Posted by Gregory F. Vizza on April 02, 2012

Trustee's Preference Complaint Gets Iqbal-ed

Gregory Vizza

When drafting an adversary complaint to recover a preference, trustees must make a showing of entitlement to relief in compliance with the Supreme Court’s decisions in Twombly and Iqbal.  In dismissing the Trustees preference complaint for failure to state a claim, Judge Walrath’s opinion in Gellert v. The Lenick Company outlines what facts must be alleged in a preference claim to survive a motion to dismiss.  

The Litigation Trustee (“Trustee”) in Gellert, appointed under the Debtor’s confirmed plan of reorganization, filed a complaint against The Lenick Company (“Lenick”) to, inter alia, avoid transfers under sections 547 and 548 of the Bankruptcy Code.  Lenick moved to dismiss the Complaint pursuant to Rules 8(a) and 12(b)(6) arguing that the Complaint fails to establish a plausible claim for avoidance of preferential transfers. 

Relying on the pleading standards the Supreme Court espoused in Twombly and Iqbal, as well as subsequent Third Circuit precedent, the Court dismissed the Trustee’s preference count because it failed to establish a plausible claim.  Judge Walrath determined that in order to survive a motion to dismiss, a preference complaint must include:

(a) an identification of the nature and amount of each antecedent debt and

(b) an identification of each alleged preference transfer by:

(i) date of the transfer,
(ii) name of the debtor/transferor,
(iii) name of the transferee, and
(iv) the amount of the transfer.

Attached to the Trustee’s complaint was an exhibit that provides the name of the transferee, check numbers, check amounts, invoice dates, invoice numbers, and the clear dates of the transfers sought to be avoided.  It also clearly shows that the transfers took place within the 90-day preference period.  Further, the Trustee asserts that § 547’s presumption of insolvency and the allegation that Lenick received more than it would have under a chapter 7 bankruptcy, along with the exhibit, alleges sufficient facts to provide Lenick ample notice of what transfers are sought to be avoided and establishes that the preference count is plausible on its face.

Initially, the Court determined that actual copies of invoices, bills, and canceled checks or other tangible evidence are not required to substantiate the Trustee’s claims at the motion to dismiss stage.  Additionally, Judge Walrath states that the exhibit adequately alleges facts identifying the date of transfer, name of transferee and transfer amount.

However, there are two areas of deficiency.  First, the Trustee did not sufficiently identify the transferor of the alleged preferential payments, who must be identified by name.  Use of the generic “one or more of the Debtors made transfers” will not permit a claim to withstand a motion under Rule 12(b)(6).  Second, the nature of the alleged antecedent debt was not provided in sufficient detail.  While check numbers, dates and amounts are included on the exhibit, no other information was provided to explain the nature of the debt.  In fact, the complaint does not provide sufficient detail to establish that there was, in fact, an antecedent debt or any evidence of a pre-existing debtor/creditor relationship from which an antecedent debt could have arisen.  The Trustee’s exclusive reliance on a recitation of the elements of § 547 with regard to the presence of an antecedent debt resulted in dismissal of the preference claim.

Posted by Kory Grushka on March 05, 2012

Secured Lender Loses to IP Owner in Dispute Over Proceeds of Trademarked Inventory

By:  Robert B. Stein and Kory Grushka

Robert B. Stein

Kory Grushka

In an unorthodox ruling, a North Carolina appellate court recently held that a factor of trade receivables had neither a valid ownership interest nor security interest in certain of its borrower's accounts receivable, or the proceeds thereof, because those accounts receivable were generated from inventory sold in violation of a third party's trademark rights.

In Variety Wholesalers, Inc. v. Prime Apparel, LLC, 2011 WL 6036084 (N.C.App. Dec. 6, 2011), the borrower sold to a customer certain goods that incorporated a trademark owned by the borrower's vendor. Prior to the customer's payment for the goods, the vendor demanded that the customer cease payment to the borrower for the goods. The customer, unsure of the rightful payee, deposited the payment with a North Carolina state trial court and asked the court to determine to whom the payment should be made. The borrower's factor, which had purchased the underlying receivables and had also made secured advances against them, claimed that it had a superior interest in the payment because it had a valid and perfected ownership interest and security interest in such receivables and the proceeds thereof.

Because it failed to respond to a series of pleadings, the trial court entered a default judgment against the borrower for trademark infringement and violation of state unfair trade practices law. Separately, the court found that the vendor was entitled to the proceeds as damages for these violations, and that the factor had no interest in such proceeds. On appeal, the North Carolina Court of Appeals affirmed. Without any discussion of its reasoning or citation of dispositive case law, the appellate court held that the borrower had no right to the goods or the proceeds from the sale and, as a result, there were "no accounts receivable it could [assign] to [the factor] through their prior agreement." Although the appellate court did not elaborate, its holding suggests that it viewed the proceeds of the receivables arising from the infected inventory sales as subject to a constructive trust for the benefit of the vendor—a draconian remedy.

This case highlights an often overlooked category of risk for secured lenders—the risks associated with financing inventory sold in violation of third-party intellectual property rights. The court in this case took an aggressive position with respect to trademark infringement remedies. Even in instances where damages are awarded for trademark violations, it is unusual, though not without precedent, for a court to determine that the proceeds of the infringing sales may be subject to a constructive trust.

This said, federal and state law does provide courts with substantial latitude in crafting remedies for trademark infringement violations, some of which may impact an infringing seller's secured lender. Courts have broad powers to issue injunctions against future infringing sales, to freeze assets during the pendency of a trial and/or to require the infringing party to take certain actions such as accounting for the profits realized. As Variety illustrates, courts also have the power to award various categories of damages. In most cases, however, any such judgment for damages will constitute an unsecured claim—and the trademark owner will not be entitled to any special status vis-à-vis the other creditors of the infringing seller. While the remedy imposed by the Variety court is unusual, the case serves as a warning to lenders that the outcome of a trademark infringement case can be unpredictable.

Posted by Regina Stango Kelbon on February 28, 2012

The Aftermath of Stern v. Marshall: The Bankruptcy Court's Power to Hear and Decide Fraudulent Transfer

By:  Regina Stango Kelbon, Lora Epstein, and Alan Root

Regina Stango
Kelbon

Lora Epstein

Alan Root
 

For decades, bankruptcy courts have been hearing and entering final judgments in fraudulent conveyance and preference actions with little question as to their authority to do so.  However, in June of last year, the Supreme Court’s decision in Stern v. Marshall, 131 S. Ct. 2594, 2616 (2011), has led courts and practitioners to question the bankruptcy court’s power in areas that previously were considered “core” or traditional bankruptcy claims.   Stern held unconstitutional the bankruptcy court’s power to adjudicate “counterclaims to proofs of claim” that, though statutorily defined as “core” under 28 U.S.C. § 157(b)(2), were premised on state law independent of the bankruptcy case.  Despite the fact that the Stern Court characterized its holding as a “narrow” one and not intended to change the bankruptcy landscape, it has caused lower courts to reexamine whether bankruptcy courts have the constitutional authority to hear and decide other statutorily codified “core” actions under § 157(b)(2).  For the most part, the few cases since Stern with respect to preference actions generally support the bankruptcy courts’ authority to hear and decide such actions.  However, courts have diverged with respect to fraudulent transfer actions.   

Though the Supreme Court majority emphasized that Stern was to be interpreted narrowly, the lower court case law that has followed evidences that there are many unanswered questions as to the bankruptcy court’s power over other defined “core” proceedings in § 157(b)(2), especially with respect to fraudulent conveyance actions.  

Since Stern, the cases generally have been decided in one of three ways:

(1)   First, the bankruptcy court continues to hear and decide the fraudulent transfer proceeding and provide a final ruling on the controversy before it.  As added protection, such rulings may also include a caveat that should the district court find that the bankruptcy court lacked authority to enter a final ruling, the opinion should be deemed the bankruptcy court’s proposed findings of fact and conclusions of law. 

(2)   Second, in accordance with § 157(c)(1), the bankruptcy court hears the fraudulent transfer proceeding but does not enter a final judgment.  Instead, the bankruptcy court only provides recommendations to the district court for its final judgment.  In essence, the bankruptcy court treats the statutory “core” matters as “non-core.”

(3)   Third, under the strictest interpretation of the Stern decision, the bankruptcy court finds that its authority is completely void as to the fraudulent transfer proceeding and the proceeding must immediately be withdrawn to district court.  Some courts have even held that there exists a statutory gap as a result of Stern that leaves the bankruptcy court without authority to even hear the matter. 

To read more about the Stern decision, its aftermath and the uncertainty that has ensued and how courts are handling such uncertainty, please click here.

Posted by Alan Root on February 27, 2012

In re USDigital, Inc.: The Delaware Bankruptcy Court Analyzes Stern v. Marshall

Alan Root

In In re USDigital, Inc., 461 B.R. 276 (Bankr. D. Del. Dec. 20, 2011), a recent opinion from a Delaware bankruptcy court analyzing the reach and impact of the Supreme Court’s decision in Stern v. Marshall, 131 S. Ct. 2594, 2616 (2011), Judge Sontchi interpreted the Stern holding very narrowly.  The specific issue before the bankruptcy court was whether a count in an adversary proceeding seeking equitable subordination of certain defendants’ claims under § 510(c) of the Bankruptcy Code was a core or non-core proceeding. 

Prior to analyzing the specific issue in front of it, the bankruptcy court provided seven general observations about Stern and its limits and import. 

  • First, Stern in no way limits the bankruptcy court’s subject matter jurisdiction. 
  • Second, Stern does not affect whether a proceeding is statutorily core or non-core under 28 U.S.C. § 157. 
  • Third, to determine if a proceeding is truly core, a two step analysis must be undertaken: first, the proceeding must be core under the statute.  Next, if the proceeding is core under the statute, the bankruptcy court must have the judicial authority under the constitution to enter a final order in the proceeding.
  •  Fourth, if the matter is core under the statute and the Constitution, then the bankruptcy court can enter a final order.
  • Fifth, non-core proceedings are those that are either not core under the statute or those that are core under the statute but on which the bankruptcy court does not have the judicial authority under the constitution to enter a final order.
  •  Sixth, a bankruptcy court’s authority over non-core proceedings is limited to issuing proposed findings of fact and conclusions of law that are subject to de novo review by the district court.
  • Seventh, a finding that a matter is non-core does not, in and of itself, result in dismissal of the matter. 

Applying the two-part test discussed above, the bankruptcy court found that the equitable subordination claim was a core proceeding under § 157.  The court first analyzed whether the claim for equitable subordination fell under one of the core proceedings specifically enumerated in § 157(b)(2), ultimately finding that it did not.  Notwithstanding this finding, because  § 157(b)(2) is merely an illustrative list of core proceedings, the bankruptcy court went on to determine whether, under existing Third Circuit law, the claim for equitable subordination was a non-enumerated core proceeding under the statute, ultimately finding that it was. 

Next, the bankruptcy court analyzed whether it had the judicial authority under the constitution to enter a final order on the equitable subordination claim.  In order to answer this question, according to the bankruptcy court, it must first determine if Stern applies to the proceeding at hand. If Stern does not apply, then the analysis complete, the proceeding is core and the court has the judicial authority to enter a final order.  However, if Stern applies, then the court must apply Stern and determine if it has the judicial power under the constitution to enter a final order.  The bankruptcy court then undertook an extensive analysis of Stern to determine if the holding applied to the proceeding at hand.  While acknowledging that there is language in the majority’s opinion that could be interpreted to allow for a broad reading of Stern, Judge Sontchi concluded that Stern must be read narrowly in order to remain true to the “letter and spirit” of the majority’s holding.  As such, the bankruptcy court limited the Stern holding to the following: “the bankruptcy court lacks constitutional authority to enter a final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.”  Turning back to the claim in front of the court, Judge Sontchi quickly concluded that Stern did not apply because equitable subordination does not involve a state law counterclaim to a creditor’s proof of claim.

 

Posted by Rocco A. Cavaliere on February 16, 2012

Does a Secured Creditor Have a Right to Credit Bid in a Sale Conducted Under a Plan? Stay Tuned as the Supreme Court has Granted Certiorari to Decide the Issue

By:  Regina Stango Kelbon and Rocco Cavalieri

Regina Stango
Kelbon

Rocco Cavaliere
 

A secured creditor’s right to credit bid its secured claims in a Chapter 11 plan context is one of the hottest topics in bankruptcy law at this time.  This topic has been addressed in three recent Circuit Court opinions issued in just the last 2 ½ years.  The most recent decision from the 7th Circuit titled In re River Road Hotel Partners, LLC, 651 F.3d 642 (7th Cir. 2011) vindicated a secured creditor’s right to credit bid in Chapter 11 plan sales.  The 7th Circuit disagreed with the decisions from the Fifth Circuit in In re Pacific Lumber Co., 584 F.3d 229 (5th Cir. 2009) and the Third Circuit in In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3rd Cir. 2010), each of which had found that secured creditors may not have a right to credit bid their claims in an asset sale conducted under a Chapter 11 plan if the debtors proposed a plan which provided the secured creditors with the “indubitable equivalent” of such claims.  Please see the following link for a prior blog article by Kevin O’Malley summarizing the River Road case.

After the Seventh Circuit’s River Road decision, the bankruptcy court confirmed an alternative plan of reorganization for the River Road debtors.  However, the Radlax Debtors, affiliated debtors to the River Road debtors, filed a petition for a writ of certiorari. In their petition, the Radlax Debtors stated that “th[e] circuit split creates uncertainty regarding a central component of plan sales in bankruptcy and invites forum shopping by potential debtors…[and]… it further upsets the settled expectations of the secured lending industry.”  The Loan and Syndications Association, a leading financial trade organization filed an amicus brief supporting the Radlax Debtors’ petition for review by the Supreme Court, expressing a desire for certainty in the area of credit bidding.  In their amicus brief, the LSTA stated, among other things, that “secured creditors’ ability to credit bid at auctions of their collateral is central to the detailed scheme of protections that the Bankruptcy Code provides them.” 

On December 12, 2011, the Supreme Court granted the petition for a writ of certiorari.  See Radlax Gateway Hotel v. Amalgamated Bank, 181 L. Ed. 2d 547 (December 12, 2011).  Oral argument has been scheduled for April 23, 2012 with a decision expected thereafter. Please see the following link for an article addressing credit bid rights in a plan context authored by Regina Stango Kelbon and Rocco A. Cavaliere which has been submitted to the Pennsylvania Business Institute in connection with an upcoming program on March 14, 2012.  Stay tuned for the Supreme Court’s decision later this year which we will discuss in a future blog article.

Posted by Peter Jazayeri on January 31, 2012

Did You Fill Out Your Proof of Claim Form Correctly? How the IRS's Failure to do so Prevented it from Recovering on a $46 Million Claim

Peter Jazayeri

In November of 2011, the Court of Appeals for the Eleventh Circuit (“11th Circuit” or “Court”) in United States v. Oscher (In re J.H. Investment Services, Inc.) ruled that the Internal Revenue Service (“IRS”) failed to properly submit an official proof of claim form (the “Form”), thereby denying the IRS recovery on what the IRS believed was a priority, secured claim for $46 million in unpaid taxes. The decision is important because it provides guidance on how to properly fill out an official bankruptcy claim form that is used in every bankruptcy court throughout the United States.  It is applicable to situations where a creditor’s claim is secured against collateral that is worth less than the value of the creditor’s claim, and thus, is particularly vital to secured creditors holding claims against distressed real property assets that are worth less than the value of the mortgage. 

Facts 

J.H. Investment Services (the “Debtor”) operated a fraudulent real estate scheme that resulted in an involuntary bankruptcy and appointment of a Chapter 11 trustee (the “Trustee”).  The Trustee sold forty real properties, and the bankruptcy court ordered that one percent of the proceeds (approximately $83,000) be set aside for the Debtor’s general unsecured creditors (the “Carve-Out”).  The IRS submitted the Form, indicating that its claim was for $46 million in unpaid taxes, and categorizing the entire amount as secured (the “Claim”).

After the Form was filed, the Trustee filed a disclosure statement and reorganization plan (“Plan”) stating that the bankruptcy estate’s assets were worth $750,000.  Two months later, and one week prior to confirmation hearing, the IRS filed an objection to the Plan, contending that the Claim asserted an unsecured claim that was allowed pursuant to 11 U.S.C. § 502[1] and that the Claim was entitled to priority pursuant to 11 U.S.C. § 507(a)(8)[2].  Thus, the IRS argued that the Plan violated 11 U.S.C. § 1129(a)(9)(C)[3] because it paid the Carve-Out to the Debtor’s general unsecured creditors before paying the IRS’s Claim in full.  The Trustee argued that the Form did not assert an unsecured claim, and thus the IRS did not have one.  The bankruptcy court agreed with the Trustee.

The IRS then appealed to the district court, which affirmed the bankruptcy court’s ruling.  The district court concluded that undersecured creditors must provide notice of their intent to pursue a deficiency claim[4].  This notice alerts interested parties that more than a secured claim may be forthcoming and provides them with an opportunity to contest such a claim.  Because the Form did not indicate an unsecured claim, neither the Trustee nor other creditors had notice of the IRS’s unsecured claim.  Thus, the district court concluded that permitting the IRS to collect on a claim which no party had the opportunity to contest would violate due process.

            Analysis

The 11th Circuit affirmed the decision of both the bankruptcy and district courts. 

The IRS argued that, pursuant to 11 U.S.C. § 506(a)(1)[5], an undersecured creditor holds both a secured claim and unsecured claim, and thus, as a matter of law, its claim was automatically bifurcated into a secured and unsecured claim.  Because 11 U.S.C. § 502(a) provides that a claim is deemed allowed unless someone objects, the IRS contended that the unsecured claim was allowed under 11 U.S.C. § 502 as no one had objected to the Claim.  The IRS also contended that 11 U.S.C. § 506(a)(1) provided the Trustee and other interested parties with sufficient notice regarding the IRS’s deficiency claim, and alternatively, that the IRS’s objection to the Plan also constituted sufficient notice for due process purposes.

The 11th Circuit rejected the IRS’s arguments.  First, the Court explained that under the Bankruptcy Code, a creditor must take an affirmative step to pursue an unsecured claim by filling out a one page form, Official Bankruptcy Form 10 (“Form 10”).  See 11 U.S.C. § 501 (stating that “a creditor … may file a proof of claim”) (emphasis added) and Federal Rules of Bankruptcy Procedure 3002(a) (stating that an unsecured creditor “must file a proof of claim …for the claim … to be allowed), 3003(c)(2) (stating that “any creditor who fails to [file a proof of claim] shall not be treated as a creditor with respect to such claim for purposes of voting and distribution.”). 

Next, the Court explained that 11 U.S.C. § 506(a)(1) does not automatically assert a deficiency claim.  Rather, the Court noted that Federal Rule of Bankruptcy Procedure 3001(a) requires that a proof of claim conform substantially to Form 10.  Form 10 permits a secured creditor to note a secured claim, and the amount of such secured claim.  However, in the same box and right next to the line for the amount of the secured claim, Form 10 asks for the amount of the claim which is unsecured.  See Form 10, Box 4.  In addition, the Court noted that the instructions to Form 10 “clearly explain that an undersecured creditor should note both the secured and unsecured value of its claim”.  See Form 10, at 2 (“The amount of the secured claim cannot exceed the value of the property.  Any amount owed to the creditor in excess of the value of the property is an unsecured claim”).  “Thus, to substantially comply with Form 10, a creditor should note the portion of its claim that it believes is unsecured.” 

In this case, the Court noted that the IRS did not bother to properly fill out box 4 of Form 10 by indicating any amount that is unsecured, or check box 5 of  Form 10 (which permits a creditor to note if any of its claims are entitled to priority under Bankruptcy Code § 507).  Simply put, according to the 11th Circuit, the IRS failed to properly fill out the form.

Moreover, the Court found that the IRS’s failure to properly fill out the form was far from harmless.  “A Form 10 which evinces an undersecured creditor’s intent to pursue a deficiency claim puts the interested parties on notice of that claim, ….and gives those interested parties an opportunity to object to it….But when a Form 10 does not evince such an intent, the Trustee and other creditors have no reason to object.”  The 11th Circuit also noted that an undersecured creditor who fails to assert a deficiency claim could always seek to amend its proof of claim, and that such amendments are regularly granted.

In addition, the 11th Circuit also disabused the IRS of the notion that the Trustee should have known what the IRS meant.  “The Code does not force creditors to pursue deficiency claims.  The motive for a creditor’s decision is irrelevant as far as the Trustee is concerned.  The Trustee has no duty to ask the undersecured creditor why he elected not to pursue a deficiency claim.”  See In re Padget, 119 B.R. 793, 798 (Bankr. D. Co. 1990)(“The Trustee should not, and is not charged with the obligation to examine a claim with a purpose and view to increasing the claim or improving a claimant’s status over that asserted by other creditors.”). 

Conclusion and Practice Tip

The morale of this story, aside from always reading and following directions, is simple and critical.  If you have a secured claim, and your claim is or may be undersecured, make sure you properly indicate the unsecured amount of such claim in box 4 of Form 10.  If you have already submitted a Form 10 on a secured claim that may be unsecured, you should immediately consider amending the claim to indicate any amount that is unsecured.  

 

[1] Bankruptcy Code § 502 provides that a proof of claim that is filed is deemed allowed unless a party in interest objects. 

[2] Bankruptcy Code § 507 provides for priorities of certain expenses and claims.  § 507(a)(8) provides priority for certain tax claims.  

[3] Bankruptcy Code § 1129 provides the requirements for confirming a reorganization plan.  § 1129(a)(9)(C) provides requirements for certain administrative or priority claims. 

[4] A deficiency claim is that portion of a secured creditor’s claim that is not covered by the value of collateral or security pledged.

[5] The relevant provisions of Section 506(a)(1) state that “An allowed claim of a creditor secured by a lien on property in which the estate has an interest, … is a secured claim to the extent of the value of such creditor’s interest in the estate’s interest in such property…and is an unsecured claim to the extent that the value of such credtior’s interest is less than the amount of such claim.”

Posted by Josef Mintz on January 18, 2012

Third Circuit Revives Claims for Deepening Insolvency and Breaches of Fiduciary Duties In Action Against Lemington Home Officers and Directors

Josef Mintz

Although commentators and courts have questioned the viability of an independent cause of action for deepening insolvency, Federal Courts interpreting Pennsylvania law will continue to hear such claims.  This development occurred in the recent Third Circuit of Appeals opinion in connection with the bankruptcy proceeding, In re Lemington Home For The Aged.  There, the Third Circuit noted that it was bound to follow its deepening insolvency precedent from Official Comm. of Unsecured Creditors v. R. F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001).  The debtor in Lemington, (the “Home”) was a historic, non-profit home for the elderly.  The Home filed for Chapter 11 after what was alleged to have been a continued financial and operational deterioration.

The Creditors Committee (“Plaintiff”), critical of the Home’s long decline culminating in a transfer of assets to affiliated non-profits that shared directors with the Home, requested leave of the Bankruptcy court to commence an adversary proceeding against the Home’s officers and directors.  The motion was granted.  The action was commenced in the District Court for the Western District of Pennsylvania.  Plaintiff, on behalf of the debtor, alleged that the officers and directors of the Home (“Defendants”) were liable for breaches of fiduciary duties of care and loyalty and for deepening insolvency.  Defendants moved for summary judgment and the District Court dismissed Plaintiff’s claims, holding that Defendants were protected by the business judgment rule defense and the doctrine of in pari delicto.  Also, the District Court dismissed the claim for deepening insolvency, holding that Plaintiff failed to show key elements of that tort:  fraud and causation.

On appeal, the Third Circuit reversed.  The Third Circuit held that the lower court applied the wrong legal standard to its business judgment analysis, incorrectly applied the adverse interest exception to the in pari delicto doctrine, and incorrectly considered Plaintiff’s allegations of fraud and causation necessary to prove deepening insolvency.

With regard to Plaintiff’s claims for breach of fiduciary duties of care and loyalty, the Third Circuit noted that Pennsylvania applies a negligence standard in evaluating the business judgment rule for the directors and officers of a non-profit.  In Pennsylvania, negligence of a non-profit’s directors in relying on the reports of their officers as well as negligence in the discharging of their duties is sufficient to overcome the business judgment presumption under ordinary circumstances.  Here, the Third Circuit found that Plaintiff’s allegations of gross mismanagement of the Home combined with numerous allegations of patient care deficiencies and citations, including the deaths of two residents, were sufficient to overcome the business judgment rule and survive summary judgment. 

In considering Defendants’ in pari delicto arguments, the Third Circuit held the decision to close the Home and transfer the Home’s assets to an affiliate could have been for the personal benefit of the officers and directors and not for the benefit of the Home.  Therefore, the adverse interest exception to the in pari delicto rule applied and the complaint should have survived dismissal for that reason as well.

Finally, the Third Circuit addressed Plaintiff’s claim for deepening insolvency.  Although no Pennsylvania court has ever affirmatively held that the tort of deepening insolvency exists under Pennsylvania law, the Third Circuit, interpreting Pennsylvania law in Lafferty, previously found that the tort is actionable.  Therefore, the court was bound to follow its precedent in this case, and the court noted that even if its own precedent was erroneous, this case was not the proper forum to resolve the error.  The court went on to find that Plaintiff alleged sufficient facts to prove the elements of  fraud and causation and make a plausible case for deepening insolvency – a case that was at least strong enough to survive Defendants’ motion to dismiss.  As a result, the Third Circuit found that the lower court’s dismissal of the deepening insolvency count was improper.

The case was remanded for trial in the District Court for the Western District of Pennsylvania.

Posted by Michael P. Trainor on January 06, 2012

"Robo-Signing" Gets Sanctioned: Mortgage Foreclosure Law Firm's Reliance on Third-Party Computer Records Does Not Amount to Reasonable Inquiry Required by Rule 11

Michael Trainor

In In Re: Niles C. Taylor, 2011 U.S. App. Lexis 17651 (March 22, 2011), the U.S. Court of Appeals for the Third Circuit considered whether two lawyers, their law firm, the managing partner of the law firm, and their client could be sanctioned for the lawyers’ decision to rely on information provided by a client’s third party computer system in pursuing creditor claims in a bankruptcy matter. 

Niles and Angela Taylor filed for a Chapter 13 Bankruptcy in 2007 wherein they listed, among other things, a mortgage on their home.  The bank on the mortgage filed a proof of claim and retained counsel to seek relief from the automatic stay.   Counsel for the bank was retained through a third party computer service which assigned cases to firms who handled high-volume foreclosure work.  Relying solely on the information provided by the third party computer system and failing to take any steps to verify the accuracy of the information provided by the third party computer system with its client, the bank’s counsel filed a motion for relief so that the bank could pursue foreclosure.  The bank’s attorney also filed a response to the debtors’ objection to the bank’s proof of claim. 

The proof of claim contained several errors, including a misstatement of the debtors’ monthly mortgage payment and a misstatement of the value of the debtors’ home.  Debtors subsequently provided written evidence to support the fact that the monthly payment on the proof of claim was incorrect.  Yet, despite clear evidence to the contrary, the bank’s counsel maintained in its response to the debtors’ objections that the bank’s proof of claim was accurate.  The bank’s counsel also moved for the admission into evidence of requests for admissions due to the debtors’ failure to submit timely responses. 

The bankruptcy court held a hearing on the motion for relief and claim objection, during which counsel for the bank urged the court to grant relief and to admit the requests for admissions.  Counsel made these requests even though counsel had been given information to show that the motion and admissions contained falsehoods.  It was only upon probing by the court that counsel acknowledged that the debtors had made every payment on the underlying mortgage and that, therefore, the proof of claim and motion for relief were inaccurate.  The court denied counsel’s motion for the admissions to be entered into evidence, remarking that the firm and its attorneys “closed their eyes” to the fact that there was evidence that conflicted with the admissions and to evidence that proved that the assertions in the motion for relief were inaccurate.

The bankruptcy court then issued an order to show cause upon the bank and its attorneys as to why the motion, the response to the claim objection, and the requests for admissions were submitted without investigation into the proper and correct facts surrounding the debtors’ mortgage loan.  After four hearings held over several days, the bankruptcy court issued sanctions on the bank, the law firm, the managing partner of the law firm, and two individual attorneys at the firm based, in large part, on the fact that representations were made to the court without first making a reasonable inquiry as to their validity. 

The law firm and its attorneys appealed the sanctions order to the District Court, which ultimately overturned the order.[1] The United States Trustee then appealed the District Court’s decision to the Third Circuit Court of Appeals, which upheld the sanctions as to the bank, the law firm and its attorneys but overturned the ruling as to the managing partner of the firm.  In maintaining its imposition of sanctions against the individual attorneys and the law firm, the court stated, in part, as follows: “We appreciate that the use of technology can save both litigants and attorneys time and money, and we do not, of course, mean to suggest that the use of a data base or even certain automated communications between counsel and client are presumptively unreasonable. However, Rule 11 requires more than a rubber-stamping of the results of an automated process by a person who happens to be a lawyer.  Where a lawyer systematically fails to take any responsibility for seeking adequate information from her client, makes representations without any factual basis because they are included in a “form pleading” she has been trained to fill out, and ignores oblivious indications that her information may be incorrect, she cannot be said to have made reasonable inquiry.”  The sanctions against the managing partner of the firm were overruled, in part, because the managing partner did not have hands on contact with the subject case or any of the incorrect filings submitted to the bankruptcy court.  The sanctions against the bank were upheld because the bank did not appeal the bankruptcy court’s original order of sanctions.    

 

 

 

 

[1] Appellant United States trustee appealed an order of the District Court for the Eastern District of Pennsylvania that reversed sanctions originally imposed in a bankruptcy court on the law firm.

Posted by Mathew S. Rotenberg on November 30, 2011

Can a Refinancing be "Collapsed" with a Prior Leveraged Acquisition and Avoided as a Fraudulent Transfer?

Mathew
Rotenberg

A recent decision of the Delaware bankruptcy court serves as a reminder of a key risk for lenders who finance leveraged transactions—namely, that a bankruptcy court may “collapse” the components of a leveraged transaction in order to avoid the lender’s liens and the debtor’s loan obligations as fraudulent transfers.

In Official Committee of Unsecured Creditors v. The CIT Group/Business Credit, Inc. (In re Jevic Holding Corp.), 2011 Bankr. LEXIS 3553 (Bankr. D. Del. Sept. 15, 2011), the equity sponsor (the “Sponsor”) financed the acquisition of a target company (the “Debtor”) with an acquisition loan, which was secured by the Debtor’s assets.  Within one month after the acquisition closing, the loan was repaid with the proceeds of a refinancing facility, which was also secured by the Debtor’s assets.  The Debtor defaulted under the refinancing facility shortly after closing.  The Debtor and the refinancing lender (the “Lender”) operated under a forbearance arrangement for approximately 2 years before the Debtor filed for bankruptcy.  The creditors’ committee (the “Committee”) objected to the Lender’s claims in the bankruptcy and sued the Lender and the Sponsor under several theories—the primary one being that the court should collapse the refinancing with the prior acquisition and acquisition loan in order to avoid the Lender’s liens on the Debtor’s assets, together with the Debtor’s loan obligations, as fraudulent transfers.  The Lender filed a motion to dismiss. 

Importantly, from a procedural standpoint, in ruling on a motion to dismiss, the court was required to assume the truth of the Committee’s factual allegations and construe them in the light most favorable to the Committee.  The ruling on the motion to dismiss was not a decision on the merits of the parties’ legal arguments, but rather it was a decision on whether the Committee should be entitled to proceed to the next phase of the litigation.  Generally speaking, it can be difficult for a lender to win at the motion-to-dismiss phase in this type of litigation.

The court ruled that, for purposes of overcoming the motion to dismiss, the Committee sufficiently alleged facts that could support a collapsing of the refinancing with the prior acquisition and acquisition loan into a single transaction.  While it would not be unusual for a court to collapse the components of a leveraged transaction (e.g., the acquisition and acquisition loan) into a single transaction in a fraudulent transfer case, it would be unusual for a court to collapse a refinancing with a prior acquisition and acquisition loan.  In Jevic, the refinancing occurred within one month of the acquisition closing and the Committee alleged that the Lender had been involved from the outset of the transaction, e.g., the Committee alleged that the reason the Sponsor obtained the acquisition loan was because the Lender needed additional time to complete its approval and syndication processes.  While the Jevic facts are distinguishable from a typical refinancing (e.g., a refinancing that occurs long after the acquisition closing), the ruling in Jevic may invite a creditors’ committee to “test the waters” on a weaker set of facts.  From a strategic standpoint, the opportunity for a creditors’ committee to move beyond the motion-to-dismiss phase of litigation (e.g., in an attempt to create leverage for a settlement) is significant.  Lenders will want to see future decisions limit Jevic to its facts.

Posted by Jane Bee on November 23, 2011

U.S. Trustee Office Proposes New Fee Application Guidelines

Jane Bee

On November 4, 2011, the Executive Office of the United States Trustee Program released proposed revisions to the Guidelines for Reviewing Applications for Compensation filed under Bankruptcy Code section 330.  The current guidelines became effective in 1996.

If adopted, the new guidelines would impact applications for attorney compensation in chapter 11 cases where the debtor (or jointly administered debtors) has more than $50 million in combined assets and liabilities.  

The U.S. Trustee Program describes the proposed revisions as involving six changes:

  1. Electronic Data: Fee applications should be submitted in an open electronic data format.  The use of electronic billing has become common, if not standard, with respect to most significant engagements outside of bankruptcy. This requirement would impose little or no additional burden on applicants.
  2. Categories and Tasks:  To more precisely capture key actions in a bankruptcy case, new project categories, as well as activity-based sub-categories, have been added.  These additions are generally consistent with the Uniform Task-Based Management System (“UTBMS”) Bankruptcy Code Set and other codes developed or ratified by the UTBMS governing bodies.
  3. Verified and Other Statements:  Clients should provide verified statements in connection with a fee application to disclose, among other matters, whether the client reviewed fees and compared them to its approved budget, whether the attorney and client discussed billing rates and terms compared to the attorney’s other engagements, and whether the client gave prior approval for any rate increases.
    Further, attorneys should answer specific questions regarding, among other matters, billing rates for other engagements, whether the attorney offered and agreed to any variations from standard rates, and whether the application includes any entries for reviewing and redacting billing records for privileged information.
    Attorneys also should answer additional questions in conjunction with the retention application that could affect future applications for compensation, including whether the attorney informed the client how fees and terms for the engagement compare to the firm’s other engagements and whether any firm client was charged lower or higher rates in the preceding 12 months.
  4. Budgets and Staffing Plans:  To bring predictability and accountability to the attorney-client relationship, and to provide a benchmark for evaluating fee applications, budgets and staffing plans will be encouraged. 
  5. Additional Disclosures:  For all professionals included in a fee application, the United States Trustee will seek disclosure of the lowest, highest, and average rates billed for the preceding year for estate-paid bankruptcy work and for all other work combined. The United States Trustee will also seek disclosure of information by professional category (e.g., partner, associate, etc.) about a firm’s lowest, highest, and average rates for the preceding year in its bankruptcy practice and all its other practices combined, if any.  Applicants should also disclose the amount of fees attributable to any rate increases since the inception of the case.  Applicants representing debtors should estimate the fees sought that would have been incurred regardless of the bankruptcy.
  6. Special Fee Review Procedures: The proposed guidelines set forth models and principles for the use of independent fee examiners, fee committees, and fee committees with independent chairs.

The proposed revisions are designed to meet a number of goals, including:  making bankruptcy professional fees subject to market forces that would apply outside of bankruptcy, ensuring professional compensation is reasonable and necessary and maintaining the burden of proof of professionals to show their fees are reasonable and necessary, increasing transparency in compensation of estate-paid professionals, increasing client accountability for estate-paid professionals, encouraging the adoption of budgets and staffing plans by clients and their professionals, increasing efficiency, and increasing public confidence in the integrity of the bankruptcy compensation process.

If adopted, these would be the first revisions to the guidelines since they were promulgated in 1996.  Comments on the proposed revisions are due by January 31, 2012.  Click here to view a pdf of the Draft for Public Comment.  The current guidelines and additional information about the proposed revisions are available at http://www.justice.gov/ust.