A decade ago, the thought of legalized marijuana—even for medicinal purposes—was cutting edge and controversial. In 2021, the conversations around legalized cannabis have dramatically evolved. While there are still critics of legalized cannabis, we have seen a nationwide and largescale embrace of cannabis use ranging from treatment for medical conditions to recreational marijuana. Hemp and CBD products have become mainstream. As of this writing, thirty-seven states, the District of Columbia, and four US territories allow for the use of medical marijuana. Thirteen states and one territory have decriminalized the use of cannabis. Additionally, eighteen states, two territories and the District of Columbia have enacted laws to allow the recreational use of marijuana. Eleven states allow for the use of low THC, high CBD products for medical reasons. These numbers are trending upward, with several states expected to enact various cannabis legalization bills in 2022. Only three states (Idaho, Kansas, and Nebraska) still do not allow the use of cannabis in any capacity.

Despite the overwhelming majority of states allowing for the use of cannabis at some level, the federal legalization structure is lacking. This complex interplay makes it difficult for business lawyers to advise clients whose businesses involve cannabis—whether those clients are legally selling cannabis or if those clients are cannabis-adjacent. This article will explore how the conflict of law between the narrow federal landscape and the expansion of state cannabis laws has created numerous business law complications, including its impact on the banking rules and regulations, and decisions lawyers and bankers must make without clear guidance and direction. Additionally, this article will provide a high-level overview of the questions a business lawyer should be asking, such as: What are the ethical rules that I should be aware of, and what are the areas I need to troubleshoot for my client that I may never have contemplated would be impacted by the changing state-based marijuana laws?

While this article hopes to provide guidance and advice for the business lawyer in the cannabis space, the conflict that exists between federal law and the state laws may present more questions than we can currently answer. However, even with uncertainty in some of the questions raised, this is an area that is growing and evolving, and every business lawyer should be prepared for issues and questions that may arise in this space.

State Law vs. Federal Law

As we examined in the beginning, states have moved towards embracing the use of cannabis. The federal government, meanwhile, has not made the same move. Under federal law, cannabis is still classified as a Schedule I substance under the Controlled Substance Act. This means it is considered to have a high potential for dependency and no recognized medical use. For context, other Schedule I substances include ecstasy, heroin, and LSD. Distribution of a Schedule I substance is a federal offense.

Some progress was made on the federal level with the passage of the 2014 and 2018 Farm Bills. While the Farm Bills did not change the legal classification of cannabis, they did remove hemp from Schedule I of the Controlled Substances Act and permitted states to create industrial hemp programs. There was hope that the Farm Bills would also lead to the Food and Drug Administration (FDA)—which retains regulatory authority over drugs—to issue detailed guidance that would provide clarity on whether (and how) CBD could be used. The Farm Bills, however, have led to more confusion. Many thought that the Farm Bills legalized CBD. The day the 2018 Farm Bill became effective, the FDA released a statement asserting its policy that marketing CBD as foods or dietary supplements remained unlawful. This has led to great consumer confusion and even more uncertainty as the market is now saturated with hemp and CBD products that may or may not actually be allowed under federal law.

In 2021, U.S. Senators Cory Booker, D-NJ, Ron Wyden, D-OR, and Charles “Chuck” Schumer, D-NY, proposed the Cannabis Administration and Opportunity Act as a Discussion Draft (hereinafter the “Draft”). The sponsors indicated that the Draft is in anticipation of a final proposal, which Senate Majority Leader Schumer recently stated would be introduced in April 2022. The Draft would remove cannabis from the Controlled Substances Act and direct the Attorney General to remove cannabis from the list of controlled substances. The Draft would impose a federal excise tax on cannabis products. Importantly, the Draft also contains a number of decriminalization provisions and would allow state-compliant marijuana business to have access to financial services such as bank accounts and loans.

Financial Services Concerns

While this Draft is a significant step towards a comprehensive regulatory scheme, federal action (including its inaction) has already created a conflict of laws in the cannabis space. The federal-state law conflict is particularly evident in the financial services sector. State and federally chartered banks rely on federal agencies for regulatory oversight, insurance and access to funding and payment systems. While a few states have enacted bills intended to protect financial institutions from state financial regulators and other forms of state-wide enforcement in relation to cannabis banking, cannabis remains a federally illegal substance. Thus financial institutions providing banking services to state-licensed cannabis businesses, and even to other companies which sell services and products to those businesses, could find themselves subject to criminal and civil liability under the Controlled Substances Act and subject to regulatory sanctions under certain federal banking statutes.

These risks have significantly inhibited the ability (and willingness) of financial institutions to provide services to cannabis businesses and companies. This limits the ability of cannabis-related businesses—and the financial institutions that want to serve them—to engage in core activities, such as opening accounts, deposits, using checking accounts, accepting credit cards, authorizing electronic transfers, and so on. Some banks and credit unions have cautiously begun entering this market space. While Congress tried to advance a narrow solution through the Secure and Fair Enforcement Banking Act of 2021 (SAFE Banking Act), the bill passed the House of Representatives six times, but has never been taken up in the Senate. Lawyers advising financial institutions that are evaluating whether to offer services to state licensed marijuana-related businesses will need to consider robust risk assessment and compliance programs, along with staying abreast of state and federal law developments.

Other Impacts

In addition to the prime example from the banking space, there are many other areas impacted by the conflict of federal and state laws. For example, the transportation sector is rife with issues. A driver holding federal Department of Transportation certifications and crossing state lines faces a myriad of conflicting state laws and the federal prohibition on cannabis. For example, such a driver could face the loss of their certifications if they test positive for cannabis use, even if they are not intoxicated while driving and if the cannabis was legally used in a state.

There are inherent issues raised in the cannabis space that it is natural for a prudent business attorney to wonder whether they should be doing this work at all. After all, cannabis is still illegal on the federal level. Arguably, a lawyer advising a cannabis company is advising the violation of law and breaking the professional oath they took upon being sworn into the Bar. Most states that have legalized cannabis have provided at least some degree of protection for attorneys who advise clients on how to legally operate within state regulatory frameworks. Some states, like New York, have gone as far as saying that an attorney can not only advise clients, but also accept partial ownership of a recreational marijuana business in lieu of a fee, and when fully legalized, partake of recreational marijuana without jeopardizing their law license. The state rules and regulations are ever evolving, and it is incumbent on any attorney to understand the guiding ethical rules and regulations for the jurisdiction in which they practice. To try to give detailed information in this area is complicated by the ever-changing rules.

Overall, there are many nuances to this ever-evolving issue. The landscape in the cannabis area is constantly changing, and by the time this article is published, some of the information contained herein may have already changed. It is imperative that a business lawyer working in this area stay abreast of each development so that they are properly advising their clients.

Editors

§ 1.1. Supreme Court

City of Chicago vs. Fulton, 141 S. Ct. 585 (2021). In the case before the Court, the City of Chicago impounded the debtors’ vehicles for failure to pay fines. The debtors then filed chapter 13 bankruptcy cases. Following the filing of the cases, the debtors requested that the city return the vehicles. The city refused and the bankruptcy court held that those refusals each constituted a violation of the automatic stay. The Seventh Circuit affirmed and held that “by retaining possession of the debtors’ vehicles after they declared bankruptcy,” the city had violated section 362(a) of the Bankruptcy Code by exercising control over the debtors’ property. The Supreme Court granted certiorari “to resolve a split in the Courts of Appeals over whether an entity that retains possession of the property of a bankruptcy estate violates § 362(a)(3).”

The Court began its analysis by noting that the filing of a bankruptcy petition has certain immediate consequences. The first is that it is the creation of an estate that, with limited exceptions, includes all of the debtor’s legal or equitable interests and property as of the commencement of the case. The Court noted that a second automatic consequence of the filing of a bankruptcy petition, again with certain limited exceptions, is that the petition operates as a stay of all efforts to collect from the debtor outside of the bankruptcy case. Among the many efforts prohibited by the state is “any act in possession of property of the estate or of property from the estate or to exercise control over property of the estate.” Justice Alito, writing for the Court, concluded that the language used in section 362(a)(3) suggests that simply retaining possession of estate property does not violate the stay. The Court noted that the stay bars “any act” to exercise control over property of the estate. The Court concluded that the most natural reading of the statutory language was to prohibit affirmative acts that would disturb the status quo of estate property as of the time of the bankruptcy filing. The Court further concluded that any ambiguity in the language of the Bankruptcy Code would be resolved in the non-debtor’s favor because of section 542. That provision, entitled “Turnover of Property to the Estate,” provides for the delivery of estate property to the trustee. Interpreting the automatic stay to cover mere retention of property would, in the Court’s analysis, create two problems. First, it would render section 542 largely superfluous, which would be contrary to basic principles of statutory interpretation. Moreover, this alternative reading of the automatic stay would render the automatic stay and the turnover provisions contradictory. The Court reached this conclusion because section 542 has exceptions for, inter alia, the turnover of inconsequential property. Reading section 362 as the debtors urged would have the automatic stay commanding turnover of property, when the more specific turnover provision would not. Accordingly, the court held that the mere retention of estate property after the filing of a bankruptcy petition does not violate the automatic stay.

In a concurring opinion, Justice Sotomayor emphasized that the Court did not decide whether and when the automatic stay’s other provisions might require a creditor to return a debtor’s property. Justice Sotomayor also noted that the Court did not address how bankruptcy courts should go about enforcing the commands of section 542(a), and that the city’s conduct could very well violate one or both of these provisions. Justice Sotomayor concluded by noting that any gaps in the efficacy of the turnover process would be “best addressed by rule drafters and policy makers, not bankruptcy judges,” and urged the Advisory Committee on Rules of Bankruptcy Procedure “to consider amendments to the Rules to insure prompt resolution of debtors’ requests for turnover under [section] 542(a), especially where debtors’ vehicles are concerned.”

§ 1.2. First Circuit

Union de Trabajadores de la Industria Electrica y Riego v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 7 F.4th 31 (1st Cir. 2021). In one of the latest of many decisions stemming from the proceedings under Title III of the Puerto Rico Oversight Management and Economic Stability Act (“PROMESA”), the First Circuit recently affirmed the decision of the court overseeing the Title III proceedings (the “Title III Court”) that section 503(b)(1)(A) of the Bankruptcy Code applies to Title III proceedings, notwithstanding that there is no “estate” in Title III proceedings.

In July 2017, the Financial Oversight and Management Board for Puerto Rico (“FOMB”), established by PROMESA to oversee the restructuring proceedings of Puerto Rico and its various instrumentalities, commenced Title III proceedings for the Puerto Rico Electric Power Authority (“PREPA”) after the public power utility—one of the largest in the United States and the only electrical energy distributor in Puerto Rico—became unable to service its debt. Almost a year later, in June 2018, Puerto Rico passed an act to partially privatize PREPA. As a result, a competitive bidding process was undertaken to find a private entity to assume control over PREPA’s power transmission and distribution system (“T&D System”). Two years later, in June 2020, LUMA Energy (“LUMA”) won the bid and entered into a contract to gradually assume operations and management of PREPA (“T&D Contract”). Under the T&D Contract, LUMA would provide front-end transition services to PREPA that would facilitate LUMA’s operational takeover, for which PREPA would pay an estimated $136 million, plus any late fees that might become due as a result of untimely payments. In addition, PREPA agreed to file a motion with the Title III Court seeking administrative expense treatment for any accrued and unpaid amounts required to be paid by PREPA during the front-end transition period; if the court refused to grant the motion, LUMA reserved the right to terminate the T&D Contract. Various prepetition creditors of PREPA opposed the motion, arguing the fees and expenses due under the T&D Contract could not be given administrative expense priority under section 503(b)(1)(A), notwithstanding that PROMESA incorporates section 503 of the Bankruptcy Code in its entirety, because there is no “estate” to preserve in Title III proceedings. The Title III Court rejected this argument, and determined that both the text and structure of PROMESA made it clear that PREPA’s operating expenses were entitled to administrative expense priority, to the extent that they were to preserve the property of a debtor in Title III debt adjustment proceedings. Nonetheless, the Title III Court denied the motion in part, without prejudice, solely to the extent that the motion sought an allowed administrative expense claim for late payment fees that might be incurred in the future.

The First Circuit agreed with the Title III Court, holding that the creditors’ interpretation would render meaningless 48 U.S.C. § 2161(a), which incorporates various Bankruptcy Code provisions referring to an “estate” into Title III of PROMESA. In addition, the First Circuit rejected the creditors’ argument that 48 U.S.C. 2161(c)(5), which provides that “[t]he term ‘property of the estate,’ when used in a section of [the Bankruptcy Code] made applicable in a case under this subchapter by subsection (a), means property of the debtor,” does not apply to section 503(b)(1)(A) because section 503(b)(1)(A) uses the terminology “estate” rather than the terminology “property of the estate.” Relying on 48 U.S.C. § 2161(b), which states that “[a] term used in a section of [the Bankruptcy Code], made applicable in a case under this subchapter by subsection (a), has the meaning given to the term for the purpose of the applicable section, unless the term is otherwise defined in this subchapter,” the court held that “‘the meaning given to’ the term ‘estate’ for ‘the purposes’ of § 503(b)(1)(A) is the meaning given to it under § 541, which is ‘property of the estate.’” Because the term “property of the estate” is otherwise defined in 48 U.S.C. § 2161(c)(5) to mean “property of the debtor,” there was no reason to read section 503(b)(1)(A) out of PROMESA.

In addition, the First Circuit rejected challenges to the Title III Court’s finding that the T&D Contract fees (other than late fees) satisfied the requirements of section 503(b)(1)(A) and affirmed the Title III Court’s determination that the FOMB had sole jurisdiction to review a fiscal plan for compliance with 48 U.S.C. § 2141(b)(1).

Pinto-Lugo v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 987 F.3d 173 (1st Cir. 2021). In another decision arising from the PROMESA proceedings, the First Circuit applied the doctrine of equitable mootness to dismiss three consolidated appeals of the plan of adjustment for the Puerto Rico Sales Tax Financing Corporation (“COFINA”). In so doing, the First Circuit undertook an analysis of (i) the Supreme Court’s decision in Mission Product Holdings, Inc. v. Tempnology, LLC, 139 S. Ct. 1652 (2019) and whether that decision rendered the doctrine of equitable mootness invalid, and (ii) whether the doctrine of equitable mootness could be applied to a Title III proceeding, or to municipal bankruptcy proceedings generally. On both issues, the First Circuit resolved that equitable mootness was applicable to the current cases in controversy.

Certain holders of COFINA bonds objected to a settlement between the Commonwealth of Puerto Rico and COFINA resolving which entity had the superior right in the Commonwealth’s sales and use tax revenues (the “SUT Revenues”). The settlement, which formed the basis of COFINA’s plan of adjustment, allocated 53.65% of the SUT Revenues to COFINA, while the Commonwealth kept the remainder. To implement the settlement, the Commonwealth was required to pass new bond legislation, reorganizing COFINA, allocating the SUT Revenues as agreed under the settlement, and authorizing COFINA to issue replacement bonds. During the legislative session when the new bond legislation was brought to the floor of the Puerto Rico House of Representatives, a minority party representative stood to oppose the bill, but was ignored by the president of the House. The bill was subsequently passed and signed into law by the governor on November 15, 2018.

One contingent of bondholders (the “Pinto-Lugo Group”) filed a complaint seeking declaratory judgment that the law was invalid, asserting that the treatment of the minority representative amounted to a violation of the Puerto Rico legislative rules and the Puerto Rico Constitution. The complaint also sought a ruling that the predecessor act was invalid because it violated limitations on Commonwealth borrowing under the Puerto Rico Constitution. The action was removed to the Title III Court in January 2019.

Also in January 2019, the Title III Court heard objections to the proposed COFINA plan of adjustment, incorporating the settlement. In addition to an objection by the Pinto-Lugo Group, on grounds similar to the complaint, the plan also drew objections from a separate contingent of COFINA bondholders (the “Elliot Group”) and a single bondholder seeking to assert his individual claim. The Title III Court overruled all objections to the plan and dismissed the individual’s proof of claim as duplicative of an omnibus proof of claim filed on behalf of all bondholders, including the individual. The Title III Court approved the plan on February 5, 2019, and the plan was implemented a week later on February 12, 2019. These appeals followed.

The FOMB and others opposed the appeals on grounds of equitable mootness. The First Circuit considered two arguments raised regarding the threshold applicability of the doctrine before examining the merits of dismissing on the basis of equitable mootness. First, the Elliot Group argued that Mission Product undermined the doctrine of equitable mootness. Examining that holding, the First Circuit determined that, in Mission Product, the Supreme Court addressed the jurisdictional ramifications of equitable mootness, whereas in these appeals, the issue was whether the parties’ inaction and the passage of time rendered the relief sought inequitable. Accordingly, Mission Product did not pose an obstacle to the applicability of equitable mootness in the instant action. Second, the Elliot Group contended that the doctrine of equitable mootness was inapplicable to a municipal bankruptcy, and especially to a Title III case under PROMESA. The First Circuit rejected this argument, noting that all circuits to have considered the applicability of equitable mootness to municipal bankruptcy proceedings had treated it as applicable, and that the reasons for making the doctrine applicable to chapter 11 reorganizations applied equally to adjustments under PROMESA.

On the merits, the First Circuit considered: (i) whether the objectors had pursued with diligence all available remedies to obtain a stay; (ii) whether the challenged plan had proceeded beyond practicable annulment; and (iii) whether providing the relief sought would harm innocent third parties. The court found that both the Elliot Group and the Pinto-Lugo Group had “sat on their hands,” since they did not (a) object to the Bankruptcy Rule 3020(e) waiver in the plan, which permitted the plan to be implemented immediately; (b) move for a stay either before the Title III Court or the First Circuit; or (c) seek to expedite the appeal, but rather sought extensions of the briefing schedules themselves. The Pinto-Lugo Group asserted that they did not need to seek a stay to vindicate “fundamental constitutional rights,” but the First Circuit disagreed, holding that “the presence of underlying constitutional claims does not act as a per se bar to the applicability of the doctrine [of equitable mootness].” The court also found, without difficulty, that there was “no practical way to undo” the implementation of the plan, when the replacement bonds had been traded on the open market for over a year, and that any efforts to unwind the plan would inevitably result in harm to “innocent third parties who, due to the . . . objectors’ lack of diligence, justifiably came to rely on the confirmation order.” Accordingly, the First Circuit dismissed the appeals as equitably moot.

Mayoral v. Fin. Oversight & Mgmt. Bd. (In re Fin. Oversight & Mgmt. Bd.), 998 F.3d 35 (1st Cir. 2021). A third decision from the PROMESA proceedings speaks to the ability of investors in a mutual fund that had invested in bonds issued by the Commonwealth of Puerto Rico to bring a claim against the Commonwealth in its Title III proceedings. Notwithstanding the broad construction of the definition of a “claim” under the Bankruptcy Code, the Title III Court found, and the First Circuit affirmed, that these investors did not have standing to recover their losses against the Commonwealth.

Two individual investors each filed proofs of claim against the Commonwealth for a total of approximately $328,400, asserting as the basis for such claim an “investment in mutual funds.” The FOMB objected to the claims on grounds that these individuals were not creditors of the Commonwealth, and thus did not have standing to assert claims against the Commonwealth. Although the individuals argued that they were “co-owners” of the bonds with the mutual funds, and therefore had standing, the Title III Court agreed with the FOMB and disallowed the claims. After two motions for reconsideration before the Title III Court, the individuals appealed to the First Circuit.

First considering the merits of the Title III Court’s initial order disallowing the claims, the First Circuit found that the individuals were not creditors of the Commonwealth under section 501(a) of the Bankruptcy Code, as applicable to Title III proceedings by virtue of 48 U.S.C. § 2161(a). The Bankruptcy Code defines a “creditor” as an “entity that has a claim against the debtor that arose at the time of or before the order for relief concerning the debtor.” 11 U.S.C. § 101(10)(A). A “claim” is defined as a “right to payment” or a “right to an equitable remedy for breach of performance if such breach gives rise to a right to payment.” 11 U.S.C. § 101(5). And a “‘right to payment’ . . . ‘is nothing more nor less than an enforceable obligation.’” Id. at 41 (quoting Cohen v. de la Cruz, 523 U.S. 213, 218 (1998)). Because the claimants did not provide any evidence of an enforceable obligation existing between themselves and the Commonwealth, the First Circuit held that they were not creditors of the Commonwealth. Furthermore, the court found no injury separate from any injury the mutual funds may have suffered, creating a further barrier for standing. Accordingly, the First Circuit found no error in the Title III Court’s original holding and no abuse of discretion in connection with the denials of reconsideration.

Kupperstein v. Schall (In re Kupperstein), 994 F.3d 673 (1st Cir. 2021). In a recent examination of the police power exception to the automatic stay as related to contempt proceedings, the First Circuit adopted a liberal approach, determining that the contempt proceedings were not pursued for a pecuniary purpose, but even if there was an element of the proceedings that served a pecuniary purpose, based on the “totality of the circumstances,” the predominant purpose related to enforcement of public policy such that the contempt proceedings fell within the police power exception.

Donald C. Kupperstein was leasing a property belonging to the estate of Fred Kuhn and collecting rents from its tenants. Because the Kuhn estate owed a debt to the Massachusetts Office of Health and Human Services (“MassHealth”), the estate, MassHealth, and Kupperstein ended up in Massachusetts Probate Court. Kupperstein disregarded the probate court’s order to pay “any and all” rents collected from the property to MassHealth, and continued to rent the property for his own gain, despite the court’s order voiding the original transfer of the property to Kupperstein. Between August 2017 and January 2018, the probate court twice held Kupperstein in contempt and set a contempt hearing for early January 2018. The day before his contempt hearing, Kupperstein filed for bankruptcy in the United States Bankruptcy Court for the District of Massachusetts, listing the Kuhn property as his own property. The following day, at his contempt hearing, despite Kupperstein’s argument that his bankruptcy filing automatically stayed the probate court proceedings against him, the probate court jailed Kupperstein for the day for previously violating the court’s orders four times. At the next court date, Kupperstein narrowly avoided a 30-day jail sentence by finally turning over the keys to the property and producing $5,400, which he had been ordered to pay to MassHealth in December 2017. Kupperstein then vanished, and the probate court held him in contempt twice more for missing three court dates and continuing to violate its previous orders. The probate court also ordered Kupperstein to pay over $50,000 in outstanding rents and over $10,000 in attorneys’ fees as sanctions for repeatedly flouting the court’s orders and issued a warrant for Kupperstein’s arrest.

The Kuhn estate and MassHealth both filed motions in the bankruptcy court to lift the automatic stay to permit the state court actions to proceed; Kupperstein (through his counsel, because he was still “at large”) opposed the motions and moved the bankruptcy court to hold MassHealth in contempt and impose monetary sanctions because MassHealth participated in the probate court’s various contempt proceedings in violation of the bankruptcy court’s automatic stay. The bankruptcy court found “good cause” to lift the stay and ordered that the state court actions could proceed, including the assessment by the courts against Kupperstein of any restitution and sanction amounts, but that the Kuhn estate and MassHealth could not seek to enforce against Kupperstein any judgment with respect to a nearly $200,000 MassHealth reimbursement claim or attempt to collect all or any of such amount from Kupperstein. The bankruptcy court also denied Kupperstein’s motion to hold MassHealth in contempt and to impose sanctions, noting that “[a] court’s imposition and enforcement of a monetary sanction for contemptuous conduct is an exercise of its police power and is excluded from the automatic stay by Bankruptcy Code § 362(b)(4).” After the district court affirmed the bankruptcy court’s rulings, Kupperstein appealed to the First Circuit.

The First Circuit, examining whether the police power exception to the automatic stay applied to the probate court’s contempt proceedings and resultant penalties, concluded that the police power exception applied and that the bankruptcy court did not abuse its discretion. Considering the full array of contempt orders issued by the probate court—which included not only monetary fines, but also orders instructing Kupperstein to turn over the keys to the Kuhn property, to cease leasing the property to tenants as the landlord and not to engage in any new leases, and to turn over any documents he had previously executed regarding renting the property—the First Circuit found that the probate court’s contempt orders were “plainly not an attempt to collect money and there [wa]s simply nothing in the ‘pecuniary interest’ test or the Bankruptcy Code, generally, forbidding a court from ordering that a debtor hand over the keys to a house that he does not own.” As to the monetary fines, the First Circuit rejected Kupperstein’s argument that orders involving money were automatically for a “pecuniary purpose,” since such a position elided the distinction between “a judgment prematurely awarding assets to creditors ahead of the process permitted by the bankruptcy court . . . and an order commanding disgorgement of ill-gotten gains accumulated in direct violation of a court order.” Because neither the Kuhn estate nor MassHealth would gain any priority as a result of the probate court’s order, due to the carveout for enforcement of judgments relating to the $200,000 amount, there was no pecuniary purpose to the probate court’s contempt orders. The First Circuit ventured further still, holding that, even if there was some pecuniary purpose to the financial aspects of the probate court’s orders, it would not affect the court’s determination: “Where the application of the police power exception contains various elements, some of which effectuate a public policy and others of which could involve pecuniary interests, we examine the totality of the circumstances and what the governmental action is designed primarily to [do].” (internal citations omitted). Because “Kupperstein’s own refusal of earlier orders that had no money at stake created this situation . . .,” he could not use the automatic stay to forestall the imposition of the probate court’s contempt orders, including the monetary fines.

Miranda v. Banco Popular de P.R. (In re Cancel), 7 F.4th 23 (1st Cir. 2021). The First Circuit implicitly re-affirmed the Butner principle in a recent decision arising out of an individual chapter 7 case when the chapter 7 trustee sought to avoid an unrecorded Puerto Rican mortgage.

After initially granting the chapter 7 trustee summary judgment based on Massachusetts law, the bankruptcy court reversed on reconsideration, granting summary judgment in favor of the bank on the basis that Puerto Rico law does not treat an unrecorded mortgage as a property interest.

On appeal, the First Circuit considered the nature of Puerto Rican property law. “Puerto Rico has a fundamentally different scheme of mortgage rights. It uses a Property Registry system. A deed is not ‘recorded’ until the Property Registry judges that the deed is valid.” Accordingly, “[u]nder Puerto Rican law, a mortgage must be recorded for it to confer any interest in the underlying real property.” In addition, the First Circuit considered precedent established by the Supreme Court of Puerto Rico, wherein the court held that “a mortgage-holder does not acquire property rights to the underlying real property until the mortgage is recorded, or at least until the mortgage-holder begins the registration process.”

As such, the First Circuit concluded that an unrecorded mortgage in Puerto Rico does not trigger the trustee’s avoidance powers under section 544 of the Bankruptcy Code.

Roy v. Canadian Pac. Ry. Co. (In re Lac-Megantic Train Derailment Litig.), 999 F.3d 72 (1st Cir. 2021). In a question of first impression for the First Circuit, the court held that the Federal Rules of Bankruptcy Procedure—not the Federal Rules of Civil Procedure—govern the procedures in cases that have come within the federal district courts’ jurisdiction as cases “related to” pending bankruptcy proceedings under 28 U.S.C. § 1334(b).

This case arose out of a tragic train derailment and explosion involving a transnational shipment of crude oil, which caused many deaths, extensive personal injuries, and large-scale property damage. Montreal, Main and Atlantic Railway (“MMA”) eventually assumed responsibility for the rail cars in which the oil was transported, and subsequently sought the protection of the bankruptcy court in the District of Maine. Many lawsuits ensued, which were eventually consolidated in the District of Maine pursuant to 28 U.S.C. § 157(b)(5), which allows a district court having jurisdiction over a bankruptcy proceeding to order the transfer to it of any “personal injury tort and wrongful death claims” related to the bankruptcy proceeding. Eventually, the plaintiffs settled with all of the named defendants except for Canadian Pacific Railway Company (“Canadian Pacific”).

Canadian Pacific moved to dismiss the plaintiffs’ consolidated complaint for, among other reasons, lack of in personam jurisdiction, insufficient service of process, and forum non conveniens. In opposition, the plaintiffs sought leave to file a second amended complaint. The district court granted Canadian Pacific’s motion to dismiss, denied the plaintiffs’ motion to amend, and denied all other pending motions as moot, entering final judgment in favor of Canadian Pacific. Twenty-eight days after final judgment was entered, the plaintiffs moved for reconsideration in the district court of the denial of their motion to file an amended complaint. Canadian Pacific opposed the motion on a number of grounds, including timeliness, arguing that the Bankruptcy Rules—which allow only a fourteen-day window for motions for reconsideration—controlled and that, therefore, the plaintiffs’ motion for reconsideration was untimely. After the district court denied reconsideration, the plaintiffs filed a notice of appeal, purporting to challenge the district court’s denial of their motion for leave to amend.

The threshold issue before the First Circuit was whether the plaintiffs’ appeal was timely, which inquiry was determined by the applicable procedural rules: if the Civil Rules applied, the appeal was timely; if the Bankruptcy Rules applied, the appeal was untimely. The First Circuit began by noting that precedent favored the Bankruptcy Rules: all three of the courts of appeals to have considered the issue concluded that the Bankruptcy Rules apply to non-core, “related to” cases pending in a federal forum and that the leading treatise in the bankruptcy field also endorsed this view. The First Circuit read the statutory text as supporting this view, and noted that a procedural scheme that required a district court adjudicating both core and non-core cases in any given bankruptcy proceeding to simultaneously apply two different sets of rules, or that required a district court reviewing a bankruptcy court’s proposed findings of fact and conclusions of law in a non-core case to apply the Civil Rules after the bankruptcy court had applied the Bankruptcy Rules, “would be in marked tension with the bankruptcy system’s goal of resolving claims efficiently.” The First Circuit thus held that “[t]he text of the Bankruptcy Rules, read in conjunction with Congress’ redesign of the bankruptcy system in 1984, makes pellucid that the Bankruptcy Rules apply to non-core, ‘related-to’ cases adjudicated in federal district courts under section 1334(b)’s ‘related to’ jurisdiction.” As a result of this holding, the plaintiffs’ attempted appeal in the case, which would have been timely under the Civil Rules but not timely under the Bankruptcy Rules, was found to be untimely and had to be dismissed for want of appellate jurisdiction.

§ 1.3. Second Circuit

Clinton Nurseries, Inc. v. Harrington (In re Clinton Nurseries, Inc.), 998 F.3d 56 (2d Cir. 2021). After a bankruptcy court rejected the debtors’ constitutional challenge to quarterly fees imposed during the pendency of the debtors’ bankruptcy proceeding, the Second Circuit reversed, finding that the fees assessed in judicial districts in which the United States Trustee Program oversees bankruptcy administration (“UST Districts”), which were higher than the fees assessed in judicial districts in which judicially appointed bankruptcy administrators perform the same function (“BA Districts”), violated the uniformity requirement of the Bankruptcy Clause of the United States Constitution.

In 2017, Congress passed an amendment (the “2017 Amendment”) to the statute setting forth quarterly fees in bankruptcy cases. The 2017 Amendment increased quarterly fees in UST Districts only, and BA Districts did not immediately adopt an equivalent fee increase. In 2020, Congress passed the Bankruptcy Administration Improvement Act of 2020 (the “2020 Act”), which mandated that UST Districts and BA Districts charge equal fees. The debtors, who filed for bankruptcy in a UST District in 2017, incurred fees in accordance with the increase set forth in the 2017 Amendment during the period after that amendment but before the effective date of the 2020 Act. Accordingly, although the 2020 Act ensured the uniform application of fees in UST Districts and BA Districts, the Second Circuit was left with the question of whether Clinton was charged unconstitutional fees before the BA Districts fully implemented the 2017 Act’s fee increase.

After addressing the debtor’s standing to bring the constitutional challenge, the Second Circuit turned to the merits of the argument, rejecting the U.S. Trustee’s position that the 2017 Amendment was “an administrative funding measure, not a substantive bankruptcy law,” and thus did not implicate the uniformity requirement of the Bankruptcy Clause. Noting that this argument “has been repeatedly rejected by other courts,” the Second Circuit held that “[t]he subject of the 2017 Amendment plainly fits within the Supreme Court’s broad definition of ‘bankruptcy’ as ‘the subject of the relations between an insolvent or nonpaying or fraudulent debtor and his creditors, extending to his and their relief.’” Because the 2017 Amendment “governs debtor-creditor relations and impacts the relief available, it is a bankruptcy law subject to the Bankruptcy Clause and is constitutional only if ‘uniform.’”

The Second Circuit next addressed the question of whether the 2017 Amendment violated the uniformity requirement of the Bankruptcy Clause. The Second Circuit held that the delayed and inconsistent implementation of the fee increase in BA Districts contravened facially uniform statutory language. The 2017 Amendment stated that designated fees “shall” be imposed on debtors in UST Districts, while stating, by contrast, that the Judicial Conference “may” impose the same fees in BA Districts. The Second Circuit refused to ignore the distinction between “shall” and “may,” finding that there was no ambiguity in the statute’s grant of permissive authority to the Judicial Conference to adjust fees and that the statute was thus unconstitutional.

The Second Circuit also rejected the Trustee’s secondary argument, that a narrowly defined exception to the uniformity requirement—the “geographically isolated problem” exception—justified the fee discrepancy. This “geographically isolated problem” exception was first recognized in Blanchette v. Connecticut Gen. Ins. Corp., 419 U.S. 102 (1974), when the Supreme Court addressed the constitutionality of the Rail Act, which set special laws for bankrupt railroads and expressly applied only to a particular geographic region. Stating that “the uniformity clause was not intended to hobble Congress by forcing it into nationwide enactments to deal with conditions calling for remedy only in certain regions,” the Supreme Court concluded that the Rail Act did not contravene the Bankruptcy Clause’s uniformity requirement because all of the country’s bankrupt railroads at that time were located in the designated region and, therefore, in targeting the national rail transportation crisis, the statute addressed a geographically isolated problem. Other courts have applied the “geographically isolated exception” to uphold the constitutionality of the 2017 Amendment. E.g., In re Buffets, L.L.C., 979 F.3d 366 (5th Cir. 2020); In re Circuit City Stores, Inc., 996 F.3d 156 (4th Cir. 2021). The Fifth Circuit in Buffets, for example, reasoned that “[j]ust as it did in addressing the failure of railroads in the industrial heartland, Congress confronted the problem of an underfunded Trustee Program where it found it: in the Trustee Districts.” 979 F.3d at 378. The Second Circuit split from the Fourth and Fifth Circuits, “concerned . . . that the bankruptcy courts and the Buffets and Circuit City opinions [] overlooked a critical distinction” between the Rail Act in Blanchette and the 2017 Amendment at issue in Buffets, Circuit City, and here.

The Second Circuit acknowledged that, although the Blanchette court held that Congress may “take into account differences that exist between different parts of the country, and…fashion legislation to resolve geographically isolated problems,” 419 U.S. at 159, the Supreme Court later clarified that “[t]o survive scrutiny under the Bankruptcy Clause, a law must at least apply uniformly to a defined class of debtors.” Ry. Labor Execs.’ Ass’n v. Gibbons, 455 U.S. 457, 473 (1982). “In Blanchette, all members of the class of debtors impacted by the statute were confined to a sole geographic area: [t]he statute applied only to bankrupt railroad companies, and there were no bankrupt railroad companies located outside the statutorily designated region. Here, by contrast, the 2017 Amendment’s fee increase applies to the class of debtors whose disbursements exceed $1 million, and there has been no suggestion that members of that broad class are absent in BA Districts.” Clinton Nurseries, 998 F.3d at 68-69 (internal citations omitted). The Second Circuit thus viewed this case as presenting the exact problem avoided in Blanchette: “[t]wo debtors, identical in all respects save the geographic locations in which they filed for bankruptcy, [] charged dramatically different fees.” Id. at 69. Because the distinction between UST Districts and BA Districts appears to exist only because Congress chose to create a dual bankruptcy system, and because the funding shortfall plaguing the UST system was not caused by a “geographically isolated problem” that would place the entire class of affected debtors only in UST Districts, the Second Circuit refused to apply the “geographically isolated problem” exception to the 2017 Amendment, instead finding that prior to the 2020 Act, the 2017 Amendment was unconstitutionally nonuniform on its face because it mandated a fee increase in UST Districts but only permitted a fee increase in BA Districts.

PHH Mortg. Corp. v. Sensenich (In re Gravel), 6 F.4th 503 (2d Cir. 2021). On appeal, the Second Circuit vacated the imposition of punitive sanctions on creditor PHH Mortgage Corporation by the United States Bankruptcy Court for the District of Vermont in three chapter 13 cases, holding that Bankruptcy Rule of Procedure 3002.1 does not authorize punitive monetary sanctions.

This appeal involves punitive sanctions in three chapter 13 cases in Vermont. Rule 3002.1, which governs installment payments on home mortgages in chapter 13 plans, mandates, among other things, that mortgage creditors must serve on the trustee a notice itemizing all fees “within 180 days after the date on which the fees, expenses, or charges are incurred.” Fed. R. Bankr. P. 3002.1(c). If a creditor fails to comply with the 180-day timeline, a bankruptcy court may preclude the creditor from presenting the claim or award the debtor other relief, including expenses and attorneys’ fees. Fed. R. Bankr. P. 3002.1(i). When the Gravels reached the end of their chapter 13 plan, the bankruptcy court issued an order confirming that the Gravels had cured all pre-petition arrearages or defaults existing when the case was filed and made all post-petition payments. Five days later, PHH issued a monthly mortgage statement with an old charge for “property inspection fees,” which had grown to $258.75 over at least 25 monthly statements. The chapter 13 trustee moved for a finding of contempt and sanctions on the ground that the charge violated the bankruptcy court’s order and that each of the 25 charges violated Rule 3002.1. PHH admitted that the fee was not properly noticed, removed it from the mortgage statement, and opposed the motion for sanctions. Around the time the chapter 13 trustee filed its motion in the Gravel case, the same trustee moved for a finding of contempt and sanctions in another chapter 13 proceeding, for the Beaulieus, on the same basis—for late-noticed fees in violation of Rule 3002.1 and the court’s order in that case. The same chapter 13 trustee also moved for sanctions under Rule 3002.1(i) for late-noticed fees in the Knisley case, but did not allege PHH to be in contempt, as no court order had yet been issued in that case. After a consolidated hearing, the bankruptcy court granted the trustee’s motion, finding that PHH had violated Rule 3002.1(c) 25 times in each of the three bankruptcy cases, sanctioning PHH $75,000 pursuant to Rule 3002.1(i), and sanctioning PHH $200,000 in the Gravel case and $100,000 in the Beaulieu case pursuant to its inherent power and section 105 of the Bankruptcy Code for violating the court orders in those cases.

The United States District Court for the District of Vermont vacated both sanctions, holding that the $75,000 and $300,000 sanctions exceeded the bankruptcy court’s statutory and inherent powers because it lacks power to impose serious punitive sanctions. The bankruptcy court then issued a second sanctions order, imposing the same $75,000 sanction for the Rule 3002.1 violation, but reducing the sanctions for violation of the court orders to $150,000 and $75,000, respectively. PHH appealed the second sanctions order to the district court, but the bankruptcy court granted the trustee’s request to certify the order for direct review by the Second Circuit, which then granted the trustee’s petition for direct review.

First addressing the $225,000 sanction for violation of the bankruptcy court’s orders, the Second Circuit held that, because the bankruptcy court relied on its contempt power, its review was limited to whether it abused its discretion in exercising that power. Holding that the court orders were not a clear and unambiguous prohibition on PHH’s sanctioned conduct, the Second Circuit found that the bankruptcy court’s orders thus lacked the requisite clarity that would allow that court to hold PHH in contempt.

The bankruptcy court invoked Rule 3002.1’s authorization to “award other appropriate relief” to impose the $75,000 sanction for PHH’s repeated violations of Rule 3002.1. Presenting an issue of first impression among the circuit courts, the Second Circuit held that Rule 3002.1’s authorization to “award other appropriate relief” does not authorize punitive sanctions. Rule 3002.1 ensures that debtors are informed of new post-petition obligations, such as fees, and ultimately serves to prevent lingering deficits from surfacing after their bankruptcy case ends. The last subdivision of the rule provides for an enforcement mechanism: if a creditor fails to give the requisite notice, the bankruptcy court may preclude the creditor from presenting evidence of its claim in the case, Fed. R. Bankr. P. 3002.1(i)(1), and the court may also “award other appropriate relief, including reasonable expenses and attorney’s fees caused by the [creditor’s] failure [to give the requisite notice].” Fed. R. Bankr. P. 3002.1(i)(2). Because “‘other appropriate relief’ is a general phrase amid specific examples,” the Second Circuit decided that “it is best ‘construed in a fashion that limits the general language to the same class of matters as the things illustrated.’” Sensenich, 6 F.4th at 514 (quoting Canada Life Assurance Co. v. Converium Ruckversicherung (Deutschland) AG, 335 F.3d 52, 58 (2d Cir. 2003)). Noting that reasonable expenses and attorneys’ fees are compensatory forms of relief that expressly remedy harms to the debtor, the Second Circuit interpreted this to suggest that “other appropriate relief” is limited to non-punitive sanctions. Further supporting the Second Circuit’s interpretation of the non-punitive nature of the sanctions authorized under Rule 3002.1, the court reasoned that the other sanction provided for in the enforcement mechanism of Rule 3002.1(i)—preventing a creditor from collecting an improperly noticed claim—makes an exception for harmless non-compliance, and thus prospectively serves the remedial goal of shielding debtors from unforeseen charges, rather than a punitive purpose. Finally, the court noted that other sections of the Bankruptcy Code explicitly authorize punitive damages, whereas Rule 3002.1 does not. On appeal, the chapter 13 trustee argued, in the alternative, that the $75,000 sanction was authorized under the bankruptcy court’s inherent power. However, because the bankruptcy court did not assess whether the sanction was authorized pursuant to its inherent power, the Second Circuit could not properly consider that argument: “[t]he sanction was imposed under Rule 3002.1(i), and [the Second Circuit’s] holding is that the sanction went beyond the relief authorized by that rule.”

§ 1.4. Third Circuit

In re Weinstein Co. Holdings LLC, 997 F.3d 497 (3d Cir. 2021). In a case arising out of the Weinstein Company bankruptcy proceedings, the Third Circuit examined the definition of “executory contracts” in the context of a work-for-hire contract to find that the non-executory contract had been properly sold by the debtors as a non-executory contract, and thus the purchaser was not required to cure existing defaults under the contract.

In June 2018, the Weinstein Company and its affiliates (“TWC”) filed bankruptcy petitions to facilitate the sale of substantially all of their assets to Spyglass Media Group, LLC (“Spyglass”) under section 363 of the Bankruptcy Code. Among the assets sold was TWC’s work-made-for-hire contract with Bruce Cohen (the “Cohen Agreement”) to produce the critically acclaimed 2012 film Silver Linings Playbook. In October 2018, Spyglass filed a declaratory judgment action against Cohen seeking a determination that the Cohen Agreement was not an executory contract. Under the Cohen Agreement, Cohen was entitled to approximately $400,000 in previously unpaid contingent compensation: if the Cohen Agreement was an executory contract, Spyglass would assume the liability as part of the cure amount; if the Cohen Agreement was not an executory contract, the liability remained with the TWC debtors and would be payable on par with other general unsecured creditors of the debtors’ estate for cents on the dollar. On a motion for summary judgment, the bankruptcy court found that the contract was not executory and was properly sold as part of the TWC asset sale to Spyglass. After the district court affirmed the bankruptcy court’s decision, Cohen timely appealed to the Third Circuit.

Applying the Countryman test to determine whether the Cohen Agreement was an executory contract, the Third Circuit analyzed “whether the [Cohen] Agreement ‘contained at least one obligation for both [TWC] and [Cohen] that would constitute a material breach under New York law if not performed.’” Because New York law incorporates the substantial performance doctrine, the court also analyzed whether Cohen had breached the Cohen Agreement such that it would have excused TWC from not paying the contingent compensation then outstanding (i.e., whether Cohen had failed to substantially perform). The Third Circuit held that, “[o]n TWC’s side, its obligation to pay contingent compensation to Cohen is clearly material,” but, on Cohen’s side, “he contributed almost all his value when he produced the movie.” Noting that “other courts agree that the employee in a work-made-for-hire contract usually does not have material obligations after the work is completed despite ancillary negative covenants or indemnification obligations,” the Third Circuit decided that “none of Cohen’s remaining obligations go to the ‘root of the contract’ or ‘defeat the purpose of the entire transaction’ if breached.”

Cohen argued that, because the Agreement stated that TWC must pay contingent compensation provided Cohen was “not otherwise in breach or default,” all of his obligations were material, as even a breach of a technical provision would excuse TWC’s obligation to pay contingent compensation. The Third Circuit acknowledged that parties can indeed contract around the default substantial performance rule but held that Cohen and TWC did not clearly and unambiguously avoid the substantial performance rule under New York law. Thus, the Third Circuit “agree[d] with the Bankruptcy and District Courts that Cohen’s remaining obligations are immaterial and ancillary to the purpose of the contract…[so] the Cohen Agreement is not executory.” Accordingly, Spyglass was not obligated to cure the existing defaults as part of its purchase of the Cohen Agreement.

In re Orexigen Therapeutics, Inc., 990 F.3d 748 (3d Cir. 2021). The Third Circuit held that section 553 of the Bankruptcy Code, which governs creditor setoffs, requires “strict bilateral mutuality.” In so holding, the Third Circuit decided that creditors cannot set off obligations owed to debtors in bankruptcy against obligations that the debtors owe to creditors’ affiliates, notwithstanding parties’ contracts to the contrary.

Orexigen Therapeutics Inc. (“Orexigen”) entered into a pharmaceutical distribution agreement (“distribution agreement”) with McKesson Corp. Inc. (McKesson), pursuant to which Orexigen sold pharmaceuticals to McKesson. The distribution agreement included broad setoff rights permitting “each of McKesson and its affiliates . . . to set-off, recoup and apply any amounts owed by it to [Orexigen’s] affiliates against any [and] all amounts owed by [Orexigen] or its affiliates to any of [McKesson] or its affiliates.” Orexigen also entered into a services agreement (“services agreement”) with a McKesson subsidiary, McKesson Patient Relationship Solutions (“MPRS”), pursuant to which MPRS advanced funds to certain pharmacies on Orexigen’s behalf. Less than two years after entering into these agreements, Orexigen filed for bankruptcy in the United States Bankruptcy Court for the District of Delaware. As of the petition date, McKesson owed Orexigen almost $7 million under the distribution agreement and Orexigen owed MPRS approximately $9 million under the services agreement, and McKesson sought to exercise its contractual right under the distribution agreement to set off the amount it owed to Orexigen against the amount Orexigen owed to MPRS. The Bankruptcy Court rejected McKesson’s attempt to enforce its setoff right, holding that section 553 of the Bankruptcy Code imposes a mutuality requirement that private parties cannot contract around. The United States District Court for the District of Delaware affirmed the bankruptcy court’s ruling and McKesson appealed.

The Third Circuit affirmed the bankruptcy court and the district court. A question of first impression for the Third Circuit, the Court definitively rejected the permissibility of triangular setoffs under section 553 of the Bankruptcy Code, strictly construing section 553’s mutuality requirement to mean that the debt and claim sought to be setoff must be between the same two parties. The Third Circuit based its decision, in part, on Congress’ “inten[t] for mutuality to mean only debts owing between two parties, specifically those owing from a creditor directly to the debtor and, in turn, owing from the debtor directly to that creditor” and the absence of congressional intent “to include within the concept of mutuality any contractual elaboration on that kind of simple, bilateral relationship.” Holding that triangular setoffs are prohibited and cannot be contracted around, the Third Circuit observed that McKesson could have enjoyed the mutuality contemplated by section 553 by signing the services agreement itself instead of through its subsidiary, MPRS. The Third Circuit also noted that MPRS’ contract with Orexigen could have provided MPRS with a security interest in Orexigen’s accounts receivable, which, once perfected, would have given MPRS a priority right to the amount that McKesson sought through setoff without running afoul of the Bankruptcy Code.

In re Energy Future Holdings Corp., 990 F.3d 728 (3d Cir. 2021). The United States Court of Appeals for the Third Circuit held that, pursuant to section 503(b)(1)(A) of the Bankruptcy Code, stalking horse bidders may assert administrative expense claims for costs incurred while attempting to close on unsuccessful transactions even if the stalking horse bidders are not entitled to any breakup or termination fees.

Chapter 11 debtors Energy Future Holdings Corp. and its affiliates terminated the merger agreement between them and a stalking horse bidder after the stalking horse bidder failed to obtain the regulatory approval necessary to consummate the agreement. After the Third Circuit affirmed the bankruptcy court’s denial of the stalking horse bidder’s application for payment of a termination fee, the stalking horse bidder then filed an administrative expense application for costs incurred in connection with its unsuccessful efforts to complete the merger. In response to the application for administrative expenses, various bondholders jointly filed a motion to dismiss and a motion for summary judgment. The bankruptcy court granted both motions, which the district court affirmed, and the stalking horse bidder appealed.

The Third Circuit reversed the bankruptcy and district courts. The Third Circuit held that the plain language of the merger agreement permitted recovery of expenses specified under section 503(b)(1)(A) of the Bankruptcy Code. In so holding, the Third Circuit determined that it was appropriate to consider what ultimately transpired in connection with the merger in determining whether the estate received an actual benefit from the expenses incurred by the stalking horse bidder. In other words, the court could evaluate the necessity of the expenses using the benefit of hindsight. Notwithstanding that the contemplated merger was not ultimately realized, the Third Circuit found that the stalking horse had plausibly alleged a benefit to the estate because, among other things, the stalking horse had provided valuable information and paved a path forward for a later, successful transaction. Although the benefit to the estate could not be monetized, the allegations provided a plausible factual basis such that the stalking horse bidder’s application for administrative expenses should not have been denied on a motion to dismiss.

Davis v. California (In re Venoco LLC), 998 F.3d 94 (3d Cir. 2021). Interpreting and extending Supreme Court precedent in Central Virginia Community College v. Katz, 546 U.S. 356 (2006), the Third Circuit held that, where a liquidating trustee brought a bankruptcy adversary proceeding against the State of California and its Lands Commission asserting an inverse condemnation claim, neither the State nor its Lands Commission were entitled to sovereign immunity in the face of such claims.

Debtor Venoco LLC and its affiliates (collectively, “Venoco”) operated an oil drilling rig off the coast of Santa Barbara (the “Offshore Facility”). After being extracted at the Offshore Facility, the oil and gas would then be transported to an onshore processing and refining facility (the “Onshore Facility”). Venoco leased, and did not own, the Offshore Facility, but did own the Onshore Facility. After a pipeline rupture in 2015 and an unsuccessful reorganization attempt in 2016, Venoco filed a second chapter 11 proceeding on April 17, 2017. On the same day, Venoco abandoned its leases pertaining to the Offshore Facility, at which point the California State Lands Commission took over decommissioning the rig and plugging the abandoned wells. Initially, the Lands Commission agreed to pay Venoco approximately $1.1 million per month to continue operating both facilities. When a third-party contractor took over operations for Venoco, a new agreement was reached wherein the Lands Commission would pay Venoco approximately $100,000 per month for access to and use of the Onshore Facility. Eventually, however, the Lands Commission stopped paying and invoked its police powers to continue using the Onshore Facility without making further payments to Venoco.

In May 2018, the Bankruptcy Court confirmed the Venoco plan of liquidation, pursuant to which the estates’ assets, including the Onshore Facility, were transferred to a liquidation trust. Shortly after the plan became effective, the court-appointed trustee of the liquidation trust commenced an adversary proceeding against the Lands Commission and the State (together, the “California Parties”), asserting a claim for inverse condemnation: “a cause of action against a governmental defendant to recover the value of property which has been taken in fact by the government defendant.” Knick v. Twp. of Scott, 139 S. Ct. 2162 (2019). The California Parties filed motions to dismiss, arguing, among other things, that they were immune from suit as sovereigns. The Bankruptcy Court denied the motions. The District Court granted leave for an interlocutory appeal only on the sovereign immunity defense. The District Court then affirmed the Bankruptcy Court, rejecting the California Parties’ assertion of both Eleventh Amendment sovereign immunity and state law immunity from liability.

On appeal, the Third Circuit considered the applicability of the Supreme Court’s decision in Katz. The Third Circuit interpreted Katz to stand for the proposition that, “States cannot assert a defense of sovereign immunity in proceedings that further a bankruptcy court’s in rem jurisdiction no matter the technical classification of that proceeding.” Davis, 998 F.3d at 104. Then, adopting the Eleventh Circuit’s interpretation of Katz, the Third Circuit found that the following constitutes a bankruptcy court’s in rem jurisdiction: “[1] the exercise of exclusive jurisdiction over all of the debtor’s property, [2] the equitable distribution of that property among the debtor’s creditors, and [3] the ultimate discharge that gives the debtor a ‘fresh start’ by releasing him, her, or it from further liability for old debts.” Id. (quoting In re Diaz, 647 F.3d 1073, 1084 (11th Cir. 2011)). Based on this framework, the court then concluded that the adversary proceeding implicated two of the three Diaz examples of a bankruptcy court’s in rem jurisdiction. First, it implicated the bankruptcy court’s exclusive jurisdiction over the Venoco debtors’ property, because it sought a ruling on rights in the Onshore Facility. Although the suit was for money damages, the Third Circuit focused on the function of the suit—to decide rights in Venoco’s property—over the form of the relief sought. Second, the adversary proceeding facilitated distributions to creditors due to the significance of the Onshore Facility as an asset of the Venoco debtors’ estates. Accordingly, the court would not permit the California Parties to avoid liability using sovereign immunity. The Third Circuit further expanded Katz to apply to assertions of state-law substantive immunity from liability, in addition to Eleventh Amendment sovereign immunity.

§ 1.4. Fourth Circuit

Siegel v. Fitzgerald (In re Circuit City Stores, Inc.), 996 F.3d 156 (4th Cir. 2021). Splitting with the Second Circuit’s decision in Clinton Nurseries, Inc. v. Harrington (In re Clinton Nurseries, Inc.), 998 F.3d 56 (2d Cir. 2021), the Fourth Circuit held that the 2017 Amendment is not unconstitutionally nonuniform. The Fourth Circuit further held that the 2017 Amendment is not unconstitutionally retroactive.

United States bankruptcy courts operate under two distinct programs for the handling of their proceedings: the Trustee (“UST”) program and the Bankruptcy Administrator (“BA”) program. These bankruptcy court programs utilize distinct funding sources. The judiciary’s general budget funds the BA program whereas the bankruptcy debtors in UST program districts primarily fund the Trustee program through, among other fees, chapter 11 quarterly fees based on the quarterly disbursements that debtors make to their creditors until the cases are converted or dismissed. BA programs and UST programs required chapter 11 debtors to pay quarterly fees consistent with the same disbursement formula from 2002 until January 1, 2018, when an amendment Congress passed (the “2017 Amendment”) to the statute setting forth quarterly fees in bankruptcy cases took effect. The 2017 Amendment altered the quarterly fees formula and increased the fees due in large chapter 11 bankruptcy cases in the UST program only. The UST program implemented the increased fees for disbursements for all cases after January 1, 2018, so both new and pending chapter 11 bankruptcy debtors incurred increased fees beginning in the first quarter of 2018. The Judicial Conference adopted an amended fee schedule in September 2018 and applied the increased fees to those bankruptcy cases filed in the BA program on or after October 1, 2018, such that any debtor in the BA program that filed for bankruptcy prior to October 1, 2018, would not owe increased quarterly fees, regardless of how long the bankruptcy case remained pending.

In 2008, Circuit City Stores, Inc., and its affiliates (collectively “Circuit City”) filed for chapter 11 bankruptcy protection in the Eastern District of Virginia, which is in the UST program. The cases remained pending after the 2017 Amendment went into effect. Although the Circuit City trustee initially paid the increased fees, he later contested them after the Bankruptcy Court for the Western District of Texas ruled in February 2019 that the 2017 Amendment was unconstitutional because it created nonuniform bankruptcy laws in contravention of the Bankruptcy Clause and was unconstitutionally retroactive. The Bankruptcy Court for the Eastern District of Virginia granted the Circuit City trustee’s request for relief, ruling that the quarterly fees could be classified as either a tax or user fee under the Bankruptcy Code and, under either designation, the 2017 Amendment contravened both the Bankruptcy Clause and the Uniformity Clause of the Constitution. The court also addressed Circuit City’s retroactivity contention, finding that the increased quarterly fees in UST programs do not contravene any anti-retroactivity Constitutional principles because the 2017 Amendment is “substantively prospective” rather than retroactive. Following the U.S. Trustee’s appeal to the district court challenging the Bankruptcy Opinion’s ruling that the 2017 Amendment was unconstitutional due to lack of uniformity, and the Circuit City trustee’s cross-appeal of the Opinion’s ruling on retroactivity, the parties jointly sought permission for direct appeals, bypassing the district court, which the Fourth Circuit granted.

The Fourth Circuit began by noting that the case from the Bankruptcy Court for the Western District of Texas—which had persuaded the Circuit City trustee and the Bankruptcy Court for the Eastern District of Virginia that the increased quarterly fees in the UST program were unconstitutional—was reversed on direct appeal to the Court of Appeals for the Fifth Circuit. The Fourth Circuit went on to explain and agree with the Fifth Circuit’s reasoning, holding that “the uniformity requirement does not deny Congress the power to enact legislation that resolves regionally isolated problems.” The Fourth Circuit echoed the Fifth Circuit’s emphasis that the Bankruptcy Clause forbids only “arbitrary” geographic districts and, accordingly, “when Congress determined that it needed to remedy a shortfall in funding for the Trustee districts, it was entitled to ‘solve the evil to be remedied with a fee increase in just the underfunded districts.’” Although “the establishment of separate Trustee and Administrator districts was” admittedly “an ‘irrational and arbitrary’ distinction for which Congress [gave] ‘no justification,’” the Fourth Circuit found that Congress provided “a solid fiscal justification” for the 2017 Amendment, which was to ensure that the UST program was sufficiently funded by its debtors rather than by taxpayers. Thus, the Fourth Circuit reversed the bankruptcy court, finding that the 2017 Amendment does not contravene the uniformity mandate of either the Uniformity Clause or the Bankruptcy Clause.

Turning to the cross-appeal pursued by the Circuit City trustee, the Fourth Circuit affirmed the bankruptcy court’s decision that the 2017 Amendment is not unconstitutionally retroactive. Although the 2017 Amendment increased the quarterly fees large chapter 11 debtors had to pay, the Fourth Circuit reasoned that those debtors were reasonably expected to pay fees pursuant to some formula, and that the 2017 Amendment did not increase a debtor’s liability for past conduct or impose new duties with respect to transactions already completed, and thus did not give rise to Fifth Amendment due process concerns.

§ 1.6. Fifth Circuit

Off. Comm. of Unsecured Creditors of Walker Cnty. Hosp. Corp. v. Walker Cnty. Hosp. Dist. (In re Walker Cnty. Hosp. Corp.), 3 F.4th 229 (5th Cir. 2021). A county hospital filed for Chapter 11 bankruptcy protection and endeavored to auction off its assets. Although thirty-six parties received an offering memorandum, none submitted a bid. However, there was a stalking horse bid. At the time that the stalking horse bid was being considered, an unsecured creditors’ committee was formed. The committee believed that the stalking horse bid was too low. Ultimately, the debtor, the stalking horse bidder, and the committee reached a compromise that would govern the sale of the hospital’s assets. As part of this compromise, the committee agreed to not object to the sale to the stalking horse bidder. A critical component of the bid was that the stalking horse purchaser would receive certain Medicaid payments. After a sale order was entered, the stalking horse’s lender began its due diligence. Because of delays associated with that due diligence and the timing of the Medicaid payment, the debtor filed an emergency motion with the bankruptcy court seeking to amend the sale order. The amended sale order lowered the purchase price and made other adjustments to the transaction. Because time was of the essence to consummate the sale, the debtor asked the bankruptcy court to waive the 14-day stay typically provided by Rule 6004(h) of the Federal Rules of Bankruptcy Procedure. Shortly after the debtor’s motion was filed, the bankruptcy court entered its amended order granting the relief that had been requested. The amended order provided that it was effective immediately upon its entry and authorized the parties to close the transaction immediately. The committee did not seek a stay, but two weeks later appealed the bankruptcy court’s amended sale order to the district court, claiming various bankruptcy rules were not followed and that its procedural due process rights had been violated. The district court dismissed the appeal on grounds of statutory mootness. An appeal to the Fifth Circuit ensued.

The Fifth Circuit based its ruling on section 363(m) of the Bankruptcy Code, and its case law interpreting that section, which it found to be abundantly clear: “[A] failure to obtain a stay is fatal to a challenge of a bankruptcy court’s authorization of the sale of property. . . . And fatal means fatal: challenges to authorized bankruptcy sales are dismissed when the party challenging the sale has not sought a stay. This result is made unmistakable by our precedent.” The court noted that the committee made two interrelated arguments in an attempt to skirt the effects of section 363(m). First, the committee argued that it was only appealing the amended order and not the underlying sale order. Thus, while the sale order was rendered pursuant to section 363(b), the amended order did not mention that subsection or section 363(c), which are the only two subsections that authorize sales to which section 363(m) could apply. The Fifth Circuit found these arguments to be unpersuasive. The committee was correct that the amended order did not mention section 363(b), but this was because it did not authorize a new or different sale, it simply amended the sale order that had previously been entered. That is, the amended order was “integrally linked to, and indeed, inseparable from, the sale order.” The court, therefore, held that section 363(m) foreclosed the appeal when the committee failed to seek the required stay, finding the committee’s argument that it appealed an order not subject to section 363(m) unpersuasive. The court concluded its opinion succinctly: “In short: no stay, no pay.”

Edwards Fam. P’ship, L.P. vs. Johnson (In re Cmty. Home Fin. Servs. Inc.), 990 F.3d 422 (5th Cir. 2021). A bankruptcy court awarded fees to debtor’s counsel for work performed prior to the appointment of a trustee. Creditors appealed that award to the district court and the district court vacated the fee award. The district court’s order was appealed to the Fifth Circuit.

The dispute arose from the bankruptcy of Community Home Financial Services, Inc. (“CHFS”), which was not a party to the appeal. Upon the commencement of the case, CHFS remained the debtor-in-possession and its president was its designated representative. The bankruptcy court approved counsel’s representation of the debtor. Counsel initiated a series of adversary proceedings against the debtor’s principal creditors. Those same creditors objected to the proposed plan of reorganization and moved to appoint a trustee and to convert the case to Chapter 7. While the case was pending, the debtor’s president transferred over $9 million of the debtor’s funds to a Panamanian bank account and fled the country. Counsel then filed a disclosure informing the court of the transfer. Following the disclosure, the bankruptcy court appointed an emergency trustee. Counsel thereafter withdrew. Counsel sought fees for the services they had performed in connection with the adversary proceedings before the appointment of the trustee. The bankruptcy court awarded fees to counsel. The creditors appealed the awards of fees. The district court then affirmed, but remanded for further findings of fact regarding the fees awarded for commencing and litigating the adversary proceedings. On remand, the bankruptcy court again awarded fees to counsel for those adversary proceedings, concluding that they were necessary to the administration of the bankruptcy case and reasonably likely to benefit the estate. A second appeal to the district court ensued and the district court vacated the fee award. The district court concluded that the decision to pursue the adversary proceedings “was not a good gamble.” Counsel and the trustee appealed arguing that the district court improperly evaluated the benefit of the adversary proceedings retrospectively. Counsel settled their fee dispute, but the trustee continued to pursue the appeal. The creditors moved to dismiss the appeal due to lack of standing.

The creditors contended that their settlement with counsel mooted the appeal. The trustee asserted that the case remained live because of her “ongoing duty throughout the pendency of a bankruptcy proceeding to represent the interests of the bankruptcy estate in the award of fees.” The court noted that the requirement of an adverse pecuniary interest is not required of the trustee to establish standing. The trustee “is distinct from all other bankruptcy parties because the trustee is responsible for the administration of the bankruptcy estate.” The court noted that other circuits have concluded that trustees can never establish that they were pecuniarily affected by a bankruptcy order because they did not have pecuniary interests in cases. A trustee’s standing does not arise from his or her own pecuniary interest, but rather from the trustee’s duty to enforce the bankruptcy laws in the public interest. The First, Fourth, Sixth, and Ninth Circuits each have recognized that the pecuniary-interest test does not apply to trustee standing, and the Fifth Circuit’s own precedent has “implicitly recognized that trustee standing does not depend on a pecuniary interest.” Based on the foregoing, the Fifth Circuit held “that the Trustee in this case has standing and this case is not moot because the payment of fees to [counsel] directly affects the administration of the bankruptcy estate.” Having concluded that the case was not moot, the Fifth Circuit turned to the substantive issue and found that the district court’s decision to vacate the fee awards was contrary to clear Fifth Circuit law that the services must be evaluated as of the time they were rendered. “The district court was wrong to vacate the bankruptcy court award based on its own retrospective assessment of the propriety of the adversary proceedings without giving ‘the deference that is the hallmark of abuse-of-discretion review.’” Applying a prospective standard, pursuit of the adversary proceedings was necessary to the administration of the case. Accordingly, the Fifth Circuit reversed the judgment of the district court and remanded for the district court to reinstate the bankruptcy court’s fee award.

Hobbs vs. Buffets, L.L.C. (In re Buffets L.L.C.), 979 F.3d 366 (5th Cir. 2021). In Chapter 11, debtors pay both a filing fee as well as quarterly fees until the bankruptcy case is closed. In 2017, Congress imposed a temporary, but substantial, increase in quarterly fees for Chapter 11 debtors. The fee increase was intended to fund the United States Trustee (“UST”) Program. Accordingly, the fee went into effect in the 88 judicial districts that utilized the UST Program. There was a nine-month lag before a similar fee adjustment was applied in the six judicial districts that did not use the UST Program. Debtors nationwide have challenged the increased fees. In particular, some debtors have claimed that the delayed implementation of the fee in the non-UST Program districts violated the constitutional requirement that Congress establish uniform bankruptcy laws throughout the United States. In the instant case, the debtor filed a Chapter 11 petition in 2016. The petition was filed in the United States Bankruptcy Court for the Western District of Texas, which utilizes the UST Program. The plan of reorganization was confirmed in 2017, but the case remained pending in 2018, after the increased fee became effective. Because the debtor reported over $1 million in total disbursements during each of the first three quarters of 2018, and because the balance of funds in the United States Trustee system was below the threshold amount, the United States Trustee assessed quarterly fees of $250,000 on the debtors. The debtors refused to pay and asked the bankruptcy court to focus on disbursements made under the plan and not those for normal operating expenses. Had the bankruptcy court agreed, the debtors would have been able to avoid the new, higher fees as their disbursements would have been less than $1 million per quarter. The UST objected. In response, the debtors claimed classifying operating expenses as disbursements for purposes of the fee violated the Constitution’s “Fundamental Fairness Clause.”

The bankruptcy court denied the debtors’ motion. When the debtors moved for reconsideration, they also challenged the constitutionality of the increased fees. On reconsideration, the bankruptcy court agreed that the fee increase was unconstitutional: both because of non-uniformity and because the imposition of the fee on a case that was filed before the increase was enacted was an impermissibly retroactive imposition of duties and liabilities for transactions already completed. Both the UST and the debtors appealed and the district court certified questions about the new law’s applicability and constitutionality to the Fifth Circuit.

The Fifth Circuit first addressed the debtors’ contention that the disbursements should be limited to bankruptcy-related expenses, and not ordinary expenses. The court looked to the ordinary meaning of the term “disbursements” and found that such plain meaning would include all payments made by the debtors and not just their bankruptcy-related expenses. The court also found it problematic that adopting the debtors’ interpretation would give the term “disbursements” a different meaning before and after confirmation. Moreover, the Fifth Circuit stated that adopting the debtors’ interpretation of “disbursements” would create a circuit split, and acknowledged that the normal reluctance to create circuit splits is even stronger in the context of bankruptcy law. Accordingly, the court held that disbursements include all payments a debtor makes.

The court then turned to the question of whether the 2017 fee increase applied to cases that were pending when the new fees took effect. The court noted that Congress had passed legislation that explicitly applied the new fees to debtors whose plans were confirmed both before and after the legislation took effect. Accordingly, the court held that new disbursements, not new cases, trigger the higher fees. Because the new fee applies only to future disbursements, which are triggered by the debtor’s conduct occurring after the law’s effective date, the 2017 fee increase was prospective and did not impair rights the debtors had when they filed for bankruptcy.

Finally, the court turned to what it called the “main event”: whether the fee increase violated the constitutional uniformity requirement. Even assuming that the fees are legislation subject to the uniformity requirement of the bankruptcy clause, the court found no uniformity problem. The uniformity requirement does not bar every law that allows for a different outcome depending upon where a bankruptcy is filed. Instead, the uniformity requirement only bars “arbitrary regional differences in the provisions of the Bankruptcy Code.” The court held that as long as the dual systems exist, with some districts having the United States Trustee Program and others utilizing the prior bankruptcy administrator system, each will face unique funding problems. Accordingly, it is reasonable for Congress to have those who benefit from the United States Trustee Program provide for its funding. The court noted that the debtors did not challenge the dual system as unconstitutional. Given this conclusion, the Fifth Circuit held that the fee increase easily survived the rational basis review that was required.

Judge Clement concurred in part and dissented in part. She opined that the majority opinion “relies on a flawed tautology: Congress can justify treating bankrupts differently because it has chosen to treat them differently (higher fees because different programs).” Because grouping some debtors into the UST Program and others into the bankruptcy administrator system is itself “an arbitrary regional difference,” Judge Clement found that the debtors’ argument did include a challenge to the structure of the law (i.e., the dual system) and not just its effects. Judge Clement also noted that the government had addressed the issue in its briefing. In conclusion, Judge Clement wrote: “[f]or no better reason than political influence, debtors in two states enjoy a system subject to lower fees than those in the other forty-eight states. This is the type of ‘regionalism’ the Uniformity Clause was intended to prevent.” (internal citations omitted).

§ 1.7. Sixth Circuit

Eplet, LLC v. DTE Pontiac N., LLC, 984 F.3d 493 (6th Cir. 2021). The Sixth Circuit applied state law to determine whether certain agreements were integrated or severable, and thus whether the debtor’s rejection of certain agreements under section 365 of the Bankruptcy Code eliminated the obligations of a commercial tenant who elected to remain in possession of the property pursuant to section 365(h) of the Code.

General Motors (“GM”) sold a power plant and leased for ten years the land under the plant to an energy company, DTE Energy Pontiac North, LLC (“DTEPN”). DTEPN agreed to sell utilities produced at the plant to GM, maintain the plant according to specific criteria, and take care of any environmental issues caused by the plant. DTEPN’s parent company, DTE Energy Services, Inc., (“DTE Energy”) guaranteed that DTEPN would meet GM’s utility needs and its maintenance and environmental responsibilities or DTE Energy itself would step in to fulfill DTEPN’s obligations. GM filed for bankruptcy two years after the sale and lease to DTEPN, and DTEPN agreed to GM’s rejection of those two contacts while also exercising its right as a tenant to continue occupying the power plant’s grounds. DTEPN remained in possession of the premises until the lease expired, at which time it turned the land over to the environmental trust that was created to assume ownership of some of GM’s industrial property as part of GM’s reorganization. The trust discovered that DTEPN had allowed the power plant to fall into disrepair and contaminate the property and subsequently sued DTEPN and DTE Energy for breach of contract and various other claims. The district court dismissed the claims against DTE Energy based on its findings that (1) the trust’s allegations did not support piercing the corporate veil under Michigan law and (2) DTE Energy’s guaranty terminated after GM rejected the associated contracts in bankruptcy. On appeal, the Sixth Circuit concluded that the district court erred in both of its rulings, and reversed and remanded to the district court.

In reviewing the district court’s first finding, the Sixth Circuit found that DTEPN ignored its maintenance and environmental responsibilities at the direction of DTE Energy. And by allegedly directing its wholly owned subsidiary to stop maintaining the facility, DTE Energy exercised its control over DTEPN in a way that wronged the trust, which, under Michigan law, allows the trust to pierce the corporate veil. Accordingly, the Sixth Circuit held the trust had adequately pleaded facts that supported piercing the corporate veil under Michigan law and that the defendants’ arguments were more appropriate for a summary judgment proceeding rather than a dismissal.

The Sixth Circuit’s review of the district court’s second finding—whether DTE Energy’s guaranty terminated after GM rejected the associated contracts in bankruptcy—began with an overview of section 365, which is the mechanism by which GM rejected the associated agreements. Section 365 of the Code allows a debtor-in-possession to assume or reject any executory contract or unexpired lease, subject to the bankruptcy court’s approval. A further requirement under section 365 is that the contract or lease must be assumed or rejected in its entirety. Section 365(h) of the Code specifically provides that when a debtor rejects a contract leasing real property in which the debtor is the landlord, the tenant may choose either to terminate the lease or remain in possession of the property. Thus, the question for the Circuit Court on appeal was whether the lease and utility services agreement were one integrated contract, such that DTEPN could not assume the lease without also assuming the utility services agreement, on the one hand, or whether the lease and utility agreement were severable, such that DTEPN could assume the lease without also assuming the utility services agreement, on the other. To answer the question of severability, the Sixth Circuit turned to state law. Under Michigan state law, the intent of the parties is the primary consideration in determining severability and the Sixth Circuit ultimately determined that “[g]iven the express language of the agreements, the related subject matters, the interdependent obligations and considerations, and the parties’ positions in GM’s bankruptcy proceedings, the district court erred in finding that the lease and utility services agreement were severable as a matter of law at the motion-to-dismiss stage.”

Alliance WOR Properties, LLC v. Ill. Methane, LLC (In re HNRC Dissolution Co.), 3 F.4th 912 (6th Cir. 2021). The Sixth Circuit recently found that notice by publication did not satisfy the Due Process Clause when considering whether a contract counterparty was given reasonable notice of a section 363 sale “free and clear of all Liens, Claims, encumbrances and other interests” in 2002.

In 1998, the Old Ben Coal Company (“Old Ben”) conveyed its right to “all of the methane gas” in its coal estates to Illinois Methane, LLC (“Methane”), while retaining for itself the coal rights from the block of coal reserves and leases located in Illinois. The conveyance was subject to certain covenants “running with the ownership of the coal and methane gas,” including a covenant that provided that Methane would not explore for or produce methane gas if Old Ben was mining coal in the same area, and in exchange, Old Ben would pay an “adjusted delay rental” to Methane. The deed memorializing this transaction was recorded with the Hamilton County Recorder.

In 2002, Old Ben and a number of affiliates (collectively, the “Debtors”) filed petitions to commence chapter 11 proceedings. During the bankruptcy proceedings, the Debtors moved for an order pursuant to section 363 of the Bankruptcy Code authorizing the sale of substantially all of their assets, including the Hamilton County coal reserves, “free and clear” of all liens, claims, encumbrances and other interests. The Debtors published notice of the impending bankruptcy sale in several regional and national newspapers, but did not provide or attempt to provide notice to Methane directly. The bankruptcy court approved the sale to Lexington Coal Company, finding that the Debtors’ publication notice was sufficient.

The Hamilton County coal reserves eventually came to be held by Alliance WOR Properties, LLC (“Alliance”), which is in privity with Lexington Coal Company. But one of Alliance’s predecessors-in-title applied for a permit to mine coal from a portion of the Hamilton County reserves. This application eventually led Methane to file suit against Alliance in Illinois state court, seeking over $11 million in accumulated delayed rent. Alliance moved to reopen the bankruptcy case, seeking an order from the bankruptcy court that Methane’s efforts to recover against Alliance violated the section 363 sale order. Instead, the bankruptcy court held that the Debtors’ notice by publication did not satisfy due process as to Methane because Methane had a “known” interest in the Hamilton County reserves at the time of the sale, and thus needed notice “sufficient to satisfy constitutional due process.” Accordingly, the bankruptcy court found that the sale order had no effect on Methane’s interest. The district court affirmed, and this appeal followed.

The decision turned on the nature of Methane’s interest in the reserves—whether Methane’s interest was “known” or “unknown” by the Debtors at the time of the bankruptcy proceedings—since “due process generally requires that the debtor attempt to provide notice directly” for “known” parties. Alliance, 3 F.4th at 919 (citing Tulsa Pro. Collection Servs., Inc. v. Pope, 485 U.S. 478, 487 (1988)). Quoting the Third Circuit, the Sixth Circuit explained that “‘[k]nown’ parties are those ‘whose identity’ and interest are ‘either known or reasonably ascertainable by the debtor.’” Id. at 919 (quoting Chemetron Corp. v. Jones, 72 F.3d 341, 346 (3d Cir. 1995)) (internal quotations omitted). Alliance argued that Methane had a speculative, prepetition contingent claim, while Methane argued that it had a vested, non-contingent real property right in the delayed rental obligations. Examining Illinois state law, the Sixth Circuit held that the delayed rental obligations conferred a “vested property interest” on Methane. Accordingly, Methane was a known party and entitled to more than publication notice.

§ 1.8. Seventh Circuit

Algozine Masonry Restoration, Inc. v. Local 52 Chi. Area Joint Welfare Comm. for the Pointing, Cleaning & Caulking Indus. (In re Algozine Masonry Restoration, Inc.), 5 F.4th 827 (7th Cir. 2021). Algozine Masonry Restoration, Inc., employed members of a local union and, pursuant to a collective bargaining agreement (“CBA”) with the union, was required to submit contributions to three employee benefit funds on behalf of employees covered by the CBA. Algozine fell behind on its contributions to the three funds and subsequently filed a chapter 11 bankruptcy petition. The three funds filed separate proofs of claims under section 507(a)(5) of the Bankruptcy Code, which affords priority status up to a specified point to certain types of unsecured claims, including claims for unpaid contributions to an employee-benefit plan. Algozine objected to the funds’ proofs of claims, asserting that the funds erred by applying the priority cap in section 507(a)(5) to each individual fund’s claims rather than the funds’ aggregated claims, while the funds insisted that section 507(a)(5) does not require assessing distinct benefit plans collectively. The bankruptcy court agreed with the funds, as did the district court. Because the Seventh Circuit found that the text of section 507(a)(5) unambiguously supports the conclusions those courts reached, it affirmed the lower courts’ decisions.

When interpreting a statute, the Seventh Circuit stated “we look first to the statutory language… When the language is plain we enforce it without further ado. Other tools come into play if it is ambiguous, but they are unnecessary in the case before us.” The Seventh Circuit noted that section 507(a)(5) allows “each such” employee benefit plan to file priority claims for services rendered within the applicable period, and quoted the bankruptcy court’s observation that section 507(a)(5) “clearly contemplates that, in a single bankruptcy case, more than one ‘employee benefit plan’ may file a claim, i.e., ‘claims for contributions’ and that the priority limit set forth therein applies to ‘each such plan’; which, could only refer to – each claim that is filed in the case by, or on behalf of, an employee benefit plan.”

§ 1.9. Eighth Circuit

FishDish, LLP v. VeroBlue Farms USA, Inc. (In re VeroBlue Farms USA, Inc.), 6 F.4th 880 (8th Cir. 2021). The Eighth Circuit considered the increasingly controversial doctrine of equitable mootness and, while not rejecting it outright, found that the district court did not apply a sufficiently rigorous test to determine whether bankruptcy equities and pragmatics justified foregoing Article III judicial review of a bankruptcy court order confirming a chapter 11 plan, and remanded for further district court proceedings.

VeroBlue Farms USA, Inc., and its affiliated entities, (collectively, the “debtors”) filed a voluntary chapter 11 bankruptcy petition in 2018. FishDish LLP, one of the debtors’ preferred shareholders, appealed the bankruptcy court’s plan confirmation order to the district court, arguing that the plan violated various provisions of the Bankruptcy Code, including the absolute priority rule, the feasibility requirement, and the best interest of creditors test. The plan sponsor and sole shareholder of the reorganized debtors slated to assume management, Alder Aqua, argued that FishDish’s appeal was equitably moot. The district court entered an order dismissing FishDish’s appeal as equitably moot, and FishDish appealed.

The Eighth Circuit reversed the district court after finding that it had made no inquiry into whether the record supported its holding that relief could not be granted without undermining the plan, thereby affecting third parties. Holding that Article III appellate courts have “a virtually unflagging obligation” to exercise subject matter jurisdiction, and concerned that equitable mootness often results in the arbitrary “refusal of the Article III courts to entertain a live appeal over which they indisputably possess statutory jurisdiction and in which meaningful relief can be awarded,” the Eighth Circuit ruled that a sufficiently rigorous test must be applied prior to a determination that “bankruptcy equities and pragmatics justify foregoing Article III judicial review of a bankruptcy court order confirming a Chapter 11 plan.” The Eighth Circuit thus remanded the case to the district court with directions to at least preliminarily review the merits of FishDish’s appeal of the plan confirmation order “to determine the strength of FishDish’s claims, the amount of time that would likely be required to resolve the merits of those claims on an expedited basis, and the equitable remedies available . . . to avoid undermining the plan and thereby harming third parties.”

§ 1.10. Eleventh Circuit

Reynolds v. Behrman Capital IV L.P., 988 F.3d 1314 (11th Cir. 2021). This case arose out of the bankruptcies of Atherotech, which operated a laboratory that conducted blood tests, and its owner, Atherotech Holdings. Artherotech Holdings, in turn, was owned by three shareholders: Behrman Capital IV LP, Behrman Brothers LLC, and Midcap Financial Investment, LP. After the bankruptcy court appointed Mr. Reynolds as the chapter 7 trustee for both bankruptcies, he filed a complaint in Alabama state court, initially naming 30 defendants: Behrman Capital and its 15 limited partners; Behrman Brothers and its 12 members; and MidCap. The defendants removed the case to federal district court, then sought dismissal for lack of personal jurisdiction. The district court allowed Mr. Reynolds to file an amended complaint, which Mr. Reynolds filed against only two of the defendants. Again, the defendants named in the amended complaint moved to dismiss for lack of personal jurisdiction. Mr. Reynolds asserted that there was personal jurisdiction under the Alabama long-arm statute, and alternatively requested that the district court transfer the case to the Southern District of New York pursuant to 28 U.S.C. section 1406 if it concluded that it lacked personal jurisdiction over the defendants. The district court ruled that, under Alabama’s long-arm statute, it could not exercise personal jurisdiction over the defendants and that transfer would be futile “because the derivative removal jurisdiction bars any federal court from acquiring personal jurisdiction over this suit after its removal from a state court that lacked such personal jurisdiction.” Mr. Reynolds filed a notice of appeal in which he named all of the original defendants and sought review of the district court’s dismissal of both his original and amended complaints.

As an initial matter, MidCap—one of the defendants named in the original complaint but not in the amended complaint—argued that Mr. Reynold’s failure to name it as a defendant in the amended complaint constituted a waiver by Mr. Reynolds of any argument that the district court erred by initially dismissing it for lack of personal jurisdiction. The Eleventh Circuit stated that although an amended complaint supersedes and replaces the original complaint, “a plaintiff does not waive his right to appeal the dismissal of a claim in the original complaint by amending the complaint and omitting the dismissed claim.” Because the district court dismissed MidCap from the original complaint, it was clear that it had rejected Mr. Reynolds’ arguments that personal jurisdiction existed over MidCap, and so the Eleventh Circuit held that reiterating those claims against MidCap in the amended complaint would have been “futile.” The Eleventh Circuit thus determined that “[u]nder these circumstances, Mr. Reynolds did not waive his right to appeal the district court’s dismissal of MidCap from the original complaint for lack of personal jurisdiction.”

The Eleventh Circuit next addressed the parties’ dispute as to whether the doctrine of derivative jurisdiction prevented the post-removal use of Bankruptcy Rule 7004(d) to establish personal jurisdiction over the defendants. The Supreme Court previously explained that “[t]he jurisdiction of the federal court on removal is, in a limited sense, a derivative jurisdiction. If the state court lacks jurisdiction of the subject-matter or of the parties, the federal court acquires none, although it might in a like suit originally brought there have had jurisdiction.” Reynolds, 988 F.3d at 132 (quoting Lambert Run Coal Co. v. Baltimore & Ohio R.R. Co., 258 U.S. 377, 382 (1922)). Splitting with a number of other circuits, the Eleventh Circuit narrowly held that “at least in this case,” the doctrine of derivative jurisdiction does not apply to removed cases in which the state court lacked personal jurisdiction over the defendants.

Acknowledging that the Supreme Court has described the doctrine as encompassing both subject-matter and personal jurisdiction, the Eleventh Circuit stated that the Supreme Court has nonetheless applied the doctrine of derivative jurisdiction only in cases where the state court lacked subject-matter jurisdiction. The Eleventh Circuit also looked to the Supreme Court’s decision in Freeman v. Bee Machine Co., 319 U.S. 448 (1943), which acknowledged that while jurisdictional defects are not cured or waived by removal, district courts have the power to cure or fix whatever jurisdictional defects may exist. Accordingly, the Eleventh Circuit held that, under Freeman, the district court to which the defendants had removed the case could have used Bankruptcy Rule 7004(d)—which looks to a defendant’s national contacts and permits nationwide service of process to establish personal jurisdiction—as part of the “full arsenal of authority with which [it has] been endowed” to establish personal jurisdiction over the defendants. The Eleventh Circuit thus held that the district court could exercise jurisdiction following removal—notwithstanding lack of personal jurisdiction over the defendants under Alabama’s long-arm statute—and that it could look to Bankruptcy Rule 7004(d) to decide whether personal jurisdiction existed. The court then remanded the case for further proceedings consistent with its ruling.

USF Fed. Credit Union v. Gateway Radiology Consultants, P.A. (In re Gateway Radiology Consultants, P.A.), 983 F.3d 1239 (11th Cir. 2020). In response to the COVID-19-induced economic fallout, Congress passed the Coronavirus Aid, Relief, and Economic Security Act (“Act”), which was in large part aimed at helping businesses make payroll and pay operating expenses in order to keep people employed throughout the economic downturn. One of the Act’s programs designed to accomplish that goal is the Paycheck Protection Program (“PPP”), which was directed at small businesses with the principal function of providing forgivable loans to them. Under the PPP, loans were given to eligible businesses; if the loaned funds were used for specified expenses, those loans would be forgiven. The Small Business Administration (“SBA”) was responsible for administering the PPP, and was given rulemaking power directly related to the PPP by Congress. Acting on its statutory mandate from Congress, the SBA issued several rules implementing the PPP. Of relevance here are the SBA’s first and fourth interim final rules. The first interim final rule, among other things, addressed borrower eligibility for PPP loans. Although it did not specify that all bankruptcy debtors were ineligible, it required all applicants to submit a PPP application form, on which the first question asked was whether the applicant was “presently involved in any bankruptcy,” and unequivocally stated that if the answer to that question was “yes” the loan would not be approved. The fourth interim final rule stated that “[i]f the applicant or the owner of the applicant is the debtor in a bankruptcy proceeding, either at the time it submits the application or at any time before the loan is disbursed, the applicant is ineligible to receive a PPP loan.”

Gateway, a chapter 11 bankruptcy debtor since May 2019, applied online to USF Federal Credit Union (“USF”) for a PPP loan. In its application, Gateway answered “no” to the first question on the form, asking whether the applicant was presently involved in any bankruptcy. USF subsequently approved a $527,710 loan, believing that Gateway was not in bankruptcy. Because Gateway was a bankruptcy debtor when it applied and was approved for the PPP loan, it was required to obtain the bankruptcy court’s approval to take on the debt, pursuant to section 364(b) of the Bankruptcy Code. Gateway thus filed with the bankruptcy court an emergency motion to borrow the PPP loan, to which the SBA filed a limited objection, “insofar as [Gateway] seeks an Order that [Gateway] is eligible to participate in the PPP, entitled to loan forgiveness, or that SBA must guarantee [Gateway’s] loan.” In response to the SBA’s limited objection, Gateway filed an adversary proceeding against the SBA and USF seeking declaratory and injunctive relief, asking the bankruptcy court to declare that the SBA’s rule could not be enforced against Gateway, to order USF to release the funds, and to order the SBA to guarantee and forgive the loan just as it would a PPP loan to a non-bankrupt small business. The bankruptcy court ruled in Gateway’s favor, finding that the non-bankruptcy eligibility rule was unlawful under the Administrative Procedure Act (“APA”) because the SBA exceeded its authority in adopting the rule and that the rule was arbitrary and capricious. The bankruptcy court subsequently certified a direct appeal to the Eleventh Circuit; Gateway and USF each petitioned for permission to directly appeal, and the Eleventh Circuit granted USF’s petition.

After a lengthy analysis confirming its appellate jurisdiction, the Eleventh Circuit began by applying the two-step Chevron framework to determine whether the SBA exceeded its statutory authority. Under the first Chevron step, the court must determine whether Congress has spoken directly to the question at issue, in which case both the court and agency must give effect to Congress’ clear intent. If the statute is ambiguous, then the second Chevron step is to determine whether the agency’s interpretation of the statute is reasonable, meaning it is rational and consistent with the statute. Under Chevron step two, courts “may not substitute [their] own construction of a statutory provision for a reasonable interpretation made by the administrator of an agency.” Under step one, the Eleventh Circuit determined that Congress did not speak directly to the question at issue, which was whether bankruptcy debtors were eligible for PPP loans, and found “good reason to think it intended to delegate authority to the SBA to answer that question.” Based on the location of the PPP, which was added into an existing program administered by the SBA, and the context of the Act and the delegation of general rulemaking authority to the SBA, the Eleventh Circuit found that “[t]here is at least an implicit delegation of authority for the SBA to [determine and apply eligibility requirements]. And Chevron recognizes implicit delegations of authority.” Because the Act did not unambiguously answer the question before the Eleventh Circuit, the court moved on to step two of the Chevron framework and decided that “[g]iven all of the circumstances and the urgency with which it was forced to act, the SBA’s interpretation was reasonable,” noting that “[w]e do not say this is an inevitable interpretation of the statute; but it is assuredly a permissible one.”

The Eleventh Circuit next addressed the bankruptcy court’s finding that the SBA’s first and fourth final interim rules were arbitrary and capricious. Even when an administrative agency does not act in excess of statutory jurisdiction, it may nonetheless have acted arbitrarily and capriciously, which the Eleventh Circuit has defined by the occurrence of one of four things: (1) agency reliance on factors which Congress did not intend it to consider; (2) entire failure by an agency to consider an important aspect of the problem; (3) an offered explanation for an agency’s decision that runs counter to the evidence before the agency; or (4) total implausibility such that an agency’s action could not be ascribed to a difference in view or the product of agency expertise. The economic emergency created by the COVID pandemic deprived the SBA of the benefit of the usual notice and comment period, which led the Eleventh Circuit to state that it could not find that the SBA failed to consider any important aspect of the problem or that it “offered an explanation contradicted by evidence that was put before it—[because] there was no evidence put before it.” The Eleventh Circuit also held that the SBA did not rely on factors which Congress did not intend it to consider, nor was its explanation implausible, “much less…so implausible that it could not have been based on a difference in view or could not be a product of the SBA’s expertise.” The Eleventh Circuit’s findings—that the SBA did not exceed its authority in adopting a rule excluding bankruptcy debtors from PPP eligibility, that the rule did not violate the Act, that the rule was based on a reasonable interpretation of the Act, and that the SBA did not act arbitrarily and capriciously in adopting the rule—resulted in a dismissal and vacatur in part, and remand back to the bankruptcy court for proceedings consistent with the Eleventh Circuit’s opinion.

Pension Benefit Guar. Corp. v. 50509 Marine LLC, 981 F.3d 927 (11th Cir. 2020). In the absence of an on-point ERISA provision or state law, and mindful of ERISA’s scheme and protectionist goals, the Eleventh Circuit created a new common law rule: where the sponsor of an ERISA plan dissolves under state law but continues to authorize payments to beneficiaries and is not supplanted as the plan’s sponsor by another entity, it remains the constructive sponsor such that other members of its “controlled group” may be held liable for the plan’s termination liabilities.

In the late 1980s, Joseph Wortley owned Liberty Lighting Co., Inc. (“Liberty”), a unionized electrical supply manufacturing company, which was the plan sponsor and administrator of the Liberty Lighting Co., Inc. Pension Plan for IBEW Employees (the “Plan”) under Title IV of ERISA. Following financial trouble in the early 1990s, Liberty entered bankruptcy, surrendered its assets to a creditor, and was thereafter administratively dissolved under Illinois state law. Wortley eventually also filed for personal bankruptcy, pursuant to which he surrendered all of his assets to a trustee, including his stock in Liberty, of which he was the sole owner. Wortley nevertheless continued to act as the Plan’s administrator, signing paper on behalf of the Plan at the request of the Plan’s actuary for years after Liberty’s purported dissolution, which signatures were necessary to effect continuing payments to pensioners. In 2012, when the Plan’s funds ran low, the bank administering the Plan notified the Pension Benefit Guaranty Corporation (“PBGC”), the federal agency charged with protecting the retirement incomes of workers in private-sector defined benefit pension plans, of the Plan’s looming insolvency. PBGC and Wortley reached a settlement that represented Liberty as having dissolved in the 1990s and contained language that Wortley believed established a final cutoff date for his remaining liability by conveying all of Wortley’s authority over Liberty and the Plan to PBGC. Six years later, PBGC brought suit in the United States District Court for the Southern District of Florida against nineteen other companies owned by Wortley (“the Companies”), alleging that they were part of a “controlled group” with Liberty and therefore were still liable for Liberty’s unpaid pension benefits, premiums, interest, and penalties. The district court was persuaded by PBGC’s theory that, because Liberty was unable to meet its ERISA obligations to its former employees, Wortley’s other companies must foot the bill, and granted summary judgment to PBGC, which the Companies timely appealed.

The liability for the “controlled group”—other entities under common control with the sponsor of a plan under ERISA— is established by 29 U.S.C. section 1307(e)(2). The purpose and effect of this provision is to prevent the sponsor of a defunct pension plan from funneling its assets into other entities it owns, leaving PBGC “holding the bag” for the plan’s continuing liabilities. ERISA thus provides that if a sponsor is on the hook for unfunded pension obligations, then every other entity sharing a specified percentage ownership interest is also on the hook, jointly and severally. ERISA does not, however, provide for pension liabilities when the sponsor of a plan has dissolved but the plan has continued to operate, nor does Illinois law. Where ERISA is silent, the Eleventh Circuit stated that courts are “required to develop a federal common law of rights and obligations under ERISA-regulated plans… In deciding whether a rule should become part of ERISA’s common law,” the court “must decide whether the rule, if adopted, would further ERISA’s scheme and goals, which are (1) protection of the interests of employees and their beneficiaries in employment benefit plans… and (2) uniformity in the administration of employee benefit plans.” The Eleventh Circuit “follow[ed] the Supreme Court’s instruction” to “fill in ERISA’s gaps with common-law rules…and [held] that where the sponsor of an ERISA plan dissolves under state law but continues to authorize payments to beneficiaries and is not supplanted as the plan’s sponsor by another entity, it remains the constructive sponsor such that other members of its controlled group may be held liable for the plan’s termination liabilities.” Accordingly, the Eleventh Circuit, “[u]nder the narrow rule [it] craft[ed] here,” found that “the Companies are liable to PBGC for the Plan’s termination liabilities for the simple reason that Liberty persisted as the Plan’s sponsor even as it dissolved as an Illinois corporation.” In reaching this rule and conclusion, the Eleventh Circuit was largely motivated by the facts that the Companies did not provide a possible alternative sponsor, PBGC was never notified at the time of Liberty’s bankruptcy or that the company was dissolving so that it could lodge an appropriate claim as a creditor to the bankrupt corporate estate and make provision for protecting retirees’ future benefit payments, and no provision in ERISA contemplates a plan without a sponsor. The Eleventh Circuit expressed concern that “[r]uling for the Companies would mean holding that an extant pension plan may be left without a sponsor for decades, which could have vast ripple effects across even unrelated provisions of ERISA… The implication that an ERISA plan may function without a sponsor risks chaos,” and the Eleventh Circuit “decline[d] the Companies’ invitation to create this uncertainty in ERISA law.”

As the use of captive insurance companies continues to grow, one issue businesses may face is whether to incorporate cells within a captive cell program. This article addresses some of the relevant considerations.

In simple terms, a captive insurance company is an insurance company owned by the entity to which the captive issues insurance. Captive insurance companies can take several different forms. A single-parent captive is one owned by a single entity. A group or association captive is a captive that is owned by two or more different entities. A rental captive is created by a third party and, for a fee, allows other entities to obtain the benefits of captive insurance without needing to form their own captive insurance company. This often takes the form of a captive cell; in that form, each “rental captive” is created as a captive cell within the larger captive such that the assets and liabilities of each cell are shielded from other entities’ “rental captive.”

As an alternative, a single entity could create a captive cell program. In that circumstance, the entity would create a cell captive insurance company and then create captive cells within that company. Cells could be created to segregate different types of insurance, thereby protecting the assets held to insure low-risk types of coverage from those held to insure high-risk types of coverage. Cells may also be created to segregate insurance of different projects.

An issue businesses confront when creating a captive cell is whether to form the cell as an incorporated entity or an unincorporated entity. One possible advantage of unincorporated cells is that they may be easier to form and maintain. An unincorporated cell can avoid the administrative burdens and costs of an incorporated cell. It may not need to prepare more standard formation documents like articles of incorporation or bylaws. In addition, unincorporated cells usually do not need to have officers and directors, hold annual board meetings, or file separate tax returns. Because unincorporated cells are not legal entities, they generally cannot enter into contracts, requiring the core captive to do so. Depending on the jurisdiction, however, captive laws and regulations may still protect the assets and liabilities of an unincorporated cell from those of the core captive and other cells within that core captive.

A potential advantage of an incorporated cell is that it can further establish the goal of segregating cell assets and liabilities. For example, unlike unincorporated cells, incorporated cells can enter into contracts and thus can issue the insurance policies to the policyholder. Likewise, they can sue and be sued. Each of those characteristics of an incorporated cell can further protect the cell’s assets and liabilities from those of other cells and the core captive. However, incorporated cells may impose additional administrative burdens and costs that are not imposed by unincorporated cells.

Case law on these issues is sparse, to say the least. In one of the few decisions addressing the issue, a federal court in Montana ruled on one consequence of an unincorporated cell. Pac Re 5-AT v. Amtrust N. Am., Inc., 2015 WL 2383406, at *4 (D. Mont. May 13, 2015). There, the court found that, without a separate legal identity, and absent a statutory grant to the contrary, the unincorporated cell there lacked the capacity to sue or be sued. Id. As a result, and contrary to the unincorporated cell’s and the core captive’s arguments, the court found that the core captive was properly named as a party in a demand for arbitration for alleged breaches of a captive reinsurance agreement and would be appropriately bound by the results of the arbitration. Id. at *5. However, that court also recognized the Montana statute that protected the assets of a cell from the liabilities of other cells or the core captive. Id. at *4 (quoting Montana Stat. § 33-28-301(4), which provides that “[t]he assets of a protected cell may not be chargeable with liabilities arising from any other insurance business of the protected cell captive insurance company”).

Cell captive insurers could be brought into litigation involving insurance issued by an unincorporated cell. For instance, when a policyholder requests coverage from other insurance companies, those other insurers may argue that the policyholder’s captive insurance must provide coverage first. Those arguments can be based on other-insurance clauses or on contribution principles. They could also involve a policyholder seeking coverage under a vendor’s insurance policy or seeking indemnity from a vendor. In those circumstance, those other insurers may bring the captive insurer into any litigation between the policyholder and those other insurers. But, even if the core captive is a party to the arbitration, its assets may still be protected from paying the liabilities of a protected cell.

Ultimately, the decision of whether to incorporate cells within a captive cell program will likely depend on a variety of factors, including the goals and needs of the business as well as state-specific laws and regulations.

“A Step You Can Take to Promote the Rule of Law” is the seventh article in a series on intersections between business law and the rule of law, and their importance for business lawyers, created by the American Bar Association Business Law Section’s Rule of Law Working Group. Read more articles in the series.

In January, the Rule of Law Working Group wrote about the important role of business lawyers as custodians of the Rule of Law. We observed that the Rule of Law is in decline globally, including in the United States, and highlighted the need for the legal profession to take a leadership role in strengthening that “durable system of laws institutions, norms, and community commitment” that has become synonymous with the Rule of Law.^[1]

People with legal training should have a better appreciation of the essential role that the Rule of Law plays in our democracy. But we should not assume that people who are not members of the legal profession share that understanding.

When the Rule of Law is mentioned, the first reaction of the public, and many lawyers, is that the interests primarily implicated are those of people who are regularly involved in litigation. But the typical business lawyer no less than people who are regularly involved in litigation has a stake in a well-functioning legal system, and businesspeople have such a stake even when they are not engaged in litigation. This is because we have only one legal system. The principles and processes that apply to individuals and non-business issues also apply to businesses. Likewise, the system evolves, or deteriorates or is strengthened, systemwide.

When business lawyers pause and reflect on how the Rule of Law is the underpinning of the work they do on a daily basis in their professional lives, namely, “helping their clients navigate the legal landscape in which they operate,”^[2] it becomes clear that business lawyers have as much a stake in the Rule of Law—if not a greater stake—as do people who are regularly engaged in litigation. We hope that such reflection motivates you to help strengthen the Rule of Law.

A Lumen Learning course on the Importance of Rule of Law to Business begins with an explanation of what is at stake for businesses as follows:

Can you imagine trying to do business without being able to have any reasonable expectations of other people’s behavior? Would you be willing to conduct business if you had no legal means by which to protect your property interests? And in the case of a dispute, without a rule of law system, there would be no established way to resolving it. Without the rule of law, business would be chaotic.^[3]

The United States Chamber of Commerce has a Coalition for the Rule of Law in Global Markets. The Rule of Law Coalition observes that “The Rule of Law is among the most crucial factors in a company’s ability to do business profitably in any given market over time.”^[4] It highlights the importance of transparency, predictability, stability, enforceability/accountability, and due process.^[5] It is our hope that when you help businesspeople pause and reflect on how important the Rule of Law is to what they do on a daily basis, they too will be motivated to actively support the Rule of Law.

So what can you do, and will it make a difference?

The Rule of Law Working Group is promoting an initiative to recruit members of our Section to talk with a business client or a business group (e.g., local chamber of commerce or trade association) about a topic related to our legal system sometime during the month of May. We chose the month of May because Law Day^[6] is May 1^st, and it was established by President Dwight D. Eisenhower to celebrate the role of law in our society and to cultivate a deeper understanding of the legal profession. Members of Section leadership have already committed to participating.

The Rule of Law Working Group has identified a number of possible formats for such engagement with business clients or business groups. These include a talk followed by a question-and-answer period; a panel discussion with you as a moderator or one of the participants; a quiz or contest; a video presentation/slide show followed by a discussion involving the whole group or small groups; and inviting a client or group of clients to your office for lunch and any of the above. If you have any additional ideas, please pass them along to us, and we will share them. In the next few weeks, the Rule of Law Working Group will be posting on its website information about resources related to specific topics.

Your participation will make a difference, because it will take many of us, not just a few Section leaders, to have an impact. In The Tipping Point, Malcolm Gladwell writes about how ideas spread: “Ideas and products and messages and behaviors spread just like viruses do.”^[7] He references “the mystery of the word of mouth—a phenomenon that everyone seemed to agree was important but no one seemed to know how to define.”^[8] Gladwell observes “that we are about to enter the age of word of mouth, and that, paradoxically, all of the sophistication and wizardry and limitless access to information of the New Economy is going to lead us to rely more and more on very primitive kinds of social contacts.”^[9]

Gladwell’s thesis finds support in our nation’s history, namely, the broad-based nature of the movement that led to the creation of our democracy. When students first learn about the American Revolution, they are taught stories about a few events and a few great men. But it is “We the people” who make things happen. As Ray Raphael writes in Founding Myths,

In popular narratives, only leaders function as agents of history. They provide the motive force; without them, nothing would happen. The famous founders, we are told, made the American Revolution. They dreamed up the ideas, spoke and wrote incessantly, and finally convinced others to follow their lead. But honoring these people as the architects of our nation’s independence is like honoring Lyndon Johnson as the architect of civil rights. In both cases, powerful men finalized the deal, but others placed the deal on the table and pushed it forward. ^[10]

So we hope you will take the step we suggest, with other members of your Section, to promote the Rule of Law so that together we can have a meaningful impact. If you are willing to join in this initiative, please contact Lakshmi Gopal at [email protected], and we will put you on the list of participants so that we can keep you updated.

For the Rule of Law Working Group,

John H. Stout, Co-Chair
Alvin W. Thompson, Co-Chair
Lakshmi Gopal, Vice Chair

1. World Justice Project, What is the Rule of Law?, https://worldjusticeproject.org/about-us/overview/what-rule-law (last visited March 15, 2022). ↑

2. Kimberly Lowe, The Business Lawyer and the Rule of Law—The Rule of Law Is Our Business (June 29, 2021), https://businesslawtoday.org/2021/06/the-business-lawyer-and-the-rule-of-law-the-rule-of-law-is-our-business/ (last visited March 15, 2022). ↑

3. Lumen Learning, Legal and Social Environment in Business, 1.4 Importance of Rule of Law to Business, https://courses.lumenlearning.com/legsocenvirnbusleap/chapter/1-4-importance-of-rule-of-law-to-business/ (last visited March 15, 2022). ↑

4. U.S. Chamber of Commerce, Rule of Law Coalition, https://www.uschamber.com/program/international-affairs/americas/rule-of-law-coalition (last visited March 15, 2022). ↑

5. Id. ↑

6. For more information on Law Day, see https://www.americanbar.org/groups/public_education/law-day/history-of-law-day/ (last visited March 15, 2022). ↑

7. Malcom Gladwell, The Tipping Point: How Little Things Can Make a Big Difference, 7 (Back Bay 2002). ↑

8. Id. at 264. ↑

9. Id. at 264-65. ↑

10. Ray Raphael, Founding Myths: Stories That Hide Our Patriotic Past, 268 (The New Press 2004). ↑

Bankruptcy practitioners across the United States are all too familiar with the Chapter 11 case of Neiman Marcus Group Ltd, LLC^[1] (“Neiman Marcus”). Most restructurings under the Bankruptcy Code involve at least a few surprises, as debtors progress toward plan confirmation. Few include a committee chairman violating his fiduciary duties and serving prison time for conduct during the case. On February 3, 2021, Daniel Kamensky, founder and manager of Marble Ridge Capital, LP (“Marble Ridge”)—the former co-chair of the Official Committee of Unsecured Creditors in Neiman Marcus’ Chapter 11 case—pled guilty to bankruptcy fraud in the United States District Court for the Southern District of New York.^[2] Kamensky was sentenced to six months in prison, plus six months of supervised release under home detention and a $55,000 fine.

The ordeal stemmed from a global settlement resolving potential claims for fraudulent transfers of substantially all of the equity in the retail giant’s e-commerce unit, MyTheresa, to its parent company, Neiman Marcus Group, Inc. (the “Parent Company”). The settlement called for the Parent Company to distribute 140 million shares of Series B preferred shares in MyTheresa for distribution to general unsecured creditors. To create liquidity for unsecured creditors, Marble Ridge agreed to backstop the purchase of 60 million shares at $0.20 per share.^[3] But those shares were subject to an (unofficial) higher and better offer by Jefferies Financial Group, Inc. (“Jefferies”) for the purchase of 140 million shares at somewhere between $.30 and $.40 per share.^[4]

After discovering the competing offer, Kamensky exploited his role as Chairman of the Committee to pressure Jefferies into abandoning its bid.^[5] Within 24 hours, Kamensky contacted representatives at Jefferies, threatening to discontinue Marble Ridge’s business relationship with Jefferies if it did not cease all efforts to bid on the equity.^[6] And the rest is history.

Neiman Marcus’ Chapter 11 case illustrates an issue often faced by practitioners and their clients serving as members of a creditors’ committee. Although creditors generally share a common goal of maximizing the value of the estate, each creditor’s individual interests create an inherent conflict. Members must often wear two hats and balance competing interests between their constituencies. This begs the question, what should committee members do once they encounter confidential information in the course of their duties? The answer is simple: play by the rules. The inherent tension amongst the member’s own interests, the committee’s interests, and those of the general creditor body underscores the need for strict compliance with governance procedures. In most cases, committees will adopt bylaws through which members can resolve disputes or conflicts of interest. Counsel should ensure that the bylaws address several key aspects of committee operations, including how to resolve conflicts of interests and to handle confidential information.

Part I of this article provides an overview on the appointment of a committee and the legal authority governing a committee member’s fiduciary duties. Part II provides an overview of the pertinent facts preceding and during the Neiman Marcus Chapter 11 case. Part III summarizes best practices for committee counsel to properly manage conflicts of interest. Part IV concludes with key takeaways.

Part I: The Unsecured Creditors’ Committee: Role, Powers, Duties

The Bankruptcy Code contemplates that the Official Committee of Unsecured Creditors (“Committee”) plays a critical role in a bankruptcy case.^[7] Section 1102(a) of the Bankruptcy Code requires the United States Trustee to appoint the Committee and, in appropriate cases, additional creditor or equity committees:^[8] “[A]s soon as practicable after the order for relief under chapter 11 of this title, the United States Trustee shall appoint a committee of creditors holding unsecured claims and may appoint additional committees of creditors or of equity security holders as the United States Trustee deems appropriate.”^[9] The bankruptcy court may, however, order the appointment of additional committees of creditors or of equity security holders if necessary to assure adequate representation of creditors or of equity security holders.^[10] If the court orders the appointment of an additional committee, “the United States trustee shall appoint any such committee.”^[11]

Once appointed by the trustee, the Committee functions as the proverbial “watchdog” on behalf of the body of creditors it represents. Section 1103(c) of the Bankruptcy Code sets forth the powers and duties of committees appointed under Section 1102, including: “consult[ing] with the trustee or debtor in possession concerning the administration of the case” and “investigat[ing] the acts, conduct, assets, liabilities and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business, and any other matter relevant to the case or to the formulation of a plan.”^[12]

The Committee advances the interests of the class of creditors at each stage of the bankruptcy process “to arrive at a plan that can be confirmed under section 1129.”^[13] In that regard, the Committee serves as a fiduciary for the class of creditors as whole.^[14] Courts have long recognized that members of the Committee assume a fiduciary obligation to other members, the creditors whom they were elected to represent.^[15] In exercising that fiduciary duty, the committee must “guide its actions so as to safeguard as much as possible the rights of minority as well as majority creditors.”^[16] The Committee must be “honest, loyal, trustworthy and without conflicting interests.”^[17]

But that duty is not limitless. The Committee’s fiduciary obligations create constant tension with an individual member’s right to advance its own interests. A Committee member’s fiduciary obligations do not render its own interests meaningless.^[18] Creditors’ individual interests are not required to perfectly align with the interests of the class as a whole.^[19] Committees often include creditors with differing or even conflicting interests.^[20] Unlike a debtor-in-possession, the committee is not a fiduciary of the estate. Courts generally recognize that “[n]o two creditors have identical interests.”^[21] Committee members are “hybrids who serve more than one master. Every member of the Committee is, by definition a creditor. Thus, she is in competition with every other creditor for a piece of a shrinking pie. She may assert her rights as a creditor to the detriment of the creditor body as a whole without running afoul of her fiduciary obligations.”^[22]

Individual members may act in their own best interest as long as the action does not injure other creditors. Committee members must avoid conflicts of interest that might compromise their loyalty to the creditor class and cannot use their positions on the Committee to further their own self-interest to the detriment of the class.^[23] Should a conflict arise and its constituents, the majority of courts will not necessarily require that the classes’ interest take priority as a matter of law if the members does not use his position to the detriment of other creditors.

Part II: Neiman Marcus

Kamensky’s misconduct was the bitter finale of a longstanding dispute between Marble Ridge and the sole owners of Neiman Marcus’s Parent Company, Ares Capital and the Canadian Pension Plan Investment Board (collectively, the “Sponsors”). The dispute centered on a stock transfer of the retail giant’s relatively profitable e-commerce unit, MyTheresa. In 2018, Neiman Marcus disclosed that it transferred substantially all of its equity in MyTheresa to the Parent Company at the behest of the Sponsors.

The transaction sparked outrage amongst Neiman Marcus’s creditors. Marble Ridge believed that Neiman’s bankruptcy was inevitable and that Neiman Marcus fraudulently transferred the shares to the Parent Company to divert a valuable asset away from Neiman’s creditors. The transaction was subject of two state court lawsuits filed by or on behalf of Marble Ridge.^[24]

The state litigation continued for over a year until Neiman Marcus filed for Chapter 11 relief in the United States Bankruptcy Court for the Southern District of Texas on May 7, 2020. Shortly thereafter, the United States Trustee appointed the Official Committee of Unsecured Creditors. Marble Ridge served as a member on the Committee and Marble Ridge managing partner, Daniel Kamensky, was subsequently elected as one of three co-chairs.

In hindsight, it seems that Marble Ridge’s appointment was the root of Kamensky’s problems. The parties eventually agreed to a global settlement under which the Parent Company would contribute preferred equity in MyTheresa to the estate for the benefit of unsecured creditors. Marble Ridge initially offered to play the role of white knight, agreeing to purchase 60 million shares at $.20 per shares.^[25] But on July 31, 2020, Jefferies expressed an interest in placing a higher bid on the preferred equity to the Committee’s financial advisor.^[26] The unofficial bid would have topped Marble Ridge’s offer at somewhere between $.30 and $.40 per share.^[27]

Kamensky was outraged. Within minutes of learning that Jefferies was the competing bidder, Kamensky contacted representatives of Jefferies through a series of texts and Bloomberg chat messages to “stand DOWN,”^[28] “DO NOT SEND IN A BID, ”^[29] and even threatened to use his position as co-chair of the Committee to prevent Jefferies from bidding on MyTheresa’s shares.^[30] Worse, Kamensky leveraged Marble Ridge’s ongoing business relationship with Jefferies to provide the investment bank’s representatives an ultimatum:^[31] Cease all efforts to bid on MyTheresa’s equity, or Marble Ridge would cease doing business with Jefferies and they would no longer be partners moving forward.^[32] Jefferies never placed a bid on the preferred equity and disclosed to the Committee that its decision was a result of Kamensky’s demands.^[33]

Unfortunately, that disclosure prompted Kamensky to make a bad situation even worse. On July 31, 2020, Kamensky contacted a Jefferies’ representative and demanded to know why the investment bank disclosed their discussions to the Committee.^[34] Kamensky stated that if Jefferies continued to cooperate with the Committee, “I’m going to jail, okay? Because they’re going to say that I abused my position as a fiduciary, which I probably did, right? Maybe I should go to jail. But I’m asking you not to put me in jail.”^[35] He then urged Jefferies to take part in the bidding process,^[36] and in an apparent attempt to undo the harm, stated to the representative that the “conversation never happened.”^[37]

The end of the story did not bode well for Marble Ridge or Kamensky. On August 5, 2020, the bankruptcy court charged the United States Trustee with conducting an investigation. The bankruptcy court found that “the substantial evidence collected to date clearly demonstrates that … Kamensky breached his fiduciary duty to unsecured creditors on July 31 … After being told of the existence of a rival bid and the identity of the bidder, Mr. Kamensky sought to exploit that information for his benefit by contacting Jefferies and pressuring them to withdraw their initial bid, to the likely detriment of all other creditors.”^[38]

On August 20, 2021, Marble Ridge notified investors of its plan to wind down its funds and liquidate over $1 billion in assets under management.^[39] On September 3, 2020, Kamensky was arrested and charged for fraud during the offer or sale of securities, bribery, and obstruction of justice. On February 3, 2021, Kamensky pled guilty to one count of bankruptcy fraud and thereafter was sentenced to serve six months in prison.

As for MyTheresa, the preferred shares were distributed directly to unsecured creditors, and on January 25, 2021, MyTheresa had an initial public offering. Since then, the shares have traded in excess of $35 a share—a far cry from the $0.20 offer that Marble Ridge initially made.

Part III: Conflict—You Cannot Avoid It

Kamensky’s fate could have been avoided. And this article is in no way intended to suggest that Committee counsel did anything wrong here. The reality is that Kamensky simply failed to play by the rules and failed to follow what the committee bylaws likely required. Kamesnky could have disclosed his intentions to the committee counsel before taking any action in connection with the bidding process. Better yet, as soon as Kamensky determined he had an interest in potentially participating, he could have resigned from the Committee altogether. Of course, we know he did neither.

Plainly, the role of Committee counsel can be very challenging. In order for a Committee to effectively fulfill its duties in a case, members should have full and complete access to information concerning the debtor’s affairs.^[40] That information invariably includes confidential information that could be misused for competitive or operational reasons. In this regard, the role of Committee counsel contemplates the identification, management, and resolution of conflicts of interest in real time and on a proactive basis. This requires counsel to anticipate, identify, and resolve conflicts in the ordinary course. This challenge in turn requires counsel to have in place restrictions and procedures to mitigate the temptation for possible self-dealing by members.

The interests of an individual member, the Committee, and the creditor class as a whole may not always align. While the collective goal of value maximization will generally encompass the interests of members, participation on a committee is generally driven by self-interest.^[41] Committee counsel must be mindful of these competing interests, as the engagement will often extend far beyond the normal role of an advocate.^[42] Counsel will wear a number of hats as an educator, advisor, and intermediary of Committee and inter-creditor disputes.^[43] And to succeed in this regard, counsel must effectively anticipate and manage potential conflicts, including the following best practices.

Committee Governance. Committee counsel should immediately draft and implement Committee bylaws to address and manage conflicts of interest. The bylaw provisions should:

1. impose upon each member a continuing obligation to disclose any and all prior connections with the debtor and other parties in interest, all economic interests related to the Debtor, including claims, ownership interests, competitive interests, and contracts, as well as any actual or potential conflicts that may arise;
2. include limitations on access to information that may potentially serve any of the potential conflicts or competing interests;
3. delineate procedures to vet and select a chairperson; and
4. provide for exclusion of a member from Committee participation on any matter on which the member is determined to have an actual or potential conflict of interest, provided that the member can take independent action that does not result in a breach of any fiduciary obligation as a Committee member (in which case that member should resign from the Committee).

Under the guidance of counsel, the Committee must insist upon complete disclosure of the nature and components of each member’s claims and other interests related to the debtor. Should the Committee fail to provide a procedure for members to assert their individual positions and differentiate those actions from measures undertaken by the Committee, the fiduciary duties of all of the members may be compromised.

Voting Procedures. Bylaws of the Committee should also address voting procedures as soon as possible after committee formation. These procedures should include vehicles for breaking ties, particularly where one or more members must abstain. The challenge is anticipating what changes will occur of the course of the case. In many instances, the dynamics of the Committee can quickly shift. For example, with larger committees appointed in cases that run longer, some members may become less active or entirely inactive as the case progresses. The potential for misconduct or abuse of the Committee process can increase as inactive members are asked to vote on critical issues, perhaps regarding plan formulation, about which they may be less informed and more reliant on other members or counsel. As a safeguard to limit this potential for abuse, most creditors’ Committees prohibit voting by proxy and may implement a minimum quorum to vote on substantive matters at meetings.

Protective Orders. In most cases, the debtor requires the Committee and its members to execute a confidentiality agreement or protective order concerning the disclosure of non-public information. Protective or confidentiality orders generally prohibit disclosure, use or dissemination of non-public information obtained through Committee membership. The information provided to the Committee, either from non-public sources or from analyses by the debtor’s or Committee’s professionals, as well as the deliberations of the Committee, must be kept in strict confidence. And the level of scrutiny and restriction must be heightened in the circumstance of a committee member conflict. It is not enough to simply have the member abstain from voting; the bylaws should require the withholding of confidential information, deliberations, and even the final votes from those committee members who are forced by conflicts to abstain. Strict compliance with confidentiality restrictions encourages the free-flowing production and sharing of information between the debtor and Committee, which is necessary to facilitate a successful and ideally consensual reorganization.

Moreover, a confidentiality agreement or protective order may heighten the members’ awareness of the appropriate (and inappropriate) uses (or misuses) of information and the need for limiting disclosure to properly conduct the tasks of the Committee. The confidentiality agreement or protective order will generally restrict the members’ use of confidential information acquired only through the Committee membership. But cases can move quickly, and thus members who fail to sign the confidentiality agreement must be excluded from disclosures and discussions involving confidential Committee information until they sign. The early stages of a committee appointment are ripe for lax enforcement and abuse, but the beginning is the best time to make clear the importance of strict compliance.

Part IV: Key Takeaways

The representation of Committees in bankruptcy proceedings will almost always involve the management and control over a free flow of information between and among the debtor, Committee members, and the Committee’s professionals. For Committee counsel, that information should include early and ongoing disclosure by all members of their interests and connections in the debtor and the proceedings. In the course of service on the committee, members will invariably encounter confidential information that could be used to their own benefit or to other’s detriment. Committee counsel must anticipate and implement appropriate safeguards to manage and resolve these potential conflicts before they occur. Practitioners representing Committees should be acutely aware of the inevitability of the conflicts that arise when members receive proprietary information during the course of a case. Under those circumstances, Committee counsel and members should look to their governance documents and conscience for guidance. Put clear procedures in place, enforce those procedures strictly, and always, always err on the side of caution.

1. In re Neiman Marcus Group LTD, LLC, et al., No. 20-32519 (DRJ) (Bankr. S.D. Tex. Aug. 19, 2020) (Jointly Administered). ↑

2. Statement of the Acting United States Trustee Pursuant to Court Order Regarding the Conduct of Marble Ridge Capital LP & Dan Kamensky at 22, In re Neiman Marcus Group LTD, LLC, et al., No. 20-32519 (DRJ) (Bankr. S.D. Tex. Aug. 19, 2020), ECF No. 1485 (the “Report”). ↑

3. Id. at 11. ↑

4. The Report, pg. 10. ↑

5. Id. at 29. ↑

6. Jefferies was Marble Ridge’s ninth largest trading partner. The Report, pg. 10, at fn. 7. ↑

7. See, e.g., 11 U.S.C. § 1103(a). ↑

8. 11 U.S.C. § 1102(a). ↑

9. Id. ↑

10. 11 U.S.C. § 1102(a)(2). ↑

11. Id. ↑

12. 11 U.S.C. § 1103(c). ↑

13. See James White & Raymond Nimmer, Bankr. Cases and Mat. 65 (3d ed. 1996); see also In re STN Enter., 779 F.2d 901, 905 (2d Cir. 1985) (granting committee standing to sue); In re A. C. Williams Co., 25 B.R. 173, 177 (Bankr. N.D. Ohio 1982) (stating committee should be active in arriving at plan). See generally 11 U.S.C. § 1129 (1994) (providing for prerequisite for confirmation of restructuring plan). ↑

14. See Westmoreland Human Opportunities, Inc. v. Walsh, 246 F.3d 233, 256 (3d Cir. 2001). ↑

15. In re Enduro Stainless, Inc., 59 B.R. 603, 605 (Bankr. N.D. Ohio 1986) (stating that member of creditors’ committee undertakes to act in fiduciary capacity and may not act as to promote only that creditors’ interest); In re Bohack Corp., 607 F.2d 258, 262 n.4 (2d Cir. 1979) (“[T]he committee owes a fiduciary duty to the creditors, and must guide its actions so as to safeguard as much as possible the rights of minority as well as majority creditors”). ↑

16. Shaw & Levine v. Gulf & Western Indus. (In re Bohack Corp.), 607 F.2d 258, 262 n.4 (2d Cir. 1979). ↑

17. In re Johns-Manville Corp., 26 B.R. 919, 925 (Bankr. S.D.N.Y. 1983); see also In re Tucker Freight Lines Inc., 62 B.R. 213, 216 (Bankr. W.D. Mich. 1986) (“At a minimum, this fiduciary duty requires that the committee’s determinations must be honestly arrived at, and, to the greatest degree possible, also accurate and correct.”). ↑

18. Official Unsecured Creditors’ Comm. v. Stern (In re SPM Mfg. Corp.), 984 F.2d 1305, 1317 (1st Cir. 1993) (citation omitted). ↑

19. See, e.g., In re Plabell Rubber Prods., Inc., 140 B.R. 179, 181 (Bankr. N.D. Ohio 1992) (stating that all committee members need not have parallel interests); In re Texaco, Inc., 79 B.R. 560, 567 (Bankr. S.D.N.Y. 1987). ↑

20. In re Microboard Processing, Inc., 95 B.R. 283, 285 (Bankr. D. Conn. 1989). ↑

21. SPM Mfg. Corp., 984 F.2d at 1317 (citation omitted). ↑

22. In re Rickel & Associates, Inc., 272 B.R. 74 (Bankr. S.D.N.Y. 2002). ↑

23. Johns-Manville, 26 B.R. at 925 (“Conflicts of interest on the part of representative persons or committees are thus not [to] be tolerated.”); In re Haskell-Dawes Inc., 188 B.R. 515, 522 (Bankr. E.D. Pa. 1995) (committee members have a fiduciary duty that prohibits them from “using their position to advance their own individual interests”). ↑

24. The Report, at pg. 5. ↑

25. Id. at pg. 9. ↑

26. Id. at pg. 10. ↑

27. Id. at pg. 11. ↑

28. Id.at pg. 13. ↑

29. Id. at pg. 13-14 (capitalizations original). ↑

30. Id.at pg. 16. ↑

31. See id. ↑

32. Id. ↑

33. Id. at pg. 21-22. ↑

34. Id. at 22. ↑

35. Id. ↑

36. Id. at 21. ↑

37. Id. at 24. ↑

38. Id.at pg. 29. ↑

39. CNN Business, Jazmin Goodwin, Hedge Fund Founded Charge Over Fraud Connected to Neiman Marcus Bankruptcy Bid, https://www.cnn.com/2020/09/03/investing/neiman-marcus-marble-ridge-bankruptcy-fraud/index.html (September 3, 2020). ↑

40. See, e.g., In re Channel Master Holdings, Inc., 309 B.R. 855, 862 (Bankr. D. Del. 2004) (holding that creditors’ committee was entitled to review and oppose debtor’s Key Employee Retention Plan). ↑

41. See In re Microboard Processing, Inc., 95 B.R. 283, 285 (Bankr. D. Conn. 1989) (describing inherent conflict of interest of unsecured creditors as axiomatic). ↑

42. See Texas Extrusion Corp. v. Lockheed Corp. (In re Texas Extrusion Corp.), 844 F.2d 1142, 1163 (5th Cir. 1988) (authorizing attorney for creditors’ committee to consult with creditors); In re Wire Cloth Prod., 130 B.R. 798, 812 (Bankr. N.D. Ill. 1991) (stating that attorneys for creditors’ committee must further economic interests of unsecured creditors); In re Pettibone Corp., 74 B.R. 293, 309 (Bankr. N.D. Ill. 1987) (delineating counsel’s functions necessary to creditors’ committee performance). ↑

43. See generally Carl A. Eklund & Lynn W. Roberts, The Problem with Creditors’ Committees in Chapter 11: How to Manage the Inherent Conflicts Without Loss of Function, 5 Am. Bankr. Inst. L. Rev. 129, 138 (1997). ↑

Economists have long argued that economic activity influences businesses filing for bankruptcy. This relationship is grounded in the simple idea that economic downturns can sufficiently reduce liquidity such that debtors are unable to meet debt obligations as they become due and might require court-driven solutions.^[1]

Indeed, in the past two years a lengthy list of companies filed for bankruptcy in a wide array of industries, including: retail, commercial real estate, leisure and travel, air travel, restaurant and food service, energy, and communications.^[2]

Filings and Economic Activity

To illustrate the relationship between bankruptcy filings and economic activity, one can observe bankruptcy filings over the business cycle. The two Figures below show the seasonally adjusted number of Chapter 7 and Chapter 11 filings (two common forms of bankruptcy) and an index of economic activity published by the Federal Reserve.^[3]

Figure 1: Business Chapter 7 Filings and Coincident Economic Activity Index

2013 ̶ Sep 2021

Figure 2: Business Chapter 11 Filings and Coincident Economic Activity Index

2013 ̶ Sep 2021

Both Figures show that up until the start of the COVID-19 recession, the continued expansion of economic activity generally corresponded with a reduction in filings for Chapter 7 and Chapter 11. In other words, there is an inverse relationship between the number of filings and the level of economic activity. But Figure 1 also illustrates that the economic contraction in 2020 corresponded with a sharp decline in Chapter 7 filings, rather than the increase in filings predicted by the historic relationship between the two indicators. Business Chapter 11 filings, on the other hand, increased even if not as much as the historical relationship would indicate.

Therefore, these Figures pose a relevant question: Has the most recent economic downturn been associated with levels of bankruptcy filings similar to those in the past? And, if the number of filings didn’t follow the historical pattern, what can explain the new trend?

Recent Filing Rates

To help answer these questions, we next compare monthly filings in each of 2020 and 2021 to those that occurred during the same month of 2019. This comparison should help control for factors other than the COVID-19 recession. We also break down bankruptcy filings into business and non-business Chapter 7 and business Chapter 11.

Figure 3: Business and Non-Business Bankruptcy Filings

2020 ̶ Sep 2021 (Benchmark Year = 2019)

Confirming the pattern presented above, Figure 3 shows that both non-business and business Chapter 7 filings (which tend to be associated with small-to-medium size companies) were down in 2020, compared to 2019. And the number of cases did not reach the 2019 levels in the first three quarters of 2021 either. In contrast, Chapter 11 filings were significantly higher in 2020, compared to 2019. However, this trend reverted in 2021 with filings on average 28% lower than 2019 levels.

Hypotheses and Explanations

A group of economists have analyzed the rate of bankruptcy filings during 2020 in deeper detail and found comparable results. They further reported, for example, that filings by companies with asset value greater than $50 million increased by nearly 200% in 2020.^[4]

As shown in Figure 3, small-to-medium businesses (and households) have filed for bankruptcy less frequently than what might have been expected. The economists provide a list of potential reasons why this might have happened, including: policy responses, access to bankruptcy courts, liquidity, and uncertainty. We explain these factors next.

The first factor refers to policy responses which might have contributed to differing filing rates among different economic actors. Policy responses such as the Coronavirus Aid, Relief, and Economic Security Act (“CARES Act”) (which included a foreclosure moratorium), the Paycheck Protection Program (“PPP”), and other measures activated by state and local governments reduced the demand for bankruptcy protection among households and smaller businesses.^[5] To the extent these policies targeted smaller business and households, this factor would explain the decline in their filing rate. On the other hand, the CARES Act expanded on a new law that streamlined the Chapter 11 process (the Small Business Reorganization Act (“SBRA”)).^[6] Specifically, the CARES Act raised the debt threshold required to take advantage of the streamlined Chapter 11 process envisioned under the SBRA, allowing for a larger pool of eligible companies. This could explain part of the observed increase in Chapter 11 filings.^[7]

Second, households and smaller businesses may have had trouble accessing bankruptcy courts—and meeting with any bankruptcy counsel they might have retained—because of pandemic-induced changes in court operations. More difficult access to bankruptcy courts would naturally translate into less filings.^[8] A related factor is that busier courts could have hindered small companies’ opportunity to file. A study shows that as bankruptcy courts see higher caseloads, the focus shifts towards larger companies at the expense of smaller ones.^[9]

Third, economists have found that the existence of bankruptcy fees generally prevents households from filing. For example, a study using data from 2001 and 2008 tax rebates found that consumers who received a tax rebate increased their propensity to file for bankruptcy compared to those that did not.^[10] This theory would suggest that if households or smaller businesses had constrained liquidity during the COVID-19 recession, they would have been less likely to file bankruptcy. On the other hand, an increase in liquidity would correspond to an increase in filings. This theory would be consistent with the increase in Chapter 7 filings immediately following April 2020, when the first stimulus check was distributed (and the PPP bill was signed). However, an increase in filings is not apparent after the stimulus checks distributed in December 2020 and March 2021, respectively.^[11]

Lastly, the uncertainty surrounding the COVID-19 pandemic may have contributed to the slower household bankruptcy filing rates. Because households typically must wait 8 years before they can file for Chapter 7 a second time, economists argue that there is a benefit to waiting and seeing how pervasive an economic crisis is before filing for bankruptcy.^[12] For businesses, a wait-and-see policy is likely more valuable for Chapter 7 compared to Chapter 11 because the former implies liquidating assets whereas the latter is often a reorganization of the business. This hypothesis explains the lower filing rates experienced by households and smaller businesses but would also predict an increase in these filings when (and if) COVID-related uncertainty dissipates, everything else being equal. A look at Figure 3 indicates that if this hypothesis is true, uncertainty remained high during the period we collected data for.

Conclusion

In summary, while economic research continues to produce insights into the broad implications of the COVID-19 pandemic, this article highlighted that COVID-related effects on bankruptcy filings by households and small businesses were different than the effects on larger companies, at least in 2020. The 2021 data indicates that this difference has largely disappeared even though filings for bankruptcy remain lower than 2019 levels. Further statistical analysis can provide clues as to the importance of the potential causes for the trends explained in this article.

1. For example, seminal work by Prof. Altman showed that bankruptcy can be predicted by financial ratios such as working capital to total assets, retained earnings to total assets, EBIT to total assets, market equity to total liabilities, and sales to total assets. See Edward Altman, “Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,” Journal of Finance 23, 1968, pp. 589–609. ↑

2. A partial list of corresponding companies includes J.C. Penney, Neiman Marcus, Lord & Taylor, Pennsylvania Real Estate Investment Trust, Hertz, LATAM, Sizzler, Chesapeake Energy, Diamond Offshore Drilling, and Frontier. ↑

3. See Federal Reserve Bank of Philadelphia, Coincident Economic Activity Index for the United States [USPHCI], retrieved from FRED, Federal Reserve Bank of St. Louis. Available at http://fred.stlouisfed.org/series/USPHCI. ↑

4. Jialan Wang, Jeyul Yang, Ben Iverson, and Renhao Jiang, “Bankruptcy and the COVID-19 Crisis,” Working Paper, March 2021. ↑

5. Robin Greenwood, Ben Iverson, and David Thesmar, “Sizing Up Corporate Restructuring in the Covid Crisis,” Brookings Papers on Economic Activity, Fall 2020 (Special Edition): 391-428. See also, Alan Hochheiser, “Consumer Bankruptcy in the Age of COVID-19,” Business Law Today, American Bar Association, June 25, 2021. ↑

6. Lei Lei Wang Ekvall, and Timothy Evanston, “The Small Business Reorganization Act: Big Changes for Small Businesses,” Business Law Today (February 2020). Available at https://www.americanbar.org/groups/business_law/publications/blt/2020/02/small-business-reorg/. ↑

7. Sands Anderson, “The New Small Business Reorganization Act Comes with New Forms and Rules,” May 27, 2020. Available at https://www.jdsupra.com/legalnews/the-new-small-business-reorganization-20197/ . ↑

8. Paige Marta Skiba, Dalie Jimenez, Michelle McKinnon Miller, Pamela Foohey, and Sara Sternberg Greene, “Bankruptcy Courts Ill-Prepared for Tsunami of People Going Broke from Coronavirus Shutdown,” The Conversation, May 2020. See, also, Bob Lawless, “A Coming Consumer Bankruptcy Tsunami, Wave, or Ripple?” Available at https://www.creditslips.org/creditslips/2020/04/a-coming-consumer-bankruptcy-tsunami-wave-or-ripple.html. ↑

9. Ben Iverson, “Get in Line: Chapter 11 Restructuring in Crowded Bankruptcy Courts,” Management Science 64 (11), 2018, 4967-5460. ↑

10. Tal Gross, Matthew Notowidigdo, and Jialan Wang, “Liquidity Constraints and Consumer Bankruptcy: Evidence from Tax Rebates,” Review of Economics and Statistics, 2014, 96(3), 431-443. ↑

11. See Figure 3 supra and https://www.usa.gov/covid-stimulus-checks. ↑

12. Tal Gross, Raymond Kluender, Feng Liu, Matthew J. Notowidigdo, and Jialan Wan, “The Economic Consequences of Bankruptcy Reform,” National Bureau of Economic Research Working Paper #26254, 2020. See, also, Michelle White, “Why Don’t More Households File for Bankruptcy?” Journal of Law, Economics, & Organization, 1998, pp. 205-231. ↑

February 2022 saw several court decisions concerning the Illinois Biometric Information Privacy Act (“BIPA”) (740 ILCS 14/1 et seq.). Regarding the two state court decisions, one looks at the exclusivity provisions of the Illinois Workers’ Compensation Act in the light of BIPA, and the other examines Section 301 of the Labor Management Relations Act (29 U.S.C. §185) and how BIPA reflects on collective bargaining agreements. This article provides a brief review of each of these two cases and concludes with some thoughts for business leaders to reflect upon when considering their BIPA compliance and potential liabilities.

BIPA and Workers’ Compensation

In a February 3, 2022, decision, the Illinois Supreme Court held that the exclusivity provisions of the Illinois Workers’ Compensation Act [(“Compensation Act”) (820 ILCS 305/1 et seq.)] do not bar a claim for statutory damages under the Biometric Information Privacy Act (“BIPA”) where an employer is alleged to have violated an employee’s statutory privacy rights under BIPA.

The plaintiff (employee) in McDonald v. Symphony Bronzeville Park, LLC, et al., 2022 WL 318649 (Illinois Supreme Court, 20220203) was seeking damages under BIPA and attempting to form a class. The defendants (the employer) filed a motion to dismiss the plaintiff’s class action complaint, asserting, inter alia, that plaintiff and the putative class’s alleged claims were barred by the exclusive remedy provisions of the Compensation Act. In particular, defendant argued that the Compensation Act is the exclusive remedy for accidental injuries transpiring in the workplace and that an employee has no common-law or statutory right to recover civil damages from an employer for injuries incurred in the course of her employment.

In its analysis the Illinois Supreme Court stated, “The personal and societal injuries caused by violating the Privacy Act’s prophylactic requirements are different in nature and scope from the physical and psychological work injuries that are compensable under the Compensation Act. The Privacy Act involves prophylactic measures to prevent compromise of an individual’s biometrics. Rosenbach, 2019 IL 123186, ¶ 36 [432 Ill.Dec. 654, 129 N.E.3d 1197]. McDonald’s [plaintiff’s] claim seeks redress for the lost opportunity ‘to say no by withholding consent.’ Id. ¶ 34. McDonald [plaintiff] alleges that Bronzeville [employer] has violated her and the class’s right to maintain their biometric privacy. See id.” (For a more detailed discussion of Rosenbach, see “Biometric Information – Permanent Personally Identifiable Information Risk” available at http://bit.ly/BIP-PII-RISK-ABA-BUS-CORP-LIT20190702.)

The Illinois Supreme Court distinguished the different purposes of the Compensation Act and BIPA and commented on the legislative intent:

We are cognizant of the substantial consequences the legislature intended as a result of Privacy Act violations. Pursuant to the Privacy Act, the General Assembly has adopted a strategy to limit the risks posed by the growing use of biometrics by businesses and the difficulty in providing meaningful recourse once a person’s biometric identifiers or biometric information has been compromised. Rosenbach, 2019 IL 123186, ¶ 35 [432 Ill.Dec. 654, 129 N.E.3d 1197]; see also 740 ILCS 14/5(c) (West 2016) (once biometrics are compromised, the individual has no recourse, is at heightened risk for identity theft, and is likely to withdraw from biometric-facilitated transactions). The General Assembly has tried to head off such problems before they occur by imposing safeguards to ensure that the individuals’ privacy rights in their biometric identifiers and biometric information are properly protected before they can be compromised and by subjecting private entities who fail to follow the statute’s requirements to substantial potential liability (740 ILCS 14/20 (West 2016)) whether or not actual damages, beyond violation of the law’s provisions, can be shown. Rosenbach, 2019 IL 123186, ¶ 36 [432 Ill.Dec. 654, 129 N.E.3d 1197]. “It is clear that the legislature intended for this provision to have substantial force.” Id. ¶ 37.

“When private entities face liability for failure to comply with the law’s requirements without requiring affected individuals or customers to show some injury beyond violation of their statutory rights, those entities have the strongest possible incentive to conform to the law and prevent problems before they occur and cannot be undone.” Id.

BIPA and Collective Bargaining Agreements

In a February 22, 2022, decision, the Appellate Court of Illinois, First District, held that plaintiff (union employee) and his fellow unionized employees are not prohibited from pursuing redress for a violation of their right under BIPA to biometric privacy—they are simply required to pursue those rights through the grievance procedures in their collective bargaining agreement rather than in state court in the first instance. In essence, the Illinois Appellate Court determined that a union member-employee (plaintiff) “cannot bypass his union, his sole and exclusive bargaining agent,” to demand that the employer “deal with him directly” on this issue.

The plaintiff (union member-employee) in William Walton, Individually and on Behalf of Others Similarly Situated, v. Roosevelt University, 2022 WL 522760 (Appellate Court of Illinois, 1^st District, 2^nd Division, 20220222) alleged claims under BIPA. The defendant argued that the claims asserted by the plaintiff are preempted and moved to dismiss the complaint. The circuit court denied the motion to dismiss but certified the relevant question (“Does Section 301 of the Labor Management Relations Act (29 U.S.C. § 185) preempt [Privacy Act] claims (740 ILCS 14/1) asserted by bargaining unit employees covered by a collective bargaining agreement?”) for interlocutory review.

The Illinois Court of Appeals noted that while the Walton appeal was pending, the United States Court of Appeals for the Seventh Circuit directly addressed the question brought to bear in this appeal. In Fernandez v. Kerry, Inc., 14 F.4th 644, 646-47 (7th Cir. 2021), the U.S. court of appeals found that unionized employees’ claims that their employer violated the BIPA were preempted by the Labor Management Relations Act (29 U.S.C. § 185). As Walton (plaintiff) conceded at oral argument, the relevant factual and legal circumstances of this case were indistinguishable from Fernandez, so, as noted by the Court, the Court’s real objective in this appeal was to determine whether the court of appeals’ ruling on a matter of federal law was wrongly decided in such a way that the Court would deem it to be without logic and reason. (For a more detailed discussion of Fernandez, see “Biometric Information Privacy Act and Collective Bargaining Agreements” available at https://bit.ly/BIPA_Collective_Bargining_Agmts_MIB_202109.)

In addressing the issues raised by the certified question, the Court reasoned:

In contrast to finding the court of appeals’ decision to be without logic or reason (see State Bank of Cherry, 2013 IL 113836, ¶ 54), we think it is the proper interpretation of the Privacy Act when viewed through the prism of the Labor Management Relations Act’s preemptive effect. The Privacy Act contemplates the role of a collective bargaining unit that may act as an intermediary on issues concerning the employee’s biometric information. See 740 ILCS 14/15(b) (West 2020). The Privacy Act provides that “[n]o private entity may collect *** a person’s *** biometric identifier or biometric information, unless it first: (1) informs the subject or the subject’s legally authorized representative in writing that a biometric identifier or biometric information is being collected or stored; (2) informs the subject or the subject’s legally authorized representative in writing of the specific purpose and length of term for which a biometric identifier or biometric information is being collected, stored, and used; and (3) receives a written release executed by the subject of the biometric identifier or biometric information or the subject’s legally authorized representative.” (Emphases added.) Id. Under the Privacy Act, it is clearly within a union’s purview to negotiate with the employer about its members’ biometric information. The grievances that Walton has raised against Roosevelt are all things that his union can bargain about, but his complaint raises the question of whether such bargaining has occurred, either implicitly or explicitly.

The collective bargaining agreement at issue in this case contains a broad management rights clause. The agreement makes the union the sole and exclusive bargaining agent for the employees in the union. Walton and any other similarly situated employees agreed to their employment being covered by the subject collective bargaining agreement. The timekeeping procedures for workers are a topic for negotiation that is clearly covered by the collective bargaining agreement and requires the interpretation or administration of the agreement. The members of the collective bargaining unit in this case have surrendered their individual right to bargain with their employer about timekeeping procedures, even where those timekeeping procedures also include the collection and use of the employees’ biometric information. …

Unions frequently bargain for matters concerning their members’ privacy and protection. Collective bargaining agreements may include express and implied terms (id.), and it is up to an arbitrator, not a state court, to define the scope of the parties’ agreement (Fernandez, 14 F.4th at 646-47).

In answering the certified question, the Illinois Court of Appeals held:

Walton and his fellow unionized employees are not prohibited from pursuing redress for a violation of their right to biometric privacy—they are simply required to pursue those rights through the grievance procedures in their collective bargaining agreement rather than in state court in the first instance. Walton cannot bypass his union, his sole and exclusive bargaining agent, to demand that Roosevelt deal with him directly on this issue. Walton comes to the court attempting to represent a class of similarly situated employees over a workplace grievance, but that is a place for his union, not Walton himself. Federal law prevents state courts from stepping in and usurping the bargained-for dispute resolution framework where the parties have elected to establish a working relationship that comes within the purview of the Labor Management Relations Act. Accordingly, we answer the certified question in the affirmative and find that Privacy Act claims asserted by bargaining unit employees covered by a collective bargaining agreement are preempted under federal law.

Conclusion

The bottom line is that employers using, or planning to use, biometric devices (e.g., timeclocks, facial recognition, etc.) in the workplace need to be aware of the biometric privacy legislation applicable to the jurisdictions where they do business and where their employees (and others interacting with those biometric devices) reside. In particular, employers subject to a Workers’ Compensation Act or collective bargaining agreement under the Labor Management Relations Act (29 U.S.C. § 185 (2018)) need to understand their compliance responsibilities in light of the employer’s use of biometric devices and the relationship to their employees’ rights, and the business’s liabilities (which can be significant under BIPA-type legislation).

Offices are open. Employees are coming back. But it won’t be an easy return. “Returning is going to pose one of the most complex financial-cultural-operational-technological-recruiting and retention-organizational challenges that law firms have faced in years,” one observer noted.^[1] There is no one-size-fits-all answer, because firms’ rules will need to reflect the makeup of each firm. Key differences include:

• Generational distribution within the workforce
• Practice areas’ need to be together in the office
• Individuals’ work assignments—e.g., drafting vs. brainstorming
• Personal preferences

One of the most disruptive areas of change relates to the need to attract and retain talent. Living through the two-year pandemic aberration changed people’s minds about the importance of work, the place of work in their lives, the ability to work effectively from anywhere, and the importance of being valued and sharing values. Now they want their workplaces to change, too.

Law firm associates want to be treated as individuals and future leaders rather than as fungible worker bees putting in crazy long hours to meet billable hour requirements. Other non-equity lawyers want to be acknowledged for their skills instead of denigrated for their lack of interest in attaining equity status. Marketing and management staff no longer want to be relegated to a “non-lawyer” category (i.e., less important, less bright but necessary). All these understandable desires run up against traditional firm cultures, which:

• measure and reward time instead of results,
• believe that in-person collaboration and communication provide the only environment in which new lawyers can learn the art of lawyering, and
• assume small leadership cohorts should make decisions for everyone without asking for or paying attention to the opinions of the rest of the firm.

Let’s look at some of the specific areas of disconnect and possible solutions.

Hybrid Office Rules That Maximize Individual Flexibility and Autonomy

Most employees do not want to return to the 2019 office. They want to continue the taste of choice they had when COVID-19 sent everyone home: the ability to work from anywhere and set their own work schedule and work hours. They remember the positives of remote work: time flexibility, better integration of work into their whole life, and an opportunity to focus on what’s important. They forget the negatives of burnout, loneliness, and inability to set work boundaries.

For firm leadership, two important elements emerge:

1. The need to structure work to maximize productivity and collaboration while addressing remote/in-office scheduling and the causes of burnout.
   1. What kind of scheduling will meet the demand for flexible work time, the right to work away from the office, and the need for productive teams?
   2. What kind of manager-employee communication creates a workplace that people want to be part of?
2. The need to respond to the emphasis on values—personally important and also important as part of firm culture.
   1. How do you show that a person is valued?
   2. How do you help them develop the skills needed to progress in a career?
   3. Is the firm’s mission larger than just making more money for equity partners? How does it help improve the world?

A Framework for Hybrid Office Work

Schedules are essential as a framework for work. There needs to be some certainty as to where people are, when. At the same time, employers should assume nonlinear days and asynchronous work schedules are consequences of remote work options and flexible work schedules. According to a Future Forum survey, 76% of non-executive knowledge workers want flexibility in where they work and 93% want flexibility in when they work.^[2]

Some possible ways to establish a modern framework that balances the competing needs:

• Invest in modern technology and make sure that everyone has similar equipment for their home office.
• Maximize use of technology that encourages and supports communication up, down, and sideways.
• Require everyone to be in the office two to three days a week, or require teams and colleagues who work with them to set days when they are together in person.
• Facilitate individual flexibility regarding when and where people work, balancing it with established times for collaboration.
• Address personal burnout by setting “core hours” when everyone has to be online or offline. Make weekends email-free time. Expect people to have work-free weekends most of the time.

A Framework for Recognition

Few law firm associates spread tales of partner kindnesses. Rather, they complain about overwork and negative feedback. What they want is appreciation for what they do and a feeling of personal interest in them and their career from those they report to. Law firm leaders at all levels, from managing partner to team leader, need to learn to use emotional intelligence to understand their own hot buttons, control them, and listen to their subordinates with empathy and interest.

“The Future Forum puts it another way, advising executives to embrace flexibility, reward inclusion, and build connection through transparency─in other words, pay attention to what staff want and give it to them.”^[3]

To address employee demands, law firm leaders and managers need to create training and development opportunities for everyone in the firm. Online training programs can supplement in-person opportunities to watch and learn. This changes the tone of the culture because when programs connect with individuals’ needs, they feel invested in, and this makes them feel happier about their work and their firm.

Some strategies to respond to employees’ requests for training, career planning, and values alignment:^[4]

• Include training in the firm culture and necessary soft skills as part of the onboarding process. In addition, pair each new hire with a peer-level mentor to support them as they learn the ropes.
• Encourage “job crafting,” the process through which employees have input into their roles. It increases their motivation to succeed because it demonstrates that the firm is willing to invest in them.
• “Agile firms” that can attract and keep talent will “redefine productivity to include ongoing learning, . . . and identify advancement opportunities for every employee.”
• Leaders will encourage transparency. Rather than decree how it will be, they will discuss their ideas with the people who will be impacted by them and try to incorporate their feedback.
• Invest too in leader training, especially for next-generation leaders. Actively look for nascent leaders among the rank and file, those informal leaders whom others follow.
• Gen Z and millennial employees want to work for firms whose values align with theirs. To meet them halfway, firms should share their values and work with interested employees to implement them through concrete activities.

“The days of command and control management are gone. Employees are now in the driver’s seat. … [E]ncourage intentional listening (listening with intent to understand not the intent to respond) to find out what they [employees] want and need to be happy and successful.”

Concluding Thoughts

Of course, this discussion of remote work options, flexible work time, and robust, firmwide training avoids the elephant in the room─equating productivity to billable hours instead of to results. Other knowledge firms─accountants, consultants─set prices based on the value of their knowledge, rather than the time needed to produce results. As AI tools, apps, and programs become more common in law firms, the move away from billable hours as the basic revenue generator will move faster. To continue to make money, firms will have to transition to results-based measurements.

This article suggests new interactions between leaders and led, all designed to attract and retain talent, a necessary competitive advantage for any firm. The next article will focus on ways to restructure firms to support DEI─diversity, equity, and inclusion.

1. Bruce MacEwen, “Back to the Office! (Say What?),” July 25, 2021, https://www.adamsmithesq.com/2021/07/back-to-the-office-say-what/ ↑

2. Future Forum is a research group backed by Slack. Nicole Kobie, “Why Bosses are Inflexible About Flexible Work Arrangements,” November 22, 2021, https://www.wired.co.uk/article/employers-flexible-working-post-pandemic ↑

3. Id. ↑

4. Adapted from Meighan Newhouse, “Breaking With Tradition: Cultural Shifts Laws Firms Must Embrace to Attract and Retain Talent,” March 4, 2022. https://www.law.com/njlawjournal/2022/03/04/breaking-with-tradition-cultural-shifts-law-firms-must-embrace-to-attract-and-retain-talent/ ↑

SPACs are running into choppy water these days. The Delaware Court of Chancery’s January 2022 opinion denying motions to dismiss in the MultiPlan Corp. litigation may be a significant source of concern for SPACs. Certainly, the case and Vice Chancellor Will’s 61-page opinion are of great interest to all in the SPAC community.

First and foremost, MultiPlan is the first time Delaware courts have applied fiduciary duty principles in the SPAC context. The courts’ decisions in this case could foretell its treatment of increasing numbers of SPACs that find themselves faced with lawsuits in Delaware court, a state where many SPACs are registered.

Second, the opinion touches on multiple topics, including conflicts of interest, disclosure, and the legal standard to be used for SPAC-related cases. Many law firms have put out excellent summaries and analyses of the case, including Skadden, DLA Piper, Mayer Brown, and Cooley.

Most articles analyzing this decision, however, do not discuss its directors and officers (D&O) insurance-related implications. From the insurance perspective, there are several interesting points to note.

Which SPAC D&O Insurance Policy Would Respond?

The first point of interest is which D&O insurance policy will be tapped to cover defense costs for the defendants. The defendants here, like in many other SPAC-related suits, are the SPAC (Churchill Capital Corp. III), the SPAC’s sponsor (managed by an entity wholly owned by Michael Klein, a serial SPACer), and the SPAC’s directors and officers, Klein among them.

The shareholder plaintiffs allege that defendants breached their fiduciary duty when they issued a false and misleading proxy statement. The plaintiffs allege that there should have been disclosure about the fact that MultiPlan’s largest customer was building an in-house platform to compete with MultiPlan. This lack of disclosure, according to the plaintiffs, impaired Class A stockholders’ informed exercise of their redemption and voting rights.

Even though the MultiPlan lawsuit was brought four months after the close of the business combination, the allegations relate to misstatements in the proxy statement that was filed prior to the business combination. Therefore, the policy that would respond on behalf of the SPAC and its directors and officers would be the D&O policy placed at the time of the SPAC IPO or to be more precise, its tail.

The tail is very important here. Remember that D&O insurance policies are “claims made” policies, meaning that the policy cannot have expired and must be active for it to respond to a claim. A “tail” is a reference to paying additional premium so that the policy stays open for claims past its natural expiration. In the case of SPACs, the initial IPO policy is typically an 18- or 24-month policy. These policies typically include pre-negotiated terms for a six-year tail. When the SPAC closes its business combination, it must ensure that the tail premium is paid as part of the closing of the business combination.

The concern is what happens if—as was exactly the case in MultiPlan—shareholders decide to sue the SPAC and its directors and officers after the deal closes. Here, the lawsuit was brought four months after the close of the business combination and the related “change of control” as that term is typically defined in D&O policies. Presumably in this case, as is typical, the SPAC purchased the SPAC IPO’s tail policy at the time business combination closed. As a result, one would expect the SPAC’s original D&O insurance policy to respond to the pending litigation on behalf of the SPAC and the SPAC’s directors and officers.

It’s worth noting that while the go-forward public company may have agreed to indemnify the SPAC and the SPAC’s directors and officers against future claims brought after the deal closed, the go-forward public company’s D&O insurance will almost always exclude coverage for these types of claims. This, in addition to the fact that the target’s purchasing of the tail is market practice, is a big reason why the go-forward public company is typically willing to provide the funds for the SPAC’s tail policy.

Unscrupulous Behavior by Certain Brokers

It is also worth noting that some unscrupulous D&O insurance brokers have started suggesting to SPACs that they should purchase their tail from new carriers instead of adhering to the pre-negotiated tail terms they agreed to at the time of the SPAC IPO. Unlike in a traditional M&A context, this practice is heavily frowned upon in the SPAC context. Recall that carriers who wrote the SPAC IPO policy did it with the expectation of their ultimate receipt of the full premium. The first portion of the SPAC D&O policy premium is paid at the time of the initial IPO, with the second portion paid when the business combination closes.

Indeed, to offset high upfront costs for working capital–poor SPACs, most carriers have historically agreed to under-charge at the time of the IPO because they understand that the tail will be purchased from them. SPAC directors and officers who choose to ignore this understanding may find it difficult, if not impossible, to get good terms for their next SPAC. Unsurprisingly, insurance carriers keep close track of which SPAC teams are “shopping” the tail.

D&O Insurance Carriers Are Concerned about Conflicts of Interest

Another MultiPlan case theme that insurance carriers are monitoring closely is the issue of conflicts of interest. Vice Chancellor Will discusses at length the conflicts of interest existing in this case among the SPAC, its CEO and Chairman Michael Klein, and his affiliate, The Klein Group LLC. The SPAC’s board selected The Klein Group LLC as its financial advisor and paid it $30.5 million in connection with the merger and its financing. These interrelations led Vice Chancellor Will to conclude that the less defendant-friendly “entire fairness standard” rather thanthe more common “business judgement rule” standard should be applied in this case. This determination essentially made winning a motion to dismiss impossible for the defendants.

Judge Will’s conclusions intersect with insurance carrier concerns in two different ways. One is that D&O insurance underwriters have become highly sensitive to potential conflicts of interest between SPAC teams, their sponsors, and directors on one hand; and public shareholders on the other. It is standard now for an insurance underwriter to ask multiple follow-up questions and request to see extensive disclosure around all potential conflicts of interest. If these questions and requests are not satisfied, and in some cases even if they are, many insurers are unwilling to offer coverage for claims arising out of transactions with affiliated entities of the SPAC or will only do so at elevated pricing.

Insurance carriers are also interested in the issue of whether claims in MultiPlan are direct or derivative. Direct cases are easier to bring because, unlike the derivative ones, they do not need to go through an extra step of satisfying demand futility requirements. In MultiPlan, Vice Chancellor Will decided that the claims are direct because “the plaintiffs are not suing because Churchill did not combine with MultiPlan on more favorable terms. They are suing because the defendants, purportedly for self-serving purposes, induced Class A stockholders to forgo the opportunity to convert their Churchill shares into a guaranteed $10.04 per share in favor of investing in” the combined entity.

From a D&O insurance perspective, there is a real consequence to the direct versus derivative distinction because of the way the insurance agreements work. The “Side A” part of the ABC D&O insurance program responds on a first-dollar basis, but only to non-indemnifiable claims. Settlements of derivative suits are usually not indemnifiable under Delaware corporate law, while direct suits are indemnifiable. While many SPAC D&O insurance programs are structured as traditional “ABC” programs, some SPAC teams, as a cost-saving alternative, are choosing to structure their programs as “Side A” only.

To the extent that a SPAC purchased a Side A–only policy, and the lawsuit is determined, like in MultiPlan, to be a direct one, there may be no D&O insurance response for a settlement (outside of a corporate bankruptcy).

For more about the various insurance agreements for a D&O insurance policy, you can refer to this article: Side A Insurance Overview for Directors & Officers. As a reminder, as long as a company is solvent, defense costs are always indemnifiable, which is to say not covered by a Side A–only D&O insurance program.

The Potential Effects of the Multiplan Case on the D&O Insurance Market

D&O insurance carriers, along with the rest of the SPAC market, are worried that cases like MultiPlan are easier to bring because they are direct and not derivative cases. If plaintiffs decide that this is a lucrative venue for them, litigation frequency will, of course, go up. If litigation frequency increases, SPACs will be more difficult to insure, and rates for D&O insurance for SPACs, which are already quite high, will surely rise.

Some have suggested that the MultiPlan litigation has prompted many SPAC teams to consider incorporating their SPACs outside of the United States, with the Cayman Islands being the preferred jurisdiction. The theory is that plaintiffs will be less successful in attempting lawsuits against Cayman-organized SPACs. This solution may create more problems than it may solve. Setting aside complex tax structuring and other difficulties, SPACs organized in the Cayman Islands will have a harder time securing D&O insurance because many US insurance carriers will not be able to offer D&O coverage for non-US entities.

An earlier version of this article appeared in the Woodruff Sawyer SPAC and D&O Notebooks on March 8, 2022.

The directive on cross-border conversions,^[1] mergers and divisions that was adopted by the European Parliament and the Council (Directive (EU) 2019/2121) on November 27, 2019 (the “Directive”), will bring beneficial changes to the legal frameworks for European Union (EU) cross-border transactions but will also come along with lengthy and more stringent requirements compared to the status quo. 

Under current legal regimes, cross-border conversions of companies are one of the simplest ways to move business activities from one to another EU Member State or abroad and should be considered by U.S. and non-U.S. multinationals in the context of cross-border group reorganizations and restructurings.

Germany, Luxembourg, the Netherlands, Italy and France are among the Members States that implement the majority of all cross-border corporate transactions including mergers, conversions and divisions at an EU level. Germany and Luxembourg, in particular, go strong, with Germany heading the overall number of transactions and Luxembourg ranking number one in implementing conversions within and outside of the EU, outnumbering by far all other Member States.^[2]

Luxembourg is one of very few Members States that have codified provisions on cross-border conversions within and outside of the EU. Luxembourg’s long-established, widely tested and reliable practice adds legal certainty and predictability when it comes to implementing cross-border conversions or other operations. Member States with no such legal provisions may cross-border convert based on numerous court cases in which the European Court of Justice has confirmed the possibility for companies to cross-border convert between Member States on the basis of the freedom of establishment. However, the absence of codified rules, and the differing applications and interpretations of the principle of freedom of establishment on cross-border conversions throughout all Member States, leaves a level of uncertainty and unpredictability when it comes to implementation of cross-border operations which can result in a reorganization or restructuring being lengthier and costlier.

The Directive will bring significant change to the existing legal cross-border conversion framework.

Twelve questions and answers about the implementation of the Directive into national laws:

1. What are the aims of the Directive?

The Directive aims to create a common legal framework for cross-border conversions and divisions and to clarify the existing provisions on cross-border mergers within the EU.

While the laws of many Member States currently provide codified provisions for cross-border mergers of limited liability companies (e.g., the Netherlands in its Dutch Civil Code under Article 2:308 et seq., or Luxembourg in its Company Law under Article 1020-1 et seq.), those laws either completely lack or include only marginal codified provisions on cross-border conversions or cross-border divisions. Once implemented into national laws, the Directive will close this gap, enhancing legal certainty and harmonization of rules on cross-border conversions and divisions throughout the EU, in addition to strengthening the rights of shareholders, employees and creditors in EU cross-border operations.

2. Which types of companies benefit from the Directive?

The Directive has a limited scope. It covers limited liability companies, i.e., private limited liability companies such as a Luxembourg S.à r.l. (société a responsabilité limitée) or a Dutch B.V. (besloten vennootschap met beperkte aansprakelijkheid) and public limited liability companies such as a Luxembourg S.A. (société anonyme) or a Dutch N.V. (naamloze vennootschap). Those types of companies are outside of the scope of the Directive if they are subject to a liquidation, insolvency proceeding or preventive restructuring measure.^[3]

The rationale behind the Directive’s limited scope is that limited liability companies are the most widely used company forms for cross-border operations in the EU. In addition, legal provisions on limited liability companies are sufficiently harmonized throughout the EU while this is not yet the case for other company forms.^[4]

The currently applicable Luxembourg law goes beyond the Directive’s scope and permits cross-border conversions not only for limited liability companies but for all commercial companies as long as they have a legal personality, including partnerships limited by shares (SCA or société en commandite par actions) or the European company (SE or société européenne). It is to be seen how Member States will implement the Directive into national law, so its impact on the current scope of law in Luxembourg cannot be determined at this point.

3. What is the jurisdictional scope of the Directive?

The Directive covers cross-border conversions between Member States. Cross-border conversions from or to a jurisdiction outside of the EU are outside of the Directive’s scope and must be based on applicable national legislation and regimes.

Today, most Member States including Luxembourg already allow for cross-border conversions from and to countries that are not EU Member States, thereby providing easy access of foreign companies to the EU financial market, as well as exit strategies to leave it.

4. When do the new provisions kick in?

All Member States will need to implement the Directive into national law by January 31, 2023, at the latest.

As of the date of this article, to the best of our knowledge, no Member State has implemented the Directive into national law.

5. What is a cross-border conversion under the Directive?

A cross-border conversion is the conversion of the legal form of a company with legal personality in a departure Member State into another legal form in a destination Member State. The converting company does not dissolve, wind up or liquidate and retains its legal personality. It continues to own all its assets and hold all its liabilities post-conversion without interruption. All agreements that existed pre-conversion continue to exist post-conversion.

In addition to cross-border mergers, the Directive foresees cross-border divisions through the creation of one or more limited liability companies by means of (i) a split-up (i.e., a full division); (ii) a split-off (i.e., a partial division); and (iii) a transfer to a newly formed subsidiary (i.e., a division by separation). In the last case, it is the dividing company itself (rather than the shareholder(s) of the dividing company) that acquires shares in the acquiring company or companies.

6. How do the real seat theory and the incorporation theory affect a cross-border conversion?

In a cross-border conversion, a company’s registered office (or registered seat) must be transferred from the departure country to the destination country.

If the country of destination applies the “real seat theory,” the place of central administration or principal place of business must be transferred to the country of destination in addition to the registered office.

If the country of destination applies the “incorporation theory,” neither the central administration nor the principal place of establishment must be transferred to the country of destination.

7. What will the cross-border conversion procedure look like?

The cross-border conversion procedure is to a large extent a replication of the merger procedure provisions made available by the directive relating to certain aspects of company law (Directive (EU) 2017/1132) of the European Parliament and the Council of June 14, 2017.

The key steps and documents include:

• Management conversion proposal published with a notice to stakeholders.
• Management report to shareholders and employees explaining and justifying the legal and economic aspects of the conversion, and implications for future business.
• Compliance with employee information, consultation and participation rights.
• Independent expert report examining and reporting on draft conversion proposal.
• At least one month after conversion proposal publication date, holding of general meeting of shareholders approving conversion. Majority requirements (i.e., between 2/3 and 90% of voting rights and equal to or lower than the merger majority requirements).
• Pre-conversion certificate issuance certifying completion of conversion steps in departing Member State within three months. No issuance if conversion serves fraudulent, abusive or criminal purposes. Automatic transmission of certificate to destination Member State competent authority.
• Destination Member State verification by competent authority of compliance with local law incorporation and registration rules.

8. Will waivers of the requirements to prepare certain documents be available?

Waivers are an option for some requirements, including for the preparation of a management report explaining and justifying the legal and economic aspects to shareholders and employees and of an independent expert report thereon.

9. How will cross-border conversion effectiveness be determined?

The destination Member States laws determine the date of effectiveness of the conversion between and toward third parties.

10. What kind of creditor, shareholder or employee protection is available?

Creditors may apply for adequate safeguards within three months of the date of publication of the draft conversion proposal, and creditors whose claims predate the publication of the draft conversion proposal may start proceedings in the departure Member State within two years of the effective date of the conversion.

Shareholders are protected by two means from becoming a shareholder in a foreign company resulting from a cross-border conversion (or a cross-border merger or division as regards the company ceasing to exist). One, shareholders can disapprove the cross-border conversion, and two, if they disapprove, shareholders have a right to exit the company by selling their shares and to receive cash compensation.

Employees will have advisory, retention and participation rights among others.

11. What are the advantages of the current applicable regime for cross-border conversions to and from Luxembourg?

Outbound cross-border conversions from Luxembourg to a Member State or non-EU Member State currently benefit from a short implementation period with minimal documentation required. Another key benefit of the current regime is that cross-border conversions are within the control of the shareholder(s) involved.

They key documents required from a Luxembourg legal perspective are shareholder approval resolutions to cross-border convert, to be taken in form of a notarial deed. Depending on the destination jurisdiction, supplementary documentation may be required, such as a legal opinion confirming permissibility of cross-border conversions with legal continuity of the personality and compliance with all applicable formalities.

The Luxembourg steps can usually be completed within one to two weeks. No waiting periods must be observed, and, apart from a Luxembourg notary public, no other competent authorities are involved in the process that could cause delay or make the completion of the Luxembourg steps more burdensome.

The steps to be taken in the destination country vary, but they usually also require the execution of shareholder(s) resolutions approving the cross-border conversion and can also typically be completed rather swiftly.

Inbound cross-border conversions from an EU or non-EU Member State to Luxembourg can be implemented within the same time frame and with the same requirements as outbound cross-border conversions, with the exception that the Luxembourg notary almost always requires a legal opinion confirming the laws of the departing jurisdiction permit cross-border conversion to the EU, as well as documentation confirming that the equity of the company to be converted is sufficient for Luxembourg legal purposes.

The steps to be taken in the departing country may vary but usually require the execution of shareholder(s) resolutions.

12. What are the pros and cons of the Directive?

On the one hand, the Directive enhances legal certainty by creating harmonized rules throughout the EU and stakeholder protection rights for employees, creditors and shareholders of limited liability companies, including a shareholder exit right in case of disapproval of a cross-border conversion. Other benefits of the Directive are that it provides for modernized rules throughout, and promotes legal mobility of companies within, the EU.

On the other hand, once implemented into national laws, cross-border conversions will, at an EU level, be more complex and time-consuming and less predictable, due to a significant increase in required documentation, the involvement of additional parties such as independent experts, and additional stakeholder rights that need to be factored in. Moreover, the process will be lengthier, with less planning predictability regarding the completion date, because of the inclusion of a one-month waiting period, and the involvement of public authorities for pre-conversion requirement verifications will be stricter than the currently applicable regime.

Disclaimer:

This article has been prepared for general informational purposes only and is not intended to be relied upon as accounting, legal, tax, or other professional advice. Please refer to your advisors for specific advice.

1. Depending on the jurisdictions involved, terminology varies throughout the EU Member States, and other commonly used references for cross-border conversions in the EU are “re-domiciliations” or “migrations.” ↑

2. “Cross-border Corporate Mobility in the EU: Empirical Findings 2020 (Edition 1),” Maastricht University, Marcus Meyer and Thomas Biermeyer, pg. 11. ↑

3. Luxembourg company law permits companies subject to insolvency proceedings or in liquidation to carry out a cross-border merger or division, unless the allocation of their assets among their shareholders has already been initiated. No express provisions exist for cross-border conversions. ↑

4. Explanatory Memorandum of Proposal for Directive (EU) 2019/2121, p.5. Directive (EU) 2017/1132, for example, provides a harmonized procedure at EU level for limited liability companies. ↑