Benchnotes Apr 2002

Benchnotes Apr 2002

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In In re Autostyle Plastics Inc., 269 F.3d 726 (6th Cir. 2001), insiders had acquired a participation interest in the lead lender's credit facility. A subordinate creditor challenged the right of the insiders to share the first priority status, asserting four legal theories. Initially the subordinate lender claimed that the participation agreement itself was invalid. The court noted that a participation agreement is not a loan, but rather a contractual obligation between a lender and a third party where the third party—the participant—provides funds to the lender. As such, the parties to the participation agreement may choose whatever terms they wish, and the agreement will generally be enforced as to its terms. Relying on In re Coronet Co., 142 B.R. 78 (Bankr. S.D.N.Y. 1992), the court held that there is a four-part definition of a "true" participation agreement: (1) the money is advanced by a participant to a lead lender; (2) the participant's right to repayment only arises when the lead lender is paid; (3) only the lead lender can seek legal recourse against the borrower; and (4) the document is evidence of the parties' true intentions. After finding that the participation agreement in question met this definition and was legal and enforceable, the court then rejected the argument that the participants were required to file notices pursuant to §9-402 of the UCC, noting that the UCC does not require participants to obtain separate security agreements or to file separate financing statements, nor does it require the lead lenders financing statement to identify participants. The court then addressed the argument that pursuant to §510(c), the insiders alleged that inequitable conduct required equitable subordination. The court addressed the traditional three-prong argument found in Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977): (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. The court noted that satisfaction of the three-part standard does not mean that a court is "required" to equitably subordinate, but rather the court is permitted to take such action. There were three arguments represented in support of the alleged inequitable conduct: (1) that the participations were actually disguised as bridge loans, which the court rejected as "baseless;" (2) that there was lack of notice to the junior lender, which also failed because the junior lender was clearly aware of the senior lenders and had to challenge the senior lender's loan; and (3) that the debtor was under-capitalized. Noting that the fact that the debtor was undercapitalized would not "by itself" be enough to allow the party to prevail on a claim of equitable subordination, the court found that there was no evidence of any activity beyond initial undercapitalization that would support a claim for subordination. Thus, absent such additional evidence, the challenge must also fail. Finally, the subordinate lender argued that the alleged debt should be recharacterized as equity. The court examined the factors set forth in Roth Steel Tube Co. v. Comm'r. of Internal Revenue, 800 F.2d 625 (6th Cir. 1986): (1) the names given to the instruments, if any, evidencing the indebtedness; (2) the presence or absence of a fixed maturity date and schedule of payments; (3) the presence or absence of a fixed rate of interest and interest payments; (4) the source of repayments; (5) the adequacy or inadequacy of capitalization; (6) the identity of interest between the creditor and stockholder; (7) the security for the advances; (8) the corporation's ability to obtain outside financing; (9) the extent to which advances were subordinated to claims of outside creditors; (10) the extent to which advances were used to acquire capital assets; and (11) the presence or absence of a sinking fund to provide repayments. The court found that the lender was unsuccessful in establishing these factors sufficient to result in recharacterization of the debt. As a result, the insiders were allowed to assert a secured claim under the participation agreement senior to that of the subordinate lender.

Surcharge Claims for Administrative Claimants

In In re Suntastic USA Inc., 269 B.R. 846 (Bankr. D. Ariz. 2001), Bankruptcy Judge Charles G. Case II addressed circumstances under which a chapter 7 trustee could be arguably compelled to pursue surcharge claims on behalf of specific administrative claimants. Relying on In re JKJ Chevrolet Inc., 26 F.3d 481 (4th Cir. 1994), the court noted that the trustee owes a fiduciary duty to the creditors of the estate. Judge Case concluded that the test of whether a trustee may refuse to pursue a §506(c) claim after request by administrative claimant is whether doing so may conceivably benefit the estate, without regard to whether the action will benefit the requesting claimant. Examples of such circumstances could include situations where a payment of a legitimate surcharge claim from the secured creditor's collateral would increase the pool of unencumbered assets remaining to pay other administrative or perhaps even unsecured creditors that do not have a legitimate basis on which to seek a surcharge. In such event, the net result would be an increase in the pro rata distribution available to other creditors—clearly a benefit to the estate. However, under these facts, there were no unencumbered funds, and the only basis for payment of the administrative claimants is whether they can individually establish entitlement to a surcharge. Whether they do or do not has no impact on the estate as a whole or on other creditors. Thus, the court held that it is not part of the trustee's mandatory exercise of a fiduciary obligation to take action, the end result of which can only benefit an individual creditor or claimant.

Right of Recoupment Not "Claim"

In In re Abco Industries Inc., 270 B.R. 58 (Bankr. N.D. Tex. 2001), Bankruptcy Judge Robert C. McGuire addressed and distinguished setoff vs. recoupment in the context where the claimant had actually filed a proof of claim, which was eventually disallowed. Although the defensive use of setoff (or recoupment) is not necessarily precluded by the failure to file a proof of claim, the court held that setoff is not to be permitted if the claim that is sought to be used as a setoff is actually disallowed. However, as the equitable right of recoupment is not addressed in the Code or subject to the restrictions found in §553 relating to setoff, "it is not a right specifically part of a claims allowance or disallowance process." Thus, the court held that a right to assert recoupment was not lost when a claim is disallowed and is not precluded from being raised as a defense. In addition, the court noted that the right of recoupment is not a "claim" in bankruptcy because it does not give rise to a right to actual payment, it merely reduces a debt and thus is a defense and not a renewed claim.


Journal Date: 
Monday, April 1, 2002