 2319-2320.
(d) Potential Applications of Fibreboard
i. Companies for which Chapter 11 Is Not a Solution or Is Too
Dangerous
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Both Fibreboard and Amchem proposed class action settlements hinged
on obtaining injunctions against or releases from the filing of claims included in
the settlement classes, except for the expressly permitted opt-outs in Amchem.
See 521 U.S. at 608; 119 S. Ct. at 2305. This is the essence of the exercise of
the bankruptcy power under which claimants are enjoined from prosecuting their
discharged claims. The Supreme Court has charted the permissible boundaries
of the exercise of the bankruptcy power by ruling Congress: “may prescribe any
regulations concerning discharge in bankruptcy that are not so grossly
unreasonable as to be incompatible with fundamental law….” Hanover National
Bank v. Moyses, 186 U.S. 181, 192 (1902). Laws on the subject of bankruptcies
may include laws tending to further distribution of a debtor’s property and
discharge of a debtor’s debts which are not so unreasonable and arbitrary as to
deny due process.” Kuehner v. Irving Trust Co., 299 U.S. 445, 450 (1937).
Clearly, a pro rata distribution as mentioned in Fibreboard satisfies these
standards if applicable to all creditors of like rank.
Some companies fear they will not survive chapter 11. The causes range
from potential customer or supplier reactions, to costs, to special contractual
problems untouched by the Bankruptcy Code. For instance, some companies
have assets in foreign countries subject to seizure by creditors not subject to the
automatic stay. Other companies have derivative contracts with bankruptcy
termination clauses fully enforceable under Bankruptcy Code sections 555, 556,
559, and 560.
ii. Use of Fed. R. Civ. P. 23(b)(1)(B) in place of Chapter 11?
Fibreboard itself provides Rule 23(b) should not be used to undermine
chapter 11. 119 S. Ct. at 2321n.34. Thus, settlements leaving material portions
of a company for its old equity would likely not qualify for limited fund treatment
absent special circumstances. But, restructurings under which bondholders
obtain the bulk of the company and all other debt (i.e., secured debt, trade debt,
etc.) is paid in full may well qualify.
35. Can Single Asset Cases Be Confirmed Over An Undersecured Lender's Rejection, Or
Not?
A. Impact of Bankruptcy Abuse Prevention and Consumer Protection Act of 2005
for Cases Commenced on and after October 17, 2005
i. 11 U.S.C. § 362(d)(3) provides:
“(d) On request of a party in interest and after notice and a hearing,
the court shall grant relief from the stay provided under subsection
(a) of this section, such as by terminating, annulling, modifying, or
conditioning such stay—
(3) with respect to a stay of an act against single asset real estate
under subsection (a), by a creditor whose claim is secured by an
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interest in such real estate, unless, not later than the date that is 90
days after the entry of the order for relief (or such later date as the
court may determine for cause by order entered within that 90-day
period) or 30 days after the court determines that the debtor is
subject to this paragraph, whichever is later –
(A) the debtor has filed a plan of reorganization that has a
reasonable possibility of being confirmed within a reasonable time;
or
(B) the debtor has commenced monthly payments that –
(i) may, in the debtor’s sole discretion,
notwithstanding section 363(c)(2) be made from rents or other
income generated before, on, or after the date of the
commencement of the case by or from the property to each creditor
whose claim is secured by such real estate (other than a claim
secured by a judgment lien or by an unmatured statutory lien); and
(ii) are in an amount equal to interest at the then
applicable nondefault contract rate of interest on the value of the
creditor’s interest in the real estate…”
11 U.S.C. § 101(51B) provides:
“(51B) The term ‘single asset real estate’ means real property
constituting a single property or project, other than residential real
property with fewer than 4 residential units, which generates
substantially all of the gross income of a debtor who is not a family
farmer and on which no substantial business is being conducted by
a debtor other than the business of operating the real property and
activites incidental.”
ii. Consequences of 11 U.S.C. § 362(d)(3)
Absent an order extending time for cause under 11 U.S.C. § 362(d)(3) or
a finding the debtor has proposed a plan having a reasonable possibility of being
confirmed in a reasonable time, single asset real estate cases will only be
prosecutable if the debtor makes monthly payments in the amount of the
nondefault contract interest on the mortgagee’s secured claim. This adds a
significant cash flow burden to the debtor’s estate during the chapter 11 case and
frequently before new financing is arranged.
In In re Deep River Warehouse, Inc., 2005 Bankr. LEXIS 1090 (Bankr.
M.D. N.C. 2005), the debtor proposed a plan and in response to the mortgagee’s
request for stay relief proposed commencing payments more than 6 months after
the chapter 11 case commenced. The court denied stay relief finding the
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mortgagee was at most slightly undersecured and confirmation could be made
possible by various possibilities.
Significantly, the monies paid to a mortgagee having an undersecured
claim should not constitute interest because section 506 does not provide for
interest on undersecured claims. United Savings Ass’n of Texas v. Timbers of
Inwood Forest Assocs., Ltd., 484 U.S. 365 (1988). Rather, the payments will
reduce the principal balance of the mortgage.
When the mortgagee’s secured claim is the sum of the value of the real
property and the encumbered rents not spent on maintaining the real property,
the use of the rents to make payments to the mortgagee will reduce the amount
of the secured claim by reducing the unused cash collateral.
B. Which Cases Cannot Be Confirmed?
Bankruptcy Code section 1129(a)(10) requires at least one impaired class
of claims to accept a plan (without counting insider acceptances) before it can be
confirmed, unless no classes are impaired. Therefore, in a classic single asset
real estate case with a dissident mortgagee having an unsecured deficiency
claim and a group of trade creditors holding unsecured claims, the question
becomes whether there is some legal way to construct an accepting, impaired
class.
i. Potential Treatments of Secured Claims.
The mortgagee's secured claim must be in its own class. If the secured
claim is fully repaid in cash by refinancing, it remains impaired and may reject the
plan, unless it is also paid postpetition interest and all other valid charges in
which case it appears unimpaired under section 1124(1). Neither will its
unimpairment under section 1124(2) satisfy the requirement of Bankruptcy Code
section 1129(a)(10). If the secured claim is compelled to accept a new secured
note in the amount of the secured claim, having an interest rate that will yield the
present value of the face amount of the secured claim as of the plan's effective
date (i.e., cramdown under section 1129(b)(2)(A)), the involuntary treatment
imposed on the mortgagee will not satisfy section 1129(a)(10). Finally, if the
secured claimant makes the section 1111(b)(2) election, it can still reject the plan
as a secured claim. The election will simply require that the face amount of the
note be in the full amount of the claim, with the interest rate adjusted so that the
present value of the note does not exceed the secured amount of the claim.
ii. Potential Treatments of Unsecured Claims.
The undersecured mortgagee will hold an unsecured deficiency claim
unless (i) it makes the section 1111(b)(2) election, or (ii) the collateral security is
to be sold under the plan within a reasonable time pursuant to a written contract
or at an auction at which the mortgagee can credit bid the full amount of its claim,
not simply the amount of its secured claim. See Bankruptcy Code section
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1111(b)(1)(A); T-H New Orleans Limited Partnership v. Financial Security
Assurance, Inc. (In re T-H New Orleans Limited Partnership), 10 F.3d 1099 (5th
Cir. 1993); In re National Real Estate Ltd. Partnership II 104 B.R. 968, 974
(Bankr. E.D. Wis. 1989); In re Western Real Estate Fund, Inc., 75 B.R. 580, 589
(Bankr. W.D. Okla. 1987), reversed in part on other grounds, see In re Western
Real Estate Fund, Inc., 109 B.R. 455, 457 (Bankr. W.D. Okla. 1990); Georgetown
Park Apartments, Ltd., 103 B.R. 248 (Bankr. S.D. Cal. 1989); Tampa Bay
Associates, Ltd. v. DRW Worthington, Ltd. (In re Tampa Bay Associates, Ltd.),
864 F.2d 47 (5th Cir. 1989); In re DRW Property Co. 82, 57 B.R. 987 (Bankr.
N.D. Tex. 1986); In re Woodridge North Apts., Ltd., 71 B.R. 189 (Bankr. N.D. Cal.
1987).
If the mortgagee does have an unsecured claim, then if it is classified with
the unsecured trade claims, it can cause the class of unsecured claims to reject if
it is more than one-third of the total amount of unsecured claims that vote.
Bankruptcy Code section 1126(c). Therefore, the first question becomes
whether the unsecured deficiency claim can be classified separately from the
other unsecured claims. If it can be separately classified, then the class of
unsecured trade claims may accept the plan and satisfy the section 1129(a)(10)
requirement.
Notably, now that section 1124 no longer provides that payment in full in
cash of an unsecured claim (without interest) renders it unimpaired, it is possible
to offer creditors cash payments in the full prepetition amounts of their claims and
have them deemed impaired for voting purposes.
C. Can the Mortgagee's Unsecured Deficiency Claim be Separately Classified?
According to most courts, the cardinal rule is: "Thou shalt not classify
similar claims differently in order to gerrymander an affirmative vote on a
reorganization plan...." In re Greystone III Joint Venture, 948 F.2d 134, 139 (5th
Cir. 1991), withdrawn in part, reinstated in part on reh'g (5th Cir. 1992),231 cert.
denied, 113 S.Ct. 72 (1992). Accord Boston Post Road Limited Partnership v.
FDIC (In re Boston Post Road Limited Partnership), 21 F.3d 477 (2d Cir.
1994)(absent a legitimate business reason for separately classifying mortgagee's
deficiency claim and trade claims held by claimants not essential to debtor's
future, separate classification is unlawful), cert. denied, 513 U.S. 1109 (1995);
John Hancock Mutual Life Insurance Co. v. Route 37 Business Partner
Associates (In re Route 37 Business Partner Associates), 987 F.2d 154, 23 BCD
231In re Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994), takes issue with Greystone,
observing:
"Thus, we cannot accept the proposition implicit in Greystone that separate
classification of a § 1111(b) claim is nearly conclusive evidence of a debtor's
intent to gerrymander an affirmative vote for confirmation...."
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1537 (3d Cir. 1993); In re 500 Fifth Avenue Associates, 148 B.R. 1010, (Bankr.
S.D.N.Y. 1993), aff'd No. 93 Civ. 844 (May 21, 1993) (Freeh, D.J.)(stayed
pending appeal to Second Circuit); In re One Times Square Associates, 159 B.R.
695 (Bankr. S.D.N.Y. 1993); In re Pine Lake Village Apartment Co., 19 B.R. 819
(Bankr. S.D.N.Y. 1982); cf. In re Lumber Exchange Bldg. Ltd. Partnership, 968
F.2d 647 (8th Cir. 1992); In re Bryson Properties, XVIII, 961 F.2d 496 (4th Cir.
1992). In the instance of a nonrecourse, undersecured mortgage which only has
a deficiency claim by virtue of Bankruptcy Code section 1111(b), the deficiency
claim can not be separately classified on the basis that it does not exist outside
bankruptcy while the trade claims do. In re 500 Fifth Avenue Associates, 148
B.R. 1010 (Bankr. S.D.N.Y. 1993), aff'd No. 93 Civ. 844 (May 21, 1993) (Freeh,
D.J.)(stayed pending appeal to Second Circuit); In re D&W Realty Corp., 165
B.R. 167 (S.D.N.Y. 1994). reversing 156 B.R. 140 (Bankr. S.D.N.Y. 1993)
(section 1111(b)(1)(A) mandates separate classification of mortgagee's
deficiency claim).
Conversely, based on any of three theories, some courts allow or even
mandate separate classification of the nonrecourse mortgagee's section 1111(b)
deficiency claim. One theory is that the section 1111(b) deficiency claim is not
substantially similar to the other unsecured claims because the deficiency claim
will not exist in other chapters of the Bankruptcy Code. Another theory is that the
best interests test in Bankruptcy Code section 1129(a)(7) can almost never be
satisfied if the deficiency claim is in the same class as the other unsecured
claims because it dilutes what would be available to the other unsecured claims
that would not have to share with it in chapter 7. The third theory is that the
mortgagee was not supposed to have a veto power over every single asset
chapter 11 plan. In re Woodbrook Associates, 19 F.3d 312 (7th Cir.
1994)(Chapter 11 case dismissed for cause because plan was not confirmable
and caused unreasonable delay: "We find that, at least where the debtor is a
partnership comprised of a fully encumbered single asset, the legal rights of a §
1111(b) claimant are substantially different from those of a general unsecured
claimant. Accordingly, we hold that §§ 1111(b) and 1122(a) not only permit but
require separate classification of HUD's § 1111(b) unsecured deficiency claim in
Class 4.); In re SM 104 Ltd., 160 B.R. 202, 218 & n. 35 (Bankr. S.D. Fla.
1993)(voting incentive rationale "is highly persuasive when viewed in light of the
logic underlying § 1129(a)(10)... [which was] intended not to give the real estate
lobby a veto power, but merely to require 'some indicia of creditor support' for
confirmation of a proposed Chapter 11 plan").
In re D&W Realty Corp., 156 B.R. 140 (Bankr. S.D.N.Y. 1993),reversed,
165 B.R. 127 (S.D.N.Y. 1994), focuses on the language in Bankruptcy Code
section 1111(b)(1)(A) that provides that a nonrecourse claim is allowed as a
recourse claim unless "the class of which such claim is a part elects, by at least
two-thirds in amount and more than half in number of allowed claims of such
class, application of paragraph (2) of this subsection." In turn, section 1111(b)(2)
provides that if the election is made, the entire claim is treated as a secured
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claim. D&W Realty Corp. reasons that the nonrecourse claim must be classified
separately from other unsecured claims because other unsecured claims are not
granted the 1111(b)(2) election. Therefore, the "class" referred to in section
1111(b)(1)(A) must be a different class than the class of other unsecured claims.
The fallacy of D&W Realty Corp. is its assumption that the "class" referred
to in section 1111(b)(1)(A) is the class of unsecured deficiency claims. It is not.
Rather, the class referred to in section 1111(b)(1)(A) is the class of secured
claims. It is that class that is entitled to elect to be treated as having a secured
claim in the amount of the value of the collateral security or a secured claim in
the total amount of the mortgage debt. If that class makes the 1111(b)(2)
election, there is no unsecured deficiency claim to be put in any class. If it does
not make the election, then the unsecured deficiency claim becomes classifiable
in accordance with applicable law. The error of D&W Realty Corp. is its
contention that the right to elect section 1111(b)(2) treatment is a right granted to
unsecured claims rather than to secured claims.
Moreover, the entire purpose of section 1111(b) was to grant the
undersecured mortgagee the power to prevent confirmation of a plan in a single
asset real estate case over the mortgagee's rejection, so as to prevent a
reoccurrence of In re Pine Gate Associates, Ltd., 2 B.C.D. 1478 (Bankr. N.D. Ga.
1976). By providing the nonrecourse mortgagee with a recourse deficiency
claim, section 1111(b) enables the mortgagee to cause the class of unsecured
claims to reject the plan so that there will be no class of impaired claims
accepting the plan as required for confirmation by Bankruptcy Code section
1129(a)(10). The bankruptcy court's opinion in D&W Realty Corp. creates the
result opposite to what section 1111(b) was intended to create.
Notably, when there is a good business reason for separate classification,
the nonrecourse mortgagee's deficiency claim can be separately classified, as
recognized by the same circuit that decided Greystone. Heartland Federal
Savings & Loan Assoc. v. Briscoe Enterprises, Ltd. (In re Briscoe Enterprises,
Ltd.), 994 F.2d 1160 (5th Cir. 1993). In Briscoe the first mortgagee's deficiency
claim and the city's deficiency claim were separately classified, but given the
same treatment. By that means, an accepting class of impaired claims was
created because the city accepted. The court applied the clearly erroneous
standard, apparently viewing classification as a fact question, and found the
bankruptcy court was not clearly erroneous in approving the separate
classification because the city's $20,000 per month rental assistance was
essential to the underlying project. Significantly, the test applied by the Fifth
Circuit was whether "the debtor's ongoing business would be affected if separate
classification were not permitted." 994 F.2d at 1167.
Similarly, in Steelcase Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th
Cir. 1994), the court affirmed confirmation of a plan separately classifying one
claim arising from a guaranty given by the debtor because (i) the claim was being
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litigated, (ii) the claim was partially secured by assets of an affiliate of the debtor,
and (iii) to the extent the claim were allowed, it would be paid faster than all other
unsecured claims. All claims in the case were supposed to obtain full payment
plus interest over time.
Regrettably, the United States Supreme Court did not rule on the
classification issue because it was not raised in Bank of America v. 203 North
LaSalle Street Partnership, 119 S. Ct. 1411, 1415n.7 (1999).
D. When Separate Classification is Allowed, Unfair Discrimination Is Not.
In the unlikely event that the mortgagee's unsecured deficiency claim is
separately classified for a valid reason, the plan proponent must still obtain an
accepting, impaired creditor class. If the plan proponent must offer the class of
trade claims 50 cents on the dollar to accept, it can not offer the mortgagee's
deficiency claim 2 cents on the dollar. That treatment would run afoul of the
prohibition against unfair discrimination in respect of a dissenting class (the
mortgagee's deficiency class). Bankruptcy Code section 1129(b)(1). Not so,
however, in the Seventh Circuit. There, based on the rationale of In re
Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994), the mortgagee’s
nonrecourse deficiency claim must be separately classified, and because the
deficiency claim would receive nothing in chapter 7, it is okay to pay it 16% of its
claim while other trade claims are paid in full, and in fact, artificially impaired to
create an impaired accepting class. In re 203 N. LaSalle Street Partnership, 126
F.3d 955 (7th Cir. 1997), reversed on other ground, Bank of America v. 203
North LaSalle Street Partnership, 119 S. Ct. 1411 (1999).
In the unlikely event that the mortgagee's unsecured deficiency claim is
separately classified for a valid reason, the plan proponent must still obtain an
accepting, impaired creditor class. If the plan proponent must offer the class of
trade claims 50 cents on the dollar to accept, it can not offer the mortgagee's
deficiency claim 2 cents on the dollar. That treatment would run afoul of the
prohibition against unfair discrimination in respect of a dissenting class (the
mortgagee's deficiency class). Bankruptcy Code section 1129(b)(1). Not so,
however, in the Seventh Circuit. There, based on the rationale of In re
Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994), the mortgagee’s
nonrecourse deficiency claim must be separately classified, and because the
deficiency claim would receive nothing in chapter 7, it is okay to pay it 16% of its
claim while other trade claims are paid in full, and in fact, artificially impaired to
create an impaired accepting class. In re 203 N. LaSalle Street Partnership, 126
F.3d 955 (7th Cir. 1997).
E. When The Obstacles of Separate Classification and Unfair Discrimination are
Overcome, The New Value Obstacle Remains.
Assuming the debtor can separately classify the trade claims and the
mortgagee's deficiency claim to create an accepting class for purposes of
Bankruptcy Code section 1129(a)(10), and assuming the mortgagee deficiency
class rejects the plan, but that there is no unfair discrimination, the absolute
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priority rule remains an obstacle. Pursuant to Bankruptcy Code section
1129(b)(2)(B)(ii), no class junior to the rejecting mortgagee deficiency class can
“receive or retain” any property under the plan “on account of such junior claim or
interest” unless the mortgagee's deficiency claim is paid in full. Therefore, the
only basis on which the debtor may potentially retain ownership of the
reorganized debtor is based on the dictum in Case v. Los Angeles Lumber
Products Co., 308 U.S. 106 (1939), suggesting old owners my retain property by
making a new contribution of value in money or money’s worth, necessary for the
reorganization and in an amount commensurate with the value of the reorganized
entity. Notably, not all courts believe the new value exception survived
enactment of the Bankruptcy Code, and in any event, it is clear that promises of
future labor (sweat equity) do not count as new value. Norwest Bank
Worthington v. Ahlers, 485 U.S. 197 (1988). In Bank of America v. 203 North
LaSalle Street Partnership, 119 S. Ct. 1411, 1417 (1999), the Supreme Court
again wrote it was not deciding “whether the statute includes a new value
corollary or exception” because the plan at issue would not satisfy the statute.
The Supreme Court did opine that while it has doubt old equity is the only source
of significant capital for reorganizations, “old equity may well be in the best
position to make a go of the reorganized enterprise and so may be the party
most likely to work out an equity-for-value reorganization.” 119 S. Ct. at 1421.
The circuit courts are split as to whether the new value exception survived.
Compare Bonner Mall Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner
Mall Partnership), 2 F.3d 899 (9th Cir. 1993)(new value exception survived and is
actually not an exception to the absolute priority rule under which an exclusive
warrant to repurchase the debtor is granted to old equity before creditors are paid
in full, but rather a corollary principle describing limitations of the rule), cert.
granted, 114 S. Ct. 681 (1994); with Coltex Loop Central Three Partners, L.P. v.
BT/SAP Pool C Associates, L..P. (In re Coltex Central Three Partners, L.P.), 138
F.3d 39 (2d Cir. 1998) (debtor’s principals’ exclusive right to retain the debtor’s
property on making a capital contribution is itself property and is on account of
principals’ prior subordinated position in the debtor when the market for the
property is not adequately tested and other creditors unsuccessfully seek to
propose chapter 11 plan), and Travelers Ins. Co. v. Bryson Properties, XVIII (In
re Bryson Properties, XVIII), 961 F.2d 496, 504 (4th Cir.), cert. denied, 113 S.Ct.
191 (1992) (granting old equity the exclusive right to purchase equity in the
reorganized debtor violates Bankruptcy Code section 1129(b)(2)(B)(ii)).
Bonner Mall recites the requirements from Case v. Los Angeles Lumber,
308 U.S. 106, 121-122 (1939), to satisfy the new value "corollary principle," 2
F.3d at 906, as follows: The new value must be new, substantial, money or
money's worth, and necessary for a successful reorganization, and reasonably
equivalent to the value or interest received. 2 F.3d at 908. The court's rationale
for holding the principle survived enactment of the Bankruptcy Code and does
not violate the rule in section 1129(b)(2)(B)(ii) that equity shall not receive
335

property "on account of" its old interests if a more senior rejecting class is not
paid in full, is that there is not a sufficient level of causation. 2 F.3d at 899.
Only money paid by the effective date counts as new value, and a
$32,000 payment amounting to less than 0.5% of the unsecured claims does not
pass the substantial test. Liberty National Enterprises v. Ambanc La Mesa
Limited Partnership (In re Ambanc La Mesa Limited Partnership), 115 F.3d 650
(9th Cir. 1997).
In Steelcase Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th Cir. 1994),
the court held that once the bankruptcy court finds a plan is feasible and will pay
each dissenting class in full as of the effective date, it is not a violation of the
absolute priority rule to distribute property and funds to the debtor's owner after
the effective date, but prior to completion of a stream of payments to the rejecting
classes.
In Coltex, the mortgagee held a $7.2 million mortgage claim against a 10story
office building, the debtor’s sole asset. The bankruptcy court found the
property was worth $2.95 million. There were tax claims of $355,000 and
unsecured trade claims of $123,000. The case was filed the day of the
foreclosure sale.
New Value. Under the chapter 11 plan, the debtor’s principals
would fund $3.4 million, which would pay the mortgagee’s secured claim, the tax
claims (which the mortgagee alleged were artificially impaired), and the 10%
distribution to unsecured claims. Significantly, $3.4 million of the new value was
gratuitous in the sense that the debtor’s principal could have given the
mortgagee a nonrecourse secured note instead of cash. Presumably, at some
early point the debtor would be able to obtain a new first mortgage in an amount
of at least 80% of the secured claim amount. Thus, the court may not have
viewed the entire $3.4 million as new value.
Exclusivity. The mortgagee was prepared to propose its own plan
under which unsecured claims would be paid in full and the principals would
receive nothing. The bankruptcy court denied the mortgagee’s request to
terminate exclusivity to enable that plan to be filed.
Marketing. In the year prior to confirmation, the debtor had
approached only 1 lender and it rejected the debtor’s request for financing. No
mortgage brokers or outside consultants were retained to help locate other
sources of equity or financing, and the principals did not consider bringing in new
equity partners to fund the plan.
Holding. “In conclusion, we hold that any plan providing for old
equity to contribute new capital to fund a Chapter 11 reorganization cramdown
plan, is limited by the various requirements for confirmation set forth in 11 U.S.C.
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§ 1129, including 11 U.S.C. § 1129(b)(2)(B)(ii). Each such plan must be
examined to make sure that old equity does not retain or receive property of the
debtor “on account of” its prior subordinate position. Where no other party seeks
to file a plan or where the market for the property is adequately tested, old equity
may be able to demonstrate that it can meet the requirements of 11 U.S.C. §
1129 and that, in essence, it receives nothing on account of its prior position.
This is not such a case. This was an insider’s plan for the benefit of insiders. It
was of little benefit to any creditor, and the major creditor was stymied in its
legitimate attempts to obtain the value of its claims. The plan was not fair and
equitable.” Coltex, 138 F.3d at 45.
The Crux of Coltex. Coltex holds the debtor’s principals were
retaining property “on account of” their prior subordinate position in the debtor.
Conversely, it can be argued they retained property because of exclusivity, and
not due to their prior position. Notably, that Congress granted the debtor
exclusivity in Bankruptcy Code section 1121 can be interpreted to show
Congress’ intent to allow such a new value plan, as clearly as the words “on
account of” can be used to show it was overturning the new value exception.
Interestingly, Coltex, in part, finds it persuasive that unsecured claims would
have done better under the mortgagee’s plan. But, the National Bankruptcy
Review Commission routes the new value to paying down the mortgagee’s
secured claim to an 80% loan to value ratio, infra. By aligning the new value with
the secured and tax claims, the Coltex plan creates an impression there was little
or no new value because, presumably, the property can be mortgaged to
replenish a good portion of the $3.4 million new value infusion.
The Coltex plan, however, may have been more realistic than the
mortgagee’s plan which would pay unsecured claims in full, other than insider
claims and the mortgagee deficiency claim. The Second Circuit is somewhat
contradictory when it reasons the property should have been exposed to market
forces, but also emphasizes the mortgagee’s plan would pay unsecured claims.
If the market had shown the property would sell for more than $2.95 million, then
the mortgagee’s secured claim would have increased. There still would be no
value available for unsecured claims. Thus, the question becomes why
distributions to unsecured claimholders should matter if the claims are being paid
in accordance with their entitlements.
Let’s assume the property had been marketed and was shown to be worth
$3.5 million. If the principals had borrowed $3 million against the property and
infused the last $500,000, then there would be no issue as to whether the
mortgagee obtained fair value. Next, let’s assume the principals infuse another
$125,000 to pay all the unsecured claims other than the mortgagee’s deficiency
claim. If the mortgagee objects, would the payment of unsecured trade claims be
unfair discrimination under section 1129(b)(1)? Would the principals’ retention of
the property be on account of their prior subordinated position in the debtor?
337

F. Have You Thought About Bankruptcy Code Section 1111(b)(1)(A)(ii) Lately?
Cramdown Attorneys Have.
i. Bankruptcy Code Section 1111(b)(1)(A)(ii) provides:
A claim secured by a lien on property of the
estate shall be allowed or disallowed under section
502 of this title the same as if the holder of such claim
had recourse against the debtor on account of such
claim, whether or not such holder has such recourse,
unless--
(i) The class of which such claim is a
part elects, by at least two-thirds in
amount and more than half in number of
allowed claims of such class, application
of paragraph (2) of this subsection; or
(ii) such holder that does not have
such recourse and such property is
sold under section 363 of this title or
is to be sold under the plan.
ii. The Issue
1.
is whether a debtor can deprive its mortgagee of a deficiency
claim with which it can cause unsecured claims to reject the
plan, by providing that the mortgaged property will be
operated and ultimately sold by the debtor sometime in the
future. The question is whether a hoped for sale after
confirmation qualifies as a "sale under the plan" to extinguish
the deficiency claim.
2. Background.
Virtually all the section 1111(b)(1) decisions agree that the Bankruptcy
Code grants deficiency claims to undersecured nonrecourse mortgagees to
prevent the recurrence of the result in In re Pine Gate Associates, Ltd., 2 B.C.D.
1478 (Bankr. N.D. Ga. 1977) (cramdown in undersecured, nonrecourse, single
asset, real estate case). Taken to its logical extreme, if any sale under a plan
deprives the mortgagee of its deficiency claim, then all chapter 11 plans should
provide for sales ten or twenty years in the future as mechanisms to circumvent
the law.
3. Sword and Shield Uses of § 1111(b)(1)(A)(ii)
a. An Additional Reason to Obtain Stay Relief.
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Paradoxically, some courts will grant stay relief to a mortgagee if there will
be assets left in the estate after the mortgagee's foreclosure and without
foreclosure the mortgagee's nonrecourse claim will convert into a recourse
deficiency claim that will consume the bulk of the remaining estate.
In In re Canal Place Ltd. Partnership, 921 F.2d 569, 578 (5th Cir. 1991),
the Fifth Circuit affirmed a bankruptcy court's order granting stay relief, based in
part, on the beneficial effect of using foreclosure to eliminate a recourse claim
against the remaining estate.
In Canal Place the bankruptcy court granted stay relief to the first
mortgagees on the grounds there was concededly no equity (the deficiency was
$130 million) and "the implicit objective of the Plan is to delay foreclosure by
Aetna and Travelers until the Debtor can either sell Canal Place or wait for the
return of the favorable office and retail market." 921 F.2d at 577. Notably, the
principals were offering to infuse $18.4 million into the property.
Notably, to buttress its result, the bankruptcy court had ruled that by
granting stay relief to the first mortgagees it was improving prospects for other
unsecured claimholders because they will obtain more from the few
unencumbered assets when the first mortgagees are deprived of their deficiency
claims under section 1111(b)(1). In sum and substance, the court held that a
transfer of the collateral security by foreclosure would deprive the mortgagees of
their deficiency claims if the foreclosure were before or contemporaneous with
confirmation. The court was not asked whether the deficiency claims would be
lost if the transfers were delayed for up to two years after confirmation, as here.
iii. Mortgagor Cannot Gamble with Mortgagee's Collateral.
In In re Western Real Estate Fund, Inc., 75 B.R. 580, 589 (Bankr. W.D.
Okla. 1987), reversed in part on other grounds, see In re Western Real Estate
Fund, Inc., 109 B.R. 455, 457 (Bankr. W.D. Okla. 1990), the court wrote it "is not
required to, and does not, determine the length of time which may be allowed to
transpire after confirmation before a proposed sale or the degree of specificity
required in the terms and conditions of any proposed sale in order to permit the
application the ' 1111(b)(1)(A)(ii) exception to the 'preferred status' afforded by '
1111(b)(1)(A)." The court denied confirmation of the plan because, among other
things, it deprived the mortgagee of its deficiency claim based on a
postconfirmation sale "at some unspecified future time, to some unspecified
purchaser, at an unspecified price and on unspecified terms." 75 B.R. at 589.
After the foregoing decision, the debtor amended its plan to provide the first
mortgagees with secured and unsecured claims. The court confirmed the plan
and the first mortgagees appealed on the ground the interest rate was too low.
On appeal, the first mortgagees won. Because the debtor could not afford to pay
a higher interest rate, it again amended its plan to provide for the abandonment
of the collateral security to the first mortgagees. The debtor contended the
339

abandonment was equivalent to a sale under the plan, which would deprive the
first mortgagees of their deficiency claims. The first mortgagees argued they
should have deficiency claims because the abandonment was occurring two and
one half years after confirmation. Significantly, the court disagreed, not because
a sale could occur two and one half years after confirmation, but rather because
as to the first mortgagees they were obtaining their collateral on confirmation.
The court reasoned the reversal had undone the first confirmation and started the
clock all over again. 109 B.R. at 466.
In In re Georgetown Park Apartments, Ltd., 103 B.R. 248 (Bankr. S.D. Cal.
1989), the debtor tried to eliminate the mortgagee's deficiency claim by proposing
a plan calling for a sale of the property four years after confirmation, with interest
payments to be made from confirmation to sale. The court denied approval of
the disclosure statement because the plan was not confirmable. The court
reasoned that Congress granted nonrecourse mortgagees deficiency claims to
prevent the debtor from speculating with the mortgagee's collateral value. Only if
the collateral is sold will the mortgagee's lien be satisfied before equity holders
realize any value. The court opined that:
103 B.R. at 250.
it may well be that the exception is only available in
those circumstances where the debtor has proposed
a sale (under ' 363 or pursuant to a plan) at a public
auction or under a binding contract of sale to an
identifiable buyer at a time substantially
contemporaneous with confirmation....
1. The Mortgagee Can Credit Bid its Deficiency Claim.
In Tampa Bay Associates, Ltd. v. DRW Worthington, Ltd. (In re Tampa
Bay Associates, Ltd.), 864 F.2d 47 (5th Cir. 1989), the first mortgagee claimed it
was entitled to a deficiency claim against the estate after it foreclosed its
nonrecourse undersecured mortgage. The mortgagee reasoned it was entitled to
a deficiency claim unless the property had been sold under Bankruptcy Code
section 363 or under the plan. Neither had occurred.
The Fifth Circuit held the mortgagee was not entitled to a deficiency claim
because (i) a foreclosure sale is similar to a section 363 sale, and (ii) after the
foreclosure sale the mortgagee lacked the secured claim necessary to invoke
section 1111(b) in the first place. En route to its holding, the Fifth Circuit
enunciated the following test:
"... Through these exceptions [section 363 sale and
sale under plan] it appears that Congress intended to
protect the nonrecourse undersecured creditor only if
such a creditor is not permitted to purchase the
340

collateral at a sale or if the debtor intends to retain the
collateral after bankruptcy and not repay the debt in
full..."
864 F.2d at 50 (emphasis supplied). The Fifth Circuit cited with approval In re
DRW Property Co. 82, 57 B.R. 987 (Bankr. N.D. Tex. 1986), and In re Woodridge
North Apts., Ltd., 71 B.R. 189 (Bankr. N.D. Cal. 1987). In DRW, in the context of
ruling on a disclosure statement, the court held a mortgagee loses its deficiency
claim if it forecloses on its property. 57 B.R. at 993. The court also opined that
the "safeguards placed in the Code for non-recourse creditors were placed there
to protect the creditor where the Debtor intends to keep the property for sale or
use in the reorganization process..." Id. (emphasis in original).
In In re Woodridge North Apts., Ltd., 71 B.R. 189 (Bankr. N.D. Cal. 1987),
the court was asked to grant stay relief. In reviewing the debtor's proposed plan
to determine if an effective reorganization were possible the court found the
debtor was trying to deprive the undersecured mortgagee of its deficiency claim
by providing for a sale of the collateral to a new entity under the plan, which
entity's stock would be owned by the reorganized debtor. The court precluded
that result by ruling the mortgagee must be allowed to credit bid at the sale. That
would prevent confirmation. Therefore, the court granted stay relief. 71 B.R. at
193.
John Hancock Mutual Life Insurance Co. v. California Hancock, Inc. (In re
California Hancock, Inc.), 88 B.R. 226 (B.A.P. 9th Cir. 1988), also held the
mortgagee must be allowed to credit bid at the sale. There, the debtor proposed
a plan attempting to eliminate the mortgagee's deficiency claim by selling the
collateral to a third party subject to the secured portion of the mortgage claim
while requiring the buyer to grant the reorganized debtor a net profits interest in
the collateral.
Notably, the court ruled the purpose of allowing the mortgagee to credit
bid was to enable it to obtain "the full amount of any value in the property..." 88
B.R. at 231 (emphasis in original). The court ruled that the retention by the
debtor of the profits interest caused the mortgagee to obtain less than the full
value. Id.
In re 222 Liberty Associates, 108 B.R. 971 (Bankr. E.D. Pa. 1990), also
holds the undersecured mortgagee must be allowed to credit bid at a sale of
collateral under the plan.
iv. No Credit Bidding after Electing § 1111(b)(2).
1.
Finally, In re Broad Associates Limited Partnership, 125 B.R. 707 (Bankr.
D. Conn. 1991), holds a creditor making the section 1111(b)(2) election does not
have the right to credit bid at a sale subject to the lien (as opposed to free and
clear of the lien). In re Kent Terminal Corp., 166 B.R. 555, 564 (Bankr. S.D.N.Y.
341

1994). The section 1111(b)(2) election is an election to have an undersecured
mortgage claim be treated as a fully secured claim. For example, a mortgage of
$3 million secured by collateral worth $2 million would be treated as a $3 million
secured claim if the election is made. But, the plan need only pay the mortgagee
a stream of payments totaling $3 million, while having a present value of $2
million. When making the election, the mortgagee waives its right to have a $2
million secured claim entitled to a present value of $2 million, and an unsecured
$1 million deficiency claim entitled to whatever unsecured claims would obtain in
liquidation.
Broad Associates may be explained on the ground that once a mortgagee
waives its deficiency claim by making the election, it should not be entitled to
take it back by credit bidding. Indeed the court notes the plan may not be
confirmable if the election were not available and the mortgagee could not credit
bid. 21 B.C.D. at 1061. But, at a foreclosure sale, the mortgagee would be able
to credit bid.
“[T]he holder of an undersecured claim cannot elect fully secured status
under a plan that calls for the sale of his collateral…’because of the secured
party’s right to bid in the full amount of his allowed claim at any sale of collateral
under section 363(k).’” In re 183 Lorraine Street Associates, 198 B.R. 16, 27-28
(E.D.N.Y. 1996)(quoting 124 Cong. Rec. H11,103-104 (daily ed. Sept. 28, 1978);
124 Cong. Rec. S17,420 (daily ed. Oct. 6, 1978)).
Interestingly, Lorraine takes the position in dictum that only the trustee or
debtor can sell property under Bankruptcy Code section 363(b), so that a creditor
must effectuate a sale under section 1123(b)(4). 198 B.R. at 21n.15.
One debtor proposed a plan hoping for a rezoning of his property within 2
years of confirmation. Absent rezoning, the mortgagee could take the deed in
lieu of foreclosure. Otherwise, the debtor could either pay the mortgagee the
amount of its secured claim over time, or sell the property to pay off the note,
without allowing the mortgagee to credit bid. In the context of granting a motion
for stay relief, the court ruled credit bidding is the mortgagee’s protection against
judicial undervaluation of the collateral, and the plan is unconfirmable when it
deprives the mortgagee of its section 1111(b)(2) election and its right to credit bid
at the sale. In re 183 Lorraine Street Associates, 198 B.R. 16, 27-28 (E.D.N.Y.
1996).
G. Bank of America v. 203 North LaSalle Street Partnership, 119 S. Ct. 1411
(1999)
i. Facts.
In Bank of America v. 203 North LaSalle Street Partnership, 119 S. Ct.
1411 (1999), the bankruptcy court had determined the mortgagee held a $54.5
million secured claim and a $38.5 million deficiency claim. The debtor’s chapter
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11 plan provided the bank a 7 to 10 year secured note for its secured claim and
installments equal to 16% (present value) of its unsecured claim which was
classified separately from other unsecured claims. Trade claims held by
outsiders were approximately $90,000 and would be paid in full without interest
on the plan’s effective date. The debtor’s interest holders would retain ownership
of the reorganized debtor for a present value of $4.1 million and would thereby
avoid approximately $20 million of taxes chargeable if the mortgagee foreclosed.
ii. Issue
“The issue in this Chapter 11 reorganization case is whether a
debtor's prebankruptcy equity holders may, over the objection of a
senior class of impaired creditors, contribute new capital and
receive ownership interests in the reorganized entity, when that
opportunity is given exclusively to the old equity holders under a
plan adopted without consideration of alternatives. We hold that old
equity holders are disqualified from participating in such a "new
value" transaction by the terms of 11 U.S.C. § 1129(b)(2)(B)(ii),
which in such circumstances bars a junior interest holder's receipt
of any property on account of his prior interest.”
119 S. Ct. at 1414.
iii. Holding
The Supreme Court, without deciding whether the new value exception
exists, ruled the plan violated § 1129(b)(2)(B)(ii) in any event because the
interest holders were retaining interests on account of their preexisting interests
notwithstanding that the mortgagee rejected the plan in its capacity as the holder
of the deficiency claim which was the only claim in its class. 119 S. Ct. at 1417.
“…Under a plan granting an exclusive right, making no
provision for competing bids or competing plans, any
determination that the price was top dollar would necessarily
be made by a judge in bankruptcy court, whereas the best
way to determine value is exposure to a market….This is a
point of some significance, since it was, after all, one of the
Code’s innovations to narrow the occasions for courts to make
valuation judgments, as shown by its preference for the
supramajoritarian class creditor voting scheme in §
1126(c)…In the interest of statutory coherence, a like disfavor
for decisions untested by competitive choice ought to extend
to valuations in administering subsection (b)(2)(B)(ii) when
some form of market valuation may be available to test the
adequacy of an old equity holder’s proposed contribution.”
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“Whether a market test would require an opportunity to
offer competing plans or would be satisfied by a right to bid for
the same interest sought by old equity, is a question we do
not decide here. It is enough to say, assuming a new value
corollary, that plans providing junior interest holders with
exclusive opportunities free from competition and without
benefit of market valuation fall within the prohibition of §
1129(b)(2)(B)(ii).”
Bank of America v. 203 North LaSalle Street Partnership, 119 S. Ct. 1411, 1423-
24 (1999) (Souter, J.) (citations and footnotes omitted).
iii. Rationale
The Supreme Court expounded the policies to be served by chapter 11
as: “preserving going concerns and maximizing property available to satisfy
creditors.” 119 S. Ct. at 1421. Then, it explained “[c]ausation between the old
equity’s holdings and subsequent property substantial enough to disqualify a plan
would presumably occur on this view of things whenever old equity’s later
property would come at a price that failed to provide the greatest possible
addition to the bankruptcy estate, and it would always come at a price too low
when the equity holders obtained or preserved an ownership interest for less
than someone else would have paid. A truly full value transaction, on the other
hand, would pose no threat to the bankruptcy estate not posed by any
reorganization, provided of course that the contribution be in cash or be
realizable money’s worth, just as Ahlers required for application of Case’s new
value rule.” 119 S. Ct. at 1421-22 (footnotes and citations deleted).
The Supreme Court ruled the exclusive right to buy equity is property and
cited authority for the proposition that options to buy interests at market values
trade for a positive price. 119 S. Ct. at 1422. The court also explained the old
interest holder’s rights to buy interests in the reorganized debtor were exclusive
and therefore were property even though the debtor’s exclusive opportunity to
propose a plan is not itself property within the meaning of subsection
1129(b)(2)(B)(ii). The logic was that upon confirmation of the plan the old
interest holders were in the same position they would have been in had they
exercised an exclusive option under the plan to buy the equity in the reorganized
entity, or contracted to purchase it from a seller who had first agreed to deal with
no one else. 119 S. Ct. at 1422.
Interestingly, the Supreme Court recognized leverage as property. The
court explained that the very fact that liquidation would trigger tax liability for the
old equity may be valuable for others “precisely as a way to keep the Debtor from
implementing a plan that would avoid a Chapter 7 liquidation.” 119 S. Ct. at
1422.
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The significance of the Supreme Court’s observations is they explain why
the bankruptcy court’s having determined the mortgagee’s secured claim does
not eliminate the possibility of there being additional value in the estate. In other
words, the mortgagee’s secured claim equals the value of the real property. But,
the debtor’s old interest holders may still find value in controlling the reorganized
entity to avoid tax liability. That element of value is not part of the mortgagee’s
collateral.
Accordingly, the Supreme Court ruled that to avoid violating §
1129(b)(2)(B)(ii), there must be a market test. “Whether a market test would
require an opportunity to offer competing plans or would be satisfied by a right to
bid for the same interest sought by old equity, is a question we do not decide
here. It is enough to say, assuming a new value corollary, that plans providing
for junior interest holders with exclusive opportunities free from competition and
without benefit of market valuation fall within the prohibition of §
1129(b)(2)(B)(ii).” 119 S. Ct. at 1424.
iv. How Does North LaSalle Work?
How can the prepetition interest holders compete with the mortgagee?
Clearly, at an auction of the property free and clear of the mortgage lien, the
mortgagee can bid up to the amount of the sum of its secured claim and
deficiency claim because the amount bid, less administrative expenses, will all go
back to the mortgagee. If this is the test, the old interest holders can’t win!
Alternatively, perhaps the test is whether a third party would bid for the
property (subject to the secured claim) more than the present value of $4.1
million that the old interest holders were offering. Indeed the Supreme Court
suggested as much when it wrote: “Whether a market test would require an
opportunity to offer competing plans or would be satisfied by a right to bid for
the same interest sought by old equity, is a question we do not decide here.
119 S.Ct. at 1424 (emphasis supplied). Notably, the Supreme Court rendered its
ruling in the context of figuring out whether the amount of new value was
sufficient. Accordingly, it would be illogical to assume the Supreme Court
intended that the mechanism for determining whether the old interest owners are
paying sufficient new value would be a mechanism to ensure that they would be
unsuccessful.
The Supreme Court also alluded to the possibility of having competing
plans. How is the court supposed to decide which plan to confirm?
v. Aftermath In North LaSalle
On remand, the bankruptcy court terminated exclusivity and was called on
to determine whether (a) a prepetition subordination agreement between the first
and second mortgagees applied to the deficiency claim of the first mortgagee’s
nonrecourse mortgage, and (b) whether the first mortgagee could enforce the
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provision of the subordination agreement under which the first mortgagee could
vote the second mortgagee’s claim in the chapter 11 case. Bank of America v.
North LaSalle Street Limited Partnership (In re 203 North LaSalle Street
Partnership), 246 B.R. 325 (Bankr. N.D. Ill. 2000).
The court held the subordination agreement did apply to the nonrecourse
deficiency claim, reasoning the rule of explicitness in In re Time Sales Fin. Corp.,
491 F.2d 841,844 (3d Cir. 1974), probably did not survive enactment of the
Bankruptcy Code, except to the extent state law would require the subordination
agreement to be explicit about rights granted in a chapter 11 case. 246 B.R. at
330 (citing Chemical Bank v. First Trust of New York (In re Southeast Banking
Corp.), 156 F.3d 1114 (2d Cir. 1998)).
On the voting issue the court ruled the senior claimant could not enforce
the provision of the subordination agreement entitling the senior claimant to vote
the subordinated debt. 246 B.R. at 330-332. The court reasoned that (a) “it
would defeat the purpose of the Code to allow parties to provide by contract that
the provisions of the Code should not apply,” 246 B.R. at 331, (b) the definition of
subordination shows it affects priorities, but not voting rights, and (c) Bankruptcy
Rule 3018(c) requires the claimholder to vote. Id.
The decision does not cite jurisprudence showing a subordination is an
equitable assignment of a claim to the senior claimant. In re Itemlab Inc., 197 F.
Supp. 194 (E.D.N.Y. 1961); In re Credit Indus. Corp, 366 F.2d 402 (2d Cir. 1966);
In re Alda Commercial Corp., 300 F.Supp. 294 (S.D.N.Y. 1969); Meinhard, Greeff
& Co. v. Brown, 199 F.2d 70 (4 th Cir. 1952); Walker v. Brown, 165 U.S. 654
(1987) (equitable lien). Additionally, parties can easily transfer voting rights by
having the junior claimant take a junior participation in the senior creditor’s claim.
H. The Answer.
Except in jurisdictions following Woodbrook, whenever the dissident,
undersecured mortgagee's deficiency claim in a single asset case would equal
more than one-third of total general unsecured claims, the debtor can only
confirm a plan if:
• the mortgagee is a junior mortgagee and a senior mortgagee is
impaired and accepts the plan;
• the plan validly provides for sale of the collateral and deprives
the nonrecourse mortgagee of a deficiency claim under
Bankruptcy Code section 1111(b)(1)(A)(ii);
• the plan somehow validly separately classifies the mortgagee's
deficiency claim and other unsecured claims and the other
claims accept the plan without there being unfair discrimination
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and with a valid invocation of the new value exception! A valid
invocation must not violate § 1129(b)(2)(B)(ii). At a minimum,
this will require that junior interest holders only retain or obtain
interests in the reorganized debtor based on a competitive
process exposing the property to market valuation; or
• the plan provides for a sale of the collateral within the meaning
of Bankruptcy Code section 1129(b)(2)(A)(ii).
•
36. Prejudgment Attachment, As an Equitable Remedy, Is Beyond the Federal Courts’
Power
A. Grupo Mexicano v. Alliance Bond Fund, 527 U.S. 308 (1999) (5-4)
i. Facts.
Alliance purchased approximately $75 million of $250 million of notes
issued by Grupo to help it finance the construction of a toll road in Mexico.
Because of problems in the Mexican economy, the Mexican government agreed
to issue Toll Road Notes in the amount of approximately $309 million to Grupo to
help it finance the toll road. After the failure of negotiations with its noteholders,
Grupo announced it would place $17 million of its Toll Road Notes in trust for
employees and would transfer its right to receive $100 million of Toll Road Notes
back to the Mexican Government to pay back taxes. Grupo was also negotiating
with its bank creditors owed $256 million. Alliance accelerated its notes and
requested a preliminary injunction preventing Grupo from transferring its rights to
receive the Toll Road Notes.
Finding Grupo at risk of insolvency if not already insolvent, and finding its
only substantial asset was its entitlement to Toll Road Notes and that it planned
to use them to satisfy Mexican creditors to the exclusion of Alliance, the district
court enjoined Grupo from dissipating, disbursing, transferring, conveying,
encumbering or otherwise distributing any right to the Toll Road Notes, if Alliance
posted a $50,000 bond (which it did).
While the preliminary injunction was on appeal, final judgment was issued
in favor of Alliance, and the injunction was made permanent.
ii. Holding.
Reversed. “…[T]he equitable powers conferred by the Judiciary Act of
1789 did not include the power to create remedies previously unknown to equity
jurisprudence. Even when sitting as a court in equity, we have no authority to
craft a ‘nuclear weapon’ of the law like the one advocated here.” 119 S. Ct. 1961
at 1973.
iii. Rationale.
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Reinvigorating its holding of 139 years earlier, the Supreme Court explained:
“’Our laws determine with accuracy the time and manner in
which the property of a debtor ceases to be subject to his
disposition, and becomes subject to the rights of his creditor.
A creditor acquires a lien upon the lands of his debtor by a
judgment; and upon the personal goods of the debtor, by the
delivery of an execution to the sheriff. It is only by these liens
that a creditor has any vested or specific right in the property
of his debtor. Before these liens are acquired, the debtor has
full dominion over his property; he may convert one species of
property into another, and he may alienate to a purchaser.
The rights of the debtor, and those of a creditor, are thus
defined by positive rules; and the points at which the power of
the debtor ceases, and the right of the creditor commences,
are clearly established. These regulations cannot be
contravened or varied by any interposition of equity.’”
119 S. Ct. 1961 at 1970n.6 (quoting Moran v. Daawes, 1 Hopk. Ch. 365, 367
(N.Y. 1825), as quoted in Adler v. Fenton, 65 U.S. 407, 24 HOW 407, 411-412
(1861).
iv. Consequences
According to the Supreme Court, “[t]he law of fraudulent conveyances and
bankruptcy was developed to prevent such conduct; an equitable power to
restrict a debtor’s use of his unencumbered property before judgment was not.”
119 S. Ct. at 1970. The ultimate prejudgment remedy is bankruptcy because it
prevents the debtor from transferring property to pay prepetition debts without
court approval. In fact, the Supreme Court observed that Alliance was no the
only creditor and “[b]ecause any rational creditor would want to protect his
investment, such a remedy might induce creditors to engage in a ‘race to the
courthouse’ in cases involving insolvent or near-insolvent debtors, which might
prove financially fatal to the struggling debtor.” 119 S. Ct. at 1974. Interestingly,
the Court nowhere mentioned whether a bankruptcy remedy was available and
likely effective to Alliance.
37. Can a Chapter 11 Debtor in Possession Assume An Executory Contract If It Cannot
Assign It?
A. Bankruptcy Code section 365(c)(1) provides:
(c) The trustee may not assume or assign an
executory contract or unexpired lease of the
debtor, whether or not such contract or lease
348

prohibits or restricts assignment of rights or
delegation of duties; and
(1)(A) applicable law excuses a party, other
than the debtor, to such contract or lease from
accepting performance from or rendering
performance to an entity other than the debtor
or the debtor in possession whether or not such
contract, or lease, prohibits or restricts
assignment of rights or delegation of duties; and
(1) such party does not consent to such
assignment or assumption.
B. Bankruptcy Code section 365(f)(1) provides:
(f)(1) Except as provided in subsection (c) of this section,
notwithstanding a provision in an executory contract or
unexpired lease of the debtor, or in applicable law, that
prohibits, restricts, or conditions the assignment of such
contract or lease, the trustee may assign such contract or
lease under paragraph (2) of this subsection; except that the
trustee may not assign an unexpired lease of nonresidential
real property under which the debtor is an affected air carrier
that is the lessee of an aircraft terminal or aircraft gate if
there has occurred a termination event.
C. Perlman v. Catapult Entertainment, Inc. (In re Catapult Entertainment, Inc.),
165 F.3d 747 (9 th Cir. 1999)
i. Facts
Perlman granted two nonexclusive licenses to Catapult to exploit
technologies for online gaming networks. Subsequently, Catapult commenced a
chapter 11 case and proposed a plan calling for the assumption of the licenses.
The bankruptcy court confirmed the plan and approved the assumption. Under
Ninth Circuit precedent, federal patent law is “applicable law” under section
365(c) and nonexclusive patent licenses are “personal and assignable only with
the consent of the licensor.” Everex Systems v. Cadtrak Corp. (In re CLFC, Inc.),
89 F.3d 673, 680 (9 th Cir. 1996).
ii. Holding
“[W]here applicable nonbankruptcy law makes an executory contract
nonassignable because the identity of the nondebtor [sic] party is material, a
debtor in possession may not assume the contract absent consent of the
349

nondebtor party.” 165 F.3d 747, 1999 U.S. App. LEXIS 1072, at 24. (It appears
the court misspoke and intended to refer to the identity of the debtor being
material, not the nondebtor).
iii. Rationale and Irrationale
The court reasoned the plain language of section 365(c) bars assumption
(absent consent) when an executory is not assignable due to the identity of the
contracting party because the plain language does not produce a “patently
absurd result.” But, the court reached a patently absurd result. Catapult had 2
licenses and improved its balance sheet with the help of chapter 11. If Catapult’s
license was enforceable prior to bankruptcy, how is it not absurd that Catapult
should lose its license after it improves its balance sheet?
The court rebuts the argument that its reading of section 365(c)(1) effaces
section 365(f)(1) by agreeing with other circuits that section 365(c)(1) only
impairs the operation of section 365(f)(1) when “applicable law” prohibits
assignment on the rationale the identity of the contracting party is material to the
agreement. In re James Cable Partners, 27 F.3d 534 (11 th Cir. 1994); In re
Magness, 972 F.2d 689 (6 th Cir. 1992).
The court discounts the legislative history because it believes the statute
is not ambiguous and the legislative history actually relates to a bill that was
ultimately superceded by the actual legislation. The legislative history, however,
shows Congress intended exactly the opposite of the court’s holding. It provides:
“This amendment makes it clear that the
prohibition against a trustee’s power to assume
an executory contract does not apply where it
is the debtor that is in possession and the
performance to be given or received under a
personal service contract will be the same as if
no petition had been filed because of the
personal service nature of the contract.”
H.R. Rep. No. 1195, 96 th Cong., 2d Sess. § 27(b) (1980).
To rebut the policy argument that its reading of section 365(c)(1) is contrary to
sound bankruptcy policy, the court simply rules that “Congress is the policy
maker, not the courts.” Notably, numerous courts have held section 365(c)(1)
should be interpreted based on the “actual test” (i.e., is the debtor in possession
actually assigning the contract to a third party, which assignment would run afoul
of applicable law?), rather than the “hypothetical test” (i.e., if the debtor in
possession attempted to assign the contract, would the assignment be permitted
under applicable law?). See, e.g., Institut Pasteur v. Cambridge Biotech Corp.,
104 F.3d 489 (1 st Cir.), cert. denied, 117 S. Ct. 2511 (1997); Texaco Inc. v.
Louisiana Land and Expl. Co., 136 B.R. 658 (M.D. La. 1992); In re GP Express
350

Airlines, Inc., 200 B.R. 222 (Bankr. D. Neb. 1996); In re Am. Ship Bldg. Co., 164
B.R. 358 (Bankr. M.D. Fla. 1994); In re Fulton Air Service, Inc., 34 B.R. 568
(Bankr. N.D. Ga. 1983). Contra In re West Electronics, Inc., 852 F.2d 79 (3d Cir.
1988); In re James Cable Partners, L.P., 27 F.3d 534 (11 th Cir. 1994); In re
Catron, 158 B.R. 629 (E.D. Va. 1993), aff’d without opinion, 25 F.3d 1038 (4 th Cir.
1994).
D. In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005)
i. Facts.
Footstar, through a corporation 49% owned by Kmart and 51% owned by
Footstar, operated shoe departments in Kmart’s more than 1500 stores. Footstar
moved to assume the agreement under which the jointly owned corporation has
the exclusive right to operate a shoe department in each of Kmart’s stores.
Kmart objected to the assumption on numerous grounds. 323 B.R. at 568.
ii. Issue.
The instant decision resolved only one ground Kmart asserted to block
assumption, namely that 11 U.S.C. § 365(c)(1) bars assumption of the
agreement if the agreement can not be assigned.
iii. Holding.
Without deploying either the ‘actual test’ or the ‘hypothetical test,’ the court
held Footstar could assume the agreement even if it could not assign the
agreement. 323 B.R. at 570.
iv. Rationale.
The court ruled the plain meaning of 11 U.S.C. § 365(c)(1) does not bar
Footstar’s assumption of the agreement because it bars the “trustee” and not the
debtor in possession from assuming contracts under certain circumstances. 323
B.R. at 570.
11 U.S.C. § 1107(a) provides:
“Subject to any limitations on a trustee serving in a case under this
chapter, and to such limitations or conditions as the court
prescribes, a debtor in possession shall have all the rights, other
than the right to compensation under section 330 of this title, and
powers, and shall perform all the functions and duties, except the
duties specified in sections 1106(a)(2),(3), and (4) of this title, of a
trustee serving in a case under this chapter.”
Footstar observes that “no provision of the Banrkuptcy Code states in
words or substance that references in the Code to ‘trustee’ are to be construed to
mean’debtor’ or ‘debtor in possession.’ A basic misconception, in this Court’s
view, underlies the three Circuit Court decisions adopting the ‘hypothetical” test,
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in that all three proceed from the premise, expressed or unstated, that ‘trustee’
as used in Section 365(c)(1) means ‘debtor in possession….’” 323 B.R. at 571.
“There is no doubt that the prefatory clause in Section 1107 [subject to
any limitations on a trustee] applies to the limitation on assumption and
assignment prescribed in Section 365(c)(1). However, merely substituting
‘debtor in possession’ for ‘trustee’ in Section 365(c)(1) does not illuminate the
limitation set forth by Congress in Section 365(c)(1), nor how that limitation
should, or even can, be applied to a debtor in possession under Section
1107….’” 323 B.R. at 573. “…Indeed, where the debtor seeks to assume but not
assign a contract, to read the statute to say that ‘the debtor in possession may
not assume…any contract if…applicable law excuses [the counterparty]… from
accepting performance from or rendering performance to an entity other than the
debtor in possession…’ would render the provision a virtual oxymoron, since
mere assumption (without assignment) would not compel the counterparty to
accept performance from or render it to ‘an entity other than’ the debtor.” 323
B.R. at 573.
E. Bonneville Power Administration v. Mirant Corp. (In re Mirant Corp.), 440 F.3d 238
(5th Cir. 2006)
i. Facts
Bonneville Power Administration (“BPA”) had a prepetition executory
contract with Mirant Corp., chapter 11 debtor in possession (“Mirant”), for the
future purchase of electric power. BPA terminated the contract to trigger Mirant’s
obligation to make a liquidated damage termination payment to BPA based on
the ipso facto clause in the contract and the fact that the Anti-Assignment Act, 41
U.S.C. § 15, is applicable law that prevents the transfer of the contract for
purposes of 11 U.S.C. § 365(e)(2)(A).
Notably, BPA would not have exercised its option to utilize the contract
because the contract price was higher than market prices. But, pursuant to the
contract, its termination would lead to Mirant being liable to BPA for the
termination payment. 440 F.3d at 242.
The bankruptcy court ruled BPA was not a forward contract merchant,
thereby eliminating its rights to be insulated from the automatic stay by 11 U.S.C.
§ 556. BPA later moved for relief from the automatic stay. The bankruptcy court
ruled BPA had violated the stay by terminating the contract and ruled there were
no grounds to terminate the stay. The district court affirmed. 440 F.3d at 244-
245.
ii. Issue
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Does 11 U.S.C. § 365(e)(2)(A) permit automatic termination of the
contract because it can not be assumed due to the Anti-Assignment Act, 41
U.S.C. § 15?
iii. Holding
No. “Review of this Circuit’s law, however, reveals that our adoption today
of the actual test, in resolving the availability of § 365(e)(2)(A)’s exception, is
consistent with prior caselaw.” 440 F.3d at 249.
iv. Rationale
The Fifth Circuit formulated refreshing and compelling reasons to interpret
11 U.S.C. § 365(c)(1) and 365(e)(2)(A) to mean that an estate’s executory
contract is only barred from being assumed if the debtor or trustee is actually
attempting to transfer it to a third party under which applicable law would excuse
the nondebtor contract party from accepting performance form the third party
assignee.
“The plain text of § 365(e)(2)(A) requires an actual test for determining
whether a law is ‘applicable’ under the exception, permitting enforcement of an
ipso facto clause. According to the statute’s plain language, an executory
contract’s ipso facto clause may be enforced if ‘applicable law excuses a
[nondebtor] party… from accepting performance from or rendering performance
… to an assignee of such contract’ and that non-debtor party does not consent to
‘such assumption or assignment.’ 11 U.S.C. § 365(e)(2)(A). Congress might
have chosen the exception to apply if any law prohibited the assignment, but
instead Congress tethered the exception to ‘applicable’ law that ‘excuses a
party.’ It is axiomatic that an applicable law must apply to a set of circumstances;
BPA creates smoke and erects mirrors when it argues that a contract not
assignable as a matter of law, even if no such assignment existed in fact and no
excuse existed in fact for the nondebtor party to refuse acceptance or
performance in a particular situation, satisfies the language chosen by Congress
in drafting the § 365(e)(2)(A) exception.” 440 F.3d at 249-250.
In addition to reasoning that section 365(e)(2)(A) must refer to an actual
situation, or else one could not know if the applicable law barred assignment, the
Fifth Circuit also pointed out that the Anti-Assignment Act has many exceptions
in 41 U.S.C. § 15(b), whose applicability can only be ascertained in the context of
an actual transfer of the contract. 440 F.3d at 250-251.
Because the actual test applies, the Fifth Circuit conclude “that the
automatic stay must precede any enforcement of an ipso facto clause ultimately
permitted by a bankruptcy court under § 365(e)(2)(A). 440 F.3d at 251.
F. When Failure of Adequate Assurance Validly Defeats Assignment: In re
Fleming Companies, Inc.), 499 F.3d 300 (3d Cir. 2007)
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i. Facts
Fleming was a wholesale supplier of grocery products. It had two supply
contracts with Albertsons, one of which specified that Fleming would supply
Albertsons from its Tulsa facility which had been constructed and operated by
Albertsons. Use of the Tulsa facility allowed Albertsons to continue using its
electronic ordering systems and order codes, "recognizing the critical importance
of consistency in the competitive grocery industry." 499 F.3d at 302-303.
After Fleming commenced its chapter 11 case, it sold and assigned its
assets to C&S Acquisition LLC, and provided it the right to designate third party
purchasers for certain assets including the supply contracts with Albertsons. 499
F.3d at 303. C&S designated AWG. Fleming closed the Tulsa facility and at
AWG's direction, rejected its Tulsa lease with court approval. 499 F.3d at 303.
"Neither Albertson's nor Fleming could operate the Tulsa Facility profitably." 499
F.3d at 307. Fleming also requested an order approving its assumption and
assignment to AWG of the two supply agreements with Albertsons. Albertson
objected on the ground it would suffer a real and cognizable economic detriment
from contravention of the essence of the contract embodied in the term
"'supply…from the Tulsa Facility.'" 499 F.3d at 303. AWG countered with
evidence that "Albertsons would be able to purchase its products from AWG at
the same price and on the same terms that Albertson's expected to receive from
Fleming, pursuant to the FSA's, including freight charges." 499 F.3d at 304.
The bankruptcy court denied approval of the assignment of the Tulsa
supply contract to AWG on the ground that fulfillment from the Tulsa facility is an
essential element of the agreement. 499 F.3d at 304. The district court affirmed.
ii. Issues
Does AWG's failure to abide by the contract provision requiring supply
from the Tulsa facility constitute a failure to provide adequate assurance of future
performance for purposes of 11 U.S.C. § 365(f)(2)(B)?
Is the contract provision requiring supply from the Tulsa facility
unenforceable pursuant to 11 U.S.C. § 365(f)(1) as a de facto anti-assignment
provision.
iii. Holdings
Yes. The standard is whether the contract term is "material and
economically significant" as set forth in In re Joshua Slocum Ltd., 922 F.2d 1081,
1092 (3d Cir. 1990). 499 F.3d at 305-306. "The resolution of this dispute does
not depend on whether a term is 'economically material.' Rather, the focus is
rightly placed on the importance of the term within the overall bargained-for
exchange; that is, whether the term is integral to the bargain struck between the
parties (its materiality) and whether performance of that term gives a party the full
benefit of his bargain (its economic significance)." 499 F.3d at 306.
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No. "Section 365(f)(1) is not limited to explicit anti-assignment provisions.
Provisions which are so restrictive that they constitute de facto anti-assignment
provisions are also rendered unenforceable. See In re Rickel Home Ctrs., Inc.,
240 B.R. 826, 831-32 (D. Del. 1999)(citing Joshua Slocum, 922 F.2d at 1090)."
499 F.3d at 307.
"…We recognize that a fine line exists between reading a contractual term
as a burdensome obligation or as a de facto restriction on assignment. However,
we draw the line where a party refuses to accept part of the contract's obligation,
and as a result it cannot perform a material bargained-for term of the contract.
Here, AWG rejected the Tulsa Facility lease, and now complains that it is
impossible to comply with an integral term of the contract. This term could have
been performed by some party. It is not now an anti-assignment provision simply
because AWG made the decision not to take on a necessary burden…" 499
F.3d at 308.
iv. Implications
While the holding concluded the assignee failed to provide adequate
assurance due to its nonperformance of the contract provision requiring supply
from the Tulsa facility, Fleming acknowledges that "the bankruptcy court can
excise or refuse enforcement of terms of a contract in order to permit
assignment…" 499 F.3d at 305.
Fleming is also notable for the fact that the contract itself only provided for
supply from the Tulsa facility and did not elaborate on the continued use of
certain bar codes and protocols that were important to Albertsons. Thus, the
court went outside the contract to determine the importance of the breached
provision.
38. Devan v. Simon Debartolo Group, 180 F.3d 149 (4 th Cir. 1999).
i. Facts.
Merry-Go-Round, as chapter 11 debtor in possession, entered into a new
lease. When the case proved unsuccessful, a going out of business sale was
held during the chapter 11, and then the case converted to chapter 7. After
unsuccessfully trying to sell the lease, the chapter 7 trustee returned the keys to
the landlord and an order was entered deeming the lease rejected. The
bankruptcy court granted the landlord a chapter 11 administrative claim for
unpaid rent (subject to mitigation under state law), and the district court affirmed.
ii. Holding.
The landlord has an allowable chapter 11 damage claim for breach of the
postpetition lease. But, “[w]hether or not the future rent of a particular lease in a
particular case is entitled to administrative priority is to be determined on a case-
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y-case basis just like any other administrative claim.” 180 F.3d at 156. The test
is whether the claim arises out of a postpetition transaction and was a necessary
cost of preserving the estate. Here, it was entered into postpetition. The chapter
7 trustee’s argument that it was of no benefit to the estate after conversion does
not negate its being a necessary cost of preserving the estate because creditors
can not be induced to enter into transactions with debtors in possession if they
lose valid claims once the deal turns sour for the estate.
iii. Dangerous Dictum about Rejection
The chapter 7 trustee argued that the lease was rejected. The appellate
courts and the bankruptcy court ruled rejection only applies to leases entered into
by the debtor, and not by the debtor in possession. The reason this issue is
troubling is its implied significance. Rejection is actually nothing but a material
breach. Bankruptcy Code section 365(g). The implication of the discussion,
however, is that rejection would somehow make the lease go away, and the
damage claim along with it. There is, however, no such thing as a rejection
avoiding power.
356