Recently, Judge Jacqueline P. Cox in the U.S. Bankruptcy Court for the Northern District of Illinois issued an opinion which reviewed Seventh Circuit precedent in determining the appropriate rate of post-petition interest for unsecured creditors in Chapter 11 cases where the debtor is solvent. The legal implications of the Judge’s decision are interesting and worthy of examination, as are the details of the bankruptcy case itself.
Daniel Dvorkin was a successful developer who built a sizeable commercial real estate business in the Chicagoland area over the course of several decades prior to his downfall. His portfolio included over seventy (70) parcels of real property valued at $70 million. He generally financed each parcel with mortgages. When the economy faltered in 2008 he was unable to pay back a handful of loans. These loans were purchased by a Texas based investor who sued Dvorkin in civil court, winning an $8.2 million judgment in February of 2012. When mediation failed, Mr. Dvorkin called an acquaintance to propose a novel way to make the issue go away: hire him to kill the Texas-based creditor. He explained that he was appealing the judgment and thought that if the creditor “wasn’t breathing” and did not respond the funds wouldn’t have to be paid out.
The rattled acquaintance contacted local police and the FBI and began to cooperate by recording future conversations. The plan called for $50,000 up front with another $50,000 upon completion. He would also arrange private air travel so the hit man’s name wouldn’t appear on any commercial flight records. Dvorkin planned to be out of the country at the time. By May he confided to his acquaintance that he had hired someone else, a cheaper hit man who only required $20,000, with $2,000 upfront. The FBI then moved in to arrest Mr. Dvorkin and arrange for the safety of the Texas creditor. Dvorkin would be convicted of solicitation of murder after a week-long jury trial in August 2013. He was sentenced to 8 years in federal prison.
Without its figurehead and facing operational issues related to the scandal, on August 7, 2012, Dvorkin Holdings LLC (the “Debtor”) filed a voluntary petition for Chapter 11 bankruptcy protection. At the time of the petition, the Debtor still had ownership interests in more than seventy (70) parcels of real property with a total value of approximately $70 million. Given the soft real estate market and significant leverage at each property, it was generally believed at the time that there would be very little, if any, funds left over for equity holders (including members of Mr. Dvorkin’s immediate family).
Shortly after the filing, the Bankruptcy Court entered an order to engage a Chapter 11 Trustee to administer the Debtor’s estate. Gus Paloian (of Seyfarth Shaw LLP) was appointed Trustee and, in the two years subsequent to his appointment, Paloian sold more than 20 properties while reaching numerous settlements with creditors and other parties in interest. Most of the Debtor’s creditors were local commercial banks that held mortgage notes and, importantly, guarantees from the parent for the full amount of the loans. Despite having the serendipity to liquidate commercial properties in a rising real estate market, many of the sales were at levels below the mortgage amount, resulting in numerous multimillion dollar unsecured deficiency claims against the estate.
By late 2014 things were looking much brighter for the estate as a rising real estate market and the Trustee’s efforts had resulted in the recovery of tens of millions of dollars. Meanwhile, as early as December 2013, ASM Capital, a distressed debt investor, purchased the unsecured deficiency claims of two regional banks.  By early 2015, the estate held over $28 million of cash and began to look like a “surplus estate”, i.e., there were more liquidated assets than claims.
On January 23rd, 2015, in an unusual step, creditor ASM Capital filed a Disclosure Statement and Plan , which sought to liquidate all remaining assets of the Debtor to pay unsecured creditors the full amount of their claims (100%) plus post-petition interest at the higher of 9% or the contractual default rate. A week later, the Trustee and the Equity Interest Holders (“Equity”) responded by filing a Joint Disclosure Statement and Plan  which sought to pay unsecured creditors the full amount of their claims (100%) plus post-petition interest at the much lower federal judgment rate (0.17%), with Equity retaining their interests in the Debtor and its remaining assets.
In its objection to ASM’s Plan, the Trustee made sure to highlight to the Court that ASM was not a pre-petition creditor and that it purchased two general unsecured claims for “pennies on the dollar” (later revealed to be 26.87%) after “it became evident that the Trustee was in the process of recovering tens of millions of dollars for the benefit of creditors in this Case.” If ASM prevailed, it would mean millions of dollars less for the Equity. After several months of legal back and forth, the adversaries agreed to file briefs and let Judge Cox determine the “legal rate” of interest to be paid to holders of allowed unsecured claims, a decision that would inevitably determine which of the two competing plans would go forward.
ASM Capital’s Memorandum of Law  regarding the appropriate post-petition interest rate focused on several legal precedents and provisions of the Code. ASM argued that in the case of a solvent estate, the Seventh Circuit is clear: a bankruptcy court’s task is “simply to enforce creditors’ rights according to the tenor of the contracts that created those rights” (which includes the right to recover at the contract rate). Moreover, ASM argued that the absolute priority rule mandates that, where a debtor has the financial wherewithal to pay all pre-petition claims and interest in full, unsecured creditors must receive the amounts to which they are entitled under applicable non-bankruptcy law – most importantly, the amounts for which they bargained in their contractual arrangements with the debtor – before any amounts can be paid to equity (the “fair and equitable” requirements of 11 U.S.C. § 1129(b)(2)(B)). In addition, ASM argued that the Joint Plan of the Trustee and Equity Interest Holders failed to meet Section 1129(a) of the Code (the so-called “best interests of creditors test””) which mandates that impaired unsecured creditors of chapter 11 debtors must receive at least the same recovery that they would receive under a chapter 7 liquidation. (In a chapter 7 liquidation where the debtor is solvent, a creditor must receive post-petition interest on its claim before equity holders receive any distributions (11 U.S.C. § 726(a)(5))).
In its own Memorandum of Law , the Trustee argued that ASM’s Plan was not confirmable as a matter of law because Bankruptcy Code Section 502(b)(2) contains a general prohibition against payment of post-petition interest on allowed unsecured claims. The statutory exceptions to the Section 502(b) general prohibition on the payment of post-petition interest on unsecured claims include Sections 506(b) and 726(a)(5). The Trustee argued that Section 506(b) does not apply because this case relates to post-petition interest on unsecured claims rather than over-secured claims. Furthermore, the Trustee pointed out that Section 726(a)(5) does permit payment of post-petition interest on unsecured claims at the federal judgment rate in “solvent debtor” chapter 7 cases, which is also applicable in chapter 11 cases pursuant to the best interests test if a holder of a claim or interest that is impaired does not accept a plan. However, the Trustee argued that the ASM Plan is not confirmable under the best interests test because the post-petition interest rate proposed in the ASM Plan far exceeds the federal judgment rate permitted by Section 726(a)(5).
On May 7th, 2015, Judge Cox entered an order approving the adequacy of the Trustee and Equity Interest Holders’ Joint Disclosure Statement, likewise finding that ASM’s Plan is patently unconfirmable “due to the illegal post-petition interest rate”. In her order, Judge Cox cites Section 502(b) and its prohibition on the payment of unmatured post-petition interest. Judge Cox was not swayed by ASM’s argument that the contract rate of interest is required by the Seventh Circuit’s ruling in In re Chicago, Milwaukee, St. Paul and Pacific Railroad Co., 791 F.2d 524, 530 (1980). Although the court in that case did observe that “when the debtor is solvent the judicial task is to give each creditor the measure of his contractual claim…,” it had made that determination based on the Bankruptcy Act of 1898 (the case was filed in 1977 under § 77). However, as Judge Cox pointed out, the Bankruptcy Code (“Code”), enacted in 1978 (and thus the controlling law for over 30 years prior to the Dvorkin case) clearly establishes its own distribution provision for liquidation cases in 11 U.S.C. § 726. Section 726(a)(5) provides that: “. . . in payment of interest at the legal rate from the date of the filing of the petition, on any claim paid…”
Judge Cox referenced Collier on Bankruptcy:
The reference in the statute to the “legal rate” suggests Congress envisioned a single rate, probably the federal statutory rate for interest on judgments set by 28 U.S.C. § 1961. As the Court of Appeals for the Ninth Circuit held in Onink v. Cardelucci (In re Cardelucci), awarding all creditors interest at the same rate also furthers the general principles of equitable, ratable distribution to creditors. While some courts have looked to contract rates or to state law statutory rates, use of those varying rates in a single case would cause interest distributions to range widely, leading to arbitrary differences in how different creditors are treated. Moreover, had Congress intended contract rates to apply, it presumably would have used language other than “the legal rate,” a term that typically refers to a statutory rate. (4 Collier on Bankruptcy ¶ 726.05 (Alan N. Resnick & Henry J. Sommer eds., 16th ed.)[footnotes omitted]
Judge Cox ruled that the Bankruptcy code (“Code”) provision controls in this case, not the Seventh Circuit’s ruling under the Bankruptcy Act. Finally, Judge Cox concluded that the exceptions to the prohibition on the payment of post-petition interest, Sections 506(b) and 726(a)(5) are not relevant to this situation and thus do not support ASM’s arguments.
Dvorkin Holdings shows us that it is possible for a chapter 11 debtor to go from the depths of insolvency to a “surplus estate” (rare though that may be). Furthermore, Judge Cox’s interpretation of the Bankruptcy Code indicates that in such instances where there are ample funds to pay the principal of all allowed unsecured claims, post-petition interest may be paid on such claims only at the federal judgment rate, however meager that rate may be at the time.
Footnotes: Schedules and Summary of Schedules, U.S. Bankruptcy Court, Case No. 12-31336. Dockets 20 and 21, August 21, 2012.  Order Granting Motion to Appoint Chapter 11 Trustee, U.S. Bankruptcy Court, Case No. 12-31336. Docket 80, October 1, 2012.  Transfer of Claim, U.S. Bankruptcy Court, Case No. 12-31336. Docket 415, December 30, 2013.  Transfer of Claim, U.S. Bankruptcy Court, Case No. 12-31336. Docket 550, December 4, 2014.  Summary Cash Receipts and Cash Disbursements for the Period of January 1, 2015 through January 31, 2015, U.S. Bankruptcy Court, Case No. 12-31336. Docket 576, February 2, 2015.  Disclosure Statement and Chapter 11 Plan of Liquidation, U.S. Bankruptcy Court, Case No. 12-31336. Dockets 563 and 564, January 23, 2015.  Joint Chapter 11 Plan of Reorganization, U.S. Bankruptcy Court, Case No. 12-31336. Docket 566, January 30, 2015.  Joint Objection to Disclosure Statement, U.S. Bankruptcy Court, Case No. 12-31336. Docket 582, February 19, 2015.  Memorandum Regarding Legal Rate of Post-Petition Interest, U.S. Bankruptcy Court, Case No. 12-31336. Docket 684, April 16, 2015.  Joint Memorandum Regarding Legal Rate of Post-Petition Interest, U.S. Bankruptcy Court, Case No. 12-31336. Docket 689, April 16, 2015.  Order Granting Motion for Approval of Disclosure Statement, U.S. Bankruptcy Court, Case No. 12-31336. Docket 582, May 7, 2015.
Adam is co-founder and portfolio manager at Pioneer, a bankruptcy trade claim investment fund. Over the past ten years Adam and the team have invested in more than 100 bankruptcy cases. In support of these investment activities, he has developed a unique expertise in analyzing all aspects of commercial bankruptcy cases. Adam has served on…
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