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    Posts Tagged ‘“Second Circuit Court of Appeals”’

    It’s Not the Gift That Matters – It’s the Way You Give It.

    Tuesday, February 8th, 2011

    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.

    Seal of the United States Court of Appeals for...

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    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.”

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    Pushing the Envelope

    Monday, January 25th, 2010

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

    Collapse of the Canadian Asset Backed Commercial Paper Market

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

    But times did not stay flush.

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

    The Big Freeze – And The Planned Thaw

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

    Releases for Third Parties

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

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

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

    Recognition and Enforcement In the US

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

    Comity

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

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

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

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

    What It All Means

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

    Something to think about.

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    The Chrysler Sale – Back to the Future?

    Monday, September 28th, 2009

    The bankruptcy blogosphere is replete with commentary on Chrysler LLC’s sale, through Section 363 of the Bankruptcy Code, to a newly-formed entity.  The sale, of substantially all of Chrysler’s assets for $2 billion, gave secured creditors an estimated $0.29 on the dollar.  Other, unsecured creditors received more.  Though challenged, the sale ultimately received the 2d Circuit’s approval in a decision issued August 5.

    Was the Chrysler sale proper?  Or did it constitute an inappropriate “end run” around the reorganization provisions that ordinarily apply in a confirmed Chapter 11 plan?

    Harvard Law’s Mark Roe and Penn Law’s David Skeel tackle this question in a paper released earlier this month entitled “Assessing the Chrysler Bankruptcy.”  Roe and Skeel argue, in essence, that there was no way to tell whether or not the sale was proper because the sale lacked valuation, an arm’s length settlement, or a genuine market test (i.e., an auction) – all traditional measures of whether or not secured creditors received appropriate value for their collateral.  They then suggest that the Chrysler transaction may portend a return of sorts to the equitable receiverships used to reorganize the nation’s railroads at the end of the ninenteenth century.

    Roe and Skeel follow two fundamental strands of thought.

    First, they review the basic facts of the Chrysler sale against the context of other so-called “363 sales” and ask where Chrysler fits within this context.

    Their answer is that it really doesn’t fit.

    Most complex bankruptcy sales (i.e., sales that effectively determine priorities and terms that the Code is structured to determine under Section 1129) are insulated from running afoul of the Code’s reorganization provisions through judicial innovations such as expert valuations or priority determinations, creditor consents, or competitive auctions.  According to Roe and Skeel, the Chrysler sale had none of these.  Instead,

    “[Chrysler's] sale determined the core of the reorganization, but without adequately valuing the firm via [Section] 1129(b), without adequately structuring a . . . bargain [with creditors or classes of creditors], and without adequately market testing the sale itself.  Although the bankruptcy court emphasized an emergency quality to the need to act quickly . . . there was no immediate emergency.  Chrysler’s business posture in early June did not give the court an unlimited amount of time to reorganize, but it gave the court weeks to sort out priorities, even if in a makeshift way.”

    How was the Chrysler sale deficient in these respects?

    Though it involved a valuation presented by Chrysler, “the court did not give the objecting creditors time to present an alternative valuation from their experts . . . .  Here, the judge saw evidence from only one side’s experts.”

    For those who may protest that the Chrysler sale did, indeed, enjoy the consent of Chrysler’s secured lenders, Roe and Skeel argue that the largest of these lenders were beholden to the U.S. Treasury and to the Federal Reserve – not only as regulators, but as key patrons via the federal government’s rescue program.  They were, therefore, willing to “go along with the program” – and the Bankruptcy Court was inclined to use their consent to overrule other objections from lenders not so well situtated.  On this basis, Roe and Skeel contend that the secured lenders’ “consent” – such as it may have been – wasn’t independent “consent” at all.

    Roe and Skeel also point out that the “market test” proposed as a means of validating the sale was, in fact, not a test of Chrysler’s assets, but of the proposed sale: “There was a market test of the Chrysler [sale], but unfortunately, it was a test that no one could believe adequately revealed Chrysler’s underlying value, as what was put to market was the . . . [sale] itself.”

    The authors then go on to argue that the sale was mere pretense – and that, in fact, “there was no real sale [of Chrysler], . . . at its core Chrysler was a reorganization”:

    “Consider a spectrum.  At one end, the old firm is sold for cash through a straight-forward, arms-length sale to an unaffiliated buyer.  It’s a prime candidate to be a legitimate [Section] 363 sale.  At the other end, the firm is transferred to insider creditors who obtain control; no substantial third-party comes in; and the new owners are drawn from the old creditors.  That’s not a [Section] 363 sale; it’s a reorganization that needs to comply with [Section] 1129.

    . . . .

    [To determine where a proposed sale falls along this spectrum,] [a] rough rule of thumb for the court to start with is this stark, two-prong test: If the post-transaction capital structure contains a majority of creditors and owners who had constituted more than half of the old company’s balance sheet, while the transfer leaves significant creditor layers behind, and if a majority of the equity in the purportedly acquiring firm was in the old capital structure, then the transaction must be presumed to be a reorganization, not a bona fide sale.  In Chrysler, nearly 80% of the creditors in the new capital structure were from the old one and more than half of the new equity was not held by an arms-length purchaser, but by the old creditors.  Chrysler was reorganized, not sold.”

    Was the Chrysler transaction – however it may be called – simply a necessary expedient, borne of the unique economic circumtsances and policy concerns confronting the federal government during the summer of 2009?

    Roe and Skeel argue that, in fact, the government could have acted differently: It could have picked up some of Chrysler’s unsecured obligations (i.e., its retiree obligations) separately.  It could have offered the significant subsidies contemplated by the deal to qualified bidders rather than to Chrysler.  It could even have paid off all of Chrysler’s creditors in full.  But it did none of this.

    Second, Roe and Skeel consider that “[t]he deal structure Chrysler used does not need the government’s involvement or a national industry in economic crisis.”  Indeed, it has already been offered as precedent for proposed sales in the Delphi and Phoenix Coyotes NHL team bankruptcies – and, of course, in the subsequent GM case.

    One very recent case in which South Bay Law Firm represented a significant trade creditor involved a similar acquisition structure, with an insider- and management-affiliated acquirer purchasing secured debt at a significant discount, advancing modest cash through a DIP facility to a struggling retailer, and proposing to transition significant trade debt to the purchasing entity as partial consideration for the purchase.

    The deal got done.

    What’s to become of this new acquisition dynamic?  Employing a uniquely historical perspective, Roe and Skeel travel back in time to observe:

    “The Chrysler deal was structured as a pseudo sale, mostly to insiders . . . in a way eerily resembling the ugliest equity receiverships at the end of the 19th century.  The 19th century receivership process was a creature of necessity, and it facilitated reorganization of the nation’s railroads and other large corporations at a time when the nation lacked a statutory framework to do so.  But early equity receiverships created opportunities for abuse.  In the receiverships of the late 19th and early 20th century, insiders would set up a dummy corporation to buy the failed company’s assets.  Some old creditors – the insiders – would come over to the new entity.  Other, outsider creditors would be left behind, to claim against something less valuable, often an empty shell.  Often those frozen-out creditors were the company’s trade creditors.”

    They trace the treatment of equity receiverships, noting their curtailment in the US Supreme Court’s Boyd decision, the legislative reforms embodied in the Chandler Act of 1938, and the 1939 Case v. Los Angeles Lumber Products decision which articulated the subsequently-enacted “absolute priority rule” (but preserved the “new value exception”).  Against this historical background, “Chrysler, in effect, overturned Boyd.”

    But with a twist.

    “One feature of Chrysler that differed from Boyd may portend future problems.  Major creditors in Chrysler were were not pure financiers, but were deeply involved in the automaker’s production.”  In cases where the value of the assets is enhanced by the continued involvement of key non-financial creditors, “players with similar [legal] priorities will not . . . be treated similarly.”

    Translation: When non-financial creditors are driving enterprise value, a Chrysler-style sale suggests that some will make out, and some creditors – even, on occasion, some secured lenders – will get the shaft.

    If accurate, Roe’s and Skeel’s Chrysler analysis raises some significant considerations about access to and pricing of business credit.  It raises new concerns for trade creditors.  It likewise presents the possibility that the Chapter 11 process – which has, in recent years, tilted heavily in favor of secured lenders – may not be quite as predictable or uniformly favorable as in the past.

    Meanwhile . . . it’s back to the future.

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