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1 April 2014 In re Hawker Beechcraft, Inc.: Southern District of New York Holds that a Private Whistleblower May Assert Non-Dischargeable Claims under the False Claims Act at Any Time Contents Introduction On March 27, 2014, the United States District Court for the Southern District of New York (the District Court ) held in an interlocutory appeal arising from the Hawker Beechcraft chapter 11 case that a whistleblower in a qui tam action under the federal False Claims Act (the FCA ) 1 has standing to assert the nondischargeability of a $2.3 billion damages claim on behalf of the federal government under section 1141(d)(6)(A) of the U.S. Bankruptcy Code. In addition, the District Court held there is no deadline for seeking a determination of the non-dischargeability of such damages claims. As a result of the District Court s decision, Hawker Beechcraft Corporation ( HBC ) could face billions of dollars in damages and civil penalties that arose pre-bankruptcy that may not have been discharged by its confirmed chapter 11 plan, likely contrary to its and its stakeholders expectations when negotiating and agreeing to the terms of the chapter 11 plan. Although the District Court acknowledged that its decision would add uncertainty to restructuring efforts and punish innocent creditors for the bad acts of the corporation, it rejected such policy considerations in favor of a plain reading of the applicable statutory language. This decision will have a meaningful impact on the restructuring preparations of companies whose core business depends on being paid under contracts with the federal government, such as those in the defense (as is the case with HBC) or healthcare sectors. To the extent that such companies are faced with pending FCA claims, the company along with its stakeholders may decide to restructure out-of-court because a chapter 11 plan may not provide them with protection against the FCA claims or, if a chapter 11 is necessary, attempt to transfer its assets through a section 363 sale free and clear of the FCA claims and leave 1 The FCA permits whistleblowers to bring claims against companies that have submitted to the U.S. federal government false claims for payment or false records in connection therewith and share in any judgment or settlement proceeds obtained from the company. The federal government may, but is not required to, intervene in the action after it conducts an investigation of the allegation. The FCA provides for treble damages and civil penalties ranging from $5,500 to $11,000 per falsely submitted invoice. The FCA does not require actual fraud; knowledge of the falsity or reckless disregard may be sufficient for claims to be actionable under the FCA. Introduction... 1 Statutory Background of the Applicable Provisions in the Bankruptcy Code... 2 The Hawker Beechcraft Bankruptcy Case and Bankruptcy Court Decision The District Court s Decision. 3 Significance... 4 As a result of the District Court s decision, [HBC] could face billions of dollars in damages and civil penalties that arose prebankruptcy that may not have been discharged by its confirmed chapter 11 plan, likely contrary to its and its stakeholders expectations when negotiating and agreeing to the terms of the chapter 11 plan. 1

2 creditors and the FCA plaintiffs to battle over the sale proceeds. 2 Otherwise, absent a settlement with the FCA plaintiffs, the debtor should commence a dischargeability proceeding shortly after commencing its chapter 11 case in order to resolve this issue as quickly as possible. The next phase of the litigation in Hawker Beechcraft will focus on whether the allegedly false claims submitted by HBC fall within the scope of the nondischargeability provisions of the U.S. Bankruptcy Code and, if so, to what extent damages that exceed the government s actual pecuniary loss are dischargeable. Statutory Background of the Applicable Provisions in the Bankruptcy Code The District Court s decision relied on the interplay between sections 523 and 1141(d)(6)(A) of the Bankruptcy Code. Added as part of the 2005 amendments to the Bankruptcy Code, section 1141(d)(6)(A) excepts from the chapter 11 plan discharge for a debtor that is a corporation (i) fraud-related debt, including damages and penalties, of a type set forth in section 523(a)(2)(A) or (B) that is owed to a domestic governmental unit ( Clause 1 ) and (ii) debt owed to an individual bringing suit under the FCA or a similar state statute ( Clause 2 ). Although the District Court acknowledged that its decision would add uncertainty to restructuring efforts and punish innocent creditors for the bad acts of the corporation, it rejected such policy considerations in favor of a plain reading of the applicable statutory language. Section 523(a)(2)(A) provides that a debt is not dischargeable to the extent it is obtained by either false pretenses, a false representation or actual fraud. Section 523(a)(2)(B) provides that a debt is not dischargeable to the extent it is obtained by use of a written statement regarding a debtor s or an insider s financial condition that is materially false, which was made with an intent to deceive and on which the creditor reasonably relied. Section 523(c) requires that a notice and hearing be held to determine whether a debt under section 523(a)(2) is dischargeable. The associated Bankruptcy Rules require that a complaint to determine dischargeability under section 523(a)(2) be filed no later than 60 days after the first date set for a creditors meeting. As noted in the District Court s decision, the prefatory language to section 523(a) refers to an individual debtor. The Hawker Beechcraft Bankruptcy Case and Bankruptcy Court Decision On May 3, 2012, HBC and certain affiliates, all of which are involved in manufacturing aerospace components and U.S. military aircraft, commenced chapter 11 cases in the United States Bankruptcy Court for the Southern District of New York (the Bankruptcy Court ). HBC s and its affiliates joint chapter 11 plan of reorganization was confirmed by the Bankruptcy Court on February 1, 2013 and became effective on February 15, Even if a court permits a transfer of assets free and clear of the FCA claims, this approach may be a case of winning the battle but losing the war. To the extent that the business being transferred is still dependent on contracting with the federal government, the government has substantial commercial and legal leverage to insist on an outcome that protects its interests. 2

3 On September 27, 2012, two former employees of an HBC subsidiary (the Relators ) commenced an adversary proceeding seeking a non-dischargeability determination under each of the two clauses in section 1141(d)(6)(A) for FCA claims totaling more than $2.3 billion that they were prosecuting in a separate qui tam action filed in a Kansas federal court in The Relators alleged that certain HBC subsidiaries made misrepresentations in their certifications to the U.S. government regarding military aircraft components sold to the government. HBC moved to dismiss the adversary proceeding on the basis that the complaint was time-barred under the 60-day requirement in the Bankruptcy Rules, that the Relators lacked standing to assert the non-dischargeability of their qui tam claims on behalf of the government under Clause 1 and that the Relators had not asserted any claims constituting debts owed to a person under Clause 2. As a preliminary matter, the Bankruptcy Court held in a case of first impression that the two non-dischargeability clauses under section 1141(d)(6)(A) were separate and independent from each other. Accordingly, the procedural requirements contained in section 523(c) could not apply to Clause 2, as only Clause 1 references section 523. The next phase of the litigation in Hawker Beechcraft will focus on whether the allegedly false claims submitted by HBC fall within the scope of the nondischargeability provisions of the U.S. Bankruptcy Code and, if so, to what extent damages that exceed the government s actual pecuniary loss are dischargeable. The Bankruptcy Court held that the procedural requirements under section 523(c) applied to Clause 1 and, therefore, the Relators were time-barred from asserting non-dischargeability under Clause 1 because the 60-day period for asserting non-dischargeability had expired. Separately, while the Relators were not time-barred under Clause 2, the Bankruptcy Court held that the $2.3 billion in damages and penalties sought on behalf of the government in the qui tam action were not covered by Clause 2 because they could not be categorized as debts owed to a person. However, the Bankruptcy Court held that the Relators claims for attorneys fees and expenses in connection with prosecuting the qui tam action may not be dischargeable because they could be categorized as debts owed to a person within the scope of Clause 2. The District Court s Decision On appeal, the District Court reversed the Bankruptcy Court s decision. Although the District Court agreed with the Bankruptcy Court that Clause 1 and Clause 2 are separate and independent clauses, it determined that this interpretation is not dispositive of the question of whether the procedural and timing requirements in section 523(c) were incorporated into Clause 1. The District Court began its analysis of that question by noting that section 1141(d)(6)(A) is self-executing as it contains no procedural or timing requirements. Thus, in order for the District Court to adopt the Bankruptcy Court s analysis of the applicability of section 523(c) to Clause 1, there needed to be a statutory connection between Clause 1 and section 523(c). The District Court did not find one. Based on its analysis of the language in Clause 1, the District Court concluded that Congress incorporated by reference only the two definitional provisions from 3

4 section 523(a) and nothing more. Importantly, the District Court believed that section 523(c) must be construed in connection with the prefatory language in section 523(a), which limits the applicability of section 523 to individual debtors. The District Court noted that this language stands in contrast to section 1141(d)(6)(A), which applies to corporate debtors. Although the District Court acknowledged that its decision would add uncertainty to restructuring efforts and punish innocent creditors for the bad acts of the corporation, it rejected such policy considerations in favor of a plain reading of the applicable statutory language. Moreover, the District Court held that FCA damages and civil penalties asserted by a relator in a qui tam action are properly classified as debts owed to a domestic governmental unit under Clause 1, notwithstanding the fact that the claim is technically asserted by a non-governmental party. In so holding, the District Court relied upon the Supreme Court s decision in Vermont Agency of Natural Resources v. U.S. ex rel. Stevens, 529 U.S. 765 (2000), which established that qui tam relators have standing to prosecute FCA claims even though the injury complained of is an injury to the U.S. government. Because the District Court held that the Relator s claims for damages and penalties may be non-dischargeable under Clause 1, it concluded that it was unnecessary to address whether such claims could also be non-dischargeable under Clause 2 on the basis that they are debts owed to a person when brought by a relator. Any restructuring preparations [for companies whose core business is contracting with the federal government] will now have to take into account the risk that the plaintiffs prosecuting an FCA claim have significant substantive and procedural advantages that could add another layer of cost and complexity to restructurings. On remand, the Bankruptcy Court will determine whether the Relator s FCA claims for damages and penalties are non-dischargeable as a debt of a type set forth in section 523(a)(2)(A) or (B). Previous case law in the Chapter 7 context suggests that a higher level of misconduct is required to fall within the dischargeability exception under section 523(a)(2)(A) than is required to be liable under the FCA (which requires reckless disregard). It will also be noteworthy whether the Bankruptcy Court decides that amounts that exceed the government s actual pecuniary loss are dischargeable as has been held in previous cases. Significance The District Court s interpretation of section 1141(d)(6)(A) raises the possibility that (i) a private relator can assert damages and civil penalties under the FCA in connection with pre-petition conduct that would not be discharged by confirmation of a chapter 11 plan and (ii) such an assertion of non-dischargeability can be made at any time, including following confirmation of a chapter 11 plan. However, it should be noted that, for Clause 1 to apply, in addition to establishing a violation of the FCA, the government or a relator must separately establish that the debt is of a type enumerated in either section 523(a)(2)(A) or (B). 4

5 Contacts For further information please contact: The District Court s decision reminds debtors and creditors of the importance of engaging in a comprehensive review of the debtor s potential liability under the FCA in evaluating the feasibility and merits of a chapter 11 plan. This is particularly true for companies whose core business is contracting with the federal government, such as those in the defense or healthcare sectors. Any restructuring preparations will now have to take into account the risk that the plaintiffs prosecuting an FCA claim have significant substantive and procedural advantages that could add another layer of cost and complexity to restructurings. Paul Hessler Partner paul.hessler@linklaters.com Aaron Javian Partner aaron.javian@linklaters.com Martin Flics of Counsel martin.flics@linklaters.com Robert Trust Counsel robert.trust@linklaters.com Edward Rasp edward.rasp@linklaters.com Nancy Chu nancy.chu@linklaters.com Colin O Regan colin.oregan@linklaters.com Authors: Some of the individuals listed as Contacts. This publication is intended merely to highlight issues and not to be comprehensive, nor to provide legal advice. Should you have any questions on issues reported here or on other areas of law, please contact one of your regular contacts, or contact the editors. Linklaters LLP. All Rights reserved 2014 Linklaters in the U.S. provides leading global financial organizations and corporations with legal advice on a wide range of domestic and cross-border deals and cases. Our offices are located at 1345 Avenue of the Americas, New York, New York Linklaters LLP is a multinational limited liability partnership registered in England and Wales with registered number OC It is a law firm authorized and regulated by the Solicitors Regulation Authority. The term partner in relation to Linklaters LLP is used to refer to a member of Linklaters LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on Please refer to for important information on our regulatory position. We currently hold your contact details, which we use to send you newsletters such as this and for other marketing and business communications. We use your contact details for our own internal purposes only. This information is available to our offices worldwide and to those of our associated firms. If any of your details are incorrect or have recently changed, or if you no longer wish to receive this newsletter or other marketing communications, please let us know by ing us at marketing.database@linklaters.com. Scott Rolnik scott.rolnik@linklaters.com 1345 Avenue of the Americas New York, NY Telephone Facsimile Linklaters.com 5