ABA

SECTION OF BUSINESS LAW

FALL MEETING
OCTOBER 18-21, 2009
BANKRUPTCY COMMITTEE
TASK FORCE ON CURRENT
DEVELOPMENTS IN BANKRUPTCY LAW

PRESENTERS
Martin J. Bienenstock
Dewey & LeBeouf
1301 Avenue of the Americas
New York, NY 10019

Michael R. Enright
Robinson & Cole
One Commercial Plaza
Hartford, Connecticut 06103

Judith W. Ross
Baker Botts L.L.P.
2001 Ross Ave.
Dallas, Texas 75201

Kay Standridge Kress

Pepper Hamilton LLP
Suite 3600
100 Renaissance Center
Detroit, Michigan 48243

Robert B. Millner
Sonnenschein Nath & Rosenthal
Sears Tower, Suite 8000
233 South Wacker Drive
Chicago, Illinois 60606

RECENT DEVELOPMENTS
REGARDING
CLAIMS IN BANKRUPTCY

ABA SECTION OF BUSINESS LAW

FALL MEETING
OCTOBER 19, 2009
LAS VEGAS, NEVADA

Kay Standridge Kress

Pepper Hamilton LLP
100 Renaissance Center, Suite 3600
Detroit, Michigan 48243
(313) 393-7365
kressk@pepperlaw.com

Table of Contents
Page
INTRODUCTION ......................................................................................................................1
I. OVERVIEW OF THE CLAIMS PROCESS IN BANKRUPTCY..........................................1
II. FILING CLAIMS AND THE CLAIMS OBJECTION PROCESS.........................................3
A. Implications and Consequences of Filing a Claim............................................................3
B. Withdrawal of a Proof of Claim .......................................................................................4
C. Informal Proofs of Claim .................................................................................................4
D. Evidentiary Issues............................................................................................................5
1. Proofs of Claim..........................................................................................................5
2. Objections to Proofs of Claim ....................................................................................8
E. Untimely Proofs of Claims ..............................................................................................9
1. Chapter 9 and 11 Cases..............................................................................................9
2. Chapter 7, 12 and 13 Cases ......................................................................................10
F. Amending Proofs of Claim ............................................................................................11
G. Transferring Claims.......................................................................................................12
H. Claims Reconsideration .................................................................................................12
III. STATUTORY LIMITATIONS ON THE ALLOWANCE OF CLAIMS .............................13
A. The Scope of 11 U.S.C. 502........................................................................................13
B. Claims Not Enforceable in Bankruptcy..........................................................................13
C. Claims For Unmatured Interest ......................................................................................15
D. Tax Assessment Claims .................................................................................................15
E. Lease Rejection Claims .................................................................................................16
F. Estimation of Claims .....................................................................................................17
G. Claims of Entities From Which Property is Recoverable................................................17
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H. Reimbursement and Contribution Claims.......................................................................18

IV. SUBORDINATION ............................................................................................................18
A. Subordination Agreements.............................................................................................18
B. Sale of Stock .................................................................................................................19
C. Equitable Subordination ................................................................................................20

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INTRODUCTION
This material is intended as an overview of certain trends and significant
decisions in recent case law relating to claims in bankruptcy. It deals primarily with unsecured
claims and does not include all recently decided cases or address all areas of law relating to
bankruptcy claims. Rather, this material is intended as a survey of certain recurring themes in
cases decided in the last year.
I.

OVERVIEW OF THE CLAIMS PROCESS IN BANKRUPTCY

11 U.S.C. 501 and 502 and the Federal Rules of Bankruptcy Procedure

(FRBP or Bankruptcy Rules) 3001, 3002, 3003, 3005, 3006, 3007 and 3008 govern the way
in which creditors and equity security holders present their claims or interests to the bankruptcy
court, and provide the guidelines within which such claims are allowed or disallowed in the
bankruptcy proceeding. There are different rules for filing and allowing claims in cases under
Chapters 9 and 11 than for filing and allowing claims in cases under Chapters 7, 12 and 13.
11 U.S.C. 501 and FRBP 3001 generally govern the filing of proofs of claim. A
proof of claim is a written statement setting forth a creditors claim which must conform
substantially to the appropriate Official Form by including (a) the name and address of the
creditor, (b) basis for the claim, (c) date the debt was incurred, (d) classification of the claim, (e)
amount of the claim, and (e) include copies of any documents supporting the claim. In re
Andrews, 394 B.R. 384 (Bankr. E.D.N.C. 2008); In re Rogers, 391 B.R. 317 (Bankr. W.D. La.
2008); In re Brooks, 2008 WL 2993948 (Bankr. E.D. Pa. 2008). In addition, the proof of claim
must be executed by the creditor or the creditors authorized agent. FBRP 3001(b). In re
North Bay General Hospital, Inc., 404 B.R. 443 (Bankr. S.D. Tex. 2009)(the unsecured creditor
agent under the confirmed plan in the debtors prior bankruptcy case did not have authority to
file a proof of claim on behalf of a group of unsecured creditors in the second bankruptcy case).
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There is nothing in the Bankruptcy Rules or Bankruptcy Code that specifically

permits the filing of a class proof of claim. In re Protected Vehicles, Inc., 397 B.R. 339, 347
(Bankr. D.S.C. 2008)(the Bankruptcy Rules do not allow a class representative to file a proof of
claim on behalf of other class members absent a prior determination that a class claim may be
filed). Bankruptcy Courts are generally hesitant to certify a class in bankruptcy cases. See In re
Bally Total Fitness of Greater New York Inc., 402 B.R. 616, 621 (Bankr. S.D.N.Y.
2009)(applying the test articulated by the predominant line of cases, the Court found that the
certification of a class was unnecessary to protect the rights of employees of the debtor).
The Bankruptcy Rules govern the form and substance of the proof of claim. In
cases under Chapters 7, 12 and 13, except for certain specifically defined exceptions, a proof of
claim must be filed within ninety (90) days after the first date set for the first meeting of creditors
under 11 U.S.C. 341. FRBP 3002. In re Hyde, 2009 WL 1066087 (Bankr. D. Idaho 2009); In
re Mozingo, 2009 WL 703206 (Bankr. E.D.N.C. 2009); In re Brooks, 2009 WL 189849 (Bankr.
E.D. Pa. 2009); In re Stansbury, 403 B.R. 741 (Bankr. M.D. Fla.); In re Franco, 2008 WL
3413293 (Bankr. E.D.N.C. 2008); In re Lattimer, 2008 WL 5102868 (Bankr. D. Dist. Col. 2008).
But see In re Gulley, 400 B.R. 529 (Bankr. N.D. Tex. 2009)(when a Chapter 13 bankruptcy case
is disrupted by the dismissal of the case, and the proof of claims bar date expires before the case
is reinstated, the bankruptcy court has the power to nullify the original proof of claim deadline
and recalculate it). Bankruptcy Rule 3002 applies only to filing a proof of claim; it does not
specify a time or deadline for filing a proof of interest. In the Matter of American Building
Storage, 285 Fed. Appx. 375 (9th Cir. 2008).
In cases under Chapters 9 and 11, a proof of claim must be filed only if (i) the
claim is listed in the debtors Schedules of Liabilities (the Schedules) as disputed, contingent

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and/or unliquidated, or (ii) the creditor disagrees with the amount of the claim as listed in the
Schedules. FRBP 3003(c)(2). If a proof of claim is filed, it supersedes the amount scheduled by
the debtor. In re Carraway Methodist Health Systems, 2008 WL 2937781 (Bankr. N.D. Ala.
2008). If, however, the proof of claim is subsequently disallowed because it was not timely
filed, the scheduled claim will be reinstated for purposes of distribution.
Neither the Bankruptcy Code (the Code) nor the Bankruptcy Rules provide a
time by which creditors asserting claims in cases under Chapters 9 and 11 must file proofs of
claim. Rather, the time is set either by local rule or by order of the Court upon motion of the
debtor or another party in interest. FRBP 3003(c)(3).
If a creditor relies on the debtors Schedules filed in a case under Chapter 11 (and
does not file a proof of claim), and the case is subsequently converted to a case under Chapter 7,
the creditor cannot continue to rely on the Chapter 11 Schedules. All unsecured creditors in a
case under Chapter 7 that did not file proofs of claim in the case under Chapter 11 must file
proofs of claim once the case is converted. FRBP 1019(6). If a case, however, is converted from
a case under Chapter 7 to a case under Chapter 13, a creditor may file a claim, even if the
creditor did not timely file a claim in the Chapter 7 case. In re Walter, 399 B.R. 714 (Bankr.
M.D. Fla. 2009).
If a creditor fails to file a proof of claim within the prescribed time period, the
debtor or trustee may file a claim on behalf of the creditor within thirty (30) days after the
applicable time period. FRBP 3004. In re Sacko, 394 B.R. 90, 96 (Bankr. E.D. Pa. 2008).
II.

FILING CLAIMS AND THE CLAIMS OBJECTION PROCESS

A.

Implications and Consequences of Filing a Claim

The filing of a proof of claim triggers the claims allowance and disallowance

process, and, accordingly, the bankruptcy courts core jurisdiction under 28 U.S.C.
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157(b)(2)(B).

In re Exide Technologies, 544 F.3d. 196, 217 (3rd Cir. 2008)(filing a proof of

claim subjects the claimant to the jurisdiction of the bankruptcy court, but does not transform
state law claims against non-debtor defendants into core matters to be resolved by the bankruptcy
court).
B.

Withdrawal of a Proof of Claim

Generally, a creditor may withdraw a proof of claim as of right, unless (i) an

objection to the claim has been filed, (ii) a complaint was filed against the creditor in an
adversary proceeding, (iii) the creditor accepted or rejected the plan, or (iv) the creditor
otherwise participated significantly in the case, at which time the creditor must have an order of
the court to withdraw its claim. FRBP 3006. In re Manchester, 2008 WL 5273289 (Bankr. N.D.
Tex. 2008); In re Bryant, 397 B.R. 903 (N.D. Ind. 2008); In re Teknek, 394 B.R. 884 (Bankr.
N.D. Ill. 2008).
C.

Informal Proofs of Claim

Although FRBP 3001(a) provides that a proof of claim should conform

substantially to the appropriate Official Form, under certain circumstances, courts allow
informal proofs of claim. The informal proof of claim doctrine may allow a creditor's pre-bar
date filing to constitute an informal proof of clam if: (1) the proof of claim is in writing; (2) the
writing contained a demand by the creditor to the debtor's estate; (3) the writing expresses an
intent to hold the debtor liable for the debt; and (4) the proof of claim was filed with the
bankruptcy court. In re Dana Corp., 2008 WL 2885901 (Bankr. S.D.N.Y 2008). If the filing

The bankruptcy courts core jurisdiction under 28 U.S.C. 157(b)(2)(B) does not extend to the
liquidation or estimation of contingent or unliquidated personal injury tort or wrongful death claims.

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meets these factors, the court may consider a fifth factor - whether it would be equitable to allow
an amendment of the informal proof of claim. While the informal proof of claim may be
recognized, a creditor may not be permitted to amend an informal proof of claim. Compare, In
re Nowak, 385 B.R. 799 (B.A.P. 6th Cir. 2008)(BAP agreed with the bankruptcy court that it
would be inequitable to allow creditor to amend an informal proof of claim when creditor failed
to explain why it had failed to file a timely proof of claim in four years and allowance of the
claim would substantially diminish the return for other unsecured creditors), and In Rowe
Furniture, Inc., 384 B.R. 732 (Bankr. E.D. Va. 2008)(because the creditor filed a pleading in the
case before the claims bar date, the formal proof of claim filed one month after the bar date was
held timely).
D.

Evidentiary Issues
1.

Proofs of Claim

A Chapter 11 debtors Schedules (filed pursuant to 11 U.S.C. 521(1)) constitute

prima facie evidence of the validity and amount of the claims of creditors. FRBP 3003(b)(1). A
filed proof of claim must conform substantially to the appropriate Official Form which imposes a
requirement to attach supporting documentation. FRBP 3001(a).

Creditors filing a proof of

claim based on writing must attach either the original or a copy of the writing. Rule 3001(c). In
re Stauder, 396 B.R. 609 (Bankr. M.D. Pa. 2008)(when the claim does not attach the
documentation required by Bankruptcy Rule 3001(c) the claim cannot served as prima facie
proof of its validity); In re Rogers, 391 B.R. 317 (M.D. La. 2008); In re Brooks, 2008 WL
2993948 (Bankr. E.D. Pa. 2008); In re Reyna, 2008 WL 2961973 (Bankr. W.D. Tex. 2008). A
summary may be used if the supporting documents are too voluminous. If the claim includes
pre-petition interest, attorneys' fees, or other charges, a statement providing a breakdown of the
elements of the claim is required. If the creditor is an assignee of the debtor's original creditor,
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the assignee must attach a copy of the assignment and sufficient other information to evidence
the assignee's ownership. In re King, 2009 WL 960766 (Bankr. E.D. Va. 2009)(claim may be
disallowed if it contains no evidence of the ownership of the debt by the claimant); In re
Gilbreath, 395 B.R. 356 (Bankr. S.D. Tex. 2008); In re White, 2008 WL 269897
(Bankr.N.D.Tex. 2008); In re Nosek, 2008 WL 1899845 (Bankr.D.Mass. 2008).
A proof of claim filed in conformity with these rules constitutes prima facie
evidence of the validity of the claim. Rule 3001(f). Claims not filed in accordance with the
Rules are not entitled to the presumption. In re Jacobsen, 2009 WL 1577992 (E.D. Tex. 2009);
In re Vasquez, 2008 WL 4425304 (S.D. Ga. 2008); In re Tracey, 394 B.R. 635 (B.A.P. 1st Cir.
2008); In re Melillo, 392 B.R. 1 (B.A.P. 1st Cir. 2008): In re Wells, 407 B.R. 873 (Bankr. N.D.
Ohio 2009); In re Hess, 404 B.R. 747 (Bankr. S.D.N.Y. 2009); In re Tammarine, 405 B.R. 465
(Bankr. N.D. Ohio 2009); In re Regan, 2009 WL 1067197 (Bankr. D. Mass. 2009); In re
Transcapital Financial Corp., 2009 WL 1116842 (Bankr. S.D. Fla. 2009); In re Keefer, 2009 WL
1587593 (Bankr. N.D. Ohio 2009); In re Freeman, 2009 WL 1107916 (Bankr. W.D. Pa. 2009);
In re Cramer, 406 B.R. 267 (Bankr. M.D. Pa. 2009); In re Peterson, 2009 WL 994945 (Bankr.
N. D. Ill. 2009); In re Pettingill, 403 B.R. 624 (Bankr. E.D. Ark. 2009); In re King, 2009 WL
960766 (Bankr. E.D.Va. 2009); In re Waston, 402 B.R. 294 (Bankr. N.D. Ind. 2009); In re
Nixon, 400 B.R. 27 (Bankr. E.D. Pa. 2008); In re Day, 2008 WL 5191683 (Bankr. D.N.M.
2008); In re Plastech, 399 B.R. 1 (Bankr. E.D. Mich. 2008); In re Charlton, 2008 WL 5539789
(Bankr. D. Kan. 2008): In re Plourde, 397 B.R. 207 (Bankr. D.N.H. 2008); In re Massaquoi,
2008 WL 4861513 (Bankr. E.D. Pa. 2008); In re Lundberg, 2008 WL 4829846 (Bankr. D. Conn.
2008); In re Briana, 2008 WL 4833083 (Bankr. D. Mass. 2008); In re Fleming, 2008 WL
4736269 (Bankr. E.D. Va. 2008); In re Taylor, 2008 WL 4723364 (Bankr. D. Mont. 2008); In re

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Jones, 2008 WL 4539486 (Bankr. D. Mass. 2008); In re Taylor, 2008 WL 4286500 (Bankr. D.
Mont. 2008); In re Simpson, 2008 WL 4216317 (Bankr. N.D. Ala. 2008); In re Rose, 2008 WL
4205364 (Bankr. E.D. Tenn. 2008); In re Hayes, 393 B.R. 259 (Bankr. D. Mass. 2008); In re
Purney, 2008 WL 3876130 (Bankr. N.D. Ohio 2008); In re Hight, 393 B.R. 484 (Bankr. S.D.
Tex. 2008); In re Prevo, 394 B.R. 847 (Bankr. S.D. Tex. 2008); In re Ginko Associates, L.P.,
2008 WL 3200713 (Bankr. E.D. Pa. 2008); In re Dugar, 392 B.R. 745 (Bankr. N. D. Ill. 2008);
In re Samson, 392 B.R. 724 (Bankr. N.D. Ohio 2008); In re Rouse, 2008 WL 2986281 (Bankr.
M.D.N.C. 2008); In re Reyna, 2008 WL 2961973 (Bankr. W.D. Tex. 2008); In re Rogers, 391
B.R. 317 (Bankr. M.D. La 2008); In re Dorway, 2008 WL 5111882 (Bankr. S.D. Fla. 2008); In
re Owens, 2008 WL 2937855 (Bankr. D. Dist. Col. 2008); In re Owens, 2008 WL 2705199
(Bankr. D. Dist. Col. 2008). Even if a proof of claim does not satisfy the requirements of Rule
3001(c) and thus, not prima facie evidence of a claim, absent objection, it will not be
automatically disallowed. In re Rogers, 391 B.R. 317 (Bankr. M.D. La. 2008); In re Todays
Destiny, Inc. 2008 WL 5479109 (Bankr. S.D. Tex. 2008).
A proof of claim is deemed allowed until an objection is filed. If a creditor
subsequently files a timely and properly executed proof of claim, such claim supercedes the
debtors Schedules. FRBP 3003(c)(4).

If an objection is filed and sufficient evidence is

presented to overcome the prima facie validity, however, the claim will be disallowed. 11
U.S.C. 502(a). The objector must produce sufficient evidence to rebut the presumption raised
by the proof of claim.

If such evidence is produced, the claimant must then prove by

preponderance of the evidence that the claim is valid. The claimant bears the ultimate burden of
persuasion. In re Baggett Brothers Farm, Inc., 2008 WL 3979493 (N.D. Fla. 2008); In re
Depugh, 2009 WL 1657473 (Bankr. S.D. Tex. 2009); In re Shafer, 2009 WL 1241307 (Bankr.

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E.D. N.C. 2009): In re Cordier, 2009 WL 890604 (Bankr. D. Conn. 2009); In re Briana, 2008
WL 4833083 (Bankr. D. Mass. 2008); In re Baltimore Emergency Services II, 2008 WL
4596619 (Bankr. D. Md. 2008); In re Cleveland, 396 B.R. 83 (Bankr. N.D. Okla. 2008); In re
Miller, 394 B.R. 114 (Bankr. D. S.C. 2008); In re Ealy, 392 B.R. 408 (Bankr. E.D. Ark. 2008);
In re Simon, 2008 WL 2953471 (Bankr. E.D. Va. 2008); In re Agway, Inc. 2008 WL 2827439
(Bankr. N.D.N.Y. 2008); In re Reading Broadcasting Inc., 2008 WL 2705547 (Bankr. E.D. Pa.
2008); In re Young, 390 B.R. 480 (Bankr. D. Me. 2008).
2.

Objections to Proofs of Claim

In order to contest a proof of claim or interest, FRBP 3007 requires that the
objection be in writing, be filed and served on the creditor thirty (30) days prior to the hearing
date set for such objection. Most courts have determined that an objection to a claim must only
be served on the claimant at the address and pursuant to the information reflected on the proof of
claim.
Claims objections are contested matters which are governed by FRBP 9014. If an
objection to a claim, however, is joined by a demand for relief of a kind under Rule 7001, it
becomes an adversary proceeding. FRBP 3007. In re Hook, 2008 WL 4482247 (D. Colo. 2008);
In re Taylor, 2008 WL 4723364 (Bankr. D. Mont. 2008)(requesting attorneys fees and costs as
part of a claims objection, requires an adversary proceeding); In re Protected Vehicles, Inc. 392
B.R. 633 (Bankr. D.S.C. 2008); In re Rogers, 391 B.R. 317 (Bankr. M.D. La. 2008)(debtors
request for damages in connection with the filed proofs of claim is properly raised in an
adversary proceeding).
Generally, all parties in interest have standing to object to the filed claims. In re
Burke, 2008 WL 4452133 (D. Colo. 2008)(Chapter 7 debtor has standing to object to proofs of
claim when it appears that, if the contested claim is disallowed there will be a surplus after
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unsecured creditors claims are paid); In re Malsch, 2009 WL 1657475 (Bankr. N.D. Ohio
2009)(a Chapter 7 debtor will have standing to object to a proof of claim if there are sufficient
assets available for distribution to pay all administrative expenses and creditors in full or to any
claim for which the underlying debt is non-dischargeable); In re ULZ, 401 B.R. 321 (Bank. N. D.
Ill. 2009)(a party-in-interest allowed to object to a proof of claim is anyone who has a legally
protected interest that can be affected by the bankruptcy proceeding); In re Lona, 393 B.R. 1
(Bankr. N.D. Cal. 2008).
E.

Untimely Proofs of Claims

1.

Chapter 9 and 11 Cases

As a general rule in cases under Chapters 9 and 11, claims that are not timely filed
are disallowed, and any creditor who files a late claim is prohibited from participating in the case
and receiving any payment with respect to its claim. FRBP 3003. In a Chapter 11 case, a proof
of claim is deemed filed if it appears in the Schedules and is not scheduled as disputed,
contingent, or unliquidated. In re Seaquest Diving, LP, 2008 WL 243670 (Bankr.S.D.Tex.
2008). Even if the debtor subsequently amends its schedule to reflect that the claim is disputed,
a claim will still be considered timely if the amendment to the schedule was made after the
deadline to file a proof of claim. Id.
There is, however, one exception to this rule. FRBP 9006(b)(1) allows the court
to enlarge the time for filing a proof of claim, if the claimant establishes that the delay in filing is
due to excusable neglect. In Pioneer Investment Services Company v. Brunswick Associates
Limited Partnership, 507 U.S. 380, 113 S. Ct. 1489, 1498 (1993), the United States Supreme
Court articulated a non-exclusive balancing test which examined the following factors to
determine whether a claimants neglect in filing a timely proof of claim was excusable:
1.

The danger of prejudice to the debtor if the untimely filing is allowed;

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2.

The length of the delay and its potential impact on the judicial
proceedings;

3.

The reason for the delay, including whether the delay was beyond the
reasonable control of the person whose duty it was to perform; and

4.

Whether the creditor acted in good faith.

As with the application of any balancing test, the courts, using the Pioneer
standard, have great discretion in deciding whether to allow an untimely-filed proof of claim.
Accordingly, all of the published decisions discussing the Pioneer balancing test are very fact
specific. For examples of cases in which the courts apply the Pioneer standard, see In re Delphi
Corp., 2009 WL 803598 (S.D.N.Y. 2009)(the bankruptcy court correctly applied the Pioneer
factors and denied the request of the claimant to file a late claim because the debtor would be
prejudiced and allowing late filings would open the door to the other late claimants); In re
Smidth & Co., 2009 WL 704062 (D. Del. 2009)(late-filed claim disallowed because of the
creditors failure to timely file the claim did not qualify as excusable neglect); In re Continuum
Care Services, 398 B.R. 708 (Bankr. S.D. Fla. 2008)(attorneys mistake of failing to timely file
proof of claim was not excusable neglect); In re Peninsular Oil Corp., 399 B.R. 532 (Bankr.
M.D. Fla. 2008)(failure of claimant to hire counsel or file the proof of claim until two years after
the claims bar date is not excusable neglect); In re Asarco, LLC, 2008 WL 4533733 (S.D. Tex.
2008)(claimants failed to establish that their failure to act is the result of excusable neglect and
all four of the Pioneer factors weigh in favor of the debtor).
2.

Chapter 7, 12 and 13 Cases

In Chapter 7, 12 and 13 cases, FRBP 3002(c) provides six exceptions to the

general rule that claims must be filed within ninety (90) days of the first meeting of creditors.
Most courts have taken the position that these specifically enumerated exceptions are the only

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reasons for a creditor not filing a proof of claim in a timely manner, and that the Pioneer
excusable neglect standard does not apply.
With the enactment of the 1994 amendments and the addition of 502(b)(9), most
courts have consistently held that untimely filed claims filed in Chapter 7 and 13 cases must be
disallowed, even if the creditor did not receive notice of the filing or the claims bar date. See In
re Mozingo, 2009 WL 703206 (Bankr. E.D.N.C. 2009)(the courts power to extend the deadline
for filing a proof of claim in a chapter 13 case is limited to the exceptions provided under FRBP
3002(c)); In re Todays Destiny, Inc., 2008 WL 5479109 (Bankr. S.D. Tex. 2008)(tardily-filed
proofs of claim in a chapter 7 case are automatically subordinated by law under 11 U.S.C.
726(a)(3)); In re Houston, 2008 WL 104076 (Bankr.D.Dist.Col. 2008).
F.

Amending Proofs of Claim

Amendments to timely filed proofs of claim are generally allowed when the

purpose is to cure a defect in the original claim, to describe the claim with greater particularity or
to plead a new theory of recovery on the facts set forth in the original claim. In re Sacko, 394
B.R. at 96 (a creditor will be allowed to amend the claim filed by the debtor under FRBP 3004
within a reasonable time after it was filed). But see In re Joy Global, Inc., 2009 WL 1442694
(D.Del. 2009)(claim amended over eight years after the claims bar date is untimely and will not
be considered by the court); In re Gilbreath, 395 B.R. 356, 367 (Bankr. S.D. Tex. 2008)(creditors
should not be permitted to file woefully deficient proofs of claim in hopes that the debtor will
not object and then file amendments at the eleventh hour and rely on the amendments at the
hearing). See also In re Winn-Dixie Stores, Inc., 2009 WL 980798 (M.D. Fla. 2009)(bankruptcy
court did not err in denying claimants post-confirmation amendment to their claims after stock
had been issued under the terms of the confirmed plan).

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G.

Transferring Claims
Claims may be transferred, both before and after a proof of claim is filed. FRBP

3001(e). Rule 3001(e) sets the procedures for transferring previously filed claims. Rule 3001(e)
was amended in 1991 to limit the court's role to the adjudication of disputes regarding transfers
of claims. If a timely objection is filed, the court's role is to determine whether a transfer has
been made that is enforceable under non-bankruptcy law. Only the transferor has standing to
object to the assignment of the claim.

In re Final Analysis, Inc., 2008 WL 2095752

(Bankr.D.Md. 2008).
H.

Claims Reconsideration
The Bankruptcy Code allows a court to reconsider an allowed or disallowed claim

for cause according to the equities of the case. 11 U.S.C. 502(j) and FRBP 3008. Factors to
be considered in determining cause are: 1) extent and reasonableness of the delay; 2) prejudice to
a party in interest; 3) effect on efficient court administration; and 4) moving party's good faith.
U.S. Bank National Association v. U.S. Environmental Protection Agency, 563 F.3d 199, 208
(6th Cir. 2009)(reconsideration of a claim is within the discretion of the court); In re Smith, 305
Fed. Appx. 683 (2nd Cir. 2008)(if reconsideration is granted, the court may allow or disallow the
claim according to the equities of the case); In re Best Payphones, Inc., 2008 WL 2705472
(Bankr. S.D.N.Y. 2008); In re Russell, 386 B.R. 229 (B.A.P. 8th Cir. 2008); In re Shepard, 2009
WL 1658124 (Bankr. W.D. Mo. 2009). Many courts look to Rule 60(b) for the standards for
reconsideration of claims and the definition of cause. See In re Tender Loving Care Health
Services, Inc., 562 F.3d 158 (2nd Cir. 2009)(an objection to claim is a contest triggering the one
year limitation in Rule 9024, therefore the reconsideration of the claim more than one year after
the claim was allowed was improper by the bankruptcy court); In re Butler, 2009 WL 103351
(S.D. Ohio 2009)(a bankruptcy court exercises broad discretion in determining whether to
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reconsider disallowance of a claim); In re Babb, 2009 WL 1073105 (Bankr. E.D.N.C.

2009)(moving party must establish cause); In re Dorway, 2008 WL 5120903 (Bankr. S.D. Fla.
2008)(the movant must show cause for reconsideration).
III.

STATUTORY LIMITATIONS ON THE ALLOWANCE OF CLAIMS

A.

The Scope of 11 U.S.C. 502

A bankruptcy court is given the jurisdiction and authority to determine the amount

of a claim as of the date of the filing of the petition. 11 U.S.C. 502. The court must determine
the amount of the claim in United States currency by using the exchange rate that prevails as of
the petition date. In re LeBlanc, 404 B.R. 793, 798 (Bankr. M.D. Pa. 2009); In re Global Power
Equip. Group, Inc., 2008 WL 435197 (Bankr. D. Del. 2008).
A majority of bankruptcy courts have determined that a proof of claim may only
be disallowed based upon the nine statutory reasons enumerated in 11 U.S.C. 502(b). In re
Lentz, 405 B.R. 893, 897 (Bankr. N.D. Ohio 2009)(filing a proof of claim with debtors
unredacted Social Security number and her non-filing daughters full name and date of birth was
not grounds for disallowing the claim); In re Rogers, 391 B.R. at 322 (failure to attach
supporting documentation to a proof of claim is not grounds for disallowing the claim); In re
Hill, 399 B.R. 472 (Bankr. W.D. Ky. 2008)(that assignee of credit card debt may have paid
significantly less than face amount of credit card debt did not provide a basis for disallowing the
claim).
B.

Claims Not Enforceable in Bankruptcy

Section 502(b)(1) provides that a claim shall be allowed except to the extent that

"such claim is unenforceable against the debtor and property of the debtor, under any agreement
or applicable law for a reason other than because such claim is contingent or unmatured." In re
SNTL Corporation, ___ F.3d ___ (9th Cir. 2009)(rejecting the majority line of cases that finds
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that Section 502(b)(1) precludes the allowance of attorneys fees arising out of a pre-petition
contract but incurred post-petition, the court held that fees claims for post-petition attorneys fees
cannot be disallowed simply because the claim of the creditor is unsecured); In re Glatzer, 2008
WL 4449439 (S.D.N.Y. 2008)(any defense to a claim outside of bankruptcy is also available in
bankruptcy); In re Rogers, 405 B.R. 428 (M.D. La. 2009)(Section 502(b)(1) contemplates a
creditor filing a proof of claim on time-barred debt, therefore filing the claim cannot be the basis
for a cause of action by the debtor under the Fair Debt Collection Practices Act); In re Hess, 404
B.R. at 751 (claims barred by statute of limitations under applicable state law will be disallowed
if asserted in proofs of claim); In re Premier Entertainment Biloxi, LLC, 2009 WL 1230795
(Bankr. S.D. Miss. 2009)(liquidated damages are not allowed under Mississippi law and
therefore not enforceable in bankruptcy); In re Hall, 403 B.R. 224 (Bankr. D. Conn. 2009)(claim
based upon a judgment disallowed when the court determined that the State court lacked
personal jurisdiction over the debtor); In re ULZ, 401 B.R. 321 (Bankr. N.D. Ill. 2009)(a claim
based upon an assignment of a judgment against a debtor is not enforceable under Illinois law);
In re McGregor, 398 B.R. 561 (Bankr. N.D. Miss. 2008)(a proof of claim statutorily barred by a
period of limitations may be disallowed under Section 502(b)(1), but the filing of the claim does
not constitute a cause of action); In re Plastech Engineered Products, 399 B.R. 1 (Bankr. E.D.
Mich. 2008)(the bank was not a secured creditor under the terms of the security agreement); In re
Stauder, 396 B.R. 609 (Bankr. M.D. Pa. 2008)(failure to produce an assignment to the current
holder of the claim is sufficient to disallow the claim); In re W.R. Grace & Co., 397 B.R. 701
(Bankr. D. Del. 2008); In re Pearce, 2008 WL 5096009 (Bankr. E.D. La. 2008); In re Ginther,
2008 WL 4533714 (Bankr. S.D. Tex. 2008); In re Cleveland, 396 B.R. at 99 (when debtor
presents no evidence to rebut the claimants evidence with respect to validity, ownership or

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amount of the claim, the court cannot disallow it); In re Andrews, 394 B.R. at 389; In re
Williams, 395 B.R. 33 (Bankr. S.D. Ohio 2008); In re Partners Group Financial, LLC, 394 B.R.
68 (Bankr. E.D. Pa. 2008); In re Simpson, 2008 WL 4216317 (Bankr. N.D. Ala. 2008). In
determining the amount of a claim which has been objected to, the bankruptcy court must first
look to the law that gave rise to the claim.

In re Melillo, 392 B.R. 1 (B.A.P. 1st Cir.

2008)(alleged assignees failure to provide any proof of its ownership of the credit card account
as required under Massachusetts law for it to enforce the alleged debt is sufficient grounds for
disallowance of the claim); In re Van Eck, 2009 WL 981141 (Bankr. D. Conn. 2009)(bankruptcy
courts are required to consult state law in determining the validity of most claims); In re Brown,
403 B.R. 1 (Bankr. E.D. Ark. 2009)(the enforceability of the claim based upon credit card debt
was determined by state law); In re Baltimore Emergency Services II, 401 B.R. 209 (Bankr. D.
Md. 2008)(claim is disallowed when there is no evidence it would be enforceable under state
law).
C.

Claims For Unmatured Interest

11 U.S.C. 502(b)(2) disallows the payment of unmatured interest (or post-

petition interest) on unsecured claims. In re Taylor, 2008 WL 4723364 (Bankr. D. Mont. 2008).
There is an exception to this rule, however, when a debtor is solvent. In re W.R. Grace & Co.,
2009 WL 1469831 (Bankr. D. Del 2009).
Although under section 502(b)(2), post-petition interest on unsecured claims
cannot be charged against the debtor, interest on non-discharged debts continues to run against
the individual debtor. In re Benum, 386 B.R. 59 (Bankr.D.N.J. 2008).
D.

Tax Assessment Claims

11 U.S.C. 502(b)(3) provides that the court allow claims, except to the extent

that such claim is for a tax assessed against property of the Estate, and such claims exceed the
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value of the interest of the Estate of such property. In re Van Beckum, 2009 WL 122754
(Bankr. E.D. Wis. 2009)(real property tax claims are disallowed when the property has been sold
at foreclosure).
E.

Lease Rejection Claims

11 U.S.C. 502(b)(6)2 limits the claim of a landlord whose lease is rejected by a

debtor during a bankruptcy proceeding. Section 502(b)(6) is designed to compensate a landlord

for the loss suffered by termination of a lease, while not permitting large claims for breaches of
long-term leases to prevent other general unsecured creditors from recovering from the estate. In
re Cajun Forge Company, Inc., 2008 WL 5144536 (Bankr. W.D. La. 2008). The Bankruptcy
Code clearly provides that a claim for damages based upon the termination of a real property
lease is limited by 502(b)(6). In re Brown, 398 B.R. 215 (Bankr. N.D. Ohio 2008)(the cap
applies to refitting costs of the lessor because the claim only arises upon a default and is
therefore resulting from the rejection).

11 U.S.C. 502(b)(6) provides, in pertinent part, that:

(b) [T]he court . . . shall allow [a] claim . . ., except to the extent that -(6)
if such claim is the claim of the lessor for damages resulting from the termination of a lease of real
property, such claim exceeds-(A) the rent reserved by such lease, without acceleration, for the greater of one year, or 15 percent, not to
exceed three years, of the remaining term of such lease, following the earlier of -(i) the date of the filing of the petition; and
(ii) the date on which such lessor repossessed, or the lessee surrendered the leased property; plus
(B)

any unpaid rent due under such lease, without acceleration, on the earlier of such dates.

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F.

Estimation of Claims
11 U.S.C. 502(c)3 allows the bankruptcy court to estimate, for purposes of

allowance, any contingent or unliquidated claim, if the liquidation of such claim would unduly
delay the administration of the bankruptcy case. Neither the Bankruptcy Code nor the Rules
provides any guideline for estimation. The bankruptcy judge may use any method suited to the
particular contingencies at issue. In re Kivler, 2009 WL 1545821 (Bankr. D. N.J. 2009)(court
estimated a malpractice claim); In re Cantu, 2009 WL 1374261 (Bankr. S.D. Tex. 2009)(court
estimated claim for voting purposes under the plan); In re Englehaupt, 2009 WL 691294 (Bankr.
C.D. Ill. 2009); In re Leidheiser, 2009 WL 1587431 (Bankr. N.D. Ohio 2009); In re Simon, 2008
WL 2953471 (Bankr. E.D. Va. 2008).
G.

Claims of Entities From Which Property is Recoverable

11 U.S.C. 502(d) disallows a claim on the basis that the claimant received an

avoidable transfer and must first return the transfer before it can participate in the distribution of
the estate. The courts are unsettled as to whether a judicial order is required to object to a claim
using 502(d). In re Falcon Products, Inc., 2009 WL 248596 (Bankr. E.D. Mo. 2009)(the use of
502(d) to disallow a claim is dependent upon establishing liability for an avoided transfer); In re
IFS Financial Corp., 2008 WL 4533713 (Bankr. S.D. Tex. 2008)(section 502(d) operates to
enforce orders and judgments and not to disallow claims based on theoretically avoidable

11 U.S.C. 502(c) provides that:

(c)

There shall be estimated for purpose of allowance under this section --

(1)
any contingent or unliquidated claim, the fixing or liquidation of which, as the case may be, would
unduly delay the administration of the case; or
(2)

any right to payment arising from a right to an equitable remedy for beach of performance.

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transfers). See also In re Popular Club Plan, Inc., 395 B.R. 587 (Bankr. D. N.J. 2008)(section
502(d) is limited in its application to providing a debtor with a defense to a creditors claim and
did not confer reciprocal rights on a creditor to dispute avoidance actions on the basis of
previously settled claims).
The bankruptcy court in In re Sentinental Management Group, Inc., 398 B.R. 281
(Bankr. N.D. Ill. 2008), however, held that the debtor could in its plan separately classify the
claims of creditors against which the debtor had an avoidance action and withhold distribution
until final resolution of the pending adversary proceeding without violating 11 U.S.C.
1123(a)(4).
In a case of first impression, the court in In re Plastech Engineered Products, 394
B.R. 147 (Bankr. E.D. Mich. 2008) held that 502(d) does not apply to administrative expenses,
including those arising under 11 U.S.C. 503(b)(9).
H.

Reimbursement and Contribution Claims

11 U.S.C. 502(e)(1)(B) requires disallowance of any claim for reimbursement or

contribution of a co-debtor, surety, or guarantor of any obligation of the debtor that is contingent
as of the time of allowance or disallowance of the claim. In re Altheimer & Gray, 393 B.R. 603
(N.D. Ill. 2008)(a claim for indemnification and reimbursement must be disallowed when the
underlying claim is disallowed); In re Agway, Inc., 2008 WL 2827439 (Bankr. N.D.N.Y. 2008);
In re Alper Holdings USA, 2008 WL 4186333 (Bankr. S.D.N.Y. 2008).
IV.

SUBORDINATION
A.

Subordination Agreements
11 U.S.C. 510(a) provides that a subordination agreement is enforceable in a

case under this title to the same extent that such agreement is enforceable under applicable
nonbankruptcy law. If the subordination provisions are clear on their face, the words should be
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given their plan and ordinary meaning. In re Enron Creditors Recovery Corp., 380 B.R. 307
(S.D.N.Y. 2008)(affirming bankruptcy court's decision with regards to the respective rights of
the indentures). But see In re Bank of New England Corp., 404 B.R. 17 (Bankr. D. Mass.
2009)(ambiguous language in subordination provisions, which did not clearly provide whether,
in the event issuer filed for bankruptcy relief, payment of junior indebtedness would be
subordinate even to the payment of post-petition interest to senior indenture trustee, would be
interpreted in light of law in effect at the time and would not be subordinate to payment of postpetition interest to the senior indenture trustee).
B.

Sale of Stock
11 U.S.C. 510(b) subordinates claims arising from the purchase or sale of stock4

to the claims of general unsecured creditors. Brown v. Owens Corning Inv. Review Comm., 541
F.Supp.2d 958 (N.D.Ohio 2008). Therefore, the claims of a security holder based upon alleged
fraud, rescission, or other tort in the sale of the security cannot and will not be elevated to the
status of general unsecured claims. "Arising from" requires some nexus or casual link between
the claim and the purchase or sale of security. In re Patriot Aviation Services, Inc., 396 B.R. 780
(Bankr. S.D. Fla. 2008)(claim for damages for chapter 11 debtors alleged breach of a letter of
intent anticipating the sale of secured debt instruments which was never consummated possessed

11 U.S.C. 510(b) provides that:

For purposes of distribution under this title, a claim arising from recession of a purchase or sale of a
security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a
security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be
subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security,
except that if such security is common stock, such claim has the same priority as common stock.

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the requisite causal connection to the sale of the secured debt instruments and had to be
subordinated to secured debt claims).
C.

Equitable Subordination
Congress enacted 11 U.S.C. 510(c) to codify case law, including Pepper v.

Litton, 308 U.S. 295 (1939). It allows claims to be subordinated under certain circumstances.5
Equitable subordination is remedial rather than penal; therefore, a claim should be equitably
subordinated only to the extent necessary to offset the harm suffered by the debtor and its
creditor as a result of the inequitable conduct.

In re Kreisler, 546 F.3d 863 (7th Cir.

2008)(subordination is not appropriate unless there is harm to other creditors even if there is
misconduct by insiders). In addition, a creditors claim may only be subordinated to the claims
of other creditors, not to equity interests. In re Winstar Communications, Inc., 554 F.3d 382 (3rd
Cir. 2009)(upheld the determination that equitable subordination was appropriate for the lender
and equipment supplier, but reversed on the subordination of the claim to equity interests).
The seminal case on equitable subordination is Benjamin v. Diamond (In re
Mobile Steel Co.), 563 F.2d 692, 699-700 (5th Cir. 1977), wherein the United States Court of
Appeals for the Fifth Circuit established three requirements for the application of the doctrine of
equitable subordination:
5

11 U.S.C. 510(c) provides that:

(c)

Notwithstanding subsections (a) and (b) of this section, after notice and hearing the court may --

(1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an
allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another
allowed interest; or
(2) order that any lien securing such a subordinated claim be transferred to the estate.

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1.

the claimant must have engaged in some type of inequitable conduct;

2.

the misconduct must have resulted in injury to the creditors of the debtor
or conferred an unfair advantage on the claimant; and

3.

equitable subordination of the claim must not be inconsistent with the

provisions of the Bankruptcy Code.

When reviewing the first prong of the Mobile Steel test, courts frequently look to
the following three non-exclusive categories of inequitable conduct, enunciated in Wilson v.
Huffman (In re Missionary Baptist Foundation, Inc.), 712 F.2d 206 (5th Cir. 1983), revd on
other grounds, 818 F.3d 1135 (8th Cir. 1997):
1.

fraud, illegality, or breach of fiduciary duty;

2.

undercapitalization; or

3.

claimants use of the debtor as an instrumentality or alter ego.

In examining a claim for equitable subordination, and in evaluating the first

requirement articulated in Mobile Steel, (whether the claimant engaged in some sort of
inequitable conduct), special scrutiny is given to the conduct of insiders, and the allocation of the
burden of proof is adjusted accordingly. A non-insider creditor must be found to have engaged
in wrongful conduct that is egregious, constitutes gross management tantamount of fraud,
misrepresentation, overreaching or spoliation. In re Sunbelt Grain WKS, LLC, 406 B.R. 88,
2009 WL 1708814 (Bankr. D. Kan. 2009)(exercising rights under loan documents is not
misconduct allowing equitable subordination); In re Fedders North America, 405 B.R. 527
(Bankr. D. Del. 2009)(court dismissed equitable subordination count in the complaint by the
unsecured creditors committee against the prepetition lenders because it contained no allegations
of egregious action on the part of the lenders).
Most courts have held that all three requirements of the Mobile Steel test must be
present, in order for equitable subordination to be appropriate. In re M&S Grading, Inc., 541
-21-

F.3d 859 (8th Cir. 2008)(merely receiving preferential transfers is not inequitable conduct, even if
those receiving the transfers are fiduciaries and there can be no equitable subordination without
inequitable conduct); In re Burns Excavating & Concrete Construction, Inc., 2008 WL 5064271
(S.D. Ill. 2008)(section 510(c) requires some evidence of wrongdoing); In re Morande
Enterprises, 2008 WL 4459143 (M.D. Fla. 2008)(section 510(c) requires inequitable conduct and
cannot be used to subordinate tax penalties); In re Montagne, 2009 WL 1065427 (Bankr. D. Vt.
2009)(an equitable subordination cause of action must allege misconduct); In re Thurston, 2008
WL 4866180 (Bankr. D. Neb. 2008)(a finding of inequitable conduct is fact specific); In re
Delphi Corp., 2008 WL 3486615 (Bankr. S.D.N.Y 2008)(section 510(c) requires more that an
breach of contract; it requires advantage taking).
A creditor sued for equitable subordination does not have the affirmative defense
of the unclean hands of the debtor. In re Automotive Professionals, Inc., 398 B.R. 256 (Bankr.
N.D. Ill 2008).

#11319806 v1

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ABA FALL MEETING

OCTOBER 2009

UPDATE ON EXEMPTIONS

JUDITH W. ROSS
BAKER BOTTS L.L.P.
2001 ROSS AVENUE
DALLAS, TX 75201-2980
214.953.6500
judith.ross@bakerbotts.com

DAL02:544284.3

UPDATE ON EXEMPTIONS
This paper reflects developments in the area of exemptions since November 2008. It
does not purport to include every case decided in the area, but includes cases that should be of
interest to most practitioners regardless of where they practice law.
Is the Homestead Exemption Available to Debtors Who Fraudulently Transferred the
Homestead but Cured Such Fraudulent Transfer Pre-Petition?
1.

In re David Hill, 562 F.3d 29 (1st Cir. 2009)

In this case, the Court of Appeals for the First Circuit considered whether a debtors
homestead exemption may be denied under 11 U.S.C. 522(g) if the residential property was
fraudulently transferred but reconveyed pre-petition in response to actions taken by a creditor.
The bankruptcy court denied the debtors claimed homestead exemption; however the
bankruptcy appellate panel ruled in favor of the debtor on this issue. The Court of Appeals
ultimately affirmed the panels decision.
In May of 2004, the debtors, David Hill and Tina Hill, purchased a home with $550,000
in cash and $450,000 in the form of a mortgage loan. No homestead declaration was recorded on
the property. Prior to this purchase, in the year 2000, Mrs. Hill personally guaranteed a loan
made to a creditor corporation.
In August of 2004, the debtors transferred the home to be held exclusively by Mrs. Hill
for $1.00. Mrs. Hill then recorded a declaration of homestead. On January 18, 2005, the creditor
sued on the guaranty and sought to attach the home. In its suit, it alleged that the home had been
fraudulently conveyed. In effort to correct the potential problems caused by the conveyance, the
debtors reconveyed the home to their joint names and recorded a declaration of homestead.
In April of 2005, the debtors filed a bankruptcy petition under chapter 7. In so doing,
they claimed a $500,000 homestead exemption under Massachusetts law. The creditor objected.
The bankruptcy court capped the homestead exemption at $125,000 because the home had been
acquired within 1,215 days of the filing of the bankruptcy petition. In addition, the court held
the exemption was not available at all because the home had been voluntarily transferred and
then reconveyed as a result of a creditors efforts. Finally, the bankruptcy court refused to grant
the debtors a discharge because it found that the debtors transferred the property with the intent
to hinder, delay, or defraud a creditor. The bankruptcy appellate panel upheld the denial of the
discharge, but ruled that the statutory cap was inapplicable and that the exemption was available
because section 522(g) only applies to property that the trustee recovers, whereas here the home
was reconveyed as a result of the creditors actions.
The Court of Appeals for the First Circuit focused its analysis on the plain reading of
section 522(g). The court concluded that the words trustee and creditor are not synonymous
and the section only applies to property the trustee recovers under chapter 5 of the Bankruptcy
Code. The court also determined that the term recovers required that there be a net gain by the
bankruptcy estate. Here, the home was reconveyed prior to the filing of the petition and thus
prior to the existence of the estate.

DAL02:544284.3

-1-

As a matter of policy, the court agreed that most of the time, recoveries by trustees are for
the benefit of the estate and not the debtors. The court cited legislative history evidencing a
congressional desire to not have the trustee make the effort to recover fraudulently transferred
property only to have the debtor later exempt it. Here, however, the fraudulent transfer was
voluntarily cured pre-petition. Even though the suit by the creditor prompted the reconveyance,
the exemption was still available to the debtors.
Does the Supremacy Clause Preclude States from Opting Out of the Federal Exemption
Regime and Creating Exemptions That Apply Only to Bankruptcy Cases?
2.

In re Sheehan, et al., 2009 WL 2196136 (4th Cir. 2009)

This opinion resulted from consolidated appeals from eight bankruptcy cases filed by
individual debtors in West Virginia. In these cases, the debtors claimed that all of their property
was exempt from the bankruptcy estate under West Virginia Code 38-10-4. The trustee
objected, arguing that this statute is preempted by federal law or otherwise violated the
supremacy clause of the Constitution. The bankruptcy court overruled the trustees objection
and allowed the exemptions. The Court of Appeals for the Fourth Circuit affirmed the
bankruptcy courts decision, holding that state exemptions that apply only in bankruptcy
proceedings do not violate the supremacy clause.
The Bankruptcy Code allows debtors to choose either exemptions under federal
bankruptcy law (unless state law prohibits such option) or exemptions under state law together
with exemptions under federal non-bankruptcy law. However, states may opt out and remove
the federal bankruptcy exemptions as an option. West Virginia chose to opt out under that
statute. The West Virginia statute also provides exemptions that are similar to federal
bankruptcy exemptions, and which only apply in bankruptcy proceedings. The debtors relied on
these bankruptcy-like exemptions in claiming that all of their property was exempt.
The trustee argued that state exemptions that apply only in federal bankruptcy proceeding
are preempted by the federal bankruptcy exemptions provided in the bankruptcy code. The
trustee further argued that state exemption laws that apply only in bankruptcy cases are
inconsistent with the Bankruptcy Codes objectives regarding the distribution of assets. The
court held that Congress, through section 522(b)(1) of the Bankruptcy Code, gave states the
authority to grant residents only those exemptions allowed under state law. As a result, there is
an express delegation to the states of the power to create exemptions , and therefore there was no
preemption of West Virginias statute. By this holding, the Court of Appeals for the Fourth
Circuit determined that Congress did not mandate that state exemptions apply equally to
bankruptcy and non-bankruptcy cases.
Claiming a Homestead Exemption on Property Held by a Limited Partnership
3.

Steffen v. United States, 405 B.R. 486 (M.D. Fla. 2009)

In this case, the debtor filed a Chapter 11 petition and claimed a homestead exemption on
certain property. However, debtors limited partnership, and not the debtor, owned the property.
The District Court held that on the date the chapter 11 petition was filed, the debtor did not have

DAL02:544284.3

-2-

the requisite ownership interest in the property to meet Floridas requirements for claiming a
homestead exemption.
The Florida statute (Fla. Const. Art. X, 4(a)) requires that the property subject to the
claim for a homestead exemption must be owned by a natural person. The debtor argued that
she, as the claimant, is a natural person. However, the court dismissed this argument as being
contrary to the express language of the statute. As a result, the court turned its focus to whether
the debtor owned the property on the filing date.
The debtor was the 100% stockholder of the general partner of the limited partnership
that held the property. In addition, the debtor was the sole beneficiary of a trust which was the
99% limited partner of the limited partnership. The debtor conceded that a stockholder could not
claim a homestead exemption. However, the debtor argued that she was claiming the exemption
as the beneficiary of the trust. In support of this argument, the debtor cited several cases
allowing beneficiaries of a revocable trust to claim property held by the trust as an exempt
homestead. The court ultimately held that these cases were distinguishable because in each of
them, the property was actually held by the trust. The debtor could not provide any cases
reaching the same conclusion for limited partnerships.
The court distinguished between revocable trusts and limited partnerships on the grounds
that a debtor could revoke a trust at any time and the property would revert to the debtor, which
results in a beneficial ownership that is sufficient to claim the homestead exemption. This is not
true, however, of limited partnerships.
What Factors May be Considered in Considering Whether a Private Retirement Plan is For
Retirement Purposes and Therefore Eligible for Exemption?
4.

In re Rucker, et al., 570 F.3d 1155 (9th Cir. 2009)

In 1997, Loyd Rucker was sued by an individual and had judgment rendered against him.
In 2001, the Rucker established and began funding a defined benefit pension plan and several
401(k) plans. Rucker was the sole employee beneficiary of these plans. He had also over funded
these plans according to limits imposed by the Internal Revenue Code. In addition, Rucker
failed to accurately disclose these contributions. The pension plan purchased real property in
2003, where Rucker lived rent free for six months. Other than this free rent, Rucker did not
withdraw any other funds from the plans.
Rucker filed for chapter 7 relief in 2005 to avoid the collection efforts of the judgment
creditor. Under California law, a debtor is eligible for an exemption for all amounts held,
controlled, or in process of distribution by a private retirement plan. The judgment-creditor
objected to this exemption, arguing the plans did not qualify because they were not designed or
used primarily for retirement purposes. The bankruptcy court sustained the objection because it
found that the debtor used the plans to shield his assets from the judgment creditor. The court
emphasized that the debtor over funded the plans, that he took the free rent and that he did not
fully disclose the contributions to the IRS. The debtor appealed and the District Court reversed
based on the fact that the plans were designed and used primarily for retirement purposes.

DAL02:544284.3

-3-

The Court of Appeals for the Ninth Circuit first held that the District Court should not
have reviewed the decision of the bankruptcy court de novo, but rather should have used the
clear error standard for its review. The court acknowledged that the exemption itself has a
valid purpose in allowing a judgment debtor to place funds beyond the reach of creditors if they
qualify for the exemption under law. The plan must still be designed and used, however, for
retirement purposes. Certain other factors, including the subjective intent of the debtor, can be
considered in determining the purposes of the plan.
The Court of Appeals reasoned that the lack of loans or withdrawals was an important
factor, but only a review of the totality of the circumstances can fully answer the question of
whether the plan was used primarily for retirement purposes. Ultimately, the court held that
under a clear error standard and based on the totality of the circumstances, the Bankruptcy
Courts ruling should have been upheld. The Court emphasized the egregious and deceptive
conduct by the debtor in funding the plans; the debtor over funded the plans, lied to the IRS, and
secretly contributed money to the plans using an offshore corporation and foreign bank account.
The court decided that a debtor with a genuine retirement purpose would not engage in this kind
of conduct. Finally, the fact that the debtor caused the corporations to contribute more to the
plans than they paid to the debtor in wages and the fact that the debtor admitted that he never
intended to pay the judgment also influenced the courts decision.
When a married couple claims two homesteads, can one spouse release a homestead on
property that is solely owned by the other spouse?
5.

In re Gunnison, 397 B.R. 186 (Bankr. D. Mass. 2008)

In Gunnison, a Massachusetts bankruptcy court was faced with two interesting issues of
first impression: (i) whether a husband and wife living apart can each claim a separate
homestead exemption on different properties where one property is solely owned, and
(ii) whether one spouse can release a prior homestead declared by, and covering a property solely
owned by, the other spouse by declaring a subsequent homestead on a different property.
Jennifer and Brian Gunnison filed a chapter 13 petition as co-debtors and listed two
residences as exempt on their bankruptcy schedules. Although married, the Gunnisons lived
apart, and together they sought to retain the equity in the two properties. Prior to the bankruptcy,
Jennifer had filed a homestead declaration on Property A in 2007, which she solely owned.
Brian had filed a homestead declaration on Property B in 2008. The chapter 13 trustee objected
to the exemption of Property A, claiming that the second filing on Property B divested the couple
of their homestead in Property A, rending $88,000 in equity non-exempt and available for
distribution through their chapter 13 plan.
In construing the Massachusetts homestead statute, the Bankruptcy Court first held that
although the Debtors were separated in fact, they remained legally married and thus constituted a
single family for purposes of the homestead statute. The result of this interpretation was that
only one of the two homestead declarations could be valid. The debtors argued that because
Jennifer owned Property A separately, Brian could not release the familys homestead thereon by
declaring a homestead on Property B. The Court disagreed and held that regardless of whether
Property A was held solely by Jennifer or jointly between the debtors, the acquisition of a new

DAL02:544284.3

-4-

homestead estate by Brian, as a member of her family and for her benefit, terminated the prior
homestead estate. The trustees objection was sustained and the debtors were denied the
exemption.

DAL02:544284.3

-5-

Recent Developments Affecting Chapter 11 Cases

"If it is black-letter law that the terms of an unambiguous
private contract must be enforced irrespective of the parties'
subjective intent, see 11 R. Lord, Williston on Contracts 30:4 (4th
ed. 1999), it is all the clearer that a court should enforce a court
order, a public governmental act, according to its unambiguous
terms. This is all the Bankruptcy Court did."
***
"Those orders are not any the less preclusive because the
attack is on the Bankruptcy Court's conformity with its subject-matter
jurisdiction, for '[e]ven subject-matter jurisdiction may not be
attacked collaterally.' Kontrick v. Ryan, 540 U.S. 443, 455n.9
(2004).So long as respondents or those in privity with them were
parties to the Manville bankruptcy proceeding, and were given a fair
chance to challenge the Bankruptcy Court's subject-matter
jurisdiction, they cannot challenge it now by resisting enforcement of
the 1986 Orders."
***
"The willingness of the Court of Appeals to entertain this sort of
collateral attack cannot be squared with res judicata and the practical
necessity served by that rule. 'It is just as important that there should
be a place to end as that there should be a place to begin litigation,'
Stoll v. Gottlieb, 305 U.S. 165, 172 (1938), and the need for finality
forbids a court called upon to enforce a final order to 'tunnel backfor
the purpose of reassessing prior jurisdiction de novo,' In re Optical
Technologies, Inc. 425 F.3d 1294, 1308 (CA11 2005)."
Travelers Indemnity Co. v.
Bailey, 557 U.S. ___, 129 S. Ct.
2195, 2204, 2205, 2206 (2009)
(Souter, J.) (7-2)(footnotes
omitted).

Prepared for Task Force on Current

Developments of Business Bankruptcy
Subcommittee of the Section of
Business Law of the American
Bar Association
Fall Meeting: October 2009

Martin J. Bienenstock
Dewey & LeBoeuf LLP

Table of Contents

1.

SECTION 363 SALES FREE AND CLEAR V. SUB ROSA CHAPTER 11 PLANS..................... 1
A.
INDIANA STATE POLICE PENSION TRUST V. CHRYSLER LLC (IN RE CHRYSLER LLC), ___ F.3D ___
(2D CIR., AUGUST 5, 2009).......................................................................................................................... 1
i. Facts ............................................................................................................................................... 1
ii. Issues .............................................................................................................................................. 1
iii.
Holdings ..................................................................................................................................... 2
iv.
Rationale..................................................................................................................................... 3
v. Analysis........................................................................................................................................... 3

2. THE BANKRUPTCY CODE DOES NOT PER SE DISALLOW PREPETITION CLAIMS FOR
ATTORNEYS FEES INCURRED LITIGATING POSTPETITION BANKRUPTCY ISSUES......... 5
A.
TRAVELERS CASUALTY & SURETY CO. OF AMERICA V. PACIFIC GAS & ELECTRIC CO., 549 U.S.
443 (2007)................................................................................................................................................... 5
i. Facts. .............................................................................................................................................. 5
ii. Issue ................................................................................................................................................ 6
iii.
Holding ....................................................................................................................................... 6
iv.
Rationale..................................................................................................................................... 6
B.
VIOLATION OF TRAVELERS? NATIONAL ENERGY & GAS TRANSMISSION, INC. V. LIBERTY
ELECTRIC POWER, LLC (IN RE NATIONAL ENERGY & GAS TRANSMISSION, INC.), 492 F.3D 297 (4TH CIR.
2007), REHEARING DENIED (AUGUST 6, 2007) ............................................................................................ 7
i. Facts ............................................................................................................................................... 7
ii. Issues .............................................................................................................................................. 8
iii.
Judgments ................................................................................................................................... 8
iv.
Rationale..................................................................................................................................... 9
v. Analysis and Implications ............................................................................................................... 9
1. The Judgments Reliance on principles of equity Does Not Identify the Equity Accomplished because
There is None....................................................................................................................................................... 9
2. The Judgment Yields Illogical and Absurd Consequences Demonstrating its Fallacy.............................. 10
3. The Judgment Resulted from Arbitrary Sequencing. ................................................................................ 11
4. The Judgment Undermines Public Policy ................................................................................................. 12

C. TRAVELERS AND 11 U.S.C. 1123(D) SUPPORT DEFAULT RATE INTEREST IN GENERAL ELECTRIC
CAPITAL CORP. V. FUTURE MEDIA PRODUCTIONS INC., 536 F.3D 969 (9TH CIR. 2008)...............................12
i.Facts ....................................................................................................................................................12
ii. Issues .................................................................................................................................................12
iii.
Holdings ....................................................................................................................................12
iv.
Rationale....................................................................................................................................13
v. Analysis..........................................................................................................................................13
3. NON-DEBTORS CAN NOT DEPRIVE DEBTORS POSTPETITION OF THE OPTION TO
ASSUME OR REJECT EXECUTORY CONTRACTS ..........................................................................14
A.COR ROUTE 5 CO. V. PENN TRAFFIC CO. (IN RE PENN TRAFFIC CO.), 524 F.3D 373 (2D CIR. 2008)......14
i. Facts ..............................................................................................................................................14
ii. Issues .............................................................................................................................................15
iii.
Holding ......................................................................................................................................15
iv.
Rationale....................................................................................................................................15
v. Analysis..........................................................................................................................................16
B.SPECIFIC PERFORMANCE ........................................................................................................................18
i. Specific Performance under the UCC ................................................................................................18
ii. Specific Performance of Real Property Sales Granted by the Bankruptcy Code ..........................20
iii.
Rights to Specific Performance Are Often Nondischargeable ...................................................27
4.

PERILS OF DISAPPROVED POSTPETITION LENDING. .........................................................36

A.

5.

ALFS V. WIRUM (IN RE STRAIGHTLINE INVESTMENTS, INC.), 525 F.3D 870 (9TH CIR. 2008) ...........36
i. Facts ..............................................................................................................................................36
ii. Issues .............................................................................................................................................36
iii. Holdings ...........................................................................................................................................37
iv.
Rationale....................................................................................................................................37
v. Punitive Damages? ........................................................................................................................38
ARE TRIANGULAR SETOFF AGREEMENTS ENFORCEABLE IN TITLE 11 CASES? ......38

A.IN RE SEMGROUP, L.P., 399 B.R. 388 (BANKR. D. DEL. 2009) (BLS) ....................................................39
i.Facts ....................................................................................................................................................39
ii. Issues .............................................................................................................................................39
iii.
Holdings ....................................................................................................................................40
iv.
Rationale....................................................................................................................................41
v. Analysis..........................................................................................................................................43
6. MUCH DIMINISHED STATE SOVEREIGN IMMUNITY IN THE BANKRUPTCY COURT ....60
A.CENTRAL VIRGINIA COMMUNITY COLLEGE V. KATZ, 546 U.S. 356, 126 S. CT. 990 (2006)...................60
i. Facts. .............................................................................................................................................60
ii. Issue. ..............................................................................................................................................60
iii.
Holding ......................................................................................................................................60
iv.
Rationale....................................................................................................................................61
B.TENNESSEE STUDENT ASSISTANCE CORPORATION V. HOOD, 124 S. CT. 1905 (2004) ............................64
i. Facts. ..................................................................................................................................................64
ii. Issue...................................................................................................................................................64
iii.Holding..............................................................................................................................................65
iv.
Rationale....................................................................................................................................65
v. The Eleventh Amendment provides: ..............................................................................................65
C. SUPREME COURT PRECEDENTS GOVERNING ENFORCEMENT OF FEDERAL BANKRUPTCY LAW AGAINST
STATES .......................................................................................................................................................66
i. The Discharge of a Debt by a Bankruptcy Court ..............................................................................66
ii. States are Bound by Bankruptcy Discharges Whether They Participate or Not ...............................66
iii. But, Bankruptcy Court Enforcement of a Bankruptcy Discharge against a State is An Open
Question.................................................................................................................................................66
vi.
Sales Free and Clear .................................................................................................................67
D. HOODS UNANSWERED QUESTION: WHETHER CONGRESS CAN CONSTITUTIONALLY ABROGATE
STATES SOVEREIGN IMMUNITY FROM PRIVATE SUITS UNDER THE BANKRUPTCY CODE...........................67
7. STATE LAW CAN NOT OUST FEDERAL BANKRUPTCY COURTS OF SUBJECT
MATTER JURISDICTION GRANTED BY 28 U.S.C. 1334 ...............................................................70
A.

MARSHALL V. MARSHALL, 126 S. CT. 1735 (2006)........................................................................70

i. Facts. .............................................................................................................................................70
ii. Issue. ..............................................................................................................................................71
iii.
Holding. .....................................................................................................................................72

8. WHEN MUST VALID CLAIMS UNDER STATE LAW BE DISCOUNTED TO BE

ALLOWABLE UNDER BANKRUPTCY LAW? ....................................................................................72
A.

IN RE OAKWOOD HOMES CORPORATION, 449 F.3D 588 (3D CIR. 2006)(2-1) .................................72
i. Facts ..............................................................................................................................................72
ii. Issue ...............................................................................................................................................73
iii.
Holding ......................................................................................................................................73
iv.
Rationale....................................................................................................................................73
v. An Easier Way ...............................................................................................................................74
B.
WHEN DEBT IS RESTRUCTURED BY EXCHANGING DEBT, FOR DEBT IN THE SAME FACE AMOUNT
WITH DIFFERENT COVENANTS, THE DIFFERENCE BETWEEN THE NEW DEBTS TRADING VALUE AND PAR IS
NOT UNALLOWABLE ORIGINAL ISSUE DISCOUNT .......................................................................................74
i. Facts. .............................................................................................................................................75

ii

ii. History ...........................................................................................................................................75

iii.
Analysis......................................................................................................................................75
iv.
In re Chateaugay Corp., 961 F.2d 378 (2d Cir. 1992); In re Pengo Industries, Inc., 962 F.2d
543 (5th Cir. 1992). ...............................................................................................................................75
v. The Constant Interest Method Measures Original Issue Discount ...............................................76
9. LIMITS AND EXTENSIONS OF OFFICIAL UNSECURED CREDITORS' COMMITTEE V.
STERN (IN RE SPM MANUFACTURING CORP.), 984 F.2D 1305 (1ST CIR. 1993) ...........................76
A.
OFFICIAL UNSECURED CREDITORS' COMMITTEE V. STERN (IN RE SPM MANUFACTURING CORP.),
984 F.2D 1305 (1ST CIR. 1993) ..................................................................................................................76
i. Facts ..............................................................................................................................................76
ii. Issue ...............................................................................................................................................77
iii.
Holding ......................................................................................................................................77
iv.
Rationale....................................................................................................................................78
v. Implications ...................................................................................................................................78
B. IN RE ARMSTRONG WORLD INDUSTRIES, 432 F.3D 507 (3D CIR. 2005) .................................................79
i. Facts ...................................................................................................................................................79
ii. Issues .................................................................................................................................................80
iii. Holdings ...........................................................................................................................................80
iv.
Analysis......................................................................................................................................81
B. LIMITS AND EXTENSIONS OF SPM .........................................................................................................81
i. After Armstrong, Secured Claimholders Can Still Voluntarily Cede Collateral Proceeds to General
Creditors, Skipping Priority Creditors (In re World Health Alternatives, Case No. 06-10166 (Bankr.
D. Del., July 7, 2006)) ...........................................................................................................................81
ii. Transferring Property Outside a Chapter 11 Plan May Be Permissible when The Same Transfers
Inside a Plan May be Barred .................................................................................................................83
iii. Some Courts Allow Senior and Secured Creditors to Use Chapter 11 Plans to Reallocate Their
Distributions to Other Creditors Not Otherwise Entitled to Them ........................................................84
3.

WHAT ARE THE STANDARDS FOR SUBSTANTIVE CONSOLIDATION? ...........................85

A.
CREDIT SUISSE FIRST BOSTON V. OWENS CORNING (IN RE OWENS CORNING), 419 F.3D 195 (3D
CIR. 2005), AMENDED, 2005 U.S. APP. LEXIS 18043 (3D CIR., AUGUST 23, 2005), CERT. DEN. 2006 U.S.
LEXIS 3492, 3493 (U.S., MAY 1, 2006) ....................................................................................................85
i. Facts. .............................................................................................................................................85
ii. History ...........................................................................................................................................85
iii.
Holding ......................................................................................................................................86
iv.
Rationale....................................................................................................................................87
B.
PRINCIPLES UNDERLYING SUBSTANTIVE CONSOLIDATION .................................................................88
i. Authority for Substantive Consolidation........................................................................................88
ii. Reasons Why All Appellate Courts Rule Substantive Consolidation Must Be Used Only Sparingly
90
iii.
Substantive Consolidation is Not Based on a Scoring System of Miscellaneous Indicia of
Corporate Overlap ................................................................................................................................91
iv.
Use of a Subsidiary to Benefit the Parent Company Does Not Justify Piercing the Subsidiarys
Corporate Form.....................................................................................................................................91
v. Use of a Subsidiary to Benefit the Parent Directly or Indirectly Does Not Justify Avoidance of
Intercompany Debt ................................................................................................................................93
vi.
Use of Subsidiaries to Minimize Taxes Does Not Render Their Corporate Form Illegitimate .94
vii.
Substantive Consolidation Can Not Be Ordered Based on a Balancing of Benefits and Burdens
95
viii. When Substantive Consolidation is Ordered, Creditors Who Relied on the Separateness of an
Entity Being Consolidated Are Entitled to Priority Claims against the Entity ......................................98

4.

HOW DO X-CLAUSES WORK? ....................................................................................................99

A.DEUTSCHE BANK, AG V. METROMEDIA FIBER NETWORK, INC. (IN RE METROMEDIA FIBER NETWORK,
INC.), 416 F.3D 136 (2D CIR. 2005) ............................................................................................................99

iii

i. Facts. .............................................................................................................................................99
ii. Issue. ..............................................................................................................................................99
iii.
Holding. .....................................................................................................................................99
iv.
Rationale..................................................................................................................................100
v. Analysis........................................................................................................................................100
5. WHEN DO LEASE ASSIGNMENTS RENDER APPEALS MOOT PURSUANT TO 11 U.S.C.
363(M)? ......................................................................................................................................................100
A.WEINGARTEN NOSTAT, INC. V. SERVICE MERCHANDISE COMPANY, INC., 396 F.3D 737 (6TH CIR. 2005)
.................................................................................................................................................................100
i. Facts. ...........................................................................................................................................100
ii. Issue. ............................................................................................................................................101
iii.
Holding. ...................................................................................................................................101
iv.
Rationale..................................................................................................................................101
B.MADE IN DETROIT, INC. V. OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF MADE IN DETROIT,
INC. (IN RE MADE IN DETROIT, INC.), 414 F.3D 576 (6TH CIR., 2005) .......................................................102
i. Facts .................................................................................................................................................102
ii. Issue.................................................................................................................................................102
iii. Holding...........................................................................................................................................102
v. Rationale......................................................................................................................................102
13. DOES 11 U.S.C. 363(F) AUTHORIZE A SALE FREE OF A LESSEES POSSESSORY
INTERESTS PRESERVED ON LEASE REJECTION BY 11 U.S.C. 365(H)? ...............................103
A. PRECISION INDUSTRIES, INC. V. QUALITECH STEEL SBQ, LLC (IN RE QUALITECH STEEL CORP.), 327
F.3D 537 (7TH CIR. 2003) ..........................................................................................................................103
i. Facts. ................................................................................................................................................103
ii. Holding ............................................................................................................................................104
iii. Rationale ........................................................................................................................................104
iv.
Precision Industries Is Right for the Wrong Reasons: Section 365(h) Does Not Elevate a
Lessees Possessory Right Above a Prior Mortgagees Undersecured Lien; But Sections 363(f), 363(l),
and 365(h), Can Not Correctly be Interpreted to Empower a Court to Divest a Lessee of Its
Possessory Rights under Section 365(h) ..............................................................................................105
a) The Leases Susceptibility to Extinguishment in a Mortgage Foreclosure Is Dispositive ....................... 105
b) The Plain Meaning of Sections 363(l) and 365(h)(1)(A)(ii) Was Disregarded ....................................... 106
c) The Seventh Circuits Interpretation Yields Absurd Results Contrary to the United States Supreme
Courts Rule that Statutory Interpretation Should Avoid Absurd Results........................................................ 109

14. CRAM DOWN INTEREST RATES NEED NOT RENDER THE LENDER SUBJECTIVELY
INDIFFERENT BETWEEN PRESENT FORECLOSURE AND FUTURE PAYMENTS ................116
A. TILL V. SCS CREDIT CORP., 124 S. CT. 1951 (2004)(CHAPTER 13) .....................................................116
i. Facts. ...........................................................................................................................................116
ii. Issue. ............................................................................................................................................117
iii.
Holding. ...................................................................................................................................117
iv.
Rationale..................................................................................................................................118
v. A New Twist on Statutory Interpretation .....................................................................................119
B.
BANK OF MONTREAL V. OFFICIAL COMMITTEE OF UNSECURED CREDITORS (IN RE AMERICAN
HOMEPATIENT, INC.), 420 F.3D 559 (6TH CIR. 2005) .................................................................................120
i. Facts. ...........................................................................................................................................120
ii. Issue. ............................................................................................................................................120
iii.
Holding. ...................................................................................................................................120
iv.
Rationale..................................................................................................................................120
v. Other Cramdown Interest Rate Decisions Since Till ...................................................................121
C. OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. DOW CORNING CORP., 456 F.3D 668 (6TH CIR.
2006)........................................................................................................................................................121
i. Facts .................................................................................................................................................121
ii. Issues ...............................................................................................................................................122

iv

iii. Holdings .........................................................................................................................................122

iv.
Rationale..................................................................................................................................122
15. BARTON V. BARBOUR, 104 U.S. 126 (1881), IS ALIVE AND WELL. .......................................123
A. BECK V. FORT JAMES CORP. (IN RE CROWN VANTAGE, INC.), 421 F.3D 963 (9TH CIR. 2005)...............123
i. Facts. ................................................................................................................................................123
ii. Issues. ..............................................................................................................................................125
iii. Holdings. ........................................................................................................................................125
iv. Rationale.........................................................................................................................................126
16. ONLY THE DEBTOR IN POSSESSION/TRUSTEE CAN INVOKE 11 U.S.C. 506(C). ..........128
A. HARTFORD UNDERWRITERS INSURANCE CO. V. UNION PLANTERS BANK, 120 S. CT. 1942 (2000)
(SCALIA, J.) ..............................................................................................................................................128
i. Facts. ................................................................................................................................................128
ii. Holding ............................................................................................................................................128
iii. Unanswered Questions ...................................................................................................................129
iv.
Lessons Learned. .....................................................................................................................130
17. CAN COURTS GRANT DERIVATIVE STANDING TO PARTIES IN INTEREST TO BRING
AVOIDANCE ACTIONS? .......................................................................................................................130
A. OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF CYBERGENICS CORP., ON BEHALF OF
CYBERGENICS CORP., DEBTOR IN POSSESSION V. CHINERY,330 F.3D 548 (3D CIR. 2003), REPLACING 304
F.3D 316(3D CIR. 2002)(3-0), VACATED AND REHEARING EN BANC GRANTED, 310 F.2D 785 (3D CIR.,
2002)........................................................................................................................................................130
i. Facts. ................................................................................................................................................130
ii. Issue.................................................................................................................................................131
iii. Holding...........................................................................................................................................131
iv.
Bankruptcy Code Sections 506(c) and 544(b). ........................................................................131
v. Rationale......................................................................................................................................131
vi.
Reasons Cybergenics En Banc is Correct. ..............................................................................132
1. Defining the trustee may in section 544(b)(1) as only the trustee/debtor in possession may does not
resolve the question whether the trustee/debtor in possession may avoid a transfer by authorizing a creditors
committee to sue in the debtor in possessions name
. .................................................................... 132
2. Interpreting Section 544(b)(1) to Bar Derivative Actions, Renders Section 503(b)(3)(B) a Practical
Absurdity . ...................................................................................................................................................... 136
3. 11 U.S.C. 1123(b)(3) Does Not Support Barring Derivative Actions .................................................. 138
4. The Panel Decision in Cybergenics Violated the Rule of Statutory Construction in Midlantic National
Bank v. New Jersey Department of Environmental Protection, 474 U.S. 494 (1986), to Continue Pre-Code Law
Absent a Showing of Congressional Intent to Change It .
...................................................................... 140
5. The Panel Decision in Cybergenics Undermined Two Vital Congressional Policies
. ..................... 141
6. Barring Derivative Actions Would Violate the Rule of Construction in Dewsnup v. Timm, 502 U.S. 410
(1992), Under Which The Same Statutory Language Must Be Interpreted Differently In Two Provisions To
Continue Pre-Code Law Unless Congress Evidences An Intent To Change It . ............................................. 144

B.
SMART WORLD TECHNOLOGIES, LLC V. JUNO ONLINE SERVICES, INC. (IN RE SMART WORLD
TECHNOLOGIES, LLC), 423 F.3D 166 (2D CIR. 2005) ...............................................................................145
i. Facts ............................................................................................................................................145
ii. Issue .............................................................................................................................................147
iii.
Holding ....................................................................................................................................147
iv.
Rationale..................................................................................................................................147
C.
ACC BONDHOLDER GROUP V. ADELPHIA COMMUNICATIONS CORP. (IN RE ADELPHIA
COMMUNICATIONS CORP.), 361 B.R. 337 (S.D.N.Y. 2007) .....................................................................147
i. Facts ............................................................................................................................................147
ii. Issue .............................................................................................................................................148
iii.
Holding ....................................................................................................................................148
iv.
Rationale..................................................................................................................................148
v. Subsequent History ......................................................................................................................149

18. DOES A STATUTORY COMMITTEE REQUIRE COURT APPROVAL OR DEBTOR/TRUSTEE CONSENT TO

COMMENCE AN ADVERSARY PROCEEDING THE BANKRUPTCY CODE DOES NOT ASSIGN EXCLUSIVELY TO
THE TRUSTEE? ..........................................................................................................................................150
A.
Official Committee of Unsecured Creditors v. Halifax Fund, L.P. (In re Applied Theory
Corp.), 493 F.3d 82 (2d Cir. 2007) .....................................................................................................150
i.

Facts ........................................................................................................................................................ 150

ii. Holding ........................................................................................................................................150

iii.
Rationale..................................................................................................................................150
iv.

Analysis .............................................................................................................................................. 151

19. CAN CREDITORS COMMENCE DERIVATIVE ACTIONS WITHOUT CONSENT OR

COURT APPROVAL? .............................................................................................................................155
A. PW Enterprises, Inc. v. North Dakota Racing Commission (In re Racing Services, Inc.), 540 F.3d
892 (8th Cir. 2008) ...............................................................................................................................155
i.
ii.
iii.
iv.

B.

Facts ........................................................................................................................................................ 155

Issues ...................................................................................................................................................... 155
Holdings ............................................................................................................................................. 156
Analysis .............................................................................................................................................. 157

AFTER DERIVATIVE STANDING IS GRANTED, IT CAN BE TAKEN AWAY .......................................157

i. Official Committee of Equity Security Holders v. Official Committee of Unsecured Creditors (In
re Adelphia Communications Corp.), 544 F.3d 420 (2d Cir. 2008) ....................................................157
a)
b)
c)
d)

Facts ........................................................................................................................................................ 157

Issues ...................................................................................................................................................... 158
Holding ................................................................................................................................................... 158
Analysis .................................................................................................................................................. 159

C.
DOES THE TRANSFER OF A CLAIM RENDER THE TRANSFERREE VULNERABLE TO DEFENSES
PERSONAL TO THE TRANSFEROR? ............................................................................................................159
1. Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007),
motion for certification of interlocutory appeal denied, 2007 Dist. LEXIS 70731 (S.D.N.Y., Sept. 2,
2007)....................................................................................................................................................159
i.
ii.
iii.
iv.
v.

Facts ........................................................................................................................................................ 159

Issue ........................................................................................................................................................ 160
Holding ............................................................................................................................................... 160
Rationale............................................................................................................................................. 160
Analysis .................................................................................................................................................. 162

20. MUST A CHAPTER 11 PETITION BE FILED WITH A VALID REORGANIZATIONAL

PURPOSE? ................................................................................................................................................165
A.
OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. NUCOR CORP. (IN RE SGL CARBON
CORPORATION), 200 F.3D 154 (3D CIR. 1999)..........................................................................................165
i. Facts. ...........................................................................................................................................165
ii. Holding. .......................................................................................................................................166
iii.
Analysis....................................................................................................................................166
B.
SOLOW V. PPI ENTERPRISES (U.S.), INC. (IN RE PPI ENTERPRISES (U.S.), INC.) 324 F.3D 197 (3D
CIR. 2003) ................................................................................................................................................167
i. Facts ............................................................................................................................................167
ii. Issues ...........................................................................................................................................169
iii.
Holdings ..................................................................................................................................170
iv.
Rationale and Evaluation ........................................................................................................171
C.
NMSBPCSLDHB, L.P. V. INTEGRATED TELECOM EXPRESS, INC. (IN RE INTEGRATED TELECOM
EXPRESS, INC.), 384 F.3D 108 (3D CIR. 2004), REHEARING DENIED, 389 F.3D 423 (3D CIR. 2004)...........174
i. Facts. ...........................................................................................................................................174
ii. Issue .............................................................................................................................................175
iii.
Holding. ...................................................................................................................................175
iv.
Rationale..................................................................................................................................177
v. Analysis........................................................................................................................................177

vi

21. THE INTERFACE OF STATE LAW CORPORATE GOVERNANCE AND BANKRUPTCY

LAW ...........................................................................................................................................................178
A. ESOPUS CREEK VALUE LP V. MARKS, 913 A.2D 593 (DEL. CH. 2006) ................................................178
i. Facts .................................................................................................................................................178
ii. Issue .............................................................................................................................................179
iii.
Holding ....................................................................................................................................179
iv.
Rationale..................................................................................................................................180
v. Analysis........................................................................................................................................180
B.
NO FIDUCIARY DUTIES TO CREDITORS: NORTH AMERICAN CATHOLIC EDUCATIONAL
PROGRAMMING FOUNDATION, INC. V. GHEEWALLA, 930 A.2D 92 (DEL. 2007) .......................................182
i. Facts ............................................................................................................................................182
ii. Issue .............................................................................................................................................183
iii.
Holding ....................................................................................................................................183
iv.
Rationale..................................................................................................................................183
v. Aftermath .....................................................................................................................................185
vi.
What of the Trust Fund Doctrine? ...........................................................................................186
C.
DEEPENING INSOLVENCY: TRENWICK AMERICA LITIGATION TRUST V. ERNST & YOUNG, L.L.P.,
906 A.2D 168 (DEL. CH. 2006), AFFD TRENWICK AMERICA LITIGATION TRUST V. BILLETT, 2007 DEL
LEXIS 357 (DEL., AUG. 14, 2007) ...........................................................................................................187
i. Facts ............................................................................................................................................188
ii. Issues ...........................................................................................................................................188
iii.
Holding ....................................................................................................................................189
iv.
Rationale..................................................................................................................................190
v. But, Is Deepening Insolvency a Valid Damage Measure for Breach of a Director's Fiduciary
Duties of Care, Loyalty, or Good Faith? See Miller v. McCown DeLeeuw & Co. (In re The Brown
Schools), 386 B.R. 37 (Bankr. D. Del. 2008). ......................................................................................192
1.
2.
3.
4.

Facts ........................................................................................................................................................ 192

Issues ...................................................................................................................................................... 194
Holdings.................................................................................................................................................. 195
Analysis .................................................................................................................................................. 195

D.
LOAN TO OWN: OFFICIAL COMMITTEE OF UNSECURED CREDITORS OF RADNOR HOLDINGS CORP.
V. TENENBAUM CAPITAL PARTNERS (IN RE RADNOR HOLDINGS CORP.), 353 B.R. 820 (BANKR. D. DEL.
2006) 203
i. Facts ............................................................................................................................................203
ii. Issues ...........................................................................................................................................204
iii.
Holdings ..................................................................................................................................204
iv.
Rationale..................................................................................................................................204
22. CRITICAL VENDOR PAYMENTS OF PREPETITION CLAIMS: IN RE KMART CORP., 359
F.3D 866 (7TH CIR. 2004), REHEARING DENIED, 2004 U.S. APP. LEXIS 9050, (7TH CIR. MAY 6,
2004), CERT. DENIED, 2004 U.S. LEXIS 2649 (U.S., NOV. 15, 2004). ................................................208
i. Facts. ...........................................................................................................................................208
ii. Issues. ..........................................................................................................................................208
iii.
Holdings. .................................................................................................................................208
iv.
Rationale: ................................................................................................................................209
v. Analysis........................................................................................................................................210
(i) No Per Se Rule Barring Payment of Prepetition Debt with Court Approval ........................................... 210
(ii)
Acts to Collect Prepetition Debts May Be Automatic Stay Violations ............................................... 211
(iii)
Foreign Vendors Having No Minimum Contacts with United States ................................................. 211
(iv)
Procedure ............................................................................................................................................ 212
(v)
No Authority to Pay Unallowable Prepetition Claims ........................................................................ 212
(vi)
No Authority to Pay Prepetition Claims without Offsetting Benefit to Estate .................................... 213
(vii)
No Authority to Cross Collateralize Prepetition Debt with Postpetition Collateral without Offsetting
Benefit to Estate............................................................................................................................................... 213
(viii) Paying Prepetition Debt Does Not Violate Equitable Subordination Rules if the Unpaid Prepetition
Debt Benefits ................................................................................................................................................... 213
(ix) The Bankruptcy Code Allows Payment of Prepetition Debt in Numerous Instances ................................ 214

vii

(x)
(xi)

Prepetition Debt Can Not Be Paid without Court Approval ............................................................... 214
The Bankruptcy Codes Priority Scheme Includes Substantial Flexibility ......................................... 214

23. TO WHAT EXTENT CAN A DEBTOR IN POSSESSION INDEMNIFY ITS FINANCIAL

ADVISOR?.................................................................................................................................................215
A. IN RE UNITED ARTISTS THEATRE CO., 315 F.3D 217 (3D CIR. 2003) ...................................................215
1. Facts ............................................................................................................................................215
ii. Issue .............................................................................................................................................216
iii.
Holding ....................................................................................................................................216
iv.
Rationale..................................................................................................................................217
v. Consequences ..................................................................................................................................218
24. THE STAMP TAX EXEMPTION REQUIRES A PREVIOUSLY CONFIRMED CHAPTER 11
PLAN ..........................................................................................................................................................218
A. FLORIDA DEPARTMENT OF REVENUE V. PICCADILLY CAFETERIAS, INC., 554 U.S. ___ (2008) ...........218
i. Facts .................................................................................................................................................218
ii. Issue.................................................................................................................................................219
iii. Holding...........................................................................................................................................219
iv. Rationale.........................................................................................................................................219
v. The Dissent ..................................................................................................................................220
vi.
Analysis....................................................................................................................................220
vii.
Consequences ..........................................................................................................................221
viii. Prior Law.................................................................................................................................221
25. CAN CONFIRMATION NEGATE STAY RELIEF? ......................................................................222
A.

ATALANTA CORP. V. ALLEN (IN RE ALLEN), 300 F.3D 1055 (9TH CIR. 2002) ................................222
i. Facts ............................................................................................................................................222
ii. Holding ............................................................................................................................................223
iii. Rationale ........................................................................................................................................223
iv. Analysis...........................................................................................................................................223

26. CAN UNMATURED INTEREST BE ALLOWED AS DAMAGES UNDER AN INTEREST

RATE SWAP? ...........................................................................................................................................223
A.

THRIFTY OIL CO. V. BANK OF AMERICA, 310 F.3D 1188 (9TH CIR. 2002) .....................................223
i. Facts ............................................................................................................................................224
ii. Issue.................................................................................................................................................224
iii. Holding...........................................................................................................................................224
iv. Rationale.........................................................................................................................................225

27. IS GOOD FAITH TOO AMBIGUOUS A STANDARD? ................................................................225

A. IN RE CORAM HEALTHCARE CORP., 271 B.R. 228 (BANKR. D. DEL. 2001). ........................................225
i. Facts. ................................................................................................................................................225
ii. Holding ........................................................................................................................................227
iii.
Rationale..................................................................................................................................227
iv.
A Proper Application of Good Faith under Section 1129(a)(3)? ............................................228
B.
IN RE BIDERMANN INDUSTRIES U.S.A., INC., 203 B.R. 547 (BANKR. S.D.N.Y. 1997) .................229
i. Facts. ...........................................................................................................................................229
ii. Holdings. .....................................................................................................................................230
iii.
Should the Committee Have Broken Its Word? .......................................................................230
28. NATIONAL GYPSUM REVISITED: NEW NATIONAL GYPSUM COMPANY V. NATIONAL
GYPSUM COMPANY SETTLEMENT TRUST (IN RE NATIONAL GYPSUM COMPANY), 219
F.3D 478 (5TH CIR. 2000)(2 TO 1) ............................................................................................................231
I. FACTS. ...................................................................................................................................................231
II. HOLDINGS ............................................................................................................................................232
III. LESSONS LEARNED..............................................................................................................................233

viii

29. AVOIDANCE ACTIONS ARE PROPERTY OF NEITHER THE DEBTOR, NOR THE
DEBTOR IN POSSESSION, NOR THE ESTATE; BUT HOW ABOUT THEIR PROCEEDS? .....233
A. OFFICIAL COMMITTEE OF UNSECURED CREDITORS V. CHINERY (IN RE CYBERGENICS CORP.), 226 F.3D
237 (3D CIR. 2000). ..................................................................................................................................233
i. Facts. ...........................................................................................................................................233
ii. Holding ........................................................................................................................................234
iii.
What About Bankruptcy Code Section 541(a)(3)? ...................................................................234
B.
AVOIDANCE ACTIONS CAN ONLY BE BROUGHT TO BENEFIT CREDITORS ....................................235
30.

RELEASES OF NON-DEBTORS................................................................................................236

A.
THE GENERAL RULE.....................................................................................................................236
B. RES JUDICATA. ....................................................................................................................................237
C. IN RE INGERSOLL, INC., 562 F.3D 856 (7TH CIR. 2009)..........................................................................238
i. Facts ............................................................................................................................................238
ii. Issues ...........................................................................................................................................239
iii.
Holdings ..................................................................................................................................239
iv.
Rationale..................................................................................................................................240
v. Analysis........................................................................................................................................240
D.
AIRADIGM COMMUNICATIONS, INC. V. FEDERAL COMMUNICATIONS COMMISSION (IN RE
AIRADIGM COMMUNICATIONS, INC.), 519 F.3D 640 (7TH CIR. 2008) ........................................................241
i. Facts ............................................................................................................................................241
ii. Issues ...........................................................................................................................................242
iii.
Holdings ..................................................................................................................................242
iv.
Rationale..................................................................................................................................242
v. Analysis........................................................................................................................................244
E. TRAVELERS INDEMNITY CO. V. BAILEY, 129 S. CT. 2195 (2009) .....................................................244
i. Facts ............................................................................................................................................244
ii. Issues ...........................................................................................................................................245
iii.
Holdings ..................................................................................................................................245
iv.
Rationale..................................................................................................................................246
v. Does Travelers Implicitly Overrule Metromedia and Drexel Burnham? ....................................248
F. DEUTSCHE BANK, AG V. METROMEDIA FIBER NETWORK, INC. (IN RE METROMEDIA FIBER
NETWORK, INC.), 416 F.3D 136 (2D CIR. 2005) ........................................................................................249
i. Facts. ...........................................................................................................................................249
ii. Issue. ............................................................................................................................................249
iii.
Holding. ...................................................................................................................................250
iv.
Rationale..................................................................................................................................250
G. LACY V. DOW CORNING CORP. (IN RE DOW CORNING CORP.), 280 F.3D 648 (6TH CIR. 2002) ............250
i. Facts ............................................................................................................................................250
ii. Issue .............................................................................................................................................251
iii.
Holding ....................................................................................................................................251
iv.
Rationale..................................................................................................................................251
H.
GILMAN V. CONTINENTAL AIRLINES (IN RE CONTINENTAL AIRLINES), 203 F.3D 203 (3D CIR. 2000)
252
i. Facts ............................................................................................................................................252
ii. Holding ........................................................................................................................................252
iii.
Rationale..................................................................................................................................252
I. BRUNOS, INC. V. W.R. HUFF ASSET MANAGEMENT CO. (IN RE PWS HOLDING CORP.), 228 F.3D 224
(3D CIR. 2000)..........................................................................................................................................253
i. Facts ............................................................................................................................................253
ii. Holding ........................................................................................................................................253
iii.
Rationale..................................................................................................................................253
J. MONARCH LIFE INSURANCE CO. V. ROPES & GRAY, 65 F.3D 973 (1ST CIR. 1995). .........................254
i. Facts ............................................................................................................................................254

ix

ii. Holding. The confirmation order has collateral estoppel effect barring suits against Ropes &
Gray. Its ambiguity could have been litigated at confirmation. .........................................................255
K.
RESORTS INTERNATIONAL, INC. V. LOWENSCHUSS (IN RE LOWENSCHUSS), 67 F.3D 1394 (9TH CIR.
1995). 255
31. SUPERPRIORITY CLAIMS UNDER BANKRUPTCY CODE SECTION 507(B) HAVE MET
RESISTANCE; BUT HOW ABOUT NON-SUPER ADMINISTRATIVE CLAIMS? LNC
INVESTMENTS, INC. V. FIRST FIDELITY BANK, 247 B.R. 38 (S.D.N.Y. 2000) ...........................255
A. FACTS ..................................................................................................................................................255
B.
ISSUE ............................................................................................................................................255
C. HOLDING .............................................................................................................................................256
D. RATIONALE..........................................................................................................................................257
E. RATIONALE OR IRRATIONALE ..............................................................................................................258
F. SUBSEQUENT HISTORY: LNC INVESTMENTS, INC. V. NATIONAL WESTMINSTER BANK, 308 F.3D 169
(2D CIR. 2002), CERT. DENIED, 2003 U.S. LEXIS 3729 (2003) ................................................................260
i. Facts ............................................................................................................................................260
ii. Issue .............................................................................................................................................260
iii.
Holding ....................................................................................................................................260
32. AT ELECTROMAGNETIC LICENSE AUCTIONS, WHATS FOR SALE? .............................261
A.

FEDERAL COMMUNICATIONS COMMISSION V. NEXTWAVE PERSONAL COMMUNICATIONS, INC. (IN

RE NEXTWAVE PERSONAL COMMUNICATIONS, INC.), 200 F.3D 43 (2D CIR. 1999), CERT. DENIED, 121
S.CT. 298 (2000) ......................................................................................................................................261
i. Facts ............................................................................................................................................261
ii. Holding ........................................................................................................................................262
iii.
Rationale..................................................................................................................................262
iv.
Consequences of Holding ........................................................................................................263
B.
IN RE GWI PCS 1 INC., 230 F.3D 788 (5TH CIR. 2000) ..................................................................263
i. Facts ............................................................................................................................................263
ii. Holding ........................................................................................................................................263
iii.
Rationale..................................................................................................................................264
C.
FEDERAL COMMUNICATIONS COMMISSION V. NEXTWAVE PERSONAL COMMUNICATIONS INC., 537
U.S. 293, 123 S. CT. 832 (2003)(8-1), AFFIRMING, 254 F.3D 130 (D.C. CIR. 2001)..................................264
i. Bankruptcy Code section 525(a) provides:..................................................................................264
ii. History Subsequent to 200 F.3d 43 (2d Cir. 1999), cert. denied, 121 S.Ct. 298 (2000) ..............265
iii.
Holding ....................................................................................................................................265
33. PURCHASING DISTRESSED DEBT CLAIMS WITH INTENT TO PROSECUTE THEM IS
STILL LEGAL ELLIOTT ASSOCIATES, L.P. V. BANCO DE LA NACION, 194 F.3D 363 (2D
CIR. 1999) ..................................................................................................................................................267
I.
II.
III.
IV.

FACTS...............................................................................................................................................267
ISSUE ................................................................................................................................................267
HOLDING ......................................................................................................................................268
RATIONALE ..................................................................................................................................268

34.
LESSONS FROM A FAILED LIMITED FUND SETTLEMENT CLASS ACTION ORTIZ
V. FIBREBOARD CORP., 119 S. CT. 2295 (1999) ................................................................................269
I.
II.
III.

FACTS...............................................................................................................................................269
HOLDING ..........................................................................................................................................271
RATIONALE ..................................................................................................................................271
(a)
Historical Limited Fund Mandatory Class Actions .................................................................271
(b)
Criteria for Limited Fund Class Actions under Fed. R. Civ. P. 23(b)(1)(B). ..........................271
(c)
Potential Constitutional Impediments to Application of Fed. R. Civ. P. 23 (b)(1) to Mass Torts
272
(d)
Causes of Reversal...................................................................................................................272
iv.
Certain Unanswered Questions ...............................................................................................276

V.

i.
ii.

POTENTIAL APPLICATIONS OF FIBREBOARD .....................................................................................277

Companies for which Chapter 11 Is Not a Solution or Is Too Dangerous ..................................277
Use of Fed. R. Civ. P. 23(b)(1)(B) in place of Chapter 11? ........................................................277

35. CAN SINGLE ASSET CASES BE CONFIRMED OVER AN UNDERSECURED LENDER'S

REJECTION, OR NOT? ..........................................................................................................................278
A. IMPACT OF BANKRUPTCY ABUSE PREVENTION AND CONSUMER PROTECTION ACT OF 2005 FOR CASES
COMMENCED ON AND AFTER OCTOBER 17, 2005 .....................................................................................278
i. 11 U.S.C. 362(d)(3) provides: ..................................................................................................278
ii. Consequences of 11 U.S.C. 362(d)(3) .......................................................................................279
B.
WHICH CASES CANNOT BE CONFIRMED?.....................................................................................279
i. Potential Treatments of Secured Claims. ....................................................................................279
ii. Potential Treatments of Unsecured Claims. ................................................................................280
C.
CAN THE MORTGAGEE'S UNSECURED DEFICIENCY CLAIM BE SEPARATELY CLASSIFIED? ...........281
D.
WHEN SEPARATE CLASSIFICATION IS ALLOWED, UNFAIR DISCRIMINATION IS NOT. ...................283
E. WHEN THE OBSTACLES OF SEPARATE CLASSIFICATION AND UNFAIR DISCRIMINATION ARE
OVERCOME, THE NEW VALUE OBSTACLE REMAINS. ...............................................................................284
F. HAVE YOU THOUGHT ABOUT BANKRUPTCY CODE SECTION 1111(B)(1)(A)(II) LATELY? CRAMDOWN
ATTORNEYS HAVE. ..................................................................................................................................287
i. Bankruptcy Code Section 1111(b)(1)(A)(ii) provides:.................................................................287
ii. The Issue ......................................................................................................................................288
a)
b)

iii.
a)

Background. ............................................................................................................................................ 288

Sword and Shield Uses of 1111(b)(1)(A)(ii) ........................................................................................ 288

Mortgagor Cannot Gamble with Mortgagee's Collateral. ......................................................289

The Mortgagee Can Credit Bid its Deficiency Claim. ............................................................................ 290

iv.

No Credit Bidding after Electing 1111(b)(2). .......................................................................291

BANK OF AMERICA V. 203 NORTH LASALLE STREET PARTNERSHIP, 119 S. CT. 1411 (1999) ......292
i. Facts. ...........................................................................................................................................292
ii. Holding ........................................................................................................................................292
iii.
Rationale..................................................................................................................................294
iv.
How Does North LaSalle Work? .............................................................................................295
v. Aftermath In North LaSalle .........................................................................................................295
H.
THE ANSWER................................................................................................................................296
G.

36. PREJUDGMENT ATTACHMENT, AS AN EQUITABLE REMEDY, IS BEYOND THE

FEDERAL COURTS POWER ...............................................................................................................297
36. GRUPO MEXICANO V. ALLIANCE BOND FUND, 527 U.S. 308 (1999) (5-4) ..........................297
i. Facts. ...........................................................................................................................................297
ii. Holding. .......................................................................................................................................297
iii.
Rationale..................................................................................................................................297
iv.
Consequences ..........................................................................................................................298
37. CAN A CHAPTER 11 DEBTOR IN POSSESSION ASSUME AN EXECUTORY CONTRACT
IF IT CANNOT ASSIGN IT?...................................................................................................................298
A. BANKRUPTCY CODE SECTION 365(C)(1) PROVIDES: ............................................................................298
B.
BANKRUPTCY CODE SECTION 365(F)(1) PROVIDES:......................................................................299
C.
PERLMAN V. CATAPULT ENTERTAINMENT, INC. (IN RE CATAPULT ENTERTAINMENT, INC.), 165
F.3D 747 (9TH CIR. 1999) ..........................................................................................................................299
i. Facts ............................................................................................................................................299
ii. Holding ........................................................................................................................................299
iii.
Rationale and Irrationale ........................................................................................................299
B.
IN RE FOOTSTAR, INC., 323 B.R. 566 (BANKR. S.D.N.Y. 2005) ...................................................301
i. Facts. ...........................................................................................................................................301
ii. Issue. ............................................................................................................................................301
iii.
Holding. ...................................................................................................................................301
iv.
Rationale..................................................................................................................................301

xi

C.
BONNEVILLE POWER ADMINISTRATION V. MIRANT CORP. (IN RE MIRANT CORP.), 440 F.3D 238
(5TH CIR. 2006)........................................................................................................................................302
i. Facts ............................................................................................................................................302
ii. Issue .............................................................................................................................................302
iii.
Holding ....................................................................................................................................303
iv.
Rationale..................................................................................................................................303
D.
WHEN FAILURE OF ADEQUATE ASSURANCE VALIDLY DEFEATS ASSIGNMENT: IN RE FLEMING
COMPANIES, INC.), 499 F.3D 300 (3D CIR. 2007) .....................................................................................304
i. Facts ............................................................................................................................................304
ii. Issues ...........................................................................................................................................304
iii.
Holdings ..................................................................................................................................304
iv.
Implications .............................................................................................................................305
38.

DEVAN V. SIMON DEBARTOLO GROUP, 180 F.3D 149 (4TH CIR. 1999). .........................305
i. Facts. ...........................................................................................................................................305
ii. Holding. .......................................................................................................................................306
iii.
Dangerous Dictum about Rejection .........................................................................................306

xii

1. Section 363 Sales Free and Clear v. Sub Rosa Chapter 11 Plans
A. Indiana State Police Pension Trust v. Chrysler LLC (In re
Chrysler LLC), ___ F.3d ___ (2d Cir., August 5, 2009)
i.

Facts

Chrysler commenced its chapter 11 case on April 30, 2009 with a proposal
to sell, pursuant to Bankruptcy Code section 363, substantially all its operating
assets (including manufacturing plants, brand names, certain dealer and supplier
relationships, etc.) to New Chrysler in exchange for New Chryslers assumption
of certain liabilities and $2 billion cash. Slip op. at 7-8. The bankruptcy court
approved the sale by order dated June 1, 2009. Slip op. at 9.
The United States Court of Appeals for the Second Circuit affirmed on
June 5, 2009, but entered a short stay pending Supreme Court review. The
Supreme Court extended the stay, but declined a further extension and the sale
closed on June 10, 2009. Slip op. at 9.
Under the sale, [n]ot one penny of value of the Debtors assets is going
to anyone other than the First Lien Lenders. Slip op. at 25. [A]ll the equity
stakes in New Chrysler were entirely attributable to new value including
governmental loans, new technology, and new management which were not
assets of the debtors estate. Slip op. at 25. The linchpin of [the bankruptcy
courts] analysis was that the only possible alternative to the Sale was an
immediate liquidation that would yield far less for the estate and for the
objectors. Slip op. at 25-26.
New Chryslers membership interests were 55% to an employee benefit
entity created by the United Auto Workers union, 8% to the United States
Treasury, and 2% to Export Development Canada. Slip op. at 8. Fiat, for its
contributions, would immediately own 20% of the equity with rights to acquire
more (up to 51%), contingent on payment in full of the debts owed to the United
States Treasury and Export Development Canada. Slip op. at 8-9. Fiat had
conditioned its commitment on the Sale being completed by June 15, 2009.
While this deadline was tight and seemingly arbitrary, there was little leverage to
force an extension. Slip op. at 27. The union employees would be working
under new union contracts containing a six-year no-strike provision. Slip op. at
28.
ii.

Issues

1. Is the sale an impermissible sub rosa plan, unapprovable under

Bankruptcy Code section 363?

2. Does the sale conform to Bankruptcy Code section 363(f)? Does the
Sale impermissibly [subordinate the Indiana Pensioners] interests as
secured lenders and [allow] assets on which they have a lien to pass
free of liens to other creditors and parties, in violation of 363(f)? Slip
op. at 10.
3. Is it constitutional to use TARP funds to finance the sale?
4. Can the sale be made free and clear of present and future tort and
asbestos claims?
iii.

Holdings

1. No. On this record, and in light of the arguments made by the parties,
the bankruptcy courts approval of the Sale was no abuse of discretion.
With its revenues sinking, its factories dark, and its massive debts
growing, Chrysler fit the paradigm of the melting ice cube. Going
concern value was being reduced each passing day that it produced
no cars, yet was obliged to pay rents, overhead, and salaries.
Consistent with an underlying purpose of the Bankruptcy Code
maximizing the value of the bankrupt estate it was no abuse of
discretion to determine that the Sale prevented further, unnecessary
losses. See Toibb v. Radloff, 501 U.S. 157,163 (1991) (Chapter 11
embodies the general [Bankruptcy] Code policy of maximizing the
value of the bankruptcy estate.). Slip op. at 27-28.
2. [T]he secured lenders have consented to the Sale, as per 363(f)(2).
Slip op. at 10.
3. We conclude that the Indiana Pensioners lack standing to raise this
challenge to the use of TARP funds. Slip op. at 10.
4. The sale was legally approved free and clear of tort claims. Because
appellants claims arose from Old Chryslers property, 363(f)
permitted the bankruptcy court to authorize the Sale free and clear of
appellants interest in the property. Slip op. at 49-50. This includes
present asbestos claims. Bankruptcy Code section 524(g) only applies
to a chapter 11 plan, and the sale order did not violate it. Slip op. at
51. In respect of whether the sale order legally approved the transfer
of assets free of future asbestos claims: We affirm this aspect of the
bankruptcy courts decision insofar as it constituted a valid exercise of
authority under the Bankruptcy Code. However, we decline to
delineate the scope of the bankruptcy courts authority to extinguish
future claims, until such time as we are presented with an actual claim
for an injury that is caused by Old Chrysler, that occurs after the Sale,
2

and that is cognizable under state successor liability law. Slip op. at
52.
iv.

Rationale

Thus a 363(b) sale may well be a reorganization in effect without

being the kind of plan rejected in Braniff. See, e.g., Fla. Dept of Revenue v.
Piccadilly Cafeterias, Inc., 128 S. Ct. at 2330 n.2. Slip op. at 23-24. Braniff
rejected a proposed transfer agreement in large part because the terms of the
agreement specifically attempted to dictat[e] some of the terms of any future
reorganization plan. The [subsequent] reorganization plan would have to
allocate the [proceeds of the sale] according to the terms of the [transfer]
agreement or forfeit a valuable asset. Slip op. at 22 (brackets in original).
Braniffs holding did not support the argument that a 363(b) asset sale must be
rejected simply because it is a sale of all or substantially all of a debtors assets.
Thus a 363(b) sale may well be a reorganization in effect without being the kind
of plan rejected in Braniff.9 Slip op. at 9 & n.9 (n9: The transaction at hand is
as good an illustration as any. Old Chrysler will simply transfer the $2 billion in
proceeds to the first lien lenders, and then liquidate. The first lien lenders
themselves will suffer a deficiency of some $4.9 billion, and everyone else will
likely receive nothing from the liquidation. Thus the Sale has inevitable and
enormous influence on any eventual plan of reorganization or liquidation. But it
is not a sub rosa plan in the Braniff sense because it does not specifically
dictate, or arrange ex ante, by contract, the terms of any subsequent plan.).
Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722
F.2d 1063, 1069 (2d Cir. 1983), reject[ed] the requirement that only an
emergency permits the use of 363(b). Slip op. at 14. Lionel required a
good business reason for a 363(b) transaction. Slip op. at 15.
As 363(b) sales proliferate, the competing concerns identified in Lionel
have become harder to manage. Debtors need flexibility and speed to preserve
going concern value; yet one or more classes of creditors should not be able to
nullify Chapter 11s requirements. A balance is not easy to achieve, and is not
aided by rigid rules and prescriptions. Lionels multi-factor analysis remains the
proper, most comprehensive framework for judging the validity of 363(b)
transactions. Slip op. at 21.
v.

Analysis

The term sub rosa plan has taken on two meanings. The original
meaning was shown in Pension Benefit Guaranty Corp. v. Braniff Airways, Inc.
(In re Braniff Airways, Inc.), 700 F.2d 935 (5th Cir. 1983), to be a sale transaction
that also included distributions of sale proceeds which would otherwise be
distributed in a chapter 11 plan. In Braniff, the appellate court held the
3

transaction was illegal because it included at least three elements outside the
scope of section 363, which would otherwise be subject to the Bankruptcy
Codes confirmation requirements. They were the requirements that: (a) Braniff
pay $2.5 million to the buyer for travel scrip which had to be distributed to former
Braniff employees or shareholders, (b) the secured lenders vote a portion of their
deficiency claim in favor of any future plan secured approved by a majority of the
creditors committee, and (c) all parties release Braniff, its secured lenders, and
its officers and directors. Braniff, 700 F.2d at 939-940. In Motorola, Inc. v.
Official Committee of Unsecured Creditors (In re Iridium Operating LLC), 478
F.3d 452 (2d Cir. 2007), a settlement between the debtor and the secured
lenders provided for left over funds for litigation, if any, to be distributed to
unsecured claimholders, rather than be available for unpaid administrative
claims. 478 F.3d at 459-460. At the time of the settlement, however, it was still
unclear whether there would be unpaid, allowed administrative claims. 478 F.3d
at 464. Therefore, the court declined to hold the bankruptcy court cannot
approve a settlement outside a plan, which settlement may violate the
Bankruptcy Codes distribution scheme. 478 F.3d at 464. Rather, the court
ruled: In the Chapter 11 context, whether a settlements distribution plan
complies with the Bankruptcy Codes priority scheme will often be the dispositive
factor. However, where the remaining factors weigh heavily in favor of approving
a settlement, the bankruptcy court, in its discretion, could endorse a settlement
that does not comply in some minor respects with the priority rule if the parties to
the settlement justify, and the reviewing court clearly articulates the reasons for
approving, a settlement that deviates from the priority rule. 478 F.3d at 465.
The second meaning of sub rosa plan has been a transaction that does
not distribute proceeds in lieu of a chapter 11 plan distribution, but disposes of a
crown jewel asset that may restrict the type of chapter 11 plan that must result.
See, e.g., Richmond Leasing co. v. Capital Bank, N.A., 762 F.2d 1303, 13121313 (5th Cir. 1985)(affirmed assumption of amended lease creating large
administrative claims based on valid exercise of debtors business judgment,
while cautioning that assumption and other factors could sometimes create sub
rosa plan) ; Inst. Creditors of Continental Air Lines, Inc. v. Continental Air Lines,
Inc. (In re Continental Air Lines, Inc.), 780 F.2d 1223 (5th Cir. 1986). In
Continental, the appellate court reversed the bankruptcy courts approval of the
debtor entering into leases of two large aircraft because the court had not
considered whether the objecting creditors would have been able to block the
leases if proposed in a chapter 11 plan. 780 F.2d at 1227-1228.
In Chrysler, the section 363 transaction included (a) the distribution of
sale proceeds to the first lien holders, rather than simply have the liens attach to
the proceeds, which distribution clearly eliminated the estates use of the funds
(subject to adequate protection requirements) for reorganization, and (b) the
payment of prepetition, unsecured trade debt. The objectors to the Chrysler
transaction did not raise either of these features in their objections, but they
clearly rendered the transaction a partial sub rosa plan.

The appellate courts deferral of its review of the enforceability of the sale
orders provision that the sale was free of successor liability for future claims,
sets up an interesting dynamic. When and if a claimant asserts a future claim
against the buyer, the buyer may attempt to enforce the sale order in the
bankruptcy court which issued it by suing the claimant for contempt of the
injunction in the sale order. Alternatively, the claimant may start out by
requesting relief from the injunction in the bankruptcy court. The bankruptcy
court will presumably have little choice but to enforce the order. The district court
and Second Circuit will then determine whether the order can be collaterally
attacked and, if so, whether it was valid. Travelers Indemnity Co. v. Bailey, 129
S. Ct. 2195 (2009), certainly creates a question as to whether the order can be
collaterally attacked.

2.
The Bankruptcy Code Does Not Per Se Disallow Prepetition Claims
for Attorneys Fees Incurred Litigating Postpetition Bankruptcy Issues
A.
Travelers Casualty & Surety Co. of America v. Pacific Gas &
Electric Co., 549 U.S. 443 (2007)
i. Facts.
Prepetition, PG&E had indemnified Travelers for the surety bonds
Travelers issued guaranteeing PG&Es payment of state workers compensation.
Pursuant to the indemnity agreements, PG&E was liable for any loss Travelers
incurs in connection with the bonds, including attorneys fees incurred in
pursuing, protecting, or litigating Travelers rights in connection with those bonds.
Travelers Casualty & Surety Co. of America v. Pacific Gas & Electric Co., 127 S.
Ct. 1199, 1202 (2007).
With bankruptcy court approval, PG&E agreed to include in its chapter 11
plan language protecting Travelers rights to indemnity and subrogation in the
event of a default by PG&E. But, PG&E and Travelers ended up litigating the
protective language and then settling the litigation in a bankruptcy court approved
stipulation. Id. at 1202-1203.
Travelers filed an amended proof of claim seeking to recover the
attorneys fees it incurred in connection with PG&Es chapter 11 case. PG&E
objected arguing on the basis of In re Fobian, 951 F.2d 1149 (9th Cir. 1991), that
Travelers can not recover attorneys fees incurred litigating issues of bankruptcy
law. Id. at 1203. The bankruptcy court, district court, and Ninth Circuit Court of
Appeals agreed those fees were not allowable claims in bankruptcy. Id.

Fobian was in conflict with the Fourth Circuits decision in In re ShangraLa, Inc., 167 F.3d 843, 848-849 (4th Cir. 1999).
ii. Issue
We are asked to consider whether federal bankruptcy law precludes an
unsecured creditor from recovering attorneys fees authorized by a prepetition
contract and incurred in postpetition litigation. Id. at 1202.
This case requires us to consider whether the Bankruptcy Code disallows
contract-based claims for attorneys fees based solely on the fact that the fees at
issue were incurred litigating issues of bankruptcy law. Id. at 1204.
iii. Holding
We conclude that it does not. Id.
Accordingly, we express no opinion with regard to whether, following the
demise of the Fobian rule, other principles of bankruptcy law might provide an
independent basis for disallowing Travelers claim for attorneys fees. We
conclude only that the Court of Appeals erred in disallowing that claim based on
the fact that the fees at issue were incurred litigating issues of bankruptcy law.
Id. at 1207-1208.
iv. Rationale
Pursuant to 11 U.S.C. 502(b), when a party in interest objects to a claim,
the court shall allow the claim except to the extent that the claim implicates
any of the nine exceptions enumerated in 502(b). Id. at 1204 (quoting from 11
U.S.C. 502(b)).
Section 502(b)(1) is most naturally understood to provide that, with limited
exceptions, any defense to a claim that is available outside of the bankruptcy
context is also available in bankruptcy. Id. at 1204. This reading of
502(b)((1) is consistent not only with the plain statutory text, but also with the
settled principle that [c]reditors entitlements in bankruptcy arise in the first
instance from the underlying substantive law creating the debtors obligation,
subject to any qualifying or contrary provisions of the Bankruptcy Code. Raleigh
v. Illinois Dept. of Revenue, 530 U.S. 15, 20 (2000). Id. at 1205
Indeed, we have long recognized that the basic federal rule in
bankruptcy is that state law governs the substance of claims, Congress having
generally left the determination of property rights in the assets of a bankrupts
estate to state law. Ibid. (quoting Butner v. United States, 440 U.S. 48, 57, 54

(1979); citation omitted). Accordingly, when the Bankruptcy Code uses the word
claim which the Code itself defines as a right to payment, 11 U.S.C.
101(5)(A)it is usually referring to a right to payment recognized under state
law. As we stated in Butner, [p]roperty interests are created and defined by
state law, and [u]less some federal interest requires a different result, there is no
reason why such interests should be analyzed differently simply because an
interested party is involved in a bankruptcy proceeding. 440 U.S., at 55; Id.
at 1205.
In Travelers, the lower courts did not conclude Travelers claim was
rendered unenforceable by any Bankruptcy Code provision. Id. at 1205.
11 U.S.C. 502(b)(4) disallows a particular category of attorneys fees,
which suggests that other categories are allowed. Id. at 1206.
B.
Violation of Travelers? National Energy & Gas Transmission,
Inc. v. Liberty Electric Power, LLC (In re National Energy & Gas
Transmission, Inc.), 492 F.3d 297 (4th Cir. 2007), rehearing denied
(August 6, 2007)
i.

Facts

Liberty had a prepetition energy contract (the Agreement) with National

Energy & Gas Transmission Energy Trading Power, L.P. (ET Power).
To back up ET Powers financial obligations under the Agreement, Liberty
also procured guaranties from ET Powers corporate parent, National Energy
& Gas Transmission, Inc. (NEGT) and from an NEGT subsidiary, Gas
Transmission Northwest Corporation (GTN). The guaranties guaranteed
payment of all amounts payable by [ET Power] under the Agreement,
subject to a cap of $140 million. 492 F.3d at 299.
ET Power and NEGT commenced chapter 11 cases and ET Power
rejected the Agreement. Liberty received an arbitral award of $140 million
plus, among other things, interest from the date of rejection. The postpetition
interest approximated $17 million. NEGT sold GTN during the arbitration
proceedings. To facilitate the closing, $140 million was first escrowed and
then paid to Liberty to satisfy the GTN guaranty and to stop interest from
further accruing. Id. at 300.
Liberty allocated the $140 million first to interest and then to principal,
thereby leaving unpaid approximately $17 million of principal. Then, Liberty
asserted against ET Power a claim of $140 million, subject to the limitation
that it could not collect more than the $17 million of principal to make it whole.
As a practical matter, Liberty made this allocation because it knew that
Bankruptcy Code section 502(b)(2) bars Liberty from having an allowable
7

claim against ET Power for the $17 million of postpetition interest. Id. at 300.
Therefore, by collecting the postpetition interest from GTN, it left principal
unpaid.
ii.

Issues

We initially consider the debtors contention that the value of Libertys

claim must be reduced by the $140 million it received from GTN in order to reflect
accurately the amount currently owed to Liberty. Because Liberty is currently
owed only approximately $17 million, the debtors argue its claim should be
limited to this amount. Id. at 300-301.
We next turn to the more fundamental question presented by this appeal:
whether the Bankruptcy Code bars Liberty from collecting the $17 million it now
seeks. Id. at 301.
iii.

Judgments

The debtors argument is foreclosed by the combination of Ivanhoe

Building & Loan Assn of Newark v. Orr, 295 U.S. 243 (1935), and New York law,
which governs pursuant to the Agreement. In Ivanhoe, the Supreme Court held
that a creditor need not deduct from his claim in bankruptcy an amount received
from a non-debtor third party in partial satisfaction of an obligation. Thus, as a
matter of bankruptcy law, ET Powers debt to Liberty is not reduced by the
amount which Liberty received from GTN. Id. at 301. Under N.Y. Gen. Oblig. L.
15-103, GTN was a surety for ET Powers obligations to Liberty.
Accordingly, the value of ET Powers debt to Liberty under state law is not
reduced by the $140 million received from GTN. Id. at 301.
The Primary Decision (Circuit Judge Shedds opinion) agrees that Liberty
can classify GTNs payment as interest. (Liberty is free to classify GTNs
payment as interest Id. at 303n.5). But, the Primary Decision holds that
Libertys classification of the GTN payment as interest is not binding on ET
Power. (We merely hold that Liberty may not affect the rights of a party in
bankruptcy by its classification of a payment received from a non-debtor
guarantor. Id. at 303n.5).
[W]e conclude that 502(b)(2) prevents Liberty from collecting the
additional $17 million which it seeks from the estate. Id. at 303.
Judge Duncan dissented. Id. 304-306. It is uncontested, he stressed, that
Section 502(b)(2) has no impact on the accrual of unmatured interest against . .
. non-debtor guarantors. Id. at 304. The lead opinions construction of this
provision, however, limited the non-debtor guarantors liability for interest: the
majority would have the bar to recovery of interest from the debtor swallow the
8

accrual of interest on the debt across all parties liable for it. Id. 305. Not only is
there no provision in the Bankruptcy Code demanding this result, the dissent
observed, but it is contradicted by Section 524(e) of the Code, which provides
that the discharge of a debt of the debtor does not affect the liability of any other
entity on . . . such debt. 11 U.S.C. 524(e).
iv.

Rationale

The Primary Decision reasons that principles of equity, id. at 302, require
it to apply Bankruptcy Code section 502(b)(2) by disregarding Libertys
classification of GTNs payment: The 502(b)(2) bar to collection of interest is
not overcome by Libertys classification of the $17 million it now seeks as
principal.Because ET Powers debt was capped at $140 million by the filing of
the bankruptcy petition and because the debt was increased only by the accrual
of interest pursuant to the arbitration award, we view Libertys claim for an
additional $17 million as disallowed post-petition interest no matter how Liberty
chooses to classify it. Id. at 302-303.
Notably, no decision contends the bankruptcy court was clearly erroneous
in characterizing Libertys claim as a claim for principal.
v.

Analysis and Implications

1. The Judgments Reliance on principles of equity
Does Not Identify the Equity Accomplished
because There is None

Vanston Bondholders Protective Committee v. Green, 329 U.S. 156, 158

(1946)(cited in the Primary Decision), made clear it was disallowing a claim for
interest on interest because the claims allowance would leave less assets for
other creditors. Here, no such equity exists and the decisions identify none.
Rather, the judgment creates a windfall for GTN based on no identified policy or
purpose. Indeed, it appears the decisions here do not even recognize that they
have no impact on the debtor, but simply injure Liberty to bestow a windfall on
GTN.
1. Liberty undisputably held a $140 million allowable claim for principal
against ET Power and a claim for postpetition interest unallowable
pursuant to 11 U.S.C. 502(b)(2).
2. ET Power was liable to make a ratable distribution to Liberty on the $140
million principal claim.
3. Because Liberty was already paid $140 million by GTN, GTN inherited the
right to procure reimbursement from ET Power by way of indemnity or
subrogation. See 11 U.S.C. 502(e) and 509.

4. If GTNs payment to Liberty is characterized as $140 million of principal,

then GTN has an allowable indemnity or subrogation claim against ET
Power for $140 million.
5. If GTNs payment to Liberty is characterized as $123 million of principal
and $17 million of postpetition interest, then:
a. Liberty has a $140 million claim against ET Power; but
b. By way of indemnity or subrogation, GTN inherits from Liberty, all
distributions it receives from ET Power in excess of $17 million.
6. Under both number 4 and 5 above, ET Power makes the same distribution
in respect of a $140 million claim for principal. Therefore, neither ET
Power nor its creditors are burdened with any distribution for postpetition
interest. Thus, there is no equity that compels number 4 over number 5
because there is NO impact whatsoever on the ET Power estate.
7. The difference between numbers 4 and 5 only impacts GTN and Liberty.
a. Under number 4, GTN obtains reimbursement (through indemnity
or subrogation) equal to ET Powers ratable distribution on a claim
for $140 million.
b. Under number 5, GTN obtains reimbursement equal to ET Powers
ratable distribution on a claim for $140 million LESS $17 million
that goes to Liberty.
8. Accordingly, the judgment makes ET Powers and its creditors, no better
off and no worse off. Rather, it makes GTN, as guarantor, $17 million
better off while depriving Liberty of $17 million of postpetition interest that
GTN guaranteed.
9. The judgment does no equity. Instead, it impairs commercial credit
enhancement by depriving Liberty of one of the two benefits it bargained
for by having a guaranty of all obligations whether allowable against ET
Power or not. The judgment is simply a windfall to GTN. It guaranteed
postpetition interest, but can get reimbursement from ET Power as if it did
not.
Significantly, the decisions at bar identify neither any equity served nor
which factors to take into account. The most important equity would presumably
be the impact on the debtors estate. But, there is no impact. Are we to take into
account how well Liberty does on its guaranties? If so, why? Liberty is not in the
same position as creditors without guaranties. Are we to take into account the
amount of reimbursement of a nondebtor (GTN)? If so, why? The imposition of
unidentified equity here renders the judgment a cloud over the enforcement of
commercial guaranties because there is no logic that can give rise to predictable
results. Put differently, every panel looking at the issue could come out
differently due to the absence of any articulated principles on which to apply
equity.
2. The Judgment Yields Illogical and Absurd
Consequences Demonstrating its Fallacy

10

Libertys guaranty from GTN was of all amounts payable by ET Power

under the Agreement. It is undisputed this included principal and interest. The
judgment, however, deems Liberty to have collected all principal from GTN even
though Liberty exercised its contract right to allocate some of GTNs payment to
interest.
Lets consider a slightly different guaranty. Lets assume Liberty did
business with ET Power and with XYZ Corp, and GTN guaranteed their
respective obligations to Liberty up to a maximum of $140 million in the
aggregate. When ET Power commenced its bankruptcy case, ET Power owed
Liberty $140 million and XYZ Corp. owed Liberty $140 million. GTN paid Liberty
$140 million and Liberty allocated the amount to XYZ Corp.s obligation. Next,
Liberty asserts its $140 million claim against ET Power. Is there any basis to tell
Liberty it must allocate GTNs payment to ET Powers obligation and not to XYZ
Corp.s obligation? Of course not.
When Liberty has the right to allocate GTNs payment to interest there is
no basis to eliminate that contract right, especially without compensation.
Now, lets assume Libertys guaranty from GTN were SOLELY for interest.
In that situation, neither Judge Shedd nor Judge Wilson could argue Liberty was
endrunning section 502(b)(2) by asserting a principal claim against ET Power.
Thus, Liberty would be allowed to assert a $140 million principal claim against ET
Power if its guaranty from GTN were solely for interest. But, according to the
judgment, the instant guaranty of principal AND interest deprives Liberty of its
right to assert any principal claim against ET Power. How can a better guaranty
(guaranty of principal and interest) from a nondebtor give Liberty lesser rights
against its primary obligor than it would have with an inferior guaranty (guaranty
of interest only)?
3. The Judgment Resulted from Arbitrary
Sequencing.
Yet another means to show the illogic of the judgment is to consider its
dependence on Libertys sequencing of its claim collections. As conceded by all
the decisions, Liberty had an allowable claim against ET Power in the amount of
$140 million as of the first day of ET Powers chapter 11 case. All the decisions
also concede Liberty has the right to assert its full $140 million claim against ET
Power and each guarantor, so long as it does not collect in the aggregate more
than the full amount of its claim.
If Liberty had proceeded against ET Power before collecting from GTN,
there would be no basis to hold that ET Power did not have to provide Liberty
with a ratable distribution on its $140 million claim. Then, Liberty would be free
to collect from GTN all principal it did not receive from ET Power (i.e,, ET Power
may distribute less than 100 cents on the dollar) and all postpetition interest.
But, according to the judgment at bar, Libertys rights to collect full principal and
11

interest change if Liberty collects $140 million first from GTN. Manifestly,
Libertys rights of collection can not rationally or validly be impacted based on
whether it collects first from ET Power or first from GTN. But, the judgment is
totally dependent on the sequencing.
4. The Judgment Undermines Public Policy
Guaranties are a standard form of credit enhancement in the world of
commercial finance. Entities that are not themselves creditworthy, frequently
obtain credit when the lender can obtain a guaranty. Similarly, guaranties reduce
the cost of credit because they reduce the risk of loss. Equally obvious is that
interest is an essential component of credit because no lender can afford to lend
money for no return.
C. Travelers and 11 U.S.C. 1123(d) Support Default Rate Interest in
General Electric Capital Corp. v. Future Media Productions Inc., 536
F.3d 969 (9th Cir. 2008)
i.Facts
When the debtor commenced its chapter 11 case, GECC was an
oversecured creditor and its credit agreement provided that contract interest
would increase by 2 percentage points after default. 536 F. 3d at 971. The
debtor sold the collateral pursuant to 11 U.S.C. 363 prior to any chapter 11
plan. The proceeds inclusive of default interest and all fees were paid to GECC,
subject to the statutory creditors' committee's rights to litigate GECC's entitlement
to default interest and attorneys' fees. 536 F.3d at 972.
The bankruptcy court disallowed default interest based on In re EntzWhite Lumber and Supply, Inc., 850 F.2d 1338 (9th Cir. 1988), and disallowed
attorneys' fees because GECC lost the litigation. 536 F.3d at 972.
ii. Issues
Does the Entz-White rule disallowing default interest on obligations reinstated
under a chapter 11 plan with defaults cured, apply to preplan sales, and if not,
should default rate interest be allowable?
iii.

Holdings

12

Entz-White does not apply to preplan sales, and its continued validity for
sales under a plan is questionable due to the enactment of 11 U.S.C. 1123(d).1
536 F.3d at 974, 974n.2.
"We read Travelers to mean the default rate should be enforced, subject
only to the substantive law governing the loan agreement, unless a provision of
the Bankruptcy Code provides otherwise...." 536 F.3d at 973.
"Because the Bankruptcy Code does not provide a 'qualifying or contrary
provision' to the underlying substantive law here, the bankruptcy court's
extension of Entz-White to the loan agreement's default rate was error.
Consistent with the Supreme Court's holding in Travelers, we hold that the
parties' arms length bargain, governed by New York law, controls." 536 F.3d at
974.
"[W]e remand to allow the bankruptcy court to decide whether the default
rate should apply under the rule adopted by the majority of federal courts. That
rule simply stated is: the bankruptcy court should apply a presumption of
allowability for the contracted for default rate, 'provided that the rate is not
unenforceable under applicable nonbankruptcy law.' 4 Collier on Bankruptcy,
506.04[2][b][ii] (15th Ed. 1996)" 536 F.3d at 974. Therefore, default rate
interest should be allowed if it is enforceable under New York law.
"We reject the creation of a bright line rule that would accept 2% as an
allowable default rate differential." 536 F.3d at 975.
iv.

Rationale

Entz-White disallowed default rate interest under a chapter 11 plan where

the default was cured under 11 U.S.C. 1124(2)(A). But, there is no cure that
would nullify defaults in a section 363 sale.
v.

Analysis

Although the Ninth Circuit's decision makes the default rate issue a
function of its enforceability under state law, the Ninth Circuit cites two decisions
for the proposition that there is a presumption in favor of allowing default rate
1 11

U.S.C. 1123(d) provides:

Notwithstanding subsection (a) of this section and sections 506(b),
1129(a)(7), and 1129(b) of this title, if it is proposed in a plan to
cure a default the amount necessary to cure the default shall be
determined in accordance with the underlying agreement and
applicable nonbankruptcy law.
13

interest subject to rebuttal based on equitable considerations. 536 F.3d at 974

(citing In re Layman, 958 F.2d 72, 75 (5th Cir. 1992) and In re Terry Ltd. P'ship,
27 F.3d 241, 243 (7th Cir. 1994). The question that jumps off the page is whether
default rate interest provisions are preempted by the Bankruptcy Code's priority
scheme.
3.
Non-Debtors Can Not Deprive Debtors Postpetition of the Option to
Assume or Reject Executory Contracts
A.COR Route 5 Co. v. Penn Traffic Co. (In re Penn Traffic Co.),
524 F.3d 373 (2d Cir. 2008)
i.

Facts

Penn Traffic operated supermarkets and COR was a real estate

development company. 524 F.3d at 376. They had entered into a project
agreement under which Penn Traffic would convey certain land to COR and
lease back the land and a supermarket constructed on it, in exchange for COR
reimbursing $3.5 million of the construction cost and conveying certain parcels to
Penn Traffic. 524 F.3d at 376-377. When Penn Traffic commenced its chapter
11 case, COR had performed all its obligations under the project agreement
except for reimbursing the $3.5 million and tendering the lease back to Penn
Traffic. 524 F.3d at 377. Penn Traffic had not conveyed the supermarket parcel
to COR. 524 F.3d at 377.
Several months after commencement of Penn Traffics chapter 11 case,
COR tendered reimbursement of the $3.5 million as well as a signed lease. 524
F.3d at 377. Penn Traffic declined to accept the tender, and several months later
moved to reject the project agreement. 524 F.3d at 377.
Initially, the bankruptcy court ruled the project agreement was executory
on the petition date, but that CORs tender rendered it nonexecutory and
therefore not subject to rejection. 524 F.3d at 377. The bankruptcy court
observed the debtors motion to reject the agreement, had it been executory,
appeared to satisfy the low threshold for rejecting the agreement of the business
judgment test because the supermarket parcel had been appraised at $9.8
million and the triggering event for the debtors conveyance of the parcel to COR
was the reimbursement payment of $3.5 million. 524 F.3d at 377. The district
court reversed, holding postpetition performance cannot alter the executoriness
of a contract, and remanded. 524 F.3d at 377. COR appealed, but the circuit
appellate court dismissed the appeal for lack of appellate jurisdiction due to the
further proceedings on remand. 524 F.3d at 377. The bankruptcy court entered
an order approving the rejection and providing COR was not waiving its position
that the contract was not executory. 524 F.3d at 378. On appeal to the district
court, that court reinstated its first decision and affirmed the subsequent rejection
order, and COR appealed to the Second Circuit. 524 F.3d at 378.

14

ii.

Issues

The principal issue presented on this appeal is whether the non-debtor

party to a contract that is executory at the time a bankruptcy case is commenced
can, by post-petition tender or performance of its own outstanding obligations
under the contract, deprive the debtor party of the ability to exercise its statutory
right to reject the contract as disadvantageous to the estate. 524 F.3d at 378.
Does COR have rights to specific performance or rights under 11 U.S.C.
365(i)-(j)?
iii.

Holding

We hold that it cannot. 524 F.3d at 378.

Because these arguments anticipate issues that may arise in claimsadjudication proceedings that have not yet commenced, we think it best to
permit the Bankruptcy Court to consider these arguments in the first
instance. 524 F.3d at 383n.5.
iv.

Rationale

Sympathy for the non-debtor that may, through no fault of its own,
bear some significant burden from the debtors rejection of an executory
contract due to the happenstance of an unforeseen bankruptcy
proceeding is understandable. The notion that a non-debtor could prevent
the exercise of 365 rights with regards to an executory contract through
post-petition performance of the non-debtors contractual obligations is,
however, inconsistent with both the plain language and the policy of the
Code.The Code does not condition the right to assume or reject on lack
of prejudice to the non-debtor party, and the satisfaction of claims at less
than their full non-bankruptcy value is common in bankruptcy proceedings,
as is the disruption of non-debtors expectations of profitable business
arrangements. 524 F.3d at 382.
However long this process may take, however onerous the
dilemmas faced by the non-debtor party to an executory contract may be
while the non-debtor awaits the debtors decision, and whether or not the
bankruptcy judge grants a motion by the non-debtor party to accelerate
the debtors timetable for making its election to assume or reject, the
power to make that election is, as we made clear in In re Chateaugay
Corp., that of the debtor alone. 10 F.3d at 955 (Section 365 does not
confer any power of election upon the other contracting party.); 524
F.3d at 382-383.

15

v.

Analysis

Consistent with bankruptcy policy and precedent, it is hornbook law that,

subject to equitable principles,2 the debtor in possession has the option to
assume or reject executory contracts in accordance with which alternative is
better for its estate.3
If the nondebtor party could proffer performance postpetition and thereby
compel the debtor to perform contracts for which it has superior alternatives, the
equity policy would be turned upside down. Rather than the nondebtor contract
party sharing losses with other creditors, the nondebtor would be paid in full while
causing other creditors to take greater losses.
Just imagine a debtor having an executory contract to purchase 100
widgets at $10 per widget when the market price is $7 per widget. The debtor
should reject the contract and purchase widgets in the market for $7 per widget
to save $300. The nondebtor party can file a prepetition damage claim of $300.
But, if the estate pays claims at less than 100 cents on the dollar, the estate and
its other creditors will be better off. The notion that the nondebtor widget seller
can prevent rejection of the contract by tendering 100 widgets and eliminating its
executoriness, would gut the estates right and power to make economically
rational decisions.
Thus, the fundamental issue determined in Penn Traffic, that the
nondebtor contract party can not eliminate executoriness by postpetition activity,
was obviously corrected determined. The decision, however, fails to deal with
two other issues embedded in the decision, one it mentions and one
unmentioned.
The unmentioned issue is whether the nondebtor party would be better off
as a consequence of the contract not being executory. Clearly, COR believes it
would be better off and would presumably have the right to the conveyance of
2 See, e.g., Brotherhood of Railway, Airline and Steamship clerks v. REA Express,
Inc. (In re REA Express, Inc.), 523 F.2d 164 (2d Cir. 1975), cert. denied, sub nom.
International Assoc. of Machinists & Aerospace Workers, AFL-CIO v. REA
Express, Inc., 423 U.S. 1073 (1976); Control Data Corp. v. Zelman (In re Minges),
602 F.2d 38, 44 (2d Cir. 1979 ); In re Penn Central Transp. Co., 458 F.Supp. 1346,
1356 (E.D. Pa. 1978); Software Customizer, Inc. v. Bullet Jet Charter, Inc. (In re
Bullet Jet Charter, Inc.), 177 B.R. 593, 603 (Bankr. N.D. Ill. 1995) (denying debtors
motion to reject a contract for sale of an aircraft, in part, because such motion was
just another device to pressure [the buyer] to pay more money, not an effort to sell
[the aircraft] for more to another likely purchaser).
American Anthracite & Bituminous Coal Corp. v. Leonardo Arrivabene, S.A.,
280 F.2d 119, 126 (2d Cir. 1960).
3

16

the supermarket parcel in exchange for the $3.5 million and the lease. But, that
is hardly clear. When a contract is not assumed and the nondebtor party tenders
performance, the debtor is, by definition, not bound by the terms of the contract.
The contract provides a rebuttable presumption of what the debtor is obligated to
provide, but the presumption is rebuttable by the market value and the debtor
may have to provide more or less than what the contract would require. 4
Therefore, CORs tender of the $3.5 million and the lease, would not entitle it to
the conveyance of land worth $9.8 million absent the debtors assumption of the
project agreement which did not occur.
The issue the court acknowledged, but did not determine, was whether
upon rejection of the project agreement COR would be entitled to specific
performance of the conveyance of real property (the supermarket parcel), which
issue is discussed below. 524 F.3d at 383n.5. It does not appear, however, that
the court could properly determine the appeal of the project agreements
rejection without knowing the answer to the specific performance issue. If the
debtors rejection of the project agreement would entitle COR to conveyance of
the supermarket parcel, then it does not appear the debtors estate can satisfy
the business judgment test for rejection because the estate would not be better
off. Indeed, the estate may be worse off because in addition to having to convey
the parcel, the estate would be liable for breach (rejection) of contract and that
could add other damages such as attorneys fees and the like. It could even put
into question whether COR would have to pay $3.5 million once Penn Traffic
breaches the contract by rejecting it.
Finally, if the consequences of rejection have to be known before the court
can determine whether the business judgment test supports rejection, then the
matter before the circuit court may not have been a final order over which it had
appellate jurisdiction. Rather, because the rejection determination would have to
await a bankruptcy court determination as to whether COR would be entitled to
specific performance, the order on appeal may not amount to a final order.

4 NLRB v. Bildisco & Bildisco, 465 U.S. 513, 531 (1984); In re Thompson, 788 F.2d 560 (9th Cir. 1986)
(the fair and reasonable value of the benefits on the open market controls, not the value to the debtor);
Peoples Gas Sys., Inc. v. Thatcher Glass Corp. (In re Thatcher Glass Corp.), 59 B.R. 797 (Bankr. D. Conn.
1986) (same), but see American Anthracite & Bituminous Coal Corp. v. Leonardo Arrivabene, S.A., 280
F.2d 119, 126 (2d Cir. 1960); GATX Leasing Corp. v. Airlift Int'l, Inc. (In re Airlift Int'l, Inc., 761 F.2d
1503, 1508 (11th Cir. 1985); Philadelphia Co. v. Dipple, 312 U.S. 168, 174 (1941); Quincy M&PR Co. v.
Humphreys, 145 U.S. 82 (1892); Palmer v. Palmer, 104 F.2d 161, 163 (2d Cir. 1939); In re United Cigar
Stores Co., 69 F.2d 513 (2d Cir.), cert. denied sub nom. Reisenwebers, Inc. v. Irving Trust Co., 293 U.S.
566 (1934); In re Lane Foods, Inc., 213 F. Supp. 133, 166 (S.D.N.Y. 1963); In re O.P.M. Leasing Servs.,
Inc., 14 B.C.D. 83, 86 (Bankr. S.D.N.Y. 1986); In re Bohack, 1 B.C.D. 287 (Bankr. E.D.N.Y. 1974). One
court holds that even a postpetition lease entered into in the ordinary course of business without requiring
court approval gives rise to administrative expense claims only in the amount the court determines is the
fair market value of the debtor's use of the leased premises. Burlington N.R.R. Co. v. Dant & Russell, Inc.
(In re Dant & Russell, Inc.), 853 F.2d 700 (9th Cir. 1988).

17

B.Specific Performance
i. Specific Performance under the UCC
Pursuant to section 2-716 of the Uniform Commercial Code, a buyer may
be entitled to specific performance where the goods are unique or in other
proper circumstances, and the Official Comment makes crystal clear that supply
contracts for unique parts are the prototypical proper circumstances. Sections
2-716(1)-(2) of the Uniform Commercial Code provide:
(1)
Specific performance may be decreed where
the goods are unique or in other proper circumstances.
(2)
The decree for specific performance may
include such terms and conditions as to payment of the price,
damages, or other relief as the court may deem just.
Official Comment 2 to section 2-716 provides:
In view of this Articles emphasis on the commercial
feasibility of replacement, a new concept of what
are unique goods is introduced under this section.
Specific performance is no longer limited to goods
which are already specific or ascertained at the
time of contracting. The test of uniqueness under
this section must be made in terms of the total
situation which characterizes the contract. Output
and requirements contracts involving a particular or
peculiarly available source or market present today
the typical commercial specific performance
situation, as contrasted with contracts for the sale
of heirlooms or priceless works of art which were
usually involved in the older cases. However,
uniqueness is not the sole basis of the remedy
under this section for the relief may also be granted
in other proper circumstances and inability to
cover is strong evidence of other proper
circumstances.
Consistent with the Official Comment, specific performance is granted when the
buyer has an inability to cover.5
5 See International Casings Group, Inc. v. Premium Standard Farms, Inc., 358 F.
Supp. 2d 863, 876 (W.D. Mo. 2005) (holding that a buyer of hog casings could
not find cover goods to replace the casings manufactured by the seller because
those casings were not fungible and were not readily available on the spot
market); Software Customizer, Inc. v. Bullet Jet Charter, Inc. (In re Bullet Jet
18

Courts consistently rule specific performance is available to prevent

irreparable harm where the remedy at law is inadequate.6 Courts grant buyers
specific performance of purchase contracts when monetary damages are deemed
inadequate and the buyers would be irreparably harmed7 by termination of the
purchase contracts.8
In DaimlerChrysler Corp. v. Lear Corp.9 DaimlerChrysler Corporation
(DCC) filed a complaint against Lear Corporation (Lear), a sole source supplier
of seats and other parts for Chrysler vehicles, on the ground that Lears threats to
cease production of certain parts to DCC unless DCC would agree to Lears
demanded price increases constituted anticipatory reputation by Lear of the supply
contract and entitled DCC to specific performance. The Michigan Circuit Court
issued a temporary restraining order restraining Lear from repudiating or
threatening to breach its purchase contracts with DCC for a certain term or
refusing to fulfill any of its supply obligations to DCC.10 The court found DCC
Charter, Inc.), 177 B.R. 593, 599 (Bankr. N.D. Ill. 1995) (specific performance
granted where buyer of an aircraft was unable to cover, if at all, without
considerable inconvenience, expense, and delay.).
6 Edidin v. Detroit Econ. Growth Corp., 352 N.W.2d 288, 291 (Mich. Ct. App.
1984); see also Shell Oil Co. v. AMPM Enters., Inc., No. 95-CV-75117-DT, 1996
U.S. Dist. LEXIS 4667, *14 (E.D. Mich. Mar. 18, 1996); Wirth v. United States,
No. 2:91-CV-099, 1991 U.S. Dist. LEXIS 16038, *9 (W.D. Mich. June 26, 1991).
7 See , Zurn Constructors, Inc. v. The B.F. Goodrich Co., 685 F. Supp. 1172,
1181 (D. Kan. 1988) ([n]umerous cases support the conclusion that loss of
customers, loss of goodwill, and threats to a business viability can constitute
irreparable harm.).
8 See, e.g., Laclede Gas Co. v. Amoco Oil Co., 522 F.2d 33, 39 (8th Cir. 1975)
(decreeing specific performance of a long-term contract to supply propane gas to
a distributor for distribution to a specific subdivision even though propane gas
was readily available on the market and the distributor had propane gas
immediately available to it under other contracts with other suppliers because the
distributor probably would not have been able to enter into a similar long-term
contract with anyone else and monetary damages for the considerable expense
and trouble of rearranging distribution from other sources to the subdivision
supplied by the defendant would have been difficult to estimate); Zurn
Constructors, Inc. v. The B.F. Goodrich Co., 685 F. Supp. 1172, 1187 (D. Kan.
1988) (granting specific performance to a buyer of polyvinylchloride (PVC) pipe
grade resin, an essential raw material used by buyer to manufacture PVC pipes,
because the buyer was not able to purchase a sufficient amount of PVC pipe
grade resin from other sources due to a shortage, and the buyer would have
been irreparably harmed by the termination of the supply contract because the
inability to buy the raw material for its products would potentially have put it out of
business, and money damages would thus have been inadequate).
9 No. 05-70865, slip op. (Mich. Cir. Ct. Dec. 1, 2005).
10 Id. at *2.
19

would suffer irreparable harm [to its] customer goodwill, business reputation, and
existence if Lear ceased delivery of parts and DCC would not have an adequate
remedy at law.11
ii.

Specific Performance of Real Property Sales Granted

by the Bankruptcy Code

California.To obtain specific performance for breach of contract under California

law, a plaintiff must show (1) the inadequacy of his legal remedy; (2) an
underlying contract that is both reasonable and supported by adequate
consideration; (3) the existence of a mutuality of remedies; (4) contractual terms
which are sufficiently definite to enable the court to know what it is to enforce;
and (5) a substantial similarity of the requested performance to that promised in
the contract. Real Estate Analytics, LLC v. Vallas, 160 Cal. App. 4th 463, 472
(Cal. Ct. App. 2008). The party seeking specific performance cannot be in
material breach of the contract. See Cal. Civ. Code 3392; Galvez v. Yoo, No.
B193913, 2007 WL 4465139, at *2 (Cal. Ct. App. Dec. 21, 2007) (plaintiff must
plead and prove he is ready, willing and able to specifically perform contract).
Moreover, courts will not specifically enforce a contract against a party if that
partys assent was obtained by misrepresentation, concealment, circumvention,
or unfair practices by the party seeking specific performance, or if the partys
asset was given under the influence of mistake, misapprehension, or surprise.
Cal. Civ. Code 3391. Ultimately, the specific performance of a contract is not
a matter of course, but rests in the sound discretion of the Court, upon a view of
all the circumstances. See, e.g., Cooper v. Pena, 21 Ca. 403, 411 (1863).
The California legislature has enacted a statute specifically prescribing
that [i]t is to be presumed that the breach of an agreement to transfer real
property cannot be adequately relieved by pecuniary compensation. Cal. Civ.
Code. 3387. Where the real property at issue is a single-family dwelling in
which the party seeking performance intends to live, the presumption is
conclusive; for all other real property, the presumption is rebuttable and shifts the
burden of proof to the party opposing enforcement to prove that damages would
be adequate. Id.; Real Estate Analytics, 160 Cal. App. 4th at 474. By shifting the
burden, the Legislature intended that a damages remedy for a nonbreaching
party to a commercial real estate contract is the exception rather than the rule.
Real Estate Analytics, 160 Cal. App. 4th at 474. The question of what evidence
suffices to rebut the presumption of inadequacy of damages is an open one, but
it is clear that the mere fact that the party seeking specific enforcement seeks the
property for investment purposes, as opposed to dwelling or commercial
purposes, is insufficient standing alone. Id. (that plaintiff was motivated solely to
make a profit from the purchase of the property does not overcome the strong
statutory presumption that all land is unique; noting that the property at issue
was unique in physical attributes and location, as well as in its investment
potential and the reasonableness of the contract price).
11 Id. (emphasis added).
20

With respect to the third element (the mutuality of remedy requirement),

California courts will not enforce a contract where the party seeking enforcement
cannot himself be compelled to perform it, unless (a) specific performance is
otherwise an appropriate remedy, and (b) the agreed counter-performance has
been substantially performed, is assured, or can be secured to the satisfaction of
the court. See, e.g., Cooper, 21 Ca. at 410; Cal. Civ. Code 3386. To that end,
obligations to render personal services or to employ another in personal service
cannot generally be specifically enforced. See, e.g., Cal. Civ. Code 3390;
Cooper, 21 Ca. at 410; but see Ellis v. Mihelis, 60 Cal. 2d 206, 215 (1963)
(Where a party commences an action to compel the specific enforcement of an
agreement for the sale of property, the requirement of mutuality is satisfied, the
theory being that by bringing the action the plaintiff has submitted himself to the
jurisdiction of equity and thereby enables the court to assure performance of
him.).
Nevada. Under Nevada law, specific performance is available when (1) the
terms of the contract are definite and certain, (2) the remedy at law is
inadequate, (3) the plaintiff has tendered performance or is ready, willing, and
able to perform, and (4) the court is willing to order it. Carcione v. Clark, 96 Nev.
808, 810 (1980) (internal citations omitted). In Nevada, as in California, the
remedy at law is generally deemed inadequate when the contract at issue is for
real property, on the theory that each parcel of land is unique. Id.; see also Stoltz
v. Grimm, 100 Nev. 529, 533 (1984). Thus, in Nevada, as in California, specific
enforcement is generally granted in cases where the contract at issue calls for
the transfer of real property, provided the foregoing requirements are satisfied.
That said, in Nevada as in California the decision whether to award specific
performance is committed to the sound discretion of the court, see, e.g., Cohen
v. Rasner, 97 Nev. 118, 120 (1981), and the decision will not be disturbed on
appeal unless an abuse of discretion is shown, McCann v. Paul, 90 Nev. 102,
103-04 (1974).
Florida. Under Florida law, the decision whether to decree specific performance
of a contract is a matter that lies within the sound judicial discretion of the trial
court and it will not be disturbed on appeal unless it is clearly erroneous. Free v.
Free, 936 So.2d 699, 702 (Fla. App. 2006); Bird Lakes Dev. Corp. v. Muruelo,
626 So.2d 234, 238 (Fla. App. 1993) (affirming denial of specific enforcement
where the party seeking enforcement of a contract for the sale of real property
could be adequately compensated by money damages). The exercise of that
discretion is governed by consideration of all of the facts and circumstances of
the case and application of well-settled legal and equitable principles. Free, 936
So.2d at 702. [T]he ultimate goals to be achieved by invocation of specific
performance are justice and fairness, and if these goals would be contravened
by a grant of specific enforcement, the court will not grant the remedy. Id.12
12
Under Florida law, when parties have contracted for specified remedies in the event of breach,
their agreement will generally control, provided the remedy is mutual, unequivocal and reasonable. See

21

Florida courts have held that specific performance is uniquely capable of

rectifying breaches of contract involving the sale of real estate. See Bell v. Alsip,
435 So.2d 840, 842 (Fla. App. 1983). This is because real estate is unique and
[m]oney damages upon breach of a purchase and sale agreement adequately
compensates neither a seller, burdened with ownership, nor a buyer, deprived of
ownership and possession. Id.; see also Bermont Lakes LLC v. Rooney, No.
2D07-3138, 2008 WL 1883980, at *4 (Fla. App. Apr. 30, 2008) ([M]oney
damages are considered an inadequate remedy at law to a purchaser of land
because all land is considered unique.); Henry v. Ecker, 415 So.2d 137, 140
(Fla. App. 1982) (Since all land is considered unique, money damages to a
contract purchaser of lands is an inadequate remedy at law.).
Arizona. Under Arizona law, specific performance is ordinarily available to
enforce contracts for the sale of real property because land is viewed as unique
and an award of damages is usually considered an inadequate remedy.
Queiroz v. Harvey, No. 1 CA-CV 07-0309, 2008 WL 2058233, at *7 (Ariz. App.
Div. May 15, 2008) (quoting Woliansky v. Miller, 135 Ariz. 444, 446 (App. 1983)).
There is, however, a potential exception to this general rule. Specifically, the
Arizona Court of Appeals has held that [i]n case where the purchaser does not
desire the real property for personal use but instead wants to acquire the land
merely for the profit to be gained upon resale, damages would theoretically be an
adequate remedy. Woliansky, 135 Ariz. at 446 (remanding case to trial court to
determine the appropriate remedy for breach of contract to sell parcel of real
property).
Ultimately, the decision to grant specific performance is never a matter of
absolute right, and the trial court is afforded wide discretion to determine
whether or not damages would be an adequate remedy in contracts concerning
the sale of real property. Queiroz, 2008 WL 2058233, at *7.13
Utah. Under Utah law, specific performance is the presumed remedy for the
breach of an agreement to sell real property. Knighton v. Bowers, No.
20030170-CA, 2004 WL 797560, at *1 (Utah Ct. App. Apr. 15, 2004).14 Indeed,
Seaside Cmty Dev. Corp. v. Edwards, 573 So.2d 142, 147 (Fla. App. 1991) (granting money damages for
breach of real estate contract despite the fact that the contract provided that the available remedies for
breach by the seller were specific performance or refund of earnest money; statute of limitations for
specific enforcement had expired, and the return of earnest money deposit was neither reasonable or
mutual).
13
Note that once a contract is rejected [in bankruptcy], the equitable remedy of specific
performance is no longer available. TPG of Scottsdale, LLC v. Scott Desert Shadows, LLC, Bankr. Adv.
P. No. 06-00003, 2006 WL 1775828, at *4 (Bankr. D. Ariz. Apr. 14, 2006).
14
In fact, specific performance may be granted even where the contract at issue does not identify
specific performance as a possible remedy, provided the remedies identified in the contract are not properly
deemed exclusive remedies. See Kelley v. Leucadia Fin. Corp., 846 P.2d 1238, 1241-42 (Utah 1993)
(holding buyer was entitled to specific performance where the contractual remedies were not properly
deemed exclusive and did not in any way limit the traditional common law or equitable remedies available

22

specific performance is generally available when the contract involves property

which is unique or possesses special value, and real property is assumed to be
unique. Id. That said, [s]pecific performance is an equitable remedy, and
accordingly, the trial court is granted wide discretion in applying and formulating
it. Id. The remedy is not, in other words, a matter of absolute right and the trial
court after evaluating equitable considerations may properly deny it. Id.
(affirming denial of specific performance of contract involving real property where
party seeking specific performance delayed nearly four years in bringing suit);
see also Morris v. Sykes, 624 P.2d 681, 684 (Utah 1981) (affirming denial of
specific performance involving real property where plaintiff was delinquent in
payments and defendant had sold the property to another entity); Prop.
Assistance Corp. v. Roberts, 768 P.2d 976, 979 (Utah Ct. App. 1989) (Specific
performance is a remedy of equity which his addressed to the sense of justice
and good conscience of the court, and accordingly, considerable latitude of
discretion is allowed in [the trial courts] determination as to whether it shall be
granted and what judgment should be entered.)
Colorado. Under Colorado law, specific performance may be granted when the
party seeking enforcement of the contract cannot be fully compensated at law
because of the nature of the property or its speculative value; the property at
issue need not be real property to warrant specific enforcement. See Bernhardt
v. Hemphill, 878 P.2d 107, 113 (Colo. Ct. App. 1994) (holding that time-share
contracts, although not creating interests in real property, may be specifically
enforced).
Generally, real property is deemed unique and legal remedies are,
therefore, inadequate to compensate for a breach. See Prosser v. Schmidt, 197
P.2d 318, 319 (Colo. 1948) (legal remedies for breach of a contract conveying
real estate are presumed inadequate; different tracts of land are not of equal
type and value like bushels of wheat from the same bin.); White v. Greenamyre,
234 P. 164, 165 (Colo. 1925) (The general rule is that specific performance of a
contract for the sale of land will be granted, even thought he plaintiff might be
fully compensated in damages for any injury resulting from a failure of the
defendant to convey.). However, [e]quity will not decree specific performance
of a contract to convey land if there is an adequate remedy at law. Schreck v. T
& C Sanderson Farms, Inc., 37 P.3d 510, 514 (Colo. Ct. App. 2001). Thus, at
least one court has held that a party seeking specific performance of a contract
involving real property must demonstrate that the property at issue has unique
qualities that are important to the party. Id. In addition, another court has implied
that specific performance of a contract concerning real property may not be
specifically enforced where the party seeking enforcement is interested in the
property for primarily financial and not personal reasons. See Hornick v.
Boyce, Civ. No. 03-cv-02504-REB-CBS, 2007 WL 8392, at *11 (D. Colo. Jan. 2,
to the plaintiff). Further, when specific performance is in order, the buyer may be entitled to an award of
lost rents or profits, while the seller may be entitled to interest on the purchase money withheld by the
purchaser. Saunders v. Sharp, 840 P.2d 796, 808 (Utah Ct. App. 1992).

23

2007) (specific performance was impracticable due to disposition of the property

to a third party; in any event, the remedy may not have been warranted where
the plaintiffs interest in the property was primarily financial and not personal, and
where the agreement at issue demonstrated that the plaintiff was not interested
in specific, unique property but rather in a membership interest in a LLC).
Minnesota. Under Minnesota law, [s]pecific performance is an equitable remedy
addressed to the discretion of the court. Saliterman v. Bigos, 352 N.W.2d 494,
496 (Minn. Ct. App. 1984). It is not an absolute right and if enforcement would
be unconscionable or inequitable, performance will not be decreed. See Giles
Props., Inc. v. Kukacka, No. A06-1275, 2007 WL 1191801, at *2 (Minn. Ct. App.
Apr. 24, 2007) (quotations omitted).
Courts applying Minnesota law consider several factors when determining
whether to grant specific performance of a contract involving real property.
Namely, courts analyze the following factors:
(a) the contract must be established by clear, positive, and
convincing evidence; (b) it must have been made for adequate
consideration and upon such terms which are otherwise fair and
reasonable; (c) it must have induced without sharp practice,
misrepresentation, or mistake; (d) its enforcement must not cause
unreasonable or disproportionate hardship or loss to the
defendants or to third persons; and (e) it must have been
performed in such a manner and by the rendering of services of
such a nature and under such circumstances that the beneficiary
cannot be properly compensated in damages.
Saliterman, 352 N.W.2d at 496; see also Giles Props., 2007 WL 1191801, at *3.
In addition, the party seeking enforcement shall have been prompt, ready, and
eager to perform upon his part and have exercised good faith and been diligent.
See Boulevard Plaza Corp. v. Campbell, 94 N.W.2d 273, 283 (Minn. 1959).
Finally, although not determinative, courts will consider whether the contract
allows for mutuality of remedy. Saliterman, 352 N.W.2d at 496.
Land is generally deemed to be unique; [w]hile the remedy of specific
performance of enforceable real estate purchase/sale agreements is not
automatic, the remedy will ordinarily lie where performance is feasible. Giles,
2007 WL 1191801, at *4 (quoting In re Kreger, 296 B.R. 202, 209 (Bankr. D.
Minn. 2003)); cf. Schumacher v. Ihrke, 469 N.W.2d 329, 335 (Minn. Ct. App.
1991) (If real property is involved, specific performance is a proper remedy,
even if the other remedies would be adequate.) Where, however, the evidence
demonstrates that land is purchased for investment purposes, the general
principle that specific performance should be granted because the land is unique
is less persuasive. See Hilton v. Nelsen, 283 N.W.2d 877, 881 (Minn. 1979)
(denying specific performance to purchaser where contract provided that, upon

24

sellers default, purchaser would be entitled to seek specific performance or

damages; reasoning, in part, that the purchaser purchased the property for
investment purposes). That is not to say that a claim for specific performance is
automatically defeated by the fact that the party seeking performance intends to
purchase the land for investment purposes; rather, it is simply one of several
factors courts will consider when making a determination of whether to grant
specific performance. See Hilton, 283 N.W.2d at 883; Giles, 2007 WL 1191801,
at *4.
Texas (3%)
Texas. It is well-settled that, under Texas law, specific performance is
more readily available as a remedy for the sale of real estate than for the sale of
personal property. Rus-Ann Dev., Inc. v. ECGC, Inc., 222 S.W.3d 921, 927
(Tex. App. 2007).15 This is because damages are generally believed to be
inadequate in connection with real property. Rus-Ann Dev., 222 S.W.3d at 927.
There is arguably conflicting authority regarding whether, when
appropriately invoked, specific performance is a right or simply one possible
remedy. In Graves, the court suggested that the remedy is a right, holding that,
[a] purchaser of real estate is entitled to specific performance of a contract for
sale of land. 132 S.W.3d at 17-18 (quoting Abraham Inv. Co. v. Payne Ranch,
Inc., 968 S.W.2d 518, 527 (Tex. App. 1998)); see also, e.g., Hubler, 700 S.W.2d
at 698 (It is as much a matter of course for a court to decree specific
performance of a contract to sell real estate as it is to give damages for its
breach.); Claflin, 645 S.W.2d at 633 ([A] contract for the sale of land will be
enforced as a matter of right, regardless of its wisdom or folly, if fairly and
understandingly made . . . [C]ourts cannot arbitrarily refuse specific performance
of a contract, because they deem it unwise, or because subsequent events
disclose that it will result in a loss to defendant; but to justify the refusal of this
relief it must appear that the defendant had been misled and overreached to
such an extent that the contract is unconscionable. (quoting Bennett v.
Copeland, 235 S.W.2d 605, 609 (Tex. 1951)).
Other authorities have held, however, that specific performance is not a
matter of right, but merely often granted when the party seeking enforcement of
a contract for real estate makes the requisite showings. See, e.g., Scott v.
Sebree, 986 S.W.2d 364, 369 (Tex. App. 1999) (Although specific performance
is not a matter of right, it is often granted where a valid contract to purchase real
property is breached by the seller.); Magram v. Lewis, 618 S.W.2d 420, 422
(Tex. App. 1981) (Specific performance of a contract for the sale of [l]and is
ordinarily granted where the action is based upon a valid contract, but the relief is
not a matter of right.); Fisher v. Wilson, 185 S.W.2d 186, 190 (Tex. Civ. App.
1945) (specific performance is not an absolute right, and that [g]enerally
15
As a general rule, Texas courts will not grant specific performance of a contract relating to
personal property. See Nash v. Conatser, 410 S.W.2d 512, 520 (Tex. Civ. App. 1966).

25

speaking, it may be said that specific performance, where permissible under the
terms of contract, will be granted when it is apparent from a view of all the
circumstances that it will serve the ends of justice, and it will be withheld when,
from a like view, it is apparent that performance will result in hardship or injustice
to either of the parties.). At least one court has noted (albeit in dicta) that Texas
law provides damages as an alternative remedy to specific performance for
breach of contract for the transfer of real property; as such, even in cases where
specific performance is available, damages may be awarded in its stead. See
Swinehart v. Stubbeman, McRae, Sealy, Laughlin & Browder, Inc., 48 S.W.3d
865, 885 (Tex. App. 2001) (specific performance was not available because the
contract failed to satisfy the statute of frauds, but stating that, even if specific
performance were available, money damages are an alternative remedy for
breach of contract for the transfer of real property; as a result, the contract gave
right to a claim for bankruptcy purposes). The resolution to this apparent
conflict may depend upon the remedies the parties identify in their contract.
Indeed, in a case with particularly strong language favoring the theory that
specific performance is a right, the contract specifically provided that the seller
was entitled to elect as remedies either specific enforcement or termination of the
contract and liquidated damages; the court emphasized the agreed-upon
remedies in affirming the trial courts award of specific performance to the seller.
See Claflin, 645 S.W.2d at 632.
Maryland. Under Maryland law, specific performance is an extraordinary
equitable remedy; it may be granted where traditional remedies, such as
damages, are either unavailable or inadequate. Archway Motors, Inc. v.
Herman, 27 Md. App. 674, 681 (Md. Ct. Spec. App. 1977). Courts have held that
this remedy is particularly appropriate in the context of contracts for the sale of
land, because of the presumed uniqueness of land itself, no parcel being exactly
like another. Archway, 27 Md. App. at 681 (citing Restatement of Contracts
360 (1932)). In other words, when a contract is for the sale of land, traditional
remedies are generally presumed to be uncertain and inadequate. Id. at 683-84.
Under Maryland law, where all criteria are satisfied, it is as much a matter
of course for a court of equity to decree its specific performance as it is for a
court of law to give damages for its breach. Archway, 37 Md. App. at 684, 686
(noting that specific performance under these circumstances has been held to be
a matter of course or duty).16 The decree of special enforcement need not
be identical with that promised in the contract. Such a decree may be drawn so
as best to effectuate the purposes for which the contract was made, and it may
be granted on such terms and conditions as justice requires. Boyd, 28 Md. App.
at 23.
16
In addition to specific performance, the party seeking enforcement may be entitled to ancillary
money damages to compensate that party for losses caused by the defending partys breach of the contract.
Archway, 37 Md. App. at 687-88. Further, specific performance may be granted even though not identified
as a remedy in the contract at issue, unless the contract clearly indicates that the identified remedies are
exclusive. See Miller v. United States Naval Inst., 47 Md. App. 426, 435-36 (Md. Ct. Spec. App. 1980)

26

Virginia. Under Virginia law, suits for specific performance of contracts relating to
land are appropriately addressed to the discretion of a court sitting in equity
because of the unique nature of such a contract. In such cases, the court may
grant specific performance if: (1) there is a valid, certain, and definite contract
between the parties that is itself not inequitable; (2) specific performance is a
practical form of relief in the circumstances; (3) there are mutual performance
obligations, such that each party may comply with obligations under the contract;
and (4) there are no legal or equitable defenses to enforcement of the
agreement. Adams v. Doughtie, No. 03-0484, 2003 WL 23140076, at *11 (Va.
Cir. Ct. Dec. 31, 2003); see also City of Manassas v. Bd. of County Supervisors
of Prince William County, 250 Va. 126, 134 (1995) ([T]he terms of the contract
sought to be specifically enforced must be definite.); Firebaugh v. Hanback, 247
Va. 519, 526 (1994) (noting that the court has denied specific performance of
contracts executed under a mutual mistake of fact and further holding that he
who asks equity must do equity, and he who comes into equity must come with
clean hands.);17 Duke v. Tobin, 198 Va. 758, 760 (1957) (It is an elementary
principle that a court of equity will not specifically enforce a contract unless it be
complete and certain. All the essential terms of the contract must be finally and
definitely settled.). In addition, the party seeking enforcement must demonstrate
that he has been able, ready, prompt, eager and willing to perform the contract
on his part. Alaragy v. Dengler, No. 181411, 2004 WL 1662279, at *3 (Va. Cir.
Ct. June 9, 2004).
As a general matter, where a contract respecting real property is in its
nature and circumstances unobjectionable, it is as much a matter of course for
courts of equity to decree specific performance of it, as it is for a court of law to
give damages for a breach of it. Bond v. Crawford, 193 Va. 437, 444 (1952)
(quotations omitted). Specific performance of a contract is not a matter of
absolute right but rests in a sound judicial discretion. Alaragy, 2004 WL
1662279, at *3; Chesapeake Builders, Inc. v. Lee, 254 Va. 294, 300 (1997)
(Specific performance of a contract does not lie as a matter of right, but rests in
the discretion of the chancellor, and may be granted or refused under established
equitable principles and the facts of a particular case.). That discretion must be
exercised with a view to the substantial justice of the case. Chesapeake
Builders, 254 Va. at 300.
iii.

Rights to Specific Performance Are Often

Nondischargeable

17
Although one seeking equity must have clean hands, the clean hands maxim does not operate to
bar a sinner forever from a court of equity. Bond v. Crawford, 193 Va. 437, 447 (1952). To defeat a
claim for specific performance, [t]he misconduct relied on must relate directly to the matter in litigation.
It is not sufficient that the wrongdoing is remotely or indirectly connected with the subject of the suit. Id.

27

Significantly, the Bankruptcy Code itself grants certain federal rights of

specific performance regardless of whether they exist under state law. For
instance, entities holding executory contracts to purchase real property from the
debtor, who are in possession of the property, have rights to specific performance
if the debtor in possession or trustee rejects the contract.18 Licensees of
intellectual property are also granted rights to continue to use a rejected license.19
Rejection of an executory contract breaches it, but does not terminate it or
avoid it.20 For example, [c]onsistent with bankruptcy laws general deference to
state-law rights in or to specific property, rejection of a contract does not terminate

18

Bankruptcy Code section 365(i) provides:

(1) If the trustee rejects an executory contract of the debtor for the
sale of real property or for the sale of a timeshare interest under a
timeshare plan, under which the purchaser is in possession, such
purchaser may treat such contract as terminated, or, in the
alternative, may remain in possession of such real property or
timeshare interest.
(2) If such purchaser remains in possession
(A) such purchaser shall continue to make all payments due under
such contract, but may, offset against such payments any damages
occurring after the date of the rejection of such contract caused by
the nonperformance of any obligation of the debtor after such date,
but such purchaser does not have any rights against the estate on
account of any damages arising after such date from such
rejection, other than such offset; and
(B) the trustee shall deliver title to such purchaser in accordance
with the provisions of such contract, but is relieved of all other
obligations to perform under such contract.

19 11

U.S.C. 365(n).
20 Medical Malpractice Ins. Assn v. Hirsch (In re Lavigne), 114 F.3d 379, 386387 (2d Cir. 1997), affg, 183 B.R. 65, 72 (Bankr. S.D.N.Y. 1995) (Rejection . . .
does not extinguish all rights under an executory contract. . . . State-law rights
embodied within executory contracts survive rejection.); Eastover Bank for
Savings v. Sowashee Venture (In re Austin Development Co.), 19 F.3d 1077,
1081-1084 (5th Cir. 1994); In re Modern Textile, Inc., 900 F.2d 1184, 1191 (8th
Cir. 1990); Leasing Service Corp. v. First Tennessee Bank, Nat'l Ass'n, 826 F.2d
434, 436-37 (6th Cir. 1987); Michael T. Andrew, Executory Contracts in
Bankruptcy: Understanding Rejection, 59 U. Colo. L. Rev. 845, 931 (1988)
(quoted approvingly by Second Circuit in Lavigne at 114 F.3d at 387); Creators
Way Associated Labels, Inc. v. Mitchell (In re Mitchell), 249 B.R. 55, 58 (Bankr.
S.D.N.Y. 2000); Cohen v. Drexel Burnham Lambert Group Inc. (In re Drexel
Burnham Lambert Group, Inc.), 138 B.R. 687, 709 (Bankr. S.D.N.Y. 1992).
28

such rights that arise from rejected contracts.21 Accordingly, [b]ecause rejection
constitutes only a breach, not a termination, an obligation in a rejected contract
continues to bind a debtor unless the obligation is discharged.22
Only liabilities on claims are discharged by confirmation of a chapter 11
plan. Section 101(5) of the Bankruptcy Code defines claim as:
23

(A) right to payment, whether or not such right is reduced to

judgment, liquidated, unliquidated, fixed, contingent, matured,
unmatured, disputed, undisputed, legal, equitable, secured, or
unsecured; or
(B) right to an equitable remedy for breach of performance if such
breach gives rise to payment, whether or not such right to an
equitable remedy is reduced to judgment, fixed, contingent,
matured, unmatured, disputed, undisputed, secured, or
unsecured.24
Accordingly, a right to an equitable remedy for breach of performance that does
not give rise to payment is not a dischargeable claim. The issue becomes whether
the equitable remedy for the breach imposed by rejection gives rise to payment for
purposes of section 101(5)(B).
As the first step in the analysis, it is crystal clear a creditors right to
equitable remedies is not rendered dischargeable simply because the court is
empowered to grant equitable and monetary relief for the same breach. In Ohio v.
Kovacs,25 the United States Supreme Court decided whether a prepetition
injunction ordering a debtor to remove specified wastes from the property,26 was
dischargeable when the debtor had been dispossessed from the site by a receiver
and the state conceded the only performance sought from Kovacs was the
payment of money.27

21 Drexel Burnham, 138 B.R. at 709 (quotations omitted); see also Licensing by
Paolo, Inc. v. Sinatra (In re Gucci), 126 F.3d 380, 389 (2d. Cir. 1997) (non-debtor
party has a reasonably strong argument that rejection of its licensing contract
[pursuant to which the non-debtor party had a right to license the prepetition
designs created by the debtor] does not eliminate the transfer of the property
right created under it).
22 Abboud v. Ground Round, Inc. (In re Ground Round, Inc.), Case No. 05-039,
2005 Bankr. LEXIS 2595, *19 (1st Cir. B.A.P. Dec. 15, 2005).
23 11 U.S.C. 1141(d)(1).
24 Id. 101(5) (emphasis added).
25 469 U.S. 274 (1985).
26 Id. at 275.
27 Id. at 283.
29

The Supreme Court held the injunction was a dischargeable claim precisely
because the cleanup order had been converted into an obligation to pay
money.28 The court went out of its way to caution it was not addressing what the
legal consequences would have been had Kovacs taken bankruptcy before a
receiver had been appointed and a trustee had been designated with the usual
duties of a bankruptcy trustee.29 Given that cleaning up and paying for cleanup
procure the identical result as occurred in Kovacs, the Supreme Court clearly did
not see the possibility of a money judgment as automatically rendering an
injunction dischargeable.
Notably, the Supreme Court rejected the argument that its analysis of what
a claim is under section 101(5)(B) should differ according to whether a civil statute
is being enforced or a contract is breached.30 The Supreme Court also observed
that Congress had considered two versions of section 101(5)(B).31 One version
only discharged rights to payment and the other version discharged rights to
payment and equitable remedies. Congress enacted a compromise version.32
Significantly, the key question that the Supreme Court announced it did not
decide in Kovacs (i.e., whether the injunction against the debtor in possession to
clean up hazardous waste would have been dischargeable as giving rise to a right
to payment if the debtor had remained in possession and had the ability to
remediate) was later decided in United States v. LTV Corp. (In re Chateaugay
Corp.).33 There, LTV had deposited hazardous substances prepetition, which
substances continued to contribute to pollution postpetition.34 The United States
Environmental Protection Agency (EPA) had ordered LTV to clean up the
affected sites. LTV, unlike Kovacs, remained in possession of its property during
its chapter 11 case.
The United States Court of Appeals for the Second Circuit conceded: It is
true that, if in lieu of such an order, EPA had undertaken the removal itself and
sued for the response costs, its action would have both removed the accumulated
waste and prevented continued pollution.35 But, applying the definition of claim in
section 101(5)(B), the Second Circuit ruled the cleanup order was
nondischargeable because a portion of the cleanup order was not convertible to a
right to payment.36
28 Id.
29 Id. at 284.
30 Id. at 278-279.
31 Id. at 280.
32 Id.
33 944 F.2d 997 (2d Cir. 1991).
34 Id. at 999, 1008.
35 Id. at 1008.
36 Id. (Since there is no option to accept payment in lieu of continued pollution,
any order that to any extent ends or ameliorates continued pollution is not an
30

Under most or all state laws, specific performance is only given when
money damages do not suffice as shown above.
Significantly, the Second Circuit volunteered it could have decided
Chateaugay somewhat differently.37 The other possibility would have been more
in line with the Bankruptcy Codes fresh start policy because it would have relieved
the debtor of an ongoing liability to clean up prepetition hazardous releases. The
Court observed it could have placed on the non-claim side only those injunctions
ordering a defendant to stop current activities that add to pollution (e.g., depositing
new hazardous substances), while leaving on the claim side all other injunctions,
including those that direct the cleanup of sites from which hazardous substances,
previously deposited, are currently contributing to pollution.38 Previously,
however, the Second Circuit had warned:
Of course, the comprehensive nature of the bankruptcy statute
does not relieve us of the obligation to construe its terms, nor may
we resolve all issues of statutory construction in favor of the fresh
start objective, regardless of the terms Congress has chosen to
express its will. . . . But we are obliged to apply the bankruptcy
laws that Congress enacted, not to reformulate it as theorists
would prefer to see it.39
Then, the Second Circuit rejected its alternate resolution, explaining:
We think we must endeavor to apply the claim definition as
written, mindful of the purposes of bankruptcy law but without the
prerogative of rewriting it to maximize bankruptcy objectives that
Congress might not have fully achieved.40
In sum and substance, the Second Circuit (now joined by other circuits)41
logically determined that section 101(5)(B)s provision that a breach must give rise
order for breach of an obligation that gives rise to a right of payment and is for
that reason not a claim.).
37 Id. at 1009.
38 Id.
39 Id. at 1002, 1003.
40 Id. at 1007.
41 See In re: Udell, 18 F.3d 403, 406, 407-8 (7th Cir. 1994) (holding that the
ability of a party to obtain injunctive relief and liquidated damages gives rise to
non-dischargeable claim if, under state law, such remedies are cumulative, not
alternative); Air Line Pilots Assoc. v. Continental Airlines (In re Continental
Airlines), 125 F.3d 120, 135, 136 (3d Cir. 1997), cert. denied, 522 U.S. 1114
(1998) (adopting same test for whether an equitable remedy is a dischargeable
claim: whether money damages are only cumulative or independently will
31

to payment to be a dischargeable claim, must refer to a payment that is an

adequate substitute for specific performance. Anything less would create an
exception that swallows the rule because courts can always order payment for
breach of performance.
Demonstrating that the right to payment under section 101(5)(B) must be an
adequate substitute for performance, the United States Court of Appeals for the
Seventh Circuit held the debtors contractual covenant not to compete gave rise to
a nondischargeable claim in In re Udell,42 even though the contract at issue
included a liquidated damages clause.
suffice to remedy the alleged violation); In re Ben Franklin Hotel Ass., 186 F.3d
301 (3d Cir. 1999) (defrauded partner not barred from pursuing equitable
demand for reinstatement of its partnership interest because such ownership
interest was not a claim or debt, and since monetary payment was not a viable
remedy, it was not subject to bankruptcy discharge); Sheerin v. Davis (In re
Davis), 3 F.3d 113 (5th Cir. 1993) (holding section 101(5)(B) of the Bankruptcy
Code does not require creditors entitled to an equitable remedy to select a
suboptimal remedy of money damages); see also Abboud v. Ground Round, Inc.
(In re Ground Round, Inc.), Case No. 05-039, 2005 Bankr. LEXIS 2595 (1st Cir.
B.A.P. Dec 15, 2005) (holding non-debtor lessor entitled to specific performance
of a lease rejected under section 365 requiring debtor to transfer liquor license to
lessor because liquor license was a unique item and for which money damages
would be inadequate). But see Lubrizol Enterprises, Inc. v. Richmond Metal
Finishers, Inc., 756 F.2d 1043, 1048 (4th Cir. 1985) (Although the Lubrizol court
concluded that rejection eliminates specific performance, it reached that result by
erroneously drawing an inference from legislative history of a proposed version of
the Bankruptcy Code later changed before enactment. Lubrizol inferred from
House Report No. 95-595, 95th Cong., 2d Sess. (1977) at 349, that section
365(g) provides only a damages remedy for the nondebtor. Id. at 1048. That
legislative history provides: The purpose [of section 365(g)] is to treat rejection
claim [sic] as prepetition claims. When the House Report was issued in 1977,
the House version of the Bankruptcy Code (H.R. 8200) defined claim to include
all legal and equitable rights including specific performance, by providing claim
means a right to payment . . . or a right to an equitable remedy for breach of
performance if such breach does not give rise to a right to payment . . .
(emphasis added). As finally enacted and as the Supreme Court acknowledged
in Kovacs, 469 U.S. at 280, claim means right to payment or a right to an
equitable remedy for breach of performance if such breach gives rise to a right to
payment . . . (emphasis added). In short, the legislative history relied on by
Lubrizol refers to claims, and the meaning of claims changed from including to
excluding specific performance after the legislative history was written. By
carving out of the universe of claims, rights to equitable remedies that do not give
rise to rights of payment, Congress excluded specific performance from
discharge when a right to payment is not an adequate substitute for it, as here.)
42 18 F.3d 403 (7th Cir. 1994).
32

Udell commenced its analysis by stating the issue as whether 101(5)(B)

requires any connection between the equitable and the legal remedies beyond the
fact that both remedies arise from the same breach of performance.43 Based on
Kovacs, Johnson v. Home State Bank,44 Chateaugay, and In re CMC Heartland
Partners,45 the Seventh Circuit found it easy to rule out the notion that if a breach
gives rise to an equitable remedy and money damages, the breach automatically
creates only a dischargeable claim.46 Rather, the court ruled the right to
performance and the right to payment must be substitutes for one another or
related in a manner that the debtor is entitled to stop the performance remedy,
such as foreclosure, by paying money:
[W]e hold that a right to an equitable remedy for breach of
performance is a claim if the same breach also gives rise to a
right to payment with respect to the equitable remedy. If the right
to payment is an alternative to the right to an equitable remedy,
the necessary relationship clearly exists, for the two remedies
would be substitutes for one another. . . . As the Supreme Courts
decision in Home State Bank implies, relationships other than
outright substitution may also suffice. For example, the right to
foreclose on a mortgage, though not strictly an alternative to the
right to the proceeds from the sale of the debtors property,
nonetheless gives rise to a corollary right to payment (and may in
fact be considered an alternative to money in the sense that the
debtor can stop the foreclosure by paying the full debt). The two
remedies are sufficiently related that the Supreme Court classified
the right to foreclose as a claim.47
Udells application of its holding to its facts is instructive. The court ruled
that state law allows an injunction in addition to liquidated damages, and thus, the
remedies are cumulative, unless the parties intended them to be substitutes at the
election of the party by whom the money is to be paid.48 Because the remedies
were cumulative and not alternative, the court ruled the right to an injunction was
not a dischargeable claim. Indeed, based on Kovacs, the court reasoned: the fact
that both remedies are triggered by a single act does not mean that the right to an
injunction gives rise to a right to liquidated damages. . . Lacking is the derivative
relationship between the two remedies exemplified by Home State Bank, supra,
where the equitable remedy of foreclosure was the means for realizing the right to
the proceeds from the sale of the debtors property.49
43 Id. at 406.
44 501 U.S. 78 (1991).
45 966 F.2d 1143 (7th Cir. 1992).
46 Udell, 18 F.3d at 407-08.
47 Id. at 408 (emphasis added) (footnote omitted).
48 Id.
49 Id. at 409, 410; accord Kennedy v. Medicap Pharmacies, Inc., 267 F.3d 493
(6th Cir. 2001) (equitable remedy of an injunction for breach of covenant not to
33

The concurrence in Udell utilizes a different, but equally persuasive analysis

concluding the covenant not to compete was a nondischargeable claim. Circuit
Judge Flaum reasons that any other result would create a patently absurd
interpretation of the statute.50
One court has provided guidance as to how to determine whether money
damages are adequate. In Creators Way Associated Labels, Inc. v. Mitchell (In re
Mitchell),51 the individual chapter 7 debtor contended his contract to provide
recordings exclusively for Creators Way was dischargeable. Chief Bankruptcy
Judge Bernstein articulated the test as follows:
As noted, the determinative question is whether the unperformed
obligation gives rise to a right to payment under state law, which
right is an adequate alternative to equitable relief.52
Judge Bernstein recognized that breach of the recording contract ordinarily gives
rise to a damage claim for lost profits.53 But, [t]he availability of the monetary
remedy, however, does not automatically mean that damages are an adequate
alternative under state law.54 Judge Bernstein ruled that to prove
nondischargeability, there would have to be proof the debtors services are
extraordinary or unique, or can not be replaced, or that damages are
inadequate.55
Notably, the equities compelling state courts to grant specific performance
must be fairly vindicated and not simply subordinated to other creditors desire to
maximize value no matter what the consequence to the injured contract party.
Public Auditorium Authority of Pittsburgh v. HBRM, LLC (In re Pittsburgh Sports
Associates Holding Co.),56 held an injunction against a debtor based on a lease
covenant nondischargeable, and explained:
Even if we assume, however, that claim holders and equity
interest holders would fare less well if a permanent injunction is
issued, the irreparable harm suffered by [the arena owners], and
the community at large in the absence of a permanent injunction
outweighs that experienced by claim holders and interest holders
in the presence of one. . . . It is not sufficient for purposes of
compete was not dischargeable claim because the requested injunction was not
an alternative to the right of payment).
50 Id. at 412.
51 249 B.R. 55 (Bankr. S.D.N.Y. 2000).
52 Id. at 60 (emphasis added).
53 Id.
54 Id.
55 Id.
56 1999 Bankr. LEXIS 1870, *23-24, 33 (Bankr. W.D. Pa. 1999).
34

101(5)(B) that the equitable remedy and the right to money

damages are related only to the extent that both happen to be
disjunctively available in the event of a breach.
Bankruptcy courts across the country adjudicate whether an equitable remedy is
dischargeable by determining whether money damages are an alternative remedy
as opposed to being an additional or cumulative remedy.57 That specific
performance under state law is often discretionary with the trial judge, does not
mean money damages are always an alternative. It is axiomatic that discretionary
decisions are reversible for abuse of discretion. Therefore, if it would be an abuse
of discretion to fail to grant specific performance, money damages would not be a
substitute.
As explained in In re Walnut Assocs.:58
[U]nless specific performance is available to the nondebtor party
under applicable state law, the debtor cannot be compelled to
render its performances required under the contract. However, if
state law does authorize specific performance under the rejected
executory contract, it means that the non-debtor should be able to
57 See, e.g., In re Indian River Estates, Inc., 293 B.R. 429, 434 (Bankr. N.D. Ohio
2003) (the dischargeability test is: could a monetary award substitute for the
equitable remedy. . . . 101(5)(B) does not require that a party accept a monetary
alternative if it is not in proportion to the equitable remedy. (citations omitted);
(breach of contract remedy to convey 8 lots held nondischargeable); In re Willets,
262 B.R. 552, 556 (Bankr. N.D. Fla. 2001) (order to remove pool and concrete
deck and to replace wooden deck nondischargeable because money damages not
an alternative); In re Bush, 273 B.R. 625, 628-629 (Bankr. S.D. Cal. 2002)
(contract to convey residence nondischargeable because state law provides it can
not be adequately relieved by pecuniary compensation); cf. In re Nickels Midway
Pier, LLC, 332 B.R. 262, 275-276 (Bankr. D.N.J. 2005) (An equitable remedy can
be a claim in bankruptcy under 101(5) provided that it can be reduced to
monetary damages.) (when the nondebtors right to specific performance for
breach of contract is already protected by the Bankruptcy Codes grant of specific
performance in sections 365(i) or (j), the Bankruptcy Codes specific performance
provisions control); In re Alongi, 272 B.R. 148, 155-156 (Bankr. D.Md. 2001)
(covenant to employer by individual debtor-doctor not to compete and covenant to
pay tail insurance held nondischargeable because debtor triggered those
provisions by postpetition termination of contract); Stone StreetCapital, Inc. v.
Granati (In re Granati), 270 B.R. 575, 586-587 (Bankr. E.D. Va. 2001) (debtors
specifically enforceable obligation to turn over annuity payments to entity that paid
debtor lump sum for such payments held nondischargeable based on
Chateaugay).
58 145 B.R. 489 (Bankr. E.D. Pa. 1992).
35

enforce the contract against the Debtor, irrespective of his rejection

of it.59
4.

Perils of Disapproved Postpetition Lending.

A. Alfs v. Wirum (In re Straightline Investments, Inc.), 525 F.3d
870 (9th Cir. 2008)
i.

Facts

The debtor, Straightline, operated a sawmill and did custom lumber milling
when it commenced its chapter 11 case. 525 F.3d at 875. Straightline requested
bankruptcy court approval to borrow up to $500,000 from Aalfs. 525 F.3d at
875. Straightlines president personally guaranteed Aalfs against all losses Aalfs
may incur from any lending to Straightline. 525 F.3d at 875. The bankruptcy
court authorized Straightline to borrow up to $100,000 from Aalfs secured by a
junior lien against equipment and a senior lien against inventory. But, the court
specifically denied requests to authorize any further borrowing, including loans
secured by accounts receivable. 525 F.3d at 876. Despite the order, from
September 30, 1997 through March 9, 1998 Aalfs advanced money to
Straightline in exchange for accounts receivable. 525 F.3d at 876. Aalfs paid
$186,455 for accounts having a face value of $200,600, and Aalfs collected
$163,007 from the accounts. 525 F.3d at 876. Aalfs referred to the transaction
as a factoring transaction. The Ninth Circuit notes that factoring is a sale of
accounts receivable at a discounted price that gives the seller the benefit of
immediate cash and the benefit that the factor assumes the risk of loss. 525
F.3d at 876n.1.
In April 1998, a chapter 11 trustee was appointed and then the case was
converted to chapter 7. The trustee commenced an action to avoid the factoring
transactions. The bankruptcy court ordered that the transfers of the accounts
receivable should be avoided which meant that Aalfs should return to the estate
the $163,007 it collected, the remaining accounts receivable it had not collected,
interest, and costs. 525 F.3d at 876. The Bankruptcy Appellate panel affirmed.
525 F.3d at 876.
ii.

Issues

Are the transfers of accounts receivable avoidable pursuant to 11 U.S.C.

549?
59 Id. at 494 (emphasis added); see also Fellerman & Cohen Realty Corp. v.
Clinical Plus Inc. (In re Hirschhorn), 156 B.R. 379, 381-82 (Bankr. E.D.N.Y. 1993)
(Section 365(g) is intended to affect only the monetary rights of creditors. . . .
Section 365(g) does not disturb the equitable non-monetary rights arising from
the breach of contract.).
36

Were the transfers of accounts receivable conducted in the ordinary

course of business?
Was the bankruptcy courts remedy under 11 U.S.C. 550 an abuse of
discretion?
iii. Holdings
Yes. The transfers were avoidable pursuant to 11 U.S.C. 549(a) and
the bankruptcy courts finding that the transaction was a disguised loan in
contravention of its earlier order was not clearly erroneous. 525 F.3d at 885.
The defenses of earmarking and recoupment were not established. 525 F.3d at
885.
The transfers were not conducted in the ordinary course of business. 525
F.3d at 885.
The recovery under 11 U.S.C. 550 was an appropriate equitable
remedy. 525 F.3d at 885.
iv.

Rationale

Bankruptcy Code section 549(a) provides:

Except as provided in subsection (b) or (c) of this section, the
trustee may avoid a transfer of property of the estate
(1) That occurs after the commencement of the case; and
(2) (A) that is authorized only under section 303(f) or 542(c)
of this title; or
(B) that is not authorized under this title or by the court.
The Ninth Circuit reasoned that regardless of whether the transaction was
a sale or a loan, it was a transfer after commencement of the case. In response
to Aalfs argument that section 549(a) does not apply when the transfer does not
deplete the estate, the Ninth Circuit ruled: We decline to expand the diminution
of estate doctrine, from its established application in 547 and 548 cases, to
this 549 case. Although the primary purpose of 11 U.S.C. 549 is to allow the
trustee to avoid post-petition transfers of property which deplete the estate, see 5
Lawrence P. King, Collier on Bankruptcy 549.02 (15th ed. 2005), the plaintiffs
failure to demonstrate a measurable depletion of the estate is not enough to
allow a transfer to stand when it is otherwise avoidable under 549 because it
satisfies all of the explicit requirements of an avoidable postpetition transfer.
525 F.3d at 878 (footnote omitted).

37

Aalf argued that the transfer was authorized by 11 U.S.C. 363(c)

because it was in the ordinary course. First applying the creditor expectation
test, see Burlington N. R.R. Co. v. Dant & Russell, Inc. (In re Dant & Russell,
Inc.), 853 F.2d 700, 704 (9th Cir. 1988), the court agreed with the bankruptcy
court that creditors would have expected notice and hearing after the court
disapproved the loan based on the accounts receivable. Second, the court ruled
similar businesses would not engage in the sale in the ordinary course based on
the evidentiary record. 525 F.3d at 881.
Earmarking requires that a third party lend money to a debtor for the
specific purpose of paying a selected creditor. Here there was no selected
creditor. 525 F.3d at 881-882.
Recoupment will not allow Aalf to collect back the amount he paid for the
accounts receivable because it is an equitable remedy and Aalf engaged in
inequitable conduct. 525 F.3d at 882.
11 U.S.C. 550(a) only allows the transferee to set off the amount it paid
in circumstances not relevant here. 525 F.3d at 884-885.
v.

Punitive Damages?

Plainly, the lender who may have been doing the debtor a favor, ended up
being tagged with compensatory and punitive damages. He lost the accounts
receivable he purchased and lost his purchase price, while the estate obtained a
windfall. As a matter of fairness, this appears only justifiable if the transaction is
viewed as an intentional circumvention of the bankruptcy courts order. That
characterization, however, is unlikely because the court did not order the debtor
not to use the collections from its accounts receivable. Thus, if the account
debtors had paid quickly, the debtor could have used the money to continue its
business. What the decision demonstrates, however, is that a dispassionate
application of 11 U.S.C. 363(c), 549(a), and 550(a) yields an exceptionally
harsh result because no credit is given for the amount paid for the accounts
receivable.
Finally, who was in the wrong? Bankruptcy Code section 364(a) controls
what debt the debtor may incur, and the bankruptcy court ordered the debtor not
to incur more debt or to borrow against its accounts receivable. The debtor
violated the statute and the courts direction. But, the court punished the lender,
while the debtor and its creditors obtained a windfall benefit for the debtors
wrongful conduct.
5.

Are Triangular Setoff Agreements Enforceable in Title 11 Cases?

38

A.In re SemGroup, L.P., 399 B.R. 388 (Bankr. D. Del. 2009) (BLS)
i.Facts
Chevron entered into prepetition derivative transactions with three
affiliated debtors. As credit enhancement, Chevron held the guaranty of
SemGroup, L.P. for all its transactions with SemGroups affiliates, and all the
parties entered into agreements containing triangular setoff authorizations which
provided:
in the event either party fails to make a timely payment of monies
due and owing to the other party, or in the event either party fails to
make timely delivery of product or crude oil due and owing to the
other party, the other party may offset any deliveries or payments
due under this or any other Agreement between the parties and
their affiliates.
399 B.R. at 391.
Upon commencement of the chapter 11 cases of SemGroup and its
affiliates, Chevron owed SemCrude $1,405,878.40, while Chevron was owed
$10,228,439.34 by SemFuel, and an additional $3,302,806.03 by SemStream.
399 B.R. at 392. Accordingly, Chevron requested relief from the automatic stay
(11 U.S.C. 362(a)(7)) to effectuate a setoff against what it owed SemCrude of
amounts it was owed by SemFuel or SemStream.
ii.

Issues

As a result of the triangular setoff provision, do Chevron and SemCrude

owe each other mutual debts for purposes of setoff under 11 U.S.C. 553(a)?60
60

11 U.S.C. 553(a) provides:

Setoff
(a) Except as otherwise provided in this section and in sections 362
and 363 of this title, this title does not affect any right of a creditor to
offset a mutual debt owing by such creditor to the debtor that arose
before the commencement of the case under this title against a
claim of such creditor against the debtor that arose before the
commencement of the case, except to the extent that-(1) the claim of such creditor against the debtor is disallowed;
(2) such claim was transferred, by an entity other than the debtor,
to such creditor--

39

[M]ay debts owing among different parties be considered mutual when there
are contractual netting provisions governing all parties business relationship
(sic)? 399 B.R. at 396.
Are triangular setoff arrangements permitted exceptions to the mutual debt
requirement in 11 U.S.C. 553(a)? 399 B.R. at 396.
iii.
Holdings
Chevron asserts that the terms of its contracts with the Debtors permit it to setoff
[sic] the debt it owes to one corporation, SemCrude, against the debt owed to it
by two other corporations, SemFuel and SemStream, thus effecting a triangular
setoff. The Court does not need to determine whether the specific terms of these
various contracts grant SemCrude this right, however. Instead, the Court holds
that Chevron is not permitted to effect such a setoff against the Debtors in this
case because section 553 of the Code prohibits a triangular setoff of debts
against one or more debtors in bankruptcy as a matter of law due to lack of
mutuality." 399 B.R. at 392-393.
Accordingly, the Court holds that non-mutual debts cannot be
transformed into a mutual debt under section 553 simply because a multi-party
agreement allows for setoff of non-mutual debts between the parties to the
agreement. 399 B.R. at 398.
The Court finds nothing in the language of the Code upon which to base a
conclusion that there is a contractual exception to the mutual debt requirement.
Absent a clear indication from the text of the Code that such an exception exists,
the Court deems it improper to recognize one. 399 B.R. at 399 (footnote
omitted).

(A) after the commencement of the case; or

(B)
(i) after 90 days before the date of the filing of the petition; and
(ii) while the debtor was insolvent (except for a setoff of a kind
described in section 362(b)(6), 362(b)(7), 362(b)(17), 362(b)(27),
555, 556, 559, 560, or 561); or
(3) the debt owed to the debtor by such creditor was incurred by
such creditor-(A) after 90 days before the date of the filing of the petition;
(B) while the debtor was insolvent; and
(C) for the purpose of obtaining a right of setoff against the debtor
(except for a setoff of a kind described in section 362(b)(6),
362(b)(7), 362(b)(17), 362(b)(27), 555, 556, 559, 560, or 561).

40

For these reasons, the Court holds that no exception to the mutual debt
requirement in section 553 can be created by private agreement. 399 B.R. at
399.
iv.

Rationale

In order to effect a setoff in bankruptcy, courts construing the Code

have long held that the debts to be offset must be mutual, prepetition debts. See,
e.g., Scherling v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181
B.R. 730, 738-39 (Bankr. S.D. N.Y. 1995).
The authorities are also clear that debts are considered mutual only
when they are due to and from the same persons in the same capacity.
Westinghouse Credit Corp. v. D'Urso, 278 F.3d 138, 149 (2d Cir. 2002)(citing
Westchester, 181 B.R. at 740). Put another way, mutuality requires that each
party must own his claim in his own right severally, with the right to collect in his
own name against the debtor in his own right and severally. Garden Ridge, 338
B.R. at 633-34 (quoting Braniff Airways, Inc. v. Exxon Co., U.S.A., 814 F.2d
1030, 1036 (5th Cir. 1987)). Because of the mutuality requirement in section
553(a), courts have routinely held that triangular setoffs are impermissible in
bankruptcy. See, e.g., Matter of United Sciences of America, Inc., 893 F.2d 720,
723 (5th Cir. 1990) (The mutuality requirement is designed to protect against
triangular set-off; for example, where the creditor attempts to set off its debt to
the debtor with the latters debt to a third party.); Elcona Homes Corp. v. Green
Tree Acceptance, Inc., 863 F.2d 483, 486 (7th Cir. 1988) (holding that the Code
speaks of a mutual debt and therefore precludes triangular set offs).
Moreover, because each corporation is a separate entity from its sister
corporations absent a piercing of the corporate veil, a subsidiarys debt may not
be set off against the credit of a parent or other subsidiary, or vice versa,
because no mutuality exists under the circumstances. Sentinel Products Corp.,
192 B.R. at 46 (citing MNC Commercial Corp. v. Joseph T. Ryerson & Son, Inc.,
882 F.2d 615, 618 n. 2 (2d Cir. 1989)). Allowing a creditor to offset a debt it
owes to one corporation against funds owed to it by another corporation even a
wholly-owned subsidiary would thus constitute an improper triangular setoff
under the Code. 399 B.R. at 393-394 (footnotes omitted).
Most triangular setoff decisions trace back to In re Berger Steel Co., 327
F.2d 401 (7th Cir. 1964). There, the court denied a triangular setoff due to its
finding that no such agreement existed, but the court cited certain decisions
allowing triangular setoffs under state law and in equity receiverships. 61 399 B.R.
at 395.

61 Piedmont

Print Works v. Receivers of Peoples State Bank, 68 F.2d 110 (4th

Cir. 1934), and Bromfield v. Trinidad Nat. Inv. Co., 36 F.2d 646 (10th Cir. 1929).
41

Having determined that mutual debts must exist, the SemGroup court
determined debts created by a tripartite agreement can not be mutual:
The court finds the definition of mutuality embraced by other
courts to be instructive in this matter. The overwhelming majority of
courts to consider the issue have held that debts are mutual only if
they are due to and from the same persons in the same capacity.
See, e.g., Westinghouse, 278 F.3d at 149; Garden Ridge, 338 B.R.
at 633; Westchester, 181 B.R. at 740. It is also widely accepted that
mutuality is strictly construed against the party seeking setoff. In re
Bennett Funding Group, Inc., 212 B.R. 206, 212 (2d Cir. BAP
1997). See also Garden Ridge, 338 B.R. at 634; In re Clemens,
261 B.R. 602, 606 (Bankr. M.D. Pa. 2001). The effect of this narrow
construction is that each party must own his claim in his own right
severally, with the right to collect in his own name against the
debtor in his own right and severally. Garden Ridge, 338 B.R. at
633-34 (quoting Braniff Airways, Inc., 814 F.2d at 1036).
Construing the generally accepted definition of mutuality
narrowly, as it is obliged to do, the Court concludes that mutuality
cannot be supplied by a multi-party agreement contemplating a
triangular setoff. Unlike a guarantee of debt, where the guarantor is
liable for making a payment on the debt it has guaranteed payment
of, an agreement to setoff funds does not create an indebtedness
from one party to another.62 An agreement to setoff funds, such as
the one claimed by Chevron in this case, does not give rise to a
debt that is due to Chevron and due from SemCrude. A party
such as SemCrude does not have to actually pay anything to a
creditor such as Chevron under a tripartite setoff agreement; rather,
it only sees one of its receivables reduced in size or eliminated.
SemCrude does not owe anything to Chevron, thus there are no
debts in this dispute owed between the same persons in the same
capacity.
Likewise, Chevron does not have a right to collect against
SemCrude under the agreement in this case. At most, the
agreement of the parties would give Chevron a right to offset a
right to pay less than it would otherwise have to pay to the extent of
62

This

is not to say that setoff would necessarily be appropriate against

SemCrude if it were a guarantor of SemStream or SemFuels debt, however. The
Court notes that a split of authority exists regarding the issue of whether an
unpaid guarantee can create mutuality for purposes of section 553. Compare
Ingersoll, 90 B.R. at 172, with Bloor, 32 B.R. at 1001- 02. The Court does not
reach this issue in this case because the only guarantor in this matter is
SemGroup, an entity that is not owed a debt by Chevron. 399 B.R. at 397n.7.

42

the setoff. The agreement does not call for SemCrude to make a
payment to Chevron, however. Consequently, the agreement does
not call for Chevron to collect anything from SemCrude. Chevron
is thus without a right to collect from SemCrude. At bottom,
Chevron may enjoy privity of contract with each of the relevant
Debtors, but it lacks the mutuality required by the plain language of
section 553.
399 B.R. at 396-397.
Ultimately, the SemGroup court determines that Chevron can not have
mutual debts between it and SemCrude because Chevron does not even have a
claim against SemCrude:
Regardless of whatever contractual right to setoff these debts
against each other it might have under state law, the fact remains
that Chevron only owes a debt to one debtor, SemCrude, and
SemCrude owes nothing to Chevron. Chevron does not even have
a claim against SemCrude because to have a claim it must have a
right to payment from SemCrude. See 11 U.S.C. 101(5).63 As
noted above, a right to effect a setoff can never impose a right to
payment, it only can yield a right to pay less than one would
otherwise have to pay. Therefore, the setoff advocated by Chevron
falls outside the express terms of section 553, and is
impermissible.
399R. at 397-398.
v.

Analysis

Significantly, while SemCrude ruled with a broad brush, it did not and
could not rule that parties are not allowed to convert non-mutual debts into
mutual debts. For instance, if A owes B, and a subsidiary of B owes A, there is
no law barring B from assuming or becoming jointly and severally liable for the
debt its subsidiary owes A, thereby creating mutual debts between A and B.
101(5) of the Code defines a claim as a right to payment, whether or
not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent,
matured, unmatured, disputed, undisputed, legal, equitable, secured, or
unsecured or a right to an equitable remedy for breach of performance if such
breach gives rise to a right to payment, whether or not such right to an equitable
remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed,
undisputed, secured, or unsecured. Although Chevron may be able to assert a
state law right to the equitable remedy of setoff, this right is not based on a
breach of performance that gives rise to a right to payment, as noted above. A
setoff agreement such as the one in this case only creates a right to pay less or
nothing, not a right to receive a payment. 399 B.R. at 398n.8.
63

Section

43

Such a debt assumption would only be voidable if B's incurrence of the debt
would be a fraudulent transfer. SemCrude did hold, however, that triangular
setoff agreements will not convert non-mutual debts into mutual debts.64
SemCrude raises, but leaves unanswered whether B's guaranty of its
subsidiary's debt will transform the non-mutual debts into mutual debts.65
Chevron's second argument raised the pivotal question, namely whether a
private agreement requiring triangular setoffs can transform non-mutual debts
into mutual debts. SemCrude says no. The crux of SemCrude's reasoning is
that granting A the right to reduce the amount A owes B, by the amount C owes
A, does not grant A the right to collect money from B. From the absence of A's
right to payment from B, SemCrude concludes A has no claim against B, and A
can not have a debt from B that is mutual with A's debt to B.66 This logic may
seem valid from the Bankruptcy Code's definition of claim in section 101(5) as a
"right to payment," and its definition of a debt in section 101(12) as a liability on a
claim. But, it is not valid for two reasons. The first reason is that Bankruptcy
Code section 102(2) eliminates the need for a right to payment. The second
reason is that section 101(5)(A) was misapplied.
SemCrudes logic is as follows:
Regardless of whatever contractual right to setoff these debts
against each other it might have under state law, the fact remains
that Chevron only owes a debt to one debtor, SemCrude, and
SemCrude owes nothing to Chevron. Chevron does not even have
a claim against SemCrude because to have a claim it must have a
right to payment from SemCrude. See 11 U.S.C. 101(5).67 As
noted above, a right to effect a setoff can never impose a right to
payment, it only can yield a right to pay less than one would
otherwise have to pay. Therefore, the setoff advocated by Chevron
falls outside the express terms of section 553, and is
impermissible.68
Accordingly, the Court holds that non-mutual debts cannot be transformed into a mutual debt
under section 553 simply because a multi-party agreement allows for setoff of non-mutual debts
between the parties to the agreement. 399 B.R. at 398.
65
399 B.R. at 397n.7.
66
399 B.R. at 396-398.
67
Section 101(5) of the Code defines a claim as a right to payment, whether or not such right is
reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed,
undisputed, legal, equitable, secured, or unsecured or a right to an equitable remedy for breach
of performance if such breach gives rise to a right to payment, whether or not such right to an
equitable remedy is reduced to judgment, fixed, contingent, matured, unmatured, disputed,
undisputed, secured, or unsecured. Although Chevron may be able to assert a state law right to
the equitable remedy of setoff, this right is not based on a breach of performance that gives rise
to a right to payment, as noted above. A setoff agreement such as the one in this case only
creates a right to pay less or nothing, not a right to receive a payment. 399 B.R. at 398n.8.
68
S399 B.R. at 397-398.
64

44

Chevron Held a Claim against SemCrude

Bankruptcy Code section 553(a) safeguards the offset of a mutual debt
owing by a creditor to the debtor against "a claim of such creditor against the
debtor" Section 102(2) provides: "'claim against the debtor' includes claim
against property of the debtor."
Simply put, the triangular setoff agreement grants Chevron a claim against
property of the debtor, namely SemCrude's receivable from Chevron. Therefore,
pursuant to the plain language of the Bankruptcy Code section 102(2), the
triangular setoff agreement grants Chevron a claim against the debtor
(SemCrude) because it grants Chevron a claim against property of the debtor.
Accordingly, SemCrude's conclusion that Chevron has no claim against
SemCrude is unequivocally wrong. The SemCrude court may not have
considered and discussed section 102(2) because it does not appear Chevron
made this contention.
Bankruptcy Code section 102(2) is normally associated with nonrecourse
claims against the debtor's property.69 Significantly, Congress could have
provided that a secured claim against the debtor includes a claim against
property, as opposed to a claim against the debtor includes a claim against
property. It did not do so. Additionally, Congress provided in Bankruptcy Code
section 506(a)(1) that an allowed claim subject to setoff will be a secured claim to
the extent of such setoff amount and an unsecured claim for the balance, if any.
Therefore, it appears Congress intentionally wrote section 102(2) broadly to
incorporate secured and unsecured claims against property of the debtor to
capture setoff claims. In any event, [w]hen the statutes language is plain,*the

69

The legislative history of 11 U.S.C. 102(2) provides:

"Paragraph (2) specifies that 'claim against the debtor' includes claim
against property of the debtor. This paragraph is intended to cover nonrecourse
loan agreements where the creditor's only rights are against property of the
debtor, and not against the debtor personally. Thus, such an agreement would
give rise to a claim that would be treated as a claim against the debtor
personally, for the purposes of the bankruptcy code. However, it would not
entitle the holders of the claim to distribution other than from the property in
which the holder had an interest."
th

Senate Report No. 95-989, 95 Cong., 2d Sess. (1978) at 315. After the Senate Report was
issued and during the House-Senate conference to reconcile their respective bankruptcy bills, 11
U.S.C. 1111(b)(1)(A) was added, see 124 Congressional Record H 11089 (September
28,1978)(statement of Congressman Don Edwards), which actually does entitle holders of
nonrecourse claims to distributions from property in which they do not have an interest in some
circumstances. See footnote 71 below.

45

sole function of the courts* at least where the disposition required by the text is
not absurd -- *is to enforce it according to its terms.*70
That a right to payment is not a required element of a claim is
independently corroborated by section 1111(b)(1)(A) of the Bankruptcy Code.
There, the Bankruptcy Code refers to an entity holding a nonrecourse lien
against property of the estate as holding a claim.71
Next, Bankruptcy Code section 101(12) provides that "debt" means
"liability on a claim." Given that Chevron holds a claim against SemCrude's
account receivable, and thus, SemCrude pursuant to section 102(2), Chevron
also holds a debt from SemCrude which is SemCrude's liability on Chevron's
claim. SemCrude's liabilities under the triangular setoff agreement include its
obligation to reduce its account receivable from Chevron to the extent of
Chevron's accounts receivable from SemFuel and SemStream. Conversely,
Chevron's liabilities to SemCrude are to reduce its account receivable from
SemCrude by the amounts of SemCrude's accounts receivable from Chevron's
affiliates.
Although section 102(2) shows a right to payment is an unnecessary
component of a claim (and a debt) if the creditor has a claim against the debtors
property, Chevron also has a right to payment that SemCrude overlooked. The
second reason SemCrude erroneously determined Chevron did not hold a claim
against SemCrude is that SemCrude misapplied Bankruptcy Code section
101(5). SemCrude tested whether Chevron had a right to payment from
SemCrude by looking to see whether the triangular setoff contract expressly
granted Chevron a right to payment. SemCrude reasoned that a right to effect a
setoff can never impose a right to payment, it only can yield a right to pay less
than one would otherwise have to pay.72
But, to determine whether a contractual right is a claim, section 101(5)
makes clear you must look at the remedy for breach, not just whether the
70

Hartford Underwriters Insurance Co. v. Union Planters Bank, 530 U.S. 1, 6 (2000)(quoting
United States v. Ron Pair Enterprises, Inc., 489 U.S. 235, 241(1989), quoting Caminetti v. United
States, 242 U.S. 470, 485 (1917)).
71
11 U.S.C. 1111(b)(1)(A) provides:
A claim secured by a lien on property of the estate shall be allowed or disallowed
under section 502 of this title the same as if the holder of such claim had
recourse against the debtor on account of such claim, whether or not such holder
has such recourse, unless
(i) the class of which such claim is a part elects, by at least two-thirds in amount
and more than half in number of allowed claims of such class, application of
paragraph (2) of this subsection; or
(ii) such holder does not have such recourse and such property is sold under
section 363 of this title or is to be sold under the plan.
72

399 B.R. at 398.

46

contract requires the debtor to pay money. In pertinent part, section 101(5)
provides a claim is a right to payment, whether or not such right is reduced to
judgment, or a right to an equitable remedy for breach of performance if such
breach gives rise to a right to payment The Bankruptcy Code's references to
reduced to judgment and remedy for breach make clear that the inquiry goes
to what type of judgment the nonbreaching contract party can procure if the
debtor breaches the contract. Here, if SemCrude were to breach the triangular
setoff agreement and require that Chevron pay SemCrude without setting off,
there is no question Chevron could obtain a money judgment for the amount it
was wrongfully required to pay. Conceptually, it is also clear that the remedy for
the breach of a financial contract such as a triangular setoff agreement would be
money damages.
That the court must look to the remedy for breach and not to whether the
contract requires the debtor to pay money under the express terms of the
contract, is critical. For instance, if A has a contract with B under which A agrees
not to compete with B in a certain geographical area, and A commences a
chapter 11 case and rejects the contract, SemCrude would preclude B from filing
an allowable damage claim against A because B has no right to payment from A
under the contract, notwithstanding that under state law B would certainly be
entitled to a money judgment for damages.
Similarly, if A has a contract to sell widgets to B for $1 per widget, and A
commences a chapter 11 case and rejects the contract because widgets are
selling for $3 per widget, SemCrudes holding would bar B from filing an
allowable claim against A for damages because under the contract B does not
have a right to payment from A. B only has a right to widgets from A. Indeed,
Bankruptcy Code section 502(b) provides that except to the extent a claim is not
allowable, the court shall determine the amount of such claim in lawful currency
of the United States as of the date of the filing of the petition, and shall allow the
claim in such amount It would be unnecessary for the statute to require the
allowance of claims in U.S. dollars if the failure of a contract to require payment
of U.S. dollars would render unallowable any claim under it.
Manifestly, the right to payment is determined on breach. Otherwise, the
entire policy underlying the Bankruptcy Code to provide debtors fresh starts
would be frustrated because multiple contracts would not give rise to claims. If
contracts requiring performance not involving the payment of money do not
create claims, those contract rights will not be dischargeable because
Bankruptcy Code sections 727(b), 1141(d)(1)(A), 1228(a), and 1328(a) only
discharge claims. Thus, the consequences of SemCrudes reasoning undermine
the key purpose of the definition of "claim" in the Bankruptcy Code to permit "the
broadest possible relief in the bankruptcy court."73 It is beyond doubt that these
consequences were unintended by the SemCrude court. The consequences
73

th

Senate Report No. 95-989, 95 Cong., 2d Sess. (1978) at 309.

47

leave no doubt that SemCrude's test for determining whether a claim exists is
erroneous.
Based on the foregoing analysis of Bankruptcy Code sections 101(5),
101(12), and 102(2), the triangular setoff agreement grants Chevron a prepetition
claim and debt against SemCrude recognized by the Bankruptcy Code because:
(a) the triangular setoff agreement grants Chevron a claim against
SemCrude's property which is its account receivable from Chevron,
(b) section 102(2) renders Chevron's claim against SemCrude's property a
claim against SemCrude, and Chevron's contract rights independently provide
Chevron a claim against SemCrude because Chevron would be entitled to a
money judgment on breach of the setoff agreement, and
(c) section 101(12) defines SemCrude's liability on Chevron's claim as a
debt.
Chevron and SemCrude had Mutual Debts
A given fact in the decision is that SemCrude has a prepetition claim and
debt against Chevron.74 Therefore, the remaining requirement for purposes of
setoff under Bankruptcy Code section 553(a) is whether Chevron and
SemCrude's respective debts are mutual debts.
SemCrude concluded mutual debts can not be created by a triangular
setoff agreement based on its reasoning that Chevron lacked any rights to
payment, claims, and debts against SemCrude. At the outset of its analysis of
the mutual debt question, however, SemCrude recited the accepted formula
defining mutual debts for setoff purposes, as follows:
"The overwhelming majority of courts to consider the issue have
held that debts are mutual only if 'they are due to and from the
same persons in the same capacity.' See, e.g., Westinghouse, 278
F.3d at 149; Garden Ridge, 338 B.R. at 633; Westchester, 181 B.R.
at 740. It is also widely accepted that 'mutuality is strictly construed
against the party seeking setoff.' In re Bennett Funding Group, Inc.,
212 B.R. 206, 212 (2d Cir. BAP 1997). See also Garden Ridge, 338
B.R. at 634; In re Clemens, 261 B.R. 602, 606 (Bankr. M.D. Pa.
2001). The effect of this narrow construction is that 'each party
must own his claim in his own right severally, with the right to
collect in his own name against the debtor in his own right and
severally.' Garden Ridge, 338 B.R. at 633-34 (quoting Braniff
Airways, Inc., 814 F.2d at 1036)."75

74
75

399 B.R. at 392.

S399 B.R. at 396.

48

The first test is whether Chevron and SemCrude have debts "due to and
from the same persons in the same capacity."76 Here, a given fact is that
SemCrude holds a claim against and debt from Chevron of approximately $1.4
million.77 Based on the analysis above, pursuant to the triangular setoff
agreement, Chevron holds a claim against and debt from SemCrude. In each
instance, SemCrude and Chevron hold their respective debts in their corporate
capacities, and not as an agent, trustee, or other capacity. Thus, the first test is
satisfied.
The second test is that "each party must own his claim in his own right
severally, with the right to collect in his own name against the debtor in his own
right and severally." In re Garden Ridge Corp., 338 B.R. 627, 633-634 (Bankr. D.
Del. 2006). Here, there is no dispute that SemCrude owned its claim with the
right to collect in its name against Chevron. Based on the triangular setoff
agreement, Chevron owns a prepetition claim against SemCrude. Indeed, it was
entered into precisely to enable Chevron to collect from SemCrude by reducing
Chevron's account payable to SemCrude. If SemCrude were to breach and
disallow setoff, Chevron has a valid state law claim entitling it to collect money
damages from SemCrude. In each instance, Chevron and SemCrude hold the
claims in the same capacities and can collect against each other severally.
Accordingly, the second test for mutual debts is also passed.
Another way to determine whether Chevron and SemCrude owe each
other mutual debts is to look at the substance of the triangular setoff transaction.
Assume that after Chevron trades with SemCrude and SemStream for one day,
Chevron owes SemCrude $1.4 million and SemFuel owes Chevron $10.2 million.
Further assume the three parties have entered into a master agreement
providing that on each payment or settlement date, SemCrude must assume joint
and several liability for SemFuel's debt in the amount, if any, that Chevron would
otherwise have to pay SemCrude on that date. Once SemCrude assumes joint
and several liability for a SemFuel debt to Chevron, there can be no question that
SemCrude and Chevron owe each other mutual debts for purposes of
Bankruptcy Code section 553(a). While this would enable Chevron to sue
SemCrude severally to collect the amount of debt SemCrude assumed, Chevron
would not have to go to the trouble of doing so because, in or out of bankruptcy,
it would be able to set off its debt to SemCrude against the SemCrude debt to
Chevron that SemCrude assumed from SemFuel.
Rather than going to the trouble of having SemCrude assume SemFuel's
debt to Chevron on each payment date, the triangular setoff agreement
eliminates the formal assumption step by authorizing the setoff which grants
Chevron the right to collect from SemCrude by setting off, or suing severally for

76
77

Washington Credit Corp., v. D'Urso, 278 F.3d 138, 149 (2d Cir. 2002).
399 B.R. at 392.

49

the money if SemCrude breaches and does not allow a setoff.78 Thus, the
master agreement and the triangular setoff agreement put the parties in the exact
same place. Substantively they are equivalent.
Therefore, whatever test is used, Chevron and SemCrude have mutual
debts for purposes of Bankruptcy Code section 553(a). Here, the terms of the
triangular setoff agreement expressly grant the right of setoff only upon the
failure of a counterparty to timely pay what it owes. That does not appear to
impact any of the mutual debt tests, and SemCrude does not rely on it to
conclude the debts are not mutual.
Public Policy
SemCrude attempts to corroborate its conclusions that Chevron and
SemCrude do not hold mutual debts, and setoff is unauthorized, by looking to
policy:
"One of the primary goals if not the primary goal of the Code is
to ensure that similarly-situated creditors are treated fairly and
enjoy an equality of distribution from a debtor absent a compelling
reason to depart from this principle. By allowing parties to contract
around the mutuality requirement of section 553, one creditor or a
handful of creditors could unfairly obtain payment from a debtor at
the expense of the debtors other creditors, thereby upsetting the
priority scheme of the Code and reducing the amount available for
distribution to all creditors."79
SemCrude's policy argument is circular. The policy that similarly situated
creditors should be treated alike, does not help determine whether creditors
having triangular setoff agreements are similarly situated to creditors not having
them. It certainly appears, they are not similarly situated. More importantly,
SemCrude distorts the policy that similarly situated creditors should be treated
alike, into a destructive policy that courts should strive to treat creditors as if they
78

See, e.g., In re Lang Machinery Corporation (Equibank v. Lang Machinery Co.), 1988 WL
110429 (Bankr.W.D.Pa.1988)(For a valid triangular setoff to exist, Debtor must have formally
agreed to permit aggregation of debts by two creditors), cited with approval in U.S. Bank v.
Custom Coals Laurel (In re Custom Coals Laurel), 258 B.R. 597, 607 (Bankr. W.D. Pa. 2001); In
re Virginia Block Co., 16 B.R. 560, 562 (Bankr. W.D. Va. 1981) (citing Inland Steel Co. v. Berger
Steel Co., Inc., 327 F.2d 401, 403-04 (7th Cir. 1964)) ("The Berger court found that a setoff
arrangement accommodating a parent corporation and its subsidiary would be allowable only in
those unique situations in which the parties to the transaction had, at the outset of their
relationship, entered into a separate agreement clearly establishing the intention of the parties to
treat the parent and subsidiary as one entity. Given this strict construction, it is clear in this
proceeding that the debts are not mutual debts within the meaning of s 553."); In re Balducci Oil
Co., Inc., 33 B.R. 847, 853 (Bankr. D. Colo. 1983) (mutuality found between three parties, as a
matter of contract law, where there was an express contractual agreement clearly evincing the
intent of the parties to treat the parent and subsidiary as one entity).
79
399 B.R. at 399 (footnote omitted).

50

are similarly situated. There is no virtue or benefit in the latter. As Judge

Friendly bluntly explained: Equality among creditors who have lawfully
80
bargained for different treatment is not equity but its opposite.
Notably, the Bankruptcy Code freely allows debtors and creditors to
contract for special treatment. The statute expressly acknowledges that creditors
can bargain to be secured, and the statute treats secured claims better than
unsecured claims. This is critical because often a debtor can not raise money
without granting collateral security. Similarly, debtors and creditors are allowed
to transact business with one another in a fashion that allows for setoff and
recoupment. In commodity trading, logic and common sense tell us that Chevron
would be willing to do more trading with SemGroup if each of the SemGroup
entities took responsibility for each other's debts by allowing Chevron to set off
against one entity amounts that were originally owed by another. SemCrude
retards public policy by hampering commerce and chilling Chevron's willingness
to trade with SemGroup entities absent the credit enhancement provided by
triangular setoff.
Allowance and Avoidance of Setoff Rights
Once a setoff right is established, however, the question remains whether
it is disallowable or avoidable. There appear to be four areas of inquiry.
First, the setoff right must pass muster under state law, except as modified
or preempted by the Bankruptcy Code. Bankruptcy Code section 502(b)(1)
provides a claim shall be allowed except to the extent that:
such claim is unenforceable against the debtor and property of the
debtor, under any agreement or applicable law for a reason other
than because such claim is contingent or unmatured
Pursuant to some states' laws, mutual debts may be set off when
liquidated and calculable, even if not matured.81 Here, the triangular setoff
agreement provided Chevron could set off when and if an affiliate of SemCrude
did not timely pay monies due and owing. Thus, while perhaps unnecessary
given the wording of 11 U.S.C. 502(b)(1), the monies Chevron was owed were
both uncontingent and matured. Likewise, the amount was liquidated and does
not even appear to have been in dispute. Whether Chevrons setoff claim is
conceptualized as its claim against SemCrudes receivable as interpreted by
80

Chem. Bank N.Y. Trust Co. v. Kheel (In re Seatrade Corp.), 369 F.2d 845, 848 (2d Cir. 1966).
The triangular setoff agreement is governed by Texas law. Texas law recognizes the right of
setoff so long as such amounts are liquidated and calculable. See e.g., Alley v. Bessemer Gas
Engine Co., 228 S.W. 963, 966 (Tex. Civ. App. Amarillo 1991), writ dismissed (June 15, 1921);
Commercial State Bank v. Van Hutton, 208 S.W. 363 (Tex. Civ. App. San Antonio 1919); see also
In re Williams, 61 B.R. 567, (Bankr. N.D. Tex. 1986) (Under Texas law, debtor's bank that issued
a promissory demand note had a valid right of offset on date petition was filed, even though the
note had not matured by its terms.)
81

51

Bankruptcy Code section 102(2), or as its claim for damages for breach by
SemCrude of its triangular setoff agreement under Bankruptcy Code section
101(5), the amount of the claim appears fully liquidated.
Second, is Chevrons setoff right disallowed by 11 U.S.C. 553(a)(3)?82
To be disallowable under section 553(a)(3), Chevrons claim against SemCrude
would have had to have been outside the Bankruptcy Code's safe harbors
(discussed below) and incurred by Chevron within 90 days before SemCrudes
bankruptcy, while SemCrude was insolvent, and for the purpose of obtaining a
right of setoff against SemCrude (except for certain setoffs within the Bankruptcy
Codes safe harbors for derivative transactions). For arguments sake, let us
assume Chevrons claim was incurred within 90 days prior to SemCrudes
chapter 11 petition and that SemCrude was insolvent. The question becomes
whether it was incurred to obtain a right of setoff. This is a question of intent.
The decision does not tell us whether Chevron incurred its claim before or after
its affiliates incurred their respective claims. The existence of the triangular
setoff agreement shows both Chevron and SemCrude wanted their respective
net exposures to equal the net amount that would be owing if neither of them had
any affiliates. Thus, it is not possible from the SemCrude decision to determine
the intent issue. The jurisprudence, of necessity, is case specific, but logically
shows, for instance, that an assignment of a judgment claim between affiliates for
no apparent reason other than to create a right of setoff, implies an intent to incur
a right of setoff.83
Conversely, SemCrude did, in fact, incur SemFuel or SemStreams debt to
Chevron for the purpose of providing Chevron a right of setoff. This was required
by the triangular setoff agreement. This would not satisfy the literal terms of
section 553(a)(3), which requires the nondebtor to incur the debt. Even if the
statute were read to encompass the debtors incurrence of a debt to allow the
creditor a right of setoff, there is still a question as to timing. SemCrudes
incurrence of the debt was pursuant to the triangular setoff agreement
presumably entered into when the two parties started trading. Thus, even if
SemFuel and/or SemStreams trades occurred within 90 days before
SemCrudes bankruptcy, incurrence of their debts to Chevron may be traced
back to when SemCrude entered into the triangular setoff agreement. Whether
to place the incurrence of debt on the triangular setoff agreement date, the trade
date, or the settlement date is not yet addressed in the jurisprudence, but, as
seen below, is immaterial for trades falling within the safe harbors for derivatives
and expressly insulated from the operation of this avoidance power by
Bankruptcy Code sections 546 and 553.
To address this uncertainty, however, it appears trading parties desiring to
enforce triangular setoff should enter into mutual guaranties of their respective
82

See footnote 7, supra.

Equibank v. Lang Machinery Co. (In re Lang Machinery Corp.), 1988 WL110429*3 (Bankr.
W.D. Pa. 1988).
83

52

affiliates debts at the outset of the trading relationship, which guaranties should
expressly provide for each affiliate to assume its affiliate's debt for purposes of
allowing setoffs on settlement dates. Here, that would have rendered SemCrude
liable in the first place for SemStream and SemFuels debts to Chevron so that
Chevron would have had a setoff right without the triangular setoff agreement
and section 553(a)(3) would be inapplicable.84 The guaranties could provide that
they should be enforced only to the extent of available setoffs on settlement
dates, if the parties want to replicate the effects of a triangular setoff agreement.
Of course, the uncertainty may also be addressed by having the affiliates
assume joint and several liability for each other's trades, but that could create
liability beyond the setoffs contemplated by triangular setoff agreements, unless
the affiliates assume joint and several liability only up to the amount available for
setoff which is substantively what happens under triangular setoff agreements.
Third, if the right of setoff is not otherwise allowable under section 553, is
it nevertheless rendered allowable by one of the safe harbors in the Bankruptcy
Code or in that section? Chevron is not reported to have asserted its setoff right
is enforceable due to a safe harbor, but it may well have that protection. For
example, if the contracts were qualifying85 forward contracts, the triangular setoff
agreement, which provides credit enhancement, would come within the portion of
84

In In re Ingersoll, 90 B.R. 168, 171 (Bankr. W.D. N.C. 1987), a corporation (Rosdon) owed a
husband and wife over $440,000, which debt was guaranteed by Rosdon's owner. The note
provided Rosdon could set off against its note, any amounts the husband or wife owed Rosdon.
Subsequently, the husband and wife became indebted to Rosdon's owner for $22,000, and the
husband orally advised the owner he could offset the $22,000 against Rosdon's note if the
$22,000 were not paid. When the wife commenced a chapter 13 case, the owner requested
leave to set off the $22,000 against the $440,000. The court denied the owner's request, ruling
"[a]ny comments [husband] may have made regarding [owner's] right to set off Rosdon's debt do
not constitute a contractual right for offset. Those statements lack the formality of a binding
contract and amount at most to a statement of opinion...." Id. In respect of the owner's
contention that his guaranty of Rosdon's note rendered the two debts mutual, the court ruled:
"While that may be the effect of his guaranty, it does not change the fact that the debts are
between different parties in different capacities, and, thus, not subject to offset. Id. The latter
ruling may be justified on the facts because there was no cross default and therefore the $22,000
debt was matured due to bankruptcy, while the $440,000 was unmatured. "An unmatured claim
may not be offset against a matured claim unless the indemnitor is insolvent. Collum v.
Commercial Credit Co., 134 S.W.2d 826, 827 (Tex.Civ.App.-Amarillo 1939, writ dism'd w.o.j.)." In
re The Charter Co., 63 B.R. 568, 571 (Bankr. M.D. Fla. 1986). Otherwise, Ingersoll is contrary to
Bloor v. Shapiro, 32 B.R. 993, 1002 (S.D.N.Y. 1983)(Bankruptcy Act Chapter X case), where the
court ruled: "If the guarantee agreements entitled the [guarantors] to assert the [primary obligors']
claims, which were closely related to the guarantees, then the trustee's liability under such claims
would be debts owed to the [guarantors], to the extent of the [guarantors'] liability under the
guarantees. Such claims could thus be asserted by the [guarantors] as set-offs." Accordingly,
as belt and suspenders, trading parties will better position themselves to avoid attacks on
triangular setoffs if they utilize guarantees containing express triangular setoff language. The
master agreements and termination provisions should assure the parties will be setting off
matured debts against matured debts.
85
References to qualifying contracts in this article are to contracts (a) held by one of the entities
listed in Bankruptcy Code sections 555, 556, 559, 560, or 561, and (b) constituting one of the
types of contracts whose liquidation, termination, and enforcement are protected by such sections
when held by one of such entities.

53

the definition of forward contracts in Bankruptcy Code section 101(25)(E), 86

which includes any other credit enhancement related to qualifying forward
contracts. Chevron could then invoke the safe harbor in Bankruptcy Code
section 556,87 which safeguards Chevrons ability to liquidate, terminate, or
accelerate qualifying forward contracts by providing they shall not be stayed,
avoided, or otherwise limited by operation of any provision of this title or by the
order of a court in any proceeding under this title. Notably, given that section
556 overrides any provision of title 11, even provisions of section 553 must give
way to their enforceability under section 556. This is partially recognized in
section 553(a)(2) and (3) by those subsections express carveouts of safe
harbors including section 556. Significantly, however, section 556 and the other
similar safe harbors in the Bankruptcy Code provide the contractual rights to
liquidate, terminate, or accelerate a qualifying contract, which includes credit
enhancements, shall not be limited by operation of any provision of title 11. In
addition, contractual right is broadly defined to include a right, whether or not
evidenced in writing, arising under common law, under law merchant or by
reason of normal business practice, suggesting that even dealings in the ordinary
course of the derivatives business gives rise to contractual rights. Therefore, it
86

11 U.S.C. 101(25)(E) provides:

The term forward contract means
(E) any security agreement or arrangement, or other credit enhancement related
to any agreement or transaction referred to in subparagraph (A), (B), (C), or (D),
including any guarantee or reimbursement obligation by or to a forward contract
merchant or financial participant in connection with any agreement or transaction
referred to in any such subparagraph, but not to exceed the damages in
connection with any such agreement or transaction, measured in accordance
with section 562.

87

11 U.S.C. 556 provides:

The contractual right of a commodity broker, financial participant, or forward
contract merchant to cause the liquidation, termination, or acceleration of a
commodity contract, as defined in section 761 of this title, or forward contract
because of a condition of the kind specified in section 365 (e)(1) of this title, and
the right to a variation or maintenance margin payment received from a trustee
with respect to open commodity contracts or forward contracts, shall not be
stayed, avoided, or otherwise limited by operation of any provision of this title or
by the order of a court in any proceeding under this title. As used in this section,
the term contractual right includes a right set forth in a rule or bylaw of a
derivatives clearing organization (as defined in the Commodity Exchange Act), a
multilateral clearing organization (as defined in the Federal Deposit Insurance
Corporation Improvement Act of 1991), a national securities exchange, a national
securities association, a securities clearing agency, a contract market designated
under the Commodity Exchange Act, a derivatives transaction execution facility
registered under the Commodity Exchange Act, or a board of trade (as defined in
the Commodity Exchange Act) or in a resolution of the governing board thereof
and a right, whether or not evidenced in writing, arising under common law,
under law merchant or by reason of normal business practice.

54

appears the plain language of the safe harbor provisions bars the limitation of
setoffs of debts whether mutual or not, if effective under state law.
The same analysis applies to any qualifying commodity contract because
its definition also includes credit enhancements related to them.88 Similarly,
securities contracts are defined to include credit enhancements,89 and are
protected by the safe harbor in Bankruptcy Code section 555. The same
analysis applies to qualifying repurchase agreements, swap agreements, and
master netting agreements.90
In addition to safeguarding contractual rights to liquidate, terminate, and
accelerate qualifying derivative contracts and their credit enhancements, the
Bankruptcy Code also insulates the holders of those contracts from most
avoidance powers such as preferences and fraudulent transfers, other than
fraudulent transfers with actual intent to hinder, delay, or defraud creditors.91
Thus, the liquidation of qualifying derivative contracts and the exercise of the
triangular setoff should not be voidable as a preference or constructively
fraudulent transfer (a fraudulent transfer not based on actual intent to hinder,
delay, or defraud creditors).
The entering into of the triangular setoff agreement, however, is not within
the safe harbor which only protects transfers under qualifying derivative
88

11 U.S.C. 761(4)(J).
11 U.S.C. 741(7)(A)(ix).
90
11 U.S.C. 101(38A)(A)(master netting agreement), 101(47)(A)(v)(repurchase agreement),
101(53B)(A)(vi)(swap agreement), 559, 560, 561.
91
11 U.S.C. 546(e-g) provide:
89

(e) Notwithstanding sections 544, 545, 547, 548 (a)(1)(B), and 548 (b) of this title,
the trustee may not avoid a transfer that is a margin payment, as defined in
section 101, 741, or 761 of this title, or settlement payment, as defined in section
101 or 741 of this title, made by or to (or for the benefit of) a commodity broker,
forward contract merchant, stockbroker, financial institution, financial participant,
or securities clearing agency, or that is a transfer made by or to (or for the benefit
of) a commodity broker, forward contract merchant, stockbroker, financial
institution, financial participant, or securities clearing agency, in connection with a
securities contract, as defined in section 741 (7), commodity contract, as defined
in section 761 (4), or forward contract, that is made before the commencement of
the case, except under section 548 (a)(1)(A) of this title.
(f) Notwithstanding sections 544, 545, 547, 548 (a)(1)(B), and 548 (b) of this title,
the trustee may not avoid a transfer made by or to (or for the benefit of) a repo
participant or financial participant, in connection with a repurchase agreement
and that is made before the commencement of the case, except under section
548 (a)(1)(A) of this title.
(g) Notwithstanding sections 544, 545, 547, 548 (a)(1)(B) and 548 (b) of this title,
the trustee may not avoid a transfer, made by or to (or for the benefit of) a swap
participant or financial participant, under or in connection with any swap
agreement and that is made before the commencement of the case, except
under section 548 (a)(1)(A) of this title.

55

contracts. Therefore, the entering into of the triangular setoff agreement may be
avoided as a constructively fraudulent transfer if, for instance, it is entered into
after the derivative trading has begun and its effect is to cause a debtor to
assume affiliate debt without any corresponding, reasonably equivalent benefit to
the debtor and while the debtor is insolvent or rendered insolvent. If the
agreement itself is avoided, transactions under it may be avoided.
The Bankruptcy Code also excludes from the operation of the automatic
stay, setoffs of mutual debts under or in connection with qualifying commodity
contracts, forward contracts, securities contracts, repurchase agreements, swap
agreements, and master netting agreements.92
Fourth, if Chevrons right of setoff against SemCrudes account receivable
from Chevron is conceptualized as Chevron having a security interest in that
account receivable, then should the security interest be avoided pursuant to
Bankruptcy Code section 544(a)(1)93 and preserved for the benefit of the debtors
estate pursuant to Bankruptcy Code section 551,94 thereby stripping Chevron of
its right to set off? If Chevrons setoff right were an unperfected security interest
and unprotected by a safe harbor, it would be subject to avoidance by the trustee
or debtor in possessions hypothetical status as a judicial lien creditor. If the
triangular setoff agreement, however, is a qualified derivative contract for which a
safe harbor exists, the safe harbor would insulate Chevron from attacks by a
trustee or debtor in possession pursuant to Bankruptcy Code section 544.95 The
safe harbor would not, however, insulate Chevron from an attack by an entity
holding a perfected security interest in SemCrudes account receivable from
Chevron because the Uniform Commercial Codes priority scheme gives the
perfected security interest priority over the unperfected security interest.96

92
93

11 U.S.C. 362(b)(6), 362(b)(7), 363(b)(17), and 362(b)(27).

11 U.S.C. 544(a)(1) provides:
(a) The trustee shall have, as of the commencement of the case, and without
regard to any knowledge of the trustee or of any creditor, the rights and powers
of, or may avoid any transfer of property of the debtor or any obligation incurred
by the debtor that is voidable by
(1) a creditor that extends credit to the debtor at the time of the commencement
of the case, and that obtains, at such time and with respect to such credit, a
judicial lien on all property on which a creditor on a simple contract could have
obtained such a judicial lien, whether or not such a creditor exists

94

11 U.S.C. 551 provides:

Any transfer avoided under section 522, 544, 545, 547, 548, 549, or 724 (a) of
this title, or any lien void under section 506 (d) of this title, is preserved for the
benefit of the estate but only with respect to property of the estate.

95
96

See 11 U.S.C. 546(e-g) at footnote 32, supra.

U.C.C. 9-322(a) provides:

56

Because Bankruptcy Code section 102(2) provides a claim includes a

claim against property, and does not require a secured claim against property,
the Bankruptcy Code clearly does not require that the setoff right be considered a
perfected or unperfected secured claim as a condition of qualifying as a claim.
Therefore, it is consistent with the Bankruptcy Code that Chevrons setoff right be
characterized as an unsecured claim against property of SemCrude pursuant to
section 102(2), namely a simple unsecured claim under the triangular setoff
agreement. The allowability of the claim is further corroborated by Bankruptcy
Code section 506(a)(1) which renders the setoff claim a secured claim to the
extent it is subject to setoff under section 553.
If Chevrons setoff claim is considered a contract claim or defense,97 then
Uniform Commercial Code subsections 9-404 (a) and (b)98 govern.99 In short, if
(a) [General priority rules.]
Except as otherwise provided in this section, priority among conflicting security
interests and agricultural liens in the same collateral is determined according to
the following rules:
(1) Conflicting perfected security interests and agricultural liens rank according to
priority in time of filing or perfection. Priority dates from the earlier of the time a
filing covering the collateral is first made or the security interest or agricultural
lien is first perfected, if there is no period thereafter when there is neither filing
nor perfection.
(2) A perfected security interest or agricultural lien has priority over a
conflicting unperfected security interest or agricultural lien.
(3) The first security interest or agricultural lien to attach or become effective
has priority if conflicting security interests and agricultural liens are unperfected.

97

U.S. Aeroteam, Inc. v. Delphi Automotive Systems LLC (In re U.S. Aeroteam, Inc.), 327 B.R.
852, 863 (Bankr. S.D. Ohio 2005)(triangular setoff right treated and referred to as contractual
right).
98
U.C.C. section 9-404(a)-(b) provide:
(a) [Assignee's rights subject to terms, claims, and defenses; exceptions.]
Unless an account debtor has made an enforceable agreement not to assert
defenses or claims, and subject to subsections (b) through (e), the rights of an
assignee are subject to:
(1) all terms of the agreement between the account debtor and assignor and any
defense or claim in recoupment arising from the transaction that gave rise to the
contract; and

57

Chevron obtained the setoff right against SemCrudes account receivable from
Chevron, prior to Chevrons receiving notification100 of a security interest in the
(2) any other defense or claim of the account debtor against the assignor which
accrues before the account debtor receives a notification of the assignment
authenticated by the assignor or the assignee.
(b) [Account debtor's claim reduces amount owed to assignee.]
Subject to subsection (c) and except as otherwise provided in subsection (d), the
claim of an account debtor against an assignor may be asserted against an
assignee under subsection (a) only to reduce the amount the account debtor
owes.
99

Pursuant to U.C.C. 9-109(d)(10)(B), article 9 of the U.C.C. does not apply to recoupments
and setoffs, except section 9-404 applies to defenses or claims of an account debtor.
100
U.C.C. 1-202 provides:
1-202. Notice; Knowledge.
(a) Subject to subsection (f), a person has "notice" of a fact if the person: (1) has
actual knowledge of it; (2) has received a notice or notification of it; or (3) from all
the facts and circumstances known to the person at the time in question, has
reason to know that it exists.
(b) "Knowledge" means actual knowledge. "Knows" has a corresponding
meaning.
(c) "Discover", "learn", or words of similar import refer to knowledge rather than
to reason to know.
(d) A person "notifies" or "gives" a notice or notification to another person by
taking such steps as may be reasonably required to inform the other person in
ordinary course, whether or not the other person actually comes to know of it.
(e) Subject to subsection (f), a person "receives" a notice or notification when:
(1) it comes to that person's attention; or (2) it is duly delivered in a form
reasonable under the circumstances at the place of business through which the
contract was made or at another location held out by that person as the place for
receipt of such communications.
(f) Notice, knowledge, or a notice or notification received by an organization is
effective for a particular transaction from the time it is brought to the attention of
the individual conducting that transaction and, in any event, from the time it
would have been brought to the individual's attention if the organization had
exercised due diligence. An organization exercises due diligence if it maintains
reasonable routines for communicating significant information to the person
conducting the transaction and there is reasonable compliance with the routines.
Due diligence does not require an individual acting for the organization to
communicate information unless the communication is part of the individual's
regular duties or the individual has reason to know of the transaction and that the
transaction would be materially affected by the information.

58

account receivable, such as the debtor in possessions hypothetical lien, then

Chevrons setoff right takes precedence and can be enforced.
Conclusions:
1. A dispassionate reading of sections 101(5), 101(12), and 102(2) of the
Bankruptcy Code shows triangular setoff agreements can create mutual debts
for purposes of setoff pursuant to Bankruptcy Code section 553(a).
2. There is no valid public policy encouraging a court to treat creditors with
triangular setoff agreements like creditors without them. Indeed, such similar
treatment of different creditors would chill and distort commerce by
discouraging creditors from extending additional credit to debtors that provide
credit enhancement through triangular setoff agreements.
3. When a triangular setoff agreement is entered into in connection with
qualifying derivative contracts, the safe harbors in the Bankruptcy Code
should protect setoff rights arising under them as credit enhancements,
although they do not protect the entering into of the triangular setoff
agreement. Therefore, if the agreement is entered into after trading has
commenced and only has the effect of causing an insolvent entity to incur
additional debt, the agreement may be avoided. Otherwise, the triangular
setoffs should neither be avoided as preferences, constructively fraudulent
transfers, or unperfected security interests.
4. If, however, the setoffs are deemed unperfected security interests, they will
be subject to any perfected security interests in the account to be set off.
5. Finally, if the triangular setoffs are more properly deemed contract rights or
defenses, they should be enforceable against any party holding a perfected
security interest in the account to be set off, including a bankruptcy trustee,
who obtains the security interest after the setoff right is created, but not
against parties obtaining perfected security interests beforehand and causing
the nondebtor party to be notified of same beforehand.
6. To mitigate the possibilities that the setoff right will not be considered a setoff
of mutual debts, or that the setoff may be avoided under Bankruptcy Code
section 553 or treated as an unperfected security interest, the parties may
enter into mutual guarantees of their respective affiliates debts at the
inception of trading, and the guarantees should provide that they shall be
enforced by setoffs on settlement dates if the parties desire to replicate the
rights and remedies of the triangular setoff agreement. The master
agreements and their termination provisions should expressly provide that
affiliates assume their affiliates' debt for purposes of enabling the parties to
set off on settlement dates.

Notification is not satisfied by the filing of a security interest; it requires actual notice. Iowa Oil
Co. v. Citgo Petroleum Corp (In re Iowa Oil Co.) , 2004 U.S. Dist. LEXIS 20734, 2004 WL
2326377, *6 , 55 U.C.C. Rep. Serv. 2d (Callaghan) 48 (N.D. Iowa, September 30, 2004).

59

6. Much Diminished State Sovereign Immunity in the Bankruptcy

Court
A.Central Virginia Community College v. Katz, 546 U.S. 356,
126 S. Ct. 990 (2006)
i.

Facts.

A bankruptcy court appointed liquidating supervisor of Wallace

Bookstores, Inc. commenced an action in the bankruptcy court against Virginia
educational institutions entitled to sovereign immunity to recover preferences
under 11 U.S.C. 547(b) and 550(a) and to collect accounts receivable. 126 S.
Ct. at 994. The supervisor filed a letter with the Supreme Court indicating his
intent not to pursue the accounts receivable claims. 126 S. Ct. at 996. Based on
Hood v. Tennessee Student Assistance Corporation (In re Hood), 319 F.3d 755
(6th Cir. 2003), the district court and United States Court of appeals for the Sixth
Circuit affirmed the bankruptcy courts denial of the governmental units motions
to dismiss grounded in sovereign immunity.
ii.

Issue.

The Supreme Court granted certiorari to consider the question left open by
Tennessee Student Assistance Corporation v. Hood, 541 U.S. 440 (2005),
namely whether Congress attempt to abrogate state sovereign immunity in the
amendment of 11 U.S.C. 106(a) is valid. But, the Supreme Court ultimately
decided the case based on the more dramatic issue of whether the United States
Constitution itself abrogates sovereign immunity in the bankruptcy court,
rendering 11 U.S.C. 106(a) unnecessary.
iii.

Holding

The relevant question is not whether Congress has abrogated States

immunity in proceedings to recover preferential transfers. See 11 U.S.C.
106(a). (footnote omitted). The question, rather, is whether Congress
determination that States should be amenable to such proceedings is within the
scope of its power to enact Laws on the subject of Bankruptcies. We think it
beyond peradventure that it is. 126 S. Ct. at 1005.
Congress may, at its option, either treat States in the same way as other
creditors insofar as concerns Laws on the subject of Bankruptcies or exempt
them from operation of such laws. Its power to do so arises from the Bankruptcy
Clause itself; the relevant abrogation is the one effected in the plan of the
Convention, not by statute. 126 S. Ct. at 1005.
[T]he ratification of the Bankruptcy Clause does represent a surrender by
the States of their sovereign immunity in certain federal proceedings. 126 S.
60

Ct. at 1000n.9. *** As we explain in Part IV, infra, it is not necessary to decide
whether actions to recover preferential transfers pursuant to 550(a) are
themselves properly characterized as in rem. (footnote omitted). Whatever the
appropriate appellation, those who crafted the Bankruptcy Clause would have
understood it to give Congress the power to authorize courts to avoid preferential
transfers and to recover the transferred property. 126 S.Ct. at 1001-1002.
Insofar as orders ancillary to the bankruptcy courts in rem jurisdiction,
like orders directing turnover of preferential transfers, implicate States sovereign
immunity from suit, the States agreed in the plan of the Convention not to assert
that immunity. 126 S.Ct. at 960. *** [T]ext aside, the Framers, in adopting
the Bankruptcy Clause, plainly intended to give Congress the power to redress
the rampant injustice resulting from States refusal to respect one anothers
discharge orders. As demonstrated by the First Congress immediate
consideration and the Sixth Congress enactment of a provision granting federal
courts the authority to release debtors from state prisons, the power to enact
bankruptcy legislation was understood to carry with it the power to subordinate
state sovereignty, albeit within a limited sphere. 126 S.Ct. at 1004.
The ineluctable conclusion, then, is that States agreed in the plan of the
Convention not to assert any sovereign immunity defense they might have had in
proceedings brought pursuant to Laws on the subject of Bankruptcies. *** The
scope of this consent was limited; the jurisdiction exercised in bankruptcy
proceedings was chiefly in rem a narrow jurisdiction that does not implicate
state sovereignty to nearly the same degree as other kinds of jurisdiction. But
while the principal focus of the bankruptcy proceedings is an was always the res,
some exercises of bankruptcy courts powers issuance of writs of habeas
corpus included unquestionably involved more than mere adjudication of rights
in a res. In ratifying the Bankruptcy Clause, the States acquiesced in a
subordination of whatever sovereign immunity they might otherwise have
asserted in proceedings necessary to effectuate the in rem jurisdiction of the
bankruptcy courts. (footnote 15) 126 S.Ct. at 1004-1005.
To be sure, footnote 15 will provoke further litigation. It provides: We do
not mean to suggest that every law labeled a bankruptcy law could, consistent
with the Bankruptcy Clause, properly impinge upon state sovereign immunity.
126 S.Ct. at 1005n.15.
iv.

Rationale

The Supreme Court had agreed in Seminole Tribe of Fla. v. Florida, 517
U.S. 44 (1966), that Congress unequivocally expressed its intent to abrogate
state immunity, 517 U.S. at 56, but ruled the abrogation applicable there was not
pursuant to a valid exercise of power. Both the majority and dissent in Seminole
signaled the bankruptcy, antitrust, and copyright laws ought to correspondingly
fail to abrogate validly the states sovereign immunity. Seminole, 517 U.S. at 73

61

(majority) and 93-94 (Justice Stephens dissent). Accordingly, the Supreme

Court first dealt with whether its prior observations were binding.
The majority reasoned based on Cohens v. Virginia, 6 Wheat. 264 (1821),
that the court was not bound to follow our dicta in a prior case in which the point
now at issue was not fully debated. See id., at 399-400 (It is a maxim not to be
disregarded, that general expressions, in every opinion, are to be taken in
connection with the case in which those expressions are used. If they go beyond
the case, they may be respected, but ought not to control the judgment in a
subsequent suit when the very point is presented for decision.). 126 S.Ct. at
996.
The Supreme Court reasoned based on Gardner v. New Jersey, 329 U.S.
565, 574 (1947), that bankruptcy jurisdiction, at its core, is in rem, and includes
power to issue compulsory orders to facilitate administration and distribution of
the res. 126 S.Ct. at 995. Then, the court explains based on the history of the
Bankruptcy Clause, the reasons it was inserted in the Constitution, and the
legislation enacted under its auspices immediately after the Constitutions
ratification, the Bankruptcy Clause was not just a grant of legislative authority to
Congress, but also authorized a limited subordination of state sovereign
immunity in bankruptcy. 126 S.Ct. at 996.
To demonstrate the delegates to the Constitutional Convention
understood the bankruptcy clause must subordinate sovereign immunity to
enforcement of federal bankruptcy laws, the Supreme Court demonstrates
England and the 13 American colonies had widely divergent laws governing
debtors. Discharges referred to discharge from debtors prison and discharge
from debt. Until 1705, the English Parliament did not discharge debtors from
debt, but only from prison, and in 1705 it only started to discharge traders and
merchants from debt. 126 S.Ct. at 997.
In the some States, debtors fared worse than common criminals in prison,
in that they had to provide their own food, fuel, and clothing. 126 S.Ct. at 997.
The State laws governing discharge varied widely. Some discharged debtors
from prison upon surrender of their property and some included a discharge of
debts. Some States required indentured servitude for a release from prison.
Some States provided no relief to debtors at all. 126 S.Ct. at 997-998 .
The Supreme Court found one delegate to the Constitutional Convention,
Jared Ingersoll, had been the attorney in two separate actions involving
nonuniform state insolvency laws. In the first action, James v. Allen, 1 Dall. 199
(C.P. Phila. Cty. 1786), Ingersoll successfully represented a creditor who caused
a debtor to be arrested and imprisoned for nonpayment of debt in Pennsylvania
after the debtor had received a discharge from prison in New Jersey. 126 S.Ct.
at 998. In the second action, Miller v. Hall, 1 Dall. 229 (Pa. 1788), Ingersoll
successfully argued against the principle of James saying the discharge of the

62

Defendant in one state ought to be sufficient to discharge [a debtor] in every

state. 126 S.Ct. at 999. The Committee of Detail at the Constitutional
Convention was charged with preparing a draft of the Constitution based on
delegates proposals and considered inclusion of insolvency laws within the
coverage of the Full Faith and Credit Clause. A few days later, the Committee of
Detail reported it recommended adding the power to establish uniform laws upon
the subject of bankruptcies to the Naturalization Clause of what later became
Article I. 126 S.Ct. at 999. Thus, the Supreme Court concluded: The absence
of extensive debate over the text of the Bankruptcy Clause or its insertion
indicates that there was general agreement on the importance of authorizing a
uniform federal response to the problems presented in cases like James and
Millar. 126 S.Ct. at 999-1000.
The text of Article I, 8, cl. 4, of the Constitution, however, provides that
Congress shall have the power to establish uniform Laws on the subject of
Bankruptcies throughout the United States. Although the interest in avoiding
unjust imprisonment for debt and making federal discharges in bankruptcy
enforceable in every State was a primary motivation for the adoption of that
provision, its coverage encompasses the entire subject of Bankruptcies. The
power granted to Congress by that Clause is a unitary concept rather than an
amalgam of discrete segments. 126 S.Ct. at 1000.
That the Bankruptcy Clause was understood to authorize Congress to
pass laws enforceable against the States is also demonstrated by Congress
early grant to federal courts of the power to issue in personam writs of habeas
corpus directing States to release debtors from state prisons. 126 S.Ct. at 1001.
The nations first bankruptcy act, the Bankruptcy Act of 1800, provided for federal
courts to issue writs of habeas corpus effective to release debtors from state
prisons. 126 S.Ct. at 1001. It took 67 years before the writ of habeas corpus
would be generally available to state prisoners. Id. At the time, the nation was
quite aware of the sovereign immunity issue as teed up by Chisholm v. Georgia,
2 Dall. 419 (1793), yet there was no record of any objection to the bankruptcy
legislation or the grant of habeas corpus power to federal courts based on
infringement of sovereign immunity. 126 S.Ct. at 1003. The notion that a writ of
habeas corpus is against a state official rather than the state is not a meritorious
reason to argue the bankruptcy laws did not subordinate state sovereignty
because the notion was adopted in Ex parte Young, 209 U.S. 123, 159-160
(1908), over a century after enactment of the first bankruptcy act. 126 S.Ct. at
1005n.14.
In dissent, Justice Thomas argues the majority opinion can not be squared
with the Supreme Courts state sovereign immunity jurisprudence and can not be
reached without overruling Hoffman v. Connecticut Dept. of Income
Maintenance, 492 U.S. 96 (1989). 126 S.Ct. at 1006.

63

As explained in the majority decision, the Supreme Court never confronted

the issue as to whether the Bankruptcy Clause abrogates state sovereign
immunity in bankruptcy cases.
The second point is especially easy to refute. Hoffman was a plurality
decision in which a fifth justice joined in the judgment. Justice Thomas claims a
majority of justices agreed (1) a preference action in bankruptcy against a state
agency is barred by sovereign immunity, and (2) absent the States consent,
overcoming that immunity requires a clearer abrogation than Congress had
provided. 126 S.Ct. at 1007. Both points are wrong. Four justices agreed the
preference action was barred by sovereign immunity because Congress had not
evidenced a clear intention to abrogate it. Hoffman at 104. Only two justices,
Justices OConnor and Scalia, claimed Congress did not have the power to
abrogate it. Hoffman at 105. After Hoffman was decided, Congress amended 11
U.S.C. 106 to make clear its intention to abrogate the immunity. Thus,
Hoffman nowhere deals with the amended statute, has only 2 justices opining
Congress can not waive the States sovereign immunity, and offers no opinion on
whether the Constitution already waives State immunity in bankruptcy.
B.Tennessee Student Assistance Corporation v. Hood, 124 S.
Ct. 1905 (2004)
i. Facts.
When Hood commenced her no-asset chapter 7 case, she had an
educational loan guaranteed by a governmental unit. Accordingly, the general
discharge she obtained did not discharge her student loan. Hood did not list her
student loan in her chapter 7 case. Later, Hood procured the reopening of her
chapter 7 case requesting a determination that her student loans were
dischargeable as an undue hardship pursuant to 11 U.S.C. 523(a)(8). Hood
requested that determination by filing a complaint naming the governmental unit
as a defendant.
ii. Issue.
The governmental unit moved to dismiss Hoods complaint for lack of
jurisdiction based on its Eleventh Amendment sovereign immunity. The
bankruptcy court, bankruptcy appellate panel, and United States Court of
Appeals for the Sixth Circuit agreed the motion should be denied. The circuit
appellate court ruled Art. 1, 8, cl. 4 of the U.S. Constitution provided Congress
with the necessary authority to abrogate state sovereign immunity on the theory
Congress can only pass uniform laws on the subject of bankruptcy if it can
impose the laws against the states. But, the Supreme Court ultimately decided
Hood without determining whether Congress validly abrogated the states
sovereign immunity in 11 U.S.C. 106(a).

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iii.Holding.
The United States Supreme Court affirmed on the ground the undue
hardship determination sought by Hood in this case is not a suit against a State
for purposes of the Eleventh Amendment. 124 S. Ct. at 1913. This is not to
say, a bankruptcy courts in rem jurisdiction overrides sovereign immunity,
United States v. Nordic Village, Inc., 503 U.S. 30, 38 (1992), but rather that
the courts exercise of its in rem jurisdiction to discharge a student loan debt is
not an affront to the sovereignty of the State. Nor do we hold that every exercise
of a bankruptcy courts in rem jurisdiction will not offend the sovereignty of the
State. No such concerns are present here, and we do not address them. 124
S. Ct. at 1913 n. 5.
The fact that the discharge proceeding had to be commenced by service
of a summons and complaint on the State did not violate the States sovereign
immunity based on the indignity of having to submit itself to personal jurisdiction
of the bankruptcy court because it doesnt have that effect in that only a
discharge is requested. 124 S. Ct. at 1913-1916.
iv.

Rationale.

The discharge of a debt in bankruptcy is an in rem proceeding, and the

bankruptcy court can provide a debtor a fresh start despite lack of participation
by all creditors because its jurisdiction is premised on the debtor and his estate,
and not on his creditors. 124 S. Ct. at 1910. A bankruptcy courts in rem
jurisdiction permits it to determin[e] all claims that anyone, whether named in the
action or not, has to the property or thing in question. The proceeding is one
against the world. 16 J. Moore, et al., Moores Federal Practice 108.70[1], p.
108-106 (3d ed. 2004). Because the courts jurisdiction is premised on the res,
however, a nonparticipating creditor cannot be subjected to personal liability.
See Freeman v. Alderson, 119 U.S. 185, 188-189 (1886) 124 S. Ct. at 1911.
To make the service of the summons and complaint a violation of
sovereign immunity would effectively cause the Bankruptcy Rule requiring the
complaint to have an impermissible effect under 28 U.S.C. 2075 of rendering a
dischargeable debt nondischargeable. 124 S. Ct. at 1914.
v.

The Eleventh Amendment provides:

The Judicial power of the United States shall not be construed to

extend to any suit in law or equity, commenced or prosecuted
against one of the United States by Citizens of another State, or by
Citizens or Subjects of any Foreign State.

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C. Supreme Court Precedents Governing Enforcement of

Federal Bankruptcy Law against States
i. The Discharge of a Debt by a Bankruptcy Court
is an in rem proceeding. Gardner v. New Jersey, 329 U.S. 565, 574 (1947);
Straton v. New, 283 U.S. 318, 320-321 (1931); Hanover Nat. Bank v. Moyses,
186 U.S. 181, 192 (1902); New Lamp Chimney Co. v. Ansonia Brass & Copper
Co., 91 U.S. 656, 662 (1876).
ii. States are Bound by Bankruptcy Discharges
Whether They Participate or Not
When a state does not timely file its tax claim, the bankruptcy court can
bar the States claim because if the State wants to participate it must submit to
appropriate requirements. New York, v. Irving Trust Co., 288 U.S. 329
(1933)(state sovereign immunity held inapplicable). Exercise of in rem
jurisdiction to discharge a debt does not infringe on state sovereignty. Cf.
Hoffman v. Connecticut Dept. of Income Maintenance, 492 U.S. 96, 102 (1989).
iii. But, Bankruptcy Court Enforcement of a
Bankruptcy Discharge against a State is An Open
Question
Hood did not rule on whether the bankruptcy court can enforce a
discharge injunction against a state without violating its sovereign immunity. 124
S. Ct. at 1911 n. 4. But, based on Missouri v. Fiske, 290 U.S. 18, 29
(1933)(federal court has no power to order State to subject itself to federal courts
determination of stock ownership for probate purposes), the court noted the
State might still be bound by a federal courts adjudication even if the federal
court can not issue an injunction against the State to carry out its adjudication.
Id.
Notably, International Shoe Company v. Pinkus, 278 U.S. 261 (1929),
reversed a judgment of the Supreme Court of Arkansas affirming the dismissal of
a creditors enforcement action against a state court receiver on the ground [t]he
enforcement of state insolvency systems, whether held to be in pursuance of
statutory provisions or otherwise, would necessarily conflict with the national
purpose to have uniform laws on the subject of bankruptcies throughout the
United States. 278 U.S. at 268. There, a debtor commenced a receivership
action the same day a creditor obtained a judgment against the debtor. Under
the states insolvency law, creditors granting releases to the debtor had a right to
distributions on their claims prior to rights of creditors not granting releases. The
debtor had been a bankrupt under federal law in the last six years, thereby
precluding him from obtaining a discharge in a new bankruptcy case. Thus, the

66

state insolvency law would have granted the debtor relief unavailable under the
federal statute.
The United States Supreme Court ruled that even in the absence of
pending proceedings under the Bankruptcy Act, the operation of the state
insolvency law was unconstitutional because states are without power to make or
enforce any law governing bankruptcies that impairs the contracts of persons
outside their jurisdiction or conflicts with the national bankruptcy laws. 278 U.S.
at 263-264; Sturges v. Crowninshield, 4 Wheat. 122; Ogden v. Saunders, 12
Wheat. 213, 369; Baldwin v. Hale, 1 Wall. 223,228; Denny v. Bennett, 128 U.S.
489, 497-498; Brown v. Smart, 145 U.S. 454, 457; Stellwagen v. Clum, 245 U.S.
605, 613.
Significantly, the complaining creditor in Pinkus was not the federal
government; it was International Shoe Company. The United States Supreme
Court had no problem ruling the state courts could not enforce their insolvency
laws. That ruling implicitly suggests the states sovereign immunity against
enforcement of the federal bankruptcy laws is abrogated.
vi.

Sales Free and Clear

The bankruptcy court has authority to sell a debtors property free and
clear of a States tax lien. Van Huffel v. Harkelrode, 284 U.S. 225, 228-229
(1931).
D. Hoods Unanswered Question: Whether Congress Can
Constitutionally Abrogate States Sovereign Immunity from
Private Suits under the Bankruptcy Code
The key question answered affirmatively by the lower courts decision, but
left unanswered by the Supreme Courts affirmance in Hood, was whether at the
Constitutional Convention the states granted Congress the power to abrogate
their sovereign immunity under Article I, section 8 of the United States
Constitution. The lower court concluded that when the states granted Congress
in the Constitution the power to make uniform bankruptcy laws, they intended to
grant exclusive legislative power to the federal government on the subject of
bankruptcies and to cede their immunity to suit. Hood v. Tennessee Student
Assistance Corp., 319 F.3d 755, 767-768 (6th Cir. 2003), affd judgment on other
ground, 124 S. Ct. 1905 (2004).101

101 Five courts of appeal have ruled suits against states under the Bankruptcy Code in the bankruptcy court
are barred by sovereign immunity. Schlossberg v. State of Maryland (In re Creative Goldsmiths of
Washington, D.C., Inc.), 119 F.3d 1140 (4th Cir. 1997), cert. denied, 523 U.S. 1075 (1998); Dept of
Transp. & Dev. , State of Louisiana v. PNL Asset Mgmt. Co., LLC (In re Fernandez), 123 F.3d 241,
corrected, rehearing denied, 130 F.3d 1138 (5th Cir. 1997); Sacred Heart Hosp. of Norristown v.
Pennsylvania (In re Sacred Heart Hospital of Norristown), 133 F.3d 237 (3d Cir. 1998); Mitchell v.

67

The states sovereign immunity from suit in federal court presents perhaps
the grandest question of statutory interpretation in federal jurisprudence.
Moreover, those justices known for ruling the plain meaning of the statute ends
the inquiry unless the result is absurd, are in the position of arguing it is absurd to
interpret the Constitution to deprive states of the English monarchys traditional
insulation from suit based on the myth the king can do no wrong, when the
Constitution by its express terms provides subject matter jurisdiction over actions
between States and citizens of States and the Eleventh Amendment only bars
such actions when they involve judicial power and are between a State and
citizens of another State. See generally, Metromedia Fiber Network, Inc. v.
Various State and Local Taxing Authorities (In re Metromedia Fiber Network,
Inc.), 299 B.R. 251, 257-258 (Bankr. S.D.N.Y. 2003).
The United States Constitution provides plainly in Article III, section 2 that:
The Judicial Power shall extend, (5) To controversies between two or more
States; between a State and citizens of another State; between citizens of
different States How then can there even be a question as to the
susceptibility of states to suit in federal court?
The first time this question was presented to the Supreme Court, it
determined almost unanimously that a citizen of South Carolina could sue the
State of Georgia in federal court for assumpsit to recover money. Chisolm v.
State of Georgia, 2 U.S. 419 (1793). Justice Iredell, in dissent, looked to the
Judiciary Act of 1789 under which Congress carried out the Constitutions grant
of power to create federal courts and noted that section 13 provided:
That the Supreme Court shall have exclusive jurisdiction of all
controversies of a civil nature; where a State is a party, except
between a State and its citizens; and except also, between a State
and citizens of other States, or aliens, in which latter case it shall
have original, but not exclusive jurisdiction.
From section 13s grant of original, but not exclusive jurisdiction, Justice Iredell
deduced that Congress only granted the federal courts the same power the state
courts had and he opined they did not have power to sue the sovereign for
assumpsit. 2 U.S. at 431-438. Notably, Justice Iredell expressly left open the
possibility Congress may have the constitutional power to grant federal courts
power against states. 2 U.S. at 434; Seminole, infra, at 79 (Justice Stephens
dissent).
Chisolm was a very unpopular decision and Congress and the states
speedily passed the Eleventh Amendment in reaction to it.

Franchise Tax Bd., State of California (In re Mitchell), 209 F.3d 1111 (9th Cir. 2000); Nelson v. Lacrosse
County Dist. Attorney (State of Wisconsin) (In re Nelson), 301 F.3d 820 (7th Cir. 2002).

68

A hundred years later, the Supreme Court was faced with the question
whether a state can be sued by one of its own citizens in federal court. The
wording of the Eleventh Amendment only bars suits in federal court against
states by citizens of other states. Based on Alexander Hamiltons remarks in The
Federalist No. 81 where he announced state sovereignty would be preserved
except for surrenders of immunity in the plan of the convention, the court ruled a
state can not be sued in federal court by its own citizens. Hans v. Louisiana, 134
U.S. 1 (1890).
The portion of Alexander Hamiltons remarks in The Federalist No. 81 that
might convince a court of the absurdity of interpreting the Constitution to
abrogate states sovereign immunity provides:
The contracts between a nation and individuals are only binding
on the conscience of the sovereign, and have no pretension to a
compulsive force. They confer no right of action independent of the
sovereign will. To what purpose would it be to authorize suits
against States for the debts they owe? How could recoveries be
enforced? It is evident that it could not be done without waging war
against the contracting State; and to ascribe to the federal courts by
mere implication, and in destruction of a pre-existing right of the
state governments, a power which would involve such a
consequence, would be altogether forced and unwarrantable.
Over the years, states sovereign immunity has been rendered even
broader. For instance, in Federal Maritime Commission v. South Carolina, 535
U.S. 743 (2002), the Supreme Court held state sovereign immunity also bars a
federal agency (Federal Maritime Commission) from adjudicating a private
partys complaint against the state for violation of the Shipping Act of 1984, 46
U.S.C. 1701, even though judicial power was not being exercised and the
Eleventh Amendment only bars use of judicial power.
In Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996)(5 to 4), the
Supreme Court held the Indian Commerce Clause of the Constitution does not
grant Congress the power to allow a tribe to sue a state to enforce a federal
statute passed under that clause if the state does not consent to be sued, and
the Ex Parte Young doctrine (209 U.S. 123 (1908)) whereby a tribe may have
sued an official of the state for prospective injunctive relief was inapplicable
because Congress had legislated a remedial scheme. 517 U.S. at 47.
Interestingly, the statutory scheme ultimately provided for the Secretary of
the Interior to prescribe procedures under which gaming may be conducted on
Indian lands if mediation did not result in consensus, and the lower court granted
the Indians immediate recourse to the Secretary because it dismissed the
Indians suit due to sovereign immunity. Thus, the Indians obtained the ultimate

69

relief they sought and the States enforcement of its sovereign immunity was a
pyrrhic victory..
Although the Eleventh Amendment, by its terms, only bars use of judicial
power against a State in a diversity jurisdiction case and Seminole involved a
federal question case, the Supreme Court reaffirmed its prior rulings that the
Eleventh Amendment stands not so much for what is says, but for the
presuppositionwhich it confirms. Blatchford v. Native Village of Noatak, 501
U.S. 775, 779(1991). That presupposition, first observed over a century ago in
Hans v. Louisiana, 134 U.S. 1(1890), has two parts: first, that each State is a
sovereign entity in our federal system; and second, that it is inherent in the
nature of sovereignty not to be amenable to the suit of an individual without its
consent Seminole, 517 U.S. at 54.
The Supreme Court agreed in Seminole that Congress unequivocally
expressed its intent to abrogate state immunity, 517 U.S. at 56, but ruled the
abrogation was not pursuant to a valid exercise of power. The Supreme Court
had recognized only two sources of a valid power, the Fourteenth Amendment
(inapplicable here) and the Interstate Commerce Clause (Art. I, 8, cl. 3). The
Supreme Court overruled the plurality of Pennsylvania v. Union Gas Co., 491
U.S. 1 (1989), that held the Interstate Commerce Clause was a valid source of
power. Seminole, 517 U.S. at 66.
Based on the latter holding, both the majority and dissent in Seminole
signaled the bankruptcy, antitrust, and copyright laws might also fail to abrogate
validly the states sovereign immunity. Seminole, 517 U.S. at 73 (majority) and
93-94 (Justice Stephens dissent).
In the aftermath of Seminole, the Supreme Court also ruled nothing in
Article I of the United States Constitution authorizes Congress to subject
nonconsenting states to private suits for damages under federal statutes (the Fair
Labor Standards Act of 1938, as amended, 29 U.S.C. 201 et seq.) in state
courts. Alden v. Maine, 527 U.S. 706 (1999).
7. State Law Can Not Oust Federal Bankruptcy Courts of Subject Matter
Jurisdiction Granted by 28 U.S.C. 1334
A. Marshall v. Marshall, 126 S. Ct. 1735 (2006)
i.

Facts.

Vickie Lynn Marshall (a/k/a Anna Nicole Smith) commenced a chapter 7

case in the Central District of California. She is the widow of J. Howard Marshall
who left her nothing in his will. After one of Mr. Marshalls sons filed a proof of
claim for defamation, accusing the debtor of having wrongly accused him of
forgery, fraud, and overreaching to gain control of his fathers assets, the debtor

70

counterclaimed that the son had tortiously interfered with a gift she expected.
126 S. Ct. at 1742.
The bankruptcy court granted summary judgment against Mr. Marshall on
his proof of claim, ruled the claim and counterclaim were core proceedings, and
issued a judgment in favor of the debtor on her counterclaim in the amount of
$449 million compensatory damages and $25 million punitive damages. 126 S.
Ct. at 1742. The bankruptcy court also ruled Mr. Marshall waived the probate
exception to the courts subject matter jurisdiction and waived mandatory
abstention by untimely raising those issues. 126 S. Ct. at 1742, 1746 n.3. On
appeal, the district court determined the counterclaim was not a core proceeding
and treated the bankruptcy courts judgment as proposed rather than final. 126
S. Ct. at 1743.
The district court determined Mr. Marshall had tortiously interfered with the
debtors expectancy evidenced by her husbands having instructed his lawyers to
prepare a trust to provide her with half the appreciation of his assets from the
date of his marriage. The district court found the son conspired to suppress or
destroy the trust document and to strip his father of assets by backdating,
altering, and falsifying documents, arranging for surveillance of his father and the
debtor, and presenting documents to his father under false pretenses. 126 S. Ct.
at 1744. The district court awarded the debtor $44.3 million of compensatory
damages and $44.3 million of punitive damages. Id.
The United States Court of Appeals for the Ninth Circuit reversed, ruling
the probate exception bars federal jurisdiction as did the State of Texas grant of
exclusive jurisdiction to the state probate court. 126 S. Ct. at 1744.
In the meantime, after the bankruptcy court ruled in the debtors favor, the
debtor dismissed her claims in the Texas probate court that her husbands will
was invalid and that Mr. Marshall had tortiously interfered. 126 S. Ct. at 1743.
After a jury trial, the Texas probate court declared the living trust and the debtors
husbands will were valid. 126 S. Ct. at 1743. The state courts ruling became
final after the bankruptcy court issued its ruling that the district court treated as a
proposal and approximately one month before the district court issued its
judgment in favor of the debtor. 126 S. Ct. at 1750. The Ninth Circuit did not
address whether the debtors claim was core and whether Mr. Marshalls
arguments about claim and issue preclusion were valid. 126 S. Ct. at 1750.
ii.

Issue.

Does the judicially created probate exception to federal subject matter

jurisdiction apply not only to direct challenges to a will or trust, but also to
questions which would ordinarily be decided by a probate court in determining
the validity of the decedents estate planning instrument? 126 S. Ct. at 1741.

71

iii.

Holding.

We hold that the Ninth Circuit had no warrant from Congress, or from
decisions of this Court, for its sweeping extension of the probate exception. 126
S. Ct. at 1741.
It is also clear, however, that Texas may not reserve to its probate
courts the exclusive right to adjudicate a transitory tort. We have long
recognized that a State cannot create a transitory cause of action and at the
same time destroy the right to sue on that transitory cause of action in any court
having jurisdiction. Tennessee Coal, Iron & R. Co. v. George, 233 U.S. 354,
360, 34 S. Ct. 587, 58 L. Ed. 997 (1914)Directly on point, we have held that the
jurisdiction of the federal courts, having existed from the beginning of the
Federal government, [can] not be impaired by subsequent state legislation
creating courts of probate. McClellan v. Carland, 217 U.S. 268, 281, 30 S. Ct.
501, 54 L. Ed. 762 (1910) 126 S. Ct. at 1749.
On remand, the lower court can consider whether the debtors claim was a
core proceeding and whether claim and issue preclusion apply in respect of the
probate courts rulings. 126 S. Ct. at 1750.
8. When Must Valid Claims under State Law be Discounted to be Allowable
under Bankruptcy Law?
A. In re Oakwood Homes Corporation, 449 F.3d 588 (3d Cir.
2006)(2-1)
i.

Facts

The debtor was in the business of manufacturing prefabricated homes and

selling them to customers in exchange for purchase money mortgages. The
debtor then securitized the mortgages by selling them to a trust which paid for
them by selling certificates having different priorities of payment. 449 F.3d at
589-590. The debtor guaranteed repayment of the certificates. 449 F.3d at 590.
Repayment of the principal amount of the certificates stretched out to 2030.
On behalf of the B-2 certificate holders, a $400 million claim was filed
against the debtors estate. The $400 million consisted of $116 million of
principal, $1 million of prepetition interest, and the balance was unmatured
interest. The claim for unmatured interest was disallowed under 11 U.S.C.
502(b)(2). That was not appealed to the Third Circuit and the Third Circuit
expressly stated it was expressing no view. 449 F.3d at 595. Because the $116
million claim for principal represented principal payments over time through 2030,
the bankruptcy court reduced the principal claim to present value using a 7.74%
discount rate and allowed the claim in the amount of $30.49 million. 449 F.3d at
591. The district court affirmed.

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ii.

Issue

[W]hether the Bankruptcy Court erred by double disounting when it

discounted the principal component of the claims to present value after also
having disallowed the post-petition interest portion of the claims. 449 F.3d at
592.
iii.

Holding

We conclude that the language used in 502(b) does not clearly and
unambiguously require discounting an interest-bearing obligation to present
value in light of the words plain meanings and the language used elsewhere in
the Bankruptcy Code. The Bankruptcy Court erred: Interest-bearing debt should
not be discounted to present value after unmatured interest has been disallowed
pursuant to 502(b)(2). 449 F.3d at 603. We do not hold here that 11 U.S.C.
502(b) never authorizes discounting a claim to present value, but instead that the
statute does not clearly and unambiguously require it for all claims evalueated
under 502. 449 F.3d at 598. Once the Bankruptcy Court disallowed postpetition interest pursuant to 502(b)(2), the legislative history of the provision,
the economic reality of the transaction, and fundamental tenets of bankruptcy law
do not permit further discounting of the principal. 449 F.3d at 599.
iv.

Rationale

The preamble of 11 U.S.C. 502(b) requires the court to determine the

amount of such claimas of the date of the filing of the petition. This raises the
question whether after unmatured interest is disallowed under 11 U.S.C.
502(b)(2), the court must present value the stream of principal payments, and
section 502(b) is far from clear and unambiguous. 449 F.3d at 593. The
remainder of the Bankruptcy Code refers to value, as of to signify discounting
to present value and amount and value are not synonymous. 449 F.3d at 595.
The legislative history of section 502(b)(2) provides:
Section 502(b) thus contains two principles of present law. First,
interest stops accruing at the date of the filing of the petition, because
any claim for unmatured interest is disallowed under this paragraph.
Second, bankruptcy operates as the acceleration of the principal
amount of all claims against the debtor. One unarticulated reason for
this is that the discounting factor for claims after the commencement
of the case is equivalent to [the] contractual interest rate on the claim.
Thus, this paragraph does not cause disallowance of claims that have
not been discounted to a present value because of the irrebutable
presumption that the discounting rate and the contractual interest rate
(even a zero interest rate) are equivalent.

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449 F.3d at 600 (quoting H.R. Rep. No. 95-595, at 352-54 (1977), same as S.
Rep. No. 95-989, at 62-65 (1978)). From this legislative history, the Third Circuit
concludes: To the extent that the Code in any way contemplates discounting to
present value, such discounting is not permitted where the claim is for principal
plus interest, and the interest has already been disallowed pursuant to
502(b)(2). 449 F.3d at 600.
v.

An Easier Way

The Third Circuit struggled with the notion of when a stream of principal
payments needs to be present valued, especially after the unmatured interest is
disallowed pursuant to 11 U.S.C. 502(b)(2). Significantly, the legislative history
quoted above provides section 502(b) does not cause disallowance of claims that
have not been present valued because of the irrebutable presumption the
discounting rate and the contract interest rate are equivalent even if the contract
rate is zero. This does not mean that a note providing for payment of its principal
amount in 10 years in a balloon payment with no interest, is not present valued if
the note was issued at a discount because the original issue discount is treated
as unmatured interest.
The Third Circuit would have had an easier time if it invoked 11 U.S.C.
502(b)(1) which disallows a claim to the extent such claim is unenforceable
against the debtor and property of the debtor, under any agreement or applicable
law for a reason other than because such claim is contingent or unmatured.
Thus, when nonbankruptcy law requires that a claim be present valued, it can
only be allowed in the amount of its value as of the petition date. For example, if
A lends $1,000 to B, to be repaid in 10 years in a balloon payment, but with
interest payable at 6% per year, nonbankruptcy law would allow A to obtain a
judgment for at least $1,000 if B defaults on the first interest payment. Similarly,
if the note did not carry interest, but provided for acceleration on bankruptcy,
state law would allow a judgment for at least $1,000 if B commences a
bankruptcy case.
Another guidepost the Third Circuit could have used is the practicality of
the law providing an allowed claim for less than an entity loans a moment after it
makes the loan. In other words, if A lends $1,000 to B at 8% interest for 20
years, and B commences a bankruptcy case the next day, what is As claim. We
know the unmatured interest is disallowed by 11 U.S.C. 502(b)(2). If the
$1,000 has to be present valued because it is not repayable for 20 years, then a
moment after making the loan for $1,000, A could have an allowed claim of only
about $200. If that were the law, then B should obtain that loan and go into
bankruptcy immediately to repay the $1,000 loan with $200. Clearly, the law is
not designed to produce that result.
B. When Debt is Restructured by Exchanging Debt, for Debt in
the Same Face Amount with Different Covenants, the
74

Difference between the New Debts Trading Value and Par is

not Unallowable Original Issue Discount
i.
Facts.
Outside bankruptcy a distressed company issued new debentures and
stock in exchange for its old debentures in the same face amount, but with
amended provisions for interest rates, sinking funds, and maturities.
ii.

History

The bankruptcy court held the amount of the new debentures would be
disallowed as unmatured interest under Bankruptcy Code section 502(b)(2) to
the extent the value of the stock and face amount of the new debentures
exceeded the market value of the old debentures when exchanged. In re
Chateaugay Corp., 109 B.R. 51 (Bankr. S.D.N.Y. 1990), aff'd without analysis,
130 B.R. 403 (S.D.N.Y. 1991).
iii.

Analysis

Chateaugay Corp. was wrong for numerous reasons. Primarily, no

"original issue discount" is created when new debt is exchanged for old debt of
the same amount.
Chateaugay Corp. caused immense damage to large and small
companies and their creditors attempting to restructure public and private debt
outside bankruptcy. Holders of public debentures were deterred from
exchanging debentures because the new debentures would not be allowable
claims in their full amounts, even when the old debentures would be. Holders of
private debt, such as banks and insurance companies, ran the risk that amending
old notes to change interest rates, amortization schedules, and maturities would
render the new or amended notes subject to partial disallowance. Indeed,
Chateaugay Corp. would have compelled that result.
iv.
In re Chateaugay Corp., 961 F.2d 378 (2d Cir. 1992);
In re Pengo Industries, Inc., 962 F.2d 543 (5th Cir. 1992).
The United States Courts of Appeal for the Second and Fifth Circuits have
repudiated the lower courts' decisions and held that debt for debt exchanges do
not create new original issue discount disallowable in bankruptcy cases.
Neither appellate court ruled on whether a debt for equity exchange as
was consummated in In re Allegheny Int'l, Inc., 100 B.R. 247 (Bankr. W.D. Pa.
1989) (debt exchanged for preferred stock), could result in original issue discount
disallowable in bankruptcy. Indeed, there is no reason why it should not if the
face amount of the debt exceeds the market value of the capital stock being
exchanged.
75

v.
The Constant Interest Method Measures Original
Issue Discount
Finally, the Second Circuit affirmed that portion of Chateaugay Corp. (and
thereby disapproved that portion of Allegheny Int'l) which determined how original
issue discount is amortized. In Chateaugay Corp., the old debt had been issued
at a discount, thereby creating actual original issue discount, the unamortized
part of which is disallowable under Bankruptcy Code section 502(b)(2). The
dispute was whether the original issue discount is amortized by an equal amount
each day (the straight line method), or whether by a slightly greater amount each
day to take into account the compounding of a constant interest rate (the
constant interest method or yield to maturity method). Because the constant
interest method better describes economic reality, the Second Circuit adopted
that method.
9. Limits and Extensions of Official Unsecured Creditors' Committee v.
Stern (In re SPM Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993)
A. Official Unsecured Creditors' Committee v. Stern (In re SPM
Manufacturing Corp.), 984 F.2d 1305 (1st Cir. 1993)
i.
Facts
The statutory creditors' committee representing creditors owed $5.5 million
determined a reorganization under existing management was unfeasible and a
liquidation would leave nothing for any creditor other than the secured
claimholder. 984 F.2d at 1307-1308. The committee agreed with the creditor
holding a $9 million claim secured by all estate assets except certain
encumbered real estate that the two entities would cooperate to (i) take all
actions reasonably necessary to replace the debtor's chief executive officer, (ii)
formulate a joint chapter 11 plan, and (iii) negotiate in good faith to reach
mutually acceptable agreements with respect to a number of details of the plan.
984 F.2d at 1307n.2, 1308. The secured creditor agreed to allocate the net
proceeds it obtains in reorganization or liquidation between itself and the
committee according to a schedule under which the committee obtains 10% of
the first $3 million, 20% of the next $3 million, 30% of the next $3 million, $40%
of the next $3 million, and 100% of any further proceeds the secured creditor
obtains. 984 F.2d at 1308.
The Internal Revenue Service held a $750,000 unsecured priority tax
claim for unpaid withholding taxes certain insiders would be responsible for if not
paid by the debtor. 984 F.2d at 1307. The IRS is not a party to the appeal and
appears not to have participated in the bankruptcy court.

76

The committee filed the agreement as an exhibit to a motion, and the court
expressed concern and characterized the agreement as a tax-avoidance
scheme. 984 F.2d at 1308. At no time did any creditor or insider object to the
agreement and it was never formally approved or disapproved until a chapter 7
trustee requested that the secured claimholder turn over to the estate the funds
allocable to unsecured claimholders under the agreement. Id.
The agreement expressly stated the committee was making the
agreement on behalf of general unsecured creditors "exclusive of the Internal
Revenue Service and potential 'insider' creditors." 984 F.2d at 1308.
When the case was converted to chapter 7, the chapter 7 trustee opposed
a joint motion of the secured claimholder and the committee to distribute the
secured claimholder's net proceeds in accordance with the agreement. The
bankruptcy court ruled the proceeds allocable to the committee should go to the
estate for distribution in accordance with chapter 7 priorities including the Internal
Revenue Service. 984 F.2d at 1309. The bankruptcy court treated the joint
motion as a motion to approve the agreement and refused to grant it. 974 F.2d
at 1309n.5. The district court affirmed. 974 F.2d at 1310.
ii.

Issue

Did the bankruptcy court err as a matter of law in ordering the secured
claimholder to pay a portion of its secured interest to the chapter 7 estate as
opposed to the unsecured claimholders under the agreement? 974 F.2d at 1310.
iii.

Holding

The court of appeals reversed and vacated the bankruptcy court's award
of the committee's allocation to the estate.
While a creditors committee and its members must act in accordance
with the provisions of the Bankruptcy Code and with proper regard for the
bankruptcy court, the committee is a fiduciary for those it represents, not for the
debtor or the estate generally. 974 F.2d at 1315.
The creditors committee is not merely a conduit through whom the debtor
speaks to and negotiates with creditors generally. On the contrary, it is
purposely intended to represent the necessarily different interests and concerns
of the creditors it represents. It must necessarily be adversarial in a sense, tough
its relation with the debtor may be supportive and friendly. There is simply no
other entity established by the Code to guard those interests. The committee as
the sum of its members is not intended to be merely an arbiter but a partisan
which will aid, assist, and monitor the debtor pursuant to its own self-interest.
974 F.2d at 1316.

77

We conclude, therefore, that the bankruptcy court erred as a matter of

law insofar as it felt that the Committee was under a particular duty to negotiate
the sharing provision of the Agreement for the benefit of the estate as a whole.
974 F.2d at 1316.
The appellate court noted the secured lender was willing to abide by its
agreement, and that the issue of the agreement's enforceability was not before it.
974 F.2d at 1318.
Additionally, the court of appeals ruled the committee's allocable portion of
the proceeds was not estate property once the automatic stay terminated and the
court ordered the sale proceeds distributed to the creditor, and therefore the
bankruptcy court had no jurisdiction to order its return to the estate. 974 F.2d at
1313. Therefore, the matter was remanded for the bankruptcy court to determine
whether the estate or the secured lender should be responsible for distributing
the committee's allocation, with the appeals court warning that appellant had not
pointed to any basis in the Bankruptcy Code for authorizing, let alone requiring,
the bankruptcy court or trustee to administer a distribution of nonestate funds
pursuant to a private agreement. 974 F.2d at 1319.
iv.

Rationale.

The court of appeals explained the committee is not a fiduciary for the
debtor or estate as a whole. Rather, it is a fiduciary only for those whom it
represents. "It is charged with pursuing whatever lawful course best serves the
interests of the class of creditors represented....It must necessarily be adversarial
in a sense, though its relation with the debtor may be supportive and
friendly....The committee as the sum of its members is not intended to be merely
an arbiter but a partisan which will aid, assist, and monitor the debtor pursuant to
its own self-interest." Because the committee was only obtaining a share of
whatever would be distributed to the secured lender, the court did not believe any
other creditor, such as the IRS, was unfairly hurt.
In response to arguments that such agreements conflict with bankruptcy
policies, the court of appeals noted the bankruptcy court's power to disqualify
votes cast in bad faith and to reconstitute creditors' committees failing to be
properly representative enable it to control the tenor of proceedings. The court
noted the good faith requirement bars creditors from casting votes for ulterior
motives, such as coercing a higher payment from the estate, pure malice, and
advancing the interests of a competing business. 974 F.2d at 1317.
v.

Implications

Prior to bankruptcy there is no law against intercreditor agreements

allocating future distributions from a bankruptcy case. Indeed, subordination
agreements do that everyday. The question becomes whether something

78

changes the innocuous nature of such agreements when consummated

postpetition, especially by a statutory committee.
In SPM, the agreement itself was somewhat defensive. It was drafted as
an agreement to join in a reorganization plan, when its bottom line purpose was
to evade the requirements of a plan in 11 U.S.C. 1129(a)(9)(C) that the priority
tax claim be paid in full. Thus, the agreement actually contemplated a liquidation
in chapter 7.
The agreement entered into in SPM diminished the committee's incentive
to avoid the secured lender's lien, albeit there is nothing in the decision to
suggest that was possible. Moreover, it flat out committed the committee to try to
replace management. If the committee entered into that commitment to obtain
compensation for creditors rather than because it believed management was
subpar, Bankruptcy Rule 9011 would be implicated if the committee filed motions
to replace management without good grounds therefor. There is nothing to
suggest it did.
Notably, the decision shows that creditors not represented by a statutory
committee can not count on the committee to police the case. The creditors will
have to do so themselves, usually at their own expense. Additionally, the
bankruptcy court was never asked to approve the agreement until the time came
to disburse the funds. Therefore, whether the committee had a good basis to join
forces with the secured lender and perhaps not vigorously attack the security
interests was never tested. Other creditors may not have known about the
agreement.
Finally, it is not clear the committee had the capacity to enter into the
agreement, to be held to it, or to bind its constituency to it. But, the committee
was able to fulfill the agreements requirements to the creditor. The agreement
also provided no mechanism to resolve creditors claims before distributions of
the amount obtained from the secured claimholder. The appellate court
suggested strongly that the bankruptcy court should not be used to implement a
private agreement to distribute nonestate funds. Had the funds been deemed
estate funds, then they would have to be paid to the IRS instead to general
unsecured claimholders.
B. In re Armstrong World Industries, 432 F.3d 507 (3d Cir.
2005)
i. Facts
The debtor, Armstrong, negotiated a chapter 11 plan in its mass tort
asbestos case. Pursuant to the proposed plan, general nonasbestos creditors
would recover approximately 59.5% of their $1.651 billion of claims, while the
asbestos claims and demands would initially recover 20% of their claims from a
79

fund of $1.8 billion, and shareholders would receive warrants worth $35 million to
$40 million. 432 F.3d at 509. The proposed plan provided that if the
nonasbestos claimants rejected the plan the warrants would be distributed to the
asbestos claimants; provided further, that the asbestos claimants would
automatically waive receipt of the warrants which would then be issued to the
shareholders. Id.
Although the commercial creditors committee initially approved of the
proposed plan, it later withdrew support largely because Armstrong would have
to pay only up to $805 million (instead of $1.8 billion) for asbestos claims if
Congress passed asbestos legislation. The class of commercial creditors then
rejected the plan and the commercial creditors committee objected to
confirmation on the ground it violated the absolute priority rule and because
commercial creditors would have a greater return if the legislation passed. 432
F.3d at 510.
The bankruptcy court recommended confirmation of the proposed plan on
the ground the waiver by the class of asbestos claimants did not violate the
absolute priority rule, and because the commercial creditors committee waived
its right to object to the plan when it entered into a consensual plan providing for
the waiver. 432 F.3d at 510. The district court denied confirmation on the
ground it violated the absolute priority rule and because no equitable exception to
the absolute priority rule applied. In re Armstrong World Indus., Inc., 320 B.R.
523 (D. Del. 2005).
ii. Issues
Does the absolute priority rule apply when the rejecting class is not an
intervening class between the class yielding value to a junior class and the junior
class?
Is the absolute priority rule violated when an accepting class of claims
having dissenting members (Class 7) agrees to transfer a portion of its
distribution to an equity class (Class 12) when a co-equal class of claims (Class
6) rejects the plan?
Is there a basis to create an equitable exception to the absolute priority
rule when (a) the creditors committee negotiates, endorses, and then withdraws
support for the plan, (b) the transfer to the junior class does not come at the
expense of the rejecting class, (c) the transfer to the junior class is of a relatively
small value, (d) the rejecting class has a majority in number (though not in
amount) accepting the plan, and (e) the rejecting class caused delay?
iii. Holdings

80

The plain language of the statute makes it clear that a plan cannot give
property to junior claimants over the objection of a more senior class that is
impaired, but does not indicate that the objecting class must be an intervening
class. 432 F.3d at 513.
In turn, Class 7 automatically waived the warrants in favor of Class 12,
without any means for dissenting members of Class 7 to protest. Allowing this
particular type of transfer would encourage parties to impermissibly sidestep the
carefully crafted strictures of the Bankruptcy Code, and would undermine
Congresss intention to give unsecured creditors bargaining power in this context.
See H.R. Rep. No. 95-595, at 416, reprinted in 1978 U.S.C.C.A.N. 5963, 6372 (
[Section 1129(b)(2)(B)(ii)] gives intermediate creditors a great deal of leverage in
negotiating with senior or secured creditors who wish to have a plan that gives
value to equity.). 432 F.3d at 514-515.
In addition, our application of equitable considerations in Penn Central
[596 F.2d 1127, 1142 (3d Cir. 1979)] did not mean that the absolute priority rule
was abandoned. Rather, we held firm to the idea that the rule still requiredthat
provision be made for satisfaction of senior claims prior to satisfaction of junior
claims. Id. at 1153. 432 F.3d at 517.
iv. Analysis
Armstrong, at its core, bars the expansion of SPM to enable an accepting
class with dissenting members or an accepting class having less than a
unanimous vote, to cause a portion of its distribution to be transferred to a junior
class when a class senior to the junior class rejects and is not paid in full.
Armstrong also answers the question as to whether the absolute priority
rule should be modified, as a matter of policy, to allow a class to transfer value to
a junior class when a senior class rejects. Armstrong explains, using legislative
history, that such a modification would deprive creditors of the negotiating
leverage Congress gave them with the absolute priority rule. One can easily
conjure up scenarios in which debtors or equity classes could use such a
modification to condition their proposal of a chapter 11 plan on a creditors class
agreement to transfer value to equity. This possibility would, in turn, cause
uncertainty in the capital markets as to how to value the creditor claims and
result in inefficient asset allocation.
B. Limits and Extensions of SPM
i. After Armstrong, Secured Claimholders Can Still
Voluntarily Cede Collateral Proceeds to General
Creditors, Skipping Priority Creditors (In re World
Health Alternatives, Case No. 06-10166 (Bankr. D.
Del., July 7, 2006))

81

In In re World Health Alternatives, Case No. 06-10166 (Bankr. D. Del.,

July 7, 2006), the prepetition secured lender granted a postpetition loan subject
to the right of creditors to challenge the allowability of its prepetition claim within
certain time limits. The rights of all creditors other than the statutory creditors
committee to challenge the claim expired. Meanwhile, the debtor moved to sell
substantially all the estates assets and the prepetition lender attempted to be the
stalking horse bidder.
Subject to bankruptcy court approval, the committee agreed to withdraw
its objection to the sale and to some of the prepetition lenders liens and to
release certain claims, in exchange for $1.625 million from the lender, which the
committee could use to prosecute actions to benefit all creditors of the estate or
to distribute to the general prepetition creditors, skipping the IRS tax claim in
excess of $4 million. Prior to an uncontested conversion of the case to chapter
7, the debtors and the committee requested approval of the agreement over the
United States trustees objection. The IRS did not object.
The crux of the United States trustees objection was that the committee
isnot authorized to borrow and/or compromise estate claims and causes of
action at the expense of priority creditors in chapter 11. Slip Op. at 12. The
bankruptcy court overruled the objection, holding:
Although the general unsecured creditors will receive money
before the priority creditors, that money does not belong to the
estate it belongs to CapSource. See Official Comm. of
Unsecured Creditors v. Stern (In re SPM Mfg. Corp.), 984 F.2d
1305, 1313 (1st Cir. 1993). In other words, the payout to the
general unsecured creditors is a carve out of the secured creditors
lien and not estate property. I believe the Bankruptcy Code does
not prohibit this arrangement and reported cases so hold. Id. at
1313.
Slip. op. at 12-13. The bankruptcy court explained Armstrong did not apply
because the settlement World Health was not arising in a chapter 11 plan
implicating the absolute priority rule, the secured lender could distribute its own
proceeds, and the distribution was a carve out from the lien. Slip. op. at 15-16.
Notably, parties should not and can not be allowed to evade the absolute
priority rule by doing something in a court approved settlement as opposed to a
plan. But, the bankruptcy courts other rationales for approving the settlement
are valid because unlike Armstrong where creditors were being compelled to part
with a portion of their entitlements, in World Health the secured lender was doing
it voluntarily.
The United States trustees most potent argument was that the estates
defenses and causes of action should not be used to benefit general creditors

82

before priority creditors. Significantly, the IRS could have prevented that result
by itself objecting to the lenders liens and thereby placing itself in the way of a
deal between the lender and the committee. It allowed its rights to expire. The
bankruptcy court did not take sides on the issue of whether the committee owed
fiduciary duties to priority creditors contrary to substantial authority,102 but did
opine that refusal to approve the settlement would only help the secured lender.
ii. Transferring Property Outside a Chapter 11 Plan
May Be Permissible when The Same Transfers Inside
a Plan May be Barred
In SPM, the secured claimholder transferred a portion of its collateral
proceeds in chapter 7 and the appeals court approved it while questioning
whether the bankruptcy court could be further involved in the actual distribution of
funds and determination of claims of the unsecured claimant recipients. 974
F.2d at 1319.
In In re Sentry Operating Co. of Texas, 264 B.R. 850 (Bankr. S.D. Tex.
2001), the secured claimholder allowed a portion of its collateral to be paid to one
of two classes of unsecured claims pursuant to a proposed chapter 11 plan. The
recipient class would receive 100% recovery while the other class would receive
a 1% recovery. 264 B.R. at 855. The debtors rationale for the different
treatment was that the class being paid 100% contained local trade creditors and
the funeral home operations would terminate or suffer if they were not paid. The
court found the debtors presidents testimony to that effect credible and true.
264 B.R. at 856.
The court ruled the rationale for separate classification was valid, but the
actual classification was invalid under 11 U.S.C. 1122 because the class being
paid 100% contained many national creditors whose payment was not tied to
maximizing the value of estate assets. 264 B.R. at 861. The court also held the
different treatment of the two classes of unsecured claims constituted unfair
discrimination under 11 U.S.C. 1129(b) because a secured creditor can not
decide which creditors get paid without reference to fairness. 264 B.R. at 865.
Accordingly, while no law prevents the secured creditor from paying
certain local trade creditors outside a chapter 11 plan, putting their payment into
the plan made a difference. The dilemma faced by the debtor was likely that
without a separate classification in the plan, it would not obtain an impaired
accepting class of unsecured claims for purposes of 11 U.S.C. 1129(a)(10).

102 In

re SPM, 984 F.2d 1305 ,1316 (1st Cir. 1993); Official Dalkon Shield
Claimants Comm. v. Mabey (In re A.H. Robins Co.), 880 F.2d 769, 771 (4th Cir.
1989); In re Intl Swimming Pool Corp., 186 F.Supp. 63, 64 (S.D.N.Y. 1960);
Creditors Comm. of Trantex Corp. v. Baybank Valley Trust Co., (In re Trantex
Corp.), 10 B.R. 235, 238 (Bankr. D. Mass. 1981).
83

But, the plan could easily have impaired the secured claimholder who could
provide the impaired accepting class.
Similarly, in In re Snyders Drug Stores, Inc., 307 B.R. 889 (Bankr. N.D.
Ohio 2004), the chapter 11 plan proposed by the debtor and creditors committee
contained 3 classes of unsecured claims: one for reclamation claimants, one for
trade creditors, and one for landlord claims. The reclamation claimants would
receive 27% distributions, the trade creditors 6-7%, and the landlords 0%. 307
B.R. at 892. The plan proponents argued against an unfair discrimination
objection that the return to the unsecured claims was not property of the estate.
The court ruled it was and sustained the objection, reasoning SPM did not apply
because its distribution was outside a plan and was not from property of the
estate. 307 B.R. at 896.
iii. Some Courts Allow Senior and Secured Creditors to
Use Chapter 11 Plans to Reallocate Their Distributions to
Other Creditors Not Otherwise Entitled to Them
By contrast, in In re Parke Imperial Canton, Ltd., 1994 Bankr. LEXIS 2274
(Bankr. N.D. Ohio 1994), two secured claimholders proposed a chapter 11 plan
under which the estates hotel leasehold would be sold with the proceeds
allocated to the secured claimholders, except for amounts a secured claimholder
may use to satisfy its guaranty to one class of unsecured claimholders that it
would receive at least a 10% return. The court did not sustain an objection that
the plan discriminated unfairly by providing one class of claims a 10% guarantee,
reasoning that the guarantee would not be paid from estate assets and was
allowed under SPM. 1994 Bankr. LEXIS 2274 at *32-33.
Similarly, in In re MCorp Financial, Inc., 160 B.R. 941 (S.D. Tex. 1993),
the court confirmed a chapter 11 plan under which the FDIC received a
distribution of $33.054 million in settlement of its claims against the estate and
the estates counterclaims, 160 B.R. at 948, based on the rationale that the FDIC
could receive a higher distribution than the estates subordinated bondholders
who were subordinate to senior bondholders, but not to the FDIC, based on
SPM. 160 B.R. at 960. Because the senior bondholders accepted the plan
under which the FDIC received a distribution that would otherwise have
increased only the senior bondholders distribution, the court confirmed the plan,
reasoning: That the creditor [in SPM] was secured is not relevant; it was the
creditors status as prior to the IRS that allowed it to share with those under the
IRS, just as the seniors priority over the juniors allows them to fund the FDIC
settlement. 160 B.R. at 960.
Citing MCorp and SPM, In re Genesis Health Ventures, Inc., 266 B.R. 591
(Bankr. D. Del. 2001), overruled an objection to classification under a chapter 11
plan that separately classified punitive damage claims from other unsecured
claims and provided no distribution to the punitive damage claims (except from

84

insurance proceeds) while providing a 7.34% dividend in stock to other

unsecured claims, because the secured claimholders held liens against all estate
assets and were not being paid in full. 266 B.R. at 598, 601-602.
Notably, while the foregoing decisions allow secured and senior
claimholders to use a chapter 11 plan to distribute distributions of theirs to other
creditors, they do not explicitly hold such distributions are exempt from
classification and unfair discrimination restrictions.
3. What are the Standards for Substantive Consolidation?
A.
Credit Suisse First Boston v. Owens Corning (In re
Owens Corning), 419 F.3d 195 (3d Cir. 2005), amended, 2005
U.S. App. LEXIS 18043 (3d Cir., August 23, 2005), cert. den.
2006 U.S. LEXIS 3492, 3493 (U.S., May 1, 2006)
i. Facts.
Owens Corning (OC) and its subsidiaries and limited liability companies
comprised a multinational corporate group. Members of the group existed for
different reasons such as to limit liability concerns, to gain tax benefits, or for
regulatory reasons. Each entity observed corporate formalities, maintained its
own business records, and documented intercompany transactions. There may
have been some sloppy bookkeeping. But, two officers testified the financial
statements of all subsidiaries were accurate in all material respects. Credit
Suisse First Boston v. Owens Corning (In re Owens Corning), 419 F.3d 195, 200201 (3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., August 23,
2005)
In 1997, OC needed a loan to acquire Fibreboard Corporation and had a
poor credit rating due to its growing asbestos liability. The banks made a loan
proposal which from the outset required guarantees from subsidiaries as credit
enhancements. The banks loaned $2 billion pursuant to a credit agreement that
had many covenants recognizing the guarantees. The credit agreement also
contained numerous covenants requiring each subsidiary to remain separate,
maintain books and records, and deal with OC without incurring losses. Id. at
201.
After OC commenced its chapter 11 case, it proposed a chapter 11 plan
premised on a deemed consolidation of OC with its subsidiaries, whereby there
would be no actual merger, but all the guarantees of the bank debt would be
deemed eliminated. Id. at 202.
ii. History
After the district judge tried the substantive consolidation motion, he was
recused. In re Kensington Intl Ltd., 368 F.3d 289 (3d Cir. 2004). The new

85

district judge reviewed the trial record and granted substantive consolidation, but
reserved for the confirmation hearing a determination of whether the banks are
entitled to a priority or secured claim for the guarantees they would lose in the
deemed consolidation. In re Owens Corning, 316 B.R. 168 (Bankr. D. Del.
2004). The banks appealed and the appellate court denied a motion to dismiss
the appeal as interlocutory. Credit Suisse First Boston v. Owens Corning (In re
Owens Corning), 419 F.3d 195, 202-204 (3d Cir. 2005), amended, 2005 U.S.
App. LEXIS 18043 (3d Cir., August 23, 2005).
iii. Holding
Reversed. Id. at 216. Substantive consolidation must be based on the
following principles:
(1) Limiting the cross-creep of liability by respecting entity separateness
is a fundamental ground rule[]. Kors, supra, at 410. As a result, the general
expectation of state law and of the Bankruptcy Code, and thus of commercial
markets, is that courts respect entity separateness absent compelling
circumstances calling equity (and even then only possibly substantive
consolidation) into play.
(2) The harms substantive consolidation addresses are nearly always
those caused by debtors (entities they control) who disregard separateness. n 18
Harms caused by creditors typically are remedied by provisions found in the
Bankruptcy Code (e.g., fraudulent transfers, 548 and 544(b)(1), and equitable
subordination, 510 (c)).
(3) Mere benefit to the administration of the case (for example, allowing a
court to simplify a case by avoiding other issues or to make postpetition
accounting more convenient) is hardly a harm calling substantive consolidation
into play.
(4) Indeed, because substantive consolidation is extreme (it may
profoundly creditors rights and recoveries) and imprecise, this rough justice
remedy should be rare and, in any event, one of last resort after considering and
rejecting other remedies (for example, the possibility of more precise remedies
conferred by the Bankruptcy Code).
(5) While substantive consolidation may be used defensively to remedy
the identifiable harms caused by entangled affairs, it may not be used offensively
(for example, having a primary purpose to disadvantage tactically a group of
creditors in the plan process or to alter creditor rights). Id. at 211.
The upshot is this. In our Court what must be proven (absent consent)
concerning the entities for whom substantive consolidation is sought is that (i)
prepetition they disregarded separateness so significantly their creditors relied on
the breakdown of entity borders and treated them as one legal entity, or (ii)
postpetition their assets and liabilities are so scrambled that separating them is
prohibitive and hurts all creditors. Id at 211.

86

Proponents of substantive consolidation have the burden of showing one

or the other rationale for consolidation. The second rationale needs no
explanation. The first, however, is more nuanced. A prima facie case for it
typically exists when, based on the parties prepetition dealings, a proponent
proves corporate disregard creating contractual expectations of creditors that
they were dealing with debtors as one indistinguishable entity. Kors, supra, at
417-18; Christopher W. Frost, Organizational Form, Misappropriation Risk and
the Substantive Consolidation of Corporate Groups, 44 Hastings, L.J. 449, 457
(1993). Proponents who are creditors must also show that, in their prepetition
course of dealing, they actually and reasonably relied on debtors supposed
unity. Kors, supra, at 418-19. Creditor opponents of consolidation can
nonetheless defeat a prima facie showing under the first rationale if they can
prove they are adversely affected and actually relied on debtors separate
existence. n22 (n22 As noted already, supra n. 16, we do not decide here
whether such a showing by an opposing creditor defeats totally the quest for
consolidation or merely consolidation as to that creditor.) Id. at 212.
iv. Rationale
To protect prepetition expectations of creditors, the first test for
substantive consolidation allows consolidation when the debtor intentionally or
inadvertently misleads creditors into believing multiple entities are one entity. Id.
at 211 n. 19.
Owens Cornings first test conforms to widespread jurisprudence. The
judge-made rule of substantial identity has as its most critical element that it must
connote that creditors of the various entities consider them as one entity to which
they are extending credit and the determination of substantial identity must be
based on evidence that creditors believed they were dealing with one entity and
not several different entities. See, e.g., Flora Mir Candy Corp. v. R.S. Dickson &
Co., 432 F.2d 1060, 1062 (2d Cir. 1970); In re Bonham, 229 F.3d 750, 766 (9th
Cir. 2000); Olshan v. Southern Motel Assoc., 935 F.2d 245, 249 (11th Cir. 1991).
The second test is based on the practicality that all creditors are better off
with consolidation if the value to all of them is greater than it will be if the assets
and liabilities can not be separated at an expense leaving greater value for each
creditor. Id. at 211 n. 20. Moreover, the benefit to creditors should be from
cost savings that make assets available rather than from the shifting of assets to
benefit one group of creditors at the expense of another. Mere benefit to some
creditors, or administrative benefit to the Court, falls far short. Id. at 214.
There was no meaningful evidence of hopeless commingling in Owens
Corning. There was no question which entity owns which principal assets and
has which material liabilities. Id. at 214. Neither the impossibility of perfection in
untangling the affairs of the entities nor the likelihood of some inaccuracies in
efforts to do so is sufficient to justify consolidation. Id. at 214.

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In Owens Corning, the banks did the deal world equivalent of Lending
101, and undoing that bargain is a demanding task. Id. at 212. While the banks
actually did have considerable information about the subsidiary guarantors, even
if disregard of the debtors corporate form were proven, we cannot conceive of a
justification for imposing the rule that a creditor must obtain financial statements
from a debtor in order to rely reasonably on the separateness of that debtor.
Creditors are free to employ whatever metrics they believe appropriate in
deciding whether to extend credit free of court oversight. We agree with the
Banks that the reliance inquiry is not an inquiry into lenders internal credit
metrics. Rather, it is about the fact that the credit decision was made in reliance
on the existence of separate entities Id. at 213-214. Thus, even if Owens
Corning had made a prima facie case that creditors treated it as one entity, the
banks overcame that case with their separate guarantees and credit agreement.
Substantive consolidation was also inappropriate because (a) Owens
Corning was using it offensively to deprive the banks of voting rights in each
subsidiary and (b) Owens Corning was using it to eliminate the guarantees of the
bank debt rather than satisfy the Bankruptcy Code requirements of fraudulent
transfer law to avoid the guarantees. Id. at 215. But perhaps the flaw most fatal
to the consolidation sought was deemed (i.e., a pretend consolidation for all
but the Banks). If Debtors corporate and financial structure was such a sham
before the filing of the motion to consolidate, then how is it that post the Plans
effective date this structure stays largely undisturbed, with the Debtors reaping all
the liability-limiting, tax and regulatory benefits achieved by forming subsidiaries
in the first place? In effect, the Plan Proponents seek to remake substantive
consolidation not as a remedy, but rather a stratagem to deem separate
resources reallocated to OCD to strip the Banks of rights under the Bankruptcy
Code, favor other creditors, and yet trump possible Plan objections by the Banks.
Such deemed schemes we deem not Hoyle. Id. at 216.
No principled, or even plausible, reason exists to undo OCDs and the
Banks arms-length negotiation and lending arrangement, especially when to do
so punishes the very parties that conferred the prepetition benefit a $2 billion
loan unsecured by OCD and guaranteed by others only in part. To overturn this
bargain, set in place by OCDs own pre-loan choices of organization form, would
cause chaos in the marketplace, as it would make this case the Banquos ghost
of bankruptcy. Id. at 216.
b. Principles underlying Substantive Consolidation
i.

Authority for Substantive Consolidation

In enacting section 302(b), Congress made clear substantive

consolidation should not be used to change creditors rights under the

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Bankruptcy Code. As stated in In re Lewellyn, 26 B.R. 246, 250 (Bankr. S.D.

Iowa 1982):
The section, of course, is not license to consolidate in
order to avoid other provisions of the title to the detriment of either
the debtors or their creditors. It is designed mainly for ease of
administration. (Emphasis added). H.R.Rep. No. 595, 95th Cong.,
1st Sess. (1977), U.S.Code Cong. & Admin. News 1978, p. 5787;
S.Rep. No. 989, 95th Cong., 2d Sess. (1978),
U.S.Code Cong. & Admin. News 1978, p. 5787.
Congress authorization of substantive consolidation in chapter 11
of spouses estates, certainly implies it chose not to authorize consolidation of
corporate estates. The only possible source of power to consolidate corporate
estates is 11 U.S.C. 105(a), providing the court may issue any order, process,
or judgment that is necessary or appropriate to carry out the provisions of this
title. Union Savings Bank v. Augie/Restivo Baking Co. (In re Augie/Restivo
Banking Co.), 860 F.2d 515, 518 (2d Cir. 1988); FDIC v. Colonial Realty Co., 966
F.2d 57, 59 (2d Cir. 1992).
Because section 105(a) only authorizes orders carrying out the
Bankruptcy Code, orders undermining it are beyond the courts subject matter
jurisdiction. For example, this Court recently held Congress enactment of 11
U.S.C. 524(g) protecting debtors under certain circumstances from future
asbestos claims negates any section 105(a) power to protect nondebtors from
nonderivative asbestos claims. The Court ruled:
The general grant of equitable power contained in 105(a)
cannot trump specific provisions of the Bankruptcy Code, and must
be exercised within the parameters of the Code itself. See
generally Norwest Bank Worthington v. Ahlers, 485 U.S. 197,206
(1988) (Whatever equitable powers remain in the bankruptcy
courts must and can only be exercised within the confines of the
Bankruptcy Code.) When the Bankruptcy Code provides a
specified means for a debtor to obtain a specific form of equitable
relief, those standards and procedures must be observed. See In
re Fesco Plastics Corp., 996 F.2d 152, 154-55 (7th Cir.
1993)([W]hen a specific Code section addresses an issue, a court
may not employ its equitable powers to achieve a result not
contemplated by the Code.); Resorts Intl v. Lowenschuss (In re
Lowenschuss), 67 F.3d 1394, 1402 (9th Cir. 1995)(Section 105
does not authorize relief inconsistent with more specific law); In re
Zale Corp., 62 F.3d at 760 (5th Cir. 1995) (A 105 injunction
cannot alter another provision of the [C]ode).

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In re Combustion Engineering, Inc., 391 F.3d 190, 236 (3d Cir. 2004).
ii.

Reasons Why All Appellate Courts Rule

Substantive Consolidation Must Be Used Only
Sparingly

Based on the wholesale frustrations of fundamental rights, statutory

rights, and commercial expectations wrought by substantive consolidation, it is
not surprising that all courts of appeal addressing the issue emphasize
substantive consolidation must be used sparingly or as a last resort. See, e.g.,
Credit Suisse First Boston v. Owens Corning (In re Owens Corning), 419 F.3d
195, 211 (3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., Aug.
23, 2005); Augie/Restivo, 860 F.2d at 518; Flora Mir, 432 F.2d at 1062; Kheel,
369 F.2d at 847; Alexander v. Compton (In re Bonham), 229 F.3d 750, 767 (9th
Cir. 2000); Reider v. FDIC (In re Reider), 31 F.3d 1102, 1109 (11th Cir. 1994).
Constitutional Right to Fair Share of Debtors Assets. As a threshold
matter, substantive consolidation destroys the constitutional right of a creditor to
the equitable distribution of the debtors assets among his creditors, Kuehner v.
Irving Trust Co., 299 U.S. 445, 451 (1937), in favor of a distribution from a
hodgepodge of multiple debtors assets to their aggregate liabilities [B]ecause
every entity is likely to have a different debt-to-asset ratio, consolidation almost
invariably redistributes wealth among the creditors of the various entities. This
problem is compounded by the fact that liabilities of consolidated entities inter se
are extinguished by the consolidation. Drabkin v. Midland-Ross Corp. (In re
Auto-Train Corp.), 810 F.2d 270 at 276 (D.C. Cir. 1987).
Right to Enforce Corporate Separateness. Likewise, substantive
consolidation destroys creditors rights to enforce corporate separateness absent
fraud. United States v. Bestfoods, 524 U.S. 51, 62 (1998).
Right to Enforce Intercompany Claims Regardless of Reliance.
Additionally, absent substantive consolidation, creditors can enforce claims valid
under state law regardless of whether they relied on them at all, let alone to the
trial judges satisfaction. Gould v. Levin (In re Credit Indus. Corp.), 366 F.2d 402,
410 (2d Cir. 1966) (a senior creditor can enforce in bankruptcy a subordination
agreement which was executed for his benefit without alleging or proving that he
advanced funds in reliance thereon); Kira v. Holiday Mart, Inc. (In re Holiday
Mart, Inc.), 715 F.2d 430 (9th Cir. 1983); First Natl Bank v. Am. Foam Rubber
Corp., 530 F.2d 450 (2d Cir. 1976).
Right to Enforce Creditors Claim and Intercompany Claims Absent
Wrongful Conduct. Absent substantive consolidation, any claim including a
guaranty claim can not be subordinated, let alone eliminated, unless the claimant
engaged in wrongful conduct. United States v. Noland, 517 U.S. 535 (1996);
Citicorp Venture Capital, Ltd. v. Comm. of Creditors, 160 F.3d 982 (3d Cir. 1998).
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Because substantive consolidation frustrates these rights, it is reserved for

unavoidable situations involving either a hopeless commingling of several entities
assets and liabilities, or a substantial identity among several entities causing
creditors to believe they were extending credit to a group as opposed to one
entity.
iii.

Substantive Consolidation is Not Based on a

Scoring System of Miscellaneous Indicia of
Corporate Overlap

Many decisions determine hopeless commingling or substantial identity

based on the number of incidences of overlap between entities, such as common
officers and directors, common headquarters, central cash management, etc.
See, e.g. In re Vecco Constr. Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va.
1980). The problem with this is that items having no real significance as to
whether the assets and liabilities can be separated or whether creditors were
misled into believing there was only one entity, are counted as meaningful.
Too often the factors in a check list fail to separate the unimportant from
the important, or even to set out a standard to make the attempt.This often
results in rote following of a form containing factors where courts tally up and spit
out a score without an eye on the principles that give the rationale for substantive
consolidation (and why, as a result, it should so seldom be in play). Credit
Suisse First Boston v. Owens Corning (In re Owens Corning), 419 F.3d 195, 210
(3d Cir. 2005), amended, 2005 U.S. App. LEXIS 18043 (3d Cir., Aug. 23, 2005).
iv.

Use of a Subsidiary to Benefit the Parent

Company Does Not Justify Piercing the
Subsidiarys Corporate Form

Some litigants believe that if a subsidiary does not operate to maximize its
own profit, then its corporate form need not be observed because it is not acting
like a real corporation. This contention is based on a fundamentally erroneous
premise that any legitimate corporation must operate for its own benefit. To the
contrary, as shown below, a corporation is supposed to operate for the benefit of
its shareholder(s). In reversing substantive consolidation, Owens Corning
acknowledges that many subsidiaries were used for liability-limiting, tax, and
regulatory benefits, id. at 200, 216, all of which benefits benefited only the parent
company and not the individual subsidiaries.
[I]n a parent and wholly-owned subsidary context, the
directors of the subsidiary are obligated only to manage the affairs
of the subsidiary in the best interests of the parent and its
shareholders.

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Anadarko Petroleum Corp. v. Panhandle Eastern Corp., 545 A.2d 1171, 1174
(Del. 1988).
A wholly-owned subsidiary is to be operated for the benefit of
its parent. A subsidiary board is entitled to support a parent's
business strategy unless it believes pursuit of that strategy will
cause the subsidiary to violate its legal obligations. Nor does a
subsidiary board have to replicate the deliberative process of its
parent's board when taking action in aid of its parent's acquisition
strategies.
Trenwick America Litigation Trust v. Ernst & Young, 906 A.2d 168, 174
(Del. Ch. 2006).

The foregoing rule applies except when the subsidiary is not wholly owned
and the parent is causing the subsidiary to enter into a transaction that is
beneficial to the parent at the expense of the minority shareholders of the
subsidiary. Sinclair Oil Corp. v. Levien, 280 A.2d 717, 720 (Del. 1971)(business
judgment rule applies to parents transactions with subsidiary unless the parent,
by virtue of its domination of the subsidiary, causes the subsidiary to act in such
a way that the parent receives something from the subsidiary to the exclusion of,
and detriment to, the minority stockholders of the subsidiary.).
In Anardarko, Panhandle had spun off to its shareholders its subsidiary,
Anardarko. Anardarko sued its former directors and former parent claiming they
breached their fidicuciary duties before the spinoff by modifying various
agreements between Panhandle and Anardarko after the spinoff dividend was
declared but before it was made. The court affirmed summary judgment
dismissing the claim because prior to the spinoff, the subsidiarys directors were
supposed to manage it in the best interests of its corporate parent.
The duty of a subsidiary to act for the best interests of its parent is so clear
and strong that the directors of the parent have a duty to stop the subsidiary from
acting in its own interests if the subsidiarys action would be adverse to the
parent corporation and its shareholders. Grace Brothers v. UniHolding Corp.,
C.A. No. 17612, 2000 Del Ch. LEXIS 101 (Del. Ch. July 12, 2000).
It is by no means a novel concept of corporate law that a whollyowned subsidiary functions to benefit its parent. n. 31 (n 31 E.g.,
Stenberg v. ONeil, Del. Supr., 550 A.2d 1105, 1124 (1988);
Anadarko Petroleum Corp. v. Panhandle Eastern Corp., Del. Supr.,
545 A.2d 1171, 1174 (1988)). To the extent that members of the
parent board are on the subsidiary board or have knowledge of
propsosed action at the subsidiary level that is detrimental to the
parent, they have a fiduciary duty, as part of their management

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responsibilities, to act in the best interests of the parent and its

stockholders.
Grace Brothers v. UniHolding Corp., C.A. No. 17612, 2000 Del Ch. LEXIS 101 at
*40 (Del. Ch. July 12, 2000).
It is considered settled law that:
(1) a parent does not owe a fiduciary duty to its wholly owned
subsidiary, and (2) in a parent and wholly-owned subsidiary
context, the directors of the subsidiary are obligated only to
manage the affairs of the subsidiary in the best interests of the
parent and its shareholders.
Shaev v. Wyty, C.A. No. 15559, 1998 Del. Ch. LEXIS 2, at *7 (Del. Ch. Jan. 6,
1998)(quoting Anadarko Petroleum Corp. v. Panhandle Eastern Corp., Del.
Supr., 545 A.2d 1171, 1174 (1988)).
v.

Use of a Subsidiary to Benefit the Parent

Directly or Indirectly Does Not Justify
Avoidance of Intercompany Debt

Based on the foregoing principle that a subsidiary has a duty to act to

benefit its parent corporation, directly or indirectly, when a parent corporation
sells assets to its subsidiaries in exchange for intercompany debt, creditors of the
subsidiaries are not entitled to avoidance of the intercompany debt as would
occur in a substantive consolidation unless the incurrence of the debt is actually
avoided in a fraudulent transfer action. Creditors are not entitled to avoidance of
the debt on the ground they would have preferred that the parent have made a
capital contribution to the subsidiary.
The jurisprudence shows clearly that a parent company has no duty to a
subsidiarys creditors to make capital contributions of assets rather than sell
assets to a subsidiary. That directors of each subsidiary owe duties to its
shareholder and not its creditors is well ingrained in the jurisprudence cited
above.
For instance, Revlon tried to defeat a hostile tender offer by granting a
white knight a lock up option on certain of Revlons businesses. Revlon Inc. v.
MacAndrews & Forbes Holdings, Inc., 506 A.2d 173, 175-176, 182 (Del. 1986).
In exchange, Revlon obtained the white knights commitment to support the par
value of certain of Revlons debt securities issued in an early phase of Revlons
takeover defense. Id. at 182-184. The Delaware Supreme Court invalidated the
lock up option on the ground that once Revlons takeover was inevitable, the
directors breached their duty of loyalty to shareholders by preferring the interests

93

of debtholders over obtaining the highest price for shareholders. Id. at 182;
accord Pittelman v. Pearce, 8 Cal. Rptr. 2d 359 (1992); C-T of Virginia, Inc. v.
Barrett, 124 B.R. 689, 692-293 (W.D. Va. 1990) (holding that directors owed no
fiduciary duties to creditors in connection with leveraged buyout since one
directors determined that the best way to serve shareholder interests was to
place the firm on the market.the directors duties were limited to gain[ing]
the highest price for its shareholders. [This] duty cannot extend to the interests
of current or future unsecured creditors of the company.).
Similarly, following the sale of Federated Department Stores, a debtholder
sued the company for causing the downgrading of its debt in violation of its duty
of good faith and fair dealing. The debtholder lost on the ground it was entitled to
no greater protection than that provided in its indenture. Hartford Fire Ins. Co. v.
Federated Dept Stores, 723 F. Supp. 976, 992 (S.D.N.Y. 1989); accord
Metropolitan Life Ins. v. RJR Nabisco Inc., 716 F. Supp. 1504 (S.D.N.Y. 1989);
Harff v. Kerkorian, 324 A.2d 215 (Del. Ch. 1974).
Owens Corning tried to use substantive consolidation to eliminate its
subsidiaries guarantees of the bank debt rather than satisfy the Bankruptcy
Code requirements of fraudulent transfer law to avoid the guarantees, id. at 215,
and the court rejected the tactic because substantive consolidation was being
deployed as a sword and not as a shield. Id. at 216.
Similarly, Owens Cornings effort to have the intercompany debt
eliminated in substantive consolidation on the ground the accounting was
imperfect was rejected, with the appellate court ruling the trial court could
oversee an accounting process that would sufficiently account for the claims. Id.
at 215.
It has long been the law that when one subsidiary has a claim against
another, the creditors of the first subsidiary can block a substantive consolidation
of the subsidiaries to protect their rights to their subsidiarys intercompany claim.
Flora Mir Candy Corp. v. R. S. Dickson & Co. (In re Flora Mir Candy Corp.), 432
F.2d 1060, 1062-1063 (2d Cir. 1970).
vi.

Use of Subsidiaries to Minimize Taxes Does

Not Render Their Corporate Form Illegitimate

Organizing a corporate group to legally minimize the groups tax

burden is consistent with the directors fiduciary duties. It is well settled that
directors are required to act on behalf of the corporation as would ordinarily
prudent and diligent men . . . under similar circumstances. . . . Briggs v.
Spaulding, 141 U.S. 132, 152 (1891). In furtherance of this fiduciary duty of care,
Delaware law imposes on a board of directors the duty to manage the business
and affairs of the corporation. 8 Del.C. 141(a). This broad mandate includes a
conferred authority to set a corporate course of action, including time frame,
designed to enhance corporate profitability. Paramount Communications, Inc. v.
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Time Inc., 571 A.2d 1140, 1150 (Del.1989) (emphasis added). It is self evident
that a principal way to enhance corporate profitability is to reduce expenses,
including the payment of unnecessary taxes.
There is nothing sinister in arranging ones affairs so as to
minimize taxes. Sullivan v. United States of America, 618 F.2d 1001, 1007 (3d
Cir. 1980) (citing Commr v. Newman, 159 F.2d 848, 850 (2d Cir. 1947) (Hand,
J., dissenting) ([O]ver and over again courts have said that there is nothing
sinister in so arranging ones affairs as to keep taxes as low as possible.
Everybody does so, rich or poor; and all do right, for nobody owes any public
duty to pay more than the law demands: taxes are enforced exactions, not
voluntary contributions. To demand more in the name of morals is mere cant.);
Gregory v. Helvering, 293 U.S. 465, 469 (1935) (The legal right of a taxpayer to
decrease the amount of what otherwise would be his taxes, or altogether avoid
them, by means which the law permits, cannot be doubted.); Commr v. First
Sec. Bank of Utah, 405 U.S. 394, 398 n.4 (1972) (Taxpayers are, of course,
generally free to structure their business affairs as they consider to be in their
best interests, including lawful structuring (which may include holding companies)
to minimize taxes.).
vii.

Substantive Consolidation Can Not Be Ordered

Based on a Balancing of Benefits and Burdens

As Nesbit v. Gears Unlimited, Inc., 347 F.3d 72, 86 n. 7 (3d Cir.

2003), observes, some courts apply a 7-factor test from In re Vecco Constr.
Indus., Inc., 4 B.R. 407, 410 (Bankr. E.D. Va. 1980). Vecco suffers from two
defects: 1. it involved no controversy, and 2. it cited no authority for its liberal
trend.
In 1979, with the effectiveness of the Bankruptcy Code, the West
Reporter first published bankruptcy court decisions. Some bankruptcy judges,
therefore, wrote decisions without pending disputes. Vecco is an example. With
no opposition, no one being harmed, everyone benefiting, and creditors having
done business with the group and not with an individual debtor, Vecco, 4 B.R. at
411, the debtors wanted to consolidate because the parent had already acquired
all the assets and assumed the liabilities of the subsidiaries, and no records of
intercompany transfers had been kept for over a year. All the assets had been
scrambled for over a year and there was no way to track the intercompany
accounts.
The facts of Vecco satisfied the stringent tests for consolidation
described above (and there was no harm and no objection), and Vecco cited the
same Second Circuit authority cited above. Instead of simply granting the
consolidation motion, the court wrote a decision without a controversy to decide.
The decision announced a liberal trend allowing consolidation in recent
jurisprudence it did not cite, Id. at 409, and proffered a 7-factor test. Id. at 410.
Then, Murray Industries, infra, cited Vecco and Eastgroup, infra, cited Murray
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Industries and Vecco as they followed the liberal trend. Most recently, Veccos
purported trend has been criticized. See, e.g., World Access, 301 B.R. at 257,
n.57 (Although certain courts have observed a modern trend toward more
liberal application of the doctrine, see, e.g., Murray Indus., Inc., 119 B.R. at 828,
this Court is skeptical of the liberal approach).
Owens Corning (419 F.3d at 209n. 15) unabashedly declares we
disagree with the assertion of a liberal trend toward increased use of
substantive consolidation, citing as examples of decisions asserting it:
Eastgroup Props. v. S. Motel Assocs., Ltd., 935 F.2d 245 (11th Cir. 1991); In re
Murray Industries, Inc., 119 B.R. 820, 828 (Bankr. M.D. FLa. 1990), and Vecco.
Id
The problem with the so-called trend is it renders substantive
consolidation an unpredictable coin toss violating parties fundamental rights
which are not trendy. This is best illustrated in Eastgroup. Notably, virtually all
consolidation opinions cite the Second Circuit authorities, but some pay lip
service and some actually follow them. Eastgroup is in the former category.
In Eastgroup, common owners set up two partnerships, SMA and
GPH. SMA procured motels by purchasing or leasing them, and then leased or
subleased the motels to GPA which operated them. Eastgroup, 935 F.2d at 246247. SMA charged GPH the same amount SMA had to pay in rent or mortgage
payments for its motels. Id. at 247. Their common chapter 7 trustee requested
their substantive consolidation when SMA had $861,205 and GPH had $283,917.
Id. SMA was liable for $600,000 of chapter 7 expenses and $800,000 of chapter
11 expenses. GPH was liable for $1 million of chapter 11 expenses. Its chapter
7 expenses were unknown. The upshot of this is that consolidation would make
available from SMA another $261,205 for administrative expenses generated by
GPH. Absent consolidation, the $261,205 would be available to pay accrued
chapter 11 expenses of SMA such as rent and mortgage payments owed to the
persons objecting to consolidation.
Towards the end of SMAs tenure in chapter 11, GPH failed to pay
rent to SMA for three or four months. The treasurer testified it was likely GPH
paid some of SMAs unsecured obligations, but she couldnt recall any specific
instance and testified each entity had claims against the other. Eastgroup, 935
F.2d at 247 n. 8. The employees of each partnership were the same and they
didnt allocate expenses to SMA although most of the work was for GPH. Id. at
247. SMA and GPH did hold themselves out to creditors as separate
corporations. Id. at 248. At one point, GPH represented to a contractor that
GPH owned a motel that SMA actually owned and the contractor did work for
GPH on that property. Id. Although $12 million of total claims against SMA
would have to be reduced to less than $861,205 before a distribution to equity
would be possible, the trustee who wanted consolidation testified a distribution to

96

SMAs equity holders was possible depending on objections to claims. Id. at

251.
Alluding to the modern or liberal trend, Eastgroup ruled the
basic criterion by which to evaluate a proposed substantive consolidation is
whether the economic prejudice of continued debtor separateness outweighs
the economic prejudice of consolidation. Eastgroup, 935 F.2d at 249 (quoting
In re Snider Bros., Inc., 18 B.R. 230, 234 (Bankr. D. Mass. 1982)). Then,
Eastgroup nominally adopted the Auto-Train standard, Drabkin v. Midland-Ross
Corp. (In re Auto-Train Corp.), 810 F.2d 270 (D.C. Cir. 1987), which is different
than the balancing test Eastgroup sets out. Finally, Eastgroup suggests the 7factor test from Vecco may be used to establish a prima facie case under AutoTrain. Id. Ultimately, Eastgroup finds the parties conceded to the substantial
identity component and the court had to determine whether there were benefits
to be realized or harms to be avoided from consolidation, and whether the
objectors relied on the entities separate credit. Id. at 251.
Here is Eastgroups analysis. First, Eastgroup refers to the
testimony that GPH likely paid some SMA expenses and reasons consolidation is
beneficial because it will lessen the harm to GPHs creditors done by GPHs
payments. Eastgroup, 935 F.2d at 251. What principled rule caused the court to
focus on GPHs possible payment of some SMA expenses, and to ignore the
certainty that GPH failed to pay SMA rent for 3 to 4 months during its chapter 11
case? What principle caused the court to ignore the fact that GPH and SMA had
claims against one another? What good will consolidation do for GPH creditors,
given that money flows first to chapter 7 administrative claims? In short,
Eastgroups selective benefit is wholly arbitrary and completely unprincipled and
unpredictable.
Eastgroups second determination is that consolidation will benefit
creditors such as the contractor who rendered services to SMAs motel because
GPH misrepresented that GPH owned it. Eastgroup, 935 F.2d at 251.
Eastgroup says such creditors must have relied on the combined credit of both
partnerships. Id. If GPH misrepresented the facts, why should SMAs creditors
suffer? What is the benefit of consolidation?!
Significantly, in Reider v. FDIC (In re Rieder), 31 F.3d 1102 (11th
Cir. 1994), the Eleventh Circuit revisited the issue of substantive consolidation
and debtor misrepresentations and took a different position. There, a request
was made to consolidate a wifes assets and liabilities with her debtor-husbands
estate. To get credit, the husband had represented he owned property that was
actually owned by his wife. The court reversed the granting of substantive
consolidation. Reider, 31 F.3d at 1109.
Eastgroups third determination is that consolidation is beneficial
because it will benefit GPHs administrative and priority creditors. Id. And

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exactly why is their benefit at SMAs creditors expense a net benefit of

consolidation? How does one make that judgment?
Simply put, each of Eastgroups reasons for consolidation is so
arbitrary and unpredictable, it shows substantive consolidation is reduced to legal
mush when reduced to a weighing test of any factors that come to mind and
disregard of the fundamental rights being violated.
viii.

When Substantive Consolidation is Ordered,

Creditors Who Relied on the Separateness of
an Entity Being Consolidated Are Entitled to
Priority Claims against the Entity

In Sampsell v. Imperial Paper & Colorcorp., 313 U.S. 215, (1941),

an individuals estate was substantively consolidated into the estate of the
corporation where he had placed his assets to hinder creditors. A creditor of the
corporation requested a priority claim to the corporations assets. The Supreme
Court denied it because the creditor had aided the fraudulent transfer of the
individuals assets into the corporation, but announced the general rule:
All questions of fraudulent conveyance aside, creditors of the
corporation normally would be entitled to satisfy their claims out of
the corporate assets prior to any participation by the creditors of the
stockholder.
313 U.S. at 218 (citing Withers v. White (In re Foley), 4 F.2d 154 (9th Cir. 1925)
and Miller v. Ehrlich (In re Smith), 16 F.2d 697 (2d Cir. 1929)).
In re Lewellyn, 26 B.R. 246, 251 (Bankr. S.D. Iowa 1982), states the rule
as follows: There is also a rule that a creditor who relies on the sole credit of
one entity is entitled to have its claim satisfied out of that entity's assets even if
the entity is no more than a corporate pocket of a parent entity. Commerce Trust
Co. v. Woodbury, 77 F.2d 478 (8th Cir. 1935), cert. denied, 296 U.S. 614, 80 L.
Ed. 435, 56 S. Ct. 134 (1935).
The granting of priority claims to those creditors proving they relied on
separate entities is required. See Stone v. Eacho (In re Tip Top Tailors, Inc.),
127 F.2d 284, 290 (4th Cir. 1942), rehearing denied and priority reaffirmed, 128
F.2d 16 (4th Cir. 1942); FDIC v. Hogan (In re Gulfco Investment Corp.), 593 F.2d
921, 929 (10th Cir. 1979).

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4. How Do X-Clauses Work?

A.Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re
Metromedia Fiber Network, Inc.), 416 F.3d 136 (2d Cir. 2005)
i. Facts.
Subordinated noteholders of the debtor, MFN, were bound by a
subordinated indenture containing the following provisions concerning the
respective rights of the senior and junior noteholders:
Upon the payment or distribution of the assets of [MFN n1]
of any kind or characterto creditors upon any dissolution,
winding-up, liquidation or reorganization of [MFN]any payment or
distribution of assets of [MFN] of any kind or characterto which
the Holders [of the Notes] or the Trustee on behalf of the Holders
would be entitledshall be paid or deliveredto the holders of the
Senior Indebtedness
But, the indenture exempted from subordination:
securities of [MFN] as reorganized or readjusted, or securities of
[MFN] or any other Person provided for by a plan of reorganization
or readjustment, junior, or the payment of which is otherwise
subordinate, at least to the extent provided in this Article 12, with
respect to the Notes, to the payment of all Senior Indebtedness.
416 F.3d at 139.
In the MFN chapter 11 case, the senior noteholders were given a
combination of cash, common stock, and warrants (identical to the warrants
given to the subordinated noteholders), all of which together did not amount to
full payment. Id. at 140. The chapter 11 plan provided for the warrants allocated
to the junior noteholders to be channeled to the senior noteholders under the
foregoing provisions. Id.
ii. Issue.
Under the foregoing facts, are the subordinated noteholders allowed to
retain their warrants pursuant to the x-clause without impairing the priority
assured to the senior noteholders?
iii. Holding.
No. 416 F.3d at 140-141.

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iv. Rationale.
If appellants can keep their warrants, they would be able to buy the same
class of common stock allocated to the Senior Indebtedness giving appellants
and the Senior Indebtedness equal priority to any future distributions. Therefore,
allowing appellants to retain the warrants would effect an impairment of
seniority. Id. at 140-141. Based on the American Bar Foundations
Commentaries on Model Debenture Indenture Provisions
(1971)(Commentaries), the court reasoned that when subordinated and senior
note holders are given securities under a plan of reorganization, an X-Clause
allows the subordinated note holder to retain its securities only if the securities
given to the senior note holder have higher priority to future distributions and
dividends (up to the full amount of the senior notes). This provides for full
payment of the senior notes before any payment of the subordinated notes is
made. In such a case, the senior note holder enjoys unimpaired the priority to
payment that it had under its notes, i.e., payment on the subordinated note
holders securities are subordinateto the payment of all Senior Indebtedness.
Id. at 140 (quoting Commentaries, 14-5 at 570).
The MFN courts reasoning is consistent with In re Envirodyne Indus., 29
F.3d 301, 306 (7th Cir. 1994).
v. Analysis.
The theme of the X-Clause analysis is that subordinated notes can obtain
securities allowing them cash from the debtor on a basis junior to the securities
distributed to the senior noteholders if the senior noteholders receive securities
entitling them to distributions constituting payment in full. Otherwise, the
subordinated noteholders would have a right to a distribution when the senior
noteholders will not have been paid in full. Significantly, however, the junior
security itself may nevertheless have value that the junior noteholder can sell
immediately on receipt and thereby obtain cash before the senior noteholders are
paid in full. But, the cash the junior noteholder receives for its subordinated
security will not be cash from the debtor.
5. When Do Lease Assignments Render Appeals Moot pursuant to
11 U.S.C. 363(m)?
A.Weingarten Nostat, Inc. v. Service Merchandise Company,
Inc., 396 F.3d 737 (6th Cir. 2005)
i. Facts.
The bankruptcy court approved the assumption and assignment of a
shopping center lease over the landlords objections that it was not provided

100

adequate assurance of future performance and the assignee was subletting

space to a store that competes directly with an existing tenant in the mall.
Weingarten Nostat, Inc. v. Service Merchandise Company, Inc., 396 F.3d 737,
739 (6th Cir. 2005). The existing tenants lease allowed the tenant to reduce its
rent by a third or to terminate the lease if another tenant selling competing goods
moved into the mall. Id. The landlord had objected to the assignment under 11
U.S.C. 365(b)(3)(A), 365(b)(3)(C), and 365(b)(3)(D).
The landlord vigorously sought a stay pending appeal and even a writ of
mandamus from the United States Court of Appeals for the Sixth Circuit, all of
which was denied due to the absence of probability of success on the merits
even though irreparable harm was assumed. Id. at 740.
Two days after the district court denied th
e stay, the assignment
was made and a week later the sublease was executed. Then, the district court
affirmed and the landlord appealed. The assignor then moved to dismiss the
appeal under 11 U.S.C. 363(m).
ii. Issue.
Was the appeal moot under 11 U.S.C. 363(m) which provides:
The reversal or modification on appeal of an authorizationof a
sale or lease of property [under 363(b)] does not affect the validity
of a sale or lease under such authorization to an entity that
purchased or leased such property in good faith, whether or not
such entity knew of the pendency of the appeal, unless such
authorization and such sale or lease were stayed pending appeal.
iii. Holding.
Yes. Id. at 742.
iv. Rationale.
Even though the assumption and assignment of a lease is governed by 11
U.S.C. 365, the assignment for a valuable consideration is a sale of property to
which section 363(m) applies. Id. at 742; Dev. Co. of America, Inc. v. Adamson
Co., Inc. (In re Adamson Co., Inc.), 159 F.3d 896, 898 (4th Cir. 1998); LRSC Co.
v. Rickel Home centers, Inc. (In re Rickel Home Centers), 209 F.3d 291, 295 (3d
Cir. 2000).
The policy underlying section 363(m) is to afford finality to the orders and
judgments of the bankruptcy court relied on by third parties in ordering their
affairs. Id. at 303-304.

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Some circuits apply a per se rule that the absence of a stay pending
appeal moots the appeal under section 363(m). See, e.g., Pittsburgh Food &
Beverage, Inc. v. Ranallo, 112 F.3d 645, 650-51 (3d Cir. 1997)(citing decisions in
the 1st, 2d, 5th, 7th, and 11th circuits as adopting a per se rule). The Third Circuit
holds that even if section 363(m) applies, failure to obtain a stay does not
dispose of the appeal if some remedy can be fashioned that does not disturb the
validity of the sale at issue. Krebs Chrysler-Plymouth, Inc. v. Valley Motors, Inc.,
141 F.3d 490, 499-500 (3d Cir. 1998).
B.Made In Detroit, Inc. v. Official Committee of Unsecured
Creditors of Made in Detroit, Inc. (In re Made In Detroit, Inc.),
414 F.3d 576 (6th Cir., 2005)
i. Facts
The debtor and its creditors committee proposed competing chapter 11
plans. The debtors plan was premised on obtaining a loan to develop the
property, while the committees plan provided for an immediate liquidation. Made
In Detroit, Inc. v. Official Committee of Unsecured Creditors of Made in Detroit,
Inc. (In re Made In Detroit, Inc.), 414 F.3d 576, 579 (6th Cir. 2005). The court
confirmed the committees plan. After every court addressing the debtors
request for a stay pending appeal (including the Sixth Circuit) denied the stay,
the committee closed the sale of its land and the land was subsequently resold.
Id. at 580.
ii. Issue
On appeal to the Sixth Circuit, the appeal was limited to the issue of
whether the purchaser was a good faith purchaser.
iii. Holding.
The purchaser was a good faith purchaser and the appeal is moot. Id. at
583.
v. Rationale.
Section 363(m) protects the reasonable expectations of good faith thirdparty purchasers by preventing the overturning of a completed sale, absent a
stay, and it safeguards the finality of the bankruptcy sale. Official Comm. of
Unsecured Creditors v. Trism, Inc. (In re Trism, Inc.), 328 F.3d 1003, 1006 (8th
Cir. 2003). As a result, section 363(m) maximizes the purchase price of assets
because without this assurance of finality, purchasers could demand a large
discount for investing in a property that is laden with the risk of endless litigation
as to who has rights to estate property. Made In Detroit, Inc. v. Official

102

committee of Unsecured Creditors (In re Made In Detroit, Inc.), 414 F.3d 576,
581 (6th Cir. 2005) (quoting In re Gucci, 126 F.3d 380, 387 (2d Cir. 1997)).
A good faith purchaser is one who purchases the assets for value, in
good faith and without notice of adverse claims. In re Rock Indus. Mach. Corp.,
572 F.2d 1195, 1197 (7th Cir. 1978). Id. at 581. Thus, good faith and value
must be proved. In re Abbotts Dairies of Pennsylvania, Inc., 788 F.2d 143, 147
(3d Cir. 1986). [T]o show lack of good faith, the debtor must demonstrate that
there was fraud or collusion between the purchaser and the seller or the other
bidders, or that the purchasers actions constituted an attempt to take grossly
unfair advantage of other bidders. 255 Park Plaza Assocs. Ltd. Pship v. Conn.
Gen. Life Ins. Co. (In re 255 Park Plaza Assocs. Ltd. Pship), 100 F.3d 1214,
1218 (6th Cir. 1996); . Made In Detroit, Inc. v. Official committee of Unsecured
Creditors (In re Made In Detroit, Inc.), 414 F.3d 576, 581 (6th Cir. 2005).
13. Does 11 U.S.C. 363(f) Authorize a Sale Free of a Lessees Possessory
Interests Preserved on Lease Rejection by 11 U.S.C. 365(h)?
A. Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re
Qualitech Steel Corp.), 327 F.3d 537 (7th Cir. 2003)
i. Facts.
Precision had 2 prepetition agreements with the debtor, Qualitech. One
agreement was a supply agreement under which Precision would construct a
supply warehouse on Qualitechs property and operate it for 10 years while
providing supply services. The other agreement was a 10-year land lease
providing for rent of $1 per year. It provided Precision exclusive possession of
the warehouse with a right to remove all improvements and fixtures on early
termination of the lease. At the normal maturity of the lease, Qualitech had the
right to purchase the warehouse and fixtures and other improvements for $1.
The lease was not recorded. 327 F.3d at 540.
During Qualitechs chapter 11 case substantially all the estate assets were
sold to the secured claimholders for their credit bid of $180 million. Their
outstanding mortgage claim was more than $263 million. The order approving
the sale directed Qualitech to convey the assets free and clear of all liens,
claims, encumbrances, and interests. 327 F.3d at 541. Precision had notice
and did not object to the sale order. Id. Neither did it request adequate
protection of its interest. 327 F.3d at 548. The sale order reserved for the
purchaser the debtors right to assume and assign executory contracts pursuant
to 11 U.S.C. 365. The sale closed before assumption of either agreement, but
the parties extended the deadline for assumption on 4 occasions while
negotiating. Ultimately, the lease and supply agreement were de facto rejected.
327 F.3d at 541

103

Although Precision padlocked its warehouse, New Qualitech hired a

locksmith and took possession. Then, Precision filed an action with the District
Court for wrongful eviction and other relief and New Qualitech asked that it be
referred to the bankruptcy court, which it was. The bankruptcy court ruled the
sale order provided New Qualitech the assets free of Precisions possessory
rights. 327 F.3d at 541-542. But, the District Court reversed holding 11 U.S.C.
365(h) prevails over 11 U.S.C. 363(f). 327 F.3d at 542. Neither party asserted
the requirements of section 363(f) were unsatisfied. 327 F.3d at 546.
ii. Holding
With these points in mind, it is apparent that the two statutory provisions
can be construed in a way that does not disable section 363(f) vis a vis leasehold
interests. Where estate property under lease is to be sold, section 363 permits
the sale to occur free and clear of a lessees possessory interest provided that
the lessee (upon request) is granted adequate protection for its interest. Where
the property is not sold, and the debtor remains in possession thereof but
chooses to reject the lease, section 365(h) comes into play and the lessee
retains the right to possess the property. So understood, both provisions may be
given full effect without coming into conflict with one another and without
disregarding the rights of lessees. 327 F.3d at 548.
iii. Rationale
The appellate court first observed neither section 363(f) nor section 365(h)
limits the other by their terms. Second, section 365(h), by its terms, has a limited
scope insofar as it pertains to rights arising on rejection of leases. Third, section
363 provides a mechanism to protect parties whose interests may be adversely
affected by the sale of estate property. Namely, section 363(e) directs the
bankruptcy court, on request, to prohibit or condition the sale as necessary to
provide adequate protection. 327 F.3d at 547. In turn, adequate protection
does not guarantee continued possession, but does demand the lessee be
compensated for the value of its leasehold typically from the proceeds of the
sale. 327 F.3d at 548. The Seventh Circuit reasoned adequate protection will
protect the rights of parties whose interests may be adversely affected by the
sale of estate property. 327 F.3d at 547.
As shown below, sections 363(l) and 365(h)(1)(A)(ii) do limit section 363(f)
by their terms and adequate protection protects the value of the lease when the
lease rent is less than market rent, but does not protect the lessees investments
in the location such as marketing expense, employee training, nearby distribution
centers, and the like.
Significantly, the Seventh Circuit Court of Appeals adopted the following
statutory interpretation principles from decisions of the United States Supreme
Court:
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We are not at liberty to pick and choose among

congressional enactments, and when two statutes are capable of
co-existence, it is the duty of the courts, absent a clearly expressed
congressional intention to the contrary, to regard each as effective.
Morton v. Mancari, 417 U.S. 535, 551, 94 S. Ct. 2474, 2483, 41 L.
Ed. 2d 290 (1974). We should read federal statutes to give effect
to each if we can do so while preserving their sense and purpose.
Watt v. Alaska, 451 U.S. 259, 267, 101 S. Ct. 1673, 1678, 68 L. Ed.
2d 80 (1981); see also United States v. Fausto, 484 U.S. 439, 453,
108 S. Ct. 668-77, 98 L. Ed. 2d 830 (1988).
3273d at 544.
iv.
Precision Industries Is Right for the Wrong Reasons:
Section 365(h) Does Not Elevate a Lessees Possessory
Right Above a Prior Mortgagees Undersecured Lien; But
Sections 363(f), 363(l), and 365(h), Can Not Correctly be
Interpreted to Empower a Court to Divest a Lessee of Its
Possessory Rights under Section 365(h)
a) The Leases Susceptibility to Extinguishment in a
Mortgage Foreclosure Is Dispositive
Outside bankruptcy, absent a nondisturbance agreement, a lease
(including its possessory rights) can be extinguished by foreclosure of a prior
undersecured mortgage lien. Nothing in 11 U.S.C. 365(h) grants lessees rights
to stymie senior mortgages. Indeed, the bankruptcy jurisprudence has
recognized for a long time that the lessees rights can be extinguished in
bankruptcy by prior undersecured mortgage liens. In re Hotel Governor Clinton,
96 F.2d 50 (2d Cir.), cert. denied, 305 U.S. 613 (1938). Any congressional effort
to subordinate senior mortgage liens to lessee rights would have created quite a
furor in commercial finance.
Therefore, Precision Industries could and should have been decided,
consistent with Hotel Governor Clinton, on the simple and narrow ground that the
lease was subject to extinguishment in foreclosure because it was subordinate to
a mortgage lien of over $263 million secured by property worth no more than
$180 million. The lease was not even recorded.
The problem with Precision Industries is its holding rested instead on an
exercise in statutory interpretation concluding broadly (and unhinged to whether
the lease is susceptible to extinguishment in a foreclosure) that possessory rights
preserved by 11 U.S.C. 365(h) can be extinguished by a sale of the property
under 11 U.S.C. 363(f) as long as the lessees rights are provided adequate
protection under 11 U.S.C. 363(e). Accordingly, the correctness of that
statutory interpretation is the issue.
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b) The Plain Meaning of Sections 363(l) and

365(h)(1)(A)(ii) Was Disregarded
As step 1, the Seventh Circuit adopted the United States Supreme Courts
rule that statutory interpretation begins with the words of the statute and courts
must presume that a legislature says in a statute what it means and means in a
statute what it says there.When the words of a statute are unambiguous, then,
this first canon is also the last: judicial inquiry is complete. Precision
Industries, 327 F.3d at 544, quoting Connecticut Natl Bank v. Germain, 503 U.S.
249, 253-254 (1992) (quoting Rubin v. United States, 449 U.S. 424, 430 (1981)).
It is difficult to quarrel with the Seventh Circuits conclusion that the literal
terms of 11 U.S.C. 363(f)103 authorize the sale of estate property free of the
possessory interest preserved by 11 U.S.C. 365(h) if one only reads section
363(f) and not sections 363(l) and 365(h).
But, failure to consider the entire statutory scheme, runs afoul of hornbook
law set forth in Bank of America National Trust and Savings Association v. 203
North LaSalle Street Partnership, 526 U.S. 434, 452 (1999), that there is an
interpretive obligation to try to give meaning to all the statutory language. 104
This also runs afoul of the rule in United Savings Association of Texas v.
Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365 (1988), that one section
of a statute should not be interpreted to make another section a nullity or an
absurdity.105
103 11 U.S.C. 363(f) provides:
The trustee may sell property under subsection (b) or (c) of this section
free and clear of any interest in such property of an entity other than the estate,
only if
(1) applicable nonbankruptcy law permits sale of such property free and
clear of such interest;
(2) such entity consents;
(3) such interest is a lien and the price at which such property is to be sold
is greater than the aggregate value of all liens on such property;
(4) such interest is in bona fide dispute; or
(5) such entity could be compelled, in a legal or equitable proceeding
proceeding, to accept a money satisfaction of such interest.
104 In 203 North LaSalle, the Supreme Court rejected an interpretation of 1129(b)(2)(B)(ii) that
would have made the words on account of a redundancy. Bank of America National Trust and
Savings Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 452 (1999)
105 There, an undersecured creditor contended it was entitled to relief from the automatic stay
because the debtors failure to pay it monthly use or interest payments on the secured portion of
its claim deprived it of adequate protection for purposes of section 362(d)(1). 484 U.S. at 368369. 11 U.S.C. 362(d)(1)-(2) provide:

106

Here, Precision Industries interpretation of section 363(f) contradicts the

plain language of section 365(h)(1)(A)(ii) and renders sections 363(l) and 365(h),
(i), and (n) nullities and absurdities.
Section 365(h)(1)(A)(ii) provides:
(h)(1)(A) If the trustee rejects an unexpired lease of real property
under which the debtor is the lessor and
(ii) if the term of such lease has commenced, the lessee may retain
its rights under such lease (including rights such as those relating
to the amount and timing of payment of rent and other amounts
payable by the lessee and any right of use, possession, quiet
enjoyment, subletting, assignment, or hypothecation) that are in or
appurtenant to the real property for the balance of the term of such
lease and for any renewal or extension of such rights to the extent
that such rights are enforceable under applicable nonbankruptcy
law.
Section 365(h) makes clear that notwithstanding the debtor-lessors
rejection of a lease, the lessee retains is rights under the lease, including rights
of use, possession, quiet enjoyment, subletting, assignment, and hypothecation,
to the extent enforceable under nonbankruptcy law. Nonbankruptcy law is clear
that the covenant of quiet enjoyment insulates the tenant against any act or
On request of a party in interest and after notice and a hearing, the
court shall grant relief from the stay provided under subsection (a) of
this section, such as by terminating, annulling, modifying, or
conditioning such stay
(1) for cause, including the lack of adequate protection of an interest in
property of such party in interest; or
(2) with respect to a stay of an act against property under subsection
(a) of this section, if -(A) the debtor does not have an equity in such property; and
(B) such property is not necessary to an effective reorganization.
The Supreme Court remarked that statutory construction is a holistic endeavor often
clarified by the remainder of the statutory scheme. 484 U.S. at 371. Then, it interpreted section
362(d)(1) by reference to section 362(d)(2). If an undersecured creditor not receiving use or
interest payments would be entitled to stay relief for lack of adequate protection under section
362(d)(1), then why would any creditor resort to section 363(d)(2) for stay relief which requires
both that (a) the creditor be undersecured (which assures the debtor has no equity in the
property), and (b) the property not be necessary to an effective reorganization. The Supreme
Court ruled petitioners interpretation of 362(d)(1) makes nonsense of 362(d)(2)..This
renders 362(d)(2) a practical nullity and a theoretical absurdity. 484 U.S. at 374, 375.

107

omission on the part of the landlord, or anyone claiming under him, which
interferes with a tenants right to use and enjoy the premises for the purposes
contemplated by the tenancy. Petroleum Collections Incorporated v. Swords, 48
Cal. App. 3d 841 (1975); Friedman, Friedman on Leases, 29.201 (The
covenant [of quiet enjoyment] is to the effect that the tenant shall have quiet and
peaceful possession, as against the lessor or anybody claiming through or under
the lessor or anybody with a title superior to the lessor. ) at pp. 1462-1471
(collects authorities) (3d ed. 1990). Significantly, leases lacking express
covenants of quiet enjoyment have the best covenants of quiet enjoyment
because the best covenant is implied. Friedman, Friedman on Leases, 29.202
at p. 1468 (3d ed. 1990).
Thus, in section 365(h)(1)(A)(ii), Congress provided lessees retain their
rights to have quiet and peaceful possession against their lessors after their
leases are rejected. Congress choice of the word retain shows Congress
never intended that the nondebtor-tenant ever be deprived of the covenant of
quiet enjoyment before or after rejection of the lease. By itself, the
Congressional edict that the nondebtor-tenant retains the lessors covenant of
quiet enjoyment, bars lessors from invoking section 363(f) to nullify the quiet
enjoyment Congress safeguarded for them..106 Moreover, when Congress wants
to override nonbankruptcy law, it knows how to say so. See, e.g., 11 U.S.C.
1123(a) and 1142(a). While it certainly appears there is nothing unclear or
ambiguous about this, at the very least this meaning of section 365(h)(1)(A)(ii)
prevents any rote determination that section 365(f) does not impinge on section
365(h) before its implications are fully analyzed.
Thus, even if the foregoing meaning of section 365(h)(1)(A)(ii) is somehow
deemed less than fully dispositive of the issue the Seventh Circuit decided in
Precision Industries, it definitely raises sufficient doubt about the Seventh
Circuits interpretation of sections 363(f) and 365(h) to require consideration of
the statutory scheme and whether the Seventh Circuits interpretation yields
absurd results.
Notably, section 363(f) allows for sales under section 363(b) and (c) to be
free and clear of any interests in the property sold. But, section 363(l)107 renders
106 Under the facts of Precision Industries, the determination to assume or reject the lease was
left for after the closing of the sale under sections 363(b) and (f). 327 F.3d at 541. Even if
section 365(h)(1)(A)(ii) is interpreted to reimpose (rather than retain or safeguard) the debtorlessors covenant of quiet enjoyment, nothing in the facts suggests either party agreed to waive
the consequences of assumption or rejection. Significantly, the Seventh Circuits decision
squarely deals with the courts power to order property sold free of possessory rights under
section 365(h)(1)(A)(ii) and does not turn on entry of the sale order prior to the actual rejection of
the lease.
107 11 U.S.C. 363(l) provides:
Subject to the provisions of section 365, the trustee may use, sell, or lease
property under subsection (b) or (c) of this section, or a plan under chapter 11,
12, or 13 of this title may provide for the use, sale, or lease of property,

108

all sales under section 363(b) and (c) subject to 11 U.S.C. 365(h). While the
Seventh Circuit, whose decision does not mention section 363(l), takes comfort
from its own reading of section 365(h) that its preservation of possessory rights
only occurs on rejection of a lease, 327 F.3d at 547, every sale of property
subject to a lease is preceded by or results in the assumption or rejection of the
lease. Thus, section 363(l) is more than plausibly read to render section 363(f)
sales subject to section 365(h), even when section 365(h) is interpreted as the
Seventh Circuit interprets it to be effective only when a lease is rejected as
opposed to showing the nondebtor tenant has the benefit of the debtor-lessors
covenant of quiet enjoyment at all times.
Significantly, the Seventh Circuit buttresses its interpretation by observing
that while sections 363(d) and 365(a) contain cross references making certain of
their provisions subject to other statutory mandates, neither section 363(f) nor
section 365(h) contains a cross reference indicating the broad right to sell estate
property free of any interest is subordinate to the section 365(h) protections for
lessees. 327 F.3d at 547. As explained above, section 365(h) doesnt need a
cross reference because its language declaring the lessee retains its rights to
possession and quiet enjoyment stops a debtor-lessor from exercising section
363(f). But, the Seventh Circuits observation is also incomplete. Not only does
it fail to mention the cross reference in section 365(l), the Seventh Circuit doesnt
mention that in other Bankruptcy Code sections (i.e., sections 303(f), 303(k),
363(e), 363(h), 365(b)(4), 502(d), 505(c), 510(c), 522(f)(1), 522(g), 522(j), 546(e),
546(f), 546(g), 1107(b), 1112(f), 1123(d), 1125(f), 1126(f), 1126(g), 1129(b)(1),
1129(c), and 1129(d)) Congress uses the terminology notwithstanding section x
of this title, when it wants to show that one section trumps another. Section
363(f) has no such notwithstanding section 365(h) language to indicate
Congress wanted it to trump section 365(h).
Because Congress has used various linguistic techniques to cause one
section to curtail another, it would be incorrect to argue that because section
363(f) does not contain the language notwithstanding section 365(h), section
363(f) can not override section 365(h). Rather, the point is that the Seventh
Circuits observation that sections 363f) and 365(h) do not cross reference each
other is no more support for arguing section 363(f) is not curtailed by section
365(h), than section 363(f)s lack of notwithstanding section 365(h) language is
support for arguing section 363(f) does curtail section 365(h).
c)
The Seventh Circuits Interpretation Yields
Absurd Results Contrary to the United States
notwithstanding any provision in a contract, a lease, or applicable law that is
conditioned on the insolvency or financial condition of the debtor, on the
commencement of a case under this title concerning the debtor, or on the
appointment of or the taking possession by a trustee in a case under this title or a
custodian, and that effects, or gives an option to effect, a forfeiture, modification,
or termination of the debtors interest in such property.

109

Supreme Courts Rule that Statutory Interpretation

Should Avoid Absurd Results
The Seventh Circuit recognized its mandate to read federal statutes to
give effect to each if we can do so while preserving their sense and purpose.
327 F.3d at 544, quoting Watt v. Alaska, 451 U.S. 259, 267 (1981). To that end,
the Seventh Circuit first explained section 365(h) strikes a balance between the
debtor-lessor and lessee by enabling the debtor to reject burdensome obligations
under the lease while allowing the tenant to retain possession for the term of the
lease. 327 F.3d at 546. Then, the Seventh Circuit explained that when estate
property is sold, the lessees possessory interest is entitled to adequate
protection, while the ability to sell free of the possessory interest is consistent
with the process of marshaling the estates assets for the twin purposes of
maximizing creditor recovery and rehabilitating the debtor, which are central to
the Bankruptcy Code. 327 F.3d at 548.
To be sure, the Seventh Circuit believed it did not reach an absurd result.
Based on the foregoing analysis, the Seventh Circuit concluded it was both
reasonable and correct to interpret and to reconcile sections 363(f) and 365(h) to
enable 365(h) to operate only on rejection while allowing the preserved
possessory interest to be extinguished in exchange for adequate protection on a
sale.
Lets examine that analysis.
Pursuant to the Seventh Circuits ruling, if a debtor in possession desires
to retain property while ousting its tenant of possession, it need only reject the
lease and then propose a plan that sells the property to a new entity pursuant to
section 363(f). This can be easily manufactured. Instead of distributing to
creditors the new stock of the reorganized debtor, the plan can provide for
creation of a new entity that will purchase the property from the estate and its
stock will be distributed to the estates creditors.
This raises the question why Congress would preserve a lessees
possessory rights when its lease is rejected by the debtor-lessor, but not
preserve those rights when the debtor-lessor sells the property. The Seventh
Circuit opines the sale free and clear of the possessory rights serves the twin
bankruptcy policies of maximizing creditor recovery and rehabilitating the debtor.
This explanation does not hold up. First, a sale under which the estate must pay
the lessee the value of its leasehold may not yield more for the estate than a sale
subject to the lessees possessory rights and rental obligations. Second, the sale
may occur when the debtor is not rehabilitating as was the case in Precision
Industries, 327 F.3d at 540. In fact, sections 363(f) and 365(h) apply in chapter 7
liquidation cases. Third, if those bankruptcy policies are the policies to be
served, why would they be any less applicable when the debtor does not sell the
property? It is far more likely a debtor is rehabilitating when it retains its property.

110

Its rehabilitation may well be enhanced if the debtor can eliminate a lessees
possessory rights when it has a better use for the property.
Significantly, the consequence of the Seventh Circuits ruling is not limited
to the fact that it will almost always enable the debtor to defeat the lessees
section 365(h) possessory rights by proposing a plan that transfers the
underlying property. Contrary to the comfort the Seventh Circuit took from the
adequate protection requirement in 11 U.S.C. 363(e), the transfer of the
property will frequently result in no payment to the lessee notwithstanding that it
sustains material economic harm.
The measure of the value of a lease is the present value of the positive
difference, if any, between the market rent and the lease rent. See Connecticut
Ry. & Lighting Co. v. Palmer, 305 U.S. 493 (1939), after remand, 311 U.S. 544
(1941), rehg denied, 312 U.S. 713 (1941). The lessees claim for loss of its
lease will be zero when the lease rent and market rent are equivalent. Even
when the lease rent is less than the market rent, the lessees damage claim does
not include components for the lessees economic injury by being dispossessed.
For instance, a tenant operating a retail store advertises its location, develops a
clientele in the vicinity, has trained employees whose families live in the vicinity,
and so forth. If the tenant has to move, none of these items figure in the value of
the lost leasehold. Adequate protection is designed by the terms of 11 U.S.C.
361 to compensate for loss of the value of an interest in property. The market
value is based on a comparison of lease rent to market rent, not on the original
lessees individual investment in advertising, clientele, employee training, and the
like.
Thus, the value Congress preserved for lessees in section 365(h), is not
reimbursed to them under section 363(e). But, under the Seventh Circuits
holding, lessees retain this value if the debtors estate does not sell the property,
but do not retain it if it does sell. As a practical matter, if Congress had only
intended to preserve for lessees the value of their leaseholds, Congress could
quite simply have provided them administrative claims for the values of their
leases when rejected, regardless of whether the estate sells the property.
Congress did not have to give them the right to retain possession if Congress
was only concerned about furnishing them their leasehold values. Clearly,
Congress gave lessees a possessory remedy in section 365(h) that protects
certain lessee investments independently of what is covered by adequate
protection under section 363(e). Why would Congress do that in a manner the
estate can so easily circumvent under the Seventh Circuits interpretation of
section 363(f)?
Why would Congress create uncertainty in the real estate finance industry
for lenders, lessees, and title insurers? Based on the holding in Precision
Industries, imagine the dilemma of a leasehold lender when an entity leases land
for 100 years and wants financing to build an office building on the land. How is

111

the lender supposed to evaluate the risk the lessor will sell the property free of
the land lease during bad economic times under section 363(f), and a judge will
determine how much value out of the sale price goes to the lessee? Who would
write title insurance for the lessee and its financer? The mere possibility of an
undervaluation will make the initial financing more expensive or unavailable. If
the financing is done and the lessor ultimately commences a chapter 11 case,
the mere prospect of a section 363(f) sale and an undervaluation by the judge
will provide the debtor-lessor enormous leverage over the leasehold financers.
Significantly, Congress knew before the Bankruptcy Code became
effective on October 1, 1979, that the uncertainty about a lessees possessory
rights in bankruptcy was a material issue and the court in charge of the
reorganization of Penn Central Transportation Company had ruled it would be
inequitable to deprive lessees of their possessory rights, even in the context of
the railroads reorganization. See In re Penn Cent. Transp. Co., 458 F. Supp.
1346 (E.D. Pa. 1978).
Finally, other subsections of section 365 show the Seventh Circuits
statutory interpretation is at odds with the statutory regimen. Just as possessory
interests are preserved on rejection for lessees by section 365(h)(1), sections
365(h)(2) and 365(i) preserve leased and sold time share interests and rights to
acquire real property by purchasers in possession of it, and section 365(n)
preserves licensed intellectual property rights. Just as upon rejection section
365(h)(1)(A)(ii) preserves for the lessee its right to quiet enjoyment of the
premises for the duration of the lease inclusive of renewals, section 365(i)(2)(B)
requires that the time share or real property purchaser be granted title in
accordance with the purchase contract, and section 365(n)(3) requires that the
intellectual property licensee be granted continued use of the license and that the
debtor-licensor not interfere with the licensees rights in the license. In each
situation, the debtors estates sale of the time share property, real property, or
intellectual property free of the purchasers interests would violate these
subsections of section 365.
Indeed, section 365(n) was enacted to protect licensees against the
financial nightmare of building a $100 million factory to make use of a license,
and then losing the license when the licensor rejects it in the licensors title 11
case. The Intellectual Property Bankruptcy Protection Act, Pub. L. No. 100-506,
102 Stat. 2538-2540 (1988), thereby overturned Lubrizol Enterprises, Inc. v.
Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), cert. denied, 106
S. Ct. 1285 (1986), which allowed the rejection of a license to deprive the
licensee of its use. There is no assurance whatsoever that if the licensor sells its
intellectual property free of the license, the sale proceeds allocable to the license
will compensate the licensee for the factory as well as continued exploitation of
the license would.108
th

108 Notably, in FutureSourceLLC v. Reuters Limited, 312 F.3d 281 (7 Cir. 2002), cert. denied,
155 L. Ed. 513 (2003), without citing section 365(n), in dicta the court observed a debtor can sell

112

Accordingly, the Seventh Circuits statutory interpretation produces,

among others, the following absurd results:
1. The Bankruptcy Code and Bankruptcy Rules provide for a lessee
to obtain a determination for cause (11 U.S.C. 365(d),
Bankruptcy Rule 6006(b)) whether the debtor in possession will
assume or reject a lease; while there is no provision entitling the
lessee, for any reason, to obtain a determination whether the
lessee will be allowed to retain possession;
2. if a debtor-lessor wants to use the property it can not dispossess
the lessee (except by manufacturing a transfer to a new entity); but
if it does not want to use the property it can dispossess the lessee;
3. a lessees right to retain possession turns on whether the debtor
transfers the property or gives creditors ownership rights in the
debtor-entity;
4. a lessees noncompensable investments are preserved for it if the
debtor retains the property, but not if the debtor transfers the
property;
5. the debtors ability to deprive the lessee of possession creates
uncertainty throughout leasehold financing;
6. the lessees possessory rights under section 365(h) are illusory
due to the ease with which the debtor can eliminate them by
transferring a lease to a new entity its creditors control.
The United States Supreme Court consistently articulates an age old
principle of statutory interpretation that while plain statutes should be enforced
according to their terms, they should not be interpreted to produce absurd
results. Hartford Underwriters Insurance Co. v. Union PlantersBank, 530 U.S. 1,
6 (2000)([w]hen the statutes language is plain,*the sole function of the courts*
at least where the disposition required by the text is not absurd -- *is to enforce
assets free of a license-interest in intellectual property under section 363(f), at least when the
interest holder consents by not objecting. 312 F.3d at 285-286. There, a debtor had sold free and
clear of liens, claims, encumbrances, and interests, its assets with which it provided reformatted
financial markets data. A party holding a prepetition contract from the debtor for such data, sued
the purchaser to supply the data. The United States Court of Appeals for the Seventh Circuit
ruled the contract party had no claim against the purchaser because the sale was free and clear,
the purchaser did not inherit the prepetition contract, and, in any event, the contract party was
demanding reformatted data that did not yet exist. The court was right. The legislative history of
section 365(n) provides: The benefits of the bill are intended to extend to such license
agreements, consistent with the limitation that the licensees rights are only in the underlying
intellectual property as it existed at the time of the filing. S. Rep. No. 100-505, 100th Cong.., 2d
Sess. (1988) at p. 8.

113

it according to its terms.*)(quoting United States v. Ron Pair Enterprises, Inc.,

489 U.S. 235, 241(1989), quoting Caminetti v. United States, 242 U.S. 470, 485
(1917)). Significantly, the United States Court of Appeals for the Seventh Circuit
agrees..109
But ascertainment of the meaning apparent on the face of a single
statute need not end the inquiry. Train v. Colorado Public Interest Research
Group, 426 U.S. 1, 10 (1076); United States v. American Trucking Assns., Inc.,
310 U.S. 534, 543-544 (1940). This is because the plain-meaning rule is rather
an axiom of experience than a rule of law, and does not preclude consideration
of persuasive evidence if it exists. Boston Sand Co. v. United States, 278 U.S.
41, 48 (1928)(Holmes, J.). The circumstances of the enactment of a particular
legislation may persuade a court that Congress did not intend words of common
meaning to have their literal effect. E.g., Church of the Holy Trinity v. United
States, 143 U.S. 457, 459 (1892); United States v. Ryan, 284 U.S. 167, 175
(1931). Watt v. Alaska, 451 U.S. 259, 266 (1981).
In Watt v. Alaska, Congress had amended a statute (16 U.S.C. 715s(c))
in 1964 to provide for the government to obtain 75% of royalties from minerals on
public lands acquired or reserved for conservation and protection of certain fish
and wildlife. Congress did not amend a prior statute in the Mineral Leasing Act of
1920 (30 U.S.C. 191) which allocated to the State of Alaska 90% of such
royalties. Even though on its face the newer statute applied, the Supreme Court
determined from the absence of legislative history showing a Congressional
intent to alter the prior formula for distribution of substantial funds that the newer
statute only applied to mineral revenues from acquired lands. 451 U.S. at 272273.
Watt cites Church of the Holy Trinity. In Holy Trinity a religious society
had contracted to employ a rector and pastor who would immigrate to the United
States from England. The United States government contended the contract was
illegal under a federal statute rendering it unlawful to encourage the
importation of any alieninto the United Statesunder contractmade
previous to the importationto perform any labor or service of any kind.
Notwithstanding the plain meaning of the statute, the Supreme Court ruled
however broad the language of the statute may be, the act, although within the
letter, is not within the intention of the legislature, and therefore cannot be within
the statute. 143 U.S. at 472.
In deriving its ruling, the United States Supreme Court tracked examples
of statutes that can not be interpreted in accordance with their plain meaning due
to the absurd results such interpretations would yield:
109 Nonsensical interpretations of contracts, as of statutes, are disfavored.Not because of a
judicial aversion to non-sense as such, but because people are unlikely to make contracts, or
legislators statutes, that they believe will have absurd consequences. FutureSourceLLC v.
th
Reuters Limited, 312 F.3d 281, 284-285 (7 Cir. 2002) (Posner, C.J.).

114

If a literal construction of the words of a statute be absurd, the

act must be so construed as to avoid the absurdity. The court must
restrain the words. The object designed to be reached by the act
must limit and control the literal import of the terms and phrases
employed. [quoting Margate Pier Co. v. Hannam, 3 B. & Ald. 266,
270]. All laws should receive a sensible construction. General
terms should be so limited in their application as not to lead to
injustice, oppression or an absurd consequence. It will always,
therefore, be presumed that the legislature intended exceptions to
its language which would avoid results of this character. The
reason of the law in such cases should prevail over its letter. The
common sense of man approves the judgment mentioned by
Puffendorf, that the Bolognian law which enacted that whoever
drew blood in the streets should be punished with the utmost
severity. Did not extend to the surgeon who opened the vein of a
person that fell down in the street in a fit. The same common
sense accepts the ruling, cited by Plowden, that the statute of 1st
Edward II., which enacts that a prisoner who breaks prison shall be
guilty of felony, does not extend to a prisoner who breaks out when
the prison is on fire, for he is not to be hanged because he would
not stay to be burnt. And we think that a like common sense will
sanction the ruling we make, that the act of Congress which
punishes the obstruction or retarding of the passage of the mail, or
of its carrier, does not apply to a case of temporary detention of the
mail caused by the arrest of the carrier upon an indictment for
murder. [Quoting United States v. Kirby, 7 Wall. 482, 486].
Church of the Holy Trinity, 143 U.S. at 460. Significantly, the Supreme
Courts examples of absurd results requiring statutes to be interpreted
differently than their overt plain meanings are frequently not accompanied
by legislative history showing Congress did not intend a certain result.
Rather, the fact Congress did not intend an absurd result is inferred.
An example of the need to avoid an absurd result in the bankruptcy
context was identified in a concurrence, where the issue was whether an
entitys right to an injunction enforcing a non-compete covenant would be
made dischargeable because the entity was entitled to money damages in
addition to the injunction and not in place of it:
To appreciate the patent absurdity of implementing the plain
text of Section 101(5)(B) one must keep in mind that this is a
bankruptcy statute. If, following the plain language, an injunction
may be stayed in bankruptcy anytime the underlying breach of
contract or law also happens to give rise to money damages, the
real-world results would be ludicrous. If we were to apply the plain

115

text of 101(5)(B) to individuals restrained by court orders e.g.

trespassers, polluters, stalkers, batterers theoretically, simply by
filing bankruptcy, the violator could escape from any restraining
order prompted by a breach that also gave rise to an award of
money damages. Certainly the parade of horribles is extensive,
and I need not belabor it further. Since the text of 101(5)(B)
presents one of those extremely unique circumstances of patent
absurdity, we may turn to the purpose, context and policy of
101(5)(B) to supplement its plain language.
In re Udell, 18 F.3d 403, 412 (7th Cir. 1994) (C.J. Flaum concurring) (footnotes
omitted).
Here, the plain meaning of the statute appears to be the opposite of the
Seventh Circuits interpretation for the reasons set forth above. But, if the plain
meaning conforms to the Seventh Circuits interpretation, that meaning should be
set aside because it yields the absurd results described above that Congress can
be safely assumed not to have intended. As the Seventh Circuit ruled in In re
Handy Andy home Improvement Centers, Inc., 144 F.3d 1125, 1128 (7th Cir.
1998): Statutory language like other language should be read in
context.When context is disregarded, silliness results.
14. Cram Down Interest Rates Need Not Render the Lender
Subjectively Indifferent between Present Foreclosure and Future
Payments
A. Till v. SCS Credit Corp., 124 S. Ct. 1951 (2004)(Chapter 13)
i.

Facts.

The chapter 13 debtors owed their lender $4,894.89 secured by a truck

purchased with the loan which had a value of $4,000 in bankruptcy. They
proposed a chapter 13 plan under which they would assign $740 of their wages
each month to repay debt including the $4,000 at an interest rate of 9.5% derived
by taking the 8% risk free rate and adding 1.5% to reflect borrowers of similar
risk. The lender objected claiming it was entitled to a 21% interest rate because
it could foreclose and use the money to lend out at 21% interest which is the
prepetition rate charged to the debtors. 124 S. Ct. at 1956-1957.
The district court and United States Court of Appeals for the Seventh
Circuit reversed the bankruptcy courts adoption of the 9.5% interest rate and
ruled a coerced loan approach should be used. 124 S. Ct. at 1957-1958.

116

ii.

Issue.

Should the cram down interest rate under 11 U.S.C. 1325(a)(5)(B)(ii) be

determined in accordance with the coerced loan approach, presumptive contract
rate approach, cost of lenders funds approach, or the formula approach?
iii.

Holding.

A plurality joined by Justice Thomas concurrence ruled in chapter 13, the

court should use the formula approach. [T]he approach begins by looking to the
national prime rate, reported daily in the press, which reflects the financial
markets estimate of the amount a commercial bank should charge a creditworthy
commercial borrower to compensate for the opportunity costs of the loan, the risk
of inflation and the relatively slight risk of default. Because bankrupt debtors
typically pose a greater risk of nonpayment than solvent commercial borrowers,
the approach then requires a bankruptcy court to adjust the prime rate
accordingly. The appropriate size of that risk adjustment depends, of course, on
such factors as the circumstances of the estate, the nature of the security, and
the duration and feasibility of the reorganization plan. The court must therefore
hold a hearing at which the debtor and any creditors may present evidence about
the appropriate risk adjustment. Some of this evidence will be included in the
debtors bankruptcy filings, however, so the debtor and creditors may not incur
significant additional expense. Moreover, starting from a concededly low
estimate and adjusting upward places the evidentiary burden squarely on the
creditors, who are likely to have readier access to any information absent from
the debtors filing (such as evidence about the liquidity of the collateral market,
post, at 1973 (SCALIA, J., dissenting)). Finally, many of the factors relevant to
the adjustment fall squarely within the bankruptcy courts area of expertise. 124
S. Ct. at 1961 (emphasis in original, footnote omitted). If the court is certain a
debtor would complete his plan, the prime rate would be adequate. 124 S. Ct. at
1961 n. 18.
It is sufficient for our purposes to note that, under 11 U.S.C.
1325(a)(6), a court may not approve a plan unless, after considering all creditors
objections and receiving the advice of the trustee, the judge is persuaded that
the debtor will be able to make all payments under the plan and to comply with
the plan. Ibid. Together with the cram down provision, this requirement
obligates the court to select a rate high enough to compensate the creditor for its
risk but no so high as to doom the plan. If the court determines that the
likelihood of default is so high as to necessitate an eye-popping interest rate,
301 F.3d at 593 (Rovner, J., dissenting), the plan probably should not be
confirmed. 124 S. Ct. at 1962.

117

Because numerous lenders advertise financing for chapter 11 debtors in

possession, in chapter 11 cases it might make sense to ask what rate an
efficient market would produce. 124 S. Ct. at 1960 n. 14.
Notably, the dissent described its disagreement with the plurality narrowly,
saying: The plurality would use the prime lending rate a rate we know is too
low and require the judge in every case to determine an amount by which to
increase it. I believe that, in practice, this approach will systematically
undercompensate secured creditors for the true risks of default. I would instead
adopt the contract rate i.e., the rate at which the creditor actually loaned funds
to the debtor as a presumption that the bankruptcy judge could revise on
motion of either party. 124 S. Ct. at 1968 (emphasis in original).
iv.

Rationale

The language of section 1325(a)(5)(B)(ii) requires that when the secured

claimholder does not accept the plan, the plan should be confirmed only if the
value, as of the effective date of the plan, of property to be distributed under the
plan on account of such claim is not less than the allowed amount of such claim.
The Supreme Court reasoned that the determination of value must be an
objective one, as opposed to a subjective determination of what would make the
secured claimholder indifferent between the plan and immediate foreclosure:
That is, although 1325(a)(5)(B) entitles the creditor to property whose
present value objectively equals or exceeds the value of the collateral, it does not
require that the terms of the cram down loan match the terms to which the debtor
and creditor agreed prebankruptcy, nor does it require that the cram down terms
make the creditor subjectively indifferent between present foreclosure and future
payment. Indeed, the very idea of a cram down loan precludes the latter result:
By definition, a creditor forced to accept such a loan would prefer instead to
foreclose. Thus, a court choosing a cram down interest rate need not consider
the creditors individual circumstances, such as its prebankruptcy dealings with
the debtor or the alternative loans it could make if permitted to foreclose. Rather,
the court should aim to treat similarly situated creditors similarly, and to ensure
that an objective economic analysis would suggest the debtors interest
payments will adequately compensate all such creditors for the time value of their
money and the risk of default. 124 S. Ct. at 1959-1960 (emphasis in original,
footnote omitted).
The plurality discarded arguments that the interest rate should reflect the
lenders costs and opportunities (the coerced loan approach) because it would
(a) produce the absurd result of granting higher rates to inefficient, poorly
managed lenders, (b) require debtors to gather information about each lender,
and (c) overcompensate creditors because the market lending rate must be high
enough to cover factors like lenders transactions costs and overall profits that
are no longer relevant in a court administered and supervised cram down loan.
124 S. Ct. at 1960.
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v.

A New Twist on Statutory Interpretation

Significantly, in his concurrence, Justice Thomas points to the plain

meaning of the statute as barring a debtor-specific risk adjustment:
I agree that a promise of future payments is worth less than
an immediate payment of the same amount, in part because of the
risk of nonpayment. But this fact is irrelevant. The statute does not
require that the value of the promise to distribute property under the
plan be no less than the allowed amount of the secured creditors
claim. It requires only that the value of property to be distributed
under the plan, at the time of the effective date of the plan, be no
less than the amount of the secured creditors claim. 11 U.S.C.
1325(a)(5)(B)(ii) (emphasis added). Both the plurality and the
dissent ignore the clear text of the statute in an apparent rush to
ensure that secured creditors are not undercompensated in
bankruptcy proceedings. But the statute that Congress enacted
does not require a debtor-specific risk adjustment that would put
secured creditors in the same position as if they had made another
loan. 124 S. Ct. at 1965.
***
Respondent argues, and the plurality and the dissent agree,
that the proper interest rate must also reflect the risk of
nonpayment. But the statute contains no such requirement. The
statute only requires the valuation of the property to be
distributed, not the valuation of the plan (i.e., the promise to make
the payments itself). Thus, in order for a plan to satisfy
1325(a)(5)(B)(ii), the plan need only propose an interest rate that
will compensate a creditor for the fact that if he had received the
property immediately rather than at a future date, he could have
immediately made use of the property. In most, if not all, cases,
where the plan proposes simply a stream of cash payments, the
appropriate risk-free rate should suffice. 124 S. Ct. at 1966.
Significantly, the plurality agrees Justice Thomas demonstrated section
1325(a)(5)(B)(ii) may be read to support the conclusion that Congress did not
intend the cram down rate to include any compensation for the risk of default.
124 S. Ct. at 1963. As the plurality notes, the United States, as Amicus Curiae,
makes the same point, but advocates the formula approach the plurality adopted.
124 S. Ct. at 1964 n. 25.
To overcome that reading, the plurality reasons that because so many
judges who have considered the issue (including the authors of the four earlier
opinions in this case) have rejected the risk-free approach, we think it is too late
in the day to endorse that approach now. Of course, if the text of the statute
119

required such an approach, that would be the end of the matter. We think,
however, that 1325(a)(5)(B)(ii)s reference to value, as of the effective date of
the plan, of property to be distributed under the plan is better read to incorporate
all of the commonly understood components of present value, including any risk
of nonpayment. 124 S. Ct. at 1964.
B. Bank of Montreal v. Official Committee of Unsecured
Creditors (In re American Homepatient, Inc.), 420 F.3d 559 (6th
Cir. 2005)
i.

Facts.

At a contested confirmation hearing, the bankruptcy court valued the bank

lenders collateral at $250 million and fixed the interest rate at 6.785% which
equaled 3.5% above the risk free rate for a 6-year treasury note. The banks had
requested a valuation of between $300 million and $320 million and an interest
rate of 12.16%.
ii.

Issue.

How should the cramdown interest rate for a secured loan be computed in
chapter 11 cases?
iii.

Holding.

This means that the market rate should be applied in Chapter 11 cases
where there exists an efficient market. But where no efficient market exists for
a Chapter 11 debtor, then the bankruptcy court should employ the formula
approach endorsed by the Till plurality. This nuanced approach should obviate
the concern of commentators who argue that, even in the Chapter 11 context,
there are instances where no efficient market exists. 420 F.3d at 568.
iv.

Rationale.

Although the lenders argue that the rate chosen by the bankruptcy court was
not the rate produced by an efficient market, this is a question that was fully
considered by that court. Its conclusion that the appropriate market rate
would be 6.785% was reached only after carefully evaluating the testimony of
various expert witnesses. The fact that the bankruptcy court utilized the rubric
of the "coerced loan theory" that was criticized in Till provides no basis to
reverse the bankruptcy court's decision because Till pointed out that, if
anything, the coerced loan theory "overcompensates creditors . . . ." Till , 542
U.S. at 477 (emphasis added). We therefore concur in the result reached by
both the bankruptcy court and the district court on this issue. 420 F.3d at 569.
120

v.

Other Cramdown Interest Rate Decisions Since Till

At least one court that has examined cramdown interest rates post- Till
has concluded that Till does not apply in a Chapter 11 context. See In re
Prussia Assocs., 322 B.R. 572, 585, 589 (Bankr .E.D. Pa. 2005) (holding that
" Till is instructive, but it is not controlling, insofar as mandating the use
of the 'formula' approach described in Till in every Chapter 11 case," and
noting that "[ Till 's] dicta implies that the Bankruptcy Court in such
circumstances (i.e., efficient markets) should exercise discretion in evaluating
an appropriate cramdown interest rate by considering the availability of market
financing").
Several outside commentators, however, have argued that Till 's formula
approach should apply to Chapter 11 cases as well as to Chapter 13 cases,
noting that the two are not all that dissimilar. See 7 Collier on Bankruptcy P
1129.06[1][c][i] ("The relevant market for involuntary loans in chapter 11 may
be just as illusory as[**20] in chapter 13."); Ronald F. Greenspan & Cynthia
Nelson, 'Un Till ' We Meet Again: Why the Till Decision Might Not Be the Last
Word on CramdownInterest Rates, Am. Bankr. Inst. J., Dec.-Jan. 2004, at 48
("So we are left to wonder if footnote 14 nullifies Till in a chapter 11 context
(or at least where efficient markets exist), modifies its application or is
merely an irrelevant musing."); Thomas J. Yerbich, How Do You Count the
Votes--or Did Till Tilt the Game?, Am. Bankr. Inst. J., July-Aug. 2004, at 10
("There is no more of a 'free market of willing cramdown lenders' in a chapter
11 (or a chapter 12, for that matter) than in a chapter 13."). And at least one
court has concluded that Till does apply in a Chapter 11 context. See
Official Unsecured Creditor's Comm. of LWD, Inc. v. K&B Capital, LLC (In re
LWD, Inc.), -- B.R. --, 2005 Bankr. LEXIS 384, 2005 WL 567460 (Bankr. W.D.
Ky. Feb. 10, 2005) . American Homepatient, 420 F.3d at 567-568.
C. Official Committee of Unsecured Creditors v. Dow Corning
Corp., 456 F.3d 668 (6th Cir. 2006)
i. Facts
Class 4 rejected Dow Cornings chapter 11 plan. The class consisted of
approximately $1 billion of unsecured commercial debt The estate was solvent.
456 F.3d at 671-672. The bankruptcy court had interpreted the plan to provide
the class with interest at the nondefault contract rate on the debtors petition
date, and denied requests for default interest, attorneys fees, costs, and
expenses because none of them were incurred in the litigation of the validity of
their claims. The district court affirmed. 456 F.3d at 673-674.

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ii. Issues
Did the bankruptcy court abuse its discretion in interpreting the plan not to
require default interest in a solvent case for unsecured claimholders entitled to
interest at the default rates in their contracts if that interpretation would cause the
plan to violate 11 U.S.C. 1129(b), 456 F.3d at 677, and are they entitled to their
attorneys fees, costs, and expenses incurred in enforcing their claims (and not
for litigating the validity of their contracts) if they have valid claims under state
law?
iii. Holdings
Despite the equitable nature of bankruptcy proceedings, the bankruptcy
judge does not have free-floating discretion to redistribute rights in accordance
with his personal views of justice and fairness, Id. at 528 [quoting In re Chicago,
791 F.2d 524 (7th Cir. 1986)]. Rather, absent compelling equitable
considerations, when a debtor is solvent, it is the role of the bankruptcy court to
enforce the creditors contractual rights. See Chicago, 791 F.2d at 528([I]f the
bankrupt is solvent the task for the bankruptcy court is simply to enforce creditors
rights according to the tenor of the contracts that created those rights.). 456
F.3d at 679. We conclude like the other courts to have considered this issue,
that there is a presumption that default interest should be paid to unsecured
claim holders in a solvent debtor case. 456 F.3d at 680.
In this circuit, an unsecured creditor may recover those costs to which it
has a state-law based right against a solvent debtor, regardless of the nature of
the federal proceedings. State law may, of course, require an examination of the
nature of the proceedings in federal court, but absent such state law concerns,
the federal law of this circuit does not limit contractual awards of attorneys fees
to situations where the issue of contract enforceability was litigated in bankruptcy
court. [footnote omitted]. Although arguably in tension with the Ninth Circuit, our
decision is consistent with that of other courts that have awarded attorneys fees
to which a party was contractually entitled, despite the fact that the litigation did
not involve enforcement of the contract itself. 456 F.3d at 686.
Both issues were remanded for determination by the bankruptcy court as
to whether there are compelling equitable considerations that overcome default
interest and whether state law enforces claims for attorneys fees, costs, and
expense of enforcement of contract claims.
iv.

Rationale

When a class of unsecured claims rejects a plan in a solvent case, it

would violate the absolute priority rule for equity to participate before creditors
claims are paid in full. Therefore, if they have valid claims for default interest,
they must be paid absent compelling equitable circumstances. Whether a
122

company is solvent or insolvent in either the equity or the bankruptcy sense, any
arrangement of the parties by which the subordinate rights and interests of the
stockholders are attempted to be secured at the expense of the prior rights of
credtiors comes within judicial denunciation. (quoting Consolidated Rock
Prods. Co. v. Du Bois, 312 U.S. 510, 527 (1941)).
11 U.S.C. 506(b) expressly allows postpetition interest for secured
claims to the extent the collateral value can pay it; but that is necessary because
section 502(b)(2) disallows unmatured interest. Because there is no general
prohibition against claims for attorneys fees, costs, and expenses, there is no
need for an express allowance of such claims against solvent debtors. 456 F.3d
at 682. The Sixth Circuit does not follow Thrifty Oil Co. v. Bank of Am., 322 F.3d
1039, 1040-1042 (9th Cir. 2003), which held that even if provided for by
contractual provisions valid under state law, creditors may never be awarded
attorneys fees expended litigating issues solely of federal bankruptcy law. 456
F.3d at
15. Barton v. Barbour, 104 U.S. 126 (1881), Is Alive and Well.
A. Beck v. Fort James Corp. (In re Crown Vantage, Inc.), 421
F.3d 963 (9th Cir. 2005)
i. Facts.
In 1995, James River spun off assets related to its communications
papers and packaging business by transferring the assets to subsidiaries (the
Crown Entities) and dividending their stock. Prior to the spinoff, James River
entered into a contribution agreement with the Crown entities. That agreement
led to various disputes, all of which were settled in 1998. The settlement
agreement provided each side with releases and provided the sole forum to
litigate disputes arising out of it would be the state and federal courts in
Delaware. 421 F.3d at 967.
In 2000, the Crown Entities commenced chapter 11 cases in the Northern
District of California. During the chapter 11 cases, the creditors committee
requested authority to investigate whether an action should be commenced
against Fort James (successor by merger to James River) relating to the spinoff.
Fort James commenced an adversary proceeding for a declaration that the
spinoff was not a fraudulent transfer and that, in any event, the settlement
agreement released Fort James. 421 F.3d at 967-968. The debtors in
possession commenced an adversary proceeding against Fort James asserting
the settlement agreement release was a fraudulent transfer. 421 F.3d at 968. All
the actions were consolidated into one action, 421 F.3d at 968, and the reference
was withdrawn to the district court in the Northern District of California. 421 F.3d
at 969.

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Ultimately, the bankruptcy court confirmed a chapter 11 plan providing for

all assets to be transferred to a liquidating trust, whose trustee would liquidate
the assets and bring authorized causes of action including a fraudulent transfer
action against Fort James. The trustee would be substituted as the debtors
successor in all actions. 421 F.3d at 968. The confirmation order provided the
court retained ;exclusive jurisdiction over all matters arising out of, and related
to, the Chapter 11 cases and the Plan to the fullest extent permitted by law,
including but not limited to, the matters set forth in Article XII of the Plan. 421
F.3d at 968.
Article XII of the plan provided the bankruptcy court would, as legally
permissible, retain exclusive jurisdiction over all matters arising out of or relating
to the chapter 11 cases including jurisdiction to hear and determine all adversary
proceedings and contested matters. 421 F.3d at 968.
The chapter 11 plan also provided the bankruptcy court would retain
jurisdiction over the liquidating trust and the agreement establishing it, including
the agreements interpretation and enforcement. 421 F.3d at 969.
After confirmation, the liquidating trust commenced an action in California
state court against the law firm (McGuire Woods) that represented James River
in the spinoff and other entities. The defendants removed the action to federal
court and the district court refused to remand because of substantial overlap
with the consolidated action. 421 F.3d at 969.
Next, Fort James and McGuire Woods commenced an action in
Delaware Chancery Court for a declaration that the (a) California actions were
barred by the settlement agreement and (b) liquidating trustee breached the
settlement agreement by prosecuting the California actions. The Delaware
action requests damages from the liquidating trustee, costs, and attorneys fees.
421 F.3d at 969. The liquidating trustee removed the Delaware action to the
district court in Delaware and moved to dismiss, or alternatively transfer it to
California. The district court granted the Fort James entities motion to remand
and denied the motion to dismiss or transfer as moot. 421 F.3d at 969. Then,
the liquidating trustee moved to dismiss the action or stay it pending resolution of
the California actions. 421 F.3d at 969.
The Fort James entities requested an order in the California district court
that their Delaware action did not violate the automatic stay or the Barton
doctrine. That doctrine derives from Barton v. Barbour, 104 U.S. 126 (1881),
where the Supreme Court ruled that the common law barred suits against
receivers in courts other than the court charged with the administration of the
estateThe Supreme Court held in Barton that, before suit is brought against
such a receiver, leave of the court by which the trustee was appointed must be
obtained. 421 F.3d at 970n.4. The Fort James entities asserted Barton was
inapplicable; the Delaware action was against the liquidating trustee as the legal

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representative of the Crown entities and not in his personal capacity; and there
was a presumptively valid forum selection clause. 421 F.3d at 970.
The California district court ruled the bankruptcy court should determine
the Fort James entities issues in the first instance. 421 F.3d at 970. The
liquidating trustee commenced an adversary proceeding in the California
bankruptcy court requesting an order enjoining the Fort James entities from
prosecuting the Delaware action. The Delaware Chancery Court stayed a ruling
on the liquidating trustees motion to dismiss pending resolution of the adversary
proceeding. 421 F.3d at 970.
Next, the bankruptcy court enjoined prosecution of the Delaware action on
the ground it violated Barton, and the court ruled the settlement agreements
forum selection clause did not control. 421 F.3d at 970. On appeal to the district
court, the district court ruled the liquidating trustee would likely prevail that the
Delaware action violated Barton, but vacated the preliminary injunction enjoining
the Delaware action because the liquidating trustee had not proven irreparable
harm. 421 F.3d at 970.
ii. Issues.
Does the Barton doctrine apply to liquidating trustees under chapter 11
plans?
To enforce Barton with an injunction, must the movant prove irreparable
harm?
iii. Holdings.
We join our sister circuits in holding that a party must first obtain leave of
the bankruptcy court before it initiates an action in another forum against a
bankruptcy trustee or other officer appointed by the bankruptcy court for acts
done in the officers official capacity. See Muratore v. Darr, 375 F.3d 140, 147
(1st Cir. 2004); Carter v. Rodgers, 220 F.3d 1249, 1252 (11th Cir. 2000); In re
Linton, 136 F.3d 544, 546 (7th Cir. 1998); Lebovits v. Scheffel (In re Lehal Realty
Assocs.), 101 F.3d 272, 276 (2d Cir. 1996); Allard v. Weitzman (In re DeLorean
Motor Co.), 991 F.2d 1236, 1240 (6th Cir. 1993). In our circuit, the doctrine was
recognized by our Bankruptcy Appellate Panel in Kashani v. Fulton (In re
Kashani), 190 B.R. 875, 883-85 (9th Cir. BAP 1995). 421 F.3d at 970.
Further, the fact that the officer involved is not a bankruptcy trustee, but
rather a liquidating trustee, is of no moment. As the Sixth Circuit has observed,
under the Barton doctrine, court appointed officers who represent the estate are
the functional equivalent of a trustee Delorean, 991 F.2d at 1241. Here, as
part of a liquidating Chapter 11 reorganization proceeding, the bankruptcy court

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chose the mechanism of a liquidating trust to liquidate and distribute the assets
of the estate. The bankruptcy court retained jurisdiction over the case. In this
context, the Liquidating Trustee is the functional equivalent of the bankruptcy
trustee and is entitled to Barton protection. Id. 421 F.3d at 973.
Pursuant to 11 U.S.C. 105(a), injunctions can be issued to prevent
impairment of the bankruptcy courts jurisdiction without regard to irreparable
harm. It would thwart the purpose of the Barton doctrine to add an additional
requirement that the party show irreparable harm before being able to obtain
relief. The essence of the Barton doctrine is that parties may not commence or
maintain unauthorized litigation. The only appropriate remedy, therefore, is to
order cessation of the improper action. There is no requirement in Barton or any
of its progeny that the aggrieved party bear the additional burden of showing
irreparable harm, nor does such a requirement make any sense in the Barton
context. Indeed, even in the non-bankruptcy context, we have held that courts
appointing a receiver are invested with broad power to issue orders barring
actions which would interfere with its administration of that estate. Diners Club,
Inc. v. Bumb, 421 F.2d 396, 398 (9th Cir. 1970). 421 F.3d at 976.
iv. Rationale.
Barton held that if leave of court were not obtained, then the other forum
lacked subject matter jurisdiction over the suit. Barton, 104 U.S. at 127. Part of
the rationale underlying Barton is that the court appointing the receiver has in
rem subject matter jurisdiction over the receivership property. Id. at 136. As the
Supreme Court explained, allowing the unauthorized suit to proceed would have
been a usurpation of the powers and duties which belonged exclusively to
another court. Id. n5. 421 F.3d at 971.
This explains why the forum selection clause has no effect. The Delaware
forum lacked subject matter jurisdiction over the action commenced by the Fort
James entities.
Thus, the district court in which the bankruptcy case is commenced
obtains exclusive in rem jurisdiction over all of the property in the estate. Hong
Kong and Shanghai Banking Corp., Ltd. V. Simon (In re Simon), 153 F.3d 991,
996 (9th Cir. 1998). The courts exercise of in rem bankruptcy jurisdiction
essentially creates a fiction that the property regardless of actual location is
legally located within the jurisdictional boundaries of the district in which the court
sits. Id. (citations omitted). Thus, the jurisdiction of the bankruptcy court
exceeds that of any other court-appointed receiver. The requirement of uniform
application of bankruptcy law dictates that all legal proceedings that affect the
administration of the bankruptcy estate be brought either in bankruptcy court or
with leave of the bankruptcy court. 421 F.3d at 971.

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Crown Vantage acknowledges that 28 U.S.C. 959(a)110 is a limited

statutory exception to Barton. 421 F.3d at 971. But, section 959(a) had no
application because it only applies to actions related to pursuing the business as
an operating enterprise and does not apply to actions taken in the mere
continuous administration of property. 421 F.3d at 972.
The public policies underlying the Barton doctrine were articulated by
Circuit Judge Posner:
Just like an equity receiver, a trustee in bankruptcy is working in
effect for the court that appointed or approved him, administering
property that has come under the courts control by virtue of the
Bankruptcy Code. If he is burdened with having to defend against
suits by litigants disappointed by his actions on the courts behalf,
his work for the court will be impeded. This concern is most acute
when suit is brought against the trustee while the bankruptcy
proceeding is still going on. The threat of his being distracted or
intimidated is then very great

Without the [Barton] requirement, trusteeship will become a

more irksome duty, and so it will be harder for courts to find
competent people to appoint as trustees. Trustees will have to pay
higher malpractice premiums, and this will make the administration
of the bankruptcy laws more expensive (and the expense of
bankruptcy is already a source of considerable concern).
Furthermore, requiring that leave to sue be sought enables
bankruptcy judges to monitor the work of the trustees more
effectively. It does this by compelling suits growing out of that work
to be as it were prefiled before the bankruptcy judge that made the
appointment; this helps the judge decide whether to approve this
trustee in a subsequent case.
In re Linton, 136 F.3d 544, 545 (7th Cir. 1998).

110 28 U.S.C. 959(a) provides:

Trustees, receivers or managers of any property including debtorin-possession, may be sued, without leave of the court appointing
them, with respect to any of their acts or transactions in carrying on
business connected with such property. Such actions shall be
subject to the general equity power of such court so far as the
same may be necessary to the ends of justice, but this shall not
deprive a litigant of his right to trial by jury.
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Bankruptcy courts can enjoin proceedings in other courts when satisfied

they would defeat or impair the bankruptcy courts jurisdiction over the case
before it and does not need a showing of an inadequate remedy at law or
irreparable harm. Crown Vantage, 421 F.3d at 975; In re L&S Industries, Inc.,
989 F.2d 929, 932 (7th Cir. 1993); Allard v. Weitzman (In re DeLorean Motor Co.),
991 F.2d 1236, 1242 (6th Cir. 1993); Manville Corp. v. Equity Security Holders
Comm. (In re Johns-Mannville Corp.), 801 F.2d 60, 63 (2d Cir. 1986).

16. Only the Debtor in Possession/Trustee Can Invoke 11 U.S.C.

506(c).
A. Hartford Underwriters Insurance Co. v. Union Planters
Bank, 120 S. Ct. 1942 (2000) (Scalia, J.)
i. Facts.
The chapter 11 debtors prepetition lender was owed approximately $4
million secured by a lien against substantially all the debtors real and personal
property. Once the chapter 11 case commenced, the bankruptcy court approved
the lenders advance of another $300,000 and the use of the new money and the
cash collateral to pay expenses including workers compensation insurance.
After the chapter 11 case was converted to chapter 7, the insurer first
learned of the bankruptcy and was owed $50,000 in unpaid premiums the debtor
failed to make during its chapter 11 case.
The insurer requested a payment of its administrative claim pursuant to 11
U.S.C. 506(c). The bankruptcy court granted the request and was affirmed by
the district and circuit courts. Then, the circuit court, en banc, reversed and the
Supreme Court agreed to review it.
11 U.S.C. 506(c) provides:
The trustee may recover from property securing an
allowed secured claim the reasonable, necessary costs and
expenses of preserving, or disposing of, such property to the
extent of any benefit to the holder of such claim.
ii. Holding
We conclude that 11 U.S.C. 506(c) does not provide an administrative
claimant an independent right to use the section to seek payment of its claim.
120 S. Ct. at 1951.

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The class of cases in which 506(c) would lie dormant without

nontrustee use is limited by the fact that the trustee is obliged to seek recovery
under the section whenever his fiduciary duties so require. 120 S. Ct. at 1950.
Even if this issue had arisen during the chapter 11 case, we do not read
1109(b)s general provision of a right to be heard as broadly allowing a creditor to
pursue substantive remedies that other Code provisions make available only to
other specific parties. 120 S. Ct. at 1948.
iii. Unanswered Questions
We do not address whether a bankruptcy court can allow other interested
parties to act in the trustees stead in pursuing recovery under 506(c). 120 S.
Ct. at 1951n.5.
Also identified, but not addressed, is whether the trustees recovery under
section 506(c) goes into the estate to be distributed in accordance with the
Bankruptcy Codes priority provisions or whether it goes to the administrative
claimant who benefited the collateral. Likewise, whether the trustee may use
section 506(c) prior to paying the expense for which reimbursement is sought is
an open question. 120 S. Ct. at 1950n.4.
The latter questions raise perplexing issues. For instance, assume the
trustee repairs the lenders collateral at a cost of $1,000 paid from
unencumbered funds. The trustee can then recoup from the collateral the
$1,000. This may be by having the secured claimant pay the estate $1,000 or by
simply reducing the amount of the secured claim by $1,000. Notably, the
wording of section 506(c) creates only a nonrecourse claim of the trustee. It
provides the trustee may recover from property, not from the claim holder.
Therefore, if after repairing the collateral, it is or becomes worth less than $1,000,
the trustee cannot collect more than its value.
Now, assume the trustee repairs the lenders collateral, but does not pay
the repairperson the $1,000. When the trustee asserts rights under section
506(c) against the property, the secured claimant agrees to reduce its secured
claim by $1,000, theoretically increasing the trustees equity in the property by
$1,000. Does the repairperson obtain the exclusive benefit of that $1,000?
It appears this will turn on whether section 506(c) is intended to protect
unsecured claimholders against the depletion of unencumbered funds to improve
a lenders collateral, or whether section 506(c) is intended to protect the
administrative claimant. Logically, if it were to protect the administrative
claimant, one would think the administrative claimant would have standing to
enforce section 506(c) by itself, which the Supreme Court held it does not have.

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iv.

Lessons Learned.

Administrative claimants who can not protect themselves with liens or

other credit support should advise the debtors responsible officers or trustee at
the outset that their fiduciary duties require them to take necessary steps to
ensure payment of their claims, including the enforcement of rights under section
506(c). As a tactical matter, the trustee and the claimant have more leverage at
the outset. They can advise the secured lender that they will not preserve the
collateral absent consent in advance to reimbursement of the necessary cost of
doing so. Of course, the secured claimant may respond that if the trustee opts
not to protect the collateral, stay relief should be granted. In many cases,
however, the secured claimholder does not want to foreclose because its
collateral is worth more as part of the debtors business than it is worth as
standalone property.
Additionally, as the Supreme Court opined, such claimants should protect
themselves by paying attention to the status of their accounts. 120 S. Ct. at
1950.
17. Can Courts Grant Derivative Standing to Parties in Interest to
bring Avoidance Actions?
A. Official Committee of Unsecured Creditors of Cybergenics
Corp., on behalf of Cybergenics Corp., debtor in possession v.
Chinery,330 F.3d 548 (3d Cir. 2003), replacing 304 F.3d 316(3d
Cir. 2002)(3-0), vacated and rehearing en banc granted, 310
F.2d 785 (3d Cir., 2002)
i. Facts.
The statutory creditors committee requested the debtor in possession to
prosecute fraudulent transfer actions under 11 U.S.C. 544(b), which claims
arose out of a leveraged buyout. The debtor in possession refused, and the
committee obtained bankruptcy court authorization to bring the claims
derivatively on behalf of the debtor in possession. 330 F.3d at 554. After the
committee filed its complaint, the reference of the adversary proceeding was
withdrawn on consent and defendants moved to dismiss on the ground the estate
had previously sold its avoidance actions. The district court granted the motion
and the appellate court reversed. In re Cybergenics Corp., 226 F.3d 245 (3d Cir.
2000). Then, defendants moved to dismiss on the ground, among others, the
committee lacked standing. The district court granted the motion finding the
Bankruptcy Code does not authorize a committee to bring a fraudulent transfer
avoidance action derivatively. That decision was affirmed on appeal, then
vacated and reversed en banc. 330 F.3d at 555.

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ii. Issue.
The question on appeal is whether the decision of the United States
Supreme Court in Hartford Underwriters Ins. Co. v. Union Planters Bank, 530
U.S. 1(2000), a Chapter 7 case which interpreted the text of 11 U.S.C. 506(c)
to foreclose anyone other than a trustee from seeking to recover administrative
costs on its own behalf, operates to prevent the Bankruptcy Court from
authorizing a creditors committee to sue on the estates behalf to avoid a
fraudulent transfer in a chapter 11 case. 330 F.3d at 552.
iii. Holding.
[B]ankruptcy courts can authorize creditors committees to sue
derivatively to avoid fraudulent transfers for the benefit of the estate. 330 F.3d
at 580.
iv.

Bankruptcy Code Sections 506(c) and 544(b).

Section 506(c) provides:

The trustee may recover from property securing an allowed
secured claim the reasonable, necessary costs and
expenses of preserving, or disposing of, such property to
the extent of any benefit to the holder of such claim.
Section 544(b)(1) provides:
Except as provided in paragraph (2), the trustee may avoid
any transfer of an interest of the debtor in property or any
obligation incurred by the debtor that is voidable under
applicable law by a creditor holding an unsecured claim
that is allowable under section 502 of this title or that is not
allowable only under section 502(e) of this title.
v.

Rationale.

We believe that Sections 1109(b), 1103(c)(5), and 503(b)(3)(B) of the

Bankruptcy Code evince Congresss approval of derivative avoidance actions by
creditors committees, and that bankruptcy courts equitable powers enable them
to authorize such suits as a remedy in cases where a debtor-in-possession
unreasonably refuses to pursue an avoidance claim. 330 F.3d at 553.

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vi.

Reasons Cybergenics En Banc is Correct.

The interpretation of Bankruptcy Code section 544(b)(1) to bar derivative

actions is not compelled by any plain language or meaning, creates absurd
results, is contradicted by another Third Circuit decision rendered three days
after the Cybergenics (now vacated) panel decision, is contradicted by a prior
Second Circuit decision, and conflicts with (i) Bankruptcy Code section
503(b)(3)(B), (ii) pre-Code law, (iii) express Congressional intent underlying
Bankruptcy Code chapter 11, and (iv) rules of statutory construction deployed by
the Supreme Court when interpreting the Bankruptcy Code.
1. Defining the trustee may in section 544(b)(1) as
only the trustee/debtor in possession may does not
resolve the question whether the trustee/debtor in
possession may avoid a transfer by authorizing a
creditors committee to sue in the debtor in
possessions name
.
Defining the words the trustee may in section 544(b) to mean only the
trustee/debtor in possession may,111 because Hartford Underwriters uses that
definition in section 506(c), does not yield the result the vacated Cybergenics
decision reached, namely that committees can not sue derivatively under section
544(b). Indeed, the Supreme Court noted it was not addressing a creditors right
to sue derivatively under section 506(c), and added that whatever the validity of
that [derivative action] practice [under section 544(b)], it has no analogous
application here, since petitioner did not ask the trustee to pursue payment
Hartford Underwriters, 530 U.S. at 13.
Put differently, by defining the trustee may in both sections 506(c) and
544(b) to mean only the trustee/debtor in possession may, neither section
grants other entities the causes of action embodied in those sections. But, that
definition does not answer the question as to how the trustee/debtor in
possession can prosecute its actions. Thus, the holding in Hartford Underwriters
that section 506(c) grants the trustee, but not a creditor, the right to share in
another creditors collateral, does not help determine Cybergenics where the
question is whether a trustee/debtor in possession can avoid transfers for the
estate under section 544(b)(1) only by itself or by using a creditors committee.
111 Based

on 11 U.S.C. 1107(a) as confirmed by Hartford Underwriters

(530 U.S. at 6n.3) and the Third Circuits earlier decision in In re Cybergenics
Corp., 226 F.3d 237, 243 (3d Cir. 2000)([t]he terms trustee and debtor in
possession, as used in the Bankruptcy Code, are thus essentially
interchangeable.), Cybergenics agrees that when section 544(b)(1) authorizes
the trustee to avoid any transfer the debtor in possession may do so as well. 304
F.3d at 318n.1.

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Most likely because transplanting to section 544(b)(1) the definition of the

trustee may in section 506(c) does not determine whether section 544(b)(1) bars
derivative standing, three days after Cybergenics was rendered, another panel of
the Third Circuit rendered a conflicting decision with no reference to Hartford
Underwriters. In In re Pillowtex, 304 F.3d 246 (3d Cir., September 23, 2002), the
appellate court held that whether the debtors attorneys received a preference
required resolution before approval of the retention of the debtors attorneys
could be assessed. In suggesting who had standing to bring the preference
action, the appellate court noted:
There was some confusion at oral argument about
whether the U.S. Trustee has standing to pursue the
preference action below. Although we leave the question
to the District Court on remand in the first instance, we call
to its attention our discussion in U.S. Trustee v. Columbia
Gas Sys. Inc. (In re Columbia Gas Sys. Inc.), 33 F.3d 294
(3d Cir. 1994), where we observed of section 307 of the
Code, it is difficult to conceive of a statute that more clearly
signifies Congresss intent to confer standing. Id. at 296.
304 F.3d at 321n.7. Significantly, 11 U.S.C. 307 grants U.S. trustees standing
the same as section 1109(b) grants creditors committees standing. (U.S.
Trustee v. Columbia Gas Sys. Inc. (In re Columbia Gas Sys. Inc.), 33 F.3d 294
(3d Cir. 1994), held the U.S. trustee has standing to enforce section 345 of the
Bankruptcy Code against the debtor in possession.).
The preference action referred to by Pillowtex arises from Bankruptcy
Code section 547(b) which includes the identical language Hartford Underwriters
and Cybergenics rely on, namely the trustee may. 11 U.S.C. 547(b), in
pertinent part provides:
Except as provided in subsection (c) of this section, the
trustee may avoid any transfer of an interest of the debtor
in property
(Emphasis supplied). Accordingly, when Pillowtex suggested the U.S. trustee
could bring a preference action based on its standing under 11 U.S.C. 307112,

112 11

U.S.C. 307 provides:

The United States trustee may raise and may appear and
be heard on any issue in any case or proceeding under this
title, but may not file a plan pursuant to section 1121(c) of
this title.

133

the circuit court was clearly opining Hartford Underwriters does not apply to suits
brought on behalf of the estate.
Prior to Pillowtex, but after Hartford Underwriters, a creditors committees
standing to prosecute the estates avoidance actions was upheld by the Second
Circuit in Commodore International Limited, by and through the Official
Committee of Unsecured Creditors v. Gould, 262 F.3d 96 (2d Cir. 2001), without
any reference to Hartford Underwriters. In Commodore, bankruptcy cases for the
debtors were pending in the Bahamas and under the Bankruptcy Code. The
Bahamian liquidators of the debtors consented to the creditors committee
appointed under the Bankruptcy Code prosecuting the estates claims for fraud,
mismanagement, and waste. 262 F.3d at 98. The lower courts decisions show
these claims included claims for preferences and fraudulent transfers, thereby
invoking Bankruptcy Code sections 544(b)(1) and 547. In re Commodore
International Limited, 231 B.R. 175, 176 (Bankr. S.D.N.Y. 1999); see also In re
Commodore International, Limited, 242 B.R. 243, 247 (Bankr. S.D.N.Y. 1999).
The committee commenced its action, and subsequently the liquidators
brought identical claims in a separate action because defendants moved to
dismiss the committees action. 262 F.3d at 98. The committees action was
dismissed for lack of standing and the committee appealed to the Second Circuit
raising 2 issues: whether it validly obtained standing by consent and whether the
standing can be unilaterally revoked. 262 F.3d at 98-99. The Second Circuit
reviewed numerous decisions allowing creditors or committees to sue in the
name of the debtor in possession under section 544(b) and otherwise, and held a
committee can obtain standing if the trustee or debtor in possession unjustifiably
refuses to bring an action or if the trustee/debtor in possession consents and the
committees action is necessary and beneficial to resolution of the bankruptcy.
262 F.3d at 99-100. Because the liquidators had commenced their own action
and the Bahamian court ruled they should not have consented, the Second
Circuit upheld the dismissal of the committees action because it was no longer
necessary and beneficial. 262 F.3d at 100.
Significantly, appellant and appellee in Commodore were represented by
Stroock & Stroock & Lavan, LLP and Cahill Gordon & Reindel, respectively. 262
F.3d at 96. The Second Circuit judges on the Commodore panel were Chief
Circuit Judge Walker and Circuit Judges Cabranes and Straub, with the opinion
written by Chief Judge Walker. Id. at 96-97. It is impossible that these eminent
judges and law firms were unaware of Hartford Underwriters. The only possible
explanation is they did not mention Hartford Underwriters because they didnt
view it as having any application to derivative standing.
In section 506(c), Congress grants the trustee/debtor in possession a
cause of action to collect from a creditors collateral security under certain
circumstances. In general, section 506(c) provides that if the trustee or debtor in
possession uses estate resources to preserve a creditors collateral, the trustee

134

or debtor in possession may obtain reimbursement from the collateral. In

Hartford Underwriters an unpaid insurer claimed the trustee benefited a creditors
collateral by procuring the insurance, but did not pay for the insurance with estate
resources or otherwise. Therefore, the unpaid insurer wanted to collect from the
creditors collateral under section 506(c).
In Hartford Underwriters the Supreme Court did not need to decide
whether the trustees recovery under section 506(c) would go into the estate for
pro rata distribution or would go to the estate for ultimate distribution to the
secured claimholder. 530 U.S. at 12n.4. Rather, it could easily answer the
question as to whether section 506(c) grants entities other than the trustee a
cause of action against a secured claimholders collateral by determining that by
granting the trustee a cause of action in section 506(c), Congress was not
granting the secured claimholder or anyone else a cause of action. Since the
creditor in Hartford Underwriters was suing for its own account and not for the
estate, it was simple to conclude section 506(c) does not grant private causes of
action.
In section 544(b)(1), Congress grants the trustee/debtor in possession the
power to avoid transfers for the benefit of the estate. We know its for the benefit
of the estate because sections 541(a)(3) and (4)113 render the recoveries
property of the estate. Therefore, the question presented by the meaning of the
words the trustee may in section 544(b)(1) is not whether section 544(b)(1)
grants entities other than the trustee causes of action to avoid transfers. Rather,
the question is whether the trustee or debtor in possession can use other entities
to exercise the trustees power to avoid transfers for the estates benefit.
Interpreting section 544(b)(1) to mean only the trustee/debtor in possession
may avoid any transfer, does not answer the question as to how the trustee may
do it. When a creditors committee acts for a trustee or debtor in possession it
sues in the name of the debtor in possession or trustee on behalf of the estate as
the caption of Cybergenics shows. Therefore, the prosecution of an avoidance
action by a committee acting derivatively is simply a method for the trustee or
debtor in possession to exercise its avoiding power.
Most recently, in In re Housecraft Industries USA, Inc., 310 F.3d 64, 67
(2d Cir. 2002), the defendant moved to dismiss for lack of standing, arguing that
[Bankruptcy Code] 548 and 549 only authorize trustees or debtors-in113 11

U.S.C. 541(a)(3)-(4) include the following in property of the estate:

(3) Any interest in property that the trustee recovers
under section 329(b), 363(n), 543, 550, 553, or 723 of this
title.
(4) Any interest in property preserved for the benefit of or
ordered transferred to the estate under section 510(c) or
551 of this title.
135

possession not creditors to bring avoidance actions. The Second Circuit

rejected the argument, noting: While some courts require individual creditors to
satisfy a more stringent standard than creditors committees in order to obtain
standing, such a requirement is unnecessary in our circuit because under
Commodore, we only grant standing to creditors either individuals or
committees when doing so is in the best interest of the estate. 310 F.3d at
71n.7.
2. Interpreting Section 544(b)(1) to Bar Derivative
Actions, Renders Section 503(b)(3)(B) a Practical
Absurdity
.
Interpreting section 544(b)(1) to bar a creditor and a committee from
bringing suit derivatively to recover property under section 544(b)(1) renders
section 503(b)(3)(B) a practical absurdity. 11 U.S.C. 503(b)(3)(B) provides:
(b)

After notice and a hearing, there shall be

allowed administrative expenses, other
than claims allowed under section 502(f)
of this title, including

(3)

the actual, necessary expenses, other than

compensation and reimbursement
specified in paragraph (4) of this
subsection, incurred by

(B)

a creditor that recovers, after the courts

approval, for the benefit of the estate any
property transferred or concealed by the
debtor;

(emphasis supplied).
Section 503(b)(3)(B) expressly provides for creditors to obtain allowed
administrative claims to reimburse them for recovering property if they recover it
after procuring court approval. The wording of section 503(b)(3)(B) shows clearly
it is referring to avoidance actions to retrieve property the debtor fraudulently or
preferentially transferred. If under section 544(b)(1) the courts cannot grant
approval to a creditor to recover property for the estate, then section 503(b)(3)(B)
serves no purpose. Put differently, section 503(b)(3)(B) shows Congress did not
intend that section 544(b)(1) be interpreted to bar derivative actions.
There is no application for the words after the courts approval in section
503(b)(3)(B) if section 544(b)(1) is interpreted to mean the court can not approve
a creditor pursuing recovery of property transferred by a debtor. This runs afoul
of hornbook law set forth in Bank of America National Trust and Savings
Association v. 203 North LaSalle Street Partnership, 526 U.S. 434, 452 (1999),
that there is an interpretive obligation to try to give meaning to all the statutory

136

language. (In 203 North LaSalle, the Supreme Court rejected an interpretation
of 1129(b)(2)(B)(ii) that would have made the words on account of a
redundancy. Id.).
The foregoing analysis is consistent with and required by the Supreme
Courts statutory interpretation of 11 U.S.C. 362(d)(1) in United Savings
Association of Texas v. Timbers of Inwood Forest Associates, Ltd., 484 U.S. 365
(1988). There, an undersecured creditor contended it was entitled to relief from
the automatic stay because the debtors failure to pay it monthly use or interest
payments on the secured portion of its claim deprived it of adequate protection
for purposes of section 362(d)(1). 484 U.S. at 368-369. 11 U.S.C. 362(d)(1)(2) provide:
On request of a party in interest and after notice and a
hearing, the court shall grant relief from the stay provided
under subsection (a) of this section, such as by terminating,
annulling, modifying, or conditioning such stay
(1) for cause, including the lack of adequate protection of
an interest in property of such party in interest; or
(2) with respect to a stay of an act against property under
subsection (a) of this section, if -(A) the debtor does not have an equity in such property;
and
(B) such property is not necessary to an effective
reorganization.
The Supreme Court remarked that statutory construction is a holistic
endeavor often clarified by the remainder of the statutory scheme. 484 U.S. at
371. Then, it interpreted section 362(d)(1) by reference to section 362(d)(2). If
an undersecured creditor not receiving use or interest payments would be
entitled to stay relief for lack of adequate protection under section 362(d)(1), then
why would any creditor resort to section 363(d)(2) for stay relief which requires
both that (a) the creditor be undersecured (which assures the debtor has no
equity in the property), and (b) the property not be necessary to an effective
reorganization. The Supreme Court ruled petitioners interpretation of
362(d)(1) makes nonsense of 362(d)(2)..This renders 362(d)(2) a practical
nullity and a theoretical absurdity. 484 U.S. at 374, 375.
Here, the interpretation of section 544(b)(1) to bar derivative actions would
render section 503(b)(3)(B) nonsense, a practical nullity, and a theoretical
absurdity. Section 503(b)(3)(B)s grant of reimbursement to a creditor who
recovers property after the courts approval, is all of those things if the court
cant give approval.

137

Significantly, the Supreme Court strained to find a possible application of

section 362(d)(2), if section 362(d)(1) were interpreted to require stay relief if
monthly payments are not made to an undersecured creditor. It found one. If the
debtor does make monthly payments to an undersecured creditor, thereby
furnishing adequate protection, then, conceivably, the creditor could still request
stay relief under section 362(d)(2) on the ground the property is unnecessary to
reorganization. Notwithstanding that section 363(d)(2) could still serve a
purpose, the Supreme Court maintained its ruling that the creditors interpretation
of section 362(d)(1) rendered section 362(d)(2) absurd. It observed the creditor
offers no reason why Congress would want to provide relief for such an
obstreperous and thoroughly unharmed creditor. 484 U.S. at 375.
Accordingly, even if some conceivable application of section 503(b)(3)(B)
could be imagined, notwithstanding a repudiation of its language that the court
can approve a creditors recovery of property the debtor transferred, the abstract
application of section 503(b)(3)(B) would not save the section from being
rendered a practical nullity.
In re Blount, 276 B.R. 753, 754, 759 (Bankr. M.D. La. 2002)(chapter 7
case), holds section 503(b)(3)(B) is statutory authority to confer derivative
standing on creditors to act for the estate.114
3. 11 U.S.C. 1123(b)(3) Does Not Support Barring
Derivative Actions
Bankruptcy Code section 1123(b)(3) provides:
(b) Subject to subsection (a) of this section, a plan may
(3) provide for
(A) the settlement or adjustment of any claim or interest
belonging to the debtor or to the estate; or
(B) the retention and enforcement by the debtor, by the
trustee, or by a representative of the estate appointed for
such purpose, of any such claim or interest.
The panel decision in Cybergenics treated this section as supporting its position:
Furthermore, 1123(b)(3)(B) suggests that Congress
was aware of the issue of proper estate representation and
114 In

reTogether Development Corp., 262 B.R. 586, 589 (Bankr. D.Mass. 2001),
also finds statutory authority to grant derivative standing to a committee in 11
U.S.C. 1103(c)(5) and 1109(b).
138

could have incorporated language allowing a non-trustee

estate representative to bring claims under 544.
Congress did not do so, just as it did not allow for the
prosecution of a case under 506(c) by a party that is not
a trustee.
304 F.3d at 324n.11. Section 1123(b)(3)(B) supports the opposite
conclusion.
First, section 1123(b)(3)(B) lists provisions that may be included in chapter
11 plans. But, its reference to a representative of the estate could be a
representative of the estate granted derivative standing prior to any chapter 11
plan. It would be completely consistent with pre-Code practice for a
representative of the estate to commence an action prior to confirmation, and the
chapter 11 plan would provide for the representative to continue it. Cybergenics
assumption that the representative referred to would first come into existence on
confirmation of the plan has no basis.
Second, lets analyze the logic or illogic of Congress authorizing derivative
standing under a plan, but not prior to a plan. A statutory creditors committee is
appointed by a United States trustee and can only retain professionals without
certain conflicts and connections, approved by the court, and paid with court
approval. 11 U.S.C. 328(a), 328(c), 330, 1102(a)(1), and 1103(b). Does it
make any sense that Congress would not want that committee to prosecute
estate avoidance actions, but would then allow the debtor, trustee, or an estate
representative to pursue the action after plan confirmation? Does it make any
sense that the Congress that granted every creditor and creditors committee
standing to raise, appear, and be heard on every issue in the case under 11
U.S.C. 1109(b)115 would not allow the committee to commence an avoidance
action? There is no rational reason for Congress to make that distinction.
Section 1123(b)(3)(B) makes far more sense if its reference to an estate
representative includes a representative granted derivative standing prior to
confirmation who has not yet completed its avoidance action. In view of section
503(b)(3)(B) which expressly refers to court approval of creditors bringing
avoidance actions, there can be little doubt that the panel decision in
Cybergenics wrongly interpreted sections 544(b) and 1123(b)(3)(B).

115 11

U.S.C. 1109(b) provides:

A party in interest, including the debtor, the trustee, a
creditors committee, an equity security holders committee,
a creditor, an equity security holder, or any indenture
trustee, may raise and may appear and be heard on any
issue in a case under this chapter.
139

4.

The Panel Decision in Cybergenics Violated

the Rule of Statutory Construction in Midlantic
National Bank v. New Jersey Department of
Environmental Protection, 474 U.S. 494 (1986), to
Continue Pre-Code Law Absent a Showing of
Congressional Intent to Change It
.
.

In Midlantic, the bankruptcy trustee requested authority to abandon

contaminated waste oil in leaky containers, 474 U.S. at 497, pursuant to 11
U.S.C. 554(a) which provides:
After notice and a hearing, the trustee may abandon any
property of the estate that is burdensome to the estate or
that is of inconsequential value and benefit to the estate.
There was no question the literal requirements of section 554(a) were
satisfied in that the waste oil and the property it was on were burdens to the
estate. Id. Nevertheless, the City and State of New York objected on the ground
the abandonment would violate local laws.
The Supreme Court held a trustee may not abandon property in
contravention of a state statute or regulation that is reasonably designed to
protect the public health or safety from identified hazards. 474 U.S. at 507.
The Supreme Court explained its rationale for interpreting section 554(a)
to add on conditions to abandonment undisputedly not included in section 554s
language:
Thus, when Congress enacted 554, there were wellrecognized restrictions on a trustees abandonment power. In
codifying the judicially developed rule of abandonment,
Congress also presumably included the established corollary
that a trustee could not exercise his abandonment power in
violation of certain state and federal laws. The normal rule of
statutory construction is that if Congress intends for legislation
to change the interpretation of a judicially created concept, it
makes that intent specific. Edmonds v. Compagnie Generale
Transatlantique, 443 U.S. 256, 266-267 (1979). The Court has
followed this rule with particular care in construing the scope of
bankruptcy codifications.
474 U.S. at 501. Based on three pre-Code decisions, the Supreme Court
determined that under pre-Code practice abandonment could not be done in
violation of local laws reasonably designed to protect the public health or safety.
474 U.S. at 500-501.
140

Similarly, in Kelly v. Robinson, 479 U.S. 36, 50 (1986), the Supreme Court
interpreted 11 U.S.C. 523(a)(7) to render restitution obligations
nondischargeable when part of a state courts criminal sentence, based on preCode practice.
It is acknowledged that pre-Code law was even more clear in allowing
creditors and committees to sue derivatively for a bankruptcy trustee. See, e.g.,
Trimble v. Woodhead, 102 U.S. 647 (1881); Moyer v. Dewey, 103 U.S. 301
(1881); Gochenour v. Cleveland Terminals Bldg. Co., 118 F.2d 89 (6th Cir.
1941). Even the panel decision in Cybergenics acknowledged the existence of
the pre-Code practice. 304 F.3d at 331 (court admits pre-Code practice of
derivative actions on fraudulent transfers is more compelling than the practice
on section 506(c)).
In United States v. Ron Pair Enterprises, Inc., 489 U.S. 235 (1989), the
Supreme Court interpreted section 506(b) of the Bankruptcy Code to grant
holders of involuntary oversecured liens postpetition interest, notwithstanding
that the debtor asserted the result was contrary to pre-Code law. 489 U.S. at
243. Referring to Midlantic and Kelly, the Supreme Court explained it preserved
pre-Code law or practice in those decisions, but was not doing so in Ron Pair
because this natural interpretation of the statutory language does not conflict
with any significant state or federal interest, nor with any other aspect of the
Code. 489 U.S. at 245.
In Cybergenics, there is no natural interpretation of the statute that bans
derivative standing.
5. The Panel Decision in Cybergenics Undermined Two
Vital Congressional Policies
.
At the conclusion of the panel decision, Cybergenics announced its
holding leaves a creditor or committee several options when a debtor in
possession refuses to sue. Specifically, the court ruled:
Section 1103(c)(4) expressly authorizes a
creditors committee to move for the appointment of a
trustee under 1104. In addition, as a party in interest,
the Committee could have moved to dismiss the
bankruptcy petition under 1112 so that it could pursue its
state law avoidance claims in state court.
304 F.3d at 333.

141

It is an understatement to say there are deeply embedded Congressional

policies against trustees or dismissal, for the sake of bringing an avoidance
action the debtor in possession is not best suited to bring.
First, the statute shows the steep standard required by Congress for a
trustees appointment. In pertinent part, 11 U.S.C. 1104(a)(1)-(2) provide for
the appointment of a trustee:
(1) for cause, including fraud, dishonesty, incompetence,
or gross mismanagement of the affairs of the debtor by
current management, either before or after the
commencement of the case, or similar cause, but not
including the number of holders of securities of the
debtor or the amount of assets or liabilities of the
debtor; or
(2) if such appointment is in the interest of creditors, any
equity security holders, and other interests of the estate,
without regard to the number of holders of securities of
the debtor or the amount of assets or liabilities of the
debtor.
Frequently, a debtor in possession will not want to sue vendors or other
entities to recover preferences or fraudulent transfers based on business
judgment. These entities may be ongoing vendors or financers for the business.
Similarly, appearances may render it inappropriate, or certainly less than optimal,
for a debtor in possession to sue former management. Some creditors or equity
security holders may not believe the debtor in possession will sue as vigorously
as a creditors committee would. According to Cybergenics, the appointment of a
trustee is the answer.
That answer conflicts with section 1104(a) for several reasons. First,
section 1104 makes clear that business judgment and appearances fall far short
of the standard for a trustee. They do not approach the fraud or dishonesty
required. Indeed, one of the statutes leading indicators of the ultra high standard
required for a trustees appointment is the requirement of proof of gross
mismanagement. Mismanagement alone is not enough!
Second, a trustee must be in the best interests of equity security holders if
the trustee appointment is under section 1104(a)(2), and absent dishonesty of
current management, equity security holders rarely ever believe their interests
will fare as well with a trustee who does not answer to directors as with a chief
executive officer who does answer to directors having fiduciary duties to
shareholders.

142

In addition to the statute itself, the Bankruptcy Codes legislative history

speaks volumes. First, the United States Senate passed a proposed bankruptcy
code rendering trustees mandatory for any company having at least $5 million of
non-trade debt and 1000 security holders. S.2266, 94th Cong., 1st Sess. (1977)
at section 1101(3) and 1104(a). The Senates trustee provisions were rejected in
favor of the House version quoted above. The House of Representatives
recognized debtors would wait too long before seeking chapter 11 relief if a
trustee would automatically be appointed. House Report No. 95-595, 95th Cong.,
1st Sess. (1977) at 233-234. It is so common for debtors in possession and
creditors committees to want the committees to prosecute avoidance actions
that is that need is now ground for a trustee, the panel decision in Cybergenics
creates the very deterrent to the use of chapter 11 that Congress went to great
lengths to avoid.
Moreover, by deterring management from seeking chapter 11 relief until
there is no alternative and the business can not be saved, the panel decision in
Cybergenics eliminates the benefits Congress targeted for reorganizations: By
permitting reorganization, Congress anticipated that the business could continue
to provide jobs, to satisfy creditors claims, and to produce a return for its
owners. H.R. Rep. No. 95-595, 95th Cong., 1st Sess. (1977) at 220.
Notably, creditors frequently do not want chapter 11 trustees. It is more
and more common for creditors to prevail on a debtor to retain a new turnaround
manager, satisfactory to the creditors, in the capacity of a chief restructuring
officer or chief executive officer. In either case, the creditors do not want their
nominee displaced by a trustee appointed by the United States trustee.
The panel decision in Cybergenics other solution when a debtor in
possession does not bring an avoidance action is for creditors to move for
dismissal of the case under 11 U.S.C. 1112(b). Its probably a blessing that
failure to bring an avoidance action is not a ground for dismissal under section
1112(b). Pursuant to 11 U.S.C. 362(c)(2)(B), the automatic stay terminates on
dismissal of a chapter 11 case. That means every creditor is free to enforce its
rights against the debtor and its property as soon as the case is dismissed. That
means dismissal begins the race to the courthouse by each creditor and the
onslaught of grab law. Reorganization becomes impossible. Thus, under
Cybergenics panel decision, if a debtor in possession fails to bring an avoidance
action, creditors have a choice if they dont want a trustee: forfeit the avoidance
action or forfeit the reorganization and resort to grab law.
The panel in Cybergenics acknowledged that on dismissal of a chapter 11
case, the avoidance actions under state law may yield smaller recoveries than
under the Bankruptcy Codes avoidance provisions. 304 F.3d at 333n.17.
Indeed, unless the court orders otherwise, 11 U.S.C. 349(b) reinstates voidable
transfers and recoveries as they existed at the commencement of the case.

143

6. Barring Derivative Actions Would Violate the Rule of

Construction in Dewsnup v. Timm, 502 U.S. 410
(1992), Under Which The Same Statutory Language
Must Be Interpreted Differently In Two Provisions To
Continue Pre-Code Law Unless Congress Evidences
An Intent To Change It
.
As explained above, interpreting the phrase the trustee may in both
sections 506(c) and 544(b)(1) to mean only the trustee/debtor in possession
may does not resolve the issue in Cybergenics as to whether the debtor in
possession can proceed derivatively through a committee. But, if that is wrong
and the definition does cause section 544(b)(1) to ban derivative actions, that
statutory construction violates the Supreme Courts ruling in Dewsnup where it
showed the same words in different sections of the Bankruptcy Code should be
interpreted differently when necessary to preserve pre-Code law unless
Congress indicated an intent to change it which is not the case here.
In Dewsnup, two undersecured creditors held a $120,000 recourse claim
against property valued at $39,000. 502 U.S. at 414. Thus, pursuant to 11
U.S.C. 506(a), the creditors had a secured claim of $39,000 and an unsecured
claim of $81,000. Section 506(a) provides:
An allowed claim of a creditor secured by a lien on
property in which the estate has an interest, or that is
subject to setoff under section 553 of this title, is a secured
claim to the extent of the value of such creditors interest in
the estates interest in such property, or to the extent of the
amount subject to setoff, as the case may be, and is an
unsecured claim to the extent that the value of such
creditors interest or the amount so subject to setoff is less
than the amount of such allowed claim. Such value shall
be determined in light of the purpose of the valuation and of
the proposed disposition or use of such property, and in
conjunction with any hearing on such disposition or use or
on a plan affecting such creditors interest.
The chapter 7 debtor commenced an adversary proceeding to avoid the
portion of the creditors lien securing anything more than $39,000 pursuant to 11
U.S.C. 506(d), which provides:
To the extent that a lien secures a claim against the debtor
that is not an allowed secured claim, such lien is void,
unless
(1) such claim was disallowed only under section 502(b)(5)
or 502(e) of this title; or

144

(2) such claim is not an allowed secured claim due only to

the failure of any entity to file a proof of such claim
under section 501 of this title.
The debtor contended the phrase allowed secured claim must have the
same meaning in sections 506(a) and 506(d), thereby requiring that the lien
securing anything over $39,000 be void pursuant to section 506(d). That would
enable the debtor to obtain any appreciation in the property over $39,000.
Conversely, the creditors contended the phrase allowed secured claim in
section 506(d) is not used as in section 506(a), but rather means a claim that is
allowed first, and is secured by a lien, second. Since the creditors claim was
allowed and was secured by a lien, it would not be void under section 502(d).
The Supreme Court held:
Therefore, we hold that 506(d) does not allow
petitioner to strip down respondents lien, because
respondents claim is secured by a lien and has been fully
allowed pursuant to 502. Were we writing on a clean
slate, we might be inclined to agree with petitioner that the
words allowed secured claim must take the same meaning
in 506(d) as in 506(a). But, given the ambiguity in the
text, we are not convinced that Congress intended to
depart from the pre-Code rule that liens pass through
bankruptcy unaffected.
502 U.S. at 417 (footnote deleted).
Defining the trustee may in section 544(b)(1) to mean only the
trustee/debtor in possession may leaves an ambiguity far more material than
any ambiguity in section 506(d) because only the trustee/debtor in possession
may does not answer the question as to whether the trustee may avoid a
transfer by authorizing a creditors committee to prosecute the action in the
debtor in possessions name. The existence of prior law allowing committees to
do so and the absence of any indication Congress wanted to change it should
invoke the same rule of construction used in Dewsnup, which would preserve
pre-Code law. Indeed, the dissent of two justices in Dewsnup considered section
502(d) seemingly clear. 502 U.S. at 435.
B. Smart World Technologies, LLC v. Juno Online Services,
Inc. (In re Smart World Technologies, LLC), 423 F.3d 166 (2d
Cir. 2005)
i. Facts

145

The chapter 11 debtor in possession, Smart World Technologies, LLC

(Smart World), was prosecuting in the bankruptcy court its claim against the
postpetition purchaser of its internet service business for failure to pay the full
purchase price. Under the sale contract, the purchaser was supposed to pay a
price that increased with the number of qualified subscribers of Smart World that
used the purchasers services. Smart World claimed the purchaser circumvented
the process for tracking subscribers by causing a database dump. 423 F.3d at
169.
For three years, the bankruptcy court allowed Smart Worlds adversary
proceeding to stall based on the purchasers representations that settlement was
imminent. In the first year, the purchaser negotiated with Smart Worlds creditors
and represented a settlement was reached, which caused the bankruptcy court
to terminate discovery. The purchaser had negotiated with one creditor,
Worldcom, that admitted it was not motivated by the merits of Smart Worlds
claims, but rather by the need to quickly resolve a deteriorating situation. 423
F.3d at 171.
Ultimately, the purchaser and Smart Worlds creditors filed a motion for
approval of a settlement of Smart Worlds claims under Bankruptcy Rule 9019.
Pursuant to the proposed settlement, Juno would pay $5.5 million to Worldcom in
satisfaction of its disputed secured claim and an ancillary dispute between
Worldcom and the purchaser, and $1.8 million to the creditors committee for its
expenses. 423 F.3d at 172n.9. Smart World objected to the settlement on the
grounds (a) it did not require the purchaser to pay its admitted liability to Smart
World, (b) the settlement paid a highly suspect and overstated secured claim to
Worldcom, (c) the settlement was premature because Smart World was not
granted meaningful discovery, (d) Smart World was actively pursuing its claims
and the creditors should not be allowed to settle them, and (e) the creditors
lacked standing to settle over Smart Worlds objection. 423 F.3d at 172.
At the settlement hearing, the bankruptcy court displayed hostility towards
Smart World for trying to argue the merits of its claims rather than the
reasonableness of the settlement. The bankruptcy court announced its intention
to approve the settlement unless Smart World satisfied a condition it could not
meet, namely that it post a supersedeas bond securing the amount of the
settlement. 423 F.3d at 173.
The bankruptcy court approved the settlement finding Smart Worlds
refusal to join the settlement was unreasonable in view of the risks, expense, and
delay, and because Smart World was gambling with a recovery that otherwise
would go to creditors. It found creditors had a right to intervene and determined
the bankruptcy court had equitable powers to approve the settlement. The
district court affirmed finding the bankruptcy court had equitable power to allow
Worldcom and the statutory creditors committee to settle. 423 F.3d at 173.

146

ii. Issue
Did the bankruptcy court err in granting Smart Worlds creditors standing
to settle the adversary proceeding between Smart World and Juno, without
Smart Worlds participation and over Smart Worlds objections? 423 F.3d at 174.
iii. Holding
[W]hile authority to pursue a Rule 9019 motion may, in certain limited
circumstances, be vested in parties to the bankruptcy proceeding other than the
debtor-in-possession, those circumstances are not present here. 423 F.3d at
174. We do not rule out that in certain, rare cases, unjustifiable behavior by the
debtor-in-possession may warrant a settlement over the debtors objection, but
this is not such a case. 423 F.3d at 177.
iv. Rationale
Bankruptcy Rule 9019 and Bankruptcy Code section 323 show that only
the trustee and debtor in possession are authorized to bring a settlement motion
and be the estate representative. 423 F.3d at 174. Bankruptcy Code section
1106(a) holds the debtor in possession accountable to maximize value. 423 F.3d
at 175. Derivative standing is available when the debtor in possession
unjustifiably fails to bring suit, In re STN Enterprises, 779 F.2d 901 (2d Cir.
1985), or the debtor consents, Commodore Intl Ltd. v. Gould (In re Commodore
Intl Ltd.), 262 F.3d 96, 100 (2d Cir. 2001). Bankruptcy Code section 1109(b)
allows creditors to intervene in adversary proceedings, not to take ownership of
the debtors claims. 423 F.3d at 182. [T]he bankruptcy courts power to act
pursuant to 105(a) does not provide an independent basis upon which to grant
appellees standing. 423 F.3d at 184.
C. ACC Bondholder Group v. Adelphia Communications Corp.
(In re Adelphia Communications Corp.), 361 B.R. 337 (S.D.N.Y.
2007)
i.

Facts

The bankruptcy court established a process to resolve disputes between

the affiliated debtors. The debtors and statutory creditors committee were
ordered to remain neutral. Several unofficial creditors committees were
deputized to litigate on behalf of the different debtors. While a right was reserved
for the debtors to compromise one or more of the issues, the authorized litigants
had the right to object to the compromise and to assert the debtors had no
authority to compromise those issues. Then, the bankruptcy court authorized the

147

debtors to propose a chapter 11 plan that included a proposed settlement, but

conditioned that right on offering creditors the option of voting for the plan without
the intercreditor settlement. Ultimately, the debtors entered into a settlement with
all the committees except the committee for the parent debtor. That committee
had 23 members and two (later 3 more) signed the settlement in their individual
capacities.
The plan was accepted by all classes. At the confirmation hearing, the
court treated the proposed settlement as a settlement entitled to be assessed
under Protective Committee for Independent Stockholders of TMT Trailer Ferry,
Inc. v. Anderson, 390 U.S. 414, 424 (1968), and In re W.T. Grant Co., 699 F.2d
599, 608 (2d Cir. 1972), whereby the settlement is approved if it reaches the
lowest level of the range of reasonableness. The court confirmed the plan and
the ACC Bondholder Group requested a stay pending appeal on many grounds.
ii.

Issue

Does the ACC Bondholder Group have a substantial possibility of success

in prevailing on its confirmation objection that there was no settlement or that it
was improperly approved?
iii.

Holding

Yes. It must be remembered that it was the ACC Noteholders

Committee not each individual member of that Committee that was
authorized to act on behalf of the ACC Debtor. Thus, in the absence of the
approval of that Committee, the authorized litigant for ACC had not agreed to the
Settlement. 361 B.R. at
iv.

Rationale

The non-consenting members of the ACC Noteholders Committee raised these

very objections at the Confirmation Hearing. In addressing these objections, the
Bankruptcy Court first declared that the Committee was dysfuncion[al]
apparently because only two (later five) of its members supported the settlement,
while the majority of the others did not. Relying on Smart World, the court then
found that the objections were meritless, because the Debtor always retains the
authority to settle an estates claims. This literal reading of Smart World,
however, ignores the facts of both that case and this bankruptcy proceeding. In
Smart World, the settling creditors had no authority to act on behalf of the Debtor.
Here, the ACC Noteholders committee (of which the objecting creditors were
members) had been given the authority to settle claims, thus acting as a proxy
for the Debtor. By contrast, the Debtor here had retained only limited authority to
propose a settlement under clearly articulated conditions. Thus, just as the two
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creditors in Smart World could not settle the claims out from under the Debtor,
two individual creditors (acting without court authority) could not settle the claims
out from under the ACC Noteholders Committee, acting on behalf of and in place
of the Debtor. 361 B.R. at 356-357.
v.

Subsequent History

While the district court ruled there were at least 4 independent grounds on
which there was a substantial possibility of reversal, the court required a $1.3
billion bond. Later, the court considered lowering the bond to $250 million, but
appellants maximum upside was not more than $250 million and it made no
sense for appellants to post a bond to protect all debtors estates when
appellants claims were only against one debtor. When the court determined to
require the bond even though Bankruptcy Rule 8005 does not render it
mandatory, appellants did not post it and the appeal was dismissed as equitably
moot. ACC Bondholder Group v. Adelphia Communications Corp. (Inn re
Adelphia Communications Corp.), 367 B.R. 84, 99 (S.D.N.Y. 2007). Notably, the
extreme result was not necessarily required. "[W]hen a court can fashion 'some
form of meaningful relief,' even if it only partially redresses the grievances of the
prevailing party, the appeal is not moot." Resolution Trust Corp. v. Swedeland
Development Group, Inc. (In re Swedeland Development Group, Inc.), 16 F.3d
552, 560 (3d Cir. 1994)(in banc) (quoting Church of Scientology v. United States,
113 S. Ct. 447, 450 (1992)). Significantly, Swedeland also points out in the
context of an appeal from an order approving a borrowing secured by a priming
lien under 11 U.S.C. 364(d), that there is a "practical consideration that it may
be impossible for a pre-petition creditor with a meritorious appeal to obtain a stay
of a section 364(d) order." Resolution Trust Corp. v. Swedeland Development
Group, Inc. (In re Swedeland Development Group, Inc.), 16 F.3d 552, 561 (3d
Cir. 1994). Swedeland reasons that this practical consideration justifies and
makes fair its determination to affirm the granting of some relief on appeal rather
than dismissing the appeal for mootness. The reasoning is even more
compelling in the context of a confirmation order when a few creditors who are
wronged are told they must post a bond in an amount creating a risk that no
prudent investor should take.
The latter decision demonstrates that confirmation orders riddled with
reversible error can avoid article III review and any review if courts do not
expedite appeals rapidly while not requiring a bond. Notably, district courts can
revoke the reference of confirmation, while allowing the bankruptcy court to try
confirmation and propose findings of fact and conclusions of law to the district
court. Using that procedure, the district court is able to review the bankruptcy
courts proposals before an order is entered and before any bond could be
required.

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18. Does a Statutory Committee Require Court Approval or

Debtor/Trustee Consent to Commence an Adversary Proceeding the
Bankruptcy Code Does Not Assign Exclusively to the Trustee?
A. Official Committee of Unsecured Creditors v.
Halifax Fund, L.P. (In re Applied Theory Corp.),
493 F.3d 82 (2d Cir. 2007)
i.

Facts

The bankruptcy court denied authority to the statutory creditors committee

to sue to equitably subordinate a creditors claim to all other creditors claims or
to recharacterize it as equity. 493 F.3d at 84. The committees theory was that
the creditor had acted unfairly prepetition in obtaining collateral security for $30
million of preexisting unsecured debt in exchange for providing $4 million of new
secured debt. 493 F.3d at84. The chapter 11 trustee had investigated the claim
and determined it lacked merit. 493 F.3d at 85. The district court affirmed the
bankruptcy courts denial. Official Committee of Unsecured Creditors v. Halifax
Fund, L.P. (In re Applied Theory Corp.), 345 B.R. 56 (S.D.N.Y. 2006).
ii.

Holding

The circuit appellate court affirmed the district courts judgment.

iii.

Rationale

While the Bankruptcy Code authorizes a creditors committee to raise

and . . . appear and be heard on any issue in a case under Chapter 11, 11
U.S.C. 1109(b), this provision does not allow the committee to usurp the
trustees role as a representative of the estate with respect to the initiation of
certain types of litigation that belong exclusively to the estate, Hartford
Underwriters Ins. Co. v. Union Planters Bank, N.A., 503 U.S. 1, 8-9 (2000)
(quoting 7 Collier on Bankruptcy 1109.05 (Lawrence P. King et al. eds., rev.
15th ed. 1999)). Moreover, the Bankruptcy Code contains no explicit authority
for creditors committees to initiate adversary proceedings. STN, 779 F.2d at
904. 493 F.3d at 85.
Nevertheless, the Committee argues that STN and Commodore [In re
STN Enterprises, 779 F.2d 90 (2d Cir. 1985) and Commodore Intl Ltd. v. Gould
(In re Commodore Intl Ltd.), 262 F.3d 96 (2d Cir. 2001)] are inapplicable
because they involved derivative claims brought on behalf of a trustee or
debtor-in-possession, whereas its claim for equitable subordination is direct.
According to the Committee, section 510(c) indicates that an equitable
subordination claim is a direct claim that can be commenced by parties in interest

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other than the trustee without first seeking court approval. Unlike other sections
of the code, 510(c), the Committee contends, does not provide that only the
trustee may bring equitable subordination claims. See, e.g., 11 U.S.C. 547,
548 (preference and fraudulent conveyance claims). Citing only out-of-circuit
authority In re Vitreous Steel Prods. Co., 911 F.2d 1223 (7th Cir. 1990) the
Committee urges us to adopt a bright-line rule, under which equitable
subordination claims may be brought directly by a creditor, creditors, or a
creditors committee, without Bankruptcy Court approval. We are not
persuaded. 493 F.3d at 86.
In any event, regardless of how the Committee characterizes it, any
equitable subordination claim brought by the Committee would allege harm to the
Debtor generally and would seek to subordinate the Lenders to other creditors.
Since the Committee is not itself a creditor, it does not have any rights held by
any creditor to assert such a claim against another creditor. In other words, the
Committee has not sustained an injury for which a direct claim might otherwise
be available. 493 F.3d at 87.
iv.

Analysis

Applied Theory erroneously holds a statutory committee requires court

approval to bring an equitable subordination claim for three independently
sufficient reasons. It overlooks (a) 11 U.S.C. 502(a) which expressly grants the
committee authority to object to any claim, (b) the basis of a claim for equitable
subordination as adopted by the Supreme Court,116 which requires inequitable
conduct which injures, not the debtor, but rather, other creditors, and (c) Term
Loan Holder Committee v. Ozer Group, L.L.C., (In re Caldor Corp.), 303 F.3d
161, 162 (2d Cir. 2002), which holds a party in interests right to raise any issue
in a case applies equally in adversary proceedings and contested matters.
11 U.S.C. 502(a) provides:
(a) A claim or interest, proof of which is filed under section 501 of
this title, is deemed allowed, unless a party in interest, including a
creditor of a general partner in a partnership that is a debtor in a
case under chapter 7 of this title, objects.
In turn, 11 U.S.C. 1109(b)117 provides a creditors committee is a party in
interest. Thus, a creditors committee is expressly authorized to object to any
116 United States v. Noland, 517 U.S. 535, 538 (1996).
117 11 U.S.C. 1109(b) provides:

(b) A party in interest, including the debtor, the trustee, a creditors

committee, an equity security holders committee, a creditor, an equity
security holder, or any indenture trustee, may raise and may appear and
be heard on any issue in a case under this chapter.

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proof of claim. Bankruptcy Rule 3001(a) requires a proof of claim to conform

substantially to the Official Forms. Official Form 10 governs proofs of claim and
requires the claimant to list its amount, security, and priority. A party objecting to
a claim, may object to any part of it, including its priority. Section 502(a) should
have begun and ended this dispute. Inexplicably, it is not mentioned in the
district court and Second Circuits opinions. There is no indication the parties
brought it to the courts attention.
Separately, Applied Theory is premised on the notion that the debtor in
possession or trustee starts out owning the interest in equitably subordinating a
claim and the committee has no such interest.118 In fact, the trustee and estate
do not gain or lose anything if one creditor is paid ahead of another. Conversely,
the committee represents all general unsecured claimholders who do gain if the
committee prevails on subordinating a $34 million secured claimholder to the
unsecured claimholders. Thus, Applied Theory assumes the estate owns the
objection to the priority of a secured claim, for which objection the estate receives
no remedy for itself.
To try to make its case that an action for equitable subordination belongs
to the trustee or debtor in possession, Applied Theory assumes that equitable
subordination must allege harm to the debtor generally.119 That is both wrong
and irrelevant. It is wrong because there is no such requirement. It is irrelevant
because the relief requested does not compensate the estate in any way
whatsoever. Rather, eligibility for such relief depends on showing unfairness to
other creditors.
When the United States Supreme Court compiled the grounds for
equitable subordination it did not require that inequitable conduct harm the
debtor, but did recite the need for injury to creditors:
The judge-made doctrine of equitable subordination
predates Congress's revision of the Code in 1978. Relying in part
on our earlier cases, see, e. g., Comstock v. Group of Institutional
Investors, 335 U.S. 211, 92 L. Ed. 1911, 68 S. Ct. 1454 (1948);
Pepper v. Litton, 308 U.S. 295, 84 L. Ed. 281, 60 S. Ct. 238 (1939);
118 The Committee has demonstrated no interest of its own in subordination separate and apart
from the interests of the estate as a whole, and has failed to demonstrate why it should be
permitted to step into the shoes of the trustee. Cf. St. Paul Fire & Marine Ins. Co. v. PepsiCo,
Inc., 884 F.2d 688, 700-03 (2d Cir. 1989). Slip Op. at 7.
119 In any event, regardless of how the Committee characterizes it, any equitable
subordination claim brought by the Committee would allege harm to the Debtor generally and
would seek to subordinate the Lenders to other creditors. Since the Committee is not itself a
creditor, it does not have any rights held by any creditor to assert such a claim against another
creditor. In other words, the Committee has not sustained an injury for which a direct claim
might otherwise be available. Slip Op. at 7-8.

152

Taylor v. Standard Gas & Elec. Co., 306 U.S. 307, 83 L. Ed. 669,
59 S. Ct. 543 (1939), the Fifth Circuit, in its influential opinion in In
re Mobile Steel Co., 563 F.2d 692, 700 (CA5 1977), observed that
the application of the doctrine was generally triggered by a showing
that the creditor had engaged in "some type of inequitable
conduct." Mobile Steel discussed two further conditions relating to
the application of the doctrine: that the misconduct have "resulted in
injury to the creditors of the bankrupt or conferred an unfair
advantage on the claimant," and that the subordination "not be
inconsistent with the provisions of the Bankruptcy Act." Ibid.120
The fact that the remedy for equitable subordination only benefits
some creditors against another creditor and provides no benefit to the
debtor or estate, shows that the trustee or debtor in possession have little
or no interest in a claim for equitable subordination.
Applied Theory also reasons the committee had no direct claim for
equitable subordination of a secured claim.121 That is technically true. It
is the committees constituency, general unsecured claimholders, who
held the direct claim. Applied Theory, however, in attempting to show the
trustee owned the equitable subordination action appears to overlook that
the debtor in possession or trustee are not allowed to bring creditors
claims other than avoidance actions. Caplin v. Marine Midland Grace
Trust Co., 406 U.S. 416 (1972); Shearson Lehman Hutton Inc. v.
Wagoner, 944 F.2d 114, 118 (2d Cir. 1991)( It is well settled that a
bankruptcy trustee has no standing generally to sue third parties on behalf
of the estate's creditors, but may only assert claims held by the bankrupt
corporation itself. Caplin, 406 U.S. at 434 (trustee in Chapter 10
reorganization has no standing to sue indenture trustee, who allegedly
permitted corporation to violate indenture, on behalf of holders of
debentures issued by the corporation). Of course, debtors in possession
and trustees, as parties in interest, are authorized by section 502(a) to
object to claims, including their priorities. In sum, the trustee is authorized
by statute to object to the claim, as is every party in interest such as the
creditors committee. But, the trustee is barred by lack of statutory
authorization and the jurisprudence from suing a creditor on behalf of
other creditors for money damages except for avoidance actions whose
proceeds are made property of the estate by 11 U.S.C. 541(a)(3).
Bankruptcy Rule 7001(7) and (8) provide a proceeding for equitable relief
or to subordinate a claim is an adversary proceeding. Applied Theory appears to
give weight to the notion that because under the Bankruptcy Rules, equitable
subordination requires an adversary proceeding, the committee needs court
approval to commence it. Applied Theory asserts the Bankruptcy Code contains
120 United States v. Noland, 517 U.S. 535, 538-539 (1996).
121 Slip Op. at 8.

153

no explicit authority for creditors committees to initiate adversary proceedings.122

But, in Term Loan Holder Committee v. Ozer Group, L.L.C., (In re Caldor Corp.),
303 F.3d 161, 168-171 (2d Cir. 2002), the Second Circuit exhaustively showed
that when pursuant to 11 U.S.C. 1109(b) the Bankruptcy Code grants a right to
a party in interest such as a creditors committee, to raise any issue in a case,
that right applies to adversary proceedings: We hold, therefore, that the phrase
any issue in a case plainly grants a right to raise, appear and be heard on any
issue regardless whether it arises in a contested matter or an adversary
proceedingAny other construction given to the statute would be contrary to the
accepted principles of statutory interpretation. Id. at 169-170.
The Bankruptcy Rules cannot deprive litigants of rights granted by the
statute. In re Smart World Techs., LLC, 423 F.3d 166, 181 (2d Cir. 2005)
("where a conflict between a Rule and a statutory provision exists . . . the Rules
Enabling Act requires that [the Court] apply the statutory provision." ).
Finally, on the facts of Applied Theory, the holding did no substantive
harm to creditors because their theory underlying equitable subordination was
doomed from the start. In 11 U.S.C. 547(b), Congress showed it would avoid a
transfer collateralizing unsecured debt within 90 days of bankruptcy if certain
other conditions are satisfied, but would not avoid the transfer if made more than
90 days before bankruptcy. Indeed, if the debtor had repaid the debt, instead of
securing it, more than 90 days before bankruptcy, there would be no avoidance
action against the creditor. If repayment is unavoidable, than surely something
less such as collaterizing debt is not voidable. In Applied Theory the transfer had
to have occurred more than 90 days before bankruptcy because otherwise the
creditors would simply have avoided the transfer as a preference. But, when
Congress creates a bright line test of 90 days, it would be completely incongruent
for a court to grant relief when the collateral was granted more than 90 days
before bankruptcy. Moreover, the creditor provided $4 million of new money on a
secured basis. While the creditors committee claims the new money was safe,
the facts that the debtor commenced a bankruptcy case which would initially stop
debt service, and that the committee would try to subordinate the entire $34
million shows the new loan was not commercially safe.
Thus, the harm of Applied Theory is its potential application in future
cases to block committees from pursuing relief in the interest of their creditor
constituencies when the debtor has no incentive to request the relief. Hopefully,
122 While the Bankruptcy Code authorizes a creditors committee to raise and . . . appear and
be heard on any issue in a case under Chapter 11, 11 U.S.C. 1109(b), this provision does not
allow the committee to usurp the trustees role as a representative of the estate with respect to
the initiation of certain types of litigation that belong exclusively to the estate, Hartford
Underwriters Ins. Co. v. Union Planters Bank, N.A., 503 U.S. 1, 8-9 (2000) (quoting 7 Collier on
Bankruptcy 1109.05 (Lawrence P. King et al. eds., rev. 15th ed. 1999)). Moreover, the
Bankruptcy Code contains no explicit authority for creditors committees to initiate adversary
proceedings. STN, 779 F.2d at 904. Slip Op. at 4.

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this harm can be avoided by timely citing of 11 U.S.C. 502(a) and the other
authorities listed above.
19. Can Creditors Commence Derivative Actions without Consent or
Court Approval?
A. PW Enterprises, Inc. v. North Dakota Racing
Commission (In re Racing Services, Inc.), 540 F.3d 892
(8th Cir. 2008)
i.

Facts

Three days before the statute of limitations would expire, a creditor owed
$2 million filed a preference and fraudulent transfer complaint against a
governmental entity holding a $6 million tax priority claim. 540 F.3d at 896. The
creditor contended the government had received a payment improperly classified
as a tax payment. Before the filing, the creditor showed its draft complaint to the
chapter 7 trustee who declined to bring the action. 540 F.3d at 896. Two months
later, the creditor requested bankruptcy court permission to pursue the claims.
The trustee did not oppose the request, but obtained a clarification that the
creditor was bringing it for the estates benefit and was advancing the fees and
costs. 540 F.3d at 897.
The bankruptcy court denied the creditors request for derivative standing
on the ground it had not shown the trustee abused his discretion or acted
unjustifiably by failing to pursue the avoidance claims. 540 F.3d at 897. The
court did not address the consent issue. The bankruptcy appellate panel
affirmed. 540 F.3d at 897. On appeal to the circuit appellate court, the state
argued the bankruptcy courts denial of derivative standing was correct because
the creditor waited till after filing the complaint to request permission. 540 F.3d at
897.
ii.

Issues

What are the requirements for obtaining derivative standing?

In this case, we must decide whether the bankruptcy court erred in
holding that, as a matter of law, a creditor may never obtain derivative standing
to pursue avoidance claims absent a showing that the trustee was unable or
unwilling to do so. 540 F.3d at
Can a creditor be granted derivative standing when the trustee does not
oppose it or consents?
Can a creditor be granted derivative standing when it files the complaint
before seeking permission from the bankruptcy court?

155

iii.

Holdings

[T]o establish derivative standing, a creditors must show: (1) it petitioned

the trustee to bring the claims and the trustee refused; (2) its claims are
colorable; (3) it sought permission from the bankruptcy court to initiate an
adversary proceeding; and (4) the trustee unjustifiably refused to pursue the
claims.To satisfy its burden, the creditor, at a minimum, must provide the
bankruptcy court with specific reasons why it believes the trustees refusal is
unjustified.*** At bottom, the determination of whether the trustee unjustifiably
refuses to bring a creditors proposed claims will require bankruptcy courts to
perform a cost-benefit analysis. 540 F.3d at 900, 901 (Emphasis in original;
footnotes omitted).
Like the Second Circuit, we are persuaded by the reasoning of In re
Spaulding Composites, and hold that a creditor may proceed derivatively when
the trustee (or debtor-in-possession) consents (or does not formally oppose) the
creditors suit.*** We also adopt the Second Circuits standard for establishing
derivative standing when the trustee (or debtor-in-possession) consents:
A creditor[]may acquire standing to pursue the debtors
claims if (1) the [creditor] has the consent of the debtor in
possession or trustee, and (2) the [bankruptcy] court finds that suit
by the [creditor] is (a) in the best interest of the bankruptcy estate,
and (b) is necessary and beneficial to the fair and efficient
resolution of the bankruptcy proceedings.
540 F.3d at 902.
We therefore make plain that a trustees consent is a necessary, but
not sufficient condition for granting a creditor derivative standing in this
context. Regardless of whether a creditor seeks derivative standing
because the trustee unjustifiably refuses to pursue its claims or consents
to the creditors complaint, the bankruptcy court has the same obligation - to carefully scrutinize the request and satisfy itself that derivative
standing is proper under the circumstances. 540 F.3d at 903.
Our rejection of a per se rule forbidding retroactive grants of derivative
standing should not be understood as limiting the bankruptcy courts
authority to deny such requests in the appropriate circumstances. But
bankruptcy courts should not, as a matter of course, either reject or grant
motions for retroactive authorization. Rather, they must evaluate each
request independently. We caution bankruptcy courts, however, from
exclusively relying on the fact that a creditor filed its motion after its
complaint as a basis for denying meritorious derivative actions. 540 F.3d
at 904 (emphasis in original).

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We conclude that a creditor (or creditors committee may obtain

derivative standing to pursue avoidance actions under circumstances in
which the trustee (or debtor-in-possession) either unjustifiably refuses to
bring the creditors proposed claims or consents to the creditor pursuing
such claims in his stead. We also hold that the bankruptcy courts may
retroactively grant a creditor derivative standing. We emphasize,
however, that under no circumstances may a creditor prosecute its
derivative complaint without the bankruptcy courts permission. 540 F.3d
at 904-905 (emphasis in original).
iv.

Analysis

As the Eighth Circuit acknowledges, it largely adopts the Second Circuits

standards for the grant of derivative standing, with one exception. Namely, the
Eighth Circuit expressly allows a creditor to commence a derivative action before
obtaining bankruptcy court approval. While the facts here were that there was
little or no time to obtain approval before the statute of limitations expired, that
portion of the ruling is troublesome for two reasons.
First, commencing an action that the trustee controls is a violation of the
automatic stay under 11 U.S.C. 362(d)(3). The stay was not discussed in the
decision.
Second, once creditors and committees know they can commence
derivative actions before obtaining court approval, the case dynamics and game
theory change. Debtors in possession will not want to risk losing control of
actions to third parties. Therefore, this decision motivates them to be more
trigger happy to eliminate the risk that a third party may take control. In the
future, debtors may attempt to obtain declaratory judgments that derivative
standing should not be granted, to eliminate the risk of a third party grabbing
control of a cause of action and becoming a factor in negotiations with the party
being sued.
B. After Derivative Standing is Granted, It Can be
Taken Away
i.

Official Committee of Equity Security Holders v. Official

Committee of Unsecured Creditors (In re Adelphia Communications
Corp.), 544 F.3d 420 (2d Cir. 2008)
a)

Facts

In the Adelphia chapter 11 case, a statutory equity committee was

appointed when there existed a possibility of residual value for equity holders.
544 F.3d at 422. After the debtor rejected a demand to bring certain claims

157

against its bank lenders and investment banks, the court granted the equity
committee derivative standing to do so, and the debtor neither objected nor
supported the equity committees request to do so. 544 F.3d at 422-423.
Subsequently, the bankruptcy court confirmed Adelphias chapter 11 plan
under which the action controlled by the equity committee would be transferred to
a litigation trust managed by 5 trustees appointed by the creditors committee.
544 F.3d at 423. The bankruptcy court determined creditors would have to
recover $6.5 billion before there would be money to flow to shareholders, and
that rendered the equityholders hopelessly out of the money. In re Adelphia
Communications Corp., 368 B.R. 140, 272 (Bankr. S.D.N.Y. 2007), quoted at .
544 F.3d at 423. The class of equityholders accepted the plan. 544 F.3d at
426n.7. The equity committee appealed and the district court dismissed the
appeal as equitably moot. In re Adelphia Communications Corp., 371 B.R. 660
(S.D.N.Y. 2007).
b)

Issues

After granting the equity committee derivative standing, could the

bankruptcy court retract the derivative standing without the equity committees
consent? If so, did the bankruptcy court abuse its discretion in doing so?
c)

Holding

Yes. We hold that, to the contrary, a court may withdraw a committees

derivative standing and transfer the management of its claims, even in the
absence of that committees consent, if the court concludes that such a transfer
is in the best interests of the bankruptcy estate. 544 F.3d at 423.
We do not mean to trivialize, but only to place in context, the role of the
derivative plaintiff. It serves with the approval and supervision of a bankruptcy
court and shares the labor of litigation with the debtor-in-possession.
Commodore, 262 F.3d at 100. Contrary to the Equity Committees arguments,
however, it does not usurp the central role of the court or debtor in overseeing
and managing the estates legal claims. In re Adelphia Communications Corp.,
544 F.3d 420, 427 (2d Cir. 2008).
The bankruptcy court did not abuse its discretion in transferring the equity
committees derivative standing to the litigation trust because the trustees of the
litigation trust were required by the plan to maximize the value of the transferred
Causes of Action, whether by litigation, settlement or otherwise, and the trustees
are liable for deliberately intending to injure, or recklessly disregarding the best
interests of, interest holders in the litigation trust (including equity holders), and
the bankruptcy court conducted a reasonable analysis of the costs and benefits
of the Equity Committees continued management of the claims. 544 F.3d at
425.

158

d)

Analysis

It is always dangerous for litigation to be controlled by a party having no

interest in it unless it results in a grand slam homerun, as was the case here. As
a practical matter, a party given derivative standing can not prosecute or settle a
claim effectively if the debtor retains the right to settle. Therefore, it becomes an
important part of case management for the bankruptcy court to make clear that a
party given derivative standing is the only party who can prosecute or settle until
such time as the bankruptcy court transfers the derivative standing after notice
and hearing and after determining the transfer is in the best interests of the
estate.
C. Does the Transfer of a Claim Render the Transferree Vulnerable
to Defenses Personal to the Transferor?
1. Enron Corp. v. Springfield Associates,
LLC (In re Enron Corp.), 379 B.R. 425
(S.D.N.Y. 2007), motion for certification
of interlocutory appeal denied, 2007
Dist. LEXIS 70731 (S.D.N.Y., Sept. 2,
2007).
i.

Facts

When Enron commenced its chapter 11 case on December 2, 2001,

pursuant to a short term credit agreement it owed Citibank over $1.7 billion.
During Enrons chapter 11 case, approximately $5 million of Citibanks claim was
transferred first to Deutsche Bank and then to Springfield Associates. Each
transfer included sales and assignment agreements and each one indemnified
the buyer against equitable subordination and disallowance of the transferred
claim. Enron Corp. v. Springfield Associates, LLC (In re Enron Corp.), 379 B.R.
425, 428-429 (S.D.N.Y. 2007). Enron commenced an adversary proceeding
against Citibank seeking equitable subordination of its claims, disallowance of its
claims pursuant to 11 U.S.C. 502(d), and compensatory and punitive damages
for aiding and abetting fraud and breach of fiduciary duty. 379 B.R. at 429.
Subsequently, Enron commenced adversary proceedings against Springfield and
other transferees, alleging their claims should be equitably subordinated and
disallowed pursuant to 11 U.S.C. 502(d), all based on facts relating to Citibank.
379 B.R. at 429.
The district court granted leave to Springfield to prosecute interlocutory
appeals of the bankruptcy courts denials of Springfields motions to dismiss the
adversary proceedings. 379 B.R. at 430.

159

The bankruptcy court had reasoned: [B]ased on the Court's previous

policy analysis, no legal and policy basis supports the premise that transferees of
bonds or notes should be treated differently than those holding the transferred
loan claims. All the post-petition transferees assume the risk that their claims
may be subject to subordination." Enron Corp. v. Springfield Assocs., L.L.C. (In
re Enron Corp.), Nos. 01-16034, 05-01025, slip op. (Bankr. S.D.N.Y. Nov. 28,
2005) (emphasis added)); Enron Corp. v. Avenue Special Situations Fund II, LP
(In re Enron Corp.), 340 B.R. 180, 201 n. 23 (Bankr. S.D.N.Y. 2006) (stating the
same, but substituting "disallowed" for "subordinated" and "section 502(d)
disallowance" for "subordination").
ii.

Issue

The question presented, as the Court stated in its January 30, 2007 Opinion
granting leave to file this interlocutory appeal, is whether equitable subordination
under 510(c) and disallowance under 502(d) can be applied, as a matter of law,
to claims held by a transferee to the same extent they would be applied to the
claims if they were still held by the transferor based on alleged acts or omissions
on the part of the transferor." 379 B.R. at 427-28. (quoting Enron Corp. v.
Springfield Assocs., L.L.C. (In re Enron Corp.), No. M47, 2007 U.S. Dist. LEXIS
9151, 2007 WL 313470, at *1 (S.D.N.Y. Feb. 1, 2007).
iii.

Holding

I conclude that equitable subordination under section 510(c) and

disallowance under section 502(d) are personal disabilities that are not fixed as
of the petition date and do not inhere in the claim. Nevertheless, Springfield may
be subject to equitable subordination and disallowance based solely on the
conduct of the transferor if the claims were transferred to Springfield by way of an
assignment. Accordingly, the Bankruptcy Court's Subordination Order and
Disallowance Order are VACATED, and the matter is REMANDED to the
Bankruptcy Court to decide the motion to dismiss consistent with this Opinion.
379 B.R. at 448-449. (emphasis in original).
iv.

Rationale

Initially, the court rejected Enrons contention that based on Sexton v.

Dreyfus, 219 U.S. 339 (1911), and United States v. Marxen, 307 U.S. 200
(1939), the priority and allowability of claims is fixed on the petition date. 379
B.R. at 438. The district courts rationale was that equitable subordination can
not be determined on the petition date because it requires court action, is
discretionary, and is sometimes based on postpetition conduct, and disallowance
under 11 U.S.C. 502(d) depends on whether the claimant returns voidable
transfers it received. 379 B.R. at 438-439.

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Next, the court ruled that equitable subordination and disallowance

pursuant to 11 U.S.C. 502(d) are personal disabilities that do not inhere in the
claim; therefore they are only transferred to the transferee if the claim is
assigned, as opposed to sold. 379 B.R. at 439-442.
The district court adopted the rule that the assignment of a claim puts the
transferee in the shoes of the transferor and thereby entitles the counterparty to
assert against the transferee whatever defenses it has against the transferor
even if they do not relate to the assigned claim, from Caribbean S.S. Co., S.A. v.
Sonmez Denizcilik Ve Ticaret A.S., 598 F.2d 1264, 1266-67 (2d Cir. 1979) and
29 Williston on Contracts 74:47 (4th ed. 2003) (an assignee is "subject to all
defenses that the obligor may have against the assignor, including . . . defenses .
. . that relate to the assigned obligation itself, but also rights . . . [that] aris[e] out
of separate matters that the obligor might have asserted against its original
creditor, the assignor"). 379 B.R. at 436.
The district court acknowledged an exception to the rule exists if the
assignee is a holder in due course of a negotiable instrument. 379 B.R. at 436437. But, given that UCC 3-302 provides that a holder cannot be a holder in
due course if it takes the debt with knowledge it is overdue, someone who
purchases debt after the debts maker is in bankruptcy cannot qualify as a holder
in due course. 379 B.R. at 437. (Additionally, debt from a credit agreement
would not qualify as a negotiable instrument in the first place because under
UCC 3-314 it contains promises other than unconditional promises to pay.)
The district court also acknowledged that states following the third party
latent equities doctrine do not allow the assignee to be subject to personal
defenses of the maker of which it was unaware. 379 B.R. at 437.
Conversely, the district court reasoned a sale of a claim to a good faith
purchaser has a different result then an assignment based on UCC 8-202(d):
See, e.g., N.Y. U.C.C. 8-202(d) (stating that all defenses of the
issuer of a security with enumerated exceptions, are ineffective
against a purchaser for value who has taken the security without
notice of the particular defense (emphasis added)).
379 B.R. at 436 n. 58. The district court cites In re Latham Lithographic Corp.,
107 F.2d 749, 750 (2d Cir. 1939), to support its ruling that sale of debt does not
allow the borrower to assert personal defenses against the purchaser. Latham
Lithographic holds that if a claim is sold, the purchaser can vote the claim for or
against a reorganization plan even if the seller would have been unable to vote it.
Based on its reasoning that the outcome of the case turns on whether the
claim was transferred by assignment or sale, the district court rejects In re
Metiom, 301 B.R. 634 (Bankr. S.D.N.Y. 2003), because it assumes assignment
principles apply. Ironically, the district court also rejects In re Wood & Locker,
161

Inc., No. MO 88 CA 011, 1988 U.S. Dist. LEXIS 19501 (W.D. Tex. June 17,
1988), because, although it refused to attribute to the transferee the conduct of
the transferor, it focused on the conduct of the transferee instead of analyzing
whether the claim was transferred by sale or assignment. 379 B.R. at 444-445.
To determine whether a claim is transferred by sale or assignment, the
district court noted that the transfer documents will sometimes provide the
answer, but in other situations it will be obvious. Specifically, the court notes that
sales of claims on the open markets are indisputably sales and subrogation of a
surety to the rights under a claim is indisputably an assignment. 379 B.R. at
446 n. 104.
Finally, although the district court observes that its decision is driven by
the statutes and case law, and it will not make policy decisions reserved for the
legislature, the district court explains that its decision will only allow for claims
washing in limited circumstances (when the claim is sold to a bona fide
purchaser for value) and there the debtor can sue the claim-transferor, albeit the
timing and standard of proof may be longer and higher. 379 B.R. at 448.

v.

Analysis

By seizing on the word purchaser in UCC 8-202(d) to create a

distinction between sales and assignments, the district court overlooked the
Uniform Commercial Codes definitions of purchase and purchaser. In short, a
purchaser takes by purchase and a purchase is not only a sale, but also any
other voluntary transaction creating an interest in property.123 Therefore, a
purchase is a sale and is also an assignment because an assignment is a
voluntary transaction creating an interest in property.
The district court also did not take into account section 13-105 of the New
York General Obligations law. There is no indication it was brought to the courts
attention. Pursuant to section 13-105, when a claim is transferred, the debtor
can defend against the claim with any defense or counter-claim, existing against

123 U.C.C. 1-201(29-30) provides:

29) "Purchase" means taking by sale, lease, discount, negotiation,
mortgage, pledge, lien, security interest, issue or reissue, gift, or any
other voluntary transaction creating an interest in property.
(30) "Purchaser" means a person that takes by purchase.

162

the transferrer, before notice of the transfer 124 A transfer includes both
sales and assignments as the district court acknowledges. 379 B.R. at 435 n.
52.
Likewise, the district court overlooked UCC 9-404(a)(2) and (b) 125 which
provide an assignee of bank debt takes the claim subject to any other defense
or claim of the account debtor, to reduce the amount the account debtor owes.
Equitable subordination is subsumed within reducing the amount the account
debtor owes because its effect is to lower the assigned claims priority which may
result in the account debtor paying the claim amount or a reduced amount.
New York General Obligations Law 13-105 provides:

124

Effect of transfer of claim or demand

Where a claim or demand can be transferred, the transfer thereof
passes an interest, which the transferee may enforce by an action or
special proceeding, or interpose as a defense or counter-claim, in his
own name, as the transferrer might have done; subject to any defense
or counter-claim, existing against the transferrer, before notice of the
transfer, or against the transferee. But this section does not apply,
where the rights or liabilities of a party to a claim or demand, which is
transferred, are regulated by special provision of law; nor does it vary
the rights or liabilities of a party to a negotiable instrument, which is
transferred.
125

UCC 9-404 (a) and (b) provide:

RIGHTS ACQUIRED BY ASSIGNEE; CLAIMS AND DEFENSES AGAINST

ASSIGNEE.
(a) [Assignee's rights subject to terms, claims, and defenses; exceptions.]
Unless an account debtor has made an enforceable agreement not to assert
defenses or claims, and subject to subsections (b) through (e), the rights of an
assignee are subject to:
(1) all terms of the agreement between the account debtor and assignor and any
defense or claim in recoupment arising from the transaction that gave rise to the
contract; and
(2) any other defense or claim of the account debtor against the assignor which
accrues before the account debtor receives a notification of the assignment
authenticated by the assignor or the assignee.
(b) [Account debtor's claim reduces amount owed to assignee.]
Subject to subsection (c) and except as otherwise provided in subsection (d), the
claim of an account debtor against an assignor may be asserted against an
assignee under subsection (a) only to reduce the amount the account debtor owes.

163

The district courts reliance on In re Latham Lithographic Corp., 107 F.2d

749, 750 (2d Cir. 1939), to support its thesis that the purchase of a claim
insulates it from being subordinated is based on a misunderstanding of
bankruptcy law and a misreading of Latham Lithographic. The Bankruptcy Code
and prior case law disallowed creditor votes for a trustee, not claims. Indeed, the
Latham Lithographic court explained the purpose of the statute was to prevent
entities owning interests in the bankrupt from voting to elect a trustee too friendly
to the bankrupt. 107 F.2d at 750. There is nothing in the decision to suggest
that the court would hold that once the claim is no longer held by an insider
creditor, it can not be voted if it were assigned, but can be voted if it were sold.
Rather, the court referred to a creditor who would be disqualified to vote who
assigns it [the claim] in good faith to a purchaser who is not disqualified 107
F.2d at 750 (emphasis supplied). Thus, the courts own language embraces
assignments and purchases (and purchases include sales and assignments),
and makes clear that once a claim is held by a purchaser who is not
disqualified, 107 F.2d at 750, it can be voted. After referring to the fact that part
of the claim was assigned, the court ultimately did not allow the claimholder to
vote the claim because the actual claim was held in trust and could be voted by a
trustee, and what was assigned was only a beneficial interest in the claim. 107
F.2d at 751.
Accordingly, while it appears the courts ruling that when claims are
assigned they are assigned subject to defenses against the transferor (with
certain exceptions described above) is consistent with applicable statutes and
case law, the courts different holding for sales of claims appears inconsistent
with applicable law.
Additionally, the courts rejection of the principle that claims should be
adjudicated as of the petition date appears flawed. While it is not possible to
determine a claims allowability on the petition date, it can be done as of the
petition date. And, the fact that equitable subordination is discretionary is no bar.
Discretion must be exercised one way or the other and is reversible for abuse of
discretion. The reason for determining claims as of the petition date is to avoid
postpetition tactical behavior as explained in In re Brints Cotton, 737 F.2d 1338
(5th Cir. 1984). The importance of this concept cannot be overemphasized. For
instance, a debtor may propose a plan classifying a claim likely to be equitably
subordinated in a separate class because it would not be similar to
unsubordinated claims and therefore would be ineligible for classification with
them pursuant to 11 U.S.C. 1122. On the eve of confirmation, the claimant
could wash its claim by selling it to a market buyer. The underpinning of the
whole plan could be upset. Put differently, the district courts decision provides a
recipe for claim owners to wash their claims.
Finally, in many cases, the availability of an action to equitably
subordinate a claim does not mean the debtor has any valid action against the

164

creditor for affirmative damages. Equitable subordination requires conduct

inequitable to other creditors, United States v. Noland, 517 U.S. 535 (1996), and
may or may not include conduct for which the debtor has a cause of action.
For now, claim buyers will continue to want to make sure they have
indemnity against defenses applicable to the claim transferor. But, it will be in
the interests of the claim transferor and claim transferee to document the transfer
as a sale and to negate its transfer as an assignment. This is not necessarily
easily done when trading bank claims because the purchaser has to step into the
shoes of the transferor because it assumes the transferors obligations to the
bank agent, such as to make advances, pay agent fees, and the like.
20. Must A Chapter 11 Petition Be Filed with A Valid Reorganizational
Purpose?
A. Official Committee of Unsecured Creditors v. Nucor Corp. (In re
SGL Carbon Corporation), 200 F.3d 154 (3d Cir. 1999)
i.

Facts.

SGL was an American subsidiary of a German company. It manufactured

and sold graphite electrodes used in steel production. The United States
government commenced a price-fixing investigation of SGL, which was followed
by class action and individual antitrust lawsuits by private parties. SGL took a
$240 million reserve for liability and filed its chapter 11 petition prior to the guilty
pleas of its chairman and its agreement to pay a $135 million criminal fine.
Upon filing, SGL issued press releases. One provided it filed to protect
itself against excessive demands made by plaintiffs in civil antitrust litigation and
in order to achieve an expeditious resolution of the claims against it.
SGL CARBON Corporation is financially healthy. 200 F.3d at 157. On a
conference call with security analysts, SGLs chairman said its chapter 11
petition was fairly innovative [and] creative because usually Chapter 11 is used
as protection against serious insolvency or credit problems, which is not the case
[with SGL Carbons petition.] Id. at 158
In deposition testimony, SGLs vice president stated the chapter 11 case
would change the negotiating platform with plaintiffs and increase the pressure
on plaintiffs to settle. Id. SGL officers expressly and repeatedly
acknowledged Chapter 11 petition was filed solely to gain tactical litigation
advantages. Id. at 167.

165

SGL also proposed a plan impairing only the plaintiffs. It provided the
plaintiffs could purchase SGLs product at discounts for 30 months after
confirmation and barred plaintiffs from bringing any action against SGLs affiliates
arising out of their claims against SGL. Id. at 157
The bankruptcy court found the antitrust litigation posed a serious threat to
SGLs continued operations and a judgment could cause the company financial
and operational ruin. Id. at 158-159.
ii.

Holding.

The Court of Appeals held the findings clearly erroneous because the
evidence showed the company was not losing customers and was meeting its
targets and because the officers were insisting the company was financially
healthy. Also, there was no evidence of the amount being sought by plaintiffs
and SGLs records showed an estimate of $54 million. Id. at 163. Then, the
court ruled there is a requirement under Bankruptcy Code section 1112(b) that a
filing have a valid reorganizational purpose.
The mere possibility of a future need to file, without more does not
establish that a petition was filed in good faith. Id. at 164.
Significantly, the court conceded the Bankruptcy Code encourages early
filing.It is well established that a debtor need not be insolvent before filing for
bankruptcy protection.It also is clear that the drafters of the Bankruptcy Code
understood the need for early access to bankruptcy relief to allow a debtor to
rehabilitate its business before it is faced with a hopeless situation.Such
encouragement, however, does not open the door to premature filing, nor does it
allow for the filing of a bankruptcy petition that lacks a valid reorganizational
purpose. Id. at 163.
Although the proposed plan would be subject to a good faith
determination, where a debtor attempts to abuse the bankruptcy process,
proceedings should end well before formal consideration of the plan." Id. at
167n.19.
iii.

Analysis.

First, the appellate courts overturning of the bankruptcy courts findings

shows 2 things: the making of a poor record and a lack of reality. Empirically,
even the most financially strapped debtors make press releases boasting of
financial health after they file. The releases are true in the context of the debtor
in possession that doesnt have to worry about its prepetition debt. Any other
type of release is a recipe to lose all future business in a hurry! Can you imagine
a debtor issuing a press release that its operations are in jeopardy?! SGL should
166

have explained that in the record. Presumably, SGS did not take good attorneys
advice to emphasize the need to quickly resolve the litigation to avoid a
downward spiral in the business.
SGLs initial proposed plan was also suspect. Although it was a good idea
to file a proposed plan at the outset of the case to demonstrate the debtor wants
to reorganize its balance sheet and move on, the terms of the plan were
offensive. Clearly, the plaintiffs would reject a plan offering them nothing but
discounts. There does not appear to be any basis to discriminate against the
plaintiff class. To determine the value of the discounts as a percentage of
plaintiffs claims, the bankruptcy court by estimation or otherwise (or another
tribunal) would have to try the claims. In short, the plan was not well conceived.
Clearly, SGL should not have postured the case as a litigation tactic. It
should have postured it as a prudent method of preserving its assets for all
creditors while resolving its litigation in a responsible way without the threat of
judgments and levies that could destabilize its operations.
Second, the appellate court overlooked the fact that chapter 11 is a
process to cause a fair allocation of a companies asset value. Notwithstanding
SGLs proposed chapter 11 plan, creditors may have proposed competing plans
and the court was not required to confirm SGLs plan because section 1129(a)(3)
does require that plans be proposed in good faith. Theres the rub. It was
unnecessary for the court to impose a good faith filing requirement. That
requirement suffers from 2 major problems.
First, the chapter 11 process is conditioned on the mindset of the
individuals determining to file the petition. That makes no sense. The fair
allocation of value should not depend on the mindset of the control persons. The
filing puts SGL at risk of having a plan that will sell the company and pay off all
claims leaving the shareholders with nothing. The chapter 11 process may well
not favor the debtor!
Second, the holding will create much litigation over petitions due to its
carefully couched language on the one hand acknowledging the need to file
early, while on the other hand imposing a hard-to-define requirement for a valid
reorganizational purpose.
B. Solow v. PPI Enterprises (U.S.), Inc. (In re PPI Enterprises (U.S.),
Inc.) 324 F.3d 197 (3d Cir. 2003)
i. Facts
Solow leased office space in 1989 to PPI Enterprises (PPIE) for 10
years. Annual rent was $620,000 per year for the first five years, then $650,000
167

per year thereafter. Poly Peck, the indirect corporate parent of PPIE guaranteed
the lease and Sanwa Bank issued Solow a stand-by letter of credit for $650,000
which the lease required PPIE to replenish or replace with a security deposit to
the extent the letter of credit was used. 324 F.3d at 200. The lease required a
security deposit, but provided a letter of credit would satisfy the requirement. 324
F.3d at 210. About two years after the lease commenced, Polly Peck
commenced insolvency proceedings in Great Britain and PPIE faced defaults
exceeding $17 million. 324 F.3d at 200.
Solow contended PPIE engaged in transactions designed to reduce his
eventual damages claim. For instance, PPIEs parent sold stock for $15 million
to a third party, transferred the $15 million to Sanwa Bank, and treated the
transfer as a loan to PPIE, even though PPIE owed no obligation to Sanwa Bank.
324 F.3d at 200n. 3. Also, PPIE acquired a 2% interest in Del Monte Food Co.
for $12.6 million, but transferred the interest to Polly Peck for an accounting
credit. Later, Polly Pecks English administrators sold the stock back to PPIE for
$12. 6 million and PPIEs vice president for finance reduced its balance sheet
value to $3.5 million. 324 F.3d at 200n.3. When during PPIEs chapter 11 case
Del Monte agreed to repurchase the interest for $1.6 million subject to higher
offers, Solow objected and ultimately purchased the interest for $11 million and
resold it to Texas Pacific Group for $30 million. 324 F.3d at 201n. 5.
In 1991, PPIE abandoned the office space and ceased paying rent. After
liability was established and the parties negotiated, Solow asked the court to
schedule a damages hearing. On the eve of that hearing, PPIE commenced its
chapter 11 case in 1996. PPIE stated its chapter 11 case had 4 objectives: (a)
the Polly Peck wind down, (b) liquidating PPIE, (c) invoking provisions to reject
the restriction on the sale of the Del Monte stock, and (d) limiting Solows lease
termination damages under Bankruptcy Code section 502(b)(6). 324 F.3d at
201. Solow moved to dismiss the chapter 11 case for bad faith alleging it was
filed to create value for Polly Peck and its creditors at his expense and without
any intent to effectuate a corporate reorganization. The bankruptcy court denied
the motion without prejudice. 324 F.3d at 201.
PPIE proposed a chapter 11 plan in which Solow was in Class 2 (noninsider general unsecured claims), which was to be paid 100 cents on the dollar
in cash and other consideration as required. 324 F.3d at 201n. 6. In Class 2,
PPIE solicited votes even though it contended the class was unimpaired. Solow
voted no and one creditor voted yes. Solow contends the class rejected the
plan. 324 F.3d at 202.
At confirmation, Solow renewed his motion to dismiss and contended his
claim was improperly classified as unimpaired. The bankruptcy court determined
Solows damage claim of $4,757,824.94 was subject to the statutory cap in
Bankruptcy Code section 502(b)(6) and had to be further reduced by the
$650,000 Solow had drawn on the letter of credit. The court also ruled the

168

chapter 11 case was filed in good faith and that Solow was unimpaired and
therefore deemed to have accepted the plan. 324 F.3d at 202. The district court
affirmed without opinion.
ii. Issues
Does 11 U.S.C. 502(b)(6) render Solows claim impaired under 11
U.S.C. 1124126?
Is a claim impaired under 11 U.S.C. 1124 if it is paid in full in cash
without postpetition interest?
126 Bankruptcy Code section 1124 provides:
Impairment of claims or interests. Except as provided in section
1123(a)(4) of this title, a class of claims or interests is impaired
under a plan unless, with respect to each claim or interest of such
class, the plan
(1)

leaves unaltered the legal, equitable, and contractual

rights to which such claim or interest entitles the
holder of such claim or interest; or

(2)

notwithstanding any contractual provision or

applicable law that entitles the holder of such claim or
interest to demand or receive accelerated payment of
such claim or interest after the occurrence of a
default
(A)
cures any such default that occurred before or
after the commencement of the case under this title,
other than a default of a kind specified in section
365(b)(2) of this title;
(B)
reinstates the maturity of such claim or interest
as such maturity existed before such default;
(C)
compensates the holder of such claim or
interest for any damages incurred as a result of any
reasonable reliance by such holder on such
contractual provision or such applicable law; and
(D)
does not otherwise alter the legal, equitable, or
contractual rights to which such claim or interest
entitles the holder of such claim or interest.

169

Does the amount of the letter of credit held by the lessor reduce the
lessors allowable claim under 11 U.S.C. 502(b)(6)127?
Is a chapter 11 petition filed in good faith for purposes of 11 U.S.C.
1112(b) and a chapter 11 plan proposed in good faith for purposes of 11 U.S.C.
1129(a)(3) if filed and proposed to avail the debtor of 11 U.S.C. 502(b)(6)?
iii. Holdings
Impairment based on Statute. Accordingly, we hold that where
502(b)(6) alters a creditors nonbankruptcy claim, there is no alteration of the
claimants legal, equitable, and contractual rights for the purposes of impairment
under 1124(1). 324 F.3d at 204.
Impairment based on Lack of Postpetition Interest. In other words,
1124(1) and (3) were different exceptions to the presumption of impairment, and
the repeal of one should not affect the other. We agree with the Bankruptcy
Courts analysis. Contrary to Solows representations, the legislative history
does not reflect a sweeping intent by Congress to give impaired status to
creditors more freely outside the postpetition interest context. Instead, as the
Bankruptcy Court noted, the legislative history accompanying the repeal of
1124(3) indicated the principal change in the repeal relates to the award of post
petition interest. The congressional committee specifically referenced the New
Valley decision without referencing the text of 1124(1) or the many cases
addressing its provisions, including Solar King. Therefore, the legislative history
supports our holding. 324 F.3d at 207.
127 Bankruptcy Code section 502(b)(6) provides:
If an objection to a claim is made, the court, after notice and a
hearing, shall determine the amount of such claim in lawful
currency of the United States as of the date of the filing of the
petition, and shall allow such claim in such amount, except to the
extent that if such claim is the claim of a lessor for damages
resulting from the termination of a lease of real property, such claim
exceeds
(A)
the rent reserved by such lease, without acceleration,
for the greater of one year, or fifteen percent, not to exceed three
years, of the remaining term of such lease, following the earlier of
(i) the date of the filing of the petition; and (ii) the date on which
such lessor repossessed, or the lessee surrendered, the leased
property; plus
(B)
any unpaid rent due under such lease, without
acceleration, on the earlier of such dates.
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Application of Letter of Credit Proceeds towards Capped Claim.

Nonetheless, we need not decide the underlying question because it is clear the
parties intended the letter of credit to operate as a security deposit. 324 F.3d
at 210. In turn, the court affirmed the ruling that Solows allowable claim was
limited to the amount computed under the cap in section 502(b)(6) minus the
amount Solow drew on the letter of credit.
Good Faith. A good faith determination must be a fact-intensive inquiry.
Here, the Bankruptcy Court analyzed the purpose of 502(b)(6) and the totality
of the circumstances, and determined that PPIEs bankruptcy filing did not
contravene the good faith requirement. Under the circumstances, we see no
abuse of discretion. 324 F.3d at 211-212. In NMSBPCSLDHB, L.P. v. Integrated
Telecom Express, Inc. (In re Integrated Telecom Express, Inc.), ___ F.3d ___, ___
(3d Cir. 2004), the court ruled PPI stands for the proposition that an insolvent
debtor can file under Chapter 11 in order to maximize the value of its sole asset
to satisfy its creditors, while at the same time availing itself of the landlord cap
under 502(b)(6).
iv. Rationale and Evaluation
No Impairment by Statute. Generally, we agree with the Solar King [90
B.R. 808 (Bankr. W.D. Tex. 1988)] analysis. The relevant impairment language
requires bankruptcy plans to leave unaltered those rights to which the creditors
claim or interest entitles the holder of such claim or interest. 11 U.S.C.
1124(1). This language in 1124(1) does not address a creditors claim under
nonbankruptcy law. The use of a present-tense verb suggests a creditors rights
must be ascertained with regard to applicable statutes, including the 502(b)(6)
cap. In other words, a creditors claim outside of bankruptcy is not the relevant
barometer for impairment; we must examine whether the plan itself is a source of
limitation on a creditors legal, equitable, or contractual rights. 324 F.3d at 204.
In sum, PPIEs Chapter 11 Plan intends to pay Solow his legal
entitlement and provide him with full and complete satisfaction of his claim on
the date the Plan becomes effective. Solow is only entitled to his rights under
the Bankruptcy Code, including the 502(b)(6) cap. Solow might have received
considerably more if he had recovered on his leasehold claims before PPIE filed
for bankruptcy. But once PPIE filed for Chapter 11 protection, that hypothetical
recovery became irrelevant. Solow is only entitled to his legal, equitable, and
contractual rights, as they now exist. Because the Bankruptcy Code, not the
Plan, is the only source of limitation on those rights here, Solows claim is not
impaired under 1124(1). 324 F.3d at 205.
This result is virtually guaranteed by logic and common sense. If the
holder of a capped claim being paid in full in cash on the effective date is allowed
to reject a plan, what are the possible consequences? If the rejection causes the
171

class to reject, but the plan is still confirmable, then section 1129(b)(2)(B) is
triggered and the same plan can be confirmed as long as the rejecting class is
paid in full before any junior class participates. In that scenario, the rejection
does not yield a different result than the deemed acceptance by an unimpaired
class. If, however, the rejection makes confirmation impossible because there is
no impaired accepting class without counting insider votes, then there are 2
potential consequences. One is that the case is converted to chapter 7 and the
rejecting capped claim receives the same or less than what is would receive
under the plan. This can not possibly be a result desired by Congress or the
rejecting landlord. The other potential consequence is that the case is
dismissed. This would mean that if a landlord doesnt like the statutory cap on its
claim and has enough voting power, the landlord can prevent all parties in
interest from obtaining the benefits of chapter 11. Put differently, the statutory
cap imposed by Congress for fairness purposes, would be used to create
unfairness to all other parties. It is inconceivable Congress intended such a
result.
No Impairment Due to Lack of Postpetition Interest in Insolvent Estate.
The United States Court of Appeals for the Third Circuit opined based on
references to In re New Valley Corp., 168 B.R. 73 (Bankr. D.N.J. 1994), in the
legislative history accompanying Congress repeal of 11 U.S.C. 1124(3) (a
class of claims is impaired unless the plan (3) provides that, on the effective
date of the plan, the holder of such claim or interest receives, on account of such
claim or interest, cash equal to (A) with respect to a claim, the allowed amount
of such claim.) that Congress only intended to render fully paid claims
impaired when, as in New Valley, they were entitled to postpetition interest from
a solvent estate. 324 F.3d at 206-207.
Although some courts have held allowed claims against insolvent estates
that are fully paid in cash on the effective date are impaired due to the repeal of
section 1124(3), see, e.g., In re Seasons Apartments, L.P., 215 B.R. 953, 955956 (Bankr. W.D. La. 1997); In re Crosscreek Apartments, Ltd., 213 B.R. 521,
536 (Bankr. E.D. Tenn. 1997); Equitable Life Ins. Co. of Iowa v. Atlanta-Stewart
Partners, 193 B.R. 79, 80 (Bankr. N.D. Ga. 1996); In re David Green Property
Management, 1994 Bankr. LEXIS 206 (Bankr. W.D. Mo. 1994), the legislative
history and the wording of section 1124(1) convinced the appellate court that
denial of postpetition interest from insolvent estates is not a basis for impairment.
The jurisprudence has long entitled unsecured claimholders to postpetition
interest from solvent estates. See, e.g., Consol. Rock Prods. Co. v. Dubois, 312
U.S. 510 (1941); Debentureholders Protective Committee of Continental Inv.
Corp. v. Continental Inv. Corp., 679 F.2d 264, 269 (1st Cir. 1982).
Those courts that treat claims paid in full in cash as impaired, enable plan
proponents in certain cases to obtain an impaired accepting class for purposes of
11 U.S.C. 1129(a)(10) and to deploy section 1129(b)(2) against rejecting

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classes. The notion that a fully paid class should satisfy the impaired accepting
class requirement is contrary to the democratic theme built into the Bankruptcy
Code. That said, even prior to the elimination of section 1124(3), a class paid
99.9 cents on the dollar was indisputably impaired and its acceptance would
count for purposes of section 1129(a)(10).
The Claim Limited by Section 502(b)(6) is Reduced by Letter of
Credit Draws. It has long been the law that a landlord holding a security deposit
from its debtor-tenant must reduce its claim capped by the bankruptcy statutes
by the amount of the security deposit. Oldden v. Tonto Realty Corp., 143 F.2d
916, 921 (2d Cir. 1944). The issue here is whether proceeds from outside the
estate, namely from the letter of credit issuer, should also count to reduce the
landlords remaining allowable claim.
After explaining that under Solows view, Solow could keep the letter of
credit proceeds and claim the same amount again against the debtors estate
while the letter of credit issuer could also claim against the estate to recover that
amount, the court determined it did not need to determine the effect of the letter
of credit because the lease made clear the parties intended the letter of credit to
operate as a security deposit. 324 F.3d at 210. The lease provided the tenant
could provide a letter of credit in place of a security deposit.
That rationale is less than meritorious because it provides no rationale
why a lease providing for a security deposit or a letter of credit must yield the
same bankruptcy results regardless of which option is chosen. Put differently,
had the lease provided how the landlords claim would be treated in bankruptcy,
the court would clearly declare the parties are powerless to change the
bankruptcy law by contract. Moreover, it makes no more sense to limit the
landlords claim to its amount as if it had a security deposit when it really had a
letter of credit, than it makes sense to treat the landlords claim as if it had a letter
of credit when it really had a security deposit defined as a letter of credit.
Thus, the question remains whether the landlords claim under section
502(b)(6) is reduced by the landlords recovery on a letter of credit. In the
context of preferences, a creditor can not evade receipt of a voidable preference
by having the debtor provide collateral to a letter of credit issuer rather than
directly to the creditor. Kellogg v. Blue Quail Energy, Inc. (In re Compton Corp.),
831 F.2d 586, 595 (5th Cir. 1987). Thus, if the debtor provides collateral to a
letter of credit issuer instead of providing a security deposit directly to a landlord,
the debtors estate should not be reduced more simply because it passed the
security deposit through a middleman. If a debtor convinces the letter of credit
issuer to issue the letter of credit without first receiving collateral security for the
issuers reimbursement claim, the damage cap in section 502(b)(6) would be
circumvented if the estate could be liable both to the landlord and to the letter of
credit issuer for the same amount in the form of reimbursement. The language of
section 502(b)(6) which caps the claim of a lessor for damages appears broad

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enough to enable the court to subtract what the lessor received from the letter of
credit given that it enables the court to subtract what the lessor receives from a
security deposit under Oldden.
If, however, the debtor convinces a bank to issue to the debtors landlord a
letter of credit for an amount in excess of the landlords capped claim in the
debtors title 11 case, what happens? Under Oldden, if the debtor provides a
security deposit in excess of the capped damage claim, the landlord must return
the excess. If the debtor provides the letter of credit issuer with collateral for the
letter of credit, does the letter of credit issuer return the excess or does the
landlord return it? Because the monies the letter of credit issuer pays the
landlord are not property of the debtors estate, it appears the landlord may retain
them. But, must the letter of credit issuer return the collateral in excess of the
damage cap to the estate? If the letter of credit issuers reimbursement claim in
excess of the statutory cap is disallowed under section 502(e)(1)(A), then the
issuer must return the excess collateral. As a corollary, if the issuer determines
to pursue subrogation to the landlords claim rather than reimbursement, the
issuer will have to return the excess collateral because the landlord has been
paid its maximum claim. Finally, if the issuers reimbursement claim is not
disallowed under section 502(e)(1)(A) (i.e., if the issuer is not deemed liable with
the debtor on or to have secured the claim of a creditor), then the issuer may
be allowed to retain the collateral unless the transaction is collapsed and the
court determines it can not be enforced because it circumvents section 502(b)(6).
Notably, in EOP-Colonnade of Dallas Limited v. Faulkner (In re
Stonebridge Technologies, Inc.), 430 F.3d 260, 274 (5th Cir. 2005), the court held
502(b)(6) does not apply to cap the proceeds that EOP [lessor] may claim
against the Letter of Credit because EOP never filed a claim for damages against
the Stonebridge estate. Stonebridge explains that section 502(b)(6) allows only
one thing, namely disallowance of the filed claim to the extent it exceeds the cap.
430 F.3d at 270. It appears, therefore, that Stonebridge went an extra mile to
avoid ruling that PPI Enterprises is wrong. Stonebridge could more properly
have ruled that the section 502(b)(6) cap has no impact on a landlords right to
draw on a letter of credit, but that a landlords proof of claim is still subject to the
cap.
C. NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (In re
Integrated Telecom Express, Inc.), 384 F.3d 108 (3d Cir. 2004),
rehearing denied, 389 F.3d 423 (3d Cir. 2004)
i. Facts.
The debtor, Integrated, was a supplier of software and equipment to the
broadband communications industry. In the summer of 2000, Integrated entered
into a 10- year lease in Silicon Valley at $200,000 per month increasing 5%
annually. 2001 was a very poor year for Integrated and it retained Lehman
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Brothers to help evaluate its alternatives. Unable to find a third party willing to
enter into a merger and unable to identify an alternative business model,
Integrateds board of directors prepared a plan of liquidation and dissolution. A
securities class action arising out of Integrateds initial public offering
commenced, requesting $93.24 million.
Integrated had $105 million in cash, a $20 million insurance policy for the
class action, and $1.5 million of other assets. Its liabilities consisted of the class
action claim which Integrated believed would be resolved inside its insurance
policy limits, its liability on the lease of approximately $26 million, and another
$430,000 of miscellaneous obligations. [I]n a smoking gun resolution approved
by the Board, and notwithstanding its strong financial position, Integrated
authorized a letter to the Landlord threatening that if it did not enter into a
settlement of the lease in the amount of at least $8 million, Integrated would file
for bankruptcy so as to take advantage of 502(b)(6), which sharply limits the
amount that a landlord can recover in bankruptcy for damages resulting from the
termination of a lease. 384 F.3d at 129.
Integrated managed to sell its assets during its chapter 11 case for $1
million more than the sale price it negotiated outside bankruptcy. 384 F.3d at
126.
Integrated proposed a chapter 11 plan and the bankruptcy court confirmed
it. The plan provided for the securities class action claimants to receive up to the
insurance policy proceeds and another $5 million, and the claimants accepted
that treatment. The landlords allowable claim for rejection of its lease was set at
$4.3 million. Confirmation was stayed pending appeal.
ii. Issue
The issue on appeal is whether, on the facts of this case, a Chapter 11
petition filed by a financially healthy debtor, with no intention of reorganizing or
liquidating as a going concern, with no reasonable expectation that Chapter 11
proceedings will maximize the value of the debtors estate for creditors, and
solely to take advantage of a provision in the Bankruptcy Code that limits claims
on long-term leases, complies with the requirements of the Bankruptcy Code.
384 F.3d 112.
iii. Holding.
To be filed in good faith, a petition must do more than merely invoke
some distributional mechanism in the Bankruptcy Code. It must seek to create or
preserve some value that would otherwise be lost not merely distributed to a
different stakeholder outside of bankruptcy. This threshold inquiry is
particularly sensitive where, as here, the petition seeks to distribute value directly

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from a creditor to a companys shareholders.Because Integrated was not in

financial distress, its Chapter 11 petition was not filed in good faith as it could not
and did not preserve any value for Integrateds creditors that would have
been lost outside bankruptcy. 384 F.3d at 129.
The incremental $1 million of sale proceeds for Integrateds assets does
not justify invoking chapter 11 under the circumstances in Integrated where the
assets were sold to insiders who had been willing to purchase them outside
bankruptcy and the price may have increased because the assets were not
adequately marketed. 384 F.3d at 126-127.
In respect of Integrateds argument that invoking chapter 11 to deploy
section 502(b)(6) shows good faith, the court held: The far more relevant
question is whether a desire to take advantage of a particular provision in the
Bankruptcy Code, standing alone, establishes good faith. We hold that it does
not. 384 F.3d at 128.
The court also recognized that chapter 11 may be invoked to liquidate as
well as reorganize, but ruled liquidation plans, no less than reorganization plans,
must serve a valid bankruptcy purpose. That is, they must either preserve some
going concern value, e.g., by liquidating a company as a whole or in such a way
as to preserve some of the companys goodwill, or by maximizing the value of the
debtors estate. 384 F.3d at 120.
The law is clear that the burden is on the bankruptcy petitioner to
establish that its petition has been filed in good faith. 384 F.3d at 128n.8, citing
Solow v. PPI Enters. (U.S.), Inc. (In re PPI Enters. (U.S.), Inc.), 324 F.3d 197,
211 (3d Cir. 2001), and Official Committee of Unsecured Creditors v. Nucor
Corp. (In re SGL Carbon Corporation), 200 F.3d 154 (3d Cir. 1999).
Notably, dissenting from the denial of a motion for rehearing, Circuit
Judges Ambro and Rendell offered the following caution about the limited scope
of the holding:
We voted for rehearing en banc not because we believe
that the panel has necessarily reached the wrong result. The core
effect, as we perceive, it, of the panels holding that equity
holders of a debtor may not file a chapter 11 bankruptcy petition
solely to reap [for themselves] a substantial gain through
bankruptcy at the expense of the [debtors] sole creditor. Op. n.4
may pass muster with the unique facts this case presents. Our
problem is this: counsel in other cases may argue the panels
opinion to go further in requiring good faith than anyone on the
panel intended. We thus voted for rehearing en banc to allow the
full Court to dispel this argument, for we believe the panels opinion
is limited to its snow in August facts.

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NMSBPCSLDHB, L.P. v. Integrated Telecom Express, Inc. (Integrated Telecom

Express, Inc.), 389 F.3d 423, 424 (3d Cir. 2004).
iv. Rationale.
The court reasoned it could not identify any value of Integrateds assets
that was threatened outside bankruptcy. 384 F.3d at 129. It explained that while
invoking 11 U.S.C. 502(b)(6) does not establish bad faith, it also does not
establish good faith. 384 F.3d at 128, and that any rule that any tenant willing to
undergo chapter 11 can cap its landlords claim would obviate the need for a
good faith requirement. 384 F.3d at 129. The court also explained that unlike
the debtor in PPI, Integrated was solvent even with the securities action claim,
384 F.3d at 125n.6, and that Integrated had no inchoate claims that needed to be
liquidated or barred. 384 F.3d at 127.
v. Analysis.
The Third Circuits articulation of its holding provides it is limited to the
circumstances of Integrated. 384 F.3d at 129-130. Additionally, the court made
numerous observations about the facts that should help prevent the misuse of
the holding to prevent chapter 11 relief when it is not invoked solely to
redistribute value. Specifically, the court observes that the chapter 11 case was
not being used to: (a) maximize value of the company, 384 F.3d at 120, 125, (b)
realize any efficiencies in chapter 11 unavailable under state law, 384 F.3d at
126, (c) face such financial difficulty that, if it did not file at that time, it could
anticipate the need to file in the future, 384 F.3d at 121 (quoting from In re
Cohoes Indus. Terminal, Inc., 931 F.2d 222, 228 (2d Cir. 1991), (d) maximize the
value of an asset by selling it free of restrictions that would otherwise limit its
value, when, critically, the debtor is insolvent as in Solow v. PPI Enters. (U.S.),
Inc. (In re PPI Enters. (U.S.), Inc.), 324 F.3d 197 (3d Cir. 2001), 384 F.3d at 123,
(e) distribute value in the face of any financial distress, 384 F.3d at 129, (f) sell
property free of liens when the estates solvency was unclear and ultimately pay
the secured lienholder its default rate rather than the contract rate of interest, as
in Platinum Capital, Inc. v. Sylmar Plaza, L.P. (In re Sylmar Plaza, L.P.), 314
F.3d 1070 (9th Cir. 2002), 384 F.3d at 123, (g) avoid any threat to value because
the securities class action did not threaten any value the debtor sought to
preserve, 384 F.3d at 125, (h) liquidate or bar inchoate claims, 384 F.3d at 127,
or (i) seek a chance for a financially troubled company to remain in business, 384
F.3d at 129.
Integrated presented no basis for chapter 11 relief other than wealth
redistribution from a landlord to shareholders. It is virtually impossible to argue
plausibly that Congress ever enacted a bankruptcy law to override state law
calculations of damages under a simple real estate lease to benefit shareholders.
Notably, however, if the court had simply overturned confirmation on the ground

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the plan was not proposed in good faith under 11 U.S.C. 1129(a)(3), the case
would have remained extant so that 11 U.S.C. 502(b)(6) may still have been
applied. Thus, the decision strongly suggests that just as avoidance actions are
supposed to benefit creditors and not shareholders (Although the Bankruptcy
Code contains many provisions that have the effect of redistributing value from
one interest group to another, these redistributions are not the Codes purpose.
Instead, the purposes of the Code are to preserve going concerns and to
maximize the value of the debtors estate. 384 F.3d at 128-129), the cap in 11
U.S.C. 502(b)(6) should similarly be used only for creditors, at least when other
uses of chapter 11 are unnecessary.
21. The Interface of State Law Corporate Governance and Bankruptcy Law
A. Esopus Creek Value LP v. Marks, 913 A.2d 593 (Del. Ch. 2006)
i. Facts
A Delaware corporation, Metromedia International Group, Inc.
(Metromedia), had publicly traded preferred stock and common stock. Its
principal asset was a 50.1% equity interest in Magticom, the Republic of
Georgias leading mobile telephony provider. The equity interest generated
sizable free cash flow and EBITDA, and Metromedias stock had increased from
3 cents a share to more than $1.50 per share since February 2003. The
corporation had no substantial long term or secured debt.
Since March 2005, however, Metromedia had delayed filing its SEC
Forms 10K and 10 Q, blaming its auditor for not signing off on its audited
financials due to an issue involving only 2 cents a share.
In mid-2006, Metromedia received an offer for its Magticom stake that far
exceeded any previous offer and was an objectively fair valuation of the stake.
Pursuant to 8 Del. C. 271(a), a majority vote of common shareholders was
required to approve the sale because it was a sale of all or substantially all
Metromedias assets. Metromedia was advised, however, that because its
shares were registered under section 12 of the Securities Exchange Act of 1934,
section 14c barred it from calling a shareholders meeting or soliciting proxies
while it was not current in its SEC filings. Metromedia had not considered
requesting an exemption from the SEC.
Accordingly, Metromedias board negotiated a sale to be implemented in a
chapter 11 case and locked up approximately 80% of its preferred shares to vote
for it after providing their holders under a confidentiality agreement much nonpublic information to value their interests. In a liquidation (which the sale did not
constitute under Metromedias certificate of designation) Metromedias preferred
shareholders were entitled to a liquidation preference of $50 per share plus all
accrued but unpaid dividends. Pursuant to the lockup for the $480 million offer,

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the preferred shareholders would take a discount on their claims, but if the sale
price increased over the range of $506 million to $535 million, they would receive
more than the certificate of designation would provide them. Metromedia
planned to commence a chapter 11 case, request sale approval under 11 U.S.C.
363, and then propose a chapter 11 plan. By locking up 80% of the preferred
shares, Metromedia assured itself that the class of preferred shares would
accept the plan under 11 U.S.C. 1126(d). Metromedias proposed chapter 11
plan presumed the common shares would be unimpaired and that, in any event,
they would receive at least as much as they would in a liquidation in a chapter 7
case for purposes of 11 U.S.C. 1129(a)(7).
Holders of 8.2% of the common shares commenced an action to
preliminarily enjoin Metromedia from executing an agreement with the buyer
absent an affirmative vote of a majority of Metromedias common shares. At oral
argument, the parties agreed (a) the sale would be subject to a common
shareholder vote under 8 Del. C. 271(a), (b) the directors would make a
concerted effort to obtain exemptive relief from the SEC to solicit proxies and
provide robust financial information, (c) regardless of exemptive relief, the
company would distribute all information required under Delaware law to ensure
the section 271 vote is informed, (d) the company would encourage common
shareholders to attend the section 271 meeting, and (e) the Delaware court
would reserve jurisdiction over the dispute and to adjust any terms of the agreed
order. Notably, approximately 44% of the common shares were already known
to support the terms of the sale.
ii.

Issue

Should the Delaware Chancery Court enjoin Metromedias board of

directors from binding Metromedia to a transaction to sell Magticom before first
complying with 8 Del. C. 271?
iii.

Holding

In sum, the actions of Metromedias directors in structuring the proposed

transactions they did resulted in a theoretically legal, yet undeniably inequitable,
reallocation of control over the corporate enterprise. That reallocation does not
withstand close judicial scrutiny. There is reason to believe the SEC will grant
exemptive relief to allow Metromedia to convene a common shareholders
meeting to vote on the sale. But, if no meeting occurs, the Court of Chancery
enjoys the ability to appoint a receiver when and if a corporation refuse[s], fail[s],
or neglect[s] to obey any order or decree of any [Delaware court]
These facts, when viewed in light of the underlying rehabilitative
purposes of the bankruptcy code, persuade the court that Metromedias
proposed transactional scheme, though technically within the letter of the law,
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works a profound inequity upon the companys common stockholders and is thus
prohibited by the teachings of Schnell v. Chris-Craft Industries, Inc. [285 A.2d
437 (1971)]. And while the defendants are correct that the Supremacy Clause of
the United States Constitution and federal preemption jurisprudence prevent this
court from issuing an order enjoining them from filing a bankruptcy petition, this
court unquestionably has the power to prevent the board of directors from
binding the company to a transaction to sell Magticom before first complying with
the mandates of 8 Del. C. 271. (footnotes omitted).
iv.

Rationale

Metromedias financial circumstances provide strong evidence of the

inequity of a bankruptcy sale.It therefore seems an abuse of the bankruptcy
process for a robust and healthy company, encumbered by virtually no debt, to
seek out the vast and extraordinary relief a bankruptcy court is capable of
providing. While the Chancery Court did not presume to determine good faith
under the Bankruptcy Code, it ruled that standard provide[s] ample support for
the notion that the boards conduct here inequitably abridged the justified
expectations of the common stockholders.
In lieu of holding a statutory right as residual owners to approve the
proposed Magticom sale, the common stockholders find themselves relegated to
the status of sideline objectors in bankruptcy court.
The primary interests protected by the bankruptcy process are those of
creditors. Because of this simple fact, the bankruptcy code does not contemplate
a freestanding right to vote by the holders of common equity. Were such a vote
available, the legal rights of the creditors to the remaining assets of the entity
would take a subsidiary position to the interests of the residual owners who, at
least where a company is insolvent, no longer have any cognizable financial
interest to protect.
Nevertheless, it is important to note that a state law process is
available to deal with managements inability to properly fulfill its duty to hold an
election a process well capable of protecting the interests of all constituent
groups.
v.

Analysis

Did the Delaware Chancery Court overlook whether the bankruptcy court
would have subject matter jurisdiction over Metromedias chapter 11 case
brought to evade state law corporate governance?
Yes, although it strongly implied the case would be dismissed for lack of
good faith. All federal bankruptcy legislation emanates from the bankruptcy
power granted Congress by article I, section 8 of the United States Constitution.
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The bankruptcy power encompasses discharges of debts, Hanover Natl Bank v.

Moyses, 186 U.S. 181 (1902), distributions of a debtors property, id., and
reorganizations, Continental Ill. Natl Bank & Trust Co. v. Chicago, Rock Island &
Pac. Ry., 294 U.S. 648 (1935), In re Reiman, 20 F. Cas. 490 (S.D.N.Y. 1874),
affd, 20 F. Cas. 500 (C.C.S.D.N.Y. 1875) (No. 11,675).
The bankruptcy power does not encompass the power to change a
companys corporate governance when its debts do not need to be reorganized
or discharged. In In re Texaco, Inc., 81 B.R. 806, 809 (Bankr. S.D.N.Y. 1988),
the Icahn Group requested termination of Texacos exclusivity to enable the
group to propose a chapter 11 plan substantially the same as Texacos
proposed plan, except that it includes certain proposed amendments to further
corporate democracy. The Icahn Groups proposed corporate governance
provisions do not address any bankruptcy issues that relate to an effective
Chapter 11 reorganization. The issues raised by the Icahn Group do not involve
the relationship between the debtors and their creditors, nor do the corporate
governance proposals involve the relationship between the debtors creditors and
their shareholders. Id.
Therefore, the bankruptcy court held: The Chapter 11 Reorganization
process is not the appropriate vehicle for introducing changes in Texacos
existing system of corporate governance. The changes proposed by the Icahn
Group should be dealt with in an appropriate state law forum, rather than the
Bankruptcy Court. Id. at 813.
Similarly, Metromedia would be unable to show the need for any relief
within the bankruptcy power and its chapter 11 case would be vulnerable to
dismissal for lack of subject matter jurisdiction to grant its requested relief,
namely a change in corporate governance to accomplish the sale.
Is the Delaware Chancery Courts injunction against Metromedia and its
directors barring a sale of its stake in Magticom absent a shareholder vote
enforceable in a Metromedia chapter 11 case?
Unless reorganization is threatened, the bankruptcy court lacks power to
alter a debtors corporate governance. Mannville Corp. v. Equity Sec. Holders
Comm. (In re Johns-Mannville Corp.), 801 F.2d 60, 64-69 (2d Cir. 1986).
Therefore, if the board is unauthorized to propose a sale without a shareholder
vote, it is not clear there is any federal bankruptcy statute that preempts that
restriction, unless failure to propose a sale under 11 U.S.C. 363 would cause
Metromedia to breach its fiduciary duties under the Bankruptcy Code. In
practice, debtors do not seek shareholder approval when proposing chapter 11
plans disposing of all their assets, presumably because they can not carry out
their responsibilities under the Bankruptcy Code without doing so and therefore
any contrary state law restrictions would be preempted. But, shareholders can
police this by objecting at the confirmation hearing. The restriction on
Metromedia and its board, however, would not preclude other parties in interest
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such as creditors or preferred shareholders or common shareholders from

requesting permission to propose chapter 11 plans providing for the sale.
Did the Delaware Chancery Court correctly reason that the
bankruptcy code does not contemplate a freestanding right to vote by the holders
of common equity?
To the extent common shares are impaired, such as when the preferred
shares obtain more than they are entitled to, the common shares do vote and are
protected by the best interests test in 11 U.S.C. 1129(a)(7) and the cramdown
provisions in 11 U.S.C. 1129(b)(2)(C) under which holders of common shares
are entitled to the shares value. To the extent common shares are unimpaired,
their legal, equitable, and contractual rights must be unaltered under 11 U.S.C.
1124(1) or must be compensated pursuant to 11 U.S.C. 1124(2)(C)-(D).
B. No Fiduciary Duties to Creditors: North American Catholic
Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92
(Del. 2007)
i.

Facts

NACEPF owned radio wave spectrum licenses. It agreed to grant

Clearwire Holdings, Inc. rights in the licenses. NACEPF, as a creditor and not a
shareholder of Clearwire, sued the directors of Clearwire who served at the
behest of Goldman Sachs (a minority of the board) for breach of fiduciary duty.
According to their complaint, the directors induced NACEPF to enter into a
master agreement to transfer rights in its licenses by representing Clearwires
purpose was to create a national system of wireless connections to the internet.
The complaint alleges that in fact, Goldman Sachs did not intend to carry out that
business plan which would have required it to pay $23.4 million for licenses.
When the market for the licenses collapsed after WorldCom announced its
accounting problems, Clearwire started negotiating to pay small amounts to
extract itself from its payment obligations by threatening to file for bankruptcy.
NACEPFs complaint alleged (a) the directors fraudulently induced
NACEPF to enter into the master agreement and to maintain its licenses
available for sale to Clearwire, (b) Clearwire was insolvent or in the zone of
insolvency and the directors owed fiduciary duties to NACEPF which they
breached by holding onto NACEPFs license rights to help Goldman Sachs keep
its investment in play, and (c) the directors tortuously interfered with NACEPFs
prospective business opportunity to sell its licenses to others by causing
Clearwire to wrongfully assert it had the right to acquire NACEPFs wireless
spectrum.

182

ii.

Issue

whether, as a matter of law, a corporation's creditors may assert direct

claims against directors for breach of fiduciary duties when the corporation is
either: first, insolvent or second, in the zone of insolvency. 930 A.2d at 97.
iii.

Holding

In this opinion, we hold that the creditors of a Delaware corporation

that is either insolvent or in the zone of insolvency have no right, as
a matter of law, to assert direct claims for breach of fiduciary duty
against the corporation's directors.
930 A.2d at 94, 103.
iv.

Rationale

It is well established that the directors owe their fiduciary

obligations to the corporation and its shareholders.
While
shareholders rely on directors acting as fiduciaries to protect their
interests, creditors are afforded protection through contractual
agreements, fraud and fraudulent conveyance law, implied
covenants of good faith and fair dealing, bankruptcy law, general
commercial law and other sources of creditor rights. Delaware
courts have traditionally been reluctant to expand existing fiduciary
duties.
Accordingly, the general rule is that directors do not owe
creditors duties beyond the relevant contractual terms."
930 A.2d at 99 (footnotes omitted).
In this case, the need for providing directors with definitive
guidance compels us to hold that no direct claim for breach of
fiduciary duties may be asserted by the creditors of a solvent
corporation that is operating in the zone of insolvency. When a
solvent corporation is navigating in the zone of insolvency, the
focus for Delaware directors does not change: directors must
continue to discharge their fiduciary duties to the corporation and its
shareholders by exercising their business judgment in the best
interests of the corporation for the benefit of its shareholder owners.
Therefore, we hold the Court of Chancery properly concluded that
Count II of the NACEPF Complaint fails to state a claim, as a

183

matter of Delaware law, to the extent that it attempts to assert a

direct claim for breach of fiduciary duty to a creditor while Clearwire
was operating in the zone of insolvency.
930 A.2d at 101.
It is well settled that directors owe fiduciary duties to the
corporation. 36 When a corporation is solvent, those duties may be
enforced by its shareholders, who have standing to bring derivative
actions on behalf of the corporation because they are the ultimate
beneficiaries of the corporation's growth and increased value. 37
[**26] When a corporation is insolvent, however, its creditors take the
place of the shareholders as the residual beneficiaries of any
increase in value.
36 See, e.g., Guth v. Loft, Inc., 23 Del. Ch. 255, 5 A.2d 503, 510
(Del. 1939).
37 See, e.g., Aronson v. Lewis, 473 A.2d 805, 811 (Del. 1984)
partially overruled on other grounds by Brehm v. Eisner, 746 A.2d
244 (Del. 2000).
Consequently, the creditors of an insolvent corporation have
standing to maintain derivative claims against directors on behalf of
the corporation for breaches of fiduciary duties. 38 The corporation's
insolvency "makes the creditors the principal constituency injured by
any fiduciary breaches that diminish the firm's value." 39 Therefore,
equitable considerations give creditors standing to pursue derivative
claims against the directors of an insolvent corporation. Individual
creditors of an insolvent corporation have the same incentive to
pursue valid derivative claims on its behalf that shareholders have
when the corporation is solvent.
38 Agostino v. Hicks, 845 A.2d 1110, 1117 (Del. Ch. 2004); see
also Tooley v. Donaldson, Lufkin & Jenrette, Inc., 845 A.2d at 1036
("The derivative suit has been generally described as 'one of the
most interesting and ingenious of accountability mechanisms for
large formal organizations.'" (quoting Kramer v. W. Pac. Indus., Inc.,
546 A.2d 348, 351 (Del. 1988); Guttman v. Huang, 823 A.2d 492,
500 (Del. Ch. 2003) (noting the "deterrence effects of meritorious
derivative suits on faithless conduct.").
39 Production Resources Group, L.L.C. v. NCT Group, Inc., 863
A.2d at 794 n.67.
930 A.2d at 101-102.

184

Recognizing that directors of an insolvent corporation owe

direct fiduciary duties to creditors, would create uncertainty for
directors who have a fiduciary duty to exercise their business
judgment in the best interest of the insolvent corporation. To
recognize a new right for creditors to bring direct fiduciary claims
against those directors would create a conflict between those
directors' duty to maximize the value of the insolvent corporation for
the benefit of all those having an interest in it, and the newly
recognized direct fiduciary duty to individual creditors. Directors of
insolvent corporations must retain the freedom to engage in
vigorous, good faith negotiations with individual creditors for the
benefit of the corporation. 46
46 Production Resources Group, L.L.C. v. NCT Group, Inc., 863
A.2d at 797.
Accordingly, we hold that individual creditors of an insolvent
corporation have no right to assert direct claims for breach of
fiduciary duty against corporate directors. Creditors may
nonetheless protect their interest by bringing derivative claims on
behalf of the insolvent corporation or any other direct nonfiduciary
claim, as discussed earlier in this opinion, that may be available for
individual creditors.
930 A.2d at 103.
v.

Aftermath

The former Chief Justice of the Delaware Supreme Court, E. Norman

Veasey, summed up the law as follows:
"So it is clear that creditors have no direct fiduciary duty
claims against directors of an insolvent corporation or a solvent
one, whether or not it is in the 'zone of insolvency.' If the
corporation is actually insolvent, they may have derivative claims to
make on behalf of the corporate entity, if the facts support such a
claim. Whether creditors may bring derivative claims against
directors of a corporation that is solvent but in the zone of
insolvency is unclear, but doubtful as a practical matter."
E. Norman Veasey, "Counseling the Board of Directors of a Delaware
Corporation in Distress," ABI Journal, Vol. XXVII, No. 5 (June 2008)
(emphasis in original).

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vi.

What of the Trust Fund Doctrine?

Curiously, Gheewalla reaches its holding that directors of insolvent

corporations owe no fiduciary duties to creditors, without mentioning the trust
fund doctrine. While this might have been oversight, it also appears the trust
fund doctrine would not change Gheewalla's holding.
The trust fund doctrine originated in Wood v. Dummer, 30 F. Cas. 435
(Cir. D. Me. 1824). There, a bank whose charter expired issued dividends of its
capital stock to the bank's shareholders. Then, the bank's noteholders sued to
be paid by the recipients of the dividends. The court reasoned that "the charters
of our banks make the capital stock a trust fund for the payment of all the debts
of the corporation." 30 F. Cas. at 436. "The stockholders have no right to any
thing but the residuum of the capital stock, after payment of all the debts of the
bank. The funds in their hands, therefore, have an equity attached to them, in
favour of the creditors." 30 F. Cas. at 439.
Later, the United States Supreme Court was asked to rule in Hollins v.
Brierfield Coal and Iron Co., 150 U.S. 371 (1893), whether contract creditors of
an insolvent corporation have a lien against its property or whether its property is
charged with a direct trust for their benefit. The answer was no. 150 U.S. at
386-387. The Supreme Court canvassed the jurisprudence and ruled:
"While it is true language has been frequently used to the effect that
the assets of a corporation are a trust fund held by a corporation for
the benefit of creditors, this has not been to convey the idea that
there is a direct and express trust attached to the property. As said
in 2 Pomeroy's Equity Jurisprudence, 1046, they 'are not in any
true and complete sense trusts, and can only be called so by way
of analogy or metaphor.'" 150 U.S. at 381-382.
"'The property of a corporation is doubtless a trust fund for the
payment of its debts, in the sense, that when the corporation is
lawfully dissolved and all its debts paid out of the corporate
property before any distribution thereof among the stockholders. It
is also true, in the case of a corporation, as in that of a natural
person, that any conveyance of property of the debtor, without
authority of law, and in fraud of existing creditors, is void as against
them.'" 150 U.S. at 384 (quoting Wabash, St. Louis & Pacific
Railway v. Ham, 114 U.S. 587, 594 (1885)).
"These cases negative the idea of any direct trust or lien
attaching to the property of a corporation in favor of its creditors,
and at the same time are entirely consistent with those cases in
which the assets of a corporation are spoken of as a trust fund,

186

using the term in the sense that we have said it was used." 150
U.S. at 385.
Based on Brierfield, modern day courts conclude: "The doctrine doesnot,
in fact, involve the application of any actual 'trust' at allAmerican National Bank
of Austin v. Mortgageamerica Corp. (In re Mortgageamerica Corp.), 714 F.2d
1266, 1269 (5th Cir. 1983).
The Delaware Chancery Court addressed the trust fund doctrine when a
judgment creditor sued an insolvent corporation claiming its directors could not
prefer some non-insider creditors over other non-insider creditors. Amussen v.
Quaker City Corp., 18 Del. Ch. 28 (Del. Ch. 1931). The court ruled:
"as among creditors, no trust exists which prevents the directors
of an insolvent corporation from preferring some over others,
notwithstanding the corporation is in failing circumstances and
manifestly headed for disaster." 18 Del. Ch. at 31.
"So that any creditor, who is unwilling to entrust his chances of
fair treatment to the officers and directors of the corporation, has
recourse open to him to resort to the courts where he may ask that
the corporate assets be drawn under judicial administration upon a
basis of equality. The creditor is therefore not helpless. While it
may be said that to compel creditors to seek protection by
receivership proceedings casts upon them the burden of vigilance,
the reply is that such is a burden that creditors have always been
generally expected to assume." 18 Del. Ch. at 34.
The Delaware Chancery Court again addressed the trust fund doctrine
when it was faced with the question whether an insolvent corporation can prefer
an insider (director) creditor over non-insider creditors:
"The principle upon which the rule rests that forbids a directorcreditor to enjoy a preference over others in the circumstance of the
company's insolvency, is variously stated. By most of the
authorities it is posited on the so-called 'trust fund theory' by which
capital assets are said to constitute a trust fund for creditors. By
others it is said to be based on the inequity of allowing a director to
take advantage of the superior means of information which he
enjoys over other creditors, conjoined as it is with a power or
influence which enables the possessor to reap a personal
advantage over others whose claims are equally meritorious."
Pennsylvania Company v. South Broad St. Theatre Co., 20 Del.
Ch. 220, 228 (Del. Ch. 1934).
C. Deepening Insolvency: Trenwick America Litigation Trust v.
Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), affd Trenwick
187

America Litigation Trust v. Billett, 2007 Del LEXIS 357 (Del., Aug.
14, 2007)
i. Facts
On December 31, 1998, the Trenwick Group had assets of $1.4 billion,
stockholders equity of $348 million, and a stock price of $31.49 per share.
Trenwick, 906 A.2d at 176. The parent holding company embarked on a strategy
of growth by acquisition and acquired 3 insurance companies in 2 years. In
connection with two of the acquisitions, the holding companys top U.S.
subsidiary assumed or guaranteed hundreds of millions of dollars of debt,
although its financial statement still showed a positive asset value over $200
million. The trust contends the book numbers were the product of creative
accounting and hid insolvency. Trenwick, 906 A.2d at 184. Five years after the
growth strategy started, the holding company and its U.S. subsidiary commenced
chapter 11 cases because the insurance companies acquired turned out to have
more liabilities than assets. The chapter 11 plan of the U.S. subsidiary created a
litigation trust holding the subsidiarys claims. That trust brought an action
against the holding companys directors (10 of 11 of which were independent
directors) and its advisors, as well as the subsidiarys directors. The corporate
charter exculpated directors from breaches of their duty of care.
The action essentially alleges that the directors embarked, due to a lack of
diligence, on an imprudent strategy as shown by its result. The action seeks to
hold defendants liable for breach of duties of care and loyalty, deepening
insolvency, and aiding and abetting it. The advisors are accused of malpractice
and breach of their duties as advisors to the parent to protect the subsidiary from
harm. Trenwick, 906 A.2d at 188. The action attempts to capitalize on the
companies insolvencies. Trenwick, 906 A.2d at 172-173. Defendants moved to
dismiss the action for failure to state a claim.
ii. Issues
Can a litigation trust formed by a debtors chapter 11 plan bring actions belonging
to the debtors creditors if the creditors do not assign them to the trust?
Does Delaware law recognize a cause of action for deepening insolvency?
Does a parent corporation owe duties to its subsidiary or its creditors?
What must be shown to overcome a corporate charters exculpation of directors
from a duty of care?
What must be shown to state a claim for breach of duty of loyalty?

188

iii. Holding
No. Based on Caplin v. Marine Midland Grace Trust Co.,406 U.S. 416
(1972), a litigation trust is not allowed to bring its creditors claims. Trenwick, 906
A.2d at 191.
What Delaware law does not do is to impose retroactive
fiduciary obligations on directors simply because their chosen
business strategy did not pan out. That is what the Litigation Trust
seeks here, to emerge from the wreckage wielding the club that the
holding company's own failed subsidiary can now accuse the
holding company's directors of a breach of fiduciary duty. To
sanction such a bizarre scenario would undermine the wealthcreating utility of the business judgment rule.
Trenwick, 906 A.2d at 173-174.
Equally important, however, is that Delaware law does not
recognize this catchy term as a cause of action, because catchy
though the term may be, it does not express a coherent concept.
Even when a firm is insolvent, its directors may, in the appropriate
exercise of their business judgment, take action that might, if it
does not pan out, result in the firm being painted in a deeper hue of
red. The fact that the residual claimants of the firm at that time are
creditors does not mean that the directors cannot choose to
continue the firm's operations in the hope that they can expand the
inadequate pie such that the firm's creditors get a greater recovery.
By doing so, the directors do not become a guarantor of success.
Put simply, under Delaware law, "deepening insolvency" is no more
of a cause of action when a firm is insolvent than a cause of action
for "shallowing profitability" would be when a firm is solvent.
Existing equitable causes of action for breach of fiduciary duty, and
existing legal causes of action for fraud, fraudulent conveyance,
and breach of contract are the appropriate means by which to
challenge the actions of boards of insolvent corporations.
Trenwick, 906 A.2d at 174.
Under settled principles of Delaware law, a parent corporation does not
owe fiduciary duties to its wholly-owned subsidiaries or their creditors.66
66 E.g., Anadarko Petro. Corp. v. Panhandle Eastern Corp., 545 A.2d
1171, 1174 (Del. 1988). Although it is said in general terms that a parent
corporation owes a fiduciary obligation to its subsidiaries, this obligation
does not arise as such unless the subsidiary has minority stockholders.
See DAVID A. DREXLER, LEWIS S. BLACK, JR., & A. GILCHRIST
SPARKS, III, DELAWARE CORP. LAW AND PRACTICE 15.11, at 15-72
(2002).

189

Trenwick, 906 A.2d at 191-192.

To state a claim for gross negligence, a complaint might allege,
by way of example, that a board undertook a major acquisition
without conducting due diligence, without retaining experienced
advisors, and after holding a single meeting at which management
made a cursory presentation. To state a claim of disloyalty, a
complaint might allege that a board undertook an acquisition of a
company controlled by one of its directors because that director
was having financial problems and the board, in bad faith, decided
to prefer his interests to that of the company. What a plaintiff may
not do, however, is simply allege that a majority independent board
undertook a business strategy that was "all consuming and
foolhardy" and that turned out badly and thereby seek to have the
court infer that the later failure resulted from a grossly deficient
level of effort or from disloyal motives.
Trenwick, 906 A.2d at 194.
iv. Rationale
Wholly-owned subsidiary corporations are expected to
operate for the benefit of their parent corporations; that is why they
are created. Parent corporations do not owe such subsidiaries
fiduciary duties. That is established Delaware law.
That is not to say that Delaware law leaves the creditors of
subsidiaries without rights. That would be inaccurate. Delaware has
a potent fraudulent conveyance statute enabling creditors to
challenge actions by parent corporations siphoning assets from
subsidiaries. And Delaware public policy is strongly supportive of
freedom of contract, thereby supporting the primary means by
which creditors protect themselves - through the negotiations of
toothy contractual provisions securing their right to seize on the
assets of the borrowing subsidiary.
Trenwick, 906 A.2d at 174.
A wholly-owned subsidiary is to be operated for the benefit of
its parent. A subsidiary board is entitled to support a parent's
business strategy unless it believes pursuit of that strategy will
cause the subsidiary to violate its legal obligations. Nor does a
subsidiary board have to replicate the deliberative process of its
parent's board when taking action in aid of its parent's acquisition
strategies.

190

Trenwick, 906 A.2d at 174.

Finally, it is important to point out that my refusal to conclude
that a wholly- owned subsidiary may sue the directors of its parent
company on the premise that their improvident business strategies
ultimately led to the bankruptcy of the subsidiary does not leave
open a gap in the law. There is no chasm.
The laws of all states and the federal bankruptcy laws address
precisely the scenario the Litigation Trust contends occurred in the
reorganization but fails to plead. They do so through a body of law
that might be fairly called the "law of fraudulent transfer."
Trenwick, 906 A.2d at 198 (footnote omitted).
The incantation of the word insolvency, or even more
amorphously, the words zone of insolvency should not declare
open season on corporate fiduciaries. Directors are expected to
seek profit for stockholders, even at risk of failure. With the
prospect of profit often comes the potential for defeat.
The general rule embraced by Delaware is the sound one. So
long as directors are respectful of the corporation's obligation to
honor the legal rights of its creditors, they should be free to pursue
in good faith profit for the corporation's equityholders. Even when
the firm is insolvent, directors are free to pursue value maximizing
strategies, while recognizing that the firm's creditors have become
its residual claimants and the advancement of their best interests
has become the firm's principal objective.
Trenwick, 906 A.2d at 174-175.

Delaware law imposes no absolute obligation on the board

of a company that is unable to pay its bills to cease operations and
to liquidate. Even when the company is insolvent, the board may
pursue, in good faith, strategies to maximize the value of the
firm.
Trenwick, 906 A.2d at 204.
But business failure is an ever-present risk. The business
judgment rule exists precisely to ensure that directors and
managers acting in good faith may pursue risky strategies that
seem to promise great profit. If the mere fact that a strategy turned
out poorly is in itself sufficient to create an inference that the
directors who approved it breached their fiduciary duties, the

191

business judgment rule will have been denuded of much of its

utility.
Trenwick, 906 A.2d at 193 (footnote omitted).
To this point, I also do not believe that Trenwick America is
permitted to do an end-run around Trenwick's exculpatory charter
provision. A judicial acknowledgement that, as a matter of the
common law of equity, directors of a public company protected by
an exculpatory charter provision may be exposed to negligencebased liability claims made by the public company's wholly-owned
subsidiaries would undercut the important public policy reflected in
8 Del. C. 102(b)(7). Out of nowhere independent directors of
parent corporations would face, in a litigation context in which firm
failure is a given, due care claims by entities to which our law has
said the parent itself does not owe any fiduciary duties. To sanction
such bizarre claims would discourage board service and create
uncertainty about the extent to which parent corporations could
deploy their organization's assets in a good faith effort to undertake
risky strategies that promise future profit. Put simply, even if one
were to conclude (as I do not) that Trenwick America can proceed
against the Trenwick directors directly, at the very least Trenwick
America would have to plead a claim not exculpated by the
Trenwick charter. It has failed to do so.
Trenwick, 906 A.2d at 194.
If simple failure gave rise to claims, the deterrent to healthy risk
taking by businesses would undermine the wealth-creating potential
of capitalist endeavors. For that reason, our law defines causes of
action that may be pled against business fiduciaries and advisors
with care, in order to balance society's interest in promoting goodfaith risk-taking and in preventing fiduciary misconduct. The
Litigation Trust has failed to meet its burden to plead facts stating
claims of that kind against the defendants in this case.
Trenwick, 906 A.2d at 218.
v. But, Is Deepening Insolvency a Valid Damage Measure for
Breach of a Director's Fiduciary Duties of Care, Loyalty, or
Good Faith? See Miller v. McCown DeLeeuw & Co. (In re
The Brown Schools), 386 B.R. 37 (Bankr. D. Del. 2008).
1. Facts

192

Brown Schools is a decision on a motion to dismiss a complaint.

Accordingly, the 'facts' are the court's interpretation of the complaint's allegations
and not the court's findings. 386 B.R. at 41.
McCown De Leeuw & Co., Inc. ("MDC") acquired control of The Brown
Schools, Inc. ("TBS") in 1997 and 1998. Id. It acquired 65% of the stock for $63
million. Id. MDC also procured an advisory services agreement under which it
would be paid the greater of $400,000 or 0.3% of revenues. Id. TBS also
obtained a $100 million credit commitment from CSFB, secured by substantially
all TBS' assets. Id.
In 1999, TBS obtained a $15 million loan from TIAA, subordinated to the
CSFB loan, in exchange for interest payments at 18% per year and warrants to
purchase 40,000 shares. Id. at 42. In 2000, TBS obtained a $5 million loan from
MDC, subordinated to both the CSFB and TIAA debt, in exchange for interest
payments at 12% per year, but the interest was payable in kind. MDC also
obtained warrants to purchase 74,000 shares. Id.
Later in 2000, when the CSFB debt was in default, TBS restructured it by
agreeing to sell $32 million of assets, with the proceeds to be used to pay down
the CSFB debt. Id. CSFB also procured an increase in its interest rate and
required TBS to raise an additional $7.5 million by selling additional PIK notes to
MDC. Id.
By April 7, 2003, TBS owed approximately $47 million to CSFB, $18.4
million to TIAA, $12.5 million plus interest to MDC, and $22 million to other
creditors. Id. Additionally, TBS was a defendant in over 30 lawsuits. Id. During
April 2003, TBS sold all its residential treatment centers for $64 million. TBS
used the proceeds to repay CSFB in full, to pay $907,000 to TBS' financial
advisors, $578,000 to TBS' attorneys, $278,000 to CSFB' legal and financial
advisors, and $1.7 million to MDC. Id. (Plaintiff, the chapter 7 trustee of the
estate of TBS, contends the $1.7 million payment was a vehicle to unlawfully
prefer MDC over other creditors since MDC provided no compensable services
beyond those for which it was being paid by its advisory services agreement. Id.).
In May 2003, TBS retained the Winstead firm at MDC's direction. Id. In
July 2004, TBS restructured its debt again. It gave TIAA a first lien against
substantially all its assets and TIAA agreed to waive defaults. TIAA's debt of
$20.95 million was restructured into 4 tranches. TBS agreed to sell $7 million of
assets to reduce TIAA's debt. Subsequently, TIAA and MDC entered into an
intercreditor agreement under which MDC was entitled to receive up to $2.9
million from monies thereafter received by TIAA. Id. TBS granted TIAA and
MDC security interests and then liquidated more than $18 million of assets,
whose proceeds were paid to TIAA which shared them with MDC. Id.

193

In March 2005, TBS filed chapter 7 petitions. Id. The chapter 7 trustee
filed a complaint against MDC, the director MDC installed at TBS, and Winstead.
Defendants filed motions to dismiss which were granted in part with permission
to replead. Miller v. McCown DeLeeuw & Co. (In re The Brown Schools), 368
B.R. 394 (Bankr. D. Del. 2007). Although the complaint alleged creditors were
damaged, the Trustee in every instance also asserts that the Debtors were
damaged. 368 B.R. at 400. On that basis, the court denied the first motion to
dismiss on standing grounds because even though a trustee lacks standing to
assert claims on behalf of creditors, it can assert claims on behalf of the estate.
Id.
"The Trustee asserts that MDC wrongfully prolonged the existence of the
Debtors so that MDC could profit at the expense of the Debtors and their
creditors, in violation of its duties of good faith, honest governance, and loyalty
which required a prompt bankruptcy filing and liquidation of the Debtors. As an
example, the Trustee points to the April 2003 transaction where the Debtors sold
all of their residential treatment centers for $64 million and paid MDC $1.7
million. In addition, the Trustee asserts that MDC effectuated the July 2004
Restructuring in breach of its fiduciary duty to the Debtors' creditors in order to
prefer MDC over non-insider creditors. Therefore, the Trustee seeks to recover
$18 million in damages caused by the Debtors paying TIAA as part of the
restructuring." Id. at 45.
The repleaded complaint, among other things, alleged (a) defendants
were liable for deepening insolvency, (b) MDC was liable, in the amount of the
$18 million paid to TIAA, for breach of fiduciary duties by wrongfully prolonging
TBS' existence and damaging TBS, so MDC could profit at the expense of TBS
and its creditors, such as by receiving the $1.7 million, (c) aiding and abetting
fraudulent transfers, (d) the MDC director was liable for the fraudulent transfers
received by MDC because he benefited based on his affiliation with MDC, (e) the
MDC director was liable for aiding and abetting fraudulent transfers, (f) the MDC
director was liable for civil conspiracy and aiding and abetting a civil conspiracy,
namely MDC and other defendants caused TBS to retain Winstead to devise a
strategy to prefer MDC over other creditors in breach of MDC's fiduciary duties to
other creditors, and (g) Winstead was liable for breach of fiduciary duty, aiding
and abetting breach of fiduciary duty, conspiracy, fraudulent transfers, and aiding
and abetting fraudulent transfers.
2. Issues
Is there a valid cause of action for deepening insolvency?
11. If a cause of action for breach of fiduciary duty to creditors and the debtor is
brought to recover damages measured by deepening insolvency, is the cause
of action a disguised action for deepening insolvency?
12. Is there a cause of action for aiding and abetting a fraudulent transfer?
10.

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13. If a defendant is neither an initial transferee, nor an immediate, nor a mediate

transferee of a fraudulent transfer, can it be liable for the fraudulent transfer
based on indirect benefits?
14. Is there a cause of action for civil conspiracy or aiding and abetting a civil
conspiracy to breach fiduciary duties to creditors or the debtor?
3. Holdings
1.

2.
3.
4.

5.

No. Miller v. McCown DeLeeuw & Co. (In re The Brown Schools), 386 B.R.
37, 44 (Bankr. D. Del. 2008). There is no cognizable cause of action In
Delaware for deepening insolvency. Trenwick Am. Litig. Trust v. Billett, 2007
Del. LEXIS 357, at *1 (Del. 2007).
Deepening insolvency can be a valid theory of damages for breach of
fiduciary duties. Id. at 48.
Under Delaware law, there is no valid cause of action for aiding and abetting
a fraudulent transfer. Id. at 53.
Being an employee of a transferee of a fraudulent transfer, does not alone
establish that the employee was a transferee or benefited from the transfer.
Id. at 54.
The allegations that the MDC installed director conspired with Winstead to
have Winstead act to prefer MDC's interests over the interests of other
creditors and that the purpose was achieved through the restructuring in 2004
state claims against the director and Winstead for civil conspiracy and aiding
and abetting civil conspiracy (which is a confederation of two or more persons
to do an unlawful act in furtherance of the conspiracy which results in actual
damages to plaintiff). Id. at 55-56.
4. Analysis

Miller v. McCown DeLeeuw & Co. (In re The Brown Schools), 386 B.R. 37
(Bankr. D. Del. 2008), poses the ultimate predicament for investors in distressed
companies. Namely, once distress is recognized, what actions can the investor
take to try to recoup some of its investment without incurring personal liability to
the company in amounts equaling or exceeding other creditors' unpaid claims?
Here, the private equity investor that paid $63 million for its ownership stake, put
in another $12.5 million on a subordinated basis once trouble surfaced, but is
being sued for over $18 million because it allegedly breached fiduciary duties by
trying to prefer itself and by not earlier depositing the company into bankruptcy.
The chapter 7 trustee also complains of and demands disgorgement from the
investor of the $1.7 million it was paid when the first lien debt was reduced and
the $2.9 million it received from a paydown of the second institution's debt, but no
fraud or dishonesty is alleged.128
128 MDC

is also accused of having taken collateral security for its $12.5 million.
But, it appears MDC never benefited from that collateral security and the
company commenced its chapter 7 case less than a year after the security was
195

This predicament has serious implications. If working out a distressed

situation without fraud or dishonesty can carry personal liability if the workout is
unsuccessful, the availability of capital to start or to grow businesses will shrink
and become more expensive. For the same reasons, the market's ability and
willingness to undertake out-of-court restructurings would diminish materially.
Conversely, if the law does not enforce fiduciary duties of directors and senior
officers, capital availability will seriously diminish due to lack of confidence in the
system.
Thus, the question becomes whether in the absence of fraud and
dishonesty, controlling shareholders, directors, and senior management have
fiduciary duty liability, independent of and beyond the liability imposed by the
preference and fraudulent transfer statutes, for deferring bankruptcy liquidation
while they try to enable the dominant shareholder to recoup a portion of its
investment and they hope for a change of fortune.129
Starting with the basics, entities use corporations and limited liability
companies precisely to limit their liability. When the United States government
tried to hold a parent corporation liable for its subsidiary's environmental liability,
the Unites States Supreme Court articulated the black letter law:
It is a general principle of corporate law deeply ingrained in our
economic and legal systems that a parent corporation (so-called
because of control through ownership of another corporations
stock) is not liable for the acts of its subsidiaries.
United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876, 1884 (1998) (quoting
Douglas & Shanks, Insulation from Liability Through Subsidiary Corporations, 39
Yale L.J. 193 (1929)(Douglas).
Thus it is hornbook law that the exercise of the control which stock
ownership gives to the stockholderswill not create liability beyond
the assets of the subsidiary. That control includes the election of
directors, the making of by-lawsand the doing of all other acts
granted, thereby likely rendering the collateral security a voidable preference to
an insider pursuant to 11 U.S.C. 547(b)(4)(B).
129 Bearing in mind that the decision arose in the context of a motion to dismiss
based on the face of the complaint, we have to analyze the allegations that MDC
kept TBS out of bankruptcy solely to prefer itself, without consideration of MDCs
possible defenses at trial such as that it validly formed a business judgment that
it would maximize value by conducting sales outside bankruptcy or that a
turnaround could occur. Thus, the question is simply whether a controlling
shareholder would breach a fiduciary duty by avoiding bankruptcy solely to
improve its own position.
196

incident to the legal status of stockholders. Nor will a duplication of

some or all of the directors or executive officers be fatal.
United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876, 1884 (1998)(quoting
Douglas at 196, footnotes omitted).
But there is an equally fundamental principle of corporate
law, applicable to the parent-subsidiary relationship as well as
generally, that the corporate veil may be pierced and the
shareholder held liable for the corporations conduct when, inter
alia, the corporate form would otherwise be misused to accomplish
certain wrongful purposes, most notably fraud, on the shareholders
behalf.
United States v. Bestfoods, 524 U.S. 51, 118 S. Ct. 1876, 1885 (1998).
In the case of TBS, the chapter 7 trustee determined to proceed against
the shareholder by way of breach of fiduciary duty rather than piercing the
corporate veil, possibly because no fraud could be alleged in the complaint.
Insofar as fiduciary duties are concerned, the Delaware Supreme Court has
recently nullified two avenues of recovery for the trustee. First, the court made
clear that directors and officers owe no fiduciary duties to creditors even when
the debtor is in the zone of insolvency or insolvent.130 Besides, a chapter 7
trustee is unauthorized to bring creditor claims131 other than avoidance
actions.132 Second, the court made clear Delaware does not recognize a cause
of action for deepening insolvency.133
Therefore, the chapter 7 trustee is left with enforcing the directors'
fiduciary duties to the corporation.134 As a former Chief Justice of the Delaware
Supreme Court sums it up: "Directors owe fiduciary duties of due care and

130 North

American Catholic Educational Programming Foundation, Inc. v. Rob

Gheewalla, Gerry Cardinale and Jack Daly, 930 A.2d 92, 103 (Del. 2007)( In this
opinion, we hold that the creditors of a Delaware corporation that is either
insolvent or in the zone of insolvency have no right, as a matter of law, to assert
direct claims for breach of fiduciary duty against the corporation's directors.).
131 Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972).
132 11 U.S.C. 544.
133 Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168
(Del. Ch. 2006), affd Trenwick America Litigation Trust v. Billett, 2007 Del LEXIS
357 (Del., Aug. 14, 2007).
134 It is well established that the directors owe their fiduciary obligations to the
corporation and its shareholders." North American Catholic Educational
Programming Foundation, Inc. v. Rob Gheewalla, Gerry Cardinale and Jack
Daly, 930 A.2d 92, 99 (Del. 2007).
197

loyalty to the enterprise."135 While these are broad sounding terms, they
certainly do not mean that whenever a corporation loses money, the directors are
personally responsible. Obviously, such a rule would undermine the entire
purpose of using the corporate form and would deter most persons from serving
as director.
In the case of TBS, the trustee's contention that the directors violated their
duties of care and loyalty to the enterprise arises in the awkward scenario where
the trustee is contending the enterprise should have been killed earlier.
Prior to the bankruptcy courts decision on PEs motion to dismiss, the
Delaware Supreme Court held that (a) creditors of a Delaware corporation that
is either insolvent or in the zone of insolvency have no right, as a matter of law,
to assert direct claims for breach of fiduciary duty against the corporation's
directors.,136 and (b) Delaware has no cognizable cause of action for
deepening insolvency.137 Put simply, under Delaware law, deepening
insolvency is no more of a cause of action when a firm is insolvent than a cause
of action for shallowing profitability would be when a firm is solvent.138
(Pennsylvania law does recognize a cause of action for deepening
insolvency).139 The bankruptcy court explained that if the trustee were asserting
a claim for breach of the fiduciary duty of care, claims alleging a duty of care
violation could be viewed as a deepening insolvency claim by another name.140
Additionally, the court observed that duty of care violations are indemnifiable
under Delaware law and can be defeated by proving the process of reaching the
final decision was not the result of gross negligence.141 But, the bankruptcy court
denied PEs motion to dismiss because [f]or breach of loyalty claims, on the
other hand, the plaintiff need only prove that the defendant was on both sides of
the transaction, after which the defendant has the burden to prove that the
transaction was entirely fair.142
Whether the trustee stated a claim for a breach of the fiduciary duty of
loyalty is quite significant. Our nations underlying public policy driving economic
growth is to encourage others to assume entrepreneurial and risk-taking
135 E.

Norman Veasey, "Counseling the Board of Directors of a Delaware

Corporation in Distress," ABI Journal, Vol. XXVII, No. 5 June 2008.
136 North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930 A.2d
92, 103 (Del. Sup. Ct. 2007).
137 Trenwick America Litig. Trust v. Billet, 931 A.2d 438 (Del. 2007), affg Trenwick Am. Litig.
Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006).
138 Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174 (Del. Ch. 2006).
139 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir.
2001).
140 Miller v. McCown De Leeuw & Co. (In re The Brown Schools), 386 B.R. 37, 47 (Bankr. D.
Del. 2008).
141 Id.
142 Miller v. McCown De Leeuw & Co. (In re The Brown Schools), 386 B.R. 37, 47 (Bankr. D.
Del. 2008).

198

activities by protecting them against personal liability when they have performed
in good faith and with due care, however unfortunate the consequence.143
Half of new businesses fail within their first five years.144 Should their
creators be sued for the losses on the ground they allowed personal goals to
overshadow risks to their creditors?
A glance at recent economic history further illustrates the issue.
Routinely, American enterprise makes bets. A few years ago, Wall Street bet the
country needed stadium movie theaters and invested billions to build them, which
were mostly lost.145 Stadium theaters in the face of growing movie distribution
over the internet and in competition with pre-existing theaters was a high wire act
which went awry. If, using hindsight, the directors and officers were sued for
making that bet in breach of their duty of loyalty on the ground they approved use
of investors funds in a risky bet so they could collect directors fees,
compensation, and bonuses, should they have had to prove it was fair to bet the
funds and endanger creditors while they collected benefits regardless of the
outcome? Today, the public airlines are losing billions and are destined to fail if
oil prices do not subside dramatically in a relatively short time. Which way oil
prices will go is no more predictable than a roulette ball -- maybe less. If their
directors and officers are sued for not having placed the airlines in bankruptcy
now to avoid future losses, while instead preferring to continue their positions
and benefits, should they have to prove it is fair to bet the funds and endanger
creditors while they collect benefits? Should the directors and officers of our auto
manufacturers be sued for breach of loyalty and have to prove that they have not
put the auto companies into bankruptcy even though they are losing billions
because they are making a good bet that they can solve the auto companies
declining market shares, retiree expenses, uncompetitive wage structures, and
not because they want to maintain their jobs and benefits?
When the issue in TBS is replicated for the stadium theaters, airlines, and
auto manufacturers, a fundamental question occurs across each scenario.
Namely, why would bankruptcy produce a better result for shareholders or
creditors? In TBS, the trustee alleged that while PE kept TBS out of bankruptcy,
its insolvency deepened by over $22 million, leaving shareholders with zero and
creditors further in the red. But, the TBS trustee nowhere alleged that (a) an
earlier bankruptcy could have attained as much sale proceeds as TBS procured
outside bankruptcy to retire over $98 million in debt and (b) an earlier bankruptcy
would not have cost millions of dollars more while all the properties were
143 Continuing Creditors Committee of Star Telecomm., Inc. v. Edgecomb, 385 F.Supp.2d 449,
458 (D.Del. 2004) (quoting Duesenberg, The Business Judgment Rule and Shareholder
Derivative Suits: A View from Inside, 60 Wash. U.L.Qu. 311, 314 (1982)).
144
http://www.sba.gov/smallbusinessplanner/plan/getready/SERV_SBPLANNER_ISENTFORU.html.
145 See, e.g., In re UA Theatre Co., Case No. 00-3514 (PJW) , 2004 Bankr. LEXIS 1258 (Bankr.
D.Del. August 25, 2004); In re Winstar Communications Inc., 378 B.R. 756 (Bankr. D.Del. 2007);
In re GC Companies, Inc., 274 B.R. 663 (Bankr. D.Del. 2002);

199

administered, operated, and sold in bankruptcy. Put differently, the trustees

complaint did not allege what it needed to allege to aver that TBS or its creditors
were worse off by not having an earlier bankruptcy. Without those allegations
which would be exceedingly difficult to prove, the complaint lacked a prima facie
case of any harm. But, it appears the bankruptcy court was not asked to dismiss
the breach of loyalty claim on that ground.
Additionally, in each of these hypotheticals, as well as in the case of TBS,
the duty of loyalty is owed initially to shareholders. By failing to put TBS or any of
the stadium theaters, airlines, or auto manufacturers into chapter 7 liquidation
cases, all shareholders prospects, however tenuous, are preserved. Therefore,
there does not appear to be any breach of a duty of loyalty to the shareholders.
To the extent the controlling shareholder or directors also owe their duty of
loyalty to the company, it is incongruous to assert the shareholder breached its
duty of loyalty to the company by not killing it earlier, terminating all jobs, hurting
customers, and eliminating it as a competitor in the economy.
To be sure, a control person breaches his or her fiduciary duty of loyalty
when she puts her own interests, whether financial or personal, ahead of the
company.146 "[T]he central insight of the entire fairness test...is that when a
fiduciary self-deals he might unfairly advantage himself even if he is subjectively
attempting to avoid doing so."147 This raises the question as to whether
controlling shareholders, directors, and officers can get bogged down in litigation
every time a party alleges they acted for personal motives in breach of their
fiduciary duty of loyalty.
To try to deter and avoid unwarranted attacks on controlling shareholders'
and directors' loyalties, there are safeguards to deploy. First and foremost, the
goal is to invoke the business judgment rule presumption that the directors were
disinterested, did not lack independence and acted in good faith.148 To do so, the
controlling shareholder or interested directors need a board of directors having
two or more independent and disinterested directors who can objectively assess
transactions in which the controlling shareholder or interested directors have
personal interests. The jurisprudence provides other safeguards. For instance,
receipt of directors' fees149 and ownership of the company's stock150 are mostly
held not to be factors rendering directors interested, unless a single director

146 See Venhill Limited Partnership v. Hillman, 2008 Del. Ch. LEXIS 67, *9 (Del. Ch. June 3,
2008)(not released for publication; subject to revision or withdrawal); In re RJR Nabisco, Inc.
S'holders Litig., 1989 WL 7036, at *15 (Del. Ch. Jan. 31, 1989).
147 Id. at *68.
th
148 See Block, Barton, Radin, The Business Judgment Rule (5 ed. 1991) at 264.
149 Unitrin, Inc. v. American Gen. Corp., 651 A.2d 1361, 1380 (Del. 1995); Tabas v. Mullane, 608
F. Supp. 759, 766 (D.N.J. 1985).
150 OBerly v. Kirby, 592 A.2d 1268 (Del. 1991).

200

serves on multiple boards of companies controlled by the same investment

advisor.151
From the complaint in TBS, it does not appear that PE created a board
having disinterested directors who could have assessed the transactions in which
PE received benefits that other creditors or shareholders did not. Had that been
done, the trustee's complaint may not have survived the pleading stage. To
survive a motion to dismiss, the trustee's complaint would have to "plead around
the business judgment rule."152 The Delaware courts scrupulously require
particularized pleading showing why the business judgment rule presumption
does not apply, such as by identifying which directors approved a transaction and
alleging why they were not independent and disinterested.153 Many private
equity firms find much value added from independent directors who can provide
objective views and industry insights. Having such directors provides both
valuable ideas and legal defenses.
The TBS complaint also raises the issue as to the correct remedy for
wrongful transfers. The complaint emphasizes that PE was paid $1.7 million for
a sales transaction yielding $64 million, notwithstanding that PE received
consulting fees of up to $800,000 per year. At face value, if PE did nothing extra
to earn the $1.7 million and TBS was insolvent, then the transfer was a
constructively fraudulent transfer and PE will have to disgorge the $1.7 million
plus interest. Similarly, if PE granted the second institutional lender a security
interest in TBS' assets solely to give it a priority in exchange for which the lender
would share $2.9 million of collateral proceeds with PE and not with TBS' other
creditors, Delaware law has a fraudulent transfer statute that would void the
transfer to PE if TBS were insolvent at the time and PE had reasonable cause to
believe TBS was insolvent.154 The special treatment for the institutional lender is
not actionable as Delaware law allows insolvent debtors to prefer a non-insider
creditor over another and explains the 'trust fund' doctrine does not require a
different result.155 Insider creditors, however, can not be preferred.156 Notably,
when the Delaware Supreme Court ruled that directors of insolvent corporations
owe no direct fiduciary duties to creditors, it did not even mention the trust fund
doctrine.157

151 Strougo v. Scudder, Stevens & Clark, Inc., 964 F. Supp. 783, 794 (S.D.N.Y. 1997),
reargument denied, [1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) 99,533 (S.D.N.Y. Aug. 18,
1997).
152 Stanziale v. Nachtomi (In re Tower Air, Inc.), 416 F.3d 229, 238 (3d Cir. 2005).
153 See, e.g., Nelson v. Emerson, 2008 Del. Ch. LEXIS 56, *6 (Del. Ch. May 6, 2008)(Strine,
V.C.)(not released for publication and subject to revision and withdrawal).
154 6 Del.C. 1305(b); Joseph v. Frank (In re Troll Communications, LLC), 385 B.R. 110, 122
(Bankr. D.Del. 2008).
155 Pennsylvania Co. v. South Broad St. Theatre Co., 20 Del. Ch. 220, 227, 229-230 (Del. Ch.
1934).
156 Amussen v. Quaker City Corp., 18 Del. Ch. 28 (Del. Ch. 1931).
157 See North American Catholic Educational Programming Foundation, Inc., v. Gheewalla, 930
A.2d 92 (Del. Sup. Ct. 2007).

201

Similarly, the grant of the junior lien to PE for its subordinated claim of
$12.5 million would likewise be a voidable preference if granted within a year of
TBS' bankruptcy while it was insolvent and if TBS benefited from it which is
unclear.158 Notably, while Congress enacted a preference statute applicable to
insiders that recovers transfers to them up to a year before bankruptcy as
opposed to ninety days for non-insiders, Congress thereby knowingly allowed
insiders to keep repayments of debt received more than a year before
bankruptcy.
The trustee's complaint proceeds on the premise that the combination of
PE's failure to put TBS into chapter 7 earlier and PE's receipt of potentially
voidable transfers creates a larger damage award equal to the deepening
insolvency of TBS by more than $22 million. The larger damages are said to
arise from PE's breach of its duty of loyalty. As explained above, it is not clear
that the deepening insolvency was a harm to TBS or its creditor body because an
earlier liquidation in bankruptcy may have produced a much worse result.
Notably, the use of deepening insolvency as a damage measure is rejected by
many courts.159 The bankruptcy court in TBS did not reject it, but ironically relied
on a decision that refused to disclaim deepening insolvency as a damage
measure,160 but expressly explains that the correct damage measure would
require the plaintiff to prove "that the defendants' actions forced the debtors to
dissipate corporate assets that would have been retained otherwise (and then
quantify the value of those assets)."161 Applying that to TBS, the trustee would
have to prove that PE's operation of the business outside bankruptcy realized
less or cost more than what could have been realized in bankruptcy, which is not
pled in the complaint.
Finally, history also has some bearing on the trustee's complaint against
PE. The Bankruptcy Act of 1898, as amended, contained an indemnity
requirement. Bankruptcy courts were authorized to order debtors to post bonds
to indemnify the estate against subsequent loss or diminution.162 Congress
discontinued that requirement under the Bankruptcy Code. Now, the remedy for
substantial or continuing losses is that a chapter 11 case may be converted to
chapter 7 or dismissed, but only if there is an absence of a reasonable likelihood
of rehabilitation.163 Rehabilitation does not have to repay creditors in full or any
such thing. It only requires that the business survives. This was not raised by
PE in the context of its motion to dismiss, but this history clearly shows Congress
158 11 U.S.C. 547(b)(4)(B).
159 See, e.g., Seitz v. Detweiler, Hershey and Associates (In re CITX Corp.), 448 F.3d 672, 678
th
(3d Cir. 2006); Wooley v. Faulkner (In re SI Restructuring, Inc.), 2008 U.S. App. LEXIS 13140 (5
Cir. 2008); Joseph v. Frank (In re Troll Communications, LLC), 385 B.R. 110, 122 (Bankr. D.Del.
2008).
160 Alberts v. Tuft (In re Greater Southeast Community Hospital Corp.), 353 B.R. 324, 338
(Bankr. D.D.C. 2006).
161 Id.
162 Former 11 U.S.C. 326 (Chapter XI), 426 (Chapter XII).
163 11 U.S.C. 1112(b)(4)(A).

202

has quite a tolerance for investors attempting to continue their businesses in the
hope of rehabilitation, even at the expense of incurring losses to creditors who
will not be made whole for such losses. That tolerance may preempt
jurisprudence disallowing the continuation of businesses.
The world is still safe for capitalism for those who learn from history.
Whether starting a business or rescuing one, the control persons should bring
themselves under the umbrella of the business judgment rule by the use of
independent directors, expert opinions, or comparable methods. The preliminary
decision in TBS, does not mean private equity funds should not collect consulting
fees from their portfolio companies and should not collect additional fees for
arranging capital transactions. It means the services for such fees should be
carefully documented. Indeed, private equity firms can save their portfolio
companies small fortunes by providing treasury functions that few executives can
provide. It is only a matter of making that clear and having independent directors
objectively assess it. Private equity firms can also rescue their portfolio
companies and can do so with secured debt, so long as independent directors
are satisfied. Breaches of the fiduciary duty of loyalty can be avoided, with good
planning by experts who have seen what can go wrong. That is the lesson of
TBS.
D. Loan to Own: Official Committee of Unsecured Creditors of
Radnor Holdings Corp. v. Tenenbaum Capital Partners (In re
Radnor Holdings Corp.), 353 B.R. 820 (Bankr. D. Del. 2006)
i. Facts
After Radnors financial advisor (Lehman Brothers) had contacted 40
potential investors, Tenenbaum Capital Partners agreed to purchase $25 million
of preferred stock and $95 million of senior secured debt. 353 B.R. at 828.
Tenenbaum was granted the right to designate a board member and a person to
monitor board meetings, and had the right to name more board members if
certain financial targets were not met. 353 B.R. at 828. Tenenbaum also had
the right to veto certain employment agreements and transactions with affiliates.
The court found it would be irrational to believe Tenenbaum invested in stock
while believing the company was insolvent. 353 B.R. at 830. When Radnor
failed to meet its projections, Tenenbaum made an additional $23.5 million
secured loan. 353 B.R. at 832. The unsecured noteholders consented. 353
B.R. at 834. Tenenbaum refrained from declaring certain defaults such as a
failure to satisfy and ebitda covenant while the banks insisted on the debtors
retention of a turnaround consultant. 353 B.R. at 834. Radnor commenced its
bankruptcy case because its bank creditors determined they had overadvanced
against their collateral and they stopped lending. 353 B.R. at 834.

203

Tenenbaum did not want to be a stalking horse bidder for Radnor, but was
convinced by the board that without Tenenbaum as stalking horse, the case
could result in a chapter 7 liquidation. 353 B.R. at 834. The Tenenbaum
representative resigned from the board and the asset purchase agreement was
negotiated at arms length. Id.
As part of the order approving bidding procedures, the bankruptcy court
authorized the statutory creditors committee to sue Tenenbaum and others.
Tenenbaum would be allowed to credit bid at the sale, whatever amount of its
$128.8 million secured claim survived the committees complaint. 353 B.R. at
826-827.
ii. Issues
Should Tenenbaums claim be recharacterized as equity?
Should Tenenbaums claim be equitably subordinated to general
unsecured claims?
Is Tenenbaum or the director it nominated liable for breach of fiduciary
duty or aiding and abetting breach of fiduciary duty?
iii. Holdings
Neither Tenenbaum nor the director it nominated have any liability on the
foregoing counts.
iv. Rationale
The overriding consideration in a recharacterization case is the intent of
the parties. Cohen v. KB Mezzanine Fund II (In re SubMicron Systems Corp.),
432 F.3d 448 (3d. Cir. 2006). Tenenbaums knowledge that Radnor was
experiencing a liquidity crisis when it made its $23.5 million loan, does not
change the loan into equity because its rational for an existing lender to protect
its debt with an additional loan. Id. at 457. Thus, the loan cannot be
recharacterized on the ground no prudent lender would make a loan in those
circumstances. 353 B.R. at 840. Here, the parties at all times treated the loan
as a loan and not equity. 353 B.R. at 839.
Tenenbaum engaged in no inequitable conduct that harmed other
creditors. Moreover, its access to inside information did not make it an insider or
put it in control for purposes of applying to it a more stringent standard. 353 B.R.
at 841.

204

Based on Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168
(Del. Ch. 2006) and Seitz v. Detweiler, Hershey & Assoc. (In re CitX Corp), 448
F.3d 672 (3d Cir. 2006), there is no breach of fiduciary duty simply because a
board attempts to rehabilitate an insolvent company while maintaining
operations:
As I conclude below, the Trenwick opinion made quite clear
that under Delaware law, a board is not required to wind down
operations simply because a company is insolvent, but rather may
conclude to take on additional debt in the hopes of turning
operations around.
353 B.R. at 842.
Delaware law allows a corporations certificate of incorporation to
exculpate directors from their duty of care: 8 DEL. CODE ANN. 102(b)(7).
Section 102(b)(7) provisions act as a complete bar to liability
even when creditors or a trustee, rather than stockholders, are
suing derivatively. Production Res. Group, L.L.C. v. NCT Group,
Inc., 863 A.2d 772, 793 (Del. Ch. 2004); Pereira v. Farace, 413
F.3d 330, 342 (2d Cir. 2005), cert. denied, 126 S. Ct. 2286, 2006
U.S. LEXIS 3965, 164 L. Ed. 2d 812.
However, the fact that the Committee has dropped its duty of
care claims does not render Article Seventh and 102(b)(7)
meaningless to this case. To the contrary, much of the Committee's
case at trial at best would have implicated the duty of care, not the
duty of loyalty. By way of example only, if the Radnor board should
not have approved a $ 55 million EBITDA maintenance covenant
because that number was too high (and the Court need not and
does not make such a finding here), it did not do so in bad faith;
rather, the only potential breach would have been in not
understanding that the Company's projections were optimistic and
that the maintenance covenant, set at the $ 55 million level, ran too
high of a risk of causing a default. That is a quintessential duty of
care claim. Simply alleging that Mr. Kennedy desired funding at any
cost does not convert this claim into one implicating the duty of
loyalty. Thus, Article Seventh and 102(b)(7) would have barred
any such claims against the board, and Tennenbaum and Mr.
Feliciano therefore could not have possibly been held liable for
aiding and abetting such claims.
353 B.R. at 842-843.

205

Tenenbaum was also not liable for aiding or abetting a breach of fiduciary
duty and deepening insolvency is not a recognized cause of action in Delaware:
TCP never aided and abetted a breach of fiduciary duty.
The elements for aiding and abetting a breach of fiduciary duty
under Delaware law are as follows: "(1) the existence of a fiduciary
relationship, (2) a breach of the fiduciary's duty and (3) a knowing
participation in the breach by the non-fiduciary defendant." Cantor
Fitzgerald, L.P. v. Cantor, 724 A.2d 571, 584 (Del. Ch. 1998). The
evidence does not support a finding that any of these elements
have been satisfied.
.Even if the Debtors were insolvent at the time of the
Tranche A, B and C transactions, the Radnor [**50] Board's
actions would not have breached any fiduciary duties owed to the
Debtors' unsecured creditors. As the Court of Chancery
acknowledged in Trenwick, Delaware law does not impose an
absolute obligation on the board of an insolvent company to cease
operations and liquidate. See Trenwick, 906 A.2d at 204. Rather,
directors of an insolvent company may pursue strategies to
maximize the value of the company, including continuing to operate
in the hope of turning things around. See id.; Equity-Linked
Investors, L.P. v. Adams, 705 A.2d 1040 (Del. Ch. 1997) (permitting
board of company within days of a bankruptcy filing to incur new
secured debt in aid of funding risky but promising new products
over the objection of preferred stockholders with liquidation
preference).

353 B.R. at 843.

The business judgment rule protects the directors of solvent, barely
solvent, and insolvent corporations against claims of creditors and
shareholders. 353 B.R. at 843.

The Court holds that Mr. Feliciano did not breach his duty of
loyalty. The Committee has failed to prove that Mr. Feliciano was
interested in any transaction and voted in favor of it due to his
outside financial interests rather than voting in the best interests of
Radnor. Cede & Co. v. Technicolor Inc., 634 A.2d 345, 363 (Del.
1993) ("to establish a breach of duty of loyalty, [plaintiff] must
present evidence that the director either was on both sides of the
transaction or 'derive[d] any personal financial benefit from it in the
sense of self-dealing, as opposed to a benefit which devolves upon
the corporation or all stockholders generally."') (emphasis in
original).

206

353 B.R. at 844-845 (emphasis in original).

The Delaware doctrine of acquiescence also bars relief here:
The Committee's equitable subordination and breach of
fiduciary duty Counts are causes of action sounding in equity. In
addition to holding that the Committee has failed to prove its casein-chief on these Counts, I conclude that the Committee's claims
are barred by the equitable defense of acquiescence, as applied by
the Delaware courts.

It has long been the law of Delaware that where a transaction

cannot be accomplished without stockholder approval, a
stockholder who either votes in favor of the transaction or accepts
the consideration offered by the transaction is barred from asserting
[**65] claims in claims in connection with that transaction. See,
e.g., Kahn v. Household Acquisition Corp., 591 A.2d 166, 176-77
(Del. 1991); Bershad v. Curtiss-Wright Corp., 535 A.2d 840, 848
(Del. 1987); Elster v. Am. Airlines, 34 Del. Ch. 94, 100 A.2d 219,
220-221 (Del. Ch. 1953); Finch v. Warrior Cement Corp., 16 Del.
Ch. 44, 141 A. 54, 60 (Del. Ch. 1928). Here, 95% of the
noteholders, including a majority of the members of the Committee,
did both: they voted in favor of Tranche C and accepted $ 675,000
in exchange for their consent. Thus, they have acquiesced to the
Tranche C Loans. Having acquiesced to it, they cannot now be
heard to argue that Tranche C should be treated as equity, nor that
entering into Tranche C was a breach of fiduciary duty.
While the Committee is a separate legal entity from the
noteholders who approved Tranche C, the Delaware cases draw no
such distinction. They typically arise in a class action context,
where like the seven members of the Committee, a stockholder
attempts to bring claims not only on his or her own behalf, but on
behalf of all stockholders, including stockholders that [**66] did not
acquiesce. Nevertheless, the Delaware courts have barred the
stockholders who acquiesced from asserting such claims on behalf
of those who did not. See, e.g., Kahn, 591 A.2d at 176-77; In re
Lukens Inc. Shareholders Litig., 757 A.2d 720, 738 (Del. Ch. 1999),
aff'd sub. nom., Walker v. Lukens, Inc., 757 A.2d 1278 (Del. 2000)
(TABLE) (noting, because a "large majority of the putative plaintiff
class . . . both voted in favor of the merger and received the
benefits of it," that "plaintiffs would confront substantial obstacles in
continuing the action on behalf of those persons"). I find that the
noteholders who control the Committee are in the same position

207

and cannot maintain their equitable subordination and breach of

fiduciary duty claims.
353 B.R. at 848.
22. Critical Vendor Payments of Prepetition Claims: In re KMART Corp.,
359 F.3d 866 (7th Cir. 2004), rehearing denied, 2004 U.S. App. LEXIS 9050,
(7th Cir. May 6, 2004), cert. denied, 2004 U.S. LEXIS 2649 (U.S., Nov. 15,
2004).
i.

Facts.

On the first day of its chapter 11 case, KMART requested permission to

pay in full at its discretion the prepetition claims of all critical vendors who agreed
to furnish goods on customary trade terms for the next two years. The order
granting the request provided the relief was in the best interests of the debtors,
their estates, and creditors. No notice had been given to the non-critical vendors.
Kmart used its authority to pay 2,330 suppliers approximately $300 million from
$2 billion of new credit. The non-critical vendors ultimately received about 10
cents on the dollar, mostly in stock. 359 F.3d at 868-869
A creditor timely appealed the order and it was reversed 14 months later,
just before confirmation of Kmarts chapter 11 plan. 359 F.3d at 869. Certain
critical vendor-appellants argued the reversal was too late to require
disgorgement of the funds, 359 F.3d at 869, and one appellant who intervened in
the circuit court appeal argued that its not having been named earlier in the
appeal meant the reversal couldnt affect it, 359 F.3d at 870.
ii.

Issues.

Does the Bankruptcy Code grant the bankruptcy court authority to prefer
some vendors over others? 359 F.3d at 872.
Can the critical payments be recovered after confirmation? 359 F.3d at
869-870.
Does the failure to have named a critical vendor in the appeal of the
critical vendor order prevent the appellate decision from affecting the unnamed
vendor? 359 F.3d at 870.
iii.

Holdings.

Section 363(b) is a more promising underpinning than any other

Bankruptcy Code provision to authorize a critical vendor order because

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satisfaction of a prepetition debt to keep critical supplies flowing is a use of

property other than in the ordinary course of administering an estate in
bankruptcy. 359 F.3d at 872. Even if 363(b)(1) allows critical-vendors orders
in principle, preferential payments to a class of creditors are proper only if the
record shows the prospect of benefit to the other creditors. 359 F.3d at 874.
What the Supreme Courts holdings (United States v. Reorganized CF&I
Fabricators, of Utah, Inc., 518 U.S. 213 (1996) and United States v. Noland, 517
U.S. 535 (1996)) principally say is that priorities do not change unless a statute
supports that step; and if 363(b)(1) is such a statute, then there is no
insuperable problem. If the language is too open-ended, that is a problem for the
legislature. Nonetheless, it is prudent to read, and use, 363(b)(1) to do the least
damage possible to priorities established by contract and by other parts of the
Bankruptcy Code. We need not decide whether 363(b)(1) could support
payment of some pre-prepetition debts, because this order was unsound no
matter how one reads 363(b)(1). 359 F.3d at 872.
[T]he bankruptcy court did not explore the possibility of using a letter of
credit to assure vendors of payment. The court did not find that any firm would
have ceased doing business with Kmart if not paid for pre-petition deliveries,.
The court did not find that discrimination among unsecured creditors was the only
way to facilitate a reorganization. It did not find that the disfavored creditors were
at least as well off as they would have been had the critical vendors order not
been entered. 359 F.3d at 873-874.
The doctrine of necessity is just a fancy name for a power to depart from
the Bankruptcy Code and did not survive its passage. Older doctrines may
survive as glosses on ambiguous language enacted in 1978 or later, but not as
freestanding entitlements to trump the text. 359 F.3d at 871.
No provision of the Bankruptcy Code forbids revision of the critical vendor
order as the Bankruptcy Code does for certain other orders. 359 F.3d at 869.
Judges do not invent missing language. 359 F.3d at 869.
As a party to the appeal in the circuit court, the intervening appellant will
not be allowed to contest matters resolved there. 359 F.3d at 870-871.
Unnamed and nonintervening critical vendors will be subject to the precedential
effect of the appellate decision as opposed to the preclusive force of the
appellate decision. 359 F.3d at 871.
iv.

Rationale:

Bankruptcy Code section 105(a) empowers the bankruptcy court to

implement the Bankruptcy Code, not to override it. 359 F.3d at 871. The fact
that a [bankruptcy] proceeding is equitable does not give the judge a free-floating

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discretion to redistribute rights in accordance with his personal views of justice

and fairness, however, enlightened those views may be. 359 F.3d at 871
(quoting In re Chicago, Milwaukee, St. Paul & Pacific R.R., 791 F.2d 524, 528
(7th Cir. 1986)).
If paying the critical vendors would enable a successful reorganization
and make even the disfavored creditors better off, then all creditors favor
payment whether or not they are designated as critical. This suggests a sue of
363(b)(1) similar to the theory underlying a plan crammed down the throats of an
impaired class of creditors: if the impaired class does at least as well as it would
have under a Chapter 7 liquidation, then it has no legitimate objection and cannot
block the reorganization. 359 F.3d at 872-873.
v.

Analysis.

While Kmart affirms the reversal of a critical vendor order, it also provides
a potential roadmap for using section 363(b)(1) to authorize critical vendor
orders. To do so, debtors must show their critical vendors really wont supply
goods as long as they are assured of payment by the debtor having a line of
credit, posting a letter of credit, or other means, as well as showing the noncritical vendors will not be worse off due to the payments.
The United States District Court for the Northern District of Illinois in
Capital Factors Inc. v. Kmart Corp., 291 B.R. 818 (N.D. Ill. 2003), corrected by
Capital Factors, Inc. v. Kmart Corp.,2003 U.S. Dist. LEXIS 17437 (N.D. Ill.,
Sept. 29, 2003), had reversed the order of the bankruptcy court in the Kmart
chapter 11 case authorizing payment of critical vendor prepetition claims. It
announced a per se rule that critical vendor payments simply are not
authorized under the Bankruptcy Code. 291 B.R. at 823 (Nevertheless, it is
clear that however useful and practical these payments may appear to
bankruptcy courts, they simply are not authorized by the Bankruptcy Code.
Congress has not elected to codify the doctrine of necessity or otherwise
permit pre-plan payment of prepetition unsecured claims. Because we hold
that the bankruptcy court did not have either the statutory or equitable power to
authorize the pre-plan payment of prepetition unsecured claims, we need not
address the second and third issues Capital raises on appeal.)(unchanged by
corrected opinion).
(i) No Per Se Rule Barring
Payment of Prepetition Debt with
Court Approval
Notably, the affirmance by the United States Court of Appeals for the
Seventh Circuit leaves the order in the Kmart case vacated, but effectively
undoes the district courts announcement of the rule barring payment of critical

210

vendors prepetition claims based on the courts purported lack of power to

authorize such payments.
From a policy and common sense perspective, there is no question the
bankruptcy court should be empowered to authorize a debtor in possession to
pay prepetition when the payment will create more value for the estate than the
amount of the payment. As observed in Kmart, 359 F.3d at 872, section 363(b)
may authorize such payments as it is very open ended. These situations can
arise in numerous scenarios. For instance, if the debtors operations depend on
receipt of certain goods or services not susceptible of timely replacement by
alternate vendors, and the vendor itself will fail if its prepetition debt is not paid,
then the debtor confronts the need to shut down or pay the vendors prepetition
claim. Normally, shutdown destroys far more value and jobs than the amount of
the prepetition claim. Sometimes, failure to pay prepetition materialmens claims
leave the unpaid vendor with a secured claim. In those situations, the debtor
loses nothing by paying the prepetition claim if it is fully secured. Alternatively, if
a vendor is operating at capacity, it may have the luxury of determining to
upgrade its customer list which may mean dropping the debtor. Unless alternate
supplies at comparable price and quality are available, the debtor may lose more
value by not paying the vendors prepetition claim than the amount of the claim.
(ii)
Acts to Collect Prepetition Debts May Be
Automatic Stay Violations
To be sure, a vendor who simply threatens a debtor that it will stop
supplying goods unless its prepetition debt is paid, may be violating the
automatic stay against taking acts to collect prepetition claims. 11 U.S.C.
362(a); see Sportfame of Ohio, Inc. v. Wilson Sporting Goods (In re Sportfame
of Ohio, Inc.), 40 B.R. 47; (Bankr. N.D. Ohio 1984).
Moreover, most vendors are smart enough to know that refusing to sell
goods tomorrow at a profit to a debtor in possession having an adequate credit
line due to a prepetition debt existing is economically irrational. Kmart, 359
F.3d at 873.
(iii)

Foreign Vendors
Having No Minimum
Contacts with United
States

Foreign vendors having no minimum contacts with the United States of

America and therefore not being subject to the bankruptcy courts power to
enforce the automatic stay, frequently have the leverage to demand payment of
their prepetition claims and the debtors estate is better off paying the claims
when termination of supplies from the foreign vendors will destroy more estate
value than the amount of the claims to be paid.

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While there are many situations where the issuance of critical vendor
orders is warranted, the courts need to guard against abuse. For instance, no
vendor should be paid simply because of its relationships with management.
(iv)

Procedure

Significantly, debtors and their estates and creditors are better off not
naming the creditors who are critical. That eliminates the possibility of the debtor
convincing the vendor to supply new goods and services without having its
prepetition debt paid. Thus, the debtors showing might include evidence that the
estate can not take the risk of a cessation of supplies and must have the
authority to do the necessary to obtain supplies vital to maintaining their
operations as a going concern and to a successful reorganization. The courts
power to revise its orders and the creditors committees later ability to review the
debtors basis for each critical vendor payment can provide sufficient restraint on
the debtors management not to abuse the authority it gets to make such
payments. Notably, by recognizing the critical vendor order was issued the first
day of the case and by verifying that payments made can be recovered if
wrongful, the Kmart decision does not prohibit the issuance of critical vendor
orders, if needed, on the first day of a case, but sets very rational parameters for
entry of such orders.
(v)
No Authority to Pay Unallowable Prepetition
Claims
The various authorities and theories used to reject critical vendor orders
as illegal on a per se basis, are each inapplicable to situations where the estate
gains more value than it loses by paying a critical vendors prepetition claim. For
example, in the A.H. Robins chapter 11 case resulting from injuries to women
using the Dalkon Shield, the debtor and examiner wanted to make $15 million
available to fund reconstructive surgery for women whose child bearing ability
might terminate prior to plan confirmation. Official Comm. of Equity Sec. Holders
v. Mabey, 832 F.2d 299 (4th Cir. 1987).
The United States Court of Appeals for the Fourth Circuit reversed the
district court order approving the emergency fund because the womens claims
were not allowed claims and the payments would precede plan confirmation.
There was also no certainty the payments could be recovered from women who
later turned out not to have had allowed claims. In short, the A.H. Robins
situation was a sympathetic attempt to pay prepetition debt without any offsetting
benefit to the estate. Section 363(b), therefore, could not help and the decision
appears inapplicable to critical vendor payments that do create value or avoid
harm to a debtors estate.

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(vi)

No Authority to Pay
Prepetition Claims
without Offsetting
Benefit to Estate

In the chapter 11 case of Oxford Management Inc., over the debtors

objection, the bankruptcy court ordered the debtor to pay a prepetition claim for a
brokerage commission. Fortunately, the United States Court of Appeals for the
Fifth Circuit reversed. Chiasson v. J. Louis Matherne Assocs. (In re Oxford
Management Inc.), 4 F.3d 1329 (5th Cir. 1993). There was no showing that
paying the prepetition claim would add value to the estate or avoid any harm.
Instead, one creditor would benefit at the expense of other creditors of equal
rank. This is the opposite of the rationale for critical vendor payments under
which the payment is only justified if it avoids harm or adds value for other
creditors.
(vii) No Authority to Cross Collateralize Prepetition
Debt with Postpetition Collateral without Offsetting
Benefit to Estate
Cross collateralization of $24 million of prepetition debt was denied by the
United States Court of Appeals for the Eleventh Circuit in the chapter 11 case of
Saybrook Manufacturing Co. Shapiro v. Saybrook Mfg. Co. (In re Saybrook Mfg.
Co.), 963 F.2d 1490 (11th Cir. 1992). There, the debtor proposed to collateralize
$24 million of prepetition debt in exchange for a new loan of $3 million. That is
certainly consistent with the notion that payment of prepetition debt of critical
vendors should not be authorized unless it results in a benefit to the estate
exceeding the payment. Paying or securing $24 million in exchange for the
benefit of a $3 million loan doesnt pass the section 363(b) test. Nowhere was
the $3 million loan shown to be worth $24 million in the Saybrook situation.
Thus, other unsecured claimholders would have been hurt, not helped.
(viii) Paying Prepetition Debt Does Not Violate
Equitable Subordination Rules if the Unpaid
Prepetition Debt Benefits
The rationale for denying payment of prepetition debt in the chapter 11
case of FCX Inc. is also quite interesting. In re FCX Inc., 60 B.R. 405 (E.D.N.C.
1986). There, the United States district court ruled that in elevating certain
prepetition unsecured claims over the debtors other creditors, the bankruptcy
court subordinated the claims of the debtors remaining creditors without
satisfying the standards for equitable subordination. Those standards require
that a creditor act wrongfully to benefit itself and harm other creditors before its
claim should be equitably subordinated.

213

The unique aspect of equitable subordination, however, is that the

subordination of the creditors claim results in the creditor obtaining a smaller (or
zero) distribution from the estate. Conversely, in the context of critical vendor
payments, they should only be authorized when they result in the estate having
greater value than it would have if the payment were not made. Under these
circumstances, the other so-called subordinated creditors who do not receive
payment of their prepetition debt do not obtain lesser distributions from the
estate. Rather, they obtain more.
(ix) The Bankruptcy Code Allows Payment of
Prepetition Debt in Numerous Instances
Moreover, in the numerous circumstances under the Bankruptcy
Code when prepetition debt must be paid prior to plan confirmation, such as
when a debtor assumes an executory contract or unexpired lease and pays the
cure cost, it is never a condition precedent that other creditors not having their
prepetition claims cured satisfy the requirements for equitable subordination of
their claims. Indeed, the test for assuming an executory contract is generally the
same as for invoking section 363(b) to pay a prepetition claim. Namely, the
value of the assumed contract to the estate should exceed the cure amount.

(x)

Prepetition Debt Can Not Be Paid without Court

Approval

In the chapter 11 case of B&W Enterprises, Inc., the United States

Court of Appeals for the Ninth Circuit affirmed a decision of the district court
overturning critical vendor payments made without court approval. B&W
Enterprises Inc. v. Goodman Comp., 713 F.2d 534 (9th Cir. 1983). In dicta, the
court opined it was not convinced the necessity of payment rule should be
applied to a debtor in the trucking industry. Since the payments had not been
submitted for court approval before they were made and the case was converted
to a chapter 7 liquidation case, there was no record showing whether the estate
was better off for making them.
(xi)
The Bankruptcy Codes Priority Scheme
Includes Substantial Flexibility
Significantly, the most prevalent rationale of courts ruling the Bankruptcy
Code bars payment of prepetition debt prior to plan confirmation is that
payment would alter the distribution scheme imposed by Congress. To assess
this rationale, several factors must be considered. See, e.g., Capital Factors,
Inc. v. Kmart Corp.,2003 U.S. Dist. LEXIS 17437 at *8-*9 (N.D. Ill., Sept. 29,
2003) (The Bankruptcy Code sets forth a priority scheme for the payment of
claims. See 11 U.S.C. 503, 507. The Code does not carve out priority or
administrative expense status for prepetition general unsecured claims based

214

on the critical or "integral" status of a creditor. But the effect of the

bankruptcy court's orders was to elevate the claims of the critical vendors
over those of other unsecured creditors and to subordinate the claims of noncritical unsecured creditors. The bankruptcy court altered the priority scheme
set forth in the Bankruptcy Code.).
No provision of the Bankruptcy Code expressly bars such
payments. Several provisions such as section 363(b) appear to allow such
payments. Additionally, the distribution scheme Congress imposed in the context
of plan confirmation is rather flexible and allows for some creditors to be treated
better than similarly situated prepetition claimholders when valid business
reasons for separate classification exist. And, most importantly, when payment
of the prepetition debt results in every other creditor obtaining more than it would
otherwise receive because the payment increased the estates value or averted a
loss, it does not appear the flexible Congressional distribution scheme Congress
imposed for plan confirmation is altered. It also furthers the fundamental purpose
of a chapter 11 reorganization.
To avoid having to request court approval for payment of these
claims, the prudent debtor with sufficient resources will prepay critical vendors
prior to the chapter 11 case commencing in exchange for commitments to
continue shipping on customary terms. Most debtors, however, do not have the
resources to prepay these claims and therefore will have to request court
approval. Before filing a motion a debtor should verify that no other alternative
source of supply for the product exists. A debtor should also instruct vendors
that conditioning continued shipment of product on payment of a prepetition claim
is a violation of the automatic stay. Only after a debtor is convinced that no
alternative source of supply exists, and the estate will lose profits or value without
the vendors goods, in excess of the prepetition debt to be paid, should it seek
authority to pay the vendors prepetition debt.
23. To What Extent Can A Debtor in Possession Indemnify Its
Financial Advisor?
A. In re United Artists Theatre Co., 315 F.3d 217 (3d Cir. 2003)
1. Facts
United Artists, as chapter 11 debtor in possession (UA), requested an
order approving its retention of Houlihan, Lokey, Howard & Zukin Capital
(HLHZ) as its financial advisor. The proposed retention agreement provided
UA would indemnify Houlihan Lokeys reasonable attorneys fees and expenses,
as well as any losses incurred by Houlihan Lokey with respect to, inter alia, its
providing of services. The letter also contained an exception for any Losses that
are finally judicially determined to have resulted from the gross negligence, bad

215

faith, willful misfeasance, or reckless disregard of its obligations or duties on the

part of Houlihan Lokey. 315 F.3d at 222.
UAs motion supplemented the gross negligence and willful misconduct
carveouts for indemnity in subparagraph (d) above by providing that, in the case
of a judicial determination, it must be final and find that either the gross
negligence or willful misconduct is solely the cause of any claim or expense of
Houlihan Lokey. The order approving the application contains the same
language. 315 F.3d at 222.
ii.

Issue

The United States trustee objected that the agreement exempted HLHZ
from its own negligence, violating the Bankruptcy Code, public policy, and basic
tenets of professionalism. The United States trustee contended the indemnity
was unreasonable under sections 327(a) and 328(a) because they undermine
the principal purpose of bankruptcy to conserve debtors assets to pay creditors.
315 F.3d at 224. The district court approved the retention and a chapter 11 plan
was subsequently confirmed containing certain exculpation provisions under
which, among other things, the debtors released HLHZ from all claims related in
any way to the chapter 11 case and each creditor accepting the plan released
HLHZ from all claims. 315 F.3d at 224. The plan also provided that the debtors
professionals shall not incur to any person any liability in respect of the plan,
provided that this provision would have no effect on any liability determined in a
final order to have been gross negligence or willful misconduct. 315 F.3d at 225.
iii.
Holding
The upshot for this case is that, to the extent that fiduciaries may obtain
indemnity for their negligence, financial advisors in bankruptcy (who may or may
not be fiduciaries) may do the same.***Delaware courts have resolved the
negligence conundrum in the corporate sphere by evaluating the process by
which boards reach decisions, rather than the final result of those decisions. A
boards failure to inform itself of all material information reasonably available
results in a finding of gross negligence.*** Delaware has navigated the Scylla of
condoning directors misconduct and the Charybdis of stifling their business
decisions with a rule that stresses not the end result, but the path taken to reach
it. Under this approach, courts do not interfere with advice by financial advisors
when they (1) have no personal interest, (2) have a reasonable awareness of
available information after prudent consideration of alternative options, and (3)
provide that advice in good faith.In the corporate sphere this is known as the
business judgment rule. A creature of common lawit acknowledges a judicial
syllogism derived from five fundamental tenets. 315 F.3d at 231, 232-233.
Here, where a debtors financial affairs the pith of a reorganization are
shaped by its financial advisors, they lay out the economic choices and assess
216

their risks, and (though not sureties of success) can be held accountable for not
advising with the level of care or loyalty expected, transposing the business
judgment rule from its corporate ambit to bankruptcy appears well suited. For by
this transposition we have a means to distinguish gross from simple negligence,
and thus a benchmark for approving as reasonable an arrangement for indemnity
that includes common negligence. 315 F.3d at 233.
We reach this result with two caveats. The first is that Houlihan Lokey
attempted to supplement its retention agreement with a provision in the retention
application and approving order that in effect mandates indemnification to
Houlihan Lokey for even its gross negligence if that negligence is not judicially
determined to be solely the cause of its damages. In other words, the Debtors
would be bound to indemnify Houlihan Lokey when its gross negligence
contributed only in part to its damages. This attempted end run goes out of
bounds for acceptable public policy. 315 F.3d at 234.
SecondlyHoulihan Lokey in the Plan sought indemnity only for actions in its
professional capacity. The retention agreement arguably goes further, for it
requires indemnification of Houlihan Lokey for contractual disputes with the
Debtors. To the extent Houlihan Lokey seeks indemnity for a contractual dispute
in which the Debtors allege the breach of Houlihan Lokeys contractual
obligations, this is hardly an indemnity-eligible activity. 315 F.3d at 234.
Financial advisors are an essential part of reorganizations. Our decision today
recognizes the need for safeguards from the second-guessing of creditors and,
ultimately, the courts. At the same time, it assigns courts their accustomed task
of evaluating the process by which advice is given. If financial advisors take the
appropriate steps to arrive at a result, the substance of that result should not be
questioned. So understood, agreements to indemnify financial advisors for their
negligence are reasonable under section 328(a) of the Bankruptcy Code. 315
F.3d at 234.
iv.

Rationale

In re Busy Beaver Bldg. Ctrs., Inc., 19 F.3d 833 (3d Cir. 1994), shows that
reasonable compensation is based on a market driven approach. Indemnity
against negligence is becoming a common market occurrence. Although marketdriven does not mean the market is determinative, the market should be
considered subject to the courts special supervisory role. 315 F.3d at 229-230.
Though directors and officers are fiduciaries of the corporations they
serve, we do not hold financial advisors like Houlihan Lokey to be fiduciaries.
Still, in the bankruptcy context they may owe a higher level of care than in
ordinary practice. 315 F.3d at 231n.14.

217

Courts are increasingly recognizing the awkwardness inherent in using

the terms negligence and gross negligence in the area of corporate
governance. The art of governing (it is emphatically not a science) is replete with
judgment calls and bet the company decision (negligent) alternatives, but rather
face a range of options, each with its attendant mix of risk and reward. Too
coarse a filter, the traditional negligence construct does not allow these nuances
to emerge 315 F.3d at 231.
v. Consequences
Although the concurring opinion of Judge Rendell, 315 F.3d at 235-239,
takes exception with the wide scope of the main opinion and identifies new
issues to arise in applying the gross negligence test it espouses, unquestionably,
the opinion will serve as a guidepost for assessing financial advisors liability and
may effectively cloak them with their own business judgment rule. More
importantly, the decision approves the terms of the indemnity which require
payment by the debtor in possession of the financial advisors defense costs and
losses until and unless the financial advisor is adjudged by final order to have
acted with gross negligence, bad faith, willful misfeasance, or reckless disregard
of its obligations or duties. Empirically, assertion of claims against postpetition
financial advisors is very rare. But, the ability to bring an action and create a
nuisance is relatively easy and current payment of defense costs as incurred is
critical to the financial advisor. Protections normally inserted into a plan, such as
requirements that any actions against the advisor be brought in the bankruptcy
court, should probably be included in the orders approving their retentions to
enable the bankruptcy court to control and supervise the case.

24. The Stamp Tax Exemption Requires a Previously Confirmed Chapter 11

Plan
A. Florida Department of Revenue v. Piccadilly Cafeterias, Inc., 554
U.S. ___ (2008)
i. Facts
After commencing its chapter 11 case, Piccadilly requested a sale of
substantially all its assets as a going concern, and as a precondition to the sale,
entered into a global settlement with committees of its secured and unsecured
claimholders dictating the priority of distribution of the sale proceeds. The
bankruptcy court approved the proposed sale and settlement agreement, and
also ruled the transfer was exempt from stamp taxes under 11 U.S.C.

218

1146(a).164 Ten days after the sale closed, Piccadilly filed its proposed plan and
later amended it. The plan provided for distributions in a manner consistent with
the settlement agreement. Florida objected to the plan contending its stamp tax
assessment of $39,200 was outside the exemption because the transfer had not
been under a plan confirmed.
The bankruptcy court granted summary judgment for Piccadilly and the
district court affirmed. Then, the Eleventh Circuit affirmed, finding the statute
was ambiguous and should be interpreted consistent with the principle that a
remedial statute such as the Bankruptcy Code should be liberally construed. In
re Piccadilly Cafeterias, Inc., 484 F.3d 1299, 1304 (11th Cir. 2007).
ii. Issue
Does the 11 U.S.C. 1146(a) stamp tax exemption apply to
preconfirmation transfers?
iii. Holding
In the context of 1146(a), the decision whether to transfer a given asset
under a plan confirmed must be made prior to submitting the Chapter 11 plan to
the bankruptcy court, but the transfer itself cannot be under a plan confirmed
until the court confirms the plan in question. Only at that point does the transfer
become eligible for the stamp-tax exemption. (Footnote omitted).
"Because Piccadilly transferred its assets before its Chapter 11 plan
was confirmed by the Bankruptcy Court, it may not rely on 1146(a) to avoid
Florida's stamp taxes."
iv. Rationale
While both sides present credible interpretations of 1146(a), Florida has
the better one. To be sure, Congress could have used more precise language
i.e., under a plan that has been confirmedand thus removed all ambiguity.
But the two readings of the language that Congress chose are not equally
plausible: Of the two, Floridas is clearly the more natural. (Emphasis in
original).
164

Bankruptcy Code section 1146(a) provides:

(c) The

issuance, transfer, or exchange of a security, or the making

or delivery of an instrument of transfer under a plan confirmed
under section 1129 of this title, may not be taxed under any law
imposing a stamp tax or similar tax.
219

To read the statute as Piccadilly proposes would make 1146s

exemption turn on whether a debtor-in-possessions actions are consistent with a
legal instrument that does not existand indeed may not even be conceived of
at the time of the sale.
We find it informative that Congress placed 1146(a) in a subchapter
entitled, POSTCONFIRMATION MATTERS. To be sure, a subchapter heading
cannot substitute for the operative text of the statuteThe placement of
1146(a) within a subchapter expressly limited to postconfirmation matters
undermines Piccadillys view that 1146(a) covers preconfirmation transfers.
To the contrary, this Court has rejected the notion that Congress had
a single purpose in enacting Chapter 11. Toibb v. Radloff, 501 U.S. 157, 163
(1991). Rather, Chapter 11 strikes a balance between a debtors interest in
reorganizing and restructuring its debts and the creditors interest in maximizing
the value of the bankruptcy estate.The Code also accommodates the interests
of the States in regulating property transfers
[W]e see no absurdity in reading 1146(a) as setting forth a simple,
bright-line rule instead of the complex, after-the-fact inquiry Piccadilly
envisions.
v.

The Dissent

"The statute's purpose is apparent on its face. It seeks to further Chapter

11's basic objectives: (1) 'preserving going concerns' and (2) 'maximizing
property available to satisfy creditors.' Bank of America Nat. Trust and Sav.
Assn. v. 203 North LaSalle Street Partnership, 526 U.S. 434, 453 (1999)."
"'Statutory interpretation is not a game of blind man's bluff. Judges are
free to consider statutory language in light of a statute's basic purposes.' Dole
Food Co. v. Patrickson, 538 U.S. 468, 484 (2003) (Breyer, J., concurring in part
and dissenting in part). It is the majority's failure to work with this important tool
of statutory interpretation that has led it to construe the present statute in a way
in my view, runs contrary to what Congress would have hoped for and expected."
vi.

Analysis

The majority's interpretation of section 1146(a) is hard to quarrel with

because it is a plausible reading of the statute. While the Bankruptcy Code's
dominant purposes may well include maximizing property available to creditors,
Congress actually made it quite clear that other forces were also at work. The
fact is that there is no stamp tax exemption in chapter 7. That is inconsistent with
the notion that maximizing property available to creditors is always dominant.
Additionally, if the absence of the exemption in chapter 7 is rationalized by
positing that to get the exemption the debtor has to reorganize, Congress did not
220

implement that concept either because under a confirmed plan the exemption is
available whether it's a reorganization plan or liquidation plan.
The dissent's essential point is that no rational theory explains why
Congress would want to make the exemption available after confirmation, but not
before. But, Congress did not make the exemption available in chapters 7, 12, or
13 at any time.
Notably, while the majority wrote the placement of section 1146(a) in the
subchapter entitled "POSTCONFIRMATION MATTERS," "undermines
Piccadilly's view that 1146(a) covers preconfirmation transfers," neither the
majority nor the dissent observed that section 1146(b) authorizes the bankruptcy
court to authorize a plan proponent to request an advance ruling on the tax
effects of a plan and to determine the debtor's state and local tax liability prior to
confirming a plan if there are any disputes. Senate Report No. 95-989, 95th
Cong., 2d Sess. (1978) at p. 133. Thus, it is fairly clear that Congress placed in
the subchapter on postconfirmation matters, provisions that will affect
postconfirmation economics, but that contemplate actions and results prior to
confirmation.
vii.

Consequences

The majority's determination that section 1146(a) sets forth "a simple,
bright-line rule," will likely be used to come within the stamp tax exemption.
Perhaps real property will be transferred into a wholly-owned subsidiary of a
debtor without recording a deed and incurring stamp taxes, and then the
subsidiary will transfer the property to the buyer pursuant to a simple confirmed
chapter 11 plan for the subsidiary. Such mechanisms are likely to flourish now
that the simple, bright-line rule is articulated.
viii.

Prior Law

Under the Bankruptcy Act of 1898, as amended, section 267165 of Chapter

X provided for the stamp tax exemption under confirmed plans, and the
165

Section 267 provided:

The issuance, transfer, or exchange of securities or the making or
delivery of instruments of transfer under any plan confirmed under
this chapter, shall be exempt from any stamp taxes now or
hereafter imposed under the laws of the United States or of any
State.

Prior to the enactment of section 267, section 77B(f) of the Bankruptcy Act
exempted the issuance, transfers, exchanges of securities or making or delivery
of conveyances to make effective any plan of reorganization confirmed under the
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legislative history of the Bankruptcy Code shows Congress intent to continue it.
S. Rep. No. 95-989, 95th Cong., 2d Sess. (1978) at p. 132; House Report No.
95-595, 95th Cong., 1st Sess. (1977) at p. 421.
25. Can Confirmation Negate Stay Relief?
A. Atalanta Corp. v. Allen (In re Allen), 300 F.3d 1055
(9th Cir. 2002)
i.

Facts

Allen, a kiwi fruit farmer, had property encumbered by liens held by

Atalanta and Anatom securing $1,000,000 and $550,000, respectively. In his
chapter 11 case, Allen stipulated with the lien holders that the automatic stay
would terminate as to 5 parcels as of December 1, 1998, but that if by February
1, 1999 Allen paid $325,000 to Atalanta and $175,000 to Anacom, they would
release their liens on 4 of the 5 parcels. The stipulation also provided that on
March 1, 1999, Atalanta could foreclose liens against 3 other parcels, and that
Allen would harvest the 1998 crop and Atalanta would market it. The court
approved the stipulation which did not provide it would be incorporated into any
chapter 11 plan.
In April 1999, the bankruptcy court confirmed Allens chapter 11 plan that
did not incorporate the stipulation. Instead, it provided Atalanta and Anacoms
debts would be paid in annual installments with the entire balance due in balloon
payments in May 2004 and May 2005 and did not allow their foreclosures to
continue. 300 F.3d at 1058. Another creditor had a stipulation that provided its
terms would be incorporated into a plan and they were incorporated.
Atalanta and Anacom appealed. The district court affirmed, but remanded
for specific findings as to the interest rates for the Atalanta and Anacom loans.
Then, they appealed to the circuit court.
In an earlier decision, the Ninth Circuit had held an order approving a
stipulation providing it would bind the debtors in any chapter 11 plan could only
be modified or reversed if the bankruptcy court found special circumstances
such as preventing forfeiture of a family farm, and the bankruptcy court must take
maximum steps reasonably practical to put the other party in a position close to
what the stipulation provided. In re Lenox, 902 F.2d 737 (9th Cir. 1990).

provisions of this section from certain federal tax provisions. Thus, section 267
amplified the exemption.
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ii. Holding
A preconfirmation stipulation and order modifying the automatic stay, but
not providing it will bind the debtor or the court in a chapter 11 plan does not do
so.
iii. Rationale
The court reasoned the requirements for confirming a plan are not
complied with in connection with approving a stipulation affecting the automatic
stay and notice is not given all interested parties unless the stipulation provides it
will bind any plan. Therefore, the stipulation only lasts until confirmation and the
rule against overturning stipulations has no role to play. 300 F.3d at 1059.
iv. Analysis
This is a situation where the important thing is to know the rule, not so
much what the rule is. Now, we all know that if a stipulation regarding the
automatic stay does not provide it can not be changed in a chapter 11 plan, then
it can be. Because an order terminating the automatic stay only allows a
lienholder to foreclose, it is not necessarily inconsistent with such an order for a
chapter 11 plan to restructure the lien. Indeed, the chapter 11 plan can
restructure all debts of the estate and until a foreclosure is completed, the debt
and lien remain in existence. There is nothing inherent in stay relief that renders
the debt and lien immune to restructuring or to repayment pursuant to a plan.
Moreover, courts sometimes terminate the automatic stay to allow the lienholder
to foreclose up to but not including the foreclosure sale. That way, if the debtor
does not reorganize, no time is lost. But, if the debtor does reorganize, it can
retain the use of the encumbered property.
Significantly, the notion that approval of a stipulation regarding the
automatic stay will be noticed to all interested parties is an interesting issue.
Normally, requests for stay relief are served on a shortened service list that
includes the debtor, the statutory creditors committee, and all entities that
requested notice. Absent a settlement, the court will grant complete stay relief if
the requirements of section 362(d) are satisfied. That relief may well affect the
balance of the case.
26. Can Unmatured Interest Be Allowed as Damages under an Interest
Rate Swap?
A. Thrifty Oil Co. v. Bank of America, 310 F.3d 1188 (9th Cir. 2002)

223

i.

Facts

The borrower wanted a $75 million loan to refinance a $52.1 million

secured note and to finance capital improvements, at a fixed interest rate of 11%.
310 F.3d at 1192. The final loan proposal from the bank provided for a floating
rate term loan and required the borrower to enter into interest rate swaps to
hedge the interest rate fluctuation risk. The lender allowed the borrower to obtain
the swaps from any suitable swap dealer. Ultimately, the borrower took the loan
and swaps from the same lender and they were cross defaulted and cross
collateralized. 310 F.3d at 1193.
Under the swaps, the borrower paid the lender a fixed rate on a notional
amount of $45 million and received a floating rate on the same notional amount.
Between the term loan and swaps, the borrower ended up paying 9.83% interest.
When the borrower commenced a chapter 11 case and a plan was
confirmed, the lender asserted a swap claim of $5.4285 million and the debtor
objected that it was unallowable unmatured interest and was alternately
disallowable under Californias Bucket Shop Law.
ii. Issue
[I]n this case BofA provided both the loan and the three interest rate
swaps, an arrangement that creates a theoretical possibility that the periodic
swap payments form part of BofAs compensation for the risk and delay
associated with the term loan. The question therefore becomes whether or
under what circumstances, BofAs dual role as lender and swap dealer converts
GWRs periodic swap payments from derivative cash flows into interest on the
term loan. 310 F.3d at 1199.
iii. Holding
[T]he price a borrower pays for an interest rate swap may contribute to
overall funding costs but does not necessarily comprise that element of the
borrowers funding costs attributable to interest. 310 F.3d at 1198.
[T]he speculative possibility that a lender could use interest rate swaps to
evade Section 502(b)(2) does not overcome the strong Congressional policy of
encouraging the innovative use of interest rate swaps, or justify eschewing the
benefits available to counterparties who obtain swaps from their lenders. A case
where such abuse could occur would involve, for example, a lender that does not
maintain a swap portfolio, an unsophisticated borrower, non-standard swap
documentation or artificially inflated swap pricing. However, where the lender
provides a standard interest rate swap to a sophisticated borrower and the swap
serves a legitimate non-bankruptcy purpose, the lenders claim for termination
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damages is, for all purposes, indistinguishable from a claim filed by a non-lending
swap dealer. Allowing the lender to collect termination damages in such a case
offends none of the principles and policies of Section 502(b)(2). 310 F.3d at
1201-1202.
The swap claim was neither unallowable unmatured interest under
Bankruptcy Code section 502(b)(2), nor unallowable under the Bucket Shop Law.
iv. Rationale
Bankruptcy Code section 502(b)(2) provides a claim shall not be allowed if
such claim is for unmatured interest. It has 3 underlying reasons: (1) to avoid
penalizing a debtor by making it pay interest for delays due to the laws
prohibition on its paying interest during a case; (2) to avoid the inconvenience of
forcing a debtor to constantly recalculate the amount owed each creditor; and (3)
to prevent each party from gaining or suffering due to delays inherent in
liquidation and distribution of the estate. 310 F.3d at 1195-1196.
Payments made under an interest rate swap cannot possibly compensate
for the delay and risk associated with borrowed money because no loan has
taken place between the counter-parties. 310 F.3d at 1197.
If the swap dealer had been an entity different from the lender, it would be
clear that the dealers interest rate swap claim is not for interest because no
money would have been borrowed between the dealer and the debtor. Notably,
swap agreements can have money being owed from the swap dealer to the
debtor. Therefore, interest rate swaps are not inherently unmatured interest
claims.
27. Is Good Faith Too Ambiguous a Standard?
A. In re Coram Healthcare Corp., 271 B.R. 228 (Bankr. D. Del.
2001).
i. Facts.
In 1997, 3 investors purchased $250 million of the debtors unsecured
notes. The debtors, Coram, had become a leading provider of alternative site
infusion therapy services. From Junje 1998 through July 24, 2000, a
representative of one of the noteholders, Cerberus, served as one of Corams
directors. In 1998 or 1999, Crowley joined Cerberus bench of ceo consultants
available to work for Cerberus with troubled companies. Cerberus principal
orally agreed that Cerberus would pay Crowley $80,000 per month plus
expenses to serve as a consultant to distressed companies in which Cerberus
had a stake. In August 1999, at Cerberus suggestion, the debtors hired Crowley

225

as a consultant to their ceo. As a result of the debtors severe financial

difficulties, their ceo resigned in the fall of 1999 and the debtors agreed to hire
Crowley as ceo as a condition to a restructuring and forbearance agreement with
the noteholders. In November 1999, Crowley sent a personal and confidential
letter to Cerberus principal requesting additional compensation from Cerberus in
the form of incentive bonuses for consulting work he was doing on Cerberus
behalf for other distressed companies. The additional compensation was to be
paid in consideration for Crowley signing an employment contract with the
debtors. 271 B.R. at 230-231.
On November 18, 1999, Crowley signed a 3-year employment agreement
with the debtors. The next day, Crowley signed a consulting agreement with
Cerberus under which he would receive $80,000 per month and an increased
performance bonus based bonus for his work on another distressed company.
Such amounts would be paid by Cerberus, but reduced by amounts Crowley
receives from the companies to which he is assigned. Section 2.3 of the
agreement required Crowley to use his best efforts to promote the success of
Cerberus business or the business of companies to which hes assigned.
Section 6.3 of the agreement entitles Cerberus to terminate Crowley for cause
including Crowleys failure to follow the reasonable instructions of [Cerberus],
[Cerberus principal], or the Board of Directors of [the debtors]. 271 B.R. at 231.
Neither Crowley nor the Cerberus principal on the debtors board of
directors disclosed the terms of the consulting agreement to the debtors. 271
B.R. at 231.
By the end of 1999 the debtors faced enormous financial difficulties and
consulted bankruptcy attorneys. In June 2000, the debtors sold their pharmacy
business for net cash of $38 million and used some of it to pay down on secured
revolver debt that had been provided by the noteholders and, at Crowleys
direction without prior notice to the board of directors or bankruptcy attorneys,
paid $6.3 million of interest on the unsecured notes that could have been paid in
kind by adding $6.3 million to the outstanding principal. 271 B.R. at 231.
A few days later, the noteholders representative resigned from the
debtors board and on August 8, 2000, the debtors commenced their chapter 11
cases. Crowley continues to serve as ceo. The debtors schedules show the
noteholders were owed more than $252 million and trade creditors were owed
$7.5 million. The statutory creditors committee was comprised of 2 noteholders
and one trade creditor. Additionally, the U.S. trustee appointed a statutory equity
committee.
The debtors first proposed chapter 11 plan extinguished the equity and
provided the new equity to the noteholders and $2 million cash to the trade
creditors. The bankruptcy court denied confirmation on the ground Crowleys
consulting agreement with Cerberus created an actual conflict of interest that

226

tainted the restructuring of the debtors debt and operations, and its negotiations.
As a result, the court determined it was unable to find the plan was proposed in
good faith for purposes of Bankruptcy Code section 1129(a)(3).
On February 26, 2001, the bankruptcy court granted the debtors motion to
retain Goldin Associates, LLC to investigate the extent of Crowleys conflict and
the damage, if any, that was done to the debtors as a result of the conflict.
Goldin was also directed to try to mediate a plan.
Goldin concluded that while Crowley and Cerberus should have disclosed
the full extent of their relationship to the debtors other directors and officers,
there was neither evidence Cerberus ever instructed Crowley to act contrary to
the debtors interests, nor evidence Crowley or Cerberus expected Crowley wold
seek to advance Cerberus interests to the detriment of the debtors. Goldin
found the $6.3 million payment did not affect the noteholders position vis--vis
other creditors or impact other creditors. The debtors were found to have
suffered damages from the undisclosed conflict comprised of the expense up to
$6 million of professional fees for the failed confirmation and possible business
losses of $7 million to $9 million resulting from the inability to obtain confirmation.
Goldin recommended that Crowleys bonus be reduced by $7.5 million to $5.9
million.
The debtors proposed a second chapter 11 plan that treated Crowley as
Goldin recommended, gave the new equity to the noteholders, and offered $10
million to the equity holders if they accepted the plan and if the creditors do not
object on the basis of the absolute priority rule. The equity did not accept the
plan and the equity committee objected to confirmation again.
At the confirmation hearing on the second proposed plan, the court found
Goldin had not investigated the continuation after December 2000 of Crowleys
conflict and whether he continued to get payments from Cerberus. Goldin
testified, however, that he assumed Crowley would do no harm to the debtors
after his arrangement with Cerberus was revealed because he had done no harm
beforehand. A member of the debtors board testified Goldin was hired to
sprinkle holy water on the situation and make everything all right.
ii.

Holding

The bankruptcy court denied confirmation again on the ground the

continuous conflict of interest by the CEO of the Debtor precludes the Debtors
from proposing a plan in good faith under 1129(a)(3).
iii.

Rationale

Crowley cannot serve the interests of both the Debtors and a large
creditor, Cerberus. Under the Consulting Agreement, Cerberus has the
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discretion to fire Crowley if he fails to follow its instructions, resulting in the loss of
$1 million per year in compensation to Crowley. 271 B.R. at 236. Crowley
has a fiduciary duty to the estate which includes a duty of loyalty to avoid a
direct, actually conflict of interest. Id. For instance, Crowley did not cause the
debtors to sue to avoid the $6.3 million interest payment. Although that action is
preserved under the proposed plan, it will not likely be brought because the
noteholders would control the reorganized debtor. Crowleys conflict of
interest is a violation of his fiduciary duty to the Debtors and the estate and is so
pervasive as to taint the Debtors restructuring of its debt, the Debtors
negotiations towards a plan, even the Debtors restructuring of its
operationsThe Debtors hiring of Goldin to sprinkle holy water on the
situation does not cure the conflict or evidence good faith. 271 B.R. at 240.
Given the fact that Crowley had not disclosed the agreement in the first place,
the Debtors should have asked for full disclosure and required that Crowley
sever all agreements with Cerberus as a condition of continued employment.
The dont ask, dont tell approach adopted by the Debtors and their Special
Committee does not fulfill their fiduciary duty to these estates. 271 B.R. at 238.
iv.

A Proper Application of Good Faith under Section

1129(a)(3)?

While the failure to disclose the consulting agreement to all creditors and
the directors disrespectful (and apparently unprepared and unlawyered)
testimony that Goldin was retained to sprinkle holy water on the process create a
prima facie violation making denial of confirmation seem natural, the courts
ruling creates potentially unjustified leverage for equity holders rather than any
potential remedy for any wrong committed. The decision contains no indication
the estate was anywhere near solvent, and the creditor litigants contend the
estate was at least $100 million insolvent.
In short, the question is why the court should not have confirmed the plan
while preserving for shareholders any actions they had against Crowley or
Cerberus.
Put differently, what if the noteholders had proposed the chapter 11 plan
instead of the debtors? Certainly, no one can contend the noteholders lack good
faith for proposing a plan that maximizes their benefit. Perhaps they would also
have been held to lack good faith for not disclosing Crowleys consulting
agreement. The trade creditors, however, could propose the same plan without
being blameworthy for failure to disclose. No evidence suggests the equity could
have been in the money in any scenario. The failure of the Crowley to seek to
recover the $6.3 million interest payment from the noteholders, may have had no
impact because the money would simply go back to the company the
noteholders would own.

228

Notably, while Crowley and Cerberus were found not to have disclosed
their agreement, the court also found the debtors employed Crowley as a
condition to obtaining a forbearance agreement from Cerberus and the other
noteholders. Therefore, it was certainly disclosed and known that Crowley was
there because Cerberus and the other noteholders wanted him as the debtors
ceo. Once that was known, there can be little doubt that anyone involved in the
case would assume Crowley had an incentive to try to please the entities that put
him there, namely the noteholders. The incremental allegiance that Crowley had
due to the consulting agreement appears marginal. Although the court makes
much of the fact that Cerberus could cancel its obligation to pay Crowley $1
million per year if he didnt follow Cerberus instructions, Crowley was actually
getting more than $1 million from the debtors and therefore under the consulting
agreement, Cerberus would not have to pay Crowley. Moreover, its certainly
possible to interpret the consulting agreement as deferring to Crowleys duties to
any company that employed him and not requiring him to obey Cerberus if that
meant violating duties to the debtors.
B. In re Bidermann Industries U.S.A., Inc., 203 B.R. 547 (Bankr.
S.D.N.Y. 1997)
i. Facts.
Prior to bankruptcy, the debtor had retained turnaround consultants, one
of whom served as ceo at $700,000 per year and one of whom was retained at
$350,000 per year. When the chapter 11 case commenced, the bankruptcy court
approved the arrangement.
The debtor requested the bankruptcy court to approve a letter agreement
setting up a process to accomplish a leveraged buy out of the debtor under which
the turnaround consultants and an investor they procured would acquire the
debtor. The turnaround consultant serving as ceo would remain ceo and the
amount of the equity investment would be probably $40 million and up to $60
million in the discretion of the buyers. The cooperation of the prepetition majority
shareholder was assured by providing him a 10-year option to acquire 2% of
the common stock at the same price as the buyers pay as well as numerous
other options to purchase stock and assets of the company. 203 B.R. at 549-50.
Additionally, the shareholder would receive a consulting agreement paying him
$300,000 per year for 5 years and $750,000 for his covenant not to compete.
Reimbursement, Topping Fee, No Shop Clause, etc Under the letter
agreement, the investor would be entitled to up to $2 million in expense
reimbursement, a topping fee of $2 million and up to $3.8 million, a broad
indemnification, no solicitation or competing bid encouragement by the debtor
except to the extent the debtors fiduciary duties would be violated, the

229

prohibition of any insider filing an inconsistent plan, and the granting of an

administrative expense priority to the investor for the foregoing obligations.
The debtors agreed to the deal without retaining an investment banker or
testing the waters for a more favorable deal. The ceo admitted the business was
a different enterprise than it was two years earlier when it had an investment
banker. The ceo also admitted the debtors could reorganize without the buyout
and that a strategic buyer would pay more than a financial buyer like the investor
at issue. 203 B.R. at 551, 554.
Statutory Committee Support. The statutory creditors committee
supported the deal. Its constituency would be paid $13.5 million cash for $26
million in claims. The support was based on a prior arrangement agreed to by
the committee and the institutional note holders.
The letter agreement was objected to by 2 institutional noteholders who
were not part of the agreement. The debtors and the committee attacked the
objectors claiming they were only trying to earn a windfall on the claims they
purchased at a discount!
ii. Holdings.
The court denied approval of the letter agreement and scheduled a
hearing to consider why an examiner with expanded powers should not be
appointed. 203 B.R. at 554.
Initially, the court observed the ceo had a clear conflict: he was trying to
acquire the debtor for the lowest possible price while he had a fiduciary obligation
to obtain the highest possible price for creditors and shareholders. 203 B.R. at
551. The failure to retain an investment banker and the no shop clause were
ruled astounding and incomprehensible, respectively. 203 B.R. at 551, 552.
The court ruled the business judgment test should not be applied to test
the letter agreement because it only applies when the directors are disinterested,
which the debtors directors were not. See Official Committee v. Integrated
Resources, Inc. (In re Integrated Resources, Inc.), 147 B.R. 650 (S.D.N.Y. 1992),
appeal dismissed, 3 F.3d 49 (2d Cir. 1993).
iii. Should the Committee Have Broken Its Word?
When the debtor argued that although management was not
disinterested, the committee participation saves the day, the court ruled:
I understand how it is that the committee agreed to this proposal; it
agreed because the proposal satisfied the arrangement earlier
negotiated between the committee and the institutional note

230

holders. However, once it became apparent that the debtors were

amenable to a sale of the businesses, the committee should have
explored whether its constituency might fare better than they would
pursuant to the agreement with the note holders...
203 B.R. at 553.
28. National Gypsum Revisited: New National Gypsum Company
v. National Gypsum Company Settlement Trust (In re National
Gypsum Company), 219 F.3d 478 (5th Cir. 2000)(2 to 1)
i. Facts.
In 1993, the bankruptcy court confirmed a chapter 11 plan for National
Gypsum Company. Pursuant to the plan, a new Delaware corporation, New
National Gypsum (New NGC), was formed to purchase the debtors operating
assets. The bankruptcy court found it was worth $350 million. The value of that
company was given to bond and trade creditors of the debtor owed
approximately $1.1 billion, thereby providing them less than 35 cents on the
dollar on average.
The old company was left with an engineering firm worth approximately
$125 million, asbestos insurance worth between $300 million and $600 million,
and $10 million cash. That company and a trust created to hold some of its
assets were dedicated to the debtors then and future asbestos claims. Based
on the facts as then existed, it appeared likely, though not a certainty, that all
asbestos claims would be paid in full. As a backup in the event the Georgine
nationwide class action asbestos settlement were not approved (as it ultimately
was not, Amchem Products, Inc. v. Windsor, 521 U.S. 591 (1997)), the chapter
11 plan provided for an alternate claims facility to be used to pay each present
and future asbestos claimant an equivalent percent of its claim.
The plan proponents had included a permanent injunction in the chapter
11 plan, barring the assertion of asbestos claims against New NGC. The
bankruptcy court, at the urging of the legal representative for unknown claimants,
refused to confirm the plan with the permanent injunction, reasoning it did not
have jurisdiction to enjoin persons who did not yet hold claims. The court did
allow the plan to include a channeling order under which asbestos claims would
have to be asserted against the trust until it is exhausted before any claimant
could attempt to assert them against New NGC. All then existing asbestos
claims were discharged. The bankruptcy court noted New NGC could defend
against the assertion of any future asbestos claims under non-bankruptcy law by
claiming it was not a successor to the debtors liability.
As confirmed, the plan provided that New NGC would not assume
asbestos liabilities of the debtor which shall be the sole responsibility of the trust.
Additionally, the bankruptcy court approved the agreement under which New
231

NGC purchased the debtors operating assets. That agreement provided New
NGC would not assume any asbestos liability including unknown claims. Then,
the plan was consummated and New NGC issued its securities which were
traded in the public markets.
In May 1996, the Georgine settlement was overturned. The trust created
under the plan returned to the bankruptcy court and requested a determination
that New NGC has liability for the future/unknown asbestos liability by reason of
the bankruptcy courts having denied the permanent injunction. The bankruptcy
court ruled:
[T]he plan as confirmed by order of this court implicitly
imposes or maintains liability on New NGC for asbestos
disease non-Bankruptcy Code claims not discharged by the
confirmation order and not satisfied by the Trust.By
implicitly addressing this asbestos liability, rather [than]
explicitly doing so, and by deferring the matter as
provided in the plan, the court enabled New NGC to
emerge in the marketplace post-confirmation as an
effective entity, poised, under the right market conditions
to prosper, and thereby benefit all the constituencies.
(Emphasis supplied).
The bankruptcy court admitted there are no express statements
in the plan or confirmation order that affirm New NGCs liability for
unknown claims. In fact, the bankruptcy court opined at a February
1993 hearing: in the event that theres anything to fight about, in the
event that some claims in the futurethey can proceed with their rights,
and new NGC can defend and say were not a successor.
The channeling portion of the confirmation order provided
nothing therein shall preclude an Unknown Asbestos Disease
Claimant form pursuing his rights, if any, under applicable nonbankruptcy law against any Person who may be liable to such Unknown
Claimant after exhausting the remedy or remedies provided by the
[Trust]. (Emphasis supplied).
The confirmation order also provided that New NGC was
purchasing assets free and clear of all Liens, Claims, Interests and
other liabilities, obligations, charges or encumbrances thereon or there
againstto the maximum extent permitted by the Bankruptcy Code.
The bankruptcy court did bar unknown claimants from asserting
punitive damage claims against New NGC.
ii. Holdings

232

Then, when subsequently it became apparent that the Trust would be

insufficient to fund Unknown Claims, the bankruptcy court unreasonably altered
the meaning of the Plan documents to hold that future asbestos claimants could
go after New-NGC. While this impulse may have been noble, and perhaps even
socially desirable, the bankruptcy court cannot now ignore the plain meaning of
the documents that created New-NGC as a separate operating company with no
liability as a reorganized debtor. 219 F.3d at 492.
Once the bankruptcy court determined the unknown claims were not
claims within the meaning of 11 U.S.C. 101(5), it no longer retained jurisdiction
to limit punitive damages awards in favor of those claimants.
iii. Lessons Learned
Imagine being the attorney for an underwriter of an initial public offering
and knowing the company has a potential mass tort liability, but intentionally not
disclosing it so the company can emerge in the market place and prosper.
Thats hard to imagine. Now, imagine a federal judge helps you do it. Next,
imagine the victim must go unvindicated in the district court and is finally
vindicated in the circuit court of appeals by a two to one margin.
The only legal principle embodied in this decision is the principle that
express terms in the documents can not be overridden by implicit rulings
nowhere to be found.
This decision is here to show that confidence in our bankruptcy court
system can be easily shaken by decisions carrying out a yearning by a court to
do a certain type of unpredictable equity at the expense of third parties
purposefully kept ignorant of the risks they were incurring.
29. Avoidance Actions Are Property of Neither the Debtor,
Nor the Debtor in Possession, Nor the Estate; But How
About Their Proceeds?
A. Official Committee of Unsecured Creditors v.
Chinery (In re Cybergenics Corp.), 226 F.3d 237 (3d
Cir. 2000).
i.

Facts.

At the outset of its chapter 11 case, the chapter 11 debtor in possession

sold all of the rights, title, and interest of Cybergenics in and to all of the assets
and business as a going concern of Cybergenics, according to its sale
agreement. 226 F.3d at 239. The bankruptcy court order authorizing and
directing the sale provided it is acknowledged that all of the assets of the Debtor

233

[defined to include Cybergenics as debtor and debtor in possession] are being

conveyed to the Purchaser." 226 F.3d at 241.
Subsequently, the statutory creditors committee was authorized to bring a
fraudulent transfer action against entities that had sold Cybegenics in a
leveraged buyout more than a year before the chapter 11 case commenced.
Those entities moved to dismiss the complaint on the ground the fraudulent
transfer action had been sold to the purchaser. The U.S. District Court granted
the motion. 226 F.3d at 240. The fraudulent transfer claim was not listed as an
asset on the debtors schedules and the purchaser of the assets did not appear
and did not take the position that it had purchased the claim. 226 F.3d at 245246.
ii.

Holding

The United States Court of Appeals for the Third Circuit reversed. It
reasoned that the fraudulent transfer claims being brought under Bankruptcy
Code section 544(b) were initially creditors claims. 226 F.3d at 245. Although
the debtor in possession is empowered to pursue those claims for the benefit of
all creditors, [t]he avoidance power itself, which we have analogized to the
power of a public official to carry out various responsibilities in a representative
capacity, was likewise not an asset of Cybergenics, just as this authority would
not have been a personal asset of the trustee, had one been appointed. 226
F.3d at 245. Issues relating to property of the estate are simply not relevant to
the inquiry into whether the fraudulent transfer claims in the Committees
complaint were assets of Cybergenics as debtor or debtor in possession. 226
F.3d at 246.
In a footnote, the appellate court explained that even if an analysis of
property of the estate were necessary, its analysis would not change because
[s]ubject to a few specifically enumerated exceptions, the bankruptcy estate
contains only the interests of the debtor in property as of the time of the
bankruptcy filing, no more, no less. In re Jones, 768 F.2d 923, 927 (7 th Cir.
1985) (citation omitted). As we already have explained, the fraudulent transfer
action belonged ot Cybergenics creditors as of the time of the bankruptcy filing.
It bears emphasis that we focus here on the cause of action to avoid the transfer,
not on any sort of equitable interest that some courts have said may be retained
by a debtro in fraudulently-transferred property. 226 F.3d at 247n.16.
iii.

What About Bankruptcy Code Section 541(a)(3)?

Notably, the Bankruptcy Code does not render avoidance actions property
of the estate. But, pursuant to Bankruptcy Code section 541(a)(3), the estate
includes [a]ny interest in property that the trustee recovers under section 329(b),
363(n), 543, 550, 553, or 723 of this title. In turn section 550(a) provides for
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recoveries of transfers avoided pursuant to section 544. Therefore, the

recoveries from the fraudulent transfer action were property of the estate.
Based on the facts, property of the estate was not sold. Therefore, the
court appears to have correctly determined that the purchasers did not purchase
the recoveries from the action. Additionally, the failure of the purchaser to lay
claim to the fraudulent transfer action or its proceeds suggests strongly it did not
intent to buy the action.
The courts footnote 16, however, appears erroneous to the extent it
implies property of the estate would not include recoveries from the fraudulent
transfer action.
B. Avoidance Actions Can Only Be Brought to Benefit Creditors
To buttress its argument that the avoidance power is a power a debtor in
possession or trustee can use for creditors, but not an asset of the debtor in
possession, Cybergenics points to several interesting decisions barring
avoidance actions whose results will help the equity owner but not creditors. 226
F.3d at 244.
In Wellman v. Wellman, 933 F.2d 215 (4th Cir. 1991), the chapter 11 plan
paid all administrative and general unsecured creditors in full. The secured
creditors were paid in cash, collateral, and a $600,000 interest in the avoidance
action that the reorganized debtor was allowed to prosecute or not in his
discretion. 933 F.2d at 2116-217. After all those payments, the estate had a
cash surplus of $2,524,769 for the debtor. 933 F.2d at 219.
The appellate court ruled the reorganized debtor could not prosecute the
fraudulent transfer action which was against his brother for having paid him too
little for his stock in a family business years earlier. The surplus cash and the
reorganized debtors absolute right not to prosecute the action convinced the
court the action was unnecessary to get creditors paid. Id.
In Whiteford Plastics Co. v. Chase National Bank, 179 F.2d 582 (2d Cir.
1950) (Chapter XI case), the debtor proposed a chapter XI plan providing for
10% payments to unsecured creditors. Before the plan was confirmed, the debtor
brought an action to avoid liens against two steam generators on the ground the
creditor, due to inadvertence, failed to perfect the liens by recordation. The court
held the debtor never offered to contribute the lien value to the unsecured
creditors and can not obtain it for its own benefit. 179 F.2d 584.
Query: What if the lien had been avoided prior to any plan proposal and
the creditors had agreed the debtors shareholder could retain value in excess of
the value of the avoided liens? Should the avoidance be undone? What is the
test?

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In Vintero Corp. v. Corporacion Venezolana de Fomento (In re Vintero

Corp.), 735 F.2d 740 (2d Cir. 1984), the debtor had contracted to sell two ships
for $17 million and granted the guarantor of the sales price a nonrecourse lien
against the ships. When the ships were moved, the guarantor failed to refile its
security interest and it became unperfected. The chapter XI debtor in possession
took the position that its adversary proceeding to avoid the lien together with the
nonrecourse nature of the claim would prevent the guarantor from making any
claim whatever against the estate. 735 F.2d at 741.
The appellate court reasoned the perfection requirements are for the
benefit of third parties, not the debtor. Accordingly, it held the lien could be
avoided, but the nonrecourse creditor could share in the proceeds of the ships on
a pro rata basis with all unsecured creditors. 735. F.2d at 743.
30. Releases of Non-Debtors
A. The General Rule.
For constitutional reasons, the bankruptcy court generally and often can
not discharge nondebtors. First, exercise of the bankruptcy power to discharge
debt can not be constitutionally accomplished absent a contemporaneous fair
allocation of the debtor's assets to the debtors creditors. Kuehner v. Irving Trust
Co., 299 U.S. 445, 450, 452, 455 (1937). Second, Bankruptcy Code section
524(e) provides the debtor's discharge does not discharge nondebtors, as
follows:
Except as provided in subsection (a)(3) of this section, discharge
of a debt of the debtor does not affect the liability of any other entity
on, or the property of any other entity for, such debt.166
See, e.g., American Hardwood, Inc. v. Deutsche Credit Corp. (In re American
Hardwoods Inc.), 885 F.2d 621, 626 (9th Cir. 1989); Landsing Diversified
Properties-II v. First Natl Bank & Trust Co. (In re Western Real Estate Fund,
Inc.), 922 F.2d 592 (10th Cir. 1990), modified on other grounds, 932 F.2d 898
(10th Cir. 1991); Underhill v. Royal, 769 F.2d 1426 (9th Cir. 1985); Consolidated
Motor Inns v. BVA Credit Corp. (In re Consolidated Motor Inns), 666 F.2d 189
(5th Cir. 1982) Union Carbide Corp. v. Newboles, 686 F.2d 593 (7th Cir. 1982).
As shown below, the circuit courts differ as to whether and under what
circumstances the bankruptcy court can discharge or release nondebtors. One
simple cause of the dispute is that some courts start the analysis by asking the
166

Bankruptcy Code section 547(d) purports to discharge a surety to the extent

the surety bonded an obligation and received collateral security for its
reimbursement right and the lien would have been avoidable.

236

constitutional question, while other courts skip that step and start by looking at
the statutory jurisdictional grant to the bankruptcy court. Because 11 U.S.C.
1334(b) broadly grants the bankruptcy court power over all civil proceedings
"related to cases under title 11," it is clear the court has the raw statutory power
to grant discharges to nondebtors.
The courts that start their analysis with section 1334(b) next wrestle with
the unfairness of a nondebtor obtaining a discharge or a release from certain
liability without subjecting its assets to the provisions of title 11. 11 U.S.C.
105(a) empowers the court to issue any ordernecessary or appropriate to
carry out the provisions of title 11. Given that title 11 prescribes an elaborate
set of requirements before any entity can receive a discharge, the question
becomes whether granting a nondebtor a discharge of one or more debts without
satisfying all title 11 requirements is consonant with section 105(a). Courts
granting such discharges or releases attempt to limit the unfairness by restricting
such discharges to situations where they are necessary for the reorganization
and are unlikely to harm creditors materially.
Bankruptcy Rule 3016(c)167 requires the plan and disclosure statement, if
the plan enjoins conduct not otherwise enjoined by the Bankruptcy Code, to
disclose in bold, italic, or underlined text "all acts to be enjoined and identify the
entities that would be subject to the injunction." Normally, releases are
accompanied by injunctions against suing to enforce the released claims.
Bankruptcy Code section 524(a)(2) automatically imposes an injunction against
enforcing claims against the debtor or estate that are discharged pursuant to
section 1141(d)(1)(A).
B. Res Judicata.
Notwithstanding the illegalities of discharging nondebtors, when it does
occur on notice to an affected creditor and is not reversed, the discharge is
binding due to res judicata and may not be collaterally attacked except perhaps
in extraordinary circumstances. Travelers Indemnity Co. v. Bailey, 129 S. Ct.
2195 (2009); Stoll v. Gottlieb, 305 U.S. 165 (1938); Levy v. Cohen, 19 Cal. 3d
165 (Sup. Ct. 1977).
Significantly, notice of the discharge must pass constitutional muster and
the rules. In Century Indemnity Co. v. National Gypsum Company Settlement
Trust (In re National Gypsum Company), 208 F.3d 498 (5th Cir. 2000), cert.
167 Bankruptcy

Rule 3016(c) provides:

Injunction under a Plan. If a plan provides for an injunction against

conduct not otherwise enjoined under the Code, the plan and
disclosure statement shall describe in specific and conspicuous
language (bold, italic, or underlined text) all acts to be enjoined and
identify the entities that would be subject to the injunction.
237

denied, 121 S.Ct. 172 (2000), the reorganized debtor asserted it discharged the
cure amount claim of the nondebtor party to one of its executory contracts by
providing in its chapter 11 plan that the contract to be assumed had a cure
amount of zero. The evidence on summary judgment did not show the
nondebtor party had notice other than a general notice of the pendency of the
chapter 11 case.
On appeal, the Fifth Circuit affirmed the district courts affirmance of the
bankruptcy court and held 1141(d) cannot be read to provide for discharge of
amounts in default under assumed contracts in a manner that would nullify the
cure requirement of section 365(b)(1). 208 F.3d at 509.
But, the bankruptcy court had also held the nondebtor party was bound to
the zero cure amount based on res judicata. The district court reversed and the
Fifth Circuit affirmed the reversal. Notably, the appellate courts did not require
that the nondebtor party receive a standalone motion to assume listing the cure
amount as zero. Rather, the Fifth Circuit held the debtor must demonstrate
delivery of the proposed plan of reorganization or some other court-ordered
notice that set forth National Gypsums intent to assume the Wellington
Agreement with a $0 cure amount. 208 F.3d at 513. The court approved other
decisions holding the motion to assume was made when the non-debtor party
to the lease was served notice of the plans filing. 208 F.3d at 513 (citing Riddle
v. Aneiro (In re Aneiro), 72 B.R. 424, 428 (Bankr. S.D. Cal. 1987); In re Hall, 202
B.R. 929, 932-933 (Bankr. W.D. Tenn. 1996).
C. In re Ingersoll, Inc., 562 F.3d 856 (7th Cir. 2009)
i. Facts
Ingersoll Cutting Tool Company ("ICTC"), and its parent company,
Ingersoll International, Inc. ("Ingersoll") had been controlled by the Gaylords.
When the Gaylords learned that the outside ceo and directors were trying to
cause ICTC to be sold, the Gaylords retained a law firm to stop the sale, 562
F.3d at 859, which firm explained it would need help from an attorney at another
firm. 562 F3d at 859. The parties negotiated fee arrangements that led to
multiple disputes down the road. Ultimately, ICTC was sold and Ingersoll ended
up in chapter 11.
Ultimately, Ingersoll's liquidation plan was confirmed and contained a
release of the Gaylords, providing the Gaylords:
"shall be released from any and all claims and causes of action by
all creditors, parties-in-interest, directors, officers, shareholders,
agents, affiliates, parent entities, successors, assigns,
predecessors, members, partners, managers, employees, insiders,
agents and representatives of the Debtors and their estates arising
from or relating to the Gaylord Actions, including, without limitation,
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any claims causes of action, and counterclaims by any present or

former party to any of the Gaylord Actions."
562 F.3d at 862. One of the Gaylords' attorneys was served with a copy
of the confirmed chapter 11 plan, but nevertheless sued the Gaylords in state
court contending the Gaylords were breaching their arbitration agreement by
suing the attorney in state court. 562 F.3d at 862. The Gaylords requested the
bankruptcy court to enjoin the attorney from suing them and to hold the attorney
in contempt. The bankruptcy court held the attorney's suit was within the release
language in the chapter 11 plan and enjoined him from pursuing his claim, and
also held the plan's release of the (nondebtor) Gaylords from claims of the
(noncreditor) attorney was valid because it was central to the negotiation and
ultimate success of the plan. 562 F.3d at 862-863.
The district court remanded the attorney's appeal for the bankruptcy court
to determine if the attorney was a creditor of the debtor. 562 F.3d at 863. On
remand, the bankruptcy court ruled the attorney was not a creditor, but that the
release was needed to ensure the success of the bankruptcy plan and he did not
change his ruling that the release was proper. Then, the district court affirmed.
562 F.3d at 863.
ii. Issues
1.

Was the release "by its terms broad enough to cover [the
attorney's] claim?

2.

Was the release legally valid even though it released a nondebtor

from claims of entities who were not creditors of the debtor?
iii. Holdings

1.

Yes. 562 F.3d at 864.

2.

Yes. 562 F.3d at 863.

3.

"Yet, it is important to note in all this what we are not saying. We

are not saying that a bankruptcy plan purporting to release a claim
like Miller's is always or even normally valid. In the unique
circumstances of this case, however, we believe it is. We go no
further than to apply the rule we adopted in Airadigm to the facts at
hand. In most instances, releases like the one here will not pass
muster under that rule. Bankruptcy litigants should keep that in
mind when they sit down at the negotiating table." 562 F.3d at 865.

239

iv. Rationale
Section 105 of title 11 "authorizes a bankruptcy court to 'issue any order,
process, or judgment that is necessary or appropriate to carry out the provisions
of [the bankruptcy code]." 562 F.3d at 864. "This 'residual authority' is consistent
with a bankruptcy court's 'traditionally broad' equitable powers, In re Airadigm
Comm., Inc., 519 F.3d 640, 657 (7th Cir. 2008)" 562 F.3d at 864. The
equitable powers "also make an appearance within the context of reorganization
plans. Similar to 105, 11 U.S.C. 1123(b)(6) allows a court ot include in a plan
'any other appropriate provision not inconsistent with the applicable provisions of
[the bankruptcy code].'" 562 F.3d at 864.
"[T]he release does not provide blanket immunity. As in Airadigm and in
contrast to Metromedia it is narrowly tailored and critical to the plan as a whole.
The release only covers claims arising from or relating to two cases (the Gaylord
Actions), so it is far from a full-fledged 'bankruptcy discharge arranged without a
filing and without the safeguards of the Code.'Just as importantly, the
bankruptcy court found that the release was an 'essential component' of the plan,
the fruit of 'long-term negotiations' and achieved by the exchange of 'good and
valuable consideration' by the Gaylords that 'will enable unsecured creditors to
realize distribution in this case.'" 562 F.3d at 865.
"When the plan was confirmed (following an objection period), the debtors
served copies of the plan on creditors and parties in interest. Miller received a
copy as a party-in-interest." 562 F.3d at 862.
v. Analysis
The appellate decision analyses the issue from the viewpoint of whether
the release of a nondebtor is authorized by sections 105 and 1123. The decision
skips right to the statute, and nowhere asks whether the bankruptcy power
granted in article I of the U.S. Constitution grants authority to Congress to pass
laws discharging nondebtors from any claims. While the court does observe that
the release of the Gaylords was not a blanket release, thereby not creating a
discharge without the Gaylords abiding by all the other provisions of title 11, the
court does not determine whether the power granted to Congress to discharge
debtors, can be applied to nondebtors. Indeed, in Kuehner v. Irving Trust Co.,
299 U.S. 445, 450, 452, 455 (1937), the Supreme Court ruled exercise of the
bankruptcy power to discharge debt can not be constitutionally accomplished
absent a contemporaneous fair allocation of the debtor's assets to the debtors
creditors. Accord ACC Bondholder Group v. Adelphia Communications Corp. (In
re Adelphia Communications Corp.), 361 B.R. 337, 358n. 98 (S.D.N.Y. 2007)(" In
order for the implementation of the Bankruptcy law to be constitutional, it must
provide for a fair distribution of assets to a debtor's creditors. See Kuehner v.
Irving Trust Co., 299 U.S. 445, 451, 57 S. Ct. 298, 81 L. Ed. 340 (1937).).

240

Finally, the attorney who lost his claim against the nondebtors, received a
copy of the confirmed plan, but the facts do not show he received a copy in time
to object to confirmation. Conversely, the decision does not discuss that issue,
so the attorney presumably did not raise it on appeal. Perhaps the attorney did
not raise it because he was able to argue his objection to the bankruptcy court
when the issue arose after confirmation.
D. Airadigm Communications, Inc. v. Federal Communications
Commission (In re Airadigm Communications, Inc.), 519 F.3d
640 (7th Cir. 2008)
i. Facts
During Airadigm's first chapter 11 case commenced in 1999, the FCC
cancelled Airadigm's personal communications services licenses which Airadigm
had purchased at a 1996 auction for cash and debt. Airadigm owed the FCC
$64.2 million when it commenced its chapter 11 case. That case resulted in a
confirmed chapter 11 plan that assumed the FCC had properly cancelled the
licenses. The chapter 11 plan was financed by Telephone and Data Systems
("TDS"), which would pay the FCC different amounts on its proof of claim
depending on whether the FCC would reinstate the licenses during two years
after confirmation.
Then, in 2003, the United States Supreme Court decided FCC v.
NextWave Personal Communications, Inc., 537 U.S. 292 (2003), where it
overturned the FCC's license cancellation in similar circumstances to Airadigm
and the FCC acknowledged its cancellation of the Airadigm licenses was
ineffective. Airadigm then commenced a second chapter 11 case in 2006 and
commenced an adversary proceeding against the FCC requesting a divesting of
the FCC of any further interest in the licenses. The bankruptcy court granted the
FCC summary judgment rejecting Airadigm's claims.
Later in 2006, the bankruptcy court confirmed Airadigm's chapter 11 plan.
Based on the licenses then being worth $33 million, the plan treated the FCC as
having a $33 million secured claim and a deficiency claim for the balance of the
$64.2 million. The FCC could take an immediate payout of $33 million and lose
its liens in the licenses, or it could make the section 1111(b)(2) election. If it
made the election, the debtor would purchase and hold $33 million of
government-backed or low risk securities having different maturities, such that
over time (no more than 30 years) the principal and interest from the securities
would pay the FCC $64.2 million. If the reorganized debtor were to sell the
licenses, the FCC would receive the sale proceeds, and if less than $64.2 million,
would retain its lien against the licenses.
The FCC objected to its treatment. First, it objected that its lien was not
being preserved because its regulations provided that on a sale, the entire
241

balance becomes due. Second, the FCC objected to the plan's release of its
third party financer from "any act or omission arising out of or in connection with
theconfirmation of this Planexcept for willful misconduct." The bankruptcy
court determined that without the financer the debtor would have to finance $188
million and the financer would not go forward without the release.
ii. Issues
1.
Airadigm asserts its first chapter 11 plan extinguished the FCC's
liens.
2.
Airadigm also asserts the FCC's interests in the licenses were
avoidable by its strongarm powers.
3.
The FCC challenged the interest rate being paid on its claim if it
made the section 1111(b)(2) election.
4.
The FCC contended its liens were not being preserved due to the
absence of a 'due-on sale' sale clause in the plan.
iii. Holdings
1.

Airadigm's first chapter 11 plan did not extinguish the FCC's liens.

2.

Airadigm's strongarm powers can not avoid the FCC's liens.

3.
The FCC waived its interest rate argument by not raising it in the
bankruptcy court.
4.
The FCC's liens were preserved because the due-on sale clause is
not part of the lien.
In light of these provisions, we hold that this 'residual authority' permits
the bankruptcy court to release third parties from liability to participating creditors
if the release is 'appropriate' and not inconsistent with any provision of the
bankruptcy code."
iv. Rationale
Bankruptcy Code section 1141(c) provides that "after confirmation of a
plan, the property dealt with by the plan is free and clear of all claims and
interests of creditors" But for the plan to 'deal[ ] with' property for purposes of
1141(c), the plan itself must give some indication that it has compensated the
creditor for or otherwise impliedly affected its interest." Here, the plan
assumed the licenses were cancelled and did not deal with them.

242

Bankruptcy Code section 544(a)(1) provides Airadigm the "rights and

powers of a creditor that extends credit to the debtor at the time of the
commencement of the case, and that obtains, at such time and with respect to
such credit, a judicial lien" against the property. If a hypothetical creditor could
have obtained an interest superior to the FCC's at the time of Airadigm's filing,
the FCC would be an unsecured claimholder.
Here, "the property itself the license is a creature of federal law.
Accordingly, federal law also defines the FCC's retained interest in that
license.And as defined by federal law, the FCC does not have to perfect its
interest in a spectrum license because federal law prevents another creditor from
holding a superior interest. *** These statutory and regulatory provisions indicate
that federal law precludes a private party from obtaining a superior interest to the
FCC. *** But if the forced sale of the PCS licenses were to occur with the FCC as
merely an unperfected secured creditor, the sale would conflict with the statutes
and regulations covering the FCC's licensing scheme. This conflict gives rise to
a negative inference controlling in this case that federal law does not allow
private creditors to obtain an interest in PCS licenses superior to the FCC's."
"The due-on-sale provisions contained in the FCC's regulations do not
constitute part of its lien that the bankruptcy court had to 'retain' in order to
approve the plan pursuant to 1129. The bankruptcy code [sic] defines a 'lien'
as a 'charge against or interest in property to secure payment of a debt or
performance of an obligation.' 11 U.S.C. 101(37). The due-on-sale provision
contained in the federal regulation is not a 'charge against or interest in property'
but is instead a regulation regarding the terms of payment for the debt."
Section 524(e) is a savings clause and provides the "discharge of a debt
of the debtor does not affect the liability of another entity on, or the property of
any other entity for, such debt." If section 524(e) were meant to limit the
bankruptcy court's power to release a nondebtor it would have said the discharge
of a debtor shall not affect the liability of another entity. In contrast, section 34 of
the Bankruptcy Act of 1898, as amended, provided: "'[t]he liability of a person
who is a co-debtor with, or guarantor or in any manner a surety for, a bankrupt
shall not be altered by the discharge of such bankrupt." Thus, Union Carbide
Corp. v. Newboles, 686 F.2d 593 (7th Cir. 1982)(all nondebtor releases were
prohibited under the prior version of the Bankruptcy Code), "is no longer
controlling on this point of view."
"Section 1123(b)(6) permits a court to 'include any other provision not
inconsistent with the applicable provisions of this title.'In light of these
provisions, we hold that this 'residual authority' permits the bankruptcy court to
release third parties from liability to participating creditors if the release is
'appropriate' and not inconsistent with any provision of the bankruptcy code."

243

v. Analysis
Both section 524(e) and its predecessor, section 34, solely provide that
the debtor's discharge does not discharge liability of a third party. The distinction
the court makes between section 34 which uses the word "shall" and section
524(e) which does not, is a distinction without a difference because neither
section talks to the court's power to release third parties. Accordingly, by
bypassing the constitutional issue and by overlooking the big picture, namely that
the Bankruptcy Code has an elaborate set of requirements preceding the release
of liability which is not satisfied by the nondebtor, the court manages to conclude
the court is empowered to and can validly release a nondebtor.
As a practical matter, however, there is nothing in the facts indicating the
FCC or any creditor had any claim against the financer. The bankruptcy court
clearly could have ordered that any claims against the financer arising out of the
chapter 11 case be filed in its court by a date certain. Thus, the equivalence of
the release could likely have been achieved.
E. Travelers Indemnity Co. v. Bailey, 129 S. Ct. 2195 (2009)
i. Facts
As what was called the "cornerstone" of the reorganization, and as part of
Johns-Manville Corp.'s ("Manville") settlement with its insurers for $770 million,
Travelers, as Manville's primary insurer, paid nearly $80 million. 129 S. Ct. at
2199. "There would have been no such payment without the injunction"
providing "'all Persons are permanently restrained and enjoined from
commencing and/or continuing any suit, arbitration or other proceeding of any
type or nature for Policy Claims against any or all members of the Settling Insurer
Group.'" 129 S. Ct. at 2199. "'Policy Claims'" were defined as "'any and all
claims, demands, allegations, duties, liabilities and obligations (whether or not
presently known) which have been, or could have been, or might be asserted by
any Person against any or all members of the Settling Insurer Group based
upon, arising our of or relating to any or all of the Policies.'" Id.
Various plaintiff groups subsequently filed direct action lawsuits against
Travelers and other insurers on a variety of legal theories falling into two broad
categories: violation of state consumer-protection statutes by conspiring with
other insurers and asbestos manufacturers to hide dangers of asbestos and to
raise a fraudulent 'state of the art' defense to personal injury claims; and violation
of common law duties by failing to warn the public about the dangers of asbestos
or by acting to keep its knowledge of those dangers from the public. 129 S. Ct.
at 2200.
Travelers requested the bankruptcy court to enjoin the lawsuits. 129 S.
Ct. at 2200. After a mediation, 3 classes of plaintiffs settled with Travelers
paying over $400 million. Id. The settlements were conditioned on entry of a
244

bankruptcy court order clarifying that the direct action lawsuits are and have
always been prohibited by the 1986 confirmation order and related orders. Id.
The bankruptcy court issued the order after finding that Travelers learned
virtually everything it knew about asbestos from its relationship with Manville and
that "'[t]he gravamen of [the] Direct Action Claims were acts or omissions by
Travelers arising from or relating to Travelers['] insurance relationship with
Manville.'" 129 S. Ct. at 2201. The bankruptcy court also reasoned that the
Second Circuit's earlier decision, MacArthur Co. v. Johns-Manville Corp., 837
F.2d 89, 93-94 (2d Cir. 1988), was controlling. 129 S. Ct. at 2202. That decision
rejected a claim that the provisions of the confirmation order and settlement order
exceeded the bankruptcy court's jurisdiction.
ii. Issues
1.
After the bankruptcy court confirmed Manville's chapter 11 plan and
enjoined certain lawsuits against Manville's insurers including Travelers, does the
injunction bar "state-law actions against Travelers based on allegations either of
its own wrongdoing while acting as Manville's insurer or of its misuse of
information obtained from Manville as its insurer? 129 S. Ct. at 2198.
2.
"[W]hether the Bankruptcy Court had subject-matter jurisdiction
to enter the Clarifying Order." 129 S. Ct at 2205.
iii. Holdings
1.
"We hold that the terms of the injunction bar the actions and that
the finality of the Bankruptcy Court's orders following the conclusion of direct
review generally stands in the way of challenging the enforceability of the
injunction." 129 S. Ct at 2198.
2. "The answer is easy: as the Second Circuit recognized, and
respondents do not dispute, the Bankruptcy Court plainly had jurisdiction to
interpret and enforce its own prior orders. See Local Loan co. v. Hunt, 292 U.S.
234, 239, 54 S. Ct. 695, 78 L. Ed. 1230 (1934)" 129 S. Ct. at 2205.
"Our holding is narrow. We do not resolve whether a bankruptcy court, in
1986 or today, could properly enjoin claims against nondebtor insurers that are
not derivative of the debtor's wrongdoing. As the Court of Appeals noted, in 1994
Congress explicitly authorized bankruptcy courts, in some circumstances, to
enjoin actions against a nondebtor 'alleged to be directly or indirectly liable for the
conduct of, claims against, or demands on the debtor to the extent such alleged
liability . . . arises by reason of . . . the third party's provision of insurance to the
debtor or a related party,' and to channel those claims to a trust for payments to
asbestos claimants. 11 U.S.C. 524 (g)(4)(A)(ii). On direct review today, a
channeling injunction of the sort issued by the Bankruptcy Court in 1986 would
have to be measured against the requirements of 524 (to begin with, at least).

245

But owing to the posture of this litigation, we do not address the scope of an
injunction authorized by that section. 8
8
Section 524(h) provides that under some circumstances 524(g)
operates retroactively to validate an injunction. We need not decide
whether those circumstances are present here.
Nor do we decide whether any particular respondent is bound by the 1986
Orders. We have assumed that respondents are bound, but the Court of Appeals
did not consider this question. Chubb, in fact, relying on Amchem Products, Inc.
v. Windsor, 521 U.S. 591, 117 S. Ct. 2231, 138 L. Ed. 2d 689 (1997), and Ortiz v.
Fibreboard Corp., 527 U.S. 815, 119 S. Ct. 2295, 144 L. Ed. 2d 715 (1999), has
maintained that it was not given constitutionally sufficient notice of the 1986
Orders, so that due process absolves it from following them, whatever their
scope. See 340 B. R., at 68. The District Court rejected this argument, id., at 6869, but the Court of Appeals did not reach it, 517 F.3d at 60, n. 17. On remand,
the Court of Appeals can take up this objection and any others that respondents
have preserved." 129 S. Ct. at 2207.
iv. Rationale
"Respondents seek further refuge in evidence that before entry of the
1986 Orders some parties to the Manville bankruptcy (including Travelers)
understood the proposed injunction to bar only claims derivative of Manville's
liability. They may well be right about that: we are in no position to engage in
factfinding on this point, but there certainly are statements in the record that
seem to support respondents' contention. See App. for Respondent Chubb 1a3a, 5a, 13a-14a. But be that as it may, where the plain terms of a court order
unambiguously apply, as they do here, they are entitled to their effect. See, e.g.,
Negron-Almeda v. Santiago, 528 F.3d 15, 23 (CA1 2008) ('[A] court must carry
out and enforce an order that is clear and unambiguous on its face'); United
States v. Spallone, 399 F.3d 415, 421 (CA2 2005) ('[I]f a judgment is clear and
unambiguous, a court must adopt, and give effect to, the plain meaning of the
judgment' (internal quotation marks omitted)). If it is black-letter law that the
terms of an unambiguous private contract must be enforced irrespective of the
parties' subjective intent, see 11 R. Lord, Williston on Contracts 30:4 (4th ed.
1999), it is all the clearer that a court should enforce a court order, a public
governmental act, according to its unambiguous terms. This is all the Bankruptcy
Court did." 129 S. Ct. at 2204.
"Those orders are not any the less preclusive because the attack is on the
Bankruptcy Court's conformity with its subject-matter jurisdiction, for '[e]ven
subject-matter jurisdiction . . . may not be attacked collaterally.' Kontrick v. Ryan,
540 U.S. 443, 455, n. 9, 124 S. Ct. 906, 157 L. Ed. 2d 867 (2004). See also
Chicot County Drainage Dist. v. Baxter State Bank, 308 U.S. 371, 376, 60 S. Ct.
317, 84 L. Ed. 329 (1940) ('[Federal courts] are courts with authority, when

246

parties are brought before them in accordance with the requirements of due
process, to determine whether or not they have jurisdiction to entertain the cause
and for this purpose to construe and apply the statute under which they are
asked to act. Their determinations of such questions, while open to direct review,
may not be assailed collaterally'). So long as respondents or those in privity with
them were parties to the Manville bankruptcy proceeding, and were given a fair
chance to challenge the Bankruptcy Court's subject-matter jurisdiction, they
cannot challenge it now by resisting enforcement of the 1986 Orders. See
Insurance Corp. of Ireland v. Compagnie des Bauxites de Guinee, 456 U.S. 694,
702, n. 9, 102 S. Ct. 2099, 72 L. Ed. 2d 492 (1982) ('A party that has had an
opportunity to litigate the question of subject-matter jurisdiction may not . . .
reopen that question in a collateral attack upon an adverse judgment'); Chicot
County, supra, at 375, 60 S. Ct. 317, 84 L. Ed. 329 ('[T]hese bondholders, having
the opportunity to raise the question of invalidity, were not the less bound by the
decree because they failed to raise it'). 6
6 The rule is not absolute, and we have recognized rare situations in
which subject-matter jurisdiction is subject to collateral attack. See, e.g.,
United States v. United States Fidelity & Guaranty Co., 309 U.S. 506, 514,
60 S. Ct. 653, 84 L. Ed. 894 (1940) (a collateral attack on subject-matter
jurisdiction is permissible "where the issue is the waiver of [sovereign]
immunity"); Kalb v. Feuerstein, 308 U.S. 433, 439-440, 444, 60 S. Ct. 343,
84 L. Ed. 370 (1940) (where debtor's petition for relief was pending in
bankruptcy court and federal statute affirmatively divested other courts of
jurisdiction to continue foreclosure proceedings, state-court foreclosure
judgment was subject to collateral attack). More broadly, the Restatement
(Second) of Judgments 12, p. 115 (1980), describes three exceptional
circumstances in which a collateral attack on subject-matter jurisdiction is
permitted:
'(1) The subject matter of the action was so plainly beyond the court's
jurisdiction that its entertaining the action was a manifest abuse of
authority; or
'(2) Allowing the judgment to stand would substantially infringe the
authority of another tribunal or agency of government; or
'(3) The judgment was rendered by a court lacking capability to make an
adequately informed determination of a question concerning its own
jurisdiction and as a matter of procedural fairness the party seeking to
avoid the judgment should have opportunity belatedly to attack the court's
subject matter jurisdiction.'
This is no occasion to address whether we adopt all of these
exceptions. Respondents do not claim any of them, and we do not see how
any would apply here. This is not a situation, for example, in which a
bankruptcy court decided to conduct a criminal trial, or to resolve a custody
dispute, matters "so plainly beyond the court's jurisdiction" that a different
result might be called for." 129 S. Ct. at 2205-2206.

247

v. Does Travelers Implicitly Overrule Metromedia and Drexel

Burnham?
Significantly, the Supreme Court reversed the Second Circuit's holding
that the bankruptcy court's injunction could be collaterally attacked. By doing so,
the Supreme Court had no occasion to opine on whether the Second Circuit's
underlying reasoning was correct that a bankruptcy court lacks subject matter
jurisdiction to release claims against a non-title 11 debtor which were not
derivative of the title 11 debtor's wrongdoing. Indeed, the Supreme Court
expressly announced it was not resolving that issue. 129 S. Ct. at 2207.
Therefore, it is possible that the Second Circuit has narrowed or changed its
previous jurisprudence allowing third party releases important to the
reorganization.
Previously, the Second Circuit has acknowledged the bankruptcy court's
subject matter jurisdiction to grant third party releases when they are important to
the reorganization. [A] court may enjoin a creditor from suing a third party,
provided the injunction plays an important part in the debtors reorganization
plan. Drexel Burnham Lambert Trading Corp. v. Drexel Burnham Lambert
Group, Inc. (In re Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 293 (2d
Cir. 1992).
Fundamentally, the words of the grant of subject matter jurisdiction to the
bankruptcy court encompass the granting of third party releases because they
are so broad. Pursuant to 28 U.S.C. 1334(b), subject matter jurisdiction is
granted "of all civil proceedings arising under title 11, or arising in or related to
cases under title 11." At a minimum, the grant of a third party release to a
nondebtor that injects cash into the estate, is "related to" the case. As the United
States Supreme Court observed in Celotex Corp. v. Edwards, 514 U.S. 300,308
(1995), Congress' choice of the words "related to" "suggests a grant of some
breadth," and "must be read to give district courtsjurisdiction over more than
simply proceedings involving the property of the debtor or the estate." The court
noted the test of Pacor, Inc. v. Higgins, 743 F.2d 984, 994 (3d Cir. 1984) for
related to jurisdiction: "The usual articulation of the test for determining whether
a civil proceeding is related to bankruptcy is whether the outcome of that
proceeding could conceivably have any effect on the estate being administered
in bankruptcy.Thus the proceeding need not necessarily be against the debtor
or against the debtor's property. An action is related to bankruptcy if the outcome
could alter the debtor's rights, liabilities, options, or freedom of action (either
positively or negatively) and which in any way impacts upon the handling and
administration of the bankruptcy estate." (emphasis supplied by Pacor). But, the
impediments to third party releases are the constitutional concerns listed above
and the danger of abuse alluded to below in Metromedia.
The question at hand is whether the portion of the Second Circuit's
decision in Johns-Manville Corp. v. Chubb Indem. Ins. Co. (In re Johns-Manville

248

Corp.), 517 F.3d 52 (2d cir. 2008), rev'd, 129 S. Ct. 2195 (2009), that was not
reached by the Supreme Court eliminates the Second Circuit's holdings in Drexel
and Metromedia that releases of third parties from claims that are not paid from
estate assets are still available when "important" to the reorganization. In Drexel,
the Second Circuit affirmed approval of a class action settlement with the debtor
in possession under which one subclass was permanently enjoined from bringing
any future actions against Drexel's directors and officers and another subclass
was given the exclusive right to share in a portion of the settlement funds. Drexel
Burnham Lambert Trading Corp. v. Drexel Burnham Lambert Group, Inc. (In re
Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 288-89 (2d Cir. 1992). The
Second Circuit's decision reversed on jurisdictional grounds by Travelers, sub
silencio harkens back to the old subject matter jurisdictional regimen under the
Bankruptcy Act of 1898, as amended, which turned on property of the estate, the
res. The new statutory jurisdictional grant goes beyond limiting subject matter
jurisdiction to the res as conceded in Celotex, supra. To be sure, in a case
where insurance proceeds were very important as in Manville, had the issue
arisen at confirmation as to whether Travelers and the other insurers would have
entered into the settlement at the same amount if they had known their release
would not include a release of claims not payable from their insurance policies,
the answer would almost certainly have been no. Under the Drexel and
Metromedia standard, their releases would have been approved under the
'important to reorganization' standard. The Second Circuit's decision reversed on
jurisdictional grounds by Travelers makes it uncertain at best whether that
standard has survived.
F. Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re
Metromedia Fiber Network, Inc.), 416 F.3d 136 (2d Cir. 2005)
i. Facts.
Pursuant to MFNs chapter 11 plan, the Kluge Trust together with its
insiders would receive a release from all claimholders against MFN of all claims
arising out of any matter related to MFN or its affiliates through the effective date
of the plan. Deutsche Bank, AG v. Metromedia Fiber Network, Inc. (In re
Metromedia Fiber Network, Inc.), 416 F.3d 136, 141 (2d Cir. 2005). In exchange
for the release, the Kluge Trust would forgive approximately $150 million of
claims, convert $15.7 million of senior secured claims to equity, invest $12.1
million in the reorganized debtors and purchase up to $25 million of common
stock in the reorganized debtors. Id.
Additionally, the chapter 11 plan released former and current MFN
personnel from claims related to the bankruptcy, except for claims based on
gross negligence or willful misconduct, and from claims related to MFN, the
debtors, or the chapter 11 plan. Id. at *141n. 5.
ii. Issue.

249

Were the releases authorized by the Bankruptcy Code on the findings

made by the bankruptcy court? Id. at 141.
iii. Holding.
No. Id. at 143. But, rather than remand to determine if findings can
support the releases, the appeal must be dismissed for equitable mootness
because reversal would be inequitable and appellants had neither sought a stay
of the confirmation order nor sought an expedited appeal. Id. at 144.
iv. Rationale.
In bankruptcy, a court may enjoin a creditor from suing a third party,
provided the injunction plays an important part in the debtors reorganization
plan. Drexel Burnham Lambert Trading Corp. v. Drexel Burnham Lambert
Group, Inc. (In re Drexel Burnham Lambert Group, Inc.), 960 F.2d 285, 293 (2d
Cir. 1992).
Two considerations create a judicial reluctance to approve nondebtor
releases. First, only section 524(g) of the Bankruptcy Code provides for
nondebtor releases and section 105(a) cannot be used to create substantive
rights. Id. at 142. Second, nondebtor releases lend themselves to abuse
because nondebtors thereby obtain a bankruptcy discharge without the other
safeguards of the Bankruptcy Code. Id.
Here, there was a finding below that the Kluge Trust made a material
contribution to the estate, id. at *143, but there was no finding the release itself
was important to the plan or necessary for the plan. Id. A nondebtor release in
a plan of reorganization should not be approved absent the finding that truly
unusual circumstances render the release terms important to success of the
plan Id.
Because the Kluge transaction can not be undone without violence to the
overall agreement and the court can not predict what will happen if the settlement
is altered, the appeal is equitably moot. Id. at 145.
G. Lacy v. Dow Corning Corp. (In re Dow Corning Corp.), 280 F.3d
648 (6th Cir. 2002)
i. Facts
Dow Corning proposed a chapter 11 plan under which Dows product
liability insurers, Dows shareholders, and Dows operating reserves provided
$2.35 billion for payment of personal injury claimants, government health care
payers, and other creditors asserting claims related to silicone-implant product
liability claims. As a quid pro quo, Dows insurers and shareholders would be

250

released from all further liability on claims arising out of settled personal injury
claims and claimants would be permanently enjoined from bringing related claims
against them. 280 F.3d at 255. The bankruptcy court interpreted the plan to
mean the release and injunction would only apply to consenting claimants. But,
the district court interpreted it to apply to all creditors and affirmed confirmation.
280 F.3d at 655-666.
ii. Issue
Whether a bankruptcy court has the authority to enjoin a non-consenting
creditors claims against a non-debtor to facilitate a reorganization plan under
Chapter 11 of the Bankruptcy Code? 280 F.3d at 656.
iii. Holding
We hold that when the following seven factors are present, the
bankruptcy court may enjoin a non-consenting creditors claims against a nondebtor: (1) There is an identity of interests between the debtor and the third
party, usually an indemnity relationship, such that a suit against the non-debtor
is, in essence, a suit against the debtor or will deplete the assets of the estate;
(2) The non-debtor has contributed substantial assets to the reorganization; (3)
The injunction is essential to reorganization, namely, the reorganization hinges
on the debtor being free from indirect suits against parties who would have
indemnity or contribution claims against the debtor; (4) The impacted class, or
classes, has overwhelmingly voted to accept the plan; (5) The plan provides a
mechanism to pay for all, or substantially all, of the class or classes affected by
the injunction; (6) The plan provides an opportunity for those claimants who
choose not to settle to recover in full and; (7) The bankruptcy court made a
record of specific factual findings that support its conclusions. 280 F.3d at
658.
iv. Rationale
The Bankruptcy Code provides in section 105(a) that the bankruptcy court
can issue any order necessary or appropriate to carry out the provisions of the
Bankruptcy Code. 280 F.3d at 658. The statutory grant of power in section
105(a) renders Grupo Mexicano v. Alliance Bond Fund Inc., 527 U.S. 308 (1999),
inapplicable to bar equitable relief, and brings the case within the realm of United
States v. First National City Bank, 379 U.S. 378 (1965), which upheld use of an
injunction granted pursuant to a statute (26 U.S.C. 7402(a)(1964)) granting
courts power to issue injunctions necessary or appropriate for the enforcement
of the internal revenue laws. 280 F.3d at 657-658. Notably, the court did not
rely on the general jurisdictional grant in 28 U.S.C. 1334.

251

H. Gilman v. Continental Airlines (In re Continental Airlines), 203

F.3d 203 (3d Cir. 2000)
i. Facts
During its chapter 11 case, Continental Airlines, with court approval,
entered into a triparty agreement with its directors and officers insurers and
directors and officers. Under the settlement, the insurers paid $5 million to
Continental. Continental released the insurers and the directors and officers.
And, the directors and officers released Continental. Plaintiffs in then pending
securities fraud class action suits against the directors and officers did not object
to the settlement. Prior to the settlement, the bankruptcy court had temporarily
restrained plaintiffs from prosecuting the directors and officers. Then,
Continentals chapter 11 plan released the directors and officers from plaintiffs
claims and enjoined plaintiffs from pursuing them. Over plaintiffs objections the
plan was confirmed and the confirmation was affirmed in the district court 5 years
later.
ii. Holding
The United States Court of Appeals for the Third Circuit reversed the
district court, holding [p]laintiffs, who have never had their day in court, have
been forced to forfeit their claims against non-debtors with no consideration in
return, 203 F.3d at 211, and the release and injunction were legally
unsupportable. 203 F.3d at 218.
iii. Rationale
Without deciding whether non-debtor releases are never legal absent
consent, or are legal when fair to the claimants and necessary to the
reorganization, the court found there were no findings in the record to justify the
release in either situation. 203 F.3d at 214.
First, there was nothing in the record showing the released directors and
officers provided a critical financial contribution to the Continental Debtors plan
that was necessary to make the plan feasible in exchange for receiving a release
of liability for Plaintiffs claims. 203 F.3d at 215.
Second, the court questioned whether the reorganized debtor would really
have to indemnify the directors and officers given that federal courts disfavor
indemnity obligations for violating federal securities laws. 203 F.3d at 216.
Third, the court questioned the proposition that claims against the
directors and officers would implicate the debtors insurance policy because the
directors and officers may have direct rights to proceeds of the property. 203
F.3d at 216.

252

I. Brunos, Inc. v. W.R. Huff Asset Management Co.

(In re PWS Holding Corp.), 228 F.3d 224 (3d Cir.
2000)
i. Facts
Pursuant to the confirmed chapter 11 plan for Brunos, Inc., fraudulent
transfer claims against affiliates of the debtors shareholders and others were
released. Additionally, the confirmation order provided:
[n]one of the Debtors, the Reorganized Debtors, New Brunos, the
Creditor Representative, the Committee or any of their respective
members, officers, directors, employees, advisors, professionals or agents
shall have or incur any liability to any holder of a Claim or Equity Interest
for any act or omission in connection with, related to, or arising out of, the
Chapter 11 Cases, the pursuit of confirmation of the Plan, the
consummation of the Plan or the property to be distributed under the Plan,
except for willful misconduct or gross negligence, and in all respects, the
Debtors, the Reorganized Debtors, New Brunos, the Creditor
Representative, the Committee and each of their respective members,
officers, directors, employees, advisors, professionals and agents shall be
entitled to rely upon the advice of counsel with respect to their duties and
responsibilities under the Plan. 228 F.3d at 246.
A holder of $290 million of $421 million of subordinated debt appealed the
confirmation order on numerous grounds including (a) that the release of
fraudulent transfer defendants violated the absolute priority rule, and (b) that the
provision quoted above violates 11 U.S.C. 524(e) and the Third Circuits
decision in Gilman v. Continental Airlines (In re Continental Airlines), 203 F.3d
203 (3d Cir. 2000).
ii. Holding
The United States Court of Appeals for the Third Circuit affirmed the
confirmation order because, among other things, the releases of avoidance
claims were not on account of the shareholders equity interests in the debtor and
the protections afforded under the confirmation order are consistent with the
standard of liability under the Bankruptcy Code. 228 F.3d at 229-230.
[w]e announce a narrow rule that, without direct evidence of causation,
releasing potential claims against junior equity does not violate the absolute
priority rule in the particular circumstance in which the estates claims are of only
marginal viability and could be costly for the reorganized entity to pursue. 228
F.3d at 242.
iii. Rationale

253

The examiner in the chapter 11 case had concluded the avoidance claims
had little or no value. 228 F.3d at 242. Nevertheless, the objector had offered
$100,000 and sharing of proceeds in exchange for the claims. The appellate
court affirmed their release for no consideration, reasoning the District Court did
not err in concluding that the potential cost of defending and paying
indemnification claims, cross claims, and counterclaims arising out of the
prosecution of the claims was high, and that the claims were extinguished not on
account of KKRs interest in the Debtors, but because the Debtors determined
that they were unlikely to have any value. 228 F.3d at 242. [T]he claims were
extinguished because, in the judgment of the plan proponents, extinguishment
was the approach most likely to provide the greatest possible addition to the
bankruptcy estate. Id.
The appellate court concluded the protections granted to the creditors
committee and professionals who rendered services to the debtor do not violate
11 U.S.C. 524(e) because they do not affect liability of another entity on a debt
of the debtor. Rather, the protections are consistent with the limited immunity
granted to committees and professionals who serve the debtors. See, e.g., Pan
Am Corp. v. Delta Air Lines, Inc., 175 B.R. 438, 5114 (S.D.N.Y. 1994); In re L.F.
Rothschild Holdings, Inc., 163 B.R. 45, 49 (S.D.N.Y. 1994); In re Drexel Burnham
Lambert Group, Inc., 138 B.R. 717, 722 (Bankr. S.D.N.Y. 1992), affd, 140 B.R.
347 (S.D.N.Y. 1992); In re Tucker Freight Lines, Inc., 62 B.R. 213, 216, 218
(Bankr. W.D. Mich. 1986).
J. Monarch Life Insurance Co. v. Ropes & Gray, 65 F.3d 973 (1st
Cir. 1995).
i.

Facts

In the context of a chapter 11 plan proposed for Monarch Capital by its

creditors and former subsidiary, Monarch Life, the court enjoined, among other
things:
commencement or continuation of any action or proceeding
arising from or related to a claim against [Monarch Capital]
against or affecting or [sic]any property of [Monarch Capital],
or any direct or indirect transferee of any property of, or direct
or indirect successor in interest to, any of the foregoing...
After confirmation, Monarch Life sued Ropes & Gray for allegedly having
represented simultaneously Monarch Life and Monarch Capital and having
deliberately concealed from Monarch Life the ongoing use by Monarch Capital of
Monarch Life's funds when there was no realistic prospect of repayment. The
logic of the release of Ropes & Gray and others was that although they were not
contributing to the funding of the plan, actions against them would lead to the
impleader of other parties who were contributing to the plan and who would not
contribute unless they were assured of no further exposure.
254

ii.

Holding. The confirmation order has collateral

estoppel effect barring suits against Ropes & Gray.
Its ambiguity could have been litigated at
confirmation.

K. Resorts International, Inc. v. Lowenschuss (In re

Lowenschuss), 67 F.3d 1394 (9th Cir. 1995).
Here, Resorts International first filed a claim against Lowenschuss, but
then realized its claim was against the Lowenschuss pension plan for having
wrongfully tendered stock to Resorts International. Accordingly, Resorts
International requested leave to withdraw its claim without prejudice to
reinstatement if the pension plan were ultimately consolidated with Lowenschuss'
estate. The bankruptcy court, however, told Resorts International to litigate its
claim or withdraw it with prejudice even though the chapter 11 plan included a
global release releasing the pension plan from Resorts International's claims.
When Resorts International asked the bankruptcy court what the outcome would
be if the pension plan were later consolidated, the court responded: Thats just
tough. That's tough." 67 F.3d at 1400.
On appeal, the court ruled Resorts International should be allowed to
withdraw its claim without prejudice and affirmed the district court's vacation of
the global release.
31. Superpriority Claims under Bankruptcy Code Section
507(b) Have Met Resistance; But How About Non-Super
Administrative Claims? LNC Investments, Inc. v. First
Fidelity Bank, 247 B.R. 38 (S.D.N.Y. 2000)
A. Facts
At the outset of the Eastern Airlines (Eastern) chapter 11 case, Eastern
had secured bonds outstanding in the amount of $453,765,000. 247 B.R. at 40.
The collateral consisted of 104 aircraft worth $681,100,000. The collateral value
eroded to an appraised value between $475 million and $590 million, and on
November 14, 1990, the indenture trustees filed a motion for adequate protection
or stay relief. Id. Eastern discontinued operations and on January 18, 1991
stipulated to return the aircraft to the trustees. 247 B.R. at 41. Ultimately, the
bondholders holding second and third liens against the aircraft were left with
insufficient collateral value and they sued the indenture trustees for breach of
fiduciary duty in waiting too long before propounding their motion. Id.
B. Issue

255

The bondholders undertook to show that if the indenture trustees had

earlier made their motion and it had been denied, the bondholders would have
been entitled to superpriority claims under Bankruptcy Code section 507(b).
Accordingly, the trial court needed to determine for purposes of giving jury
instructions whether on a proper construction of the Code a secured creditors
claim is entitled to superpriority status if the creditor files a motion with the
bankruptcy court for an order lifting the stay of proceedings against the debtor or,
in the alternative, for an order of adequate protection, the bankruptcy court
denies any relief, and the creditors collateral subsequently proves inadequate to
cover its claim. 247 B.R. at 40.
Bankruptcy Code section 507(b) provides:
If the trustee, under section 363, 363, or 364 of this title,
provides adequate protection of the interest of a holder of a claim
secured by a lien on property of the debtor and if,
notwithstanding such protection, such creditor has a claim
allowable under subsection (a)(1) of this section arising from the
stay of action against such property under section 362 of this
title, from the use, sale or lease of such property under section
363 of this title, or from the granting of a lien under section
364(d) of this title, then such creditors claim under such
subsection shall have priority over every other claim allowable
under such subsection.
C. Holding
While acknowledging the closeness of the question, and the fact that the
prior judge presiding over the case had rendered one decision holding section
507(b) superpriority claims are not triggered by denials of stay motions and then
another decision holding the opposite, 247 B.R. at 42n.4, the court held the
denial of a motion for adequate protection, or alternatively stay relief, does not
trigger the creditors superpriority claims under section 507(b). 247 B.R. at 50.
But, the court also held en route to its ultimate holding that the
bondholders have an allowable administrative claim for their deficiency.
The parties differences arise out the first prerequisite to
507(b) superpriority status, found in the subsections introductory
phrases. There are other prerequisites, 507(b) requires that a
secured creditors claim be allowable under subsection (a)(1) of
this section and arising form conduct covered by 362, 363,
or 364(d). The Bondholders claims satisfy these conditions.
507(a)(1) cross-references 503(b)(b), which provides that
administrative expenses include the actual, necessary costs and
expenses of preserving the estate. The use of collateral to keep
a business operating qualifies as an administrative expense.
256

See In re J.F.K. Acquisitions Group, 166 B.R. 207, 212 (Bankr.

E.D.N.Y. 1994) (Since the Debtors use of the Hotel and its
proceeds went to maintain the property and operate the
business, it was an essential aspect of its efforts to reorganize.
The use of the collateral was an actual and necessary cost of
preserving the estate. Therefore, the claim of Americana is
allowable as an administrative claim under Section 503(b)).
One cannot imagine a more essential aspect of an airlines
efforts to reorganize than the use of its aircraft. Moreover, the
Bondholders claims arise from the automatic stay imposed by
362(a)(1), which prevented the Trustee from foreclosing on the
collateralized aircraft.
247 B.R. at 42n.4.
D. Rationale
First, the court reasons from the phrase If the trustee, under section 363,
363, or 364 of this title, provides adequate protection, that section 507(b) can
only be triggered by providing adequate protection after the petition date and that
an order denying an adequate protection or stay relief motion cant satisfy the
word provides in the statute. 247 B.R. at 46, 47. From that, the court rules the
creditors must show the literal application of section 507(b) is absurd (citing Holy
Trinity Church v. United States, 143 U.S. 457 (1892)) if they are to convince the
court not to interpret it literally. 247 B.R. at 46-47.
Second, the court reasons the overhanging, intimidating presence of a
multimillion dollar superpriority claim may chill the willingness of others to do
business with a debtor-in-possession, dooming that resolution preferred by
Congress, a successful reorganization, and leading to a liquidation. 247 B.R. at
48-49.
Third, the court applies a balancing test. I think that the Code protects
secured creditors up to a point, but not beyond, and the point of demarcation is
reached when granting superpriority status would imperil other identifiable
objectives of the Code, which include a preference for economically feasible
reorganizations. 247 B.R. at 49.
Fourth, the court acknowledges it is anomalous for the grating and denial
of an adequate protection motion to have such disparate consequences, when
the bankruptcy courts error in assessing adequacy and the consequent prejudice
to the secured creditor are the same. However, in view of the language
Congress used and the manner in which the Codes sections cross-reference
each other, that is an anomaly that the Congress must remedy. 247 B.R. at 50.

257

E. Rationale or Irrationale
It is unclear why the court believed the language of section 507(b) means
its superpriority claim is not triggered when an adequate protection or stay relief
motion is denied. Bankruptcy Code section 363(e) grants every secured
claimholder an unconditional, absolute right to adequate protection. It provides:
Notwithstanding any other provision of this section, at
any time, on request of an entity that has an interest in property
used, sold, or leased, or proposed to be used, sold, or leased, by
the trustee, the court, with or without a hearing, shall prohibit or
condition such use, sale, or lease as is necessary to provide
adequate protection of such interest. (emphasis supplied).
Likewise, Bankruptcy Code section 363(d)(1) mandates the court to
grant stay relief if the secured claim is not adequately protected. It
provides:
On request of a party I interest and after notice and a hearing,
the court shall grant relief from the stay provided under
subsection (a) of this section, such as by terminating,
annulling, modifying, or conditioning such stay -(1) For cause, including lack of adequate protection of an
interest in property of such party in interest; or (emphasis
supplied).
Therefore, the only time a court can deny a motion for adequate
protection or for stay relief is when adequate protection is being provided
by the trustee or debtor in possession. Such protection can take multiple
or alternate forms such as equity cushions, procurement of insurance,
maintenance of the collateral, etc. But, it must always be provided. The
court appears to have been influenced by semantics, namely that an
order denying adequate protection would be an order than no adequate
protection is needed. The statute rebuts that interpretation by granting
an absolute right to adequate protection to every secured claimant.
Once it is recognized that such motions can only be denied when
adequate protection is being provided, the plain meaning of section
507(b) becomes the reverse of what the court inferred. Section 507(b)
then plainly means that whenever the stay is maintained in effect and it
turns out the creditors secured position erodes while the creditor is
restrained from possessing its collateral, the creditors loss from that
erosion qualifies as a superpriority claim.
The courts second rationale does not comport with logic or
practice. The overhanging, intimidating presence of a multimillion dollar

258

superpriority claim will exist no matter which way the court decides the
issue. Thus, it is illogical for the court to deny the triggering of the
superpriority claim in the current instance. Entities doing business with
debtors in possession or trustees will still have to be concerned about
superpriority claims emanating from each court decision that grants
adequate protection.
In practice, trade creditors and others do not grant credit to
debtors in possession based on their analyses of the esoterics of section
507(b). Rather, they look at the credit available to the debtor in
possession and determine whether they want to take the risk of granting
unsecured or secured credit.
The courts theory that it should interpret section 507(b) so as not
to trigger a superpriority claim because the contrary holding would
imperil reorganizations is both demonstrably wrong and contrary to the
Bankruptcy Code. It is demonstrably wrong because the courts own
conclusion that the creditor, in any event, has an allowable, nonsuprepriority administrative claim for its losses due to the automatic stay
and the debtors use of the collateral, makes the creditors claim for such
losses payable in full in cash on the effective date of the chapter 11 plan.
Once that is established, the fact that the creditors claim should be paid
as a suprepriority before other administrative claims has no effect
whatsoever on the prospects for reorganization because all
administrative claims of whatever priority must be paid in full in cash on
the effective date of the plan unless the claimant consents otherwise.
Bankruptcy Code section 1129 (a)(9)(A).
It is contrary to the Bankruptcy Code because sections 362(d)(1)
and 363(e) expressly make clear that a secured claimholders right to
adequate protection is absolute and unconditional. There is no room to
deny adequate protection or stay relief if the claimholder is not
adequately protected regardless of its effect on the prospects for
reorganization. It is also illogical to conclude that the superpriority claim
granted under section 507(b) should be denied when the creditors
absolute and unconditional right to adequate protection or stay relief is
denied. That is the very instance when the creditor needs the
superpriority claim!
Finally, the courts acknowledgment of the anomaly caused by its
decision satisfies the courts own standard that its reading of section
507(b) must yield absurd results before the court will interpret it
differently. Based on the courts reading of section 507(b), an adequate
protection order directing the debtor to provide one additional dollar of
collateral would yield a superpriority claim if its insufficient, while an

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order denying adequate protection would yield no superpriority claim. By

any standard, that is absurd.
F. Subsequent History: LNC Investments, Inc. v. National
Westminster Bank, 308 F.3d 169 (2d Cir. 2002), cert. denied, 2003 U.S.
LEXIS 3729 (2003)
i.

Facts

At the jury trial, the court instructed the jury that if the bankruptcy court
grants a motion for adequate protection or denies stay relief and the protection
proves insufficient, the creditor is entitled to a superpriority claim. But, if the
motion is denied, the creditor is not entitled to a superpriority claim. 308 F.3d at
174-175. The trial court denied the bondholders the right to claim imprudence by
the indenture trustees for not pursuing an ordinary administrative claim because
they raised it at the eleventh hour before trial. 308 F.3d at 175. The jury
returned a special verdict finding the indenture trustees did not act imprudently
and judgment was entered in their favor. 308 F.3d at 175. The bondholders
appealed claiming the trial court should have instructed the jury that the making
of an adequate protection or stay relief motion would have resulted in a
superpriority claim under section 507(b) regardless of whether the bankruptcy
court granted any additional protection or denied the motion. 308 F.3d at 175.
ii.

Issue

The appellate court ruled the issue of whether the bondholders were
correct in their interpretation of section 507(b) would only be relevant if the
hypothetical prudent indenture trustee must be presumed to know the true legal
effect of such a motion. 308 F.3d at 175.
iii.

Holding

At the time the indenture trustees were supposed to have made a motion
for adequate protection or stay relief, the meaning of section 507(b) was
unsettled. Accordingly, the hypothetical prudent indenture trustee should not be
presumed to know the true legal effect of such a motion. Therefore, the jurys
special verdict that the trustees did not act imprudently should not be overturned.
The true meaning of section 507(b) would go to the issue of causation of
damages, but is not reached if the indenture trustees did not act imprudently in
the first place, 308 F.3d at 175-176, and the court expressly concluded it would
not decide that issue, 308 F.3d at 171.
In a concurring opinion, Judge Parker ruled the interpretation of section
507(b) did need to be determined because if the bondholders were correct, the
indenture trustees failure to have made a motion would appear a clear decision
not to take steps that would surely protect the bondholders. 308 F.3d at 179.

260

Judge Parker concurred because he concluded the denial of a motion for stay
relief or adequate protection would not create a superpriority claim under section
507(b). 308 F.3d at 179-180.
32. At Electromagnetic License Auctions, Whats For Sale?
A. Federal Communications Commission v.
NextWave Personal Communications, Inc. (In re
NextWave Personal Communications, Inc.), 200
F.3d 43 (2d Cir. 1999), cert. denied, 121 S.Ct. 298
(2000)
i. Facts
At the FCC auction in May and July 1996, NextWave made the winning
bid of $4.74 billion for 63 C-block licenses. On January 3, 1997, the FCC
conditionally granted the licenses to NextWave after NextWave submitted a plan
to bring its capital structure into compliance. On February 14, 1997, the FCC
granted NextWave the licenses conditioned on receiving the promissory notes.
On February 19, 1997, NextWave executed the notes in the amount of $4.27
billion for the unpaid portion of the purchase price. By then, the licenses were
worth less than a quarter of their purchase price. 200 F.3d at 47.
Three times, the FCC issued restructuring orders allowing winning bidders
to return their licenses in exchange for forgiveness of debt or to return some
licenses. The FCC determined not to allow bidders to retain licenses at reduced
prices. 200 F.3d at 48.
NextWave commenced a chapter 11 case on June 11, 1998 after the FCC
denied its request for more time to consider its options. The bankruptcy court
determined in an adversary proceeding that NextWave incurred its debt on
February 19, 1997 when the licenses were worth $1,023,211,000 and it had
already paid $474,364,806. Accordingly, the bankruptcy court ruled NextWaves
issuance of $4.27 billion of notes for licenses worth a little over $1 million was a
constructively fraudulent transfer, and avoided NextWaves note debt down to a
level of $548,846,194 (which together with its down payments equaled the full
value of the licenses). The district court affirmed. 241 B.R. 311 (S.D.N.Y. 1999).

261

ii. Holding
We are merely holding that NextWave may not collaterally attack or
impair in the bankruptcy courts the license allocation scheme developed by the
FCC. 200 F.3d at 55. By holding that for a price of $1.023 billion NextWave
would retain licenses for which it had bid $4.74 billion, the bankruptcy and district
courts impaired the FCCs method for selecting licensees by effectively awarding
the Licenses to an entity that the FCC determined was not entitled to them.
200 F.3d at 55.
We limit ourselves here to finding that NextWaves obligations were incurred
at the close of auction and that the transaction in which they were incurred was
therefore not constructively fraudulent. 200 F.3d at 59.
iii. Rationale
The appellate court explained that licenses are not property. Additionally,
the FCC was simply using an auction to help perform its function of allocating
electromagnetic spectrum. Congress therefore enacted 47 U.S.C. 309(j)
authorizing the FCC to develop a system for allocating spectrum through a
competitive bidding process. 200 F.3d at 51. The fact that market forces are
the technique used to achieve that regulatory purpose does not turn the FCC into
a mere creditor, any more than it turns an FCC license won at auction into a
property estate in spectrum. 200 F.3d at 54-55.
Accordingly, the court held the bankruptcy court had no authority to
allocate spectrum licenses in defiance of the FCCs determination to take the
allocation away from NextWave. If the conditions to which a license is subject
are not met, the FCC may revoke the license. It is beyond the jurisdiction of a
court in a collateral proceeding to mandate that a licensee be allowed to keep its
license despite its failure to meet the conditions to which the license is subject.
200 F.3d at 54.
The radio (or electromagnetic) spectrum belongs to no one. It is not
property that the federal government can buy or sell. It is no more governmentowned than is the air in which Americans fly their airplanes or the territorial
waters in which they sail their boats. 200 F.3d at 50. Although not owned by
the federal government, the radio spectrum is subject to strict governmental
regulation. 200 F.3d at 50. A license does not convey a property right; it
merely permits the licensee to use the portion of the spectrum covered by the
license in accordance with its terms. 200 F.3d at 51 (quoting FCC v. Sanders
Bros. Radio Station, 309 U.S. 470 (1940) ([N]o person is to have anything in the
nature of a property right as a result of the granting of a license.)).
On the issue of the constructively fraudulent transfer, the appellate court
held the date NextWave incurred its debt for the full purchase price was the date

262

of the close of the auction because the FCCs own interpretation of its own
regulations deserve a presumption of correctness. 200 F.3d at 58.
iv. Consequences of Holding
Significantly, the Second Circuits ruling that the licenses are not property
and do not create property rights changes the landscape for the fraudulent
transfer analysis. The underpinning of the courts analysis was that if NextWave
became liable for the full amount of the winning bid at the auction, then the
incurrence of debt can not be voidable because it was by definition the amount of
the market tested value of the licenses NextWave was purchasing. Therefore,
NextWave must have been receiving reasonably equivalent value in exchange
for the debt. But, if NextWave is now deemed not to have received any property
at the auction or subsequently, then how could it have received fair value in
exchange for its debt?
B. In re GWI PCS 1 Inc., 230 F.3d 788 (5th Cir. 2000)
i. Facts
On May 6, 1996, GWI was the high bidder for 14 PCS licenses. On
January 27, 1997, the FCC approved the granting of the licenses to GWI. On
March 10, 1997, GWIs subsidiaries executed notes to the FCC for the unpaid
portion of the purchase price, $954 million. 230 F.3d at 792-793. On October
20, 1997, GWIs subsidiaries commenced their chapter 11 cases and on October
29, 1997 they commenced an adversary proceeding to avoid the notes. 230
F.3d at 794.
At trial, the bankruptcy court found that although the licenses were worth
$1.06 billion when the auction closed, they had declined to $166 million by
January 27, 1997. 230 F.3d at 794. The court ruled the transfer would be
evaluated as of January 27, 1997, the date the licenses were issued. Therefore,
the transfer was constructively fraudulent because the debt incurred was $894
million in excess of the value of the licenses received.
Then, the bankruptcy court confirmed a chapter 11 plan with some
modifications it imposed to provide the FCC larger secured and unsecured
claims depending on what relief the FCC obtains on appeal.
Ultimately, the district court dismissed parts of the FCCs appeal of the
adversary proceeding and the confirmation order on the ground of equitable
mootness. 245 B.R. 59, 64 (N.D. Tex. 1999). The court affirmed the balance of
the judgments. 230 F.3d at 799.
ii. Holding

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Although the bankruptcy court possibly erred in permitting avoidance

and enjoining the FCC from revoking the subsidiary debtors licenses for failing to
remit the full bid price, thereby taking onto itself a quasi-regulatory function held
by the FCC, the FCCs challenge on this point and request that the avoidance
judgment, in its entirety, and the enjoinment order, be reversed are barred by
equitable mootness. 200 F.3d at 804. The Second Circuits decision, In re
Nextwave Personal Communications, Inc., 200 F.3d 43 (2d Cir. 1999)although
casting doubt on the merits of the bankruptcy courts assuming a quasiregulatory role, does not dissuade us from ruling that the FCCs challenge on this
issue is equitably moot. 230 F.3d at 804.
Therefore, we conclude that the bankruptcy court properly determined
January 27, 1997 as the appropriate date to evaluate the avoidance motion.
With respect to this issue, the FCCs challenge fails, and we affirm the avoidance
of the approximately $894 million of the obligation of the subsidiary debtors (and
of any such obligation of GWI PCS) to the FCC. 230 F.3d at 810.
iii. Rationale
The Fifth Circuit cited substantial evidence that the FCC adopted its
interpretation of its regulations as to the date GWI incurred its liability to pay the
full purchase price in light of the actual litigation. 230 F.3d at 06-807.
Accordingly, it did not afford them deference. Rather, the court recognized the
FCC auction was not typical. Under the C-block auction rules, the winning
bidder is not entitled to the license until after receiving subsequent FCC approval
and does not become obligated for the full bid price until the notes securing the
full bid price are thereafter signed. 230 F.3d at 810. The court deduced the
foregoing, in part, from regulations limiting the winning bidders liability to
expectation damages. 230 F.3d at 808. Query whether the limitation of liability
to expectation damages shows the winning bidder was liable for less than the full
bid as of the close of bidding?
C. Federal Communications Commission v.
Nextwave Personal Communications Inc., 537
U.S. 293, 123 S. Ct. 832 (2003)(8-1), affirming, 254
F.3d 130 (D.C. Cir. 2001)
i. Bankruptcy Code section 525(a) provides:
Except as provided in the Perishable Agricultural
Commodities Act, 1930, the Packers and Stockyards Act,
1921, and section 1 of the Act entitled An Act making
appropriations for the Department of Agriculture for the fiscal
year ending June 30, 1944, and for other purposes, approved
July 12, 1943, a governmental unit may not deny, revoke,
suspend, or refuse to renew a license, permit, charter,
franchise, or other similar grant to, condition such a grant

264

to, discriminate with respect to such a grant against deny

employment to, terminate the employment of, or
discriminate with respect to employment against, a
person that is or has been a debtor under this title or a
bankrupt or a debtor under the Bankruptcy Act, or
another person with whom such bankrupt or debtor has
been associated, solely because such bankrupt or debtor
is or has been a debtor under this title or a bankrupt or
debtor under the Bankruptcy Act, has been insolvent
before the commencement of the case under this title, or
during the case but before the debtor is granted or denied
a discharge, or has not paid a debt that is dischargeable
in the case under this title or that was discharged under
the Bankruptcy Act. (Emphasis supplied).
ii. History Subsequent to 200 F.3d 43 (2d Cir.
1999), cert. denied, 121 S.Ct. 298 (2000)
After the United States Court of Appeals for the Second Circuit reversed
the bankruptcy courts holding that Nextwaves incurrence of debt for its licenses
was voidable as a fraudulent transfer, Nextwave proposed a chapter 11 plan
under which it would pay in full for the licenses. The bankruptcy court declared
null and void the FCCs cancellation of the licenses on the ground the FCC
violated the automatic stay, reasoning that the FCC had no regulatory interest in
the timely payment requirement of the license price. The Second Circuit
reversed holding there can be little doubt that if full payment is a regulatory
condition, so too is timeliness.. In re FCC, 217 F.3d 125, 136 (2d Cir. 2000).
Additionally, the appellate court ruled it was outside the jurisdiction of the
bankruptcy court to determine if the FCC was arbitrary: It is for the FCC to
state its conditions of licensure, and for a court with power to review the FCCs
decisions to say if they are arbitrary or valid. Id. at 137.
When Nextwave asked the FCC to reconsider its license cancellation, the
FCC ruled Nextwave was late because the cancellation was built into the original
transaction, and that the Second Circuits decision was res judicata on
Nextwaves Bankruptcy Code arguments. 15 Fcc Rcd 17500, Fcc 00-335 P 10,
26.
iii. Holding
First, pursuant to the Administrative Procedure Act, the court must hold
unlawful agency action not in accordance with law, 5 U.S.C. 706(2), which
means any law and not simply the laws the agency enforces. 123 S. Ct. at 838.
Notably, the FCC never denied that if Nextwave had made its payments timely, it
could have retained its licenses. 123 S. Ct. at 838. Similarly, the FCC did not
deny that Nextwaves obligations to make its payments were enforceable debts.

265

Second, Bankruptcy Code section 525 prohibits the FCC from revoking
licenses held by a debtor in bankruptcy upon the debtors failure to make timely
payments owed to the FCC for purchase of the licenses.
Third, [t]he FCC has not denied that the proximate cause for its
cancellation of the licenses was NextWaves failure to make the payments that
were due. It contends, however, that 525 does not apply because the FCC had
a valid regulatory motive for the cancellation.In our view, that factor is
irrelevant. When the statute refers to failure to pay a debt as the sole cause of
cancellation (solely because), it cannot reasonably be understood to include,
among the other causes whose presence can preclude application of the
prohibition, the governmental units motive in effecting the cancellation. Such a
reading would deprive 525 of all force. It is hard to imagine a situation in which
a governmental unit would not have some further motive behind the cancellation
assuring the financial solvency of the licensed entity, 123 S. Ct. at 838-839.
Some may think (and the opponents of 525 undoubtedly thought) that there
ought to be an exception for cancellations that have a valid regulatory purpose.
Besides the fact that such an exception would consume the rule, it flies in the
face of the fact that, where Congress has intended to provide regulatory
exceptions to provisions of the Bankruptcy Code, it has done so clearly and
expressly, rather than by a device so subtle as denominating a motive a
cause. 123 S. Ct. at 839.
Fourth, the FCC contended NextWaves license obligations are not debts
dischargeable in bankruptcy. This is nothing more than a retooling of
petitioners recurrent theme that regulatory conditions should be exempt from
525. No matter how the FCC casts it, the argument loses. Under the Bankruptcy
Code, debt means liability on a claim,and claim, in turn, includes any right
to paymentWe have said that claim has the broadest available definition,
and have held that the plain meaning of a right to payment is nothing more nor
less than an enforceable obligation, regardless of the objectives the State seeks
to serve in imposing the obligationIn short, a debt is a debt, even when the
obligation to pay it is also a regulatory condition. 123 S. Ct. at 839. The
appellate court had rejected the FCCs argument that timely payment of the
license obligation was a regulatory requirement and not a dischargeable debt.
The court reasoned the FCC was creating a regulatory purpose exception to
section 525. 254 F.3d at 152. The court pointed out that section 525 carves out
the regulatory purposes and statutes Congress wanted to carve out, showing
Congress did not intend a general regulatory purpose exception. 123 S. Ct. at
839.
Fifth, it is not beyond the bankruptcy courts jurisdictional authority to
discharge a debt unless it falls within an express exception to discharge. The
appellate court had rejected the FCCs argument that section 525 is inapplicable
because the U.S. Court of Appeals for the Second Circuit held the bankruptcy
court lacked jurisdiction to discharge Nextwaves license obligation and section

266

525 by its terms only applies to dischargeable debts. The D.C. Circuit Court of
Appeals reasoned the issue is whether the license obligation is dischargeable
under the Bankruptcy Code by a court of competent jurisdiction, not whether the
bankruptcy court can discharge or modify it. 254 F.3d at 152. The United States
Supreme Court agreed that except for the 9 kinds of debts saved from discharge
in 11 U.S.C. 523(a), a discharge in bankruptcy discharges the debtor from all
debts that arose before bankruptcy. 123 S. Ct. at 840.
Notably, the U.S. Court of Appeals had also rejected the FCCs argument
that section 525 does not bar actions not exempted from the automatic stay
under section 362(b)(4) as governmental regulatory actions. Such an
interpretation would be inconsistent with the plain language of section 525. 254
F.3d at 150. Moreover, section 362(b)(4) does not exempt any acts from the
automatic stay of actions to create, perfect, or enforce liens under section
362(a)(4). Therefore, the FCC is wrong that its actions were not automatically
stayed. 254 F.3d at 151.
33. Purchasing Distressed Debt Claims with Intent to
Prosecute Them Is Still Legal Elliott Associates, L.P. v.
Banco De La Nacion, 194 F.3d 363 (2d Cir. 1999)
i. Facts
In October 1995, an investment fund whose primary types of investment
included investments in distressed debtors purchased $28.75 million of
Panamanian sovereign debt for $17.5 million. In July 1996, it brought suit
against Panama for full payment. The fund was guided by a consultant and
attorney having previously purchased sovereign debt of several other countries
prior to filing lawsuits for full payment. 194 F.3d at 365-366. Panama was
finalizing its Brady Plan restructuring which is not binding on creditors unless
they consent. 194 F.3d at 366. Between January and March 1996, the fund
purchased for $11.4 million, $20.7 million of bank debt guaranteed by Peru. The
trial court found the fund timed its purchases with key events in litigation by
another fund to enforce its debt. 194 F.3d at 367.
When the fund sued to enforce its Peruvian debt claims, the district court
denied its motion for prejudgment attachment of U.S. Treasury bonds and
ultimately dismissed the funds complaint on the ground the fund violated Section
489 of the New York Judiciary Law because it purchased the Peruvian debt with
the intent and purpose to sue. 194 F.3d at 368 (quoting from 12 F. Supp. at
332).
ii. Issue
The pivotal issueis whether, within the meaning of Section 489 of the
New York Judiciary Law, Elliotts purchase of Peruvian sovereign debt was with

267

the intent and for the purpose of bringing an action or proceeding thereon,
thereby rendering the purchase a violation of law. 194 F.3d at 371.
Section 489 provides:
No person or co-partnership, engaged directly or
indirectly in the business of collection and adjustment of claims,
and no corporation or association, directly or indirectly, itself or
by or through its officers, agents or employees, shall solicit, buy
or take an assignment of, or be in any manner interested in
buying or taking an assignment of a bond, promissory note, bill
of exchange, book debt, or other thing in action, or any claim or
demand, with the intent and for the purpose of bringing an action
or proceeding thereon; provided however, that bills receivable,
notes receivable, bills of exchange, judgments or other things in
action may be solicited, bought, or assignment thereof taken,
from any executor, administrator, assignee for the benefit of
creditors, trustee or receiver in bankruptcy, or any other person
or persons in charge of the administration, settlement or
compromise of any estate, through court actions, proceedings or
otherwise. Nothing herein contained shall affect any assignment
heretofore or hereafter taken by any moneyed corporation
authorized to do business in the state of New York or its
nominee pursuant to a subrogation agreement or a salvage
operation, or by any corporation organized for religious,
benevolent or charitable purposes. Any corporation or
association violating the provisions of this section, and any
officer, trustee, director, agent or employee of any person, copartnership, corporation or association violating this seciton who,
directly or indirectly, engages or assists in such violation, is guilty
of a misdemeanor.
iii.

Holding

[W]e are convinced that, if the New York Court of Appeals, not us, were
hearing this appeal, it would rule that the acquisition of a debt with intent to bring
suit against the debtor is not a violation of the statute where, as here, the primary
purpose of the suit is the collection of the debt acquired. Consequently, we must
reverse the judgment of the district court. 194 F.3d at 372. [W]e hold that
Seciton 489 is not violated when, as here, the accused partys primary goal is
found to be satisfaction of a valid debt and its intent is only to sue absent full
performance. 194 F.3d at 381.
iv. Rationale
New York cases show Section 489s predecessor was intended to curtail
the practice of attorneys filing suit merely to obtain costs, which at that time
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included attorney fees. 194 F.3d at 373. To violate Section 489 the primary
purpose of the debt purchase must be to enable the attorney to commence a
suit, rather than to be paid and to commence suit only if payment is not
forthcoming.
As policy matters, the appellate court also recognized that a holding
rendering debt unenforceable when purchased with the intent to sue for full
payment would add to the risk of lending to developing nations and would disrupt
or destroy the secondary market for defaulted debt. 194 F.3d at 380. Such a
holding sould also create a perverse result because it would permit defendants
to create a champerty defense by refusing to honor their loan obligations. 194
F.3d at 380 (quoting Banque de Gestion PriveeSib v. La Republica de Paraguay,
787 F. Supp. 53, 57 (S.D.N.Y. 1992)).
34. Lessons from a Failed Limited Fund Settlement
Class Action Ortiz v. Fibreboard Corp., 119 S.
Ct. 2295 (1999)
i. Facts.
To try to settle all its present and future asbestos liability, Fibreboard
approached certain leading plaintiffs attorneys. The plaintiffs attorneys
represented plaintiffs holding then pending claims. But, they also negotiated on
behalf of potential future claimants. Fibreboards insurance companies had been
contesting coverage, but also agreed to join the settlement and to provide $1.535
billion. Fibreboard had a net worth of approximately $235 million (excluding
asbestos liability), and agreed to furnish $10 million to the settlement fund of
which all but $500,000 came from other insurance. Just prior to the proposed
class action settlement, one of the plaintiffs law firms procured a separate
settlement for its 45,000 pending claims. In that settlement, the settlement
amounts were higher than average with one-half due on closing and the
remainder contingent on either a global settlement or Fibreboards success in its
litigation against its insurers.
At the plaintiffs firms insistence, the insurers reached an additional
settlement under which they would provide $2 billion in coverage if the class
action settlement did not win approval.
Under the putative settlement, Fibreboard and the insurers would obtain
full releases from class members in exchange for setting up the settlement fund
in a trust. Claimants would be required to try to settle with the trust and had to
exhaust mediation, arbitration, and a mandatory settlement conference before
litigating. Once litigating, the claimants would be limited to no more than
$500,000 and would be unable to obtain prejudgment interest or punitive
damages. Claims resolved without litigation would be paid over 3 years. Claims
resolved with litigation would be paid over 5 to 10 years.

269

When the class action settlement was fully documented, a group of

plaintiffs filed an action in the United District Court for the Eastern District of
Texas seeking certification for settlement purposes of a mandatory class
pursuant to Fed. R. Civ. P. 23(b)(1).168 The class excluded claimants with actions
pending against Fibreboard and claimants who had formerly sued Fibreboard
and dismissed their actions for consideration with right to sue again upon
168 Fed.

R. Civ. P. 23(b) provides:

Class Actions Maintainable. An action may be maintained as a

class action if the prerequisites of subdivision (a) are satisfied,
and in addition:
(1) the prosecution of separate actions by or against
individual members of the class would create a risk of
(A) inconsistent or varying adjudications with respect to
individual members of the class which would establish
incompatible standards of conduct for the party
opposing the class, or
(B) adjudications with respect to individual members of the
class which would as a practical matter be dispositive
of the interests of the other members not parties to the
adjudications or substantially impair or impede their
ability to protect their interests; or
(2) the party opposing the class acted or refused to act on
grounds generally applicable to the class, thereby
making appropriate final injunctive relief or
corresponding declaratory relief with respect to the
class as a whole; or
(3) the court finds that the questions of law or fact
common to the members of the class predominate over
any questions affecting only individual members, and that
a class action is superior to other available methods for
the fair and efficient adjudication of the controversy. The
matters pertinent to the findings include: (A) the interest of
members of the class in individually controlling the
prosecution or defense of separate actions; (B) the extent
and nature of any litigation concerning the controversy
already commenced by or against members of the class;
(C) the desirability or undesirability of concentrating the
litigation of the claims in the particular forum; (D) the
difficulties likely to be encountered in the management of
a class action.
270

development of an asbestos-related malignancy. The court appointed a guardian

ad litem to review the fairness of the settlement to class members.
The district court approved the mandatory class action settlement, the
United States Court of Appeals for the Fifth Circuit affirmed.
ii. Holding
The United States Supreme Court reversed. We hold that applicants for
contested certification on this rationale [limited fund theory under Fed. R. Civ. P.
23(b)(1)(B)] must show that the fund is limited by more than the agreement of the
parties, and has been allocated to claimants belonging within the class by a
process addressing any conflicting interests of class members. 119 S. Ct. at
2302.
iii.

Rationale
(a) Historical Limited Fund Mandatory
Class Actions

In Dickinson v. Burnham, 197 F.2d 973 (2d Cir.), cert. denied, 344 U.S.
875 (1952), investors furnished $600,000 to save a failing company. The
monies were misused, but a pool remained of secret profits on the investment.
To allocate the fund, the court approved the class action.
In Guffanti v. National Surety Co., 196 N.Y. 452 (1909), the defendant
converted money furnished him for steamship tickets, but had posted a $15,000
bond before being adjudicated bankrupt. The appellate court sustained the
equitable class suit citing the limited fund subject to pro rata distribution.
In early creditors bills equity would order a master to call for all creditors
to prove their debts, to take account of the entire estate, and to apply the estate
in payment of the debts. See 1 J. Story, Commentaries on Equity Jurisprudence
547, 548 (I. Redfield 8th rev. ed. 1861).
(b) Criteria for Limited Fund Class
Actions under Fed. R. Civ. P.
23(b)(1)(B).
There are 3 requirements. First, the fund must be insufficient to pay all
the claims when the maximum fund is compared to the maximum potential
claims. The limited fund creates the necessity for the class action.
Second, the whole of the inadequate fund must be devoted to the
overwhelming claims. Otherwise, the defendant may procure a deal better than
available to claimants in seriatim litigation.

271

Third, all claimants must be treated equitably among themselves and it is

assumed the class includes all claimants. Pro rata distribution provides the
required fairness.
(c) Potential Constitutional Impediments
to Application of Fed. R. Civ. P. 23
(b)(1) to Mass Torts
Fed. R. Civ. P. 23 requires no notice requirement beyond whats required
under Fed. R. Civ. P. 23(e)169 for settlement purposes. This may or may not be
curable by notice to the class of the fairness hearing and an opportunity to be
heard and to participate in the litigation. Next, the settlement implicates the class
members rights to jury trials under the Seventh Amendment. Here, class
members were limited to verdicts of $500,000 or less as compared to
multimillion-dollar verdicts in some asbestos jury trials. Next, with limited
exceptions, a person should not be bound by a judgment in litigation in which he
is not a party or has not been served. The exceptions include situations in which
the persons interests are adequately represented by someone with the same
interests or where a special remedial scheme exists expressly foreclosing
successive litigation as in bankruptcy or probate.
(d)

Causes of Reversal

The trial court failed to demonstrate that the fund was limited except by
the agreement of the parties, and it showed exclusions from the class and
allocations of assets at odds with the concept of limited fund treatment and the
structural protections of Rule 23(a) explained in Amchem.170 119 S. Ct. at 2316
(footnote added).
In Amchem, the Supreme Court was asked to reverse the Third Circuits
reversal of the district courts approval of an asbestos class action settlement
under Fed. R. Civ. P. 23(b)(3). To satisfy the requirements of Rule 23(b)(3), the
requirements of Rule 23(a)171 must be satisfied and (1) common questions must

169 Fed.

R. Civ. P. 23(e) provides:

Dismissal or Compromise. A class action shall not be dismissed

or compromised without the approval of the court, and notice of
the proposed dismissal or compromise shall be given to all
members of the class in such manner as the court directs.
170 Amchem
171 Fed.

Products, Inc. v. Windsor, 521 U.S. 591 (1997).

R. Civ. P. 23(a) provides:

272

predominate over any questions affecting only individual members and (2) class
resolution must be superior to other available methods for the fair and efficient
adjudication of the controversy. Amchem, 521 U.S. at 615.
The Supreme Court ruled common questions did not predominate. For
instance, some claimants manifested injury from asbestos and some were simply
exposed. Some had cancer. Some had only asymptomatic pleural changes.
Moreover, the state law applicable to each varied. Amchem, 521 U.S. at 624.
The Supreme Court also ruled the settlement flunked the adequacy-ofrepresentation requirement in Fed. R. Civ. P. 23(a)(4). This focuses on both the
plaintiffs and the competency and conflicts of class counsel. 521 U.S. at 625,
625n.20. The plaintiffs had diverse medical conditions, yet no subclasses were
established to deal with the conflicts between the currently injured who want
generous immediate payments and the exposure-only plaintiffs who want an
inflation protected fund for the future. 521 U.S. at 626. The settlement embodied
implicit allocation decisions. For instance, there would be no adjustments for
inflation. Only a few claimants a year could opt out. And, loss-of-consortium
claims were extinguished with no compensation. 521 U.S. at 627. There was no
assurance the named plaintiffs operated under a proper understanding of their
representational responsibilities. 521 U.S. at 628.
On the issue of whether constitutional notice could ever be given to
exposure-only claimants, the Supreme Court opined: In accord with the Third
Circuit, however, see 83 F.3d at 633-634, we recognize the gravity of the
question whether class action notice sufficient under the Constitution and Rule
23 could ever be given to legions so unselfconscious and amorphous. 521 U.S.
at 628. Notably, the limited fund situation makes this problem more soluble
because the appointment of a guardian ad litem to obtain for future claimants
what might otherwise cease to exist (i.e., their fair share of the fund) has no real
alternative.
The limited fund finding is comprised of two elements, namely, the
maximum claim amount and the maximum fund amount. Here, the fund assets
would be limited if the total of demonstrable claims would render the insurers
insolvent or if the policies had limits less than the total claims, in either case by

Prerequisites To A Class Action. One or more members of a

class may sue or be sued as representative parties on behalf of
all only if (1) the class is so numerous that joinder of all members
is impracticable, (2) there are questions of law or fact common to
the class, (3) the claims or defenses of the representative parties
are typical of the claims or defenses of the class, and (4) the
representative parties will fairly and adequately protect the
interests of the class.
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an amount more than Fibreboards value.172 119 S. Ct. at 2317. To determine

the amount of insurance available, the lower courts used the settlement values
($1.55 billion or $2 billion). The Supreme Court ruled:
Settlement value is not always acceptable, however.
One may take a settlement amount as good evidence of the
maximum available if one can assume that parties of equal
knowledge and negotiating skill agreed upon the figure through
arms-length bargaining, unhindered by any considerations
tugging against the interests of the parties ostensibly
represented in the negotiation. But no such assumption may be
indulged in this case, or probably in any class action settlement
with the potential for gigantic fees. 30 (FN 30: In a strictly
rational world, plaintiffs counsel would always press for the limit
of what the defense would pay. But, with an already enormous
fee within counsels grasp, zeal for the client may relax sooner
than it would in a case brought on behalf of one claimant.) In
this case, certainly, any assumption that plaintiffs counsel could
be of a mind to do their simple best in bargaining for the benefit
of the settlement class is patently at odds with the fact that at
least some of the same lawyers representing plaintiffs and the
class had also negotiated the separate settlement of 45,000
pending claims, 90 F.3d at 969-970, 971, the full payment of
which was contingent on a successful global settlement
agreement or the successful resolution of the insurance
coverage dispute (either by litigation or by agreement, as
eventually occurred in the Trilateral Settlement
Agreement)Class counsel thus had great incentive to reach
any agreement in the global settlement negotiations that they
thought might survive a rule 23(e) fairness hearing, rather than
the best possible arrangement for the substantially unidentified
global settlement class.The resulting incentive to favor the
known plaintiffs in the earlier settlement was, indeed, an
egregious example of the conflict noted in Amchem resulting
from divergent interests of the presently injured and future
claimants.
119 S. Ct. at 2317-2318. The federal courts have used different methods to
determine whether a fund is limited in cases involving mass torts. Some courts
hold the proponents must demonstrate allowing the adjudication of individual
Supreme Court observed the district court at least heard evidence and
made an independent finding of Fibreboards value, unlike its adoption of the
parties agreement as to the limited insurance funds. 119 S. Ct. at 2317n.28.
But, the Supreme Court also noted that while an investment banker testified to
Fibreboards $235 million value, the company was acquired in 1997 for $515
million plus $85 million in assumed debt. Id.
172 The

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claims will inescapably compromise the claims of absent class members, while
others require a showing of only a substantial probability (less than a
preponderance, but more than a mere possibility) that claims will exceed fund
assets. 119 S. Ct. at 2316n.26.
Thus, the Supreme Court demonstrated acute insights into the workings of
the industry of plaintiffs attorneys in the asbestos industry. In short, these
attorneys obtain percentages of all collections. They have obvious economic
motivations to collect sooner rather than later. Therefore, from any fund, they
would have an economic motivation to allocate more to the current claimants
than the future claimants because they would receive the money faster. This
conflict led the Supreme Court to reverse the approval of a settlement these
attorneys made between the present and future claimants, both represented, at
least in part, by the same attorneys.
Additionally, the Supreme Court ruled the settlement fell short in respect of
the inclusiveness of the class. The class excluded 45,000 pending claims as well
as claimants who had previously sued Fibreboard and withdrew their claims with
a right to reassert them on development of an asbestos related malignancy. The
Supreme Court observed the 45,000 excluded claims may be as much as a third
of the class and were represented by class counsel. 119 S. Ct. at 2319. The
Supreme Court left open the issue of how far a mandatory settlement class may
be depleted by prior dispositions of claims and still qualify as such a class. 119
S. Ct. at 2319. The Supreme Court also mentioned without deciding that it might
make a difference if the excluded claimants were receiving comparable benefits.
Id. Here, that was not the case.
The Supreme Court also overturned the settlement due to the lack of
fairness of distribution within the class. When it is not possible to do a straight
forward pro rata distribution, the settlement must seek equity by providing for
procedures to resolve the difficult issues of treating such differently situated
claimants with fairness as among themselves. 119 S. Ct. at 2319. First, there
were no homogenous subclasses of present claimants and future claimants with
separate attorneys for each. The named plaintiffs were not named until after the
settlement was reached. The adequacy of the named plaintiffs and counsel are
both important for fairness purposes. Id. Moreover, the class distribution
scheme did not differentiate between persons exposed to asbestos before and
after 1959 even though the insurance policies did not cover liability for exposure
after 1959. Therefore, claimants exposed before 1959 had more valuable
claims, but did not receive more under the settlement.
The Supreme Court rejected the argument that all claimants common
interests in a global settlement override the foregoing deficiencies. The court
ruled the settlement can not under Fed. R. Civ. P. 23(e) override Fed. R. Civ. P.
23(a) and 23(b). 119 S. Ct. at 2320-2321.

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Without deciding whether the settlements failure to provide claimants with

all the assets available for payment of claims would itself be fatal, the Supreme
Court wrote it must identify the issue so its decision would not be misleading.
119 S. Ct. at 2321. Here, Fibreboard was left with virtually its entire net worth.
The Supreme Court noted:
We need not decide here how close to insolvency a limited fund
defendant must be brought as a condition of class certification.
While there is no inherent conflict between a limited fund class
action under Rule 23(b)(1)(B) and the Bankruptcy Code, cf., e.g.,
In re Drexel Burnham Lambert Group, Inc., 960 F.2d 285, 292
(CA2 1992), it is worth noting that if limited fund certification is
allowed in a situation where a company provides only a de
minimis contribution to the ultimate settlement fund, the
incentives such a resolution would provide to companies facing
tort liability to engineer settlements similar to the one negotiated
in this case would, in all likelihood, significantly undermine the
protections for creditors built into the Bankruptcy Code.
119 S. Ct. at 2321n.34.
In response to the trial courts contention that the enormous transaction
costs saved may justify Fibreboards retention of its net worth, the Supreme
Court wrote: If a settlement thus saves transaction costs that would never have
gone into a class members pocket in the absence of settlement, may a credit for
some of the savings be recognized in a mandatory class action as an incentive to
settlement? It is at least a legitimate question, which we leave for another day.
119 S. Ct. at 2321.
iv.

Certain Unanswered Questions

The Supreme Court questioned without deciding whether Fed. R. Civ. P.

23 (b)(1)(B) is applicable to liquidate actual and potential tort claims. Also, the
court raised without deciding whether the class claims were nonjusticiable under
Article III based on the exposure-only claimants being without injury in fact and
hence without standing to sue.
On the first issue, the Supreme Court cautioned that use of the mandatory
settlement class for mass torts must at least be done without abridging Rule 23
or allowing the rules to abridge substantive law contrary to the Rules Enabling
Act, 28 U.S.C. 2072(b); with any deviations from the historical paradigm of
limited fund settlements to be justified by the proponents. 119 S. Ct. at 2312,
2322-2323. On the second issue, the court did not provide guidance, but
expressly took into account the future claims when determining they deserved
separate attorneys and were prejudiced by having a settlement negotiated for
them by attorneys hoping to be paid on present claims. 119 S. Ct. at 2319-2320.

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v.

Potential Applications of Fibreboard

i. Companies for which Chapter 11 Is Not a
Solution or Is Too Dangerous

Both Fibreboard and Amchem proposed class action settlements hinged

on obtaining injunctions against or releases from the filing of claims included in
the settlement classes, except for the expressly permitted opt-outs in Amchem.
See 521 U.S. at 608; 119 S. Ct. at 2305. This is the essence of the exercise of
the bankruptcy power under which claimants are enjoined from prosecuting their
discharged claims. The Supreme Court has charted the permissible boundaries
of the exercise of the bankruptcy power by ruling Congress: may prescribe any
regulations concerning discharge in bankruptcy that are not so grossly
unreasonable as to be incompatible with fundamental law. Hanover National
Bank v. Moyses, 186 U.S. 181, 192 (1902). Laws on the subject of bankruptcies
may include laws tending to further distribution of a debtors property and
discharge of a debtors debts which are no so unreasonable and arbitrary as to
deny due process. Kuehner v. Irving Trust Co., 299 U.S. 445, 450 (1937).
Clearly, a pro rata distribution as mentioned in Fibreboard satisfies these
standards if applicable to all creditors of like rank.
Some companies fear they will not survive chapter 11. The causes range
from potential customer or supplier reactions, to costs, to special contractual
problems untouched by the Bankruptcy Code. For instance, some companies
have assets in foreign countries subject to seizure by creditors not subject to the
automatic stay. Other companies have derivative contracts with bankruptcy
termination clauses fully enforceable under Bankruptcy Code sections 555, 556,
559, and 560.
ii. Use of Fed. R. Civ. P. 23(b)(1)(B) in place
of Chapter 11?
Fibreboard itself provides Rule 23(b) should not be used to undermine
chapter 11. 119 S. Ct. at 2321n.34. Thus, settlements leaving material portions
of a company for its old equity would likely not qualify for limited fund treatment
absent special circumstances. But, restructurings under which bondholders
obtain the bulk of the company and all other debt (i.e., secured debt, trade debt,
etc.) is paid in full may well qualify.

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35. Can Single Asset Cases Be Confirmed Over An Undersecured Lender's

Rejection, Or Not?
A. Impact of Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005 for Cases
Commenced on and after October 17, 2005
i. 11 U.S.C. 362(d)(3) provides:
(d) On request of a party in interest and after notice and a hearing,
the court shall grant relief from the stay provided under subsection
(a) of this section, such as by terminating, annulling, modifying, or
conditioning such stay
(3) with respect to a stay of an act against single asset real estate
under subsection (a), by a creditor whose claim is secured by an
interest in such real estate, unless, not later than the date that is 90
days after the entry of the order for relief (or such later date as the
court may determine for cause by order entered within that 90-day
period) or 30 days after the court determines that the debtor is
subject to this paragraph, whichever is later
(A) the debtor has filed a plan of reorganization that has a
reasonable possibility of being confirmed within a reasonable time;
or
(B) the debtor has commenced monthly payments that
(i) may, in the debtors sole discretion,
notwithstanding section 363(c)(2) be made from rents or other
income generated before, on, or after the date of the
commencement of the case by or from the property to each creditor
whose claim is secured by such real estate (other than a claim
secured by a judgment lien or by an unmatured statutory lien); and
(ii) are in an amount equal to interest at the then
applicable nondefault contract rate of interest on the value of the
creditors interest in the real estate
11 U.S.C. 101(51B) provides:
(51B) The term single asset real estate means real property
constituting a single property or project, other than residential real
property with fewer than 4 residential units, which generates
substantially all of the gross income of a debtor who is not a family
farmer and on which no substantial business is being conducted by
a debtor other than the business of operating the real property and
activites incidental.
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ii. Consequences of 11 U.S.C. 362(d)(3)

Absent an order extending time for cause under 11 U.S.C. 362(d)(3) or
a finding the debtor has proposed a plan having a reasonable possibility of being
confirmed in a reasonable time, single asset real estate cases will only be
prosecutable if the debtor makes monthly payments in the amount of the
nondefault contract interest on the mortgagees secured claim. This adds a
significant cash flow burden to the debtors estate during the chapter 11 case and
frequently before new financing is arranged.
In In re Deep River Warehouse, Inc., 2005 Bankr. LEXIS 1090 (Bankr.
M.D. N.C. 2005), the debtor proposed a plan and in response to the mortgagees
request for stay relief proposed commencing payments more than 6 months after
the chapter 11 case commenced. The court denied stay relief finding the
mortgagee was at most slightly undersecured and confirmation could be made
possible by various possibilities.
Significantly, the monies paid to a mortgagee having an undersecured
claim should not constitute interest because section 506 does not provide for
interest on undersecured claims. United Savings Assn of Texas v. Timbers of
Inwood Forest Assocs., Ltd., 484 U.S. 365 (1988). Rather, the payments will
reduce the principal balance of the mortgage.
When the mortgagees secured claim is the sum of the value of the real
property and the encumbered rents not spent on maintaining the real property,
the use of the rents to make payments to the mortgagee will reduce the amount
of the secured claim by reducing the unused cash collateral.
B.

Which Cases Cannot Be Confirmed?

Bankruptcy Code section 1129(a)(10) requires at least one impaired class

of claims to accept a plan (without counting insider acceptances) before it can be
confirmed, unless no classes are impaired. Therefore, in a classic single asset
real estate case with a dissident mortgagee having an unsecured deficiency
claim and a group of trade creditors holding unsecured claims, the question
becomes whether there is some legal way to construct an accepting, impaired
class.
i.

Potential Treatments of Secured Claims.

The mortgagee's secured claim must be in its own class. If the secured
claim is fully repaid in cash by refinancing, it remains impaired and may reject the
plan, unless it is also paid postpetition interest and all other valid charges in
which case it appears unimpaired under section 1124(1). Neither will its
279

unimpairment under section 1124(2) satisfy the requirement of Bankruptcy Code

section 1129(a)(10). If the secured claim is compelled to accept a new secured
note in the amount of the secured claim, having an interest rate that will yield the
present value of the face amount of the secured claim as of the plan's effective
date (i.e., cramdown under section 1129(b)(2)(A)), the involuntary treatment
imposed on the mortgagee will not satisfy section 1129(a)(10). Finally, if the
secured claimant makes the section 1111(b)(2) election, it can still reject the plan
as a secured claim. The election will simply require that the face amount of the
note be in the full amount of the claim, with the interest rate adjusted so that the
present value of the note does not exceed the secured amount of the claim.
ii.

Potential Treatments of Unsecured Claims.

The undersecured mortgagee will hold an unsecured deficiency claim

unless (i) it makes the section 1111(b)(2) election, or (ii) the collateral security is
to be sold under the plan within a reasonable time pursuant to a written contract
or at an auction at which the mortgagee can credit bid the full amount of its claim,
not simply the amount of its secured claim. See Bankruptcy Code section
1111(b)(1)(A); T-H New Orleans Limited Partnership v. Financial Security
Assurance, Inc. (In re T-H New Orleans Limited Partnership), 10 F.3d 1099 (5th
Cir. 1993); In re National Real Estate Ltd. Partnership II 104 B.R. 968, 974
(Bankr. E.D. Wis. 1989); In re Western Real Estate Fund, Inc., 75 B.R. 580, 589
(Bankr. W.D. Okla. 1987), reversed in part on other grounds, see In re Western
Real Estate Fund, Inc., 109 B.R. 455, 457 (Bankr. W.D. Okla. 1990); Georgetown
Park Apartments, Ltd., 103 B.R. 248 (Bankr. S.D. Cal. 1989); Tampa Bay
Associates, Ltd. v. DRW Worthington, Ltd. (In re Tampa Bay Associates, Ltd.),
864 F.2d 47 (5th Cir. 1989); In re DRW Property Co. 82, 57 B.R. 987 (Bankr.
N.D. Tex. 1986); In re Woodridge North Apts., Ltd., 71 B.R. 189 (Bankr. N.D. Cal.
1987).
If the mortgagee does have an unsecured claim, then if it is classified with
the unsecured trade claims, it can cause the class of unsecured claims to reject if
it is more than one-third of the total amount of unsecured claims that vote.
Bankruptcy Code section 1126(c). Therefore, the first question becomes
whether the unsecured deficiency claim can be classified separately from the
other unsecured claims. If it can be separately classified, then the class of
unsecured trade claims may accept the plan and satisfy the section 1129(a)(10)
requirement.
Notably, now that section 1124 no longer provides that payment in full in
cash of an unsecured claim (without interest) renders it unimpaired, it is possible
to offer creditors cash payments in the full prepetition amounts of their claims and
have them deemed impaired for voting purposes.

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C.

Can the Mortgagee's Unsecured Deficiency Claim be

Separately Classified?

According to most courts, the cardinal rule is: "Thou shalt not classify
similar claims differently in order to gerrymander an affirmative vote on a
reorganization plan...." In re Greystone III Joint Venture, 948 F.2d 134, 139 (5th
Cir. 1991), withdrawn in part, reinstated in part on reh'g (5th Cir. 1992),173 cert.
denied, 113 S.Ct. 72 (1992). Accord Boston Post Road Limited Partnership v.
FDIC (In re Boston Post Road Limited Partnership), 21 F.3d 477 (2d Cir.
1994)(absent a legitimate business reason for separately classifying mortgagee's
deficiency claim and trade claims held by claimants not essential to debtor's
future, separate classification is unlawful), cert. denied, 513 U.S. 1109 (1995);
John Hancock Mutual Life Insurance Co. v. Route 37 Business Partner
Associates (In re Route 37 Business Partner Associates), 987 F.2d 154, 23 BCD
1537 (3d Cir. 1993); In re 500 Fifth Avenue Associates, 148 B.R. 1010, (Bankr.
S.D.N.Y. 1993), aff'd No. 93 Civ. 844 (May 21, 1993) (Freeh, D.J.)(stayed
pending appeal to Second Circuit); In re One Times Square Associates, 159 B.R.
695 (Bankr. S.D.N.Y. 1993); In re Pine Lake Village Apartment Co., 19 B.R. 819
(Bankr. S.D.N.Y. 1982); cf. In re Lumber Exchange Bldg. Ltd. Partnership, 968
F.2d 647 (8th Cir. 1992); In re Bryson Properties, XVIII, 961 F.2d 496 (4th Cir.
1992). In the instance of a nonrecourse, undersecured mortgage which only has
a deficiency claim by virtue of Bankruptcy Code section 1111(b), the deficiency
claim can not be separately classified on the basis that it does not exist outside
bankruptcy while the trade claims do. In re 500 Fifth Avenue Associates, 148
B.R. 1010 (Bankr. S.D.N.Y. 1993), aff'd No. 93 Civ. 844 (May 21, 1993) (Freeh,
D.J.)(stayed pending appeal to Second Circuit); In re D&W Realty Corp., 165
B.R. 167 (S.D.N.Y. 1994). reversing 156 B.R. 140 (Bankr. S.D.N.Y. 1993)
(section 1111(b)(1)(A) mandates separate classification of mortgagee's
deficiency claim).
Conversely, based on any of three theories, some courts allow or even
mandate separate classification of the nonrecourse mortgagee's section 1111(b)
deficiency claim. One theory is that the section 1111(b) deficiency claim is not
substantially similar to the other unsecured claims because the deficiency claim
will not exist in other chapters of the Bankruptcy Code. Another theory is that the
best interests test in Bankruptcy Code section 1129(a)(7) can almost never be
satisfied if the deficiency claim is in the same class as the other unsecured
claims because it dilutes what would be available to the other unsecured claims
that would not have to share with it in chapter 7. The third theory is that the
mortgagee was not supposed to have a veto power over every single asset
173In re Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994), takes issue with Greystone,
observing:
"Thus, we cannot accept the proposition implicit in Greystone that separate
classification of a 1111(b) claim is nearly conclusive evidence of a debtor's
intent to gerrymander an affirmative vote for confirmation...."

281

chapter 11 plan. In re Woodbrook Associates, 19 F.3d 312 (7th Cir.

1994)(Chapter 11 case dismissed for cause because plan was not confirmable
and caused unreasonable delay: "We find that, at least where the debtor is a
partnership comprised of a fully encumbered single asset, the legal rights of a
1111(b) claimant are substantially different from those of a general unsecured
claimant. Accordingly, we hold that 1111(b) and 1122(a) not only permit but
require separate classification of HUD's 1111(b) unsecured deficiency claim in
Class 4.); In re SM 104 Ltd., 160 B.R. 202, 218 & n. 35 (Bankr. S.D. Fla.
1993)(voting incentive rationale "is highly persuasive when viewed in light of the
logic underlying 1129(a)(10)... [which was] intended not to give the real estate
lobby a veto power, but merely to require 'some indicia of creditor support' for
confirmation of a proposed Chapter 11 plan").
In re D&W Realty Corp., 156 B.R. 140 (Bankr. S.D.N.Y. 1993),reversed,
165 B.R. 127 (S.D.N.Y. 1994), focuses on the language in Bankruptcy Code
section 1111(b)(1)(A) that provides that a nonrecourse claim is allowed as a
recourse claim unless "the class of which such claim is a part elects, by at least
two-thirds in amount and more than half in number of allowed claims of such
class, application of paragraph (2) of this subsection." In turn, section 1111(b)(2)
provides that if the election is made, the entire claim is treated as a secured
claim. D&W Realty Corp. reasons that the nonrecourse claim must be classified
separately from other unsecured claims because other unsecured claims are not
granted the 1111(b)(2) election. Therefore, the "class" referred to in section
1111(b)(1)(A) must be a different class than the class of other unsecured claims.
The fallacy of D&W Realty Corp. is its assumption that the "class" referred
to in section 1111(b)(1)(A) is the class of unsecured deficiency claims. It is not.
Rather, the class referred to in section 1111(b)(1)(A) is the class of secured
claims. It is that class that is entitled to elect to be treated as having a secured
claim in the amount of the value of the collateral security or a secured claim in
the total amount of the mortgage debt. If that class makes the 1111(b)(2)
election, there is no unsecured deficiency claim to be put in any class. If it does
not make the election, then the unsecured deficiency claim becomes classifiable
in accordance with applicable law. The error of D&W Realty Corp. is its
contention that the right to elect section 1111(b)(2) treatment is a right granted to
unsecured claims rather than to secured claims.
Moreover, the entire purpose of section 1111(b) was to grant the
undersecured mortgagee the power to prevent confirmation of a plan in a single
asset real estate case over the mortgagee's rejection, so as to prevent a
reoccurrence of In re Pine Gate Associates, Ltd., 2 B.C.D. 1478 (Bankr. N.D. Ga.
1976). By providing the nonrecourse mortgagee with a recourse deficiency
claim, section 1111(b) enables the mortgagee to cause the class of unsecured
claims to reject the plan so that there will be no class of impaired claims
accepting the plan as required for confirmation by Bankruptcy Code section

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1129(a)(10). The bankruptcy court's opinion in D&W Realty Corp. creates the
result opposite to what section 1111(b) was intended to create.
Notably, when there is a good business reason for separate classification,
the nonrecourse mortgagee's deficiency claim can be separately classified, as
recognized by the same circuit that decided Greystone. Heartland Federal
Savings & Loan Assoc. v. Briscoe Enterprises, Ltd. (In re Briscoe Enterprises,
Ltd.), 994 F.2d 1160 (5th Cir. 1993). In Briscoe the first mortgagee's deficiency
claim and the city's deficiency claim were separately classified, but given the
same treatment. By that means, an accepting class of impaired claims was
created because the city accepted. The court applied the clearly erroneous
standard, apparently viewing classification as a fact question, and found the
bankruptcy court was not clearly erroneous in approving the separate
classification because the city's $20,000 per month rental assistance was
essential to the underlying project. Significantly, the test applied by the Fifth
Circuit was whether "the debtor's ongoing business would be affected if separate
classification were not permitted." 994 F.2d at 1167.
Similarly, in Steelcase Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th
Cir. 1994), the court affirmed confirmation of a plan separately classifying one
claim arising from a guaranty given by the debtor because (i) the claim was being
litigated, (ii) the claim was partially secured by assets of an affiliate of the debtor,
and (iii) to the extent the claim were allowed, it would be paid faster than all other
unsecured claims. All claims in the case were supposed to obtain full payment
plus interest over time.
Regrettably, the United States Supreme Court did not rule on the
classification issue because it was not raised in Bank of America v. 203 North
LaSalle Street Partnership, 119 S. Ct. 1411, 1415n.7 (1999).
D. When Separate Classification is Allowed, Unfair
Discrimination Is Not.
In the unlikely event that the mortgagee's unsecured deficiency claim is
separately classified for a valid reason, the plan proponent must still obtain an
accepting, impaired creditor class. If the plan proponent must offer the class of
trade claims 50 cents on the dollar to accept, it can not offer the mortgagee's
deficiency claim 2 cents on the dollar. That treatment would run afoul of the
prohibition against unfair discrimination in respect of a dissenting class (the
mortgagee's deficiency class). Bankruptcy Code section 1129(b)(1). Not so,
however, in the Seventh Circuit. There, based on the rationale of In re
Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994), the mortgagees
nonrecourse deficiency claim must be separately classified, and because the
deficiency claim would receive nothing in chapter 7, it is okay to pay it 16% of its
claim while other trade claims are paid in full, and in fact, artificially impaired to
create an impaired accepting class. In re 203 N. LaSalle Street Partnership, 126

283

F.3d 955 (7th Cir. 1997), reversed on other ground, Bank of America v. 203
North LaSalle Street Partnership, 119 S. Ct. 1411 (1999).
In the unlikely event that the mortgagee's unsecured deficiency claim is
separately classified for a valid reason, the plan proponent must still obtain an
accepting, impaired creditor class. If the plan proponent must offer the class of
trade claims 50 cents on the dollar to accept, it can not offer the mortgagee's
deficiency claim 2 cents on the dollar. That treatment would run afoul of the
prohibition against unfair discrimination in respect of a dissenting class (the
mortgagee's deficiency class). Bankruptcy Code section 1129(b)(1). Not so,
however, in the Seventh Circuit. There, based on the rationale of In re
Woodbrook Associates, 19 F.3d 312 (7th Cir. 1994), the mortgagees
nonrecourse deficiency claim must be separately classified, and because the
deficiency claim would receive nothing in chapter 7, it is okay to pay it 16% of its
claim while other trade claims are paid in full, and in fact, artificially impaired to
create an impaired accepting class. In re 203 N. LaSalle Street Partnership, 126
F.3d 955 (7th Cir. 1997).
E. When The Obstacles of Separate Classification and Unfair
Discrimination are Overcome, The New Value Obstacle
Remains.
Assuming the debtor can separately classify the trade claims and the
mortgagee's deficiency claim to create an accepting class for purposes of
Bankruptcy Code section 1129(a)(10), and assuming the mortgagee deficiency
class rejects the plan, but that there is no unfair discrimination, the absolute
priority rule remains an obstacle. Pursuant to Bankruptcy Code section
1129(b)(2)(B)(ii), no class junior to the rejecting mortgagee deficiency class can
receive or retain any property under the plan on account of such junior claim or
interest unless the mortgagee's deficiency claim is paid in full. Therefore, the
only basis on which the debtor may potentially retain ownership of the
reorganized debtor is based on the dictum in Case v. Los Angeles Lumber
Products Co., 308 U.S. 106 (1939), suggesting old owners my retain property by
making a new contribution of value in money or moneys worth, necessary for the
reorganization and in an amount commensurate with the value of the reorganized
entity. Notably, not all courts believe the new value exception survived
enactment of the Bankruptcy Code, and in any event, it is clear that promises of
future labor (sweat equity) do not count as new value. Norwest Bank
Worthington v. Ahlers, 485 U.S. 197 (1988). In Bank of America v. 203 North
LaSalle Street Partnership, 119 S. Ct. 1411, 1417 (1999), the Supreme Court
again wrote it was not deciding whether the statute includes a new value
corollary or exception because the plan at issue would not satisfy the statute.
The Supreme Court did opine that while it has doubt old equity is the only source
of significant capital for reorganizations, old equity may well be in the best
position to make a go of the reorganized enterprise and so may be the party
most likely to work out an equity-for-value reorganization. 119 S. Ct. at 1421.

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The circuit courts are split as to whether the new value exception survived.
Compare Bonner Mall Partnership v. U.S. Bancorp Mortgage Co. (In re Bonner
Mall Partnership), 2 F.3d 899 (9th Cir. 1993)(new value exception survived and is
actually not an exception to the absolute priority rule under which an exclusive
warrant to repurchase the debtor is granted to old equity before creditors are paid
in full, but rather a corollary principle describing limitations of the rule), cert.
granted, 114 S. Ct. 681 (1994); with Coltex Loop Central Three Partners, L.P. v.
BT/SAP Pool C Associates, L..P. (In re Coltex Central Three Partners, L.P.), 138
F.3d 39 (2d Cir. 1998) (debtors principals exclusive right to retain the debtors
property on making a capital contribution is itself property and is on account of
principals prior subordinated position in the debtor when the market for the
property is not adequately tested and other creditors unsuccessfully seek to
propose chapter 11 plan), and Travelers Ins. Co. v. Bryson Properties, XVIII (In
re Bryson Properties, XVIII), 961 F.2d 496, 504 (4th Cir.), cert. denied, 113 S.Ct.
191 (1992) (granting old equity the exclusive right to purchase equity in the
reorganized debtor violates Bankruptcy Code section 1129(b)(2)(B)(ii)).
Bonner Mall recites the requirements from Case v. Los Angeles Lumber,
308 U.S. 106, 121-122 (1939), to satisfy the new value "corollary principle," 2
F.3d at 906, as follows: The new value must be new, substantial, money or
money's worth, and necessary for a successful reorganization, and reasonably
equivalent to the value or interest received. 2 F.3d at 908. The court's rationale
for holding the principle survived enactment of the Bankruptcy Code and does
not violate the rule in section 1129(b)(2)(B)(ii) that equity shall not receive
property "on account of" its old interests if a more senior rejecting class is not
paid in full, is that there is not a sufficient level of causation. 2 F.3d at 899.
Only money paid by the effective date counts as new value, and a
$32,000 payment amounting to less than 0.5% of the unsecured claims does not
pass the substantial test. Liberty National Enterprises v. Ambanc La Mesa
Limited Partnership (In re Ambanc La Mesa Limited Partnership), 115 F.3d 650
(9th Cir. 1997).
In Steelcase Inc. v. Johnston (In re Johnston), 21 F.3d 323 (9th Cir. 1994),
the court held that once the bankruptcy court finds a plan is feasible and will pay
each dissenting class in full as of the effective date, it is not a violation of the
absolute priority rule to distribute property and funds to the debtor's owner after
the effective date, but prior to completion of a stream of payments to the rejecting
classes.
In Coltex, the mortgagee held a $7.2 million mortgage claim against a 10story office building, the debtors sole asset. The bankruptcy court found the
property was worth $2.95 million. There were tax claims of $355,000 and
unsecured trade claims of $123,000. The case was filed the day of the
foreclosure sale.

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New Value. Under the chapter 11 plan, the debtors principals

would fund $3.4 million, which would pay the mortgagees secured claim, the tax
claims (which the mortgagee alleged were artificially impaired), and the 10%
distribution to unsecured claims. Significantly, $3.4 million of the new value was
gratuitous in the sense that the debtors principal could have given the
mortgagee a nonrecourse secured note instead of cash. Presumably, at some
early point the debtor would be able to obtain a new first mortgage in an amount
of at least 80% of the secured claim amount. Thus, the court may not have
viewed the entire $3.4 million as new value.
Exclusivity. The mortgagee was prepared to propose its own plan
under which unsecured claims would be paid in full and the principals would
receive nothing. The bankruptcy court denied the mortgagees request to
terminate exclusivity to enable that plan to be filed.
Marketing. In the year prior to confirmation, the debtor had
approached only 1 lender and it rejected the debtors request for financing. No
mortgage brokers or outside consultants were retained to help locate other
sources of equity or financing, and the principals did not consider bringing in new
equity partners to fund the plan.
Holding. In conclusion, we hold that any plan providing for old
equity to contribute new capital to fund a Chapter 11 reorganization cramdown
plan, is limited by the various requirements for confirmation set forth in 11 U.S.C.
1129, including 11 U.S.C. 1129(b)(2)(B)(ii). Each such plan must be
examined to make sure that old equity does not retain or receive property of the
debtor on account of its prior subordinate position. Where no other party seeks
to file a plan or where the market for the property is adequately tested, old equity
may be able to demonstrate that it can meet the requirements of 11 U.S.C.
1129 and that, in essence, it receives nothing on account of its prior position.
This is not such a case. This was an insiders plan for the benefit of insiders. It
was of little benefit to any creditor, and the major creditor was stymied in its
legitimate attempts to obtain the value of its claims. The plan was not fair and
equitable. Coltex, 138 F.3d at 45.
The Crux of Coltex. Coltex holds the debtors principals were
retaining property on account of their prior subordinate position in the debtor.
Conversely, it can be argued they retained property because of exclusivity, and
not due to their prior position. Notably, that Congress granted the debtor
exclusivity in Bankruptcy Code section 1121 can be interpreted to show
Congress intent to allow such a new value plan, as clearly as the words on
account of can be used to show it was overturning the new value exception.
Interestingly, Coltex, in part, finds it persuasive that unsecured claims would
have done better under the mortgagees plan. But, the National Bankruptcy
Review Commission routes the new value to paying down the mortgagees
secured claim to an 80% loan to value ratio, infra. By aligning the new value with

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the secured and tax claims, the Coltex plan creates an impression there was little
or no new value because, presumably, the property can be mortgaged to
replenish a good portion of the $3.4 million new value infusion.
The Coltex plan, however, may have been more realistic than the
mortgagees plan which would pay unsecured claims in full, other than insider
claims and the mortgagee deficiency claim. The Second Circuit is somewhat
contradictory when it reasons the property should have been exposed to market
forces, but also emphasizes the mortgagees plan would pay unsecured claims.
If the market had shown the property would sell for more than $2.95 million, then
the mortgagees secured claim would have increased. There still would be no
value available for unsecured claims. Thus, the question becomes why
distributions to unsecured claimholders should matter if the claims are being paid
in accordance with their entitlements.
Lets assume the property had been marketed and was shown to be worth
$3.5 million. If the principals had borrowed $3 million against the property and
infused the last $500,000, then there would be no issue as to whether the
mortgagee obtained fair value. Next, lets assume the principals infuse another
$125,000 to pay all the unsecured claims other than the mortgagees deficiency
claim. If the mortgagee objects, would the payment of unsecured trade claims be
unfair discrimination under section 1129(b)(1)? Would the principals retention of
the property be on account of their prior subordinated position in the debtor?
F.

Have You Thought About Bankruptcy Code Section

1111(b)(1)(A)(ii) Lately? Cramdown Attorneys Have.
i.

Bankruptcy Code Section 1111(b)(1)(A)(ii) provides:

A claim secured by a lien on property of the

estate shall be allowed or disallowed under section
502 of this title the same as if the holder of such claim
had recourse against the debtor on account of such
claim, whether or not such holder has such recourse,
unless-(i) The class of which such claim is a
part elects, by at least two-thirds in
amount and more than half in number of
allowed claims of such class, application
of paragraph (2) of this subsection; or
(ii) such holder that does not have
such recourse and such property is
sold under section 363 of this title or
is to be sold under the plan.

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ii.

The Issue

is whether a debtor can deprive its mortgagee of a deficiency

claim with which it can cause unsecured claims to reject the
plan, by providing that the mortgaged property will be
operated and ultimately sold by the debtor sometime in the
future. The question is whether a hoped for sale after
confirmation qualifies as a "sale under the plan" to extinguish
the deficiency claim.
a)

Background.

Virtually all the section 1111(b)(1) decisions agree that the Bankruptcy
Code grants deficiency claims to undersecured nonrecourse mortgagees to
prevent the recurrence of the result in In re Pine Gate Associates, Ltd., 2 B.C.D.
1478 (Bankr. N.D. Ga. 1977) (cramdown in undersecured, nonrecourse, single
asset, real estate case). Taken to its logical extreme, if any sale under a plan
deprives the mortgagee of its deficiency claim, then all chapter 11 plans should
provide for sales ten or twenty years in the future as mechanisms to circumvent
the law.
b)

Sword and Shield Uses of 1111(b)(1)(A)(ii)

An Additional Reason to Obtain Stay Relief .

Paradoxically, some courts will grant stay relief to a mortgagee if there will
be assets left in the estate after the mortgagee's foreclosure and without
foreclosure the mortgagee's nonrecourse claim will convert into a recourse
deficiency claim that will consume the bulk of the remaining estate.
In In re Canal Place Ltd. Partnership, 921 F.2d 569, 578 (5th Cir. 1991),
the Fifth Circuit affirmed a bankruptcy court's order granting stay relief, based in
part, on the beneficial effect of using foreclosure to eliminate a recourse claim
against the remaining estate.
In Canal Place the bankruptcy court granted stay relief to the first
mortgagees on the grounds there was concededly no equity (the deficiency was
$130 million) and "the implicit objective of the Plan is to delay foreclosure by
Aetna and Travelers until the Debtor can either sell Canal Place or wait for the
return of the favorable office and retail market." 921 F.2d at 577. Notably, the
principals were offering to infuse $18.4 million into the property.
Notably, to buttress its result, the bankruptcy court had ruled that by
granting stay relief to the first mortgagees it was improving prospects for other
unsecured claimholders because they will obtain more from the few

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unencumbered assets when the first mortgagees are deprived of their deficiency
claims under section 1111(b)(1). In sum and substance, the court held that a
transfer of the collateral security by foreclosure would deprive the mortgagees of
their deficiency claims if the foreclosure were before or contemporaneous with
confirmation. The court was not asked whether the deficiency claims would be
lost if the transfers were delayed for up to two years after confirmation, as here.
iii.
Mortgagor Cannot Gamble with Mortgagee's
Collateral.
In In re Western Real Estate Fund, Inc., 75 B.R. 580, 589 (Bankr. W.D.
Okla. 1987), reversed in part on other grounds, see In re Western Real Estate
Fund, Inc., 109 B.R. 455, 457 (Bankr. W.D. Okla. 1990), the court wrote it "is not
required to, and does not, determine the length of time which may be allowed to
transpire after confirmation before a proposed sale or the degree of specificity
required in the terms and conditions of any proposed sale in order to permit the
application the ' 1111(b)(1)(A)(ii) exception to the 'preferred status' afforded by '
1111(b)(1)(A)." The court denied confirmation of the plan because, among other
things, it deprived the mortgagee of its deficiency claim based on a
postconfirmation sale "at some unspecified future time, to some unspecified
purchaser, at an unspecified price and on unspecified terms." 75 B.R. at 589.
After the foregoing decision, the debtor amended its plan to provide the first
mortgagees with secured and unsecured claims. The court confirmed the plan
and the first mortgagees appealed on the ground the interest rate was too low.
On appeal, the first mortgagees won. Because the debtor could not afford to pay
a higher interest rate, it again amended its plan to provide for the abandonment
of the collateral security to the first mortgagees. The debtor contended the
abandonment was equivalent to a sale under the plan, which would deprive the
first mortgagees of their deficiency claims. The first mortgagees argued they
should have deficiency claims because the abandonment was occurring two and
one half years after confirmation. Significantly, the court disagreed, not because
a sale could occur two and one half years after confirmation, but rather because
as to the first mortgagees they were obtaining their collateral on confirmation.
The court reasoned the reversal had undone the first confirmation and started the
clock all over again. 109 B.R. at 466.
In In re Georgetown Park Apartments, Ltd., 103 B.R. 248 (Bankr. S.D. Cal.
1989), the debtor tried to eliminate the mortgagee's deficiency claim by proposing
a plan calling for a sale of the property four years after confirmation, with interest
payments to be made from confirmation to sale. The court denied approval of
the disclosure statement because the plan was not confirmable. The court
reasoned that Congress granted nonrecourse mortgagees deficiency claims to
prevent the debtor from speculating with the mortgagee's collateral value. Only if
the collateral is sold will the mortgagee's lien be satisfied before equity holders
realize any value. The court opined that:

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it may well be that the exception is only available in

those circumstances where the debtor has proposed
a sale (under ' 363 or pursuant to a plan) at a public
auction or under a binding contract of sale to an
identifiable buyer at a time substantially
contemporaneous with confirmation....
103 B.R. at 250.
a)

The Mortgagee Can Credit Bid its Deficiency

Claim.

In Tampa Bay Associates, Ltd. v. DRW Worthington, Ltd. (In re Tampa

Bay Associates, Ltd.), 864 F.2d 47 (5th Cir. 1989), the first mortgagee claimed it
was entitled to a deficiency claim against the estate after it foreclosed its
nonrecourse undersecured mortgage. The mortgagee reasoned it was entitled to
a deficiency claim unless the property had been sold under Bankruptcy Code
section 363 or under the plan. Neither had occurred.
The Fifth Circuit held the mortgagee was not entitled to a deficiency claim
because (i) a foreclosure sale is similar to a section 363 sale, and (ii) after the
foreclosure sale the mortgagee lacked the secured claim necessary to invoke
section 1111(b) in the first place. En route to its holding, the Fifth Circuit
enunciated the following test:
"... Through these exceptions [section 363 sale and
sale under plan] it appears that Congress intended to
protect the nonrecourse undersecured creditor only if
such a creditor is not permitted to purchase the
collateral at a sale or if the debtor intends to retain the
collateral after bankruptcy and not repay the debt in
full..."
864 F.2d at 50 (emphasis supplied).
The Fifth Circuit cited with approval In re
DRW Property Co. 82, 57 B.R. 987 (Bankr. N.D. Tex. 1986), and In re Woodridge
North Apts., Ltd., 71 B.R. 189 (Bankr. N.D. Cal. 1987). In DRW, in the context of
ruling on a disclosure statement, the court held a mortgagee loses its deficiency
claim if it forecloses on its property. 57 B.R. at 993. The court also opined that
the "safeguards placed in the Code for non-recourse creditors were placed there
to protect the creditor where the Debtor intends to keep the property for sale or
use in the reorganization process..." Id. (emphasis in original).
In In re Woodridge North Apts., Ltd., 71 B.R. 189 (Bankr. N.D. Cal. 1987),
the court was asked to grant stay relief. In reviewing the debtor's proposed plan
to determine if an effective reorganization were possible the court found the
debtor was trying to deprive the undersecured mortgagee of its deficiency claim
by providing for a sale of the collateral to a new entity under the plan, which
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entity's stock would be owned by the reorganized debtor. The court precluded
that result by ruling the mortgagee must be allowed to credit bid at the sale. That
would prevent confirmation. Therefore, the court granted stay relief. 71 B.R. at
193.
John Hancock Mutual Life Insurance Co. v. California Hancock, Inc. (In re
California Hancock, Inc.), 88 B.R. 226 (B.A.P. 9th Cir. 1988), also held the
mortgagee must be allowed to credit bid at the sale. There, the debtor proposed
a plan attempting to eliminate the mortgagee's deficiency claim by selling the
collateral to a third party subject to the secured portion of the mortgage claim
while requiring the buyer to grant the reorganized debtor a net profits interest in
the collateral.
Notably, the court ruled the purpose of allowing the mortgagee to credit
bid was to enable it to obtain "the full amount of any value in the property..." 88
B.R. at 231 (emphasis in original). The court ruled that the retention by the
debtor of the profits interest caused the mortgagee to obtain less than the full
value. Id.
In re 222 Liberty Associates, 108 B.R. 971 (Bankr. E.D. Pa. 1990), also
holds the undersecured mortgagee must be allowed to credit bid at a sale of
collateral under the plan.
iv.

No Credit Bidding after Electing 1111(b)(2).

Finally, In re Broad Associates Limited Partnership, 125 B.R. 707 (Bankr.

D. Conn. 1991), holds a creditor making the section 1111(b)(2) election does not
have the right to credit bid at a sale subject to the lien (as opposed to free and
clear of the lien). In re Kent Terminal Corp., 166 B.R. 555, 564 (Bankr. S.D.N.Y.
1994). The section 1111(b)(2) election is an election to have an undersecured
mortgage claim be treated as a fully secured claim. For example, a mortgage of
$3 million secured by collateral worth $2 million would be treated as a $3 million
secured claim if the election is made. But, the plan need only pay the mortgagee
a stream of payments totaling $3 million, while having a present value of $2
million. When making the election, the mortgagee waives its right to have a $2
million secured claim entitled to a present value of $2 million, and an unsecured
$1 million deficiency claim entitled to whatever unsecured claims would obtain in
liquidation.

Broad Associates may be explained on the ground that once a mortgagee

waives its deficiency claim by making the election, it should not be entitled to
take it back by credit bidding. Indeed the court notes the plan may not be
confirmable if the election were not available and the mortgagee could not credit
bid. 21 B.C.D. at 1061. But, at a foreclosure sale, the mortgagee would be able
to credit bid.

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[T]he holder of an undersecured claim cannot elect fully secured status

under a plan that calls for the sale of his collateralbecause of the secured
partys right to bid in the full amount of his allowed claim at any sale of collateral
under section 363(k). In re 183 Lorraine Street Associates, 198 B.R. 16, 27-28
(E.D.N.Y. 1996)(quoting 124 Cong. Rec. H11,103-104 (daily ed. Sept. 28, 1978);
124 Cong. Rec. S17,420 (daily ed. Oct. 6, 1978)).
Interestingly, Lorraine takes the position in dictum that only the trustee or
debtor can sell property under Bankruptcy Code section 363(b), so that a creditor
must effectuate a sale under section 1123(b)(4). 198 B.R. at 21n.15.
One debtor proposed a plan hoping for a rezoning of his property within 2
years of confirmation. Absent rezoning, the mortgagee could take the deed in
lieu of foreclosure. Otherwise, the debtor could either pay the mortgagee the
amount of its secured claim over time, or sell the property to pay off the note,
without allowing the mortgagee to credit bid. In the context of granting a motion
for stay relief, the court ruled credit bidding is the mortgagees protection against
judicial undervaluation of the collateral, and the plan is unconfirmable when it
deprives the mortgagee of its section 1111(b)(2) election and its right to credit bid
at the sale. In re 183 Lorraine Street Associates, 198 B.R. 16, 27-28 (E.D.N.Y.
1996).
G.

Bank of America v. 203 North LaSalle Street Partnership,

119 S. Ct. 1411 (1999)
i.

Facts.

In Bank of America v. 203 North LaSalle Street Partnership, 119 S. Ct.

1411 (1999), the bankruptcy court had determined the mortgagee held a $54.5
million secured claim and a $38.5 million deficiency claim. The debtors chapter
11 plan provided the bank a 7 to 10 year secured note for its secured claim and
installments equal to 16% (present value) of its unsecured claim which was
classified separately from other unsecured claims. Trade claims held by
outsiders were approximately $90,000 and would be paid in full without interest
on the plans effective date. The debtors interest holders would retain ownership
of the reorganized debtor for a present value of $4.1 million and would thereby
avoid approximately $20 million of taxes chargeable if the mortgagee foreclosed.
ii.

Holding

The Supreme Court, without deciding whether the new value exception
exists, ruled the plan violated 1129(b)(2)(B)(ii) in any event because the
interest holders were retaining interests on account of their preexisting interests

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notwithstanding that the mortgagee rejected the plan in its capacity as the holder
of the deficiency claim which was the only claim in its class. 119 S. Ct. at 1417.
Under a plan granting an exclusive right, making no
provision for competing bids or competing plans, any
determination that the price was top dollar would necessarily
be made by a judge in bankruptcy court, whereas the best
way to determine value is exposure to a market.This is a
point of some significance, since it was, after all, one of the
Codes innovations to narrow the occasions for courts to make
valuation judgments, as shown by its preference for the
supramajoritarian class creditor voting scheme in
1126(c)In the interest of statutory coherence, a like disfavor
for decisions untested by competitive choice ought to extend
to valuations in administering subsection (b)(2)(B)(ii) when
some form of market valuation may be available to test the
adequacy of an old equity holders proposed contribution.
Whether a market test would require an opportunity to
offer competing plans or would be satisfied by a right to bid for
the same interest sought by old equity, is a question we do
not decide here. It is enough to say, assuming a new value
corollary, that plans providing junior interest holders with
exclusive opportunities free from competition and without
benefit of market valuation fall within the prohibition of
1129(b)(2)(B)(ii).
Bank of America v. 203 North LaSalle Street Partnership, 119 S. Ct. 1411, 142324 (1999) (Souter, J.) (citations and footnotes omitted)

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iii.

Rationale

The Supreme Court expounded the policies to be served by chapter 11

as: preserving going concerns and maximizing property available to satisfy
creditors. 119 S. Ct. at 1421. Then, it explained [c]ausation between the old
equitys holdings and subsequent property substantial enough to disqualify a plan
would presumably occur on this view of things whenever old equitys later
property would come at a price that failed to provide the greatest possible
addition to the bankruptcy estate, and it would always come at a price too low
when the equity holders obtained or preserved an ownership interest for less
than someone else would have paid. A truly full value transaction, on the other
hand, would pose no threat to the bankruptcy estate not posed by any
reorganization, provided of course that the contribution be in cash or be
realizable moneys worth, just as Ahlers required for application of Cases new
value rule. 119 S. Ct. at 1421-22 (footnotes and citations deleted).
The Supreme Court ruled the exclusive right to buy equity is property and
cited authority for the proposition that options to buy interests at market values
trade for a positive price. 119 S. Ct. at 1422. The court also explained the old
interest holders rights to buy interests in the reorganized debtor were exclusive
and therefore were property even though the debtors exclusive opportunity to
propose a plan is not itself property within the meaning of subsection
1129(b)(2)(B)(ii). The logic was that upon confirmation of the plan the old
interest holders were in the same position they would have been in had they
exercised an exclusive option under the plan to buy the equity in the reorganized
entity, or contracted to purchase it from a seller who had first agreed to deal with
no one else. 119 S. Ct. at 1422.
Interestingly, the Supreme Court recognized leverage as property. The
court explained that the very fact that liquidation would trigger tax liability for the
old equity may be valuable for others precisely as a way to keep the Debtor from
implementing a plan that would avoid a Chapter 7 liquidation. 119 S. Ct. at
1422.
The significance of the Supreme Courts observations is they explain why
the bankruptcy courts having determined the mortgagees secured claim does
not eliminate the possibility of there being additional value in the estate. In other
words, the mortgagees secured claim equals the value of the real property. But,
the debtors old interest holders may still find value in controlling the reorganized
entity to avoid tax liability. That element of value is not part of the mortgagees
collateral.
Accordingly, the Supreme Court ruled that to avoid violating
1129(b)(2)(B)(ii), there must be a market test. Whether a market test would
require an opportunity to offer competing plans or would be satisfied by a right to
bid for the same interest sought by old equity, is a question we do not decide

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here. It is enough to say, assuming a new value corollary, that plans providing
for junior interest holders with exclusive opportunities free from competition and
without benefit of market valuation fall within the prohibition of
1129(b)(2)(B)(ii). 119 S. Ct. at 1424.
iv.

How Does North LaSalle Work?

How can the prepetition interest holders compete with the mortgagee?
Clearly, at an auction of the property free and clear of the mortgage lien, the
mortgagee can bid up to the amount of the sum of its secured claim and
deficiency claim because the amount bid, less administrative expenses, will all go
back to the mortgagee. If this is the test, the old interest holders cant win!
Alternatively, perhaps the test is whether a third party would bid for the
property (subject to the secured claim) more than the present value of $4.1
million that the old interest holders were offering. Indeed the Supreme Court
suggested as much when it wrote: Whether a market test would require an
opportunity to offer competing plans or would be satisfied by a right to bid for
the same interest sought by old equity, is a question we do not decide here.
119 S.Ct. at 1424 (emphasis supplied). Notably, the Supreme Court rendered its
ruling in the context of figuring out whether the amount of new value was
sufficient. Accordingly, it would be illogical to assume the Supreme Court
intended that the mechanism for determining whether the old interest owners are
paying sufficient new value would be a mechanism to ensure that they would be
unsuccessful.
The Supreme Court also alluded to the possibility of having competing
plans. How is the court supposed to decide which plan to confirm?
v.

Aftermath In North LaSalle

On remand, the bankruptcy court terminated exclusivity and was called on

to determine whether (a) a prepetition subordination agreement between the first
and second mortgagees applied to the deficiency claim of the first mortgagees
nonrecourse mortgage, and (b) whether the first mortgagee could enforce the
provision of the subordination agreement under which the first mortgagee could
vote the second mortgagees claim in the chapter 11 case. Bank of America v.
North LaSalle Street Limited Partnership (In re 203 North LaSalle Street
Partnership), 246 B.R. 325 (Bankr. N.D. Ill. 2000).
The court held the subordination agreement did apply to the nonrecourse
deficiency claim, reasoning the rule of explicitness in In re Time Sales Fin. Corp.,
491 F.2d 841,844 (3d Cir. 1974), probably did not survive enactment of the
Bankruptcy Code, except to the extent state law would require the subordination
agreement to be explicit about rights granted in a chapter 11 case. 246 B.R. at

295

330 (citing Chemical Bank v. First Trust of New York (In re Southeast Banking
Corp.), 156 F.3d 1114 (2d Cir. 1998)).
On the voting issue the court ruled the senior claimant could not enforce
the provision of the subordination agreement entitling the senior claimant to vote
the subordinated debt. 246 B.R. at 330-332. The court reasoned that (a) it
would defeat the purpose of the Code to allow parties to provide by contract that
the provisions of the Code should not apply, 246 B.R. at 331, (b) the definition of
subordination shows it affects priorities, but not voting rights, and (c) Bankruptcy
Rule 3018(c) requires the claimholder to vote. Id.
The decision does not cite jurisprudence showing a subordination is an
equitable assignment of a claim to the senior claimant. In re Itemlab Inc., 197 F.
Supp. 194 (E.D.N.Y. 1961); In re Credit Indus. Corp, 366 F.2d 402 (2d Cir. 1966);
In re Alda Commercial Corp., 300 F.Supp. 294 (S.D.N.Y. 1969); Meinhard, Greeff
& Co. v. Brown, 199 F.2d 70 (4th Cir. 1952); Walker v. Brown, 165 U.S. 654
(1987) (equitable lien). Additionally, parties can easily transfer voting rights by
having the junior claimant take a junior participation in the senior creditors claim.
H.
The Answer.
Except in jurisdictions following Woodbrook, whenever the dissident,
undersecured mortgagee's deficiency claim in a single asset case would equal
more than one-third of total general unsecured claims, the debtor can only
confirm a plan if:

the mortgagee is a junior mortgagee and a senior mortgagee is

impaired and accepts the plan;

the plan validly provides for sale of the collateral and deprives
the nonrecourse mortgagee of a deficiency claim under
Bankruptcy Code section 1111(b)(1)(A)(ii);

the plan somehow validly separately classifies the mortgagee's

deficiency claim and other unsecured claims and the other
claims accept the plan without there being unfair discrimination
and with a valid invocation of the new value exception! A valid
invocation must not violate 1129(b)(2)(B)(ii). At a minimum,
this will require that junior interest holders only retain or obtain
interests in the reorganized debtor based on a competitive
process exposing the property to market valuation; or

the plan provides for a sale of the collateral within the meaning
of Bankruptcy Code section 1129(b)(2)(A)(ii).

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36. Prejudgment Attachment, As an Equitable Remedy, Is

Beyond the Federal Courts Power
36. Grupo Mexicano v. Alliance Bond Fund, 527 U.S. 308 (1999) (5-4)
i. Facts.
Alliance purchased approximately $75 million of $250 million of notes
issued by Grupo to help it finance the construction of a toll road in Mexico.
Because of problems in the Mexican economy, the Mexican government agreed
to issue Toll Road Notes in the amount of approximately $309 million to Grupo to
help it finance the toll road. After the failure of negotiations with its noteholders,
Grupo announced it would place $17 million of its Toll Road Notes in trust for
employees and would transfer its right to receive $100 million of Toll Road Notes
back to the Mexican Government to pay back taxes. Grupo was also negotiating
with its bank creditors owed $256 million. Alliance accelerated its notes and
requested a preliminary injunction preventing Grupo from transferring its rights to
receive the Toll Road Notes.
Finding Grupo at risk of insolvency if not already insolvent, and finding its
only substantial asset was its entitlement to Toll Road Notes and that it planned
to use them to satisfy Mexican creditors to the exclusion of Alliance, the district
court enjoined Grupo from dissipating, disbursing, transferring, conveying,
encumbering or otherwise distributing any right to the Toll Road Notes, if Alliance
posted a $50,000 bond (which it did).
While the preliminary injunction was on appeal, final judgment was issued
in favor of Alliance, and the injunction was made permanent.
ii. Holding.
Reversed. [T]he equitable powers conferred by the Judiciary Act of
1789 did not include the power to create remedies previously unknown to equity
jurisprudence. Even when sitting as a court in equity, we have no authority to
craft a nuclear weapon of the law like the one advocated here. 119 S. Ct. 1961
at 1973.
iii. Rationale.
Reinvigorating its holding of 139 years earlier, the Supreme Court explained:
Our laws determine with accuracy the time and manner in
which the property of a debtor ceases to be subject to his
disposition, and becomes subject to the rights of his creditor.
A creditor acquires a lien upon the lands of his debtor by a
judgment; and upon the personal goods of the debtor, by the
delivery of an execution to the sheriff. It is only by these liens

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that a creditor has any vested or specific right in the property

of his debtor. Before these liens are acquired, the debtor has
full dominion over his property; he may convert one species of
property into another, and he may alienate to a purchaser.
The rights of the debtor, and those of a creditor, are thus
defined by positive rules; and the points at which the power of
the debtor ceases, and the right of the creditor commences,
are clearly established. These regulations cannot be
contravened or varied by any interposition of equity.
119 S. Ct. 1961 at 1970n.6 (quoting Moran v. Daawes, 1 Hopk. Ch. 365, 367
(N.Y. 1825), as quoted in Adler v. Fenton, 65 U.S. 407, 24 HOW 407, 411-412
(1861).
iv. Consequences
According to the Supreme Court, [t]he law of fraudulent conveyances and
bankruptcy was developed to prevent such conduct; an equitable power to
restrict a debtors use of his unencumbered property before judgment was not.
119 S. Ct. at 1970. The ultimate prejudgment remedy is bankruptcy because it
prevents the debtor from transferring property to pay prepetition debts without
court approval. In fact, the Supreme Court observed that Alliance was no the
only creditor and [b]ecause any rational creditor would want to protect his
investment, such a remedy might induce creditors to engage in a race to the
courthouse in cases involving insolvent or near-insolvent debtors, which might
prove financially fatal to the struggling debtor. 119 S. Ct. at 1974. Interestingly,
the Court nowhere mentioned whether a bankruptcy remedy was available and
likely effective to Alliance.
37. Can a Chapter 11 Debtor in Possession Assume An Executory Contract
If It Cannot Assign It?
A. Bankruptcy Code section 365(c)(1) provides:
(c) The trustee may not assume or assign an
executory contract or unexpired lease of the
debtor, whether or not such contract or lease
prohibits or restricts assignment of rights or
delegation of duties; and
(1)(A) applicable law excuses a party, other
than the debtor, to such contract or lease from
accepting performance from or rendering
performance to an entity other than the debtor
or the debtor in possession whether or not such
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contract, or lease, prohibits or restricts

assignment of rights or delegation of duties; and
(1)

such party does not consent to such

assignment or assumption.
B. Bankruptcy Code section 365(f)(1) provides:

(f)(1) Except as provided in subsection (c) of this section,

notwithstanding a provision in an executory contract or
unexpired lease of the debtor, or in applicable law, that
prohibits, restricts, or conditions the assignment of such
contract or lease, the trustee may assign such contract or
lease under paragraph (2) of this subsection; except that the
trustee may not assign an unexpired lease of nonresidential
real property under which the debtor is an affected air carrier
that is the lessee of an aircraft terminal or aircraft gate if
there has occurred a termination event.
C. Perlman v. Catapult Entertainment, Inc. (In re
Catapult Entertainment, Inc.), 165 F.3d 747 (9th
Cir. 1999)
i.

Facts

Perlman granted two nonexclusive licenses to Catapult to exploit

technologies for online gaming networks. Subsequently, Catapult commenced a
chapter 11 case and proposed a plan calling for the assumption of the licenses.
The bankruptcy court confirmed the plan and approved the assumption. Under
Ninth Circuit precedent, federal patent law is applicable law under section
365(c) and nonexclusive patent licenses are personal and assignable only with
the consent of the licensor. Everex Systems v. Cadtrak Corp. (In re CLFC, Inc.),
89 F.3d 673, 680 (9th Cir. 1996).
ii.

Holding

[W]here applicable nonbankruptcy law makes an executory contract

nonassignable because the identity of the nondebtor [sic] party is material, a
debtor in possession may not assume the contract absent consent of the
nondebtor party. 165 F.3d 747, 1999 U.S. App. LEXIS 1072, at 24. (It appears
the court misspoke and intended to refer to the identity of the debtor being
material, not the nondebtor).
iii.

Rationale and Irrationale

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The court reasoned the plain language of section 365(c) bars assumption
(absent consent) when an executory is not assignable due to the identity of the
contracting party because the plain language does not produce a patently
absurd result. But, the court reached a patently absurd result. Catapult had 2
licenses and improved its balance sheet with the help of chapter 11. If Catapults
license was enforceable prior to bankruptcy, how is it not absurd that Catapult
should lose its license after it improves its balance sheet?
The court rebuts the argument that its reading of section 365(c)(1) effaces
section 365(f)(1) by agreeing with other circuits that section 365(c)(1) only
impairs the operation of section 365(f)(1) when applicable law prohibits
assignment on the rationale the identity of the contracting party is material to the
agreement. In re James Cable Partners, 27 F.3d 534 (11th Cir. 1994); In re
Magness, 972 F.2d 689 (6th Cir. 1992).
The court discounts the legislative history because it believes the statute
is not ambiguous and the legislative history actually relates to a bill that was
ultimately superceded by the actual legislation. The legislative history, however,
shows Congress intended exactly the opposite of the courts holding. It provides:
This amendment makes it clear that the
prohibition against a trustees power to assume
an executory contract does not apply where it
is the debtor that is in possession and the
performance to be given or received under a
personal service contract will be the same as if
no petition had been filed because of the
personal service nature of the contract.
H.R. Rep. No. 1195, 96th Cong., 2d Sess. 27(b) (1980).
To rebut the policy argument that its reading of section 365(c)(1) is contrary to
sound bankruptcy policy, the court simply rules that Congress is the policy
maker, not the courts. Notably, numerous courts have held section 365(c)(1)
should be interpreted based on the actual test (i.e., is the debtor in possession
actually assigning the contract to a third party, which assignment would run afoul
of applicable law?), rather than the hypothetical test (i.e., if the debtor in
possession attempted to assign the contract, would the assignment be permitted
under applicable law?). See, e.g., Institut Pasteur v. Cambridge Biotech Corp.,
104 F.3d 489 (1st Cir.), cert. denied, 117 S. Ct. 2511 (1997); Texaco Inc. v.
Louisiana Land and Expl. Co., 136 B.R. 658 (M.D. La. 1992); In re GP Express
Airlines, Inc., 200 B.R. 222 (Bankr. D. Neb. 1996); In re Am. Ship Bldg. Co., 164
B.R. 358 (Bankr. M.D. Fla. 1994); In re Fulton Air Service, Inc., 34 B.R. 568
(Bankr. N.D. Ga. 1983). Contra In re West Electronics, Inc., 852 F.2d 79 (3d Cir.
1988); In re James Cable Partners, L.P., 27 F.3d 534 (11th Cir. 1994); In re
Catron, 158 B.R. 629 (E.D. Va. 1993), affd without opinion, 25 F.3d 1038 (4th Cir.
1994).
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B.

In re Footstar, Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005)

i.

Facts.

Footstar, through a corporation 49% owned by Kmart and 51% owned by

Footstar, operated shoe departments in Kmarts more than 1500 stores. Footstar
moved to assume the agreement under which the jointly owned corporation has
the exclusive right to operate a shoe department in each of Kmarts stores.
Kmart objected to the assumption on numerous grounds. 323 B.R. at 568.
ii.

Issue.

The instant decision resolved only one ground Kmart asserted to block
assumption, namely that 11 U.S.C. 365(c)(1) bars assumption of the
agreement if the agreement can not be assigned.
iii.

Holding.

Without deploying either the actual test or the hypothetical test, the court
held Footstar could assume the agreement even if it could not assign the
agreement. 323 B.R. at 570.
iv.
Rationale.
The court ruled the plain meaning of 11 U.S.C. 365(c)(1) does not bar
Footstars assumption of the agreement because it bars the trustee and not the
debtor in possession from assuming contracts under certain circumstances. 323
B.R. at 570.
11 U.S.C. 1107(a) provides:
Subject to any limitations on a trustee serving in a case under this
chapter, and to such limitations or conditions as the court
prescribes, a debtor in possession shall have all the rights, other
than the right to compensation under section 330 of this title, and
powers, and shall perform all the functions and duties, except the
duties specified in sections 1106(a)(2),(3), and (4) of this title, of a
trustee serving in a case under this chapter.
Footstar observes that no provision of the Banrkuptcy Code states in
words or substance that references in the Code to trustee are to be construed to
meandebtor or debtor in possession. A basic misconception, in this Courts
view, underlies the three Circuit Court decisions adopting the hypothetical test,
in that all three proceed from the premise, expressed or unstated, that trustee
as used in Section 365(c)(1) means debtor in possession. 323 B.R. at 571.

301

There is no doubt that the prefatory clause in Section 1107 [subject to

any limitations on a trustee] applies to the limitation on assumption and
assignment prescribed in Section 365(c)(1). However, merely substituting
debtor in possession for trustee in Section 365(c)(1) does not illuminate the
limitation set forth by Congress in Section 365(c)(1), nor how that limitation
should, or even can, be applied to a debtor in possession under Section
1107. 323 B.R. at 573. Indeed, where the debtor seeks to assume but not
assign a contract, to read the statute to say that the debtor in possession may
not assumeany contract ifapplicable law excuses [the counterparty] from
accepting performance from or rendering performance to an entity other than the
debtor in possession would render the provision a virtual oxymoron, since
mere assumption (without assignment) would not compel the counterparty to
accept performance from or render it to an entity other than the debtor. 323
B.R. at 573.
C.

Bonneville Power Administration v. Mirant Corp. (In re

Mirant Corp.), 440 F.3d 238 (5th Cir. 2006)
i.

Facts

Bonneville Power Administration (BPA) had a prepetition executory

contract with Mirant Corp., chapter 11 debtor in possession (Mirant), for the
future purchase of electric power. BPA terminated the contract to trigger Mirants
obligation to make a liquidated damage termination payment to BPA based on
the ipso facto clause in the contract and the fact that the Anti-Assignment Act, 41
U.S.C. 15, is applicable law that prevents the transfer of the contract for
purposes of 11 U.S.C. 365(e)(2)(A).
Notably, BPA would not have exercised its option to utilize the contract
because the contract price was higher than market prices. But, pursuant to the
contract, its termination would lead to Mirant being liable to BPA for the
termination payment. 440 F.3d at 242.
The bankruptcy court ruled BPA was not a forward contract merchant,
thereby eliminating its rights to be insulated from the automatic stay by 11 U.S.C.
556. BPA later moved for relief from the automatic stay. The bankruptcy court
ruled BPA had violated the stay by terminating the contract and ruled there were
no grounds to terminate the stay. The district court affirmed. 440 F.3d at 244245.
ii.

Issue

Does 11 U.S.C. 365(e)(2)(A) permit automatic termination of the

contract because it can not be assumed due to the Anti-Assignment Act, 41
U.S.C. 15?

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iii.

Holding

No. Review of this Circuits law, however, reveals that our adoption today
of the actual test, in resolving the availability of 365(e)(2)(A)s exception, is
consistent with prior caselaw. 440 F.3d at 249.
iv.

Rationale

The Fifth Circuit formulated refreshing and compelling reasons to interpret

11 U.S.C. 365(c)(1) and 365(e)(2)(A) to mean that an estates executory
contract is only barred from being assumed if the debtor or trustee is actually
attempting to transfer it to a third party under which applicable law would excuse
the nondebtor contract party from accepting performance form the third party
assignee.
The plain text of 365(e)(2)(A) requires an actual test for determining
whether a law is applicable under the exception, permitting enforcement of an
ipso facto clause. According to the statutes plain language, an executory
contracts ipso facto clause may be enforced if applicable law excuses a
[nondebtor] party from accepting performance from or rendering performance
to an assignee of such contract and that non-debtor party does not consent to
such assumption or assignment. 11 U.S.C. 365(e)(2)(A). Congress might
have chosen the exception to apply if any law prohibited the assignment, but
instead Congress tethered the exception to applicable law that excuses a
party. It is axiomatic that an applicable law must apply to a set of circumstances;
BPA creates smoke and erects mirrors when it argues that a contract not
assignable as a matter of law, even if no such assignment existed in fact and no
excuse existed in fact for the nondebtor party to refuse acceptance or
performance in a particular situation, satisfies the language chosen by Congress
in drafting the 365(e)(2)(A) exception. 440 F.3d at 249-250.
In addition to reasoning that section 365(e)(2)(A) must refer to an actual
situation, or else one could not know if the applicable law barred assignment, the
Fifth Circuit also pointed out that the Anti-Assignment Act has many exceptions
in 41 U.S.C. 15(b), whose applicability can only be ascertained in the context of
an actual transfer of the contract. 440 F.3d at 250-251.
Because the actual test applies, the Fifth Circuit conclude that the
automatic stay must precede any enforcement of an ipso facto clause ultimately
permitted by a bankruptcy court under 365(e)(2)(A). 440 F.3d at 251.

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D.

When Failure of Adequate Assurance Validly Defeats

Assignment: In re Fleming Companies, Inc.), 499 F.3d 300 (3d
Cir. 2007)

i.
Facts
Fleming was a wholesale supplier of grocery products. It had two supply
contracts with Albertsons, one of which specified that Fleming would supply
Albertsons from its Tulsa facility which had been constructed and operated by
Albertsons. Use of the Tulsa facility allowed Albertsons to continue using its
electronic ordering systems and order codes, "recognizing the critical importance
of consistency in the competitive grocery industry." 499 F.3d at 302-303.
After Fleming commenced its chapter 11 case, it sold and assigned its
assets to C&S Acquisition LLC, and provided it the right to designate third party
purchasers for certain assets including the supply contracts with Albertsons. 499
F.3d at 303. C&S designated AWG. Fleming closed the Tulsa facility and at
AWG's direction, rejected its Tulsa lease with court approval. 499 F.3d at 303.
"Neither Albertson's nor Fleming could operate the Tulsa Facility profitably." 499
F.3d at 307. Fleming also requested an order approving its assumption and
assignment to AWG of the two supply agreements with Albertsons. Albertson
objected on the ground it would suffer a real and cognizable economic detriment
from contravention of the essence of the contract embodied in the term
"'supplyfrom the Tulsa Facility.'" 499 F.3d at 303. AWG countered with
evidence that "Albertsons would be able to purchase its products from AWG at
the same price and on the same terms that Albertson's expected to receive from
Fleming, pursuant to the FSA's, including freight charges." 499 F.3d at 304.
The bankruptcy court denied approval of the assignment of the Tulsa
supply contract to AWG on the ground that fulfillment from the Tulsa facility is an
essential element of the agreement. 499 F.3d at 304. The district court affirmed.
ii.

Issues

Does AWG's failure to abide by the contract provision requiring supply

from the Tulsa facility constitute a failure to provide adequate assurance of future
performance for purposes of 11 U.S.C. 365(f)(2)(B)?
Is the contract provision requiring supply from the Tulsa facility
unenforceable pursuant to 11 U.S.C. 365(f)(1) as a de facto anti-assignment
provision.
iii.

Holdings

Yes. The standard is whether the contract term is "material and

economically significant" as set forth in In re Joshua Slocum Ltd., 922 F.2d 1081,
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1092 (3d Cir. 1990). 499 F.3d at 305-306. "The resolution of this dispute does
not depend on whether a term is 'economically material.' Rather, the focus is
rightly placed on the importance of the term within the overall bargained-for
exchange; that is, whether the term is integral to the bargain struck between the
parties (its materiality) and whether performance of that term gives a party the full
benefit of his bargain (its economic significance)." 499 F.3d at 306.
No. "Section 365(f)(1) is not limited to explicit anti-assignment provisions.
Provisions which are so restrictive that they constitute de facto anti-assignment
provisions are also rendered unenforceable. See In re Rickel Home Ctrs., Inc.,
240 B.R. 826, 831-32 (D. Del. 1999)(citing Joshua Slocum, 922 F.2d at 1090)."
499 F.3d at 307.
"We recognize that a fine line exists between reading a contractual term
as a burdensome obligation or as a de facto restriction on assignment. However,
we draw the line where a party refuses to accept part of the contract's obligation,
and as a result it cannot perform a material bargained-for term of the contract.
Here, AWG rejected the Tulsa Facility lease, and now complains that it is
impossible to comply with an integral term of the contract. This term could have
been performed by some party. It is not now an anti-assignment provision simply
because AWG made the decision not to take on a necessary burden" 499
F.3d at 308.
iv.

Implications

While the holding concluded the assignee failed to provide adequate

assurance due to its nonperformance of the contract provision requiring supply
from the Tulsa facility, Fleming acknowledges that "the bankruptcy court can
excise or refuse enforcement of terms of a contract in order to permit
assignment" 499 F.3d at 305.
Fleming is also notable for the fact that the contract itself only provided for
supply from the Tulsa facility and did not elaborate on the continued use of
certain bar codes and protocols that were important to Albertsons. Thus, the
court went outside the contract to determine the importance of the breached
provision.
38. Devan v. Simon Debartolo Group, 180 F.3d 149 (4th Cir. 1999).
i. Facts.
Merry-Go-Round, as chapter 11 debtor in possession, entered into a new
lease. When the case proved unsuccessful, a going out of business sale was
held during the chapter 11, and then the case converted to chapter 7. After
unsuccessfully trying to sell the lease, the chapter 7 trustee returned the keys to
the landlord and an order was entered deeming the lease rejected. The

305

bankruptcy court granted the landlord a chapter 11 administrative claim for

unpaid rent (subject to mitigation under state law), and the district court affirmed.
ii. Holding.
The landlord has an allowable chapter 11 damage claim for breach of the
postpetition lease. But, [w]hether or not the future rent of a particular lease in a
particular case is entitled to administrative priority is to be determined on a caseby-case basis just like any other administrative claim. 180 F.3d at 156. The test
is whether the claim arises out of a postpetition transaction and was a necessary
cost of preserving the estate. Here, it was entered into postpetition. The chapter
7 trustees argument that it was of no benefit to the estate after conversion does
not negate its being a necessary cost of preserving the estate because creditors
can not be induced to enter into transactions with debtors in possession if they
lose valid claims once the deal turns sour for the estate.
iii. Dangerous Dictum about Rejection
The chapter 7 trustee argued that the lease was rejected. The appellate
courts and the bankruptcy court ruled rejection only applies to leases entered into
by the debtor, and not by the debtor in possession. The reason this issue is
troubling is its implied significance. Rejection is actually nothing but a material
breach. Bankruptcy Code section 365(g). The implication of the discussion,
however, is that rejection would somehow make the lease go away, and the
damage claim along with it. There is, however, no such thing as a rejection
avoiding power.

306