Loan Forgiveness as Basis for Fraudulent Transfer Claims

posted in: Chapter 11, fraudulent transfer | 0

By Jeffrey Cohen, Michael A. Kaplan, and Colleen M. Maker (Lowenstein Sandler)

Jeffrey Cohen
Michael A. Kaplan
Colleen M. Maker

In Loan Forgiveness as Basis for Fraudulent Transfer Claims, authors Jeffrey CohenMichael A. Kaplan, and Colleen M. Maker address fraudulent transfer litigation as a valuable weapon in the bankruptcy code arsenal, to target assets transferred or disposed of prior to bankruptcy with the potential to provide at least some recovery to creditors of the debtor’s estate. The article examines debt cancellation as an overlooked, but still potentially viable and valuable, basis for a fraudulent transfer cause of action.

Avoidance actions may include not only transfers with fraudulent intent, but also constructive fraud through loan forgiveness or debt cancellation. For example, if a company makes loans to subsidiaries and then formally or informally either writes off, forgives and cancels the loan prior to bankruptcy, that action has the same impact as a fraudulent transfer: creditors are left holding the bag while the beneficiary is unaffected and may even receive a windfall at the expense of the creditors.

Intercompany transfers are often considered within the ordinary course of business in a complex corporate structure, and loans to directors and officers are not rare. However, avoidance actions regarding forgiveness of debt are seldom brought due of issues of standing, resources, discovery, and cost weighed against the viability of the claim. Parties must assess whether the possibility of recovery outweighs the risks or if limited resources are better used elsewhere, perhaps through direct distribution to creditors. 

Critical Vendor Order Insufficient to Protect Critical Vendors Against Preference Claims

By Nicholas A. Koffroth (Fox Rothschild)

Nicholas A. Koffroth

In Insys Liquidation Trust v. MeKesson Corporation (In re Insys Therapeutics, Inc.), No. 21-50176 (JTD), No. 21-50176, 2021 WL 3083325 (Bankr. D. Del. July 21, 2021), the United States Bankruptcy Court for the District of Delaware reminded practitioners to exercise caution when analyzing the scope of protections offered by critical vendor orders.  The order at issue in Insys Therapeutics provided that “[t]he Debtors are authorized, but not directed . . . to maintain and administer the Customer Programs” and that “[n]othing contained . . . in this Final Order is intended to be or shall be construed as . . . (c) a waiver of any claims or causes of action that may exist against any creditor or interest holder.”  These common provisions proved critical in the Court’s holding that “something more is required” to insulate critical vendors from preference liability.

In the opinion, the Court denied a motion to dismiss the complaint brought by a group of critical vendors for three reasons.  First, the Court held that preferential payments that occur before the entry of a critical vendor order cannot be protected by a subsequent authorization to pay outstanding prepetition claims unless specifically provided in the order.  Second, the permissive language of the critical vendor order did not support the vendors’ claim that the prepetition payments would necessarily have been authorized had they been made postpetition.  Third, the critical vendor order expressly preserved the estates’ claims against critical vendors.  Additionally, the Court analyzed and rejected application of the limited “critical vendor defense.”

The article discusses the Court’s holding in greater detail and offers practical considerations for practitioners. The full article is available here.

Courts in Puerto Rico Case Adopts Alternative Test to Find Settlement Agreements Were Executory

By John Beck and Jennifer Lee (Hogan Lovells)

John Beck
Jennifer Lee

A debtor can elect to either assume or reject an executory contract under section 365 of the Bankruptcy Code. Because the Bankruptcy Code does not define “executory”, courts have historically overwhelmingly applied the “Countryman” test – which asks whether the contract parties have remaining unperformed obligations such that the failure of either party to complete performance would constitute a material breach of the agreement – to determine if a contract is executory.  In a recent decision, however, Judge Laura T. Swain, the district court judge presiding over the 2017 Puerto Rico Oversight, Management, and Economic Stability Act proceedings, declined to utilize the Countryman test and adopted the alternative “functional approach” to determine whether the agreements at issue were executory. The “functional approach” focuses on the post-petition benefit to the debtor from assumption or rejection of a contract instead of the pre-petition obligations under the contract.  The decision is the latest among a string of recent cases that have relied on non-Countryman tests to determine whether a contract is executory, with the “functional approach” emerging as the prevailing alternative. Read the full article here.

Voting Rights Assignment Unenforceable, but Subordinated Creditor Lacked Standing to Participate in Chapter 11 Plan Confirmation Process

By Dan B. Prieto (Jones Day) and Mark G. Douglas (Jones Day)

Dan B. Prieto
Mark G. Douglas

In In re Fencepost Productions Inc., 629 B.R. 289 (Bankr. D. Kan. 2021), the U.S. Bankruptcy Court for the District of Kansas recently addressed the enforceability of a provision in a pre-bankruptcy subordination agreement under which a subordinated creditor assigned to a senior creditor its right to vote on any chapter 11 plan proposed for the borrower. The bankruptcy court ruled that such a provision is not enforceable because it conflicts with the Bankruptcy Code. In a twist, however, the court concluded that the subordinated creditor lacked “prudential standing” to participate in the confirmation process because it was extremely out-of-the-money and therefore had no stake in the outcome of the case, but was attempting to assert the rights of third parties.

Courts disagree over whether an assignment of plan voting rights in an intercreditor or subordination agreement is enforceable. Regardless of the particular approach adopted by a court on this issue, the growing consensus is that agreements that seek to limit or waive junior creditors’ voting rights must contain express language to that effect. The ruling in Fencepost adds yet another chapter to the ongoing debate on this issue.

 The Fencepost court’s conclusion that the subordinated creditor lacked prudential standing would appear to be driven in part by the facts of the case, which involved a subordinated, clearly out-of-the-money creditor intent upon impeding an otherwise consensual reorganization.

The Bankruptcy Code, however, expressly provides to the contrary by, among other things, giving every “party in interest” (including creditors and interest holders, without making an exception in cases where there is no value available for distribution to them), the right to appear and be heard “on any issue” in a chapter 11 case, the right to vote on a chapter 11 plan, and the right to object to confirmation of a plan. These provisions arguably indicate that Congress intended to modify or abrogate prudential standing requirements when it enacted the Bankruptcy Code. Moreover, the “rights” any out-of-the-money creditor or shareholder would be seeking to enforce by participating in the confirmation process are arguably their own, rather than the rights of third parties.

A logical extension of the rationale articulated in Fencepost is that clearly out-of-the-money creditors or shareholders of an insolvent corporation would never have prudential standing to participate in the chapter 11 plan confirmation process. That approach would be contrary to court rulings and general practice in many chapter 11 cases.

The full article can be accessed here.

What’s Done is Done: Third Circuit Upholds Equitable Mootness and Rules Out Possibility of Individualized Relief for Timely Objecting Party

By Robert Lemons (Weil) and Patrick Feeney (Weil)

Robert Lemons
Patrick Feeney

Over the past several years, certain circuits criticized the Equitable Mootness doctrine for its lack of statutory basis and effect of avoiding review of chapter 11 plans on the merits.  However, the Third Circuit recently held in In re Nuverra Environmental Solutions, Inc. v. Hargreaves, Case No. 18-3084, 834 Fed. Appx. 729 (3d Cir. Jan. 6, 2021), that the Equitable Mootness doctrine is still alive and well.

 The Third Circuit rejected the appeal of Hargreaves, a creditor who timely objected to the chapter 11 plan and timely appealed the bankruptcy court’s entry of the plan’s confirmation order, because the plan was already substantially consummated and could not be unwound.  Further, the Third Circuit held that it could not grant Hargreaves “individualized relief” because such relief would violate Bankruptcy Code § 1123(a)(4)’s restriction on preferential treatment of class members and § 1129(b)(1)’s prohibition on unfair discrimination between classes. 

 In a concurring opinion, Judge Krause rejected the application of Equitable Mootness, finding the majority did not sufficiently analyze whether disparate treatment of creditors within a class is permissible on appeal when parties choose not to object to, or appeal confirmation of, the plan.  Judge Krause also noted that denial of the appeal on Equitable Mootness grounds precluded consideration of substantive arguments and development of the Third Circuit’s bankruptcy jurisprudence.  

While Judge Krause’s concurring opinion highlights difficulties plan objectors face when appealing plan confirmation, the majority opinion signals that Equitable Mootness is still a healthy doctrine in the Third Circuit.

The full article is available here.

Hidden Wealth Transfers in Bankruptcy Asset Sales: A Real Option Analysis

By Jordan Neyland (Assistant Professor of Law, Antonin Scalia Law School at George Mason University) and Kathryn St. John (Legal Associate, Supreme Court of Victoria)

Jordan Neyland
Kathryn St. John

One of the most important decisions that firms and courts face in bankruptcy is how to dispose of company assets. The differences between the available options are not trivial. A popular mechanism is contained in §363 of the bankruptcy code, which enables the sale of a firm’s assets with court approval. This allows for a quick sale of a firm without the need for developing and approving a plan of reorganization under Chapter 11, which can save both time and money, as the firm’s assets may otherwise sit idle or depreciate. 

Despite the benefits of a quicker resolution, 363 sales are contentious because certain classes of claimants, particularly shareholders and unsecured creditors, may lose a valuable opportunity to “wait and see” if the value of the assets will increase. Given that unsecured creditors and shareholders are last in line to get paid, they may gain if the asset value increases, whereas secured creditors prefer a quick sale to cash out before any value is potentially lost. But how much shareholder and unsecured creditor wealth is lost as the lottery-like opportunity, or “option” to wait, disappears? Without an active market for these rights, this value is unseen, yet very real.

In a recent article, we investigate the value of this option and how it affects the wealth of the parties to the bankruptcy. We use well-established financial models (i.e., Black-Scholes-Merton) to put a dollar value on how much shareholders lose with the approval of a 363 sale. We take numerical values from the seminal case In re Lionel Corp., 722 F.2d 1063 (2d Cir. 1983), which provides an ideal case study because most of the firm value was from equity holdings in a publicly traded company. 

The results are dramatic. Under certain conditions, shareholders stand to lose value worth more than one quarter of total firm assets from a 363 sale. That is, by forgoing the “wait and see” option, shareholder value decreases from around one quarter of the firm’s assets to close to zero. In the Lionel case, where the value of the firm’s assets was about $170 million, this decline in value equates to wiping out nearly $45 million in shareholder wealth. Higher priority claimants capture that value.

Even under more conservative estimates, we show that shareholder and lower-priority creditor wealth is dramatically affected by the loss of the “wait and see” option. Large amounts of wealth may be transferred from shareholders to creditors by bringing forward assets sales by just a few months.

We identify factors that are likely to influence the magnitude of the “hidden” shareholder and lower-priority creditor wealth loss. These include the volatility and value of the asset to be sold, in addition to the difference between the time required to arrange an asset sale and the time it may take to finalize a plan of reorganization. We note that the current common law rules governing 363 sales do not require consideration of this set of factors, which are potentially more value-relevant than factors, such as asset depreciation, that courts currently use to determine whether a business justification for a sale exists.

We suggest that courts consider the factors identified in our analysis and the “hidden” wealth effects when deciding whether to approve a 363 sale. This consideration should improve courts’ understanding of parties’ stakes and incentives, leading to better informed decision-making.

The full article is available here.