Recent Developments Affecting Insolvency and Commercial Finance in California

• Publication year: 2015
• Author: Dan Schechter

Recent Developments Affecting Insolvency and Commercial Finance in California

Dan Schechter¹

This article briefly summarizes key features of decisions affecting insolvency and commercial finance rendered by state and federal courts within the Ninth Circuit. It also provides the author's editorial comments related to these decisions.²

I. Bankruptcy.

A. The Trustee's Avoidance Powers and Related Claims.

• An "initial transferee" of a fraudulent transfer made by an insolvent corporation was strictly liable under the "pure dominion" rule, even though the debtor corporation's insider was the party who exercised indirect control over the funds and even though the recipient of the money (a vendor of real property) was unaware of its source. (In re The Mortgage Store, Inc., 2014 WL 6844630 (9th Cir. 2014).)

Comment: It is telling that the court's policy defense of the strict "initial transferee" rule goes on for so many paragraphs; to quote Shakespeare, "The lady doth protest too much, methinks." (Hamlet, Act III, Scene II.) The court implicitly recognizes that this is a very harsh rule and that there is really no practical way for the vendor (or any other ordinary payee) to protect itself.

• A bankruptcy trustee cannot prosecute a fraudulent transfer action against the recipients of a bankrupt debtor's property, when the assets in question were transferred following the confirmation of the debtor's plan of reorganization. (In re Kenny G. Enterprises, LLC, 512 B.R. 628 (C.D. Cal. 2014).)

Comment: Here is the court's own summary of its reasoning: "[S]ince the strong-arm powers exist at the commencement of the case, and since § 544(a) is limited to 'any transfer of property of the debtor,' these powers could only ever apply to prepetition transfers." But that syllogism is flawed: although it is true that the strong-arm powers exist at the commencement of the case, where does the statute say that those powers come to an end before the termination of the case? And if it is true (as the court admits) that the statute applies to the property of the "debtor," isn't it also true that the asset in question became the debtor's property following confirmation?

The debtor in this case intentionally understated the true value of the property, sold it for a premium, absconded with the money, and eviscerated the suite of income-generating property that was supposed to be available to pay the estate's creditors. Are the bankruptcy courts really powerless to protect the creditors from these sorts of shenanigans?

• A claim asserted by a liquidating trust on behalf of an estate against a tortfeasor was barred by the doctrine of in pari delicto, and language in a Ninth Circuit opinion to the contrary was just dicta. [In re Mortgage Fund '08 LLC, 2014 WL 543685 (Bankr. N.D. Cal. 2014).)

Comment: I disagree. The ninth circuit has said that there is nothing equitable about shielding wrongdoers from their own misconduct by invoking an equitable defense against a receiver or a trustee: "[T]he equities between a party asserting an equitable defense and a [predecessor] . . . are at such variance with the equities between the party and a receiver of the bank that equitable defenses good against the bank should not be available against the receiver."³

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• A successor fiduciary cannot be subjected to the unclean hands doctrine by imputation stemming from a predecessor's misconduct. (Stine vs. Dell'Osso, 230 Cal. App. 4th 834,178 Cal.Rptr.3d 895 (2014).)

Comment: This decision could be viewed as a sharp limit on the "imputed unclean hands" doctrine, a hot issue in the area of bankruptcy litigation. Trustees in corporate bankruptcy cases often sue third parties who have allegedly colluded with faithless insiders; those third parties routinely claim that since the bankrupt company was involved in the wrongdoing, the trustee simply steps into the company's shoes and is barred by imputed unclean hands, or the rule of "in pari delicto."

B. Chapter 11.

• A "new value" Chapter 11 reorganization plan requires a genuine market test of the value of the equity, a lender's deficiency claim could not be gerrymandered where the guarantor was insolvent, and the artificial impairment of a consenting class cannot be the result of abusive conduct. (In re NNN Parkway 400 26, LLC, 505 B.R. 277 (Bankr. C.D. Cal. 2014).)

Comment: This opinion adds a healthy dose of common sense to the murky jurisprudence surrounding the cramdown process. First, the court required genuine efforts by the debtors to "market test" their new value plan, going so far as to spell out the investor outreach program that a debtor must undertake. Second, the court's rejection of gerrymandering in this case adds an important qualification to the rule invoked by the Ninth Circuit B.A.P. in In re Loop 76, LLC⁴: it is not enough to show that the lender holds a guarantee. Instead, the debtor must also show that the guarantor is solvent.

Third, the court's "reality-based" rejection of "artificial impairment" is refreshing. The court was able to look at the circumstances surrounding the collusive creation of the "impaired consenting class" and to reject the debtors' transparent gamesmanship.

C. Other Bankruptcy Issues.

• When a bankruptcy court is confronted with a core claim that cannot constitutionally be determined by that court, the claim should be treated as non-core and is then subject to de novo review by the district court. (Executive Benefits Insurance Agency vs. Arkison,-U.S. -, 134 S. Ct. 2165189 L. Ed.2d 83 (2014).)

Comment: For those of us who have been following the aftermath of Stern v. Marshall,⁵ this opinion was a huge letdown. The Supreme Court ducked the significant issues raised by the ninth circuit's thoughtful analysis of the question of consent, condemning the bankruptcy bar to another several years of jurisprudential fumbling. Given the constitutional strictures of Stern, I cannot see how this problem can be fully resolved by legislation, even assuming that Congress could marshal the political will to address it (an unrealistic assumption in the current political climate). One wishes that this entire jurisdictional mess could be statutorily overhauled from stem to stern, but bankruptcy jurisdiction appears to be rotten at its constitutional core.

The only really big news is that Justice Thomas capitalized the term "Chapter 7," contrary to prevailing usage. Perhaps the lower courts will now do the same. (Or perhaps the article 1 bankruptcy courts will not, But The Article III District Courts Will.)

• Parties may consent to the entry of a final judgment by a bankruptcy court on claims that are beyond the scope of the court's constitutional powers. [Mastro vs. Rigby, 764 F.3d 1090 (9th Cir. 2014).]

Comment: The circuits are in conflict on the issue of consent. We will soon know whether the ninth circuit's position will prevail: the Supreme Court recently granted certiorari as to that exact question in Wellness International Network, Ltd. vs. Sharif⁶ I reluctantly predict that when the issue of consent is squarely addressed (this term!) by the Supreme Court, the Court will hold that consent cannot cure the bankruptcy court's lack of jurisdiction.

• Although a trustee's sale of fully encumbered property pursuant to a "carve-out" agreement is presumptively improper, the trustee may rebut that presumption.

(In re KVN Corp., Inc., 514 B.R. 1 (9th Cir. B.A.P. 2014).)

Comment: Does this presumption of impropriety really make sense? I understand that in the past, a few trustees abused "carve-out" agreements for personal gain. But it is often in the secured party's best interests to encourage the trustee to cooperate during the liquidation process, and "carve-out" fees provide a reasonable tool for obtaining that cooperation. As long as the terms of the "carve-out" are fully disclosed, the chance of misconduct is minimized.

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• An "in rem" order granting a lender retroactive relief from the automatic stay in order to foreclose was binding on the tenants of the original owner, even though the tenants' lease predated the issuance of the order; thus, the lender was entitled to evict the tenants, despite the filing of their own bankruptcy petition. [In re Black, 514 B.R. 605 (Bankr. E.D. Cal. 2014).]

Comment: This is a new twist on the "in rem" remedy. In most "in rem" situations, the party affected by the order is someone who took title to the property after the entry of the order. Here, the lease executed in favor of the tenants in this case substantially preceded the entry of the "in rem" order; yet the order was deemed binding on the tenants.

• Attorneys' fees incurred by an individual debtor in defense of the automatic stay may be recovered, even though prior ninth circuit authority holds that fees incurred in pursuit of a damages claim for violation of the stay are not recoverable. [In re Schwartz-Tallard, 765 F.3d 1096 (9th Cir. 2014).]

Comment: The court's attempt to distinguish Sternberg v. Johnston,⁷ is unpersuasive; instead of twisting and turning to escape from Sternberg, the...