Legal Notes

Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 333 B.R. 205 (Bankr. S.D.N.Y. Nov. 17, 2005) (A transferred claim can be equitably subordinated based solely upon the transferring creditor's inequitable conduct.)

In a decision likely to have significant consequences for purchasers and sellers of distressed credits, including loans and trade claims, the United States Bankruptcy Court for the Southern District of New York has held that a claim, even though transferred to a good faith purchaser, can be equitably subordinated based upon the inequitable conduct of the selling creditor.

Prior to its Chapter 11 filing, Enron borrowed approximately $1.7 billion from a group of banks, which included Fleet National Bank, pursuant to a certain credit agreement. Fleet later transferred its portion of the indebtedness owing under the credit agreement (the "Claims") to various third parties (the "Transferees").

Following the transfer of the Claims, and nearly two years after the commencement of the Chapter 11 case, Enron commenced an adversary proceeding against several banks, including Fleet, alleging preferences, fraudulent conveyances and inequitable conduct relating to a series of prepaid forward transactions (the "Forward Transactions"). The Forward Transactions were unrelated to the loans made by Fleet pursuant to the credit agreement.

After the filing of the adversary proceeding against Fleet, Enron commenced an adversary proceeding against the Transferees, seeking to subordinate and disallow the Claims (now held by the Transferees) on the basis of Fleet's alleged inequitable conduct in the Forward Transactions. According to Enron, regardless of the fact that Fleet no longer held the Claims, and even though the Transferees were not alleged to have engaged in any inequitable conduct, the Claims should nevertheless be subordinated and disallowed. In support of its position, Enron argued that the failure to subordinate and disallow the Claims would encourage wrongdoers to "wash" their claims by transferring them to third parties in order to escape subordination.

The Transferees responded by filing a motion to dismiss the complaint, arguing that equitable subordination applies to a creditor who is found to have participated in the inequitable conduct, not to the particular claim at issue. The Transferees further argued that, even if equitable subordination were to apply to the Claims, the Transferees were entitled to assert a "good faith" defense as they had no knowledge of the inequitable conduct.

The bankruptcy court denied the Transferees' motion to dismiss. In rendering its decision, the bankruptcy court focused on three distinct inquiries. The first inquiry was whether Section 510(c) of the Bankruptcy Code allows a court to subordinate a claim that, although unrelated to any inequitable conduct, was originally held by a creditor who is found to have engaged in inequitable conduct. Noting the absence of any case law or statutory authority to the contrary, the bankruptcy court held that the doctrine of equitable subordination is not limited only to those claims related to the inequitable conduct at issue. The Court found its conclusion to be consistent with the underlying policy of the Bankruptcy Code that a court can exercise its authority to subordinate a claim in order to rectify harm to the estate and achieve a fair distribution for creditors.

The bankruptcy court next addressed the question of whether, and to what extent, a claim subject to equitable subordination in the hands of a transferor remains subject to equitable subordination in the hands of a transferee. On this issue, the bankruptcy court held that the transfer of a claim does not shield the claim from equitable subordination in the hands of a transferee. According to the Court, the transferee of a claim should not enjoy greater rights than the transferor. Responding to the Transferees' argument that such a ruling would undermine confidence in the claims trading market, the bankruptcy court found that participants in the claims trading market are aware (or should be aware) of the risks involved with the purchase of claims, including the possibility that the claims could be subordinated.

The third and final inquiry addressed by the bankruptcy court was whether innocent transferees should be entitled to assert a "good faith" defense to avoid equitable subordination of a claim. The Transferees argued they should be entitled to assert a "good faith" defense because they acted in good faith, paid value for the Claims and had no knowledge of the inequitable conduct. Rejecting the Transferees' argument, the bankruptcy court found that the "good faith" defense was not applicable in the context of equitable subordination. Moreover, the bankruptcy court noted that even if it were applicable, a "good faith" defense asserted by the transferee of a bankruptcy claim would necessarily fail because such transferee, by purchasing a claim against a bankrupt company, is on notice that an action might be brought against the claim.

As illustrated by the Enron decision, what you don't know can hurt you. Accordingly, purchasers of distressed credits, including loans and trade claims, should conduct thorough due diligence prior to purchasing a claim, and should also attempt to obtain indemnification from the transferor against potential claims based on the transferor's conduct.

N.C.P. Marketing Group, Inc. v. Billy Blanks (In re N. CP. Marketing Group, Inc.), 337 B.R. 230 (D. Nev. 2005) (Because a nonexclusive trademark license is personal and non-assignable, a debtor-in-possession may not assume it without the consent of the licensor.)

Lenders increasingly find themselves making loans to borrowers whose businesses are dependent on a few, or even one, license from an intellectual property owner. Indeed, these days much of the value of a business (and the lender's collateral) may reside in a single intellectual property license. For example, some businesses are dependent on a trademark license from a trademark owner in order to advertise and sell a particular product that is critically important to its business. In such situations, the ability of the borrower/licensee to continue using the trademark after it files a Chapter 11 case is likely to be the difference between being able to reorganize the company and being forced to liquidate it. Determining whether a debtor-in-possession can assume a trademark license without the consent of the licensor is an important issue for both the borrower/licensee and a lender whose collateral includes the trademark license rights.

There are currently two different tests employed by courts to determine whether a debtor-in-possession can assume an intellectual property license: the "actual test" and the "hypothetical" test. Under the "actual test," employed by the First Circuit, see Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489, 493 (1st Cir. 1997), the debtor-in-possession is treated functionally like the original licensee. Accordingly, if applicable intellectual property law prevents assignments to a third party who is not the original licensee, then a debtor-in-possession will only be prevented from assuming the license without the consent of the licensor if the debtor-in-possession actually intends to assume the license and then assign it to another third party. Thus, the debtor-in-possession will be permitted to assume the license so long as it does not actually intend to assign it subsequently.

Under the "hypothetical test" (currently used by the Fourth, Third, Ninth and Eleventh Circuits), if applicable intellectual property law prevents assignments to a third party who is not the original licensee, then assumption by the debtor-in-possession is not allowed without the consent of the licensor, even if the debtor-in-possession has no intention of assigning the license to a third party after assuming. Functionally, under this test the debtor-in-possession is treated as if it were a new third-party, and the law of assumption in bankruptcy tracks the law of assignments regardless of whether or not the debtor-in-possession later plans to assign the license to another party. In effect, the debtor-in-possession is treated as if it hypothetically intended to assign the lease to a third party, even if it merely wished to use the license in its own business.

In a recent case, the District Court for the District of Nevada decided what it described as "an issue of first impression in the [Ninth] circuit": whether a debtor-in-possession in a Chapter 11 case may assume a nonexclusive trademark license without the consent of the licensor. Because this court is in the Ninth Circuit, which uses the "hypothetical test," the essential question that the court addressed was what underlying trademark law says about the assignability of nonexclusive trademark licenses. N.C.P. Marketing Group involved an agreement between Billy Blanks and Gayle Blanks, the creators and owners of the trademark TAE BO?, and N.C.P. Marketing Group, Inc. ("NCP"), as the licensee. The agreement granted NCP the right to advertise and sell products containing the Blanks TAE BO trademark. Soon after entering into this agreement, the parties became involved in a dispute about their respective obligations. Consequently, the parties entered into a Settlement Agreement, confirming the Blanks' ownership of the TAE BO mark, and a License Agreement, detailing how NCP was to use the Blanks' mark in marketing and selling products. However, not long after entering the Settlement Agreement and the License Agreement, NCP materially breached both agreements by not paying the Blanks' the required amount of royalties. Accordingly, the Blanks initiated an arbitration proceeding, in which the arbitrator ordered NCP to pay the Blanks $2.1 million in royalties.

Rather than pay the royalties, NCP filed for Chapter 11 bankruptcy protection. As part of the bankruptcy case, NCP attempted to assume the trademark licensing agreement so it could either continue operating its business or assign the license to a third party in exchange for cash. The Blanks responded that, under applicable law, any rights that NCP had in the TAE BO trademark were nonassumable and, therefore, NCP could not subsequently assign rights in the TAE BO mark to any other party. The Blanks also made clear that they did not consent to NCP's assumption of the license. Moreover, they argued that if, under applicable trademark law, a licensor could reject performance from a third party (i.e., reject the assignment of the trademark license to another party who was a stranger to the original license agreement signed by the licensor), then, under Ninth Circuit law, a debtor-in-possession cannot assume a trademark license without the licensor's consent, even if the debtor-in-possession does not later intend to assign the licensee to a third party. The bankruptcy court agreed with the Blanks.

On appeal to the district court, NCP argued that it did not need the Blanks consent because, under applicable trademark law, the Blanks were not excused from accepting performance from a party other than the original licensee. NCP also argued that the Blanks' had consented to assignment of the license in the Settlement Agreement and License Agreement. However, the district court agreed with the bankruptcy court, holding that the trademark license could not be assumed by a Chapter 11 debtor-in-possession without consent of the licensor, and that the licensor had in fact not consented. The district court held that the Settlement Agreement and License Agreement contained time limits for licensing third parties, which had expired. Because any third-party license signed by NCP outside of the time limits prescribed in the agreements would not be valid, the district court held that any consent that might have been manifested by the agreements had expired. Accordingly, the district court held that the Blanks had not consented to the assignment of the trademark license and, therefore, NCP could not assume the license.

By ruling in favor of the Blanks, the district court followed the general trend that started with the Ninth Circuit's decision in In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999). Catapult dealt with patent law, where consent of the licensor is generally required for assignment of certain patent licenses (also true under copyright law), and held that applicable patent law made exclusive patent licenses personal and non-assignable and, therefore, nonassumable by a debtor-in-possession without the consent of the licensor. In N.C.P. Marketing Group, however, NCP claimed that trademarks were fundamentally different from patents and copyrights because "trademark law was designed to protect the consumer from deception and confusion and not the interests of the trademark holder." 337 B.R. at 235. The district court, while not denying that protection of the public was an object of trademark law, noted that another object of trademark law was to preserve a trademark holder's good will in its "business name and products." Id. at 236. Because a trademark owner/licensor has a duty to control the quality of goods sold under a mark, the trademark owner/licensor has an interest in the party to whom a trademark is assigned. Accordingly, the district court held that "trademark rights are personal to the assignee and not freely assignable to a third party." Id. Therefore, employing the "hypothetical test" used in the Ninth Circuit, NCP could not even assume the nonexclusive trademark license and bring it into its Chapter 11 bankruptcy estate without the consent of the Blanks.

Given the holding in the N.C.P. Marketing Group case, lenders must consider that if a borrower who is the licensee under an important nonexclusive trademark license fails to obtain consent from the licensor for the assignment of the license before the lender extends credit to the borrower, the lender runs the risk that the borrower will lose its license rights when a Chapter 11 is filed, a result that could have dire consequences for the lender by making reorganization impossible. The only other option for a debtor/licensee who has not obtained such up-front consent from a licensor to assume a non-exclusive trademeark license is to file a Chapter 11 case in a jurisdiction that employs the "actual test" rather than the "hypothetical test."

Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448 (3d Cir. 2006) (Reclassification and equitable subordination are not liberally employed by the courts.)

In November of 1999, SubMicron's pre-petition secured lenders, after having already made numerous advances to keep SubMicron viable, made two additional loans totaling over $11 million. Despite the additional loans, SubMicron continued to suffer losses.

Seeking to avoid a liquidation, SubMicron began acquisition discussions in July of 1999. The secured lenders, not Submicron's management, conducted the negotiations, eventually reaching an agreement on the terms of an acquisition to occur in the context of a prepackaged bankruptcy. In August 1999, SubMicron entered into an asset purchase agreement with Akrion LLC, a newly formed entity created to serve as an acquisition vehicle. Pursuant to the asset purchase agreement, the secured lenders received 30% of the stock in the newly formed entity and, in exchange, the secured lenders agreed to credit bid their claims against the purchase price at the subsequent sale. The following day, SubMicron filed a Chapter 11 bankruptcy petition and immediately sought the approval of the asset sale pursuant to Section 363 of the Bankruptcy Code.

After the sale had been approved, the plan administrator for SubMicron brought an action on behalf of unsecured creditors, seeking to reclassify and equitably subordinate a portion of the secured lenders' claims. With respect to the reclassification argument, the plan administrator argued that the additional financing (approximately $11 million) should be reclassified as an equity infusion, given the dire financial condition of SubMicron at the time the additional financing was extended. The Third Circuit rejected the plan administrator's argument, instead agreeing with the district court that the additional financing was in the form of debt, not equity. In this regard, the Third Circuit noted that the additional financing had fixed maturity dates and interest rates, both of which supported characterization as debt.

The plan administrator also argued that the secured lenders' participation on the SubMicron Board (the secured lenders had selected three of SubMicron's four Board members) also provided a basis for reclassifying a portion of the secured lenders' claims. The Third Circuit rejected this argument, finding that the participation of the secured lenders on the SubMicron Board did not, in and of itself, provide support for an equity reclassification. In this regard, the Third Circuit agreed with the district court's finding that it is not unusual for lenders to have designees on a company's Board, particularly when the company is distressed.

Having determined that the additional financing represented an extension of debt (as opposed to equity), the Third Circuit next addressed the issue of equitable subordination. Relying on the district court's finding that the unsecured creditors were not injured as a result of the secured lenders' dealings with the buyer, the Third Circuit declined to equitably subordinate the claims of the secured lenders. In support of its conclusion, the Third Circuit pointed out that equitable subordination is remedial, not penal, and should only be applied to the extent necessary to offset specific harm that creditors have suffered as a result of inequitable conduct.

Cohen confirms that reclassification and equitable subordination are not liberally employed remedies. As illustrated in Cohen, even in a situation where the lender controls the board, reclassification and equitable subordination claims are not likely to succeed absent a strong showing that the lender intended to make an equity contribution or that the lender's actions resulted in harm to creditors.

In re Vartec Telecom, Inc., 335 B.R. 631 (Bankr. N.D. Tex. 2005) (Texas law rejects the concept of "deepening insolvency.")

In a contested Chapter 11 case, a secured lender must expect to have its liens and claims scrutinized from top to bottom and mountains made out of the mole hill of a defect in its position. In recent years, in addition to the usual array of marginal avoidance and equitable subordination actions directed against the secured lender, the lender may also be accused of having caused the debtor's prepetition "deepening insolvency," which has been defined as "the fraudulent prolongation of a corporation's life beyond insolvency, resulting in damage to the corporation caused by increased debt." In re Vartec Telecom, Inc., 335 B.R. 631, at 636.

When first asserted, "deepening insolvency" was aimed primarily at corporate officers and directors, as a basis for measuring the damages for breach of their fiduciary duties by continuing the business to permit them to siphon off corporate assets. The passage of time has seen the concept morphed into a new common law tort extending to lawyers, accountants, bankers and other financial and insolvency professionals. While some courts recognize deepening insolvency as a separate tort (Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 349-52 (3d Cir. 2001), other courts continue to interpret it as a measure of damages resulting from the commission of a separate tort, e.g., the breach of a fiduciary duty owed to the corporation or its creditors (In re Global Service Group, LLC, 316 B.R. 451, 457-59 (Bankr. S.D.N.Y. 2004)).

In Vartec, the United States Bankruptcy court for the Northern District of Texas held that Texas law does not recognize deepening insolvency as a separate cause of action. Like the Global Service decision, Vartec also noted that the damages recoverable in a deepening insolvency action are substantially duplicated by other torts. Vartec cautioned against the recognition of a new tort that only leads "to duplicative litigation, encouraging inefficient litigation of issues better handled within the context of the core cause of action." 335 B.R. at 642.

In dismissing the deepening insolvency count asserted by the Creditor's Committee, the Court ruled that, under Texas law, the lender would be liable only if it controlled the debtor's business activities, thereby giving rise to a duty to the debtor's creditors. However, the court also held that the existence of control by the lender was inadequately plead, and thus the count was subject to dismissal. The decision observed that making a bad loan is not a tort, and the lender's continuing extensions of credit did not cause corporate assets to be siphoned off.

Hopefully, the reasoning reflected in Global and Vartec, both of which narrowly interpret deepening insolvency, will ultimately carry the day. It is one thing to guard against an avoidance or subordination claim. It is another to face the bottomless pit of having wrongfully perpetuated an insolvent's life, especially when, in many cases, the lender's efforts also help to preserve the viability of the company and maximize the chance for the unsecured creditors to receive a return.

Collins v. Kohlberg & Co. (In re Southwest Supermarkets, LLC), 325 B.R. 417 (Bankr. D. Ariz 2005) (Bankruptcy trustee may bring an affirmative cause of action against a third party by stepping into the shoes of a hypothetical creditor.)

In 1995, Kohlberg & Co. acquired Southwest Supermarkets, LLC, which became a wholly owned subsidiary of Kohlberg. In connection with the acquisition, Southwest agreed to pay Kohlberg a $1 million acquisition fee, plus a yearly management fee to cover certain tax liabilities arising from Kohlberg's ownership of Southwest. In 2001, Southwest filed for Chapter 11 protection.

Subsequently, the Chapter 11 trustee brought an action against Kohlberg alleging breach of fiduciary duty (i.e., fraudulent self-dealing) and actual fraudulent transfers on account of, among other things, the fact that the pre-petition tax liability payments made by Southwest to Kohlberg were approximately twice the actual accrued amount of the tax liabilities.

In Kohlberg, the Bankruptcy Court addressed the question of whether Section 544(a)(2) of the Bankruptcy Code permitted the Chapter 11 trustee to seek affirmative relief against Kohlberg. In relevant part, Section 544(a)(2) provides:

The trustee shall have, as of the commencement of the case, and without regard to any knowledge of the trustee or any creditor, the rights and powers of, or may avoid any transfer of property by the debtor or any obligation incurred by the debtor that is voidable by .... a .... creditor .... whether or not such a creditor exists. (Emphasis added.)

In essence, Section 544(a)(2) empowers a trustee to step into the shoes of a "hypothetical creditor" and thereby avoid certain unrecorded transfers or secret liens.

While the Bankruptcy Court did acknowledge that Section 544(a)(2) has generally been used only to provide the trustee with avoidance powers, the Bankruptcy Court nevertheless concluded that the "rights and powers" of a hypothetical creditor under Section 544(a)(2) include the ability to bring affirmative causes of action. Thus, not only did the Bankruptcy Court allow the trustee to step into the shoes of a hypothetical creditor to avoid the transfers from Southwest to Kohlberg, it also allowed the trustee to step into the shoes of a hypothetical creditor to assert whatever causes of action such creditor might have against Kohlberg (i.e., breach of fiduciary duty).

The availability of affirmative relief under Section 544(a)(2) of the Bankruptcy Code may have even broader significance. By permitting a trustee to step into the shoes of a hypothetical creditor, and from there bring affirmative causes of action against a third party, a trustee may be able to avoid the defenses that such third party would otherwise have against the debtor. For example, in light of Collins, a court might conclude that a trustee can bring an action to pierce the corporate veil, even if, under applicable state law, the debtor corporation could not pierce its own veil.

By permitting the Chapter 11 trustee to step into the shoes of a hypothetical creditor to assert affirmative causes of action against a third party, Collins represents a departure from the current interpretation of Section 544(a)(2). As such, we do not know whether the Collins decision will be followed. In fact, Collins was recently criticized by the United States Bankruptcy Court for the District of Colorado in the case of In re Greater Southeast Community Hosp. Corp., 333 B.R. 506 (Bankr. D. Colo. 2005), where it was noted that the strong arm provision of the Bankruptcy Code does not transform the trustee into a "super creditor."

In re Stonebridge Technologies, Inc., 430 F.3d 260 (5th Cir. 2005) (Windfall to real property lessors by avoiding the cap Section 502(b)(6) of the Bankruptcy Code)

Section 502(b)(6) of the Bankruptcy Code, whose origin goes back to a 1934 amendment to the Bankruptcy Act, places a cap on the claim a lessor of real property may assert if its lease is rejected by the lessee in the lessee's bankruptcy. Prior to the decision in Stonebridge, the rule of law was that the proceeds of a letter of credit posted by the lessee as security for the performance of its real property lease was subject to the Section 502(b)(6) cap. See Solow v. PPI Enterprises, Inc., 324 F.3d 197 (3d Cir. 2003) and Redback Networks, Inc. v. Mayan Networks Corp., 306 B.R. 295 (9th Cir. BAP 2004). Now, in a per curiam opinion, the Fifth Circuit has held that the cap does not apply to letter of credit proceeds where the lessor did not file a proof of claim in the bankruptcy case.

In Stonebridge, the September 21, 2000, lease between Stonebridge and its lessor, EOP-Colonnade ("EOP"), provided for a security deposit of $105,000 in cash and a letter of credit for $1.43 million. The letter of credit was issued by Bank of Oklahoma and was secured by Stonebridge's pledge of a $1.25 million certificate of deposit. Stonebridge filed a Chapter 11 case on September 6, 2001, a date within one year of the lease agreement. EOP drew the full amount of the letter of credit, which amount significantly exceeded the cap allowable under Section 502(b)(6). Subsequent to the draw, the bank obtained relief from the automatic stay to apply the certificate of deposit in reduction of its claim for reimbursement arising from EOP's draw under the letter of credit. Stonebridge's trustee in bankruptcy thereafter sued EOP for, among other things, the amount received by EOP in excess of the Section 502(b)(6) cap. The bankruptcy court ordered the turnover of the excess amount, which decision was affirmed by the district court.

On appeal, the Fifth Circuit reversed. Outcome determinative for its ruling was that EOP had not filed a proof of claim in the bankruptcy case, that the letter of credit was not property of the estate but an independent obligation between the Bank and EOP, and that Section 502(b)(6) did not contain an avoidance power to recover the excess payment. The opinion stated:

By its terms, ? 502(b) applies only to claims against the bankruptcy estate. See, e.g., In re SKA! Design, Inc., 308 B.R. 777, 781 (Bankr. N.D. Tex. 2004) ("Section 502 deals only with allowance by a landlord of a claim, if presented, against the bankruptcy estate."). . . Stated simply, the claim of a lessor against the assets of the estate is an essential precondition to applying the damages cap at all. . . . Thus, the damages cap of ? 502(b)(6) does not apply to limit the beneficiary's entitlement to the proceeds of the letter of credit unless and until the lessor makes a claim against the estate. 430 F.3d 269, 270.

Despite the apparent conflict among the decisions, no petition was filed with the Supreme Court.

It is difficult to reconcile the Stonebridge decision with fundamental principles of bankruptcy law. The fact that the lessor did or did not file a proof of claim should not determine the applicability of Section 502(b)(6) to the case. The legal significance of filing a proof of claim is that it subjects the creditor to the claims allowance process, which is an equitable rather than a legal proceeding. See Granfinanciera, S.A. v. Nordberg, 492 U.S. 33 (1989). But even if a creditor does not file a claim, it is subject to suit in the bankruptcy court pursuant to 28 U.S.C. ? 1334(b) for an avoidable transfer, breach of contract, or a tort suit. Thus, perhaps the trustee should have argued that the receipt by EOP of an amount in excess of the Section 502(b)(6) constituted a fraudulent transfer subject to attack either under Section 548 or Section 544(b) of the Bankruptcy Code, or simply that EOP's retention of the surplus gave rise to a claim for unjust enrichment.

Bankruptcy courts should look to the substance of a transaction, not its form. Yet, under the holding in Stonebridge, diametrically opposite results flow when a certificate of deposit is pledged as security to a lessor (in which event the cap applies) than when the certificate of deposit is pledged to secure the issuance of a letter of credit in favor of the lessor (in which event the cap does not apply).