November 2012: Bankruptcy Litigation Update

by Quinn Emanuel Urquhart & Sullivan, LLP


Jefferson County Section 928 Decision: In a matter of first impression and potential importance in the municipal bond market, the Bankruptcy Court for the Northern District of Alabama held in Bank of New York Mellon v. Jefferson County, Alabama, 474 B.R. 725, 763-64 (Bankr. N.D. Ala. 2012), that where a trust indenture provides sufficient funding for operating expenses, the “minimal standard” of “necessary operating expenses” imposed by Bankruptcy Code section 928(b) is inapplicable. Section 928(b) provides that “[a]ny [ ] lien on special revenues, other than municipal betterment assessments, derived from a project or system shall be subject to the necessary operating expenses of such project or system, as the case may be.” 11 U.S.C. § 928(b). The Bankruptcy Court rejected Jefferson County’s contention that section 928(b) overrode the provisions of the parties’ trust indenture and permitted it to characterize depreciation, amortization, capital expenditures, reserves for any of the same, or reserves for professional fees and expenses, as operating expenses that it could deduct prior to funding debt service. The Bankruptcy Court agreed with the plaintiffs that “a pledge of special revenues [is] unaffected unless it is at odds with the policies incorporated in 928.” Id. at 756. It found that “unbridled inclusion of costs that under generally accepted accounting principles are capitalized, whether in the context of a gross revenue or a net revenue pledge, is capable of undoing what the 1988 Amendments were designed to [achieve],” i.e., the post-petition preservation of special revenue liens, protecting the benefits of parties’ bargains, and ensuring continued municipal access to capital markets. Id. at 760-61. Finally, the Bankruptcy Court concluded that the parties’ “mutual exercise of business judgment ... incorporated into a special revenue financing transaction [ ] should not be second guessed in a municipal bankruptcy absent clear evidence of an unreasonable exercise or that it is a certainty that 928(b) is not met. In other words, for pledges that are not gross revenues, a court should defer to the agreed pledge and distributive design representing the business judgments of the parties that is expressed in the contract between them.” Id. at 763.

CIT Section 510(b) Decision: The Second Circuit recently held that mandatory subordination under section 510(b) of the Bankruptcy Code must be interpreted narrowly in accordance with its underlying purpose. In re CIT Group Inc., 2012 WL 3854887, at *2 (2d Cir. Sept. 6, 2012). The underlying Bankruptcy Court (In re CIT Group Inc., 460 B.R. 633 (Bankr. S.D.N.Y. 2011)) had clarified the scope of section 510(b), which requires the subordination of a claim “arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, [or] for damages arising from the purchase or sale of such a security . . . .” The debtor and its former parent, in connection with the debtor’s pre-petition initial public offering, had entered into a tax sharing agreement whereby the debtor agreed to pay its former parent any tax benefits resulting from the debtor’s use of certain net operating losses (the “NOLs”). The Bankruptcy Court rejected the debtor’s attempt to subordinate the former parent’s claim, which arose from the debtor’s rejection of the tax sharing agreement, concluding that Congress had enacted section 510(b) to prevent equity claims in bankruptcy from being disguised as higher-priority creditor claims. The court reasoned that subordination is appropriate only if the claimant “‘(1) took on the risk and return expectations of a shareholder, rather than a creditor, or (2) seeks to recover a contribution to the equity pool presumably relied upon by creditors in deciding whether to extend credit to the debtor.’” Id. at 638 (citation omitted). Tax sharing agreements generally create only contractual debtor-creditor relationships. Even though the debtor’s ability to use the NOLs depends upon its future revenues, the former parent does not have an interest in the debtor’s future equity value, and thus has no expectation of sharing in the debtor’s profits without limitation. Thus, the court concluded, and the Second Circuit has now affirmed, subordination is not warranted.

Sentinel Fraudulent Transfer Decision: In In re Sentinel Management Group, the Seventh Circuit affirmed that a debtor’s repayment of debt owed to creditors with funds taken from the debtor’s own customers’ accounts was not made with an intent to hinder, delay, or defraud the customers (who became creditors of the debtor by virtue of this comingling of funds) and thus was not an intentional fraudulent conveyance under section 548(a)(1)(A) of the Bankruptcy Code. 689 F.3d 855, 861-64 (7th Cir. 2012). The Sentinel Court explained that “fraudulent conveyance law exists for very different purposes that does not include attempts to choose among creditors as contrasted with restitution and preferences.” Id. at 862-63. Based on this principle, the Court held that the debtor’s “preference of one of set of creditors . . . to another . . . is properly reserved for [the plaintiff]’s preferential transfer claims[.]” Id. at 863. The Court further stated that “a debtor’s ‘genuine belief that’ he could repay all his debts if only he could ‘weather a financial storm’ won’t ‘clothe him with a privilege to build up obstructions’ against his creditors . . . but that does not mean that actions taken to survive a financial storm require a legal finding that the debtor intended to hinder, delay, or defraud[.]” Id. (quoting Shapiro v. Wilgus, 287 U.S. 348, 354 (1932)).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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