he right to recover a preference is an asset of the estate that may be assigned or distributed to a particular class of creditors in order to satisfy their claims, the U.S. Court of Appeals for the Seventh Circuit recently held. Mellon Bank N.A. (as agent for 14 pre-petition senior lenders of Qualitech Steel Corp.) v. Dick Corp., 2003 WL 22861982 (7th Cir. Dec. 4, 2003). Adopting a broad definition of "benefit to the estate," Circuit Judge Easterbrook's decision in Mellon Bank N.A. sets an important precedent, providing for increased flexibility of debtors-in-possession (DIPs) and trustees in bankruptcy proceedings.

Qualitech: An Overview

Having built two plants for producing specialty steel products that were unexpectedly time-consuming and costly, Qualitech Steel Corp. and its parent company, Qualitech Steel Holdings Corp. (collectively, "Qualitech"), filed for chapter 11 relief on March 22, 1999. Official Comm. of Unsecured Creditors v. Bank Group, 2001 WL 899637 at 1 (Bankr. S.D. Ind. July 5, 2001). Most Qualitech creditors, both secured and unsecured, agreed to the sale of the Qualitech plants in light of the company's bankruptcy. In order to finance the company through the time of this sale, lenders were recruited to support Qualitech by providing DIP financing. As adequate protection for pre-petition secured creditors, the bankruptcy judge granted, to the extent of any diminution in the value of their collateral, a security interest in all the debtor's remaining assets including any preference recoveries.

The fears of pre-petition lenders were realized when the sale of the assets did not satisfy both the new DIP loans and the claims of pre-petition lenders. Faced with a penniless and defunct estate, a committee of secured lenders represented by Mellon Bank financed preference actions to collect allegedly preferential transfers on behalf of Qualitech (the then-dissolved DIP) from Dick Corp. and GE Supply Co. (collectively, "preference recipients.") The preference recipients contended that the recoveries sought that "would flow straight to the pockets of secured creditors were not 'for the benefit of the estate' as §550(a) uses the phrase," and consequently, Mellon Bank's case should be dismissed. Mellon Bank at 1. Noting policy implications, "[a] legal rule that the quick sale of a business precludes avoidance actions by eliminating any benefit to the estate would derail many beneficial sales," the court dismissed the preference recipients' contention and held that the right to recover a preference is an asset of the estate that could be assigned or distributed to a particular class of creditors in order to satisfy their entitlements, thereby constituting a benefit to the estate. Id. at 4.

In defining "benefit to the estate" the Seventh Circuit specifically rejects a definition that requires that some benefit flow directly to unsecured creditors. In addressing this allegation, the court states, "lest this way of resolving the issue be taken to assume that §550(a) requires that some benefit flow to unsecured creditors, we add that the statute does not say this. Section 550(a) speaks to 'benefit of the estate'—which in bankruptcy parlance denotes the set of all potentially interested parties—rather than to any particular class of creditors." Id. at 3. In adopting a definition of "benefit to the estate" that may be indirect and not necessarily linked to payment to unsecured creditors, the court has given DIPs and trustees additional flexibility in structuring a case to benefit interested parties other than general unsecured creditors. This significantly expands the options available to debtors-in-possession and trustees in bankruptcy.

Paving the Way for Qualitech: Redefining Benefit in 2003

While Mellon Bank sets precedent throughout the federal court system, the decision comes on the heels of a recent bankruptcy court decision published on June 12, 2003, which adopted a similarly broad definition of benefit to the estate. In In re Furrs, the U.S. Bankruptcy Court for the District of New Mexico held that a trustee's prosecution of avoidance proceedings and payment of a portion of the proceeds to lenders pursuant to the settlement agreement constituted a "benefit to the estate" as used in §550(a) of the Bankruptcy Code. In re Furrs, 294 B.R. 763, 783 (Bankr. D. N.M. 2003). Specifically, the defendants challenged the standing of the trustee on the ground that the agreement to pay part of the proceeds of the sale of assets to the lender meant that the recovery is not for the benefit of the estate as required by 11 U.S.C. §550(a). Id. at 768. The district court dismissed this contention, focusing its inquiry on what constitutes a benefit to the estate.

According to In re Furrs, "benefit to the estate" as used in §550(a) demands a broad interpretation. Benefit to the estate should be defined as any benefit accrued "when the action increases the value of the estate." Id. at 772. Specifically, the court noted that "[t]he term 'estate' is broader than the term 'creditors.'" Id. (internal citations omitted), quoting NextWave Personal Communications Inc. v. Federal Communications Commission (In re NextWave Personal Communications Inc.), 235 B.R. 305, 308 (Bankr. S.D.N.Y.), aff'd., 241 B.R. 311 (S.D.N.Y.), rev'd. on other grounds, 200 F.3d 43 (2nd Cir. 1999), quoting Trans World Airlines Inc. v. Travelers Int'l. A.G. (In re Trans World Airlines Inc.), 163 B.R. 964, 972 (Bankr. D. Del. 1994). It encompasses indirect benefit. Id. at 773. "A better working definition would be that the estate benefits which action increased the value or assets of the estate." In re Furrs at 772.

The court explained that the policy behind this broad interpretation squares plainly within the goal of the bankruptcy courts: "[T]he Code gives a trustee a variety of mechanisms to permit her to fulfil [sic] a primary goal of the bankruptcy process—namely, to pursue as equal a distribution of assets to creditors as possible by undoing pre-petition transactions that have the effect of favoring one creditor over another." In re Furrs at 775. "Given this goal, the language of the Code should be interpreted to permit a trustee to engage in litigation and transactions that generally will result in a more even distribution of the debtor's property among its creditors and specifically will allow the estate to benefit from the proceeds of these avoidances (should there be any)." Id.

Application of Benefit to the Estate: Sales of Assets under §363(f)

It is well established that the sale of assets pursuant to §363(f) of the Bankruptcy Code must provide benefit to the estate. However, many bankruptcy courts have established as their "home rule" a requirement that this benefit mandates a distribution on account of claims of pre-petition unsecured creditors. However, the broad definition of "benefit to the estate" adopted by the Seventh Circuit in Mellon Bank lends support to the argument that benefit to the estate should be broadly construed and includes benefit to interested parties other than general unsecured creditors.

Interested parties to a §363(f) sale other than unsecured creditors include all of the debtor's constituencies. Employees are an example. Federal law and many state laws provide that dislocated workers are entitled to wages for a period of time that they do not work in the event that their jobs are terminated without notice. See, e.g., Federal WARN Act, 29 U.S.C. §2102 (2003); see, also, Wis. Stat. §109.09 (2003). A sale of assets under §363(f), which contemplates the continuation of employment, provides a benefit to this class of creditors in that the continuation of their employment will provide jobs with the associated salaries and benefits. The estate is benefited to the extent that there are not claims for the violation of WARN acts when the purchaser of the debtor's assets agrees to hire substantially all of the debtor's employees. Benefits of this type appear to be contemplated by Judge Easterbrook's decision in Mellon Bank.

Conclusion: Releasing the Burden of Benefit to the Estate

In summation, Mellon Bank clarifies the definition of what constitutes a benefit to the estate as required in §550(a) of the Bankruptcy Code, thereby proposing a broader definition of the term. This definition of "benefit to the estate" may be applied in other aspects of the Bankruptcy Code, thereby providing greater flexibility to trustees and DIPs in bankruptcy proceedings. The per se rule that benefit to the estate contemplates providing a cash payment to unsecured creditors no longer appears applicable.

Footnotes

¹ Randall Crocker is a shareholder in von Briesen & Roper's Milwaukee office and chair of the firm's Banking, Bankruptcy and Business Restructuring Practice Group. The author extends his thanks to Anne Weissmueller, a law clerk with the Banking, Bankruptcy and Business Restructuring Practice Group, for her assistance in the preparation of this article. Return to article