Bankruptcy Happenings

Overview

The courts keep cranking out the bankruptcy opinion involving farmers and others.  The uniqueness of the cases presents interesting issues that are important to understand – not only for those involved in the litigation, but for others that can learn the various issues that can arise in a bankruptcy matter.

In today’s post, I take a look at several bankruptcy-related issues that came up in recent cases – the payment of administrative claims; the deprioritization of taxes in a Chapter 12 bankruptcy; and the necessity of clarity when describing collateral in a security agreement and financing statements. 

A potpourri of bankruptcy-related matters – it’s the topic today’s post. 

Administrative Expense Claimant Not Entitled to Notice of Conversion. 

In re Roberts, 610 B.R. 900 (Bankr. D. N.M. 2019)

Bankruptcy lawyers wouldn’t likely assist a client through the bankruptcy process unless getting paid for their services were ensured.   But, the services of a bankruptcy attorney are essential to for the parties involved – structuring a successful reorganization of the business in a reorganization bankruptcy; ensuring proper payment to creditors in a liquidation bankruptcy; and seeing to it that the debtor’s expectations are met in difficult circumstances.

The Bankruptcy Code ensures that bankruptcy legal counsel gets paid by allowing legal fees to be paid as an administrative expense of the bankruptcy.  It’s an expense that is entitled to priority over the claims of general unsecured creditors with pre-petition claims.  See 11 U.S.C. §§503(b); 507(a)(2). 

In Roberts, the debtors had farmed for forty years before filing Chapter 11 bankruptcy. Although the debtors were farmers, they were not eligible to file Chapter 12 (farm) bankruptcy as family farmers due to excessive debt.  Unfortunately for the debtors, they filed Chapter 12 before the Congress, in August of 2019, increased the debt level for Chapter 12 filers.

Several creditors objected to the debtors’ reorganization plan, arguing that the plan had significant deficiencies. After mounting expenses and the disbarment of their lawyer for unethical conduct, the debtors were forced to retain new bankruptcy counsel and file a new plan. The creditors argued that the new plan also contained deficiencies, namely that the plan did not propose to pay unsecured creditors in full. After the change in law that increased the debt limit for Chapter 12 filers, the debtors and creditors agreed to convert the case to chapter 12. The debtors’ initial bankruptcy counsel objected, arguing that she had not been given adequate notice of the conversion as an administrative expense claimant, and it would be inequitable to convert the case because her claim might be converted to a pre-petition claim.

The bankruptcy court held that the debtors were eligible to convert their pending Chapter 11 case to Chapter 12 and that the debtors need not give administrative claimants notice of their motion to convert. The bankruptcy court determined that the debtors only needed to give notice to the trustee and all creditors when seeking to convert their case.  An administrative claimant is not a “creditor” as that term is defined in the Bankruptcy Code.  11 U.S.C. §101(10).  

Further, the bankruptcy court held that the debtors’ conversion would not cause any administrative expense claims to be treated as pre-petition claims. The prior bankruptcy counsel argued that her administrative expenses would be subordinated upon conversion of the Chapter 11 case to a Chapter 12. The bankruptcy court, however, held that while that argument was true for converting a Chapter 11 case to a Chapter 7, when a Chapter 11 case is converted to Chapter 12, the Chapter 12 plan must provide for full payment of all Chapter 11 administrative expenses. Finally, the bankruptcy court held that conversion to Chapter 12 was equitable as it gave the debtors a chance to reorganize, and it gave the creditors and administrative expense claimants the best chance of getting paid. 

Withheld Tax Not Deprioritized in Bankruptcy 

In In re DeVries, No. 20-6011, 2020 Bankr. LEXIS 3323 (B.A.P. 8th Cir. Nov. 25, 2020), rev’g., No. 19-0018, 2020 U.S. Bankr. LEXIS 1154 (Bankr. N.D. Iowa Apr. 28, 2020)

The debtors filed Chapter 12 and sold a significant amount of farmland and farming machinery in 2017, triggering almost $1 million of capital gain income and increasing their 2017 tax liability significantly. The tax liability was offset to a degree by income tax withholding from the wife’s off-farm job. Their amended Chapter 12 plan called for a refund to the estate of withheld federal and state income taxes.

In the fall of 2019, the debtors submitted pro forma state and federal tax returns as well as their traditional tax returns for 2017 to the bankruptcy court in conjunction with the confirmation of their amended Chapter 12 plan. The pro-forma returns showed what the debtors’ tax liability would have been without the sale of the farmland and farm equipment. The pro-forma returns also showed, but for the capital gain, the debtors would have been entitled to a full tax refund of the taxes already withheld from the wife’s off-farm job. The amended plan required the IRS and the Iowa Department of Revenue (IDOR) to refund to the debtors’ bankruptcy estate withheld income taxes. The taxing authorities objected, claiming that the withheld amounts had already been applied against the debtor’s tax debt as 11 U.S.C. §553(a) allowed. The debtors claimed that 2017 legislation barred tax debt arising from the sale of assets used in farming from being offset against previously collected tax. Instead, the debtors argued, the withheld taxes should be returned to the bankruptcy estate. If withheld taxes weren’t returned to the bankruptcy estate, the debtors argued, similarly situated debtors would be treated differently.

The bankruptcy court was faced with the issue of whether 11 U.S.C. §1232(a) entitled the bankruptcy estate to a refund of the withheld tax. The IRS and IDOR claimed that 11 U.S.C. §553(a) preserved priority position for tax debt that arose before the bankruptcy petition was filed. The court disagreed, noting that 11 U.S.C. §1232(a) deals specifically with how governmental claims involving pre-petition tax debt are to be treated – as unsecured, non-priority obligations. But the court noted that 11 U.S.C. §1232(a) does not specifically address “clawing-back” previously withheld tax. It merely referred to “qualifying tax debt” and said it was to be treated as unsecured and not entitled to priority.

Referencing the legislative history behind both the 2005 and 2017 amendments, the bankruptcy court noted that the purpose of the priority-stripping provision was to help farmers have a better chance at reorganization by de-prioritizing taxes, including capital gain taxes. The court pointed to statements that Sen. Charles Grassley made to that effect. The bankruptcy court also noted that the 2017 amendment was for the purpose of strengthening (and clarifying) the original 2005 de-prioritization provision by overturning the result in Hall v. United States, 566 U.S. 506 (2012) to allow for de-prioritization of taxes arising from both pre and post-petitions sales of assets used in farming. Accordingly, the court concluded that 11 U.S.C. §1232(a) overrode a creditor’s set-off rights under 11 U.S.C. §553(a) in the context of Chapter 12. The debtors’ bankruptcy estate was entitled to a refund of the withheld income taxes.

On appeal, the bankruptcy appellate panel for the Eighth Circuit reversed. The appellate panel determined that 11 U.S.C. §1232(a) is a priority-stripping provision and not a tax provision and only addresses the priority of a claim and does not establish any right to or amount of a refund. As such, nothing in the statue authorized a debtor’s Chapter 12 plan to require a taxing authority to disgorge, refund or turn-over pre-petition withholdings for the benefit of the bankruptcy estate. The statutory term “claim,” The court reasoned, cannot be read to include withheld tax as of the petition date. Accordingly, the statute was clear and legislative history purporting to support the debtor’s position was rejected. 

Adequate Protection Denied Due to Unperfected Security Interest

In re Blackjewel L.L.C.,No. 3:19-bk-30289, 2020 Bankr. LEXIS 3413 (Bankr. S.D. W. Va. Dec. 7, 2020)

In this case, the debtor was a coal company that voluntarily filed for Chapter 11. The debtor operated 32 properties and held more than 500 mining permits around the country. At the time it filed bankruptcy, the debtor owed six million dollars to its 1,700 workers in Wyoming and Central Appalachia, $32 million to an international investment firm, and over $17 million in ad valorem taxes (the country version of severance taxes that contribute to local services and state education).  In total, at the time of filing, the debtor owed approximately $245 million to various creditors and had $138,000 in a bank account. 

The debtor and creditor entered into a loan and security agreement in connection with a note and other financial accommodations. The creditor filed a financing statement, indicating collateral that included debtor accounts, receivables and inventory. After amending the original loan and security agreement, the creditor filed a new financing statement that no longer referred to the debtor accounts, receivables and inventory. The new financing statement indicated a security interest in the debtor’s bank accounts, accounts receivable, and liens. The debtor and creditor then entered into a joinder agreement, where another business joined the original debtor as a co-borrower under the loan and security agreement. As a result, the creditor filed a new financing statement with respect to the new debtor again indicating a security interest in the debtors’ bank accounts, accounts receivable, and liens. The debtors subsequently entered into a coal purchase and sale agreement (PSA) with another party.

When the debtors filed their Chapter 11 petition, they had failed to pay prepetition wages to employees related to the PSA. The debtors and other party settled, whereby the other party paid the debtors for post-petition accounts receivable pertaining to the PSA. The debtors used the bulk of the settlement to pay employees for unpaid work. The creditor filed a motion for adequate protection, requesting payment of the residual settlement proceeds as a form of adequate protection. The creditor argued that it held a valid security interest in the debtors’ accounts receivable and the proceeds thereof. The debtors argued that the settlement proceeds could not be proceeds of the debtors’ prepetition accounts receivable because at the time of the petition date, there were no accounts receivable owed to the debtors. The creditor argued that it held a prepetition perfected security interest that included the debtors’ PSA and the proceeds thereof.

The bankruptcy court held that the creditor had established its security interest in the debtors’ PSA. Specifically, the bankruptcy court held that because the debtors had granted the creditor a security interest in all its receivables under the loan and security agreement, the creditor had a security interest in the contract rights to the PSA. However, the bankruptcy court held that the creditor failed to establish that its security interest in the PSA and its proceeds was perfected. The creditor argued that it perfected its security interest in the PSA by filing a financing statement when the co-borrower joined the original debtor under the loan and security agreement. The bankruptcy court held that the description of the collateral in the financing statement was insufficient as it did not reasonably identify the debtors’ PSA by specific reference or other means as determined under the UCC. The bankruptcy court held that creditor’s financing statement that indicated a security interest in all the debtors’ accounts receivable was insufficient to perfect its security interest under the UCC. The bankruptcy court noted that there is a distinction between a security interest in accounts receivable and a security interest in an underlying contract such as the PSA at issue. Further, the court noted that the creditor’s financing statement did not contain any specific reference to the PSA, while other specific contracts were described.

The creditor argued that its financing statement should be read to indicate collateral consisting of agreements related to the payment of accounts receivable. Alternatively, the debtors argued that the creditor had a lien on the debtors’ liens and not an independent lien on the prepetition PSA. The bankruptcy court agreed with the debtors, and held that adopting the creditor’s interpretation would lead to a security interest in all debtors’ agreements and in all debtors’ agreements related to the payment of the debtors’ agreements. Finally, the bankruptcy court held that it would have been inequitable for any liens to attach to the post-petition proceeds in this case as the proceeds arose out of unencumbered inventory to the estate. The bankruptcy court held that allowing the creditor to receive the proceeds would have been inequitable to the unsecured creditors. As a result, the bankruptcy court denied the creditor’s motion for adequate protection due to its unperfected security interest.

Clearly, had the financing statement referenced “all assets” the creditor would have prevailed.  Also, if the financing statement had said “collateral described on the security agreement,” then other parties examining it would have contacted the creditor to verify the collateral.  The statements made on a financing statement are critical and can make a huge difference in perfection. 

Conclusion

Bankruptcy is complex and good bankruptcy counsel is a must.  The issues are varied and the best results can be obtained by being able to spot issues that might arise in advance and make proper plans.  Also, words matter on financing instruments.