Notable Business Bankruptcy Decisions Of 2012

ALLOWANCE/DISALLOWANCE/PRIORITY/DISCHARGE OF CLAIMS

"Key employee" retention plans proposed by bankrupt companies have been subject to rigorous scrutiny since Congress amended the Bankruptcy Code in 2005 to add section 503(c), which makes it much more difficult to implement such programs. Several notable court rulings were handed down in 2012 concerning the propriety under section 503(c) of payments to key employees. Many of these decisions concern the increasing frequency with which chapter 11 debtors have characterized proposed payments to personnel as a key employee incentive program ("KEIP"), which is generally governed by the less stringent requirements of section 503(c)(3), rather than as a key employee retention plan ("KERP"), which is strictly regulated by section 503(c)(1).

During 2012, several courts adopted the "business judgment" standard applied to a proposed nonordinary-course use, sale, or lease of estate property pursuant to section 363(b) of the Bankruptcy Code as a litmus test for payments governed by section 503(c)(3). See, e.g., In re Dewey & LeBoeuf LLP, 2012 WL 3065275 (Bankr. S.D.N.Y. July 30, 2012); In re Global Aviation Holdings Inc., 478 B.R. 142 (Bankr. E.D.N.Y. 2012); In re Velo Holdings Inc., 472 B.R. 201 (Bankr. S.D.N.Y. 2012).

In Velo Holdings, the court concluded that the chapter 11 debtors' proposed KEIP established incentive targets that, although tied to the debtors' compliance with a debtor-in-possession budget, required key employees to "stretch" in order to qualify for plan payments, so as not to constitute a retention plan subject to the restrictions set forth in sections 503(c)(1) and (2). The court ruled that the debtors met their burden of proving that the proposed KEIP was primarily incentive-based as it related to key employees and that implementation of the plan was a valid exercise of sound business judgment under sections 363 and 503(c)(3).

In In re Hawker Beechcraft, Inc., 479 B.R. 308 (Bankr. S.D.N.Y. 2012), the court denied the debtor's motion to implement a KEIP that would have paid bonuses of up to $5.3 million to a "senior leadership team" and concluded that, although the KEIP included elements of incentive compensation, "when viewed as a whole, it set[] the minimum bonus bar too low to qualify as anything other than a retention program for insiders."

In In re Residential Capital, LLC, 478 B.R. 154 (Bankr. S.D.N.Y. 2012), the court denied the debtors' bid to pay more than $7 million in bonuses to 17 top executives and ruled that the plan had been improperly structured to ensure that top management would not leave the company rather than to incentivize them to meet performance goals. "Ultimately, the Debtors have failed to carry their burden," the court wrote, pointing to a provision that 63 percent of the bonus money could be earned simply by the debtors' closing the sales of two loan portfolios that had been substantially negotiated prepetition. However, the court later approved the payments after the debtors made changes to the KEIP designed to make it more incentivizing.

In In re Blitz U.S.A., Inc., 475 B.R. 209 (Bankr. D. Del. 2012), the court concluded that a bonus plan proposed by the debtor was an ordinary-course transaction, and therefore not subject to section 503(c), because the debtor had implemented similar plans for the three years preceding its chapter 11 filing and because other manufacturers had employed similar plans.

In keeping with courts' narrow construction of what constitutes "substantial contribution" in a chapter 11 case within the meaning of section 503(b)(3)(D) of the Bankruptcy Code, the bankruptcy court in In re AmFin Financial Corp., 468 B.R. 827 (Bankr. N.D. Ohio 2012), denied administrative-expense priority to the fees and expenses of senior noteholders, noting, among other things, that "the efforts by the Senior Noteholders to settle their own claims [were] not properly characterized as a substantial contribution to the case."

In Machne Menachem, Inc. v. Spritzer (In re Machne Menachem), 2012 WL 8570 (3d Cir. Jan. 3, 2012), the Third Circuit, addressing the power of a court to recharacterize debt as equity, affirmed a bankruptcy court's ruling that certain advances made by a purported lender to a not-for-profit debtor were not loans. The bankruptcy court had looked to the intent of the parties as it existed at the time of the transaction; analyzed the parties' intent in keeping with the Third Circuit's earlier ruling in Cohen v. K.B. Mezzanine Fund II (In re SubMicron Sys. Corp.), 432 F.3d 448 (3d Cir. 2006); and held that the advances were donations. The Third Circuit ruled that the bankruptcy court's determination was not clearly erroneous because: (i) "there [was] no written instrument for the court to analyze and determine whether the terms suggest[ed] an expectation of repayment," even though some of the checks had "loan" written on them; and (ii) there was "no evidence of intent on behalf of [the debtor] to accept or authorize the purported loans, such as a resolution from the board of directors, or evidence that the board was aware of the loans."

In Wright v. Owens Corning, 679 F.3d 101 (3d Cir. 2012), the Third Circuit held that, although it had previously reversed the rule stated in Avellino & Bienes v. M. Frenville Co. (In re M. Frenville Co.), 744 F.2d 332 (3d Cir. 1984), governing when a "claim" arises for purposes of discharge in bankruptcy, due-process considerations mandated that the claims of certain unknown defective-product claimants not be discharged - thereby resuscitating Frenville's results in certain circumstances and adding another layer of complexity to the analysis of discharged claims.

In In re Heritage Highgate, Inc., 679 F.3d 132 (3d Cir. 2012), the Third Circuit ruled that, in a chapter 11 reorganization, the term "value," as applied to section 506(a), should mean the fair market value of collateral as of plan confirmation. In so ruling, the court of appeals rejected the market-based, or "wait and see," approach recommended by a group of secured creditors, whose subordinated claims would be rendered unsecured unless the court included projected revenues from the debtor's chapter 11 plan in the valuation analysis. Applying the fair-market-value approach to calculate the amount of a creditor's secured claim, the Third Circuit held, does not constitute impermissible lien stripping. In addition, the court adopted a burden-shifting approach to the question of who bears the burden of demonstrating value.

In Statek Corp. v. Dev. Specialists, Inc. (In re Coudert Bros. LLP), 673 F.3d 180 (2d Cir. 2012), the Second Circuit considered as a matter of first impression which choice-of-law rules should apply when a bankruptcy court sitting in one state is resolving a bankruptcy claim arising from a state-law action previously filed in another state. The court ruled that: (i) where a claim is wholly derived from another legal claim pending in a parallel nonbankruptcy proceeding in another state; and (ii) where the pending original claim was filed in a court prebankruptcy, the bankruptcy court must apply the choice-of-law rules of the state where the underlying prepetition claim was filed (in this case, Connecticut).

AVOIDANCE ACTIONS/TRUSTEE'S AVOIDANCE AND STRONG-ARM POWERS

In Senior Transeastern Lenders v. Official Committee of Unsecured Creditors (In re TOUSA, Inc.), 680 F.3d 1298 (11th Cir. 2012), the Eleventh Circuit ruled that the bankruptcy court's findings that subsidiaries of residential construction company TOUSA, Inc., did not receive reasonably equivalent value in exchange for liens they granted to secure financing to fund the parent company's settlement with its joint-venture lenders were not clearly erroneous. Accordingly, the Eleventh Circuit held, those findings supported the bankruptcy court's determination that the transaction was a fraudulent transfer under section 548(a)(1)(B) of the Bankruptcy Code. The TOUSA litigation has been closely followed by the loan market because of the significant implications for both lenders and borrowers when structuring loan transactions with comparable structural features, such as upstream guarantees with standard "savings clauses."

Reconciling discordant orders issued in the same chapter 11 case, a Delaware bankruptcy court ruled in Industrial Enterprises of America v. Burtis (In re Pitt Penn Holding Co., Inc.), 2012 WL 204095 (Bankr. D. Del. Jan. 24, 2012), that the two-year statutory "look-back" period during which a fraudulent transfer may be avoided pursuant to section 548 of the Bankruptcy Code cannot be "equitably tolled."

BANKRUPTCY-COURT POWERS/JURISDICTION

Putting it mildly, the U.S. Supreme Court's 2011 ruling in Stern v. Marshall, 132 S. Ct. 56 (2011), cast a wrench into the day-to-day operation of bankruptcy courts scrambling to deal with a deluge of challenges - strategic or otherwise - to the scope of their "core" authority to issue final orders and judgments on a wide range of disputes. In Stern, the Court ruled that, to the extent that 28 U.S.C. § 157(b)(2)(C) purports to confer authority on a bankruptcy court to finally adjudicate a state-law counterclaim against a creditor that filed a proof of claim, the provision is constitutionally invalid. The mayhem among bankruptcy and appellate courts continued throughout 2012.

In Onkyo Electronics v. Global Technovations Inc. (In re Global Technovations Inc.), 694 F.3d 705 (6th Cir. 2012), the Sixth Circuit became the first court of appeals to consider whether, in the aftermath of Stern, a bankruptcy court has authority to enter a final judgment in an action seeking to avoid a fraudulent transfer. The Sixth Circuit held that the bankruptcy court did have authority to do so because the creditor had filed a proof of claim. According to the court, it was "crystal clear that the bankruptcy court had constitutional jurisdiction under Stern to adjudicate whether the sale [to the debtor of a...