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

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

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

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

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

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

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

One of the little-emphasized features of the 2005 Bankruptcy Code is a series of amendments designed to insulate the financial markets from the effects of corporate bankruptcy.  These changes build upon earlier provisions designed to accomplish the same objective, and continue a more general Congressional policy toward the separation of bankruptcy and securities law dating back to the Chandler Act of 1938.

But are the securities markets and the Bankruptcy Courts better off for this “insulation”?  Do the Bankruptcy Code’s various “securities exemptions” truly work as advertised?

That is the question raised by the University of Pennsylvania’s David A. Skeel, Jr.

Skeel, Penn Law School’s S. Samuel Arsht Professor of Corporate Law, explores the intersection between bankruptcy and securities law in a recently-authored Penn Institute for Law and Economics research paper titled “Bankruptcy Boundary Games.”  The paper focuses on Bankruptcy Code provisions intended to subordinate corporate bankruptcy protections to the work-a-day operation of securities markets.  In particular, Skeel focsuses on three examples of this deference:

- The Chapter 11 “brokerage exclusion” set forth in Bankruptcy Code Section 109(d);

- Section 546(e)’s ”avoidance safe harbor” for securities-related “settlement payments;” and

- Special treatment of “derivative transactions” under Section 362(b)(7) and elsewhere in the Code.

According to Skeel, “Debtors have sidestepped the brokerage exclusion from Chapter 11, the settlement safe harbor has been invoked in contexts well outside the transactions it was originally designed to protect, and the exemption from the stay for derivatives and other financial contracts performed much differently than advertised when Bear Stearns, Lehman Brothers and then AIG failed.”

Specifically, Skeel delves into recent case law and Chapter 11 filings to argue:

- Congress’s original contemplation that a Chapter 7 liquidation would be “cleaner” and more efficient than Chapter 11 has been superseded by the current, actual corporate structure of investment banking, which has permitted firms such as Lehman to utilize Chapter 11 and the “363 sale” process to accomplish the same result, more quickly and economically than might occur in a brokerage’s ”straight 7.”  As a result, this exclusion is largely irrelevant to the realities of present financial markets and their participants.

- Section 546(e)’s “avoidance safe harbor,” hobbled by a circular and virtually useless definition of the key term “settlement payment,” has been inconsistently applied by Bankruptcy Courts faced with challenges made on this ground to avoidance actions.  These challenges are often raised in contexts far different from what Congress appears to have originally contemplated.  In the context of LBO-related avoidance claims, courts are divided over when – or if – the “safe harbor” applies.  In Enron, the “safe harbor” defense was interposed with respect to at least three different types of transactions, and each defense appears to have been resolved on fact-specific grounds – with differing results.  Skeel suggests that this “safe harbor” may leave markets insulated, but at the cost of extreme uncertainty regarding specific transactions.

- The exemption of derivatives from the Code’s automatic stay and other provisions were originally implemented in order to avoid a feared “domino effect” in the securities markets created by a corporate Chapter 11 filing.  Ironically, however, these exemptions appear to do as much to invite systemic problems in the markets (e.g., runs in the event of financial distress) as they do to avoid them.  Among other examples, Skeel argues that Bear Stearns’ 2008 bailout (in lieu of a Chapter 11 filing) was borne of precisely this concern.  He suggests these exemptions have, in reality, done little to curb the “spill-over” effects in the securities markets that result from corporate bankruptcies.

In an environment where a great deal of federal securities regulation is up for fresh review, is it time for a legislative re-write of the Bankruptcy Code’s “securities exemptions?”

Perhaps, suggests Skeel.

But ”Bankruptcy Boundary Games” also hints at a more immediate and pragmatic approach to reconiling the Code’s provisions with the realities of the market: Creative lawyering and intelligent judging.  “Overall,” he writes, “the Bankruptcy Courts have done a relatively good job of handling the fallout from the sweeping protection of securities markets.”

A point well taken.

“There’s a cement slab on Ridge Lane, topped with a few pipes, an electrical box and a porta-john.  Nearby, an empty house, a large sign in the driveway declaring ‘inventory home.’  Around the corner, a few muddy lots, rimmed with construction fences … ‘If [the developer] is gone,’ [Kathy] Koss [a resident in the neighborhood] said, ‘what is going to happen to these houses?’”

This quote from a story in March 15’s Charlotte Observer opens an extensive and intriguing study assembled by Sarah P. Woo, entitled “A Blighted Land: An Empirical Study of Residential Developer Bankruptcies in the United States – 2007-2008.”  Woo is an independent risk management consultant and doctoral scholar at Stanford University with prior experience as a research manager at Moody’s KMV London and a background in corporate finance at White & Case LLP.  She offers a simple premise as the basis for her 194-page work, which also serves as her dissertation:

Until the housing sector is stabilized, there will simply be no recovery in America.  And as financially distressed residential developers and home builders are forced into liquidation or foreclosure, the unfinished projects they leave behind affect not only the immediate community, but area housing prices as well.

Woo is not alone in her assessment of the persistent weakness of the US residential housing sector.  A Deutsche Bank study released in early August and briefly summarized in a CNN-Money article last Wednesday indicates that home prices may fall another 14% before hitting a bottom, leaving as many as 48% of mortgage holders “underwater” by 2011.

Ouch.

Among Woo’s findings on developers who have filed Chapter 11 cases over the last 2 years:

- Only 5.3% were able to successfully reorganize.  In fact, the majority of cases were actually dismissed or converted to Chapter 7 – leaving real estate to be foreclosed or liquidated in forced sales.

- 72% of the cases sampled involved at least one request by a secured lender to lift the stay for purposes of foreclosure.  In such instances, relief was granted approximately 90% of the time.  However, foreclosure may not always have been the best outcome for the bank.  According to Ms. Woo, “[i]n one case, the bank which repossessed the property not only had trouble with the remaining development process but also found itself in a position where it could not necessarily sell the property as a going concern . . . .  In [another] case, the bank which repossessed the property was seized by regulators 2 months later for being insufficiently capitalized, raising the issue of the extent to which a bank’s own financial problems might have contributed to its preference for liquidation during bankruptcy proceedings.”

- Where properties were disposed of through “363 sales,” Woo “uncovered a pattern of winning credit bids where secured lenders acquired the properties . . . at low prices.”

- Access to DIP financing appears to have been severely impaired for developers (as it has been for many Chapter 11 debtors this cycle, regardless of industry).  Even where DIP financing has been available, such financing often occurred in cases where the debtor was ultimately liquidated or packaged for sale (again, a common scenario this cycle regardless of the debtor’s industry).

Is the near-certain prospect of liquidation or sale facing struggling residential home developers a good one for the sector?

On the one hand, Woo’s study appears to suggest that the control available to lenders through mechanisms such as DIP financing and stay relief litigation, employed by highly regulated and troubled US banks desperate to raise capital by seizing and liquidating collateral, puts housing developers who might reorganize in Chapter 11 on a very slippery slope with little prospect of survival.  On the other, it suggests that the industry may be ridding itself of weak performers very quickly, leaving only the strongest to survive as the residential housing sector struggles back to prior levels.

Where real estate development and the residential housing sector are concerned, is the shortest way up . . . straight down?

2009 is shaping up to be an extraordinary year for business bankruptcy.  Headlines and hoopla aside, however, it hasn’t been all about domestic Chapter 11 work.  The following brief summaries (drawn from news reports and from the national dockets) highlight some of the more newsworthy cross-border matters of the past 60 days:

- WC Wood – Guelph, Ontario-based W.C. Wood Ltd., manufacturer of freezers, fridges and commercial dehumidifiers, sought Chapter 15 recognition in Delaware along with its affiliates concurrently with the companies’ application for protection under the Canadian Companies’ Creditors Arrangement Act.  The US filing was commenced to further the Canadian reorganization, and to extend the automatic stay to protect officers and directors of the companies.

- Kumkang Valve – Kumkang Valve Co. Ltd. sought Chapter 15 recognition in Houston to protect its US -based assets while it pursued a “revival proceeding” in the District Bankruptcy Court for Daegu, South Korea, where it is headquartered. To do so, the manufacturer of trunnion mount ball valves for the oil and gas industry had to overcome objections lodged by Enterprise Products Operating LLC, who had previously filed a US District Court suit alleging that Kumkang knowingly supplied faulty valves to Enterprise when it was constructing facilities in Wyoming and Colorado.  Bankruptcy Judge Wesley Steen is presiding over the US proceeding.

- Gandi Innovations – Canadian grand-format inkjet manufacturer Gandi Innovations, which operates under the brand name Gandinnovations, obtained recognition from Bankruptcy Judge Leif Clark in San Antonio, TX very shortly after its entry into Canadian Companies’ Creditors Arrangement Act proceedings.  The company sought to protect US assets and stay litigation then pending in Bexar County, TX while it prosecuted a plan of arrangement in Toronto.

- Straumur-Burdaras Investment Bank – Iceland’s Straumur-Burdaras Investment Bank hf is seeking recognition of its Reykjavík-based restructuring efforts from New York Bankruptcy Judge Robert E. Gerber. Recognition would protect Straumur-Burdaras’ US-based assets, valued at $190 million.  The commercial bank’s Chapter 15 petition, filed June 2, follows that of three other Icelandic financial institutions – Glitnir Banki hf, Kaupthing Bank hf and Landsbanki Islands hf – all of which sought similar protection in New York. Straumur-Burdaras’ recognition hearing is calendared for July 14.

- Fraser Papers – Toronto-based lumber, pulp and paper producer Fraser Papers Inc. and affiliates sought recognition in Delaware for their restructuring under the Canadian Companies’ Creditors Arrangement Act (CCAA). According to papers filed in connection with the related June 18 petitions, the filing was commenced to further the effect of orders already entered under the CCAA and designed both to protect the companies’ US assets and to enjoin suits against officers and directors.

- Nanbu – Tokyo-based Nanbu Inc. has requested that US Bankruptcy Judge Robert J. Faris of Honolulu grant recognition of its foreign bankruptcy proceeding currently pending in the Civil Affairs division of Tokyo District Court. Court papers reveal virtually nothing about the company or its Japanese proceeding, and note only that recognition was sought in the US so that the company’s foreign representative, Tsunehiro Sasanami, can take title to and convey certain timeshare properties located in Hawaii.  A hearing on the recognition request is calendared for July 13; however, under the Bankruptcy Court’s local rules, a recognition order may be entered without a formal hearing where there are no objections.