In re Del Biaggio, 496 B.R. 600 (Bankr. N.D. Cal. 2012) –

The creditors committee objected to proofs of claim filed by a group of unsecured lenders who had received partial payment from a non-debtor co-obligor, arguing that the claims should be reduced by the payments.  If you bet that the creditors committee would prevail, you would lose.

The debtor borrowed $39.25 million from a group of lenders.  The loans were supposed to be secured by a pledge of stock owned by the debtor and held by a broker-dealer.  In fact, the debtor did not own the stock, although at his behest an employee of the broker-dealer fabricated documentation to show ownership.  Both the debtor and the broker-dealer employee were convicted of securities fraud; and the lenders sued the broker-dealer, asserting negligence with respect to the employee.  The parties settled, and the broker-dealer paid $6.9 million to the lenders.

The lenders filed proofs of claim in the debtor’s bankruptcy asserting claims for the full balance of the loan without deducting the payment.  The creditors committee objected, arguing that the claims must be reduced by the amount already paid by the broker-dealer (the Reduction-of-Claim Approach), while the lenders asserted they did not have to take the payment into account unless the dividend received in the bankruptcy would result in more than a full recovery (the Limitation-of-Dividend Approach).

Relying on an old pre-Bankruptcy Code Supreme Court case – Ivanhoe Bldg. & Loan v. Orr, 295 U.S. 243, 55 Sup. Ct. 685, 79 L. Ed. 1419 (1935) – the bankruptcy court sided with the lenders.  In Ivanhoe, the debtor owed $10,740, which was also secured by real property owned by a third party.  (The debtor originally owned the property, and transferred it subject to the mortgage securing the debt.)  Prior to the bankruptcy, the creditor foreclosed the mortgage and acquired the property with a credit bid of $100.

The debtor’s bankruptcy trustee argued that the debtor was entitled to offset the value of the foreclosed property ($9,000) rather than the $100 bid against the loan amount.  The bankruptcy court, district court and court of appeals agreed with the trustee.  However, the Supreme Court reversed:  (1) the debtor was entitled to a credit of only $100, and (2) the credit would not reduce the creditor’s unsecured claims unless failure to do so would allow the creditor to recover from all sources more than the full amount of the claim.

This analysis implicitly takes into consideration the “reasonable assumption” that the bankruptcy estate will not pay a claim in full, and permits the creditor to receive a larger dividend than it would if the claim itself was reduced by any credits.  The bankruptcy court concluded that Ivanhoe remains good law since there is nothing in the Bankruptcy Code nor the legislative history indicating that Congress intended to overrule the case.

The creditors committee countered with the argument that claims are generally defined by non-bankruptcy state law, and applicable state law provided that payment reduces the amount of the claim.  However, the bankruptcy court concluded that the approach taken by state courts did not require the court to reject the approach adopted by Ivanhoe.  Although state law generally determines the existence and amount of a claim, Congress has broad power to modify those rights:

• Ivanhoe “chooses to value equality of treatment by the debtor’s estate above equality of overall outcomes among creditors having different rights against third parties.”
• This is a question of federal bankruptcy law.  The choice between the two approaches matters only when the debtor is in bankruptcy.
• The state law cases cited did not even address insolvency and appeared to assume that the debtor would pay the full amount of the claim, permitting a full recovery.
• The choice between approaches does not involve general rules regarding contractual liabilities or property rights under state law, but rather how to calculate claim payments when the debtor is insolvent and in bankruptcy.

Consequently, the committee objection was overruled, and the lenders were permitted to assert claims that were not reduced by the payments received from the broker-dealer, unless and to the extent that this would lead to a double recovery.

Not all courts would follow this approach.  However, for those that do, it can make a significant difference in a creditor’s recovery.  For example, assume that a parent and four subsidiaries are jointly and severally liable for a $100 loan.  The loan is also guaranteed by a third party.  The parent and subsidiaries each file for bankruptcy, and each proposes a plan of reorganization that provides for a 10% dividend on unsecured deficiency claims.  (Assume the cases are not substantively consolidated.)

In the meantime, the third party guarantor had paid $50 on the debt.  Under the Reduction-of-Claim Approach, the lender’s claim would be limited to $50 in each case – so that it would receive $5 in each case, resulting in a recovery of $75 (5 x $5 + $50).  Under the Limitation-of-Dividend Approach, it would be permitted to assert a $100 claim in each case – so that it would receive $10 in each case, resulting in a total recovery of $100 (5 x $10 + $50).

In addition to arguing that the lender’s claim should have been reduced by the guarantor’s payment, one might also be tempted to argue that the lender should not be allowed to assert a $100 claim in each of the five bankruptcies because of the potential for recovering more than the full amount of the claim.  However, in a court that follows Ivanhoe, this obviously would be a non-starter.  If actual payment doesn’t affect a claim, then clearly potential payment will not have any effect.

Vicki R. Harding, Esq.