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- Insider’s Scoop: Judge Silverstein Imposes Heightened Standard Regarding Appointment of Future Claims Representative
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Delaware District Court Disagrees with Bankruptcy Court’s Ruling and Holds That Committee’s Challenge Rights Survived Entry of the Sale Order and Consummation of Sale
In this decision, the Delaware District Court reversed in part the Delaware Bankruptcy Court’s July 6, 2018 ruling issued in the chapter 11 cases of In re Katy Industries, Inc. dismissing with prejudice the Committee’s complaint for, among other things, recharacterization and equitable subordination of $7.5 million of the secured lenders’ claim despite clear language in the Sale Order preserving the Committee’s challenge rights. In reversing and remanding to the Bankruptcy Court, Chief Judge Stark held that the Committee’s challenge “survived both entry of the Sale Order and the closing of the transaction.” Opinion at 13.
The Debtors filed for chapter 11 bankruptcy protection on May 14, 2017 to consummate a sale of substantially all of their assets to Jansan, the stalking horse purchaser. Opinion at 2. Jansan was a joint venture between the Debtors’ prepetition secured second-lien lenders, i.e., Victory Park and Centrex, and Highview Capital, which provided cash in connection with the DIP financing. Opinion at 2. The stalking horse APA contemplated a credit bid of the entire prepetition second-lien debt. Opinion at 3.
After its appointment, the Committee promptly initiated an investigation into, among other things, prepetition advances in the amount of $7.5 million the Debtors had received from Victory Park, and whether these advances “were more properly characterized as an equity infusion or [were] susceptible to equitable subordination.” Opinion at 3. At the beginning of July 2017, when the Debtors filed their proposed final sale order, the Committee’s investigation into the advances “revealed colorable grounds for recharacterization or subordination.” Opinion at 4. To preserve its challenge rights, the Committee timely filed an objection and reservation of rights with respect to the proposed final sale order. Prior to the hearing, the Debtors, Jansan, and the Committee agreed that the following paragraph 48 be added to the final sale order:
Notwithstanding anything to the contrary contained in this Order or in the Final APA, entry of this Order and approval and consummation of the transactions contemplated hereby shall not limit or otherwise affect the rights or remedies of the Debtors’ estates or the Committee with respect to any ‘Challenge’ as defined in paragraph 26 of the Final DIP Order.
Opinion at 5. Various statements made by Debtors’ and Committee’s counsel during the sale hearing further indicate that it was the parties’ understanding that the Committee’s challenge rights would be preserved. Indeed, Debtors’ counsel stated on the record that this additional language “simply makes clear that the challenge rights of the committee . . . are in no way impacted by the [entry of the sale order] . . ., and [that] all of [the Committee’s] rights and remedies are preserved.” Opinion at 5. The sale of substantially all of the Debtors’ asset to Jansan closed a few days after the entry of the Sale Order. Opinion at 6.
The Adversary Complaint and the Bankruptcy Court’s Decision
Shortly after the approval of the sale, the Committee commenced an adversary proceeding by filing a complaint against Victory Park, Jansan, and Charles Asfour, the former principal of Victory Park, asserting, among other causes of action, recharacterization or equitable subordination of Victory Park’s claims on account of the $7.5 million prepetition advances. Opinion at 6. Victory and Jansan moved to dismiss the complaint arguing, among other things, that as a result of the credit bid, the prepetition second-lien debt was no longer subject to recharacterization or subordination. Opinion at 6-7. The Committee disagreed arguing that its challenge rights were specifically preserved by the inclusion of paragraph 48 of the Sale Order. Opinion at 7. At the hearing on the dismissal motion, the Committee emphasized that it did not seek to disturb the sale, but rather that it sought to “adjust  the economics” as it is authorized to do pursuant to its preserved challenge rights. Opinion at 7. The Committee further asked the Bankruptcy Court that, to the extent it found that it could not provide a remedy under Bankruptcy Code sections 544, 549, and 550, it could fashion a remedy under the Bankruptcy Court’s broad equitable powers. Opinion at 7.
In agreeing with Victory Park and Jansan and dismissing the complaint with prejudice in its entirety, the Bankruptcy Court, despite having acknowledged the “gating issue” before it, namely, whether the Committee successfully preserved its challenge rights with respect to the $7.5 million advances, did not decide the issue. Opinion at 8. Instead, it ruled that “reshaping the economics of the deal to reflect a hypothetical reduction of $7.5 million in 363(k) currency would have no tangible, ameliorative effect for the Committee.” Opinion at 8. Judge Carey further stated that granting the Committee’s request would “turn on its head the finality necessary for the legitimacy” of the sale as it would require Jansan to submit $7.5 million to the bankruptcy estate. Opinion at 8, 11. Concluding that it “cannot appropriately fashion a remedy” under these circumstances, the Bankruptcy Court held that the Committee has failed to state a claim upon which relief could be granted. Opinion at 9.
The District Court Reverses and Remands to the Bankruptcy Court
Emerald Capital Advisors, as the Plan Administrator and successor to the Committee, appealed Judge Carey’s ruling. On appeal, Victory and Jansan argued, among other things, that the “highly general” nature of paragraph 48 of the Sale Order would not encompass the Committee’s particular challenge with respect to the $7.5 million advances and that the Challenge right should rather be seen as a “limited right” to challenge the validity, priority, and extent of the purchaser’s claims and liens. Opinion at 13. The Appellees further asserted that the Committee’s argument with respect to section 363(k), namely that the second-lien debt was not fully allowed and could therefore not have been credit bid pursuant to the plain language of section 363(k), could not “pass legal muster” as the Bankruptcy Court, in approving the sale that included the credit bid, must have necessarily also concluded that the underlying claim was an allowed claim for purposes of section 363(k). Opinion at 14.
Chief Judge Stark rejected all of the Appellee’s arguments. In agreeing with the Committee, His Honor found that the Sale Order expressly preserved the Committee’s “Challenge embodied in its Complaint against any effect that otherwise might have resulted from the entry of the Sale Order or the closing of the sale transaction.” Opinion at 12. The Court further found that the term “Challenge” was broad enough to include all the claims the Committee brought in its Complaint. Opinion at 13. As such, the Court concluded that the lower court’s holdings “are in direct conflict with paragraph 48 of the Sale Order” and that “[t]he [Bankruptcy Court’s] decision does not square its ruling on the Dismissal Motion with the provision of the Sale Order.” Opinion at 12.
The opinion does not only highlight the importance of including specific language that preserves a committee’s challenge rights in the sale documents; it should also provide comfort that courts will enforce such provisions.