Update on Corporate Bankruptcy Tax Refund Litigation
by | posted in: Bankruptcy, Bankruptcy Administration and Jurisdiction, Supreme Court | 0

By Michael L. Cook (Schulte Roth & Zabel)

Michael L. Cook

Federal courts regularly resolve consolidated corporate tax refund disputes in bankruptcy cases.  In the current economic downturn, the ownership of a large tax refund paid to an affiliated group of corporate debtors can be significant.  See, e.g., FDIC v. AmFin Corp., 757 F.3d 530, 532 (6th Cir. 2014) ($170 million refund).  If a corporate debtor’s parent owns the refund, it is part of the parent’s bankruptcy estate, and the subsidiary may be an unsecured creditor for any claimed benefits.  But if the debtor parent is an agent or trustee for its affiliates, the parent cannot use the refund to repay its creditors.

Corporate parents and their subsidiaries often file a consolidated tax return.  That enables affiliates to offset their losses against each other so as to reduce the group’s overall tax liability.  Because only the corporate parent may file a consolidated return, any refund is also paid to the parent, not to individual affiliates.  Affiliated groups, therefore, usually enter into tax sharing or allocation agreements.  These agreements – or their absence – have generated a spate of litigation.

The Circuit Courts of Appeals had been sharply split on how to resolve tax refund ownership issues until the U.S. Supreme Court resolved the issue this past February in Rodriguez v. FDIC (In re Western Bancorp, Inc.), 589 U.S. ___, 140 S. Ct. 713 (Feb. 25, 2020).  Without deciding the merits, the Court remanded the case to the Tenth Circuit, directing it to apply state law to resolve the refund ownership dispute between the parent’s bankruptcy trustee and a subsidiary.  The Supreme Court also rejected a purported federal default rule promulgated by the Ninth Circuit in 1973 that had been adopted by a few other Circuits, describing it as inappropriate federal “common lawmaking.”  On May 26, 2020, following the Supreme Court’s remand, the Tenth Circuit, applied Colorado law, construed the relevant group tax sharing agreement, and held for the subsidiary bank, now in the hands of a FDIC receiver.

This article describes relevant issues litigated over the past fifty years.  It also notes open issues that will continue to be litigated following the Rodriguez decision.

The full article is available here.

Involuntary Bankruptcy: Limited Remedy and Strong Sanctions for Abuse
by | posted in: Bankruptcy Administration and Jurisdiction, Bankruptcy Roundtable Updates | 0

By Michael L. Cook (Schulte Roth & Zabel LLP)

Involuntary bankruptcy cases are relatively rare. According to the Second Circuit “far fewer [cases] are initiated as involuntary petitions by creditors, much less a single creditor,” citing statistics from the Administrative Office of the United States Courts. In re Murray, 900.

F.3d 53, 59 (2d Cir. 2018) (less than 1/10 of 1% of all bankruptcies). The numbers suggest that involuntary bankruptcy is a limited creditors’ remedy, causing at least 5 courts of appeals to pen strong opinions in the past 4 years that define the limits of this remedy and describe the sanctions available to an aggrieved debtor.

This article shows why courts have declined to allow bankruptcy courts to become collection agencies for a single creditor when available state law remedies are adequate. The courts have also not shied away from sanctions and damage awards to discourage the filing of improper involuntary bankruptcy petitions. The Third Circuit even held that “bad faith provides an independent basis for dismissing an involuntary petition,” despite the creditors’ having met all of the “statutory requirements,” stressing the “equitable nature of bankruptcy…” In re Forever Green Athletic Fields Inc., 804 F.3d 328, 334 (3d Cir. 2015).

The article also discusses a well-reasoned bankruptcy court decision sanctioning creditors who had “abuse[d]. . . the power given to [them] to file an involuntary bankruptcy petition.” In re Anmuth Holdings LLC, 2019 WL 1421169, *1 (Bankr. E.D.N.Y. Mar. 27, 2019). In that case, after trial, the court awarded not only attorneys’ fees and costs of about $115,000, but also punitive damages of $600,000, noting the petitioning creditors’ “egregious bad faith conduct,” their “lack of remorse and threats of future involuntary petitions,” plus their “knowingly false statements.”

Involuntary bankruptcy, when used as part of a collective process for all creditors, can insure the orderly and fair distribution of a debtor’s estate. But it is hardly a mechanism for resolving a two-party dispute. Whatever an involuntary bankruptcy petition may be, it is always a risky, limited remedy.

The full article is available here.

Three Provocative Business Bankruptcy Decisions of 2018
by | posted in: Arbitration, Insider Status, Supreme Court, Trademarks | 0

By Michael L. Cook (Schulte, Roth & Zabel LLP).

The appellate courts have issued at least three provocative, if not questionable, business bankruptcy decisions in the past six months.

Lakeridge:  In March, 2018, the U.S. Supreme Court avoided the substantive merits of a 2016 split decision by the Ninth Circuit that had permitted a Chapter 11 debtor to manipulate the reorganization plan process.  Despite the Court’s narrow holding approving the Ninth Circuit’s “clear error” standard for reviewing a bankruptcy court’s fact findings, four Justices wrote two separate opinions challenging the Court’s limited review of the Ninth Circuit’s stunning decision in the face of a powerful dissent.

In re Anderson:  The Second Circuit, on March 7, 2018, held that an asserted bankruptcy discharge violation was not arbitrable due to a conflict between the Federal Arbitration Act and the Bankruptcy Code.  Two months later, though, the Supreme Court stressed that it had rejected every effort to “conjure” conflicts between the Arbitration Act and a raft of other Federal statutes.

In re Temptnology:  the First Circuit, on January 12, 2018, in a split decision, wiped out the rights of a trademark licensee, explicitly rejecting a 2012 decision by the Seventh Circuit.  The First Circuit’s majority opinion relied on a heavily criticized 1985 Fourth Circuit decision, premising its  holding on the primacy of Federal bankruptcy law over Federal trademark law and distinguishing between a statutory breach and a common law breach.

The losing parties in the First and Second Circuit cases filed petitions for certiorari in June, 2018.  Given the Circuit split in one case and the later Supreme Court arbitration ruling in the other, both cases warrant Supreme Court review.

The full article is available here.

We at the Bankruptcy Roundtable will take a break from posting this August and hope that you too will be able to get away from your desk at work. We’ll be back after Labor Day.

Merit Management v. FTI: Law Firm Perspectives
by | posted in: Avoidance, Financial Firms and Safe Harbors, fraudulent transfer, Statutory Interpretation, Supreme Court | 0

On February 27, the Supreme Court decided Merit Management Group, LP v. FTI Consulting, Inc., holding unanimously that the § 546(e) safe harbor does not protect allegedly fraudulent transfers “in which financial institutions served as mere conduits.” The Court’s decision resolves a circuit split on the reach of § 546(e). In reaching its conclusion, the Court focused on the “end-to-end transfer” that the trustee seeks to avoid, rather than any “component parts of the overarching transfer.” In FTI, because the overarching transfer was made between two parties not otherwise shielded by the safe harbor, the transfer will now fall outside the safe harbor.

As many law firms recognize, this decision will have wide-ranging implications on the finality of securities transactions effected through financial institutions, especially leveraged buyouts. Mayer Brown notes that as the decision enhances a trustee’s ability to recover fraudulent transfers, it also increases the bankruptcy estate’s leverage against recipients of pre-petition transfers. Cleary observes that “debtors or trustees may strategically frame avoidance actions in order to limit the scope of the safe harbor.” Mayer Brown concludes that the decision may also expose investors, investment funds and similar entities to fraudulent transfer litigation risks.

The bottom line, as Davis Polk notes, is that the § 546(e) safe harbor is no longer a blanket safe harbor for the recipients of transactions that pass through financial institutions. But the safe harbor will still shield financial institutions operating as escrow agents or clearinghouses, as the Court expressly stated that a financial institution under § 546(e) is protected whether the institution acts as a principal or as an intermediary.

Firms have noted that the decision also left open some ambiguities. First, Schulte Roth & Zabel writes that the Court leaves open possible arguments that any “customer” of a “financial institution” is also itself a “financial institution” under § 546(e). Second, Mayer Brown points out that the Court did not address whether the transaction at issue actually qualified as a transfer that is a “settlement payment” or made in connection with a “securities contract” under § 546(e). These ambiguities will draw the attention of defendants in future fraudulent transfer litigation.

Finally, Weil notes that the decision raises the question of how the preemption of state-law creditor remedies under § 546(e) will be applied in light of the Supreme Court’s now-narrow construction of the safe harbor.

By Jianjian Ye, Harvard Law School, J.D. 2018.

The roundtable has posted on FTI before. Some of those posts are: an analysis of the FTI oral argument, the Amici Curiae Brief of Bankruptcy Law Professors, an article by Ralph Brubaker on the meaning of § 546(e), and a roundup of law firm perspectives on the Seventh Circuit’s decision in FTI Consulting, Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).

Successor Liability in § 363 Sales
by | posted in: Bankruptcy Administration and Jurisdiction | 0

By Michael L. Cook of Schulte, Roth & Zabel LLP

Bankruptcy Code §363(f)(1) empowers a bankruptcy court to order a debtor’s assets sold “free and clear of any interest in such property.” Courts in the business bankruptcy context have been wrestling with successor liability, i.e., whether an asset buyer can be held liable for the debtor-seller’s liabilities. In 2009, the Second Circuit affirmed a bankruptcy court order barring creditors of the selling debtor from pursuing the asset buyer “for product defects in vehicles produced by” the debtor. In re Chrysler LLC, 576 F.3d 108, 123-24 (2d Cir. 2009), vacated as moot, 558 U.S. 1087 (2009) (held, successor liability claims are interests covered by a sale order under Code § 363(f)(1)).

Most recently, on July 13, 2016, the Second Circuit held that the bankruptcy court’s asset sale order in the General Motors reorganization case limiting specific pre-bankruptcy product liability claims required prior “actual or direct mail notice” to claimants when the debtor “knew or reasonably should have known about the claims.” In re Motors Liquidation Co., 2016 U.S. App. LEXIS 12848, *46-47 (2d Cir. July 13, 2016). Although the substance of the sale order may have been enforceable otherwise, “mere publication notice” to known or knowable claimants was insufficient. Had the complaining product liability claimants received adequate notice, reasoned the court, they “could have had some negotiating leverage [regarding the terms of any sale order] . . . and [a meaningful] opportunity to participate in the proceedings.” Id. at *61. The court noted a “trend…toward a more expansive reading of ‘interests in property’ which encompasses other obligations that may flow from ownership of the property.” Id., at 124, citing In re Trans World Airlines, Inc., 322 F. 3d 283, 285-90 (3d Cir. 2003).

The full memo is available here.

Texas Supreme Court Resolves Good Faith Value Defense Issue For Fifth Circuit
by | posted in: Avoidance | 0

By Michael L. Cook, Schulte Roth & Zabel LLP

The Uniform Fraudulent Transfer Act (“UFTA”) (§ 8(a)), like Bankruptcy Code 548(c), provides a complete defense for a “good faith” transferee who gives “reasonably equivalent value” when receiving cash from a fraudulent debtor. Courts have been split as to whether the good faith defense is available to transferees of Ponzi scheme debtors in the fraudulent transfer context. Thus, the Fifth Circuit held an advertising firm in an SEC receiver’s Texas fraudulent transfer suit liable for $5.9 million it had received in good faith from a Ponzi scheme debtor. Janvey v. Golf Channel Inc., 780 F.3d 641, 646-47 (5th Cir. 2015 (advertising services had “no value” to Ponzi scheme creditors although services might be “quite valuable” to creditors of a legitimate business; reversed district court’s holding that defendant “looks more like an innocent trade creditor than a salesman…extending [debtor’s] Ponzi scheme.”)

The Fifth Circuit vacated its decision three months later and certified the question of “what showing of ‘value’ under [the Texas version of the [UFTA]] is sufficient for a transferee to prove…the [good-faith] affirmative defense….” 2016 WL 1268188, at *2. The Texas Supreme Court answered the question on April 1, 2016, after discussing the statutory purpose and reviewing what other federal and state courts have done. According to the court, the UFTA “does not contain separate standards for accessing ‘value’ and ‘reasonably equivalent value’ based on whether the debtor was operating a Ponzi scheme…. Value must be determined objectively at the time of the transfer and in relation to the individual exchange at hand rather than viewed in the context of the debtor’s enterprise.”

The full memo is available here: Texas Supreme Court Resolves Good Faith Defense Issue for Fifth Circuit

Fifth Circuit Affirms Secured Lender Surcharge
by | posted in: Cramdown and Priority | 0

By Michael L. Cook, Schulte Roth & Zabel LLP

The cost of maintaining a secured lender’s collateral is usually borne by the unencumbered assets of the debtor’s bankruptcy estate.  In other words, administrative expenses of the debtor’s estate (e.g., professional fees) cannot be recovered from the secured lender’s collateral because the trustee or Chapter 11 debtor-in-possession acts for the benefit of unsecured creditors, not the secured creditor.  Bankruptcy Code §506(c) provides an exception to the general rule, however, when the trustee incurs properly identified preservation expenses that primarily benefit the secured lender if the lender has either caused or consented to the accrual of these expenses.

The Fifth Circuit, on December 29, 2015, required a secured lender to “pay the [encumbered] property’s maintenance expenses incurred while the [bankruptcy] trustee was trying to sell the property.”  In re Domistyle, Inc., 811 F.3d 691 (5th Cir. 2015).  Explaining the Code’s “narrow” and “extraordinary” exception to the general rule meant to prevent a windfall to a secured creditor at the expense of unsecured creditors, the court rejected the lender’s argument that it had not benefited from the expenses paid by the trustee to preserve the property.  On the facts of the case, the court found that all of the surcharged expenses related only to preserving the property’s value and preparing it for sale – e.g., security expenses, lawn mowing and roof repairs.

This article briefly summarizes those appellate decisions explaining why courts usually deny surcharge requests.  It also describes the few cases permitting surcharge.

The full article can be found here.

Bankruptcy Court Approves Non-Market Cramdown Rate on Momentive Secured Creditors
by | posted in: Valuation | 0

By Adam C. Harris and Karen S. Park of Schulte Roth & Zabel LLP

A recent decision from the Bankruptcy Court for the Southern District of New York provides guidance on the “fair and equitable” requirement as it relates to secured creditors in a so-called “cramdown plan.” Section 1129(b) of the Bankruptcy Code provides the means by which a Chapter 11 debtor may obtain confirmation of a plan of reorganization over the objection of a dissenting class of creditors, including secured creditors.  To cram down a plan on a class of secured creditors, the plan must be “fair and equitable” to that class.  One way to meet the “fair and equitable” requirement is to provide that the secured creditors retain their liens and receive deferred cash payments having a present value equal to the allowed amount of their secured claims.

In In re MPM Silcones LLC, 2014 WL 4436335 (Bankr. S.D.N.Y. Sept. 9, 2014), the Bankruptcy Court held that the interest rates on secured claims in a “fair and equitable plan” should be derived using a formula that starts with a “risk free” Treasury rate for similar duration instruments, and adds a risk premium generally in the range of 1%-3%.  Importantly, the Bankruptcy Court rejected the objecting secured credtiors’ arguments that the interest rates should be based on the market, i.e., the rates that would be charged to the same debtor entity for a loan having the same terms and duration by a third party lender.

The Bankruptcy Court’s ruling has been appealed.  If upheld, the decision could have far-reaching implications for distressed debt investors as well as on the availability and pricing of capital for borrowers.

Please find a full-length version of the article here.

Court of Appeals Vacates DIP Financing Order for Lender’s Lack of Good Faith
by | posted in: Bankruptcy Administration and Jurisdiction | 0

By Michael L. Cook, Schulte Roth & Zabel LLP

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The Bankruptcy Code encourages lenders to make debtor-in-possession (“DIP”) loans to Chapter 11 debtors. Because of Bankruptcy Code § 364(e), an appeal from a financing order will ordinarily be moot when the lender acted “in good faith” unless the appellant obtains a stay pending appeal.  It is hence noteworthy when appellate courts overturn DIP financing orders that were not stayed pending the appeal.

The Fifth Circuit, on September 3, 2014, vacated five bankruptcy court and district court DIP financing orders due to (1) the lender’s lack of good faith in relying on a third party’s shares of stock as collateral; and (2) the bankruptcy court’s lack of subject matter jurisdiction to authorize a lien on third party collateral subject to disputed ownership claims.   In re TMT Procurement Corp., 2014 WL 4364894 (5th Cir. Sept. 3, 2014).  On October 23, 2014 the Fifth Circuit denied the petition for panel rehearing.

The Fifth Circuit rejected the debtors’ argument that the appeals were moot because of the lower courts’ repeated findings that the lender had made the loan in good faith.  TMT provides a new test regarding the Code’s “good faith” requirement for lenders, based on the lender’s knowledge of possible insider manipulation of the bankruptcy process.  The court also found a lack of subject matter jurisdiction because the debtors’ insiders used the bankruptcy financing process to “interfere with” unrelated state court litigation against the debtors’ controlling shareholder.

The full version of the article was recently published in The Bankruptcy Strategist. It is available online here.

Another Court of Appeals Broadly Reads Settlement Payment Safe Harbor
by | posted in: Financial Firms and Safe Harbors | 0

By Michael L. Cook, Schulte Roth & Zabel LLP

The Courts of Appeals, with few exceptions, have broadly read the safe harbor defense contained in Bankruptcy Code §546(e) over the past 24 years.  It insulates a “settlement payment” or “margin payment” on a “securities contract,” “commodity contract” or “forward contract” from a trustee’s fraudulent transfer or preference claims unless the debtor makes the payment with “actual intent to hinder, delay or defraud creditors.”  Despite policy arguments by lower courts, trustees, creditors and commentators, the appellate courts have claimed to rely on the Code’s “plain language” to deny recovery.  In this Article, we discuss a recent Seventh Circuit decision that (a) reversed a district court’s “policy” decision purporting to divine Congress’s intent as to the proper application of the safe harbor provision; (b) rejected decisions by the Fifth and Ninth Circuits that refused to apply the safe harbor in the context of a Ponzi scheme; and (c) followed recent decisions of the Second and Fourth Circuits.

We discuss the Seventh Circuit’s close reading and application of the statutory language, “clearly and predictably using well established principles of statutory construction.”  Citing Supreme Court precedent, the court refused to rely on legislative history that was “neither passed by a majority of either House nor signed into law.”  Instead, the court explained why the safe harbor in the case before it yielded a sensible result, avoiding instability and uncertainty in the securities business.

We also review recent conflicting decisions in the lower courts that have resulted from imaginative attempts by lawyers to avoid application of the safe harbor defense.  Finally, we discuss another case pending in the Second Circuit that pushes the safe harbor defense to its outer limits.  That case asks (a) whether an intermediary is required in a safe harbor case, and (b) whether the defendant must show an adverse effect on financial markets.

Schulte Roth & Zabel Client Alert, April 3, 2014:  http://www.srz.com/Seventh_Circuit_Reads_Bankruptcy_Safe_Harbor_Broadly_to_Insulate_Preferential_Settlement_Payment_to_Commodity_Broker/