Bankruptcy - W. Homer Drake, Jr. and Michael M. Duclos

• Publication year: 1997

Bankruptcyby W. Homer Drake, Jr.^* and

Michael M. Duclos"

I. Introduction

During 1996, the United States Court of Appeals for the Eleventh Circuit decided twenty-three cases in the area of bankruptcy law. These decisions covered a wide variety of issues arising under the Bankruptcy Code,¹ as well as several issues concerning nonbankruptcy law. This Article is a survey of the bankruptcy decisions rendered by the Eleventh Circuit in 1996.

II. MUNFORD and the consequences of a leveraged buyout

A. Settlement of Potential Claims

The Eleventh Circuit issued three significant decisions in the Munford bankruptcy case. There, the debtor operated convenience and specialty stores and filed for bankruptcy shortly after being purchased through a leveraged buyout ("LBO") transaction. The first Munford decision² concerned a bankruptcy court's authority to enjoin contribution and indemnification claims among nondebtor parties. The debtor commenced an adversary proceeding against various shareholders, former officers and directors, and Valuation Research Corporation ("VRC") in an attempt to recover damages resulting from the failed LBO. VRC offered to settle the claim, but only if the bankruptcy court issued an order enjoining the other nonsettling defendants from asserting claims for contribution and indemnification against VRC. The debtor accepted the offer, and the bankruptcy court issued the order.³ The other defendants appealed, but the district court affirmed.⁴

On further appeal to the Eleventh Circuit, defendants first argued that the bankruptcy court did not have subject matter jurisdiction over their state law contribution claims that had not been asserted in the adversary proceedings.⁵ However, the Eleventh Circuit found that without the order enjoining the contribution claims, the debtor would have lost its option to settle the claim with VRC.⁶ As a result, a sufficient nexus existed between the dispute and the bankruptcy case, thereby giving the bankruptcy court subject matter jurisdiction.⁷

In their next argument, the nonsettling defendants contended that the bankruptcy court lacked the legal authority to enjoin their claim.⁸ However, the Eleventh Circuit found the necessary legal authority in section 105(a) of the Bankruptcy Code⁹ and rule 16 of the Federal Rules of Civil Procedure.¹⁰ Under section 105, a bankruptcy court "may issue any order . . . that is necessary or appropriate to carry out the provisions of this title."¹¹ Under rule 16, a bankruptcy court has the authority to take any appropriate action with respect to settlements.¹² The combination of these two provisions provided the bankruptcy court with ample authority to enter an order barring the enforcement of the contribution claims.¹³

B. Liability for the Failed LBO

The second Munford decision¹⁴ involved the liability of the debtor's corporate directors under state law for the LBO that led to Munford's demise.¹⁵ The bankruptcy and district courts concluded that Georgia's stock distribution and repurchase statutes applied to a leveraged acquisition of a corporation.¹⁶ At the time of the LBO, section 14-2-91 of the Official Code of Georgia Annotated ("O.C.G.A.") provided that corporate directors may distribute to shareholders surplus capital, but no such distribution is to be made if the corporation is insolvent or would be rendered so by the distribution.¹⁷ In addition, O.C.G.A. section 14-2-92 prohibited directors of a corporation from authorizing the corporation to repurchase its own shares if doing so would render the corporation insolvent.¹⁸ Finally, under O.C.G.A. section 14-2-154, directors who acted in violation of these statutes were jointly and severally liable for the amounts involved.¹⁹ The directors argued that the statutes were inapplicable to an LBO because in an LBO transaction the control of the corporation changes hands.²⁰ This argument did not persuade the Eleventh Circuit. The court found instead that the LBO transaction was a "paper merger" of the debtor and a shell corporation with no assets.²¹ To allow the directors to escape state law liability under these circumstances "would frustrate the restrictions imposed upon directors who authorize a corporation to distribute its assets or to repurchase its shares from stockholders when such transactions would render the corporation insolvent."²² Thus, the court held that an LBO was subject to Georgia's stock distribution and repurchase statutes.²³

In the final Munford decision,²⁴ the court discussed the liability of various other parties as a result of the LBO and resulting bankruptcy.²⁵ The debtor sought to recover as fraudulent transfers the payments the two largest shareholders received for their shares in the LBO.²⁶ Both the bankruptcy and district courts concluded that such payments were "settlement payments," and in accordance with section 546(e) of the Bankruptcy Code,²⁷ not subject to recovery by the debt- or. Section 546(e) provides that "the [debtor-in-possession] may not avoid a transfer that is ... a settlement payment . . . made by or to a commodity broker, forward contract merchant, stockbroker, financial institution, or securities clearing agency."²⁹ The term "settlement payment" refers to various types of payments "commonly used in securities trade."³⁰ Disagreeing with the lower courts, the Eleventh Circuit concluded that the payments in question were not protected under section 546(e) because the shareholders received the payments from the debtor.³¹ In order for section 546(e) to shield a transfer, the payment must be made to the shareholder from one of the entities listed in that section.³² As a result, the shareholders could face liability on the debtor's fraudulent transfer claim.³³

The next issue discussed involved the debtor's tort claims against its officers and directors for breach of fiduciary duty, negligence, mismanagement, and waste of corporate assets.³⁴ Looking to Georgia law,³⁵ the Eleventh Circuit stated that under the "business judgment rule," officers and directors are protected from liability "when they make good faith business decisions in an informed and deliberate manner."³⁶ The undisputed evidence was that the officers and directors of Munford consulted legal and financial experts throughout the LBO process and that by doing so, they satisfied their state law duty.³⁷ Therefore, the officers and directors escaped liability on the debtor's tort claim. Likewise, the financial adviser, Shearson Lehman Brothers, escaped liability when the court refused to recognize a state law claim for "aiding and abetting" a breach of fiduciary duty.³⁸

In another claim, the debtor argued that severance contracts Munford entered into with three of its top officers were fraudulent transfers because the agreements lacked consideration.³⁹ Under the agreement, the officers promised to continue in Munford's employment until the closing of the sale of Munford.⁴⁰ The Eleventh Circuit found that under Georgia law, continued employment in a terminable-at-will employment situation constituted consideration.⁴¹ Also, had the officers terminated their employment and frustrated Munford's plan to sell its stock, the severance contract would have provided Munford with recourse against the officers.⁴²

III. Contempt Power Over the Internal Revenue Service

A. Violation of the Automatic Stay

The liability of the Internal Revenue Service ("I.R.S.") for violating the automatic stay was the heart of the issue in Jove Engineering, Inc. v. Internal Revenue Service.⁴³ After the debtor, Jove Engineering, filed a Chapter 11 bankruptcy petition, the I.R.S. made repeated attempts to force payment of prepetition taxes in violation of the automatic stay.⁴⁴ Eventually, Jove Engineering filed a motion with the bankruptcy court to hold the I.R.S. in civil contempt.⁴⁵ The district court found that all the violations committed by the I.R.S. were merely inadvertent, as compared to intentional and malicious, and only awarded Jove Engineering five hundred dollars for attorney fees.⁴⁶

Jove Engineering appealed the decision to the Eleventh Circuit, contesting the limited recovery.⁴⁷ Specifically, the debtor claimed that section 362(h) of the Bankruptcy Code⁴⁸ provided a source for the relief it sought.⁴⁹ However, the Eleventh Circuit concluded that section 362(h) did not authorize an award of damages in this case.⁵⁰ Section 362(h) grants relief to "[a]n individual injured by any willful violation" of the automatic stay.⁵¹ Under the plain meaning of this provision,

Jove Engineering was not entitled to relief because it was a corporation, not an individual.⁵²

The Eleventh Circuit then considered Jove Engineering's alternative argument that section 105 of the Bankruptcy Code⁵³ authorized finding the I.R.S. in contempt for violating the automatic stay.⁵⁴ Under section 105, a court has broad powers to issue "any" type of order that is "necessary or appropriate" to carry out the provisions of the Bankruptcy Code.⁵⁵ The use of the broad term "any" led the Eleventh Circuit to conclude that section 105 included orders awarding monetary relief.⁵⁶ Furthermore, the court found that an award for monetary relief was "necessary or appropriate" for certain violations of the automatic stay.⁵⁷ As a result, the Eleventh Circuit concluded that section 105 allowed Jove Engineering to seek an order granting monetary relief for the I.R.S.'s repeated violations of the automatic stay.⁵⁸

The Eleventh Circuit further found that the I.R.S.'s violations were willful.⁵⁹ A violation is "willful" if the I.R.S. (1) knew that the automatic stay was in place and (2) intended the actions that violated the stay.⁶⁰ Under the undisputed facts of the case, the I.R.S. was notified several times of the pending bankruptcy, but it nevertheless intentionally took actions that violated the automatic stay.⁶¹ In other words, the fact that the I.R.S. did not intend to violate the automatic stay did not relieve it of liability, because it...