Reviewing Key Bankruptcy Decisions of 2008

This article originally appeared in the New York Law Journal, a sister publication of this newsletter.

During the past year, we have witnessed a steady increase in corporate bankruptcy filings. Alongside the rise in unemployment and the decline in consumer spending, the retail and housing industries have been particularly hard hit.

At least 24 major retailers filed for bankruptcy in 2008, compared with only seven in all of 2007. However, virtually all industries have experienced operational difficulties and, as a result, Chapter 11 bankruptcy filings are up by 43% over 2007 and 78% over 2006.

An unprecedented feature of the latest bankruptcy upsurge is the prevalence of business failure throughout the financial sector, which has been a harbinger of deepening instability across a panoply of businesses.

Given the widespread nature of weakness pervading the U.S. economy, the trend of increased bankruptcy filings is likely to continue into 2009 as the disruptions in the credit markets strike at the core of corporate America.

As we look ahead to the coming year, it is instructive to review the important bankruptcy decisions of 2008. As bankruptcy filings continue to increase, the decisions summarized below may have important ramifications on a variety of issues.

Stamp Tax Exemption

Florida Department of Revenue v. Piccadilly Cafeterias Inc. In June, the U.S. Supreme Court (“Supreme Court”) decided Florida Dept. of Revenue v. Piccadilly Cafeterias Inc. , 128 S.Ct. 2326 (2008), a case interpreting '1146(a) of the Bankruptcy Code. Section 1146(a) provides an exemption from any stamp tax or similar tax to instruments of transfer that are effected “under a plan confirmed under '1129.” 11 U.S.C. '1146(a). This provision in the Bankruptcy Code is meant to provide an incentive for buyers to purchase assets in a bankruptcy sale.

Before Piccadilly, courts were split on whether a sale of the debtor's assets before confirmation of a plan of reorganization could be exempted from certain state stamp taxes if such sale was consummated prior to, but in connection with, a confirmed plan of reorganization. The circuit courts diverged on whether the exemption applied in those cases where the sale occurred before a plan was actually confirmed even though some nexus may have existed between the preconfirmation sale and the confirmed plan. The Supreme Court decided that the language used by Congress in '1146(a) required that a plan must be confirmed for the transfer to qualify for the exemption.

Citing principles of federalism that limit federal encroachment on state taxation, the Supreme Court found that it was up to Congress to clarify '1146(a), and that the statutory text must be interpreted to mean that the tax exemption is only available if the transfer is effected pursuant to or following the confirmation of a plan.

The majority opinion chose to interpret the language narrowly and without considering bankruptcy policy and the purpose of '1146(a). Notably, Justice Stephen Breyer's dissenting opinion is more aligned with the spirit of the Bankruptcy Code and the policy interest of promoting successful reorganizations. Justice Breyer reasoned that the grant of a stamp tax exemption before confirmation is consistent with the purpose of facilitating reorganization and this is a more accurate interpretation of the language.

Because many bankruptcy asset sales occur preconfirmation and usually serve as a method for debtors to obtain the cash needed to reorganize, it is unlikely Congress intended the benefit of a stamp tax exemption only for those sales occurring post-confirmation. Piccadilly portends that many asset sales, which often must occur early in a case to maximize value, may be chilled by the absence of a tax exemption.

Lien-Stripping in Asset Sales

Clear Channel Outdoor Inc. v. Knupfer (In re PW LLC). The U.S. Bankruptcy Appellate Panel for the Ninth Circuit (Ninth Circuit BAP) decided Clear Channel Outdoor Inc. v. Knupfer (In re PW LLC), 391 B.R. 25 (9th Cir. B.A.P. 2008) last May. PW involved an asset sale free and clear of any liens to DB Burbank LLC (“DB”), the senior lienholder which was held to be a good faith purchaser. DB credit bid the full amount of its lien to purchase the property. Clear Channel Outdoor Inc. (“Clear Channel”) held a junior lien on the same property and challenged the sale on the ground that the property could not be sold free and clear of its lien under Bankruptcy Code '363(f). Typically, under '363(m), bankruptcy sales to good faith purchasers cannot be unwound. However, the Ninth Circuit BAP excluded the lien-stripping aspect of a bankruptcy sale from the protection granted under '363(m) of the Bankruptcy Code, kept the bankruptcy sale in place, but reinstated a junior lien on the sold property.

Under '363(f), a debtor may sell its property free and clear of any liens or interests if: 1) applicable nonbankruptcy law would permit such a sale, 2) the lienholder consents, 3) the property is sold for a value greater than all liens on the property, 4) the interest in the property is in bona fide dispute, or 5) the party holding the lien or interest could be compelled to accept a money satisfaction of such interest. 11 U.S.C. '363(f).

The Ninth Circuit BAP found there was no support under '363(f)(3) or (5) to sell the property free of all liens. No ground existed under '363(f)(3) because it allows a sale free and clear of all liens when the purchase price exceeds the value of all liens on the property. As the credit bid was only for the value of the senior lien, this requirement was not met.

The second basis failed as well. Under '363(f)(5), property may be sold free of its liens if the lienholder may be compelled to accept a money satisfaction of his interest. The Ninth Circuit BAP found the cram-down provisions under Bankruptcy Code '1129 did not qualify as a legal or equitable proceeding and, thus, no basis existed to compel Clear Channel to accept a money satisfaction. The ruling in this case portends the introduction of inefficiencies in the bankruptcy sale process as senior creditors have less incentive to participate and may be more inclined to commence state foreclosure proceedings prior to a bankruptcy filing, which in turn may cause debtors to precipitously file for bankruptcy.

Whether other courts follow the Ninth Circuit BAP's reasoning or move away from it will be an important development to watch for in 2009.

Claims Trading

In re Kreisler. The Seventh U.S. Circuit Court of Appeals upheld a debtor's right to buy claims against its own estate in In re Kreisler, No. 06-3881, 2008 WL 4613880 (7th Cir. Oct. 20, 2008), a decision entered last October. Two Chapter 7 debtors, whose cases were being jointly administered, formed a corporation, Garlin Mortgage Corp. (“Garlin”), which then hired Barry Kreisler, one of the debtors, to negotiate the purchase of a secured creditor's claim against the two estates. In return for negotiating the purchase of a $900,000 claim for $16,500, Garlin agreed to pay Kreisler $35,000 when the claim was paid. Upon learning of the transaction, the bankruptcy court equitably subordinated the claim, and the district court affirmed on the ground that a debtor should not be compensated from the estates when there were insufficient funds to pay unsecured creditors.

The Seventh Circuit reversed the decision, finding that the doctrine of equitable subordination was improperly applied to this situation. The debtors were entitled to participate in claim trading, even if the claims were against their own estates, so long as the conduct did not disadvantage other creditors.

Although the transaction at issue may have included some misconduct by the debtors, the Seventh Circuit found no disadvantage to any creditor. The fact that Kreisler stood to gain much of the profit obtained from the transaction through Garlin's payment to him did not disadvantage any creditors. As nothing in the Seventh Circuit's reasoning is intrinsic to a Chapter 7 case, similar reasoning will likely apply in Chapter 11.

Though this decision may seem troubling to potential unsecured creditors, the payment to which a debtor such as Kreisler would be entitled to receive would otherwise go to the original secured creditor, which would leave the unsecured creditors' position unchanged regardless of the recipient of the payment on the secured claim.

Executory Contracts Rejection or Assumption

Giant Eagle Inc. v. Phar-Mor Inc. The Sixth Circuit decided Giant Eagle Inc. v. Phar-Mor Inc. , 528 F.3d 455 (6th Cir. 2008) in May. Pursuant to '365 of the Bankruptcy Code, the debtor, Phar-Mor Inc., rejected an equipment lease it had with Giant Eagle Inc. Giant Eagle then mitigated its damages by re-leasing the equipment to a subsequent lessee. The subsequent lessee later filed for bankruptcy protection and rejected its lease. Giant Eagle then sought claims in Phar-Mor's case for liquidated damages in lieu of prospective monthly lease payments (as permitted under the terms of the lease) less the amount mitigated. The bankruptcy court sustained Phar-Mor's objection to such claim. The Sixth Circuit overturned this ruling, holding that Giant Eagle's claim could be revived after a subsequent lessee rejected a lease during the previous lessee's remaining lease term.

Phar-Mor's argument was that Giant Eagle's execution of a new lease mitigated all future damages claims Giant Eagle may have had against it. However, the Sixth Circuit found that a party may seek damages at the time it asserts its claim in a bankruptcy proceeding, even if such assertion comes after a subsequent lease is executed and then rejected. The Sixth Circuit found that the amounts paid by the subsequent lessee could decrease what Phar-Mor owed, but the execution of the subsequent lease did not extinguish Phar-Mor's obligations.

When, as here, a subsequent lessee rejects a lease prior to the settlement of the lessor's claims against the prior debtor-lessee, a claim may be revived. The Sixth Circuit essentially eliminated any downside risk of mitigating damages. However, this decision does raise additional issues that may need to be resolved in future cases, such as whether the claims against an initial lessee should be adjusted if the lessor succeeds on additional claims against the subsequent lessee.

COR Route 5 Co., LLC v. The Penn Traffic Co. (In re Penn Traffic Co.). In April, the Second Circuit decided In re Penn Traffic Co., 524 F.3d 373 (2d Cir. 2008), which involved a dispute between COR Route 5 Co. LLC (“COR”) and the debtor, The Penn Traffic Co., over an agreement that obligated both parties to make certain transfers of property and money.

At the time of Penn Traffic's bankruptcy filing, major obligations under the COR-Penn Traffic agreement remained unperformed. Several months later, Penn Traffic declined COR's attempt to tender its performance, and then rejected the agreement. COR brought a claim on the ground that the agreement was not executory and thus could not be rejected by Penn Traffic under '365 of the Bankruptcy Code. The bankruptcy court and district court disagreed, and COR appealed the decision to the Second Circuit.

The Second Circuit agreed with the lower courts and affirmed that Penn Traffic could reject the contract because it remained executory. The Second Circuit held that a contract becomes nonexecutory when it expires post-petition or when the debtor takes affirmative action that affects the obligations under the contract. Neither of these situations existed in Penn Traffic. The court reasoned that allowing COR to alter the “executoriness” of a contract by tendering post-petition performance would interfere with the debtor's right under '365 to evaluate its executory contracts and determine which ones should be rejected in order to alleviate the burdens on its estate. Existing Second Circuit precedent makes it clear that a debtor's right to elect which contracts to reject or assume lies only with such debtor, and a nondebtor party cannot interfere with such right.

Penn Traffic reinforces a critical debtor right. If a nondebtor party were given the option to tender performance post-petition and thereby make a previously executory contract nonexecutory, a debtor could become saddled with contracts it might otherwise have rejected. More importantly, such an action could detrimentally interfere with a debtor's ability to reorganize. The Second Circuit appropriately affirmed the lower court's decision to ensure that debtors retain exclusive control over decisions to reject or assume their executory contracts.

Conclusion

Interestingly, the U.S. Supreme Court has not accepted any bankruptcy issues for resolution during the current term. However, in 2009 the bankruptcy bar will be quite immersed in a multitude of major filings, featuring an array of complexity, magnitude, and breadth that may be unmatched by any year in recent history. With this interesting mix of new cases, many issues of significance are bound to arise.

This article originally appeared in the New York Law Journal, a sister publication of this newsletter.