The Essential Resource for Today’s Busy Insolvency Professional
Lien on Me
By Adam D. Wolper and Ross J. Switkes
Chapter 7 Monopoly: To Pass Go,
Trustee Must Pay “Meaningful”
Toll to Unsecured Creditors
E
Adam D. Wolper
Trenk, DiPasquale,
Della Fera & Sodono,
PC; West Orange, N.J.
Ross J. Switkes
Trenk, DiPasquale,
Della Fera & Sodono,
PC; Trenton, N.J.
Adam Wolper is a
partner with Trenk,
DiPasquale, Della
Fera & Sodono, PC
in West Orange, N.J.
Ross Switkes is an
associate in the firm’s
Trenton, N.J., office.
very day, chapter 7 trustees and secured creditors enter into carve-out agreements in connection with the sale of encumbered estate
property. In a typical carve-out, the secured creditor
allows a portion of the sale proceeds of its collateral
to go to the estate and be administered in the order
of priority that has been set forth in the Bankruptcy
Code. In some situations, trustees will attempt to
draw water from an otherwise dry well (i.e., they
will enter into carve-outs in connection with the sale
of fully encumbered assets). While some courts tend
to disfavor proceeding in such a manner, it is fair to
say that the practice has become common. It would
be difficult to find a chapter 7 trustee who has not
entered into such an agreement, and the supporting rationale is simple: It is the secured creditors’
money, and they can do what they want with it.
However, a recent decision by the Ninth Circuit
Bankruptcy Appellate Panel (BAP) serves as a
reminder that not all courts will approve a carveout agreement simply because the secured creditor
consents. In In re KVN Corp.,1 the court made it
clear that in reviewing a carve-out agreement for
fully encumbered estate property, a “rebuttable presumption of impropriety”2 arises. In order to rebut
the presumption, the parties must satisfy a number
of factors, the most important of which being that
the sale is likely to result in a “meaningful distribution” to unsecured creditors.3
If the KVN court’s analysis is broadly adopted, it has the potential to materially affect not just
carve-out agreements, but various other decisions
made pursuant to a trustee’s business judgment. The
upshot is that trustees (and their professionals) must
1 514 B.R. 1 (B.A.P. 9th Cir. 2014).
2 Id. at 7.
3 Id. at 8.
carefully scrutinize their decisions before a bankruptcy court does. In the meantime, practitioners
will continue to grapple with the sometimes-elusive
definition of “meaningful distribution.”
Background
In KVN, the trustee sought to sell assets of the
debtor’s estate that had an approximate sale value
of $10,000. The assets were fully encumbered by a
$310,000 lien in the favor of Wilshire State Bank,
and general unsecured claims against the debtor’s
estate totaled $108,000. In a stipulation, the bank
agreed to a carve-out for the estate of 50 percent of
the sale proceeds that remained after the payment
to the auctioneer, with the bank paying all storage
costs (the “stipulation”).
The trustee proceeded to file a motion to approve
the stipulation, probably expecting very little in the
way of court scrutiny of an arrangement involving such paltry sums. However, that expectation
was dashed when the bankruptcy court denied the
motion and held that “sharing arrangements” such
as the one between the bank and the trustee were
“dangerous” because they could lead to “improper
activity.”4 When compared to the court’s concerns
for “the proper role of the trustee and the bankruptcy
system,” the potential benefits to the estate from the
stipulation were insufficient.5 Stated differently, the
court held that the trustee did not rebut the presumption of impropriety that attaches to sales of property
that would be fully encumbered but for a carve-out.
Holding her ground, the trustee moved for
reconsideration, arguing that nothing in the Code
prevented the stipulation, there was no suggestion
4 Id. at 4.
5 Id.
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of impropriety between her and the bank, and § 506‌(c) of
the Bankruptcy Code authorized administrative expenses to
be paid from the sale of secured assets even if there was no
benefit to unsecured creditors.6 The bankruptcy court denied
the reconsideration motion in a stern opinion, stressing the
general presumption of impropriety afforded to “side deals”
with secured creditors, and again noting that the trustee completely failed to give the court the evidence that it needed to
find that the presumption had been overcome.7
BAP’s Opinion
On appeal, the trustee argued that the text of §§ 704‌(a)‌(1),
506‌(c) and 363‌(f)‌(2) of the Bankruptcy Code compelled a
finding that the bankruptcy court erred by applying the presumption of impropriety. As set forth in greater detail below,
the bankruptcy court rejected the trustee’s argument.
The BAP began its analysis by noting the “universally
recognized” rule — borne out by both case law and the U.S.
Trustee’s Handbook for Chapter 7 Trustees — that sales of
fully encumbered assets are generally prohibited. In such
instances, “the trustee’s proper function is to abandon the
property, not administer it, because the sale would yield no
benefit to unsecured creditors.”8
However, the court recognized that neither the Code,
case law nor Handbook per se ban the sale of a fully-encumbered property pursuant to a carve-out agreement.9 Rather,
the BAP made it clear that a presumption of impropriety
does attach, but it might be rebutted if the trustee can show
that the answer to the following three questions is “yes”:
(1) “Has the trustee fulfilled his or her basic duties; (2) [i]‌s
there a benefit to the estate — i.e., prospects for a meaningful distribution to unsecured creditors; and (3) [h]‌ave the
terms of the carve-out agreement been fully disclosed to the
bankruptcy court”?10
In applying the three factors, the BAP found that the first
and third questions were clearly met, but that the bankruptcy court never considered the second question. “[W]‌hether
$5,000 from the lien proceeds will result in a meaningful
distribution to the unsecured creditors is a question of fact
that is, on this sparse record, susceptible to diverse inferences
resulting in different conclusions ... we find it necessary to
remand for factual findings on this issue.”11 It is this issue
that continues to be an amorphous concept for practitioners
and the courts to grapple with.
Observations
KVN serves as a reminder to trustees and their professionals of the analysis that must be undertaken not only in
sales subject to carve-out agreements, but to all transactions
involving estate property. Indeed, in the short time since its
publication, KVN has been applied against the trustee in two
written opinions, addressing reasonable compensation and
approval of a settlement, respectively.12 In both opinions, the
courts looked to whether a meaningful distribution to unsecured creditors occurred.
For each decision made on behalf of the estate, practitioners must carefully examine the basis for the transactions
entered into, and anticipate a court’s analysis when it is considering whether to authorize such decisions of a trustee.
The goal should be to scrutinize the decisions before the
court does. To that end, a trustee should not only consider
the commission earned on a sale of estate property in relation to an anticipated distribution to unsecured creditors, but
he/she should also take into account all expenses incurred
by the estate such as professional fees — even tax liabilities — associated with a sale because professional fees are
an unsecured priority claim. As a result, a trustee might draw
scrutiny from a court if their commission and professional
fees are a large percentage of the unsecured creditor body. A
distribution to unsecured priority and general claims that is
less than a trustee’s fees might not be considered meaningful. As such, trustees must take into account all expenses
incurred by an estate in a transaction and compare them to
the anticipated distribution to creditors.
If the KVN trend continues, its analysis and rationale will
go beyond the context of the sale of fully encumbered assets
to reach other business decisions of a trustee. KVN and the
cases that follow do not provide a bright-line rule as to what
amounts to a meaningful distribution to unsecured creditors, and it appears to be an analysis that must be done on a
case-by-case basis. Typically, the trustee’s business judgment
would be the basis for many of his/her decisions, and what
KVN teaches is that sometimes that is not enough. Trustees
and their professionals must be prepared to articulate in detail
how they accomplished their duties, fully disclose all aspects
of a pending deal, and provide justification for the transaction for which court approval is sought. This will not only
assist a trustee in overcoming a presumption of impropriety
when selling fully encumbered assets pursuant to a carve-out
agreement, but helps drive the trustee’s analysis as he/she is
structuring potential deals. By scrutinizing their decisions
before the court does, trustees can maximize the chances of
court approval. abi
Reprinted with permission from the ABI Journal, Vol. XXXIV,
No. 1, January 2015.
The American Bankruptcy Institute is a multi-disciplinary, nonpartisan organization devoted to bankruptcy issues. ABI has
more than 12,000 members, representing all facets of the insolvency field. For more information, visit abi.org.
6
7
8
9
In re KVN Corp., No. 13-10477, 2013 WL 2991141 (Bankr. N.D. Cal. June 17, 2013).
Id.
KVN, 514 B.R. at 5.
In fact, the Handbook states that a trustee may sell such assets if it will result in a meaningful distribution to creditors.
10KVN, 514 B.R. at 8.
11Id.
12In re Scoggins, No. 12-42158, 2014 WL 4425905 (Bankr. E.D. Cal. Sept. 8, 2014); In re Galloway,
No. 13-1085, 2014 WL 4212621 (B.A.P. 9th Cir. Aug. 27, 2014).
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