Blog Posts
Bankruptcy
Crypto Frame Taking Shape in Real Time
In 2022, CNBC reported on the EthCC conference in Paris, a gathering for hardcore Ethereum developers and technologists. A special spinoff event was a limited invitation only rave party in the Catacombs of Paris, labyrinth of centuries-old tunnels 65 feet underground, which hold the skeletal remains of around six million Parisians.[1] Visiting the Catacombs is considered illegal, although it appears to be tolerated. The CNBC report portrayed the event as surrounded by secrecy. Multiple teams were assembled via an anonymous Telegram group and gathered across the 14th arrondissement of Paris to sneak into the underground landmark. Meanwhile, on this side of the Atlantic Ocean, the crypto world navigated a different kind of labyrinth – those of a chapter 11 reorganization in U.S. bankruptcy courts. In July 2022, two crypto players filed chapter 11 petitions in the Bankruptcy Court for the Southern District of New York– Voyager Digital, LLC, and its affiliates, and Celsius Network LLC and its affiliates. WHY IS THIS SIGNIFICANT? Voyager Digital operates a cryptocurrency brokerage that allows customers to buy, sell, trade, and store cryptocurrency on an easy-to-use and “accessible-to-all” platform. In addition to providing brokerage services, Voyager offers custodial services for customers who store cryptocurrency on Voyager’s platform. Voyager provides loans, typically in the form of a specific type of cryptocurrency, to counterparties in the cryptocurrency sector to facilitate liquidity or trade settlement. Interest earned from the Company’s loans is passed along to customers, who earn a “yield” on their stored cryptocurrency. See Declaration of Stephen Ehrlich, Chief Executive Officer of the Debtors in Support of Chapter 11 Petitions and First Day Motions, Doc. No. 15. Celsius is a cryptocurrency-based finance platform that provides financial services to institutional, corporate, and retail clients across over 100 countries. According to the filings, Celsius was created in 2017 to be one of the first cryptocurrency platforms to which users could transfer their crypto assets and (a) earn rewards on crypto assets and/or (b) take loans using those transferred crypto assets as collateral. Headquartered in Hoboken, New Jersey, Celsius has more than 1.7 million registered users and approximately 300,000 active users with account balances greater than $100. See Declaration of Alex Machinsky, Chief Executive Officer of Celsius Network LLC in Support of Chapter 11 Petitions and First Day Motions, Doc. No. 23. The bankruptcy court was flooded with letters from individuals who feel robbed by the debtors and call for return of their deposits. The treatment of crypto is not addressed in the Bankruptcy Code and the bankruptcy courts are just starting to grapple with the treatment of cryptocurrency as an asset in bankruptcy proceedings. In fact, cryptocurrency, for more than ten years, has been characterized by price volatility and uncertainty regarding its legal status. Yet, in 2021, the crypto market’s value skyrocketed from $965 billion to as much as $2.6 trillion, according to a Morningstar analysis. After many years of debating whether cryptocurrency should be considered security or commodity and which federal agency should be the primary regulator, the more important question for the retail customers is whether they could recover in kind from a crypto brokerage like Voyager or a platform like Celsius whose model resembles bank operations – take deposits and use the deposit to make loans, but without the regulatory oversight that banks experience and without FDIC protection. For customers of securities brokers, there are regulatory mechanisms that provide certain protections. Securities brokers regulated by the Securities and Exchange Commission are subject to a net capital rule—they must cease operations before their assets fall below the level that allows customer claims to be met. In addition, broker-dealers must belong to the Securities Investor Protection Corporation (SIPC), which provides an insurance scheme whereby customers of failed broker-dealers may receive up to $500,000 from the SIPC fund. For customers dealing with futures, section 4d(a)(2) of the Commodity Exchange Act (C.E.A.) provides certain protections as it requires that customer funds received by a future commission merchant to margin, guarantee, or secure a customer’s futures contracts be held in segregated accounts, and not be commingled with the funds of the future commission merchant itself, nor used to guarantee the trades or contracts of any person other than the customer. Futures commission merchants must compute daily the amount of segregated funds on hand and the amount required to be held. Any shortfall must be reported immediately to the Commodity Futures Trading Commission. 17 C.F.R. Section 1.32. None of these protections would be available in these recent filings at first glance. These crypto reorganization proceedings could potentially chart the way forward and address critical questions like – Would cryptocurrency be treated as a commodity or currency, and when could it be treated as a security? How can the cryptocurrency be used in the marketplace to generate recovery, and what’s the proper timing for valuation of crypto assets? Would withdrawals of accounts within the 90-day period before the filing be subject to avoidance actions? [1] https://www.cnbc.com/2022/07/19/ethcc-paris-crypto-developers-gather-as-turmoil-grips-industry.html For further information, please feel free to reach out to Albena Petrakov
July 29, 2022
Bankruptcy
When Does the Automatic Stay Protect Companies that are Not in a Bankruptcy Proceeding?
In June 2022, Reuters published an article titled “How a “Bankruptcy Innovation” Halted Thousands of Lawsuits from Sick Plaintiffs.” The mechanism used to halt ongoing lawsuits was the automatic stay triggered by the bankruptcy filing of an affiliate of the defendant companies. The “bankruptcy innovation” is the so-called Texas Two-Step. The Texas Two-Step is not a lottery game or a country dance, or “a controversial legal maneuver,” as Investopedia calls it, but a statutorily established corporate transaction. It allows a company to complete a divisional merger under Texas corporate law, i.e. to separate assets and liabilities of a company into two different entities by creating a new entity and then liabilities and some assets are transferred into the newly created entity. The entity is then placed into bankruptcy to invoke the automatic stay. The main asset remaining with the entity that takes on the liabilities is a funding agreement, whereby the entity keeping the assets agrees to pay certain of the liabilities of the other (typically for mass tort claims). The primary benefit of the Texas Two-Step is that it keeps an operating company outside of bankruptcy but provides to the operating company the benefits of a bankruptcy filing. The Reuters article highlights four companies that used the Texas Two-Step: Georgia-Pacific, Saint-Gobain, Trane Technologies and Johnson & Johnson. The company that is currently in the spotlight for using the Texas Two-Step is Johnson & Johnson (“J&J”), and in particular, one of J&J’s subsidiaries – Johnson & Johnson Consumer Inc. (“J&J Consumer”). Following certain pre-2015 intercompany transactions, J&J Consumer assumed responsibility for all claims alleging that J&J’s talc-containing baby powder and other products caused ovarian cancer and other diseases. In October 2021, J&J Consumer engaged in a divisional merger under the Texas corporate statute. As a result of the divisional merger, J&J Consumer ceased to exist and two new companies, LTL and Johnson & Johnson Consumer Inc (“New J&J Consumer”) were created. LTL assumed all talc-related liabilities of the old company and filed a bankruptcy petition (initially in North Carolina but the case was transferred to New Jersey in November 2021). The talc plaintiffs challenged the filing and the use of Texas Two-Step. The bankruptcy court ruled in favor of J&J/LTL and rejected the challenge. The bankruptcy court’s decision is now on appeal (review of this challenge will be included in one of our next issues). Meanwhile, LTL had asked the bankruptcy court for permission to extend the automatic stay to thousands of cosmetic talc-related claims with respect to J&J, J&J Consumer, New J&J Consumer. The automatic stay serves to protect the debtor that filed a bankruptcy petition, by stopping all collection efforts, including not only halting pending lawsuits but any acts that constitute an attempt to exercise control over assets subject to bankruptcy protection, thereby giving the debtor a respite from creditors and a chance to attempt a repayment or reorganization plan. Technically, the stay is not extended. Rather, the bankruptcy court issues an injunction having the effect of “extending” the stay to the entity not in bankruptcy. Although the scope of automatic stay is broad, its protections typically apply only to debtors in bankruptcy, not non-debtor defendants. Shortly after the commencement of the bankruptcy proceeding, the North Carolina bankruptcy court granted a temporary restraining order and enjoined the prosecution of talc claims against the non-debtors (“Initial PI Order”). After the case was transferred to New Jersey, on February 25, 2022, the New Jersey bankruptcy court issued a decision that would extend the duration of relief granted under the Initial PI Order, including the issuance of a preliminary injunction for the duration of the Chapter 11 case, subject to the court revisiting continuation of the automatic stay and the preliminary injunction on June 29, 2022, and every four months thereafter. The court found that Section 362 of the Bankruptcy Code and Section 105 provide independent bases for granting an injunctive relief to non-debtor parties. The critical factor in the Court’s analysis was the impact of the non-debtor litigation on the bankruptcy estate. The Court concluded that continued litigation against the non-debtor parties would liquidate pending tort claims, as well as indemnification claims, against LTL outside of Chapter 11 and potentially deplete available shared insurance coverage, thereby frustrating the purpose of the automatic stay. Since the claims against the debtor and the non-debtor parties involved the same products, same time periods, same alleged injuries, and same evidence, continued litigation could prejudice the debtor. For guidance on this matter, contact Albena Petrakov at apetrakov@offitkurman.com or at 212.380.4106.
June 30, 2022
Bankruptcy
Lenders Beware
WHEN IS A LENDER CROSSING THE LINE AND ENTERING LENDER LIABILITY WONDERLAND? A 2022 decision out of a bankruptcy court in Texas reminded lenders that an overly aggressive approach to a borrower can result in lender liability[1] and substantial damages. In this case, brought by a Chapter 7 trustee, the bankruptcy court concluded that the lender destroyed the debtor’s enterprise value and future as a going concern and ultimately drove the debtor out of business. The Court found that for the lender’s actions, the debtor would not have failed as a going concern and would not have had to file bankruptcy. As a result, the Court awarded $16,966,928 in damages for breach of contract and breach of the duty of good faith and fair dealing, fraudulent misrepresentation, contractual and business interference, and willful violation of the automatic stay. The lender unsuccessfully tried to argue that the debtor was dead on arrival. [1] As the bankruptcy court put it, “[l]ender liability” is a broad umbrella term often used to describe various theories through which a borrower (or its trustee in bankruptcy) seeks to impose liability (or a remedy of some sort) against a former lender in a lending relationship that has soured.” THE STORY BEHIND THE AWARD Bailey Tool & Manufacturing Company and its subsidiaries and affiliates (“Bailey”) was the debtor/borrower in this tragic story. Republic Business Credit, LLC (“Republic”) was the lender. Before filing bankruptcy, Bailey and Republic entered into a factoring arrangement and an asset-based loan facility in February 2015. Republic performed substantial diligence in late 2014 and early 2015 before entering into the agreements. During the due diligence process, Republic had identified several issues, including unpaid ad valorem taxes, stretched accounts payable, and a major customer (the Department of Defense) that paid on a milestone rather than progressive billing basis. Despite these issues, the underwriter viewed the proposed transaction as a “strong deal” and approved it. Four months after entering into the agreements, Republic refused to advance funds as expected, declared default and made payments to itself from Bailey’s lockbox under the factoring agreement to pay down the ABL (Asset Based Lending) facility. The Court found that Republic took complete and total control of Bailey’s cash. It controlled not only the collections through the lockbox and all disbursements too. All funds advanced from July 2015 forward were sent directly to vendors selected by Republic vendors and a payroll company for the payroll of employees selected by Republic. The Court held that the lender’s handling of disbursement was inconsistent with the parties’ agreements—specifically, the Factoring Agreements contemplated that Republic would “pay to Seller [Bailey] an Advance.” In September 2015, Republic stopped funding altogether. Republic also became involved in replacing management and otherwise micromanaging the Debtor. It forced the Debtor’s Chief Executive Officer to give the Republic a lien on his exempt homestead. THE DECISION In a meticulous 145-page decision, the Court analyzed the Republic’s conduct, including and highlighting numerous internal lender email communications produced in discovery and presented during the trial. The Court adopted the bankruptcy trustee’s theory of the case, i.e. that the lender: (i) refused to advance funds in good faith and in the manner promised almost immediately after the agreements were signed taking a stance that the businesses were in an “over-advanced” position, which was not a defined concept in the agreements and was problematic in light of several weeks of due diligence and awareness regarding certain slow-paying accounts and inventory status; (ii) charged fees, expenses, penalties and other items against “reserves” (contributing to the alleged “over-advanced” position), without any transparency; (iii) exercised excessive control over the businesses by controlling what vendors, employees, and expenses got paid and insisting on direct payments to them by the factoring company rather than funding to the businesses as contemplated by the underlying agreements (i.e., the argument being that this was an improper exertion of control; there were no amendments of documents or forbearance agreements to justify deviating from the underlying agreements). WHAT ACTION TO AVOID AS A LENDER This decision can now serve as a roadmap for borrowers to establish lender liability. In summary, the factors considered by the Court include: Taking over the business function and exercising business judgment – Without the requisite knowledge and experience, Republic approved payments to certain vendors and materials suppliers, reordered the sequence in which different products at Bailey were manufactured, and changed the manufacturing priorities from keeping long-term customers, to doing “quick-turn” projects; Controlling the workforce at Bailey through controlling the payroll and ordering who got paid and who did not and what types or classifications of employees could get paid; Directing vendors of Bailey to pay Republic instead of Bailey under the threat of litigation, destroying the goodwill that Bailey had built up with these vendors; Lack of transparency and misrepresentations as to why: (i) why it considered Bailey to be in default, (ii) the status of funds availability or lack thereof, (iii) application of funds collected and charging numerous fees and expenses. The conduct of the lender, in this case, appears egregious. Still, it is a reminder for lenders to closely review with counsel contractual remedies and exercise caution in implementing these remedies.
March 31, 2022
Bankruptcy
Subchapter V Corner
The $7,500,000 debt ceiling for Subchapter V filings ended in the spring of 2022. With the enactment of Subchapter V of Chapter 11 (Sub V) of the Bankruptcy Code, viable small and medium-sized businesses have a more cost-efficient restructuring mechanism. Who is eligible? – Businesses and individuals engaged in commercial or business activities with no more than $2,725,625 of noncontingent liquidated secured and unsecured debt as of the date of filing or the order for relief. The business or individual cannot have owning of single-asset real estate as its primary activity. The CARES Act, however, increased the debt ceiling to $7,500,000 until March 27, 2021, and further extended it until March 27, 2022, with the COVID-19 Bankruptcy Relief Extension Act of 2021, Democrats and Republicans are now weighing an extension of Subchapter V’s $7.5 million debt limit before it is due to sunset back to the previous amount under the Code. Without another renewal, the increased debt limit applies only to cases filed after the effective date of the CARES Act and before March 27, 2022. What is the advantage of a Subchapter V filing? There are several modifications of the traditional restructuring process that make a Subchapter V proceeding a more straightforward and cheaper path to reorganization: It allows the owner of the business to preserve their equity even when the business is not in a position to pay in full its secured and unsecured creditors (i.e., abrogates the so-called “absolute priority rule”). The creditors’ ability to block confirmation is significantly weakened because Subchapter V eliminates the traditional requirement that at least one impaired class of creditors accepts the reorganization plan. A reorganization plan will be deemed fair and equitable to objecting unsecured creditors if the debtor pays projected disposable income to be received over at least three years. A Subchapter V plan may provide for later payment of administrative expenses (i.e., payment through the plan) as opposed to payment on the effective date of the plan. Only the debtor can file a plan (i.e., eliminates the ability of creditors to propose their own restructuring plan). It eliminates US Trustee quarterly fees and other procedural and reporting burdens. For guidance on this matter, contact Albena Petrakov at apetrakov@offitkurman.com or at 212.380.4106.
March 22, 2022
