The advent of the information age has given rise to economies built not on steel, but on ideas.  It is therefore no surprise that intellectual property assets have assumed an increasingly important component of firm balance sheets – and firm value – throughout advanced economies worldwide.

And yet, though the value of intellectual property is universally recognized and the rights attaching to it increasingly protected, “knowledge assets” are not always treated in the same manner whenever – and wherever – the firm enters restructuring or liquidation.  The story of Qimonda AG is the story of what happens when one country’s rules governing the treatment of an insolvent firm’s intellectual property collide with those of another.

 As the following post suggests, that story is far from over.

Quimonda AG’s Insolvency.

Qimonda AG (Qimonda), a producer of Dynamic Random Access Memory (DRAM) chips, also holds a portfolio of approximately 12,000 patents.  A little more than one-third of this intellectual property originated in the US (i.e., it consists of US patents or pending applications); the balance is of German or other international origin.

Over a 13-year period, Qimonda entered into a series of joint venture and cross-licensing agreements with a number of semiconductor manufacturers.  Under those agreements, Qimonda and these manufacturers cross-licensed tens of thousands of patents.

During 2007 and 2008, prices for PC-based DRAM technology collapsed.  Despite efforts to restructure, Qimonda entered German insolvency proceedings in January 2009.  The Munich court overseeing the proceeding appointed Dr. Michael Jaffé as Qimonda’s insolvency administrator.

Subsequently, Dr. Jaffé sought and obtained recognition in the US for Qimonda’s German insolvency proceeding.  Dr. Jaffé also obtained concurrent, discretionary relief making certain sections of the US Bankruptcy Code applicable to Qimonda’s Chapter 15 proceeding.  These sections included Section 365, which governs executory contracts – including licensing agreements.

Both the German Insolvency Code and the US Bankruptcy Code address the administration of executory contracts.  However, US insolvency practitioners will be aware the US Bankruptcy Code – specifically, section 365(n) – protects the intellectual property licensees of a bankrupt licensor.  Under this subsection, the licensee – at its own option – may preserve its rights under an intellectual property license, despite the bankruptcy trustee’s efforts to reject the license.

The German Insolvency Code provides no such protection.  Instead, Section 103 of that statute simply provides that the court-appointed insolvency administrator may elect performance of contractual obligations or affirm that they remain unenforceable against the estate by electing non-performance.

Dr. Jaffé’s Proposed Treatment of Qimonda’s Cross-Licensing Agreements.

Sometime after obtaining recognition and discretionary relief in Virginia, Dr. Jaffé, acting pursuant to German law, provided notification to certain of Qimonda’s cross-licensing partners of his elected non-performance of Qimonda’s patent cross-licensing agreements.

Those partners, understandably, protested – and argued further that Section 365(n) (made applicable to Qimonda’s Chapter 15 proceeding at Dr. Jaffé’s own request) now prohibited Dr. Jaffé from electing non-performance.  In response, Dr. Jaffe sought the US Bankruptcy Court’s amendment of his previously-granted relief in order to clarify the basis for his non-performance of the cross-licensing agreements.  Specifically, Dr. Jaffé sought a modification of the prior order to provide that Section 365 (and, therefore, Section 365(n)) would be applicable only in such instances where he sought rejection of agreements pursuant to the US statute.

The Cross-Licensing Partners’ Appeal.

Following a hearing held 28 October 2009, US Bankruptcy Court Judge Robert Mayer issued a decision granting Dr. Jaffé’s further request, thereby clearing the way for him to elect non-performance of the cross-licensing agreements under German insolvency law.  Qimonda’s partners promptly appealed to the US District Court for Virginia’s Eastern District, arguing (i) that Section 365 – including Section 365(n) – applies automatically to foreign proceedings recognized under Chapter 15 (and, presumably, may therefore not be “modified” or otherwise trifled with by the Bankruptcy Court in the manner proposed by Dr. Jaffé); and, further (ii) that principles of comity applicable under US case law (and the provisions of Chapter 15) did not require the requested modification of the Bankruptcy Court’s prior order.

In an appellate decision issued 2 July 2010, US District Judge Thomas Selby (Tim) Ellis III remanded the matter back to Judge Mayer for further clarification of two issues – one factual, one legal.  Along the way, however, Judge Ellis offered several important observations regarding the construction of Sections 1521(a) (governing the provision of “any appropriate relief” to the representative of a recognized foreign proceeding) and 1509(c) (governing a recognized administrator’s requests for comity).

Section 1521(a).

A significant portion of Judge Ellis’ 36-page decision is devoted to the conclusion that Section 365 of the US Bankruptcy Code does not apply automatically upon recognition of a foreign “main proceeding.”  This seems unremarkable, given that a simple reading of Section 1520(a) makes only select provisions of the Bankruptcy Code applicable automatically in Chapter 15, and that Section 365 is not among them.  As a result, Section 365 – available to a foreign representative only through specific request pursuant to Section 1521(a) – is susceptible to selective or otherwise limited application by the US Bankruptcy Court.  Indeed, the Bankruptcy Court may determine it does not apply at all.

Far more interesting is Judge Ellis’ conclusion that Dr. Jaffe’s request had been granted without the requisite balancing test set forth in Section 1522.  That section requires that, upon a request for modification of relief previously granted through Section 1519 or 1521, the Court may so modify only after ensuring that “the interests of the creditors and other interested entities, including the debtor, are sufficiently protected.”  11 U.S.C. §1522(a).  Because the evidence relied upon by the Bankruptcy Court to balance creditors’ interests was “anemic,” Judge Ellis remanded the matter for a more full-bodied factual inquiry.

Specifically, Judge Ellis directed focus on two primary issues:

How the application of § 365(n) would unavoidably “splinter” or “shatter” the Qimonda patent portfolio “into many pieces that can never be reconstructed,” thereby diminishing its value and rendering the Qimonda patent portfolio essentially unsalable  (“Left unexplained, in particular, is why this is so, given that the continuation of appellants’ non-exclusive licenses for an unspecified percentage of the Qimonda patent portfolio would preclude neither the sale of the patents themselves nor the grant of additional, non-exclusive licenses.”).

The nature of the U.S. patents licensed to appellants, and whether cancellation of licenses for those patents would put at risk appellants’ investments in manufacturing or sales facilities in this country for products covered by the U.S. patents (“At best, the Bankruptcy Court stated (i) that the application of dissimilar bankruptcy laws to different portions of Qimonda’s patent portfolio ‘may well be detrimental to parties who are or wish to license patents,’ and (ii) that appellees’ demanding that appellants pay new licensing or royalty fees was an ‘unfortunate but an inevitable result’ of Qimonda’s insolvency . . . . It is not readily apparent why this is so.”).

Though leaving little doubt that Section 365’s applicability to a Chapter 15 proceeding was entirely within the Bankruptcy Court’s sound discretion, Judge Ellis nevertheless observed that “the Bankruptcy Code nonetheless ‘limits the opportunity for a completely unencumbered new beginning to the honest but unfortunate debtor,’ as ‘statutory provisions governing nondischargeability reflect a congressional decision to exclude from the general policy of discharge certain categories of debts.’”

Under Judge Ellis’s reading of Sections 1521 (and 1522), a Bankruptcy Court enjoys broad discretion – not only to provide “any appropriate relief” to a foreign representative, but to further amend, modify, or terminate the same relief – provided that the Court engage in the affirmative exercise of articulating why the interests of the debtors and the creditor are protected.

Section 1509(c).

Judge Ellis’ treatment of judicial discretion did not end with Section 1521.  On appeal, Qimonda’s cross-licensing partners also called into question the Bankruptcy Court’s decision to grant comity to Dr. Jaffé’s application of German insolvency law to the cross-licensing agreements.

By contrast to the broad discretionary application of “appropriate relief” under Section 1521, Judge Ellis found that a US Bankruptcy Court’s discretion regarding the comity to be afforded determinations rendered under foreign law and pursuant to Section 1509 is far more limited:

Section 1509 states, in mandatory terms, that “a court in the United States shall grant comity or cooperation to the foreign representative.” 11 U.S.C. § 1509(b)(3) (emphasis added).  . . .  [U]nder the plain terms of § 1509(b)(3), the Bankruptcy Court lacked general discretion to deny the Foreign Administrator’s request for comity; rather, the Bankruptcy Court could only have refused to defer to German Insolvency Code § 103 on the ground that applying German law, instead of § 365(n), would be “manifestly contrary to the public policy of the United States” under § 1506.  Put another way, §§ 1509(b)(3) and 1506, read in pari materia, provide that comity shall be granted following the U.S. recognition of a foreign proceeding under Chapter 15, subject to the caveat that comity shall not be granted when doing so would contravene fundamental U.S. public policy.

What sort of foreign relief would “contravene fundamental US public policy?”

Judge Ellis’ review of decisions addressing the “public policy” exception to Chapter 15’s comity mandate indicated that the focus of this exception is on (i) procedural inequity (e.g., a lack of “due process” as that term is commonly understood by US courts); and (ii) frustration of a US court’s ability to administer the Chapter 15 proceeding and/or severe impingement of a U.S. constitutional or statutory right, particularly if a party continues to enjoy the benefits of the Chapter 15 proceeding (e.g., frustration of the “automatic stay” made applicable upon recognition of Chapter 15).

However, Judge Ellis further found that – as with the “balancing test” required by Section 1522 – the Bankruptcy Court had not gone far enough in its analysis.

Congress enacted Section 365(n) in direct response to contrary case law and in order to protect the US-based licensees of intellectual property.  Yet the entire section is subject to modification or amendment in Chapter 15 upon the Bankruptcy Court’s discretion – or not applicable at all.

In light of these mixed judicial signals, is the protection of Section 365(n) therefore “fundamental?”  Or not?  In granting Dr. Jaffé’s request, the Bankruptcy Court had not explicitly decided this question, so Judge Ellis direct that it do so upon remand.

What Does It Mean?

Judge Ellis’ Qimonda decision is significant for its analysis of Sections 1509 and 1522 – it appears to endorse, at least in general terms, the flexibility required of an internationally-oriented recognition statute and the latitude potentially available to recognized foreign representatives.

However, Judge Ellis’ Qimonda analysis is perhaps most significant for what it doesn’t say.  It leaves unanswered what general factors courts might apply to the “balancing test” of creditors’ and debtors’ interests mandated by Sections 1521 and 1522.  And though it describes the outer bounds of “fundamental US public policy” such that otherwise-mandatory comity ought not to apply to the determinations of non-US tribunals, it does little to address the import (if any) to be derived from Congressional amendments specifically intended to protect the rights (or the interests) of general or special US economic interests.

Continued global economic uncertainty and an impending 3d quarter slow-down in the US have translated into active global restructuring in recent months. Some of the 2d and 3d quarter’s more newsworthy cross-border filings include:

Compania Mexicana de Aviacion – Compania Mexicana de Aviacion, generally known as Mexicana, filed for insolvency in Mexico City and Chapter 15 bankruptcy protection in New York on August 2.

The airline reportedly made its move after failing to reach a new cost-cutting deal with its unions – it claims Mexicana’s labor costs “are well above the average for the industry at the global level, so a leveling is essential for achieving a restructuring with creditors and the company’s viability.” Mexicana claims it will have to slash 40 percent of pilot and flight attendant jobs, with those remaining with the carrier being asked to take 40 percent pay cuts.

At the time of filing, the company also reported three of Mexicana’s 64 aircraft already had been seized by the leasing companies that own them.

Fairfield Sentry Ltd., Fairfield Sigma Ltd. and Fairfield Lambda Ltd. – Three financial services companies, established in 1990 as “feeder funds” for the purpose of investing in Bernard L. Madoff Investment Securities LLC, received joint recognition in Manhattan on July 22 in connection with their respective British Virgin Islands insolvency proceedings.

As reported by the Daily Deal on July 27, all three entities sold shares to individuals who were neither residents nor citizens of the United States. Such investors also included pension and profit-sharing trusts, charities and other tax-exempt entities. Fairfield Sentry, the largest of the feeder funds, offered its shares in U.S. dollars, while Fairfield Sigma offered shares in Euros and Fairfield Lambda provided them in Swiss francs.

Fairfield Lambda was placed into liquidation by the Eastern Caribbean Supreme Court in the High Court of Justice in British Virgin Islands in April 2009 upon application by Commerzbank AG, then known as Dresdner Bank AG. Fairfield Sentry’s and Fairfield Sigma’s liquidations were approved by the same court in July following similar creditor requests.

Cozumel Caribe SA de CV – The Mexico City-based operator of the 348-room Hotel Park Royal Cozumel resort sought recognition for a previously-commenced concurso mercantil proceeding (filed in the Third District Court of the Mexican State of Quintana Roo) on July 20 in Manhattan.

Cozumel Caribe blamed its financial woes on declines in Mexican tourism, which has been beleaguered of late by a weak Mexican peso, the outbreak of H1N1 flu virus, and State Department advisories regarding increased crime in Mexico. Cozumel Caribe’s own cash woes were allegedly further compounded by lender CT Investment Management Co.’s alleged failure to withhold tax receipts and funds to cover daily operations.

Minster Insurance Co. Ltd. – The London insurer and its affiliate, Malvern Insurance Co. Ltd., sought recognition on July 19 in furtherance of its previously-approved solvent scheme of arrangement, made pursuant to Part 26 of the U.K. Companies Act 2006. A hearing to consider the recognition is scheduled for Aug. 27.

Controladora Comercial Mexicana SAB de CV – The operator of Costco Wholesale Corp. outlets in Mexico, and the country’s third-largest retailer, sought recognition in New York on July 16 in furtherance of its prenegotiated concurso mercantil proceeding in Mexico City.

As reported by the Daily Deal, CCM will restructure a total of $3.3 billion through its prenegotiated bankruptcy filing, including approximately $2.2 billion worth of derivative obligations owed to J.P. Morgan Chase NA, Barclays Bank plc, Goldman Sachs Group Inc., Bank of America Merrill Lynch, Banco Santander (Mexico) SA, Banco Nacional de Mexico SA and Citibank NA, and $99.4 million in unsecured debt owed to seven unspecified Mexican commercial banks. The restructuring is purportedly supported by 85% of its debt holders.

CCM’s prenegotiated plan follows an earlier, failed 2008 concurso bid, which subsequently drove the parties to the bargaining table.

ABC Learning Centres Ltd. – The Australian childcare center operator sought recognition of its voluntary winding up proceeding over the objection of RCS Capital Development LLC.  ABC and RCS are involved in litigation over the development of child care centers in Arizona and Nevada.  In addition to opposing recognition, RCS sought relief from the automatic stay to enter judgment upon a jury verdict rendered in its favor in Arizona, and to assert that judgment as an offset against claims made by ABC in Nevada.

At a hearing held August 9, Delaware Bankruptcy Judge Kevin Gross took both matters under advisement. As of the date of this writing, no decision has been rendered.

From the 9th Circuit last week, a decision providing creditors and their representatives with a potentially new source of preferential recoveries: pre-petition criminal restitution payments.

Jeffrey and Faye Silverman – electrical contractors – were indicted in 2005 for fraud and underpayment of workers’ compensation insurance premiums.  In March of that year, they paid the California State Compensation Insurance Fund $101,531 in restitution as part of a plea agreement and their court-ordered sentence.  Less than 60 days later, they sought relief under Chapter 7.

Their trustee sought recovery of the restitution payment from the State Fund under the theory that the payment was a preferential transfer under Section 547(b) of the Bankruptcy Code.

Both sides moved for summary judgment.  For its part, the State Fund argued that Section 547(b) doesn’t apply to criminal restitution payments, citing Kelly v. Robinson, 479 U.S. 36 (1986) and Becker v. County of Santa Clara (In re Nelson), 91 B.R. 904 (N.D. Cal. 1988).  Kelly held that criminal restitution payments are non-dischargeable under Section 523(a)(7).  Nelson extended Kelly to hold that payments on such non-dischargeable obligations are not recoverable as preferences.

The Bankruptcy Court for the Central District of California was not persuaded – nor was the District Court, which heard the matter on appeal following entry of summary judgment in the trustee’s favor.

The Ninth Circuit agreed.  Finding that criminal restitution payments are, in fact, subject to the preference statute, the Ninth Circuit held that State Fund enjoyed no “judicial exception” to Section 547(b)’s reach.  In the 3-judge panel’s view, an obligation’s non-dischargeability is separate and distinct from recovery of its pre-petition payment as a preference.  Further, the restitution payments to State Fund were “to or for the benefit of” State Fund within the contemplation of Section 547(b)(1) - State Fund’s arguments to the contrary notwithstanding.

The decision is an important one for creditors’ representatives and committees seeking possible additional sources of recovery where the debtor has been attempting to resolve criminal problems pre-petition.

As the economy lurches forward into an uncertain back half of 2010, the DIP lending market remains in flux.  In a short piece appearing in the Journal of Corporate Renewal last Wednesday, Imran Choudhury and Frank Merola – both of Jeffries & Co., Inc. - offer a concise overview of the factors affecting credit availability and expense over the last two years.

After a sharp contraction in 2008, Choudry and Merola show how DIP funding has increased – both in terms of deal size and in terms of new money . . .

and likewise, how spreads have eased during the same period . . . .

Their walk-away, in light of this data:

“The overall state of the DIP financing market has changed over the last couple of years as the broader credit markets have changed. Lower yields due to improvements in the overall credit markets have resulted in lower rates in the DIP loan market as well.

While it is difficult to say precisely what DIP yields will be over the next year or so, it seems very likely that the worst part of the credit cycle is over and DIP yields are not going to reach the same levels as they did in late 2008 and early 2009. Even though yields on DIP loans are not at their peak levels, the loans will still likely be used for . . . strategic reasons—protecting existing debt positions or controlling restructuring processes or acquiring assets through credit bids.”

In a globalized business environment, it should be no surprise that some of the more interesting – and better – economic reporting on the US economy now comes from offshore.

Last month, China’s Xinhua news agency reported that California leads the nation in small-business bankruptcies.  The report – based on data reported by Equifax – covers small business filings under all applicable chapters of the Bankruptcy Code (i.e., Chapters 7, 11, and 13).  The Xinhua report (it broke the story a day before the Orange County Register) is here.

Equifax’s reporting shows that California remains the most impacted state, with the Los Angeles and Riverside/San Bernardino MSA’s leading the nation in small business bankruptcy flings by a significant margin.  

The chart below provides a closer look at this trend.

                                                    # of
                 MSA         # of Bankruptcies Bankruptcies  % of Increase
                                    Q1 2009        Q1 2010
    Los Angeles-Long
     Beach-Glendale, CA                899          1035          15.13%
    Riverside-San
     Bernardino-Ontario,
     CA                                663           736          11.01%
    Sacramento-Arden-
     Arcade-Roseville,
     CA                                462           522          12.99%
    Houston-Sugar Land-
     Baytown, TX                       365           399           9.32%
    San Diego-Carlsbad-
     San Marcos, CA                    345           387          12.17%
    Portland-Vancouver-
     Beaverton, OR-WA                  276           386          39.86%
    Denver-Aurora, CO                  304           382          25.66%
    Santa Ana-Anaheim-
     Irvine, CA                        359           370           3.06%
    California -Rest of
     State                             233           335          43.78%
    Phoenix-Mesa-
     Scottsdale, AZ                    234           327          39.74%
    Dallas-Plano-
     Irving, TX                        348           323          -7.18%
    Chicago-Naperville-
     Joliet, IL                        395           314         -20.51%
    Atlanta-Sandy
     Springs-Marietta,
     GA                                336           304          -9.52%
    Oregon -Rest of
     State                             235           299          27.23%
    ---------------                    ---           ---          -----
    New York-White
     Plains-Wayne, NY-
     NJ                                335           272         -18.80%
    ------------------                 ---           ---         ------

Inc. Magazine picked up the story last week, commenting that “no area has been insulated from the recession and the economy clearly isn’t rebounding quickly enough.”

No kidding.

A couple of prior posts on this blog (here and here) have explored the economic and regulatory reasons behind 2008’s financial meltdown, while others (here and here) have explored proposed means of handling distressed financial institutions deeemed systemically important to the nation’s financial markets.

History and propositions are now overtaken by reform.  Last Wednesday, the Financial Reform Act (aka the Dodd Frank Act) became law.

Over at Credit Slips, Seton Hall Law Professor Stephen Lubben has offered a very succinct, immediately accessible summary of the Act’s intersection with the US Bankruptcy Code – as well as some helpful links to other, useful material.

Very important reading for those who want the “bullet points” without wading through the nearly 2,300 pages of legislation.

Happy reading.

A recent post over the July 4 holiday weekend offered a “30,000 foot view” of the 2008 world-wide financial meltdown and offered some broad observations about its causes – and remaining challenges to recovery.

From the Federal Bank of New York last week comes yet another broad overview – this one of the “shadow banking” system that has come to comprise a significant portion of the US’s (and the world’s) financial infrastructure – particularly that of the world financial markets.

In Shadow Banking, researchers Zoltan Pozsar, Tobias Adrian, Adam Ashcraft, and Hayley Boesky describe the financial components of this ad hoc banking system, its role in recent asset bubbles, its brittleness under stress, and the role of the Federal Reserve and other federal agencies in relieving that stress.

As described in the abstract:

The rapid growth of the market-based financial system since the mid-1980s changed the nature of financial intermediation in the United States profoundly. Within the market-based financial system, “shadow banks” are particularly important institutions. Shadow banks are financial intermediaries that conduct maturity, credit, and liquidity transformation without access to central bank liquidity or public sector credit guarantees. Examples of shadow banks include finance companies, asset-backed commercial paper (ABCP) conduits, limited-purpose finance companies, structured investment vehicles, credit hedge funds, money market mutual funds, securities lenders, and government-sponsored enterprises.

Shadow banks are interconnected along a vertically integrated, long intermediation chain, which intermediates credit through a wide range of securitization and secured funding techniques such as ABCP, asset-backed securities, collateralized debt obligations, and repo.

This intermediation chain binds shadow banks into a network, which is the shadow banking system. The shadow banking system rivals the traditional banking system in the intermediation of credit to households and businesses. Over the past decade, the shadow banking system provided sources of inexpensive funding for credit by converting opaque, risky, long-term assets into money-like and seemingly riskless short-term liabilities. Maturity and credit transformation in the shadow banking system thus contributed significantly to asset bubbles in residential and commercial real estate markets prior to the financial crisis.

We document that the shadow banking system became severely strained during the financial crisis because, like traditional banks, shadow banks conduct credit, maturity, and liquidity transformation, but unlike traditional financial intermediaries, they lack access to public sources of liquidity, such as the Federal Reserve’s discount window, or public sources of insurance, such as federal deposit insurance.  The liquidity facilities of the Federal Reserve and other government agencies’ guarantee schemes were a direct response to the liquidity and capital shortfalls of shadow banks and, effectively, provided either a backstop to credit intermediation by the shadow banking system or to traditional banks for the exposure to shadow banks.  Our paper documents the institutional features of shadow banks, discusses their economic roles, and analyzes their relation to the traditional banking system.

Last weekend’s July 4 holiday afforded members of the US business and restructuring community an opportunity for reflection on recent economic history.  Those who took the opportunity to do so would have benefitted from “The Great Recession of 2008-2009: Causes, Consequences and Policy Responses,” a recent discussion paper authored by Sher Verick and Iyanatul Islam and prepared under the auspices of the Institute for the Study of Labor (an independent think-tank associated with the University of Bonn, Germany).

According to the authors’ abstract:

“Starting in mid-2007, the global financial crisis quickly metamorphosed from the bursting of the housing bubble in the US to the worst recession the world has witnessed for over six decades.

Through an in-depth review of the crisis in terms of the causes, consequences and policy responses, [the] paper identifies four key messages. Firstly, contrary to widely-held perceptions during the boom years before the crisis, the paper underscores that the global economy was by no means as stable as suggested, while at the same time the majority of the world’s poor had benefited insufficiently from stronger economic growth.

Secondly, there were complex and interlinked factors behind the emergence of the crisis in 2007, namely loose monetary policy, global imbalances, misperception of risk and lax financial regulation.

Thirdly, beyond the aggregate picture of economic collapse and rising unemployment, this paper stresses that the impact of the crisis is rather diverse, reflecting differences in initial conditions, transmission channels and vulnerabilities of economies, along with the role of government policy in mitigating the downturn.

Fourthly, while the recovery phase has commenced, a number of risks remain that could derail improvements in economies and hinder efforts to ensure that the recovery is accompanied by job creation. These risks pertain in particular to the challenges of dealing with public debt and continuing global imbalances.”

Verick and Islam’s work offers an excellent overview for anyone seeking to view economic events of the last two years through a “wide-angle” lens.

What’s it worth to learn from prior mistakes or misdeeds?

For interested parties in most large Chapter 11 cases, apparently not much.

Bankruptcy “examiners” are private individuals appointed by the Office of the Unites States Trustee at the direction of a Bankruptcy Court to investigate and report on the causes of a company’s failure.

Chapter 11 of the Bankruptcy Code provides that examiners “shall” be appointed if requested in any case involving, among other things, more than $5 million in certain types of unsecured debt.  In creating this position, Congress apparently expected examiners to be ubiquitous in the reorganization of large, public companies.

Nevertheless, it simply ain’t so.  Anyone with restructuring experience can attest to the truisim that examiners are a rarity in Chapter 11 cases.

Earlier this month, Temple University Professor Jonathan Lipson posted statistical analysis on the appointment of bankruptcy examiners – and why, despite the mandatory language addressing their appointment in the Bankruptcy Code – so few are, in fact, actually appointed.

In ”Understanding Failure: Examiners and the Bankruptcy Reorganization of Large Public Companies,” Lipson – whose work will appear in a forthcoming edition of the American Bankruptcy Institute Law Journal – observes that examiners are rarely sought in Chapter 11 cases, and even less frequently appointed.  Lipson’s docket-level analysis of 576 of the largest chapter 11 reorganizations from 1991 to 2007 shows they were requested in only 15% of cases.  Despite the seemingly mandatory language of the Bankruptcy Code, examiners were appointed in fewer than half of the cases where sought, or less than 7% of the sample.

So what does it take to get an examiner appointed?  Lipson summarizes the article’s findings as follows:

- Size matters. Cases in which examiners are sought are huge. The average case in which an examiner was sought was almost twice as large as the sample measured by median asset values and more than four times larger measured by mean asset values. Holding other things equal, a request for an examiner was three times more likely in a case with a debtor having at least $100 million in net assets. Cases in which examiners were appointed had mean liabilities twice the size of cases where the motions were not granted.

- Conflict matters. Cases in which examiners were sought or appointed were much more likely to be contentious, as measured by docket size and requests for chapter 11 trustees, than were cases without.  Holding other things equal, a request for a chapter 11 trustee in a large case increases the odds of an examiner request by a factor of five.

- Venue matters. Examiners are much more likely to be sought—although not necessarily appointed—in the two districts that tend to have the largest cases, Delaware and the Southern District of New York (SDNY). Together, Delaware and the SDNY had forty-six (52%) of requests for an examiner, but actually appointed an examiner in only seventeen cases (about 43%). By contrast, examiners were appointed in twenty-two cases (about 57% of appointments) when requested in other districts.

- Fraud matters—somewhat. Although requests for an examiner correlated with allegations of pre-bankruptcy fraud—the paradigm grounds for an examiner—they were nevertheless rare even when a bankruptcy was precipitated by that form of wrongdoing: Of the thirty-one cases in the sample that allegedly involved fraud, examiners were sought in only nine and, of those, were appointed in only five.

- Strategy matters—somewhat.  There is evidence that examiners will sometimes be sought for strategic, not information-seeking, reasons. Requests to appoint an examiner were withdrawn in fourteen cases (about 17% of requests in the sample) and rendered moot by subsequent events (e.g., plan confirmation) in sixteen cases (about 20% of requests). Judges and system participants interviewed for [Lipson's] paper indicated that they believed that, in many cases, the arguably “mandatory” language of the Bankruptcy Code produces gamesmanship,not enlightenment.

- Investors do not matter much.  Notwithstanding a purported goal of protecting the “investing public,” individual investors made only eighteen requests for examiners.  Far more likely to request an examiner (thirty-two cases) were individual creditors whose claims did not arise from investment securities (such as bonds) or fraud, but who apparently held claims for unpaid goods or services.

Lipson’s work provides empirically grounded insight on this little-used feature of Chapter 11, and is well worth a read.

It is perhaps stating the obvious that Chapter 11 of the US Bankruptcy Code offers a well-known and very flexible means of extracting the most value from distressed assets.  But in these economic times, it is worth remembering that Chapter 11 is by no means the only avenue for addressing insolvency – nor is it always the best . . . or most appropriate.

Bankruptcy (or “Section 363”) sales have been a time-honored and tested means of moving distressed assets quickly and cost-efficiently from buyer to seller.  But the lack of credit necessary to fund the transition period required for such sales during the recent downturn, combined with a handful of recent appellate decisions which cast doubt on the validity of contested sales, serve as reminders that other transactional structures sometimes work just as well – or even better.

The folks at Turnaround Management Association (TMA) released a spate of articles last week which illustrate the point: Two of TMA’s pieces (one on ABC’s and Receiverships and one on alternative sale structures for distressed acquisitions) compare and contrast federal bankruptcy proceedings with other means of optimizing the transfer of distressed assets. A third focuses on “strict foreclosures” (or “Article 9 sales”).

All three are well worth a read.

A brief update on Stanford (earlier posts are available here):

Evidentiary hearings scheduled for late January in the ongoing struggle for control over the financial assets of Stanford International Bank, Ltd. (SIB), the cornerstone of Allen Stanford’s financial-empire-turned-Ponzi-scheme, were cancelled by presiding US District Court Judge David Godbey.

As readers of this blog are aware, Antiguan liquidators Peter Wastell and Nigel Hamilton-Smith’s efforts to obtain recognition in the US for their Antiguan wind-up of SIB, and US receiver Ralph Janvey’s competing efforts to do the same in Canadian and UK courts, were to culminate in a hearing set for late last month.  But shortly after a scheduled status conference on pre-hearing matters, the evidentiary was cancelled.

Recent reporting by Reuters (available here) may provide a reason for the change: Reuters reported on February 5 that the liquidators and Mr. Janvey may, in fact, be settling. According to staff writer Anna Driver, a dispute over $370 million in assets traced to Stanford, as well as $200 million located in Switzerland and the UK, are driving the parties toward a deal.

But there may be other pressures as well. The Associated Press reported (here) that last Thursday, Judge Godbey indicated his intent to rule on a request by third-party investors to commence their own involuntary bankruptcy filing, thereby replacing Mr. Janvey as a receiver.

Stay tuned.

While some global economic indicators suggest an economic recovery is getting underway in earnest, research released earlier this month by global accountancy Grant Thornton LLP (and co-sponsored by the Association for Corporate Growth) argues that a fresh wave of business bankruptcy is nevertheless about to wash over US Bankruptcy Courts.

In “The Debt Effect“, a white paper addressing the present state of private equity, Grant Thornton’s Harris Smith – Los Angeles-based head of the firm’s Private Equity practice group – agrees that ”[a] global recovery is under way, albeit slowly, and there are reasons to be cautiously optimistic about 2010 and beyond.”  Against that backdrop, however, he cautions the arrival of a nascent global recovery does not mean deal-making and the lending supporting it will immediately return to its prior levels – or that it will all look the same as before when it does.  More importantly, he demonstrates that additional corporate distress is likely on the way.

Specifically, Harris notes that mergers and acquisition activity remains at levels that are a mere fraction of what the same activity was during 2006 and 2007.  Moreover, a significant portion of deals done earlier in the decade are now in jeopardy:  According to Moody’s, over 50 percent of the deals done between 2004 and 2007 by big private equity funds are now either in default or distress.  Many of these situations have been addressed – at least temporarily – through debt extensions and other types of forbearance.  But many of these temporary fixes are set to expire.  Moreover, Harris’ research projects that “[t]he number of maturating loans will steadily increase until it peaks in 2013.  The opportunities for distress buyers will continue to grow during this time because many companies will not be able to meet their debt obligations.”

According to Grant Thornton’s Marti Kopacz, national managing principal of the firm’s Corporate Advisory and Restructuring Services, “We expect the restructuring wave to be a three- to five-year wave.  This is only the first year.”

With both the global and regional Southern California economies showing early signs of life – but still lacking the broad-based demand for goods and services required for robust growth – opportunities abound for strong industry players to make strategic acquisitions of troubled competitors or their distressed assets.

Ray Clark, CFA, ASA and Senior Managing Director of VALCOR Consulting, LLC, is no stranger to middle-market deals.  His advisory firm provides middle market restructuring, transactional and valuation services throughout the Southwestern United States from offices in Orange County, San Francisco, and Phoenix.

As most readers are likely aware, distressed mergers and acquisitions can be handled through a variety of deal structures.  Last week, Ray dropped by South Bay Law Firm to offer his thoughts on a process commonly known in bankruptcy parlance as a “Section 363 sale.”

In particular, Ray covers the “pros and cons” of this approach.

The floor is yours, Ray.

Today’s economic environment has created an opportunity to acquire assets of financially distressed entities at deeply discounted prices, and one of the most effective ways to make those acquisitions is through a purchase in the context of a bankruptcy under Section 363 of the Bankruptcy Code (the “Code”).  When purchasing the assets of a failed company under Section 363, there are distinct advantages to being first in line.  Depending on the circumstances, however, it may be best to wait and let the process unfold – and then, only after surveying the entire landscape, submit a bid.

The 363 Sale Process

A so-called “363 Sale” is a sale of assets of a bankrupt debtor, wherein certain discrete assets such as equipment or real estate – or substantially all the debtor’s business assets – are sold pursuant to Section 363 of the Bankruptcy Code (11 USC §363).  Upon bankruptcy court approval, the assets will be conveyed to the purchaser free and clear of any liens or encumbrances. Those liens or encumbrances will then attach to the net proceeds of the sale and be paid as ordered by the Bankruptcy Court.

A Section 363 sale looks much like a traditional controlled auction.  Basic Section 363 sale mechanics include an initial bidder, often referred to as the “stalking horse,” who reaches an agreement to purchase assets – typically from the Chapter 11 debtor, or “debtor-in-possession” (DIP).  The buyer and the DIP negotiate an asset purchase agreement (APA), which rewards the stalking horse for investing the effort and expense to sign a transaction that will be exposed to “higher and better” or “over” bids.  The Bankruptcy Court will approve the bidding procedures, including the incentives, i.e., a “bust-up” fee, for the stalking horse bidder, and will pronounce clear rules for the remainder of the sale process.  Notice of the sale will be given, qualified bids will arrive and there will be an auction.  The sale to the highest bidder will commonly close within four to six weeks after the notice and the stalking horse will either acquire the assets or take home its bust-up fee and expense reimbursement as a consolation. 

Advantages for the Stalking Horse Bidder

Bidding Protections - During negotiations with the debtor for the purchase of assets, the stalking horse will also typically negotiate certain protections for itself during the bidding process.  These bidding protections, which include a bust-up fee and expense reimbursement, will be set forth in the 363 sale motion and are generally approved by the bankruptcy Court.  As a result, stalking horse bidders seek to insulate themselves against the risk of being out-bid.  To do so, proposed stalking-horse bidders commonly require that any outside bidder will typically have to submit not only a bid that is higher than that of the stalking horse, but will also need to include an amount to cover the stalking horse’s transactional fees and expenses.

Bidding Procedures – The stalking horse will also negotiate certain bidding procedures with the debtor, which will be set forth in the 363 sale motion that will be evaluated, and most likely approved, by the Court.  The sale procedures generally include the time frame during which other potential bidders must complete their due diligence and the date by which competing bids must be submitted.

Other delineated procedures typically included in the motion include the amount of any deposit accompanying a bid and the incremental amount by which a competing bid must exceed the stalking horse bid.  In addition, if the sale procedures provide for an abbreviated time frame in which to complete an investigation of the assets, a competing bidder will be at a distinct disadvantage and may be unable, as a result, to even submit a bid.

Deal Structure – As the first in line, the stalking horse bidder will also negotiate all of the important elements of the transaction, including which assets to acquire, what contracts – if any – to assume, the purchase price and other terms and conditions.  In doing so, it establishes the ground rules by which the sale process will unfold and the framework for the transaction, which will be difficult, if not impossible, for another outside bidder to change. 

“First Mover” Advantage – The stalking horse bidder will typically be viewed by the Court as the favored asset purchaser in that it will have negotiated all of the relevant terms and procedures, and established its financial ability and intent to acquire the assets.  As a result, short of an overbid by an outside party, which typically involves an additional amount to cover the stalking horse’s bust-up fee and expenses, the stalking horse bidder will prevail.

Cooperation of Stakeholders – As the lead bidder, the stalking horse also has an opportunity to negotiate with other key stakeholders in the process and establish a close relationship with those parties that may prove advantageous when all offers are evaluated.

Bust-up Fee and Expense Coverage – Lastly, if an outside party happens to submit the high bid, the stalking horse will typically receive its bust-up fee and expense reimbursement. This generally includes items such as due diligence fees, legal and accounting fees, and similar expenses, but is limited by negotiation. 

Disadvantages to the Stalking Horse Bidder

Risk of Being Outbid – As noted, the stalking horse will expend a great deal of time, energy, and resources analyzing and negotiating for the purchase of the assets.  All a competing bidder must do is show up to the sale and submit an over-bid.  If the competing over-bidder prevails, the stalking horse runs the risk of walking away with only its bust-up fee and expense reimbursement.

Risk of Bidding Too High – After negotiating the APA, the stalking horse then participates in the 363 sale process.  If no other bidders materialize, it may be because the stalking horse effectively over-paid for the assets. 

Inability to Alter Terms – If some new information comes to light that would otherwise suggest a reduction in the price or alteration of the terms, the stalking horse may have difficulty altering either of these and may be locked in to the negotiated structure.

Questions?

Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

Meanwhile, happy hunting.

JSC BTA Bank – A recent post appearing here discussed JSC BTA Bank (BTA)’s petition for recognition in the Southern District of New York’s U.S. Bankruptcy Court.  BTA, reportedly Khazakstan’s second-largest bank, sought recognition of its state-sponsored restructuring in Khazakstan as a “foreign main proceeding.”  On March 2, Judge James Peck in Manhattan granted the bank’s request.  A copy of Judge Peck’s ruling is available here.

White Birch Paper Co.  – The second-largest newsprint company in North America – Greenwich, Conn.’s White Birch Paper – followed the largest (Montreal’s AbitibiBowater Inc.), into bankruptcy in both Canada and the US on February 24.

White Birch and 10 affiliates, which together operate paper mills in Gatineau, Quebec; Riviere-du-Loup, Quebec; and Quebec City filed their request for protection under the Canadian Companies’ Creditors Arrangement Act in Montreal, and a concurrent request for recognition of 6 of those proceedings in Virginia’s Eastern District before Chief Bankruptcy Judge Douglas O. Tice, Jr.  They were joined by US affiliate Bear Island Paper Co. of Ashland, which sought protection under Chapter 11.

Pleadings filed in White Birch’s cases claim that the companies controlled approximately 12% of the North American newsprint market as of last December.  The filings were triggered by the continued shift from print to digital media and the attendant decline in revenues.  In addition, the widening spread between the Canadian and US currencies also hurt operations, as payables are frequently accepted in US dollars, while expenses are paid in Canadian dollars.  Finally, the companies’ operational woes were compounded by the burden of a January 2008 purchase of SP Newsprint Co. for approximately $350 million.

Cost-cutting efforts commenced in late 2009 were not sufficient to prevent White Birch’s default on first- and second-lien credit facilities.  Attempts to restructure the debt out of court were likewise unsuccessful.  Judge Tice’s Order granting recognition and entering a preliminary injunction was entered yesterday.

JSC Alliance Bank – Khazakstan’s sixth-largest bank followed BTA’s lead, seeking similar recognition in Manhattan’s Southern District less than 2 weeks after the larger Kazakh institution did so. 

Like BTA, Alliance sought relief from creditors and litigation in the US while it restructures itself out of debt defaults and liquidity problems arising, in part, from its need to foreclose on bad loans and its subsequent difficulty selling foreclosed assets.  In its papers, Alliance claims that last December, it obtained approval for a restructuring plan from creditors holding more than 94 percent of its claims.

Mega Brands Inc. – Toymaker Mega Brands has sought recognition in Delaware before Bankruptcy Judge Christopher Sontchi for its Canadian restructuring, commenced in mid-February before the Superior Court of Quebec in Montreal.

The global supplier of construction toys, stationery and other children’s toys and activity instruments plans to implement a global restructuring, which is reportedly supported by more than 70% of the company’s secured debt holders and all of its debenture holders – and on which lenders and shareholders will vote on March 16.  In pleadings submitted with the petition, the company blames its need to restructure on the downturn in global demand, resulting stagnation in the North American toy industry, and fluctuations in raw materials prices.

Japan Airlines – On January 19, Japan Airlines (JAL), Asia’s largest airline, sought Chapter 15 protection in New York in furtherance of its reorganization in the Tokyo District Court under Japan’s Corporate Reorganization Act.  Bankruptcy Judge James Peck – the same judge presiding over BTA Bank’s Chapter 15 proceeding (see above) – recognized the Japanese proceeding in mid-February.  According to JAL’s Court pleadings, US assets protected by the Chapter 15 recognition order include aircraft and real estate interests in New York and Los Angeles.  Judge Peck’s Order granting JAL’s recognition is here.

In light of the tumultuous economic events of 2008 and 2009, a number of proposals for significant bankruptcy reform have surfaced – many of which have been summarized on this blog.

One of last year’s posts focused on the ongoing debate over the impact of credit derivatives on failing companies, and on the continued usefulness of Bankruptcy Code provisions designed to insulate the financial markets from the bankruptcy process.

Last week, Harvard’s Mark Roe added to that discussion with a paper entitled “Bankruptcy’s Financial Crisis Accelerator: The Derivatives Players’ Priorities in Chapter 11”

The essence of Professor Roe’s proposal is set forth at p. 3:

Although several of [the Bankruptcy Code’s safe-harbor super-priorities for derivatives and repurchase agreements] are functional and ought to be kept, the full range is far too broad. Most are more likely to destabilize financial markets than to stabilize them and most need to be repealed.

Professor Roe’s thoughtful analysis is a worthwhile read.

A number of advanced commercial jurisdictions – such as the US, the UK, Germany, and Japan – permit a debtor’s bankruptcy administrator or trustee to pursue and recover preferential or fraudulent transfers.  Unwinding such transfers, typically made from the debtor to a third party located in the same country, is often an important source of recovery for creditors.

But what happens when the transfer crosses international borders?  More specifically, which country’s avoidance law applies:  The law of the jurisdiction where the transfer was initiated?  Or the law of the “destination” jurisdiction?

An important decision issued last Thursday by the Fifth Circuit Court of Appeals provides a preliminary answer for at least a portion of this question.

 “Before” Chapter 15.

Prior to the enactment of Chapter 15, US bankruptcy courts disagreed on whether – and how – the administrator of a foreign insolvency proceeding could pursue such transfers in the US.  Some courts permitted non-US administrators to pursue such recovery efforts directly (through an ancillary proceeding), under the fraudulent transfer law of the debtor’s home jurisdiction.  Others permitted such recoveries only under US law, and only through a separately filed (and far more expensive and time-consuming) Chapter 11 or 7 bankruptcy case.

“After” Chapter 15.

Chapter 15 resolved at least a portion of this debate.  Section 1521(a)(7) provides that upon recognition of a foreign proceeding, the court may grant “any appropriate relief” including “additional relief that may be available to a trustee, except for relief available under [the avoidance sections of the US Bankruptcy Code].” Section 1523(b) authorizes the bankruptcy court to order relief necessary to avoid acts that are “detrimental to creditors,” providing that, upon recognition of a foreign proceeding, a foreign representative has “standing in [the debtor’s US bankruptcy] case . . . to initiate [avoidance] actions.”  In other words, Congress appeared to clear up the question where recovery efforts are initiated under US law:  A full Chapter 11 (or 7) case is required.

But what about recovery efforts commenced under non­-US law?

Courts visiting this issue under Chapter 15 appear almost as divided as those who looked at it prior to the Bankruptcy Code’s 2005 amendments.

Two cases, both addressing the question in dicta, have gone in opposite directions.  In one, the Bankruptcy Court forbade a sale “free and clear” of an avoidable English lien on procedural grounds – but along the way, acknowledged that avoidance actions under the US Bankruptcy Code are cognizable only if the debtor is the subject of a case under another chapter of the Bankruptcy Code.  In another, the Bankruptcy Court denied a request by the administrator of a Danish insolvency proceeding for turnover of previously-garnished funds on the grounds that such turnover provisions were not applicable in Chapter 15 – but nevertheless went out of its way to note that nothing in Chapter 15’s legislative history – or in prior US cross-border law – prohibited avoidance actions commenced under the law of the debtor’s home jurisdiction.

To date, however, only one case has addressed the issue directly.

Condor Insurance and the Bankruptcy Code’s Deafening Silence.

Condor Insurance, Limited (“Condor”), a Nevis-incorporated insurer and surety bond issuer, was placed into a winding-up proceeding in its home jurisdiction in 2007.  The following year, Condor’s liquidators sought recognition in Mississippi – in part, to pursue alleged fraudulent transfers aggregating more than $313 million to Condor affiliates and principals.

The Bankruptcy Court and District Court Decisions.

The Condor defendants moved to dismiss, claiming the Bankruptcy Court lacked jurisdiction to grant the relief requested. The Bankruptcy Court agreed, and – on appeal, and in a published decision – the District Court affirmed.  Central to the District Court’s reasoning was the idea that, in US courts, “the choice of law that is to be applied to a lawsuit is determined by a court having jurisdiction over the case, and the parties are not permitted to choose whatever law they wish when filing a lawsuit.”  As a result, the District Court found it lacked jurisdiction to hear the avoidance action.  Instead, it suggested that the liquidators commence and resolve the avoidance claims in Nevis – and then, upon procurement of a judgment, seek enforcement under principles of international comity.

The Fifth Circuit Decision.

In a decision issued last week, the Fifth Circuit Court of Appeals respectfully disagreed.  Writing for a 3-judge panel, Judge Patrick Higgenbotham observed Chapter 15’s “international origins” to encompass “international law.”  For the panel, Chapter 15 is not merely a procedural vehicle by which foreign administrators may cost-effectively protect assets domiciled, or control litigation originating, in the US.  Instead, foreign administrators may import the substantive insolvency law of foreign jurisdictions into US courts, which have jurisdiction to apply such law to disputes pending in the US.  See pp. 8-9 (“Whatever its full reach, Chapter 15 does not constrain the federal court’s exercise of the powers of foreign law it is to apply.”).

As a result, the statute’s silence speaks volumes.  Once recognized in the US court system through Chapter 15, foreign administrators have direct access to the panoply of federal judicial powers available to assist their administration of insolvency-related matters in the US, limited only by the specific “carve-outs” for US avoidance actions reserved in Section 1521:

“The structure of Chapter 15 provides authority to the district court to assist foreign representatives once a foreign proceeding has been recognized by the district court. Neither text nor structure suggests additional exceptions to available relief. Though the language does not explicitly address the use of foreign avoidance law, it suggests a broad reading of the powers granted to the district court in order to advance the goals of comity to foreign jurisdictions.  And this silence is loud given the history of the statute including the efforts of the United States to create processes for transnational businesses in extremis.”  Decision at pp. 9-10.

-          What About “Section Shopping?”

The Fifth Circuit recognized the appellees’ concern over “section shopping” – i.e., the strategic use of Chapter 15 (rather than Chapter 11 or Chapter 7) by foreign administrators to leverage the benefits of foreign avoidance law in US forums.  But where Congress had not taken further steps to guard against this threat, the Fifth Circuit overruled the District Court’s own efforts to do so.  In fact, Judge Higgenbotham and his colleagues did not appear bothered by the spectre of “section shopping,” noting that in the case before it – that of a foreign insurance company – Chapters 7 and 11 were not eligible relief.  Moreover, the District Court’s suggestion that the foreign administrator should simply obtain an avoidance judgment in Nevis, then seek enforcement of that judgment in the US, was “no answer.  Not all defendants are necessarily within the jurisdictional reach of the Nevis court.”  Decision at p.14.

-          What Of “Mixing and Matching?”

Instead of “section shopping,” Judge Higgenbotham saw the danger of “mixing and matching” foreign insolvency proceedings with US avoidance law, arising in connection with a Chapter 11 or Chapter 7 case.  See p. 11 (“When courts mix and match different aspects of bankruptcy law, the goals of any particular bankruptcy regime may be thwarted and the end result may be that the final distribution is contrary to the result that either system applied alone would have reached.”).  The Fifth Circuit traced the development of the UNCITRAL’s efforts to address choice of law in avoidance actions while drafting the model law that forms the basis for Chapter 15, concluding:

“The application of foreign avoidance law in a Chapter 15 ancillary proceeding raises fewer choice of law concerns as the court is not required to create a separate bankruptcy estate.  It accepts the helpful marriage of avoidance and distribution whether the proceeding is ancillary applying foreign law or a full proceeding applying domestic law—a marriage that avoids the more difficult depecage rules of conflict law presented by avoidance and distribution decisions governed by different sources of law.”  Decision at p.13.

The Fifth Circuit panel also found its own approach more consistent with that of US cross-border law that pre-dated Chapter 15, noting Bankruptcy Courts could – and sometimes did – apply either US avoidance law or foreign avoidance law to an action pending in an ancillary case under former Section 304.  At least one court, however, had criticized this approach for the same “mixing and matching” of foreign and domestic insolvency law noted by the Fifth Circuit.  See p.16 (citing and discussing In re Metzeler, 78  B.R. 674, 677 (Bankr. S.D.N.Y. 1987)):

“In sum, under section 304, avoidance actions under foreign law were permitted when foreign law applied and would provide for such relief.  Congress essentially made explicit In re Metzeler’s articulation of the bar on access to avoidance powers created by the U.S. Code by foreign representatives in ancillary proceedings.”  Decision at p.16.

-          Wholesale Importation of Foreign Avoidance Actions?

As for concerns that US insolvency courts – and US businesses – might find themselves awash in avoidance claims arising under non-US law, the Fifth Circuit again reverted to the international policies undergirding the legislation:

“Providing access to domestic federal courts to proceedings ancillary to foreign main proceedings springs from distinct impulses of providing protection to domestic business and its creditors as they develop foreign markets. Settled expectations of the rules that will govern their efforts on distant shores is an important ingredient to the risk calculations of lenders and corporate management. In short, Chapter 15 is a congressional implementation of efforts to achieve the cooperative relationships with other countries essential to this objective.”

The Unanswered Question.

The Fifth Circuit’s Condor decision leaves unanswered the question of whether avoidance actions commenced under Section 544 of the Bankruptcy Code – which itself references “applicable [non-bankruptcy] law” – includes foreign law.  Section 1521, by its terms, excludes avoidance actions predicated on this section.  But the Bankruptcy Court, the District Court, and the Fifth Circuit all ducked this issue.

One Manhattan bankruptcy judge recently observed, in dicta, that Section 544(b) gives the trustee the standing of a judgment lien creditor.  Because a preference action under foreign law would not appear to depend on status as a judgment lien creditor, this section would appear inapplicable to preference claims. A preference action under foreign law might therefore be available as “additional assistance” under § 1507.  See In re Atlas Shipping A/S, 404 B.R. 726, 744 at n.16 (Bankr. S.D.N.Y. 2009).

But Condor’s brief analysis didn’t address preference claims.  It addressed avoidance actions, which – at least in the US – do depend upon judgment lien creditor status.  As a result, the availability of foreign avoidance actions, while resolved in the Fifth Circuit – remains likely unanswered elsewhere.

Many readers of this blog understand the importance of asset and enterprise valuation at a number of stages of the bankruptcy process.  Whether it be specific collateral (to address a secured creditor’s concerns) or enterprise value (to determine the viability of a Chapter 11 plan), or for purposes of a fraudulent transfer or an asset sale, the discipline and methodology of valuation forms a fundamental touchstone of business insolvency practice.

A recent Delaware Bankruptcy Court decision highlights the use of valuation in yet another context:  The appointment of equity committees.  In the Chapter 11 cases of Spansion, Inc. and its affiliates, Judge Kevin Carey reviewed the request of an ad hoc equity committee’s request for official sanction and appointment by the Office of the US Trustee.  To evaluate the committee’s request, Judge Carey turned to case law holding that the appointment of an equity committee depends upon:

- the substantial likelihood of a distribution to equity holders after all creditors are paid; and

- equity holders’ inability to represent themselves without such an official committee.

Central to Judge Carey’s decision was a detailed analysis of the anticipated distribution to equity holders.  Spansion’s disclosure statement, submitted with its proposed Chapter 11 plan, valued the debtors’ enterprise value at less than the amount of creditors’ claims and therefore left nothing for equity.  The ad hoc equity committee (not surprisingly) believed enterprise value after payment was sufficient that equity holders should have a collective voice with respect to the proposed plan.

Both sides submitted extensive evidence in support of their positions.  Unlike the debtors’ “full-blown” valuation, however, the ad hoc equity committee submitted a “sensitivity analysis” based on the debtors’ numbers and including an analysis of “precedent transactions,” comparable trading multiple analysis, and a discounted cash flow (DCF) analysis.

A substantial portion of Judge Carey’s 20-page decision denying the ad hoc equity committee’s request revolves around a careful weighing of the parties’ competing valuation evidence.  The ad hoc equity committee’s valuation evidence ultimately faltered on four points:

- The future of the debtors’ market:  For Judge Carey, the ad hoc equity committee’s analysis was not sensitive enough.  It inferred growth estimates based on the broader semiconductor and memory markets rather than for the debtors’ smaller (and much less healthy) specific memory market.

- The estimated DCF terminal value:  The ad hoc equity committee’s valuations assumed constant cash flow growth (a view not shared by the debtors), higher EBITDA multiples, and higher terminal values.  By contrast, the debtors’ valuation assumed flat to negative growth, and a lower terminal value.

- Valuation of specific assets:  The ad hoc equity committee claimed certain valuable assets – such as cash, litigiation claims held by the debtors, and net operating losses - were not accounted for in the debtors’ estimate of enterprise value.  While acknowledging that cash ought to be included in enterprise value, Judge Carey nevertheless found that the ad hoc equity committee offered no support for its valuation of the litigation claims at issue.  He found, further, that ambiguity surrounding the effect of the debtors’ net operating losses was not sufficiently resolved by the ad hoc equity committee to assign it any value for the committee’s analysis.

- Total amount of claims:  The ad hoc equity committee’s claimed equity stake derived at least in part from its estimate of claims.  However, Judge Carey found that the committee had neglected to include administrative claims and cash requirements necessary to exit from Chapter 11.  The committee also had neglected to estimate the value of claims from as-yet-to-be-rejected contracts.

In the end, Judge Carey found that “[t]he only thing certain . . . is the uncertainty of the valuations” – and that, as a result, the ad hoc equity committee’s “uncertain” estimate had not established the “substantial likelihood” of distribution required for official appointment.

Judge Carey’s valuation analysis is instructive.  Specifically, it highlights the evidentiary burden that can attend valuation fights in a bankruptcy case, as well as the thoroughness with which a court may investigate enterprise value.

Something to consider in a variety of bankruptcy contexts.

A great deal of scholarly ink has been spilled over last year’s well-publicized sales of Chrysler and GM, each authorized outside a Chapter 11 plan.  Some of that ink is available for review . . . here.

It’s worth noting that both Chrysler and GM have enjoyed a considerable presence in Canada.  Indeed, the Canadian government participated in the automakers’ Chapter 11 cases.  Yet their bankruptcy sales were not recognized under Canadian cross-border insolvency law, nor were Canadian insolvency proceedings ever initiated.

Why not?

Seton Hall’s Stephen Lubben and York University’s Stephanie Ben-Ishai collaborated last month to offer an answer to that question.  The essence of their article, “SALES OR PLANS: A COMPARATIVE ACCOUNT OF THE ‘NEW’ CORPORATE REORGANIZATION“ comes down to two points of difference between the Canadian reorganization process and US Chapter 11 – speed and certainty – and is captured in the following excerpt:

[B]oth the United States and Canada have well-established case law that supports the “pre-plan” sale of a debtor’s assets.  The key difference between the jurisdictions thus turns not on the basic procedures, but rather the broader context of those procedures . . . .   [I]n the United States it is generally possible to sell a debtor’s assets distinct from any obligations or liabilities associated with those assets.  Indeed, the only obligations that survive such a sale are those that the buyer willing[ly] accepts and those that must survive to comport with the U.S. Constitution’s requirements of due process.

[I]n Canada the debtor has less ability to “cleanse” assets through the sale process.  Particularly with regard to employee claims, a pre-plan sale under the CCAA is not apt to be quite as “free and clear” as its American counterpart.

The jurisdictions also differ on the point at which the reorganization procedures – and the sale process – can be invoked.  Canada, like most other jurisdictions, has an insolvency prerequisite for commencing [a reorganization] proceeding, whereas Chapter 11 does not.  And the Canadian sale process is tied to the oversight of cases by the [court-appointed] monitor: without the monitor’s consent, it is unlikely that a Canadian court would approve a pre-plan asset sale.  In the United States, on the other hand, there is no such position.  Accordingly, a [US] debtor can seek almost immediate approval of a sale upon filing.  Finally, there remains some doubt and conflicting case law in Canada about the use of the CCAA in circumstances that amount to liquidation, particularly following an asset sale.  In the US, it is quite clear that Chapter 11 can be used for liquidation.

[T]hese latter factors are the more likely explanations for the failure to use the CCAA in [GM's and Chrysler's] cases . . . .  [I]t is the questions of speed and certainty that mark[] the biggest difference between the two jurisdictions . . . .  In the case of GM and Chrysler, where the governments valued speed above all else, these issues came to the fore.

The article offers a very interesting perspective on the strategic use of specific insolvency features of different jurisdictions to effect cross-border bankruptcy sales, and is well worth the read.

Many readers of this blog will be well aware that “venue shopping” – usually to a known, “debtor-friendly” jurisdiction such as Delaware or the Southern District of New York – is a common feature of Chapter 11 practice.  For those who may not be, the primary idea is that the debtor’s management, looking to increase the likelihood of a successful reorganization, often identifies a “debtor-friendly” jurisdiction and seeks to fit within the venue provisions for commencing a reorganization case there.

But though the federal venue provisions (at least as interpreted by these courts) generally make it easy to obtain access to file a Chapter 11 case, not every such case filed in New York or Delaware stays there without a fight from one or more creditors who disagree with the debtor’s choice of forum.

Last week, another example of creditors disagreeing with the debtor’s choice of forum - in the strongest possible terms – presented itself in the recently-filed Chapter 11 bankruptcies of Rock & Republic Enterprises, Inc.  and Triple R, Inc.

The purveyors of high-end jeans sought Chapter 11 protection on April 1 in Manhattan.  Though the bulk of their management and facilities – and their creditors – are located in the Los Angeles metropolitan area, the companies opted for an East Coast venue, each citing a single office – and a showroom – as the basis for their request to reorganize in New York’s Southern District.

The companies’ primary secured creditor, RKF, LLC, wasn’t pleased.  It immediately filed an “Emergency Motion to Transfer Venue” to the Central District of California, alleging:

 - The companies’ status as California corporations;

- The companies’ management offices, books and records, and address for service of process are in the Los Angeles area;

- All but 2 of 10 of the companies’ leased premises are in the Los Angeles area;

- 16 of the companies’ top 25 creditors are based in Los Angeles (only 2 are in New York); and

- 9 of 14 litigation matters involving the companies are being heard in California.

On Friday, RKF was joined by Zabin Industries, Inc.  Zabin is one of the companies’ self-described “larger unsecured creditors” and is also based in Southern California.

No word yet on a date for the hearing on RKF’s “Emergency Motion” – as of this writing, presiding Judge Arthur Gonzales hadn’t set one.  Meanwhile, the Judge has set an accelerated hearing date on the companies’ request to reject an exclusive distribution agreement with Richard I Koral, Inc. (dba “Jessica’s”), the companies’ present off-price distributor.

International readers of this blog – and those in the US who practice internationally – are more than likely aware of the doctrine of “comity” embraced by US commercial law.  In a nutshell, “comity” is shorthand for the idea that US courts typically afford respect and recogntion (i.e., enforcement) within the US to the judgment or decision of a non-US court – so long as that decision comports with those notions of “fundamental fairness” that are common to American jurisprudence.

In the bankruptcy context, “comity” forms the backbone for significant portions of the US Bankruptcy Code’s Chapter 15.  Chapter 15 – enacted in 2005 – provides a mechanisim by which the administrators of non-US bankruptcy proceedings can obtain recogntion of those proceedings, and further protection and assistance for them, inside the US.

But in at least some US bankruptcy courts, “comity” for non-US insolvencies only goes so far.  Last month, US Bankruptcy Judge Thomas Argesti, of Pennsylvania’s Western District, offered his understanding of where “comity” stops – and where US bankruptcy proceedings begin.

Judge Argesti currently presides over Chapter 15 proceedings commenced in furtherance of two companies – Canada’s Railpower Technologies Corp. (“Railpower Canada”) and its wholly-owned US subsidiary, Railpower US.  The two Railpower entities commenced proceedings under the Canadian Companies Creditors’ Arrangement Act (“CCAA”) in Quebec in February 2009.  Soon afterward, their court-appointed monitors, Ernst & Young, Inc., sought recogntition of the Canadian Railpower cases in the US.

Railpower US’ assets and employees – and 90% of its creditors – were located in the US.  The company was managed from offices in Erie, PA.  Nevertheless, it carried on its books an inter-company obligation of $66.9 million, owed to its Canadian parent.  From the outset, Railpower US’ American creditors asserted this “intercompany debt” was, in fact, a contribution to equity which should be subordinate to their trade claims.  Judge Argesti’s predecessor, now-retired Judge Warren Bentz, therefore conditioned recognition of Railpower US’ case upon his ability to review and approve any proposed distribution of Railpower US’ assets.  After the company’s assets were sold, Judge Bentz further required segregation of the sale proceeds pending his authorization as to their distribution.  Finally, after the Canadian monitors obtained a “Claims Process Order” for the resolution of claims in the CCAA proceedings and sought that order’s enforcement in the US, Judge Bentz further “carved out” jurisdiction for himself to adjudicate the inter-company claim if the trade creditors received anything less than a 100% distribution under the CCAA plan.

Railpower US’ assets were sold – along with the assets of its Canadian parent – to R.J. Corman Group, LLC.  Railpower US was left with US$2 million in sale proceeds against US$9.3 million in claims (other than the inter-company debt).  The Canadian monitor indicated its intention to file a “Notice of Disallowance” of the inter-company debt in the Canadian proceedings, but apparently never did.  Meanwhile, approximately CN$700,000 was somehow “upstreamed” from Railpower US to Railpower Canada.  Finally, despite the monitor’s assurances to the contrary, Railpower Canada’s largest shareholder – and an alleged secured creditor – sought relief in Quebec to throw both Railpower entities into liquidation proceedings under Canada’s Bankruptcy and Insolvency Act.

Enough was enough for Railpower US’ American creditors.  In August 2009, they filed an involuntary Chapter 7 proceeding against Railpower US, seeking to regain control over the case – and Railpower US’ assets – under the auspices of an American panel trustee.

The Canadian monitor requested abstention under Section 305 of the Bankruptcy Code.  Significantly re-drafted in the wake of Chapter 15’s enactment, that section permits a US bankruptcy court to dismiss a bankruptcy case, or to suspend bankruptcy proceedings, if doing so (1) would better serve the interests of the creditors and the debtor; or (2) would best serve the purposes of a recognized Chapter 15 case.

Judge Argesti’s 14-page decision, in which he denied the monitors’ motion and permitted the Chapter 7 case to proceed, is one of apparent first impression on this section where it regards a Chapter 15 case.

Where the “better interests of the creditors and the debtor” are concerned, Judge Argesti’s discussion essentially boils down to the proposition that because creditors representing 85% – by number and by dollar amount – of Railpower US’ case sought Chapter 7, those creditors have spoken for themselves as to what constitutes their “best interests” (“The Court starts with a presumption that these creditors have made a studied decision that their interests are best served by pursuing the involuntary Chapter 7 case rather than simply acquiescing in what happens in the Canadian [p]roceeding.”).

The more interesting aspect of the decision concerns Judge Argesti’s discussion of whether or not the requested dismissal “best serve[d] the purposes” of Railpower’s Chapter 15 cases.  For guidance on this issue, Judge Argesti turned to Chapter 15’s statement of policy, set forth in Section 1501 (“Purpose and Scope of Application”) – which states Chapter 15’s purpose of furthering principles of comity and protecting the interests of all creditors.  Then, proceeding point by point through each of the 5 enunciated principles behind the statute, he arrived at the conclusion that the purposes of Chapter 15 were not “best served” by dismissing the involuntary Chapter 7 case.  As a result, Railpower US’ Chapter 7 case would be permitted to proceed.

Judge Argesti’s analysis appears to focus primarily on (i) the Canadian monitors’ apparent delay in seeking disallowance of the inter-company debt in Canada; (ii) the “upstreaming” of CN$700,000 to Railpower Canada; and (iii) the monitors’ apparent failure, as of the commencement of the involuntary Chapter 7, to “unwind” these transfers or to recover them from Railpower Canada for the benefit of Railpower US’ creditors.  It also rests on the fact that Railpower US was – for all purposes – a US debtor, with its assets and creditors located primarily in the US.

In this context, and in response to the monitors’ protestations that comity entitled them to judicial deference regarding the Chapter 15 proceedings, Judge Argesti noted that:

comity is not just a one-way street.  Just as this Court will defer to a [non-US] court if the circumstances require it, so too should a foreign court defer to this Court when appropriate.  In this case it was clear from the start that [this Court] expressed reservations about the distribution of Railpower US assets in the Canadian [p]roceeding . . . .  The Monitor has [not] explained how this [reservation] is to be [addressed] unless the Canadian Court shows comity to this Court.

Judge Argesti’s decision may be limited to its comparatively unique facts.  However, it should also serve as a cautionary tale for representatives seeking to rely on principles of comity when administering business assets in the US.  In addition to his more limited construction of “comity,” Judge Argesti also noted that recognition of Railpower US’ Chapter 15 case was itself subject to second-guessing where subsequently developed evidence suggested that the company’s “Center of Main Interests” was not in Canada, but in the US.

For anyone weighing strategy attendant to the American recognition of a non-US insolvency proceeding, this decision is important reading.

Two prior posts on this blog (here and here) have traced the progress of an obscure – but potentially important – piece of California legislation designed to regulate the ability of local California governments to seek relief through the municipal debt adjustment process of Chapter 9.

Relatively little-known California State Assembly Bill 155 would, if voted and signed into law, require local public entities to first seek approval from the California Debt and Investment Advisory Commission (which operates under the auspices of the State Treasurer’s Office) prior to seeking the federal debt adjustment relief presently available to them by local government decision.

Though ostensibly addressing the “debt” and “investments” of local governments, the bill is in fact aimed squarely at protecting public employee unions who – unnerved by the 2008 Chapter 9 filing commenced by the City of Vallejo, California – have backed the legislation since its introduction into the California legislature nearly 18 months ago.  According to analysis produced last July by the State Senate’s Local Government Committee, “labor unions and others want to require state oversight of local governments’ bankruptcy petitions.”

The reason?  Public employee pensions and other employee benefits.

The details of public employees’ hiring and retention arrangements are typically governed by collective bargaining agreements (or “Memoranda of Understanding” in the context of public labor relations), brokered by the employees’ unions and their public employers.  As presicently noted in an article on municipal collective bargaining agreements authored 3 years ago, “Public sector unions have successfully obtained comparatively generous compensation and benefits packages even as the fortunes of American labor have continued to decline. In particular, municipal pensions may jeopardize the fiscal survival of many public sector employers.”

With perrenial state and local budget deficits, declining property values and a shrinking tax base, and significantly reduced revenues, many local governments are now in precisely the sort of “survival mode” suggested by this article . . . and the unions know it.  As a result, AB 155 has quietly made its way through the State Assembly and now appears poised to go to the State Senate floor.

Is “bankruptcy by committee” an appropriate balance between state interests and local government control?  Does it hamstring local govrenment officials from responding effectively to a local fiscal crisis?  Because municipal bankruptcies have always been used very sparingly, and only 2 such proceedings (including Vallejo’s) have filed statewide since 2008, is committee approval truly necessary?  Or is it merely a means by which public employee unions can improve their bargaining position outside of bankruptcy?  And what happens if a local government in financial crisis can’t get committee approval?

These questions appear, to date, unanswered.

But last week, AB 155 took a step forward, clearing the Senate’s Local Government Committee.  The bill will now go to the Senate Appropriations Committee for review.

A recent post by University of Illinois’ Professor Bob Lawless over at the always-stimulating “Credit Slips” blog focuses on an often-ignored, but important, corner of the Chapter 11 world: “Small Business” Chapter 11’s.  Perhaps more accurately, the post focuses on Chapter 11’s that could be – but aren’t – formally designated as “Small Business” Chapter 11’s.

Prof. Lawless – whose research interests include empirical methodologies in legal studies – recently reviewed bankruptcy data from 2007, observing that of 2,299 chapter 11s filed in 2007 where the debtor (i) was not an individual; (ii) claimed predominately business debts; and (iii) scheduled total liabilities between $50,000 and $1,000,000, only 36.8% were designated “small business” bankruptcies.  Anecdotally, Prof. Lawless refers to one of the cases he surveyed:  a manufacturer that scheduled about $800,000 in debt and yet did not self-designate as a small-business debtor.

So why don’t more “small businesses” that commence Chapter 11 proceedings (many don’t, but this is a different issue) claim “small business” status?

The answers from practitioners – some of whom responded on the post, and others who voiced their views on a national list-serve also maintained by Prof. Lawless. – appear to coalesce around the following:

- Congress’ 2005 amendments impose additional filing requirements.  Section 1116 requires the provision of “the most recent” balance sheet, profit-and-loss statement, and statement of cash flows, as well as the most recent Federal income tax return.  One busy LA practitioner noted that he avoids the “Small Business” designation for this reason.

- The “small business” deadlines are too compressed.  For example, the Code’s exclusivity provisions generally “caps” the time period in which a “Small Business” debtor may file a Chapter 11 Plan and Disclosure Statement at 300 days.  This period can, of course, be extended within the original 300-day period if the debtor can demonstrate that plan confirmation within a “reasonable period” is “more likely than not.”  But as a practical matter, the debtor has about 10 months to get a Chapter 11 Plan and Disclosure Statement filed.

- The combination of increased reporting and compressed deadlines puts any “small business” case on a hair-trigger under the expanded dismissal provisions of Section 1112.

- Some practitioners simply overlook the designation – which appears as a “check-the-box” on the face page of the petition’s official form.

- The concept of separate “small business” treatment emerges out of “local practices” implemented by bankruptcy judges for the purpose of streamlining their own dockets, but which were never really a good idea from a practical perspective.

With the possible exception of attorney oversight, these all appear emininently practical reasons for staying away from “Small Business” Chapter 11’s.

But are they always?

It may be that “small business” cases are perceived as problematic because, in fact, they cut against the grain of the traditional law firm business model.  For example:

- Additional filing requirements.  There may be circumstances where the client’s non-compliance with income tax filing requirements preclude any “small business” self-designation.  But most businesses – even troubled ones – can generate a very rudimentary set of financial statements.  Even for clients who generally operate without them, it should be possible to generate such statements (albeit very cursory ones) at the initial client interview or very shortly thereafter.  It’s worth noting that in California’s Central District, the additional “up-front” filing requirements are offset, at least to some degree, by the dramatically reduced monthly reporting requirements with the US Trustee’s Office.  In one “small business” Chapter 11 case handled last year by South Bay Law Firm, the extremely relaxed monthly operating reporting requirements were one – though certainly not the only – reason a “small business” filing was recommended for the client.

- Compressed deadlines.  Part of South Bay Law Firm’s pre-petition planning involves a review of the client’s “exit strategy.”  The fundamental question is: What is the client’s perceived business objective for the contemplated Chapter 11?  If there isn’t one, the client has more fundamental issues to consider – and the conversation typically turns to a discussion of whether or not Chapter 11 makes business sense.  If there is a business purpose for the contemplated Chapter 11, the business purpose and the “exit strategy” are typically reduced to an informal “Plan Term Sheet” which will, itself, become the nucleus of a combined Chapter 11 Plan-Disclosure Statement.  At South Bay Law Firm, our experience is that the combined document is generally a bit easier and less time-consuming to draft than 2 separate documents.  And with the “end game” relatively well-defined at or near the outset of the case, getting to a successful exit just got a lot easier.  This is a factor critical to the speed that is so important to an economically successful Chapter 11.

- More reasons for dismissal.  It is certainly true that Section 1112 imposes draconian consequences for failure to make required filings.  But more often, the real challenge isn’t Section 1112 – or the US Trustee’s Office.  Instead, it’s helping the “small business” Chapter 11 debtor focus on the administrative requirements of a Chapter 11 – and in California’s Central District, there are many.  To that end, the extra discipline required up-front for a “small business” Chapter 11 is, in fact, an important test of the debtor’s ability and willingness to get through the process with success.  If the debtor can’t even comply with a few additional filing requirements, it’s preferable to know right away that this debtor will have difficulty dealing with the myriad other contingencies that are certain to emerge in even a small Chapter 11 case.

- It’s all an impractical (though perhaps well-intended) judicial idea.  For the reasons described above, the additional filing requirements and compressed deadlines of a “Small Business” Chapter 11 may, in fact, bt very practical – at least in the larger scope of Chapter 11 economics.  But even if the practicalities are questionable (practicality is, after all, in the eye of the practitioner), their result - docket efficiency and speed of administration – are both great sources of judicial pleasure.  The judicial clerkship experience resident at South Bay Law Firm attests that there really is no better way to make friends with everyone behind the bench than making their job easier – even if the job is just a tad bit harder on counsel’s end.  We’ll gladly invest a little extra effort if it will mean the benefit of the doubt on a “jump ball” in front of the person wearing the black robe.

All of this may be very interesting, but how does it implicate the law firm business model?

Only this way: In an industry predominated by an “hourly fee” pricing model and on bringing as much business in the door as possible, the pressure on increased speed and discipline in a “small business” Chapter 11, requires more focus (and time) up-front, drives down administrative costs, demands an internal adherence to business process, and “weeds out” many candidates unsuitable for Chapter 11 – “small business” or otherwise.  This, in turn, has the effect of making “small business” Chapter 11’s generally quicker and cheaper – and therefore potentially less profitable, at least from an “hourly fees” point of view.  It also tends, at least initially, to restrict or limit overall client “volume.”

However, it also has the effect of creating a relatively well-defined “product” which is potentially salable to a larger segment of troubled small businesses.  And a larger overall market segment means a larger absolute number of “small business” debtors who are possessed of the discipline and determination to reorganize their businesses successfully.

Leveraged buy-outs (LBO’s) are a time-honored means of financing the acquisition of companies.  They tend to occur in waves, finding greatest popularity when credit is easy and money is cheap.

Because of their dependence on favorable credit conditions, LBO’s are also rather risky.  When credit markets tighten and asset values drop – as they did most recently during the “Great Recession” of 2008 – the risk is borne primarily by unsecured creditors of the acquisition target. 

LBO’s, popular during the “roaring 80’s” and again during the “go-go” years of the George W. Bush Administration, are once again crashing and burning in significant numbers.  Recent victims include household names like Chrysler, Hawaiian Telcom, Linens ‘N Things, Simmons, LyondellBasell, Capmark Financial Group Inc., and Tribune Co.  Others, including Clear Channel Communications, Harrah’s Entertainment, and TXU, have defaulted on their LBO debt.  Indeed, nearly half of non-financial American companies that defaulted on Moody’s-rated debt instruments in 2009 were reportedly leveraged acquisitions of private-equity funds.

Companies with overburdened balance sheets are forced to “de-leverage” and restructure their debt, typically at the expense of these creditors.  Because the essence of an LBO is the use of secured debt to finance an acquisition, the historical response to ”de-leveraging” has been for unsecured creditors to attempt to unwind the security interests encumbering the company’s assets.  These efforts are typically undertaken through fraudulent transfer claims – which are reportedly on the rise in the wake of last year’s financial turmoil.

The original idea behind fraudulent transfer claims – which trace their roots back nearly half a millenium in Anglo-American commercial law – was that debtors shoudln’t be able to place valuable assets beyond the reach of their creditors.  The idea is a simple one, but proving a debtor’s subjective intent is often far more difficult than it looks.

In light of this difficulty, courts have developed certain “objective tests” to determine whether a transaction is “construtively fraudulent.”  Though a number of modern variations exist, their primary theme is that transfers made (or liabilities incurred) by a debtor in a financially precarious position may be “avoided” (i.e., unwound).

A debtor is generally considered to be in a financially precarious position if it receives less than “reasonably-equivalent value” in exchange for property or debt while the debtor (1) is insolvent at the time of the exchange; (2) is rendered insolvent by the exchange; (3) is left, following the exchange, with “unreasonably small capital” for the business in which it is engaged or is about to engage; or (4) intends to or believes it will incur, debts it would be unable to pay as they matured.

Where an LBO is found to have been a fraudulent transfer, the court’s order that the transfer is avoided may include: (1) stripping the lender of its liens; (2) recovery of loan payments and fees; (3) subordination or disallowance of lender’s claims in bankruptcy; and (4) recovery of fees paid to professionals in connection with a leveraged buyout.

As attractive as all this might sound for unsecured creditors, unwinding an LBO as “constructively fraudulent” is unfortunately only slightly less difficult than establishing subjective fraudulent intent.  As a result, such creditors have little recourse but to settle fraudulent transfer claims very cheaply.  LBO participants, on the other hand, are incentivized to take on risky acquisitions at the creditors’ [potential] expense.

That, at least, is the argument put forth by John Ginsberg in his recently-uploaded draft article entitled “Remedying Law’s Failures to Remedy Fraudulent Transfers in Leveraged Buyouts” (downloadable at SSRN).

Ginsberg, an in-house lawyer at an unnamed federal agency, focuses on the “unreasonably small capital” test (the test most commonly used in attacking an LBO) and argues that the standard for meeting that test – whether insolvency is ”reasonably foreseeable” – requires far greater certainty in order for creditors to realize the protections intended for them by fraudulent transfer law.

In essence, Mr. Ginsberg argues that rather than asking whether insolvency is “reasonably foreseeable,” courts ought to clarify “reasonable foreseeability” in probabalistic terms.  It should be easier to attack (or to defend) a fraudulent transfer if it can be shown, for example, that the “probability” of insolvency at the time of an LBO was 50% – or 60%, or 75%.  Further, courts ought to articulate what, for them, constitutes an acceptable margin of error (say, 40% risk of insolvency with a margin of error of +/- 15%).

Finally, Mr. Ginsberg argues that a “probabalistic” approach eliminates the potential confusion arising when a subsequent “insolvency triggering event” is blamed for sinking a perhaps-somewhat-risky-but-otherwise-perfectly-viable LBO: If the probability of insolvency is established ahead of such a “trigger event,” it is far easier to determine whether or not that event is, in fact, a significant factor in the company’s failure.

Mr. Ginsberg’s article (a working copy of which is available on SSRN) is an interesting read – not least because it offers a succinct and accessible snapshot of recent decisions addressing fraudulent transfers and LBOs.

Mr. Ginsberg’s proposed approach is also not the only one available to those seeking a more “objective” treatment of LBO financing.  A number of authors have suggested that the “foreseeability of insolvency” may be best determined by reference to prevailing industry liquidity and solvency ratios.  These are easily accessible through research databases, and provide some objective benchmarks as to what the participants in an LBO transaction might reasonably have anticipated at the time of the transfer.

That said, even these more “objective” approaches are not without their problems.

For example, if courts in a particular jurisdiction have enunciated a 50% or greater probability as the threshold for “reasonably foreseeable” insolvency, won’t the parties engaging in an LBO simply adjust their forward-looking assumptions to be certain that the “probability” is something less than 50%?  And what level of probability rises to the level of “reasonably foreseeable” in the first place?  Ginsberg’s article acknowledges this last uncertainty, and leaves the matter open for discussion.

Ratio-based tests also have their own problems.  Which solvency ratios are most meaningful to a particular industry?  And which ones is a court most likely to apply to a particular transaction?  Though ratios are comparatively easy to compute, their application has been a subject for juducial hand-wringing and scholarly suggestions for the better part of 8 decades.

Something to think about.

The esoteric world of credit default swaps and other derivative securities often appears far removed from the everyday practice of Chapter 11.  But the impact of this little-known (and often less-understood) corner of the securities market upon the bankruptcy world has recently garnered considerable academic interest – and is now attracting some legislators’ attention as well.

Several posts on this blog (beginning here) have summarized the intersection between credit default swaps and bankruptcy.  Some academics have explored the potential indirect effect of these securities upon out-of-court netogiations – focusing primariliy on the potential problems of “holdout” creditors and the ”empty creditor hypothesis.”  Others (here and here) have offered their preliminary thoughts on the continued usefulness of the Bankruptcy Code’s “securities safe harbors,” originally included to shield financial markets from the effects of large bankruptcy filings – but now perceived as distorting creditor priorities and possibly exacerbating the financial risk created by such events.

Some portions of this debate (such as the true impact of CDS’s on corporate insolvency) continue to play out in the realities of Chapter 11 economics.  Other portions (such as the continued viability of the Bankruptcy Code’s “safe harbor” rules) are beginning to work themselves – albeit slowly – into legislative proposals.

Within the last 30 days, Florida’s Sen. Bill Nelson has offered a brief, 2-page amendment to the proposed financial reform legislation now working its way through the US Senate.  In essence, the amendment would strip the “safe harbors” out of the Bankruptcy Code, ostensibly “leveling the playing field” for all creditors.

For its simplicity, the amendment – which has no co-sponsors – has provoked still further discussion amongst academics.  Seton Hall’s Steve Lubben commends it as a good “first step” toward amending the Bankruptcy Code, but believes further compromise is necessary (his proposed compromises are outlined here).  Harvard’s Mark Roe says, in an updated research paper, that the amendment deserves “central consideration” in connection with financial reform legislation.

Practitioners and business people who have toiled in and around US-based restructuring work are well-acquainted with one of the great strengths (and primary threats) of Chapter 11:  The ability of a debtor to restructure its secured obligations over the objection of a lender through the use of the “cram-down” procedures of Section 1129(b).

For those who may be less familiar, the concept of “cram-down” is not as difficult than the colorful term might suggest.  Essentially, a debtor may confirm a Chapter 11 plan and restructure its debts over the objection of secured creditors so long as the debtor’s plan offers those creditors the present value of their allowed secured claims, such that they receive an appropriate rate of interest which accurately maintains the present value of their concern.

Fighting over “cram-down,” therefore, really boils down to fighting over which interest rate ought to apply to the lender’s restructured loan.

In an era where real estate and other collateralized capital assets are under significant duress (and “risk-free” rates of interest are near all-time lows), the issue of “cram-down” is once again a matter of immediate relevance – and its resolution can often spell the difference between restructuring or foreclosure.

Because the notion of “cram-down” has been part of US insolvency jurisprudence for decades, US Courts have accumulated considerable collective sophistication in addressing the financially-oriented evidence and arguments that surround “cram-down fights.”

But sophistication does not mean consistency.

Last week, Ray Clark of Orange County-headquartered VALCOR Consulting, LLC released a succinct overview of some of the more notable case law surrounding “cram down” developed in the years since the US Supreme Court decided Till v. SCS Credit Corp., 541 U.S. 465, 124 S.Ct. 1951 (2004).

Tracing several key cases issued by Circuit Courts of Appeal since Till, Ray – who has previously appeared on this blog as a guest – offers a very concise, readable summation of what it takes to win (or defeat) a “cram down” effort in Chapter 11.

One of Ray’s strengths is his ability to make the often unfamiliar and complex financial underpinnings of restructuring work accessible to the average, intelligent business person.  His summary is available here – and is well worth a read.

Questions?

Contact rclark@valcoronline.com or mgood@southbaylawfirm.com.

From the Fifth Circuit Court of Appeals, a recent decision regarding the curious (and well-aged) bankruptcy of Yuval Ran offers a thought-provoking consideration of what is required to obtain US recognition of a foreign individual’s bankruptcy case.

The Curious Case of Mr. Ran

Mr. Ran, an Israeli citizen, was at one point a director or shareholder in almost one hundred Israeli companies – some publicly-traded, and the largest of which was Israel Credit Lines Supplementary Financial Services Ltd. (“Credit Lines”), a public company co-founded and run by Ran, who served as CEO.

After raising millions of dollars from investors and acquiring interests in numerous other companies, Credit Lines ultimately found itself in liquidation through an Israeli bankruptcy proceeding. Credit Lines’ bankruptcy receiver asserted claims against Ran for millions of dollars in damages.

In June 1997, an involuntary bankruptcy proceeding was commenced against Ran in the Israeli District Court of Tel Aviv-Jaffa – but not before Ran and his family had departed Israel for Houston, Texas. Since their departure, Ran and his wife purchased a home and went to work for a local furniture company. Ran’s wife and five children are US citizens, and Ran himself is a permanent resident seeking US citizenship. With the exception of some minimal collection work on Credit Lines’ behalf shortly after he arrived in the US, Ran did no further business in Israel.

In December 2006 – nearly a decade after Ran and his family emigrated, and more than eight years after being appointed receiver of Ran’s estate – Zuriel Lavie, the receiver appointed for Ran’s Israeli assets, sought recognition of the Israeli bankruptcy proceeding as a foreign main or non-main proceeding under Chapter 15 of the Bankruptcy Code in the Southern District of Texas’ Bankruptcy Court.

Levie’s petition was denied the following May. After two rounds of appeals to the District Court, the parties finally found themselves before the Fifth Circuit Court of Appeals.

In affirming the District Court and the Bankruptcy Court’s denials, the Fifth Circuit briefly reviewed the procedural requirements for recognition set forth in Section 1517 of the Bankruptcy Code, then turned its attention to the one item of substance – whether the debtor’s bankruptcy proceeding qualified either as a foreign “main” or “non-main” proceeding as contemplated by Chapter 15.

“Main Proceeding” – Where is COMI?

Under US law – as under the UNCITRAL Model Law upon which it is based – a foreign “main proceeding” qualifies as such if the jurisdiction where it is pending is the debtor’s “center of main interests” (COMI). In the case of an individual such as Ran, COMI is presumptively the debtor’s “place of habitual residence” – a concept roughly equivalent to the debtor’s “domicile,” or physical presence coupled with an intent to remain there. One acquires a “domicile of origin” at birth, and that domicile continues until a new one (a “domicile of choice”) is acquired.

A similar concept – that of “habitual residence” – likewise applies under foreign law when the individual intends to stay in a specified location permanently. Factors pertinent to establishing an individual’s “habitual residence” include: (1) the length of time spent in the location; (2) the occupational or familial ties to the area; and (3) the location of the individual’s regular activities, jobs, assets, investments, clubs, unions, and institutions of which he is a member.

Under these facts, Ran’s COMI was presumptively in the US – and not in Israel. However, the presumption of COMI may be rebutted. Levie sought to do so by introducing evidence at the District Court that: (1) Ran’s creditors are located in Israel; (2) Ran’s principal assets are being administered in bankruptcy pending in Israel; and (3) Ran’s bankruptcy proceedings initiated in Israel and would be governed by Israeli law.

Ran countered by pointing out that: (1) Ran along with his family left Israel nearly a decade prior to the filing of the Chapter 15 petition; (2) Ran has no intent to return to Israel; (3) Ran has established employment and a residence in Houston, Texas; (4) Ran is a permanent legal resident of the United States and his children are United States citizens; and (5) Ran maintains his finances exclusively in Texas.

In weighing this evidence, the Fifth Circuit relied on earlier analysis in In re SPhinX, Ltd., 351 B.R. 103 (Bankr. S.D.N.Y. 2006), aff’d, 371 B.R. 10 (S.D.N.Y. 2007) – and more specifically, on analysis in In re Loy, 380 B.R. 154. 162 (Bankr. E.D. Va. 2007) (the only case to address the concept of COMI with respect to an individual debtor) – in which the Bankruptcy Court noted that factors such as (1) the location of a debtor’s primary assets; (2) the location of the majority of the debtor’s creditors; and (3) the jurisdiction whose law would apply to most disputes, may be used to determine an individual debtor’s COMI when there exists a serious dispute. The Fifth Circuit found that, unlike the Loy decision, the initial presumption (and the ultimate preponderance of evidence) under these factors weighed in Ran’s favor.

Undeterred, Lavie argued that the Fifth Circuit ought not to confine its COMI inquiry to the “snapshot” of Ran’s domicile that existed at the time the Chapter 15 petition was filed. Instead, he argued that the Fifth Circuit ought to look back to Ran’s “operational history” in Israel for a more comprehensive determination of COMI.

The Fifth Circuit panel was not persuaded. Instead, it looked to the statute’s use of present tense (i.e., a “main proceeding” is a “foreign proceeding pending in the country where the debtor has the center of its main interests”) to determine the COMI inquiry as dispositive of what evidence was relevant, and what evidence was not.

The panel then went on to provide policy bases for the “snapshot” approach to COMI, explaining that locating COMI as of the date the petition is filed aids international harmonization and promotes predictability. Perhaps most significantly the panel noted “it is important that the debtor’s COMI be ascertainable by third parties . . . . The presumption is that creditors will look to the law of the jurisdiction in which they perceive the debtor to be operating to resolve any difficulties they have with that debtor, regardless of whether such resolution is informal, administrative or judicial.”

“Non-Main” Proceeding

On the question of whether Ran’s proceeding was a foreign “non-main” proceeding, the Fifth Circuit panel pondered its definition, i.e., “a foreign proceeding, other than a foreign main proceeding, pending in a country where the debtor has an establishment.” Lavie argued that Ran’s involuntary proceeding in Israel was, in itself, an “establishment.” Section 1502(2), however, defines an “establishment” as “any place of operations where the debtor carries out a nontransitory economic activity.”

Unlike COMI, the existence of an “establishment” is a simple factual determination with no presumptions in anyone’s favor.  However, one court has noted that “the bar is rather high” to prove the debtor maintains an “establishment” in a foreign jurisdiction.

In essence, the Fifth Circuit found that in order to have an “establishment,” Ran must have had “a place from which economic activities are exercised on the market (i.e. externally), whether the said activities are commercial, industrial or professional” at the time that Lavie filed the petition for recognition.

For the same reasons that gave rise to the Fifth Circuit’s weight of the evidence in Ran’s favor regarding the “main proceeding,” the Israeli proceeding was determined not to be a “non-main” proceeding – and, therefore, not entitled to any recognition within the US.

In addition to being the first appellate decision addressing an individual’s COMI, the Ran case is noteworthy for the proposition that the mere existence of an individual’s insolvency proceeding, pending in another jurisdiction, is insufficient to qualify for recognition under US law. Instead, there must be a demonstration of ongoing activity – either through a showing of COMI, or through the “establishment” of ongoing activity – to qualify.

Further, though it is specifically limited to its own facts, the Ran decision offers a glimpse into the Fifth Circuit’s general approach to COMI – in particular, its observance that the debtor’s COMI should be ascertainable by third parties. This observance may prove significant in the event that similar disputes over the much larger and more contentious Stanford proceedings (see prior posts about Stanford here) ever make their way to the Circuit Court.

The Advisory Committee on Bankruptcy Rules of the Administrative Office of the U.S. Courts has pulled back from its earlier position on the disclosure required of hedge fund and other distressed debt investors participating as ad hoc committees or other, loosely organized creditor groups in Chapter 11 cases.

An earlier version of proposed amendments to Federal Rule of Bankruptcy Procedure 2019 would have required such investors to disclose the dates and prices paid for their purchases of distressed securities.  These changes were resisted by investor groups such as the Loan Syndications and Trading Association, and created some press coverage last year (an earlier post on the amendments is available here).

That said, investors will still be required to reveal the “disclosable economic interest” they each hold in a company, including debt and derivatives. This includes the identity of specific investors and the date such investors acquired their interests.

Morever, Committee notes to the proposed rule indicate that the previously-contested disclosures of pricing and purchase dates may be compelled through discovery or by the Court acting under its own authority outside the proposed rule.

A copy of the proposed rule, along with a summary of comments received on earlier versions and the Committee’s advisory notes, is available here.