Restructuring

Contributed by Rich Mullen
As one bankruptcy court has said, “[b]ecause deals are the heart and soul of the [c]hapter 11 process, bankruptcy courts enforce them as cut by the parties.” Unfortunately, however, deals do not always turn out as the parties expected and there is sometimes litigation to determine what exactly was bargained for in a chapter 11 plan. The parties learned this in The Litig. Trust for the Trust Beneficiaries of SNTL Corp. v. JP Morgan Chase (In re Superior Nat’l Ins.). In Superior National, the United States Bankruptcy Court for the Central District of California granted in part and denied in part a motion to dismiss filed in an adversary proceeding commenced against the chapter 11 plan sponsor, a lender who purchased all of equity in the parent debtor to benefit from the debtors’ net operating loss carryforwards, or NOLs, but had not made any payments to the trust that was established to receive payment from the plan sponsor and distribute funds to the debtors’ stakeholders. The plan sponsor firmly believed that the bargain struck through the chapter 11 plan, and specifically the formula used to calculate the plan sponsor’s obligations thereunder, did not require any payment to the trust created for the benefit of the debtors’ stakeholders. The bankruptcy court’s decision, however, allowed the trust’s claims for equitable remedies of unjust enrichment and reformation to survive the motion to dismiss stage, leaving the plan sponsor to defend matters that it believed were resolved by confirmation of the chapter 11 plan.
Background
Fourteen years ago, a parent holding company and several of its subsidiaries filed for relief under chapter 11 of the Bankruptcy Code. Unsuccessful in their business endeavors, the debtors’ primary assets were more than $1 billion of NOLs. To realize value on the NOLs, the debtors structured a chapter 11 plan that transferred 100% of the common stock of the holding company to a plan sponsor, a lender that held $19 million of the debtors’ $100 million senior debt. As consideration, the plan sponsor issued an earn-out note to a trust that was created for the benefit of the debtors’ stakeholders. The note provided that the plan sponsor would make payments to the trust under a formula set forth in the plan – this “NOL Utilization Value” was allegedly meant to capture most of the value of the plan sponsor’s tax savings as a result of obtaining the NOLs.
More than a decade after confirmation of the plan, the trust commenced an adversary proceeding against the plan sponsor by filing a complaint asserting, among other things, claims of unjust enrichment and reformation of the plan alleging that the plan sponsor had the benefit of over $2.2 billion of NOLs, which resulted in a tax savings to the plan sponsor of over $775 million, but that the plan sponsor had not satisfied its obligations under the note, as the plan sponsor had not paid anything to the trust. Specifically, the trust alleged, among other things, that (a) the plan sponsor falsely inflated components of the NOL Utilization Value formula to reduce its payments under the note, (b) the plan sponsor received the advantage of NOLs that were based on prepetition operations, but were not known to exist when plan negotiations were on-going (the “Later-Recognized NOLs”), and were thus not included in the NOL Utilization Value formula, and (c) the plan did not require the plan sponsor to pay interest on the millions of dollars of time benefit on NOLs that were utilized by the plan sponsor but later subject to turnaround (the “Turn-Around NOLs”), and thus not included in the NOL Utilization Value formula. Believing that it had acted within the confines of the bargained for and confirmed chapter 11 plan, the plan sponsor moved to dismiss the trust’s claims.
Unjust Enrichment
Despite the confirmed chapter 11 plan, the trust asserted that, through its use of the Later Recognized NOLs and the time value of the Turn-Around NOLs, neither of which were contemplated by the plan, the plan sponsor was unjustly enriched at the expense of the trust and the debtors’ stakeholders. Thus, the trust sought restitution for the benefits gained by plan sponsor.
The plan sponsor argued that restitution on the unjust enrichment claim is barred by the existence of the plan, which was a contract that covered the subject matter of the claim for restitution. To support this argument, the plan sponsor further argued that the subject matter should be interpreted broadly as referring to the general subject matter of the contract, rather than any specific term. Specifically, the plan unambiguously excluded the Later-Recognized NOLs by covering only NOLs “in existence and available immediately after the Effective Date” of the plan, and the plan provided that the trust was to be paid interest only on the NOL Utilization Value that was distributable to the trust.
The bankruptcy court acknowledged that a claim for restitution is barred if there is a valid contract between the parties governing the same subject matter, and that the plan and the note needed not specifically address the Later-Recognized NOLs or the interest on the Turn-Around NOLs for these items to be within the subject matter of the plan and the note. That said, the bankruptcy court determined that it was improper to dismiss the restitution claim at the pleading stage because the Later-Recognized NOLs and the interest on the Turn-Around NOLs were not “specifically and unequivocally” covered by the plan and the note. Additionally, the court stated that at least one provision of the note concerning interest was vague and that the plan sponsor was ignoring the fact that there is a difference between “interest” and the benefit of “time value.”
Reformation of the Plan
The trust also asserted a claim for reformation of the plan, which was founded upon an allegation that the plan was based on either a mutual mistake or a unilateral mistake because the parties contemplated that the plan would require the plan sponsor to make payment to the trust for the benefit of the debtors’ stakeholders. Thus, the trust believed that the plan should be reformed to properly express the parties’ intent.
In support of its motion to dismiss, the plan sponsor argued that reformation would be a modification of the plan under section 1127 of the Bankruptcy Code, and, because the plan had been substantially consummated, the plan could not be modified under section 1127. The plan sponsor argued that section 1101(2)(A) of the Bankruptcy Code focuses on the transfer of property to and from the debtor, and that all such transfers contemplated under the plan had been completed, i.e., the transfer from the plan sponsor to the trust was not a transfer that was required for substantial consummation of the plan. Moreover, the plan sponsor argued that distributions to creditors under the plan had commenced by way of distribution of the trust certificates to the debtors’ creditors and the payment of administrative claims. Finally, the plan sponsor pointed out that the plan specifically stated that amendments to the plan were not allowed without the plan sponsor’s consent.
The bankruptcy court rejected the plan sponsor’s arguments. First, the bankruptcy court noted that section 1101(2)(A) is not restricted to transfers of “property of the estate” or transfers “to or from the debtor.” Thus, because the plan sponsor had not made the requisite transfers to the trust, the plan had not been substantially consummated.
Even if the plan had been substantially consummated, the court determined that the reformation claim could not be dismissed because reformation of the plan is different from plan modification. Although the plan sponsor’s consent would be needed to amend or modify the plan, such consent was not required for the reformation of the plan because reformation is an equitable remedy that merely determines parties’ intent and the legal effect of any given contract.
Wrap-Up
Debtors, their stakeholders, and plan sponsors should be aware of cases like Superior National and the risk that a bargained-for deal may be attacked long after confirmation of a chapter 11 plan. Superior National highlights the great care and critical thinking that counsel must undertake when structuring a chapter 11 plan, and serves as a reminder that a chapter 11 plan is a contract that can be subject to typical contractual remedies like reformation and restitution. This is especially true when a chapter 11 plan involves complicated formulas like that at issue in Superior National and the plan does not turn out to benefit debtors and/or their stakeholders as expected. Parties that value certainty should be sure to clarify any ambiguities and be as specific as possible in drafting a chapter 11 plan to address any foreseeable contingencies.