Court Opinion Review: The Second Circuit’s Purdue Decision, Indefeasible Interim Payments, Liability Management Two-Steps, the Tehum Care Tort Two-Step and a Delaware DIP Denial

Reorg’s Court Opinion Review provides an update on recent noteworthy bankruptcy and creditors’ rights opinions, decisions and issues across courts. We use this space to comment on and discuss emerging trends in the bankruptcy world; our opinions are not necessarily those of Reorg as a whole. Today we consider the Second Circuit’s Purdue nondebtor release decision, indefeasible payment of prepetition debt in Avaya, Monitronics and Diebold, the liability management chapter 11 spree, the Tehum Care two-step “status quo” and a DIP denial in DeCurtis.

Sound and Fury, Signifying Nothing

Last Tuesday, May 30, a piercing call echoed across the land, waking the Court Opinion Review and prematurely ending our three-month darkness retreat: The Second Circuit has finally spoken! And lo, the word from on high is disappointing. Not because the court of appeals affirmed Judge Robert Drain’s decision approving the nondebtor releases in the Purdue plan and tossed the shocking district court decision that secured opioid claimants an additional billion bucks, mind you. Like all good lawyers, our jaundiced eye searches for flaws in Der Proceß, not ’dem outcomes. And the process employed by the majority in the Purdue decision is kind of uninspiring.

It’s right there on the wrapper: The parties, the majority says, “debate the very nature of bankruptcy, including the role it is intended to serve and the parties it is intended to benefit.” That’s the stuff! “But, our role in this appeal does not require us to answer all of these serious and difficult questions.” Sigh.

Instead, Circuit Judge Jon Newman, writing for himself and Circuit Judges Eunice Lee and Richard Wesley, approves the Purdue releases in deference to the fact-finding primacy of the bankruptcy court and sets out a seven-part “standard” for nondebtor releases that adds absolutely nothing to the existing case law on the subject.

The closest the majority comes to the heart of the issue is their derivation of bankruptcy courts’ statutory authority to impose nondebtor releases on the unwilling. Congress granted bankruptcy courts this power, the majority says, via section 105(a) (stop laughing) and - drumroll please - section 1123(b)(6) of the Bankruptcy Code.

Section 105(a)? Sure, but that’s never enough on its own these days. Section 1123(b)(6)? Well, welcome to section 105(a)’s younger brother. What does this amazing, refuge of last resort provision of the Bankruptcy Code provide? What thundering language does it contain to plainly evidence Congress’ intent to provide nondebtors with relief unavailable in class-action cases, deprive litigants of their Seventh Amendment right to a jury trial in a constitutionally sanctioned Article III court and allow bankruptcy judges to channel the claims of sovereign states over their objections?

Section 1123(b)(6) provides that a plan may “include any other appropriate provision not inconsistent with the applicable provisions of this title.” Oh. Well. A boilerplate catch-all provision. That will do, I guess.

But wait: Judge Wesley, whose questioning at oral argument gave us hope for some kind of more fulsome discussion on the “very nature of bankruptcy,” issued a concurring opinion! Surely the Great Concurrer would tear through the reams of bad precedent on the nondebtor release issue and demand that the Article III courts take a stand against the indiscriminate deployment of this constitutionally questionable “extraordinary” relief! After all, Judge Wesley describes himself as “conservative in nature, pragmatic at the same time, with a fair appreciation of judicial restraint.”

Alas, no. Judge Wesley’s concurrence exudes exhaustion at the sheer volume of all that bad precedent and what it forces him to do: “reluctantly” go along with the majority. “Does a bankruptcy court have the power to release direct or particularized claims asserted by third parties against nondebtors without the third parties’ consent?” Judge Wesley asks rhetorically, surely setting up a righteous Federalist Society separation-of-powers smackdown based on some excerpt from James Madison’s diary. “Yes - this Court said so in In re Drexel Burnham Lambert Grp., Inc., 960 F.2d 285, 293 (2d Cir. 1992).” “[T]hat ship has, for better or worse, sailed,” Judge Wesley concludes, rather lamely.

Bigger ships have been dragged back into port against stiffer winds, Judge Wesley. The judge goes on and on about what he might have done if given a time machine, but that’s so much, say, water under the bridge, or a horse out of the barn, or whatever other metaphors the judge rejected in his drafts of this alternative history. Of course, he also implores the Supreme Court to review the issue; good luck with that.

The Second Circuit did make sure to acknowledge the new bankruptcy reality at one point, however. While covering their be-robed behinds against criticism for sanctioning the continuing expansion of bankruptcy court jurisdiction to take control of everything (including some major questions of tort reform policy) without really confronting the issues, the majority warns that for the purpose of determining whether the released parties share an “identity of interest” with the debtors - one of those “new” factors we’ve been applying since time immemorial - the majority warns that an indemnification granted in anticipation of chapter 11 maybe, kind of, sort of, perhaps will not do.

“[T]o the extent that there is a fear that this opinion could be read as a blueprint for how individuals can obtain third-party releases in the face of a tsunami of litigation, we caution that the key fact regarding the indemnity agreements at issue is that they were entered into by the end of 2004 - well before the contemplation of bankruptcy,” the majority says. “Acts taken ‘in contemplation of’ bankruptcy ha[ve] long been, and continue[] to be, associated with abusive conduct.’”

Putting aside the obvious - that by 2004, you can very much bet bankruptcy was at least considered as a way for Purdue and the Sacklers to deal with their already increasing opioid exposure, considering all the mass tort case law to that point - this seems like a jab at the Texas two-step. All those policy issues raised by the claimants and all the damage done to the legitimacy of bankruptcy courts can be swept aside without serious discussion when dealing with the worst public health crisis in U.S. history, the majority hints, but do not sully our dockets with your Texas divisional mergers and funding agreements.

Also, and really this feels like a knee-jerk need to complete the bankruptcy appeal bingo card, the Second Circuit rules quite definitively that releases like those granted to the Sacklers need Article III court blessing under Stern v. Marshall. OK. We heard the new documentary is good.

Maybe the most egregious issue here: The Second Circuit took more than a year from oral argument to issue this milquetoast pronouncement. Even the Supreme Court - which, admittedly, gets to pick and choose its docket - works faster. The Third Circuit’s decision in LTL came about four months after oral argument. The Fifth Circuit’s Highland opinion was about five months after oral argument. The parties in Purdue took the awkward step of begging the Second Circuit for a ruling a year after oral arguments, and the opinion came out a month later.

Do we have to beg? Judge Michael Park alluded to some behind-the-scenes drama regarding delays in the Revlon mistaken wire transfer appeal, and got a rather pathetic mea culpa with tones of “don’t air out our laundry” from Judge Pierre Leval. We are not fans of the Young Turks of Foley Square on substance, but as far as timing, they have a point.

First Day, Last Day

On May 1, Avaya’s straddle prepack plan went effective without much incident after convertible noteholders read out their Sad Script of Surrender at the Feb. 15 first day hearing. But the ramifications of this quarter-pound nothingburger of a case could be considerably bigger than the sparse docket might suggest.

At the Avaya first day, the debtors asked Judge David R. Jones to approve a DIP facility that included a novel provision: The proceeds would be immediately available on interim approval to indefeasibly cash out a $128 million prepetition ABL. The debtors also proposed to send $221 million in an escrow account to another group of secured creditors without any way for the estate to get that money back.

The U.S. Trustee objected, arguing the obvious: Generally, debtors are not given carte blanche to indefeasibly pay off secured prepetition debt at the first day hearing before a committee is formed or more than a day’s notice is given. To anyone reading this less than two years after taking a bankruptcy law course, this seems pretty obvious. The official committee of unsecured creditors’ job is to maximize recoveries for unsecured creditors, and one of the key tools in the committee’s kit is challenging prepetition secured creditors’ liens and claims.

If a secured creditor gets paid in full before the committee is even appointed, without any chance of clawback should the committee find, say, a perfection issue, then unsecured creditors have been deprived of their opportunity - however long a shot it may be - to claim some of that money for their constituency.

This is why interim DIP orders include all that boilerplate about the UCC having a challenge period and challenge budget and any payments of prepetition debt under the interim order being subject to clawback: to avoid the obvious due process implications of sending $128 million in estate assets to potentially unsecured creditors before the committee even gets its boots on.

The debtors and the RSA parties responded with the usual: The indefeasibility of the ABL payoff was an integral part of the DIP deal, and removing it could cost the debtors their financing and lead to liquidation. You guessed it - the “parade of horribles,” our very own Frank Stallone.

Judge Jones went along, of course, saying he had “no problem” with the indefeasible payment of a secured creditor before unsecured creditors could investigate the validity and extent of their liens and claims. The judge undertook a careful balancing of the equities and considered the limits of debtors’ emergency first day authority - sorry, I can’t even bother to pretend anymore - he cited the “carefully constructed structure” of the DIP deal and said that “the market is working as it should work,” which was both irrelevant and a real wake-up call for Keynesian economics.

The judge did not add that he would approve this extraordinary relief just this one time, only here, just this once, because that’s the difference between the Houston complex panel and the Second Circuit - the Houston gang feels no need to hedge, no matter how half-heartedly, for problematic precedent once it is set in ink.

Well, maybe we are being too harsh on Houston. After all, Judge Christopher Lopez, the new man on the panel, at least bothered with the judicial window dressing when he approved similar relief at the Monitronics chapter 22 case first day hearing on May 16.

This time, the straddle prepack debtors asked for authority to use DIP proceeds to indefeasibly pay $294 million in super senior first-out exit loans from the company’s prior bankruptcy. The U.S. Trustee again objected, pointing out that if the payment of that prepetition secured debt is indefeasible, then the interim DIP order challenge period for any UCC is “superfluous.” On cross-examination by the UST, the debtors’ financial adviser specifically confirmed this.

How did the debtors respond? You guessed it: the parade of horribles. The indefeasible payment of the first-out debt is an integral part of the DIP deal and yadda-yadda chaotic value-destroying liquidation. Of course, they also cited Judge Jones’ approval of the indefeasible payment in Avaya!

Unlike Judge Jones, Judge Lopez took every effort to make it appear he was taking the UST’s objection seriously, going so far as to take a break and consider the matter before issuing a ruling approving the indefeasible payment. The judge also took pains to make clear he was not relying on the Avaya decision; every case “is viewed differently,” Judge Lopez remarked. Okay. Anyway, the judge said, Monitronics needs the money, and the money has this string attached, so I’m fine with the string.

As any bad journalist knows, three incidents makes a trend, so: On May 30, Diebold announced a restructuring support agreement, straddle prepack plan and proposed DIP facility that contemplates the payoff of a $219 million prepetition ABL and $400 million prepetition superpriority term loan (including a related make whole premium) from a refinancing transaction that closed in December 2022, just six months ago. On June 1, the debtors filed in Houston, which, of course.

Predictably, the proposed Diebold interim DIP order authorizes the debtors to use interim DIP proceeds to “indefeasibly pay in full in cash Prepetition ABL Obligations” and “indefeasibly pay in full in cash Prepetition Superpriority Obligations (including the Make Whole Amount).” For some reason the proposed order still includes the “superfluous” UCC challenge provisions; old habits die hard.

At the first day hearing on Friday, June 2, Diebold sold Judge Jones on the immediate rollup as the debtors’ idea, rather than the lenders’. Presumably the lenders did not object! Unsecured creditors did not object, because they just received notice of this case a few days ago.

Judge Jones duly approved the indefeasible “interim” repayment without any issue but, in characteristic fashion, then solemnly chided the debtors for trying to give the DIP lenders a lien on the proceeds of avoidance actions on the first day. This being a prepack with trade creditors paid in full, those avoidance actions will almost certainly never be brought, but a judge has got to pick his battles with the debtors’ bar.

Judge Jones also remarked that the DIP financing is expensive, including a backstop premium of 13.5% of reorganized equity, an upfront premium of 6.5% of reorganized equity, an “additional premium” of 7% of reorganized equity and a “participation premium” of 10% of reorganized equity. To alleviate his concerns, the judge put off approval of these exorbitant fees for at least a few days to allow for notice and an opportunity for other creditors to be heard.

Just kidding! Judge Jones simply asked Diebold CFO James Barna to confirm the DIP “is a plus from the company’s side.” After Barna responded in the affirmative, Judge Jones, rather than following Judge Lisa Beckerman’s example and questioning Barna using his extensive experience in the field (see below), said he would “have to accept that.” Astounding Barna did not crumble under that kind of intense cross-examination.

Keeping Up With the Joneses

Yes, that subhead is a bit on-the-nose, but with all these new chapter 11 filings that’s the best you’re going to get. Way back in February, we suggested that the hot new bankruptcy two-step involves a “liability management” transaction - often an uptier exchange - followed by a chapter 11 proceeding designed to secure bankruptcy court approval (well, Judge Jones approval) of the deal.

At the time, we focused on Serta and Revlon. We called the Serta debtors’ adversary proceeding asking Houston Judge Jones to bless the company’s 2020 uptier “a summary judgment motion on the claims previously upheld” by U.S. District Judge Katherine Failla, “presented to Judge Jones as an immediate must-have for an essential, time-sensitive ‘retail’ reorganization.”

We noted that based on Judge Jones’ initial comments in the case, “it became pretty quickly apparent that Judge Jones is going to decide the claims against the nonparticipating lenders, and fast.” Although we endorsed the idea of bankruptcy judges refereeing a little bit of creditor-on-creditor ultraviolence among sophisticated parties, we worried about Judge Jones’ “casual rejection” of a New York district judge’s prepetition decision on the open-market purchase issue and “his repeated insistence that the matter is ripe for summary judgment before anyone has filed a motion.”

And lo, it came to pass: On March 28, less than two months after the debtors filed the adversary proceeding, Judge Jones granted their motion for summary judgment on the open-market purchase issue, rejecting Judge Failla’s prepetition determination that the phrase “open-market purchase” is too ambiguous to rule for the company and participating lenders on the nonparticipating lenders’ breach of contract claims as a matter of law.

Judge Jones’ “reasoning” for his decision confirmed that he had made up his mind pretty much as soon as the case was filed, as he really just reiterated his vibes-based first impression from the scheduling conference on Jan. 27. In his oral ruling on March 28, the judge remarked that unlike Judge Failla, he deals with credit agreement disputes “every single day.” The parties, too, “do these transactions every single day,” Judge Jones suggested.

“For the nature of what was being transacted, it fits within the definition of an open-market purchase,” the judge said of the Serta deal. He added that the decision was “very easy for me,” which is really kind of breathtaking even for us, the most cynical of the cynical. Judge Jones did allow the nonparticipating lenders’ good-faith and fair-dealing claims to proceed - but more on that later.

Again, we have no beef with Judge Jones handling this dispute, and we think it absolutely makes sense for bankruptcy courts generally to do this. But by all-but-formally prejudging the issue and then following up with a “trust me, I know credit agreements” ruling, Judge Jones sent a message to potential debtors that they could always get away with these deals.

Yes, predictability is good, to a point: Uncertainty over judicial rulings can actually foster compromise and settlement. Remember Purdue? According to opioid claimants, the Sacklers never bent from their petition date offer to settle the opioid claims. Why? It’s not hard to make the leap that it was because they knew very well Judge Drain would confirm a plan based on that offer over the claimants’ objections.

But after U.S. District Judge Colleen McMahon reversed the confirmation order on appeal, a level of uncertainty was injected into the proceedings. The Second Circuit could not be counted on to do what Judge Drain was counted on to do - so the Sacklers started negotiating, and agreed to provide an additional $1 billion-plus to the opioid settlement fund.

Our point is not that bankruptcy judges should keep their cards close to their vest to ensure creditors recover more, but that maybe unpredictability leads to more efficient outcomes. Had Judge Drain been less predictable, the Sacklers might have ponied up the extra funds earlier in the case to secure claimants’ consent, avoiding all kinds of confirmation litigation and two years of expense and delay from the subsequent appeals.

Of course, prospective debtors heard the message from Judge Jones in Serta loud and clear. On May 15, Envision Healthcare filed in Houston with a restructuring support agreement that assumes the validity of its controversial 2022 recapitalization transaction and uptier exchange. Nonparticipating creditors would get a few warrants unlikely to ever vest.

The case essentially seeks court approval to complete the spinoff of the company’s more valuable AmSurg business, 83% of which already went to lenders participating in those transactions. The remaining 17% would go to those lenders under the plan - the second step of the spinoff. The nonparticipating group has organized, of course, but what are their odds of convincing Judge Christopher Lopez to go a different direction than his senior colleague down the hall (see above)?

Then, on Thursday, June 1, Incora filed in Houston and actually blamed the chapter 11 in part on litigation over the company’s 2022 uptier exchange transaction. Well, if you don’t want to get sued over your questionable liability management transaction, don’t do a questionable liability management transaction - especially if, as with so many similar deals, it fails to manage your liabilities such that you need to file for bankruptcy soon afterward.

The Incora case went to Judge Jones, and of course the debtors, like Serta, quickly filed an adversary proceeding to shut down litigation over the uptier in the New York state courts, which, like Judge Failla, have generally allowed such claims to proceed to discovery. You can bet the Incora debtors will ask Judge Jones to rule on the uptier, which, again, fine - but the problem is you can also pretty confidently bet that Judge Jones will rule exactly the same way he did in Serta.

In our February column, we suggested that New York Judge David Jones handled the Revlon liability management litigation more responsibly. At his own liability management litigation scheduling conference in that case, New York Judge Jones agreed to put the litigation on a “rocket pace,” but unlike Houston Judge Jones declined to obviously telegraph how he would rule on the merits.

What happened in Revlon? The debtors, facing the uncertainty of a trial - however expedited - before a judge that had not already made up his mind, decided to settle with the nonparticipating lenders and secure their consent to an amended plan. On April 3, after a one-day, largely uncontested confirmation hearing, the plan was confirmed. After a quick kerfuffle with the U.S. Trustee, appeals were quickly dismissed, and the reorganized debtors are on their way.

What happened in Serta? On May 26, Houston Judge Jones took the nonparticipating lenders’ good-faith and fair-dealing claims and confirmation of the debtors’ plan under advisement after a drawn-out, expensive four-day evidentiary trial. Judge Jones told the parties he canceled his vacation to get the ruling out quickly. The fact that we haven’t seen a ruling yet has led to one of our monthly “people can change” / “no they can’t” debates here. Jason Sanjana is 0-17 in siding with the better angels.

Which is the better, more efficient approach? Seems obvious to us. Also obvious: Liability management two-step debtors are filing in Houston for a reason.

And just one more point: Take a look at those DIP “fees” (especially for preselected backstop parties) in Diebold. We know you know this, but it is pretty easy these days to accomplish the economics of a non-pro-rata exchange in bankruptcy, so come on back! The water is warm.

In Good Hands

Last time around we hinted that the Tehum Care Services Texas two-step case in the Southern District of Texas would serve as a litmus test for Judge Lopez’ willingness to keep the bon temps rolling for big chapter 11 cases in Houston. Debtors’ counsel will be pleased to learn that Judge Lopez passed the multiple-choice portion of the test with flying colors on March 3, granting 23 nondebtors (including two-step operating affiliates, management and correctional facilities named as co-defendants - keep that last one in mind) a 75-day litigation injunction to preserve the “status quo.”

Of course, Judge Lopez was careful to recite the traditional benedictions. “I’m not granting the debtors’ [requested] relief today,” the judge sternly lectured debtors’ counsel. “I want an evidentiary hearing where these things will be taken up in full.” Instead of approving the debtors’ proposed order, Judge Lopez explained, “I’m doing it on my own” under section 105(a). Perhaps Judge Lopez has been reading this column in preparation for his call-up to the Show?

“For me to do my job, I’ve got to preserve where things are,” the judge reasoned. To “preserve where things are,” the judge then stayed all litigation against 23 nondebtors for 40 days longer than the debtors requested. But Judge Lopez insisted this was not about the debtors at all - he actually wants to protect the plaintiffs’ due process rights! “What’s important to me is we preserve the right of the parties to make a full objection to the relief requested,” the judge solemnly told the arrayed claimants, many of whom objected to the stay and extensively cross-examined the debtors’ witness.

Giving debtors more relief than they asked for while professing to give them no relief at all, and couching the relief as a favor for creditors? Excellent work, young padawan.

The fact is, protecting the “status quo” at the filing of the bankruptcy case would entail allowing the litigation against nondebtors to continue until the debtor proved up its case for a stay extension or litigation injunction. After all, section 362(a)(1) is crystal clear: The automatic stay of litigation against the debtors applies only to the debtors. Debtors bear the burden of proving that the stay should be extended or that litigation against nondebtors should be enjoined under section 105(a). Until they do so, the status quo allows the claimants to pursue the nondebtors.

Sure, the debtors couched their motion as a request for extension of the automatic stay and argued the stay applied to the nondebtors automatically - but as Judge Jeffrey Graham pointed out in his Aearo Technologies litigation injunction denial decision, there really is no difference between “extending the stay” and a section 105(a) injunction. Plus, Judge Lopez specifically grounded his 75-day stay on section 105(a), made clear he was not granting the debtor’s motion and cautioned that the debtor bears the evidentiary burden to prove the stay should be extended to each co-defendant in each case.

Even more extraordinary, Judge Lopez stayed litigation not only against nondebtor affiliates and management but also unaffiliated correctional department codefendants. According to a demonstrative exhibit filed by the debtor, these include officials from the Alabama, Arizona, Florida, Idaho, Michigan and Missouri, correctional departments, plus the city of New York, Clackamas County, Oregon, and Genesee County, Michigan.

Remember in 2019 when unaffiliated opioid manufacturers floated a trial balloon suggesting they might try to use the Purdue chapter 11 plan to get them all releases without having to file bankruptcy? Well, folks: This is that. As even the most aggressive debtors’ counsel will concede, nondebtor litigation injunctions and releases generally apply to affiliates and management, not totally unaffiliated co-defendants. Not only has Judge Lopez used a 75-day “equitable” stay to upend the status quo he professes to protect, he has also created precedent for halting litigation against unrelated co-defendants under section 105(a).

You might suggest that this is no big deal: It’s just a 75-day stay, right? Well, what if a trial was scheduled in 30 days? Or tomorrow? Maybe Endo could have filed the day before jury selection in an opioid trial, and asked for a section 105(a) stay halting the case against Teva to preserve the “status quo.”

On May 17, Judge Lopez took the next “obvious” step: He extended his “temporary” “status quo” stay another 60 days and sent the parties to mediate with, you guessed it, Judge Jones. Wonder if Judge Jones’ status as the judge down the hall will influence that mediation.

At least Judge Lopez took pains to not make his eventual ruling on the litigation injunction obvious to the parties. Any substantive ruling, the judge said, could “materially affect the future viability of any future mediation.” In other words, judges making decisions prematurely could - gasp - discourage the parties from resolving the matter consensually. Crazy idea!

Delaware DIP Denial

Meanwhile, the bankruptcy judges in Delaware continue their campaign to drive big chapter 11 cases away and protect their nonrefundable vacation plans. On May 26, Judge J. Kate Stickles denied final approval of the DeCurtis Holdings debtors’ proposed DIP facility, which was to be provided by some, but not all, of the debtors’ prepetition lenders. According to Judge Stickles, the debtors’ proposal to undertake a sales process alone did not provide sufficient adequate protection for the prepetition liens of Corbin Capital, which was not participating in the DIP.

Which, duh. Senior lenders’ collateral can be sold outside bankruptcy, or even by a chapter 7 trustee, so how would doing a chapter 11 bankruptcy sale of the collateral by itself adequately protect a prepetition lender from being buried in new DIP debt (including a $7.5 million exit fee and a $4.5 million backstop fee)?

The debtors argued that maybe a going-concern bankruptcy sale would generate more proceeds than a liquidation. The judge pointed out that the only bid so far came from, you guessed it, putative DIP lender Invictus. As for that whole “going-concern” thing, well, prior to the petition date former customer Carnival Cruise Lines secured a $21 million judgment against the debtors for patent infringement and has asked for stay relief to permanently bar the debtors from continuing to use the patents, so prospects for that going concern seem a bit concerning.

Invictus’ counsel of course trotted out the “parade of horribles,” calling the DIP facility “outcome dispositive” and suggesting denial would lead to a “chaotic” and “value destructive” liquidation. No motion to convert was filed yet; we are waiting with bated breath.

Also, Invictus is throwing around some real baller vibes these days. Hopefully, you are following the Tuesday Morning case. Holy guacamole, Batman!

--Kevin Eckhardt