Legislative and judicial developments in 1999: Part I

Vis summary of judicial developments from November 1998 through October 1999 covers decisions of particular interest to the asset-based financial services industry.

Bankruptcy Code Preferences - Section 547

Krafsur v. Scurlock Permian Corp. (In re El Paso Refinery, L.P.), 171 F.3d 249

The Fifth Circuit Court of Appeals has held that payments received by a secured creditor during the preference period were not preferences where the payments were from proceeds of the secured creditor's collateral. Krafsur v. Scurlock Permian Corp. (In re El Paso Refinery, L.P.), 171 F.3d 249 (5th Cir. 1999). The court reached this result even though the payments literally qualified as preferences under 547(b) of the Bankruptcy Code in that they allowed the secured creditor to receive more than it would have received if (i) the payments had not been made, and (ii) the debtor were liquidated in a Chapter 7 proceeding. If the payments had not been made and a bankruptcy had ensued, the proceeds would have been shared between the secured creditor and another creditor that had a contractual right to proceeds of the same collateral. As a result, the court effectively found that the bankruptcy estate was not prejudiced by the transfers. Furthermore, the bankruptcy trustee did not have standing to recover the payments on behalf of the creditor who was arguably prejudiced by the transfers.

Prior to the bankruptcy, El Paso Refinery was financed, on a secured basis, by Bank Brussels Lambert ("BBL") and bought crude oil on credit from Scurlock Permian Corporation ("Scurlock"). El Paso's obligations to Scurlock were secured by a first lien on, among other things, accounts receivable and inventory. However, pursuant to an intercreditor agreement, Scurlock had agreed that, upon an event of default under the relevant agreements, BBL and Scurlock would be deemed to each have liens on the collateral of "equal dignity," and the parties would share that collateral in proportion to the amount of their debt. During the preference period, Scurlock received approximately $82 million in payments from the proceeds of the shared collateral, and El Paso's bankruptcy trustee sought to recover all of these payments as preferences.

The Fifth Circuit found that none of the payments to Scurlock constituted a preferential transfer. The court first noted that a fully secured creditor who receives a payment from its collateral does not receive a preference. Instead, the secured creditor simply receives what it would have been entitled to in a bankruptcy - i.e., the value of its collateral. The case was complicated, however, by the fact Scurlock had agreed to effectively share its first priority lien with BBL. The bankruptcy trustee argued that since some of the $82 million in payments should have been received by BBL under the parties' intercreditor agreement, Scurlock did receive more than it would have received in a bankruptcy had the payments not been made. The court found, however, that, while Scurlock may have received more than its rightful share of the collateral, the party who should sue as a result was BBL, not the bankruptcy trustee. In reaching this conclusion, the court specifically noted that the intercreditor agreement contained a provision which stated that the agreement was not for the benefit of the debtor. As a result, the debtor could not sue Scurlock for receipt of payments arguably contrary to the intercreditor agreement.

The El Paso case is important for two reasons. First, the court affirmed the well established principle that a secured creditor who receives the proceeds of its collateral does not receive a preference. In addition, the case indicates the importance of indicating clearly in an intercreditor agreement that the debtor has no rights under, and is not a beneficiary of, the agreement. Such language allowed the Fifth Circuit to quickly dispense with an argument that the bankruptcy trustee could sue Scurlock to recover preferences for the benefit of BBL.1

Roost v. Associates Home Equity Servs., Inc. (In re Williams), 234 B.R. 801 (Bankr. D. Or. 1999) (Deprizio rationale applied to avoid lien granted to a non-insider creditor more than ninety days but less than one year before bankruptcy).

A recent bankruptcy court decision makes clear that the 1994 amendments to 550 of the Bankruptcy Code failed to eliminate entirely the problems presented by Levit v. Ingersoll Rand Fin. Corp. (In re Deprizio Constr. Corp.), 874 F.2d 1186 (7th Cir. 1989). In Roost v. Associates Home Equity Servs., Inc. (In re Williams), 234 B.R. 801 (Bankr. D. Or. 1999), the bankruptcy court held that while the 1994 amendments eliminated part of the Deprizio problem - by preventing recovery under 550 of a transfer to a noninsider creditor that occurred more than 90 days prior to the debtor's bankruptcy filing - 547, which was not similarly amended, nonetheless continues to permit a trustee to avoid a lien granted in favor of a noninsider creditor more than 90 days prior to bankruptcy.

In Deprizio, the Deprizio Construction Company made payments to its lenders on debts that had been guaranteed by company insiders. After the company filed for bankruptcy, the trustee sued the lenders to recover the payments as preferences under 547 and 550 of the Bankruptcy Code. Although the payments had been made more than ninety days prior to the company's bankruptcy and were not made to insiders, the Seventh Circuit held that the payments were for the benefit of insider creditors because they reduced the contingent liability of the insider guarantors under their guarantee. Thus, the payments were recoverable from the lender as preferential transfers.2

In response to lender concerns, Congress attempted to resolve the Deprizio problem in the 1994 amendments to the Bankruptcy Code by adding a new 550(c), which provides that avoidable transfers made to an insider more than ninety days prior to a bankruptcy filing may be recovered only from the insider who actually benefitted from the transfer, and not from the transferee. This amendment thus insulates a lender from having a payment recovered when that payment was made more than ninety days prior to bankruptcy and reduced an insider guarantor's liability on its guarantee. Although this amendment was intended to overrule Deprizio, as Williams demonstrates, Congress' focus on preventing recovery of payments, while failing to similarly amend 547 to prevent avoidance of liens, has resulted in confusion with respect to the continued viability of the lien avoidance aspect of Deprizio.

In Williams, the lender perfected its lien in the debtor's mobile home more than ninety days, but less than a year, prior to the debtor's bankruptcy filing. The trustee sought to avoid the lender's lien on the basis that the transfer was for the benefit of the debtor's wife, an insider who was also liable on the debt. The court held that while Congress did partially overrule Deprizio by the 1994 amendments to the Bankruptcy Code, thus preventing a trustee from recovering payments under 550 based upon a Deprizio theory, the trustee could nevertheless avoid the lender's lien. In so holding, the court made clear that 547 affords an avoidance remedy distinct from the recovery remedy provided under 550; that is, avoidance of a lien or security interest can be sought under 547 even when recovery under 550 is unavailable. Moreover, the court found it noteworthy that Congress chose to amend only 550 of the Bankruptcy Code and did not amend 547. The court reasoned that had Congress intended to completely overrule Deprizio, it would have done so by amending 547 as well.

Williams confirms that security interests and liens obtained more than ninety days but less than one year before bankruptcy, which benefit an insider creditor of the debtor, are still susceptible to preference attack under a Deprizio-type rationale, notwithstanding the passage of the Bankruptcy Reform Act of 1994. CFA has actively participated in drafting proposed legislation which, if enacted, would eliminate Deprizio once and for all. However, this legislation is part of a much larger and more comprehensive revision of the Bankruptcy Code which is unlikely to pass this year. Thus, Deprizio will likely remain a problem for the foreseeable future.

Postpetition interest, fees and expenses - Sections 506(b), 506(c) and 726(a)(5)

Southland Corp. v. Toronto-Dominion (In re Southland Corp.), 160 F.3d 1054 (5th Cir. 1998) (Oversecured creditor entitled to postpetition interest at the prepetition contractual default rate).

The Fifth Circuit Court of Appeals has ruled that an oversecured creditor was entitled to postpetition interest on its prepetition debt at the default rate specified in its loan agreement. The court's holding was based upon, among other things, the fact that (i) the margin between the default rate and nondefault rate was only two percent, (ii) the secured creditor had not caused delay in the bankruptcy proceeding, and (iii) junior creditors would not be harmed by payment at the higher interest rate. In addition, the secured creditor's right to receive postpetition interest at the default rate was not affected by it having received either prepetition restructuring fees or interest during the bankruptcy at the nondefault rate (as adequate protection). Southland Corp. v. Toronto-Dominion (In re Southland Corp.), 160 F.3d 1054 (5th Cir. 1998).

Prior to filing for bankruptcy, Southland defaulted under its credit agreement with a bank group, and the banks sent a default notice to the company indicating that the banks were reserving their right to collect interest at the default rate prospectively. Southland subsequently filed for Chapter 11 and, within four months thereafter, confirmed a plan of reorganization which reinstated the credit agreement in full. No bank voted against confirmation of Southland's plan. Prior to confirmation, the banks had filed their proofs of claim. These claims were calculated using the contractual default interest rate, although they did not explicitly provide that they were claiming interest at the default rate. After confirmation, Southland objected to payment of default interest accruing during the bankruptcy based upon, among other things, the reinstatement of the credit agreement under the plan and the equities of the case.

The Fifth Circuit found that reinstatement of the credit agreement under the plan had the effect of treating the banks' claims as if the bankruptcy had not been filed, rather than as if a default had never occurred. As a result, the banks were entitled to interest during the bankruptcy at the default rate. As to the equities of the case, the court first found that an oversecured creditor is presumptively entitled to default rate interest, and it is effectively the debtor's burden to demonstrate that payment at that rate would be inequitable. The Fifth Circuit then approved of the bankruptcy court's decision to award default rate interest, a decision based upon that court's finding that (i) creditor classes other than the banks under the Southland plan would be "unscathed" by payment at the higher rate, and (ii) the banks did not "ambush" Southland with their claims for default rate interest. The Fifth Circuit further noted that the default rate was appropriate because it was only two percent higher than the banks' nondefault rate, and the banks did not delay Southland's plan.

Southland argued that the banks should not receive default rate interest because, prepetition, they had received restructuring fees, and, postpetition, they received adequate protection payments equal to interest on their prepetition claims at the nondefault rate. The court found, however, that receipt of restructuring fees did not deprive the banks of their "bargained-for default interest," especially since the additional interest would not affect postconfirmation distributions to Southland's other creditors. The court also found meritless Southland's argument that the banks' receipt of adequate protection payments at the nondefault rate constituted a waiver by the banks of their right to receive postpetition interest at the default rate.

The Southland decision is an important confirmation of the right of an oversecured lender to receive postpetition interest at the default rate.' The decision does not, however, support payment of the default rate under all circumstances. In particular, the opinion strongly implies that to receive default interest, an oversecured lender will likely have to (i) limit the default rate to only a few percentage points above the nondefault rate,' (ii) be perceived as not delaying or obstructing the bankruptcy process, and (iii) be relatively clear during the case that it is claiming a right to postpetition default interest.' The opinion also confirms the ability of a lender to receive prepetition restructuring fees and adequate protection payments equal to interest at the nondefault rate without risking its ability to receive postpetition interest at the contractual default rate following confirmation of the debtor's plan.

Kord Enters. II v. California Commerce Bank (In re Kord Enters. 11), 139 F.3d 684 (9th Cir. 1998) (Oversecured creditor permitted to recover attorneys fees and expenses related to issues peculiar to bankruptcy law).

The Ninth Circuit recently interpreted 506(b) of the Bankruptcy Code in a manner that allowed an oversecured creditor to recover attorney fees relating to issues peculiar to bankruptcy law when recovery of such fees was generally, but not expressly, provided for in the underlying loan documents. Kord Enters. II v. California Commerce Bank (In re Kord Enters. 11), 139 F.3d 684 (9th Cir. 1998).

The facts in Kord Enters. II are relatively straightforward. California Commercial Bank (the "Bank") and the debtor entered into three separate secured loan agreements. The first two contained fee recovery provisions which, although broad, did not specifically provide for recovery of fees incurred in a bankruptcy proceeding. The third, in contrast, stated that the Bank could recover fees and expenses in a variety of circumstances, including bankruptcy proceedings. The debtor sought to overturn the bankruptcy court's award of fees on two grounds: (i) oversecured creditors are prohibited from recovering fees related to issues that arise only in bankruptcy and (ii) the relevant attorneys' fees provisions in the documents did not adequately provide for the recovery of fees related to bankruptcy law issues.

In addressing the former issue, the court noted that the language of 506(b) provides that a creditor is entitled to attorney fees if "(i) the claim is an allowed secured claim; (ii) the creditor is oversecured; (iii) the fees are reasonable; and (iv) the fees are provided for under the [loan] agreement." In light of this clear statutory mandate, the court rejected the debtor's attempt to read into 506(b) the additional requirement that the fees must be related to nonbankruptcy issues. The court distinguished all but one of cases cited by the debtor on the basis that these cases did not involve 506(b). The only case which was on point was expressly overruled.

After resolving this issue, the court turned its attention to the question of whether the fee recovery provisions in the loan agreements adequately provided for the recovery of fees incurred in a bankruptcy proceeding. The court easily determined that the debtor's position on this issue was "meritless" because the fee recovery provisions were broad and did not prohibit the recovery of fees in bankruptcy proceedings. It is notable that in so doing the court did not interpret the bankruptcy-specific language in the third set of loan documents to imply that recovery of such fees was not contemplated by the two previous agreements.

This decision, which is in accord with the majority of courts that have resolved these issues, is important for two reasons. First, this decision limits language in previous Ninth Circuit decisions that at least one lower court thought compelled the denial of recovery of bankruptcy-related fees. Second, the court read both 506(b) and the relevant fee recovery provisions broadly, ensuring that well-drafted loan documents should enable oversecured lenders to recover all reasonable fees incurred in a bankruptcy proceeding.

Hartford Underwriters Ins. Co. v. Magna Bank, NA. (In re Hen House Interstate, Inc.), 177 F.3d 719 (8th Cir. 1999) (en banc), petition for cert. filed, 68 USLW 3154 (September 3, 1999) (Only a trustee has standing to surcharge a secured party's collateral under 506(c)).

As reported in our 1998 Annual Report, the Eighth Circuit Court of Appeals ruled that a secured creditor who agrees to the preservation of the debtor's business as a going concern subjects its collateral to the reasonable and necessary postbankruptcy costs and expenses of third-party creditors of debtor. Subsequently, the Eighth Circuit granted rehearing en banc, but limited its rehearing to the issue of whether a creditor (as distinguished from a trustee or debtor in possession) has standing to pursue priming claims under 506(c). Upon rehearing, the Eighth Circuit, by a 6-5 vote, vacated the panel decision, holding that only a trustee has standing under 506(c) to surcharge a secured party's collateral. Hartford Underwriters Ins. Co. v. Magna Bank, NA. (In re Hen House Interstate, Inc.), 150 F.3d 868 (8th Cir. 1998) overruled, 177 F.3d 719 (en banc), petition for cert. filed, 68 USLW 3154 (September 3, 1999).

At the panel hearing, Magna Bank had argued, among other things, that Hartford Underwriters lacked standing to surcharge its collateral because the language of 506(c) only permits a trustee to bring such a claim. Although two of the three panel members agreed with Magna Bank's position in the original Eighth Circuit opinion, the panel noted that the Eighth Circuit had previously held that parties other than a trustee can move to surcharge collateral.

United States v. Boatmen's First Nat'l Bank, 5 F.3d 1157 (8th Cir. 1993).1 Because only the entire panel of the Eighth Circuit Court of Appeals sitting en banc could overturn the Boatmen's opinion, the panel was required to find that Hartford Underwriters had standing to surcharge Magna Bank's collateral.

Upon rehearing, the Eighth Circuit Court of Appeals first stated that 506(c) was the only Code provision which conferred standing to surcharge a secured party's collateral. The court then proceeded to examine the language of 506(c), which states that "[t]he trustee may recover from property securing an allowed secured claim the reasonable, necessary costs and expenses of preserving, or disposing of, such property to the extent of any benefit to the holder of such claim." Rejecting both policy arguments and a majority of circuit court decisions (including Boatmen's) to the contrary,' the Eighth Circuit held that the plain language of 506(c) allows only a trustee to surcharge a secured lender's collateral.

Although not addressed by the Eighth Circuit en banc, the portion of the panel decision that sets an extremely low threshold to be met before surcharging a secured parties' collateral' is no longer good law in the Eighth Circuit. This is important because the panel decision could have been read to require a secured lender who is not providing postbankruptcy financing to request immediate liquidation of the debtor lest the secured creditor's claims be effectively subordinated to all administrative expenses incurred during the debtor's bankruptcy proceeding.

In re Dow Corning Corp., 237 B.R. 380 (Bankr. E.D. Mich. 1999) (Solvent debtor must pay interest to unsecured creditors at the federal judgment rate during pendency of its bankruptcy case).

A bankruptcy court has held that creditors holding unsecured claims against a solvent debtor are entitled to interest during the pendency of the bankruptcy case at the federal judgment rate. In re Dow Corning Corp., 237 B.R. 380 (Bankr. E.D. Mich. 1999). In doing so, the court rejected the argument that the interest rate an unsecured creditor must receive is based upon its contract rate or, in the absence of such a rate, the rate state law imputes to a contract lacking a specific interest rate.

The Bankruptcy Code's best interest of the creditors test, codified at 1129(a)(7), requires that a plan of reorganization (i) be accepted by each creditor or

(ii) distribute property valued at or above that which a rejecting creditor would receive in a Chapter 7 liquidation. In a Chapter 7 liquidation, equity holders cannot receive a distribution unless unsecured creditors are paid in full, including "interest at the legal rate from the date of filing." 726(a)(5) (emphasis added).

In Dow Corning all parties agreed that the debtor would be solvent regardless of how the court interpreted the phrase "interest at the legal rate," and under the proposed plan of reorganization the debtor's shareholders retained their equity interests. The debtor argued that the legal rate it was required to pay was the federal judgment rate, while the unsecured creditors asserted that the debtor was required to pay the contract rate or, if no contract rate existed, the otherwise applicable state statutory rate. After an exhaustive review of the previous decisions on point, the court agreed with the debtor, holding that adoption of the federal judgment rate would (i) achieve equality of distribution,

(ii) enhance the ability of a trustee to administer the debtor's estate, (iii) comport with the plain language of the Code, which incorporates the "legal rate" rather than the "legal rates," and (iv) utilize the definition of "legal rate" accepted at the time the Code was enacted.

Although decided at the bankruptcy court level, Dow Corning is important because the previous decisions on this subject have reached inconsistent results and contained cursory, incomplete or clearly flawed analyses. As the first decision to discuss the issue at length and in-depth, Dow Corning could become a leading case in this area. CFA will continue to monitor this case and report the results of any appeals.

Fraudulent transfers - Sections 548 and 546(e) Lowenschuss v. Resorts Int'l, Inc. (In re Resorts Int'l, Inc.), 181 F.3d 505 (3rd Cir. 1999), petition for cert. filed, USLW - (September 28, 1999) (Section 546(e) insulates from avoidance actions payments to shareholders made through financial institutions in LBO transactions).

Section 546(e) of the Code exempts "settlement payment[s] ... made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, or securities clearing agency . . ." from avoidance actions. The Third Circuit has interpreted this section as applicable to payments made through a financial institution in exchange for stock in an LBO transaction. Lowenschuss v. Resorts Int'l, Inc. (In re Resorts Int'l, Inc.), 181 F.3d 505 (3rd Cir. 1999), petition for cert. filed, - USLW - (September 28, 1999).

Less than a year prior to filing for bankruptcy, the debtor in Resorts Int'l was the target of an LBO, pursuant to which shareholders were paid $36 per share. In a fraudulent conveyance action, the debtor sought to recover approximately $1.4 million paid to a shareholder in the LBO (the "LBO Payment"). Rather than focusing on whether the requirements for establishing a fraudulent conveyance were met, the court turned to the 546(e) defense asserted by the shareholder. The first step in doing so was to determine whether the payments in question

were "settlement payments. "I After noting that Congressional intent in exempting "settlement payments" would be advanced by a giving this term an expansive interpretation, the court noted that "[fln the securities industry, a settlement payment is generally the transfer of cash or securities made to complete a securities transaction." Adopting this broad definition, the court concluded that the transfer in question was a "settlement payment." In addition, because the money in question passed through two financial institutions before finally being paid to the shareholder, the court held that the plain language of 546(e) insulated the payments from fraudulent conveyance recovery.

In adopting this approach, the Third Circuit explicitly rejected the holding of Munford v. Valuation Research Corp. (In re Munford), 98 F.3d 604 (11 th Cir. 1996), cert. denied sub nom. DFA Inv. Dimensions Group Inc. v. Munford Inc. (In re Munford), 118 S.Ct. 738 (1998). 11 In Munford, the Eleventh Circuit held that 546(e) did not insulate payments made in an LBO transaction where the financial institution intermediary was a mere conduit that never acquired a beneficial interest in either the funds or the shares being exchanged. The Third Circuit rejected Munford, stating that the language of 546(e) simply does not require the financial institution to acquire a meaningful interest in settlement payment funds. The Third Circuit's approach is consistent with Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser Steel), 952 F.2d 1230 (10th Cir. 1991), cert. denied, 505 U.S. 1213 (1992)."

Offset - Section 553 United States v. Maxwell, 157 F.3d 1099 (7th Cir. 1998) (Federal governmental agency may offset a debt owed to a debtor against a claim asserted by a different governmental agency).

In a case of first impression in the Seventh Circuit, the Court of Appeals has held that separate federal governmental agencies constitute one entity for purposes of set-off under 553 of the Bankruptcy Code. United States v. Maxwell, 157 F.3d 1099 (7th Cir. 1998). This decision allows a governmental agency to offset a debt it owes against a claim asserted by a different governmental agency.

The facts in Maxwell can be summarized as follows: over the course of several years, Pyramid Industries ("Pyramid") borrowed money from the U.S. Small Business Administration (the "SBA") on three separate occasions. During this time, Pyramid also entered into a construction contract with the United States Navy_(the "Navy"). To ensure performance on this contract, Pyramid provided the Navy with both performance and surety bonds. Pyramid filed for bankruptcy, however, and it was subsequently determined that these bonds were "worthless." After the Navy settled with Pyramid, agreeing that it A owed the debtor just over $50,000, the SBA asserted that it, rather than the debtor's estate, was entitled to- these A funds as an offset to its claim. Both the bankruptcy and district courts rejected this argument A and established a per se rule that prohibited the offset of debts owed by and to different federal governmental agencies.

On appeal, the Seventh Circuit first noted that the Code neither expands nor constricts otherwise available common law rights of setoff. In addition, the court found that outside of bankruptcy, the federal government is considered a single entity for setoff purposes. As a result, the Seventh Circuit reversed the lower-court decisions and joined the other circuit courts that have addressed this issue by holding that there is no per se prohibition against interagency setoff. Instead, setoff between governmental agencies should be denied only when specific conduct renders it inequitable. Although the Seventh Circuit did not elaborate upon what conduct might render interagency setoff inequitable, it held that mere negligence in confirming that the bonds posted by Pyramid had value did not, by itself, render setoff inequitable.

As an exception to the rule that similarly situated parties should be treated equally, setoff allows a creditor to benefit at the expense of other creditors. Exercise of this right by governmental agencies greatly expands the likelihood that nongovernmental unsecured creditors will recover less because of the "pervasive nature" of the government.

The new value rule

Bank of America NT&SA v. 203 North LaSalle St. Partnership, 119 S.Ct. 1411 (1999) (Supreme Court curtails "new value" exception).

In a long-awaited decision, the United States Supreme Court has dramatically curtailed the possible use of the so-called "new value" exception to the absolute priority rule in bankruptcy by holding that no new value plan could be confirmed unless the "value" to be paid was determined by a market test, rather than a judicial determination. Bank of America NT&SA v. 203 North LaSalle St. Partnership, 119 S.Ct. 1411 (1999). In so doing, the Court has shifted the leverage between debtors and creditors in a way that will be particularly pronounced in real estate and closely held business bankruptcies (including cases involving insolvent subsidiaries of otherwise healthy companies).

203 North LaSalle involved an office building in Chicago in which the equity owners were permitted to confirm a plan of reorganization -over the objection of the secured lender, by contributing "new value" worth $4.1 million in exchange for their ownership, and giving the lender, on account of its secured claim, a note equal to the judicially-determined value of the property (which assessment was not challenged on appeal). The Seventh Circuit, by a 2-1 decision, held that the plan complied with the new value exception to the absolute priority rule, under which the debtor's old equity holders could retain their interests in the debtor by making a substantial contribution of new value which is necessary for the reorganization, notwithstanding the general principle that, in a nonconsensual plan, parties cannot retain any value under a plan unless all senior classes of claims have been paid in full.

The Supreme Court reversed the Seventh Circuit. The majority ruled that even assuming the Code retains a newvalue exception - an issue it was not deciding - no such "new value" plan would be permissible where the old equity was the only entity which has the ability to propose the new-value plan. Such exclusivity, the Court held, meant that the old equity was in fact obtaining something of value - the sole right to bid - on account of its prepetition interest, in violation of 1129(b)(2)(B)(ii). The Court also expressed a general distaste for judicial valuations where market tests are available, and stated that, absent protection of the market's scrutiny by means of competing bids or even competing plan proposals (the Court reserving whether the former alone was sufficient), no new-value plan could be confirmed. Thus, at a minimum, any new-value plan would require a market test, and the bankruptcy court's determination of value would not suffice.

By limiting the ability of equity holders to cram down new value plans, the decision will affect both pre and postpetition negotiations and resulting reorganization plans. In the typical real estate context, where the new-value plan is motivated by old equity's desire to avoid tax recapture (as it was in 203 North LaSalle), old equity is still likely to pay the highest price in a market test. However, the requirement that others have an opportunity to bid including the secured creditor itself, which is likely to get most if not all of the bid proceeds in real estate cases means that if equity does retain the property, the secured creditor will have obtained some portion of the tax savings. There will be a similar impact in other commercial cases where the threat of a new-value plan has been used to extract concessions from creditors, and where creditors will now have an enhanced ability to wrest control of the bankruptcy process and to emerge with control over the reorganized enterprise.

Executory contracts - Section 365 In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999), cert. dismissed, 67 USLW 3749 (October 12, 1999) (Debtor in possession cannot assume an executory contract without nondebtor's consent where applicable law bars assignment of the contract).

The Ninth Circuit has adopted the "hypothetical test" endorsed by the Third and Eleventh Circuits 12 in applying 365(c) of the Bankruptcy Code, thereby precluding a debtor in possession from assuming an executory contract without the nondebtor's consent where applicable law would prohibit assignment of the contract. In re Catapult Entertainment, Inc., 165 F.3d 747 (9th Cir. 1999), cert. dismissed, 67 USLW 3749 (October 12, 1999). In so holding, the Ninth Circuit reversed the bankruptcy court's application of the "actual test" upheld by the First Circuit and a majority of lower courts, which would prevent the debtor in possession's assumption of an executory contract only in instances where the nondebtor has withheld the requisite consent and the debtor in possession actually intends to assign the contract.

Pursuant to its Chapter 11 reorganization plan, Catapult Entertainment, Inc. (the "Debtor") sought to assume approximately 140 executory contracts and leases as a debtor in possession. These contracts included two nonexclusive patent licenses from Stephen Perlman ("Perlman") to the Debtor for the use of certain patents and patent applications relevant to the Debtor's operation as an online network for video games. Despite Perlman's objections to the Debtor's assumption of the patent licenses, the bankruptcy court adopted the aforementioned "actual test" in applying 365(c). Since the Debtor had no intention of assigning the licenses, the bankruptcy court granted the Debtor's motion to assume the contracts and approved the reorganization plan. The district court affirmed the bankruptcy court's ruling.

Although 365(a) grants a trustee in bankruptcy (or debtor in possession) authority to "assume or reject any executory contract or unexpired lease of the debtor,"

365(c) limits that right. Under 365(c), a trustee or debtor in possession "may not assume or assign any executory contract or unexpired lease of the debtor... if (1)(A) applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor or the debtor in possession... and (B) such party does not consent to such assumption or assignment. . ." Reversing the lower courts, the Ninth Circuit held that a literal reading of 365(c) prohibited the Debtor from assuming the patent licenses since federal patent law renders nonexclusive patent licenses personal and nondelegable, and Perlman, as the applicable nondebtor, had not consented to the Debtor's assumption of the licenses. The court disregarded the Debtor's lack of actual intent to assign the licenses.

Interpreting the statute to prohibit assumption and assignment without the requisite nondebtor consent, rather than assumption or assignment, the Debtor contended that Congress intended to permit debtors in possession to assume their own contracts without nondebtor consent if no future assignments were contemplated, thereby enabling debtors in possession to continue as going concerns. The Ninth Circuit rejected this argument, along with the Debtor's more specific claims that the "hypothetical test" (i) creates internal inconsistencies within 365(c)(1) and between 365(c)(1) and each of 365(f) and 365(c)(2), (ii) affronts applicable legislative history and (iii) violates sound bankruptcy policy. Despite its acknowledgment that sensible bankruptcy policy supports the "actual test," the Ninth Circuit refused to engage in a "judicial rewrite" of the statute.

Although this case focuses primarily upon the relationship between trustees or debtors in possession and third parties, the "hypothetical test" will adversely impact secured parties who lend against collateral significantly affected by executory contracts (including patent licenses) later determined to be nonassumable. For example, if an advance rate against raw materials is established with the belief that the raw materials can be converted into finished goods inventory irrespective of the manufacturer's bankruptcy (provided, of course, the lender advances the cost of completion), and if the conversion process involves a patent or patented process subject to a nonexclusive license in favor of the manufacturer, bankruptcy is likely to impair the completion of the inventory unless the patent licensor can be convinced to permit assumption of the license. This may be very difficult to accomplish postbankruptcy and almost impossible to achieve prebankruptcy. Lenders should be aware of this issue and plan accordingly.

Damages limitations on lease claims - Section 502(b)(6)

Arden v. Motel Partners (In re Arden), 176 F.3d 1226 (9th Cir. 1999) (Section 502(b)(6) cap applies to lease guarantor).

In a matter of first impression in the Ninth Circuit Court of Appeals, the court followed what appears to be a leading trend in holding that the damage cap of 502(b)(6) of the Bankruptcy Code applies not only to lessees, but also to lease guarantors." Arden v. Motel Partners(In re Arden), 176 F.3d 1226 (9th Cir. 1999).

In Arden, Arden unconditionally guaranteed a sublease of property owned by Motel Partners. The sublessee breached the lease and Motel Partners filed suit in state court against the sublessee and Arden as the guarantor. Prior to resolution of the state court case, Arden filed for protection under Chapter 11 of the Bankruptcy Code. Motel Partners filed a proof of claim for the entire amount of the prejudgment attachment. Arden argued, however, that the damage cap contained in 502(b)(6) of the Bankruptcy Code, which limits a lessor's claim for damages resulting from the termination of a long-term lease, was applicable to him as a lease guarantor and therefore, the amount of Motel Partner's allowed claim was substantially less than that asserted in the proof of claim. Motel Partners, on the other hand, argued that the damage cap contained in 502(b)(6) of the Bankruptcy Code applied only to limit a lessor's claims against a lessee, not against another party such as a lease guarantor.

When Arden did not timely file his own plan of reorganization, Motel Partners filed its own plan which proposed a compromise of its lease termination claim substantially higher than the amount to which Motel Partners would be entitled were the damage cap to apply. The bankruptcy court confirmed Motel Partners' plan, holding that the damage cap contained in 502(b)(6) did not apply because (i) Arden was the guarantor of the lease rather than the lessee, and (ii) Arden appeared solvent even if Motel Partners' claims were paid in full. On appeal to the Bankruptcy Appellate Panel for the Ninth Circuit (the "BAP"), the BAP reversed the bankruptcy court's holding, and the Ninth Circuit affirmed.

The Ninth Circuit, applying a plain language interpretation of 502(b)(6), held that the damage cap is applicable to lease guarantors as well as lessees." The court began its analysis by noting that the statute has two predicates for its application: (i) that it is a "claim of a lessor," and (ii) that the claim is for "damages resulting from the termination of a lease of real property." Thus, the court reasoned that it is the claim of the lessor resulting from the termination of a lease of real property, not the status of the lessee or its agent or guarantor, that triggers the application of the damage cap. Accordingly, the court held that because Motel Partners was a lessor and because its claim resulted from the termination of a lease of real property, Motel Partner's claim against Arden was limited by the damage cap of (sections)502(b)(6), regardless of whether Arden was the lessee or merely the lease guarantor.

This case seriously undermines a lessor's ability to recover the full amount of its damages from an insolvent guarantor of a lease as well as from the lessee itself. Thus, lessors should be aware that when a lease is guaranteed by a financially troubled guarantor, any damages for lease termination the lessor attempts to recover from the guarantor may be limited should the guarantor file for bankruptcy protection. Moreover, while a waiver by a lease guarantor of application of the damage cap would likely he enforceable outside bankruptcy, the Arden holding makes it much less likely that it would be enforceable inside a bankruptcy proceeding.

The author gratefully acknowledges the assistance of Ralph Gundrum of Sidley & Austin

in the preparation of this Report. Part JJ of this article will appear in the March/April issue.