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. 66 Canal Center Plaza, Suite 600 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abi.org 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). 66 Canal Center Plaza, Suite 600 • Alexandria, VA 22314 • (703) 739-0800 • Fax (703) 739-1060 • www.abi.org
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