Source: https://www.bankruptcylawinsights.com/
Timestamp: 2019-04-21 14:35:59+00:00

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Southeastern Grocers (operator of the Winn-Dixie, Bi Lo and Harvey’s supermarket chains) recently completed a successful restructuring of its balance sheet through a “prepackaged” chapter 11 case in the District of Delaware. As part of the deal with the holders of its unsecured bonds, the company agreed that under the plan of reorganization it would pay in cash the fees and expenses of the trustee for the indenture under which the unsecured bonds were issued. In an important ruling for indenture trustees, Judge Mary Walrath approved the plan and rejected a challenge to the payment, a decision that will help to blunt some of the uncertainty which has arisen around this issue. (Kelley Drye & Warren LLP represented the indenture trustee in this matter).
Payment by a debtor of an indenture trustee’s fees and expenses in cash is a significant business point in cases such as Southeastern Grocers, where bonds typically are surrendered in exchange for new common stock. Otherwise, the indenture trustee must recover its fees and expenses out of the distribution to the bondholders under a priority provision in the indenture known as the “charging lien.” Exercising the charging lien against newly-issued shares and then monetizing such shares can be a difficult and time consuming process, particularly where the new shares are not intended to be publicly traded. This reduces the bondholders’ recovery and delays the debtor’s emergence from chapter 11.
Under the Southeastern Grocers plan, the unsecured bondholders were the only impaired creditor class, and voted unanimously in favor. The office of the United States Trustee (“UST”) in Delaware nevertheless filed an objection to plan confirmation. It contended, among other issues, that payment of the indenture trustee’s fees and expenses contravened section 503(b) of the Bankruptcy Code. The objection by the UST (a representative of the U.S. Department of Justice that serves a watchdog function in large bankruptcy cases) in Southeastern Grocers is consistent with the stance USTs have been taking against the payment of indenture trustees’ fees and expenses in districts across the country.
The UST’s objection was that section 503(b) provides the only basis upon which the fees and expenses of an indenture trustee and other parties in interest can be paid in a chapter 11 case. Under that section, payments are permissible only upon a showing of “substantial contribution” in the case, a difficult standard to meet. Courts have held that the type of actions that satisfy the “substantial contribution” test is “exceedingly narrow,” and, among other things, the party seeking such payment must demonstrate that it was not merely protecting its own interests but that its actions were for the benefit of all parties.
Because the “substantial contribution” standard is so difficult to satisfy, the key issue is whether subsection 503(b)(3)(D) in fact provides the sole authority under the Bankruptcy Code for such payments.
In Southeastern Grocers, the debtor, the indenture trustee and the bondholders responded to the UST’s objection by arguing, as some courts have held, that subsection 503(b)(3)(D) is simply the means by which an indenture trustee or other party in interest can compel payment of its fees and expenses, and that there is nothing in that subsection which in any way prevents a debtor from agreeing to pay such fees and expenses as part of a settlement. Further, those courts have pointed out that section 1123(b)(6) of the Bankruptcy Code, which states that a plan of reorganization may include “any . . . appropriate provision not inconsistent with the applicable provisions of this title[,]” provides a bankruptcy court with a “broad grant of authority” to permit the payment of an indenture trustee’s reasonable fees and expenses without the need to find compliance with section 503(b).
[Section] 503(b)(3)(D) is not the only way where such expenses can be approved and paid in a case. And I think it is perfectly appropriate to agree . . . to the payment of those expenses without the necessity of a court having to approve them after the fact in order to get the parties to come to the table and negotiate [a] successful reorganization . . . I think that the fact that [Southeastern Grocers] agreed to that . . . was perfectly appropriate, and that there is no necessity that I review those expenses or otherwise interfere with that agreement.
This is a favorable decision for indenture trustees and parties to negotiated settlements to cite in future cases as persuasive authority. Judge Walrath is a highly regarded jurist, and her summary rejection of the UST position and express statement that section 503(b)(3)(D) is not the only basis for payment of an indenture trustee’s fees and expenses should carry weight with other judges in Delaware and in other districts.
The Supreme Court recently heard arguments in a patent dispute case, Oil States Energy Services, LLC v. Greene’s Energy Group, LLC. Although the case has nothing to do with bankruptcy law, its outcome could have a substantial impact on bankruptcy practice and litigation. Oil States Energy concerns the limits of Congress’s ability to create courts pursuant to Article I of the Constitution rather than under Article III, and therefore raises separation of power issues similar to those considered by the Court in Stern v. Marshall, its 2011 decision limiting the authority of U.S. bankruptcy courts.
The facts of Oil States are straight-forward. Oil States Energy sued Greene’s Energy Group for patent infringement. Greene’s Energy responded by commencing a procedure known as “inter partes review”, an administrative process that permits parties to seek review by the Patent and Trademark Office (PTO) of patent grants. Under this process, an administrative board within the PTO can invalidate the issuance of a patent, subject to appeal and review by the U.S. Court of Appeals for the Federal Circuit. When the PTO board found for Greene’s Energy in this instance and held the patent grant to Oils States Energy to be invalid, Oil States Energy challenged its constitutionality, contending, among other things, that Congress had impermissibly vested Article III “judicial power” in an Article I forum.
The Supreme Court has been wrestling with the limits of the constitutional authority of Article I courts off and on for well over a century. A line of cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public” rights (e.g., cases involving claims of citizens against the government). Claims of citizens against one another typically are “private rights” that must be heard by an Article III judge.
With respect to bankruptcy courts, the common understanding has been that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power” under Article I, Section 8, constitutes a type of “public right” which can be heard and decided by an Article I bankruptcy judge. The Court has never expressly held this, however, or handed down a clear ruling as to where the line between “public rights” and “private rights” should be drawn in bankruptcy proceedings. Although in some recent cases involving non-bankruptcy Article I tribunals the Court has taken an expansive and pragmatic view of the “public rights” doctrine, in Stern the Court adopted a more constricted approach. It ruled that although an Article I bankruptcy judge could appropriately enter a final order regarding a creditor’s claim against a bankruptcy estate, a common law tort claim held by the bankruptcy estate against the same creditor nevertheless constituted a “private right” if it was not related to the initial claim against the estate, and that it was therefore unconstitutional for Congress to have authorized a non-Article III court to render a final determination on it.
As the Court in Stern candidly noted, “the distinction between public and private rights – at least as framed by some of our recent cases – fails to provide concrete guidance[.]” Stern did nothing to clarify this problem, and bankruptcy practitioners and judges have struggled since the opinion was handed down to understand the limits it placed on bankruptcy court authority.
Both bankruptcy and patent law fall squarely within the scope of Congress’s power under Article I, Section 8, and in both instances Congress has created specialized forums in an effort to allow parties to address issues which are not susceptible to efficient disposition in Article III courts. Accordingly, any ruling that the Court makes in Oil States on the distinction between “public rights” and “private rights,” and on the limits of the authority of courts created under Article I, is almost certain to have a significant impact on U.S. bankruptcy courts.
In December 2015, U.S. Bankruptcy Court Judge Laurie Silverstein of the District of Delaware confirmed a plan of reorganization in the Millennium Lab Holdings chapter 11 case that included the non-consensual release of certain claims against various non-debtor third parties. Earlier this year, ruling on an appeal from that decision, U.S. District Court Judge Leonard Stark remanded the case to Judge Silverstein and directed her to consider whether the grant of the releases exceeded her constitutional power as an Article I judge, in view of the issues raised by the U.S. Supreme Court in its 2011 decision in Stern v. Marshall.
Judge Silverstein recently issued a comprehensive opinion in which she determined that her confirmation of the plan was constitutional and did not contravene Stern. Her analysis brings much-needed clarity to what has been a muddled discussion. Her unstated premise – that a viable specialized court system is necessary to address matters of bankruptcy, and that Congress unquestionably has the power under Article I to create such forums – offers a pathway out of the uncertainty created by Stern over the constitutional power of the U.S. bankruptcy courts.
The Supreme Court in Stern raised long dormant separation of power concerns. Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III. Congress, however, established the U.S. bankruptcy courts in their current form in 1978 pursuant to its bankruptcy power under Article I. A line of Supreme Court cases has limited the authority of courts created by Congress pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (i.e., cases involving claims of citizens against the government). Claims of citizens against one another under state law, such as for breach of contract or common torts, are “private rights” that must be heard by an Article III judge.
The Court, in the 1982 Northern Pipeline case, invalidated the 1978 grant of jurisdiction to the bankruptcy courts, ruling that Congress had impermissibly vested Article III “judicial power” in Article I courts by allowing a bankruptcy court to hear and rule on a debtor’s breach of contract claim against another party, a “private rights” dispute. It did, however, provide some guidance to Congress by suggesting that disputes pertaining to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constituted a type of “public right” which could be heard and decided by an Article I bankruptcy judge. Congress responded with a new grant of jurisdictional power providing that bankruptcy courts could issue final orders with respect to a variety of enumerated “core” matters intended to implicate only such “public rights,” but that with respect to “non-core” matters affecting “private rights,” a bankruptcy court could only submit proposed findings of fact and conclusions of law, and requiring that a final order on such matters be entered by an Article III district court following a full review.
The constitutionality of the “core” – “non-core” dichotomy appeared to have been long-settled by 2011, as in cases involving other Article I tribunals the Court took an expansive view of the “public rights” doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters. So it took most bankruptcy practitioners and commentators by surprise when, in Stern, the Court held that Congress had again improperly granted authority to bankruptcy courts to make certain final rulings. Stern ruled that Congress could not designate a debtor’s counterclaim against a creditor as a “core” matter if the counterclaim would not be resolved as part of the same process whereby the creditor’s claim against the debtor’s bankruptcy estate was determined. The Court in Stern ruled that it would be unconstitutional for the counterclaim in that case, a tort action under Texas state law, to be decided by an Article I bankruptcy judge. In the Court’s view, if the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling.
The problem with this reasoning is that the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy are usually determined by state law. State law issues accordingly are intertwined with most “core” matters. Although the Court in Stern characterized its ruling as “narrow,” its formulation of the issue suggested that “core” matters could often implicate “private rights.” By opening up issues of bankruptcy court power regarding “core” matters to constitutional challenge, the Court created ongoing confusion regarding the extent to which U.S. bankruptcy judges can issue final rulings, which in turn has caused uncertainty in the administration of bankruptcy cases.
In Millennium Lab Holdings, the debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests. The plan confirmed by Judge Silverstein in 2015 embodied a compromise, whereby the equity holders were to pay $325 million in exchange for a release of all claims against them held either by the debtor’s estate or directly by third parties. Certain of the debtor’s lenders commenced litigation against the equity holders in federal district court, and objected to the releases in the plan that would preclude their claims. Judge Silverstein overruled the objections. She held that the non-consensual releases met the required standards under Third Circuit precedents and could be approved in connection with the confirmation of a plan of reorganization.
The constitutional issues were raised for the first time on appeal. The lenders contended that under Stern the releases were tantamount to resolving a “private rights” dispute between two non-debtor parties, and that Judge Silverstein therefore lacked constitutional authority to enter a final order resolving it. Judge Stark agreed that the lenders were entitled to Article III adjudication of their claims, but determined that the issue had not been properly presented to Judge Silverstein, and remanded the case so that she could make the determination in the first instance.
In her ruling, Judge Silverstein noted first the Supreme Court’s own admonition in Stern that it was intended to be a narrow opinion, and that its actual outcome “tread little new ground” beyond Northern Pipeline. She then looked closely at the interpretations applied to Stern by various courts since its issuance. Some bankruptcy judges have applied what she characterized as a “Narrow Interpretation,” limiting Stern to similar circumstances involving state law counterclaims against creditors that are not resolvable in the process of ruling on the creditor’s claims against the debtor. Other bankruptcy judges have put forward a “Broad Interpretation” of Stern, holding that it may apply to any state law or common law cause of action commenced by a debtor or trustee against a creditor or other party. Under what she describes as the “Broadest Interpretation,” bankruptcy judges have questioned their ability to enter final orders in other enumerated “core” proceedings.
The lenders argued that Stern did not permit Judge Silverstein to enter a final order confirming a plan of reorganization that would interfere with their causes of action against the debtor’s equity holders. She rejected the lenders’ argument as “inverse” and “backward” reasoning: “[I]t examines the legal consequence of the confirmation order to find fault with the entry of the order, rather than examining the propriety of issuing the confirmation order in the first instance.” She determined instead that an Article I judge should not step aside from issuing a ruling on a “core” matter simply because third parties’ rights under state or common law would be affected.
Adopting the interpretation of Stern urged by the lenders, she observed, would effectively end the viability of the U.S. bankruptcy court system, and require substantially greater involvement by Article III district court judges in bankruptcy matters – an outcome directly at odds with the Supreme Court’s stated intention in Stern that its ruling would not “meaningfully change the division of labor” between bankruptcy and district courts. She noted several types of orders commonly entered by bankruptcy judges which, under the lenders’ reading of Stern, would instead need to be entered by Article III judges due to their possible impact on the rights of non-debtors under state law. These would include orders approving sales of assets free and clear of successor liability claims under Section 363 of the Bankruptcy Code, rulings on substantive consolidation, and determinations regarding the recharacterization or subordination of debts.
Judge Silverstein tangentially alluded to the real problem raised by Stern – that by failing to articulate clearly the importance of federal bankruptcy law and a specialized bankruptcy court system as “public rights,” the Court allowed Stern to become fodder for “gamesmanship by both debtors and creditors in the bankruptcy context.” Citing a recent Third Circuit ruling, In re Linear Electric Company, Inc., she expressly held “core” matters under the Bankruptcy Code to be “public rights.” As such, it fell directly within her power as an Article I bankruptcy judge to confirm the Millennium Lab Holdings plan. In Judge Silverstein’s view, “[t]here is no question [that] if the proper standard is met, a bankruptcy judge may enter a final order in a core matter that impacts or even precludes a state law action between two non-debtors.” The preclusive effect of a ruling on the “private rights” of a non-debtor party might be an argument for a bankruptcy court to consider in weighing the merits of the releases themselves, but it could not limit the constitutional authority of a U.S. bankruptcy judge to make such a ruling.
In articulating the limits of Stern under any of its plausible interpretations, Judge Silverstein has provided guidance that can and should be followed by other courts towards viewing “core” matters as “public rights” squarely within the constitutional authority of an Article I court. The key factor in resolving questions of bankruptcy court constitutional authority should be the nexus of any particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights under state law are affected. Placing the focus on the “public” side of the public/private rights dichotomy can provide a path away from the confusion engendered by Stern, and restore the proper balance of U.S. bankruptcy courts’ constitutional power.
The Supreme Court two years ago ruled in Baker Botts v. Asarco that bankruptcy professionals entitled to compensation from a debtor’s bankruptcy estate had no statutory right to be compensated for time spent defending against objections to their fee applications. Since then, “estate professionals,” i.e., those retained in a bankruptcy case by a trustee, debtor in possession or an official committee of creditors, have sought ways to limit the potentially harsh impact of that decision. A subsequent opinion in a Delaware bankruptcy case, In re Boomerang Tube, declined to allow Baker Botts to be circumvented by contract. However, decisions in another Delaware case, Nortel Networks, and more recently in a New Mexico case, Hungry Horse LLC, have distinguished Boomerang Tube and permitted contractual provisions that allow payment for the defense of fees. The pragmatic approach taken in Hungry Horse in particular offers a template that other courts will likely be urged to adopt.
In every bankruptcy case, the retention of estate professionals must be approved by the bankruptcy court. Their fees and expenses are paid out of the debtor’s bankruptcy estate and are subject to review and approval by the bankruptcy court pursuant to Section 330 of the Bankruptcy Code. Objections from other parties have always been a recognized hazard for such professionals. Prior to Baker Botts a majority of courts permitted the recovery of fees incurred in defending against such challenges.
The Court’s analysis in Baker Botts was straight-forward. Under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees unless there is an applicable statute or agreement that provides otherwise. Section 330(a)(1) of the Bankruptcy Code states: “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services[.]” The Court ruled that the plain text of Section 330(a) does not support a deviation from the “American Rule” regarding attorneys’ fees. The Court’s majority stated, “[t]he word ‘services’ ordinarily refers to ‘labor performed for another.’” Since Baker Botts was litigating to defend its own fees, the Court reasoned that it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitled to compensation for such time.
Baker Botts makes clear that the Bankruptcy Code does not provide a statutory exception to the American Rule. The question remaining is whether estate professionals can sidestep it by contract.
In Boomerang Tube, Judge Mary Walrath answered that question in the negative. The law firm chosen in that case to represent the official committee of unsecured creditors, in its application to the bankruptcy court, asked for the approval order to include a provision that would entitle it to be compensated from Boomerang Tube’s bankruptcy estate for fees incurred in defending its fees against any challenges. The firm pointed to Section 328 of the Bankruptcy Code, which allows for the retention of estate professionals “on any reasonable terms and conditions.” It argued that the Supreme Court in Baker Botts had noted that parties could and regularly did contract around the American Rule.
Judge Walrath denied the request. She first held that Section 328 does not create a statutory exception to the American Rule, as it makes no mention of awarding fees or costs in the context of an adversarial proceeding. She observed in contrast that several discrete Bankruptcy Code provisions do contain express language providing for payment of fees to a prevailing party. She next rejected the law firm’s argument that Section 328 permitted a contractual agreement for the payment of defense fees. The retention agreement was between the law firm and the official creditors’ committee, but it would be Boomerang Tube’s bankruptcy estate, a non-party to such agreement, that would bear the costs. Finally, she determined that the proposed fee shifting provisions were simply not “reasonable” terms of employment of professionals with the meaning of Section 328.
In view of the extent to which challenges to estate professionals’ fees (or at least the threat of doing so) are ingrained in chapter 11 practice, it was unlikely that Boomerang Tube would be the last word on this issue. Recent decisions in two cases, Nortel Networks and Hungry Horse, have distinguished Boomerang Tube.
Judge Kevin Gross, a Delaware colleague of Judge Walrath, ruled in Nortel Networks that Baker Botts and Boomerang Tube did not apply to a fee dispute between an indenture trustee and certain bondholders, and permitted the trustee to recover its attorneys’ fees for defending against the challenge. Although this case is not directly on point as it did not involve an estate professional, and Judge Gross was not opining on whether Section 328 would permit such an agreement, he held that the bond indenture qualified as a contractual exception to the American Rule, noting that, unlike the retention agreement in Boomerang Tube, it was an agreement directly between the debtor and the trustee.
In Hungry Horse New Mexico Bankruptcy Judge David Thuma looked to Nortel Networks for support in holding that a retention agreement in a chapter 11 case between proposed debtor’s counsel and the debtor could pass muster under Section 328, thereby permitting a contractual work-around to Baker Botts. Judge Thuma first determined that nothing in Baker Botts prevented a bankruptcy court from finding a fee defense provision in a retention agreement to be “reasonable” within the meaning of Section 328. In his reading of Baker Botts, the Court simply limited the compensation an estate professional could receive under Section 330 to fees for services to the client, rather than on its own behalf, and noted that Section 328 had no applicability to that issue.
Fee Defense. The Client agrees to pay all reasonable legal fees and expenses incurred by the Firm, and also by any counsel retained by the unsecured creditors’ committee (if one is formed in the Client’s bankruptcy case) for successfully defending their respective fee applications. The bankruptcy court must approve all of such fees as reasonable. The Client will have no obligation to pay for any fees or expenses the Firm incurs defending fees that are not allowed.
Disputes over payment of estate professionals’ fees will invariably remain part of the bankruptcy landscape. Estate professionals in chapter 11 cases are likely to ask bankruptcy judges in other jurisdictions to follow the pragmatic approach of Judge Thuma in Hungry Horse in order to blunt the detrimental impact of Baker Botts.
The Supreme Court recently granted certiorari in PEM Entities LLC v. Levin, in which it will decide whether federal or a state law should apply when a debt claim held by a debtor’s insider is sought to be recharacterized in bankruptcy as a capital contribution and treated as equity. The case raises important questions about the extent to which the commencement of a proceeding under the U.S. Bankruptcy Code can and should affect parties’ rights and interests as they exist under non-bankruptcy law. For this reason alone, the impact of PEM Entities is likely to be significant.
It is also possible that it could lead the Court more broadly to consider the scope of Congress’s bankruptcy power. In such event, PEM Entities potentially could provide the Court with a coherent rationale to start resolving the uncertainty it created six years ago in Stern v. Marshall regarding the constitutional authority of bankruptcy courts.
The facts of PEM Entities are straightforward. A group of investors created an investment vehicle, Province Grande Olde Liberty, LLC (“Province”), in order to acquire real estate in North Carolina for the purpose of developing a golf course and surrounding homes. Province obtained a bank loan of approximately $6.5 million, secured by the real estate itself, and received a separate, unsecured loan in the amount of $188,000 from an investment fund, Lakebound Fixed Return Fund LLC (“Lakebound”).
When the secured loan went into default and the bank threatened to foreclose, certain of Province’s investors formed PEM Entities LLC, and purchased the secured loan from the bank for approximately $1.24 million. The development efforts ultimately failed, however, and Province filed for protection under chapter 11 of the Bankruptcy Code. When PEM sought to enforce its rights as a secured creditor under the purchased bank loan, certain investors in Lakebound brought an action to have the claim recharacterized as equity, and thus subordinate to Lakebound’s unsecured claim.
The bankruptcy court ruled in favor of the Lakebound investors, applying a federal standard for recharacterization in bankruptcy cases that is broader than the test that would have applied had it looked to applicable (North Carolina) state law. Under North Carolina law, the form of the transaction would probably have determined the outcome and, since PEM had purchased a loan made by a third party, PEM would have been able to enforce its rights as a secured creditor. Under the federal test, adapted from decisions in tax cases, courts look beyond the form of the transaction to consider whether, in essence, the money at issue was invested for the purpose of being repaid with interest at an established date, or instead was a bet on the ultimate success of the venture. The bankruptcy court, among other things, determined that when PEM acquired the bank loan, Province would not have been able to obtain financing from a non-affiliated third party, and that the PEM investors were mainly motivated to salvage their initial investment in Province.
The bankruptcy court’s ruling was affirmed on appeal by both the district court and the U.S. Court of Appeals for the Fourth Circuit, both of which similarly applied the federal standard. The Supreme Court granted certiorari in order to resolve a split among circuits as to whether federal or state law governs debt recharacterization.
PEM will argue that debt recharacterization is essentially a form of claim disallowance and is therefore governed by the plain language of section 502(b) of the Bankruptcy Code. That section provides that claims filed against a bankruptcy estate are allowed unless the “claim is unenforceable . . . under applicable law[.]” Since under North Carolina state law, the “applicable law” in this circumstance, the debt would not be subject to recharacterization, PEM will contend that its secured claim must be allowed. PEM will also point to the Court’s decision in Butner v. United States, in which the Court expressly held that property rights in bankruptcy are determined by applicable state law unless “some federal interest” requires otherwise.
The Lakebound investors will counter that the equitable power of bankruptcy courts allows for the rejection of form over substance, and that the majority of circuit courts which have considered the issue have found that bankruptcy courts have the authority to recharacterize debt under section 105(a) of the Bankruptcy Code, which provides that bankruptcy courts “may issue any order, process, or judgment that is necessary or appropriate to carry out the provisions of this title.” They will argue that recharacterization by bankruptcy courts is an essential part of maintaining the Bankruptcy Code’s priority scheme, and that using the federal test is well within the “appropriate” means of section 105(a).
In its petition for Supreme Court review, PEM described the question as a split among federal courts of appeal as to “whether (a) the doctrine [of recharacterization] is part of some general power of bankruptcy administration or (b) the existing obligations of the debtor based on the law of the [fifty] states.” (emphasis added). This description could apply equally to numerous other provisions of the U.S. Bankruptcy Code, which in essence constitutes a federal law structure overlaying substantive rights between private parties which are governed by applicable state law. Bankruptcy judges must often determine whether “some federal interest,” mandates a different outcome for the parties under the Bankruptcy Code than under state law.
The Court will probably rule on this question narrowly in PEM Entities and limit it to the issue of debt recharacterization. However, it is intriguing to consider where a broader ruling on the extent of “some general power of bankruptcy administration” could lead. In particular, it could provide the Court with a pathway out of the constitutional maze it created a few years ago in Stern v. Marshall regarding bankruptcy court authority.
In Stern, the Court disrupted a long standing delicate constitutional balance between the need for an effective system of specialized courts existing pursuant to Congress’s bankruptcy power under Article I, Section 8, and the vesting of the judicial power of the United States in the federal courts under Article III. Since the Court in cases going back to the nineteenth century had limited the final decisional authority of Article I courts to cases involving “public” rights (e.g., cases involving claims of citizens against the government), the ability of bankruptcy courts to hear and determine cases under the Bankruptcy Code was predicated on the notion that “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted a type of “public” right which could be heard and decided by an Article I bankruptcy judge.
Stern has created a constitutional quandary. Since (per Butner) parties’ rights in bankruptcy are usually based on state law, “core” matters will often implicate “private” rights. The ability of bankruptcy judges to rule on fundamental matters such as determining whether certain property belongs to a bankruptcy estate has been questioned because they are governed by state law. Although Stern’s quandary has been narrowed somewhat by subsequent Court decisions, it continues to cause confusion and uncertainty in the adjudication of bankruptcy cases.
The constitutional authority questions arising from Stern and the decisional law question of PEM Entities are very different. However, if the Court in PEM Entities were to issue a ruling broadly focused on the scope of “the general power of bankruptcy administration” as a “federal interest” requiring the application of federal law to the question of debt recharacterization, it could lead to a viable view of such power as a “public” right. This in turn could allow courts to make the key constitutional factor in resolving questions of bankruptcy court authority to be the nexus of a particular dispute to “the restructuring of debtor-creditor relations,” instead of whether parties’ rights would separately exist under state law. Such a focus on the “public” side of the public/private rights dichotomy could provide a path away from the confusion engendered by Stern, and restore the constitutional balance of bankruptcy court authority.
In Millennium Lab Holdings, Delaware District Court Judge Leonard Stark, on an appeal from a bankruptcy court order confirming a plan of reorganization, recently upheld a challenge to the bankruptcy court’s constitutional authority to release claims against non-debtor third parties under the plan. Judge Stark’s opinion demonstrates the extent to which the constitutional questions raised by the Supreme Court six years ago in Stern v. Marshall continue to cast a shadow over the adjudication of bankruptcy cases.
In Stern, the Supreme Court raised separation of powers concerns regarding the authority of United States bankruptcy courts that had long been viewed as settled. Congress established the U.S. bankruptcy courts pursuant to its power to establish uniform laws on bankruptcy under Article I of the Constitution, rather than under Article III. A line of Supreme Court cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public” rights (e.g., cases involving claims of citizens against the government). Although claims of citizens against one another typically are “private” rights that must be heard by an Article III judge, the common understanding regarding bankruptcy courts is that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” (emphasis added) constitute a type of “public” right which can be heard and decided by an Article I bankruptcy judge.
Prior to Stern, the statute passed by Congress in 1984 conferring jurisdiction on Article I bankruptcy courts was viewed as having established the appropriate constitutional limits of such courts. Section 157 of title 28 of the United States Code provides that bankruptcy courts can issue final orders with respect to a variety of enumerated “core” matters, but that with respect to “non-core” matters, a bankruptcy court can only submit proposed findings of fact and conclusions of law, and that a final order on such matters must be entered by an Article III district court following a full, or “de novo,” review. Although the Court never ruled on the constitutionality of the “core” and “non-core” bankruptcy jurisdictional construct, in other cases involving Article I tribunals the Court took an expansive and pragmatic view of the “public” rights doctrine, one that had appeared to be sufficiently broad to encompass the list of “core” bankruptcy matters set forth in the statute.
In Stern, however, the Court adopted a more constricted view of “public” rights. It held that a matter listed as “core” under the statute, a debtor’s counterclaim against a creditor, nevertheless constituted a “private” right if it was not related to the creditor’s claim against the bankruptcy estate. The Court ruled that it was therefore unconstitutional for Congress, by designating such counterclaims as “core” matters, to authorize a non-Article III court to render a final determination on them.
Stern, by making clear that bankruptcy court rulings regarding “core” matters could be subject to constitutional challenge, has created continuing uncertainty regarding the extent to which bankruptcy courts can issue final rulings. The problem engendered by the ruling in Stern is this: the Court described the query for constitutional purposes as “whether the action at issue stems from the bankruptcy itself [i.e., Congress’s bankruptcy power under Article I].” If the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling. Stern’s conundrum is that although the list of matters under 28 U.S.C. Section 157, such as ruling on claims against the bankruptcy estate or on the turnover of property to the estate, go to the “core” of “restructuring debtor-creditor relations,” the Supreme Court has expressly stated in other cases that parties’ rights in bankruptcy, such as for breach of contract or regarding title to property, are based on state law. State law issues accordingly are intertwined with most “core” matters. For purposes of ascertaining a bankruptcy court’s constitutional authority, which aspect of such adjudications should control?
Two follow-up Supreme Court cases and numerous lower court opinions have failed to clarify the questions raised by Stern regarding the constitutional limits of bankruptcy court authority. Millennium Lab Holdings is the latest case to demonstrate the extent to which the ambiguity of Stern remains unresolved.
The facts of Millennium Lab Holdings are complicated, but the issues faced by Judge Stark on appeal were fairly straight-forward. Among them was whether the plan of reorganization could release the debtor’s insiders from claims of third parties absent such parties’ consent. The debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests, and were named by certain of the debtor’s lenders as defendants in an action brought outside of the bankruptcy court. Under the plan, the equity holders were to pay $325 million in exchange for a release of all claims held either by the debtor’s estate or directly by third parties such as the lenders.
The question of whether a bankruptcy court has statutory authority and subject matter jurisdiction to enjoin and release claims non-consensually against non-debtors has long been unclear, and some courts have ruled that bankruptcy courts have no power at all to resolve disputes between non-debtor parties. Other courts, however, relying on the general equitable power provided under section 105 of the Bankruptcy Code, and the jurisdictional authority to hear proceedings “related to” a debtor’s case, have granted such releases. Judge Laurie Silverstein, the bankruptcy judge in Millennium Lab Holdings, determined that non-consensual third party releases could be approved if necessary in connection with the confirmation of a plan of reorganization and where basic standards of fairness were satisfied.
The lenders argued on appeal that, regardless of whether the bankruptcy court had statutory and jurisdictional power, under Stern the releases were tantamount to resolving a “private” rights dispute between two non-debtor parties, and that the bankruptcy court therefore lacked constitutional authority to enter a final order resolving it. Judge Stark agreed that constitutional authority had to be shown. He rejected the debtor’s response that the releases could resolved by the bankruptcy court because they were a key component of the confirmation of the debtor’s plan of reorganization, which in turn could be viewed as a “public” right. “Appellants appear to be entitled to Article III adjudication of these claims, and Stern dictates that no final order could be entered on such claims by an Article I court barring consent of the parties (which has not been provided here).” He concluded, however, that the issue had not been properly presented or considered by the bankruptcy court, and remanded the case to Judge Silverstein so that she could make the determination in the first instance.
Judge Stark’s opinion in Millennium Lab Holdings highlights the ongoing uncertainty created by Stern. “Core” matters invariably implicate “private” rights of parties under state law. The Supreme Court at some point will need to address directly how Article I bankruptcy courts can fit within the scope of the “public” rights doctrine. Until the Court resolves this ambiguity, which may require a strict limitation or even overturning of Stern, challenges to bankruptcy courts’ constitutional authority will continue.
Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware handed down an important ruling last week that turned aside most of an unusual challenge to the fees and expenses of an indenture trustee in the long-running Nortel chapter 11 case. The dispute has been watched closely by financial institutions that serve as trustees on bond issuances. (Kelley Drye & Warren LLP represented a large creditor in the Nortel case but took no part in the issues discussed here).
The dispute that arose in Nortel between one of the indenture trustees and its noteholders stemmed from the extraordinary length and complexity of that case. Nortel filed for bankruptcy in January 2009. An official committee of unsecured creditors (the “Nortel Committee”) was named shortly afterwards. It has long been deemed consistent with the “prudent person” standard for indenture trustees for unsecured notes to serve on official committees of unsecured creditors in chapter 11 cases, and the indenture trustee for Nortel’s 7.875% unsecured notes sought and obtained appointment. By the time Nortel succeeded in obtaining confirmation of its plan of reorganization in January 2017, the indenture trustee had incurred fees and expenses of approximately $8 million.
The outstanding amount due on the 7.875% notes at the time the case commenced was approximately $150 million. Nortel’s plan provided for payment in full of the $150 million, but no postpetition interest. It also provided for payment of up to $4.25 million of the indenture trustee’s fees and expenses, which meant that the indenture trustee would have the right to obtain payment of its remaining fees and expenses out of the $150 million payment under the plan.
At the plan confirmation hearing, the 7.875% noteholders requested that the indenture trustee not be permitted to exercise its charging lien with respect to the remaining $3.75 million of fees and expenses, pending a determination by Judge Gross of the reasonableness of such fees. A substantial basis for the objection was that it was not “reasonable” for the indenture trustee to exercise its charging lien with respect to a portion of the fees incurred in serving on the Nortel Committee for the eight years of the case. Judge Gross confirmed the plan and reserved the noteholders’ rights.
After settlement efforts failed, an evidentiary hearing was held in late February. At the hearing, the 7.875% noteholders contended that they were not challenging the appropriateness of the indenture trustee sitting on the Nortel Committee per se, but noted that when an indenture trustee does sit on a committee, it is essentially carrying out two sets of duties – one to noteholders under the bond indenture, and one to all general unsecured creditors. The 7.875% noteholders argued that the exercise by the indenture trustee of the charging lien for payment of fees and expenses must be limited to fees incurred on behalf of the noteholders only.
The indenture trustee argued that its obligation to act as a prudent person required it to be involved in many aspects of the case, even if they may not have directly benefited the noteholders. It noted that day to day involvement in a case of Nortel’s size and complexity was necessary, as it was not feasible “to parachute in and out” when necessary to protect the noteholders’ interests. It further contended that the determination as to whether involvement was prudent had to be made at the time, and should not be subject to hindsight.
Judge Gross overruled most of the 7.875% noteholder objections.
In making his ruling, he looked closely at the language of the 7.875% bond indenture, noting that the indenture trustee “[is] authorized in performing its duties to ‘act through agents or attorneys,’ and to ‘consult with counsel of its selection.’” He also considered the “prudent person” standard under New York law (the governing law of the indenture), and stated that “prudence is not something the Court can readily review in hindsight.” He framed the questions to be decided as “whether the Indenture Trustee acted prudently in assigning the Lawyers to their tasks, and whether the Lawyers’ work was reasonable.” With a few exceptions, Judge Gross answered both questions in the affirmative.
Judge Gross did reduce a portion of the fees based on certain other factors, including for times when the firms representing the indenture trustee had multiple lawyers participating on committee calls or attending meetings.
The importance of this last point should not be overlooked. Together with its strong recognition of the breadth of the “prudent person” standard, Judge Gross’s Nortel decision significantly strengthens the ability of financial institutions to get paid for undertaking the duties of a trustee under bond indentures.

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