Fall

08

Bankruptcy Outline

[Company Address]

Troy McKenzie I. Introduction

CLASS NOTES Debt !t is a "ood t#in"$ Better%o&&' access to credit' makes consumption more smoot#' it e(ens out income' &osters in(estment$ Debt obli"ation to pay ) creditor *+uity no contractual obli"ation to pay ) o,ner -residual claimants./ t#ere is no limit on t#e upside 0!1A1C!A2 D!3T4*33 capital structure makes it di&&icult to sur(i(e 5enerates enou"# income to pay production costs' but not enou"# to pay production costs 6 debt7 ) &in distress$ Bankruptcy can play a role in t#ese situations by c#an"in" t#e capital structure o& t#e &irm$ Court decision to li+uidate it -scrap (alue. or to reor"anize it -on "oin" (alue o& t#e &irm.$ *CO1OM!C D!3T4*33 business is not doin" "ood$ % 8( o& &irm9s income : -is lo,er. t#an 8( o& &irm9s e;penses ) eco distress o Bankruptcy cannot #elp &irms in t#is situation o 3olution end t#e business' li+uidate t#e remainin" assets$ [Butner ( <3] % 8re bankruptcy code case % =8>8 Bankruptcy Act % 5olden insol(ent Debtor -D./ Butner ,ants to "et pais$ ?e is a secured creditor #olds !! Mort"a"e % Durin" proceedin" t#e property is "eneratin" income collected by a"ent appointed &or t#at purpose &or a total amount o& @=A0'000$ % 0irst instance appointment o& a"ent means t#at t#ere ,as a c#an"e in possession o& t#e property' Butner can attac# #is lien to t#e rents$ % 3upreme Court certiorari because di&&erent circuit ,ere dissentin" on t#e issue$ o Bour ri"#ts as a creditor do not depend on bankruptcy ri"#ts o 1ort# Carolina la, ,ill "o(ern' not &ederal la,$ [*rie]

o 0indin" di&&erently means t#at your ri"#ts as a creditor ,ill (ary ,#et#er t#ere is a bankruptcy proceedin" or not$ Allo,s &or &orum s#oppin"$ o Bankruptcy ,ill respect state ri"#ts unless t#ere is a reason to depart &rom t#is$ 3ubstanti(e ri"#ts ,ill not c#an"e$ Credit =$ 5ral !O< "eneral creditor$ Obli"ation to repay t#e debt a. ask &or t#e payment' b. sell t#e obli"ation to someone else' c. Cannot resort to sel&%#elp' d. court de&ault Dud"ment' Ereduce your claim to a Dud"ment' t#is "i(es you a 2!*1$ T#e 2ien allo,s you to "o to t#e s#eri&& -,rit o& e;ecution. #e can seize t#e property and sell it to satis&y t#e Dud"ment$ 2ien "i(es you priority o(er ot#er creditors$ 0irst in time$ C$ 3ecured en&orcement mec#anism statutory$ !& it is a secured interest in land is ,ill be a Mort"a"e' i& it is personal property <CC F >$ A secured creditor can lay claim to a speci&ic asset$ ?e can a. take possession' publicly declarin" t#at #e #as a security interest in t#e encumbered property$ <CC &ilin"7 *asy' &ill out a &orm ,it# t#e 3ecretary o& 3tate o& 1B' makes t#is publicly a(ailable$ D "i(es a security interest interest attac#es to t#e property/ public notice o& t#e interest per&ects t#e interest priority o(er ot#er creditors$ 3el&%#elp so lon" as t#ere is no breac# o& peace$ <CC F > allo,s a secured creditor to take possession o& t#e collateral and sell it at an auction$ FOUNDATIONS GACK3O1 % % % % % Basic Dusti&ication &or indi(idual bankruptcy insurance$ 0uture income i& Debtor is under ,ater #e ,ill not remain c#ained &ore(er$ FRESH START come out o& bankruptcy ,it# your &uture income intact$ Mandatory &irm o& insurance &orces lenders to policy entensions o& credit$ !ndi(idual person e;ternalities is related to ot#ers and t#ese mi"#t su&&er as ,ell$ C00H c#an"e in t#e Bankruptcy Code too many D ,ere #a(in" access to t#e &res# start ,eak people ,ere "ettin" into trouble and t#ere ,as a need to put a stop to t#e instant "rati&ication t#at ,ould put t#em in trouble in t#e &uture education solution

 income test i& earnin" abo(e certain median' D &orced into a C? J or =I compromise &uture income$ KA44*1%BA!4D % K bankruptcy ,as t#ere to resol(e problems ,it# eco%&in distress$ K#en t#ere is insol(ency someone #as to bear t#e loss bankruptcy is all about ,#o s#ould bear t#is loss indi(iduals' employees' communityL % B t#ere is a sin"le rationale &or B collecti(e problem multiple de&aults C# J EcaseM umbrella matters$ -8roceedin"s are indi(idual t#in"s t#at #appen durin" t#e course o& a case. 2i+uidation proceedin" Collect assets taken a,ay all but *N*M8T*D$ Distributed to creditors 0res# start &or indi(iduals/ &irm "one$ Trustee is in c#ar"e o& ma;imizin" (alue o& t#e estate$ C# == &irms in &inancial distress/ plan o& reor"anization$ Bou can also li+uidate$ Debtor in 8ossession -D!8. enDoys t#e same ri"#ts as t#e Trustee mana"ement retains its position$ C# =I indi(idual keeps property/ ,orks a plan ,it# creditors &or payment o(er time$ T#ere is no disc#ar"e$ A$ Casebook 0ramin" t#e 8roblem % % % % *;tensions o& credit #elp bot# creditorOdebtor$ !ndi(iduals depend on credit to &inance t#eir educations' #omes' or"anize t#eir li(es$ Business (entures need capital O(er,#elmin" maDority o& loans to indi(iduals and &irms are repaid in &ull$ Creditors remedies t#at can be in(oked indi(idually 6 <3 system also o&&ers a "roup debt collection remedy$ Bankruptcy$ 1on%bankruptcy rules o !ndi(iduals =. premised on indi(idual creditors pursuin" t#eir o,n remedies$ ECollecti(e action problemM' C. premised on t#e assumption t#at t#ere enou"# assets &or all$ Bankruptcy9s E&res# startM is an insurance policy$ o 0irms =. &ailed in t#e market place t#is system does not o&&er a sensible ,ay to s#ut t#e &irm' "eneratin" discrimination amon" creditors' C. ,#en a &irm could

sur(i(e as a "oin" concern pre(ents it &rom readDustin" its capital structure$ DEBT COLLECTION OUTSIDE OF BANKRUPTCY % 8rocedural and substanti(e components procedurally tells us #o, t#e creditors are "oin" to en&orce t#eir claims (s$ debtor "o to court' success&ul reduces its claim to Dud"ment' t#e creditor may t#en call on t#e state to seize t#e debtor9s assets and sell t#em to repay t#e creditor$ 8rocedural rules demarcate t#e substanti(e ri"#ts o& creditors and debtors$ -i$e$ lay claim only to a Q o& a ,orker9s ,a"es' e;empt property' etc. 5eneral creditorsOlien creditorsOsecured creditors contract la, 4i"#ts (s$ ot#er creditors E8riorityM$ One o& t#e most important +uestions in bankruptcy is t#e e;tent to ,#ic# t#ese non% bankruptcy priorities s#ould be reco"nized inside bankruptcy$ 4i"#ts o& ENERAL CREDITOR o Debt collection process 1on Gudicial 4emedies send anot#er billOstop your side o& t#e bar"ainOask &or paymentOt#reaten to sueOsell debt to collection a"encyOreportin" t#e debtor9s name to a credit bureau$ o G<D!C!A2 remedies sel&% #elp remedies are not a(ailable to unsecured creditors$ =. 8ro(isional Measures' not &reely a(ailable' post a bond' s#o, some dan"er' C. Kin la,suit in order to establis# priority and to obtain payment Dud"mentdocketed recorded on a Dud"ment roll$ 2and more &ormalities' public records$ !n most states Dud"ment establis#es a 2!*1 on a debtor9s real property encumbers t#e property in t#e creditor9s &a(or establis#in" priorities 8ersonal 8roperty takin" p#ysical possession o& t#e obDect$ Docketin" "i(es creditor t#e ri"#t to obtain a E,rit o& e;ecutionM &rom t#e clerk o& t#e court$ Directs t#e s#eri&& to seize and sell su&&icient property to pay t#e Dud"ment entered in creditor9s &a(or$ K#en assets not readily mo(able Ele(yM disarm mac#ine' put ot#ers on notice$ !ntan"ible assets E"arnis#mentM money$ 0orce t#e bank or customer to pay t#e creditor instead o& debtor$ 3tate 3uper(ised 3ale &or bot# kinds o& property$ !n some states t#e property is appraised settin" an Eupset priceM belo, ,#ic# t#e property cannot sell rationale protection o& debtor and Dunior creditors$

% % % %

3urplus a&ter payin" e;penses' Dud"ment' is distributed to Dunior creditors or returned to debtor$ o *N*M8T*D property e+uity in debtor9s #ome/ li&e insurance policies/ pension &unds/ tools o& trade/ #ouse#old &urniture.$ 0ederal la, Consumer Credit 8rotection Act limits to ,a"es "arnis#es$ 4i"#ts o& SECURED CREDITORS o Contin"ent property interest t#at ripens ,#en t#e debtor de&aults$ 8riority o(er ot#er creditors$ E3ecurity !nterestM 2and Mort"a"es$ 1otices per&ect t#e interest$ *state 4ecords 8ersonal 8roperty Article > <ni&orm Commercial Code$ A"reement ,it# debtor take collateral in t#e e(ent o& de&ault$ !& not in ,ritin" t#e creditor must take possession o& t#e collateral$ -Attac#ed. tan"ible personal prop' cure problem o& ostensible o,ners#ip by takin" possession$ Bot# steps E8er&ectedM 3el& #elp repossession be&ore "oin" to courtonly i& t#ere is no breac# o& peace$ A> <CC -,#en t#e debtor does not obDect. <nder state la, property e;empt &rom e;ecution by unsecured creditors "enerally is a(ailable as collateral &or secured debt$ Timin" A> <CC noti&y t#e ,orld o& t#eir claim$ 0ilin" &inancial statement' id t#e type o& collateral !ntan"ible property account recei(able per&ection only possibly t#rou"# &ilin"$ 3uper priorities 8urc#ase Money 3ecurity interest$ A> <CC 0ollo, rules &ile promptly$ Debtor must in&orm ot#er secured creditors o& t#is super priority$ $

THEORETICAL BASES OF BANKRUPTCY i$ O(er(ie, [Butner] 8re%bankruptcy Code case 5olden insol(ent%debtor/ Butner ,ants to "et paid$ 3ecured Creditor #olds second mort"a"eproperty "eneratin" income durin" t#e proceedin"$ o A"ent appointed to Collect 4ents @=A0'000 ?eld appointin" a"ent meant t#at t#ere ,as a c#an"e in possession on t#e property/ Butner can attac# #is lien to t#e rents

o 3upreme Court your ri"#ts as a creditor don9t depend on bankruptcy ri"#ts$ 1ort# Carolina la, ,ill "o(ern$ <nderlyin" ri"#ts ,ould be di&&erent ,#et#er a bankruptcy entails or not encoura"es &orum s#oppin"$ o 3tate la, applies unless t#ere is a special reason to depart &rom it$ E Con"ress #as "enerally le&t t#e determination o& property ri"#ts in t#e assets o& a bankrupt estate to state la,$ <nless some &ederal interest re+uires a di&&erent result t#ere is no reason ,#y suc# interests s#ould be analyzed di&&erently simply because an interests part is in(ol(ed in a bankruptcy proceedin"$M Bankruptcy la, c#an"es in some ,ays t#e ri"#ts o& creditors and debtors$ [Butner] Bankruptcy la, respects ri"#ts t#at e;ist outside o& bankruptcy unless s speci&ic bankruptcy pro(ision or policy re+uires a di&&erent rule$ 8urpose =$ Collecti(e Action problem &orces di(erse creditors to ,ork to"et#er and stops t#e destructi(e race to assets C$ 0res# 3tart insurance to all borro,ers$ At t#e be"innin" t#is ,as not soRmain purpose punis# debtor$ C#an"ed ,it# 3tatute o& Annekeep HQ and be &ree o& pre% bankruptcy obli"ations$ I$ 4eor"anization 0irms t#at are in &inancial distress' not economic$ 0irms C? == pro(ides a process t#rou"# ,#ic# &irms can restructure t#eir capital structure$ ii$ !ndi(iduals iii$ 0irms BANKRUPTCY COURT ! CODE % =8>8 Bankruptcy Act o Disc#ar"e to indi(iduals C? J -a&ter C00H re&orm no lon"er a(ailable to e(eryone$ ?i"# income indi(idualsc#anneled to C? =I o 4estructure obli"ations C? =I o 0inancial Distress' C? == process permits t#e creditors o& insol(ent &irm to keep t#e &irm intact i& it is economically (iable$ % De&initions F=0= #eart o& t#e code$ 0ocal point in many disputes$ !ntroduction to t#e lan"ua"e$ % C#apter !!! case administration$ Court scrutinizes t#e #irin" o& la,yers and ot#er pro&essionals$ Disinterested$

% % %

C#apter Sii trustee' C? N! debtor in possession$ <$3 Trustee in c#ar"e o& pro(idin" administrati(e o(ersi"#t o& bankruptcy cases and ensurin" t#at t#ey do not lan"uis#ed in bankruptcy court$ F IAC automatic stay upon all creditors$ Cease debt collection e&&orts &rom t#e moment t#e petition is &iled$ !t is Dust a presumption$ Court may li&t it ,#en creditors s#o, t#at t#ere is cause or t#at t#e interest is not ade+uately protected$

II.

CO""ENCE"ENT OF THE CASE A. DEBTOR

# $%& 'a( # $%$ '&() '*$( #$%& 'd( i. Ca+e,oo-. Types o& *ntities eli"ible &or bankruptcy$ Discretion o& a Dud"e to dismiss cases ,#en t#e debtor is properly be&ore t#e court but its problems are better sol(ed else,#ere$ % *li"ibility o F=0> bankruptcy relie& appropriate &or F=0> -a. 2imits it to E8*43O1M de&ined by F =0=-P=. indi(iduals' partners#ips' corporations ,#o resides or #as domicile' a place o& business' or property in t#e <nited 3tates$ o Corporation &urt#er de&ined F=0= ->. describes (arious entities t#at be#a(e as a corporation$ o Beyond t#is =0> describes t#e eli"ibility by type o& debtor &or eac# c#apter -4*AD 3*CT!O1. C? J li+uidation c#apter/ cannot be used by railroads -&orced into C?==.' domestic or &orei"n insurance companies' banks' sa(in"s banks' sa(in" and loan association' credit unions or t#e like -COM82*T*2B e;cluded &rom bein" debtors under bankruptcy code.$ C? > a(ailable only to EmunicipalitiesM political subdi(ision or public a"ency or instrumentality o& t#e 3tate$ C? == reor"anization a(ailable to any person ,#o may be a debtor under C? J 6 railroads B<T not a stockbroker or commodity broker % %

-e;cluded &rom #ere s#ould "o to C? J special rules "o(ernin" t#e li+uidation.$ F=0> -d. C# =I a(ailable O12B to an indi(idual ,it# re"ular incomeRo,e less t#an unsecured o& IIA' >00 6 secure ='0=0'AH0 3acri&ice some &uture income earned t#rou"# #er #uman capital but at t#e same time is able to retain some or all o& ot#er none;empt assets$ % Business Trust included in de&inition o& a corporation and #ence a EpersonM ,it#in meanin" o& F=0=-P=. eli"ible &or bankruptcy$ EMassac#usetts business trustM predates t#e corporation$ 0orm o& t#e commercial enterprise t#at most e&&ecti(ely limited t#e liability o& its in(estors to t#e amount o& capital t#ey contributed$ [!n re Treasure !sland 2and Trust] PLAINTIFF FACTS T#e debtor is not entitled to be a Debtor % 8etition &iled in name o& T!2T on 1o( C>' =>J> % 1o( I0 secured creditors mo(ed to dismiss t#e petition on t#e basis t#at t#e Trust is not entitled to be a D*BTO4$ % Trust contractual document 2and Trust A"reement$ =>J=$ % F=0>-a. only a persona t#at resides in t#e <3 or #as a domicile a place o& business or property in t#e <3 can be a debtorR -d. only a person t#at may be a debtor under C? JR de&inition o& person in F=0=-P=.Rde&inition o& corporation F=0=->. !ncludes business trusts$ T!2T is in reality a simple trust and as suc# it cannot be a debtor under t#e Bankruptcy Code$ Mo(ants present a motion to dismiss$ Motion to dismiss "ranted$ % Debtor =$ Contends t#at it is a business trust$ -!llinois trust land is similar to business trust' present state la,$ a$ ?o,e(er no,#ere in t#e instrument does t#e ,ord land trust appear' not !llinois$ 0lorida 2a, "o(erns$ C$ 2ook at economic realities' not &orm7 Created to carry on business and t#en di(ide pro&its$ Operates as a business enterprise$

LE AL ISSUE HOLDIN REASONIN

>

a$ <nable to point to any business acti(ity$ b$ Court is &aced ,it# continuous assertions and conduct to t#e contrary 3*C &ilin"$ Trust sou"#t to a(oid re"istration re+uirements o& 3ecurities la,s$ *stoppel t#eory bindin" t#e creditor to its o,n representationsL Mo(ants contend t#at t#ey are not look at t#e lan"ua"e o& t#e instruments creatin" t#e trust$ o Di&&erence bO, business trust and ot#ers is t#at it is created ,it# t#e purpose o& carryin" on some kind o& business or commercial acti(ity &or pro&it$ -obDect o& t#e ot#ers protect and preser(e t#e trust assets. 2an"ua"e o& A H Trusts Eto #old title and protect and conser(e property until sale' li+uidation or dispositionM 6*+uity consideration embraces consistency$ Courts (ie, T!2T #as become a business trust on 1o(ember C>' =>J> a day a&ter it &iled its petition$ 1ot re"istered in 0lorida as a business trust as re+uired by 0lorida la,$ 6T!2T does not +uali&y as a business trust ,it#in t#e meanin" o& t#e code$ Motion to dismiss "ranted7 o Mo(in" to dismiss t#is entity is not a person &or t#e purposes o& t#e bankruptcy code o F =0>%B de&ines person corporation business trust$ o Kere not re"ulated by 3*C represented t#ey ,ere not a business trust' E,e Dust #old assetsM$ !n B court t#ey ar"ue t#at t#ey are a business trust$ *conomic reality s#o,s t#ey are in &act a business trust$ *stoppel Ar"ument make t#em stand &or ,#at t#ey #a(e represented be&ore$ o 1o coordination problem in t#is case' secured creditors ,ere t#e only one t#at mattered$ o Motion to dismiss "ranted7 Because t#ey are a trust t#at does not come under t#e de&inition o& person under F =0>' t#ey cannot be D in bankruptcy$

=0

B. THE PETITION # /%$ # /%/ F I0= (oluntary petition automatically tri""ers bankruptcy mac#inery petition itsel& is an order &or relie&$ F I0I in(oluntary petition is #arder to obtain re+uirements in terms o& Creditors and amounts o& claims -cannot be contin"ent.$ Debtor responds' claimant re+uired to post a bond$ 8re%commitment di&&iculty in creatin" a bankruptcy remote pro(ision ne"ates t#e basic policy b as an insurance &or D$ -Gackson Ecannot commit not to seek bankruptcy protection. i. Ca+e,ooO0er0ie1 % Mec#anics o& commencement re+uires action by Debtor or Creditor$ % Can parties a"ree in ad(ance not to &ile &or bankruptcy relie&L % Soluntary &ilin" FI0= ser(es as an order &or relie& petition satis&ies conditions necessary &or t#e court to administer t#e case$ -no insol(ency re+uirement or ot#er. % !n(oluntary FI0I in C? J T== not (s$ c#aritable or"anizations or &armers$ 8etition o& I or more entities' #older o& a claim (s$ debtorR$#old non%contin"ent claims' speci&ic amountR 8artners#ip any "eneral partner can commence it 8etition o& a &orei"n representati(e o& t#e estate in a &orei"n proceedin" concernin" t#e debtor$ 2imitations $ 8rotect "oin" concern (alue $ Creditor could apart &rom bein" t#at be a competitor ,is#in" to put #im out o& business +uickly$ $ Commencement o& t#e case is 1OT an order &or relie&$ Court ,ill issue one a&ter t#e &ilin" i& t#e petition is not contro(erted by t#e debtor$ FI0I-#.$ !& contro(erted' court ,ill issue t#e order o& relie& i& t#e debtor is E"enerally not payin" its debts as t#ey become dueM$

C. BANKRUPTCY RE"OTE PRO2ISION ==

[!n re Kin"ston 3+uare Associates] %Mort"a"e back securitization 6 corporate "o(ernance pro(ision kno,n as bankruptcy remote$ Desi"ned to make bankruptcy una(ailable to a de&aultin" borro,er ,it#out t#e a&&irmati(e consent o& t#e mort"a"ee9s desi"nee on t#e borro,er9s BOD$ FACTS %5roup o& entities o,nin" apartment comple;es #ad t#is clauses$ Despite t#e belie& o& t#e principal t#at t#e properties #ad (alue o(er and abo(e t#e encumbrances a"ainst t#em$ % To pre(ent loss o& t#is claimed (alue and potential &or reor"anization' Debtor paid a la, &irm to solicit creditors to &ile &or in(oluntary C? == petitions$ %Mo(ants C#ase and 4*05 F===Cb$ 5insber" colluded ,it# petitionin" creditors and t#eir counsel %Debtor became indebted to t#e Mo(ants C loans M25 ! T !! mort"a"e on eac# property 6 cross collaterzation 6 cross de&ault pro(isions$ *ac# company needs unanimity in BOD to &ile &or (oluntary relie&$ %Appraisal (aluin" properties @I8PMRe+uity may e;ist in t#e properties$ % A"ent no kno,led"e o& &iduciary duties as Director$ Only a&ter in(oluntary &ilin"s did #e learn t#at #e o,ed duties to 3# and Creditors$ 4ic#ardson$ 1o understandin" o& bankruptcy remote pro(ision$ Ou"#t t#e solicited &ilin" be dismissed as Ebad &ait# &ilin"sML Kas t#ere collusionL 0ilin"s ,ere solicited but not collusi(e$ Mo(ants Cite to [Cortez] certain circumstances a collusi(e &ilin" o& a bankruptcy case is &raud upon t#e Durisdiction o& B Court and susceptible o& immediate dismissal$ %Bankruptcy proo& pro(ision in a byla, does not pre(ent outside creditors &rom bandin" to"et#er to &ile an in(oluntary pro(ision$ % 4espondents did orc#estrate t#e &ilin" intention ,as to circum(ent t#e inability to act in &ace o& t#e &oreclosures to preser(e (alue o& t#e estate$ %Bad%&ait# ,ill not de &ound ,#ere t#e primary moti(ation o& petitionin" creditors ,as to pre(ent &urt#er dissipation o& assets t#rou"# &oreclosure in an =C

LE AL ISSUE HOLDIN REASONIN

attempt to &acilitate an orderly ,orkout amon" all creditors$ % F ===C-b. re+uires consideration o& ,#at is in t#e best interests o& creditors and t#e estates$ On record only ,#o ,ould bene&it &orm t#e dismissal ,ould be t#e Mo(ants$ % 5eneral 4ule D cannot ,ai(e t#e ri"#t to &ile &or bankruptcy$ Applied to indi(iduals and corporations$ % [<nited 3tates ( 4oyal Business 0unds] dicta suc# ,ai(ers "enerally ,ere not en&orceable$ % Allo,ed t#e &unctional e+ui(alent o& a ,ai(er in circumstances ,#ere t#e D is not an indi(idual$ 3ecuritization sale o& recei(ables to a 38S$ 38S9s assets ,ould not be subDect to t#e &irm9s bankruptcy$ D. DIS"ISSAL AND ABSTENTION % % % Court or party can #a(e a case dismissed despite proper commencement because t#e D does not #a(e problems t#at B la, is desi"ned to sol(e$ D reasons &or resortin" to bankruptcy =. relie(e debt burden' C. reor"anize' I. abuse spend credit card &or #olidays' etcR C00H Bankruptcy Act o 1e, limits on indi(idual consumer debts$ Court may dismiss C# J case' or ,it# consent con(ert it to a C? =I' == i& t#e court considers t#at t#e "rant o& relie& ,ould be an abuse o& t#e bankruptcy process$ o 1e, "rounds &or dismissal or con(ersion earn more t#an median income in t#e debtor9s #ome state' certain people can mo(e &or suc# a dismissal or con(ersion or court on its o,n motion$

[!n re Colonial 0ord] FACTS %Gan JJ9 Colonial 0ord' D' ceased operation as automobile dealers#ip$ %May JH9 liti"ation ,it# 0ord I la,suits one Dud"ment (s$ Colonial &or C'8>J'=CH$ %Guly 8=9 Colonial and creditors settled di&&erences$ Concluded I la,suits$ 4educed claims 6 > mont# "race period to sell or re&inance t#e dealers#ip site$ !& t#is did not #appen a decree o& &oreclosure ,ould be entered$ %Colonial unable to comply ,it# settlement$ 0iled =I

LE AL ISSUE HOLDIN REASONIN

8etition under C# ==' Marc# 8C9$ %0ord Credit &iled a motion to abstain FI0H-a.-=.$ Can Court "rant a motion to dismiss "i(en t#at t#ere ,as a compre#ensi(e out o& court ,orkout in placeL Motion to Dismiss 5ranted7 $ FI0H a%= policy embodies in se(eral section o& Code &a(ors E,orkoutsM pri(ate' ne"otiated adDustments o& creditor%company relations$ Bankruptcy last resort$ $ Most business arran"ements occur out o& courts also kno,n as common la, composition$ Uuick and ine;pensi(e$ $ K#en inade+uate bankruptcy court is alternati(e$ $ K#y &a(or ,orkoutsL *;peditious$ 0le;ibility conduci(e to speed$ Bankruptcy is lon"' creditors loose (alue o& money Code try to amend t#is -creditors can &ile plans' modi&ication absolute priority rule' e;pensi(e Durisdiction o& t#e court. *conomic a(oids t#e superstructure o& t#e reor"anization trustee' committees' pro&essional representati(es 3ensible participation &rom all parties in interest' "ood &ait#' conciliation and candor$ $ 3ome t#reaten to disrupt out%o&%court ne"otiations by &ilin" in(oluntary petitionObuyers remorse seeks recapitulation o& settlement in bankruptcy #/%3 a4 $. Court 5a6 di+5i++7 a8ter notice and 9earin:7 or +u+;end7 i8 t9e intere+t o8 creditor+ and t9e de,tor 1ould ,e ,etter +er0ed$ $ Applicable in (oluntary and in$ Consistent ,it# policy encoura"in" ,orkouts$ $ !n t#is case interests are better ser(ed ,it# dismissal t#ey a"ree to a ,orkout because it ended liti"ation' compromised t#eir claims' t#e 8S amounts realized at payout or &oreclosure e;ceeded ,#at t#ey mi"#t #a(e "ained o(er time$ 1ot a ,orkout ,it# an eye to reco(ery$ $ FI0H a%= use&ul ac#ie(in" "oal o& &a(orin" ,orkouts$ Order o& dismissal under t#is 3ection non%

=P

re(ie,able77 <se appropriate77

sparin"ly$

!n

t#is

case

it

is

% 8ossible ,#en all creditors a"reeRt#is in turn means t#at one o& t#e maDor purposes o& b court is not en"a"ed collecti(e action problem$

III.

THE AUTO"ATIC STAY

F IAC/ -d./ i. Ca+e,ooCreditor+ % 0or collecti(e bankruptcy proceedin" to be e&&ecti(e A22 e&&orts by creditors to obtain repayment o& t#eir debts must 3TO8$ % Automatic 3tay$ 8re(ent a race to t#e debtor9s assets but ot#er,ise to alter t#e relations#ip bet,een D and society$ % FIAC o stays creditors &rom brin"in" actions or en&orcin" Dud"ments a"ainst t#e D ,#en t#ey arise &rom prepetition li&e$ o 8re(ents anyone &rom takin" possession o& D assets o e;ercisin" control o(er it$ o 3tartin" place$ But !0 Ird parties ,ant to reac# property t#at is not necessary &or te D reor"anization or in ,#ic# D #as no e+uity t#en t#ey can ask &or t#e stay to be li&ted$ F IAC-d. =$ 2imits actions by creditors C$ D property not dissipated ,#ile its a&&airs are bein" sorted out

=H

I$ 5o(ernment$ 8olice and re"ulatory po,er -establis#in" ri"#ts as opposed to e;ecutin" t#em. %Tantamount to an inDunction by operation o& la, % FIAC a list o& pro#ibitions$ 3tay commencement or continuation o& any action (s$ t#e D Any act to collect assess or reco(er a claim (s$ D *n&orcement o& a prepetition Dud"ment Disallo,s any action to "ain possession o&Oe;ercise o& control o(er property o& t#e bankrupt estate$ !ncludin" any act to create' per&ect or en&orce a security interest or ot#er lien r to set%o&& any debt$ 2imits 1ot apply to actions (s$ !!! 8arties or property o& !!! 8arties$ -still dra, on letter o& credits. Creditors may pursue "uarantors or code&endants o& t#e D [O&&icial Bond#olders Committee ( C#ase Man#attan Bank] FACTS %80Q o& Mar(el9s common stock is o,ned or controlled by I #oldin" companiesRin turn t#ese are o,ned by 8erelman$ % =8$8Q public stock#olders % >I%>P9 Mar(el ?oldin" Co$ raised @8>PM t#rou"# issuance o& bonds %Bonds issued pursuant to I separate indentures and secured by a pled"e o& 80Q o& M stock and by =00Q o& M 8arent and ?oldin"s$ %!ndenture Trustee appointed to act &or bond#olders under t#e indentures$ T)E2a3alleM % Dec >A9 M and subs &iled separate petitions &or relie& C? ==$ Consolidated %3#ortly a&ter Debtors and M ?oldin" &iled' Bond#olders Committee ,as &ormed %Gan >J9 Bond#olders Comm$ mo(ed to li&t t#e stay to allo, t#em to &oreclose on and (ote t#e pled"ed s#ares o& stock as a result o& ?old Co$ de&ault under t#e indentures$ %0eb >J9 Bankruptcy court li&ted t#e stay %Marc# >J noti&ied intent to (ote on t#e pled"ed s#ares and replace M BOD$ %D &iled a complaint askin" &or T4O temporary restrainin" order and preliminary inDunction &rom (otin" s#ares and replace BOD$

=A

LE AL ISSUE HOLDIN REASONIN

Can t#e creditors e;ercise corporate "o(ernance ri"#ts in bankruptcy Bes' i& t#ere is no clear abuse' corporate "o(ernance ri"#ts are not pro#ibited in bankruptcy$ $ Bankruptcy Court automatic stay pre(ents bond#olders and !nd$ T &rom (otin" pled"ed s#ares to replace BOD unless t#ey &irst seek and obtain relie& &rom t#e stay$ $ District court Kell settled t#at t#e ri"#t to compel 3? meetin" &or purpose electin" ne, BOD persists durin" reor"anization proceedin"s$ *nDoined O12B under circumstances demonstratin" clear abuse$ -Killin"ness to risk re#abilitation alto"et#er to ,in lar"er s#are &or e+uity$ 4i"#t to abro"ate more po,er is not indicia &or clear abuse$ Automatic 3tay pro(isions are not implicated by t#e e;ercise o& 3? corporate "o(ernance ri"#ts$ Debtors rely on C cases [0airmont] [Bicoastal]$ ?ere t#e courts applied automatic stay pro(isions to pre(ent creditors o& debtors &rom "ainin" control o& t#e D estates t#rou"# t#e e;ercise o& corporate "o(ernance ri"#ts$ D ar"ue t#at #ere tooRBond#olders tryin" to e;ercise ri"#ts accruin" to t#em as creditors rat#er t#an as traditional 3?$ o Creditors #o,e(er did not ac+uire ri"#ts as creditors o& Mar(el but as creditors o& Mar(el ?oldin"$ 4e+uired to seek and obtain -,#ic# t#ey did. li&t o& automatic stay in t#e mar(el ?oldin" Co case$ Bank Court erred in #oldin" t#at FIAC-=.-I. pre(ents bond#olders and t#e !nd$ Trustee &rom (otin" t#e pled"ed s#ares to replace M BOD unless t#ey &irst seek and obtain relie& &rom t#e automatic stay$ C#ase ar"ues to maintain t#e T4O under e+uitable po,ers o& court$ ?o,e(er Bcourt #as already denied t#is' because &ailure to s#o, irreparable #arm$

=J

2ittle "uidance as to t#e action &orbidden o& a 3? t#at is also a creditor$ Creditors pro#ibited &rom collectin" debt &rom D FI0= order &or relie&$ [O&&icial Bond#olders ( C#ase] -corporate "o(ernance ri"#ts. Bond?olders ?oldin" Co$ Mar(el *+uity 3ecured Creditors Trustee represent t#e Bond#olders ,ant to turn t#em into 3? o& mar(el$ C#an"e t#e BOD' lookin" &or control' "ettin" @ out o& mar(el$ ?oldin" Co &iled &or C# == relie& automatic stay$ FIAC a-I. added in =>>P$ EAct to obtain possession o& property' property or e;ercise control o(er property o& t#e estateM B. SCOPE D non%e;empt prepetition assets and any income deri(ed &rom t#ose assets are reser(ed &or t#e bankruptcy estate to satis&y t#e prepetition claims$ 4ationale t#ese ideas are no,#ere to be &ound in Bankruptcy code$ 1on%creditor t#ird party e;ercises a termination ri"#t &or reason t#at mayOmay not be related to t#e circumstances t#at led to t#e &ilin" o& t#e petition$ May be e;ercisin" t#is ri"#t because o& bankruptcy &ilin"$ Anyone ,it# an on"oin" relations#ip ,it# t#e D at time o& &ilin" s#ould assumin" its interests are ade+uately protected -Dust as secured creditors are. be &orced to ,ait until t#e D problems are sorted out at least o& t#e t#ird party action mi"#t endan"er t#e D ability to reor"anize e&&ecti(ely$

[Ca#okia Do,ns] PLAINTIFF FACTS 4epresentati(e o& ?olland !nsurance Co$ %Ca#okia D' Dela,are corp$ Operates a race%track &acility on land leased &rom Ca#okia 2and Trust$ % April =>80 3portser(ice %lar"est creditor% &iled in(oluntary petition' ,#ic# Ca#okia consented to it$ *&&orts to &ormulate a plan or arran"ement$ % Guly J> ?olland American !nsurance Co$ entered into a policy o& insurance ,it# CD$ %4ace track operated on a seasonal basis' rest o& year s#ut do,n$ %April 809 ,it#out aut#orization o& court and a&ter &ilin"' t#e 8lainti&& attempted to cancel t#e policy o&

=8

LE AL ISSUE HOLDIN REASONIN

insurance pursuant to a clause in t#e contract Ecancel upon t#irty days ,ritten noticeM$ % 3portser(ice &iled a petition &or inDuncti(e relie& (s$ t#e cancellation t#is court t#e automatic stay is statutory and applies to t#e cancellation o& t#e insurance$ %October J> denied racin" dates to t#e D$ Application &or t#e termination o& t#e automatic stay$ Denied$ $ 1o attempts ,ere made to cancel t#e policy be&ore April/ premium #as been paid$ $ T#e insurance is essential &or t#e re#abilitation o& t#e D and protection o& t#e creditors$ $ 4eal reason &or t#e attempted cancellation ,as t#e &ilin" o& bankruptcy$ $ Con"ress "a(e po,er to t#e court to protect ri"#ts o& t#e parties in interest' F=0H/ IAC-a.' IAI2 -applicable in spite o& t#e &act t#at t#e pro(ision does not re&er to insol(ency or &inancial condition o& t#e D.IAH a$ F IAI -2. Trustee may use' sell or lease property not,it#standin" any pro(ision o& t#e contract$ -Kipes a,ay ipso &acto clauses like i& you &ile &or bankruptcy or become insol(ent t#e contract e;pires.

o FIAI -2. trumps state la, ipso &acto clauses are not en&orceable$ o FIAI -H. pre(ents t#ird parties &rom ,alkin" a,ay &orm dealin" ,it# t#e D$ o !nsurance policy is necessary &or t#e D -protects important assets' in t#is case t#e only asset.$ [MG TK Co$] FACTS %8C9 Brooklyn la, 3c#ool 6 D entered a"reement "rantin" D e;clusi(e ri"#t' permission' license and pri(ile"e to operate 2a, 3c#ool Bookstore$ %0ull &orce &or period = year ,it# I year o& B23 satis&ied ,O ser(ice$ %3ince e;piration parties #a(e not made (erbalO,ritten arran"ement to e;tend' rene, or ot#er,ise modi&y t#e A"reement$ %D ability to secure book orders is critical to t#e

=>

LE AL ISSUE HOLDIN REASONIN

e&&icient operation o& t#e la, sc#ool$ %3ept >I9 Dean recei(ed memo complainin" about bookstore$ One o& many protests by 0aculty$ 4elie& &rom t#e automatic stay$ B23 *ntitled to relie& &rom t#e automatic stay Bookstore license$ 2on"%term contract$ $ O(er a year #as to be in ,ritin"$ 3tatute o& 0raud$ $ 2icense &i;ed period ,#ic# #as lapsed it terminable at ,ill by eit#er party$ Only limit party act in "ood &ait#$ $ B23 *ntitled to relie& &rom t#e automatic stay$

C. E<ce;tion+ #/=/ ',() 'd( % FIAC-a. desi"ned to pre(ent creditor collection t#at bypasses t#e bankruptcy process$ -lar"er scope. o -=. 8ro#ibition on t#e commencementOcontinuation o& Dudicial or administrati(e processes (s$ D o -I. 8ro#ibition on any act to obtain property o& t#e estate FIAC -b. *;ceptions are t#ere so t#at FIAC -a. is not read so broadly as to e;cuse D &rom (iolations o& t#e la,$ FIAC -b. -P. "eneral principle$ 8ermits "o(ernmental unit to en&orce its police and re"ulatory po,ers includin" t#e en&orcement o& a Dud"ment ot#er t#an a money Dud"ment$ FIAC -b. -I. permits creditor action to per&ect or maintain t#e per&ection o& a security interest ,#ere t#e automatic stay ,ould cut s#ort a "race period &or suc# action t#at e;ists under state la, and t#at t#e trustee must #onor in bankruptcy$ -b.-C. actions &or t#e establis#ment o& paternity or t#e suspension o& a dri(er9s license as ,ell as &or alimony$

% % %

[in 4e 0ederal Communication Commission] FACTS % 1e;t Ka(e in 3ummer >A9 #i"#er bidder at 0CC auctions &or AI personal communication ser(ices spectrum licenses$ P$JPB@ % 1e;t Ka(e small business' only =0Q cas#$ % 2icenses "ranted conditioned upon issuance o& promissory notes &or P$CJB@ % At time issuance' ot#er auctions &or muc# less @@$ % 1e;tKa(e &iled bankruptcy petition under C? == Kas t#e cancellation o& t#e license by t#e

LE

AL

C0

ISSUE HOLDIN REASONIN

"o(ernment in (iolation o& t#e automatic stayL 3upreme Court yes$ Cancellation only because t#ey &iled &or bankruptcy (iolation o& automatic stay$ % 8urpose o& spectrum auctions ,as re"ulatory$ % 0CC e;clusi(e Durisdiction o(er licensin" matters e;tends to conditions placed on licenses$ % Because t#ey are re"ulatory in nature' approac# o& bankruptcy court and district court' ,#ic# allo,ed 1e;tKa(e to keep t#e licenses e(en ,#en not complyin" ,it# conditions' ,as ,ron"7 % *(en ,#ere t#e re"ulatory conditions imposed on a license take t#e &orm o& a &inancial obli"ation' b and d courts lack Durisdiction to inter&ere in t#e 0CC allocation$ % Gan 00 o&&ered to pay its notes in t#e present (alue ,it# a lump sum$ % 1e;t day 0CC re%auction o& t#e licenses$ % 0CC made timely payment a re"ulatory condition$ % Automatic stay #as limits F IAC -b.-P. 0CC is a "o(ernmental unit t#at is seekin" to en&orce its re"ulatory po,er

o IAC -d. you "o to court and ask &or t#e automatic stay to be li&ted/ or &or ade+uate protection./ IAC -b. is an e;ception$ T#e automatic stay does not e(en apply$ *(eryone tries to "et into t#is section$ o F IAC -b. action or proceedin" o& "o(ernment unit' en&orcement o& t#eir po,ers ot#er t#an a money Dud"ment$ [<nited 3tates ( 1icolet] PLAINTIFF DEFENDAN
T

<3 1icolet Complaint sou"#t reimbursement o& en(ironmental response costs e;pended and to be e;pended in t#e &uture to clean up an asbestos site in 8ennsyl(ania$ *n(ironmental 8rotection A"ency #ad en"a"ed pri(ate contractors to abate t#e #azard &rom t,o ,aste piles and incurred costs o& =M@ %At time clean up site o,ned by 1icolet$ 8urc#ased &rom a Turner T 1e,all 3ubsidiary % 1icolet &iled &or reor"anization under C? ==$ District Court applied to automatic stay to C*4C2A ci(il suit$ % <3 mo(ed &or reconsideration o& t#is last order$

FACTS

C=

LE AL ISSUE HOLDIN REASONIN

A&ter <3 mo(ed to #a(e t#e stay li&ted' t#e District Court a"reed and "ranted t#e order$ Appeal$ District Court ,as correct in li&tin" t#e stay$ Order a&&irmed$ % <3 suit ,as by a "o(ernmental unit to en&orce its police or re"ulatory po,er$ *;pressly e;empt &rom automatic stay under F IAC -b.-P.$ % 1icolet because <$3$ seeks to secure a Dud"ment &or prepetition e;penditures' it is in &act an attempt to collect money and outside t#e scope o& t#e police po,er e;emption$ % <3$ Assumin" a (erdict in its &a(or' t#ey ,ould not e;ecute on t#e Dud"ment$ % 2e"islati(e ?istory speci&ic lan"ua"e addressin" t#e E&i;in" o& dama"es &or a (iolation o& suc# a la,M$ % [8enn Terra] seizure o& a D9s property to satis&y t#e Dud"ment obtained by a plainti&&%creditor' ,#ic# is proscribed by ss IAC-b.-H. % District Court did not err in li&tin" t#e stay$ Order a&&irmed$

o F IAC-b.-P. speci&ically ousts t#e e;ecution o& a money Dud"ment$ o Cnd circuit lan"ua"e o& t#e bankruptcy code does not command one solution$ T#e circuit is sensiti(e o& t#e role t#e "o(ernment is playin" in t#is speci&ic situation$ T#ey are actin" in &urt#erance o& a statutory mandate$

I2. Clai5+ A. When a Claim Arises Once a bankruptcy petition is &iled and t#e automatic stay takes e&&ect' all dent collection acti(ity mo(es to t#e bankruptcy process$ 3imply put' t#is process determines ,#o "ets ,#at &rom t#e debtor$ Clai5 '#$%$'3((. is Vany ri"#t to payment ,#et#er or not suc# ri"#t is reduced to Dud"ment' li+uidated' unli+uidated' &i;ed' contin"ent' CC

matured' unmatured' disputed' undisputed' le"al' e+uitable' secured' or unsecured$V A claim is also Va ri"#t to an e+uitable remedy &or breac# o& per&ormance i& suc# breac# "i(es rise to any suc# Vri"#t to paymentV$ Once admitted' t#e #older o& t#e claim must ,ait to see ,#et#er t#e claim ,ill be Vallo,edV$ 3ection H0C disallo,s speci&ied types o& obli"ations e(en t#ou"# t#ese obli"ations +uali&y as claims under F=0=-H.$ Only allo,ed claims are entitled to a s#are o& t#e debtorWs assets$ Moreo(er i& t#e debtor lacks su&&icient assets &ully to satis&y all allo,ed claims' at least some portions o& some claims ,ill by necessity remain unpaid at t#e close o& t#e bankruptcy process$ 2oca,ular6 note. An unliquidated claim is a claim t#at is not reduced to Dud"ment$ Notes from class: 8articipation in t#e case means t#at t#e creditor ,ill #a(e a (oice in t#e case' but also t#at #e stands up in line to recei(e payment$ T#e &ormal act o& &ilin" a claim is called a proo& o& claim$ T#e proo& o& claim is presumed (alid' unless it is obDected by t#e debtor or by a creditor committee$ A claim ,ill be obDected on t,o "rounds a. T#e (alue o& t#e claim -! donWt o,e you t#at muc#/ and b. T#e e;istence o& t#e claim -Bou are not e(en a creditor.$

Ohio v. Kovacs !n t#is case a state "o(ernment order a debtor to conduct an en(ironmental cleanup' t#en seeks to ac+uire t#e debtorWs assets ,#en t#e debtor &ails to comply ,it# t#e order$ T#e +uestion is ,#et#er t#e "o(ernmentWs po,er to e&&ectuate t#e obDecti(e o& its order in t#is ,ay constitutes a claim$ 1976: T#e 3tate sued Ko(acs and t#e business entities in state court &or pollutin" public ,aters' maintainin" a nuisance and causin" &is# kills' all in (iolation o& state en(ironmental la,s$ Ko(acs and t#e ot#er de&endants &ailed to comply ,it# t#eir obli"ations under t#e inDunction$ T#e 3tate t#en obtained t#e appointment o& a recei(er$ T#e recei(er took possession o& t#e site but #ad not completed #is tasks ,#en Ko(acs &iled a personal bankruptcy petition$

CI

T#e 3tate &iled a complain in t#e bankruptcy court seekin" a declaration t#at Ko(acWs obli"ation ,as not disc#ar"eable in bankruptcy because it ,as not a debt' a liability on a claim' ,it#in t#e meanin" o& t#e Bankruptcy Code$ T#e bankruptcy court ruled a"ainst O#io' as did t#e district court$ T#e Court o& Appeals o& t#e 3i;t# Circuit a&&irmed' #oldin" t#at O#io essentially sou"#t &rom Ko(acs only a monetary payment and t#at suc# a re+uired payment ,as a liability on a claim t#at ,as disc#ar"eable t#e bankruptcy statute$ T#e 3upreme Court "ranted certiorari to determine t#e disc#ar"eability o& Ko(acWs obli"ation$ T#e pro(ision at issue #ere is F=0=-H.-B. Arguments of Ohio: =$ T#e 3tate ar"ues t#at t#e inDunction it #as secured is not a claim a"ainst Ko(acs &or bankruptcy purposes because -=. Ko(acWs de&ault ,as a breac# o& t#e statute' not a breac# o& an ordinary commercial contract ,#ic# concededly ,ould "i(e rise to a claim/ and -C. Ko(acWs breac# o& #is obli"ation under t#e inDunction did not "i(e rise to a ri"#t to payment ,it#in t#e meanin" o& F=0=-H.-B. Arguments of the u!reme Court: =$ T#ere is no indication in t#e lan"ua"e o& t#e statute t#at t#e ri"#t to per&ormance cannot be a claim unless it arises &rom a contractual arran"ement$ C$ !t is apparent t#at Con"ress desired a broad de&inition o& a VclaimV and kne, #o, to limit t#e application o& a pro(ision to contracts ,#en it desired to do so$ I$ T#e rulin"s o& t#e courts belo, ,ere ,#olly consistent ,it# t#e statute and its le"islati(e #istory$ P$ On t#e &acts be&ore it' and ,it# t#e recei(er in control o& t#e site' t#e 3upreme Court cannot &ault t#e Court o& Appeals &or concludin" t#at t#e cleanup order #ad been con(erted into an obli"ation to pay money' an obli"ation t#at ,as disc#ar"eable in bankruptcy$ Notes from class: !n t#is case t#ere is a settlement t#at #as t#ree parts =. 3top' C. Clean' and I. 8ay$ FHCI #as a list o& claims t#at cannot be disc#ar"ed$ 3ome o& t#em respond to #istorical reasons' ot#ers #a(e more to do ,it# lobby in t#e Con"ress$ T#is section cannot be used by O#io because en(ironmental clean%up is not in t#e list$ T#is is ,#y t#ey #a(e to "o t#e #ard ,ay ar"uin" t#at t#is is not actually a claim$ T#e +uestion is ,#et#er or not t#is is a debt$ "!stein v. #nsecured creditors CP

A debtorWs prebankruptcy ne"li"ent be#a(ior ,ill cause accidents lon" a&ter t#e bankruptcy case is o(er$ T#e +uestion is ,#et#er t#e debtorWs ne"li"ence "i(es raise to bankruptcy claims e(en t#ou"# t#at ne"li"ence does not yet "i(e rise to cause o& action under applicable bankruptcy la,$ 8iper #as been manu&acturin" and distributin" "eneral a(iation aircra&t and spare parts$ $ul% 1& 1991: 8iper &iled a (oluntary petition under C#apter ==$ A!ril '& 199(: 8iper and 8ilatus Aircra&t 2imited si"ned a letter o& intent pursuant to ,#ic# 8ilatus ,ould purc#ase 8iperWs assets$ T#e letter o& intent re+uired 8iper to seek t#e appointment o& a le"al representati(e to represent t#e interests o& &uture claimants by arran"in" a set%aside o& monies "enerated by t#e sale to pay o&& &uture product liability claims$ $ul% 1)& 199(: *pstein -le"al representati(e o& t#e &uture claimants. &ile a proo& o& claim on be#al& o& t#e 0uture Claimants in t#e appro;$ amount o& @=00'000'000$ T#e claim ,as based on statistical assumptions re"ardin" t#e number o& persons likely to su&&er' a&ter t#e con&irmation o& t#e reor"anization' personal inDury or property dama"e caused by 8iperWs precon&irmation manu&acture' sale' desi"ns' distribution and support o& aircra&ts and spare parts$ T#e O&&icial Committee o& <nsecured Creditors' and later 8iper obDected to t#e claim on t#e "round t#at t#e 0uture Claimants do not #old F=0=-H. claims a"ainst 8iper$ T#e bankruptcy court a"reed and t#e *pstein appealed and t#e district court a&&irmed$ *pstein no, appeals &rom t#e district courtWs order' c#allen"in" in particular its use o& t#e prepetition relations#ip test to de&ine t#e scope o& a claim under F=0=-H.$ Arguments of the a!!ellant: =$ *pstein primarily c#allen"es t#e district courtWs application o& t#e prepetition relations#ip test$ ?e ar"ues t#at t#e conduct test' ,#ic# some courts #a(e adopted in mass tort cases' is more consistent ,it# t#e te;t' #istory and policies o& t#e Code$ <nder t#e conduct test' a ri"#t to payment arises ,#en t#e conduct "i(in" rise to t#e alle"ed liability occurred$ C$ *psteinWs position is t#at any ri"#t to payment arisin" out o& t#e prepetition conduct o& 8iper' no matter #o, remote' s#ould be deemed a claim$ ?e ar"ues t#at t#e rele(ant conduct "i(in" rise

CH

to t#e alle"ed liability ,as 8iperWs prepetition manu&acture' desi"n' sale and distribution o& alle"edly de&ecti(e aircra&t$ Arguments of the a!!ellees: =$ T#e O&&icial Committee and 8iper dispute t#e breadt# o& t#e de&inition o& claim asserted by *pstein' ar"uin" t#at t#e scope o& claim cannot e;tent so &ar as to include unidenti&ied' and presently unidenti&iable indi(iduals ,it# no discernible prepetition relations#ip to 8iper$ Arguments of the Court: =$ T#e le"islati(e #istory o& t#e Code su""ests t#at Con"ress intended to de&ine t#e term claim (ery broadly under F=0=-H.' so t#at all le"al obli"ation o& t#e debtor' no matter #o, remote or contin"ent' ,ill be able to be dealt ,it# t#e bankruptcy case$ C$ 3ince t#e enactment o& F=0=-H. courts #a(e de(eloped se(eral tests to determine ,#et#er certain parties #old claims pursuant to t#at section t#e accrued state la, claim test=' t#e conduct test and t#e prepetition test$ I$ <pon e;amination o& t#e (arious t#eories' t#e Court a"rees ,it# Appellees t#at t#e district court utilized t#e proper test$ *psteinWs interpretation o& claim and application o& t#e conduct test ,ould enable anyone to #old a claim a"ainst 8iper by (irtue o& t#eir potential &uture e;posure to any aircra&t in t#e e;istin" &leet$ P$ K#ile ackno,led"in" t#at t#e district courtWs test is more consistent ,it# t#e purposes o& t#e Bankruptcy Code t#an is t#e conduct test supported by *pstein' t#e Court &inds t#at t#e test as set &ort# unnecessarily restricts t#e class o& claimants to t#ose ,#o could be identi&ied prior to t#e &ilin" o& t#e petition$ H$ T#e Court t#ere&ore modi&ies t#e test and adopts t#e Vpiper testV in determinin" t#e scope o& t#e term claim under F=0=-H. an indi(idual #as a F=0=-H. claim a"ainst a debtor manu&acturer i& -i. e(ents occurrin" be&ore con&irmation create a relations#ip' suc# as a contact' e;posure' impact or pri(ity' bet,een t#e claimant and t#e debtorWs product/ and -ii. t#e basis &or liability is t#e debtorWs prepetition conduct in desi"nin"' manu&acturin" and sellin" t#e alle"edly de&ecti(e or dan"erous product$ T#e debtorWs prepetition conduct "i(es rise to a claim to be administered in a case only i& t#ere is a relations#ip establis#ed be&ore con&irmation bet,een an identi&iable claimant or "roup o& claimants and t#at prepetition conduct$ A$ !n t#is case it is clear t#at t#e &uture claimants &ail t#e minimum re+uirements o& t#e 8iper test$ T#ere is no pre%con&irmation
T#e accrued state la, claim t#eory states t#at t#ere is no claim &or bankruptcy purposes until a claim #as accrued under state la,$
1

CA

connection establis#ed bet,een 8iper and t#e 0uture Claimants' so t#ey do not #old a F=0=-H. claim$ Notes: !n eac# o& t#ese cases it is important to understand t#at bein" &ound to #old a claim comes ,it# bot# an upside and a do,nside$ Only t#ose #oldin" claims s#are in t#e assets o& t#e estate' but' subDect to a &e, speci&ied e;ceptions' claims are disc#ar"ed as ,ell$ K#en one #olds an obli"ation t#at does not &all ,it#in t#e ambit o& a claim' t#e situation is re(ersed$ One does not s#are in t#e distribution o& t#e debtorWs assets at t#e close o& t#e bankruptcy case' but t#e obli"ation sur(i(es t#e debtorWs bankruptcy and can be asserted a"ainst t#e debtor a&ter bankruptcy$ Moreo(er' under t#e state la, doctrine o& Vsuccessor liabilityV' t#e #older o& t#e obli"ation may be able to brin" an action a"ainst an entity t#at #as purc#ase t#e bulk o& a debtorWs assets$ Notes from class: T#e idea &or &ilin" &or bankruptcy in t#is case is t#at 8iper ,as #a(in" a lot o& problems ,it# massi(e liti"ation because o& de&ects in t#e planes$ T#e Con"ress passed a bill limitin" t#e liability o& small plane manu&acturers but t#is bill ,as not retroacti(e so 8iper needed to ,orry about t#e liability claims t#at in t#e &uture could arise but &rom &acts occurred in t#e past' and t#us not co(ered by t#e liability cap o& t#e bill$ T#is case #as a &i"#t bet,een t#e creditors committee' ,#o &irst obDected t#e claim' and t#e debtor$ 8ro&essor t#inks t#is is a &i"#t to ,in control o(er t#e case$ K#at t#e Court ,ants in t#is case is to "i(e a ca(eat as to ,#at a claim is' because ot#er,ise e(eryone can #a(e a &uture claim$ T#e Court t#inks t#at t#ere must be some kind o& relations#ip bet,een t#e debtor and t#e &uture creditor$ T#e Court applies ,#at is called t#e Vpre%petition relations#ip testV$ But t#e Court modi&ies t#at sli"#tly to include a relations#ip t#at may be &ormed durin" t#e course o& t#e debtorWs case$ *. Claim Allo+ance and "stimation T#e process o& claim satis&action be"ins ,#en a creditor' or t#e debtor on t#e creditorWs be#al&' &iles ,it# t#e bankruptcy court a ;roo8 o8 clai5 under FH0=$ Once &iled' t#e claim is deemed allo1ed unless a ;art6 in intere+t ,it# respect to t#e claim' usually t#e debtor'

CJ

obDects to allo,ance$ 3ee FH0C-a.$ !& a party in interest does obDect' t#en t#e court must decide ,#et#er or in ,#at amount to allo, t#e claim$ 3ee FH0C-b. T -c.$ Allo,ance o& a claim reco"nizes t#e creditorWs ri"#t to s#are in t#e assets o& t#e estate$ At t#e end o& t#e bankruptcy process a debtorWs assets' or interests in t#ose assets are distributed to #olders o& allo,ed claims$ FH0C-b.-=. embodies simple principles i& an obli"ation is o,ed under nonbankruptcy la,' a claim is "enerally allo,ed$ !& no obli"ation is o,ed' a claim is not "enerally allo,ed$ !& an obli"ation ,ould be allo,ed' but &or t#e &act t#at it #as not #ad time to accrue' a claim is allo,ed &or t#e unaccrued obli"ation$ !n essence' t#e Bankruptcy Code treats a ;etition 8or ,an-ru;tc6 a+ a notional de8ault on all o,li:ation+7 ,#ic# are deemed to be due immediately and are allo,ed accordin"ly$ T#e "eneral rule #as e;ceptions' ,#ic# are enumerated in FH0C-b.-C.% ->.$ By (irtue o& t#ese pro(isions' certain claims are disallo,ed e(en i& t#ey are (alid under applicable nonbankruptcy la,$ 3ome o& t#ese e;ceptions are =$ A di(orced parentWs &uture c#ild support obli"ations C$ A claim may be disallo,ed i& a proo& o& claim is not &iled in a timely &as#ion$ I$ T#e Code disallo,s claims &or unmatured interest$ T#is is di&&icult to e;plain$C P$ T#e Code places caps on a lessorWs and an employeeWs claim &orm dama"es &rom breac# o& a real estate lease and an employment contract respecti(ely$ -3ee FH0C-b.-A. T -J..$ ,aleigh v. -llinois .e!artment of ,evenue T#e 3upreme CourtWs opinion in ,aleigh s#o,s #o, claims in bankruptcy are understood by re&erence to substanti(e nonbankruptcy la,$ T#e +uestion raised #ere is ,#o bears t#e burden o& proo& on a ta; claim in bankruptcy court ,#en t#e substanti(e la, creatin" t#e ta; obli"ation puts t#e burden on t#e ta;payer' in t#is case t#e trustee in bankruptcy$

!n de&ense o& interest claim disallo,ance' t#e le"islati(e #istory o&&ers an Virrebuttable presumptionV t#at t#e rate o& interest on e(ery obli"ation is e+ual to t#e appropriate discount rate &or t#e obli"ation$ Con"ress understood t#at' in reality' a contractual interest rate could di&&er &rom t#e applicable discount rate' but t#is approac# simpli&ies matters and may be Dusti&ied' "i(en t#at in t#e mine%run o& cases t#e claims "reatly e;ceed t#e debtorWs unencumbered assets$
2

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C#andler *nterprises !nc$ bou"#t a plane$ Killiam 3toecker' &or ,#om petitioner 4alei"# is a trustee ,as t#e president o& C#andler in =>88 ,#en C#andler entered into a lease%purc#ase a"reement &or t#e plane' mo(ed to !llinois' and ultimately took title under t#e a"reement$ Accordin" to t#e 3tate Department o& 4e(enue' t#e transaction ,as subDect to t#e !llinois use ta;' a sales%ta; substitute imposed on !llinois residents ,#o buy out o& 3tate$ T#e buyer must &ile a return and pay t#e ta; ,it#in I0 days a&ter t#e aircra&t enters t#e 3tate$ C#andler &ailed to do t#is$ !llinois la, pro(ides t#at a corporate o&&icer ,#o &ails in #is ta; obli"ations s#all be personally liable &or a penalty e+ual to t#e total amount o& ta; unpaid by t#e corporation$ T#e Court o& Appeals #eld t#at t#e burden remained on t#e trustee' Dust as it ,ould #a(e been on t#e ta;payer #ad t#e proceedin"s taken place outside o& bankruptcy$ Arguments of the de/tor 0trustee1: =$ T#e trustee says t#at t#e courts operatin" in t#e days o& t#e Bankruptcy Act' ,#ic# ,as silent on t#e burden to pro(e t#e (alidity o& claims' almost uni&ormly placed t#e burden on t#ose seekin" a s#are on t#e bankruptcy estate$ Because t#e code "enerally incorporates pre%Code practice in t#e absence o& e;plicit re(ision' and because t#e Code is silent #ere' t#e trustee su""ests t#at t#e pre%code practice s#ould be &ollo,ed' e(en ,#en t#is ,ould re(erse t#e burden imposed outside bankruptcy$ C$ T#is tradition makes sense' petitioner ur"es' because in bankruptcy ta; aut#orities are no lon"er opposed to t#e ori"inal ta;payer' and t#e c#oice is no lon"er merely ,#et#er t#e ta; claim is paid but ,#et#er ot#er innocent creditors must s#are t#e bankruptcy estate ,it# t#e ta; "o(ernment$ I$ T#e trustee makes a di&&erent appeal to Code silence su""estin" t#at allo,ance o& claims is a &ederal matter$ P$ T#e trustee ar"ues t#at t#e Code mandated priority enDoyed by ta;in" aut#orities o(er ot#er creditors' re+uires a compensatin" e+uality o& treatment ,#en it comes to demonstratin" (alidity o& claims$ Arguments of the Court: =$ T#e Court &inds #istory less a(ailin" to t#e trustee t#an #e says$ Kit#out t#e ,ei"#t o& solid aut#ority on t#e trusteeWs side' ,e cannot treat t#e Code as predicated on an alteration o& t#e substanti(e la, o& obli"ations once a ta;payer enters bankruptcy$ C$ K#ile it is true t#at &ederal la, #as "enerally e(ol(ed to impose t#e same procedural re+uirements &or claim submission on ta; C>

aut#orities as on ot#er creditors' not#in" in t#at e(olution #as touc#ed t#e underlyin" la,s on t#e elements su&&icient to pro(e a (alid state claim$ I$ 4e"ardin" ar"ument X P o& t#e trustee' t#e court says t#at suc# ar"ument distorts t#e le"itimate po,ers o& a bankruptcy court and be"s t#e +uestion about t#e rele(ant principle o& e+uality$ Bankruptcy Courts do indeed #a(e some e+uitable po,ers to adDust ri"#ts bet,een creditors' but t#e scope o& suc# e+uitable po,er must be understood in t#e li"#t o& t#e principle t#at t#e (alidity o& a claim is "enerally a &unction o& underlyin" substanti(e la,$I Bankruptcy courts are not aut#orized in t#e name o& e+uity to make ,#olesale substitution o& underlyin" la, controllin" t#e (alidity o& creditorWs entitlements' but are limited to ,#at t#e Bankruptcy Code itsel& pro(ides$ P$ Moreo(er' e(en on t#e assumption t#at a bankruptcy court ,ere to #a(e a &ree #and' t#e case &or a rule placin" t#e burden o& proo& uni&ormly on all bankruptcy creditors is not sel&%e(idently Dusti&ied by t#e trusteeWs in(ocation o& e+uality$ Certainly t#e trustee #as not s#o,n t#at e+ual treatment o& all bankruptcy creditors in pro(in" debts is more compellin" t#an e+ual treatment o& comparable creditors in and out o& bankruptcy$ H$ T#e uncertainty and increased comple;ity t#at ,ould be "enerated by t#e trusteeWs position is anot#er reason to stick ,it# t#e simpler rule t#at t#e burden o& proo& on a ta; claim in bankruptcy remains ,#ere t#e substanti(e ta; la, puts it$ Notes from class: T#is is one o& t#e most e;citin" cases o& t#e semester because it is t#e con&luence o& ta; la,' bankruptcy' e(idence and ci(il procedure$ T#e underlyin" idea #ere is t#at you can "o to t#e state ne;t door to buy a plane and t#en come back pretendin" not to pay your ta;es$ K#at #appens in t#ese cases is t#at t#e 3tate ,ill
Be&ore e;posin" t#e ar"uments o& t#e trustee and its position' t#e Court opens t#e decision ,it# t#e &ollo,in" remarks Do t#e 3tateWs ri"#t and t#e ta;payerWs obli"ation include t#e burden o& proo&L T#e ans,er is a&&irmati(e$ 5i(en its importance to t#e outcome o& cases' t#e Court #as lon" #eld t#e burden o& proo& to be a Vsubstanti(eV aspect o& a claim$ T#at is' t#e burden o& proo& is an essential element o& t#e claim itsel&/ one ,#o asserts a claim is entitled to t#e burden o& proo& t#at normally comes ,it# it$ Ta; la, is no candidate &or e;ception &rom t#is "eneral rule' &or t#e (ery &act t#at t#e burden o& proo& #as o&ten been placed on t#e ta;payer indicates #o, critical t#e burden rule is' and re&lects se(eral compellin" rationales t#e (ital interest o& t#e "o(ernment in ac+uirin" t#e re(enue/ t#e ta;payerWs readier access to t#e rele(ant in&ormation/ and t#e importance o& encoura"in" (oluntary compliance by "i(in" ta;payers incenti(es to sel&%report and to keep ade+uate records in case o& dispute$ 8lus' t#ere is no si"n t#at Con"ress meant to alter t#e burdens o& production and persuasion on ta; claims$
3

I0

come up ,it# a number and o& t#e ta;payer doesnWt like it' t#en t#e ta; payer #as t#e burden o& production o& e(idence t#at undermines t#e 3tateWs number$ T#e ta;payer #as t#e burden o& proo& and t#e burden o& persuasion$ T#is case is a rea&&irmation i& t#e *utner principle' so t#e black letter rule #ere is t#at t#e claim comes ,it# t#e burden o& proo&$ T#e Court is a little bit #ostile to t#e idea o& a ta; creditor "ettin" a#ead o& t#e rest o& creditors$ K#yL Because it is t#e ta; aut#ority t#e one ,#o determines t#e claim' t#ere is no notice to t#e ,orld' it is a VsecretV ta; claim$ *ittner v. *orne Chemical Co. T#is case presents a courtWs attempt to estimate t#e (alue o& a claim t#at is intractably uncertain at t#e time o& t#e bankruptcy$ T#e stock#olders o& t#e 4ol&ite Company -43?. appeal &rom t#e Dud"ment o& t#e district court' a&&irmin" t#e decision o& t#e bankruptcy court to assi"n a zero (alue to t#eir claims in t#e reor"anization proceedin"s o& Borne C#emical Company' !nc$ 8rior to &ilin" its (oluntary petition under C#apter ==' Borne commenced a state court action a"ainst 4ol&ite &or t#e alle"ed piratin" o& trade secrets and proprietary in&ormation &rom Borne$ 4ol&ite &iled a counterclaim alle"in"' inter alia' t#at Borne #ad tortiously inter&ered ,it# a proposed mer"er by unilaterally terminatin" a contract to manu&acture 4ol&ite products and by brin"in" t#e suit$ T#e 43? sou"#t relie& &rom t#e automatic stay so t#at t#e state court proceedin"s mi"#t be continued$ Borne t#en &iled a motion to disallo, temporarily t#e 4ol&ite claims until t#ey ,ere &inally li+uidated in t#e state court$ T#e bankruptcy court li&ted t#e automatic stay but also "ranted BorneWs motion to disallo, temporarily t#e claims$ Because o& internal proceedin"s in t#e bankruptcy case' t#e district court (acated t#e temporary disallo,ance and directed t#e bankruptcy court to #old an estimation #earin"$ A&ter ,ei"#tin" t#e e(idence' t#e court assi"ned a zero (alue to t#e 4ol&ite claims and reinstated t#e order to disallo, temporarily t#e claims until li+uidated in sate court$ <pon appeal t#e district court a&&irmed$ T#e Court o& Appeals o& t#e T#ird Circuit no, re(ie,s$ Arguments of a!!ellants 0, 21: =$ Accordin" to 43?' t#e estimate ,#ic# FH0C-c.-=. re+uires is t#e present (alue o& t#e probability t#at appellants ,ill be success&ul I=

in t#eir state court action$ T#e 43? contend t#at instead o& estimatin" t#eir claims in t#is manner' t#e bankruptcy court assessed t#e ultimate merits and belie(in" t#at t#ey could not establis# t#eir case by preponderance o& t#e e(idence' (alued t#e claims at zero$ C$ T#e 43? &urt#er contend t#at' re"ardless o& t#e met#od ,#ic# t#e bankruptcy court used to (alue t#eir claims' t#e court based its estimations on incorrect &indin"s o& &act$ T#e 43? ar"ue t#at in assessin" t#e merits o& its state court action &or t#e purpose o& e(aluatin" t#eir claims a"ainst Borne' t#e bankruptcy court erred bot# in &indin" t#e &acts and in applyin" t#e la,$ Arguments of the Court of A!!eals: =$ Despite t#e lack o& e;press direction on t#e manner in ,#ic# contin"ent or unli+uidated claims are to be estimated' t#e Court is persuaded t#at t#e Con"ress intended t#e procedure to be undertaken by t#e bankruptcy Dud"e' usin" ,#ate(er met#od is best suited to t#e particular contin"encies at issue$ ,#en t#ere is su&&icient e(idence on ,#ic# to base a reasonable estimate o& t#e claim' t#e bankruptcy Dud"e s#ould determine t#e (alue$ !n doin" so' t#e court is bound by t#e le"al rules ,#ic# may "o(ern t#e ultimate (alue o& t#e claim$ !n re(ie,in" t#e met#od by ,#ic# a bankruptcy court #as ascertained t#e (alue o& a claim under FH0C-c.-=.' an appellate court may only re(erse i& t#e bankruptcy court #as abused its discretion$ T#at standard o& re(ie, is narro,$ T#e appellate court must de&er to t#e con"ressional intent to accord ,ide latitude to t#e decisions o& t#e tribunal in +uestion$ T#e Court o& Appeals cannot &ind t#at t#e (aluation met#od used by t#e bankruptcy court in t#is case is an abuse o& discretion con&erred by FH0C-c.-=.$ C$ T#e (alidity o& t#e estimation must be determined in li"#t o& t#e policy underlyin" reor"anization proceedin"s$ !n order to realize t#e "oals o& C#apter ==' reor"anization must be accomplis#ed +uickly and e&&iciently$ I$ !& t#e bankruptcy court estimated t#e (alue o& t#e 43?Ws claims accordin" to t#e ultimate merits o& t#eir state court action' suc# a (aluation met#od is not inconsistent ,it# t#e principles ,#ic# imbue C#apter ==$ T#ose claims are contin"ent and unli+uidated$ Accordin" to t#e bankruptcy courtWs &indin"s o& &act' t#e 43?Ws c#ances o& ultimately succeedin" in t#e state court action are uncertain at best$ Bet i& t#e court #ad (alued t#e 43?Ws claims accordin" to t#e present probability o& success' t#e 43? mi"#t ,ell #a(e ac+uired a si"ni&icant' i& not controllin" (oice in t#e reor"anization proceedin"s$ T#e bankruptcy court may ,ell #a(e decided t#at suc# a situation ,ould at best unduly complicate t#e reor"anization proceedin"s and at ,orst undermine BorneWs IC

attempts to re#abilitate its business and preser(e its assets &or t#e bene&it o& its creditors and its employees$ 3uc# a solution is consistent ,it# t#e C#apter == concerns o& speed and simplicity but does not depri(e t#e 43? o& t#e ri"#t to reco(er on t#eir contin"ent claims a"ainst Borne$ P$ T#e court cannot a"ree ,it# t#e 43? ar"ument X C$ An appellate court may o(erturn &indin"s o& &act only ,#en t#ey are clearly erroneous$ T#e CourtWs ultimate &indin" o& &act %t#at t#e 43?Ws claims in t#e reor"anization procedure ,ere ,ort# zero%must be up#eld since it is not clearly erroneous$ Notes: !n Bittner t#e court disallo,s t#e claims but also re+uired a V,ai(er o& disc#ar"eV o& t#ose claims$ T#is means t#at despite t#e disallo,ance t#e 43? are &ree to ad(ance t#eir claims a"ainst t#e reor"anized Borne C#emical$ !& Borne emer"es reor"anized' it is #ard to ima"ine a le"itimate purpose &or t#e 43?Ws obDection$ One mi"#t conclude t#at t#e 43? do not #old le"itimate claims but a desire &or undue in&luence$ !& t#is conclusion is correct' t#en t#e combination o& disallo,ance and ,ai(er is a "ood result$ Notes from class: T#e *stimated Salue o& a claim ) pA p)probability o& success A)(alue o& t#e claim 3o' in t#is case *S)-0$P>.-@=00 millions <3D. *S)@P> million T#is is t#e ,ay sop#isticated parties (alue t#e &uture claims$ !& t#e &ormula ,ould #a(e been applied' t#e result ,ould #a(e been @P> million in estimated (alue$ ?o,e(er t#e court arri(ed to a (alue o& 0$ K#yL Because t#e Court didnWt ,ant 4ol&ite to #a(e a (oice in t#e case$ T#is case is about control$ !& t#e Court ,ould #a(e estimated t#e (alue o& t#e claim like t#is' t#e 4ol&ite ,ould #a(e a bi" incidence in t#e reor"anization procedure$ -n ,e A.2. ,o/ins Co. ?ere t#e Court disallo,s a claim &or puniti(e dama"es on e+uitable "rounds' e(en t#ou"# t#e court lacks e;plicit statutory aut#ority to do so$ T#e matter be&ore t#e court addresses t#e issue as to t#e propriety o& allo,in" a claim &or puniti(e dama"es to ,omen ,#o ,ere alle"edly

II

inDured by t#e Dalkon 3#ield intrauterine de(ice !<D ,it#in t#e conte;t o& a C#apter == proceedin"$ A$?$ 4obins company en"a"es in t#e researc#' de(elopment' manu&acture and marketin" o& p#armaceuticals and consumer products$ T#ey ac+uired t#e e;clusi(e ri"#ts to t#e !<D$ Alt#ou"# t#e !<D ,as in(ented and marketed as t#e ne,est' sa&est met#od o& birt# control &or ,omen' its use resulted in bot# sli"#t and serious inDuries to many users$ Commencin" =>J= t#e inDured parties be"an to &ile claims a"ainst t#e company &or bot# compensatory and puniti(e dama"es$ K#en t#e issue o& puniti(e dama"es &irst arose' t#e parties disa"reed o(er ,#et#er puniti(e dama"es s#ould be allo,ed in t#is C#apter == =$ T9e Dal-on S9ield Clai5ant+ Co55ittee. ar"ued t#at claimants s#ould be able to reco(er puniti(e dama"es &rom 4obins based on t#e companyWs #istory o& e"re"ious conduct$ C$ T9e Co55ittee 8or Future Tort Clai5ant+. ar"ued t#at ,#ile puniti(es are allo,able' t#ey s#ould' ne(ert#eless' be subordinated to all ot#er "eneral unsecured claims$ I$ T9e O88icial Co55ittee o8 Un+ecured Creditor+. t#ey present t#ree alternati(es =. T#ey ar"ue t#at FH0C-b.-=. proscribes t#e a,ard o& puniti(e dama"es because suc# an a,ard ,ould be contrary to t#e la,s o& some 3tates$ Basically t#e ar"ument is t#at t#ere is not le"itimate purpose t#at can any lon"er be ser(ed by t#e a,ard o& puniti(e dama"es$ C. T#e Court #as t#e po,er to disallo, puniti(e dama"es under t#e "eneral e+uity po,ers' and since suc# a a,ard ,ould preclude a success&ul reor"anization' t#ey s#ould be disallo,ed$ I. !& puniti(e dama"es are not disallo,ed' t#ey s#ould as a minimum be subordinated to all ot#er "eneral unsecured claims pursuant to FH=0-c.$ P$ T9e O88icial Co55ittee o8 E>uit6 Securit6 Holder+ ! Ro,in+ 'de,tor(. t#ey bot# ar"ue &or t#e disallo,ance o& claims$ T#ey ar"ue similar positions as t#e pre(ious$ Arguments of the Court 0.istrict Court of 3irginia1 =$ About t#e &irst ar"ument o& t#e <nsecured Creditors' t#e Court &inds t#at its position is premised on assumptions t#at are not properly assumable$ T#ey assume t#at an a,ard &or puniti(e dama"es #as only t,o purposes =. to punis# t#e de&endant' and C. to deter &uture ,ron"doin"$ T#is premise &ollo,s t#e maDority (ie, &or a,ardin" puniti(e dama"es' but t#ere are still a minority o& 3tates t#at ascribe to a di&&erent p#ilosop#y' &or e;ample compensatory purposes' reco(ery o& attorney &ee$ T#us' ,#ile t#e <nsecured CreditorsW application o& FH0C-b.-=. mi"#t Dusti&y t#e disallo,ance o& puniti(e dama"es in some 3tates' it certainly IP

C$

I$

a. b. c. d. P$

,ould not Dusti&y disallo,ance in all states$ Moreo(er' t#e position on t#e <nsecured Creditors is #i"#ly contro(ersial' and #as not been endorsed and up#eld in any Durisdiction as a reason &or disallo,in"$ Accordin"ly' t#e re+uest &or disallo,ance o& t#e <nsecured Creditors ,ould be an in(itation to commit Dudicial error$ T#e Court declines t#at in(itation$ !n t#e past' bankruptcy courts #a(e resorted to t#eir e+uitable po,ers to determine ,#et#er a claim ,ill be allo,able$ T#e Court cites t#e cases$ !n 8epper ($ 2itton' t#e 3upreme Court #eld t#at in passin" on an allo,ance o& claims' t#e court sits as a court o& e+uity$ Conse+uently' t#e court #as &ar%reac#in" po,ers to Vsi&t t#e circumstances surroundin" any claim to see t#at inDustice or un&airness is not done in administration o& t#e bankrupt estate$V Most o& t#e ot#er opinions cited by t#e Court ,ere ,ritten in t#e earlier part o& t#e =>00s ,#en t#e Bankruptcy Acts ,as t#e controllin" rule o& la,$ But t#e Court says t#at t#e underlyin" principles o& t#ese cases are e+ually applicable to t#e present "o(ernin" la,' t#e Bankruptcy Code$ T#e e;traordinary ability o& a court to in(oke e+uity as not only a source o& remedial relie&' but also as a source o& Dudicial po,er' is as pre(alent under t#e Code as it ,as under t#e Act$ *+uity pro(ides t#e Court t#e po,er to disallo, puniti(e dama"es i& t#e Court determines t#at suc# an allo,ance ,ould &rustrate t#e success&ul reor"anization o& t#e company$ !n t#is case' as in any case' puniti(e dama"es cannot be estimated$ T#is unkno,n liability ,ould destroy t#e ability o& 4obins to reor"anize because t#e impossibility o& estimatin" a liability o& t#e company renders compliance ,it# numerous pro(isions o& t#e Bankruptcy Code (irtually impossible T#e presence o& puniti(e dama"es ,ould constitute t#e deat# knell o& any &easible reor"anization plan$ !n order to con&irm a plan' t#e court needs to determine its 8ea+i,ilit6. !t ,ould be similarly di&&icult &or t#e court to determine ,#et#er t#e Vbest interest o& creditorsV test o& F==C>-a.-J. #as been met$ !n t#e e(ent any class #as reDected t#e plan' ,#et#er t#e elements o& cramdo,n under F==C>-b.-C.-B. could #a(e been satis&ied$ T#e disclosure statement ,#ic# meets t#e Vade+uate in&ormation standardV o& section ==CH is not likely to be pro(ided to creditors$ T#e Court also re&uses t#e opinion t#at puniti(e dama"es s#ould not be disallo,ed but subordinated to ot#er unsecured claims$ K#ile subordination may' in some cases' ,ork as a solution to an ot#er,ise ine+uitable distribution o& assets' it ,ould not ser(e any suc# purpose in t#e instant case$ T#e problems t#at t#e Court ,ould &ace i& it ,ere to allo, an a,ard o& puniti(e dama"es' ,ould not be resol(ed t#rou"# a subordination$ IH

H$ Disallo,ance o& puniti(e dama"es protects t#ose ,omen ,#o #a(e su&&ered &rom t#e Dalkon 3#ield/ absent t#e loomin" spectre o& puniti(es' a trust #as been establis#ed ,#ic# ,ill i& mana"ed and maintained as contemplated by t#e Court as e;pressed in its opinion &indin" t#at t#e 8lan ,as &easible' pro(ide t#em &ull and &air compensatory relie&$ !& puniti(es ,ere allo,ed' compensation to t#e ,omen ,#o &iled t#e claims and to ot#er creditors o& t#e debtor ,ould be mani&estly Deopardized$ A$ 0or t#e abo(e reasons t#e Court &inds it imperati(e to disallo, all puniti(e dama"e claims in t#e bankruptcy$ Notes: !n 4obins' t#e reor"anization plan proposed a @J00 million distribution to 3?$ !t is possible t#at disallo,ance o& claims &or puniti(e dama"es bene&ited not ot#er creditors' but t#e 3?$ Because 3? controlled t#e &irm ,#ile it sold t#e Dalkon 3#ield' one could ar"ue t#at t#e 3? s#ould #a(e borne t#e burden o& t#e puniti(e dama"es' ,#ic# are desi"ned to discoura"e a partyWs irresponsible be#a(ior$ Notes from class: T#e company #ere ,as "eneratin" su&&icient income$ T#e problem is t#e e;posure to puniti(e dama"es$ T#e 8ro&essor notes t#at t#e Court in t#is case decided to disallo, under t#e ar"ument t#at puniti(e dama"es are (ery di&&icult to estimate' but ,#y canWt ,e say t#e same t#in" about compensatory dama"esL T#e reason is t#at in puniti(e dama"es t#ere are no standards' ,#ile t#ere are some in compensatory dama"es -&or e;ample' t#e medical bills' etc$.$ !n t#e tatefarm case' t#e Court said t#at t#e puniti(e dama"es could only be a one di"it ratio o& compensatory dama"es$ T#is comes &rom t#e due process clause$ T#e idea in t#is case is t#at t#ey are "oin" to compensate e(erybody and in t#e end i& t#ere is any money le&t t#en t#ey ,ill distribute t#e le&t%o(ers as puniti(e dama"es$ But in reality' trust &unds almost al,ays run out o& money' so in reality disallo,in" t#e puniti(e dama"es and sendin" t#em to t#e back o& t#e line is t#e same as sayin" t#at t#ey ,ill not "et paid at all$ C. ecured Claims 8ut simply' secured credit is a loan supported by a contin"ent property interest$ Outside o& bankruptcy' de&ault on t#e loan satis&ies t#e

IA

contin"ency and tri""ers t#e creditorWs ri"#t to take t#e property t#e debtor #as pled"ed as collateral$ T#e creditor t#en conducts a &oreclosure sale$ !& t#e proceeds &rom t#e sale are less t#an t#e outstandin" loan' t#e creditor maintains a claim a"ainst t#e debtor &or t#e de&iciency$ 3ection HHP allo,s t#e bankruptcy trustee to a,andon collateral' t#ereby permittin" a secured creditor to take t#e assets by &oreclosin" under state la,$ T#e secured creditor may participate in t#e bankruptcy proceedin"s &or t#e di&&erence bet,een t#e amount realized on &oreclosure and t#e amount o,ed$ <nless t#e secured creditor a"rees ot#er,ise at t#e time o& t#e loan' t#at creditor possesses all t#e ri"#ts o& an unsecured creditor$ Collateral "i(es a creditor e;tra ri"#ts$ !& t#e trustee doesnWt ,ant to abandon t#e collateral' #e may intend t#e debtor to keep t#e property as part o& t#e reor"anization$ !n t#is case' bankruptcy la, pro(ides a procedure t#at substitutes &or a &oreclosure saleWs (aluation o& property$ 3ection H0A-a. o& t#e Code instructs t#e bankruptcy court to (alue a creditorWs interest in t#e property and to desi"nate a creditorWs claim a Vsecured claim to t#e e;tent o& t#e (alue o& suc# creditorWs interest$V Any remainin" claim amount is desi"nated an Vunsecured claimV$ T#e Bankruptcy Code treats t#e portion o& a claim subDect to +eto88 ri:9t as a secured claim and t#e balance as an unsecured claim$ T#ou"# strai"#t&or,ard on its &ace' t#is "eneral description o& t#e claim bi&urcation process belies its real ,orld comple;ity$ A court must decide #o, to (alue t#e collateral$ T#at is not a simple task$ Associates Commercial Cor!. v ,ash T#is case deals ,it# an indi(idual debtor ,#o &iles a bankruptcy petition under C#apter =I' but t#e Code pro(ision in +uestion -FH0A-a.. applies e+ually in C#apter == reor"anizations$ 19'9: 4espondent 4as# purc#ased &or @JI'J00 a tractor trick to use in #is business$ ?e made a do,n payment and a"reed to pay t#e remainder in A0 mont#ly installments and pled"ed t#e trick as collateral on t#e unpaid balance$ T#e seller assi"ned t#e loan and its lien to Associates Commercial Corporation ACC$

IJ

4a% 199): 4espondent &iled &or bankruptcy under C#apter =I$ At t#is time t#e balance o,ed to ACC on t#e truck ,as @P='=J=$ ACC ,as listed as a creditor #oldin" a secured claim$ To +uali&y t#e con&irmation under C#apter =I' t#e plan #as to satis&y t#e re+uirements set &ort# in F=ICH-a.-H.$ <nder t#is pro(ision' a planWs proposed treatment o& secured claims can be con&irmed i& one o& t#ree conditions is satis&ied a. T#e secured creditor accepts t#e plan' b. T#e debtor surrenders t#e property securin" t#e claim to t#e creditor' c. T#e debtor in(okes t#e Vcramdo,nV po,er$ <nder t#is po,er' t#e debtor is permitted to keep t#e property o(er t#e obDection o& t#e creditor/ t#e creditor retains t#e lien securin" t#e claim' and t#e debtor is re+uired to pro(ide t#e creditor ,it# payments' o(er t#e li&e o& t#e plan' t#at ,ill total t#e present (alue o& t#e allo,ed secured claim -t#e present (alue o& t#e collateral.$ T#e (alue o& t#e allo,ed secured claim is "o(erned by FH0A-a.$ 4as# in(oked t#e cramdo,n po,er$ 4as#Ws plan said t#at t#e present (alue o& t#e truck ,as @C8'H00$ ACC obDected to t#e plan and asked t#e bankruptcy court to li&t t#e automatic stay so ACC could repossess t#e truck$ ACC also &iled a proo& o& claim alle"in" t#at its claim ,as &ully secured in t#e amount o& @P='=J=$ 4as# &iled an obDection to t#e ACC claim$ T#e bankruptcy court #eld an e(identiary #earin" ,#ere a. ACC. maintained t#at t#e proper (aluation ,as t#e price t#at 4as# ,ould #a(e to pay to purc#ase a like (e#icle -an e;pert estimated to be @P='000.$ b. Ra+9. maintained t#at t#e proper (aluation ,as t#e net amount ACC ,ould realize upon &oreclosure and sale o& t#e collateral -amount estimated to be @I='8JH.$ T#e bankruptcy court a"reed ,it# 4as#' t#en t#e Court o& Appeals o& t#e 0i&t# Circuit re(ersed' but on re#earin" en banc t#e 0i&t# Circuit a&&irmed t#e district courtWs decision limitin" t#e claim to @I='8JH$ T#e Bankruptcy Code pro(ision central to t#e resolution o& t#is case is FH0A-a.$ T#e 3upreme Court decided t#at in case o& cramdo,n' t#e (alue o& t#e property -and t#us t#e amount o& t#e secured claim under FH0A-a. is t#e price a ,illin" buyer in t#e debtorWs trade' business or situation ,ould pay to obtain like property &rom a ,illin" seller$ Arguments of the u!reme Court: =$ 4eDectin" t#e replacement%(alue standard' and selectin" instead t#e typically lo,er &oreclosure%(alue standard' t#e 0i&t# Circuit I8

C$

I$

P$

H$

A$

trained its attention on t#e &irst sentence o& FH0A-a.$ But t#e 3upreme Court does not &ind in t#e ,ords Vt#e creditorWs interest in t#e estateWs interest in suc# propertyV t#e &oreclosure%(alue meanin" ad(anced by t#e 0i&t# Circuit$ T#at p#rase reco"nizes t#at a court may encounter' and in suc# instances must e(aluate' limited or partial interests in collateral$ !t Dust says t#e court ,#at it must e(aluate' but it doesnWt say more$ !t is not enli"#tenin" on #o, to (alue t#e collateral$ T#e second sentence o& FH0A-a. does speak to t#e #o, +uestion Vsuc# (alueV' t#e sentence pro(ides' Vs#all be determined in li"#t o& t#e purpose o& t#e (aluation and o& t#e proposed disposition or use o& suc# propertyV$ As t#e Court compre#ends FH0A-a.' t#e Vproposed disposition or useV o& t#e collateral is o& paramount importance to t#e (aluation +uestion$ Applyin" a &oreclosure%(alue standard ,#en t#e cramdo,n option is in(oked attributes no si"ni&icance to t#e di&&erent conse+uences o& t#e debtorWs c#oice to surrender t#e property or retain it$ A replacement%(alue standard' on t#e ot#er #and' distin"uis#es retention &rom surrender and renders meanin"&ul t#e key ,ords Vdisposition or useV$ !& a debtor keeps t#e property and continues to use it' t#e creditor obtains at once neit#er t#e property not its (alue and is e;posed to double risks T#e debtor may a"ain de&ault and t#e property may deteriorate &rom e;tended use$ AdDustments in t#e interest rate and secured creditor demands &or more Vade+uate protectionV' do not &ully o&&set t#ese risks$ O& prime si"ni&icance' t#e replacement%(alue standard accurately "au"es t#e debtorWs use o& property$ T#e debtor in t#is case elected to use t#e collateral to "enerate an income stream$ T#at actual use' rat#er t#an a &oreclosure sale t#at ,ill not take place' is t#e proper "uide under a prescription #in"ed to t#e propertyWs Vdisposition or useV$ T#e 0i&t# Circuit considered t#e replacement%(alue standard disrespect&ul to state la,' ,#ic# permits t#e secured creditor to sell t#e collateral' t#ereby obtainin" its net &oreclosure (alue and not#in" more$ !n allo,in" debtors to retain and use collateral o(er t#e obDection o& secured creditors' t#e Bankruptcy Code #as res#aped debtor and creditor ri"#ts in marked departure &rom state la,$ T#at c#an"e' ordered by &ederal la,' is attended by a direction t#at courts look to t#e Vproposed disposition or useV o& t#e collateral in determinin" its (alue$ T#e 3upreme Court is not persuaded t#at t#e split%t#e%di&&erence approac# adopted by t#e 3e(ent# Circuit$ K#ate(er t#e attracti(eness o& a standard t#at picks t#e midpoint bet,een &oreclosure and replacement (alues' t#ere is no ,arrant &or it in t#e Code$ I>

J$ !n sum' under FH0A-a.' t#e (alue o& property retained because t#e debtor #as e;ercised t#e F=ICH-a.-H.-B. cramdo,n option is t#e cost t#e debtor ,ould incur to obtain a like asset &or t#e same proposed use$ $ustice tevens& .issenting T#e dissentin" Dud"e t#inks t#e te;t points to &oreclosure as t#e proper met#od o& (aluation in t#is case$ T#e lan"ua"e o& t#e &irst sentence o& FH0A-a. su""ests t#at t#e (alue s#ould be determined &rom t#e creditorWs perspecti(e -,#at t#e collateral is ,ort#' on t#e open market' in t#e creditorWs #ands.$ T#e second sentence talks about t#e Vpurpose o& t#e (aluationV is to put t#e creditor in t#e same s#oes as i& #e ,ere able to e;ercise #is lien and &oreclose$ !t is crucial to keep in mind t#at FH0A-a. is a VutilityV pro(ision t#at operates in many di&&erent conte;ts t#rou"# out t#e Bankruptcy Code$ !n t#is conte;t' t#e dissentin" Dud"e t#inks t#e &oreclosure standard best comports ,it# economic reality$ Allo,in" any more t#an t#e &oreclosure (alue simply "rants a "eneral ,ind&all to undersecured creditors at t#e e;pense o& unsecured creditors$ Notes: !n essence' t#e 4as# Court #as to decide ,#et#er (alue in FH0A-a. means (alue to t#e debtor or (alue to t#e creditor$ T#e tractor truck likely #ad no subDecti(e (alue to t#e debtor' so t#e (alue o& t#e collateral to t#e debtor ,as simply t#e debtorWs cost o& replacement' presumably a retail price$ T#e (alue o& t#e collateral to t#e creditor is t#e amount t#e creditor ,ould recei(e in a &oreclosure sale' presumably a lo,er' ,#olesale price$ As a matter o& policy' Gustice 3te(ens belie(es t#at bankruptcy s#ould not en#ance a secured creditorWs position$ ?e t#us concludes in dissent t#at t#e purpose o& a FH0A-a. (aluation is to Vput t#e creditor in t#e same s#oes$$$V T#e C00H Bankruptcy Act codi&ies and clari&ies t#e opinion in 4as#$ T#e ne, lan"ua"e applies narro,ly and does not address a corporate debtor or any debtor in C#apter == and does not apply to real property$ !n t#e book t#ere are some notes on t#e Till decision about (aluation o& t#e collateral$ ! am not "oin" to copy t#at discussion777 2. Pro;ert6 o8 t9e E+tate

P0

A bankruptcy process re+uires bot# &i;in" t#e (alue o& claims o& t#e creditors and assemblin" t#e assets a(ailable &or distribution to t#ese creditors$ T#e task o& determinin" ,#at assets are a(ailable &or claimants %identi&yin" Vproperty o& t#e estateV%be"ins by identi&yin" t#e property interests o& t#e debtor t#at become property o& t#e estate$ Ke must &ocus #ere on property t#at t#e estate deri(es t#rou"# t#e trusteeWs ability to assert t#e ri"#ts o& t#e debtor$ A. 5he .e/tor6s "state T#e assembled assets o& t#e debtor &orm ,#at is called an e+tate. <nder Bankruptcy Code FHP=-a.-=. t#is estate comprises all Vle"al or e+uitable interests o& t#e debtor property as o& t#e commencement o& t#e caseV$ T#e estate also includes all o& DebtorWs intan"ible property' includin" t#e accounts recei(able' as ,ell as ,#ate(er patents' trade secrets and copyri"#ts Debtor mi"#t o,n$ !n addition' t#e estate includes any proceeds or o&&sprin" &rom property o& t#e estate$ As a &irst appro;imation' t#en' t#e estate is simply any ri"#t t#e debtor enDoys t#at #as (alue in t#e debtorWs #ands at t#e time o& t#e commencement o& t#e case$ T#ere are some important +uali&ications ,#en t#e debtor is an indi(idual$ ! am not "oin" to ,rite t#ese do,n' but t#ere indeed some Ve;empt propertyV$ Creditors can look to all o& a corporationWs &uture earnin"s$ !& ,e are dealin" ,it# a corporation' t#e creditors are entitled to ,#ate(er t#e debtor #as' includin" &uture income$ FHP= lets t#e trustee sell t#e debtorWs e+uipment' collect money o,ed to t#e debtor' and brin" t#e la,suits t#e debtor #as a"ainst t#ird parties &or t#e bene&it o& t#e "eneral creditors$ T#e reason is clear T#e creditors t#emsel(es could #a(e reac#ed t#ese assets i& t#e bankruptcy proceedin" #ad ne(er started$ T#ey could #a(e resort to indi(idual met#ods o& debt collection$ T#ere is not#in" about t#e bankruptcy process t#at Dusti&ies limitin" t#e trusteeWs ri"#t to reac# t#ese assets$ ?ence t#ey become property o& t#e estate$ T#e debtorWs ri"#ts de&ine t#e outer limit o& ,#at a trustee can claim under FHPC-a.-=.$ !& t#e debtor #olds interests in property' t#en t#e estate includes t#ose interests' but no more$ T#e debtorWs property ri"#ts do not increase by #appenstance o& bankruptcy$ Anot#er ,ay to concei(e o& property o& t#e estate under FHP= is to ima"ine t#at t#e estate includes property in ,#ic# t#e debtor #as an interest' but subDect to all limitations t#at are applicable outside o& bankruptcy$ T#is idea rests at t#e &oundation o& bankruptcy la, and ,as de&initely set out in C#ica"o Board o& Trade ($ Go#nson$ T#e principle establis#ed in P=

C#ica"o Board o& Trade can be seen as a (ariant o& t#e *utner principle$ 8roperty can also be brou"#t to t#e estate' not by (irtue o& t#e debtorWs ri"#ts' but by (irtue o& t#e trusteeWs a0oidance ;o1er+. T#e a(oidance po,ers are cra&ted to e;pand t#e pools o& assets a(ailable to creditors' ,#ile at t#e same #onorin" t#e *utner principle$ T#e a(oidin" po,ers translate indi(idual creditor ri"#ts to t#e bankruptcy &orum and' in process' may brin" additional property into t#e bankruptcy estate$ 3ee FHP=-a.-I. or -P.$ 3ection HP=-a. contains additional miscellaneous pro(isions &or ot#er au"mentations o& t#e bankruptcy estate #3*$'a('?(. brin"s into t#e estate speci&ied interest o& t#e debtor or t#e debtorWs spouse in community property$ #3*$'a('3(. brin"s into t#e estate speci&ied property ac+uired by an indi(idual on account o& anot#erWs deat# or a settlement bet,een t#e debtor and t#e debtorWs spouse$ #3*$'a('=(. brin"s into t#e estate property "enerated by ot#er property o& t#e estate$ 3ection HP=-c.-=. brin"s property into t#e estate not,it#standin" limitations on t#e debtorWs interests tri""ered by t#e debtorWs bankruptcy' insol(ency or ,eak &inancial condition$ T#ere are +tatutor6 e<clu+ion+ to ;ro;ert6 o8 t9e e+tate ' most reside in t#e e;press pro(isions o& FHP=-b.$ Our primary &ocus #ere is on t#e &irst o& t#e trusteeWs estate buildin" tools #3*$'a('$(. Notes from class: All interests o& t#e debtor become property o& t#e estate' so any ri"#t t#at #as (alue in t#e debtorWs #ands is considered part o& t#e debtorWs estate$ Ke are talkin" about intere+t o& t#e debtor in property$ -n ,e 753 teel Com!an%& -nc. !n 2TS' t#e debtor steel corporation created a special subsidiary ,it# a sin"le purpose' to &acilitate ,#at #as become kno,n as structured &inance$ !n a typical structured &inance arran"ement' t#e debtor trans&ers to a subsidiary t#e debtorWs in(entory or recei(ables' t#e #as t#e subsidiary borro,' on a secured basis' &rom a bank t#at becomes t#e subsidiaryWs only creditor$ T#e debtor #as t#e subsidiary distribute

PC

t#e debtor t#e loan proceeds' ,#ic# t#e debtor uses in its operations$ T#e transaction structures as a sale' is desi"ned to be Vbankruptcy remoteV$ T#at is' t#e lender is able to realize on t#e in(entory and recei(ables e(en in t#e e(ent t#at t#e debtor &iles &or bankruptcy$ T#e automatic stay does not apply' as t#e in(entory no lon"er belon"s to t#e debtor %at least is t#e transaction is deemed a true sale% and t#e subsidiary ne(er &iles &or bankruptcy$ 2TS raises t#e +uestion o& ,#et#er bankruptcy la, s#ould upset suc# structures$ Debtor is one o& t#e lar"est manu&acturers o& ,#olly%inte"rated steel products in t#e <nited 3tates$ T#e current contro(ersy stems &rom a series o& &inancial transactions t#at Debtor e;ecuted a&ter its pre(ious reor"anization$ T#e transactions in +uestion are kno,n as asset% backed securitization or structured &inancin" -AB3. and are "enerally desi"ned to permit a debtor to borro, &unds at a reduced cost in e;c#an"e &or a lender securin" t#e loan ,it# assets t#at are trans&erred &rom t#e borro,er to anot#er entity$ 2ike t#is' t#e lender #opes to ensure t#at its collateral ,ill be e;cluded &rom t#e borro,erWs bankruptcy estate in t#e e(ent t#at t#e borro,er &iles a bankruptcy petition$

PI

.ecem/er )9&)888: T#e debtor &iled a motion seekin" an interim order permittin" it to use cas# collateral$ T#is cas# collateral consisted o& t#e recei(ables t#at are ostensible o,ned by 3ales 0inance$ Debtors stated to t#e Court t#at it ,ould be &orced to s#ut its doors and cease operations i& it did not recei(e aut#orization to use t#is cas# collateral$ !nterim aut#orization ,as "ranted' ,it# Abbey 1ational to recei(e as substitute collateral ne,ly "enerated in(entory and recei(ables$ Arguments of A//e% National: =$ Abbey 1ational ar"ues t#at t#e interim cas# collateral order s#ould be modi&ied because t#ere is no basis &or t#e court to determine t#at t#e recei(ables ,#ic# AbbeyWs collateral are property o& t#e DebtorWs estate$ C$ Abbey contends t#at t#e interim order is &la,ed because' on its &ace' t#e transaction is c#aracterized as a true sale$ T#ere&ore' t#e debtor #as no interest in t#e recei(ables and t#ey are not property o& t#e estate$ Arguments of the Court: =$ To su""est t#at debtor lacks some o,ners#ip interest in products t#at it creates ,it# its o,n labor' as ,ell as t#e proceeds to be deri(ed &rom t#at labor' is di&&icult to accept$ Accordin"ly' t#e court concludes t#at debtor #as at least some e+uitable interest in t#e in(entory and recei(ables' and t#at t#is interest is property o& t#e debtorWs estate$ T#is e+uitable interest is su&&icient to support t#e entry o& t#e interim cas# collateral order$ C$ !t is readily apparent t#at "rantin" Abbey relie& &rom t#e interim cas# collateral order ,ould be #i"#ly ine+uitable$ T#e order is necessary to keep t#e debtorWs doors open and continue to meets its obli"ations to its employees' retirees' customers and creditors$ Allo,in" Abbey to modi&y t#e order ,ould also allo, it to en&orce its state la, ri"#ts as secured creditor$ T#is ,ould put an immediate end to t#e debtorWs business' put t#ousands o& people out o& ,ork' depri(e =0'000 retirees &rom medical bene&its and #a(e more &ar reac#in" economic e&&ects on t#e "eo"rap#ic areas ,#ere t#e debtor does businesses$ I$ Maintainin" t#e current status +uo permits Debtor to remain in business ,#ile it searc#es &or substitute &inancin"' and ade+uately protects and preser(es Abbey 1ationalWs ri"#ts$ T#e e+uities o& t#is situation #i"#ly &a(or Debtor$ As a result' t#e court declines to e;ercise its discretion to modi&y t#e interim order$ Notes:

PP

 K#ate(er one t#inks about t#e substanti(e outcome o& 2TS' t#e court is (alidly concerned t#at t#e &ormality o& structured &inance not "i(e a secured creditor "reater ri"#ts t#an it ,ould #a(e under ordinary circumstances$ T#at is' one mi"#t ,ell ar"ue t#at t#e economics o& secured lendin" rat#er t#an t#e corporate structure o& t#e debtor and its a&&iliates s#ould determine ,#et#er collateral is property o& t#e estate$ T#ere is a connection bet,een C#ase Man#attan Bank -Mar(el Comics. and 2TS$ !n Mar(el' t#e court ,arned t#at e; ante contractual arran"ements bet,een debtor and t#ird parties ,ould not be permitted to inter&ere ,it# t#e re#abilitation o& t#e debtor$ 2TS ec#oes t#is concern$ T#is said' t#e con&lict bet,een D!8 and a secured creditor may occur less &re+uently no,' "i(en t#e increasin" incidence o& secured creditor control o& t#e bankruptcy process$ Notes from class: T#e idea be#ind structured &inancin" is to keep t#e accounts recei(ables out o& bankruptcy$ 1ote t#at t#e debtor &iled in O#io' ,#ere t#e #ead+uarters o& t#e company are located$ <sually 1e, Bork or Dela,are are better places to &ile &or bankruptcy' so ,#y c#oosin" O#ioL T#is is a strate"ic mo(e &rom t#e debtor' because it is usin" t#e ar"ument o& t#reatenin" to s#ut do,n operations in O#io$ But t#e t#reat ,as not t#e reason ,#y t#e Court ruled in &a(or o& t#e debtor$ T#e Court uses t#e labor t#eory o& property$ !t is used to de&ine ,#at property o& t#e estate is$ T#e 8ro&essor t#inks t#is is an absurd ar"ument but t#e Court uses it Dust because t#ere is a t#reat$ But t#e 8ro&essor t#inks t#e case is ,ell decided' #e Dust t#inks it ,ould be possible to reac# to t#e same conclusion ,it#out usin" a NS!! century ridiculous ar"ument$ A cleaner ar"ument #ere ,ould be t#at t#is is not a true sale$ <sually t#at is t#e ,ay t#ese cases are liti"ated$ 4ead t#e last note o& t#e book a&ter t#e decision -! copied t#e note. T#e 8ro&essor says t#at t#is note is entirely true' because t#ese days e(eryt#in" is about control o(er t#e case$ *. -!so 9acto Clauses FHP=-c.-=.-B.' commonly kno,n as @anti4i;+o48acto clau+e@ ;ro0i+ion' applies ,#ere' but &or t#e pro(ision' bankruptcy' insol(ency or &inancial distress s#ort o& insol(ency ,ould Vipso &actoV modi&y %includin" t#rou"# &or&eiture or termination% a debtorWs interest in

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property$ !pso &acto clauses allo, indi(idual creditors to e(ade bankruptcyWs collecti(e process$ Conse+uently' Con"ress dra&ted FHP=-c.-=.-B. e&&ecti(ely to disallo, any modi&ication o& a debtorWs interest in property is suc# modi&ication applies not "enerally' but only ,#en bankruptcy or anot#er process &or t#e distribution o& a debtorWs assets occurs or seems imminent$ T#e pro#ibition o& ipso &acto clauses does not necessaril% #onor non% bankruptcy ri"#ts$ !t is one t#in" to say t#at an ipso &acto clause cannot remo(e property &rom t#e bankruptcy process/ it is anot#er to say t#at t#e ri"#ts contained in t#ose clauses are unen&orceable$ 3ection HP=-c.-=. certainly says t#e &ormer$ !t may also say t#e latter$ T#e aut#or t#en "i(es an e;ample usin" t#e MG T K case$ ! do not understand (ery ,ell but t#e conclusion is VCourts do not separate t#e ri"#t immediately to en&orce an ipso &acto clause &rom t#e ri"#t ultimately to bene&it &rom t#at clause$ !nstead' courts reac# all%or%not#in" decisions$ *it#er a clause is a (iolation o& t#e ipso &acto pro#ibition and it is ,#olly nulli&ied' or it is not a (iolation and t#e property it a&&ects ne(er comes into t#e estate$ -n ,e. 7. 7ou Allen T#e debtor is a motor carrier t#at is no lon"er in business but #as claims a"ainst its costumers based on underc#ar"es &rom past ser(ices$ T#e debtor is subDect to t#e 1e"otiated 4ates Act 14A' ,#ic# disallo,s underc#ar"e claims by carriers t#at #a(e ceased operations$ T#us' t#e condition o& &or&eiture is not bankruptcy' insol(ency' or ,eak &inancial condition' but it is ar"uably a pro;y &or one t#ese conditions$ T#e Court must decide ,#et#er FHP=-c.-=.-B. pro#ibits t#e 14AWs disallo,ance o& underc#ar"es$ T#e 14A is a &ederal la,$ But FHP=-c.-=. -B. operates ,it# respect to all applicable non%bankruptcy la,$ 0or t#e rele(ant discussion' t#e Court assumes t#at Con"ress did not intend t#e 14A to supersede t#e Bankruptcy Code$ T#e plainti&& 2$ 2ou Allen' trustee on be#al& o& t#e bankruptcy estate o& T3C *;press Co$' seeks to reco(er &rei"#t c#ar"es &or transportation ser(ices pro(ided to t#e De&endant K4!$ 4a% 1:& 1991: T3C &iled &or bankruptcy under C#apter J$ T3C ,as a motor common carrier truckin" company$ T#e company #ad acti(ities intrastate under t#e 5eor"ia 2a, and interstate pursuant to t#e !nterstate Commerce Act$ Once t#e company in bankruptcy t#e trustee contracted au audit o& all T3C &rei"#t bills in order to determine t#e

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di&&erence bet,een t#e rates &iled by T3C to t#e commission P -re&erred to as tari&&. and t#e rates t#at T3C #ad ne"otiated and billed K4!$ Based on t#e audit results' t#e trustee billed K4! @=C'C>> &or underc#ar"es$ K4! #as re&used to pay$ T#e trustee no, seeks to reco(er t#e underc#ar"es' pre%Dud"ment interests o& @C'>I> and any ot#er costs$ !n =>>I t#e 14A establis#ed t#at V!t s#all be an unreasonable practice &or a motor carrier to attempt to c#ar"e or to c#ar"e &or a transportation ser(ice$$$t#e di&&erence bet,een t#e applicable rate t#at is la,&ully in e&&ect pursuant to a tari&&$$$and t#e ne"otiated rate &or suc# transportation ser(ice i& t#e carrier$$$is no lon"er transportin" propertyV$ Arguments of the 5rustee: =$ T#e trustee ar"ues t#at t#e 14A nulli&ies FHP=-c.-=.-B.$$$read$$$ Arguments of the Court: =$ T#e 14A does not con&lict ,it# FHP= as it is not tri""ered by t#e &inancial condition o& t#e debtor' an essential and necessary condition o& FHP=-c.-=.-B.$ T#e 14A applies ,#en a carrier is no lon"er transportin" property$ T#is criterion is separate and distinct &rom a re+uirement t#at depends on t#e &inancial status o& t#e debtor$ T#e essential distinction is t#at t#e &orces o& t#e marketplace and t#e incenti(e to maintain "ood business relations ,ill restrain operatin" carriers &rom makin" un&ounded or tenuous underc#ar"e claims' but t#ere is no suc# c#eck on nonoperatin" carriers$ C$ T#e &inancial condition o& t#e debtor is only one reason ,#y a motor carrier may cease transportin" property$ T#e 14A ,ould apply in (arious ot#er circumstances' includin" ,#en a con"lomerate decides to lea(e t#e motor common carrier industry or ,#en t#e o,ner o& a company decides to retire and close up s#op$ I$ T#e 14A ,ould not apply to a motor common carrier in bankruptcy and still transportin" property$ T#e 14A does not contain t#e p#rase V&inancial conditionV or any similar p#rase$ Alt#ou"# t#e 14A is applicable non%bankruptcy la,' it is not conditioned on t#e &inancial condition o& t#e debtor$ T#ere&ore t#e 14A does not (iolate FHP=-c.-=.-B.$ Notes:

4e&ers to t#e !nterstate Commerce Commission .

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 T#e court did not treat FHP=-c.-=. as merely a pro(ision to pre(ent a contractual or le"islati(e opt out o& t#e bankruptcy process$ !nstead' t#e court applied FHP=-c.-=. as a pro(ision t#at' i& applicable at all' can substanti(ely alter non%bankruptcy entitlements$ T#is is an all%or%not#in" approac#$ One mi"#t ar"ue t#at a motor carrier t#at no lon"er transports property &or t#e purposes o& t#e 14A is a carrier ,it# altered &inancial condition &or t#e purposes o& FHP=-c.-=.$ K#en a carrier no lon"er recei(es re(enues' its &inancial condition is c#an"ed$ T#e Allen court ar"ued t#at &inancial condition cannot be read so broadly$ But an interpretation di&&erent to t#e one "i(en by t#e court is possible$ *(en i& some &inancially sound carriers ,ill cease operations' it seems more likely t#at most carriers ,#o do so ,ill #a(e &ailed economically$ And many o& t#ese &ailed carriers ,ill be &inancially burdened by debt' o&ten to t#e point o& insol(ency$ T#is means t#at' e;cept (ery &e, cases' t#e 14A may be seen as an indirect attempt to accomplis# ,#at in t#e courtWs (ie, is &orbidden by t#e Bankruptcy Code a modi&ication o& a debtorWs property ri"#ts based on t#e debtorWs &inancial crises$ Notes from class: T#e 8ro&essor is relatin" t#is case to Caho;ia .o+ns$ !n t#at case t#e pro(ision ,as not bankruptcy speci&ic pro(ision$ ?ere it is not a bankruptcy speci&ic pro(ision eit#er$ K#y is t#e result not t#e same in bot# casesL T#is is a black #at%,#ite #at case$ !n t#is case' t#e clause is neutral ,#en it comes to bankruptcy and t#e &acts o& t#e case do not su""est t#at t#e clause is intended to be used a"ainst t#e bankruptcy case$ !n Caho;ia' t#e clause itsel& ,as also neutral but t#e &acts o& t#e case lead t#e court to t#ink t#at t#e insurance company ,as in reality takin" into consideration t#e bankruptcy o& t#e debtor$ 2I. E<ecutor6 Contract+ A. *ac;ground !n t#e pre(ious c#apters ,e #a(e distin"uis#ed bet,een claims a"ainst t#e estate on t#e one #and and assets o& t#e estate on t#e ot#er$ !n t#is c#apter ,e look at somet#in" t#at is an asset and a liability simultaneously$ K#en a contract is e;ecutory' t#e debtor is obli"ed to a party and t#at party is obli"ed to t#e debtor$ 1eit#er party #as completed material per&ormance under t#e contract$

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T#ese contracts can be sorted into t,o types =$ Net a++et. T#e (alue o& t#e debtorWs asset is "reater t#an t#e associated liability$ C$ Net lia,ilit6. T#e liability e;ceeds t#e (alue o& t#e asset$ T#e Bankruptcy Code FIAH "o(erns e;ecutory contracts and une;pired leases to ,#ic# a debtor is party$ !n t#e main it ensures t#at bankruptcy #onors t#e nonbankruptcy ri"#ts o& bot# parties$ T#e &ormal process by ,#ic# t#e trustee takes ad(anta"e o& t#e &a(orable contract -and li(es up to t#e debtorWs obli"ations under t#e contract. is called a++u5;tion. K#en t#e trustee assumes t#e contract and brin"s it into t#e bankruptcy estate' t#e estate enDoys all t#e bene&its o& t#e contract' but bears t#e entire burden as ,ell$ As under FHP=-c.' t#e trustee under FIAH can brin" t#is asset into t#e estate e(en i& t#e contract &orbids t#e assi"nment or relie(es a party o& its obli"ation in case o& insol(ency o& t#e ot#er$ 3ection IAH parallels ,#at ,e #a(e seen be&ore ,#en t#e e;ecutory contract is a net liability as ,ell$ T#e trustee #as t#e ri"#t to breac# t#e contract' t#e breac# trans&orms t#e obli"ation into a claim &or money dama"es and t#us puts t#e party on t#e same &ootin" as t#e "eneral creditors$H T#is po,er to trans&orm net liability contracts into a dama"e claim by breac# is' in t#e lan"ua"e on t#e Bankruptcy Code t#e ability to reAect an e;ecutory contract$ T#e Bankruptcy Code de&ines neit#er Ee;ecutory contractM nor Eune;pired leaseM$ T#e &irst concept is more di&&icult to de&ine$ T#e Book and t#e maDority o& t#e decisions accept t#e de&inition "i(en by S*41 CO<1T4BMA1 Material per&ormance re+uired by bot# sides$ But se(eral courts #a(e su""ested t#at ,#ere t#e only per&ormance remainin" by t#e debtor is t#e payment o& money' t#ere can be no e;ecutory contract e(en i& t#e ot#er sideWs per&ormance is not completed eit#er$ T#ese courts rely on a statement &rom t#e le"islati(e #istory t#at an obli"ation on a note is not usually an e;ecutory contract but t#is ar"ument seems misplaced -2ubrizol *nterprises ($ 4ic#mond Metal 0inis#ers.$ Anot#er Dud"e' &or e;ample' decided t#at a contract ,as not e;ecutory because t#e c#aracterization o& t#e contract as e;ecutory ,ould not #a(e bene&ited t#e estate -!n 4e Boot#.$ "nerg% "nter!rises Cor!. v. #nited tates !n t#is bankruptcy matter' t#e T#ird Circuit must decide ,#et#er certain terms in a class action settlement a"reement constitute an
5

<nless t#e nonbankruptWs claim is some#o, secured$

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e;ecutory contract under FIAH$ T#e !nternal 4e(enue 3er(ice !43 contended t#at t#e settlement a"reement ,as not an e;ecutory contract$ Bot# t#e bankruptcy court and t#e district court a"reed ,it# t#e !43' and t#e class member appealed$ T#e T#ird Circuit a&&irms$ !n t#e back"round o& t#is case' t#ere is a class action bet,een producers o& natural "as and a corporation called TCO$ T#e class members alle"ed t#at TCO breac#ed t#eir "as purc#ase contracts by payin" less t#an t#e ma;imum price a&ter it in(oked a cost reco(ery clause$ On Gune =8' =>>= t#e parties entered into a settlement a"reement t#at re+uired TCO to deposit @I0 million into an escro, account Vin settlement o&' and as a &ull and complete disc#ar"e and release o& TCO' &or all o& t#e class membersW claims$ T#e @I0 million ,ere to be paid in t,o payments one on Marc# C=' =>>= -&or #al& t#at sum. and t#e ot#er one on Marc# CI' =>>C$ TCO paid t#e &irst @=H million on time but t#en &iled &or bankruptcy$ <nder t#e a"reement' class members ,ere entitled to recei(e t#eir s#are o& t#e money only a&ter t#ey e;ecuted a release o& claims and a supplemental contract$ By Guly I=' =>>= t#e class members #ad e;ecuted t#e release but on t#at day TCO &iled &or bankruptcy under C#apter ==$ TCO and t#e class members #ad a"reed t#at TCO ,ould assume t#e settlement a"reement under FIAH and Dointly &iled a proposed order$ A&ter notice o& t#e proposed order ,as sent to t#e proper parties t#e !43' one o& TCOWs creditors' &iled an obDection &indin" t#at t#e settlement a"reement ,as not an e;ecutory contract ,it#in t#e meanin" o& FIAH$ T#e bankruptcy court and t#e District Court o& Dela,are &ound t#at t#e contract ,as not e;ecutory$ Arguments of the Court of A!!eals of the 5hird Circuit: =$ T#e &irst t#in" t#at t#e Court notes is t#at t#e settlement is a contract Valt#ou"# settlement a"reements may be Dudicially appro(ed' t#ey s#are many c#aracteristics o& (oluntary contracts and are construed accordin" to traditional precepts o& contract construction$ !n a nonbankruptcy conte;t' a settlement a"reement is a contractV$ C$ T#e le"islati(e #istory su""ests a broad readin" o& Ve;ecutoryV to include contracts on ,#ic# per&ormance remains due to some e;tent on bot# sides$ I$ *;ecutory contracts is bankruptcy are best reco"nized as a combination o& assets and liabilities to t#e bankruptcy estate/ t#e per&ormance t#e nonbankrupt o,es t#e debtor constitutes an asset and t#e per&ormance t#e debtor o,es t#e nonbankrupt is a liability$ T#e debtor ,ill assume an e;ecutory contract ,#en t#e H0

P$

H$

A$ J$

8$ a.

packa"e o& assets and liabilities is a net asset to t#e estate$ K#en it is not' t#e debtor ,ill -or ou"#t to. reDect t#e contract$ Because assumption acts as a rene,ed acceptance o& t#e terms o& t#e e;ecutory bar"ain' t#e Bankruptcy Code pro(ides t#at t#e cost o& per&ormin" t#e debtorWs obli"ations is an administrati(e e;pense o& t#e estate$ T#rou"# t#e mec#anism o& assumption' FIAH allo,s t#e debtor to continue doin" business ,it# ot#er ,#o mi"#t ot#er,ise be reluctant to do so because o& t#e bankruptcy &ilin"$ 4eDection' is e+ui(alent to a nonbankruptcy breac#$ !n cases ,#ere t#e nonbankrupt party #as &ully per&ormed' it makes no sense to talk about assumption or reDection$ At t#at point only a liability e;ists &or t#e debtor -a simple claim #eld by t#e nonbankrupt a"ainst t#e estate.$ 2ike,ise i& t#e debtor #as &ully per&ormed' t#e per&ormance o,ed by t#e nonbankrupt is an asset o& t#e bankruptcy estate and s#ould be analyzed as suc#' and not as an e;ecutory contract$ 4eDection at t#is point is not di&&erent &rom abandonment o& property o& t#e estate$ T#ese consideration lead t#e Court to adopt t#e &ollo,in" de&inition An e;ecutory contract &or purposes o& FIAH is Va contract under ,#ic# t#e obli"ation o& bot# t#e bankrupt and t#e ot#er party to t#e contract are so &ar unper&ormed t#at t#e &ailure o& eit#er to complete per&ormance ,ould constitute a material breac# e;cusin" per&ormance o& t#e ot#er$V T#e time &or testin" ,#et#er t#ere are material unper&ormed obli"ations on bot# sides is ,#en t#e bankruptcy petition is &iled$ At stake in t#is case is t#e relati(e priority o& t#e claims o& t#e !43 and t#e class members to TCOWs assets in bankruptcy -administrati(e e;pense or "eneral unsecure claim.$ T#e contract ,as clearly e;ecutory on TCOWs side ,#en it &iled &or bankruptcy$ TCO #ad not paid &or @=H million and #ad ot#er administrati(e details -t#ese are ar"uably non%material' but t#e obli"ation to pay is un+uestionably a material obli"ation t#at is &ailed ,ould constitute breac#$ T#e materiality o& t#e class membersW unper&ormed obli"ations is a di&&erent +uestion$ T#ey #ad t,o obli"ations' and t#e Court e;plores t#em separately E<ecution o8 t9e relea+e+. T#e lan"ua"e o& t#e settlement a"reement makes clear t#e parties intended to make e;ecution o& t#e releases a condition o& payment rat#er t#an a duty$ Also' t#e parties speci&ied t#at t#e claims ,ould be e;tin"uis#ed by t#e court order acceptin" t#e a"reement$ T#us' t#e releases ser(ed no more t#an t#e administrati(e purpose o& a condition to t#e class membersW ability to "et payment &rom t#e escro, &und$ A class member ,#o &ailed to e;ecute t#e release ,ould not "et its s#are on t#e settlement &und' but TCO ,ould still "et t#e H=

bene&it o& t#e class memberWs inability to sustain a cause o& action$ T#is means t#at no &ailure to e;ecute t#e release could #a(e created a material breac#$ b. Co5;letion o8 Su;;le5ental Contract 8or Future a+ Sale+ to TCO. T#ese contracts ,ere desi"ned to take t#e terms o& t#e "lobal settlement a"reement created by t#e class and TCO and apply t#em speci&ically to eac# class member$ As suc# t#ey ,ere &unctionally ministerial duties' t#ey did not alter t#e relations#ip &or"ed by t#e settlement a"reement$ !n &act' t#e supplemental contracts ,ere more important to t#e class members t#at to TCO$ !t ,as unlikely t#at t#e parties intended t#at &ailure to e;ecute t#em ,ould be a breac# by t#e class members$ >$ An e;amination o& t#e purpose o& FIAH leads to t#e same result$ !& t#e contract ,ere to be considered e;ecutory' assumption ,ould "i(e a #i"# priority to t#e @=H million' but in return TCO ,ould "ain not#in" o& (alue t#e releases add no ri"#ts to t#e estate not already "i(en by t#e district courtWs order' and t#e supplements pro(ide only a mar"inal bene&it to TCO$ =0$ T#e Court &ound t#at t#e settlement ,as not e;ecutory$ *. Assum!tion An e;ecutory contract or une;pired lease t#at is &a(orable to t#e debtor is a net asset$ T#e bankruptcy trustee s#ould be able to preser(e suc# an asset$ 8reser(ation o& a net asset contract or lease is called Va++u5;tionV and it is e;plicitly permitted by FIAH-a.' subDect to court appro(al' is assumption is timely under FIAH-d. and complies ,it# ot#er speci&ied re+uirements suc# as t#e cure o8 de8ault+ as pro(ided by FIHA-b.$ T#e VcureV re+uirement may seem strai"#t&or,ard' but some breac#es are by nature VincurableV$ A literal interpretation o& t#e VcureV re+uirement could depri(e a debtor o& an opportunity to assume' e(en i& t#e debtor could pay dama"es &or t#e breac# and still pro&it &or t#e contract$ I5;ortant. 4ead 3ection /=3'c( t#at carries an odd limitation to t#e kind o& contracts t#at may be assumed$ 3ection IAH-c.-=. seems to establis# a #ypot#etical test T#e trustee may not assume an e;ecutory contract o(er t#e non%debtorWs obDection i& applicable la, ,ould bar assingment to a #ypot#etical t#ird party$ T#e limitation applies e(en ,#en t#e trustee #as no intention o& assi"nin" t#e contract in +uestion to any suc# t#ird party$ T#e lan"ua"e o& t#e section may lead to unintended results t#at are a"ainst bankruptcy policy$ Con"ress intended t#e lan"ua"e Vmay HC

not assumeV to protect indi(idual debtors &rom &orced labor &or t#e bene&it o& creditors$ T#e pro(ision sa&es indi(iduals &rom an a""ressi(e trustee$ T#e same lan"ua"e' #o,e(er' ,#en applied to a corporate debtor' depri(es t#e bankruptcy estate &rom a (aluable asset$ !n t#e case o& corporations' t#e unintended bene&iciary o& t#e rule is t#e non%debtor party t#at ,ill be released &rom its obli"ations because o& t#e #appenstance o& bankruptcy$ Anot#er problem arises 3ection /=3'8('$( allo,s t#e trustee to assi"n a contract not,it#standin" a pro(ision in t#e contract pro#ibitin" assi"nment or one in applicable la,$ Once t#e trustee assi"ns t#e contract' t#e assi"nee alone is liable &or breac#' e(en t#ou"# under state la, t#e assi"nor remains liable unless released by t#e ot#er party -3ee FIAH-k..$ T#e di&&iculty arises because' unlike FHP=' FIAH links assumption and assi"nment$ T#e e&&ect is to de&ine assumption too narro,ly and assi"nment too broadly$ K#en t#e trustee assumes a contract t#at is in de&ault' #e must cure de&aults or pro(ide ade+uate assurance o& cure' includin" compensation &or inDury' and pro(ide ade+uate assurance o& &uture per&ormances$ T#e trustee must also "i(e ade+uate assurances o& per&ormance ,#ene(er t#e contract is assi"ned' re"ardless o& ,#et#er t#ere #as been a de&ault$ <erlman v. Cata!ult "ntertainment& -nc. Appellant 8erlman licensed certain patents to appellee Catapult$ ?e no, seeks to bar Catapult' ,#ic# #as since become a C#apter == D!8' &rom assumin" t#e patent licenses as part o& its reor"anization$ T#e reor"anization plan' included a mer"er ,it# anot#er corporation M8CAT' lea(in" Catapult as t#e sur(i(in" entity$ As part o& t#e plan' Catapult &iled a motion ,it# t#e bankruptcy court seekin" to assume =P0 e;ecutory contracts and leases' includin" t#e 8erlman licenses$ T#e rele(ant part o& t#e statute in +uestion #ere is FIAH-c.-=. 4ead777 Arguments of the A!!ellant=<erlman: =$ 8erlman contends t#at Catapult cannot assume t#e licenses ,it#out its consent$ C$ 8erlman also contends t#at e(en i& Catapult ,ere entitled to assume t#e 8erlman licenses' FIHA-c.-=. also pro#ibits t#e assi"nment o& t#e 8erlman licenses to Mpat#' accomplis#ed by Catapult t#rou"# t#e contemplated M8CAT%Mpat# re(erse trian"ular mer"er$ Because t#e Court concluded t#at FIAH-c. HI

-=. bars Catapult &rom assumin" t#e 8erlman licenses' t#e court e;pressed no opinion re"ardin" ,#et#er t#e mer"er ,ould #a(e resulted in a pro#ibited Vassi"nmentV ,it#in t#e meanin" o& FIAH-c.-=.$ Arguments of the A!!ellee=Cata!ult: =$ !n CatapultWs (ie,' FIAH-c.-=. s#ould be interpreted as embodyin" t#e Vactual testV t#e statute bars assumption by t#e D!8 only ,#ere t#e reor"anization in +uestion results in t#e non%debtor actually #a(in" to accept per&ormance &rom a t#ird party$ T#e ar"uments supportin" t#is position can be di(ided into t#ree a. T#e literal readin" creates inconsistencies ,it#in FIAH$ b. T#e literal readin" is incompatible ,it# t#e le"islati(e #istory$ c. T#e literal readin" &lied in t#e &ace o& sound bankruptcy policy$ Arguments of the Court: =$ T#e Court "oes t#rou"# eac# o& CatapultWs ar"uments$ 4e"ardin" t#e &irst one %t#e potential con&lict bet,een -c.-=. and -&.-=. &or t#eir respecti(e treatments o& t#e p#rase Vapplicable la,V% t#e Court concludes t#at a literal readin" o& subsection -c.-=. does not ine(itably set it at odds ,it# subsection -&.-=.$ T#e Court e;plained t#at in determinin" ,#et#er Vapplicable la,V stands or &alls under FIAH-&.-=.' a court musk ask ,#y t#e Vapplicable la,V pro#ibits assi"nment$ Only i& t#e la, pro#ibits on t#e rationale is t#at t#e identity o& t#e contractin" party is material to t#e a"reement ,ill subsection -c.-=. rescue it$ -2ook in t#e notes section &or . C$ Catapult ne;t &ocuses on t#e internal structure o& FIAH-c.-=. t#at renders t#e p#rase Vor t#e debtor in possessionV super&luous$ T#e Court disa"rees ,it# t#is position$ T#e Court e;plains t#at by its terms' subsection -c.-=. addresses t,o di&&erent e(ents assumption and assi"nment$ Conse+uently' ,#en a nondebtor consents to t#e assumption' subsection -c. -=. ,ill #a(e to be applied a second time i& t#e D!8 ,is#es to assi"n t#e contract in +uestion$ I$ Catapult ne;t ar"ues t#at le"islati(e #istory re+uires disre"ard o& t#e plain lan"ua"e o& FIAH-c.-=.$ T#e Court doesnWt really resort to le"islati(e #istory because it discerns no ambi"uity in t#e plain statutory lan"ua"e$ P$ Catapult t#en makes t#e appealin" ar"ument t#at t#ere are policy reasons to pre&er t#e Vactual testV$ T#at may be so' but Con"ress is t#e policy maker' not t#e courts$

HP

H$ Because t#e statute speaks clearly' and its plain lan"ua"e does not produce a patently absurd result or contra(ene any clear le"islation #istory' t#e Court #olds Con"ress to its ,ords$ Accordin"ly t#e Court #eld t#at' ,#ere applicable nonbankruptcy la, makes an e;ecutory contract nonassi"nable because t#e identity o& t#e nondebtor party is material' a D!8 may not assume t#e contract absent consent o& t#e nondebtor party$ A strai"#t&or,ard application o& FIAH-c.-=. to t#e circumstances in t#is case precludes Catapult &rom assumin" t#e 8erlman licenses o(er 8erlmanWs obDection$ A$ T#e literal lan"ua"e o& FIAH-c.-=. establis#es a V#ypot#etical testV a D!8 may not assume an e;ecutory contract o(er t#e nondebtorWs obDection i& applicable la, ,ould bar assi"nment to a #ypot#etical t#ird party' e(en ,#ere t#e D!8 #as no intention o& assi"nin" t#e contract in +uestion to any suc# t#ird party$ !n t#is case &ederal patent la, makes non% e;clusi(e patent licenses personal and nondele"able$ Notes: T#e aut#or o& t#e book t#inks t#at t#is ar"ument o& t#e Court is tautolo"ical because e(ery pro#ibition on assi"nment is based on t#e rationale t#at t#e identity o& t#e contractin" party is material to t#e a"reement$ T#e aut#or proposed anot#er ,ay o& reconcilin" t#e t,o subsections FIAH-c. pre(ents t#e trustee &rom assumin" any contract i& state la, pro(ides e;plicitly t#at suc# contracts cannot be assi"ned$ But t#at kind o& state la, is to be distin"uis#ed &rom t#e more "eneral state la, t#at ,ould simply en&orce an a"reement pro#ibitin" assi"nment$ 3o despite FIAH-c.' t#e trustee may assume contracts t#at contain clauses pro#ibitin" assi"nment' e(en i& nonbankruptcy la, ,ould en&orce suc# clauses$ FIHA-&. "oes on to pro(ide t#at t#e trustee can assi"n suc# contracts' not,it#standin" a clause pro#ibitin" assi"nment$ -nstitut <asteur v. Cam/ridge *iotech Cor!. !n October =>8>' CBC and 8asteur entered into a mutual cross% license a"reement' ,#ereby eac# ac+uired a none;clusi(e perpetual license to use some o& t#e tec#nolo"y patented or licensed by t#e ot#er$ 3peci&ically' CBC ac+uired t#e ri"#t to incorporate 8asteurWs ?!SC procedures -procedures &or dia"nosin" ?!S (irus. into any dia"nostic kits sold by CBC in t#e <nited 3tates' Canada' Me;ico' Australia' 1e, Yealand and else,#ere$

HH

$ul% 7& 199:: CBC &iled its C#apter == petition$ T#e plan proposed t#at CBC assume t#e cross%license a"reement and continue to operate normally' and sell all CBC stock to a subsidiary o& BioMerieu;' a biotec#nolo"y corporation and 8asteurWs direct competitor$ 8asteur obDected t#e plan' citin" FIAH-c. contended t#at t#e proposed sale o& stock amounted to CBCWs assumption o& t#e patent cross%licenses and t#eir de &acto Vassi"nmentV to a t#ird party' in contra(ention o& t#e presumption o& nonassi"nability ordained by t#e &ederal common la, o& patents' as ,ell as t#e e;plicit nonassi"nability pro(ision contained in t#e cross%licenses$ Arguments of <asteur: =$ 8asteur ar"ues t#at t#e CBC plan e&&ects a de &acto assi"nment its t,o cross%licenses to BioMerieu; contrary to t#e Bankruptcy Code FIAH-c.-=.$ 8asteur ar"ues t#at t#e &ederal common la, o& patents presumes t#at patent licenses' suc# as CBC' may not sublicense to t#ird parties absent t#e patent #olderWs consent$ T#is is Vapplicable la,V ,it#in t#e meanin" o& FIAH-c.-=.-A.$ Arguments of the Court: =$ T#is Court -Court o& Appeals o& t#e 0i&t# Circuit. decided a pre(ious case called 7erou> ,#ere it reDected t#e proposed V#ypot#etical testV' #oldin" instead t#at FIAH-c. and -e. contemplate a case%by%case in+uiry into ,#et#er t#e nondebtor party -in t#is case 8asteur. actually ,as bein" V&orced to accept per&ormance under its e;ecutory contract &rom someone ot#er t#an t#e debtor party ,it# ,#om it ori"inally contracted$V K#en t#e transaction en(isions t#at t#e D!8 ,ould assume and continue to per&orm under an e;ecutory contract' t#e bankruptcy court cannot presume as a matter o& la, t#at t#e D!8 is a le"al entity materiall% distinct &rom t#e prepetition debtor ,it# ,#om t#e nondebtor party contracted$ T#e bankruptcy court must &ocus on t#e per&ormance actually to be rendered by t#e D!8 ,it# a (ie, to ensure t#at t#e nondebtor party ,ill recei(e t#e &ull bene&it o& its bar"ain$ C$ 8asteur insists t#at t#e reor"anized CBC is di&&erent &rom t#e prepetition entity$ T#e Court does not a"ree ,it# t#is position$ <nder t#e (ie, o& t#e Court' CBCWs separate le"al identity and its o,ners#ip o& t#e patent cross%licenses' sur(i(e ,it#out interruption not,it#standin" repeated and e(en drastic c#an"es in its o,ners#ip$ !nterpreted as 8asteur proposes' CBCWs o,n ri"#ts under t#e cross%licenses ,ould terminate HA

,it# any c#an"e in t#e identity o& any CBC s#are#older$ Also' t#e cross%licenses pro(isions do not allo, &or 8asteurWs interpretations$ T#e licenses e;pressly aut#orize CBC to s#are its ri"#ts ,it# any Va&&iliated companyV' ,#ic# on its &ace presumably encompasses a parent corporation suc# a BioMerieu;Ws subsidiary$ 8asteur s#ould #a(e &oreseen' t#at CBC mi"#t under"o c#an"es o& stock o,ners#ip' ,#ic# ,ould not alter its corporate le"al entity' but nonet#eless c#ose not to condition t#e continued (iability o& its cross%licenses accordin"ly$ I$ T#e Court o& Appeal a&&irmed t#e decision o& t#e Bankruptcy Court and t#us t#e assumption is aut#orized$ Notes: Bot#' 8erlman and !nstitut 8asteur #a(e &ederal patent la, at t#e center o& t#e case$ T#e Court in anot#er case called "vere> %stems &ound t#at patent licenses must be nonassi"nable because t#e patent #older ,ould ot#er,ise lose control o& #er patent and ,it# it muc# o& t#e incenti(e to inno(ate t#at under"irds &ederal intellectual property la,$ T#e Court in 8asteur implies t#at a t#ird party can limit a corporate control transaction t#rou"# contract$ 3uc# classes #o,e(er are &unctionally identical to contractual limitations on assi"nments' limitations t#at FIAH-&.-=. strikes do,n$ C. ,e?ection #/=3'a(. 8ro(ides in "eneral t#at t#e trustee' subDect to t#e CourtWs appro(al' may reDect any e;ecutory contract or une;pired lease o& t#e debtor$ T#e "eneral rule is t#at reDection constitute a breac# o& t#e contract or lease immediately be&ore t#e date o& t#e &ilin" o& t#e debtorWs bankruptcy petition -FIAH-".. A claim arisin" &rom t#e reDection and breac# ,ill be allo,ed or disallo,ed t#e same as i& suc# claim #ad arisen be&ore t#e date o& t#e &ilin" o& t#e petition$ T#ese pro(isions ensure t#at t#e creditor ,ill #a(e t#e same ri"#ts in bankruptcy as outside$ 4eDection is a decision not to assume$ !t is not a +;ecial ;o1er to ter5inate or re+cind t#e debtorWs obli"ations$ T#e conse+uences o& reDection are =$ T#e estate is no lon"er under any obli"ation to per&orm$ C$ T#e estate is no lon"er entitled to recei(e t#e bene&its o& t#e contract$ I$ 4eDection is a breac# o& t#e contract creatin" an unsecured prepetition claim &or t#e nondebtor party$

HJ

P$ T#is claim -and not#in" else. is disc#ar"eable in t#e bankruptcy proceedin"$ <nder FIAH-d. t#e party may re+uest an accelerated assumption or reDection decision$ 1eit#er o& t#ese "uarantees payment' #o,e(er$ 4ead77 Muc# o& t#e di&&iculty in reconcilin" case la, on t#e reDection o& e;ecutory contracts stems &rom t#e &ailin" o& some courts to distin"uis# bet,een t#e po,er o& reDection and t#e conse+uences t#at &lo, &rom reDection$ 7easing ervices Cor!. v. 9irst 5ennessee *an; On October CI' =>80 C#atam Mac#inery leased t,o cranes to Metler$ T#e leases ,ere assi"ned to 23C$ T#e amounts due under t#e leases ,ere secured by a security interest in MetlerWs in(entory' "oods' e+uipment and mac#inery$ 23C per&ected its security interest$ A&ter per&ection' t#e Bank made se(eral loans to Metler and obtained a security interest in t#e same collateral$ T#e Bank per&ected as ,ell$ .ecem/er 11& 19':: Metler ,as place in in(oluntary bankruptcy under C#apter J$ Metler surrendered all o& its e+uipment and mac#inery to t#e Bank' e;cept &or t#e t,o cranes$ T#e Bank sold t#is collateral and realized @PPI' 8>H &rom t#e sale$ T#e trustee did not assume t#e lease a"reement so 23C reclaimed possession o& t#e cranes and sold t#em' establis#in" a de&icit balance o& @8='P>I$ Octo/er 1& 19'@: 23C &iled a suit a"ainst t#e Bank seekin" payment o& @8='P>I plus interests and &ees$ 23C asserted t#at it #ad a security interest in t#e proceeds realized &rom t#e sale o& t#e collateral t#at ,as superior to t#at o& t#e Bank$ But t#e Bank re&used to pay$ On Marc# P' =>8A t#e district court "ranted summary Dud"ment in &a(or o& 23C' #oldin" t#at 23CWs security interest ,as superior to t#at o& t#e bank$ Arguments of the A!!ellant=*an;: =$ T#e Bank contends t#at t#e lease a"reements bet,een Metler and 23C ,ere e;ecutory contracts' or une;pired leases and' pursuant to FIAH-d.-=.' t#e reDection o& t#e lease a"reements by t#e trustee operated as a matter o& la, as a reDection o& all co(enants contained in t#e leases' includin" t#e "rant o& t#e security interest$ T#us' t#e Bank ar"ues t#at t#e reDection o& t#e leases constituted a breac# o& t#e e;ecutory and none;ecutory portions o& t#e contracts' lea(in" 23C in t#e position on an unsecured creditor$ H8

Arguments of the A!!ellee=7 C: =$ 23C ar"ues t#at ,#ile reDection o& a lease obli"ation does #a(e t#e e&&ect o& a breac# o& contract' it does not a&&ect t#e creditorWs secured status$ Arguments of the Court: =$ T#e Court a"rees ,it# 23C$ 4eDection denies t#e ri"#t o& t#e contractin" creditor to re+uire t#e bankrupt estate to speci&ically per&orm t#e t#en e;ecutory portions o& t#e contract$ 4eDection also limits t#e creditorWs claim to dama"es &or breac# o& contract$ But reDection or assumption determines only t#e status o& t#e creditorWs claim ,#et#er it is a prepetition obli"ation o& t#e debtor or it is entitled to priority as an e;pense o& administration o& t#e estate$ T#e e;tent to ,#ic# a claim is secured is ,#olly una&&ected$ T#e Court cites a case named $enson v. Continental 9inancial Cor!. ,#ere t#e security a"reement ,as &ound to be none;ecutory and ,as not subDect to reDection by t#e trustee$ C$ T#e Court said t#at similarly in t#is case' t#e security interest "ranted to 23C ,as &ully (ested$ T#e consideration ,as t#e lessor a"reein" to lease t#e cranes to Metler and 23C a"reein" to take an assi"nment o& t#e leases$ T#us t#e security interest ,as non e;ecutory and t#ere&ore not subDect to t#e reDection po,er o& t#e trustee$ I$ Applicable state la, mandates t#at t#e &irst creditor to per&ect a security interest #as priority status$ !n t#e present case' 23C ,as t#e &irst to per&ect its interest$ T#us t#e district court ,as correct in statin" t#at an acceptance o& t#e BankWs ar"ument V,ould be to ad(ance t#e BankWs later%per&ected security interest abo(e 23CWs prior lien' ne"atin" t#e priority pro(isions set &ort# in Article > o& t#e <ni&orm Commercial Code$V P$ Accordin"ly' t#e Court a&&irms t#e "rant o& summary Dud"ment in &a(or o& 23C$ -n ,e ,egister T#e issue presented is ,#et#er a co(enant%not%to%compete contained in a &ranc#ise a"reement is still en&orceable a&ter t#e debtors reDected t#e e;ecutory &ranc#ise a"reement$ T#e plainti&& il; <lants is seekin" to enDoin t#e debtors &rom operatin" a business in apparent (iolation o& t#e co(enant%not%to%compete$ On Marc# 8' =>8A' t#e 4e"isters e;ecuted a &ranc#ise a"reement ,it# t#e plainti&& "rantin" t#e 4e"isters a &ranc#ise to operate a 3ilk 8lants' etc$ specialty retail store o&&erin" arti&icial &lo,ers' plants and related H>

items$ <nder part o& t#e &ranc#ise a"reement t#e debtors co(enanted not to en"a"e in any capacity in a business o&&erin" to sell or sellin" merc#andise or products similar to t#ose sold in 3ilk 8lants etc$ &or a period o& t,o years a&ter t#e termination o& t#e &ranc#ise a"reement$ t#e co(enant ,as limited to a ten%mile radius o& t#e 4e"isterWs store$ 4arch 1@& 19'': T#e 4e"isters &iled a C#apter =I bankruptcy petition$ On May =8 =>88 T#e 4e"isters reDected t#e &ranc#ise a"reement and since t#en t#ey #a(e been operatin" a business (ery similar to t#eir &ormer 3ilk 8lants *tc$ &ranc#ise$ Arguments of the 4ovants= il; <lants: =$ 3ilk 8lants ,ants to enDoin t#e 4e"isters &rom operatin" t#at store ar"uin" t#at suc# acti(ities (iolate t#e co(enant%not%to% compete contained in t#e ori"inal &ranc#ise a"reement$ C$ T#ey ar"ue t#at t#e co(enant%not%to%compete ,as not e;ecutory and so cannot be reDected$ T#ey say t#e co(enant ,as se(erable &rom t#e e;ecutory parts o& t#e contract and ,as based on a separate consideration ,#ic# 3ilk 8lants *tc$ #ad &ully pro(ided$ T#is separate consideration ,as t#e pro(ision o& trainin" and in&ormation at t#e be"innin" o& t#e &ranc#ise relations#ip$ I$ 3ilk 8lants ar"ues t#at a co(enant%not%to%compete is en&orced by an inDunction and ot#er e+uitable relie& and not by a suit &or money dama"es$ T#ere&ore t#e breac# does not "i(e raise to a claim as de&ined by F=0=-H.$ 3ilk plantWs ri"#t to e+uitable relie& s#ould not be a&&ected by t#e bankruptcy$ 3ilk 8lants cites some cases' but t#e Court &ound t#at t#ose cases can be distin"uis#able &rom t#e present case' because on t#em' t#e bankruptcy &ilin" #ad elements o& bad &ait#$ Arguments of the Court: =$ T#e primary purposes be#ind allo,in" debtors to reDect e;ecutory contracts are =. to reli(e t#e estate &rom burdensome obli"ations ,#ile t#e debtor is tryin" to reco(er &inancially' C. To e&&ect a breac# o& contract allo,in" t#e inDured party to &ile a claim$ Bot# obDecti(es are &urt#ered by permittin" debtors to reDect co(enants%not%to%compete ,it# t#e rest o& t#e e;ecutory contract$ !n &act' e+uitably en&orcin" suc# clauses in contracts ,ould directly &rustrate t#e purposes o& relie(in" debtors &rom burdens t#at ,ould #inder re#abilitation$ 0or t#is reason' 4e"isters s#ould be able to reDect t#e co(enant%not%to% compete alon" ,it# t#e rest o& t#e e;ecutory contract' ,#ile 3ilk 8lants *tc$ s#ould be able to &ile a claim &or t#e inDury resultin" in t#e breac# o& t#e contract$ T#is is consistent ,it#

A0

C$

I$

P$

H$

t#e "eneral rule t#at e;ecutory contracts must be accepted or reDected as a ,#ole$ 4e"ardin" ar"ument X C o& 3ilk 8lants' t#e Court said t#at t#e a"reement' ,#en taken as a ,#ole' s#o,s t#at t#e parties contemplated t#at t#e co(enant ,ill only be en&orceable i& 3ilk 8lants per&ormed on t#e entire &ranc#ise a"reement' not Dust t#e sections re+uirin" it to pro(ide special trainin" to t#e debtors$ !& 3ilk 8lants #ad reDected t#e contract in a bankruptcy proceedin" or #ad ot#er,ise breac#ed t#e &ranc#isin" a"reement' t#e debtors clearly ,ould not #a(e #ad to #onor t#e co(enant%not%to%compete$ 3ilk 8lant relies on 7easing ervice Cor! v. 5ennessee *an; $ But t#e Court notes t#at a security interest is (ery di&&erent &rom a co(enant%not%to%compete$ Once per&ected' t#e security interest is a present interest in property' it establis#es t#e priority o& t#e #older and t#e e;istence o& t#e security interest is not dependent on t#e #olderWs per&ormance o& t#e rest o& t#e contract$ ?ere' t#e &ranc#isorWs ability to en&orce t#e co(enant is totally dependent on #is &ait#&ul per&ormance o& t#e entire a"reement$ T#us t#e co(enant is not se(erable &rom t#e rest o& t#e contract$ 4e"ardin" ar"ument X I' t#e Court said t#at Alt#ou"# state courts #a(e ruled t#at t#ey cannot put a dollar amount on t#e inDury incurred &or breac# o& t#e co(enants%not%to%compete' t#e court belie(es t#at it is possible$ T#e court #eld t#at t#e co(enant%not%to%compete terminated ,#en t#e contract ,as reDected and t#at 3ilk 8lants may &ile a claim &or breac# o& t#e entire &ranc#ise a"reement' includin" t#e co(enant%not%to%compete' under FH0C-".$

Notes: Bankruptcy Code FIAH-n. is a reaction to t#e case 7u/riAol "nter!rises v. ,ichmond 4etal 9inishers& ,#ere t#e court ruled t#at reDection in bankruptcy o& a license a"reement depri(ed t#e licensee o& t#e ri"#t to use t#e debtorWs intellectual property' and le&t t#e licensee ,it# a mere claim &or dama"es$ FIAH-n. allo,s a licensee o& intellectual property to retain its ri"#ts despite reDection o& an e;ecutory contract$ Con"ress #ad pre(iously "ranted similar dispensations under FIAH-#. and -i.$ !ronically' suc# protections o& nondebtor classes support t#e #oldin" o& cases as ,egister. 5oin" &urt#er' it is possible to sustain t#at t#e (ery adoption o& FIAH itsel& may &airly be interpreted as a con"ressional attempt to displace t#e protections o& nonbankruptcy la,$ But t#e aut#or o& t#e book ar"ues t#at it is not clear ,#at principle supports de(iation &rom t#e rules o& ot#er,ise applicable la,$ A=

 T#e C00H Bankruptcy Act re(ises Bankruptcy Code FJ0J-b.' ,#ic# pro(ides t#e circumstances under ,#ic# a court ,ill dismiss or con(ert a C#apter J bankruptcy petition &or abuse o& t#e bankruptcy process$ 3ection J0J-b.-I.-B. e;pressly "i(es as an e;ample o& potential abuse a debtorWs attempt to reDect a personal ser(ices contract$ Notes from class: 0or t#e 8ro&essor it is e(ident t#at t#e result in t#is case is stran"e' because it actually creates a ,eird incenti(e to t#e &ranc#isee to &ile &or bankruptcy Dust to escape t#e obli"ation not%to%compete$ 0or sure a normal court ,ould #a(e ne(er be as sympat#etic to t#e debtor as t#is court' because t#is decision allo,s strate"ic use o& bankruptcy$ T#e 8ro&essor t#inks t#at t#e reason &or t#is stran"e result is t#at t#is is about a C#apter =I case' ,#ere t#e debtor must be entitled to a &res# start$ North+estern Airlines Cor!. v. Association of 9light Attendants CWA e!tem/er )88@: 1ort#,est &iled &or protection under C#apter == o& t#e Bankruptcy Code$ 1ort#,estWs plan o& reor"anization re+uired t#at its employees make si"ni&icant concessions$ Most o& t#e unions t#at represent "roups o& 1ort#,est employees #a(e since ne"otiated ne, a"reements$ <nable to reac# an a"reement ,it# t#e &li"#t attendants' 1ort#,estern &ile a motion to reDect t#e CBA -collecti(e%bar"ainin" a"reement.$ T#e Bankruptcy Court "ranted t#e debtorsW F===I relie&$ Alon" ,it# t#is relie&' t#e court permitted 1ort#,est to impose t#e terms o& a pre(ious tentati(e a"reement upon t#e &li"#t attendants$ T#e A0A -Association o& 0li"#t Attendants. responded to t#e imposition o& t#e a"reement by noti&yin" 1ort#,est o& its intent to disrupt 1ort#,estWs ser(ice by usin" a tactic named C?AO3 -Create ?a(oc Around Our 3ystem.' ,#ic# entails mass ,alkouts &or limited periods o& time and pinpoint ,alkouts at certain airports or "ates$ T#e procedural #istory o& t#is case t#en "oes =$ 1ort#,estern mo(ed to enDoin t#e strike$ T#e bankruptcy Dud"e denied t#e motion on t#e basis t#at 1ort#,estWs reDection o& t#e CBA and imposition o& t#e a"reement amounted to a unilateral action in c#an"in" t#e status +uo t#at in turn &rees t#e employees to take Dob action$ C$ On appeal t#e district court re(ersed and "ranted preliminary inDunction on t#e "rounds t#at t#e union remained bound by t#e status +uo pro(isions o& t#e 42A -4ail,ay 2abor Act.' ,#ic# &orbid t#e e;ercise o& sel&%#elp pendin" t#e e;#austion o&

AC

(arious mec#anisms to resol(e disputes' includin" 1MB mediation$ T#e A0A and Air 2ine 8ilots Association &iled a timely appealed$ I$ T#e Court o& Appeals o& t#e 3econd Circuit must re(ie, &or abuse o& discretion' but it ,ill re(ie, t#e application o& la, de novo. T#e Court needs t#en to determine i& 1ort#,estern #as s#o,n' &irst' irreparable dama"e' and second' eit#er a. likeli#ood o& success on t#e merits' or b. su&&iciently serious +uestions "oin" to t#e merits and a balance o& #ards#ips decidedly tipped in &a(or o& t#e party ,#o &iled t#e preliminary inDunction$ 5he a!!eal turns on North+est6s li;elihood of success on the merits. 5he arguments of the Court on this regard are: =$ 3ection ===I-a. pro(ides t#at a carrier subDect to t#e 42A may reDect a CBA i& t#e bankruptcy court determines' inter alia' t#at t#e balance o& t#e e+uities clearly &a(ors reDection o& suc# a"reement and t#at reDection is necessary to permit t#e reor"anization$ 4ead t#e ,#ole section because t#ere are some ot#er determinations t#at t#e court #as to make$ C$ T#e 42A creates an almost interminable re%ne"otiation process' but durin" t#e pendency o& t#is re%ne"otiation process' t#e 42A obli"ates t#e parties to maintain t#e status +uo$ But t#e ,ord Vstatus +uoV &ound t#rou"# out t#e casela, appears no,#ere in t#e 42A$ T#e 42A re&ers to maintainin" obDecti(e ,orkin" conditions durin" t#e pendency o& any dispute or durin" re% ne"otiation$ I$ But ot#er t#an t#e status +uo pro(isions' t#e 42A also imposes a separate duty carriers and unions must e;ert e(ery reasonable e&&ort to make a"reements and to settle all disputes$ P$ T#e Court concludes t#at t#e district court ,as allo,ed to enter t#e preliminary inDunction because t#e unionWs proposed strike ,ould (iolate t#is separate duty$ T#e union concedes t#at it #as an on"oin" duty to ne"otiate but ne(ert#eless ar"ues t#at it is V&ree to strikeV because 1ort#,est unilaterally altered t#e contractual status +uo$ T#e Court sais t#at t#is ar"ument &ails because t#e separate duty operates independently o& t#e 42AWs status +uo pro(isions$ H$ T#e Court reac#es t#ree conclusions =. 1ort#,estWs reDection o& t#e CBA a&ter obtainin" court aut#orization abro"atin" -,it#out breac#in". t#e e;istin" CBA bet,een t#e A0A and 1ort#,est' ,#ic# t#erea&ter ceased to e;ist/ C. T#e abro"ation o& t#e CBA necessarily terminated t#e status +uo created by t#e a"reement so all t#e status +uo pro(isions ceased to apply/ I. T#e A0AWs proposed strike ,ould' at present' (iolate t#e unionWs

AI

independent duty under t#e 42A to e;ert e(ery reasonable e&&ort to make an a"reement and t#us may be enDoined$ A$ T#e Court does not dispute t#at a union ,ould be &ree to strike &ollo,in" contract reDection under FIAH$ <nder FIAH i& a debtor reDects an e;ecutory contract' breac# is deemed to occur immediately prior to t#e bankruptcy petition$ 4eDection under FIAH t#us leads to a le"al &iction at odds ,it# t#e te;t o& -and impetus be#ind. F===I$ Consistent ,it# Con"ressWs purpose' t#e Court is obli"ed to construe t#e statutory sc#eme to distin"uis# t#e le"al conse+uences o& reDection under FIAH &rom reDection under F===I$ J$ !n cases "o(erned by t#e 124A -1ational 2abor 4elations Act.' t#e Court #as also #inted t#at a union is &ree to strike' e(en &ollo,in" contract reDection under F===I$ But a unionWs ri"#t to strike under t#e 124A depends upon t#e terms o& t#e CBA to ,#ic# it is a party$ And i& a party' usin" F===I abro"ates a CBA' it &ollo,s t#at t#e union subDect to t#e 124A ,ould become &ree to strike precisely because it ,ould no lon"er be bound to any contractual no%strike rule$ At t#e same time' #o,e(er' a union subDect to t#e 42A ,ould still be under an obli"ation to e;ert e(ery reasonable e&&ort to make a"reements and settle disputes$ 8$ T#e Court concludes VAlt#ou"# t#is is a complicated case' one &eature is simple enou"# to describe 1ort#,estWs &li"#t attendants #a(e pro(en intransi"ent in t#e &ace o& 1ort#,estWs mani&est need to reor"anize$V On t#at basis t#e Court concluded t#at t#e A0A (iolated t#e 42A and a&&irmed t#e preliminary inDunction$ Notes: T#is case can be reduced to a simple obser(ation Alt#ou"# t#e Bankruptcy Code F===I does not "rant a court t#e po,er to enDoin a strike' neit#er does it remo(e suc# po,er i& pro(ided by anot#er source$ K#en a court in(okes F===I and modi&ies a collecti(e bar"ainin" a"reement' one mi"#t #a(e t#ou"#t t#at t#e a&&ected union or ,orkers ,ould at t#e (ery least be entitled to a prepetition claim &or dama"es under FIAH-".$ T#e court in North+est Airlines su""ests ot#er,ise #o,e(er$ T#e aut#or o& t#e book can not e;plain t#is A "roup bene&it &rom bankruptcy is not a reason &or an ordinary creditor ,#o losses its collection ri"#t to lose its claim as ,ell$ !t is not clear ,#y a union as a party to a Vc#an"edV e;ecutory contract s#ould lose its claim$ Notes from class: T#e key part o& t#is case is t#at t#e Court interprets t#at t#ere

AP

is no collecti(e bar"ainin" a"reement$ T#e Court says t#at t#e obli"ation to not modi&y ,ent a,ay ,it# t#e reDection o& t#e contract$ T#is case deals ,it# a part &rom t#e Bankruptcy Code t#at ,as put in place to pre(ent t#e use o& bankruptcy to c#an"e t#e terms o& t#e collecti(e bar"ain$ 2II. T9e Tru+teeB+ A0oidin: Po1er+ A. 5he 5rustee as a Creditor T#e Bankruptcy Code "rants t#e trustee t#e ri"#t to step into t#e s#oes o& ot#er people' #ypot#etical and actual$ #3**'a(. Allo,s t#e trustee to act as a #ypot#etical lien creditor A and in t#e case o& real property' as a #ypot#etical purc#aser$ #3**',(. Allo,s t#e trustee to a(oid and reco(er &or t#e estate a debtorWs trans&ers t#at an actual creditor could #a(e a(oided$ =$ T#e ?ypot#etical 2ien Creditor 3ection HPP-a. is about allo,in" t#e trustee to take certain actions t#at a creditor or purc#aser could take under applicable nonbankruptcy la,$ 3ection 3**'a('$( is kno,n as t#e Vstron"%armV po,er makes t#e trustee an ideal' #ypot#etical lien creditor at t#e time o& t#e debtorWs bankruptcy a. Ideal. because no actual kno,led"e is imputed t#at mi"#t' under nonbankruptcy la,' de&eat an action' b. H6;ot9etical. because t#e trustee can act ,#et#er or not t#ere is a real Dud"ment creditor J ,#o could e;ercise ri"#ts or po,ers or a(oid a trans&er$

A @lien creditor@ means a creditor ,#o #as ac+uired a lien on t#e property in(ol(ed by attac#ment' le(y or t#e like and includes an assi"nee &or bene&it o& creditors &rom t#e time o& assi"nment' and a trustee in bankruptcy &rom t#e date o& t#e &ilin" o& t#e petition or a recei(er in e+uity &rom t#e time o& appointment$ !t is a creditor ,#o is secured by a lien$
J

A @Aud:5ent creditor@ is a party to ,#ic# a debt is o,ed t#at #as pro(ed t#e debt in a le"al proceedin" and t#at is entitled to use Dudicial process to collect t#e debt/ t#e o,ner o& an unsatis&ied court decision$ A party t#at ,ins a monetary a,ard in a la,suit is kno,n as a Dud"ment creditor until t#e a,ard is paid' or satis&ied$ T#e losin" party' ,#ic# must pay t#e a,ard' is kno,n as a Dud"ment debtor$ A Dud"ment creditor is le"ally entitled to en&orce t#e debt ,it# t#e assistance o& t#e court$

AH

 A typical application o& t#is section is ,#en t#e trustee attacks a security interest #eld a"ainst t#e debtorWs property but unper&ected at t#e time o& bankruptcy$ By t#e use o& t#is po,er' t#e unper&ected secured creditor becomes a mere "eneral creditor T#e idea to &ollo, in t#is section is t#at ,#ene(er a lien creditor could #a(e pre(ailed outside o& bankruptcy' t#e trustee pre(ails inside$ An interest unper&ected at t#e time o& t#e debtorWs bankruptcy becomes part o& t#e estate and is t#us s#ared by all creditors includin" t#e ori"inal #older o& t#e interest t#at #as been a(oided$ #3**'a('?( Allo,s t#e trustee to play t#e role o& a Dud"ment creditor t#at must e;ecute on t#e Dud"ment to ,in t#e race a"ainst t#e unper&ected secured creditor$ #3**'a('/(. Allo,s t#e trustee to play t#e role o& a creditor ,#o #as completed t#e process a"ainst real property$ # 3*=. contains pro(isions t#at cut back on t#e trusteeWs FHPP-a. po,ers$ T#ere is a time limit &or t#e trustee to act' and t#ere are some special%case e;emptions$ T#ese protect a sellerWs interest in t#e reclamation o& "oods sold and protect mar"in' settlement or s,ap transactions in t#e securities industries$ Once t#e trustee applies FHPP-a.' t#e process is complete i& t#e trustee #as establis#ed a superior interest in t#e debtorWs o,n property' as in t#e unper&ected security interest$ !n t#at case' subordination is all t#e trustee needs' because t#e property is already in t#e debtorWs estate$ But i& t#e trustee #as establis#ed a superior interest in property t#at t#e debtor #as already trans&erred to anot#er party' t#en t#e trustee must a&&irmati(ely reco(er t#e property$ #33%'a('$(. Allo,s t#e trustee to reco(er t#e a(oided trans&er or its (alue &rom t#e initial trans&eree or t#e entity &or ,#ose bene&it t#e trans&er ,as made$ #33%'a('?( and ',(. 8ermit reco(ery &rom subse+uent trans&eree do,n t#e line until ,e reac# a trans&eree ,#o takes t#e property &or (alue and ,it#out kno,led"e t#at t#e initial trans&er ,as (oidable$ T#e trustee may not reco(er &rom #im' or &rom any subse+uent "ood &ait# trans&eree$ #33%'d(. 2imits t#e trustee to a sin"le reco(ery$ #33%'e(. !n case o& reco(ery' t#e trans&eree retains a lien &or t#e cost o& t#e impro(ement to t#e property' limited to t#e (alue o& t#e impro(ements$

AA

#33$. 8reser(es &or t#e bene&it o& t#e estate any trans&er a(oided by t#e trustee$ 3ections HH0 T HH= make e;plicit ,#at is implicit in t#e ri"#ts and po,ers o& t#e trustee under FHPP-a.$ Kors -nc v. 2o+ard *an;

Kors &iled &or bankruptcy and t#e trustee sold all o& Kors e+uipment &or @='=00'000$ T#e issue o& t#is case is' pursuant to FFHPP and HH= o& t#e Code' t#e trustee in bankruptcy can obtain ri"#ts under a subordination a"reement t#at is aut#orized by FH=0-a. o& t#e Code$ Arguments of the Court: =$ 8ursuant to FHPP-a.' t#e trustee can a(oid unper&ected liens on property belon"in" to t#e bankruptcy estate$ Once t#e Trustee #as assumed t#e status o& a #ypot#etical lien creditor under FHPP-a.-=.' state la, is used to determine ,#at t#e lien creditorWs priorities and ri"#ts are$ <nder Sermont la,' t#e Bank &ailed to per&ect its security interest in t#e Kros e+uipment$ 3ince Sermont la, "i(es a lien creditor ri"#ts superior to t#ose o& t#e #older o& an unper&ected security interest' t#e trustee pursuant to FHPP-a. -=. o& t#e Code' #as ri"#ts superior to t#ose o& t#e bank on t#e date o& t#e bankruptcy &ilin"$ C$ T#e trusteeWs subro"ation po,ers under FHPP-a.-=. and FHH= do not e;tend to a subordination a"reement protected by FH=0-a. -permits creditors to subordinate t#eir priorities by a"reement i& permitted to do so by nonbankruptcy la,$

AJ

I$ !n t#is case' t#e trustee sold t#e e+uipment$ FFHPP-a.-=. and HH= put t#e trustee in t#e s#oes o& t#e bank ,it# respect to t#e unper&ected security interest' ?ence' t#e trustee properly preser(ed t#e bankWs lien in t#e proceeds o& t#e sale$ !t ,as improper #o,e(er &or t#e trustee to be subro"ated to t#e bankWs ri"#ts under t#e subordination a"reement amon" 4!DC' 3B!C and t#e Bank$ <nder Sermont la,' t#e trustee ,ould not accede to t#e bene&its o& t#e subordination a"reement because Kors ,as not a part o& t#at a"reement$ T#e trustee ,as (ested only ,it# t#e ri"#ts t#e Bank #ad a"ainst Kors pursuant to t#e 3ecurity A"reement$ T#e BankWs subordination ri"#ts e;isted a"ainst 3B!C and 4!DC' not Kors$ P$ T#e Court a&&irmed t#e Dud"ment o& t#e district court -because t#is ,as an appeal. ,#ic# basically ordered t#e proceeds o& t#e sale o& t#e e+uipment to be paid in accordance ,it# t#e subordination a"reement$ Notes: Kors is a simple case no lien creditor at t#e time o& t#e bankruptcy could trump t#e per&ected interests o& 3B!C or 4!DC' so t#ose interests sur(i(e attack under FHPP-a.$ T#e order o& priority t#en is 3B!C or 4!DC' t#e trustee and lastly t#e bank$ T#is is a (ictory &or t#e bank because it ,ill bene&it &rom t#e side deal -t#e subordination a"reement. ,#ereby 3B!C and 4!DC a"ree to "i(e t#e bank ,#ate(er (alue t#ey recei(e &rom t#e collateral$ T#e interpretation t#e Court "a(e o& t#e section o& t#e Code in t#is case is a bit problematical &rom a doctrinal perspecti(e$ T#e Court interprets t#at t#e trustee does not merely #old an interest superior to t#e BankWs unper&ected security interest' as ,ould a lien creditor/ t#e trustee #olds t#e security interest itsel&$ T#is interpretation raises t#e +uestion ,#et#er t#e interest includes BankWs ri"#ts under t#e subordination a"reement$ !t seems like FHH= is unnecessary' as FHH0 also applies broadly and permits t#e trustee to reco(er an a(oided trans&er or its (alue$ FHH= #o,e(er' address a priority circularity problem t#at can sometimes arise under &acts similar to t#ose in Kors$ C$ T#e Actual Creditor <nder #3**',(t#e trustee takes on t#e role o& an actual creditor' to ,#om t#e debtor incurred an obli"ation be&ore bankruptcy' ,#ile under #3**'a( t#e trustee takes on t#e role o& a #ypot#etical creditor ,#o makes a loan at t#e time o& bankruptcy$

A8

3ection HPP-b. brin"s into t#e estate property t#at creditors could #a(e reac#ed outside o& bankruptcy but t#at t#e #ypot#etical lien creditor test o& FHPP-a. &ails to reac#$ T#e amount t#at t#e actual creditor is o,ed does not put a ceilin" on t#e amount t#at t#e trustee can reco(er$ Any reco(ery "oes to t#e estate t#us all creditors enDoy it$ 0raudulent con(eyances dominate t#e case la, surroundin" FHPP-b. -n ,e OAar; ,estaurant "qui!ment Co. T#is case considers a (eil%piercin" action -alter e"o action. ,#ere a creditor o& t#e debtor' not t#e debtor itsel&' #as a claim a"ainst t#e controllin" s#are#olders o& a debtor &or t#e 3?Ws misbe#a(ior$ T#e sole issue on t#is appeal is ,#et#er t#e trustee #as standin" to assert on be#al& o& t#e debtor corporationWs creditors' an alter e"o action a"ainst t#e principals o& t#e corporation$ Basically t#e trustee alle"ed t#at because o& t#e de&endant%principalWs abuses o& t#e corporation' t#e corporate (eil s#ould be pierced and t#e indi(iduals s#ould be personally liable &or OzarkWs debts$ T#e bankruptcy court a"reed ,it# A>

t#e trustee' but t#e district court re(ersed on t#e "rounds t#at t#e trustee #ad no standin" on #is o,n to brin" an alter e"o action on be#al& o& t#e debtorWs creditors$ Arguments of the 5rustee: =$ T#e trustee maintains t#at #e #as standin" to brin" t#e action on be#al& o& t#e unsecured creditors based on t#ree di&&erent parts o& t#e Code =. FHPP' C. FJ0P T FHP=' and I.F=0H$ Arguments of the Court of A!!eals: =$ <pon e;amination o& FJ0P and HP= and t#e nature o& t#e alter e"o action' t#e trusteeWs standin" ar"ument must &ail$ 0irst' it is clear t#at t#e causes o& action belon"in" to t#e debtor at t#e commencement o& t#e case are included ,it#in t#e de&inition o& property o& t#e estate$ K#ene(er a cause o& action Vbelon"sV to t#e debtor corporation' t#e trustee #as t#e aut#ority to pursue it in bankruptcy proceedin"s$ But ,#ere t#e applicable state la, makes suc# obli"ations and liabilities run to t#e corporate creditors personally' rat#er t#an to t#e corporation' suc# ri"#ts o& action are not assets o& t#e estate$ 5enerally t#e corporate (eil is not pierced &or t#e bene&it o& t#e corporation or its 3?$ T#e action is concei(ed to assist a t#ird party$ C$ T#e trusteeWs ri"#ts and po,ers under FHPP are e;tensi(e but t#ey do not encompass t#e ability to liti"ate claims' suc# as t#e alter e"o cause o& action on be#al& o& t#e debtorWs creditors$ T#e Court relies on a case called Ca!lin t#at e(en i& decided under t#e Bankruptcy Act is still "ood la,' and it is t#e only case applicable on t#is subDect$ !n t#at case t#e 3upreme Court #eld t#at a reor"anization trustee lacked standin" to assert' on be#al& o& t#e bankrupt corporationWs creditors' claims o& misconduct a"ainst a t#ird party$ Alt#ou"#' t#e ne, Bankruptcy Code clari&ied and e;panded t#e trusteeWs role ,it# respect to creditors' in no ,ay ,as it c#an"ed to aut#orize t#e trustee to brin" suits on be#al& o& t#e estateWs creditors a"ainst t#ird parties$ !n &act' t#e le"islati(e #istory su""ests t#e opposite$ I$ FHPP-a. and -b. are &la(ored ,it# t#e notion o& t#e trustee #a(in" t#e po,er to a(oid Vtrans&ersV o& t#e debtor$ An alter e"o action' #o,e(er' does not entail in(alidatin" o& a trans&er o& interest' but instead imputes t#e obli"ations o& one party to anot#er re"ardless o& any Vtrans&ersV$ P$ !n summary' no,#ere in t#e Code is t#ere any su""estion t#at t#e trustee #as been "i(en t#e aut#ority to collect money not o,ed to t#e estate$ H$ !& t#e trustee ,ere allo,ed to brin" t#e action' t#ere ,ould ob(iously be +uestions as to ,#ic# creditors ,ere bound by t#e settlement$ T#is is because t#e trustee is not t#e real party in J0

interest and does not #a(e t#e po,er to bind t#e creditors to any Dud"ment reac#ed in liti"ation$ A$ Because not pro(ision in t#e Code "i(es t#e trustee standin" to assert t#e alter e"o claim' any e+uitable relie& under F=0H must be denied$ J$ T#e district courtWs order is a&&irmed$ Notes: Once can ar"ue t#at t#e trustee s#ould pre(ail in t#e (eil% piercin" action under FHPP-b.$ T#is pro(ision allo,s t#e trustee to a(oid any trans&er o& an interest o& t#e debtor in property t#at any actual creditor #oldin" an unsecured claim could a(oid$ One mi"#t c#aracterize a (eil%piercin" action as one t#at seeks to reco(er &rom 3? assets t#at could belon" to t#e corporation and s#ould t#us be a(ailable &or t#e creditors$ 3o c#aracterized' t#is di(ersion o& assets may be deemed a trans&er$ But t#ere ,ould be a dan"er &or t#e la, to adopt a (ery e;pansi(e (ie, o& Vtrans&erV &or t#e purposes o& FHPP-b.$ A line o& ar"ument premised only upon ,#et#er an action is a(ailable to t#e creditor -and not ,#et#er it in(ol(es ac actual trans&er o& assets. is too muc#$ T#ere must be a link bet,een t#e action t#at a creditor #as and t#e creditorWs relations#ip ,it# t#e debtor$ A +uestion t#at arises &rom t#is case is ,#y t#e alle"ed mal&easance o& t#e debtorWs principals did not "i(e rise to a claim by t#e debtor a"ainst t#em$ suc# a claim ,ould ine(itably belon" to t#e trustee' ,#o mi"#t bar t#e claim o& indi(idual creditors as deri(ati(e$ AttentionCCC Read #D%*'a('$(. T#is section "i(es t#e trustee aut#ority to brin" an action &or dama"es on be#al& o& a debtor corporation a"ainst corporate principals &or alle"ed misconduct' mismana"ement' or breac# o& &iduciary duty' because t#ese claims could #a(e been asserted by t#e debtor corporation or by its 3? in a deri(ati(e action$

J=

D4B. Fraudulent con0e6ance E Sec. 3*F % !n cases ,#ere t#e mana"er o& a corporate debtor is dishonest and transfers assets to an accomplice so t#at t#e debtor appears to #a(e no assets' t#e basic state%debt collection process may not be su&&icient to protect t#e creditor o& t#e corporate debtor$ T#e &raudulent con(eyance la, ensures t#at t#e creditor can reach fraudulently transferred property' at least i& t#e trans&eree ,as an accomplice to t#e &raud$ T#e pro(ision protects t#e ot#er creditors &rom diminution o& t#eir s#are in t#e bankruptcy estate$ T#e la, is based on t#e <ni&orm 0raudulent Con(eyance Act -<0CA. and t#e <ni&orm 0raudulent Trans&er Act -<0TA.' ,#ic# ser(ed as models &or state la,$ T#e trans&eree can only keep t#e property i& s#e is a bona fide purc#aser o& t#e property and paid t#e &air (alue o& t#e property$ !& not paid &air (alue' t#e trans&eree #as to render t#e property but can demand a return o& t#e property$ T#e term fraudulent is to some e;tent misleadin" because t#e la, also comprises trans&ers t#at ,ere not dis#onest or at least demonstrably dis#onest but t#at simply represent a gift causin" t#e company not to be able to pay &or a loan anymore$ 3o' t#e trans&er does not actually al,ays #a(e to be &raudulent$ !t is t#e debtor9s intent t#at controls i& t#e property #as to be returned' not t#e creditor9s intent$

% %

JC

% %

% %

0urt#ermore' t#e la, comprises trans&ers t#at are made &or less than fair value o& t#e property$ T#e trans&er is constructively fraudulent re"ardless o& t#e debtor9s intent -no need to proo&.$ 4e+uirements o Transfer renders the debtor insolvent or lea(es t#e debtor ,it# unreasonably small capital$ T#e same rules apply &or obligations incurred by t#e debtor$ o Unreasonably small value in return &or t#e property trans&erred$ T#e trustee can avoid fraudulent conveyances under bankruptcy' accordin" to Sec. 548' as ,ell as #e can a(oid ot#er trans&ers accordin" to 3ec$ HPP-b.$ 3ec$ HP8-b. allo,s to proceed under state la,$ T#e only di&&erence is t#e t,o year status o& limitation be&ore t#e &ilin" o& t#e petition' ,#ereas some state la,s allo, lon"er ,indo,s -P or A year ,indo,s.$ T#e &raudulent con(eyance la, o& t#e Bankruptcy Code is applicable as soon as t#e debtor &iles &or bankruptcy but usually leads to t#e same outcome$ T#e Bankruptcy Code uses t#e same lan"ua"e as t#e <0TA O <0CA o <0CA 3ec$ J ) 3ec$ HP8-a.-=.-A. BCode' &raudulent trans&ers -intentional. o <0TA 3ec$ H ) 3ec$ HP8-a.-=.-B. BCode' obli"ation incurred -constructi(e. o <0TA 3ec$ P ) 3ec$ HP8-a.-=.-B. BCode' constructi(ely &raudulent o <0TA 3ec$ I ) 3ec$ HP8-d.-C. BCode' de&inition o& t#e term E(alueM Alt#ou"# bankruptcy la, and state la, &or &raudulent con(eyance are (ery similar' bankruptcy la, in some cases "i(es rise to &urt#er claims t#at are not -anymore. a(ailable under state la,' &or e;ample ,#en t#e period #as e;pired$ T#e reason &or t#is is t#at t#e trustee is protected &rom sortin" out t#e con&licts o& la, under eac# Durisdiction in(ol(ed$ E<ce;tion Trans&ers to religious institutions and other charitable entities or or"anizations are not considered &raudulent con(eyances' Sec. 548(a)(2). Once t#e trans&er or obli"ation is a(oided' t#e property is preser(ed &or t#e estate accordin" to 3ec$ HH=$ T#e trans&eree recei(es a lien &or t#e cost o& #er impro(ements to t#e property' limited by t#e (alue o& t#ose impro(ements$

CASE. BFP 0. Re+olution Tru+t Cor;.

JI

Fact+.

% %

% % %

T#e Bartons and 8edersens &ormed a partners#ip' called EB08M' to buy a #ouse$ T#e partners#ip took title o& t#e #ouse subDect to a deed o& trust -) mort"a"e. in &a(or o& !mperial bank to secure payment o& a loan to t#e partners#ip at @IHAK$ 3#ortly a&ter,ards' B08 "rants anot#er deed o& trust to t#e sellers o& t#e #ouse as security &or a promissory note o& anot#er @C00K$ !mperial bank started &oreclosure sale o& t#e #ouse and sold it to Osborne$ A&ter #a(in" &iled &or bankruptcy' B08 seeks to set aside t#e con(eyance o& t#e #ouse to Osborne accordin" to t#e rules o& &raudulent con(eyance' based on t#e &acts t#at t#e #ouse ,as ,ort# @JCHK and ,as sold &or @PPIK$ T#us' t#ere ,as not enou"# money to repay bot# loans &rom t#e &oreclosure price' alt#ou"# t#e &irst creditor ,as o(ersecured and t#us #as no interest to sell t#e #ouse especially #i"#$ K#at does Ereasonably e+ui(alent (alueM mean in t#e conte;t o& a real estate &oreclosure ,#ere t#e c#allen"ed trans&er is not (oluntaryL Kas t#e con(eyance o& t#e #ouse to Osborne a &raudulent trans&er in t#e sense o& 3ec$ HP8L Can a non%collusi(e and re"ularly conducted nonDudicial &oreclosure be +uali&ied as E,it#out reasonably e+ui(alent (alueML Does t#e &oreclosure #a(e to come up ,it# a &air market (alueL T#e B urrett ruleC -rule &rom .urrett v. Washington Nat. -ns. Co..' ,#ic# states t#at any &oreclosure t#at yields less t#an J0Q is in(alid' is not a;;lica,le and ,as reDected by -n ,e *undles' ,#ic# #eld t#at t#ere is a rebuttable presumption t#at t#e &oreclosure price ,as su&&icient' so t#at all t#e &acts and circumstances #a(e to be considered$ !air mar"et value cannot -or not al,ays. be t#e benc#mark$ T#e ,ords &air market (alue does not appear in 3ec$ HP8 but in HCC$ Con"ress did not use t#is lan"ua"e and acts intentionally ,#en it omits certain lan"ua"e -Chicago v. "nvironmental .efense 9und.$ 0urt#ermore' t#e &air market (alue is t#e opposite concept o& a &orced sale$ JP

Le:al I++ue.

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Holdin: G Rea+onin:.

T#e court #olds t#at as lon" as all t#e re+uirements o& t#e 3tate9s &oreclosure la, #a(e been complied ,it#' t#e price in &act recei(ed at t#e &oreclosure is t#e reasonably e+ui(alent (alue &or t#e real property$ T#is means t#at t#e price paid must be an e+ui(alent (alue to t#e debtor9s interests and not to t#e real (alue o& t#e property$ !& a debtor subDects its property to &oreclosure rules as part o& t#e &air e;c#an"e &or money borro,ed' it is #ardly a &raudulent con(eyance under 3ec$ HP8 &or a creditor later to recei(e per&ormance on its bar"ain$

Co55ent+ on t9e ca+e. % 3ec$ HP8 contains t#e ,ords in(oluntary A1D (oluntary trans&er' ,#ic# means t#at t#ere s#ould be a di&&erence in measurement bet,een a case ,#ere t#e trans&er ,as t#e result o& a &oreclosure and a (oluntary trans&er by t#e debtor$ T#us' &air market (alue cannot be t#e benc#mark &or a &oreclosure$ But in &act' t#e lan"ua"e ,as inserted by Con"ress in order to make sure t#at also a &oreclosure can result in an unreasonably e+ui(alent consideration$ Gustice 3calia' dissentin"' is o& t#e opinion t#at i& a &oreclosure is not accepted as reasonable e+ui(alent (alue and is +uali&ied as a &raudulent con(eyance' t#is ,ill cast a s#ado, on a number o& transactions in t#e &uture -undermine &oreclosures.$ A rule based on numbers ,ould be easier to #andle but ,ould not ser(e t#e indi(iduality o& t#e case$ TMcK T#e decision o& t#e 3upreme Court a"ain s#o,s t#at it is not (ery sop#isticated in bankruptcy la, because it takes t#e lan"ua"e o& t#e la, literally$

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Le0era:ed Bu6out+ 'LBO+( =$ 3ecured lendin" a"reement &rom a lender C$ 4epurc#ase o& s#ares o& t#e corporation by t#e corporation I$ 8urc#ase o& ne, s#ares by t#e buyer -#i"#ly concentrated o,ners#ip. P$ !ssuin" o& Dunk bonds -subordinated. to repay t#e lender$ H$ T#e concentrated o,ner also ,orks as mana"er and cleans up t#e company and makes it pro&itable in order to resell it some years later at some pro&it$ JH

CASE. "ood6 0. Securit6 Paci8ic Bu+ine++ Credit7 Inc. Fact+. % Geannette Corporation ,as a pro&itable enterprise &or many years' until a "roup o& in(estors ac+uired it in a le(era"ed buyout$ 2ess t#an #al& a year later' t#e corporation ,as &orced into bankruptcy$ G$ Corp$ purc#ased Geannette ,it# &unds comin" out o& a @=H$Hmio credit &rom 3ecurity 8aci&ic ,#ic# ,as secured by all o& t#e assets o& Geannette$ G$ Corp$ ne(er repaid any portion o& t#e amount$ All t#e corporation recei(ed ,as access to ne, credit and ne, mana"ement$ T#e present (alue o& all assets e;ceeded t#e total loan by @=%Cmio so t#at t#e corporation ,as tec#nically not rendered insol(ent by t#e buyout$ A&ter t#e purc#ase' t#e &inancial stability o& Geannette deteriorated dramatically until one o& t#e trade creditors &iled &or in(oluntary C#apter J$ T#e creditors claim t#at t#e 2BO le&t t#e corporation ,it# unreasonably small capital in t#e meanin" o& 3ec$ HPP-b. or at least a transaction ,it#out &air consideration$ K#at does Eunreasonably small capitalM meanL <nder ,#ic# circumstances does a le(era"ed buyout constitute a &raudulent con(eyance' (oidable under 3ec$ HPP-b.L Kas t#e 2BO a &raudulent con(eyance ,it#out &air consideration and le&t t#e corporation ,it# unreasonably small capitalL #nreasona/l% small ca!ital is not de&ined by t#e Code' but t#e court #olds t#at t#e term denotes a &inancial condition near e+uitable insol(ency -inability to pay debts as t#ey mature.$ !nsol(ency is determined as o& t#e time o& t#e con(eyance -Angier v. Worrell.$ Assets #a(e to be (alued on a "oin" concern basis and not on a li+uidation basis$ T#e (aluation o& t#e capital le&t o(er depends on t#e proDections &or t#e &irm$ T#e test #ere is rea+ona,le JA

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Le:al I++ue.

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Holdin: G Rea+onin:.

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8ore+eea,ilit6 -reasonable proDections. at t#e time t#e trans&er is bein" made$ !n t#is case' t#e proDections ,ere reasonable and t#e corporation9s &ailure ,as caused by a dramatic drop in sales due to &orei"n and domestic competition but not due to t#e +uality o& t#e business plan$ T#e proDections ,ere in a ,ay optimistic but not unreasonably optimistic$ At t#e time t#e proDections ,ere made' t#ere ,as no e(idence t#at t#e trans&er ,ould lea(e t#e company ,it# unreasonably small capital$ T#e transaction did not render t#e corporation in a &inancial situation s#ort o& e+uitable insol(ency' as it ,as able to realize @Amio in t#e A mont#s a&ter t#e deal$ T#ere is no e(idence t#at t#e parties #ad t#e intention to de&raud t#e ot#er creditors because t#e deal did not render t#e corporation insol(ent$ T#ere&ore' t#e deal does not constitute a con(eyance ,it#out &air consideration in t#e meanin" o& 3ec$ HPP-b.$

Co55ent+ on t9e ca+e. % % % % T#ere is no actual &raud in t#e case$ T#e debtor ,as not insol(ent and t#e transaction did not render t#e debtor insol(ent$ T#us t#e case is about i& t#e trans&er ,as made ,it#out reasonable consideration$ <nreasonably small capital is similar to insol(ency but still di&&erent because it takes into account t#e mar"in &or error o& t#e company$ T#e 2BO in(estors ,anted to make money' ,#ic# t#ey could only do i& t#e company succeeded$ T#is indicates to t#e court t#at t#ere ,as no intention to lea(e t#e company ,it# so little money t#at it #ad no mar"in &or error and lead it into bankruptcy$ T#e in(estors risk t#eir reputation ,#en t#ey are not success&ul$ K#o ,ould bene&it &rom a decision +uali&yin" t#e trans&er as a &raudulent con(eyanceL T#e "eneral creditors$ But t#ese creditors came alon" a&ter t#e 2BO t#at all kne, about t#e &inancial structure o& t#e company$ 3o' t#ere is no need to protect t#ese post%2BO creditors' because t#ey already c#ar"ed a muc# #i"#er interest rate ,#en t#ey lent money to t#e company$ T#is already o&&set t#eir risk$ 5rantin" t#e &raudulent con(eyance claim ,ould "i(e t#em a double payment$ JJ

o *;ample 8roDect costs @=0$ !n "ood state -prob$ 80Q. it brin"s returns o& @C0' and in bad state it returns @I$ T#e e;pected (alue t#us is @A$A o K#en t#e proDect no, is &inanced ,it# 80Q debt and C0Q e+uity Debt return -8.-0$8.6-I.-0$C.)J$ T#us' t#e e;pected return is ne"ati(e$ 0or t#is reason' t#e debt ,ill re+uire a muc# #i"#er interest rate ood 8ait9 E PonHi +c9e5e+ % % *(en i& a trans&er is +uali&ied as a &raudulent con(eyance' bein" in "ood &ait# "i(es t#e creditor a lien$ T#e cases #a(e t,o steps o Fir+t t#ere #as to be 8raud by t#e debtor$ !n 8onzi sc#emes' t#ere is a ;re+u5;tion t#at t#ere ,as &raud$ o T#e +econd step t#en is to see i& t#e trans&eree maybe acted in :ood 8ait9$

CASE. In re "an9attan In0e+t5ent Fund Ltd. Fact+. % % % Ber"er' a con(icted &elon and &u"iti(e' used a &und as a sc#eme to e;ecute &raud in t#e &orm o& a 8onzi system -sno,ball system.$ !n t#e year be&ore t#e &und &iled &or bankruptcy' it made a number o& trans&ers &rom an account in Bermuda to an account maintained by Bear 3tearns$ A&ter t#e 3*C &ound out about t#e &raud' Bear 3tearns put t#e account on Eclosin" onlyM so t#at no money could be ,it#dra,n &rom t#e &und9s account until all positions ,ere closed$ 3till' upon re+uest o& t#e &und' Bear 3tearns trans&erred a massi(e amount o& money &rom t#e account to t#e &und9s account at C#ase Man#attan$ T#e bank recei(ed @C$Pmio in re(enue &or its ser(ices$ T#e creditors o& t#e &und c#allen"e t#e trans&er and payment &or ser(ices to Bear 3tearns as &raudulent con(eyance because o& bad &ait#$ T#ey consider t#e bank as a trans&eree$ J8

Bear 3tearns ar"ues t#at it ,as not an initial trans&eree but only a conduit and e(en s#ould it be considered to be an initial trans&eree' it accepted t#e trans&ers in "ood &ait# under 3ec$ HP8-c. ,it#out kno,led"e o& t#e &raud$ K#at is E"ood &ait#M in t#e conte;t o& &raudulent con(eyance la, &or t#e purpose o& 3ec$ HP8-c.L Kere t#e trans&ers made in bad &ait#' meanin" to #inder' delay or de&raud payment to creditorsL Kas Bear 3tearns a Emere conduitM or ,as it an initial trans&ereeL T#e 8onzi system itsel& is proo& -assumption. &or t#e intent to #inder' delay or de&raud payment to creditors o& t#e debtor -,ieser v. 2a%sli!.$ K#en t#e debtor makes a payment to participants o& t#e system' it is clear t#at t#is payment is to t#e detriment o& &uture creditors$ !n determinin" i& Bear 3tearns ,as a mere conduit or an initial trans&eree so t#at t#e trans&er can be a(oided by t#e trustee accordin" to 3ec$ HH0-a.-=.' t#e court applies t#e dominion and control test' ,#ic# leads to t#e assumption t#at Bear 3tearns ,as an actual trans&eree and not only a conduit as it ,as in control o& t#e trans&ers -a"reements.$ T#e la, doesn9t de&ine good faith& but t#e courts a"reed t#at it means #onest belie&' t#e absence o& malice and t#e absence o& desi"n to de&raud or to seek an unconscionable ad(anta"e' but also &reedom &rom kno,led"e o& circumstances' ,#ic# ou"#t to put t#e #older on in+uiry --n ,e 4D7 *usiness 4ach. Co.& -nc..$ !n addition to t#at' t#e trans&eree may not remain ,ill&ully i"norant o& &acts t#at ,ould cause it to be on notice o& a &raudulent purpose and put on blinders be&ore enterin" into transactions --n ,e World 3ision "ntertainment& -nc1$ Kas Bear 3tearns in "ood &ait#L Bear 3tearns ,as on in#uiry notice o& t#e &raud due to a number o& con(ersations and ,as ,earin" blinders$ T#ere ,as a #u"e "ap bet,een t#e &und9s actual per&ormance and its purported per&ormance$ Bear 3tearns ,as t#us re+uired to ask t#e ,ron"doer i& #e ,as doin" ,ron"' but didn9t do so$ T#ey ,ere not in "ood &ait# so t#at t#e trans&ers can be a(oided by t#e trustee accordin" to 3ec$ HP8$ J>

Le:al I++ue.

% % %

Holdin: G Rea+onin:.

Co55ent+ on t9e ca+e. % Kas t#e bank about to unco(er t#e &raud and t#us ,as not in "ood &ait# any lon"erL TMcK 1o' t#ey ,ent to a bi" auditor -Deloitte. and asked &or an auditin" o& t#e &und and "ot t#e result t#at e(eryt#in" ,as alri"#t$ And in addition to t#is' t#e bank ,ent to t#e 3*C' ,#ic# caused to ,#ole system to &all apart$ T#e court interprets t#is as t#at t#e bank already t#ou"#t t#at t#ere ,as somet#in" "oin" on in t#e &und$ T#is decision incenti(izes t#e banks in t#e &uture not to researc# and analyze anymore ,#en it comes to &is#y cases like t#is$ T#is means t#at a bank is not re+uired to acti(ely in(esti"ate as lon" as t#ere is no reason to doubt t#e la,&ulness o& t#e transactions due to ob(ious reasons$ T#e opinion is bene&icial to securities in(estors$ On &irst access' t#e case looks like a plain (anilla burden o& proo& case$ But actually' it is a +uestion about ,#o are t#e ,ron"doers in t#is case$ T#e bank "ets a &ee &rom t#e system t#at increases t#e lon"er t#e system #olds up$ !t seems t#at t#e bank ,anted to keep t#e system ali(e$ 0or t#is reason' t#e court #eld t#at t#e bank ,as on in+uiry notice$ Case "ot re0er+ed later on' and t#us is no lon:er :ood la1$

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S9ort +ellin:. =$ C$ I$ P$ H$ Borro, a security t#at is supposed to "o do,n in (alue 3ell t#e security at today9s price Kait &or t#e security to drop 4epurc#ase t#e security at t#e lo,er price 4eturn t#e asset -return is t#e di&&erence.

$lass %5

D4C. 2oida,le Pre8erence+ E Sec. 3*D',(

80

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T#e descent o& a #ealt#y &irm into insol(ency and t#en into bankruptcy is a lon" one and can in many cases be &oreseen in t#e last period be&ore t#e &ilin"$ 3ec$ HPJ -(oidable pre&erences. is a pro(ision t#at is desi"ned to root out pre&erences -money trans&ers' trans&ers o& property in in(entory etc$. t#at are made on t#e e(e o& bankruptcy and inter&ere ,it# t#e norms o& bankruptcy la,$ !t a(oids t#at alert creditors "et &ully paid o&& s#ortly be&ore t#e bankruptcy to t#e detriment o& ot#er creditors$ De8inition Accordin" to Sec. 3*D',(' a trans&er is presumably pre&erential i& it is made o to or &or t#e bene&it o& a creditor on account of an antecedent debt' o during the &' days be&ore t#e bankruptcy petition -= year &or insiders.' o and ,#ile t#e debtor is insolvent -presumed in t#e >0 day ,indo,.' o pro(ided t#at t#e transfer leaves that creditor better off t#an it ,ould #a(e been #ad t#e trans&er not been made and #ad t#e debtor9s assets been li+uidated -lar"er s#are o& t#e estate.$ o (ntent does not matter) o *(ery reduction o& t#e amount o& t#e insu&&iciency claim t#at e;isted e;actly >0 days be&ore t#e &ilin"' is considered a preference t#at is t#en (oidable$ T#e rule is' as e(ery bri"#t%line rule' o(er and underinclusi(e !t cannot reac# a creditor t#at recei(es a payment more t#an >0 days prior to t#e &ilin" e(en ,#en #e kne, about t#e &inancial status o& t#e company' but it ,ill reac# a creditor t#at is paid in "ood &ait#' not kno,in" about t#e problems$ A lot o& payments to bi" creditors can be obser(ed >= days be&ore t#e &ilin"$ T#us' ,#en t#e trans&er is made to an insider' t#e trans&er can be a(oided up to one year prior to t#e &ilin"$ T#e pre&erence can take many di&&erent &orms' suc# as t#e payment to an undersecured creditor Dust be&ore &ilin"' "i(in" a security interest to a "eneral creditor Dust be&ore &ilin" etc$ *(en t#ou"# t#e trustee cannot strike do,n t#e trans&er usin" a stron" arm po,er -HPP.' #e can (oid t#e trans&er under HPJ$ K#ile a trans&er is potentially (oidable ,#et#er it is (oluntary or in(oluntary' actin" strate"ically or instead innocentl6 makes a di&&erence$ T#e latter creditor may #a(e a c#ance to s#ield t#e trans&er under +a8e 9ar,or pro(isions located in Sec. 3*D'c($ !n e(ery (oidable pre&erence case' t#ere #as to be determined ,#en t#e debt ,as incurred and ,#en t#e trans&er occurred$ T#e de,t 9a+ to ,e incurred ,e8ore t9e tran+8er $ 0urt#ermore'

8=

t#e e(il about t#e trans&er must be t#at t#ere is no (alue t#at t#e debtor "ets in return$ T#us' ,#en a bank "i(es a credit to t#e debtor a day be&ore bankruptcy &ilin" and recei(es a security interest in t#e debtor9s assets' t#is does not constitute a trans&er in t#e sense o& HPJ' because t#e tran+8er ,as not made on account o8 an antecedent de,t$ !t "ets more problematic ,#en t#ird persons are in(ol(ed$ T#en' it is #ard to determine ,#at kind o& trans&er ,as made as t#ere ,ere tec#nically no pre&erences made because t#e bank O etc$ is t#ere as an intermediary$

CASE. P.A. Ber:ner ! Co. 0. Ban- One Fact+. % Ber"ner and Bank One entered into a standby letter o& credit a"reement under ,#ic# Bank One a"reed to issue standby letters o& credit as security &or some o& Ber"ner9s credit obli"ations$ At Ber"ner9s re+uest' t#e bank issued a number o& letters o& credit to Ber"ner9s suppliers$ Ber"ner needed t#e letters o& credit to pro(ide added security &or its contracts ,it# t#e supplier to purc#ase merc#andise &rom it$ T#e e&&ect o& t#e standby letter o& credit is t#at t#e issuer -Bank One. promises to pay t#e bene&iciary -t#ird party. in an e(ent t#at entitles t#e bene&iciary to dra, on t#e letter$ T#e account party -Ber"ner. promises to repay t#e bank later$ T#e bank in return "ets a &ee$ !n case o& de&ault by t#e account party' t#e account party ,as obli"ated to pay t#e &ull amount o& all dra&ts t#at could be presented under outstandin" letters o& credit$ K#en Bank One re&used to rene, t#e standby letters o& credit' t#e supplier planned to e;ercise t#eir ri"#ts to dra, do,n t#e &ull amount o& t#e credit$ !n order to pre&und t#e amount due be&ore Bank One ,ould pay t#e amount back' Bank One o&&ered Ber"ner a credit' ,#ic# #e turned do,n as too e;pensi(e$ !nstead' Ber"ner turned to 3,iss bank "roup and lent @I0mio t#ere' ,#ic# t#e bank trans&erred to Ber"ner9s account$ Bank One t#en took t#e money and repaid AMC' t#e supplier$ K#en Ber"ner ,as about to &ile &or bankruptcy' Bank One considered t#is an e(ent o& de&ault and 8C

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,it#dre, @Amio' t#e amount o& all possible dra&ts' &rom Ber"ner9s account on t#e day o& t#e &ilin" and put it in a separate collateral account$ Ber"ner no, claims t#e amount o& @I0mio plus @Amio to be pre&erential trans&ers to Bank One$ Bank One ar"ues t#at t#ere ,ere no e&&ects on t#e estate because o T#e trans&er o& t#e @Amio ,as no diminution because t#e money is still on t#e collateral account$ o T#e @I0mio ,ere Dust mo(ed &rom 3,iss bank to t#e bene&iciary t#rou"# Bank One' but Bank One ,as ne(er a trans&eree$ Does t#e bank #a(e to pay back t#e money to Ber"ner -@IAmio.L Did t#e trans&ers constitute pre&erential trans&ersL Bank One #ad t#e obli"ation to pay t#e bene&iciaries upon a dra&t supported by documents and Bank One recei(ed a &ee &or t#is obli"ation$ T#us' it #as t#e obli"ation to pay t#e @I0mio$ T#is means t#at t#e moment Bank One incurred t#e obli"ation to t#e supplier' a debt arose bet,een Bank One and Ber"ner$ K#en Ber"ner t#en recei(ed t#e money &rom 3,iss bank and put it on t#e account at Bank One' ,#ic# trans&erred it to AMC' t#e re+uirements o& 3ec$ HPJ-b. are "i(en o T#e trans&er ,as made on account o& Ber"ner9s antecedent obli"ation under t#e 32CA contract o !t occurred ,it#in >0 days prior to t#e &ilin" o Ber"er ,as insol(ent at t#at time T#e same is true &or t#e ot#er amount o& @Amio$ Ber"ner is t#us entitled to reco(er under 3ec$ HH0-a.$

Le:al I++ue. Holdin: G Rea+onin:.

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Co55ent+ on t9e ca+e. % % T#e court does not apply t#e conduit theory& ,#ic# ,ould +uali&y t#e bank Dust as an intermediary t#at passes on t#e money' but looks at t#e trans&ers independently$ T#e economic reality o& a case like t#is is t#at t#e money is trans&erred &rom 3,iss bank to t#e bene&iciaries$

8I

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But t#e court applies an independent transaction (ie,' takin" into account t#e (alue o& t#e letter o& credit$ T#e result in t#e case ,ill Dust result in #i"#er &ees &or letters o& credit' ,#ic# in t#e &uture e(ens out t#e bank9s liability t#reat$ TMcK T#e court "ot annoyed by t#e &act t#at Bank One #ad its &ees c#ar"ed and no, ,ants to "et out o& t#e a&&air by not payin" &or t#e obli"ation$

Ear5ar-in: Doctrine % K#en a ne, lender directly pays an antecedent debt' or t#e debtor is obli"ated to use t#e proceeds o& a ne, loan to repay suc# debt' t#e ne, loan can be (oided accordin" to t#e (oidable pre&erence rules' unless t#e trans&er can be +uali&ied as an earmar"ed loan$ As t#ere is no e;plicit statutory la, &or an earmarked loan e;ception in t#e Code' t#e courts #a(e de(eloped t#e earmar"ed doctrine$ T#e doctrine allo,s an e;ception &rom 3ec$ HPJ-b. in t#e case ,#ere an insol(ent debtor uses a ne, loan9s proceeds to repay an antecedent debt on t#e e(e o& bankruptcy$ T#e loan t#en is not +uali&ied as a (oidable pre&erence and t#us not a(oided accordin" to t#e (oidable pre&erence rules under 3ec$ HPJ$ !nstead' an earmarked &und ne(er becomes property o& t#e debtor -o& t#e estate. and t#us cannot be a(oided by 3ec$ HPJ-b.$

CASE. In Re Heit-a5; Fact+. % % T#e ?eitkamps build and sell #ouses$ 0or t#is reason' t#ey obtained mort"a"e secured loan &rom t#e bank$ Be&ore completin" t#e proDect' t#ey obtained anot#er loan &rom t#e bank' ,#ic# t#e bank used to issue cas#ier9s c#ecks to t#e subcontractors$ T#e ?eitkamps in return recei(ed mec#anic9s lien ,ai(ers in e;c#an"e &or t#e c#ecks$ T#e ?eitkamps "a(e t#e bank a second mort"a"e on t#e #ouse$ 3ome days later' t#e ?eitkamps &iled &or C#apter J$ T#e bankruptcy trustee no, ,ants to set aside t#e second mort"a"e interest trans&er to t#e bank under 3ec$ HPJ-b.$ 8P

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Le:al I++ue.

Does t#e earmarkin" doctrine pre(ent t#e trustee &rom settin" aside -a(oidin". t#e second mort"a"e trans&erL T#e earmarkin" doctrine applies$ Accordin" to t#e earmarkin" doctrine' t#ere is no a(oidable trans&er o& t#e debtor ,#en a ne, lender and a debtor a"ree to use loaned &unds to pay a speci&ied antecedent debt$ T#e transaction as a ,#ole does not diminis# t#e (alue o& t#e estate' because it Dust replaced one creditor by anot#er o& t#e same priority$ T#is does not brin" any ad(anta"e to t#e bank$ T#e trans&er is t#us not (oidable accordin" to t#e rules o& 3ec$ HPJ-b.$ T#e trustee #ad t#e burden o& proo& to s#o, t#at t#e earmarkin" doctrine doesn9t apply and &ailed to do so$

Holdin: G Rea+onin:.

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Co55ent on t9e ca+e. % % T#e bank steps in t#e s#oes o& t#e debtor by payin" t#e ot#er creditors and #as an interest in t#em &inis#in" t#e proDect' ,#ic# ,ill lead to a #i"#er (alue o& t#e #ouse$ T#e debtors #ad t#e same amount o& credit and t#e same priority$

$lass %*

Sa8e Har,or+ E Sec. 3*D'c(

8H

8re&erential trans&ers t#at are presumpti(ely (oidable under 3ec$ HPJ-b. and t#at are not reac#ed by t#e earmarkin" doctrine' may still not be reac#ed by t#e trustee' ,#en t#ey are co(ered by t#e sa&e #arbor e;ceptions in 3ec$ HPJ-c.$ T#e sa&e #arbor rules "o(ern trans&ers t#at appear to be routine and not last%minute attempts to sa&e a creditor9s position$ o -c.-=. e;c#an"e intended by t#e creditor and t#e debtor as contemporaneous e;c#an"e &or ne, (alue is "i(en to t#e debtor -sale o& "oods.$ o -c.-C. debt incurred ,it#in t#e ordinary course of business -retailer purc#ases in(entory and "ets paid. or payment made according to ordinary business terms$ o -c.-I. debtor trans&ers security interest on account o& an antecedent debt t#at ,as incurred &or t#e transfer of property -mac#ine bou"#t on credit.$ o *tc$ Trans&ers t#at are presumpti(ely (oidable are only s#ielded by t#e sa&e #arbor rules i& t#ey are EinnocentM and do not purport to be an attempt by a creditor to opt out o& a bankruptcy proceedin"$ Intent normally does not matter in pre&erence la,' but doe+ 5atter &or t#e sa&e #arbor rules$

CASE. Union Ban- 0. Iola+ Fact+. % % % % % Holdin: G Rea+onin:. % % % Debtor borro,ed @Jmio &rom bank$ 3#ortly a&ter' debtor &iles &or bankruptcy$ Durin" t#e >0 day period' debtor made t,o interest payments on t#e loan' totalin" @=00K$ Do payments on lon"%term debt constitute a sa&e #arbor e;ception accordin" to 3ec$ HPJ-c.-C.L Does t#e payment +uali&y as a payment durin" t#e ordinary course o& businessL 2on"%term debt interest payments can +uali&y &or t#e ordinary course o& business$ T#e te;t pro(ides no support t#at 3ec$ HPJ-c.-C. is limited only to s#ort%term debt$ T#e #istory o& t#e section does not support t#e limitation o& t#e section because it ,as limited to s#ort%term credit ,#en t#e pre&erence rules at t#e same time ,ere si"ni&icantly narro,er t#an today$

Le:al I++ue.

8A

T#e recei(er o& an interest payment does not recei(e more t#an #e ,ould #a(e recei(ed in t#e bankruptcy process because t#e interest payment is only a part o& t#e ,#ole sum t#at #e can claim$ T#e current e+pense doctrine' ,#ic# is a common la, rule' does not apply because a current e;pense is an e;pense t#at is necessary to run t#e daily business -suc# as electricity bill' c#eck payment in store' etc$.$ T#ere is a contemporary e;c#an"e o& (alue &or t#e current e;pense payment -t#e debtor recei(es electricity in e;c#an"e &or t#e payment o& t#e bill.$ A payment on a lon"%time credit does not +uali&y as a current e;pense in t#e sense o& t#e doctrine$

Co55ent+ on t9e ca+e. % T#e C00H Bankruptcy Act allo,s payments i& t#ey are eit#er made in t#e ordinary course o& t#e business O4 it is made accordin" to ordinary business terms$ T#is broadens t#e nature o& 3ec$ HPJ-c.-C.$ TMcK T#e &act t#at t#e court sees payments on t#e lon"%term debt as ordinary business can be seen ambi"uously$ !t de&initely cannot be seen as ordinary i& t#e debtor makes t#e decision not to pay ot#er creditors at t#e same time$ A payment made a&ter t#e decision to pre&er one creditor o(er anot#er cannot be seen as ordinary$ TMcK 3ec$ HPJ-c.-C. does not say anyt#in" about t#e terms o& t#e loan$ T#e +uestion ,#et#er a loan is s#ort%term or lon"%term does not really determine ,#et#er t#e payments occur in t#e ordinary course o& business or not$ T#e (oidable pre&erence la, "i(es t#e debtor some sort o& bar"ainin" po,er$ T#is policy reason does not apply #ere because t#ere is no need to protect t#e debtor$ T#e lon"%term creditor is "oin" to court' t#e s#ort%term creditor is "oin" to cut o&& t#e debtor and stop deli(ery$ T#is ,ill cause t#e debtor to "o under$ 0or t#is reason' t#e s#ort%term creditor must be protected -premature li+uidation must be pre(ented.$ T#is does not apply to t#e lon"%term creditors$ T#us' it is not ob(ious t#at t#e court dealt ri"#t ,it# t#e case' treatin" t#e lon"%term and s#ort%term creditors e+ually$

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8J

D4D. Seto88+ E Sec. 33/ % A debtor9s assets may include an obli"ation o,ed to t#e debtor by one o& t#e debtor9s creditors' suc# as ,#en a bank o,es t#e obli"ation to pay money t#at t#e debtor #olds on a deposit account$ By contract t#e bank #as t#e ri"#t to o&&set t#e obli"ation on t#e account to satis&y t#e debtor9s loan obli"ation ,#en it comes due$ T#e bankruptcy code treats seto&&s as a security interest' accordin" to 3ec$ H0A-a.$ T#is means t#at an e;ercise o& t#at ri"#t is a trans&er' 3ec$ =0=-HP.$ T#e debt must be mutual and must arise prepetition &or a seto&& ri"#t to arise$

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Sec. 33/'a( J incurrin: a de,t % 5enerally' t#e Code does not a&&ect seto&& ri"#ts t#at arise &rom mutual debts in 3ec$ HHI-a.$ But t#ere are e;ceptions to t#is' ,#ere t#e seto&& is not #onored$ T#is e;ception resembles t#e pre&erred trans&er pro(ision and does not allo, seto&&s i& t#ey occur o Kit#in >0 days be&ore t#e &ilin" o O4 a&ter t#e commencement o& t#e case o K#ile t#e debtor is insol(ent T#e section is desi"ned to pre(ent indirect payments to creditors t#at ot#er,ise ,ouldn9t #a(e recei(ed t#e &ull amount because t#ey ,ere unsecured$ T#us' 3ec$ HHI also &orbids o&&settin" ,it# a debt ,#en t#e debt incurred by t#e creditor ,as &or t#e purpose o& obtainin" a ri"#t to seto&& a"ainst t#e debtor$

Sec. 33/',( J e<erci+e o8 t9e +eto88 ri:9t % T#e trustee may reco(er a"ainst a creditor t#at o&&sets a mutual debt ,it#in >0 days prior to t#e &ilin"' to t#e amount t#at an insu&&iciency is lo,er t#an t#e insu&&iciency ,as on t#e day >0 days be&ore t#e &ilin"$ (nsufficiency means t#e amount by ,#ic# a claim a"ainst t#e debtor e;ceeds t#e mutual debt o,in" to t#e debtor by t#e #older o& t#e claim$ T#is is similar to t#e improvement test in 3ec$ HPJ-c.-H.$

88

CASE. Brani88 Air1a6+ Inc. 0. E<<on Co. Fact+. % % % Brani&& made prepayments &or t#e use o& &uel eac# ,eek$ T#e ,eek o& t#e &ilin"' B$ #ad made a @H00K prepayment and #ad used @=00K o& it$ *;;on t#us o,ed @P00K to Brani&&$ !n addition to t#at' *;;on and Brani&& #ad a contract accordin" to ,#ic# *;;on deli(ered oil etc$ Durin" t#e >0%day period be&ore Braini&& &iled &or bankruptcy' Brani&& made a payment o& @=H0K on t#at obli"ation deri(in" &rom t#e contract$ Brani&& and *;;on a"reed t#at #al& o& t#e amount is paid under t#e e;ception o& 3ec$ HPJ-c.-C. so t#at it cannot be a(oided as a pre&erential payment$ T#e remainin" #al& can only be reco(ered under 3ec$ HPJ-b. i& *;;on ,as better o&& t#an ,it#out t#e trans&er$ T#is depends on t#e +uestion ,#et#er *;;on could seto&& t#e amount due by t#e amount o,ed to Brani&&' accordin" to 3ec$ HHI-a.$ A claim subDect to seto&& under sec$ HHI is secured to t#e e;tend o& t#e amount subDect to seto&&' 3ec$ H0A-a.' so t#at a payment ,ouldn9t #a(e rendered *;;on in a better position$ Can *;;on seto&& pursuant to 3ec$ HHI-a.L T#is determines ,#et#er t#ere ,as a (oidable pre&erence$ *;;on does #a(e a ri"#t to o&&set pursuant to 3ec$ HHI-a. but e(ery seto&& can be reco(ered by Brani&& pursuant to 3ec$ HHI-b.$ T#ere ,as no Ballmet relation$ !t is not ob(ious i& t#e bank really impro(ed its position$ 0or t#is reason' remand to t#e &act&inder is necessary in order to determine t#is$

% %

Le:al I++ue.

% % % % %

Holdin: G Rea+onin:.

8>

2III. THE DEBTORKS ESTATE A. PROPERTY OF THE ESTATE

Code F HP=-a.-=.%-I.' -A.' T -J.' -c.' T -d. Code F HP=-b. -skim. Code F HPC "ANA IN THE ESTATE

Bankruptcy proceedin"s take time$ Dual obDecti(es o& bankruptcy la,' ,#ic# s#ould' -i. ensure t#at t#e passa"e o& time does not c#an"e t#e (alue o& creditors9 ri"#ts relati(e to one anot#er/ and -ii. #a(e as small an e&&ect as possible on t#e debtor9s relations#ip ,it# t#e rest o& t#e ,orld$

TURNO2ER OF PROPERTY 3ection HP= o& t#e Code -<ro!ert% of the "state. establis#es t#e EestateM' and IAC -Automatic ta%. is desi"ned to keep t#e estate to"et#er &or t#e purposes o& bankruptcy proceedin"s$ 3ection HPC -5urnover of <ro!ert% to the "state. "enerally re+uires t#e turno(er o& property t#at t#e trustee may use' sell' or lease under 3ection IAI - #se& sale& or lease of !ro!ert%.' or t#at t#e debtor may e;empt under 3ection HCC -">em!tions.$ T#e bankruptcy estate consists o& interests in property' and t#e trustee can "at#er property in ,#ic# t#e debtor #as an interest e(en i& anot#er -e$"$' secured creditor. also #as an interest' and no matter to ,#om t#e bankruptcy process ,ill ultimately a,ard t#e property or its (alue$

>0

!mportant #ard +uestions may arise about ,#et#er t#e debtor9s interest in property e;ists at t#e time o& bankruptcy or #as been e;tin"uis#ed so t#at t#ere is no property to ,#ic# a turno(er obli"ation can attac#$ UNITED STATES 0. IHITIN POOLS7 INC. <nited 3tates 3upreme Court' =>8I -PAC <$3$ =>8.

!acts , K#itin" o,ed @>C'000 in ta;es' but #ad &ailed to pay -rocedura upon demand by t#e !43$ Conse+uently' a ta; lien in l -osture t#at amount ,as attac#ed to all o& K#itin"Ws property$ On 0=O=PO=>8=' t#e !43 seized K#itin"Ws tan"ible assets pursuant to t#e le(y' and t#e ne;t day K#itin" &iled a petition &or reor"anization under C#apter ==$ *stimated li+uidation (alue o& t#e property seized ) @IH'000 O *stimated "oin"%concern (alue ) @=AC'8JA$ <$3$ mo(ed in t#e Bankruptcy Court &or a declaration t#at t#e automatic stay pro(ision is inapplicable to t#e !43 or' in t#e alternati(e' &or relie& &rom t#e stay$ K#itin" counterclaimed &or turno(er o& t#e seized property o(er to t#e bankruptcy estate pursuant to F HPC-a.$ T#e Bankruptcy Court -i. determined t#at t#e !43 ,as bound by t#e automatic stay' and -ii. directed t#e !43 to turn t#e property on t#e condition t#at K#itin" ,ould pro(ide t#e !43 ,it# speci&ied protection &or its interests$ District Court re(ersed' and t#e Court o& Appeals re(ersed t#e District Court decision$ .egal (ssue(s) /olding(s) , 0ule(s) K#et#er F HPC-a. o& t#e Code aut#orized t#e Bankruptcy Court to subDect t#e !43 to a turno(er order ,it# respect to t#e seized property$ 4eor"anization estate includes property o& debtor t#at #as been seized by a creditor prior to &ilin" o& petition &or reor"anization$ T#e !43 is subDect to F HPC-a. o& t#e Code' and t#ere&ore t#e Bankruptcy Court can order t#e !43 to turn o(er property ,#ic# it #ad seized to satis&y ta; lien prior to &ilin" o& reor"anization petition$

0easoning

1hether 2 542(a) generally authori3es the turnover of a debtor4s property sei3ed by a secured creditor prior to the commencement of

>=

reorgani3ation proceedings Con"ress intended a broad ran"e o& property' includin" property in ,#ic# a creditor #as a secured interest' to be included in t#e estate$ K#yL 8olicy o& encoura"in" t#e reor"anization o& troubled enterprises$ 3ecured creditors are protected by imposin" limits or conditions on t#e trusteeWs po,er to sell' use' or lease property subDect to a secured interest' no by e;cludin" suc# property &rom t#e estate$ 3tatutory interpretation 3ection HP=-a.-=. pro(ides t#at t#e estate s#all include Eall le"al or e+uitable interests o& t#e debtor and property as o& t#e commencement o& t#e case'M and t#is includes any property made a(ailable to t#e estate by ot#er pro(isions o& t#e Code' suc# as F HPC-a.$ A di&&erent interpretation ,ould depri(e t#e reor"anization estate o& t#e assets and property essential to its re#abilitation e&&ort' and &rustrate t#e con"ressional purpose be#ind t#e reor"anization pro(isions$

1hether the (0S is bound by 2 542(a) to the same e+tent as any other creditor T#e !43 is bound by F HPC-a. to t#e same e;tent as any secured creditor$ T#e Code e;pressly states t#at t#e term EentityM in F HPC-a. includes a "o(ernmental unit$ K#en property seized by t#e !43 pursuant to a ta; lien prior to &ilin" o& bankruptcy petition is dra,n into C#apter == reor"anization estate' t#e !43Ws ta; lien does not dissol(e nor is its status as a secured creditor destroyed$ F HPC-a. ,ould not apply i& a ta; le(y or seizure trans&erred to t#e !43 o,ners#ip o& t#e property seized$ ?o,e(er' t#e !nternal 4e(enue Code does not trans&er o,ners#ip o& suc# property until t#e property is sold to a bona &ide purc#aser at a ta; sale$ !43 remains entitled to -i. t#e ade+uate protection &or its interests ,#ic# is applicable to >C

all secured creditors in "eneral' and -ii. to speci&ic pri(ile"es applicable to t#e !43 in particular$ But t#e !43 is re+uired to seek protection o& its interests accordin" to con"ressionally establis#ed bankruptcy procedures' rat#er t#an by ,it##oldin" seized property &rom debtorWs e&&orts to reor"anize$ 5otes , $lass discussion T#is case applies "enerally to all secured creditors ,#o #a(e repossessed collateral be&ore t#e &ilin" i& t#e petition but #a(e not yet disposed o& it$ ?o,e(er' in t#e case o& a "o(ernmental entity' t#e trustee ,ill be unable to &orce it to turn o(er collateral because o& so(erei"n immunity' unless t#e "o(ernmental entity &iles a claim in t#e bankruptcy proceedin" -2offman v. Connecticut .e!artment of -ncome 4aintenance.$ T#e de&inition o& Eproperty o& t#e estateM re&ers to EinterestsM in property' not to t#e property itsel&$ T#e debtor9s only EinterestsM remainin" in repossessed property are t#ose o& redemption and surplus' but t#e Court in Whiting <ools a(oids t#is issue by statin" t#at t#e statutes re&erred to Eproperty o& t#e estateM s#ould be read as a de&inition o& ,#at is included in t#e estate' rat#er t#an as a limitation$

>I

B. Code Code Code Code

ADELUATE PROTECTION OF CREDITORS F F F F HHC IAC-d.-=. T -C. -reread. IAC-d.-I. H0A -reread.

Once in t#e possession or control o& property t#at makes t#e property o& t#e estate' t#e trustee or debtor%in%possession must maintain t#e property &or t#e bene&it o& t#e creditors$ !n principle' t#e trustee retains collateral only i& t#e collateral is ,ort# more to t#e debtor as a continuin" enterprise t#an to anot#er ,#o ,ould purc#ase t#e collateral in li+uidation sale$ 3ection HHC-b. "enerally permits t#e post petition attac#ment o& a security interest in t#e proceeds' products' o&&sprin"' pro&its' and rents o& or &rom collateral subDect to an una(oided security interest$ T#e creditor may &ear t#at t#e trustee ,ill dissipate t#e (alue o& t#e creditor9s security e(en i& t#e interest &ormally sur(i(es/ in t#at case' t#e creditor can seek protection o& its security interest by re+uestin" t#at a court li&t t#e automatic stay under IAC-d.$ 8ossible scenarios IAC-d.-C. Z 2i&t o& automatic stay ,it# respect to stay o& an act a"ainst property i& -i. Debtor does not #a(e e+uity in suc# property/ and -ii. 3uc# property is not necessary to an e&&ecti(e or"anization$ *;ample D o,es to B @H00'000 secured by a parcel o& land ,ort# no more t#an @I00'000$ D &iles petition under C#apter J' or attempts to reor"anize under C#apter == ,it#out t#e intention o& retainin" t#e parcel o& land$ !n eit#er case' t#ere is no reason &or t#e trustee to retain t#e parcel because' -i. D #as no e+uity in t#e property' and -ii. none o& t#e debtor9s ot#er assets ,ill lose (alue' and t#ere&ore t#e parcel is not necessary to an e&&ecti(e or"anization$

>P

 IAC-d.-I. Z 2i&t o& automatic stay ,it# respect to creditor ,it# a security interest in sin"le asset real estate as de&ined by 3ection =0=-H=B.$ To a(oid &oreclosure' t#e debtor must eit#er -i. 0ile a plan o& reor"anization t#at #as a reasonable possibility o& bein" con&irmed ,it#in reasonable time/ or -ii. Be"in mont#ly interest payments to t#e creditor on t#e secured portion o& its claim at a contract rate o& t#e related loan$ !& t#e parcel o& land "enerates substantially all o& t#e debtor9s "ross income and is ot#er,ise sin"le% asset real estate' IAC-d.-I. makes it easier &or a creditor ,it# a security interest in it to obtain relie& &rom t#e automatic stay' because in t#is case -i. t#ere is little c#ance o& collecti(e action problems' and -ii. t#ere is no t#reat to a "oin" concern nearly comparable to ,#at one ,ould encounter i& t#e debtor ,ere a manu&acturer ,it# multiple assets syner"istically connected$

Di&&icult situation arises ,#en t#e debtor does #a(e e+uity in collateral t#at is part o& a more comple; enterprise or ,#en t#e collateral is necessary to keep a business runnin" Z t#en t#e court ,ill be reluctant to allo, t#e secured creditor &oreclose on t#e property$ *;ample D is a retailer ,#o o,es to B @H00'000 secured by t#e debtor9s computer so&t,are' ,ort# at least @A00'000 i& sold to anot#er business$ Trustee mi"#t ,is# to retain t#is collateral -i. to ensure t#at t#e collateral sell &or t#e #i"#est possible price -proceeds in e;cess o& @H00'000 ,ould "o to "eneral creditors./ and -ii. collateral mi"#t be essential to t#e debtor9s continued operation$

IAC-d.-=. Z 5i(es t#e creditors ability to li&t t#e automatic stay &or cause/ most common cause is t#e lack o& ade+uate protection$ Ade+uate 8rotection re+uires t#e debtor to protect t#e secured creditor &rom any loss o& t#e collateral9s (alue$ !n addition' i& t#e ade+uate protection pro(ided ultimately pro(es inade+uate' t#e secured creditor is entitled to a &irst priority claim a"ainst any o& t#e debtor9s unencumbered assets$

>H

 Concept o& ade+uate protection also appears in -i. 3ection IAI-e.' ,#ic# "i(es an entity ,it# an interest in property t#e ability to condition any use' sale or lease on t#e pro(ision o& ade+uate protection' and -ii. 3ection IAI-c.-C.' ,#ic# pro(ides t#at t#e debtor cannot use' sell or lease cas# collateral$ T#e precise meanin" o& Eade+uate protectionM ,as subDect to #ot debate in t#e early =>809s Z in&lation ran double di"its and a main concern o& creditors in bankruptcy ,as t#e time (alue o& t#eir claims @=00 is still @=00 in real terms a&ter t#e lapse o& time' but @=00 a year &rom no, is not as (aluable as @=00 today$ T#ere&ore' creditors ar"ued t#at t#ey #ad to be compensated &or t#e amount t#eir claims declined in (alue bet,een t#e time t#ey ,ould #a(e &oreclosed and t#e time t#e bankruptcy is o(er$ T#e trustees ,ould ar"ue t#at creditors ,ere only entitled to #a(e t#e nominal (alue o& t#eir interest protected$ T#ere ,as di(ision amon" courts' and in 5im/ers t#e 3upreme Court resol(ed t#is issue by #oldin" t#at nominal (alues rat#er t#an real (alues s#ould be used$

>A

UNITED SA2IN S ASSOC. 0. TI"BERS OF INIOOD FOREST ASSOCIATES7 LTD. <nited 3tates 3upreme Court' =>88 -P8P <$3$ IAH. !acts , Timbers o,es to <3 3a(in"s @P$= million in principal -rocedura under a note secured by security interest in l -osture apartment proDect o,ned by Timbers' an interest t#at includes an assi"nment o& rents &rom t#e proDect$ On 0IO0PO=>8H Timbers &iled C#apter ==' and s#ortly t#erea&ter <3 3a(in"s mo(ed &rom relie& &rom t#e automatic stay ar"uin" t#at t#ere ,as lack o& ade+uate protection$ T#e (alue o& collateral ,as some,#ere bet,een @C$A and @P$C million' and t#e property ,as appreciatin" sli"#tly in (alue$ !t ,as t#ere&ore undisputed t#at <3 3a(in"s ,as an undersecured creditor$ Timbers a"reed to pay t#e post petition rents &rom t#e apartment proDect' minus operatin" e;penses$ <3 3a(in"s contended' #o,e(er' t#at it ,as entitled to additional compensation$ T#e Bankruptcy Court a"reed' and it conditioned continuance o& t#e stay on mont#ly payments by Timbers$ Timbers appealed to t#e District Court and petitioner cross%appealed on t#e amount o& t#e ade+uate protection payments$ T#e District Court a&&irmed but t#e 0i&t# Circuit re(ersed$ .egal (ssue(s) /olding(s) , 0ule(s) K#et#er undersecured creditors are entitled to compensation under IAC-d.-=. &or t#e delay caused by t#e automatic stay in &oreclosin" on t#eir collateral$ E!nterest in propertyM protected by IAC-d.-=. [allo,in" undersecured creditor relie& &rom stay on "round o& lack o& ade+uate protection] does not include creditorWs ri"#t to immediate &oreclosure$ <ndersecured creditors are not entitled to compensation under IAC-d.-=. &or t#e delay caused by t#e automatic stay in &oreclosin" on t#eir collateral$

0easoning

Statutory interpretation

>J

 IAC-d.-=. s#ould not be read in isolation Z in ,#ic# case t#ere ,ould be "rounds to sustain t#at Einterest in propertyM also includes t#e secured partyWs ri"#t to take immediate possession o& t#e de&aulted security' and apply it in payment o& t#e debtZ' but in t#e li"#t o& ot#er pro(isions o& t#e Code &rom ,#ic# it can be implied t#at t#e Einterest in propertyM protected by IAC-d.-=. does not include creditorWs ri"#t to immediate &oreclosure$ 0irstly' t#e meanin" o& t#e p#rase Einterest in propertyM in IAC-d.-=. is clari&ied by t#e use o& similar terminolo"y in H0A-a.' ,#ere it must be interpreted to mean only t#e creditorWs security interest in t#e property ,it#out re"ard to #is ri"#t to immediate possession on de&ault$ 3econdly' <3 3a(in"9s interpretation is structurally inconsistent ,it# 3ection HHC$ T#irdly' petitionerWs interpretation o& IAC-d.-=. makes nonsense o& IAC-d.-C.$ 6ther arguments <3 3a(in"s contends t#at denyin" it compensation under IAC-d.-=. is inconsistent ,it# t#e p#rase Eindubitable e+ui(alentM in IA=-I.' ,#ic# also appears in ==C>-b.-C.-A.-iii.$ <3 3a(in"s contends t#at t#e p#rase #as de(eloped a ,ell% settled meanin" connotin" t#e ri"#t o& a secured creditor to recei(e present (alue o& #is security Z t#us re+uirin" interest i& t#e claim is to be paid o(er time$ T#e Court disa"rees$ 8etitioner also contends t#at t#e Code embodies a principle t#at secured creditors do not bear t#e costs o& reor"anization$ !t deri(es t#is &rom t#e rule t#at "eneral administrati(e e;penses do not #a(e priority o(er secured claims$ But t#e "eneral principle does not &ollo, &rom t#e particular rule$ T#at secured creditors do not bear one kind o& reor"anization cost #ardly means t#at t#ey bear none o& t#em$ T#e Code rule on administrati(e e;penses merely continues pre%Code la,$ But it ,as also pre%Code la, t#at undersecured creditors ,ere not entitled to postpetition interest as compensation &or t#e delay o& reor"anization$ Con"ress could #ardly #a(e understood t#at t#e readoption o& t#e rule on administrati(e e;penses ,ould ,ork a

>8

c#an"e in t#e rule on postpetition interest' ,#ic# it also readopted$ <3 3a(in"s contends t#at its interpretation is supported by t#e le"islati(e #istory o& IA= and IAC-d.-=.' relyin" on statements t#at E[s]ecured creditors s#ould not be depri(ed o& t#e bene&it o& t#eir bar"ain$M 3uc# "eneralizations are inade+uate to o(ercome t#e plain te;tual indication in H0A and IAC-d.-C. o& t#e Code t#at Con"ress did not ,is# t#e undersecured creditor to recei(e interest on #is collateral durin" t#e term o& t#e stay$

5otes , Accordin" to Troy' e(erybody t#inks t#at t#is case is $lass ,ron"ly decided$ discussion

>>

C.

USIN

AND SELLIN

PROPERTY

Code # /=/',('$(7 'c('$(7 ! '8( Code # 33* AD"INISTERIN PROPERTY

!n bankruptcy cases ,#ere some or all assets ,ill be kept to"et#er it ,ill be necessary to keep t#e debtor9s business runnin" at least &or a time$ T#e trustee -or more likely in a reor"anization' t#e debtor%in%possession. must deal ,it# suppliers and ,it# buyers' and suc# operation o& business entails a risk to all assets$ T#e bankruptcy process tries to ensure t#at decisions about t#e use o& assets are in t#e Doint interest o& all t#ose ,it# ri"#ts in t#em$ 3ection IAI Z primary pro(ision "o(ernin" t#e use' sale' or lease o& property o& t#e estate$ E8roperty o& t#e estateM #ere re&ers to properly in ,#ic# t#e estate #as an interest Zany property in t#e possession or control o& t#e trustee or debtor$ A distinction is made bet,een cases in ,#ic# Et#e business o& t#e debtor is aut#orized to be operatedM Zin a case o& reor"anization or debt adDustment under C#apter ==' =C' or =I operation is automatically aut#orized' unless ot#er,ise ordered by t#e courtZ and cases ,it#out suc# aut#orization Zunder C#apter J operation #as to be aut#orized. K#en operation is aut#orized' t#e debtor may use' sell' or lease property in t#e ordinary course o& business ,it#out court permission' but use' sale' or lease outside t#e ordinary course o& business must be speci&ically appro(ed by t#e court a&ter notice and a #earin"$ K#en operation is not aut#orized' no use' sale' or lease is presumed to be in t#e ordinary course o& business' and court permission is re+uired

K#en ot#ers #a(e an interest in property t#at t#e debtor seeks to use' some special pro(isions apply$ 0or e;ample' under conditions speci&ied in IAI-&. Zsuc# as ,#en collateral is ,ort# more t#an all obli"ations it securesZ' t#e trustee or debtor can sell property &ree &rom encumbrance$

=00

3ection HHP permits t#e trustee or debtor' a&ter notice and #earin"' to Eabandon any property o& t#e estate t#at is burdensome to t#e estate or t#at is o& inconse+uential (alue and bene&it to t#e estateM Z t#is deals ,it# t#e cases in ,#ic# t#e debtor #as no use &or a particular item o& property' because its ,ort#less or because it is so encumbered by liens or security interests t#at it #as no (alue to t#e "eneral creditors$

USE OF ASSETS 4a/e% and Kmart in(ol(e payment o& prepetition claims to "eneral creditors be&ore t#e conclusion o& t#e bankruptcy case$ A payment to creditors be&ore t#e end o& a case is "enerally not permitted$

=0=

OFFICIAL CO""ITTEE OF ELUITY SECURITY HOLDERS 0. "ABEY <nited 3tates Court o& Appeals' Pt# Circuit' =>8J -8IC 0$Cd C>>. !acts , 4obins Co$ sou"#t relie& under C#apter == a&ter t#e -rocedura &ilin" o& a multitude o& ci(il actions by ,omen ,#o l -osture alle"ed t#at t#ey ,ere inDured by t#e use o& t#e Dalkon 3#ield intrauterine de(ice$ A plan o& reor"anization ,as proposed' but a&ter a mer"er proposal a re(ised plan #ad to be submitted$ 8rior to t#is' t#e Dalkon 3#ield claimants &lied a motion seekin" t#e establis#ment o& an *mer"ency Treatment 0und' under ,#ic# @=H million ,ould be set aside and put into an interest bearin" account$ T#is money ,ould "o to Dalkon 3#ield claimants &or t#em to "et sur"ery to re(erse in&ertility' or "et in% (itro &ertilization i& re+uired$ Any amounts paid under t#e 8ro"ram on be#al& o& a claimant ,ould be deducted &rom t#e amount o& disbursement t#e claimant ,ould ot#er,ise recei(e under a con&irmed C#apter == plan o& reor"anization o& 4obins$ T#e district court appro(ed t#is motion' and t#e e+uity security #olders -*+uity Committee. appealed' ar"uin" t#at t#e Dalkon 3#ield claimants s#ould "o t#rou"# t#e ,#ole reor"anization plan process to "et paid$ T#e district court denied t#e appeal relyin" upon its Ee;pansi(e e+uity po,erM$ .egal (ssue(s) K#et#er t#e court can set aside money &rom t#e debtor prior to allo,ance o& claims' and prior to con&irmation o& t#e debtor9s plan o& reor"anization' on t#e "rounds o& its Ee;pansi(e e+uity po,erM$ Creation o& emer"ency treatment &und &or Dalkon s#ield claimants' prior to allo,ance o& claims o& ,omen ,#o ,ould bene&it &rom &und' and prior to con&irmation o& debtorWs plan o& reor"anization' ,as (iolation o& Bankruptcy Code ,#ic# could not be Dusti&ied as e;ercise o& courtWs e+uitable po,ers$ 8ro"ram ,ould bene&it only certain unsecured #olders o& Dalkon s#ield claims and ,ould a&&ord pre&erential treatment to suc# claimants o(er ot#er

/olding(s) , 0ule(s)

=0C

similarly situated unsecured Dalkon s#ield claimants and o(er "eneral unsecured creditors$ 0easoning T#e district court relied upon t#e Ee;pansi(e e+uity po,erM o& t#e courts emanatin" &rom 3ection =0H-a. to Dusti&y its decision$ ?o,e(er' t#e court o& appeals stated t#at' alt#ou"# t#e e+uitable po,ers emanatin" &rom =0H-a. are +uite important in t#e "eneral bankruptcy sc#eme' and ,#ile suc# po,ers may encoura"e courts to be inno(ati(e' and e(en ori"inal' t#ese e+uitable po,ers are not a license &or a court to disre"ard t#e clear lan"ua"e and meanin" o& t#e bankruptcy statutes and rules$ T#e &act t#at a proceedin" is e+uitable does not "i(e t#e Dud"e a &ree%&loatin" discretion to redistribute ri"#ts in accordance ,it# #is personal (ie,s o& Dustice and &airness' #o,e(er enli"#tened t#ose (ie,s may be$ T#e Bankruptcy Code does not permit a distribution to unsecured creditors in a C#apter == proceedin" e;cept under and pursuant to a plan o& reor"anization t#at #as been properly presented and appro(ed$ T#e clear lan"ua"e o& 3ections ==C=% ==C> does not aut#orize t#e payment in part or in &ull' or t#e ad(ance o& monies to or &or t#e bene&it o& unsecured claimants prior to t#e appro(al o& t#e plan o& reor"anization$ T#e creation o& t#e *mer"ency Treatment 8ro"ram #as no aut#ority to support it in t#e Bankruptcy Code and (iolates t#e clear policy o& C#apter == reor"anizations by allo,in" piecemeal' pre%con&irmation payments to certain unsecured creditors$ 3uc# action also (iolates Bankruptcy 4ule I0C= ,#ic# allo,s distribution to creditors only a&ter t#e allo,ance o& claims and t#e con&irmation o& a plan$ Barry *$ Adler et al$ Creditors as a ,#ole ,ould #a(e been better o&& e(en i& t#ey ,ere not paid in &ull$ !t is better to pay a small amount &or sur"ery -in t#is case' =H@ million. t#an to pre(ent claimant &rom #a(in" t#e sur"ery and "eneratin" suc# a lar"e potential claim a"ainst t#e estate$ !n t#is case' creditors understood t#is and did not obDect Zt#e

5otes , $lass discussion

=0I

obDection came &rom t#e e+uity #olders' and t#ey did so &rom a strate"ic standpoint to obtain concessions ,it#in t#e C#apter == bar"ainin"$ T#e 4a/e% court re(ersed t#e order and stated t#at t#e "eneral e+uitable po,ers o& t#e court could not sustain suc# an order$ But t#e court could #a(e relied on -i. HP>-a.-C. o& t#e Code' ,#ic# ar"uably implies t#at a trans&er o& assets prior to t#e conclusion o& t#e bankruptcy case can be aut#orized by eit#er t#e Code or t#e court' or -ii. IAI' ,#ic# &or e;ample could enable t#e trustee to spend resources to maintain t#e (alue o& t#e &irm9s assets' pro(ided al,ays t#at t#ere is notice and a #earin" so t#at it can be pro(ed t#at t#e payments ,ould #a(e t#e promised e&&ects$

=0P

IN RE K"ART CORP. <nited 3tates Court o& Appeals' Jt# Circuit' C00P -IH> 0$Id 8AA. !acts , Kmart &iled C#apter == and immediately t#erea&ter -rocedura sou"#t permission to pay immediately' and in &ull' t#e l -osture pre%petition claims o& certain suppliers &rom ,#ic# obtainin" merc#andise ,as essential &or t#e purposes o& carryin" out its business -Ecritical (endorsM.$ Kmart claimed t#is ,ould make e(en t#e dis&a(ored creditors better o&& t#ey may not be paid in &ull' but t#ey ,ill recei(e a "reater portion o& t#eir claims t#an t#ey ,ould i& t#e critical (endors cut o&& supplies and t#e business s#ut do,n$ Bankruptcy Gud"e appro(ed t#is' and Kmart paid @I00 million to t#e critical (endors Zt#is ,as &inanced t#rou"# a C@ billion D!8 loan$ Ot#er (endors not considered critical ,ere paid not#in"' and ultimately recei(ed' to"et#er ,it# ot#er PI'000 unsecured creditors' =0cents on t#e dollar' mostly in t#e stock o& t#e reor"anized Kmart$ District Dud"e re(ersed t#e order aut#orizin" payment$ .egal (ssue(s) /olding(s) , 0ule(s) 4e+uirements t#at must be met &or t#e purposes o& makin" pre&erential payments pursuant to IAI-b.-=.$ 8re&erential payment to (endors is possible under IAI-b.-=.' but t#e debtor must pro(e' and not Dust alle"e' t,o t#in"s -i. t#at' but &or immediate &ull payment' (endors ,ould cease dealin"/ and -ii. t#at t#e business ,ill "ain enou"# &rom continued transactions ,it# t#e &a(ored (endors to pro(ide some residual bene&it to t#e remainin"' dis&a(ored creditors' or at least lea(e t#em no ,orse o&&$ 8re&erential payment cannot be ordered merely on t#e basis o& 3ection =0H-a.$ T#is does not create discretion to set aside t#e CodeWs rules about priority and distribution/ t#e po,er con&erred by F =0H-a. is one to implement rat#er t#an o(erride$ T#is statute does not allo, a bankruptcy Dud"e to aut#orize &ull payment o& any unsecured debt' unless all unsecured creditors in t#e class are paid in &ull$ A Edoctrine o& necessityM is Dust a &ancy name &or a po,er to depart &rom t#e Code$ T#is doctrine ,as

0easoning

=0H

applied in t#e days be&ore bankruptcy la, ,as codi&ied' but today it is t#e Code t#at must pre(ail$ 3ources o& aut#ority &or une+ual treatment Z IAI-b.-=. can be used &or t#ese purposes' but it is prudent to read' and use' IAI-b.-=. to do t#e least dama"e possible to priorities establis#ed by contract and by ot#er parts o& t#e Bankruptcy Code$ T#is re+uires proo& bot# t#at dis&a(ored creditors ,ould be as ,ell o&& ,it# reor"anization as ,it# li+uidation' and t#at supposedly critical (endors ,ould #a(e ceased deli(eries i& old debts ,ere le&t unpaid ,#ile liti"ation continued$

!n t#e present case' some supposedly critical (endors #ad lon"%term contracts' and automatic stay pre(ent t#em &rom ,alkin" a,ay Zso t#ere ,as no need to pay t#em$ Kell%mana"ed businesses are unlikely to abDure ne, pro&its' so as lon" as Kmart continued to pay &or ne, products' t#ey s#ould not ,alk a,ay because o& old debts$ !n addition' Kmart could #a(e used part o& t#e C@ billion D!8 loan to issue a standby letter o& credit on ,#ic# t#e bankruptcy Dud"e could aut#orize unpaid (endors to dra,$ 1ot#in" o& t#is ,as considered by t#e bankruptcy court' so t#e critical%(endors order cannot stand$ 5otes , Troy t#is ,as a success&ul C#apter == case ZKmart $lass #ad (ery sop#isticated ad(isors$ T#e Dud"e ,anted discussion t#e (endors to deal ,it# Kmart on t#e ordinary business terms$ !n C00H t#e Code ,as amended as response to Kmart opinion certain (endors ,#o #a(e debts incurred be&ore C0 days o& &ilin" "et some priority treatment' but not immediate payment$ 3o Kmart is still an important case$ Barry *$ Adler et al$ t#is case does not reDect IAI as a basis to pay prepetition debts to critical (endors' but rat#er stands &or t#e proposition t#at a debtor9s payment o& prepetition claims is e;traordinary and re+uires demonstratin" necessity' ,#ic# is not assumed$

=0A

SALE OF ASSETS !n 7ionel and 5WA t#e courts e;amine t#e e;tent to ,#ic# t#e procedures in C#apter == set implicit limits on ,#et#er a debtor may sell assets under IAI$ !n 7ionel t#e +uestion ,as ,#et#er t#e sale could occur at all' and in 5WA t#e +uestion ,as ,#et#er t#e assets sold ,ould be &ree and clear &rom claims$

IN RE LIONEL CORP. <nited 3tates Court o& Appeals' Cnd Circuit' =>8I -JCC 0$Cd =0AI. !acts , -rocedura l -osture On 0CO=>O=>8C t#e 2ionel Corporation &iled C#apter ==$ MaDor creditors o& 2ionel #oldin" @80 million in claims ,ere represented by an O&&icial CreditorsW Committee$ T#e remainin" @HH million is scattered amon" t#ousands o& small creditors$ 2ionelWs most important asset is its o,ners#ip o& 8CQ o& t#e common stock o& Dale' a pro&itable listed corporation$ On 0AO=PO=>8I 2ionel &iled an application under section IAI-b. seekin" aut#orization to sell its interest in Dale' and &our days later &iled a plan o& reor"anization conditioned upon a sale o& Dale ,it# t#e proceeds to be distributed to creditors$ A #earin" ,as #eld' and 8eabody emer"ed as t#e success&ul bidder ,it# an o&&er o& @H0 million$ 2ionel9s C*O and an in(estment banker Zt#e only ,itnesses producedZ testi&ied in support o& t#e application' and 2ionelWs C*O stated t#at t#ere ,as no reason ,#y t#e sale o& Dale stock could not be accomplis#ed as part o& t#e reor"anization plan' and t#at t#e sole reason &or 2ionelWs application to sell ,as t#e CreditorsW CommitteeWs insistence upon it$ Bankruptcy Gud"e made no &ormal &indin"s o& &act' and #e simply noted t#at cause to sell ,as su&&iciently s#o,n by t#e CreditorsW CommitteeWs insistence upon it$ T#e Committee o& *+uity 3ecurity ?olders appealed t#is order claimin" t#at t#e sale' prior to appro(al o& a reor"anization plan' depri(es t#e e+uity #olders o& t#e Bankruptcy CodeWs sa&e"uards o& disclosure' solicitation and acceptance and di(ests t#e debtor o&

=0J

a dominant and pro&itable asset ,#ic# could ser(e as a cornerstone &or a sound plan$ T#e 3*C also appeared and a"reed$ T#e CreditorsW Committee claimed t#at t#e sale ,as in t#e best interests o& 2ionel' bein" e;pressly aut#orized by IAI-b. o& t#e Code' and t#at it ,ill pro(ide t#e estate ,it# t#e lar"e block o& t#e cas# needed to &und its plan o& reor"anization$ .egal (ssue(s) To ,#at e;tent C#apter == permits a bankruptcy Dud"e to aut#orize t#e sale o& an important asset o& t#e bankruptWs estate' out o& t#e ordinary course o& business and prior to acceptance and outside o& any plan o& reor"anization$ A Dud"e determinin" a F IAI-b. application must e;pressly &ind &rom t#e e(idence presented be&ore #im at t#e #earin" a sound business reason to "rant suc# an application$ Debtor applyin" &or permission to conduct sale outside t#e ordinary course o& business carries burden o& demonstratin" t#at use' sale or lease out o& t#e ordinary course o& business ,ill aid debtorWs reor"anization/ obDectant is re+uired to produce some e(idence respectin" its obDections$

/olding(s) , 0ule(s)

0easoning

0e#uirements for a sale of assets out of the ordinary course of business and prior to acceptance and outside of any plan of reorgani3ation. IAI-b. appears to permit disposition o& any property o& t#e estate ,it#out resort to t#e statutory sa&e"uards set &ort# in C#apter ==$ ?o,e(er' a literal readin" o& IAI-b. ,ould unnecessarily (iolate t#e con"ressional sc#eme &or corporate reor"anizations under C#apter ==$ A #istorical interpretation o& C#apter == and t#e lo"ic underlyin" it supports t#e conclusion t#at t#ere must be some articulated business Dusti&ication' ot#er t#an appeasement o& maDor creditors' &or usin"' sellin" or leasin" property out o& t#e ordinary course o& business be&ore t#e bankruptcy Dud"e may order suc# disposition under IAI-b.$

=08

4esol(in" t#e apparent con&lict bet,een C#apter == and IAI-b. does not re+uire an all or not#in" approac#$ *(ery sale under IAI-b. does not automatically s#ort%circuit or side%step C#apter ==/ nor are t#ese t,o statutory pro(isions to be read as mutually e;clusi(e$ !nstead' i& a bankruptcy Dud"e is to administer business reor"anization success&ully under t#e Code' t#en some play &or t#e operation o& bot# F IAI-b. and C#apter == must be allo,ed &or$ A bankruptcy Dud"e must consider all salient &actors pertainin" to t#e proceedin" and' accordin"ly' act to &urt#er t#e di(erse interests o& t#e debtor' creditors and e+uity #olders' alike$ ?e mi"#t' &or e;ample' look to suc# rele(ant &actors as t#e proportionate (alue o& t#e asset to t#e estate as a ,#ole' t#e amount o& elapsed time since t#e &ilin"' t#e likeli#ood t#at a plan o& reor"anization ,ill be proposed and con&irmed in t#e near &uture' t#e e&&ect o& t#e proposed disposition on &uture plans o& reor"anization' t#e proceeds to be obtained &rom t#e disposition (is%[%(is any appraisals o& t#e property' ,#ic# o& t#e alternati(es o& use' sale or lease t#e proposal en(isions and' most importantly per#aps' ,#et#er t#e asset is increasin" or decreasin" in (alue$ T#is list is not intended to be e;clusi(e' but merely to pro(ide "uidance to t#e bankruptcy Dud"e$

7urden of proof K#ile a debtor applyin" under F IAI-b. carries t#e burden o& demonstratin" t#at a use' sale or lease out o& t#e ordinary course o& business ,ill aid t#e debtorWs reor"anization' an obDectant' suc# as t#e *+uity Committee #ere' is re+uired to produce some e(idence respectin" its obDections$ issent T#e e&&ect o& t#e present decision is to lea(e t#e debtor%in%possession po,erless as a le"al matter to sell t#e Dale stock outside a reor"anization plan and unable as an economic matter to sell it ,it#in one$ T#is pleases t#e e+uity #olders ,#o' #a(in" introduced no e(idence demonstratin" a disad(anta"e to t#e bankrupt estate &rom t#e sale o& t#e Dale stock' are no, "i(en a (eto o(er it to be used as le(era"e in ne"otiatin" a better deal &or t#emsel(es in reor"anization$ T#e likely results

=0>

o& t#e decision are t,o&old -i. T#e creditors ,ill at some point durin" t#e rene,ed protracted ne"otiations re&use to e;tend more credit to 2ionel' t#us t#,artin" a reor"anization entirely/ and -ii. not,it#standin" t#e maDority decision' t#e Dale stock ,ill be sold under 3ection IAI-b. &or e;actly t#e same reasons o&&ered in support o& t#e present proposed sale$ ?o,e(er' t#e ultimate reor"anization plan ,ill be more &a(orable to t#e e+uity #olders' and t#ey ,ill not (eto t#e sale$ 5otes , T#e ar"ument t#at ,ins in t#is case is t#at you #a(e $lass to make a "ood s#o,in" t#at t#ere is a business discussion reason &or sale$ Bou cannot Dust say ,e don9t care ,#et#er to sell or not$ 2ionel is one o& t#e most important IAI decisions in #istory$ T#ere is some amount o& burden s#i&tin" Z t#e debtor bears t#e burden o& persuadin" t#e court' but some ,ei"#t is put on t#e s#oulders o& obDectors to pro(e somet#in" more t#an ,e Dust ,ant some more po,er in t#e case$

==0

IN RE TRANS IORLD AIRLINES <nited 3tates Court o& Appeals' Ird Circuit' C00I -ICC 0$Id C8I. !acts , -rocedura l -osture TKA &iled &or C#apter ==$ As part o& t#e reor"anization plan' substantially all o& TKA9s assets ,ere to be sold to American Airlines in a court appro(ed biddin" process$ T#e sale order' on t#e "rounds o& IAI-&. o& t#e Code' e;tin"uis#ed t#e successor liability on t#e part o& American Airlines &or -=. employment discrimination claims a"ainst TKA and -C. &or t#e Tra(el Souc#er 8ro"ram a,arded to TKAWs &li"#t attendants in settlement o& a se; discrimination class action$ 0li"#t attendants9 claims s#ould be treated as unsecured claims$ Dispute concernin" t#e meanin" o& Einterest in suc# propertyM as used in IAI-&. o& t#e Code$ Appellants assert t#at t#e Tra(el Souc#er 8ro"ram and t#e pendin" c#ar"es are not interests in property ,it#in t#e meanin" o& t#is section$ T#ey assert t#at interests in property are limited to Eliens' mort"a"es' money Dud"ments' [R]M and cannot encompass successor liability claims$ Appellants assert t#at t#eir claims are outside t#e scope o& IAI-&. because t#ey could not Ebe compelled' in a le"al or e+uitable proceedin"' to accept a money satis&action o& [t#eir] interest[s]$M T#e Airlines' ar"ue t#at' ,#ile Con"ress did not e;pressly de&ine Einterest in property'M t#e p#rase s#ould be broadly read to aut#orize a bankruptcy court to bar any interest t#at could potentially tra(el ,it# t#e property bein" sold$ T#ey also assert t#at appellantsW claims lie ,it#in t#e scope o& F IAI-&.-H.' and t#ere&ore' can be e;tin"uis#ed because appellants can be compelled to accept a money satis&action o& t#eir claims$

.egal (ssue(s) /olding(s) , 0ule(s)

K#et#er successor liability may be e;tin"uis#ed ,#en sellin" assets under IAI-&.$ Airline ,orkersW employment discrimination claims a"ainst TKA' as ,ell as &li"#t attendantsW ri"#ts under tra(el (ouc#er pro"ram t#at debtor%airline #ad establis#ed in settlement o& se; discrimination action'

===

bot# +uali&ied as Einterests in propertyM under IAI-&. as lon" as one o& &i(e conditions is satis&ied$ 0easoning (nterest in -roperty 3ome courts #a(e narro,ly interpreted interests in property to mean in rem interests in property' suc# as liens$ ?o,e(er' t#e trend seems to be to,ard a more e;pansi(e readin" o& Einterests in propertyM ,#ic# Eencompasses ot#er obli"ations t#at may &lo, &rom o,ners#ip o& t#e property$M To e+uate interests in property ,it# only in rem interests suc# as liens ,ould be inconsistent ,it# section IAI-&.-I.' ,#ic# contemplates t#at a lien is but one type o& interest$ T#is becomes apparent in re(ie,in" section IAI-&.-I.' ,#ic# pro(ides &or particular treatment ,#en Esuc# interest is a lien$M Ob(iously t#ere must be situations in ,#ic# t#e interest is somet#in" ot#er t#an a lien/ ot#er,ise section IAI-&.-I. ,ould not need to deal e;plicitly ,it# t#e case in ,#ic# t#e interest is a lien$ 8oney satisfaction T#e Bankruptcy Court determined t#at' because t#e tra(el (ouc#er and **OC claims ,ere bot# subDect to monetary (aluation' t#e &i&t# condition #ad been satis&ied$ Ke a"ree$ ?ad TKA li+uidated its assets under C#apter J o& t#e Bankruptcy Code' t#e claims at issue ,ould #a(e been con(erted to dollar amounts and t#e claimants ,ould #a(e recei(ed t#e distribution pro(ided to ot#er "eneral unsecured creditors on account o& t#eir claims$ A tra(el (ouc#er represents a seat on an airplane' a tra(el bene&it t#at can be reduced to a speci&ic monetary (alue$ 6ther considerations 5i(en t#e stron" likeli#ood o& li+uidation absent t#e asset sale to American' a sale o& t#e assets o& TKA at t#e e;pense o& preser(in" successor liability claims ,as necessary in order to preser(e some C0'000 Dobs' includin" t#ose o& Kno;%3c#illin"er and t#e **OC claimants still employed by TKA' and to pro(ide &undin" &or employee%related liabilities' includin" retirement bene&its$ 5otes , Claimants apparently ,anted to #a(e t#eir piece o& t#e

==C

$lass discussion

cake and to eat it too$ T#ey did not dispute t#at t#e sale o& TKA assets to AA ma;imized t#e debtor9s (alue$ A&ter t#e sale' #o,e(er' t#e claimants co(eted AA9s deep pockets$

==I

D.

DEBTOR4IN4POSSESSION FINANCIN

Code F H0I-b.-=. Code F IAP-b.' -c.' -d.' T -e. FINANCIN THE ESTATE

0irms in bankruptcy are o&ten still in t#e need to borro, on an on"oin" basis$ !n addition to payin" suppliers and employees' bankruptcy reor"anization itsel& is costly' and t#ose ,#o pro(ide re+uisite ser(ices insist on bein" paid on an on"oin" basis$ 3ections IAP and H0I "o(ern &inance o& a debtor in bankruptcy$ 3ection IAP-a. Zaut#orizes trusteeOdebtor%in%possession to obtain unsecured credit in the ordinary course of business ,it#out special permission &rom t#e court$ 8arallels section IAI' ,#ic# aut#orizes t#e trustee to use property in t#e ordinary course o& business$ T#e credit e;tension is unsecured' but entitled to priority o(er prepetition unsecured claims because it is classi&ied as Eadministrati(e e;penseM under section H0I-b.$ 3ection IAP-b. Zaut#orizes trusteeOdebtor%in%possession to obtain unsecured loans outside of the ordinary course of business -e$"$' to &inance a ne, proDect. but only ,it# court appro(al a&ter notice and #earin"$ 3ection IAP-c. Zi& trusteeOdebtor%in%possession is unable to obtain unsecured credit under IAP-b.' t#e court' a&ter notice and a #earin"' may aut#orize t#e trusteeOdebtor%in% possession to "i(e a security interest$ Three types of e+tra 9security: t#at do not inter&ere ,it# #olders o& ot#er property ri"#ts Debt ,it# priority certain administrati(e e;penses/ Debt secured by a lien on property not pre(iously encumbered/ Debt secured by Dunior liens on property pre(iously encumbered$

3ection IAP-d. Zre&u"e o& last resort$ !t enables t#e court to aut#orize t#e trusteeOdebtor%in%possession to obtain

==P

credit secured by a senior or e#ual lien on property of the estate that is already sub;ect to a lien ' on t#e conditions t#at - T#e credit is not ot#er,ise obtainable -burden o& proo& lies on t#e trusteeOdebtor%in%possession./ and - *;istin" secured creditor is ade+uately protected$ 3ection H0J-b. and 3ection H0I-b. ZAdministrati(e e;penses priorities are set out in H0I-b.' ,#ic# ,orks in conDunction ,it# H0J$ !& t#e trustee o&&ers ade+uate protection under IAP and i&' despite t#at assurance o& ade+uate protection' t#e creditor in &act turns out not to #a(e been ade+uately protected' H0J-b. pro(ides t#at t#e creditor "ets a kind o& EsuperpriorityM o(er all ot#er administrati(e e;pense claims

DEBTOR4IN POSSESSION FINANCIN D!8 &inancin" a ne, loan Zcredit &rom a supplier or cas# &rom a bankZ to t#e debtor ,#o &iled &or C#apter ==$ O&ten' t#e source o& suc# loan is t#e lender ,#o ,as t#e debtor9s principal source o& credit be&ore &ilin" &or bankruptcy$ !t is c#eaper' because suc# lender already #as enou"# in&ormation about t#e debtor &rom t#eir pre(ious relations#ip$ $ross<collaterali3ation clauses t#e creditor-s. ,#o "rant-s. t#e D!8 loan additionally #old unsecured prepetition claims' and by (irtue o& t#is clause t#ey obtain security' not only securin" t#eir postpetition claims -t#ose arisin" under t#e D!8 loan.' but also securin" t#eir prepetition claims$ T#us' t#is clause e&&ecti(ely ele(ates t#e priority o& suc# creditor-s. unsecured prepetition claims o(er t#at o& t#e debtor9s ot#er unsecured claims e(en t#ou"# t#e latter are ot#er,ise entitled to t#e same priority as t#e &ormer$ Cross%collateralization is contro(ersial' because it disrupts t#e nonbankruptcy priority amon" t#e creditors$ 3out#ern District o& 1e, Bork "uidelines &or D!8 lendin" treat cross%

==H

collateralization and similar pro(isions as e;traordinary' but t#ey re&lect a belie& t#at suc# pro(isions are permissible$ IN RE SAYBROOK "ANUFACTURIN CO. <nited 3tates Court o& Appeals' ==t# Circuit' =>>C ->AI 0$Cd =P>0. !acts , 3aybrook sou"#t relie& under C#apter ==' and -rocedura immediately t#erea&ter &iled a motion to incur secured l -osture debt$ T#e bankruptcy court appro(ed$ At t#e time t#e petition ,as &iled' 3aybrook o,ed Manu&acturers ?ano(er appro;$ @IP million$ T#e (alue o& t#e collateral &or t#is debt ,as less t#an @=0 million$ 8ursuant to t#e order' Manu&acturers ?ano(er a"reed to lend t#e debtors an additional @I million' and in e;c#an"e recei(ed a security interest in all o& t#e debtorsW property securin" bot# t#e @I million o& post%petition credit but also @IP million pre%petition debt$ T#is arran"ement en#anced Manu&acturers ?ano(erWs position vis=E=vis ot#er unsecured creditors' includin" t#e 3#apiros' in t#e e(ent o& li+uidation$ T#e 3#apiros &iled obDections$ .egal (ssue(s) /olding(s) , 0ule(s) 0easoning K#et#er cross%collateralization clauses are aut#orized by t#e Bankruptcy Code$ Cross%collateralization is inconsistent ,it# bankruptcy la,$ Cross%collateralization is an e;tremely contro(ersial &orm o& C#apter == &inancin" appro(ed by se(eral bankruptcy courts$ *(en t#e courts t#at #a(e allo,ed cross%collateralization ,ere "enerally reluctant to do so$ T#e court in -n re 3anguard noted t#at cross% collateralization s#ould only be used as a last resort' and #eld t#at in order to appro(e t#is clause t#e court re+uired t#e debtor to demonstrate -=. t#at its business operations ,ould &ail absent t#e proposed &inancin"' -C. t#at it is unable to obtain alternati(e &inancin" on acceptable terms' -I. t#at t#e proposed lender ,ill not accept less pre&erential terms' and -P. t#at t#e proposed &inancin" is in t#e "eneral creditor bodyWs best interest$ T#is &our%part test #as since been adopted by ot#er bankruptcy courts ,#ic# permit cross%collateralization$ Cross%collateralization is inconsistent ,it# bankruptcy la, &or t,o reasons$ 0irst' cross%

==A

collateralization is not aut#orized as a met#od o& post%petition &inancin" under section IAP$ 3econd' cross%collateralization is beyond t#e scope o& t#e bankruptcy courtWs in#erent e+uitable po,er because it is directly contrary to t#e &undamental priority sc#eme o& t#e Bankruptcy Code$ Bankruptcy courts may not permit t#is practice under t#eir "eneral e+uitable po,er because t#is e+uitable po,er is not unlimited$ Creditors ,it#in a "i(en class are to be treated e+ually' and bankruptcy courts may not create t#eir o,n rules o& superpriority ,it#in a sin"le class$ Cross% collateralization does e;actly t#at$ As a result o& t#is practice' post%petition lendersW unsecured pre% petition claims are "i(en priority o(er all ot#er unsecured pre%petition claims$ Ke disa"ree ,it# t#e district courtWs conclusion t#at' ,#ile cross%collateralization may (iolate some policies o& bankruptcy la,' it is consistent ,it# t#e "eneral purpose o& C#apter == to #elp businesses reor"anize and become pro&itable$ 4e#abilitation is certainly t#e primary purpose o& C#apter ==$ T#is end' #o,e(er' does not Dusti&y t#e use o& any means$ Cross%collateralization is directly inconsistent ,it# t#e priority sc#eme o& t#e Bankruptcy Code$ Accordin"ly' t#e practice may not be appro(ed by t#e bankruptcy court under its e+uitable aut#ority$ 5otes , $lass discussion On balance' t#e rule t#an bans cross% collateralization may be t#e ri"#t one$ ?o,e(er' t#ere are times t#at t#e only plausible lender' particularly on s#ort notice' ,ill be a prepetition lender &amiliar ,it# t#e debtor' ,#o mi"#t in &act o&&er better terms i& it can rely on cross% collateralization or similar clauses$ T#is mi"#t put t#e debtor in t#e situation ,#ere it #as to c#oose bet,een #i"#er interest rates and no cross% collateralization' or lo,er interest rates ,it# cross% collateralization$ T#ere&ore' t#e propriety o& t#ese clauses is not easy to determine in t#e abstract$ Ot#er appellate courts #a(e declined to &ollo, a%/roo;$ And' as t#e 3out#ern District o& 1e, Bork

==J

5uidelines indicate' bankruptcy courts #a(e continued to appro(e cross%collateralization clauses' as ,ell as ot#er related pro(isions suc# as roll%ups and ,ai(ers o& lien c#allen"e Z,#ic# #a(e t#e common e&&ect o& impro(in" a lender9s position ,it# respect to prepetition debt in e;c#an"e &or postpetition &inance$

==8

E.

AD"INSTRATI2E EMPENSES Administrati(e e;pense priority Zinte"ral part o& bankruptcy9s solution to t#e debtor9s problem o& maintainin" relations#ips ,it# suppliers' customers' and ot#ers$ K#en a debtor in bankruptcy enters or assumes a contract' t#e debtor incurs obli"ations under t#e contract necessary to obtain t#e promised per&ormance o& t#e ot#er party$ T#us' t#e debtor9s obli"ations under suc# a contract are administrati(e e;penses entitled to priority' in t#e e(ent o& debtor9s breac#' Dust as a postpetition loan obli"ation is entitled to priority$ Di&&icult cases Z,#en a postpetition debtor incurs an e;pense -i. not t#e product o& a postpetition decision to become indebted' -ii. not e;plicitly co(ered by t#e Code$ READIN CO. 0. BROIN <nited 3tates 3upreme Court' =>A8 -I>= <$3$ PJ=.

!acts , -rocedura l -osture

Kni"#t 4ealty Corporation &iled a petition &or an arran"ement under C#apter N! o& t#e Bankruptcy Act$ Bro,n' respondent #ere' ,as appointed t#e recei(es and #e ,as aut#orized to conduct t#e debtorWs business consistin" on leasin" an industrial structure$ T#e buildin" ,as totally destroyed by a &ire ,#ic# spread and destroyed real and personal property o& petitioner 4eadin" Company and ot#ers$ 8etitioner &iled a claim &or @HH>'JI0$8I in t#e arran"ement' based on t#e asserted ne"li"ence o& t#e recei(er$ !t ,as styled a claim &or \administrati(e e;pensesW o& t#e arran"ement$ Ot#er &ire loss claimants &iled =PA additional claims o& a similar nature$ T#e total o& all suc# claims ,as in e;cess o& @I'H00'000' more t#an t#e total assets o& t#e debtor$ Kni"#t 4ealty ,as (oluntarily adDudicated a bankrupt and respondent ,as subse+uently elected trustee in bankruptcy$ T#e trustee mo(ed to e;pun"e t#e claims o& petitioner and ot#ers on t#e "round t#at t#ey ,ere not &or e;penses o& administration$ T#e

==>

<nited 3tates' #oldin" a claim &or unpaid prearran"ement ta;es admittedly superior to t#e claims o& "eneral creditors and in&erior to claims &or administration e;penses' entered t#e case on t#e side o& t#e trustee$ T#e re&eree disallo,ed t#e claim &or administration e;penses$ 4e&eree ,as up#eld by t#e District Court$ T#e Court o& Appeals a&&irmed t#e decision$ .egal (ssue(s) K#et#er t#e ne"li"ence o& a recei(er administerin" an estate under a C#apter N! arran"ement "i(es rise to an \actual and necessary9 cost o& operatin" t#e debtorWs business$ Dama"es resultin" &rom ne"li"ence o& a recei(er actin" ,it#in scope o& #is aut#ority as recei(er "i(e rise to Eactual and necessary costsM o& administration in a C#apter N! arran"ement' entitled to priority under statute$ T#e Act does not de&ine \actual and necessary'9 nor #as any case directly in point been brou"#t to our attention$ Ke must look to t#e "eneral purposes o& 3ection APa' C#apter N!' and t#e Bankruptcy Act as a ,#ole$ !n addition to &acilitatin" re#abilitation o& insol(ent businesses and to preser(in" a ma;imum o& assets &or distribution amon" t#e "eneral creditors s#ould t#e arran"ement &ail' one important' and #ere decisi(e' statutory obDecti(e is &airness to all persons #a(in" claims a"ainst an insol(ent$ 8etitioner su&&ered "ra(e &inancial inDury &rom ,#at is #ere a"reed to #a(e been t#e ne"li"ence o& t#e recei(er and a ,orkman$ Ke see no reason to indul"e in a strained construction o& t#e rele(ant pro(isions' &or ,e are persuaded t#at it is t#eoretically sounder' as ,ell as lin"uistically more com&ortable' to treat tort claims arisin" durin" an arran"ement as actual and necessary e;penses o& t#e arran"ement rat#er t#an debts o& t#e bankrupt$ !n t#e &irst place' in considerin" ,#et#er t#ose inDured by t#e operation o& t#e business durin" an arran"ement s#ould s#are

/olding(s) , 0ule(s)

0easoning

=C0

e+ually ,it#' or reco(er a#ead o&' t#ose &or ,#ose bene&it t#e business is carried on' t#e latter seems more natural and Dust$ *;istin" creditors are' to be sure' in a dilemma not o& t#eir o,n makin"' but t#ere is no ob(ious reason ,#y t#ey s#ould be allo,ed to attempt to escape t#at dilemma at t#e risk o& imposin" it on ot#ers e+ually innocent$ Decisions in analo"ous cases su""est t#at \actual and necessary costsW s#ould include costs ordinarily incident to operation o& a business' and not be limited to costs ,it#out ,#ic# re#abilitation ,ould be impossible$ !t #as lon" been t#e rule o& e+uity recei(ers#ips t#at torts o& t#e recei(ers#ip create claims a"ainst t#e recei(ers#ip itsel&/ in t#ose cases t#e statutory limitation to \actual and necessary costsW is not in(ol(ed' but t#e e;plicit reco"nition e;tended to tort claims in t#ose cases ,ei"#s #ea(ily in &a(or o& considerin" t#em ,it#in t#e "eneral cate"ory o& costs and e;penses$ issent T#e Court #as misinterpreted t#e term \costs and e;penses o& administration9 as intended by APa-=. o& t#e Bankruptcy Act and' by de(iatin" &rom t#e natural meanin" o& t#ose ,ords' #as "i(en t#e administrati(e cost priority an un,arranted application$ T#e e&&ect o& t#e #oldin" in t#is case is t#at t#e ne"li"ence o& a ,orkman may completely ,ipe out t#e claims o& all ot#er classes o& public and pri(ate creditors$ ! do not belie(e Con"ress intended to accord tort claimants suc# a pre&erence$ T#e Act e;pressly directs t#at eli"ible ne"li"ence claims are to s#are e+ually ,it# t#e unsecured claims in a pro rata distribution o& t#e debtorWs none;empt assets$ Departin" &rom t#is statutory sc#eme' one class o& tort claims are sin"led out &or special treatment$ T#e status o& a tort claimant depends entirely upon ,#et#er #e is &ortunate enou"# to #a(e been inDured a&ter rat#er t#an be&ore a recei(er #as been appointed$ And i& t#e claimant is in t#e select class' #e may be permitted to e;#aust t#e estate to t#e e;clusion o& t#e "eneral creditors as ,ell as o& t#e ,a"e claims and "o(ernment ta; claims &or ,#ic# Con"ress #as s#o,n an

=C=

unmistakable pre&erence$ 5otes , Dissentin" opinion may be seen in t#e li"#t o& t#e $lass *utner principle Z(ie, t#at t#e rule s#ould be t#e same discussion in bankruptcy as out$

IN RE IALL TUBE ! "ETAL PRODUCTS CO. <nited 3tates Court o& Appeals' At# Circuit' =>8J -8I= 0$Cd ==8. !acts , -rocedura l -osture Kall Tube occupied property in Tennessee under a lease$ T#e companyWs manu&acturin" processes "enerated #azardous substances ,#ic# ,ere stored on t#e site$ Kall Tube s#ut do,n t#e &acility' and t#erea&ter an inspector &or t#e Tennessee Department o& ?ealt# and *n(ironment inspected t#e site and &ound #azardous substances$ T#e inspector issued a notice o& (iolation' and recommended t#at Kall Tube immediately dispose o& t#e ,astes on t#e site$ T#e situation remained unc#an"ed in spite o& t#e notice$ Kall Tube &iled C#apter J' and t#e trustee o& t#e debtorWs estate ,as noti&ied o& t#e #azardous substances and t#e (iolation o& t#e 3tateWs en(ironmental la,' T#e trustee "a(e notice o& #is intent to con(ey most o& t#e property to its ori"inal lessors$ A &urt#er inspection o& t#e &acility took place' and it concluded t#at ,#ile t#e property trans&er con(eyed some o& t#e #azardous substances' ot#er tanks containin" #azardous ,astes remained part o& t#e debtorWs estate$ Conse+uently' t#e 3tate &iled a &ormal re+uest &or administrati(e e;pense treatment o& its e;penses$ A&ter a #earin"' t#e bankruptcy court denied t#e re+uest' &indin" t#at t#e e;penses ,ere not Eactual' necessary costs and e;penses o& preser(in" t#e estateM ,it#in t#e meanin" o& H0I-b.$ T#e court #eld t#at since t#e 3tateWs acti(ity neit#er bene&itted t#e estate nor &ul&illed a le"al obli"ation under 3tate la,' t#e 3tateWs reco(ery costs could not be accorded administrati(e e;pense status$ District court a&&irmed and t#e 3tate appealed$

=CC

.egal (ssue(s)

K#et#er t#e response costs' reco(erable by t#e 3tate o& Tennessee under &ederal la,' are allo,able as administrati(e e;penses in a C#apter J bankruptcy proceedin"$ ?azardous ,aste site response costs incurred by state and reco(erable under &ederal la, ,ere allo,able administrati(e e;penses in C#apter J bankruptcy proceedin" ,#ere' absent compliance ,it# en(ironmental la,s by debtorWs estate' costs ,ere actual and necessary' bot# to preser(e estate in re+uired compliance ,it# state la, and to protect #ealt# and sa&ety o& potentially endan"ered public$ Kall Tube (iolated t#e Tennessee ActWs re+uirement o& proper disposal and stora"e o& #azardous ,astes$ T#e (iolation ,as disco(ered be&ore t#e bankruptcy petition ,as &iled and continued a&ter t#e Kall Tube trustee ,as noti&ied$ Kall TubeWs trustee' under t#ose circumstances' could not #a(e abandoned t#e property$ !t &ollo,s t#at i& t#e trustee could not #a(e abandoned t#e estate in contra(ention o& t#e 3tateWs en(ironmental la,' neit#er t#en s#ould #e #a(e maintained or possessed t#e estate in continuous (iolation o& t#at same la,$ Trustee s#ould #a(e complied ,it# t#e 3tateWs #azardous substance la,s$ 3ince #e did not comply' despite ample opportunity to do so bot# be&ore and a&ter t#e con(eyance' t#e 3tate ,as compelled to remedy t#e en(ironmental #ealt# #azard at public e;pense$ 0ollo,in" ,eading& and ot#er decisions -4idlantic and Kovacs. ,#ic# #a(e created a special emp#asis on t#e importance o& complyin" ,it# la,s t#at protect t#e public #ealt# and sa&ety' t#e e;pense incurred by t#e 3tate ,as an actual' necessary cost and e;pense' bot# -i. &or preser(in" t#e estate' and -ii. &or protectin" t#e #ealt# and sa&ety o& a potentially endan"ered public$

/olding(s) , 0ule(s)

0easoning

5otes , 1OA $lass discussion

=CI

"ICROSOFT CORP. 0. DAK INDUSTRIES7 INC. <nited 3tates Court o& Appeals' >t# Circuit' =>>H -AA 0$Id =0>=. !acts , Microso&t and DAK !ndustries entered into a E2icense -rocedura A"reementM "rantin" DAK certain none;clusi(e' l -osture ,orld,ide Elicense ri"#tsM to Microso&tWs Kord$ T#e a"reement pro(ided t#at DAK ,ould pay a Eroyalty rateM o& @HH per copy o& Kord t#at it distributed$ <pon si"nin" t#e a"reement' DAK became obli"ated to pay Microso&t a Eminimum commitmentM o& @C'JH0'000 in &i(e installments' re"ardless o& #o, many copies o& Kord it sold$ Microso&t did not per&ect a security interest in any o& DAKWs property$ DAK paid t#e &irst t#ree installments' but later &iled a petition &or bankruptcy' lea(in" unpaid t#e &inal t,o installments' totalin" @='I>H'8II$ Microso&t mo(ed in t#e bankruptcy court &or an order &or t#e payment o& an administrati(e e;pense' claimin" it s#ould be compensated &or t#e debtorWs post% bankruptcy petition EuseM o& t#e license a"reement' because t#e debtor continued to distribute Kord$ T#e bankruptcy court denied Microso&tWs administrati(e e;pense claim' concludin" t#at t#e payment structure o& t#e a"reement ,as more analo"ous to payments on a sale o& "oods t#an to royalty payments &or t#e continuin" use o& an intellectual property$ As suc#' t#e debt ,as a prepetition unsecured claim' not a postpetition administrati(e e;pense claim$ Microso&t appealed t#e bankruptcy courtWs denial o& its administrati(e e;pense claim to t#e district court$ T#e district court concluded t#at t#e debtor #ad recei(ed bene&its &rom its postpetition distribution o& Kord$ ?o,e(er' t#e court concluded t#at t#e payment sc#edule resembled installment payments &or t#e sale o& "oods' not periodic royalties &or t#e use o& intellectual property$ T#ere&ore' t#e obli"ations &or t#e amounts due under t#e a"reement ,ere incurred prepetition$ T#e court also concluded t#at Microso&t ,as neit#er induced to nor continued to pro(ide so&t,are units at its e;pense a&ter t#e &ilin" o& t#e petition$ Accordin"ly' Microso&t #ad pro(ided no postpetition consideration to debtor$ T#e court reDected Microso&tWs administrati(e e;pense claim' t#ereby lea(in" t#e remainin" amount due under t#e =CP

a"reement as a prepetition' unsecured claim$ .egal (ssue(s) K#et#er prepetition a"reement bet,een debtor and creditor ,as lump sum sale o& "oods Zt#us bein" an unsecured prepetition claimZ' or "rant o& permission to use intellectual property postpetition Zt#e post% bankruptcy EuseM o& t#e license a"reement bein" an administrati(e e;pense$ Microso&t' ,#ic# #ad entered prepetition a"reement allo,in" debtor to install so&t,are on computers t#at debtor sold' ,as not entitled to administrati(e e;pense claim &or so&t,are t#at debtor distributed postpetition/ a"reement ,as lump sum sale o& so&t,are units to debtor' rat#er t#an "rant o& permission to use intellectual property and' t#us' t#e debt arose prepetition' and t#e (endor "a(e no consideration postpetition$ 7urden of proof , interpretation issues Burden o& pro(in" administrati(e e;pense claim is on claimant$ Administrati(e e;pense claimant must s#o, t#at debt asserted to be administrati(e e;pense -=. arose &rom transaction ,it# debtor%in% possession as opposed to t#e precedin" entity -or' alternati(ely' t#at claimant "a(e consideration to debtor%in%possession. and -C. directly and substantially bene&itted t#e estate$ To keep administrati(e costs to bankruptcy estate at minimum' actual' necessary costs and e;penses o& preser(in" t#e estate are construed narro,ly$ =nalysis of the transaction !n t#is case' a&ter t#e petition' t#e debtor continued to distribute copies o& t#e so&t,are pro(ided under t#at contract$ T#e estate directly and substantially bene&ited &rom t#ese postpetition sales o& Kord$ T#ere&ore' Microso&t ,ould be entitled to an administrati(e e;pense claim i& t#e debt outstandin" on t#e contract arose a&ter t#e petition or i& Microso&t pro(ided consideration to t#e debtor a&ter t#e petition$ K#en applyin" t#e bankruptcy code to t#is

/olding(s) , 0ule(s)

0easoning

=CH

transaction' one must look t#rou"# its &orm to t#e economic realities o& t#e particular arran"ement Applyin" t#is standard' t#is a"reement is best c#aracterized as a lump sum sale o& so&t,are units to DAK' rat#er t#an a "rant o& permission to use an intellectual property$ Accordin"ly' debt arose prepetition and Microso&t "a(e no consideration postpetition$ T#is conclusion ,as reac#ed &or se(eral reasons -i. DAKWs entire debt to Microso&t arose prepetition because' upon si"nin"' DAK ,as absolutely obli"ated to pay @C'JH0'000' e(en i& it sold only one copy o& Kord/ -ii. t#e pricin" structure o& t#e a"reement indicates t#at it ,as more akin to a sale o& an intellectual property t#an to a lease &or use o& t#at property/ -iii. as in a sale' DAK recei(ed all o& its ri"#ts under t#e a"reement ,#en t#e term o& t#e a"reement commenced %initially' DAK made a do,n payment on its @C'JH0'000 minimum commitment/ -i(. it is more accurate to describe t#is a"reement as "rantin" DAK a Eri"#t to sellM t#an Epermission to useM an intellectual property/ and -(. Microso&t did not pro(ide anyt#in" at its e;pense to t#e debtor a&ter t#e petition Zat t#e time o& t#e petition' Microso&t #ad already "ranted DAK t#e ri"#t to sell at least H0'000 copies o& Kord' and Microso&t does not contend t#at DAK sold more t#an t#is amount$ 0urt#ermore' t#e debtor did not accept any Kord updates o&&ered by Microso&t a&ter t#e petition' and Microso&t did not incur any additional e;pense postpetition by makin" its "enerally a(ailable so&t,are #otline ser(ice also a(ailable to DAKWs customers$ -olicy considerations 5rantin" Microso&t priority o(er ot#er unsecured creditors ,ould not ser(e t#e purpose o& H0I' namely to induce entities to do business ,it# a debtor a&ter bankruptcy by insurin" t#at t#ose entities recei(e payment &or ser(ices rendered$ !n t#is case' Microso&t ,as not induced to and did not do business ,it# t#e debtor postpetition$ , 1OA

5otes $lass discussion

=CA

IM. F.

PRIORITY OF CLAI"S CODIFIED PRIORITIES

Code F H0J Code F H0I-c.

=CJ

5enerally' i& particular ri"#ts are reco"nized outside o& bankruptcy' t#e claimant #oldin" t#ese ri"#ts ,ill be able to assert t#em &ully in bankruptcy -*utner principle.$ 3ection JCH Zdirects t#e trustee to dispose o& any property in ,#ic# an entity ot#er t#an t#e estate #as an interest$ T#e purpose o& t#is section is to "i(e t#e court t#e appropriate aut#ority to ensure t#at collateral or its proceeds is returned to t#e proper secured creditor$ 4ankin" amon" creditors ,#o don9t #old property interests A&ter secured creditors #a(e #ad t#eir property interests satis&ied' t#e +uestion becomes #o, to di(ide up t#e remainin" assets amon" t#e debtor9s remainin" obli"ations Z 3ection H0J pro(ides t#e basic list o& bankruptcy priorities' and H0C and H0I pro(ide &urt#er distinctions in t#e #ierarc#y$ Broadly' t#e rankin" is as &ollo,s -i. -ii. -iii. domestic support obli"ations Zapplicable by nature only to indi(idual debtors/ administrati(e e;penses/ and claims t#at' at one time or anot#er' Con"ress t#ou"#t especially ,ort#y o& protection' and ,#ic# not necessarily track nonbankruptcy ri"#ts Ze$"$' claims o& unpaid ,orkers' claims o& t#e ta; collector' etc$

Once a debtor9s assets or t#e proceeds t#ere&rom are applied to claims "i(en priority under 3ection H0J' any property t#at remains is applied under 3ection JCA o,n priority pro(isions$ 3ection H=0 Zaddresses subordination H=0-a. #onors a contractual subordination a"reement to t#e e;tent en&orceable under applicable nonbankruptcy la,$ H=0-b. subordinates claims t#at arise &rom purc#ase or sale o& a security o& t#e debtor$ All creditors ,ill be paid a#ead o& t#e claim based on securities (iolation$

=C8

H=0-c. pro(ides &or Ee+uitable subordinationM applied ,#en t#e courts &ind t#at Dustice re+uires an alteration o& t#e statutory pro(isions$

.ana deals ,it# Con"ress9 manipulation o& bankruptcy priority in t#e ,ake o& t#e *nron and KorldCom scandals' ,#ic# included at least t#e perception o& insiders enric#in" t#emsel(es at t#e companies9 e;pense$ T#is case pro(ides a "limpse o& 3ection H0I-c. in action' and re(eals t#e "reat &le;ibility t#at a Dud"e #as in its application$

=C>

IN RE DANA CORPORATION <nited 3tates Bankruptcy Court' 3$D$1$B$' C00A -IH8 Bankr$ HAJ. !acts , C#apter == debtors mo(ed &or order aut#orizin" t#em -rocedura to enter into employment a"reements ,it# t#eir C*O l -osture and senior e;ecuti(es' and t#e Bankruptcy Court denied motion$ Debtors mo(ed &or reconsideration$ Dana ar"ues t#at t#e compensation pro(ided in t#e *;ecuti(e Compensation Motion is necessary and appropriate' and represents a reasonable e;ercise o& t#e DebtorsW business Dud"ment' pursuant to sections IAI' IAH and H0C o& t#e Bankruptcy Code' and are permissible under section H0I-c. o& t#e Bankruptcy Code$ !n addition to base salary and an annual incenti(e plan -t#e EA!8M.' t#e key terms o& t#e -modi&ied. *mployment A"reements o& t#e C*O and 3enior *;ecuti(es ,ere as &ollo,s -ension 7enefits Assumption o& one #undred percent o& t#e 3enior *;ecuti(esW pension plans -ran"in" bet,een @>>>'000 and @C$J million. and si;ty percent o& t#e C*OWs pension plan -A0Q o& @H$> million.' ,it# t#e remainin" &orty percent bein" allo,ed as a "eneral unsecured claim$ Assumption ,ould take place upon emer"ence &rom bankruptcy or t#e 3enior *;ecuti(esW in(oluntary termination ,it#out cause' and ,it# respect to t#e C*O' (oluntary termination &or "ood reason$ To t#e e;tent not assumed' one #undred percent o& t#e pension bene&its o& C*O and 3enior *;ecuti(es ,ould be treated as allo,ed "eneral unsecured claims in t#eir (ested amount as o& t#e 8etition Date' ,it# all postpetition accruals and credits allo,ed as administrati(e claims$ Severance 3#ould t#e need arise' t#e Debtors propose to pay t#e C*O and 3enior *;ecuti(es se(erance in an amount t#at complies ,it# section H0I-c.-C. o& t#e Bankruptcy Code$ 5on< isclosure =greement and -re<>mergence or -ost<>mergence $laim !n consideration &or t#e assumption o& t#eir *mployment A"reements and receipt o& payments =I0

under t#e 2T!8' t#e 3enior *;ecuti(es ,ould e;ecute a ne, non%compete' non%solicitation' non%disclosure and non%dispara"ement a"reement -collecti(ely' t#e E1DA A"reementsM.$ !n t#e e(ent t#e C*O is in(oluntarily terminated ,it#out cause or resi"ned &or "ood reason prior to or a&ter t#e DebtorsW emer"ence &rom c#apter ==' t#e C*O ,ould be pro#ibited &rom acceptin" a position ,it# a competitor o& Dana' disclosin" DanaWs con&idential in&ormation to t#ird parties' solicitin" any employees o& Dana or dispara"in" Dana &or si; mont#s$ T#e pre%emer"ence claim o& t#e C*O ,ould be an allo,ed "eneral unsecured claim in t#e amount o& @P million -,it# reco(ery limited to @I million' less any se(erance actually paid under section H0I-c.-C. o& t#e Bankruptcy Code.$ 8ost%emer"ence claim o& @I million$ <nder t#e 2T!8' t#e C*O and 3enior *;ecuti(es ,ould be eli"ible &or a lon"%term incenti(e bonus i& t#e company reac#es certain *B!TDA4 benc#marks$ !n sum' i& all *B!TDA4 "oals ,ere reac#ed' o(er a t#ree year period' t#e 2T!8 pro(ides &or @== million payments in total to t#e si; e;ecuti(es and t#e C*O$ .egal (ssue(s) /olding(s) , 0ule(s) K#et#er t#e *;ecuti(e Compensation Motion presented be&ore t#e court (iolates 3ection H0I-c. o& t#e Code$ By presentin" an e;ecuti(e compensation packa"e t#at properly incenti(izes t#e C*O and 3enior *;ecuti(es to produce and increase t#e (alue o& t#e estate' t#e Debtors #a(e establis#ed t#at section H0I-c.-=. does not apply to t#e *;ecuti(e Compensation Motion$ Additionally' t#e Debtors #a(e satis&actorily establis#ed t#at none o& t#e payments proposed (iolate section H0I-c.-C.' as t#e *;ecuti(e Compensation Motion speci&ically limits Ese(eranceM payments to t#ose permissible under section H0I-c.-C. and any ot#er payments are non% se(erance in nature$ T#e assumption o& t#e *mployment A"reements and t#e adoption o& t#e 2T!8 are &air and reasonable and ,ell ,it#in t#e DebtorsW business Dud"ment' conditioned on an appropriate ceilin" or cap on t#e total le(el o& yearly compensation to be earned by t#e C*O and 3enior *;ecuti(es durin" t#e course o& t#e bankruptcy proceedin"s$

=I=

0easoning

0actors t#at bankruptcy courts consider in determinin" ,#et#er to appro(e' under Esound business Dud"mentM test' a compensation proposal &or debtorWs key employees t#at is not in nature o& key employee retention payment or se(erance bene&it are -=. ,#et#er t#ere is reasonable relations#ip bet,een t#e plan proposed and results to be obtained/ -C. ,#et#er cost o& plan is reasonable in li"#t o& debtorWs assets' liabilities and earnin" potential/ -I. ,#et#er scope o& plan &air and reasonable/ -P. ,#et#er plan or proposal is consistent ,it# industry standards/ -H. ,#at due dili"ence t#e debtor e;ercised ,#en in(esti"atin" need &or plan/ and -A. ,#et#er debtor recei(ed independent counsel in per&ormin" due dili"ence and in creatin" and aut#orizin" t#is incenti(e compensation$ 8roposed assumption o& employment a"reements cannot be re"arded as a re+uest &or payment' as administrati(e e;pense' o& any key employee retention or se(erance bene&it Z t#us' it can be appro(ed as e;ercise o& &air and reasonable business Dud"ment takin" into account t#at payments to ,#ic# C*O and senior e;ecuti(es ,ould be entitled under a"reements ,ere &i;ed ,it# assistance &rom outside e;pert on e;ecuti(e compensation and ,it# input &rom creditorsW and e+uity committee$ Annual !ncenti(e 8lan did not di&&er si"ni&icantly &rom debtorsW prepetition practice' it bein" a common component o& debtorsW employee compensation plans &or t#e last H0 years Zt#us' it is ,it#in ordinary course o& debtorsW business' and could be implemented by debtor ,it#out need &or court appro(al$ ?o,e(er' payments to be made under t#is incenti(e plan to debtorsW e;ecuti(es #ad to be considered in conte;t o& determinin" ,#et#er debtorsW o(erall compensation proposal ,as proper e;ercise o& debtorsW business Dud"ment$ 2on"%term incenti(e plan ,as made dependant upon a series o& benc#marks ,#ose ac#ie(ement ,as certainly not "uaranteed and ,#ic# represented

=IC

tar"ets t#at ,ould be di&&icult to reac#$ T#ere&ore' t#e plan ,as &air and reasonable and ,ell ,it#in debtorsW business Dud"ment' conditioned upon an appropriate ceilin" or cap on total le(el o& yearly compensation to be earned by C*O and senior e;ecuti(es durin" course o& bankruptcy proceedin"s$ . ELUITABLE SUBORDINATION H=0-c. o& t#e Code Zpermits a bankruptcy court to employ principles o& e+uitable subordination to alter t#e distribution priorities t#at ,ould ot#er,ise apply$ <sin" t#ese principles' a court may subordinate' in ,#ole or in part' ant claim or interest and may eliminate a lien t#at secures a claim t#is subordinated$ *;ample Zsin"le s#are#older o,ns all t#e stock in a debtor corporation' ,#ic# is subDect to a loan &rom a bank$ T#e debtor becomes insol(ent' and t#e s#are#older ,#o controls t#e &irm' eit#er con(erts some stock into debt or lends t#e debtor ne, &unds in an e&&ort to re(i(e t#e &ailin" &irm$ K#en t#e &irm &ails' t#e s#are#older attempts to collect ,it# or a#ead o& t#e creditors t#at dealt ,it# t#e debtor at arm9s len"t#$ 3uc# a loan can substantially increase t#e risk t#at t#e arm9s len"t# creditors ,ill not reco(er$ 5i(en t#e potential loss to creditors' a court mi"#t mo(e beyond &raudulent con(eyance doctrine and e+uitably subordinate a controllin" s#are#older9s last%minute e;c#an"e ,it# t#e debtor Ze+uitable subordination may be seen as an alternati(e or supplement to &raudulent con(eyance la,$ *+uitable subordination Znot al,ays limited to t#e case o& an o(erreac#in" insider$ 3ome courts ,ill' at times' subordinate t#e loan o& a t#ird%party creditor ,#o' in t#e court9s (ie,' acts sel&is#ly at t#e e;pense o& t#e debtor or ot#er creditors . Clar; <i!e e;plores t#is issue$

IN RE CLARK PIPE ! SUPPLY CO.7 INC. <nited 3tates Court o& Appeals' Ht# Circuit' =>>> -8>I 0$Cd A>I. !acts , Associates -creditor. and Clark -debtor. e;ecuted -rocedura se(eral re(ol(in" loan a"reements secured by an

=II

l -osture

assi"nment o& accounts recei(able and an in(entory mort"a"e$ T#e amount t#at Associates ,ould lend ,as determined by a &ormula' i$e$' a certain percenta"e o& t#e amount o& eli"ible accounts recei(able plus a certain percenta"e o& t#e cost o& in(entory$ T#e a"reements pro(ided t#at Associates could reduce t#e percenta"e ad(ance rates at any time at its discretion$ ClarkWs business slumped' and Associates be"an reducin" t#e percenta"e ad(ance rates so t#at Clark ,ould #a(e Dust enou"# cas# to pay its direct operatin" e;penses$ Clark used t#e ad(ances to keep its doors open and to sell in(entory' t#e proceeds o& ,#ic# ,ere used to pay o&& t#e past ad(ances &rom Associates$ Associates did not e;pressly dictate to Clark ,#ic# bills to pay$ 1eit#er did it direct Clark not to pay (endors or t#reaten Clark ,it# a cut%o&& o& ad(ances i& it did pay (endors$ But Clark #ad no &unds le&t o(er &rom t#e ad(ances to pay (endors or ot#er creditors ,#ose ser(ices ,ere not essential to keepin" its doors open$ A&ter unpaid creditors initiated &oreclosure proceedin"s' Clark &iled &or reor"anization' and t#e case ,as later con(erted to a C#apter J$ T#e trustee brou"#t proceedin"s a"ainst Associates and sou"#t e+uitable subordination o& AssociatesW claims$ Bankruptcy court entered Dud"ment subordinatin" AssociatesW claims$ !n essence' t#e court &ound t#at once Associates realized ClarkWs desperate &inancial condition' Associates asserted total control and used Clark as a mere instrumentality to li+uidate AssociatesW unpaid loans$ Moreo(er' it did so' t#e trustee ar"ues' to t#e detriment o& t#e ri"#ts o& ClarkWs ot#er creditors$ T#e district court a&&irmed$ K#et#er t#e bankruptcy court ,as Dusti&ied in e+uitably subordinatin" AssociatesW claims$ Control ,#ic# lender asserted o(er debtorWs &inancial a&&airs did not rise to le(el o& unconscionable conduct necessary to Dusti&y application o& doctrine o& e+uitable subordination' ,#ere lender #ad ri"#t to reduce &undin" pursuant to loan a"reement e;ecuted at inception o& lendin" relations#ip$ T#e court applied t#e t#ree%pron"ed test' ,#ic# establis#es t#ree re+uirements t#at must be met &or

.egal (ssue(s) /olding(s) , 0ule(s)

0easoning

=IP

a claim to be e+uitably subordinated -=. t#e claimant must #a(e en"a"ed in some type o& ine+uitable conduct/ -C. t#e misconduct must #a(e resulted in inDury to t#e creditors o& t#e bankrupt or con&erred an un&air ad(anta"e on t#e claimant/ and -I. e+uitable subordination o& t#e claim must not be inconsistent ,it# t#e pro(isions o& t#e Bankruptcy Code$ T#ree "eneral cate"ories o& conduct #a(e been reco"nized as su&&icient to satis&y t#e &irst pron" o& t#e t#ree%part test -=. &raud' ille"ality or breac# o& &iduciary duties/ -C. undercapitalization/ and -I. a claimantWs use o& t#e debtor as a mere instrumentality or alter e"o$ T#e sort o& control Associates asserted o(er ClarkWs &inancial a&&airs does not rise to t#e le(el o& unconscionable conduct necessary to Dusti&y t#e application o& t#e doctrine o& e+uitable subordination$ 8ursuant to t#e loan a"reement' Associates #ad t#e ri"#t to reduce &undin" as ClarkWs sales slo,ed$ 1o e(idence t#at Associates e;ceeded its aut#ority under t#e loan a"reement' or t#at Associates acted ine+uitably in e;ercisin" its ri"#ts under t#at a"reement$ 1o e(idence t#at t#e loan documents ,ere not ne"otiated at armWs len"t#' or t#at t#ey are atypical o& loan documents used in similar asset%based &inancin"s$ K#en ClarkWs business be"an to decline' Clark prepared a bud"et at AssociatesW re+uest t#at indicated t#e disbursements necessary to keep t#e company operatin"$ T#e bud"et did not include payment to (endors &or pre(iously s#ipped "oods$ Amount o& ad(ances continued to be based on t#e applicable &undin" &ormulas$ T#rou"# its loan a"reement e(ery lender e&&ecti(ely e;ercises EcontrolM o(er its borro,er to some de"ree$ T#e purpose o& e+uitable subordination is to distin"uis# bet,een t#e unilateral remedies t#at a creditor may properly en&orce pursuant to its a"reements ,it# t#e debtor and ot#er ine+uitable conduct suc# as &raud' misrepresentation' or t#e e;ercise o& suc# total control o(er t#e debtor as to #a(e essentially

=IH

replaced its decision%makin" capacity ,it# t#at o& t#e lender$ AssociatesW control o(er ClarkWs &inances ,as based solely on t#e loan a"reement$ T#ere is not#in" in#erently ,ron" ,it# a creditor care&ully monitorin" #is debtorWs &inancial situation or ,it# su""estin" ,#at course o& action t#e debtor ou"#t to &ollo,$ A creditor is under no &iduciary obli"ation to its debtor or to ot#er creditors o& t#e debtor in t#e collection o& its claim$ Apart &rom (oidable pre&erences and &raudulent con(eyances proscribed by t#e Bankruptcy Act' t#ere is "enerally no obDection to a creditorWs usin" #is bar"ainin" position' includin" #is ability to re&use to make &urt#er loans needed by t#e debtor' to impro(e t#e status o& #is e;istin" claims$

H.

SUBSTANTI2E CONSOLIDATION

IN RE OIENS CORNIN CORP. <nited 3tates Court o& Appeals' Ird Circuit' C00H -P=> 0$Id =>H. !acts , -rocedura l -osture Credit 3uisse 0irst Boston -EC30BM. is t#e a"ent &or a syndicate o& banks t#at e;tended a @C billion unsecured loan to O,ens Cornin" -OCD. and certain o& its subsidiaries' ,#ic# ,as en#anced in part by "uarantees made by ot#er OCD subsidiaries$ OCD and its subsidiaries comprise a multinational corporate "roup' in ,#ic# di&&erent entities ,it#in t#e "roup #a(e di&&erent purposes -e$"$' limit liability concerns "ain ta; bene&its' re"ulatory reasons.$ *ac# subsidiary ,as a separate le"al entity t#at obser(ed "o(ernance &ormalities$ Despite some EsloppyM bookkeepin"' &inancial statements o& all t#e subsidiaries ,ere accurate in all material respects$ Takin" into account t#e poor credit ratin" o& OCD' C30B and t#e ot#er creditors under t#e syndicated loan re+uested subsidiary "uarantees' ,#ic# ,ere Eabsolute and unconditionalM and eac# Econstitute[d] a "uarant[ee] o& payment and not a "uarant[ee] o& collection$M K#en ne"otiatin" t#e loan' C30B ne"otiated e;pressly to limit t#e ,ays in ,#ic# OCD could deal ,it# its subsidiaries Z&or

=IA

e;ample' it could not enter into transactions ,it# a subsidiary t#at ,ould result in losses to t#at subsidiary$ !mportantly' t#e loan contained pro(isions desi"ned to protect t#e separateness o& OCD and its subsidiaries$ T#e subsidiaries a"reed e;plicitly to maintain t#emsel(es as separate entities$ OCD and certain o& its subsidiaries &iled C#apter == o& t#e Bankruptcy' and some mont#s a&ter t#e Debtors and certain unsecured creditor "roups proposed a reor"anization plan predicated on obtainin" Esubstanti(e consolidationM o& t#e Debtors alon" ,it# t#ree non%Debtor OCD subsidiaries$ T#e District Court "ranted a motion to consolidate t#e assets and liabilities o& t#e OCD borro,ers and "uarantors in anticipation o& a plan o& reor"anization' concludin" t#at -i. t#ere e;isted substantial identity bet,een OCD and its ,#olly% o,ned subsidiaries' -ii. t#ere ,as no basis &or a &indin" t#at' in e;tendin" credit' t#e Banks relied upon t#e separate credit o& any o& t#e subsidiary "uarantors' -iii. t#e substanti(e consolidation ,ould "reatly simpli&y and e;pedite t#e success&ul completion o& t#e bankruptcy proceedin"' and -i(. it ,ould be e;ceedin"ly di&&icult to untan"le t#e &inancial a&&airs o& t#e entities$ C30B appealed' ar"uin" t#at t#e Court erred by "rantin" t#e motion' as it misunderstood t#e reasons &or' and standards &or considerin"' t#e e;traordinary remedy o& substanti(e consolidation' and in any e(ent did not make &actual determinations necessary e(en to consider its use$

.egal (ssue(s) /olding(s) , 0ule(s)

<nder ,#at circumstances a court e;ercisin" bankruptcy po,ers may substanti(ely consolidate a&&iliated entities$ K#at must be pro(en -absent consent. concernin" t#e entities &or ,#om substanti(e consolidation is sou"#t is t#at -i. prepetition t#ey disre"arded separateness so si"ni&icantly t#eir creditors relied on t#e breakdo,n o& entity borders and treated t#em as one le"al entity' or -ii. postpetition t#eir assets and liabilities are so

=IJ

scrambled t#at separatin" t#em is pro#ibiti(e and #urts all creditors$ 0easoning 3ubstanti(e consolidation emanates &rom e+uity$ !t treats separate le"al entities as i& t#ey ,ere mer"ed into a sin"le sur(i(or le&t ,it# all t#e cumulati(e assets and liabilities -sa(e &or inter%entity liabilities' ,#ic# are erased.$ T#e result is t#at claims o& creditors a"ainst separate debtors morp# to claims a"ainst t#e consolidated sur(i(or$ Consolidation restructures -and t#us re(alues. ri"#ts o& creditors and &or certain creditors t#is may result in si"ni&icantly less reco(ery$ !n addition to substanti(e consolidation' ot#er remedies &or corporate disre"ard include t#e Ealter e"oM doctrine' piercin" o& t#e Ecorporate (eilM' turno(er o& assets' e+uitable subordination' etc$ 3ubstanti(e consolidation "oes in a direction di&&erent -and in most cases &urt#er. t#an any o& t#ese remedies$ !t is not limited to s#are#olders' it a&&ects distribution to innocent creditors' and it mandates more t#an t#e return o& speci&ic assets to t#e predecessor o,ner$ !t brin"s all t#e assets o& a "roup o& entities into a sin"le sur(i(or$ 8rinciples t#at s#ould be borne in mind ,#en orderin" substanti(e consolidation -=. Courts s#ould respect entity separateness absent compellin" circumstances callin" e+uity -and e(en t#en only possibly substanti(e consolidation. into play/ -C. T#e #arms substanti(e consolidation addresses are nearly al,ays t#ose caused by debtors -and entities t#ey control. ,#o disre"ard separateness$ ?arms caused by creditors typically are remedied by pro(isions &ound in t#e Bankruptcy Code - e$"$' &raudulent trans&ers' FF HP8 and HPP-b. -=.' and e+uitable subordination./ -I. Mere bene&it to t#e administration o& t#e case Z&or e;ample' allo,in" a court to simpli&y a case by a(oidin" ot#er issues or to make postpetition accountin" more con(enient% is #ardly a #arm callin" substanti(e consolidation into play/ -P. 3ubstanti(e consolidation is e;treme and imprecise' and t#us t#is Erou"# DusticeM remedy s#ould be rare and' in any e(ent' one o& last resort

=I8

a&ter considerin" and reDectin" ot#er remedies/ and -H. K#ile substanti(e consolidation may be used de&ensi(ely to remedy t#e identi&iable #arms caused by entan"led a&&airs' it may not be used o&&ensi(ely Z &or e;ample' #a(in" a primary purpose to disad(anta"e tactically a "roup o& creditors in t#e plan process or to alter creditor ri"#ts$ !n t#e present case' t#ere is no e(idence o& t#e prepetition disre"ard o& t#e OCD entitiesW separateness$ To t#e contrary' OCD -no less t#an C30B. ne"otiated t#e lendin" transaction premised on t#e separateness o& all OCD a&&iliates$ Commin"lin" Dusti&ies consolidation only ,#en separately accountin" &or t#e assets and liabilities o& t#e distinct entities ,ill reduce t#e reco(ery o& e(ery creditor Zt#at is' ,#en e(ery creditor ,ill bene&it &rom t#e consolidation$ Moreo(er' t#e bene&it to creditors s#ould be &rom cost sa(in"s t#at make assets a(ailable rat#er t#an &rom t#e s#i&tin" o& assets to bene&it one "roup o& creditors at t#e e;pense o& anot#er$ Mere bene&it to some creditors' or administrati(e bene&it to t#e Court' &alls &ar s#ort$

M. CHAPTER $$. REOR ANINATIONS I. THEORY a. Cla++ Note+ ?ypot#etical sale 4eor"anization includes a #ypot#etical sale to t#e #olders o& claims' ,#ic# means t#at t#ere are no direct proceeds &rom a sale t#at can be di(ided amon" t#e claim #olders upon &ilin" by t#e debtor old claim #olders surrender t#eir claims a"ainst claims and ri"#ts a"ainst t#e ne, company t#at t#ey o,n to"et#er' a company ,it# no debt -cancelled a"ainst t#e ri"#ts.' so reor"anization also

=I>

contains a disc#ar"e &rom all debts' accordin" to 3ec$ ==P=' ,it# t#e e;ception o& 3ec$ HCI-a. T#ree conditions &or reor"anization =$ 3ubstantial (alue o& t#e &irm as a "oin" concern C$ !n(estors cannot sort t#in"s out ,it# ordinary bar"ainin" and re+uire C#== collecti(e &orum I$ Business cannot be readily sold as a "oin" concern 777 C#== is a(ailable also to indi(iduals777 !deas be#ind C#== C#== rules are made &or companies suc# as railroad -or modern companies ,it# pieces 3i"ni&icant c#an"es bet,een t#e =>t# century idea o& C#== and lar"e corporations -especially in terms o& creditor structure and ,#at can be preser(ed by keepin" company as a "oin" concern./ t#ere&ore' many lar"e C#== cases use t#e court to conduct a sale to t#e #i"#est bidder' no matter i& piecemeal or "oin" concern 4eor"anization rules in C#== are increasin"ly outdates' but still used' Dust in di&&erent ,ays t#an intended ,#en t#ey ,ere created C#== allo,s continuation o& t#e entity in &inancial distress' pro(ided t#at t#e &irm is not in economically distress 3teps in(ol(ed in C#== case Ability o& t#e incumbent mana"ement to remain in control o& t#e debtor -as opposed to C#J. Ad(ance ne"otiations bet,een t#e debtor and constituents -creditors' sO#s. bi" bar"ain 8lan proposal usually by debtor in possession -D!8. si"ni&icant assets. t#at #a(e a as a "oin" concern (alue si"ni&icantly #i"#er t#an t#e (alue o& li+uidated

=P0

T#ere can be more t#an one competin" plans' but t#is is not common

8lan (otin" Sotin" by class O&ten an impaired class -a class ,#ose claim is not satis&ied in &ull. is &orced to accept t#e plan -Ecramdo,nM. Cramdo,n non%consensual acceptance o& t#e plan' o(er t#e non%acceptance o& an impaired class -as opposed to consensual acceptance' by all t#e classes.--n re Armstrong. Con&irmation o& t#e plan and emer"ence o& t#e debtor as a reor"anized entity 2i+uidation reor"anization is allo,ed under t#e Code 8lan ,ill still be called a plan o& reor"anization e(en i& t#e company is e(entually li+uidated -C?== as (e#icle &or rati&yin" t#e sale or slo, li+uidation o& t#e business. ,. Foundation+ o8 Ban-ru;tc6 La1 BairdO4asmussen T#e *nd o& Bankruptcy -p$ C=>. Ar"uments a"ainst reor"anizations T#e structure o& modern businesses C?== sc#eme is based on t#e assumption t#at "oin" concern is ,ort# more t#an li+uidation (alue/ t#at is no lon"er true in case o& modern businesses Old &as#ioned company Z e;$ railroad "oin" concern (alue si"ni&icantly #i"#er t#en pieces o& t#e assets Modern company Z real assets are intelli"ible and &un"ible -!8' #uman capital. "oin" concern (alue is not substantially #i"#er t#an li+uidation (alue =P=

Capital structures More streamlined t#ese days t#an be&ore' so t#e need to #a(e t#e collecti(e &orum o& parties ,it# con&lictin" interests is not t#at si"ni&icant Once a debtor de&aults on loan co(enants' secured creditors ac+uire control o& t#e debtor' so in reality t#ere is no collecti(e action problem 3enior creditor is more likely to e;ercise t#e control o(er t#e debtor in a more sensible &as#ion t#an t#e mana"ers -,#ic# is t#e case durin" C#== reor"anization. or b%cy Dud"e

C#an"e in capital markets Muc# easier to obtain &inancin" &or "oin" concern sales &rom t#e capital markets

Conclusion 4eor"anizations don9t #appen anymore and t#ey s#ouldn9t #appen anymore because t#e reality #as c#an"ed since C#== ,as &irst adopted C#== can play its traditional role only in en(ironments in ,#ic# specialized assets e;ist' ,#ere t#ose assets must remain in particular &irm' ,#ere control ri"#ts are badly allocated and ,#ere "oin" concern sales are not possible 3O not in lar"e corporations' but only small &irms

T#e purpose o& C#== no,adays

=PC

Collecti(e &orum ,#ere all t#e parties can come to"et#er and decide ,#at to do ,it# t#e business ?o,e(er' most o& t#is ne"otiation is occurrin" be&ore b% cy any,ays' so t#is is not really t#at important -t#e prepacka"ed cases.

B%cy is used as end point in most o& t#e deals -e;$ in cases o& indentures' because outside o& b%cy it is di&&icult to con(ince indi(idual bond#olders to "i(e up some ri"#ts' but possible in b%cy.

2o8ucki 4esponse to BairdO4asmussen Corporate reor"anizations are boomin" and t#e number o& lar"e public &irms &ilin" under C#apter == is lar"er t#an e(er T#e assumption t#at "oin" concern (alue only e;ists in conDunction ,it# &irm%speci&ic assets is ,ron" !nstead' t#e "oin" concern (alue o& a &irm consists o& t#e countless relations#ips t#at e;ist bet,een assets' employees and ot#er people$ !& a business is demolis#ed' t#e cost to rebuild t#e relations#ips must be incurred a"ain' i& t#e &irm is closed' t#e (alue' ,#ic# represents t#e "oin" concern (alue' disappears' so t#at t#e sum o& t#e parts is ,ort# less t#an t#e "oin" concern$ *(en i& assets are not &irm speci&ic' t#ey are industry speci&ic T#e top price &or t#e assets can only be obtained &rom t#e buyer &rom t#e same industry T#e ,#ole industry mi"#t be in t#e same &inancial distress as t#e debtor' so t#ere is no buyer t#at can o&&er ade+uate price &or t#e assets

=PI

 Baird and 4asmussen err in t#e assumption t#at t#e lender controls t#e business because t#ere is still t#e residual claimant ,#o bears and su&&ers t#e risk and ,#o is t#e per&ect person to control t#e company 4esidual claimant one ,#o only "ets ,#at is le&t o& t#e assets a&ter e(eryone else #as satis&ied t#eir claim T#e lendin" contract does not allocate control ri"#ts amon" in(estors t#at allo,s co#erent decision makin"$ Baird An <neasy Case &or Corporate 4eor"anizations 4eor"anization is truly a sale ?ypot#etical sale !nstead o& sellin" to t#e ,orld' t#e assets are sold to t#e prepetition creditors -o(er(ie,ed by Dudicial o&&icer. Disc#ar"e prepetition creditors "i(e up t#eir claims

a"ainst t#e debtor in e;c#an"e &or claims a"ainst t#e interests in a reor"anized &irm t#at #as been stripped o& all prepetition liabilities *(en t#ou"# ,e call it disc#ar"e' t#e reor"anization plan becomes a ne, document "o(ernin" debtor9s obli"ations 3ale s#ould be conducted by t#e residual claimant 4esidual claimant ,ill e;pend su&&icient ener"y to brin" #i"# dollar (alue in t#e sale because #e #as a personal interest in "ettin" as muc# (alue as possible -a creditor #i"# in t#e #ierarc#y does not #a(e suc# incenti(e because #is claim ,ill "et paid o&& in &ull any,ays.

=PP

3ometimes di&&icult to see ,#o t#e residual claimant is -sometimes sO#s' sometimes "eneral creditors.' usually t#e "eneral unsecured creditors/ may be more t#an one

c. Cla++ note+ C#apter == remarks by Troy Amon" sc#olars' C#apter == is a ,aste because too muc# e&&ort and costs -la,yers etc$./ t#ese costs sometimes e;ceed t#e bene&its t#at a li+uidation ,ould #a(e brou"#t$ B<T C#== cases t#ese days run muc# +uicker t#an t#ey used' especially in 1B and Dela,are 3o at least &or sop#isticated &irms is not muc# problem any more 4i"#t call &or a Dud"e distressedL is it economically or &inancially

*conomically ne(er reor"anization' only li+uidation 0inancially consider reor"anization T,o reasons ,#y &irms enter t#e bad state 0irm in(ested in bad proDects i& t#is is t#e only reason' no problem because c#an"in" t#is mi"#t sa(e t#e &irm/ !ndustry or economy ,ide do,nturn i& t#is is t#e case' and t#e &irm #as industry speci&ic assets' a sale is "oin" to be di&&icult' so t#at t#e best (alue can be recei(ed &rom a reor"anization -a buyer ,ouldn9t pay an ade+uate price in an economy ,ide do,nturn.$ Criticism too muc# po,er "i(en to mana"ement in C#== K#at is t#e complications alternati(eL Gust sale' ,#ic# leads to

!n &act is not possible to "et rid o& t#at

Mandatory auction systems T#e mana"ers #a(e a le" in biddin" process

=PH

T#e creditors "et better in&o in +uick auction Uuick auction impro(es t#e situation o& t#ose ,#o #a(e "ood r%s#ip ,it# mana"ers -because t#ey #a(e more in&ormation. <n&ortunately' t#ey &a(or mana"ers and bi" creditors end up o,nin" t#e &irm 1ot necessarily you ,ipe out t#e problems o& selection ,#et#er t#e &irm s#ould continue or be resol(ed and t#e problems o& bad mana"ement ,it# t#e &ollo,in" ar"uments o&

Troy doesn9t a"ree BairdO4asmussen

T#ere ,as no ade+uate capital market in t#e times o& t#e railroads t#at ,ould enable to buyers to obtain &inancin" &or purc#asin" "oin" concern companies -G8 Mor"an "ranted suc# &inancin". T#e capital structures o& modern companies are t#at di&&erent &rom railroads

II. CHAPTER $$ O2ER2IEI a( Ca+e,oo- -p$ AAJ%A8J. 8lan o& reor"anization % 3T*83 =$ 0ilin" &or a plan Corporation is ,ort# keepin" as "oin" concern Old mana"ers continue to run t#e business <nder ==C= Debtor #as t#e e;clusi(e ri"#t to propose a plan o& reor"anization durin" t#e &irst =C0 days a&ter t#e order &or relie& at t#e start o& t#e case

=PA

!& t#e debtor &iles t#e plan ,it#in t#e =C0 days' t#e e;clusi(ity period is e;tended &or an additional A0 days to "i(e t#e debtor a c#an"e to solicit acceptance o& t#e plan ,it#out competition &rom ot#er plan proposals !& t#e e;clusi(ity period e;pires' any party in interest may propose a plan

C$ Trustee appoints Committee o& creditors Typically consists o& creditors ,it# se(en lar"est unsecured claims

8ossible E,orkoutM "roup "roup o& creditors t#at attempted to restructure t#e debt outside o& b%cy 8ossible additional creditor committees and committees o& e+uity #olders

I$ Class di(ision ==CI 4eor"anization plan must di(ide t#e claims into (arious classes Courts "enerally a"ree t#at eac# secured claim belon"s to a class o& itsel& -Esubstantially similarM issue/ Koodbrook case.

P$ 8lan con&irmation Class is deemed to accept a plan i& t#e class is unimpaired ,it#in t#e meanin" o& section ==CP Class is unimpaired i& t#e plan ,ould cure any de&ault' ot#er t#an ipso &acto clauses tri""ered by b%cy or &inancial crisis' and reinstate t#e claim or interest accordin" to its ori"inal terms

Disclosure statement is &iled by t#e debtor -section ==CH.

=PJ

Sotin" and appro(al ==CA appro(al re+uires positi(e (otes by t#ose ,#o #old COI o& in t#e amount o& t#e claims MaDority by number -more t#an #al& in number. ==C>-a.-=0. so lon" as at least one class o& creditors is impaired under t#e plan' at least one class must (ote to appro(e t#e plan -t#e plan #as to be appro(ed by at least one impaired class. *+uity #olders don9t #a(e suc# protection Cram do,n As lon" as at least one impaired class #as appro(ed t#e plan' t#e proponent o& t#e plan can seek to #a(e it con&irmed o(er t#e obDection o& ot#er classes T#e absolute priority rule re+uires t#e debtor to s#o, t#at T#e plan does not discriminate un&airly a"ainst t#e dissentin" class T#e plan treats t#e dissentin" class in a ,ay t#at is &air and e+uitable T#e absolute priority rule cannot be in(oked by an indi(idual creditor on t#e "round t#at its claim is treated ,orse t#at claims entitled to t#e same priority but in di&&erent classes/ only ,#en a class reDects t#e plan can t#e issue be raised$ Dissent by indi(idual creditor More common t#an dissent by a class T#e best interests test -==C>-a.-J.. t#e dissenter may block t#e plan only i& t#e dissenter is not to recei(e a distribution at least e+ual in (alue to t#e distribution

=P8

s#e ,ould #a(e recei(ed #ad t#e debtor been li+uidated under C#J T#e plan must pro(ide payin" o&& o& t#e administrati(e e;pense obli"ations in &ull in cas# on t#e e&&ecti(e day o& t#e plan -==C>-a.->.-A.. T#e plan must pro(ide cas# &or speci&ied prebankruptcy claims' suc# as obli"ations to employees and employee bene&it plans' a&&orded #i"# priority by H0J T#e plan must pro(ide &or a re"ular installment payments o& ta;es 0easibility test -==C>-a.-==. a plan ,ill not be con&irmed unless t#e court is satis&ied t#at con&irmation is not likely to be &ollo,ed by t#e li+uidation or &urt#er reor"anization o& t#e debtor -unless suc# is contemplated by t#e plan itsel&.

Con&irmation o& t#e plan ==P= con&irmation disc#ar"es all debts t#at arose prior to con&irmation

0ast track C#== procedure 0or small business debtor' as de&ined in section =0=-H=.-D. ,( Cla++ note+ C#apter == in "eneral Applicable Code rules 4ules in C# =' I and H o& t#e Code apply 8riority rules in C# J also apply

A(ailable bot# to corporations and indi(iduals Di&&erence bet,een C#J and C#== Control o& t#e debtor

=P>

C#J trustee C#== old directors and o&&icers remain in place and run t#e business' absent &raud or special circumstances/ t#ey enDoy t#e po,ers o& t#e trustee' includin" t#e ri"#t to sell and lease -section IAI and IAP.

Continuation o& t#e business permitted in bot# in C?J and C#==' but a&ter t#e close o& t#e case C? J business #as to be sold as a unit C#== suc# sale is not re+uired

0it &or C#J companies in &inancial' but not economical distress C#== only t#ose &irms in &inancial distress t#at are ,ort# keepin" intact as "oin" concerns

C#== is not a set o& de&ault rules' but rat#er a mandatory re"ime t#at parties can contract around D!8 possession Bot# e;ecuti(es -mana"ement. and board are in possession -t#ey still super(ise t#e board. But t#ey are ,earin" t,o #ats because t#ey are also responsible to creditors -still also s#are#olders./ t#e &iduciary duties in C#== run to bot# "roups

III. CLASSIFICATION OF CLAI"S a( Ca+e,oo- -p$ A8J%A>=. T cla++ note+ ==CI-a.-P. All claims or interests in a class must be treated t#e same unless t#e #older o& any less &a(orably treated claim or interest consents

=H0

3ome in class cannot "et cas#' and ot#er Dust promissory notes or some cannot "et H cents per dollar ,#en ot#ers "et =0 cents per dollar T#e only ,ay to ac#ie(e t#at ,ould be to create di&&erent classes -Because o& ==CC belo,.

==CC-a. Only substantially similar claims ,it# di&&erent le"al ri"#ts can occupy a sin"le class T#is pro(ision re+uires t#at at least claims ,it# di&&erent le"al ri"#ts are classi&ied separately T#is is ,#y eac# secured claim is typically a class by itsel&

T#e Code doesn9t tell us ,#en claims can be put in separate classes 5errymanderin" o& classes t#e courts try to pre(ent t#at' t#e Code doesn9t address t#at speci&ically

T,o approac#es -bot# can potentially lead to abuse. *;cept &or administrati(e con(enience claims' substantially similar claims must be put into t#e same class -==CC-b. lan"ua"e. ==CC-a. does not e;plicitly re+uire t#at t#e substantially similar claims are put in t#e same class T#e court s#ould look at t#e le"al relations#ip ,it# t#e debtor *;ample de&iciency claim and a claim o& a lon"%term trade creditor are not substantially similar merely because t#ey are bot# unsecured claims/ to t#e contrary' because o& t#e relations#ip ,it# t#e debtor' t#ese claims are su&&iciently di&&erent

Classi&ication o& claims can be subDect to manipulation because ,#en claims are put in one class' t#e ability o& one o& t#em to

=H=

in(oke t#e absolute priority rule may turn on ,#et#er t#e ot#er member ,ants t#at as ,ell Debtor can make (arious classes' suc# as class o& creditors to be repaid in cas# and a class to be repaid in lon"%term notes In re Iood,roo- A++ociate+ FACTS 4eal estate company t#at #as one bi" asset -apartment comple;./ business not "oin" ,ell so t#ey &ile &or C?==$ T#ere is a secured claim -?<D. Z &irst priority mort"a"e on t#e #ousin" comple;' but it is undersecured$ T#is is a non recourse loan' ,#ic# means t#at ?<D can only "o a&ter t#e property itsel&' but not in personam action a"ainst t#e mort"a"or$ 3ec$ ====-b.-=. allo,s an undersecured creditor ,it# a non%recourse loan to treat t#e loan as a recourse loan ,it#in C#apter ==' ,#ic# "i(es ?<D an unsecured claim ne;t to its secured claim a"ainst t#e property$ ?<D "ets t#e de&iciency claim in b%cy$ *(en t#ou"# outside b%cy t#e mort"a"ee ,ouldn9t be able to pursue t#e de&iciency claim' but in C?== t#ey are entitled to do t#at$ K?BL -t#is is not in accordance ,it# Butner principle. if the firm is going to continue& the secured creditor +ould /e losing the a/ilit% of doing of +hat it could do outside /=c% 0meaning ?ust ta;e the !ro!ert%& not necessaril% sell1. ,ight to foreclose is ?ust !rocedural right. -f the !ro!ert% is to remain +ith the firm& the secured creditor canFt get its hand on the !ro!ert%& so he gets an e>tra voice in reorg !rocess. 5his is someho+ deviation of *utner& /ut the !ur!ose is to even u! the scale for the /enefit of secured creditor. Sarious classes -=. secured claim -class by itsel&.' -C. "eneral unsecured claims' -I. unsecured mana"ement claim and -P. ?<D de&iciency claim$ ?<D ,ants to &oreclose because t#ey can make more on t#is sale -more (alue o& t#eir claim in li+uidation.$ ?<D is supposed to be repaid in I0 years' ,#ic# is =HC

e;tremely lon" -e(en considerin" JQ interest it is not "oodR.$ T#ey Dust don9t ,ant to "et paid on t#is lon" term loan' t#is is ,#y t#ey pre&er to &oreclose$ T#e mana"ement ,ants t#e &irm to continue because t#ey ,ant t#eir Dobs$ T,o abo(e "eneral unsecured claimants -?<D9s de&iciency claim and mana"ement claim. are classi&ied as separate claims$ ?<D de& claim and mana"ement bot# are "oin" to be impaired$ But t#e ?<D claim ,ill be so bi" so t#ey claims ,ill be put in C di&&erent classes$ T#e plan can be crammed do,n o(er ?<D9s dissent' because t#e mana"ement as impaired as ,ell ,ill (ote &or t#e claim$ And t#is is enou"# &or t#e plan to be appro(ed$ ?<5 complaints a"ainst suc# classi&ication$ LE AL ISSUE HOLDIN Are t#e abo(e unsecured claims -t#e mana"ement claim and ?<D unsecured claim. Esubstantially similarM ,it#in t#e meanin" o& section ==CC-a.L T#e t,o claims #a(e to be in di&&erent classes because t#ey are di&&erent not only in interests but also in nature$ ?<D9s claim doesn9t e;ist outside bankruptcy so t#at it can9t be put in t#e same class as t#e claim o& t#e unsecured creditor t#at #as a claim outside bankruptcy$ Claims are put in di&&erent classes i& t#ere is di(er"ence o& interest$ T#ere is di(er"ence because t#e claim#olders ,ould (ote di&&erently$ T#e ot#er reason ,#y t#ey are in di&&erent classes is t#at ?<D9s de&iciency claim is le"ally di&&erent because outside o& b%cy t#is claim doesn9t e;ist7 T#is claim can only e;ist in b%cy$ 3o' t#e "eneral claim in ,#ic# creditor is simply pursuin" t#ose ri"#ts t#at it ,ould be entitled to outside b%cy s#ouldn9t be treated t#e same as claim o& creditor ,ould #a(e no suc# ri"#ts ,it#in b%cy$ 3o' not only is it permissible to put ?<D claim in di&&erent class' it is actually re+uired$ K#at i& ?<D claim e;isted outside o& b%cyL !s it still permissible to put it in separate classL 8robably yes' but not re+uired$ And it is also not so e(ident$ T#e separation o& de&iciency claim as a class itsel& is permissible i& t#is classi&ication is done &or reason =HI

REASONIN

TROYKS CO""ENT S

independent o& Dust solicitin" (otes$ !ssue ,#at is t#e purpose o& makin" separate classL T#ere must be reason independent &rom Dust "ettin" (otes$ T#e court a(oids t#e #ard +uestion ,#et#er similar claims can be put in separate classes/ it Dust says t#at t#e claims #ere ,ere not similar and t#is ,#y t#ey s#ould be in separate classes$ K#o is t#e residual claimantL % T#e claimant t#at #as bi""est incenti(e to ma;imize (alue$ !s it ?<D or mana"ementL ?<D is on t#e top and t#is is ,#y t#ey are least likely to be t#e residual claimant$ Mana"ement t#ey "et payment &rom bein" mana"ers' so t#ey de&initely ,ant to continue$ 3o t#ey are a lo"ical residual claimant$ 3till' Troy doesn9t t#ink t#at eit#er o& t#em is a "ood residual claimant$ !t is common &or creditors to buy do,n "eneral claims t#at are impaired in order to (ote t#em do,n$ T#e de&iciency class in not impaired' but t#e creditor buys t#e impaired creditors to pre(ent t#em &rom opposin" t#e plan and to e&&ectuate t#e cramdo,n$ T#e B%cy rules #a(e recently c#an"ed to address t#is problem$

I2. 2OTIN a( Ca+e,oo- -p$ A>J%A>>. T cla++ note+ ==CH Once a plan is dra&ted' its proponents must prepare a disclosure statement T#e proponents may solicit acceptance o& t#e plan until a court determines t#at t#e disclosure statement contains ade+uate in&ormation -as de&ined in section ==CH-a.. T#e #earin" replaces t#e scrutiny t#at t#e securities la,s re+uire outside o& bankruptcy

=HP

 T#e procedural burden is lessened in case o& small business and e(en outside o& small business' t#e court may adopt suc# practice in strai"#t&or,ard cases Debtor may obtain a conditional appro(al o& t#e disclosure statement

T#e court may appro(e t#e disclosure statement ,it#out (aluation o& t#e debtor or appraisal o& t#e debtor9s assets 3olicitation o& (otes T,o e;ceptions to t#e rule t#at t#e creditors and sO#s (ote on t#e plan ==CA-&. any #older o& a claim or interest not impaired -as de&ined in ==CP. by t#e plan is deemed to #a(e accepted t#e plan ==CA-". a class t#at recei(es not#in" under t#e plan is deemed to #a(e reDected t#e plan But t#is is not &atal because plan appro(al doesn9t "et stopped by t#e (ote o& t#is class/ instead ,e look at ,#at t#e impaired classes do

==CA-e. allo,s t#e court to dis+uali&y (otes t#at are not procured and e;ercise in "ood &ait# Appro(al Class (otin" rule At lest COI o& t#e (alue o& t#e claims More t#an H0Q in t#e number o& claims

T#ere is a problem o& claim tradin" Z acti(e market Debtor ,#o is tryin" to "et t#e plan appro(ed' &aces a mo(ement o& claims/ #e doesn9t in &act kno, ,#at t#e particular claim#olders ,ould do' because t#ey mo(e around

In re Fi:ter Ltd.

=HH

FACTS

0i"ter &iled a (oluntary petition under C#apter ==$ Teac#er is 0i"ter9s only secured creditor and supposed to "et &ull payment under t#e plan$ But Teac#ers doesn9t like t#e plan' due to a real estate problem -part o& t#e estate is supposed to be con(erted into condos' some ,ill remain rental property.' t#ey (ote a"ainst t#e plan and purc#ased C= out o& IP claims o& class I -impaired class. in order to (ote t#ese claims a"ainst t#e plan$ As a conse+uence' Teac#ers controls t#is impaired class and it can a"ainst t#e debtor9s plan -3ec$ ==C>-b..$ !& T ,ouldn9t buy class I' it ,ould #a(e no interest t#ere ,#atsoe(er -#e #as no de&iciency claim because it is &ully secured.$ !t Dust doesn9t ,ant to be stuck ,it# t#is mi;ed condo and rental property$ And t#is is t#e only reason ,#y it buys up class I Z to (ote do,n t#e plan$ 0i"ters alle"es t#at Teac#ers s#ould be precluded &rom (otin" its purc#ases in class I because it did not buy t#em in E"ood &ait#M' 3ec$ ==CA-e. and s#ould be limited to one (ote t#at includes all C= (otes it purc#ased' accordin" to 3ec$ ==CA-c.$ -=. Do t#e purc#ased claims o& Teac#ers #a(e to be treated as one claim as opposed to C= claims so t#at Teac#ers does not #a(e t#e necessary COI o& t#e claims anymoreL -C. Kas Teac#ers allo,ed to (ote t#e purc#ased (otes in class IL Kas t#is in "ood &ait# in t#e sense o& 3ec$ ==CA-e. to buy t#e claims and t#en (ote t#em a"ainst t#e planL Teac#ers acted in "ood &ait# and is t#ere&ore allo,ed to (ote t#e purc#ased s#ares in class I$ T#e court adopted and applied a bad &ait# test Z ,as t#ere any ulterior moti(e in (otin" t#e claims in class I apart &rom Dust sel& interestL T#e court &inds T9s action ok because it doesn9t &ind t#at T ,as actin" ,it# some ulterior moti(e$ 3till' t#e court admits t#at T acted in sel&%interest$ *;amples o& ulterior moti(e blackmail and pure malice$ T#e mere &act t#at T purc#ased t#e claims &or t#e purpose o& protectin" t#eir o,n e;istin" claim does not s#o, bad &ait#' meanin" t#at t#e creditor can act out o& pure sel&%interest ,it#out s#o,in" bad &ait#$ As lon" as t#e creditor acts to preser(e ,#at #e reasonably =HA

LE AL ISSUE

HOLDIN REASONIN

percei(es as #is &air s#are o& t#e estate' bad &ait# ,ill not be attributed to #is purc#ase o& claims to control a class (ote$ !n addition to t#is' Teac#ers did not intend to #arm any member o& t#e class' as t#ey o&&ered t#e purc#ase to e(eryone in t#e class$ T#e purc#ased claims cannot be treated as one claim ,it# one (ote as t#e lan"ua"e in 3ec$ ==CA-c. clearly does not re&er to t#e number o& creditors #oldin" claims' but to t#e number o& claims in t#at class' ,#ic# eac# arose &rom di&&erent transactions and t#us #a(e to be treated separately$
TROYKS CO""ENT S

T#e distinction bet,een sel&%interest and ulterior moti(e is (ery #ard to distin"uis#' t#e border bet,een t#ose t,o is blurred$ T#e court doesn9t really "i(e muc# e;planation #o, to assess t#at' ,e don9t really "et a "ood test$ Creditors o&ten sell claims/ e(en i& t#ey "et less on t#e dollar' but t#ey "et it no,' ,#ic# is ,ort# it$ 3o' e;istin" claim#olders are better o&& i& t#ere is claim tradin"$ But' look at t#e interest o& t#e debtor Z t#e competitors mi"#t buy t#e claims to tras# t#e debtor$ T#ere is a protection in &orm o& a disclosure statement' in ,#ic# t#e purc#aser o& t#e claim #as to claim t#at #e is not Dust buyin" t#e claim to blo, up t#e plan and destroy t#e debtor$ !n addition' i& you look at claim#olders' t#ey are better o&&$ Bene&its o& claim tradin" -literature. -=. bene&it e;istin" claim#olders -t#ere is a li+uid market &or t#em' creditors are not stuck in t#e procedure' competition &or t#e claims is created./ -C. tradin" "i(es some sense o& t#e (alue o& t#e debtor9s estate$ !t can "i(e t#e idea ,#at is t#e ma; return on t#e dollar -and t#is is usually a (ery di&&icult +uestion.$ K#at is t#e claim tradin" is done by secured creditor' ,#o #as de&iciency unsecured claimL T#is is ok' because t#ey are only doin" t#is to "et t#emsel(es some economic bene&it in connection ,it# t#e case -so t#e Ein connectionM part is important.$ T#e decision can be seen critically' as Teac#ers clearly purc#ased t#e claims in class I only &or t#e =HJ

reason to (ote t#em a"ainst t#e plan' not takin" into account any o& t#e considerations o& t#e class$ T#is could be seen as t#e mere reason to (ote a"ainst t#e plan' as t#e court ,ould +uali&y bad &ait#$ Buyin" claims t#us disrupts t#e process o& bar"ainin" in a C#apter == case because it is di&&icult to "ain acceptance o& a reor"anization plan i& t#e o,ners o& t#e claims s#i&t constantly$ T#ere are cases all o(er t#e place ,#at constitutes "ood &ait# (otin" ,#ic# is done in t#e conte;t o& claim tradin" -more t#an =0 years a"o.$ And Dud"es are more ,illin" to &ind bad &ait# (otin"$ K?B #ed"e &unds tend to buy out claims to pursue strate"y$ <sually secured creditors buy out unsecured claims' so t#ey control ot#er classes$

2. ABSOLUTE PRIORITY RULE a( Ca+e,oo- -p$ J0J%J=P. and cla++ note+ Absolute priority rule T#e Dunior class cannot be paid i& t#e senior class #as not been paid in &ull' absent t#e senior class consent 3ection ==C>-b.-=. is in(oked ,#en a reor"anization plan &ails to "arner t#e acceptance o& all impaired classes and t#us &ails to satis&y section ==C>-a.-8. -re+uirin" t#at all impaired classes #a(e to accept t#e plan &or it to be con&irmed. 3ection ==C>-b.-=. t#e court can con&irm t#e plan o(er t#e o& t#e impaired class' i& -=.T#e plan doesn9t discriminate un&airly/ *asy to meet

=H8

Claims t#at enDoy t#e same priority outside o& b%cy' #a(e t#e same priority in b%cy But not necessarily t#e identical treatment -some can be paid later' some in cas# and some in notes' etc$.

-C.0air and e+uitable treatment o& t#e dissentin"' impaired class Most liti"ation #ere mostly battles bet,een unsecured creditors and old e+uity Class based ri"#t/ trumps t#e best interest test -belo,. o T#e #older o& an indi(idual claim can demand at least t#at ,#ic# it ,ould #a(e recei(ed in C#J li+uidation/ i& #o,e(er' a class (otes to make a sacri&ice o& t#is priority' a dissenter ,it#in t#e appro(in" class cannot block t#e plan on t#e basis o& t#at sacri&ice

3peci&ic re+uirements &or secured and unsecured claims 3ecured claims o *ac# #older o& a secured claim recei(es at least a stream o& payments ,it# discounted present (alue e+ual to t#e (alue o& t#e collateral o !& t#e collateral is sold' t#e creditor9s lien attac#es to t#e proceeds o T#e plan must also pro(ide a stream o& payments e+ual to t#e &ace amount o& t#e secured claims -to be crammed do,n o(er t#e secured creditors. -but t#is re+uirement is usually redundant and only necessary i& t#e secured creditor elects to #a(e #is entire claim treated as secured re"ardless o& t#e collaterals (alue' pursuant to sec$ ====-b.-C.. <nsecured claims

=H>

o T#e plan must pro(ide eac# #older o& an unsecured claim ,it# property t#at is at least e+ual in (alue to t#e amount o& suc# claim -t#e old e+uity cannot be paid unless t#e unsecured creditors are repaid in &ull.$ 8re&erred s#are#olders o 1o payments can "o to t#e common s#ares unless t#e &irm pays t#e pre&erred s#are#olders speci&ied amounts analo"ous to interest and principal on a debt Common s#are#olders o T#e plan must pro(ide t#e property o& a (alue at least e+ual to t#e (alue o& t#ose interests *;ception to t#e E&air and e+uitableM treatment rule ,#en can t#e old e+uity be paid o(er t#e unsecured creditorsL 5orthern -acific 0ailroad v. 7oyd T#e old e+uity cannot be paid o(er t#e unsecured creditors' e(en i& t#e old s#are#olders no, become t#e s#are#olders o& t#e ne, company -reor"anized debtor. A&ter Boyd' a plan could not bypass Dunior creditors unless suc# creditors #ad t#eir day in court T#e +uestion remained' #o,e(er' ,#et#er and under ,#at circumstances a nonconsensual bypass o& Dunior creditors ,as permissible e(en "i(en t#eir day in court/

$ase v. .os =ngeles .umber -roducts T#is case incorporated t#e absolute priority rule into t#e Code !t ,as establis#ed t#at s#are#olders cannot participate in t#e reor"anized debtor o(er t#e creditor9s obDection T#e s#are#olders #ad to also pay a &air (alue &or t#eir continuin" interest in t#e reor"anized debtor

=A0

T#is case incorporated t#e absolute priority rule into t#e Code T#e &ull ri"#t o& absolute priority comes into play only i& t#e ,#ole class opposed t#e plan

3till' t#e +uestion remained' ,#et#er and under ,#at circumstances may old e+uity participate in t#e reor"anized debtor o(er t#e obDection o& t#e class o& creditors

Alt#ou"# e+uity #olders are o& lo,est priority' in a C#apter == reor"anization' in many cases t#ey obtain part o& t#e (alue e(en t#ou"# t#e debt #olders are not paid in &ull' due to t#e &ollo,in" reasons T#e e+uity #olders can delay t#e plan because t#eir consent is re+uired &or t#e plan to be adopted$ !& t#ere is a delay' t#e (alue o& t#e &irm can dramatically decrease due to additional &inancial distress$ !& a C#apter J sale ,ould result in losses compared to a reor"anization$ T#is "i(es t#e e+uity #olders bar"ainin" po,er ,it# respect to t#e plan$ T#e outcome is Dusti&ied ,#en t#e Dunior claim#olders can pro(ide ne, supplies' e;pertise or capital to t#e ne, company t#at is &a(orable to e(eryone' includin" t#e senior claim #olders$ OBan- o8 A5erica 0. Nort9 LaSalle Street Partner+9i;P FACTS BoA ,as t#e maDor creditor o& 2a3alle' #a(in" lent @>Imm' secured by a non%recourse mort"a"e on t#e debtor9s principal assets' a buildin" in C#ica"o$ <pon de&ault' BoA started &oreclosure ,#ic# t#e debtor responded to ,it# a C#apter == (oluntary petition' tryin" to ensure t#at t#e partners retain title to t#e property' ,#ic# ,ould &all due i& t#e bank &oreclosed$ !& BoA &oreclosed' t#e debtor ,ould incur #u"e ta; liability$ 5enerally' t#e debtor ,as dri(en by ta; conse+uences ,#ile &ormin" t#e plan$ T#e (alue o& t#e property ,as less t#an t#e amount due -BoA undersecured' resultin" in an unsecured de&iciency

=A=

claim under 3ec$ H0A-a. and 3ec$ ====-b..$ T#e Bank ,anted to +uickly &oreclose and sell and not to reor"anize t#e debtor$ T#e p T#e plan pro(ided t#e &ollo,in" structure 4epayment o& COI o& t#e loan Disc#ar"e o& t#e rest Contribution o& @Amm by t#e old o,ners in e;c#an"e &or t#e entire property o& t#e partners#ip$ BoA blocked t#e plan -it could do it because its de&iciency claim ,as impaired.' seekin" t#at t#e absolute priority rule ,as not reco"nized in t#e plan$ T#e ot#er unsecured creditors ,ould not obDect because t#ey ,ould pre&er to "et paid ,it#out interest' but +uickly$ T#ey are trade creditors ,#o #ad lon" term r%s#ip and ,#ose payments depend on t#e debtor -t#ey Dust ,ant to continue business.$ T#e debtor ,ants to cram do,n t#e Bank9s de&iciency claim$ K#et#er and under ,#at circumstances can t#e old e+uity be paid o(er t#e unsecured creditorsL K#at are t#e e;ceptions to absolute priority ruleL T#e old e+uity cannot #a(e an e;clusi(e ri"#t -in t#e absence o& any competin" plan. to obtain property interest in t#e reor"anized debtor o(er t#e unsecured creditors' ,it#out payin" &ull (alue &or an option to be able to obtain t#is property$ !nstead o& "i(in" suc# e;clusi(e ri"#t to t#e old e+uity' a market test s#ould be establis#ed to assess ,#et#er t#e old e+uity o&&ers t#e #i"#est bid &or t#e property in t#e reor"anized debtor' or ,#et#er t#ere are #i"#er bids out t#ere$ T#e court analyzed t#e t#ree interpretations o& t#e e;pression Eon account o&M in sec$ ==C>-b.-iii.-B.-ii. !& on account o& means Ein e;c#an"e &orM' t#ere plan does not (iolate t#e absolute priority rule as lon" as t#e e+uity makes a ne, contribution to t#e ne, &irm$ T#is is not t#e case as t#e lan"ua"e o& t#e code -Eor retainin" propertyM. clearly s#o,s$ !nstead' t#e p#rase could mean Ebecause o&M as it also means in ot#er parts o& t#e code' meanin" t#at t#e casual relations#ip bet,een #oldin" o&

LE AL ISSUE HOLDIN

REASONIN

=AC

t#e prior claim and recei(in" property in t#e reor"anized debtor acti(ates t#e absolute priority rule$ T#e +uestion #ere is t#en' ,#y t#e p#rase ,as not Dust omitted i& old e+uity #olders s#ould Dust be e;cluded &rom recei(in" ne, e+uity$ T#e p#rase t#us #as to be understood correctly as a reconciliation o& policies preser(in" "oin" concerns and ma;imizin" property a(ailable to satis&y creditors -t#is is t#e correct interpretation accordin" to t#e court.$

<nder t#e debtor9s plan' t#e bene&it o& e+uity in t#e reor"anized p%s#ip can be obtained only by t#e old e+uity partners$ <pon t#e court9s appro(al o& t#e plan' t#e partners ,ere in t#e same position t#at t#ey ,ould #a(e enDoyed #a(e t#ey e;ercised an e;clusi(e option under t#e plan to buy t#e e+uity in t#e reor"anized entity' or contracted to purc#ase it &rom a seller$ At t#e moment o& t#e plan9s appro(al t#e debtor9s partners necessarily enDoyed an e;clusi(e opportunity t#at ,as in no economic sense distin"uis#able &rom t#e ad(anta"e o& t#e e;clusi(ely entitled o&&eror or option #older$ K#ile it can be ar"ued t#at suc# opportunity #as no market (alue' bein" si"ni&icant only to old e+uity because o& t#eir potential ta; liability' it is establis#ed t#at any co"nizable property interest must be treated as su&&iciently (aluable to be reco"nized under t#e Code$ T#e opportunity to buy in t#e reor"anized debtor #as (alue -like call option.$ T#e opportunity to "i(e (alue is already an asset and t#e old e+uity #as not paid &or t#at -option to buy ne, e+uity on account on #a(in" old e+uity.$ T#is is ,#at t#e court claims (iolates t#e absolute priority rule$ T#e court #as doubts ,#y t#e old e+uity s#ould #a(e t#is e;clusi(e opportunity to purc#ase t#e ne, e+uity$ !& t#e price t#at t#e ne, e+uity o&&ers is t#e best' t#ey don9t need suc# protection -,e trust t#e market to do suc# e(aluation.$ T#us' t#e court establis#es t#e market test' but does not elaborate on it &urt#er$
TROYKS CO""ENT S

T#e court un&ortunately did not reac# t#e +uestion ,#et#er e+uity can participate by contributin" ne, (alue in satis&action o& a market test$ =AI

T#ere is a problem o& imbalance o& in&ormation so t#e old e+uity and secured creditors could be t#e only ones to e(aluate t#e estate$ B<T t#is is sin"le asset only' so t#e (aluation is +uite strai"#t&or,ard$ !n suc# situation' t#e old e+uity s#all not #a(e t#e e;clusi(e ri"#t to obtain (alue in t#e reor"anized debtor/ t#ey s#ould demonstrate some#o, t#at t#ey price t#ey are payin" is t#e best$ 3till' t#e e+uity can ar"ue t#at t#ey brin" additional (alue' suc# as e;pertise' kno,led"e o& t#e debtor$ T#e ot#er ar"ument is t#at i& t#e e+uity doesn9t #a(e t#is option' t#ey mi"#t #a(e not incenti(e to in(est in t#e reor"anized debtor$ 3till' t#ere mi"#t be ot#er participants in t#e market' t#at ,ould$ T#is case is read by some as so&tenin" o& 2umber$ At &irst "lance it seems restricti(e' but t#en in 2a3alle t#e court opened up t#e ne, (alue e;ception more t#an be&ore in 2umber and e(er$

OIn re Ar5+tron: Iorld Indu+trie+P FACTS Armstron" &iled C#== plan creatin" == classes o& debt and e+uity #olders$ T#e class o& asbestos claimants a"reed to s#are part o& t#eir proposed distribution ,it# t#e e+uity #olders$ T#e net result ,ould be t#at t#e e+uity #olders ,ould recei(e debtor9s property on account o& t#eir e+uity interest' alt#ou"# a more senior class -unsecured creditors.' but more Dunior class t#an t#e asbestos claimants' ,ould not "et paid in &ull$ Does an arran"ement' ,#ere t#e more senior class "i(es part o& its distribution to e+uity #olders' on t#e e;pense o& unsecured creditors' a (iolation o& t#e absolute priority ruleL Bes' an arran"ement' ,#ere t#e more senior class "i(es part o& its distribution to e+uity #olders' on t#e e;pense o& unsecured creditors' is a (iolation o& t#e absolute priority rule$ A plan is not &air and e+uitable ,#en it distributes o,ners#ip to t#e old o,ners ,#ile one class o& t#e creditors #as not been paid in &ull$ T#is also means t#at a senior class cannot sacri&ice its distribution to =AP

LE AL ISSUE HOLDIN

REASONIN

a Dunior class to t#e detriment o& a more senior class -meanin" t#at it #as not been paid in &ull yet.$ ?o,e(er' t#e court9s e+uitable po,ers -to reDect an un&air and ine+uitable plan. do not e;tend to subordination -s#arin" a"reements.' entered into C#J -,#ere sec$ ==C>-b. does not apply$
TROYKS CO""ENT S

Bou can9t suc# arran"ement in t#e plan itsel&' but you can contract it on t#e side$ T#is is t#e subordination a"reement' in t#at case t#is is &ine$ But' ,#at is in t#e plan' is not contractual a"reement' so you can9t do it in t#e plan$ Troy t#is doesn9t make any sense at all7 Bou can do it outside o& t#e plan' but not in t#e plan$ 8robably t#e only reason ,#y it is not possible is t#e le"islati(e #istory ar"ument$ Maybe t#is is because t#e courts s#ould not #a(e too muc# po,er -too muc# ad #oc balancin". to "o around t#e absolute priority rule$ Cramdo,ns are e;pensi(e$ T#e plan s#ould be &ormalistic and t#is is ,#at t#e parties ,ould ,ant/ "uarantees simple and strai"#t&or,ard process' ,#ere bar"ainin" ,ill be more clear$ 3till' in t#e side a"reement it is &ine$

2I. BEST INTEREST TEST a( Ca+e,oo- -p$ JIC%JII. and cla++ note+ Best interest test 3ection ==C>-a.-J. Allo,s eac# #older o& a claim or interest in an impaired class to insist on recei(in" Eproperty o& a (alue' as o& t#e e&&ecti(e date o& t#e plan' t#at is not less t#an t#e amount t#at suc# #older ,ould so recei(e or retain i& t#e debtor ,ere li+uidatedM under C#J$ 8rotects t#e indi(idual claim#older ,#en t#e class as a ,#ole &a(ors t#e plan

T#e li+uidation entitlement is not arbitrary Z it rou"#ly re&lects ,#at eac# creditor or interest #older ,ould #a(e e;pected to

=AH

recei(e #ad b%cy not inter(ened and pre(ented indi(idual creditors &rom usin" t#eir nonbankruptcy remedies o& &oreclosure and le(y T#e purpose o& C#== is to preser(e t#e "oin" concern (alue o& t#e debtor -on t#e assumption t#at it is #i"#er t#an t#e sum o& its parts.$ T#e best interest test can be seen as a reco"nition t#at ac#ie(ement o& t#is "oal need not and s#ould not re+uire any creditor or e+uity #older to accept less t#an t#e return in ,ould #a(e enDoyed absent reor"anization Conse+uently' t#e creditor ,ill attempt to pro(e #i"#est as possible li+uidation (alue o& t#e debtor9s estate.

(n re $ro?thers 8c$all -attern FACTS 8etitioner is a manu&acturer and seller t#at &iled &or C#apter ==$ One o& t#e classes and opponent o& t#e plan alle"es t#at t#e plan is not in t#e best interests o& t#e creditors as t#e li+uidation (alue is #i"#er t#an t#e "oin" concern (alue$ <nder sec$ ==C>-a.-J.-A.-ii.' t#e comparison bet,een t#e li+uidation (alue and t#e "oin" concern (alue o& t#e estate s#ould be per&ormed on t#e e&&ecti(e day o& t#e plan$ But' does t#is mean t#at t#e comparison in(ol(es a &ire sale' takin" place ,it#in only one dayL T#e li+uidation o& t#e debtor does not #a(e to be a &ire sale &or t#e purpose o& comparin" t#is li+uidation (alue ,it# "oin" concern (alue$ T#e sale #as to an orderly li+uidation' keepin" some o& t#e sta&& to s#ip in(entory and e(en reprint catalo"ues to ad(ertise t#e remainin" in(entory' ma;imizin" t#e distribution to t#e creditors' etc$ T#is is because t#e "oal o& t#e trustee is to ma;imize t#e li+uidation (alue$ T#e market is (ery small' e(en s#rinkin"' &e, competitors' not dynamic' but stable and mature$ T#e most important t#in" in (aluation is &i"urin" out ,#at t#e market is$ T#e assets are (ery specialized' so t#e debtor claims t#at t#ey probably #a(e scrap (alue$ But t#e court doesn9t a"ree' because t#e competitors can buy it on market price -doesn9t =AA

LE AL ISSUE

HOLDIN REASONIN

TROYKS CO""ENT S

matter #o, old and specialized t#e e+uipment is.$ Also' t#e "ood,ill' intan"ibles and t#e trademark are ,ort# a lot' ,#ic# indicates t#at probably t#e li+uidation (alue is #i"#er t#an t#e "oin" concern (alue$ T#e court is reluctant to do market testin" #er by #a(in" t#e real auction$ Doin" t#e market test is only easy in t#eory' but not in reality an probably t#e result o& market testin" ,ould not be ade+uate &or t#e &ollo,in" reasons$ Only t#e t,o competitors ,ill s#o, at t#e bid' but maybe also t#e old mana"ement and old e+uity$ T#e insiders kno, t#e business t#e best' t#ey kno, t#e real "oin" concern (alue' so t#ey ,ill probably in&luence t#e bids o& t#e competitors -probably t#e competitors ,ill not bid #i"#er t#an t#e mana"ers and e+uity.$ But' "ettin" t#e same le(el o& in&ormation as insiders ,ill in(ol(e a lot o& time and money' so most likely t#e bidders ,ill not bot#er ,it# t#at -probably t#ey Dust ,ant to buy some mac#ines.$ 3o' t#ere is no incenti(e to compete ,it# insider$ T#e insider in addition #as an incenti(e to o(erbid' because it ,ould like to retain t#e business' ,#ile t#e ot#er bidders don9t #a(e t#is incenti(e$ T#is ,#ole situation makes t#e auction process not ideal$ 8lus' t#ere is a secured creditor ,#o ,ants to take control o(er t#e debtor$ *(en ,it# t#e secured creditor in t#e "ame' doesn9t mean t#at t#e market testin" ,ill be ade+uate$ 3ummin" up' t#e decision clearly sets out t#at t#e standard &or t#e #ypot#etical li+uidation on t#e e&&ecti(e date is one ,#ere t#e trustee' on be#al& on eac# creditor t#at ,ould &oreclose on eac# item o& property' takes reasonable steps to obtain #i"# sale prices$

=AJ