Thu 03/04/2021 15:41 PM
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Reorg’s Court Opinion Review provides an update on recent noteworthy bankruptcy and creditors’ rights opinions, decisions and issues across courts. Today we consider a Delaware court’s decision on insurance coverage for chapter 11 settlement payments, a New York decision on discharge of unknown environmental claims and Judge Jones’ management of a middle market tug and barge bankruptcy.

Reimbursement for Restitution

Ethically challenged insurance salesman Walter Neff once said the insurance companies “know more tricks than a carload of monkeys.” Neff tried to beat the insurers at their own game and ended up with a slug in the alderman thanks to the incomparable Barton Keyes. Insurance disputes are rarely pretty and can drag on for decades. Sycamore Capital, however, appears to have taken its insurers to the cleaners, thanks to some careful policy exclusion language and the friendly Delaware legislature. Continue reading as our Americas Core Credit team analyzes and reviews the court opinions from the previous week and Request a Trial for access to the linked documents as well as our analysis and reporting on hundreds of other stressed, distressed and performing credits.

Back in April 2014, Sycamore sponsored a take-private leveraged buyout of The Jones Group, parent of the Nine West shoe store chain and other retail brands. A new entity, Nine West Holdings Inc., or NWHI, borrowed about $874 million to cash out public shareholders, including executives. Sycamore and KKR contributed $120 million in equity, and Sycamore also pocketed the non-Nine West brands. According to critics of the deal - which would soon be legion - Sycamore flipped those brands for a $336 million profit after siphoning out $160 million in dividends. The deal, creditors later argued, enriched Sycamore and shareholders but left NWHI an overleveraged shell.

Sycamore knows the drill, so like any rational sponsor it procured insurance to cover NWHI’s officers and directors. Of course, state law generally limits the extent to which someone can insure their own dirty deeds, in order to prevent “moral hazard” - the elimination of economic disincentives to bad behavior through insurance. The thinking goes that if an officer or director can insure themselves against their liability to third parties for ill-gotten gains, then there is little reason for them not to loot the company. That’s some film-noir-level cynicism about humanity, but we hard-boiled bankruptcy lawyers know the score.

The trick is that different states define uninsurable losses differently - and the folks at Sycamore made sure they would get the long end of the stick when it came down to coverage for any malfeasance in the IPO.

The relevant policy, written in 2016, required the insurers to indemnify directors and officers for any “Loss,” including “settlements,” “judgments,” “damages” and defense costs, except “amounts which are uninsurable under the law most favorable to” the insured. Not only did the insurers not specify which losses would be uninsurable, they also agreed that Sycamore would have the option to choose which state’s law would apply in determining whether a loss would be uninsurable.

The policy did specifically exclude coverage for return of ill-gotten gains stemming from “unlawful” conduct. But that exclusion itself included an important exception: an actual finding of “unlawful” conduct had to be made by a court in a final, non-appealable order. So if Sycamore settled claims for recovery of any ill-gotten gains - say, $160 million in dividends and $336 million in profits from those non-Nine West brands - the policy would arguably still pay out.

In summary: The insurance companies not only left it to Sycamore to choose the law of the state that suited them on insurability, they also gave Sycamore the option to unilaterally eliminate the ill-gotten gains exclusion simply by choosing to settle rather than going to trial on any claim for restitution or unjust enrichment. You know where this is going.

On Feb. 6, 2018, NWHI filed for chapter 11. You will not be surprised to hear that in the first day declaration, the debtors noted that, prior to the filing, independent directors were appointed to review potential claims against Sycamore arising from the 2014 LBO. Also unsurprising: Noteholders and the official committee of unsecured creditors were highly skeptical of those independent directors’ independence from the beginning. After a lengthy struggle, Sycamore agreed to pay $120 million to buy a plan release, and on Feb. 25, 2019 Judge Shelley Chapman confirmed the debtors’ plan. The release provisions of the plan included carve-outs for certain non-Sycamore defendants, who were later sued by the indenture trustee for NWHI’s notes; that suit remains pending but isn’t relevant to the insurance dispute.

Sycamore then turned around and submitted a claim on the D&O policy to recoup part of the $120 million settlement and defense costs. The insurers denied coverage, arguing that under New York law - the jurisdiction where Sycamore was headquartered, and where they said the alleged looting of Nine West took place - the settlement payment qualified as an uninsurable loss traceable to “disgorgement of, or restitution for, ill-gotten gain.” That’s probably correct, but it only matters if New York law governs the uninsurable loss issue.

In September 2019, Sycamore sued the insurers in Delaware state court seeking reimbursement under the policy, and after some procedural hijinks it filed a motion for judgment on the pleadings on the uninsurable loss issue. Sycamore argued that Delaware law rather than New York law applied because Delaware law favors Sycamore, and the policy allows Sycamore to choose whichever law favors its claims. According to Sycamore, Delaware law on uninsurable losses doesn’t forbid insuring against “disgorgement of, or restitution for, ill-gotten gain.”

On Feb. 26, Delaware Superior Court Judge Abigail LeGrow issued an opinion siding with Sycamore. Judge LeGrow found that the “law most favorable” provision in the policy operates as an enforceable choice of law provision, notwithstanding that it does not name a particular state. The judge also rejected the insurers’ argument that enforcing the provision would offend the public policy of New York because “it frustrates New York’s interest in preventing the indemnification of wrongful gains.” According to Judge LeGrow, “seller’s remorse is not a commercially reasonable basis for avoiding a choice of law clause,” and a “mere difference between the laws of two states” does not make the law of one of those states automatically “contrary to the public policy” of the other.

As for that difference between New York and Delaware law: The judge agreed that no Delaware statute makes restitution or disgorgement settlements uninsurable. In their search for some Delaware statute on which to hang their hat, the insurers argued that the court could infer the Delaware legislature’s intent to make ill-gotten gains unreimbursable from the state’s fraudulent transfer statute. Judge LeGrow was unconvinced. “If courts understood every statute prohibiting conduct also to preclude insurance for any remedies associated with that conduct, there would be little or nothing left to insure,” the judge concluded.

Judge LeGrow then provided a (perhaps unintentional) lesson on just how little Delaware worries about “moral hazard.” “Delaware has a strong public policy against fraud, but nevertheless permits insurance against fraud claims,” the judge noted, adding that “polluting the environment is against Delaware public policy, but insuring cleanup costs is not.” Nor is it against public policy, the judge added, to insure against the costs of “a defense of corporate fiduciaries charged with criminal conduct.”

The judge finally twisted the knife a bit: Insurers are of course not required to insure restitution or disgorgement under Delaware law, she noted, since the insurers had a chance to explicitly exclude these claims under the policy - they simply failed to do so.

The Takeaway: This one isn’t over yet, as Judge LeGrow’s decision still leaves other potential exclusions for litigation at an upcoming trial. But the elimination of the uninsurable claim defense clears a big hurdle for Sycamore and should comfort other sponsors concerned about their recovery on those expensive D&O policies (on which the portfolio companies inevitably pay the premiums) - so long as they make sure Delaware law governs.

The Fine Print: Nondebtors can be at the crux of bankruptcy cases, and their recourse to insurance may often be the tail that wags the dog in sorting out various stakeholders’ motivations in the case. Unfortunately for purveyors of distressed debt intelligence, such fights rarely see the light of day.

Toxic Discharge

After all that chicanery in Nine West, let’s make a “fresh start.” Since the enactment of the Bankruptcy Code in 1978, a significant number of companies have filed chapter 11 to put a concrete sarcophagus over mass tort liabilities - generally asbestos suits, products liability actions and today’s subject, environmental claims. Like insurance disputes, these situations generally involve large numbers of suits, a multitude of jurisdictions and an endlessly long tail, with claims discovered and asserted decades after purchase, use or contamination.

Generally debtors use one or more of three mechanisms to wrest free of the financial straitjacket created by these liabilities: Rule 9019 settlements, sales of assets free and clear under section 363 and chapter 11 plan releases and “channeling” injunctions. Substantial precedent guides courts in deploying each of these tools. There is one key limitation, however: A debtor can only use bankruptcy to jettison prepetition or pre-confirmation claims. And a recent decision from the district court in New York relating to the Tronox/Anadarko settlement shows that the line between pre-bankruptcy and post-bankruptcy claims is about as clear as creosote-contaminated mud.

Xennial or older bankruptcy practitioners all know the Tronox/Kerr-McGee/Anadarko story, but in brief: Kerr-McGee management hatched a plan to shed the company’s massive environmental liabilities at its oil and gas businesses and secure a “fresh start” by spinning off its valuable chemical business into a new company, later acquired by Anadarko. The liabilities would stay behind in the original company, now named Tronox. One problem: Trying to manufacture a “fresh start” outside of bankruptcy typically doesn’t work - that’s why you’ve got to file and pay the toll. After Tronox filed chapter 11, the estates brought fraudulent transfer claims against Anadarko to recover the transferred assets to pay the leftover environmental liabilities. In December 2013, Judge Allen Gropper ruled in favor of the debtors and pegged the legacy environmental liabilities of Tronox at between $5.15 billion and $14.46 billion. In November 2014, Judge Gropper approved a settlement whereby Anadarko would pay Tronox $5.15 billion, the lowest point in the liability range, in exchange for a release and channeling injunction.

Specifically, under the settlement order, all pre-existing environmental claims against the debtors and legacy Kerr-McGee, whether known or unknown, would be channeled to a trust that would distribute the settlement proceeds 12% to tort claimants and 88% for environmental cleanup. The order specifically enjoined holders of known and unknown claims channeled to the trust from asserting claims directly against Anadarko, with a carve-out: Unknown claims would be covered only to the extent allowed under applicable law. In other words, unknown claims would only be barred and channeled to the extent that they did not qualify as pre-bankruptcy claims.

In 2019, Larry Ashworth, the owner of land adjacent to a former Kerr-McGee property, discovered creosote contamination on his property. In July 2020, Ashworth sued Anadarko in federal court in Louisiana. Anadarko ran back to the bankruptcy court in New York and asked for sanctions against Ashworth for violating the settlement injunction. Ashworth’s claim, Anadarko argued, qualified as a pre-bankruptcy environmental claim “administered” under the chapter 11 settlement because the contamination began before the bankruptcy - even though Ashworth had no idea the contamination existed when the settlement was approved, and therefore could not have objected to the settlement as a potential claimant even if he were given actual notice.

The issue, Judge Oetken explained in a Feb. 19 opinion, “turns on when Ashworth’s claims arose, legally speaking: Anadarko contends the claims arose when the contamination occurred,” while Ashworth “maintains that his claim could only have been discharged in earlier rulings if he were identifiable to Anadarko before the bankruptcy petition was filed.”

The judge first considered what standard to apply in determining when Ashworth’s claim arose. Anadarko argued that in considering when an environmental contamination claim arises for bankruptcy purposes, the only relevant question is when the conduct giving rise to the claim - the contamination - took place. Courts call this the “conduct test.” For example, the Fourth Circuit concluded in a 1988 decision in the A.H. Robins chapter 11 that “the Dalkon Shield claim in the case before us, when the Dalkon Shield was inserted in the claimant prior to the time of filing of the petition, constitutes a ‘claim’ ‘that arose before the commencement of the case.’”

Ashworth, however, argued that Judge Oetken should consider not only when the conduct giving rise to the claim occurred but also whether he had a prepetition relationship with the debtors “such as contact, exposure, impact, or privity.” Courts call this the “prepetition relationship” test. The Second Circuit endorsed the “prepetition relationship” test over the “conduct” test in a 2016 decision in the General Motors case, finding that a claim may be discharged through a “free and clear” sale if it both “arose before the filing of the petition or resulted from pre-petition conduct” and there was “some minimum contact” or “relationship” between debtor and claimant “such that the claimant is identifiable.” Anadarko argued that the GM decision was not binding because it could apply only to products liability claims and not environmental claims.

Judge Oetken sided with Ashworth and adopted the “prepetition relationship” test in the environmental claim context. “Focusing purely on the act of contamination veers towards the ‘conduct test,’ which the Second Circuit has never formally adopted and others have criticized as overly broad,” the judge reasoned. The judge also cited “inherent due process considerations,” without elaboration, and later notes that the prepetition relationship standard is meant to prevent “unfair” discharge and “a potential denial of due process” that would preclude “a claimant from seeking redress due to no fault of her own.”

The opinion also quotes a 2017 decision from a Florida court: “How can a ‘claim’ be administered during a bankruptcy case if the alleged holder does not know enough to articulate it and the debtor does not know enough to be able to notify the future claimants or estimate their claims?” It is “nonsensical,” Judge Oetken maintained, “to pretend that a claim was administered during a bankruptcy if neither claimant nor debtors knew anything about the claim.”

Turning to the question of whether a prepetition relationship existed between Anadarko and Ashworth, the judge found that the requisite relationship must either allow the debtor to identify “a class of potential future injury claimants” or allow the claimants to “have, during the case, knowledge of facts connecting them or their property to the debtor’s conduct ‘so as to be aware of the potential impact of a bankruptcy discharge.’” No relationship existed that could satisfy either of those requirements in this case, Judge Oetken concluded, although at the time of the bankruptcy, Ashworth owned property five miles from a known Superfund site owned by Anadarko.

Perhaps our main issue with Judge Oetken’s decision is that it provides a bit too much reasoning. After all, a review of the case law shows that a number of courts, including the Fourth Circuit, do not believe it is “nonsensical” to find that unknown claims were administered in a bankruptcy case and thus discharged or channeled by a settlement, sale order or confirmed plan. Nor is it uncommon for claims to be disallowed “due to no fault” of the claimant, in both bankruptcy and other contexts. Consider statutes of repose, which eliminate claims at the expiration of a set period after negligence or misconduct even if the claimant could not possibly discover the injury before the end of the period.

This fuzzy logic creates uncertainty - and uncertainty in this area has real costs. Judge Oetken himself quotes an earlier decision: “The Court is certainly cognizant of the inherent uncertainty that allowing successor liability claims ... imposes upon purchasers of debtor assets in a bankruptcy. However, to whatever extent maximizing the value of the estate is an important policy of the Bankruptcy Code, it is no more fundamental than giving claimants proper notice and opportunity to be heard before their rights are affected, to say nothing of constitutional requirements of due process.”

Like much of the legal discussion on the prepetition claim/discharge issue - see, for example, the Third Circuit’s 2010 Jeld-Wen decision, in which the court of appeals bends itself into a pretzel to avoid endorsing either the conduct or the prepetition relationship test - this quote does nothing more than restate the problem. Yes, both the fresh start and due process are important - but how can debtors, co-defendants and buyers predict how courts will balance them, given the current morass of case law? We’d love some further appellate guidance but also wager that courts are likely to take the pretzel / Oracle at Delphi approach than Judge Oetken’s full-throated dive into providing the parties before him real answers.

The Takeaway: As with many bankruptcy issues, there is a simple solution sitting right there, just waiting for responsible legislators to intervene. After the first wave of asbestos bankruptcies, Congress added section 524(g) to the Bankruptcy Code. Section 524(g) provides specific rules and procedures for discharging and channeling undiscovered asbestos claims. Congress could simply amend that section so it applies to all future claim situations, including environmental claims. Once again, we ask: Why are specialized bankruptcy judges constantly asked to apportion risk and sacrifice between debtors and creditors in massively important situations better addressed by sound legislative policy?

The Fine Print: About a month ago, we wondered why the National Rifle Association of America filed chapter 11 when the claims of its most dogged adversary, the New York attorney general, likely could not be discharged in bankruptcy. The distinction here: The question in that case is whether claims for injunctive relief can be scrubbed in bankruptcy. The mass tort cases require consideration of which monetary claims can be discharged, released or channeled.

You’re Fired

The Bouchard Transportation case now pending in Houston is an early front-runner for chapter 11 mess of the year, though Judge David Jones’ recent intervention might spoil the fun. Just imagine “The Life Aquatic With Steve Zissou,” but with a search for adequate corporate governance and reliable DIP funding rather than the elusive jaguar shark. Oh and there are mustaches you can set your watch to.

The New York-based oceangoing barge and tugboat company, “one of the largest in the United States,” filed chapter 11 on Sept. 28, 2020, intending to “pay creditors in full in cash on account of allowed claims.” The debtors claimed $229.5 million of funded debt and approximately $930 million in unencumbered assets as of August 2018, and attributed the filing to a 2017 vessel explosion that killed two crew members and cost the company key regulatory certifications (along with, you guessed it, Covid-19). The debtors filed when they did in order to stop a foreclosure sale of some of their vessels by maritime lienholders. In terms of concrete plans, the debtors said they would sell aircraft (a Gulfstream business jet, not a yellow helicopter) under section 363 to raise cash.

And then … nothing happened. No immediate DIP financing motion, no emergency first day hearing. The proposed Portage Point CRO’s “first day” declaration was finally filed on Oct. 12. On Oct. 21, the debtors got around to filing their “first day” motions and promised that they were canvassing the market for DIP financing. Later, on Oct. 21, the debtors filed a motion to approve a $60 million new-money DIP facility from Hartree Partners, which would be secured by nine unencumbered vessels. The first day hearing was uneventful for debtors’ counsel at Kirkland & Ellis; Judge Jones quipped that approval of the Hartree Partners DIP was one of the “easiest” calls he has had to make in years. It appeared the debtors were thoroughly, if belatedly, underway.

The second day hearing on Nov. 17 also went fine. Ryan Bennett of Kirkland & Ellis, counsel for the debtors, told the judge that the debtors had negotiated a letter of intent to sell the aircraft for $10 million more than the mortgage held by Fortress, and hoped to close that sale by the end of 2020. On Nov. 29, the debtors filed a motion to establish a process for a sale of the aircraft via a private sale rather than the typical bankruptcy auction, and Judge Jones granted the motion on Dec. 2. On Dec. 21, the judge also approved the Hartree DIP on a final basis, subject to some lingering adequate protection issues. At a status conference on Jan. 15, 2021, the debtors indicated that they were “full steam ahead” toward restarting operations with new regulatory certificates.

Alas, a shaky captain appears to have steered the debtors toward rocky shoals. On Feb. 24, the debtors filed an emergency motion to amend the Hartree DIP financing that indicated the initial $30 million draw on the facility was gone and Hartree had refused to provide the final $30 million because of a failure of conditions precedent. The debtors also notified the court that the aircraft sale, which was supposed to close before year-end, would not actually close until March 15. The debtors asked Judge Jones to force Hartree to fund $10 million, which led to an absolutely bonkers hearing on Feb. 24.

At that hearing, Hartree told Judge Jones that it had “no idea” where its $30 million had been spent because management claimed its use of some of the funds was “proprietary” information. The money doesn’t appear to have gone to some pretty important expenses: The debtors missed the prior week’s payroll, failed to pay $3.5 million in vendor expenses and - worst of all - failed to cover $4 million in professional fees. The judge made it clear he would not compel Hartree to fund $10 million under the circumstances.

Debtors’ counsel also introduced Matthew Ray of Portage Point Partners as the debtors’ “proposed” CRO, despite the fact that the judge had already entered an order approving his retention. On questioning from Judge Jones, counsel admitted that Ray would not take his post until the debtors secured D&O insurance, which management felt was not a “priority.” Ray also hesitated to confirm that Portage Point was “reconciling” the “books” of the company, explaining that historical accounting practices were not ideal and outside advisors were still getting up to speed.

Judge Jones had heard enough. “I’ve got a million questions, and it’s only going to get worse,” the judge remarked. Debtors’ counsel saw an opening, offering that “corporate governance” actions alluded to by the judge might enhance the value of the estate. In other words, please, Judge Jones, give us someone who will listen to our advice (and also pay our bills).

At a status conference on Feb. 26, debtors’ counsel told the judge that Hartree still had not agreed to advance more DIP funds and revealed that management would not “engage” on asset sales (a precondition for Hartree). The prospect of new management to replace CEO Morton Bouchard was now squarely on the table in discussions between stakeholders and counsel’s presentation to the court - but please, not a chapter 11 trustee. Judge Jones decided that the CEO’s control over the eponymous debtors’ operations “ends today” and agreed to enter an order vesting proposed CRO Ray with control over the debtors until a new three-person board could be appointed.

The judge’s authority to simply fire the CEO and replace him with a proposed estate professional as “responsible person” on a provisional basis seems a bit shaky, since some courts have seen the appointment of a chapter 11 trustee as the only available option in such situations, as we briefly noted in our discussion of the NRA case last month. But at the next status conference on March 2, the judge went even further, suggesting that he could himself act as a sort of de facto director. Debtors’ counsel told the judge at that status conference that instead of a three-member board composed of Ray and two independent directors, the debtors had determined that Ray and only one other independent director were necessary. Judge Jones responded that if those two deadlocked, he would break the tie. The judge also suggested - as is Judge Jones’ “standard” policy - that the CRO could bring any “concerns” to the court’s attention. Fortunately, the judge indicated that he knows “what happens to a fleet of vessels that is undercapitalized” and wants “to do the best that we can to come out of this with an operating company.”

The judge’s impromptu interview for a gig as judicial chairman of the board seems to have gone well - on March 3, Hartree agreed to another $1.3 million draw on the DIP facility to cover payroll, though a long-term solution remains outstanding.

The Takeaway: Judge Jones, like most bankruptcy judges, appears almost allergic to the idea of appointing a chapter 11 trustee, even though this case seems to present an absolutely ideal situation for an independent fiduciary.

The Fine Print: At the March 2 hearing, Judge Jones warned counsel for the official committee of unsecured creditors that it always “bothers” him when a claims trader and lawyer “control[s] the committee,” and reminded counsel that he was “watching” the UCC’s behavior. The judge further warned that he did not want to see the debtors “bogged down” in UCC discovery requests and that he would cap the committee’s budget if it attempted to do so. We understand Judge Jones’ concerns, but considering his potential role in breaking ties on the debtors’ board of directors, it seems odd for him to tell the UCC how to do their job too.

Other Cases:

  • Deep Freeze: Keep an eye on the Brazos Electric case filed on March 1. Brazos filed because of $1.8 billion in charges related to the Texas electrical system collapse back in mid-February. The debtor asserts that it “will not foist this catastrophic ‘black swan’ financial event onto its members and their consumers.” In other words, the debtor intends to use the bankruptcy court to try and unravel the complex web of claims and debts triggered by the blackout. Once again, a bankruptcy judge could be asked to address and resolve serious policy considerations and conflicts. The case has been assigned to Judge Jones, so expect a hands-on approach. Also, expect the appointment of Judge Marvin Isgur as a mediator.

  • Dress for Success: On Dec. 1, 2020, Tailored Brands announced that its chapter 11 plan had gone effective. In a press release, the company said that it was “thrilled to emerge from Chapter 11” with $686 million of debt eliminated from its balance sheet and a “strengthened capital structure, consisting of a $430 million ABL facility, a $365 million exit term loan and $75 million of cash from a new debt facility.” Exactly four months later, the company announced that it had secured $75 million in emergency funding from Silver Point because of severe underperformance against financial projections in December and early 2021. We get it, stuff happens, but such results make us wonder if an old-world personal liability regime for bankruptcy fiduciaries would lead to different results.


--Kevin Eckhardt
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