Reorg’s Court Opinion Review provides an update on recent noteworthy bankruptcy and creditors’ rights opinions, decisions and issues across courts. Today, we consider pessimistic assumptions in chapter 11, the effect of prior decisions on bankruptcy courts and the expiration of the automatic stay. Continue reading for the Americas Core Credit team's court opinion review of the bankruptcy failure bias, issue preclusion and the long arm of the automatic stay, and request a trial to access reporting and analysis of hundreds of other stressed, distressed and performing credits.
The Price of Pessimism
Back on Sept. 10, we discussed
the inventory valuation dispute in the Sears Holdings case and suggested that the outcome might stem from a sort of constitutional pessimism among bankruptcy judges and professionals. “Of course, bankruptcy judges have little experience with debtors that are able to sell their assets for a profit,” we wrote at the time. “That’s why companies are in bankruptcy, right? The amount of their debts exceeds the value of their assets.” Of course, the Sears case did not end happily for all, but that company’s collapse could be traced to larger economic trends - the “retail apocalypse,” the supposedly pernicious opportunism of private equity sponsors
, etc. The Covid-19 pandemic has brought a different kind of case into bankruptcy court lately, either out of desperation or opportunism - and these cases present an interesting way of considering the effect of a theoretical “failure bias” in our industry.
First, consider car rental giant Hertz. On Oct. 29, Judge Mary Walrath approved a $1.65 billion new-money DIP facility
for Hertz to fund, among other things, the acquisition of up to 229,000 new vehicles under a $4 billion ABS facility
. The DIP includes an $800 million working capital sublimit. Does Hertz need a committed $800 million in DIP financing at this point? The situation was dire when the debtors filed
on May 26. “[D]ried-up” demand for used vehicles and the “largely frozen” market for used cars put “substantial pressure on market depreciation rates,” requiring Hertz to pay an additional $135 million in April “to maintain access to funding at existing levels.”
By October, however, used car prices were 16% higher year over year, according to the Manheim Index
. The debtors’ initial DIP budget
includes only one $250 million draw on the facility, in the week of Nov. 6. The debtors’ latest monthly operating report
, for the period ending Sept. 30, showed a monthly cash burn of $66 million and $933 million in the bank, before the DIP was approved. This does not necessarily look like a company that needs a commitment for $800 million to fund operating expenses right now. Thomas Lauria of White & Case, the debtors’ counsel, told Judge Walrath at the DIP hearing that the proceeds should be sufficient for the debtors to “comfortably” operate through the end of 2021, which is “hopefully” “much longer than we will need” to exit chapter 11. So, the debtors have secured a commitment now to fund losses they may
incur well after
the debtors believe the case will be finished. And on Oct. 27, the debtors filed a motion
to place the proceeds of the DIP facility in a money market account at J.P. Morgan rather than in a deposit account that does not bear interest. This somewhat unusual request suggests that Hertz intends to hold on to a significant portion of the DIP proceeds for a significant amount of time, rather than spending them.
So a balance-sheet solvent company (according to the petition) faced with a short-term liquidity crisis (the depreciation true-up payments caused by the used car market seizing up) secured permission, without much controversy, to borrow up to $800 million to fund operations “comfortably” until well after it expects to emerge from bankruptcy, and it has a plan to invest the DIP cash it borrows but does not use to earn interest over time. This makes sense if you assume that the debtors would not be able to secure financing in the future, when they actually have a more acute need for it, an assumption grounded in constitutional pessimism - the “failure bias” in bankruptcy court - even though this debtor is not really like all the others.
Another unusual debtor that has played the worst-case-scenario card at every possible opportunity is Garrett Motion. The combined briefs filed by the debtors in support of their $250 million DIP would make a scary bedtime story for auto parts executives’ children: imminent loss of customers placing orders for engines to be built three years from now, rapacious opportunism from Chinese suppliers, competitors calling the customers, employees ready to jump ship and, of course, the pandemic. Some stakeholders
have called the debtors’ filing unnecessary and wasteful and the DIP a ploy to bury litigation adversary Honeywell International and shareholders under new debt and out of the money from a “lowball” KPS Capital bid. The debtors responded with a do-over
of their DIP budget, adding in some extra liabilities, and argued
that they “require significant cash on hand because of significant fluctuations in liquidity that occur in the ordinary course” and “anticipated loss of credit, vendor contraction, and volume fluctuations as the Debtors move through chapter 11 and the remainder of 2020.” The Garrett debtors also played the Covid-19 card, of course: The debtors fear “an industry shut-down or disruption from a second-wave of COVID-19.” Perhaps every DIP budget from here on out should include an item for “pandemic reserve,” just in case.
The Garrett Motion debtors ended up getting the DIP approved on a consensual basis after they realized
that they needed only $200 million, not $250 million, in their piggy bank (non-interest-bearing) for a rainy day. This is a real company with real assets and real income that is arguably solvent, not a hopeless victim
of the retail apocalypse headed for dead-brand purgatory until today’s styles return to fashion in 2035.
Admittedly, these are unusual cases. But you can see the failure bias at play clearly in a much more distressed industry: the E&P space. If an E&P debtor wants to get something approved, all it has to do is cite the “volatility” of the commodities markets. The fact that commodities markets are volatile is self-evidently true, but it has also always been true, and bankruptcy judges may be overlooking that this volatility sometimes works in the producers’ favor - it is exactly what the sponsors and, after emergence, reorganized equity holders are betting on.
This isn’t just a phenomenon with DIP motions - take stalking horse bidder protections as another example. Garrett again: In that case, the debtors secured approval
to pay $84 million in stalking horse protections to lock in a $2.6 billion bid from KPS, even though the alternative plan
sponsors made a competitive offer for a standalone plan that was supported by the vast majority of stakeholders, and KPS had raised
its bid by $500 million in response to that alternative plan offer prior to
the protections being approved. Judge Michael Wiles found that the debtors’ board properly decided not to risk KPS walking away if the stalking horse protections were not approved, even though one of the debtors’ own witnesses testified that she had never
seen KPS walk from a publicly announced deal.
In these situations, the debtors made good use of a parade of horribles, and the courts accepted, generally without skepticism, the debtors’ assumption that a dollar in the bank at the current price beats going out into the market in three or four months, when the debtors’ business might be cratered by volatile commodities markets, poor supply-chain management, a subsequent wave of Covid-19 or a Martian invasion. We can all appreciate the warm, comfortable feeling of excess liquidity stashed in an interest-bearing money market fund for a rainy day or a locked-in (but easily terminated) bid, but there is a cost to purchasing these assurances against unlikely, or at least plausibly improbable, adverse events - rollups, DIP fees, commitment fees, interest on draws and breakup fees. And, as the objectors pointed out in Garrett, sometimes locking up a lender or bidder locks up the debtor as well.
: As long as bankruptcy courts continue to assume that the worst will inevitably happen - that the debtor won’t be able to get credit when it actually needs it, or find an alternative buyer at a decent price - they will uncritically allow debtors to pay these costs. In many situations this is probably the right thing to do, but not all.
The Fine Print
: These days, chapter 11 is not typically an emergency room where desperate measures are employed to save a critically injured patient, as evidenced by the fact that so few patients end up in the morgue.
At a hearing
on Oct. 29, the Mallinckrodt debtors argued that allowing an Acthar-related antitrust class action
to proceed against nondebtor co-defendants not covered by the debtors’ automatic stay could result in, among other things, a judgment against the co-defendants that could somehow bind the debtors. In their brief
, the debtors specifically warn of the possibility of “record taint” and “collateral estoppel” that could “adversely affect [the] debtors’ reorganization.” With some other big litigation-centric cases floating around, now seems like a decent time for us to delve into the strange legal world of collateral estoppel (also known as “issue preclusion”).
Judge Marvin Isgur analyzed this concept in an Oct. 29 opinion
in the 2017 Vanguard Natural Resources case (not to be confused with the 2019 filing
by the same company, now known as Grizzly Energy). In the 2017 case, Vanguard argued that a net profits interest, or NPI, held by third parties was an “encumbrance” extinguished by confirmation of their plan (the 2017 confirmed plan
, not the 2019 confirmed plan
). The counterparties responded that they did not have a contractual claim or encumbrance that could be discharged but a royalty interest that “runs with the land” under Wyoming law - and the plan actually preserved those interests. The NPI holders also suggested that Judge Marvin Isgur could avoid the thorny “runs with the land
” issue here because in 2010 a Wyoming district court found that these very NPI interests “run with the land” under Wyoming law. The Wyoming Supreme Court later reversed that decision, but on remand to the district court the NPI holders won again, and no one appealed.
But it isn’t as simple as you might think to determine exactly what a prior court actually decided, or who is bound by that decision. In order for a prior decision on an issue to bind a later court, the parties must be the same and the issue must be “necessary or essential” to the prior decision, and not what lawyers call “dicta,” or surplusage. If Tom sues Bob for negligence, and the court finds that Bob was negligent and also that the Houston Astros 2017 World Series title should bear an asterisk, the decision does not preclude subsequent litigation by the Astros to remove the asterisk, because the Astros weren’t involved in (and thus couldn’t defend) the prior suit, and the illegitimacy of their title had nothing to do with negligence.
On the “necessary or essential” issue, the debtors noted that when the Wyoming Supreme Court reversed the district court’s first decision, it found, in a footnote, that the “runs with the land” issue need not be decided to rule for the NPI holders. Thus, the debtors maintained, the second post-remand “running with the land” holding was not necessary or essential. If so, the debtors asserted, Judge Isgur could decide the issue anew. Vanguard also argued that it was not bound by the Wyoming judgment because it was not a party to that case - it acquired its interest later, after the decision was already issued.
Judge Isgur nevertheless rejected the debtors’ arguments and concluded that he was bound by the Wyoming court’s earlier determination that the interests at issue run with the land. First, the judge found, the debtors were effectively a party to the Wyoming litigation for preclusion purposes because they were in “privity” with the original parties from whom they acquired their interests. “The touchstone of privity,” Judge Isgur helpfully explained, “is the existence of a ‘close or significant’ relationship between the parties, such that the predecessor acted as the ‘virtual representative’ of the party against whom preclusion is asserted.” Such a relationship exists in the instant case, the judge held, because “[t]here is also a traceable chain of title from the working interest held by Vanguard today to an identical working interest held by Lance [a party] at the time of the Wyoming Litigation.” If you buy a house from someone after they have litigated a boundary dispute with a neighbor, you are bound by the ruling in that dispute because you step into the shoes of your seller. You can’t try to litigate the dispute all over again. Further, Judge Isgur found, the “run with the land” finding in the remand decision was “essential” to that decision. “While it is true that the Supreme Court noted (in a footnote) that it need not decide whether the NPI was a realty or a contractual right to payment, the Court’s intent was not to undermine the district court’s reasoning,” Judge Isgur stated, citing “the footnote’s placement in a section not addressing the continued existence of the NPI” and “the absence of any reference to the district court’s finding that the NPI was a covenant running with the land.”
So what does this mean in the Mallinckrodt context? In bankruptcy, issue preclusion is most often used defensively
- a debtor seeks to stay litigation pending in non-bankruptcy courts against nondebtors to prevent those courts from entering judgments on issues that could bind the debtor. For example, Mallinckrodt seeks an injunction preventing the city of Rockford action from proceeding against nondebtor co-defendant Express Scripts because it fears a decision against Express Scripts might be used against the debtor at a later date. You end up with a strange inversion of the Vanguard situation: a debtor arguing that future litigation may be preclusive against it and a plaintiff contending that the debtors would not be bound.
The problem here is that the threat of preclusive effect does not necessarily justify taking claims involving nondebtors away from the non-bankruptcy court where they are pending and putting them on ice just to protect a debtor. There does not appear to be a compelling reason why bankruptcy debtors and bankruptcy courts should pre-empt the normal functioning of non-bankruptcy litigation to protect a debtor from preclusion in every case. If Tom sues Dan for negligence in state court, and Bob is worried that that proceeding could bind him if he is sued by Tom later in federal court, Bob must intervene and participate in the state court litigation. He can’t run to his local federal court and ask it to put a halt to the earlier-filed state court suit just because the result could bind him and he doesn’t want (or can’t afford) to participate.
: If you are considering filing a lawsuit involving a potential bankruptcy debtor (say, a company that just converted its executive bonus program to cash), it may be a good idea to leave off the putative debtor as a defendant.
The Fine Print
: Bankruptcy courts should perhaps explore fewer injunctions and stays on non-bankruptcy courts adjudicating disputes involving nondebtors and deal with the preclusion analysis later, like non-bankruptcy courts whose jurisdiction is not limited to restructuring matters.
The automatic stay of section 362(a) of the Bankruptcy Code automatically prevents creditors from commencing or continuing claims against the debtors or their property when a case is filed. But here’s a question we rarely see litigated in big cases: When, exactly, does the stay disappear? Generally, upon confirmation of a plan a reorganized debtor receives a discharge eliminating prepetition claims, which obviously keeps creditors holding those claims from prosecuting them except in the bankruptcy claims process. Some plan injunction boilerplate covers that. But what if a debtor wants to continue the stay to prevent creditors from commencing or continuing actions on non-discharged claims or rights, say under an insurance policy? That was the issue addressed in a recent appellate decision in the Philadelphia Energy Solutions case.
Recall that the PES debtors filed
in July 2019 after a “catastrophic” explosion at the company’s Girard Point refinery. According to the first day declaration, the debtors intended to continue pursuing “property and business interruption insurance claims for the losses caused by the Girard Point Incident” and claimed “$1.25 billion in property and business interruption insurance coverage to protect against these kinds of losses.” The insurers disagreed, but the debtors did not want them to bring their own claims regarding the policies, which would not be discharged, in a non-bankruptcy court after confirmation. So, their plan provides that the automatic stay would “remain in full force and effect with respect” to “the Insurers” until “the closing of these Chapter 11 Cases,” which could take years. On Feb. 13, 2020, Judge Kevin Gross entered an order
confirming the PES debtors’ plan of reorganization and overruling the insurers’ objection to that provision after a brief statement at the confirmation hearing, and the insurers appealed. “Hours later,” according to the insurers, the debtors filed an adversary proceeding
in bankruptcy court seeking declaratory relief, which is currently set for trial in April or May 2021.
On appeal to the U.S. District Court for the District of Delaware, the insurers pointed out
that section 362(c)(2) of the Bankruptcy Code specifically provides that the automatic stay continues until “the time a discharge is granted or denied.” Because confirmation resulted in a discharge, the insurers argued, the debtors’ stay necessarily ended on confirmation and could not be extended any further, except to the extent the debtors satisfied the “traditional standard” for an injunction under federal law - which did not happen. “Nothing in the language of § 362(c)(2)(C) or the provisions of Chapter 11 grants a bankruptcy court any authority to continue the automatic stay beyond the limits that Congress established in § 362 of the Bankruptcy Code,” the insurers asserted. The debtors responded
that nothing in section 362(c)(2) of the Bankruptcy Code forbids
a bankruptcy court from extending the automatic stay, and pointed out that a number of bankruptcy courts have approved stay extensions of this kind, often to cover the period between confirmation (when discharge occurs) and the effective date - although the debtors did not indicate whether the issue was actually raised in any of those cases.
At a hearing
on Oct. 28, U.S. District Judge Richard Andrews issued an oral ruling siding with the debtors. Judge Andrews said that he is “confident” that the bankruptcy court has the power to enjoin litigation post-confirmation. Considering the size of the policies at issue here, the insurers will probably appeal this one to the U.S. Court of Appeals for the Third Circuit, putting another “routine” bankruptcy practice under higher-level scrutiny.
: Although most chapter 11 plans include some kind of stay extension through the effective date, expect more of them to now include a blanket extension of the stay until the case is closed.
The Fine Print
: At some point, some higher court will have to consider a bankruptcy court’s injunctive powers in more detail, with more analysis than a profession of “confidence.”
- That Justice and Accountability Business: On Nov. 2, the NAACP filed an interesting motion seeking to reopen and intervene in the long-closed Tronox chapter 11. Recall that in 2013, Judge Alan Gropper entered a judgment avoiding a spinoff of environmental liabilities by Kerr-McGee and awarding billions to Tronox. In 2014, the district court approved a $5.15 billion settlement. The NAACP now seeks to reopen Tronox’s chapter 11 case because the settlement funds “have not been used for the actual remediation and development of the communities” but “for administration expenses and the enrichment of consultants.” “The NAACP’s goal,” the motion says, “is to place limitations to the fullest extent allowed by law and within this Court's authority and discretion to ensure these settlement funds reach the communities of color damaged by Kerr-McGee and to assure the funds are spent for the intended purposes.”
- Complex Real Estate Finance Update: Recall that on Sept. 10 we discussed Wilmington Trust’s effort to replace debtor Le Tote’s affiliate and insider Hudson’s Bay Co. as landlord under the Lord & Taylor master lease. “Covenants, representations, warranties and lockboxes will not protect your novel financing structure from the vagaries of chapter 11,” we warned. On Oct. 30, Judge Keith Philips in Richmond denied Wilmington Trust’s motion, finding that the trustee “failed to take the steps necessary to stand in the shoes of the L&T Landlords,” and thus the ability to compel payment of rent “must remain with the L&T Landlords.” I’m sure HBC, which holds a $30 million secured note, 25% of the debtors’ equity and two board seats, will get right on that.
- More Sealed Filings: Way back in August, the Extraction Oil & Gas debtors (see above) filed a motion to redact the recipients of its political contributions from the company’s publicly filed statements of financial affairs. In support of their request to keep those identities secret, the debtors maintained that “disclosure of the specific recipients of the Debtors’ Contributions would jeopardize many of the Debtors’ business relationships” and “adversely affect the Debtors’ longstanding relationships with both state and local governments.” The UST argued in an objection that the debtors failed to provide any evidence to substantiate these fears. In a Sept. 29 reply, the debtors asserted that “there are currently no federal laws or regulations requiring companies to disclose their political contributions in SEC filings,” disregarding the requirements of the Bankruptcy Code and the fact that it was the debtors who chose to file chapter 11. Judge Christopher Sontchi granted the motion at a hearing on Oct. 2. Don’t expect much unredacted disclosure of political contributions in chapter 11 cases going forward.
- Good Deeds Never Go Unpunished: On Nov. 5, Judge James Garrity entered an order denying the Cole Schotz firm’s application for reimbursement from the Synergy Pharmaceuticals debtors for its services as counsel to an ad hoc equity group. Cole Schotz argued, according to the judge, “that the Ad Hoc Shareholders Group should be rewarded” because it “‘conducted itself in a commercially reasonable matter and stayed far clear from the all-too common ‘obstructionist’ behavior this Court observes from other committees.” The firm also contended that the committee “was surgical in its approach and made good faith efforts to reach consensus.” That’s all really nice, but have we reached the point that an ad hoc committee deserves an “award” simply for not being “obstructionist” and making “good faith efforts”? Judge Garrity thought not: “The Court finds that the Firm overstates the significance of the role that the Ad Hoc Shareholders Group played in these cases.”
- Moonshot Brief of the Month: In a Nov. 5 objection to the proposed claims bar date in the Mallinckrodt case, the Acthar antitrust action plaintiffs (same group discussed above) became the first party to cite both the Covid-19 pandemic and the ongoing presidential election vote count in a pleading. “[T]here has been a recent resurgence in the COVID-19 pandemic and it is uncertain what the status will be when the Mailing Date occurs,” the plaintiffs argue. “As is currently playing out in the elections in Pennsylvania and elsewhere, the U.S. mail has been delayed due to budget and staffing cuts, and other issues.”