Chapter 11 Plan Adequately Reserved Bankruptcy Rights Transferred to a Liquidating Trust

The United States Bankruptcy Court of the Northern District of Texas recently held that a confirmed chapter 11 plan of a liquidated company, R.L. Adkins Corp. (the “Corporation”), was not required to specifically preserve bankruptcy-created rights of the Corporation against its former principal.  See Harvey L. Morton v. Robert Lewis Adkins, Sr. (In re Robert Lewis Adkins, Sr.), Adversary No. 13-01028 (Bankr. N.D.T.X. March 27, 2015.)  In doing so, the Bankruptcy Court analyzed the Fifth Circuit Court of Appeals‘ precedent in Dynasty Oil & Gas, LLC v. Citizens Bank (In re United Operating, LLC), 540 F.3d 351 (5th Cir. 2008) and the text of the Bankruptcy Code.

R.L. Adkins Bankruptcy

The Corporation was initially placed in an involuntary chapter 7 liquidation proceeding, but a month later converted to a chapter 11 reorganization case.  In a chapter 11 case, the management of a debtor normally maintains control and operations of the company during the reorganization process, subject to certain restrictions under the Bankruptcy Code.  See 11 U.S.C. §§ 1107 and 1108. In other words, a chapter 11 debtor is generally allowed to operate in the same manner it operated outside of bankruptcy.

In R.L. Adkins Corp.’s case, however, three months after the case was converted to chapter 11, the Bankruptcy Court appointed a trustee to take over the control and operations of the Corporation, pursuant to 11 U.S.C. §  1104.  Generally, the appointment of a trustee in a chapter 11 case is a drastic remedy and requires a finding that the debtor, under existing management, has exhibited a practice of not complying with the various obligations and duties under the Bankruptcy Code.  That appeared to be the case in R.L. Adkins Corp.’s case.  The Bankruptcy Court nonetheless believed that it was in the best interest of creditors for the bankruptcy case to proceed under chapter 11, instead of a chapter 7 liquidation.

Several years later the Bankruptcy Court confirmed (approved) the a chapter 11 plan, which had been proposed, not by the chapter 11 trustee, but one of the Corporation’s creditors (who was out a fair amount of money).  The chapter 11 plan established a liquidating trust that, upon plan confirmation, was transferred and received all the assets in the bankruptcy estate of the Corporation, including all potential claims and causes of action of the Corporation against third parties (the “retained claims”).  The purpose of the liquidating trust was to liquidate all of the assets of the Corporation, including prosecuting the retained claims, and ultimately make a distribution to creditors from those liquidated assets.

The chapter 11 plan defined retained claims as “all estate causes of action belonging to the Debtor and estate based on federal or state law, and any claims, counterclaims, rights, defenses, setoffs, recoupments, and actions in law or equity arising under the Bankruptcy Code or applicable non-bankruptcy law.”  The plan then illustrated a number of claims that were retained claims, including claims for breach of fiduciary duty and common law actions.

Principal’s Bankruptcy

Separate and apart from R.L. Adkins Corp.’s bankruptcy, the owner of the Corporation separately filed for chapter 7 bankruptcy relief.  The purpose of an individual chapter 7 bankruptcy case is to distribute all non-exempt assets of the debtor to his or her creditors and allow the debtor to obtain a discharge of all of his or her pre-bankruptcy debts.

Section 523 of the Bankruptcy Code, however, excepts certain pre-bankruptcy debts from being discharged. Examples of non-dischargeable debts include certain tax liabilities, fraud claims, breach of fiduciary duty claims and other claims that public policy disfavors discharging (e.g., child support obligations).

In the principal’s individual bankruptcy,  the liquidating trustee appointed under the Corporation’s confirmed plan filed an action against the principal to determine that certain claims that the Corporation had against the principal were non-dischargeable, pursuant to section 523(a)(4) and (a)(6) of the Bankruptcy Code.  These claims revolved around the principal’s alleged breach of fiduciary duty to the Corporation.

In the non-dischargeability action, the principal moved to dismiss the liquidating trustee’s claims for lack of subject matter jurisdiction, based on the fact that the Corporation’s confirmed plan did not specifically mention that non-dischargeability claims under the Bankruptcy Code were included as retained claims.  The Bankruptcy Court was left to decide this issue pursuant to guiding Fifth Circuit precedent and section 1123(b) of the Bankruptcy Code.

Four Quarners of Plan

In Dynasty Oil & Gas, LLC v. Citizens Bank (In re United Operating, LLC), the Fifth Circuit held that

[f]or a debtor to preserve a claim, the [chapter 11] plan must expressly retain the right to pursue such actions.

540 F.3d at 355.  According to the Fifth Circuit, the reservation in the plan must be “specific and unequivocal.”  See id.  In other words, a blanket and generic reservation of all claims is not proper.  See id. at 356.  More recently, the Fifth Circuit relaxed the standard for reserving a claim, finding that a bankruptcy court may review other material, in addition to the plan, like solicitation material associated with the plan (i.e., disclosure statement), to determine whether a claim is properly reserved. See Spicer v. Laguna Madre Oil & Gas II, LLC (In re Texas Wyoming Drilling, Inc.), 647 F.3d 547 (5th Cir. 2011).   In Spicer, the Fifth Circuit held that a plan properly reserved avoidance claims when it reserved “claims under Chapter 5 of the Bankruptcy Code” and the related disclosure statement described “various potential avoidable transfers that can be recovered under Chapter 5.”  See id at 549, 552.

The requirement to properly reserve a claim derives from section 1123(b)(3) of the Bankruptcy Code, which specifically provides that a chapter 11 plan may provide for “the retention and enforcement by the debtor, by the trustee, or by a representative of the estate appointed for such purpose, of any claim or interest [belonging to the debtor or its estate].”  See 11 U.S.C. § 1123(b)(3) (emphasis added).

The policy underlying the proper reservation of claims is grounded on “the nature of a bankruptcy, which is designated to secure prompt, effective administration and settlement of all debtor’s assets and liabilities within a limited time.”  See Union Operating, 540 F.3d at 355.  “To facilitate this timely, comprehensive resolution of an estate, a debtor [or trustee] must put its creditors on notice of any claim it wishes to pursue after confirmation.”  Id.  Creditors are entitled to notice either because the claims would enlarge the bankruptcy estate (and thus provide a higher recovery) or the creditors might be targets under the plan.  This enables creditors to properly vote on the chapter 11 plan, a requirement for plan confirmation.  See In re Gulf States Long Term Acute Care of Covington, LLC, 487 B.R. 713, 715 (Bankr. E.D. La. 2013).

Application of Fifth Circuit Precedent

In the principal’s chapter 7 bankruptcy, using guiding Fifth Circuit precedent and the text of section 1123(b)(3), the Bankruptcy Court found that the Corporation’s plan did specifically reserve breach of fiduciary duty claims, such as those that the liquidating trustee was ultimately pursuing (after the prosecution of the non-dischargeability action).  While the plan did not specifically reserve a non-dischargeability action, the Bankruptcy Court found that such an action did not amount to a claim (i.e., a right to payment), as defined in section 101(5)(A) of the Code.  Instead, such action merely determines whether an underlying claim is dischargeable in bankruptcy.  Because the non-dischargeability action was not seeking a right to payment, the Bankruptcy Court held that it was not a claim and did not fall within the parameters of section 1123(b)(3), which uses the word “claim” when describing what a chapter 11 plan can reserve.  Therefore, according to the Bankruptcy Court, the chapter 11 plan was not required to specifically reserve this type of action.

Further Insight

While the Bankruptcy Court was correct in determining that section 1123(b)(3) uses the term “claim” and does not expressly require reservation of non-dischargeability actions pursuant to section 523 of the Bankruptcy Code, arguably the Court ignored that section 1123(b)(3) provides for the reservation of both “claims” and “interests.”   Unlike the term “claims,” the term “interests” is not defined in the Bankruptcy Code and generally is understood to have a broader meaning.  Thus, some may wonder why having an underlying claim, like breach of fiduciary duty, deemed non-dischargeable is not a valuable “interest” that belongs to a debtor or its bankruptcy estate.  If it is, then section 1123(b) and leading Fifth Circuit precedent would require proper reservation.

On the other hand, if a non-dischargeability action is merely an extension of the underlying claim (which will be pursued later), then why wouldn’t the specific mention of the underlying claim suffice to reserve the related non-dischargeability action?  In addition, if the Fifth Circuit’s Spicer opinion holds that a description of “claims under Chapter 5 of the Bankruptcy Code” is sufficient to reserve such claims, then why wouldn’t the R.L. Adkins Corp.’s reservation of “all rights . . . under the Bankruptcy Code” be sufficient?  Unfortunately, these questions were not addressed in the Bankruptcy Court’s opinion, but hopefully they will be addressed in future opinions. Until then, stay tuned.