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    Archive for October, 2009

    Small Business Chapter 11′s – Swift and Silent

    Monday, October 26th, 2009

    A recent study conducted by risk management solutions provider PayNet, Inc. highlights an interesting trend amongst small businesses: Of 750 small business bankruptcy filers owing an aggrate of $58 million, 50 percent were current with one or more of their lenders when they filed.

    The study, released at last week’s Equipment Leasing and Finance Association meeting in Southern California and summarized in a recent Bloomberg piece, indicates that borrowers are refusing to telegraph their distress before they throw in the towel. According to PayNet President Bill Phelan, such borrowers “pay and pay and pay, . . . and then they file for bankruptcy.”

    The article highlights the increased risk this type of borrower behavior creates for lenders who typically monitor their borrowers’ accounts for any sign of delinquency.  According to Bloomberg, the PayNet study also indicates that most borrowers who sought bankruptcy protection had at least one account in delinquency.  The upshot, according to Phelan (as quoted in Bloomberg), is that lenders who can see how borrowers are performing on obligations other than their own enjoy a better chance of identifying at-risk borrowers:

    “Just because you’re getting paid doesn’t mean everything’s OK . . . . It’s not the full picture.”

    The loans analyzed by PayNet are typical of those held by very small businesses – the study is based on an an average loan size of just over $77,000.  Taken at face value, Bloomberg’s assessment of the PayNet study suggests many small business owners have grown far more savvy about “strategic defaults.”

    As noted, lenders should beware.  And so should vendors and equipment lessors.

    Creditors and equipment lessors should pay close attention to trends in accounts payable aging, the recordation of a UCC-1 (if applicable), the presence (or availability) of personal guaranties from principals or other third parties, and the “mix” of goods and services provided (an analysis which may impact the priority of a claim in the debtor’s bankruptcy) . . . among other things.

    The small loans addressed by PayNet are indication of a larger trend: PayNet reports that an estimated 100,000 small businesses have sought bankruptcy protection in the last year alone.  This data corresponds with earlier predictions about the anticipated “ripple effect” of larger Chapter 11 filings, reported here.

    Amidst the “green shoots” of a claimed economic recovery, “swift and silent” small business Chapter 11′s are something to think about.

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    The Stanford Saga – Chapter 10: “Bleak House” Redux?

    Monday, October 19th, 2009

    Postings on this blog have focused on the cross-border battle between Antiguan liquidators Peter Wastell and Nigel Hamilton-Smith and federal receiver Ralph Janvey for control of the financial assets previously controlled by Sir Allen Stanford, including Stanford International Bank, Ltd. (SIB).  A complete digest of prior posts is available here.

    Mr. Janvey, meanwhile, has had to address yet another challenge to his receivership - from investors seeking to commence an involuntary Chapter 7 case.  In early September, an ad hoc group of CD and deposit-holders fronted by Dr. Samuel Bukrinsky, Jaime Alexis Arroyo Bornstein, and Mario Gebel requested an expedited hearing on their request for leave to commence an involuntary bankruptcy against the Stanford entities.

    The ad hoc investor group’s September request was not their first: In May of this year, the same investors requested essentially the same relief.  That request was never acted on, presumably because presiding US District Court Judge David Godbey already had imposed a 6-month moratorium on interference with the receivership.

    With the moratorium’s expiration, the investors have raised the issue once again.

    A Receivership Run Wild?

    Their second request largely repeats the investors’ prior arguments, many of them rather personal: No one is happy with the way this receivership has been run, they claim.  Specifically, the receivership is far too expensive and the lack of meaningful participation deprives creditors of significant due process rights.  Instead, an involuntary liquidation under Chapter 7 of the US Bankruptcy Code is the best and most efficient means of reining in expenses and preserving those rights.  The investors’ brief offers a picture of the 21st century Stanford receivership more closely resembling Dickens’ 19th century “Bleak House”: Professional fees accruing at an “alarming” rate (in this case, an estimated $1.1M per week); an estate at risk of being consumed entirely by administrative costs; and investors ultimately twice victimized.

    The investors further argue that an injunction prohibiting creditors’ access to the US bankruptcy system is, at best, an interim measure.  As such, it can never be employed on a permanent basis - and, therefore, cannot survive the standards for injunctive relief articulated under the Federal Rules of Civil Procedure.  They cite a variety of decisions which stand – according to them – for the proposition that the US Bankruptcy Court offers the best forum for complex liquidations such as the one at hand.

    Creditors Who Don’t Know What’s Best For Them?

    Predictably, Mr. Janvey disagrees in the strongest terms.

    As he sees it (and as he sees a string of federal cases referenced in his response), a federal equity receivership – and not a federal bankruptcy proceeding – is the accepted, “decades-long practice” of federal courts in winding up entities that were the subject of alleged Ponzi schemes and other frauds.  Moreover, Mr. Janvey suggests that if creditors are dissatisfied with the expense and claimed inefficiency of this proceeding, transition to a liquidation under the US Bankruptcy Code would be even more so.  In support, Mr. Janvey offers a “parade of horribles,” such as the “procedural nightmare” involved in transitioning much of the complex litigation already underway in the receivership to a bankruptcy trustee’s administration, the likely existence of multiple creditors’ committees (and the attendant expense of their counsel), and the need to sort out the Antiguans liquidators’ competing Chapter 15 recognition request even if a Chapter 7 petition is filed.

    Perhaps most significantly, however, Mr. Janvey believes that flexibility regarding a plan of distribution should govern the administration of the Stanford matters:

    Like the Bankruptcy Code, equity receiverships ensure that persons similarly situated receive similar treatment. In a case such as this involving massive deception, however, a searching evaluation of the facts is required to discern relevant differences between and among categories of creditors. Unlike a trustee in bankruptcy, the Receiver can take into account relative fault within a class of creditors, and fashion an equitable plan of distribution that does not treat all creditors within a class identically if they are not deserving of equal treatment.

    Mr. Janvey does not develop how a receiver’s application of equitable principles might differ from the equitable and other subordination provisions of Bankruptcy Code section 510.  Ultimately, his response reduces itself to a simple proposition for Judge Godbey and for creditors:

    “Trust me.”

    Unfortunately, Messr’s. Bukrinsky, Bornstein, and Gebel do not.  Their reply brief - submitted last Friday – again reiterates that the Stanford receivership has outlived its usefulness in this highly complex insolvency.  According to them, the Stanford record speaks for itself.  It is time for a new regime.

    Like the liquidators’ request for US recognition of their Antiguan-based wind-up of SIB, the parties now await Judge Godbey’s decision.

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    Taking the Punchbowl Away from the Party

    Monday, October 12th, 2009

    Business bankruptcies in the US can be big business for hedge funds trading in distressed debt.  But that business may be sharply curtailed – or effectively eliminated – if proposed new disclosure rules in bankruptcy take effect.

    In a recent series of articles dealing with these proposed changes, the Hedge Fund Law Report (HFLR) has explored their anticipated impact on hedge funds’ participation in bankruptcy proceedings – and has graciously included in its analysis a couple of quotes by members of South Bay Law Firm.

    Some background may be helpful.

    Hedge Funds and Rule 2019

    Hedge funds have become major participants in recent bankruptcy proceedings, in which they often form unofficial or ad hoc committees in order to aggregate their claims and benefit from the additional leverage such aggregation provides.  For example, a committee might seek to consolidate a “blocking position” with respect to a class (or classes) of the distressed firm’s debt, then negotiate for financial or other concessions regarding the debtor’s reorganization plan.  Though their investment strategies may differ, hedge funds are typically uniform in their insistence on the privacy and confidentiality of their investments.  Further, such secrecy is viewed as necessary to protect the funds’ proprietary trading models from duplication.

    The fiercely guarded privacy of hedge funds contrasts sharply with the insistence on disclosure that pervades American Bankruptcy Courts.  The two have never co-existed comfortably.  Bankruptcy Courts and other parties seeking to look behind the veil of secrecy surrounding a participating group of funds have looked for help to Bankruptcy Rule 2019.  That Rule essentially requires disclosure of certain information from informal “committees” in a bankruptcy case.

    Rule 2019 traces its roots to the correction of abuses unearthed in the 1930s, when a series of hearings conducted for the SEC by [as-of-then-yet-to-be-appointed Supreme Court Justice] William O. Douglas uncovered the frequent practice of inside groups (so-called “protective committees”) working with bankrupt companies to take advantage of creditors.  Douglas’ investigation uncovered “[i]nside arrangements, unfair committee representation, lack of oversight, and outright fraud [that] often cheated investors in financially troubled or bankrupt companies out of their investments.”

    Hedge funds do not occupy the same role as the “protective committees” of 70 years ago.  But creditors have nevertheless relied on the Rule’s provision to claim that ad hoc committees must “open the kimono” to reveal not only their members’ purchased positions in the debtor, but the timing and pricing of those purchases.  This most hedge funds will not do – at least not without without a very stiff fight.

    Reaction to this use of Rule 2019 has been mixed.  In a pair of decisions issued in 2007, the Bankruptcy Courts for the Southern District of New York and the Southern District of Texas went in opposite directions, finding that ad hoc committees in the respective cases of Northwest Airlines Corp. and Scotia Development LLC must comply (in New York) or were exempt (in Texas) from the provisions of Rule 2019.  The measure of hedge funds’ resistance to this disclosure is gauged by the fact that in the wake of the court’s decision in Northwest Airlines, several funds withdrew from the case rather than divulge the information otherwise required of them.

    Proposed Amendments to Rule 2019

    On August 12, 2009, the Advisory Committee on the Federal Rules of Bankruptcy Procedure weighed in on this dispute by proposing a significant revision of Rule 2019.  The Rule has been essentially re-drafted.  According to the Committee Notes, subdivision (a) of the Rule defines a “disclosable economic interest” – i.e., “any economic interest that could affect the legal and strategic positions a stakeholder takes in a chapter 9 or chapter 11 case.”  The term is employed in subdivisions (c)(2), (c)(3), (d), and (e), and – according to the Rules Committee that drafted it – is intended to extend beyond claims and interests owned by a stakeholder.

    In addition to applying to indenture trustees (as the Rule presently does), subdivision (b) extends the Rule’s coverage to “committees . . . consist[ing] of more than one creditor or equity security holder,” as well as to any “group of creditors or equity security holders that act in concert to advance common interests, even if the group does not call itself a committee.”  If these extensions of Rule 2019 weren’t broad enough, subdivision (b) goes even further.  It permits the Court, on its own motion, to require “any other entity that seeks or opposes the granting of relief” to disclose the information specified in Rule 2019(c)(2).  Although the Rule doesn’t automatically require disclosure by an individual party, the court may require disclosure when it “believes that knowledge of the party’s economic stake in the debtor will assist it in evaluating that party’s arguments.”

    Subdivision (c) – and, in particular, (c)(2) – is the heart of the Rule.  It requires disclosure of the nature, amount, and timing of acquisition of any “disclosable economic interest.”  Such interests must be disclosed individually – and not merely in the aggregate.  The court may, in its discretion, also require disclosure of the amount paid for such interests.

    Subdivision (d) requires updates for any material changes made after the filing of an initial Rule 2019 statement, and subdivision (e) authorizes the court to determine where there has been a violation of this rule, any solicitation requirement, or other applicable law.  Where appropriate, the court may impose sanctions for any such violation.

    Though potentially broad-reaching, one of the obvious flashpoints for the amended Rule’s application will be on the continued participation of hedge funds in Chapter 11 cases.

    WIll the Amendments Work?

    Are the amendments necessary?  Or helpful?  And how – if at all – will they affect the participation of hedge funds or other parties in Chapter 11 cases?

    Comments gathered by HFLR suggest that certain aspects of the amendments may, in fact, assist in blunting the effect of credit default swaps – derivative securities through which the holder of distressed debt can shift the economic risk of the debtor’s obligation to a non-debtor third party, and therfore refuse to negotiate with the debtor.  But other provisions may, in fact, permit abuse similar to the type perceived by William O. Douglas’s original investigation: The debtor’s management may use the new Rule in collusion with a friendly committee (or other creditors) to harrass, embarrass, and pressure an individual creditor, who may not be in an economic position to resist this treatment.

    Some hedge funds have offered the argument that Rule 2019′s disclosure requirements run afoul of the Bankruptcy Code section 107′s protection of “trade secrets,” which may be protected from the public through the sealing of papers filed with the Court.  But is a hedge fund’s trading information in a specific case really a “trade secret?”  HFLR quotes South Bay Law Firm’s Michael Good, who notes that “Where hedge funds are concerned, the plausibility of a ‘trade secret’ argument depends upon what can or can’t be reverse engineered, something that only people with access to and familiarity with the funds’ ‘black box’ trading models and expertise in understanding them can know.”

    To date, Bankruptcy Courts have not been persuaded by the “trade secret” argument.  The Bankruptcy Court for the Southern District of New York specifically rejected it in Northwest Airlines.

    Even so, Bankruptcy Courts have questioned whether or not case-specific trading information (such as the timing and pricing of a fund’s purchase) is truly relevant to the disclosure issues that arise before them.  HFLR cites to the Delaware Bankruptcy Court’s handling of similar concerns raised by parties in the Sea Containers bankruptcy case, where the court ordered attorneys for a group of five bondholders to “revise the 2019 statement to provide the information that’s required by 2019(a)(1), (2), and (3) but not (4) [subsection (4) requires disclosure of the purchase price, which is the information considered most sensitive by hedge fund managers] because I don’t think that [the purchase price] is relevant in any way.”

    Many practitioners agree with this assessment.  South Bay Law Firm’s Good opined that the Sea Containers court’s balancing of interests “is probably right. I don’t know that it is truly problematic for parties, hedge funds or others, to disclose who they are or what are their aggregate holdings.  The problems more commonly arise with the revelation of the price at which they purchased distressed securities, and occasionally with the timing of the purchase.  Though it might be relevant in certain circumstances, trading information is often far less relevant than identifying the participants in bankruptcy, their relationships with one another, and the conflicts of interest that can surface through the disclosure of these relationships.”

    So What?

    Why all the fuss, anyway?  What’s really at stake with these amendments?

    On the one hand, Temple law professor Jonathan Lipson has argued in a recent article that the business bankruptcy process serves an important informational function for the markets and for the economy generally by “outing” poor corporate practices and systemic inefficiencies that can only be addressed and corrected after they’ve seen the light of public scrutiny.  Consequently, the proposed amendments should keep the bankruptcy process honest – and are therefore necessary.

    But other scholars have suggested elsewhere that the glare of public scrutiny will keep many well-heeled investors out of the distressed investment market altogether.  According to them, hedge funds are widely perceived as facilitating more competitive financing terms and increased liquidity in the debt markets.  They are also particularly useful in the restructuring process because they can make different types of investments (debt and equity) in a single company.  Additionally, their exemption from traditional regulation allows them to quickly adapt their investment strategies to the situation at hand.  The proposed amendments to Rule 2019 – and even the proposed application of Rule 2019 in its present form – may effectively remove this “market lubricant” and may further deprive distressed firms of the liquidity they need at a time when they need it most.

    Comment on the proposed amendments is due by February 16, 2010.

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    Chapter 15 Round-Up: July-September 2009

    Monday, October 5th, 2009

    After a blazing start during the first half of 2009, it was a longer, slower summer for newsworthy Chapter 15 filings.  The last 3 months have produced a handful of new cases, including:

    - Stomp Pork – The Saskatoon, Saskatchewan-based pig-farm operator sought Chapter 15 protection in Iowa’s Northern District on May 29 after being placed into receivership the same day under the Bankruptcy and Insolvency Act in the Court of the Queen’s Bench, Judicial Centre of Saskatoon.  It was the company’s second trip to bankruptcy court after a prior, 2008 reorganization under the Companies’ Creditors Arrangement Act.

    The company’s Candian receiver, Ernst & Young Inc., planned to liquidate the company’s assets and distribute the proceeds to its creditors.  Prior to seeking protection in the US, the company received approval from the Candian court to sell its 130,000 pigs to Sheldon, Ohio-based G&D Pork LLC for $2.8 million.  Of these proceeds, creditor National Bank reportedly received $2.7 million.

    The filing was made in an abundance of caution, but ultimately proved unnecessary: Following the sale and the distribution of proceeds, the debtor obtained a dismissal of the recognition petition on the grounds that no further assets remained for the Iowa Bankruptcy Court to protect.

    - Sky Power Corp. – The Toronto-based developer of solar and wind-powered energy projects in Canada, the US, India and Panama (and portfolio company of bankrupt Lehman Brothers) sought protection in Delaware in August, seven days after seeking protection under Canada’s Companies’ Creditors Arrangement Act in the Ontario Superior Court of Justice.

    The company characterized its bankruptcy as part of a “domino effect” created by Lehman’s bankruptcy (Lehman was the major shareholder), as well as on reduced liquidity and on defaults triggered with respect to its senior debt by Lehman’s filing.

    At the time of the filing, the company was reportedly relying on a $15 million DIP financing commitment from CIM Group Inc. for liquidity.  The facility was priced at prime plus 875 basis points (prime is given a 3.5% floor), matures November 30, and permits CIM Group to credit bid the DIP obligation toward a purchase of SkyPower.

    Judge Peter Walsh entered a recognition order on September 15.

    - Daewoo Logistics Corp. - The Seoul, Korea-based shipping company sought protection in New York in mid-September to protect US-based assets from the immediate effects of an adverse arbitration ruling.

    In addition to the award – obtained by Saga Forest Carriers International for $609,638 in New York’s Southern District – the company also faced 12 other actions, including five others pending in New York.

    The company had previously sought creditors’ protection under the Republic of Korea’s Debtor Rehabilitation and Bankruptcy Act with the 8th Bankruptcy Division of the Seoul Central District Court.  The Korean filing was allegedly a result of plummeting profits stemming from a decline in the market value of dry bulk shipping contracts.  The company also identified a failed land purchase in Madagascar, which was disrupted by a military coup in that country, as a source of financial stress.

    Bankruptcy Judge Burton Lifland granted a preliminary injunction on September 24.

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