Landlords Are Entitled To Priority Treatment of Lease Payments Which First Come Due During the Gap Period of an Involuntary Bankruptcy

In a case of first impression, Judge Montali had to decide whether a landlord’s claim for payment of rent during the gap period of an involuntary bankruptcy is entitled to priority.

Before delving into the facts of the case, a quick primer is appropriate. The treatment of a commercial landlord’s claims in bankruptcy is too complicated and will be discussed in more depth in a future article so this “quick primer” is very limited.

When a company files for bankruptcy, the landlord in a nonresidential context is usually the most powerful player in the scene. The landlord is entitled to be paid contract rate lease payments until the Debtor decides to either reject or assume the lease. This is provided for under § 365(d)(3) which states that “The trustee shall timely perform all the obligations of the debtor … arising from and after the order for relief under any unexpired lease of nonresidential real property … until such lease is assumed or rejected, notwithstanding section 503 (b)(1) of this title….”

That last bit, the “notwithstanding section 503 (b)(1)” portion means that the landlord is entitled to payment until the lease is rejected; even if it is not an actual, necessary cost or expenses of preserving the estate. Not only is the landlord entitled to an administrative claim, but the payments must commence immediately (for the most part).

Howrey LLP was a global law firm that practiced antitrust, global litigation and intellectual property law. At its peak Howrey had more than 700 attorneys in 17 locations worldwide. In early 2011, Howrey began to wind down its business and was hit with a petition for an involuntary Chapter 7 petition. For simplicity, we are going to assume the case was never a Chapter 7 case; meaning it went from an involuntary Chapter 7 to a voluntary Chapter 11.

 

Section 502(f) states that “In an involuntary case, a claim arising in the ordinary course of the debtor’s business or financial affairs after the commencement of the case but before the earlier of the appointment of a trustee and the order for relief shall be determined as of the date such claim arises, and shall be allowed … the same as if such claim had arisen before the date of the filing of the petition.”

Furthermore, even though the claim is an unsecured prepetition claim, it is entitled to priority under § 507(a)(3): “(3) Third, unsecured claims allowed under section 502 (f) of this title.”

The creditors’ committee and Chapter 11 Trustee argued that the landlord’s claims did not fall under § 502(f) because § 502(f) “only applies to claims arising in the ordinary course of a debtor’s business or financial affairs after the commencement of the case.” The court rejected this argument for several reasons including that the code was designed to protect landlords and that the landlord’s claim arose during the gap period and not when the lease was signed.

The creditors’ committee also argued that § 502(g)(1) applied to this situation. That argument was summarily dismissed because § 502(g)(1) applies to rejected leases; the leases were not rejected during the gap period.

Most surprising was the Court’s relatively short discussion on whether the landlord’s claims were incurred during the ordinary course of Debtor’s business.  The creditors’ committee argued that since the Debtor was winding down its business, the rents were no longer in the ordinary course of the Debtor’s business. In rejecting that argument, the Court took the position that “the focus is on the circumstances under which the right to payment of current rent “arises”, which is when the occupancy continues, when the status quo vis-a-vis the Landlords continues.”

The result is fair but I am not sure whether it is technically correct. I would have expected a more detailed vertical and horizontal dimension analysis. Assuming no bankruptcy, would creditors or even the landlord expect the Debtor to stay current on rent? If not, why is this payment ordinary course?

You can find the case here.

Is It Community Property Or Separate Property?

The 9th Circuit really confused a lot of people in 2003 when it incorrectly interpreted California community property laws. The confusion spread to California courts of appeal until finally corrected by the California Supreme Court in 2014!

In Hanf v. Summers (In re Summers), 332 F.3d 1240 (9th Cir.2003), the pertinent facts are as follows: Husband, Wife and Daughter bought real property and titled it as joint tenants. The bankruptcy court held that the property was held in a joint tenancy! The BAP affirmed, and the 9th Circuit affirmed the BAP.

The basic idea was since the property was titled as joint tenants, the property was owned as a joint tenancy. The problem with this is that Cal. Fam.Code § 852(a) provides that “[a] transmutation of real or personal property is not valid unless made in writing by an express declaration that is made, joined in, consented to, or accepted by the spouse whose interest in the property is adversely affected.”

So there you have it, the property is community property because the parties did not have an express declaration otherwise. But that is not how the Circuit Court decided this case. It held that § 852 has historically only been applied to inter-spousal transactions and so it did not apply to the facts of this case due to the parties having bought the property from a third party.

Since most spouses purchase their first home after marriage, this holding had the practical effect of making virtually all post-marriage purchases of real property a joint tenancy instead of community property. It is difficult to understand why the Circuit court would believe this was something the legislature would have intended particularly when the 1984 amendments were made to prevent exactly that!

Now the law as it stands today, according to In re Marriage of Valli (2014) 58 Cal.4th 1396, 1400:

Property that a spouse acquired before the marriage is that spouse’s separate property.

Property that a spouse acquired during the marriage is community property unless it is:

traceable to a separate property source;
acquired by gift or bequest; or
earned or accumulated while the spouses are living separate and apart.
Finally, spouses may change the character of property during the marriage by what is called a “transmutation.” To do so, they need to comply with § 852 even if the property is purchased from a third party.

The Valli Court was critical of the 9th Circuits holding, stating that “There, the federal appellate court was attempting to construe and apply California law ‘to determine whether the requirements of California’s transmutation statute . . . must be met when realty is transferred from a third party to spouses as joint tenants.’”

It further criticized the Court’s holding as “not persuasive insofar as [it] purport[s] to exempt from the transmutation requirements purchases made by one or both spouses from a third party during the marriage.” The California Supreme Court did not think the 9th Circuit’s rationale reconciled the exemption with the state legislatures purpose in enacting § 852.

The court went one step further and said that in so far as Evidence Code section 662, which states that “[t]he owner of the legal title to property is presumed to be the owner of the full beneficial title,” applies to a situation, it does not apply when it conflicts with transmutation statutes.

The Court left open whether § 662 can ever apply to marital dissolution proceedings.

The concurring opinion is a work of art but too long for me to go over. I highly recommend it to anyone who would like a deeper understanding of the subject matter. You can find it here.

Note: This is important, not only in bankruptcy proceedings and marital dissolution proceedings but also for tax purposes. If the tenancy is a joint tenancy, then upon death, only the deceased spouses “share” of the property will have a step up in basis. If held as community property, then the whole property receives the benefit of a step up in basis.

Bankruptcy Judges Might Not Be Able to Remand Removed Cases!

This is a dangerous article to write but I am hoping the comments will be worth it.

So the Wellness case came out and the Supreme Court seems to have taken a pragmatic view by allowing parties to consent (implied or explicit) to the jurisdiction of bankruptcy courts. Fine. But is there more to this story?

The Court believed the central question that must be answered was “whether allowing bankruptcy courts to decide Stern claims by consent would ‘impermissibly threate[n] the institutional integrity of the Judicial Branch.’ Schor, 478 U. S., at 851.”

The court then concluded that allowing parties to consent to adjudication of Stern claims does not usurp the constitutional prerogatives of Article III courts for several reasons:

  1. Bankruptcy judges, like magistrate judges, “are appointed and subject to removal by Article III judges;”
  2. They “serve as judicial officers of the United States district court;” and
  3. collectively “constitute a unit of the district court” for that district.

But I wanted to quote this language in particular:

“Furthermore, like the CFTC in Schor, bankruptcy courts possess no free-floating authority to decide claims traditionally heard by Article III courts. Their ability to resolve such matters is limited to “a narrow class of common law claims as an incident to the [bankruptcy courts’] primary, and unchallenged, adjudicative function.” Id., at 854. “In such circumstances, the magnitude of any intrusion on the Judicial Branch can only be termed de minimis.” Id., at 856.”

It seems to indicate that since the magnitude of the intrusion is de minimis, waiver is okay.

But what if the Bankruptcy Court enters an order divesting the District Court of jurisdiction? Can it do that?

On June 8, 2015, in Flam v. Flam, the US Court of Appeals for the Ninth Circuit joined other sister circuits in holding that a motion to remand is a dispositive motion and that it is beyond the scope of a magistrate judge’s authority to issue a remand order under 28 U.S.C. § 1447(c) . You can find the case here.

In Flam, the Court focused on the fact that an order granting remand is final and not subject to review by the District Court. 28 U.S.C. § 1447(d). It conclusively takes away the litigant’s right to federal courts, as was previously held, the effect of a remand order is to end all federal proceedings.

A Bankruptcy Court’s order granting remand is also final and not subject to review by the District Court. 28 U.S.C. § 1334(d). It conclusively takes away the litigant’s right to federal courts. In effect, a Bankruptcy Court’s order has the effect of ending all federal proceedings. This is certainly not de minimis.

So why can a bankruptcy judge do it when a magistrate can’t?

Not All Expenses Of A Professional May Be Compensable By The Estate, Even In The Face Of A Clear Retainer Agreement And An Approved Employment Application!

The facts of the situation are not in dispute. The Debtor in a Chapter 11 case needed to hire a forensic accountant. The Debtor applied for permission to hire the accountant under § 327(a) of the Bankruptcy Code. The employment application did not contain any special provisions but the engagement letter contained the following clause:

In the event we are requested or authorized by Debtor or are required by government regulation, subpoena, court order, or other legal process to produce our documents or our personnel as witnesses with respect to our engagements for Debtor, Debtor will, so long as we are not a party to the proceeding in which the information is sought, reimburse us for our professional time and expenses, as well as the fees and expenses of our counsel, incurred in responding to such requests.

No objection to employment was filed and the Court entered an order approving the application.

Flash forward and after the forensic accountant had finished preparing its report, the Bank decided to subpoena and depose the accountant.  Debtor’s counsel refused to defend the accountant so the accountant was forced to hire an attorney for the deposition. The attorney cost the accountant about $8,000.

The Court did not allow the expense. It reasoned that under § 330(a)(1)(B) only reimbursement of actual, necessary expenses would be allowed. Under the standard articulated by the court, only those expenses necessary to accomplish the task the professional is hired to accomplish are compensable. The Court’s reason was that Without such a limitation, potentially, whenever a bankruptcy court-approved professional deems it necessary to employ another professional to protect its interests in the bankruptcy case, that cost would be taxed to the bankruptcy estate, effectively negating the Code’s regimen requiring prior notice to other interested parties, and the necessary scrutiny by the court, before committing the limited resources of the bankruptcy estate to the payment of professional compensation.

Author’s comments: The case noted a split of authority in the Southern District of New York and no binding law in the 9th Circuit which necessarily means there is a lot more room to litigate this matter.

The Court focused on the fact that the retainer agreement contained a clause which would allow the accountant to be paid by the debtor but focused on the fact that the employment application itself did not contain the language or allude to it. One workaround for this rule may be to clearly articulate any special clauses for attorney fees inside the application to employ the professional.

In my experience as debtor’s counsel, most professionals rely on me to obtain court approval of their employment. At the same time, my duty is to the Estate. So what am I supposed to do?

You can find the full case here.

Judge Bauer Reversed, Trustee Clawback Power Strengthened

In this case, the sole shareholder, director and president of a company (all the same Individual) transferred about $8,000,000 into a secret bank account which he then used to pay personal debts. The question before the Court was whether the transfers to the bank account made the Individual, in his personal capacity, an initial transferee within the meaning of § 550.

The surprising answer (although not stated in this way) is that it depends on whether the secret bank account was opened in the name of the company or individual. In this case, the secret account was completely under the dominion and control of the Individual; the Individual’s wife was a signatory on the account and the only purpose it served was to pay personal expenses. None of that mattered. The account was opened under the company’s name. The District Court held that the Individual was not an initial transferee since the account was a company account.

This is a big deal because it meant that 3rd parties who were paid from that account could not raise certain defenses, discussed below.

Under § 550(a) of the Bankruptcy Code, a trustee of the debtor may recover a fraudulent transfer of estate property from either “(1) the initial transferee of such transfer or the entity for whose benefit such transfer was made; or (2) any immediate or mediate transferee of such initial transferee.”

The distinction between an “initial transferee” and a subsequent transferee is critical because the trustee’s right to recover from an initial transferee is absolute. A subsequent transferee, on the other hand, has a defense. A trustee may not recover from a subsequent transferee if “the subsequent transferee accepted the transfer for value, in good faith, and without knowledge of the transfer’s voidability.” 11 U.S.C. § 550(b)(1).

Since initial transferee is not defined by the code, Courts have created their own definitions. The major tests are the “dominion” test and the “control test.” According to the district court, the 9th Circuit has explicitly adopted the dominion test to the exclusion of the control test.

Under the dominion test, a transferee is one who has dominion over the money or other asset, i.e. the right to put the money to one’s own purposes. The test focuses on whether someone had legal authority over the money and the right to use the money however desired. The control test, on the other hand, takes a more gestalt view of the entire transaction to determine who, in reality, controlled the funds in question.

According to the district court, the control test shifts the risk too far towards creditors of the debtor because an unscrupulous insider could make an “initial transfer” to himself insolating any subsequent transfers. After analysis of 9th Circuit law, the court concluded: “As these cases demonstrate, a corporation’s principal who effects a transfer from the corporation in his representative capacity does not have dominion over those funds in his personal capacity, and therefore does not constitute an initial transferee of those funds under the Bankruptcy Code.”

Author’s comments: The analysis should turn on whether the transfer is to an intermediary/conduit to facilitate the transfer. Conduit / intermediary transfers should not be designated as “initial transferees” thereby shielding a subsequent transfer to the actual “initial transferee.” That is a fair reading of the code.

I do not think the analysis should be limited to either the “dominion” test, the “control test” or as some courts have applied it, the “dominion and control” test because if we assume clawback actions are fair, then why hinge the entire analysis on how title to the bank account was held? If the president of the company had transferred the funds from the initial, secret, company account to his own personal account and paid the defendant from that personal account, then the defendant here would have been shielded. That is too trivial of a distinction for me to be happy with.

Query: Should you advise your client, who is about to sell something to a wholly owned company, to have the company first transfer its funds into the company’s owner’s account before paying your client? The committee notes seem to indicate that this type of “washing” is not prohibited by the good faith requirement.

You can find the district court opinion here.

9th Circuit BAP Opinion Allows For Stripping Wholly Unsecured Junior Liens in a Chapter 20

On June 9, 2015, the 9th Circuit Bankruptcy Appellate Panel held that a Debtor not eligible for a Chapter 13 discharge may strip off a wholly unsecured lien through a Chapter 13 Plan. You can find the case here.

This is common practice in the Central District and I am happy the BAP went the right way. I was a little worried after reading their Wages where the Court held that the anti-modification provision under §1123(b)(5) applies to any loan secured only by real property that the debtor uses as a principal residence. When the law is ambiguous, why rule in favor of the bank! You can find that case here.

Questions the author has yet to consider:

So what happens in a Chapter 11? 1111(b)(1) says nonrecourse debts become recourse debts but it starts out with “A claim secured by a lien on property of the estate…”

Postconfirmation Subject Matter Jurisdiction of Bankruptcy Courts

A trend among Chapter 11 practitioners over the last ten years has been to use general provisions in the Plans of Reorganization they draft. They copy and paste these provisions in all their Plans, close their eyes and hope for the best.

One of those clauses is this “retention of jurisdiction” clause. Some practitioners have a bland one, “The Court shall retain jurisdiction to the maximum extent possible under the law.” To me, that means nothing. The problem is this clause is not helpful. It doesn’t tell the court specifically what it’s allowed to do and not allowed to do, inviting litigation over this issue before the merits are even considered!

So other practitioners responded to this problem by listing a litany of situations where they would like the court to retain jurisdiction, for example:

After confirmation of the Plan and occurrence of the Effective Date, in addition to jurisdiction which exists in any other court, the Bankruptcy Court will retain such jurisdiction as is legally permissible including for the following purposes:

  • To resolve any and all disputes regarding the operation and interpretation of the Plan and the Confirmation Order;
  • To determine the allowability, classification, or priority of claims and interests upon objection by the Debtor, the Reorganized Debtor, or by other parties in interest with standing to bring such objection or proceeding;
  • To determine the extent, validity and priority of any lien asserted against property of the Debtor or property of the Debtor’s estate.
  • To construe and take any action to enforce the Plan, the Confirmation Order, and any other order of the Court, issue such orders as may be necessary for the implementation, execution, performance, and consummation of the Plan, the Confirmation Order, and all matters referred to in the Plan, the Confirmation Order, and to determine all matters that may be pending before the Court in this case on or before the Effective Date with respect to any person or entity related thereto;

… this thing goes on for pages and pages. While slightly helpful, some judges won’t allow these clauses into the Plan, but for those that do, case law has demonstrated they are also not very good.

The main situation where the problems arise is in situations where the Debtor is trying to preserve litigation rights. The Plan wiped away the rights of others to sue the Debtor but retained Debtor’s right to sue and do so in Federal Bankruptcy Court!

A few months ago, the District Court for the Eastern District of North Carolina joined the 3rd Circuit, 4th Circuit, and 9th Circuits in invalidating these clauses in so far as they purport to retain jurisdiction for the bankruptcy courts to decide these cases.

Practitioners need to tailor the retention of jurisdiction clause to fit the needs of each client on an individual basis. The first start is to explicitly list the potential litigation matter and the second step is to tie recovery of that litigation to payments due under the Plan. This is not only easy to do but a must for those of us who wish to save our clients the further headache of litigating jurisdiction!

For further reading, the seminal 9th Circuit case on this topic is: In re Pegasus Gold Corp., 394 F. 3d 1189 – Court of Appeals, 9th Circuit 2005

Basic Introduction to Unsecured Creditors’ Committee

This article is a quick introduction to unsecured creditors’ committees.

When an individual or company files bankruptcy, there are generally two routes it can take (for the purpose of this discussion, Chapter 13, a limited form of reorganization for individuals, is omitted.)

The first route is Chapter 7 liquidation where assets are liquidated for payment to creditors.

A Chapter 7 bankruptcy is structured as follows: a Chapter 7 Trustee is appointed; the trustee is a professional whose job is to maximize the value of the assets (referred to as the Estate) and to pay creditors as much as possible. The Department of Justice oversees the Chapter 7 Trustee. Creditors may participate in this process but since the Chapter 7 Trustee is a professional, experienced and neutral, the role of creditors is limited. They may seek to protect themselves but generally stay out of the Chapter 7 Trustee’s business.

The second route is Chapter 11 reorganization where assets are either liquidated to pay creditors or the company/individual’s debt is restructured and a payment plan is formulated where creditors are repaid some portion of their claims.

The major difference is that upon commencement of a Chapter 11 bankruptcy, a professional trustee is not appointed to the case. The company’s management remains in control as “debtor-in-possession” (called a DIP) with virtually all the powers and responsibilities as a professional trustee. The Department of Justice continues to oversee the DIP but creditors are allowed to, and should monitor the case more closely since the individuals responsible for the company’s financial situation continue to operate it.

Congress realized that if individual creditors each have to monitor the Chapter 11 case, the cost to each creditor will be burdensome. Furthermore, having 150+ creditors’ attorneys in a single hearing would be impractical.

To solve this problem, the Unsecured Creditors’ Committee was invented. The Committee is supposed to represent a cross section of unsecured creditors. However, most of the time, it is comprised of the three to seven creditors who hold the largest claims. The idea is for the Committee to be the voice of all unsecured creditors so smaller creditors are allowed to be committee members if the Department of Justice believes it is proper. Since a committee provides significant judicial economy and operates as an additional watchdog over the Debtor, Congress decided that the Debtor should pay for the Committee’s attorneys, accountants and other professionals.

Tactical Use of Bankruptcy when a Lis Pendens is Recorded

On June 2, 2015, the California Court of Appeals issued a decision where it reversed the Superior Court’s decision to grant priority to a judgment lien recorded by a party after a lis pendens was recorded by a different party. While some nuances about the interaction of fraudulent transfer judgments and lis pendens were discussed, the result appears to be correct and is certainly fair.

Delving into the facts, it appears the following scheme was stopped:

Husband defrauded “ex-wife” by hiding assets in a company called BTM. BTM transferred this property to third parties without the knowledge of ex-wife or creditors. Creditors later recorded a lis pendens and proceeded to trial. Meanwhile ex-wife proceeded to trial for essentially the same thing.

While Husband stalled creditors, he stipulated to judgment with ex-wife. AHA! Ex-wife recorded her abstract of judgment which became a second priority lien against the property. At the time of the appeal, Husband and ex-wife had rekindled their love and were married! This is a brilliant strategy for husband. He obtained the benefit of the loans made by creditors but the creditors now stood to receive nothing as the wife’s lien left them wholly unsecured.

Since the Court of Appeals reversed, the priority of the second judgment related back to the date the lis pendens was recorded thereby moving the creditors’ secured status up a notch resulting in the creditors being in second position and the ex-wife being in third position.

This scenario got me thinking. What would have happened if after ex-wife recorded her abstract of judgment, husband filed for bankruptcy? (Assuming no preference problems.)

On the petition date, the bank would have a secured first priority lien, the ex-wife a secured second priority lien and the creditors would have an unliquidated, disputed potential judgment for $21,000,000.

One course of action would be for the property to be sold, the lienholders to be paid and for any remaining proceeds to be paid to the creditors. This result would be contrary to what happened in state court. This is what the schemer’s apparently wanted to happen.

The other course of action would be to allow the creditors to proceed to judgment, then allow them to record an abstract of judgment thereby making them secured.

But what happened to fixing the rights of creditors as of the petition date? You can find a copy of the state court case here.

Does an annuity inherited by a spouse constitute “retirement funds” within the meaning of § 522(b)(3)(C)?

For the purpose of this blog, I am going to assume that the annuity in question would be exempt had the decedent been alive.

At first, I thought the answer was simple:

Assuming the annuity was a retirement fund to begin with, the answer is yes, it continues to be a retirement fund because under the IRC, an inherited retirement fund is NOT treated as “inherited” if the spouse is the person who inherited it. That is in 28 U.S.C. 408(d)(3)(C)(ii)(II), quoted for convenience:

(ii)Inherited individual retirement account or annuity An individual retirement account or individual retirement annuity shall be treated as inherited if—

(I)the individual for whose benefit the account or annuity is maintained acquired such account by reason of the death of another individual, and
(II)such individual was not the surviving spouse of such other individual.
Looking at Clark v. Rameker, the Court says, “If the heir is the owner’s spouse, as is often the case, the spouse has a choice: He or she may [1] “roll over” the IRA funds into his or her own IRA, or he or she may [2] keep the IRA as an inherited IRA (subject to the rules discussed below).” The parenthetical suggests that either one of two things must happen: the Debtor has gone with route [1] and the annuity is exempt or has gone with route [2] and it is not exempt.

Debtor may also have an argument that the annuity is community property to the extent the res in the annuity was funded by community funds and is therefore, at least half his even if title is completely in the wife’s name. I am not sure if this argument is persuasive.

To top it off, not all annuities are exempt! So the inquiry should start there.