United States: Commercial Restructuring & Bankruptcy Alert,Vol. I, No. 3 (November 2005)

Last Updated: November 17 2005

Equitable Subordination of ESOP Stock Redemption Reversed

Citing United States Supreme Court precedent, a federal appeals court has held that bankruptcy courts may not, as a rule, automatically subordinate stock redemption claims that arise from employee retirement plans.

The ruling means that in the First Circuit, stock redemptions from plans qualified under the Employee Retirement Income Security Act of 1974 (ERISA) may not be equitably subordinated unless a court makes a specific finding that such subordination is justified in an individual case.

The dispute in Merrimac Paper Company, Inc. v. Harrison (In re Merrimac Paper Co., Inc.), 420 F.3d 53 (1st Cir. 2005) arose following the retirement of Ralph Harrison, who worked for Merrimac from 1963 to 1999. Harrison participated in an ERISA-qualified employee stock ownership plan (ESOP), which Merrimac adopted in 1985. At the time of Harrison’s retirement, he held approximately 6 percent of Merrimac’s common stock. He indicated his intention to exercise his put option, and the stock was appraised at a value of $1,116,200.

After exercising his put option, Harrison constructively received the shares and sold them back to the debtor, which gave him a promissory note for $916,300 (the appraised amount minus a cash advance). Harrison received one payment, but Merrimac fell into financial difficulties and failed to make the next annual payment. Harrison sued the company in Massachusetts state court for breach of contract. He then brought a second action in federal court, alleging that the trustee of Merrimac’s ESOP breached its fiduciary duties.

Merrimac filed for chapter 11 bankruptcy protection and filed an adversary proceeding to have Harrison’s claim subordinated. Under the debtor’s reorganization plan, the general unsecured creditors would have priority over stock redemption claims, and since the plan provided for the impairment of general unsecured claims, Harrison’s note would be extinguished.

The bankruptcy court ruled that under traditional principles of equitable subordination, all claims based on stock redemption notes must be subordinated, including Harrison’s claim.

On appeal, the First Circuit disagreed. The appeals court noted that principals of equitable subordination generally require the claimant to be found to have engaged in inequitable conduct; that such conduct either resulted in injury to creditors or gave the claimant an unfair advantage; and that the equitable subordination of a claim does not conflict with federal bankruptcy law.

Merrimac argued that older case law supported the general principal that stockholders may not receive any assets of an insolvent corporation until the corporation’s creditors are paid in full.

However, the First Circuit noted that two recent Supreme Court cases "dispel any notion that a bankruptcy court must categorically impose equitable subordination merely because a claim arises out of a note taken in connection with a redemption of corporate stock." The cases, United States v. Noland, 517 U.S. 535 (1996) and United States v. Reorganized CF & I Fabricators of Utah, Inc., 518 U.S. 213 (1996), stand for the proposition that the "categorical reordering of priorities" takes place at the legislative level and is beyond the scope of judicial authority, the court stated.

In Merrimac, the bankruptcy court erred in subordinating Harrison’s claims because such subordination was not premised on the specific facts of the case, but rather on the "taxonomic status" of the claim, the court stated.

"We…hold that claims founded on stock redemption notes are not to be automatically subordinated solely on the basis of their intrinsic nature," the court concluded.

The court cautioned, however, that the general principle that "equity holders should not be able to artificially evade the debt-over-equity paradigm is generally sound… .[A] court sitting in equity must…consider whether subordinating a particular claim would be fair based on the totality of circumstances in the individual case."

In considering the ESOP transaction at issue in Merrimac, the First Circuit noted that "ERISA seeks to ensure that ‘if a worker has been promised a defined pension benefit upon retirement—and if he has fulfilled whatever conditions are required to obtain a vested benefit—he will actually receive it.’" Hence, under an ESOP, employees assume the market risk of stock ownership during their period of employment, but ERISA seeks to eliminate that risk once retirement occurs, the court stated.

Harrison made clear his intention to convert his shares to cash, and therefore the Note should be viewed as partial payment of retirement plan benefits, the court stated. Since there was no evidence that Harrison’s conduct justified equitable subordination, the Bankruptcy Court erred in subordinating his claims, the court concluded.

Court Could Oversee Sale of Ships Not Within Its Jurisdiction

A bankruptcy court could order the sale of marine vessels free and clear of liens, even though the vessels were not arrested within the court’s jurisdiction, because the objecting lienors litigated their claims before the bankruptcy court, the U.S. Court of Appeals for the Second Circuit recently held.

The congressional grant of subject matter jurisdiction to the district courts to adjudicate in bankruptcy "all ... property, wherever located," 28 U.S.C. § 1334(e), extends to vessels that have not been arrested within the district court’s jurisdiction, the court determined in Universal Oil Ltd. v. Allfirst Bank (In re: Millenium Seacarriers, Inc., et al.),No. 04-0631-bk, 04-0633-bk (2d. Cir., Aug. 11, 2005) Because the lienors litigated their claims before the bankruptcy court, the bankruptcy court had equitable jurisdiction to extinguish their maritime claims.

Millennium Seacarriers filed for chapter 11 relief in January 2002 and reached an agreement with its lenders to sell its assets to satisfy its outstanding ship mortgages. Pursuant to that agreement, the bankruptcy court approved a Sale Motion establishing procedures to sell Millenium’s assets free and clear of liens, claims and interests.

Three lienors objected: Universal Oil, Ltd. ("Universal"), which claimed maritime liens for unpaid deliveries of tanks of oil in Panama; the Liberian International Ship & Corporate Registry ("LISCR"), which claimed maritime liens for unpaid tonnage taxes; and Praxis Energy Agents S.A. ("Praxis"), which claimed maritime liens for unpaid fuel deliveries.

Universal and LISCR argued that the bankruptcy court lacked in rem jurisdiction over the vessels because none of the vessels had been arrested within the court’s jurisdiction.

The parties also objected to the bankruptcy court’s handling of the case. The court had ordered the debtor, Millnenium, to file an adversary proceeding on behalf of the objecting lienors, naming them as plaintiffs in the action. While the lienors objected to being named as plaintiffs in an action they didn’t bring, they declined the court’s offer to remove them from the action.

On appeal, the Second Circuit expressed skepticism concerning "this unorthodox procedure" of permitting the debtors to file an adversary proceeding on the lienors’ behalf without the lienors’ consent. However, the lienors waived their objections by declining to withdraw from the proceeding, the court determined.

Turning to the question of subject matter jurisdiction, the Second Circuit noted that "…an in rem suit against a vessel to quiet title by expunging its liens is ‘distinctively an admiralty proceeding, and is hence within the exclusive province of the federal courts’ sitting in admiralty." In such suits, "jurisdiction does not attach until the vessel is arrested within the jurisdiction."

However, the appeals court also determined that admiralty law allows for individual lien claims to be expunged when lienors themselves choose to submit their claims to the equitable jurisdiction of another court. In the case at hand, the lienors submitted their maritime lien claims to the bankruptcy court for adjudication in the adversary proceeding.

"[T]hey submitted themselves to the bankruptcy court’s equitable jurisdiction, thereby invoking one of admiralty’s exceptions to the exclusivity of the in rem proceeding," the court stated. "[W]e simply need not address the murky question of whether the bankruptcy court improperly wielded the admiralty power that is ‘within the exclusive province of the federal courts.’"

The decision does not address the question of what would have happened to the lienors’ claims had they declined to participate in the bankruptcy proceedings.

UCC Corner

Sixty-Day Notice Provision Doesn’t Apply to Encoding Errors

A provision in an account agreement requiring a bank customer to notify the bank within 60 days of any errors to its account did not apply to encoding errors, and therefore did not prevent the bank from being held liable for a $216,000 encoding error that was brought to its attention after the 60-day period had run.

The decision by the U.S. Court of Appeals for the Eighth Circuit in Douglas Companies, Inc. v. Commercial National Bank of Texarkana, No. 04-1643/04-2203 (8th Cir., Aug. 19, 2005), leaves in place a jury finding that the Commercial National Bank of Texarkana (CNB) was negligent and therefore liable for the error.

The case arose out of a transaction between Douglas Companies, a wholesale grocery, beverage and tobacco supplier, and USA Express (USA), the owner of several convenience stores in Arkansas and Texas. In April 2000, USA issued Douglas a check for $240,000 to pay for merchandise, and Douglas deposited the check into its account at CNB.

CNB’s proof operator mistakenly encoded the check as $24,000 instead of $240,000 and sent it to USA’s bank, Wells Fargo. Wells Fargo failed to notice the encoding error and debited USA’s account for $24,000. Douglas’s account then was credited with only $24,000, or $216,000 less than the payment by USA.

Douglas’s controller had quit in late 1999 and the new controller became ill in the spring of 2000. As a result, Douglas did not reconcile its bank statement until November 2000. Upon discovering the mistake, Douglas’s controller immediately called CNB, and CNB reviewed its records and advised the controller the mistake would be corrected.

That same month, CNB conditionally credited Douglas’ account and requested an adjustment to Wells Fargo through the Federal Reserve System. The Federal Reserve does not process adjustment requests that are more than 180 days old and rejected the request. CNB then sent an adjustment request directly to Wells Fargo. This request was transferred to a regional adjustment center, which acknowledged receipt of the request, but found no record of the check and closed the request.

In the meantime, USA was facing insolvency and agreed to sign over its assets in lieu of foreclosure to its bank, Credit Suisse First Boston (CSFB). CSFB formed Houston Convenience (Houston) to continue operating the convenience stores. Houston agreed to bring all of USA’s accounts with Douglas up to date, closed USA’s account at Wells Fargo in November 2000, and transferred the funds into its account.

In January 2001, CNB followed up on its adjustment request. Wells Fargo’s regional adjustment center then located USA’s April check and confirmed the encoding error. But by then, the account had been closed and Wells Fargo denied the adjustment request. Shortly thereafter, Houston filed for bankruptcy and refused a request to pay Douglas the $216,000 at issue.

CNB then debited Douglas’s account for $216,000, and Douglas sued CNB, alleging negligence and breach of contract for improperly encoding USA’s check. CNB claimed Douglas’s suit was barred by the parties’ account agreement that required Douglas to review its bank statement and bring errors to CNB’s attention within 60 days. CNB also argued that it exercised reasonable care in handling Douglas’s account. CNB also filed a third-party complaint against Wells Fargo, and Wells Fargo counterclaimed alleging violation of the Uniform Commercial Code encoding warranty.

The federal district court held the agreement’s 60-day notice provision only applied to alterations or forgeries and not to encoding errors. It also held the relative negligence of the parties was a question for the jury. The jury awarded Douglas $216,000, and rejected CNB’s third-party claims against Wells Fargo.

On appeal, the Eighth Circuit examined the 60-day notice provision, which provided, in part, that:

"You…agree that if you fail to report any unauthorized signatures, alterations, forgeries or any other errors in your account within 60 days of when we make the statements available, you cannot assert a claim against us on any items in that statement…." [emphasis added]

The appeals court determined that the agreement was governed by § 4-4-406 of the Uniform Commercial Code, which requires customers to inform banks within one year after the statement of an alteration or unauthorized signature.

CNB contended that UCC § 4-4-103 permits banks and their customers to deviate, by agreement, from UCC provisions that otherwise would control their relationships.

However, while § 4-4-103 allows the parties to alter the time limit or statute of limitations for notifying a bank, it does not allow the parties to modify the scope of § 4-4-406, the appeals court determined.

"[W]e find no authority, and CNB fails to cite any, permitting parties to expand the scope of § 4-4-406 to impose a duty on customers to give notice of encoding errors. In the absence of such authority, we hold the agreement applies only to the types of transactions or errors specifically identified in § 4-4-406, i.e. unauthorized signatures and alterations."

CNB also argued that its encoding error was not a question of negligence for the jury. The bank argued that encoding error is part and parcel of the banking industry, and that compliance with Federal Reserve regulations and operating circulars presumptively establishes ordinary care.

The Eighth Circuit rejected this argument and upheld the district court’s holding that the issue of CNB’s negligence was for a jury to decide. The court rejected arguments that any actions by other parties—Douglas’s failure to discover the encoding error, as well as Wells Fargo’s failure to act on the adjustment request while sufficient funds were in USA’s account—were sufficient intervening causes to sever the causal connection between CNB’s negligence and the loss.

The decision leaves the loss with CNB, which arguably caused the loss through its encoding error. It also establishes the rule that encoding errors fall outside of notice provisions in bank account agreements.

UCC Corner

Reclaiming Seller Has Priority Over an Unperfected Secured Creditor

In a case illustrating the dangers of floor financing gone awry, a federal bankruptcy court in Arizona has ruled that where a creditor failed to perfect its interests in the vehicles at issue, a seller could reclaim those vehicles.

The dispute in Davis v. Par Wholesale Auto, Inc., et al. (In re Tucker), No. 2-02-06324-PHX-RJH (Bankr.D.Ariz., Aug. 11, 2005) arose out of the purchase of three vehicles by the debtor Edward Tucker, d/b/a as the Harvest Car Co., from Par Wholesale Auto in Texas.

Tucker maintained a floor financing arrangement with DAVCO Enterprises, under which Tucker would sign the certificates of title to newly purchased vehicles and deliver them to DAVCO. DAVCO would hold these "open" titles until Tucker sold the vehicles. For the three cars at issue, DAVCO did not record its interests with the Arizona Motor Vehicle Division, nor did it file a UCC-1 financing statement.

The check tendered by Tucker to pay for the vehicles failed to clear, and Par demanded replacement funds or return of the vehicles. Tucker returned the automobiles.

Shortly thereafter, DAVCO terminated its financing agreement with Tucker, and demanded return of the vehicles, claiming that as holder of the vehicle titles, it was the owner of the vehicles rather than merely a secured lender.

The U.S. Bankruptcy Court for the District of Arizona disagreed. Because the vehicles remained on Tucker’s used car lot, and DAVCO did not file the certificates of title with the Arizona Motor Vehicle Division, the public and creditors would have no knowledge that the vehicles allegedly had been transferred to DAVCO, the court noted.

Hence, DAVCO’s interests were limited to that of a secured creditor. But because DAVCO never perfected its interests either by filing a UCC financing statement or reflecting its lien on the certificates of title before Par executed its reclamation, DAVCO’s security interests were unperfected, the court determined.

"A seller has a right to reclaim goods when the seller discovers that the buyer has received goods on credit while insolvent," the court noted. "A long line of cases suggest that perfection is required to qualify for the good faith purchaser priority over reclaiming sellers.

"This Court concludes that an inventory financier such as DAVCO fails to observe reasonable commercial standards of fair dealing when it fails to file a financing statement so that credit sellers can become aware of the risk to their reclamation rights and protect themselves."

The decision reinforces the importance of perfecting security rights in each vehicle covered under floor financing arrangements.

La. District Court Upholds GECC Purchase of Debtor’s Ship

The U.S. District Court for the Eastern District of Louisiana has upheld the $18.36 million purchase by the General Electric Capital Corporation (GECC) of a ship sold pursuant to bankruptcy proceedings. The sale had been challenged by the Official Committee of Unsecured Creditors, which sought instead to develop a competing plan of reorganization for the debtor.

To successfully challenge the sale, the unsecured creditors would have needed to show specifically what rights and benefits the creditors were deprived of by the sale that would have accrued to them under a plan of reorganization, the court concluded in In re: Torsch Offshore, Inc., et al., No. 05-2193 (E.D.La., June 24, 2005).

The debtor, the owner and operator of an 11-vessel fleet in the Gulf of Mexico, filed for chapter 11 bankruptcy and proposed to sell off all or most of its assets, citing declining prospects for successfully reorganizing its business. As part of the plan, three of the vessels, which were subject to a lien in favor of GECC, would be sold to GECC for $18.36 million or to the highest bidder.

The sales were conducted under § 363 of the Bankruptcy Code, which allows the sale of estate property other than in the ordinary course of business, so long as there are business justifications.

GECC purchased the vessels subject to its lien for the anticipated price. Total asset sales brought just more than $100 million.

However the unsecured creditors’ committee maintained that the company’s assets were worth $228 million. They argued the sales constituted a sub rosa plan of reorganization that violated the standard established by In re Braniff Airways, Inc., 700 F.2d 935 (5th Cir. 1983).

Braniff stands for the proposition that a debtor may not "gut the bankruptcy estate before reorganization or to change the fundamental nature of the estate’s assets in such a way that limits a future reorganization plan," the court noted. However, case law interpreting Braniff has required creditors objecting to a § 363 transaction to "specify exactly what protection is being denied."

In the case at hand, the debtor met its obligation to demonstrate that there were sound business justifications for the asset sales, the court noted. Maintaining the vessels was costing the debtor "an exorbitant amount of money," the condition of the vessels was deteriorating, and no plan of reorganization had been put forth in the six months since the debtor filed for bankruptcy.

Although the creditors listed the procedural chapter 11 protections they would lose following the asset sales, they failed to demonstrate how the sales deprived them of the ability to file a competing reorganization plan, the court held. The unsecured creditors did not demonstrate that under a competing plan the company could operate profitably, or that the assets could have been sold for a higher price. The debtor received almost 100 bids at the auctions at issue.

Hence the court upheld all of the asset sales, including the settlement with GECC. The ruling makes it more difficult for unsecured creditors to successfully object to § 363 asset sales.

Judge Rejects the Release of Debtor’s Principals From Personal Liability

A federal bankruptcy court in Massachusetts has ruled that the principals of a leasing company did not meet the factors required to obtain a release of personal liability, which they sought as part of the reorganization plan of their debtor companies.

The decision in In re M.J.H. Leasing, Inc. and M.A.T. Marine, Inc., Nos. 04-18802-WCH, 04-19106-WCH (Bankr.D.Mass., Aug. 5, 2005) sustains objections brought by the Trustee and an insurance company that argued its indemnification from the principals served as added security to claims against the debtor companies.

In April 2005, the debtor companies filed a Disclosure Statement ("Disclosure Statement") and proposed Joint Plan of Reorganization along with their principals Michael and Kathleen Hallam. The Disclosure Statement explained that the debtors, which operated as a single unit, performed marine and land-based contracting and excavating work. They fell into financial difficulty after purchasing an excavating machine in 2002.

After filing for chapter 11 relief, the debtors sold the excavator, negotiated with creditors and resumed profitable operations, according to the Disclosure Statement. The Disclosure Statement further noted that under the plan, the Hallams had committed to working for M.A.T., which would enable it to pay its debts in full, and also had agreed to subordinate their own claims to those of the debtors’ creditors.

In exchange, the proposed Plan provided for a release and discharge of claims against the Hallams held by the Gulf Insurance Company under its Bonds and General Indemnity Agreement. Gulf Insurance had sued the Hallams individually upon the filing of the M.J.H. case and obtained an attachment on their home as security.

The Trustee objected to the Disclosure Statement, claiming the debtors failed to demonstrate they could meet the multifactor test the court had used in previous cases to weigh the appropriateness of nondebtor third-party releases.

Citing In re Mahoney Hawkes, LLP, 289 B.R. 285, 300 (Bankr.D.Mass. 2002), the court described the following factors to consider for third-party releases:

(1) There is an identity of interest between the debtor and the third party such that a suit against the nondebtor is one against the debtor and will deplete the estate

(2) The nondebtor has contributed substantial assets to the reorganization

(3) The release is essential to the reorganization

(4) The affected classes have voted in favor of the plan

(5) The plan provides a mechanism for the payment of all, or substantially all, of the claims of the class or classes affected by the release

Taking the factors in turn, the court noted first that the lawsuit brought by Gulf Insurance against the Hallams did not rest on the same set of facts as Gulf’s claims against the Debtor, but was an independent claim that arose from its Agreement with the Hallams, and that any recovery against the Hallams would not deplete the assets of the estate.

In considering the second factor, the court stated that "the Hallams’ proposed contribution of their ‘sweat equity’ would not be considered new value for other plan purposes."

Neither had the Hallams demonstrated the release was "essential" to the reorganization, the court concluded. They did not allege that without the release they would refuse to work for the debtors, and in fact, had every incentive to continue to work for the debtors.

The fourth factor also weighed against the Hallams because Gulf Insurance had objected to the Plan.

In looking to the final factor of its test, the court stated it could not determine whether the Plan would result in full payment of all claims without the additional security of the Agreement Gulf sought to enforce.

The court concluded the Hallams failed to establish they were entitled to a discharge of personal liability under the Plan. The decision is a favorable one for creditors seeking to enforce personal guaranty agreements.

State Watch: California

Lender Bound by Arbitration Agreement Not Contained in Loan Agreement

A California court of appeals has held that a lender must submit its fraud allegations to arbitration, even though the loan agreement provided that the disputes could be litigated in court, because the same loan documentation referenced an assignment agreement that contained an arbitration provision.

In Comerica Bank v. GFT Circle Films, Inc., et al., No. B180622 (Cal. Ct. App., Sept. 15, 2005) (not for publication), the court rejected the bank’s arguments that it should not be forced to arbitrate its claims that the defendants fraudulently obtained film financing by forging foreign distribution license agreements.

The dispute involved two types of documents. Comerica signed "Loan and Security Agreements" (loan agreements) with the defendants, seven corporate entities, to provide financing for seven motion pictures. In each of the loan agreements, the film financing was secured by license fees guaranteed from foreign distributors prior to the film’s production. The defendants produced a "Notice and Acknowledgement of Assignment" (assignment agreement) for each film that provided the license fees were to be assigned to the plaintiff.

The bank brought suit, alleging that the loans were never repaid, and that the plaintiffs had fraudulently represented that they obtained valid license agreements by forging the signatures of various distributors on the license agreements.

The defendants moved to stay the suit on the ground that each assignment contained a binding arbitration clause.

The bank responded that the arbitration clauses should not be enforced because the loan agreements didn’t contain arbitration provisions; the arbitration provisions were not incorporated into the loan agreements; and the assignment agreements were forged and therefore void.

The California Court of Appeal for the Second Appellate District rejected all of these arguments.

"A party may be bound by an arbitration clause which has been incorporated by reference from another agreement," the court stated. In the case at hand, the plaintiff intended to incorporate the assignments into the loan agreements, the court concluded. "The loan agreements do not utilize the word ‘incorporate’; but they certainly ‘guide the reader to the incorporated document,’" the court noted.

The court also disagreed with the contention that the arbitration agreement was unenforceable because the assignments were alleged to be subject to revocation for fraud. Fraud may be used to set aside agreements to arbitrate only in cases "where the party opposing arbitration has shown that the asserted deceit goes to ‘the making of the agreement to arbitrate’ rather than to ‘the making of the agreement’ in general," the court stated.

The appeals court reversed a trial court decision to deny a motion to compel arbitration, but also concluded that the lower court had not ruled on whether to exercise its discretion to refuse to compel arbitration to avoid the possibility of conflicting rulings as to the different parties. The case was remanded for a ruling on the latter issue.

Although the opinion drew a dissent, following this case, parties contracting in California should examine their loan documentation carefully to ensure that any referenced agreements do not change the parties’ abilities to litigate disputes.

State Watch: Ohio

Secured Creditor Not Liable for Payments From Closed Account

Absent a showing that a secured creditor knew fraud was being perpetrated, the creditor had no duty to return funds that came from illegal drafts on a closed bank account, an Ohio court has ruled.

The suit in Firstar Bank, N.A. v. Prestige Motors, Inc., et al. and Chrysler Financial Corp., No. H-04-037 (Ohio Ct. App., Aug. 26, 2005) stemmed from illegal drafts, totaling approximately $750,000, drawn on a closed Firstar account by David Pearson, owner and manager of Prestige Motors Inc.

Chrysler Financial Corporation ("CFC") intervened as a third-party defendant, seeking to protect assets which secured its financing to Prestige. Firstar amended its complaint, claiming it was entitled to the return of funds paid to CFC by Prestige. Firstar claimed that because CFC had access to business records, it knew or should have known that Prestige was insolvent and had no funds from its business operations.

The trial court dismissed Firstar’s complaint against CFC for failure to plead all the elements of fraud. Firstar appealed, arguing it was not required to plead fraud because its claims instead were for unjust enrichment and conversion.

The Court of Appeals of Ohio noted that to recover on a claim for unjust enrichment, a party must demonstrate that a benefit was conferred, and that the retention of the benefit would be unjust. "The conferral of the benefit must be the product of fraud, misrepresentation or bad faith by the party accepting and retaining the benefit," the court stated. "In this case…[t]here is absolutely nothing in the complaint to specifically indicate that CFC had notice of the fraudulent transactions, took the payments, and concealed it from Firstar."

Similarly, bad faith "is not simply bad judgment. It is not merely negligence. It imports a dishonest purpose," the court determined. "It partakes of the nature of fraud…. It means ‘with actual intent to mislead or deceive another’," the court stated, citing precedent.

Suggesting that CFC was negligent in accepting funds from a closed account was not enough to obtain recovery, the court concluded.

"Absent some contractual duty, we can discern no Ohio law which requires one creditor to monitor the finances of its debtor for the purpose of protecting the interests of the other creditors."

The court also rejected Firstar’s claims with regard to conversion.

"Funds drawn on one bank used to pay loans owed to a second bank have been held not to be subject to conversion claims absent bad faith, i.e., knowledge by the second bank that it lacked the right to accept the funds," the court stated. "Again, the facts, as alleged by the appellant, simply do not show that CFC had any actual knowledge of any wrongdoing by Prestige at the time it accepted payments."

The decision is in line with recent circuit court decisions holding that lenders aren’t liable for the misdeeds of debtors. (See Commercial Restructuring & Bankruptcy Alert, Aug. 2005, p. 1, "Lenders Have No Duty To Warn Creditors of Debtors’ Misdeeds," citing B.E.L.T., Inc., et al., v. Wachovia Corporation, 403 F.ed 474 7th Cir. 2005) and Sharp International Corp. v. State Street Bank and Trust Co. (In re Sharp International Corp.), 403 F.3d 43 (2d Cir. 2005).

Market Watch

S&P Report Suggests Recovery Prospects Better for Second-Lien Lenders

Standard & Poor’s has released a report indicating recovery prospects from distressed borrowers are improving for second-lien lenders.

Second-lien financing structures historically have offered substantial protections for the second-lien lender. Lenders in the first and second lien positions understood each other’s lending philosophies, and second-lien financing arrangements reflected an appreciation of cooperative behavior during times of borrower stress. However, when second-lien loans entered the syndicated loan market, the financings often were stripped of protections for the second-lien lenders, and many were left without any material collateral management rights in the borrower prior to and during insolvency.

Standard & Poor’s reports that the pendulum appears to have swung back, and second-lien holders are again benefiting from the previously commonplace protections, including material collateral management rights. Therefore, recovery prospects for second-lien lenders recently have improved. Conversely, the risk of loss in a default for first-lien lenders is reported to have increased.

More information on the report, "Second-Lien Evolution Creates Higher Recovery Prospects—At First Lien Lenders Expense," can be obtained at www.standardandpoors.com or by calling 212.438.9823.

Quick Check

Cases of Note

Creditor prosecution of debtor claims—Creditors may pursue claims on behalf of the debtor in Adelphia Communications Corp., et al. v. Bank of America, N.A., et al., No. 02-41729 (Bankr. S.D.N.Y., Aug. 30, 2005). In determining whether the Creditors’ and Equity Committees could sue commercial banks and investment affiliates alleged to have assisted Adelphia’s former management in looting the company, the U.S. Bankruptcy Court for the Southern District of New York noted that the only parties opposed were the defendants in the litigation to be prosecuted.

The Creditors’ Committee "easily" satisfied the requisite standards, demonstrating: (1) they had colorable claims; (2) prosecution by the creditors would permit the debtor to concentrate its resources on rehabilitating the business; (3) the creditors’ interests did not conflict with the debtor; (4) assignment would not prejudice the equality of distribution among creditors; and (5) litigation was consistent with maximization of the value of the estate.

The court allowed the litigation to go forward, despite the fact that many of the commercial banks to be prosecuted had provided DIP financing that contained provisions specifically limiting the claims that could be brought against them. The ultimate test in determining whether the creditors should be able to act on behalf of the debtor was whether such litigation "will be a sensible expenditure of estate resources," the court stated. "It also means, as a practical matter, that the prospective rewards can reasonably be expected to be commensurate with the litigation’s foreseeable cost."

Attorney liability for fraud—Lawyers for Global Crossing Ltd. must defend allegations that they aided, abetted, and conspired to commit fraud, in the company’s massive scheme to prop up earnings by trading capacity with other telecom companies. James C. Gorton, who served as general counsel to Global Crossing, and Jackie Armstrong, who was in-house counsel with the company, unsuccessfully argued in JP Morgan Chase Bank v. Winnick, et al., No. 03 Civ. 8535 (GEL) (S.D.N.Y., Aug. 16, 2005) that their routine actions in papering the deals involved, and even opposition to such deals, was insufficient to survive dismissal.

The underlying action was brought by a syndicate of commercial banks against various officers, directors and employees of Global Crossing. Under New York law for aiding and abetting fraud, the banks must prove: (1) the existence of a fraud; (2) the defendant’s knowledge of the fraud; and (3) that the defendant provided substantial assistance to advance the fraud’s commission. Armstrong and Gorton conceded that the banks adequately alleged the existence of fraud, but argued for dismissal based on the second and third elements.

The court concluded that certain email presented by the banks that the attorneys were aware of the scheme and provided transactional support to the deals provided enough evidence to allow the case to go forward. However, the court also warned that, "[a]lthough the allegations in the Complaint are sufficient to survive these motions, the claims do not strike the Court as particularly potent as to these individual defendants….If sufficient evidence can be mustered to survive summary judgment challenge, the Banks would nonetheless be well-advised to consider whether chasing multiple individual defendants on what appear to be weak claims is worth the candle."

The case has nonetheless caused a stir for its apparent conclusion that lawyers can be liable for aiding and abetting a client’s fraud by merely engaging in their everyday business practices if they know a debtor client is attempting to defraud a creditor.

Fraudulent transfer releases – A confirmed chapter 11 plan, which released fraudulent transfer claims that debtors or other parties might have asserted against lenders, barred the plaintiffs in a class action suit from pursuing those claims, even though they had objected to confirmation of the bankruptcy plan. In In re Gentek Inc., et al., No.02-12986 (Bankr.D.Del., Aug. 11, 2005), the debtor filed for relief under chapter 11 after its Richmond, California, chemical facility allegedly released sulfur dioxide and sulfur trioxide into the environment, leading to a class action law suit in state court.

Under its plan, the debtors released the lenders from avoidance actions in exchange for cash collateral. In addition, the debtor’s plan released the lenders from fraudulent transfer claims and enjoined "all" parties from bringing such claims. Nonetheless, the California plaintiffs sought to bring fraudulent transfer claims for a $90 million stock transfer to the Prestolite Wire Corporation for the stock of Digital Communications, as well as a grant of a $750 million lien on the debtor’s assets to JPMorgan. The plaintiffs argued the issue should be decided in state court, and that a Case Management Stipulation between the debtors and plaintiffs modified the plan injunction, permitting them to bring their claims.

The U.S. Bankruptcy Court for the District of Delaware disagreed, noting that "[t]he California Plaintiffs overlook the fundamental bankruptcy principle that the right to pursue fraudulent transfer claims shifts to the debtor in possession upon the filing of a chapter 11 petition notwithstanding that, outside of bankruptcy, such claims belong solely to the creditors." The debtors decided not to pursue the claims at issue, releasing them as part of "various settlements and compromises with the Lenders and the Creditors Committee… [that] were approved as part of the confirmation of the Plan, enabling the unsecured creditors (including the California Plaintiffs) to receive a distribution."

Substantive consolidation – The bankruptcy estates of three debtor companies could be substantively consolidated in a case in which the debtors had the same officers, directors and shareholders; conducted the same general business operations under similar names; engaged in intercompany dealings without the usual corporate formalities; and were regarded by creditors as a single entity when extending credit terms. The holding in Lisanti, et al. v. Lubetkin (In re Lisanti Foods, Inc., et al.), No. CIV.A. 03-388 (D.N.J., Aug. 9, 1005) was issued less than a week before the U.S. Court of Appeals for the Third Circuit rejected substantive consolidation in another case and articulated a heightened standard for substantive consolidation.

In Lisanti, the bankruptcy court approved the sale of the assets of the three debtor companies, Lisanti Foods, Inc., Lisanti Foods of Arizona, Inc. and Lisanti Foods of Texas, Inc. Several nondebtor entities with ties to the debtors appealed the bankruptcy court’s decision to substantively consolidate the estates of the debtors, which were wholesale distributors of Italian specialty foods and related products. The appellants claimed that Lisanti Foods, Inc had a lower debt-to-asset ratio than the other companies, and therefore the creditors of the former would obtain a diluted recovery by being forced to share, pro rata, in proceeds from the consolidated estate.

A judge for the U.S. District Court for the District of New Jersey found "ample evidence" to uphold the bankruptcy court’s order substantively consolidating the estates. The court noted testimony that consolidation would benefit creditors by eliminating the need to allocate liabilities and expenses, reducing professional fees of administering the estates separately, and eliminating intercompany debts. Acknowledging "the theoretical merit" of the appellant’s position, the court pointed out that the company’s market value was "significantly less" than the total assets listed on its schedules. That fact suggested "that Appellants’ anticipated recovery on a consolidated basis would not necessarily be less than on a separate estate-by-estate basis," the court stated.

The district court in Lisanti came to the opposite conclusion from that reached by the Third Circuit in In re Owens Corning, No. 04-4080 (3rd Cir., Aug. 15, 2005) (see "Third Circuit Nixes Substantive Consolidation," Commercial Restructuring Bankruptcy Alert, Sept. 2005). Rejecting substantive consolidation in that case, the Third Circuit held that the equitable remedy of substantive consolidation may be used defensively to remedy harm resulting from entangled corporate affairs, but may not be used offensively to disadvantage a group of creditors or alter creditor rights.

Merger financing – An action against the General Electric Capital Corporation ("GECC") for failure to consummate and finance a merger between two grocery store chains has been allowed to go forward. The U.S. District Court for the Southern District of New York denied GECC’s motion to dismiss counterclaims against it in General Electric Capital Corp. v. D’Agostino Supermarkets, Inc., No. 03 CV 8539 (RO) (S.D.N.Y., July 18, 2005). GECC originally brought suit in the D’Agostino case seeking $431,000 in out-of-pocket expenses for a failed merger between D’Agostino and King’s Supermarkets, Inc.

D’Agostino, which had paid nonrefundable fees of more than $1.1 million to GECC for assistance with, and financing for, the merger, countersued, claiming that GECC breached its contractual obligations. GECC replied that its nonperformance was excused by the failure to obtain senior and subordinated financing arrangements. D’Agostino alleged that GECC declined to fund the merger at a very late stage because of intercreditor conflicts. However, GECC was responsible for successfully managing those conflicts because of its dual role serving both as the leading underwriter of a multicomponent financing arrangement as well as a subordinated lender, D’Agostino further claimed.

The court held there was insufficient evidence to justify GECC’s nonperformance at the pleadings stage. "Assuming these allegations to be true for purposes of this motion, GECC cannot excuse its nonperformance…by invoking the nonoccurrence of aspects of the transaction it was charged with furthering," the court stated.

The court also refused to dismiss a counterclaim against GECC based on an implied covenant of good faith and dealing. While a commitment letter signed by the parties extended "sweeping withdrawal rights" to GECC, "New York courts have imposed an implied duty to use ‘reasonable efforts’ to advance primary goals of a contract," the court stated. The court dismissed D’Agostino’s counterclaims based upon fraud and misuse of confidential information, with leave to replead those claims, and dismissed entirely claims based upon tortious interference.

Fiduciary duty—In a lengthy, strongly worded opinion, the Delaware Court of Chancery rejected an attempt by institutional shareholders to enjoin the acquisition of Toys "R" Us, Inc. by a private investment group. The plaintiffs in In re Toys "R" Us, Inc., Shareholder Litigation, Cons. C.A. No 1212-N (June 24, 2005) claimed that the board breached its fiduciary duty to by failing to act reasonably in pursuit of the highest attainable value under the standard established by Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986). The decision in Toys "R" Us is notable for its support of the board’s actions under traditional pre-Sarbanes-Oxley corporate fiduciary standards.

The plaintiffs, represented by lead counsel Lerach Coughlin Stoia Geller Rudman & Robbins and others, put forth many claims. However Vice Chancellor Leo E. Strine, Jr. noted the claims boiled down to two primary complaints: that the board of directors failed to sufficiently shop offers to buy the company as a whole, after originally soliciting offers to sell only the Global Toys division but then shifting gears midstream; and that the board unreasonably locked up the winning bid by agreeing to deal termination measures that precluded any topping bid.

Following poor retail results in the Christmas season of 2003, the board of Toys "R" Us, which comprised nine independent directors and the company’s CEO, hired Credit Suisse First Boston to help examine strategic options to deliver more value to investors. The board hired its own counsel as well as deal counsel, and obtained two separate valuations of the company and its three primary units—Global Toys, Babies "R" Us and Toys Japan. The board ultimately decided to sell Global Toys, which accounted for the largest share of revenue, and concentrate on running Babies "R" Us, which had higher profit margins.

However, when bids were solicited, a group offered to buy the company as a whole, and the board then invited the four bidding finalists to bid both for Global Toys and the whole company. A group of investors put together by Kohlberg Kravis & Roberts submitted the winning bid, which at $6.6 billion or $26.75 per share was $1.50 per share over the next highest bid. That bid represented a 123 percent premium over the $12.00 per share trading price of Toys "R" Us stock in January 2004, when the board initially began its public search for strategic alternatives. The board voted to accept the offer, and through negotiation agreed to a 3.75 percent termination fee; a matching right; and other deal protection measures.

The plaintiffs sought injunctive relief, claiming that once the board determined to sell the company as a whole, it should have solicited offers from a wider group of potential buyers, and that it should have demanded a lower termination fee.

In rejecting the plaintiffs arguments, Chancellor Strine concluded that "the board’s process cannot reasonably be characterized as unreasonable."

He noted that the board had undergone an extensive process to sell the company, meeting 14 times before considering the final KKR offer; the Executive Committee had met 18 times. Any bidder interested in the company as a whole logically also would have been interested in its largest unit, he reasoned. He strongly disagreed with the plaintiffs’ argument that other bidders might have been willing to purchase the whole company had they known it was for sale. "The M&A market, as [the plaintiffs] view it, is comprised of buyers of exceedingly modest and retiring personality, too genteel to make even the politest of uninvited overtures: a cotillion of the reticent," the judge wrote. However, he stated, the "players of the M&A market…are not like some of us were in high school. They have no problem with rejection."

The judge also noted that the board had bargained to reduce the termination fee down from the 4 percent originally demanded by KKR, and stated that it would be "hubris" to conclude that the board acted unreasonably in compromising on the termination fee in order to guarantee a higher stock price.

"The central purpose of Revlon is to ensure the fidelity of fiduciaries," the judge noted. "It is not a license for the judiciary to set arbitrary limits on the contract terms that fiduciaries acting loyally and carefully can shape in the pursuit of their stockholders’ interests. It is even less the purpose of Revlon to push the pricing of sales to the outer margins (or beyond) of their social utility."

With regard to many other claims made by the plaintiffs, Chancellor Strine wrote, "[i]t is not hyperbole to say that one could spend hundreds of pages swatting these nits out of the air." The judge questioned the plaintiffs motives in bringing suit, noting they already had "hedged their bets" by selling a large number of shares for a lower price preceding consummation of the deal. "The balance of the equities does not favor these plaintiffs," the judge concluded. The Toys "R" Us deal was consummated in July.

This article is presented for informational purposes only and is not intended to constitute legal advice.

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