Judge Christopher M. Klein's decision to accept the City of Stockton's petition for bankruptcy on April 1, 2013 set the stage for a battle over whether public workers' pensions can be reduced through municipal reorganization.

Stockton's public revenues tumbled dramatically when the recession hit, leaving Stockton unable to meet its day-to-day obligations. Stockton slashed its police and fire departments, eliminated many city services, cut public employee benefits and suspended payments on municipal bonds it had used to finance various projects and close projected budget gaps. Stockton continues to pay its obligations to California Public Employees' Retirement System ("CalPERS") for its public workers' pensions. Pension obligations are particularly high because during the years prior to the recession, city workers could "spike" their pensions—by augmenting their final year of compensation with unlimited accrued vacation and sick leave—in order to receive pension payments that grossly exceeded their annual salaries.

Stockton will have the opportunity to present a plan of adjustment, which must be approved through the confirmation process. No plan of adjustment can be confirmed over rejection by a particular class of creditors unless the plan (1) does not discriminate unfairly, and (2) is fair and equitable with respect to each class of claims that is impaired under or has not accepted a plan. Judge Klein said that if Stockton "makes inappropriate compromises, the day of reckoning will be the day of plan confirmation."

Stockton's plan of adjustment will likely propose periods of debt service relief and interest-only payments for some municipal bonds, followed by amortization. Stockton intends to actually impair other municipal bonds, potentially paying only cents on the dollar. However, Stockton does not intend to reduce its pension obligations to CalPERS under the plan. Provisions of the California Constitution and state statutes prohibit the reduction of public workers' pensions, even in bankruptcy proceedings. These California state law provisions were thought to make public pensions virtually untouchable. Yet, the plan may not be confirmable if it impairs Stockton's obligations to bondholders but not its obligations to CalPERS. Bondholders and insurers will surely vote against and object to the plan, claiming it unfairly discriminates against them, and Judge Klein will have to decide whether the treatment constitutes unfair discrimination. The unfair discrimination claim may have merit, because an overarching goal of federal bankruptcy law is to equitably allocate losses among competing creditors. Federal bankruptcy law often trumps state laws, but there is no precedent for how federal bankruptcy law applies to California's pension provisions.

For now, cash-strapped municipalities around the country—and their creditors—are watching to see just how Stockton will restructure its obligations.

On April 30, 2013, the United States Court of Appeals for the Ninth Circuit held that the bankruptcy court has authority to recharacterize as equity, rather than debt, advances of funds made purportedly as a loan to the recipient prior to its bankruptcy. In re Fitness Holdings International, Inc., --- F.3d ----, 2013 WL 1800000 (9th Cir. 2013). The Ninth Circuit, in reversing the district court, held that the fact that the same result of recharacterization can be obtained through the statutory remedy of equitable subordination under section 510 of the Bankruptcy Code does not deprive the bankruptcy court of the authority to employ the separate and distinct remedy of recharacterization.

With respect to the first issue, the Court concluded that a transfer is made for a “reasonably equivalent value” if it is made in repayment of a claim that the Court concluded to be a “right to payment” determined under state law.

Regarding the second issue, the Court held that “a court may recharacterize an obligation that does not constitute ‘debt’ under state law.” In so holding, the Court disagreed with the decision of the Ninth Circuit BAP in In re Pacific Express, Inc., 69 B.R. 112, 115 (B.A.P. 9th Cir.1986)), which held that bankruptcy courts were limited to the statutory remedy of equitable subordination under 11 U.S.C. § 510. The Court found the BAP’s conclusion to be incorrect because “recharacterization and equitable subordination address distinct concerns.”

In holding courts have the authority to recharacterize claims, the Ninth Circuit joins other circuits, including the Fifth Circuit that reached a similar conclusion in In re Lothian Oil, 650 F.3d 539, 542-43 (5th Cir. 2011). The Ninth Circuit also approved of the Fifth Circuit’s approach to recharacterization. According to the Ninth Circuit, Lothian Oil’s multi-factor approach based on state law for distinguishing between debt and equity, rather than a federal test based on the court’s equitable power under 11 U.S.C. § 105, is the approach more consistent with the Supreme Court precedent.

Fitness Holdings lends significant strength to a claim of recharacterization in the Ninth Circuit, which was previously perceived to be difficult to maintain. It is now possible to make a claim for recharacterization separate from and in addition to a claim for equitable subordination under section 510 of the Bankruptcy Code. In contrast to equitable subordination, recharacterization does not usually require a finding of inequitable conduct. As such, the lack of inequitable conduct by parties extending credit to a potentially troubled company can no longer insulate their claims from being relegated to a lower priority in the company’s potential bankruptcy case. In addition, such parties should be vigilant in ensuring that the terms of such credit are properly documented in compliance with the applicable state law requirements for creating a “right to payment.”

Alan H. Martin, Practice Group Leader
714.424.2831 (office) 
amartin@sheppardmullin.com

Ed H. Tillinghast, Practice Group Leader  
212.634.3050 (office) 
etillinghast@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

Conventional wisdom says that it is nearly impossible to obtain a discharge of student loan debt in bankruptcy. Indeed, Section 523(a)(8) expressly excepts student loans from discharge, unless the exception of such indebtedness from discharge would impose an undue hardship upon the debtor. But two recent developments may signal that this bedrock principle is eroding – i.e., (i) the Seventh Circuit's affirmance of a bankruptcy court's ruling that an impoverished but otherwise healthy woman's student loan debts were dischargeable, and (ii) the recent introduction of a Congressional bill that would make it easier to discharge privately issued student loan debt.

In Krieger v. Educ. Credit Mgmt. Corp., 2013 U.S. App. LEXIS 7202 (7th Cir. Apr. 10, 2013), the court of appeals examined the facts and circumstances related to a $25,000 student loan obligation owed by Ms. Krieger, a 53-year-old woman, and concluded that the bankruptcy court did not err when it determined that Krieger qualified for a hardship discharge of her student loan.

In arriving at its conclusion, the court of appeals explained that Ms. Krieger "is essentially out of the money economy and living a rural, subsistence life[,]" and her circumstances were unlikely to change at any point in the future.

While the majority opinion did not explicitly state that its decision should be of limited applicability because of Ms. Krieger's unusually dire straits, a concurring opinion did exactly that, suggesting that she should have instead been required to participate in the William D. Ford Income-Based Repayment Plan. Under such plan, a debtor is required to pay 15% of his or her discretionary income every month, with the debt being discharged after 25 years.

House Bill Proposes Different Treatment for Private Student Loans

A House bill introduced on February 6, 2013 proposes to amend the Bankruptcy Code to treat private student loan debt the same as any other debt, meaning it would be dischargeable in bankruptcy without the debtor having to prove undue hardship. The bill, H.R. 532, would not affect federal direct loans. Although this bill has previously failed four times, the recent increased focus on student loan debt may give it a better chance of being enacted this time around.

Conclusion

While it has traditionally been exceedingly difficult for a debtor to obtain a discharge of his or her student loan debts, the above developments could portend major shifts in the way bankruptcy courts treat student loan debt in the future. According to a report by the Consumer Financial Protection Bureau, there is approximately $1 trillion in student loan debt in the United States, $150 billion of which has been privately funded, thereby suggesting that this possible shift in the treatment of student loans may have tremendous significance for the lending community. Accordingly, we urge lenders to stay abreast of these developments and begin to factor how these developments might affect their future lending practices and existing student loan portfolios.

Alan H. Martin, Practice Group Leader
714.424.2831 (office) 
amartin@sheppardmullin.com

Ed H. Tillinghast, Practice Group Leader  
212.634.3050 (office) 
etillinghast@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

In an unpublished decision in In re The Village at Lakeridge, LLC, BAP Nos. NV-12-1456 and NV-12-1474 (B.A.P. 9th Cir. Apr. 5, 2013), the United States Bankruptcy Appellate Panel of the Ninth Circuit held that a vote on a plan of reorganization submitted by a non-insider claimant is not to be disregarded under Bankruptcy Code section 1129(a)(10) merely because the claimant purchased the claim from an insider. In other words, the transferee of a claim does not step into the shoes of the transferor vis à vis the transferor’s status as an insider.

The secured creditor in the case filed a motion seeking to designate Rabkin’s claim under Bankruptcy Code section 1126(e) and to disallow his claim for purposes of voting on the proposed plan. The bankruptcy court granted the motion in part, holding that because the debtor’s sole member was a statutory insider, Rabkin acquired the same status when he purchased the claim. Thus, the bankruptcy court held that Rabkin’s vote on the plan could not be considered for voting purposes, leaving the debtor without the assenting class of impaired claims it needed to confirm its plan.

The Bankruptcy Appellate Panel reversed, finding that the bankruptcy court applied an erroneous legal rule. Citing to the general rule that “insider determination . . . is made on a case-by-case basis, after the consideration of various factors,” the Panel noted that it was undisputed that Rabkin was not himself a statutory insider. The Panel analyzed and distinguished the case law cited by the bankruptcy court in support of its decision, which included two cases where an insider that purchased the claim of a non-insider had its vote on a plan excluded due to the purchaser’s insider status. The Panel reasoned that if the bankruptcy court’s ruling was upheld and the vote of a non-insider like Rabkin were disregarded because the transferor was an insider in whose shoes Rabkin now stood, it would follow logically that the vote of an insider that purchased a claim would not be disregarded if the transferor were a non-insider. The Panel stated that such a result could not obtain, as “both before and after the assignment, the insider is still an insider.”

While unpublished and non-precedential, the reasoning of the Lakeridge case may be cited as persuasive in some jurisdictions depending on the local rules. With that in mind, the Panel’s decision in Lakeridge emphasizes that plan proponents and opponents alike need to consider the status of the parties who actually held the impaired claims when the ballots were submitted, rather than the status of the parties who held such claims at the outset of the case, when determining whether a proposed plan has obtained or may obtain the votes necessary for acceptance. This consideration is especially important for a party such as a secured creditor that is considering purchasing claims in order to block or secure the vote of an impaired class. Furthermore, from the point of view of a debtor acting as a plan proponent, the Panel’s decision suggests that a debtor’s insiders may be able to manufacture a consenting impaired class by merely selling off their unsecured claims against the debtor at a discounted price to unrelated third parties who view them as an investment opportunity, which is exactly what occurred in Lakeridge.

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

Round one of the fight between the City of Stockton, California and its creditors is finally over. On April 1, 2013, Bankruptcy Judge Christopher M. Klein held that Stockton satisfied the eligibility requirements for a Chapter 9 debtor.

Back on June 28, 2012, Stockton filed a petition seeking to adjust its debts under Chapter 9 of the United States Bankruptcy Code.

In reply, Stockton argued that it had satisfied all of the requirements for bankruptcy protection and that the conclusions of the bond insurers’ experts were based upon flawed assumptions and sloppy methodology. Stockton further argued that its staffing, compensation and benefits reductions demonstrated its good faith, as did the agreements it reached with its unions, and that any further cutbacks or reductions would have jeopardized Stockton’s ability to provide needed services to its citizens.

CalPERS, touted as Stockton’s largest creditor, filed a brief in support of Stockton’s petition explaining that Stockton is in good standing and current on its payments to the system. According to CalPERS, “there is no debt to CalPERS that will be adjusted in the City’s plan.”

At the April 1, 2013 hearing, Judge Klein held that Stockton satisfied the eligibility requirements under Bankruptcy Code Section 109 because it: (i) is a municipality within the meaning of § 109(c); (ii) is authorized under California law to be a debtor; (iii) was insolvent at the time of the filing of its petition because it was unable to pay debts as they became due; (iv) is desirous of effecting a plan to adjust its debts, as demonstrated by its “Ask” at the court-ordered mediations; and (v) negotiated in good faith with its creditors in satisfaction of § 109(c)(5)(B), as demonstrated by the substantial agreements reached on the collective bargaining agreements.

The ruling makes Stockton the largest U.S. city to seek bankruptcy protection. Nonetheless, Judge Klein’s decision will not end the fight between Stockton and its bond insurers, as round two invariably will involve a major battle over the terms of Stockton’s forthcoming plan of adjustment. Stay tuned…

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

In a recent Fifth Circuit decision, Western Real Estate Equities, LLC v. Village at Camp Bowie I, L.P., No. 12-10271 (5th Cir. 2013), the court held that the acceptance vote from a minimally and “artificially impaired” class of claims meets the 11 U.S.C. § 1129(a)(10) requirement for the confirmation of a non-consensual “cramdown” chapter 11 plan.

In objecting to the plan, Western argued that the plan did not receive the vote “of at least one class of claims that is impaired under the plan” required under § 1129(a)(10). This was, Western argued, because the Unsecured Creditors’ claims were “artificially impaired” and thus an inadequately impaired class to meet the voting requirement of an impaired class. Western argued that Debtor minimally and “artificially impaired” Unsecured Creditors’ claims by delaying payment for three months instead of paying them in full at plan confirmation, which Debtor had sufficient cash flow to do. In the alternative, Western argued that such “artificial impairment” violated the good faith requirement of § 1129(a)(3).

The bankruptcy court rejected Western’s objections and confirmed the plan, which the Fifth Circuit affirmed on appeal. While reviewing for “clear error,” the Fifth Circuit held “that § 1129(a)(10) does not distinguish between discretionary and economically driven impairment.” The court explained that this was because the plain meaning of impairment under § 1124 contains no “motive inquiry” or “materiality requirement.” The court reasoned that impairment is not required to be driven by economic motives and can be discretionary, which was the case here. Further, the court found that the three month delay in full payment to Unsecured Creditors without interest sufficiently impaired their claims because the Bankruptcy Code does not recognize a distinction between de minimis and material impairments.

Moreover, the court held that artificial impairment does not constitute bad faith as a matter of law. Rather, the court stated that a debtor’s artificial impairment would be one factor in the totality of circumstances analysis for a finding of good faith. Because Debtor “proposed a feasible cramdown plan for the legitimate purpose of reorganizing its debts, continuing its real estate venture, and preserving its non-trivial equity in its properties,” the court held that the good faith requirement was met.

While the impact of Camp Bowie upon the restructuring community remains to be seen, there exist two clear takeways. First, debtors have greater leeway when designing an impaired class of creditors for the purpose of a cramdown plan of reorganization, which is particularly helpful in the context of single asset real estate cases. Second, secured lenders and distressed real estate investors can no longer rely upon the expectation that a de minimis impairment of claims is enough to block a cramdown plan of reorganization, but must employ more robust planning strategies to protect against a cramdown plan.

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

In a recent decision, In re Castleton Plaza, LP, 2013 WL 537269 *1 (Feb. 14, 2013), the Seventh Circuit held that the absolute priority rule – which requires that creditors be paid in full before equity holders receive anything on account of their equity interests under a plan of reorganization – applies equally to the “insiders” of a debtor. In so holding, the Seventh Circuit is accused of extending the scope of the absolute priority rule to the point that it threatens the ability of debtors to reorganize. However, the Court’s holding merely requires that any non-consensual reorganization plan that leaves creditors unpaid and proposes to distribute equity to insiders be subject to competition, as mandated by the U.S. Supreme Court in Bank of American National Trust & Savings Ass’n v. 203 North LaSalle St. P’ship, 526 U.S. 434 (1999). This competition requirement preserves the Bankruptcy Code’s priority scheme to ensure that creditors are paid before equity holders, and protects creditors from creative efforts by equity holders to funnel value to insiders in the face of creditor dissent.

In this case, Castleton Plaza, whose sole asset was a shopping center in Indiana, filed for bankruptcy protection after defaulting on a $10.2 million secured loan. Its proposed plan of reorganization (the “Plan”) reduced the secured claim to $8.2 million (the value ascribed to the shopping center by the Bankruptcy Court), with the rest treated as an unsecured claim (to be paid 15 cents on the dollar). The Plan cancelled all equity interests, including those of Mr. George Broadbent, who held 98% of the pre-petition equity, but transferred the equity in the reorganized entity to Mr. Broadbent’s wife in exchange for a “new value” contribution of $75,000 (later increased to $375,000). EL-SNPR Notes Holdings, LLC, the secured creditor, objected to the Plan and, believing the assets had been undervalued, offered to purchase the equity for $600,000. No other creditor objected. The debtor rejected the offer, and the Bankruptcy Court confirmed the Plan over the secured creditor’s objection, finding that the debtor was not required to subject Mrs. Broadbent’s new value acquisition of the equity in the reorganized company to competitive bidding.

On direct appeal, the Seventh Circuit reversed the Bankruptcy Court, holding that the debtor could not avoid the requirements of the absolute priority rule and the associated restrictions upon new value plans by arranging for the new value to be contributed by, and the equity in the reorganized company to go to, an “insider” of the debtor. The Court reasoned that the competition requirement of LaSalle was meant to “curtail evasion of the absolute-priority rule” and that a plan that granted equity to an investor’s spouse could violate the absolute priority rule to the same extent as a plan that granted the equity to the original investor. Mr. Broadbent would receive value under the Plan by virtue of the opportunity offered exclusively to his wife to purchase the equity in the reorganized debtor, and, consequently, the Plan had to be subjected to competitive bidding.

On March 7, 2013, the debtor filed a motion seeking rehearing of the Seventh Circuit’s decision en banc. Essentially, the debtor argues that the Court has improperly expanded the absolute priority rule to apply to insiders, and has misconstrued the LaSalle market test to make competitive bidding the only means of evaluating new value. The debtor also takes issue with the Court’s finding that creditors can bid the value of their loans during such bidding. Instead, in order to address concerns about an insider paying a fair price for the equity, the debtor suggests that a bankruptcy court be required to either evaluate the transfer with stricter scrutiny (like the Bankruptcy Court did here) or terminate the debtor’s exclusivity to permit competing plans to be filed.

The Seventh Circuit’s decision addresses the dangers of permitting a debtor’s insiders to obtain new equity without competition and emphasizes that regardless of who contributes new value to a plan of reorganization, such a plan must be subject to competition. In addition, the decision suggests that terminating a debtor’s exclusivity is insufficient competition -- Castleton Plaza had permitted exclusivity to terminate, yet the Court found that the Plan had not been tested and remanded the case to the Bankruptcy Court for competitive bidding. In doing so, the Seventh Circuit makes a strong statement to creditors that their priority in payment will be protected.

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

In a recent decision from the California Court of Appeals entitled Jolley v. Chase Home Finance, LLC, the Court severely curtailed lenders’ ability to dispose of lender liability claims on summary judgment, thereby adopting a marked departure from existing law. In so doing, the Court admonished lenders that the “world [has been] dramatically rocked in the past few years by lending practices colored by short-sighted self-interest.”

Jolley should be a familiar story: (1) Jolley obtained a construction loan, (2) he then defaulted, (3) he then requested a loan modification, (4) Chase decided not to modify the loan and instead pursued foreclosure, and (5) on the eve of foreclosure, Jolley filed a lawsuit alleging that Chase was guilty of, among other things, fraud, breach of contract and negligence. Chase filed a successful motion for summary judgment at the trial court level.

The Court of Appeals reversed, holding that Chase’s statements to Jolley that the requested modification was “highly probable”, “likely” and “look[ed] good” were not just opinion and could be fraudulent. The Court further held that such statements could be sufficient to bind Chase to enter into a modification. These holdings precluded the grant of summary judgment for Chase on the borrower’s fraud and breach of contract claims.

The Court of Appeals then reversed an entire body of case law that favored Chase on Jolley’s negligence claim. The Court held that the determination of whether a lender can be liable for negligence is a question of fact. As a consequence, lenders may no longer be able to dispose of a disgruntled borrower’s negligence claims at the summary judgment level.

Even more troublesome was the fact that the Court relied on legislation primarily directed to consumer loans, some of which will not go into effect until 2018, as a potential basis for a finding of negligence in the commercial loan context. That legislation will, among other things, require lenders to provide defaulted borrowers with a “single point of contact” for all matters related to the loan, and prevents lenders under certain circumstances from “dual-tracking” (i.e., simultaneously pursuing foreclosure while negotiating a modification).

Jolley is cause for much concern in the lending community. Chase has already filed a request for rehearing, and may appeal the decision to the California Supreme Court if the request is denied.

Thus, while the final chapter in this litigation has yet to be written, we encourage lenders to consider adopting the following practices to mitigate its impact:

• First, although pre-dispute jury trial waivers are ineffective in California, lenders and borrowers can enter into “judicial reference” agreements at any time that may require a borrower to litigate in front of a retired judge or attorney rather than a jury.
• Second, if a potential modification is to be discussed, the lender should insist that the borrower first execute a pre-negotiation agreement, in which the borrower acknowledges, among other things, that there is no modification unless and until all necessary approvals have been obtained and all loan modification documents have been duly executed.
• Finally, once a borrower defaults, lenders need to be extremely careful about their communications with the borrower. Phone calls and meetings should be summarized in confirmatory letters or e-mails, and all contemplated written communications from the lender should be vetted by counsel before delivery to the borrower.

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

The bankruptcy of the largest U.S. city to file a chapter 9 bankruptcy petition has yielded a decision with serious implications for municipal creditors. Specifically, the United States Bankruptcy Court for the Eastern District of California overruled the objections asserted by retired employees of the City of Stockton, California and authorized the City to suspend the retiree’s health benefits during the City’s Chapter 9 case. Ass’n of Retired Employees of the City of Stockton, et al. v. City of Stockton, California (In re City of Stockton), 56 Bankr.Ct.Dec. 250 (Bankr. E.D. Cal.). Bankrutcy Judge Klein acknowledged the potential hardship to the retirees, but citing Section 904 of the Bankruptcy Code stated that the court has no power to interfere with the property or revenues of the debtor during Chapter 9.]]>

The retirees contended that retirement benefits are vested contract rights, protected from impairment by the Contracts Clause of the U.S. Constitution, which precludes a state from impairing contract obligations. However, the Bankruptcy Court held that the Contracts Clause does not protect contract obligations from federal interference. The Court explained that, although the suspension of benefits may have been a state action, the protection of the bankruptcy process amounts to federal action, thereby trumping the Contracts Clause.

The Court went on to describe the constraints of Sections 903 & 904 of the Bankruptcy Code, which restrict federal courts from interfering with the political or governmental powers of a municipal debtor, the property or revenues of the debtor, or the debtor’s use or enjoyment of income producing property, regardless of whether the debtor’s action is fair.

In reaching this decision, the Court distinguished the temporary restraining order issued in the Orange County bankruptcy, Orange Cnty. Emps. Ass’n v. Cnty. Of Orange (In re Cnty. Of Orange), 179 B.R. 177, 185 (Bankr. C.D. Cal. 1995), on the grounds that the TRO issued therein concerned the employment status of the County’s employees, rather than the County’s property or revenues.

The Court similarly rejected the retiree’s argument that Bankruptcy Code Section 1114, which requires a Chapter 11 debtor to pay insurance benefits to retired employees during the case, mandates continuation of the retiree’s health insurance benefits, explaining that such Code provision does not apply to a Chapter 9 debtor.

This decision gives Chapter 9 debtors a great deal of flexibility to modify the rights of contractual counterparties, making Chapter 9 potentially even more unfavorable to creditors than the more well-traveled chapters of the bankruptcy code. Though municipal debt has traditionally been stable, the creditor-hostile nature of Chapter 9 should give potential creditors pause. If municipal bankruptcies continue to become more commonplace, creditors of various stripes -- including institutional lenders, contractors, individual bond-holders, and workers negotiating compensation and pensions -- would be wise to reevaluate their investment strategies so as to account for the greater risk of payment default or non-consensual credit modification.
 

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

On March 4, 2013, ‘SA’ NYU WA, Inc., a tribally-chartered corporation wholly owned by the Hualapai Indian Tribe, filed a Chapter 11 bankruptcy petition in the United States Bankruptcy Court, District of Arizona. This is a very important case for tribes and any party conducting business with tribes because the petition will raise a question of first impression for the Bankruptcy Court. The Bankruptcy Court will have to decide whether a tribal corporation is eligible to be a debtor under the Bankruptcy Code.]]> In re Platinum Oil Properties, LLC, 465 B.R. 621 (Bankr. D.N.M. 2011) reconsideration denied, 11-09-10832 JA, 2011 WL 6293132 (Bankr. D.N.M. Dec. 12, 2011); Russell v. Ft. McDowell Yavapai Nation, 293 B.R. 34 (Bankr. D. Ariz. 2003); Davis Chevrolet Inc. v. Navajo Nation, 282 B.R. 674 (Bankr. D. Ariz. 2002); Turning Stone Casino v. Vianese, 195 B.R. 572 (Bankr. N.D.N.Y. 1995); Gilbert v. Shape, 25 B.R. 356 (Bankr. D. Mont. 1982); In re Sandmar Corp., 12 B.R. 910 (Bankr. N.M. 1981). Additionally, last year the United States Bankruptcy Court, Southern District of California dismissed a Chapter 11 petition filed by the Santa Ysabel Resort and Casino, a gaming enterprise of the Iipay Nation of Santa Ysabel, a federally recognized Indian tribe. The dismissal order of the Court simply granted the creditors’ motions to dismiss the petition.

However, in this case, the debtor alleges that it is a chartered tribal corporation, separate from the Hualapai Indian Tribe which owns it. The Bankruptcy Code allows a “corporation” to file for bankruptcy protection. The United States Bankruptcy Court, District of Arizona will have to decide whether a corporation organized under tribal law is a “corporation” for purposes of the Bankruptcy Code. In the non-bankruptcy context, the Seventh Circuit, in a case interpreting the federal Indian Gaming Regulatory Act and the federal diversity statute, 28 U.S.C. § 1332, held in Wells Fargo v. Lake of the Torches, 658 F.3d 684 (7th Cir. 2011), that a tribal corporation was a “corporation” and a citizen of the state of Wisconsin for purposes of determining federal diversity jurisdiction.

Outside of the bankruptcy context, federal and tribal law applicable to Indian tribes extends to a tribe’s wholly-owned instrumentalities and entities; however, whether the relief and remedies typically available with respect to non-tribal corporate debtors under the Bankruptcy Code is available to tribal corporate debtors, likely will be addressed by the Arizona bankruptcy court. For example, just as in the case of a tribe, land used or beneficially owned by a tribal corporation may actually be owned by the United States in trust for the tribe and therefore cannot be subject to sale or alienation in a bankruptcy case. Similarly, federal approvals may need to be obtained with respect to use or disposition of assets owned by a tribal corporation. If a tribal corporation is engaged in Indian gaming operations, which the debtor in the present case is not engaged in, federal law restricts the ownership of such gaming operations to the tribe on whose lands the tribal casino is located and requires third party managers to obtain federal approval.

The petition has the potential to make new law in other respects. For example, if a tribal corporation is found to be eligible as a debtor under the Bankruptcy Code, can creditors in future cases force tribal corporations into involuntary bankruptcy, despite the potential sovereign immunity of tribal corporations? If a tribal corporation is eligible as a debtor, can creditors “pierce” the corporate veil of the tribal corporation and reach assets of the shareholder tribe, or will the Bankruptcy Court follow non-recourse provisions that may be found in the tribal corporation’s organic documents or in its business contracts? Outside the context of bankruptcy, courts considering whether suits against a tribal corporate entity may also proceed against the parent tribe have declined to apply veil-piercing principles. See, e.g., Morgan Buildings & Spas, Inc. v. Iowa Tribe of Oklahoma d/b/a BKJ Solutions et al., Case No. CIV-09-730-M, 2011 WL 308889, *1 (Jan. 26, 2011 W.D. Okla.).

Given recent tribal defaults and restructurings, the outcome of this case will no doubt be watched by tribes and lenders to tribes.

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office) 
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office) 
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

The California Supreme Court recently held that a borrower may rely upon oral promises to support a fraud claim against its lender even when such oral promises contradict the written agreement.

In Riverisland Cold Storage, Inc. v. Fresno-Madera Production Credit Association, 55 Cal. 4th 1169 (2013), borrowers, after falling behind on their loan payments, restructured their debt. In the fully integrated written agreement, the borrowers agreed to a modified payment schedule and pledged eight properties as additional collateral. In exchange, the lender agreed to delay enforcement action for three months.]]>

The trial court granted summary judgment for the lender, relying on Bank of America v. Pendergrass, 4 Cal. 2d 258, 263 (1935) (“Pendergrass”) to exclude evidence of the oral representations. The Court of Appeal reversed, finding an exception to the Pendergrass rule.

The California Supreme Court affirmed, but rather than fitting the case within an exception to the Pendergrass rule, overruled Pendergrass all-together and reaffirmed the statutory exception to the parol evidence rule allowing oral evidence “to establish… fraud.” Cal. Civil Code § 1625.

The parol evidence rule generally excludes evidence of prior and contemporaneous oral statements that contradict the clear and unambiguous terms of an integrated written agreement. Such oral statements are thus inadmissible to support an interpretation of a contract that differs with its plain meaning. Nonetheless, the Court held that the parol evidence rule does not preclude evidence of oral statements used to establish a fraudulent inducement claim.

As a consequence, the risk analysis for lenders has changed – cases will be more difficult to win on demurrer or at summary judgment. A borrower alleging that a contract is unenforceable as a result of fraud may now present oral statements that contradict the plain terms of the contract.

Although the implications of Riverisland remain to be seen, there are several practices that may mitigate its impact upon lenders:

Obtain a Pre-Negotiation Agreement. At the outset of workout discussions, all parties should execute a pre-negotiation agreement that sets forth the ground rules for negotiations, including: (i) no rights are waived or obligations incurred until a written agreement is executed and delivered by all parties, (ii) all negotiations and communications (whether written or verbal) are privileged and constitute settlement negotiations for evidentiary purposes, and (iii) only written agreements shall bind the parties.

Give Ample Time to Review Documents. Parties should be given ample time to review all amended loan documents.

Highlight the Integration Clause and Have Signatories Initial Their Understanding of the Provision. Lenders can highlight the integration clause by drafting the integration clause in ALL CAPS or in larger font. Further emphasis can be placed on the integration clause by requiring all signatories to initial their understanding directly under the integration language.

These practices may mitigate the risk that the borrower will be able to avoid its obligations under a written loan agreement by claiming that the lender made false representations that differ from the terms of the written agreement.

If you have any questions, would like to further discuss this matter, or any other finance and bankruptcy matters facing your organization, please contact any one of the following Sheppard Mullin attorneys below:

Geraldine A. Freeman, Practice Group Leader  
415.774.2966 (office)
gfreeman@sheppardmullin.com

Alan H. Martin, Practice Group Leader 
714.424.2831 (office)
amartin@sheppardmullin.com

Todd L. Padnos, Editor 
415.774.2938 (office) 
tpadnos@sheppardmullin.com

On June 28, 2012, Stockton, California became the most recent municipality to file for bankruptcy under chapter 9, after having concluded a mandatory mediation process with its creditors. See, In re City of Stockton, California, Case No. 12-32118 (Bankr. E.D. Cal.). Many parties affected by a potential filing by other similarly situated California public entities are seeking to understand the process that precedes a Chapter 9 filing and how to plan for a possible filing. This summary provides an overview of the protocol before a California entity may file for Chapter 9 protection.]]>

The Code’s “specifically authorized to be a Chapter 9 debtor” requirement refers to state law eligibility rules. In California, a new law requires that distressed municipalities seeking bankruptcy protection must undergo a 60-day mediation with creditors before they may file a Chapter 9 petition—though either the municipality or a majority of creditors may extend the mediation for an additional 30 days. Municipalities must participate in the mediations unless they are facing a fiscal emergency. The City of Stockton, for example, engaged in the required mediation process for 90 days without success. This law was adopted with the hope that pre-filing mediations would ease the length, cost and consequences of a municipality’s bankruptcy on all interested parties. Together, the state and federal eligibility criteria shape the process through which a municipality files for bankruptcy in California.

The impact of the 60-day mediation requirement is largely felt by those municipalities which are not yet insolvent but which are fiscally distressed. Such municipalities must enter into the mediation under California law and negotiate in good faith under federal law. Because the municipality must spend at least 60-90 days in mediation, it cannot threaten to pull out of the mediations during that time frame, absent the fiscal emergency referenced above. Moreover, because of the federal good faith requirement, it is unlikely that the municipality could simply initiate the mediation process and then take no action; neither could it initiate the mediation process but thereafter engage in conduct which tended to thwart the purposes of the mediation.

The 60-day mediation requirement may obviously create certain hardships for municipalities and their residents. Some municipalities may need to drastically cut services to residents in order to maintain solvency during the mediation process. The City of Stockton, for instance, is reportedly operating its police force at approximately 60% of suggested staffing levels. To address residents’ safety concerns, the City has adopted a “Marshall Plan” to reduce crime and increase public safety, despite the reduced police force. Other distressed municipalities may likewise seek to turn to strategic alternatives to alleviate the effect of service cuts.

While the municipality may find that it initially has less leverage since it has no immediate recourse to bankruptcy, its leverage will likely increase – and creditors’ leverage will likely decrease – as the mediation period winds down. If the municipality ends up in bankruptcy, under the Code it has the exclusive right to propose a plan of adjustment. Neither creditors nor the court may control the daily affairs of a municipality directly, and may not do so indirectly by proposing a plan of adjustment of the municipality's debts that would govern the municipality's future taxes and expenditures. 

Contacts: 

Alan Martin, Partner
D: 714.513.2831
AMartin@sheppardmullin.com

Alan Feld, Partner
D: 213.617.4133
AFeld@sheppardmullin.com

David Garcia, Partner
D: 310.228.3747
DGarcia@sheppardmullin.com

Kyle Mathews, Partner
D: 213.617.4236
KMathews@sheppardmullin.com

Geraldine Ann Freeman, Partner
D: 415.774.2966
GFreeman@sheppardmullin.com

Malani Cademartori, Partner
D: 212.634.3085
MCademartori@sheppardmullin.com

Martin Smith, Partner
D: 213.617.5490
MSmith@sheppardmullin.com

Robert Philibosian, Of Counsel
D: 213.617.5420
RPhilibosian@sheppardmullin.com

Ron Holland, Partner
D: 415.774.3177
RHolland@sheppardmullin.com

Todd Padnos, Partner
D:415.774.2938
TPadnos@sheppardmullin.com

Matthew Holbrook, Associate 
D: 714.424.8225 
MHolbrook@sheppardmullin.com

On May 29, 2012, the Supreme Court ruled 8-0 that a debtor could not confirm a plan over a secured creditor’s objection if the plan provided for the sale of the secured creditor’s collateral free and clear of liens, but did not provide the secured creditor with the option of credit-bidding at the sale. RadLAX Gateway Hotel, LLC v. Amalgamated Bank, No. 11-166, 2012 U.S. LEXIS 3944 (U.S. May 29, 2012). Such a plan, the Supreme Court held, does not meet the statutory requirements for “fair and equitable” treatment of an objecting secured class in 11 U.S.C. § 1129(b)(2)(A).

In RadLAX, the chapter 11 debtors proposed a plan that would dissolve the debtors and sell substantially all of their assets pursuant to a “Sale and Bid Procedures Motion.” The contemplated bid procedures were based on a stalking horse bid of $47.5 million, later increased to $55 million. The sale proceeds would fund the chapter 11 plan, primarily repaying the secured creditor, who was owed over $120 million. Importantly, the proposed bid procedures would not permit the secured creditor to credit-bid at the auction, and instead required the secured creditor to bid cash.

The bankruptcy court denied the debtors’ Sale and Bid Procedures Motion on the grounds that it was not fair and equitable to the secured creditor. The bankruptcy court certified the issue for direct appeal to the Seventh Circuit Court of Appeals, which affirmed. See, River Road Hotel Partners, LLC v. Amalgamated Bank, 651 F.3d 642 (7th Cir. 2011). The Supreme Court granted certiorari, likely to resolve a circuit split. The Third Circuit Court of Appeals, in In re Philadelphia Newspapers, LLC, 599 F.3d 298 (3d Cir. 2010), had previously held that the “indubitable equivalent” option in 11 U.S.C. § 1129(b)(2)(A)(iii) allowed a debtor to confirm a cramdown plan based on a free and clear sale without providing the secured creditor with the right to credit-bid.

Justice Scalia authored the opinion of the Court, which is an exercise in statutory interpretation. The Court examined the three options for fair and equitable treatment of an objecting secured creditor set forth in clauses (i), (ii) and (iii) of section 1129(b)(2)(A). The Court noted that clause (ii) specifically deals with free and clear sales, and through the express incorporation of Bankruptcy Code section 363(k), requires that the secured creditor be allowed to credit-bid at such sales, unless the bankruptcy court orders otherwise. The Court stated that the debtors in RadLAX were seeking to implement a plan that did precisely what clause (ii) envisioned, without complying with the requirements of that clause. The Court rejected the debtors’ argument that the bid procedures were nonetheless permissible under the “indubitable equivalent” option in clause (iii) as “hyperliteral and contrary to common sense.”

In the Court’s view, this was “an easy case” that was resolved by the general/specific canon of statutory interpretation, pursuant to which a specific statutory provision governs over a general one. The Court found that the general language of clause (iii), though broad enough on its own to encompass a free and clear sale, does not apply to a free and clear sale because that situation is specifically dealt with in clause (ii). The Court stated that this was not an absolute rule, and it could be overcome by “textual indications that point in the other direction.” The Court found no such textual indications here. The Court also refrained from getting into an argument about the purposes of the Bankruptcy Code, pre-Code practices and credit-bidding, stating that pre-Code practices would only be relevant to the extent that there were textual ambiguities, which there were not, and that “the pros and cons of credit-bidding are for the consideration of Congress, not the Courts.”

"IMPORTANT NOTICE [14-point boldface type if printed or in capital letters if typed]

IF YOUR PROPERTY IS IN FORECLOSURE BECAUSE YOU ARE BEHIND IN YOUR PAYMENTS, IT MAY BE SOLD WITHOUT ANY COURT ACTION, [14-point boldface type if printed or in capital letters if typed] and you may have the legal right to bring your account in good standing by paying all of your past due payments plus permitted costs and expenses within the time permitted by law for reinstatement of your account, which is normally five business days prior to the date set for the sale of your property. No sale date may be set until approximately 90 days from the date this notice of default may be recorded (which date of recordation appears on this notice).

This amount is __________ as of __________ (Date) and will increase until your account becomes current.

While your property is in foreclosure, you still must pay other obligations (such as insurance and taxes) required by your note and deed of trust or mortgage. If you fail to make future payments on the loan, pay taxes on the property, provide insurance on the property, or pay other obligations as required in the note and deed of trust or mortgage, the beneficiary or mortgagee may insist that you do so in order to reinstate your account in good standing. In addition, the beneficiary or mortgagee may require as a condition to reinstatement that you provide reliable written evidence that you paid all senior liens, property taxes, and hazard insurance premiums.

Upon your written request, the beneficiary or mortgagee will give you a written itemization of the entire amount you must pay. You may not have to pay the entire unpaid portion of your account, even though full payment was demanded, but you must pay all amounts in default at the time payment is made. However, you and your beneficiary or mortgagee may mutually agree in writing prior to the time the notice of sale is posted (which may not be earlier than three months after this notice of default is recorded) to, among other things, (1) provide additional time in which to cure the default by transfer of the property or otherwise; or (2) establish a schedule of payments in order to cure your default; or both (1) and (2).

Following the expiration of the time period referred to in the first paragraph of this notice, unless the obligation being foreclosed upon or a separate written agreement between you and your creditor permits a longer period, you have only the legal right to stop the sale of your property by paying the entire amount demanded by your creditor.

To find out the amount you must pay, or to arrange for payment to stop the foreclosure, or if your property is in foreclosure for any other reason, contact:

_______________________________
(Name of beneficiary or mortgagee)

_______________________________
(Mailing address)

_______________________________
(Telephone)

If you have any questions, you should contact a lawyer or the governmental agency which may have insured your loan.

Notwithstanding the fact that your property is in foreclosure, you may offer your property for sale, provided the sale is concluded prior to the conclusion of the foreclosure.

Remember, YOU MAY LOSE LEGAL RIGHTS IF YOU DO NOT TAKE PROMPT ACTION. [14-point boldface type if printed or in capital letters if typed]"

The new changes are noted in bold in the above excerpt of the statute. The phrase "approximately 90 days" replaced the phrase "three months" in the first paragraph of the prior version of the statute. The phrase "three months after this notice of default is recorded" replaced the phrase "the end of the three-month period stated above" in the fourth paragraph of the prior version of the statute. Section 2924c(b)(1) also contains other requirements for such notices, including that such notices must appear in at least 12-point boldface type unless otherwise specified in the statute.

California has many other requirements for foreclosure of a deed of trust or mortgage on real property in California. Parties to a foreclosure should seek the counsel of an experienced foreclosure attorney to ensure compliance with all applicable requirements.

Authored By:

Jenny Park Garner

(415) 774-2949
jpark@sheppardmullin.com

(b) A case under chapter 11 of title 11 in which the person that is the subject of the case is a corporation may be commenced only in the district court for the district--

 

(1) in which the principal place of business in the United States, or principal assets in the United States, of such corporation have been located for 1 year immediately preceding such commencement, or for a longer portion of such 1-year period than the principal place of business in the United States, or principal assets in the United States, of such corporation were located in any other district; or
 

(2) in which there is pending a case under chapter 11 of title 11 concerning an affiliate of such corporation, if the affiliate in such pending case directly or indirectly owns, controls, or holds with power to vote more than 50 percent of the outstanding voting securities of such corporation.[1]

 

The amendment effectively prohibits forum-shopping by requiring a debtor to file the bankruptcy case in the district where its principal place of business or principal assets are located. Proponents of the bill argue that chapter 11 debtors should not be able to leave their home districts and shop for a forum whose judicial precedent on bankruptcy law may be the most favorable to them. They further contend that when a large case is filed far away from the debtor's principle place of business, employees, creditors, and the community in which the business operates feel out of touch with the reorganization process, and interested parties frequently have to travel long distances to present evidence to support their claims.   

Conversely, opponents of the bill argue that the Delaware and New York bankruptcy courts are remarkably effective at handling complex chapter 11 filings. They also point out that approximately 90% of Chapter 11 cases are filed where the company has its principal place of business, so the vast majority are filed in the most convenient district.

This bill is currently in the House Committee on the Judiciary, which will continue to deliberate, investigate, and revise the bill prior to any general debate or vote by the House. Stay tuned to http://www.bankruptcylawblog.com/ for further updates on this pending legislation. 

Authored by:

Stephanie M. Seidl
(213) 617-4177
sseidl@sheppardmullin.com