Making Bankruptcy Remoteness More Remote

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I sense a sea change in the recent Delaware decision in Intervention Energy Holdings, LLC, 2016 WL 3185576 (6/3/16), refusing to enforce a bankruptcy proofing provision of a Delaware LLC’s operating agreement. Until recently, the trend had been to accept the fundamental principles of bankruptcy remoteness, although courts sometimes found ways to avoid honoring anti-bankruptcy devices in specific cases. In contrast, Intervention Energy Holdings slices to the core and relies upon the anti-bankruptcy purpose and effect of the provision to invalidate it on public policy grounds.

Common bankruptcy proofing devices are based on pretty technical legal points. For example, to block a voluntary bankruptcy filing by a corporation or other artificial entity, the techniques focus on what it takes for an artificial entity to undertake an effective voluntary action. Since bankruptcy courts look to the underlying state corporate law to determine whether a corporate bankruptcy filing is a valid corporate action, modern anti-bankruptcy provisions either deprive the entity of the power to file bankruptcy or of the ability to “decide” to file bankruptcy. The provision at issue in Intervention Energy was the latter type and operated by giving the lender a “golden share” – a single membership unit (out of 22,000,001 units) issued for $1 that had veto power over the decision to file bankruptcy. In a world where state corporate law governs, there are limited avenues to attack such provisions.

An obvious line of attack is fiduciary duty for those situations where the lender uses its veto power to block a bankruptcy filing that is in the corporate entity’s best interest. However, Delaware permits the members of an LLC to contract away their fiduciary duty liability. See 6 Del. C. § 18-1101(e). Thus, when the lender moved to dismiss Intervention Energy’s voluntary petition, it probably expected an easy victory.

Rather than engage in an analysis of the state law of fiduciary duty and the extent to which it can be waived, Judge Carey jumped directly to federal bankruptcy policy. He asserted a very forceful view of its anti-waiver principle that voids a provision whose sole purpose and effect is to give a creditor ultimate authority over the debtor’s right to file bankruptcy. While Judge Carey added a few other qualifications, his focus on purpose and effect means that Intervention Holdings does not merely raise some technical point that must be drafted around in the next iteration of bankruptcy proofing. Instead, it represents a frontal attack on the very concept that a corporate entity can waive or give away its right to file for bankruptcy protection.

Let’s Hear it for Walls (of Debt)

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It seems that walls are a hot topic nowadays, playing a central role in the presidential race — with even the Pope joining in. While Democrats and Republicans appear to disagree about walls, restructuring professionals of all political stripes are excitedly awaiting the arrival of the “Wall of Debt.” Younger professionals think of the Wall of Debt as a mirage that is visible on the horizon but disappears by the time you get there. That was certainly true of the 2013 and 2014 debt maturity walls predicted in 2010.

A mirage maybe, but an awfully big one is looming on corporate debt horizon. As reported by Bloomberg, $9.5 trillion, with a “T”, in corporate debt will reach maturity in the next five years, with U.S. companies accounting for $4.1 trillion of that. That figure makes our earlier walls look like mere flower box borders. While much of the debt is investment grade right now, about a quarter of it is junk-rated debt.

Will the wall be whittled down and moved off into the future by the time the maturity dates arrive, or will a massive restructuring effort be required to resolve it? Only time will tell, but several factors suggest that restructuring likely will be at least part of the solution.

Many of the borrowers are very highly leveraged, having taken advantage of stimulus programs and low rates to replace equity with debt on their balance sheets. The amount of debt is so large that it will require a strong bond market in order to refinance it. Right now, the bond market seems to have lost its appetite, especially for highly leveraged debt. Recent articles recount the difficulties encountered selling bonds backing the Solera Holdings buyout, and suggest that even investment grade offerings are being scaled back due to weak demand. The turmoil in global markets caused by the unexpected collapse of oil prices and concerns about China are unlikely to calm investors’ nerves. The current effort by a major retailer to refinance almost two billion dollars in junk-rated bonds coming due in the next two years should provide an early test of the market’s willingness to push maturities forward.

So what can I say to restructuring professionals about this looming Wall of Debt? To borrow a favorite phrase from one of our presidential candidates, “You’re gonna love it.”

Bankruptcy Law and the Post-Scalia Supreme Court

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220px-Antonin_Scalia,_SCOTUS_photo_portraitJustice Scalia’s death is big news in the larger political world. His passing leaves a Supreme Court that may be evenly split on a wide range of politically and socially charged legal questions. Its impact on bankruptcy law will be more subtle. Although one can view many bankruptcy law questions through a political or social policy lens, the Justices rarely see the cases they take in that way. Instead, they treat most of their bankruptcy appeals as technical questions of statutory interpretation.

Justice Scalia undoubtedly had a major impact on the development of bankruptcy law. He is best known for his textualist approach to statutory construction, and bankruptcy law is one area where the literal or plain language approach has taken root. Although neither the Court nor Justice Scalia consistently applied that approach to bankruptcy questions, it has become the Court’s dominant approach to bankruptcy law questions.

His dissent in the lien-stripping case of Dewsnup v. Timm is Scalia the textualist at his best, blasting the majority’s position that the phrase “allowed secured claim” had different meanings in subsections (a) and (d) of section 506 of the Code. His worst? His majority opinion in BFP v. Resolution Trust Corp. where he did not trust his theory enough to apply plain language when it violated his view of the harmony between fraudulent transfer law and mortgage foreclosure law. Instead, he replaced the statutory language “reasonably equivalent” with a judge-made and very detailed statutory-sounding test that insulated regularly conducted judicial foreclosure sales from fraudulent transfer attack.

Predictions can be dangerous, especially when no one knows who will replace Justice Scalia. But, on the other hand, if I’m proven wrong in a few years, none of you will remember my prediction and, if I am right, I can remind you! So, here goes…

I predict that the most significant bankruptcy impact of Justice Scalia’s death will be a shift away from his ardent plain language approach to bankruptcy matters. Justice Breyer has very strong views on statutory construction and they conflict with Justice Scalia’s approach. Justice Breyer’s approach is more purposive and he views legislative history as a useful tool. Only Justice Thomas comes close to Justice Scalia’s absolutist stance, so without Justice Scalia to challenge Justice Breyer, expect to see purpose-based arguments fare better in bankruptcy appeals. As noted above, bankruptcy is an area where the interpretive approach seems to matter more than the Justice’s political leanings, so a change in approach will matter a lot in bankruptcy.

I don’t intend to catalogue all of the bankruptcy issues where Justice Scalia’s absence might make a difference, but one other deserves mention. Bankruptcy courts traditionally have been viewed as courts of equity and the Supreme Court has struggled to define the limits of the bankruptcy court’s equitable powers. Justice Scalia was very hostile to the idea of equitable powers and his opinion in Law v. Siegel threatened the very idea of bankruptcy courts as courts of equity. His departure leaves that side of the debate without a strong advocate and likely shifts the balance back towards more robust equitable powers in bankruptcy. I will be watching so I can remind you, but only if I was right.

A Lien Strip Tease from the Supremes

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This week’s unanimous Supreme Court decision barring the strip off of wholly unsecured junior liens in chapter 7 cases is one of the stranger recent opinions of the Court.  See Bank of America, N.A. v. Caulkett, No. 13-1421, ___ U.S. ___ (June 1, 2015).  While the result is not particularly surprising, what is unusual is that the Court goes out of its way to question its two decades old decision in Dewsnup and may even be hinting that it is ready to overrule that decision.  See Dewsnup v. Timm, 502 U.S. 410 (1992).

Dewsnup certainly is a great candidate for reversal.  The case held that section 506(d) could not be used in a chapter 7 case to avoid that portion of a secured claim that exceeded the value of the collateral (or “strip down” the lien to the value of the collateral).  In reaching that result, the Dewsnup majority held that the phrase “allowed secured claim” had a different meaning in subsection (d) of section 506 than it did in subsection (a) of the same provision.  Justice Scalia filed a vigorous dissent pointing out that the “allowed secured claim” phrase was a term of art used throughout the Bankruptcy Code and predicting that the Dewsnup approach would breed confusion.  Confusion did result for a while until most courts ignored Dewsnup’s reasoning and limited it to the specific issue it addressed.  The case and its “liens pass through bankruptcy” principle still pop up occasionally to create mischief, most recently in the line of cases requiring that secured creditors actually “participate” in reorganization cases before the plan can avoid their liens.  See, e.g., In re S. White Trans., Inc., 725 F.3d 494 (5th Cir. 2013).

In Caulkett, the Supreme Court was asked whether Dewsnup should be limited to the strip down of partly secured claims or whether it should also protect from avoidance liens that are completely out of the money (a “strip off”).  The Court easily rejected that distinction as “artificial” and applied Dewsnup.

One might expect the Court either to say that Dewsnup was correctly decided and apply it, or to apply it while simply stating that it was bound by the precedent.  What is strange about Caulkett is that Justice Thomas, writing for the full Court, goes out of his way to criticize Dewsnup.  He starts by saying that a “straightforward” reading of section 506(d) supports the strip off approach and pokes fun at the alleged “ambiguity” that Dewsnup addressed as merely involving “self-interested parties [who] . . . disagreed over the term’s meaning.”  He adds a footnote citing criticism by him, Justice Scalia and other judges and academics (three Justices did not join in the footnote).  Finally, he damns Dewsnup with faint praise in the opinion’s penultimate paragraph by stating, “Even if Dewsnup were deemed not to reflect the correct meaning of §506(d), the debtors’ solution would not either.”

Why not just overrule Dewsnup?  That brings us to the strangest aspect of the opinion.  Not once, not twice, but three times in the short seven-page opinion, Justice Thomas states that the debtors did not ask the Court to overrule Dewsnup.  In one passage, Justice Thomas writes, “Despite this criticism, the debtors have repeatedly insisted that they are not asking us to overrule Dewsnup.”  Of course the Court could have overruled Dewsnup without being asked, so why emphasize the debtors’ failure to request it?  Could it be that there is strong support on the Court for overruling Dewsnup, but that some Justices are hesitant to do so without full briefing and argument on the point?

Wellness: To Consent or Get the Bankruptcy Judge Anyway

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A collective sigh of relief was the main effect of this week’s much-awaited Supreme Court decision on bankruptcy jurisdiction in Wellness International Network, Ltd. v. Sharif, No. 13-935, ___ U.S.___ (May 26, 2015, Sotomayor, J.). While a number of minor issues remain, the majority’s ruling that bankruptcy judges can issue judgments and final orders with the parties’ consent means that the current bankruptcy system can continue to function normally.

The Wellness case involved the bankruptcy court’s jurisdiction to determine whether assets purportedly held in a trust were actually property of the debtor’s bankruptcy estate. The case presented the Court with two possible issues involving bankruptcy jurisdiction. The first was whether the non-Article III bankruptcy judges could constitutionally exercise jurisdiction over that dispute and the second was whether the debtor’s alleged consent permitted the bankruptcy judge to enter a final order even if it otherwise lacked the constitutional authority to do so. The majority and dissenting opinions disagreed on which issue was the easier one and the one that should be resolved first. The majority chose to avoid the question of bankruptcy court power by holding that consent cured any problem that might otherwise exist. This is consistent with prior Supreme Court case law upholding the consent jurisdiction of federal magistrate judges.

It is also a good practical solution to the problem. The consent approach will allow bankruptcy judges to issue almost all of the rulings they issued before their powers were questioned by Stern v. Marshall, ___ U.S. ___, 131 S.Ct. 2594 (2011). This is because parties likely will consent in almost all cases.

Why would you refuse to consent? Maybe you think you will get a better outcome from the district judge. Will that work? If one party refuses to consent, the most likely response will be to have the bankruptcy judge hear the matter and submit proposed findings of fact and conclusions of law to the district judge. This approach still leaves most of the proceedings in front of the same bankruptcy judge. Might there still be an advantage to withholding consent? If the fear is that the bankruptcy judge will interpret the law differently from the district judge, withholding consent should make no difference because the district judge would review the legal conclusions de novo in both cases. However, if the concern is that the bankruptcy judge will make an unfavorable factual determination, withholding consent may provide an advantage because the party can get de novo review of the bankruptcy judge’s factual findings. However, that factual review likely will be on a cold record. There may also be some perceived advantage in the delay and extra steps added by this process.

The other option for dealing with a refusal to consent would be for the district judge to withdraw the reference and both hear and determine the matter. While this may be the non-consenting party’s desired outcome, it will likely be a rare result. It might occur if the matter is the type that the district judge would have withdrawn anyway, but in that case there is no Stern effect (other than the fact that refusing to consent may add a little weight to the withdrawal side of the equation). The other situation where withdrawal might occur is where the matter is of such urgency that there is no time for the proposed order, de novo review approach. In such a case, a party might succeed in moving the matter to the district judge even though that would not have happened before Stern. This possibility should arise in a fairly small number of matters so it should be well within the ability of the district courts to manage without greatly diminishing the efficiency of the bankruptcy process.

Thus, after the adjustment made by Wellness, Chief Justice Roberts’ statement in Stern that the decision did “not meaningfully change the division of labor” between the bankruptcy and district judges may be true. Of course, Justice Roberts dissented in Wellness so maybe that wasn’t what he meant by those words.

Spinach for the Strong Arm Power

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In a little-noticed November opinion, the Seventh Circuit greatly expanded the ability of a bankruptcy trustee to avoid a security interest for documentation errors under section 544(a)(1) of the Bankruptcy Code.  See State Bank of Toulon v. Covey (In re Duckworth), 776 F.3d 453 (7th Cir. 2014).

In Duckworth, the written security agreement stated that it secured a note “dated December 13, 2008,” but the note was not signed until two days later — so it was dated December 15.  Although everyone testified that the security agreement was intended to secure the debt evidenced by the December 15 note, the Court held that the strong arm power allowed the trustee to rely on the written terms of the agreement.  Since there was no December 13 note, there was no secured debt that could support the bank’s security interest and the bank was left unsecured.

The section 544(a) strong arm power gives the trustee the powers of a hypothetical lien creditor and is regularly used to attack defects in a UCC financing statement.  In that context, errors in the debtor’s name or the collateral description may lead to avoidance of a security interest.  However, minor errors that are not seriously misleading are excused.  See UCC § 9-506(a).

Duckworth enlarges the strong arm power into a tool that can attack errors in the security agreement and, apparently, there is no room for even minor mistakes.  It does this by announcing a bankruptcy version of the D’Oench Duhme doctrine that a trustee is bound only by the written agreement.  Compare D’Oench Duhme & Co. v. FDIC, 315 U.S. 447 (1942) (establishing that a federal receiver is bound only by the written records of a failed bank).

The Duckworth court seemed unaware of how revolutionary its approach was.  It relied upon the old 1968 First Circuit opinion of Safe Deposit Bank & Trust Co. v. Berman, 393 F.2d 401 (1st Cir. 1968), as though it was applying well-settled established law.  While Berman might be distinguished on the basis that it involved a missing “other indebtedness” clause (section 9-204(c) requires these be express), it does include language that supports the Duckworth result.  However, if Berman established such an important rule, one would expect it to have been widely cited in the intervening five decades.  It hasn’t been.  In the past 25 years, only three cases other than Duckworth have even cited the relevant part of the Berman opinion.  Prior to Duckworth, Berman’s reasoning was adopted by one court and rejected by one court.

Duckworth may upset a number of generally-accepted principles of secured transactions law.  First, UCC § 9-203(b)(3)(A) appears to require that only the collateral be described in writing, with other security agreement terms open to oral agreement or oral modification.  Duckworth extends the writing requirement to the description of the secured indebtedness and possibly all other terms.  Duckworth also ignores the important distinction between reliance parties like later lenders who advance new credit in reliance on a prior lender’s misleading written security agreement and a non-reliance lien creditor or bankruptcy trustee.  Equitable principles might prevent reformation of an erroneous written security agreement to the detriment of a reliance party, but not a lien creditor.

Of far greater importance, Duckworth holds that the “composite document” rule does not apply to a bankruptcy trustee.  The “composite document” rule allows a secured party to supplement an incomplete or erroneous written security agreement (usually missing an adequate collateral description) with other related documents to create a composite security agreement where the missing description is supplied by one of the other documents.  Collateral description errors are probably far more common than erroneous debt references and many reported bankruptcy cases apply the composite document rule in the description context.  If generally accepted, the Duckworth approach will likely have its greatest impact here.

Santa Left New York a Revised UCC

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Click here for a related article which was published in Law360. 

In a little-noticed action and after years of being the nation’s most backward Uniform Commercial Code (UCC) state, New York finally adopted modern versions of UCC Articles 1, 7 and 9 in a bill signed by Governor Andrew M. Cuomo just before Christmas. See 2014 Sess. Law News of N.Y. Ch. 505 (A. 9933) (McKinney’s). New York’s failure to adopt the most current version of the UCC was both embarrassing and created a great risk of confusion because New York is the nation’s pre-eminent commercial law jurisdiction and its law is chosen as the governing law for many sophisticated commercial transactions.

While the recent amendment brings most of New York’s UCC up to date, the legislation did not address New York’s archaic versions of UCC Article 3 (commercial paper) and Article 4 (bank deposits and collections), which date to the 1960’s. In addition, New York did not adopt all of the changes proposed by the 2010 amendments to Article 9. The final act is missing random uniform amendments to Article 9. None of the missing provisions are controversial and there is no apparent reason for their deletion. Nonetheless, careful review of the statute will be necessary to avoid surprise. Thus, in several important respects, New York’s version of Article 9 is still out of sync with that of most states.

The biggest problem is the act’s confusing effective date provision. Most of the UCC revisions are technical and do not reflect substantial changes in the law, but some of the Article 9 amendments affect the jurisdiction in which a UCC financing statement must be filed or the name that must be used in order to perfect a security interest. The proposed 2010 amendments to Article 9 contained a carefully crafted set of transition rules to address the problems raised by such changes. For example, the uniform version provided a five-year grace period to revise pre-amendment financing statements to satisfy the new debtor name requirements, after which time non-complying financing statements would become ineffective. This ties into the five-year financing statement expiration period, so that financing statements could be revised as they are continued.

Unfortunately, New York did not include those transition rules, but instead provides that the changes “shall take effect immediately and shall apply to transactions entered into on or after” December 17th. Already, commentators disagree whether the changes apply to pre-amendment transactions. The “immediately” language suggests that they do, but the “transactions entered into” language suggests that they do not.

If the act applies immediately to pre-act transactions, then secured creditors have only four months, until mid-April 2015, to amend their financing statements. See UCC 9-316 & 9-507. Otherwise they risk becoming unperfected. In some cases it may already be too late. On the other hand, if the amendments apply only to post-enactment transactions, then pre-existing secured creditors are saved the trouble of revising their financing statements – probably forever. But this interpretation creates a host of other complications.

For example, the new rules require that the “driver’s license” name be used on financing statements for individual debtors. Under the proposed uniform version of the amendments, a pre-amendment financing statement using a different, but previously adequate, human name would have to be revised to reflect the driver’s license name within five years. New York’s failure to include such a “drop dead” date presumably means that a prospective lender many years in the future will have to search under both the old and new rules in order to be certain there is no prior financing statement that might prime its lien. Worse, if an existing lender decides to amend its financing statement to reflect a driver’s license name (and that name is one that would not be sufficient under prior law), will it become unperfected since the transaction was entered into before December 17th and is not governed by the amendments? Further, when is a transaction covering after-acquired property or future advances “entered into” for purposes of the effective date provision – when the deal was signed or when the later-acquired assets become collateral or the later advances are made? In addition, many of the Article 9 changes resolve unclear issues, generally in a way favorable to secured creditors, but those fixes may apply only to new transactions.

The problem of a potential lapse in perfection affects significant commercial lending transactions as well. For example, Massachusetts-type business trusts are now included in the definition of “registered organization,” which can change both the state where a financing statement must be filed and the name that must be used for the debtor. In addition, the name rules for decedent’s estates and property held in trust now require inclusion of additional information – information which must be in a separate part of the financing statement, not in the name box. Since New York did not adopt the uniform national filing form rules, but creates its own forms, the current forms do not include check boxes for this information so parties must be careful to add it in an addendum. In light of the uncertainty about the transition rules, secured parties should determine whether their existing financing statements are adequate under both sets of rules. If an amendment is required, adding the new name in an “additional debtor” box would be safer than a name amendment since that would preserve any perfection that might depend on the pre-amendment name.

While it is beyond the scope of this blog post to catalog all of the changes made by the legislation, a few stand out. UCC Article 1 contains generally applicable provisions and most of the UCC definitions. While the uniform version added an objective definition of good faith, the New York amendment retains the prior subjective “honesty in fact” definition. The new version of Article 7 tracks the model law and accommodates the development of electronic documents of title, like electronic bills of lading and warehouse receipts. The legislation also amends UCC Article 8 to overrule the Highland Capital Mgt LP v. Schneider, 8 N.Y.3d 406 (N.Y. App. 2007), holding that promissory notes not traded on an exchange could be “securities” governed by Article 8, instead of “instruments” governed by Article 3.

The major changes are in Article 9. As noted above, several important changes affect financing statements filed against human debtors, trusts, decedent’s estates, and business trusts. New York did not adopt a change that would have made it easier to perfect a security interest in electronic chattel paper by control. However, the legislation adopts a non-uniform amendment that makes it easier to perfect a security interest in a deposit account. Now, in addition to the three previously-allowed methods of obtaining control of a deposit account, a secured creditor can achieve control: (1) through an agent (which is consistent with the uniform version); (2) by the acknowledgement that a party already in control holds for its benefit; (3) by listing its name on the account (whether or not it becomes the bank’s customer); or (4) by indicating in the name on the account that it holds a security interest.

A Wellness Check for Bankruptcy: Confusion Reigns

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Last week’s Supreme Court arguments on bankruptcy jurisdiction in Wellness Int’l Network Ltd. v. Sharif, No. 13-935 (S.Ct.), are enough to strike fear into the heart of any bankruptcy buff. What emerges from the transcript of the oral arguments is, in a word, confusion. This bodes ill for an early resolution of the upheaval created by the Supreme Court’s decision in Stern v. Marshall, ___ U.S. ___, 131 S.Ct. 2594 (2011), limiting the power of bankruptcy judges to decide certain matters that arise in bankruptcy proceedings. While it is foolhardy to predict the Court’s ruling based on questions asked in oral argument, the arguments raised a few interesting points.

Everything Old is New Again.

The most frightening point was Justice Sotomayor’s suggestion of a “simpler” jurisdictional rule that would give the bankruptcy judges power to decide questions involving property if the debtor “possess[es] it physically, or [has] legal title to it.” While we have been inching closer and closer to the old Bankruptcy Act’s distinction between summary and plenary jurisdiction as we adjust to the line of Supreme Court cases that have limited the expansive jurisdiction granted in the 1978 Bankruptcy Code, it would be a shame to return to something like Sotomayor’s proposed test. (Basically, the summary/plenary distinction turned on whether the property was in the actual or constructive possession of the court.) As the jurisdictional case law that developed under the Bankruptcy Act attests, the “simplicity” of such a test is largely illusory. Justice Sotomayor was not content to let her suggestion drop, and returned to it numerous times during the argument. In addition, much of the discussion with other Justices also involved the old summary/plenary distinction.

Can I Get a Vote Please?

Losers don’t count, so one should discount the views expressed by the four Justices who dissented in Stern. What is needed in order for Wellness to affirm that bankruptcy judges possess at least some power to issue final judgments is for one of the five Justices in the majority to switch sides. Unfortunately most of the questioning came from the dissenting Justices and none of the questions from Chief Justice Roberts, or Justices Alito, Kennedy, and Scalia (Justice Thomas sticking to his “no questions” tradition) hinted at their views of the extent to which Article III of the Constitution might permit non-Article III bankruptcy judges to yield Article III power. Here, it is important to note that, as Justice Scalia pointed out in his concurrence in Stern, the Supreme Court has never upheld the exercise of any jurisdiction by bankruptcy judges.

Two for the Price of One!

The Justices were very interested in which of the two questions for which certiorari was granted was more important to decide: (1) whether Article III permits a bankruptcy judge to determine whether disputed property is property of the estate, or (2) whether consent cures the Article III problem. Interestingly, Justice Breyer suggested that the Court might deviate from its usual procedure and decide both questions even though an answer to only one might be sufficient. Justice Scalia, of course, seemed to strongly disagree with that approach.

Where Does it All End?

The arguments moved into some very interesting discussions about the impact of a ruling in Wellness on both the magistrate system and arbitration. Questioning by some of the Justices suggested that a ruling against consent jurisdiction in Wellness would also invalidate the consent jurisdiction exercised by federal magistrate judges. More interesting was the discussion of arbitration, with Justices Kagan, Scalia, and Sotomayor all asking questions suggesting that federal court enforcement of arbitration awards raised greater Article III problems than the exercise of power by bankruptcy judges.

Fee-Fi-Fo-Fum: Compensation for Fee Defense

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It’s always risky when the Supreme Court grants certiorari in a bankruptcy case. While the Court’s opinion may bring clarity to the narrow question upon which certiorari was granted, it often creates a host of unintended problems in other areas.

This month’s grant of certiorari to resolve the split between the Fifth and Ninth Circuits over the compensability of legal fees incurred by estate counsel in defending a fee award may present far more downside risk to bankruptcy professionals than upside potential. See In re ASARCO, L.L.C.), 751 F.3d 291 (5th Cir. 2014), cert. granted, Baker Botts L.L.P. v. ASARCO L.L.C., 2014 WL 3795992 (Oct. 2, 2014).

On the narrow question, the current strong majority view is that there is discretion to award fees for the successful defense of a fee award in an appropriate case. While the Fifth Circuit adopted a per se rule prohibiting such awards, it may have been better for bankruptcy professionals to leave that decision as the outlier than to risk its nation-wide adoption by the Supreme Court.

Since the statutory language is not very clear on the issue, the Court may resort to a policy approach and that risks new pronouncements about professional fees in bankruptcy that could implicate a host of compensation issues. While it is unlikely that the Court would return to the economy standard rejected by the Code, there is plenty of criticism of bankruptcy compensation practices in the academic literature and in reported decisions that may be brought to the Justices’ attention either by the Respondent or their law clerks’ research. That’s the downside. On the upside, the Court may aggressively affirm the comparable services approach. Anyone want to bet on the pro- or anti-bankruptcy lawyer views of each of the nine Justices?

Bankruptcy compensation has always been a hard sell since there is an intuitive negative reaction to professionals being well compensated when employees, pensioners and other creditors are taking a bath. That sentiment led to the now-rejected economy approach and the “bankruptcy haircut” known to older professionals who practiced under the Bankruptcy Act. In that sense, the ASARCO case is as good as any for this issue since the bankruptcy court called the case the most successful Chapter 11 in the history of the Code and the law firm’s success resulted in full payment of creditors.

On the other hand, the firm was handsomely compensated, with a fee award of more than $100 million plus a $4 million bonus. The Fifth Circuit’s opinion suggests that the Court thought that seeking compensation for fee defense costs on top of such a generous award was a bit too aggressive. It even used the kind of language that justified the old economy approach.

While in ASARCO the fee defense costs ran to several million dollars, in most cases issue is not of great importance. Let’s hope the Justices don’t “smell the blood of [a bankruptcy lawyer]” or decide to “grind his bones to make [their] bread.”

Make Whole Premiums and Unmatured Interest

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Judge Drain’s recent decision confirming the Momentive Performance Materials Inc. plan is just the latest in a series of recent cases involving “make whole” premiums. As in several of the recent cases, the lenders lost because the contract did not clearly enough provide for the make whole premium in the event of an acceleration rather than prepayment.

So what is a make whole premium? It is a type of prepayment penalty that is imposed if the loan is paid off early to compensate the lender for the interest that it was not able to earn over the remaining term of the loan. Normally it will be calculated to reflect the difference between the higher rate charged on the early-terminated loan and the lower current market rate since that is the lost expectation interest, or damages, the lender suffers as a result of early repayment. Make whole premiums are important to lenders in times like these when rates are very low and will diminish in importance if and when rates begin to rise.

Many of the recent cases have rejected the premiums by narrowly interpreting the contractual provisions. That has allowed them to avoid the very difficult issue of whether such fees constitute unmatured interest. That classification is important because the Code disallows any claim to the extent that it is for unmatured interest. See 11 U.S.C. § 502(b)(2). The cases that have reached the issue are split – largely on the form vs. substance divide that we often see in the law.

On the form side, a make whole premium is not in the form of an interest charge. It is a fee charged for an option – the option to pay the loan off early – that is a fully matured obligation at the time of prepayment, and not a charge for the use of money that accrues over time. That view makes sense if you think of it as a fancy type of prepayment penalty. For example, a simple modest flat fee imposed for prepayment looks nothing like an interest charge.

However, the make whole premium is not a flat fee, but rather is calculated using approximately the same formula one would use to calculate the breach of contract damage claim for paying early. Note that under the “perfect tender in time” rule, a borrower has no right to pay a loan off early absent a contractual term permitting prepayment. Thus, prepayment would constitute a breach of contract entitling the lender to damages for its lost expectation of interest. In fact, the lenders in Momentive made that argument as a fall-back position. Judge Drain rejected that claim as violating the section 502(b)(2) prohibition on unmatured interest.

This brings us to the substance approach. If a damage claim for unearned interest would fail under section 502(b)(2), then how can a make whole provision that does the same thing pass muster? That view makes sense if you think of a make whole provision as a liquidated damages clause covering unmatured interest.

A deeper question is why the Bankruptcy Code doesn’t recognize a lender’s legitimate state law future interest expectation damages as part of its allowed claim, when the future expectation damages of most other contract counter parties are allowed. This forces lenders to absorb the losses they incur when a debtor ceases to perform, while other creditors get to recover at least part of their losses.

That appears, however, to be the result intended by section 502(b)(2) and it’s disallowance of unmatured interest. The legislative history suggests that it is designed to limit lenders’ claims in the way that section 502(b)(6 & 7) caps landlord and employee claims rather than to merely avoid the administrative difficulty of calculating pendency interest at varying rates on all claims from the filing date to the distribution date. Indeed the legislative history specifically rejects the formalistic approach in at least one situation by requiring that original issue discount be treated as unmatured interest and pro-rated.

With Delaware seen as a pro make whole jurisdiction and the Southern District of New York seen as a hostile jurisdiction, hopefully some deeper analysis by the courts will clarify the issue before rising interest rates cause it to fade from the radar.

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