Selective Payment of Prepetition Claims in Chapter 11 Before Distributions to Creditors Generally

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1 Selective Payment of Prepetition Claims in Chapter 11 Before Distributions to Creditors Generally 33 rd Annual Southeastern Bankruptcy Law Institute Atlanta, Georgia April 12-14, 2007 David Neier Winston & Strawn LLP 200 Park Avenue New York, New York (212)

2 Selective Payment of Prepetition Claims in Chapter 11 Before Distributions to Creditors Generally I. Payment of prepetition claims under the Bankruptcy Code A. The Bankruptcy Code provides that similarly situated creditors should receive equal treatment. See 11 U.S.C. 1122, 1123(a)(4), 1129(b). B. Equality of distribution among creditors is a central policy of the Bankruptcy Code." Begier v. Internal Revenue Serv., 496 U.S. 53, 58 (1990). Further, statutory priorities are to be narrowly construed, because it is presumed that the debtor's limited resources should be equally distributed among its creditors. See Trustees of the Amalgamated Ins. Fund. v. McFarlin's Inc., 789 F.2d 98, (2d Cir. 1986). C. Numerous courts have derided the payment of prepetition creditors. See Martin- Trigona v. Champion Fed. Sav. & Loan Ass n, 892 F.2d 575, 577 (7th Cir. 1989) (citing In re Holtkamp, 669 F.2d 505, 508 (7th Cir. 1982) ( The fundamental purpose of bankruptcy... is to prevent creditors from trying to steal a march on each other. ); In re Vermont Real Estate Inv. Trust, 25 B.R. 808, 809 (Bankr. D. Vt. 1982) (determination and payment to a creditor prior to the development of a plan would frustrate the goals of reorganization). II. Reclamation/Administrative Priority for Suppliers11 U.S.C. 503(b)(9) A. Reclamation 1. BAPCPA amended Section 546(c) to provide that if the debtor was insolvent within 45 days of the petition date, the a seller of goods has 45 days after receipt of the goods by the debtor or 20 days after the petition date, whichever is later, to assert a reclamation claim. 2. Reclamation is actually a state law remedy, generally under recognized under UCC Section 2-702(2). 3. Reclamation, considered to be a weak remedy prior to BAPCPA s enactment, has now been largely eviscerated. a. Reclamation rights are subordinate to the interests of prepetition secured lenders. Reclamation claimants only have rights in the goods, but prepetition secured lenders have rights in the goods and proceeds thereof. b. BAPCPA removed language from the prior version of Section 546(c) that allowed a bankruptcy court to give a reclaiming vendor 1

3 B. 503(b)(9) an administrative claim in lieu of a return of the goods. Sole remaining remedy under Section 546(c) is recovery of the actual merchandise. c. Significant issues for sellers of goods in identifying the goods subject to reclamation. 1. Under new Section 503(b)(9), a seller of goods may assert an administrative claim for the value of any goods received by the debtor within 20 days prior to the petition date. Sellers of goods are not required to file claims in order to preserve their status as administrative priority creditors. Section 503(b)(9) claims have a second administrative priority under Section 507(a)(2). 2. Some debtors have sought authority under Section 503(b)(9) to pay the prepetition claims of their suppliers. Section 503(b)(9) provides a sound statutory basis on which to pay critical vendors. 3. Some debtors, typically where the prepetition secured lenders are undersecured, have opposed payment of Section 503(b)(9) claims. The timing of payment of administrative claims is discretionary. In re Colortex Industries, Inc., 19 F.3d 1371, 1348 (11th Cir. 1994). Some courts have ruled that Section 503(b)(9) claims do not have to be paid until confirmation. See Global Home Products, LLC., Case No (KG) (Bankr. D. Del. December 21, 2006). III. Critical Vendors A. Doctrine of Necessity 1. Courts typically cite to the doctrine of necessity as support for allowing critical vendor payments. In re Ionosphere Clubs Inc., 98 B.R. 174 (Bankr. S.D.N.Y. 1989); In re Penn Central Transp. Co., 467 F.2d 100, 102 n.1 (3d. Cir. 1972). The doctrine of necessity is based on a Supreme Court case, Miltenberger v. Logansport Ry., 106 U.S. 286, 312 *1882) (payment of pre-receivership claim prior to reorganization permitted to prevent stoppage of [crucial] business relations ), that was subsequently cited to justify payment of prepetition claims beyond railroad reorganization cases. Dudley v. Mealey, 147 F.2d 268 (2d Cir. 1945), cert. denied, 325 U.S. 873 (1945). In addition, some courts are now using Section 503(b)(9) as a justification for allowing prepetition payments to critical trade creditors. 2

4 2. Courts in the Fourth, Fifth, Seventh and Ninth Circuits have rejected the doctrine of necessity as support for allowing critical vendor payments. In re Kmart Corp., 359 F.3d 866 (7th Cir. 2004); In re Oxford Management Inc., 4 F.3d 1329 (5th Cir. 1993); Official Comm. of Equity Sec. Holders v. Mabey, 832 F.2d 299 (4th Cir. 1987); In re B&W Enters. Inc., 713 F.2d 534 (9th Cir. 1983). Nevertheless, many bankruptcy courts across the country continue to find support based on an evidentiary record providing for critical vendor payments pursuant to Section 363(b). In re NVR L.P., et al., 147 B.R. 126, 127 (Bankr. E.D. Va. 1992). B. Bankruptcy Code 1. Some courts have relied on Section 105(a) as justifying critical vendor payments. See In re Structurelite Plastics Corp., 86 B.R. 922, 931 (Bankr. S.D. Ohio 1988), where the court indicated its accord with the principle that a bankruptcy court may exercise its equity powers under section 105(a) to authorize payment of prepetition claims where such payment is necessary to permit the greatest likelihood of survival of the debtor and payment of creditors in full or at least proportionately. The court stated that a per se rule proscribing the payment of prepetition indebtedness may well be too inflexible to permit the effectuation of the rehabilitative purposes of the Code. Id. at Some courts have also relied on Section 363(b) in support of critical vendor payments, which provides for out of the ordinary course of business transactions to be approved. See In re Chateaugay Corp., 973 F.2d 141, 143 (2d Cir. 1992) (holding that a judge determining a section 363(b) application must find from the evidence presented before him a good business reason to grant such application). 3. A few courts have begun to rely on Section 503(b)(9) as a justification for allowing critical vendor payments. IV. Vendors of Foreign Subsidiaries A. Courts have allowed payments to creditors of foreign subsidiaries that are not protected by the Automatic Stay to prevent the use of enforcement remedies. In re Eastern Airlines, Case No. 89 B (Bankr. S.D.N.Y. 1989) (allowing payment of prepetition obligations to foreign creditors on the basis that such creditors may exercise remedies in contravention of the Automatic Stay in foreign jurisdictions with impunity) see also In re Loral Space & Communications Ltd. et al., Case No (RDD) (Bankr. S.D.N.Y. July 15, 2003) (authorizing payment of $5 million of prepetition obligations to foreign creditors); In re WorldCom, Inc., Case No (AJG) (Bankr. S.D.N.Y. July 22, 2002) (authorizing payment of $35 million of prepetition obligations to foreign creditors); In re Global Crossing, Ltd., et al., Case No (REG) (Bankr. 3

5 S.D.N.Y. January 28, 2002) (authorizing payment of $25 million of prepetition obligations to foreign creditors); In re Enron Corp., et al., Case No (AJG) (Bankr. S.D.N.Y. Dec. 3, 2001) (authorizing payment of $19 million of prepetition obligations to foreign creditors); In re Ames Department Stores, Inc., et al., Case No (REG) (Bankr. S.D.N.Y. Aug. 20, 2001) (authorizing payment of $28.2 million of prepetition obligations to foreign creditors); In re Casual Male Corp., et al., Case No (REG) (Bankr. S.D.N.Y. May 18, 2001) (authorizing payment of $1.1 million of prepetition obligations to foreign creditors). B. As a result of the enactment of Chapter 15, some courts have begun to restrict such payments unless there is some evidence that the foreign jurisdiction will not respect the United States Bankruptcy Code. V. Assumption of Contracts A. Section 365(a) provides that a debtor may assume or reject any executory contract or unexpired lease of the debtor." Bankruptcy court approval is granted if the determination to assume is within the reasonable business judgment of the debtor and whether the Debtors' estates would benefit from such assumption. See N.L.R.B. v. Bildisco and Bildisco, 46 U.S. 523,523 (1984); Control Data Corp. v. Zelman (In re Minges), 602 F.2d 38'43 (2d Cir. 1979); In re Bradlee's Stores, Inc., 194 B.R. 555,558 (Bankr. S.D.N.Y. 1996). B. Assumption of a contract is a classic method for a debtor to provide for a prepetition payment. C. BAPCPA is likely to compel debtors to cure defaults and assume agreements prior to confirmation. Section 365(d)(4) of the Code now limits the period of time for the debtor to assume or reject a lease of nonresidential real property to a maximum of 210 days in which to assume or reject such real property leases. VI. Employee Claims A. Some courts have allowed wages and benefits to be paid only up to the administrative priority amounts set forth in Sections 507(a)(4), 507(a)(5). However, most courts have routinely allowed prepetition wages to be paid even if the amounts are above the administrative priority amount. Mich. Bureau of Workers Disability Compensation v. Chateaugay Corp. (In re Chateaugay Corp.), 80 B.R. 279, (S.D.N.Y., 1987), appeal dismissed 838 F.2d 59 (2d Cir. 1988) (approving lower court order authorizing payment of prepetition wages, salaries, expenses, and benefits). B. Many states impose criminal and personal liability on companies that do not pay wages and benefits. Thus, debtors have a powerful motivation to ensure that their employees are paid. 4

6 VII. Settlements A. Settlements are another classic way of paying prepetition creditors. B. Courts have occasionally rejected settlement on this basis. In re Quality Beverage Co., 181 B.R. 887, 895 (Bankr. S.D. Tex. 1995) (rejecting settlement because the effect of the settlement would distribute all the assets of the estate). C. Many courts have approved settlements with creditors prior to confirmation as a way of making progress towards confirmation of a plan. VIII. Taxes A. Few debtors race to pay their taxes, but their have been some exceptions, particularly where a debtor s officers and directors are advised of their potential personal liability under both federal and state law. B. Most courts will not refuse to allow payment of prepetition taxes by a debtor who wishes to willingly pay such taxes. C. Section 505(a)(1) of the Bankruptcy Code provides that the bankruptcy court may determine the amount of tax owed by a debtor, but does not mandate that the Court do so. New Haven Projects LLC v. City of New Haven (In re New Haven Projects LLC), 225 F.3d 283, (2d Cir. 2000); Miller v. Internal Revenue Service (In re Miller), 300 B.R. 422, 431 (Bankr. N.D. Ohio 2003). The bankruptcy court s decision whether to undertake the determination of a debtor s tax liability under Section 505 should involve a balancing of at least the following factors: (1) the complexity of the tax issue to be decided; (2) the need to administer the bankruptcy case in an expeditious, orderly and efficient fashion; (3) the burden on the Bankruptcy Court s docket; (4) the length of time required to conduct the hearing and render a decision thereafter; (5) the asset and liability structure of the debtor; and (6) the potential prejudice to the debtor, the taxing authority and the creditors. In re New Haven Projects, 225 F.3d at 289; D Alessio v. Internal Revenue Serv., 181 B.R. 756, 759 (Bankr. S.D.N.Y. 1995); In re Galvano, 116 B.R. 367, 373 (Bankr. E.D.N.Y. 1990); In re ANC Rental Corp., 316 B.R. 153 (Bankr. D. Del. 2004); In re Miller, 300 B.R. at 432; Northbrook Partners, LLP v. Hennepin (In re Northbrook Partners, LLP), 245 B.R. 104, 118 (Bankr. D. Minn. 2000). 5

THE UNITED STATES BANKRUPTCY COURT FOR THE EASTERN DISTRICT OF MICHIGAN SOUTHERN DIVISION

THE UNITED STATES BANKRUPTCY COURT FOR THE EASTERN DISTRICT OF MICHIGAN SOUTHERN DIVISION In re: Chapter 11 GROEB FARMS, INC. Case No. 13-58200 Debtor. Honorable Walter Shapero MOTION FOR ENTRY OF AN ORDER