Contents

  • 1031 Exchange Agreements: Drafting Failure Can Lead to Unsecured Status
  • Courts Send Mixed Messages on WARN Act Claims in Bankruptcy
  • Fifth Circuit Rules in Credit Bidder's Favor
  • Right to Credit Bid Upheld Under Intercreditor Agreement
  • Transfer Voided as Fraudulent Conveyance; Recipient Has Knowledge of Judgment
  • Secured Creditor's Loan Equitably Subordinated; Loan Found to Benefit Lender, Not Debtor
  • Extension of Financial Accommodations Clarified
  • Landlord Can Seek Payment for Use During 'Stub' Period

1031 Exchange Agreements: Drafting Failure Can Lead to Unsecured Status
By Jeanne S. Lofgren

A Virginia bankruptcy court has issued a decision that should be a major eye-opener for any entity that engages in tax-free exchanges under section 1031 of the Internal Revenue Code.

The court warned that if 1031 exchange agreements are not drafted properly, parties that place exchange funds with a qualified intermediary will be general unsecured creditors if the QI declares bankruptcy. Millard Refrigerated Servs., Inc. v. LandAmerica 1031 Exchange Servs., Inc. (In re LandAmerica Fin. Group, Inc., et al.), No. 08-03147, 2009 Bankr. LEXIS 940 (Bankr. E.D. Va. April 15, 2009).

In Millard, the court concluded that a 1031 Exchange Agreement that provides for the seller to relinquish all right, title, and control over the exchange funds does not establish a trust relationship between the Qualified Intermediary (QI) and the seller—even if the exchange funds are segregated into accounts clearly traceable to the seller. The consequences: the exchange funds will constitute property of a bankrupt QI's bankruptcy estate should the QI seek bankruptcy protection, and the seller will have a general unsecured claim for breach of the exchange agreement.

This means the seller only is entitled to a pro rata distribution of the exchange funds at the conclusion of the QI's bankruptcy proceeding. Accordingly, not only does the seller lose the right to immediate full possession of the exchange funds, but the seller also potentially will incur tax liability for failing to effect timely the 1031 like-kind exchange.

The LandAmerica 1031 Exchange Agreements

The facts giving rise to the Millard decision are as follows: Prior to its bankruptcy petition date, LandAmerica 1031 Exchange Services, Inc. ("LES") entered into three identical exchange agreements as the QI, with Millard Refrigerated Services, Inc. ("Millard") as the seller. The exchange agreements, among other things, required LES to hold the net proceeds from the sale of Millard's property (the "Exchange Funds") in three segregated accounts titled to LES, but containing readily traceable information linking the segregated accounts to Millard.

The purpose of the exchange agreements was to defer Millard's tax liability on the gains realized from the sale of its property pursuant to section 1031, by preventing Millard from constructively receiving the proceeds from the sale while Millard sought out like-kind investment property to purchase within 180 days (the "1031 Exchange").

The exchange agreements governed the parties' rights and obligations in connection with Millard's 1031 Exchange. Specifically, the exchange agreement at issue provided that, "LES shall have sole and exclusive possession, dominion, control and use of all Exchange Funds, including [earned] interest ... [Millard] shall have no right, title, or interest in or to the Exchange Funds or any earnings thereon and [Millard] shall have no right ... to ... otherwise obtain the benefits of any of the Exchange Funds...."

Notwithstanding this provision, the exchange agreements acknowledged that any earned interest in the segregated accounts would be payable to Millard.

At issue in the case was whether the Exchange Funds constituted property of LES' bankruptcy estate available for distribution to all creditors, or whether Millard was entitled to immediate possession of the Exchange Funds, in full, so it could complete its like-kind exchanges.

Bank Account Presumption

In ruling that the Exchange Funds constituted property of LES' bankruptcy estate, the bankruptcy court first acknowledged the presumption under federal bankruptcy law that property held in a bank account titled in the name of the debtor is presumed to be property of the estate. In this case, while the segregated accounts holding the Exchange Funds contained information making them traceable to Millard, the accounts, nonetheless, were titled to LES.

Based on the legal title of the segregated accounts and the fact that the exchange agreements conveyed complete dominion and control over the accounts to LES, the court held that Millard had to rebut the presumption that the Exchange Funds contained in the segregated accounts were property of LES' estate.

To rebut the presumption, Millard had to show that it retained some right to the funds recognized under applicable state law—here, Virginia law. Millard argued that LES was holding the Exchange Funds in trust for Millard's benefit to facilitate the 1031 Exchange, and Millard never relinquished that beneficial interest. In support of its argument, Millard noted that the Exchange Funds were maintained in segregated sub-accounts associated with Millard's name and taxpayer identification number, that LES incurred no risk of loss that is commonly associated with ownership interests, and that Millard retained the benefits of accrued interest earned on the Exchange Funds.

The court disagreed with Millard's assessment. Under Virginia law, an express trust is only created by either using express language to that effect in the agreement, or under "circumstances which show with reasonable certainty that a trust was intended to be created." In this case, the court never examined the circumstances of the situation because it determined that the language in the exchange agreement unambiguously did not create a trust.

No Trust Created

The court acknowledged that, while the use of the word "trust" in the agreement is not a necessity, the absence of the word anywhere in the agreement is notable. More importantly, however, the court found that the language of the agreement evidenced the parties' intention not to create a trust. For example, Millard conveyed exclusive possession, dominion, control and use of the Exchange Funds to LES, while at the same time disclaimed any right, title or interest in the Exchange Funds. This conveyance of control combined with the disclaimer of rights was inconsistent with the establishment of a trust.

The court noted that while the Internal Revenue Code prohibits Millard from taking constructive possession of the Exchange Funds to effect a 1031 Exchange, nothing in the code requires Millard to disclaim all interests in the Exchange Funds. On the contrary, the code contemplates a qualified trust pursuant to which the seller retains beneficial interests in the exchange property as one of the four possible safe harbors a seller can use to effect a qualifying like-kind exchange.

Additionally, the exchange agreement imposed no fiduciary duties whatsoever on LES, a hallmark for the establishment of a trust. Instead, the agreement provided that LES would not undertake any duties not expressly set forth in the exchange agreement, including any duties implied or imposed by operation of law. Accordingly, the court held it would be improper to infer a fiduciary duty in this case.

Finally, the exchange agreements contained integration clauses. As such they were complete agreements, and because they were unambiguous, the court's assessment of the parties' relationship under the agreements was limited to the four corners of the documents; extrinsic evidence to modify or alter the terms of the agreements would not be considered. The court quickly dismissed Millard's alternative argument that the exchange agreements created a "resulting trust" by holding that a resulting trust cannot be recognized where the applicable agreements so clearly evidences an intent not to create a trust relationship.

After noting that the Exchange Funds in the segregated accounts were entirely and completely vulnerable to attachment and levy by third-party creditors of LES, the court concluded that the Exchange Funds were property of LES' bankruptcy estate, subject to distribution among all creditors.


Courts Send Mixed Messages on WARN Act Claims in Bankruptcy
By Mark W. Eckard

As bankruptcy courts continue to play a key role in restructuring the U.S. economy, courts appear to be at odds as to whether WARN Act claims should proceed through adversary proceedings or through the bankruptcy claims process. While courts have come to differing conclusions on the issue, a commonality appears to be that generally courts will lean toward resolving WARN Act claims through whichever process is the most efficient in a particular case.

For example, the U.S. District Court for the District of Arizona recently affirmed the District of Arizona Bankruptcy Court's dismissal of a WARN Act class action adversary proceeding as duplicative of the bankruptcy claims process. Binford v. First Magnus Fin. Corp. (In re First Magnus Fin. Corp.), 403 B.R. 659 (D. Ariz. 2009). In light of significant law to the contrary, however, the First Magnus decisions may be of limited use in an attempt to force WARN Act claimants out of a class action and into the bankruptcy claims process.

The District of Arizona Bankruptcy Court dismissed the WARN Act adversary proceeding primarily because all eight of the plaintiffs also filed proofs of claim for the same damages sought in the adversary proceeding. "Therefore," the bankruptcy court stated, "it seems to be a waste of judicial resources to move forward on [the] adversary complaint when the claims process is moving the same issues down a parallel track."1

The bankruptcy court also noted that principles of estoppel played a role in its decision.2 The court viewed the plaintiffs' filed proofs of claim as an election to have their claims resolved through the claims process. The court's decision was primarily focused on conservation of judicial resources and its discretion to manage its own docket. For these reasons, the bankruptcy court dismissed the adversary proceeding, thereby forcing the plaintiffs to litigate their claims through the bankruptcy claims process.

Duplicative Process

On appeal, the district court held that the bankruptcy court's decision was not clearly erroneous and agreed with the bankruptcy court that the WARN Act adversary proceeding was duplicative of the normal bankruptcy claims process. The district court noted the bankruptcy court's broad discretion to control its docket and its inherent powers under section 105(a) of the Bankruptcy Code to dismiss a case on its own initiative if necessary or appropriate to perpetuate "the proper use of the bankruptcy mechanism."3

The district court focused on the large number of claims filed in the First Magnus bankruptcy case and stated, "[t]he high number of claims filed indicates that any concerns regarding persons holding small claims not seeking to prosecute them absent class procedures are unfounded."4

The bankruptcy court's dismissal of the First Magnus WARN Act class action in favor of the bankruptcy claims process, and the district court's affirmation thereof, may be contrary to the weight of authority on the subject.

The district court applied the bankruptcy court's narrow interpretation of cases from various bankruptcy and district courts around the country that have allowed WARN Act class actions to proceed for the sake of efficiency. Like the bankruptcy court, the district court limited the usefulness of those cases to "the particular facts of those cases."5

Numerous other cases on the subject, however, provide a more thoroughly reasoned basis for allowing WARN Act claims to continue as class action adversary proceedings.

Adversary Proceedings

Other bankruptcy courts have consistently reasoned that WARN Act claims are properly brought as an adversary proceeding pursuant to Rule 7001(7) of the Federal Rules of Bankruptcy Procedure as an action for equitable relief.6 This analysis is premised on law stating that (i) a WARN Act claim is essentially a claim for back pay,7 and (ii) back pay, as a form of restitution, is an equitable remedy.8

These courts also have focused on the efficiency of a class action adversary proceeding versus resolution of individual proofs of claims for large groups of aggrieved employees.

At least one court subsequently has limited the bankruptcy court's dismissal of the First Magnus WARN Act adversary proceeding to the specific facts of that case. In In re Bill Heard Enterprises, Inc.,9 the Bankruptcy Court for the Northern District of Alabama focused on the fact that First Magnus involved eight plaintiffs, all of whom already had filed a proof of claim.

In Bill Heard, by contrast, the proposed class of aggrieved employees was composed of approximately 2,300 claimants. Without reaching the substantive legal issues addressed above, the Bill Heard court allowed the class action to proceed because to do so would "be more efficient than handling same in a piecemeal fashion through the claims process."10

It therefore appears that principles of judicial economy and efficiency will dictate whether, in a given case, WARN Act claims are allowed to proceed through an adversary proceeding or the bankruptcy claims process. At first glance, the First Magnus class action appears to have been dismissed for the same reasons that other WARN Act adversary proceedings have been allowed to proceed. It may be safe to predict that whichever process is more efficient under the circumstances will be the process chosen to resolve WARN Act claims in a given case.

Editor's note: For previous coverage of WARN Act issues, see E. McGovern, "WARN Act Claims Not Entitled to Administrative Priority," CRaB Alert, January 2009, p. 2 (summarizing In re Powermate Holding Corp., 394 B.R. 965 (Bankr. D. Del. 2008)).


Fifth Circuit Rules in Credit Bidder's Favor
By Alex Terras

The U.S. Court of Appeals for the Fifth Circuit has issued a case useful for credit bidders that successfully bid on their own collateral at a bankruptcy sale, which goes forward without a specific agreement "carving out" expenses. Borrego Springs Bank N.A. v. Skuna River Lumber L.L.C., (In re Skuna River Lumber, LLC), 564 F.3d 353 (5th Cir. 2009).

In Borrego Springs, the debtor Skuna filed bankruptcy and decided to sell substantially all of its assets at auction. Skuna hired a business broker to locate buyers. The bankruptcy court approved the auction procedure and granted the business broker the right to seek payment of its expenses and commission. Although the business broker did find some bidders, the successful bid at the bankruptcy sale under section 363 of the Bankruptcy Code was a credit bid by the senior secured party, Borrego Springs Bank.

After the bankruptcy sale closed, Skuna filed an adversary case against the bank to recover the expenses of sale, consisting of the business broker's commission and marketing costs, under section 506(c) of the Bankruptcy Code. Section 506(c) provides:

The trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim ....

The bankruptcy and district courts held in favor of Skuna.

The Fifth Circuit reversed, holding that, while section 506(c) impressed the bank's collateral with the possibility of a "surcharge" claim, no such claim could be asserted after the collateral was sold and was no longer within the jurisdiction of the bankruptcy court. The bank, having acquired its collateral by credit bid "free and clear of interests," could not, therefore, be compelled to pay expenses of sale pursuant to section 506(c).

To the extent that section 363 provides that liens and interests continue in the proceeds of sale, the Fifth Circuit pointed out to the misfortune of the unpaid business broker that the only proceeds were a reduction in debt.

Going Forward

The holding of this case is useful in bankruptcy cases in which a lender becomes a successful credit bidder for its own collateral at a bankruptcy sale that goes forward without a specific agreement "carving out" expenses. The decision reinforces the notion that section 506(c) is to be narrowly construed and cannot be used to affix liability on the creditor, but only the collateral and only while that collateral remains within the bankruptcy court's jurisdiction.


Right to Credit Bid Upheld Under Intercreditor Agreement
By Aaron B. Chapin

Under section 363(f) of the bankruptcy code, a trustee may sell assets of the bankruptcy estate free and clear of liens and other interests. Generally, absent consent of the lienholder, a trustee may only sell assets free and clear of liens under one of the following conditions:

  • If some provision of nonbankruptcy law would permit the sale free and clear of the lien
  • If the sale would produce a large enough surplus to satisfy the lien
  • If there is a bona fide dispute concerning the validity of the lien
  • If the lienholder could be compelled, in a legal or equitable proceeding, to accept a lesser amount

Because these conditions will not exist in many bankruptcy cases, a creditor's right to withhold consent to the sale of its collateral is a powerful tool to protect its security interest.

Another powerful tool available to creditors is the right to place a credit bid at any sale for the amount of the indebtedness, rather than merely the value of the collateral. Thus, in cases in which a trustee may sell the assets free and clear of liens without the lienholders' consent, the right to place a credit bid can protect a creditor from losing its security.

Case in point: In a recent opinion, the Bankruptcy Court for the District of Delaware held that a lienholder waived its right to withhold consent to the release of its lien, but affirmed the lienholder's right to credit bid at a sale of assets free and clear of liens. In re GWLS Holdings, Inc., No. 08-12430, 2009 WL 453110 (Bankr. D. Del. Feb. 23, 2009).

Intercreditor Agreement

The GWLS Holdings decision followed from a murky factual scenario involving the interpretation of an intercreditor agreement. Like many businesses in the transportation industry, Greatwide Logistic Services ("Greatwide") experienced severe financial troubles in recent years, but by early 2008, Greatwide's debt load became inescapable. In October, its debt structure consisted of $337 million secured by first priority liens, and $117 million secured by second priority liens.

Greatwide's creditors, seeing the writing on the wall, started preparing for an inevitable bankruptcy filing. The first lien lenders entered into a series of agreements, in which they appointed a "Collateral Agent" to supervise, manage, and protect their interests. The second lien lenders did the same, appointing their own "Collateral Agent." The two Collateral Agents then entered into an intercreditor agreement, binding all the first and second lien lenders.

In late 2008, Greatwide and its related entities filed voluntary petitions under chapter 11 of the Bankruptcy Code. Soon after the petition date, the debtors-in-possession (acting as a trustee) filed a motion under section 363(f) to sell substantially all their assets free and clear of liens. The bidding procedures motion and the sale motion contemplated that the first lien lenders would place a credit bid for the full amount of the debt owed.

All of the first lien lenders consented to the credit bid and agreed to release their liens on the collateral, except for one—Grace Bay Holdings LLC and Grace Bay Holdings II, LLC ("Grace Bay"), which held approximately $1 million in first priority liens. The reasons for Grace Bay's refusal to release its lean were not explained in the court's opinion, but the creditor may have been unsatisfied with the bidding procedures, or simply may have wanted to have its cake and eat it too.

Despite Grace Bay's objecting to the bidding procedures motion, the first lien Collateral Agent supported to the debtors' attempted sale, resulting in the dispute that led to this opinion.

Consent to Sale

The issue for the court was one of contractual interpretation of the intercreditor agreements. Grace Bay cited provisions of these agreements that required "unanimous written consent" of the first lien lenders to waive provisions of, or modify, the intercreditor agreements. In response, the first lien Collateral Agent cited provisions of the intercreditor agreements providing that the first lien lenders appoint the Collateral Agent and authorized it to "sell, lease, license, sublicense, assign, give option or options to purchase, or otherwise dispose of and deliver the Collateral or any part thereof."

The court found in favor of the Collateral Agent. It determined that the "unanimous written consent" requirement applied only to waivers and modifications of the agreements themselves, not to the first lien creditors' rights under the agreements. Grace Bay, by entering into these agreements, had authorized the Collateral Agent to place the credit bid on its behalf. Under the same reasoning, Grace Bay waived its right to withhold consent to the release of its lien.

Consequently, the Collateral Agent was entitled to place the credit bid over Grace Bay's objection.

Credit Bid Affirmed

While the main thrust of the opinion focused on the interpretation of contracts between the parties, the court did not hesitate to affirm the secured creditor's right to credit bid. This right is preserved by section 363(k) of the Bankruptcy Code and is vital for secured creditors to preserve the value of their collateral.


Transfer Voided as Fraudulent Conveyance; Recipient Has Knowledge of Judgment
By Stephen T. Bobo

The U.S. Court of Appeals for the Seventh Circuit recently determined that a judgment-debtor's transfer of property to a transferee with knowledge of the judgment was voidable under the Uniform Fraudulent Transfer Act. See For Your Ease Only, Inc. v. Calgon Carbon Corp., 560 F.3d 717 (7th Cir. 2009).

Though the transferee had given reasonably equivalent value to the judgment-debtor in exchange for the transfer, the court found that the transferee did not take the judgment debtor's assets in good faith because its principal knew that judgment had been entered.

The appeal arose from a suit brought in the Northern District of Illinois by For Your Ease Only, Inc. ("FYEO") for patent misuse and tortuous interference with business relations against several competitors relating to certain jewelry boxes sold on the Home Shopping Network. FYEO obtained a default judgment in excess of $2 million against the defendants.

One of the defendants, Mark Schneider, moved to Costa Rica during the litigation. Another defendant, which was an entity owned by Schneider, transferred its principal asset—the right to receive payments from Home Shopping Network—to another company that Schneider owned, Sevenquest, LLC. Following entry of the judgment in 2006, FYEO attempted to enforce the judgment by serving a subpoena on Schneider's brother-in-law, Doug Fournier. The December 2006 subpoena informed Fournier of the entry of the judgment against the defendants.

Judgment-Debtor's Transfer

A month after receiving the subpoena, Fournier flew to Costa Rica to meet with Schneider. Schneider gave Fournier a letter addressed to Home Shopping Network that purported to transfer Sevenquest's right to the Home Shopping Network payments to another entity called Anewco Corp., which was to be formed by Fournier. Although Anewco did not yet exist at the time that Schneider gave him the letter, Fournier formed it shortly after returning to the United States.

FYEO learned that Home Shopping Network had been making its payments to Sevenquest and then to Anewco. It challenged the transfer of the payment rights to Sevenquest and Sevenquest's transfer of those rights to Anewco on fraudulent conveyance grounds. FYEO also challenged the payments that Home Shopping Network thereafter made to Anewco.

The district court found that the initial transfer of the right to receive the payments to Sevenquest possessed sufficient "badges of fraud" to be presumptively fraudulent under the Illinois Uniform Fraudulent Transfer Act: the transfer was effected from one Schneider-owned company to another; Schneider continued to control the property after the transfer; the transfer had been concealed by Schneider's efforts to avoid discovery; Schneider made the transfer after being sued; the transfer was of substantially all of his assets; and he became insolvent shortly after the transfer.

The district court took a different view, however, of the subsequent transfer from Sevenquest to Anewco. It found that Anewco had taken the payment rights for reasonably equivalent value and in good faith. The value was Fournier's prior agreement to provide services to develop the Home Shopping Network for a three-year period for a small commission. In exchange, at the conclusion of this period, Schneider would transfer the business to him.

The district court based its good faith finding on the fact that Fournier did not have a legal or financial relationship with Schneider at the time of the transfer. Schneider did not have involvement with Anewco, and after the transfer he had no control over the Home Shopping Network payments. Therefore, the court determined that the transfer to Anewco was not voidable under UFTA.

Seventh Circuit Review

On appeal, the Seventh Circuit accepted the district court's finding that reasonably equivalent value had been exchanged in the transfer, but focused on Fournier's knowledge of the judgment against Schneider when he traveled to Costa Rica. The court examined Illinois case law, and cited decisions in which courts have found lack of good faith, where the transferee knew of a judgment against the transferor or even a pending lawsuit against the transferor.

Even if Schneider or his companies had no continuing legal or financial relationship with Anewco following the transfer, it was clear that Fournier had knowledge of the outstanding judgment against Schneider. He knew about FYEO's judgment from the subpoena it had sent to him, and he flew to Costa Rica immediately after learning of it to protect "his" business with Home Shopping Network from the judgment.

The Seventh Circuit ruled that Fournier's knowledge of the judgment precluded his company from receiving the payment rights in good faith, even if he and his company had given reasonably equivalent value. Therefore, the transfer of the right to receive the payments was voidable under the UFTA.


Secured Creditor's Loan Equitably Subordinated; Loan Found to Benefit Lender, Not Debtor
By Alex Terras

In a harshly worded decision, a federal bankruptcy judge concluded that a syndicated loan product was so one-sided in favor of the lender as to "shock the conscience" of the court. The judge therefore equitably subordinated the secured lender's claim. See In re Yellowstone Mountain Club, LLC, No. 08-61570, 2009 WL 1324950 (Bankr. D. Mont. May 12, 2009).

Yellowstone Mountain Club

The case arose out of the financing of the Yellowstone Mountain Club. A gentleman by the name of Mr. Blixseth traded some Montana timberland with the federal government and came to control at least 13,500 formerly federal acres adjacent to Yellowstone Park. His goal was to turn this land into a private ski resort.

Having found a few buyers for lots at "pre-development" prices, and some Class B equity investors, Yellowstone Mountain Club, LLC (the "Club") was in business but operating mostly at losses from 2002-2004. In 2005, a branch of Credit Suisse in the Cayman Islands sold Mr. Blixseth on a new syndicated loan product.

Bankruptcy Judge Ralph B. Kirscher described the transaction as follows:

In 2005, Credit Suisse was offering a new financial product for sale. It was offering the owners of luxury second-home developments the opportunity to take their profits up front by mortgaging their development projects to the hilt. Credit Suisse would loan the money on a non-recourse basis, earn a substantial fee, and sell off most of the credit to loan participants. The development owners would take most of the money out as a profit dividend, leaving their developments saddled with enormous debt. Credit Suisse and the development owners would benefit, while their developments – and especially the creditors of their developments – bore all the risk of loss. This newly developed syndicated loan product enriched Credit Suisse, its employees and more than one luxury development owner, but it left the developments too thinly capitalized to survive. Numerous entities that received Credit Suisse's syndicated loan product have failed financially ....

Credit Suisse ... and [those] on the Credit Suisse team only earned fees if they sold loans. Credit Suisse thus devised a loan scheme whereby it encouraged developers of high-end residential resorts, such as Blixseth, to take unnecessary loans. The higher the loan amount, the fatter the fee to Credit Suisse. This program essentially puts the fox in charge of the hen house and was clearly self-serving for Credit Suisse.

Mr. Blixseth caused the Club to loan $209 million of the loan proceeds to another entity he controlled, thereby cashing out his developer's equity, phantom as it proved.

Bankruptcy Filing

Credit Suisse, having syndicated its loan "applying a new valuation methodology [relying] almost exclusively on ... future financial projections, even though such projections bore no relation to ... historical or present reality," proposed to increase the Club's debt load by at least six times and "could not have believed under any set of circumstances that [the Club] could service such an increased debt load."

The Club filed bankruptcy in 2008.

Bankruptcy Judge Kirscher found the following:

The only plausible explanation for Credit Suisse's actions is that it was simply driven by the fees it was extracting from the loans it was selling, and letting the chips fall where they may. Unfortunately for Credit Suisse, those chips fell in this Court with respect to the Yellowstone Club loan. The naked greed in this case combined with Credit Suisse's complete disregard for the Debtors or any other person or entity who was subordinated to Credit Suisse's first lien position, shocks the conscience of this Court. While Credit Suisse's new loan product resulted in enormous fees to Credit Suisse in 2005, it resulted in financial ruin for several residential resort communities. Credit Suisse lined its pockets on the backs of the unsecured creditors.

As a result, Bankruptcy Judge Kirscher equitably subordinated Credit Suisse's secured claim to most of the other debt in the Club's bankruptcy.


Extension of Financial Accommodations Clarified
By Ann E. Pille

A Florida bankruptcy court recently clarified what constitutes a contract to extend financial accommodations for the benefit of the debtor, and the circumstances in which those contracts could be assumed, rejected or terminated. In re Ernie Haire Ford, Inc., 403 B.R. 750 (Bankr. M.D. Fla. 2009).

The issue came before the bankruptcy court after several third-party automobile finance companies terminated their individual contract purchase agreements with the debtor, Ernie Haire Ford, Inc., an auto dealership. Under its prepetition arrangement with the finance companies, the debtor would negotiate a retail installment sales contract with a prospective automobile purchaser and obtain credit information from the purchaser.

Thereafter, the debtor would circulate information regarding the proposed vehicle sales contract and the purchaser's credit information to the finance companies, which would have discretion to enter into the transaction. If one of the finance companies accepted a transaction, the finance company would provide the debtor with the purchase price for the vehicle, and the purchaser would make payments directly to the finance company. The finance company was under no obligation to accept any particular transaction or to finance any of the proposed purchase contracts.

After Ernie Haire filed for bankruptcy protection, the finance companies informed the debtor that they would be closing the debtor's accounts and no longer would be financing transactions related to the debtor. In response, the debtor filed a motion to compel the finance companies to comply with their pre-petition contract purchase agreements.

Financial Accommodations?

In response, the finance companies first argued that their contract purchase agreements with the debtor were not assumable. Specifically, they argued that the contract purchase agreements were agreements to extend financial accommodations to or for the benefit of the debtor. See 11 U.S.C.A. § 365(c)(2) (West 2009) ("The trustee may not assume or assign any executory contract ... if ... such contract is a contract to make a loan, or extend other debt financing or financial accommodations, to or for the benefit of the debtor, or to issue security of the debtor.").

The bankruptcy court, however, found that this type of arrangement did not constitute a contract to make a loan or extend other debt financing. See In re Ernie Haire Ford, 403 B.R. at 755-58. The court determined that contracts qualify for treatment under section 365(c)(2) "only when the principal purpose of a contract is to extend financing to or guarantee the financial obligations of the debtor." Id. at 755. The court noted that "in nearly every instance where a financial accommodation has been found to exist, the debtor has been directly or secondarily liable for the debt incurred." Id. at 757. In this case, the debtor had no obligation to the finance companies under their ultimate contract with the purchaser.

As a result, the bankruptcy court found the agreements at issue did not qualify for treatment under section 365(c)(2).

Right to Terminate

The finance companies next argued that they had no obligation under the contract purchase agreements because these contracts contained language making them terminable at will.

The bankruptcy court disagreed, and instead found that the timing of the finance companies' decision to terminate the contracts—which occurred immediately after the bankruptcy filing—was based solely on the filing of the debtor's chapter 11 petition and therefore violated the congressional policy against ipso facto provisions. Id. at 758-60. Thus, the court refused to recognize the termination.

Finally, the finance companies argued that even if they were not entitled to formally terminate the contract purchase agreements, they were entitled to functionally terminate the agreements by declining to accept any transactions from the debtor to finance new vehicles.

The bankruptcy court again disagreed. Finding that the finance companies could be compelled to honor the contract purchase agreements, the court noted that there was an obligation on the part of the finance companies to operate under the agreements in good faith. "[T]he bankruptcy case of [the debtor] cannot be the reason for rejecting every Consumer Contract without regard to the merits of the individual transaction, with the result of effectively terminating the contract purchase agreements in violation of the automatic stay." Id. at 761.

The court concluded that the finance companies not only were compelled to perform under the terms of the contract purchase agreements, but also were required to perform under those agreements in good faith. Specifically, the court found that although there were no objective criteria in the contracts that would require the finance companies to accept any particular financing transaction, the court could require the finance companies to operate under the agreements in good faith and to, it seems, accept financing agreements in a similar manner and frequency as they would have done pre-petition.

Going Forward

The Ernie Haire Ford case is a notable reminder that depending on the circumstances, non-debtor parties to an executory contract in bankruptcy may have an obligation to go beyond the express terms of a contract to operate under the contract in "good faith."


Landlord Can Seek Payment for Use During 'Stub' Period
By Derek J. Baker

The United States District Court for the District of Delaware has held that a landlord could seek payment for the debtor's ongoing use and occupation of leased premises, after the petition date but before the next "scheduled" rental payment date. The court concluded the landlord could seek administrative priority treatment for claims covering this "stub" period, in addition to the mandatory monthly payment rights specified by the Bankruptcy Code. See Goody's Family Clothing, Inc. v. Mountaineer Prop. Co. II, LLC (In re Goody's Family Clothing, Inc.), 401 B.R. 656 (D. Del. 2009).

The facts giving rise to Goody's are not unlike many routine commercial bankruptcy cases involving retail establishments. Goody's Family Clothing, Inc. (the "Debtor") was an apparel retailer that operated 350 stores nationwide. On June 9, 2008, the Debtor commenced a bankruptcy case. After commencement of the case, the Debtor remained in possession of its various leasehold interests through the remainder of the month of June.

In accordance with the requirements of section 365(d)(3) of the Bankruptcy Code, the Debtor commenced regular monthly payments on each of its leasehold interests on the next payment due date (primarily, the first day of each month), July 1, 2009. After demands made by certain landlords for payment of rent associated with the Debtor's use and occupancy of the locations between the Petition Date and June 30, 2008, various landlords filed applications seeking allowance of administrative claims with the Bankruptcy Court.

Rather than seeking to compel payments under section 365(d)(3) of the Bankruptcy Code, the landlords sought to compel payments pursuant to section 503(b)(1) of the Bankruptcy Code. The Bankruptcy Code ultimately allowed the landlords' claims pursuant to section 503(b)(1) of the Bankruptcy Code over the Debtor's objection. The Debtor appealed.

Landlord's Rights Expanded

In the district court, the Debtor argued that because section 365(d)(3) of the Bankruptcy Code provided a specific mechanism for payment of rent to landlords under the statutory scheme, the landlord's right to payment on account of rent was limited to those specific provisions.

The landlords countered that while section 365(d)(3) of the Bankruptcy Code provided a mechanism for payment of rent in accordance with the terms in the lease as and when due (in accordance with the "billing date" approach endorsed by the United States Court of Appeals for the Third Circuit), landlords nonetheless could seek compensation for the use and occupancy of its space for the time prior to the date to commence monthly payments in accordance with section 365(d)(3) of the Bankruptcy Code.

The district court analyzed the structure and scheme of the Bankruptcy Code. The court noted that prior to the 1984 amendments which inserted section 365(d)(3) into the Bankruptcy Code, landlords generally were required to prove their right to recover against for a debtor's use and occupancy of certain leased space pursuant to section 503(b)(1) of the Bankruptcy Code. To establish a right to payment pursuant to section 503(b)(1), a landlord must establish that it afforded an actual benefit to the estate, and that the costs and expenses are necessary to preserve value to estate assets.

The court noted that the 1984 amendments were meant to "ease" a landlord's burden to establish a right to payment. The court determined that nothing in the statutory scheme suggests that section 365(d)(3) of the Bankruptcy Code is the exclusive mechanism for recovery of rent. In fact, the two sections of the Bankruptcy Code relied upon by the parties (i.e., sections 365(d)(3) and 503(b)(1)) are not mutually exclusive. Except for the introductory word "notwithstanding" in the beginning of section 365(d)(3) of the Bankruptcy Code, the sections do not otherwise reference one another.

According to the court, section 365(d)(3) of the Bankruptcy Code was meant to insure that landlords would not be required to establish actual benefit conferred on an estate by the ongoing use and occupancy during continuation of a bankruptcy case. Although section 365(d)(3) of the Bankruptcy Code was a mechanism for recovery, nothing prevented the landlord from also seeking recovery under section 503(b)(1). Here, the court noted that the Debtor remained in the location and conducted going-out-of-business sales generating substantial revenue for the Debtor's ongoing operations. Therefore, the actual benefit conferred (compared with the minimal expense incurred) justified the allowance sought by the landlords.

In affirming the bankruptcy court, the district court concluded that the landlords were able to establish that the Debtor's use and occupancy provided actual benefit to the Debtor's estate and was a necessary expense to preserving estate's assets. Therefore, the court concluded allowance of an administrative claim pursuant to section 503(b)(1) of the Bankruptcy Code was authorized.

Welcome Support

This case is welcome support for landlords in their attempts to collect the Debtor's use and occupancy during various "stub" periods. Many practitioners have asserted that the federal circuit in which a bankruptcy case is pending will determine whether or not a landlord may be entitled to collect on account of certain stub rent obligations. This case makes clear that section 503(b)(1) of the Bankruptcy Code provides a recovery avenue for landlords in addition to the mandatory statutory scheme of section 365(d)(3).

But an additional avenue of recovery does not necessarily mean more money in a landlord's pocket.

One concern is that recovery under section 503(b)(1) requires a more exacting showing and is not limited to the "contract rate" of the lease. Although in Goody's the court allowed a claim for the "stub" rent, the costs associated with pursuit of an allowed claim pursuant to section 503(b)(1) of the Bankruptcy Code (under its more exacting standards) may not be justifiable in other circumstances in light of the requirement to show the amount of benefit the landlord conferred.

A second issue to note is that the simple allowance of a claim pursuant to section 503(b)(1) does not ensure payment. Courts retain discretion to determine the ultimate timing of payments on allowed claims and generally (with limited exceptions) will not require payment of administrative expense claims until a plan of reorganization is confirmed in a debtor's overall bankruptcy case.


Footnotes

1.Binford v. First Magnus Fin. Corp. (In re First Magnus Fin. Corp.), No. 07-00060, 2008 WL 348805, at *1 (Bankr. D. Ariz. Feb. 6, 2008).

2.Id.

3.Binford v. First Magnus Fin. Corp. (In re First Magnus Fin. Corp.), 403 B.R. 659, 664 (D. Ariz. 2009).

4.Id.

5.Id.

6.See, e.g., Cain v. Inacom Corp., No. 00-1724, 2001 WL 1819997, at *1-2 (Bankr. D. Del. Sept. 26, 2001) (WARN Act class action adversary proceeding allowed to proceed as an action for equitable relief); Loehrer v. McDonnell Douglas Corp., 1992 Dist. LEXIS 22555, No. 91-1747, (E.D. Mo. Oct. 5, 1992) (same); In re Protected Vehicles, Inc., 392 B.R. 633, 639-42 (Bankr. D.S.C. 2008) (same); Grady v. Quantegy, Inc. (In re Quantegy, Inc.), 343 B.R. 689, 693 (Bankr. M.D. Ala. 2006) (same).

7.29 U.S.C.A. § 2104(a)(1) (West 2009) (employers who violate the WARN Act are liable to aggrieved employees for "back pay for each day of violation").

8.Chauffers, Teamsters & Helpers, Local No. 391 v. Terry, 494 U.S. 558, 570 (1990) (back pay sought from an employer under Title VII would generally be restitutionary and, thus, equitable in nature) (citing Albemarle Paper Co. v. Moody, 422 U.S. 405, 415-418 (1975) and Curtis v. Loether, 415 U.S. 189, 197 (1974) (back pay is a form of restitution, an integral part of an equitable remedy)); Consolidated Rail Corp. v. Darrone, 465 U.S. 624, 630 (1984) (characterizing a claim for back pay from a former employer is "an equitable action"); Protos v. Volkswagen of America, Inc., 797 F.2d 129, 138 n.5 (3d Cir. 1986), cert. denied, 479 U.S. 972 (1986) ("we made clear that the recovery of lost pension benefits . . . is, like an award of back pay itself, actually a form of equitable restitution.") (internal quotation omitted); Waddell v. Small Tube Prods., Inc., 799 F.2d 69, 78 (3d Cir. 1986) ("back pay is an equitable remedy").

9.In re Bill Heard Enters., Inc., 400 B.R. 795 (Bankr. N.D. Ala. 2009).

10.Id. at 801.

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