Category Archives: Publications

Sections 542 and 543—Turnover of Property of the Estate (2018)

Co-Authored by 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 2017 Annual Survey.

To read the article, click here.

This article appears in the Norton Annual Survey of Bankruptcy Law & Practice, 2018 Edition, and is posted with permission. Copyright © 2018 Thomson Reuters/Westlaw. For more information about this publication please visit http://legalsolutions.thomsonreuters.com/.

Delaware Supreme Court Precludes Fraudulent Inducement of LLC Agreement and Employment Agreement as Defense in Advancement Proceeding

By Jason Jowers

Recognizing that Delaware LLCs should have the ability to encourage capable individuals to serve in management positions, the LLC Act provides that “a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.” 6 Del. C. § 18-108 (emphases added). The Court of Chancery has repeatedly interpreted this language as granting LLC agreement drafters complete discretion on the issues of whether to grant members or managers indemnification or advancement. This freedom of contract on the issue of advancement raises the question: are typical contractual defenses, such as fraudulent inducement, available in a summary proceeding seeking to enforce a party’s advancement rights? In the recent decision of Trascent Management Consulting, LLC v. Bouri, __A.3d __, 2016 WL 6947014 (Del. Nov. 28, 2016), the Delaware Supreme Court found that a defendant may not avoid advancing fees by arguing that the underlying LLC agreement was fraudulently induced.

First published in Business Law Today, February 2017. Link to article.
Reprinted with permission.

Be Careful What You Ask For: Court of Chancery Finds Corporate Law Governs LLC Based on Drafting of LLC Agreement

By Jason Jowers

It is the policy of the Delaware Limited Li­ability Company Act (LLC Act) “to give the maximum effect to the principle of freedom of contract and to the enforce­ability of limited liability company agree­ments.” Indeed, cases routinely refer to LLCs as “creatures of contract,” given that the LLC Act generally cedes governance of the entity to the terms of the LLC agree­ment, establishing few mandatory provi­sions and normally only providing “gap fillers” where an LLC agreement is silent. But what happens when drafters of LLC agreements use their statutorily granted freedom to adopt a governance structure that is similar to that of a corporation? Does adopting a corporate-style structure also adopt the cor­porate case law interpreting that structure? This article analyzes how the recent case of Obeid v. Hogan, 2016 WL 3356851 (Del. Ch. June 10, 2016) answers these questions. In Obeid, the Delaware Court of Chancery confirmed that a Delaware LLC may adopt a governance structure that looks more like a corporation than a traditional LLC, but it also explained that “[t]he choices that the drafters make have consequences.” By adopting a corporate-style of governance, such as a board of directors, the Court of Chancery will to some extent turn by anal­ogy to Delaware’s case law governing corporate boards of directors.

First published in Business Law Today, September 2016. Link to article.
Reprinted with permission.

When Deciding Whether to Judicially Dissolve an LLC, the Court May Find the “Purpose” of the LLC to Be Different Than What Is Stated in the LLC Agreement

By Jason Jowers
Although it occurs less often than dissolutions based on deadlock, the Delaware Court of Chancery may also dissolve an LLC “where the defined purpose of the entity was fulfilled or impossible to carry out.” In re Seneca Invs. LLC, 970 A.2d 259, 263 (Del. Ch. 2008). This basis for judicial dissolution begs the question: how is the “purpose” of the entity defined? In the recent case of Meyer Natural Foods LLC v. Duff, 2015 WL 3746283 (Del. Ch. June 4, 2015), the Court of Chancery found that its analysis of an LLC’s purpose should not, necessarily, be limited to what the LLC agreement identified as the purpose. Although the Court acknowledged that a purpose clause is of “primary importance,” it went on to determine that the purpose clause is not the only evidence the Court may consider, even where the purpose clause is unambiguous and the LLC agreement contains an integration clause. In particular, the Court considered other agreements executed by the members of the LLC around the same time as the LLC agreement in determining the purpose of the LLC. This article examines: 1) the pre-Meyer case law limiting the LLC’s purpose to that defined in the LLC agreement; 2) the facts and holdings of Meyer; and 3) the lessons taught and questions raised by Meyer.

First published in Business Law Today, December 2015. Link to article.
Reprinted with permission.

The Increasing Role of Equity in Delaware LLC Litigation

Co-authored by Jason Jowers

This article examines the increasing role of equity in LLC litigation, particularly in cases involving breach of fiduciary duties and requests for dissolution. Both the case law and an amendment to the Delaware LLC Act in recent years demonstrate Delaware’s rejection of a solely contractarian view of LLCs. The recent Delaware Court of Chancery decision of In re Carlisle Etcetera LLC provides new lessons on the subject of equity’s reach. Although the length of equity’s powerful arm into the area of LLC litigation may surprise some practitioners, there is a consistent theme in the case law that may provide comfort: the Court of Chancery normally will only exercise its equitable powers when the parties have left gaps in their operating agreement.

First published in Business Law Today, October 2015. Link to article.
Reprinted with permission.

Failure to Make Capital Contribution Does Not Necessarily Result in Reduction of Interest in LLC or LP

By Jason Jowers

This article addresses the appropriate remedy for the failure of a member of an LLC or partner of an LP to make a required capital contribution. A recent decision by the Delaware Court of Chancery makes clear that, at least in the case of an initial capital contribution, a member’s failure to make the full amount of the contribution does not result in dilution of that member’s interest unless the LLC’s operating agreement so provides. The logic of the Court’s opinion could extend to the appropriate remedy for subsequent capital calls from Delaware LLCs or LPs that go unanswered.

First published in Business Law Today, December 2014. Link to article.
Reprinted with permission.

Inadvertently Waiving Right to Seek Judicial Dissolution of LLC: It is Easier to do than You Think

By Jason Jowers

This article examines the evolution of the Delaware Court of Chancery’s position on waiver of an LLC member’s right to seek judicial dissolution. In particular, the article addresses the Court of Chancery’s recent ruling that a provision in an LLC operating agreement opting-out of all default rights under the Delaware Limited Liability Company Act also waives the right of a member to seek judicial dissolution. Although the Court of Chancery had found in the past that a specific provision in an LLC agreement expressly waiving the members’ right to seek judicial dissolution was enforceable, this was the first time the Court has found that a more general provision opting-out of all default rights also waived the right to judicial dissolution if that right was not then preserved in a specific provision of the LLC agreement.

First published in Business Law Today, January 2014. Link to article.
Reprinted with permission.

The Debate on How to Remedy the Problem of Fast-Filing Plaintiffs in Derivative Actions Continues

By Jason Jowers

In Louisiana Municipal Police Employees’ Retirement System v. Pyott, 46 A.3d 313 (Del. Ch. 2012), the Delaware Court of Chancery issued a controversial decision that attempted to remedy the problem of multiple plaintiffs’ firms rushing to file actions in multiple jurisdictions, without first investigating the claims, immediately following the announcement of a corporate trauma by a Delaware corporation. The Court of Chancery attempted to create a Delaware-centric solution pursuant to which plaintiffs would have to investigate claims through books and records inspection actions filed in Delaware before filing so-called Caremark claims for directors’ breach of oversight responsibility. On April 4, 2013, in Pyott v. Louisiana Municipal Police Employees’ Retirement System, __ A.3d __, 2013 WL 1364695 (Del. 2013), the Delaware Supreme Court reversed. As discussed in my article, however, the Delaware Supreme Court’s opinion raises as many questions as it answers, and continues the debate on how to remedy the problem of fast-filing plaintiffs.

First published in Business Law Today, May 2013. Link to article.
Reprinted with permission.

Collateral Estoppel Doesn’t Bar Second Derivative Case After First is Dismissed

By Jason C. Jowers

This article analyzes the recent decision by the Delaware Court of Chancery in Louisiana Municipal Police Employees’ Retirement System v. Pyott, __ A.3d __, 2012 WL 2087205 (Del. Ch. June 11, 2012), which could prove to be the most significant derivative action decision by the Court of Chancery in years. In Pyott, the defendant directors moved to dismiss a second shareholder derivative action based on collateral estoppel after a substantially similar derivative action brought by different shareholders was dismissed in California. The Delaware Court of Chancery, disagreeing with a prior Court of Chancery case as well as a growing body of federal case law applying the collateral estoppel doctrine in the derivative action context, denied the motion to dismiss, finding that a derivative shareholder plaintiff does not have authority to step into the shoes of the corporation until a court finds either that (1) demand on the board of directors is excused as futile or (2) the board is wrongfully refusing the demand. Because neither of these conditions precedent was met in the first derivative case, the first group of plaintiffs never became synonymous with the corporation. Thus, the court determined that the first derivative plaintiffs were never in privity with either the corporation or the subsequent Delaware derivative plaintiffs, and collateral estoppel did not bar a subsequent derivative action involving the same facts.

This article addresses: (1) the court’s rationale for its decision; (2) the court’s disagreement with prior case law; and (3) the potential impact on derivative litigation involving Delaware corporations post-Pyott, assuming the decision survives appeal.

First published in Business Law Today, July 2012. Link to article
Reprinted with permission.

Fiduciary Duties of Managers of LLCs: The Status of the Debate in Delaware

Co-authored by Jason Jowers

In Auriga Capital Corporation v. Gatz Properties, LLC, __ A.3d __, 2012 WL 361677 (Del. Ch. Jan. 27, 2012), the Delaware Court of Chancery found that, unless eliminated or restricted in the LLC agreement, managers of LLCs owe default fiduciary duties of loyalty and care. Delaware Chief Justice Myron T. Steele’s writings on the subject off the bench, however, suggest that he would not reach the same conclusion. In their article, Jowers and Lazarus: (1) analyze Chancellor Strine’s opinion in Auriga Capital; (2) summarize Chief Justice Steele’s writings on the topic; and 3) provide key takeaways to practitioners based on the current state of the law.

First published in Business Law Today, February 2012. Link to article.
Reprinted with permission.

The Implied Covenant of Good Faith and Fair Dealing: Does it Protect Members of Delaware LLCs?

Co-authored by Jason Jowers

The Delaware Supreme Court’s three to two decision in Nemec v. Shrader, 991 A.2d 1120 (Del. 2010), raises two issues regarding Delaware’s application of the implied covenant. First, while the traditional test of when to apply the covenant, in part, asked whether the parties at the time of formation would have proscribed the conduct had they thought to negotiate about that conduct, the Nemec majority limits the application of the implied covenant to situations where the parties could not have anticipated, rather than simply failed to consider, the conduct later sought to be proscribed. Second, although Nemec did not involve an LLC dispute, the majority’s opinion illustrates limitations on the ability of members of LLCs to use the implied contractual covenant to police the exercise of an LLC manager or managing member’s discretion. Mr. Jowers and Mr. Lazarus begin by explaining the pre-Nemec standard, then examine the Nemec decision, and conclude by discussing Nemec’s implications for practitioners advising members and managers of Delaware LLC’s.

First published in Business Law Today, November 2011. Link to article.
Reprinted with permission.

Keeping Current: LLC Governance

Co-authored by Jason Jowers

This article examines the Delaware Court of Chancery’s application of the right of inspection of an LLC’s books and records in a recent case. The court has found that the right of inspection may be broader or narrower than that provided by the LLC Act. As discussed more fully in the article, the court’s ruling teaches three key lessons for practitioners. First, although the court found that 6 Del. Code § 18-305, the LLC Act’s right of inspection, might be useful in interpreting an ambiguous inspection provision in an LLC agreement, absent an ambiguity, the plain language of the contract should govern and the court will enforce the parties’ bargain. Second, because the court will enforce the benefit of the bargain, drafters must be precise in drafting language to govern both the right to and procedures for inspection. Third, if the terms governing inspection, such as “reasonable access,” are not defined, the court may rely not only on books and records cases involving the LLC Act but also upon analogous cases applying 8 Del. Code § 220, the Delaware General Corporation Law’s statute permitting shareholders to inspect corporate books and records.

First published in Business Law Today, May/June 2008. Link to article.
Reprinted with permission.

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.

Click here to read the article in its entirety.

**©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.

Click to read full article.

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

 

 

 

Peter B. Ladig- Commercial Litigation and Court of Chancery Litigation Attorney at Bayard, P.A.

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.

Click here to read the full article.

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

Sections 542 and 543—Turnover of Property of the Estate (2017)

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.

 

Click here to read full article.

 

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.

 

Click the image below for PDF version of article.

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.