Business & Restructuring

ReviewIN THIS ISSUE

B U S I N E S S R E S T R U C T U R I N G

Recent Developments in Bankruptcy and Restructuring Vol. 1 No. 3 June 2002

1 No Indemnification of Chapter11 Financial Advisors

A California bankruptcy court de-nied an application to retain a fi-nancial advisor because theindemnification provision in the fi-nancial advisor’s engagement letterwas not reasonable

3 What’s New At Jones Day

4 Tax-Free Asset Transfers NotConfined to Post-ConfirmationSales

According to a Delaware districtcourt, asset transfers need not nec-essarily take place in conjunctionwith confirmation of a chapter 11plan of reorganization to be exemptfrom stamp or similar taxes

6 Severance Payable UnderPre-Bankruptcy EmploymentContract Not Entitled to Ad-ministrative Expense Priority

The Fifth Circuit ruled that anemployee’s claim for severance willbe entitled to administrative prior-ity only if the employee can showthat the bankruptcy estate was ben-efited by the severance provision

8 Solvent Chapter 11 Debtor MustPay Interest on UnsecuredClaims at Federal Rate

The Ninth Circuit held that a sol-vent chapter 11 debtor must paypost-petition interest on unsecuredclaims at the federal judgment rate

9 Legislative Alert

10 From The Top

No Indemnification of Chapter11 Financial AdvisorsA California bankruptcy court denied a creditors’ committee’s motion to retaina financial advisor under an agreement which provided that the chapter 11 es-tate was obligated to indemnify the advisor “against any and all . . . liabilitiesarising out of or related to . . . any actions taken or omitted to be taken by [theadvisor] (including acts or omissions constituting ordinary negligence) in con-nection with [the advisor’s] provisions of services to the Committee.” In In reMetricom, Inc., the court ruled that the indemnification, contribution and ex-culpation provisions in the financial advisor’s engagement letter were not “rea-sonable” terms of employment under the circumstances.

Retention of Professionals in BankruptcyBankruptcy trustees, chapter 11 debtors and official committees are permittedto retain a wide variety of professionals, including lawyers, accountants, auction-eers and investment bankers, to represent their interests during the bankruptcycase. Any employment of professionals must be approved in advance by thebankruptcy court. The terms governing a proposed engagement may vary de-pending on the circumstances, the scope of the engagement and the type of pro-fessional involved. The Bankruptcy Code provides that a trustee, chapter 11debtor-in-possession or committee may employ a professional “on any reason-able terms and conditions of employment, including on a retainer, on an hourlybasis, or on a contingent fee basis.” Bankruptcy courts consequently have con-siderable discretion to authorize the employment of professionals under termsand conditions that are appropriate in light of the circumstances. In some cases,the court retains the power to modify those conditions even after it has approvedthe engagement. However, it may do so only if it concludes that the terms andconditions governing a professional engagement “prove to have been improvi-dent in light of developments not capable of being anticipated at the time ofthe fixing of such terms and conditions.” The party seeking to employ a pro-fessional bears the burden of demonstrating that the terms of the employmentare reasonable.

2 I J o n e s , D a y , R e a v i s & P o g u e

Bankruptcy courts willgenerally subject anyproposed engagementwhose terms include in-demnification of theprofessional to strictscrutiny to determinewhether it is reasonablefor the estate and itscreditors to answer forthe professional’s mis-conduct. More oftenthan not, the answer tothat question has beenno.

Indemnification ProvisionsQuite frequently, financial advisors re-tained in a restructuring engagement in-sist that the client indemnify themagainst liabilities incurred in performingservices. A typical indemnification pro-vision will obligate the client to indem-nify the financial advisor and its agentsagainst claims by third parties that ariseout of the advisor’s services, and/or tocontribute to any expenses incurred bythe advisor in defending against or sat-isfying such claims. It may also containan “exculpation” provision precludingthe client from suing the financial advi-sor and its agents for damages caused byits services, unless the injury is deter-mined to have been the result of willfulmisconduct, bad faith or gross negli-gence.

Indemnity or contribution and ex-culpation are different methods of at-taining a similar result. In general,indemnity means that if a third party

sues a professional based upon theprofessional’s services to the client, theclient will pay to defend the professionaland will pay any judgment against theprofessional. Contribution means thatif a third party sues both the profes-sional and the client, the client will con-tribute some or all of the professional’scosts to defend and to satisfy any judg-ment. Exculpation means that the cli-ent agrees not to sue the professionalbased upon the services provided by theprofessional. Under each of these ar-rangements, the client bears some or allof the financial consequences of theprofessional’s actions.

Indemnification provisions havebeen greeted with considerable skepti-cism in bankruptcy cases. The principalreason for this is that professionals hiredin a bankruptcy case are subject to thesame fiduciary duties owed by the cli-ents they represent, and the idea of mak-ing the estate liable for damagesresulting from an estate fiduciary’s mis-conduct is widely perceived as being an-tithetical to the fiduciary relationship.This and other considerations led thebankruptcy court in In re Metricom, Inc.to conclude that indemnification maynot be a “reasonable” term of employ-ment in a bankruptcy case.

BackgroundMetricom, Inc. filed a chapter 11 peti-tion in 2001. An official committee ofbondholders appointed in the case (the“Committee”) sought to retain the firmHoulihan Lokey Howard & ZukinCapital (“Houlihan”) as its financial ad-visor in connection with the case. Theengagement letter detailing the terms ofHoulihan’s proposed retention providedthat the debtor “agrees to indemnify andhold harmless [Houlihan] and its affili-ates . . . from and against any and alllosses, claims, damages or liabilities . . .

arising out of or related to [the employ-ment and], any actions taken or omittedto be taken by [Houlihan] (includingacts or omissions constituting ordinarynegligence) in connection with[Houlihan’s] provision of services to theCommittee.” It relieved the debtorfrom its indemnity obligations if any li-ability incurred by Houlihan was judi-cially determined to have resulted fromits willful misconduct or gross negli-gence. Finally, the engagement letteralso contained an “exculpation” clauseproviding that the debtor, its creditorsand its shareholders waived any claimsagainst Houlihan arising from servicesthe firm was to provide, except to theextent that such claims were based uponwillful misconduct or gross negligence.

The United States Trustee, a quasi-governmental office created to overseemany of the administrative aspects ofbankruptcy cases, objected to the reten-tion of Houlihan by the Committee. Itmaintained that the indemnificationprovisions in Houlihan’s engagementletter were not “reasonable,” as requiredby the Bankruptcy Code. According tothe U.S. Trustee, the protectionsHoulihan sought from the estate in theform of indemnity/contribution and ex-culpation might be available from aninsurer, such that it would not be nec-essary (and hence not “reasonable”) forthe estate to incur that burden. It alsoargued that the Committee had notdemonstrated that it was not able toobtain comparable services for the sameprice from another financial advisorwithout having to agree to the indem-nification provisions. All things con-sidered, the U.S. Trustee insisted,forcing the estate to indemnifyHoulihan was clearly not reasonable,and the Committee’s application to re-tain Houlihan on that basis should bedenied.

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 3

continued on page 12

John J. Rapisardi (New York) moder-ated a panel discussion on creditor re-coveries at the American BankruptcyInstitute’s May 6, 2002 conference inNew York City. His bimonthly bank-ruptcy column entitled “CommercialLease Proration Dispute in BankruptcyHeats Up” appeared in the May 16,2002 edition of the New York LawJournal.

Richard M. Cieri (Cleveland) wasamong the outstanding bankruptcyprofessionals featured in the 2002 edi-tion of the K & A Restructuring Regis-ter: America’s Top 100. He will bespeaking in New York City on June 17,2002 at the American BankruptcyInstitute’s second annual conference onWorkouts, Restructurings and M&ATransaction Alternatives: The Deal-Maker’s Perspective.

Corinne Ball (New York) was a panel-ist on May 15, 2002 at a Practicing

Law Institute conference in New YorkCity entitled “Vulture Capital & Corpo-rate Restructuring: Protecting YourClient’s Interests in Difficult Times.” OnSeptember 26, 2002, she will be apanelist at the “Corporate Mergersand Acquisitions” program jointlysponsored by the American Law Insti-tute and the American Bar Associationin New York City. She will also beparticipating in a program entitled“Doing What We Can After theLaSalle Remand” at the National Con-ference of Bankruptcy Judges on Oc-tober 15, 2002.

Debra K. Simpson (Dallas) and DanielP. Winikka (Dallas) co-authored anarticle entitled “The Broad Scope ofSubordination Claims Under Section

510(b) of the Bankruptcy Code” thatwill be appearing in the July or August2002 issue of the Annual Survey ofBankruptcy Law.

Neil P. Olack (Atlanta) moderated apanel discussion on professional reten-tion issues at the 18th Annual Bank-ruptcy & Restructuring Conference ofthe Association of Insolvency and Re-structuring Advisors held in Atlanta onMay 15-18, 2002. He also served onthe planning committee for the confer-ence. On May 29, 2002, Mr. Olacklectured on bankruptcy law as a mem-ber of the faculty of the GraduateSchool of Banking at Louisiana StateUniversity. He has served on the fac-ulty since 1996.

What’s New at Jones Day?

Log on to www.jonesday.com for additional information concerning Jones Day’sRestructuring and Reorganization Practice as well as the firm’s other practicegroups throughout the world.

The bankruptcy court agreed. Itrefrained from adopting a per se ruleagainst indemnity/contribution and/orexculpation for financial advisors, stat-ing that “the issue is whether particularterms are reasonable under given cir-cumstances, and such a determinationcan only be made on a case by case ba-sis.” The court noted that a majority ofbankruptcy courts that have addressedthe propriety of such clauses have ruledthat they are inappropriate. Among thereasons articulated by these courts werethat indemnification is not consistentwith professionalism, in that profession-als should not be insulated from theconsequences of their own negligence,and that the concept is “shockingly in-consistent” with the fiduciary responsi-bilities borne by professionals retainedin bankruptcy cases. It found the ma-

jority approach to be the better reasonedone, but declined to impose an absoluteprohibition on indemnification or simi-lar provisions.

Rather, the bankruptcy court ex-plored whether the Committee (andHoulihan) had demonstrated that theproposed indemnification provisionswere “reasonable” in light of the particu-lar circumstances of Metricom’s chapter11 case. It concluded that they had not.The court noted, for example, that therewas no evidence that Houlihan couldnot obtain insurance to cover any liabili-ties it might incur based upon the ser-vices it intended to provide to theCommittee. It also found no evidenceindicating that the Committee couldnot have retained other comparable fi-nancial advisors without having to agreeto indemnify them. In fact, the court

remarked, both Metricom and anotherofficial committee in the case had doneprecisely that, indicating both that com-parable services without the indemnitywere indeed available and that “suchprovisions are not de rigeur in the indus-try.” Finally, the court emphasized,Houlihan itself never contended that itwould not have provided services to theCommittee without the indemnificationprovisions. Acknowledging that “theBankruptcy Code was intended to beapplied ‘flexibly’ in order to encourageprofessionals to serve in bankruptcycases,” the court concluded that the in-demnification provisions in Houlihan’sengagement letter were not reasonableunder the specific circumstances ofMetricom’s chapter 11 case. It then de-nied the Committee’s application.


Tax-Free Asset Transfers Not Confinedto Post-Confirmation SalesWhether a debtor can sell its assets orbusiness during the course of a chapter 11case without incurring state transfer taxeswas addressed by a Delaware district courtin In re GST Telecom, Inc. By ruling thata chapter 11 asset sale may be exemptfrom certain taxes if the sale is made in an-ticipation of confirming a chapter 11 planof reorganization, the court reaffirmed theimportance of the Bankruptcy Code’sprovisions designed to facilitate reorgani-zation in as many cases as possible.

Tax Free Transfers under the Bank-ruptcy CodeBankruptcy Code section 1146(c) pro-vides that “[the issuance, transfer, or ex-change of a security, or the making ordelivery of an instrument of transfer un-der a plan confirmed under [the Bank-ruptcy Code], may not be taxed underany law imposing a stamp tax or similartax.” The Bankruptcy Code does notdefine “stamp”or “similar” taxes. Stamptaxes are commonly imposed under stateor local law in connection with the trans-fer of real or personal property. In mostcases, the tax rate is a relatively small per-centage of the value of the assets, and thetax is imposed irrespective of whether theseller realizes any gain or loss from thesale. They include state documentarytransfer taxes, such as New York’s realproperty transfer tax, which imposes a taxon deeds of $2 for every $500 of consid-eration or value and must be paid as a pre-requisite to recording a deed.

Bankruptcy Code section 1146(c)serves the dual purpose of providingchapter 11 debtors and prospective pur-chasers with some measure of tax reliefwhile concurrently facilitating asset salesin bankruptcy and enhancing a chapter11 debtor’s prospects for a successful re-organization. Two areas of controversyhave arisen concerning the scope of thestatute’s tax exemption. First, becausethe Bankruptcy Code does not define“stamp” or “similar” tax, bankruptcycourts are frequently called upon to de-cide what kind of taxes qualify for theexemption. The second focus of debateconcerns whether asset transfers must bemade pursuant to a confirmed chapter 11plan of reorganization, as opposed to in aseparate transaction occurring at someother time during the chapter 11 case.Both issues were addressed by the Dela-ware district court in In re GST Telecom.

BackgroundGST Telecommunications (“GST”) suf-fered the same fate as many other firmsin the volatile telecommunications in-dustry. After being launched as a prom-ising venture in 1994 and undergoingsignificant expansion, the company ex-perienced a drastic reversal of fortune asthe industry became glutted with play-ers and was compelled to seek chapter11 protection in 1999. Upon filing forbankruptcy, GST actively searched for apurchaser for its assets. It ultimatelyfound one in Time Warner Telecom

(“Time Warner”). The district court(sitting as a bankruptcy court) grantedGST’s motion to sell its assets to TimeWarner, and GST began to transfer itsassets to Time Warner in a series of saletransactions. Although GST had filed achapter 11 plan of reorganization, theplan had not been confirmed by thecourt prior to the sales.

The assets sold by GST to TimeWarner included approximately $68million in real and personal property lo-cated in the State of Washington.Washington levied various state and lo-cal “use” taxes against Time Warner inconnection with the sale equal to ap-proximately 7.5% of the value of the as-sets. It then objected to confirmation ofGST’s proposed plan of reorganizationbecause the plan did not provide forpayment of the taxes. According toWashington, the transfer by GST toTime Warner was not exempt from stateuse taxes pursuant to Bankruptcy Codesection 1146(c) because the transfer tookplace before confirmation of GST’s planof reorganization. It also argued that the“use” taxes levied on the transaction werenot stamp or “similar” taxes within themeaning of the statute.

The district court rejectedWashington’s restrictive interpretation ofthe statutory exemption to apply only topost-confirmation asset transfers. Eventhough Bankruptcy Code section1146(c) expressly refers to a “transferunder a plan confirmed” by the bank-


Exempting asset transfers under a plan of reorganization from stamp or

similar taxes serves the dual purpose of providing chapter 11 debtors and

prospective purchasers with some measure of tax relief while concurrently

facilitating asset sales in bankruptcy and enhancing a chapter 11 debtor’s

prospects for a successful reorganization.

ruptcy court, the district court ex-plained, it would be inconsistent withthe purpose of the exemption to restrictits scope to asset transfers that take placeafter confirmation of a plan of reorgani-zation incorporating the sale. The courtemphasized that waiting until confirma-tion to sell assets is not a viable strategyin a significant percentage of chapter 11cases. After reviewing other BankruptcyCode provisions that create specific tem-poral restrictions governing the planconfirmation process, the court deter-mined that the absence of any such re-striction in Bankruptcy Code section1146(c) indicates that Congress did notintend to impose one. It concludedthat, “[g]iven the reality of business andbankruptcy practice,” the more appro-priate and practical interpretation of thestatutory exemption is to apply it to en-compass “transfers made in anticipationor contemplation of a plan.”

The State of Washington fared bet-ter on its “use” tax argument. Accord-ing to Washington, the amount of its“use” tax is significantly larger than mosttaxes found to qualify as “stamp” taxesunder Bankruptcy Code section

1146(c). The district court agreed.Since stamp taxes are generally low andin no case exceed one-percent of thevalue of the asset transferred, it ruled,only taxes with rates nearly equivalent toa one percent stamp tax rate should beconsidered “similar” taxes for purposesof Bankruptcy Code section 1146(c).The court then sustained Washington’sobjection to GST’s plan of reorganiza-tion because it did not provide for pay-ment of the tax.

AnalysisGST Telecom’s interpretation of the scopeof section 1146(c)’s tax exemption rep-resents the view of the majority ofcourts. It also appears to be the betterone, given the practical realities of achapter 11 case and the utility of chap-ter 11 as a vehicle for both rehabilitat-ing an ailing enterprise and realizing themaximum value from a debtor’s assetsfor the benefit of its estate and creditors.The Delaware district court’s decisionreaffirms the important policy consider-ations underpinning the tax exemption.

However, the district court’s deci-sion is also troubling. After comparing

Washington’s use tax to other taxes thathave been deemed to be precluded byBankruptcy Code section 1146(c), thedistrict court found that althoughWashington’s use tax shared all of theother characteristics of a stamp or “simi-lar” tax, it was not covered by the stat-ute simply because it was too large. Insome respects, this determination is con-sistent with the holdings of courts, likethe Second Circuit Court of Appeals inIn re 995 Fifth Avenue Assocs., L.P., thatfind taxes payable upon the transfer ofreal property in the amount of up to10% of any gain realized by the sellerineligible for the stamp or “similar” taxexemption. However, a distinctionbased solely upon the amount of the tax,rather than its purpose, is unwarrantedand largely indefensible, given the pur-pose of the statute and the clear messageit sends to taxing authorities intentupon removing their taxes from thescope of the exemption._________________________In re GST Telecom, Inc., 2002 WL442233 (D. Del. March 20, 2002).In re 995 Fifth Avenue Assocs., L.P., 963F.2d 503 (2d Cir.), cert. denied, 506U.S. 947 (1992).


Severance Payable Under Pre-BankruptcyEmployment Contract Not Entitled toAdministrative Expense Priority

In a case of first impression beforethe Fifth Circuit, the Court of Appealsheld that if an employer enters into anemployment contract containing a sev-erance payment provision prior to filingfor bankruptcy and terminates the em-ployee after the petition date, theemployee’s severance payment is not en-titled to first priority status as an ex-pense of administering the chapter 11estate. In In the Matter of Phones for All,the Court ruled that because the em-ployee failed to demonstrate that thebankruptcy estate derived any benefitfrom the severance provision in his em-ployment agreement, the employee’sclaim for severance pay was not entitledto administrative status.

Priority Claims in BankruptcyThe Bankruptcy Code classifies all man-ner of “claims” against a debtor and pri-oritizes them according to specificrules depending upon, among otherthings, when the claim arose, whether itis secured or unsecured and whether itshould be entitled to some specially el-evated status of payment in accordancewith various policy considerations andspecial-interest concerns identified byCongress. In general, secured claimshave the highest priority and will berelatively unaffected by the bankruptcycase. Unsecured claims fare less well,and are likely to receive a smaller pro-rata distribution from a bankruptcy es-tate that contains insufficient assets tosatisfy all creditor claims.

Moreover, not all unsecured claimsare treated equally. Bankruptcy Codesection 507(a) establishes nine separatecategories of claims that must be paidbefore the holder of any other unsecuredclaim can receive a distribution from theestate. Foremost among these unse-cured priorities are the post-petition ex-penses of administering the bankruptcyestate (discussed below). Other priorityclaims include contributions to em-ployee benefit plans, claims asserted byfarmers and fisherman, alimony andsupport claims, certain tax claims, and,as relevant here, claims for “wages, sala-ries and commissions, including vaca-tion, severance and sick leave pay earnedby an individual,” but only to the extentthat they were earned within 90 days ofthe bankruptcy filing and do not exceeda periodically adjusted amount. Prior-ity pre-petition severance pay claims arejunior only to secured claims, post-pe-tition administrative claims and certainclaims arising during an involuntarybankruptcy case. However, because aclaim for severance is generally deemedto be a claim for “damages resultingfrom the termination of an employmentcontract,” it may be capped at anamount equal to approximately oneyear’s compensation.

Priority of Post-Petition AdministrativeExpensesA claim for severance pay can enjoyhigher priority if it qualifies as an “ad-

ministrative expense.” BankruptcyCode section 503(b)(1) provides that“administrative expenses” include “theactual, necessary costs and expenses ofpreserving the estate, including wages,salaries, or commissions for services ren-dered after the commencement of thecase.” Essentially, any obligation in-curred by a trustee or chapter 11 debtorduring the course of a bankruptcy caseis conferred with a special priority enti-tling it to payment prior to all pre-bank-ruptcy unsecured obligations. Theenhanced priority was intended in partto encourage vendors and other credi-tors to do business with, or extend creditto, a bankruptcy trustee or chapter 11debtor. It was also designed to encour-age employees, officers, directors andconsultants to continue working for thedebtor so that it can continue operating,or restructure its operations with the as-sistance of qualified personnel. Regard-less of the kind of claim involved, it canbe conferred with administrative ex-pense status only “if it gives rise to anactual and necessary expense of preserv-ing the estate.” Courts interpret thatstandard very narrowly and sparinglygrant administrative status to a claim.

Severance as an Administrative ExpenseIf the debtor enters into an employmentagreement after filing for bankruptcy,the employee’s claims for compensationand severance payable under the agree-ment are generally entitled to adminis-


An employee can be as-sured that his or herseverance payments willenjoy priority as an ad-ministrative expense onlyif the chapter 11 debtorassumes the employmentagreement, and therebytransforms it into apost-petition contract,or reaffirms the sever-ance provisions in a newcontract.

trative expense priority. The same goesfor a claim arising under almost anycontract entered into the debtor duringthe bankruptcy case. Where the debtorenters into an employment agreementbefore filing for bankruptcy, and theemployee continues to work for thedebtor during the case before being ter-minated, the priority of the employee’sseverance claim is more difficult to de-termine. This is so because severancepay claims do not fit neatly into the pre-petition/post-petition paradigm under-pinning the administrative prioritydetermination — unlike ordinary wages,severance pay can be “earned” at differ-ent times during the course of employ-ment. Some courts, like the SecondCircuit Court of Appeals in Straus-Duparquet, Inc. v. Local U. No. 3 Int.Bro. of Elec. Wkrs., subscribe to the viewthat severance pay is compensation forthe hardship which all employees, re-gardless of their length of service, sufferwhen they are terminated, and that it istherefore earned when an employee isdismissed. However, this approach hasbeen largely discredited. Most courtswill carefully examine the particular typeof severance payment involved to deter-mine whether the employee’s claim shouldqualify for administrative priority.

There are two general types of sev-erance pay. The first consists of a pay-ment to the employee at terminationbased upon the length of his employ-ment. As exemplified by the NinthCircuit’s ruling in Lines v. System Board(In re Health Maintenance Foundation),most courts find that “length of service”severance does not qualify for adminis-trative expense priority because the ben-efit was earned prior to the bankruptcyfiling. Other courts have adopted a less

draconian approach. Some will proratethe severance claim into pre-petitionand post-petition amounts correspond-ing to the duration of the employee’sservice during both periods, and rulethat the latter qualifies for administra-tive priority, while the former mayqualify at least in part as a priority pre-petition unsecured claim.

The second general type of sever-ance is a payment at termination in lieuof advance notice of termination. Thiskind of severance is generally perceivedas compensating a terminated employeefor being deprived of advance notice oftermination, and it is therefore “earned”on the termination date. Most courtsaccordingly hold that “termination inlieu of notice” severance qualifies foradministrative priority.

Other severance packages don’t fitinto either category or may have charac-teristics of both. For example, manycompanies struggling to restructure theiroperations and avoid bankruptcy retaincrisis managers and other workout pro-fessionals under employment agree-ments with severance provisionsentitling the employee to “severance” ifhe or she is terminated at any time af-ter executing the agreement. Courtsconfronted with hybrid severance ar-rangements have sometimes struggled toarticulate a rational standard to apply tothe employee’s request that the claim beconferred with priority status. By de-fault, many bankruptcy courts apply thestandard governing other types of ad-ministrative claims — i.e. the claim willbe conferred with administrative ex-pense status only if the expense was nec-essary and benefited the debtor’s estate.A majority of courts find that severancepayable under a pre-bankruptcy em-

ployment agreement does not qualify.The Fifth Circuit’s ruling in In the Mat-ter of Phones for All exemplifies the ma-jority position.

BackgroundFive months before filing for chapter 11in November of 1999, Phones For All,Inc. (“PFA”) entered into an employ-ment agreement with Isaac Lasky. Un-der the agreement, Lasky agreed toassume the position of Phones for All’sexecutive vice president for a base an-nual salary of $165,000. PFA and Laskyfurther agreed that Lasky would receiveseverance pay if he was terminated with-out cause. The severance was to be paidcommencing on the date of Lasky’s ter-mination at the annual rate of his basesalary plus a bonus, annualized, at thetime of termination. The paymentswere to continue until the greater of oneyear or April 1, 2002.



Solvent Chapter 11 DebtorMust Pay Interest on UnsecuredClaims at Federal RateIn a case of apparent first impression inthe Circuit Courts of Appeal, the NinthCircuit ruled that a solvent chapter 11debtor’s plan of reorganization could notbe confirmed unless it provided for thepayment of post-petition interest on un-secured claims at the federal statutoryrate, rather than the rate of interest pre-scribed by state law or in any contractbetween the parties. In Onink v.Cardelucci (In re Cardelucci), the NinthCircuit affirmed a California districtcourt’s determination that post-petitioninterest should be calculated using thestatutory rate applied to federal judg-ments.

Entitlement to Interest in BankruptcyAs a general rule, interest ceases to ac-crue on unsecured obligations once thedebtor files for bankruptcy. Although asecured creditor is entitled to post-peti-tion interest and other fees and costsspecified in its loan agreement to theextent that the value of its collateral ex-ceeds the amount of its claim, an unse-cured creditor’s claim for “unmaturedinterest” will be disallowed by virtue ofBankruptcy Code section 502( b)(2).Fixing the petition date as the cutoffpoint for the accrual of interest on un-secured claims is a rule of conveniencedesigned to ensure fairness in distribu-tions to similarly-situated creditors. Theprohibition also reflects the sentimentthat “interest payments are penalties ordamages assessed against the debtor forhis detention of the creditor’s money . .. and therefore it would be unjust to al-

low the creditor to recover such penal-ties or damages from other creditorswho were not to blame for the deten-tion.” It would be possible to pay inter-est on unsecured debts during abankruptcy case. However, Congressopted otherwise, considering the admin-istrative burden and delay attendant tocomputing interest on contractual andnon-contractual claims, the fact that inthe vast majority of cases unsecuredcreditors are very likely to receive distri-butions amounting to a small fraction oftheir claims and the important bank-ruptcy policy disfavoring disparate treat-ment of similar claims.

There is an exception to the rule.In the rare case where the debtor turnsout to be solvent and the estate containssufficient assets to pay all claims in full,unsecured creditors are entitled to inter-est accruing after the bankruptcy peti-tion date. Conceptually, thisrequirement is based in part upon theperception that it would be inappropri-ate for a bankruptcy trustee or chapter11 debtor-in-possession to return sur-plus assets to the post-bankruptcy entitywithout compensating unsecured credi-tors in some way for the delay in receiv-ing payment on their claims. Theexception applies to cases under chapters7, 11, 12 and 13 of the BankruptcyCode, but for different reasons.

In chapter 11 reorganizations, fam-ily-farmer bankruptcies under chapter12 and wage-earner bankruptcies underchapter 13, the requirement applies byreason of the “best interests test.” No

chapter 11 or chapter 12 plan of reorga-nization or chapter 13 wage-earner re-payment plan can be confirmed over theobjection of a creditor whose claim is“impaired” by the plan (i.e. without giv-ing effect to all of the creditor’s legal andcontractual rights) unless the creditorreceives property under the plan ofequal or greater value than the distribu-tion it would be entitled to receive in achapter 7 liquidation. The distributionscheme governing liquidations underchapter 7 of the Bankruptcy Code man-dates that unsecured creditors receive“interest at the legal rate from the dateof the filing of the petition” before anyproperty is distributed to the debtor.Thus, because unsecured creditorswould be entitled to post-petition inter-est in a chapter 7 liquidation if thedebtor is solvent, they are also entitledto post-petition interest in the case of asolvent chapter 11, chapter 12 or chap-ter 13 debtor. In chapter 11 cases in-volving solvent debtors, bankruptcycourts sometimes find that a plan of re-organization that does not pay post-pe-tition interest on unsecured claims is not“fair and equitable,” and that the plancannot be confirmed over the objectionsof dissenting creditors because it fails torecognize the rights of unsecured credi-tors to interest under applicable non-bankruptcy law.

The Bankruptcy Code requires in-terest to be paid at the “legal rate.”However, it does not define the term.The Ninth Circuit addressed that ques-tion in In re Cardelucci.

BackgroundSamuel Duke Cardelucci owned andoperated several waste removal compa-nies in California. He filed a chapter 11case in 1993 to prevent certain custom-ers from executing on a state court judg-


LEGISLATIVEA L E R T

Despite four years of overwhelming

bipartisan support for legislation

that would enact the most sweeping

changes in U.S. bankruptcy law in

nearly a decade, the proposed leg-

islation is still mired in congres-

sional trenches. Nearly two

months after members of a House-

Senate conference committee nego-

tiated a compromise on how much

home equity a debtor can shield

from creditors, they have failed to

reach an agreement on whether

anti-abortion protesters should be

allowed to avoid paying court

judgments or fines by filing for

bankruptcy. Abortion appears to

be bankruptcy reform’s last hurdle,

but it may be insurmountable,

given the partisan split over the

emotionally charged issue. Senate

Democrats insist that the bank-

ruptcy bill include a provision that

prohibits people who illegally re-

strict access to abortion clinics from

discharging debts incurred as a re-

sult of lawsuits against them.

House Republicans contend that the

Senate amendment would punish

nonviolent protesters and people

who did not intend to break the

law. Current bankruptcy law al-

ready prohibits people who will-

fully injure people or damage

property from discharging debts

that result from those actions.

ment against him in the amount of over$5 million. Cardelucci was solvent andcapable of paying all of his creditors.His plan of reorganization provided forpayment in full of all claims, includingthe judgment claim, together with post-petition interest “at the rate specified inthe Bankruptcy Code.” Cardelucci andthe judgment creditors disputedwhether the appropriate rate of interestshould be California’s state statutory in-terest rate of 10% or the 3.5% interestrate on federal judgments specified intitle 28 of the United States Code. Thebankruptcy court ruled that the federalrate applied, and the customers ap-pealed. After the California districtcourt affirmed, they appealed to theNinth Circuit.

The Court of Appeals affirmed. Atthe outset, it noted that no circuit courthas addressed this issue and that bank-ruptcy courts have split over the correctinterpretation of the phrase “interest atthe legal rate.” The Ninth Circuit con-cluded, however, that “principles ofstatutory interpretation lend strong sup-port to the conclusion that Congress in-tended ‘interest at the legal rate’ in [theBankruptcy Code] to mean interest atthe federal statutory rate pursuant to[title 28].” It determined that the lan-guage of the statute evidenced thelegislature’s intention that a single sourcebe used to determine the appropriateinterest rate, and that the source bestatutory.

According to the Court of Appeals,the appropriate statute is a federal stat-ute, rather than any state statute speci-fying the rate of post-judgment interest.This conclusion, the Ninth Circuit em-phasized, is consistent with the principlethat federal law should determinewhether a creditor’s claim should be al-lowed or disallowed once a debtor files

for bankruptcy. It also comports withthe bankruptcy principles promotingequality of distribution to creditors as-serting similar claims and administrativeefficiency. Some creditors, the court re-marked, would receive more than othersif the post-judgment interest rates ofseveral states were applied to theirclaims. Moreover, the court noted, re-quiring the trustee or chapter 11 debtorto calculate post-petition interest at sev-eral different rates could delay the caseand create a significant administrativeburden. Finally, the court recognizedthat in cases with few creditors and suf-ficient assets to pay everyone, the inter-ests of fairness among creditors andadministrative efficiency may be of lim-ited relevance and the debtor may re-ceive a windfall by reason of the lowerfederal interest rate. Notwithstandingthis concern, the Ninth Circuit con-cluded that “‘interest at the legal rate’ isa statutory term with a definitive mean-ing that cannot shift depending on theinterests invoked by the specific factualcircumstances before the court.”

AnalysisThe In re Cardelucci court’s claim to bethe first court of appeals to address thequestion of the appropriate rate of inter-est on unsecured claims asserted againsta solvent bankruptcy estate is not strictlytrue. In a 1999 opinion (In re Shoen),the Ninth Circuit remarked in dicta that“[a]lthough the statute refers to the “le-gal rate” of interest, it is commonly un-derstood that this means the federaljudgment rate.” Moreover, prior to theenactment of the Bankruptcy Code in1978, other circuit courts in cases underthe former Bankruptcy Act recognizedthe same exception to the rule cuttingoff the accrual of interest on unsecured



Fixing the petition date

as the cutoff point for

the accrual of interest

on unsecured claims is

a rule of convenience

designed to ensure fair-

ness in distributions

to similarly-situated

creditors.

claims as of the bankruptcy petitiondate. Most concluded that a solventdebtor was obligated to pay post-peti-tion interest at the “statutory or legalrate,” which refers to the federally-pre-scribed rate of interest. Of course, thosecourts were interpreting a bankruptcystatute that did not incorporate the spe-cific language contained in the Bank-ruptcy Code regarding the payment ofpost-petition interest on unsecuredclaims.

Many lower courts have interpretedthe current statute to require the pay-ment of interest by a solvent debtor atthe federal judgment rate. Some, how-ever, like the bankruptcy court in In reDow Corning Corp., distinguish betweenordinary unsecured creditors and credi-tors who are contractually entitled tointerest at a specified rate. These courtsinterpret the Bankruptcy Code to man-date the payment of interest by a solventchapter 11 debtor at the contract rate,failing which the debtor’s plan of reor-ganization cannot be confirmed.

Whether or not it was the first, theNinth Circuit’s decision is instructive forseveral reasons. First, it resolves any ap-parent ambiguity in the BankruptcyCode concerning the applicable rate ofinterest to be paid to unsecured creditorsin the bankruptcy case of a solventdebtor. Second, it illustrates the impor-tant bankruptcy policy considerationsunderpinning both the prohibition ofpost-petition interest on unsecuredclaims and the exception to the rule inthe rare cases involving solvent debtors.

The court’s reasoning in In re Cardelucciis premised upon uniformity in the ap-plication of the Bankruptcy Code, ad-ministrative convenience and equality oftreatment of similarly-situated creditors.

___________________Onink v. Cardelucci (In re Cardelucci),285 F.3d 1231 (9th Cir. 2002).In re Shoen, 176 F.3d 1150 (9th Cir.1999), cert. denied, 528 U.S. 1075(2000).In re Dow Corning Corp., 237 B.R. 380(Bankr. E.D. Mich. 1999).In re Dow Corning Corp., 270 B.R. 393(Bankr. E.D. Mich. 2001).In re Vogt, 250 B.R. 250 (M.D. La.2000).

From the TopThe Supreme Court had relatively

little to say in the realm of bank-

ruptcy during the first half of 2002.

In Lapides v. Board of Regents of

the University System of Georgia,

the Court reaffirmed its earlier rul-

ing in Gardner v. New Jersey that

a state waives its Eleventh Amend-

ment immunity from suit by filing a

proof of claim in a bankruptcy

case. In Young v. United States, the

Court held that the three-year

lookback period allowing the IRS to

collect taxes against a chapter 7

debtor is tolled during the pen-

dency of a chapter 13 case pre-

viously filed by the debtor. Looking

to the remainder of 2002, the Su-

preme Court recently agreed to

hear a series of appeals involving

the FCC’s attempts to cancel li-

censes for broadband personal

communications services auctioned

to bankrupt NextWave Personal

Communications, Inc. in deroga-

tion of the Bankruptcy Code’s pro-

scription of license revocation by

governmental entities based solely

upon the debtor-licensee’s failure to

pay a debt that is dischargeable in

its bankruptcy case.


PFA terminated Lasky’s employ-ment without cause three weeks after fil-ing for chapter 11. Lasky ultimatelyclaimed that he was entitled to morethan $430,000 in severance. He con-tended that his claim was entitled to ad-ministrative priority because he wasterminated after PFA filed for bank-ruptcy. The bankruptcy court dis-agreed. Initially, the court found thatbecause Bankruptcy Code section507(a) expressly includes “severance”pay among the claims entitled to thirdpriority of payment, but BankruptcyCode section 503(b)(1) does not specifi-cally refer to severance in defining ad-ministrative expenses, Congress meantto exclude claims for severance pay fromadministrative priority status. Next, thecourt found that Lasky’s claim for sev-erance arose prior to the bankruptcy fil-ing date because he obtained the right tothe payment when he entered into hisemployment agreement.

Finally, the bankruptcy court em-phasized that “[w]hether or not sever-ance benefits fit within the statutoryrequirement of wages or salaries, [theBankruptcy Code] also requires that toqualify as an administrative expense, thepayment of the severance compensationmust benefit [PFA’s] estate and its credi-tors.” It concluded that PFA had al-ready received the benefit derived by theseverance compensation when Laskycommenced his employment pre-peti-tion, and that PFA’s bankruptcy estatedid not derive any benefit from the sev-erance provision. The court’s conclu-sion was bolstered by Lasky’s admissionthat he “did not rely on the bankruptcy

estate, post-petition, to pay him sever-ance compensation in the event of ter-mination.” Almost as an afterthought,the bankruptcy court stated that even ifit were to find that Lasky’s severanceprovision did benefit the estate, Lasky’sadministrative claim should consist onlyof the prorated portion attributable tohis post-petition services.

Lasky’s appeal to the district courtwas unsuccessful. He did no better be-fore the Fifth Circuit. Noting that ithad not “squarely faced this type of is-sue before,” the Court of Appeals “es-sentially agree[d]” with the bankruptcycourt’s analysis and ruled that Lasky’sseverance claim was not entitled to ad-ministrative priority. Figuring mostprominently in the court’s analysis, how-ever, was its determination that in orderto qualify as an administrative expense,a claim for severance must have arisenfrom a transaction with the debtor-in-possession and “must then confer a ben-efit on the debtor’s estate.” The Courtof Appeals found no fault with thebankruptcy court’s determination thatLasky failed to demonstrate that PFA’sestate benefited in any way from the sev-erance provision. It concluded with theadmonition that “[t]his reading of thestatutory provisions makes clear theclaimant’s burden to reconfirm or rene-gotiate post-petition any severance pack-ages they may have if they continue towork for the debtor.”

AnalysisPhones For All’s significance is twofold.First, the decision illustrates that claimsagainst a debtor in bankruptcy will not

necessarily be entitled to administrativeexpense status merely because the pay-ment obligation is triggered during thecourse of the case. Regardless of whena payment obligation accrues, a bank-ruptcy court will carefully examinewhether the obligation arose from thedebtor’s conduct during the course ofthe case and whether the estate derivedany benefit as a consequence of incur-ring it. Claims that cannot pass musterunder that standard will be relegated toeither non-preferred or a lesser preferredstatus.

Phones For All and the increasingnumber of cases employing the samereasoning also send a clear message toanyone who is party to an employmentagreement containing a severance provi-sion. If the employer files for bank-ruptcy, an employee can be assured thathis or her severance payments will enjoypriority as an administrative expenseonly if the debtor assumes the employ-ment agreement, and thereby transformsit into a post-petition contract, or reaf-firms the severance provisions in a newcontract.

________________________________________In the Matter of Phones For All, Inc., 288F.3d 730 (5th Cir. 2002).Straus-Duparquet, Inc. v. Local U. No. 3Int. Bro. of Elec. Wkrs., 386 F.2d 649,650-51 (2d Cir. 1967).Lines v. System Board (In re Health Main-tenance Foundation), 680 F.2d 619 (9th

Cir. 1982).

continued from page 7


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Analysis Indemnification of bankruptcy profes-sionals is a thorny issue. It promises tobecome even thornier. Professionals re-tained in chapter 11 cases that do notresult in a successful reorganization areincreasingly being sued by litigants con-tending that the professional’s conductor misconduct contributed to the melt-down. It is therefore not surprising thatfinancial advisors and other bankruptcyprofessionals want some measure of pro-tection as a quid pro quo for providingservices to debtors.

Courts will generally subject anyproposed engagement whose terms in-clude indemnification of the profes-sional to strict scrutiny to determinewhether it is reasonable for the estateand its creditors to answer for theprofessional’s misconduct. More oftenthan not, the answer to that questionhas been no. Thus, In re Metricom isconsistent with the reasoning applied bya majority of courts that have ruled onthe propriety of indemnifying bank-

ruptcy professionals. In cases likeUnited Companies Financial Corp.,Gillett Holdings, Inc., The DrexelBurnham Lambert Group, Mortgage &Realty Trust and Allegheny International,the bankruptcy courts have rejected in-demnity/contribution and/or exculpa-tion provisions for financial advisors.Still, there is no blanket rule prohibitingthe practice. Some courts, such as aNew York bankruptcy court in In reJoan and David Halpern, Inc., havefound that it was reasonable under thecircumstances of the case for the estateto indemnify financial advisors (al-though even in Joan & David, where allmajor creditor constituencies consentedto the indemnity provisions, the U.S.Trustee, who had no economic stake inthe outcome of the case, still objected tothe indemnity).

The California bankruptcy courtdid not discuss the propriety of indem-nifying a financial advisor for liabilityascribed to ordinary negligence, as op-posed to willful misconduct or gross

negligence. Expansion of the scope ofan indemnity to encompass ordinarynegligence has become more commonin recent times, as bankruptcy profes-sionals (with the exception of lawyersand accountants, who are ethically pro-hibited from attempting to limit theirliability for negligence) increasinglystrive to limit their exposure. An emerg-ing trend in many cases involving pro-fessionals seeking indemnification forordinary negligence is to place the bur-den of proof on the professional to dem-onstrate that its conduct was notnegligent. Also, some courts, like anIllinois bankruptcy court in In re KMartCorporation, will allow the estate to in-demnify a financial advisor for liabilitiesresulting from ordinary negligence onlyif it is judicially determined that theclaim primarily resulted from actionstaken in good faith or with a reasonableand prudent belief that such actionswere in the best interests of the estate.___________________In re Metricom, Inc., 275 B.R. 364 (Bankr.N. D. Cal. 2002).In re United Companies Financial Corp.,241 B.R. 521 (Bankr. D. Del. 1999).In re Gillett Holdings, Inc., 137 B.R. 452(Bankr. D. Colo. 1991).In re The Drexel Burnham Lambert Group,133 B.R. 13 (Bankr. S.D.N.Y. 1991).In re Mortgage & Realty Trust, 123 B.R.626 (Bankr. C.D. Cal. 1991).In re Allegheny International, Inc., 100B.R. 244 (Bankr. W.D. Pa. 1989).In re Joan & David Halpern, Inc., 248B.R. 43 (Bankr. S.D.N.Y. 1999), aff ’d,2000 WL 1800690 (S.D.N.Y. Dec. 6,2000).In re KMart Corporation, No. 02 B 02474(Bankr. N.D. Ill. Mar. 28, 2002 (unpub-lished record disposition granting debtors’amended application to retain financialadvisor).

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