Review. Court-Approved Professionals. Not Insulated from Avoidance Liability

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1 Review BUSINESS Recent Developments in Bankruptcy and Restructuring Vol. 1 No. 4 July 2002 RESTRUCTURING Court-Approved Professionals Not Insulated from Avoidance Liability Robbin S. Rahman and Mark G. Douglas The heightened scrutiny brought to bear on corporate conduct by creditors, shareholders, regulatory and other government agencies in the aftermath of the rash of corporate misdeeds dominating recent headlines has increasingly been directed toward the company s outside professionals, particularly those retained by companies that may be on the brink of bankruptcy or in acute financial distress. That inquiry has not been confined to the professional s conduct in performing services for its clients, but encompasses the professional s relationships with other entities that may create conflicts of interest. If the company files for bankruptcy protection, the Bankruptcy Code imposes its own special requirements on professionals retained during the case to ensure that professional conduct comports with the best interests of the bankruptcy estate. Among those requirements is the obligation of every professional employed during a bankruptcy case to disclose the full extent of its relationships with the debtor, any of its creditors or shareholders and certain other interested parties. In In re PHP Healthcare Corp., a Delaware bankruptcy court confronted a bankruptcy professional who was less than candid in disclosing all aspects of its relationship with the debtor. The court s decision demonstrates the importance of complete and accurate disclosure of all information regarding a professional s relationship with the debtor. It also highlights the dire consequences of failing to abide by the rules. Retention of Bankruptcy Professionals The Bankruptcy Code permits bankruptcy trustees, chapter 11 debtors-in-possession and official committees to employ professional persons with court approval to represent or perform services on their behalf. These professional persons may include, among others, attorneys, accountants, appraisers, auctioneers and financial advisors. With certain exceptions, any professional retained in a bankruptcy case must satisfy two basic requirements: (1) the professional must not hold an interest (or represent anyone else with an interest) that is adverse to the debtor s estate; and (2) the professional must be disinterested. IN THIS ISSUE 1 Court-Approved Professionals Not Insulated from Avoidance Liability A Delaware bankruptcy court held that approval of a professional s retention and fee requests will not insulate the professional from liability if its disclosure later proves to be deficient. 3 What s New At Jones Day 4 When the Federal Arbitration Act and the Bankruptcy Code Collide Delaware and New York bankruptcy courts recently examined the inherent conflict between the Bankruptcy Code and the FAA. 6 Supreme Court Addresses Ability to Sue States The High Court reaffirmed that a state that files a proof of claim in a bankruptcy case waives its 11 th Amendment immunity from suit. 8 Chapter 11 Plan Need Not Specifically Identify Potential Avoidance Defendants According to a Delaware bankruptcy court, a general reservation of rights clause in a reorganization plan is sufficient to preserve the estate s ability to commence postconfirmation litigation. 9 Lock-Up Could Mean Lock-Out 11 Legislative Alert

2 While adverse interest is not defined in the Bankruptcy Code, courts have found that a professional has an adverse interest if he possesses or asserts an economic interest that would tend to lessen the value of the bankruptcy estate or would create either an actual or potential dispute in which the estate is a rival claimant. In addition, a professional may hold an adverse interest if he possesses a meaningful incentive to act contrary to the best interests of the estate and its sundry creditors. A professional is disinterested so long as he is not a creditor, shareholder or insider of the debtor, he is not in any way affiliated with an investment banker of the debtor s securities within a prescribed period, and the professional does not have an interest materially adverse to the estate for any other reason. The court may deny compensation or reimbursement of expenses to any professional if, at any time during the course of the professional s employment, he is not disinterested. A bankruptcy professional s first hurdle to getting retained is to prepare and file a retention application. The application is a formal request for court permission to employ the professional. It must disclose several things, including: (a) the services the professional intends to provide; (b) the amount of fees the professional will charge; (c) any significant conflicts of interest or other connections with the debtor or any of the other interested parties in the bankruptcy case; and (d) the nature of the relationship the professional had with the debtor prior to the petition date, including a description of payments received by the professional from the debtor in the 90 days preceding the case. If the bankruptcy court determines that a professional is disinterested and has no adverse interest, the professional will be authorized to perform services during the case on behalf of the estate. Bankruptcy Court approval of a professional s retention and fee requests will not insulate the professional from potential liability if its disclosure later proves to be deficient. Anything less than full disclosure is an invitation to liability. Compensation of Bankruptcy Professionals Bankruptcy professionals are paid in accordance with the interim and final compensation procedures contained in the Bankruptcy Code. These procedures contemplate the periodic submission of fee applications to the bankruptcy court, which will evaluate the request by applying certain recognized criteria to ascertain whether the fee request is reasonable and whether the services in question actually benefited the estate. At the conclusion of the representation, the professional will file a final fee application seeking allowance of any unpaid fees and expenses, including certain amounts that are routinely held back from payment until the end of the case. At this time, the bankruptcy court is permitted to re-evaluate the propriety of any fees paid to the professional during the case. Interim fee allowances are merely provisional. The court retains the discretion to modify or rescind fees previously awarded if it determines that the fees were unreasonable, or if the services provided by the professional did not benefit the estate. Legal Effect of Retention and Fee Orders An order authorizing the retention of a professional will contain a legal determination that the professional satisfies the disinterested and no adverse interest requirements contained in the Bankruptcy Code. Orders allowing interim or final compensation to the professional may or may not expressly contain such a finding, but each such order implicitly reconfirms the bankruptcy court s initial determination that the professional was qualified to represent the trustee, chapter 11 debtor or creditors committee. Certain legal implications of fee and retention orders were at issue in PHP Healthcare. Background PHP Healthcare Corporation ( PHP ) filed for chapter 11 on November 19, 1998 in Delaware. The bankruptcy court authorized it to retain accountants and financial advisors (the Advisor ). The court confirmed PHP s plan of reorganization in October of The plan created a liquidating trust whose mandate included prosecuting all avoidance actions on behalf of the estate for the benefit of PHP creditors. In keeping with that mandate, the liquidating trust commenced an adversary proceeding the following year against the Advisor seeking to avoid as preferential a $900,000 payment allegedly received by it from PHP within the 90 day period immediately preceding PHP s chapter 11 filing. According to the complaint, the Advisor never disclosed that it received the payment when PHP sought and obtained court authority to retain the Advisor. In lieu of addressing the adversary complaint on its merits, the Advisor filed a motion for summary judgment, contending that because PHP failed to 2 I Jones, Day, Reavis & Pogue

3 What s New at Jones Day? John J. Rapisardi s (New York) bimonthly bankruptcy column entitled Circuit Split Continues over Propriety of Compensating Chapter 7 Debtor s Counsel appeared in the July 18, 2002 edition of the New York Law Journal. He moderated a panel discussion on creditor recoveries at the American Bankruptcy Institute s May 6, 2002 Conference in New York City. Rick Cieri (Cleveland) spoke in New York City on June 17, 2002 at the American Bankruptcy Institute s second annual conference on Workouts, Restructurings and M&A Transaction Alternatives: The Deal-Maker s Perspective. On June 21, 2002, he was a participating speaker at Renaissance American Management, Inc. s Fifth Annual Conference on Corporate Reorganizations in Chicago. On September 26, 2002, Corinne Ball (New York), will be a panelist at the Corporate Mergers and Acquisitions program in New York City jointly sponsored by the American Law Institute and the American Bar Association. She will also be participating in a program entitled Doing What We Can after the LaSalle Remand at the National Conference of Bankruptcy Judges on October 15, She is among the outstanding professionals featured in the 2002 edition of the K&A Restructuring Register: America s Top 100. Paul Leake (New York) participated in a thesis defense presentation on May 29, 2002 at St. John s University School of Law as part of its LL.M. program in Bankruptcy. David G. Heiman (Cleveland) will speak at the American Bankruptcy Institute s 7 th Annual Southeastern Bankruptcy Conference on August 7-10, 2002 in a workshop entitled Ethical and Other Liability Issues for Professionals, Officers, Directors and Committee Members. The topic of his presentation will be the Fiduciary Duties of Officers and Directors of Financially Troubled Companies. He is among the outstanding professionals featured in the 2002 edition of the K&A Restructuring Register: America s Top 100. Debra K. Simpson (Dallas) and Daniel P. Winikka (Dallas) co-authored an article entitled The Broad Scope of Subordination Claims Under Section 510(b) of the Bankruptcy Code that will be appearing in the July or August 2002 issue of the Annual Survey of Bankruptcy Law. Michele Morgan Harner (Chicago) spoke on June 21, 2002 at Renaissance American Management, Inc. s Fifth Annual Conference on Corporate Reorganizations in Chicago. The topic of her discussion was the chapter 11 cases of Burlington Industries, Inc. and affiliates. Log on to for additional information concerning Jones Day s Restructuring and Reorganization Practice as well as the firm s other practice groups throughout the world. object to or appeal from the bankruptcy court s orders approving the Advisor s retention and granting its final fee application, the liquidating trust was precluded from seeking to recover the payment in question as a voidable preferential transfer. More specifically, the Advisor asserted, its retention and fee orders expressly or implicitly contained a legal finding that the Advisor was disinterested and had no adverse interest. According to the Advisor, PHP s failure to challenge those orders on appeal precluded it by reason of the legal doctrine of res judicata from challenging those legal determinations. The liquidating trust s allegation in its complaint that the Advisor was the recipient of a preference, the Advisor reasoned, directly contradicted the bankruptcy court s binding legal determinations because any recipient of a voidable transfer would not satisfy the Bankruptcy Code s disinterested and no adverse interest requirements. The liquidating trust countered with the contention that the bankruptcy court s retention and fee orders had no preclusive effect because the Advisor failed to disclose that it had received a preference, thereby preventing the court from making an informed determination as to whether the firm was disinterested as required by the Bankruptcy Code. The bankruptcy court explained that the doctrine of res judicata precludes re-litigation of a matter when there has been a final judgement on the merits involving the same parties and the subsequent action is based on the same cause of action as in the first case. Applying that standard, it denied the Advisor s motion for summary judgment. Its ruling hinged on the fundamentally different nature of the legal questions involved in retention and fee applications, on the one hand, and litigation seeking to avoid a preferential transfer, on the other. Having concluded that different causes of action were involved, the bankruptcy court held that neither the Advisor s appointment as a professional nor the approval of its fees in the case would prohibit an action to recover an undisclosed and allegedly preferential payment. Analysis PHP Healthcare reiterates the importance of full and accurate disclosure of a professional s relationship with a debtor prior to the commencement of a bankruptcy case. This includes both information that is known prior to the professional s retention and information that comes to light afterward. Failure to continued on page 11 Business Restructuring Review I 3

4 When the Federal Arbitration Act and the Bankruptcy Code Collide Brian E. Greer Whether an arbitration clause in a contract will be enforced by the bankruptcy courts in accordance with the Federal Arbitration Act has been the focus of numerous court decisions over the last few years. Recently, two bankruptcy decisions, In re Charter Behavioral Health Sys., LLC and In re Hagerstown Fiber Ltd. P ship, have addressed the issue. These decisions affirm prior case law holding that an arbitration clause should be upheld by the bankruptcy court in disputes that do not implicate the bankruptcy court s core jurisdiction as well as in certain disputes that do. The Federal Arbitration Act The Federal Arbitration Act (the FAA ) requires a federal court to enforce an arbitration agreement and stay litigation that contravenes it. In enacting the FAA, Congress declared a liberal federal policy favoring arbitration agreements. This congressional policy is so strong that an arbitration agreement must be enforced notwithstanding the presence of other persons who are parties to the underlying dispute but not to the arbitration agreement. When faced with a motion to compel arbitration a court must consider the following factors: (1) whether the parties agreed to arbitrate; (2) whether the dispute falls within the scope of their arbitration clause; (3) if federal statutory claims are raised, whether Congress intended those claims to be arbitrable; and (4) if the court concludes that some but not all of the claims are arbitrable, whether it should stay the non-arbitrable claims pending the conclusion of the arbitrtration. In applying these factors, courts look initially to the arbitration agreement. The first question is whether the arbitration clause is broad or narrow. If the clause is broad, arbitration will be presumed. If narrow, the court must determine whether the dispute is on its face within the purview of the clause, or instead, involves a collateral agreement or issue that is somehow connected to the main agreement that contains the arbitration clause. The resolution of this issue hinges on the factual allegations underlying the dispute between the parties. If the arbitrable dispute involves a federal statutory right, the court must determine whether Congress intended to except the dispute from arbitration. In addition, assuming some but not all claims are arbitrable, the court must determine whether to stay litigation with respect to the claims that are not. A blanket stay may be appropriate where the arbitrable claims predominate the lawsuit and the non-arbitrable claims are of questionable merit, or where the stay will promote judicial economy, avoidance of confusion and possible inconsistent results without working an undue hardship on or prejudicing the plaintiff. Arbitration in Bankruptcy Proceedings When arbitration law meets bankruptcy law an inherent conflict exists, i.e., should the goal of adjudicating all matters relating to a debtor before the bankruptcy court to effectuate the efficient administration of the debtor s estate trump the liberal policy of enforcing arbitration agreements between the debtor and third parties. In the seminal case of Hays & Co. v. Merrill Lynch Pierce Fenner & Smith, Inc., the Third Circuit Court of Appeals held that a bankruptcy trustee was bound by an arbitration clause contained in the debtor s prepetition contract. In so holding, the court ruled that a lower court is required to enforce arbitration of non-core claims brought by the trustee unless the trustee can demonstrate that the purpose of the Bankruptcy Code somehow conflicts with the enforcement of an arbitration clause. A matter falls within a bankruptcy court s core jurisdiction if it either invokes a substantive right created by federal bankruptcy law or could not exist outside of a bankruptcy case. By contrast, non-core matters generally involve disputes that have only a tenuous relationship to the bankruptcy case and would in all likelihood have been litigated elsewhere but for the broad nexus created by the debtor s bankruptcy filing. For example, a contract dispute between the debtor and a third party is a non-core matter. The distinction between core and non-core matters is a crucial, yet not necessarily determinative, one in defining a bankruptcy court s discretion when confronting an arbitrable dispute. In In re National Gypsum Co., the Fifth Circuit addressed the issue of whether a bankruptcy court should compel arbitration in core matters. Although the court refused to compel arbitration, it recognized that the core nature of a dispute is in and of itself insufficient to create the kind of inherent conflict with the FAA that would permit a bankruptcy court to refuse to enforce an arbitration agreement. The court held that where a cause of action arises entirely from rights conferred by the Bankruptcy 4 I Jones, Day, Reavis & Pogue

5 When arbitration law meets bankruptcy law an inherent conflict exists, i.e., should the goal of adjudicating all matters relating to a debtor before the bankruptcy court to effectuate the efficient administration of the debtors estate trump the liberal policy of enforcing arbitration agreements between the debtor and third parties. Code (i.e. is within the court s core jurisdiction), the bankruptcy court retains significant discretion to determine whether arbitration would be inconsistent with the purposes of the Bankruptcy Code. This approach was recently followed by the Second Circuit Court of Appeals in a tandem of carefully reasoned decisions. Delaware and New York bankruptcy courts were likewise asked to address the interaction between the FAA and the Bankruptcy Code in In re Charter Behavioral Health Sys., LLC and In re Hagerstown Fiber Ltd. P ship. In re Charter Behavioral Health Sys., LLC On or about April 17, 1998, Charter Behavioral Health Sys., LLC ( Charter ) and Managed Health Network, Inc. ( MHN ) entered into an agreement pursuant to which Charter was required to provide specified mental health services to MHN. The agreement contained a mandatory arbitration clause. After filing for chapter 11 in 2000, Charter commenced an adversary proceeding against MHN seeking to recover $151, allegedly owed under the agreement. In answering the complaint, MHN did not assert that the dispute was subject to arbitration. The bankruptcy court entered a scheduling order which set various discovery deadlines in connection with the adversary proceeding. That order expressly recited that the parties had determined after discussion In re Hagerstown Fiber Ltd. P ship that the matter could not be resolved at In Hagerstown, the trustee of an involuntary debtor s chapter 7 estate com- this juncture by binding arbitration. MHN moved to dismiss the adversary proceeding in favor of arbitration. the debtor s prepetition contractor and menced an adversary proceeding against Because the adversary proceeding constituted a non-core matter, the court contract, fraud, and knowing participa- various third parties alleging breach of held that it was without discretion to tion in breach of fiduciary duty, and deny enforcement of the arbitration seeking to recover fraudulent transfers clause. Nevertheless, its analysis did not and other property of the estate held by end here. Charter agreed that the matter was non-core, but asserted that quently moved for arbitration pursuant the contractor. The contractor subse- MHN waived its right to arbitration because it participated in the litigation and contract (the Agreement ) which pro- to a provision in the construction waited approximately six months to vided for the arbitration of any dispute raise its right to arbitration. that arises under this Agreement. The The bankruptcy court rejected bankruptcy court found that that the Charter s waiver argument, emphasizing provision was a narrow arbitration that waiver of the right to arbitrate is clause which required that it determine, predicated upon a finding of prejudice to with respect to each cause of action the nonmoving party. After considering stated in the trustee s complaint, the factors traditionally applied by courts whether arbitration should be required. in determining whether there has been a The court compelled arbitration of waiver, the court held that MHN had not the breach of contract claims because they waived its right to arbitrate because its related to the performance of the parties participation in the adversary proceeding under the Agreement, and the dispute was was limited. Moreover, the court noted, only tenuously within the bankruptcy entry of the scheduling order did not constitute a waiver of MHN s rights because pelled arbitration of the fraud claims as court s core jurisdiction, if at all. It com- it provided merely that at this juncture, well, finding that though denominated as the dispute between the parties could not sounding in fraud, the claims were really be resolved by arbitration. As such, the claims for breach of the parties failure to court held that the order did not amount perform under the Agreement. A party to an unequivocal waiver of MHN s right may not evade arbitration, it emphasized, to arbitrate its dispute with Charter. continued on page 12 Business Restructuring Review I 5

6 Supreme Court Addresses Ability to Sue States Anne Marie Bredin A primary purpose of our nation s bankruptcy system is to provide financially distressed parties with the opportunity for a new beginning. This fresh start philosophy, however, is not universally applied. In certain instances, states are deemed to be outside of the umbrella of the bankruptcy arena and are thus immune to the dictates of the bankruptcy court. Given the wide range of state agencies that may play a role in bankruptcy cases particularly as creditors in the ever-increasing number of chapter 11 corporate reorganizations it is important to understand the scope of federal bankruptcy law with respect to states. A recent decision of the United States Supreme Court, Lapides v. Board of Regents of the University System of Georgia, provides some potentially significant insights on the intersection of bankruptcy law and the doctrine of government, or sovereign, immunity. The Doctrine of Sovereign Immunity The breadth of a bankruptcy court s personal jurisdiction generally extends to any person or entity residing in, or having sufficient minimum contacts with, the United States. However, there are certain exceptions. For instance, the Eleventh Amendment of the United States Constitution provides that [j]udicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State. Sovereign immunity also bars suits in federal court against a state by its own citizens. This language has been interpreted as a grant of sovereign immunity to the states against suit in federal court, including the bankruptcy courts. Under limited circumstances, however, a state s sovereign immunity may be circumvented. One way to provide judicial power over suits against states despite the prohibition created by the Eleventh Amendment is for Congress to expressly abrogate such immunity by federal statute. In section 106 of the Bankruptcy Code, Congress set forth certain limitations on the sovereign immunity of governmental units in bankruptcy cases. The constitutionality of the limitations contained in section 106 has been the subject of considerable judicial scrutiny and scholarly debate. So much so, in fact, that many courts have found that Congress overstepped its constitutional mandate when it purported to abrogate state sovereign immunity in Bankruptcy Code section 106(a), which provides that a state is not immune from suit in actions involving certain specifically identified sections of the Bankruptcy Code (e.g., avoidance actions and proceedings involving the dischargeability of debts). Waiver of Sovereign Immunity Although Eleventh Amendment immunity is in the nature of a jurisdictional bar, it does not implicate a federal court s jurisdiction in any ordinary sense, and thus may be forfeited by a state s failure to assert it, or may be waived. A waiver of sovereign immunity may result from affirmative activity by the state. States and their agencies or other instrumentalities commonly become involved in bankruptcy cases by reason of their status as creditors, such as state taxing authorities and state agencies entrusted with administering student loan programs. In a key pre-bankruptcy Code decision from the 1940s, Gardner v. New Jersey, the Supreme Court held that when a state becomes the actor and files a claim against the [estate] it waives any immunity which it otherwise might have had respecting the adjudication of the claim. However, the court s ruling is not particularly instructive as to the precise extent of a state s waiver when it files a proof of claim. Congress attempted to clarify that issue in Bankruptcy Code section 106(b), which provides that any governmental unit, which includes any state, as well as most state agencies and instrumentalities, that has filed a proof of claim in the case is deemed to have waived sovereign immunity with respect to a claim against such governmental unit that is property of the estate and that arose out of the same transaction or occurrence out of which the claim of such governmental unit arose. Thus, the filing of a proof of claim does not constitute a general waiver of a state s sovereign immunity under the Eleventh Amendment, but only as to claims belonging to the debtor that arose out of the same transaction or occurrence as those upon which the state s claim is based. Whether a counterclaim meets that criterion has been the subject of considerable litigation. Some courts and commentators have questioned the constitutionality of section 106(b) and the validity of Gardner in light of the Supreme Court s landmark 1996 decision, Seminole Tribe of Florida v. Florida, in which the Court held that Congress may not abrogate a state s Eleventh Amendment immunity by enacting legislation pursuant to an exercise of powers enumerated in Article I of the Constitution, the article that created the legislative branch and preceded the enactment of the Eleventh Amendment. The Court in Seminole found that the so-called 6 I Jones, Day, Reavis & Pogue

7 commerce clause of Article I did not grant Congress the power to abrogate a states sovereign immunity. Although Seminole did not involve bankruptcy law, a number of judges and other scholars have construed the High Court s decision as effectively overruling Gardner. Their rationale generally is that the Article I grant of authority to Congress to create bankruptcy law, like the commerce clause at play in Seminole, is not sufficient to empower Congress to effectively negate the protections of the Eleventh Amendment, either as held by a court in Gardner or as enacted by Congress in section 106(b). The Lapides decision is significant for a number of reasons, including the fact that the Supreme Court is quite clear that the holding in Gardner remains good law, but the Court s ruling falls short of resolving the controversy. Background In Lapides, a professor employed by the Georgia state university system initiated a lawsuit in Georgia state court. He sued the Board of Regents of the University System of Georgia ( Georgia ) and university officials acting in both their personal capacities and as agents of the state. The lawsuit alleged that university officials placed allegations of sexual harassment in his personnel files, in violation of Georgia and federal law. All of the defendants joined in removing the case to federal district court, where they sought dismissal. Those individuals whom the professor had sued in their personal capacities argued that the doctrine of qualified immunity barred the professor s federal law claims against them, and the district court agreed. Georgia, while conceding that under Georgia law it waived immunity in suits commenced in state court, contended that by virtue of the Eleventh Amendment, it remained immune from suit in federal court. The district court disagreed, finding that by removing the case from state to federal court, Georgia had waived its Eleventh Amendment immunity. Georgia appealed the district court s ruling to the Eleventh Circuit Court of Appeals, which reversed. The court concluded that state law was, at the least, unclear as to whether Georgia s attorney general possessed the authority to waive the state s Eleventh Amendment immunity. In light of this ambiguity, the court found, Georgia retained the legal right to assert its immunity, even after removal. The Supreme Court s Ruling The Supreme Court agreed to decide the issue of whether a state waive[s] its Eleventh Amendment immunity when it removes a case to federal court. In a unanimous decision, the Court reversed the judgment of the Court of Appeals, holding that Georgia s joinder in removing the case to federal court waived its Eleventh Amendment immunity. The Court first noted that there is considerable dissension among the lower courts regarding a state s waiver of sovereign immunity by its litigation conduct. Addressing this inconsistency, the Court noted: It would seem anomalous or inconsistent for a State both (1) to invoke federal jurisdiction, thereby contending that the Judicial power of the United States extends to the case at hand, and (2) to claim Eleventh Amendment immunity, thereby denying that the Judicial power of the United States extends to the case at hand. And a Constitution that permitted States to follow both claims in the same case could generate seriously unfair results. The Court cited examples of judicial holdings in which a state s voluntary appearance in federal court amounted to a In the context of a bankruptcy case, a state waives any immunity respecting the adjudication of a claim that it voluntarily files in federal court. waiver of its Eleventh Amendment immunity. Citing Gardner, the Court specifically noted that, in the context of a bankruptcy case, a state waives any immunity... respecting the adjudication of a claim that it voluntarily files in federal court. The Court stated that it saw no reason to abandon the general principle embodied in cases such as Gardner. The Court rejected Georgia s contention that its benign motive for removal was of any significance, noting that [m]otives are difficult to evaluate, while jurisdictional rules should be clear. The Court was also unpersuaded by Georgia s argument that Georgia state law, while authorizing the attorney general to represent the state in civil actions, did not authorize the attorney general to waive the state s Eleventh Amendment immunity. Citing Gardner, the Court noted that it consistently has found a waiver when a State s attorney general, authorized (as here) to bring a case in federal court, has voluntarily invoked the Court s jurisdiction. The Court concluded that Gardner and similarly reasoned cases avoid inconsistency and unfairness by endorsing a rule of federal law that finds waiver continued on page 11 Business Restructuring Review I 7

8 Chapter 11 Plan Need Not Specifically Identify Potential Avoidance Defendants Mark G. Douglas A Delaware bankruptcy court ruled that a chapter 11 plan of reorganization need not specifically identify every potential defendant in avoidance proceedings to be commenced by a liquidating trustee following confirmation of the plan. In Cohen v. TIC Financial Systems (In re Ampace Corp), the court held that as long as a chapter 11 plan contains a general reservation of rights to initiate avoidance litigation post-confirmation, the plan s failure to specifically identify a particular defendant does not preclude the post-confirmation commencement of an action against it. The decision also addresses the substantive and procedural requirements for modifying a plan of reorganization after it has been voted on by creditors, as well as describing the claims resolution process and its impact on creditor rights. Modification of Chapter 11 Plan The terms of a proposed chapter 11 plan can be modified at any time prior to the plan s confirmation by the bankruptcy court, so long as the modifications comport with the requirements of the Bankruptcy Code. If creditors and shareholders have already voted on the plan, but the plan has not yet been confirmed, post-voting alterations are permitted only if the bankruptcy court finds, after appropriate notice, that the proposed modification does not adversely change the treatment of the claim of any creditor or the interest of any equity security holder who has not accepted in writing the modification. Absent such a finding, a plan can be altered prior to confirmation only if the debtor or other plan proponent resubmits the plan (together with a disclosure statement) to creditors and shareholders for voting. The rules change after the plan is confirmed by the bankruptcy court. Postconfirmation modifications to a chapter 11 plan may be made only under carefully defined circumstances. At one extreme, the Bankruptcy Code provides that an order confirming a plan of reorganization can be revoked entirely if the order was procured by fraud. Short of fraudulent procurement justifying revocation of confirmation, the terms of a confirmed plan of reorganization may be modified only if the plan has not been substantially consummated. Substantial consummation occurs when all or nearly all of the property to be transferred under the plan has been transferred, the reorganized debtor or its successor assumes management of the debtor s business or its property, and plan distributions to creditors have commenced. A confirmed plan may be altered prior to substantial consummation only if circumstances warrant such modification and the court, after notice and a hearing, confirms such plan as modified. Once a chapter 11 plan of reorganization is substantially consummated, it can no longer be modified. The consequences of substantial consummation and the final status of the bankruptcy court s order lie principally in the binding nature of the plan s provisions. Binding Nature of Plan s Factual and Legal Determinations With certain exceptions, the terms of a confirmed plan are binding on all creditors and shareholders whether or not they voted to accept it. The significance of this idea goes beyond the fairly obvious maxim that the debtor (unless it is an individual with non-dischargeable debts or a liquidating corporation) is discharged from pre-confirmation debts except as provided otherwise in the plan. It also means that every factual and legal determination contained in the plan and the order confirming it may become binding in any subsequent litigation by reason of the legal doctrine of res judicata. In other words, an order confirming a plan of reorganization bars litigation of the claims raised or asserted in the bankruptcy proceedings or the confirmation proceedings, except as expressly reserved in the plan itself or the confirmation order. Thus, for example, if a plan classifies and provides for the payment of the claim of an equipment lessor as one for unpaid rent, the reorganized debtor might be precluded from arguing in litigation with the lessor post-confirmation that the equipment lease should properly be designated as a secured financing agreement. In addition, if a plan omits to mention something, such as the existence of a document or agreement, the omission could be construed as a legal determination that the item in question does not exist and cannot be introduced into evidence by the reorganized debtor in subsequent litigation. Claims Allowance Process in Bankruptcy Among the legal determinations made in every plan of reorganization is that certain claims are either recognized, or allowed, as legitimate and enforceable obligations of the chapter 11 debtor, or are disputed in whole or in part by the debtor, and the dispute will be resolved via litigation, arbitration or settlement as part of the postconfirmation claims resolution process. 8 I Jones, Day, Reavis & Pogue

9 Whether a claim is allowed or disputed, and the process by which it is awarded either designation, depends on a number of factors. When a debtor files its chapter 11 petition, it must submit to the bankruptcy court a list of all of its known creditors indicating whether or not each debt is undisputed. If a debt is scheduled as undisputed, the creditor need not file a proof of claim (assuming it is scheduled in the proper amount and priority) and its claim will be deemed allowed under the Bankruptcy Code. This designation does not preclude a challenge to the claim during the chapter 11 case, but the burden of proving that an allowed claim is invalid is borne by whomever objects to it. If the debtor omits to schedule a claim, schedules it erroneously or schedules it as disputed, unliquidated in amount or contingent upon the occurrence of a future event, the allowed amount of the claim, if any, must be determined as part of the claims resolution process. Typically, this means that the debtor will file an objection to the claim during the chapter 11 case, and the claim will either be allowed or disallowed after litigation in the bankruptcy court. In large chapter 11 cases, the claims resolution process may extend long after confirmation of the debtor s plan. This is possible because a debtor s plan of reorganization can contain a mechanism to resolve claims post-confirmation and to pay them from funds set aside in the plan to satisfy disputed claims that later become allowed. No matter how a claim gains the allowed designation, it will be treated in accordance with the terms of the debtor s plan of reorganization and discharged upon confirmation of the plan (except as expressly provided otherwise). Thus, confirmation of the plan acts as a binding determination that an allowed claim was valid and enforceable prior to being discharged. In Cohen v. TIC Financial Systems (In re Ampace Corporation), a Delaware bankruptcy court explained the ramifications of plan confirmation as it pertains to the rights of a creditor holding an allowed claim, as well as the significance of a debtor s failure to specifically refer in a confirmed plan to potential defendants in post-confirmation litigation. Background Ampace Corporation and Ampace Freightlines (collectively referred to as Ampace ) filed voluntary petitions for relief under chapter 11 on December 15, The bankruptcy court confirmed Ampace s joint plan of reorganization approximately one year later. The effective date of the plan essentially a closing date for the various transactions contemplated by the plan was December 14, On that date, a liquidating trust was established to hold and liquidate Ampace s non-operating assets for the benefit of Ampace s creditors. The liquidating trustee appointed under the plan to administer the trust was authorized to analyze and prosecute all causes of action formerly belonging to Ampace, including causes of action seeking to avoid fraudulent or preferential transfers. Specifically, the plan provided that [all] Avoidance Actions,... all transfers recoverable under Section 550 of the Bankruptcy Code,... and any other cause of action in favor of [Ampace] are hereby preserved and retained for enforcement subsequent to the Effective Date exclusively by Ampace Liquidating Trust. The liquidating trustee s responsibilities specifically included prosecuting any cause of action of [Ampace s] estate, inlcuding Avoidance Actions. Ampace s plan of reorganization also gave the liquidating trustee the exclusive right to object to the allowance of any claim. All objections had to be filed with the bankruptcy continued on page 10 ACCESS DENIED Lock-Up Could Mean Lock-Out In what may be a significant development affecting the composition of chapter 11 creditors committees, the office of the United States Trustee for region three, which encompasses Delaware, Pennsylvania and New Jersey, recently refused, in a chapter 11 case filed in Delaware, to appoint to the creditor s committee any bondholders who had entered into a pre-bankruptcy lock-up agreement with the debtor whereby the bondholders agreed to support a pre-negotiated plan of reorganization. Moreover, the bankruptcy court denied the bondholders request to reconstitute the committee, finding that the U.S. Trustee s decision was not an abuse of discretion. Although unclear, it appears that the U.S. Trustee for region three may have adopted a position excluding creditors who are party to lock-up agreements from sitting on creditors committees. Should this become a standard policy supported by the courts, it could substantially impact efforts to guide debtors through prenegotiated chapter 11 cases with relative dispatch. Business Restructuring Review I 9

10 A general reservation of rights clause in a plan of reorganization is sufficient to preserve the bankruptcy estate s ability to commence post-confirmation litigation against the recipients of fraudulent or preferential transfers. court not later than ninety (90) days after the Effective Date of the plan (the Objections Deadline ). TIC Financial Systems ( TIC ) filed six proofs of claim against Ampace aggregating approximately $500,000. Its claims were deemed allowed under the Bankruptcy Code in the absence of a timely objection by the liquidating trustee. However, in lieu of filing an objection to TIC s claims prior to the Objections Deadline, the trustee (post-confirmation, but prior to substantial consummation) sought a series of orders from the bankruptcy court extending the deadline. The bankruptcy court granted the extensions without requiring creditor notification and a hearing. The trustee finally filed an objection to TIC s claims on November 8, 2002 nearly 20 months after the original Objections Deadline had expired. The bankruptcy court ultimately upheld the trustee s objection in part, reducing TIC s claim to approximately $350,000. Prior to objecting to TIC s claims, the liquidating trustee commenced an action against TIC seeking to avoid certain pre-bankruptcy transfers from Ampace to TIC as being preferential. TIC moved for summary judgment, arguing that the bankruptcy court s orders extending the Objections Deadlines were improper because they disregarded the requirements for modifying a plan of reorganization post-confirmation. TIC also contended that, given the trustee s failure to comply with the Objections Deadline, the ensuing conclusion that TIC s claims were therefore allowed, and the plan s failure to specifically identify TIC as a potential post-confirmation defendant in avoidance litigation, the trustee should be precluded from pursuing any litigation against TIC because confirmation of the plan cut off his rights to do so. The bankruptcy court agreed with TIC s initial argument. It found that the liquidating trustee s motions seeking to extend the Objections Deadline did not comply with the plan modification requirements in the Bankruptcy Code. At the outset, the court determined that the deadline was a material part of the plan, stating that [if], as here, the parties choose to [fix a time for filing objections], the resulting objections deadline, which is akin to a statute of limitations, certainly constitutes a substantive matter. As noted, substantive modifications of a confirmed plan are possible only if circumstances warrant such modification and the court, after notice and a hearing, confirms such plan as modified. The court carefully distinguished the situation before it from cases in which a bankruptcy court is asked merely to interpret or clarify the terms of a confirmed plan. In this case, the court emphasized, the plan clearly and unambiguously established the Objections Deadline without any language indicating that the deadline was subject to extension, as is commonly the practice. The court ruled that the modifications were ineffective because they took place without the required notification to creditors and hearing before the court. Thus, it found that the liquidating trustee s objection to TIC s claims was untimely, and that TIC held an allowed claim in the original amount filed. TIC s victory was largely pyrrhic. The bankruptcy court rejected TIC s contention that the liquidating trustee s preference action should be precluded because TIC was the holder of an allowed claim. According to the court, the legal issues implicated in an action to avoid a preferential transfer are fundamentally different than the determinations present in a claims objection proceeding. Next, it found that because Ampace s plan of reorganization expressly reserved to the liquidating trustee the right to prosecute avoidance actions, the trustee would not be precluded from suing TIC even if the avoidance action and the trustee s claim objection proceeding did involve similar factual and legal issues. The court rejected TIC s contention that Ampace s plan had to specifically identify TIC as a potential defendant. It held that a general reservation of rights clause is sufficient, stating that it is both impractical and unnecessary for a Disclosure Statement and/or Plan to list each and every possible defendant against which a debtor or its representative may bring an avoidance action. Based upon its determination that the liquidating trustee was not precluded from suing TIC, the bankruptcy court denied TIC s motion for summary judgment. Analysis Although In re Ampace Corporation addresses a number of conceptually complicated issues regarding the ramifications of plan confirmation and the claims resolu- 10 I Jones, Day, Reavis & Pogue

11 tion process, the decision illustrates some fundamental principles in a chapter 11 reorganization. First, all constituencies in a chapter 11 cases must be vigilant to ensure that they fully comprehend how their legal rights will be affected by the terms of a plan of reorganization. Once the plan is confirmed and substantially consummated, its provisions become final and unalterable. Next, by joining the growing number of courts that find a general reservation of rights clause sufficient to preserve the estate s ability to commence post-confirmation litigation, the bankruptcy court in In re Ampace Corporation reaffirms the utility of a chapter 11 plan as a means of realizing the maximum recovery possible from estate assets for the benefit of creditors. Cohen v. TIC Financial Systems (In re Ampace Corporation), 279 B.R. 145 (Bankr. D. Del. 2002). continued from page 3 do so carries potentially disastrous consequences for the professional, including disqualification from representing the trustee, chapter 11 debtor or committee, disgorgement of fees earned during the case, and as in PCP Healthcare, potential avoidance liability that may require disgorgement of fees earned pre-bankruptcy. PHP Healthcare aptly demonstrates that bankruptcy court approval of a professional s retention and fee requests will not insulate the professional from potential liability if its disclosure later proves to be deficient. Anything less than full disclosure is an invitation to liability. In re PHP Healthcare Corp., 2002 WL (Bankr. D. Del. May 07, 2002). continued from page 7 through a state attorney general s invocation of federal court jurisdiction. Analysis While Lapides is not a bankruptcy case, the decision is significant because it resolves at least one controversy. The Supreme Court s express endorsement of Gardner would appear to put to rest the speculation that Gardner was invalidated by Seminole. Also, the decision thwarts the practice increasingly common in the bankruptcy court of having a state official initiate a federal proceeding and subsequently invoking immunity against counterclaims, arguing that the official was empowered only to commence the suit, not to waive sovereign immunity. Perhaps most significantly, the rationale of Lapides extends beyond the limited issue of whether the filing of a proof of claim waives a state s immunity. The decision appears to address the broader issue of whether any litigation activity engaged in by a state in a bankruptcy proceeding waives sovereign immunity. Still, Lapides leaves some important questions unanswered. It is still unclear, for example, whether the filing of a proof of claim by a state waives its Eleventh Amendment immunity for all purposes or only with respect to compulsory counterclaims, i.e. claims arising out of the same facts or transactions as the state s proof of claim. As such, deprived of any clear guidance from Congress or the High Court, bankruptcy courts will continue to struggle with 11th Amendment immunity and Bankruptcy Code section 106. Lapides v. Board of Regents of the University System of Georgia, 122 S. Ct (2002). Gardner v. New Jersey, 329 U.S. 565 (1947). Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996). LEGISLATIVE ALERT Congressional conferees did not complete work on bankruptcy reform legislation before the July Fourth recess, but prospects appear good for final action on the measure before Congress s August break. Conferees last met May 22, but failed to resolve their differences over proposed controversial language that would bar the discharge of debts incurred as a result of acts of violence and other protest activities directed at abortion clinics. In what amounted to a breakthrough for the 11-month-old conference committee, opposing sides finally agreed to attend meetings to find language the two could agree on. Meanwhile, the U.S. is not the only country caught up in the bankruptcy reform maelstrom. The United Kingdom s House of Lords is currently going through its second reading of proposed legislation that would create a distinction between innocent debtors, whose debts would be discharged in bankruptcy after one year or less, rather than the current three, and reckless and culpable bankrupts, who would face a more stringent regime. Like our own Congress, Britain s legislature is also struggling to enact tougher rules to prevent unscrupulous individuals from playing the system for personal gain while at the same time curbing predatory lending practices. Business Restructuring Review I 11