First Circuit Clarifies That When Determining The Value of Legal Claims as Collateral, a “Gallimaufry” of Factors Must Be Addressed to Meet Burden of Proof

The Bottom Line

In Wheeling & Lake Erie Ry. Co. v. Keach (In re Montreal, Me. & Atl. Ry.), No. 19-1894 (1st Cir. Apr. 9, 2020), the First Circuit held that when determining the value of legal claims as collateral, the party with the burden of proof must establish the likely validity of the claim and the likelihood of recovery — demonstrating possible damages alone does not suffice.

What Happened?

Background

The First Circuit’s ruling in Wheeling & Lake Erie Ry. Co. v. Keach is the result of seven years of protracted litigation following the catastrophic derailment of a freight train carrying crude oil in Quebec in 2013, which killed nearly 50 people and partially destroyed a town. One month after the derailment, the carrier — the Montreal, Maine & Atlantic Railway (MMA) — filed bankruptcy in both Canada and the United States.

In 2009, Wheeling & Lake Erie Railway Company (Wheeling) extended a $6 million line of credit to MMA, secured by an interest in MMA’s “[a]ccounts and other rights to payment (including Payment Intangibles),” which included non-tort claims. Soon after MMA filed bankruptcy, Wheeling initiated an adversary proceeding against MMA and its estate representative, Robert Keach, seeking to protect its security rights.

Around the same time, Keach initiated a suit against Western Petroleum Company (the Shipper), the party that arranged for MMA to transport the crude oil. Keach alleged that the Shipper labeled the crude oil as less volatile than it was, causing MMA not to take as many precautions as it would have otherwise. The Shipper and Keach negotiated a settlement whereby the Shipper agreed to pay $110 million for the benefit of the derailment victims in exchange for the release of all claims and counterclaims between the Shipper and the estate arising out of the derailment. The Shipper also agreed to assign the estate certain claims against non-MMA carriers involved in the derailment. The settlement became effective only after confirmation of the proposed plans in the U.S. and Canada bankruptcy proceedings, which incorporated a third-party release that provided that all persons and entities were barred from pursuing derailment-related claims against the Shipper.

Before MMA’s liquidation plan was confirmed in the U.S., Wheeling objected to the settlement, complaining that Keach had agreed to release non-tort claims against the Shipper, which Wheeling claimed constituted a portion of its collateral. The United States Bankruptcy Court for the District of Maine (the Bankruptcy Court) approved the plan of liquidation but added a clause in the confirmation order stating that neither the order nor the settlement agreement “limit[ed] or affect[ed] Wheeling’s ability to contend, and [Keach’s] ability to contest, that Wheeling’s security interest, if any, attache[d] to the Settlement Payments (whether as original collateral, proceeds, products or otherwise).” 

Lower Court Decisions

Litigation between Keach and Wheeling continued. Wheeling and Keach stipulated that the derailment caused MMA to suffer net economic damages of no less than $10 million (the Stipulation). In 2018, the Bankruptcy Court found that Wheeling’s collateral was not “used” by MMA to leverage a settlement because the estate did not have any cognizable non-tort claims against the Shipper, and that even if such claims existed, Wheeling had not carried its burden of proving the value of its collateral (the non-tort claims). Wheeling appealed, and in 2019, the United States District Court for the District of Maine found that non-tort claims existed, but because Wheeling had not proven their value, it was not entitled to compensation. Wheeling appealed to the First Circuit.

First Circuit Opinion

The First Circuit assumed, without deciding, that the estate possessed and released cognizable non-tort claims against the Shipper, which constituted part of Wheeling’s collateral. The First Circuit agreed that Wheeling bore the burden of proof to demonstrate the value of the released non-tort claims and noted that Section 506(a)(1) of the Bankruptcy Code supplies the applicable standard for valuation. For background, Section 506(a)(1) of the Bankruptcy Code directs a court to determine the value of property in which a creditor has a secured interest in light of the disposition or use of such property. Thus, Wheeling bore the burden of showing the settlement value of the non-tort claims (i.e., their value as a bargaining chip for the settlement with the Shipper).

Wheeling argued that the Stipulation that the derailment caused MMA to suffer at least $10 million of net economic damages should prove that the value of the non-tort claims was not less than $10 million, which was higher than the amount of Wheeling’s secured claim. However, the First Circuit held, “At its most elementary, the settlement value of a claim is the amount that the claimant would recover if he prevailed in litigating the claim multiplied by the probability of recovery.” The First Circuit explained that “the probability of recovery depends on a gallimaufry of factors, such as the strength of the claimant’s evidence, the viability of any defenses, and the ability of the defendant to satisfy a judgment.” Accordingly, “[E]ven a claim alleging a substantial figure for damages may have no settlement value at all if the cost, difficulty, or uncertainty of litigation makes it not worthwhile to pursue.”

The First Circuit held that the Stipulation did not take into account the likelihood of a successful litigation against the Shipper (or the ability to actually recover from the Shipper), so the Stipulation alone failed to show the value of the non-tort claims. Alternatively, Wheeling argued that because the Shipper paid $110 million, released claims against MMA and assigned certain claims against other carriers to the estate, the non-tort claims must have had significant value. The First Circuit responded that “Wheeling’s argument vastly oversimplifies the exchange and completely ignores the other items of value that the Shipper received as part of the settlement,” including Keach’s release of a negligence claim (not part of Wheeling’s collateral) against the Shipper. Additionally, the First Circuit emphasized that the settlement became effective only upon entry of orders barring all derailment-related claims against the Shipper — meaning that as a result of the settlement, the Shipper faced no further liability arising out of the derailment. Because Wheeling did not carry its burden of proving the value of its collateral, the First Circuit held that Wheeling was not entitled to compensation.

Why This Case Is Interesting

Section 506 of the Bankruptcy Code provides that the allowed amount of a secured claim is equal to the value of collateral securing the claim, which “shall be determined in light of the purpose of the valuation and of the proposed disposition or use of such property.” However, the Bankruptcy Code does not provide further instruction on how to value nontangible collateral like legal claims. The First Circuit clarified that when determining the value of legal claims as collateral, the party with the burden of proof must establish the likely validity of the claim and the likelihood of recovery. The First Circuit observed that though a cause of action may be a difficult asset to value, one potential way to demonstrate value would be to have an expert witness analyze the range of factors that may affect the value and give expert opinion testimony before a bankruptcy court. Finally, the First Circuit rejected Wheeling’s contention that its holding would “encourage [debtors] to use the difficult-to-value collateral of secured creditors for the benefit of unsecured creditors without paying any compensation for such use.” While, in the circumstances of the case, no value was assigned to the claims on which the secured creditor had a lien, that was based not on the debtor’s decision not to allocate but rather on the secured creditor’s failure of proof.