Federal District and Bankruptcy Courts

Originally published in Reed Smith's Commercial Restructuring & Bankruptcy Alert, January 2006

Administrative Fees Restored—Houlihan, Lokey, Howard & Zukin Capital, Inc. v. Northwestern Corp. (In re Northwestern Corp.), 332 B.R. 534 (D. Del. 2005)

The U.S. District Court in Delaware reversed a bankruptcy court order determining that the monthly fees requested by Houlihan, Lokey, Howard & Zukin Capital, Inc. ("Houlihan") in its final fee application were unreasonable and improvident. Early in the case, the bankruptcy court approved Houlihan’s $175,000 monthly fee as "reasonable" pursuant to section 330(a) of the Bankruptcy Code.

The district court found that once a determination has been made as to the reasonableness of the terms of a professional’s compensation, the court thereafter may reduce such compensation only if it is determined to be "improvident" pursuant to section 328(a) of the Bankruptcy Code. When a professional’s engagement letter sets forth services that may be duplicative of other professionals in the case, the district court held that such duplication is not unforeseeable and therefore is not improvident under the Bankruptcy Code.

Antitrust Jurisdiction—Ticket Center, Inc. v. Banco Popular De Puerto Rico, 2005 U.S. Dist. LEXIS 27228 (D.P.R. Nov. 8, 2005)

In its Younger, Burford, and Colorado River decisions, the U.S. Supreme Court cautioned federal courts to use their discretion in abstaining from cases that involve important state interests and policies if they are currently being litigated at the state level. The District Court in Puerto Rico has recently ruled, however, that such discretion does not extend to cases involving federal antitrust cases. In Ticket Center, a corporation engaged in the business of selling tickets sued a bank in federal court for violations of U.S. antitrust laws. The bank in turn filed a motion to dismiss, arguing that the district court should abstain from entertaining the suit because the corporation had sued the bank in other state judicial and administrative proceedings for claims arising out of the same transaction and occurrence as the federal complaint.

Denying the bank’s motion, the district court held that federal courts have exclusive jurisdiction over private federal antitrust cases, and that remedies for violations of antitrust laws may not be pursued in state courts. The court concluded by stating that although state courts may properly consider federal antitrust claims raised as defenses in a state court (and a federal court may abstain in this circumstance), state courts may not grant affirmative relief based on claims for which federal jurisdiction is exclusive. The federal court must hear the case in this instance.

LLC Property Not Part of Debtor Owner’s Estate—Woodard v. Balcourt (In re Ferraro), No. 00-63241 (Bankr. N.D.N.Y. Nov. 23, 2005)

In a recommendation to the district court arising from a noncore proceeding, the U.S. Bankruptcy Court for the Northern District of New York determined that property of a limited liability corporation is not property of the estate notwithstanding the debtor’s ownership interest in such corporation. In the Ferraro case, debtor Daniel P. Ferraro and business partner Alan Balcourt each owned a 50 percent share in two LLCs. Balcourt allegedly stole about $400,000 in assets from the LLCs. The chapter 7 trustee filed an adversary proceeding against Balcourt seeking to recover the stolen property for the benefit of the estate’s creditors. Although the debtor’s ownership interest in the LLCs is property of the estate, the specific property stolen belongs to the corporations.

The bankruptcy court determined that the trustee cannot assert a claim that belongs to the corporate entities. Because the issue was not before it, the bankruptcy court declined to rule on whether the trustee had standing to file a shareholder derivative suit.

Recharacterization and Equitable Subordination—American National Bank and Trust Co. of Chicago v. Matrix IV, Inc. (In re S.M. Acquisitions Co., d/b/a Stylemaster Inc.), 223 B.R. 346 (Bankr. N.D. Ill. 2005)

In a ruling that discusses the lengths to which a bank may go to secure its credit line with a failing debtor, the U.S. Bankruptcy Court for the Northern District of Illinois has held that a competing creditor failed to demonstrate sufficient evidence to warrant either recharacterization of the bank’s loan as equity or equitable subordination. The plaintiff bank filed an adversary action in a lien dispute with Matrix, which claimed a lien through its work on certain molds owned by the debtor. The bank obtained its lien through a loan structured as a revolving credit line. The bank protected its lien through recordings; Matrix did not. However, Matrix argued the bank’s loan should be recharacterized as equity, alleging the loan was extended in exchange for allowing two of the bank’s customers to purchase interest in the debtor. The court rejected this argument, stating there was no evidence to show that the customers were "instrumentalities" of the bank or vice versa.

Matrix also argued that the bank loan should be equitably subordinated based on the alleged control the bank exerted over the debtor. Actions cited by Matrix included (i) the requirement that the debtor hire a business consultant, (ii) a Stock Pledge Agreement executed on behalf of the bank, (iii) a requirement that all collected receivables be placed in a lock box, and (iv) following the debtor’s loan default, bank control over which creditors were paid. The bank’s efforts to protect itself were not to "such degree of control or any type of egregious conduct" to support subordination of its loan, the court concluded. "In taking these steps, the Bank was not attempting to manage the Debtor; rather, it sought to manage the risk posed to its collateral by the Debtor’s shaky and deteriorating financial condition."

Disgorgement of Carve-Out Funds—In re: US Flow Corporation, et al., Case No. 03-09863 (Bankr. W.D. Mich., Oct. 29, 2005)

Once a court has approved carve-out funds pursuant to a DIP financing order in a chapter 11 case, the conversion of that case to a chapter 7 case does not mean the carve-out funds must be disgorged, a federal bankruptcy court in Michigan has held. "This issue arises in one of those detestable administratively insolvent estates," grumped the court. US Flow and four related companies filed chapter 11 cases in August 2003, and the court appointed two law firms to represent the company and the Official Committee of Unsecured Creditors. During the chapter 11 case, the court authorized DIP financing, as well as a $55,000 carve-out to benefit the chapter 11 court-appointed professionals. Less than one month later, the case was converted to chapter 7, and the order authorizing the DIP financing was terminated. The U.S. Trustee therefore requested a court determination that the $55,000 carve-out is property of the chapter 7 estate.

The court noted that the U.S. Court of Appeals for the Sixth Circuit has held "that interim compensation granted in a chapter 11 case must be disgorged in a converted chapter 7 ‘when necessary to achieve pro rata distribution’ among similarly situated creditors," citing Specker Motor Sales Co. v. Eisen, 393 F.3d 659, 664 (6th Cir. 2004). However, the court distinguished Specker, stating that the latter addressed prepetition retainers, which are property of the estate. In the case at hand, the carve-out funds were to be paid from property of the secured creditors, who had agreed to the carve-out. The bankruptcy court’s order creating the carve-out was not appealed by other creditors, creating an "unassailable" lien, the court stated. "[T]he proceeds transferred from the Secured Creditors for the benefit of the court-appointed professionals may not be recovered for the benefit of the bankruptcy estate."

This article is presented for informational purposes only and is not intended to constitute legal advice.