The New York Times, the Associated Press, The Hill, and many other media outlets are reporting that former Credit Slips blogger Katie Porter has won her election for California's 45th Congressional District. Anyone who knows Katie's work knows that she will fight for middle-class households. As happy as I am for Katie and for the country, it is bittersweet to lose a great co-author and research collaborator.
We also have been remiss in not congratulating another former blogger, Senator Elizabeth Warren, on her reelection. It is hard to believe that this modest little blog now has two former bloggers in Congress.
Sears is supposedly considering trying to raise liquidity through the post-petition sale of intracompany debt. The details of the debt and the proposed transaction aren't clear, but as a general matter, the post-petition sale of intracompany debt (or Treasury stock) seems problematic to me as with any lead into gold transaction. Here's the issue: if the debt is sold, is it still intracompany debt or does it become general unsecured debt?
The viability of Sears' strategy depends on the answer to this question. If it is still intracompany debt post-sale, it's not going to sell for very much; if it is general unsecured debt, it's much more valuable. (This is putting aside the weird arbitrage with the CDS settlement auction market that gets warped by the CDS volume exceeding the reference debt volume.)
In most bankruptcies, intracompany obligations between affiliated debtors are either subordinated or cancelled outright. Nothing in the Bankruptcy Code compels this, but it's pretty standard. It tends to follow from a separate classification of intracompany obligations (again, not compelled by the Code) and from the difficulty in determining net intracompany obligations--deemed consolidation for voting and distribution is standard operating procedure in large bankruptcies. If the leaden intracompany claims can be transformed into golden general unsecured claims, it's a huge siphoning of value away from other general unsecured creditors. General unsecured creditors are paid pro rata on their claims, so an increase in the size of the general unsecured claim pool dilutes recoveries on the debt.
So would a sale of intracompany obligations transform them into arms' length obligations?
I don't have a definitive answer about whether the sale transforms the character of the debt. Perhaps it relates to the form of the debt (formal notes, rather than accounts receivable), but I don't think it should, even if one might conceive of intracompany notes as part of an internal capital market. The issue seems akin to the question of whether disallowance or equitable subordination travels with a claim, something I wrote about at the beginning of my academic career (here and here), and which has never been clearly resolved by the courts. In the claims trading, context, there are at least workarounds with contractual warranties, however. In the case of a post-petition sale, there's only the sale order.
Given that there's no inherent subordination of intracompany claims, the case against their transformation seems weak, but the sale of intracompany debt is further complicated because it comes with governance rights, which are subordinated. 11 USC 1129(a)(10) requires that a cram down plan be accepted by at least one impaired class, not counting the votes of insiders (i.e., intracompany votes). Cf. Section 316(a) of the Trust Indenture Act, which also disregards insider votes. Selling intracompany debt thus changes the bankruptcy electorate. On the one hand, we might not be concerned because if the debt is held by non-insiders, the issues with insider voting go away. On the other hand, though, has the clear dilutive effect on general unsecured claimants' voting power.
All of which is to say that there seems to be some grounds to potentially challenge the sale of intracompany obligations. Yes, they raise liquidity for the debtor, but if the debtor can't get liquidity through DIP financing or cash collateral, should it really be reorganizing? If you've got to burn the furniture to heat the apartment, you can't afford the keep operating the apartment. I suppose a court could always say that the distributional/voting issues raised by a sale of intracompany obligations is an issue to be addressed later with plan objections (good faith perhaps? Or vote designation or subordination motions?), but it seems to me that it's an issue that the court would do well to resolve upfront as clarifying parties' respective rights will make it easier to negotiate deals without the uncertainty about the deals' enforceability. Perhaps the solution is a proposed sale order that addresses the issue, and lets the parties have the fight up-front. Of course, that might be exactly what Sears doesn't want--it wants funding now and to worry about priorities later. But lack of clear priorities should depress sale values, so there's a trade-off between liquidity and speed that will have to be considered.
Let me just note, however, that if the sale does transform the quality of the debt from being intracompany to arms' length general unsecured debt, it should be standard operating practice in Chapter 11 as a matter of maximizing the value of the assets of the estate. That fact that it is not suggests that there are real concerns about the ability of a sale to turn lead into gold.
It seems no surprise that President Trump has named Matthew Whitaker as Acting Attorney General: it turns out that he's a Mini-Trump. There are two rather remarkable parallels to Trump in Whitaker's history. First, his involvement with the operation known as World Patent Marketing closely parallels Donald Trump's involvement with the fraud known as Trump University. And second, both have used charities as their own personal piggybanks. Classy.Both World Patent Marketing and Trump University were at core bilking scams: took payments in exchange for a service and did not provide any meaningful service. Trump University promised world class real estate investing advice and it gave out packets one could have downloaded from the Internet. World Patent Marketing promised to help inventors get their products patented and to market, and, according to the FTC, did basically nothing. Both operations were facilitated by their use of Trump University played on Trump's endorsement and his supposed real estate investing acumen, while World Patent Marketing bonded itself by putting Whitaker on its advisory board and then trumpeting his background as a US Attorney as a way of establishing credibility. A WPM news release quoted Whitaker as saying, "As a former U.S. Attorney, I would only align myself with a first class organization. World Patent Marketing goes beyond making statements about doing business 'ethically' and translate [sic] those words into action."
[Pro tip: when someone calls a company a "first class organization," it's probably not. When it puts out a news release that it does business ethically, it probably doesn't. When was the last time you saw a reputable firm put out a news release like this?]
Whitaker apparently did more than just vouch for the company, however. He also spoke about the company's clients' inventions in promotional videos, and wrote a threatening email in response to a complaint about the company. The threatening email seems potentially problematic to me in two ways. First, it violates in spirit, if not in letter, a Model Rule of Professional Conduct for an attorney. Second, I think it opens the door to civil and criminal liability for Whitaker.
Whitaker walks perilously close to the line of violating Model Rule of Professional Conduct 4.1 with this letter. Lawyers write dick letters like this all the time, but that doesn't mean that it's ethical to do so. MRPC 4.1 says that in the course of representing a client, a lawyer shall not knowingly make a false statement of material fact or law to a third party. When you write a letter on behalf of someone who is paying you in which you name drop your past as a US attorney and warn of civil and criminal liabilities, I think you're acting as their counsel, even without any formal representation agreement. The statement that Whitaker made is not 100% false—there are criminal libel laws in some jurisdictions—but they're almost never prosecuted, and a complaint to the BBB wouldn't trigger one, not least because the facts alleged remain confidential. Likewise, an on-line review wouldn't necessarily constitute criminal libel because it would have to be knowingly false and defamatory. Of course, Whitaker might just be ignorant, and therefore not acting "knowingly," but this is a case where he should have known before writing. All in all, Whitaker's letter might not violate the letter of the rule, but it does seem to violate the spirit, and it makes him seem like a grammatically challenged bully.
Whitaker might also have some civil and/or criminal liability from his involvement with WPM. WPM settled with the FTC without admitting guilt, but to the extent it engaged in fraud, Whitaker's involvement with the company (and particularly the email trying to squash a complainant) might also open him up to liability for aiding and abetting the fraud (and with it also a violation of MRPC 8.4 on attorney misconduct). His use of an email to advance a civil fraud could also open him up to wire fraud charges. Yes, there are lots of possible defenses, e.g., lack of scienter. Still, this is not the sort of background that should be hanging over an Acting Attorney General.
The Trump parallels don't stop with the scam-association. They also extend to abuse of charities. Trump used his charitable foundation to cover his legal settlements and buy vanity portraits of himself. Whitaker took a salary from a charity that in one year exceeded half of the donations the charity received. That makes it seems as if Whitaker himself was the charitable cause. The IRS has rules against inurement of excessive private benefit. There's no bright line definition of what's an excessive private benefit, but I think taking home over half of a charity's revenue would readily qualify. That could result in either the loss of the charity's 501(c)(3) status.
With a hat tip to Taylor Swift: Grifters gonna grift, grift, grift, and scammers gonna scam, scam, scam.
The Supreme Court granted cert today in the bankruptcy case of Mission Product Holdings v. Tempnology, LLC. It sounds like another one of those cases only bankruptcy nerds can love, but it has potentially broad implications. On its face, it is about trademark licenses, but the Supreme Court could fix some case law about all contracts in bankruptcy. Several Credit Slips bloggers (including me) signed a "law professors" amicus brief in support of certiorari.
I asked the inimitable Professor Ted Janger of Brooklyn Law School (and former Credit Slips guest blogger) to write with his thoughts on the case. Ted had a lot to do with the professors' brief. Here is what he wrote:
The split in the lower courts arose when the First Circuit inexplicably resuscitated the questionable proposition, first articulated in Lubrizol Enters., Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), that rejection of an intellectual property license rescinds that license and terminates the licensee’s rights. Congress reversed Lubrizol for copyright and patent by enacting section 365(n), and in 2012, the Seventh Circuit rejected the reasoning of Lubrizol for trademarks, in Sunbeam Prods., Inc. v. Chi. Am. Mfg., LLC, 686 F.3d 372 (7th Cir. 2012). While there remained some question as to the continued vitality of Lubrizol outside the patent and copyright context, the holding was, at best moribund. At least, that is, until the First Circuit’s decision in Tempnology.
In Tempnology, the debtor manufactured branded sportswear with a patented wicking technology. The debtor gave an exclusive territorial license to Mission Products to sell these branded goods. When Tempnology filed for bankruptcy, it rejected the license, and sought to transfer those exclusive rights to a purchaser. Under the reasoning in Sunbeam and the language of section 506(g), the effect of rejection would be merely to “breach” the contract. By contrast, under the reasoning in Lubrizol, the effect of rejection would be to rescind the license. This potentially left Mission Products with a large amount of inventory that it could not sell without infringing. Or to put it another way, if Mission wanted to liquidate the inventory, they would have to pay a second time for trademark rights they had already purchased.
By taking this case, the Supreme Court has the opportunity to answer a question that has long haunted courts – whether the power to reject a contract under section 365 is an avoiding power. As both Jay Westbrook and Michael Andrew pointed out over twenty years ago, the answer to that question is a resounding, “no.” The trustee’s power to reject is merely the power to breach.
Simple examples illustrate the importance of this distinction. Consider a solvent merchant who sells a laptop along with warranties and a service contract, delivers the laptop, and then breaches by failing to perform the ongoing warranties and/or service obligations. The breach would not “unsell” the laptop. Similarly, if the seller were to file for bankruptcy, rejection of the contract by the seller/debtor would free the debtor of its warranty obligations and obligations under the service contract, but it would not undo the sale and entitle the debtor to get the laptop back. A trademark license similarly grants the licensee the right to use the trademark under certain conditions and a defense against an infringement lawsuit brought by anyone (including non-parties) for any covered use. The licensor may have other ongoing obligations, too—akin to the service and warranty obligations above—but if the licensor fails to perform on those obligations under the license (i.e., “breaches”), the license will nonetheless continue to operate as a defense against any claim of infringement, provided that the licensee continues to live up to its own obligations under the license. The same result is specified by Section 365(g) if the breach occurs through rejection in the bankruptcy context; the debtor/licensor’s rejection is simply given effect as a breach of the debtor’s obligations under the license agreement as of the bankruptcy petition date.
While this case has come up in the context of trademark rights, the implications are broader than that. The question arises any time contract rights and property rights are entwined in a contract, and it is time for the Supreme Court to put the ghost of Lubrizol to rest.
Thank you, Ted. And, stayed tuned for more.