JSC BTA Bank (BTA), reportedly the second largest bank in Khazakstan, sought protection for its US-based assets through Chapter 15 last Thursday in New York’s Southern District.

The Chapter 15 filing in Manhattan appears to be part of Khazakstan’s own banking bailout for BTA.  In papers submitted to Bankruptcy Judge James Peck, BTA Chairman Anvar Saidenov represented, through BTA’s counsel, that between 2004 and 2007 BTA expanded rapidly with significant increases in its total assets and number of branches and cash offices.  This expansion was primarily funded through short- and medium-term bank borrowings and the issue of securities in the international capital markets.  Khazakstan’s credit-rating downgrade in late 2007 precluded BTA from refinancing its short-term credit lines, which in turn curtailed BTA’s ability to make new loans.

Beyond the Kazakh credit downgrades, BTA allegedly further suffered “significant losses” due to “fraudulent and ulawful transactions entered into by [BTA's] former management prior to February 2009.”

Before last February, the Republic of Kazakhstan and its Agency for Regulation and Supervision of Financial Markets and Financial Organizations (FMSA) had previously announced a proposal to recapitalize BTA as part of a broader plan to stabilize the country’s financial system. The plan involved JSC National Welfare Fund Samruk-Kazyna (Samruk-Kazyna), Kazakhstan’s sovereign wealth fund, providing financial support to struggling financial institutions.  At the same time, Samruk-Kazyna acquired a controlling 75.1 % of BTA’s total share capital.  BTA also continued to down-size its operating activities in response to the deteriorating market and BTA’s financial condition.

BTA’s recapitalization triggered “change-of-ownership” clauses and demands for repayment under some of its lines of credit from foreign lenders.  These and other, continuing regulatory problems inside Khazakstan ultimately led to a preliminary restructuring plan in mid-2009.

At the end of August 2009, the Kazakh government enacted banking regulatory legislation which put into place, among other things, an insolvency regime to deal with the restructuring of financial institutions.  BTA sought protection under this new legislation less than 45 days after its enactment, thereby obtaining a stay of all relevant claims of BTA’s creditors and protection of BTA’s property from execution and attachment until completion of the restructuring.

BTA’s restructuing - presently contemplated within the third quarter of 2010 - presently contemplates that creditors of the Bank, including Samruk-Kazyna and certain related parties (excluding depositors and certain government agencies funding special loan programs) will receive a mixture of cash, senior debt, subordinated debt, other forms of debt, equity and so-called “recovery notes” in consideration for the restructuring of their claims.  Payments on the “recovery notes” will be funded by cash recoveries on any provisioned assets, litigation recoveries, and deferred tax recoveries.

The market collapse of 2008 and resulting financial crisis have led to significant reflection on a number of systemic features of our financial markets and on the stability of institutions that play significant roles in their function.

That reflection has produced a fresh round of legal scholarship on what role - if any - the federal Bankruptcy Code should play in addressing the financial difficulties of these institutions.  In a recent paper, Columbia’s Harvey R. Miller Professor of Law Edward R. Morrison asks, “Is the Bankruptcy Code an Adequate Mechanism for Resolving the Distress of Systemically Important Institutions?”

The issue, at least as put by Professor Morrison in the opening paragraphs of his paper, is framed as follows:

The President and members of Congress are considering proposals that would give the government broad authority to rescue financial institutions whose failure would threaten market stability. These systemically important institutions include bank and insurance holding companies, investment banks, and other “large, highly leveraged, and interconnected” entities that are not currently subject to federal resolution authority.  Interest in these proposals stems from the credit crisis, particularly the bankruptcy of Lehman Brothers.

That bankruptcy, according to some observers, caused massive destabilization in credit markets for two reasons.  First, market participants were surprised that the government would permit a massive market player to undergo a costly Chapter 11 proceeding. Very different policy had been applied to other systemically important institutions such as Bear Stearns, Fannie Mae, and Freddie Mac.  Second, the bankruptcy filing triggered fire sales of Lehman assets. Fire sales were harmful to other, non-distressed institutions that held similar assets, which suddenly plummeted in value. They were also harmful to any institution holding Lehman’s commercial paper, which functioned as a store of value for entities such as the Primary Reserve Fund. Fire sales destroyed Lehman’s ability to honor these claims.

Lehman’s experience and the various bailouts of AIG, Bear Stearns, and other distressed institutions have produced two kinds of policy proposals. One calls for wholesale reform, including creation of a systemic risk regulator with authority to seize and stabilize systemically important institutions.  Another is more modest and calls for targeted amendments to the Bankruptcy Code and greater government monitoring of market risks.  This approach would retain bankruptcy as the principal mechanism for resolving distress at non-bank institutions, systemically important or not.

Put differently, current debates hinge on one question: Is the Bankruptcy Code an adequate mechanism for resolving the distress of systemically important institutions? One view says “no,” and advances wholesale reform. Another view says “yes, with some adjustments.”

Morrison’s paper sets out to assess this debate, and concludes by advocating [again, in his words] ”an approach modeled on the current regime governing commercial banks. That regime includes both close monitoring when a bank is healthy and aggressive intervention when it is distressed. The two tasks - monitoring and intervention - are closely tied, ensuring that intervention occurs only when there is a well-established need for it.” As a result of the close relationship between the power to intervene and the duty to monitor, however, any proposed legislation “is unwise if it gives the government power to seize an institution regardless of whether it was previously subject to monitoring and other regulations.”

Elsewhere in the Empire State, at the University of Rochester, Distinguished Professor Thomas H. Jackson proposes “Chapter 11F: A Proposal for the Use of Bankruptcy to Resolve (Restructure, Sell, or Liquidate) Financial Institutions.“  According to Jackson:

Bankruptcy reorganization is, for the most part, an American success story. It taps into a huge body of law, provides certainty, and has shown an ability to respond to changing circumstances. It follows (for the most part) nonbankruptcy priority rules - the absolute priority rule - with useful predictability, sorts out financial failure (too much debt but a viable business) from underlying failure, and shifts ownership to a new group of residual claimants, through the certainty that can be provided by decades of rules and case law.

Notwithstanding its success, bankruptcy reorganization has a patchwork of exceptions, some perhaps more sensible than others.  Among them are depository banks (handled by the FDIC), insurance companies (handled by state insurance regulators), and stockbrokers and commodity brokers (relegated to Chapter 7 and to federal regulatory agencies).  In recent months, there has been a growing chorus to remove bankruptcy law, and specifically its reorganization process, from “systemically important financial in-stitutions (SIFIs),” with a proposed regulatory process substituted instead, run by a designated federal agency, such as the Federal Reserve Board or the Securities and Exchange Commission.

Putting aside political considerations, behind this idea lie several perceived objections to the use of the bankruptcy process.  First, it is argued, bankruptcy, because it is focused on the parties before the court, is not able to deal with the impacts of a bankruptcy on other institutions - an issue thought to be of dominant importance with respect to SIFIs, where the concern is that the fall of one will bring down others or lead to enormous problems in the nation’s financial system.  Second, bankruptcy - indeed, any judicial process - is thought to be too slow to deal effectively with failures that require virtually instant attention so as to minimize their consequences.  Third - and probably related to the first and second objections - even the best-intentioned bankruptcy process is assumed to lack sufficient expertise to deal with the complexities of a SIFI and its intersection with the broader financial market.

Jackson’s response to this growing chorus of objections is to propose amending existing Chapter 11 legislation.  Again, in his words:

The premise of [Jackson's] “Chapter 11F” proposal, which [he] flesh[es] out [in his paper], is that, assuming the validity of each of these objections, they, neither individually nor collectively, make a case for creating yet another (and very large) exception to the nation’s bankruptcy laws and setting up a regulatory system, run by a designated federal agency, that operates outside of the predictability-enhancing constraints of a judicial process. Rather, bankruptcy’s process can be modified for SIFIs - [Jackson's] Chapter 11F - to introduce, and protect, systemic concerns, to provide expertise, and to provide speed where it might, in fact, be essential. Along the way, there is probably a parallel need to modify certain other existing bankruptcy exclusions, such as for insurance companies, commodity brokers, stockbrokers, and even depository banks, so that complex, multi-faceted financial institutions can be fully resolved within bankruptcy.

With views as divergent as these, one might be tempted to look for a fundamental assessment of the differences between the banking regulatory system and the Chapter 11 process.  And that assessment is, in fact, available from the Congressional Research Service - which last April provided its own comparison of “Insolvency of Systemically Significant Financial Companies: Bankruptcy v. Conservatorship / Receivership.“  As summarized by its author, Legislative Attorney David H. Carpenter:

One clear lesson of the 2008 recession, which brought Goliaths such as Bear Sterns, CitiGroup, AIG, and Washington Mutual to their knees, is that no financial institution, regardless of its size, complexity, or diversification, is invincible. Congress, as a result, is left with the question of how best to handle the failure of systemically significant financial companies (SSFCs). In the United States, the insolvencies of depository institutions (i.e., banks and thrifts with deposits insured by the Federal Deposit Insurance Corporation (FDIC)) are not handled according to the procedures of the U.S. Bankruptcy Code. Instead, they and their subsidiaries are subject to a separate regime prescribed in federal law, called a conservatorship or receivership. Under this regime, the conservator or receiver, which generally is the FDIC, is provided substantial authority to deal with virtually every aspect of the insolvency. However, the failure of most other financial institutions within bank, thrift, and financial holding company umbrellas (including the holding companies themselves) generally are dealt with under the Bankruptcy Code.

In March of 2009, Treasury Secretary Timothy Geithner proposed legislation that would impose a conservatorship/receivership regime, much like that for depository institutions, on insolvent financial institutions that are deemed systemically significant. In order to make a policy assessment concerning the appropriateness of this proposal, it is important to understand both the similarities and differences between insured depositories and other financial institutions large enough or interconnected enough to pose systemic risk to the U.S. economy upon failure, as well as the differences between the U.S. Bankruptcy Code and the FDIC’s conservatorship/receivership authority.

[Carpenter's] report first discusses the purposes behind the creation of a separate insolvency regime for depository institutions. The report then compares and contrasts the characteristics of depository institutions with SSFCs. Next, the report provides a brief analysis of some important differences between the FDIC’s conservatorship / receivership authority and that of the Bankruptcy Code. The specific differences discussed are: (1) overall objectives of each regime; (2) insolvency initiation authority and timing; (3) oversight structure and appeal; (4) management, shareholder, and creditor rights; (5) FDIC “superpowers,” including contract repudiation versus Bankruptcy’s automatic stay; and (6) speed of resolution. This report makes no value judgment as to whether an insolvency regime for SSFCs that is modeled after the FDIC’s conservatorship/receivership authority is more appropriate than using (or adapting) the Bankruptcy Code. Rather, it simply points out the similarities and differences between SSFCs and depository institutions, and compares the conservatorship/receivership insolvency regime with the Bankruptcy Code to help the reader develop his/her own opinion.

Fascinating reading . . . and an awful lot of it.

From New York’s Southern District comes the strange tale of the Canadian asset backed commercial paper market, and a decision that raises the question of whether foreign courts provide a possible strategic “end run” around US law for parties doing business in the US - and even for US litigants with a business presence overseas.

Collapse of the Canadian Asset Backed Commercial Paper Market

Asset backed commercial paper (ABCP) is a Canadian short-term investment with a low interest yield.  Generally marketed as a “safe” investment, ABCP is considered “asset backed” because the cash used to purchase these notes goes to create a portfolio of financial or other assets, which are then security for repayment of the originally issued paper.  In flush times, ABCPs were typically paid off with the proceeds from the purchase of new paper - or simply rolled over into new paper purchases themselves.

But times did not stay flush.

By 2007, ABCPs were collateralized by everything from auto loans to residential mortgages - which, unlike the “short-term” paper they backed, had much longer maturities.  With the rapidly-cresting economic downturn, uncertainty began to ripple through the ABCP market by mid-2007.  Because ABCPs were not transparent investments and investors could not determine which assets backed their paper, the uncertainty soon grew into a full-scale liquidity crisis.

The Big Freeze - And The Planned Thaw

In August 2007, approximately CAN$32 billion of non-bank sponsored ABCP in the Canadian market was frozen after an agreement between the major market participants.  This “freeze” was implemented pending an attempt to resolve the crisis through a restructuring of the market.  A “Pan-Canadian Investors Committee” was created, which introduced a creditor-initiated Plan of Compromise and Arrangement under the Canadian Companies’ Creditors Arrangement Act (CCAA).  The Plan was sanctioned in June 2008 in the Metcalfe cases.  Essentially, the Plan converted the noteholders’ frozen paper into new, long-term notes with a discounted face value that could be traded freely, in the hope that a strong secondary market for the notes would emerge in the long run.

Releases for Third Parties

Part of the Plan required that market participants, including banks, dealers, noteholders, asset providers, issuer trustees, and liquidity providers be released from any liability related to ABCP, with the exception of certain narrow fraud claims.  Among those receiving these releases were Bank of America, Deutsche Bank, HSBC Bank USA, Merrill Lynch International, UBS, and Wachovia Bank and their respective affiliates.

These third party releases were themselves the subject of appellate litigation in Canada, but were eventually upheld as within the ambit of the CCAA.  The Plan became effective in January 2009, and the court-appointed monitors (Ernst & Young, Inc.) sought US recognition of the Metcalfe cases in New York the following October.  More specifically, the monitors sought enforcement in the US of the third-party releases which were a centerpiece of the Canadian Plan.

Third-party releases of non-bankrupt parties are significantly limited under US bankruptcy law - and, in a number of circuits, prohibited altogether.  In the 2d Circuit - where the recognition cases are pending - they are permissible only where (i) “truly unusual circumstances render the release terms important to the success of the plan;” and (ii) the released claims “directly affect the res (i.e., the property) of the bankruptcy estate.”  In Bankruptcy Judge Martin Glenn’s view, the Canadian releases went a bit further than what the 2d Circuit would otherwise permit.  Nevertheless, Ernst & Young asked Judge Glenn to permit them.

Recognition and Enforcement In the US

Ernst & Young’s request was based, first, on Section 1509, which requires that if a US Bankruptcy Court grants recognition in a foreign main proceeding, it “shall grant comity or cooperation to the foreign representative.”  Moreover, where recognition is granted, the US court “may provide additional assistance to [the] foreign representative” (Section 1507(a)), provided that such assistance is “consistent with the principles of comity” and serves one or more articulated policy goals set forth in Section 1507(b).  The decision to provide such assistance “is largely discretionary and turns on subjective factors that embody principles of comity.”  It is also subject to a general but narrowly construed ”public policy” restriction in Section 1506.

Comity

Though it is given prominence in Chapter 15, the American concept of “comity” in fact grows out of many decades of US commercial experience: Over a century ago, the emerging freedom of markets, comparatively few limits on imports, exports, immigration and exchanges of information and capital flows gave rise to what has been termed as the “first age of globalization.” In keeping with the spirit of that age, US courts of the period sought to resolve commercial disputes involving international litigants in a manner that would facilitate free international trade. They did so by preserving, where possible, the sanctity of rulings rendered in foreign tribunals as those rulings pertained to US citizens involved in foreign transactions. Those efforts found their expression through application of the case law doctrine of “comity.”

As expressed long ago by the US Supreme Court, “comity” is that “recognition which one nation allows within its territory to the legislative, executive or judicial acts of another nation.” As described by more modern precedent, US courts will recognize the “[a]cts of foreign governments purporting to have extraterritorial effect” when those acts are consistent with US law and policy.

It is worth noting that “consistent with US law and policy” does not mean identical with US law and policy.  As Judge Glenn observed, “[t]he relief granted in the foreign proceeding and the relief available in a [US] proceeding need not be identical.”  Instead, the “key determination” is “whether the procedures used in [the foreign court] meet [US] fundamental standards of fairness.”

“Fundamental standards of fairness” are understandably vague, and - beyond the basic idea of due process - often difficult to establish.  In this case, Judge Glenn essentially found that though the releases in question likely went beyond what would pass muster under US law, third party releases weren’t completely unheard of - and besides, the decision of a Canadian court of competent jurisdiction should be entitled to recognition as a matter of comity in any event.

What It All Means

The Metcalfe decision is interesting.  One one hand, it seems to provide merely another example of the well-recognized fact that Canadian judgments are routinely upheld by US courts.  However, it also suggests that parties with access to foreign tribunals with insolvency schemes resembling the US, but providing relief somewhat different from (i.e., more favorable to) that available under US insolvency law, may be able to maneuver around US law by filing a “main [insolvency] case” in a foreign jurisdiction, then seeking recognition and enforcement of that relief in the US - on the basis of comity.

Something to think about.

Recent federal assistance to the banking sector has focused attention on how failing banks are regulated - and why.  From the University of Virginia School of Law, professors Richard M. Hynes and Steven D. Walt visit this issue in their recent article entitled “Why Banks Are Not Allowed in Bankruptcy.”

Here’s the article - and the authors’ abstract:

Unlike most other countries, the United States uses different procedures to resolve insolvent banks and non-bank firms. When non-bank firms file for bankruptcy, the Bankruptcy Code divides control among the various claimants and a judge supervises the resolution process. By contrast, the FDIC acts as the receiver for an insolvent bank and has almost complete control. Other claimants can sue the FDIC, but they cannot obtain injunctive relief, and their damages are limited to the amount that they would have received in liquidation. The FDIC has acted as the receiver of insolvent banks since the Great Depression, and the concentration of power in the FDIC is traditionally justified by two arguments: i) the need for a timely disposition of the bank’s assets to maintain the liquidity of deposits and encourage faith in the banking system, and ii) the FDIC’s role as the largest creditor gives it an incentive to maximize the recovery from the assets. We revisit these arguments in light of the dramatic changes that have occurred in banking and ask whether they still (or ever did) justify FDIC control. We suggest that the first argument fails because it conflates the need for a timely satisfaction of the claims of insured depositors by the FDIC with the need to quickly dispose of the failed bank’s assets. As stated, the second argument does not justify FDIC control as one must generally ask whether the largest creditor will take actions that are harmful to the other claimants on the failed firm’s assets. However, if modified the second argument is much more persuasive. A detailed survey of the capital structure of failed banks reveals that the FDIC is usually the only major creditor and that the value of the FDIC’s claim nearly always exceeds the value of a failed bank’s assets. The FDIC is therefore the residual claimant and has the incentive to make the right decisions in disposing of the bank’s assets. We question whether this principle can justify recent proposals to extend FDIC control over the resolution of large bank holding companies. We further note that this principle limits the circumstances in which the FDIC should retain control over the resolution of the banks themselves. Four limits are considered: i) capital structure is endogenous - the absence of claims junior to the FDIC may reflect the lack of voice given to these claimants in a bank resolution process, ii) agency costs internal to the FDIC may prevent the FDIC from maximizing the recovery from the failed bank’s assets, iii) the FDIC may not be the residual claimant of extremely large banks with complex liability structures, and iv) debt conversion schemes which allow for automatic financial restructuring of a failed bank may render bank resolution procedures less necessary. The Article argues that these limits do not justify removing the FDIC from control in resolving most bank failures.

When a foreign business entity commences a bankruptcy proceeding, US courts’ recognition of that proceeding depends on whether or not it is a “foreign main proceeding” under the meaning of US Bankruptcy Code.  Whether or not a foreign bankruptcy is a recognized “foreign main proceeding” depends on the location of the debtor’s “center of main interests” (or “COMI”).

The concept of a debtor’s “COMI” has become a critical one - not only in the US, but in a number of foreign jurisdictions including the UK.  Because the same legal concept arises in multiple jurisdictions, the manner in which the “COMI” concept is applied across international boundaries carries with it the potential for the same sort of duplication, jurisdictional confusion, and mischief that led to the development and implementation of UNCITRAL’s model cross-border insolvency law in the first place.  Consequently, getting COMI right - and getting it consistent across jurisdictional borders - has become a matter of international concern.

The importance of COMI has come to light most recently in the Stanford matter (see prior posts here), where multiple courts have been asked to determine COMI for Stanford International Bank, Ltd. (SIB).  In Texas, Judge David Godbey has taken extensive briefing from the parties in advance of a decision on recognition.  In London, Mr. Justice Lewison’s original decision finding SIB’s COMI to be Antigua - rendered last July - saw approximately 5 days of appellate argument at the end of last year.  The parties presently await a decision from the English Court of Appeal.

The Stanford matter highlights a fundamental question about COMI:  Should it be a flexible concept, susceptible to broad judicial discretion?  Or should COMI be based purely on objective factors, precisely and mechanically applied?

Mr. Justice Lewison’s prior decision in London (summarized and avaialable here) took an essentially mechanistic approach to determining COMI, focusing primarily - as the UK Regulation requires - on what creditors objectively perceived about the debtor.  US law - which, like England’s, is based on the UNCITRAL model - likewise places similar emphasis on creditors’ perceptions in dealing with the debtor.

But did legislators in the UK or the US intend that the analysis should stop with what creditors knew or likely would have known about the debtor?

After all, Stanford’s operation was a sham.  And where creditors’ perceptions of SIB were based on a sham, is it appropriate to perpetuate the sham in determining COMI?

While the English Court of Appeal deliberates Lewison J’s decision, Judge Godbey appears headed in a slightly different analytical direction.  Specifically, the questions on which he’s requested briefing in the Texas proceeding appear to focus more specifically on the similarity of COMI to a debtor’s “principal place of business” as that concept is recognized under US law.  Though not inconsistent with what creditors would have perceived about the debtor, it tends to focus more broadly on factors which, though objective, are not tied as closely to what the debtor held out to specific parties.  Instead, the debtor’s “principal place of business” views the totality of the debtor’s operations - whether or not such operations were completely visible to creditors or other third parties - and, on the basis of these specific facts, determines the debtor’s principal place of business.

Whether a possible change in COMI analysis means a change in SIB’s COMI remains to be seen.

Evidentiary hearings are scheduled for later this month 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.  A series of posts on this blog have covered 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.

The Stanford case is of considerable significance in the US - and in the UK and Canada, where it has spawned at least two decisions and related appeals over the parties’ efforts to obtain cross-border recognition for their respective efforts to clean up the Stanford mess.

In Dallas, Texas, where an enforcement action commenced by the American Securities and Exchange Commission remains pending (and where Mr. Janvey has been appointed as a receiver for the purposes of marshalling Stanford assets for distribution to creditors), US District Court Judge David Godbey has taken prior pleadings from both sides under advisement and, in advance of this month’s hearing, has requested further briefing on three issues.  Mr. Janvey’s brief, submitted last week, addresses each of these as follows:

The Current State of Fifth Circuit Law on What Constitutes an Entity’s “Principal Place of Business,” Including Whether Stanford International Bank’s (”SIB”) Activities Were Active, Passive or “Far Flung.”

The Liquidators have argued that, under applicable Fifth Circuit standards, SIB’s “principal place of business” was Antigua and that its activities were actively managed from Antigua, and were not “far flung” so as to render SIB’s Antiguan location irrelevant.

Predictably enough, Mr. Janvey responds that under appropriate circumstances, the Fifth Circuit applies principles of alter ego and disregards corporate formalities in determining an entity’s “principal place of business:”  “The Fifth Circuit applies alter ego doctrines not only to enforce liability against shareholders and parent companies, but also to determine a corporation’s ‘principal place of business’ for jurisdictional purposes.” (citing Freeman v. Nw. Acceptance Corp., 754 F.2d 553, 558 (5th Cir. 1985)).

Based on this construction of Fifth Circuit law - and because COMI is generally equated to an entity’s “principal place of business” under US corporate law -   Janvey then argues that consistency and logic require the same rules be followed for COMI purposes.  He then goes on to argue that Stanford’s Ponzi scheme activities were “far flung,” that SIB’s Antiguan operations were “passive,” and that its “nerve center” and “place of activity” were both in the U.S.

The Relationship Between SIB and the Financial Advisors Who Marketed SIB’s CDs to Potential Investors.

Wastell and Hamilton-Smith have argued that financial advisors who sold SIB’s CDs to potential investors were, in fact, independent agents employed by other, independent Stanford broker-dealer entities and were not controlled by SIB.

Mr. Janvey pours scorn on this argument.  According to him, it does not matter that there were inter-company “contracts” purporting to make the Stanford broker-dealer entities agents for SIB in the sale of CDs.  As Mr. Janvey views it, a fraud is a fraud . . . from beginning to end.  Consequently, there was no substance to the “contracts” as all the entities involved were instruments of Stanford’s fraud.

The “Single Business Enterprise” Concept as Part of the “Alter Ego” Theory of Imposing Liability.

As noted above, Mr. Janvey takes the position that “alter ego” treatment of the Stanford entities is not only viable - it is the only appropriate means of treating SIB’s relationship to other, US-based Stanford entities, and of determining COMI for SIB.  He argues further that substantive consolidation - the bankruptcy remedy referred to by Messr’s. Wastell and Hamilton-Smith - can be just as effectively accomplished through a federal receivership, which affords US District Courts significant latitude in fashioning equitable remedies and determining distributions to various classes of creditors.

Mr. Janvey’s argument appears quite straightforward.  Because a fraud is a fraud, geography matters very little in determining its “center of main interests.”  According to him, what should count instead is the location of the fraudsters and the place from which the fraud was managed and directed.  Yet even Mr. Janvey acknowledges that “Antigua played a role in [Stanford's Ponzi] scheme . . . [in that] [Antigua] was where Stanford could buy off key officials in order to conduct his sham business without regulatory interference.”  In other words, geography was important . . . at least for Stanford.  Specifically, geography provided Stanford direct access to a corrupt regulator who would afford cover for the conduct of Stanford’s fraudulent CD sales to investors.

Mr. Janvey addresses this potential problem by taking aim at the entire Antiguan regulatory structure:

“Chapter 15 contains a public policy exception: ‘Nothing in the chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States.’ 11 U.S.C. § 1506. The facts warrant application of the public policy exception here. The very agency that first appointed the Antiguan [l]iquidators and then obtained their confirmation from the Antiguan court was complicit in Stanford’s fraud. That same agency has allowed financial fraud to flourish on Antigua for decades. It would be contrary to public policy for this Court to cede to Antigua the winding up of a company that bilked Americans and others out of billions when it was Antigua that permitted the fraud.”

Mr. Janvey then goes further still, arguing that Messr’s. Wastell and Hamilton-Smith (and their employer, British-based Vantis plc) are precluded by Antiguan law from complying with the disclosure requirements Judge Godbey has imposed on the US receivership - and therefore simply unable to concurrently administer a “main case” in Antigua and cooperate with the Receiver (or with the District Court) in the US.

Finally, Mr. Janvey gets directly personal: He recites the opinion of the Canadian court that revoked Vantis’ administration of Stanford’s Canadian operations and refused recognition of the Antiguan wind-up on the grounds that “Vantis’ conduct, through [Messr's. Wastell and Hamiton-Smith], disqualifies it from acting and precludes it from presenting the motion [for Canadian recognition], as [Vantis] cannot be trusted by the [Canadian] Court . . . .”  The Canadian court’s opinion has been upheld on appeal, and is now final.

In a nutshell, Mr. Janvey argues that geography shouldn’t matter where a fraud is concerned . . . but if it does matter, it ought to count against jurisdictions such as Antigua, an “impoverished island” which has a population “about 80% that of Waco, Texas” and a history of financial fraud.

As is sometimes said in Texas, “Them’s fightin’ words.”

The SEC’s brief, like Mr. Janvey’s, is also on file.  Messr’s. Wastell and Hamilton-Smith’s reply will be due shortly.

A significant amount of ink has been spilled in recent months over the state of the financial derivatives markets and their role in 2008’s financial melt-down.

Some of that ink has spilled into the area of corporate insolvency - and in particular, into an examination of whether or not credit default swaps (CDSs) - a type of derivative instrument designed to let a creditor hedge its risk with a debtor - have any impact on the dynamics of work-out negotiations when the debtor experiences difficulty repaying the debt.

This blog has devoted two prior posts (here and here) to the role of CDSs and bankruptcy.  One of the troubling issues raised by researchers (and noted here) in connection with the distressed debt market has been whether or not high-risk investors (i.e., speculators) might be incentivized to buy CDSs on distressed debt, banking on the debtor’s default (akin to “naked short selling” of a company’s stock) on the anticipation that the debtor would fail - thereby triggering a payout on the CDS.  This issue is known more popularly as the “empty creditor problem” - so-called because speculators holding the CDSs issued with respct to a distressed company are not legitimate creditors, but merely risk-takers maneuvering to profit from (and thereby attempting to engineer) corporate failure.

As 2009 draws to a close, the International Swaps and Derivatives Association (ISDA) has stepped into the debate with a recently published research paper on the matter.  Entitled “The Empty Creditor Hypothesis,” the ISDA’s research paper argues - convincingly - that this sort of speculation is far less a problem than some have suggested.  This is so primarily because the pricing on CDSs begins to rise dramatically as the CDS-backed debtor begins to falter.  Therefore, the profits to be made from purchasing such CDSs are, effectively, non-existent - and there is little reason to speculate in them.

The ISDA’s point is that there simply isn’t enough of a profit to be made in purchasing CDSs typically issued on distressed firms - and therefore, insufficient potential payoff to attract the sort of “empty creditors” that have concerned distressed debt researchers.  As a result, the “empty creditor problem” really isn’t a “problem.”

But speculation isn’t the only point of impact that CDSs may have on a distressed debtor’s efforts to negotiate with creditors.  Where the holder of a CDS is also the original lender or the holder of CDS-backed debt, the existence of such derivative securities - which effectively “back-stop” the underlying debt similar to the way in which a fire insurance policy “back-stops” the risk of loss on a building - may incentivize the company’s creditors to be far less flexibile in their discussions with the debtor.

The ISDA attempts to address this potential effect by pointing to a small sample of data available for the research paper, which suggests that during the period that CDS hedging has been available, workouts (i.e., restructuring events) have grown as a percentage of the number of defaults recorded during the same period.  Therefore, “the . . . statistics presented . . . would not appear to support the empty creditor hypothesis, according to which the availability of credit default swaps would make restructurings less likely.”  However, the ISDA admits that

“[a] full analysis of the relationship between [the] likelihood of restructuring and availability of hedging with credit default swaps would require extensive data collection, . . . and is beyond the scope of this note.”

The ISDA’s research paper has received attention - and succinct summaries - from the New York Times, London’s Financial Times, and Reuters.

The ISDA’s suggestion that CDSs have essentially no impact on corporate restructuring smacks of whistling by the graveyard: In fact, the impact of CDSs has been noted, at least anecdotally, in several large corporate bankruptcy filings during 2008 and 2009.  Nevertheless, the precise nature and extent of the “CDS effect” remains to be seen - and is likely fodder for another research paper . . . or five.

Several posts this year - the most recent one here - have noted the general buyers’ market prevalent for strategic buyers shopping for distressed M&A.

A recent CFO.com article drives home the same point, but with more specificity . . . and an important caveat.  Kate O’Sullivan’s piece entitled “Strategic Buyers Still in the Catbird Seat” observes that though overall M&A activity has been off by as much as 1/3 from 2008 levels, strategic buyers closed 94% of this year’s deals.  Strategic buyers appear to have a continued advantage heading into 2010, and - as was the case this year - distressed assets are expected to comprise a significant portion of next year’s deal activity.

However, the current buyers’ market is not necessarily a bargain-hunters’ bonanza.  Though a recent survey by the Association for Corporate Growth (ACG) and Thomson Reuters (summary available here, with statistical summary here) suggests a modest pick-up in transactional volume for 2010, O’Sullivan (citing the ACG data) notes continued constraints on credit and - perhaps more importantly - a fundamental disconnect over valuations buyers and sellers are willing to accept.

Either or both factors may hamper any significant increase in deal volume over 2009, but the ACG survey suggests that pricing multiples may be the sticking point for many deals.  “[M]ultiples for middle-market transactions in general have fallen markedly, from a high of 10.1 times EBITDA (earnings before interest, taxes, depreciation, and amortization) in 2007 to 8.4 times EBITDA today, according to survey respondents. They may go still lower: 80% of respondents say they expect to pay no more than 5 times EBITDA for targets in the next six months.”

Not surprisingly, most sellers will be reluctant to sell at prices reflecting just half the multiple they could have obtained only 36 months ago: “37% of survey respondents cite valuation problems as the biggest hurdle for deals right now.  ‘Sellers try to argue that you shouldn’t look at the current environment when valuing their company, that it’s just a bump in the road.  But buyers are reluctant to buy that argument,’ says [ACG Chairman Den] White.”

What buyers will buy remains to be seen.  Stay tuned for a fascinating 2010.

An update regarding Peter Wastell and Nigel Hamilton-Smith’s dispute with federal Receiver Ralph Janvey over control of Stanford International Bank Ltd. (SIB)’s financial assets, and the 13th in a series on this blog covering the dissolution of Allen Stanford’s erstwhile financial empire and alleged international “Ponzi scheme” - a dissolution playing out in Montreal, London, and Dallas.

Wastell and Hamilton-Smith, liquidators appointed by Antiguan regulators for the purpose of winding up SIB in Antigua, and Janvey - a federal Receiver appointed at the behest of the US Securities and Exchange Commission to oversee the dissolution of Stanford’s financial interests in connection with an enforcement proceeding in the US - have sought recognition of their respective efforts in courts outside their home jurisdictions.  Each has met with mixed results: Janvey’s request for recognition was denied in the UK, while Wastell and Hamilton-Smith, originally recognized in Canada, have been removed and replaced by a Canadian firm.  Each of these results has been appealed.

Meanwhile, Wastell and Hamilton-Smith have sought recognition of the Antiguan wind-up in Janvey’s home court pursuant to Chapter 15 of the US Bankruptcy Code.  Initial briefing was submitted several months ago; supplemental filings (including copies of the decisions rendered in London and Montreal) have been trickling in.  US District Court Judge David Godbey has set an evidentiary hearing for mid-January 2010.

Messr’s. Wastell and Hamilton-Smith’s supplemental brief, filed last week in Dallas, addresses three issues, apparently raised by Judge Godbey during a recent conference call with the parties:

The Current State of Fifth Circuit Law on What Constitutes an Entity’s “Principal Place of Business,” Including Whether Stanford International Bank’s (”SIB”) Activities Were Active, Passive or “Far Flung.”

The liquidators acknowledge that while Chapter 15 of the US Bankruptcy Code doesn’t refer to an entity’s “principal place of business” in dealing with a cross-border insolvency, many US courts nevertheless analogize an entity’s “principal place of business” to its “center of main interests” (COMI) for purposes of determining the forum that should host the “main case.”   The American approach is, according to the liquidators, similar to that followed by European courts.

That said, what constitutes an entity’s ”principal place of business” is not a settled question under US federal case law: The Fifth Circuit (where the Stanford matters are pending) applies a “total activity” test, which is also applied by the Sixth, Eighth, Tenth and Eleventh Circuits, whereas the Ninth Circuit applies a “place of operations” test, the Seventh Circuit applies a “nerve center” test, and the Third Circuit examines the corporation’s center of activity.  The liquidators suggest in a footnote that these “varying verbal formulas” are functional equivalents, and “generally amount to about the same thing” under nearly any given set of facts.

A significant portion of the liquidators’ brief is devoted to applying the facts of SIB’s dissolution to the Fifth Circuit’s “verbal formula;” i.e., “(1) when considering a corporation whose operations are far-flung, the sole nerve center of that corporation is more significant in determining principal place of business, (2) when a corporation has its sole operation in one state and executive offices in another, the place of activity is regarded as more significant, but (3) when the activity of a corporation is passive and the ‘brain’ of that corporation is in another state, the situs of the corporation’s brain is given greater significance.”  See J.A. Olson Co. v. City of Winona, 818 F.2d 401, 411 (5th Cir. 1987).

The liquidators argue:

- SIB’s principal place of business was in Antigua;

- SIB’s activities were neither “passive” nor “far flung” and thus the “nerve center” test should not predominate; but

- even if SIB’s operations were passive or far flung (which they were not), its “nerve center” was in Antigua.

The Relationship Between SIB and the Financial Advisors Who Marketed SIB’s CDs to Potential Investors.

The liquidators are emphatic that financial advisors who marketed and sold SIB’s CD’s to potential investors were not, in fact, agents of SIB.  Rather, “they operated individually under management agreements with SIB, or were employed by other Stanford companies which had management agreements with SIB . . . .  These advisors worked for Stanford related entities all over the world, including Antigua, Aruba, Canada, Colombia, Ecuador, Mexico, Panama, Peru, Switzerland, and Venezuela, as well as in the United States . . . . All of the financial advisors marketed the CDs but none had authority to contract on behalf of SIB . . . . Further, Liquidators understand that the financial advisors sold other Stanford-related products besides SIB CDs.”  Those advisors who were located in the US ‘worked for an entity called the Stanford Group Companies (”SGC”), and though they marketed SIB CDs to potential depositors, they were not agents of SIB.’”

Put succinctly, the liquidators’ argument is that an international network of independent sales agents does not create the sort of “agency” that would alter cross-border COMI analysis under US law: “[US] Courts analyzing similar circumstances have consistently held that a company’s COMI or its principal place of business is in the jurisdiction where its operations are conducted even if the company has sales representatives in other jurisdictions.”

The “Single Business Enterprise” Concept as Part of the “Alter Ego” Theory of Imposing Liability.

 Finally, the liquidators argue that SIB is neither part of a “single business enterprise” nor an “alter ego” of other Stanford entities or of Stanford’s senior managers - and their respective “principal place[s] of business” in the US cannot be imputed to SIB for purposes of determining SIB’s COMI.  This is so, according to Messr’s. Wastell and Hamilton-Smith, because:

- The doctrine of “single business enterprise” liability is a particular creature of Texas law - which, in addition to being inapplicable to an Antiguan-chartered international bank such as SIB, is itself no longer viable even in Texas.  See SSP Partners v. Gladstrong Invs. (USA) Corp., 275 S.W.3d 444, 456(Tex. 2008) (rejecting the theory because Texas law does not “support the imposition of one corporation’s obligations on another” as permitted by the theory); see also Acceptance Indemn. Ins. Co. v. Maltez, No. 08-20288, 2009 WL 2748201, at *5 (5th Cir. June 30, 2009) (unpublished) (recognizing the holding of Gladstrong).

- The doctrine of “alter ego” does not apply because its primary use is to permit corporate creditors to “pierce the corporate veil” and seek recourse from the corporation’s parent or individual shareholders.  Here, the liquidators argue, Mr. Janvey is attempting to pierce the corporate veil in the opposite direction:  He is attempting to permit creditors of a corporate parent or individual principals to seek recourse from a distinct and separate foreign subsidiary.  Such “reverse veil piercing” is properly obtained (if at all) through the “extreme and unsual” remedy of substantive consolidation through bankruptcy.  However, liquidation of the Stanford entities through a federal bankruptcy proceeding is something Mr. Janvey has, to date, ”studiously avoided.”

- The equitable purposes of the “alter ego” doctrine would be frustrated in this case.  The “injustice” that “alter ego” relief is designed to reverse would, in fact, only be furthered where SIB investors would see their recoveries diluted by creditors of other Stanford entities.

Mr. Janvey’s response is due December 17.

Prior to the economic downturn - when sales were rising and debt was cheap - many businesses found it convenient to spur further growth by taking on “second-tier” secured financing, or engaging in aggressive leveraged buy-outs (LBO’s).  With the recession and resulting steep drop-off in firm revenues worldwide, many of the same businesses (and LBO targets) found themselves over-leveraged and struggling to service their debt.  First priority lenders have responded to this distress by negotiating exclusively with their debtors for pre-arranged “restructuring” plans that, in effect, provide for the transfer of assets and repayment of the first-priority debt - but provide little, if anything, to “second-tier” lenders and other creditors.

A recent piece from Reuters discusses what junior creditors are doing about it.

As illustrated in recent Chapter 11 cases such as Six Flags Inc., Pliant Corp., and Trump Entertainment Resorts, Inc., junior creditors are attempting to fight back with competing restructuring plans of their own - proposed plans that provide them with better returns, or with a meaningful equity stake in the reorganized debtor. 

A review of the dockets in each of those cases indicates that these efforts have met with varying degrees of success.  The Reuters piece suggests three variables that can impact the success of this strategy:

- Valuation.   Arguably the most critical factor in supporting a plan that competes with one pre-negotiated with the first-priority creditors is evidence demonstrating that the debtor is, in fact, worth more than the first-priority creditors claim.  That demonstration can be challenging, particularly in light of today’s uncertain economy and pricier debt.  Even so, junior creditors are likely to argue credibly that a company whose revenues were historically strong should not be under-valued purely on the basis of weaker performance in a generally weaker economy.  Still other junior creditors seeking to preserve their original position may be willing to advance additional funds, thereby opening up a possible source of financing otherwise unavailable to the debtor.

- The Court.  Concerns such as docket management and the court’s philosophical disposition to maximize enterprise value or protect the position of junior creditors - or not - are factors that have real effect on the success of junior creditors’ bid to present a competing plan.

- Cost-Benefit.  Finally, the presence - or absence - of effective negotiation between the parties can impact the perceived benefit of a competing plan.  When everyone is talking and a plan can be effectively built, a successful outcome is more likely than a full-blown “plan fight” which weighs down the estate with administrative expense and can, if sufficiently large, even jeopardize the debtor’s successful post-confirmation operations.