Cravath’s always-well-done quarterly update of significant bankruptcy decisions, prepared by New York partner Richard Levin, has been recently completed. The most recent edition is available here.
Canadian gold mining concern Crystallex International Corp. filed for protection under Canada’s Companies’ Creditors Arrangement Act (CCAA) on Dec. 23, 2011. The company operates an open pit mine in Uruguay and three gold mines in Venezuela.
Among its Venezuelan projects is the 9,600-acre Las Cristinas mine. Court papers said the site’s untapped gold deposits are among the largest in the world, containing an estimated 20 million ounces of gold. Crystallex filed for Chapter 15 bankruptcy protection in Delaware on the same date to protect its US assets while seeking a Canadian restructuring. Delaware Bankruptcy Judge Peter Walsh granted recognition on January 20.
Crystallex’s financial troubles allegedly stem from the Venezuelan government’s threatened revocation of Crystallex’s operating agreement for the Las Cristinas project as a result of the company’s failure to obtain an environmental permit. Crystallex blames this failure on the Venezuelan government’s own continued failure to grant the permit.
The company continues to operate, but appears to be staking its restructuring hopes primarily on arbitration claims for $3.8 billion in alleged losses suffered in connection with the Las Cristinas agreement. Crystallex said it has invested more than C$500 million in the uncompleted Las Cristinas project. The company believes an arbitration award will provide sufficient funds to pay all its creditors in full while leaving value for the company’s shareholders.
Those creditors include secured lenders China Railway Resources Group (owed C$2.5 million) and Venezolano Bank about (owed $1 million). They also include $104.14 million in 9.34% senior unsecured notes the company issued on Dec. 23, 2004. Crystallex’s CCAA filing and its concurrent Chapter 15 petition were filed on the same date its notes matured.
Recently, the company sought to alleviate its immediate liquidity concerns by means of an auctioned DIP facility. Specifically, Crystallex sought a debtor-in-possession loan of C$35 million, convertible into an “exit facility.”
Crystallex reported to the US Bankruptcy Court that it was in receipt of multiple expressions of interest in such a facility. Meanwhile, pending the completion of due diligence and approval by the Canadian Court, Cyrstallex sought recognition of a much smaller C$3.125 million “bridge facility” from Tenor Special Situations Fund, L.P., which the Canadian Court approved January 20.
The bridge facility expires April 16, and required US Bankruptcy Court approval by February 20. Judge Walsh provided that approval at a hearing held yesterday.
Crystallex’s Chapter 15 proceeding is pending as Case No. 11-bk-14074.
- Crystallex files for bankruptcy (business.financialpost.com)
- Crystallex nears insolvency (business.financialpost.com)
- Crystallex close to securing financing before filing for protection (business.financialpost.com)
- Nationalism Tops Crisis as Key Risk to Mine Supply: Commodities (businessweek.com)
For those practitioners practicing locally here in SoCal – or for those who need to appear pro hac in one of the many Chapter 11’s pending in the nation’s largest bankruptcy district – the Central District has very recently collaborated with the local bankruptcy bar to produce a detailed list of individual judicial preferences.
In a District with nearly 30 sitting bankruptcy judges scattered over five divisions, a “score-card” like this one is essential reading. A copy of the survey is available here.
Other Posts of Interest:
- South-Central Texas bankruptcies fall 25% (mysanantonio.com)
- Barney’s on verge of Chapter 11: report (marketwatch.com)
- You: Past cases show Kodak faces pain in Chapter 11 – Rochester Democrat and Chronicle (democratandchronicle.com)
JonesDay’s comprehensive and always-readable summary of notable bankruptcies, decisions, legislation, and economic events was released just over a week ago. A copy is available here.
As 2012 gets off to an uncertain start, some more recent headlines are accessible immediately below.
Thanks to an active lobby in Congress, commercial landlords have historically enjoyed a number of lease protections under the Bankruptcy Code. Even so, those same landlords nevertheless face limits on the damages they can assert whenever a tenant elects to reject a commercial lease.
Section 502(b)(6) limits landlords’ lease rejection claims pursuant to a statutory formula, calculated as “the [non-accelerated] rent reserved by [the] lease . . . for the greater of one year, or 15 percent, not to exceed three years, of the remaining term of such lease . . . .”
This complicated and somewhat ambiguous language leaves some question as to whether or not the phrase “rent reserved for . . . 15 percent . . . of the remaining term of such lease” is a reference to time or to money: That is, does the specified 15 percent refer to the “rent reserved?” Or to the “remaining term?”
Many courts apply the formula with respect to the “rent reserved.” See. e.g., In re USinternetworking, Inc., 291 B.R. 378, 380 (Bankr.D.Md.2003) (citing In re Today’s Woman of Florida, Inc., 195 B.R. 506 (Bankr.M.D.Fl.1996); In re Gantos, 176 B.R. 793 (Bankr.W.D.Mich.1995); In re Financial News Network, Inc., 149 B.R. 348 (Bankr.S.D.N.Y.1993); In re Communicall Cent., Inc., 106 B.R. 540 (Bankr.N.D.Ill.1989); In re McLean Enter., Inc., 105 B.R. 928 (Bank.W.D.Mo.1989)). These courts calculate the amount of rent due over the remaining term of the lease and multiply that amount times 15%.
Other courts calculate lease rejection damages based on 15% of the “remaining term” of the lease. See, e.g., In re Iron–Oak Supply Corp., 169 B.R. 414, 419 n. 8 (Bankr.E.D.Cal.1994); In re Allegheny Intern., Inc., 145 B.R. 823 (W.D.Pa.1992); In re PPI Enterprises, Inc., 324 F.3d 197, 207 (3rd Cir.2003).
For more mathematically-minded readers, the differently-applied formulas appear as follows:
|Rent-Based Formula:||Maximum Rejection Damages = (Rent x Remaining Term) x 0.15|
|Term-Based Formula:||Maximum Rejection Damages = Rent x (Remaining Term x 0.15)|
Earlier this month, a Colorado bankruptcy judge, addressing the issue for the first time in that state, sided with those courts who read the statutory 15% in terms of time:
“In practice, by reading the 15% limitation consistently with the remainder of § 502(b)(6)(A) as a reference to a period of time, any lease with a remaining term of 80 months or less is subject to a cap of one year of rent [i.e.,15% of 80 months equals 12 months] and any lease with a remaining term of 240 months or more will be subject to a cap of three years rent [i.e., 15% of 240 months equals 36 months]. Those in between are capped at the rent due for 15% of the remaining lease term.”
In re Shane Co., 2012 WL 12700 (Bkrtcy. D.Colo., January 4, 2012).
The decision also addresses a related question: To what “rent” should the formula apply – the contractual rent applicable for the term? Or the unpaid rent remaining after the landlord has mitigated its damages? Under the statute, “rents reserved” refers to contractual rents, and not to those remaining unpaid after the landlord has found a new tenant or otherwise mitigated.
Colorado Bankruptcy Judge Tallman’s decision, which cites a number of earlier cases on both sides of the formula, is available here.
Can a senior secured lender require, through an inter-creditor agreement, that a junior lender relinquish the junior’s rights under the Bankruptcy Code vis á vis a common debtor?
Though the practice is a common one, the answer to this question is not clear-cut. Bankruptcy Courts addressing this issue have come down on both sides, some holding “yea,” and others “nay.” Late last year, the Massachusetts Bankruptcy Court sided with the “nays” in In re SW Boston Hotel Venture, LLC, 460 B.R. 38 (Bankr. D. Mass. 2011).
The decision (available here) acknowledges and cites case law on either side of the issue. It further highlights the reality that lenders employing the protective practice of an inter-creditor agreement as a “hedge” against the debtor’s potential future bankruptcy may not be as well-protected as they might otherwise believe.
In light of this uncertainty, do lenders have other means of protection? One suggested (but, as yet, untested) method is to take the senior lender’s bankruptcy-related protections out of the agreement, and provide instead that in the event of the debtor’s filing, the junior’s claim will be automatically assigned to the senior creditor, re-vesting in the junior creditor once the senior’s claim has been paid in full.
Last year, the Supreme Court issued one of its more significant bankruptcy decisions in recent years with Stern v. Marshall (a very brief note concerning the Stern decision as reported on this blog is available here). Stern, which addressed the limits of bankruptcy courts’ “core” jurisdiction, has been the focus of a considerable amount of academic and professional interest – primarily because of its possible fundamental effect on the administration of bankruptcy cases.
Three weeks ago, the Seventh Circuit capped off 2011 with a decision – the first at an appellate level – discussing and applying Stern.
The procedural history of In re Ortiz is straightforward. Wisconsin medical provider Aurora Health Care, Inc. had filed proofs of claim in 3,200 individual debtors’ bankruptcy cases in the Eastern District of Wisconsin between 2003 and 2008. Two groups of these debtors took issue with these filings, claiming Aurora violated a Wisconsin statute that allows individuals to sue if their health care records are disclosed without permission. One group of debtors filed a class action adversary proceeding against Aurora in the Bankruptcy Court for Wisconsin’s Eastern District, while the other filed a similar class action complaint against Aurora in Wisconsin Superior Court.
For all their differences, it appears neither the debtor-plaintiffs nor Aurora wanted to have these matters heard by the US Bankruptcy Court. Aurora removed the Superior Court Action to the Bankruptcy Court, then immediately sought to have the US District Court for Wisconsin’s Eastern District withdraw the reference of these actions to the Bankruptcy Court and hear both matters itself. Both groups of debtor-plaintiffs, on the other hand, sought to have their claims heard by the Wisconsin Superior Court by asking the Bankruptcy Court to abstain from hearing them, and remand them to the state tribunal.
Both parties’ procedural jockeying for a forum other than the US Bankruptcy Court ultimately proved unfruitful: The District Court denied Aurora’s request to hear the matters, and the Bankruptcy Court declined to remand them back to Wisconsin Superior Court or otherwise abstain from hearing them. The District Court’s and the Bankruptcy Court’s reasoning was essentially the same – since the original “disclosure” of health records took place in the context of proofs of claim filed in individual debtors’ bankruptcy proceeding, both courts believed the matters were therefore “core” proceedings which Bankruptcy Courts were entitled to hear and determine on a final basis.
Ultimately, the Bankruptcy Court granted summary judgment and dismissed the class actions because both groups of debtors had failed to establish actual damages as required under the Wisconsin statute. Both the plaintiffs and Aurora requested, and were granted, a direct appeal to the Seventh Circuit Court of Appeals.
But if Ortiz’ procedural history is straightforward, the Seventh Circuit’s disposition of the appeal was not. After the case was argued on appeal in February 2011, the Supreme Court issued its decision in Stern v. Marshall. In that decision, the high court called into question the viability of Congress’ statutory scheme in which bankruptcy courts were empowered to finally adjudicate “core” proceedings – i.e., those proceedings “arising in a bankruptcy case or under title 11″ of the US Code. The Stern court held that a dispute – even if “core” – was nevertheless improper for final adjudication by a bankruptcy court if the dispute was not integral to the claims allowance process, and constituted a private, common-law action as recognized by the courts at Westminster in 1789. Such matters were – and are – the province of Article III (i.e., US District Court) judges, and it was not up to Congress to “chip away” at federal courts’ authority by delegating such matters to other, non-Article III (i.e., Bankruptcy) courts.
In order to resolve the Aurora class actions in a manner consistent with Stern, the Seventh Circuit requested supplemental briefing, and then undertook a lengthy analysis of that decision. To isolate and identify the type of dispute that the Stern court found “off-limits” for final decisions by bankruptcy courts, it distinguished the Aurora class action disputes from those cases which:
- Involved “public rights” or a government litigant;
- Flowed from a federal statutory scheme or a particularized area of law which Congress had determined best addressed through administrative proceedings; or
- Were “integral to the restructuring of the debtor-creditor relationship” or otherwise part of the process of allowance and disallowance of claims.
Instead, the Aurora disputes had nothing to do with the original claims filed by Aurora in the debtors’ cases, was between private litigants, and was not a federal statutory claim or an administrative matter. Consequently, the Bankruptcy Court had no jurisdiction to determine it on a final basis. Consequently, the Seventh Circuit had no jurisdiction to hear the appeal.
Ortiz, like Stern, has received a considerable amount of attention within the bankruptcy community. Among some of the community’s immediate reactions to Ortiz:
- Despite the fact that the class actions arose out of Aurora’s filing proofs of claim in bankruptcy cases, the bankruptcy court could not decide those class actions. More importantly, the Seventh Circuit suggested that a bankruptcy judge may not even have “authority to resolve disputes claiming that the way one party acted in the course of the court’s proceedings violated another party’s rights.” In other words, it seems possible to argue, under Ortiz (and Stern), that though US District Courts have authority to police their own dockets, Bankruptcy Courts do not.
- The Seventh Circuit’s decision appears circular in some respects. Specifically, the Seventh Circuit declined to hear the appeals from the bankruptcy court as proposed findings of fact and conclusions of law (rather than as a final judgment), because such recommendations from a bankruptcy court are available only in “non-core” proceedings – and since the Aurora class actions were “core,” an appellate review of such proposed findings and conclusions simply wasn’t available. But if a “core” matter is outside a bankruptcy court’s jurisdiction, is it really “core”? In other words, wouldn’t it have been easier for the Seventh Circuit to have simply sent the matter back to the bankruptcy court as a recommended resolution, not yet ripe for an appeal?
As the results of Stern begin to percolate their way through the bankruptcy system and other circuits weigh in on the Supreme Court’s 2011 guidance, it appears the administration of bankruptcy cases faces some significant adjustment.
Outside of bankruptcy, a creditor whose loan is secured by collateral typically has the right to payment in full when that collateral is sold – or, if the collateral is sold at an auction, to “credit bid” the face amount of the debt against the auction price of the collateral.
Inside bankruptcy, however, the right to “credit bid” is not always guaranteed.
In July, this blog predicted Supreme Court review of a Seventh Circuit case addressing the question of whether a bankruptcy court may confirm a plan of reorganization that proposes to sell substantially all of the debtor’s assets without permitting secured creditors to bid with credit. The courts of appeals are divided two to one over the question, with the Third and Fifth Circuits holding that creditors are not entitled to credit bid and the Seventh Circuit holding to the contrary (for a review of the more recent, Seventh Circuit decision, click here).
The question is one of great significance for commercial restructuring practice, with several bankruptcy law scholars suggesting the answer “holds billions of dollars in the balance.”
Apparently, the Supreme Court agrees. Last week, the justices granted review of the Seventh Circuit decision. For the petitioners’ brief, respondent’s opposition, and amicus briefs, click here.
- Supreme Court to Weigh ‘Meaty and Sexy’ Corporate-Bankruptcy Case (blogs.wsj.com)
- Appeals Courts Split on Creditors’ Right to Bid in Auction Sales (dealbook.nytimes.com)
Nearly 16 months ago, this blog covered the story of Qimonda AG – a German chip manufacturer whose cross-border liquidation created waves on both sides of the Atlantic. As noted in that prior post, Qimonda’s insolvency proceeding illustrates what can happen when one country’s rules governing the treatment of an insolvent firm’s intellectual property assets collide with those of another.
But what can happen is not always what does happen.
As a liquidating entity, Qimonda’s primary assets were its portfolio of patents, licensed to other firms under a series of cross-licensing agreements. Though not completely settled law in Germany, patent cross-licenses are widely viewed by German practitioners as executory agreements. Such agreements are automatically unenforceable unless the insolvency administrator (the functional equivalent of a trustee under US bankruptcy law) affirmatively elects to perform the contracts. In practice, to avoid any implied election of performance, an insolvency administrator will usually send a letter of non-performance to the counter-party. Consistent with this practice, Qimonda’s administrator had issued non-performance letters to a number of licensees in connection with his proposed disposition with Qimonda’s patents, which were the company’s most valuable remaining asset following a decision to liquidate. The business strategy was to maximize the value of Qimonda’s patents by canceling, then re-negotiating, the company’s patent licenses with Qimonda’s original licensees.
In response, the licensees asserted rights with respect to Qimonda’s US patents under Bankruptcy Code section 365(n), which – contrary to German law – specifically protects the rights of patent licensees in the event of a licensor’s bankruptcy. Qimonda’s recognition under Chapter 15 of the Bankruptcy Code had made Section 365 “applicable” to the company’s ancillary proceedings in the US.
Qimonda’s administrator sought the Bankruptcy Court’s elimination or restriction of Section 365’s applicability to the company’s US patents, in light of his proposed disposition of the patents under conflicting German insolvency law. The Bankruptcy Court restricted 365(n)’s applicability, but the District Court remanded on appeal for a determination of whether doing so was “manifestly contrary to the public policy of the United States” and whether the licensees would be “sufficiently protected” if Section 365(n) did not apply.
After four days of evidentiary hearings and one day of argument, the Bankruptcy Court concluded that:
- Chapter 15 of the US Bankruptcy Code, which is rooted in considerations of comity and deference to the decisions of foreign tribunals, is nevertheless limited by the “sufficient protect[ion] of creditors’ interests.” Moreover, any relief requested by a foreign representative seeking recognition and relief in the US under this statute is further limited when granting such relief “would be manifestly contrary to the public policy of the United States.”
- The protections afforded patent licensees by Section 365(n) have their origins in Congressional reaction to the Fourth Circuit’s decision in Lubrizol Enterprises, Inc. v. Richmond Metal Finishers, Inc., 756 F.2d 1043 (4th Cir. 1985), a decision involving the debtor’s rejection of a fully paid-up license to a non-bankrupt licensee for use of the debtor’s metal coating technology. Most disturbingly for Congress, the Lubrizol court found that rejection under Section 365(a) effectively prohibited the licensee’s continued receipt of specific performance under the agreement, even if that remedy would otherwise be available under a breach of this type of contract. Congress’ answer to the Lubrizol decision was to pass the “Intellectual Property Licenses Act of 1987,” which included the licensee protections of Section 365(n). According to the Congressional history behind the statute, adoption of the legislation was intended to “immediately remove [the threat of license rejection] and its attendant threat to American [t]echnology and will further clarify that Congress never intended for Section 365 to be so applied.”
- Though the nature of patent cross-licensing made it difficult – if not impossible – for the parties to establish whether the cancellation of licenses for specific patents would put at risk the licensees’ investment in manufacturing or sales facilities in the US for products covered by US patents, the administrator’s threat of infringement litigation following cancellation of Qimonda’s patent licenses was as damaging to licensees as an actual finding of infringement of specific patents. This risk, balanced against the loss in value to Qimonda’s patent portfolio, warranted the application of Section 365(n) to the administrators disposition of the company’s US patents.
- Application of the German insolvency law as an exercise of comity would “severely impinge . . . a U.S. statutory . . . right such that deferring to German law would defeat ‘the most fundamental policies and purposes’ of such right.’” For the Bankruptcy Court, the question of whether or not Section 365(n) was intended to protect a “fundamental” US policy was an extremely close one. But “[a]lthough [technological] innovation [in the US] would obviously not come to a grinding halt if licenses to U.S. patents could e cancelled in a foreign insolvency proceeding, . . . the resulting uncertainty would nevertheless slow the pace of innovation, to the detriment of the U.S. economy.” As a result, the failure to apply Section 365(n) to Qimonda’s US patent portfolio “would ’severely impinge’ an important statutory protection accorded licensees of U.S. patents and thereby undermine a fundamental U.S. public policy promoting technological innovation” – and as such, deferring to German law would be “manifestly contrary to U.S. public policy.”
The Bankruptcy Court’s most recent decision is available here.
Last week, the Judicial Conference Advisory Committees on Appellate, Bankruptcy, Civil, Criminal, and Evidence Rules proposed amendments to their respective rules and made them available for public comment.
Though it frequently makes for less-than-scintillating reading, the proposed amendments are always worth a look-through. This is especially the case in an environment such as Bankruptcy Court, where procedure can drive courtroom tactics.
Proposed revisions to the Federal Rules of Bankruptcy Procedure (FRBP) and Official Bankruptcy Forms include:
• FRBP 1007 — relieves individual debtors of the obligation to file Official Form 23 if the provider of a personal financial management course notifies the court that the debtor has completed the course.
• FRBP 3007 — allows the use of a negative-notice procedure for claim objections and clarifies the manner for serving them.
• FRBP 5009 — reflects the amendment to FRBP 1007 by providing that the Clerk of Court is not required to send notice to a debtor if a course provider has already provided notice that the debtor completed a personal financial management course.
• FRBP 9006 — makes various changes to draw attention to the fact that the rule prescribes default deadlines for serving motions and written responses; and applies deadlines to any written response to a motion.
• FRBPs 9013 and 9014 — conform to the amendments to FRBP 9006.
• Official Form 6C — reflects the Supreme Court’s decision in Schwab v. Reilly by permitting the debtor to state the value of the claimed exemption as the “full fair market value of the exempted property.”
• Official Form 7 — makes the definition of “insider” consistent with the definition in the Bankruptcy Code.
• Official Forms 22A and 22C — align the allowable deduction for telecommunication expenses with the IRS list of Other Necessary Expenses; also amends Form 22C to conform to the Supreme Court’s decision in Hamilton v. Lanning, by directing an above-median-income chapter 13 debtor to list any changes in the reported income and expenses that have already occurred or are virtually certain to occur during the 12 months following the filing of the petition.
The draft amendments, along with the Committee’s comments, are available here.
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.
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.
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.
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.
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.”
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.
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.
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.
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.
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.
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.
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.”
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.”
A New Type of Government Refund: Criminal Restitution Payments Recoverable as Preferential TransfersAugust 15th, 2010
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.
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.
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).
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.
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.
Credit Default Swaps – those largely unregulated “side bets” over the likelihood of specific companies defaulting on one or more of their credit obligations, which were all the rage during the beginning of the decade - have become, in light of the 2008 financial crisis, “the financial instrument that scholars, journalists, government officials and even some prominent financiers love to hate.”
The problematic impact of CDS’s on firms in financial distress – and their separate treatment under existing securities “safe harbors” in the US Bankruptcy Code – have likewise provoked further commentary and calls for reform from the insolvency community (some of which has been covered in various posts on this blog, and which is summarized here).
But despite the furor over much-maligned CDS’s, not everyone is casting aspersions.
Last week, Seton Hall’s Michael Simkovic and Davis Polk’s Benjamin Kaminetzky released a paper arguing that CDS pricing at the time of a credit event (such as a loan made in connection with an LBO) can – when combined with other market information about a company’s debt securities – provide important indicators of a company’s solvency at the time of that transaction.
Though it requires 58 pages (plus 12 pages of appendices) to develop, Simkovic’s and Kaminetzky’s basic premise is relatively simple:
Fraudulent transfer analysis is too often susceptible to manipulation by self-interested experts, and too prone to after-the-fact “second guessing” by bankruptcy courts, to be consistently reliable and predictable. Efficient securities markets are the best contemporaneous guides to the solvency of a debtor with publicly traded debt. As a result, bankruptcy courts attempting to determine the solvency of a debtor at the time of an alleged fraudulent transfer should use contemporaneous credit-market data as a (or as the) key indicator of the debtor’s solvency.
The idea is more than an abstract concept: Simkovic and Kaminetzky cite two relatively recent decisions in which bankruptcy courts applied public-market analysis to determine the debtor’s solvency and the resulting avoidability of a fraudulent transfer, each using equity market valuations contemporaneous with the time of the transfers. Simkovic and Kaminetzky extend this approach, arguing that credit-market instruments and their derivatives – such as credit yield spreads and CDS pricing - provide a more reliable indication of solvency than the debtor’s equity.
The idea of employing public market data is of limited use in cases where the debtor is closely held – or where public credit-market data is not readily available. But Simkovic’s and Kaminetzky’s research represents yet another recent and important effort by scholars to impose greater uniformity and predictability on the question of whether a debtor is – or has become – insolvent as a result of a pre-bankruptcy transfer for less-than-equivalent value (for another approach to the same general problem, see an earlier post here).
In light of the extensive, highly-leveraged financing that took place between 2004 and 2007 – and the correspondingly high anticipated default rates when that same debt matures over the next several years – Simkovic’s and Kaminetzky’s work also renews the focus on an important question, directly relevant to any inquiry into an alleged fraudulent transfer:
What did the participants in an allged fraudulent transfer – and all of those responsible for due diligence regarding that transfer – believe about the debtor’s present or resulting solvency at the time the transfer was made? And what (if anything) was the basis for their belief?
Last week’s post discussed public-market data as the benchmark for solvency in assessing fraudulent transfers. This week’s post covers solvency the “old fashioned” way – in addressing preference litigation.
Ray Clark, who runs Valcor Consulting – an Irvine-based restructuring, valuation, and litigation consultancy – and who contributes regularly to this blog, recently offered an overview of the solvency analysis and valuation techniques that apply when a company faces claims for payments made within 90 days of a debtor’s bankruptcy:
The question of solvency in a voidable preference action depends upon the fair valuation of the debtor’s assets at the time of the transfer, along with other solvency analyses. The question of whether to use a “going concern” valuation analysis versus a “liquidation” analysis depends upon whether the debtor was “on its death bed” at the testing date, e.g. the transfer date. If the going concern premise is applied, then the BK court typically relies on an appraisal of the business, i.e., the value of the assets used in an ongoing enterprise, as the basis for the solvency analysis. By contrast, if it is determined that the business was not a going concern at the transfer date, and then an asset-by-asset analysis under a liquidation scenario will be used. Lastly, solvency can also be judged by whether the debtor is able to pay his debts as they come due. So, there is essentially a two-pronged definition of insolvency:
- A debtor is insolvent if the sum of the debtor’s debts is greater than all the debtor’s assets, at a fair valuation, or
- A debtor who is generally not paying his debts as they become due is presumed to be insolvent.
Ultimately, stakeholders may rely on a so-called “Solvency Opinion,” which is designed to assess a company’s overall financial condition at a designated time and using a variety of tests determine whether the entity was solvent or insolvent. The three tests that are typically applied include:
- The Balance Sheet Test (with case law references),
- The Capital Adequacy Test and
- The Cash Flow Test
JSC BTA Bank (BTA), one of Khazakstan’s largest banks, sought restructuring under the guidance of the Kazakh government early this year. A prior post on BTA’s protective filing is available here. BTA’s recognition order granted BTA “all of the relief set forth in section 1520 of the Bankruptcy Code including, without limitation, the application of the protection afforded by the automatic stay under section 362(a) of the Bankruptcy Code to the Bank worldwide and to the Bank’s property that is within the territorial jurisdiction of the United States.”
Among its obligations, BTA was in default on a $20 million advance from Banque International de Commerce – BRED Paris, succursale de Geneve, Switzerland (“BIC-BRED”) for the construction of an entertainment complex in Moscow. BIC-BRED commenced Swiss arbitration proceedings regarding this obligation.
After BTA commenced its Khazakh restructuring and obtained recognition in the US, it submitted a statement in the arbitration, requesting a stay of the arbitration and claiming the universal application of the automatic stay. BIC-BRED refused to acknowledge the reach of the stay in BTA’s ancillary case. Apparently, so did the arbitrator: An award in the Swiss proceedings was entered in July 2010 against BTA.
BTA sought a determination that the automatic stay did, in fact, apply – and that BIC-BRED ought to be sanctioned for its continued prosecution of the Swiss arbitration.
In a decision issued late last month, Presiding Judge James Peck summarized the basis for his restrictive reading of the automatic stay as follows:
If the provision regarding the automatic stay in chapter 15 cases were to be construed in the manner urged by the Foreign Representative, even the court in the foreign main proceeding in Kazakhstan would be subject to the stay and would need permission from this Court before taking any action that might impact the foreign debtor. No rational cross-border insolvency regime would give a bankruptcy court in the United States so much unintended automatic extraterritorial power in conjunction with the recognition of a foreign proceeding . . . . [A]ny application of the language of section 1520(a)(1) should reject an extraterritorial interpretation that would stay miscellaneous foreign litigation or arbitration proceedings having no meaningful nexus to property of the foreign debtor located in the United States.
Instead, he concluded that
[T]he automatic stay does not afford broad anti-suit injunctive relief to the debtor entity outside the territorial jurisdiction of the United States upon entry of an order of recognition in a chapter 15 case. This conclusion is based on the need to respect the international aspects of [chapter 15], the limited and specialized definition of the term “debtor” when used in chapter 15, and the fact that cases under chapter 15 are ancillary in nature and do not create an estate within the meaning of section 541 of the Bankruptcy Code.
This is not to say, however, that the automatic stay arising under the US Bankruptcy Code is limited to the territorial reach of the US.
After reviewing – and rejecting – the administrator’s interpretation of how the automatic stay ought to apply in ancillary cases “to the debtor and the property of the debtor that is within the territorial jurisdiction of the United States” Judge Peck went on to offer two possible legitimate interpretations (the Court had previously reviewed – and rejected – the administrator’s alternative interpretation):
One possibility, but a terribly strained one, would be to construe the territorial limitation within section 1520(a)(1) as extending to both the debtor and its property. Such a reading would limit the effect of the automatic stay to actions against a debtor commenced within the United States and to debtor property located here and would tie the word ‘debtor’ to the phrase ‘within the territorial jurisdiction of the United States.’ That reading is consistent with international cooperation and avoids absurd results but fails to account for placement of the words ‘that is’ within the text of this sentence. Those words break the connection between the debtor and the United States.
An alternative, and better “reading of section 1520(a)(1), and one that is consistent with the plain meaning of the words as written, is that the stay arising in a chapter 15 case upon recognition of a foreign main proceeding applies to the debtor within the United States for all purposes and may extend to the debtor as to proceedings in other jurisdictions for purposes of protecting property of the debtor that is within the territorial jurisdiction of the United States. This more limited extraterritorial application of the automatic stay to the debtor entity fulfills the cross-border purposes of chapter 15 within the United States without broadly imposing a stay on all actions or proceedings against the debtor including those lacking any proper connection to the chapter 15 case.”
Under the latter reading, then, the automatic stay is applicable world-wide, but only where necessary to protect the US Bankruptcy Court’s in rem jurisdiction over the foreign debtor’s domesticated property.
The BTA decision is noteworthy in a broader context as well:
- This decision is one of several recent cases in which Bankruptcy Courts have sought to negotiate otherwise difficult applications of the Code’s other provisions within the context of Chapter 15 through an appeal to interpretation based on the statute’s “international aspects.” “International” in these cases really means “universal” – Courts applying this statute have gone to some lengths to employ Chapter 15 as a vehicle for extending universal administration of the “main case,” wherever that case is located.
- But “universalism” only goes so far: In Judge Peck’s view, “The bankruptcy court, at least in the setting of an ancillary chapter 15 case, should not stand in the way of a foreign arbitration process when the outcome will have no foreseeable impact on any property of the foreign debtor in the United States.” But what if the outcome of such litigation did have foreseeable impact on such property? The answer, according to Judge Peck, is clear: The US Bankruptcy Court’s in rem jurisdiction may not be trifled with, no matter where such efforts might occur.
- This decision nevertheless suggests an additional area of “section shopping” – i.e., the strategic employment of plenary or ancillary procedures to take advantage of various protections or remedies arising under the laws of the jurisdictions involved. Similar considerations attend the availability and application of avoidance powers arising under Sections 1521 and 1523 and Section 544 (which affords recoveries to unsecured creditors that would be available under “non-bankruptcy law”). See Tacon v.Petroquest Res. Inc. (In re Condor Ins. Ltd.), 601 F.3d 319, 329 (5th Cir. 2010) (foreign representative of foreign proceeding authorized to pursue non-US avoidance claims against US defendants through ancillary proceeding), and a related post here.
In April, this blog highlighted research done by Seton Hall’s Stephen Lubben and York University’s Stephanie Ben-Ishai on similarities and differences between asset sales conducted under the US Bankruptcy Code and those proceeding under the Canadian Companies Creditors’ Arrangement Act (“CCAA”).
Last week, the authors offered a revised version of their earlier work, available here. As noted by the authors’ abstract:
Ultimately, . . . questions of speed and certainty mark the biggest difference between [asset sales in the US and Canada], as the American approach [to asset sales] offers greater flexibility, which is apt to facilitate quicker . . . sales. However, . . . the Canadian approach also provides significant benefits, particularly in the realm of employee protection and the ability of the monitor to act as an independent check on quick sales proceedings. . . . [W]hile the American approach is advantageous in situations with exceptional time constraints, the Canadian approach under the . . . CCAA is more beneficial for a typical corporate reorganization, insofar as the role of the monitor and other limitations of the CCAA will prevent overuse of the quick sales process.
Most readers of this blog are aware that, under the Bankruptcy Code, a Chapter 11 debtor (or the trustee appointed in the debtor’s case) is entitled to seek “avoidance” of a limited set of pre-bankruptcy “preference” payments, provided it can establish the payments were made:
(1) to or for the benefit of a creditor;
(2) for or on account of an antecedent debt . . . ;
(3) . . . while the debtor was insolvent;
(4) . . . on or within 90 days before the date of the filing of the [bankruptcy] petition; . . . and
(5) that enables [the] creditor to receive more than [its anticipated pro rata distribution in Chapter 7].
Even if all these elements are met, however, the Bankruptcy Code provides creditors with an affirmative “ordinary course of business” defense.
Though articulated slightly differently by different courts, 11 U.S.C. §547(c)(2) essentially provides that the “ordinary course of business exception” permits a creditor to retain transfers made by a debtor to a creditor during the ninety days before the petition date if: (1) such transfers were made for a debt incurred in the “ordinary course of business” of the parties; and either (2) the transfers were made in the “ordinary course of business” of the parties; or (3) the transfers were made in accordance with “ordinary business terms.”
Once an “ordinary course” relationship is established between the debtor and the creditor who received allegedly preferential payments, the focus shifts to showing whether or not the payments at issue complied with “ordinary course” timing and terms.
To show this, the preference defendant must demonstrate that the relevant payments did not differ from past payments in “amount” or “form,” were not the result of “unusual collection or payment activit[ies],” or did not come as a result of the “creditor [taking] advantage of the debtor’s deteriorating financial condition.”
Importantly, the emphasis is on the payments themselves – rather than on what the debtor and creditor may have otherwise considered or discussed. This distinction is illustrated in a recent decision issued by Judge Christopher Sontchi in Burtch v. Detroit Forming, Inc. (In re Archway Cookies) (available here).
In Burtch v. Detroit Forming, the Trustee in a Chapter 7 case (converted from one under Chapter 11) commenced an adversary proceeding against Detroit Forming, Inc. (“DFI”) seeking to avoid as preferential six (6) transfers totaling $180,648.17. DFI asserted the “ordinary course” defense, arguing it had a two-year suppplier relationship with the debtors and that it had received the payments in question under the same timing and terms as those extant throughout this relationship.
DFI’s defense is typical of that offered under the “ordinary course” defense: It established a specific range of days-to-payment from invoicing, then showed that the payments in question were timed substantially similar to the days-to-payment average and under similar terms (i.e., by check rather than by wire transfer or COD).
Notably, the Court was not troubled by a letter sent by DFI’s CFO/Controller notifying the Debtors that no product would be shipped unless the accounts were current. For purposes of establishing “ordinary course,” it was the subjective relationship that existed between the debtor and the preference defendant which mattered – rather than the debtor’s relations with all its creditors.
Burtch v. Detroit Forming is instructive on what it takes to mount a successful “ordinary course” defense, as is the Ninth Circuit’s earlier decision in Sigma Micro v. Healthcentral.com (In re Healthcentral.com) (availabe here) – a similar case where the defendant’s “ordinary course” analysis was deemed sufficient to withstand a motion for summary judgment, and where the Ninth Circuit placed little stock in the debtor’s evidence of pre-petition “old school” cash management practices whereby the debtor’s management determined each week which creditors would be paid, and how much.
In a well-known quote, Depression-era author Thurmond Arnold once described the inside of a corporate reorganization as:
a combination of a municipal election, a historical pageant, an antivice crusade, a graduate school seminar, a judicial proceeding, and a series of horse trades, all rolled into one — thoroughly buttered with learning and frosted with distinguished names. Here the union of law and economics is celebrated by one of the wildest ideological orgies in intellectual history. Men work all night preparing endless documents in answer to other endless documents . . . . At the same time practical politicians utilize every resource of patronage, demagoguery, and coercion beneath the solemn smoke screen.
Most litigators understand the compelling power of story as a means to rationalize and persuade. In bankruptcy, a debtor’s “first day motions” are the initial means by which counsel has to weave the “wild orgy” of corporate restructuring into a cohesive narrative that will serve the client’s interests.
Because business insolvency and its resolution typically follow a well-understood process with a predictable set of possible outcomes, the “first day” narratives describing a debtor’s demise – and setting forth its “exit strategy” – likewise often follow familiar patterns. These patterns have been adapted over the decades to suit the capital structure of distressed firms and the economic conditions they face. But in the end, they remain . . . familiar patterns.
Penn Law Professor David Skeel, Jr. has recently taken up an engaging, non-empirical analysis of these patterns as they have appeared in US bankruptcy law. In Competing Narratives in Corporate Bankruptcy: Debtor in Control vs. No Time To Spare (published most recently as Research Paper No. 10-20 under the auspices of Penn Law’s Institute for Law and Economics and previously in the Winter 2009 issue of Michigan State Law Review) Skeel argues that such narratives have been utilized historically to justify and obtain judicial sanction for what, at the time, may be innovative, even controversial, reorganization techniques attempted within the strictures of a fixed bankruptcy legal structure. In bankruptcy, he suggests, the power of narrative grows out of the innovation employed to restructure a firm, and is then used to strengthen and further extend the innovation.
Skeel – who earlier authored Debt’s Dominion: A History Of Bankruptcy Law In America – traces this narrative and its variations from the early “equity receiverships” utilized to reorganize railroads through the early cases filed in the wake of the 1978 Bankruptcy Code, and to the more recent 2008-09 “headline” cases of Lehman Brothers, Chrysler, and General Motors. Observing that reorganizations proposed over the last 30 years have been explained using one of two predominant narratives – “Debtor in Control” (used most commonly to justify the debtor’s further prosecution of an ongoing reorganization) or “No Time to Spare” (often used to justify the sale of the debtor’s business assets) – he then circles back to ask whether the “innovations” proposed are justifiable under either narrative.
Skeel’s treatment of narrative – particularly, in questioning whether there was truly “no time to spare” in the Lehman, Chrysler, and GM bankruptcies – is insightful. As he sees it:
Bankruptcy’s master narratives have always been closely intertwined with the underlying legal structures, which suggests that bankruptcy judges and bankruptcy law will determine the future of . . . current, competing narratives.
Though his work covers narrative in the domestic bankruptcy context, the same complexity and requests for emergency, interim relief that require narrative explanation also arise in cross-border insolvencies.
As these “master narratives” become intertwined with multiple (and potentially conflicting) “legal structures,” their continued evolution bears close watching.
Altered Egos – The Ninth Circuit Weighs in (Again) On Whether Individual Creditors Can Pursue Their Own “Alter Ego” Claims Against a Bankrupt Entity’s PrincipalsOctober 25th, 2010
Whenever a troubled business seeks bankruptcy protection, unsecured creditors are often left scrambling to find other sources of recoveries for their claims.
In addition to individual, contractually negotiated protections such as personal guarantees and letters of credit, alter ego claims against the debtor’s principals can provide such creditors with additional pockets from which to seek payment. To do so, however, such creditors must often address the objection that they are without standing to pursue such claims, because alter ego claims are often “general” ones, by which all creditors were injured – and from which all creditors are entitled to benefit. As a result, goes the objection, only the trustee – and not individual creditors – may pursue alter ego claims against the debtor’s principals.
The idea that alter ego claims may be prosecuted only by the debtor’s bankruptcy trustee on behalf of all creditors has been endorsed by at least one Circuit Court of Appeals: The 11th Circuit has affirmed as much in Baille Lumber Company, LP v. Thompson, 413 F.3d 1293 (11th Cir. 2005).
But this view is not universally held. In fact, the 9th Circuit has long held a contrary view, as has the 8th Circuit. See Williams v. California 1st Bank, 859 F.2d 664, 667 (9th Cir. 1988) (“[N]o trustee . . . has the power under . . . the [Bankruptcy] Code to assert general causes of action, such as [an] alter ego claim, on behalf of the bankrupt estate’s creditors.”). See also In re Ozark Restaurant Equipment Co., Inc., 816 F.2d 1222, 1228 (8th Cir. 1987); Estate of Daily v. Title Guar. Escrow Services, Inc., 187 B.R. 837, 842-43 (D. Haw. 1995), aff’d. 81 F.3d 167 (9th Cir. 1996).
Despite the Ninth Circuit’s guidance, however, several lower courts in California have continued to permit bankruptcy trustees to “glom onto” alter ego claims. See, e.g., In re Advanced Packaging and Products Co., 2010 WL 234795 (C.D. Cal. 2010) (permitting a trustee in bankruptcy to settle an alter ego claim brought against the bankrupt corporation’s parent entity because the claim was “general” rather than “particularized”).
Last week – for what appears to be the third time in as many decades – the Ninth Circuit revisited this issue in Ahcom, Ltd. v. Smeding.
Ahcom’s facts are relatively straightforward: Ahcom, a UK-based corporation, contracted for almonds with California-based Nuttery Farms, Inc. (NFI). After NFI allegedly failed to deliver the almonds, Ahcom commenced arbitration in Europe, then sued in the US to collect on the arbitrator’s award – but not before NFI had filed for bankruptcy protection. Undeterred, Ahcom directly sued NFI’s non-debtor principals, Hendrik and Lettie Smeding, seeking to pierce NFI’s corporate veil. The Smedings removed the action to US District Court for the Northern District of California and successfully dismissed the action on the grounds that Ahcom’s alter ego claims were “general” in nature – and, therefore, property of NFI’s bankruptcy estate.
On appeal, the Ninth Circuit reversed, noting that in California, “there is no such thing as a substantive alter ego claim at all . . . .” (citing Hennessey’s Tavern, Inc. v. Am. Air Filter Co., 251 Cal.Rptr. 859, 863 (Ct. App. 1988)). The panel then went further to explain that California law on this issue has been misread by bankruptcy courts and by the Bankruptcy Appellate Panel for the Ninth Circuit.
As a result, “California law does not recognize an alter ego claim or case of action that will allow a corporation and its shareholders to be treated as alter egos for purposes of all the corporation’s debts. Just because NFI’s trustee could not bring such a claim against the Smedings under California law, there is no reason why Ahcom’s claims against the Smedings could not proceed.”
A circuit split worthy of resolution by the Supreme Court? Perhaps. An alternate means of recovery for unsecured creditors who can allege the right facts? Most definitely.
The American Bar Association Section of Business Law provided comments last week to the Senate and House Judiciary Committees regarding proposed technical amendments to the Bankruptcy Code. The comments are designed to correct certain errors contained in the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (“BAPCPA”).
Get a complete copy of the proposed amendments here.
Late last month, the 9th Circuit Bankrpuptcy Appellate Panel clarified earlier precedent and held that adequate protection determinations are entirely within a bankruptcy court’s discretion – and not, as suggested by a number of recent decisions, subject to a “bright line” test of the time when adequate protection was requested.
The facts in People’s Cpaital and Leasing Corp. v. Big3D, Inc (In re Big3D) weren’t in dispute: Big3D, which operated a commercial printing business and leased specialized equipment from People’s Capital (PCLC), encountered difficulties in making its equipment lease payments to PCLC. A series of lease amendments failed to rectify Big3D’s ongoing missed payments. PCLC sued Big3D for breach of contract in Fresno and obtained a prejudgment writ of possession regarding its equipment. Two days later, Big3D was in Chapter 11 protection in California’s Eastern District. Big3D’s bankruptcy schedules assigned PCLC’s equipment a value of $400,000 – about $50,000 more than the amount of Big3D’s debt to PCLC – and acknowledged that PCLC held a secured claim for this amount.
About 6 months passed. Then, in March 2009, PCLC sought relief from the automatic stay – or, alternatively, adequate protection – in Big3D’s bankruptcy case. PCLC claimed the value of its equipment had remained constant at $380,000 from the time of its lawsuit through the date of Big3D’s Chapter 11 case, and thereafter had declined $45,000 in the first 6 months of Big3D’s case “because of adverse economic conditions” - but as of the time of PCLC’s request, was depreciating at an estimated rate of approximately $3,350 monthly.
Though the facts weren’t in dispute, PCLC’s entitlement to adequate protection was. Big3D and PCLC agreed that, moving forward, PCLC should receive adequate protection payments of $3,500 monthly. But the parties were at odds over PCLC’s entitlement to adequate protection for the first 6 months of Big3D’s case, in which PCLC sat by and did nothing to protect its rights.
PCLC cited Paccom Leasing Corp. v. Deico Elect’s., Inc. (In re Deico Elect’s., Inc.), 139 B.R. 945 (9th Cir. BAP 1992), for the proposition that adequate protection should be provided to a creditor as of the time from which the creditor could have obtained its state court remedies if bankruptcy had not intervened. According to PCLC, this was immediately prior to Big3D’s case, since PCLC had already been awarded a writ of possession and was about to foreclose. Therefore, PCLC argued, its $3,500 month was perhaps a good start, but not enough – it should also receive adequate protection payments for the entire first 6 months of Big3D’s case.
The Bankruptcy Court for the Eastern District of California disagreed, instead reading Deico as granting it “discretion to fix any initial lump sum [of adequate protection], the amount payable periodically, the frequency of payments, and the beginning date [of adequate protection], all as dictated by the circumstances of the case and the sound exercise of that discretion.” The Bankruptcy Court focused on PCLC’s acknowledgment that depreciation of its equipment was related to economic conditions – and not to Big3D’s continued use during its Chapter 11 case. It also expressed concern over PCLC’s apparent delay in getting around to seeking adequate protection. In the end, the Bankruptcy Court declined to award PCLC any adequate protection for the first 6 months of Big3D’s case. PCLC appealed, claiming the Bankruptcy Court had abused its discretion.
An en banc Appellate Panel first determined that the Bankruptcy Court had not, in fact, abused its discretion. Specifically, the Panel reckoned that to exercise its remedies, PCLC would have had to take possession of the equipment and sell it for cash. It took issue with PCLC’s claim that a mere writ of possession was sufficient to entitle it to adequate protection all the way through Big3D’s case: “To be entitled to adequate protection, Deico requires that [the creditor] establish both a temporal point at which it would have ‘exercised’ its state law remedies outside of bankruptcy, and the amount the equipment declined in value after that time.” It also accorded weight to the Bankruptcy Court’s observation that PCLC hadn’t been prompt in seeking relief - but had waited for 6 months before seeking adequate protection.
The Panel further determined that, despite a gradual shift in the case law from an early focus on the petition date to a more recent emphasis on the date of the adequate protection request as the time from which adequate protection payments should apply, Deico provides bankruptcy courts with needed flexibility in determining adequate protection for specific creditors in specific cases:
“When a creditor can or could exercise its statutory or contractual remedies to realize upon collateral is an inherently factual determination, but the fact that such a determination can be complicated does not make it unworkable. The discretionary standard adopted by Deico gives bankrupcy courts the needed flexibility to make appropriate adequate protection determinations as provided for in the Bankruptcy Code, based upon the evidence presented by the parties.”
As a result, Deico remains good law in the 9th Circuit. Courts continue to have wide discretion to fashion adequate protection remedies according to the particulars of the case before them. Debtors are without a “bright line” from which to gauge the need to come up with adequate protection payments. And creditors are on notice: It is critical that any request for adequate protection be (i) supported by a thorough brief explaining when – but for the intervention of bankruptcy – state law remedies could have been exercised; (ii) backed by solid evidence detailing the loss of value in the creditor’s collateral; and (iii) on time.
Back in May, this blog featured a post on some preliminary research addressing the idea of “probability-based” fraudulent transfer analysis. PBGC lawyer (and Cadwalader alum) John Ginsburg has argued that rather than merely asking whether insolvency is “reasonably foreseeable,” courts ought to clarify “reasonable foreseeability” in probabalistic terms. The basic idea underlying this argument is that 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%.
Mr. Ginsberg argues further that 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%).
Following comments offered here and elsewhere, Mr. Ginsberg – and colleagues Zachary Caldwell, Daniel Czerwonka, and Mary Burgess – have gone through a number of revisions and have a final draft version of the article available for review prior to going to publication with ABI Law Review in March.
A discussion is hosted at http://www.bulletinboards.com/view.cfm?comcode=LBO_FT, where anyone can critique and debate the paper, upload a rebuttal from a word-processor, or upload a handwritten mark-up in PDF. In written comments to South Bay Law Firm, Mr. Ginsberg notes that the authors are particularly ”interested in hearing from private equity fund managers, from the investment bankers who finance their deals, and from the lawyers, financial analysts and others who earn fees helping put those deals together. The paper has significant implications for them.”
- Fraudulent Transfer Claims on the Rise, New Navigant Consulting Data Shows (eon.businesswire.com)
About a month ago, the Ninth Circuit clarified and restated the ability of individual creditors to pursue claims against debtors based on an alter ego theory, despite a bankruptcy trustee’s efforts to reach the same assets (discussion here).
Last week, the Ninth Circuit further expanded the reach of alter ego liability to “asset protection” trusts established by debtors. Along the way, and in dicta, it finessed earlier treatment of the same liability in the corporate context.
The facts in In re Schwarzkopf are somewhat involved, but essentially reduce themselves to the following: During the 1990’s, the debtors established two separate and allegedly irrevocable trusts – the “Apartment Trust” (to hold the debtors’ stock in a corporation which owned and operated an apartment building) and the “Grove Trust” (to hold four plots of land containing avocado groves). The Apartment Trust was established to remove the debtors’ stock from the reach of creditors while the debtors contested a judgment obtained against the corporation. The Grove Trust was subsequently established while the debtors were insolvent – and, likewise, was intended to move the debtors’ assets beyond the reach of their creditors.
During the life of both trusts, the debtors routinely sought and obtained use of the trust assets for their personal benefit and for the benefit of family members. The trustee administering the trusts apparently exercised no independent judgment regarding the debtors’ requests, commingled trust assets, and kept no books and records regarding either trust for several years after their establishment.
The debtors filed a Chapter 7 case in 2003, seeking to discharge approximately $5.4 million in debt. The appointed Chapter 7 trustee filed an adversary complaint seeking to recover approximately $4 million from the trusts. The bankruptcy court initially concluded both trusts were valid and that neither is the alter ego of the debtors, but subsequently reversed the alter ego determination as to the Grove Trust.
The District Court found that the trusts were not the debtors’ alter ego, reasoning that under SEC v. Hickey, 322 F.3d 1123 (9th Cir. 2003), legal ownership is a prerequisite for such liability in California. It also found the Apartment Trust was not valid, but remanded so the Bankruptcy Court could determine whether or not the Trustee’s complaint was time-barred in the first instance.
The Ninth Circuit quickly dispensed with the Apartment Trust, finding the statute of limitations for attacking the Apartment Trust did not begin to run until the trustee answered the avoidance complaint filed in the debtors’ Chapter 7 cases.
It then turned to the Grove Trust, finding that despite its continuing existence as a trust, it was the nevertheless the debtors’ alter ego. To reach this conclusion, it reasoned that despite its earlier decision in Hickey, which had concluded that actual ownership of stock was a prerequisite for alter ego liability in corporate cases, California law nevertheless suggested that equitable stock ownership was sufficient for alter ego liability after all . . . and that, in any event, an equitable ownership interest is “traditionally sufficient to confer ownership rights” in the trust context.
Schwarzkopf’s facts certainly suggest the Ninth Circuit was reaching to assist the trustee’s efforts to recover significant assets for the benefit of creditors. However, its relaxed treatment of the “ownership threshold” for alter ego liability may prove useful for trustees or creditors in other contexts.
Last month, this blog featured a preliminary post on Ahcom Ltd. v. Smeding (9th Cir. Oct. 21, 2010, Docket No. 09-16020), a decision restating and reemphasizing the Ninth Circuit’s position that a creditor of a corporation in bankruptcy has standing to assert a claim against the corporation’s sole shareholders on an alter ego theory.
More recently, the Insolvency Law Committee of the California State Bar’s Business Law Section released an insightful and helpful e-bulletin discussing the Ahcom decision’s impact on commercial bankruptcy practice in California.
A hard copy of the Committee’s e-bulletin is available here.
One of the historical attractions of the Bankruptcy Code as a vehicle for restructuring is the ability to sell the debtor’s assets quickly, cleanly, and with finality pursuant to a sale under Section 363.
So-called “section 363 sales” have been the subject of much recent interest and debate, as evidenced by the discussion surrounding 2009’s “section 363 sales” of both Chrysler LLC and General Motors Corporation (see, for example, blog posts here and here). In California, the effectiveness of such sales has been limited where the assets are worth less than the aggregate liens against them, and a lienholder objects to the sale.
Earlier this month, “Section 363 sales” received yet another potential challenge in California, this time from the Federal Trade Commission, which sought to undo Laboratory Corporation of America (“LabCorp”)’s acquisition of Westcliff Medical Laboratories, Inc. (“Westcliff”). According to the agency’s December 1 complaint to enjoin furtherance of the merger, filed in Washington DC and transferred to California’s Central District (redacted copy available here), the merger will substantially lessen competition among providers of capitated clinical laboratory testing services to physician groups in southern California.
LabCorp and Westcliff are clinical laboratory testing companies serving physician groups here in Southern California. In May 2010, Westcliff agreed to sell substantially all of its business assets to LabCorp for $57.5 million. As part of the sale, Westcliff agreed to file a voluntary petition for relief under Chapter 11 of the US Bankruptcy Code. The transaction was therefore subject to the approval of the US Bankruptcy Court for the Central District of California. In June, after a hearing at which no other bidder emerged to top the LabCorp offer, the court approved the sale, the parties closed the deal, and life went on – until the FTC stepped in.
Though after-the-fact challenges to mergers are not unknown, they have been – at least until recently – comparatively rare. Even rarer is the challenge to an acquisition completed with approval by the US Bankruptcy Court. The FTC claims Westcliff wasn’t a “failing firm,” whose assets otherwise would have exited the market absent the merger (and would therefore be exempt from anti-trust enforcement). Instead, the FTC alleges Westcliff was generating operating profits at the time of its sale and that there were other potential buyers available to purchase the company. According to the FTC, the reason these buyers didn’t show up was because none would have matched LabCorp’s $60 million “stalking horse” bid.
Counsel for LabCorp attempted to preempt the FTC’s action by filing an adversary complaint in Bankruptcy Court, seeking declaratory relief as well as an injunction against the FTC, arguing that the agency’s enforcement action constituted a “collateral attack” on the Bankruptcy Court’s prior sale order. The FTC responded with its own motion to dismiss and an argument that its enforcement action was limited merely to prospective violations of antitrust laws, and did not seek to disturb the bankruptcy sale. Bankruptcy Judge Theodor Albert abstained, and transferred the matter to the US District Court where the FTC’s action remains pending.
Though the Bankruptcy Court’s order authorizing the Westcliff acquisition remains undisturbed, the FTC’s action raises some important and often-overlooked questions about “363 sales”: Does counsel advising on the sale or purchase of a distressed business need to conduct or provide due diligence on the potential anti-trust effect of the transaction, despite the transaction’s failure to meet the Hart-Scott-Rodino reporting threshold? Is it necessary (or good practice) for bankruptcy counsel to obtain factual findings commensurate with the sale which would insulate the transaction from subsequent attack?
In any event, 363 sales in now carry another important caveat emptor.
- FTC to challenge LabCorp buy of small rival (reuters.com)
- FTC Challenges Acquisition of Westcliff Labs by LabCorp In Southern California-Why? (ducknetweb.blogspot.com)
- FTC Challenges LabCorp’s Acquisition of Rival Clinical Laboratory Testing Company (ftc.gov)
- FTC Challenges Acquisition by LabCorp (online.wsj.com)
- FTC Targets Yet Another Done Deal (legaltimes.typepad.com)
- 4 tips for buying a bankrupt competitor (venturebeat.com)
The distribution scheme embodied in federal bankruptcy law serves several important functions. In Chapter 7, the detailed statutory distribution scheme imposes order on the chaos that might otherwise attend the liquidation of business assets. In Chapter 11, the fixed order of priority claims and the “absolute priority rule” – along with the requirement that similarly situated classes receive identical treatment – provide predictability within the confirmation process and a framework for out-of-court negotiations.
But not all resolutions of business insolvency afford this level of predictability. In particular, state and federal receiverships afford the prospect of considerably greater flexibility and discretion on the part of the appointed receiver and the appointing court.
The scope of a receiver’s discretion was illustrated early this month by the 7th Circuit Court of Appeals’ approval of a federal receiver’s proposed pro rata distribution of the assets of six insolvent hedge funds.
SEC v. Wealth Management LLC, — F.3d — 2010 WL 4862623 (7th Cir., Dec. 1, 2010) involved an SEC enforcement action against Appleton, Wisconsin-based investment firm Wealth Management LLC and its principals, alleging, among other things, misrepresentation and fraud. At the SEC’s request, the Wisconsin District Court appointed a receiver for Wealth Management and its six unregistered pooled investment funds.
The receiver’s plan, approved by the District Court, was relatively straightforward: All investors would be treated as equity holders, and would receive pro rata distributions of the over $102 million invested in the funds. Two investors who had sought redemption of their investments pre-petition disagreed and appealed the receiver’s plan. The essence of their argument was that Wisconsin law (and Delaware law, which governed several of the funds), required that investors who sought to redeem their investments be treated not as equity holders, but as creditors of the failed funds. As a result, their redemption claims were of a higher priority than investors who had not sought to withdraw their funds. The investors also relied on 28 USC § 959(b), which provides that receivers and trustees must “manage and operate” property under their control in conformity with state law.
The 7th Circuit rejected this argument, finding instead that federal receivers and trustees need not follow the requirements of state law when distributing assets under their control. Holding that “equality is equity,” the court found that to give unpaid redemption requests the same priority as any other equity interest “promotes fairness by preventing a redeeming investor from jumping to the head of the line . . . while similarly situated non-redeeming investors receive substantially less.”
The Wealth Management decision highlights the flexibility and ambiguity of the receivership system – itself a critical distinction from the well-defined priorities of federal bankruptcy law. Though the 7th Circuit’s reasoning – rooted in “similarly situated claims” – is consistent with the policy objectives of the Bankruptcy Code, the result is diametrically opposed to the scheme of priorities on which Wealth Management’s investors undoubtedly relied.
Wealth Management – like many receivership cases – is a case based on federal securities fraud. But federal and state receiverships are applicable in a variety of contexts – including business dissolutions, directorship disputes, marital dissolutions, and judgment enforcement. Where a proposed distribution to creditors can be fairly characterized as “equitable” under the circumstances of the case and where it represents a fair exercise of the receiver’s fiduciary duty on behalf of the receivership estate, the flexibility of a receivership may justify its typically high cost.
South Bay Law Firm will be back posting in 2011. In the meantime, have a safe and prosperous New Year!
The Insolvency Law Committee for the California State Bar’s Business Law Section has produced a very helpful analysis of recent changes to the Federal Bankruptcy Rules – which (as most readers are aware) became effective as of December 1, 2010.
A copy is available here.
Norton’s recently-published 2010 Annual Survey of Bankruptcy Law offers an intriguing article focusing on an often-overlooked difference between “Section 363 sales” and Chapter 11 Plans – and suggesting that, for certain liabilities, Section 363 may actually afford broader relief than a Chapter 11 discharge.
In Classic Chapter 11 Reorganizations Versus Section 363 Sales And The Effects On Environmental Cleanup Obligations: The Choice After Apex Oil Co. And General Motors, authors Joel Gross and Christopher Anderson contend:
“[U]nless the law [surrounding Section 363 sales] changes, any debtor seeking to provide maximum protection to its surviving business from broad cleanup liabilities for divested properties would be best advised to utilize a Section 363 sale. The protection from successor liability that can be achieved through such a sale will very likely exceed the more narrow discharge from monetary claims that can be obtained if the property is transferred under a plan of reorganization.”
In support of their argument, Gross and Anderson compare the results of two recent decisions – In re Apex Oil and the 2009 In re General Motors Corp. decision.
In Apex Oil, the 7th Circuit held that, despite its prior discharge in Chapter 11, the reorganized debtor remained liable for environmental liabilities incurred years earlier on the grounds that such liabilities were not “claims” subject to discharge under Chapter 11’s provisions. A prior post regarding Apex is available here.
In General Motors – by contrast – the the US Government supported, and the Bankruptcy Court accepted, the transfer of GM’s business assets to a newly-formed entity (“New GM”) under a sale “free and clear of all . . . interests,” including successor liability claims. In reaching this decision, the Bankruptcy Court relied on the reasoning set forth in In re Trans World Airlines, Inc., 322 F.3d 283 (3d Cir.2003) – i.e., that Section 363 provides a basis for selling assets free and clear of successor liability claims.
Not every circuit permits an extension of Section 363’s “free and clear” language to successor liability claims. See Michael H. Reed, Successor Liability and Bankruptcy Sales Revisited—A New Paradigm, 61 Bus. Law. 179, 208–211 (2005) (surveying the lower courts’ application of TWA). Though at least one District Court and the Ninth Circuit Bankruptcy Appellate Panel have followed the TWA decision, the Ninth Circuit has not explicitly ruled.
Consequently, “[i]n light of the split in circuit authority, it remains to be seen whether the view that successor liability claims can ultimately be cut off via a Section 363 sale will prevail. For the time being, however, the majority of appellate courts (including the Second and Third Circuits where so many major Chapter 11 cases are fled) have held that they can, and there seems to be a similar trend in the lower courts.”
That said, the use of Section 363 to avoid environmental liabilities isn’t without its problems: “One potentially important limitation, which appears not to have been addressed by any court to date, is Section 363(e)’s requirement that all sales approved under Section 363 provide adequate protection for the interest of any entity in the property sold.”
Other issues present themselves as well. For example:
- Is it possible to provide for liens against the sale proceeds for successor interests? Gross and Anderson don’t think so – as they see it, doing so would provide otherwise-unsecured creditors with preferential treatment.
- How much are contingent successor claims truly worth? Even if it were possible to provide “adequate protection” for successor claims, doing so raises the question of what such claims are truly worth.
- Finally, the ability to shield assets from successor liability claims frequently implicates the Court’s equitable power under Section 105, and the extent of its scope.
Problematic or not, these considerations likely won’t stop debtors from taking a shot at a sale: “[G]iven the certainty following Apex Oil that at least some injunctive claims will survive a traditional chapter 11 reorganization, it can be expected that debtors with significant environmental exposure will prefer to follow the roadmap laid out in GM.”
Readers of this blog will know that a number of jurisdictions around the world have remodeled their insolvency schemes based on concepts developed originally in the US under Chapter 11 of the Bankruptcy Code. Relatively recent examples of this trend include the People’s Republic of China as well as Mexico.
But not all jurisdictions have rushed to follow the US. For one, Hong Kong – one of the world’s leading financial centers – has struck out on a different path.
With origins steeped in colonial history and a long-standing tradition of UK law, Hong Kong still follows the legal contours of most commonwealth jurisdictions, including those applicable to the resolution of insolvencies. In Hong Kong, a “winding-up” is the traditional means of achieving a moratorium on creditor activity; however, “winding up” has been limited to liquidation.
Corporate reorganization (or “corporate rescue,” as it’s sometimes called) relies on the implementation of a “scheme of arrangement.” In Hong Kong, however, schemes are deemed of little practical value where their comparative complexity and expense buy no moratorium from creditors.
Previously, corporate reorganization in Hong Kong relied upon an ad hoc solution – utilization of the “winding up” procedure to implement what was known colloquially a “provisional liquidation.” The essence of the “provisional liquidation” concept is that a voluntary winding up is commenced – and the debtor can avail itself of a moratorium against creditor action – while a court administrator is appointed to oversee the debtor until the company and its creditors can reach acceptable reorganization terms (at which time, the winding up is dismissed and the debtor reorganized consensually). Though initially accepted, such solutions were ultimately sharply limited by the Hong Kong courts.
In 2009, Hong Kong’s Financial Services and Treasury Bureau (FSTB) published a consultation paper reviewing corporate rescue procedure with the aim of reforming key reorganization issues. The FSTB paper – and the different concepts it proposes for Hong Kong reorganization vis á vis “US”-style Chapter 11’s – are the subject of recent analysis by Dr John K.S. Ho, Assistant Professor, School of Law, City University of Hong Kong and Dr Raymond S.Y. Chan, Associate Professor, School of Business, Hong Kong Baptist University.
Specifically, Dr’s Ho and Chan ask “Is Debtor-in-Possession Viable in Hong Kong?” In providing an answer, they discuss reform efforts in Hong Kong, noting that a “provisional supervision” has been and remains the preferred approach to Chapter 11 rather than a US-style “Debtor-in-Possession” (DIP) approach, where management remains in control of its own destiny.
So why doesn’t a US-oriented corporate rescue scheme work in Hong Kong? According to Ho and Chan, “[i]n order to understand the corporate rescue law of a jurisdiction, one must also recognize the economic nature and historical development of that society.” Some of the differences in economic development which shape differences in US and Hong Kong insolvency laws include:
Varying Appetites for Risk. “In the US, it is widely believed that there is a different attitude towards risk and risk-takers . . . . Debt forgiveness, both personal and business debt, ultimately was seen as critical to a vibrant American economy. These historical and economic factors explain in large part why the US business bankruptcy system is more forgiving towards the debtor than other jurisdictions are. However, the same analogy may not apply to the concept of corporate rescue in Hong Kong because the stakeholders which reform proposal in Hong Kong is most concerned with are different from Chapter 11 in the US.”
Different Stakeholders. How are Hong Kong stakeholders different? And why should corporate rescue look different in Hong Kong than in the US?
[I]n Hong Kong, the objectives for . . . corporate rescue are radically different . . . . [E]mployees should generally be no worse off than in the case of insolvent liquidation and . . . consideration should be given to allow greater involvement of creditors in the rescue process in exchange for their being bound by the moratorium once the process commences and the rescue plan is agreed . . . . [P]revious attempt[s] to introduce a corporate rescue law failed in Hong Kong because of the disappointing treatment of workers’ wages, complete exclusion of shareholders from the provisional supervision process, and the difficulty in classification of creditors. Therefore, if a law is to be successfully promulgated this time, greater consideration would need to be given to these stakeholders.
Though they explain how the proposed treatment of Hong Kong stakeholders in a corporate reorganization might differ from those in a US Chapter 11, Ho and Chan don’t really explain the why of those differences. What they do offer is an explanation for the absence of any interference with secured creditors’ rights, noting that this “is understandable given the fact that many major secured creditors [in Hong Kong] are financial institutions such as major banks and their influence both politically and economically cannot be ignored given that the growth of Hong Kong as a financial services hub has been supported largely by the banking sector.”
These differences are “in line with the legal creditor rights ratings of the two jurisdictions as reported in a financial economics study in which a creditor rights index is developed for 129 countries and jurisdictions. This index ranges from 0 to 4 (with higher scores representing better creditor rights) and measures four powers of secured lenders in bankruptcy. Hong Kong (and also the UK) has a perfect score of 4, but the US has a score of 1.”
Different Corporate Ownership and Control Structures. A more interesting difference arises from the authors’ argument that, unlike in the US, share ownership and corporate control in Hong Kong are closely related:
According to research conducted at the turn of the millennium, . . . separation of ownership and control, [has] largely become the phenomenon in the US. This trend was accompanied by a shift in bankruptcy law towards a more flexible, manager-oriented regime, assuming that managers of corporations that have filed Chapter 11 will subsequently make business decisions in the best interests of the corporations as a whole. On the bankruptcy side these developments culminated in 1978 with the enactment of the Bankruptcy Code and its DIP norm. However, in Hong Kong, [this] type of [dispersed corporate ownership] is not as prevalent. According to research on ownership structures and control in East Asian corporations, about three-quarters of the largest 20 companies in Hong Kong are under family control, while fewer than 60 per cent of the smallest 50 companies are in the same category. As for corporate assets held by the largest 15 families as a percentage of GDP, Hong Kong displays one of the largest concentrations of control, at 76 per cent. For comparison, the wealth of the 15 richest American families stands at about 3 per cent of GDP.
Because of this reality, the Ho and Chan argue that the DIP concept so common in US reorganizations simply isn’t practical in Hong Kong:
Given such context, a corporate rescue process based on the DIP concept of the US will not be practical for Hong Kong because wide dispersion of share-ownership and manager-displacing corporate reorganization simply do not exist in reality. This is consistent with the government’s proposal in rejecting the DIP given concerns that if the existing management was allowed to remain in control, a company could easily avoid or delay its obligations to creditors as the managers of a family business either are family members or are nominated by the family. They are expected to place the family’s interests in the corporation as the first priority even at the expense of creditors’ interests.
Though these differences may be true in the case of publicly held and traded US corporations, they are not so clear in the case of closely-held US companies – which many readers will acknowledge comprise the bulk of US business.
Why No Post-Petition Financing? As for post-petition financing – a mainstay of US reorganizations – Ho and Chan point out that though the US has developed a vibrant distressed debt market, “the debt market is not as developed and is materially underused in Hong Kong. The major reason for illiquidity and lack of use is best expressed as Hong Kong’s cultural background. Hong Kong lacks no resources for deal structuring but has no tradition of traded debt, and corporate governance practice has historically been insufficient to support issue of debts by large companies.”
Economic Efficiency. Finally, the authors cite well-recognized and frequently noted flaws in the Chapter 11 process: Its perceived inefficiency arising from its “one-size-fits-all” approach, as well as the arguably high rates of recidivism amongst those debtors who do successfully confirm a Chapter 11 Plan.
Whatever one’s take on Ho and Chan’s assessment of US-style reorganizations, their work affords an interesting glimpse into alternative methods of corporate rescue currently under consideration in one of the world’s most sophisticated financial jurisdictions.
The 2008 financial crisis sparked a vigorous debate over how the financial problems of troubled financial institutions ought to resolved. Ultimately, Congress’ answer to this (and a host of other regulatory matters involving financial institutions) was the Dodd-Frank Act.
But is Dodd-Frank the best answer to resolving the distress of financial insitutions? In a paper forthcoming in the Seattle Law Review, Seton Hall Professor Stephen J. Lubben discusses The Risks of Fractured Resolution – Financial Institutions and Bankruptcy. According to Professor Lubben:
Under Dodd-Frank, “[a]ll large bank holding companies, which now include former investment banks such as Goldman Sachs, and many other important institutions, with more than 85% of their activities in ‘finance,’ will be subject to a new resolution regime controlled by the FDIC and initiated by the Treasury Secretary and the Federal Reserve. But by developing a new system for addressing financial distress, instead of integrating the new system into the existing structure of the Bankruptcy Code, the financial reform act simply recreates the prior problem in a new place. The future Lehmans and AIGs will be covered by the new procedure, but other firms that have 84% of their activities in finance will not. In short, the disconnect between bankruptcy and banking has moved to a different group of firms. And we may have done nothing but protect ourselves against an exact repeat of the financial crisis.
. . . .
I use this paper to argue that there are significant gaps in the federal system for resolving financial distress in a financial firm, even after passage of the Dodd-Frank bill. These gaps represent potential sources of systemic risk – that is, risk to the financial system as a whole. They must be fixed. But I should make clear at the outset that I do not argue that these gaps must be filled with the Bankruptcy Code. Rather, the point is that the various systems for resolving financial distress among financial firms – including the FDIC bank resolution process, the new resolution authority, state insurance resolution proceedings, and the SIPC process for broker-dealers, as well as chapter 11 of the Code – must be integrated so that the result of financial distress is clear and predictable. Integrating all under the Bankruptcy Code is an option, but not the only way to achieve such clarity.”
Lubben’s work provides an insightful perspective on Dodd-Frank’s effectiveness, at least as it regards the resolution of financial institution insolvency.
- Derivatives Still Special After Overhaul (dealbook.blogs.nytimes.com)
- The New Complexity of Financial Resolution (dealbook.nytimes.com)
- Financial Distress and the Bankruptcy Code (dealbook.nytimes.com)
- Skeel on Dodd-Frank reviewed (professorbainbridge.com)
- Resolution Rules and Bankruptcy Reality (dealbook.blogs.nytimes.com)
- David Skeel’s New Financial Deal (professorbainbridge.com)
- Shiller: Dodd-Frank Does Not Solve Too Big To Fail (huffingtonpost.com)
- Repeal Dodd-Frank? (professorbainbridge.com)
Ever since the first corporate reorganizations in the US, business owners have been looking for ways to retain ownership of their restructured companies while reducing debt. And ever since owners have been trying to retain ownership, courts have been resisting them.
Today, it is commonly understood that the equity holders of a reorganizing business cannot retain their ownership unless other, senior creditors are paid in full. This principle, known as the “absolute priority rule,” has been developed and refined through various decisions which date back to the 1860’s – before the concept of “corporate reorganization” was formally recognized as such.
Despite the pedigree of the “absolute priority rule,” equity owners nevertheless have continued undaunted in creative efforts to retain some piece of the (reorganized) pie even though creditors senior to them receive less than full payment. And courts, though stopping short of prohibiting it outright, nevertheless keep raising the bar for such ownership.
Yesterday, the Second Circuit Court of Appeals raised the bar another notch with its decision in In re DBSD Incorporated.
The basic economic scenario in DBSD is a relatively common one for business reorganizations: DBSD was an over-leveraged “development stage” start-up company with reorganizable technology and spectrum licensing assets, but no operations – and therefore, no revenue. It was essentially wholly owned by ICO Global, which sought to de-leverage DBSD through Chapter 11 – but who also sought to retain an equity interest in DBSD.
To accomplish these goals, ICO Global negotiated a Chapter 11 Plan which (i) paid its first lien-holders in full; (ii) paid its second lien-holders in stock in the reorganized entity worth an estimated 51% – 73% of their original debt; and (iii) paid general unsecured creditors in stock worth an estimated 4% - 46%. The Plan further provided that ICO Global would receive equity (i.e., shares and warrants) in the newly organized entity.
One of the larger unsecured creditors objected, claiming that DBSD’s Plan violated the “absolute priority rule.” Both the Bankruptcy Court and the District Court found that that the holders of the second lien debt, who were senior to the unsecured creditors and whom the bankruptcy court found to be undersecured, were entitled to the full residual value of the debtor and were therefore free to “gift” some of that value to the existing shareholder if they chose to.
The Second Circuit disagreed. In a lengthy decision (available here), the Court of Appeals held, essentially, that merely calling a Plan distribution a “gift” doesn’t make it one. As a result, the Plan’s distribution of stock and warrants to ICO Global under the Plan was impermissible.
Nevertheless, the Second Circuit didn’t slam the door altogether on the “gifting” of stock from senior creditors to equity. Equity holders looking to de-leverage with the assistance of senior creditors may still consider the following approaches:
- A separate agreement for distributions outside the Plan. Though the DBSD decision notes that the “absolute priority rule” preceded the present Bankruptcy Code, and further devotes some discussion to the general policy reasons behind it, the Second Circuit stopped short of precluding such gifts altogether:
“We need not decide whether the Code would allow the existing shareholder and Senior Noteholders to agree to transfer shares outside of the plan, for, on the present record, the existing shareholder clearly receives these shares and warrants ‘under the plan.’”
This analysis suggests it may be possible to negotiate outside a Chapter 11 plan for the same economic result as that originally proposed (but rejected) in DBSD.
- A “consensual” foreclosure by a senior secured creditor. Along the way to its conclusion, the Second Circuit distinguished DBSD from another “gifting” case - In re SPM Manufacturing Corp., 984 F.2d 1305 (1st Cir. 1993).
In SPM, a secured creditor and the general unsecured creditors agreed to seek liquidation of the debtor and to share the proceeds from the liquidation. 984 F.2d at 1307-08. The bankruptcy court granted relief from the automatic stay and converted the case from Chapter 11 to a Chapter 7 liquidation. Id. at 1309. The bankruptcy court refused, however, to allow the unsecured creditors to receive their share under the agreement with the secured creditor, ordering instead that the unsecured creditors’ share go to a priority creditor in between those two classes. Id. at 1310. The district court affirmed, but the First Circuit reversed, holding that nothing in the Code barred the secured creditors from sharing their proceeds in a Chapter 7 liquidation with unsecured creditors, even at the expense of a creditor who would otherwise take priority over those unsecured creditors.
The Second Circuit held that DBSD’s result should be different from SPM’s because (i) SPM involved a Chapter 7 (where the “absolute priority rule” doesn’t apply); and (ii) the creditor had obtained relief from stay to proceed directly against its collateral – and therefore, the collateral was no longer part of the bankruptcy estate.
This distinction suggests that, under appropriate circumstances, a stipulated modification of the automatic stay and “consensual foreclosure” by a friendly secured creditor might likewise facilitate the transfer of property to equity holders outside the strictures of a Chapter 11 Plan.
DBSD offers interesting reading – both for its coverage of reorganization history, and for its implicit suggestions about the future of “creative reorganizations.”
- Ruling Appears to End to Chapter 11 ‘Gift’ Plans (dealbook.nytimes.com)
- DBSD Bankruptcy Plan Partly Reversed by Court (businessweek.com)
- Sprint Wins Partial Reversal of DBSD Bankruptcy Plan (businessweek.com)
- U.S. appeals court rejects DBSD North America’s reorg plan (reuters.com)
Jones Day’s Charles Oellerman and Mark Douglas have just issued The Year in Bankruptcy: 2010. It is a (relatively) concise, thorough (81 pages), and useful compendium of bankruptcy statistics, trend analyses, case law highlights, and legislative updates for the year.
What to expect for 2011? According to the authors:
[M]ost industry experts predict that the volume of big-business bankruptcy filings will not increase in 2011. Also expected is a continuation of the business bankruptcy paradigm exemplified by the proliferation of prepackaged or prenegotiated chapter 11 cases and quick-fix section 363(b) sales. Companies that do enter bankruptcy waters in 2011 are more likely to wade in rather than freefall, as was often the case in 2008 and 2009. More frequently, struggling businesses are identifying trouble sooner and negotiating prepacks before taking the plunge, in an effort to minimize restructuring costs and satisfy lender demands to short-circuit the restructuring process. Prominent examples of this in 2010 were video-rental chain Blockbuster Inc.; Hollywood studio Metro-Goldwyn-Mayer, Inc.; and newspaper publisher Affiliated Media Inc. Industries pegged as including companies “most likely to fail” (or continue foundering) in 2011 include health care, publishing, restaurants, entertainment and hospitality, home building and construction, and related sectors that rely heavily on consumers. Finally, judging by trends established in 2010, companies that do find themselves in bankruptcy are more likely to rely on rights offerings than new financing as part of their exit strategies.
During recent years, the global economy has seen significant growth in transactions which purport to be governed by classic Islamic – or Shari’a – law. Primarily, the legal and business community’s focus has been on Shari’a finance. But what happens under Shari’a law when a transaction or venture turns sour?
That is the question posed recently by Abed Awad and Robert E. Michael of Pace Univeristy in White Plains. In IFLAS AND CHAPTER 11: CLASSICAL ISLAMIC LAW AND MODERN BANKRUPTCY, Awad and Michael (both adjunct professors at Pace, and both practicing attorneys in the New Jersey-New York metropolitan area) explore this issue in some much-needed detail.
Specifically, their article:
is intended to provide an exposition and analysis of the basic precepts of this side of Islamic commercial law and, in doing so, compare them to the basic elements of western bankruptcy, notably that of the most successful and emulated one, Chapter 11 of the U.S. Bankruptcy Code. Above all, this article will discuss what the authors consider to be the five primary concepts that underpin or constitute the foundation of the Islamic law of bankruptcy: (1) the prohibition of riba (interest), and the concomitantblack of a theory of the time value of money; (2) the obligation to be socially responsible; (3) the divine directive to pay all of one’s debts if you are able to do so, with death being the only source of a final discharge; (4) the absence of a limited liability or entity shielding concept; and (5) the absence of concepts of intangible assets and many forms of non-possessory rights common in other legal systems. These five concepts are interwoven in the fabric of Islamic commercial and financial law.
In light of continuing global financial turmoil and further political turmoil in the Middle East, the article – which first appeared in last fall’s issue (Vol. 44) of SMU’s International Lawyer – is worth reading.
- The World of Islam (time.com)
Asset sales through bankruptcy are all the rage – they’re presumably [relatively] quick. And just as importantly, they’re perceived as clean – that is, they permit assets to be sold “free and clear” of an “interest” in the property.
The term “interest” has been construed broadly, and has been interpreted to extend to successor liability claims – including often prohibitively expensive environmental liabilities. Indeed, one recent post on this blog (here) notes the potentially broad reach of bankruptcy court orders authorizing asset sales – and suggests the relief available in some circumstances may even be broader than the Chapter 11 discharge.
But not all courts agree with this conclusion . . . at least not entirely.
Late last month, the Southern District of New York (the same jurisdiction which authorized the “Section 363″ sale of General Motors free and clear of environmental liabilities) reached a different result in the case of In re Grumman Olson Industries, Inc.
Grumman Olson, an auto-body manufacturer whose primary customers were Ford and General Motors, commenced Chapter 11 proceedings nearly nine years ago and completed a “363 sale” of its assets to Morgan Olson, LLC about 6 months after filing. The sale order contained provisions which purported to release both Morgan Olson and the sold assets themselves from any successor liability claims which might arise.
Ms. Frederico, a FedEx employee, sustained serious injuries on October 15, 2008 when the FedEx truck she was driving hit a telephone pole. In a New Jersey lawsuit filed after the accident, the Fredericos claimed that the FedEx truck involved in the accident was manufactured, designed and/or sold by Grumman in 1994, and was defective for several reasons. The Fredericos claimed that Morgan Olson continued Grumman‘s product line, and was, therefore, liable to the Fredericos as a successor to Grumman under New Jersey law. In response, Morgan Olson requested that Bankruptcy Judge Stuart Bernstein re-open the [now closed] Grumman Olson case, then filed an adversary proceeding to determine that the Federico’s claim was barred by the prior sale order.
Both sides sought Judge Bernstein’s summary judgment regarding the Morgan Olson suit. In a 21-page decision, Judge Bernstein ruled (following a brief discussion addressing his continuing jurisdiction to interpret the prior sale order) that Morgan Olson was, indeed, a successor for purposes of the Fredericos’ suit. This was because the Fredericos’ claimed injuries arose not from the assets sold through bankruptcy, or from personal claims against Grumman Olson that arose prior to Grumman’s Chapter 11, but from Morgan Olson’s post-confirmation conduct:
the Fredericos are basing their claims on what Morgan [Olson] did after the sale. According to their state court Amended Complaint, Morgan [Olson] is liable as a successor under New Jersey law because it “continued the product line since the purchase,” “traded upon and benefited from the goodwill of the product line,” “held itself out to potential customers as continuing to manufacture the same product line of Grumman trucks” and “has continued to market the instant product line of trucks to Federal Express.” The Sale Order did not give Morgan [Olson] a free pass on future conduct, and the suggestion that it could is doubtful.
A good portion of Judge Bernstein’s decision is devoted to a discussion of what constitutes a “claim” for bankruptcy purposes – and the circumstances under which an anticipated “future tort claim” (i.e., claim based on a defective product manufactured by the debtor which hasn’t yet caused an injury, but which will at some point in the future) may be addressed through a “Section 363″ sale.
In permitting the Fredericos to proceed with their New Jersey law suit against Morgan Olson, Judge Bernstein’s analysis focused on three areas:
- the Fredericos’ lack of any meaningful “contact” with Grumman prior to the commencement of Grumman’s case or confirmation of Grumman’s Chapter 11 plan;
- the absence of any notice by the Fredericos of the Grumman/Morgan sale; and (though less important than the lack of contact and lack of notice)
- the absence of any provision for such anticipated “future claims” in Grumman’s Chapter 11 plan.
In the end, he observed that “every case. . . addressing this issue has concluded for reasons of practicality or due process, or both, that a person injured after the sale (or confirmation) by a defective product manufactured and sold prior to the bankruptcy does not hold a ‘claim’ in the bankruptcy case and is not affected by either the § 363(f) sale order or the discharge under 11 U.S.C. § 1141(d).”
Judge Bernstein’s Grumman Olson decision serves as an important reminder that “section 363 sales” – though undoubtedly a very powerful tool for disposing of distressed assets quickly and cleanly – do not provide “bullet-proof” protection for any type of liability which might be associated with the debtor’s assets, or with its general product line.
Chapter 15 of the US Bankruptcy Code, enacted in 2005, was Congress’ effort to make cross-border insolvency proceedings just a little more predictable.
Specifically, the statute’s policy objective was to ”recognize” the efforts of foreign insolvency administrators and trustees to administer their debtors’ US-based assets – thereby helping to “standardize” the way assets and claims are treated in non-US insolvency proceedings.
Chapter 15 reflects a strong Congressional preference for what has been described as a “universalist” (rather than a “territorial”) approach to cross-border insolvency administration. But have US Bankruptcy Courts actually followed through on this “universalist” policy?
That is the question behind an empirical study on Chapter 15 recently published by Jeremy Leong, an advocate and solicitor with Singapore’s Wong Partnership. According to Mr. Leong, the study (entitled IS CHAPTER 15 UNIVERSALIST OR TERRITORIALIST? EMPIRICAL EVIDENCE FROM UNITED STATES BANKRUPTCY COURT CASES, and forthcoming in the Wisconsin International Law Journal) and its results indicate that, despite its ostensibly “universalist” objectives:
United States courts applying Chapter 15 have not unconditionally turned over [the] debtor’s assets in the United States to foreign main proceedings. The results of the study show that while United States courts recognized foreign proceedings in almost every Chapter 15 case, courts entrusted United States assets to foreign proceedings for distribution in only 45.5% of cases where foreign proceedings were recognized. When such entrustment was granted, 31.8% of cases were accompanied by qualifying factors[,] including orders which protected United States creditors by allowing them to be paid according to the priority scheme under United States bankruptcy law[,] or assurances that certain United States creditors would be paid in full or in priority. In only 9.1% of cases, entrustment of assets for distribution was ordered without any qualifications and where there were US creditors and assets at stake.
Based on this data, Mr. Leong goes on to conclude that “when deciding Chapter 15 cases, United States courts seldom grant entrustment [of assets for foreign distributions] without [protective] qualifications when United States creditors may be adversely affected.” Consequently, ”Chapter 15 is not as universalist as its proponents claim it to be and exposes the inability of Chapter 15 to resolve conflicting priority rules between the United States and foreign proceedings.”
Mr. Leong’s study is commendable as one of the earliest pieces of empirical work on how Chapter 15 is actually applied. But it raises some questions along the way. For example:
- Is a 45.5% “entrustment” rate really accurate? Mr. Leong’s claim that “courts entrusted United States assets to foreign proceedings for distribution in only 45.5% of cases where foreign proceedings were recognized” does not really compare apples to apples. That is, it measures the “entrustment” of assets across all recognized foreign proceedings – and not the smaller subset of proceedings where entrustment was actually requested.
According to Mr. Leong’s study results, “of the 88 cases where recognition was granted, the [US bankruptcy] court made orders for [e]ntrustment in only 40 cases. Of the remaining 48 cases where [e]ntrustment was not granted, [e]ntrustment had been requested by foreign representatives in 25 of these cases.” In other words, “entrustment” of assets was requested in 65 of the cases in Mr. Leong’s sample – and in those cases, it was granted in 40, providing a 61.5% success rate for the “entrustment” of assets, rather than the study’s advertised 45.5% success rate.
- Is a 45.5% “entrustment” rate really all that bad? Success rates – like many other statistics – are significant only by virtue of their relative comparison to other success rates. Assuming for the moment that the 45.5% “entrustment” rate observed where US courts apply Chapter 15 was indeed accurate, how does that rate compare against similar requests in the insolvency courts of other sophisticated business jurisdictions applying their own recognition statutes?
Without such benchmarks or relative rankings, the conclusion that US courts are not “universal” seems premature.
- Is “asset entrustment” really the true measure of “universalism?” Finally, and perhaps most fundamentally, Mr. Leong’s focus on the “entrustment” of assets – i.e., the turnover of US-based assets for distribution in a foreign insolvency case – seems to neglect the other reasons for which a US bankruptcy court’s recognition of cross-border insolvency might be sought. Such reasons include the “automatic stay” of US-initiated litigation against the debtor, access to US courts for the purpose of gaining personal jurisdiction over US-based defendants and the recovery of assets, and access to the “asset sale” provisions of the US Bankruptcy Code which automatically apply along with recognition under Chapter 15.
Given the breadth of strategic reasons for seeking recognition of a foreign insolvency in the United States (many of which are unrelated, at least directly, to the ultimate distribution of assets), the study’s focus on “entrustment” as a measure of “universalism” may be over-narrow.
These questions aside, however, Mr. Leong’s study asks thought-provoking and empirically-grounded questions about the true nature of “universalism” as applied in US bankruptcy courts. It is an important initial step in framing the proper assessment of cross-border insolvencies in coming years.
- U.S. judge OKs Mexico’s Comerci debt plan (reuters.com)
Last month, the Delaware Bankruptcy Court offered an interesting look at the preemptive effect of federal aircraft registration statutes on state law recordation requirements under the UCC.
Eclipse Aircraft Corporation (“Aircraft”), an aircraft manufacturer, filed a 2008 Chapter 11 proceeding in Delaware with about 26 aircraft orders unfinished, and in various stages of production. Aircraft’s efforts to sell its business assets through a “Section 363” sale ultimately proved unfruitful, and the case was converted to a Chapter 7. The appointed Chapter 7 trustee immediately sought authorization for another “Section 363” sale, this time to Eclipse Aerospace Inc. (“Aerospace”).
Aircraft’s customers holding pending but unfilled orders (the WIP Customers”) didn’t oppose the trustee’s sale per se, but did seek a determination that they held property interests in their respective, partially completed planes and parts which were superior to any interests and rights held by Aircraft’s bankruptcy estate, and that these rights entitled them to various equitable remedies such as replevin and specific performance, as well as the imposition of equitable liens and constructive trusts on the unfinished planes and parts.
Aerospace moved for summary judgment on theory that the WIP Customers’ imposition of a constructive trust required a showing of fraudulent conduct – and that Aircraft had never acted improperly.
Aerospace argued further that the Federal Aviation Administration (FAA) registration statute preempted the Uniform Commercial Code (UCC) (on which a number of the WIP Customers’ claims were based), thereby preventing them from asserting interests in partially completed planes based on their UCC filings.
In a brief decision, Bankruptcy Judge Mary Walrath reasoned that Aerospace’s “preemption” argument involved the impact of two decisions – Philko Aviation, Inc. v. Shacket, 462 U.S. 406 (1983) and Stanziale v. Pratt & Whitney (In re Tower Air, Inc.), 319 B.R. 88 (Bankr.D.Del.2004) – on the federal “registration” requirements applicable to any “aircraft.”
According to Judge Walrath, Philko stands for the broad proposition that “every aircraft transfer must be evidenced by an instrument, and every such instrument must be recorded [thereby preempting state law recordation statutes], before the rights of innocent third parties can be affected.” See 462 U.S. at 409-10. Therefore, it would not be enough for the WIP Customers to argue, as they did, that the mere failure to register a plane with the FAA (and to record that registration) meant it wasn’t an “aircraft.”
But what Philko might have taken away from the WIP Customers, Tower Air returned: Tower Air, according to Judge Walrath, held that Philko and its following decisions applied only to complete aircraft – and not to aircraft components or parts. See 319 B.R. at 95 (finding that Philko and its progeny “involved the conveyance of aircraft in their entirety, and neither involved or made any reference whatsoever to engines or components separate and apart from the aircraft.”).
Consequently, an unfinished plane isn’t really a plane – at least not for purposes of federal preemption.
Judge Walrath made comparatively short work of Aerospace’s other theories. She noted that, despite Aerospace’s arguments to the contrary, applicable state law did not require fraudulent or wrongful conduct for the imposition of a constructive trust, but rather the mere “breach of any legal or equitable duty” or the “commission of a wrong.” Aerospace’s further argument that the WIP Customers were unsecured creditors as a result of Aircraft’s insolvency wasn’t properly raised in its initial request for summary judgment – and therefore wouldn’t serve as the basis for such a judgment.
A South Carolina bankruptcy court decision issued earlier this month highlights and illustrates the perils facing individual sole proprietors who struggle to reorganize their financial affairs through the Chapter 11 process.
The debtors – a husband and wife who owned a business and several pieces of rental property – filed a Chapter 11 in November 2009, but the case was dismissed approximately 10 months later. In February this year, while their appeal of that dismissal was pending, they filed a second Chapter 11.
When an individual debtor seeks bankruptcy protection for a second time within 12 months, Section 362(c)(3) (added in connection with the 2005 BAPCPA amendments) terminates the automatic stay by default unless, within 30 days, the debtor can demonstrate that their second attempt is in “good faith.”
Put another way, an individual debtor’s second attempt at bankruptcy protection is presumptively in “bad faith” – and the automatic stay will self-terminate – unless the debtor can demonstrate otherwise.
Demonstrating otherwise is what the debtors attempted to do in In re Washington.
So what does it take for an individual to establish “clear and convincing” evidence of “good faith” in these circumstances?
Apparently, a good deal of personal organization – and evidence of consistent, clearly documented efforts to reorganize, with clearly documented results to show for it.
In Washington, the debtors produced evidence regarding their business income and rental receipts which the Court characterized as “inconsistent and confusing.” The Court took issue with the debtors’ estimates of present income, found holes in their testimony regarding decreased expenses, and found the debtors’ revenue projections to be “unjustifiably rosy.”
In sum, although Debtors claim that their financial circumstances have changed substantially, it appears to the Court that, with minor exceptions, Debtors have the same debt, same business, same properties, and same financial circumstances as they did in their previous case. The Court finds that there has not been a substantial change in Debtors’ financial circumstances and therefore, a presumption arises under section 362(c)(3)(C)(i)(III) that Debtors’ case was not filed in good faith.
The Court found that the same result applied under section 362(c)(3)(i)(III)(bb). That subsection imposes a presumption that a debtor’s second case was not filed in good faith if the court finds reason to conclude that the current case will not be concluded “with a confirmed plan that will be fully performed.”
But if Washington provides a cautionary tale for individual debtors who are struggling through the bankruptcy process, it also emphasizes the touchstone for every successful reorganization, no matter how small: A viable business strategy.
It is axiomatic in American business bankruptcy practice that though they may disagree strenuously on the particulars, all parties to a Chapter 11 case are interested in the same basic goal: maximization of the debtor’s asset values.
Or are they?
NYU Professor Sarah Woo has recently published an empirically-based analysis of this assumed common goal, and the results of that analysis are striking. As she describes her own research (presented in an article titled “Regulatory Bankruptcy: How Bank Regulation Causes Firesales“):
This Article demonstrates empirically that this assumption is inaccurate: the actions of banks in bankruptcy proceedings are not necessarily driven by value maximization. The findings in this Article have groundbreaking implications for bankruptcy policy which focuses on the debtor and overlooks exogenous creditor-specific factors. Where banks, which extend the bulk of the outstanding credit in the United States, are driven by financial regulatory policy to over-liquidation of their own borrowers, these actions lead to fire sales which potentially amplifyliquidity shocks and systemic risk.
Ms. Woo’s working hypothesis is that changes in the banking sector over the past decade, including increased consolidation and increased leverage, eventually pushed banks to pursue higher portfolio returns. As a result, many banks over-concentrated their portfolios in commercial real estate – a strategy which worked well during frothier times, but which proved disatrous in the aftermath of 2008’s economic collapse.
In the aftermath of the banking crisis, over-concentration by banks drew significant regulatory scrutiny – and, ultimately, significant new regulation designed to pressure banks to reduce their concentration risk. According to Professor Woo:
As with many episodes of financial instability which can be traced to misguided attempts to use regulatory power, pervasive regulatory pressure with capital adequacy as a centerpiece affected bank behavior in bankruptcy, interfering with investment expectations and diminishing asset values. In the case of IndyMac Bank, the bank shed more than a billion dollars of construction and development loans in the first six months of 2008 under regulatory pressure, partly through liquidations in bankruptcy. The actions of bank regulators thus had unintended but dire consequences of rendering the standard assumption of value maximization in bankruptcy policy obsolete by creating a different set of incentives dependent on the bank creditor’s own health. The phenomenon of regulatory bankruptcy thus demands a comprehensive reevaluation of current bankruptcy policy which has not kept up with these developments in the banking industry.
Professor Woo’s work is important, not only for the specific question of how and why banks behave the way they do in bankruptcy, but also as an example of how industry dynamics can mold and shape the bankruptcy process – and further, how empirical data can be marshalled for the benefit of informed legislative change and judicial decision-making.
When a municipality faces municipal distress, who ultimately picks up the tab? More importantly, who should pick up the tab?
That’s the issue taken up by Clayton P. Gillette, NYU’s Max E. Greenberg Professor of Contract Law, in a recent paper titled “POLITICAL WILL AND FISCAL FEDERALISM IN MUNICIPAL BANKRUPTCY.” Though the academic prose doesn’t read quite like the Economist, Professor Gillette’s discussion is a timely and important one for observers of US municipalities and their current financial troubles.
In essence, Professor Gillette argues that Chapter 9 of the Bankruptcy Code (municipal bankruptcy) is often perceived as a “dumping ground” for governmental entities who could raise taxes, but simply don’t have the political gumption to do so. Historically, municipal debtors have attempted to utilize Chapter 9 as a means of shifting the burden of imprudent debt onto creditors. But Gillette argues that in an age of government bailout and centralized governmental assistance for failing municipalities, Chapter 9 also effectively acts as a “bargaining chip” for municipal debtors dealing with federal and state agencies who would prefer to address municipal financial distress outside of bankruptcy – albeit at a moderate cost to local officials.
In support of this argument, Gillette explains that the structure of Chapter 9 offers municipalities a shot at having it both ways: They can run up a tab, then determine whom (other than themselves or their taxpayers – i.e., private creditors or states and federal agencies) they’d prefer to pick it up.
What’s the answer to this perceived recipe for irresponsibility? For Professor Gillette, it involves giving bankruptcy courts the power to impose affordable tax increases:
As a general proposition, fiscal federalism requires each level of government to internalize both the costs and the benefits of its activities. Centralized governments should, therefore, subsidize decentralized governments only to control negative spillovers of local activity or to induce activities that generate positive spillovers. Concomitantly, decentralized governments should be discouraged from engaging in activities that impose adverse external effects. In at least some cases of fiscal distress, however, – primarily those involving localities that have substantial state or national importance – municipalities can externalize some costs of idiosyncratic choices or local public goods onto more centralized levels of government or creditors. As a result, municipalities have tendencies both to overgraze on the commons of more centralized budgets and to avoid the exercise of political will to satisfy the debts they incur. The current legal structure for addressing municipal fiscal distress may interfere with, rather than advance the objectives of fiscal federalism insofar as it insulates local decisions from centralized influence and reduces the need for distressed localities to internalize the consequences of fiscal decisions. The result is that while theories of federalism typically focus on the security that decentralization confers against an onerous centralized government, the capacity of sub-national governments to exploit the financial strength of more central governments raises the possibility that the latter requires protection from the former. The claim of this Article is that judicially imposed tax increases may be used as a means of providing such protection by reducing the incentives of municipalities to [strategically] exploit bankruptcy proceedings . . . .
Whatever readers may think of the constitutionality of his idea, Professor Gillette’s article is an intriguing contribution to evolving thought on municipal distress.
- COMMENTARY: Harrisburg incinerator report to keep Chapter 9 threat on table (pennlive.com)
- Is State Bankruptcy The Next Wave in Public Employee Union Busting? (blogs.forbes.com)
- Bankruptcy works: Why Congress should consider bankruptcy for states (thehill.com)
- Why All the Noise About Muni Bankruptcies? (dealbook.nytimes.com)
Title II of the Dodd-Frank Act provides “the necessary authority to liquidate failing financial companies that pose a systemic risk to the financial stability of the United States in a manner that mitigates such risk and minimizes moral hazard.”
Under this authority, the government would have had the requisite authority to structure a resolution of Lehman Brothers Holdings Inc. – which, as readers are aware, was one of the marquis bankruptcy filings of the 2008 – 2009 financial crisis.
Readers are also aware that Dodd-Frank is an significant piece of legislation, designed to implement extensive reforms to the banking industry. But would it have done any better job of resolving Lehman’s difficulties than did Lehman’s Chapter 11?
Predictably, the FDIC is convinced that a government rescue would have been more beneficial - and in “The Orderly Liquidation of Lehman Brothers Holdings Inc. under the Dodd-Frank Act” (forthcoming in Vol. 5 of the FDIC Quarterly), FDIC staff explain why this is so.
The 19-page paper boils down to the following comparison between Chapter 11 and a hypothetical resolution under Dodd-Frank:
[U]nsecured creditors of LBHI are projected to incur substantial losses. Immediately prior to its bankruptcy filing, LBHI reported equity of approximately $20 billion; short-term and long-term indebtedness of approximately $100 billion, of which approximately $15 billion represented junior and subordinated indebtedness; and other liabilities in the amount of approximately $90 billion, of which approximately $88 billion were amounts due to affiliates. The modified Chapter 11 plan of reorganization filed by the debtors on January 25, 2011, estimates a 21.4 percent recovery for senior unsecured creditors. Subordinated debt holders and shareholders will receive nothing under the plan of reorganization, and other unsecured creditors will recover between 11.2 percent and 16.6 percent, depending on their status.
By contrast, under Dodd-Frank:
As mentioned earlier, by September of 2008, LBHI’s book equity was down to $20 billion and it had $15 billion of subordinated debt, $85 billion in other outstanding short- and long-term debt, and $90 billion of other liabilities, most of which represented intracompany funding. The equity and subordinated debt represented a buffer of $35 billion to absorb losses before other creditors took losses. Of the $210 billion in assets, potential acquirers had identified $50 to $70 billion as impaired or of questionable value. If losses on those assets had been $40 billion (which would represent a loss rate in the range of 60 to 80 percent), then the entire $35 billion buffer of equity and subordinated debt would have been eliminated and losses of $5 billion would have remained. The distribution of these losses would depend on the extent of collateralization and other features of the debt instruments.
If losses had been distributed equally among all of Lehman’s remaining general unsecured creditors, the $5 billion in losses would have resulted in a recovery rate of approximately $0.97 for every claim of $1.00, assuming that no affiliate guarantee claims would be triggered. This is significantly more than what these creditors are expected to receive under the Lehman bankruptcy. This benefit to creditors derives primarily from the ability to plan, arrange due diligence, and conduct a well structured competitive bidding process.
Convinced? You decide.
- Dodd-Frank Would Have Rescued Lehman Creditors, FDIC Says (businessweek.com)
- Lehman creditors would’ve got more with law: FDIC (marketwatch.com)
- Here’s How Lehman Should Have Gone Down (fool.com)
- New Financial Reform Law Could Have Resolved Lehman, Regulator Argues (huffingtonpost.com)
- Is Financial Reform Working, or Will It Make Things Worse? (businessinsider.com)
One of the most effective vehicles for the rescue and revitalization of troubled business and real estate to emerge in recent years of Chapter 11 practice has been the “363 sale.”
Named for the Bankruptcy Code section where it is found, the “363 sale” essentially provides for the sale to a proposed purchaser, free and clear of any liens, claims, and other interests, of distressed assets and land.
The section has been used widely in bankruptcy courts in several jurisdictions to authorize property sales for “fair market value” . . . even when that value is below the “face value” of the liens encumbering the property.
In the Ninth Circuit, however, such sales are not permitted – unless (pursuant to Section 363(f)(5)) the lien holder “could be compelled, in a legal or equitable proceeding, to accept a money satisfaction of such interest.”
A recent decision issued early this year by the Ninth Circuit Bankruptcy Panel and available here) provides a glimpse of how California bankruptcy court are employing this statutory exception to approve “363 sales.”
East Airport Development (EAD) was a residential development project in San Luis Obispo which, due to the downturn of the housing market, never came completely to fruition.
Originally financed with a $9.7 million construction and development loan in 2006, EAD’s obligation was refinanced at $10.6 million in mid-2009. By February 2010, the project found itself in Chapter 11 in order to stave off foreclosure.
A mere two weeks after its Chapter 11 filing, EAD’s management requested court authorization to sell 2 of the 26 lots in the project free and clear of the bank’s lien, then to use the excess proceeds of the sale as cash collateral.
In support of this request, EAD claimed the parties had previously negotiated a pre-petition release price agreement. EAD argued the release price agreement was a “binding agreement that may be enforced by non-bankruptcy law, which would compel [the bank] to accept a money satisfaction,” and also that the bank had consented to the sale of the lots. A spreadsheet setting forth the release prices was appended to the motion. The motion stated EAD’s intention to use the proceeds of sale to pay the bank the release prices and use any surplus funds to pay other costs of the case (including, inter alia, completion of a sewer system).
The bank objected strenuously to the sale. It argued there was no such agreement – and EAD’s attachment of spreadsheets and e-mails from bank personnel referencing such release prices ought to be excluded on various evidentiary grounds.
The bankruptcy court approved the sale and cash collateral use over these objections. The bank appealed.
On review, the Ninth Circuit Bankruptcy Appellant Panel found, first, that the bankruptcy court was within the purview of its discretion to find that, in fact, a release price agreement did exist – and second, that such agreement was fully enforceable in California:
It is true that most release price agreements are the subject of a detailed and formal writing, while this agreement appears rather informal and was evidenced, as far as we can tell, by only a few short writings. However, this relative informality is not fatal. The bankruptcy court is entitled to construe the agreement in the context of and in connection with the loan documents, as well as the facts and circumstances of the case. Courts seeking to construe release price agreements may give consideration to the construction placed upon the agreement by the actions of the parties. . . . Here, the parties acted as though the release price agreement was valid and enforceable and, in fact, had already completed one such transaction before EAD filed for bankruptcy. On these facts, [EAD] had the right to require [the bank] to release its lien on the two lots upon payment of the specified release prices, even though [the bank] would not realize the full amount of its claim. More importantly, [EAD] could enforce this right in a specific performance action on the contract. For these reasons, the sale was proper under § 363(f)(5).
The Ninth Circuit Bankruptcy Appellate Panel’s East Airport decision provides an example of how bankruptcy courts in the Ninth Circuit are creatively finding ways around legal hurdles to getting “363 sales” approved in a very difficult California real estate market. It likewise demonstrates the level of care which lenders’ counsel must exercise in negotiating the work-out of troubled real estate projects.
From Florida’s Northern District comes a cautionary tale of what can go wrong when distressed real estate requires restructuring. A copy of the decision is available here.
Davis Heritage GP Holdings, LLC (“Debtor”) was a family-owned LLC formed in 2002 to “hold, develop, and sell condominium development properties in Mississippi and Louisiana.” Its sole assets were membership interests in a series of single-member “middle-tier” LLC’s, which themselves held no assets except for interests in a series of single-member “lower-tier” LLC’s – each formed to hold separate parcels of real property.
In December 2010, the Debtor sought protection under Chapter 11, ostensibly to deal with the adverse effects of a judgment entered against it. None of the “middle-tier” or “lower-tier” LLC’s had sought bankruptcy protection. Despite their separate, three-tier structure, the Debtor’s management adminstered them as if they were a single business enterprise. Until very shortly before the Debtor’s Chapter 11 filing, the expenses and income of the enterprise were processed through the Debtor’s bank account. In fact, none of the “lower tier” LLCs held bank accounts in their names until after meeting with the Debtor’s bankruptcy counsel. From at least January 2007 through August 2010, the Debtor’s bank accounts contained several millions of dollars, at one time exceeding $22 million. The Debtor’s principals have used the Debtor’s accounts freely, to receive and disburse money to and from whomever the principals chose at any given time. Despite this fact, the Debtor only disclosed one bank account in its Schedule B and did not disclose, but rather affirmatively denied, making any transfers to insiders within one year pre-petition.
Finally, the Debtor never disclosed the properties owned by the “lower tier” LLCs (or their income and expenses) in its Schedules or any other papers filed with the Court. Nevertheless, the Debtor’s Plan is based entirely upon the liquidation of some of those very properties.
The Debtor’s difficulties arose out of the purchase of land and subsequent construction of the 21-story “Beau View” luxury condominium tower in Biloxi, Mississippi. In exchange for the land, the Debtor had executed two junior-priority promissory notes to the seller, and obtained a senior-priority acquisition loan from Wells Fargo. The Debtor then financed construction with a separate loan – also from Wells Fargo – and completed the tower.
Though it made considerable progress selling condominium units and repaying Wells Fargo’s construction loan, the Debtor made only sporadic payments on its purchase notes to the seller. Eventually, the seller obtained a judgment on the note in Mississippi, then domesticated that note in Florida and sought to foreclose on all of the debtor’s membership interests in the “middle tier” LLC’s.
To avoid foreclosure on its “middle tier” LLC interests, the Debtor made a $200,000 payment in exchange for 60 days’ forbearance – then, promptly, sought Chapter 11 protection. At the time of filing, the Wells Fargo construction loan and acquisition loans were current. The Debtor had permitted two mortgage loan actions filed against two of the “lower tier” LLC’s by Sun Trust Bank to go to default judgment.
Very shortly after filing, the seller of the Biloxi property sought relief from stay to continue its foreclosure on the “middle tier” LLC interests – or, in the alternative, dismissal of the Debtor’s Chapter 11 case. The Debtor countered with an emergency motion for the sale of certain assets – and, a day prior to the hearing on the stay relief motion, a Chapter 11 Plan.
In reviewing the evidence and determining that dismissal of the Debtor’s case was appropriate, the court observed:
[W]hen determining whether to grant stay relief for cause or dismiss a chapter 11 case, . . . a number of factors may evidence an “intent to abuse the judicial process and the purposes of the reorganizationprovisions” . . . . . Those factors include:
a. the debtor has only one asset, the property;
b. the debtor has few unsecured creditors whose claims are small in relation to the claims of the secured creditors;
c. the debtor has few employees;
d. the property is the subject of a foreclosure action as a result of arrearages of the debt;
e. the debtor’s financial problems involve essentially a dispute between the debtor and the secured creditors which can be resolved in the pending state court action; and
f. the timing of the debtor’s filing evidences an intent to delay or frustrate the legitimate efforts of the debtor’s secured creditors to enforce their rights . . . . Once a court finds that the above factors are present, “[t]he possibility of a successful reorganization cannot transform a bad faith filing into one undertaken in good faith.” All of the [above-referenced] bad faith factors are present in this case, as are additional factors indicating bad faith. . . . The Debtor’s financial problems involve a two-party dispute between it and [the judgment creditor] that can be resolved in state court. Also, the timing of this petition shows an intent to delay or frustrate the legitimate collections efforts of [the judgment creditor]—who is the only real direct creditor of the Debtor . . . .
The court then went on to explain why the essence of the Debtor’s Chapter 11 plan – essentially, an effort to pay Wells Fargo and Sun Trust at the expense of the seller of the Biloxi property – was a “sort of reverse marshalling” inappropriate for Chapter 11 under the facts of this case:
Unlike the traditional single asset case where a main creditor is stayed from collecting out of the debtor’s only asset, this case involves a three-tier corporate structure created by the Debtor and its principals whereby [the Biloxi land seller and judgment creditor] is the only creditor that is adversely affected by the automatic stay. See 11 U.S.C. § 362(a). All other creditors of the Debtor with claims to the properties owned by the “lower tier” LLCs are free to pursue those claims through foreclosure on those real properties, thereby diminishing the value of the Debtor’s only asset (membership in the “middle tier” LLCs), beyond the control of [the judgment creditor]. This fact is illustrated by Sun Trust’s pursuit of its post-petition mortgage foreclosure litigation against [two "lower-tier" LLC] properties, which has been unopposed by the Debtor and its principals. Similarly, [the Debtor's] testimony states that in spite of the bankruptcy, and the way the enterprise has historically been managed, all of the “lower tier” LLCs are doing business as usual, renting units, offering units for sale, selling property, signing contracts for sale, and paying their bills. After a history of treating all the entities as a single corporate enterprise, the Debtor now takes the position that it lacks control of its wholly-owned subsidiaries and only it, the Debtor, is subject to the rules and constraints of Chapter 11.
In reviewing Chapter 11 cases alleged to have been filed in bad faith, courts may look to all of the evidence and the totality of the circumstances to determine what is really happening, and the true intent and purpose behind the filing. . . . Here, the true intent and effect of this case and the Debtor’s Plan are plain: the Debtor’s insiders seek to donate assets subject to [the judgment creditor's] judgment lien to Sun Trust and Wells Fargo in order to shield their own assets and money from those creditors. This scheme, memorialized in the Debtor’s Chapter 11 Plan, amounts to a kind of reverse marshaling. The Plan takes the only assets available to [the judgment creditor] (and subject to its levy), property owned not by the Debtor but by the “lower tier” LLCs, and shifts that property to Sun Trust and Wells Fargo, creditors with claims [are] secured by other assets owned by the insiders. This Plan reduces the amount that [the judgment creditor] may collect and simultaneously reduces the guarantors’/insiders’ liability to Sun Trust and Wells Fargo.
The court’s discussion of what constitutes “bad faith” in filing a Chapter 11 case is instructive, as is its analysis of how “bankruptcy remote” entities can be treated in the absence of related Chapter 11 filings.
Most insolvency practitioners are familiar with the fighting which often ensues when creditors jockey for position over a troubled firm’s capital structure. From Kansas, a recent decision issued in February highlights the standards which apply to claims that a senior creditor’s claim ought to be “subordinated” to those of more junior creditors or equity-holders.
QuVIS, Inc. (“QuVIS”), a provider of digital motion imaging technology solutions in a number of industries, found itself the target of an involuntary Chapter 7 filing in 2oo9. The company converted its case to one under Chapter 11 and thereafter sought to reorganize its affairs.
QuVIS ’ debt was structured in an unusual way. When presented with some growth opportunities in the early 2000’s, the company issued secured notes under a credit agreement that capped its lending at $30,000,000. “Investors” acquired these notes for cash and received a security interest, evidenced by a UCC-1 recorded in 2002. One of QuVIS’ “investors” was Seacoast Capital Partners II, L.P. (“Seacoast”), a Small Business Investment Company (“SBIC”) licensed by the United States Small Business Administration. Between 2005 and 2007, Seacoast lent approximately $4.25 million through a series of three separate promissory notes issued by QuVIS. In 2006, and consistent with the purposes of the Small Business Investment Act of 1958, under which licensed SBICs are expected to provide management support to the small business ventures in which they invest, Seacoast’s Managing Director, Eben S. Moulton (“Moulton”), was designated as an outside director to QuVIS’ board.
In 2007, it came to Seacoast’s attention that, despite its belief to the contrary, a UCC-1 had never been filed on Seacoast’s behalf regarding its loans to QuVIS. Nor had the earlier (and now lapsed) UCC-1 filed regarding QuVIS’ other “investors” ever been modified to reflect Seacoast’s participation in the company’s loan structure. Seacoast immediately filed a UCC-1 on its own behalf in order to protect its position. Some time after QuVIS found itself in Chapter 11 in 2009, the Committee of Unsecured Creditors (and other, less alert ”investors”) sought to subordinate Seacoast’s position.
The Committee’s argument was based exclusively on 11 U.S.C. § 510(c), which provides, in pertinent part:
Notwithstanding subsections (a) and (b) of this section, after notice and a hearing, the court may— (1) under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim to all or part of another allowed claim …
“Equitable” subordination is based on the idea of “inequitable” conduct - such as fraud, illegality, or breach of fiduciary duties. Where an “insider” or a fiduciary of the debtor is the target of a subordination claim, however, the party seeking subordination need only show some unfair conduct, and a degree of culpability, on the part of the insider.
Seacoast sought summary judgment denying the subordination claim. In granting Seacoast’s request, Judge Nugent of the Kansas Bankruptcy Court distinguished Seacoast’s Managing Director from Seacoast, finding that though Moulton was indeed an “insider,” Seacoast was not. Therefore, Seacoast’s claim was not subject to subordination for any “unfair conduct” which might be attributable to Moulton. To that end, Judge Nugent also appeared to go to some lengths to demostrate that Mr. Moulton’s conduct was not in any way “unfair” or detrimental to the interests of other creditors.
Subordination claims are highly fact-specific. With this in mind, the facts of the QuVIS decision afford instructive reading for lenders whose lending arrangements may entitle them to designate one of the debtor’s directors.
When a retailer becomes insolvent, suppliers or vendors who have recently provided goods on credit typically have the ability to assert “reclamation” rights for the return of those goods. Retailers may respond to these rights by seeking the protection the federal bankruptcy laws – and, in particular, the automatic stay.
When a retailer files for bankruptcy while holding goods which are subject to creditors’ “reclamation” rights, what should “reclamation” creditors do?
The Bankruptcy Code itself provides some protection for “reclamation” creditors by providing such creditors additional time in which to assert their claims, and by affording administrative priority for a certain portion for such claims even when they are not formally asserted.
But is merely asserting a reclamation claim under the Bankruptcy Code sufficient to protect a supplier once a retailer is in bankruptcy? A recent appellate decision from Virginia’s Eastern District serves as a reminder that merely speaking up about a reclamation claim isn’t enough.
When Circuit City sought bankruptcy protection in 2009, Paramount Home Entertainment was stuck with the tab for more than $11 million in goods. Though it didn’t object to blanket liens on Circuit City’s merchandise which came with the retailer’s debtor-in-possession financing, and stood by quietly while Circuit City later liquidated its merchandise throug a going-out-of-business sale, Paramount did file a timely reclamation demand as required by the Bankruptcy Code. It also complied with what it understood to be the Bankruptcy Court’s orders regarding administrative procedures for processing its reclamation claims in Circuit City’s case. It was therefore unpleasantly surprised when Circuit City objected to Paramount’s reclamation claim – and when the Bankruptcy Court sustained that objection – on the grounds that Paramount hadn’t done enough to establish or preserve its reclamation rights.
Paramount appealed the Bankruptcy Court’s ruling, claiming that it complied with what it understood to have been the Bankruptcy Court’s administrative procedures for processing reclamation claims. Paramount argued that to have done more (i.e., to have sought relief from the automatic stay to take back its goods or commenced litigation to preserve its rights to the proceeds of such goods) would have disrupted Circuit City’s bankruptcy case.
In affirming the Bankruptcy Court, US District Judge James Spencer held that the Bankruptcy Code, while protecting a creditor’s reclamation rights, doesn’t impose them on the debtor. Instead, a reclaiming creditor must take further steps consistent with the Bankruptcy Code and state law to preserve the remedies which reclamation claims afford. Merely asserting a reclamation claim under the Bankruptcy Code – or under a Bankruptcy Court’s administrative procedure – isn’t enough:
“Filing a demand, but then doing little else in the end likely creates more litigation and pressure on the Bankruptcy Court than seeking relief from the automatic stay. . . or seeking a [temporary restraining order] or initiating an adversary proceeding. In this case, Paramount filed its reclamation demand, but then failed to seek court intervention to perfect that right. As the Bankruptcy Court held, the Bankruptcy Code is not self-executing. Although [the Bankruptcy Code] does not explicitly state that a reclaiming seller must seek judicial intervention, that statute does not exist in a vacuum. The mandatory stay as well as the other sections of the Bankruptcy Code that protect and enforce the hierarchy of creditors create a statutory scheme that cannot be overlooked. Once Paramount learned that Circuit City planned to use the goods in connection with the post-petition [debtor-in-possession financing], it should have objected. It didn’t. To make matters worse, Paramount then failed to object to Circuit City’s liquidation of its entire inventory as part of the closing [going-out-of-business] [s]ales.”
Let the seller beware.
Many insolvency practitioners are familiar with the “high-asset” individual debtor – often a business owner or owner of rental property or other significant business and personal assets – whose financial problems are too large for standard “individual debtor” treatment.
Such debtors are a prominent feature of commercial insolvency practice in California and other western states. These individuals typically have obligations matching the size of their assets: Their restructuring needs are too large for treatment through an “individual” Chapter 13 reorganization, and must instead be handled through the “business” reorganization provisions of a Chapter 11.
When Congress amended the Bankruptcy Code in 2005, it recognized the need of some individuals to use the reorganization provisions of Chapter 11. It provided certain amendments to Chapter 11 which parallel the “individual” reorganzation provisions of Chapter 13.
But certain “individual” reorganization concepts do not translate clearly into Chapter 11’s “business” provisions. Among the most troublesome of these is the question of whether an individual debtor can reorganize by paying objecting unsecured creditors less than 100% while continuing to retain existing property or assets for him- or herself.
In Chapter 13, the answer to this question is “yes.” But in Chapter 11 – at least until 2005 – the answer has historically been “no.” This is because Chapter 11, oriented as it is toward business reorganization, prohibits a reorganizing debtor from retaining any property while an objecting class of unsecured creditors is paid something less than the entirety of its claims. Known as the “absolute priority rule,” this prohibition has been a mainstay of Chapter 11 business practice for decades.
In 2005, Congress amended Chapter 11’s “absolute priority rule” provisions to provide that despite the “absolute priority” rule, individual Chapter 11 debtors could nevertheless retain certain types of property, even when objecting unsecured creditors are paid less than 100%. For instance, an individual debtor may retain certain wages and earnings earned after the commencement of the debtor’s case. But can the individual debtor retain other types of property (for example, a rental property or closely held stock in a business), while paying objecting creditors less than 100%?
Congress’ “absolute priority rule” amendments for individual debtors are ambiguous – as is the language of a section which expands the definition of “property” included within the individual Chapter 11 debtor’s estate (paralleling similar treatment of individual Chapter 13 debtors). As a result, Bankruptcy Courts are split on the question of whether or not the “absolute priority rule” applies to individual Chapter 11 debtors.
Until very recently, the Central District of California – one of the nation’s largest, and a frequent filing destination for individual Chapter 11 cases – had been silent on the issue. This month, however, Judge Theodor Albert of Santa Ana joined a growing number of courts which conclude that Congress’ 2005 “absolute priority rule” amendments apply only to individual wages and earnings, and that individuals cannot retain other types of property where objecting creditors are paid less than 100%.
In a careful, 13-page decision issued for publication, Judge Albert collected and examined cases on both sides of this question and concluded:
After BAPCPA, the debtor facing opposition of any one unsecured creditor must devote 5 years worth of “projected disposable income,” at a minimum (or longer if the plan is longer). But [the] debtor is not compelled to give also his additional earnings or after-acquired property net of living expenses beyond five years unless the plan is proposed for a period longer than five years. But there is no compelling reason to also conclude that prepetition property need not be pledged under the plan as the price for cram down, just as it has always been.
Judge Albert’s decision joins several other very recent ones going the same direction, including In re Walsh, 2011 WL 867046 (Bkrtcy.D.Mass., Judge Hillman); In re Stephens, 2011 WL 719485 (Bkrtcy.S.D.Tex., Judge Paul); and In re Draiman, 2011 WL 1486128 (Bkrtcy.N.D.Ill., Judge Squires).
- Hope May Spring Eternal . . . But the Automatic Stay Does Not. (southbaylawfirm.com)
- The Chapter 11 “Shell Game” (southbaylawfirm.com)
Chapter 11 practice – like so many other professional service specialties – is regrettably jargon-laden. Businesses that need to get their financial affairs in order “enter restructuring.” Those that must re-negotiate their debt obligations attempt to “de-leverage.” And those facing resistance in doing so seek the aid of Bankruptcy Courts in “cramming down” their plans over creditor opposition.
Likewise, the Bankruptcy Code – and, consequently, Bankruptcy Courts – employ what can seem an entirely separate vocabulary for describing the means by which a successful “cram-down” is achieved. One such means involves providing the secured creditor with something which equals the value of its secured claim: If the secured creditor holds a security interest in the debtor’s apple, for example, the debtor may simply give the creditor the apple – or may even attempt to replace the creditor’s interest in the apple with a similar interest in the debtor’s orange (provided, of course, that the orange is worth as much as the original apple).
The concept of replacing something of value belonging to a secured creditor with something else of equivalent value is known in “bankruptcy-ese” as providing the creditor with the “indubitable equivalent” of its claim – and it is a concept employed perhaps most frequently in cases involving real estate assets (though “indubitable equivalence” is not limited to interests in real estate). For this reason, plans employing this concept in the real estate context are sometimes referred to as “dirt for debt” plans.
A recent bankruptcy decision out of Georgia’s Northern District issued earlier this year illustrates the challenges of “dirt for debt” reorganizations based on the concept of “indubitable equivalence.”
Green Hobson Riddle, Jr., a Georgia businessman, farmer, and real estate investor, sought protection in Chapter 11 after economic difficulties left him embroiled in litigation and unable to service his obligations.
Mr. Riddle’s proposed plan of reorganization, initially opposed by a number of his creditors, went through five iterations until only one objecting creditor – Northside Bank – remained. Northside Bank held a first-priority secured claim worth approximately $907,000 secured by approximately 36 acres of real property generally referred to as the “Highway 411/Dodd Blvd Property,” and a second-priority claim secured by a condominium unit generally referred to as the “Heritage Square Property.” It also held a judgment lien recorded against Mr. Riddle in Floyd County, Georgia.
A key feature of Mr. Riddle’s plan involved freeing up the Heritage Square Property in order refinance one of his companies, thereby generating additional payments for his creditors. To do this, Mr. Riddle proposed to give Northside Bank his Highway 411/Dodd Blvd Property as the “indubitable equivalent,” and in satisfaction, of all of Northside’s claims.
Northside Bank objected to this treatment, respectfully disagreeing with Mr. Riddle’s idea of “indubitable equivalence.” Bankruptcy Judge Paul Bonapfel took evidence on the issue and – in a brief, 9-page decision – found that Mr. Riddle had the better end of the argument.
Judge Bonapfel’s decision highlights several key features of “indubitable equivalent” plans:
- The importance of valuation. The real challenge of an “indubitable equivalence” plan is not its vocabulary. It is valuing the property which will be given to the creditor so as to demonstrate that value is “too evident to be doubted.” As anyone familiar with valuation work is aware, this is far more easily said than done. Valuation becomes especially important where the debtor is proposing to give the creditor something less than all of the collateral securing the creditor’s claim, as Mr. Riddle did in his case. In such circumstances, the valuation must be very conservative – a consideration Judge Bonapfel and other courts recognized.
- The importance of evidentiary standards. Closely related to the idea of being “too evident to be doubted” is the question of what evidentiary standards apply to the valuation. Some courts have held that because the property’s value must be “too evident to be doubted,” the evidence of value must be “clear and convincing” (the civil equivalent of “beyond a reasonable doubt”). More recent cases, however, weigh the “preponderance of evidence” (i.e., does the evidence indicate something more than a 50% probability that the property is worth what it’s claimed to be?). As one court (confusingly) put it: “The level of proof to show ‘indubitably’ is not raised merely by the use of the word ‘indubitable.’” Rather than require more or better evidence, many courts seem to focus instead on the conservative nature of the valuation and its assumptions.
- The importance of a legitimate reorganization purpose. Again, where a creditor is receiving something less than the entirety of its collateral as the “indubitable equivalent” of its claim, it is up to the debtor to show that such treatment is for the good of all the creditors – and not merely to disadvantage the creditor in question. Judge Bonapfel put this issue front and center when he noted, in Mr. Riddle’s case:
[I]t is important to recognize that § 1129(b), the “cram-down” subsection, “provides only a minimum requirement for confirmation … so a court may decide that a plan is not fair and equitable even if it is in technical compliance with the Code’s requirements.” E.g., Atlanta Southern Business Park, 173 B.R. at 448. In this regard, it could be inequitable to conclude that a plan provision such as the one under consideration here is “fair and equitable,” if the provision serves no reorganization purpose. See Freymiller Trucking, 190 B.R. at 916. But in this case, the evidence shows that elimination of the Bank’s lien on other collateral is necessary for the reorganization of the Debtor and his ability to deal with all of the claims of other creditors who have accepted the Plan. No evidence demonstrates that the Plan is inequitable or unfair
In re Riddle, 444 B.R. 681, 686 (Bankr. N.D. Ga. 2011).
Personal liability for corporate debt has been all the rage in the Ninth Circuit. Within the last year, at least two appellate decisions (discussed here and here) have clarified the doctrine of alter ego liability – the idea that a corporate entity and its principals ought to be treated as one and the same, and therefore equally liable for corporate obligations.
It is easy to see why interest in alter ego liability has become so fashionable: When a business slips into insolvency and cannot pay its creditors in full, those creditors naturally go looking for other pockets from which to satisfy their claims.
If creditors can show that the business’ officers effectively ran the business for personal economic purposes rather than as a separate and distinct corporate entity, the doctrine of alter ego permits creditors to hold the officers responsible for the business’ obligations. This is especially the case where it appears the officers used the business to perpetrate a fraud or some other inequity on creditors. One California court noted that “[t]he general purpose of the doctrine of alter ego is to look through the fiction of the corporation and to hold the individuals doing business in the name of the corporation liable for its debts in those cases where it should be so held in order to avoid fraud or injustice.”
Earlier this year, Judge Clarkson of California’s Central District followed this fashion trend by offering his view on a non-dischargeability claim based on alter ego liability.
The facts of In re Munson are relatively straightforward. Robert and Kimberly Munson were the owners – and corporate officers – of Munson Plumbing, Inc. (“MPI”), a plumbing subcontractor on several public works projects in the Los Angeles metropolitan area. As is typically required of public works contractors, MPI’s work was backed by surety bonds issued by SureTec Insurance Company (“SureTec”). As part of the consideration for the issuance of the surety bonds, the Munsons and MPI signed a General Agreement of Indemnity (“SureTec Indemnity Agreement”), in which the Munsons agreed to jointly and severally indemnify SureTec and to deposit collateral with SureTec upon its demand. The SureTec Indemnity Agreement contained language that all project funds received by MPI would be held in trust for the benefit of SureTec.
Eventually, MPI encountered financial difficulties and could not pay its own subcontractors – thereby requiring SureTec to make payments under the bonds and finish MPI’s work.
Concurrent with MPI’s demise, the Munsons commenced individual Chapter 7 proceedings. SureTec, which had been left with over $436,000 in losses related to various MPI projects, asserted claims against the Munsons individually. It also sought to have at least a portion of those losses deemed non-dischargeable in the Munsons’ Chapter 7 case. Specifically, it claimed:
- The SureTec Indemnity Agreement created an express trust which placed fiduciary duties upon the Munsons.
- Further, because the Munsons had allegedly defrauded SureTec by diverting at least $95,000 in progress payments on the projects to non-bonded expenses, including their own personal expenses, applicable fiduciary duties upon the Munsons arose by California statutes (including Business & Professions Code §7108 and Penal Code §§§ 484b, 484c and 506.)
- The Munsons were alter egos of MPI, and therefore were liable for MPI’s obligations under the surety bonds.
- The Munsons’ obligations were non-dischargeable because they arose as a result of the Munsons’ breach of their fiduciary duties.
The Debtors sought dismissal of SureTec’s lawsuit. In a brief, 9-page decision, Judge Clarkson found that:
- The SureTec Indemnity Agreement did not impose fiduciary duties upon the Munsons. “If a trust was created, it imposed the fiduciary duty obligations on the corporation, the receiver and disburser of the project funds. The [Munsons,] [in] signing the [SureTec Indemnity Agreement] were creating only a creditor-debtor relationship (and a contingent one at that) between SureTec and the [Munsons]. They were “indemnifying” SureTec, as SureTec accurately indicates . . . .”
- Any alleged trust relationship created on a constructive, resulting, or implied basis (i.e., arising legally as a result of the Munsons’ allegedly bad acts) is not the sort of trust relationship which gives rise to a non-dischargeable debt. “The core requirements [for asserting non-dischargeability based on breach of a fiduciary duty] are that the [fiduciary] relationship exhibit characteristics of the traditional trust relationship, and that the fiduciary duties be created before the act of wrongdoing and not as a result of the act of wrongdoing.”
- SureTec’s allegations of alter ego liability were likewise insufficient to tag the Munsons with the sort of fiduciary obligations that would give rise to a non-dischargeable claim. “If a finding of alter ego were to be considered as imposing fiduciary duties, any such imposition would be ex maleficio, i.e., trusts that arose by operation of law upon a wrongful act.”
Judge Clarkson also found that SureTec’s separate non-dischargeability claim for fraud had not been pleaded with the requisite particularity, and dismissed it with leave to amend.
The Munson decision is important in several respects:
- It emphasizes the relatively narrow scope of non-dischargeability claims based on breaches of fiduciary duty in the Ninth Circuit.
- It also emphasizes the similarly narrow scope of liability derived from alter ego status.
- It highlights the importance of the alter ego doctrine as a strategic tool for both creditors and trustees in bankruptcy litigation – as well as litigants’ varying success in using it. As detailed in other posts, alter ego liability has been employed (i) unsuccessfully as a “blocking device” in an attempt to capture recoveries for the corporation’s bankruptcy estate; and (ii) successfully to preserve recoveries from self-settled trusts to which the debtors attempted to convey assets out of the reach of creditors. Here, alter ego was employed (again, without success) to “bootstrap” a creditor’s claim into “non-dischargeable” status.
- Article on Contractual Relationships and Fiduciary Duty (lawprofessors.typepad.com)
A prior post on this blog featured an article highlighting some of the basic principles from Shari’a law which apply to insolvent individuals and businesses.
Another, more recent article explores the intriguing question of what happens when an investment structured according to Shari’a law needs to be restructured in a non-Shari’a forum – such as a United States Bankruptcy Court. The University of Pennsylvania’s Michael J.T. McMillen uses the recent Chapter 11 filing of In re East Cameron Partners, LP as a case study to highlight some of the issues.
According to McMillen:
The issues to be considered [in connection with efforts to introduce Shariah principles into secular bankruptcy and insolvency regimes throughout the world] are legion. Starting at the level of fundamental principle, will the contemplated regime provide for reorganization along the lines of Chapter 11 systems, or will liquidation be the essential thrust of the system? If, in line with international trends, the system will incorporate reorganization concepts and principles, what is the Sharīʿah basis for this regime? Even the fundamental questions are daunting. For example, consideration will need to be given to debt rescheduling concepts, debt forgiveness concepts, delayed debt payment concepts, equity conversion concepts, asset sale concepts, and differential equity conceptions. There will have to be consideration of whether voluntary bankruptcies can and will be permissible. And after agreement is reached on the basic nature and parameters of the system, the long road of discovery and elucidation of specific Sharīʿah principles will have to be addressed. That undertaking will wind through a great deal of new territory, from the Sharīʿah perspective, and will entail a comparative laws analyses, and a systemic comparison, unlike any in history.
The article is available here.
On Thursday, the US Supreme Court released its second decision in the long-runing battle between the estate of Vickie Lynn Marshall (aka Anna Nicole Smith) and her erstwhile son-in-law, Pierce Marshall.
The 63-page slip opinion, available here, illustrates how the result of a high-profile celebrity bankruptcy can ultimately turn on arcane, esoteric matters of jurisdiction – and how such esoterica can be potentially ground-shifting for the US Bankruptcy Court system which has been in effect since its first constitutional challenge in 1984.
A small portion of the already considerable commentary evolving in conventional media and in the blogosphere appears below.
- Anna Nicole Smith And Charles Dickens…And The Supreme Court (dekerivers.wordpress.com)
- Supreme Court Rules on Anna Nicole Smith’s Case (lawprofessors.typepad.com)
- Anna Nicole Smith estate loses big at Supreme Court (news-briefs.ew.com)
- Ruling Against Anna Nicole Smith’s Heirs, Chief Justice Quotes Dickens [The Supremes] (jezebel.com)
- SCOTUS Decision in Stern v. Marshall (lawprofessors.typepad.com)
Ray’s piece focuses on the supportability of assumptions underlying valuations. As he notes:
Over the last year, there have been a rash of bankruptcy cases and related lawsuits involving challenges to both debtor and creditor financial experts, wherein opposing parties successfully attacked the relevance and reliability of valuation evidence. In a number of cases, even traditional methodologies were disqualified for lack of supportable assumptions, which severely impacted recoveries for various stakeholders.
The piece is here.
One of the time-honored attractions of US bankruptcy practice is the set of tools provided for the purchase and sale of distressed firms, assets and real estate. In recent years, the so-called “363 sale” has been a favorite mechanism for such transactions – its popularity owing primarily to the speed with which they can be accomplished, as well as to the comparatively limited liability which follows the assets through such sales.
But “363 sales” have their limits: In such a sale, a secured creditor is permitted to “credit bid” against the assets securing its lien – often permitting that creditor to obtain a “blocking” position with respect to sale of the assets.
Until very recently, many practitioners believed these “credit bid” protections also applied whenever assets were being sold through a Chapter 11 plan. In 2009 and again in 2010, however, the Fifth and Third Circuit Courts of Appeal held, respectively, that a sale through a Chapter 11 Plan didn’t require credit bidding and could be approved over the objection of a secured lender, so long as the lienholder received the “indubitable equivalent” of its interest in the assets (for more on the meaning of “indubitable equivalence,” see this recent post).
Lenders, understandably concerned about the implications of this rule for their bargaining positions vis a vis their collateral in bankruptcy, were relieved when, about 10 days ago, the Seventh Circuit Court of Appeals respectfully disagreed – and held that “credit bidding” protections still apply whenever a sale is proposed through a Chapter 11 Plan.
The Circuit’s decision in In re River Road Hotel Partners (available here) sets up a split in the circuits – and the possibility of Supreme Court review. In the meanwhile, lenders may rest a little easier, at least in the Seventh Circuit.
Or can they?
It has been observed that the Seventh Circuit’s River Road Hotel Partners decision and the Third Circuit’s earlier decision both involved competitive auctions – i.e., bidding – in which the only “bid” not permitted was the lender’s credit bid. The Fifth Circuit’s earlier decision, however, involved a sale following a judicial valuation of the collateral at issue.
Is it possible to accomplish a sale without credit bidding – even in the Seventh Circuit – so long as the sale does not involve an auction, and is instead preceded by a judicial valuation?