By David H. Sweeney, Jason P. Rubin, and Laura P. Warrick (Akin Gump Strauss Hauer & Feld, LLP), with Practical Law Oil & Gas
Producers of hydrocarbons generally require some level of gathering, processing, and othermidstream services to monetize hydrocarbons. Midstream services are typically securedthrough contracts between the producers and the midstream providers. The fixed facilities thatare required to perform those midstream services require significant investment by themidstream providers and have capacity constraints. To ensure producers’ performance andprotect their investment, midstream providers often include in their contracts a dedication clausestyled as a “covenant running with the land”. This clause purports to dedicate the land orreserves to the midstream infrastructure and is intended to bind third parties, including estates in bankruptcy, as an interest in real property.
Decisions in recent Chapter 11 cases have challenged the notion that midstream servicescontracts containing purported covenants running with the land are not rejectable under section365 of the Bankruptcy Code. The result is that a debtor may be able to reject a midstreamcontract containing a covenant running with the land, repudiate future performance of its duties,and a midstream service provider may find its claims reduced to a pre-petition unsecured claim for monetary damages.
This article explores some recent case law regarding covenants running with the land inbankruptcy and offers practical suggestions for how producers and midstream providers mightnavigate the newly developing reality, including:
Conducting diligence on midstream contracts to identify red flags and address potentialissues before they become problems.
Addressing the shortcomings of covenants running with the land noted by bankruptcycourts.
Replacing covenants running with the land with a substitute, such as a presentlypossessory interest or a lien.
By Melissa B. Jacoby (Graham Kenan Professor of Law – University of North Carolina School of Law)
After a district court halted OxyContin maker and hawker Purdue Pharma’s exit from bankruptcy by finding its restructuring plan unlawful in late 2021, the yellow brick road of this high-profile case forked in two. One path is traditional: more appellate process. The United States Court of Appeals for the Second Circuit agreed to review Purdue’s restructuring plan on a fast track and oral argument is expected to be scheduled for late April 2022. The second path reflects a popular development in the federal judiciary: the presiding bankruptcy judge appointed another sitting judge as a mediator to oversee negotiations between representatives of the Sackler family and states whose appeal had prevailed in the district court. According to the judicial mediator’s most recent report, the Sackler family has offered more money to resolve the dispute; many, though not all, of the objecting states are on board to settle. Expectations that a deal can be brokered run high.
Purdue Pharma is not the only big restructuring in which a judicial mediator has been tasked with managing a high-stakes matter. As another recent example, six judges from different federal courts served as mediators in the Puerto Rico bankruptcy for almost five years: from June 23, 2017 through January 22, 2022.
The use of sitting judges for this behind-the-scenes work is the topic of my forthcoming article. Why are judges mediating other judges’ cases, particularly when Congress encouraged use of private neutrals for alternative dispute resolution? Are traditional judicial accountability measures effective when judicial mediators work with parties and lawyers in a process that lacks a citable record? Finding that the standard accountability measures are an awkward fit for judicial mediation, the article calls on the Judicial Conference of the United States, the policy-making body for the federal judiciary, to take steps to maximize the benefits and minimize the risks of these practices. Whatever your own experiences have been with bankruptcy-related mediations, I hope you find this project useful.
On July 9, 2021, Southern District of New York Judge J. Paul Oetken held that §503(c) of the Bankruptcy Code prohibits board-appointed officers from receiving payments under a key employee retention plan (KERP) “absent a particularly strong showing that they do not perform a significant role in management,” as such officers are “insiders” within the definition of §101(31)(B)(ii). In re LSC Communications, Inc., 631 B.R. 818 (S.D.N.Y. 2021). This was the case even though the Bankruptcy Court found that the employees in question were officers “in title only.” Id. at 820. Judge Oetken’s ruling affects six employees who received KERP payments under the reorganization plan of LSC Communications, Inc. (“LSC”), which filed for Chapter 11 relief in April 2020.
In its initial order, the Bankruptcy Court approved payments under the KERP for all 190 covered employees. U.S. Trustee William K. Harrington appealed the decision to the District Court, claiming that, as LSC was incorporated in Delaware, the court should apply Delaware state law, which provides that any person appointed by a corporation’s board of directors is an officer. In response, LSC countered that the employees could not be considered insiders because they lacked any significant decision-making authority.
Judge Oetken wrote that case law regarding who constitutes an “officer” is “less than clear,” noting that the Bankruptcy Code does not define the term or provide any insight regarding its meaning. Id. at 824. Although Judge Oetken rejected the Trustee’s argument that state law exclusively applies when determining whether an employee is an officer under the Bankruptcy Code, he concluded that the Bankruptcy Court erred by looking beyond the fact that the six employees were appointed by LSC’s board. Even if a court chooses to undertake a more expansive analysis, he wrote, the fact that the six employees were appointed by the board and would be deemed officers under Delaware corporate law should “weigh heavily in concluding that the employees are officers for Bankruptcy Code purposes.” Id. at 826. In supporting his position, Judge Oetken claimed that giving more weight to objective criterion like appointment by the board provides greater clarity to the parties than the kind of “functional, non-exhaustive test” used by the Bankruptcy Court, although he noted that this kind of test may still be appropriate in some cases. Id. at 825.
This case, and its somewhat unusual holding, seems to present a scenario that has become exceedingly rare. In September, the Government Accountability Office (GAO) published a report finding that debtors regularly avoid restrictions in the Bankruptcy Code by paying bonuses before or after filing for bankruptcy or by designating bonuses during bankruptcy as “incentive” payments. The report stated that fewer than 1% of debtors requested court approval to pay employee bonuses during 2020 and, when debtors did seek court approval, the courts approved “nearly all” of those requests. Maria Chutchian wrote in a recent Reuters article that creditors rarely challenge such bonus payments in court, noting debtors will often arrange private deals with creditors before filing for bankruptcy. In the same article, she discusses the Mallinckrodt restructuring, in which the pharmaceutical company’s creditors chose to challenge bonus payments to executives facing accusations of misconduct related to the opioid epidemic. The judge allowed the payments, stating that “mere allegations” of misconduct did not suffice to render them inappropriate.
Finally, Jared Elias concluded in an article published in 2019 that, although fewer companies have used court-approved bonus plans in the years since the Bankruptcy Code’s bonus provisions were reformed in 2005, the overall level of executive compensation has remained the same. This lends support to the GAO’s analysis and the anecdotes collected by Reuters that KERPs are rarely used because parties have ample opportunity to achieve the same end while avoiding the scrutiny of §503(c). He argues that bankruptcy and district court judges are poorly equipped to police payments made before or after a debtor files for bankruptcy, and that the U.S. Trustee’s office and creditors struggle to do so due to information asymmetries and limited resources.
Given the above, it appears that Judge Oetken’s decision this past summer may ultimately prove to be an anomaly. In most cases, these bonus payments simply will not become a part of the bankruptcy plan. Debtors can avoid scrutiny by making payments before or after filing for bankruptcy. If they decide they must make the payments during bankruptcy, they can reduce the scrutiny they will incur by recharacterizing them as incentive payments, thereby avoiding the heightened restrictions that apply to KERPs. And, even if they decide to include the payments in their restructuring plan, it seems unlikely that creditors will challenge the payments—particularly if counsel has chosen to arrange a deal behind the scenes to avoid a dispute in court.
The COVID pandemic put unprecedented pressure on all economies around the world. Many predicted that this economic dislocation would lead to an unprecedented number of corporate bankruptcies. This did not happen. The American government and other governments responded with extraordinary measures. While these measures allowed companies to ride out the worst of the pandemic, they did have consequences. Many large companies were left with unprecedentedly large amounts of debt on their balance sheets.
Perhaps a robust economy will allow companies to grow their way out from under their debt burden. But perhaps not. To prepare for the possible future increase in large companies filing for bankruptcy, Congress should act now to build up a bankruptcy infrastructure sufficient to handle an influx in cases. Specifically, Congress should require that every circuit create a “business bankruptcy panel” designed to administer the Chapter 11 filing of large companies. As is well-known, three bankruptcy districts currently serve as dominant venues for large cases – the District of Delaware, the Southern District of New York and the Southern District of Texas. It is by no means clear that these three courts could handle a significant increase in caseloads. Creating expertise across the country would help prepare the system for any future rise in cases. A secondary benefit of this reform is that it may also ameliorate some of the concerns that have been raised over the years by the dominance of a small number of venues for large corporate cases.
Part II of Andrew Dietderich’s treatment of the practical side of forum shopping addresses the use of Chapter 11 by non-U.S. corporations with only limited U.S. contacts. The logic of international bankruptcy law – as reflected in Chapter 15 of the U.S. Bankruptcy Code and the UNCITRAL Model Law – suggests that these types of Chapter 11 filings should not happen. Instead of filing for Chapter 11, non-U.S. companies should file for plenary proceedings only in their home country, i.e., where they are headquartered or otherwise have their “center of main interest.” The role of U.S. courts should be limited to recognition and assistance of the home country proceeding under Chapter 15.
The article explains why these Chapter 11 cases happen and why “forum shopping” against the grain of international insolvency conventions is necessary for certain types of cross-border cases. Chapter 11 is sometimes the best (or the only) way to reorganize companies headquartered outside of the U.S., and U.S. courts have been uniquely effective at supervising these reorganizations in a manner fair to all stakeholders.
The article also suggests that the U.S. has a national interest in making its bankruptcy courts available for these types of cases, that principles of international comity are as active in Chapter 11 as they are in Chapter 15, and that non-U.S. stakeholders have nothing to fear from this application of Chapter 11 in the coming years. Part II appears in the October issue of the ABI Journal, available here.
Corporate debtors can decide if, when and how to file for chapter 11. Recently, there is a great deal of concern about their ability to decide where. In a series of two articles for the ABI Journal, I explain as debtor’s counsel the practice of responsible forum shopping and argues that it is, on balance, a social good.
Motivated by recently introduced legislation that would force domestic debtors to file chapter 11 only in the jurisdiction of their headquarters, Part I warns that mandating a single venue for a corporate debtor will impede legitimate restructurings and hurt companies and workers. There are important reasons why a distressed domestic corporation may need to file away from its headquarters: examples from my own experience include the need to preserve critical corporate contractual assets and to protect rank-and-file employee severance.
Since U.S. bankruptcy law necessarily varies from place to place around the country, someone has to decide what particular version of bankruptcy law should apply to each case given its unique factual context and reorganization purpose. As with many other chapter 11 decisions, the board of directors of the debtor is the least worst alternative.
Of course, there are some legitimate concerns with the current system of modified venue choice. But the venue reform legislation proposed in Congress is too blunt of an instrument. It is uninformed by experience in the trenches reorganizing distressed business and, if passed, would hurt some of the people it aims to help. Part I appears in the September issue of the ABI Journal, available here.
Part II of the series addresses international forum shopping—specifically the use of chapter 11 by non-U.S. debtors with minimal U.S. contracts—appears in the October issue of the ABI Journal.
By Lynn M. LoPucki (Security Pacific Bank Distinguished Professor of Law, UCLA School of Law)
The bankruptcy courts that compete for big cases frequently ignore the Bankruptcy Code and Rules. This Article documents that lawlessness through a detailed examination of the court file in Belk, Inc.—a one-day Chapter 11—and a series of empirical studies.
Chapter 11’s lawlessness reached a new extreme in Belk. Belk filed in Houston on the evening of February 23, 2021. The court confirmed the plan at ten o’clock the next morning, and the parties consummated the plan that same afternoon. Almost none of Chapter 11’s procedural requirements were met. The court did not give creditors notice of the disclosure statement or plan confirmation hearings until after those hearings were held. Belk filed no list of creditors’ names and addresses, no schedules, no statement of financial affairs, and no monthly operating reports. No creditors’ committee was appointed, no meeting of creditors was held, and none of the professionals filed fee applications. The ad hoc groups that negotiated the plan failed to file Rule 2019 disclosures. Because no schedules were filed, no proofs of claim were deemed filed. Only eighteen of Belk’s ninety-thousand creditors filed proofs of claim, and Belk apparently just made distributions to whomever Belk considered worthy.
The procedural failures in Belk are just the tip of the iceberg. The competing courts are ignoring impermissible retention bonuses, refusing to appoint mandatory examiners, failing to monitor venue or transfer cases, granting every request to reject collective bargaining agreements, and providing debtors with critical-vendor slush funds. The article is available here.
By Daniel J. Merrett (Jones Day) and Mark G. Douglas (Jones Day)
The ability of a bankruptcy trustee or chapter 11 debtor-in-possession (“DIP”) to avoid fraudulent transfers is an important tool promoting the bankruptcy policies of equality of distribution among creditors and maximizing the property included in the estate. One limitation on this avoidance power is the statutory “look-back” period during which an allegedly fraudulent transfer can be avoided—two years for fraudulent transfer avoidance actions under section 548 of the Bankruptcy Code and, as generally understood, three to six years if the trustee or DIP seeks to avoid a fraudulent transfer under section 544(b) and state law by stepping into the shoes of a “triggering” creditor plaintiff.
The longer look-back periods governing avoidance actions under various state laws significantly expand the universe of transactions that may be subject to fraudulent transfer avoidance. Indeed, under a ruling recently handed down by the U.S. Bankruptcy Court for the Western District of North Carolina, the look-back period in avoidance actions under section 544(b) may be much longer—10 years—in bankruptcy cases where the Internal Revenue Service (“IRS”) or another governmental entity is the triggering creditor. In Mitchell v. Zagaroli (In re Zagaroli), 2020 WL 6495156 (Bankr. W.D.N.C. Nov. 3, 2020), the court, adopting the majority approach, held that a chapter 7 trustee could effectively circumvent North Carolina’s four-year statute of limitations for fraudulent transfer actions by stepping into the shoes of the IRS, which is bound not by North Carolina law but by the 10-year statute of limitations for collecting taxes specified in the Internal Revenue Code.
Zagaroli does not break new ground on the power of a bankruptcy trustee or DIP to bring avoidance actions under section 544(b) of the Bankruptcy Code. Nevertheless, the court’s endorsement of the majority approach on the availability of a longer look-back period in cases in which the IRS is a creditor is notable. Widespread adoption of this approach could significantly augment estate avoidance action recoveries.
By Edward J. Janger (Professor, Brooklyn Law School) and Adam J. Levitin (Professor, Georgetown University Law Center)
In Distorted Choice in Corporate Bankruptcy, David Skeel offers a nuanced description of restructuring support agreements (RSAs) and how they can help a debtor to achieve the necessary consensus around a proposed Chapter 11 plan of reorganization. We take issue, however, with Skeel’s permissive view toward RSAs that permits provisions that would short circuit the “process” protections contained in Chapter 11. Such provisions include pre-disclosure lock-ups, milestones, and coercive deathtraps.
Chapter 11 contemplates bargaining in the shadow of certain basic statutory “distributional” entitlements: equal treatment, best interests, full cash payment of administrative expenses, and a guaranteed minimum-cramdown distribution. As such, RSAs can either reinforce the link between entitlement and distribution, or they can sever it.
In our view, Skeel insufficiently appreciates the purpose of process—how procedural protections such as classification, disclosure, and solicitation surrounding the vote forge the crucial link between bankruptcy bargaining and core principles of corporate governance and pre-bankruptcy entitlement. We offer, instead, an approach which sorts between process-enhancing RSAs and those that facilitate end-runs.
By Amir Licht (Professor, Interdisciplinary Center Herzliya, Israel)
In several common law jurisdictions, creditors of corporate debtors enjoy legal protections through vicinity-of-insolvency fiduciary duties, beyond what their contracts with those companies afford them. These duties form a notoriously murky area, where legal space warps. The contours of this area are fuzzy. Courts openly acknowledge that it is difficult to identify clear guideposts for its threshold—as to when exactly these duties are enlivened. In a forthcoming article, I purport to make two main contributions. First, the article expands the theoretical basis for a special legal regime in virtually insolvent firms by pointing out escalation of commitment as a potent and relevant factor that has been largely overlooked by insolvency scholars. Second, this article addresses the substantive content of the duty to protect creditors where such duties are recognized.
The standard account that is usually invoked to explain and justify special fiduciary duties to consider creditors’ interest points to the danger of opportunistic high-risk behavior by managers on behalf of shareholders. I argue that this account may be sound but is nonetheless lacking. In addition to such risk-shifting opportunism, lawmakers should also be mindful of managers’ tendency to unjustifiably continue failing projects, known as escalation of commitment. Escalation of commitment refers to a phenomenon, in which people tend to remain married to their original choices and to commit resources to them even when it is no longer rational to do so. Escalation of commitment is ubiquitous. It has been observed in organizations large and small, in business corporations and in the public sector. Escalation of commitment is not only an irrational and emotional personal behavior. More often than not, it takes place in a broader social context of one’s ingroup—in particular, the board of directors, the organization, and one’s community and culture.
Escalation of commitment poses an equal, if not greater, challenge than risk shifting does to optimal regulation of companies in looming or virtual insolvency. Being largely detached from rational calculations, escalation of commitment presents a more compelling justification for legal regulation, and a more interventionist one at that. In this view, managers—especially owner-managers—of virtually insolvent firms may not enjoy the usual level of deference that the law affords to their business judgment in regular times, as their discretion at that point is prone to be clouded by a misplaced motivation to stay the course, weather the storm, and similarly-spirited no-quitting notions.
Factors that could facilitate de-escalation include better information on costs and benefits of the project, regular evaluation and monitoring of projects, clear criteria for success and minimum target performance levels, and clear feedback about underperforming projects. Such measures will have limited efficacy, however, if the information they generate is interpreted and acted on by decision-makers who have initiated the failing project and even by different persons who are nonetheless related to those decision-makers. Change in management is thus essential.
While Delaware law rejects the idea of a pre-insolvency creditor-focused fiduciary duty, several jurisdictions do recognize duties to protect creditors, either as a duty to consider creditors’ interests or as the rule against wrongful (or insolvent, or reckless) trading. I argue that these duties should be enlivened at the very edge of the zone of insolvency, close to the latter. At that point, the mission of directors should transform from entrepreneurial to custodial. That is, they should implement strategies that aim to preserve the firm—in working condition, to the extent possible, with a view to resuming regular business—but avoid seeking new projects with a view to maximizing profits. This could mean that the shield of the business judgment rule may not be available to the same extent as in regular circumstances. The Covid-19 pandemic that swept the globe in 2020 provides a fresh context for this approach and underscores the need to implement such a regime sensibly, with high deference to business decisions even if outside the scope of the business judgment rule. The article concludes with a comparative analysis of creditor-oriented duties in several common law jurisdictions and examines how they could implement a custodial approach.