Tuesday, October 28, 2014

Supreme Court to Hear Dispute Over Fees for Defending Fee Application

The Supreme Court doesn't take many cases on bankruptcy issues.  It has only ruled on attorney's fees in bankruptcy once since the Code was adopted and that ruling was on the narrow issue of whether a chapter 7 debtor's attorney could recover fees from the estate.    As a result, it was big news when the Court granted cert in  No. 14-103, Baker Botts, LLP v. ASARCO, LLC on October 2, 2014.    The issue in ASARCO is whether an attorney can recover fees for defending his fee application or whether those expenses are merely "a cost of doing business" as held by the Fifth Circuit.   The issue matters in the particular case because Baker Botts spent $5 million in time defending its $113 million application.   

What Happened

I have previously written about the ASARCO case at length here.   This was a case where the Debtor's law firms obtained a judgment against the Debtor's parent company for somewhere between $7 and $10 billion which was "the largest fraudulent transfer judgment in Chapter 11 history."    As a result of the adverse judgment, the Debtor's parent company decided to fund a plan which paid the creditors in full and left the Debtor with $1.4 billion in cash.   

Given this incredible result, the Debtor's law firms should have had an easy time recovering their fees.  After all, when you are measuring results in the billions, what's a hundred million in fees?   However, under the Plan, ASARCO's parent regained control of the Debtor.   They were apparently not happy about paying Baker Botts and Jordan Hyden for having sued them.   
 
The Debtor submitted a discovery request to Baker Botts which required it to produce every document it had prepared in 52 months of bankruptcy.    This amounted to 2,350 boxes of hard copy documents and 189 GB of electronic data.   In case you were wondering, 1 GB of data translates into between 65,000 to 165,000 pages of documents depending upon whether the documents were Microsoft Word documents, Excel spreadsheets or emails.   Assuming 100,000 pages per GB of electronic data, that means that Baker Botts produced about 18.9 million pages of electronic documents.   (Imagine being the associate who had to review all that!)  

Notwithstanding ASARCO's efforts to contest its firms' fees, the Bankruptcy Court awarded Baker Botts $113 million in fees, an enhancement of $4.1 million and $5 million for defending its application and awarded Jordan Hyden $7 million in core fees, an enhancement of $125,000 and $15,000 for prosecuting the application.

On appeal, the Fifth Circuit upheld the fee enhancements but struck down the cost of defense fees.   ASARCO, LLP v. Jordan Hyden Womble Culbreth & Holzer, P.C. (In re Asarco, LLC), 751 F.3d 291 (5th Cir. 2014), cert. granted, 2014 U.S. LEXIS 4913 (10/2/14).   

Having been mostly successful, Baker Botts decided to go to the Supreme Court for the last $5 million which was withheld.    In filing their petition, Baker Botts was supported by the State Bar of Texas Bankruptcy Law Section and the Business Law Section of the Florida Bar.  

Why It Matters

In its opinion, the Fifth Circuit made a brief though cogent examination of section 330(a) in denying the cost of defense fees.  In particular, it ruled that section 330(a)(3) and (4) require that services be likely to benefit the estate or necessary to the administration of the estate in order to be compensated.  
Nevertheless, Section 330 states twice, in both positive and negative terms paraphrased above, that professional services are compensable only if they are likely to benefit a debtor’s estate or are necessary to case administration. Matter of Pro-Snax Distributors, Inc., 157 F.3d 414, 418 n.7 (5th Cir. 1998). The primary beneficiary of a professional fee application, of course, is the professional.
Opinion, p. 13.   The Court also concluded that because section 330(a)(6) allows fees for preparing a fee application but not for litigating one, that cost of defense fees must be denied.   

This case has both the statutory interpretation questions mentioned above and the policy question of whether one party can impose litigation costs upon another party with impunity.   Here, there is a strong hint that ASARCO's parent, now in control of the Debtor, sought to get payback against Baker Botts by running up the cost of getting compensated.   It seems curious that the Debtor would have needed to request every piece of paper created by the firm in order to judge whether their fee request was reasonable.    While the Fifth Circuit raised the prospect that fees could be awarded for vexatious fee objections, it also suggested that fees were not litigated often enough, stating:
“Too frequently, court-appointed counsel for debtor[’s] and the official creditor committees’ interests in a case, sharing the mutual goal of securing approval for their fees, enter into a conspiracy of silence with regard to contesting each other’s fee applications.”
Opinion, p. 18.

The result in this case is likely to be important beyond the narrow issue presented for the following reasons:
  • Supreme Court watchers have noted that the Court's bankruptcy decisions tend to swing between strict textual analysis and a functional approach.   If the Court goes with the textual approach, it will be likely (though not guaranteed) to uphold the Fifth Circuit, while a functional approach would support Baker Botts.
  • The Court will be required to address the meaning of likely to benefit the estate and necessary to case administration.    Because these terms are critical to interpretation of section 330, the court's opinion will provide valuable guidance on awarding fees.   While the Fifth Circuit's view that defending a fee application was for the benefit of counsel is plausible, I believe that the better answer is that it is part of the process of administering the estate.
  • The Fifth Circuit's opinion relied on one of the multiple rationales of the Pro-Snax case.  While the Court's interpretation of Pro-Snax in ASARCO was consistent with the statute, the mere fact that the case is before the Supreme Court may encourage the Fifth Circuit to walk back Pro-Snax's most aggressive holding that only actual results may be compensated.   In its amicus brief in support of the petition for cert, the State Bar of Texas Bankruptcy Law Section raised the Pro-Snax "results only" holding and mentioned my firm's case of Matter of Woerner, 758 F.3d 693 (5th Cir. 2014), which is currently the subject of a pending request for rehearing en banc.    
The importance of the case is also underscored by the fact that representatives from two state bars weighed in on the dispute.   In my experience, it is highly unusual for a section of the Texas State Bar to file an amicus brief.  I am not aware of any other case in which it has been done.   While I am speculating here, I have to believe that the Bankruptcy Section must have convinced the State Bar that this was an issue of importance to lawyers in general.    Otherwise, they would just have been taking sides in a dispute between different groups of lawyers.    This will be an interesting case to watch.


Sunday, October 12, 2014

NCBJ 2014: Ethics and Supreme Debate

Saturday concluded NCBJ with ethics and the Supreme Court review.   (There was also a program on scientific studies of mindfulness which I missed).

Wait, Wait, Don’t Tell Me! An Ethics Game Show:  Retired Judge James H. Haines as Peter Segal, Christine Devine (DeMaillie & Lougee), Judge Benjamin Goldgar, Timothy Nixon (Godfrey & Kahn), Judge Neil Olack, Prof. Nancy Rapoport and Judge Erithe Smith.  

This was an entertaining quiz show style ethics panel.    For each ethical scenario, there were three answers only one of which was correct.   Here are the questions and correct answers.  
 
1.  Can law firm be sanctioned for failure to amend obvious errors in schedules?   Yes.    Section 707(b)(4)(C) and (D) and Rule 9011 require an attorney to certify that after making a reasonable inquiry, the petition, schedules and SOFA are correct and that he does not know of any information that would make them incorrect.   The specific hypothetical involved an international law firm which filed bankruptcy but failed to mention any of its international offices.

2.  Can an attorney ethically limit its representation of a chapter 7 debtor to exclude adversary proceedings when necessary to achieve the client’s goals?  No.   While unbundling can be done with full disclosure, an attorney cannot disclaim defending adversary proceedings if it is known in advance that this will be necessary to meet the client’s objectives.   In re Seare, 2014 Bankr.LEXIS 3584 (9th Cir. BAP 2014).

3.  May CROs be employed under sections 105(a) and 363(b)(1)?  Yes.    Under what is known as the “Jay Alix Protocol,” a chief restructuring officer may be employed in the ordinary course subject to review of his fees for reasonableness.    Additionally, the CRO may only serve in one capacity.

4.  Can a Chinese Wall be used to prevent firm from being disqualified based on one attorney who is not disinterested?   The answer given was no, but that Texas follows minority rule.    An example of the majority rule is In re Essential Therapeutics, Inc., 295 B.R. 203, 211 (Bankr. D. Del. 2003), while the minority rule is illustrated by In re Cygnus Oil & Gas Corp., 2007 Bankr. LEXIS 1913 (Bankr. S.D. Tex. 2007).   I am not completely satisfied by the panel’s designation of these as majority and minority rules.  They might be worth more scrutiny.

5.  Can the same attorney be retained to represent multiple debtors with inter-company claims?    There is no per se disqualification rule.   Must decide on a case by case basis.

6.  What is appropriate sanction for undisclosed fee sharing?   Court may disqualify firm and order disgorgement of fees.   However, court should use least restrictive sanction to deter bad conduct.

7.  May an attorney withdraw when the client insists on taking a course of action that the attorney disagrees with?    Yes, but only with court permission.

8.  Can an attorney be sanctioned for “ghostwriting” a pleading for an acquaintance?  Maybe.   I think this one is too fact specific to give a definitive answer.   In the hypothetical, the attorney was asked to provide a law school acquaintance with a form claims objection which the debtor then used without modification.    In my mind, providing a form to another attorney is never “ghostwriting.”   There was some discussion that an attorney who prepares a pleading for a pro se party is required to sign it.  I am not convinced by this argument.

9.  Can a plan provide that Committee members will be able to recover their attorney’s fees?  No.  They have to justify that they made a substantial contribution.

10.  Can a firm get paid all of its fees when it obviously overstaffed the case?   No.

May You Live in Interesting Times:   The Supreme Court’s Year in Bankruptcy:   Eric Brunstad (Dechert, LLP) and Dean Erwin Chemerinsky

This panel took the form of a debate between Eric Brunstad and Erwin Chemerinsky on the subject of consent under Stern v. Marshall.   Brunstad took the position that Stern v. Marshall was correctly decided but that consent was permissible.    Chemerinsky took the position that Stern v. Marshall was wrongly decided and that if followed to its logical conclusion, consent would not be allowed.   In this section, I am referring to major Supreme Court cases by name rather than by citation.    However, they can be easily looked up on any number of free legal research sites.

Brunstad:

Brunstad argued that Article III originated from the experience in England where it was necessary to separate the judiciary from the crown.   On the other hand, the issue of who decides your case does not implicate the independence of the judiciary and can be waived.   According to Brunstad, Marathon stands for the proposition that you cannot assign a purely private dispute to an Article I tribunal.   However, in Schor, the Supreme Court indicated that the right to an Article III tribunal was a personal right which could be waived.   Granfinanciera equated the right to a jury trial and the right to an Article III tribunal.   Because a jury trial can be waived, an Article III tribunal could be as well.  

He then made the following points (which he numbered making it much easier for me to report):

1.  Schor designated the right to an Article III tribunal as a purely personal right.  Having a case decided by an Article I or an Article III judge does not implicate separate of powers concerns because separation of powers is concerned with conflicts between the judicial branch and the legislative or executive.

2.  By analogy, if you can waive your right to a jury trial, you can waive your right to an Article III judge.

3.  For hundreds of years, District Courts have relied on special masters.   With consent, a special master could make findings upon which the District Court would enter judgment.

4.  Arbitration allows decision by a non-Article III tribunal, although the arbitrator cannot enter a judgment.

5.  Bankruptcy judges are like magistrates who enjoy broad authority with consent.

6.  The consequences of not allowing consent would be detrimental to the modern administrative state.  

Chemerinsky:

According to Dean Chemerinsky, Stern v. Marshall was wrong because it misunderstood separation of powers.    He said that separation of powers is a means to an end rather than an end itself.   Separation of powers is invoked when one branch usurps or interferes in the operations of another branch.   Allowing bankruptcy courts to decide state law issues does not implicate either concern.   Therefore Stern was wrongly decided.

However, he said that once you accept that Stern adopted a formalistic approach to separation of powers rather than a functional one (which is what Dean Chemerinsky advocates), you must follow that logic to its end.   Mr. Brunstad’s arguments were functional rather than formalistic.   However, you cannot accept Stern and still take a functional approach.

Chemerinsky then argued that:

1.  Separation of powers violations cannot be overcome by consent.

2.  The authority of the federal courts cannot be changed by consent, a proposition which goes back to Marbury v. Madison.

Dean Chemerinsky went on to state that there is no good reason to distinguish between subject matter jurisdiction and authority to decide cases.    He said that under Mr. Brunstad’s logic, subject matter jurisdiction could be waived.  

While Mr. Brunstad relied on Schor, that case said that “essential attributes” are reserved to Article III courts.   

He also rejected the notion that there was a difference between personal and structural rights because all structural rights exist to protect personal liberties.   

The Dean also distinguished several of Mr. Brunstad’s analogies.   Neither a special master nor an arbitrator can issue a final judgment.   However, a bankruptcy judge can.   He said that federal magistrates are not a good comparison because their authority is still up in the air like that of bankruptcy courts.

Brunstad:

In rebuttal, Mr. Brunstad challenged Dean Chemerinsky’s contention that jurisdiction and authority to decide were similar.   He said that only Congress can create jurisdiction, but Article III does not specify the form that inferior courts must take.   Further, all Article III requires from a structural viewpoint is independence from the Executive and the Legislative branches.   By placing Bankruptcy Courts within the judicial branch, Congress insulated them from pressure by other branches.   

There are some rights which cannot be waived, such as the right against involuntary servitude.  There are other rights such as the right to a jury trial which may be waived.   The right to decision by an Article III tribunal is a right which can be waived.  

He said that Stern was decided correctly (a position he had to take since the argued for the winning side) but that it did not involve impermissible delegation of judicial powers.   He said that most things that bankruptcy courts do, such as adjudicating claims, are public rights.   Stern, on the other hand, involved a tort claim which was a purely private right.   In Stern, it was clear that Pierce Marshall did not consent to adjudication of the tort claim in bankruptcy.      

Chemerinsky:

Stern v. Marshall was decided wrongly because you should always take the functional approach to separation of powers.   Stern was wrong because there was no threat to separation of powers.  The central tension in Eric’s argument is that it takes a functional approach to a formalistic decision.   Separation of powers cannot be overcome by consent which resolves the consent issue.

Public rights are limited to suits by or against the government.   Because the government cannot be sued absent its consent due to sovereign immunity, it can allow actions to be resolved by or against it in a non-Article III tribunal.   However, most of the work of the Bankruptcy Court does not involve public rights.   Therefore, the public rights argument does not work.

Congress may create inferior courts, but it can’t give them authority beyond what Article III allows.    In Stern, Congress gave bankruptcy courts the power to decide counterclaims to proofs of claim and that authority was found to be unconstitutional.

The right to a jury trial was never structural.   Therefore it does not help on the separation of powers issue here.

Having listened to both arguments, I now have no idea how the consent issue in Wellness International will come out.  I thought that Dean Chemerinsky had the better argument in terms of consistency while Mr. Brunstad had the better argument in favor of making the system work.   Given that the Supreme Court vacillates between strict interpretation and practicalities, this one is very hard to handicap.   However, as a practitioner, the answer is easy:  bankruptcy courts need to be given as much authority as they need to do their jobs and the Constitution will still survive.

Post-script:

In the final minutes, they discussed the Court’s recent decisions.   They both observed that the court vacillates between strict statutory construction and policy concerns.   Law v. Siegel was an example of a strict statutory approach, while Clark v. Rameker (inherited IRAs are not exempt) was a practical approach.    This remains a constant tension with the court.

Saturday, October 11, 2014

NCBJ 2014: Thinking the Unthinkable: Bankruptcy for Large Financial Institutions

Jeffrey Lacker, President of the Richmond Federal Reserve Bank, made the case for why large financial institutions should subject to bankruptcy as the ABI Luncheon Keynote Speaker.  He started his address with the question "Why is a central banker interested in bankruptcy?"  His answer was that during the financial crisis of 2007-2008, the government played a role by distorting incentives of market players with multiple discretionary interventions which destabilized expectations.   He called on the government to realign incentives of major market participants by using bankruptcy instead of discretionary government interventions.   The full text of his speech is available here.

Mr. Lacker said that the advantages of the bankruptcy system are that it is a collective proceeding, it is subject to judicial supervision and is a predictable, rules-based system.    He described the bankruptcy process as "one of the best tools we have for reconciling the goals of creditors and debtors."   He said that the probability of bankruptcy versus the benefits of risk taking would change the incentives of large banks.

He gave some historical background for the problem.  When the Fed was founded 100 years ago, state law prevented branch banking.   As a result, there were 27,000 banks in the country.   This meant that banks could not pool capital between locations.  In 1933, the government adopted government funded deposit insurance primarily to protect small rural banks.   

Fast forward to the present era (my words, not his) and the government began intervening to protect the uninsured creditors of banks through assisted mergers (such as Bear Stearns) and lending on favorable terms.    These actions dampened incentives to tamp down risk.   As financial firms grew to greater size, there was a vicious circle as the government felt compelled to handle financial failure outside of bankruptcy which encouraged more risk taking.   In 1999, only 45% of the creditors of financial firms had explicit or implicit government guaranties.   By 2012, this had risen to 57%.

In 2007, there were two mutually reinforcing conditions present which led to problems.   Investors felt protected and the government felt compelled to confirm expectations.   They feared a domino effect where if they did not support firm A, investors would pull away from firm B.   

According to Mr. Lacker, the government's inconsistent actions exacerbated the problem.    The government arranged for the merger of Bear Stearns with JP Morgan, then it allowed Lehman Brothers to file bankruptcy, then it provided an emergency loan to rescue AIG.   As a result, he said that the expectations that created the problem remained alive and well.

Dodd-Frank was intended to remedy the problem.   He said that beefing up ex ante measures is good but it doesn't solve the problem once institutions are in trouble.   He said that it is asking too much for bank examiners to function as the frontline actors to prevent risky behavior.

Dodd-Frank also created the Orderly Liquidation Authority for large financial institutions.   Mr. Lacker said that while this borrows many features from bankruptcy, it retains many flaws.   The OLA allows some creditors to receive more than they would in bankruptcy.   The availability of funds injected from the treasury is like debtor-in-possession financing but without being tested by the market.    The OLA does not have the checks and balances of bankruptcy.   This system dampens creditors' incentives to monitor risk taking, he said.  If the FDIC is anticipated or assumed to provide assistance, it will likely provide it.

He also discussed the single point of entry feature of Dodd-Frank.   Under this provision, the government can take control of the top level holding company which the subsidiaries remain open.   The regulators create a bridge company to transfer the assets of the holding company to which will eventually be turned over to the private sector.   The expectation is that the shareholders of the holding company will be wiped out  while the creditors of the holding company receive the equity in the new entity.   He described this as a "bail-in" rather than a bail-out.     

Mr. Lacker said that the resolution plans required under section 165 of Dodd-Frank were a positive feature.   The goal is to have companies wound down under the Bankruptcy Code without government support.   This contrasts with past practice where there was little or no advance planning for insolvency of large financial institutions.    He stated that the recent dependence on short terms lending arose from regulators' aversion to bankruptcy, which this provision moves away from.   As a result of this planning or "living wills" for large financial institutions, they can be required to obtain more capital, restrict risk taking or divest assets.  

Lacker said that eleven banks have gone through this process but there is substantial work left to be done.   Other reforms to be addressed are requiring a "rational and less complicated legal structure," creating severability by making institutions self-contained in each country and keeping them from being dependent on inter-company lending.    However, he said that a continued problem is the excessive reliance on short term borrowing which would mandate substantial debtor-in-possession financing from the government in order to maintain operations.    

Mr. Lacker said that the Bankruptcy Code could be adapted to deal with large financial firms. He said that bankruptcy could be used to concentrate losses in the parent company.   A problem that he pointed out is that derivatives are excluded from the automatic stay and other bankruptcy provisions which encourages risk and a shadow banking system.    

Lacker stated that "if we do hard work" to make plans now, there will be a healthy realignment of expectations and incentives.   He said that this will not be complete until we allow a large financial entity to file for bankruptcy.    He said that the goal was that once we have robust provisions in place, we can eliminate the power to make ad hoc rescues.    He said that bankruptcy is advantageous for financial firms because it provides a common pool and consistent outcomes.

In closing, Mr. Lacker stated that expectations led to the financial crisis.  He said that the bailout friendly, too big to fail system is unstable and unfair.   



NCBJ 2014: Hedging Your Bets, Examining an Expert and Secured Creditors in Charge

I spent the morning listening to presentations on very disparate topics:  hedge funds, examining an expert witness and the balance between secured creditors and unsecured creditors.   I was not able to capture the full extent of the discussions and in some cases my descriptions below may be a bit cryptic.   My intent is not to provide a transcript, but rather to provide a flavoring of issues being discussed at NCBJ. 

However, the day began with the 5th annual Berkley-Bernstein 5k race.    As usual, I finished near the back of the back.   However, there is something perversely fun about seeing the sun come up over the water while gasping for breath with fellow bankruptcy practitioners and judges.   Kudos to Berkley-Bernstein for sponsoring this event.   

Watching the Hedges Grow: Inside the Mind of Distressed Investors:  Ret. Judge James Peck, William Derrough (Moelis & Co.), Bruce Bennett (Jones Day), Mark Brodsky (Aurelius Capital) and Ken Liang (Oak Hill Advisors)

This panel was billed as a chance to get inside the minds of hedge funds.   The panel explained that the difference between hedge funds and private equity funds is that hedge funds largely rely on publicly available information, while private equity funds rely on an intense review of internal documents.   There are about 350 hedge fund players and they get involved in cases as small as $50-$100 million.  

According to Ken Liang, hedge funds look for the fulcrum security.  His company believes that converting to equity produces the highest possible return, although they don't mind receiving payment either.

Mark Brodsky said that his firm may look for two or three places in the capital structure to invest and will focus on value created during the chapter 11 and then get out.

Ironically, the panelists said that hedging and short sales are only a small part of their strategy.

Hedge funds may form ad hoc committees when they feel that the agent or indenture trustee for the debt is not adequately representing the issue or when the Creditors' Committee either represents too many constituencies or is dominated by a group that excludes the hedge funds.   They added that unrepresented positions gets in trouble more often than not.   

William Derrough, who is a financial advisor to debtors, said that the challenge is to get a counter-party to talk to.   He said that there is a dance of dance of getting the fulcrum security to sit down and talk and to get them restricted from trading so that they can share nonpublic information.  This generally involves negotiation over what is confidential and how long the hedge fund should be restricted from trading.   The debtor will generally try to say that everything is confidential and secure a long restricted period, while the hedge fund will try for an extremely short period.   One of the hedge fund reps said that the case is about trying to reach a deal and that debtors are reluctant to provide information until their hand is forced.  
 
Mark Brodsky pointed out that the schedules and statement of financial affairs provide more information than is required by the SEC.    They want to get restricted early, get the information needed and be prepared to negotiate.   He also said that, "Because we are good investors, we believe that settlement is good."    He said that they frequently find themselves begging people to negotiate with them only to find that no one showed up.   He also urged courts to move cases along, stating, "The sooner you get to the courthouse steps, the sooner you settle."  

Judge Peck asked the parties whether, in light of the fact that litigation is so expensive, the threat to litigate is a tool.    Brodsky said that obtaining decisions costs money and that whether it gets that far is a function of how the case is managed.   Liang said that every dollar spent is a dollar taken away from value.   He expressed frustration with debtors who seek extensions of exclusivity.  He said that he wished they would just file a plan and tee up a value.

Judge Peck commented that the difference between hedge funds and other parties is that they have substantial resources and can pursue a credible fight, causing the other side to cave or engage in an arms race.  

Bruce Bennett said that it is important for judges to manage discovery.   He acknowledged that discovery disputes are boring, but said that not every dispute requires twenty depositions and that the court can manage disputes over documents so that the process is cheaper.  

When asked if hedge funds are good for the process, several panelists pointed to hedge funds as a source of new capital and de-leveraging the balance sheet and pointed out that they are better able to make decisions than banks and insurance companies which face regulatory pressures.    Liang said that because hedge funds buy in for less than par, they have more flexibility than banks.   Bennett said that they provide a market for distressed debt.  

Judge Peck concluded that the world of bankruptcy had changed during his time on the bench.   He said that there are now significant pools of capital available to take advantage of research and hard work to obtain solutions that would not have been possible.

All the Courtroom's A Stage:  Honing Courtroom Presentation Skills: Circuit Judge Bernice Donald (6th Circuit), Richard Wynne (Jones Day), Timothy Draeglin (FTI Consulting), Shay Agsten (von Briesen & Roper), Stephen Hessler (Kirkland & Ellis), Ori Katz (Sheppard, Mullin, Richter & Hampton) and Demetra Liggins (Thompson & Knight)

This panel provided a demonstration of examining an expert witness.   Demetra Liggins "profferred" the testimony of the expert with a presentation that was as much legal argument as expert testimony. The judges (Judge Donald and Richard Wynne) commended her for using the proffer as argument and giving a delivery that was expressive and did not sound like mere reading.  

On cross-examination, Shay Agsten (who was making a practice point) made the mistakes of asking open-ended questions on cross, reinforcing the witness's testimony and allowing the witness to evade the questions.  

Stephen Ressler on re-direct exceeded the scope of cross without objection and also elicited legal conclusions from a non-lawyer.

On re-cross, Ori Katz did a much better job of pointing the witness to specific points in his report and trying to control the witness.   He was aggressive with the witness but made the mistake of giving a smart response to the court when admonished to avoid making a sidebar.   

The cross-examining lawyers were also advised that when the witness dodged a question to ask it a different way rather than simply repeating the question.  

Whose Case Is This Anyway:  Should A Chapter 11 Case Be Run Solely for the Benefit of Secured Creditors?   Judge Barbara Houser, Ross M. Kwasteniet (Kirkland & Ellis), Jeffrey Pomerantz (Pachulski, Stang, Ziehl & Jones), Damian Schaible (Davis, Polk & Wardlaw) and Jane Lee Vris (Millstein & Co.)

This panel examined the relationship between the secured creditor seeking to control the case, the debtor and the unsecured creditors trying to salvage some value.   Topics covered included plan support agreements, floating liens, credit bidding and 363 sales.

In theory, a plan support agreement is a positive thing.   Where the debtor and the secured creditor anticipate a filing well in advance, the debtor can look for holes in the creditor's collateral and negotiate a distribution for the unsecured creditors.   The process also needs to allow sufficient time for an unsecured creditors committee to be appointed and do due diligence.   On the other hand, where the unsecured creditors are cut out or are not given time to get up to speed, a plan support agreement will simply force the committee to fight.

Jane Vris pointed out the danger that a plan support agreement and DIP financing would be intertwined and therefore locked in at an early stage.

Jeffrey Pomerantz referred to plan support agreements that cut out the committee as a "pre-packaged cram-down."    

The parties spent considerable time discussing the implications of In re Residential Capital, LLC, 501 B.R. 479 (Bankr. S.D. N.Y. 2013) on floating liens.   In this case, the junior secured creditors had blanket liens on the debtor's assets and claimed that the equity in the debtor was subject to their security agreement.   Where value is created post-petition through the bankruptcy, this is not value which secures the creditors' pre-petition claims.    The panelists discussed whether it is even possible to have a lien upon the goodwill of a company and if so, how a creditor would foreclose this lien under the UCC.

Repeating a recurring theme, Pomerantz said, "If the secured creditor wants to participate in bankruptcy, they need to pay the freight."   His point was that if a secured creditor wants to use bankruptcy to realize upon its value, it probably means that the bankruptcy will generate more value than the creditor could have obtained out of court and that this value should be shared with the unsecured creditors.  

With regard to the melting ice cube problem, the parties discussed the problem that when an expedited sales process occurs, it may be impossible to fully determine the extent of the secured creditor's lien.   Where this occurs, they suggested a hold back to protect against the possibility that part of the secured creditor's claim might be disallowed.

The panelists discussed the problem of DIP orders that preserve the secured creditor's credit bidding rights and therefore prevent the court from modifying them later.   However, a creditor can't credit bid on an asset upon which it doesn't hold a lien.    Where the extent of the creditor's lien is in dispute, the creditor should be limited to credit bidding the undisputed portion of its lien or waiting until the lien issue has been thoroughly litigated.  

Judge Houser had the final word, stating that "for me as a judge, when I'm being told that we have 22 minutes to get this case done, I tend to think that's not true and there needs to be a modicum of due process."   She said that she may schedule a status conference to ask how the unsecured creditors will be protected in the process.   She said that she didn't want to have a district judge on appeal "thinking I'm a complete idiot."



Friday, October 10, 2014

NCBJ 2014: Fed Economist Says "I've Got to Admit It's Getting Better, A Little Better All the Time (It Can't Get Much Worse)"

William A. Strauss, an economist with the Chicago Fed, delivered the keynote address for the Commercial Law League of America's luncheon Thursday.   His overall forecast was for slow but steady growth, declining unemployment and low interest rates as the country digs its way out of the Great Recession.    In other words, he predicted a good climate for reorganizing debtors.

His only reference to bankruptcy was in his opening remarks when he stated:
Bankruptcy is good.  Unemployment is good.   They are necessary evils. . . . Unemployment makes workers available to industries that are rising.   Bankruptcy makes resources available to industries that are rising.
He described the economic picture as a good news, bad news story.   He said that the United States has the strongest economy in the world, although its growth is not impressive.   He said that we should see positive growth this year.   However, he tempered his remarks by pointing out that the relevant metric is not zero.   Each year the labor force grows by 1% while productivity can be expected to grow by 1.0-1.25%.   Thus, a growth in GDP of 2.0-2.25% is the expected trend line.

He said that the outlook for the next five years was growth at:

2014 +2.0%
2015 +2.9%
2016 +3.0%
2017 +2.0%

He said that the economy is recovering slowly from the Great Recession.   After the recessions in the 70s and the 80s, the economy improved by about 20% in the five years after the trough.   Here, the recovery is only expected to be about 11%.    During the Great Recession the economy declined 4% over an eighteen month period.  Subtracting the growth which should have occurred during this period, the economy was down 7%.    

However, the American economy looks positively rosy compared to the rest of the world.   Japan is expected to increase by 1.2-1.3%, Europe by 1.0-1.5% and Russia by 0-1%.    Strauss said that the U.S. needs for the rest of the world to do well in order for our economy to do well.

The housing market illustrates the double nature of the recovery.   On the one hand, housing starts are up 40% and prices are growing by double digits.   On the other hand, 15-20% of homes are still under water financially and prices are back to their levels of ten years ago in real terms.   

The stock market appears to be at record highs, but is not when adjusted for inflation.

Employment is another weak area.   8.7 million jobs were lost during the Great Recession.   We are currently adding about 1 million jobs per year which means that it will take 6 1/2 more years to recover.   He said that the natural unemployment rate is 5.25% and that we are about half a point above that level.   Labor force participation fell by 3% during the Great Recession and is back to 1978 levels.   1.5-2% of this is due to demographics, that is, older workers dropping out of the work force, while 1.0 - 1.5% is cyclical.    What is even more concerning is that participation levels for those aged 25-64 are constant, while the 16-19 and 20-24 year old demographics are down dramatically.   

3.5 million workers have given up looking for jobs and are not counted in the unemployment rate.   He said that the true level of unemployment beyond the natural level is about 4.5 million to which is added a percentage of those working part time who would prefer full time work.   (He gave the statistic.  I just didn't get it in my notes).   

He said that we are "far removed from a labor force that is in balance."

Mr. Strauss said that the demand side of the economy is growing but not by much.  He said that producing too much of anything results in reduced prices rather than inflation.  He predicted that inflation would only be 2.2% in 2014 and 2.1% in 2015.   The Fed's target inflation rate is 2%.   Strauss said that there is nothing wrong with going above the target rate if it will help the labor market. 

He described manufacturing as a stellar sector in the economy.  However, it has only brought back 31% of workers laid off.   The remaining gains have been due to productivity.   The companies that survived are more "lean and mean."  He also said that we have "world class manufacturing in the U.S."  We have 5% of the world's population and 24% of the output in the world.   One growth area is for vehicle manufacturing.   The average car on the road is eleven years old, something that would have been unthinkable a decade ago.  However, it also means that a lot of people will be replacing their vehicles.

Strauss spent a fair amount of time talking about monetary policy.   (He is from Chicago after all).   He said that in 2008, the Fed lowered the overnight lending rate to nearly zero.   He said that he wished they could have lowered it to -4% so that people would have been forced to take money out of the bank and spend it.   However, he said that would have been too disruptive.  Apparently Cyprus did just this by taxing bank deposits and the result was bad.   

He said that he expected the overnight rate to reach its natural rate of 3.0-3.25% by 2017.  He described this as a neutral rate, "not putting the foot on the brake, just taking the foot off the accelerator."

He quoted Milton Friedman as saying that inflation everywhere is a monetary phenomenon and that it results from monetary policy, not the monetary base.

Strauss said that he never had the occasion to study with Friedman.   However, he did have occasion to attend his 90th birthday party where a newly minted Fed Governor named Ben Bernanke was the keynote speaker.   Speaking of the Great Depression, he told Friedman, "We're sorry.   We're not going to let it happen again."   During the Great Depression, the Fed added to the monetary base but not as much as was being lost from bank failures.  As a result, the money supply declined which contributed to the depression.

During the Great Recession, the Bernanke Fed grew the monetary base by 20% but only grew the money supply by 6%.    However, he was true to his word and did not let the country slip into a full blown depression.

In conclusion, he said that we will continue to grow the economy at a decent rate for the next several years and that employment will continue to rise at a moderate level.

In response to a question that I don't remember, he quoted Warren Buffett as saying "You don't know who's swimming naked until the tide goes out."   I don't remember the context, but I like the quote.
  


Thursday, October 09, 2014

NCBJ 2014: Chapter 9, Closely Held Businesses, e-Discovery, Claims Buying and Sale Free and Clear of Interests

NCBJ is in Chicago this year.   The weather is pleasantly cool compared to the continuing Austin heat and the first day of CLE had some interesting programs.   Here is a wrap of Day 1, which included Chapter 9, reorganization for closely held companies, e-discovery, an economist from the Chicago Fed, claims trading and treatment of "interests" in section 363 sales.     I will divide the day between separate posts on the educational seminars and the economist's prognostications.  There will be another Fed economist speaking tomorrow.

Chapter 9:  Judge Steven Rhodes, Daniel Heimowitz (RBC Capital Markets), Marc Levinson  (Orrick, Herrington & Sutcliffe, LLP), Ron Oliner (Duane Morris) and Judge Elizabeth Perris

While Chapter 9 may seem exotic and unusual, three California Cities, as well as Detroit and Jefferson County, Alabama have all used this mechanism.   In Texas, it has been used on a smaller scale for many road and water districts.    

Municipal finance is big business.   There is about $3.7 trillion of municipal bonds outstanding with 11,464 issued during 2013.  Nevertheless, only about 4-5 default in any given year.   However, when they do, it creates a big stir.

The  most unique aspect of chapter 9 is its public nature.   Ron Oliner referred to the process as trying both "a political and a legal case" which is challenging for lawyers not used to dealing with the political process.   One of the speakers described dealing with the "crazy" ever present media and politicians and having clients constantly talking to the media to try to influence public opinion.   In the City of San Bernadino case, the City Attorney was recalled shortly after the case was filed, prompting the Mayor to state that the City Attorney's "26 year reign of terror" had ended.   Marc Levinson described the circus nature of city council meetings where decisions must be made in public.   Judge Perris, who has been the judicial mediator for several of the California cases, explained the difficulty of mediating cases where the principals could not be in the room due to open meetings law.  She also described having the media stake out mediations and reporting on the comings and goings of the various participants.   

One important issue discussed was eligibility.   There are several hoops that a municipality must jump through in order to qualify for relief, including being authorized to file by state law and having negotiated in good faith.   Conversely, if an entity is a municipality, it is not eligible to file for chapter 11.   The New York Off-Track Betting Corporation was found to be a municipality, while the Las Vegas Mono-Rail and the Orange County investment pool were not.   In re: New York Off-Track Betting Corporation, 427 B.R. 256 (Bankr. S.D. N.Y. 2010); In re Las Vegas Monorail Co., 429 B.R. 770 (Bankr. D. Nev. 2010); In re County of Orange, California, 183 B.R. 594 (Bankr. C.D. Cal. 1995).

Frequently, labor union difficulties are a factor in Chapter 9 cases.   Because section 1113 does not apply in Chapter 9, the more lenient standard of NLRB v. Bildisco & Bildisco, 465 U.S. 513 (1984) applies to rejection of collective bargaining agreements.   Nevertheless, the politics of public unions encourages negotiated solutions.  

The requirements to confirm a plan appear similar but are tricky.   When dealing with a secured creditor, it is often necessary to engage a municipal finance expert to determine whether the bond instrument has created a pledge of funds or merely provided for funds to be paid from a particular source.   The absolute priority rule has little application since municipalities do not have equity holders.   However, the necessity of obtaining bond financing in the future deters parties from burning bridges.    Feasibility is a challenge where projections must go out forty years.   

Judge Perris pointed out the importance of mediation in Chapter 9 cases, stating that the parties need to make deals and need to make peace.    She said that many of the players in Chapter 9 cases are repeat players and are constantly worrying about what will happen in the next case down the road.

All in the Family:  Advising the Closely Held Company: Whitman Holt (Klee, Tuchin, Bogdanoff & Stern, LLP), Mindy Mora (Bilzin, Sumberg, Baena, Price & Axelrod), Douglas Rosner (Goulston & Storrs) and Michael St. Patrick Baxter (Covington & Burling)

The panel discussed the importance of spelling out the nature of the representation.   Doug Rosner said that at the beginning of the representation when the interests of the company and the shareholder are blurred that "the conversation is equally blurred."   Mindy Mora suggested obtaining an initial engagement letter specifying that the firm represented both the individual and the company prior to bankruptcy but would be representing the company only once bankruptcy was filed.   Rosner said that when talking to the individual, "my job is to tell you when you need to talk to your own counsel."

They also discussed the plight of the independent director.   While an independent director is under no obligation to stay ("it's not maritime law, you don't have to go down with the ship"), the director may benefit from staying on because decisions made on advice of counsel will likely be protected and directors can obtain releases under a plan.

There was a lot of discussion about so-called "bad boy" guarantees, where the principal's liability is triggered by a bankruptcy filing.   This creates a conflict of interest between the individual's personal interest in not having the guaranty take effect and the fiduciary duty to the company and creditor's.  Interestingly enough, in one case, the springing guaranty took effect upon an involuntary bankruptcy filed by the lender who was the beneficiary of the provision.    The panel discussed the situation in the Extend-A-Stay case where the debtor's principal sued his personal counsel after they advised him that his exposure on a breach of fiduciary duty claim was greater than his springing guaranty.   However, the case was dismissed, which was affirmed on appeal.
Another conflict of interest arises from the attorney's retainer.    Without a retainer, the company cannot obtain competent counsel.    However, the company's funds are often subject to a creditor's liens.   If the company pays counsel with encumbered funds, counsel may be forced to disgorge and be disqualified.   Trying to launder the funds through a related entity is even worse.    

Pre-bankruptcy forebearance agreements are a trap for the unwary.   Lenders may insist upon waiver of the automatic stay, disgorgement of counsel's retainer and an unlimited guaranty from the principal while providing only limited forebearance.   (The correct answer here is not to agree to these provisions).

If the company does not file, it probably will not be able to protect the principal from suits while a plan is being negotiated.    Judge Allen Gropper has two recent decisions where he refused to grant a section 105 injunction to a restaurant owner being sued for wage violations.   In re SDNY 19 Mad Park, LLC, 2014 Bankr. LEXIS 3877 (Bankr. S.D.N.Y. 2014); In re Capitale I Ventures, LLC, 2014 Bankr LEXIS 3099 (Bankr. S.D. N.Y. 2014).    (Practice point:   don't stiff your employees if you plan to file chapter 11).     

Assuring eDiscovery Does Not Become eDisaster, District Judge James F. Holderman, Jason Lichter (Pepper Hamilton), Stephen Lerner (Squire Sanders), Camisha Simmons (Rose Norton Fulbright)

While I took a lot of notes from this panel, there were several top take-aways:
  • If you have an eDiscovery issue, tell your judge to call Judge Holderman.   Even though he was considerably older than his fellow panelists, he has worked through these issues extensively and is happy to discuss them with other judges.   His phone number is 312-435-5632.
  • The Seventh Circuit Electronic Discovery Pilot Program, www.discoverypilot.com, has lots of useful information, including forms and free webinars.    The Seventh Circuit is very proud of this site and it is the current judicial state of the art.
  • If the case is going to involve eDiscovery, have your client designate an eDiscovery Liason  and have her work with an eDiscovery Liason from your firm.   Make sure that your firm understands all there is to know about how your client collects, maintains and preserves electronically stored information (ESI).
  • The ABA has a Best Practices Report on Electronic Discovery (ESI) Issues in Bankruptcy Cases. http://apps.americanbar.org/buslaw/committees/CL160000pub/newsletter/201307/esi_best_practices.pdf.
  • Before ESI issues arise in the case, develop an ESI Protocol with opposing counsel.   If opposing counsel won't agree, file a motion to establish one.   However, don't make it a first day motion.   An ESI Protocol can deal with issues such as clawback of privileged documents and parameters for searching documents.   For example, the parties could agree to a protocol that accepts that 80% accuracy in searching is acceptable.
The requirement to preserve ESI arises when an attorney "reasonably anticipates litigation."   The attorney should put in place a litigation hold consisting of written instructions to the client's custodians of ESI.

There are proposed amendments to the Federal Rules of Civil Procedure which will take effect on December 1, 2015 if approved by the Supreme Court.   Among them, Rule 37(e) will be amended to provide that a spoilation instruction can only be given where the court finds there was an "intent to deprive" the opposing party of ESI.   This would replace the current negligence standard applicable in some circuits (and no, I don't know which ones).    There is also a proposed amendment to Rule 26(b)(1) which will replace the reasonably calculated to lead to the discovery of admissible evidence standard with one which refers to information which is relevant and proportional to the needs of the case.   Proportionality looks to what is reasonable under the circumstances of the case given the resources of the parties.    

An interesting concept to discuss with your transactional lawyers is the litigation pre-nup.   It defines what ESI protocols the parties will use if there is ever litigation over the deal.   This may be the wave of the future.

The only bad thing about attending this program is that now I can't claim to be ignorant of these issues.

Bankruptcy and the Markets:  The Uneasy Relations Between Debtors, Traders and Judges: Judge Jeffrey Deller, David Eaton (Kirkland & Ellis),   Debra Grassgreen (Pachulski Stang, Ziehl & Jones), Thomas Moes Mayer (Kramer, Levin, Naftalis & Frankel, LLP), Jeffrey Rich (Rich Michaelson Magaliff Moser) 

The panel distinguished between strategic and non-strategic purchases of claims.   Non-strategic purchasing of claims is buying a claim in the hopes of recovering more than was paid.   Strategic claims purchasing, on the other hand, is purchase of claims with the intention of influencing the case.   This could mean attempting to obtain equity or control in the reorganized debtor or to block a plan and force a sale of the debtor's assets.   

Strategic claims purchases can be either good or bad depending on the motivation of the purchaser.   Good motivations are those which advance the purchaser's economic interest as a creditor.  Negative motivations can include driving a competitor out of business or extorting a disproportionate payment to stop interfering with the reorganization.   

Tools for dealing with improper use of purchased claims include designating the creditor's ballot under section 1126(e), equitable subordination and denying credit bidding.   Major cases include In re DBSD North America, Inc., 634 F.3d 79 (2nd Cir. 2011), where the court affirmed designation of the vote of a competitor who purchased claims for above par late in the case to block confirmation, In re Lightsquared, Inc., 513 B.R. 56 (Bankr. S.D. N.Y. 2014), where a creditor was allowed to vote despite an improper motive where plan was "abysmal" and any creditor would have opposed and, In re Fisker Auto Holdings, 510 B.R. 55 (Bankr. D. Del. 2014), where a creditor who purchased a claim was limited to credit bidding the amount it paid for the claim.


Section 363 Sales:  What You Get and What You are Stuck With:   Hon. David Coar (ret.), Barry Bressler (Schnader Harrison Segal & Lewis, LLP), Lisa Hill Fenning (Arnold & Porter), George W. Schuster (Wilmer Cutler Pickering Hale & Dorr), Richard W. Young (Quarles & Brady)

This panel examined what it means to sell property free and clear of "interests."   The first scenario it examined was successor liability.    In the case of  In re Trans World Airlines, Inc., 322 F.3d 283 (3rd Cir. 2003), the term "interests was defined broadly enough to extend to vouchers given to flight attendants in compromise of labor claims.    In Chrysler, the debtor proposed to sell the assets of the company and assume warranty claims for post-closing sales of vehicles but not pre-sale tort claims.   The Ad Hoc Committee of Consumer Claims appealed and the Second Circuit affirmed.  In re Chrysler, LLC, 576 F.3d 108 (2nd Cir. 2009).    The Supreme Court vacated the Second Circuit decision based on mootness.   Nevertheless, the Debtor later agreed to assume some claims for the purpose of preserving the value of unsold vehicles.    In General Motors, there was not a third party buyer.   The "sale" allocated 10% of the value in Newco for tort claimants and assumed liability for future tort claims.   However, the company did not disclose certain known claims based on cars switching off.

Intellectual property is another example of an interest possible "interest."    Intellectual property consists of patents and copyrights, which exist under federal law, trademarks, which exist under federal law, state law and common law, and trade secrets, which are created by common law.   

Liens on intellectual property can be perfected by filing under the UCC.  The Patent and Trademark Office can record an assignment of patents or copyrights but not a mortgage.   

Intellectual property can be transferred pursuant to exclusive license, non-exclusive license or sale.  An exclusive license allows the licensee to use the IP to the exclusion of other parties but may include a reversion to the licensor.  A non-exclusive licensee may use the IP but the licensor is free to grant licenses to multiple parties.   Finally, a complete transfer vests ownership in the IP to the purchaser.

A non-exclusive license may not be assigned without the consent of the licensor.   A true exclusive license may be assigned.   Originally, trademarks could not be licensed because they were identified with the owner.   However, the law subsequently allow trademarks to be licensed so long as the licensor controlled the quality.   

A debtor who is a licensee may not assign its license without consent of the licensor.   On the other hand, if the debtor is the licensor, it can assign its right to receive royalties.   However, a debtor may not sell its IP free and clear of existing licenses.   This is provided by section 365(n).        

Precision Indus., Inc. v. Qualitech Steel SBQ, LLC, 327 F.3d 537, 545 (7th Cir. 2003), Dishi & Sons v Bay Condos, LLC, 510 B.R. 696 (S.D.N.Y. 20140 and In re Spanish Peaks Holdings II, LLC, 2014 Bankr. LEXIS 913 (Bankr. D. Mt. 2014) are three cases dealing with whether property could be sold free and clear of the rights of others to use the property.   

Qualitech held that a debtor could sell property free and clear of the lessee's right to possession so long as the lessee was provided adequate protection.   The court reasoned that although the debtor could not dispossess the tenant by rejecting under section 365, section 363 allowed the sale free and clear of liens.

In Bay Condos, the Court also held that section 363(f) and 365(h) were not in conflict.  However, in order to sell under section 363(f), the debtor must meet one of five conditions stated.   While the tenants interests could have been extinguished under section 363(f), The Court found that section 363(f) would rarely ever allow a sale free and clear of the tenant's right to possession.  

Finally, in Spanish Peaks, the court found that the two sections were in conflict.   The Court allowed sale of the property free and clear of the interests of leases granted to insider affiliates of the debtor.

Wednesday, October 08, 2014

The Short Case for Venue Reform

Today I had the opportunity to debate venue reform at the National Conference of Bankruptcy Judges in Chicago.   We had two excellent teams of debaters.   Arguing for the pro-reform position were Prof. Samir Parikh, retired Bankruptcy Judge Leif Clark and myself.   The pro-status quo team consisted of Prof. Douglas Baird, retired Bankruptcy Judge Arthur Gonzalez and Dan DeFranceschi of Richards, Layton & Finger, P.A.   Jamie Sprayregen of Kirkland & Ellis moderated the debate.  We had a good, vigorous debate.     There was at least some agreement that venue for preference actions should be reformed.    The debate was sponsored by the Commercial Law League of America.

Here is the opening statement that I gave for the pro-reform side:

Good afternoon, my name is Steve Sather. My colleagues, retired Bankruptcy Judge Leif Clark and Prof. Samir Parikh and I will be arguing that the current bankruptcy venue law, 28 U.S.C. § 1408, should be reformed to prevent forum shopping in Chapter 11 cases.

By forum shopping we mean filing in a venue where the company has little or no physical presence.   Examples would include the Los Angeles Dodgers and the Chicago Tribune filing bankruptcy in Delaware.

Forum shopping is allowed by the current law for two main reasons.  First, by equating domicile with state of incorporation, the courts have allowed companies to file in jurisdictions that have little to do with their actual business operations.   Second, by allowing venue where there is a case concerning an affiliate, venue for an entire corporate group can be based on the locale of a minor subsidiary or even one created for the purpose of obtaining venue.

   Judge Leif Clark, Prof. Samir Parikh and Steve Sather debate at NCBJ
 
Forum shopping occurs with great regularity.   Prof. Parikh’s study found that 69% of large companies that filed chapter 11 during the Great Recession forum shopped.   This is not just happening in Delaware and New York.   Pilgrim’s Pride, ASARCO and Crescent Resources are all examples of cases that were forum shopped to my home state of Texas.   It is not just happening in large cases either.  In a study by the Venue Reform Group, of which I am a member, half of the 559 out of state cases filed in Delaware since 2003 had less than $15 million in assets.   The current venue law is so open-ended that it has been referred to as a non-law.

Forum shopping is a problem because it confounds creditor expectations and deters participation by local parties.    Think of the City of Detroit case where Judge Steven Rhodes viewed the local community and allotted a full day for local residents to address the court.   That could not have happened if the case had been filed in Delaware.   When a bank or a trade creditor deals with American Airlines in Fort Worth, they know that they may have to go to Ft. Worth to enforce their debt.   However, they do not expect to have to hire local counsel in Delaware to defend a preference action. 

Forum shopping also creates the perception that the process is manipulated by insiders and major players to the detriment of small creditors.  When Enron filed in New York, it looked like the company was fleeing from its very public problems in Houston.   While Houston was good enough for the criminal trials of the Enron executives, the reorganization was held elsewhere.  Bankruptcy is big business and when it takes place far away from the home forum, we can expect the public to be skeptical of the process and the results.   I don’t blame the lawyers because they are simply taking advantage of the choices given to them under existing law, but the current process feeds the Wall Street vs. Main Street narrative that is dividing our country.

While we acknowledge that there are skilled and hard working judges in New York and Delaware, there are excellent judges all over the country and we see that in cases where forum shopping is not an option such as municipal bankruptcies and the Catholic Diocese cases.    Think Steven Rhodes with the City of Detroit or Susan Kelly with the Diocese of Milwaukee.   

In our discussion today, we will offer several solutions, including separate venue provisions for individuals and artificial entities, which was the rule immediately prior to enactment of the Code, reforming the affiliate venue rules, creating a national bankruptcy court of appeals and procedural reforms to ensure that venue issues are resolved promptly and efficiently and that forum shopping is deterred.

Note:  My original post referred to Dennis DeFranceschi.   His name is actually Dan, which I knew.  I apologize to both Dan and his parents for trying to rename him.

Monday, October 06, 2014

Judge Says "Over My Dead Body" to Trustee's Mediation Plans

The importance of alternate dispute resolution to resolve cases is enshrined in federal law, 28 U.S.C. §651(a), and is encouraged by most judges.   However, one bankruptcy judge recently told lawyers in a case that they would mediate “over my dead body.”    While the court’s ruling was triggered by the parties’ failure to request permission to expend estate funds, his comments expressed a high level of skepticism toward mediation in general.  The case is In re Cody Smith, No. 12-32096 (Bankr. S.D. Tex. 9/3/14).

What Happened

The Cody Smith case involves several different adversary proceedings.   When the parties asked to abate various deadlines so that they could mediate, the following discussion took place.   This is my attempt at transcription from the electronic recording of the proceeding.   Any errors are unintentional.

The Court:               As I understand it, the Second Joint Emergency Motion is being filed because you’re going to mediate.

Mr. Wentworth (Trustee’s attorney):    That’s correct, your Honor.

The Court:                  Did I give you permission to go to mediation?

Mr. Wentworth:          Your Honor, maybe I’ll defer to Mr. Lemmon on that.  I didn’t file any motion.

The Court:                   Mr. Lemmon, did I give the Trustee permission to mediate?

Mr. Lemmon (Trustee’s Special Counsel):      No, your Honor.

The Court:                  Does the Trustee have any intention of paying the mediator out of estate funds?

Mr. Lemmon:             My firm is advancing . . . .

The Court:                 That’s not my question, not who’s advancing.    Is the Trustee eventually going to be using estate funds to pay the mediator?

Male Speaker:             I think that’s what we had envisioned.

The Court:                  Over my dead body.  I do not like mediation.    I think it is wasteful for the most part and you all needed to get my permission.  I assume counsel for the Trustee is going to the mediation and I assume counsel for the Trustee’s going to ask me to approve those fees.

Mr.  Lemmon:             Yes, your  Honor.

Male Speaker:            For the mediatior . . .

The Court:                  Aint gonna happen.   Don’t you ever do that again, Mr. Cage.

Mr. Cage (the Trustee):           Yes, your Honor.

The Court:                  I’m going to do a general order to put all my chapter 7 cases (on notice).  You are not to mediate without my approval.   Or if you’re gonna do it, you’re going to get my approval or if you’re going to do it (without my approval), I’m not going to allow attorneys to be paid.   I think for the most part mediation is a waste of time and money.  You all are grown up big boy attorneys.   You can talk settlement.   You’ve been talking settlement.    And I’m not going to allow more money to go to a mediator.   Either you settle it or you don’t.   But don’t ever do that again.

Mr. Cage:                    Understood, your Honor.

Mr. Lemmon:             This is Steve Lemmon.   I am sorry your Honor.   The idea of doing a mediation was my idea, so I apologize.

The Court:                  Mr. Lemmon, I’ll grant you a lot of judges love mediation, but I don’t.   I think mediation is undercutting the jury trial system in this country and I think it is making lawyers lazy and judges lazy and I also think it’s excess costs to pay for a mediator.   Lawyers are supposed to do two things.    They are supposed to get ready for trial and they are supposed to talk settlement professionally.    And I think it is rare that I allow people to go to mediate so don’t do it ever again.   If you want to mediate, then file a motion and come in here and explain to me why, but I’m not going to allow a mediation, not in this case certainly, so I’m going to deny the Second Joint Emergency Motion and with that you all are free to go.

Recording, 9/3/14, 3:04:01-3:07:22 (emphasis added).

My Perspective

I have not been involved in the Cody Smith case although I know most of the lawyers involved.   None of them asked me to write this article.    I heard about from an observer who happened to be in the courtroom that day.   However, I have heard Judge Bohm express similar comments informally.  The fact that the judge made the comments on the record and expressed an intent to issue a general order on the subject made it an appropriate subject for a blog article in my mind.

I am a trained mediator, although I use that experience as a participant in mediations much more than as a mediator.    More importantly, I practice with an attorney who is an artist when it comes to mediation and has successfully settled many difficult cases.   All of this gives me a bias in favor of mediation.

On the other hand, I have no problem with trying cases.   I enjoy trying cases although my work is in bankruptcy court where juries are forbidden absent consent.  In nearly twenty-eight years of practice, I have been second chair on two jury trials and I served on a jury once.   As a result, the jury system is something I have heard about more than I have experienced.

Why the Hostility to Mediation?

Judge Bohm has a legitimate point that parties wishing to use estate funds to mediate should request court permission.  However, in most courts, that request would be met with enthusiasm.    Indeed, federal policy encourages mediation.    28 U.S.C. §651(b) provides that:
Each United States District Court shall authorize by local rule adopted under section 2071(a), the use of alternate dispute resolution processes in all civil actions, including adversary proceedings in bankruptcy in accordance with this chapter  . .  . .
Southern District of Texas Local Rule 16.4 states that mediation is approved for use in bankruptcy proceedings and goes on to state that:
If the parties agree upon an ADR method or provider, the judge will respect the parties’ agreement unless the judge believes another ADR method or provider is better suited to the case and parties.
Local Rule 16.4C.

Let’s look at the reasons given by Judge Bohm for his distaste for mediation.

1.                  Mediation is a waste of time and money.    Judge Bohm expressed his opinion that “grown up big boy attorneys” should be able to “talk settlement professionally.”    If you follow Judge Bohm’s logic, either the case should be able to settle, in which case the lawyers should be able to get there on their own, or it needs to go to trial, in which case mediation would be a waste of time.    I think this logic is oversimplified.   In my experience, there are plenty of cases where qualified, professional attorneys will be unable to settle a case without assistance from a third party.   However, I do agree with Judge Bohm in part.   Attempting to mediate with the wrong mediator at the wrong time can be a waste of time.   As a result, it is important to carefully select a case for mediation and to pick the right mediator.   I will give my opinions about which cases are good for mediation below.

2.                  Mediation undermines the jury system.   This one baffles me.  Judge Bohm is a bankruptcy judge.   Juries are not allowed in bankruptcy without consent of both parties and are an extreme rarity.  As a result, allowing mediation in bankruptcy cases could never have an effect on the jury system.  However, beyond that, I wonder, what is so great about the jury system?   I have to admit a bias here.      No one ever comes to a Debtor’s lawyer and says I need to file bankruptcy because the jury got it right.    It is my personal opinion that the jury system today is often used for tactical reasons, such as to delay trial or increase costs, or in cases where emotion can be counted on to overwhelm the facts.   While juries are intended as a protection for the accused, they convict innocent people often enough to cause concern.   Having said that, the only jury that I served on voted to acquit.     Even if you acknowledge that juries serve a valuable function, they are expensive and not every case needs one.   If every civil and criminal case resulted in a jury trial, the system would quickly collapse.

3.                  Mediation makes lawyers and judges lazy.   I can’t speak for judges since I have never been one.  However, in my experience, mediation does not make good lawyers lazy.   Mediation forces a lawyer to prepare his case in order to persuade the other side that going to trial is a real option.  It also forces lawyers to examine the weaknesses in their case and to find ways around them.    Mediation also allows lawyers to spend focused time with their client talking about the case.    Mediation is about finding a better alternative than trial, not for the unprepared lawyer to avoid trial  Some cases are really difficult and will inevitably lead to a bad outcome for both sides if they go to court.  I have witnessed mediation resolve disputes that had festered for a decade or more.  As a result, I believe that dedicated, hard-working attorneys can use mediation as a tool.   Obviously, mediation can be used as a crutch by the unprepared or unwilling, but that is the fault of the lawyer rather than the procedure.

What Makes for a Good Mediation?

Economics teaches that an efficient market depends upon a willing buyer and a willing seller with access to complete information.   Lawsuits are similar.   In order to settle, there have to be parties who are willing to negotiate in good faith and have good information.   Mediation can change a party’s willingness to settle if the unwillingness was based on an unreasonable attorney or where the mediation process allows the party to save face.  This is especially true where emotional considerations rather than money are driving the case. Otherwise, having an unwilling party probably means an unsuccessful mediation.   

Mediation can be very successful when parties have been acting on incomplete information.    Attorneys are supposed to be both counselors and advocates.   However, the process of obtaining clients often depends on projecting strength and confidence rather than giving good counsel about the weaknesses of a case.   Other times, a client will filter out information he doesn’t want to hear.    A combination of a good lawyer and a good mediator can help a difficult client evaluate his case more accurately and reach an agreement.  

There are also cases involving difficult situations which require a lot of creativity to solve.   While the parties could theoretically resolve these cases on their own, the presence of a neutral third party can help the attorneys and the parties consider solutions they would not have thought of otherwise in a format allowing vigorous give and take.   This is especially true of multi-party cases.   

Finally, there are a few cases where both sides show up ready to make a deal and arrive at a sensible result within a short period of time.   There is no reason that these cases should not have settled without mediation.  However, sometimes the mediation process itself serves to focus a party’s attention on settling better than a series of calls with counsel.   

Final Thoughts

I can agree with Judge Bohm to a very limited extent.    Mediation can be a waste of time and money if the parties are doing it for the wrong reasons or are not prepared.    I can also agree with Judge Bohm that a lazy attorney may seek out mediation if he is not ready for trial and is trying to stall.     However, when good attorneys tell the court that they favor mediation, the Court should defer to their judgment, as I believe is required by Local Rule 16.4C.  

I agree that it is a good practice to seek court approval for mediation on any number of grounds.   First, it helps to keep the Court informed and allow the Court to ask questions as to the reasons for the mediation.    Good lawyers should be prepared to give good answers to those questions.    Second, I agree with Judge Bohm that paying a mediator is an expense not in the ordinary course of business which should be approved in advance.  I don’t think it is necessary for attorneys who represent estates to get special permission to participate in a mediation.  When an attorney is appointed in a case where litigation is involved, mediation is inherently part of that appointment.   Finally, I think that mediation pursuant to court order is useful because it binds the parties to mediate in good faith.   While the parties will ordinarily agree to mediation in advance, a court order makes it harder for parties to back out at the last minute to try to secure a tactical advantage.     A court order also helps to impress the parties with the seriousness of the process.

Federal Rule of Civil Procedure 1 states that the rules "should be construed and administered to secure the just, speedy, and inexpensive determination of every action and proceeding."    I believe that mediation is a valuable tool to achieve these goals in appropriate cases.   I would encourage Judge Bohm to reconsider his hostility toward mediation, or at the very least, to discuss the issue in a public forum where a back and forth dialog can take place..