5th Circ. Bond Claim Ruling Shows Creditors Must Be Vigilant

With its January opinion in Raymond James & Associates Inc. v. Jalbert, the U.S. Court of Appeals for the Fifth Circuit held that the bankruptcy debtor's indemnification obligations were discharged by the confirmed plan because the indemnified party failed to speak up.[1]

Key takeaways include when an unscheduled creditor may be bound to a confirmed plan, whether a liquidating trust assumes the debtor's liabilities, and what creditors with contingent and unliquidated recoupment and offset claims must do to preserve those claims post-confirmation.

Background

According to the opinion, Louisiana Pellets, the debtor, sold bonds to raise money to build a multimillion-dollar wood-processing facility to refine raw wood into specialized fuel pellets.

Investment bank Raymond James & Associates purchased some of these bonds and resold them to investors by using bond-offering memoranda with statements provided by the debtor. As part of the offering, the debtor agreed to indemnify the broker for any untrue or misleading statements within those offering memoranda.

Soon after the wood-processing facility was completed, the debtor encountered financial problems and ceased operations, followed by defaults under the bonds. The debtor then filed for Chapter 11 bankruptcy in the U.S. Bankruptcy Court for the Western District of Louisiana.

The debtor did not schedule the broker as a creditor and the broker did not receive formal notice of the bankruptcy. The broker was aware of and monitored the bankruptcy case, but did not file a proof of claim.

The bankruptcy case eventually culminated in a confirmed Chapter 11 plan, which appointed a liquidating trustee to oversee a liquidating trust  and liquidate the debtor's assets. The bondholder sustained substantial losses under the confirmed plan.

The Trustee's Lawsuit Against the Broker

The bondholders held claims against the broker for alleged misstatements in the bond offering memoranda.

More than a year after confirmation, the bondholders assigned these claims to the trustee. The trustee then sued the broker in Louisiana state court based on misstatements on the offering memoranda.

The broker responded by asserting recoupment and offset premised on the argument that the trustee was bound to the debtor's agreement to indemnify the broker for any alleged misstatements in the offering memoranda.

The trustee responded by filing an adversary proceeding in the bankruptcy case arguing that the confirmed plan enjoined the broker's recoupment and offset defenses, and that the debtor's indemnity obligation did not transfer to the trustee.

The Court's Ruling

In an opinion authored by U.S. Circuit Judge Dana Douglas, a three-judge panel of the Fifth Circuit agreed with the trustee.

First, the court ruled that language in the plan did bind the broker and enjoin the recoupment and setoff defense.

While, according to the court's opinion, a debtor's failure to schedule a creditor "typically means the unlisted creditor's claims are exempt from discharge" the opinion relied on what it referred to as a catch: "If an interested party has 'notice or actual knowledge' of the bankruptcy, that party must 'come forward and protect their enhanced rights ... or else lose their rights through the sweeping discharge of Chapter 11.'"[2]

Second, the court ruled that even if the broker could show that the terms of the confirmation plan were invalid, the trustee would not be the appropriate party against whom to raise its defenses because "post-confirmation entities and the debtor's estate are distinct."

Takeaways

Creditors need to be proactive to protect their rights.

Despite not being scheduled, the plan still applied to the broker because it had actual knowledge of the case, which, according to the opinion, "obligated [it] to come forward with its indemnity claim. But it never did; [the broker] chose not to assert any rights it had against [the debtor] during the company's bankruptcy proceedings."[3]

And in response to the broker's argument that this was inequitable and unjust because it did not know that it would get sued based on the offering memoranda, it was still a prepetition right and the broker was "a sophisticated financial services firm and was aware of its litigation risks upon the filing of [the debtor's] bankruptcy," according to the opinion.[4]

This is also a reminder that proofs of claim are not just for liquidated claims or existing causes of action. Here, the cause of action was contingent — upon a future claim against the broker based on alleged misrepresentations in the offering memoranda — but a proof of claim was still necessary.

The court continued its line of reasoning by stating: "Nor did [the broker] object to the plan's provisions that threatened to extinguish its pre-petition rights."[5]

This final point is crucial. Initially, after having filed a proof of claim, the contingent creditor needed to make sure that the plan did not extinguish that right. But not only that, the plan would have needed to preserve that right against the reorganized debtor or, in the case, the trust.

This final takeaway encompasses the court's final point — that the trust did not owe indemnification because it and the debtor were "distinct legal entities."

In citing this last line of reasoning, the court cited its 2008 opinion in In re: United Operating LLC.[6] There, the court held that a reorganized debtor did not preserve its preconfirmation claims because they were absent from, and thus discharged by the confirmed plan.

With respect to this final point, creditors and counsel should be mindful of Section 553 of the U.S. Bankruptcy Code, which generally prohibits the extinguishment of a setoff right, subject to various exceptions.

The Fifth Circuit did not explicitly address this provision, but seemingly sidestepped it by citing United Operating to reason that the debtor and the trust were distinct legal entities — that Section 553 only applies to a mutual debt by and between the debtor and the creditor, not a liquidating trust and the creditor.

Conclusion

Creditors need to be vigilant to protect their claims, even if those claims remain contingent and unliquidated throughout the bankruptcy proceeding. In this case, it was an indemnity obligation.

This might also apply in instances where a contractor or developer owing warranties files for bankruptcy.

As is often the case with bankruptcy, there is no hard-and-fast rule — there are instances where creditors will want to file proof of claims, and instances where they may not.

This ruling is a veritable reminder, though, that it doesn't pay to watch and wait.

Republished with permission. This article, "5th Circ. Bond Claim Ruling Shows Creditors Must Be Vigilant," was published by Law360 on May 29, 2024.

[1] Raymond James & Associates Inc. v. Jalbert  (In re German Pellets Louisiana LLC ), 23-30040, 2024 WL 339101 (5th Cir. Jan. 30, 2024).

[2] Id. at 809 (quoting In re Christopher, 28 F.3d 512, 515, 519 (5th Cir. 1994)).

[3] Id. at 810.

[4] Id.

[5] Id.

[6] In re United Operating LLC , 540 F.3d 351, 355 (5th Cir. 2008).