1 FOR PUBLICATION 2 UNITED STATES BANKRUPTCY COURT

EASTERN DISTRICT OF CALIFORNIA

3 4 In re: ) ) 5 Matheson Flight Extenders, Inc., ) Case No. 22-21148-C-11 Matheson Postal Services, Inc., ) Case No. 22-21149-C-11 6 Matheson Trucking, Inc., ) Case No. 22-21758-C-11 ) 7 Substantively Consolidated ) DCN: NH-132 Debtors. ) 8 ___________________________________) 9 10 OPINION SUBORDINATING PUNITIVE DAMAGES 11 This Chapter 22 adventure includes a ride down the 12 bankruptcy liquidation waterfall. The issue is: can a prior 13 Chapter 11 plan cleanse debt of the taint of punitive damage 14 status in a later case for purposes of distributions pursuant to 15 Bankruptcy Code § 726(a)(4)? The answer is no. 16 The Plan Administrator under the liquidating Chapter 11 plan 17 for the consolidated cases of Matheson Flight Extenders, Inc. 18 (“MFE”), Matheson Postal Services, Inc. (“MPS”), and Matheson 19 Trucking, Inc. (“MTI”), seeks an order determining that seven 20 claims are mandatorily subordinated to other unsecured claims as 21 having originated in a punitive damages award. 22 The claimants contend that their treatment in a prior 23 chapter 11 case eliminated punitive damage status. 24 25 2015 Chapter 11 Case 26 Chapter 22 rears its head because MFE used a Chapter 11 case 27 in 2015 to settle a $14 million punitive damages award before 28 post-trial motions were decided. The award imperiled lifeblood 1 contracts with the U.S. Postal Service, threatening collapse of 2 the business. 3 The judgment was entered February 27, 2015, in U.S. District 4 Court, District of Colorado, in Camara, et al. v. Matheson Flight 5 Extenders, Inc. & Matheson Trucking, Inc., No. 12-CV-03040-CMA- 6 CBS, on a jury verdict for unlawful discrimination practices. 7 The $14,968,100 Final Judgment in favor of the seven 8 plaintiffs was for back pay and compensatory damages (total 9 $968,000) and punitive damages ($14,000,000). 10 MFE filed an immediate Chapter 11 case in the District of 11 Nevada to forestall post-trial motions and appeals in Colorado 12 while negotiating a settlement. In re Matheson Flight Extenders, 13 Inc., No. 15-50541-btb (Bankr. D. Nevada 2015) (“MFE Ch. 11”). 14 The ensuing $8,000,000 settlement was baked into a Chapter 15 11 plan in a deal providing for withdrawal of post-trial motions, 16 no appeal, and dismissal of the civil action with prejudice. 17 The dollar terms of the settlement were: (1) payment of 18 $328,571 to each of the seven plaintiffs (total $3,000,000) 19 before the effective date of plan; (2) payment by MFE of $714,286 20 to each plaintiff (total $5,000,000) in 32 equal quarterly 21 installments commencing April 1, 2016; and (3) stipulated 22 judgment against MTI for $2,700,000 for any payment default. The 23 choice of law in the settlement agreement and in Article 7.4 of 24 the Second Amended Plan is Nevada law. 25 The Second Amended Plan implementing the settlement was 26 confirmed December 28, 2015, and went effective January 19, 2016. 27 The $3,000,000 paid before the effective date exceeded the 28 cumulative $968,100 back pay and compensatory damage liabilities 1 (with all taxes paid on the back pay), leaving only punitive 2 damages to be paid in the 32 scheduled installments. 3 MFE timely made 25 of the 32 scheduled installments (78%), 4 amounting to $558,036 of the $714,286 due each plaintiff (total 5 $3,906,252). Each plaintiff was owed $156,250 as of the payment 6 suspension triggered by the new Chapter 11 filings. 7 8 2022 Chapter 11 Cases 9 MFE and MPS filed Chapter 11 cases May 5, 2022. MTI added 10 its case on July 14, 2022. The cases were administratively 11 consolidated and eventually substantively consolidated. 12 When filed, prospects for enterprise reorganization seemed 13 promising. But, the U.S. Postal Service’s recalcitrance and then 14 termination of the Matheson contracts in 2024 spelled doom. 15 The ensuing Debtors and Creditors’ Committee Joint Plan of 16 Liquidation confirmed with a Plan Administrator appointed to 17 liquidate and assemble whatever value can be salvaged from the 18 wreckage for distribution in accordance with the bankruptcy 19 waterfall specified by 11 U.S.C. § 726(a). 20 The Disclosure Statement in support of the Joint Plan 21 estimated that non-priority unsecured claim holders would receive 22 about 26 percent of the allowed claims under the Bankruptcy 23 Code’s distribution scheme. 24 The Joint Plan was confirmed with a finding under the “best 25 interest” test that each holder of an unsecured claim would 26 receive not less than the value, as of the plan effective date, 27 that such holder would receive if the debtor were liquidated 28 under chapter 7 on such date. 11 U.S.C. § 1129(a)(7)(A)(ii). 1 Chapter 22 2 Consecutive Chapter 11 cases for the same debtor invite 3 |} scrutiny for the bona fides of the second case. 4 While there is no per se prohibition of serial Chapter 11 5 || filings, there must be a good reason for another case. Elmwood 6 | Dev. Co. v. Gen’l Electr. Pension Trust (In re Elmwood Dev. Co.}, 71964 F.2d 508, 511-12 (5th Cir.1992); Fruehauf Corp. v. Jartran 8 (In re Jartran, Inc.), 886 F.2d 859, 867 (7th Cir. 1989). 9 Filings made to circumvent the binding effect of § 1141 10 |} in the prior case or to renege on earlier agreements are 11 vulnerable to dismissal, either for bad faith or as a collateral 12 |} attack on the first order of confirmation. The analysis of any 13 || given situation includes how the two cases are related in time 14 and substance. E.g., Lincoln Nat’l Life Ins. Co. v. Bouy, Hall & 15 | Howard & Assocs., 208 B.R. 737, 744 (Bankr. S.D. Ga. 1995). 16 The Ninth Circuit BAP applies a two-part inquiry to assess 17 | whether a chapter 22 case passes scrutiny: (1) the case must not 18 | have been filed in bad faith; and (2) there must be unforeseeable 19] and extraordinary changed circumstances that substantially impair 20 | performance under the confirmed plan. Caviata Attached Homes, LLC 21|v. U.S. Bank, N.A. (In re Caviata Attached Homes, LLC), 481 B.R. 22 || 34, 48-50 n.12 (9th Cir. BAP 2012). 23 Here, the two MFE cases are fundamentally different in 24} scale, purpose, and circumstance. The first MFE case in 2015 was for the limited purpose of resolving a single judgment against and MTI. The second MFE case in 2022 is part of an enterprise 27 | group reorganization effort dictated by changed economic and 28 || operating conditions that were not foreseeable in 2015.

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1 In the second case, the debtors did not question the 2 allowability of claims based on the settlement in the first case. 3 There was no intent to circumvent the effect of § 1141. Nor was 4 it foreseen that the new case would collapse into liquidation. 5 When the second MFE case imploded following the U.S. Postal 6 Service’s termination of Matheson contracts, the status of the 7 remaining 2015 debt for purposes of liquidation became relevant 8 for the first time. 9 The matrix for analysis is the ”bankruptcy waterfall” 10 necessitating making precise distinctions among various debts. 11 12 Bankruptcy Waterfall 13 Congress prescribed the “bankruptcy waterfall” (or “ladder”) 14 as the order of distribution in Bankruptcy Code § 726(a). 15 There are six tiers of distribution for property of the 16 estate: 17 (1) § 507 priority claims and expenses (with sub- tiers); 18 (2) timely filed allowed unsecured claims + tardily filed claims by creditors without notice or actual knowledge 19 of the case whose proofs of claim arrive in time to permit payment; 20 (3) allowed unsecured claims tardily filed; (4) allowed claims, whether secured or unsecured for 21 any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier 22 of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages 23 are not compensation for actual pecuniary loss suffered by the holder of such claim; 24 (5) payment of interest at the legal rate from the date of the filing of the petition on any claim paid under tiers 25 (1) through (4); and (6) to the debtor. 26 11 U.S.C. § 726(a). 27 Distribution must be made in the order Congress prescribed. 28 Payment is pro rata within each tier. 11 U.S.C. § 726(b). 1 If funds are not adequate to pay in full all claims within a 2 particular tier, then all claims in that tier are paid pro rata. 3 A corollary of the § 726(b) pro rata rule is that where the 4 pro rata share of a particular tier is less than 100%, then all 5 inferior tiers receive zero. 6 A so-called “surplus” case means that after full payment of 7 § 726(a) tiers (1) through (5), funds remain for a § 726(a)(6) 8 distribution to the debtor. 9 The waterfall is a mandatory subordination scheme fixing the 10 order of distributions. 11 In other words, in § 726(a)(4) Congress subordinated to 12 timely and tardily filed allowed unsecured claims under 13 §§ 726(a)(2) and (3) all allowed secured and unsecured punitive 14 damage claims that are not compensation for actual pecuniary loss 15 suffered by the holder. 16 The Congressional enactment materials for the 1978 17 Bankruptcy Code were explicit that both §§ 726(a)(3) and 18 726(a)(4) are “subordination provisions.” H.R. Rep. No. 595, 95th 19 Cong., 1st Sess. 412-413 (“subordination provisions”)(1977); 7 R. 20 Levin & H. Sommers, eds., COLLIER ON BANKRUPTCY ¶ 1129.02[7][c] (16th 21 ed. 2009) (“7 COLLIER”). 22 Three other forms of subordination are recognized at § 510 23 and are affixed to the § 726(a) distribution scheme by the 24 preambular language of § 726(a): “Except as provided in section 25 510 of this title...” 11 U.S.C. § 726(a). 26 Subordination under § 510 is on a claim-by-claim basis. It 27 may be contractual subordination. 11 U.S.C. § 510(a). It may be 28 mandatory subordination. 11 U.S.C. § 510(b). Or, it may be 1 equitable subordination. 11 U.S.C. § 510(c). 2 Subordination of a claim should be distinguished from 3 disallowance of a claim. Subordination entails adjusting an 4 allowed claim’s position in the waterfall queue. Disallowance 5 formally entails rejecting a claim on the merits, but 6 colloquially is sometimes used to include lack of funds to pay. 7 8 Bankruptcy Waterfall in Chapter 11 9 The bankruptcy waterfall pertains to chapter 11 cases 10 primarily by way of the “best interest” test for plan 11 confirmation. 12 A fundamental economic justification for reorganization in 13 chapter 11 is that a plan provides for greater return to 14 creditors than what would result from a chapter 7 liquidation. 15 The best interest test is an essential element for 16 confirmation of a chapter 11 plan with respect to holders of 17 impaired claims that have not accepted the plan. Such holders 18 must receive under the plan value at least, or greater than, what 19 they would receive in a hypothetical chapter 7 liquidation. 11 20 U.S.C. § 1129(a)(7)(A)(ii). 21 The hypothetical chapter 7 liquidation analysis for chapter 22 11 confirmation that is required when not all holders of impaired 23 claims have accepted the plan necessarily focuses on the 24 hierarchy of the bankruptcy waterfall. 25 The House Committee Report on the 1978 Bankruptcy Code 26 explained the § 1129(a)(7)(A)(ii) confirmation requirement 27 regarding the hypothetical chapter 7 liquidation: 28 In order to determine the hypothetical distribution in a liquidation, the court will have to consider the various 1 subordination provisions of proposed 11 U.S.C. 510, 726(a)(3), 726(a)(4), and the postponement provisions of 2 proposed 11 U.S.C. 724. 3 H.R. Rep. No. 595, at 412-413; 7 COLLIER ¶ 1129.02[7][c]. The 4 Senate ultimately acquiesced in the House version.1 5 The net effect of § 726(a)(4) is that punitive damages 6 claims that are not compensation for actual pecuniary loss are 7 mandatorily subordinated and cannot be paid as § 726(a)(2) 8 unsecured claims. 9 If a chapter 11 plan provides for liquidation, then the 10 subordinations inherent in the chapter 7 bankruptcy waterfall 11 become mandatory. 12 Although it is possible to sidestep § 726 when all holders 13 of impaired claims have accepted a chapter 11 plan, a plan of 14 liquidation ordinarily plunges everybody down the waterfall. 15 In short, there not having been universal acceptance by all 16 impaired claimants, honoring the § 726(a)(4) subordination of 17 punitive damages under the “best interest” test was an essential 18 element for this Court’s confirmation of the Joint Plan. 19 20 21 1The Senate Subcommittee Chair explained: 22 Section 1129(a)(7) adopts the position taken in the House Bill in order to insure that the dissenting members of an 23 accepting class will receive at least what they would otherwise receive under the best interest of creditors test; 24 it also requires that even the members of class that has rejected the plan be protected by the best interest of 25 creditors test for those rare cramdown cases where a class of creditors would receive more on liquidation than under 26 reorganization of the debtor. 27 Statement by Hon. Dennis DeConcini, Subcommittee Chairman Upon 28 Introduction of Senate Amendment to House Amendment to H.R. 8200. 124 Cong. Rec. S 17406 (Daily Ed. October 6, 1978). 1 Plan Administrator’s Arguments 2 The Plan Administrator objects that the bankruptcy waterfall 3 requires that the claims based on the 2015 judgment against MFE 4 and MTI, together with the $2,700,000 payment default provision, 5 be treated under § 726(a)(4) as being on account of punitive 6 damages that were not compensation for actual pecuniary loss by 7 the holders of the claims. 8 In addition, the objection questions allowability on the 9 merits of the $2,700,000 payment default provision as being an 10 unenforceable penalty under governing Nevada law. 11 12 Claimants’ Arguments 13 Claimants argue that the 2015 plan implementing the 14 settlement of the 2015 judgment transformed the debt from status 15 as punitive damages to status as garden-variety contract debt. 16 The theory is, first, that the settlement was a contract that 17 extinguished the judgment by way of dismissing the Complaint and, 18 second, that the $2,700,000 payment default provision was part of 19 the bargained-for consideration in 2015. 20 Claimants further urge that the order confirming the plan in 21 the 2015 Chapter 11 case is binding as to the status of the debt. 22 23 Analysis 24 Straightforward analysis leads to the conclusion that the 25 Plan Administrator’s objections prevail. 26 27 Punitive Damages Mandatorily Subordinated: § 726(a)(4) 28 It is beyond dispute that § 726(a)(4) requires mandatory 1 subordination wherever it applies. 2 The claimants’ argument that the confirmation of the 2015 3 plan transformed the punitive damages into a garden-variety 4 contract runs counter to Supreme Court precedent. 5 The Supreme Court decisions in Archer v. Warner, 538 U.S. 6 314, 318-22 (2003), and in Brown v. Felsen, 442 U.S. 127, 131-38 7 (1979), settle the proposition that neither a consent decree, nor 8 the settlement of a fraud debt by way of contract, prevents a 9 Bankruptcy Court from looking behind a decree or settlement 10 contract to ascertain proper treatment of a debt in bankruptcy. 11 Those precedents permit this Court to look behind the 2015 12 plan confirmation order and the attendant settlement agreement to 13 determine the position of the debt in the § 726(a) waterfall. 14 The origin of the debt thereby compromised was the 2015 15 judgment for punitive damages. 16 As the § 726(a)(4) exception to categorical subordination of 17 punitive damages is limited to the extent to which such “damages 18 are not compensation for actual pecuniary loss suffered by the 19 holder of such claim,” an allocation among § 726 tiers sometimes 20 is needed. 21 The exception being a creature of federal statute without 22 nonbankruptcy counterpart, the burden is on the claimant to 23 demonstrate the extent, if any, of compensation for actual 24 pecuniary loss that may be embedded in a punitive damages award. 25 Here, the claimants have proffered no evidence to suggest that an 26 allocation is needed in this case. 27 The awards of “back pay” and “other compensatory damages” 28 totaling $968,000 were extinguished by the payment of $3,000,000 1 before the effective date of the plan on January 19, 2016, 2 leaving only punitive damages to be paid by way of the remaining 3 32 plan payments. 4 From the payments of all awarded “back pay” (including taxes 5 thereon) and “other compensatory damages” before the January 19, 6 2016, plan effective date, it follows that no “compensation for 7 actual pecuniary loss suffered by the holder of such claim” is 8 allocable to the punitive damages remaining for each of the seven 9 claimants for purposes of § 726(a)(4). 10 To the extent nonbankruptcy law may affect an allocation of 11 the original judgment debt, the conclusion that the remaining 12 debt solely consists of punitive damages is consistent with 13 Nevada law, which provides that when there is partial payment on 14 a judgment as to which neither the judgment creditor nor judgment 15 debtor designates allocations, the court determines the 16 allocation guided by basic principles of “justice and equity” so 17 a fair result can be achieved. 9352 Cranesbill Trust v. Wells 18 Fargo Bank, N.A., 136 Nev. 76, 80-81 (2020); Able Elec., Inc. v. 19 Kaufman, 104 Nev. 29, 32 (1988). 20 Justice and equity favor allocation of punitive damages to 21 the inferior position. 22 The procedural facts underlying the confirmation of the 2015 23 plan do not suggest a contrary conclusion. The 2015 chapter 11 24 plan could not have been confirmed without a “best interest” 25 finding under § 1129(a)(7)(A)(ii) applying the bankruptcy 26 waterfall. The evidence probative of the “best interest” facet of 27 plan confirmation included the unchallenged opinion of a 28 valuation expert that in a hypothetical chapter 7 liquidation, 1 “there would be no cash available to the unsecured creditors.” 2 Expert Opinion, MFE Ch. 11, Dkt. #341 p.5 & Dkt. #482 p.127. 3 In other words, the 2015 bankruptcy court ruled there would 4 be no distribution to general unsecured creditors under 5 § 726(a)(2) or to any creditor downstream from that tier. 6 It follows that the “best interest” test for the 2015 plan 7 confirmation required mandatory subordination of the punitive 8 damages claims pursuant to § 726(a)(4). The status of the debt as 9 punitive damages was not relevant to any question being decided 10 in the course of confirming the 2015 chapter 11 plan. 11 It warrants repetition that mandatory subordination does not 12 necessarily lead to disallowance. An allowed punitive damages 13 claim retains its status as an “allowed” claim and will be paid 14 to the extent funds remain available at the § 726(a)(4) tier. 15 Accordingly, the 2015 plan provided for paying the remaining 16 allowed punitive damage claims still remaining after the 17 effective date of the plan. 18 The claimants’ issue preclusion argument that plan 19 confirmation in the prior chapter 11 case established a new 20 status under the bankruptcy waterfall in the later chapter 11 21 case fails because the claim status of punitive damages in the 22 bankruptcy waterfall was not actually and necessarily litigated. 23 The conclusion that mandatory subordination under 24 § 726(a)(4), which is a form of categorical subordination, 25 applies to the challenged punitive damage claims makes it 26 unnecessary to rule on the Plan Administrator’s argument that 27 § 510(c) equitable subordination is also applicable here. 28 The Supreme Court has disapproved categorical § 510(c) 1 equitable subordination, approved fact-based equitable 2 subordination, and left open the question whether creditor 3 misbehavior is essential to equitable subordination. United 4 States v. Noland, 517 U.S. 535, 542-43 (1996). The question 5 remains for another day. 6 7 Stipulated Judgment for Payment Default 8 The objection to the claim for $3,793,751 subdivides into 9 two components. First, there is no objection to the $1,093,750 10 remaining unpaid under the settlement agreement. Second, there is 11 the claim for $2,700,000 based on the stipulated judgment for 12 payment default. It is objected that this sum is an unenforceable 13 penalty under governing Nevada law. This is a merits-based 14 disallowance issue, rather than a subordination issue. 15 Nevada law refuses to enforce contractual damage clauses as 16 contrary to state public policy where the clause is not designed 17 to compensate the injured party for breach, but instead requires 18 payment of a sum grossly disproportionate to actual damages. 19 E.g., Mason v. Fakhimi, 109 Nev. 1153, 1157 (1993). 20 Under the terms of the settlement contract, the $2,700,000 21 would be payable even if the only payment default was not making 22 the 32nd of the 32 required payments. In other words, it is a 23 fixed charge of $2,700,000 regardless of the actual amount of the 24 payment default. That is “grossly disproportionate” to actual 25 damages and hence, a “penalty” under Nevada law. 26 The fact that a penalty unenforceable under the chosen state 27 law was embodied in the 2015 confirmed chapter 11 plan and 28 settlement agreement does not now insulate it from attack. This Court has the power to determine in a claim objection the enforceability of the penalty under applicable nonbankruptcy law. 3 To be sure, it may seem odd that the parties agreed to an unenforceable penalty in the 2015 settlement agreement and 5] chapter 11 plan, but the choice of law provisions in the 61 settlement and plan to apply Nevada law are not ambiguous. 7 Accordingly, the objection to $2,700,000 of the $3,793,751 8 || claim will be sustained and that portion of the claim disallowed unenforceable under governing state law. 10 An appropriate separate order will issue. 11 12 Dated: July 28, 2025 □□ te 15 United States Bankruptcy Judge 16 17 18 19 20 21 22 23 24 25 26 27 28

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