Class 16 Bankruptcy, Spring, 2009 Priorities in Distribution

Class 16 Bankruptcy, Spring, 2009 Priorities in Distribution
12/5/2018 Class 16 Bankruptcy, Spring, Priorities in Distribution Randal C. Picker Leffmann Professor of Commercial Law The Law School The University of Chicago Copyright © Randal C. Picker. All Rights Reserved.

12/5/2018 725 Disposition of certain property After the commencement of a case under this chapter, but before final distribution of property of the estate under section 726 of this title, the trustee, after notice and a hearing, shall dispose of any property in which an entity other than the estate has an interest, such as a lien, and that has not been disposed of under another section of this title. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 726 Distribution of property of the estate (a) Except as provided in section 510 of this title, property of the estate shall be distributed - (1) first, in payment of claims of the kind specified in, and in the order specified in, section 507 of this title, proof of which is timely filed under section 501 of this title or tardily filed on or before the earlier of— (A) the date that is 10 days after the mailing to creditors of the summary of the trustee’s final report; or (B) the date on which the trustee commences final distribution under this section; December 5, 2018 Copyright © Randal C. Picker

12/5/2018 726 (cont.) Distribution of property of the estate (cont.) (a)(2) second, in payment of any allowed unsecured claim, other than a claim of a kind specified in paragraph (1), (3), or (4) of this subsection, proof of which is - (A) timely filed under section 501(a) of this title; (B) timely filed under section 501(b) or 501(c) of this title; or (C) tardily filed under section 501(a) of this title, if - (i) the creditor that holds such claim did not have notice or actual knowledge of the case in time for timely filing of a proof of such claim under section 501(a) of this title; and (ii) proof of such claim is filed in time to permit payment of such claim; December 5, 2018 Copyright © Randal C. Picker

12/5/2018 726 (cont.) Distribution of property of the estate (cont.) (a)(3) third, in payment of any allowed unsecured claim proof of which is tardily filed under section 501(a) of this title, other than a claim of the kind specified in paragraph (2)(C) of this subsection; December 5, 2018 Copyright © Randal C. Picker

12/5/2018 726 (cont.) Distribution of property of the estate (cont.) (a)(4) fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim; December 5, 2018 Copyright © Randal C. Picker

12/5/2018 726 (cont.) Distribution of property of the estate (cont.) (a) (cont.) (5) fifth, in payment of interest at the legal rate from the date of the filing of the petition, on any claim paid under paragraph (1), (2), (3), or (4) of this subsection; and (6) sixth, to the debtor. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 726 (cont.) Distribution of property of the estate (cont.) (b) Payment on claims of a kind specified in paragraph (1), (2), (3), (4), (5), (6), (7), or (8) of section 507(a) of this title, or in paragraph (2), (3), (4), or (5) of subsection (a) of this section, shall be made pro rata among claims of the kind specified in each such particular paragraph, except that in a case that has been converted to this chapter under section 1009, 1112, 1208, or 1307 of this title, a claim allowed under section 503(b) of this title incurred under this chapter after such conversion has priority over a claim allowed under section 503(b) of this title incurred under any other chapter of this title or under this chapter before such conversion and over any expenses of a custodian superseded under section 543 of this title. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 507 Priorities (a) The following expenses and claims have priority in the following order: (1) [domestic support obligations] [had been seventh priority] (2) Second, administrative expenses allowed under section 503(b) of this title, and any fees and charges assessed against the estate under chapter 123 of title 28. (3) Third, unsecured claims allowed under section 502(f) of this title. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 507 (cont.) Priorities (cont.) (a)(4) Fourth, allowed unsecured claims, but only to the extent of $10,950 for each individual or corporation, as the case may be, earned within 180 days before the date of the filing of the petition or the date of the cessation of the debtor’s business, whichever occurs first, for— (A) wages, salaries, or commissions, including vacation, severance, and sick leave pay earned by an individual; or (B) sales commissions […]; December 5, 2018 Copyright © Randal C. Picker

12/5/2018 507 (cont.) Priorities (cont.) (a)(5) Fifth, [certain capped and dated] allowed unsecured claims for contributions to an employee benefit plan *** December 5, 2018 Copyright © Randal C. Picker

12/5/2018 507 (cont.) Priorities (cont.) (a)(7) Seventh, allowed unsecured claims of individuals, to the extent of $2,425 for each such individual, arising from the deposit, before the commencement of the case, of money in connection with the purchase, lease, or rental of property, or the purchase of services, for the personal, family, or household use of such individuals, that were not delivered or provided. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 507 (cont.) Priorities (cont.) (b) If the trustee, under section 362, 363, or 364 of this title, provides adequate protection of the interest of a holder of a claim secured by a lien on property of the debtor and if, notwithstanding such protection, such creditor has a claim allowable under subsection (a)(2) of this section arising from the stay of action against such property under section 362 of this title, from the use, sale, or lease of such property under section 363 of this title, or from the granting of a lien under section 364(d) of this title, then such creditor’s claim under such subsection shall have priority over every other claim allowable under such subsection. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 507 (cont.) Priorities (cont.) (d) An entity that is subrogated to the rights of a holder of a claim of a kind specified in subsection (a)(1), (a)(4), (a)(5), (a)(6), (a)(7), (a)(8), or (a)(9) of this section is not subrogated to the right of the holder of such claim to priority under such subsection. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Doing Distribution Hypo Assets consist of $10,000 in equipment $10,000 in inventory $18,950 in cash Debts consist of $15,000 owed to Bank with security interest in equipment December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Doing Distribution USC owed $55,950 Trade creditors owed $30,000 Headhoncho owed $15,950 Ten employees, each owed $1000 How should we distribute the assets? December 5, 2018 Copyright © Randal C. Picker

12/5/2018 One by One The Equipment and the Secured Creditor Sell the equipment under 363 for $10,000 This gives secured creditor secured claim of $10,000 and unsecured claim of $5,000 Give $10,000 to secured creditor under 725 December 5, 2018 Copyright © Randal C. Picker

12/5/2018 One by One Sell inventory for $10,000, giving debtor $28,950 in cash Employees Distribute $1,000 each to ten employees under 507(a)(4) Distribute $10,950 to Headhoncho under 507(a)(4) Leaves debtor with $8,000 in cash December 5, 2018 Copyright © Randal C. Picker

12/5/2018 One by One Remaining USC Creditors Trade owed $30,000 Bank owed $5,000 Headhoncho owed $5,000 Under 726(b), do pro rata distribution 40,000 in debts, 8,000 in assets December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Clark Core Facts Sept 80: Associates and Clark enter into standard secured revolving lending deal Lock box collections Percentage advances based on value of receivables/inventory December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Clark Feb 82: Financial Distress Associates reduces lending percentages pursuant to the contract Vendors initiate foreclosure proceedings on assets May 82: Clark files under C11 Aug 82: Case converts to C7 December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Clark June 87 (!): B Ct finds Associates received preference and that claims should be equitably subordinated under 510(c) Appeal Clark wins in district court Clark wins in court of appeals Oops! Fifth Circuit panel retracts opinion December 5, 2018 Copyright © Randal C. Picker

12/5/2018 510 Subordination (a) A subordination agreement is enforceable in a case under this title to the same extent that such agreement is enforceable under applicable nonbankruptcy law. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 510 (cont.) Subordination (cont.) (b) For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 510 (cont.) Subordination (cont.) (c) Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may - (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim or all or part of an allowed interest to all or part of another allowed interest; or (2) order that any lien securing such a subordinated claim be transferred to the estate. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Legislative History Key Statement It is intended that the term “principles of equitable subordination” follow existing case law and leave to the courts development of this principle. To date, under existing law, a claim is generally subordinated only if the holder of such claim is guilty of inequitable conduct, or the claim itself is of a status susceptible to subordination, e.g., a penalty or a claim for damages arising from the purchase or sale of a security of the debtor. The fact that such a claim may be secured is of no consequence to the issue of subordination. However it is inconceivable that the status of a claim as a secured claim could ever be grounds for justifying equitable subordination December 5, 2018 Copyright © Randal C. Picker

Three Prong Test for Equitable Subordination
12/5/2018 Three Prong Test for Equitable Subordination One, Two, Three (1) the claimant must have engaged in some type of inequitable conduct; (2) the misconduct must have resulted in injury to the creditors of the bankrupt or conferred an unfair advantage on the claimant; and (3) equitable subordination of the claim must not be inconsistent with the provisions of the Bankruptcy Code. December 5, 2018 Copyright © Randal C. Picker

What Counts as Inequitable Conduct?
12/5/2018 What Counts as Inequitable Conduct? Three Examples (1) fraud, illegality or breach of fiduciary duties; (2) undercapitalization; (3) a claimant’s use of the debtor as a mere instrumentality or alter ego. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Sliding Slice To Quote “If he [the comptroller of Clark] had had the availability [of funds to pay a vendor or other trade creditor] that particular day, I would have said, ‘Are you sure you've got that much availability, Jim,’ because he shouldn’t have that much. The way I had structured it, he wouldn't have any money to pay his suppliers.” December 5, 2018 Copyright © Randal C. Picker

Understanding this Behavior
12/5/2018 Understanding this Behavior This is OK because … Clark agreed to it in the contract upfront and the contract was negotiated at arms’ length? Other creditors can protect their own interests? The behavior is independently socially useful? December 5, 2018 Copyright © Randal C. Picker

Substantive Consolidation: Simple Situations
12/5/2018 Substantive Consolidation: Simple Situations Balance Sheets D1 D2 $100 $50 U1: $150 U2: $150 U3: $100 U4: $100 December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Owens Corning Core Facts Banks make cross-guaranteed loans to Owens and subs Banks did not rely on credit of any single entity Competing creditors have claims against the parent and not the subs December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Auto-Train Test Three Factors The proponent must show a substantial identity between the entities to be consolidated; The proponent must show that consolidation is necessary to avoid some harm or to realize some benefit; and December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Auto-Train Test If a creditor objects and demonstrates that it relied on the separate credit of one of the entities and that it will be prejudiced by the consolidation, then the court may order consolidation only if it determines that the demonstrated benefits of consolidation “heavily” outweigh the harm December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Augie/Restivio Test Two Alternatives The creditors dealt with the entities as a single unit and did not rely on their separate identity in extending credit, or The affairs of the debtor are so entangled that consolidation will benefit all creditors because untangling is either impossible or so costly as to consume the assets. December 5, 2018 Copyright © Randal C. Picker

12/5/2018 Owens Corning Third Circuit’s Test The upshot is this. In our Court what must be proven (absent consent) concerning the entities for whom substantive consolidation is sought is that (i) prepetition they disregarded separateness so significantly their creditors relied on the breakdown of entity borders and treated them as one legal entity, or (ii) postpetition their assets and liabilities are so scrambled that separating them is prohibitive and hurts all creditors. December 5, 2018 Copyright © Randal C. Picker

Class 16 Bankruptcy, Spring, 2009 Priorities in Distribution

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