 You're watching FJTN, the Federal Judicial Television Network. A federal judicial center program, bankruptcy law update. And now, here is our moderator, Vice Dean Lawrence Ponaroff of Tulane University Law School. Hello and welcome to the second in our series of bankruptcy law update programs produced by the Federal Judicial Center here in Washington, D.C. This month, as always, our goal is to look at some of the latest and we think most important developments in bankruptcy law. To do that, we have gathered together a distinguished panel of judges, academics and practitioners to provide their insights and analysis on this constantly changing area of practice. Joining us for today's programs, our names and faces I think will be familiar to all of you. We have Professor Margaret Howard from the Vanderbilt University Law School, David Lander, head of the bankruptcy and insolvency department at Thompson Coburn in St. Louis, Judge Robert Martin, Chief Bankruptcy Judge from the Western District of Wisconsin, and Judge Thomas Small of the Eastern District of North Carolina. Thank you all for being here. We're going to begin our discussion with Professor Howard, who has written for us perhaps the most provocatively titled paper we've had on this program, Stripping Down and Stripping Off. I believe the reference is intended to be to secured claims in bankruptcy and specifically section 1322B2, but perhaps Professor Howard, you could explain the distinction between those two concepts and why they become important. Well my own reaction is that strip off is a new term that has been coined so that we're not stripping down because we know we're not supposed to strip down. So when we say strip off, we're not doing what we're prohibited from doing. The problems actually began with Doosnow, which said to us we cannot strip down an under-secured lien in a Chapter 7 context. But there are variations of fact patterns that have since come up that present new questions. And the fact pattern that has produced the strip off as opposed to the strip down is the fact pattern in which a creditor has a junior lien, and that lien is so junior it may be second, it may be third, fourth, whatever, but it's so far down in priority that there is no value in the property for that particular creditor or that property liquidated. What we would call basically an unsecured claim. We would call it an unsecured claim under our 506A instincts. Post bifurcation it would be an unsecured claim. This is a creditor that is under water. I rather like the expression under water, it says a lot to me. So the question becomes after Doosnow and after Nobleman, especially after Nobleman, whether the debtor can file a Chapter 13 and seek to eliminate the lien of that under water creditor, convert them into an entirely unsecured creditor, and treat them that way in the plan. And is there anything in Nobleman and is there anything in 1322B2 that says we can't do that? It says the debtor is prohibited from doing that. The authorities had been fairly split. I suppose they're still fairly split. One case says that the minority is a burgeoning minority, so I don't know if the division, I don't count cases in that sense. We do now have three circuit level cases that have come out this year since March. We have the McDonald case from the Third Circuit, the Bar-T case from the Fifth Circuit, and the Tanner decision out of the Eleventh. All three of them taking the position that Nobleman and 1322B2 are no bar to the debtor that wants to convert such an under water claim to an unsecured claim and treat them that way in the plan. How do these decisions deal with, as I understand the minority position in the lower courts that takes the expansive view of Nobleman, hinges the argument critically on Justice Thomas' rights analysis in Nobleman that you can't modify the rights of a secured creditor which exists independent of value or equity. How have those courts gotten around that part of the Nobleman decision? I think it's fair to say that the courts believe that there is some tension in the Nobleman decision. Yes, Justice Thomas did say that, but there's also other language in the Nobleman decision that focuses on 506A, the bifurcation section, and the Nobleman decision says that the debtors were correct in looking to 506A for a judicial valuation of the collateral and noting that because there was value in the collateral for the creditor in the Nobleman fact pattern, in other words, under secured, not under water, because there was value, the creditor in that case had a secured claim, a post bifurcation secured claim. So when you take that language suggesting that you look to 506A, it does have a role to play and then you add that to the rights discussion. These courts say there's a tension between those two views and how do you cope with that tension? Well, the way that these courts are coping with it is suggesting that the best way to read those together, and I think the McDonald case has a good explanation of how to read those together. The best way to read those together is to suggest the debtor starts with 506A. And if under 506A there is no value in the collateral, so there will not be a post bifurcation secured claim of any amount, then we don't have a problem with having a secured claim that has protected rights. Let me ask you a different kind of question. There's some policy considerations going on in these decisions as well, which I think is a product of the type of loans we're usually dealing with when we're dealing with these wholly under water liens. Are these primarily 100% plus home equity loans? Are they primarily consumer spending debt and not really home acquisition debt? How is that played? I did a quick read of as many cases as I could find at the time. I won't say that I read every case. I would say I passed the mark of due diligence. What I found were homeowners association assessments in two or three of the cases, mechanics liens, there's actually a mechanics case out there, home improvement loans, and the debt consolidation or home equity loans. One of the policy concerns is this notion that, and we get that out of the Stevens concurring opinion in Nobleman, the notion that 1322B2 was designed to protect the mortgage loan market. So we want to have mortgage lending available for debtors to be able to buy homes. The way we do that is protecting those interests in bankruptcy. Well, these are simply not the kinds of liens that are involved in the completely under water situation. I did not find one case in which we had a purchase money mortgage that was completely under water and was threatened with strip off in any one of these cases without regard to which way the court decided. You know, we ruled pretty quickly after Nobleman that if you had an under water situation, you could strip off. And so we've had a lot of experience with this. And these are not contested matters. The motions are filed and usually clearly they're under water and the liens are stripped off. Question that comes to my mind is if you can do this in Chapter 13 and you can't do this in Chapter 7, many of the Chapter 13 plans get dismissed because they don't make their payments or they have the absolute right to dismiss. What happens on a dismissal with respect to that lien that has been stripped off? Well, that's attention that runs throughout Chapter 13 on what happens pre-discharge because discharge comes at the end of the case, unlike in Chapter 11, where it comes at the confirmation of the plan. There are various other issues where we've had the same problem. And I think that probably you have to look to 349 and say on dismissal certainly then it's reinstated. Well, it's reinstated, but as a practical matter, the property may have been sold. Yeah, but if they had no interest in it and no secured claim in it, no value, then the fact that it gets sold during the short time after that's determined. I'm not too concerned that any injustice has been done. Well, if you talk about conversion rather than dismissal and you're not dealing with 349 and then you could convert to Chapter 7 and you could have stripped off and that would still be valid while you could not have done it had you filed initially under Chapter 7. What you're suggesting is that there is a way around Doosnup. Well, possibly. Which grieves me not, as I'm sure comes as no surprise. There are other ways around Doosnup. I think the filing of a 7 followed by the quick 13, this so-called Chapter 20, the Johnson v. Home State Bank, is a way potentially around Doosnup, especially given that on remand it was found not to be filing like in good faith. So this may be another backdoor way around Doosnup and you may have identified it. And of course, if that lien never had any value to begin with, then I don't think we've done the so-called secured lender any injustice by leaving them with a purely unsecured claim on 7 because that's what it is. They're definitely not a secured lender under 506 if there's no value in the collateral. So I guess I'm not distressed at all. I think that's an easy threshold to apply and a nice place for the cut-off. The nice thing is, of course, if real estate values are escalating during all this time, it gives you a situation that really makes your head spin. Well, there's the possibility you'll come into the money because of the escalation of value and of course that appreciation was on the mind of the Supreme Court in the Doosnup opinion. Well, what about valuation because that's what we're really talking about is being the $1 makes the difference between whether the lien's preserved or avoided? A number of these courts that are going with the burgeoning minority suggest that valuation is one reason why they do so because that puts such a heavy load on the valuation determination because of this $1 potential. And they can also take this another step and suggest that it invites strategic behavior by debtors who recognizing that almost undersecured lien number one is right there at the line. They stop paying secured senior lien and allow senior lien to build up in terms of debt, pushing it out of the money so it's now only partially secured and very slightly undersecured that pushes the junior completely under water. Presto, you now have the completely avoidable. But isn't that slightly a law professor's argument that in fact very few debtors have any clear notion of the value of their property, much less the balance due on their various loans to have somebody who knew enough about both of them to be that precise strains my credulity. And let me suggest another strategy. What about the junior lien holder who of course has this sort of sophisticated hold on the fact that you're thinking of, can that creditor pay a little something to the senior lien to pay down the senior lien to make them fully secured and obtain that $100 of secured claim that puts them under the protection level? What this demonstrates is how the $1 making such a huge difference creates this artificial playing field because the stakes could be very high on the basis of $1 under a $1 order. But Nobleman forces that because there's no way around the fact that partially secured debt cannot be modified in 13. And let's not overlook that it seems to me anyway that one of the things that the cases seem to behave as if we can accomplish by prohibiting a strip off is suggesting we're putting money in the pocket of the creditor and you cannot create economic value simply by such a court holding. You can't do that. At some point the debtor is going to look at the fat pattern and it's going to say look I'm being asked to pay so many hundreds of thousands maybe or thousands of dollars more than this house is worth. I'm just going to have to give it up as much as I would rather keep it. You give it up. All bets are off under Nobleman. You simply send it out for liquidation or you're in a seven to start with perhaps there's no protection for that creditor then. And then it's the economic fact of no value that comes home to them. So I don't think creditors actually should have much of an interest in pressing this too hard. Especially not at the cost that it takes to put on evaluation hearing and presumably the burden on them if there's any objection to their claim would mean that they would have essentially come forward with evidence which is a hard thing to do in valuation. What you're balancing here is an economic and a non-economic cost too from the debtor's point of view. You know they always say you can take a security interest in my bed it isn't much good to the party that has security interest but it's real valuable the person that's sleeping in it. And you sort of have the same notion here. So you're balancing an economic concern maybe the macro concern with the creditor who is looking at these cases on a national basis. I was going to say it's the idiosyncratic value to the debtor that leads the debtor to be willing to be perhaps the only person in the world who will pay more than arms length market value for that house. So these sorts of holdings if you can't have Stripoff really give the creditor a substantial amount of leverage over that debtor. If the creditor knows the economic facts knows that there's actually zero value in the property were the debtor pushed to a liquidation they don't want to push the debtor that far but the debtor is willing to pay a little more than somebody else might pay and that allows the creditor to extract this economic value and it seems to me that setting up a bankruptcy system that enables that kind of behavior is just wrong thinking. And of course in an economic sense the parties that are really hurt are the unsecured creditors who are getting less as a result of the plan payments those plan payments having to go pay that secure debt. And the chapter 13 is so often a zero sum game. Well you're not suggesting are you that even noblemen requires that you pay the full secure debt in the chapter 13 plan it just means that the discharge will not rid the debtor of the lien. But what about the monthly installment payments don't those have to continue at the same level. They may yeah which may be in practice if it extends beyond the length of the plan the effect is only that they will still there will still be an obligation at the end of the plan not that you're you have to pay the entire amount during the. Oh you can default at any time and because the secured claim survives bankruptcy Long v. Bullard and the debtor can give up the house at a later time of course. And then your point is a very good one that if there is a foreclosure and that is a second that really has little value behind a large first the market's going to wipe out the second in a way that we're saying is a bankruptcy can't do in these circumstances. So the bank wins the battle and loses the war unless it's very careful and how it how it proceeds. And you know I think the Fifth Circuit in its decision made some some reference to this in the sense that the court talked about 1322 C2 and the fact that if the term of the mortgages is going to run to maturity during the life of then you can modify indicating congressional intent that in point of fact this is really just consumer spending debt. It's it's not mortgage debt and that we should permit modification because it doesn't fit the narrow justification for 1322 C2. It's not a statutory argument but but I think there's a great deal of sense or logic to that kind of reasoning. There is a great deal of logic to that reasoning. I think it gives the Congress perhaps more credit than might be due in this situation because I'm not so sure that ever crossed the minds of the legislators. But nonetheless I think the structure of the code does suggest that very that very position. Well I think we have this problem solved. As far as we're going to be able to solve an agreement on this one let's just hope the rest of the circuits follow suit so we don't get a split and see it go up and get do's and up too. We want to turn next to another consumer bankruptcy law topic. Judge Martin I'm going to turn to you for this. I think it's fair to say that that the fraud exception to discharge ability in 523 A2 is the most important and frequently litigated of the exceptions for a long while there was some uncertainty under subparagraph A of what the elements of a non dischargeable claim were. The Supreme Court spoke to the issue in the fields versus man several years ago told us you just incorporate the elements of common law fraud. And we thought now that this issue was clarified. But the chief judge of the circuit in your circuit in the 7th Circuit has recently rendered a decision that perhaps casts that in doubt and may have some broader implications meaning it's worth discussing that exception again. Can you tell us a little bit about it? Yeah it's a tough one because just when I had started to understand the difference between reasonable reliance and the less familiar but now correct justifiable reliance Judge Posner has explained that we can have actual fraud with no reliance whatsoever. And he's probably right at least in the case he decided actual fraud in the 7th Circuit at least may occur in a form other than misrepresentation. And this is quite a movement from what we've known as common law fraud. I think most of us think of common law fraud in terms of five fingers of fraud. You know various courts have had various numbers of fingers apparently but basically there are the elements that go into the fraud which Judge Posner limits to fraud by misrepresentation. The case of McClellan versus Cantrell and the only site I have it on it is 2000 Westlaw 876933 2000 WL876933. The facts are the sort that generate novel remedies. I'll have to refer to my notes to get them in detail. McClellan sold the debtor's brother $200,000 worth of ice-making machines on a time basis. McClellan took a security interest in the machines but didn't perfect it. The brother made no payments and McClellan started a state court action to recover the machines and to enjoin any transfer of the machines. While the case was pending, the brother sold the machines to his sister who is the ultimate debtor for $10. She knew about the suit and was in collusion with her brother. Cantrell then sold the machines for $160,000 and no one knows where that money went. McClellan added the sister, Cantrell, as a defendant in the state court action for fraudulent conveyance. Two years later while the state court case was still pending, Cantrell filed Chapter 7 bankruptcy and McClellan filed an adversary proceeding to recover the debt. She owed him as a recipient of a fraudulent transfer and to have that debt declared non-dischargeable under 523A2A. The bankruptcy court dismissed the adversary proceeding and the district court affirmed because in Fields versus Man, the Supreme Court recently scoffed at the idea that a debt could be non-dischargeable under the fraud exception of 523A2A without a showing of material misrepresentation and reliance on the statement. So in essence, what Judge Posner did is that he opined that Field versus Man spoke only to fraud by misrepresentation and that there are other forms of actual fraud contemplated by 523A2A. Now it's interesting because he found no other appellate cases to support his conclusion. He did cite the general language from a 1952 case out of Oklahoma to the effect that fraud is a generic term which embraces all of the means that human ingenuity can devise for one individual to gain advantage over another. That quote and a reference to a statement in Collier's treatise apparently satisfied Judge Posner's mind that the Supreme Court's direction to look toward the common law in describing fraud. So he felt that it was sufficient description of the common law to which Field versus Man's directed the court was to have one case out of Oklahoma and a cite, quote in Collier's. The quote in Collier's is, I'll read exactly what Judge Posner said about it because I think it's important. Says Collier's treatise while assuming along with the cases we have cited that actual fraud involves misrepresentation defines the term more broadly as any deceit, artifice, trick or design involving direct and active operation of the mind used to circumvent and cheat another. Well that's really broad language and one of the things I'll just as an aside I think those of us who've been in the bankruptcy world for a while are perfectly aware of the Collier's cycle where there's an undocumented statement in Collier's which is then cited in a case and appears as a footnote in the next edition of Collier's. So I'm sure that we will now find that the Collier's statement is well supported. In getting to this point Judge Posner reasons that actual fraud in the statute is contrasted to constructive fraud only and that was the purpose of adding actual fraud in the 1978 code. Prior to that in section 17 of the act there was no reference to actual fraud it was. And he said that the addition of actual fraud to the statements about misrepresentation were to say that there was something more than misrepresentation. The way I read this is if Cantrell had purchased the ice machine for $10 but had no intention to deprive McClellan of the machine's value her fraud if any would have been at most constructive but because she colluded with her brother it was an active fraud because she possessed the intention to deprive, to cheat McClellan. And because it was actual fraud it fell within this definition. I don't know where to start with this one. Because to mix my metaphors I see this case as unleashing a can of worms. Let me just throw out a couple of things for the group. No requirement of a misrepresentation which may have interesting implications in the credit card NSF check cases. No requirement of reliance and as I understand it the debtor in the case where the debt is declared non-dischargeable was not the individual who originally incurred the debt. It's the sibling of the original debtor. That point doesn't bother Judge Posner for long because he said that the debt that ran from the bankruptcy debtor Cantrell to McClellan arose when she became the recipient of a fraudulent transfer which was not a constructive fraud but an actual fraud. So the debt that she owed did originate with a fraud. So if the original debtor files the debt is not, it is dischargeable because it's just an ordinary contractual claim but if the transferee files the debt is non-dischargeable. Judge Posner hints that even the brother would have had a non-dischargeable debt had he filed because when he made the transfer it was a transfer in actual fraud and created a new debt and that debt would have been only the size of the value of the collateral transfer or the property transferred not the total debt that was originated on the sale of the machines in first place. Is it that 523a6 and not 523a2 are we under the wrong provision entirely? Well that's what the concurring opinion by Judge Ripple suggests. I find that opinion equally unsatisfactory because in dealing with that he assumes an injury to property which at least historically again if you go back to the common law antecedents of that it was in conversion and in conversion there had to be some demand made and so there probably wasn't a demand made so there are probably elements of conversion that are lacking which would have gotten it under a6 but because that's only a concurring opinion you don't have to analyze it. We have plenty of cases that suggest when you sell collateral out from under the secured creditor and is there demand there? Haven't we already severed this link to demand? We may have. But you know that perhaps if you think about the fraudulent conveyance statutes and in terms of the way that a the remedy under those fraudulent conveyance statutes and whom they can pursue it has a parallel line with these because it basically says that the creditor can sue the transferee and ends up with a judge can go a number of different ways but one of the things they can do is get the judgment against the transferee for the amount of the fraudulent conveyance so that's sort of inferred in some of this in a way. Theoretically as I was thinking this through it was possible that you could have an innocent transferor but a fraudulent transferee had the brother merely wanted to get rid of these machines and had no real intention maybe he didn't understand the value in some sense was innocent but the sister had in fact hated McClellan for a long time and recognized a potential that her less thoughtful brother didn't see then we could have a situation where the initial transferee or the transferor was innocent but the under Judge Posner's reasoning the ultimate transferee was It starts you down those tracks That's what it does Well and Judge Posner suggests that this does not apply to constructively fraudulent That's right There is an example where by his very reasoning it would What really worries me about this opinion is the emphasis it puts on the debtor's intent it seems that all that's left after Judge Posner's analysis is that if the debtor has a negative intent and carries out any act in furtherance of that which creates a debt that debt would be non-dischargeable and that's quite a long way from what we all thought was common law fraud before you know it's a comfortable outcome in the Cantrell case it's sort of like how it finishes but if it's carried over into the credit card area we have a whole new world because so much of the recent credit card case law has focused either on the nature of the representation made or on the nature of reliance on whatever representation was made and it's at least arguable that both of those elements could be taken out of the equation by having the creditor merely allege that the debtor never intended to pay and in furtherance of that intention use the credit card I'm troubled But what's wrong with that? I mean isn't that the way the cases is supposed to come in? I mean if a person has no intention to pay they use the credit card then the debt should not be dischargeable I mean the issues that I see is where the debtor can't pay but doesn't know they can't pay any reasonable person would know that they couldn't pay but you look at that debtor's intention and if the debtor really thinks they can pay even though any reasonable person would say that they can't pay then the debt is discharged Well Tom I think that what you're pointing to is one of the other things that concerns me and the intention I agree with you completely where the intention is clear Intention however is very hard to prove and is almost always proven by circumstantial evidence and in fact fraud is one area where we have a great history of how to prove intention through the badges of fraud first there were the historical badges of fraud that most of us learned at some point in our law school career which had to do with rendering the debtor insolvent and transfers to a family member and transfers for less than adequate consideration and typically they've said that that no one of those alone will support a finding of the intention to defraud but if you get enough of them a presumption is created which then has to be rebutted so that's the way it works In the bankruptcy context I think we've had a sort of a growth of a new group of badges of fraud much more credit card specific which have to do with the amount of balance whether a notice of overuse has gone out or whether the use of the card has been restricted in some way and things of that nature Whether they've been to see a lawyer Yeah, whether they've been to see a lawyer and some of these badges of fraud are quite different from the historical badges of fraud and I guess one of my concerns is that if we use the badges of fraud to come to the intention then instead of having a debtor with a negative intention acting through the use of the credit card we'll have a debtor who's presumed to have negatively intended something because of a certain group of circumstances and then uses the credit card and that is not as comfortable to me as a direct finding of actual intent One of the things that troubles me is that we have a field remands which was a real estate deal and we now have this McClellan-Vecantrell case that is a fraudulent conveyance situation perhaps making the law making the precedent for the typical 523A2A case which is a credit card case How do you take precedence from such different factual areas and move them into something that is sui generis? Well, let me expand on that point because that's what worries me too Well, this may be Judge Martin as you alluded to earlier just unrealistic whimsy by law professors but my concern is that by taking away the neat set of requirements that we thought had pertained we've allowed the creditor to stay in court on these issues I mean, we've opened up the door to make them non-spurious claims at the outset and when you look at who has the resources and the capacity in this litigation we've put debtors at a terrible disadvantage with this notion that any artifice, trick, or device there's such nebulous open-ended terms that I just think it opens up the door to a lot more litigation In McClellan versus Cantrell there was no citation to credit card cases and there was no indication that the Seventh Circuit was thinking in that direction at all so I don't know, I agree with you that it's a problem or at least a potential problem because of the difference in bargaining power of weight in the courtroom that a credit card company can bring if they can make a plausible argument and not be subject to a 523 recovery from creditors for bringing an unreasonable case and I am fortunate, D, yeah, 5.3D then I think they're gonna feel a greater freedom to bring these we've already seen that we've already seen them using these cases as leveraged to get settlements dropping the cases in the few instances in which the debtors demonstrate they're ready to try it and the creditors pull out because they weren't able to leverage their reaffirmation or their settlement and Judge Posner may not have seen the credit card connection I don't wanna put them on the spot but I bet David's bank clients will sure, well, from a pure profit point of view watching the dischargeability claims and they turn into a certain number of dollars realizing under what set of circumstances they've historically been worth bringing if they can move this, move this logic to that vast volume of credit card debt and just make a small difference just make a small difference in how they leverage it when a few cases in that regard then it will make kind of a macro change in that regard so an interesting and troubling case and I guess we're not gonna see the full implications of it for a while well, it may be limited to the seventh circuit by other decisions but there's also a chance that this is one that could go to the Supreme Court and the other tying it to the first topic I think one of the most interesting things and all of this is as financing patterns change with consolidation of second mortgages or thirds or whatever they are and with just the huge increase in credit card lending over the last 10 years or whatever we now see the language of the bankruptcy code put against these enormous billions of dollars coming in where the stakes are very high and the beauty of the code and the job of the judges is to figure out how to take that language and make it work and do what's fair and comply with the statute as these lending patterns change well, you make a good point in any individual case the stakes are quite small but in the aggregate for the credit industry the stakes are enormous which is why there's the willingness to litigate the uneconomical individual case for the broader precedent so maybe more to come on this one I certainly think so Thank you Judge Byron, appreciate it we're gonna turn our attention now to a couple of business law topics having done a couple of consumer topics we're gonna begin with an issue that is a contemporary issue and it's been an issue Judge Small I guess in the case law for some time we all know that the sale of significant assets in chapter 11 can occur in really one of two ways the traditional way through a plan of reorganization but also through a section 363 sale obviously the procedures, the rigamarole one goes through under 363 is not nearly as complex and as daunting under 1129 and so there's an enormous temptation to look to sell substantial assets under 363 in light of that what limits ought to be placed on the sale of substantial assets outside the context of a plan? Right, this issue has been around for quite a while the two leading cases Lionel from the Second Circuit and Brana from the Fifth were decided in 1983 the dissent in the Lionel case, Judge Winner said that the language of, you couldn't find a language that's planer than 363B that you can sell the property and he says that courts should not be grafting stringent conditions on those sales whether it's in chapter seven or chapter 11 but that's exactly what courts have done in the Brana line of cases that it holds that the sale can't be a substitute for the plan or it can't be an end run around the plan requirements or the protections that chapter 11 creditors would have. The Lionel line holds that there must be a substantial business justification for the sale and there have been a lot of cases both allowing sales and disapproving sales and they list a number of factors sound business reason or an emergency depreciating value has to be proposed in good faith adequate reasonable notice and a fair and reasonable price now sometimes it's pretty hard to get a handle on those standards and it gives the court a lot of discretion and you may find a lot of diversity from court to court around the country on what sales are allowed and my own opinion is I look at really two things and that is has there been sufficient notice and I'm not talking about we're gonna sell the assets for X dollars I wanna know the circumstances the true circumstances of the sale so like you might see in a disclosure statement and also I wanna be sure that the debtor is not trying to do an end run around the protections of chapter 11 that's basically what I look for my feeling is when a debtor files chapter 11 they get tremendous benefits they get the automatic stay and virtually unfettered control of the assets on the other hand creditors get some protections too they get the right to vote they get the right to disclosure confirmation hearing plan scrutiny and absolute priority rule and in our circuit at least under Bryson properties the new capital exception to the absolute priority rule so that's what I was thinking Judge, how do you identify an end run around a plan? What does that look like on the ground? Well, it's one of these things you know it when you see it I guess but it usually involves an insider transaction where an insider is trying to sell assets to a friend or to themselves and we see this a lot in the high tech industries where you see companies that have spent all this money developing a product then they go into chapter 11 and try to sell the product to basically to themselves the insiders now that happens in chapter seven too but at least you know that the chapter seven trustee is trying to get the best price you don't always have that situation in chapter 11 A dynamic that I've observed in a couple of cases I've had but may not be generally applicable is that the debtor comes in usually in a very down market for their particular product and maybe for their whole enterprise and at that time they see any offer they can get for these assets to be quite good offer and often is presented early as an emergency we gotta sell now or the market's gonna collapse and at least in those instances where we haven't sold and it's dealt with communications one time it was television stations another time it was radio or telephone bands the market's reversed itself after the sale has been refused and strangely enough they were coming back not wanting to have sold and coming up with competing plans to produce a whole lot more money so I think one of the dynamics is that the debtor is often so desperate at the time they come in that they're presenting things as if that's the only sale they'll ever get and the creditors will get nothing if they don't sell now and how to deal with that emergency where you really can't predict what the market's gonna do in these areas the other language and I like there's a book about these sales I think it's asset sales as Richard Tilton's a wonderful book in this area he uses the phrase creeping plan that's the phrase and he uses it in a number of ways one of the things he talks about and if you look at Braniff I think is that the proposed sale motion also says how you're gonna distribute the assets it says more than all the money he's gonna come to the estate so it's interesting because some of these three issues move in that direction and that's one of the things that judges struggle with well they say creeping plan plan subroza have a lot of terminology all of which suggests that there's some improper manipulation of section 363 but I wonder and Judge Small you're the perfect one to ask whether or not in point of fact the ability to sell substantial assets in 363 in a small business case is a way of dealing with some of the problems that the expense and cumbersome procedures in chapter 11 going through the plan process makes chapter 11 very unattractive for small businesses well it certainly is more efficient to do it under 363B and it's cheaper and you can do it faster but my experience is you probably have to be more vigilant in the small case than you do in the large case because you have no creditors committees essentially in chapter 11 small business cases you've got a creditors committee in the large cases and also there's more opportunity for mischief with the insiders in the small business case than there would be in the larger case and it really makes a point I've been trying to make for years is what we need is a separate chapter for small business cases modeled on chapter 12 where you have a supervising trustee that looks at sales for instance in chapter 12 one of the chapter 12's enumerated duties is to appear and be heard with respect to sales of property of the estate you don't have anything like that in chapter chapter 11 we talked about n runs is it potentially also and run around 203 North LaSalle when you have insiders purchasing substantial assets would you now read if you have insider purchasers that you have to expose the company or the assets to some market test of value well certainly in the fourth circuit that's one of the tests that you'd have to meet you'd have to expose it to the market on the pricing properties and I would think that the property if it's going to be sold on the 363 it would have to be exposed to the market it's interesting what that means one of my experiences i think you know they often talk about chapter thirteen being so different among the different districts but truthfully i think 363 and particularly how much you have to uh... place just to demonstrate that the markets is really seen what the opportunity is here the difference in what judges require around the country is quite extraordinary in terms of some districts where they have a lot of these sales a very clear set of rules and not necessarily local rules that have been published but if you call local law you find that there's a very specific ways of doing it in the vast majority of districts where this doesn't happen all that much you find some districts where they require you to put the disclosure statement together and show what would happen if it would if we're liquidated much like you do in the disclosure statement on the plan where you show the liquidation analysis but i think from my point of view if you're not distributing uh... assets differently really comes back to how much you test the market for it you know have you really done what you somebody would expect uh... broadly see whether this value and obviously if it's an insider purchasing it it's it's even a higher standard seems right well it seems to me if there's if there the sale is pursuant to a bidding process i mean that that's one thing but when you're selling to insiders you really need some independent third party to give you some uh... evidence that this is a good transaction uh... maybe even pointing an examiner for that limited purpose or uh... appointing an expert witness to uh... to tell the court that this is a like you say it's hardly a place where it's more important to know your judge the local legal culture can be one in which the creditors even if they're not formed as a committee will object to the sales for any number of reasons in the judge will in the absence of an objection give little scrutiny in other courts the judges give tremendous scrutiny regardless of creditor action and and you just have to know what court you're in one of the sweetest things about this me is here's where three sixty three probably uh... is in a sense fairer than the plan because in three sixty three the judge is going to say what have you done to sell this business but truthfully if you put that plan together very quickly in a case you put a plan together very quickly to sell minor inside involvement so some but not major that plan and you've got dollars coming in and it's in the early stages so that you're still got the benefit of the exclusive period you're probably gonna test the market a lot less then you're gonna test the market it will require to test the market in a three sixty three sale so it really turns it upside down in some ways it sounds to me as if you sell it if you are selling major assets three sixty three you're really converting it to a liquidating plan because there won't be anything left to it's often what it is sometimes it converts and sometimes it's a liquidating plan but why is it that in so many of these cases um... Cajun Electric uh... the Condere case that that cited new materials uh... judge that one of the assets being sold is the company's claims against its officers and directors well the question of this answers itself the people that are controlling the sale maybe have ulterior motives they want to uh... get rid of their own personal liability and i think you've got to be be very careful about releasing those claims go ahead if you're a buyer in that situation and you're really a good faith third party buyer you're really in a very complicated position because and the lawyer for the debtor is in a very complicated position because now the buyer is saying i'd like to buy it i'll pay you know two million dollars or a hundred thousand whatever the number is to make that much difference it appears that that's a good track to be on you have the directors of the shareholders of the owners the closely held business saying well i'm not gonna let the sale happen unless i get off the hook so then the the we've seen some examples of what debtor's council has to do is basically here she has to really understand the fiduciary note your nature talk to their client and say you know you you are the board of directors and you could fire me but if you do try to fire me over this you're in trouble we've even seen some examples in the larger cases the threat is to replace the board with a responsible party under section of the bankruptcy code and it's a very interesting interplay if you if you if you're a good faith buyer in that circumstance to make sure that the the owners may be entitled to something but to make sure that what they're getting is is is not more than is is not being sort of drained away from the estate well i guess this is uh... an area as well that that's not going to be settled anytime soon there's so much strategic behavior that yeah potentially attends these sales there's been i guess some discussion the cases in your outline judge about for the fact we have three sixty three m that says that even uh... there's a decision on on appeal contrary to the approval of the sale that you protect uh... the uh... purchaser some parties have found that that makes this a a pretty attractive way to structure claim settlements uh... d if you've seen that i have seen that and there's a case the uh... presale case uh... that cited in the materials where uh... i guess it was the chapter seven debtor wanted to uh... uh... the trustee wanted to settle a claim that the debtor had against his employer and uh... that was settled as a sale and they uh... and therefore unless it was state pending appeal it would not be reversed on appeal i i had a situation like that where in chapter seven trustee wanted to settle the debtors claim against the employer and uh... the debtor objected saying no the forty thousand dollars that you want to pay for the claim is is uh... too low so i said well let's have an auction here and we'll have uh... seal bids and the debtor came in and bid a hundred thousand dollars to buy that claim ultimately went to court and he lost where does the debtor get a hundred thousand dollars to bid for a claim well that was an issue in the next bankruptcy generous exemptions these days in north carolina i guess uh... well an area again that uh... i guess we'll all be sensitive to we uh... we want to turn out uh... to uh... to david lander and uh... our our final uh... topic uh... dealing with a subject that's confounded the rest of the panel uh... but that david seems to have uh... mastered so uh... we all hope to learn something and i'm talking about asset securitization and the reason that that we believe this to be a timely topic and david will be talking about it but one of the uh... one of the goals of revised article nine uh... is to make uh... the world uh... safer more comfortable place for asset securitization uh... so if i might uh... ask you to indulge us and maybe start off by describing of basic asset securitization transaction and then we'll try to take it from there sure thanks sir first of all asset securitization is a pretty intimidating term i mean it just it just it's got a lot of syllables a lot more syllables than we normally use and so and so trying to move through it seems uh... i think it seems more difficult than it than it really is so let me first uh... let me break it down and let me compare it with traditional lending and uh... that one of the i think i named my paper what is asset securitization and why should a bankruptcy judge care so we'll also try to as we move through to show why the bankruptcy judge should should care traditional lending you've got uh... uh... uh... enterprise that needs some funds so i'll call that the fund seeker we usually call it the borrower and then you've got somebody wants to lend them some money funds provider or the lender so in a traditional situation uh... they're arguing over how much they're gonna borrow much they're gonna land and what the cost of it's gonna be what the interest rate is going to be what fees are or whatever traditionally what's happened is the uh... lender says okay i'll lend you a hundred thousand dollars and to reduce my risks i'm going to take a security interest or a mortgage what assets do you have and i want to be able to uh... get ahead of everybody every head of everyone else with regard to those assets so i'll take a security interest or a mortgage in those assets the borrower will continue to own the assets and use them the equipment counts receivable inventory real estate whatever it is but if there's a default the lender has some special rights the lender has a special rights so that's the traditional situation with asset securitization and let's let's build to it in a couple of steps what the funds provider says is let's do this a little differently instead of us taking a security interest suppose that tell us what you have that's gonna turn into cash and they say well we have uh... accounts or chattel paper will start with those and uh... and and then the uh... funds provider says well why don't i buy that why don't i buy those assets the chattel paper and the accounts receivable from you and they'll sell the liquidate they'll turn into cash and in fact we all probably know about the industry called factoring which has been around a long time which is the first building block to get the asset securitization in my view and so we say in a factoring situation the factor actually bought those assets bought the accounts receivable or bought the chattel paper paid some money and uh... when about its merry way now securitization takes a couple of steps further securitization says the asset the funds provider doesn't really want to own those uh... these accounts receivable or chattel paper or whatever it is anything that's going to turn into cash so they say i'm gonna organize a new company i'm gonna organize a new company and sole purpose of that company is to buy these cash producing assets from you and i'm gonna organize it in a way and make it really hard for it to file bankruptcy i'm gonna have a whole lot of bells and whistles and independent directors and maybe make it a Delaware business trust or whatever it is to make it very difficult so i'm gonna organize a new company i'm gonna make it as bankruptcy remote as we can and then how am i gonna get money for that company well the word securitization really means we're gonna take this new company and we're gonna sell it to financial institutions or the public and we're gonna tell them what they're gonna buy is they're gonna buy a company that owns these cash producing assets because it bought them from the borrower at the end of the transaction what we see is that we used to call the borrower the funds seeker we look at their balance sheet they no longer have their cash producing assets they never along no longer have the the the the accounts or chattel paper or whatever or the other kinds of things that produce cash they haven't instead what they've been paid the new company uh... is owned by whoever provided the cash and what they own is these are these cash producing assets and they are in a bankruptcy remote entity so that's that's the uh... sort of the typical now it's there's some other ways of funding i mean you don't have to just sell it to the public there's some other ways of bringing the dollars in but if you look afterwards you see a difference in the balance sheet of the borrower uh... from what you saw in a traditional asset uh... a lending situation so initially the issue is going to be if the funds seeker my party is right funds seeker files has financial problems and and files i guess the first and and the principal bankruptcy issue that we faced is whether or not those assets even if secured whether or not they're part of the estate at all yes and uh... let's look at that for a second because um... the asset securitization industry has grown as as you say in your in your question extraordinarily and it thinks it can grow a whole lot more there are a bunch more provoked on providers are in these cases funds facilitators because not even their money the person that's putting the uh... fund seeker together with money so so one of the goals of this thing is to be able to say to the fund seeker we can get you money at a lower cost and in greater amount we can make sure that if you go into bankruptcy in your business fails then what would be cash collateral on a bankruptcy you don't own and has been effectively sold and sold is the key word here effectively sold to this new company which has very limited business activity so you got a busy operating business over here that in the sense if you look at their balance sheet the fuel for what would be their chapter eleven if they went into a chapter eleven if they needed to and that is the cash collateral pool is extraordinarily thinner than it would be in the traditional borrowing situation what what brings us all here really is uh... the revisions to article nine and let's talk about those for just a minute revised article nine which is intended to go to and to affect july one two thousand one it's now been adapted adopted i think by twenty seven states even though it's been adopted them it's not going to affect until july first two thousand one that's in order to get everybody on even starting time and a lot of other states are you know considering it or or whatever so uh... likely a lot of states are gonna uh... have it by the time it goes into effect so asset securitization industry and the lawyers that represent them have been focusing on how they can make security state make the world safer for securitization as you said and so they come up with a couple of ideas they've actually gone to congress and there's a bill out there that basically says let's have congress say that the stuff that's been sold from the operating company to the new company ain't property of the estate the financial contracting netting improvements act in nineteen ninety that might be the name of it as you know this this one thing about this industry is intimidating uh... and so so staying on on this issue uh... first there's two major kinds of changes that article nine provide revised article nine provides staying with the issue of quote property of the estate we all know we start with the bankruptcy uh... casebook trying to figure out the role of state law and federal law in in what is property of the state is one of the most interesting and also one of the most confusing areas there is so what what what happened some years ago there's a case in the material called the octagon case it says uh... article nine go back a second when article nine was adopted article nine article nine's job is to provide certainty to secured lenders it's job was at that time there were twenty different ways of of providing security interest conditional sale, chattel mortgage field warehousing, account receivable financing and a lot of others and so article nine said uh... let's provide to a potential lender certainty and so if all kinds of lenders can come in and they can know that if they follow the rules the rules for making it enforceable between the lender and the borrower the rules for perfection so they can beat out the bankruptcy trustee and subsequent uh... lien creditors they'll know who they beat out and they'll know their priorities if there's other secured creditors, they'll know the rules for enforcement and all of that the genius of article nine was bringing all of these in and uh... they're extraordinarily successful now as we'll see in just a minute they left out some areas article nine applies as we all think to security interest in personal property but coming back to what i said about factoring the drafter said well we're going to bring in conditional sales why shouldn't we allow the factor who's providing a parallel uh... providing the dollars to feel just as comfortable as a traditional secured lender and they scratched their head and said how do we do that so they said let's make article let's make to find article nine security interest such that article nine applies not only a traditional sales and taking a security interest, a traditional security interest, but to certain limited sales to sales of accounts received accounts and sales of chattel paper and the purpose of that was to provide the same level of certainty to other kinds of secured lenders as they provided to factoring and it worked pretty good now there were two complications and i'll try to take them separately first is the first is what they what the exception in article nine for covering sales is very narrow to accounts and chattel paper so the asset securitization industry came along and said you know we want a lot of other things to be securitized between besides just what's defined as accounts and chattel paper so the first thing that the drafters did was they said okay we'll open the doors broader more broadly and they said okay now we'll redefine accounts so that the definition is much broader takes in some license revenues and all kinds of things that weren't in all kind of accounts even broadened the definition of chattel paper a bit to make an electronic chattel paper and we'll say that sales of promissory notes will also be subject to article nine and then we'll carve out from the article nine definition of general intangible a subcategory called payment intangibles and say that and uh... these are accounts plus or maybe what we thought of as contract rights they have a little bit like executory contracts uh... to them and they're basically what i'm calling was cash collateral producing stuff that they own so almost any asset that you might securitize will now be or come to lie one covered by revised articles yes the sale of those assets there's patents and trademarks and some specific kinds of intellectual property they chose to leave out but uh... they brought these in and and the reason that they asked that securitization people needed that so much or sought for it is they said you gave secure regular secured lenders certainty you gave uh... factors certainty but you didn't give us certainty and it's interesting because the state law that says if i buy the uh... these these various kinds of assets how do i know i'm protected from later leon creditor of the seller or a subsequent buyer all the same people that article nine provides the answer prior to the revision and this had a limiting effect on securitization was the laws uncertain because the sale of those items was not with it was uncertain and be was non-uniform it was very confused it would be non-uniform non-code law that would govern is that where octagon gas came in because it looked at the link between the seller of those uh... asset producing intangibles or whatever whether you could isolate the that that entities bankruptcy sure in in in the following way this is all about remember the provision of funds for a fund seeker and the cost okay so what one change the asset securitization people wanted was greater certainty in uniformity and they said they could lower the price so and revised article nine basically gives them the second issue the octagon cases even is really much more interesting it goes back to larry's original point of property is it property is stuff that was sold property the estate or not article nine both old and new mostly cover security interests and really defines its coverage of sale in the definition of security interest so what octagon and some other cases said women if the seller sold all of this cash collateral producing stuff to this new entity but the protection that's offered against the bankruptcy trustee and others is offered in the context of protection that's offered to a secured creditor and the sale the the protection is the protection is offered to a secured creditor is it really a sale an octagon said no they said it didn't take the cash collateral producing assets even though they called it a sale and move them to the bankruptcy remote entity and in fact it there's still there so this was at the second prong of the enormous challenge for the revisionist and what they've tried to do here is is is quite fascinating and very very complicated and there's a big dispute there's two articles that came out recently ray warner has one in the american bankruptcy institute journal and a guy named paul shupack has one in the bankruptcy law journal here's the fix they gave they gave fix of two kinds in the statute they basically said the drafters revised article nine that if you sold this stuff you don't have any more rights in it and they put a comment in another section that said we really want to overrule octagon and we don't think it makes any sense and even though this sale called a security interest it's really a sale problem don't fool with it so ray warner's piece says they fixed it paul shupack who was one of the key drafters of these provisions he says just the opposite he says that by because they weren't able to totally separate sales and security interests in article nine and they're calling a sale of security interest that the first set of cases will all be on whether it's part of the property of the estate and i called paul in preparation for this because and he thinks although he might agree with the their understanding that they just couldn't fix that problem in article nine the way they wanted he thinks that when you ask most judges to look at this situation or when you ask a lot of judges to look at it they're gonna say wait a minute you mean to tell me that you want me to find that this sale was so complete that it is nothing left in the seller even though the law that covers the whole thing and that provides protection for the buyer is article nine of the ucc that covers security interests how can that be so there's still a fact question potentially did the debtor retain any interest any of the bundle of sticks that comprise that asset and octagon is not dead and there's so much control left in the debtor with regard to these assets i mean they're generating the accounts they're they're working i mean this is the cash into the business and what the business does is going to have such an influence it's really hard to separate that to say that the debtor has no way no longer any interest in that part of its business and these transactions are structured with that in mind so as technically as much as possible talk about whether it's recourse or not recourse we talk about who's gonna be the collection arm for these things we talk about all those pieces so they're structured in a way to try to make them as clean as possible but it's a practical matter uh... it's it's it's it leaves a residue of facts that that may not provide the certainty because this is all about certainty so we have now all these cases where you try to determine whether something's a true lease or a security issue so we're going to have the same thing with all these different factors and the stakes are a lot of zeros against them that's a very good analogy that i hadn't thought about but we could really we could see that but isn't the securitization industry still better off because at least now the quote unquote sale of financial assets other than accounts and share even if it's still a security it's still under article nine which means the rules on perfection and priority are still quite clear and while they would rather be a buyer in completely remote from the bankruptcy proceeding still better to know to be a fully perfected protected secured creditor in the bankruptcy and be subject to the vagaries of non-uniform state law so there's still an advance in the uh... revised article nine from the perspective of the securitization industry absolutely and it helped demonstrate the two different kinds of changes that revised article nine makes one is it does provide great if we look at article nine if we look at it provides much greater safe certainty in all the issues that you talk about the real question is since bankruptcy allows use of cash collateral uh... use of cash collateral against the will of the secured creditor of adequate protections provided and it allows crammed on under eleven twenty nine b uh... so that they can change the bargain if you need to separate out these two things the one thing that is clearly they've clearly done successfully is to say that the normal article nine protection absent bankruptcy is an extraordinary improvement for assets that weren't covered prior to article nine and it may turn out that the changes uh... overruling octagon end up getting there too it's just that that's an additional improvement that they seek that will just have to wait and see what happens on david are we going to know whether this works when the uh... securitization uh... the entity the fund provider that's participate in securitization declines to participate in the carve out for the professionals in the chapter eleven well you know that's a great question because one question will be we might know that it works because these companies are not filing chapter eleven because they feel that the fuel the cash collateral producing assets are so thin and the chances of those initial fights will destroy the opportunity but that there will be some cases in which they will file and the battle will be fought that way or substantive consolidation or fraudulent conveyance the other issues that are out there in the revision process is they understand the banks had some concern about this vast expansion in coverage because almost by definition picks up transactions that are not really security interest and not really asset securitization things like loan participation and ultimately there was some compromise or adjustment made in in revised article nine two to appease the lending community that they would not have to go through uh... the expense and dislocation of filing financing statements and the like for for true loan participation transactions how did how did that get result that was an interesting compromise once again we have to put financial institutions into several categories because it pitted the asset securitization industry against traditional lenders who say if i lend two million dollars and i'm a small bank maybe i want to sell some of that off to smaller banks are alternatively it's a really big loan and they participate the loan out and they didn't want to have to file and they thought they were uh... covered by what we call a payment intangible payment intangible so the compromise was this with perfection for payment intangibles perfection for payment intangibles is automatic under revised article nine that means that in these in these loan participation issues they're automatically perfected so they don't have to take they don't have to file have to do anything else now it does create an additional challenge though because since there isn't two challenges there isn't a public record and therefore if somebody comes to a uh... financial system like to sell you my uh... my payment intangible payment intangibles somebody has to say well i mean i'm taking a different kind of risk altogether that they're really sold to somebody else uh... and uh... and then and then the other issue is i think true purchasers of payment intangibles things people think will because they want to make sure that if that it's re-characterized in some way that they that it's not a really a sale but it's a non-sale security interest that they're still perfect is their provision for protective filing as there is in the current law for leases and consignments uh... there's not a specific piece but i think the notion is that that will likely be done well nothing could stop you from doing it but again the SPV or the investors can't ever be sure because there's no requirement of filing that the assets they're purchasing we're not previously encumbered or even sold i guess right and just to clarify make sure i'm clear in this the uh... sales of of accounts receivable and certain other kinds of property do still require filing just payment intangibles just payment payment intangibles and a promissory notes are automatically perfected i think i may have missed one other category but i think those are the ones all right let me ask you one question uh... maybe maybe an unfair question soon revised article nine is is successful and and and it's uh... it's truly a sale and the assets are subject to and and you have this bankruptcy remote entity and the originator the the fund-seeker as you termed it files bankruptcy and judge martin looks at the situation says i'm in a substantively consolidate the SPV and the and the original uh... or the debtor is that a risk well it's a risk once again it's a risk uh... the picture that that's the picture that the the transactions trying to avoid so typically in these circumstances and we see more in opinions of counsel really than anything else what what you try to do in those situations what they try to do is identify all the factors in substantive consolidation and then as hard as possible uh... as much as possible given the practicality of the business situation uh... put the sit put the transaction together in a way that reduced that that basically uh... takes all those prongs and says they're just not there uh... but that's that is definitely an old a a significant worry i'm sure that's a letter that the price of which will go up well well well let's do you think we're we're seeing how many angels can dance on the head of a pin and point of fact this is reputedly the most uh... rapidly growing segment of u.s credit markets so we think you're gonna see lots more these transactions for for better or worse and and we hope this helps them for balance uh... david mentioned two articles on on the topic which are which are very good ray warner paul shoepack the the other view there is a lower review article that uh... david carlson has done called the rotten foundations of securitization i think of the william and mary lower review so that's that's another view that uh... you can take a look at and david thank you very much we we appreciate it uh... that is our program for today uh... again very much want to thank all our panelists uh... for coming in to help us uh... today to understand these important issues we hope you enjoy the program and found it both useful and interesting and we urge you to please fill out the one page evaluations that are included in the written materials available on our website particularly if you have something positive to say it's the only way for us to know if you find these programs useful and how we can improve them for you for the federal judicial television network and larry ponder off thanks for watching