Fri 08/18/2023 12:16 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. We use this space to comment on and discuss emerging trends in the bankruptcy world; our opinions are not necessarily those of Reorg as a whole. Today we consider two recent decisions from Delaware judges on debtor ownership of assets, postpetition challenges to the liability management transactions in Envision, the Sanchez debacle rolling on and a potential extinction-level event at One First Street.

Been Caught Stealing

Despite debtor warnings of the “parade of horribles,” the Delaware bankruptcy bench continues to stand up for the rule of law, no doubt to the dismay of the local bankruptcy bar. The latest sacred cow slaughtered in Wilmington: Quickie section 363 sales free and clear of creditors’ bona fide claims that the assets being sold were stolen by the debtors. Three cases mark the trend.

First, Lordstown Motors. On July 27, Judge Mary Walrath granted stay relief for prepetition litigation claimant Karma Automotive to proceed with a $900 million trade secrets misappropriation suit against the erstwhile electric vehicle “manufacturer,” throwing its section 363 sale strategy into doubt.

Lordstown filed with zero funded debt and listed just $70.3 million in total liabilities against $452 million in assets. The debtors also claimed to hold $136 million in cash as of the petition date. That sure looks like a lack of “financial distress” to us, Judge Thomas Ambro. The debtors shut their business down prepetition and said they would sell their assets, but - and we know this sounds crazy - moribund companies can sell their assets outside of chapter 11. So, why the filing?

If a debtor files a section 363 sale case with no serious debt to restructure and no operations, you can bet a dark litigation cloud looms over those assets. Section 363(f) allows bankruptcy courts to strip asset issues that might otherwise be borne by the buyer in a nonbankruptcy sale. Here, Lordstown hoped to strip its assets free of prepetition claims by Karma that some of the assets to be sold - specifically, the long-delayed Endurance EV’s infotainment system - were stolen by Lordstown and erstwhile Karma employees poached by Lordstown.

Karma, fka Fisker, alleges that Lordstown “lied” and “scheme[d]” to snag Karma employees who brought with them “confidential designs and computer code” related to Karma’s infotainment system. Perhaps Karma has a patent for a method to remove the buttons that control your A/C and make you dig through submenus to activate your seat heaters.

Karma came out firing at the first day hearing, openly accusing the debtors of attempting to use an unnecessarily expedited section 363 sale process to fence stolen goods. Judge Walrath put that off, but agreed with Karma that the suggestion of bankruptcy filed by Lordstown in the parties’ non-bankruptcy litigation went too far in representing the effect of the automatic stay on claims against nondebtors. The judge ordered the debtors to file an amended pleading in the non-bankruptcy litigation clarifying that the automatic stay does not automatically cover nondebtors and their property.

A small issue, perhaps - or maybe the debtors’ credibility was now in question with Judge Walrath, coloring her subsequent rulings.

Karma filed a stay relief motion on July 6, pointing out the prepetition litigation was pending for three years, and a trial was set for Sept. 6 - until Lordstown filed that dubious suggestion of bankruptcy. The debtors responded on July 14 with a motion to estimate Karma’s claims per chapter two of the litigation debtor playbook, titled “Don’t Ever Let a Jury Decide, That’s What Friendly Bankruptcy Judges Are for.”

But how could Lordstown be so sure Judge Walrath would either decide the Karma claims in their favor prior to a sale or push them off until they didn’t matter? That’s right, friends: the “parade of horribles.” According to Lordstown, estimating Karma’s claim was “critical” to avoid derailing the cases with “lengthy” and “protracted” litigation that would “unnecessarily deplet[e]” the debtors’ resources and potentially affected distributions to creditors. Sound familiar?

In a July 19 response to the stay relief motion, Lordstown doubled down on this theme. Litigating Karma’s claims the old-fashion way would require a “lengthy and protracted” trial and appeals process that “would derail the Debtors’ restructuring efforts entirely,” Lordstown warned. Further, the sale process just had to finish by Sept. 12 because the debtors have no meaningful revenue and have ceased operations and wait a second, isn’t that justification for not rushing a sale? The business is padlocked - why the rush?

Surprisingly, that is exactly how Judge Walrath saw the situation. In her July 27 ruling granting stay relief, the judge dumped an atmospheric river on Lordstown’s parade. Lordstown’s “need” for an immediate ruling in the bankruptcy court was “an emergency of the debtors’ own creation,” the judge said, pointing to the absence of a secured creditor, the lack of even the usual arbitrarily accelerated RSA or DIP milestones and the debtors’ prepetition shutdown. The judge also noted Lordstown only has an estimated $20 million in trade claims and $130 million in cash on hand.

The judge also pointed out that estimation might cap Karma’s monetary claim, but it would not resolve whether Lordstown actually owns the property Lordstown intends to sell, and that requires a real-deal adversary proceeding with pesky rules of civil procedure and evidence.

You heard that right: The judge straight-up concluded the debtors’ sale schedule was driven not by erosion of cash or loss of employees, but the desire to head off any final decision in the Karma litigation. Judge Walrath, there is a seat for you over here on the COR bench whenever you decide to move on.

On Aug. 3, Judge Walrath approved Lordstown’s bidding procedures while reiterating that she thought there was no need for speed. The judge set a “tentative” sale hearing for Oct. 5, while warning the debtors she would not proceed until convinced there are “viable bids” and a “path forward.”

Then Judge Walrath denied Lordstown’s request for an injunction preventing securities fraud claimants from going forward with discovery from officers and directors, citing a lack of “identity of interest.” Why not? After all, the judge’s other rulings already torched the “norms” debtors rely on when filing bankruptcy to get away with these shenanigans.

But it gets worse for those hoping Delaware is the new Delaware: On Aug. 9, Judge J. Kate Stickles concluded that the centerpiece of the DeCurtis Holdings debtors’ proposed asset sale to stalking horse (and DIP lender) Invictus Global Management belongs at least in part to customer Carnival Cruise Lines, despite warnings from the debtors such a finding would crater their chapter 11.

Guess that’s better than sending the whole dispute back to state court like Judge Walrath, though that wouldn’t accomplish much considering Carnival already secured a judgment prepetition.

As part of its purchase of DeCurtis, Invictus wanted to acquire the DeCurtis Experience Platform, or DXP, an onboard app for cruise passengers licensed to cruise lines such as Carnival. Problem: Carnival argued DXP is based on the debtors’ work product under an agreement with Carnival that gives Carnival ownership of such work product and derivative works.

Judge Stickles agreed with Carnival, throwing the proposed sale process straight into the circular file despite the debtors’ Lordstown-like dire warnings of disaster. Not only that, but the judge enjoined DeCurtis from using or selling DXP to third parties, e.g., its other cruise line partners, i.e., its entire business plan? The judge urged the parties to work together on a plan to allow other cruise lines to use their versions of the app while DeCurtis drowns its sorrows with Isaac Your Bartender on the Aloha Deck.

On Tuesday, Aug. 15, Judge Stickles denied Carnival derivative standing to sue Invictus for breach of fiduciary duty and seek recharacterization or subordination of Invictus’ secured claims. The judge also said she would allow Invictus to credit-bid in any sale of assets - well, assets that belong to the debtors, at least.

On Wednesday, Aug. 16, Invictus filed a notice terminating DeCurtis’ DIP, citing Judge Stickles’ DXP decision, and just yesterday the debtors said they were heading to the dreaded rubber room of chapter 7, even while the parties work on a “commercial” resolution that Invictus optimistically thinks could still involve it purchasing assets.

Rather than viewing this as some sob story of failed reorganization, think of it this way: Some debtors don’t deserve chapter 11, namely those who file chapter 11 to sell assets they don’t actually own. The system may actually be allowed to work for the honest but unfortunate debtor if we weren’t so busy finding creative ways to make it work for literally anyone.

One other thing: We just want to raise a toast to Invictus for keeping things interesting. Since first appearing in our pages in late 2020, you folks have kept us on our toes. DeCurtis, sure, but also the cash collateral fight in Tuesday Morning, throwing equity grenades in Sorrento, fighting with GE over claims transfers in LATAM, taking on lockup agreements in Grupo Aeroméxico and attacking the plan schedule in Washington Prime. Shine on, you crazy diamond.

Finally, on Aug. 10, Judge Craig Goldblatt blew up the KDC Agribusiness section 363 sale case out of - shudder - respect for a state court judge. Judge Goldblatt granted relief from stay in favor of California Safe Soil, which sued the debtors in the Delaware Chancery Court for allegedly stealing intellectual property assets to build a waste-processing facility.

Although lifting the stay would effectively “end the bankruptcy,” the judge said the need to show the “appropriate respect” for the Chancery Court left him “with no other path.” Accepting the debtors’ primary argument for keeping the stay in place - that the bankruptcy court could resolve the ownership issue “more quickly” than the Chancery Court - would be “inherently disrespectful to the Court of Chancery,” Judge Goldblatt concluded.

Judge Goldblatt added that neither he nor debtors’ counsel had been able to find a case where litigation was taken out of another court and moved into a bankruptcy court “on the theory that the bankruptcy judge and the bankruptcy judge alone” could resolve the matter more quickly. However, we’d note respectfully that this is the basic justification for every mass tort case.

The PET Two-Step

Back in February, we suggested that a new liability management bankruptcy two-step strategy is now in play, and that we kinda, sorta like this one. “Do the liability management transaction,” we proposed, but: “leave a couple steps undone. Get an RSA ready for the rest. File chapter 11 a few days after closing. Ask the bankruptcy judge to bless the whole thing, and fast, or else the deal craters and the company proceeds to liquidation. We can get behind this.”

Judge David R. Jones decided to call liability management transactions “position enhancing transactions,” or PETs, and we like that too, so we’re calling it the “PET Two-Step” from now on.

In addition to having a new name, we have a blueprint, taken from today’s fresh-off-the-presses official committee of unsecured creditors’ standing motion in the Envision/AmSurg case. The Envision UCC very much does not like the PET two-step. According to the UCC, management undertook two PETs, a recapitalization in April 2022 and an exchange in August 2022, to buy support for an “inevitable” chapter 11 plan containing nondebtor releases for, you guessed it, management.

(We’ve talked before about the role of nondebtor releases as an incentive for management to file chapter 11 rather than dragging the company further into hopeless insolvency, and we’ll mention it again below, but a warning: Former executives are very much a chit debtors are happy to throw in the burn bin.)

The Envision UCC contends that debt from a 2018 LBO left the company overleveraged, and by 2021 management knew a bankruptcy would be necessary. Instead of filing immediately and negotiating with all creditor groups postpetition, however, the UCC says management hatched a scheme to secure support for an eventual chapter 11 plan by undertaking the April 2022 recapitalization transaction, which created a new silo of debt secured by the company’s AmSurg business.

The debtors maintain that the $1 billion in new funding from the recapitalization gave them “runway” to try and escape bankruptcy, but the UCC isn’t buying it. “Even with the more than $1 billion in new loans,” the UCC maintains, “the Debtors had no reasonable expectation that they would be able to avoid bankruptcy - and yet they committed to pay hundreds of millions of dollars in fees and the AmSurg makewholes in the inevitable bankruptcy filing.”

Problem, though: The AmSurg deal did not buy the support of left-behind Envision lenders. In fact, the remaining Envision lenders were understandably mad as hell. So, the UCC alleges, management cooked up an August 2022 uptier exchange to buy the support of enough Envision lenders to get a plan confirmed.

“Instead of conducting an open, frank discussion and negotiation with their secured and unsecured creditors,” the UCC claims, “the Debtors engaged in a second series of coercive actions whereby they manufactured an Envision class of consenting creditors, again trading away hundreds of millions of dollars of estate assets to gain the support of the top priority tranches of the term loan lenders for the inevitable bankruptcy and chapter 11 plans.”

Ah yes, those famously open and frank plan negotiations we all know and cherish. Anyway, the UCC asserts that both transactions were intended to rig the plan vote prepetition “by preferring certain creditors over others and buying the silence of obvious litigation adversaries, and those actions give rise to colorable claims.”

To which we say a hearty duh. When we said we don’t have beef with the PET Two-Step as a concept, we did not mean to suggest that the bankruptcy court should just allow the debtors and favored creditors to pull it off without scrutiny, and criticized Judge Jones for doing just that in Serta by immediately telegraphing his decision rejecting the merits of the nonparticipating lenders’ challenges.

By making it clear he was going to approve the Serta uptier from the start, Judge Jones made negotiations on a consensual resolution of the dispute much less likely to succeed; hence, the nonparticipating lenders’ appeal to the Fifth Circuit (see below). By not doing that in the Revlon case, Judge David S. Jones in New York left both sides in doubt, making a consensual resolution more likely - and that’s exactly what happened.

So, bravo to the UCC for pulling back the curtain. Now, the onus is on Judge Jones’ colleague in Houston, Judge Christopher Lopez, to take the Envision UCC’s challenges seriously and let them play out quickly, but not so quickly the parties don’t get that itch to cut a deal before a decision is made. From what we’ve seen of Judge Lopez since he stepped up to the complex panel, we have confidence he will do just that, no doubt to the disappointment of the debtors.

The Neverending Story

We introduced you to Sanchez Energy, now known as Mesquite Energy, in July 2020. That was our fifth installment of this column, and looking back, Reorg probably wishes it had nipped this in the bud back then (Editors’ Note: We don’t). But then we wouldn’t have gotten to celebrate getting to the end of this saga with you, our dear readers. That’s right - our favorite case, which we have covered for three years post-emergence, has finally(?) come to an end, of sorts.

Back in July 2020, we said with characteristic understatement that “confirmation is often not the end of fights that may have a profound impact on creditor recoveries.” In December 2021, we wondered if maybe the Sanchez odyssey suggests that leaving something as crucial as post-emergence ownership of the company until after confirmation might be a bad thing. Now, we are pretty sure of that.

By way of background: Under the Sanchez plan, an allocation of 80% of reorganized equity between the secured lenders and unsecured creditors would be determined by post-emergence lien avoidance litigation. In the meantime, the DIP lenders, led by Apollo and Fidelity, would receive 20% of reorganized equity on account of their DIP loans at emergence, allowing them to appoint directors and control the company as if they held 100% while the litigation proceeded.

We suggested in late 2021 that Apollo and Fidelity might have hurried the plan to confirmation using their DIP milestones, notwithstanding the open disputes over ownership of the company because they had a plan to take advantage of their post-emergence control over the company to moot the litigation, pointing to their post-emergence maneuvers to dilute any ownership stake awarded to unsecured creditors and bury it under new debt they caused the company to incur.

Shortly after taking control of the board, Apollo and Fidelity “gave themselves the right to discounted equity that would dilute any percentage of reorganized equity awarded to unsecured creditors in the lien litigation that everybody agreed would be resolved after emergence.” Then, in November 2020, they loaned an additional $45 million to the company to finance the acquisition of assets from chapter 11 debtor Gavilan Resources. This loan provides for issuance of new equity to the lenders as fees, further diluting any future allocation of reorganized equity to unsecured creditors.

Not that Apollo and Fidelity had a monopoly on shenanigans. In May 2022, we discussed a lawsuit brought by secured noteholders (including Fidelity) against the unsecured creditor representative - Apollo and Fidelity’s adversary in the lien litigation - over $5.6 million in litigation funding. According to the secured noteholders, the creditor representative agreed to turn over a “significant portion” of any unsecured creditor recovery in the lien litigation - e.g., that 80% of reorganized equity up for grabs - to Avenue, Benefit Street, Brigade and Taconic in exchange for a war chest to pursue the lien litigation.

According to the secured noteholders, this was an attempt by those funds to dilute the recoveries of other unsecured creditors from the lien litigation - akin to a DIP or backstop premium for an ad hoc group. How did the secured noteholders have standing to challenge the unsecured creditor representative’s litigation funding structure? Well, the secured noteholders would become unsecured noteholders if they lost the lien litigation and would recover from the litigation against themselves if the creditor representative succeeded. So, you had defendants holding a contingent interest in the plaintiffs’ recovery trying to scupper the plaintiffs’ ability to borrow money to pursue that recovery.

To his credit, Judge Marvin Isgur managed to cajole the combatants into pushing these sideshows until after the lien litigation was resolved. Alternatively, Judge Isgur unwisely guaranteed there would be more litigation after the lien litigation was resolved - just like he guaranteed the lien litigation would go on for years by confirming a plan that left the central issue in the case unresolved.

On Aug. 3 - more than three years after the plan went effective - Judge Isgur finally decided who would own the reorganized debtors after emergence. The judge awarded 53.54% of reorganized equity to unsecured noteholders, 30.27% to Apollo and Fidelity as DIP lenders (including the 20% they have held for three years), 14.19% to secured noteholders and 2% to other unsecured creditors. Suddenly, Apollo and Fidelity went from owning 100% of outstanding shares (though only 20% of the authorized shares) and having full control of the company to a minority shareholder.

The creditor representative quickly appointed a director in accordance with Judge Isgur’s decision. The next board meeting may be pretty awkward. However, now that the lien litigation is finally over, we’re sure everyone will bury the hatchet and work together to ensure the company’s future success, rather than bringing more litigation over everything that happened during the three years the DIP lenders had sole control over the company.

Or perhaps not. On Aug. 11, a group of unsecured creditors sued the creditor representative and the litigation funders, alleging the litigation funding was part of a conspiracy “to promise away 90% of the equity recovered for all unsecured claimholders - now worth many hundreds of millions of dollars - as a so-called ‘return’ for providing just $5.6 million in funding.” To which we respectfully say lol, lmao.

Then, on Monday, Aug. 14, Judge Isgur had to chide Apollo and Fidelity for stalling on recognizing the creditor representative’s chosen director and threatened to sanction them unless they played nice with their new co-owners, the ones who spent three years suing them. Again, awkward board meetings ahead.

What can we take away from this mess? The easy answer is that litigation crucial to the allocation of value under a plan - especially core bankruptcy litigation, like lien avoidance actions - should be resolved before a plan is confirmed. The problem: As we have often complained - see the item right up there - too often this means rushing litigation to completion on compressed schedules or via estimation, depriving non debtor litigants of a fair chance to litigate their claims.

And if you dig into the weeds of Judge Isgur’s Sanchez ruling, there’s the whole other ball of wax stemming from wild moves in plan equity value over time. Especially in cyclical industries like Sanchez’s, pushing off litigation leaves both the numerator and denominator in play, i.e. CHAOS.

Debtors use the need to resolve litigation before DIP or RSA milestones expire as a way to shove things along using the “parade of horribles.” They also push the prospect of lengthy post-confirmation litigation as grounds to resolve everything related to the litigation, even non-plan dispositive disputes among nondebtors, in the bankruptcy court and on a rocket docket timeline.

For example, check out the fight over bankruptcy court adjudication of monetary claims against nondebtors stemming from uptier exchanges in Incora. Those nondebtor vs. nondebtor damages claims do not need to be resolved prior to confirmation - except that the defendants want them resolved. But the debtors present releases of the damages claims for the defendants as an “integral” part of the plan deal that must be considered prior to confirmation, on the defendants’ preferred (and often arbitrary) timeline.

Our suggestion: Bankruptcy judges should handle crucial pre-confirmation litigation quickly, just not too quickly. Before adopting an absurdly expedited trial schedule, especially on nondebtor vs. nondebtor monetary claims, be absolutely sure the defendants will terminate the DIP or RSA if the claims are not resolved on such a schedule. Call their bluff. Consider whether the economic terms of the DIP or RSA are sufficiently friendly to the defendants that they would probably accept the risk of post-confirmation litigation in another court.

And be creative. We actually like the structure Judge David R. Jones approved in Incora - the parties will litigate the defendants’ liability related to the uptier in the bankruptcy court prior to confirmation, but not necessarily the remedies if the defendants are found liable. Of course, the Incora debtors and defendants can be pretty sure Judge Jones will rule in their favor on liability - see the Serta “open market purchase” decision, and, well, you know - but still, not a bad plan.

Honestly, anything - even shoving litigation through on an absurdly expedited, arbitrary schedule prior to confirmation (or a section 363 sale!) - would be better than whatever Sanchez was, and will probably continue to be for years. Expect this case to be Exhibit A in support of resolving everything, however rapidly or shoddily, before a plan goes effective.

The Last Jedi

Much respect for Judge Michael Kaplan for actually listening to an order from an appellate court by dismissing LTL Management 2.0, however grudgingly. Yes, a bankruptcy judge following an appellate court’s instructions is worthy of praise; that’s where we are at this point.

To credit the erstwhile New Jersey master of torts even further, Judge Kaplan not only followed the Third Circuit’s directives but also undertook a serious analysis of the “financial distress” standard that crushed his dreams of resolving all of America’s mass tort boondoggles. We expected a four-page dismissal order if the judge failed to contort himself around the Third Circuit’s opinion, a contractually coerced performance on the level of Metal Machine Music. Instead, we got Prince’s late stuff for Warner Brothers; unwilling, but unable to be unprofessional about it.

So: Delaware and New Jersey are right out. Would the last reliable practitioner of magical bankruptcy thinking, Judge David R. Jones in Houston, take a bench-slapping from a court of appeals so gracefully? We know Judge Marvin Isgur, his former colleague on the complex “panel,” had some trouble with that. We may soon know about Judge Jones too, as the Fifth Circuit has agreed to accept direct appeals of his “open market purchase” summary judgment and plan confirmation decisions in the Serta case (see above).

What about New York? Judge Robert Drain has now passed on to a better place (a corner office at Skadden), but history isn’t through with him yet: As you all know, on Aug. 10, the Supreme Court granted certiorari to review Judge Drain’s decision approving the Purdue debtors’ nonconsensual nondebtor releases.

Should we be worried about this? Well, both the Fifth Circuit and the Supreme Court are considered overwhelmingly conservative, and that would suggest a business-friendly affirmation of both the Serta Simmons and Purdue decisions. However, as we have been warning you, there are two kinds of modern “conservative” judges: the kind flying around on billionaires’ private jets who will drop the anti-judicial activism schtick when it gets them a free luxury RV and the original intent true believers.

And, like we’ve also warned you, those Federalist Society types may not look too kindly on non-Article III phony-baloney 92% salary bankruptcy judges disposing of claims that the Constitution delivered to Article III courts. When we discussed Judge Sandra Ikuta’s true believer postpetition interest decision in PG&E, we worried that her kind of thinking “could have serious ramifications for bankruptcy courts.” “As debtors’ counsel often point out, ours are courts of equity with a flexible remit - able to grant all kinds of relief not explicitly provided for in the Code,” we said.

And we kept going: “Just take nondebtor releases: Under Judge Ikuta’s logic, Congress ‘chose’ to provide for nondebtor releases in asbestos cases by enacting section 524(g), and, by leaving other debtors out, ‘chose’ not to allow releases for non-asbestos nondebtors.”

Gird up now thy loins, and answer thou me: Will the pro-business chamber of commerce types regret stumping for the releases in Purdue if a 5-4 majority composed of three liberal justices and two true believers strikes a blow for limiting the equitable powers of bankruptcy courts, which bankrupt businesses (and a good chunk of their stakeholders) have grown to rely on? Would the disappearance of nondebtor releases remove a crucial incentive for management to put a company into bankruptcy in the first place? Will the Sacklers of the world instead barricade themselves and litigate endlessly, the very thing Judge Drain said he feared when he approved those releases?

More importantly, what will we do if our judicial idols are designated for assignment down to the minors with the SEC administrative law judges? Will they even get gavels and robes?

--Kevin Eckhardt
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