Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington. Newspapers

Transcription

1 BankruptcyUpdate Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington April 2010 News and Noteworthy On February 17, Michael H. Reed was a panelist on a teleconference and live audio webcast, Bankruptcy Discharge for Environmental Cleanup Obligations and the Impact of U.S. v. Apex Oil, sponsored by the ABA Section of Real Property, Trust and Estate Law. On February 25, Mr. Reed served as moderator and Leon R. Barson served as a panelist in a teleconference and live audio webcast, Can Section 363 Sales Maintain Their Momentum?, sponsored by ALI-ABA. Francis J. Lawall spoke on a panel, What to Expect When Serving on a Creditors Committee, and moderated a panel, Pipeline 201, at the International Energy Credit Association (IECA) Spring Conference on March On April 18-20, Francis J. Lawall is speaking at the National Petroleum Energy Credit Association s (NPE- CA) 73rd annual conference in New Orleans, LA. Mr. Lawall will be speaking as well as serving on multiple panels that cover a case study; security instruments and guarantees, corporate and personal; bankruptcy 201 and a seminar, From Contract to Bankruptcy An Overview of Legal Issues for Credit Professionals in the Petroleum Energy Industry. On April 22, Leon R. Barson will speak on a panel addressing lender liability issues in bankruptcy at the ABA Business Law Section Spring Meeting in Denver, CO. The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyerclient relationship. Please send address corrections to phinfo@pepperlaw.com Pepper Hamilton LLP. All Rights Reserved. The Power of Or : Third Circuit Denies Secured Lenders the Right To Credit Bid in Philadelphia Newspapers To d d A. Feinsmith feinsmitht@p e p p e r l a w.c o m Deborah Kovsky -Apap kovskyd@pepperlaw.com In a much-anticipated decision, the Third Circuit Court of Appeals issued an opinion on March 22, 2010, In re Phildadelphia Newspapers, LLC, affirming the district court s ruling that the secured lenders of the bankrupt Philadelphia Newspapers, LLC and its related entities (the Debtors), publishers of the Philadelphia Inquirer and Philadelphia Daily News, can be blocked from credit bidding their debt in an auction of the newspapers assets held pursuant to a plan of reorganization. The Third Circuit s decision, which caps the latest round in what dissenting Judge Thomas L. Ambro called a highstakes game of chicken between the secured lenders and a group of current and former management and shareholders for control of the Debtors, may have far-reaching consequences for Chapter 11 debtors, secured lenders and potential acquirers of assets in bankruptcy. Ba c k g r o u n d The Debtors acquired the Philadelphia Inquirer, the Philadelphia Daily News and the online publication philly.com in July 2006 for $515 million. $295 million of the purchase price was financed by a consortium of lenders (the Lenders), who took first priority liens in substantially all of the Debtors assets. The current amount outstanding under the loan is almost $320 million. The Debtors filed voluntary petitions under Chapter 11 of the Bankruptcy Code on February 22, On August 20, 2009, the Debtors filed a joint plan of reorganization (the Plan), which This publication may contain attorney advertising. in this issue... 1 The Power of Or : Third Circuit Denies Secured Lenders the Right to Credit Bid in Philadelphia Newspapers 4 Pepper Lawyers Victorious on Behalf of Quality Stores 6 New Light Shed on Important Preference Defense Issue in Delaware: Must New Value Remain Unpaid? 8 Buyer Beware: Third Circuit Denies $15 Million Break-Up Fee for Failure to Meet O Brien Standard 10 Court: Indenture Mandates That Any Credit Bid Come from Trustee, Not Noteholders 12 Evelyn J. Meltzer Elected Secretary of the Delaware Chapter of the International Women s Insolvency & Restructuring Confederation

2 In cases with plan sales under Section 1129(b)(2)(A)(iii), debtors and secured lenders should gird themselves for increasingly expensive valuation battles. provided that substantially all of the Debtors assets would be sold at auction, free and clear of all liens. The Debtors selected Philly Papers, LLC, an entity largely composed of and controlled by current and former management and shareholders of the Debtors, as the stalking horse bidder. Under the Plan, the sale of assets to the stalking horse bidder would generate approximately $37 million in cash for the Lenders. The Lenders would also receive the Debtors Philadelphia headquarters, valued by the Debtors at $29.5 million, encumbered by a two-year rent-free lease to the stalking horse bidder. The Debtors disclosed their intention to use the cram down 1 provisions of Section 1129(b) of the Bankruptcy Code to confirm the Plan over the Lenders objections. Section 1129(b)(2)(A) provides three possible routes to plan confirmation over the dissent of a secured creditor: under subsection (i), retention of liens and deferred cash payments; under subsection (ii), a free and clear sale of assets subject to credit bidding; or, under subsection (iii), provision of the indubitable equivalent of the secured interest. The Debtors argued that the Plan was confirmable under Section 1129(b)(2)(A)(iii) because it proposed to provide the Lenders with the indubitable equivalent of their secured claim through a combination of cash and encumbered real property. The Debtors filed a motion for approval of bid procedures on August 28, 2009, seeking in part to prevent the Lenders from credit bidding for the assets. A credit bid allows a secured lender to bid its debt in lieu of cash. Credit bidding, which is expressly permitted under Section 363(k) of the Bankruptcy Code, is designed to prevent the under-valuation of assets. The ability to credit bid is considered to be one of the most important rights of secured lenders in bankruptcy, since it enables them to block sales of their collateral for less than market value. 2 The Debtors rationale for barring the Lenders from credit bidding was that the proposed sale would take place as part of the Plan under Sections 1123 and 1129, rather than as an interim event under Section 363. The Bankruptcy Court and District Court Decisions Numerous objections to the Debtors bid procedures motion were filed. On October 8, 2009, the Bankruptcy Court issued an order refusing to bar the Lenders from credit bidding. The Bankruptcy Court reasoned that the Debtors Plan, though nominally proceeding under the indubitable equivalent prong of Section 1129(b)(2)(A)(iii), was actually structured as a plan sale and thus had to meet the requirements of Section 1129(b)(2)(A)(ii), which incorporates secured creditors rights under Section 363(k) to credit bid. On appeal, the District Court reversed. In a decision issued November 10, 2009, the District Court held that the Bankruptcy Code provides no legal entitlement for secured lenders to credit bid at an auction sale held pursuant to a plan of reorganization (as opposed to a Section 363 sale). The District Court relied on the plain language of Section 1129(b)(2)(A), reasoning that the three subsections were three independent routes to confirmation, separated by the disjunctive or, and therefore each was sufficient for confirmation of a plan as fair and equitable. The District Court reasoned that, because the right to credit bid was not expressly incorporated into subsection (iii), as it was in subsection (ii), Congress did not intend that a debtor who proceeded under the third prong would be required to permit credit bidding, so long as it provided secured lenders with the indubitable equivalent of their secured interests in the assets. The Third Circuit s Opinion Following a detailed discussion of the canons of statutory construction, the Third Circuit relied on what it described as the unambiguous, plain language of the statute and affirmed the District Court s conclusion based upon the disjunctive or contained in Section 1129(b)(2)(A). That critical or, the Third Circuit determined, means that the three prongs of Section 1129(b)(2)(A) are to be read in isolation from one another and that satisfaction of any of the three prongs is sufficient for confirmation. The Third Circuit held that the Lenders arguments to the contrary elevated form over substance, since in the Lenders reading of the statute even a proposed plan of reorganization that fully compensated lenders for their secured interest would necessarily fail if the plan called for a free and clear asset sale without credit bidding. 2

3 BankruptcyUpdate Under the Third Circuit s interpretation of Section 1129(b)(2) (A), a plan sale can take place under subsection (ii), in which case the debtor must permit credit bidding, or it can take place under subsection (iii), in which case the debtor need not permit credit bidding but still must demonstrate that the secured lender will receive the indubitable equivalent of its claim. Importantly, the Third Circuit emphasized as did the District Court that allowing the Debtors Plan sale to proceed under subsection (iii) is in no way a guaranty of confirmation; the Lenders retain the right to argue at confirmation that the restriction on credit bidding failed to generate fair market value for the assets, thereby depriving them of the indubitable equivalent of their claim and preventing confirmation. The Third Circuit pointedly expressed its confidence that the Bankruptcy Court would conduct a careful and thorough analysis during Plan confirmation to determine whether, in fact, the proposed return to the Lenders actually meets the requirements of subsection (iii). A Di ff e r i n g Vi e w Judge Ambro, in a lengthy dissent, disagreed with the majority s view that the plain language of Section 1129(b)(2)(A) is unambiguous. In Judge Ambro s view, there are at least two plausible interpretations of the same language, rendering it ambiguous. One interpretation adopted by the majority is that the use of the word or allows a plan sale free and clear of liens to fall under either subsection (ii) or subsection (iii). Another interpretation subscribed to by Judge Ambro is that context requires that the or be read as exclusive, in the sense that it delineates distinct routes to cramdown confirmation that apply specific requirements depending on how a given plan proposes to treat the claims of secured creditors. In this interpretation, the or restricts plan sales free of liens to subsection (ii). Given these two plausible readings of the statute, Judge Ambro wrote, the court must rely on the principles of statutory interpretation to decide which is the more plausible. Judge Ambro argued that the majority s construction is less plausible for a number of reasons. He contended that the construction creates a conflict between subsection (ii), which requires a presumptive right to credit bid at a free and clear plan sale, and subsection (iii), which in the majority s view can be used in a free and clear plan sale without a right to credit bid. The majority s construction would render subsection (ii) a nullity, since debtors could simply sidestep its requirements by proceeding under subsection (iii). Judge Ambro also argued that the majority s interpretation shifts burdens between debtors and their secured lenders: While the default rule under subsection (ii) is to allow credit bidding, the majority s approach allows the debtor to decide unilaterally to deny credit bidding, with only a belated court inquiry at confirmation to determine whether the outcome is, in fact, fair and equitable to the secured lenders. Judge Ambro suggested that this impermissibly undercuts the protections that Congress expressly extended to secured lenders when the Bankruptcy Code was enacted in Next Steps The Debtors plan to hold an auction of their assets by the end of April It is not yet known whether the Lenders will seek a rehearing en banc before the entire panel of Third Circuit judges, or seek to appeal to the Supreme Court. Potential Consequences of Philadelphia Newspapers The Third Circuit s decision, unless reconsidered or overruled, is likely to affect the dynamics of negotiations of both pre-petition lending and post-petition sales particularly as it is the second Circuit-level decision to deny secured creditors the right to credit bid under Section 1129(b)(2)(A)(iii). 3 Judge Ambro predicted that future secured creditors will adjust their pricing, potentially raising interest rates or reducing credit availability, to account for the possibility of a later bankruptcy sale without credit bidding. Other repercussions may include a more adversarial posture between debtors and their secured lenders, as the lenders push for Section 363 sales (with their attendant presumption of the right to credit bid), while debtors may try to keep control of their assets by pushing for plan sales under Section 1129(b)(2)(A) (iii). Acquirers may be more inclined to push for sales to occur in the context of a plan in order to cut off secured lenders right to credit bid and thereby keep sales prices as low as possible. First lien lenders, on the other hand, may be forced to try to raise funds to participate in cash sales to protect the valuation of their collateral or actually to pay themselves through a plan sale. Pre-petition secured lenders may also be more likely to extend defensive debtor-in-possession financing, conditioned on their absolute right to credit bid (though it is unclear whether courts would approve such a provision). In cases with plan sales under Section 1129(b)(2)(A)(iii), debtors and secured lenders should gird themselves for increasingly expensive valuation battles to determine whether a secured lender under a plan sale actually will receive the indubitable equivalent of its secured claim. 3

4 Finally, the Third Circuit s decision may have the effect of chilling bidding in some plan sales. Investors may justifiably be wary of purchasing assets out of bankruptcy in a plan sale particularly without stalking horse bid protections if there is likely to be an acrimonious confirmation showdown between the debtor and the secured lender. A well-informed investor should weigh the risks involved in investing time and money in due diligence, preparing a bid and finalizing an asset purchase agreement where the entire deal may unravel (or be delayed) for failure to satisfy Section 1129(b)(2)(A)(iii), and may need to adjust bid pricing or reconsider the decision to bid altogether. En d n o t e s 1 Section 1129 of the Bankruptcy Code addresses the confirmation of Chapter 11 plans, including plans that involve the sale of property of the estate. The debtor can cram down the plan over the objections of an impaired class of creditors under Section 1129(b) by demonstrating that the plan does not discriminate unfairly and is fair and equitable. Whether a plan is fair and equitable as to a secured lender is determined under Section 1129(b)(2)(A). 2 The ability to credit bid does not necessarily mean that the secured lender will be the successful bidder. If a third-party bidder believes that the secured lender is trying to take the collateral on the cheap, below market value, the bidder can make a bid exceeding the amount of the credit bid. 3 In In re Pacific Lumber, decided in September 2009, the Fifth Circuit held that secured creditors did not have the right to credit bid under section 1129(b)(2)(A)(iii) where they were receiving the indubitable equivalent of their secured claims in a private judicial sale. Although Pacific Lumber was decided on the facts at the confirmation hearing a stage of the proceedings not yet reached in the Philadelphia Newspapers case the Third Circuit found its reasoning persuasive. Pepper Lawyers Victorious on Behalf of Quality Stores Ro b e r t S. He r t z b e rg h e r t z b e rg r@p e p p e r l a w.c o m Lisa B. Pe t k u n petkunl@p e p p e r l a w.c o m Mi c h a e l H. Re e d re e d m@p e p p e r l a w.c o m To d d B. Re i n s t e i n r e i n s t e i n t@p e p p e r l a w.c o m Marc D. Nickel nickelm@pepperlaw.com In Quality Stores, Inc. v. United States, 1 the United States District Court for the Western District of Michigan held that severance payments made by employers to employees pursuant to an involuntary separation are not subject to FICA taxation. This case, which Pepper handled before the district court, may have far-reaching effects on employers and employees need to pay Social Security and Medicare (FICA) taxes. Even if the decision does not overturn current law with regard to FICA taxes, it could lead to further litigation on the issues addressed by the court. Accordingly, taxpayers would be well advised to preserve their refund claims, in some cases immediately, in light of the pending court proceedings. The Quality Stores Background Quality Stores operated a chain of retail stores, selling agricultural supplies and related goods. In 2001, Quality Stores went into bankruptcy and eventually closed all of its stores and terminated all of its employees. In the period before its bankruptcy petition, Quality Stores closed more than 60 stores, and terminated approximately 75 corporate employees. Under the severance plan in place, these employees received severance payments that were paid out in accordance with the normal payroll period. After the bankruptcy petition was filed, the remaining stores and distribution centers were closed and all remaining employees of Quality Stores were terminated. These employees also received severance payments; however, these employees received lump-sum payments under a different severance plan. For both the pre-petition and post-petition severance pay plans, payment of the severance was not linked to the receipt of state unemployment benefits. Quality Stores reported these payments as wages on the former employees W-2s and withheld both federal income tax and FICA from them, and paid the employer s FICA share. However, Quality Stores eventually filed refund claims for both its FICA payments and also on behalf of consenting employees for their shares of the FICA payments. After the bankruptcy court 4

5 BankruptcyUpdate The Qu a l i t y St o r e s decision, if followed by other courts, could create significant opportunities for taxpayers and generate billions of dollars in refunds for companies that have been in the unfortunate position of having to close operations or reduce their workforce. However, on February 23, 2010, the United States District Court for the Western District of Michigan affirmed the holding of the bankruptcy court that Quality Stores payments made to its laid-off employees fall within the exception to the definition of wages for SUB payments. The court rejected the IRS s argument that the payments were wages subject to FICA. The court reasoned that the plain language of Section 3402(o) 5 and the legislative history make it clear that a SUB payment is not a payment of wages, which is why Congress had to treat it as if it were a payment of wages for withholding tax purposes. It further noted that SUB payments are intended as a substitute for FICA protection for employees, and thus taxing SUB payments would run counter to the congressional intention to collect FICA so that individuals could receive remedial monetary support under the Social Security Act. Accordingly, the court held that Quality Stores was entitled to refunds for the FICA payments it had made attributable to the SUB payments. Present Impact of the Decision upheld Quality Stores refund claims, the IRS appealed. Pepper Hamilton lawyers Robert Hertzberg, Mike Reed and Lisa Petkun represented Quality Stores in the district court and wrote the district court brief. The Quality Stores Decision The crux of the Quality Stores decision is whether payments made to terminated employees fall within the definition of wages, and thus are subject to FICA, or into the exception for supplemental unemployment compensation benefits (SUB) payments and thus are exempt. Per the Internal Revenue Code, SUB payments are amounts paid to an employee because of an employee s involuntary separation resulting directly from a reduction in force, discontinuance of a plant or operation, or other similar conditions. 2 Under Revenue Ruling 90-72, 3 the IRS takes the position that in order for SUB payments to be exempt from the definition of wages, and thus exempt from federal income tax withholding and FICA, they must be paid under a plan in which severance pay is linked to the receipt of state unemployment compensation and is not paid in a lump sum. In 2008, the Court of Appeals for the Federal Circuit upheld this definition in CSX Corp. v. United States, 4 and in doing so reversed a lower court decision that was decided in favor of the plaintiff on similar grounds as Quality Stores. The Quality Stores decision, if followed by other courts, could create significant opportunities for taxpayers and generate billions of dollars in refunds for companies that have been in the unfortunate position of having to close operations or reduce their workforce. However, it is important to keep the immediate impact of the case in perspective. First, Quality Stores is a federal district court decision, in contrast to the CSX case, which was decided by the Court of Appeals for the Federal Circuit. At present, the Quality Stores decision is at best persuasive authority. By contrast, the CSX case has broad precedential authority over all decisions in the Federal Circuit, and thus true national reach. In addition, the IRS may appeal Quality Stores to the Sixth Circuit Court of Appeals. Moreover, even if the decision were to be affirmed by the Sixth Circuit, it would then be precedential only in Kentucky, Ohio, Michigan, and Tennessee the geographical boundaries of the Sixth Circuit. Second, a number of factors must come together in order for Quality Stores to become precedential in other federal circuits. Taxpayers whose refund claims were rejected would need to file lawsuits, and only when a case reached a circuit court and a circuit court made a favorable decision would the case become precedent in that circuit. It is difficult to predict how this process will unfold in the coming months. However, it is likely that many refund suits will be filed all over the country, given that present economic circumstances have forced many companies to conduct broad reductions in force. Under current tax law, all such 5

6 companies should have paid FICA taxes on SUB payments, and the IRS continues to be unwilling to grant any refund claims. That means that numerous companies could be the standardbearers to import the Quality Stores decision to other circuits. Finally, the particular facts of Quality Stores could limit its applicability to certain types of severance payments. The case only addressed severance that is paid under a plan or system designed to compensate employees because of a reduction in force, office or plant closing, or another similar situation. It did not involve payments made under a voluntary separation, such as an early retirement plan. Accordingly, if other taxpayers take the IRS to court in other jurisdictions, it is quite likely that issues regarding severance payments made to employees under other circumstances and not covered by the Quality Stores decision will be litigated. Pepper Perspective The learning from the Quality Stores decision is that even if a groundswell of companies flood the courts and cause a wholesale reversal in the treatment of severance payments for FICA purposes, this process will take years to reach a national resolution. However, taxpayers only have a three-year statute of limitations in which to seek a refund. The IRS allows taxpayers to file a protective claim that preserves the refund window while a court case regarding the same issue is pending. Protective refund claims are easy to file, generally requiring only a handful of forms and a general statement of the law upon which the taxpayer is relying. Therefore, taxpayers who made severance payments (and thus FICA payments) between 2006 and 2009 should consider filing protective refund claims to preserve their ability to seek FICA refund payments. Taxpayers that made significant payments in 2006 need to file by April 15, 2010 before the 2006 statute of limitations closes. En d n o t e s 1 No. 1:09-cv-44 (W.D. Michigan, Feb. 23, 2010). 2 I.R.C. 3402(o) C.B F. 3d 1328 (Fed. Cir. 2008). 5 Unless otherwise stated, all references to Section are to the Internal Revenue Code of 1986 (the Code), and all references to Treas. Reg. Section. are to the Treasury Regulations promulgated thereunder (the Regulations). New Light Shed on Important Preference Defense Issue in Delaware: Must New Value Remain Unpaid? J. Gregg Miller millerj@pepperlaw.com Judge Kevin Carey of the U.S. Bankruptcy Court for the District of Delaware recently decided an important preference defense issue: new value need not remain unpaid, but rather a debtor s payment for subsequent new value deprives a preference defendant of the Bankruptcy Code 547(c)(4)(B) new value defense only if the payment is unavoidable. In re Pillowtex Corp., 416 B.R. 123 (Bankr. D. Del. 2009). The subsequent new value preference defense is provided in Bankruptcy Code 547(c)(4) as follows: (c) The trustee may not avoid under this section a transfer (4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor (A) not secured by an otherwise unavoidable security interest; and (B) on account of which new value the debtor did not make an otherwise unavoidable transfer to or for the benefit of such creditor. Courts have struggled with interpreting the double negative and the meaning of the word otherwise in 547(c)(4)(B). A split in the courts of appeals has been recognized, with the Third, Seventh and Eleventh Circuits seemingly taking the position that new value must remain unpaid at the end of the preference period in order to be used effectively by a creditor to offset its preference liability, while the Fourth, Fifth and Ninth Circuits have held that 547(c)(4)(B) does not mandate a remains un- 6

7 BankruptcyUpdate paid interpretation, but rather the statute s plain, but complex, meaning requires a closer analysis of the payment in question. The proper inquiry is whether the new value has been paid for by an otherwise unavoidable transfer? This is sometimes referred to as the subsequent advance approach. Judge Carey cites scholarly commentary and language from cases construing the remains unpaid decisions as shorthand restatements of the statutory language, or unfortunate paraphrasing. He recognizes that many of the remains unpaid decisions, including the Third Circuit s In re New York City Shoes, Inc., 880 F.2d 679 (3d. Cir. 1989), are merely dictum, thereby permitting him to focus on the precise statutory language in Pillowtex. Judge Carey adopts the reasoning of the courts that believe in a plain language interpretation of the complicated, but not ambiguous language of 547(c)(4)(B). Judge Carey observed: The use of a double negative [in 547(c)(4)(B)]... is not ambiguous; its meaning may be difficult to ascertain but it is not indefinite, citing In re Check Reporting Services, Inc., 140 B.R. 425 (Bankr. W.D. Mich. 1992). In 1989, the Third Circuit seemed to establish a requirement that new value remain unpaid when it wrote in New York City Shoes as follows: The three requirements of section 547(c)(4) are well established. First, the creditor must have received a transfer that is otherwise avoidable or a preference under 547(b). Second, after receiving the preferential transfer, the preferred creditor must advance new value to the debtor on an unsecured basis. Third, the debtor must not have fully compensated the creditor for the new value as of the date that it filed its bankruptcy petition. However, the dispute in New York City Shoes had nothing to do with whether new value remained unpaid. Indeed, the parties agreed that new value had not been paid. Rather, the dispute centered on the timing of payment by postdated check in relation to the date of shipment of goods. The creditor had received a postdated check from the debtor and soon thereafter shipped goods on credit. However, the postdated check bore a payment date substantially in the future, much later than when the goods were shipped. The Third Circuit held that the second element of the new value defense had not been met, i.e., the creditor had not advanced new value to the debtor after receiving the preferential transfer. During the two decades between the decision of New York City Shoes in 1989 and Judge Carey s Pillowtex decision in October 2009, the Third Circuit was placed in the remains unpaid camp. A dozen lower courts within the Third Circuit followed New York City Shoes by quoting its language on the three requirements of section 547(c)(4) set forth above, but those courts rarely decided a case based on the third element. Exceptions were In re Lease-A-Fleet, Inc., 141 B.R. 853 (Bankr. E.D.P.A. 1992) (Held: payment of new value by the creditor s drawing on a bank letter of credit negated new value defense); In re U.S. Wood Products, Inc., 2004 Bankr. LEXIS 520 (Bankr. D. Del. 2004) (Held: full compensation pre-bankruptcy to creditor for alleged new value transfer negates subsequent new value defense); and In re Hechinger Investment Company of Delaware, Inc., 2004 Bankr. LEXIS 2156 (Bankr. D. Del. 2004) (Held: although New York City Shoes requires that new value remain unpaid in the case of a single transfer, nevertheless, it may be distinguished on its facts in the case of a running account between debtor and creditor.) In Pillowtex, Judge Carey excused the preference defendant from having to establish that new value remained unpaid after concluding that the New York City Shoes language purportedly imposing that requirement was merely dictum. The Third Circuit had not considered the remains unpaid issue on the merits and, therefore, according to established Third Circuit authority (see, e.g., McGurl v. Trucking Employees of North Jersey Welfare Fund, Inc., 124 F.3d 471, 484 (3d. Cir. 1997)), New York City Shoes did not establish a binding precedent that new value must remain unpaid. Judge Carey disagreed with the analysis of the Delaware bankruptcy court in the earlier decision in Hechinger, which seemed to assume that New York City Shoes did require that new value remain unpaid but purported to distinguish it on the grounds that Hechinger, unlike New York City Shoes, involved a running account series of transactions. In Pillowtex, Judge Carey carefully reviewed developments in decisional law and scholarly interpretation of the issue of whether new value must remain unpaid. He focused on the plain, but complex, language of the statute. In particular, he credited the careful reasoning of the court in In re Check Reporting Services, Inc., 140 B.R. 425 (Bankr. W.D. Mich. 1992), which had analyzed several aspects of 547(c)(4) and had decided, inter alia, that the word otherwise means other than under 547(c)(4). Judge Carey concluded that a debtor s payment for subsequent 7

8 new value deprives a defendant of the 547(c)(4) defense only if the payment is unavoidable. Although Judge Carey did not undertake to restate 547(c)(4) (B), eliminating the confusing double negative and clarifying otherwise, nevertheless, his decision indicates that the following restatement would be accurate: 11 U.S.C. 547 (c) The trustee may not avoid under this section a transfer (4) to or for the benefit of a creditor, to the extent that, after such transfer, such creditor gave new value to or for the benefit of the debtor (B) on account of which new value the debtor either (i) did not make a transfer to or for the benefit of such creditor, or (ii) if the debtor did make such a transfer, the transfer is subject to avoidance by the trustee, or would be subject to avoidance but for the extension of subsequent new value. In conclusion, Judge Carey s Pillowtex decision correctly indicates that the statement in New York City Shoes that new value must remain unpaid is merely non-binding dictum. In Pillowtex, Judge Carey provides a clear analysis of the plain, but complex, language of 547(c)(4)(B) that the only payment of new value that deprives a defendant of the defense is a payment that is unavoidable other than under 547(c)(4). Buyer Beware: Third Circuit Denies $15 Million Break-Up Fee for Failure to Meet O Brien Standard Da v i d B. Stratton strattond@p e p p e r l a w.c o m De b o r a h Ko v s k y -Ap a p k o v s k y d@p e p p e r l a w.c o m Stalking horse bidders are a common feature of Section 363 asset sales in bankruptcy. A stalking horse is the first bidder for the debtor s assets, who performs the initial due diligence, sets the minimum purchase price and jump-starts the bidding process, often attracting higher and better offers. In exchange for the work and risks undertaken by the stalking horse, it is typically given certain protections: Any overbids must exceed the stalking horse s bid by a certain minimum amount, and in the event that the stalking horse is outbid, it will usually be entitled to reimbursement of its expenses and payment of a break-up fee. These bid protections are not guaranteed, however, since they must be approved by the bankruptcy court. In the Third Circuit, expense reimbursements and break-up fees will not be granted unless the stalking horse bidder can demonstrate that reimbursement and fee were actually necessary to preserve the value of the estate. Calpine Corp. v. O Brien Env t Energy, Inc. (In re O Brien Env t Energy, Inc.), 181 F.3d 527, 535 (3d Cir. 1999) (emphasis added). The Third Circuit recently applied the O Brien test to deny a $15 million break-up fee to a stalking horse bidder, even though the motion to approve the fee was supported by both the debtors and the Creditors Committee, and despite the fact that, even after payment of the fee, the debtors estates still would have been solvent and able to pay all creditors in full. Kelson Channelview LLC v. Reliant Energy Channelview LP (In re Reliant Energy Channel LP), No (3d Cir. Jan. 15, 2010). In Reliant, the debtors decided to sell their largest asset, a power plant in Channelview, Texas. The plant was marketed extensively; more than 100 potential purchasers were contacted, more than three dozen signed confidentiality agreements, and 12 ultimately submitted bids. Many of the bids, however, were contingent on the bidder s obtaining financing an uncertain undertaking in the prevailing business environment. Kelson, on the other hand, submitted a complete and non-contingent bid for $468 million and was selected as the winning bidder. 8

9 BankruptcyUpdate A bidder considering acting as a stalking horse should be aware that previously-rejected bidders who announce an interest in bidding at auction may be granted standing to object to break-up fees and other bid procedures. Kelson and the debtors entered into an asset purchase agreement (APA) for the plant. Since the debtors were in bankruptcy, the APA provided that the debtors would immediately seek an order from the bankruptcy court approving the sale. Moreover, the APA required the debtors to seek an order approving certain bid protections for Kelson s benefit in the event the bankruptcy court determined there should be an auction for the plant before the sale. The proposed bid protections provided that the debtors could not accept a competing bid unless it exceeded Kelson s bid by $5 million, and that Kelson would be entitled to a break-up fee of $15 million and expense reimbursement of up to $2 million if a competing bid were accepted. While the bankruptcy court was considering the debtors motion to approve the sale without an auction, the debtors with the support of the Creditors Committee asked the court to approve the bid protection measures. Fortistar LLC, which had submitted one of the contingent bids, objected to the motion. 1 Fortistar asserted that it was willing to submit a higher and better bid at an auction, but was deterred by the proposed $15 million break-up fee and $2 million reimbursement. Following an evidentiary hearing, the bankruptcy court denied the debtors request to sell the assets without an auction, approved the $5 million overbid requirement and allowed the reimbursement of Kelson s expenses up to $2 million, 2 but denied the $15 million break-up fee. The bankruptcy court concluded that the break-up fee was not actually necessary to preserve the value of the estate based primarily on two factors: (1) Kelson s bid was not expressly conditioned on approval of the break-up fee, so that it would be bound by the APA even if it weren t approved; and (2) there was another willing bidder waiting in the wings, ready to bid at auction. As it turned out, Kelson did not participate in the subsequent auction and asserted that its offer was no longer available. Fortistar submitted the winning, fully-financed auction bid, which topped Kelson s bid by $32 million. Kelson appealed the order denying its break-up fee. The district court, and eventually the Third Circuit, affirmed the bankruptcy court s order. The Third Circuit, while recognizing the risks incurred and benefits provided by stalking-horse bidders, reiterated O Brien s position that a break-up fee isn t always necessary to induce a stalking horse to take those risks and provide those benefits. On the facts present in Reliant, where Kelson s bid was conditioned on the debtors seeking (but not actually obtaining) approval of the break-up fee, the Third Circuit found that it was clear that the break-up fee was not required to induce Kelson to bid. The Third Circuit conceded that the break-up fee could have benefited the estate in another way, by keeping Kelson committed to the purchase after the court ordered an auction. However, the Third Circuit found that the bankruptcy court had appropriately weighed that potential benefit against the detriment of deterring other bids in deciding that the break-up fee was not necessary for the protection of the estate. Fortuitously, the bankruptcy court s decision benefited the estates because Fortistar outbid Kelson by $32 million. Of course, if the bankruptcy court s gamble had been wrong, and another suitable bid did not materialize while Kelson walked away permanently from its offer, the estates would have been severely harmed. The Reliant saga has important lessons for potential stalkinghorse bidders in bankruptcy. First and foremost, a stalking-horse bidder should ensure that its bid is expressly conditioned on approval of a break-up fee. Furthermore, stalking horses should understand that where there is another party willing to bid at auction, it is highly possible that the court will deny a breakup fee. (Although the Third Circuit insisted that the bankruptcy court had not announced a per se rule against break-up fees where there is another bidder, it noted with approval the bankruptcy court s position that as a factual matter break-up fees often are not needed when there are bidders for an asset other than the initial bidder. In light of that position, it is hard to imagine a factual scenario involving another bidder where a break-up fee would be approved.) Finally, a bidder consider- 9

10 ing acting as a stalking horse should be aware that previouslyrejected bidders who announce an interest in bidding at auction may be granted standing to object to break-up fees and other bid procedures, even though such rejected bidders have no existing stake in the proceedings. In short, stalking-horse bidders must exercise greater caution and be cognizant of the increased risk that despite promises of reimbursement and break-up fees they may not walk away whole from attempted asset purchases in bankruptcy. En d n o t e s 1 Over the objections of the debtors and the Creditors Committee, the bankruptcy court determined that Fortistar, as a potential bidder, had standing to be heard on bid procedures. 2 The bankruptcy court found that the reimbursement of expenses was warranted as an administrative claim against the estates; Kelson had benefited the estates by assisting in the creation of the asset purchase agreement against which other potential purchasers would be required to bid. Court: Indenture Mandates That Any Credit Bid Come from Trustee, Not Noteholders He n r y J. Ja ff e j a ff e h@p e p p e r l a w.c o m Michael J. Custer custerm@pepperlaw.com Section 363 of the Bankruptcy Code permits credit bids for the sale of a debtor s assets. Specifically, Section 363(k) provides that, in the sale of assets subject to a lien securing an allowed claim, unless the court for cause orders otherwise the holder of such claim may bid at such sale, and, if the holder of such claim purchases such property, such holder may offset such claim against the purchase price of such property. 11 U.S.C. 363(k). A creditor s right to credit bid on an asset for sale in a bankruptcy case, however, may be compromised when the particular creditor is a bondholder or noteholder (holders) whose rights are subject to a trust indenture agreement (an indenture). In such cases, trustees appointed pursuant to such indentures (an indenture trustee) are often given the authority to take certain actions on behalf of all, or certain classes of, holders. Consequently, disputes can arise as to who is authorized to submit credit bids on behalf of some or all of the holders namely, can the holders directly credit bid the amounts of their particular bonds or notes (or, if they control a majority of the bonds or notes, can they cause all of the bonds or notes to be credit bid?), or does the indenture trustee have the sole right to make a credit bid on behalf of holders? The U.S. Bankruptcy Court for the District of Delaware recently addressed such a situation in the Chapter 11 bankruptcy case of Electroglas, Inc. Ultimately, the court found that the respective rights of the parties to submit credit bids were governed by the terms of the relevant indenture and, in this case, the court concluded that the indenture vested sole authority to credit bid in the hands of the indenture trustee. Auction and Competing Credit Bids On July 10, 2009, the debtors filed a motion requesting approval of bid procedures for the sale of all or substantially all of their assets. On July 30, 2009, Judge Peter Walsh of the Delaware bankruptcy court entered an order approving bid procedures that would govern the manner in which an auction of these assets would be conducted. Thereafter, the debtors held an auction that continued periodically over the span of several weeks. Advanced Inquiry Systems, Inc. (AISI), which by the second day of the auction had acquired 56 percent of outstanding notes the debtors issued pursuant to the applicable indenture, sought to credit bid 100 percent of the outstanding notes as part of its bid for substantially all of the debtors assets. In response, Formfactor, Inc., in conjunction with the minority noteholders, sought, as part of its bid, to credit bid the outstanding notes they held. The debtors ultimately determined Formfactor s bid to be the highest and best bid. AISI subsequently objected to the sale on 10

11 the ground that, among other things, the minority noteholders were not permitted to credit bid their minority position and the debtors had improperly valued the AISI credit bid at only the notes AISI actually held, rather than the full amount of the notes issued under the trust indenture. In response, Formfactor argued that the terms of the indenture permitted only the indenture trustee to credit bid all of the notes, and alternatively, AISI could only credit bid the portion of notes it actually held. Th e Co u r t s Decision a n d An a l y s i s in Re j e c t i n g Bo t h Credit Bids Judge Walsh first determined that the court had jurisdiction to determine the rights of the indenture trustee and the noteholders under the indenture. The court also determined that competing credit bids fell within its core jurisdiction, as the right to credit bid is specifically provided for by the Bankruptcy Code and would substantially affect the liquidation of the estate. Turning to the question of whether noteholders could credit bid directly the portion of outstanding notes they held or, in the case of AISI, cause all of the notes to be credit bid, Judge Walsh held that they could take neither action. The court found, in part, that the indenture provided that no noteholder was permitted to take an action that does not treat all noteholders equally and accrue to the noteholders common benefit. Specifically, the court looked to Section 7.4 of the indenture, which provided in relevant part: [N]o one or more holders of Notes shall have any rights in any manner whatever by virtue of or by availing of any provision of this Indenture to affect, disturb or prejudice the rights of any other holders of Notes, or to obtain or seek to obtain priority over or preference to any other such holder, or to enforce any right under this Indenture, except in the manner herein provided and for the equal, ratable and common benefit of all holders of Notes... According to the court, noteholders credit bidding their portion of the outstanding notes would violate the overarching prescription that all actions taken as to the notes be taken for the equal benefit of all noteholders. The court concluded that both the indenture and the related agreements, including a related security agreement, were set up for the benefit of the noteholders as a whole and not for the benefit of any particular group of noteholders. The court found no provision in the indenture or related agreements permitting the noteholders to act as a majority or as a minority with respect to credit bidding. Judge Walsh also found that the indenture prohibited AISI, as the majority noteholder, from credit bidding the entire amount of outstanding notes and also prohibited the minority noteholders from bidding the notes they held to acquire the debtors assets. To begin, Section 7.4 of the indenture barred noteholders from instituting any suit, action or proceeding in equity or at law upon or under or with respect to [the] Indenture unless they first made written demand to the trustee and the trustee failed to take the requested action within 60 days. The court found this provision clearly barred the noteholders from unilaterally stepping into the shoes of the indenture trustee to simply credit bid the notes themselves. Judge Walsh also looked to Section 7.5 of the indenture, which the court found specifically grants the Trustee the broadest of powers to take all actions it deems appropriate in the event of default. The clear language of the indenture therefore dictated that, from a substantive standpoint, the noteholders simply could not act separately from the trustee. The court found no provision in the indenture or related agreements permitting the noteholders to act as a majority or as a minority with respect to credit bidding. The court went on to hold that the majority noteholder could also not require the trustee to make a particular credit bid. In so holding, Judge Walsh rejected AISI s argument that certain language of the indenture permitted the majority of noteholders to direct certain substantive actions of the indenture trustee. Rather, the court viewed the operative language only to permit such noteholders to direct the indenture trustee as to the procedural steps that must be taken to accomplish an action that the trustee 11

12 had elected to take such as the time, place and method by which that action would be taken. In sum, the pertinent language would not permit a group of noteholders to go over the head of the Trustee and take an action they think appropriate simply because the Trustee has declined to take that action. Given its findings that no party but the trustee had the right to submit a credit bid with respect to some or all of the outstanding notes, and that the trustee could not be forced to do so, the court rejected both noteholders credit bids, finding them to be impermissible and unauthorized. Judge Walsh held that any credit bid would have to come from the trustee, who was the only party empowered to credit bid for the noteholders under the terms of the indenture. Finally, Judge Walsh declined Formfactor s suggestion that the court simply compare the cash portions of the competing bids in order to determine a winning bid, as he found that the impermissible credit bids were an integral part of the bids submitted. Rather, Judge Walsh ordered the debtor to reconvene the auction and conduct an all-cash auction. Evelyn J. Meltzer Elected Secretary of the Delaware Chapter of the International Women s Insolvency & Restructuring Confederation Evelyn J. Meltzer has been elected secretary of the Delaware Chapter of the International Women s Insolvency & Restructuring Confederation (IWIRC). IWIRC is a networking organization devoted to enhancing the professional status of women in insolvency and restructuring. IWIRC members comprise every discipline in the industry and are located in major markets throughout the world. Ms. Meltzer is an associate in the Corporate Restructuring and Bankruptcy Practice Group of Pepper Hamilton, resident in the Wilmington office. She has experience in representing debtors, trustees, committees of unsecured creditors, post-confirmation trusts as well as individual creditors in bankruptcy proceedings. Additionally, Ms. Meltzer acts as counsel for both plaintiffs and defendants in various litigation matters related to bankruptcy. RSS on Subscribe to the latest Pepper articles via RSS feeds. Visit today and click on the RSS button on the publications page to subscribe to our latest articles in your news reader. 12