Texas District Court Affirms Bankruptcy Court’s Use of Claim Estimation Process
Many companies that file for bankruptcy protection have liabilities that cannot be definitively quantified as of the bankruptcy petition date. Such “unmatured,” “contingent,” “unliquidated,” or “disputed” debts could arise from, among other things: (i) causes of action that are being litigated at the time of a bankruptcy filing but have not resulted in a judgment; or (ii) claims against the company that exist prior to a bankruptcy filing but have not been asserted against the company in litigation or otherwise, let alone liquidated, as of the petition date.
All of these claims must be dealt with in administering a bankruptcy estate for the benefit of stakeholders as part of a chapter 7 liquidation or a chapter 11 case (whether a liquidation or a reorganization). However, litigating such claims to conclusion can be time-consuming and expensive, particularly if the litigation has not yet been commenced or must proceed in many different forums.
To aid in this difficult process, section 502(c) of the Bankruptcy Code provides bankruptcy courts with a mechanism to estimate contingent and unliquidated claims for purposes of allowance (and, in some cases, distribution) in the bankruptcy case. A ruling recently handed down by the U.S. District Court for the Southern District of Texas illustrates the dynamics of the claim estimation process. In Mud King Prods., Inc. v. Nat’l Oilwell Varco, L.P. (In re Mud King Prods., Inc.), 2015 BL 52638 (S.D. Tex. Feb. 27, 2015), the district court upheld a bankruptcy court order estimating a chapter 11 debtor’s liabilities in pre-bankruptcy litigation involving claims asserted by a competitor of the debtor.
Claim Estimation in Bankruptcy
One of the most important aspects of a bankruptcy case is the resolution—by allowance or disallowance—of “claims” asserted by creditors against a debtor. Section 101(5) of the Bankruptcy Code defines the term “claim” broadly to mean, among other things, a “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” Accordingly, proofs of claim filed by creditors or claims scheduled by debtors may include contingent, unliquidated, disputed, or otherwise undetermined debts.
However, although such claims are not quantified when a debtor files for bankruptcy, an essential part of administering a bankruptcy estate involves assigning a monetary amount (or a range of monetary amounts) to every claim. The Bankruptcy Code provides a mechanism to estimate contingent and/or unliquidated claims. Specifically, section 502(c) of the Bankruptcy Code provides that “[t]here shall be estimated for purpose of allowance under this section . . . any contingent or unliquidated claim, the fixing or liquidation of which, as the case may be, would unduly delay the administration of the case.”
The purpose of section 502(c) is to facilitate administration of a bankruptcy case: estimating a claim avoids the need to delay the case while liability and damages issues in other forums are resolved. Furthermore, claim estimation promotes a fair distribution to creditors through a realistic assessment of uncertain or undetermined claims. In addition, claim estimation can assist parties with formulating chapter 11 plans by quickly establishing the amount of liability for potentially large, undetermined claims.
Section 502(c) expressly states that estimation is “for purpose of allowance under this section.” As such, “an estimation under section 502(c) generally should result in an allowed claim for all purposes in the bankruptcy case.” Collier on Bankruptcy ¶ 502.04 (16th ed. 2015). It follows that, unless stated otherwise and subject to certain exceptions, an order estimating a claim is final and subject to principles of judicial finality, including res judicata and collateral estoppel. Id.
In this regard, contingent or unliquidated personal injury tort or wrongful death claims can be estimated on a final basis by a bankruptcy court for purposes of allowance, but not for purposes of distribution in a bankruptcy case. Twenty-eight U.S.C. § 157(b)(2)(B) provides that “core proceedings” include “estimation of claims or interests for the purposes of confirming a plan under chapter 11, 12, or 13 . . . but not the liquidation or estimation of contingent or unliquidated personal injury tort or wrongful death claims against the estate for purposes of distribution in a case under [the Bankruptcy Code].” In addition, 28 U.S.C. § 157(b)(5) mandates that personal injury tort and wrongful death claims must be tried in a federal district court. Thus, although a bankruptcy court may estimate such claims for purposes of confirming a chapter 11 plan, the final amount of any such claim for purposes of distribution under the plan must be determined by a district court. See Collier on Bankruptcy ¶ 3.06 (16th ed. 2015).
The Bankruptcy Code does not dictate the method to be used to estimate a contingent or unliquidated claim. Bankruptcy courts generally employ whatever method is best suited to the circumstances. Various methods used by courts to estimate claims include summary trials, evidentiary hearings, and simple review of the pleadings and oral argument. See In re Cantu, 2009 BL 106556 (Bankr. S.D. Tex. May 15, 2009) (citing In re Windsor Plumbing Supply Co., 170 B.R. 503 (Bankr. E.D.N.Y. 1994)). Some courts have used an “ultimate merits” approach in which the value of the claim is estimated according to its merits. Id. at *2–3 (citing cases). Other courts have focused on a probabilistic methodology in which the estimated value of the claim is “the amount of the claim diminished by the probability that it may be sustainable only in part or not at all.” Id.
On appeal, a bankruptcy court’s decision regarding the method used to estimate a claim is reviewed under a narrow “abuse of discretion” standard. See Mud King Products, 2015 BL 52638, *3. Appellate courts will generally defer to the congressional intent to accord “wide latitude” to the bankruptcy court’s decision. Id. (citing Bittner v. Borne Chem. Co., 691 F.2d 134, 136 (3d Cir. 1982)). In Mud King Products, the district court reviewed the claim estimation process employed by a bankruptcy court to establish the debtor’s liability for claims asserted in litigation that had been pending as of the petition date for more than two years.
Mud King Products
Mud King Products, Inc. (“Mud King”) is a small, Houston-based oilfield services company that sells primarily replacement “aftermarket” pump parts used in oil rigs. Mud King and similar companies create aftermarket replacement parts by reverse engineering a pump part manufactured by another company and then selling the replica version as compatible with the original manufacturer’s product. One such original manufacturer is National Oilwell Varco, L.P. (“NOV”), a multinational manufacturer and distributor of equipment and parts used in the oil and gas industry.
In 2011, NOV discovered that one of its employees was selling blueprints for its original product designs to her brother-in-law, a Mud King manager. NOV sued Mud King in Texas state court on a variety of common law and statutory causes of action, including misappropriation of trade secrets under federal law, conversion, liability under the Texas Theft Liability Act (“TTLA”), civil conspiracy, and unjust enrichment. NOV sought and obtained a temporary restraining order from the state court prohibiting Mud King from selling any pump parts related to blueprints that were alleged to have been stolen from NOV. As damages, NOV sought disgorgement of Mud King’s alleged profits of $284,000, associated development costs of more than $4 million, and punitive damages in the amount of approximately $2.5 million, plus attorneys’ fees, costs, and prejudgment interest.
Mud King filed for chapter 11 protection in April 2013 in the Southern District of Texas, citing, among other things, escalating legal costs in defending against the NOV action, which had been removed to federal court prior to the bankruptcy filing. Mud King listed NOV’s claim on its schedules as disputed, unliquidated, and contingent. NOV filed a proof of claim indicating that the amount it was owed in respect of the claims asserted in the state court action was “unknown.”
Mud King later filed a motion to estimate NOV’s claim under section 502(c). In the motion, Mud King asserted that, of the allegedly hundreds of NOV drawings in its possession, Mud King used only 23 such drawings to make 81 parts, for which it realized only approximately $131,000 in gross profits. Mud King requested that the bankruptcy court estimate NOV’s claim at zero dollars or, alternatively, that the court enter an injunction similar to the temporary restraining order entered by the state and federal courts which would adequately protect NOV’s interests. Mud King also argued that, at the estimation hearing, each side should be permitted no more than two hours to put on its case regarding both liability and the measure of damages.
NOV responded by moving to dismiss Mud King’s chapter 11 case as having been filed in bad faith. According to NOV, Mud King was solvent at the time of the filing and was allegedly using bankruptcy as a litigation tactic to delay the pending nonbankruptcy litigation. NOV also objected to the estimation motion. It argued that estimation of its claim was improper due to Mud King’s bad faith and its efforts to use estimation as a way to short-circuit the customary discovery and litigation procedures available to parties in federal litigation. Moreover, NOV asserted that its claim should not be estimated because the claim could be litigated to conclusion in the federal court without undue delay, provided that NOV was granted relief from the automatic stay.
The bankruptcy court held an eight-day evidentiary estimation hearing. After meticulously examining each of the causes of action asserted by NOV in its complaint, the bankruptcy court ruled that NOV had established a claim for misappropriation of trade secrets, with damages in the amount of $74,434.95, plus possible prejudgment interest and attorneys’ fees in the amount of $320,893, and a claim for statutory damages under the TTLA in the amount of $1,000. The bankruptcy court held that Mud King was not liable on any of the other causes of action. The court later denied NOV’s motion to dismiss Mud King’s chapter 11 case. NOV appealed the estimation ruling.
The District Court’s Ruling
The district court affirmed both the bankruptcy court’s decision to estimate NOV’s claim and the court’s findings of fact and conclusions of law regarding the amount of the claim.
Initially, the district court explained that a bankruptcy court’s decision regarding the methodology to estimate claims pursuant to section 502(c) may be reversed only if the bankruptcy court abused its discretion. Given this standard of review, the district court examined the bankruptcy court’s estimation process. The bankruptcy court treated Mud King’s estimation motion as if it were an objection to a claim under section 502(b) of the Bankruptcy Code. Because NOV’s claim was disputed, the bankruptcy court determined that NOV had the burden of proving the amount of its claim by a preponderance of the evidence.
The district court held that it was not an abuse of discretion for the bankruptcy court to conduct a lengthy evidentiary hearing and to estimate NOV’s claim in accordance with the procedures and rules governing the resolution of claims under section 502(b). In so ruling, the district court rejected NOV’s argument that the bankruptcy court disregarded “overwhelming evidence” that Mud King filed for bankruptcy in bad faith in order to gain an unfair litigation advantage.
The district court also affirmed the bankruptcy court’s conclusions with respect to Mud King’s liability and its measure of damages on all counts.
Less than two months after the district court affirmed the estimation ruling, the bankruptcy court confirmed a chapter 11 plan of reorganization for Mud King under which NOV’s estimated claim was paid in full. Absent estimation of NOV’s claim, it might have taken months or even years to liquidate the claim, perhaps jeopardizing Mud King’s prospects for reorganization and eventual emergence from bankruptcy.
Mud King Products illustrates how section 502(c) of the Bankruptcy Code can be used to expedite and compress traditional litigation into a streamlined process that quickly establishes the amount of a creditor’s contingent or unliquidated claim in a bankruptcy case. The availability of the claim estimation process (or the prospect thereof) can also facilitate meaningful plan negotiations by providing a mechanism to assign a monetary amount to contingent and unliquidated claims.