Energy: Samson Resources’ Prenegotiated Reorganization Plan with Fulcrum Debt


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As predicted at the Commercial Finance Association’s Fourth Annual Energy Summit on September 16th, we should start seeing more and more oil & gas companies struggle to survive in the wake of continued low commodity pricing.  While we witnessed some rebound in pricing towards the end of the summer, the price of oil again dipped to under $50 a barrel in September and the price of gas continues near historic lows, at just under $3.00 MMBtu.  As Philip Cook, the Chief Financial Officer of Samson Resources Corporation, recently stated:

Oil and gas companies across the United States and around the world are feeling the pressure from the downward spiral in commodity prices, and the fate of many of these companies is yet to be determined.  Access to capital is the lifeblood of exploration and production companies.  With increasing leverage because of a constant need for capital, together with the recent rising cost of capital in the industry, operating in the current environment has been—and likely will remain—challenging . . . . Some companies will attempt to wait out the current conditions, hoping for a rebound in commodity pricing and increased access to low-cost capital; others will succumb to market pressures and be forced to sell at depressed prices or otherwise permanently halt operations.  Other companies will take a proactive approach and work to reshape their operations and balance sheet in a manner that will allow them to weather the macroeconomic environment in all circumstances.

Declaration of Philip Cook In Support of Chapter 11 Petitions and First Day Motions (Docket No. 2) at pg.1; In re Samson Resources Corp., Case No. 15-11934 (Bankr. D. Del. Sept. 17, 2015) (emphasis added).

The proactive approach mentioned above is the one that Samson Resources Corporation (“Samson” or “Company” ) appears to have chosen, when it filed for chapter 11 bankruptcy on September 17, 2015.  See In re Samson Resources Corp., Case No. 15-11934 (Bankr. D. Del. Sept. 17, 2015).  The bankruptcy filing followed lengthy and meaningful negotiations with Samson’s major constituencies.  As a result, Samson was in a position to immediately file a prenegotiated plan of reorganization shortly after it commenced its case.  The restructuring plan proposes to tackle the two main issues that have plagued Samson; liquidity and substantial debt obligations.  To whit, the plan proposes to eliminate over $3 billion in long-term debt and raise $450 million in new capital.  This Article will explore how Samson was able to accomplish this feat.


Headquartered in Tulsa, Oklahoma, Samson is an onshore oil and gas exploration and production (E&P) company, with interests in various oil and gas leases primarily in Colorado, Louisiana, North Dakota, Oklahoma, Texas and Wyoming.  Specifically, the Company and its affiliates operate, or have royalty or working interests in, approximately 8,700 oil and gas production sites.

In 2014, Samson produced approximately 530 million cubic feet equivalents (MMcfe/d) of gas and oil per day from its producing wells.  However, the Company has recently suspended exploration and drilling operations in light of its current financial distress and the turmoil in the industry.

Like other E&P companies, Samson began to experience significant liquidity constraints, when commodity prices plummeted in the latter half of 2014.  Lower pricing resulted in lower revenue, which, in turn, meant that the Company could not service its substantial long-term debt obligations and continue profitable operations, which required significant capital expenditures.  Moreover, the lower pricing reduced the borrowing base under Samson’s primary credit facility, which limited Samson’s ability to borrow its way out of its problems.

In an attempt to improve its liquidity, Samson undertook initiatives to reduce operating expenses, like suspending drilling activities, limiting capital spending and reducing its workforce by 35%.  It also attempted to improve liquidity by pursuing divestiture of certain noncore assets and drawing down the remaining availability under its primary credit facility.  However, it became apparent that these steps would not be sufficient to allow the Company to weather the current storm.

Fulcrum Debt

Merriam-Webster’s Dictionary defines a “fulcrum” as being the support on which a lever moves when it is used to lift something.  The classic example is the fulcrum of a seesaw, which simultaneously supports one side pivoting upward and another side pivoting downward.

The term “fulcrum debt” (also known as “fulcrum security”) derives from this concept. The terminology is generally used in situations where a borrower or debtor that has multiple tranches of debt is undergoing, or will undergo, a restructuring.  Inside of bankruptcy, pursuant to the absolute priority rule, (a) secured creditors generally are entitled to recover the full amount of their debt before unsecured creditors receive any recovery and (b) unsecured creditors generally are entitled to recover the full amount of their debt before any equity owners receive any recovery.

This priority scheme is often challenged, however, in instances where the debt stack of a borrower includes several tranches of debt, with varying degrees of priority, and the borrower owns insufficient assets to satisfy all such debt.  In such instances, often only the senior-most tranches may be entitled to a full recovery, leaving lower priority creditors with only a partial recovery or no recovery at all.

The least senior debt that is at least partially entitled to a recovery is generally considered to be the fulcrum debt.  Using the seesaw analogy, the fulcrum debt is the midpoint where the seesaw tilts upward for creditors entitled to a full recovery and downward for everyone else.  Falling in the middle, the fulcrum debt supports both sides of the seesaw.  Another way of looking at it is that the fulcrum debt is the tranche of debt found at the threshold of where a borrower’s assets exceed its liabilities.

Why is it important to identify the fulcrum debt?  In a restructuring scenario, where a debtor wishes to remain a going concern but does not have enough enterprise value to provide full recovery to all creditors, a restructuring strategy commonly employed is to convert the fulcrum debt to equity, as such debt is the lowest point entitled to any recovery from the debtor.  All other junior debt is “out of the money,” and while the senior secured debt must still be satisfied in full, the Bankruptcy Code enables a reorganized debtor to do so over time, thereby permitting the fulcrum debt to immediately take ownership with little or no new capital. See 11 U.S.C. § 1129(b)(2)(A)(i).

Why is this strategy good for a debtor? As demonstrated in Samson’s case, a debt for equity conversion can enable a debtor to eliminate substantial long-term liabilities and maintain scalable operations.  In the energy sector, where a substantial number of companies are overburdened with debt and need fresh capital to sustain operations, the debt-for equity swap with fulcrum debt may provide a viable means of survival.

Samson’s Prebankruptcy Negotiations

When Samson realized it would need to take additional steps besides cost-cutting and divestiture initiatives, it began negotiating with its primary constituencies regarding a potential restructuring plan.

Samson has three primary tranches of long-term debt; a first-priority, secured revolving credit facility, which is owed approximately $950 million; a second priority, secured term loan facility, which is owed approximately $1 billion; and outstanding senior unsecured notes, in the principal amount of $2.25 billion.  In addition, Samson has significant equity investors like Kohlberg Kravis Roberts, which 3 years earlier lead the acquisition of the Company for $7.2 billion. The pre-bankruptcy negotiations involved all of these groups and progressed as follows.

After negotiating loan default waivers with its first lien lenders, Samson began negotiations with its second lien lenders, which appeared to hold the fulcrum debt of the Company.  Samson and its second lien lenders eventually arrived at a proposal that provided for (a) an in-court restructuring, (b) the conversion of the entire fulcrum debt into equity in the reorganized Company and (c) rights offerings of both debt and equity securities that would raise at least $450 million in new capital upon Samson’s emergence from bankruptcy.  The rights offerings were backstopped (or guaranteed) by the second lien lenders.  On account of the estimated enterprise value of the Company, this proposal also eliminated the debt owed to the senior unsecured noteholders and all existing equity in the Company.

At the same time it was negotiating with the fulcrum debt, Samson also requested that the senior unsecured noteholders come up with an alternative restructuring proposal, as they appeared to be the stakeholders (outside of equity) that theoretically stood to lose the most from an in-court restructuring.  The noteholders arrived at a proposal that required (a) an out-of-court exchange of the current senior unsecured notes for new secured notes, at an 80% discount and (b) a new money investment of $650 million.  Under this latter proposal, both the surviving secured notes and the new money investment would be granted priority liens ahead of the fulcrum debt.  And, because this proposal involved no bankruptcy filing, existing equity ownership would remain in tack.

There were several reasons why Samson ultimately chose to pursue the proposal with the second lien lenders. Under that proposal, Samson stood to eliminate over $3 billion in long-term debt, as its last two tranches of debt (the second lien debt and senior unsecured notes) would be extinguished.  This proposal also assures that Samson will raise at least $450 million in fresh capital, which is projected to be sufficient to sustain scalable operations in the not-so-short-term future.

Unlike the fulcrum debt proposal, the noteholders’ proposal still left Samson with $3 billion in long-term debt and contained too many contingencies, including an almost unanimous noteholder consent requirement and unlikely concessions from the first lien credit facility (which would remain in place after the bankruptcy).  Furthermore, the legality of the noteholders’ exchange offer, which allowed fresh liens to jump ahead of existing liens, was likely to be challenged vigorously by the fulcrum debt, and such a challenge would jeopardize the entire restructuring process.

In addition, even though their entire $7 billion investment would be wiped out, equity supported the fulcrum debt proposal, which—unlike the noteholders’ proposal—did not contemplate equity investing new capital in Samson.

Having enough support from its major constituencies and in an attempt to speed up the in-court restructuring process, Samson filed its prenegotiated plan with the fulcrum debt on the same day that it filed bankruptcy.  In proceeding in such a fast-track manner, Samson appears to be confident that it has vetted out all viable options and has reached the best possible result for the Company.


In Samson’s case, the fulcrum debt was in a unique position of being able to help the Company arrive at a viable restructuring plan.  The fulcrum debt not only could agree to eliminate its own debt, but it could cut off all junior creditors from receiving any recovery.  The net effect of the proposed debt-for-equity convesion is the delevereging of the Company’s balance sheet by over $3 billion, substantially reducing Samson’s future debt servicing obligations.

But, the second lien lenders’ status in the debt stack does not tell the full story.  To remain a going concern, Samson still required a capital infusion of substantial amounts of money. The fulcrum debt, however, was not required to invest any more money pursuant to the Bankruptcy Code.  So, what factors convinced the second lien lenders to invest sufficient amounts of new capital in Samson?

The answer to the above question is not difficult to surmise.  The estimated enterprise value of Samson (approximately $1.4 billion) may have warranted a larger recovery to the senior unsecured notes in the form of equity, and perhaps the second lien lenders did not want to share such a large ownership in the Company.  Perhaps the second lien lenders considered the fact that they were inheriting a company that 3 years earlier was acquired at over $7 billion, and they were persuaded that the capital infusion was necessary to recoup the Company’s diminished enterprise value.  Perhaps the first lien lenders required sufficient new investments in determining whether to continue to work with Samson or exercise their own remedies, like forcing Samson to sell its assets at depressed values (as Philip Cook mentioned).  Or, perhaps the second lien lenders were influenced by the alternative proposal by the senior unsecured noteholders that would have left the fulcrum debt primed and essentially worthless.  These and other practical factors may have played a role in the decision-making process.

The real point is that, by negotiating with all of its major constituencies at the same time, Samson effectively used its leverage amongst competing groups to arrive at the best possible restructuring plan.  Now, the Company is in a good position to press forward with a fast-track bankruptcy process.  While the restructuring process is still in its early stages, if everything goes as planned, Samson’s case may well provide a useful road map for other oil and gas companies facing similar leverage and liquidity issues.

Lessons from a Retail Giant’s Recent Bankruptcy Filing


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The retail industry appears to be reaching the crossroads of complete transformation due to a significant shift in consumer sentiment.  Those companies that can embrace the change quickly enough will likely survive.  Those that cannot may simply become legends.  Indeed, we have seen well-known companies such as RadioShack, Brookstone, Frederick’s of Hollywood, dELiA*s, Cache, ALCO Stores, Deb Shops and others file for bankruptcy protection within the last year and, in many instances, ended up selling all of their assets for much less than market value.

On September 9, 2015, Quiksilver, Inc. and certain of its affiliated domestic companies (collectively “Quiksilver” or “Company”) joined the group of retailers needing special relief, when it filed for bankruptcy in Delaware.  See In re Quiksilver, Inc., et al., Case No. 15-11880 (Bankr. D. Del. Sept. 9, 2015).  However, the difference between Quiksilver and some of the other faltering retailers is that Quiksilver is not attempting to liquidate its assets in a piecemeal fashion.  It is not calling it quits.  Rather, through its chapter 11 bankruptcy, it is proposing to reorganize its global operations in a manner that more readily addresses the new challenges in the retail industry.

Changes in the Retail Industry

As demonstrated by the number of recent bankruptcy filings of notable companies, competing in the retail sector as of late has never been harder.  Among the many challenges that retailers currently face include:

  • Consumer shifts to online shopping and a corresponding decline in visits to brick-and-mortar stores;
  • Retailer’s reluctance to reduce the number and size of brick-and-mortar stores;
  • Increased advertising and staffing budgets;
  • A lack of broad-based training programs for merchandising executives; and
  • A general lack of tech savvy management.

See Peter N. Schaeffer, Old School Merchants’ Survival Threatened by Consumer Realities, Journal of Corporate Renewal, Vol. 28, No. 4, at pgs. 7, 8 and 11 (Turnaround Management Association May 2015.)

A study of sales performance between 2012 and 2013 by major retailers, like Sears, Macy’s, GAP, Kohl’s, Nordstroms and JC Penny, shows that (a) web sales have increased, on average, by approximately 21%, (b) store sales (without the web) have declined, on average, by 6.2% and (c) total sales (including both web and store) have declined approximately 3%.  See id.  At some of these retailers, like Sears, JC Penny and Abercrombie & Fitch, sales without the web declined by as much as approximately 10% or more during this period.  See id.   The results lead to the inevitable conclusion that web sales are comprising an increasing percentage of a retailer’s total sales, and some analysts believe that, as Baby Boomers retire and Generations X, Y and Z become a greater influence in the marketplace, this upward trajectory will invariably continue.  See id. at 11.

Given the current consumer trends, one would expect that, in order to regain profitability, most national retailers have considered reducing the amount of their retail space as well as corresponding staffing, advertising, and other store related expenses.  Some well-known retailers, like Sears, Aeropostale, JC Penny, Children’s Place and others, have done just that to try to stay afloat amidst these challenging times.  See Antony Karabus, Consumer Polarization Squeezes Retailers in the Middle, Journal of Corporate Renewal, Vol. 28, No. 4, at p.  13 (Turnaround Management Association May 2015.)

As discussed below, Quiksilver, itself, commenced reducing its brick-and-mortar stores in 2013.  However, few retailers, including Quiksilver, have been able to achieve the full benefit of these cost cutting initiatives outside of bankruptcy. (For a discussion regarding a debtor’s ability to restructure lease obligations in bankruptcy, please see the following articles: Buffets, Inc. Emerges from BankruptcyRitz Camera Files Second Bankruptcy; and Cap On Landlords’ Rejection Damages Claim.)

Quiksilver’s Operations

Headquartered in Huntington Beach, California, Quiksilver is one of the world’s leading manufacturers and retailers of outdoor sports apparel.  The Company was founded in 1976 as a California company making boardshorts for surfers in the U.S.  Today, the Company provides apparel and accessories all around the world that cater to a casual outdoor lifestyle associated with various outdoor activities, including surfing, skateboarding and motocross.

The Company has over 1500 employees and generates sales in over 115 countries through several distribution channels, including wholesale customers (i.e., outside retail stores), traditional Company-owned stores, and e-commerce.  At the end of 2014, the Company had approximately 266 full-price core brand stores, 75 of which were located in the U.S, and 147 factory outlet stores, 47 of which were located in the U.S.  In papers filed with the Delaware bankruptcy court, the Company disclosed that 67% of its net revenues in 2014 came from wholesale customers, 28% came from Company-owned stores and 5% came from e-commerce.

Quiksilver has four operating centers consisting of the Americas (the United States, Mexico, Brazil and Canada), EMEA (Europe, the Middle East, and Africa), APAC (Australia, New Zealand and the Pacific Rim) and corporate operations. According to documents filed in the bankruptcy case, Quiksilver’s U.S. operations generate approximately 34% of the Company’s revenues, while 66% is generated by non-debtor affiliates located outside of the U.S.

As of 2014, the Company and its non-debtor affiliates had approximately $850 million in long-term debt, consisting primarily of asset-based borrowing facilities and several secured and unsecured notes (in excess of $700 million).

The Company disclosed that it was forced to file bankruptcy because of a lack of adequate liquidity, exacerbated by underperforming retail stores and substandard delivery of product to wholesale customers.  The situation apparently was so fragile that, for example, Quiksilver disclosed that it suffered a major setback when one of its major distribution centers was slowed down by a labor dispute in a Los Angeles port.  The Company’s weakened performance further caused a contraction of trade liquidity, which caused the Company to hasten its prepetition turnaround efforts, as discussed below.

Prior to filing bankruptcy, Quiksilver looked at a range of strategic alternatives to find additional liquidity but no alternatives came to fruition.  Part of the alternatives that it pursued involved entering into new credit facilities with more borrowing capacity.  However, because most of Quiksilver’s and its non-debtor affiliate’s assets had already been pledged, new financing was difficult to obtain outside of a in-court restructuring process (which allows the restructuring of prepetition debt instruments).

Prepetition Turnaround Plan

Quiksilver has been attempting to implement a turnaround plan since 2013.  The turnaround plan is aimed at strengthening its core brands, growing sales and improving operational efficiencies.  Among other things, Quiksilver plans to focus on 3 flagship brands and divest noncore brands and product lines; re-prioritize its current marketing strategies and continue to invest in emerging markets and e-commerce; improve sales execution; optimize the Company’s supply chain; lower G&A expenses; centralize global responsibility for key functions; and close underperforming retail stores.

The Company disclosed that it had already closed several underperforming stores prior to the bankruptcy filing, whenever leases came due or they struck a deal with landlords.  In addition to cost cutting, the Company raised additional revenue by (a) divesting itself of approximately $100 million of noncore business lines in 2014 and (b) engaging two well-known liquidation companies, Hilco Merchant Resources, LLC and Gordon Brothers Retail Partners, LLC, to sell certain excess inventory through special store closing sales at various leased locations, including temporary “pop-up” stores.  Despite these initiatives, Quiksilver still could not generate enough revenues to maintain its global operations, while attempting to turn around its business.

Bankruptcy Reorganization Plan

Because Quiksilver’s strategic alternatives were limited outside of bankruptcy, it eventually struck a deal with Oaktree Capital Management, L.P., a private equity firm that owns 73% of the secured notes ($279 million) issued by the Company and a portion of the unsecured European notes ($221 million) issued by a non-debtor foreign affiliate, Boardriders S.A.  The basic game plan is to (a) provide Quiksilver with enough runway (i.e., liquidity) to implement its prepetition turnaround plan through its domestic operations and (b) leave Quiksilver’s foreign operations unaffected by the bankruptcy filing.

Specifically, the deal with Oaktree (a) involves a bankruptcy filing by Quiksilver and not its foreign affiliates and (b) requires Quiksilver to support a plan of reorganization that accomplishes, among other things:

  • converting the Company’s secured notes into equity;
  • replacing Quiksilver’s secured borrowing facility ($92 million) with an exit facility upon emergence from bankruptcy;
  • reinstating Quiksilver’s guaranties on certain foreign debt owed by its non-debtor affiliates;
  • eliminating existing equity in Quiksilver; and
  • raising additional capital upon Quiksilver’s emergence from bankruptcy through a rights offering to secured noteholders.

There is a fundamental reason that Quiksilver’s foreign affiliates are not in bankruptcy.  According to Quiksilver, the Delaware bankruptcy court could not directly exercise jurisdiction over these foreign entities, and Quiksilver’s restructuring efforts could easily become frustrated if its foreign affiliates filed elsewhere, because the governing insolvency laws in other jurisdictions vary and are not as flexible as U.S. bankruptcy laws.

As an important part of the deal with Oaktree, the Company obtained $115 million in postpetition financing from Oaktree, plus an additional $60 million in financing from one of its prepetition secured lenders, Bank of America.  The postpetition financing should provide Quiksilver with sufficient working capital and funding to restructure and maintain its global operations.  In addition, in order to leave Quiksilver’s foreign affiliates undisturbed, the Company obtained a waiver of certain defaults (i.e., those triggered by the bankruptcy filing) under the European notes issued by  Boardriders S.A.

There is much hope that Quiksilver’s turnaround plan will ultimately work.  It already has a unique customer value proposition for its products, which complements its wholesale business that generates 67% of its revenues.  It is focusing on its core brands (which historically have been popular) and optimizing its supply chain to deploy its most popular products timely.  It is re-prioritizing its marketing efforts and continues to invest in emerging markets and e-commerce, which appears to align with recent consumer sentiment.  It also is attempting to manage its operating costs by centralizing global responsibility for key functions, lowering G&A expenses and eliminating its underperforming retail stores.  According to Antony Karabus, CEO of HRC Advisors, these are some of the primary areas that retailers in Quiksilver’s position must take in order to remain competitive and weather the current storm.  See Karabus, supra, Journal of Corporate Renewal, at p.  14.  Now all Quiksilver needs is a little more time to see its plan implemented, and bankruptcy affords it such relief.

Final Thoughts

The retail industry appears to be undergoing a huge transformation due to growing changes in the way consumers like to shop. And while many retailers have been slow to confront this transformation—for one reason or another—there is still optimism that others have been learning from recent retail bankruptcies. Quiksilver is a good example of a retailer that began planning many years ago, but just needed a little more time to execute a turnaround plan.

Other retailers have also started to change the way they operate.  As mentioned, several of them have been cutting their retail space, and associated costs, nationwide.

Another interesting dynamic that we will soon see play out is the fact that a number of CEO positions have turned over within the past 2 years at major retailers, like The GAP, Things Remembered, Sur La Table, Hollister, American Apparel, Yankee Candle, Footlocker, Justice, Christopher & Banks, Bebe, New York & Company, Body Central, Abercrombe & Fitch, Gymboree, Office Depot, Michaels, Hot Topic, American Eagle and Aeropostale, to name a few. See, supra, Karabus, Journal of Corporate Renewal, at p.  14.  Typically, when a retailer makes such a change, it also results in a change in direction, including internal changes in leadership, strategy, initiatives and focus.  See id. For example, Target’s announcement in January 2015, that it was closing its Canadian business (133 stores) and taking a $5 billion write-down came 5 months after the arrival of its new CEO, Brian Cornwell, who was able to take a fresh look at that investment. See

The new retail leadership no doubt understands that their businesses must adapt to the recent changes in the retail industry.  Now, they are just charged with the enormous task of crafting a turnaround plan that can work fast enough, while navigating their companies through the storm of less liquidity.  Whether these retail leaders can implement a strategy in time to save their companies will be no easy task, as illustrated by several of the recent retail bankruptcies filed within the last year.  Quiksilver’s case serves as a good example, however, that, with some creativity and adequate planning, bankruptcy relief can help a retailer buy some extra time to properly shift gears.

Distress in the Oil & Gas Industry (Part 1)


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With oil prices having fallen more than 50% from June 2014 to January 2015, mostRIG2 pundits expect more companies in the oil & gas (O&G) industry will face significant financial distress in 2015, forcing many to either consolidate or file for bankruptcy.  Already this year several large oil and gas companies, like WBH Energy L.P., BPZ Resources, Dune Energy, Inc., Quicksilver Resources, Inc., American Eagle Energy Corp.ERG Resources, LLC and Duer Wagner III Oil & Gas, have filed for chapter 11 bankruptcy because they could no longer service their debt obligations and/or fund their ongoing operations.

While oil prices did rebound slightly in the Spring and Summer of 2015, the anticipation is that there will still be many oil and gas companies with the same financial distress during the second half of 2015, as oil prices remain much lower than $100 per barrel.  Based on the author’s experience as debtor’s counsel and lender’s counsel in several oil and gas  restructurings and workouts over the past two decades, this Article (in two parts) will discuss the oil and gas industry in the United States, the players in this industry, the financial distress experienced in this industry and the unique challenges that O&G companies face in a bankruptcy setting.

Because each of these relevant topics merits a lengthy discussion, the Article will be broken down into two parts, with the first part focusing on the trends in the industry, the players in the industry and the financial problems that some of these players are experiencing.  The second part will delve into the various aspects of bankruptcy laws that are generally implicated when an O&G company files for bankruptcy protection.

Trends in U.S. Oil & Gas Production

The United States is the world’s top producer of oil and natural gas, having overtaken Russia and Saudi Arabia several years ago.  The rise to the top was fueled by new drilling techniques, such as horizontal drilling and hydraulic fracturing, which have unlocked vast quantities of oil and gas from shale rock formations – especially in North Dakota and Texas.

According to the Drilling Productivity Report, dated April 2015, by the U.S. Energy Information Administration (EIA), 95% of U.S. production comes from 7 regions.  These regions, spread out throughout the U.S., are known as the Bakken Shale, Eagle Ford Shale, Permian Shale, Haynesville Shale, Niobrara Shale, Marcellus Shale and Utica Shale.  The diagram below demonstrates where these regions are located.

US Shales


The EIA’s more recent Drilling Report shows that, while production is expected to be down slightly from month to month, overall production in each region has increased from last year.

The Players in the Industry

Companies in the oil and gas industry are generally referred to as upstream, midstream and downstream companies.  Upstream companies, also known as exploration and production (E&P) companies, find new areas where there is untapped oil and gas and drill wells for new production.  The E&P companies commonly obtain the right to develop an area, drill wells and extract minerals from the subsurface through oil and gas leases entered into with the landowners or mineral interest owners.  Such oil & gas leases provide E&P companies with a “working interest” in the minerals underneath the ground.  This working interest grants an E&P company the exclusive right to develop and receive a net profit from the minerals produced. Because oil and gas exploration and development is extremely capital-intensive, you commonly see E&P companies farmout a portion of their working interests to other parties to assist in the development of the land and mitigate the risks of drilling unsuccessful wells.

Midstream companies are the ones that ship and store oil and gas.  They ultimately move the oil and gas from the production fields to the refining facilities and ultimately to the buyers.  These companies commonly include pipeline companies that transport oil and gas over long distances across the U.S.  After the initial pipeline transfer, midstream companies may require further transportation by land, with the use of rail and trucking companies.  Barges are also required to transport oil over oceans and large bodies of water.  Finally, midstream companies include storage facilities, where surplus oil and gas is stored before reaching refining facilities.

Downstream companies are the buyers who purchase and refine oil  and gas into consumable products.  These companies purchase and receive crude production from mid-stream companies and refine such production into gasoline and other petro-based products.

In addition to upstream, midstream and downstream companies, oil field services companies (OFS) play a significant role in the O&G industry.  In general, OFS companies provide products and services to the E&P companies, but they typically are not producers of oil and natural gas themselves.  For example, OFS companies often provide the rigs  and other equipment used to drill wells.  They also provide the massive workforce for the exploration, drilling and build out of new production facilities.  As of 2013, more 10,000 companies operated in the OFS industry, ranging from Fortune 500 companies to small local retailers.

Similarly, there are companies that provide ancillary services to the people in the oil & gas industry.  These ancillary services include things like providing man camps, apartments, restaurants, entertainment and other related services.  These companies do not represent a significant portion of the revenue in the O&G industry, but are still tied to the success and distress in this industry.

Financial Stress in the Energy Industry

Usually, a dog wags her tail, and not visa versa.  Similarly, according to John Maynard Keynes, demand in products usually dictates the amount of related manufacturing and production and not visa versa.  However, sometimes in the economy there is a disconnect between supply and demand, and the consumer–not the producer–benefits from the gap.  That is what we are currently experiencing with the recent excess production, where an oversupply has resulted in cheaper pricing.  While consumers in the U.S. are enjoying this environment, many companies in the industry are not benefiting as a result and, in fact, are experiencing substantial financial distress.

Upstream Companies

Let’s start with the finders and the drillers, i.e., the exploration companies.  The reason for the distress of E&P companies is that exploration and production is a capital-intensive industry, notwithstanding the recent technological advances.  Given the costs involved, there is a “break-even” point where the price of crude oil must be in order for E&P companies to maintain operations.  This break-even point depends, in large part, on the difficulty in drilling in certain shale formations.  When the break-even point is reached—whether it be $50 or $60 dollar per barrel—cash-strapped E&P companies are compelled to either borrow more money or obtain more investment capital to continue operations.  Unfortunately, banks and investors are currently more conservative in their lending and investment practices.

In addition, many E&P companies are facing potential defaults on their loans with lenders (bondholders and banks), due to the reappraised value of their oil and gas reserves, which have been pledged as collateral to the lenders.  Lenders generally require these reserves to be appraised every six months, and the next round of appraisals, starting in the Third Quarter of 2015, will likely reveal that the values of the pledged reserves are substantially less than required by the respective loan agreements.   At that point, the lenders will be entitled to foreclose on their collateral, forcing these E&P companies, absent obtaining waivers of the loan defaults, to sell their assets to generate revenue or file for bankruptcy.

OFS Companies

Because OFS companies provide the equipment and workforce necessary for the operations of the E&P companies, OFS companies are similarly impacted when E&P companies reduce their drilling operations.

The oil rig count in the U.S. is one of the benchmarks in determining the need for oil field services.  According to Baker Hughes (which has been monitoring rig counts since 1944), the average U.S. rig count has been declining regularly on a monthly basis and is 52% lower than last year.  While large companies, like Halliburton and Baker Hughes, can survive the significant downturn in demand, smaller companies are expected to experience significant financial distress, leading many of them to sell their assets, merge or file bankruptcy.

In addition to the reduction in revenues, OFS companies face similar challenges trying to comply with their loan covenants with lenders.  Similar to the E&P companies, loans to OFS companies generally require a collateral base; however, with OFS companies, the collateral base is comprised of equipment such as oil rigs.  When this equipment is idle, like in cases where rigs are stacked, the value of the collateral base diminishes significantly, leaving these companies with insufficient collateral to borrow future funds and, in some cases, causing them to breach loan covenants with their lenders.  The sale of assets also will likely provide OFS companies with little relief, given the depressed value of equipment in this environment.

Ancillary Services

Similarly, companies that provide ancillary services to the people in the oil & gas industry are likely to face financial distress.  Considering that the OFS workforce is currently experiencing significant layoffs, ancillary services are likewise experiencing a decline in the demand.  Those companies that have borrowed too much money in recent years may not be able to generate sufficient income to maintain profitable operations or even meet their debt obligations.  Because lenders are even more skittish about lending to these specialized businesses, when these companies run out of cash, they will likely have little options but to file bankruptcy.

Wrap Up

While the price of oil has rebounded within recent months, because world production remains high, prices may not reach their historic levels, again, for several years.  In the meantime, there will continue to be a fair amount of distress in the oil & gas industry, as demonstrated, due to the domino effect oil prices have on smaller companies.

Indeed, there currently exists a fair amount of companies that are on a general downward cash-burn trajectory. However, if these companies burn up too much of their liquidity, hoping that their luck will turn, they will soon discover that they have diminished options to restructure.

While some companies have found respite with alternative lenders who are willing to make riskier loans, such loans are generally unavailable to the vast majority of smaller players.  Such loans are also generally on costlier terms, given the higher risks involved for the lenders.  And if the companies cannot turn operations around by the time such loans mature, they may be facing bigger problems down the line.

Pundits predict that many companies ultimately will have no other option but to file bankruptcy.  Case in point, the Commercial Finance Association–Southwest Chapter is hosting its Fourth Annual Energy Summit on September 16, 2015, where several leading experts in the field will discuss the outlook in the industry.

As mentioned, Part II of this Article will discuss the unique challenges that oil & gas companies face in a chapter 11 bankruptcy.  In short, Chapter 11 does provide relief, if it is adequately planned ahead of time.  Stay tuned for more!

Secured Transaction Avoided as Unauthorized Postpetition Transfer


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The United States Bankruptcy Court for the Eastern District of North Carolina recently avoided several secured financing arrangements, entered into by a debtor without court approval, as illicit transfers under section 549(a) of the Bankruptcy Code.  See James B. Angel v. Hyosung Motors America, Inc. (In re Britt Motorsports, LLC), Case No. 14-00058 (Bankr. E.D.N.C. April 22, 2015).  The holding reminds creditors that it is better to be safe–and ask for bankruptcy court permission before entering into a postpetition transaction with a debtor–than be sorry later.


Prior to filing bankruptcy, the debtor, Britt Motorsports, LLC, was in the business of selling used motorcycles, ATVs, and watercraft and custom metric motorcycles.  Hyosung Motor America, Inc. supplied the debtor with motorcycles for sale to Britt’s customers.  Whenever the supplier provided motorcycles, both parties entered into a “Dealer Payment Agreement/Promissory Note,” which contained the following terms:

  • the supplier would deliver the motorcycles to the debtor;
  • the debtor was required to pay the supplier an initial down payment of 10% of the purchase price, followed by monthly installments;
  • the supplier retained title to each motorcycle until it was sold and the supplier received full payment of the price of the motorcycle;
  • whenever the debtor sold a motorcycle, it was required to immediately pay the supplier any balance owed for such unit; and
  • the supplier reserved the right to pick up any unsold motorcycle at any time.

Prior to and after filing bankruptcy, without obtaining bankruptcy court approval, the debtor and the supplier entered into 5 such Dealer Payment Agreements/Promissory Notes, pursuant to which the debtor made multiple postpetition payments to the supplier, in the amount of $85,742.68.

Conversion and Avoidance

Several years after filing bankruptcy, the debtor’s case was converted to chapter 7 and a trustee was appointed. Shortly after, the trustee initiated an adversary proceeding (Adv. No. 11-07688) to avoid and recover all of the postpetition payments made to the supplier, pursuant to sections 549 and 550 of the Bankruptcy Code.

Section 549 provides, in relevant part, that a trustee or debtor may avoid a postpetition transfer of property of the bankruptcy estate that is not authorized under the Bankruptcy Code or by the bankruptcy court.  11 U.S.C. § 549(a). Section 550 imposes liability on the transferee of such property to the extent the transfer is avoided under section 549. See 11 U.S.C. § 550(a).  Finally, section 541 provides that property of a bankruptcy estate includes all legal and equitable interests of the debtor in property as of the commencement of a case and any interests in property that the estate acquires postpetition. 11 U.S.C. § 541(a)(1), (7).

Through the adversary proceeding, the trustee maintained that the debtor transferred estate property (money) to the supplier and such transfers were made without proper authority.  According to the trustee, while section 1108 of the Bankruptcy Code generally allows a debtor to continue operating its business postpetition as a debtor-in-possession, section 364 of the Bankruptcy Code restricts a debtor-in-possession from obtaining certain types of credit postpetition.  See 11 U.S.C. §§ 1108, 364.

Specifically, section 364 requires a debtor to obtain bankruptcy court approval when obtaining unsecured credit or incurring unsecured debt outside of the ordinary course of business.  See id. at § 364(b).  Section 364 places even more restrictions when a debtor is seeking to obtain secured debt postpetition.  See id. § 364(c).  In that instance, the debtor must demonstrate to the bankruptcy court that it cannot otherwise obtain unsecured debt. See id. The debtor must also demonstrate that (a) a secured lender will not otherwise accept a superpriority administrative priority claim instead of collateral, (b) the debtor possesses unencumbered assets that it can pledge or (c) the debtor possesses encumbered assets that are valuable enough to afford a junior lien.  See id.  In certain circumstances, the debtor can also incur secured debt with liens that prime (or take priority over) existing liens.  See id. at 364(d).

There is a solid policy reason why the restrictions on borrowing exist under the Bankruptcy Code.  Whenever the debtor incurs new debt postpetition, whether secured or unsecured, it creates new claims that likely are entitled to a higher priority in recovery from other existing creditors.  Thus, the new postpetition debt could diminish the return to existing creditors of a bankruptcy estate. Given that existing creditors are presumptively the beneficiaries of a bankruptcy estate, diminishing their return is not favored under the Bankruptcy Code.  That is why court approval is required under section 364 when a debtor is incurring certain postpetition debts.

The problem in Britt Motorsports was that neither the debtor nor the supplier obtained court approval before entering into, and honoring, the 5 Dealer Payment Agreements/Promissory Notes.  The whole case turned on whether such transactions were, in fact, restricted by section 364 of the Code.

Consignment or Secured Financing?

The supplier argued that section 364 did not apply, because the dealer agreements did not create secured financing arrangements, but rather constituted consignments.  The bankruptcy court therefore endeavored to determine the nature of each of the dealer agreements.

State law governs whether a transaction is a secured transaction or a consignment.  In particular, in most states, Article 9 of the Uniform Commercial Code defines each type of transaction. Pursuant to section 9-102 of Article 9, a consignment is defined as follows:

“Consignment means a transaction, regardless of its form, in which a person delivers to a merchant for the purpose of sale and:

a.   The merchant:

  1. Deals in goods of that kind under a name other than the name of the person making delivery;
  2. Is not an auctioneer; and
  3. Is not generally known by its creditors to be substantially engaged in selling the goods of others;

b.    With respect to each delivery, the aggregate value of the goods is one thousand dollars or more;

c.   The goods are not consumer goods; and

d.   the transaction does not create a security interest that secures an obligation.

See N.C. Gen. Stat. § 25-9-102 (emphasis added).  The bankruptcy court found that, notwithstanding the title of the dealer agreements, the nature of the transactions covered by such agreements depended on the intent of the parties at the time they entered into the transactions. Citing In re Oriental Rug Warehouse Club, Inc., 205 B.R. 407, 410 (Bankr. D. Minn. 1997.)  Intent, in turn, is determined by examining the “economic realities of the transaction rather than the subjective intent of the parties.”  If a dispute later arises as to the parties’ intent, then the acts of the parties prevail over their designation of the transaction.

Under North Carolina law, factors that support the conclusion that the parties intended a secured transaction include:

  • the setting of a resale price by the consignee;
  • billing the consignee upon shipment;
  • commingling sale proceeds and failure to keep a proper accounting by the consignee; and
  • mixing consigned goods with goods owned by the consignee.

See id.

Factors supporting a true consignment include whether:

  • the consignor retained control over the resale price of the consigned property;
  • the consignee needs authority from consignor to sell the property;
  • the consignor may recall the goods;
  • the consignee receives a commission but not a profit from the sale;
  • the consigned property was segregated from other property of the consignee;
  • the consignor is entitled to inspect sales records and the physical inventory of the goods in the consignee’s possession; and
  • the consignee has no obligation to pay for the goods unless they are sold.

See id. at 410-11.

Ultimately, the bankruptcy court found that the 5 Dealer Payment Agreements/Promissory Notes created a security interest, rather than a consignment, because

  1. the debtor was obligated to pay for the motorcycles, by a down payment and monthly installments;
  2. the debtor (not consignor) set its own prices for the motorcycles;
  3. the debtor was billed upon shipment of the motorcycles (not upon sale);
  4. the debtor commingled proceeds from sales with his own property; and
  5. the debtor received a profit from each sale.

While the supplier retained the right to recover its motorcycles at any time and the debtor was required to permit inventory inspections, these factors did not outweigh those favoring a secured transaction.  Indeed, the court found that the debtor’s obligation to pay was likely the most important factor in demonstrating a secured transaction.

The court also rejected affidavit testimony regarding the subjective intent of the parties, finding that the majority of factors objectively demonstrated that the dealer agreements created secured transactions. Accordingly, the court held that such transactions were restricted by section 364 of the Code, and the debtor and supplier violated these restrictions when they failed to obtain court approval before entering into and honoring the financing transactions postpetition.


The opinion focused on the nature of the transactions between the parties and whether the parties properly obtained court approval.  The court, however, did not discuss the fact that the supplier actually provided significant value to the debtor postpetition, by virtue of motorcycles that were delivered. Arguably, the supplier would, at least, be entitled to an administrative priority claim under section 503(b) for the value provided and such claim would be entitled to distributions from the debtor’s estate before any other unsecured claim.  See 11 U.S.C. §§ 726, 507, 503(b).

The opinion also does not discuss whether the dealer agreements created unsecured debt in the debtor’s ordinary course of business.  It appears, at face, that the supplier always kept title to the motorcycles (until sold) and therefore was not required to obtain collateral before extending loans to the debtor.  Without collateral, there is no secured loan.  Furthermore, there is little question that buying motorcycles for resale was in the debtor’s ordinary course of business.  Had this issue been explored a little more closely, the bankruptcy court may have concluded that the dealer agreements actually created unsecured debt in the ordinary course of business,  which debt is specifically authorized by section 364(a) of the Code.

In the end, the opinion serves as a strong reminder that a bankruptcy court can characterize or recharacterize any agreement based on the economic realities of the transaction.  Thus, parties would be wise to seek bankruptcy court approval in any case where there is doubt about how an agreement can be characterized.  The irony in Britt Motorsports is that the bankruptcy court would likely have authorized the debtor’s entry into the postpetition financing with the supplier, because such transactions brought value to the debtor’s estate (in the form of profits). It appears, however, that the supplier relied too much on the ordinary course nature of the transactions in proceeding without court approval.  The supplier also forgot that a chapter 7 trustee can revisit any transaction after a case is converted and is not bound by the debtor’s subjective intent prior to conversion. In short, the supplier did not properly anticipate where the debtor’s case could be headed.

Wow! Fifth Circuit Eases Standard for Awarding Professional Fees


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In a long-awaited opinion, the Fifth Circuit Court of Appeals recently reversed its ruling in Pro-Snax Distributors, Inc., 157 F.3d 414, 426 (5th Cir. 1998), providing that a bankruptcy professional can only collect fees for services provided to a bankrupt debtor that “resulted in an identifiable, tangible, and material benefit to the bankruptcy estate.”  See Baron & Newburger, P.C. v. Texas Skyline, Limited (In re Woerner), Case No. 13-50075 (5th Cir. April 9, 2015).  This prior holding often lead to a hindsight approach, where professional fees could be challenged and denied based–not on the hard work performed by a professional–but rather on the actual results of the case.  In the recent opinion, the Fifth Circuit reversed course and adopted a more reasonable, prospective approach, which focuses on whether the professional services were objectively beneficial towards the completion of a bankruptcy case at the time the services were performed.  This holding adopts the view of most of the sister federal circuit courts of appeal and is consistent with the text and legislative history of the Bankruptcy Code.  It also spells a sigh of relief to all bankruptcy practitioners within this jurisdiction.

Common Scenario

As is well-known, there are different types of bankruptcy relief that a financially distressed company or individual can seek.  For most companies, the choices are generally limited to liquidating the company in chapter 7 or reorganizing under chapter 11.  The first choice, which requires the appointment of a trustee to manage and liquidate the company, usually results in a short-term existence, while the latter, which allows existing management to stay in place and formulate a reorganization plan, contemplates the continuation of the company on a long-term basis.

Due to miscalculation, unwarranted optimism, misfortune or fear, companies often pursue a reorganization under chapter 11, when there is not a high chance of success.  In doing so, they hire professionals to engage in an expensive chapter 11 process, and the professionals, who owe a duty to the company, often do their best to keep the optimism alive.

The bubble finally bursts, however, when the bankruptcy court loses optimism in the debtor’s ability to reorganize on its own.  That realization may occur 30 days, 90 days, 6 months, a year or two years after the bankruptcy case is commenced.  Between that time, the debtor’s professionals often provide significant services either trying to convince the company to re-evaluate its approach or litigating with creditors and other parties that are throwing stones at the debtor.

What happens then to the professionals when the bankruptcy court finally loses hope?  Are they guilty by association for delaying a case?  Are these professionals who waited to be paid because of the Bankruptcy Code’s intricate compensation procedures ultimately entitled to recover their unpaid fees once the bankruptcy court decides to appoint a trustee to take over the management of the debtor?

This unfortunate situation often leaves the bankruptcy professional in an uphill battle to collect its earned but unpaid fees.  It is hard for such a professional to demonstrate that–despite its best efforts–its services actually provided a material benefit to an estate whose prognosis has turned for the worse.  In such situations, it becomes easier for creditors to argue that all of the professional’s efforts merely delayed the process and added an extra layer of administrative expenses to the detriment of the bankruptcy estate.

This common scenario became a reality in the Woerner case.

Woerner Case

In Woerner, the debtor filed for chapter 11 relief on the eve of a state court entering a major judgment against him.  The state lawsuit alleged that the debtor had breached a partnership agreement and his fiduciary duties to an investor, by misappropriating funds belonging to the partnership. The state court had already ruled against the debtor on liability and was scheduled to rule on the damages incurred by the investor, when the debtor filed bankruptcy to avail himself of the automatic stay, which would prevent the lawsuit from moving forward.

After commencing the bankruptcy case, the debtor mistakenly believed that the plaintiff in the lawsuit would stop litigating against him.  The plaintiff did not, initiating an adversary proceeding to determine that its debt was non-dischargeable and moving for relief from the automatic stay so that the state court lawsuit could proceed to final judgment.  In addition, another active creditor commenced a separate adversary proceeding against the debtor.

During the chapter 11 proceeding, the law firm of Barron and Newburger, as bankruptcy counsel, assisted the debtor in complying with its numerous obligations under the Bankruptcy Code and in vigorously defending against the multiple allegations being made against the him by multiple parties. This fighting continued for approximately 11 months until the bankruptcy court finally decided, upon motion by one of the debtor’s adversaries, that the debtor had inappropriately attempted to conceal assets from the bankruptcy estate.  The court then converted the case to chapter 7 and appointed a chapter 7 trustee.

Once the case was converted and a trustee was appointed, the debtor no longer managed the administration of the case and the law firm was dismissed of any further duties to continue representing the debtor in the bankruptcy case.  However, the law firm was still owed approximately $134,000.00 for all the services it had provided the debtor during the course of 11 months.  As is normally the case, the law firm filed a fee application with the bankruptcy court to collect all of its fees, but this application met with firm opposition by the United States Trustee (an oversight official) and the debtor’s adversaries.  The latter claimed that the requested fees were unreasonable because (a) the debtor never held sufficient funds to proceed under chapter 11 and (b) the law firm’s assistance was dilatory and added an extra layer of administrative expense to the already nimble bankruptcy estate.

The bankruptcy court ultimately denied most of the law firm’s fee request, awarding only 85% (or $19,409.00) of the total fees requested. In doing so, the bankruptcy court relied on the Fifth Circuit’s holding in the Pro-Snax case, where the higher court found that a bankruptcy court could deny compensation of professional fees, pursuant to section 330 of the Bankruptcy Code, if the underlying services provided did not amount to an “identifiable, tangible and material benefit” to the bankruptcy estate.  See 157 F.3d at  426.  In the Woerner case, finding that most of the services provided by the law firm did not amount to success, the bankruptcy court felt that such services were not compensible, using the standard adopted in Pro-Snax.

Two subsequent appeals ensued until the matter finally stood before the Fifth Circuit Court of Appeals.

Fifth Circuit Decision

On appeal to the Fifth Circuit, the law firm argued that the material benefit standard enunciated in Pro-Snax conflicted with the text of section 330 of the Code and also was at odds with most of the Fifth Circuit’s sister circuits.  The Fifth Circuit agreed.

The Court first analyzed the language in the Bankruptcy Code, finding that the plain text of section 330 provides, in relevant part, that a bankruptcy court:

  • should “consider the nature, the extent, and the value of” the services, taking into account several factors, including “whether the services were necessary to the administration of, or beneficial at the time at which the service was rendered toward the completion of a case . . .;” and
  • cannot award compensation for certain services, including those that were not “reasonably likely to benefit the debtor’s estate.”

(citing 11 U.S.C.  § 330(a)(3) and (4)(A)(ii)).  Reading these two provisions together, the Court found that section 330 allows compensation for services that are reasonably likely to benefit a bankruptcy estate, determined as of the time the services were rendered; not at a later point in time after the bankruptcy case has tanked.  According to the Court:

The statute permits a court to compensate a [professional] no only for activities that were “necessary,” but also for good gambles–that is, services that were objectively reasonable at the time they were made–even when those gambles do not produce an ‘identifiable, tangible, and material benefit.’  What matters is that, prospectively, the choice to pursue a course of action was reasonable.

The Court found support of its position in the legislative history of section 330, which was enacted in 1978 to relax the previously stringent standard used by bankruptcy courts in awarding professional fees.  The policy behind the prior stringent standard was that bankruptcy cases should be administered as efficiently as possible and professionals who were retained acted as officers of the court–not as private individuals–and therefore should not expect to be compensated as private individuals.  The Court noted that in enacting section 330, Congress moved away from the prior strict regime of awarding fees and intended to compensate professionals commensurate with what other professionals earned outside of bankruptcy.  (citing In re UNR Indus., Inc., 986 F.2d 207, 208-209 (7th Cir. 1993) (citing  H.R. Rep. No. 95-595, at 329-30 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6286.))  Significantly, the Court also reasoned that Congress took additional steps in this direction through the 1994 amendments to the Code, which inserted the new factors found in sections 330(a)(3) and (a)(4) (cited above).

Finally, the Court found that after the 1994 amendments to the Code, the Second, Third and Ninth Circuit Courts of Appeal rejected the actual benefits test set forth in Pro-Snax, in favor of the more reasonable prospective approach.  These other Circuits reasoned that the actual benefits test (a) was not consistent with the text in section 330, (b) resulted in fee evaluations by hindsight, and (c) was inconsistent with the legislative history of section 330.  Finding more support in the other Circuits’ reasoning than in the Pro-Snax opinion (which relied on antiquated law), the Court adopted the more reasonable prospective approach used by the other Circuits.

Under the new standard adopted in Woerman, “if a fee applicant establishe[s] that its service were ‘necessary to the administration’ of a bankruptcy case or ‘reasonably likely to benefit’ the bankruptcy estate ‘at the time at which [they were] rendered’ . . . ‘then the services are compensable,'” pursuant to sections 330(a)(3) and (a)(4) of the Code.

Further Insight

While the Woerman opinion represents an enormous break from the prior practice within the Fifth Circuit, the opinion still reminds practitioners that not all services provided must be compensated under the new prospective approach.  Rather, the “reasonably likely to benefit” the estate standard will still allow bankruptcy courts to consider factor such as

  • the probability of success when services were rendered;
  • the reasonable costs of pursuing certain actions;
  • what services a reasonable professional would have performed under the circumstances;
  • whether the professional services could have been rendered by a trustee; and
  • the potential benefits of the services to a bankruptcy estate (as opposed to individuals)

Thus, even under the new Fifth Circuit standard, whether services are ultimately successful is still relevant, but not dispositive, of professional compensation.  Professionals in failed cases then are still going to be required to justify their actions during the course of a chapter 11 proceeding.  And a bankruptcy court is still not prohibited from using some hindsight in evaluating the reasonableness of those services at the time they were performed.  But, hopefully everyone will realize the new direction that the Fifth Circuit wants us to take.

Chapter 11 Plan Adequately Reserved Bankruptcy Rights Transferred to a Liquidating Trust


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The United States Bankruptcy Court of the Northern District of Texas recently held that a confirmed chapter 11 plan of a liquidated company, R.L. Adkins Corp. (the “Corporation”), was not required to specifically preserve bankruptcy-created rights of the Corporation against its former principal.  See Harvey L. Morton v. Robert Lewis Adkins, Sr. (In re Robert Lewis Adkins, Sr.), Adversary No. 13-01028 (Bankr. N.D.T.X. March 27, 2015.)  In doing so, the Bankruptcy Court analyzed the Fifth Circuit Court of Appeals‘ precedent in Dynasty Oil & Gas, LLC v. Citizens Bank (In re United Operating, LLC), 540 F.3d 351 (5th Cir. 2008) and the text of the Bankruptcy Code.

R.L. Adkins Bankruptcy

The Corporation was initially placed in an involuntary chapter 7 liquidation proceeding, but a month later converted to a chapter 11 reorganization case.  In a chapter 11 case, the management of a debtor normally maintains control and operations of the company during the reorganization process, subject to certain restrictions under the Bankruptcy Code.  See 11 U.S.C. §§ 1107 and 1108. In other words, a chapter 11 debtor is generally allowed to operate in the same manner it operated outside of bankruptcy.

In R.L. Adkins Corp.’s case, however, three months after the case was converted to chapter 11, the Bankruptcy Court appointed a trustee to take over the control and operations of the Corporation, pursuant to 11 U.S.C. §  1104.  Generally, the appointment of a trustee in a chapter 11 case is a drastic remedy and requires a finding that the debtor, under existing management, has exhibited a practice of not complying with the various obligations and duties under the Bankruptcy Code.  That appeared to be the case in R.L. Adkins Corp.’s case.  The Bankruptcy Court nonetheless believed that it was in the best interest of creditors for the bankruptcy case to proceed under chapter 11, instead of a chapter 7 liquidation.

Several years later the Bankruptcy Court confirmed (approved) the a chapter 11 plan, which had been proposed, not by the chapter 11 trustee, but one of the Corporation’s creditors (who was out a fair amount of money).  The chapter 11 plan established a liquidating trust that, upon plan confirmation, was transferred and received all the assets in the bankruptcy estate of the Corporation, including all potential claims and causes of action of the Corporation against third parties (the “retained claims”).  The purpose of the liquidating trust was to liquidate all of the assets of the Corporation, including prosecuting the retained claims, and ultimately make a distribution to creditors from those liquidated assets.

The chapter 11 plan defined retained claims as “all estate causes of action belonging to the Debtor and estate based on federal or state law, and any claims, counterclaims, rights, defenses, setoffs, recoupments, and actions in law or equity arising under the Bankruptcy Code or applicable non-bankruptcy law.”  The plan then illustrated a number of claims that were retained claims, including claims for breach of fiduciary duty and common law actions.

Principal’s Bankruptcy

Separate and apart from R.L. Adkins Corp.’s bankruptcy, the owner of the Corporation separately filed for chapter 7 bankruptcy relief.  The purpose of an individual chapter 7 bankruptcy case is to distribute all non-exempt assets of the debtor to his or her creditors and allow the debtor to obtain a discharge of all of his or her pre-bankruptcy debts.

Section 523 of the Bankruptcy Code, however, excepts certain pre-bankruptcy debts from being discharged. Examples of non-dischargeable debts include certain tax liabilities, fraud claims, breach of fiduciary duty claims and other claims that public policy disfavors discharging (e.g., child support obligations).

In the principal’s individual bankruptcy,  the liquidating trustee appointed under the Corporation’s confirmed plan filed an action against the principal to determine that certain claims that the Corporation had against the principal were non-dischargeable, pursuant to section 523(a)(4) and (a)(6) of the Bankruptcy Code.  These claims revolved around the principal’s alleged breach of fiduciary duty to the Corporation.

In the non-dischargeability action, the principal moved to dismiss the liquidating trustee’s claims for lack of subject matter jurisdiction, based on the fact that the Corporation’s confirmed plan did not specifically mention that non-dischargeability claims under the Bankruptcy Code were included as retained claims.  The Bankruptcy Court was left to decide this issue pursuant to guiding Fifth Circuit precedent and section 1123(b) of the Bankruptcy Code.

Four Quarners of Plan

In Dynasty Oil & Gas, LLC v. Citizens Bank (In re United Operating, LLC), the Fifth Circuit held that

[f]or a debtor to preserve a claim, the [chapter 11] plan must expressly retain the right to pursue such actions.

540 F.3d at 355.  According to the Fifth Circuit, the reservation in the plan must be “specific and unequivocal.”  See id.  In other words, a blanket and generic reservation of all claims is not proper.  See id. at 356.  More recently, the Fifth Circuit relaxed the standard for reserving a claim, finding that a bankruptcy court may review other material, in addition to the plan, like solicitation material associated with the plan (i.e., disclosure statement), to determine whether a claim is properly reserved. See Spicer v. Laguna Madre Oil & Gas II, LLC (In re Texas Wyoming Drilling, Inc.), 647 F.3d 547 (5th Cir. 2011).   In Spicer, the Fifth Circuit held that a plan properly reserved avoidance claims when it reserved “claims under Chapter 5 of the Bankruptcy Code” and the related disclosure statement described “various potential avoidable transfers that can be recovered under Chapter 5.”  See id at 549, 552.

The requirement to properly reserve a claim derives from section 1123(b)(3) of the Bankruptcy Code, which specifically provides that a chapter 11 plan may provide for “the retention and enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose, of any claim or interest [belonging to the debtor or its estate].”  See 11 U.S.C. § 1123(b)(3) (emphasis added).

The policy underlying the proper reservation of claims is grounded on “the nature of a bankruptcy, which is designated to secure prompt, effective administration and settlement of all debtor’s assets and liabilities within a limited time.”  See Union Operating, 540 F.3d at 355.  “To facilitate this timely, comprehensive resolution of an estate, a debtor [or trustee] must put its creditors on notice of any claim it wishes to pursue after confirmation.”  Id.  Creditors are entitled to notice either because the claims would enlarge the bankruptcy estate (and thus provide a higher recovery) or the creditors might be targets under the plan.  This enables creditors to properly vote on the chapter 11 plan, a requirement for plan confirmation.  See In re Gulf States Long Term Acute Care of Covington, LLC, 487 B.R. 713, 715 (Bankr. E.D. La. 2013).

Application of Fifth Circuit Precedent

In the principal’s chapter 7 bankruptcy, using guiding Fifth Circuit precedent and the text of section 1123(b)(3), the Bankruptcy Court found that the Corporation’s plan did specifically reserve breach of fiduciary duty claims, such as those that the liquidating trustee was ultimately pursuing (after the prosecution of the non-dischargeability action).  While the plan did not specifically reserve a non-dischargeability action, the Bankruptcy Court found that such an action did not amount to a claim (i.e., a right to payment), as defined in section 101(5)(A) of the Code.  Instead, such action merely determines whether an underlying claim is dischargeable in bankruptcy.  Because the non-dischargeability action was not seeking a right to payment, the Bankruptcy Court held that it was not a claim and did not fall within the parameters of section 1123(b)(3), which uses the word “claim” when describing what a chapter 11 plan can reserve.  Therefore, according to the Bankruptcy Court, the chapter 11 plan was not required to specifically reserve this type of action.

Further Insight

While the Bankruptcy Court was correct in determining that section 1123(b)(3) uses the term “claim” and does not expressly require reservation of non-dischargeability actions pursuant to section 523 of the Bankruptcy Code, arguably the Court ignored that section 1123(b)(3) provides for the reservation of both “claims” and “interests.”   Unlike the term “claims,” the term “interests” is not defined in the Bankruptcy Code and generally is understood to have a broader meaning.  Thus, some may wonder why having an underlying claim, like breach of fiduciary duty, deemed non-dischargeable is not a valuable “interest” that belongs to a debtor or its bankruptcy estate.  If it is, then section 1123(b) and leading Fifth Circuit precedent would require proper reservation.

On the other hand, if a non-dischargeability action is merely an extension of the underlying claim (which will be pursued later), then why wouldn’t the specific mention of the underlying claim suffice to reserve the related non-dischargeability action?  In addition, if the Fifth Circuit’s Spicer opinion holds that a description of “claims under Chapter 5 of the Bankruptcy Code” is sufficient to reserve such claims, then why wouldn’t the R.L. Adkins Corp.’s reservation of “all rights . . . under the Bankruptcy Code” be sufficient?  Unfortunately, these questions were not addressed in the Bankruptcy Court’s opinion, but hopefully they will be addressed in future opinions. Until then, stay tuned.


Biggest Texas Utility Files Bankruptcy


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Utility pixToday, Energy Future Holdings Corp. (“EFH“), a Texas corporation, and several of its subsidiaries, including TXU Energy (collectively with EFH, the “Debtors“), filed for chapter 11 bankruptcy relief.  The Debtors are the largest generator, distributor and certified retail provider of electricity in Texas.  The Debtors disclosed approximately $42 billion in funded indebtedness and EFH disclosed total assets of approximately $36.4 billion in book value.  EFH’s consolidated annual revenues for the year ending December 31, 2013, were approximately $5.9 billion.  Along with non-Debtor subsidiaries, the Debtors employ approximately 9,100 people.

Financial Restructuring

The Debtors mentioned in their “first day” papers that while their operations (i.e., Luminant, TXU Energy and Oncor) are strong, their balance sheets are over-leveraged.  Thus, chapter 11 bankruptcy provides them with an opportunity to restructure their balance sheets (and thus become more profitable in the future), while maintaining their current positions as leaders in the Texas electricity market.

Why Not Texas

This mega bankruptcy case was filed in Delaware.  However, Wilmington Savings Fund Society, FSB, the indenture trustee for certain senior secured second lien notes, filed a motion to transfer the venue of the bankruptcy cases to the United States Bankruptcy Court for the Northern District of Texas, arguing, among other things, that (a) the Debtors, as a whole, have very thin ties to Delaware. (b) the Debtors’ headquarters are located in the Northern District of Texas (i.e., Dallas, Texas) and (c) substantially all of the Debtors’ assets, employees and customers are located in Texas.

Delaware Courts are very familiar with these types of venue requests.  In general, the Bankruptcy Code provides very generous venue provisions that allow most debtors the choice of where to initiate a case.  So, do not be surprised if the case stays in Delaware.  However, this factor should bear little weight on the restructuring of the Debtors, as the Bankruptcy Code provides a uniform set of laws for all federal courts to follow and those laws are only supplemented somewhat by the judicial decisions generated by each jurisdiction.  Once the legal issues in the case surface, this may reveal more about the rationale behind the selection of venue.

In the meantime, it is highly unlikely that anyone in Texas (or any part of the world) will need to turn his or her lights off.

Retailer of Luxury Gadgets Files Prenegotiated Chapter 11


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On April 3, 2014, Brookstone Holdings Corporation and its affiliates (“Brookstone” or “Company”), developers and sellers of unique and high quality household products, filed a prenegotiated chapter 11 bankruptcy in Delaware.  See In re Brookstone Holdings Corporation, Case No. 14-10752 (Bankr. D. Del.).  But, don’t worry.  The seller of $4,000 massage chairs does not appear to be going away.  Rather, it has negotiated a deal with its secured noteholders to sell the company as a going concern through a court-supervised bankruptcy auction.


Headquartered in Merrimack, New Hampshire, Brookstone was founded in 1965 as a catalog company offering “hard-to-find tools.”  In 1973, Brookstone opened its first retail store in Peterborough, New Hampshire. Today, the Company operates 242 stores across the United States, including 47 commonly seen at airports.  While the retail segment constitutes approximately 70% of net sales, Brookstone’s product distribution also includes (a) consumer sales through traditional catalogs, e-Commerce and its website and (b) wholesale distribution to select resellers and corporate partners.

At its peak in 2007, Brookstone generated net sales of $563 million and adjusted EBITDA of $59 million.  The tepid pace of economic recovery following the 1998 recession, however, hampered Brookstone’s efforts to restore its performance to pre-recession levels.  Below is a snapshot (taken from bankruptcy filings) of Brookstone’s financial performance for the past decade through its three distribution channels (retail, catalog/e-Commerce and alternative distributions).

According to its current President, James M. Speltz, “Brookstone entered the economic downturn with a highly levered capital structure, and in an attempt to navigate the challenging environment, undertook a number of strategic initiatives to improve its cost structure, aimed primarily at boosting short-term performance and liquidity.”  These effort included:

  • eliminating unprofitable stores,
  • reducing overhead,
  • streamlining product development, and
  • cutting investment into marketing/customer acquisition.

The cuts in investment included a 50% cut in catalog circulation, which negatively impacted revenues in a significant way.  Mr. Speltz believes that as a result of these strategic initiatives, which included a 60% decrease in capital spending, “Brookstone’s stores became dated, a void was created in new merchandising, and its customer base was weakened.”  In addition, Brookstone’s various leadership changes during the past 7 years resulted in a lack of long-term strategic planning.

In 2010, the Company sought to de-lever its balance sheet through an exchange of its second lien notes for cash (invested by Brookstone’s shareholders) and replacement notes.  In 2011, Brookstone also repurchased outstanding 2012 second lien notes.  As a result, Brookstone’s noteholder debt decreased from approximately $170,000,000 to $126,500,000.  However, the remaining second lien notes would still mature in October 2014, and Brookstone was also required to make a substantial interest payment on these notes on January 15, 2014.

In Fiscal 2013, Brookstone implemented several additional cost cutting programs, including a reduction in staff and overhead expenses, in an effort to save approximately $25.8 million in annual expenses.  The Company also began re-establishing long-term growth initiatives by investing in store productivity training and modestly increasing catalog circulation.  Despite these and other efforts, however, Brookstone was unable to increase revenues and generate net income in amounts necessary to satisfy its near term debt maturities.

By the end of December 2013, it became clear to Brookstone that holiday sales would be substantially less than expected and that EBITDA would also be disappointing. Faced with a looming interest payment on, and near-term maturity of, the second lien notes, the Company engaged legal and financial advisors and began restructuring discussions with their creditors.

With the aid of investment bankers and other financial advisors, Brookstone embarked on a “dual track” strategy, pursuant to which (a) it pursued a comprehensive marketing process for the sale of Brookstone’s businesses, while (b) simultaneously negotiating with holders of second lien notes regarding a possible balance sheet restructuring (either in or outside of bankruptcy).  A the same time, the Company and its senior secured lenders lead by Wells Fargo Bank, which were owed approximately $50 million, entered into a written agreement, whereby the senior lenders agreed to forebear taking collection action or exercising their rights in the Debtors’ assets during the sale and restructuring initiatives.  This was a crucial aspect of the achieving success, because the senior lenders held first-priority liens on all of Brookstone’s assets and the Company’s financial position vis-a-vis the noteholders likely entitled the senior lenders to exercise their rights against these assets, which may have jeopardized the Company’s ability to restructure and realize a greater value for its other constituencies.


The contemplated restructuring seeks to achieve a deleveraging of Brookstone’s balance sheet through two main aspects.  First, Wells Fargo’s senior credit facility will be refinanced through a postpetition loan made by the second lien noteholders and $30 million of the second lien notes will be rolled up into postpetition debt.  Second, while the second lien noteholders initially proposed to convert their debt to 100% equity in the Company, Brookstone ultimately chose to enter into an agreement to sell the Company to Spencer Spirit Holdings, Inc., though one of its affiliates.  The majority of the sale proceeds will be used to take out most of the remaining debt to the second lien noteholders.

Pursuant to the resulting stock purchase agreement, the buyer has agreed to pay a purchase price of approximately $146,265,000 million, including $120 million in cash.  To ensure that maximum value for Brookstone, the buyer also agreed to allow his purchase price to be market tested through a competitive, bankruptcy auction process, which will be supervised by a bankruptcy court.  Brookstone believes that the buyer’s stalking horse bid and resulting auction will ultimately bring the highest value for its assets.

The contemplated restructuring is supported by a restructuring support agreement between the Company and the majority of second lien noteholders, pursuant to which Brookstone  agrees to (a) commence its chapter 11 bankruptcy; (b) obtain approval for the post-petition financing facility with the noteholders, and (c) obtain confirmation and implementation of a plan of reorganization that will be consistent with the terms and conditions of the restructuring support agreement and related term sheet with the noteholders.

The chapter 11 filing is also supported by a plan sponsorship agreement between Brookstone and Spencer, whereby Spencer agrees to acquire the Company at the agreed purchase price and pursuant to a stock purchase agreement, subject to a bankruptcy auction.  The plan support agreement also incorporates the terms of the restructuring support agreement with the second lien noteholders.

As currently contemplated by this restructuring, the senior noteholders are allotted the majority of cash from the sale of Brookstone.  However, such proceeds will likely not satisfy all of their prepetition claims, leaving them with deficiency claims that otherwise will be discharged and only partially satisfied through the plan.  General unsecured creditors are currently allotted $1 million from the sale proceeds.  Brookstone’s former shareholders will receive no recovery and their equity interests will be extinguished.  It appears that most of the other creditors of Brookstone will not be impaired.

Because Brookstone’s sale will be subject to a bankruptcy auction, there always exists the possibility that more value could be realized to provide additional recoveries to creditors.  Still, hope should be tempered by the fact that the sale was already market tested by investment bankers prior to the bankruptcy.

But, as this is a prenegotiated bankruptcy and not a prepackaged bankruptcy, details are always subject to refinement when a chapter 11 plan is proposed and creditors have an opportunity to vote and scrutinize such plan.  (For more discussion regarding the facets of prepackaged plans, see Reddy Ice to Exit Bankruptcy and Premier Publisher School Books Files Bankruptcy.)  As of yet, Brookstone has not yet filed a proposed plan, and most of the contemplated recoveries (except for equity, which is clearly out of the money) are only outlined briefly in the various plan support agreements entered into with Spencer and the second lien noteholders.  In the end, however, the chapter 11 bankruptcy process inherently generates discussion amongst the various constituencies of a debtor regarding the slice of pie that they are entitled to receive.

Tenth Circuit Upholds Recharacterization of Debt to Equity


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While not expressly authorized by the Bankruptcy Code, it is generally well-established that a bankruptcy court, as a court of equity, is not bound by a party’s characterization of a transaction and, instead, may recharacterize the nature of the transaction, acknowledging the economic realities involved.  The prime example occurs in instances where an insider purports to loan money to a debtor, but the loan is in essence a disguised equity contribution.  Based on case law in most jurisdictions, a bankruptcy court may recharacterize such a loan as an equity contribution.

In Redmond v. Cimarron Energy Co. (In re Alternate Fuels , Inc.), No. KS-12-110 (B.A.P. 10th Cir. Mar. 18, 2014), the Bankruptcy Appellate Panel (“BAP”) for the Tenth Circuit Court of Appeals recently upheld a bankruptcy court’s authority to recharacterize, notwithstanding arguments that the U.S. Supreme Court recently curbed a bankruptcy court’s authority to act outside the confines of the express language of the Bankruptcy Code.

Loan versus Equity

A “loan” is a sum of money advanced to a borrower for a specified period and repayable with agreed interest.  Typically, the amount loaned, the terms of repayment, and the interest are agreed up front when the money is loaned. Advances, interest rates, and repayment terms are not customarily left to the discretion of the lender.  The lender’s right to receive repayment is supported by consideration (money loaned) and accounted for with contemporaneous records. In short, the amount loaned and the amount to be repaid are readily calculable at the beginning of the transaction, and the obligation to repay is not conditional.

On the other hand, “equity” is an investment – an expenditure of money – in order to earn a financial return.  The amount of financial return is unknown and the entitlement to receive payment is conditional.   The amount of payment received may be unrelated to the amount advanced or may be received in exchange for little consideration.

The characterization of a transaction as a loan or equity contribution is important in bankruptcy because of the priority scheme set forth in the Bankruptcy Code.  Pursuant to that priority scheme, equity is generally not entitled to a recovery from a bankruptcy estate unless all creditor claims are satisfied.  See 11 U.S.C. § 1129(b).


In 1999, a husband and wife (the “Insiders”) became the indirect holders of all of the stock in Alternate Fuels Inc. (AFI).  The acquisition of these interests apparently was a strategic move to realize the value of the assets of AFI and an affiliated entity (Cimmaron), without being subject to all of the liabilities of AFI.  After acquiring AFI, the two Insiders purported to loan certain funds to AFI and, in return, received three promissory notes eventually secured by an assignment of potential litigation proceeds.  When AFI obtained a favorable judgment, it filed chapter 11 bankruptcy to facilitate a distribution of the litigation proceeds to its creditors.  A chapter 11 trustee was thereafter appointed.

In order to obtain a larger recovery to non-insider creditors, the chapter 11 trustee challenged the Insiders’ claims, arguing that the Insider loans were disguised equity contributions.  The bankruptcy court agreed with the trustee, finding, among other things, that there was insufficient documentation of the loan terms and the loans provided no benefit to AFI and instead were intended to obtain a recovery on the Insiders’ investment.  As a result, the loans (or equity contributions) became subordinate to the claims of other unsecured creditors of AFI.  The Insiders appealed this decision to the Tenth Circuit BAP.

Read the Text

On appeal, the Insiders argued that two recent U.S. Supreme Court opinions limited the bankruptcy court’s ability to recharacterize.  They first cited to Travelers Casualty & Surety Company of America v. Pacific Gas & Electric Company, 549 U.S. 443 (2007), where the Supreme Court held that “we generally presume that claims enforceable under applicable state law will be allowed in bankruptcy unless they are expressly disallowed,” pursuant to section 502(b) of the Code.  The Insiders contended that Travelers precludes recharacterization unless recharacterization is allowed by applicable state law.  Because in this instance applicable state law (Kansas) does not recognize recharacterization, the Insiders argued that their claim was enforceable under applicable state law and therefore could not be disallowed by an equitable federal doctrine (recharacterization), which is not expressly found in the Bankruptcy Code.

The Insiders next cited to the more recent opinion of Law v. Siegel, No. 12-5196, 571 U.S.___, 2014 WL 813702 (Mar. 4, 2014) (slip opinion), where the Supreme Court held that a bankruptcy court’s inherent powers pursuant to section 105(b) of the Code could not contravene express provisions of the Code.  For a recent discussion of the Siegel decision, see SCOTUS Restricts Inherent Bankruptcy Authority.

BAP Decision

The Tenth Circuit BAP rejected the Insiders’ arguments.  The BAP first distinguished the recharacterization remedy from the allowance or disallowance of claims proscribed in the Travelers and Siegel cases.  According to the BAP, recharacterization is not based on the enforceability of a claim; rather it is based on establishing the true substance of a transaction.  In other words, recharacterization is not a determination of whether a claim should be allowed or disallowed; it is a determination of whether a claim should be treated as a claim or an equity interest.  On the other hand, when a claim is disallowed under section 502 of the Code, it is essentially not recognized in the bankruptcy case.  If a claim is recharacterized, however, it is still recognized in the bankruptcy case, but is simply treated as an equity interest.

The BAP then reasoned that the Travelers and Siegel decisions did not deal with recharacterization of transactions and therefore neither opinion implicitly or expressly abrogated this equitable doctrine.  In doing so, the BAP found some support from the Fourth Circuit Court of Appeals’ opinion in In re Official Committee of Unsecured Creditors for Dornier Aviation (North America), Inc., 453 F.3d 225 (4th Cir. 2006).  There the Fourth Circuit held that:

[D]enying a bankruptcy court the ability to recharacterize a claim would have the effect of subverting the Code’s critical priority system by allowing equity investors to jump the line and reduce the recovery of true creditors. In light of the broad language of § 105(a) and the larger purpose of the Bankruptcy Code, we believe that a bankruptcy court’s power to recharacterize is essential to the proper and consistent application of the Code.

The BAP ultimately applied the thirteen factors announced by the Tenth Circuit in Sender v. Bronze Group, Ltd. (In re Hedged-Investments Associations., Inc.), 380 F.3d 1292 (10th Cir. 2004).  These nonexclusive factors include:

  1. the names given to the certificates evidencing the indebtedness;
  2. the presence or absence of a fixed maturity date;
  3. the source of payments;
  4. the right to enforce payment of principal and interest;
  5. participation in management flowing as a result;
  6. the status of the contribution in relation to regular corporate creditors;
  7. the intent of the parties;
  8. “thin” or adequate capitalization;
  9. identity of interest between the creditor and stockholder;
  10. source of interest payments;
  11. the ability of the corporation to obtain loans from outside lending institutions;
  12. the extent to which the advance was used to acquire capital assets; and
  13. the failure of the debtor to repay on the due date or to seek a postponement.

The purpose of these factors is to “distinguish true debt from camouflaged equity” by determining whether certain facts are more supportive of a loan or equity transaction.  However, the Tenth Circuit recognizes that these factors are not dispositive and their applicability and weight depend on the circumstances.

The BAP’s detailed and lengthy application of the Hedge-Investments factors is best explained in Redmond opinion itself.  To summarize that opinion, the BAP found that the totality of circumstances surrounding the Insiders’ loans supported recharacterization, as the Insider loans were either used to (a) acquire interests in AFI or (b) allow AFI to meet certain obligations that would release encumberances in certain assets that otherwise were available to AFI’s equity owners.  Thus, the BAP concluded that AFI received no economic benefit from the loans and the only purpose of the loans was to benefit the beneficial owners of AFI (i.e., the Insiders).


Because of the particular facts in Redmond, the BAP appeared reluctant to expand the holdings in Travelers and Siegel to abolish the equitable doctrine of recharacterization, even though such doctrine is not codified in the Bankruptcy Code. The BAP seemed focused on preserving the priority scheme set forth by the Bankruptcy Code and preventing abuse by equity owners attempting to take advantage of their unique positions with a debtor by disguising their true interests.

Whether other Circuit Courts will agree with the analysis remains to be seen.  In the future, however, the Siegel holding should raise less concerns, because that case involved a bankruptcy court order that directly contravened a Bankruptcy Code provision; namely, surcharging an exempt asset, in violation of section 522 of the Code.  Recharacterization, however, is not expressly proscribed by the Bankruptcy Code.  The holding in Travelers presents a more difficult question, because there the Supreme Court seems to suggest that section 502 allows any claim enforceable under state law unless expressly prohibited by the Code.  Significantly, section 502 of the Code–or any other provision–does not expressly prohibit a claim on recharacterization grounds.

Nonetheless, even if Travelers presents an obstacle in the future, there may exist multiple other state law arguments, like fraud, misrepresentation, or, in certain jurisdictions, recharacterization, that would still preserve the ability to disallow disguised transactions by insiders.

SCOTUS Restricts Inherent Bankruptcy Authority


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In Law v. Siegel, 571 U.S. ___ (2014) (slip opinion), the Supreme Court of the United States invalidated a bankruptcy court’s use of its inherent authority to tax (surcharge) a debtor’s exempt property with legal expenses incurred by a chapter 7 trustee during a bankruptcy case.  In doing so, the Supreme Court reminded us that a bankruptcy court cannot use its inherent authority to circumvent specific provisions the legislature imbedded into the Bankruptcy Code.


The Debtor Stephen Law (“Debtor”) filed for chapter 7 bankruptcy relief in 2004.  Upon filing, a chapter 7 trustee was appointed (“Trustee”).  Chapter 7 of the Bankruptcy Code generally allows an insolvent debtor the opportunity to discharge his or her debts by liquidating assets to pay the debtor’s creditors. 11 U. S. C. §§ 704(a)(1), 726, 727.  The filing of a bankruptcy petition under chapter 7 creates a bankruptcy “estate” comprising all of the debtor’s property.  See 11 U.S.C. § 541(a)(1).  The estate is placed under the control of a trustee, who is responsible for managing liquidation of the estate’s assets and distribution of liquidation proceeds to the debtor’s creditors. See 11 U.S.C. § 704(a)(1).

The Bankruptcy Code authorizes a debtor to “exempt,” however, certain kinds of property from the estate, enabling the debtor to retain those assets post-bankruptcy.  See 11 U.S.C. § 522(b)(1).  Except in particular situations under the Bankruptcy Code, exempt property is not liable for the payment of any pre-bankruptcy debt or any “administrative expense” incurred during the bankruptcy case.  See 11 U.S.C. § 522(c), (k).

Section 522(d) of the Bankruptcy Code provides a number of exemptions unless they are specifically prohibited by state law.  See 11 U.S.C. § 522(b)(2), (d). One exemption, commonly known as the “homestead exemption,” protects up to $22,975 in equity in the debtor’s residence.  See 11 U.S.C § 522(d)(1) and note following §522; see also Owen v. Owen, 500 U. S. 305, 310 (1991).  The debtor may elect, however, to forgo the Bankruptcy Code’s exemptions and instead claim whatever exemptions are available under applicable state or local law.  See 11 U.S.C. § 522(b)(3)(A).  Some States provide homestead exemptions that are more generous than the federal exemption; some provide less generous versions; but nearly every State provides some type of homestead exemption.

In this case, the bankruptcy estate’s only significant asset was the Debtor’s house in which the Debtor claimed equity of $75,000 that was exempt under California law.  See Cal. Civ. Proc. Code Ann. § 704.730(a)(1) (West Supp.2014).  The Debtor also represented that, due to two pre-bankruptcy liens on the house, there was no non-exempt equity in the house that could be recovered for the benefit of his other creditors.

The Alleged Sham

A few months after the Debtor filed bankruptcy, the Trustee initiated an adversary proceeding, alleging that one of the liens on the Debtor’s homestead was fraudulent and therefore should be avoided or extinguished.  If the Trustee was successful in his claim, this would theoretically leave approximately $160,000 in non-exempt equity in the homestead available to satisfy creditor claims. 

In 2009, the bankruptcy court agreed with the Trustee and found that the second lien on the homestead was created fraudulently, in order to disguise the Debtor’s equity in the homestead and perpetrate a fraud on creditors.  But, from a legal standpoint, fraud is expensive to discover.  The Trustee had incurred more than $500,000 in attorney’s fees to discover the fraud and prove it to the bankruptcy court’s satisfaction.  Appreciative of the Trustee’s efforts, the bankruptcy court allowed the Trustee to “surcharge” the entirety of the Debtor’s $75,000 homestead exemption, making those assets available to defray the Trustee’s legal fees.

The Debtor appealed the bankruptcy court’s surcharge, but, based on precedent from the Ninth Circuit Court of Appeals (see Latman v. Burdette, 366 F. 3d 774 (9th Cir. 2004)), the Bankruptcy Appellate Panel (“BAP”) upheld the bankruptcy court’s power to “equitably surcharge a debtor’s statutory exemptions” in exceptional circumstances such as “when a debtor engages in inequitable or fraudulent conduct.”  Also believing the Trustee’s actions were necessary to preserve the “integrity of the bankruptcy process,” the Ninth Circuit Court of Appeals affirmed the BAP decision, leading to an appeal to the Supreme Court.

Supremes’ Holding

The Supreme Court acknowledged, as it had in the past, that a bankruptcy court has statutory authority to “issue any order, process, or judgment that is necessary or appropriate to carry out the provision of the Bankruptcy Code,” pursuant to section 105 of the Bankruptcy Code.  See 11 U.S.C. § 105(a); Marrama v. Citizens Bank of Mass., 549 U. S. 365, 375– 376 (2007).  But the Supreme Court reiterated that, in exercising those statutory and inherent powers, a bankruptcy court may not contravene specific statutory provisions of the Code.  Indeed, the Supreme Court historically maintained that “whatever equitable powers remain in the bankruptcy courts must and can only be exercised within the confines of ” the Bankruptcy Code. See Norwest Bank Worthington v. Ahlers, 485 U. S. 197, 206 (1988); see, e.g., Raleigh v. Illinois Dept. of Revenue, 530 U. S. 15, 24–25 (2000);United States v. Noland, 517 U. S. 535, 543 (1996); SEC v. United States Realty & Improvement Co., 310 U. S. 434, 455 (1940).

In this case, the “surcharge” of the Debtor’s exempt property violated a specific provision of the Bankruptcy Code.  The Bankruptcy Code provides that exempt property is “not liable for any administrative expense” incurred during a bankruptcy case.  11 U.S.C. § 522(b)(3)(A)And since the Trustee’s legal expenses incurred in avoiding the second lien on the Debtor’s homestead were indubitably “administrative expenses,” they could not be surcharged against the Debtor’s exempt property per section 522(b)(3)(A).  The Supreme Court concluded therefore that the bankruptcy court’s ruling otherwise “exceeded the limits of its authority under section 105 and its inherent powers.”

State Law Exceptions Still Exist

While the Supreme Court found that the Bankruptcy Code could not circumvent California state law exemptions in this instance, it nonetheless recognized that any state law exemption’s scope is determined by state law and state law could otherwise provide that debtor misconduct could warrant denial of such exemption.  However, the Supreme Court found that a bankruptcy court has no authority to deny an exemption on grounds not existing under state law or specifically provided in the Code.