Bankruptcy Court Demolishes Baseless Lender Liability Complaint

The Secured Loan and Stalking Horse Bid

The lender ('TCP') made three tranches of loans totaling at least $128 million between October, 2005 and April, 2006, prior to the debtor's filing its Chapter 11 petition on Aug. 21, 2006. TCP negotiated the loans at arm's length and in good faith. Prior to seeking Chapter 11 relief, the debtor also had asked TCP to provide it with a 'stalking horse' bid for all of the debtor's assets. Although the court promptly entered an appropriate bidding procedures order with the consent of the creditors' committee early in the reorganization, the committee sought an expedited trial on its complaint against TCP prior to any judicial sale in order to prevent TCP from bidding in with its large secured claim.

The Litigation

The court held a trial over eight days after the parties had engaged in extensive pre-trial discovery. Ac-cording to the court, it heard 'testimony from 14 witnesses and admitted more than 350 documents into evidence.' Radnor, 2006 WL 3346191 at *1. After trial, the court dismissed the committee's complaint and allowed TCP's claim, making it possible for TCP to credit bid its secured claim. Id. The court's detailed reasoning follows.

No Recharacterization of Debt As Equity

All three investments made by TCP, according to the court, were 'true debt instruments and should not be recharacterized as equity,' as the committee had sought. Id. at *13. All three tranches of TCP's investment were evidenced by senior secured notes. Id. at *5. The court found also that the parties intended that all three investments would be debt, and there was no evidence to the contrary. All of the documents referred to TCP's investments as 'debt'; the parties 'consistently referred to' these investments as 'loans' and/or 'indebtedness'; they contained a 'fixed maturity date ' '; 'gave TCP the right to enforce the payment of principal and interest'; contained no voting rights; the debtor treated these investments 'as priority debt instruments' and used the loan proceeds 'for working capital and to replace and/or pay down existing debt'; and, reasoned the court, were 'secured interests given priority in a liquidation or insolvency.' Id. at *13.

The facts drove the court's conclusion, as they must. The test for recharacterization 'is a highly fact-dependent inquiry that will vary in application from case to case.' In re Dornier Aviation (North America), Inc., 453 F.3d 225, 234 (4th Cir. 2006), citing Submicron, 432 F.3d at 456 ('[n]o mechanistic scorecard suffices. And none should, for Kabuki outcomes elude difficult fact patterns.'); In re United Air Lines, Inc., 453 F.3d 463 (7th Cir. 2006) (refusing recharacterization on facts of case).

Nor was there any defect in TCP's Tranche C loan, knowingly made when the debtor was experiencing a liquidity crisis. In re SubMicron Systems Corp., 432 F.3d 448, 457 (3d Cir. 2006) ('[W]hen existing lenders make loans to a distressed company, they are trying to protect their existing loans and traditional factors that lenders consider (such as capitalization, solvency, collateral, ability to pay cash interest and debt capacity ratios) do not apply as they would when lending to a financially healthy company.'); see also In re Dornier Aviation, 453 F.3d 234 ('In many cases, an insider will be the only party willing to make a loan to a struggling business, and recharacterization should not be used to discourage good-faith loans.')

The court also found nothing unusual in TCP's having one designee on the debtor's four-member board. TCP never exercised control over the debtor's day-to-day operations, and its receipt of non-public information and ability to obtain more board seats were also 'immaterial.' Radnor, 2006 WL 3346191 at *14. If anything, TCP's conduct was 'consistent with good faith efforts to provide valuable advice to' the debtor and to conduct due diligence for its investment. Id.

No Equitable Subordination Of Claims

'The Committee failed to meet its burden of proving that (a) TCP engaged in inequitable conduct; (b) [any] misconduct caused injury to Radnor's creditors or conferred an unfair advantage on TCP; and (c) equitable subordination of the claim' would be consistent 'with the Bankruptcy Code.' Id. at *15, citing In re Citicorp Venture Capital, Ltd., 160 F.3d 982 (3d Cir. 1998). First, TCP was not an insider, and the committee failed to prove that it had exercised 'day-to-day control' over the debtor's business affairs or directed the debtor's business. Radnor, 2006 WL 3346191 at *15. Nor did TCP's having a designee on the debtor's board make it an insider. Finally, its access to performance reports and other financial information did not establish insider status.

Second, the court found that, instead of engaging in misconduct or misleading creditors, TCP had consistently 'acted in good faith with a view to maximize Radnor's value to all constituents.' Id. at *16. Indeed, TCP's loans enhanced the debtor's liquidity and allowed it to continue operating. Moreover, TCP's Tranche A and B loans 'resulted in a reduction of [Radnor's] net debt.' Id.

No Breach of Fiduciary Duty

The committee's breach of fiduciary claim essentially was tried as a 'deepening insolvency' claim, a doctrine that the Delaware courts have now rejected as a claim or as a theory of damages. Trenwick Am. Litig. Trust v. Ernst & Young LLP, 906 A. 2d 168 (Del. Ch. 2006) (no claim for relief); In re CitX Corp., 448 F. 3d 672 (3d Cir. 2006) (rejected deepening insolvency as theory of damages). As the court explained, a board is not required by Delaware law to 'wind down operations simply because a company is insolvent,' but may decide 'to take on additional debt in the hopes of turning operations around.' Radnor, 2006 WL 3346191 at *16, citing Trenwick. Moreover, TCP's initial $25M preferred stock investment decreased the likelihood of insolvency, rather than increasing it. Also, 'the making of a loan similarly does not increase insolvency; it increases liabilities (the amount of the loan) and assets (the cash provided by the loan) in the same amount.' Radnor, 2006 WL 3346191 at *16, citing CitiX, 448 F.3d at 677.

Not only did the debtor's certificate of incorporation exculpate Radnor's directors from liability for any asserted breach of the duty of care, but the Delaware statutory law also bars liability even when creditors or a trustee are suing derivatively. Nor did the evidence support a finding that TCP had aided and abetted a breach of fiduciary duty.

Delaware law imposes no obligation on the board of an insolvent company to cease operating and liquidate. Radnor, 2006 WL 3346191 at *17, citing Trenwick, 906 A. 2d at 204. Instead, directors of an insolvent corporation may pursue any strategy 'to maximize the value of the company, including continuing to operate in the hope of turning things around.' Radnor, 2006 WL 3346191 at *17. In Delaware, the business judgment rule protects the directors, and creditors have no enhanced ability to challenge 'a disinterested, good faith business decision ' ' Id., citing Trenwick, at 196 n.75. Here, the debtor's business judgment in favor of continuing its operations instead of liquidating 'was not inherently wrongful.' Radnor, 2006 WL 3346191 at *18.

The court further found that TCP's designee on the Radnor board had not breached any duty of loyalty, as alleged. When TCP made its third investment, the TCP director designee abstained from the vote. Moreover, it was Radnor, not TCP, that requested TCP's stalking horse bid shortly before bankruptcy. The TCP board designee also had not pressured the other directors into any transaction with TCP and 'there is no per se breach of fiduciary duty for an insider making a bid to purchase a company or its assets.' Id. at *20, citing In re Cysive, Inc. S'holders Litig., 836 A.2d 537 (Del. Ch. 2003).

Claim Allowed

The committee failed to offer any evidence disputing any part of the TCP claims, enabling the court to allow the $128 million of secured claims plus all post-bankruptcy interest and expenses provided for under the loan documents. When a claim is filed, it is presumptively valid, and an objecting party has to prove facts in order to have the claim disallowed. The committee did not. TCP thus was authorized to credit bid the full amount of its claim.

Liens Not Avoided

The TCP claims were supported by copies of properly recorded mortgages and financing statements. Again, because the committee offered no evidence to dispute the validity of the TCP liens, they were found to be valid.

No Preference Claim

According to the court, TCP was oversecured by at least $4 million (i.e., the undisputed value of its collateral was $132 million but its underlying claim was only $128 million). The committee offered no evidence on the value of TCP's collateral, thus failing to meet its burden of proof on one element of a preference ' that the creditor received more than it would have in a Chapter 7 case for the debtor. Moreover, interest paid to TCP was well outside the ninety-day preference period, and the court already had found that TCP was not an insider (which would have extended the preference reachback period to one year prior to bankruptcy). Any influence TCP had with the debtor arose from its loan documents, but that does not convert a secured lender into an insider. Radnor, 2006 WL 3346191 at *22. Finally, the court found another ground for dismissal of the committee's preference claim: the interest paid to TCP was paid in exchange for a new loan of $20 million.

The Committee Had Acquiesced

A majority of the committee members had voted, in their capacity as pre-bankruptcy noteholders, in favor of TCP's third loan made in April of 2006. Having acquiesced in that loan, the court found that it would be inequitable for the committee to challenge that loan now.

No Damages

The committee also failed to prove damages. The committee's expert purported to calculate the difference between value that creditors would have received if the debtor had sought bankruptcy relief prior to the TCP loans in October, 2005 and the value available to them as a result of the bankruptcy. But the court held that this form of 'deepening insolvency' was not valid as a measure of damages.

Comments

This decision is another recent example of a court rejecting so-called 'lender liability' claims that have no factual support.

Irresponsible litigants still assert untenable claims against pre-bankruptcy secured lenders (e.g., equitable subordination; debt recharacterization) for negotiating leverage, apparently hoping the lender will pay to avoid time-consuming expensive and uncertain bankruptcy court litigation.

The bankruptcy judge in Radnor, however, made clear that he, for one, was not accepting unsupported claims against a good faith lender. He also understood and applied the teachings of the Third Circuit's Sub-Micron decision.

Michael L. Cook, a member of this newsletter's Board of Editors, and Lawrence V. Gelber are partners in the Business Reorganization Group at Schulte Roth & Zabel LLP, where they represent secured and unsecured creditors, debtors, directors, licensors and other parties in Chapter 11 cases.

Now, what I want is, facts ' Facts alone are wanted in life.' Charles Dickens, Hard Times (1854)

A Delaware bankruptcy court held on Nov. 16 that a secured lender with a $128 million claim could credit bid at a judicial sale of a Chapter 11 debtor's assets, after dismissing the expansive complaint filed against the lender by the creditors' committee in the debtor's case (claims for recharacterization of debt as equity; equitable subordination; breach of fiduciary duty; invalid loans; voidable liens; and preference liability). Creditors' Committee of Radnor Holdings Corp. v. Tennenbaum Capital Partners, LLC, et al. (In re Radnor Holdings Corp.), 2006 WL 3346191 (Bankr. D. Del. 11/16/06). In his no-nonsense opinion, which relied heavily on the Third Circuit's Jan. 6, 2006, decision in Cohen v. KB Mezzanine Fund II, L.P. (In re SubMicron Systems Corp.), 432 F.3d 448 (3d Cir. 2006) (held, creditor's debt recharacterization and equitable subordination claims against lender failed because documents were debt instruments and because creditors had not been injured), bankruptcy judge Peter J. Walsh provided a road map that should sharply curtail the baseless, extortionate demands too often made by some creditors in large reorganization cases.

Significant here was the lack of evidence to support any of the committee's claims. As shown below, there were no startling legal conclusions in the court's ruling.

The Secured Loan and Stalking Horse Bid

The lender ('TCP') made three tranches of loans totaling at least $128 million between October, 2005 and April, 2006, prior to the debtor's filing its Chapter 11 petition on Aug. 21, 2006. TCP negotiated the loans at arm's length and in good faith. Prior to seeking Chapter 11 relief, the debtor also had asked TCP to provide it with a 'stalking horse' bid for all of the debtor's assets. Although the court promptly entered an appropriate bidding procedures order with the consent of the creditors' committee early in the reorganization, the committee sought an expedited trial on its complaint against TCP prior to any judicial sale in order to prevent TCP from bidding in with its large secured claim.

The Litigation

The court held a trial over eight days after the parties had engaged in extensive pre-trial discovery. Ac-cording to the court, it heard 'testimony from 14 witnesses and admitted more than 350 documents into evidence.' Radnor, 2006 WL 3346191 at *1. After trial, the court dismissed the committee's complaint and allowed TCP's claim, making it possible for TCP to credit bid its secured claim. Id. The court's detailed reasoning follows.

No Recharacterization of Debt As Equity

All three investments made by TCP, according to the court, were 'true debt instruments and should not be recharacterized as equity,' as the committee had sought. Id. at *13. All three tranches of TCP's investment were evidenced by senior secured notes. Id. at *5. The court found also that the parties intended that all three investments would be debt, and there was no evidence to the contrary. All of the documents referred to TCP's investments as 'debt'; the parties 'consistently referred to' these investments as 'loans' and/or 'indebtedness'; they contained a 'fixed maturity date ' '; 'gave TCP the right to enforce the payment of principal and interest'; contained no voting rights; the debtor treated these investments 'as priority debt instruments' and used the loan proceeds 'for working capital and to replace and/or pay down existing debt'; and, reasoned the court, were 'secured interests given priority in a liquidation or insolvency.' Id. at *13.

The facts drove the court's conclusion, as they must. The test for recharacterization 'is a highly fact-dependent inquiry that will vary in application from case to case.' In re Dornier Aviation (North America), Inc., 453 F.3d 225, 234 (4th Cir. 2006), citing Submicron, 432 F.3d at 456 ('[n]o mechanistic scorecard suffices. And none should, for Kabuki outcomes elude difficult fact patterns.'); In re United Air Lines, Inc ., 453 F.3d 463 (7th Cir. 2006) (refusing recharacterization on facts of case).

Nor was there any defect in TCP's Tranche C loan, knowingly made when the debtor was experiencing a liquidity crisis. In re SubMicron Systems Corp., 432 F.3d 448, 457 (3d Cir. 2006) ('[W]hen existing lenders make loans to a distressed company, they are trying to protect their existing loans and traditional factors that lenders consider (such as capitalization, solvency, collateral, ability to pay cash interest and debt capacity ratios) do not apply as they would when lending to a financially healthy company.'); see also In re Dornier Aviation, 453 F.3d 234 ('In many cases, an insider will be the only party willing to make a loan to a struggling business, and recharacterization should not be used to discourage good-faith loans.')

The court also found nothing unusual in TCP's having one designee on the debtor's four-member board. TCP never exercised control over the debtor's day-to-day operations, and its receipt of non-public information and ability to obtain more board seats were also 'immaterial.' Radnor, 2006 WL 3346191 at *14. If anything, TCP's conduct was 'consistent with good faith efforts to provide valuable advice to' the debtor and to conduct due diligence for its investment. Id.

No Equitable Subordination Of Claims

'The Committee failed to meet its burden of proving that (a) TCP engaged in inequitable conduct; (b) [any] misconduct caused injury to Radnor's creditors or conferred an unfair advantage on TCP; and (c) equitable subordination of the claim' would be consistent 'with the Bankruptcy Code.' Id. at *15, citing In re Citicorp Venture Capital, Ltd., 160 F.3d 982 (3d Cir. 1998). First, TCP was not an insider, and the committee failed to prove that it had exercised 'day-to-day control' over the debtor's business affairs or directed the debtor's business. Radnor, 2006 WL 3346191 at *15. Nor did TCP's having a designee on the debtor's board make it an insider. Finally, its access to performance reports and other financial information did not establish insider status.

Second, the court found that, instead of engaging in misconduct or misleading creditors, TCP had consistently 'acted in good faith with a view to maximize Radnor's value to all constituents.' Id. at *16. Indeed, TCP's loans enhanced the debtor's liquidity and allowed it to continue operating. Moreover, TCP's Tranche A and B loans 'resulted in a reduction of [Radnor's] net debt.' Id.

No Breach of Fiduciary Duty

The committee's breach of fiduciary claim essentially was tried as a 'deepening insolvency' claim, a doctrine that the Delaware courts have now rejected as a claim or as a theory of damages. Trenwick Am. Litig. Trust v. Ernst & Young LLP , 906 A. 2d 168 (Del. Ch. 2006) (no claim for relief); In re CitX Corp., 448 F. 3d 672 (3d Cir. 2006) (rejected deepening insolvency as theory of damages). As the court explained, a board is not required by Delaware law to 'wind down operations simply because a company is insolvent,' but may decide 'to take on additional debt in the hopes of turning operations around.' Radnor, 2006 WL 3346191 at *16, citing Trenwick. Moreover, TCP's initial $25M preferred stock investment decreased the likelihood of insolvency, rather than increasing it. Also, 'the making of a loan similarly does not increase insolvency; it increases liabilities (the amount of the loan) and assets (the cash provided by the loan) in the same amount.' Radnor, 2006 WL 3346191 at *16, citing CitiX, 448 F.3d at 677.

Not only did the debtor's certificate of incorporation exculpate Radnor's directors from liability for any asserted breach of the duty of care, but the Delaware statutory law also bars liability even when creditors or a trustee are suing derivatively. Nor did the evidence support a finding that TCP had aided and abetted a breach of fiduciary duty.

Delaware law imposes no obligation on the board of an insolvent company to cease operating and liquidate. Radnor, 2006 WL 3346191 at *17, citing Trenwick, 906 A. 2d at 204. Instead, directors of an insolvent corporation may pursue any strategy 'to maximize the value of the company, including continuing to operate in the hope of turning things around.' Radnor, 2006 WL 3346191 at *17. In Delaware, the business judgment rule protects the directors, and creditors have no enhanced ability to challenge 'a disinterested, good faith business decision ' ' Id., citing Trenwick, at 196 n.75. Here, the debtor's business judgment in favor of continuing its operations instead of liquidating 'was not inherently wrongful.' Radnor, 2006 WL 3346191 at *18.

The court further found that TCP's designee on the Radnor board had not breached any duty of loyalty, as alleged. When TCP made its third investment, the TCP director designee abstained from the vote. Moreover, it was Radnor, not TCP, that requested TCP's stalking horse bid shortly before bankruptcy. The TCP board designee also had not pressured the other directors into any transaction with TCP and 'there is no per se breach of fiduciary duty for an insider making a bid to purchase a company or its assets.' Id. at *20, citing In re Cysive, Inc. S'holders Litig., 836 A.2d 537 (Del. Ch. 2003).

Claim Allowed

The committee failed to offer any evidence disputing any part of the TCP claims, enabling the court to allow the $128 million of secured claims plus all post-bankruptcy interest and expenses provided for under the loan documents. When a claim is filed, it is presumptively valid, and an objecting party has to prove facts in order to have the claim disallowed. The committee did not. TCP thus was authorized to credit bid the full amount of its claim.

Liens Not Avoided

The TCP claims were supported by copies of properly recorded mortgages and financing statements. Again, because the committee offered no evidence to dispute the validity of the TCP liens, they were found to be valid.

No Preference Claim

According to the court, TCP was oversecured by at least $4 million (i.e., the undisputed value of its collateral was $132 million but its underlying claim was only $128 million). The committee offered no evidence on the value of TCP's collateral, thus failing to meet its burden of proof on one element of a preference ' that the creditor received more than it would have in a Chapter 7 case for the debtor. Moreover, interest paid to TCP was well outside the ninety-day preference period, and the court already had found that TCP was not an insider (which would have extended the preference reachback period to one year prior to bankruptcy). Any influence TCP had with the debtor arose from its loan documents, but that does not convert a secured lender into an insider. Radnor, 2006 WL 3346191 at *22. Finally, the court found another ground for dismissal of the committee's preference claim: the interest paid to TCP was paid in exchange for a new loan of $20 million.

The Committee Had Acquiesced

A majority of the committee members had voted, in their capacity as pre-bankruptcy noteholders, in favor of TCP's third loan made in April of 2006. Having acquiesced in that loan, the court found that it would be inequitable for the committee to challenge that loan now.

No Damages

The committee also failed to prove damages. The committee's expert purported to calculate the difference between value that creditors would have received if the debtor had sought bankruptcy relief prior to the TCP loans in October, 2005 and the value available to them as a result of the bankruptcy. But the court held that this form of 'deepening insolvency' was not valid as a measure of damages.

Comments

This decision is another recent example of a court rejecting so-called 'lender liability' claims that have no factual support.

Irresponsible litigants still assert untenable claims against pre-bankruptcy secured lenders (e.g., equitable subordination; debt recharacterization) for negotiating leverage, apparently hoping the lender will pay to avoid time-consuming expensive and uncertain bankruptcy court litigation.

The bankruptcy judge in Radnor, however, made clear that he, for one, was not accepting unsupported claims against a good faith lender. He also understood and applied the teachings of the Third Circuit's Sub-Micron decision.

Michael L. Cook, a member of this newsletter's Board of Editors, and Lawrence V. Gelber are partners in the Business Reorganization Group at Schulte Roth & Zabel LLP, where they represent secured and unsecured creditors, debtors, directors, licensors and other parties in Chapter 11 cases.