[Texas Two-Step and the Future of Mass Tort Bankruptcy Series] The Texas Two-Step: The Code Says it’s a Transfer

By Mark Roe and William Organek (Harvard Law School)

Note: This is the seventh in a series of posts on the Texas Two-Step, the bankruptcy of LTL Management, and the future of mass tort bankruptcies.  Check the HLS Bankruptcy Roundtable throughout the summer for additional contributing posts by academics from institutions across the country.

Earlier posts in this series can be found here (by Jin Lee and Amelia Ricketts), here (by Jonathan C. Lipson), here (by Jared A. Ellias), here (by Anthony Casey and Joshua Macey), here (by David Skeel), and here (by Ralph Brubaker).

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Mark Roe
William Organek

Considerable attention is now being paid to the Texas Two-Step in bankruptcy. The Two-Step anticipates the movement of assets and liabilities from one corporate entity to another, via a divisive merger that splits the assets and liabilities of the original entity. After the movement of the assets and liabilities, the liabilities sit in one entity (often a subsidiary of a larger enterprise). Meanwhile, the liabilities are separated from many of the assets (in the most controversial form of the Two-Steps), which sit in another entity. The entity with the bulk of the liabilities then files for bankruptcy. The Two-Step is central to the Johnson & Johnson (“J&J”) bankruptcy of a subsidiary, aiming to separate the talc liabilities from J&J’s extensive assets.

When assets are transferred from a firm that is thereby rendered insolvent, or when the assets are transferred with actual intent to hinder, delay or defraud creditors, the transferred assets can, of course, be recovered by the transferring firm as a fraudulent transfer.  Bankr. Code § 548.  Similar transactions are regularly accomplished under corporate structures as spinoffs: the firm moves assets into a subsidiary, for example, and then “spins” off the subsidiary’s stock to the firm’s stockholders. After the spinoff the old stockholders own two companies, one with the assets (and possibly some of the liabilities of the just-created subsidiary) and the other with the liabilities (and any remaining assets) of the original company.

The Texas divisive merger statute creates a fraudulent transfer conundrum, because it says movements of assets pursuant to a divisive merger are not transfers.  If there’s no transfer, there’s no fraudulent transfer liability, as there must first be a transfer for there to be liability.

If the bankruptcy process were ousted of power to control fraudulent transfers, then the debtor firm would have more freedom to move assets and liabilities in ways that would allow the firm to escape liability. No judge would get to the meaty issues (e.g., was the transferring firm insolvent? were the transfers done with intent to hinder, delay, or defraud creditors? is the bankrupt firm with the bulk of the liabilities an alter ego or successor of the original firm?) because there’d never have been a triggering transfer.

The Texas statute itself is clear on its face that there’s no transfer under Texas law:

When a merger takes effect . . . all rights, title and interests to all . . . property owned by each . . . party to the merger is allocated . . . as provided in the plan of merger without . . . any transfer or assignment having occurred . . .

Tex. Bus. Orgs. Code § 10.008(a) (emphasis added).

Commentators have noted that a Two-Stepping debtor might make such an argument. While it has not yet been explicitly raised in the LTL bankruptcy, the commentators anticipated correctly that such an argument was coming.  In another pending Texas Two-Step bankruptcy, In re DBMP, the debtor made this argument at length. In an oral ruling1 delivered a little more than a week ago, on July 7, Judge Craig Whitley agreed with the key plain meaning premises of the Two-Step argument but ultimately rejected it as facilitating “wholesale fraud.”

The court began by accepting the debtor’s interpretation that, under a plain meaning reading of the Texas statute, no transfer occurred; and under a plain meaning reading of section 548 of the Bankruptcy Code, a transfer is a necessary predicate for a fraudulent transfer to have occurred. Hence, a plain meaning construction of section 548 and the Texas statute means no fraudulent transfer exposure.

Judge Whitley saw where such a plain meaning reading led, but refused to go there, rejecting the debtor’s conclusion. Going down the plain meaning route would, he said, lead to absurd results, leaving plaintiffs with “no recourse whatsoever.” And such a reading would contradict another provision of the Texas statute, which states that a divisive merger is not meant to “abridge any . . . rights of any creditor under existing law,” Tex. Bus. Orgs. Code § 10.901. Finally, Judge Whitley went deep: such a plain language reading of the Texas statute would run contrary to longstanding general principles of Anglo-American fraudulent transfer law.

Judge Whitley’s conclusion was in our view correct. But the conclusion can be reached more directly—by a plain meaning reading of the Bankruptcy Code.

The bankruptcy courts have already been instructed by Congress not to pay attention to the Texas statute, even when the state statute declares that an asset disposition in a divisive merger is not a transfer.  True, considerable policy issues (e.g., supremacy of federal law, the extent to which state property and contract law is incorporated into the bankruptcy process) could well be brought to bear if the Bankruptcy Code were unclear here. But the most straightforward way to answer the question raised in DBMP comes from a parsimonious textual analysis of the Code.

Here’s the Bankruptcy Code’s two-step ouster of the Texas Two-Step:

Step 1:

The text of the fraudulent transfer statute, section 548, begins: “The trustee may avoid any transfer . . .  of an interest of the debtor in property . . . ” (emphasis added). If we stop there, a basis might be had for examining state law for whether a transfer cognizable under the Bankruptcy Code has taken place.  Property is, after all, transferred under state law.

But the Code does not say that state law governs whether a movement of property is a bankruptcy transfer. The Code itself defines the term “transfer” and does so independently of state laws’ appellations, leading to Step 2 of the ouster.

Step 2:

Section 101(54) defines what a “transfer” is for bankruptcy purposes, such as section 548 (governing fraudulent transfers).  It states: “The term ‘transfer’ means . . .  each mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with (i) property; or (ii) an interest in property.”

The Code thereby instructs bankruptcy courts to conclude that a transfer has occurred for each “mode . . . of disposing of . . . property . . . .”  A divisive merger under Texas law is surely a “mode . . . of disposing of . . . property. . . .”  As a result, for bankruptcy purposes a Texas two-step is a transfer, whatever the Texas authorities decide to call it.  And, therefore, the Texas Two-Step should have no import in bankruptcy for determining whether there’s been a transfer for bankruptcy purposes.  Property has been disposed of. Thus, for Code purposes there is a “transfer.”  The first statutory predicate to considering whether there has been a fraudulent transfer has been satisfied and the court could then go on to the other, meaty fraudulent transfer issues. The Texas Two-Step is a transfer because the Bankruptcy Code says it is.

While we reach an identical conclusion to that of Judge Whitley, and we do not fault his reasoning from the bench, our analytic path is better in the long run for bankruptcy decisionmaking. The court’s reliance upon the best way to interpret the potential contradictions of the Texas Business Organizations Code is a precarious foundation for the ruling. One could imagine another bankruptcy court, faced with the Texas statute’s contradictions (“it’s not a transfer” vs. “it’s not in derogation of any other right”), interpreting and concluding differently.2 Another judge might not consider such a result as absurd as Judge Whitley and we do. And yet another bankruptcy court could feel compelled to certify questions to the Texas Supreme Court on how to interpret the Texas divisive merger statute and its impact.

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The new mass tort bankruptcies present major issues of policy and statutory construction for which answers will not be assured and apparent. But the question of whether there is a transfer for bankruptcy purposes is clear. A divisive merger is a disposition of property and, hence, the Code says it’s a transfer, thereby triggering the opening prerequisite to there being a fraudulent transfer.

The Code says so. Plainly.

1: A recording of the hearing is embedded in the linked PDF, which PDF may need to be downloaded in order to access the recording; the relevant portion of the hearing begins around 20:15 in the recording.

2: See Curtis W. Huff, The New Texas Business Corporation Act Merger Provisions, 21 St. Mary’s L.J. 109, 122-25 (1989).

 

 

Delaware Bankruptcy Court Rebuffs U.S. Trustee Effort to Collect Statutory Fees from Litigation Trust Distributions

posted in: Statutory Interpretation | 0

By Paul, Weiss

On June 28, 2021, in the chapter 11 cases of Paragon Offshore plc and certain of its affiliates (“Paragon” or the “Debtors”), the United States Bankruptcy Court for the District of Delaware denied the U.S. Trustee’s motion to compel payment of $250,000 in statutory fees assessed against litigation trust distributions. In its opinion, the Bankruptcy Court concluded that the U.S. Trustee had already collected all statutory fees due: first, when Paragon transferred its litigation claims to the litigation trust (the “Trust”) under its plan, and second, when the defendant in the Trust litigation, itself a chapter 11 debtor, later paid statutory fees in its own chapter 11 case based on, among other things, the cash settlement payment it made to the Trust. Finding the U.S. Trustee’s “attempt to double, or triple collect” the statutory fees “offensive,” the Bankruptcy Court held that the Trust’s payments of settlement proceeds to its beneficiaries were not “disbursements” made by or on behalf of the Debtors within the meaning of the U.S. Trustee fee statute, and as a result, that no such fees were payable.

Read the full article 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.

Oversecured Creditor’s Right to Contractual Default-Rate Interest Allowed Under State Law

By Stacey L. Corr-Irvine and Mark G. Douglas (Jones Day)

Stacey L. Corr-Irvine
Mark G. Douglas

It is generally well understood that an “oversecured” creditor is entitled to interest and, to the extent provided for under a loan agreement, related fees and charges as part of its secured claim in a bankruptcy case. Although section 506(b) of the Bankruptcy Code provides that fees, costs or charges allowed as part of a secured claim must be “reasonable,” the provision does not expressly impose any restrictions on the amount or nature of interest allowable as part of a secured claim. A Bankruptcy Appellate Panel for the Eighth Circuit recently considered whether a secured creditor is entitled to contractual default-rate interest under section 506(b).

In In re Family Pharmacy, Inc., 614 B.R. 58 (B.A.P. 8th Cir. 2020), the panel reversed a bankruptcy court’s order disallowing a secured creditor’s claim for interest at the default rate under the parties’ contract using a penalty-type analysis generally applied to liquidated damages provisions. According to the panel, such an analysis cannot be applied to default interest provisions. The panel also held that the bankruptcy court erred when it held that the default interest rate was unenforceable based on “equitable considerations.”

The full article is available here.

Ultra III: Law Firm Perspectives

By Xiao Ma (Harvard Law School)

Xiao Ma

On November 26, 2019, the Fifth Circuit granted a petition for rehearing en banc and issued a revised opinion in In re Ultra Petroleum Corp., No. 17-20793 (5th Cir. Nov. 26, 2019). The new opinion reaffirmed the court’s prior holding that the alternation of a claim by the Bankruptcy Code does not render a claim impaired under 11 U.S.C. § 1124(1), while withdrew the court’s earlier guidance that make-whole premium was the “economic equivalent of ‘interest’” together with its prior suggestion on setting the appropriate post-petition interest rate via reference to general post-judgment interest statute or bankruptcy court’s equitable discretion.

Noting that issues relating to make-whole premiums is a common dispute in modern bankruptcy, the Fifth Circuit retracted its dicta and emphasized in the revised opinion that specific facts are essential in determining the difficult question of whether any premiums are effectively unmatured interest. The court concluded that “[t]he bankruptcy court is often best equipped to understand these individual dynamics – at least in the first instance.”

Firms took notice of the issues remain unsolved and offered perspectives on implications of this case. Morgan Lewis specifically notes that the revised opinion did not alter the original opinion’s reversal of the bankruptcy court’s ruling that creditors who are unimpaired in a bankruptcy plan pursuant to section 1124(a)(1) must receive the full amount of their claim under state law. Weil finds the opinion “does not answer the question of whether, or when, a make-whole may be payable in the Fifth Circuit”, but acknowledges that the ruling is “viewed by some as a victory” for certain creditors. Cleary highlights that the court’s revised opinion “withdrew essentially all of the guidance it had offered in its prior opinion” which had cast doubt on the enforceability of make-whole claims in bankruptcy. “Given the legal and economic significance of the questions left to be resolved”, debtors and creditors alike are likely to watch closely how the questions will proceed at the bankruptcy court, says Mayer Brown.

An earlier post on the Roundtable, Fifth Circuit’s Ultra Petroleum Decision Suggests Make-Wholes are Unenforceable in Bankruptcy, Questions Collectability of Contract Rate Postpetition Interest, discussed the original opinion on Ultra by the Fifth Circuit dated Jan. 17, 2019.

Tribune II: Law Firm Perspectives

By Xiao Ma (Harvard Law School)

Xiao Ma

On December 19, 2019, the Second Circuit issued its amended opinion in In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019), which held the “safe harbor” provision in section 546(e) of the Bankruptcy Code covers Tribune Company’s payments made to public shareholders as Tribune constitutes a “financial institution” in pursuance with the Bankruptcy Code definition, and such definition includes the “customer” of a financial institution when the financial institution acts as the customer’s “agent or custodian…in connection with a securities contract”.

The Second Circuit’s opinion was controversial in light of the Supreme Court’s recent ruling in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018) on the scope of safe harbor, with law firms perceiving it as moving away from the position of Merit by opening new room for application of safe harbor protection. Jones Day suggests that the Tribune’s reasoning “avoided the strictures of Merit”, while Nelson Mullins finds it “shifting the focus from the financial institution as a ‘mere conduit’ to an ‘agent’.” Kramer Levin comments that the decision represents a “dramatic, and perhaps unexpected, extension of the safe harbor from the position it occupied in the immediate aftermath of Merit.” Weil calls it throwing the 546(e) safe harbor a lifeline.

Firms also find the case paving a way to protect LBO payments from subsequent attacks. King & Spalding notes that the Second Circuit’s opinion provides protection for recipients involved in LBO transaction where the debtor is the “customer” of the intermediary financial institutions. Cadwalader believes that the decision may “narrow the impact” of Merit, as market participants could structure their transaction to involve a financial institution thereby bypassing the “mere conduit” carve-out. Skadden agrees on the likely trend of structured LBOs, highlights that the customer defense is “likely to continue gaining momentum” after the Second Circuit’s decision. Parties would ensure they meet the “financial institution” and “customer” criteria methodically articulated in Tribune. “An appropriately structured principal/agent relationship could continue to shelter transfers or distributions within the ambit of section 546(e) safe harbors,” says Weil, adding that the operative facts will be key to strengthen the position.

Finally, Gibson Dunn notes that Tribune is not binding on other circuits. It remains to be seen whether such holding will be extended to different circumstances by other courts. “Some courts may find (in contrast to the Second Circuit) that the Supreme Court in Merit could not possibly have intended that its narrowing of the section 546(e) safe harbor be so easily vitiated by an argument that the Court itself acknowledged in a footnote,” says Kramer Levin.

In a prior Roundtable post, Professor Bussel noted that a plain meaning interpretation of the term “financial institution” should not include the customers of commercial banks, thus precluding a sharp change from Merit.

For Roundtable’s other posts on Tribune, see Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune, Tribune Fraudulent Conveyance Litigation Roundup. For Roundtable discussions relating to the 546(e) safe harbor, please refer to the tag #Safe Harbors.

Updated Overview of the Jevic Files: How Courts Are Interpreting and Applying the Supreme Court’s Ruling on Structured Dismissals and Priority Skipping

By Shane G. Ramsey and John T. Baxter (Nelson Mullins)

Shane G. Ramsey
John T. Baxter

The U.S. Supreme Court in Czyzewski v. Jevic Holding Corp., 137 S.Ct. 973 (2017), addressed the issue of chapter 11 debtors using structured dismissals to end-run the statutory priority rules. The Court’s ruling preserved the priority system, holding that the bankruptcy court could not approve a structured dismissal of a chapter 11 case that provided for distributions that failed to follow the standard priority rules unless the affected creditors consented to such treatment. Although the Bankruptcy Code does not expressly apply its priority distribution scheme to a structured dismissal, the Court clarified that courts should do so.

As a way to track how bankruptcy courts across the country are applying the ruling in Jevic, the Nelson Mullins Bankruptcy Protector has introduced a new periodic series: the Jevic Files. As of December 31, 2019, the Jevic Files has collected and summarized twenty-one cases across nineteen jurisdictions. While the majority of the cases involved structured dismissals in the context of a chapter 11 case, courts have also applied the ruling in Jevic to the dismissal of chapter 13 plans; the priority of trustee payments in a chapter 7 case; and even a state court foreclosure hearing that came on the heels of a dismissed chapter 11 case. As Jevic continues to be interpreted and applied in bankruptcy (and other) courts throughout the country, we will continue to keep an updated summary of cases through the Jevic Files.

The article is available here.

Will Bankruptcy Preference Lawsuits Decline due to Statutory Changes?

Lisa P. Sumner
Lisa P. Sumner

By Lisa P. Sumner (Nexsen Pruet)

Two recent amendments to the U.S. Bankruptcy Code impose new hurdles for debtors and trustees to clear before filing an action against a creditor to recover the value of preferential transfers that the debtor made to the creditor prior to filing a bankruptcy petition. One amendment requires debtors and trustees to conduct a due diligence review of the circumstances surrounding a particular transfer and probable affirmative defenses before filing suit. The other amendment increases the amount that debtors and trustees must seek to recover in a preference action if they want to file the action in the court where the bankruptcy case is pending rather than in the court where the creditor is located. These creditor-friendly amendments will take effect in early 2020, and may discourage debtors and trustees from filing some preference actions.

The full article is available here.

Second Circuit Fumbles Tribune on Reconsideration

Daniel J. Bussel

By Daniel J. Bussel (UCLA School of Law)

The Second Circuit recently issued its revised opinion in Tribune Company Fraudulent Conveyance Litigation, determining that a debtor-transferor that effectuates a transfer involving a securities contract in its capacity as the customer of a commercial bank is itself a “financial institution” within the meaning of the Bankruptcy Code section 101(22)(A) and therefore the transfer is protected under section 546(e).

This ruling has critically important implications for the avoiding powers of the bankruptcy trustee. Section 546(e) insulates all transfers involving securities by or to a financial institution from avoidance except as an “actual fraud” under section 548(a)(1)(A). Virtually all transferors are customers of commercial banks and almost any transfer can be effectuated with funds transferred through the agency or in the possession of a commercial bank. The result is the virtual repeal of the avoiding powers as to any transfer involving securities that is not an actual fraud on creditors, undoing centuries of fraudulent transfer and preference law.

These considerations are powerful enough that the Second Circuit, if necessary in light of the statute’s plain language, should have striven mightily to avoid interpreting the term “financial institution” so as to include the customers of commercial banks. The Code’s avoiding power sections read as a whole make no sense if limited only to cases involving transfers by entities that are not customers of commercial banks. Moreover, such a reading of section 101(22) flies in the face of Merit Management, the recent, directly applicable, Supreme Court precedent.

The full article is available here.

For more posts on the scope of section 546(e), see Ralph Brubaker, Understanding the Scope of the § 546(e) Securities Safe Harbor Through the Concept of the “Transfer” Sought to Be Avoided.

Recent Developments in Cross-Border Insolvency and Recognition of Foreign Bankruptcy Proceedings in the US Bankruptcy Courts

By Mark G. Douglas and Dan T. Moss (Jones Day)

Mark G. Douglas
Dan T. Moss
Dan T. Moss

On July 25, 2019, the Judicial Insolvency Network announced its adoption of the Modalities of Court-to-Court Communication (the “Modalities”), which “apply to direct communications (written or oral) between courts in specific cases of cross-border proceedings relating to insolvency or adjustment of debt opened in more than one jurisdiction.” The Modalities are intended to facilitate implementation of the Guidelines for Communication and Cooperation Between Courts in Cross-Border Insolvency Matters, which since 2017 have been adopted by courts in several countries, including the Supreme Court of Singapore, the U.S. Bankruptcy Courts for the District of Delaware, the Southern District of New York and the Southern District of Florida, and courts in the United Kingdom, Australia, The Netherlands, South Korea, Canada, Bermuda, and the Eastern Caribbean. The U.S. Bankruptcy Court for the District of Delaware adopted the Modalities on an interim basis on July 25, 2019. It is anticipated that other courts will do so as well in the near term.

Mark G. Douglas (Jones Day) summarized key features of the Modalities and other developments since the Guidelines for Communication and Cooperation Between Courts in Cross-Border Insolvency Matters as developed and implemented by JIN (the judicial Insolvency Network) here.

In In re PT Bakrie Telecom Tbk, 601 B.R. 707 (Bankr. S.D.N.Y. 2019), the U.S. Bankruptcy Court for the Southern District of New York provided a primer on several important issues that a court may have to consider in ruling on a petition for recognition of a foreign bankruptcy proceeding under chapter 15 of the Bankruptcy Code. These include the requirement that a foreign debtor have property in the United States before being eligible for chapter 15, the rules regarding the appointment of a “foreign representative” for the debtor, what qualifies as a “collective proceeding” for the purpose of chapter 15 recognition, and the “public policy” exception to recognition. One notable conclusion by the court is that merely because a foreign proceeding has concluded does not prevent the later appointment of a foreign representative.

An examination of all of the issues highlighted by PT Bakrie entails a detailed factual analysis and careful application of the provisions of chapter 15 consistent with its underlying principles and purpose in providing assistance to foreign tribunals overseeing cross-border bankruptcy cases. Dan T. Moss and Mark G. Douglas (Jones Day) provided such a close examination and detailed analysis of the case here.

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