INTRODUCTION Bankruptcy encourages risk-taking (by making way out available for Ds)… Discourages “grabbing” by Cs As company w/ survival potential) begins to fail, Cs prematurely kill company to ensure payment (smell blood in water)… … AND, insiders (people running company) want to protect themselves from impending catastrophe (incentive to steal, OR “asset engineering in anticipation of insolvency”) Preserves going concern value of entity/assets When Cs “grab”, value of each part of entity suffers… … AND, thus, of entity as a whole suffers even more Bankruptcy timeline… When D-entity starts to fail, bankruptcy petition (“magic wall”) is filed 2 types… Voluntary petition Involuntary petition (powerful weapon for petitioning C(s)… BUT, premature/incorrect filing could make liable to D for damages) 2 major kinds of business petitions… Ch. 7 – liquidation (“I quit”) Ch. 11 – reorganization (tweak things a little, write off some debt, sell some assets, reemerge) Most Ds should file Ch. 7… BUT, file Ch. 11 instead… … AND, majority of Ch. 11s fail (conversion from Ch. 11 to Ch. 7) 2 reasons why Ds file Ch. 11… Good reason “D’s euphoria” (false hope/good faith mistake that everything will be OK, merely going through rough patch) Real/strategic reason D knows it can’t reorganize, BUT wants to make process more drawn-out/expensive for Cs Filing Ch. 11 scares Cs (esp. leading lenders), who are more likely to settle/cut deal… … AND, judges must be sympathetic presumptions in favor of D (even though majority of Ch. 11s fail, D MAY survive) Trustee (in Ch. 7) vs. D-in-possession (“DIP”) (in Ch. 11)… In Ch. 7 filing, trustee (3rd is chosen from panel goals of preserving estate, augmenting assets, winding up business (paid w/ % of assets)
As per CA’s race-notice recording statute (CC § 1214), an unrecorded conveyance is void against a subsequent BFP4V who records first (good faith purchaser w/ NO knowledge AND NO actual/constructive notice of prior unrecorded conveyance)… … as such, C can beat out subsequent BFP4V when TD is properly recorded… … thus, once TD is properly recorded, then C can beat out a subsequent BFP4V… AND, once C can beat out a subsequent BFP4V, then C is “federally perfected” If personal property, then transfer is “federally perfected” when, under state law, C can beat out a (hypothetical) subsequent judicial lien creditor (“JLC”) (§ 547(e)(1)(B)) As per UCC § 9317(a), C can beat out a subsequent JLC when C’s SI is perfected for state law purposes (“state-law perfected”)… … AND, as per UCC § 9308(a), SI is “state-law perfected” upon both attachment (recall 3 conditions) AND “perfection step” (filing of UCC-1)… Attachment is ONLY the creation of SI… … BUT, perfection is the giving of notice (of SI) to 3rd parties … thus, once C is perfected, then C can beat out a subsequent JLC… AND, once C can beat out a subsequent JLC, then C is “federally perfected” UCC Art. IX allows for filing of UCC-1 before loan is made (even if loan negotiations fall through) thus, C should file UCC-1 A.S.A.P. (needlessly delaying perfection, i.e. waiting for serial #, increases likelihood that debt is antecedent… AND, consequently, that SI is preferential) If transfer “takes effect” before “bell” rings, AND is “federally perfected” within 30 days thereof NOT preferential, even if perfection occurs after “bell” rings If transfer “takes effect” before “bell” rings, BUT is “federally perfected” after 30 days MAYBE preferential if delayed perfection occurs after “bell” rings Potentially different dates when debt incurred, when security agreement executed, when “bell” rings, AND when perfected
31st… AND, thus, “takes effect” (attachment) AND “federally perfected” (attachment + “perfection step”) on July 31st… … AND, thus, b/c transfer “made” (on July 31st) before “bell” rings (on August 1st), SI on AAP is NOT preferential (even though debt IS still antecedent) Potential effect of delayed perfection original property IS preferential, BUT AAP is NOT preferential On August 2nd, C makes loan to D, D executes security agreement (w/ AAP clause), D owns equipment1 (original property)… on August 9th, D acquires equipment2 (AAP)… on August 10, “bell” rings… on September 5th, UCC-1 filed… … original property IS preferential “takes effect” (attachment) on August 2nd, BUT “federally perfected” (“perfection step”) 30+ days later on September 5th… … BUT, AAP is NOT preferential “takes effect” on August 9th, AND “federally perfected” within 30 days thereof Foreclosure… 2 kinds of foreclosure in CA… Judicial foreclosure (“JF”) complaint court-supervised sale ordered, D’s deficiency liability (debt MINUS sale price) determined Non-judicial foreclosure (“NJF”) file notice of default (NO lawsuit), file notice of sale, conduct private auction (open to public, but NOT JFs fairly uncommon b/c CA generally protects D from deficiency liability… … thus, JFs generally NOT worth the hassle NJFs quicker, easier AND cheaper If TD is properly recorded, then foreclosure before bankruptcy would likely NOT be preferential b/c foreclosure did NOT make C “better off” NO economic difference b/w selling home in foreclosure sale vs. having TD on home in bankruptcy… … BUT, if TD is NOT properly recorded, then court MAY hold foreclosure right before bankruptcy as being preferential b/c C did NOT have valid lien (would NOT have taken $$ in bankruptcy)…
… AND, b/c NJF is NOT judicially-supervised, unrecorded TD MAY not be noticed Bifurcation (§ 506(a)) – undersecured C holds secured claim in amount of value of collateral AND unsecured claim in amount of deficiency If C conducts JF and obtains deficiency judgment, then deficiency judgment becomes unsecured claim in bankruptcy… … AND, collecting deficiency judgment right before bankruptcy would likely be preferential b/c it made C “better off” deficiency judgment alters C’s economic status (whereas, foreclosure does NOT) Judgment lien… After plaintiff (C) obtains judgment against defendant (D), C files judgment, obtains and records abstract (under state law) judgment lien arises (encumbering D’s property) On March 1st, C obtains judgment against D… on March 15th, “bell” rings… on March 20th, C files judgment, obtains and records abstract, judgment lien arises… … b/c judgment obtained on March 1st and judgment lien arises on March 20th, debt IS antecedent… AND, judgment lien IS preferential Obtaining judgment ONLY half the battle C must move quickly to file and obtain judgment lien (failure to do so MAY be malpractice for C’s counsel) Do title search(es) before judgment entered better able to quickly obtain judgment lien Judgment-debtor exam (discovery in aid of judgment) ask D properties Refi loan… On January 1st, old TD recorded on D’s property… on July 1st, refi loan made (new lender replaces old lender, old obligation extinguished in favor of new obligation), new TD executed, but NOT recorded… on August 1st, “bell” rings… on September 1st, new TD recorded… … as per delayed perfection, new TD IS preferential unless, 1 of 2 theories successfully asserted… Theory #1 (generally does NOT work) new lender is “federally perfected” when able to beat out a subsequent BFP4V… AND, b/c old TD was still of record, any subsequent BFP4V would have been put on notice (though, notice of old TD, NOT new TD)… thus, new TD was “federally perfected” at all times (NOT delayed) Theory #2 (mixed results, though trending against) equitable subrogation
Courts are mixed when non-D/3rd party (i.e. parent corp.) makes payment for C’s subsequent advance to D language of § 547(c)(4)(B) ONLY refers to when D (NOT 3rd party) makes payment… … thus, some courts allow C double benefit keep payment AND use to offset preference liability Payment by check NOT the same as payment by cash (date of delivery MAY be difficult to determine) Sup. Ct. has held (Barnhill) that, for § 547(b) purposes, the date of honor of check is the date that transfer of $$ is “made”… … BUT, for § 547(c)(4) purposes, the date of delivery of check controls whether subsequent advance has occurred On 29th, C ships $100K in shoes to D… on April 1st, “bell” rings… on April 5th, D delivers $100K check to C… on April 8th, C ships $70K in socks to D… on May 1st, D’s $100K check is honored… … b/c transfer (of $100K from D to C) was “made” on May 1st, YES for antecedent debt (debt incurred on March 29th)… AND, YES preferential… … BUT, b/c delivered on April 5th, AND shipment of socks on April 8th, then § 547(c)(4) defense available (b/c shipment of socks a subsequent advance) Good policy b/c C encouraged to give new value to pre-bankrupt D… … BUT, intellectually dishonest b/c (so-called) subsequent advance comes before (NOT after) transfer is “made” § 547(c)(5) protection of inventory/AR lenders Background D (manufacturing plant) has suppliers (supplying raw materials)… D processes raw materials, creates inventory… D sells inventory to customers (account Ds)… customers buy on credit, give D promise to pay (accounts receivable (“AR”))… AR collected, $$ goes to D… … BUT, D must pay suppliers (AND employees, other bills, etc.) before it collects AR always a gap in time… … thus, D borrows $$ from lender in exchange for note AND SI (w/ AAP clause) in D’s inventory/AR…
D (“vendor support program”), then suppliers more likely to give D more inventory/supplies… … thus, C-lender is NO longer in deficiency posture, BUT in sufficiency posture though, now, C-lender would have preference liability (as per exception to § 547(c)(5))… … BUT, if C-lender can get D to avoid filing bankruptcy for 90+ days, then NOT preferential (“manipulating the 2-point test”)… … though, if C is shown to be an insider, then subject to 1-yr. reach-back (instead of 90 days)… … AND, if discovered, C could face all sorts of liability tort, breach of fiduciary duty, wrongful conduct, control Valuation of collateral… Assume, on 90th day before bankruptcy, debt is $10M, collateral is $6M (D possibly salvageable)… then, disaster occurs (i.e. Northridge earthquake, 9/11)… … now, on date of bankruptcy, debt is still $10M, collateral is $7M… BUT, due to intervening events, D is now unsalvageable… D would argue for going concern (face) value of collateral C owes preference liability of $1M (as per decrease in deficiency posture from $4M to $3M) C argue for liquidation (real) value of collateral even though going concern value of collateral has increased, D is NO longer a viable entity (AND, as such, customers will flake out on AR obligations) “… to the prejudice of other [Cs] holding unsecured claims…” (NOT superfluous language) value that has gone into inventory/AR (causing increase thereof, AND subsequent decrease in deficiency) must have been “derived” from other Cs Oil as collateral/inventory increase in value caused by market forces… thus, NO prejudice to other Cs Hogs as collateral/inventory if hogs are pregnant/give during 90 days, then collateral has increased in value… AND, this increase would NOT have happened w/o other Cs (i.e. feeding, vaccinating hogs)… thus, YES prejudice to other Cs
§ 550(a)(2) subsequent transferee § 550(b) NO recovery from good faith subsequent transferee (inquiry notice standard of good faith either knew OR should have known, NO reward for deliberate ignorance) Thus, even if a BFP, initial transferee is strictly liable (NO § 550(b) defense) in best position to monitor $$ came from (OR, at least, in better position than subsequent transferee) Assume president of D-corp. owes gambling debt to casino, issues check w/ D-corp.’s $$ casino liable as initial transferee (even though casino does NOT know that president is ripping off … BUT, if president had put D-corp.’s $$ into own bank account then casino NOT liable president as initial transferee, casino as good faith subsequent transferee (YES § 550(b) defense) Initial transferee has dominion/control over $$ NOT a mere conduit/ messenger (thus, if recipient of D’s funds appears to be initial transferee, look for some escape hatch/limitation) Attorney disbursing $$ out of client trust account NOT initial transferee (acting as fiduciary to client) Telecommunications company receives $$ from D, required by statute to give portion to non-profit YES initial transferee (despite statutory requirement, still had dominion/control over $$… though, Schechter disagrees) § 550(a) states that trustee may recover “for the benefit of the estate” broadly construed… Assume, in Ch. 11, C (as DIP lender) loans $$ to estate, takes lien on trustee’s recovery recovery arguably NOT “for the benefit of the estate” if going to C… … BUT, estate does “benefit” by getting $$ from C thus, if recovery “benefitted” the estate, then it IS “for the benefit of the estate” Conflict b/w § 550(a) and CUFTA § 8(c)… Assume D house to friend, then files for bankruptcy (fraudulent transfer) at time of transfer, house worth $600K… BUT, by the time fraudulent transfer is avoided (as per § 544(b)/CUFTA), house is worth $400K… … thus, if trustee can’t recover the house itself, then which value does trustee recover?
“Upstream guaranty” (sub/D-corp. issuing guaranty for parent/SH) likely YES fraudulent transfer C-lender $$ to SH, takes note/SI on SH’s stock/equity, AND D-corp. issues guaranty D-corp. does NOT receive REV (D-corp. does NOT get dividend from SH, ONLY other way around)… … unless, pass-through of $$ from SH to D-corp. (as per Northern)… … OR, some indirect benefit which is tangible/quantifiable management expertise of parent MAY be value, but NOT necessarily REV If guaranty IS fraudulent transfer, then guaranty is extinguished if collateralized, then such collateral is freed… … AND, any payments made are recapturable guaranty” (sub issuing guaranty for other sub) MAYBE fraudulent transfer? Cross-corporate synergy indirect benefit theory for “cross-stream guaranty”… Parent-corp. owns sub1 (manufacturing) AND sub2 (distribution) C-lender loans $$ to sub1, takes note/SI on sub1’s assets, AND sub2 issues guaranty… … if sub1 is able to manufacture more goods, then sub2 is able to distribute more goods questionable whether this indirect benefit is sufficient REV (in exchange for sub2’s liability from guaranty) Courts are mixed some courts look to actual benefit received sub2 received (whether benefit actually came into existence)… whereas, other courts look to potential benefit that sub2 was likely to receive (even though NOT received) Sub2 pays non-refundable commitment fee (in addition to guaranty) YES fraudulent transfer (NO actual benefit/REV if $$ never comes) Aircraft manufacturer pays for gas to incentivize buyer to later lease aircrafts NOT fraudulent transfer (even though buyer never leases aircrafts, YES potential benefit/REV b/c seemed good at the time) “Cross-stream guaranties” are usually continuing guaranties guaranty on all debts now owed OR hereafter incurred Assume sub2 issues “cross-stream guaranty” in 2002… AND, sub1’s note is a “revolver” sub2 files for bankruptcy in 2009… … as per “revolver”, guaranty MAY have been continually refreshed even though guaranty executed in 2002 (outside of SoL),
“revolver” was likely last refreshed within SoL (while sub2 insolvent)… … thus, “cross-stream guaranty” MAY be fraudulent transfer (Evergreen) sub2 MAY have received REV in 2002, but NOT in 2009 § 6(e)(2) states that obligation in writing is incurred when writing is executed guaranty NOT refreshed (2002 controls)… … BUT, NO such language in § 548(d) (an “eloquent silence”) guaranty IS refreshed (within 2-yr. SoL)… … thus, if trustee proceeds under § 544(b), then MAY be affected by CUFTA § 6(e)(2) beneficial for trustee to plead ONLY § 548 (NOT § 544(b) AND § 548) Factoring cross-corporate guaranty into insolvency analysis… Assume C-lender loans $100M to parent… sub issues “upstream guaranty”… after sub files for bankruptcy, trustee goes after C-lender for fraudulent transfer unlikely that sub received REV… BUT, assuming lack of REV, is sub insolvent? If $100M contingent liability is on sub’s balance sheet, then YES insolvent… … BUT, if ONLY 1% chance of default by parent (primary obligor), then ONLY 1% chance of call upon sub (secondary obligor) contingent liability listed on sub’s balance sheet as ONLY $1M (likely NOT insolvent) Arguable whether contingent liability should even be on balance sheet… … BUT, as per Xonics/Covey (7th Circuit), contingent liability should NOT be on balance sheet at face value, unless contingency certain to occur rather, should be booked at real value (consideration that guarantor-sub MAY never have to pay) To prevent fraudulent transfer liability (by showing that guarantor-sub was NOT insolvent), C-lender must discount sub’s balance sheet by probability of parent’s chance of default (as liabilities decrease, equity increases) BUT, how is parent’s chance of default quantified? Dueling experts court splits the difference Self-serving document if parent IS extraordinarily solvent, then chance of default is minimal
… BUT, if/when that does NOT happen, trustee will go as fraudulent transferee (new management is NOT sufficient REV to offset million$ in debt) In Bay Plastics, BT (C-lender) loans $4M to Bay Plastics (“target corp.”), $3.5M of which goes to BPI (AV) via corporate note (disguised gift)… BPI gives this $3.5M to Bay Plastics’ old SHs in exchange for Bay Plastics’ stock… BT holds note/SI in Bay Plastics’ assets (Bay Plastics AND BPI merge, maintain “Bay Plastics” name) YES fraudulent transfer Other way to accomplish LBO BT instead loans $$ directly to BPI (which has NO assets at the time), takes note/SI w/ AAP clause (w/ Bay Plastics’ assets as AAP) Balance sheet analysis is Bay Plastics (in)solvent?… Pre-LBO $6.7M in assets, $5.5M in liabilities, $1.1M in equity (YES solvent) Why pay $3.5M for Bay Plastics (if equity ONLY $1.1M)? assets listed on balance at book value (market value MAY be appreciating)… … AND, worth of company NOT limited to equity on balance sheet (corp. itself as annual source of income) Post-LBO $7M in assets, $9M in liabilities, NO equity (NOT solvent) As per $2.25M in goodwill (cost of assets in excess of book value), Bay Plastics actually (barely) solvent $250K in equity… … BUT, even though goodwill is a generally accepted accounting principle, it is ignored by bankruptcy judges goodwill NOT an (can’t be sold) Here, parties accept balance sheet… BUT, normally, expert testimony required re: value of assets/liabilities (expensive for trustee) Nothing at risk for purchaser (new SHs/AV) at LBO… If Bay Plastics succeeds, then purchaser has bought for NO $$ down If Bay Plastics then purchaser walks away (ONLY corp. is liable for debt) Historical projections after LBO, corp. takes on huge debt… BUT, expected to earn its way out of debt based on “past performance” (which MAY not sustain in long-term)
used to offset/decrease insiders’ liability (insiders become allies of trustee) … from LBO everything… Note is avoided obligation incurred by D-corp. w/ NO REV SI is avoided transfer/lien w/ NO REV Payments on note are avoided AND recovered transfers w/ NO REV LBO lender essentially an unsecured C… … BUT, likely worse, b/c previously-encumbered assets will likely be made available first to other unsecured Cs (who were victimized by LBO) … from old SHs likely nothing Trustee may NOT avoid a settlement payment (§ 546(e))… AND, so long as $$ from LBO is funneled through a brokerage/financial institution, then it IS a settlement payment (AND, thus, insulated from attack)… … BUT, old SHs NOT insulated from potential actual fraud claim (if C-lender lied to re: LBO nature of loan) LBO lenders… When corp. markets its availability (old SHs want out), bidding war ensures corp.’s insiders often win bidding war (have inside info re: corp.’s prospects)… … BUT, final LBO price MAY be more than (conservative) lender willing to put forth… … SO, LBO lender MAY make up difference by issuing corporate (“junk”) bonds to “sub-debtors” deeply subordinated, BUT pay high interest If corp. fails, then “junk” bonds are worthless trustee has 2 options… View “sub-debtors” as allies/co-plaintiffs testify as to being misled by LBO lender (though, often contractually agreed to have done due diligence) View “sub-debtors” as defendants sue “sub-debtors” as participants in LBO (“mezzanine financing”), potentially facilitate sliding scale/Mary Carter agreement (if “sub-debtors” won’t voluntarily testify against LBO lender) Defenses for LBO lenders… § 550(b) is a complete defense, but ONLY applies to (good faith) subsequent transferee…
§ 544(a)(3) for real property, trustee is a hypothetical BFP4V (having hypothetically recorded at moment of bankruptcy)… thus, if C holds TD that is NOT properly recorded, then trustee MAY invalidate TD § 544(a)(1) AND § 544(a)(3) are both necessary b/c of differences b/w UCC Art. IX and state recording statutes UCC § 9317 does NOT refer to BFP4Vs… AND, state recording statutes (generally) do NOT refer to JLCs Assume O conveys property to A, which is NOT recorded… then, B obtains a judicial lien against O… … B could NOT attack O’s unrecorded prior conveyance to A (b/c B is a JLC, NOT a BFP4V) Mistakes in TD, if serious enough, MAY render TD unrecorded depends on state (CA is liberal/lenient)… Bad legal descriptions Errors in D’s name Errors in street addresses Misindexing Improper/missing notarization/acknowledgment Again, trustee will search for such glitches… … thus, C-lender should conduct pre-enforcement check of documentation if mistake found, then must re-document 90 days before bankruptcy… AND, may ONLY re-document w/ (i.e. 6-week forbearance) Purpose of § 544(a) do away w/ secret, unrecorded interests in D’s property If NO § 544(a), then D could simply deed away all property pre-bankruptcy in unrecorded transactions… … BUT, arguably overkill NO on trustee’s power (MAY avoid unrecorded interests regardless of injury caused by failure to record) Failure to record creates false appearance of D’s ownership/wealth… BUT, NOT all Cs check records before extending credit… … however, “ripple reliance” from major Cs (who check records AND are directly misled) MAY influence minor Cs (who do NOT check records, BUT are indirectly misled by major Cs’ reliance) “Knowledge” vs. “Notice” (for § 544(a)(3))… In McCannon v. Marston, woman owns condo in D’s building, but does NOT record (NO actual notice)… after D files for bankruptcy, trustee goes after woman’s unrecorded conveyance…
… BUT, woman’s possession of condo constitutes constructive notice thus, DIP may NOT avoid Trustee must diligently inspect for tenants on D’s property obtain estoppel certificates (tenants disclaiming ownership interest to protect trustee’s status as hypothetical BFP4V) In Ch. 11, DIP will have subjective “knowledge” of a prior unrecorded conveyance… BUT, may NOT have objective “notice” O conveys property to A, AND A is in possession… O, as DIP in Ch. 11, becomes hypothetical BFP4V DIP may NOT avoid A’s interest (DIP has “knowledge” AND “notice”) O conveys property to A, BUT A is NOT in possession… O, as DIP in Ch. 11, becomes hypothetical BFP4V DIP MAY avoid A’s interest (DIP has “knowledge”, but NO “notice”) If C’s unrecorded TD is mentioned in D’s bankruptcy petition, then this would constitute constructive notice (trustee/DIP may NOT avoid)… … BUT, b/c TD would be deemed recorded on day on bankruptcy (thus, recorded within 90 days of bankruptcy), then TD IS preferential MERS (Mortgage Electronic Registration Service) acts as “holding person” on behalf of mortgage as loans repeatedly assigned/transferred, records need NOT be changed (MERS remains on record as nominee) If/when trustee attacks MERS transaction under § 544(a)(3), some judges agree MERS does NOT have interest in loans (C-lenders NOT being reasonable w/ Ds, esp. considering foreclosure crisis)… … BUT, C-lenders NOT being reasonable b/c have NO choice can’t write down/modify loans (MAY render banks insolvent, AND bondholders hold veto power) § 551 transfer avoided is “preserved for the benefit of the estate but only with respect to property of the estate”… Assume property worth $1M, TD1 on property is worth $800K (NOT recorded), TD2 worth $300K trustee avoids TD1… … then, trustee (like hermit crab) occupies “shell” of TD1 NO windfall for holder of TD2 (remains undersecured)… … though, state law, if holder of TD2 were NOT aware of TD1, then TD2 would take priority over TD1 § 551 used in conjunction w/…
Strong-arms powers (§ 544(a)(1) AND § 544(a)(3)) Preferential avoidance Fraudulent transfer avoidance Marshaling (common law equitable doctrine)… D owns 2 parcels of real property (RP1 and RP2) C1 holds TD on RP1, AND TD1 on RP2… C2 holds TD2 on RP2… C2 is singly-funded one source of recovery (TD2 on RP2) C1 is doubly-funded two sources of recovery (TD on RP1 AND TD1 on RP2) RP1 is singly-encumbered (ONLY C1’s TD) RP2 is doubly-encumbered (C1’s TD1 AND C2’s TD2) As per marshaling, a singly-funded junior C may compel a doubly-funded senior C to first pursue singly-encumbered asset, leaving doubly-encumbered asset for remainder of debt thus, court will require C1 to go after RP1 first, then RP2 (if still owed $$) Courts are mixed re: whether trustee can invoke marshaling (on C2’s behalf)… … AND, whether trustee can marshaling (i.e. if C3 held TD2 on RP1, then would want C1 to go after RP2 first) Trusts… If D is trustee of express Cs entitled to D’s general assets, AND beneficiaries (of express trust) entitled to trust assets… Bankruptcy estate is comprised of all of D’s legal AND equitable interests (§ 541(a)(1))… AND, D holds legal title to trust assets (beneficiaries hold equitable title)… … BUT, carve-out protecting D’s trust beneficiaries (§ 541(d)) NOT property to which D holds legal, but NOT equitable, title “1031 facilitators”… Investors put million$ into own segregated accounts (organized under IRC § 1031) to be used for purchase of property when “1031 facilitator” files for bankruptcy, investors argue that § 541(d) should apply… … BUT, “1031 facilitator” holds legal AND equitable title NOT a trust, merely a restricted account (investors could have set up a trust, BUT chose NOT to)…
… as such, courts are reluctant to invoke § 541(d) merely b/c something looks like a trust (investors in “1031 facilitator” as unsecured Cs) Constructive remedy (usually) imposed in favor of fraud victim, presupposing that tortfeasor is holding property on behalf of fraud victim As opposed to resulting trust parties intended to create trust, BUT failed to formally do so Constructive trust is solely remedial if victim gives $$ to tortfeasor to buy property for victim, BUT tortfeasor buys property for himself, then court MAY trace $$ back into tortfeasor’s hands (creation of trust is NOT tortfeasor’s intent)… … whereas, w/ resulting trust, creation of trust is admitted intent of both parties D’s property going to victim in constructive trust a “constructive conveyance” (NOT recorded)… Trustee, as hypothetical BFP4V, wants to avoid victim’s interest in property as a prior unrecorded conveyance (as per § 544(a)(3))… … BUT, victim claims to be beneficiary to (constructive) trust (as per § 541(d))… … BUT, § 541(a)(3) states that bankruptcy estate is also comprised of recoveries under § 550… AND, § 550 allows for “recovery” of interests avoided § 544… “Recovery” need NOT always follow avoidance if trustee avoids a lien (non-possessory), then nothing to “recover”… … BUT, § 550 is viewed ONLY as ancillary/remedial statute likely applies whether or NOT any “recovery” is necessary … AND, § 541(a)(1) IS limited by § 541(d)… BUT, § 541(a)(3) is NOT limited by § 541(d) … thus, if trustee is attempting to bring property held in constructive trust into estate 2 “doors”… § 541(a)(1) “door” is NOT open blocked by § 541(d) (NO trust property) § 541(a)(3) “door” IS open NOT blocked by § 541(d) Mortgages § 541…
Court MAY equitably subordinate C-lender’s claim ONLY to claim of major supplier (partial equitable subordination)… … BUT, NO equitable subordination to claims of minor suppliers that were influenced by major supplier’s reliance (recall “ripple reliance”) suppliers did NOT inquire to C-lender thus, were NOT misled by C-lender… … BUT, foreseeable to C-lender that misleading major supplier would influence minor suppliers as well Subordination agreements (§ 510(a))… D goes to C-lender for additional funding, already owing C-lender $10M won’t/can’t loan more $$)… SO, D goes to emergency lender, who is willing to loan $1M… BUT, emergency does NOT want to be junior to C-lender C-lender contractually subordinates to emergency lender C-lender MAY be unable to loan more $$ if insufficient borrowing base, then can’t go “out of formula”… … BUT, C-lender MAY be willing to subordinate better alternative than D filing for bankruptcy (AND, collateral subsequently dropping in value) Subordination agreement MAY contain turn-over clause if newly-senior C obtains any $$, then must first “turn over” to newly-junior C Ordinary payments will be “turned over” to newly-junior C… BUT, newly-junior C also wants post-petition interest (which newly-senior C would NOT have received but for subordination agreement) Courts used to NOT enforce subordination agreements w/ Draconian clauses, unless explicitly set out (“rule of explicitness”)… BUT, now, courts will enforce subordination agreements to same extent as “applicable nonbankruptcy law” (negotiating for newly-junior C) AUTOMATIC STAY § 362(a) once bankruptcy petition filed, every proceeding against D (commencement AND continuation) stops… Counsel subject to discipline (i.e. sanction, civil/criminal contempt) if NOT stopping upon bankruptcy filing do NOT assume that proceeding is immune from attack (trustee/DIP will come after C, potential for punitive damages)… … rather, go to bankruptcy and seek permission/relief from automatic stay… AND, notify state court (MAY have to dismiss action against D w/o prejudice)
Language of § 362(a) does NOT invoke automatic stay for insider(s)… BUT, bankruptcy court MAY issue injunctive relief (as per § 105(a)) to protect insider(s) from Cs § 524(e) states that discharge of D does NOT affect liability of any others… AND, in 9th Circuit, if related 3rd is NOT protected by discharge of D, then NOT protected by injunctive relief… … BUT, if injunctive relief IS issued, then must be narrowly-tailored (credible threat for settlement w/ Cs) Notable exceptions to automatic stay… § 362(b)(3) “federal perfection” (as per § 547(e)(2)(A)) § 362(b)(21) foreclosure against real property if D serial bankruptcy petitions (order from prior bankruptcy prohibiting D from filing for bankruptcy again) Relief from automatic stay… § 362(d)(1) relief for D files for bankruptcy on eve of (i.e. discovery completed, judge clued in)… If P can make compelling showing of “good (i.e. claim unusually complicated, unlike other claims), then bankruptcy court MAY allow state court claim to proceed (despite pending bankruptcy)... … BUT, bankruptcy court would want authority to second-guess judgment/enforceability (strict control of remedies) Problems w/ prejudgment attachment lien… If/when P obtains/records prejudgment attachment lien (encumbering D’s assets), goal is for judgment lien to relate back to date of prejudgment attachment lien… … BUT, if D files for bankruptcy before judgment, AND P does NOT obtain relief for cause, then some CA courts hold P liable for wrongful attachment (tort claim) prejudgment attachment lien does NOT materialize to judgment lien (though, NOT b/c of lack of merit, BUT b/c of D’s bankruptcy filing)… … thus, P MAY seek relief for ONLY to avoid wrongful attachment claim few courts have allowed Relief for cause includes “lack of adequate protection”…
Assume undersecured C has SI on D’s equipment, which is declining in value (to C’s detriment) as D generates more inventory… … thus, as alternative to foreclosure (on SI), C seeks “adequate protection” 3 options (§ 361(1)-(3))… Trustee makes $$ payments (though, estate likely has NO $$… AND, if NOT spelled out in court order, then unclear whether payments go to principal OR interest) Substitute lien (though, estate likely has NO unencumbered assets) Some other relief that is “indubitable equivalent” (i.e. lien on trustee’s avoidance powers/recoveries) § 362(d)(2) action/foreclosure against property if D does NOT have equity in property –AND– property NOT necessary to an “effective reorganization” § 362(d)(2) is a 2-prong test… BUT, 2nd prong applies ONLY to Ch. 11 most courts will NOT apply 2nd prong to Ch. 7 (some courts reinterpret 2nd prong as “orderly liquidation” instead of “effective reorganization”) If D is a printing plant, then printing press IS necessary to an “effective reorganization” (printing plant can’t run w/o printing press)… … thus, even if D has NO equity in printing press (i.e. lien held by undersecured C), C may NOT foreclose… In printing plant, entire suite of assets is dependent on assembly/ turn-key value value of assets depends on suite… … thus, if C foreclose on printing press, then all other assets in printing plant would drop in value (to detriment of other Cs) … though, if C can show that there is NO hope for reorganization, then 2nd prong satisfied property NOT necessary to an “effective reorganization” b/c there will be NO such reorganization Courts do NOT like to predict that Ch. 11 will fail… … AND, if D counterargues that Ch. 11 will succeed (i.e. presents business model), then court will likely favor D As per 1st prong (lack of equity), C and D will present dueling appraisals court splits the difference
If C argues for lack of equity (claims to be undersecured), BUT court determines that there IS equity, then C (as oversecured) will argue for interest/fees/costs (as per § 506(b))… BUT, potential estoppel defense for D C admitted to being undersecured when moving for relief (D MAY plead uncertainty as defense to D’s estoppel defense) Lack of equity also relevant to § 362(d)(1) more likely to obtain relief for cause if D has NO equity in property If C seeks relief under § 362(d)(2), then D MAY attack underlying claim as preferential/fraudulent transfer if potential to trigger avoidance claim, then MAY be better for C to NOT seek relief § 362(d)(3) single asset real estate exception Single asset real estate small entity w/ single parcel generating income Special purpose entity (“SPE”) (i.e. corp./limited partnership) owns apartment building SHs (OR, limited partners) issue guaranties in favor of C-lender (holding TD on apartment building)… … SPE Ch. 11… BUT, C-lender unable to obtain relief from automatic stay under § 362(d)(2) In single real estate bankruptcies, C entitled to relief… unless, within 90 days of bankruptcy… D files plan of reorganization w/ “reasonable probability of being confirmed within reasonable time” (AND, NO such probability if deficiency claim is larger than all unsecured Cs’ claims) –OR– D makes monthly payments (unlikely) § 362(d)(4) scheme involving transfer of ownership/interest in real property OR multiple bankruptcy filings effecting property D1 owns real property subject to TD… just as C is about to foreclose, D1 files for bankruptcy… then, C obtains relief from automatic stay… BUT, D1 has transferred real property to D2… process repeats (bankruptcy, then relief, then new D) 2 ways this happens… D1 entitites (i.e. “D2”) to take title Scammers (“foreclosure consultants”) form entities to take title… … then, scammer MAY kick D1 off property rent property to tenants w/o paying off TD (“rent skimming”)…
Valuation of property critical to relief again, if C is undersecured, then claim subject to bifurcation (as per § 506(a))… 3 major techniques for valuation… Liquidation lowest possible (distressed/“fire” sale) Wholesale value above liquidation value, but NOT retail (i.e. inventory) concern value value if sold by willing seller to willing buyer Valuation technique used depends on nature of D’s business model if NO hope for reorganization, then liquidation value more likely… BUT, if D expected to emerge from Ch. 11, then going concern value more likely § 506(b) if C is oversecured, then entitled to interest AND (to extent that C is oversecured)… Loan agreement provides for contract interest (ordinary rate) AND default interest (increase in case of default)… Conservative lenders want default interest as reward for prudent ratio and/or charging low contract interest (since there is still equity in collateral)… … BUT, courts dislike default interest (eating up equity in property b/c unpaid interest folded back into principal) MAY be able to get default interest at 1-3% contract interest (anything greater is likely unreasonable) Unlikely to recover all attorney’s fees NO fees are uniformly “reasonable” Unlikely to recover pre-payment fees unreasonable per se in CA C-lender expects $$ loaned to be “working” (earning interest over time)… thus, if D prepays (i.e. refi), then C-lender must reposition $$ elsewhere to replace lost income/interest… … BUT, pre-payment fees are deemed synonymous w/ liquidated damages NO relation b/w harm suffered AND size of penalty (i.e. “If not delivered by [date], then must pay [$$]”)… unless, recitals in agreement (re: difficulty in determining damages, estimations made, reasons why)… … though, generally difficult for C-lender to justify pre-payment fees C-lender MAY re-lend $$ elsewhere (decrease in income/ interest likely NOT big) fee clauses broadly b/c courts will generally interpret narrowly (i.e. fees incurred in bankruptcy litigation used to NOT be recoverable, BUT law is changing)…
… thus, as non-bankrupt C, beneficial to NOT include default clauses (i.e. “If you go bankrupt, then your agreement is terminated”)… AND, NO penalty provisions (i.e. “If you [_], then you must pay [$$]”)… … BUT, beneficial to include termination clauses (i.e. “If you [_], then your agreement is terminated”) § 365(c)(1) trustee/DIP may NOT assume OR assign any executory contract if applicable law excuses a party from accepting performance from an entity other than D Examples… Personal services contract performer (i.e. singer) may NOT assign obligation to 3rd party-assignee (i.e. different singer) (b/c non-breaching party need NOT accept 3rd party-assignee’s performance) Patents (federal law) non-exclusive patent licensee may NOT assign license Assumption is predicate to assignment estate must assume before assigning… BUT, estate MAY assume w/o assigning Assume non-bankrupt C has executory contract w/ D (now, DIP in Ch. 11) for sale of oil (which is very lucrative to DIP) if DIP wants to stay in oil business, then DIP MAY assume executory contract (ratification of ongoing relationship w/ C)… … BUT, if DIP does NOT want to stay in oil business, then DIP MAY nonetheless assume executory contract, then assign to 3rd party 3rd party will pay DIP for right to undertake lucrative contract Assume D files Ch. 11 hoping to continue exploiting non-exclusive patent license (executory contract w/ non-bankrupt licensor) even if D ONLY hopes to assume executory contract, “applicable law” (federal patent law) states that non-breaching party (non-bankrupt licensor) need NOT accept substituted performance… even if there is NO substituted performance 9th Circuit reads statute literally (“hypothetical test”/Catapult) executory contract may NOT be assumed, even if there will be NO assignment Bad public policy if license is “mission critical” to DIP, then enabling licensor to terminate executory contract will destroy DIP’s (as if assumption by DIP is as bad as substituted performance by 3rd party)…
If C holds note/SI on D’s license, then termination of executory contract would evaporate C’s collateral… … thus, C MAY enter into cure agreement w/ licensor C agrees to cure D’s default in exchange for licensor NOT terminating license … BUT, interpreting § 365(c)(1) as written (“… assume or assign…”) Other courts have adopted “actual test” if DIP is actually going to assign executory contract to 3rd party, then DIP may NOT assume… BUT, if DIP is NOT going to assign, then DIP MAY assume (despite applicable law NOT allowing for substituted performance) § 365(c)(2) executory contract to make loan (financial accommodation contract/pre-packaged bankruptcy) may NOT be assumed… even if C-lender consents Timing of decision to assume/reject executory contract… In Ch. 7 (§ 365(d)(1)) 60 days In Ch. 11 (§ 365(d)(2)) NO set DIP negotiating whether to assume/reject executory contract MAY legitimately have NOT decided… BUT, likely stretching out Cs’ agony (force settlement)… … thus, at some point, judge will lose patience In certain commercial real property contexts, interim payments must be made during decision-making process if D-tenant is bankrupt, then increased likelihood that landlord (if NOT paid by tenant) will become bankrupt as well (i.e. default on mortgage) Post-petition defaults… Executory contract may NOT be terminated by post-petition “ipso-facto” default (§ 365(e)(1))… … unless, applicable law excuses non-breaching party from accepting substituted performance (§ 365(e)(2)) § 365(e)(1) language similar to § 365(b)(2)(A)-(C)… AND, § 365(e)(2) language similar to § 365(c)(1)… … thus, executory contract MAY be terminated if default is NOT OR, if applicable law excuses non-bankrupt from accepting substituted performance (i.e. under partnership law, if partner in limited partership becomes bankrupt, then other partners MAY dissolve partnership)
$$ from rent (collected by D-landlord) is separate from TD on D’s property… … BUT, CA allows for assignment of rents (CC § 2938) § 552 provides for availability of cash collateral owned by DIP, BUT subject to lien held by C… DIP MAY operate business in ordinary course w/o court hearing (§ 363(c)(1))… BUT, may NOT use/sell/lease cash collateral, unless w/ consent OR court authorization (§ 363(c)(2)) DIP has affirmative obligation to segregate/account for cash collateral (§ 363(c)(4))… If DIP fails to segregate/account for cash collateral, then will be replaced by trustee… AND, DIP counsel must withdraw b/c DIP has violated federal law (file motion w/ court seeking permission to withdraw, BUT w/o disclosing reason, unless crime-fraud exception OR DIP consents) If DIP fails to segregate/account for cash collateral (commingles into general account), then C-lender MAY have NO cash collateral claim against DIP (for violation of obligation) essentially worth nothing… … thus, C-lender must make sure that DIP is using separate accounts obtain court authorization of daily/weekly/monthly accountings (DIP will fight against, BUT DIP can’t be trusted) Again, after D files Ch. 11 (becomes DIP), customers will flake out on AR obligations upon payment, $$ would go into DIP’s separate account for C-lender’s cash collateral (assuming C-lender has SI on AR)… … BUT, customers ONLY pay AR to keep D happy once D becomes DIP, customers have doubts re: DIP’s survivability, do shady things (i.e. write “PAID IN FULL” on check that is NOT full payment)… … thus, C-lender/DIP must NOT cash checks w/ “PAID IN FULL” notation MAY be binding (civil code says YES, commercial code says NO) § 363(e) DIP is allowed to use cash collateral, must adequately protect In CA, DIP MAY prove adequate protection of C-lender by filing cash collateral stipulation w/ court…
… which MAY contain “sweeteners” (which CA courts are generally hostile toward)… Cross-collateralization clause post-petition collateral as security for pre-petition debt (and, MAYBE vice versa) Essentially an end-run around § 547(b) (post-petition transfer for antecedent debt)… … thus, courts may NOT approve cash collateral stipulation w/ cross-collateralization clause (though, more “special cases” in DE than CA) Findings of fact binding estate re: validity/perfection/amount of lien Again, some courts do NOT permit, while others allow for “special cases”… … BUT, if permitted, then should be binding on DIP AND successor-trustee (if conversion to Ch. 7) Findings of fact binding estate re: other Cs’ liens C-lender’s lien has priority over other liens (binding those that are NOT party to cash collateral stipulation) Waiver of § 506(c) waiver of surcharge on collateral (for preservation by 3rd party-professionals/successor-trustee… again, binding non-parties) Divesting DIP of discretion in formulation of plan of reorganization “hand-cuffing” DIP (judges dislike) Release of C-lender’s liability for pre-petition (NO in 9th Circuit) Waiver of avoidance actions against C-lender (NO in 9th Circuit) Automatic relief from automatic stay upon default (NO in 9th Circuit) Waiver of procedural requirements NO for foreclosure… … BUT, MAYBE for perfection of replacement lien (i.e. court order in place of UCC-1… though, difficult for 3rd parties to search/receive notice) Lien on claim for relief substituted collateral b/c DIP has NO unencumbered assets
MAY work w/ against 3rd party… … BUT, NOT w/ claim against C-lender (b/c tantamount to settlement) Waiver of § 363(c)(2)(B) DIP’s right to move for court authorization of use of cash collateral as alternative to C-lender’s consent (NO) Lien in excess of cash collateral (NO) One court recently allowed DIP to grant lien to C-lender on anticipated future profits… … BUT, consider chances of future profits (did NOT happen before Ch. 11) C MAY end up w/ lien on nothing Paying down of pre-petition principal MAYBE to the extent that DIP is using post-petition collateral (thereby endangering C-lender’s secured position)… … BUT, MAY look too much like cross-collateralization clause (depends on wording) Findings of fact re: matters extraneous to approval process (NO) Securitization of AR pre-petition transaction such that cash collateral may NOT be part of estate (NO case law on subject)… Pre-petition D sets up bankruptcy remote entity (“BRE”) (a.k.a. SPE, sub”) D transfers AR to BRE… C-lender loans $$ to BRE, which then goes to D (to complete “sale” for AR)… C-lender takes note/SI in AR… In BRE’s Articles of Incorporation, it states that its ONLY C is C-lender (who bonds)… … thus, C-lender has NO interest in forcing BRE into bankruptcy (renders bonds more risky) … thus, when D Ch. 11, customers continue paying AR… BUT, payments made to BRE (which is NOT bankrupt) BRE have recourse against D (if customers stop paying AR), thus more like a disguised secured transaction than a “sale” (which, if NOT perfected, could be avoided as per § 544(a)(1))… … BUT, NOT a fraudulent transfer NO actual fraud (done publicly) AND NO constructive fraud (D received REV for AR) Critical vendor orders…
… BUT, § 506(a) states that a lien is valued at the value of the property (economic value, NOT face value), AND extent beyond that is an unsecured claim… … AND, sale price ($40M) IS greater than (economic) value of property (approx. $25M) § 363(f)(5) sale free and clear OK if holder of interest could be compelled, in legal/equitable proceeding, to accept $$ satisfaction of interest JF IS a legal proceeding) would have compelled C2 to accept economic ($$) value of TD2 (again, $0)… BUT, again, PW does NOT discuss this… … though, if this interpretation were followed, then § 363(f)(5) would render § 363(f)(3) unnecessary (surplusage) Lesson learned from PW do NOT hold free and clear (b/c junior lien may NOT be extinguished, BUT, rather, MAY become senior lien on property)… instead, obtain relief from automatic stay, foreclose, AND wipe out junior interests Goal/policy #1 provide incentive to create best possible price for market… BUT, in PW, C1’s efforts (as “stalking horse” bidder, providing administrative carve-out) go unrewarded Goal/policy #2 sell property quickly and proceed w/ administration of estate (as per § 363(f)(4), NOT even litigation over a bona fide dispute is supposed to hold up sale of property)… BUT, in PW, protracted litigation keeps title to property in flux Other issues re: sales free and clear… At auction of (which estate will NOT prosecute), “stalking horse” bidder outbid by defendant to said claim unresolved whether this is a sale (as per § 363(f)) OR settlement of claim (which must comply w/ settlement approval procedure) DIP sells entire product line to new entity product line exception MAY allow plaintiff (injured by defective product made by DIP) to bring product liability claim against new entity Voting… Assume C-lender is owed $1M, TD on property worth $800K has $200K deficiency (unsecured claim)… whereas, all other unsecured (trade) Cs owed $100K (combined)…
Likewise, if/when exclusivity terminates, secured C MAY propose plan in which secured C is paid in full AND in cash, AND unsecured Cs are essentialy wiped out… … AND, b/c secured C’s rights are “altered” by this plan, secured C IS an impaired class (“altered” does NOT necessarily mean “made worse off”, MAY merely mean “changed”/ “improved”)… … thus, b/c there is one impaired class, “cramdown” will occur C-lender (victimized by “cramdown”) will seek risk premium (as per risk of conversion to Ch. 7)… BUT, likely ONLY 1-2% above contract interest rate (NOT a full default interest rate) “Absolute priority rule”… As per “cramdown”, plan must be fair/equitable to each impaired AND, a plan is NOT fair/equitable to an impaired class of unsecured claims if said class is NOT paid in full –AND– any class junior to said class receives anything (§ 1129(b)(2)(B))… … thus, if unsecured Cs receive ONLY $0.50 on the dollar, then equity holders (who are junior to Cs) may NOT receive anything… … BUT, if equity holders receive nothing, then DIP will fail in Ch. 11 Exception to “absolute priority rule” new value plan… If equity holders put new value ($$ OR $$’s worth, NOT “sweat equity”) into DIP, then equity holders MAY receive something in plan… … BUT, nonetheless, equity holders must NOT receive any “property” that is “on account of” junior claim… In 203 N. LaSalle, DIP’s old equity holders give new value in exchange for shares of reorganized corp. YES “property”… … AND, old equity holders are given this exclusive opportunity solely b/c of their status as old equity holders YES “on account of”… … thus, plan is NOT fair/equitable b/c there is NO way to determine adequacy of plan (plan proposed by DIP, AND DIP made up of old equity holders) NOT market-tested … thus, old equity holders who give new value AND receive “property” in exchange must NOT receive this opportunity “on account of” their prior status options…