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    Archive for March, 2011

    Hope May Spring Eternal . . . But the Automatic Stay Does Not.

    Saturday, March 26th, 2011

    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.”

    List of HOT and ETL lanes in the United States

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    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.

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    When a Plane Isn’t Really a Plane

    Tuesday, March 22nd, 2011

    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.

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    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.

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    Chapter 15 and US Bankruptcy Courts: How Universal is “Universalism”?

    Saturday, March 12th, 2011

    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.

    View of Capitol Hill from the U.S. Supreme Court

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    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.

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    Section 363 and the Limits of Buyer Protection

    Monday, March 7th, 2011

    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.

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    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.

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