Sample Answer to Bankruptcy (Triantis) Exam, December 2013

Question 1

The two most likely targets for the committee are the repayment to the Bank during the 90 day period
before bankruptcy and the payments to David during 2012-13.

1. Repayments of Bank loan while insolvent within 90 days of bankruptcy were preferences if they
improved the Bank’s recovery compared to what it would have been otherwise in Chapter 7. It
would, to the extent that the Bank is undersecured in its lien. In Union Bank v. Wolas, the
Supreme Court held that the safe harbor in 547(c)(2) applied to long-term debt. However, it
only applies if the debt is incurred in the ordinary course of business. This is a tough case to
make for Bank because it financed the LBO, not the business of the debtor. So, the repayments
are likely to be avoidable preferences, even if made on schedule, to the extent of the
undersecurity.
2. Payment to David during 2012-13were made while F was insolvent and may be fraudulent
transfers. F received nothing in return, unless it could prove that the payments were made as
compensation to Susan. David would have been safer if F had made the payments first to Susan
who then paid David. Under 550(a)(1), F could recover from David and from Susan, given that
the latter is a beneficiary of the transfer.

The LBO transaction itself, under which Susan acquired ownership of F, is probably fine because we
don’t have indication that it left the company undercapitalized. If that were not the case, then the
transfer of the second lien may have been in exchange for less than reasonably equivalent value to F, as
would the obligation incurred. The funds would have been viewed as being advanced to Susan, with F
as a conduit. And, in assessing the defense in 548(c), the court would have held Bank responsible for
not having conducted sufficient diligence to make sure that the transaction would not leave the debtor
undercapitalized. However, undercapitalization does not seem to have been present at the time of the
LBO. The fact that F became insolvent later in 2011 is probably insufficient evidence on its own because
such a tort is unpredictable shock.

The unsecured creditors would like to be able to reach the assets of M, which would happen if the court
substantively consolidated the two entities. Since M is presumably still solvent, the creditors of M would
not consent. The court would mandate consolidation (e.g. under Owens Corning in the 3d Cir) only if
either (a) the creditors had disregarded separateness so significantly that creditors relied on the
breakdown of entity borders and treated them as one, or (b) the assets and liabilities of the entities are
so scrambled that separating them would be prohibitive and would harm all creditors. The financial
statements have been combined and assets have moved between the companies without formality for
many years. On the other hand, Bank was able to take a lien in the assets of F, suggesting that those
assets may have been identifiable. There’s a high bar under Owens Corning, and the harm to M’s
creditors suggests that court is unlikely to mandate consolidation… but it’s worth a try.
If the requirements for consolidation are present, then the companies might argue that they should be
treated as consolidated for the purposes of determining whether there was insolvency at the times of
the transfers. It appears that, together, F and M might have been solvent throughout.

Question 2

There are two core questions here. First, is the second bid better than the first? Second, if it is, should
the court reopen the auction in order to authorize the more attractive bid and maximize the value of the
estate. As a preliminary matter, note that credit bidding is explicitly authorized in 363(k), so if it were
not for the subsequent bid, the secured creditor’s group would be sold the assets.

The post-auction includes $300,000 less cash than the auction winner, and correspondingly more value
in promissory notes. We are told that the unsecured creditors committee “valued’ the package at $4.5
million, but any valuation would be based on an assessment of the default risk on the promissory notes.
One might wonder why the unsecured committee would prefer a bid with less cash, particularly if they
wanted to reorganize the debtor as a going concern. One possibility is that they could try to cramdown
a plan that gives the secured creditor less than the value of its lien in deferred cash payments, instead of
selling the assets to the secured creditor. In any event, the court should examine the plausibility of the
$4.5 million valuation.

One wonders if there is an explanation for the lateness of the last bid. If it could be traced to
inadequate notice of the auction, then the court should allow the late-bid to be considered, or authorize
a new auction. Otherwise, the question hinges on a tradeoff between the goals of preserving the
integrity of bankruptcy auctions in this jurisdiction and getting the most value for the creditors in this
particular case. If the court accepts the post-auction bid, then it undermines its ability to set a deadline
for auctions in the future. Potential bidders are correspondingly more likely to wait for the outcome of
the auction before deciding whether and how much to bid. Essentially, they will freeride on the work of
others who might meet the deadline. Indeed, even the post-auction bidder is not immune from being
outbid by a later entrant… where will it end?

This is similar to the challenge of attracting a first bidder in an auction and the bid-protection
mechanisms that are used to encourage such bids. A stalking horse moves before an auction and, in
return, is offered a break-up fee, for example, if the debtor should sell to someone else. This might
suggest a compromise that the court could use under the facts in this question. The court might
authorize the debtor to accept the higher bid (if indeed it is higher) and pay the winner of the auction a
brea- up fee based on the industry norm. Suppose that it is 3%. Then, the auction winner will receive a
payment of 120,000 from the post-auction bid, and the debtor will receive the balance in the form of
380,000 in cash and $4 million in promissory notes.

Question 3
The Bank is challenging the separate classification of its claim under the construction loan from the
trade creditors. Although trade creditors who will continue to deal with the debtor might have a
different perspective than the unsecured creditors, the class presumably contains some trade creditors
whose contracts were rejected (after all, an assumed contract is paid in full) and who have no future
relationship with the debtor. If this is the case, then the separate classification of the bank’s
construction claim is more difficult to justify. The debtor’s vulnerability to the gerrymandering objection
is heightened by the treatment of the trade creditor class under the plan. Trade creditors are technically
speaking impaired, so as to satisfy 1129(a)(10). But, given that they are impaired by a minimal amount,
there is a question as to whether the plan has been proposed in good faith (1129(a)(3)).

To cramdown against bank’s unsecured claim, the plan must satisfy the absolute priority rule in
1129(b)(2)(B)(ii) and give nothing to the junior interest on account of such junior interest. The debtor’s
parent will continue to hold a controlling share of the equity of the debtor. This is permitted only if
there is new value in money or money’s worth. Perhaps the compensation provided to assume and
extend the management contract would come partly in the form of the new equity interest. Even so,
the court would have to find some equivalence between the value contributed and the value of the new
equity, in order to allow the cramdown over the objection of the bank. Should it be put to a market
test?

The debtor has another interesting argument. The bank’s construction loan is very similar to an equity
interest because it is repayable only out of net rents; it is not a fixed obligation, but conditional on the
profitability of the debtor. This is similar to a stockholder’s interest in the profits of a firm. The debtor
may argue that the bank’s claim is therefore a junior interest, like that of the equityholders, and
therefore not entitled to priority and the protection under 1129(b)(2)(B)(ii).

The cramdown requirement with respect to the bank’s first lien under the acquisition loan is
straightforward. The plan must provide for a stream of payments whose nominal amount is no less than
$8 million (given the 1111(b)(2) election) and whose present value is at least equal to the value of the
property in a chapter 7 liquidation, which seems to be no more than 6.8 million under the facts.

In the background of these determinations is the debtor’s claim about value creation. It claims that the
changes to the property can increase the value from no more than $6.8 million to $10 million, a very
significant – and perhaps incredible -- appreciation. If the court believes this, it would be more inclined
to give the debtor time to amend the plan in order to either reach a deal with the Bank or bolster its
cramdown case by providing a market test for the valuation of the equity and the provision of
management services.

Question 4

Let’s take the suggested example of a retailer with hundreds of contracts in default. In bankruptcy, that
retailer would assume some contracts and pay them in full; and reject others and pay them as
unsecured claims. The stakes for the counterparties are very large – the difference between dollar-for-
dollar payment and cents-on-the-dollar. There is a very substantial inequality in the distribution, and
this is problematic. It is reminiscent of the dissent’s concern in Brown v. Reading with the discrepancy
between the treatment of a pre-petition tort victim and a post-petition victim. Disparities like this are,
however, impossible to avoid in bankruptcy because of the tension between allocating losses fairly and
giving the debtor the ability to continue the going concern but with the right incentives. One could ask
whether it is necessary for the Code to compel the debtor to compensate in order to assume the
contract, given that the trade creditors should be willing to resume dealing once the problem has been
cured and their future services/deliveries are assured of being paid in full.

Another tack to eliminate the disparity might be to elevate the priority of the damages claims that arise
after a debtor is in bankruptcy, treating them like damages for torts occurring after the filing. This
solution would trade one type of discrepancy for another, because the counterparties of rejected
executory contracts would be treated more favorably than those who completely rescind their contracts
before the bankruptcy filing (and have an unsecured claim). This discrepancy would create perverse
incentives on the counterparties to postpone termination in order to have the debtor file first, or on the
debtor to terminate the contracts it plans to reject en masse the moment before it files.

The special treatment of financial and commodities contracts is motivated by a separate set of concerns
about contagion and liquidity in markets for risk. As we discussed the National Gas Distributors case,
drawing the line between contracts that raise this concern and those that don’t is a difficult problem.
Contagion and domino effect can happen in commercial markets, though perhaps less severely.

Question 5

The language in 364 requires that the debtor be unable to obtain credit by giving less than the priority
requested. It does not refer to the unavailability of other modes of financing, notably use of existing
cash collateral or assets that could be liquidated. It is unusual for debtors in bankruptcy to have
unencumbered assets. If there were, however, a court might reasonably rule (under its discretion) that
the debtor must use those non-essential assets first before borrowing at a higher priority. However, the
effect on the unsecured creditors of an asset sale and secured DIP financing is quite similar. In one case,
valuable assets are removed from the estate and in the other, they are left in the estate but there is a
new priority claim.

More likely, the non-essential assets are at least partly secured, so that any sale would have to be free
and clear of the lien, and the use of the proceeds would be conditioned on adequate protection. This
would mimic the analysis that would precede an authorization to prime the prepetition secured lender.
Here again, the effect of the asset sale and the priming DIP financing on the secured creditor is roughly
equivalent.

From a governance point of view, there are two distinct asset deployment question. Is the non-essential
asset serving any role in the bankruptcy? If not, it should be sold. Second, does the debtor have a
profitable project or going concern that requires funding? If so, the funding should be obtained if there
isn’t sufficient cash in the company. Once these questions are attended to, there is no need to tie the
DIP financing authorization to the sale of these assets or the use of the assets as collateral.