409 ALI-ABA Course of Study Commercial Lending and Banking Law April 19-21, 2007 San Francisco, California Insolvency, Bankruptcy, and Workouts By Steven H. Felderstein Felderstein Fitzgerald Willoughby & Pascuzzil LLP Sacramento, California Marc A. Levinson Orrick, Herrington & Sutcliffe LLP Sacramento, California
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411 Recording judgment lien in California is not effective for a Delaware corporation: Aura Systems, Inc. v. John Barovich, et al. (In re Aura Systems, Inc.), 347 B.R. 720 (Bankr. C.D. Cal. 2006) A Delaware corporation doing business in California settled a lawsuit concerning securities violations. When the corporation defaulted on its settlement agreement, the plaintiffs obtained a judgment. They filed a Notice of Judgment Lien under California Code of Civil Procedure 697.510, which entails the filing of a form with the Secretary of State. The judgment lien was supposed to encumber the defendant s business assets. The corporation later filed a chapter 11 petition. The debtor then attacked the judgment lien, claiming the judicial lien cannot be created against a non-california corporate debtor by filing a notice with the California Secretary of State. The Bankruptcy Judge set aside the judicial lien because it was not perfected. Under CCP 697.530(a), a judgment lien affects the debtor's assets "if a security interest in the property could be perfected under the Commercial Code by filing a financing statement at that time with the Secretary of State...." However, under 9-310 and 9-501(a) of the UCC (applicable in both California and Delaware) Delaware is the only proper place to record a judicial lien concerning a Delaware corporation, even though the assets of the corporation were located in California. While this may seem like a harsh result, it is technically correct. Allowing the judgment creditor to record in California when the debtor is incorporated in another state would defeat the point of the Article 9 amendments in 2001 that were intended to allow just one place of recording, the state of incorporation. However, it is unlikely that the drafters of the revised Code intended this result. Maybe the California Law Revision Commission will consider amending California s version of the UCC. Subordination under Bankruptcy Code 510(b): Racusin v. American Wagering (In re American Wagering), 465 F.3d 1048 (9th Cir. 2006) In 1994, Michael Racusin, a financial advisor, was hired by a subsidiary of American Wagering, a publicly-traded corporation, in connection with an IPO of
412 American Wagering s subsidiary, Leroy s Horse and Sports Palace. His compensation was set as 4% of the final valuation of the Leroy s stock, plus $150,000. During the IPO, Leroy s sued Racusin, claiming the agreement was unenforceable. Racusin obtained a judgment in state court awarding him 337,500 shares of stock worth a little over $2 million. He appealed, claiming he should have been awarded money damages. He won the appeal, and in 2003, obtained a judgment for $2.275 million. Shortly after that decision, the parent and the subsidiary filed chapter 11 cases in Las Vegas, and brought an adversary seeking to subordinate Racusin s $2.275 million claim under Bankruptcy Code 510(b). The bankruptcy court denied subordination, but the BAP reversed [326 B.R. 449]. The 9th Circuit reversed the BAP, reasoning that while the agreement pegged Racusin s compensation to the price of the stock, he had not bargained for equity in Leroy s as his compensation, and therefore the rationale for 510(b) did not apply. It also relied on the express language of 510(b), which applies the subordination only to alleged claims arising in connection with the purchase or sale of a security. Recharacterization of debt as equity: Fairchild Dornier GMBH v. The Official Committee of Unsecured Creditors (In re Dornier Aviation (North America), Inc.), 453 F.3d 225 (4th Cir. 2006) German aircraft manufacturer Dornier sold spare parts to a wholly-owned indirect subsidiary. The sales were evidenced by invoices providing that payment thereon was due within 30 days unless otherwise agreed. The wholly-owned indirect subsidiary filed bankruptcy. Subsequently, the unsecured creditors of the debtorsubsidiary sought clarification from the bankruptcy court regarding whether the sales constituted an equity investment by the parent or an unsecured loan (i.e. indebtedness). At trial, the evidence demonstrated that the subsidiary-debtor was not obligated to repay the loan until the whole operation turned positive, and that there was no fixed maturity date for repayment. The bankruptcy court determined that the sales gave rise to an equity investment, despite the fact that the underlying documents were labeled a loan. The district court affirmed the bankruptcy court. The Fourth Circuit affirmed rejecting the parent corporation s argument that the bankruptcy court s power to recharacterize does not exist independent of its power to disallow claims under 502(b) and subordinate claims under 510(c).
413 The Court of Appeals held that a bankruptcy court s equitable powers have long included the ability to look beyond form to substance, and the exercise of the power to recharacterize is essential to the implementation of the Bankruptcy Code s mandate that creditors have a higher priority in bankruptcy than those with an equity interest. Implementation of the Bankruptcy Code s priority scheme requires a determination of whether a particular obligation is debt or equity. Where that question is in dispute, the bankruptcy court must have the authority to make this determination in order to preserve the Bankruptcy Code s priority scheme. Crime-fraud exception to the attorney-client privilege: In re Enron Corporation (Enron Broadband Services LP v. Travelers Casualty and Surety Co. of America), 349 B.R. 115 (Bankr. S.D.N.Y. 2006) Enron Broadband Services L.P. ( EBS ), one of the many filing Enron entities, brought an adversary proceeding against a surety seeking recovery under a $17.75 million bond placed by the surety to ensure performance by Global Crossing, a company that had contracted to provide broadband capacity to EBS. Travelers, the bonding company, contended that on the same day that EBS had contracted to purchase broadband capacity from Global Crossing, EBS had wrongly entered into another broadband contract to sell broadband capacity to Global Crossing through Reliant Energy Sources. Travelers contended that the result of the foregoing transactions was that the bond would serve as the guaranty of a $17.75 million loan to EBS. Travelers claimed that such conduct, if proven, would constitute a fraud on Travelers and would exonerate it under the bond because New York law prohibits sureties from bonding performance under loans. Travelers sought production of all communications between two former EBS employees and Enron inside counsel relating to the bond, to the underlying broadband contract and to the second broadband contract. EBS claimed the attorney-client privilege, and the surety invoked the crime-fraud exception. Bankruptcy Judge Gonzalez ruled in favor of Travelers under the crime-fraud exception, concluding that it had produced enough evidence to provide a reasonable basis to suspect the perpetration of a fraud in connection with the second contract. He rejected the EBS contention that Travelers was compelled to demonstrate that the counsel s advice was closely related to the alleged fraud,