Dealing with Companies in Financial Distress, Texas Lawyer’s Bankruptcy Law e-Newsletter

62 Minute Read

February 2011

Publication

Robin Russell

Risk is inherent in business and that risk is heightened when you are dealing with a company in financial distress. Financial distress often leads to bankruptcy where a whole new set of rules come into play. Understanding the weapons that will be available to a debtor if it files bankruptcy can often assist you in managing and minimizing those risks. The top ten risks you face in dealing with a company in financial distress and the steps you can take to minimize those risks are discussed below.

Risk #1 - The Automatic Stay or Prohibition on “Ipso Facto” Clauses Preventing You From Taking Action Against The Debtor or Drawing on a Letter of Credit
Risk #2 - The Debtor Rejecting Your Contract or Lease
Risk #3 - Not Understanding and Not Taking Steps to Minimize Your Exposure
Risk #4 - Losing Your Rights of Set-Off
Risk #5 - Losing an Option to Purchase
Risk #6 - Losing a Right of First Refusal
Risk #7 - Having a Prebankruptcy Transaction With the Debtor Attacked as a Fraudulent Transfer
Risk #8 - Having a Prebankruptcy Payment from the Debtor Attacked as a Preferential Transfer
Risk #9 - Other Creditors Seeking to Have Your Claim Against a Debtor Equitably Subordinated
Risk #10 - Other Creditors Seeking to Have Debt Owed to You By the Debtor Recharacterized as Equity

* * *

RISK #1: THE AUTOMATIC STAY AND PROHIBITION ON “IPSO FACTO” CLAUSES

The most frustrating aspect of dealing with a debtor in bankruptcy is the inability to take action due to the automatic stay and the courts’ unwillingness to enforce “ipso facto” clauses.

The Automatic Stay

Section 362 of the Code provides for a statutory injunction in favor of a debtor and its assets upon the commencement of a bankruptcy case that protects the debtor from actions of creditors seeking to recover on their pre-petition claims. This statutory injunction is referred to as the “automatic stay.” The statute lists several actions specifically prohibited, including “any act to collect, assess, or recover a claim against the debtor that arose before the commencement of the [bankruptcy] case.” A bankruptcy court may provide a creditor relief from the automatic stay “for cause.” This is a very broad standard and the court has a great deal of discretion in determining whether and to what extent to grant relief from the automatic stay. 11 U.S.C. § 362.

The “Ipso Facto” Clause

Section 365(e)(1) of the Code provides that clauses which provide for the termination of an executory contract of the debtor as a result of the “commencement of a case under this title” are of no effect. 11 U.S.C. § 365(e)(1)(B). In general, termination clauses in a contract triggered by the debtor’s bankruptcy or insolvency. are invalid. 11 U.S.C. § 365(e)(1). (i.e. once a debtor has filed for bankruptcy, the contract counterparty can no longer terminate or modify the contract based on the debtor’s bankruptcy or insolvency.) Such clauses are commonly referred to as “ipso facto” clauses. Courts have held that bankruptcy default provisions are per se invalid, as violative of the spirit and purpose of the Code. “No default may occur pursuant to an ipso facto clause and no reliance may be placed upon an alleged default where the only cause for default is the debtor’s commencement of a bankruptcy case.” Reloeb Co. v. LTV Corp. (In re Chateaugay Corp., WL 159969 (S.D.N.Y. 1993)

Letters of Credit

Securing the debtor’s obligations with a letter of credit is the best way to minimize risk. Drawing on a letter of credit is not subject to the automatic stay that is imposed in bankruptcy because the letter of credit is not “property of the bankruptcy estate” under Section 541(a)(1). Matter of Compton Corp., 831 F.2d 586, 589 (5th Cir. 1987). Proceeds distributed pursuant to the letter of credit are also not property of the bankruptcy estate. In re San Jacinto Glass Industries, Inc., 93 B.R. 934, 937 (Bankr. S.D. Tex. 1988). Thus, an issuer does not violate the automatic stay provision by a payment to a beneficiary under a letter of credit and the claim covered by the letter of credit is not limited as it might otherwise be under the Code. In re Stonebridge Technologies, Inc., 430 F.3d 260 (5th Cir. 2005). However, if a condition precedent to drawing on the letter of credit is presentment of an invoice or demand to the debtor and such notice has not been given prior to bankruptcy a problem may exist. Care must be taken to avoid requirements that a collection-type notice be sent to the debtor prior to the draw. Drawing on a letter of credit does not violate the automatic stay but a condition precedent to draw such as demand on the debtor may.

Waiver of Consequential Damages

Finally, consideration should be given when drafting a contract to a provision waiving consequential damages so that if the debtor later claims a letter of credit was wrongfully drawn on or a contract wrongfully terminated the counter parties damages will be limited.

RISK #2: CONTRACT AND LEASE REJECTION

Section 365 of the Bankruptcy Code permits a debtor to either assume or reject executory contracts and unexpired leases. 11 U.S.C. § 365. Although the definition of an executory contract is not widely agreed on, many point to the legislative history to section 365 of the Bankruptcy Code as offering guidance as to the definition of an executory contract. This legislative history states that “executory contracts generally include contracts on which performance remains due to some extent on both sides.” It goes on to say that “a note is not usually an executory contract if the only performance that remains is payment. Performance on one side of the contract would have been completed and the contract is no longer necessary.” H.R. Rep. No. 95-595, 95th Cong., 1st Sess. 347, reprinted in 1978 U.S. CODE CONG. & ADMIN. NEWS 5787, 6303; S.Rep. No. 95-989, 95th Cong., 2d Sess. 58, reprinted in 1978 U.S. CODE CONG. & ADMIN. NEWS 5844. Section 365 of the Bankruptcy Code gives the debtor special rights with respect to executory contracts although these rights are not unlimited.

Rights of Debtor

During the bankruptcy proceeding, the non-debtor party must continue to perform while the debtor decides whether to assume or reject the contract. If the debtor chooses to reject the contract, the rejection is treated as a breach of the agreement immediately prior to the bankruptcy filing – giving rise to a claim for rejection damages as of that time. 11 U.S.C. § 365(g). The rejection claim is, in most instances, an unsecured claim – although the counterparty will usually have an administrative priority claim for goods or services provided post-petition. The debtor may generally assume and assign the contract to a third party, not withstanding a clause in the contract prohibiting or restricting assignment. 11 U.S.C. § 365(f). With respect to timing, the debtor has no hard deadline for assuming or rejecting a contract (other than prior to confirmation of a plan which can take several years). The Non-Debtor counterparties could file a motion requesting that the bankruptcy court set a deadline for assumption or rejection.

Certain limits do apply. If there has been a default under the contract, to assume the contract the debtor or trustee must (i) cure existing defaults, (ii) compensate the other party for any actual pecuniary loss resulting from the default, and (iii) provide adequate assurance of future performance. 11 U.S.C. § 365(b) (emphasis added). A debtor must assume or a reject an executory contract in its entirety. (see discussion below under Integration). The debtor may not assign a contract if applicable law excuses the non-debtor from accepting performance from, or rendering performance to, a party other than the debtor (e.g. certain contracts for personal services). 11 U.S.C. § 365(c). In certain jurisdictions, the debtor may not even assume the contract in such circumstances.

Cherry Picking Favorable Contracts

The ability of a debtor to assume favorable contracts while rejecting unfavorable ones is the central purpose of Section 365 of the Bankruptcy Code. Nevertheless, in certain instances a debtor’s ability to “cherry pick” contracts to assume with a given counterparty is limited.

Integration. One method of preventing a debtor from assuming a favorable contract while rejecting an unfavorable one is to argue that the two contracts are part of one unified agreement. As mentioned above, a fundamental requirement of the Bankruptcy Code is that an executory contract must be assumed or rejected as a whole. See, e.g., Pacific Express, Inc. v. Teknekron Infoswitch Corp. (In re Pacific Express, Inc.), 780 F.2d 1482, 1488 (9th Cir. 1986). A debtor cannot “cherry pick” portions of a contract to assume and reject unfavorable portions. Thus, if two contracts form in reality one indivisible agreement, the debtor will have to either assume both or reject both.
In applying this rule, bankruptcy courts recognize state law principles that related individual contracts may in some cases be viewed as creating one unified agreement. See Byrd v. Gardinier, Inc. (In re Gardinier, Inc.), 831 F.2d 974, 975-76 (11th Cir. 1987); In re Integrated Health Services, Inc., No. 00-389, 2000 WL 33712484, at * 3 (Bankr. D. Del. July 7, 2000); but see In re Plitt Amusement Co. of Washington, Inc., 233 B.R. at 846 & n. 10 (claiming that although state law is a guide, courts must also look to federal bankruptcy law).

Under Texas law, a contract is indivisible when by its terms, nature, and purpose it contemplates and intends that each and all parts and the consideration shall be common to each other and interdependent. whether Summers v. WellTech, Inc., 935 S.W.2d 228, 232 (Tex.App.-Houston [1 Dist.],1996). Factors courts consider include whether the agreements were supported by independent consideration and whether they were executed with distinct and identifiable purposes independent of each other. Id.
Cross-Default Provisions. Likewise, cross-default provisions throughout various agreements do not make them “integrated.” Because cross-default provisions restrict a debtor’s right to assume favorable contracts while rejecting unfavorable ones, they are not generally enforced in bankruptcy. See Lifemark Hospitals, Inc. v. Liljeberg Enterprises, Inc. (In re Liljeberg Enterprises, Inc.), 304 F.3d 410, 445 (5th Cir. 2002) (holding that cross-default provisions, while not per se unenforceable, are inherently suspect and only enforceable under certain limited conditions); The Shaw Group, Inc. v. Bechtel Jacobs Co., LLC (In re IT Group, Inc.), 350 B.R. 166, 177 (Bankr. D. Del. 2006) (“[A]ssumption under § 365 is subject to a ‘well-established’ cross-default rule: ‘[C]ross-default provisions do not integrate executory contracts or unexpired leases that otherwise are separate or severable’”) (quoting United Air Lines, Inc. v. U.S. Bank Trust Nat'l Ass'n (In re UAL Corp.), 346 B.R. 456, 467 (Bankr.N.D.Ill. 2006)); In re Braniff, Inc., 118 B.R. 819, 845 (Bankr. M.D. Fla. 1989) (“Cross default provisions are unenforceable in bankruptcy where the provisions restrict the debtor's ability to assume an executory contract.”).

The Fifth Circuit has recognized that cross-default provisions are “inherently suspect” and has held that “where the non-debtor party would have been willing, absent the existence of the cross-defaulted agreement, to enter into a contract that the debtor wished to assume, the cross-defaulted provision should not be enforced.” In re Liljeberg Enterprises, Inc., 304 F.3d at 445.

If the agreements do not have cross-default provisions, amending them to include such provisions is unlikely to help. A court is likely to find in such circumstances that the agreements would have been entered into separately because they were in fact originally entered into separately without cross-default provisions. Thus, for future planning, it is important that cross-default provisions be included in the agreements at their inception to improve the chances that they would be enforced in bankruptcy.

Adequate Assurance of Future Performance

As previously noted, prior to the Debtor assuming a contract with favorable terms, the Debtor must provide adequate assurance of its ability to perform in the future. In determining whether there is adequate assurance of future performance, courts must look to “factual conditions, including consideration of whether the debtor's financial data indicated its ability to generate an income stream sufficient to meet its obligations, the general economic outlook in the debtor's industry, and the presence of a guarantee.” Liljeberg, 304 F.3d at 438-439. The Bankruptcy Code borrows the phrase “adequate assurance” from Section 2-609(1) of the Uniform Commercial Code. See In re Texas Health Enterprises, Inc., 246 B.R. 832, 835 (Bankr.E.D. Tex. 2000).

Forward Contracts

A Debtor’s ability to assume or reject contracts may also be limited by the characterization of the contracts. Contracts may qualify as “forward contracts” which are entitled to special protections under the Bankruptcy Code. To the extent that a contract is a “forward contract,” the provisions of Section 365 of the Code are largely inapplicable. Section 556 of the Bankruptcy Code preserves the right of a “commodity broker, financial participant, or forward contract merchant to cause the liquidation, termination, or acceleration of a commodity contract . . . or forward contract” on account of the debtor’s insolvency or bankruptcy. 11 U.S.C. § 556.

The invalidation of bankruptcy termination clauses under the Bankruptcy Code does not apply as to a forward contract in the hands of a forward contract merchant. Further, the automatic stay does not prevent the forward contract merchant from terminating the forward contract pursuant to the bankruptcy termination clause. Further, damages for forward contracts are measured as of the earlier of (i) date of the rejection or (ii) date of liquidation, termination, or acceleration. 11 U.S.C. § 562(a). This is in contrast to most executory contracts, where damages are determined as of the petition date.

To determine whether the right to terminate exists, the key questions are (i) is the contract a forward contract and (ii) is the non-debtor party a forward contract merchant? If the answer to both is “yes,” then the non-debtor may terminate the contract notwithstanding the automatic stay.

A “forward contract” is defined in the Bankruptcy Code to include, among other things “a contract (other than a commodity contract, as defined in section 761)¹for the purchase, sale, or transfer of a commodity, as defined in section 761(8) of this title, or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade, or product or byproduct thereof, with a maturity date more than two days after the date the contract is entered into . . . .” 11 U.S.C. § 101(25). The fact that the contract contemplates actual delivery does not prevent it from being a forward contract. In re Olympic Natural Gas Co., 294 F.3d 737, 741-42 (5th Cir. 2002).

A “forward contract merchant” is defined in the Bankruptcy Code to include “an entity the business of which consists in whole or in part of entering into forward contracts as or with merchants in a commodity . . . or any similar good, article, service, right, or interest which is presently or in the future becomes the subject of dealing in the forward contract trade.” 11 U.S.C. § 101(26). Congress's addition of the phrase “in whole or in part” had the effect that “essentially any person that is in need of protection with respect to a forward contract in a business setting should be covered, except in the unusual instance of a forward contract between two nonmerchants who do not enter into forward contracts with merchants.” 5 Collier on Bankruptcy § 556.03[2] at 556-6 (15th ed. rev. 2001) (quoted in In re Borden Chemicals and Plastics Operating Ltd. Partnership, 336 B.R. 214, 225 (Bankr. D. Del. 2006)).

The Bankruptcy Code permits the non-debtor counterparty to a master netting agreement to terminate, liquidate, or accelerate or to offset or net termination values, payments amounts, or other obligations arising under or in connection with one or more (1) securities contracts, (2) commodity contracts, (3) forward contracts, (4) repurchase agreements, (5) swap agreements, or (6) master netting agreements. 11 U.S.C. § 561. However, to do so, the party must have the ability to terminate, liquidate, or accelerate each individual contract covered by the netting agreement under section 555 (securities contracts), 556 (forward contract), 559 (repurchase agreement), or 560 (swap agreement) of the Bankruptcy Code. 11 U.S.C. § 561(b). Hence, if, for example, the master netting agreement covers three contracts that qualify as forward contracts but also one that does not and does not fit any of the other categories covered by sections 555, 556, 559, or 560, then the counterparty will be unable to net this agreement under the master agreement without relief from the automatic stay.

Managing Risk

There are several avenues to minimizing risk.

Contract Must be Executory. A debtor’s power to assume or reject executory contracts is limited to those contracts that are actually executory. If a particular contract has been fully performed or terminated prior to the debtor’s bankruptcy filing, the debtor has no right to “resurrect” it (unless such termination constitutes a fraudulent conveyance). Accordingly, the risk to a counterparty of an unfavorable contract being assumed or a favorable contract being rejected can be eliminated if the contract can be terminated or fully performed prior to any bankruptcy.
Security. The counterparty could obtain a security interest in property of the debtor or a letter of credit issued on behalf of the debtor to ensure that it can actually recover on any damages claim arising from such rejection of its contract. Note that obtaining a security interest to secure a pre-existing unsecured debt or contract obligation may be attacked as a preference if the debtor files bankruptcy within 90 days thereafter.
Assumption. In some situations you may prefer rejection of your contract over assumption and possibly assignment to a third party. A debtor may assume executory contracts over the objection of a counterparty if adequate assurance of future performance by the assignee of the contract or lease is provided. Contractual provisions prohibiting assignment are not enforced. A debtor must also generally cure any existing defaults in executory contracts or unexpired leases as a condition to assumption. A debtor does not have to cure non-monetary defaults arising under its leases if it is impossible to remedy such default at the time of assumption. 11 U.S.C. § 365(b)(1)(A). Instead, with respect to “failure to operate” defaults under commercial real property leases, the Code now allows a debtor to remedy the default by performance (i.e. coming into compliance with such a provision). The debtor must compensate the lessor for the actual economic loss the lessor has sustained as a result of the prior breach. Personal services contracts are typically not assumable.
Cure. When the debtor files a motion to assume your contract, act promptly if defaults exist. Documenting all monetary and nonmonetary defaults as they occur and the damage to you as counterparty will assist you in preparing an objection. Your goal is a court order recognizing the existing defaults and either denying the motion to assume based on the defaults or specifically ordering their cure. Seeking discovery of financial information from the party to whom the contract will be assigned is also key. If the third party cannot establish its ability to perform under the assumed contract, it is grounds for denying the motion to assume and assign. Verifying the parties’ ability to perform (i.e. pay) under an assumed contract will also minimize the risk of post assumption default.

RISK #3: MINIMIZING EXPOSURE

If a counterparty has validly suspended performance prior to bankruptcy the suspension remains in place in bankruptcy. For this reason, caution should be taken in drafting contracts to provide for adequate assurance of future performance

Adequate Assurance. As to contracts for the sale of goods, which fall within the scope of Article 2 of the Uniform Commercial Code, a counterparty has the right under the Uniform Commercial Code to demand adequate assurance of performance if it has reasonable grounds for uncertainty that its counterparty will perform. See Tex. Bus. & Comm. Code Ann. § 2-609, which provides:

RIGHT TO ADEQUATE ASSURANCE OF PERFORMANCE

(a) A contract for sale imposes an obligation on each party that the other's expectation of receiving due performance will not be impaired. When reasonable grounds for insecurity arise with respect to the performance of either party the other may in writing demand adequate assurance of due performance and until he receives such assurance may if commercially reasonable suspend any performance for which he has not already received the agreed return.

(b) Between merchants the reasonableness of grounds for insecurity and the adequacy of any assurance offered shall be determined according to commercial standards.

(c) Acceptance of any improper delivery or payment does not prejudice the aggrieved party's right to demand adequate assurance of future performance.

(d) After receipt of a justified demand failure to provide within a reasonable time not exceeding thirty days such assurance of due performance as is adequate under the circumstances of the particular case is a repudiation of the contract. (emphasis added)

It is unclear under Texas law whether a right to adequate assurance of performance exists under contracts, that (i) are silent as to a right to adequate assurance of performance and (ii) are not subject to Article 2 of the Uniform Commercial Code. However, we note that Section 251 of the Restatement (Second) of Contracts recognizes such a right:

Where reasonable grounds arise to believe that the obligor will commit a breach by non-performance that would of itself give the obligee a claim for damages for total breach under § 243, the obligee may demand adequate assurance of due performance and may, if reasonable, suspend any performance for which he has not already received the agreed exchange until he receives such assurance.

Texas caselaw does not exist adopting the Restatement’s position or otherwise considering whether an implied common law right to adequate assurance of performance exists under a contract not subject to Article 2 of the Uniform Commercial Code.

Reasonable Grounds for Insecurity. Assuming the existence of a right to adequate assurance of performance, whether under the express terms of the contract, arising under the Uniform Commercial Code, or under common law, are the rumors regarding the Distressed Company’s financial condition and the inferences that drawn from conduct such as offering substantial discounts for cash payments sufficient grounds for insecurity as to permit a Counterparty to seek adequate assurances of performance?

Commercial Standard. Under contracts subject to the Uniform Commercial Code, “the reasonableness of grounds for insecurity . . . shall be determined according to commercial standards.” Tex. Bus. & Comm. Code § 2-609(b). See also Universal Resources Corp. v. Panhandle Eastern Pipe Line Co., 813 F.2d 77, 78 (5th Cir. 1987). Whether “reasonable grounds” for insecurity exist will be determined “in the light of all the circumstances of the particular case.” Comment (c) to Restatement (Second) of Contracts § 251. The grounds for insecurity must be based upon facts that arose after the time the contract was made and as to which the insecure party did not assume the risk when it made the contract. Id; See also Universal Resources Corp. v. Panhandle Eastern Pipe Line Co., 813 F.2d 77, 78 (5th Cir. 1987). Whether a party has reasonable grounds for insecurity is a question of fact. AMF, Inc. v. McDonald’s Corp., 536 F.2d 1167, 1170 (7th Cir. 1976); BAII Banking Corp. v. UPG, Inc., 985 F.2d 685, 702 (2d Cir. 1993). See also Phibro Energy, Inc. v. Empresa De Polimeros De Sines Sarl, 720 F. Supp. 312, 322 (S.D.N.Y. 1981).

A ground for insecurity need not arise from nor be directly related to the contract under which performance is deemed insecure. Clem Perrin Marine Towing, Inc. v. Panama Canal Co., 730 F.2d 186, 188 (5th Cir. 1984), Comment (c) to Restatement (Second) of Contracts § 251. Thus, an obligor’s failure to perform under contracts with third parties, or under unrelated contracts with the party seeking assurance of performance, could constitute a ground for insecurity, even though the obligor has not yet defaulted under the agreement as to which assurance of performance is sought. Cresuot-Loire Intern’l, Inc. v. Coppus Engineering Corp., 585 F. Supp. 45, 49 (S.D.N.Y. 1983) (a buyer of precision parts has reasonable grounds for insecurity if similar goods sold by seller to others have proved defective); Smyers v. Quartz Works Corp., 880 F. Supp. 1425, 1434 (D. Kan. 1995) (failure to pay for goods previously shipped under separate contract was a reasonable ground for insecurity as to performance of obligation to pay for future shipments under another contract with same seller); Comment (c) to Restatement (Second) of Contracts § 251.
Insolvency. Whether an obligor’s insolvency is reasonable grounds for insecurity depends on the nature of the obligor’s duties. Comment (c) to Restatement (Second) of Contracts § 251. See also BAII Banking Corp. v. UPG, Inc., 985 F.2d 685, 702-03 (2d Cir. 1993) (rumors of Seller’s financial distress and imminent bankruptcy were not reasonable grounds for insecurity in seller’s performance under petroleum sales contract where insolvency did not affect Seller’s ability to deliver product and Buyer was merely trying to avoid its own performance due to declining petroleum prices). However, where a buyer is receiving goods on credit, insolvency is a reasonable ground for insecurity. See Comment (c) to Restatement (Second) of Contracts § 251 (“If for example, [the nature of the obligor’s duties] is merely to perform personal services, the fact of insolvency alone may not give reasonable grounds to believe that the obligor will commit a breach, but if it is to pay for goods on credit it will.”)
Objective Standard. Whether reasonable grounds for insecurity exists is measured by an objective standard, not a subjective one. See Universal Resources Corp. v. Panhandle Eastern Pipe Line Co., 813 F.2d 77, 78 (5th Cir. 1987) (Buyer of natural gas was not entitled to suspend performance because of fear of lack of makeup gas where (i) there was no change or event occurring after execution of the agreement; (ii) insecurity was purely subjective and was not based on any objective, identifiable conduct of seller, and (iii) conclusion of insecurity was based on Buyer’s unsupported assumptions about the natural gas market). See also Pittsburgh-Des Moines Steel Co. v. Brookhaven Manor Water Co., 532 F.2d 572, 581 (7th Cir. 1976) (a more factual basis than subjective questioning is needed to demonstrate reasonable grounds for insecurity).
Deterioration of Market Conditions. In addition to a buyer’s insolvency, deterioration of market conditions may be a reasonable ground for insecurity. Top of Iowa Co-op v. Sime Farms, Inc., 608 N.W.2d 454, 467 (Iowa 2000) (Market conditions were facts that would support a jury finding that a buyer had reasonable grounds for insecurity). In addition, the fact that an obligor has been downgraded by a credit rating agency may support a demand for adequate assurance of performance, but a finding of such a right is not automatic and the issue must be determined in light of whether insecurity based on the downgrade was reasonable. Enron Power Marketing, Inc. v. Nevada Power Co., 55 UCC Rep. Serv. 2d 31 (SDNY 2004), supplemented, 2004 WL 3015256 (SDNY 2004).
Demand for Adequate Assurance. If the Non-Debtor concludes that it is insecure and desires adequate assurance of performance from the Distressed Company, that demand must be made in writing under those contracts that are subject to the Uniform Commercial Code. Tex. Bus. & Comm. Code Ann. § 2-609(a). As to those contracts that are not subject to the Uniform Commercial Code but nevertheless expressly provide for adequate assurance of performance, demand for such assurance would be subject to the notice provisions of the respective contracts.

The form of such assurance will be as specified in the terms of the relevant contract. If the relevant contract is silent, then the assurance of performance shall be determined “in accordance with commercial standards.” Tex. Bus. & Comm. Code Ann. § 2-609(b). “What constitutes ‘adequate assurance’ is to be determined by factual conditions; the seller must exercise good faith and observe commercial standards; his satisfaction must be based upon reason and must not be arbitrary or capricious.” Richmond Leasing Co. v. Capital Bank, N.A., 762 F.2d 1303, 1310 (5th Cir. 1985) (In a bankruptcy context, factors considered by the court in determining the adequacy of offered assurances included the obligor’s ability to generate sufficient income to meet its obligations, the “general economic outlook” in the obligor’s industry, and the presence of a guaranty).
Suspending Performance. May the Non-Debtor suspend its performance simultaneously with its demand for assurance? The Uniform Commercial Code provides that performance may be immediately suspended if it is “commercially reasonable” to suspend performance. Tex. Bus. & Comm. Code Ann. §2-609(a) (“until he receives such assurance [he] may if commercially reasonable suspend any performance for which he has not already received the agreed return”) (note the drafter’s formulation that performance may be suspended until assurance is received, rather than providing that performance may be suspended if assurance is not received). If the applicable contract provides a period in which the counterparty must provide adequate assurance or performance may be suspended, the Non Debtor cannot immediately suspend performance.

RISK #4: OFFSET RIGHTS

Setoff “allows entities that owe each other money to apply their mutual debts against each other, thereby avoiding ‘the absurdity of making A pay B when B owes A.’ ” Citizens Bank of Maryland v. Strumpf, 516 U.S. 16, 18, 116 S.Ct. 286, 133 L.Ed.2d 258 (1995) (quoting Studley v. Boylston Nat. Bank, 229 U.S. 523,528, 33 S.Ct. 806, 57 L.Ed. 1313, (1913)). Bankruptcy Code section 553 “preserves for the creditor’s benefit any setoff right that it may have under applicable nonbankruptcy law,” and “imposes additional restrictions on a creditor seeking setoff” that must be met to impose a setoff against a debtor in bankruptcy. Packaging Indus Group Inc. v. Dennison Mfg. Co. Inc. (In re Sentinel Prod. Corp. Inc.), 192 B.R. 41, 45 (N.D.N.Y. 1996). Setoff is appropriate in bankruptcy when a creditor both enjoys an independent right of setoff under applicable non-bankruptcy law, and meets the further Code-imposed requirements and limitations set forth in section 553. See, e.g., In re Tarbuck, 318 B.R. 78, 81 (Bankr.W.D.Pa. 2004) (holding that courts must look to state law to determine whether a right to setoff exists, but that “the granting or denial of a right to setoff depends upon the terms of section 553, and not upon the terms of state statutes or laws.”); see also In re Garden Ridge Corp., 338 B.R. 627, 632 (Bnkr.D.Del.2006).

Mutuality Required

In order to effect a setoff in bankruptcy, courts have held that the debts to be offset must be mutual, prepetition debts. See, e.g., Scherling v. Hellman Elec. Corp. (In re Westchester Structures, Inc.), 181 B.R. 730, 738-39 (Bankr.S.D.N.Y.1995) Debts are considered “mutual” only when “they are due to and from the same persons in the same capacity.” Westinghouse Credit corp. v. D’Urso, 278 F.3d 138, 149 (2d Cir.2002) (citing Westchester, 181 B.R. at 740). Mutuality requires that “each party must own his claim in his own right severally, with the right to collect in his own name against the debtor in his own right and severally.” Garden Ridge, 338 B.R. at 633-34 (quoting Braniff Airways, Inc. v. Exxon Co., U.S.A., 814 F.2d 1030, 1036 (5th Cir.1987)).

Triangular Set-Off Not Allowed

Because of the mutuality requirement in section 553(a), courts have held that triangular setoffs are impermissible in bankruptcy. See e.g., Matter of United Sciences of America, Inc., 893 F.2d 720, 723 (5th Cir.1990) (“The mutuality requirement is designated to protect against ‘triangular’ set off; for example, where the creditor attempts to set off its debt to the debtor with the latter’s debt to a third party.”); In re Elcona Homes Corp. (Green Tree Acceptance, Inc.), 863 F.2d 483, 486 (7th Cir.1988) (holding that the Code speaks of a “mutual debt” and “therefore precludes ‘triangular’ set offs”). Absent a piercing of the corporate veil, “a subsidiary’s debt may not be set off against the credit of a parent or other subsidiary, or vice versa, because no mutuality exists under the circumstances.” Sentinel Products Corp., 192 B.R. at 46 (citing MNC Commercial Corp. v. Joseph T. Ryerson & Son, Inc. 882 F.2d 615, 618 n. 2 (2d Cir.1989)). Allowing a creditor to offset a debt is owes to one corporation against funds owed to it by another corporation – even a wholly-owned subsidiary – constitutes an improper triangular setoff under the Code. A counterparty should be able to look to its right of setoff to protect its damages claim in a situation where the counterparty has other contracts or obligations it owes to the relevant debtor entity. The counterparty can ameliorate this risk by asserting its setoff rights in any bankruptcy proceeding. Some Courts have held that a non debtor may not offset the damages claim arising from rejected contracts against an obligation that the counterparty would have to the debtor under other contracts that the debtor has chosen to assume. In re Semcrude, 399 B.R. 388 (Bnkr.Del.20090).

RISK #5: OPTIONS TO PURCHASE

Neither the Bankruptcy Code nor case law provide a clear answer whether option contracts will be enforceable in a bankruptcy case. A non-debtor's ability to enforce its right to exercise its option in a bankruptcy will hinge upon whether or not the option has been exercised at the time bankruptcy is filed, on what obligations remain for each side at that time, and on the rational applied by the court in which the bankruptcy is filed. As previously noted under Section 365 of the Bankruptcy Code, a debtor may assume or reject executory contracts. Because no definition is given for an “executory contract” within the Bankruptcy Code or otherwise in legislation, federal courts differ on whether an option is an executory contract within the meaning of Section 365. Many courts using differing standards have held that an option contract is an executory contract such that the debtor can reject it in bankruptcy. Many other courts have held that option contracts are not executory contracts.

Timing

Regardless of the standard the bankruptcy court uses to determine whether the option contract in the case at bar is or is not executory, all courts will examine the status of the option contract on the date the bankruptcy petition is filed. See Bankr. Code 11 U.S.C.A. § 365; In re Columbia Gas Sys., Inc., 50 F.3d 233, 240 (3rd Cir. 1995). At the time the debtor files for bankruptcy, the Non-Debtor’s option to purchase could be: (i) paid for, but not yet exercised; (ii) exercised but without title having transferred (i.e. the deal not closed); (iii) exercised and closed; or (iv) expired. These situations are treated differently when determining whether the option is treated as an executory contract under federal bankruptcy law.

Clearly, if at the time bankruptcy is filed the time period available under the contract for exercise of the option has expired, performance could no longer remain due on either side, and the option would not be considered by the bankruptcy court to be executory. Similarly, if the Non-debtor has exercised the option to purchase and the deal has completely closed, no performance would be due on either side and the contract would not be executory. See In re Helms Constr. & Dev. Co., 139 F.3d 702, 705 (9th Cir. 1998); In re A.J. Lane & Co., 107 B.R. 435, 437 (Bankr. D. Mass. 1989); In re Giesing, 96 B.R. 229, 232 (Bankr. W.D. Mo. 1989). The real issue is the treatment in bankruptcy court of situations in which at the time of filing the option has been paid for, but not yet exercised, or alternatively, where the option has been exercised, but the deal has not yet closed.

A Paid for but Unexercised Option. Some courts have held that option contracts under which the optionee fully paid its price for the option to buy the property before the debtor filed for bankruptcy are not executory because no performance is due from the optionor unless the option is exercised. In re Penn Traffic Co., 524 F.3d 373, 379 (2nd Cir. 2008). However, as the bankruptcy court explained in In re Nat’l Fin. Realty Trust, other courts have treated these same types of unexercised option contracts as executory, including the Fifth Circuit. In In re Jackson Brewing Co., 567 F.2d 618 (5th Cir. 1978) where the optionee attempted to exercise its option to purchase real property after the debtor-optionor had filed bankruptcy but before the option expired under the contract, the Fifth Circuit determined the contract to be executory because: at the time of the filing the optionee, in order to exercise the option under the contract, had to (i) notify the debtor corporation of its intentions to purchase the property; (ii) pay the purchase price; and (iii) take title by a certain date).
When an option has been paid for but was not exercised at the time of trial, courts have been inconsistent in their treatment of the contract. Although the more modern and perhaps the majority of cases seem to treat these options as not executory, there is a risk, depending on where bankruptcy is filed, that the court could treat the option as executory.
An Exercised Option where Some Performance Remains Due at the Time Bankruptcy is Filed. In those situations where an option has been exercised at the time of the bankruptcy filing, most bankruptcy courts have not simply looked to the unique characteristics of an option contract but have instead conducted fact intensive inquiries as to whether performance remained due on either side of the contract. See In re Dunes Casino Hotel, 63 B.R. 939 (U.S.D.C. New Jersey 1986) (real estate purchase option agreement was executory contract at the time of bankruptcy filing, 14 days after date scheduled for closing and after prospective vendor had tendered deeds and title documents, but had not delivered them, where vendor had notified debtor prospective purchaser that it was still in default, thus triggering 15-day provisions for cure of default by purchaser, and purchaser still owed purchase price); see also In re Carlisle Homes, 103 B.R. 524 (Bankr. D.N.J. 1988) (option agreement for purchase of land was executory where only 16 of the 61 acres subject to the option agreement had been purchased by debtors and delivered by sellers and thus substantial performance remained on both sides under the agreement).

State Law

In evaluating whether or not an option contract is executory and can be rejected in bankruptcy the role of state law can be key. In the case of In re Plascencia, although the court stated that an unexercised option is not executory, the court went on to say that this does not wholly answer the question of whether the trustee is bound to the contract and questioned whether under Virginia law a recorded option is merely a contract right or whether it rises to the level of a property interest. In re Plascencia, 354 B.R. 774,780 (Bankr. E.D. Va. 2006). That court held that in Virginia an option to purchase is in the “nature of an interest in real estate which may be recorded and by that recordation protect the optionee’s interest in the real estate,” such that the option could not be treated simply as a contingent claim subject to discharge or compromise in the case. Id.

Optionees in Possession

Section 365 of the Bankruptcy Code which governs the assumption and rejection of the executory contracts and unexpired leases contains a special provision for executory contracts for sales of real estate. It provides:

(i)(1) If the trustee rejects an executory contract of the debtor for the sale of real property under which the purchaser is in possession, such purchaser may treat such contract as terminated, or, in the alternative, may remain in possession of such real property . . .
(2) If such purchaser remains in possession –

(A) such purchaser shall continue to make all payments due under such contract, but may, offset against such payments any damages occurring after the date of the rejection of such contract caused by the nonperformance of any obligation of the debtor after such date, but such purchaser does not have any rights against the estate on account of any damages arising after such date from such rejection, other than such offset; and
(B) the trustee shall deliver title to such purchaser in accordance with the provisions of such contract, but is relieved of all other obligations to perform under such contract.

(j) A purchaser that treats an executory contract as terminated under subsection (i) of this section, or a party whose executory contract to purchase real property from the debtor is rejected and under which such party is not in possession, has a lien on the interest of the debtor in such property for the recovery of any portion of the purchase price that such purchaser or party has paid. (emphasis added)

If a Non-Debtor gives notice it is exercising the option to purchase the physical assets and a contract provides it is in possession of the real estate at that point, a Non Debtor may be able to rely on Section 365(i) to force the Debtor to transfer title.

Recommendation

Because of the lack of consistent treatment in the case law, a Non Debtor can best secure its option contract by recording its option in the real property records, and by formulating the contract in a way that makes the exercise of the option extremely simple, with as few steps or restrictions as possible for exercise, payment, and delivery of documentation. The recordation would implicate state law, heightening the possibility that the Debtor would not be able to reject the contract. The simplicity of the contract would reduce the likelihood that the Debtor would file bankruptcy after the Non Debtor had announced its intention to exercise the option, or had in fact exercised it, but had not completed the deal, as that situation leads to the murkiest waters under bankruptcy interpretation and provides the greatest possibility that the contract would be dischargeable.

RISK #6: RIGHTS OF FIRST REFUSAL

The Bankruptcy Code and case law do not provide a clear answer whether rights of first refusal will be enforceable in a bankruptcy case. The Non-Debtor’s ability to enforce its rights of first refusal in a bankruptcy of the Debtor will hinge upon the rationale applied by the court in which the bankruptcy is filed. Bankruptcy courts such as Delaware have held that property rights created under operating agreements such as LLC agreements, partnership agreements and bylaws that becomes property of the bankruptcy estate remain subject to a preexisting ROFR because the debtor does not have greater rights in the property of the estate than the debtor had before filing for bankruptcy. Other courts have held that rights of first refusal, including rights in operating agreements, are executory contracts that the debtor can reject under the Bankruptcy Code.

Joint Ownership Agreements as Property of the Estate: ROFR Enforceable

In Northrop Grumman Tech. Services, Inc. v. The Shaw Group, Inc. (In re IT Group Inc.), 302 B.R. 483 (D. Del. 2003), the debtor sought bankruptcy court approval to transfer its rights under a limited liability company agreement in which the debtor was a member. The other non-debtor members of the LLC objected to the transfer because the other members did not consent to the transfer, and unanimous member consent was required under the LLC operating agreement to approve a transfer of the membership interest. The bankruptcy court held that the debtor could transfer the bare economic interest in the LLC, but the transfer was subject to the ROFR in favor of the non-debtor members contained in the LLC operating agreement. The proposed transferee appealed the bankruptcy court’s decision. The transferee argued that the bankruptcy court erred in holding that the assumption and assignment of the debtor’s bare economic interest was subject to the ROFR because the ROFR impermissibly restricted the assignment of the membership interests and was unenforceable pursuant to section 365 of the Bankruptcy Code which allows a bankruptcy court to approve the assumption and assignment of an executory contract from the debtor to a third-party regardless of the existence of a contractual restriction on such assignment. Id. at 486.

The district court analyzed the transferee’s argument that the ROFR was unenforceable under section 365(f) because it impermissibly prohibited, restricted or conditioned the assignment of the contract. The district court noted that a bankruptcy court has discretion in determining whether a contractual provision that does not expressly prohibit assignment qualifies as a de facto anti-assignment provision. The court agreed with the bankruptcy court that the ROFR was not an unenforceable restraint on assignment because the court was not persuaded that enforcing the ROFR would hamper the debtor’s ability to assign the property or foreclose the estate from realizing the full value of the debtor’s interest in the LLC. Id. The court also dismissed the transferee’s argument that public policy militates against enforcement of the ROFR because the procedure implicated by the exercise of the ROFR regarding allocation of the purchase price was too onerous. The court stated that “the holder of a ROFR is entitled to an allocation of the purchase price when the asset subject to the ROFR is part of a package, and to conclude that allocation procedures render the ROFR unenforceable would be to usurp a cognizable property right set forth by state law, a result which the Court believes would be counter to sound public policy.” Id. at 489.

ROFR as an Executory Contract Subject to Rejection

Courts which have refused to enforce ROFR have focused on the contractual nature of the right—rather than the scope and nature of the debtor’s property interest. These courts have applied either Section 365(a) or (f) of the Bankruptcy Code to avoid enforcement. Section 365 of the Bankruptcy Code permits a debtor to reject burdensome contracts. In In re Fund Raiser Products Co, Inc., 1996 WL 515504 (E.D. Pa. Aug. 30, 1996), the district court affirmed the bankruptcy court’s order approving the sale of stock owned by the debtor free of a ROFR provision contained in the company’s bylaws. The court analyzed the “matching rights clause” and determined that it was executory in nature. The party objecting to the rejection of the ROFR—relying on the property-interest cases discussed above—argued that the trustee can only sell what its owns, and it owns the stock subject to the matching right.

The district court dismissed the argument: “This argument ignores the powers given to a Trustee under the specific, central provision of 11 U.S.C. § 365, including the right to reject executory contacts. The Trustee may sell stock free and clear of a matching right provision under § 365.” Id. at *2. The court further held that that the rejection of the matching right did not terminate the bylaws because the bylaws themselves expressly stated that the remaining provisions would be valid. “Article I, section 3(c) states that ‘[t]he invalidity of any portion of the by-laws shall not affect any other portion thereof that can be given effect without such invalid portion.’ Thus, the matching right could be severed from the bylaws without rejection of the remainder. See In re Fleishman, 138 B.R. 641, 645 (Bankr. D. Mass. 1992) (severing analogous ROFR provision form).”

The Southern District of New York has also relied upon Section 365 to avoid the enforceability of a ROFR in a franchise agreement. Adelphia Comm. Corp., 359 B.R. 65, 85-90 (Bankr. S.D.N.Y. 2007). However, the Adelphia court acknowledged that they applied a “facts and circumstances” test and not aper se rule to reach their conclusions and stated that the considerations applied in Adelphia may not necessarily be the same in every ROFR case. Id. at 86. The Adelphia case dealt with a multi-asset sale/auctions where the court believed that enforcing rights of first refusal with respect to a subset of those assets would be destructive to maximizing value, and have a chilling effect on future bankruptcy auctions. Id. at 87. Because the assets were shared or used for the benefit of multiple contract counterparties, the court reasoned that the exercise of a ROFR by one contract counterparty would affect other entities, some of whom would be prejudiced by the loss of assets needed to serve them, and would at least require efforts to decouple the interlocking operations. Id. at 88.

Effect of Rejecting ROFR

Even if the Debtor is successful in rejecting the ROFR in bankruptcy, any asset sale must be in compliance with Section 363 of the Bankruptcy Code. A Section 363 sale is much like a traditional controlled auction. An initial bidder, known as a “stalking horse,” reaches an agreement to purchase assets from the chapter 11 debtor. The buyer and the debtor negotiate an asset purchase agreement which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” bids. The protections afforded to a stalking horse generally include a combination of a break-up fee averaging 3% of the sale price, expense reimbursement up to a negotiated cap, minimum increments for overbids, qualification requirements for competing bidders, strict deadlines for competing bids and dates for the run-off auction, final court approval and closing.

RISK #7: FRAUDULENT TRANSFERS

Anytime a debtor files bankruptcy, any sale or other transfer of its assets is subject to review under Sections 544 and 548 of the Code providing for recovery of fraudulent conveyances. The most basic fraudulent conveyance concern is that a bankruptcy court, with hindsight, will make a determination that the debtor did not receive a reasonably equivalent value in exchange for the transfer of its assets. This is a factual determination to be based on the preponderance of the evidence. An acquiror can attempt to insulate itself from subsequent attack by amassing evidence, including valuation opinions, that the price paid at the time of the transaction was fair. Note also that the remedy for a fraudulent conveyance may be either the recovery of the value of the property transferred or the property itself. Thus, a debtor that prevails on a fraudulent conveyance claim will seek recovery of the assets transferred if the value of that asset has increased subsequent to the time of the transfer; otherwise, it will seek recovery of the value existing at the time of the transfer. A completely different fraudulent conveyance risk is posed by a situation where the acquiror pays value to one debtor affiliate in exchange for assets from a different debtor affiliate. In such a situation, the transaction is vulnerable to attack on the grounds that the debtor that transferred its assets received nothing in exchange for such transfer. Note that simply having one debtor affiliate book an intercompany debt to another debtor affiliate does not provide sufficient “value” to the debtor whose assets are being transferred where the intercompany debt is not ultimately going to be paid in full because of an insolvency.

Lookback Period

The Code allows avoidance of fraudulent transfers within two years prior to the bankruptcy filing. See 11 U.S.C.A. § 548. State Uniform Fraudulent Transfer Acts permitting transfer avoidances up to four years or more may also be used to avoid transfers occurring more than two years before the bankruptcy filing. 11 U.S.C.A. § 544(b).

Elements of Claim

The debtor may avoid a transfer of the debtor’s property, or an obligation incurred by the debtor, if the debtor received less than “reasonably equivalent value” in exchange and the debtor:

was or became insolvent as a result of the transfer;
was engaged in business, and was left with unreasonably small capital after the transfer; or
intended to incur debts after the transfer, or believed he or she would incur debts after the transfer, that would be beyond his or her ability to pay as they matured. See 11 U.S.C.A. § 548(a)(1)(B).

If the following elements exist a constructive fraudulent transfer has taken place. Alternately, the Debtor can recover transfers made with the intent to hinder, delay or defraud creditors.

Transactions Commonly Attacked as Fraudulent Transfers

Several types of transactions are particularly susceptible to fraudulent conveyance attack. These include affiliate guaranties and third party pledges of collateral, intercompany dividends, asset transfers between affiliates and contractual obligations to third parties undertaken for the benefit of affiliates.

Guarantees and Third Party Pledges of Collateral. A guarantee is an undertaking by one person to answer for the payment of a debt or for the performance of some obligation of another person who is primarily liable for such payment or performance. Guarantees and third-party pledges of collateral are often attacked in bankruptcy as fraudulent transfers. The execution of the guaranty is a transfer within the meaning of the Code. Reasonably equivalent value for this purpose means consideration which benefits the guarantor. Reliance by the creditor will not suffice. There are three types of corporate guarantees: upstream, downstream, and cross-stream.

Upstream Guarantees. An upstream guarantee occurs when a subsidiary guarantees a loan made to its parent corporation. The Code allows a debtor to avoid an upstream guarantee given one year prior to the filing of the bankruptcy petition if the guarantor did not receive adequate consideration (i.e., “reasonable equivalent value”) and the giving of the guarantee rendered the guarantor “insolvent” or, in certain other ways, adversely affected the financial condition of the guarantor.
Cross-Stream Guarantees. A cross-stream guarantee occurs when one corporation guarantees a loan made to another corporation which is owned by the same parent corporation. These guarantees are subject to the same fraudulent conveyance problems as upstream guarantees.
Downstream Guarantees. A downstream guarantee occurs when a parent corporation guarantees a loan made to one of its subsidiaries. Generally, these guarantees are not challenged as fraudulent conveyances because of the obvious benefit which the guarantee affords to the parent’s investment in the subsidiary. However, where the parent and subsidiary have distinct creditors and the subsidiary is insolvent, the parent company’s creditors may attack the guarantee. While a transfer to a wholly-owned solvent subsidiary is often for reasonably equivalent value because the value of the parent’s stock interest in the subsidiary may be correspondingly increased, that is never the case when the subsidiary is hopelessly insolvent, because the value of those shares is zero both before and after the transfer. See, e.g., In re Duque Rodriguez, 77 B.R. 937, 939 (Bankr. S.D. Fla. 1987) aff’d, 895 F.2d 725 (11th Cir. 1990); In re Chase & Sandborn Corp., 68 B.R. 530, 533 (Bankr. S.D. Fla. 1986), aff’d, 848 F.2d 1196 (11th Cir. 1988); Robert K. Rasmussen, Guarantees and Section 548(A)(2) of the Bankruptcy Code, 52 U. CHI. L. REV. 194, 215-216 & n.69 (1985).

Other Transactions. There is no reasonably equivalent value for corporate dividends or distributions as a matter of law because only the payee, not the transferor, receives value. See Pereira v. Equitable Life Ins. Society (In re Trace Int’l Holdings, Inc.), 259 B.R. 548, 560-61 (Bankr. S.D.N.Y. 2003). Recovering a dividend as a constructive fraudulent transfer is easier than proving it was an illegal dividend. Dividends can be in the form of cash or assets. Thus asset transfers to a parent or affiliated corporation are critically analyzed.

Managing Risk

There are several ways to minimize the risk of fraudulent conveyance attack.

Valuation/Solvency Opinions. As counterparty you may wish to obtain a valuation opinion on the asset or a solvency opinion from a third party expert such as an investment banker. In order for a bankruptcy judge to give such an opinion much credibility, the expert opining must not be receiving any compensation based on the outcome of the valuation. Thus, an investment banker receiving a fee based on whether a sales transaction occurs may not be especially helpful in a subsequent court proceeding. Carefully drafted certificates of the chief financial officer are also helpful. Accounting firms are precluded from rendering solvency opinions.
Allocation of Purchase Price. As to the risk posed by a transaction involving multiple debtor affiliates, a counterparty should take care to ensure that each debtor affiliate receives fair value for its assets in any transaction. Thus, if a subsidiary’s assets are being sold, the payment for such asset should be made to the subsidiary, not to the subsidiary’s parent. Obviously, the counterparty cannot control whether a debtor affiliate subsequently transfers assets received to a parent corporation. However, by ensuring that its own transaction with each debtor affiliate was fair from that debtor affiliate’s standpoint, the counterparty should be able to insulate itself from a fraudulent conveyance claim. Note: The problem in one debtor affiliate receiving payment for another debtor affiliate’s assets stems from the possibility that the various debtor corporations have different creditor bodies and insufficient assets to pay off such creditors. Where a particular debtor affiliate has no creditors or has ample assets to pay such creditors, that debtor affiliate may have an identity of interest with its parent corporation such that there is no fraudulent conveyance risk in making payment directly to the parent corporation. Ample due diligence may allow an acquiror to satisfy itself that a particular debtor affiliate has no creditors or contingent creditors such that the transaction could not be subject to subsequent attack as a fraudulent conveyance.
Credit for Value Given. The transferee of a transfer is protected if he or she acted in good faith and gave value to the debtor. Such transferee may retain any property transferred to the extent of the value given in return. A good faith transferee from whom the trustee recovers property also has a lien against the property recovered to secure the lesser of (i) the transferee’s cost of improvements to the property made after the transfer, less the amount of any profits earned by the transferee from the property and (ii) any increase in value of the property as a result of action by the transferee. 11 U.S.C.A. § 550(e)(1).
Calculating the Benefit. If it is intended that the parent downstream (whether by loan, advance, capital contribution or otherwise) some of the loan proceeds to the subsidiary, then the subsidiary obviously stands to benefit (albeit indirectly) from the guarantee. In that situation, the issue would turn on the sufficiency of the benefit. The amounts should be well documented. Where (i) the subsidiary guarantees the entire amount of the loan to the parent and (ii) it is clear that, at most, only a portion of the loan proceeds will be made available to the subsidiary, a serious question will exist as to the adequacy of the consideration.
Limitation of Guaranty. It may be advisable to limit the subsidiary’s obligation under the guarantee. For example, the guarantee might limit the subsidiary’s liability under the guarantee to the amount of loan proceeds actually downstreamed to it by the parent. Provisions should be included in the guarantee limiting the liability of the subsidiary under the guarantee in such a way as to minimize the risk that the guarantee will render the subsidiary insolvent.

RISK #8: PREFERENTIAL TRANSFERS

Section 547 of the Bankruptcy Code (the “Code”) provides that a transfer of property to an entity that is a creditor of a debtor can be “recovered” if the transfer can be characterized as a payment in satisfaction of such creditor’s antecedent debt. Such transfers are termed “preferences.” See 11 U.S.C.A. § 547. Section 547 and its accompanying provisions are worded very broadly so that any payment that can be characterized as a payment on account of an antecedent debt can be recovered, even where the transfer was not made directly to the creditor. Thus, transfers are subject to recovery as preferences if the creditor was a direct or indirect transferee or even where the creditor was not a transferee at all, but was “benefited” by the transfer. Any transfer of a debtor’s assets occurring in the time period 90 days prior to that debtor’s bankruptcy filing is subject to attack under Section 547. Note that if a creditor can be characterized as an “insider” by virtue of its control over the debtor or other relationship with the debtor, the preference period is extended from 90 days prior to bankruptcy to one year before bankruptcy.

Elements of Preference

All of the following elements must be present to avoid a transfer as a preference. There must be:

a transfer (of property valued at $5,475 or more)
of property of the debtor
to or for the benefit of a creditor
on account of an antecedent debt
made while the debtor was insolvent (the debtor is rebuttably presumed to be insolvent during the 90 days before a bankruptcy petition is filed, see 11 U.S.C.A. § 547(f))
within 90 days prior to filing of the petition (or within one year if the transferee was an “insider” as defined in 11 U.S.C.A. § 101(31))
which allows the creditor receiving the transfer to receive more than the creditor would receive in a liquidation of the debtor’s assets. See 11 U.S.C.A. § 547(b); In re El Paso Refinery, L.P., 178 B.R. 426, 432 (Bankr. W.D. Tex. 1995), rev’d on other grounds, 171 F.3d 249 (5th Cir. 1999).

“Transfer” Broadly Defined. “Transfer” includes “every mode, direct or indirect, absolute or conditional, voluntary or involuntary, of disposing of or parting with property or with an interest in property, including retention of title as a security interest and foreclosure of the debtor’s equity of redemption.” 11 U.S.C.A. § 101(54). The creation and perfection of a contractual lien (e.g., taking and recording a trust deed on real estate, or a security interest in personal property) is a “transfer.”
Transfer Must “Prefer” Creditors. A transfer is not preferential unless it enables the creditor to receive more than it would have received in a hypothetical Chapter 7 case if the transfer had not occurred. 11 U.S.C.A. § 547(b)(5) (issuance of letter of credit to supplier to pay off antecedent unsecured debt to supplier was preferential transfer). A creditor with a security interest in a “collateral mass” (e.g., inventory or accounts receivable) is subject to preference attack to the extent it improves its position during the 90-day period before the bankruptcy petition is filed. 11 U.S.C.A. § 547(c)(5).
Intercompany Guarantees. “Insiders” who guarantee their company’s debts automatically benefit from preferential transfers made by the debtor company to reduce such debts. Every reduction of a guaranteed debt reduces the “inside” guarantor’s liability for payment thereon. Thus, an insider may be liable for payments made on guaranteed debts up to one year before the case was commenced.

Defenses

There are several defenses to a preference attack which allow the risk to be managed.

Ordinary Course of Business Transactions. The most important exception to the preference rule shelters transfers made in the ordinary course of business. The debtor may not avoid a transfer that was:

in payment of a debt incurred by the debtor in the “ordinary course of business” or financial affairs of the debtor and transferee
made in the ordinary course of business or financial affairs of the debtor and transferee
made according to ordinary business terms. See 11 U.S.C.A. § 547(c)(2); In re El Paso Refinery, L.P., 178 B.R. 426, 432 (Bankr. W.D. Tex. 1995), rev’d on other grounds, 171 F.3d 249 (5th Cir. 1999). In determining whether a challenged transfer is “ordinary,” courts employ an “objective industry” test. The transfer must comport with the prior dealings between the debtor and transferee, and the transfer must also comport with practices common to businesses similarly situated. See In re Roblin Indus., Inc., 78 F.3d 30 (2d Cir. 1996). If you notice a change in the debtor’s conduct (such as late payments indicating cash flow problems), consider options such as requiring prepayment or cash terms or not allowing the debtor to have more than one outstanding invoice.

No Antecedent Debt. There can be no preference without an “antecedent debt.” An antecedent debt is incurred before the transfer (i.e. payment). Requiring prepayment for delivery of goods or services eliminates the antecedent debt element.
Contemporaneous Exchange for New Value. The trustee may not avoid a transfer to the extent it was: (i) intended by the parties to be a substantially contemporaneous exchange for new value given to the debtor; and (ii) in fact was a substantially contemporaneous exchange; See 11 U.S.C.A. § 547(c)(1). Requiring cash on delivery is a contemporaneous exchange.
Enabling Loans. Also shielded from preference attack are certain transfers that create a security interest similar to a purchase money security interest (defined in UCC § 9.103). The security interest must secure new value that was given to enable the debtor to acquire particular property, and in fact be used to acquire such property. See 11 U.S.C.A. § 547(c)(3). Funding directly to the vendor and obtaining a PMSI eliminates the preference risk.
New Value. A transfer may be protected from preference attack to the extent the creditor gave new value to the debtor after the transfer. See 11 U.S.C.A. § 547(c)(4); the “subsequent advance” exception allows a creditor to claim a credit against preferential transfers for subsequent advances of “new value” made after transfer.
After Acquired Property Security Interests in Inventory/Receivables. Some creditors have “floating” perfected liens in the debtor’s inventory and/or receivables and the proceeds therefrom. To the extent such creditors do not improve their net positions in the collateral during the avoidance period, perfected liens on new inventory and/or receivables (and their proceeds) are not avoidable as preferences. 11 U.S.C.A. § 547(c)(5).

RISK #9: EQUITABLE SUBORDINATION

Section 510(c) of the Code authorizes a court to equitably subordinate all or part of an allowed claim to all or part of another allowed claim for purposes of distribution. Additionally, a court may order that any lien securing such subordinated claim be transferred to the bankruptcy estate. The majority of circuits employ a three prong test in determining whether a claim should be equitably subordinated:

Misconduct

The claimant must have engaged in some type of equitable misconduct. Inequitable conduct directed against the bankrupt or its creditors may be sufficient to warrant equitable subordination of a claim irrespective of whether it was related to the acquisition or assertion of the claim. There are generally three categories of misconduct which may constitute inequitable conduct: (i) fraud, illegality, and breach of fiduciary duties; (ii) claimant’s use of the debtor as a mere instrumentality or alter ego; and (iii) undercapitalization. Capitalization is inadequate if in the opinion of a skilled financial analyst, it would definitely be insufficient to support a business of the size and nature of the bankruptcy in light of the circumstances existing at the time the bankruptcy was capitalized. Once it is established that the Debtor was undercapitalized, a showing of additional inequitable conduct may be required. The majority of cases reviewed require misconduct in addition to undercapitalization. A minority of some courts have held that it is possible to have “no fault subordination.” In re Virtual Network Services Corp., 902 F.2d 1246 (7th Cir. 1990); In re Burden, 917 F.2d 115 (3rd Cir. 1990).

Injury to Other Creditors

The misconduct resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant. Claim(s) should only be subordinated to the extent necessary to offset the harm which the bankrupt and its creditors suffered on account of the inequitable misconduct; and

Consistent With Code

Equitable subordination of the claim must not be inconsistent with the provisions of the Code. See Benjamin v. Diamond (Matter of Mobile Steel Company), 563 F.2d 692, 699 700 (5th Cir. 1977).

Managing Risk

When dealing with affiliates, care should be taken to ensure that intercompany contracts are in line with terms negotiated between third parties and that the creditor does not use its position to improve the likelihood that its claims against the debtor will be paid while others will not. For nonaffiliates the creditor should not become involved in the day-to-day management of the debtor.

RISK #10: DEBT RECHARACTERIZATION

It is not uncommon for a parent corporation or major shareholder(s) to advance money to a company. In bankruptcy these loans are often subject to attack. Courts consider various factors in determining whether advances to a corporation constitute a loan or a capital contribution. The test most widely followed is that articulated in Roth Steel Tube Co. v. Comm’r. of Internal Revenue, 800 F.2d 265 (6th Cir. 1986).

Theory

The goal of the recharacterization inquiry is deciding whether what the parties called a loan was in reality an equity contribution. Debt recharacterization merely involves the question: “what is the proper characterization in the first instance of an investment”? Cohen v. KB Mezzanine Fund II, LP (In re Submicron Sys. Corp.), 432 F.3d 448, 454 (3d Cir. 2006) (internal quotations and citations omitted). The power to recharacterize debt into equity stems from the bankruptcy court’s authority to test the validity of debts, particularly shareholder loans to undercapitalized debtors. Diasonics, Inc. v. Ingalls, 121 B.R. 626, 630 (Bankr. N.D. Fla. 1990) (citing Taylor v. Standard Gas & Elec. Co., 306 U.S. 307 (1939) which created the so-called “Deep Rock” doctrine, under which a shareholder loan will be recharacterized as a capital contribution when either: (1) there is initial undercapitalization or (2) the loans were made when no disinterested lender would have extended credit.

Test

Though courts have developed numerous factors to consider, “they devolve to an overarching inquiry: the characterization as debt or equity is a court’s attempt to discern whether the parties called an instrument one thing when in fact they intended it as something else. That intent may be inferred from what the parties say in their contracts, from what they do through their actions, and from the economic reality of the surrounding circumstances.” Id. at 456. Though the courts have articulated a 13-factor analysis, they really are just using inductive reasoning—sometimes called the duck test (“If it quacks like a duck…”). The 13 factors consistently considered by courts are as follows:

Is the contribution labeled debt?
Does the contribution have a maturity date, like debt?
Is the contribution repaid independent of the business’ success, like debt?
Is repayment enforceable with appropriate safeguards, like debt?
Is the contribution given independent of management control, like debt?
Does the contribution have the subordination status of general creditors, like debt?
Did the parties objectively intend to create debt?
Was the debtor securely capitalized, like those who can take on debt?
Was the contribution given independent of equity interests, like debt?
Is the contribution primarily given in order to earn interest, like debt?
Could the contribution have been obtained from outside lenders, like other debt?
Was the contribution used to fund operations (not grow capital), like debt?
Did the debtor repay the contribution, or seek postponement if he cannot, like debt?

“Which course a court discerns is typically a common sense conclusion that the party infusing funds does so as a banker (the party expects to be repaid with interest no matter the borrower’s fortunes; therefore, the funds are debt) or as an investor (the funds infused are repaid based on the borrower’s fortunes; hence, they are equity). Form is no doubt a factor, but in the end it is no more than an indicator of what the parties actually intended and acted on.” Id. The factors used to recharacterize debt as equity have been adopted from the factors used outside the bankruptcy context, primarily the tax context. In re Submicron Sys., 432 F.3d at 455 & n.8.

Minimizing Risk

Recharacterization is a fact intensive inquiry. A thorough understanding of the factors courts consider in determining whether an advance is debt or equity is key. Intercompany transactions should be well documented. Loans should be evidenced by promissory notes which set forth payment terms, interest rates and maturity. Collateralized loans with properly perfected liens are preferred along with evidence of the company’s adequate capitalization.

CONCLUSION

Each of the identified risks is best managed by becoming and remaining informed about the financial condition of the relevant company and thoroughly documenting transactions with that company.

1. Section 761 of the Bankruptcy Code defines a commodity contract in part as “with respect to a futures commission merchant, contract for the purchase or sale of a commodity for future delivery on, or subject to the rules of, a contract market or board of trade.” 11 U.S.C. § 761(4)(A). Other types of commodity contracts relate to foreign futures commission merchants, leverage transaction merchants, and clearing organizations.

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