The Fifth Circuit found that that the bankruptcy court’s valuation of the avoided preferences created a “double recovery” not authorized by the Bankruptcy Code.
In a recent decision, the United States Court of Appeals for the Fifth Circuit determined that the language of the Bankruptcy Code, in the context of avoidance actions, limits the debtor’s recovery to either the property transferred during the “preference period” or the value of that property, but not both. In this case, the debtor’s plan provided for the release of all liens on the debtor’s property as well as a multistep litigation process that, among other things, challenged the validity and the hypothetical value of certain prepetition liens. Following confirmation of the plan, a group of secured creditors appealed, arguing that the bankruptcy court’s allocation of equity in the reorganized debtor improperly diminished the secured creditors’ share in that equity by attributing value to liens already released under the plan to the benefit of unsecured creditors. The Fifth Circuit agreed with the secured creditors, vacated the bankruptcy court’s judgement and remanded the matter for further proceedings.
Background
Sanchez Energy Corporation commenced a Chapter 11 proceeding in 2019 in the United States Bankruptcy Court for the Southern District of Texas. Prior to the petition date, the debtor’s secured creditors took actions to perfect nonpossessory liens on the majority of the debtor’s assets within 90 days of the filing of the bankruptcy petition (the “preference period”), thus subjecting those liens (which constitute a “transfer”) to possible avoidance (or reversal) under the Bankruptcy Code as preferential transfers. Following the bankruptcy filing, the debtor commenced litigation against the secured creditors to avoid the secured creditors’ liens. Eventually, the litigation was stayed in order for the parties to negotiate a plan of reorganization (the “Plan”). As part of the Plan, the debtor provided creditors with equity in the reorganized debtor in full satisfaction of their claims, which Plan was subsequently confirmed.
Pursuant to the Plan, all liens against property of the estate would be released and a three-step litigation process would be commenced to determine allocation of the reorganized equity between secured and unsecured creditors. The first step in this litigation process would determine whether the liens provided under debtor-in-possession (DIP) financing (which lenders included most of the secured creditors) were valid. If the DIP liens were invalid, step two of the litigation would determine the validity and enforceability of the prepetition liens. If the prepetition liens were avoidable as preferences under the Bankruptcy Code, then the Plan would require the bankruptcy court to determine the value returned to the estate through the step two claims.
Following confirmation of the Plan, the debtor commenced the three-step litigation process. As part of step one, the bankruptcy court found that the DIP liens were invalid. The bankruptcy court then found that the prepetition liens were avoidable as preferential transfers. Finally, as part of step three, the bankruptcy court placed a hypothetical value on the step two avoidance claims (although the avoided liens were already released and discharged under the Plan), awarding the secured creditors and unsecured creditors approximately 30 percent and 70 percent, respectively, of the reorganized equity. The bankruptcy court reopened step one two years later after determining that it had overlooked certain material issues, reversing itself and finding that the DIP liens were valid. The secured creditors subsequently filed a direct appeal to the Fifth Circuit.
Ruling
The Fifth Circuit found that that the bankruptcy court’s valuation of the avoided preferences created a “double recovery” not authorized by the Bankruptcy Code.
Where a preferential transfer is avoided, Section 550(a) of the Bankruptcy Code permits a debtor to recovery the property transferred or the value of such property. And Section 550(d) limits recovery under Section 550(a) to “only a single satisfaction.” Assuming for the purposes of the appeal that the prepetition liens were avoidable preferences, the Fifth Circuit held that the bankruptcy court improperly applied Section 550 by assigning a value in step three to the avoidance actions against the secured creditors where those same prepetition liens were already returned to the debtor’s estate through the Plan’s release provisions.
Because Section 550(d) provides only for a “single satisfaction” under Section 550(a), the Fifth Circuit held that this compels a disjunctive reading of Section 550(a). In other words, a recovery under Section 550(a) can either be of transferred property itself or that property’s value, but not both. Consequently, because the secured creditors returned their liens to the debtor’s estate, they effectuated the estate’s recovery of a single satisfaction for the preferential transfers, and the bankruptcy court erroneously applied any additional value to the avoidance actions brought by the estate with respect to those same liens. The Fifth Circuit also held that, because the bankruptcy court ultimately found that the DIP liens were valid, and those lenders’ superiority claims exceeded the enterprise value of the reorganized debtor, those lenders were entitled to 100 percent of the reorganized equity.
Conclusion
Through this appeal, the Fifth Circuit established clear rules of statutory interpretation with respect to preference claims that will affect proceedings in two of the most active bankruptcy courts in the United States. The creation of a litigation or liquidating trust that is vested with authority to pursue causes of action, including preference claims, is a common feature of many Chapter 11 plans. In those situations, where preference claims may be one of the largest, if not the only, source of recovery to creditors, valuation is especially critical. Consequently, in the Fifth Circuit, debtors or trustees will likely be unable to successfully pursue preference claims against liens that have already been released (whether through a plan or otherwise), which would impact potential creditor distributions. Secured creditors with prepetition liens on the property of a debtor should pay close attention to plan treatment of their liens, as a release and discharge under a plan could provide a powerful defense to a subsequent avoidance action.
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