Winter 2009 • Issue 35, page 1

Bay Area Bankruptcy Forum Presents Review and Discussion of Recent Key Business Bankruptcy Decisions/Cases

By Montali, Honorable Dennis, Dumas, Cecily & Oliner, Ron*

"Recent Developments in Business Bankruptcy — 2009” was the subject of a comprehensive panel presentation sponsored by the Bay Area Bankruptcy Forum for attorneys throughout the greater Bay Area on October 27 at the San Jose Fairmont Hotel.

The authors, panelists and presenters at the annual evening program – The Honorable Dennis Montali, United States Bankruptcy Judge; Cecily A. Dumas, Esq., (a partner in the firm Friedman Dumas & Springwater LLP); and Ron Mark Oliner, Esq. (a partner in the firm Duane Morris LLP) – excerpted and elaborated on facts and law from the most important bankruptcy decisions handed down in the last twelve months.

[Editors Note: Space limitations prevent the RN from reprinting the more than 80 case summaries written and discussed by the distinguished panel. We have selected a few that seem of greatest impact – and with greatest potential application to receiverships — and present them in two parts in this and in our Spring 2010 issue.]

Insolvency for Anyone! Constitutionally, Even Solvent Millionaires Can File Bankruptcy
Debtors had few general unsecured claims, a majority of which were disputed, and a judgment against them for $12M that was on appeal. Debtors were unable to post a bond to obtain a stay pending appeal. Just days before a hearing that would have allowed the creditor to enforce the judgment, debtors filed a Chapter 11 petition. Later, the judgment creditor raised several irregularities in debtors’ valuation of many of their assets listed in the schedules.

On a fair valuation, debtors might have been solvent, but were illiquid. Debtors eventually filed an amended plan of reorganization, which did not provide for any payment to judgment creditor. Judgment creditor objected to the plan on grounds that confirmation of a plan in favor of solvent debtors was unconstitutional. Both the bankruptcy court and district court disagreed.

In a well-reasoned decision affirming the bankruptcy court, the district court determined that neither the Bankruptcy Clause, U.S. Const. Art. I § 8, cl. 4, which empowers Congress “[t]o establish ... uniform Laws on the subject of Bankruptcies throughout the United States,” nor the Bankruptcy Code requires insolvency as a condition for application of the bankruptcy law. While the full scope of “the subject of Bankruptcies” in the Bankruptcy Clause has never been defined, it is broad and relates generally to the relations between creditors and debtors either unable or unwilling to pay their creditors.

Any “person” as defined by the Bankruptcy Code with good faith intent and in financial distress is eligible to be a debtor. Petitions filed in bad faith—i.e., without proper rehabilitation purpose or filed to unreasonably deter and harass creditors—can be dismissed by the court. Here, filing just days before the enforcement of a judgment, or to avoid posting an appeal bond, and aggressive asset valuations on schedules, did not constitute bad faith. Moreover, debtors’ proposal and confirmation of a plan eliminated any suspicion they were using chapter 11 for an improper purpose.
Marshall v. Marshall
, 403 B.R. 668 (C.D. Cal. 2009).

Receivers Note Well: No WARN Act Claim Against Chapter 7 Trustee.
Debtor hospital had approximately 30 patients at the time it filed for Chapter 7. The Chapter 7 trustee obtained authority from the bankruptcy court to operate debtor for a limited period of time for the purpose attending to its remaining patients, shutting down operations and complying with various government regulations. Four days after the petition date, the trustee notified debtor’s employees that they were being terminated. Employees then sued the trustee under the WARN Act for failing to provide 60 days’ notice of their termination.

The bankruptcy court dismissed the lawsuit, finding that the trustee did not qualify as an “employer” under the Act because he was not operating a “business enterprise in the normal commercial sense.” Rather, the trustee was acting as a fiduciary liquidating the debtor’s assets for the benefit of creditors. The court left open the possibility that a Chapter 7 trustee could be subject to a WARN Act claim if the trustee actually operates a debtor’s business “in the normal commercial sense” for a period of time.
Walsh v. Century City Doctors Hosp., LLC
(In re Century City Doctors Hosp., LLC), --- B.R. ---, 2009 WL 2567021 (Bankr. C.D. Cal. Aug. 17, 2009).

Fraud Perpetrated Against Court Warrants Surcharge Of Homestead Exemption.
The Debtor created a sham note and deed of trust on his residence in the amount of $168,000, held by an evidently fictitious creditor, in a scheme to protect the equity in his residence. Chapter 7 trustee was forced to spend five years and over $500,000 in attorneys’ fees litigating the matter, with the net result that creditors received nothing in what otherwise could have been a surplus case.

The Court explained that surcharge of a debtor’s claimed exemption is justified where the debtor’s misconduct amounts to a fraud on the court and the debtor’s creditors. Moreover, the surcharge must be calculated to compensate the estate for the actual damage inflicted by the misconduct. Based upon the record, the court surcharged debtor’s entire $75,000 homestead.
In re Law
, 401 B.R. 447 (Bankr. C.D. Cal. 2009).

Can a Major Auto Manufacturing Company Be a Melting Ice Cube for Sale Exigency Purposes? You Bet, Said the Second Circuit.
The economic crisis of 2008–09 may well be remembered as the moment in time when the Second Circuit recognized that §363(b) sales have all but replaced corporate reorganizations as “the preferred method of monetizing the assets of a debtor company.” The court upheld the bankruptcy court’s approval of Chrysler’s sale, just over 30 days after its filing, of substantially all of its assets to New Chrysler, an entity which would be owned by an employee benefit entity, the United States Treasury and Export Development Canada, and Fiat.

The sale order was appealed by a pension fund which held senior debt issued by Chrysler, and various tort claimants and others. The court first reviewed the sale in light of its holding in Comm. Of Equity Security Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063 (2d Cir. 1983), and concluded that the sale was justified under the Lionel factors, and in particular the fact that the evidence showed that Chrysler was hemorrhaging cash and losing going concern value of nearly $100 million a day. The court held that this precipitous depreciation in value, among other reasons, constituted a “good business reason” for the sale.

The court also rejected the pensioner’s arguments that their liens were stripped in violation of §363(f) of the Bankruptcy Code, noting that the bankruptcy court found that the agent for the pensioners had consented to the sale. The court dismissed the tort claimants’ arguments that the sale order improperly authorized the assets to be sold free and clear of successor liability claims, including tort claims. But while the opinion made it clear that the court was not limiting its Lionel holding, it discussed at length how practical realities have changed in the past 25 years since it decided Lionel.
Ind. State Police Pension v. Chrysler LLC (In re Chrysler LLC)
, 576 F.3d 108 (2d Cir. 2009).

[Editor’s note: For readers unfamiliar with bankruptcy law, many, many thousands of bankruptcy cases have been filed in recent years for the sole purpose of conducting a sale of company assets under Section 363 of the Bankruptcy Code for an amount insufficient to pay all liens on the property, with all liens to attach to proceeds of the sale. This is the “preferred method of monetizing the assets of the debtor company” the opinion describes. Such sales cannot be conducted by state courts which, unlike federal bankruptcy courts, do not have statutory authority to order a sale for a price which will not pay all lienholders in full, to the regret of many a receiver. Or do they? See below.]

Washington Bankruptcy Court Finds That Clear Channel Does Not Preclude A Sale Free And Clear For An Amount Less Than Enough To Satisfy All Liens.
[Editor’s note: The Clear Channel decision (Clear Channel Outdoor, Inc. v. Knupfer, 391B.R. 25 (9th Cir. BAP 2008)) referred to below is a recent ruling that limits the ability of a bankruptcy court to approve a sale of property for a price less than the amount necessary to pay all recorded liens in full where secured creditors do not consent to the sale. It undercut long-established standard practice in bankruptcy courts and shocked bankruptcy practitioners nationwide. This new decision discussed below finds a way around the Clear Channel holding, in part by referring to Washington State receivership law!]

Chapter 7 trustee moved to sell debtor’s personal property free and clear of liens. Lienholders objected to the sale, arguing that a bankruptcy court may not authorize a sale free and clear over the objection of a secured party unless the secured claim is being paid in full, citing to Clear Channel Outdoor, Inc. v. Knupfer (In re PW, LLC), 391 B.R. 25 (9th Cir. BAP 2008). The court disagreed, finding that if the sale could not proceed under §363(f)(3) (authorizing a sale free and clear of a lien where “the price at which such property is to be sold is greater than the aggregate value of all liens on such property”), a sale free and clear could still proceed under 363(f)(5) (authorizing a sale free and clear where the lienholder “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest”) even if the sale proceeds were insufficient to satisfy all liens.

In particular, the court found that under Washington law there are legal and equitable proceedings in which a junior lienholder may be compelled to accept a money satisfaction of its interest, such as a senior secured party’s disposition of collateral under Washington’s version of Article 9. Also, Washington law authorizes a receiver to sell free and clear of liens “whether or not the sale will generate proceeds sufficient to fully satisfy all claims secured by the property...” RCW 7.60.260.

The court went on to identify other candidates, including liquidation of a probate estate or a personal property tax sale, both under Washington law, as well as a federal tax lien sale. Moreover, with respect to real property, the court noted that judicial and nonjudicial foreclosure sales under Washington law operate to clear junior lienholders’ interests such that their liens attach to the sale proceeds (to the extent proceeds remain following satisfaction of senior liens).
In re Jolan
, 403 B.R. 866 (Bankr. W.D. Wash. 2009).

[Editor’s note: This Washington State statute authorizing receivers to sell property free and clear of liens is of suspect constitutionality. Article I of the U.S. Constitution, “The Legislative Branch,” provides in part at Section 10 “Powers Prohibited to States” as follows: “No State shall … pass any Bill of Attainder, ex post facto Law, or Law impairing the Obligation of Contracts,….” A state law that strips a lien from real property without payment in full arguably is a law that impairs the obligation of contracts. California has no counterpart to this Washington State statute. Should it?]

A Receiver Can’t Stop A Bankruptcy Filing, But A Bankruptcy Filing Doesn’t Always Get Rid of the Receiver.
The debtor, a special purpose entity that owned and operated a nursing home, defaulted on its construction loan and other debts, and a receiver was appointed to take over the facility. After a series of operational improvements, the receiver made plans to put the facility up for sale, at a price that would pay off the secured debts and maybe provide some return for unsecured creditors, but leave the owners nothing.

In the face of this possibility, the debtor’s management filed a petition for relief under Chapter 11, and moved the bankruptcy court to order the receiver to turn over its property. The receiver moved to dismiss the case on the grounds that the petition’s filing was precluded by the terms of his appointment order.

The bankruptcy court rejected that argument, explaining that the uniformity of federal bankruptcy relief would be jeopardized if its availability were subject to limitation by state-law receivership proceedings. The court also found that the debtor and its creditors would not be better served by dismissal (the standard under Bankruptcy Code §503(a)(1)), given the legitimate possibility that the debtor’s plan for a more relaxed sale schedule would bring in more money than the receiver’s “quick sale” arrangement.

But although the court refused to dismiss the case, it also declined to order the receiver to turn over the debtor’s property. Under §543(d)(1), turnover by a custodian may be excused if the creditors’ interests would be better served by his maintaining custody or control—and in this case, the debtor’s management had already shown itself far less capable than the receiver. The court also denied the debtor’s cash collateral motion, even though doing so could leave the estate unable to meet its administrative expenses. Given that the bankruptcy filing seemed to have been primarily for the benefit of the equity interest holders, the court had no problem letting them bear the case’s up-front costs, pending their hoped-for plan confirmation.
In re Orchards Village Inv., LLC
, 405 B.R. 341 (Bankr. D. Or. 2009).

Debtor Cannot Use Postpetition Financing to Pay the Lender’s Prepetition Secured Debt.
Before bankruptcy, the debtors (a group of used RV dealers) owed $288,000 to the GE Commercial Distribution Finance Corporation, secured by inventory and equipment. After filing bankruptcy, the debtors arranged short-term DIP financing of $750,000 from GE to maintain their inventory credit line, with GE receiving a new junior lien on the debtors’ real property. The debtors then announced that they wanted to use $288,000 of the DIP financing (out of a $350,000 initial draw) to pay GE’s secured pre-petition debt.

The bankruptcy court concluded that this was unacceptable. In a Chapter 11 case, prepetition creditors are generally only paid pursuant to a confirmed plan. The debtors tried to get around that restriction by arguing that their payment to GE was in the “ordinary course” of business, and that it was being made to a “critical vendor” and so was within the “doctrine of necessity.” But saying that a payment is made in the ordinary course of business is a defense against a prepetition payment being deemed preferential; it does not justify postpetition payment of a prepetition debt.

And although courts may occasionally authorize early payment to critical vendors, there must be strong evidence that the payment is critical to the debtor’s reorganization. Here, the court was unconvinced that the success of reorganization depended on routing more than 80% of the initial DIP-financing back the financier.
In re Berry Good, LLC
, 400 B.R. 741 (Bankr. D. Ariz. 2008).

*The Hon. Dennis Montali is a United States Bankruptcy Judge sitting in the San Francisco Division of the Northern District of California.

*Cecily A. Dumas, Esq. is a partner in the firm Friedman Dumas & Springwater LLP.

*Ron Mark Oliner, Esq. is a partner in the firm Duane Morris LLP.

The authors gratefully acknowledge the assistance of Peggy Brister and Valarie Grubich, Law Clerks to the Hon. Dennis Montali; Robert E. Clark, Friedman Dumas & Springwater LLP; and Geoffrey A. Heaton, Duane Morris LLP in the preparation of these extensive materials.