PROTECTING THE ORDINARY COURSE OF BUSINESS DEFENSE

By Howard Cohen

Imagine a scenario in which you have a long standing relationship with an important customer and you learn that this customer is running into financial difficulties. In the current economic cycle, this is probably not a hypothetical, but, rather, an everyday reality. During the course of the relationship, this important customer has from time to time fallen behind in paying invoices and has even reached or exceeded the credit limits your company has imposed on this customer. As things currently stand, this customer is about to once again exceed its credit limit and has requested new credit terms and a higher credit limit. You are concerned about taking aggressive collection efforts since you have some understanding that collection efforts or changes in the relationship might preclude your company from asserting an ordinary course of business defense to a preference lawsuit, should this customer file for bankruptcy protection.

In this situation, should you just sit on your hands or are you able to take any action to protect your position? While the answer to this question is not always straightforward, there have been some important decisions from the Delaware courts that suggest a company in this situation is not always required to sit idly while the customer slides into bankruptcy.

From your perspective, a request for more lenient payment terms and a higher credit limit substantially increases the risk that your company might not get paid. However, to the extent you do agree to changes and manage to receive payment in the 90 days preceding the bankruptcy filing, your company might very well get sued for the return of these payments under the preference provisions of the Bankruptcy Code. Section 547(b) of the Bankruptcy Code gives a debtor in bankruptcy the right to avoid and recover certain payments ("preferences") made before the bankruptcy filing. As it applies to this situation, section 547(b) provides that your customer (now a debtor) may recover all payments it has made to your business within the 90 days before the filing, subject to certain defenses. While the subsequent new value defense is an important defense to the return of payments and there are other defenses available depending on the nature of the relationship with the debtor, this article will focus on the ordinary course of business defense.

As a initial matter, you might ask why you should worry at all, since you do not believe that your customer is "preferring" you over its other creditors. Rather, you are doing your customer a favor by helping it with its cash flow problems if you extend payment terms and increase the credit limit. Even if the customer pays late, why should you have to worry, since the customer appears to be doing the opposite of preferring you by not paying promptly. Case law, however, is clear that even late payments may be preferences where, during the course of the relationship, your company has rarely, if ever, received late payments. This is due to the fact that, from other another creditor's perspective, the fact that you managed to get an older invoice paid off near the date of the bankruptcy filing might very well mean that their invoice was left unpaid. In other words, even though you received a late payment, you were still preferred over other creditors.

The "ordinary course" defense to preference claims is set forth in section 547(c)(2) of the Bankruptcy Code, which states that:

The [debtor] may not avoid under this section a transfer –

(2) to the extent that such transfer was in payment of a debt incurred by the debtor in the ordinary course of business or financial affairs of the debtor and the transferee, and such transfer was –

  1. made in the ordinary course of business or financial affairs of the debtor and the transferee; or
  2. made according to ordinary business terms.

By its terms, the language of section 547(c)(2) makes problematic any change in the course of business between the debtor and creditor, including mutual or even unilateral changes by the debtor that are clearly to its benefit. Changes in payment terms, the time between invoice and payment, the number of invoices included in each payment, the form of payment (e.g., check, bank check, wire transfer) could potentially take a payment out of the "ordinary course" and make it subject to avoidance in bankruptcy, even if the change is at the debtor's request.

In this situation, and based on the plain language of the Bankruptcy Code, the question becomes whether you can take any actions knowing that your customer is in financial distress while at the same time preserving a potential ordinary course of business defense. At least in Delaware, to the extent you can demonstrate that the actions you took in the 90 days before the bankruptcy filing were consistent with past actions, you might be able to assert a successful ordinary course of business defense and defeat claims for the return of funds you received in the 90-day preference period preceding the debtor's bankruptcy filing.

In one of the earlier cases decided in 2003, Troisio v. E.B. Eddy Forest Products Ltd. (In re Global Tissue, L.L.C.)1, the U.S. District Court for the District of Delaware dealt with an appeal from a bankruptcy court order that found preference period transfers made to the defendant were protected from avoidance by the ordinary course of business defense. In this case, the trustee (debtor) contended that the payment history showed that during the preference period, the debtor paid invoices faster than was usual in the pre-preference period. The trustee also argued that during the preference period, the defendant increased pressure on the debtor, and that the defendant had not produced any evidence to show that the payments were consistent with payment practices in the industry generally. The defendant countered that the evidence showed a constant pattern of late payments by the debtor during both the preference and pre-preference periods. In addition, the defendant argued that the 'economic pressure' complained of by the trustee was comprised of phone calls, which was a common practice and not an undue collection effort. In this particular case, the court was persuaded by the defendant's arguments and upheld the ruling of the lower court. Although the opinion did not set forth a comparison of the "lag times" between invoice and payment during the pre-preference and preference periods, it found the payments to be ordinary, where the preference period transfers were made "a bit faster" than payments had previously been made. Further, the appeals court was not persuaded that making calls concerning late payments constituted pressure such that the ordinary course of business defense was no longer available.

In a more recent case, decided in March 2010, In re Elrod Holdings Corp.2, debtors established a long-lasting business relationship with the defendant several years prior to its bankruptcy. Defendant provided and shipped steel and steel-related materials to the debtors for their seat manufacturing business. During the course of their business relationship, debtors and defendant established a billing and payment procedure where debtors would submit payments on a single check approximately two months after the defendant issued its invoices. Instead of submitting payment upon receipt of defendant's invoices, the debtors, as well as defendant's other customers, regularly paid at the completion of a project. This practice, while common in the steel industry, remained consistent throughout debtors' and defendant's relationship prior to the bankruptcy filing dating as far back as May 1998. The debtors and defendant memorialized their payment and billing procedure in writing when the debtors sent an account application to defendant and recommended that payment should be made within 60 days from the invoice date. After receiving debtors' request, the defendant sent its own form to the debtors that required payment to be made within 30 days from the invoice date. However, when debtors signed defendant's form, debtors' employee crossed out the 30-day term and wrote in "forty-five" days as a substitute. Debtors, however, continued to submit payment to defendant based on the understanding that payment would be accepted between 30 and 73 days pursuant to the various oral and written terms.

In May, June and July of 2006, defendant asked debtors on multiple occasions about several unpaid invoices. For each unpaid invoice, the debtors submitted payment in accordance with its regular payment practices with the defendant. From 2004 until June 2006, debtors regularly submitted payments between 35 and 73 days from the invoice date (averaging approximately two months from the invoice date). During the 90 days prior to the bankruptcy, debtors submitted payments to defendant between 30 and 74 days.

The trustee's primary argument in this case was that defendant's threats to withhold future shipments from the debtors constituted unusual collection activity. In support, the trustee cited to defendant's call logs where defendant told the debtors that it would not wait one week for payment and that defendant would hold the debtors' order until it received payment. Based on this perceived threat, the trustee contended that all payments fell outside of the ordinary course of business.

Disagreeing with the trustee, the Delaware bankruptcy court placed great weight on the fact that the debtors and defendant successfully conducted business without interruption for more than 10 years. According to the court, while the timing of payments during the 10-year relationship varied, debtors consistently and regularly made payments to the defendant averaging two months from the date of the invoice during the ordinary course of their business. Further, as evidenced by the defendant's records, debtors regularly paid multiple invoices by submitting a single check. This payment method existed for more than 10 years and was the same method debtors used to make payments during the ninety day preference period. In addressing the trustee's argument, the court found that the defendant took no unusual action in attempting to collect unpaid invoices. Throughout its ten year relationship with the debtors, defendant customarily called several times to collect unpaid invoices and threatened to withhold shipment. As with the method of payment, the court concluded that this was also the same practice used within the preference period. Furthermore, there was no evidence presented that suggested defendant took advantage of the debtors' deteriorating financial condition leading up to their bankruptcies. In fact, defendant was not even aware that the debtors filed for bankruptcy until informed by a business associate.

Finally, in In re Archway Cookies3, a case decided in September 2010, DFI provided goods to Archway, the debtor, for use in its businesses prior to Archway's bankruptcy filing. DFI and the debtors began their business relationship in October 2006. DFI provided net 20 day payment terms to the debtors, and such payment terms were stated on each invoice sent by DFI. On April 2, 2007, Peter Martz, DFI's former CFO/Controller, sent a memorandum to the debtors (referring to a previous letter sent on March 19) regarding the financial condition of Archway, expressing concerns that Archway paid many invoices beyond DFI's "20 day net payment terms," and advising Archway that starting April 9, 2007, DFI "will only release product to be shipped if the account is current." The debtors continued to order product from DFI through the bankruptcy filing.

The average number of days elapsing between the invoice date and payment was approximately 42 days during the period of October 2006 through July 7, 2008, (the "historical period") ranging from 21 to 177 days. In comparison, the average number of days between the invoice date and the payment date for transfers during the July 8, 2008 through Oct. 6, 2008, (the "preference period") was 47 days, ranging from 33 to 64 days.

In finding the payments protected by the ordinary course of business defense, an important fact for the court was that the parties' business relationship lasted over two years and involved 117 transactions. The court found that the transactions made in the historical period were sufficiently similar to those made in the preference period, as there was no evidence that the amounts paid by the debtor during the preference period were inconsistent with their historical practices, all 117 payments were made by check, and the supplier's practices of pressuring the debtors into payment were consistent with their historical dealings. In addition, the 107 transfers that occurred during the historical period were made between 21 and 177 days after the issuance of invoices, with an average days-to-pay of 42.3 days, while the 10 transfers made in the preference period ranged from 41 to 64 days after the issuance of invoice, with an average of 47.2 days-to-pay.

In terms of the pressure placed on the defendant, the court was not persuaded that pressuring the debtors into payment by requiring payment on past due invoices before shipment of new goods constituted unusual collection activity in the course of the parties' relationship sufficient to take away an ordinary course of business defense. According to the court, the April letter sent to the debtors merely evidenced that DFI's terms were enforced by refusal to ship goods until the debtors' account was current.

While these three cases are helpful in establishing an ordinary course of business defense, it appears that all three courts were persuaded by the fact that the parties had longstanding relationships and that such relationships did not materially change as the debtor approached bankruptcy. In situations where the parties do not have a longstanding relationship or make material changes during the 90 day preference period, a preference defendant will likely have a harder time proving up an ordinary course of business defense if it withholds shipment, changes credit terms or enforces credit limits. A perfect example of this comes from the 3rd U.S. Circuit Court of Appeals decision in Hechinger4, a case which is binding on the Delaware courts. In this case, the 3rd Circuit concluded that the ordinary course of business defense was not available due to the fact that the debtor was pressured to make accelerated payments during the 90-day preference period because of supplier's vigorous enforcement of its credit limit, and for the first time in their business relationship, the supplier required lump sum wire transfers as debtor approached this limit, and it shortened the time that debtor had to pay its invoices.

As a final word of caution, many courts outside of Delaware have gone out of their way to find the ordinary course of business defense unavailable in cases where the amount of pressure or variation in the relationship might appear to be slight. Since it is rare to have inside information concerning the specific jurisdiction where your customer might decide to file, it is generally advisable to consult with an experienced bankruptcy practitioner before taking any aggressive action whenever you have an important customer facing financial difficulties.

CLAIMS PURCHASERS BEWARE, YOUR VOTE MIGHT NOT COUNT

By Andrew Weissman

DBSD Case Upholds Designation of Votes Cast By a Claims Purchaser

The right to vote to accept or reject a plan of reorganization is one of the key rights given to impaired creditors in the Chapter 11 bankruptcy process. Generally, in Chapter 11 bankruptcy cases, it is up to the collective opinion of impaired creditors to decide whether a plan is acceptable. While the right to vote on a plan is fundamental, not all creditors are entitled to vote their claims. Notably, creditors whose claims are not impaired by a plan, or who will receive no distribution on a plan, or whose claims are subject to an objection are not entitled to vote. In addition, the Bankruptcy Code allows the bankruptcy court to "designate," or, in effect, to disregard, the votes of any entity whose acceptance or rejection of such plan was not in good faith. The Bankruptcy Code, however, provides no guidance about what constitutes a bad faith vote to accept or reject a proposed Chapter 11 plan.

A recent decision by the 2nd U.S. Circuit Court of Appeals in the In re DBSD North America case sheds new light on certain circumstances that may lead a court to designate the votes of a creditor. It also raises several questions – specifically, where a creditor buys claims against a debtor in bankruptcy with the intention to not maximize its return on the debt, but to gain a blocking position with respect to the debtor's plan of reorganization so that the creditor can gain control of the debtor's assets, it may be appropriate for the bankruptcy court to designate the votes of that creditor. See In re DBSD North America, Inc., 634 F. 3d 79 (2d Cir. 2011). The 2nd Circuit's decision in DBSD should be a significant consideration for any investor that purchases claims against a debtor, or even debt against a company on the eve of its bankruptcy, with the hope of using those claims to acquire the assets of the company or to control its bankruptcy case as it now runs the risk that its vote to accept or reject a plan for the debtor, and thereby control the debtor's reorganization process, will be disregarded.

The Background of the DBSD Case

DBSD was founded in 2004 to develop a mobile communications network that would use both satellites and land-based transmission towers. In its first five years, DBSD made progress toward this goal, successfully launching a satellite and obtaining certain spectrum licenses from the FCC, but it also accumulated a large amount of debt. Because its network remained in the developmental stage and had not become operational, DBSD had little if any revenue to offset its mounting obligations.

On May 15, 2009, DBSD filed a voluntary petition in the U.S. Bankruptcy Court for the Southern District of New York, listing liabilities of $813 million against assets with a book value of $627 million. Of the various claims against DBSD, the principal claims included a $40 million revolving credit facility secured by a first-priority security interest in substantially all of DBSD's assets bearing an initial interest rate of 12.5 percent (the "First Lien Debt"), and $650 million in 7.5 percent convertible senior secured notes due August 2009 (the "Second Lien Debt"). The Second Lien Debt held a second-priority security interest in substantially all of DBSD's assets. At the time of filing, the Second Lien Debt had grown to approximately $740 million.

After negotiations with various parties, DBSD proposed a plan of reorganization which provided that the holders of the First Lien Debt would receive new obligations with a 4-year maturity date and the same 12.5 percent interest rate, but with interest to be paid in kind, meaning that for the first four years the owners of the new obligations would receive as interest more debt from DBSD rather than cash. The holders of the Second Lien Debt would receive the bulk of the shares of the reorganized entity, which the bankruptcy court estimated would be worth between 51 percent and 73 percent of their original claims. The holders of unsecured claims would receive shares estimated to be worth between 4 percent and 46 percent of their original claims. Finally, the existing shareholder would receive shares and warrants in the reorganized entity.

Meanwhile, DISH Network Corp. ("DISH"), although not a creditor of DBSD before its filing, had purchased the claims of various creditors after its bankruptcy filing with an eye toward acquiring DBSD's spectrum rights. As a provider of satellite television, DISH has launched a number of its own satellites, and it also had a significant investment in TerreStar Corporation, a direct competitor of DBSD's in the developing field of hybrid satellite/ terrestrial mobile communications. DISH desired to enter into some sort of transaction with DBSD in the future, if DBSD's spectrum could be useful in its business.

Shortly after DBSD filed its plan, DISH purchased all of the First Lien Debt at its full face value of $40 million, with an agreement that the sellers would make objections to the plan that DISH could adopt after the sale. As DISH admitted, it bought the First Lien Debt not just to acquire a "market piece of paper" but also to "be in a position to take advantage of [its claim] if things didn't go well in a restructuring." Internal DISH communications also promoted an "opportunity to obtain a blocking position in the [Second Lien Debt] and control the bankruptcy process for this potentially strategic asset." In the end, however, DISH was unable to buy enough claims to control the class of Second Lien debt holders.

In addition to voting its claims against confirmation of the proposed plan, DISH argued that the plan was not feasible and that the plan did not give DISH the "indubitable equivalent" of its First Lien Debt as required to cram down a dissenting class of secured creditors under 11 U.S.C. § 1129(b)(2)(A). Separately, DISH proposed to enter into a strategic transaction with DBSD, and requested permission to propose its own competing plan (a request it later withdrew).

DBSD responded by moving for the court to designate that DISH's vote rejecting the plan was not in good faith. 11 U.S.C. § 1126(e). The bankruptcy court agreed, finding that DISH, a competitor to DBSD, was voting against the plan "not as a traditional creditor seeking to maximize its return on the debt it holds, but ... 'to establish control over this strategic asset.' " In re DBSD North America, Inc., 421 B.R. 133, 137 (Bankr. S.D.N.Y. 2009) (quoting DISH's own internal presentation slides). The bankruptcy court therefore designated DISH's vote and disregarded DISH's wholly-owned class of First Lien Debt for the purposes of determining plan acceptance under 11 U.S.C. § 1129(a) (8). Id. at 143. The bankruptcy court also rejected DISH's objections to the plan, finding that the plan was feasible and that, even assuming that DISH's vote counted, the plan gave DISH the "indubitable equivalent" of its First Lien Debt claim and could thus be crammed down over DISH's dissent. In re DBSD North America, Inc., 419 B.R. 179, 203, 208-209 (Bankr. S.D.N.Y. 2009).

After designating DISH's vote and rejecting all objections, the bankruptcy court confirmed the plan. The district court affirmed. While the 2nd Circuit affirmed the bankruptcy court's decision to designate DISH's vote, it reversed the order confirming the plan.5

Designation of Votes under section 1126(e)

Section 1126(e) permits courts to designate a vote on a plan that was not made in "good faith." The Bankruptcy Code provides no guidance about what constitutes a bad faith vote to accept or reject a plan. Rather, § 1126(e)'s "good faith" test effectively delegates to the courts the task of deciding when a party steps over the boundary. See In re Figter Ltd., 118 F.3d 635, 638 (9th Cir. 1997). Case by case, courts have taken up this responsibility.

The designation of votes under section 1126(e) is "the exception, not the rule" and should be used sparingly. In re DBSD, 643 F.3d at 102; In re Adelphia Commc'ns Corp., 359 B.R. 54, 61 (Bankr. S.D.N.Y. 2006). For this reason, a party seeking to designate another's vote bears the burden of proving that it was not cast in good faith. See id. Merely purchasing claims in bankruptcy "for the purpose of securing the approval or rejection of a plan does not of itself amount to 'bad faith.'" In re DBSD, 643 F.3d at 102; In re P–R Holding Corp., 147 F.2d 895, 897 (2d Cir. 1945); see In re 255 Park Plaza Assocs. Ltd. P'ship, 100 F.3d 1214, 1219 (6th Cir. 1996). Nor will selfishness alone defeat a creditor's good faith; the Code assumes that parties will act in their own self interest and allows them to do so. In re DBSD, 643 F.3d at 102.

Section 1126(e) comes into play when voters venture beyond mere self-interested promotion of their claims. In re DBSD, 643 F.3d at 102 "[T]he section was intended to apply to those who were not attempting to protect their own proper interests, but who were, instead, attempting to obtain some benefit to which they were not entitled." Id., In re Figter Ltd, 118 F.3d 635, 638 (9th Cir. 1997). A bankruptcy court may, therefore, designate the vote of a party who votes "in the hope that someone would pay them more than the ratable equivalent of their proportionate part of the bankrupt assets." Young v. Higbee Co., 324 U.S. 204, 211, 65 S.Ct. 594, 89 L.Ed. 890 (1945). The bankruptcy may also designate the vote of one who votes with an "ulterior motive," that is, with "an interest other than an interest as a creditor." In re DBSD, 643 F.3d at 102, See also Revision of the Bankruptcy Act: Hearing on H.R. 6439 Before the House Comm. on the Judiciary, 75th Cong. 181 (1937)(statement of SEC Commissioner William O. Douglas).

In rendering its opinion in DBSD, the 2nd Circuit was careful to note that, "not just any ulterior motive constitutes the sort of improper motive that will support a finding of bad faith." In re DBSD, 643 F.3d at 102. "After all, most creditors have interests beyond their claim against a particular debtor, and those other interests will inevitably affect how they vote the claim." Id. For instance, trade creditors who do regular business with a debtor may vote in the way most likely to allow them to continue to do business with the debtor after reorganization, or as interest rates change, a fully secured creditor may seek liquidation to allow money once invested at unfavorable rates to be invested more favorably elsewhere. Id. As the 2nd Circuit further stated, "allowing the disqualification of votes on account of any ulterior motive could have far-reaching consequences and might leave few votes upheld." Id.

In trying to define, then, what type of ulterior motive would lead to a finding of bad faith, the 2nd Circuit cited a 1936 case, Texas Hotel Securities Corp. v. Waco Development Co., 87 F.2d 395 (5th Cir. 1936), as an example of where the creditor's ulterior motive supported a finding of bad faith. In that case, Conrad Hilton purchased claims against a debtor to block a plan of reorganization that would have given a lease on the debtor's property — once held by Hilton's company — to a third party. Id. at 397– 99. Hilton and his partners sought, by buying and voting the claims, to force a plan that would give them again the operation of the hotel or otherwise reestablish an interest that they felt they justly had in the property. Id. at 398. The district court refused to count Hilton's vote, but the court of appeals reversed, seeing no authority in the Bankruptcy Act for looking into the motives of creditors voting against a plan. Id. at 400.

The Texas Hotel Securities case prompted Congress to require good faith in connection with voting claims. As the Supreme Court noted, the legislative history of the predecessor to § 1126(e) "make[s] clear the purpose of the [House] Committee [on the Judiciary] to pass legislation which would bar creditors from a vote who were prompted by such a purpose" as Hilton's. Young 324 U.S. at 211 n. 10. Following the Texas Hotel Securities case, modern cases have designated creditor votes as having been cast in bad faith in a number of circumstances, but a central theme is an effort by a creditor to purchase claims in order to gain or maintain control over the debtor's assets rather than to protect their interest as a creditor. In In re Allegheny Int'l, Inc., 118 B.R. 282, 289–90 (Bankr. W.D. Pa. 1990), a court found bad faith because a party bought a blocking position in several classes after the debtor proposed a plan of reorganization, and then sought to defeat that plan and to promote its own plan that would have given it control over the debtor. In In re MacLeod Co., 63 B.R. 654, 655–56 (Bankr .S.D. Ohio 1986), the court designated the votes of parties affiliated with a competitor who bought their claims in an attempt to obstruct the debtor's reorganization and thereby to further the interests of their own business. In In re Applegate Prop., Ltd., 133 B.R. 827, 833–35 (Bankr. W.D. Tex. 1991), the court found bad faith where an affiliate of the debtor purchased claims not for the purpose of collecting on those claims but to prevent confirmation of a competing plan.

In the DBSD case, the 2nd Circuit found that DISH's conduct fit within the pattern of conduct that constituted a lack of good faith in voting under section 1126(e). "In effect, DISH purchased the claims as votes it could use as levers to bend the bankruptcy process toward its own strategic objective of acquiring DBSD's spectrum rights, not toward protecting its claim." In re DBSD, 643 F.3d at 102. The 2nd Circuit rejected the arguments put forth by the Loan Syndications and Trading Association and DISH that the court's holding would deter future creditors looking for potential strategic transactions with Chapter 11 debtors from exploring such deals for fear of forfeiting their rights to vote their claims. The 2nd Circuit responded by stating that its decision should deter only attempts to obtain a blocking position in voting on a debtor's plan and thereby control the bankruptcy process in order to gain a strategic asset of the debtor. Id. at 105. The court declined in its decision to address the situation in which a preexisting creditor votes with strategic intentions. Id. The court further emphasized that its opinion imposes no categorical prohibition on purchasing claims with acquisitive or other strategic intentions. Id. The determination of whether a vote has been properly designated is a fact-intensive question that must be based on the totality of the circumstances, according considerable deference to the expertise of bankruptcy judges. Id.

Impact of DBSD On Strategic Transaction to Acquire a Debtor In Bankruptcy

The DBSD decision casts doubt on strategies to acquire a debtor or its strategic assets, block a proposed plan or control a bankruptcy case by purchasing claims. Such strategies will likely face a challenge from a disappointed debtor or other creditor that the investor's votes should be designated. Certainly, a competitor that purchases claims in a debtor's bankruptcy case will face a serious challenge to any vote that will block a debtor's plan. The 2nd Circuit's decision was buttressed by particularly bad facts. The court was clearly troubled by the fact that DISH acquired the claims and began to execute its strategy only after DBSD had proposed its plan. As the 2nd Circuit stated, under circumstances different than those set out in the DBSD case, the purchase of claims for acquisitive or other strategic purposes may be appropriate. For example, if DISH had acquired its claims early in the case, or in conjunction with the formulation of a plan after a debtor had lost exclusivity, would that have made the analysis different? What exactly the circumstances must be for the purchase of clams to be appropriate, however, is any one's guess as the court provided no further guidance.

Perhaps the bigger question left by the DBSD decision might be its impact on prepetition acquisition of claims and debt, especially in connection with a "loan to own" strategy. Will an investor that purchases claims or debt prior to a debtor's bankruptcy case run the risk of having the votes on its claims designated if it attempts to acquire the debtor or assert control over the debtor's assets? That question remains to be determined. Debtors and other disappointed creditors that oppose a prepetition creditor's efforts to gain control over a debtor through the voting process will likely try to extend the DBSD decision to prepetition purchases of claims. The DBSD decision will, at a minimum, give debtors and other creditors additional leverage in negotiating with strategic investors. Debtors and creditors could rely on DBSD as precedent to litigate the good faith of any plan proposed by such an investor and in an attempt to disqualify such an investor's vote against any other plan.

Still, the "loan to own" strategy has been a popular mechanism for investors to gain control over troubled companies. A prepetition agreement with the debtor may be critical in executing a loan to own strategy in bankruptcy so that the creditor can propose a plan or sale with the debtor's cooperation. Investors interested in acquiring a debtor in bankruptcy should consult with experienced bankruptcy counsel before embarking on such an acquisition.

LANDLORD WHO OBTAINS PREPETITION WARRANT OF EVICTION MAY BE BARRED FROM RECOVERING POST-PETITION RENT AS ADMINISTRATIVE EXPENSE

By Brian Morgan

A recent decision by the U.S. District Court for the Southern District of New York concluded that a landlord who obtains a judgment of possession and warrant of eviction prepetition, yet is stayed from executing on the warrant due to the debtor's bankruptcy filing, may not be entitled to post-petition rent as an administrative expense. In In re Association of Graphic Communications, Inc., No. 07- 10278 (Bankr. S.D.N.Y. July 13, 2010), the court decided that, under New York law, the prepetition warrant of eviction terminated the lease and annulled the landlord-tenant relationship, freeing the debtor from its obligation to pay post-petition rent pursuant to section 365(d)(3) of the Bankruptcy Code. The bankruptcy court's decision was subsequently affirmed by the district court. See In re Association of Graphic Communications, Inc., No. 10-6413, 2011 WL 1226372 (S.D.N.Y. Mar. 31, 2011).

In Graphic Communications, the debtor was a lessee under a lease of non-residential real property. In the summer of 2006, the debtor ceased its business operations and also stopped paying its rent. The landlord served a demand for rent and, when no rent was forthcoming, commenced a nonpayment proceeding against the debtor in state court. The state court entered a judgment of possession and warrant of eviction. The debtor filed a voluntary petition under Chapter 7 of the Bankruptcy Code one day later – just prior to the landlord executing on the warrant of eviction.

Approximately two months after the petition date, the landlord moved for relief from the automatic stay, so that it could conclude the eviction proceedings. The unopposed motion was granted by the bankruptcy court and a law enforcement officer executed on the warrant of eviction. Nearly two years after obtaining stay relief, the landlord filed a motion with the bankruptcy court seeking payment for post-petition rent as an administrative expense of the bankruptcy estate pursuant to section 365(d)(3) of the Bankruptcy Code. Section 365(d)(3) provides, in relevant part, that a "trustee shall timely perform all the obligations of the debtor ... arising from and after the order for relief under any unexpired lease of nonresidential real property, until such lease is assumed or rejected, notwithstanding section 503(b)(1) of this title." The bankruptcy court concluded that, by virtue of the issuance of warrant of eviction prepetition, the lease expired prior to the commencement of the bankruptcy. Accordingly, the bankruptcy court denied the landlord's claim for administrative rent.

According to the bankruptcy court, New York law is clear. The issuance of a warrant of eviction cancels a lease and terminates the landlord-tenant relationship. Accordingly, to the extent a warrant of eviction has been issued prepetition, there is no unexpired lease for a debtor to assume or reject, and thus no obligation to pay postpetition. The landlord, relying on opinions issued in the P.J. Clarke's Restaurant Corp. and Sweet N. Sour 7th Avenue Corp. cases, argued that the potential for reinstatement under state law renders a lease unexpired for purposes of section 365(d)(3) of the Bankruptcy Code. See In re P.J. Clarke's Restaurant Corp., 265 B.R. 392 (Bankr. S.D.N.Y. 2001); In re Sweet N Sour 7th Avenue Corp., 431 B.R. 63 (Bankr. S.D.N.Y. 2010).

In In re P.J. Clarke's, a state court issued a summary judgment order granting the landlord possession of the debtor's leased premises. Unlike the debtor in Graphic Communications, the debtor in P.J Clarke's filed a Chapter 11 petition before a judgment was entered and a warrant of eviction issued. The bankruptcy court found that, under New York law, the lease was not expired at the time of the bankruptcy filing and therefore the landlord was entitled to receive rent at the contract rate until the lease was assumed or rejected. The Graphic Communications court found P.J. Clarke's to be easily distinguishable because: (1) the warrant of eviction was not issued until after the petition date; (2) the debtor took affirmative steps to challenge the nonpayment proceeding; and (3) the debtor was attempting to reorganize and continue business operations on the leased premises.

In Sweet N Sour, as in Graphic Communications, a state court issued a warrant of eviction immediately prior to the debtor's bankruptcy filing. However, the debtor sought to assume the lease and opposed the landlord's motion for relief from the stay. The bankruptcy court conditioned the continuation of the automatic stay and the debtor's commencement of a proceeding in state court to vacate the warrant of eviction upon the debtor's continued payment of post-petition rent. The landlord in Graphic Communications directed the bankruptcy court's attention to the section of the decision in Sweet N Sour in which the court stated that "a lease may be considered unexpired for purposes of performing post-petition obligations pursuant to 365(d)(3) if it was terminated prior to the petition date but could be reinstated under state law." However, unlike the debtor in Sweet N Sour, the debtor in Graphic Communications did not contest the issuance of a prepetition warrant of eviction or the motion for relief from the stay, nor was the debtor seeking to assume the lease.

Both P.J. Clarke's and Sweet N Sour involved Chapter 11 debtors who, as part of their attempts to reorganize, sought to vacate the warrants of eviction and/or challenge the adverse judgments in the nonpayment proceedings. Moreover, the debtors in these cases continued to operate their businesses on the leased premises. In Graphic Communications, the debtor never sought to assume the lease, nor challenge the landlord's motion to lift the stay in order to proceed with the eviction. Therefore, while the bankruptcy court noted that "in certain circumstances, like those in P.J. Clarke's and Sweet N Sour, a debtor's obligations under section 365(d)(3) may remain in effect, despite a prepetition termination of the lease," the factual circumstances of Graphic Communications did not support such a finding. As the landlord-tenant relationship terminated prepetition and the debtor showed no desire to reinstate it, the landlord was not entitled to post-petition rent as an administrative expense.

As the case law demonstrates, landlords might avoid the harsh fate that befell the landlord in Graphic Communications if they act quickly at the commencement of the bankruptcy case. By waiting nearly two months from the petition date to move for relief from the automatic stay, the Graphic Communications landlord guaranteed that at least three months would pass before the premises could be re-let. A landlord who has obtained a warrant for eviction prior to the petition date would be well-advised to move for stay relief as soon as practically possible. Prompt action by a landlord may result in the landlord obtaining the debtor or trustee's consent to modification of the stay or an agreement to pay post-petition rent, while the trustee decides whether to challenge the state court judgment.

Alternatively, if the debtor remains in possession of the leased premises and desires to assume the lease, it appears that, under P.J. Clarke's and Sweet N Sour, a bankruptcy court might allow the debtor to challenge the warrant of eviction in exchange for the continued payment of rent. However, if the debtor has ceased business operations prior to filing for bankruptcy protection it is unlikely that the debtor will later move to assume the lease and the landlord should operate under the assumption that it will receive no additional rent from the debtor. In this situation, it is that important for a landlord to act quickly in order to protect its rights and consult with bankruptcy counsel.

CHALLENGING SECURED CREDITORS' LIENS IN FCC LICENSES

Kristin Going

Recently secured parties, including some indenture trustees, have found the priority, scope, validity and enforceability of seemingly properly perfected security interests in Federal Communications Commission ("FCC") licenses, authorizations and permits, and any proceeds or value derived therefrom, challenged by creditors in bankruptcy proceedings. Those challenging FCC liens have generally argued that an FCC licensee cannot grant a security interest in its license because the licensee does not have an underlying ownership right in the license and because the license is a public right to which no lien may attach, since it provides for use of the airwaves or spectrum. While parties with perfected first priority security interests have for the most part prevailed in these challenges, such litigation can nevertheless be time consuming and costly and may also carry some reputational risk for trustees.

The ION Media Networks Case

In the ION Media Networks, Inc. bankruptcy,6 Cyrus Select Opportunities Master Fund, Ltd. ("Cyrus"), a holder of second lien notes issued by the company prior to the bankruptcy filing, commenced an adversary proceeding against all the ION Media debtors, the administrative agent for the debtors' prepetition credit facility, the collateral agent under the security agreement and the trustees for the debtors' first priority senior secured notes and second priority senior secured notes. The lawsuit sought a declaratory judgment that the first lien lenders did not hold valid and enforceable security interests in the FCC licenses because such licenses could not be legitimately encumbered due to their special character as a federally sanctioned and regulated right to use the airwaves in the public interest. According to Cyrus, the FCC licenses were not – and could not be – collateral under the pledge and security agreement (and thus Cyrus was not improperly challenging the liens granted to the first lien lenders) and should therefore be available for pari passu distribution to creditors. Separately, Cyrus also objected to the debtors' DIP financing with the first priority secured lenders and to the debtors' proposed plan of reorganization. It is important to note that in purchasing second lien debt expressly subject to the terms of an intercreditor agreement, Cyrus had agreed not to raise or pursue any challenge or dispute regarding the validity of liens granted to the first lien lenders.

On Nov. 24, 2009, the bankruptcy court entered a Memorandum Decision finding that based on the restrictions in the intercreditor agreement Cyrus lacked standing to object to (1) the liens of the first lien lenders, (2) the priority of the first lien lenders' claims or (3) the plan. The bankruptcy court decision emphasized Cyrus' own breach of the intercreditor agreement and the fact that the intercreditor agreement established the relative priorities of the first priority secured parties and the second priority secured parties in respect of the collateral, even if the validity of the security interests granted in the collateral was uncertain. The court found that the security agreement's use of the phrase "purportedly securing" to describe the universe of liens granted by the debtors in favor of the secured parties evidenced the intent of the secured parties to establish their relative legal rights vis a vis each other, regardless of the ultimate validity of each individual right granted by the debtors and to insulate the first lien lenders' collateral package from attack by the second lien lenders. The court further stated that "[b]y virtue of the Intercreditor Agreement, the parties have allocated among themselves the economic value of the FCC Licenses as Collateral (regardless of the actual validity of liens in these licenses)." (emphasis added.) The court found that the intention of the parties to the intercreditor agreement to grant a security interest in the economic value of the FCC licenses to the first lien lenders was further evidenced by the utilization of special purpose subsidiaries to hold the FCC licenses, the concomitant pledge of the equity interests in each FCC License subsidiary to the secured parties and the intercreditor agreement's restrictions on actions by second lien lenders.

The court overruled Cyrus' objections to confirmation and confirmed the debtors' plan which allocated substantially all economic value to the first lien lenders, although the plan provided for the first lien lenders to receive far less than they were owed. The court found unconvincing Cyrus' arguments that it was not in violation of the intercreditor agreement in objecting to the debtors' plan because it was acting in the capacity of an unsecured creditor. The court also found that Cyrus' "willful" breaches of the intercreditor agreement and presumption of a right to act based on its "own untested" legal theories had resulted in a material and unjustified increase in administrative expenses in the debtors' cases. Cyrus appealed the bankruptcy court's confirmation order to the district court, but the district court has yet to rule on the appeal.

The TerreStar Networks Case

In the TerreStar Networks, Inc. case,7 the official committee of unsecured creditors (the "creditors committee") and a separate unsecured creditor ("Sprint"), challenged the liens granted to the indenture trustee and collateral agent for the company's senior secured payment-in-kind (PIK) notes. Unlike in the ION Media case, the parties challenging the liens granted by the debtors in the Terrestar FCC licenses were not subject to an intercreditor agreement, which allocates the economic value of the collateral and/or purported collateral, regardless of the validity of liens granted in the FCC licenses, among different classes of creditors. Nor did the challenging parties agree to refrain from disputing the validity of any liens granted in the FCC licenses.

In their separate complaints, the creditors' committee and Sprint both claimed that (1) federal law prohibits a licensee from granting a security interest in an FCC license and (2) the Bankruptcy Code and/or New York Uniform Commercial Code precludes any purported security interest granted pre-petition from attaching to proceeds or value acquired, derived or realized from the FCC licenses post-petition (so-called after-acquired proceeds). Sprint's complaint contained the additional claim that the indenture trustee's secured claim should be equitably subordinated to Sprint's unsecured claim because of the debtors' failure to reimburse Sprint for its alleged bandwidth-clearing expenses in accordance with an FCC ruling.

In response to the complaints, the indenture trustee argued that case law is nearly unanimous in upholding a debtor's private right to the profit generated from the sale of an FCC license – separate and distinct from the FCC's public right to approve the transfer of the license – and that a debtor may pledge the private property right as collateral for a loan. The indenture trustee also pointed out that the FCC itself has explained that permitting a security interest in the economic value of a license does not interfere with the FCC's statutory duty to approve every license applicant.8 In response to the claim that the indenture trustee's security interest did not attach to proceeds of the sale of an FCC license post-petition, the indenture trustee argued the courts have also been nearly unanimous in holding that a security interest in the right to proceeds of an FCC license should be considered a lien on a "general intangible" of the debtor that may be perfected prior to any sale of the license, and therefore, the proceeds of a post-petition sale of the license constitute proceeds of such intangible property. The indenture trustee further argued that a debtor acquires a general intangible when it acquires the right to pursue the intangible's economic value, not when the value materializes upon a future transfer.

In response to Sprint's claim for equitable subordination of the indenture trustee's secured claim, the indenture trustee argued that there was no evidence of any inequitable conduct on its part or by the noteholders that resulted in injury to the debtors or their creditors or that conferred an unfair advantage on the indenture trustee. The indenture trustee also noted that it was not a party to the FCC proceedings between TerreStar and Sprint and thus the FCC ruling, which explicitly stated that it was not an adjudication of the parties' claims, could have no preclusive effect upon the indenture trustee.

In their summary judgment briefs, both the plaintiffs and defendants in the TerreStar case discussed the recent decision by a bankruptcy court in the District of Colorado, In re Tracy Broadcasting.9 In that case, the court held that Section 552(a) of the Bankruptcy Code precluded a secured lender's lien on the proceeds of an FCC license because at the time of the bankruptcy filing the debtor did not have an agreement to sell the license and did not have the FCC's approval of a sale, thereby rendering the secured lender's interest in the proceeds of the license "too remote." But the defendants in the TerreStar case argued that Tracy was wrongly decided, among other reasons, because it ignores the well-settled distinction between public and private rights in an FCC license and appears to rely extensively on case law that pre-dates the addition to the uniform commercial code of general intangibles as securable assets.

An ad hoc group of holders of the debtors' senior secured PIK notes has been permitted to intervene in the TerreStar adversary proceeding and has filed briefs generally supporting the indenture trustee's position, including an opposition to the plaintiffs' motions for summary judgment.

The bankruptcy court has yet to rule on the summary judgment motions in the TerreStar adversary proceeding, and the debtors withdrew their proposed plan of reorganization, which would have distributed 97 percent of the new equity in the debtors to the holders of secured claims.

Conclusion

At a time when junior creditor interests are generally making aggressive challenges in bankruptcies and reorganizations to the liens of secured creditors, those secured creditors, including indenture trustees in some instances, will want to be cognizant of the fact that liens granted in and to FCC licenses, permits and authorizations may be subject to particular challenge because of the special character of those licenses, which include both the public's interest in regulating the airwaves and license holders' private property rights in the economic value of the proceeds of the license. While it appears the ION decision has established a precedent whereby a well written intercreditor agreement should defeat any challenge by a party to the intercreditor agreement, the Terrestar case still leaves the issue open when there is not an intercreditor agreement. As we await the Terrestar decision, perhaps the Terrestar ad hoc noteholders said it best in the summary judgment reply:

The issues presented... ultimately boil down to one simple question: will courts honor credit agreements pursuant to which money is lent to a borrower in exchange for a lien on the economic value of its FCC licenses? If the answer is 'yes,' then FCC licenses as collateral and the plethora of existing credit agreements that include such collateral grants are valid. If the answer is 'no,' then FCC licenses will be excluded from issuing secured debt backed by the economic value of their FCC licenses in the future and all existing credit agreements granting such interests are invalid.

Thus, indenture trustees should be prepared for the possibility that current deals in which an issuer has pledged an FCC license could default or need replacement collateral. Additionally, it may be beneficial for issuers and underwriters to include language regarding the risk of taking a security interest in a FCC license in future offering memorandum.

Footnotes

1 302 B.R. 808 (D. Del. 2003), aff 'd, 2004 WL 1510091 (3d Cir. 2004).

2 426 B.R. 106 (Bankr. D. Del. 2010).

3 435 B.R. 234 (Bankr. D. Del. 2010).

4 489 F. 3d (3d. Cir. 2007).

5 The Second Circuit found that the plan's proposal to distribute stock and warrants to DBSD's parent company on account of its ownership of stock in DBSD was a violation of the absolute priority rule codified in Bankruptcy Code Section 1128(b), even though such distribution was a "gift" from the holders of the Second Lien Debt, thus preventing confirmation of the DBSD plan. Ultimately, DISH was able to acquire the assets of DBSD at an auction held after the 2nd Circuit's ruling.

6 In re ION Media Networks, Inc., et al., Case No. 09-13125-JMP (S.D.N.Y.).

7 Adversary Proceeding 10-A-05461 (SHL) Sprint Nextel Corporation, et al. v. U.S. Bank National Association, et al. (In re TerreStar Networks, Inc., et al.).

8 Cf. In re Cheskey, 9 F.C.C.R. 986 (1994).

9 438 B.R. 323 (Bankr. D. Colo. 2010).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.