RECENT DEVELOPMENTS IN BANKRUPTCY AND RESTRUCTURING VOLUME 12 NO. 4 JULY/AUGUST 2013 BUSINESS RESTRUCTURING REVIEW A CAUTIONARY TALE FOR INSIDER LENDERS: NINTH CIRCUIT ENDORSES RECHARACTERIZATION REMEDY IN BANKRUPTCY Lisa G. Laukitis and Mark G. Douglas The ability of a bankruptcy court to reorder the priority of claims or interests by means of equitable subordination or recharacterization of debt as equity is gener- ally recognized. Even so, the Bankruptcy Code itself expressly authorizes only the former of these two remedies. Although common law uniformly acknowledges the power of a court to recast a claim asserted by a creditor as an equity interest in an appropriate case, the Bankruptcy Code is silent upon the availability of the remedy in a bankruptcy case. This has led to uncertainty in some courts concerning the extent of their power to recharacterize claims and the circumstances warranting recharacterization. The Ninth Circuit Court of Appeals recently had an opportunity to consider this issue. In Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings International, Inc.), 714 F.3d 1141 (9th Cir. 2013), the court ruled that “a court has the authority to determine whether a transaction creates a debt or an equity interest for purposes of § 548, and that a transaction creates a debt if it cre- ates a ‘right to payment’ under state law.” By its ruling, the Ninth Circuit overturned longstanding Ninth Circuit bankruptcy appellate panel precedent to the contrary and became the sixth federal circuit court of appeals to hold that the Bankruptcy Code authorizes a court to recharac- terize debt as equity. The decision is a cautionary tale for private equity sponsors IN THIS ISSUE 1 A Cautionary Tale for Insider Lend- ers: Ninth Circuit Endorses Rechar- acterization Remedy in Bankruptcy 6 Safe Harbor Redux: The Second Cir- cuit Revisits the Bankruptcy Code’s Protection Against Avoidance of Securities Contract Payments 7 Newsworthy 12 Tenth Circuit: Fraudulently Trans- ferred Assets Not Estate Property Until Recovered 15 Breaking New Ground: Delaware Bankruptcy Court Grants Admin- istrative Priority for Postpetition, Prerejection Lease Indemnification Obligations 19 Eurosail Supreme Court Judgment: Delineating the Boundaries of Insolvency 22 Sovereign-Debt Update 23 European Perspective in Brief 24 The U.S. Trustee’s New Chapter 11 Fee Guidelines
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RECENT DEVELOPMENTS IN BANKRUPTCY AND RESTRUCTURING
VOLUME 12 NO. 4 JULY/AUGUST 2013
BUSINESS RESTRUCTURING REVIEW
A CAUTIONARY TALE FOR INSIDER LENDERS: NINTH CIRCUIT ENDORSES RECHARACTERIZATION REMEDY IN BANKRUPTCYLisa G. Laukitis and Mark G. Douglas
The ability of a bankruptcy court to reorder the priority of claims or interests by
means of equitable subordination or recharacterization of debt as equity is gener-
ally recognized. Even so, the Bankruptcy Code itself expressly authorizes only the
former of these two remedies. Although common law uniformly acknowledges the
power of a court to recast a claim asserted by a creditor as an equity interest in an
appropriate case, the Bankruptcy Code is silent upon the availability of the remedy
in a bankruptcy case.
This has led to uncertainty in some courts concerning the extent of their power to
recharacterize claims and the circumstances warranting recharacterization. The
Ninth Circuit Court of Appeals recently had an opportunity to consider this issue.
In Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re
Fitness Holdings International, Inc.), 714 F.3d 1141 (9th Cir. 2013), the court ruled that
“a court has the authority to determine whether a transaction creates a debt or an
equity interest for purposes of § 548, and that a transaction creates a debt if it cre-
ates a ‘right to payment’ under state law.”
By its ruling, the Ninth Circuit overturned longstanding Ninth Circuit bankruptcy
appellate panel precedent to the contrary and became the sixth federal circuit
court of appeals to hold that the Bankruptcy Code authorizes a court to recharac-
terize debt as equity. The decision is a cautionary tale for private equity sponsors
IN THIS ISSUE
1 A Cautionary Tale for Insider Lend-ers: Ninth Circuit Endorses Rechar-acterization Remedy in Bankruptcy
6 Safe Harbor Redux: The Second Cir-cuit Revisits the Bankruptcy Code’s Protection Against Avoidance of Securities Contract Payments
7 Newsworthy
12 Tenth Circuit: Fraudulently Trans-ferred Assets Not Estate Property Until Recovered
15 Breaking New Ground: Delaware Bankruptcy Court Grants Admin-istrative Priority for Postpetition, Prerejection Lease Indemnification Obligations
19 Eurosail Supreme Court Judgment: Delineating the Boundaries of Insolvency
22 Sovereign-Debt Update
23 European Perspective in Brief
24 The U.S. Trustee’s New Chapter 11 Fee Guidelines
2
and other corporate insiders who advance money to their
businesses, as well as lenders considering taking an equity
stake in a borrower.
EQUITABLE SUBORDINATION AND RECHARACTERIZATION
Although the distinction between courts of equity and law
has largely become irrelevant in modern times, courts of
equity have traditionally been empowered to grant a broader
spectrum of relief in keeping with fundamental notions of
fairness, as distinguished from principles of black-letter law.
One of the tools available to a bankruptcy court in exercising
its broad equitable mandate is “equitable subordination.”
Equitable subordination is a remedy developed under com-
mon law prior to the enactment of the current Bankruptcy
Code to remedy misconduct that results in injury to credi-
tors or shareholders. It is expressly recognized in Bankruptcy
Code section 510(c), which provides that the bankruptcy
court may, “under principles of equitable subordination, sub-
ordinate for purposes of distribution all or part of an allowed
claim to all or part of another allowed claim or all or part of
an allowed interest to all or part of another allowed interest.”
However, the statute explains neither the concept nor the
standard that should be used to apply it.
This has been left to the courts. In In re Mobile Steel Co., 563
F.2d 692 (5th Cir. 1977), the Fifth Circuit Court of Appeals artic-
ulated what has become the most commonly accepted stan-
dard for equitable subordination of a claim. Under the Mobile
Steel standard, a claim can be subordinated if the claimant
engaged in some type of inequitable conduct that resulted
in injury to creditors (or conferred an unfair advantage on the
claimant) and if equitable subordination of the claim is con-
sistent with the provisions of the Bankruptcy Code. Courts
have refined the test to account for special circumstances.
For example, many courts make a distinction between insid-
ers (e.g., corporate fiduciaries) and noninsiders in assessing
the level of misconduct necessary to warrant subordination.
A related but distinct remedy is “recharacterization.” Like
equitable subordination, the power to treat a debt as if it
were actually an equity interest is derived from principles
of equity. It emanates from the bankruptcy court’s power to
ignore the form of a transaction and give effect to its sub-
stance. However, because the Bankruptcy Code does not
expressly empower a bankruptcy court to recharacterize
debt as equity, some courts disagree as to whether they have
the authority to do so and, if so, the source of such author-
ity. According to some courts (albeit a minority), because
the statute authorizes subordination but is silent concerning
recharacterization, Congress intended to deprive bankruptcy
courts of the power to recharacterize a claim.
Taken as a whole, the Ninth Circuit’s rulings are a
cautionary tale to corporate insiders (including pri-
vate equity sponsors) that make loans to a com-
pany or attempt to cash out in a refinancing or
dividend recapitalization transaction shortly before
the company files for bankruptcy.
This was the approach taken by a Ninth Circuit bankruptcy
appellate panel in In re Pacific Express, Inc., 69 B.R. 112 (B.A.P.
9th Cir. 1986). Pacific Express has been widely criticized,
however, for failing to distinguish between equitable subor-
dination and recharacterization. See, e.g., In re Daewoo Motor
America, Inc., 471 B.R. 721 (Bankr. C.D. Cal. 2012); In re The 3Do
However, the court reversed dismissal of the cause of action
seeking equitable subordination, writing that “[t]he trustee’s
allegations . . . that insiders ‘contrived’ to benefit themselves
by knowingly funneling money to themselves out of a failing
company plausibly alleged the elements of a claim for equi-
table subordination.”
Taken as a whole, the Ninth Circuit’s rulings are a cautionary
tale to corporate insiders (including private equity sponsors)
that make loans to a company or attempt to cash out in a
refinancing or dividend recapitalization transaction shortly
before the company files for bankruptcy.
6
SAFE HARBOR REDUX: THE SECOND CIRCUIT REVISITS THE BANKRUPTCY CODE’S PROTECTION AGAINST AVOIDANCE OF SECURITIES CONTRACT PAYMENTSCharles M. Oellermann and Mark G. Douglas
“Safe harbors” in the Bankruptcy Code designed to mini-
mize “systemic risk”—disruption in the securities and com-
modities markets that could otherwise be caused by a
counterparty’s bankruptcy filing—have been the focus of
a considerable amount of judicial scrutiny in recent years.
The latest contribution to this growing body of sometimes
controversial jurisprudence was recently handed down by
the U.S. Court of Appeals for the Second Circuit. The rul-
ing widens a rift among the federal circuit courts of appeal
concerning the scope of the Bankruptcy Code’s “settle-
ment payment” defense to avoidance of a preferential or
constructively fraudulent transfer. In Official Committee of
Unsecured Creditors v. American United Life Insurance Co.
(In re Quebecor World (USA) Inc.), 2013 WL 2460726 (2d Cir.
June 10, 2013), the Second Circuit held that securities trans-
fers may qualify for this section 546(e) safe harbor even if
the financial institution involved in the transfer is “merely a
conduit.” The court affirmed dismissal of the $376 million suit
brought by an official creditors’ committee on behalf of the
bankruptcy estate against a group of insurer-investors.
SECTION 546: LIMITATIONS ON AVOIDING POWERS
The Bankruptcy Code empowers a bankruptcy trustee or
chapter 11 debtor in possession (“DIP”) to invalidate certain
transfers (or obligations incurred) by a debtor during pre-
scribed periods immediately prior to (and even after) filing for
bankruptcy protection. Among these are the ability to “avoid”
transfers that are fraudulent by design or because an insol-
vent transferor did not receive fair consideration in exchange
(sections 544 and 548), the power to avoid transfers that pre-
fer one creditor over others (section 547), and the ability to
avoid postbankruptcy transfers that are not authorized by the
Bankruptcy Code or the court (section 549).
Section 546 of the Bankruptcy Code, however, imposes impor-
tant limitations on the rights and powers granted to the trustee
or DIP elsewhere in the Bankruptcy Code. These include,
among others, statutes of limitations for avoidance actions
(section 546(a)), limitations based upon the perfection rights
afforded under applicable nonbankruptcy law to entities with
interests in the debtor’s property (section 546(b)), and limita-
tions based upon reclamation rights arising under applicable
nonbankruptcy law (sections 546(c) and 546(d)).
The restrictions also include provisions prohibiting avoidance
in most cases of: (i) transfers that are margin or settlement
payments made in connection with securities, commodity, or
forward contracts (section 546(e)); (ii) transfers made by, to,
or for the benefit of a repo participant or financial participant
in connection with a repurchase agreement (section 546(f));
(iii) transfers made by, to, or for the benefit of a swap par-
ticipant or financial participant under or in connection with a
prepetition swap agreement (section 546(g)); and (iv) subject
to certain exceptions, transfers made by, to, or for the benefit
of a “master netting agreement participant” under certain cir-
cumstances (section 546(j)).
Section 546(e), which creates a safe harbor for margin or set-
then distributed the funds to the Noteholders and eventually
surrendered the Notes directly to QWI in Canada.
On January 20, 2008, QWI and its Canadian affiliates filed
for protection under the Canadian Companies’ Creditors
Arrangement Act in Montreal. QWUSA filed for chapter 11 pro-
tection in New York on January 21, 2008, less than 90 days
after making the payment for the Notes.
QWUSA’s official creditors’ committee was later authorized to
sue the Noteholders on behalf of the estate, seeking to avoid
the $376 million transfer as a preference. The Noteholders
moved for summary judgment, arguing that the transfer was
exempt from avoidance under section 546(e). Relying heav-
ily on Enron (which was decided shortly after the committee
filed its complaint), the bankruptcy court held that the pay-
ment was covered by the safe harbor.
Specifically, the court concluded that, because of Enron,
courts no longer need: (i) to consider conflicting evidence
about usage of the term “settlement payment” within the
private-placement sector of the securities industry; or (ii) to
decide whether prepetition transfers of value to the defen-
dants should be characterized as a “redemption” of private-
placement notes rather than a repurchase. Instead, the court
ruled, any transaction involving a transfer of cash to com-
plete a securities transaction is a “settlement payment” and
thus cannot be avoided.
The district court affirmed on appeal, agreeing that QWUSA’s
payment was a “settlement payment” under Enron. However,
the court did not agree that a transfer to “redeem” securities
can qualify as a “transfer made . . . in connection with a secu-
rities contract” because section 741(7)(A)(i) of the Bankruptcy
Code defines a “securities contract” as a contract “for the pur-
chase, sale, or loan of a security.” Even so, the district court
affirmed the bankruptcy court’s alternative ruling because the
transaction was in fact a “purchase” instead of a “redemption.”
THE SECOND CIRCUIT’S RULING
A three-judge panel of the Second Circuit affirmed the rul-
ing below. Writing for the court, circuit judge Denny Chin
acknowledged that there is a split of authority regarding the
role which a financial institution must play in the transaction
in order to qualify for the safe harbor. Three circuits—the
Third Circuit in Resorts International, the Sixth Circuit in QSI
Holdings, and the Eighth Circuit in Contemporary Industries—
have concluded that the plain language of section 546(e)
encompasses any transfer to a financial institution, even if it
serves only as a conduit or intermediary. Only the Eleventh
Circuit, Judge Chin explained, has held that the financial
institution must acquire a beneficial interest in the transferred
funds or securities in order to trigger the safe harbor. See
Munford v. Valuation Research Corp. (In re Munford, Inc.), 98
F.3d 604 (11th Cir. 1996); accord Rushton v. Bevan (In re D.E.I.
Systems, Inc.), 2011 WL 1261603 (Bankr. D. Utah Mar. 31, 2011).
“In Enron,” the judge wrote, “we cited the Third, Sixth, and
Eighth Circuits’ decisions with approval and concluded that
‘the absence of a financial intermediary that takes title to the
transacted securities during the course of the transaction is
[not] a proper basis on which to deny safe-harbor protec-
tion.’ ” “To the extent Enron left any ambiguity in this regard,”
Judge Chin ruled, “we expressly follow the Third, Sixth, and
Eighth Circuits in holding that a transfer may qualify for the
section 546(e) safe harbor even if the financial intermediary
is merely a conduit.”
Quebecor World continues the recent trend toward
expansive interpretation of the Bankruptcy Code’s
safe harbors for securities and commodities trans-
actions, in which courts typically cite the underly-
ing purpose of the provisions: to manage systemic
risk posed by a counterparty’s bankruptcy. With
Quebecor World and Enron, the Second Circuit has
adopted a broad approach to both the “settlement
payment” and “securities contract” prongs of sec-
tion 546(e).
Judge Chin explained that the plain language of section
546(e) indicates that a transfer may be either “for the ben-
efit of” a financial institution or “to” a financial institution, but
need not be both. This construction of the provision furthers
11
the purpose behind the exemption: to minimize displacement
caused in the commodities and securities markets in the
event of a major bankruptcy affecting those industries:
A transaction involving one of these financial inter-
mediaries, even as a conduit, necessarily touches
upon these at-risk markets. Moreover, the enu-
merated intermediaries are typically facilitators
of, rather than participants with a beneficial inter-
est in, the underlying transfers. A clear safe har-
bor for transactions made through these financial
intermediaries promotes stability in their respec-
tive markets and ensures that otherwise avoidable
transfers are made out in the open, reducing the
risk that they were made to defraud creditors.
In a footnote, Judge Chin explained that the phrase “(or
for the benefit of)” was added to section 546(e) in 2006 as
part of the Financial Netting Improvements Act. Because
the change was made after the circuit split arose regarding
the “mere conduit” issue, the Second Circuit wrote that “it is
arguable that Congress intended to resolve the split with the
2006 Amendments,” yet omitted any mention of the contro-
versy in the legislative history. Even so, given his finding that
the text of section 546(e) is unambiguous, the judge con-
cluded that resort to the legislative history was unnecessary.
Judge Chin declined to address whether the $376 million
payment was a “settlement payment,” concluding that the
court need not reach the issue due to the undisputed facts
that: (i) QWUSA’s payment “fits squarely” within the plain
meaning of the securities-contract exemption because it was
a “transfer made by (or for the benefit of) a . . . financial insti-
tution . . . in connection with a securities contract”; (ii) CIBC
is a financial institution; and (iii) the NPAs were clearly “secu-
rities contracts” because they provided for both the original
purchase and the “repurchase” of the Notes.
Judge Chin also concluded that the court need not decide
whether the transfer would still be exempt if QWUSA had
“redeemed” its own securities. Noting that the common
definition of “redeem” is “to regain possession by payment
of a stipulated price,” he agreed with the district court that
QWUSA made the transfer to “purchase,” rather than redeem,
the Notes because “it was acquiring for the first time the
securities of another corporation.” In fact, Judge Chin noted,
under the NPAs, only QWCC had the right to “pre-pay” or
redeem the Notes—its affiliates could “purchase” the Notes
only if they complied with the prepayment provisions.
OUTLOOK
Quebecor World continues the recent trend toward expan-
sive interpretation of the Bankruptcy Code’s safe harbors for
securities and commodities transactions, in which courts typ-
ically cite the underlying purpose of the provisions: to man-
age systemic risk posed by a counterparty’s bankruptcy. With
Quebecor World and Enron, the Second Circuit has adopted
a broad approach to both the “settlement payment” and
“securities contract” prongs of section 546(e).
Perhaps acknowledging the dissent’s concern in Enron regard-
ing overly broad application of section 546(e), the Second
Circuit wrote in a footnote in Quebecor World that “[o]f course,
the ‘securities contract’ safe harbor is not without limitation,
and, for example, mere structuring of a transfer as a ‘securities
transaction’ may not be sufficient to preclude avoidance.” As
an example, the court cited the possibility that a transfer could
still be avoided if it were found to be actually fraudulent.
The importance of the Bankruptcy Code’s safe harbors has
been a recurring theme in bankruptcy and appellate rulings
since the advent of the Great Recession. Yet another impor-
tant development in that connection was the Fourth Circuit’s
ruling in Grayson Consulting, Inc. v. Wachovia Securities, LLC
(In re Derivium Capital LLC), 716 F.3d 355 (4th Cir. 2013). In
addition to finding that the transfer of certain securities as
part of a Ponzi scheme could not be avoided because it did
not involve “property of the debtor,” the court, as a matter of
first impression at the appellate level, ruled that commission
payments can be shielded from recovery by the “settlement
payment” defense of section 546(e).
In addition, in Whyte v. Barclays Bank PLC, 2013 BL 152743
(S.D.N.Y. June 11, 2013), a New York district court rejected a
fraudulent-transfer suit with respect to payments made to
a swap participant. In Whyte, the trustee of a litigation trust
created by the chapter 11 plan of SemGroup LP, to which
trust certain creditors’ state-law claims had been assigned,
attempted to avoid payments made to a swap participant as
12
constructive fraudulent transfers under state law and section
544(b) of the Bankruptcy Code, despite the safe harbor for
such transfers in section 546(g).
The trustee argued that, because section 546(g) applies only
to “an estate representative who is exercising federal avoid-
ance powers under [section 544 of] the Bankruptcy Code,”
section 546(g) should not apply to “claims asserted by credi-
tors” after the bankruptcy concludes without a release of
such claims. Since creditors’ state-law fraudulent-transfer
claims had been assigned to the litigation trust, the trustee
contended that she was not asserting such claims as the
trustee of a bankruptcy estate and that section 546(g) was
therefore irrelevant.
The court rejected this contention, writing that “[t]he trouble
with this clever argument is that it would, in effect, render
section 546(g) a nullity.” It held that section 546(g) impliedly
preempted the trustee’s attempt to resuscitate fraudulent-
avoidance claims as the assignee of certain creditors “where,
as here, she would be expressly prohibited by section 546(g)
from asserting those claims as assignee of the debtor-in-
possession’s rights (or, indeed, as the functional equivalent of
a bankruptcy trustee).” According to the court:
The patent purpose and intended effects of section
546(g) would be totally undercut if, at the same time
that a trustee in bankruptcy was prohibited from
avoiding swap transactions, a Chapter 11 ‘litigation
trustee’ could hold swap-related avoidance actions
in abeyance for eventual litigation as the mere
assignee of creditors’ claims.
TENTH CIRCUIT: FRAUDULENTLY TRANSFERRED ASSETS NOT ESTATE PROPERTY UNTIL RECOVEREDJennifer L. Seidman
The U.S. Court of Appeals for the Tenth Circuit—in Rajala
v. Gardner, 709 F.3d 1031 (10th Cir. 2013)—has joined the
Second Circuit and departed from the Fifth Circuit by hold-
ing that an allegedly fraudulently transferred asset is not
property of the estate until recovered pursuant to section
550 of the Bankruptcy Code and therefore is not covered
by the automatic stay. According to the court, its decision
“gives Congress’s chosen language its ordinary meaning, and
abides by a rule against surplusage.”
BANKRUPTCY CODE STAYS ACTS TO OBTAIN POSSESSION
OF PROPERTY OF THE ESTATE
Section 362(a)(3) of the Bankruptcy Code provides that the
filing of a bankruptcy petition “operates as a stay, appli-
cable to all entities, of . . . any act to obtain possession of
property of the estate or of property from the estate or to
exercise control over property of the estate.” Sections 541(a)
(1) and 541(a)(3) of the Bankruptcy Code, respectively, define
“property of the estate” to include, with certain exceptions,
“all legal or equitable interests of the debtor in property as of
the commencement of the case” and “[a]ny interest in prop-
erty that the trustee recovers under section . . . 550” of the
Bankruptcy Code.
Under section 550(a) of the Bankruptcy Code, a trustee may
recover, for the benefit of the estate, transferred property “to
the extent that a transfer is avoided under section 544 . . . [or]
548.” Sections 544 and 548 of the Bankruptcy Code, in turn,
enable the trustee to avoid fraudulent transfers. The question
before the Rajala court was whether allegedly fraudulently
transferred property, prior to the recovery of that property
pursuant to section 550(a), is “property of the estate” under
section 541(a) and therefore subject to the automatic stay
imposed by section 362(a).
13
THE FACTS
Generation Resources Holding Company, LLC (“GRHC”) was
formed in 2002 for the purpose of developing wind-generated
power projects. In June 2005, GRHC entered into a memoran-
dum of understanding (“MOU”) with Edison Capital (“Edison”)
that contemplated Edison’s purchase of three GRHC wind-
power projects, including the “Lookout” project.
In late 2005, several GRHC insiders formed Lookout
Windpower Holding Co., LLC (“LWHC”). Not long after its for-
mation, LWHC closed a deal with Edison for the sale of the
wind-power projects that were the subject of the MOU with
GRHC. The GRHC insiders did so by causing a switch in the
identity of the projects’ developer from GRHC to LWHC. In
March 2007, LWHC entered into a contract with an Edison
subsidiary (the “Lookout Redemption Agreement”), which
provided that once Lookout achieved commercial operation,
Edison would pay 25 percent of a “Final Installment” contin-
gency fee to FreeStream Capital, LLC (“FreeStream”), which
GRHC had employed to provide advisory services, and 75
percent of the “Final Installment” to LWHC. Overburdened
with $6 million in debt, GRHC filed for chapter 7 protection in
Kansas on April 28, 2008.
In April 2009, LWHC and FreeStream sued Edison in fed-
eral district court in Pennsylvania for payment of the Final
Installment due under the Lookout Redemption Agreement.
In September 2009, GRHC’s chapter 7 trustee brought suit
against GRHC insiders (and others) in federal district court
in Kansas, asserting, among other things, that the defendants
had fraudulently transferred GRHC’s development and
redemption opportunities to LWHC.
The trustee sought an order from the Kansas district court
staying the Pennsylvania action, arguing that any proceeds
of the litigation were property of GRHC’s estate. The Kansas
district court denied the motion.
Shortly before the Pennsylvania case went to trial, the trustee
filed a motion in the Pennsylvania federal court for an order
staying the proceedings or, in the alternative, transferring the
litigation to Kansas. The basis for this motion was the trustee’s
argument that the Lookout sale price was property of the
GRHC estate and therefore subject to the automatic stay.
The court denied the motion in part and entered judgment
in favor of LWHC and FreeStream for approximately $9 mil-
lion. However, the court transferred to the Kansas bankruptcy
court the issue of whether the judgment was part of GRHC’s
estate and ordered that the judgment funds be deposited
with the bankruptcy court pending the outcome.
The reference to the Kansas bankruptcy court was then with-
drawn to the Kansas district court, where the Pennsylvania
case was consolidated with the trustee’s pending claims.
The Kansas district court held that the bankruptcy estate
does not include fraudulently transferred property until
recovered through a fraudulent-transfer action, and it accord-
ingly granted the motions to distribute the $9 million judg-
ment to LWHC and FreeStream. The district court also held
that because the Lookout Redemption Agreement provided
for FreeStream to be paid directly by Edison, FreeStream’s
contingency fee could not be considered part of GRHC’s
bankruptcy estate. The trustee appealed to the Tenth Circuit.
THE TENTH CIRCUIT’S RULING
A three-judge panel of the Tenth Circuit affirmed. As an ini-
tial matter, the court concluded that it had jurisdiction to
review the district court’s order. According to the Tenth
Circuit, because the order “deemed § 362 inapplicable to
the judgment proceeds, [it] was essentially an order grant-
ing relief from the automatic stay,” which is generally con-
sidered an “appealable final order.” The court also rejected
the defendant-appellees’ argument that the appeal was
moot because the trustee had no effective remedy, finding it
likely that at least some measure of effective relief could be
fashioned were the stay reimposed on the disbursed funds.
In addition, the Tenth Circuit affirmed the district court’s rul-
ing that FreeStream’s fee could not be considered property
of GRHC’s bankruptcy estate because, among other things,
the plain language of the Lookout Redemption Agreement
required FreeStream’s payment to come directly from Edison
(as owner of Lookout).
The Tenth Circuit then turned to the question of whether the
automatic stay applies to unrecovered property that is the
subject of a fraudulent-transfer claim. The court began by
acknowledging the circuit split on the issue. Under the Fifth
14
Circuit’s ruling in Am. Nat’l Bank of Austin v. MortgageAmerica
Corp. (In re MortgageAmerica Corp.), 714 F.2d 1266 (5th Cir.
1983), property alleged to have been fraudulently transferred
is considered property of the estate pursuant to section
541(a)(1) and is therefore subject to the automatic stay even
before it is recovered, because the debtor continues to have
a “legal or equitable interest” in the property fraudulently
transferred. By contrast, in Fed. Deposit Ins. Corp. v. Hirsch
(In re Colonial Realty Co.), 980 F.2d 125 (2d Cir. 1992), the
Second Circuit held that, because section 541(a)(3) expressly
provides that estate property includes “[a]ny interest in prop-
erty that the trustee recovers under section . . . 550,” the
automatic stay does not apply to allegedly fraudulently trans-
ferred property until the transfer is avoided under section
544 or 548 and the property is recovered under section 550.
Rajala widens a rift in the federal circuit courts of
appeal concerning inclusion in the bankruptcy
estate of property that is subject to avoidance by
a bankruptcy trustee, chapter 11 debtor in posses-
sion, or other estate representative (e.g., a creditors’
committee or plan-liquidation trustee). The ruling
is a cautionary tale. It places the burden squarely
on estate representatives to be proactive in investi-
gating potential avoidance claims and, where such
claims are deemed to be meritorious, to seek provi-
sional relief in a timely manner to ensure that poten-
tial estate property is preserved for the benefit of all
stakeholders.
The Tenth Circuit sided with the Second Circuit. First, citing
the “plain meaning” rule of statutory construction, the court
stated, “although § 541 is very broad, . . . it plainly does not
include fraudulently transferred property until that property is
recovered.” Therefore, the court wrote, “because the statute’s
plain meaning is not demonstrably at odds with Congress’s
intent, it should control.”
The court rejected the trustee’s argument that the judgment
proceeds were estate property because GRHC retained an
“equitable interest” in the funds. After considering the defini-
tion of “equitable interest”—an interest held by virtue of an
equitable title or claims on equitable grounds, such as the
interest held by a trust beneficiary—the Tenth Circuit con-
cluded that “[r]eading ‘equitable title’ to include any prop-
erty a trustee merely alleges to have been fraudulently
transferred would violate the concept of equity.” According
to the court, fundamental principles of equity jurisprudence
demand that, before a complainant can have standing in
court, he must show that he has a good and meritorious
cause of action. “[A] mere allegation, without any showing of
merit,” the court wrote, “cannot create ‘equitable title.’ ”
Again invoking principles of statutory construction, the court
explained that, “if it can be prevented, no clause, sentence, or
word shall be superfluous, void, or insignificant.” In this case,
the court wrote, Ҥ 541(a)(3) provides that the estate includes
‘[a]ny interest in property that the trustee recovers’ pursuant
to his avoidance powers.” The court agreed with the Second
Circuit’s view in Colonial Realty that “interpreting § 541(a)(1)
to include fraudulently transferred property would render §
541(a)(3) meaningless with respect to property recovered in a
fraudulent transfer action.”
The Tenth Circuit rejected the trustee’s argument that sec-
tion 541(a)(3) is “a belt and suspenders” designed to ensure
that assets will be available to satisfy creditor interests, rea-
soning that “there are already several mechanisms for safe-
guarding debtor assets.” For example, the court explained,
the trustee may seek a preliminary injunction or temporary
restraining order pending resolution of a fraudulent-transfer
claim. Because this was not one of the “rare cases” where the
plain meaning of the statute leads to an absurd result, the
Tenth Circuit concluded that the plain meaning of the statute
should control.
Lastly, though not addressed by either party, the court noted
that a broad reading of section 541 could potentially violate
the Due Process Clause (u.s. Const. amends. V and XIV, § 1) by
allowing the trustee to enjoin another party’s property rights
solely on the basis of allegations of fraud. For example, the
court explained, because the stay imposed by section 362
is automatic, the “[m]ere filing of a fraudulent-transfer claim
could deprive a bona fide purchaser of his property without
judicial supervision, a finding of probable cause, the post-
ing of a bond, or a showing of exigent circumstances—let
alone a pre-deprivation opportunity to be heard.” For this
15
additional reason, the Tenth Circuit was reluctant to adopt
the trustee’s broad interpretation of section 541. Instead, the
court adopted the statute’s plain meaning. It held that fraud-
ulently transferred property is not part of the bankruptcy
estate until recovered, and it accordingly affirmed the district
court’s determination that the automatic stay did not pre-
vent disbursement of the judgment proceeds to LWHC and
FreeStream.
OUTLOOK
Rajala widens a rift in the federal circuit courts of appeal
concerning inclusion in the bankruptcy estate of property
that is subject to avoidance by a bankruptcy trustee, chap-
ter 11 debtor in possession, or other estate representative
(e.g., a creditors’ committee or plan-liquidation trustee). The
ruling is a cautionary tale. It places the burden squarely on
estate representatives to be proactive in investigating poten-
tial avoidance claims and, where such claims are deemed to
be meritorious, to seek provisional relief in a timely manner
to ensure that potential estate property is preserved for the
benefit of all stakeholders.
BREAKING NEW GROUND: DELAWARE BANKRUPTCY COURT GRANTS ADMINISTRATIVE PRIORITY FOR POSTPETITION, PREREJECTION LEASE INDEMNIFICATION OBLIGATIONSJohn H. Chase and Mark G. Douglas
Under the Bankruptcy Code, a bankruptcy trustee or chapter
11 debtor in possession (“DIP”) is required to satisfy postpe-
tition obligations under any unexpired lease of commercial
property pending a decision to assume or reject the lease.
Specifically, section 365(d)(3) requires the trustee, with lim-
ited exceptions, to “timely perform all the obligations of the
debtor . . . arising from and after the order for relief” under
any unexpired lease of nonresidential real property with
respect to which the debtor is the lessee.
The application of section 365(d)(3) and, in particular, the
timing of certain “obligations” arising under an unexpired
lease has created some controversy. A Delaware bankruptcy
court added fuel to the fire in a ruling handed down earlier
this year. In a matter of first impression, the court held in WM
Inland Adjacent LLC v. Mervyn’s LLC (In re Mervyn’s Holdings,
LLC), 2013 BL 5408 (Bankr. D. Del. Jan. 8, 2013), that a claim
arising from an indemnification obligation under a com-
mercial lease was entitled to administrative expense status
under section 365(d)(3).
PAYMENT OF POSTPETITION COMMERCIAL LEASE
OBLIGATIONS
As noted, section 365(d)(3) provides that a trustee or DIP,
with certain exceptions, “shall timely perform all the obliga-
tions of the debtor . . . arising from and after the order for
relief under any expired lease of nonresidential real property,
until such lease is assumed or rejected, notwithstanding sec-
tion 503(b)(1) of this title.” Added to the Bankruptcy Code in
1984, the provision was intended to ameliorate the immediate
financial burden borne by commercial landlords pending the
trustee’s decision to assume or reject a lease. Prior to that
time, landlords were routinely compelled to seek payment of
rent and other amounts due under a lease by petitioning the
bankruptcy court for an order designating those amounts as
administrative expenses. The process was cumbersome and
time-consuming. Moreover, the landlord’s efforts to get paid
16
were hampered by the standards applied in determining
what qualifies as a priority expense of administering a bank-
ruptcy estate.
Section 503(b)(1) of the Bankruptcy Code provides that
allowed administrative expenses include “the actual, nec-
essary costs and expenses of preserving the estate.” Rent
payable under an unexpired commercial lease during a
bankruptcy case arguably falls into this category. Even so,
section 503(b)(1) has uniformly been interpreted to require
that in addition to being actual and necessary, an expense
must benefit the bankruptcy estate to qualify for adminis-
trative priority. Prior to the enactment of section 365(d)(3),
“benefit to the estate” in this context was determined on a
case-by-case basis by calculating the value to the debtor of
its “use and occupancy” of the premises, rather than looking
to the rent stated in the lease. Moreover, even if a landlord’s
claim for postpetition rent was conferred with administrative
priority, the Bankruptcy Code did not specify when the claim
had to be paid.
Section 365(d)(3) was designed to remedy this prob-
lem. It requires a trustee or DIP to remain current on lease
obligations pending assumption or rejection of a lease.
Nevertheless, courts have struggled with the precise mean-
ing of the provision. For example, courts are at odds over
whether the phrase “all the obligations of the debtor . . . aris-
ing from and after the order for relief” means: (i) all obliga-
tions that become due and payable upon or after the filing of
a petition for bankruptcy; or (ii) obligations that “accrue” after
filing the bankruptcy petition. The former approach—com-
monly referred to as the “performance” or “billing date” rule—
has been adopted by some courts. See, e.g., Centerpoint
Properties v. Montgomery Ward Holding Corp. ( In re
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