Restructuring

Addressing latent claims in bankruptcy cases has always been a challenge, and debtors are often left with uncertainty as to whether such claims have been discharged.  Although the legal standard for what constitutes a “claim” under the Bankruptcy Code in the Third Circuit has evolved to give debtors and potential claimants more clarity with respect to the treatment of latent claims, the uncertainty remains for plans confirmed prior to 2011.  A recent decision from the District of New Jersey, In re Kara Homes, Inc., reminds us that the Third Circuit’s Frenville decision still has lingering effects nearly five years after it was soundly rejected. 
Background
In 2006, the debtor Horizons at Birch Hill, LLC, filed for bankruptcy protection, with its sole asset a 55 acre tract of land in New Jersey that was being developed into 228 planned condominiums.  At the time the debtor filed, fewer than half of the condominium units had been sold, the development had no completed amenities, and the common area clubhouse was only forty percent complete.
The homeowners’ association was one of the debtor’s largest unsecured creditors.  Prior to the petition date, the association’s three-person board consisted of one homeowner representative and two representatives of the debtor.  During the pendency of the debtor’s chapter 11 case, the debtor turned over control of the board to two additional homeowner representatives who occupied the developer spots on a temporary basis.
The debtor ultimately reached a global settlement with Amboy National Bank, the sole secured creditor in the case, and eventually sold the property to Amboy pursuant to a section 363 sale.   Upon confirmation of the debtor’s chapter 11 plan in 2009, the debtor transferred all its remaining property to Amboy’s designee, Madison.  Madison immediately replaced the two temporary owner representatives on the association’s board with its own representatives and continued the construction and development of the property.
By 2013, Madison had competed and sold seventy-five percent of the units and had transitioned control of the board to homeowner representatives.  Following the 2013 board transition, the homeowners’ association hired professionals to undertake an investigation of certain components of the common area buildings.  The association alleged that this investigation resulted in its awareness, for the first time, of various defects and deficiencies in the design and construction of the buildings on the property.
The association commenced a state court action against the original debtor developer (Birch Hill) and the successor developer (Madison) and also filed a motion in the bankruptcy court for a determination that its claims were not barred by the debtor’s chapter 11 discharge.
Accrual of Claims
As an initial matter, the bankruptcy court noted that the timing of the confirmation of the debtor’s plan – 2009 – dictated a close examination of the evolving legal standard as to the definition of a “claim.”  As we have discussed in this blog, the Third Circuit’s narrow and controversial interpretation of the definition of a claim in Frenville was overturned with its 2010 decision in Jeld-Wen, Inc. v. Van Brunt (In re Grossman’s Inc.).  In Grossman¸ the Third Circuit rejected the Frenville “accrual test,” which focused solely on the time when a right to payment arose under applicable non-bankruptcy law and expanded the definition of a claim by establishing a two-part test that focuses on (i) whether the claimant was exposed to the debtor’s product prepetition or the conduct giving rise to the claim occurred prepetition and (ii) if so, whether due process concerns nevertheless require that the claim not be discharged.
As our readers know, the story does not end there.  In 2011, the Third Circuit was forced to revisit the issue again in Wright v. Owens Corning when the plaintiffs in that case found themselves in the unique situation – stuck between Frenville and Grossman.  At the time the plaintiffs in Wright received notice of the bankruptcy case, Frenville was still the relevant law, and under Frenville, the plaintiffs did not hold claims.  However, under the new two-part Grossman test, the plaintiffs held unanticipated claims that could potentially have been discharged.
To resolve this dilemma, the Third Circuit stated that “due process affords a re-do in these special situations to be sure all claimants have equal rights.”  In doing so, the court created a carve-out to the two-part test established in Grossman for claimants who have claims based solely on the retroactive effect of the rule – such claims are not discharged when the notice given to those persons was provided with an understanding that they did not hold claims under the Frenville test.   In those cases – where the debtor’s plan was confirmed prior to the 2011 Wright decision – the Frenville “accrual” test still applies to the discharge of pre-confirmation claims.
Latent Construction Defects
Similar to the plaintiffs in Wright, the bankruptcy court quickly determined that the homeowners’ association clearly fell within the Grossman carve-out as the debtor’s chapter 11 plan was confirmed in 2009.  After determining that Frenville was the relevant test, the bankruptcy court shifted its analysis to state law because the accrual test requires a determination of when the claimant’s right to payment arose under applicable non-bankruptcy law.
In New Jersey, a cause of action accrues when the wrongful act or omission resulting in the injury for which the law provides a remedy occurs.  Even under Frenville, this would have rendered the homeowners’ association’s claims prepetition claims.  New Jersey, however, has adopted the common law doctrine known as the “discovery rule,” which provides that a cause of action’s accrual is tolled until the injured party discovers, learns, or reasonably should learn, the existence of facts that may equate in law with an actionable claim.
In applying the discovery rule, the court concluded that it had not been presented with any credible evidence as to the knowledge of the homeowners’ association’s board regarding the construction defects prior to the debtor’s confirmation hearing; however, the court ultimately required the parties to take additional discovery on the issue before it would make a final determination.
Conclusion 
As this case illustrates, although Frenville’s narrow interpretation of a claim has been rejected, its legacy continues to haunt debtors.
Kevin Bostel is an Associate at Weil Gotshal & Manges, LLP in New York.