Kenneth A. Listwak, left, and Francis J. Lawall, right, of Pepper Hamilton.

In the day-to-day practice of bankruptcy law, it may occasionally be tempting to dismiss "reservation of rights" language as unnecessary or unimportant—after all, a pragmatically minded court will consider the economic reality of the case before it, placing greater importance on the overall transaction at hand. Right? Well, the U.S. District Court for the District of Delaware's recent ruling in Emerald Capital Advisors v. Victory Park Capital Advisors (In re KII Liquidating), No. 18-1081-LPS, 2019 U.S. Dist. LEXIS 168308 (D. Del. Sep. 30, 2019) demonstrates the flaws in that way of thinking. Indeed, the KII ruling shows the tremendous impact that reserving one's rights can have on the outcome of major bankruptcy transactions and serves as a cautionary tale to those who would overlook the importance of precision drafting.

The Katy Industries bankruptcy cases were commenced to effect a Section 363 sale to Jansan Acquisition, the debtors' DIP lender and stalking horse bidder. Jansan itself was a joint venture between the debtors' second-lien lenders, including Victory Park. First day motions sought approval of DIP financing as well as the intended 363 sale. Per standard practice, the proposed interim DIP order contained stipulations by the debtors as to the amount and validity of the second-lien debt and the absence of claims against second-lien lenders, along with affirmative releases in favor of those lenders. Consistent with Delaware's local bankruptcy rules, the interim DIP order also provided for a "challenge period" during which an appointed creditors' committee could challenge these stipulations and releases. Jansan's proposed stalking-horse APA included a credit bid of the debtors' second-lien debt as part of the purchase price.

Shortly after case commencement, the unsecured creditors' committee was appointed, which quickly objected to the proposed DIP financing and bidding procedures for the debtors' assets. Specifically, the committee noted that it was investigating whether $7.5 million of pre-petition advances by Victory Park were true debt as opposed to an equity infusion or otherwise susceptible to equitable subordination i.e., ineligible to be a part of Jansan's credit bid. Ultimately, a final DIP order was entered, with language agreeable to all parties. Like in the interim order, the final DIP order provided the committee with a challenge period.

With respect to the sale, Jansan's $63 million stalking-horse bid—including a $36.7 million credit bid—prevailed. The debtors submitted a proposed form of sale order identifying Jansan as the successful bidder. The committee, still investigating the validity of the $7.5 million pre-petition transfers, objected, seeking a reservation regarding its challenge rights under the final DIP order. Ultimately, after negotiating with the debtors, the following language was inserted at paragraph 48 of the sale order:

Notwithstanding anything to the contrary contained in this order or in the final APA, entry of this order and approval and consummation of the transactions contemplated hereby shall not limit or otherwise affect the rights or remedies of the debtors' estates or the committee with respect to any "challenge" as defined in paragraph 26 of the final DIP order.

At the sale hearing, debtors' counsel highlighted this paragraph to the Bankruptcy Court stating:

And lastly, paragraph 48, this is the language with respect to the committee. It simply makes clear that the challenge rights of the committee baked into the final DIP order are in no way impacted by the relief requested or the order being entered today, and all of their rights and remedies are preserved.

With the inclusion of the reservation of rights language, the Bankruptcy Court entered the sale order, which approved the Jansan APA and authorized the immediate closing of the transaction. At closing, Jansan applied $36.7 million of the second-lien debt against the $63 million purchase price, as planned.

Four days after sale closing, the committee initiated an adversary proceeding regarding $7.5 million of pre-petition transfers to Victory Park. In relevant part, the complaint contained counts for: recharacterization or equitable subordination of Victory Park's claims on account of the $7.5 million; avoidance of the sale to the extent it was made in exchange for a credit bit of a recharacterized or subordinated claim; and recovery of funds from Jansan, as transferee of an avoided transfer. Victory Park and Jansan moved to dismiss the complaint, arguing that the approval and consummation of the sale had terminated the committee's rights and remedies regarding its "challenge" of Victory Park's second-lien debt that was part of the credit bid. The committee opposed the motion, arguing that the reservation of rights in paragraph 48 of the sale order expressly preserved its rights to make such a challenge. The committee argued that, although it did not seek to upend the entire sale, it did seek to "adjust the economics" of the sale in accordance with its challenge rights.

The Bankruptcy Court ultimately dismissed the committee's complaint with prejudice.  Regarding equitable subordination and recharacterization, the Bankruptcy Court found that "there is no practical, useful remedy that results in any recovery to the estate," as "neither recharacterizing nor subordinating the Advances would enhance any potential distribution to creditors." This was because Jansan's bid was the only qualified bid received—even if $7.5 million of Jansan's credit bid were disqualified, Jansan would have simply gone to market with a $29.2 million credit bid, as part of an overall $55.5 million purchase price. Given the lack of any other bidders, this would have been the successful bid. Therefore, "reshaping the economics of the deal to reflect a hypothetical reduction of $7.5 million in § 363(k) currency would have no tangible, ameliorative effect for the committee." Beyond that, the relief the committee sought would partially undermine the bidding procedures order and the sale order, which would "turn on its head the finality necessary for the legitimacy of the Section 363 sale process." Likewise, the Bankruptcy Court dismissed the complaint's avoidance action counts—dismissing the Section 544 count because the $7.5 million credit bid took place post-petition, while Section 544 governs pre-petition transfers, and dismissing the Section 549 count for unauthorized post-petition transfer because the sale order authorized the transaction at bar. The Bankruptcy Court concluded by stating that, absent upsetting the entirety of the transaction, the court could not fashion an appropriate remedy.

An appeal to the district court by the plan administrator (successor to the committee) followed. The district court overturned the Bankruptcy Court's order, finding its rulings inconsistent with the reservation of rights language contained in the sale order. Specifically, the district court found that the reservation of rights expressly preserved the committee's ability to assert the challenges embodied in the complaint, notwithstanding any effect that otherwise may have resulted from entry of the sale order or the closing of the sale itself. Validity of a credit bid under Section 363(k) is premised upon a lien securing an allowed claim. Since the committee's challenge rights included the ability to contest the allowance of Victory Park's claims, it also included the credit bid. The district court found that the reservation of rights unambiguously made clear that the ability to challenge survived both the entry of the sale order and closing of the transaction. The court also rejected the argument that the reservation was overly general or insufficiently explicit because the defined term "challenge" used in the sale order captured all of the causes of action in the complaint.

The district court also rejected the notion that Jansen's purchase price was conditioned upon allowance of Victory Park's claim and, thus, its ability to credit bid.  Jansan and Victory Park argued that because a credit bid under Section 363(b) requires an underlying allowed claim, the Bankruptcy Court must necessarily have concluded that the claim was allowed when it approved the sale. Effectively, through the sale order—which approved a purchase price that included the credit bid—the Bankruptcy Court found that the $7.5 million in challenged pre-petition transfers was an allowed claim. The district court rejected this argument after focusing on the specific terms of the APA. The purchase price was defined to include the sum of various components, including a credit bid of the total second-lien debt. The term "second-lien debt" was simply defined as the amount outstanding under the second-lien credit facility with Victory Park, without reference to whether those amounts were allowed claims or capable of being used in a credit bid. The definition of purchase price did not explicitly state the amounts of each of its various components, just that the total was $63 million; it did not specify that the credit bid component of the purchase price was $36.7 million. Thus, the sale order approving the APA did not constitute a finding that the $7.5 million in challenged transfers were allowed because they were included as part of the credit bid—the total credit bit amount could have been $29.2 million (i.e., the planned credit bid less $7.5 million), but the balance of the defined "purchase price" could have come from another source to reach the total of  $63 million.

The outcome of this ruling reflects two key lessons. First, reservation of rights language can effectively preserve a party's rights and remedies, even in the most unlikely of scenarios. Courts are not known for their willingness to upset an approved 363 sale—indeed, the finality of 363 sales is a key tenet of bankruptcy jurisprudence. Yet, the unambiguous and robust reservation of rights provision of the sale order in KII effectively preserved a post-closing challenge to a credit bid.

Secondly, precise drafting matters, especially in sale orders. Had the debtors or Jansan defined the term "challenge" more narrowly, it may not have encompassed all of the committee's causes of action, leading to dismissal. Similarly, a more narrow drafting of "purchase price" to include the specific amount of credit bid or perhaps more specifically defined "second lien debt" may have made it more difficult for the district court to upend the sale order.

It probably goes without saying, but every detail in a proposed order matters—here, it may have shaped the entire outcome of the case.

Francis J. Lawall, a partner in the Philadelphia office of Pepper Hamilton, concentrates his practice on national bankruptcy matters and workouts, including the representation of major energy and health care companies in bankruptcy proceedings and general litigation throughout the United States.

Kenneth A. Listwak is an associate in the corporate restructuring and bankruptcy practice group in the firm's Wilmington office.