Business Law

In re Ditech Holdings Corporation (Bankr. S.D. N.Y) – Section 363(o)’s limitation on free and clear sales applies only to sales under Section 363, but not those conducted pursuant to a plan.

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The following is a case update written by Uzzi O. Raanan, a member of the ad hoc group of the California Lawyers Association’s (CLA) Business Law Section, analyzing a recent decision of interest:


The sale or assignment of any interest in consumer credit transactions, if achieved pursuant to a chapter 11 plan of reorganization, is not subject to the limitations imposed by 11 U.S.C. section 363(o) on the free and clear transfers of consumer credit transactions. However, Sections 363(f) and (o) must be considered in determining whether plan proponents have met their burden under the best interests test mandated by Section 1129(a)(7). In re Ditech Holdings Corporation, et al, __ B.R. __, 2019 WL 4073378 (Bankr. S.D. N.Y. Aug. 28, 2019). To review the full decision, click here.

Facts: Ditech Holding Corporation is the parent of 26 subsidiaries and trust companies, 13 of which, including Ditech Holding (collectively, the “Debtors”), filed a chapter 11 case in the United States Bankruptcy Court for the Southern District of New York. Debtors and their non-debtor subsidiaries (collectively, the “Company”) operate as an independent servicer and originator of mortgage loans and as servicer of reverse mortgage loans.

Debtors are involved in about one million agreements (the “Consumer Credit Agreements”) with consumer creditors that fall under the scope of Section 363(o). As of the petition date, Debtors were involved in “thousands of formal and informal proceedings pending in and out of court in which Consumer Creditors are asserting claims and defenses of types described in section 363(o).” The claims and defenses include Debtors’ alleged failure to comply with loan modification obligations, improper assignments of deeds of trust, violations of RESPA, and servicing errors such as misapplications of borrower payments, miscalculations of loan principal amounts, and failure to credit funds to the correct accounts, among other.

Debtors sought confirmation of their Second Amended Joint Chapter 11 Plan (the “plan”), which contemplated two going concern sale transactions: the forward loan origination and servicing business to one buyer and the reverse loan servicing business to a second buyer (collectively, the “Buyers”). Most of the assets involved in the proposed sale were Consumer Credit Agreements, which Buyers sought to purchase free and clear of consumer claims and defenses.

Because their assets were being sold through a plan, Debtors argued that the sale would be conducted under Section 1123, and not Sections 363(f) and (o). As such, they asked the court to rule that the proposed sale was “free and clear” of claims and defenses that consumers would be entitled to assert against the proposed asset purchasers with regard to purchased Consumer Credit Agreements.

The plan further incorporated a Global Settlement agreed to by the Debtors, Official Committee of Unsecured Creditors and certain lenders. Under this agreement, Debtors were required to establish a Creditor Recovery Trust (the “Trust”) for the benefit of unsecured creditors. The Trust would have included $5,000,000, less certain fees and expenses, for the sole benefit of the consumer creditors. A court-appointed Consumer Creditors Committee objected to the Global Settlement on the ground that the amount set aside for consumer claims failed to adequately account for the claims and defenses being lost by the proposed free and clear sale. It also objected to the plan on numerous grounds.

After rejecting other objections, the court concluded that Debtors failed to comply with the best interests of creditors test in Section 1129(a)(7) and denied Debtors’ plan confirmation request.

Reasoning: Bankruptcy Court Judge James L. Garrity carefully analyzed and rejected most objections to the plan, including those asserted by the United States and New York Attorneys General, who argued against aspects of the plan on policy grounds. He focused particularly on Section 1129(a)(1) through (a)(3), which require chapter 11 plans and proponents to comply with applicable title 11 provisions and be proposed by means not forbidden by law, namely in “good faith.”

Opponents of the plan argued that neither the proposed plan nor Debtors complied with applicable title 11 provisions, and the plan was “proposed by means . . . forbidden by law,” because the plan failed to comply with Section 363(o)’s proscription against stripping consumer claims and defenses from the Consumer Credit Agreements being sold under the plan. Debtors countered that the asset sales were being conducted under Sections 1123(b)(4) and 1141(c), and therefore Section 363(o) was not implicated in this plan sale.

The court noted that there are two ways to sell assets in a bankruptcy case, under Section 363 or under a plan through Section 1123. Because a sale under Section 1123 can only be affected through a confirmed plan, a sale may only be realized if the plan had met the requirements of Section 1129, including subsections (a)(1) through (a)(3). A sale under Section 363 can be made “free and clear of any interest in such property” if the sale proponent complies with the conditions set forth in Section 363(f). An exception to Section 363(f)’s “free and clear” sale is found in Section 363(o), which states in relevant part,

Notwithstanding subsection (f), if a person purchases any interest in a consumer credit transaction that is subject to the Truth in Lending Act or any interest in a consumer credit contract (as defined in section 433.1 of title 16 of the Code of Federal Regulations (January 1, 2004), as amended from time to time), and if such interest is purchased through a sale under this section, then such person shall remain subject to all claims and defenses that are related to such consumer credit transaction or such consumer credit contract, to the same extent as such person would be subject to such claims and defenses of the consumer had such interest been purchased at a sale not under this section.

11 U.S.C. § 363(o) (Emphasis added).

Here, the Debtors argued that Section 363(o) applies only to pre-plan sales conducted under Section 363, but not to sales conducted under Section 1123. They therefore asked the court to rule that consumer creditors have greater protections in a pre-plan sale as opposed to a sale conducted under a plan.

Opponents of the plan responded that any free and clear sale of bankruptcy assets, whether under Section 363 or 1123, must be conducted under section 363(f) which regulates the scope of all “free and clear” asset sales in bankruptcy cases. They therefore concluded that Section 363(f), as limited by Section 363(o), is an “applicable provision[] of the Bankruptcy Code” with which Debtors and the plan must comply under Section 1129(a)(1) through (a)(3).

The plan opponents further posited that the phrase in Section 363(o), “to the same extent as such person would be subject to such claims and defenses of the consumer had such interest been purchased at a sale not under this section” would have no meaning if Debtors’ interpretation of Section 363(o) were adopted. This is because in a pre-plan sale a purchaser who obtains consumer credit transactions is limited only to the extent it would have been limited if the sale were conducted outside Section 363. In other words, they asserted, if Section 1123 sales were not limited by Section 363(o), then Section 363(f) sales would also not be limited by Section 363(o).

The Court rejected the plan opponents’ arguments. It held that a plan sale can be made “free and clear” under Section 1141(c), and therefore plans need not comply with Section 363(f) in order to achieve free and clear sales. It further found that Section 363(o) does not independently apply to plan-based sales under Section 1123.

Plan opponents also argued that Debtors were attempting to sell assets free and clear of consumer creditor rights that cannot be expunged through bankruptcy, such as defenses and affirmative defenses including rights to setoff and recoupment.

The parties had resolved their disputes as to setoff rights prior to the confirmation motion hearing, agreeing that the plan will extinguish setoff rights against the Buyers but not against Debtors. The Court further ruled that any confirmation order would need to clearly state that consumer creditors were not losing their defenses or rights of recoupment under applicable non-bankruptcy law, as long as these defenses and recoupment rights did not require the Buyers to pay money damages, refund or otherwise pay money on behalf of or for the account of the borrowers. The Court next considered what turned out to be the key issue in the confirmation debate; it analyzed whether the plan satisfied the best interests test under Section 1129(a)(7), which states in relevant part,

With respect to each impaired class of claims or interests—

(A)each holder of a claim or interest of such class—

(i)has accepted the plan; or

(ii)will receive or retain under the plan on

account of such claim or interest property of a value, as of the effective date of the plan, that is not less than the amount that such holder would so receive or retain if the debtor were liquidated under chapter 7 of this title on such date.

Debtors had argued that, under the plan, consumer creditors would receive pro rata shares of the $5,000,000 Trust pool set aside for them by the Global Agreement, whereas they would receive a 0% recovery in a hypothetical chapter 7 liquidation.

The consumer creditors disputed this liquidation analysis, arguing that the plan failed to assign values to their individual claims and defenses, which would have economic values in a chapter 7 case, where an asset sale would be limited by Section 363(o). Such sales would not be free and clear of claims and defenses, which would therefore be retained by the consumer creditors.

The court agreed with the plan opponents on this critical issue. It rejected Debtors’ argument that the consumer creditors were trying to bootstrap Section 363(o) into a plan sale through the best interests test and that valuing the claims and defenses in a chapter 7 liquidation analysis would leave plan proponents with no option to sell credit contracts free and clear under a plan. The court explained,

Although the Court has determined that sections 363(f) and (o) are not applicable to the [plan sale], those provisions plainly are applicable in a hypothetical liquidation under chapter 7, and thus, are relevant to the Court’s determination of whether the Debtors have met their burden under section 1129(a)(7). That is so, even if, as the Debtors contend, application of those provisions will tilt the analysis in favor of liquidation.

Finding that Debtors were required to but failed to account for the values of consumer claims in the chapter 7 liquidation analysis, Debtors did not satisfy the best interests test of Section 1129(a)(7). The court acknowledged the large number of claims asserted by consumer creditors but concluded that Debtors must consider the specific factual and legal details of each claim in their liquidation analysis. Failing to do so here, they did not meet their burden of proving that the consumer creditors would receive or retain more under the plan than in a hypothetical chapter 7 liquidation. The Court ruled that this failure rendered the plan unconfirmable.

The Court also denied Debtors’ motion to approve the Global Settlement, as they failed to demonstrate that it was fair and equitable to the consumer creditors.

Author’s Comments: The court’s ruling that Section 363(o)’s limitation on free and clear sales applies only to sales under Section 363, but not those conducted pursuant to a plan, is buttressed by the plain language in Section 363(o) (e.g., “if such interest is purchased through a sale under this section”) as well as relevant legislative history. However, its finding that Debtors failed to satisfy the best interests of creditors’ test under Section 1129(a)(7) raises questions.

While the court may be correct that Debtors were required to assign some value in their chapter 7 liquidation analysis to the consumer creditors’ claims and defenses, query whether the court applied a workable standard for valuing such claims and defenses. The court relied on In re Quigley Co., Inc., 437 B.R. 102 (Bankr. S.D.N.Y. 2010), for the proposition that it should consider the value of property that each dissenting creditor would retain under the proposed plan as well as in a hypothetical chapter 7 case, as well as fairness to the parties, as long as the released claims “satisfied the definition of ‘property,’ had ‘value’ and were ‘neither speculative nor incapable of estimation.’” Id., at 145.

In addition to arguments that Quigley involved different facts, and therefore may be distinguishable, it is not clear that the court here correctly applied Quigley to the facts in this case. Allegedly applying factors advocated by Quigley, the court found that the consumer creditors’ claims fit the definition of “property,” have value and, though not liquidated, are “’neither speculative nor incapable of estimation.’” The court rejected an analysis from Debtors that estimated the overall values of approximately 3,900 proofs of claim filed by consumer creditors, using prior settlement and litigation data to value potential claims possibly alleged by these claimants. Rather, it held that Debtors must evaluate the specific factual and legal details of each relevant claim and assign values to those claims in their hypothetical chapter 7 liquidation analysis. Based on this seemingly onerous standard, the court concluded that Debtors had not satisfied Section 1129(a)(7)’s best interests test, because they didn’t assign sufficient values to the actual and potential consumer claims.

It is unclear why the Court found that the hundreds and perhaps thousands of claims alleged by Debtors’ consumer creditors were neither speculative nor incapable of estimation. In practice, a case-by-case evaluation of such claims, many of which are factually and legally undeveloped, would be prohibitively expensive, time-consuming, and fraught with other logistical obstacles. It is apparent from the court’s well-documented factual account that Debtors had a hard time locating the two Buyers, and that a sale of the assets would be negatively impacted were it not achieved free and clear of consumer creditors’ claims and defenses. It is also clear that Debtors worked hard to try to resolve all creditor objections but failed to do so regarding the consumer creditors. The court’s ruling appears to leave the Debtors and the case in precarious positions.

For practitioners who propose plans in which debtors seek to sell interests in consumer credit transactions free and clear of claims and defenses, the lesson from this case is that their clients may need to either entice consumer creditors to cooperate, using expensive financial incentives, or accept lower values for their assets. For consumer creditors, the takeaway is that this is a leverage point they can use to scuttle plans or to negotiate better carve-outs for their clients.

For discussions of cases involving related issues:

  • 2016 Comm. Fin. News. 29, NL 58, Bankruptcy Sale of GM’s Assets “Free and Clear” of Claims Did Not Insulate Purchaser from Successor Liability Because GM Concealed Product Defects and Failed to Protect Tort Victims’ Due Process Rights.
  • 2011 Comm. Fin. News. 76, Despite Order Stating That Bankruptcy Sale Is “Free and Clear” of Successor Liability Claims, Asset Purchaser Is Liable for Product Defect Claims Stemming from Products Manufactured by Prepetition Entity.
  • 2003 Comm. Fin. News. 74, Bankruptcy Sale “Free and Clear” Insulates Buyer from Successor Liability for Prepetition Torts.
  • 2003 Comm. Fin. News. 35, Assets of Bankrupt Company May Be Sold “Free and Clear” of General Unsecured Claims, Including Successor Liability Claims.

These materials were written by members of the California Lawyers Association Business Law Section for the Commercial Finance Newsletter, published weekly on Westlaw. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further distributed without the consent of Thomson Reuters.

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