Category Archives: Publications

Delaware Courts Continue to Excel in Business Litigation with the Success of the Complex Commercial Litigation Division of the Superior Court

By: Joseph R. Slights III and Elizabeth A. Powers

Although still in its infancy, the Delaware Superior Court’s Complex Commercial Litigation Division (“CCLD”) has already earned a reputation as a premier business court in keeping with the Delaware judiciary’s tradition of excellence in the resolution of corporate and business controversies. Regarded as an “accent” to the Court of Chancery, the CCLD offers businesses a forum dedicated to the resolution of commercial disputes where equitable jurisdiction is lacking. The CCLD’s collaborative and uniquely flexible approach to the management of complex commercial litigation is a model for what the modern business court should be. Not surprisingly, business litigants have embraced the CCLD, as evidenced by the wide variety of complex commercial disputes that have been filed and adjudicated in this forum. The CCLD continues Delaware’s status as the world’s most respected forum for adjudicating highly complex business disputes.

I. INTRODUCTION

Over its more than two-hundred-year history, Delaware’s Court of Chancery has emerged as the world’s most respected forum for adjudicating highly complex business disputes. But the Court of Chancery’s subject matter jurisdiction is limited; it is a court of equity. Business disputes arising from claims of contractual breach or tortious conduct, where money damages will remedy the wrong, do not sound in equity. Delaware’s general jurisdiction trial court, the Superior Court, is the proper forum to resolve these claims. The Superior Court, however, unlike the Court of Chancery, oversees a broad civil docket comprising, on average, more than four hundred cases per judge, and a felony criminal docket with thousands of cases moving through the system at any one time. Until recently, complex commercial cases in the Superior Court were placed in the civil pipeline along with every other civil case filed in the court. This dynamic frequently resulted in less-than-optimal judicial management of the court’s most demanding civil cases. Delaware business entities wanted and deserved better. The Delaware Superior Court’s Complex Commercial Litigation Division (“CCLD”) was created in 2010 to complement Delaware’s Court of Chancery and to offer businesses a forum dedicated to the resolution of business disputes where wrongs could be righted with legal remedies. In just a few short years, the CCLD has earned a reputation as a premier business court in keeping with the Delaware judiciary’s tradition of excellence in the resolution of corporate and business controversies. Its collaborative and flexible approach to the management of complex litigation is a model for the modern business court. In this article, we will briefly discuss the national “business court” movement for the sake of context. We will then discuss the CCLD’s place within this movement, highlight its unique facilitative approach to judicial case management, and extol the benefits of this approach when addressing the court’s most challenging and resource-dependent cases.

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**©2015 by the American Bar Association.  Reprinted with permission.  All rights reserved.  This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.

Judicial Dissolution: Are the Courts of the State that Brought You In the Only Courts that Can Take You Out?

Co-authored by Peter B. Ladig  

The Business Lawyer

In early 2014, the then-managing members of the limited liability company (“LLC”) that owned The Philadelphia Inquirer, the Philadelphia Daily News, and philly.com filed nearly simultaneous petitions for judicial dissolution of the LLC in the Court of Common Pleas in Philadelphia and the Delaware Court of Chancery. The dual petitions created the anomaly that everyone agreed on dissolution, but no one could agree where it should take place. Both courts were asked to address a unique question: could a Pennsylvania court judicially dissolve a Delaware LLC? According to existing precedent, the answer was not so clear. This article proposes that the answer should be clear: a court cannot judicially dissolve an entity formed under the laws of another jurisdiction because dissolution is different than other judicial remedies. This approach gives full faith and credit to the legislative acts of the state of formation, but also permits the forum state to protect its own citizens by granting the remedies it feelsnecessary, short of dissolution.

An involuntary judicial dissolution is one of the key tools available to a lawyer advising a client seeking a business divorce. Once the client decides to pursue an involuntary judicial dissolution, an attorney’s first question should be: in which court? It is often the case that even if all of the parties are citizens of the same state, those parties formed their entity under the laws of another state. Under those circumstances, can the parties ask their home state court to judicially dissolve an entity formed pursuant to the laws of a foreign state? This issue arose recently in the dissolution of Interstate General Media, LLC (“IGM”), the limited liability company that owned The Philadelphia Inquirer, the Philadelphia Daily News, and the website philly.com. IGM’s two managing members filed near simultaneous actions seeking judicial dissolution in the Commerce Court of the Philadelphia Court of Common Pleas and the Court of Chancery of the State of Delaware, respectively.

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First published in The Business Lawyer, Vol. 70, Fall 2015

 

 

 

Peter B. Ladig

Death by Auction: Can We Do Better?

By: Peter B. Ladig, Director,  Bayard, P.A.

The Business Lawyer; Vol. 73, Winter 2017–2018

The purpose of a business divorce is to sever the business relationship between or among the owners of the business. The most common judicial means of achieving this goal is a state dissolution statute. Most state dissolution statutes empower courts to sever the business relationship through various means. Some states even permit the entity or the other equity interests to avoid dissolution by exercising a statutory right to buy out the plaintiff’s interests. Delaware has eschewed this approach, instead providing few statutory directions or options and trusting its Court of Chancery to exercise its equitable discretion appropriately. Delaware courts historically were reluctant to dissolve operating, profitable entities, but in recent years Delaware courts have come to recognize the fallacy of forcing people to continue a business relationship that has fallen apart, and judicial dissolution is no longer the rarity it once was. A continuing problem, however, is that there is little common law guidance on how dissolution should be accomplished in a manner that is consistent with principles of Delaware law and that also recognizes the unique nature of these kinds of business divorces. In the absence of such guidance, Delaware courts default to what they know: an auction or sale process designed to attract the most number of bidders to maximize the entity’s value. This article suggests that the Court of Chancery should not consider an auction or other public sale process to be the default solution, that general principles of equity permit the Court of Chancery to grant many of the statutory remedies available in other states, and that a forced public sale should be the remedy of last resort.

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Reprinted with permission from The Business Lawyer, Vol. 73, Winter 2017-2018.

Sections 542 and 543—Turnover of Property of the Estate

By Bruce Grohsgal* and Gregory J. Flasser**

I.  INTRODUCTION

Section 542 of the Bankruptcy Code generally requires a noncustodial entity who has possession, custody, or control of property of the estate that the trustee may use, sell, or lease under § 363, or that the debtor may exempt under § 522, to deliver to the trustee the property or the value of the property, and to account for such property.1 Section 543 similarly requires a custodian with knowledge of the commencement of the case to deliver such property and the proceeds of such property to the trustee and account for such property.2 This paper reports on opinions regarding turnover published since the 2016 Annual Survey.

 

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This article appears in the Norton Annual Survey of Bankruptcy Law & Practice, 2017 Edition, and is posted with permission.  Copyright © 2017 Thomson Reuters/Westlaw.  For more information about this publication please visit http://legalsolutions.thomsonreuters.com/.

 

 

 

 

Breaking Up With a Portfolio Company without Breaking the Bank

By: Justin R. Alberto, Director and Sara E. Bussiere, Associate, Bayard, P.A.

July/Aug 2017 issue of the Journal of Corporate Renewal

Portfolio companies sometimes fail. This obviously isn’t breaking news, as master funds routinely divest themselves of investments. Sometimes the investment never worked out, or the portfolio may have simply run the course of its natural shelf life. Whatever the impetus may be, it’s important to understand that there are many ways effectively to wind down and dissolve a portfolio company.

Choosing the dissolution method most advantageous for the dissolving company and the master fund requires the consideration of several factors. Certainty of process and cost, and minimizing exposure for the parent and its designated executives must play into the analysis. While bankruptcy remains a common vehicle for winding down a subsidiary, the time and cost involved are not always worth the benefits.

Chapter 11 can be time-consuming (also not breaking news) because it requires the expenditure of significant resources and a focused management team and won’t result in a discharge in the liquidation context. Chapter 7, while potentially more efficient than Chapter 11, prompts the appointment of an independent trustee who will almost certainly investigate the actions or inactions of the master fund and/or its directors. Additionally, neither Chapter 7 nor Chapter 11 automatically effectuates the dissolution of the subject portfolio company following liquidation and the distribution of its assets.

So what is a fund to do when it wants to wind down a portfolio company but doesn’t want to incur the costs associated with a Chapter 11 filing or go through the hassle of Chapter 7? State law dissolution is an often overlooked, yet cost-effective and efficient, option. Delaware state law provides viable alternatives to a bankruptcy filing that may be attractive to a private equity fund looking to quickly dispose of an insolvent or otherwise disadvantageous holding, particularly in the case of a wholly owned portfolio company with a relatively simple capital structure.[1]

Under Delaware law, a corporation may be liquidated and dissolved outside of bankruptcy in one of two ways: through an unsupervised process, the non-safe harbor dissolution, or a court-supervised process, the safe harbor dissolution.[2] These state law bankruptcy alternatives allow funds to liquidate and dissolve a portfolio company, while maintaining some degree of control over the process and back-end protection against contingent and unknown claimants.

Regardless of the method selected, a parent fund may decide to invoke the assistance of a court-appointed receiver who can replace the portfolio’s management team to liquidate and dissolve the company.[3] This article provides a brief overview of these increasingly commonly used bankruptcy alternatives, which in the right situation offer a master fund increased control, flexibility, and efficiency in the liquidation process.

 

Delaware Dissolution Procedures

Pursuant to Section 275 of the Delaware General Corporation Law (DGCL), a Delaware corporation may dissolve if a majority of stockholders entitled to vote approve the measure. In the case of a wholly owned or majority-controlled subsidiary, the master fund need only execute a simple written consent to effect the dissolution. Following stockholder approval, the corporation files a certificate of dissolution with the Delaware secretary of state, at which time operations terminate and business ceases.[4] The dissolved company continues legally to exist for three years for purposes of liquidating its assets and settling its affairs.[5]

As previously noted, Delaware offers two methods of dissolution. Both allow a corporation to wind up its affairs and distribute remaining assets while protecting the corporation’s stockholders and directors, in varying degrees, against liability for their roles in approving and effecting the dissolution.[6] Choosing which alternative works best in a given situation largely depends on the complexity of the company’s affairs and capital structure and on the level of protection desired by the company’s management and stockholders.

Regardless of the option selected, the appointment of a receiver can add an additional layer of protection for directors and stockholders by replacing prior management with a court-approved fiduciary to oversee the liquidation and distribution of the company’s assets. This can be a particularly attractive option for a portfolio company whose management is comprised of employees and/or executives from the master fund.

 

Non-Safe Harbor Dissolution. The non-safe harbor dissolution is the most efficient and cost-effective vehicle available under the DGCL to dissolve a company and distribute its assets. In a non-safe harbor dissolution, the corporation liquidates its remaining assets, administers claims similar to the bar date process commonly used in the bankruptcy context, and adopts a plan of dissolution and distribution.

The plan must make reasonable provisions to (1) pay all known claims and obligations, (2) compensate claimants in pending actions against the corporation, and (3) compensate claimants with claims that may arise within 10 years of the date of dissolution.[7] If the company has insufficient assets to pay the claims against it, the plan may provide for the ratable satisfaction of claims of equal priority (e.g., general unsecured claims).

Because there is no court oversight, the non-safe harbor dissolution is more streamlined than the safe harbor dissolution. However, a non-safe harbor dissolution does not insulate stockholders, officers, or directors from liability to underpaid creditors, or if any reserves established under the plan for contingent or otherwise unknown claims later prove to be inadequate in light of facts reasonably available to the company at the time it approved the plan.

 

Safe Harbor Dissolution. The safe harbor dissolution method involves the same steps as the non-safe harbor dissolution, but provides the dissolved company’s stockholders and directors with a higher level of protection. To take advantage of the safe harbor provision of the DGCL, a company must petition the Delaware Court of Chancery to approve the amount of its proposed reserve for contingent and unknown claims that may arise within five years of dissolution.

There is no magic amount that constitutes an acceptable reserve. Rather, the amount must be reasonable based on facts available at the time the decision is made. If the court approves the reserve as adequate under the circumstances, contingent and future claimants may only look to the reserve for satisfaction of their claims. In other words, the reserve is the sole source of funds available for contingent and unknown claimants and therefore serves as a practical limitation of liability for the dissolved company’s management and stockholders. Directors and officers shall not incur any personal liability to the company’s claimants, and shareholder liability shall not exceed the amount distributed to such shareholder under the plan (i.e., there is no liability where there is no distribution to equity).

 

Dissolution by Receiver. Regardless of the manner of dissolution selected, a stockholder may petition the court to appoint a receiver to oversee the dissolution and liquidation processes. The receiver, who needn’t be a lawyer, steps into the shoes of management and takes charge of the company’s assets.

The receiver may collect any outstanding debts, reconcile claims, and do all other acts that might be done by the corporation and may be necessary to effect the full and final liquidation of the company and the distribution of its remaining assets.[8] While the Court of Chancery sets forth default rules to govern the receivership, a corporation may propose its own rules and procedures, subject to court approval.

 

Why Choose Delaware Dissolution?

Delaware dissolution procedures offer two mechanisms that allow a corporation to design a dissolution that best fits the goals of the company and/or its stockholders. Non-safe harbor dissolution allows a corporation to liquidate and dissolve quickly and efficiently. Also, because it is accomplished without court oversight, the corporation remains in control of how quickly or slowly the dissolution progresses. Control over the process allows for flexibility in how the corporation distributes its assets and when it effects the dissolution.

This flexibility can substantially reduce the costs associated with the dissolution. This method has proven particularly effective for a corporation that has few creditors and a defined universe of potential claimants. For example, a company that has ceased operations and maintains limited assets may find a non-safe harbor dissolution desirable because it likely knows what creditors hold claims, what (if any) additional claims may arise, and any other issues that may impact go-forward liability. A company in that situation efficiently can account for these foreseeable issues in the plan of dissolution.

On the other hand, a corporation that has more liability exposure (either current or future) or desires additional protection for its stockholders and management may opt for a safe harbor dissolution or seek the appointment of a receiver to minimize any current or future risk. Companies with more complex structures and diverse creditor bodies or those that manufacture hazardous products (e.g., products containing asbestos) may want the comfort of a court-approved reserve to insulate a parent and directors from future claims.

Though it can cost more than non-safe harbor dissolution, a safe harbor dissolution, with or without a receiver, can still be accomplished quickly and more efficiently than a bankruptcy filing. The Delaware Court of Chancery, as a court of equity, is sympathetic to the time sensitivities at play in many business transactions and will promptly—at times, within hours—avail itself to a corporation when the circumstances justify such treatment.

In addition, Delaware’s broad equitable powers and abundant body of case law empower the court to make swift decisions to resolve issues that arise during the liquidation and dissolution processes. Though safe harbor dissolution may be more time-consuming, it can often accomplish the corporation’s goals more quickly, efficiently, and cost-effectively than a protracted bankruptcy, while also providing significant protections to the corporation’s directors and stockholders.

Finally, a receiver can serve as a helpful intermediary between the corporation and the court. Delaware law allows the corporation to identify and propose a receiver, which, subject to court approval, oversees the winding-down and dissolution process. This flexibility can be particularly useful if the corporation is engaged in a specialized business, has a unique structure, or remains subject to certain constraints, such as time or impending transactions among related entities, to which the court may be sensitive or for which court intervention may be helpful.

 

Bankruptcy Alternatives

While bankruptcy remains the most common way to wind down a portfolio company, it is not the only option. In certain situations, state law liquidation and dissolution can be more cost-effective than bankruptcy and permit a company to retain greater control over the process, while also insulating management and its parent master fund from future liability.

However, unlike its bankruptcy counterpart, state law generally does not provide for an automatic stay of litigation and collection efforts. While the Court of Chancery can be receptive to requests to halt a proceeding or foreclosure, a company may not always avoid aggressive creditors trying to subvert the dissolution process. Thus, it is important to consider the benefits and consequences of state law liquidation and dissolution as compared to a bankruptcy filing and tailor the course of action based on the company’s particular needs and circumstances.

 

[1] Determining the best method to wind down a portfolio must start with an analysis of the company’s capital structure. Warring creditor constituencies or several tranches of competing funded debt may make a streamlined state law dissolution impracticable.

[2] 8 Del. C. Sections 280-81(a) (safe harbor); Section 281(b) (non-safe harbor).

[3] 8 Del. C. Sections 279; 291.

[4] The effective date of the certificate of dissolution may be up to, but not more than, 90 days after the filing of the certificate of dissolution, which affords the company time to wind up its affairs. 8 Del. C. Section 103(d).

[5] 8 Del. C. Section 278.

[6] See 8 Del. C. Section 282 (limiting stockholder liability to the amount distributed to him or it in the liquidation); 8 DelC. Section 281(c) (immunizing directors from personal liability if certain procedures followed).

[7] 8 Del. C. Section 281(b).

[8] 8 Del. C. Section 291.

 

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Reprinted with permission from the Journal of Corporate Renewal.

Liquidation Trustee Cannot Recover Under D&O Policy Due to Insured-vs.-Insured Exception

By: Erin Fay, Counsel, Bayard, P.A.

In a variety of contexts where reorganization through a plan is not possible, a liquidating plan is frequently the best end result for a chapter 11 case.  This is often the preferred exit strategy for cases where sale processes have concluded and the primary remaining assets in the estate are potential causes of action. These assets are sometimes the only possible source of recovery for unsecured or undersecured creditors.  As a part of the plan process, these creditors typically negotiate for the creation and control of liquidation trusts to pursue the actions.

However, a recent Sixth Circuit decision restricts the utility of this approach when underlying director and officer (D&O) liability insurance policies include “insured vs. insured” coverage exclusions. In Indian Harbor Insurance Company v. Clifford Zucker, et al., — F.3d –, 2017 WL 2641085 (6th Cir. June 20, 2017), the Sixth Circuit held that an insured vs. insured exclusion precluded coverage for a liquidation trustee’s claims against a debtor’s D&O’s, finding that the debtor in possession (DIP) and the prebankruptcy company were the same legal entity for purposes of the insured vs. insured exclusion.  As the DIP was bound by the exclusion and voluntarily assigned the claims to the trust, the exclusion applied with equal force to the trustee’s claims.

Read the full article here.

This article was featured in the October 2017 issue of the American Bankruptcy Institute Journal. Click here to learn more about ABI.

Averting the Pitfalls of Customer Claims, Noticing in Retail Bankruptcies

By Evan T. Miller, Senior Associate, Bayard P.A. and Travis Vandell, CEO & Mike Hill, Vice President, JND Corporate Restructuring

 

With the number of corporate bankruptcy filings in the retail industry nearly doubling in 2016 and continuing to climb in 2017,[1] retailers and their legal and financial professionals are faced with innumerable challenges in navigating the corporate bankruptcy process successfully in a streamlined and cost-efficient manner. Aside from the substantial task of restructuring debt in a rapid-paced, post-BAPCPA retail environment rife with constant marketplace disruption, retailer bankruptcy proceedings are often plagued with unexpected pitfalls when it comes to handling fallout from the loss of customer confidence and the potential wide array of claims owed to customers for various financial obligations, including gift cards, warranties, and rebates.

 

To address these challenges, retail debtors must proactively develop well-planned strategies to manage the intricacies of claims and noticing while efficiently and effectively communicating with creditors throughout their bankruptcy proceedings.

 

The complexity of identifying and managing customer claims in retail bankruptcies should not be underestimated. While many customers will not require notice if they have simply made purchases in the past, several subsets of the customer population could be eligible for claims as a result of their interactions with the company and the bankruptcy case. While potential creditors may vary from case to case, there are common prefiling preparations that retail debtors and their professionals can undertake to ensure that they appropriately communicate with the various subsets of their customer populations and manage their claims effectively.

 

The Retail Customer Creditor Universe

 

One of the crucial first steps in mapping out how best to manage potential customer claims is to identify the universe of customers to whom outstanding obligations could be owed and the subsets of this population to whom notice or communication should be provided. In short, retail debtors and their advisors should ask: Who are the customers, and what potential claims might they claim against the debtor’s estate? In a 363 sale scenario, certainly the purchasers already have this concern in mind. After all, a continued and loyal customer base is presumably critical to ongoing operations—and the crux of the underlying purchase.

 

To complicate matters, a significant number of customers typically are unknown, in essence, because there is no record of their contact information or the amount they are owed. For example, retail companies may not have any records pertaining to gift card holders, who have been the subject of much discussion and a handful of class action lawsuits in recent years as retailers in bankruptcy have faced challenges in honoring their obligations to these customers. As the product name implies, purchasers often end up giving the cards to others as gifts and with them the obligation of the debtor, rendering any associated address information captured at the point of sale all but irrelevant.

 

Encountering unknown populations of potential customer claimants isn’t limited to gift card holders. Given the relatively short shelf life of customer data, there is inherent difficulty associated with ensuring the long-term validity of noticing information contained in customer databases, warranties, refunds, lay-away programs, revenue sharing programs, loyalty programs, and financing programs. A litany of others may come into play, too.

 

These continuing obligations have been most recently evidenced in a number of hospital insolvency matters—after all, patients are basically “customers”—and also in the recent proceedings of a number of solar providers that gave warranties to homeowners who subsequently may have sold or otherwise moved from the properties. If ongoing obligations are owed to customers, this issue must be quickly identified by the debtors and, hopefully, by the purchasers.

 

The Economics of Noticing Customers

 

Once the debtor and its professionals have identified the appropriate customer population to which they will be serving notice throughout the bankruptcy proceedings, they must then consider how best to reach unknown creditors. By working with claims and noticing agents and strategic communications professionals, the debtor’s counsel can identify the best approach for the specific needs of the case.

 

While these unknown creditors may appear to be outliers in the grand scheme of things, they can represent a significant threat to the successful outcome of the case if they are not considered as part of the noticing strategy and within other communication efforts to reach the appropriate involved parties. Notwithstanding technological advancements and developments in how customers and consumers receive news, a common approach to dealing with unknown claimant populations remains publication notice.

 

Publication, however, while often sufficient in the eyes of the court when dealing with unknown claimant populations, can be expensive and thus can pose an issue for retailers with short liquidity runways, which is typically the case for such debtors. It is therefore important that retail debtors and their restructuring professionals anticipate the associated cost concerns at the prepetition stage.

 

To the extent the company maintains customer email addresses, perhaps a Bankruptcy Court would be willing to bless such service—it is both the quickest and most cost-effective way to notify customers of a bankruptcy scenario. To the extent hard-copy service is preferred, perhaps out of an abundance of caution or because email information was not maintained or was somehow invalidated, counsel and the debtor’s noticing agent can work together to put forward motions seeking alternative (and/or limited) noticing procedures on the basis that these would prove more effective at reaching the selected universe of potential claimants.

 

Alternatively, if the amount of potential claims resulting from a pool of customer claimants is known ahead of time to be de minimis (admittedly a rare scenario), procedures can be put into place to honor or reserve for the existing obligations at face value for a specified period of time post-petition. It is worth noting that while some goodwill or brand recognition may be maintained by continuing to honor customer programs in a bankruptcy scenario, the potential purchaser’s likely (though perhaps secretive) wish is that such existing obligation programs be invalidated or otherwise not recognized as a means of recognizing profits and maintaining sales numbers. In the retail world, this belief would be well-founded, because as much as $130 billion in gift cards went unused in 2015, up from $122 billion in 2014 and $118 billion in 2013.[2]

 

Considering Anticipated Outcomes

 

It can be helpful to consider the anticipated outcome of a retail bankruptcy to establish the context for how to approach customer claims and noticing and communications. An increasing number of retailers conclude bankruptcy with a sale rather than emerging as a going concern. In fact, an analysis of resolved retail bankruptcy filings from January 1, 2006, to June 30, 2015, found that 55 percent of retail restructurings concluded with a liquidation.[3]

 

In a perfect world, the debtor would be able to contact every single creditor to notify them of their potential claim; indeed, this scenario would certainly be applauded by any 363 purchaser. However, the reality is that with an unknown contingency of creditors and the costs of claims, noticing, and communication, debtors must take a measured and prudent approach to planning how best to serve notice to their creditors who are customers.

 

While a million or more potential claimants could be noticed, perhaps through publication or some other means—e.g., social media are occasionally used as a tool in class action scenarios—does the cost associated with such a noticing strategy outweigh the benefits of the sale? The extent to which a debtor anticipates a sale or reorganization at the conclusion of the restructuring should factor into deciding upon the communications strategy.

 

For example, if a retailer’s bankruptcy is ultimately ending in a 363 sale, it is not likely to continue a customer rewards program and therefore should tailor its noticing and communications accordingly and in advance. On the other hand, a debtor that will seek to honor existing customer programs should determine if doing so modifies the required customer noticing population and whether additional customer communications or notices would be beneficial to maintaining customer confidence and existing loyalties and relationships. Those customer programs (e.g., airline miles or hotel chain points) may be crucial to the ongoing significance/lifeblood of the brand; loyal customers expect their preferred brand to remain loyal to them. Should a sale be pursued and the purchaser seek to maintain retail operations in whole or in part, then it may behoove both parties to accept the associated noticing costs as an investment in the long-term preservation of the brand.

 

Communication with customers, of course, remains paramount. After all, two fundamental valuation components of a retail company are its intangibles, such as copyrights, trademarks, etc., and intellectual property, including customer and mailing lists. Absent a cohesive and modern communication plan, a company’s reputation may be tarnished, its customer list devalued, and any market value associated with its trademark brand eroded.

 

Providing notice to all customers can be costly, and with the limitation of the debtor’s estate, a debtor must consider the most cost-effective communication methods for reaching customers. Whether that be through mailed copies, publication, email, virtual press releases, website postings and announcements, ad placements, or even social media avenues, all options should be considered in an effort to produce a deftly navigated and desirable outcome in the retail restructuring space.

 

While not yet a mainstream practice, social media have been increasingly used not only to reach creditors but also to inform the public at large about a company’s progress through the restructuring process. The use of social media and other communications strategies carry importance beyond the notification of creditors. They also serve to buoy a company’s reputation as a going concern and to allay customer concerns and perceptions about the bankruptcy process.

 

As retail companies undergo corporate bankruptcy, there are significant ramifications for the improper handling of customer claims and noticing throughout the process. The failure to adequately prepare can potentially destroy a case and a company’s reputation. With careful preparation and the support of a knowledgeable team of professionals to advise on every stage of the process, retail companies can reach their objectives while keeping their past, current, and future customers satisfied.

 

[1] The Deal/TheStreet, Inc. “U.S. Retail Bankruptcies Skyrocket in 2016; Grim Outlook for the Industry,” TheStreet, Inc.

[2] CEB Tower Group Study, “Gift Cards 2015: Digital Tipping Point and the P2P Shift”.

[3] AlixPartners Retail Bankruptcy Study. Retrieved from legacy.alixpartners.com/en/Publications/AllArticles/tabid/635/articleType/ArticleView/articleId/1795/AlixPartners-Retail-Bankruptcy-Study.aspx#sthash.CN2A7EGL.dpuf

 

 

Journal of Corporate Renewal – October 2017

For more from the Journal of Corporate Renewal and the Turnaround Management Association, click here.

Solving the Gift Card Conundrum

By Justin R. Alberto and Gregory J. Flasser1

Retail debtors and consumers have long debated the appropriate treatment for claims on account of unredeemed gift cards. The facts giving rise to the debate, and the competing legal positions, are quite simple and easy to place into context. Consumer X purchases a gift card from Retail Debtor Y. However, before Consumer X (or his/her subsequent transferee) uses the gift card, Retail Debtor Y files for bankruptcy. Retail Debtor Y enters into a consulting agreement with a liquidation consortium, which promptly commences going-out-of-business (GOB) sales. Previously purchased gift cards are honored at the GOB sales, but many go unredeemed by the time the GOB sales have been concluded.

Having lost the ability to use the gift card, Consumer X submits a claim in the bankruptcy case to recover the lost value.2 The claim is submitted as a “deposit” priority pursuant to § 507 (a) (7) of the Bankruptcy Code, which affords priority treatment for claims of individuals (up to $2,775 per individual) “arising from a deposit, before the commencement of the case, of money in connection with the purchase, lease, or rental of property, or the purchase of services, for the personal, family, or household use of such individuals, that were not delivered or provided.”3 Retail Debtor Y objects to the claim on the basis that payment in return for a gift card is not a true “deposit” within the meaning of the statute and seeks to have Consumer X’s claim reclassified as general unsecured in nature. Consistent with the current trend, Retail Debtor Y’s bankruptcy proceeding is riddled with underwater secured creditors fighting to squeeze every dollar from their collateral, and priority claims are the only class of unsecured claims likely to receive a full recovery. Therefore, Consumer X’s ability to recover the value lost on account of the unredeemed gift card turns entirely on whose interpretation of the word “deposit” is correct.

On Aug. 4, 2016, Hon. Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware sided with Retail Debtor Y in In re City Sports Inc.4 The court’s opinion is at odds with prior decisions in Delaware and elsewhere, and while consistent with certain decisions in other districts, it will undoubtedly impact future bankruptcies filed in Delaware and beyond. This article provides a summary of the competing legal positions, certain prior case law and the bankruptcy court’s decision in City Sports.

The Parties’ Positions

Founded in 1983, City Sports Inc. was a Boston-based athletics retailer that sold its products through retail stores in Massachusetts, Rhode Island, New York, Pennsylvania, Maryland, New Jersey and Vermont.5 Facing an increasingly challenging retail environment, City Sports commenced a chapter 11 proceeding on Oct. 5, 2015, pursuant to which it closed all of its stores and liquidated all assets.6 Prior to filing for bankruptcy, City Sports sold pre-paid gift cards to consumers.7 At the conclusion of its GOB sales, City Sports estimated that gift cards totaling approximately $1.18 million remained unredeemed.

The Commonwealth of Massachusetts submitted a claim on behalf of Massachusetts residents for the full amount of City Sports’ unredeemed gift cards.8 Like Consumer X in the hypothetical, the Commonwealth sought priority status for its claim under § 507 (a) (7). In support of its argument, it cited In re WW Warehouse Inc.,9 wherein, under similar circumstances, the court found unredeemed gift certificates to be true “deposits” that must be paid on a priority basis pursuant to § 507 (a) (7).

City Sports, with the support of the unsecured creditors’ committee, objected to the Commonwealth’s claim and predictably argued that gift cards do not constitute customer deposits within the scope of the statute. According to City Sports, a “deposit” only occurs when a party provides money in return for the promise of the depositee to hold the money in trust (e.g., on account of a partial payment for a particular piece of merchandise or in a layaway transaction). By focusing on the temporal relationship between the time that consideration is given and the time that the right to use the product is vested in the consumer, City Sports asserted that the purchase of a gift card cannot possibly constitute a deposit since the transaction is completed in a single step. In other words, upon receipt of the gift card, the consumer received exactly what he/she bargained for and no additional actions were required to close the transaction. City Sports underscored this argument by noting that § 507 (a) (7) limits priority treatment to claims arising in those situations where the relevant product was not “delivered or provided” at the time of payment.10

Prior Decisions Interpreting § 507(a)(7)

A brief overview of the key decisions interpreting the “deposit” requirement of § 507 (a) (7) is instructive in analyzing the City Sports decision. Since 2004, WW Warehouse has been cited in practically every § 507(a)(7) dispute between retailers and consumers over the treatment of gift cards. Much like City Sports, WW Warehouse argued that gift certificates represent paid-in-full transactions, not deposits that can only arise in the context of a partial or down payment for a future purchase of a specific good.11 However, the WW Warehouse court declined to limit the definition of a “deposit” to a partial payment of a purchase price for specific merchandise.12 Rather, in granting priority status to the claims, the court found that “consumers do not purchase gift certificates … as the ultimate purchase,” but instead “expect merchants to apply to some or all of the face value of the gift certificate toward the ultimate purchase.”13

In 2005, the Ninth Circuit in In re Salazar14 likewise granted priority status to creditors who paid the full purchase price for a pool that was not finished by the debtor prior to filing for bankruptcy.15 The dispute centered on whether a payment in full removed the transaction from the “deposit” definition. Siding with the creditors, the Ninth Circuit noted that it is “highly unlikely that in drafting [§ 507 (a) (7)], Congress intended to protect consumers who had been induced to pay … a portion of the purchase price in advance, but not those who were induced to pay … the whole amount.”16 Thus, Salazar expanded, albeit slightly, the WW Warehouse decision by according priority status to consumers whose “deposits” were actually payment in full for specified goods.

In contrast, the support for the Commonwealth’s position begins with the Eighth Circuit’s decision in In re Northwest Financial Express Inc.17 In that case, the debtor marketed money orders through grocery and convenience stores, which in turn sold the money orders to their customers and remitted the proceeds to the debtor. The money orders purchased by each individual were transferrable and, according to the consumers, constituted a deposit. The Eighth Circuit disagreed and found that the purchase of a money order was “more akin to the purchase of a product (a transferable instrument) for immediate delivery which product is tradeable in lieu of cash.”18 As such, the court believed that the consumers got exactly what they bargained for (i.e., the money order) immediately upon payment.19 Similarly, the In re Heritage Village Church & Missionary Fellowship20 court found that pre-petition donations in return for membership benefits such as hotel accommodations were not deposits within the meaning of § 507 (a) (7).21 Like the money orders at issue in Northwest Financial Express, the court held that the “benefits” of membership were delivered and provided immediately upon completion of the transaction, which prevented the payment from being considered a true “deposit.”22

The same rationale was applied in In re Nittany Enterprises Inc.,23 where the debtor offered its members access to “confidential inside prices.”24 The claimant entered into a membership agreement with the debtor pre-petition and filed a proof of claim on the basis that he “paid $6,000 for services and received nothing.”25 The court held that “the term ‘deposit’ connotes a temporal relationship between the time consideration [has been] given and the time the right to use or possess is vested in the individual giving the consideration.”26 Finding that the claimant’s right to use the membership vested immediately, the court denied the claimant’s attempt to be paid on a priority basis.27

Finally, in In re Utility Craft Inc., the U.S. Bankruptcy Court for the Middle District of North Carolina rejected a creditor’s priority status argument on account of an unredeemed store credit.28 In Utility Craft, the creditor ordered a couch from the debtor and paid an initial deposit.29 Upon delivery, the creditor paid the balance, but because the couch was defective, the creditor returned the couch in exchange for store credit.30

The debtor filed for bankruptcy before the creditor redeemed the credit, and the creditor filed a proof of claim asserting (in part) priority status.31 Applying the reasoning from WW Warehouse, the creditor argued that the claim should be accorded priority status because it arose from the initial deposit.32 In deciding that the store credit did not qualify as a deposit within the ambit of § 507 (a) (7), the court followed the reasoning of Northwest Financial Express. Specifically, the creditor paid a deposit, received the couch and paid the remaining balance owed at the time of delivery.33 According to the court, “neither the statute, nor the legislative history, contemplates the statute’s application when a product is purchased, discovered to be defective, and then returned” because the fact remains that, with the issuance of the store credit in exchange for the defective sofa, the consumer immediately received the benefit of his/her bargain.34

The City Sports Opinion

Faced with a body of conflicting case law, Judge Gross first looked to the plain language of § 507 (a) (7), more specifically to the meaning of the term “deposit.”35 Finding that gift cards are not “deposits” within the scope of § 507 (a) (7), Judge Gross followed the reasoning from Nittany Enterprises that “‘deposit’ connotes a temporal relationship between the time consideration [has been] given and the time the right to use or possess is vested in the individual giving the consideration.”36 By utilizing a temporal analysis, one can discern a distinction between consideration tendered as a true deposit (e.g., in an incomplete transaction where the goods or services were not delivered or provided) and a mere payment for goods or services.37 According to the court, a gift card transaction is complete upon payment, as the benefit of the consumer’s bargain is immediately conferred by the receipt of a gift card.

The court analogized its rationale to the holdings in Northwest Financial Express and Utility Craft.38 According to the court, the features of the money orders at issue in Northwest Financial Express were identical to those City Sports’ gift cards in that both were purchased for cash in a transaction where the consumer immediately received the benefit of his/her bargain in the form of a freely transferable instrument.39 Likewise, the transaction in Utility Craft was complete upon the issuance of a store credit that included the initial deposit.40 The fact that the consumers in those cases and the gift card holders in City Sports failed to use the instrument prior to the retailer’s bankruptcy is irrelevant to the inquiry.

In holding that gift cards are not entitled to priority status, Judge Gross criticized the WW Warehouse decision for incorrectly focusing on “the ultimate purchase” as “an amorphous concept with potentially unlimited temporal extension.”41 The court instead focused on the limited nature of the transaction, noting that “the purchase of a gift card is a short transaction, without a temporal relationship: the consumer makes payment and simultaneously receives the gift card.”42 Finding that the purchase of a gift card is “akin to the purchase of a product (a transferable instrument) for immediate delivery,” the court refused to apply a potentially unlimited transactional duration to gift card purchases, which it found to be a completed transaction upon issuance of the instrument.43 Thus, the court concluded that gift cards cannot constitute the type of deposits that are afforded priority status.44

Conclusion

Conceptually and practically, the court’s decision in City Sports makes sense and resolves what has been a contentious issue for debtors in a variety of industries, most notably retail, grocery and dining. Gift card transactions are commercially distinct from true deposits in several important respects. As noted in City Sports and earlier decisions, the right to use a gift card vests immediately upon purchase, whereas a true deposit requires at least one additional step for the transaction to be complete (i.e., delivery of the good). Gift cards are also freely transferable — hence the name “gift card” — and do not entitle the purchaser to a right of refund as might be the case with other consumer deposits. Conferring priority status on a claim arising from a transaction that is materially different from a true deposit does not advance the consumer-protection principles discussed in the legislative history of § 507 (a) (7), which pertain primarily to payments on layaway plans or contracts with future services to be rendered, circumstances that are wholly absent from a gift card transaction.

A large priority claims pool can wreak havoc on a debtor’s ability to confirm a plan in a chapter 11 case. The City Sports decision is a positive development for debtors looking to avoid costly litigation with unredeemed gift card holders and for unsecured creditors hoping to receive a meaningful distribution on account of their claims.45


 Endnotes

1 Any opinions expressed and any legal positions asserted in this article are those of the authors and do not necessarily reflect the opinions or positions of Bayard, PA or its other lawyers.
2 The authors acknowledge that adequate notice and due process are threshold issues common to this dispute. This article assumes that Consumer X received proper notice of Retail Debtor Y’s bankruptcy proceeding and the attendant claims process.
3 11 U.S.C. § 507(a)(7).
4 In re City Sports Inc., 554 B.R. 329 (Bankr. D. Del. 2016).
5 Id. at 331.
6 Id.
7 Id.
8 Id. at 331-32.
9 In re WW Warehouse Inc., 313 B.R. 588, 595 (Bankr. D. Del. 2004).
10 11 U.S.C. § 507(a)(7). In further support of its argument, City Sports relied on a transcript ruling from RadioShack, where Hon. Brendan L. Shannon criticized the WW Warehouse decision as having been incorrectly decided. In re RS Legacy Corp., 2016 WL 1084400, at 1* (Bankr. D. Del. March 17, 2016). Indeed, the bulk of City Sports’s argument was taken from, with Judge Gross’s permission, the briefs submitted by the debtors and committee in RadioShack in support of an identical position.
11 In re WW Warehouse Inc., 313 B.R. at 590-91.
12 Id. at 593-95.
13 Id. at 595.
14 Salazar v. McDonald (In re Salazar), 430 F.3d 992 (9th Cir. 2005).
15 Id. at 994.
16 Id. at 995.
17 Northwest Fin. Express Inc. v. JWD Inc. (In re Northwest Fin. Express Inc.), 950 F.2d 561, 563 (8th Cir. 1991).
18 Id.
19 Id.
20 137 B.R. 888 (Bankr. D.S.C. 1991).
21 Id. at 896.
22 Id.
23 In re Nittany Enters. Inc., 502 B.R. 447 (Bankr. W.D. Va. 2012).
24 Id. at 450-51.
25 Id.
26 Id. at 455 (citing In re Palmas Del Mar Country Club Inc., 443 B.R. 569, 575 (Bankr. D.P.R. 2010)).
27 Id. at 456.
28 In re Util. Craft Inc., 2008 WL 5429667, at *4 (Bankr. M.D.N.C. 2008).
29 Id. at *1.
30 Id.
31 Id.
32 Id.
33 Id. at *4.
34 Id.
35 In re City Sports, 554 B.R. at 334-38.
36 Id. at 335 (quoting In re Nittany Enters. Inc., 502 B.R. 447, 455 (Bankr. W.D. Va. 2012)).
37 In re City Sports, 554 B.R. at 335.
38 Id. at 336-37.
39 Id. at 336.
40 Id. at 337.
41 Id. at 335 (citing In re WW Warehouse, 313 B.R. at 595).
42 Id.
43 Id. at 336-37 (quoting In re Northwest Fin. Express Inc., 950 F.2d at 563.
44 Id.
45 At the time that this article was written, the Commonwealth had not appealed the court’s decision but had filed a motion for reconsideration.

Reprinted with permission from the ABI Journal, Vol. XXXV, No. 12, December 2016. Link to article.

Sections 542 and 543—Turnover of Property of the Estate

By Bruce Grohsgal* and Gregory J. Flasser**

I. INTRODUCTION

Section 542 of the Bankruptcy Code generally requires a noncustodial entity who has possession, custody, or control of property of the estate that the trustee may use, sell, or lease under § 363, or that the debtor may exempt under § 522, to deliver to the trustee the property or the value of the property, and to account for such property.1 Section 543 similarly requires a custodian with knowledge of the commencement of the case to deliver such property and the proceeds of such property to the trustee and account for such property.2 This paper reports on opinions regarding turnover published since the 2015 update.3

II. JURISDICTION AND AUTHORITY OF THE BANKRUPTCY COURTS

Jurisdiction and Authority — Generally

Bankruptcy jurisdiction is essentially in rem, based on the district court’s exclusive jurisdiction over all property, wherever located, of the debtor’s estate.4 The court’s jurisdiction begins on the filing of the bankruptcy case and for most purposes ends when the property is transferred from the estate or revests in the debtor5 or the case is dismissed.6 The bankruptcy court stands in the district court’s shoes with respect to its jurisdiction over estate property, by virtue of the standing order of reference from its district court, and has exclusive jurisdiction over property of the debtor’s estate.7

The statutory framework for this jurisdiction is set forth in 28 U.S.C.A. § 157. Section 157(b) gives bankruptcy judges the statutory authority to enter final judgments on certain “core” matters arising under or arising in the bankruptcy case. “Core” matters expressly include “orders to turn over property of the estate.”8

Under § 157, a bankruptcy judge does not have authority to enter a final judgment on a matter that is not core but is merely “related to” the bankruptcy case. A ubiquitous example of a non-core action is a suit by a debtor to recover a disputed prepetition account receivable. The bankruptcy judge may hear a non-core, “related to” matter, but it cannot enter final judgment on it unless the district court has referred the matter to the bankruptcy court and the parties have consented to the bankruptcy court’s authority to enter final judgment. Absent such referral and consent, the bankruptcy judge may only submit its proposed findings of fact and conclusions of law to the district court. The district judge following its de novo consideration of both the facts and the law, then enters or declines to enter the final judgment.9

It follows from this jurisdictional foundation that a turnover action with respect to estate property is a core proceeding, and the jurisdictional statute that governs bankruptcy proceedings expressly so provides.10

The Supreme Court threw this statutory regime into Constitutional chaos when it issued its 2011 opinion in Stern v. Marshall.11 Stern held that because the bankruptcy courts are established under Article I rather than Article III of the Constitution, and bankruptcy judges do not have lifetime tenure as required for Article III judges, that a bankruptcy judge may have statutory authority but not the Constitutional authority to enter a final order on some matters defined as “core” in § 157(b). The Supreme Court would later describe this type of proceeding as “a so-called ‘Stern claim,’ that is, ‘a claim designated for final adjudication in the bankruptcy court as a statutory matter, but prohibited from proceeding in that way as a constitutional matter.’”12

The true characterization of any specific turnover claim for jurisdictional purposes was problematic before Stern, and has become more so since that case was decided. The bankruptcy court’s authority to enter a final judgment on the turnover count of a complaint depends entirely on whether the turnover action involves a straightforward surrender of estate property, or is more properly characterized as another kind of dispute, such as a prepetition contract claim, that is only “related to” the bankruptcy case. Only in the former case can the bankruptcy court enter final judgment. Accordingly turnover complaints continue to be closely scrutinized, especially in the wake of the Supreme Court’s Stern decision.

The court in Dynamic Drywall, Inc. v. McPherson Contractors, Inc. confronted this recurring issue. The Chapter 11 debtor sued for turnover based on its allegation that the defendant had converted miscellaneous equipment belonging to the debtor. The defendant moved to withdraw the reference so that the district court rather than the bankruptcy court would decide the litigation. The bankruptcy court concluded that the Chapter 11 debtor’s claims were not for turnover, but were merely “non-core state law claims, including the state law conversion claim.”13 Accordingly, the bankruptcy court recommended that the district court withdraw the reference with respect to the litigation. The district court accepted the bankruptcy court’s recommendation and withdrew the reference.14

The same result was reached in In re Garrison. Garrison, the Chapter 11 debtor, sued HSBC for turnover, alleging breach of contract and fiduciary duty against HSBC, claiming that HSBC withheld payment of “co-investment” distributions. HSBC moved to withdraw the reference. Garrison converted his case to Chapter 7, and the Chapter 7 trustee did not oppose HSBC’s motion.15 The court found that Garrison’s claims arose “not out of his bankruptcy or the resolution of the claims process but out of a contractual relationship between HSBC” and Capital Group, the beneficial sole owner of which was Garrison. The court found that the claims did not arise out of Garrison’s bankruptcy, and though resolution of the claims might affect the bankruptcy case, this fact did “not sanction their adjudication in bankruptcy court absent the consent of HSBC.” Therefore, the court granted HSBC’s motion to withdraw the reference.”16

Suits on a debtor’s prepetition accounts receivable generally are not core and thus, absent the parties’ consent, the bankruptcy court does not have authority to enter final judgment on such claims. The debtor in In re SurfaceMax, Inc. entered into a prepetition subcontract with Precision. The subcontract authorized Precision to submit any dispute under the subcontract to arbitration. The debtor filed a Chapter 11 bankruptcy petition and sued Precision for amounts owing under the subcontract, seeking turnover of those amounts and of personal property. The debtor’s case was converted to Chapter 7.17 Precision sought arbitration of the debtor’s claims.18

The SurfaceMax court noted that in a bankruptcy proceeding, “courts look to the “core” or ‘non-core’ nature of the underlying claim in determining whether to enforce an arbitration provision.”19 The court stated that a principal purpose of the Bankruptcy Code is to resolve disputes over the debtor’s assets and obligations in one forum, rather than by piecemeal litigation and conflicting judgments.20

The court held that the debtor’s claim for turnover of accounts receivable that arose pre-petition under state law was not core. The claim for turnover of the personal property, in contrast, was core. Nevertheless, in the interest of efficiently adjudicating all claims between the parties, the court also referred the debtor’s claim for turnover of the personal property to arbitration, reasoning that “[e]xtracting this claim from the remainder of the Complaint would prevent the arbitrator from squaring all claims between the parties and determining a liquidated amount owed either by Precision or the Debtor.” The court stayed the adversary proceeding until the arbitration was completed.21

Alter ego and corporate veil piercing actions pose special jurisdictional problems. The bankruptcy judge has jurisdiction and authority over property of the estate. But if the debtor secreted or otherwise transferred estate property to an alter ego or similar entity, is the property still estate property subject to turnover, or is all that remains a state law claim for recovery?

The bankruptcy court in In re Tolomeo cited Stern in concluding that a turnover claim based on alter ego and veil-piercing claims was not constitutionally core (though Stern did not involve either of those legal doctrines).

In Tolomeo the assignees of potential bankruptcy estate claims sued the Chapter 7 debtor’s spouse and corporations owned solely by his spouse, seeking a declaration that the spouse’s and corporations’ assets were property of debtor’s bankruptcy estate. In support, the plaintiffs asserted that the defendants were alter egos of debtor, and requested that the court pierce the veil of the corporate defendants and direct turnover of defendants’ assets to trustee. The assignees filed a motion for judgment on the pleadings.22

The Tolomeo court noted that, though turnover orders are statutorily defined as core matters pursuant to 28 U.S.C.A. § 157(b)(2)(E), alter ego and veil-piercing under Stern are not issues that “stem[ ] from the bankruptcy itself or would necessarily be resolved in the claims allowance process.”23 Nor had the defendants consented to the court’s jurisdiction and authority. The court treated the claims as non-core and stated that it would issue make proposed findings of fact and conclusions of law on the questions of alter ego and veil-piercing for de novo review by the district court.24 The court further ruled that it would address the plaintiffs’ turnover request after the district court’s entry of a final order adjudicating the alter ego and veil-piercing issues, as appropriate.25 The court then, after an extensive analysis, recommended that district court find, under Illinois law, that corporations owned solely by debtor’s spouse were the alter egos of debtor and that their corporate veils should be pierced.26

By comparison, the bankruptcy court in In re Roussos perfunctorily stated that it had “jurisdiction pursuant to 28 U.S.C. §§ 157 and 1334 and General Order No. 13-05 of the U.S. District Court for the Central District of California” over turnover and other claims involving alter egos and fraud on the court.27 At issue in Roussos was whether a 21-year old bankruptcy sale of two properties could be set aside for fraud on the court under Fed.R.Civ.P. 60(d)(3).28 The bankruptcy court that approved the sale relied upon declarations submitted by the Roussos brothers in their individual Chapter 11 cases, which falsely stated that the sale was an arms-length transaction, that neither brother held any interest in companies purchasing the properties, and that the properties were over-encumbered.29 The court ruled that, assuming the allegations in the complaint were true, the properties remained property of the estate and as a result “the estate was never divested of its interest in the Properties.”30 The court declined to dismiss the turnover count.31

See also Comu v. King Louie Min., LLC and In re Raymond discussed in § VII below.

Jurisdiction after Chapter 11 Plan Confirmation

The bankruptcy court in In re Wellesley Realty Associates, LLC held that § 542(a) is “inapplicable” once property has revested in the reorganized debtor pursuant to a Chapter 11 plan “because there is no longer a trustee (or debtor-in-possession) to whom property can be delivered and the estate cannot benefit.”32

Sovereign Immunity

Another area in which difficulties persist is where a turnover proceeding implicates the sovereign immunity from suit of the federal government or a state under the 11th Amendment pursuant to Seminole Tribe of Fla. v. Florida and its progeny.33 Neither the bankruptcy court nor the district court has jurisdiction if the defendant is a sovereign that has not consented to suit or agreed in the plan of the Constitutional Convention or by later joining the federal union not to assert a sovereign immunity defense in a bankruptcy proceeding.34

The Chapter 7 trustee in In re Sann brought an adversary proceeding to compel turnover of certain funds from defendants. The turnover defendants made a counterclaim against the Chapter 7 trustee alleging that the complaint “was presented for the improper purpose of coercing Defendants to deliver funds” which the Chapter 7 trustee was not yet entitled to receive under district court orders. The turnover defendants also filed a third-party complaint against the Department of Justice (DOJ) and the United States Trustee, seeking to hold them liable under the Equal Access to Justice Act (EAJA) and on agency theory for reasonable attorney fees and costs that the defendants had incurred. The DOJ and the U.S. Trustee moved to dismiss third-party complaint.35 The bankruptcy court granted the motion, finding that the defendants/third-party plaintiffs had failed to show an unequivocally expressed waiver of sovereign immunity, and holding that the federal defendants were immune from suit under the United States’ sovereign immunity.36

III. PREEMPTION OF STATE LAW BY THE BANKRUPTCY CODE; PREEMPTION OF THE BANKRUPTCY CODE BY OTHER FEDERAL LAW

The authors are not aware of any significant published opinions since last year’s Annual Survey addressing the issues of preemption in connection with turnover actions.

IV. FORM OF ACTION/SERVICE

Federal Rule of Bankruptcy Procedure 7001(1)37 includes in the list relief requiring the commencement of an adversary proceeding, “a proceeding to recover money or property, other than a proceeding to compel the debtor to deliver property to the trustee.” Thus a request for turnover of estate property from a debtor,38 and a turnover action for recorded information under § 542(e),39 may be brought by motion, while Rule 7001(1) requires an action for turnover of property that is not a document, against a third party who is not the debtor, under

§ 542(a) and (b) and § 543(a) to be commenced by an adversary proceeding.40

Courts nonetheless have granted turnover relief sought by motion against a third party. In In re Cypress Health Systems Florida, Inc. the bankruptcy court determined that a $50,000 escrow held by a title company was property of the debtor’s estate and ordered it to be turned over on the debtor in possession’s motion.41

Further, many courts have held that § 542(a) is “self-effectuating.” The Ninth Circuit Bankruptcy Appellate Panel (BAP) in In re Cinevision International, Inc. reiterated its view that: “It has long been the determination of this panel that the turnover provisions of the Bankruptcy Code are to be self-effectuating, subjecting to sanctions a party that willfully fails to comply.”42 A party who does not seek the bankruptcy courts guidance, and unilaterally decides that it does need not turn over the property, does so at the risk that it will be assessed damages or will be sanctioned for violating the automatic stay.43

The California bankruptcy court in In re Perry held that a party that had repossessed the Chapter 7 debtor’s car prepetition had the affirmative duty to end its possession once it learned of the bankruptcy case and that since the car was exempt property, “turnover to the Debtor was appropriate.”44

A party’s obligation to turn over property under § 542(a) is further subject to the “good faith” exception, set forth in § XI below.

V. STANDING

A debtor in possession, whether under Chapter 11 or Chapter 13,45 and a Chapter 7 or 11 trustee, each has standing to bring an action under Code § 542.46 Most courts have held that a Chapter 7 debtor — whose property is under the authority of the trustee — lacks standing.

In Perry, the debtor’s auto lender had repossessed his car, but had not yet sold it when the debtor commenced his Chapter 7 case a week later. The lender subsequently obtained relief from the stay and sold the car. The bankruptcy court ultimately concluded that the debtor, who was representing himself, had exempted the car. The Perry court found “puzzling” the provision of § 542(a) requiring the turnover of exempt property “where it is the chapter 7 debtor who is seeking turnover from a creditor.” Accordingly, the court noted, some courts have held that a Chapter 7 debtor has standing.47 The Ninth Circuit BAP had reached the opposite conclusion, though, and the Perry court felt itself bound by it.48

VI. BURDEN OF PROOF

The party seeking turnover has the burden of proof,49 and “must prove that the subject property constitutes property of the estate and that the defendant is in possession of that property.”50

The trustee in In re Auld filed motions to extend the deadline for filing a complaint to deny the debtor’s discharge and for the turnover of property. The bankruptcy court ruled that the trustee was required “to describe with particularity the property or documents to be turned over.” Because the trustee had sought discovery, or been specific in his requests, his motion for an order directing turnover was denied.51

An exception stated by the bankruptcy court in In re Tate is the debtor’s burden to raise the issue of the inconsequential value of the property as an affirmative defense.52

Presumptions regarding ownership interests in property may shift the burden of proof. In In re Shapphire, one spouse had transferred property that was titled in her name to the debtor prepetition. Her spouse alleged that the property belonged to both spouses as community property. Under California law, the owner of the legal title to property is presumed to be the owner of the full beneficial title. This presumption can only be rebutted by clear and convincing proof.53 The bankruptcy court ruled that the challenging spouses’ uncorroborated testimony was insufficient to rebut this presumption.54

VII. SECTION 542(a)—PROPERTY OF THE ESTATE THAT THE DEBTOR MAY USE, LEASE, SELL, OR EXEMPT

Generally — Property of the Estate

“It is crucial to the trustee’s claim that the asset to be turned over is property of the estate.”55

Property rights generally are determined by state law.56 If under the applicable state law, the debtor has no interest in the property turnover of which is sought, then the court will deny turnover.

Courts have struggled with cases involving disputed title. The bankruptcy court in In re Nurses’ Registry and Home Health Corporation recently weighed in, holding that a trustee or debtor in possession has a cause of action for turnover even if title is in dispute and needs to be determined as part of the litigation.57

But the bankruptcy court in In re Soundview Elite Ltd. reached the contrary determination. The Chapter 11 trustee in Soundview filed a complaint by which she sought, among other things, turnover of the net value of the debtor’s investment in its non-debtor subsidiary — which was effectively everything that the subsidiary would have after payment to its creditors, since the debtor was the sole shareholder in the subsidiary.58 The court stated that “the turnover power can be improperly invoked, especially when it is used as a Trojan Horse for bringing garden variety contract claims; when the property in question is not already property of the estate; or when the turnover statute is used to recover assets with disputed title when the estate’s claim of ownership is legitimately debatable. It is well established that the turnover power may not be used for such purposes.”59 The court ruled that though the matter was close, and the defendant’s defenses were largely frivolous (and the court could not even find that they were bona fide), the court could not determine that the cash or property to be delivered to the debtor was “already estate property,” or that the debtor’s rights was “yet equivalent to recovery of a fixed sum, or tantamount to substituting one kind of asset for another.”60 The court denied the trustee’s motion for summary judgment of the turnover count.61

In re Fraterfood Service, Inc. required application of the Puerto Rico law. The debtor constructed a building and other improvements on its leasehold. The debtor subsequently filed its Chapter 11 case, rejected the lease, and filed a complaint seeking payment of $1.5M from the landlord for the value of the building and improvements and alleging that the landlord had violated the automatic stay by retaining possession of the building and improvements.62 The landlord moved to dismiss the complaint and sought Bankruptcy Rule 9011 sanctions against the debtor and its counsel.63

The debtor responded that the landlord was obligated to turn over the property under

§ 542(a).64 The court extensively analyzed the applicable law of the Commonwealth of Puerto Rico, and determined that the debtor in its complaint failed to establish that the debtor had an interest in the building and improvements. The court dismissed the debtor’s complaint.65

The Fraterfood court also found that the debtor’s counsel’s filing the complaint constituted “dilatory litigation” the purpose of which was forestall payment to the landlord of the postpetition rent that had accrued prior to the debtor’s rejection of the lease. The court granted the landlord’s motion for sanctions in part, ordering the debtor’s counsel to pay the landlord’s legal costs, expenses and fees.66

A mere damage claim generally is not determined to be estate property subject to turnover. The Chapter 11 trustee in In re The Vaughan Company, Realtors, a real estate brokerage company, sued a competitor and several individuals for the defendants’ “alleged improper relocation of certain real estate brokers” who had worked at the debtor to the competitor, and “the subsequent relisting” of the debtor’s real estate listings with the new firm. The trustee sought, among other things, turnover of the commissions received on the sales of the re-listed properties. The defendants moved to dismiss. 67

The court ruled that the commissions were not property of the estate. “Property such as commissions to be recovered for the estate becomes property of the estate only if and when recovered.” Even if the trustee had sought to recover the commissions as a voidable post-petition transfer under § 549 or otherwise (which she had not), or prevail on her claim that the listings were wrongfully transferred, the commissions themselves would “never become property of VCR’s bankruptcy estate” and thus the trustee could not obtain relief under § 542(a). “A damages award in the amount of the Commissions does not make the Commissions themselves property of the estate” and the trustee’s claim under § 542(a) was “not facially plausible.”68

See also In re Shapphire Resources, LLC discussed in § VI above.

The Property Must be Property That the Debtor May Use, Lease, Sell or Exempt

Property that the Debtor May Use, Lease of Sell

The property, to be subject to turnover, must be property that the debtor may use, lease or sell under section 363, which generally means that it is property of the estate under Code § 541.69

Property that the Debtor May Exempt

The application of the turnover provisions to property asserted by the debtor to be exempt is somewhat peculiar, since the debtor’s exemption would appear to put the exempt property beyond a trustee’s reach even though § 542 requires turnover to the trustee of property that the debtor may exempt.

Courts nonetheless often deny a trustee’s request for turnover of property, if the debtor has claimed a proper exemption (see e.g., In re Perry discussed in § II above),70 and conversely grant the trustee’s motion for turnover from the debtor if the property is not exempt.

Types of Property Interests Subject to Turnover

Several opinions in the last year have made the threshold determination of whether the property sought was estate property, with respect to myriad types of property interests, as set forth in the following subsections of this § VII.

Accounts Receivable

The court in In re SurfaceMax, Inc. (discussed in II above) followed the general rule that an action to obtain payment on an account receivable — though actionable — is not a turnover proceeding.71

Alimony

The bankruptcy court in In re Millette determined that alimony is a property interest and not a personal right under New Hampshire law, and thus was property of the estate.72

Alter Ego Claims

The trustee in Comu v. King Louie Min., LLC alleged that Comu concealed his ownership of Green Automotive Company, Inc., “using, inter alia, his undisclosed, de facto ownership and control of The Barclay Group, Inc. (‘TBG’) to hold his Green Auto Stock and thereby avoid detection.” The trustee sought turnover of all prepetition assets, including the Green Auto Stock and any proceeds collected from the disposition of those assets.73

The bankruptcy court concluded that “TBG was indeed Comu’s alter ego, and that, therefore, any pre-petition shares of the Green Auto Stock owned by TBG should have been turned over to the Trustee pursuant to 11 U.S.C. § 542(a).” The court found that Comu had furthered an “elaborate scheme to dissipate TBG’s Green Auto Stock—and collect millions of dollars in cash proceeds—that should have been available to his creditors.” The court further found value of the stock to be $5,858,788, which reflected the “actual cash proceeds from the sale of Green Auto stock.”74

The district court held that the bankruptcy court had authority to order parties to turn over property subject to their control, which should have been included in the bankruptcy estate, and affirmed the monetary judgment in favor of the trustee pursuant to § 542(a).75

The bankruptcy court in In re Raymond held that control, “even pervasive control, without more, is not a sufficient basis for a court to ignore corporate formalities,” and dismissed the trustee’s alter ego claims.76

See also In re Tolomeo and In re Roussos discussed in § II above,

Avoidable Transfers

Avoided transfers are subject to turnover, but the courts continue to divide on the question of whether a transfer that is merely avoidable is subject to turnover.

The Chapter 7 trustee in In re Bruner sought turnover of a fee paid postpetition to the debtor’s criminal defense counsel. The debtor’s elderly mother wire-transferred the funds to defendant defense counsel, and the parties hotly disputed whether the debtor was “the true source of the transferred funds.” In the court’s view the parties had missed a more fundamental point, that: “turnover can only be used to demand return of estate property to the Trustee, not to avoid transfers of what was estate property.”77 The court reasoned that when the debtor “voluntarily surrendered her own title to the money, the estate lost whatever interest it had in the money.” Even though the trustee offered substantial evidence that the $50,000 was the debtor’s money and thus may have been estate property before its transfer, the trustee did not avoid the unauthorized postpetition transfer. Thus, no evidence the trustee had adduced could prove that the $50,000 fee, having been transferred from the estate, was estate property and the fee was not subject to turnover.78

But in In re Roussos, also discussed in § II above, the court ruled that the transfer of estate property pursuant to a court order under § 363(b) but in fraud on the court “never divested of its interest in the Properties” and declined to dismiss the turnover count.79

See also In re Tolomeo discussed in § II above.

Lease or Disguised Financing

The trustee in In re Hunt sought turnover of certain equipment from the debtor. The debtor objected, asserting that the property was subject to a finance lease with Shephard under Idaho law, pursuant to the terms of which Shephard was the owner of the property until the debtor completed payments to him.80 The court held that the transaction between the debtor and Shephard was a disguised financing and security interest, and thus that the debtor had an ownership interest in the equipment. As a result, the equipment was property of the estate and the court ordered turnover to the trustee.81

Proceeds and Escrows

If property of the estate, subject to turnover, was first sold, then the sale proceeds are subject to turnover. Conversely if the property is not property of the estate, then the proceeds are not subject to turnover.

If the property sold was subject to a valid and perfected lien, then the holder of the lien is entitled to the proceeds in payment of its claim, prior to any payment to estate. In In re Spence the debtor’s boat slip was sold at sheriff’s sale. The bankruptcy court found that the condominium association’s execution and levy against a boat slip were valid and that it thus held a judgment lien against the proceeds, in the amount of $37,138. The court ordered payment of $37,138 to the association and the turnover of the balance of the proceeds to the Chapter 7 trustee.82

The debtor in In re Morev entered into an agreement with a creditor, Keeler, prepetition. Under the agreement, the debtor assigned his liquor license to Keeler, who agreed to “make maximum effort to sell the license, to recoup $68,000” which represented the amount that the debtor owed to the Keeler “for the purchase of the liquor license, plus legal costs.” Keeler opened an escrow with an escrow company to accomplish the sale, the liquor license was sold, and the sale proceeds were deposited in escrow with the escrow company.83

The debtor filed his Chapter 7 petition and the trustee sought turnover of the escrowed funds. The court held that it is “well settled in the Ninth Circuit that where a seller of a liquor license becomes a debtor in a bankruptcy case after the license is sold, but before the proceeds are distributed from escrow, the proceeds become property of the bankruptcy estate and must be distributed in accordance with the bankruptcy priority scheme … while a state, as the creator of a liquor license, may validly impose conditions on its transferability for the state’s own benefit, it may not, consistently with paramount federal law, impose conditions which discriminate in favor of particular classes of creditors.”84

The escrow company argued that Keeler was entitled to the proceeds, because the debtor had assigned the liquor license to Keeler. The court held that the assignment was neither an outright transfer of, nor a grant of a security interest in, the liquor license. The assignment “was at most a grant by Debtor to Keeler of control of the license for the sole purpose of allowing Keeler to sell the license and to control (not own) the proceeds,” and ordered turnover of the proceeds.85

In In re Cypress Health Systems Florida, Inc. Partner’s Healthcare signed a letter of intent prepetition for the purchase of assets of the debtor and paid a $50,000 deposit to the title company. The sale never closed. The debtor filed its Chapter 11 petition and sought turnover of the $50,000 deposit.86

Partner’s Healthcare argued first that the debtor did not schedule the escrow as an asset, and thus had no interest in the funds. The court rejected this argument perfunctorily. Partners Healthcare next argued that the debtor failed to negotiate the sale in good faith. The court found that the letter of intent contained express terms regarding ownership and disposition of the escrow, including that the escrow “would revert permanently to the possession and control” of the debtor under certain circumstances, which the court found had occurred. The court ordered turnover.87

Property of Others

Bankruptcy Code § 541(d) “excludes from the bankruptcy estate the equitable interest in any property in which the debtor holds, as of the commencement of the case, only legal title and not an equitable interest.

The bankruptcy court in In re Raymond held that property co-owned with one’s spouse, though, is subject to turnover because pursuant to § 363(h) it can be sold and under § 363(j) the proceeds can distributed to the joint owners in accordance with their respective ownership interests.88

Spendthrift and Discretionary Trusts

Section 541(c)(2) of the Code provides that: a “restriction on the transfer of a beneficial interest of the debtor in a trust that is enforceable under applicable nonbankruptcy law is enforceable in a case under this title,” and thus “recognizes the enforceability of spendthrift provisions in trusts where the debtor is a beneficiary of a spendthrift trust.”89

The court in Safanda v. Castellano determined that, under the law of the three states that might apply, “discretionary trusts, like spendthrift provisions, validly restrict the transfer of a beneficiary’s interest.” The debtor’s beneficial interest in the trust at issue was “subject to a valid nonbankruptcy restriction on transfer.” It thus “fell within the scope of § 541(c)(2)” and was excluded from her bankruptcy estate.90

Substantive Consolidation

Substantive consolidation is a doctrine by which a bankruptcy court may pool the assets and liabilities of two or more related entities. Courts most often have substantively consolidated two or more debtors, typically because the debtors’ assets and liabilities are so commingled that it would be impossible or prohibitively expensive to disentangle their financial affairs. A court more rarely may substantively consolidate a debtor with a nondebtor. The bankruptcy court in In re Raymond citing approvingly another bankruptcy court decision that stated that: “Substantive consolidation is essentially a complex turnover proceeding because the debtor is asking the nondebtor affiliated entity to bring into the estate assets in which the debtor asserts an inseparable interest.” But the Raymond court dismissed the trustee’s substantive consolidation claim.91

VIII. SECTION 542(a)—DELIVER TO THE TRUSTEE AND ACCOUNT FOR THE PROPERTY OR THE VALUE OF SUCH PROPERTY IN POSSESSION, CUSTODY, OR CONTROL DURING THE CASE OF THE ENTITY, OTHER THAN A CUSTODIAN, FROM WHOM TURNOVER IS SOUGHT

The bankruptcy court in In re Tate followed the majority rule that the party from whom turnover is sought under § 542(a) must be “in possession, custody, or control, during the case, of the property,”92 that is, at some point “during the case,” if the turnover action is to succeed.93

The trustee in Matter of Home Casual LLC sought turnover of a bank account. The bankruptcy court found that “it suffices to note that there is no proof that there were funds in the account on the date of the bankruptcy which would be subject to turnover,” and thus there was no basis on which to compel an accounting.94

Deliver to the Trustee Property or the Value of Such Property

The person in possession, custody or control of the property “during the case” has the duty under§ 542(a) to “deliver to the trustee, and account for, such property or the value of such property.”95 Most courts hold that “during the case” means at any time during the pendency of the bankruptcy case, and not solely at the time the turnover proceeding is commenced.96 Further, if the property has been spent, transferred or otherwise dissipated that person in most cases remains obligated to turn over its value.

The bankruptcy court in Comu v. King Louie Min., LLC found that the debtor had concealed from the trustee certain stock that he owned and had failed to turn over that stock to the trustee. The court ordered the debtor to turn over the value of the stock.97

The debtor in In re Tate received an arbitration award, $110,873 of which was non-exempt property of his estate. The bankruptcy court ordered turnover of that part of the award, shortly after which Tate notified the trustee that he had spent the money on living expenses and “therefore would be unable to comply” with the court’s order.98

Tate then proceeded to try the patience of the court. Six months entry of the turnover order, the court found Tate in civil contempt. Seven months later, “after various efforts failed to coerce Tate’s compliance,” the district court at the bankruptcy court’s request issued an arrest warrant. Tate turned himself in, and was released conditioned on his appearance before the bankruptcy court to explain the whereabouts of the money. At the hearing though, “he failed to provide any additional information as to the disposition of the Arbitration Award. The court ordered Tate held in custody until he either turned over or accounted for the money, and scheduled a second hearing 48 hours later “to provide Tate an opportunity to do so.”99

Tate remained unmoved, reasserting his prior testimony that he had used the money for living expenses, including $78,542 that was withdrawn from his account when the account was closed. Following the hearing, the court gave Tate numerous deadlines and opportunities to comply, none of which were complete or satisfactory.100

Resignedly, the court acknowledged that a year-and-a-half of its “efforts to coerce Tate’s compliance” had “produced limited tangible benefits for creditors.” No matter the personal cost or risk, Tate remained unwilling to fully comply. The court transmitted a record of Tate’s actions in the case to the United States Attorney “for the purpose of considering various criminal charges.” The court tiredly conceded that a criminal prosecution would not provide creditors with any further monetary benefit. However, a monetary judgment, while Tate appeared to still be working, would “at least provide the Trustee an opportunity to recover the remaining portion of the Arbitration Award for the benefit of the creditors, rather than continue a game of cat and mouse with Tate.” Accordingly, the court entered judgment against Tate in the $91,290 value of the estate’s $110,873 share of the arbitration award.101

See also In re Spence discussed in § VII above (ordering payment of $37,138 of proceeds from the sale of the debtor’s boat slip to the judgment lien creditor, and the turnover of the balance of the proceeds to the Chapter 7 trustee).102

Notwithstanding the textual directive in § 542(a), “[n]umerous courts have recognized an equitable defense of double satisfaction in the context of a turnover action,” and the bankruptcy court In re Noram Resources, Inc. denied part of the trustee’s turnover claim because it would have constituted such an “impermissible double recovery.”103

Action for Accounting

Section 542(a) also requires an entity to account for property subject to turnover.104 The court in In re Vaughan Company, Realtors held that though the trustee had failed to state a claim under § 542, she nonetheless was “not precluded from seeking an accounting or from requesting copies of the listing agreements and closing statements under the Rule of Civil Procedure governing pre-trial discovery.”105

See also In re Tate discussed in this § VIII above.

IX. UNLESS SUCH PROPERTY IS OF INCONSEQUENTIAL VALUE OR BENEFIT TO THE ESTATE

Section 542(a) does not require turnover of “property that is of inconsequential value or benefit to the estate.”106

The bankruptcy court in In re Shapphire Resources, LLC found that, “given the nature of the Property, its renovation to be used as a home for the developmentally disabled, and its ability to generate income …, and that no party has argued that the Property is of inconsequential value or benefit to the estate, the debtor in possession who was seeking turnover had “shown, by a preponderance of the evidence, that the Property [was] not of inconsequential value or benefit to the estate.”107

The bankruptcy court in In re Noram Resources, Inc., also discussed in § VIII above, noted that “an essential element of a turnover action is that the estate property in question must have consequential value.” The court went on to state that, if the defendants, “through settling claims rightfully owned by the estates, impacted the prosecution of the subsequent lawsuits, then the claims would have consequential value” to the estate. The evidentiary record in the court’s view did “demonstrate such an impact, although it may have been minimal.”108

X. SECTION 542(b)—DEBTS MATURED OR PAYABLE ON DEMAND OR ORDER BUT § 542 NOT AVAILABLE TO LIQUIDATE DISPUTED CONTRACT CLAIMS

Bankruptcy Code § 542(b) provides that, subject to the exceptions in § 542(c) and (d) and to offset under § 553, “an entity that owes a debt that is property of the estate and that is matured, payable on demand, or payable on order, shall pay such debt to, or on the order of, the trustee.”109

The “matured debt” does not need to be evidenced by a promissory note. In In re MF Global Inc. the debtor’s customer had opened an investment trading account with the debtor prepetition pursuant to the terms of a Customer Agreement. The Customer Agreement gave the debtor “various rights, including, without limitation, the right to declare” the customer “in default without declaring a margin call and the right to liquidate his account without affording him prior notice.”110

The debtor attempted to contact the customer several times on May 6, 2010, during a severe market downturn, to notify the customer of a margin call. An email sent by the debtor toward the end of the day informed the customer that unless he paid the margin call the debtor would liquidate his account. By the end of the next day the debtor had completely liquidated the account.111

The customer sued the debtor prepetition. The litigation was stayed by the bankruptcy filing. The customer did not seek relief from the stay. The customer filed a $545,000 claim in the bankruptcy case.112

The trustee did not seek affirmative relief under § 542(a), but sought only a determination that the customer’s account was in deficit for the purpose of temporarily disallowing the customer’s claim under § 502(d).113 The court found that the trustee had established that the customer was “unconditionally liable” to the debtor for the debit balance of his account the debt was matured under § 542(b) and thus that the debt was estate property under § 541(a).114 The court held that the trustee thus had made a prima facie showing that the debit balance was subject to turnover and sustained the trustee’s objection to the customer’s claim under section 502(d) of the Code.115

But a mere contract dispute is not a “matured debt.” The bankruptcy court in In re NanoDynamics, Inc. “readily dismisse[d]” the trustee’s § 542 turnover action. Section 542 “has no utility to collect a ‘debt’ that has yet to be determined to be ‘property of the estate’ because, for example, there neither has been a determination of liability on an obligation, nor identification of a source of payment (or other satisfaction) to which a debtor has a right of ownership or possession.”116

The court in In re Soundview Elite Ltd., also discussed in § VII above, noted that “section 542(b) can be used to monetize estate assets such as notes or accounts receivable that are already property of the estate.”117 But “[u]nlike the entitlement to payment on an account receivable or a promissory note, which is simply to be converted into cash,” the debtor did “not yet own the redemption proceeds, and its entitlement” was “not yet equivalent to recovery of a fixed sum, or tantamount to substituting one kind of asset for another.”118

The debtor in In re Pantazelos filed a complaint against her former bankruptcy counsel seeking recovery of attorney’s fees paid for legal services rendered in her two earlier bankruptcy cases, both of which were bankruptcy cases dismissed.119 The defendant moved to dismiss the debtor’s suit. The bankruptcy court stated that turnover is a remedy to obtain what is acknowledged to be property of the estate, and “cannot be used as a tool to acquire property the debtor did not have a right to possess or use at the commencement of a case.” The debtor, in the court’s view, had put “the cart before the horse.”120 She did not allege a “debt” that was “clearly her property and simply not in her possession. Rather, the debtor alleged that the defendant obtained the money improperly, “alluding to possible fraud.” The court nonetheless determined that the facts, taken in the light most favorable to the debtor, established a plausible claim for common law fraud. The court held that it was not bound by the debtor’s mischaracterization of her legal theory, and denied the defendant’s motion to dismiss.121

In In re Harrelson the debtor similarly alleged that her former bankruptcy counsel and debt relief agency “took the Plaintiff’s money and failed to perform under the terms of the Agreement, failed to negotiate the settlement of the credit card debts, [and] failed to prevent further collection efforts by the creditors, including lawsuits filed against the Plaintiff …” The bankruptcy court characterized the debtor’s claim as “a quintessential allegation for breach of contract” and not a matured debt payable on demand, and noted that there appeared to be a dispute as to as to whether the debtor still had legal title to the fees that she paid to the defendants.122 The agreement among the parties required the submission of disputes to arbitration.123 The court rejected the objections to enforcement of the clause and ruled that the “turnover” claim “must be submitted to arbitration.”124

The bankruptcy court in In re 11 East 36th LLC stated that it is settled law that turnover cannot be used to liquidate contract disputes. It was clear, on the face of the complaint, that the plaintiff was attempting by one count of the complaint to liquidate a disputed debt.125 The court agreed that the plaintiff had failed to state a cause of action and dismissed that count of the complaint.126

XI. SECTION 542(c)—THE “GOOD FAITH” EXCEPTION TO TURNOVER

the authors are not aware of any significant published opinions since last year’s Annual Survey addressing issues in connection with the “good faith” exception to turnover actions.

XII. SECTION 542(e)—OBLIGATION TO TURN OVER RECORDED INFORMATION

Bankruptcy Code § 542(e) provides that “[s]ubject to any applicable privilege, after notice and a hearing, the court may order an attorney, accountant, or other person that holds recorded information … relating to the debtor’s property or financial affairs, to turn over or disclose such recorded information to the trustee.”127

In In re Auld, the bankruptcy court denied the Chapter 7 trustee’s motion for turnover pursuant to § 542, stating that to obtain an order to turn over property or recorded information, the trustee must show: (a) that the property to be turned over is property of the bankruptcy estate and the recorded information relates to property of the estate; and (b) that the property and recorded information are in the Debtor’s possession or under his control at the time the turnover motion was filed.128 The trustee’s motion in Auld requested turnover of (i) copies of the debtor’s mortgage loan or credit applications given to obtain the present mortgage against the debtor’s property; (ii) copies of loan documents and copy of the title to a 2009 Harley-Davidson motorcycle; (iii) copies of the debtor’s prepared and filed 2015 tax returns upon filing and turnover of the estate’s portion of any and all 2015 refunds immediately upon receipt; (iv) copies of titles to a 2004 and/or 2002 GMC Yukon; (v) an explanation concerning the disposition of property awarded to the debtor in his most recent divorce decree; and (vi) information concerning any life insurance policy that the debtor owned and was required by his divorce decree to maintain.

In denying the turnover motion, the Auld court analyzed each request in turn. First, the motion did not clearly identify the loan applications for the property, establish that they were in the debtor’s possession, or indicate why they were relevant. The court noted that applications that were several years old would be of questionable relevance. Second, the motion did not clearly identify or establish the relevance of the loan documents sought with respect to the motorcycle, and did not establish that those documents or the title to the motorcycle were in the debtor’s possession. The noted that since the motorcycle was scheduled subject to the lien of the secured creditor, the title most likely was being held by the lender. Third, with regard to the tax return request, the court declined to issue an order to turnover paperwork that did not yet exist. Fourth, the court found that the GMC Yukon and been exempted by the debtor and thus was no longer an asset of the estate, and the court declined to order the turnover of a document that did not relate to property of the estate. Fifth, in response to the request for an explanation concerning the award in the divorce decree, the court stated there is no legal basis to enter an order directing the debtor to provide “explanations” because an explanation is neither property of the estate nor recorded information subject to turnover. Finally, with respect to the request for information concerning life insurance policies, the court reiterated that “information” is not property or recorded information that is subject to turnover.129

In In re Allegro Law LLC, the bankruptcy court entered a default judgment against the defendants in the amount of $103 million, in part because the plaintiff offered a “mountain of evidence” in support of his claim that the defendants defrauded a large number of individuals, but also as a result of the defendants’ poor conduct (including their refusal to show up at the trial and refusal to turnover recorded information).130 The court found that the defendant, Timothy McCallan had perpetrated fraud on a massive scale by promising customers that their debts would be either paid or settled. Instead, McCallan siphoned off the money into companies controlled or closely associated to him.131 McCallan used a number of lawyers including Keith Nelms to perpetuate his scheme. Allegro Financial and Allegro Law (“Allegro”) were entities controlled by McCallan and fronted by Nelms as a law firm.132 Nelms superficially hired McCallan and AmeriCorp and Seton (also controlled by McCallan) to handle processing for Allegro. When the State of Alabama placed Allegro in receivership, Nelms and Allegro each filed Chapter 7 bankruptcy petitions.133

The Chapter 7 trustee of the Allegro bankruptcies filed suit against McCallan, AmeriCorp and Seton seeking, among other things, turnover of property of the estate. The trustee had learned that Nelms and Allegro did not keep their own business records, but rather the records were kept by AmeriCorp in an electronic form.134 The defendants disregarded two discovery orders which required them to produce the database and to allow the trustee access to the database. Though the court denied the trustee’s request for default judgment, it held the defendants in contempt and again ordered them to produce the requested database.135 The defendants eventually produced the data stored on a CD, but their production was facially deficient because they did not provide the trustee with actual access to the computer servers. The defendants later tried to cover this deficiency by claiming (falsely as it later turned out) that the servers had been deactivated and that access to the servers was not technologically possible.136 Three years into the Chapter 7 cases, the defendants finally granted the trustee access to the servers, but by then the damage had been done. The trustee then filed a third motion for sanctions, asserting that he was unable to make distributions to creditors of the Allegro bankruptcy estate due to the defendants’ “stonewalling” on discovery, and that he had incurred various fees during the time. The court granted the trustee’s motion in the amount of $999,457.95, stating the “proceedings were delayed by several years as a result of the Defendants’ well-documented obstructionist tactics.”137

XIII. SECTION 543—TURNOVER OF PROPERTY BY A CUSTODIAN

Bankruptcy Code § 543138 is entitled “Turnover of Property by a Custodian” and is the parallel to § 542. The party from whom the turnover is sought must be a custodian for § 543 to apply. A “custodian” is defined in Code § 101(11) as:

(A) receiver or trustee of any of the property of the debtor, appointed in a case or proceeding not under this title;

(B) assignee under a general assignment for the benefit of the debtor’s creditors; or

(C) trustee, receiver, or agent under applicable law, or under a contract, that is appointed or authorized to take charge of property of the debtor for the purpose of enforcing a lien against such property, or for the purpose of general administration of such property for the benefit of the debtor’s creditors.139

Subsections 543(a) and (b) provide that:

(a) A custodian with knowledge of the commencement of a case under this title concerning the debtor may not make any disbursement from, or take any action in the administration of, property of the debtor, proceeds, product, offspring, rents, or profits of such property, or property of the estate, in the possession, custody, or control of such custodian, except such action as is necessary to preserve such property.

(b) A custodian shall—

(1) deliver to the trustee any property of the debtor held by or transferred to such custodian, or proceeds, product, offspring, rents, or profits of such property, that is in such custodian’s possession, custody, or control on the date that such custodian acquires knowledge of the commencement of the case; and

(2) file an accounting of any property of the debtor, or proceeds, product, offspring, rents, or profits of such property, that, at any time, came into the possession, custody, or control of such custodian.140

Subsection 543(c)(2) provides that the court, after notice and a hearing, shall –

(2) provide for the payment of reasonable compensation for services rendered and costs and expenses incurred by such custodian.141

Subsection 543(d)(1) provides that after notice and hearing, the bankruptcy court –

(1) May excuse compliance with subsection (a), (b), or (c) of this section if the interests of creditors and, if the debtor is not insolvent, of equity security holders would be better served by permitting a custodian to continue in possession, custody, or control of such property.142

In In re Joseph and David Johnsman Limited Partnership, a secured lender of the Chapter 12 debtor obtain relief from the automatic stay from the bankruptcy court and an order of possession from the state court. The lender, instead of proceeding under the state court order, permitted the debtor to sell the collateral, which consisted of equipment and livestock, to Egbert. Egbert paid the purchase price, which was remitted to the lender on account of the debt. The debtor subsequently brought an adversary proceeding against Egbert, alleging that Egbert was a custodian under § 543(b) and seeking an accounting and turnover.143 Egbert sought summary judgment based on his assertion that he did not fall within the definition of custodian under § 101(11)(C).144 He clearly was not a court-appointed trustee or receiver of the debtor’s property or an agent or assignee under a general assignment for the purpose of administration of such property within the meaning of § 101(11)(C).145 The court found that the livestock and equipment were transferred to Egbert “for his own use and advantage or profit forever,” that the Bills of Sale included “no language in indicating that the transfers were for the purpose of administration of the property” for the benefit of the debtor’s creditors, and that the debtor’s reliance on allegations in the complaint that Egbert had orally agreed to take possession of the equipment and livestock for the general benefit of the estate, without more, was “insufficient” to defeat the motion for summary judgment.146 The court agreed with Egbert and held that he was not a “custodian.”

In In re 4522 Kateuua Ave, EEC, the court granted the motion for turnover.147 In that case, the debtor had commenced its Chapter 11 case four months after foreclosure actions were filed against its real property and a receiver was appointed. A trial was held on the debtor’s motion to compel the receiver to turn over the debtor’s real property and rents, and the reports and accounting records for the property.148 The receiver argued that before the receivership, the debtor mismanaged the properties and therefore the creditors would be better served if the receiver remained in possession.149

The Kateuua court cited In re Bryant Manor, LLC, for the proposition that: “Turnover is the general rule, however, and excuse from compliance is the exception. Therefore, a party opposing turnover must demonstrate affirmatively how creditors will be better served if the receiver is retained.”150 The Kateuua court went on to say that in evaluating an excuse from turnover under, a court must examine: (1) the debtor’s likelihood of reorganization; (2) the probability that funds required for reorganization will be available; and (3) whether the evidence shows mismanagement of the property by the debtor.151 In granting the motion for turnover, the court found that the receiver failed to show that the show that the creditors would be better served. Rather, if the receiver was removed, costs would be reduced, funds to improve the properties would become available, and the projected rental income would increase.152

Similarly, In re South & Headley Associates, Ltd. the state court-appointed receiver appealed from the bankruptcy court’s order denying the receiver’s motion to excuse the turnover requirement and keep the receiver in place.153 The district court determined that the bankruptcy court did not abuse its discretion for two reasons. First, the receiver was not as accountable to the bankruptcy court and not subject to the bankruptcy court’s jurisdiction. Second, the receiver did not have the same powers—such as avoidance powers—that the Chapter 11 trustee had.154 Furthermore, the bankruptcy court had appointed the Chapter 11 trustee in part because there was evidence of fraud, dishonesty, incompetence, or gross mismanagement by the debtor. The district court ruled that the bankruptcy court had not abused its discretion when it determined that appointing the Chapter 11 trustee to act for the debtor’s estate rather than excusing turnover and permitting the receiver to remain in possession was in the interest of creditors.155

In In re Michael Joseph Kilroy, a receiver who was excused from turning over the property under § 543(d)(1) filed an application in the bankruptcy court to employ a law firm as his legal counsel nunc pro tunc from the filing of the bankruptcy petition.156 The court denied the application, finding that the receiver had not put forth sufficient legal authority or evidence to establish that the debtor’s bankruptcy estate was or should be liable for expenses the custodian incurred in connection with performance of his duties as receiver.157 The court noted that “custodians have no responsibility for the administration of the bankruptcy case or any other duties otherwise imposed by the Code upon a trustee or debtor in possession.”158

In 29 Brooklyn, LLC v. Chesley,159 receiver turned over the real property to the debtor and sought payment of his unpaid expenses that he incurred prior to the bankruptcy and his commissions. The debtor objected but the bankruptcy court found that the receiver was entitled to $72,499.35. The debtor appealed and sought a stay of the bankruptcy court’s order.160 The bankruptcy court denied motion for stay. Two days past the date for payment fixed by the court in its order, the receiver filed a motion for a stay with the district court. The district court noted that in deciding whether to grant or deny such a motion for stay, it should consider: (i) whether the movant will suffer irreparable injury; (ii) whether a party will suffer substantial injury if a stay is issued; (iii) whether the movant has demonstrated “a substantial possibility … of success on appeal; and (iv) the public interests that may be affected.161 In an attempt to satisfy the third factor, the debtor argued that it had a substantial possibility of success on appeal based on the bankruptcy court’s failure to account for the receiver’s various violations of the receiver order and the harm occasioned by receiver’s mismanagement. Pursuant to § 543(b)(1), custodians such as receivers may be paid “reasonable compensation” for prepetition services rendered and costs and expenses incurred.162 However, under New York law, “compensation may be denied to a receiver who has grossly mismanaged the property entrusted to him.”163 The district court disagreed, finding that the bankruptcy court had found that there was no evidentiary basis to conclude that the receiver’s actions caused the poor conditions of the property.164

The bankruptcy court in Brantley Land & Timber Co. v. Guy Gebhardt stated that it is the duty of a receiver or other custodian on an order of the court to turn over the property of the debtor to the trustee and it is improper for the former receiver to retain the power to control the debtor postpetition.165

Finally, the debtor in Home Casual, LLC v. Home Casual Enterprise, Ltd. filed a Chapter 11 that was subsequently converted to a Chapter 7.166 Nearly two years later Chapter 7 trustee commenced an adversary proceeding against a non-debtor contract vendor of the debtor, Home Casual Enterprise, Ltd., to compel turnover of a bank account from the defendant under § 543.167 The court stated that there was no evidence to show that the defendant was a custodian or that there were any funds remaining in the account, where there was no written agreement concerning the nature or use of the account and the last record date of the account was 18 months prior to the debtor’s bankruptcy filing. Accordingly, the court held that there was no basis on which to compel an accounting or turnover.168

XIV. AUTOMATIC STAY/ADEQUATE PROTECTION

See In Re Cinevision International, Inc. discussed In § XVIII below.

The authors are not aware of any other significant published opinions since last year’s Annual Survey addressing the nexus between turnover under §§ 542 and 543 and the automatic stay or adequate protection under § 362.

XV. SETOFF

Section 542(b) specifically excepts a matured debt from turnover to the extent that such debt may be offset under § 553 against a claim of the debtor, as follows:

Except as provided in subsection (c) or (d) of this section, an entity that owes a debt that is property of the estate and that is matured, payable on demand, or payable on order, shall pay such debt to, or on the order of, the trustee, except to the extent that such debt may be offset under section 553 of this title against a claim against the debtor.169

In In re Emerald Casino, Inc., the Chapter 7 trustee brought an adversary proceeding against seven former officers and directors of Emerald, alleging that they breached their fiduciary duty.170 The district court found six of the defendants liable, and the trustee urged the court to disallow their proofs of claims171 pursuant to § 502(d), which provides, “the court shall disallow any claim of any entity from which property is recoverable under section 542 … 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 …”172 The defendants conceded that they owed a debt that was property of the estate, however, they claimed they were entitled to a setoff under § 553. A setoff under § 553 “generally permits a creditor to offset, on a dollar-for-dollar basis, a debt it owes to the bankrupt party on a pre-commencement debt that the bankrupt owed to the creditor.”173

But section 553(a)(1) provides that a creditor may not exercise a right of setoff if “the claim of such creditor is disallowed.174 Therefore, the Emerald Casino court was faced with the issue of determining the order of analysis in which to proceed. The trustee argued that the court must first determine whether the claims were disallowed under § 502(d) before it could evaluate whether the debt the defendants owed could be offset by that claim.175 On the other hand, the defendants argued that the court must first analyze their right to a setoff under § 553 before it could decide that the full amount of their debt was recoverable under § 542.176

Ultimately, the Emerald Casino court agreed with the trustee. “The setoff right presumes a valid claim: a creditor may not offset debt unless he or she first has a valid claim. That is, determining whether Defendants’ claims are allowed is logically antecedent to evaluating whether those claims can offset their debt.”177 The court reasoned that § 502(d) “explicitly contemplates what §§ 542 and 553 do not: a requirement that a creditor pay its debt immediately even where it also has a claim on the estate. The court temporarily disallowed the defendants’ claims under § 502(d), and ruled that the defendants were not entitled to offset their claims, if at all, until they satisfied the judgment against them.178

XVI. free exercise clause of the First AMENDMENT; FOURTH AND FIFTH AMENDMENT PRIVILEGE

The authors are not aware of any significant published opinions since last year’s Annual Survey addressing the relation between the First, Fourth or Fifth Amendment privilege and turnover actions.

XVII. SEVENTH AMENDMENT—RIGHT TO JURY TRIAL

28 U.S.C.A. § 157(e) provides “[i]f the right to a jury trial applies in a proceeding that may be heard under this section by a bankruptcy judge, the bankruptcy judge may conduct the jury trial if specifically designated to exercise such jurisdiction by the district court and with the express consent of all the parties.”179

In In re Dynamic Drywall, Inc., also discussed in § II, the defendants moved to withdraw the reference for cause in an adversary proceeding brought against them by the debtor.180 The defendants argued that the proceeding should be withdrawn to the district court because the causes of action were non-core claims within the meaning of 28 U.S.C.A. § 157(b), and because the defendants had timely demanded a jury trial. The debtor asserted in response181 that the reference should not be withdrawn because the defendants impliedly consented to the bankruptcy court’s jurisdiction by failing to file a motion to withdraw the reference within 20 days of being served with the complaint.182 The bankruptcy court noted that though the motion to withdraw the reference was filed after the 20 day period, the defendants filed the motion within the time set at the scheduling conference and had timely demanded a jury trial in their answers pursuant to Fed. R. Civ. P. 38(b). The bankruptcy judge held that “even if the defendants could be deemed to have consented to [this court’s] entering final judgment … they have clearly and unequivocally withheld their consent to my conducting a jury trial.”183 The court went further by saying, “[u]nder 28 U.S.C. § 157(e), that refusal to consent is enough reason to withdraw the reference.”184

XVIII. REVOCATION OR DENIAL OF DISCHARGE AND OTHER SANCTIONS FOR FAILURE TO TURNOVER OR COMPLY WITH TURNOVER ORDER

The court may sanction a debtor for violation of a § 542 turnover order by the revocation of a debtor’s discharge, and in addition may sanction the debtor and other parties by other means for such violation.

The bankruptcy “court has few more powerful remedies at its disposal than those provided in § 727(d). That section allows a court to revoke a debtor’s discharge when the trustee demonstrates that the debtor has refused to obey a court order and acquired, but failed to account for property of the estate.”185 Bankruptcy Code § 727(d)(3) incorporates by reference § 727(a)(6)(A) which provides that a debtor may not be granted a discharge if he has refused to obey a lawful order of the court.186

In In re Tate, also discussed in § VIII above, after more than a year and a half worth of attempts—including a brief period of incarceration for civil contempt—the court was still unable to coerce the debtor to turn over the portion of the arbitration award or even to uncover the award’s true and current location.187 Accordingly, the court entered the money judgment to provide the Chapter 7 trustee an opportunity to recover the remaining portion of the arbitration award for the benefit of the estate.188

In In re Cinevision International, Inc., also discussed in § VIII above, the United States Court of Appeals for the Ninth Circuit held that the bankruptcy court did not err in sanctioning the Chapter 7 debtor $99,745.24 for its willful refusal to turn over property belonging to the bankruptcy estate.189 The debtor argued that § 362(k) (formerly § 362(h))190 does not provide a basis for a Chapter 7trustee to recover actual damages, since the trustee is not an “individual.” The court noted, however, that the trustee never sought sanctions under § 362, but instead contended that § 542(a) provides the right of the return of property, while § 105(a) provides the remedy for a failure to do so.191 The court cited In re Dyer to point out that the Ninth Circuit had previously said that, although a trustee may not recover under § 362(k) (formerly § 362(h)), the trustee may be entitled to recovery for a violation of the automatic stay under § 105(a) as a sanction for civil contempt.192 The court also stated that in order to find a party in civil contempt, “the moving party has the burden of showing by clear and convincing evidence that the contemnors violated a specific and definite order of the court.”193 Additionally, the court indicated that the Ninth Circuit had held that § 362(k) (formerly § 362(h)) and § 105(a) require a showing not of “bad faith” or subjective intent, but rather on a finding of “willfulness.”194 Finally, the court cited In re Mwangi, where the Ninth Circuit held that “the failure to return property of the estate with knowledge of the bankruptcy is a violation of both the automatic stay and the turnover requirements of the Bankruptcy Code.”195

In upholding the sanctions and applying the standards set forth above, the Cinevision International court found that the bankruptcy court appropriately exercised its civil contempt authority to remedy a violation of a specific order where the debtor knew of the automatic stay and the debtor’s failure to turn over the property was intentional.196

See also In re Allegro Law LLC, also discussed in § XII above.

XIX. TIME LIMITATIONS FOR ACTION; ISSUE PRECLUSION; Claim Preclusion

The authors are not aware of any significant published opinions since last year’s Annual Survey addressing the issues of time limitations, issue preclusion and claim preclusion in connection with turnover actions.

XX. APPEALS

The authors are not aware of any published opinions since last year’s Annual Survey addressing the standards for review on appeal. Accordingly, the standards for review by the courts of appeals of the decisions of the district courts, and by the district courts of the decisions of the bankruptcy courts, continue to adhere to established principles.


* Bruce Grohsgal is the Helen S. Balick Visiting Professor in Business Bankruptcy Law at the Delaware Law School of Widener University, Wilmington, Delaware.
** Gregory J. Flasser is an associate at Bayard, P.A. in Wilmington, Delaware, who concentrates his practice in the areas of corporate bankruptcy and restructuring.
1 11 U.S.C.A. § 542.
2 11 U.S.C.A. § 543.
3 The opinions considered in this update are mostly from early 2014 through early 2015.
4 Central Virginia Community College v. Katz, 546 U.S. 356, 126 S. Ct. 990, 995, 163 L. Ed. 2d 945, 45 Bankr. Ct. Dec. (CRR) 254, 54 Collier Bankr. Cas. 2d (MB) 1233, Bankr. L. Rep. (CCH) P 80443 (2006).
5 In re Wellesley Realty Associates, LLC, 2015 WL 2261680, *13 (Bankr. D. Mass. 2015).
6 In re Goldsmith, 2012 WL 3201840, *2–3 (Bankr. W.D. Pa. 2012) (effect of dismissal).
7 28 U.S.C.A. § 1334(c).
8 28 U.S.C.A. § 157(b)(2)(E).
9 28 U.S.C.A. § 157(c).
10 28 U.S.C.A. § 157(b)(2)(E).
11 Stern v. Marshall, 564 U.S. 462, 131 S. Ct. 2594, 180 L. Ed. 2d 475, 55 Bankr. Ct. Dec. (CRR) 1, 65 Collier Bankr. Cas. 2d (MB) 827, Bankr. L. Rep. (CCH) P 82032 (2011).
12 Wellness Intern. Network, Ltd. v. Sharif, 135 S. Ct. 1932, 1941–1942, 191 L. Ed. 2d 911, 61 Bankr. Ct. Dec. (CRR) 32, 73 C.B.C. 1575, Bankr. L. Rep. (CCH) P 82806 (2015).
13 Dynamic Drywall, Inc. v. McPherson Contractors, Inc., 2015 WL 4744501, *2 (D. Kan. 2015).
14 Dynamic Drywall, Inc. v. McPherson Contractors, Inc., 2015 WL 4744501, at *3.
15 In re: Garrison, 2016 WL 454807, *1 (S.D. Ind. 2016).
16 In re Garrison, 2016 WL 454807, at *2.
17 In re SurfaceMax, Inc., 2015 WL 5676776, *1–2 (Bankr. E.D. N.C. 2015).
18 In re SurfaceMax, Inc., 2015 WL 5676776, *3 (Bankr. E.D. N.C. 2015).
19 In re SurfaceMax, Inc., 2015 WL 5676776, at *3, citing In re TP, Inc., 479 B.R. 373, 382 (Bankr. E.D. N.C. 2012).
20 In re SurfaceMax, Inc., 2015 WL 5676776, at *3.
21 In re SurfaceMax, Inc., 2015 WL 5676776, at *6.
22 In re Tolomeo, 537 B.R. 869 (Bankr. N.D. Ill. 2015), adopted, 2015 WL 8741730 (N.D. Ill. 2015).
23 In re Tolomeo, 537 B.R. at 872–873, citing Stern v. Marshall, 131 S.Ct. at 2618.
24 In re Tolomeo, 537 B.R. at 873, citing 28 U.S.C.A. § 157(c)(1) and Fed. R. Bankr.P. 9033(d).
25 In re Tolomeo, 537 B.R. at 873, citing Stern v. Marshall, 131 S.Ct. at 2618.
26 In re Tolomeo, 537 B.R. at 880.
27 In re Roussos, 541 B.R. 721, 738 n.1, 61 Bankr. Ct. Dec. (CRR) 248 (Bankr. C.D. Cal. 2015).
28 In re Roussos, 541 B.R. at 724.
29 In re Roussos, 541 B.R. at 724–726.
30 In re Roussos, 541 B.R. at 737–738.
31 In re Roussos, 541 B.R. at 738.
32 In re Wellesley Realty Associates, LLC, 2015 WL 2261680, at *13, citing In re General Media, Inc., 335 B.R. 66, 75, 45 Bankr. Ct. Dec. (CRR) 271 (Bankr. S.D. N.Y. 2005)
In re Goldsmith, 2012 WL 3201840, *2–3 (Bankr. W.D. Pa. 2012) (effect of dismissal).
33 Seminole Tribe of Florida v. Florida, 517 U.S. 44, 116 S. Ct. 1114, 134 L. Ed. 2d 252, 34 Collier Bankr. Cas. 2d (MB) 1199, 42 Env’t. Rep. Cas. (BNA) 1289, 67 Empl. Prac. Dec. (CCH) P 43952 (1996) (Congress does not have the power under Article I of the Constitution to abrogate a state’s sovereign immunity from suit).
34 Central Virginia Community College v. Katz, 546 U.S. 356, 126 S. Ct. 990, 163 L. Ed. 2d 945, 45 Bankr. Ct. Dec. (CRR) 254, 54 Collier Bankr. Cas. 2d (MB) 1233, Bankr. L. Rep. (CCH) P 80443 (2006) (sovereign immunity does not bar suit by Chapter 7 trustee against a state to avoid and recover an alleged preferential transfer because the state agreed in the plan of the Convention or by later joining the federal union “not to assert any sovereign immunity defense they might have had in proceedings brought pursuant to ‘Laws on the subject of Bankruptcies.’”).
35 In re Sann, 546 B.R. 840, 852 (Bankr. D. Mont. 2016).
36 In re Sann, 546 B.R. at 848.
37 Fed. R. Bankr. P. 7001(1).
38 See e.g., In re McCrory, 2011-2 U.S. Tax Cas. (CCH) P 50626, 108 A.F.T.R.2d 2011-6299, 2011 WL 4005455, *3 (Bankr. N.D. Ohio 2011); In re Rogove, 443 B.R. 182 (Bankr. S.D. Fla. 2010).
39 See e.g., In re MV Pipeline Co., 2007 WL 1452591, *8 (Bankr. E.D. Okla. 2007). A turnover action against a debtor may also be brought by adversary proceeding. In re McKenzie, 2011 WL 4600407, *6 (Bankr. E.D. Tenn. 2011), aff’d, 476 B.R. 515 (E.D. Tenn. 2012), decision aff’d, 716 F.3d 404, 57 Bankr. Ct. Dec. (CRR) 280 (6th Cir. 2013).
40 See e.g., In re MF Global Inc., 531 B.R. 424, 431, 61 Bankr. Ct. Dec. (CRR) 27, Comm. Fut. L. Rep. (CCH) P 33487, Comm. Fut. L. Rep. (CCH) P 33488 (Bankr. S.D. N.Y. 2015); In re Spence, 2009 WL 3756621 (Bankr. W.D. Tex. 2009); In re Hodge, 2009 WL 3645172 (Bankr. W.D. Tex. 2009); and In re Clark, 2009 WL 2849785 (Bankr. D. D.C. 2009).
41 In re Cypress Health Systems Florida, Inc., 536 B.R. 334, 340, 61 Bankr. Ct. Dec. (CRR) 123 (Bankr. N.D. Fla. 2015).
42 In re Cinevision International, Inc., 2016 WL 638729, *5 (B.A.P. 9th Cir. 2016), citing In re Mwangi, 432 B.R. 812, 823 (B.A.P. 9th Cir. 2010) (citing In re Abrams, 127 B.R. 239, 242–43, 21 Bankr. Ct. Dec. (CRR) 1283, 25 Collier Bankr. Cas. 2d (MB) 15, Bankr. L. Rep. (CCH) P 74023 (B.A.P. 9th Cir. 1991)) (emphasis in original).
43 In re Cinevision International, Inc., 2016 WL 638729, at *5.
44 In re Perry, 540 B.R. 710, 717 (Bankr. C.D. Cal. 2015), citing In re Mwangi, 432 B.R. 812, 823 (B.A.P. 9th Cir. 2010).
45 In re Shapphire Resources, LLC, 2016 WL 320823, *5 (Bankr. C.D. Cal. 2016) (Chapter 11 debtor in possession); In re Reisbeck, 505 B.R. 546, 2014-1 U.S. Tax Cas. (CCH) P 50180, 113 A.F.T.R.2d 2014-947 (Bankr. D. Mont. 2014) (Chapter 13 debtor).
46 See e.g., In re Flanagan, 415 B.R. 29, 36 (D. Conn. 2009) (“turnover is not a cause of action available to debtors at the time they file for bankruptcy. The language of statute clearly demonstrates that it is a claim available only to trustees after a bankruptcy petition has been filed.”).
47 In re Perry, 540 B.R. at 724, citing cases.
48 In re Perry, 540 B.R. at 724, citing In re Hernandez, 483 B.R. 713, 725 (B.A.P. 9th Cir. 2012).
49 In re Hunt, 540 B.R. 438, 443, 87 U.C.C. Rep. Serv. 2d 1259 (Bankr. D. Idaho 2015); In re In re Millette, 539 B.R. 396, 400, 2015 BNH 08 (Bankr. D. N.H. 2015); In re Tate, 535 B.R. 914, 920 (Bankr. S.D. Ga. 2015); In re Shapphire Resources, LLC, 2016 WL 320823, *5 (Bankr. C.D. Cal. 2016); In re Scotchel, 491 B.R. 739, 743, 69 Collier Bankr. Cas. 2d (MB) 1133 (Bankr. N.D. W. Va. 2013), aff’d, Bankr. L. Rep. (CCH) P 82598, 2014 WL 823379 (N.D. W. Va. 2014), aff’d, 585 Fed. Appx. 187 (4th Cir. 2014); Segarra-Miranda v. Perez-Padro, 482 B.R. 59, 74 (D.P.R. 2012); In re Mobley, 2012 WL 6086878, *1 (Bankr. N.D. Ohio 2012); In re Miller, 2011 WL 3741846, *2 (Bankr. N.D. Ohio 2011); In re Asif, 455 B.R. 768, 797 (Bankr.D.Kan.); In re McCrory, 2011-2 U.S. Tax Cas. (CCH) P 50626, 108 A.F.T.R.2d 2011-6299, 2011 WL 4005455, *3 (Bankr. N.D. Ohio 2011); In re Crump, 467 B.R. 532, 534 (Bankr. M.D. Ga. 2010); In re Brubaker, 426 B.R. 902, 905 (Bankr. M.D. Fla. 2010), decision aff’d, 443 B.R. 176 (M.D. Fla. 2011); In re Schneider, 417 B.R. 907, 919 (Bankr. N.D. Ill. 2009).
50 In re Hunt, 540 B.R. at 443; In re Millette, 539 B.R. at 400; In re Tate, 535 B.R. at 920; In re Shapphire Resources, LLC, 2016 WL 320823, *5 (Bankr. C.D. Cal. 2016); In re Scotchel, 491 B.R. at 743; In re McCrory, 2011-2 U.S. Tax Cas. (CCH) P 50626, 108 A.F.T.R.2d 2011-6299, 2011 WL 4005455, *3 (Bankr. N.D. Ohio 2011); In re Rogove, 443 B.R. 182, 185 (Bankr. S.D. Fla. 2010). See also, In re Brubaker, 426 B.R. at 905 and In re Green, 423 B.R. 867, 869 (Bankr. W.D. Ark. 2010).
51 In re Auld, 543 B.R. 676, 685 (Bankr. D. Utah 2015).
52 In re Tate, 535 B.R. at 920.
53 In re Shapphire Resources, LLC, 2016 WL 320823, at *8.
54 In re Shapphire Resources, LLC, 2016 WL 320823, at *9.
55 In re Hoerr, 2004 WL 2926156, *2 (Bankr. C.D. Ill. 2004). “Federal law determines what property is included in the estate, while state law controls whether the debtor has a legal or equitable interest in the property at the time the bankruptcy case is filed.” In re Living Hope Southwest Medical SVCS, LLC, 450 B.R. 139, 157, 54 Bankr. Ct. Dec. (CRR) 131 (Bankr. W.D. Ark. 2011), order aff’d, 2012 WL 1078345 (W.D. Ark. 2012), aff’d, 509 Fed. Appx. 578 (8th Cir. 2013); In re Miller, 66 Collier Bankr. Cas. 2d (MB) 1855, 2011 WL 6217342, *2 (Bankr. D. Colo. 2011), citing Butner v. U.S., 440 U.S. 48, 55, 99 S. Ct. 914, 59 L. Ed. 2d 136, 19 C.B.C. 481, Bankr. L. Rep. (CCH) P 67046 (1979).
56 Nobelman v. American Sav. Bank, 508 U.S. 324, 113 S. Ct. 2106, 2110, 124 L. Ed. 2d 228, 24 Bankr. Ct. Dec. (CRR) 479, 28 Collier Bankr. Cas. 2d (MB) 977, Bankr. L. Rep. (CCH) P 75253A (1993) (1978 Code case); Butner v. U.S., 440 U.S. 48, 55, 99 S. Ct. 914, 59 L. Ed. 2d 136, 19 C.B.C. 481, Bankr. L. Rep. (CCH) P 67046 (1979) (1898 Act case).
57 In re Nurses’ Registry and Home Health Corporation, 533 B.R. 590, 597–598, 61 Bankr. Ct. Dec. (CRR) 87 (Bankr. E.D. Ky. 2015), citing U.S. v. Whiting Pools, Inc., 1983-2 C.B. 239, 462 U.S. 198, 103 S. Ct. 2309, 76 L. Ed. 2d 515, 10 Bankr. Ct. Dec. (CRR) 705, 8 Collier Bankr. Cas. 2d (MB) 710, Bankr. L. Rep. (CCH) P 69207, 83-1 U.S. Tax Cas. (CCH) P 9394, 52 A.F.T.R.2d 83-5121 (1983) and In re Shelbyville Road Shoppes, LLC, 775 F.3d 789, 60 Bankr. Ct. Dec. (CRR) 117, 72 Collier Bankr. Cas. 2d (MB) 1702, Bankr. L. Rep. (CCH) P 82746 (6th Cir. 2015) and referring to other authorities “too numerous to mention.”
58 In re Soundview Elite Ltd., 543 B.R. 78, 81 (Bankr. S.D. N.Y. 2016).
59 In re Soundview Elite Ltd., 543 B.R. at 97.
60 In re Soundview Elite Ltd., 543 B.R. at 97.
61 In re Soundview Elite Ltd., 543 B.R. at 126.
62 In re Fraterfood Service, Inc., 2015 WL 4387442, *1–2 (Bankr. D. P.R. 2015).
63 In re Fraterfood Service, Inc., 2015 WL 4387442, at *1.
64 In re Fraterfood Service, Inc., 2015 WL 4387442, at *2.
65 In re Fraterfood Service, Inc., 2015 WL 4387442, at *3–4.
66 In re Fraterfood Service, Inc., 2015 WL 4387442, at *4–5.
67 In re Vaughan Company, Realtors, 61 Bankr. Ct. Dec. (CRR) 101, 2015 WL 4498748, *1 (Bankr. D. N.M. 2015).
68 In re The Vaughan Company, Realtors, 2015 WL 4498748, at *4.
69 In re The Vaughan Company, Realtors, 2015 WL 4498748, at *3.
70 In re Perry, 540 B.R. 710, 717 (Bankr. C.D. Cal. 2015), citing In re Mwangi, 432 B.R. 812, 823 (B.A.P. 9th Cir. 2010).
71 In re SurfaceMax, Inc., 2015 WL 5676776, at *6.
72 In re Millette, 539 B.R. 396, 403, 2015 BNH 08 (Bankr. D. N.H. 2015).
73 Comu v. King Louie Min., LLC, 534 B.R. 689, 696 (N.D. Tex. 2015), aff’d, 2016 WL 3209220 (5th Cir. 2016).
74 Comu v. King Louie Min., LLC, 534 B.R. at 693.
75 Comu v. King Louie Min., LLC, 534 B.R. at 697.
76 In re Raymond, 529 B.R. 455, 484 (Bankr. D. Mass. 2015), quoting Scott v. NG U.S. 1, Inc., 450 Mass. 760, 881 N.E.2d 1125, 66 Env’t. Rep. Cas. (BNA) 1129 (2008).
77 In re Bruner, 535 B.R. 726 (Bankr. E.D. Ky. 2015).
78 In re Bruner, 535 B.R. at 731.
79 In re Roussos, 541 B.R. 721
80 In re Hunt, 540 B.R. at 441.
81 In re Hunt, 540 B.R. at 445.
82 In re Spence, 545 B.R. 280, 281, 292, 296 (Bankr. W.D. Mo. 2016).
83 In re Morev, 2015 WL 9264937, *1–2 (Bankr. S.D. Cal. 2015).
84 In re Morev, 2015 WL 9264937, at *3, citing In re Leslie, 520 F.2d 761, 762 (9th Cir. 1975).
85 In re Morev, 2015 WL 9264937, at *3–4, 7.
86 In re Cypress Health Systems Florida, Inc., 536 B.R.at 336–337.
87 In re Cypress Health Systems Florida, Inc., 536 B.R.at 338–340.
88 In re Raymond, 529 B.R. at 492.
89 In re Salahi, 2012 WL 1438213, *2 (Bankr. E.D. Va. 2012), citing Patterson v. Shumate, 504 U.S. 753, 758, 112 S. Ct. 2242, 119 L. Ed. 2d 519, 23 Bankr. Ct. Dec. (CRR) 89, 26 Collier Bankr. Cas. 2d (MB) 1119, 15 Employee Benefits Cas. (BNA) 1481, Bankr. L. Rep. (CCH) P 74621A (1992) (“The natural reading of the provision entitles a debtor to exclude from property of the estate any interest in a plan or trust that contains a transfer restriction enforceable under any relevant nonbankruptcy law”).
90 Safanda v. Castellano, 2015 WL 1911130, *7–8 (N.D. Ill. 2015).
91 In re Raymond, 529 B.R. at 489–493, quoting Matter of Munford, Inc., 115 B.R. 390, 20 Bankr. Ct. Dec. (CRR) 1066, 23 Collier Bankr. Cas. 2d (MB) 60 (Bankr. N.D. Ga. 1990).
92 11 U.S.C.A. § 542(a). In addition, the party may not be a custodian. Turnover from a custodian is pursuant to § 543 as discussed in § XIII of this article.
93 In re Tate, 535 B.R. 914, 921 (Bankr. S.D. Ga. 2015), citing cases (though the trustee in Tate also established that Mrs. Tate continued to have possession of the funds turnover of which was sought throughout the case). See also, In re JMC Telecom LLC, 416 B.R. 738, 745 (C.D. Cal. 2009) (account into which funds, turnover of which was sought, were deposited was closed in 2000; bankruptcy case commenced in 2007; party from whom turnover was sought was never in custody, control or possession of the funds during the case); In re Bancredit Cayman Ltd., 419 B.R. 898, 917, 52 Bankr. Ct. Dec. (CRR) 121, 70 U.C.C. Rep. Serv. 2d 545 (Bankr. S.D. Fla. 2009) (“Even if the Plaintiff had a viable claim against the Defendant arising from the allegedly unauthorized Funds Transfer, the Defendant never had funds in its possession that would have been subject to turnover under 11 U.S.C. § 542.”); In re Schneider, 417 B.R. 907, 919–920 (Bankr. N.D. Ill. 2009) (“There is no evidence in the record, however, that [the defendant] was in possession of any of the Artwork and Furnishings at any time during the pendency of the bankruptcy case. Indeed, the Trustee state[d] in his post-trial brief that ‘[t]here is no evidence at all that the [Artwork and Furnishings] has ever been in the possession of anyone but the Debtor.’ The Trustee has not shown that [the defendant] was in possession of the Artwork and Furnishings at any time since the Petition Date. The Trustee has therefore failed to demonstrate one required element of his turnover claim. Accordingly, judgment will be entered in [the defendant’s] favor on Count IV.”). The minority position is stated in In re Pyatt, 486 F.3d 423, 429, 48 Bankr. Ct. Dec. (CRR) 70, 57 Collier Bankr. Cas. 2d (MB) 136, Bankr. L. Rep. (CCH) P 80936 (8th Cir. 2007) (trustee could not compel Debtor to turn over property no longer within Debtor’s control).
94 Matter of Home Casual LLC, 2015 WL 7755401, at *3 (Bankr.W.D.Wis.).
95 11 U.S.C.A. § 542(a) (emphasis supplied).
96 See e.g., In re Elliott, 544 B.R. 421, 435 (B.A.P. 9th Cir. 2016).
97 Comu v. King Louie Min., LLC, 534 B.R. 689 (N.D. Tex. 2015), aff’d, 2016 WL 3209220 (5th Cir. 2016).
98 In re Tate, 2015 WL 1775519, *1 (Bankr. S.D. Ga. 2015)
99 In re Tate, 2015 WL 1775519, at *1.
100 In re Tate, 2015 WL 1775519, at *2–4.
101 In re Tate, 2015 WL 1775519, at *4–5.
102 In re Spence, 545 B.R. at 296.
103 In re Noram Resources, Inc., 2015 WL 2265405, *6 (Bankr. S.D. Tex. 2015).
104 11 U.S.C.A. § 542(a).
105 In re The Vaughan Company, Realtors, 2015 WL 4498748, at *6.
106 11 U.S.C.A. § 542(a).
107 In re Shapphire Resources, LLC, 2016 WL 320823, at *10.
108 In re Noram Resources, Inc., 2015 WL 2265405, at *9.
109 11 U.S.C.A. § 542(b).
110 In re MF Global Inc., 531 B.R. 424, 426, 61 Bankr. Ct. Dec. (CRR) 27, Comm. Fut. L. Rep. (CCH) P 33487, Comm. Fut. L. Rep. (CCH) P 33488 (Bankr. S.D. N.Y. 2015).
111 In re MF Global Inc., 531 B.R. at 426–427.
112 In re MF Global Inc., 531 B.R. at 427.
113 In re MF Global Inc., 531 B.R. at 431.
114 In re MF Global Inc., 531 B.R. at 437–438.
115 In re MF Global Inc., 531 B.R. at 438.
116 In re NanoDynamics, Inc., 2015 WL 8602618, *1 (Bankr. W.D. N.Y. 2015), citing In re Charter Co., 913 F.2d 1575, Bankr. L. Rep. (CCH) P 73704 (11th Cir. 1990) and In re Trauger, 109 B.R. 502 (Bankr. S.D. Fla. 1989).
117 In re Soundview Elite Ltd., 543 B.R. at 97, n. 105.
118 In re Soundview Elite Ltd., 543 B.R. at 97–98.
119 In re Pantazelos, 543 B.R. 864 (Bankr. N.D. Ill. 2016).
120 In re Pantazelos, 543 B.R. at 876.
121 In re Pantazelos, 543 B.R. at 877.
122 In re Harrelson, 537 B.R. 16, 24 (Bankr. M.D. Ala. 2015).
123 In re Harrelson, 537 B.R. at 21.
124 In re Harrelson, 537 B.R. at 26.
125 In re 11 East 36th LLC, 2015 WL 2445075, *11 (Bankr. S.D. N.Y. 2015).
126 In re 11 East 36th LLC, 2015 WL 2445075, at *12.
127 11 U.S.C.A. § 542(E).
128 In re Auld, 543 B.R. 676, 680, 685 (Bankr. D. Utah 2015).
129 In re Auld, 543 B.R. at 683–85.
130 In re Allegro Law LLC, 545 B.R. 675, 711 (Bankr. M.D. Ala. 2016).
131 In re Allegro Law LLC, 545 B.R. at 682.
132 In re Allegro Law LLC, 545 B.R. at 682.
133 In re Allegro Law LLC, 545 B.R. at 683.
134 In re Allegro Law LLC, 545 B.R. at 684.
135 In re Allegro Law LLC, 545 B.R. at 686.
136 In re Allegro Law LLC, 545 B.R. at 686.
137 In re Allegro Law LLC, 545 B.R. at 694.
138 11 U.S.C.A. § 543.
139 11 U.S.C.A. § 101(11).
140 11 U.S.C.A. § 543(a) and (b).
141 11 U.S.C.A. § 543(c)(2).
142 11 U.S.C.A. § 543(d)(1).
143 In re Joseph and David Johnsman Limited Partnership, 2015 WL 4873014, *1 (Bankr. N.D. Ohio 2015).
144 In re Joseph and David Johnsman Limited Partnership, 2015 WL 4873014, at *7.
145 In re Joseph and David Johnsman Limited Partnership, 2015 WL 4873014, at *7.
146 In re Joseph and David Johnsman Limited Partnership, 2015 WL 4873014, at *7.
147 In re 4522 Kateuua Avenue, EEC, 2016 WL 93722, *1 (Bankr. D. Kan. 2016).
148 In re 4522 Kateuua Ave, LLC, 2016 WL 93722, at *1.
149 In re 4522 Kateuua Ave, LLC, 2016 WL 93722, at *2–3.
150 In re 4522 Kateuua Ave, LLC, 2016 WL 93722, at *2, quoting In re Bryant Manor, LLC, 422 B.R. 278 (Bankr. D. Kan. 2010).
151 In re 4522 Kateuua Ave, LLC, 2016 WL 93722, at *2–3.
152 In re 4522 Kateuua Ave, LLC, 2016 WL 93722, at *2–3.
153 In re South & Headley Associates, Ltd., 2015 WL 5112725, *5 (D.N.J. 2015).
154 In re South & Headley Associates, Ltd., 2015 WL 5112725, at *5.
155 In re South & Headley Associates, Ltd., 2015 WL 5112725, at *5.
156 In re Kilroy, 2015 WL 8228195, *1 (Bankr. C.D. Cal. 2015).
157 In re Michael Kilroy, 2015 WL 8228195, at *2.
158 In re Michael Kilroy, 2015 WL 8228195, at *2, quoting Collier on Bankruptcy, 543–18 (16th ed. 2015).
159 29 Brooklyn, LLC v. Chesley, 2015 WL 9255549, *1 (E.D. N.Y. 2015).
160 29 Brooklyn, LLC v. Chesley, 2015 WL 9255549, *1 (E.D. N.Y. 2015).
161 29 Brooklyn, LLC v. Chesley, 2015 WL 9255549, *2 (E.D. N.Y. 2015).
162 29 Brooklyn, LLC v. Chesley, 2015 WL 9255549, *3 (E.D. N.Y. 2015), citing 11 U.S.C.A. § 543(b)(1).
163 29 Brooklyn, LLC v. Chesley, 2015 WL 9255549, *3 (E.D. N.Y. 2015).
164 29 Brooklyn, LLC v. Chesley, 2015 WL 9255549, *3 (E.D. N.Y. 2015). See also, In re 29 Brooklyn Avenue, LLC, 535 B.R. 36, 58–59 (Bankr. E.D. N.Y. 2015), stay pending appeal denied, 2015 WL 8602637 (Bankr. E.D. N.Y. 2015).
165 In re Brantley Land & Timber Company LLC, 74 Collier Bankr. Cas. 2d (MB) 915, 2015 WL 5829835, *1 (Bankr. S.D. Ga. 2015).
166 Matter of Home Casual LLC, 61 Bankr. Ct. Dec. (CRR) 237, 2015 WL 7755401, *1 (Bankr. W.D. Wis. 2015).
167 Matter of Home Casual LLC, 61 Bankr. Ct. Dec. (CRR) 237, 2015 WL 7755401, *3 (Bankr. W.D. Wis. 2015).
168 Matter of Home Casual LLC, 61 Bankr. Ct. Dec. (CRR) 237, 2015 WL 7755401, *3 (Bankr. W.D. Wis. 2015).
169 11 U.S.C.A. § 553.
170 In re Emerald Casino, Inc., 2015 WL 1843271, *1 (N.D. Ill. 2015).
171 The defendants in the adversary proceeding were also creditors of the Emerald estate who had filed proofs of claims based on unpaid salaries, claims based on money loaned to Emerald, and claims based on a settlement agreement. In re Emerald Casino, Inc., 2015 WL 1843271, at *5.
172 11 U.S.C.A. § 502(d).
173 In re Emerald Casino, Inc. 2015 WL 1843271, at *5, quoting U.S. v. Maxwell, 157 F.3d 1099, 1100, 33 Bankr. Ct. Dec. (CRR) 332, 40 Collier Bankr. Cas. 2d (MB) 1423, Bankr. L. Rep. (CCH) P 77812, 42 Cont. Cas. Fed. (CCH) P 77386 (7th Cir. 1998).
174 11 U.S.C.A. § 553(a)(1).
175 In re Emerald Casino, Inc., 2015 WL 1843271, at *6.
176 In re Emerald Casino, Inc., 2015 WL 1843271, at *6.
177 In re Emerald Casino, Inc., 2015 WL 1843271, at *7.
178 In re Emerald Casino, Inc., 2015 WL 1843271, at *7, *15, citing See 4 Norton Bankruptcy L. and Practice § 73:8 (3d ed. 2011).
179 28 U.S.C.A. § 157(E) (Emphasis Added).
180 In re Dynamic Drywall, Inc., 2015 WL 4497967, *1 (Bankr. D. Kan. 2015), report and recommendation adopted, 2015 WL 4744501 (D. Kan. 2015).
181 The debtor further asserted that its cause of action for conversion should be recharacterized as a core proceeding because it was the same as a motion for turnover of property of the estate under § 542. The bankruptcy court disagreed on thoe ground that the debtor did not specifically seek a “turnover” action. re Dynamic Drywall, Inc., 2015 WL 4497967, at *2.
182 Rule 83.8.6(b)(2) of the Rules of Practice and Procedure of the United States District Court for the District of Kansas requires that a defendant seeking to withdraw the reference file a motion to do so within 20 days of being served with the complaint.
183 In re Dynamic Drywall, 2015 WL 4497967, at *2.
184 In re Dynamic Drywall, 2015 WL 4497967, at *2.
185 In re Wright, 371 B.R. 472, 479 (Bankr. D. Kan. 2007).
186 In re Wright, 371 B.R. at 479.
187 In re Tate, 2015 WL 1775519, *1, *3 (Bankr. S.D. Ga. 2015).
188 In re Tate, 2015 WL 1775519, *4–5 (Bankr. S.D. Ga. 2015).
189 In re Cinevision International, Inc., 2016 WL 638729, *1, *8 (B.A.P. 9th Cir. 2016).
190 The trustee sought relief under § 362(h) which is now codified as § 362(k) and provides that “an individual injured by any willful violation of a stay provided by this section shall recover actual damages, including costs and attorneys’ fees, and, in appropriate circumstances, may recover punitive damages.” 11 U.S.C.A. § 362(k).
191 In re Cinevision International, Inc., 2016 WL 638729, at *4.
192 In re Cinevision International, Inc., 2016 WL 638729, at *4, citing In re Dyer, 322 F.3d 1178, 41 Bankr. Ct. Dec. (CRR) 64, Bankr. L. Rep. (CCH) P 78816 (9th Cir. 2003).
193 In re Cinevision International, Inc., 2016 WL 638729, at *4, quoting In re Bennett, 298 F.3d 1059, 1069, 39 Bankr. Ct. Dec. (CRR) 256, Bankr. L. Rep. (CCH) P 78697 (9th Cir. 2002).
194 In re Cinevision International, Inc., 2016 WL 638729, at *4.
195 In re Cinevision International, Inc., 2016 WL 638729, *4 (B.A.P. 9th Cir. 2016), quoting In re Mwangi, 432 B.R. 812, 822 (B.A.P. 9th Cir. 2010).
196 In re Cinevision International, Inc., 2016 WL 638729, *5–6 (B.A.P. 9th Cir. 2016).

This article appears in the Norton Annual Survey of Bankruptcy Law & Practice, 2016 Edition, and is posted with permission.  Copyright © 2016 Thomson Reuters/West.  For more information about this publication please visit http://legalsolutions.thomsonreuters.com/. Link to article.

The Devil Is In the Details: How the Delaware Court of Chancery Permitted a Derivative Claim to Survive an Earlier Derivative Dismissal

By Stephen B. Brauerman and Sara E. Bussiere

Several recent decisions of the Delaware Court of Chancery dismissed derivative claims on collateral estoppel grounds in deference to the earlier decisions of courts in other jurisdictions dismissing such claims for failure to demonstrate demand futility. See, e.g., Laborers’ District Council Constr. Indus. Pension Fund and Hallandale Beach Police Officers and Firefighters’ Personnel Ret. Fund v. Bensoussan, 2016 WL 3407708 (Del. Ch. June 1, 2016) (hereinafterBensoussan”); In re Wal-Mart Stores, Inc. Delaware Derivative Litig., 2016 WL 2908344 (Del. Ch. May 13, 2016) (hereinafterWal-Mart”). Delaware courts showed deference to those earlier decisions notwithstanding that the Delaware complaints were “more detailed, specific, and extensive” than the first filed complaints on which the collateral estoppel dismissals were premised. Wal-Mart, 2016 WL 2909344, at *10-11. Continuing this trend, the Delaware Court of Chancery again showed deference to the earlier decision of a sister court in its August 31, 2016 In re Duke Energy Corporation Derivative Litigation decision. In re Duke Energy Corporation Derivative Litigation, 2016 WL 4543788 (Del. Ch. Aug. 31, 2016) (hereinafter “Duke Energy”). Duke Energy is, however, unique, in that the Court of Chancery’s deference was limited. Unlike Bensoussan and Wal-Mart, which dismissed the subsequent derivative claims in their entirety, Duke Energy found the rare circumstance where the claims the proposed derivative plaintiff sought to pursue in Delaware were different from the claims dismissed in the earlier North Carolina proceeding, and offered the stockholder plaintiffs a rare second bite at the apple. Duke Energy reaffirms Delaware’s deference to the demand analysis of its sister courts in first-filed derivative stockholder litigation, but provides important guidance for the unique circumstances where careful pleading can overcome the doctrine of collateral estoppel.

The Duke Energy Facts

On January 10, 2011, Duke Energy Corporation entered into a merger agreement with its smaller rival, Progress Energy, Inc. Through the merger, Progress stockholders would receive Duke stock worth nearly $13.7 billion, and Progress would become a wholly owned subsidiary of Duke. Post-merger, the Duke board would consist of 11 Duke directors and 6 Progress directors. Progress’ chief executive, William D. Johnson  would become Duke’s Chief Executive Officer; Duke’s chief executive, James E. Rogers  would become Executive Chairman. The merger was subject to regulatory approval from state and federal authorities, including the North Carolina Utilities Commission (NCUC). The stockholders of both companies overwhelmingly voted to approve the transaction.

The Delaware complaint alleges that after obtaining stockholder approval, but before obtaining regulatory approval, the 11 legacy Duke directors began to have second thoughts about allowing Johnson to head the combined company. Rather than cancel the merger agreement, which would have required the payment of a sizeable termination fee, or breach the merger agreement, the legacy Duke directors allegedly agreed to replace Johnson as Chief Executive Officer immediately after the merger was consummated. Allegedly to cover up this plan, on June 27, 2012, Duke entered into an employment agreement with Johnson that contained lucrative severance benefits. The merger closed on July 2, 2012. The Duke board met almost immediately thereafter and appointed Johnson as CEO. Before the meeting concluded, the Duke board went into executive session. During this executive session, reading from a prepared script and without any notice to the legacy Progress directors, a Duke legacy director moved to terminate Johnson and replace him with Rogers. The directors discussed the matter and ultimately voted, along party lines, to replace Johnson with Rogers. Following the public announcement of the Board’s decision, the NCUC began an investigation and public rating agencies downgraded Duke’s bonds.

Several stockholder lawsuits followed, including as relevant to this article, an action brought in state court in North Carolina by Joel Krieger (the “Krieger Action”) alleging, derivatively on behalf of Duke, that the board breached its fiduciary duties and committed waste by entering into the employment agreement, pursuant to which Duke paid Johnson $44 million in severance for what amounted to one day’s work. As with the plaintiffs in the Delaware action, Krieger did not make a demand on the Duke board before filing his suit. The North Carolina court dismissed the Krieger Action for failure to make a pre-suit demand. Applying Delaware law, the Krieger court reasoned that the Duke directors did not face a substantial likelihood of personal liability that would impair their independence from the amount and timing of the severance payment to Johnson. Because the consideration the company received from Johnson was not so inadequate as to justify waste, the North Carolina found that demand was not futile or excused.

The Delaware Court Gives Some, but Not Complete Deference to the Krieger Action

Relying heavily on the dismissal in the Krieger Action, the Delaware defendants moved to dismiss the Delaware complaint for failure to plead demand futility. The Delaware court, applying North Carolina law, found that the decision in Krieger was preclusive to the extent the Delaware complaint “seeks to recover for waste or breach of duty arising from the decisions by the Director Defendants to enter a contract with Johnson, under which discharge would obligate Duke to the payment of millions of dollars in severance—and, shortly thereafter, to fire him . . .”

Notwithstanding that finding, the court observed that “substantial allegations of the instant complaint do not involve that issue.” Rather, the Delaware complaint focused on the Duke directors’ violation of positive law—their failure to cure misleading representations to the NCUC about who would head the combined entity. Specifically, as alleged in the Delaware complaint, the director defendants decided to terminate Johnson prior to obtaining regulatory approval of the merger, but did not inform the NCUC of that decision and represented, falsely, that no facts had changed when they sought to expedite approval from NCUC following federal approval of the transaction. As to this claim, the Court of Chancery held, collateral estoppel does not apply because the North Carolina court did not address in the Krieger Action the issue of demand excusal arising from a violation of positive law.

In reaching this decision, the Court of Chancery distinguished Bensoussan and Wal-Mart, explaining that these:

decisions [held] that where an issue was presented, and rejected, by a first court, the issue is precluded before a second tribunal, regardless of the fact that the second complaint may plead facts that make the proposition advanced more likely or persuasive . . . Here, by contrast, although the causes of action arise, in the instant case and in theKrieger Action, from facts related to the Duke-Progress merger and the discharge of Johnson, the cause of injury alleged here is discrete from that in the Krieger Action, and argument that demand is excused proceeds on unique grounds.

Highlighting the difference between the Delaware and Krieger Actions, the court noted that “the allegations in the instant case involve whether the Director Defendants made a conscious decision to mislead regulators in violation of positive law, and are able to evaluate whether to authorize their corporation to pursue damages therefrom. The Krieger Action, however, involved whether the defendants could independently consider a waste claim.”

Although the court found that the Delaware Action and the Krieger Action involved different claims, the court recognized the effect its decision could have on subsequent efforts to avoid preclusive dismissals from earlier-filed actions. As the court observed, “I note that this decision should not open the door to artful crafting by plaintiffs of new causes of action based on a single factual scenario in an attempt to avoid collateral estoppel. The interests of efficiency and finality (and, with respect to litigation in different jurisdictions, comity) require a practical view of the issues presented, to preclude such gamesmanship. This unusual case pushes the limits of such analysis.”

Conclusion

The Court of Chancery’s decision in Duke Energy exemplifies the pragmatic approach Delaware Courts will take when considering motions to dismiss for failure to plead demand futility. While the Court of Chancery will show great deference to preclusive decisions of sister courts addressing the same issues, Delaware courts will not elevate form over substance by allowing a narrow dismissal to subsume later-filed claims that were not properly before the other court. Governing the court’s analysis will be the practical implications of the claims and the scope of the earlier suit. For defendants, this means that dismissals should be as broad as possible to encompass all variations of claims depending from common facts. For stockholders, this requires a creative eye for new causes of action not fairly presented the first time. Duke Energy confirms Delaware’s commitment to pragmatic and practical jurisprudence, balancing the demands of comity, efficiency, and fairness.


Published in Business Law Today, October 2016. © 2016 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Link to article.

A Profile in Balance: Kara Swasey

By James G. McGiffin, Jr., Esquire

It’s all Fun on the Kara Swasey Team

If I aspire to be the best lawyer I can be, I must first try to be the best person I can be. I am fortunate to know many lawyers who have succeeded in their work, in part, because they are excellent people. This column in The Bar Journal will feature an article on one such lawyer. Each featured lawyer will exemplify the art of balance in life. I have learned much from these people. Perhaps readers will also benefit.

– Jim McGiffin

Kara Swasey is fun. It is evident in her smile and her demeanor. Though she can be serious, fun is a priority in her life. This cannot be said of enough Delaware lawyers.

A Buffalo native and daughter of a college professor, Kara chose to attend the University of Delaware because it was available to her through a tuition exchange program. Business was her course of study. Her career plan was to lead a major corporation some day. Pretty serious stuff. And yet, she earned her science requirement credit by studying “chocolate” as a freshman. Fun.

Kara chose Villanova for her next academic endeavor. She enrolled in and completed the joint JD/MBA program in three years. Kara described the program this way: attend law school during the day and business school in the evening. That is very serious. After graduation she went with Bayard, P.A. to work in corporate litigation. To her surprise, she found that the Chancery Court litigation did not light her fire. She thought she should explore another practice area offered by the firm, so she started accepting family law appointments from Bayard director Curtis Bounds, a renowned family law attorney. She was happy to discover that a family law practice requires a great deal of client contact and courtroom time, in contrast to the corporate work that involved little of either. For Kara, family law was just more fun.

As she transitioned her practice from corporate work to family work, Kara took a number of steps to acquaint herself with the new environment. She joined a group of family law attorneys who meet regularly for lunch. She joined DSBA’s Family Law Section. Family law attorneys are fun. She volunteered for the Attorney for the Day program run by Delaware Volunteer Legal Services, handling Protection from Abuse cases for abuse victims on Fridays. She volunteered with the Domestic Violence Advocacy Program. She joined the Melson-Arsht American Inn of Court. She volunteered with the Office of the Child Advocate. All the while she enjoyed the mentorship of Curtis Bounds and the support of Bayard, where she is now a director, herself.

Kara really has the most fun with her family. Her husband, Dan, actually has fun for a living. He is a physical education teacher and soccer coach at St. Mark’s High School. Kara tells a revealing story about arriving home at 1:00 a.m., bleary-eyed after a night of “corporate litigation” and inquiring of Dan about his day. “It was great!” He explained, “We did the ping-pong unit today.” And these folks love sports. Kara is particularly proud of the fact that Dan took her to a baseball game for her birthday in 2008 and that the Phillies won the World Series in that very game. That must have been great fun.

Kara and Dan have two sons, Tom and Greg. Tom is six years old, and he is a sports prodigy. Not only does he play many sports well (he hits the ball over the fence from the tee), but he is also an amazingly knowledgeable fan. For example, he picked the winners in the 2015 NCAA Men’s Basketball Tournament (when he was five). Greg, while also athletic (and faster than Tom, apparently), is the family comedian. And, these sports fans have lots of fun. They attend Flyers, Phillies, and University of Delaware games as a family. They also attend St. Marks games to cheer on Dad and the team. Kara admits that son Greg is actually named for a St. Marks soccer star who scored three goals in the state championship final (though he was credited for only two — he was robbed of the third by the ref).

Kara Swasey brings much to all that she does. She is smart and hard-working. She is respected and knowledgeable. But, where Kara is unique is in the degree of another trait she brings to all she does: mirth. And, everyone who has contact with her is better for it.


This article originally appeared in the May 2016 issue of The Journal of the Delaware State Bar Association, a publication of the Delaware State Bar Association.  Copyright © Delaware State Bar Association 2016.  All rights reserved. Reprinted with permission. Link to article.

Setting the Clock on the Section 502(b)(6) Time vs. Rent Debate

By Justin R. Alberto

The Bankruptcy Code offers a debtor myriad tools to facilitate an effective reorganization. Two of the most fundamental devices include the permissive revaluation of executory contracts and unexpired leases under § 365 and the reconciliation of claims against the estate under § 502. While factually distinct, the intersection of the two sections has sparked a great deal of litigation and academic debate. One particular point of contention centers on the application of § 502(b)(6)’s cap of a landlord’s claim for a bankrupt tenant’s rejection of a nonresidential lease. On April 16, Judge Kevin J. Carey of the U.S. Bankruptcy Court for the District of Delaware issued an opinion in In re Filene’s Basement that should curtail at least a portion of the dispute.

Background

Filene’s Basement historically owned and operated off-price retail stores throughout the country. In November 2011, the company filed a petition under Chapter 11 of the Bankruptcy Code to finalize its affairs and to maximize the value of its real estate for the benefit of creditors.

Prior to the petition date, Filene’s leased retail space in Washington, D.C., pursuant to a lease agreement with Connecticut/ DeSales LLC as landlord.In December 2011, Filene’s rejected the lease pursuant to Bankruptcy Code § 365.2 Absent rejection, the lease would have expired on Jan. 31, 2019.3

Following rejection of the lease, the landlord timely filed a proof of claim against Filene’s for, among other things, rejection damages, subject to the Bankruptcy Code § 502(b)(6) cap.4 The landlord calculated the statutorily capped rejection damages as the total rent due for the remaining term multiplied by 15 percent.5 Filene’s objected to the claim on the basis that § 502(b)(6) caps rejection damages at 15 percent of the remaining term of the lease rather than at 15 percent of the remaining rent due under the lease. The difference in the parties’ respective positions represented approximately $105,000.

Bankruptcy Code § 502

Pursuant to Bankruptcy Code § 365, a debtor in a bankruptcy proceeding may reject any unexpired lease of nonresidential real property.6 Although the Bankruptcy Code does not specify the standard by which to assess a debtor’s decision to reject a lease, courts typically use a business judgment test and refrain from second guessing the debtor if rejection will benefit the estate.7 If a debtor carries its burden on rejection, the lease is deemed to have been breached, and the debtor is relieved from future performance.8

Under the current Bankruptcy Code, rejection of a lease gives rise to a claim for damages in favor of the landlord. However, much of the debate in this area historically focused on what, if any, aspects of a landlord’s claim should be allowed. For instance, prior to 1934, a landlord’s claim for premature lease termination damages was not recognized as a viable claim, because it was considered purely contingent and incapable of proof.9 As a result, landlords could not recoup any damages for post-termination rent. The 1934 and 1938 amendments rectified that inequity. Pursuant to the amendments, landlords received distributions for future rents, subject to certain limitations that were designed to prevent large unearned rent claims from diluting a debtor’s dividend to unsecured creditors.10 Specifically, landlord claims for future rent in liquidation cases were capped at “the year next succeeding” surrender or reentry.11 Similarly, claims by landlords in rehabilitation cases were capped at “the three years next succeeding” surrender or reentry.12

The reasoning behind the lease rejection damages limitations imposed by the 1934 and 1938 amendments was carried forward in the 1978 amendments. Congress believed the earlier compromise appropriately compensated landlords for their loss while precluding a pool of substantial claims that would prevent other general unsecured creditors from recovering a distribution from the estate.13 Eventually, the Bankruptcy Code was amended to include the current percentage calculation, which provides that a landlord’s claim is limited to the rent reserved by the lease, without acceleration, for the greater of either one year or 15 percent, not to exceed three years, of the remaining lease term following the earlier of (i) the petition date and (ii) the date of surrender or reentry.14

The Rent vs. Time Debate and Filene’s Decision

Debtors and landlords have long disputed whether § 502(b)(6)’s reference to 15 percent points to the amount of time remaining in the term of the lease or the remaining amount of rent due under the lease. It is easy to see why the varying interpretations have produced so much litigation and debate. Indeed, the difference between the two positions, as demonstrated in Filene’s, can be significant, because leases commonly contain rent and other cost escalation clauses. Landlords commonly seek to use the rent approach to take advantage of the escalation clauses over the lifetime of the lease. In response, debtors frequently seek to cap landlord claims using the time approach, so that only those escalators applicable in the first 15 percent of the term, up to a maximum of three years, can be captured. As noted by Judge Carey in the Filene’s decision, each position finds support in modern case law. On the one hand, courts in jurisdictions like California,15 Colorado,16 Florida,17 and Pennsylvania18 have applied the time approach. On the other hand, courts in Illinois,19 Michigan,20 and New York,21 have found the rent approach to be more consistent with congressional intent.

To resolve this split, the court focused its analysis on the text of the statute—“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.” Judge Carey concluded that a natural reading of this language supports utilizing the time approach over the rent approach for three reasons. First, comparing the greater or lesser of two things is only possible when using parallel units. Because the first element of the § 502(b) (6) comparison is temporal (one year), the second element (remaining term) must necessarily refer to time. Second, allowing a rent-based claim would render the “without acceleration” prohibition meaningless in situations where escalation clauses are present.22 Finally, according to the court, the time approach is more constituent with the clear congressional intent from prior versions of the statute that expressly limited damages based on temporal measurements.

While the Third Circuit has yet to weigh in on the time vs. rent debate, the court’s decision in Filene’s likely means that debtors in Delaware can successfully foil future rent-based landlord claims.23 However, until Congress clarifies the meaning of § 502(b)(6), a split of authority will remain, notwithstanding the Filene’s decision.24 As always, practitioners must know the law of the jurisdictions in which they appear for their clients.


 Endnotes

1In re Filene’s Basement, No. 11-13511- KJC, 2015 WL 1806347, at *1-2 (Bankr. D. Del. Apr. 16, 2015). The landlord was the successor in interest to an affiliated entity. Filene’s was successor in interest to a prior tenant.
2Id. at *2.
3Id.
4Id. at *2-3.
5Id.
611 U.S.C. § 365(a).
7See, e.g., Sharon Steel Corp. v. Nat’l Fuel Gas Dist. Corp. (In re Sharon Steel Corp.), 872 F.2d 36, 39-40 (3d Cir. 1989).
8Taylor Wharton Int’l LLC v. Blasingame (In re Taylor-Wharton Int’l LLC), No. 10-52792-BLS, 2010 WL 4862723, at *3 (Bankr. D. Del. Nov. 23, 2010) (noting that rejection constitutes a pre-petition breach, not rescission of the contract).
9In re Connectix Corp., 372 B.R. 488, 491 (Bankr. N.D. Cal. 2007).
10Id. at 492; see also Oldden v. Tonto Realty Corp., 143 F.2d 916, 918 (2d Cir. 1944).
11Connectix, 372 B.R. at 492.
12Id.
13Id.
1411 U.S.C. § 502(b)(6).
15Connectix, 372 B.R. at 491-93; see also In re Iron-Oak Supply Corp., 169 B.R. 414, 420 (Bankr. E.D. Cal. 1994).
16In re Shane Co., 464 B.R. 32, 40 (Bankr. D. Colo. 2012).
17In re Ace Elec. Acquisition LLC, 342 B.R. 831, 833 (Bankr. M.D. Fla. 2005).
18Sunbeam-Oster Co. v. Lincoln Liberty Ave. Inc. (In re Allegheny Int’l Inc.), 145 B.R. 823, 828 (W.D. Pa. 1992); see also In re Peters, No. 03-11077-DWS, 2004 WL 1291125, at *6 n. 20 (Bankr. E.D. Pa. May 7, 2004).
19Schwartz v. C.M.C., Inc. (In re Communicall Cent., Inc.), 106 B.R. 540, 544 (Bankr. N.D. Ill. 1989).
20In re Gantos Inc., 176 B.R. 793, 795-96 (Bankr. W.D. Mich. 1995).
21In re Andover Togs Inc., 231 B.R. 521, 540-41 (Bankr. S.D.N.Y. 1999).
22The court found unpersuasive the argument that the rent approach more appropriately provides landlords the benefit of their bargain by accounting for negotiated lease escalators. Congress started with the premise that landlords had no claim at all and, unlike other unsecured creditors, enjoy the added protection of ultimately reclaiming their property. According to the court, the time approach strikes the better balance of competing economic interests by providing landlords a set period of time to relet the premises.
23The Filene’s Basement decision was not appealed to the district court.
24The American Bankruptcy Institute Commission to Study the Reform of Chapter 11 suggested in its Final Report and Recommendations that § 502(b)(6) should be clarified consistent with the time approach.

First published in The Federal Lawyer, January/February 2016. Link to article.

The Cleansing Effect of a Statutorily Required Shareholder Vote on a Troubled Transaction

By Stephen B. Brauerman and Sara E. Bussiere

Delaware law has long recognised that the uncoerced vote of fully informed stockholders can cure even the most questionable of self-interested transactions. This policy is enforced through the standard of review Delaware courts use to judge these otherwise interested transactions. This article discusses Delaware’s increasing comfort with the curative powers of fully-informed stockholder votes, as evidenced by the Delaware Supreme Court’s recent decision in Corwin v. KKR Financial Holdings, LLC, in which the Court extended deferential judicial review to transactions approved by a majority of disinterested stockholders, even where the stockholder vote was statutorily required. Corwin exemplifies the sanitising benefits of a vote – even when the company did not call the vote for its sanitising effect.

Delaware’s standards of judicial review

The standard of review determines the deference the court will apply in reviewing a challenged transaction and is often outcome determinative. Thus, the application of the appropriate standard of review is “essential to a proper judicial review of challenges to the decision-making process of a corporation’s board of directors”. Omnicare, Inc. v. NCS Healthcare, Inc., 818 A.2d 914, 927 (Del. 2003). Delaware courts employ three levels of judicial review: (i) the business judgment rule; (ii) enhanced scrutiny; and (iii) entire fairness.

The business judgment rule, the most deferential standard, reflects the “cardinal precept of the General Corporation Law of the State of Delaware… that directors, rather than shareholders, manage the business and affairs of the corporation”. As such, under the business judgment rule, Delaware courts will uphold corporate decisions “absent an abuse of discretion”. However, a plaintiff may rebut the business judgment rule in various ways, including by showing that a controlling stockholder stood on both sides of the transaction, a majority of the board was interested in a particular transaction or lacked independence, or that the board failed to act in good faith in approving the transaction (Id.; see also eBay Domestic Holdings, Inc. v. Newmark, 16 A.3d 1, 36 (Del. Ch. 2010).

If a plaintiff successfully rebuts the business judgment rule, the burden of proof shifts to the defendant director to prove that the challenged transaction was entirely fair to the company – an exacting standard. Entire fairness requires the defendant director to “establish to the court’s satisfaction that the transaction was the product of both fair dealing and fair price”. Cede & Co. v. Technicolor, 634 A.2d 345, 361 (Del. 1993) (emphasis in original). Somewhere between the business judgment rule and entire fairness lies enhanced scrutiny, an intermediate level of judicial review that requires the defendant director to prove that the actions he or she took were reasonable”. Paramount Communications Inc. v. QVC Network, Inc., 637 A.2d 34 (Del. 2000).

Corwin and mandatory votes

In Corwin, the Delaware Supreme Court affirmed the dismissal of a complaint for breaches of fiduciary duty, and aiding and abetting such breaches, because “the voluntary judgment of the disinterested stockholders to approve the merger invoked the business judgment rule standard of review”, which plaintiffs failed to rebut. Plaintiffs’ claims arose from a stock-for-stock merger whereby KKR & CO. L.P. (KKR) acquired KKR Financial Holdings LLC (KFN).

Plaintiffs argued the Court should apply entire fairness review because KKR, which held less than 1 percent of KFN’s stock, constituted a controlling stockholder and a majority of the KFN board lacked independence. After finding that it could not reasonably infer from the well-pled facts that KKR could prevent the board from exercising its independent judgment, the Court of Chancery found that the fully informed, uncoerced vote of disinterested stockholders invoked the business judgment rule.

In reaching this conclusion, the Court of Chancery relied upon longstanding Delaware precedent to hold that the “legal effect of a fully-informed stockholder vote of a transaction with a non-controlling stockholder is that the business judgment rule applies and insulates the transaction from all attacks other than on the grounds of waste, even if a majority of the board approving the transaction was not disinterested or independent”. The Court of Chancery rejected a recent interpretation of the Delaware Supreme Court’s decision in Gantler v. Stephens, 965 A.2d 695 (Del. 2009), which suggested that a statutorily mandated stockholder vote altered this precedent (“I do not read Gantler to have altered the legal effect of a stockholder vote when it is statutorily required.”)

On appeal, the Delaware Supreme Court agreed with the Chancellor’s finding that the uncoerced, informed stockholder vote was outcome-determinative. The Court wrote: “To erase any doubt on the part of practitioners, we embrace the Chancellor’s well-reasoned decision and the precedent it cites to support an interpretation of Gantler as a narrow decision focused on defining a specific legal term, ‘ratification,’ and not on the question of what standard of review applies if a transaction not subject to the entire fairness standard is approved by an informed voluntary vote of disinterested stockholders. This view is consistent with well-reasoned Delaware precedent”.

The Supreme Court rejected plaintiffs’ argument that such a reading impairs existing stockholder protections, or exposes stockholders to abuse by directors without adequate protections. The Court explained that “the doctrine applies only to informed, uncoerced stockholder votes, and if troubling facts regarding director behaviour were not disclosed that would have been material to a voting stockholder, then business judgment rule is not invoked”. In the present matter, KKR’s interests were fully disclosed to the stockholders and therefore, the Court of Chancery properly dismissed plaintiffs’ claims (“for sound policy reasons, Delaware corporate law has long been reluctant to second-guess the judgment of a disinterested stockholder majority that determines that a transaction with a party other than a controlling stockholder in their best interests”).

Zale and Corwin’s immediate impact

Corwin’s confirmation that business judgment review applies to stockholder approval of an interested transaction, even where such stockholder vote is required by statute, had immediate impact. The Delaware Supreme Court issued Corwin on 2 October 2015. The day before, the Court of Chancery decided In re Zale Corporation Stockholders’ Litigation, 2015 WL 5853693 (Del. Ch.), in which it denied a motion to dismiss aiding and abetting claims against Zale Corporation’s (Zale) financial adviser, Merrill Lynch, Pierce, Fennell, & Smith Inc. (Merrill Lynch).

Zale involved a post-merger challenge to the all-cash acquisition of Zale by its chief competitor, Signet Jewelers Ltd. (Signet). The plaintiff alleged that the Zale board of directors breached its fiduciary duties of care and loyalty by undermining the board’s ability to maximise shareholder value through undisclosed conflicts of interest and an unfair sales process. Merrill Lynch aided and abetted the board’s breaches, according to the plaintiff, by, among other things, making a presentation to Signet extolling a potential acquisition of Zale while it had access to Zale’s confidential information. After announcing the merger, several large institutional stockholders publicly expressed their opposition, in response to which Zale made a number of filings with the Securities and Exchange Commission extolling the virtues of the transaction. With these substantial disclosures, a bare majority of Zale stockholders voted to approve the merger.

Even though a majority of Zale’s public stockholders voted to approve the merger, the Court of Chancery applied enhanced scrutiny to review the transaction because after the Zale board decided to sell the company, it had an obligation under Revlon, Inc. v. MacAndrews & Forbes Hldgs., Inc., 506 A.2d 173, 182-3 (Del. 1986) to take all reasonable steps to maximise the value of transaction. Aware of the tension between Gantler and the Court of Chancery’s decision in KKR (which was then on appeal), the Zale Court conservatively declined, “until the Supreme Court signals otherwise”, to apply business judgment review to a challenged transaction approved by a majority of fully-informed and disinterested stockholders because the stockholder vote was required under Section 251 of the DGCL.

Applying the more stringent enhanced scrutiny standard, the Court of Chancery found that it was reasonably conceivable that Merrill Lynch aided and abetted a breach of fiduciary duty because the Zale board did not learn about Merrill Lynch’s presentation to Signet until after the merger agreement was signed and the Court denied Merrill Lynch’s motion to dismiss.

The Supreme Court issued Corwin the next day. Under Corwin, business judgment review applies to a transaction approved by a fully informed majority of disinterested stockholders even where that stockholder vote is statutorily required. Citing Corwin, Merrill Lynch timely moved for reargument of the Zales decision. Corwin offered the “signal” for which the Zale Court was looking. The Court of Chancery granted Merrill Lynch’s motion for reconsideration in light of Corwin because it “misapprehended the cleansing effect of a fully informed, statutorily required vote by a majority of disinterested stockholders”.

On reconsideration and after applying the deferential business judgment rule, the Court of Chancery found that the board’s investigation of Merrill Lynch’s alleged conflicts and its ultimate decision to retain Merrill Lynch were not grossly negligent and could not support the breach of fiduciary duty claim on which the aiding and abetting claim against Merrill Lynch necessarily rested. Even though the Court found “the conduct of Merrill Lynch in this case troubling”, the fully informed stockholder vote saved Merrill Lynch and the Court dismissed the claims it previously sustained against Merrill Lynch under the less onerous business judgment standard.

Conclusion

The Corwin decision and the Court of Chancery’s self-correction in Zale following Corwin demonstrate the cleansing power of a fully informed vote of disinterested stockholders. Even when a stockholder vote is statutorily required (i.e., to approve a merger or a sale of all or substantially all of the assets of a company), the curative effects of the vote remain. As such, corporate actors can take solace knowing that if they can convince their stockholder constituencies – after full disclosure – of the merits of the deal, Delaware courts will not lightly second guess them.


First published in Corporate Disputes, Jan-Mar 2016. Link to article.

Chief Judge Stark (D. Del.) Issues a Pair of Opinions Addressing New Value, Ordinary Course of Business, and Earmarking Defenses (Part II)

By Evan T. Miller

The second of Chief Judge Stark’s two September 2015 opinions is Prudential Real Estate v. Burtch (In re AE Liquidation, Inc.), 2015 WL 5301553 (D. Del. Sept. 10, 2015). The pertinent facts of that case are as follows: in May 2006, the Debtor engaged the defendant/appellant, Prudential Real Estate and Relocation Services, Inc. and Prudential Relocation, Inc. (“Prudential”), to perform various relocation services for the Debtor’s employees. The agreement contemplated that the Debtor would pay Prudential for services within 30 days of receiving an invoice. While the Debtor was timely with its payment of invoices during the first year and a half of the parties’ agreement, the Debtor began to fall behind. As a result, Prudential placed the Debtor on “billing review,” which implemented the following conditions: (1) Prudential would not accept new employee transfers, (2) the Debtor would begin paying Prudential on a weekly, instead of monthly, basis, (3) the Debtor would pay a $900,000 lump sum to reduce the outstanding accounts receivable balance, and (4) Prudential would eventually terminate the agreement if the conditions were not satisfied. By January 18, 2008, the Debtor had complied with these terms and Prudential removed the Debtor from the payment plan.

In August 2008, Prudential learned that the Debtor had terminated 650 of its employees in light of financial difficulties. That same month, Prudential again placed the Debtor on billing review due to late payments. This second payment plan implemented the same conditions as the first plan, except for varying payment amounts. On November 25, 2008, the Debtor filed for chapter 7 bankruptcy relief in the United States Bankruptcy Court for the District of Delaware.

In the 90 days prior to the petition date, the Debtor had made 12 payments to Prudential totaling $781,702.61, which the Trustee sought to recover as preferential transfers under 11 U.S.C. §§ 547 and 550. Following trial, the Bankruptcy Court awarded judgment in favor of the Trustee for $653,323.20, which represented $781,702.61 of preferential transfers, reduced by $128,379.40 of “new value” that Prudential had provided under 11 U.S.C. § 547(c)(4). Both parties filed timely appeals to the District Court.

Prudential argued on appeal that the transfers were not preferential because they occurred in the “ordinary course of business” as defined by 11 U.S.C. § 547(c)(2). The Trustee cross-appealed, alleging that Prudential’s “new value” defense impermissibly included amounts provided after the petition date, plus the Bankruptcy Court failed to provide prejudgment interest to his judgment. The District Court first addressed the ordinary course of business defense under 11 U.S.C. § 547(c)(2). This defense provides that: “The trustee may not avoid under this section a transfer—(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was—(A) made in the ordinary course of business or financial affairs of the debtor and the transferee; or (B) made according to ordinary business terms”. Chief Judge Stark noted that courts have considered the following factors to assess if a transfer occurs in the ordinary course of business: (1) the length of time the parties engaged in the type of dealing at issue; (2) whether the subject transfers were in an amount more than usually paid; (3) whether the payments at issue were tendered in a manner different from previous payments; (4) whether there appears to be an unusual action by the debtor or creditor to collect on or pay the debt; and (5) whether the creditor did anything to gain an advantage (such as gain additional security) in light of the debtor’s deteriorating financial condition.

Prudential argued that the Bankruptcy Court erred by finding that the Debtor’s faster payments during the preference period (during which the average payment time dipped from 45.3 days historically to 28 days) meant that they were not in the ordinary course of business. Citing In re Archway Cookies, 435 B.R. 234 (Bankr. D. Del. 2010), Chief Judge Stark found that the proper inquiry is whether the change in payment timing was significant, regardless of whether it was faster or slower, as “small deviations in the timing of payments may not be so significant as to defeat the ordinariness of such payments[,] [whereas] courts have held greater deviations . . . sufficiently significant to defeat the ordinariness of such payments.” In this case, the District Court found that the Bankruptcy Court’s ruling that a 40% increase in payment timing was significant–especially when paired with the fact that Prudential insisted on the quicker payment schedule–was not clearly erroneous.

The District Court went on to reject Prudential’s arguments, based on In re Global Tissue L.L.C., 106 F. App’x 99 (3d Cir. 2004) and In re AE Liquidation, Inc., 2013 WL 5488476 (Bankr. D. Del. Oct. 2, 2013) respectively, that (i) six “extremely late” invoices out of 3,500 may have improperly skewed the average payment time and (ii) that the Bankruptcy Court was inconsistent in finding a 40% increase in payment time was significant whereas a 10-15% increase in payment time (as found in the earlier, unrelated AE Liquidation case) was not. To the former, the District Court found that the late payment pattern in Global Tissue was established consistently over two months, while in this case, it was comparatively minimal. As to the earlier AE Liquidation case, Chief Judge Stark saw nothing inconsistent with finding a 40% deviation significant and 10-15% insignificant, given the subjective nature of these types of cases.

The District Court next found that Prudential had knowledge of the Debtor’s financially deteriorating condition and subsequently used this knowledge to extract better repayment terms. Chief Judge Stark rejected the relevance of the parties’ past payment plans, a holding which he found to be congruent with In re Hechinger Inv. Co. of Delaware, Inc., 489 F.3d 568 (3d Cir. 2007). He found that the payment plans were a deviation from the “baseline” relationship the parties had established; i.e., once the conditions that precipitated the payment plan went away, the parties returned to their baseline relationship. Thus, they were not representative of the parties’ normal, ordinary arrangement.

Chief Judge Stark then turned to the Trustee’s appeal, specifically whether an improper amount of new value was allocated to Prudential. For this position, the Trustee argued that approximately $71,000 of Prudential’s $128,000 new value was provided after the petition date, which violates the precedent issued by the Third Circuit in In re Friedman’s Inc., 738 F.3d 547 (3d. Cir. 2013); see also Evan T. Miller, “The Third Circuit Draws a Line in the Sand on New Value in Friedman’s,” ABI Unsecured Trade Creditors Committee Newsletter, Vol. 12, No. 1, April 2014. Since the Bankruptcy Court did not distinguish between prepetition and postpetition payments for new value purposes, the District remanded the matter for a determination of the same.

The District Court likewise remanded the Trustee’s prejudgment interest claim to the Bankruptcy Court, so that the lower court could–as consistent with the Hechinger opinion– explain its reasoning for denying an award of prejudgment interest.


© 2016 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Link to article.

The New Lawyers’ Survival Guide

Bayard attorneys Evan T. MillerJustin R. AlbertoSteve B. BrauermanSara E. Bussiere,  and Elizabeth A. Powers contributed to the Delaware State Bar Association’s (“DSBA”)  first annual “The New Lawyers’ Survival Guide” that was distributed at the Supreme Court of Delaware Pre-admission Conference on November 12 and 13, 2015. The guide was organized by the Young Lawyers Section (“YLS”) of the DSBA and was put together as a reference for the future new lawyers attending the conference.

Evan served as an editor of the guide and a contributor to its bankruptcy section. Justin also contributed to the bankruptcy section, while Steve, Sara and Elizabeth contributed to the Court of Chancery and Supreme Court of Delaware sections.

A copy of the survival guide is available here.

Delaware Supreme Court Clarifies Divide Between Direct and Derivative Claims in Breach of Contract Actions and Demonstrates the Value of the Certified Question

By Stephen B. Brauerman and Sara E. Bussiere

The Delaware Supreme Court recently answered a certified question of Delaware law from the United States Court of Appeals for the Second Circuit pursuant to a constitutional amendment that authorizes such proceedings. The Delaware Supreme Court’s authority to consider and determine questions of law posed to it from jurisdictions across the United States, including the Securities and Exchange Commission, allows the Court quickly and efficiently to decide critical legal issues as they arise, and to develop and strengthen Delaware’s existing robust corporate law. The Court’s recent decision in NAF Holdings, LLC v. Li & Fung Trading Ltd., C.A. No. 641, 2014, 2015 WL 3896792 (Del. June 24, 2015), exemplifies this point. In NAF Holdings, the Delaware Supreme Court, in response to a question submitted by the Second Circuit, clarified the distinction between a direct and derivative action and held that “a suit by a party to a commercial contract to enforce its own contractual rights is not a derivative action under Delaware law,” even where the only economic damage the plaintiff suffered was to the value of stock of two wholly owned subsidiaries. This article provides a brief overview of Delaware’s “Certified Questions” procedures, the NAF Holdings decision, and its impact on the scope of direct and derivative claims brought under Delaware law.

Delaware’s Constitutional Mandate

In 1983, Delaware amended its constitution to permit the Delaware Supreme Court to hear questions certified to it from other state and federal courts. In 2007, the Delaware legislature amended the Delaware Constitution to include questions certified from the Securities and Exchange Commission. To effect its constitutional mandate, the Delaware Supreme Court adopted Rule 41(b), which provides that the Court may, in its discretion, accept questions certified from eligible tribunals “only where there exist important and urgent reasons for an immediate determination by this Court.” To meet Rule 41(b)’s stringent requirements, the parties may not dispute any material facts and the Court must consider whether the case involves a novel question of Delaware law, conflict in trial court decisions, or an unsettled question involving a Delaware statute or contractual provision.

Since the adoption of the “Certified Question” amendment, the Delaware Supreme Court has considered 25 certified questions and answered 23 of them. Consistent with the Court’s preferences, nearly all of these certified questions originated from non-Delaware tribunals. (The Delaware Supreme Court prefers to address questions of first impression from its own courts on a fully developed record or through an interlocutory appeal.) NAF Holdings was no exception. The NAF Holdings decision demonstrates how the Delaware Supreme Court’s authority to hear questions certified to it creates efficiency by allowing for timely resolution of critical questions of Delaware law.

The NAF Decision

In NAF Holdings, the Second Circuit asked the Delaware Supreme Court to consider whether, under Delaware law, a plaintiff who

has secured a contractual commitment of its contracting counterparty, the defendant, to render a benefit to a third party, and the counterparty breaches that commitment, may the promissee-plaintiff bring a direct suit against the promisor for damages suffered by the plaintiff resulting from the promisor’s breach, notwithstanding that (i) the third-party beneficiary of the contract is a corporation in which the plaintiff-promissee owns stock; and (ii) the plaintiffpromisee’s loss derives indirectly from the loss suffered by the third-party beneficiary corporation; or must the court grant the motion of the promisor-defendant to dismiss the suit on the theory that the plaintiff may enforce the contract only through a derivative action brought in the name of the third-party beneficiary corporation?

In other words, the Second Circuit asked whether a party to a contract may enforce its own contractual rights, even though the damages suffered by the breach of the contract it seeks to enforce occurred indirectly through the diminution of value of the stock of two subsidiaries it owns.
NAF Holdings, LLC, formed two wholly owned subsidiaries to complete its acquisition of Hampshire Group, Ltd., a public fashion apparel company. To obtain the financing necessary to complete the acquisition, NAF contracted with Li & Fung (Trading) Ltd. (“L&F Trading”) to serve as a sourcing agent. NAF’s two subsidiaries then entered into a merger agreement with Hampshire. Notably, NAF was not a party to the merger agreement. Subsequent to the entry of the merger agreement, NAF alleged that L&F Trading breached its contract, causing NAF’s funding commitments to fall through and the deal to crater. NAF filed suit against L&F Trading in the United States District Court for the Southern District of New York (the “District Court”), seeking to recover approximately $30 million in damages resulting from the diminution in value of the stock it owned in the two subsidiaries caused by the blown deal.

L&F Trading moved for summary judgment on the New York complaint because, it argued, NAF had to bring its claim derivatively on behalf of the two subsidiaries, both of which had already released their claims in a separate settlement with Hampshire. The District Court granted the motion for summary judgment, mistakenly concluding that because L&F Trading injured NAF in its capacity as the sole owner of the subsidiaries, that NAF could not maintain a direct claim for breach of contract damages. The District Court relied on the Delaware Supreme Court’s 2004 decision in Tooley v. Donaldson, Lufkin & Jenrette, 845 A.2d 1031 (Del. 2004), which set forth a test for determining whether a claim is direct or derivative. In Tooley, the Delaware Supreme Court held that in determining whether a claim is direct or derivative, a court:

should look to the nature of the wrong and to whom the relief should go. The stockholders’ claimed direct injury must be independent of any alleged injury to the corporation. The stockholder must demonstrate that the duty breached was owed to the stockholder and that he or she can prevail without showing an injury to the corporation.

Applying the test set forth in Tooley, the District Court found that NAF’s claims were not independent of its subsidiaries’ claims against L&F, and therefore, NAF’s claims should have been brought derivatively.

The District Court’s conclusion conflated direct (i.e., claims belonging to the party filing the suit) and derivative claims (i.e., claims belonging to a corporation but filed by a stockholder on behalf of the corporation because it was unwilling or unable to act). As the Delaware Supreme Court explained in Tooley, the distinction between direct claims and derivative claims is doctrinal and related to the nature of the relationship between shareholders and the corporation on behalf of which the derivative claim is brought:

The derivative suit has been generally described as one of the most interesting and ingenious of accountability mechanisms for large formal organizations. It enables a stockholder to bring suit on behalf of the corporation for harm done to the corporation. Because a derivative suit is being brought on behalf of the corporation, the recovery, if any, must go to the corporation. A stockholder who is directly injured, however, does retain the right to bring an individual action for injuries affecting his or her legal rights as a stockholder. Such a claim is distinct from an injury caused to the corporation alone. In such individual suits, the recovery or other relief flows directly to the stockholders, not to the corporation.

Tooley, 845 A.2d at 1036 (internal citations and quotations omitted).

Since a derivative claim is brought on behalf of the corporation, before a shareholder can bring such a suit, he or she must satisfy rigorous demand requirements. See Rales v. Blasband, 634 A.2d 927, 932 (Del. 1993) (“Because directors are empowered to manage, or direct the management of, the business and affairs of the corporation, 8 Del. C. § 141(a), the right of a stockholder to prosecute a derivative suit is limited to situations where the stockholder has demanded that the directors pursue the corporate claim and they have wrongfully refused to do so or where demand is excused because the directors are incapable of making an impartial decision regarding such litigation.”).

In answering the certified question, the Delaware Supreme Court distinguished between claims that belong to the corporation in which the stockholder invested (here the two subsidiaries) and claims that belong to the stockholder itself (NAF’s direct breach of contract claim against its contractual counterparty, L&F Trading). Neither of the subsidiaries were parties to the contract between NAF and L&F Trading (nor could they be because neither existed at the time the contract was executed) and did not have any direct rights to enforce the contract. While the damages NAF suffered as a result of L&F Trading’s alleged breach were indirect in that they resulted from the decreased value of the subsidiaries’ stock, NAF’s cause of action was still direct because it flowed from NAF’s (not its subsidiaries’) express contractual rights. As the Delaware Supreme Court explained, before applying the test articulated in Tooley, “a more important initial question has to be answered: does the plaintiff seek to bring a claim belonging to her personally or one belonging to the corporation itself?” If the plaintiff owns the claim, the Tooley test does not apply.

Reaffirming Delaware’s fundamental respect for the principles of freedom of contact and rejecting a reading of Delaware law that would apply “burdensome demand excusal process[es] before allowing [parties] to sue on their commercial contracts,” the Delaware Supreme Court answered the question certified by the Second Circuit by holding that “a suit by a party to a commercial contract to enforce its own contractual rights is not a derivative action under Delaware law.” As a result, the Delaware Supreme Court suggested that the District Court’s decision to grant L&F Trading’s motion for summary judgment was based on a misapplication of Delaware law.

Conclusion

NAF Holdings, while clarifying Delaware law on direct and derivate actions, aptly illustrates the Delaware legislature’s and courts’ commitment to addressing complicated issues quickly to provide certainty to Delaware companies. In NAF Holdings, the Delaware Supreme Court took just seven days to answer the Second Circuit’s certified question. The precedential value of a prompt and final answer on an important and unresolved aspect of Delaware law benefits parties, judges, practitioners, and students of Delaware law. The Delaware Supreme Court’s authority to consider and determine questions certified to it from state and federal courts, such as the one certified by the Second Circuit in NAF Holdings, has proven to be an effective method to expeditiously and efficiently decide critical legal issues while also advancing Delaware’s robust corporate and commercial law.


Published in Business Law Today, July 2015. © 2015 by the American Bar Association. Reproduced with permission. All rights reserved. This information or any 2 portion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Link to article.

Controlling Transactions with a Controlling Stockholder

By Stephen B. Brauerman and Sara E. Bussiere

Whether a large stockholder is a controlling stockholder is an important consideration when evaluating the viability or desirability of pursuing ‘interested’ transactions with controllers. Transactions with controllers are not prohibited, but generally they are subject to Delaware’s highest standard of judicial review: entire fairness, which requires proof of fair dealing throughout the transaction and fair price. However, “where the (transaction) is conditioned ab initio upon both the approval of an independent, adequately-empowered special committee that fulfils its duty of care; and the uncoerced, informed vote of a majority of the minority stockholders”, Delaware courts may apply deferential business judgment review when considering challenges from minority stockholders. Kahn vs.M&F Worldwide Corp., 88 A.3d 635, 644 (Del. 2014). This article discusses recent developments in Delaware law explaining when a stockholder becomes a controller and how companies considering transactions with controlling stockholders can increase their chances of surviving judicial scrutiny.

When a stockholder becomes a ‘controlling stockholder’

Under Delaware law, a stockholder becomes a controlling stockholder by owning a majority of the company’s shares or maintaining ‘actual control’ over the business affairs of the company. Whether a stockholder maintains actual control over the company may require a complex analysis. In 2014, several Delaware decisions examined when a minority stockholder becomes a controller. Hamilton Partners, L.P. vs. Highland Capital Management, L.P., 2014 WL 1813340 (Del. Ch.)); In re KKR Financial Holdings LLC Shareholder Litigation, 101 A.3d 980 (Del. Ch. 2014)); In re Crimson Exploration Inc. Stockholder Litigation, 2014 WL 5449419 (Del. Ch.); In re Sanchez Energy Derivative Litigation, 2014 WL 6673895 (Del. Ch.); In re Zhongpin Inc. Stockholders Litigation, 2014 WL 6778537 (Del. Ch.). These rulings show that one’s status as a controller depends on the acts he takes or influence he exerts to prevent the board from acting independently.

Crimson

In In re Crimson Exploration Inc. Stockholder Litigation, plaintiffs alleged that Oaktree Capital Management, L.P. (Oaktree) was a controlling stockholder of Crimson Exploration Inc. (Crimson) and purportedly breached its fiduciary duties by approving Crimson’s merger with Contango Oil & Gas Co. (Contango). 2014 WL 5449419. Oaktree moved to dismiss the complaint. The Court reviewed nine ‘significant cases’ where large stockholders disputed the ‘actual control’ issue. Id. at *10. The Court’s review revealed that there is no “linear, sliding scale approach whereby a larger share percentage makes it substantially more likely that the court will find the stockholder was a controlling stockholder”. Id. The Court also noted the “importance and fact-intensive nature” of assessing a stockholder’s actual control over a company. Id. The Court did not find that Oaktree controlled Crimson, notwithstanding that Oaktree controlled more than one-third of Crimson’s common stock, stood as a large Crimson creditor, had three employees on Crimson’s board, and maintained the power to designate a majority of the board and senior management. Id. at *16.

Sanchez

In re Sanchez Energy Derivative Litigation gave the Court another opportunity to determine on a motion to dismiss whether a large stockholder constituted a controller. 2014 WL 6673895. Stockholders of Sanchez Energy Corporation (Sanchez) challenged a transaction in which Sanchez purchased assets from Sanchez Resources, LLC. Although two members of Sanchez’s five member board, A.R. Sanchez Jr. and A.R. Sanchez III (defendants), together owned 21.5 percent of Sanchez, and A.R. Sanchez III served as chief executive officer (CEO) of the company, the plaintiffs could not demonstrate that the defendants actually controlled the corporation. Id. at *9. The independent stockholders retained nearly 80 percent of the voting control of Sanchez and the defendants could not remove a dissenting director on their own. The plaintiffs also did not allege that A.R. Sanchez III maintained any greater control than would a typical CEO, or that he employed aggressive tactics to maintain control. Id. Thus, the defendants were not controllers and the Court dismissed the suit. Id. at *10.

KKR Financial Holdings

In In re KKR Financial Holdings LLC Shareholder Litigation, Chancellor Bouchard granted the defendants’ motion to dismiss, finding that KKR & Co. L.P. (KKR) did not control KKR Financial Holdings LLC (KKN). 101 A.3d 980. The plaintiffs alleged that KKR, a less than 1 percent KKN stockholder, controlled KKN because of a management agreement in which a KKR affiliate managed the day-to-day KFN’s business. Id. at 983. The plaintiffs failed to show that due to KKR’s control, KFN could not “freely exercise their judgment in determining whether or not to approve and recommend to the stockholders a merger with KKR”. Id. The Court also highlighted that KKR had no right to appoint directors or dictate board action. Id. at 994.

Zhongpin

In In re Zhongpin Inc. Stockholders Litigation, the Court found that a stockholder may be ‘controlling’ even though it only owned approximately 17.3 percent of the stock of the company. 2014 WL 6778537. Xianfu Zhu (Zhu) was CEO, chairman of the board of directors, and a stockholder of Zhongpin Inc. (Zhongpin). Id. at *1. Zhu proposed to purchase the outstanding shares of Zhongpin’s common stock in a going-private transaction. Id. The Court found the plaintiffs pled facts sufficient to raise the inference that Zhu could control Zhongpin. The Court considered Zhongpin’s 10-K, which provided that Zhongpin relies “substantially on [Zhu], and our executive vice president, [Ben], to manage our operations… The loss of any one of [our key personnel], in particular Mr Zhu or Mr Ben, would have a material adverse effect on our business and operations”. Id. at *8. Thus, Zhu maintained latent and active control over Zhongpin through his stock ownership and control over the daily operations of the company. Id. Accordingly, the Court denied the defendants’ motion to dismiss.

Hamilton Partners

In Hamilton Partners, L.P. vs. Highland Capital Management, L.P., 2014 WL 1813340 (Del. Ch.), the Court considered whether the defendant Highland Capital Management, L.P. (Highland), which owned 48 percent of American HomePatient, Inc. (AHP) and was a substantial creditor of AHP, was a controller of AHP. 2014 WL 1813340. The Court concluded that one could reasonably infer that Highland was a controller of AHP due to Highland’s willingness to enter into a forbearance agreement and Highland’s later efforts to prevent AHP from refinancing its defaulted debt. Id. The Court denied Highland’s motion to dismiss.

These cases show that Delaware courts will not lightly find a large, albeit minority, stockholder constitutes a controller absent extenuating circumstances. A large stockholder with board representation becomes a controlling stockholder only upon a showing of dominance over the company’s affairs – e.g., the ability to retaliate against other board members, or exhibiting hostile behavior. Likewise, a significant stockholder who is also an officer does not control the business affairs of the company simply by virtue of his officership. Unless a minority stockholder’s influence over the company is so strong that the stockholder could essentially act as though he was a majority stockholder, the Court will not likely find that the stockholder is a controller.

What a controller and his company can do to protect themselves in interested transactions

A company that engages in an interested transaction with its controlling stockholder may protect itself from higher judicial scrutiny by, prior to negotiating the terms of the transaction, establishing an independent special committee to review and negotiate the terms of the transaction and requiring the controller to relinquish his voting power for purposes of the interested transaction to a majority of the minority stockholders. M&F Worldwide, 88 A.3d 635. In Kahn vs. M&F Worldwide, minority stockholders of M&F Worldwide Corp. (MFW) challenged a going-private merger initiated by MacAndrews & Forbes Holdings, Inc. (M&F), a 43 percent stockholder of MFW, and accepted by the MFW board of directors. Id at 688.

The Court of Chancery granted the defendants’ Motion for Summary Judgment; the plaintiffs appealed. Id. at 639. In a question of first impression, the Delaware Supreme Court affirmed the Court of Chancery’s holding and adopted business judgment review where: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisers and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority. Id. at 645.

While approving a transaction with a controlling shareholder exposes directors to risk, the relationship with the controller is further complicated by the board’s competing obligation to consider such a transaction, creating the potential for liability either way. Delaware courts have recognised that a transaction involving a controller may be the only way to maximise shareholder value. In re Cornerstone Therapeutics Inc. Stockholder Litigation, 2014 WL 4418169, at *11 (Del. Ch.). M&F Worldwide is important for board members considering an interested transaction because the Court’s analysis suggests that business judgment rule review may apply to non-going-private transactions involving controlling stockholders, so long as adequate protections are in place to protect the minority stockholders. The key to these protective measures is that independent, disinterested directors who are fully qualified and informed decide whether to recommend a transaction with a controller, and that the controlling stockholder relinquishes all voting power for purposes of the interested transaction.

Conclusion

Because transactions involving controlling stockholders give rise to greater judicial scrutiny, large stockholders negotiating a transaction with the company they control should consider the impact that their controller status may have on the transaction. To avoid controller status, a large stockholder should refrain from discussing the transaction with board members and segregate himself when possible from the company-side negotiations regarding the transaction. If a plaintiff succeeds in proving that a large stockholder is a controller, M&F Worldwide teaches that at the outset of the negotiations, the board should establish a special committee comprised of qualified, independent, and disinterested directors, and empower the special committee to be able to make an informed decision regarding the transaction. Further, the board should require the controller to relinquish at the outset all voting power regarding the interested transaction. These protective measures will increase the company’s chances of surviving judicial scrutiny.


Published in Corporate Disputes, Apr-Jun 2015. Link to article.

The Bankruptcy Court Gave and the District Court Hath Taken Away: A Commentary on the Southern District of New York’s Lehman Bros. Decision

By Justin R. Alberto

The U.S. District Court for the Southern District of New York, in an opinion written by Judge Richard J. Sullivan, recently held that a plan of reorganization that provides for the payment of professional fees of the individual members of an official committee violates § 503(b) of the Bankruptcy Code.1 The decision, in an appeal from the Lehman Brothers bankruptcy, reversed a 2013 ruling by Judge James M. Peck of the Southern District of New York Bankruptcy Court that the plan payment provision was permissible under § 1123(b)(6)’s catchall provision, as not inconsistent with § 503(b).2 The bankruptcy court’s opinion provided added support to a growing trend of cases that followed a similar 2010 decision from the SDNY Bankruptcy Court in Adelphia,3 which seemed to bless the use of plan provisions to pay a creditor’s professional fees solely on the basis of that creditor’s committee membership and without demonstrating that the creditor’s actions constituted a substantial contribution to the case. The district court’s recent decision seems to discredit this practice, but all may not be lost for creditors seeking payment of their professional fees from the bankruptcy estate.

The Interplay of §§ 503(b)(3) and 503(b)(4)

A brief review of the statutory predicates is helpful in understanding the impact of the district court’s decision. The opening clause of § 503(b)(3) indicates that certain favored post-petition expenses will be afforded administrative priority status and be paid in full from the debtor’s estate.4 Achieving administrative expense status is critical for creditors because unsecured claims commonly receive less than 100 percent recovery in Chapter 11 plans. Section 503(b)(3) lists the types of allowable administrative expenses in subsections A through F. For instance, § 503(b)(3)(D) allows a creditor or indenture trustee to recoup its actual and necessary expenses upon a showing that it made a substantial contribution to the case.5 Similarly, § 503(b)(3)(F) allows reimbursement of expenses incurred by the members of an official committee as a result of those entities’ participation on the committee.6

The opening sentence of § 503(b)(3), however, expressly excludes professional services from the administrative claims otherwise allowable under subsections A through F. Thus a creditor seeking reimbursement of legal fees incurred in the bankruptcy case must look to another section of the code. For its part, § 503(b)(4) accords administrative priority status to professional fees where the entity requesting the reimbursement holds an expense otherwise available for administrative expense status under subsections A through E of § 503(b)(3) and establishes a reasonableness standard for the court to employ in reviewing the requested fees. Notably, the category of expenses allowed by subsection 503(b)(3)(F)—committee member expenses—had been among those listed in § 503(b)(4) but was removed from the code as part of the 2005 Bankruptcy Abuse and Consumer Protection Act (BAPCPA) amendments. In other words, while a creditor that demonstrates a substantial contribution to the case under § 503(b)(3)(D) can recoup its reasonable legal fees under § 503(b)(4), a creditor may not recoup legal fees incurred solely by virtue of its membership on a committee even though its nonprofessional, out-of-pocket expenses are otherwise allowable asadministrative expenses under subsection 503(b)(3)(F).

The Bankruptcy Court’s Decision

The Lehman Brother’s bankruptcy cases were the largest in history and among, if not the, most complex cases ever filed. The varying positions and holdings of the parties, coupled with complex issues that stretched across legal and political landscapes, underscored the unprecedented nature of the proceedings. Achieving a consensual Chapter 11 plan—a primary goal of every Chapter 11 case—was an unimaginable feat at the time the cases commenced. After three years of negotiations, however, the parties, including the Official Committee of Unsecured Creditors, resolved their disputes and developed Lehman’s Third Amended Plan. Lehman’s creditors overwhelmingly approved the plan and allowed the parties to avoid what would have been, as Judge Peck put it, an impossible confirmation battle.

The parties’ success in formulating a consensual plan came at a high price, with professional fees totaling almost $2 billion. The debtors, presumably in recognition of the committee’s plan-related efforts, agreed to pay the professional fees incurred by the committee’s individual members. Section 6.7 of the plan memorialized the parties’ agreement in that respect and provided for payment from the estates of all reasonable professional fees subject only to the bankruptcy court’s entry of the confirmation order. Relying on § 6.7 of the plan, various applicants sought payment of $26.3 million collectively from the estates.

The Office of the U.S. Trustee opposed the request and argued that the payments are not permitted under § 503(b)(3), which it alleged is the exclusive pathway for a member of an official committee to receive compensation for legal fees. The plan, according to the U.S. Trustee, circumvented the standards and restrictions of § 503(b) by allowing reimbursement of professional fees on the basis of committee membership alone. Stated differently, the U.S. Trustee maintained that the omission of § 503(b)(3)(F) from § 503(b)(4) completely eliminates, under any circumstance, the possibility of recovery on account of professional fees incurred by individual members of a committee.

Judge Peck found the U.S. Trustee’s reasoning to be too restrictive, as bankruptcy plans are living, breathing documents that must be flexible to adapt to the particular concerns of a case. According to Judge Peck, § 1123(b)(6) of the Bankruptcy Code serves as Congress’ “invitation to the creativity of those who are engaged in drafting plan language” by allowing a plan to include any “appropriate provision not inconsistent with the applicable provisions of [the Bankruptcy Code.]”7 He therefore analyzed the plan’s treatment of committee members’ professional fees not under § 503(b), but under § 1123(b)(6)’s general endorsement of plan provisions that are not inconsistent with other applicable provisions of the Bankruptcy Code.

Applying this approach, the court found that § 6.7 of the plan was not inconsistent with § 503(b) because it provided for a consensual payment of professional fees, not for the payment of administrative priority expenses. According to Judge Peck, requests for administrative expenses under § 503(b) and the right to payments made consensually under a plan are distinct events, however subtly.8 “The fact that administrative claim status may not be allowed [under § 503(b)(3)] does not mean that an agreed payment under a fully consensual plan should not be permitted [under § 1123(b) (6)].”9 This decision meant that, in appropriate cases, § 503(b) would not be the only avenue for individual creditors’ professional fees to be paid from a debtor’s estate and also strengthened the marketplace’s reliance on the Adelphia decision that had approved similar plan-based payments for professional fees incurred by members of an ad hoc committee.

The District Court Reverses

On appeal by the U.S. Trustee, the Southern District of New York reversed the Bankruptcy Court’s decision. It found that while individual members of an official committee oftentimes hire their own professionals in complex cases, § 1123(b)(6) is not a tool to circumvent the prohibition against treating those fees as administrative expenses. According to the district court, the exclusive source of administrative expenses is § 503(b), which on its face does not permit the payment of professional fees to a creditor solely on the basis of committee membership, and that § 1126(b)(6) was not designed to allow parties to undermine that express statutory prohibition. The court therefore invalidated plan § 6.7 because it provided for the payment of expenses that §§ 503(b)(3) and 503(b)(4) forbid.

The district court found unpersuasive the committee’s argument that the plan did not create a new category of administrative expenses, but embodied a consensual agreement overwhelmingly approved by Lehman’s constituents to pay professional fees.10 Relying on the Adelphia decision, the appellees had argued that § 6.7 of the plan called only for permissive payments authorized by § 1123(b)(6)’s catchall language.11 The district court, however, disagreed. According to the district court, two types of creditors are paid under plans in a bankruptcy case—those that hold claims and those that are entitled to post-petition administrative expenses.12 Because professional fees incurred post-petition by a creditor can never fall into the category of a claim, they must fit the definition of an administrative expense under § 503(b) to receive a distribution pursuant to a Chapter 11 plan. Here, the court decided that § 503(b)’s facial omission of committee member professional fees was dispositive. Finally, the district court expressed concerns about allowing payment of anything other than claims or administrative expenses under a plan—whether pursuant to § 1123 or otherwise— because it “could lead to serious mischief” and potential infringement on the absolute priority rule.13 In that regard, the district court held that the need for flexibility in drafting plans does not outweigh established bankruptcy and distribution policies and rules.

Lessons Learned

The reversal of the bankruptcy court’s decision would seem to close the door, at least in the Southern District, on the ability of parties to incorporate into a plan payment of professionals serving committee members.14 But has the prospect of plan-based estate reimbursement of professional fees incurred by committee members been completely eviscerated? Although Judge Peck’s decision was reversed, the district court dismissed the U.S. Trustee’s contention that § 503(b)(3) wholly prohibits reimbursement of committee members’ professional fee expenses.15 Thus, if a member satisfies another subsection of 503(b)(3), such as substantial contribution to the case under § 503(b)(3)(D), its professionals fees would be reimbursable from the estate pursuant to § 503(b)(4) and the district court’s decision. The substantial contribution standard, while obviously a tougher litigation burden to prove than mere committee membership, provides an alternative avenue for the Lehman committee members to recoup some, if not all, of their professional fees from the estates.

Significantly, the district court’s decision does not address whether litigation is actually required to obtain a substantial contribution ruling. Creditors looking to streamline the process without filing an application could potentially use the plan confirmation process to obtain such a ruling. Plans and confirmation orders routinely include various and far-reaching findings and conclusions with respect to litigable issues such as notice, releases, settlements, and substantive consolidation. Strictly speaking, § 503(b) requires only “notice and hearing” before a court can make a substantial contribution finding. According to the rules of construction in § 102(a), the phrase “after notice and hearing” means only such notice and opportunity for a hearing that “is appropriate in the particular circumstances.”16 Proposed plans and their corresponding disclosure statements are among the most detailed and widely noticed documents filed in a Chapter 11 case. Indeed, disclosure statements and plans are considered on no less than 28 days notice to all parties in interest, including the debtor’s creditors and equity security holders.17 This is seven days more than the notice required when a substantial contribution request is presented by motion and would include a larger universe of notice parties, such as the debtor’s equity security holders.18 There is clearly an argument that a proposed substantial contribution finding noticed as part of a plan and disclosure statement would satisfy the notice and hearing requirements of § 503(b) and allow professionals to avoid a separate application process.19 It remains to be seen, however, whether this approach will be utilized and, if so, approved as a means to have committee member professionals paid in connection with a plan.


Endnotes

1 Davis v. Elliot Mgmt. Corp. (In re Lehman Bros. Holdings Inc.), No. 13 Civ. 2211, 2014 WL 1327980 (S.D.N.Y. March 31, 2014).
2 In re Lehman Bros. Holdings Inc., 487 B.R. 181 (Bankr. S.D.N.Y. 2013).
3 In re Adelphia Commc’ns Corp., 441 B.R. 6 (Bankr. S.D.N.Y. 2010).
4 11 U.S.C. § 503(b)(3).
5 11 U.S.C. § 503(b)(3)(D).
6 11 U.S.C. § 503(b)(3)(F).
7 In re Lehman Bros. Holdings Inc., 487 B.R. at 190 (quoting 11 U.S.C. § 1123(b)(6)).
8 In re Lehman Bros. Holdings Inc., 487 B.R. at 191.
9 Id.
10 Davis v. Elliot Mgmt. Corp. (In re Lehman Bros. Holdings Inc.), No. 13 Civ. 2211, 2014 WL 1327980, at *5-7 (S.D.N.Y. March 31, 2014).
11 Id.
12 Id. at 6.
13 Id.
14 At the time this article was written, the district court’s decision had not been appealed to the Second Circuit.
15 Elliot Mgmt. Corp., 2014 WL 1327980, at *7-8.
16 11 U.S.C. § 102(a) (emphasis added).
17 See Fed. R. Bankr. P. 2002 and 3017.
18 See Fed. R. Bankr. P. 2002.
19 Of course, if any objection is filed, counsel must be prepared to carry its burden at the confirmation hearing.

First published in The Federal Lawyer, July/August 2014. Link to article.

When Business Judgment Isn’t Enough: The Impact of the Standard of Review on Deal Litigation

By Stephen B. Brauerman

Three recent decisions of the Delaware Court of Chancery, all written by Vice Chancellor Laster, demonstrate the importance and impact of the application of the standard of review to the success of post-transactional shareholder litigation. The decision in In re Orchard Enterprises Inc. Stockholder Litigation, C.A. No. 7840-VCL, 2014 WL 1007589 (Del. Ch. Feb. 28, 2014), holds that entire fairness review should govern the court’s consideration at trial of the board’s approval of a squeeze-out merger effected by the company’s majority stockholder. The court’s post-trial opinion in In re Rural Metro Corp. Stockholders Litigation, C.A. No. 6350-VCL, 2014 WL 1053140 (Del. Ch. Mar. 7, 2014), applies enhanced scrutiny review to hold the company’s financial advisor liable for aiding and abetting the board’s exculpated and previously settled breaches of fiduciary duty. In Chen v. Howard-Anderson, C.A. No. 5878-VCL, 2014 WL 1366551 (Del. Ch. Apr. 8, 2014), the court also applied the enhanced scrutiny standard to grant the directors defendants’ motion for summary judgment in a challenge to a mixed cash and stock merger with a competitor at the expense of other, more lucrative transactions. In each of Orchard, Rural Metro, and Chen, the parties disputed which standard of review to apply and in each instance, the court’s resolution of that procedural question had a dispositive effect. As Delaware law strives to provide greater flexibility and certainty to corporate decision makers, the standard of review continues and will continue to play an impactful, though often unappreciated, role.

A Brief Review of the Standards of Review

Delaware courts apply three standards of review to determine whether corporate fiduciaries have complied with their duties of care and loyalty: (1) the business judgment rule, (2) enhanced scrutiny, and (3) entire fairness. Under the deferential business judgment standard, the court will uphold director conduct unless such conduct cannot be attributed to any rational business purpose.

Enhanced scrutiny, Delaware’s intermediate standard of review, applies to “specific, recurring, and readily identifiable situations involving potential conflicts of interest where the realities of the decision-making context can subtly undermine the decisions of even independent and disinterested directors,” and requires fiduciaries to show that their motivations were proper, not selfish, and reasonable in relation to their legitimate objective. Enhanced scrutiny most often applies when a board adopts defensive measures to protect against a hostile takeover (Unocal), or seeks a transaction to sell the company or cash out stockholders (Revlon).

Entire fairness review applies where the board has an interest in the transaction different from stockholders generally or a controlling shareholder stands on both sides of the deal. In such circumstances, the defendant directors must prove that the transaction is entirely fair – with respect to both process and price – to the corporation. The burden of persuasion may shift to the stockholder plaintiff if the influence of the controller or self-interested fiduciary is neutralized by the creation of a sufficiently authorized committee of independent and disinterested directors, or the transaction is conditioned on the approval a majority of independent stockholders after full disclosure of the extent of the conflicts. Even more deferential review is available if, from the beginning, a conflicted transaction is negotiated by a duly authorized independent committee and approved by a majority of the disinterested stockholders after full disclosure, where the business judgment rule will apply. Kahn v. M&F Worldwide Corp., C.A. No. 334, 2013, 2014 WL 996270 (Del. Mar. 14, 2014).

The Application and Impact of the Standard of Review

Orchard involved a stockholder challenge to a squeeze out merger orchestrated by a majority shareholder (Dimensional) and approved by a special committee chaired by a director with ties to the controlling stockholder who obtained a consulting role worth nearly $300,000 per year with the post-merger entity. In addition to the conflicts of interest, which the court found troubling but not disabling in and of themselves, the court expressed concern with the special committee’s process. First, the special committee (and its financial advisors) improperly included an inapplicable liquidation preference in favor of Dimensional in assessing the value and fairness of the majority stockholder’s offer. Second, the special committee delegated to the controlling stockholder the negotiation of a competing expression of interest to buy the company from its former chief executive. Not surprisingly, Dimensional and the former executive could not reach an agreement, especially after the former executive declined to pay the full value of Dimensional’s liquidation preference. Third, while the merger was conditioned on the approval of a majority of the company’s disinterested stockholders, the proxy statement issued before the annual meeting contained a number of incomplete and inaccurate disclosures, which tainted the vote. Relatedly and in a separate appraisal action, the Court of Chancery determined that the fair value of the company’s stock at the time of the merger was worth more than twice the closing price.

Under these facts, it is not surprising that the Court of Chancery determined on summary judgment to apply the extracting entire fairness standard at trial. Dimensional stood on both sides of the transaction, the special committee was not entirely independent, and a majority of the minority approval was based on inadequate and inaccurate disclosures. The application of the entire fairness standard of review impacts the availability of Section 102(b)(7) of the General Corporation Law of the State of Delaware’s exculpatory protection. As the court explained, Section 102(b)(7) defenses are not available at the summary judgment stage “when a case involves a controlling stockholder . . . and where there is evidence of procedural and substantive unfairness.” This is because at trial, the parties would need to litigate under the entire fairness standard, whether the board breached its duty of loyalty by favoring Dimension’s interests over those of Orchard’s minority stockholders. As the court explained, “it is premature in this case to make a determination regarding exculpation under Section 102(b)(7) without first determining whether the transaction was entirely fair, determining whether liability exists and on what basis, considering the evidence as a whole, and evaluating the involvement of each of the directors.” The court nevertheless observed that exculpation remains a strong defense, even if the application of the entire fairness standard potentially delayed its application.

The Rural Metro decision has garnered a lot of attention because of the court’s criticism of the actions of the company’s financial advisor, RBC Capital Markets, LLC (RBC). Interestingly, the directors settled before trial, so the aiding and abetting claim against RBC proceeded without the underlying breach of fiduciary duty claims. Given the court’s application of the enhanced scrutiny standard of review, the director’s breaches would have been exculpated by Section 102(b)(7). The exculpatory statute does not, however, protect aiders and abettors, and consequently provided little help to RBC.

After receiving expressions of interest from potential acquirers and considering a possible acquisition itself (of rival EMS, which had put itself on the auction block), the Rural Metro board created a special committee to explore strategic alternatives. The special committee selected RBC as its financial advisor over two other candidates. Unlike the other candidates, RBC’s presentation focused on a potential sale of the company. Although there is evidence that several members of the special committee also favored a transaction to sell the company, there was no evidence (and the stockholder plaintiffs did not contend) that the board’s approval of a cash out merger to a financial acquirer implicated the directors’ duty of loyalty.

The court was nonetheless critical of several aspects of the sale process. First, the special committee exceeded its authority because the board did not resolve to “put the company in play” until the sales process was well underway. Second, RBC and the special committee did not adequately consider the value of developing and executing the company’s growth strategy before selling the company. Third, RBC and the special committee decided to sell the company when confidentiality restrictions from the EMS sale process precluded a number of logical buyers from participating in the Rural Metro auction. Fourth, the special committee failed adequately to supervise the RBC-led sales process. Fifth, RBC did not disclose its own self-interest in pushing a sale so it could participate in the buy-side financing of the EMS transaction and bolster its reputation as a financial advisor in the healthcare sector. Sixth, the board declined to extend the sale process after receiving an expression of interest from the company that had acquired EMS, thereby giving negotiating leverage to Warburg Pinkus, LLC, which ultimately acquired Rural Metro. Finally, the court criticized the board’s failure to obtain a valuation of the company until just before it approved the transaction.

Because of the risks inherent in a cash-out merger (i.e., stockholders’ final opportunity to maximize the value of their investment), Delaware courts must apply the enhanced scrutiny standard of review. Director defendants can satisfy this standard by demonstrating the reasonableness of their conduct. The court found that the board breached its fiduciary duty of care by neglecting adequately to inform itself about the transaction that it was asked to approve or the flaws in the RBC-led sale process and by failing to actively and directly oversee RBC’s efforts. Since these breaches did not implicate the duty of loyalty, the application of the enhanced scrutiny would not have prevented the director defendants from availing themselves of the exculpatory provision in Rural Metro’s charter.

In Chen v. Howard-Anderson, the court again applied enhanced scrutiny to review a stockholder challenge to a cash-out merger between two competitors in the broadband access equipment market. As in Rural Metro, the court considered actions that fell outside the range of reasonableness. First, the board favored a mixed-cash-and-stock deal over a substantially higher, all cash sale to a different competitor (Adtran). Second, the board gave Adtran a 24-hour ultimatum to make a bid when there were no justifiable business reasons for such a tight deadline. The court observed that this ultimatum drove Adtran away. Third, the board conducted a 24-hour market check during the July Fourth holiday and, even after receiving a number of expressions of interest, neglected to pursue any of them. Fourth, inadequate disclosures and incomplete valuation metrics also concerned the court.

Despite identifying these actions as outside the range of reasonableness, the court nevertheless gave the director defendants (save one who was personally interested in the transaction due to a change of control payment he was to receive) the benefit of the company’s exculpatory charter provision. To apply the exculpatory provision, the court first had to determine whether the plaintiff’s claims implicated the duty of loyalty, since only duty of care claims are exculpated. Under enhanced scrutiny, the court observed, the duty of loyalty is implicated if directors allow “interests other than obtaining the best value reasonably available for [the company’s] stockholders to influence their decisions during the sale process.” The most common such interest, in an arm’s length transaction, is the board’s desire to protect incumbent management or their directorships in the post-sale entity. Here, however, the court did not observe any improper interest even though the board failed to maximize shareholder value. Thus the court granted summary judgment.

Why it Matters

Though it is a fairly technical matter of procedure, the standard of review has several important substantive impacts to which corporate deal makers should pay attention. The standard of review is the first indication of the level of culpability in the conduct the court is evaluating. Although the standard of review is the mechanism by which the court analyzes compliance with the standard of care (i.e., a board’s fiduciary duties), it also provides an independent qualitative assessment of the conduct being judged; the more troublesome the conduct, the higher the standard of review. Second, the application of the standard of review has important impacts on when defendant directors can avoid liability or exercise their indemnification or exculpation rights. For example, it is easier to win on a motion to dismiss when the standard is business judgment, while entire fairness virtually guarantees a trial with a difficult burden to overcome. Finally, the standard of review may dictate the availability of exculpation because the court more often finds loyalty breaches in the entire fairness context than it does under enhanced scrutiny or business judgment. While it is often difficult to tell whether the standard drives the result or the result drives the standard, the correlative effect between a higher standard of review and greater culpability is well established.

Conclusion

The Court of Chancery’s review and application of different standards of review to different transactional conducts should remind corporate actors of the importance of obtaining a favorable standard of review. The standard of review can mean the difference between substantial personal liability and the protection of exculpatory charter provisions. Orchard, Rural Metro, and Chen highlight the complicated application of these standards and illustrate their potentially dispositive impact. These cases also demonstrate the necessity of a proper sale process and that reliance on highly compensated and qualified advisors is a poor substitute for oversight by engaged and informed directors.


Published in Business Law Today, May 2014. © 2014 by the American Bar Association. Reproduced with permission. All rights reserved. This information or anyportion thereof may not be copied or disseminated in any form or by any means or stored in an electronic database or retrieval system without the express written consent of the American Bar Association. Link to article.

The Third Circuit Draws a Line in the Sand on New Value in Friedman’s

By Evan T. Miller

Seemingly straightforward on its face, certain aspects of the Bankruptcy Code’s “new value” defense1 have proven frustratingly unclear for practitioners around the country. Illustrative of this frustration is the elusive answer to perhaps the simplest question: When does it apply? More specifically, if a creditor is paid post-petition for new value that remained unpaid as of the petition date, can that creditor continue to use that same unpaid new value as a defense under § 547(c)(4) of the Bankruptcy Code? The picture remains muddled nationwide, but in the Third Circuit, at least, the answer is now clear.

The Lower Court Split

Courts at both the bankruptcy and district court levels across the country have parted ways on how to answer the foregoing question. In one camp, courts have ruled against cutting the preference analysis off at the petition date, thereby allowing post-petition payments (including, notably, payments on administrative expenses under § 503(b)(9) and payments pursuant to critical-vendor orders) to reduce a defendant’s new value defense.2 In the other camp, the prevailing view is that the petition date does become the “cutoff” date for assessing new value, such that post-petition payments on pre-petition new value have no bearing on whether a creditor can use that same new value to reduce its liability in a preference action.3

The Friedman’s Cases

In November 2011, Judge Christopher Sontchi of the U.S. Bankruptcy Court for the District of Delaware issued an opinion that placed Delaware in the latter of the two camps.4 The facts in Friedman’s were simple and uncontested: The debtor made payments to the creditor-defendant during the preference period in the amount of $81,997.57 (the “transfer”), after which the creditor provided staffing services to the debtor valued at $100,660.88 (the “new value”). The money owed for these services remained unpaid as of the petition date.

Post-petition, the debtor filed a motion in bankruptcy court seeking authority to pay pre-petition wages, compensation and related benefits. The court granted the motion, pursuant to which the debtor paid $72,412.71 (the “wage order payment”) to the creditor. More than a year later, the creditor raised the new value as a defense when the debtor’s liquidating trustee sought to avoid the transfer as a preference. The trustee argued that the new value was reduced by the amount of the wage order payment.

Judge Sontchi ruled for the creditor, finding that the Third Circuit Court of Appeals’ holding in In re New York City Shoes Inc.5 supported a reading that the petition date should act as the “cut-off” date for calculating new value.6 That decision was later affirmed on appeal by the U.S. District Court for the District of Delaware, whose ruling the trustee also appealed. As a matter of first impression, on Dec. 24, 2013, the Third Circuit Court of Appeals affirmed the lower courts for several reasons.

The Third Circuit Court of Appeals first held that its prior references on this issue, including In re New York City Shoes, were non-binding dicta because those cases did not turn on transactions that occurred post-petition.7 The court next concluded that the plain language of § 547(c)(4)(B) is silent as to when a payment must be made by a debtor to defeat a creditor’s new value defense, but the “fact that courts are divided in their interpretations of § 547(c)(4)(B) does not mean … that the provision is necessarily ambiguous.”8 The court looked at the provision in the context of the Bankruptcy Code as a whole, finding numerous indicators that pointed to the petition date as a cutoff for analysis of new value, such as:

(1) § 547 is titled “Preferences,” suggesting that it concerns transactions occurring pre-petition;9 (2) the hypothetical liquidation test under § 547(b)(5) must be performed as of the petition date;10 (3) the statute of limitations for filing a preference action under § 546 begins to run on the petition date;11 (4) § 547(c)(5)’s “improvement in position” test includes the phrase “as of the date of the filing of the petition”;12 and (5) allowing post-petition payments to affect the preference analysis would be inconsistent unless they also allowed the post-petition extensions of new value to be available as a defense — a position most courts have rejected.13

The court then rejected the trustee’s arguments that the policies underlying the preference provision and new value defense support consideration of post-petition events. Finding that congressional records indicate that the preference policy is equality of distribution, the court held that “it makes sense that the equality should be measured, and inequalities rectified, as of the petition date.”14 The policies underlying the new value defense are to “encourage trade creditors to continue dealing with troubled businesses [and] treat fairly a creditor who has replenished the estate after having received a preference.”

The trustee argued that these policies would be defeated by the creditor “double-dipping” into the same underlying new value by receiving a direct payment for such new value post-petition and indirect credit for the new value as an offset against its preference liability.15 The court rejected this argument being as misleading, however, finding that regardless of whether a creditor is paid post-petition for pre-petition new value, the creditor still replenished the debtor’s estate during the preference period, therefore aiding the debtor in avoiding bankruptcy.16

The court also rejected the trustee’s arguments that its ruling would result in unequal treatment of creditors, finding that the new value defense was not enacted to ensure equitable treatment of creditors, but “to encourage creditors to deal with troubled businesses.”17 Similarly, § 547 was designed to provide equal distribution among similarly situated creditors, not so that all creditors will be treated equally.18

As a final matter, the court addressed the trustee’s argument that In re Kiwi International Air Lines Inc.19 required it to take into account all material post-petition events in determining preference liability.20 The court found that Kiwi’s holding (i.e., that pre-petition payments made to a creditor pursuant to an executory contract that is assumed by the debtor post-petition cannot be recovered as preferences, as such payments would necessarily have been made in any event as a § 365 cure payment) demonstrated that there are unique circumstances in which other provisions of the Bankruptcy Code dealing with post-petition transactions directly interact with § 547 and, thus, “can alter the otherwise-straightforward preference analysis.”21 Nevertheless, the issue in the present case was not one of those circumstances. Accordingly, the Third Circuit Court of Appeals affirmed the district court’s order.

Conclusion

The ability of a creditor to use invoices paid post-petition as new value to offset a preference is likely to remain a hotly contested issue in jurisdictions outside the Third Circuit. Nevertheless, because of the number of preference actions filed in Delaware in particular, Friedman’s is certainly important and persuasive authority for trade creditors.


Endnotes

111 U.S.C. § 547(c)(4).
2See In re Friedman’s Inc., 2013 WL 6797958, at *5 n.2 (3d Cir. Dec. 24, 2013) (collecting cases).
3Id.
4Friedman’s Inc. v. Roth Staffing Cos. (In re Friedman’s Inc.), 2011 WL 5975283 (Bankr. D. Del. Nov. 30, 2011).
5In re New York City Shoes Inc., 880 F.2d 679 (3d Cir. 1989).
6Friedman’s, 2011 WL 5975283, at *4.
7Id.
8Id. at *5.
9Id. at *6.
10Id. at *7.
11Id.
12Id.
13Id. at *8 (collecting cases).
14Id. at *9.
15Id. at *10.
16Id.
17Id. at *12 (quoting In re Bellanca Aircraft Corp., 850 F.2d 1275, 1280 (8th Cir. 1988)).
18Id.
19In re Kiwi International Air Lines Inc., 344 F.3d 311 (3d Cir. 2003) (holding that preference period payments made to payee pursuant to a contract that is later assumed cannot be recovered as preferences, as the test set forth in § 547(b)(5) cannot be met).
20Friedman’s, 2013 WL 6797958, at *13.
21Id.

First published in ABI Unsecured Trade Creditors Committee Newsletter, Vol. 12, No. 1, April 2014. Link to article.