Purdue Pharma L.P. – The Amicus Curiae Briefs

By Uzzi O. Raanan

On August 10, 2023, the United States Supreme Court granted a writ of certiorari in William K. Harrington, United States Trustee, Region 2 v. Purdue Pharma L.P., et al.

Oral arguments were held on December 4, 2023.  For the oral argument audio:  Click Here

On June 27, 2024, the Court issued its 5-4 majority opinion drafted by Justice Gorsuch, reversing the prior ruling by the Second District Court of Appeals.  Justice Kavanaugh delivered the dissent.  603 U.S. ___ (2024).  To read the opinion:  Click Here

Question Presented by the Supreme Court:

Whether the Bankruptcy Code authorizes a court to approve, as part of a plan of reorganization under Chapter 11 of the Bankruptcy Code, a release that extinguishes claims held by nondebtors against nondebtor third parties, without the claimants’ consent.  Click Here

The Ruling:

The Court boiled down the issue presented to “whether a court in bankruptcy may effectively extend to nondebtors the benefits of a Chapter 11 discharge usually reserved for debtors.”  Applying the ejusdem generis canon, among other, the Court held that 11 U.S.C. section 1123(b)(6)’s catchall provision, namely that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title,” could not be extended to include releases for nondebtor parties against claims by nondebtor third parties.

The Court concluded that its ruling was limited to the question at hand and should not be read to question consensual third-party releases included in bankruptcy reorganization plans.  It also expressed no guidance on “what qualifies as a consensual release or [] a plan that provides for the full satisfaction of claims against a third-party nondebtor.”  The opinion left open “whether [the Court’s] reading of the bankruptcy code would justify unwinding reorganization plans that have already become effective and been substantially consummated.”

The Amicus Curiae Briefs Behind the Majority and Dissenting Opinions:

While the question posed and answered by the Supreme Court was succinct and seemingly simple, the legal and societal implications of this 5-4 split ruling could be substantial.  To understand the decision’s likely impact on bankruptcy law, stakeholders, and even the American economy, one need only read the:

*   10 Amicus Curiae briefs filed in support of Petitioner William K. Harrington, United States Trustee, Region 2,

*    12 Amicus Curiae briefs filed in support of Respondents Purdue Pharma L.P., et al., and

*    3 Amicus Curiae briefs that supported neither side.

For a complete list of those who filed Amicus Curiae briefs and their counsel, with links to the briefs, Click Here.

 

USING OUT OF STATE CHOICE OF LAW TO AVOID CALIFORNIA USURY RULES?  THINK AGAIN! 

By: Eric P. Israel

A recent case of interest held that California usury law “is [a] fundamental public policy of the state,” which can overcome the choice of law provisions in loan documents.  G Companies Management, LLC v. LREP Arizona LLC, 88 Cal. App. 5th 342, 304 Cal. Rptr. 3d 651 (2023).  In G Companies, the California Court of Appeal held that anti-usury laws represent a strong public policy of the State, and hence that ordinary choice of law rules apply notwithstanding contractual provisions referencing the law of another state that may be more creditor friendly. This appears to be a change from prior law.  See, e.g., Ury v. Jewelers Acceptance Corp., 227 Cal. App. 2d 11, 20 (1964); Gamer v. duPont Glore Forgan, Inc., 65 Cal. App. 3d 280 (1976); Hyundai Sec. Co. v. Lee, 232 Cal. App. 4th 1379 (2015); Mencor Enterprises, Inc. v. HETS Equities Corp., 190 Cal. App. 3d 432 (1987).  Violations of usury laws can have harsh consequences, including recovery of treble damages.  Cal. Civ. Code § 1916-3(a).

Oftentimes, lenders include in their loan documentation contractual provisions stating that the law of another state applies, even in situations where the transaction has few or no contacts with that other state.  Important factors triggering G Companies might be the location of the borrower, the location of the collateral, and the alternative state’s interest in the transaction.  Practitioners should be aware of the G Companies case when drafting documentation for secured transactions.  Bankruptcy trustees may be able to use G Companies to challenge the underlying debts and liens securing them on usury grounds.

The Uniform Foreign-Country Money Judgment Recognition Act provides that a court is not required to recognize a foreign judgment that is “repugnant to the public policy of this state or of the United States.”  It remains to be seen whether domestication of a foreign judgment will be open to challenge under California usury laws.

In re Matter of GFS Industries, LLC

By: Uzzi O. Raanan

Fifth Circuit Court of Appeals disagrees with the Ninth Circuit BAP as to whether corporate debtors can be sued for nondischargeability under 11 U.S.C. section 1192(2) in subchapter V cases, setting up a future challenge in the Ninth Circuit Court of Appeals

The Fifth Circuit Court of Appeals has held that nondischargeability provisions of the kind specified in 11 U.S.C. section 523(a) apply to individual and corporate debtors who confirm nonconsensual plans of reorganization under subchapter V of chapter 11 of the Bankruptcy Code.  In re Matter of GFS Industries, LLC, 99 F.4th 223 (April 17, 2024).  To read the entire opinion, click here:

Acknowledging that the issue is a “close and interesting one,” the GFS Industries court sided with the Fourth Circuit’s Cantwell-Cleary Co. v. Cleary Packaging, LLC (In re Cleary Packaging, LLC), 36 F.4th 509 (4th Cir. 2022), the only other circuit level decision to consider the issue.  The ruling disagrees with the opposite conclusion reached by the Ninth Circuit Bankruptcy Appellate Panel (BAP) in In re Off-Spec Solutions, LLC, 651 B.R. 862 (2023), that 11 U.S.C. section 1192 does not make the nondischargeability provisions of Section 523(a) applicable to corporate debtors.

At least one bankruptcy judge in the Ninth Circuit has recently predicted that the Ninth Circuit Court of Appeals would likely agree with the Fourth and Fifth Circuits’ interpretation of Section 1192, rather than with the Off-Spec ruling.  See In re Van’s Aircraft, Inc., 2024 WL 2947601 (Bankr. D. Oregon, June 11, 2024).

In re Licup (Nondischargeability Under Section 523(a)(3)(A))

By: Uzzi O. Raanan

In a published decision purporting to answer a question previously unresolved in this circuit, the Ninth Circuit Court of Appeals ruled that a debtor’s failure in an asset chapter 7 case to list or schedule a debt, as required by 11 U.S.C. section 521(a)(1), in time for the creditor to timely file a proof of claim, renders the debt nondischargeable in its entirety, unless the creditor had actual knowledge of the bankruptcy case in time to timely file a proof of claim. In re Licup, 95 F.4th 1234 (9th Cir. 2024). To read the entire opinion, click here: https://cdn.ca9.uscourts.gov/datastore/opinions/2024/03/18/23-60017.pdf 

In January 2013, creditor Jefferson Avenue Temecula, LLC (“Creditor”) obtained a default unlawful detainer judgment (“Judgment”) against Christine Tracy Castro (“Castro”) in the amount of $31,780.29.  Though the caption on the Judgment identified the defendant as “Christina Castro, D.D.S.,” the body of the Judgment erroneously stated that the Judgment debtor was “Christina Castro, LLC.”

In February 2014, Castro and her spouse Edwin Licup (“Licup,” and collectively “Debtors”) filed for bankruptcy under Chapter 7.  For some unknown reason, their bankruptcy schedules and creditor list provided an incorrect mailing address for the Creditor’s counsel.  The Creditor did not file a proof of claim in this case, where the allowed unsecured creditors received a distribution of around 5.5%.  The debt to the Creditor was nevertheless listed as discharged.

In July 2021, the Creditor filed a nondischargeability action against the Debtors pursuant to 11 U.S.C. section 523(a)(3)(A), arguing that it never received notice of the bankruptcy case.  Debtors filed a motion for summary judgment, arguing among other that the Creditor was entitled to receive a nondischargeability judgment only as to the amount it would have received had it filed a timely proof of claim, calculated at $1,614.74.  Debtors argued that the remaining portion of the debt should be discharged as it would have been had the Creditor filed a timely proof of claim.

The Ninth Circuit disagreed, affirming prior rulings by the Bankruptcy Appellate Panel (BAP) and bankruptcy court.  It held that the “plain language” in section 523(a)(3)(A) mandates that, where a creditor was not listed or scheduled and had no notice or actual knowledge of the bankruptcy case, its entire debt would be nondischargeable, regardless of the distributions creditors ultimately received in the case.  The court distinguished non-asset chapter 7 cases where a claims bar date was never set.

Practice pointer:  check and double check with the client(s) that all creditors are properly listed and scheduled.  Failure to do so could result in significant damage to the client(s) and potential malpractice exposure.

What is a “bona fide dispute”?

Two provisions of the Bankruptcy Code turn on the existence of a “bona fide dispute.”  An involuntary petition may not be filed by an alleged creditor against the alleged debtor if the creditor’s claim is “the subject of a bona fide dispute as to liability or amount.”  11 U.S.C. § 303(b)(1).  A trustee may sell property free and clear of an interest that is “in bona fide dispute.”  11 U.S.C. § 363(f)(4).  These disparate statutory provisions share a unique phrase.

What is a “bona fide dispute”?  Two recent court decisions address this question.

Consistent with canons of statutory construction,[1] the definition of the term “bona fide dispute” is the same in both section 303, where it is one of the requirements for a creditor to be eligible to file an involuntary bankruptcy petition, and section 363, where it is one of the five circumstances in which a trustee (or debtor in possession) may sell assets free and clear of liabilities. The majority of courts have adopted the “objective standard” which “requires the bankruptcy court to ‘determine whether there is an objective basis for either a factual or a legal dispute as to the validity of the debt.’”[2]

In a recent decision, the U.S. Bankruptcy Court for the Middle District of Pennsylvania, examined the standing of creditors to file an involuntary bankruptcy petition against an alleged debtor.[3]  Chief Bankruptcy Judge Henry W. Van Eck analyzed whether the petitioning creditors’ claims were the subject of a “bona fide dispute” under applicable Third Circuit precedent.  Under such precedent, a petitioning creditor’s claim “is the subject of a bona fide dispute if ‘there is a genuine issue of a material fact that bears upon the debtor’s liability, or a meritorious contention as to the application of law to undisputed facts.’”[4]  Applying this standard, the court evaluated each of the petitioning creditors’ claims.  The court noted a number of evidentiary deficiencies in the alleged claims, particularly insufficient evidence establishing the validity of the claims or rebutting the alleged debtor’s defenses.  Thus, a number of the petitioning creditors’ claims were disqualified.  However, since the court declined to find bad faith, additional creditors were not disqualified from joining in the petition, and the court set further proceedings to determine whether including joining creditors in the petition would satisfy the requirements for an involuntary petition.

In another recent decision, the U.S. District Court for the Central District of California addressed whether the bankruptcy court erred when it approved a sale of property over the objections of a secured creditor.[5]  The appellant creditor had obtained a state court judgment against the debtor appellee, who was the creditor’s former business partner.  The debtor filed for chapter 11 protection after the creditor recorded abstracts of judgments encumbering the debtor’s properties.  The case was later converted to chapter 7.  The chapter 7 trustee sold a parcel of real property of the debtor.  The bankruptcy court authorized the trustee’s sale free and clear of the creditor’s liens on the basis that those interests were the subjects of a “bona fide dispute” within the meaning of section 363(f)(4) of the Bankruptcy Code.  On appeal to the District Court, the creditor challenged the bankruptcy court’s determination that there was a bona fide dispute.  The creditor argued that the interests were not the subject of a bona fide dispute because the bankruptcy court had previously ruled that the creditors’ liens were not avoided.  In that earlier adversary proceeding the bankruptcy court had entered summary judgment in favor of the debtor ruling that the liens were subject to mandatory subordination under section 510(b), although the liens were not avoided.[6]   The creditor appealed that decision, and that prior appeal was still pending while the sale motion was before the bankruptcy court.[7]  District Court Judge Dolly M. Gee ruled that a dispute as to the priority of an interest is a bona fide dispute within the meaning of section 363(f)(4).[8]  Ultimately, the court found the bankruptcy court’s ruling “consistent with the purpose of section 363(f)(4), which seeks to prevent the delay of liquidation of the estate’s assets while disputes regarding interests in the estate are litigated.”[9]

While these two cases involve very different facts and requests for relief, the meaning of “bona fide dispute” appears to be consistent, and courts should be able to rely on the standard established in precedent when addressing a “bona fide dispute,” whether under section 303 or 363 of the Bankruptcy Code.

[1] Law v. Siegel, 571 U.S. 415, 422, 134 S. Ct. 1188, 1195, 188 L. Ed. 2d 146 (2014) (It is a “normal rule of statutory construction” that words repeated in different parts of the same statute generally have the same meaning.”) (internal quotations omitted).

[2] See In re Vortex Fishing Sys., Inc., 277 F.3d 1057, 1064 (9th Cir. 2002) (quoting In re Busick, 831 F.2d 745, 750 (7th Cir. 1987)), which discussed the standard in the involuntary petition context under section 303.  See also the following cases citing Vortex or Busick in the context of sales of estate property under section 363: In re Gaylord Grain L.L.C., 306 B.R. 624, 627 (B.A.P. 8th Cir. 2004) (citing Busick); In re Figueroa Mountain Brewing, LLC, No. 9:20-BK-11208-MB, 2021 WL 2787880, at *8 (Bankr. C.D. Cal. July 2, 2021) (citing Vortex); In re Southcreek Dev., LLC, No. 10-CV-2136, 2010 WL 4683607, at *3 (C.D. Ill. Oct. 25, 2010) (citing Vortex and Busick); In re Lexington Healthcare Grp., Inc., 363 B.R. 713, 716 (Bankr. D. Del. 2007) (citing Busick).

[3] In re Deluxe Bldg. Sols., LLC, No. 5:21-BK-00534-HWV, 2022 WL 16543189, at *4 (Bankr. M.D. Pa. Oct. 28, 2022)

[4] Id.

[5] In re Elieff, No. SA CV 21-1720-DMG, 2022 WL 4484597 (C.D. Cal. Sept. 26, 2022).

[6] Id at *6 (discussing In re Elieff, 637 B.R. 612 (B.A.P. 9th Cir. 2022)).

[7] Id. at *2.

[8] Id. (citing: In re Daufuskie Island Props., LLC, 431 B.R. 626, 646 (Bankr. D.S.C. 2010); In re Farina, 9 B.R. 726, 729 (Bankr. D. Me. 1981); In re TWL Corp., No. 08-42773-BTR-11, 2008 WL 5246069, at *5 (Bankr. E.D. Tex. Dec. 15, 2008); Salerno, et al., Is a Lien Priority Dispute a Bona Fide Dispute?, Advanced Chapter 11 Bankr. Practice § 7.109 (2022)).

[9] Id. (citing In re Clark, 266 B.R. 163, 171 (B.A.P. 9th Cir. 2001)).

Second Circuit Analyzes Concealment of a Debtor’s Beneficial Interest in Assets in the Name of Another Under Section 727(a)(2)(A): Gasson v. Premier Capital, LLC, 43 F.4th 37 (2d Cir. 2022)

By Shantal Malmed

Brief Summary

A creditor obtained judgment against the chapter 7 debtor for denial of the debtor’s discharge under 11 U.S.C. § 727.  On the first appeal, the district court affirmed.  On further appeal to the Second Circuit, the debtor challenged the court’s determinations that he had an interest in in an entity, that he concealed that interest with an intent to hinder creditors, and that the concealment occurred within the one-year statutory period.  The Second Circuit also affirmed.

Factual Background

In the mid-1990s, the chapter 7 debtor, a CPA and financial consultant, was a part owner of several financially challenged manufacturing businesses.  The debtor personally guaranteed the debts of those businesses.  Creditors obtained judgments against the debtor on account of his guaranties. While these financial struggles were ongoing, in 2001, the debtor and his wife formed Soroban, Inc., a consulting business.  The debtor’s wife was listed as the sole owner and chair of the board of Soroban.

However, the debtor took on a larger role than the ownership structure suggested.  The debtor ran Soroban’s day-to-day operations, managed the movement of funds between Soroban’s bank accounts, signed promissory notes on Soroban’s behalf, and controlled the company’s finances. The debtor was also Soroban’s sole employee.  The debtor’s wife hardly had any involvement with the business of Soroban.

In 2011, Premier Capital, LLC acquired the judgments against the debtor and began pursuing collection.  In 2012, the debtor filed for chapter 7 bankruptcy protection in the United States Bankruptcy Court for the Southern District of New York.  Premier commenced an adversary proceeding against the debtor seeking denial of his discharge pursuant to 11 U.S.C. § 727(a).  The central argument in Premier’s complaint was that the debtor violated section 727(a), specifically subsection 727(a)(2)(A) which states that “(a) [t]he court shall grant the debtor a discharge, unless . . . (2) the debtor, with intent to hinder, delay, or defraud a creditor or an officer of the estate charged with custody of property under this title, has transferred, removed, destroyed, mutilated, or concealed, or has permitted to be transferred, removed, destroyed, mutilated, or concealed—(A) property of the debtor, within one year before the date of the filing of the petition” (emphasis added).

In considering the question of whether the debtor concealed his interest in Soroban in violation of 11 U.S.C. section 727(a)(2)(B), the trial court applied the test established by the bankruptcy court in In re Carl, 517 B.R. 53 (Bankr. N.D.N.Y. 2014).  In Carl, the court considered the following five factors to determine whether a debtor had an equitable interest in a company and concealed that interest in an effort to hinder the claims of their creditors:

1. Whether the debtor previously owned a similar business;

2. Whether the debtor left his or her previous business venture under financial duress;

3. Whether the debtor transferred his or her salary, or the right to receive a salary to a family member or to a business entity owned by an insider;

4. Whether the debtor is actively and actually involved in the success of the insider business; and

5. Whether the debtor retains some of the benefits of the salary, such as having expenses paid for by the insider or the business.

Based on its application of the Carl test, the bankruptcy court found that the debtor had an equitable interest in Soroban.  The district court affirmed.

The Second Circuit’s Analysis

On appeal to the Second Circuit, the debtor argued that the Carl test is not binding precedent.  The Second Circuit agreed that Carl was not binding.  Further, the appellate court observed that the Carl decision does not recognize that state law determines a debtor’s property interest in an asset.  Accordingly, the appellate court analyzed New York state law on how to establish whether a party has a property interest in an asset.

The court looked at the New York Court of Appeals decision of Andrew Carothers, M.D., P.C. v. Progressive Ins. Co., 33 N.Y.3d 389, 104 N.Y.S.3d 26, 128 N.E.3d 153 (2019).  The Carothers court did not endorse a particular list of factors, but, affirmed the trial court because it “satisfactorily directed the jury to the ultimate inquiry of control over a professional corporation.”  The trial court had considered the following factors:

1. Whether the purported owners’ dealings with the business were designed to give [them] substantial control over the business and channel profits to themselves;

2. Whether they exercised dominion and control over business assets, including bank accounts;

3. The extent to which business funds were used for personal rather than corporate purposes;

4. Whether they were responsible for hiring, firing, and payment of salaries for the employees;

5. Whether the day-to-day formalities of corporate existence were followed;

6. Whether the business shared common office space and employees with other companies owned by the purported owners; and

7. Whether other parties played a substantial role in the day-to-day and overall operation and management of the business.

While the bankruptcy court’s application of the Carl test did not match the factors in Carothers, per se, the court concluded that, consistent with New York law as demonstrated in Carothers, the bankruptcy court did properly address the “‘ultimate inquiry of control over a professional corporation’ [and] whether the debtor ‘exhibited the attributes of ownership’ in the context of bankruptcy proceedings.”  Thus, it was not an error for the bankruptcy court to consider the Carl factors.

Moreover, under the theory of “continuous concealment” the debtor was not able to escape liability by arguing that the concealment did not occur during the one-year lookback period of section 727(a)(2)(A).  The concealment was ongoing during the year prior to bankruptcy, even if the original act of creating the hidden ownership interest occurred years earlier.

Author’s Comments

The Gasson decision is logical and equitable.  The debtor’s sole operation and control of a new entity, despite his wife’s “paper” status as owner, revealed the truth that the debtor was the equitable interest holder.  The debtor’s technical argument that the trial court’s equitable interest test was not binding precedent did not prevent the Court of Appeals from reaching its own conclusion of law consistent with the bankruptcy court’s holding.

This is also an important reminder that the one-year lookback period for concealment of assets under section 727(a)(2)(A) does not shield a debtor who intentionally concealed assets years earlier and continues to intentionally benefit from that concealment during the one-year lookback period.  As noted in footnote 2 of the decision, at least seven circuits (including the Ninth Circuit) have applied a version of the “continuous concealment” doctrine, and none have rejected it.  It’s fair to say that there is no safe jurisdiction for intentional asset concealment, and the passing of time will not shield a witting concealer from liability under section 727.

Results May be a Relevant Factor to Awards of Bankruptcy Professional Compensation, Says Sixth Circuit in In re Village Apothecary, Inc.

By Uzzi O. Raanan

When deciding what is “reasonable compensation” to award to bankruptcy professionals, including trustees and their counsel, can courts consider the ultimate “results obtained” by the professionals as one of the lodestar factors, even though this factor is not specifically included among the factors enumerated in 11 U.S.C. § 330(a)(3)?  The Sixth Circuit Court of Appeals recently answered this question in the affirmative.  See In re Village Apothecary, Inc., 2022 WL 3365131 (2022).  To read the full opinion, click here.

In Village Apothecary, the debtor’s chapter 7 trustee retained special counsel (the “Firm”) to investigate and pursue potential legal claims worth at least $1,655,962.  After a year-long investigation, the Firm identified possible claims against the debtor’s former president.  The Firm drafted a complaint but ultimately determined that the claims would be unsuccessful.  The trustee agreed to settle the claims for $38,000.  This brought the estate’s total assets to $40,710.87.  The Firm filed a fee application under 11 U.S.C. § 330, asking for a little over $37,000, representing 90.6% of the estate’s total assets.

The bankruptcy court approved only half of the requested fees.  It relied on various lodestar factors, balancing the “amount in controversy” with the “results obtained” by counsel, concluding that the level of success was minimal because it resulted in no distribution to the non-administrative creditors.

On appeal, the district court affirmed, disagreeing with the Firm’s argument that “results obtained” could no longer be used as a lodestar factor under section 330(a)(3).

On appeal of the district court’s decision, the Sixth Circuit Court of Appeals affirmed again.  The Sixth Circuit started out by explaining how professional fees are handled under the Bankruptcy Code.  Under section 330(a), courts “may” award to professionals “reasonable compensation” for actual and necessary services.  The question raised in this appeal was how do courts decide what is “reasonable compensation.”

Prior to 1994, section 330 required courts to consider the time, nature, extent, and value of the services as well as the costs of “comparable services.”  Seeking further guidance, courts crafted ways to define “reasonable compensation.”  One approach adopted by the Fifth Circuit utilized 12 factors, known as the “Johnson Factors,” that relied on Title VII to analyze reasonableness.  Another approach, adopted by the Sixth Circuit, required bankruptcy courts to first calculate a “lodestar amount” by multiplying a professional’s reasonable hourly rate by the number of hours reasonably worked.  Once this amount was derived, courts could exercise their discretion by also applying the Johnson Factors.  One of the factors was the “amount involved and the results obtained.”

In 1994, Congress amended section 330, codifying some but not all of the Johnson Factors.  Section 330(a)(3) now instructs courts to consider, “the nature, the extent, and the value of such services, taking into account all relevant factors, including” many Johnson Factors.  (Emphasis added.)  The list does not include “results obtained.”  The court noted that it has never considered whether the 1994 amendment precludes courts from considering other Johnson Factors, like the “results obtained,” that were not codified into the statute.

Using statutory interpretation canons, the court concluded that by including the modifier, “all relevant factors, including,” Congress did not intend to limit courts to the specific factors codified in section 330(a)(3).  Rather, courts may also consider factors not expressly enumerated in the statute.  The court was also influenced by the fact that professional fees under section 330(a)(1) are discretionary, stating that courts “may” but are not required to award such fees.  This discretion suggests that Congress intended the list of factors in section 330(a)(3) to be illustrative, but not exclusive.

The Sixth Circuit ultimately concluded that the bankruptcy court did not abuse its discretion by reducing the Firm’s fees by half.

 

Bankruptcy Appellate Decision Subordinates Judgment Liens Under Section 510(b)

By Eric P. Israel 

Recently, the Bankruptcy Appellate Panel for the Ninth Circuit (the “BAP”) issued a ruling on an important issue.  In Kurtin v. Ehrenberg (In re Elieff), 637 B.R. 612, 2022 WL 832417 (B.A.P. 9th Cir. March 21, 2022), the BAP ruled that, when a claim is subordinated under Section 510(b), any judgment and other liens and encumbrances securing said claim are subordinated as well.  The BAP analyzed this issue in the context of a dispute between Todd Kurtin and Bruce Elieff, two former business partners embroiled in litigation.

Before the bankruptcy filing, the two parties reached a settlement agreement whereby, in relevant part, Kurtin would transfer his ownership interest in their business entities and, in exchange, Elieff would effect a series of settlement payments from the funds of such entities.  Elieff ultimately breached the settlement agreement, and Kurtin initiated a lawsuit against Elieff, alleging a breach of contract and other causes of action.  A jury returned a verdict on the breach of contract claim in favor of Kurtin, who subsequently recorded two abstracts of judgment against Elieff.  Elieff then filed a chapter 11 petition for bankruptcy and commenced an adversary proceeding against Kurtin, alleging subordination of claims under section 510(b).  The bankruptcy court granted summary judgment on the section 510(b) claims in favor of the plaintiff, and appeal was taken to the BAP.

The BAP determined that Kurtin’s claim for breach of the settlement agreement arose from the purchase or sale of securities, per section 510(b) of the Bankruptcy Code.  In doing so, the BAP noted that “[t]he Ninth Circuit broadly interprets the scope of § 510(b)” and that a claim arises from the purchase or sale of securities “whenever it shares a ‘nexus or causal relationship’ with the purchase or sale of securities.”  Because Kurtin’s claim indisputably originated from the breach of the settlement agreement which contemplated the transfer or sale of securities, the BAP found no material difference between the matter before it and other cases in which the Ninth Circuit had found that subordination was appropriate under Section 510(b).

After an in-depth analysis, the BAP in Elieff concluded that Kurtin’s judgment liens also should be subordinated under section 510(b).  First, turning to the definition of “claim” under section 101(5), the BAP determined that subordination of a “claim” within the meaning of Section 510(b) encompasses the entirety of a right to payment, “whether personal or in rem,” meaning that Kurtin would not be entitled to “any right to payment from any means until the unsecured creditors in the case were paid in full.”  It noted that the definition of “claim” in section 101(5) included any right to payment, “secured or unsecured.”  From a policy perspective, the BAP found that interpreting the word “claim” differently would lead to incongruous results, primarily because doing so “would permit a former equity investor to elevate its lien rights ahead of the unsecured creditors § 510(b) was enacted to protect.”  For these reasons, the BAP found that subordination of Kurtin’s claim was required under section 510(b), and that “once the claim has been subordinated, the lien automatically follows the debt.”

In re Elieff is a BAP decision with a clear ruling on an otherwise murky issue in bankruptcy law:  whether section 510(b) applies to subordinate judgment liens or only the underlying unsecured claim.  This subordination applies regardless of the date of creation or perfection of the judgment liens, which might otherwise be limited to a 90 day preference window.  Additionally, it provides considerable insight as to the type of claims that are subject to mandatory subordination under 11 U.S.C. § 510(b).  While we understand that Elieff has been appealed to the Ninth Circuit Court of Appeals, bankruptcy practitioners should be aware of this decision and its potential implications in their practice.

Subchapter V Debt Limit Likely to Sunset at the End March

The subchapter V debt limit is likely to revert to $2,725,625 on March 28, 2022. Hope remains that Congress will soon restore it to $7.5 million.

By Aaron E. de Leest

On March 28, 2022, the provision in the Coronavirus Aid, Relief, and Economic Security Act or the “CARES Act,” which increased the eligible debt limit for subchapter V debtors to $7,500,000 will sunset, and the debt limit will revert to $2,725,625.  The Senate has made efforts to remove the sunset provision in the CARES Act and thereby permanently increase the debt limit to $7,500,000.  However, the Senate’s bill, which was introduced on March 14, 2022, is stalled in the Senate Judiciary Committee.  Because the House is not in session this week, it does not appear that the Senate’s bill will make it through Congress and onto the President’s desk before the March 28, 2022 sunset.  Therefore, it is likely that, at least for the short term, the debt limit for subchapter V debtors will be substantially reduced to $2,725,625.

 

What does this mean for small businesses? 

Subchapter V provides a streamlined, less expensive, chapter 11 reorganization process for small business debtors.  See our prior blog post: https://danninggill.com/the-small-business-reorganization-act-of-2019-sbra/.   When Congress created subchapter V, it made $2,725,625 the maximum amount of debt that a debtor could owe and be eligible for subchapter V.  In response to the Covid-19 pandemic, in March 2020, Congress increased the limit to $7.5 million, but the limit expired after one year.  In 2021, Congress extended the higher debt limit to March 27, 2022.  When the higher cap expires, businesses will be ineligible to file subchapter V if they have more than $2,725,625 in debt.  To seek reorganization in bankruptcy, those debtors will need to file for regular chapter 11.

Recent Case Adds to Trend of Courts Allowing Bankruptcy Trustees to “Look Back” as Far as 10 Years to Avoid Transfers When the IRS is a Creditor

In the recent case of Mitchell v Zagaroli, 2020 WL 6495156 (Bankr. W.D.N.C. 2020), 2020 WL 6495156 (Bankr. W.D.N.C. 2020), the bankruptcy court ruled that a chapter 7 trustee under 11 U.S.C. § 544(b) could “step into the shoes” of the IRS as an actual creditor to avoid a fraudulent transfer of property occurring up to ten years prior to the petition date.

Under section 544(b) of the Bankruptcy Code, the trustee of a bankruptcy estate may “avoid” (or colloquially, “claw back”) certain transfers of property.  According to section 548 of the Bankruptcy Code, the reach back period for the trustee prior to the bankruptcy filing to avoid transfers is two years.  However, section 544(b) allows a trustee to avoid any fraudulent transfer “that is voidable under applicable law by a creditor holding an unsecured claim.”  Generally, this has been applied to a trustee employing avoidance powers under applicable non-bankruptcy law (i.e. State law), typically extending the look back period by a few years.  In Zagaroli, the Court ruled that, if the IRS is an unsecured creditor of the bankruptcy estate, the look back period may extend to ten years prior to the petition date.

In Zagaroli, the debtor allegedly transferred multiple parcels of real property to his parents for no consideration in December 2010 and June 2011.  In May 2018, the debtor filed a chapter 7 petition.  The IRS filed a proof of claim in the debtor’s case.  Thereafter, the trustee filed an action to avoid the debtor’s 2010 and 2011 transfers to his parents.  The trustee claimed that section 544(b) allowed the trustee to use section 6502 of the Internal Revenue Code to avoid transfers as far back as ten years before the debtor’s petition filing.

To determine the merits of this claim, the court relied on the plain meaning of Bankruptcy Code section 544(b).  As the IRS had an unsecured claim in the debtor’s estate, the court determined that the plain language of section 544(b) allowed the trustee to “step into the shoes” of the IRS (an “actual creditor”) and use section 6502 of the Internal Revenue Code to avoid the debtor’s real estate transfers.  To support this conclusion, the court relied heavily on In re Gaither, 595 B.R. 201 (Bankr. D.S.C. 2018), which determined that section 544(b) similarly permitted the trustee to step into the IRS’s shoes and that courts should not look beyond the plain meaning of this provision.  Zagaroli cited other cases as well and characterized this as the “majority rule.”

It does appear that the majority of cases in the nation ruling on this issue have come to the same conclusion as Zagaroli, though some courts have disagreed.  For example, in In re Vaughan Co., 498 B.R. 297 (Bankr. D.N.M. 2013), the court relied more heavily on congressional intent and determined that a trustee should not be permitted to use the unique powers of the IRS.  The Vaughan Co. court opined that the federal government was not meant to be used as a “mere conduit for the enforcement of private rights which could have been enforced by the private parties themselves.”  Id. at 304 (citing Marshall v. Intermountain Elec. Co., 614 F.2d 260 (1980)).  Thus, under this court’s analysis, a trustee could step into the IRS’ shoes but would still be barred by the state’s statute of limitations, unlike the IRS.  Id. at 305.

Despite the few opposing decisions, the holding in Zagaroli suggests that courts are continuing to extend trustees’ avoiding powers by extending the look back period when the IRS is an unsecured creditor of the bankruptcy estate.  At this time, however, there is no binding authority on this issue from the Ninth Circuit.