The Role of Self-Interest in Allowance of Substantial Contribution Claims in Bankruptcy
To encourage creditors, equity interest holders, indenture trustees and unofficial committees to take actions that benefit a bankruptcy estate, section 503(b)(3)(D) of the Bankruptcy Code confers administrative priority on their claims for expenses incurred in making a "substantial contribution" in a chapter 9 or chapter 11 case. Administrative expense status is also given under section 503(b)(4) to their claims for reimbursement of reasonable professional fees incurred in making a substantial contribution. The U.S. District Court for the Eastern District of Pennsylvania addressed substantial contribution claims in In re DeVal Corp., 601 B.R. 725 (E.D. Pa. 2019). Even applying the Third Circuit's relatively stringent standard for substantial contribution claims, the district court affirmed a bankruptcy court's decision to award administrative expense claims to a secured creditor that acted "to save [the debtor] from a total implosion and becoming administratively insolvent … [and] forced the debtor to wake up and try to save the company from its own inaction."
Administrative-Expense Priority for Making a "Substantial Contribution"
Section 503(b)(3)(D) of the Bankruptcy Code grants administrative-expense priority for the "actual, necessary expenses" incurred by "a creditor, an indenture trustee, an equity security holder, or a committee representing creditors or equity security holders other than [an official committee] in making a substantial contribution in a case under chapter 9 or chapter 11." In addition, section 503(b)(4) of the Bankruptcy Code grants administrative-expense priority for "reasonable compensation for professional services rendered by an attorney … of an entity whose expense is allowable under" section 503(b)(3)(D) and "reimbursement for actual, necessary expenses incurred by such attorney." These provisions are an "accommodation between the two objectives of encouraging meaningful creditor participation in the reorganization process and keeping administrative expenses and fees at a minimum to maximize the estate for creditors." In re AmFin Fin. Corp., 468 B.R. 827, 831 (Bankr. N.D. Ohio 2012) (citing Lebron v. Mechem Fin. Inc., 27 F.3d 937, 944 (3d Cir. 1994)); Pacificorp Ky. Energy Corp. v. Big Rivers Elec. Corp. (In re Big Rivers Elec. Corp.), 233 B.R. 739, 746 (W.D. Ky. 1998)).
The Bankruptcy Code neither defines "substantial contribution" nor sets forth criteria to be used in determining whether a substantial contribution has been made in a chapter 9 or chapter 11 case. The legislative history of the provisions similarly provides little clarity. The issue, therefore, of whether an entity has made a "substantial contribution" is a question of fact, with the moving party bearing the burden of proof. Most courts narrowly construe what constitutes a "substantial contribution" in a chapter 11 case (in which the vast majority of substantial contribution claims are made), and most have taken the position that substantial-contribution claims, like other section 503(b) claims, should be strictly limited.
Courts generally distinguish between parties' actions that "incidentally" benefit the estate and those that provide direct and demonstrable benefit. In recent years, a conflict has developed among the circuits regarding whether a court, in weighing whether the benefit was incidental, should consider the claimant's motivation in undertaking an assertive role.
On the one hand, in the Third and Tenth Circuits, actions motivated solely by self-interest generally do not give rise to compensable substantial contribution claims. See Lebron v. Mechem Financial, Inc., 27 F.3d 937 (3d Cir. 1994); In re Lister, 846 F.2d 55 (10th Cir. 1988).
In Lebron, the Third Circuit explained that, in order to be "substantial," the contribution "must be more than an incidental one arising from activities the applicant has pursued in protecting his or her own interests." Lebron, 27 F.3d at 944. Therefore, a lower court in the Third Circuit is required to apply a presumption of self-interest, which the claimant may overcome only by demonstrating that its efforts have transcended self-interest.
In Lister, the Tenth Circuit similarly emphasized that "[e]fforts undertaken by a creditor solely to further his own self-interest … will not be compensable, notwithstanding any incidental benefit accruing to the bankruptcy estate." Lister, 846 F.2d at 57.
The Fifth and Eleventh Circuits, on the other hand, apply an objective standard, which recognizes, as expressed by the Fifth Circuit, that "nothing in the Bankruptcy Code requires a self-deprecating, altruistic intent as a prerequisite to recovery of fees and expenses under section 503." Hall Fin. Grp. v. DP Partners, Ltd. P'shp (In re DP Partners, Ltd. P'shp), 106 F.3d 667, 673 (5th Cir. 1997). The Fifth Circuit further noted in DP Partners that "[t]he benefits, if any, conferred upon an estate are not diminished by selfish or shrewd motivations," and that "a creditor's motive in taking actions that benefit the estate has little relevance in the determination whether the creditor has incurred actual and necessary expenses in making a substantial contribution to a case." Id. In Speights & Runyan v. Celotex Corp. (In re Celotex Corp.), 227 F.3d 1336, 1338 (11th Cir. 2000), the Eleventh Circuit similarly held that "[e]xamining a creditor's intent unnecessarily complicates the analysis of whether a contribution of considerable value or worth has been made."
DeVal Corporation ("DVC") was a high-tech manufacturer of aircraft and weapon support equipment. As of 2016, DVC owed approximately $980,000 to PDI/DeVal Acquisitions, LLC ("PDI") under a defaulted unsecured loan that later resulted in a state court judgment. DVI also owed approximately $700,000 to its senior secured lender.
PDI, which had expressed interest in acquiring DVC and had managed the company pending completion of an aborted sale transaction, proposed that DVC file for bankruptcy so that PDI could acquire the company's assets in an auction sale under section 363 of the Bankruptcy Code for $750,000, subject to better and higher offers. The proposed purchase price would have left nothing to distribute to DVC's unsecured creditors.
DVC spurned the offer but, after PDI executed on its judgment and the secured lender froze DVC's accounts, DVC nonetheless filed for chapter 11 protection in the Eastern District of Pennsylvania in November 2016. PDI renewed its offer to purchase DVC's personal property assets in exchange for payments of $675,000 to the senior secured lender, $25,000 to DVC, and forgiveness of PDI's debt. This proposal would have allowed DVC to retain equity in its real estate, and it potentially could have allowed a distribution to DVC's unsecured creditors from the proceeds of certain litigation claims. DVC declined to pursue this proposal as well.
In March 2017, DVC filed a motion to extend its exclusive periods to propose and solicit acceptances for a chapter 11 plan. At the hearing, DVC announced that the cornerstone of its plan would be a sale to another prospective buyer, Parts Life, Inc. ("Parts Life"), but that DVC needed additional time to facilitate the transaction.
PDI objected to the extension of exclusivity and requested the appointment of a chapter 11 trustee. According to PDI, by refusing to pursue viable sale offers already made (such as the offers put forth by PDI), DVC was effectively driving the business into the ground. PDI also argued that DVC had valuable contracts with the U.S. Navy that were in imminent danger of cancellation because DVC did not have the necessary liquidity to perform.
The bankruptcy court agreed to extend DVC's plan filing exclusivity for 20 days. A week after exclusivity expired, DVC filed a chapter 11 plan contemplating the sale to Parts Life, but subject to numerous contingencies. DVC also asked for an additional extension of exclusivity. The court denied the request, calling the plan "patently unconfirmable," and granted PDI's request to propose an alternative chapter 11 plan.
PDI filed a competing plan and repeated its request to appoint a chapter 11 trustee, arguing that DVC was not adequately pursuing a deal with either of the two interested purchasers. The court ultimately appointed a chief restructuring officer in lieu of a trustee to oversee the bankruptcy case.
PDI and DVC subsequently filed several other iterations of their proposed chapter 11 plans. The bankruptcy court confirmed DVC's third amended plan in August 2017 (providing for the sale to Parts Life), and denied confirmation of PDI's fifth amended plan. The final versions of both plans provided for a 100% distribution to DVC's general unsecured creditors.
PDI later sought an approximately $180,000 substantial contribution claim under sections 503(b)(3)(D) and 503(b)(4). PDI argued that it was the only creditor that took an active role in the case and that, as a result of its actions, DVC undertook active marketing efforts, resulting in an eventual sale of the business and full recovery for all creditors. While acknowledging that the ultimate goal of its involvement was to get paid on its judgment, PDI contended that it recognized several months into the bankruptcy that DVC was failing to do anything of substance to emerge from bankruptcy and PDI elected to take on an aggressive role in the case to ensure recovery not only for itself but also for other creditors.
PDI subsequently lowered its substantial contribution request to approximately $89,000. After meticulously reviewing the evidence, the bankruptcy court ruled that PDI made a substantial contribution to the case and qualified for an administrative expense claim in the amount of $84,000 under sections 503(b)(3)(D) and 503(b)(4), after reductions for various transportation expenses and counsel fees for tax analysis. The court found that "PDI's efforts conferred an actual and demonstrable benefit to [DVC's] creditors because PDI's Objection, Trustee Motion and initial PDI Plan pressured [DVC] into finally taking action to consummate a sale of its assets, after months of inaction, before it ran out of cash and collapsed." Without PDI's aggressive approach, the court found, "the unsecured creditors likely would have received nothing in this case."
The court further found that PDI overcame the "presumption of self-interest" because the aggressive actions taken by PDI were for the benefit of all creditors in the case, not just PDI. The court emphasized that PDI's actions were not fully aligned with its own self-interest, and that PDI took a huge risk in deciding to incur significant costs in seeking the appointment of a trustee and in pushing the sale through.
Parts Life and PDI appealed the decision.
The District Court's Ruling
The district court affirmed.
Parts Life argued that the bankruptcy court failed to abide by controlling Third Circuit precedent, and instead applied the more lenient legal standards adopted by the Fifth and Eleventh Circuit. According to Parts Life, because PDI acknowledged that the ultimate goal of its participation in the bankruptcy case was to secure repayment of its claim, its objectives were not devoid of self-interest.
District Judge Mark A. Kearney disagreed. He explained that the bankruptcy court correctly looked at PDI's various actions in isolation, rather than conflating "a creditor's purpose in the entire case with the creditor's purpose in taking the acts for which it [sought] an award of administrative expenses." According to Judge Kearney, in accordance with the Third Circuit's ruling in Lebron, the partial motivation of self-interest alone cannot preclude reimbursement, because most activities of an interested party that contribute to the estate will also benefit that party.
Judge Kearney found no fault with the bankruptcy court's diligent review of the documentation of PDI's expenses and the way the court identified conduct that benefited the estate, as distinguished from conduct that solely advanced PDI's interests. He also agreed with the bankruptcy court's findings that: (i) PDI would not have taken such an aggressive position in the bankruptcy case were it simply looking out for its own self-interest; and (ii) PDI's primary motivation was to rouse the debtor from inertia to avoid further depletion of the estate.
DeVal is indicative of the high bar for a party seeking reimbursement of expenses under section 503(b) in making a substantial contribution in a chapter 9 or chapter 11 case. Notwithstanding the favorable ruling in DeVal, substantial contribution claimants in the Third and Tenth Circuits face a relatively high standard for approval of their claims, whereas such claimants in the Fifth and Eleventh Circuits will experience or more lenient standard.
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