Bankruptcy Law Insights

Bankruptcy Law Insights

Commentary & Analysis on Current Events & Issues in Large & Mid-Market Chapter 11 Cases

Baker Botts v. Asarco: The Supreme Court Shows Again That It Really Doesn’t Understand Corporate Bankruptcy Cases

Posted in Chapter 11

The Supreme Court has not handled its recent major bankruptcy decisions well. The jurisdictional confusion engendered by its 2011 decision in Stern v. Marshall was only partially clarified by this term’s opinion in Wellness International Network v. Sharif. The Court’s ruling this week in Baker Botts v. Asarco, while narrower, stands as another example of obtuse judicial reasoning that will create unnecessary problems for practitioners and bankruptcy court judges.

The law firm of Baker Botts was retained to represent Asarco in its chapter 11 bankruptcy case. During the case, Baker Botts sued Asarco’s parent company to recover improperly transferred assets, and won a huge recovery for the benefit of Asarco’s creditors. At the end of the chapter 11 case Baker Botts, as the Bankruptcy Code requires for all professional firms that represent debtors or official committees, applied to the bankruptcy court for final approval of $120 million in fees and expenses, plus a performance bonus of $4.1 million. Asarco, which wound up back under the control of its parent company after all of its creditors were paid in full, objected to Baker Botts’ fee application. Following a multi-day trial, the bankruptcy court approved Baker Botts’ requested fees and also awarded it over $5 million to cover the costs incurred in defense of those fees. The Fifth Circuit reversed the award of fees for defending fees, and the Supreme Court upheld that reversal.

The Court’s analysis was straight-forward: under American jurisprudence, each side in a litigated dispute bears its own attorneys’ fees, unless there is an applicable statute or agreement that provides otherwise. Section 330(a)(1) of the Bankruptcy Code states, “After notice to the parties in interest and . . . a hearing . . . the court may award to . . . a professional person . . . reasonable compensation for actual, necessary services . . . .” In the Court’s view, the plain text of the statute does not support a deviation from the “American Rule” regarding attorneys’ fees. Citing to Webster’s New International Dictionary, the Court’s majority stated, “The word ‘services’ ordinarily refers to ‘labor performed for another.’” Since Baker Botts was litigating to defend its own fees, the Court reasoned, it was not providing an “actual, necessary service” to the bankruptcy estate and therefore was not entitle to compensation for such time.

The problem with this analysis is that the statutory language of Section 330(a) of the Bankruptcy Code is nowhere near as unambiguous as the majority read it. Unsurprisingly, the dissent offered an equally plausible alternative reading, focusing on the words “reasonable compensation.” Although the work undertaken by a law firm defending its fees may not be a “service,” in the dissent’s view, “[t]he statute permits compensation for fee-defense work as a part of compensation for the underlying services in a bankruptcy proceeding” – not for the “service” of defending the fee application. The dissent noted that Section 330(a)(6) expressly contemplates that compensation should be awarded for preparing a fee application. It reasoned that if compensation should be awarded for the preparation of a fee application, then time spent in defending the application should also be compensable.

While this may all seem to be an academic debate, the implications in chapter 11 cases could be substantial. The requirement of bankruptcy court approval for all fees paid by the bankruptcy estate to professionals employed by a debtor, a trustee or an official committee helps to maintain the fairness and integrity of the bankruptcy process, and is accepted as an inconvenient but necessary requirement by law firms and other professional firms that undertake such work. That fees may only be allowed after a “hearing” necessarily implicates a contested process, and challenges from other parties have always been a recognized hazard for such firms. Indeed, threats to contest professionals’ fees are an ingrained part of the hard-nosed negotiating process that is the hallmark of corporate restructuring practice. The common view, reflected in the vast proportion of lower court decisions, has long been that “reasonable compensation” should be provided for responding to such challenges. In other words, the dissent’s reading of Section 330(a) is more consistent with both the understanding of most bankruptcy practitioners and basic fairness.

The majority opinion needlessly ignores the realities of large corporate bankruptcy cases and long-standing commercial practice. By determining that compensation cannot be given for defending fee applications, the Court’s ruling in Baker Botts v. Asarco will invariably encourage more litigation challenges to the allowance of professional fees, and increase the costs and time necessary to wind down chapter 11 bankruptcy estates.

Supreme Court Decides to Maintain the Viability of the U.S. Bankruptcy Courts, But a Key Question Remains Unresolved

Posted in Bankruptcy

Four years ago, in Stern v. Marshall, the Supreme Court stunned many observers by re-visiting separation of powers issues regarding the jurisdiction of the United States bankruptcy courts that most legal scholars had viewed as long settled. Stern significantly reduced the authority of bankruptcy courts, and bankruptcy judges and practitioners both have since been grappling with the ramifications of that decision. It quickly became clear, notwithstanding the Court’s characterization of its holding in Stern as “narrow,” that the Court would need to address and clarify two key questions regarding the power of judges and courts created under Article I, rather than Article III, of the Constitution: the scope of what constitutes a “public right” in the context of bankruptcy that can be decided by an Article I judge, and whether the right to have a dispute determined by an Article III judge may be waived by consent

The Supreme Court this week, in Wellness International Network v. Sharif, answered one of those questions, and in doing so escaped somewhat from the formalistic straitjacket of Stern. The Court ruled that Article I bankruptcy judges can, with the knowing consent of the parties, issue final decisions on matters that would otherwise necessitate a ruling by an Article III judge. If the narrow view of the authority of bankruptcy judges articulated in Stern had prevailed in Wellness International, bankruptcy judges would no longer be able to make final rulings on issues as integral to the bankruptcy process as determinations regarding what constitutes property of the bankruptcy estate. If bankruptcy judges’ powers were so severely circumscribed, there would be little purpose served by having separate specialized bankruptcy courts. Simply put, in ruling as it did, the Court effectively preserved, for the time being, the viability of the United States bankruptcy courts. However, by leaving the other key question unanswered, the Court ensured that some uncertainty will continue to hover over issues of bankruptcy court jurisdiction.

To recap how the Supreme Court got itself to this point:

Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III. Among other things, judges of Article III courts have lifetime tenure in order to ensure judicial independence. Congress established the U.S. bankruptcy courts pursuant to its power to establish uniform laws on bankruptcy under Article I of the Constitution, rather than under Article III. U.S. bankruptcy judges are appointed for 14 year terms. A line of Supreme Court cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (e.g., cases involving claims of citizens against the government). Claims of citizens against one another under state law, such as for breach of contract or common torts, are “private rights” that must be heard by an Article III judge. It had long been believed since the Supreme Court last invalidated the grant of jurisdiction to the bankruptcy courts in 1982 and Congress responded with the Bankruptcy Reform Act of 1984, that disputes pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted a type of “public rights” that could be heard and decided by an Article I bankruptcy judge.

The Supreme Court surprised the commercial legal community in Stern by reopening the question of the constitutionality of the U.S. bankruptcy courts. The Court’s holding in Stern showed that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge is far narrower than previously understood. The Court in Stern described the query for constitutional purposes as “whether the action at issue stems from the bankruptcy itself [i.e., Congress’s bankruptcy power under Article I].” If the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling.

The problem created by the Supreme Court’s ruling in Stern is this: the Bankruptcy Code gives the bankruptcy courts power over all property of a debtor’s estate under Section 541(a). Determining what constitutes property of a debtor’s bankruptcy estate is indisputably fundamental to “the restructuring of debtor-creditor relations.” But the Supreme Court has expressly stated in other cases that property rights in bankruptcy are based on state law. State-law issues are an inseparable part of virtually every bankruptcy case. For purposes of determining “public” and “private” rights, which aspect of such adjudications should control?

Wellness International highlighted the ramifications of Stern’s cramped view of bankruptcy court authority. The case stems from Sharif’s personal bankruptcy case, which he filed after Wellness International obtained a substantial judgment against him. Wellness International brought an action before the bankruptcy court, challenging Sharif’s claim that certain assets were property of a separate trust and thus excludable from his bankruptcy estate under Section 541(a) of the Bankruptcy Code. The bankruptcy court found in favor of Wellness International, and Sharif appealed. He claimed, among other things, that in the wake of Stern, the bankruptcy court lacked the constitutional authority to enter a final judgment, because the question of ownership of the supposed trust assets was purely an issue of state law, independent of federal bankruptcy law. He also argued that the right to a determination of this issue by an Article III court was not a right that could be waived, not even by a debtor that had expressly sought the jurisdiction of an Article I bankruptcy court by filing a bankruptcy petition. The Seventh Circuit agreed with Sharif on these points and reversed the bankruptcy court ruling.

The Court ruled yesterday that the right to have a dispute determined by an Article III judge may be waived by consent. Justice Sotomayor, writing for the majority, clearly recognized the implications of a ruling against Wellness International, not only for the bankruptcy courts but also for other Article I judges, such as the U.S. magistrates. She noted that Congress has authorized 534 U.S. magistrates and 349 bankruptcy judges, a combined total of 883 Article I judges that far exceeds the 677 Article III district court judges. In the one year period between October 1, 2013 and September 30, 2014, over 960,000 cases were filed in the bankruptcy courts, more than double the number of cases filed in U.S. district and circuit courts. Magistrates handle large numbers of federal misdemeanor cases and significant pretrial work in civil and felony criminal cases. In short, without the bankruptcy judges and magistrates, Justice Sotomayor observed, “the work of the federal court system would grind nearly to a halt.”

The Court did not, however, make a decision as to whether Sharif had, by voluntarily filing his bankruptcy case and invoking the authority of an Article I bankruptcy court, “knowingly and voluntarily consent[ed] to the adjudication by a bankruptcy judge.” The Court instead remanded the case to the Seventh Circuit to make that determination. If the Seventh Circuit decides that the act of filing of a bankruptcy petition in and of itself evinces consent, it would eliminate the power of any bankruptcy debtor to challenge bankruptcy court jurisdiction. If, however, the Seventh Circuit were to rule that simply commencing a bankruptcy case is not sufficient in and of itself, then the import of this case could be significantly limited.

More importantly, the Court avoided completely the crucial question as to the scope of what constitutes a “public right” in the context of bankruptcy; i.e., whether the dispute between Sharif and Wellness International regarding whether certain assets constituted property of Sharif’s bankruptcy estate “stem[med] from the bankruptcy itself.” There invariably will be cases going forward where the consent of a party to allow bankruptcy court adjudication will not exist. The question as to the types of matters that can be decided by an Article I judge will then need to be squarely addressed. Until the Supreme Court confronts and clearly delineates the extent of bankruptcy judges’ authority, some uncertainty will continue to hover over issues of bankruptcy court jurisdiction.

Law360 Selects Kelly Drye Special Counsel Jason R. Adams As One of its 2015 ‘Rising Stars’

Posted in Bankruptcy

Kelley Drye is pleased to announce that special counsel Jason R. Adams has been honored by Law360 as one of the “Rising Stars” in bankruptcy law for 2015, which recognizes top legal talent across the United States under the age of 40.

As one of the nine honorees in the bankruptcy category, Mr. Adams was selected for having a hand in some of the most high profile bankruptcies in the country in recent years, including GT Advanced Technologies, Caesers Entertainment Operating Co. Inc. and Residential Capital LLC.  He was noted as being a key part of the expansion of Kelley Drye’s creditor committee practice and has earned a reputation as an innovative practitioner with a diverse skill set.

As far as advice to other young lawyers looking to have a successful career in restructuring work, Mr. Adams said, “In addition to finding good mentors, diverse experience is the name of the game.  That means going out to different practice areas in your firm and seeking the opportunity to do something that you know will be beneficial to your practice.”  He encourages young attorneys to work on as many varied projects as possible.

This year, 144 attorneys made the Law360 Rising Stars Under 40 list out of a pool of a record 1,200 nominees. The annual series recognizes attorneys under 40 based on their career accomplishments in their respective practice areas.  To read Jason’s Law360 article, please click here.

Judge Protects GM Against Most, But Not All, Ignition Switch Claims

Posted in Distressed M&A

Judge Robert Gerber ruled last week that General Motors LLC (“New GM”), the entity formed in 2009 to acquire the assets of General Motors Corporation (“Old GM”), is shielded from a substantial portion of the lawsuits based on ignition switch defects in cars manufactured prior to New GM’s acquisition of the assets of Old GM in 2009. Judge Gerber determined that the lawsuits are barred by the provisions of the Sale Order he entered at that time, which transferred the assets to New GM “free and clear” of claims against Old GM (other than a narrow range of expressly assumed liabilities) and protected New GM from any claims based on theories of successor liability.

The ignition switch plaintiffs argued that they should not now be bound by the Sale Order because they were never given proper notice of the sale in 2009 and were therefore denied due process. Although Judge Gerber agreed with the ignition switch plaintiffs’ contentions that the publication notice given at the time of the sale had failed to satisfy the requirements of due process, he determined that the plaintiffs mostly had not suffered prejudice as a result. Judge Gerber held that the lack of required notice did not constitute a due process violation without some showing of prejudice, and that there was no prejudice because most of the plaintiffs’ arguments regarding New GM’s post-sale liability had been made at the time by other parties and rejected.

However, he noted that one argument now being pressed by the ignition switch plaintiffs, regarding the extent to which New GM could claim protection under the Sale Order against liabilities based solely on its post-sale conduct, had not been raised by any party in 2009, and that in such respect the plaintiffs had in fact suffered prejudice from the lack of direct notice. Judge Gerber stated that because he likely would have agreed in 2009 that utilizing the Sale Order protections to cover liabilities stemming solely from post-sale actions of New GM was overbroad and impermissible, he will permit lawsuits based on such allegations against New GM to move forward.

Background

As has been widely reported, ignition switch defects in cars manufactured prior to 2009 that allegedly caused numerous deaths and injuries were known by employees of Old GM but were not properly reported (or perhaps were deliberately covered up).  Vehicle owners have sued New GM, seeking compensation for economic damages caused by the defects.  These cases have mostly been consolidated into a single class action proceeding before Judge Jesse Furman in the Southern District of New York.  New GM responded by bringing a motion in the Old GM bankruptcy case to enforce the Sale Order injunction with respect to all litigation seeking compensation for economic damages. (New GM agreed under the Sale Order to assume liability for death and personal injury claims against Old GM, and has structured a non-judicial compensation arrangement to address such claims arising from ignition switch defects.)

Judge Gerber and lawyers for New GM, the creditor trust that is the successor-in-interest to Old GM, and the vehicle owner plaintiffs spent several months last year identifying the “threshold” legal issues that would need to be addressed. At a mid-February hearing, the parties focused on whether there had been a violation of the due process rights of the ignition switch plaintiffs due to the lack of direct notice and, if so, what the appropriate remedy should be. (Kelley Drye & Warren LLP represents certain major creditors of Old GM but has had no role in these proceedings.)

Judge Gerber’s Ruling

In his opinion, Judge Gerber first considered whether the publication notice given at the time satisfied the requirements of due process. He noted that publication notice sufficed under most circumstances with respect to “unknown” claimants. As to the owners of vehicles with ignition switch defects, however, he agreed with the plaintiffs’ contention that there had been sufficient knowledge of the potential problems on the part of certain employees and officers of Old GM in 2009 to impute such knowledge to Old GM. Given the requirements to maintain data bases regarding accidents under the National Traffic and Motor Vehicle Safety Act, the plaintiffs argued, and Judge Gerber concurred, that the claimants should have been “known” in 2009 based on what Old GM was charged with knowing under federal law.  Since there had been no direct notice given to the vehicle owners, the requirements of due process with respect to “known” creditors was not satisfied.

He made clear, however, that the sufficiency of the notice given in 2009 was only part of the inquiry, and strongly disagreed with the plaintiffs’ contention that the lack of proper notice meant that they should not be bound by the Sale Order. He ruled that the plaintiffs were entitled only to “the full and fair hearing [they were] initially denied, with the Court then focusing on the extent to which prejudice actually resulted[.]” In addition, he held that he needed to consider both the appropriate remedy, and the extent to which the Sale Order could be modified.

New GM, in its briefs and during the hearing, contended that regardless of whether proper notice had been given, there was no prejudice to the plaintiffs. New GM pointed out that extensive arguments had been made by numerous parties in 2009 against the Sale Order, and rejected then by Judge Gerber, to the effect that New GM should not be able leave behind potential liabilities of Old GM nearly identical to those held by the ignition switch plaintiffs. Judge Gerber agreed. The plaintiffs, he stated, “[have not] advanced any arguments on successor liability that were not previously made, and made exceedingly well before.”

But he went on to note that the plaintiffs were making one important argument that was not based on theories of successor liability, and that had not been advanced by any other party in 2009. The Sale Order protects New GM from any liabilities (other than a few narrow categories expressly assumed) involving vehicles and parts involving Old GM. The plaintiffs contended that the breadth of this exclusion was so broad that it would effectively shield New GM from defective ignition switch lawsuits even if the only wrongful conduct alleged were on the part of New GM subsequent to the sale. Judge Gerber observed that he had in fact agreed with a similar argument that was made in 2009 with respect to environmental liabilities, and therefore would likely have agreed with the plaintiffs if they had been given the chance to make the same argument at that time. He held that the plaintiffs, by not having had the chance to make such argument, had thus shown prejudice from the lack of proper notice.

Judge Gerber then considered the appropriate remedy for the plaintiffs. He noted his agreement with New GM regarding the importance of finality in bankruptcy sales, and of protecting the expectations of purchasers of assets in bankruptcy cases that they are acquiring assets “free and clear” of any claims against the bankrupt seller or claims based on successor liability. But he then noted that due process considerations are constitutional in nature, and determined that “[a] doctrine that would bar modification of the Sale Order under less extreme circumstances has to give way to constitutional concerns.” He also disagreed with New GM’s assertion that because the provisions of the Sale Order were non-severable, the Sale Order had to be either enforced or voided in full. He held that if an order could be voided in full, then the non-severability provisions of such order could be voided, so that a court could uphold the order while simultaneously denying the enforcement of “cherry-picked components . . . that have been entered with denials of due process.”

He emphasized that New GM remained protected against all liabilities of Old GM and any claims based on theories of successor liability. But New GM will now be required to defend itself in lawsuits that seek damages based solely on New GM’s post-sale actions and conduct. The fact that such claims may happen to involve automobiles or parts manufactured by Old GM will no longer provide New GM with a shield under the Sale Order.

Energy Future Holdings Make-Whole Ruling Extends Rationale of Important SDNY Decisions to Delaware

Posted in High Yield Debt

Judge Christopher Sontchi issued a notable opinion last week in the bankruptcy case of Energy Future Holdings Corp., et al. (“EFH”), Case No. 14-10979 (D. Del.), ruling that the repayment in full of certain senior secured notes did not trigger an obligation by the debtors to pay a make-whole premium. One important aspect of this decision is that Judge Sontchi closely followed the reasoning of Judge Robert Drain last year in a similar decision involving a make-whole premium in MPM Silicones, LLC, et al. (“Momentive”), Case No. 14-22503 (S.D.N.Y.), thus extending the rationale of that decision, as well as earlier Southern District of New York cases such as In re Solutia, Inc., and In re Calpine Corp., into Delaware for the first time. (Kelley Drye & Warren LLP represents certain creditors in the EFH cases, but has had no role in these proceedings.)

Make-whole premiums are often used in connection with the issuance of debt in order to protect noteholders with long term investment horizons from being repaid early when interest rates drop. Judge Drain in Momentive held that the right to payment of a make-whole premium must be clearly stated in the applicable indenture, and denied payment in the absence of express language that it was due and owing following a default and an acceleration of the underlying notes caused by the commencement of a bankruptcy case.

The EFH cases presented similar circumstances. At the time of the bankruptcy filing of EFH in April 2014, certain of the EFH debtors were obligated under a series of 10% First Lien Notes (the “Notes”) issued by Energy Future Intermediate Holding Company (“EFIH”). Under the indenture governing the Notes (the “Indenture”), EFIH’s bankruptcy filing caused the automatic acceleration of the Notes. Shortly after the filing, EFIH sought approval of debtor-in-possession financing, in part to repay all principal and accrued interest under the Notes. The indenture trustee for the noteholders (the “Trustee”) objected, contending that the repayment by EFIH constituted an “Optional Redemption” under the Indenture, and that such a redemption gave rise to a secured claim under the Indenture for the make-whole premium. EFIH argued in response that no Optional Redemption had occurred because of the automatic acceleration under the Indenture. Once the acceleration occurred the Notes were due and owing, such that the repayment of the Notes could not constitute an Optional Redemption. Judge Sontchi overruled the Trustee’s objection and permitted EFIH to make the repayment in June 2014, while reserving the Trustee’s right to continue to seek the make-whole premium.

The Trustee subsequently commenced an adversary proceeding, in which it repeated its claim that EFIH’s repayment constituted an Optional Redemption that required the payment of the make-whole premium. It further argued that it could retroactively decelerate the Notes, so that they would not have been due and owing when they were repaid by EFIH in June 2014 with the proceeds of the debtor-in-possession financing, thus bringing the EFIH repayment clearly within the ambit of an Optional Redemption. The Trustee also contended that the deceleration of the Notes would not violate the automatic stay (or alternatively, that cause existed to lift the automatic stay). The Trustee’s complaint additionally stated that the make-whole premium should be payable because EFIH’s bankruptcy filing constituted an “intentional” default in order to avoid paying the make-whole premium, and asserted additional causes of action based alleged breaches of the Indenture and the “perfect tender” rule under New York law. Following discovery, both sides moved for summary judgment.

Judge Sontchi granted EFIH’s motion for summary judgment on most counts, and denied the Trustee’s motion. Similar to Judge Drain in Momentive, he held that “[u]nder New York law, an indenture must contain express language requiring payment of a prepayment premium upon acceleration; otherwise, it is not owed.” He looked first at what he viewed as the plain language of the Indenture, and found it to be indistinguishable from the language in the Momentive indenture (and indentures in other cases), in which there was no express language specifying that a make-whole premium would be owed upon automatic acceleration. Judge Sontchi focused carefully on the distinction between “redemption” and “acceleration.” He noted that under the Indenture, Optional Redemption “is an act separate and apart from automatic acceleration.” He parsed the Indenture closely, and agreed with EFIH that (i) the make-whole premium was due only upon an Optional Redemption, and (ii) repayment following acceleration did not constitute an Optional Redemption. He concluded that the Optional Redemption contemplated a voluntary action by EFIH, and that under New York law, “ a borrower’s repayment after acceleration is not considered voluntary.” The plain language of the Indenture therefore did not require the payment of the make-whole premium in June 2014, when EFIH repaid the Notes were following the automatic acceleration caused by the bankruptcy filing.

Judge Sontchi also turned aside the Trustee’s argument that the make-whole premium should be paid because the bankruptcy filing was an intentional default aimed at avoiding it. He noted first that there was no provision in the Indenture stating that the make-whole premium would be owed if there were an intentional default. Beyond that, he held that even though there was substantial evidence prior to the bankruptcy that EFIH intended to avoid paying the make-whole once it filed, EFIH and the debtors had ample grounds to file bankruptcy due to their unsupportable capital structure and a liquidity crisis. Once in bankruptcy, Judge Sontchi stated, EFIH was free to use whatever rights it had at its disposal to minimize estate liabilities. He also rejected the claim based on a breach of the Indenture, and ruled that there was no violation of the “perfect tender” rule under New York law for the same reason that there was no Optional Redemption – the Notes had already been accelerated.

EFIH did not win a complete victory, however. Judge Sontchi agreed with the Trustee that it has a qualified right under the Indenture to rescind the automatic acceleration that took place upon the bankruptcy filing. He further agreed that if the rescission were to be effective retroactively (i.e., prior to June 2014), then EFIH’s repayment would in fact constitute an Optional Redemption and the make-whole premium would then be due. Although the Trustee could not decelerate without violating the automatic stay, Judge Sontchi ruled that there was a material issue of fact as to whether “cause” existed to lift the stay. He therefore denied EFIH’s motion for summary judgment on this issue, and stated that a trial would need to be held on the merits of whether the Trustee could retroactively decelerate the Notes.

The Trustee will therefore have one more chance, through a motion to lift the automatic stay and an evidentiary hearing, to obtain payment of the make-whole premium. Judge Sontchi rejected the Trustee’s contention that the automatic stay should be lifted if it can be shown that EFIH is solvent (and thus there being no harm to other EFIH creditors, who would still be paid in full if the make-whole premium were to be paid), but acknowledged that solvency would be a significant factor in determining whether “cause” exists to lift the automatic stay.

Disputes over the payment of make-whole premiums in large chapter 11 cases are almost certain to continue, as other debtors will look to take advantage of the current low interest rate environment while it still lasts. Judge Sontchi’s ruling in EFH makes it clear that in Delaware now as well as New York, only clear and express language in the applicable documents will serve to support a claim for such payments.

Is GM Shielded From Ignition Switch Defect Liability? Hearing Highlights Thorny Due Process and Bankruptcy Issues

Posted in Distressed M&A

Judge Robert Gerber will be stepping down at the end of this year, ending a storied judicial career highlighted by his oversight of the 2009 chapter 11 case of General Motors Corporation (“Old GM”). In one of the most frenetic bankruptcy cases of all time, Judge Gerber signed an order (the “Sale Order”) approved the sale of substantially all of the assets of Old GM to a new entity, General Motors LLC (“New GM”), “free and clear” of claims against Old GM (other than a narrow range of expressly assumed liabilities), and with an express injunction to prevent Old GM creditors from proceeding against New GM. Now, he will be spending a substantial portion of his remaining time on the bench seeking to resolve the legal quandaries raised by the Sale Order, following the revelations last year that ignition switch defects in cars manufactured prior to 2009, which allegedly caused numerous deaths and injuries, were known by employees of Old GM but were not properly reported (or perhaps were deliberately covered up).

Vehicle owners have sued New GM, seeking compensation for economic damages caused by the defects. New GM responded by bringing a motion in the Old GM bankruptcy case to enforce the Sale Order injunction with respect to all litigation seeking compensation for economic damages. (New GM agreed under the Sale Order to assume liability for death and personal injury claims against Old GM, and has structured a non-judicial compensation arrangement to address such claims arising from ignition switch defects.)

Judge Gerber and lawyers for New GM, the Old GM creditor trust (the successor-in-interest to Old GM) and the vehicle owner plaintiffs spent several months last year identifying the “threshold” legal issues that would need to be addressed. Briefing was completed in January, and Judge Gerber recently heard arguments. (Kelley Drye & Warren LLP represents certain major creditors of Old GM but has had no role in these proceedings.)

The hearing focused primarily on whether there had been a violation of the due process rights of the ignition switch plaintiffs and, if so, what the appropriate remedy should be.

New GM focused its arguments on whether there had in fact could have been any duty to provide notice based on what was known to Old GM back in 2009, and if the lack of notice actually caused any prejudice to the claimants alleging damages stemming from the defective ignition switches.  New GM contended that notwithstanding the knowledge on the part of certain employees and officers of Old GM in 2009 of the potential problems that had arisen with the ignition switches, such knowledge could not be imputed to either Old GM or New GM, because the claims in 2009 had not been “reasonably foreseeable”.  Accordingly, no direct notice to the ignition switch plaintiffs should have been required at that time, and the general publication notice that was given satisfied the necessary due process requirements.

New GM then focused closely on certain objections that had actually been raised at the time of the 2009 sale.  New GM pointed out that extensive arguments were made by numerous parties against the Sale Order, and rejected at the time by Judge Gerber, to the effect that New GM should not be able leave behind potential liabilities nearly identical to those held by the ignition switch plaintiffs.  Those parties included the official creditors’ committee and 40 state attorneys general.  New GM argued that in 2009 it adamantly refused to take on any “successor liability” for economic loss claims, and that the protection it received in the Sale Order against any such liabilities was applicable to claims which were both known and unknown at the time.

New GM further argued that there was no deprivation of due process because no property rights held by the ignition switch plaintiffs had been affected.  The Sale Order did not prejudice any claims that were held by any party – it only directed those claims against the proceeds of the sale and allowed New GM to acquire the assets of Old GM “free and clear”.  New GM asserted that it was the subsequent orders establishing a claims bar date and confirming a plan of liquidation for Old GM that impaired the rights of the plaintiffs.  It highlighted the point that if the ignition switch plaintiffs were now permitted to go after New GM, they would be in a far better position than all of the other claimants in 2009 who received only a percentage of their allowed claims following the pro rata distribution of the sale proceeds under Old GM’s plan of liquidation.

The ignition switch plaintiffs countered each of these points.  They particularly sought to refute the notion that the ignition switch claims were not “reasonably foreseeable” in 2009.  Given the requirements to maintain data bases regarding accidents, the plaintiffs argued that the claims should have been “known” in 2009 based on what Old GM was charged with knowing under federal law.  Given such knowledge, the plaintiffs stated that there no semblance of the kind of notice that could have satisfied the requirements of due process.

The plaintiffs then took issue with New GM’s argument that there was no due process violation because they were not prejudiced by the lack of notice.  The fact that other parties made arguments regarding similar claims in 2009 was not relevant, as there could only be speculation as to what might have happened if the ignition switch plaintiffs had been given the opportunity to appear and argue at that time.

Finally, the ignition switch plaintiffs argued that a significant portion of the claims they are asserting now derive from the post-sale conduct of New GM – especially its failure to institute a recall based on the defective ignition switches until 2014.  The plaintiffs sought to highlight for Judge Gerber that regardless of whether the Sale Order provisions protecting New GM from the liabilities of Old GM could be enforced against them, claims arising from New GM’s breach of its duties subsequent to 2009 are beyond the scope of the Sale Order.

During the hearing Judge Gerber appeared to be particularly focused on what he described as efforts by both sides to obtain a “get out of jail free” card.  He expressed significant concern that the plaintiffs would in fact have an improper “leg up” over all other Old GM claimants if they were allowed at this time to go after New GM.  At the same time, he took New GM to task for what he saw as an attempt to use the Sale Order to insulate itself against post-sale actions (or failures to act), as opposed to Old GM liabilities.  He stated that the point where the “rubber hits the road” is where there could be evidence of post-2009 “independent tortious conduct” by New GM involving a car manufactured prior to the 2009 sale.

To no one’s surprise, at the conclusion of the hearing Judge Gerber took the matter under advisement.

Wellness International Oral Argument: Supreme Court Justices Grapple With Implications of Narrowing Bankruptcy Court Powers

Posted in Bankruptcy

There were nearly a million bankruptcy cases filed by individuals and businesses in 2014.  It is safe to say that only the tiniest fraction of such debtors have any familiarity with the Supreme Court’s decision in Stern v. Marshall nearly four years ago.  (If they do, it almost assuredly is only because the case arose out of the endless litigation between Anna Nicole Smith and the son of her late husband.)  Even fewer would be aware of the constitutional issues raised in that case concerning the jurisdiction and authority of the U.S. bankruptcy courts. 

Lower courts have been struggling with those issues ever since.  Now, based on some of the questions raised in last week’s oral argument in Wellness International Network v. Sharif, it appears that at least some of the justices are realizing the full implications of Stern.  The Court’s decision in Wellness International could have significant effects for nearly everyone seeking protection under the U.S. Bankruptcy Code. 

If the narrow view of the authority of bankruptcy judges articulated in Stern prevails in Wellness International, bankruptcy judges would be unable to make final rulings on issues as integral to the bankruptcy process as determinations regarding what constitutes property of the bankruptcy estate.  If bankruptcy judges’ powers were to be so severely circumscribed, there would be little purpose served by having separate specialized bankruptcy courts.  Simply put, the Supreme Court probably must resolve in Wellness International whether a viable system of bankruptcy courts created under Article I of the Constitution can exist in the wake of Stern

To recap how the Supreme Court got itself to this point:

Under the U.S. Constitution, the “judicial power” of the United States can only be exercised by courts created under Article III.  Among other things, judges of Article III courts have lifetime tenure in order to ensure judicial independence.  Congress established the U.S. bankruptcy courts pursuant to its power to establish uniform laws on bankruptcy under Article I of the Constitution, rather than under Article III.  U.S. bankruptcy judges are appointed for 14 year terms.  A line of Supreme Court cases has limited the power of Congress to create courts pursuant to Article I, rather than under Article III, to territorial courts, military tribunals, and courts created to hear cases involving “public rights” (e.g., cases involving claims of citizens against the government).  Claims of citizens against one another under state law, such as for breach of contract or common torts, are “private rights” that must be heard by an Article III judge.  It had long been believed since the Supreme Court last invalidated the grant of jurisdiction to the bankruptcy courts in 1982 and Congress responded with the Bankruptcy Reform Act of 1984, that disputes  pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” constituted the type of “public rights” that could be heard and decided by an Article I bankruptcy judge.

The Supreme Court stunned the commercial legal community in Stern by reopening the question of the constitutionality of the U.S. bankruptcy courts.  The Court’s holding in Stern showed that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge is far narrower than previously understood.  The Court in Stern described the query for constitutional purposes as “whether the action at issue stems from the bankruptcy itself [i.e., Congress’s bankruptcy power under Article I].”  If the matter would exist under state law “without regard to any bankruptcy proceeding,” then it is a “private right” upon which an Article I bankruptcy judge cannot make a final ruling. 

The problem created by the Supreme Court’s ruling in Stern is this: the Bankruptcy Code gives the bankruptcy courts power over all property of a debtor’s estate under Section 541(a).  Determining what constitutes property of a debtor’s bankruptcy estate is indisputably fundamental to “the restructuring of debtor-creditor relations.”  But the Supreme Court has expressly stated in other cases that property rights in bankruptcy are based on state law.  State-law issues are an inseparable part of virtually every bankruptcy case.  For purposes of determining “public” and “private” rights, which aspect of such adjudications should control? 

Wellness International highlights the ramifications of Stern’s cramped view of bankruptcy court authority.  The case stems from Sharif’s personal bankruptcy case, which he filed after Wellness International obtained a substantial judgment against him.  Wellness International brought an action before the bankruptcy court, challenging Sharif’s claim that certain assets were property of a separate trust and thus excludable from his bankruptcy estate under Section 541(a) of the Bankruptcy Code.  The bankruptcy court found in favor of Wellness International, and Sharif appealed.  He claimed, among other things, that in the wake of Stern, the bankruptcy court lacked the constitutional authority to enter a final judgment, because the question of ownership of the supposed trust assets was purely an issue of state law, independent of federal bankruptcy law.  He also argued that the right to a determination of this issue by an Article III court was not a right that could be waived, not even by a debtor that had expressly sought the jurisdiction of an Article I bankruptcy court by filing a bankruptcy petition.  The Seventh Circuit agreed with Sharif on these points and reversed the bankruptcy court ruling. 

Last week’s argument showed that at least some of the justices are recognizing the practical consequences of affirming the Seventh Circuit.  Justice Breyer, who dissented in Stern, put the question directly to Sharif’s counsel:

This is simply a question of whether a bankruptcy judge can [decide] who owns [certain property], and one party says State law gives them to my cousin Mary and the other party says State law gives them right to you.  Now, if we say, no, and side with you on that one, what happens to the constitutional grant to Congress to make uniform laws on bankruptcy?  I imagine it would still exist, but I can’t imagine in what form. 

The Court has two discreet questions to address in Wellness International: the scope of what constitutes a “public right” in the context of bankruptcy that can be decided by an Article I judge, and whether the right to have a dispute determined by an Article III judge can be waived by consent.  Some of the discussion during the oral argument suggests that the Court may look to resolve this case by ruling on only the second question (i.e., finding that Sharif’s voluntary bankruptcy petition constituted consent).  However, the Court at some point soon must directly confront and resolve the problems it created by its ruling in Stern, and state once and for all whether our system of specialized bankruptcy courts under Article I can fit within the scope of the “public rights” doctrine.

Energy Future Holdings – Bidding Procedures Fight Highlights Conflicts Among Affiliated Debtors

Posted in Chapter 11

Energy Future Holdings (EFH), f/k/a TXU Corp., an energy company centered in Texas, was taken private in 2007 in the largest leveraged buyout transaction that has ever taken place.  The deal was largely predicated on an anticipated rise in natural gas prices; when prices instead plummeted the company, which had borrowed nearly $40 billion, was left with a massively unbalanced capital structure.  The chapter 11 cases of EFH and its subsidiaries commenced earlier this year have been proportionately contentious and complex.  (Kelley Drye & Warren LLP represents a creditor of certain EFH subsidiaries, but has taken no part in the matters discussed here). 

EFH conducts business through two separate holding companies.  Through its subsidiary Energy Future Intermediate Holding Company LLC (EFIH), it owns an 80% interest in Oncor, a regulated electricity transmission and distribution company.  Through its indirect subsidiary Texas Competitive Electric Holdings Company LLC (TCEH), it engages in competitive energy market activities, including electricity generation, wholesale and retail electricity sales, and commodity trading.

Allocating the enterprise value of EFH and its subsidiaries among its numerous creditor constituencies would be difficult enough under normal circumstances, given the amount of debt and the intricacies of the capital structure.  Increasing the difficulty factor of these cases even further has been the overhang of billions of dollars of potential tax liabilities due to the structuring of the leverage buyout.  Developing a reorganization plan that will not trigger such liabilities has been the among the fundamental challenges facing EFH, its secured and unsecured creditors, and its private equity sponsors. 

The attempt to thread the needle through federal tax law and the requisite IRS guidelines, however, could wind up benefitting certain EFH affiliates at the expense of others.  The EFH cases highlight certain pitfalls for fiduciaries of large business enterprises where significant potential conflicts exist among individual members of the corporate structure. 

Prior to the commencement of the chapter 11 cases, EFH entered into a restructuring support agreement (RSA), intended to be effectuated through a bankruptcy plan of reorganization, with certain EFIH secured and unsecured creditors and TCEH first lien secured creditors.  The RSA contemplated a tax-free spin-off of TCEH to its first lien creditors and a recapitalization of EFIH’s debt, but provided no recovery for second lien and unsecured creditors of TCEH. 

Unsurprisingly, the junior creditors of TCEH have sought from the beginning of the cases to protect the interests of the so-called “T side” of the EFH capital structure.  Even the first day motion seeking procedural consolidation of the numerous proceedings of EFH and its subsidiaries – a routine ministerial request in virtually all other cases – gave rise to an objection.  The junior “T side” creditors have consistently raised the argument that EFH’s professionals and the overlapping EFH, EFIH and TCEH boards of directors are conflicted, and that no independent fiduciaries are looking out for the interests of the TCEH estate.

Following the receipt of an unsolicited offer from an outside party for a controlling interest in Oncor, an offer that placed a higher value on Oncor than was contemplated under the RSA, EFH announced that it would abandon the RSA and would instead conduct an auction for Oncor.  Although this step was favored in principle by most of the parties in the cases, including the junior “T side” creditors, the bidding procedures that were to govern the sale process wound up triggering an intense courtroom battle.  In addition to opposing the proposed accelerated time frame for the sale, the junior “T side” creditors argued that the bidding procedures were intended to lock in a tax-free deal structure similar to what was contemplated under the RSA, and that it would be similarly detrimental to their recoveries.  They reiterated their contentions that the fiduciary duties owed to the TCEH estate and its creditors were being ignored by EFH, its professionals and its board members. 

Judge Christopher Sontchi held an evidentiary hearing that stretched out over four full days in late October and early November.  Both sides presented testimony as to what specific actions had been approved by which boards of directors.  EFH, EFIH and TCEH denied the conflict allegations, asserting that overlapping boards in large corporate structures are the norm, and that each of their boards had at least one independent director to protect the specific interests of each company’s bankruptcy estate.  However, the junior “T side” creditors successfully demonstrated that evidence was lacking to show that the independent directors on any of those boards had actually approved the bidding procedures.  As counsel for one of the creditor groups argued in closing, “everyone seemed to say it was approved, but no one could say who actually approved [it].” 

Judge Sontchi ultimately ruled that EFH and the other debtors could proceed with the sale process, but offered up some pointed words about what he described as “flawed and insufficient corporate governance.”  He directed each of the debtors to take steps to ensure that there would be specific votes taken for each step of the process – the approval of the bidding procedures, the selection of a stalking horse bidder and the sale itself.  He also stated that, because of the potential conflicts, these actions must be approved by the independent directors of each company

EFH is no longer seeking to put the sale process on a fast track.  Since the battle over the bidding procedures, activity in the cases has slowed.  At a court hearing late in November, EFH counsel announced that settlement conferences to which all the major creditor constituencies were invited have begun taking place.  It was also announced that in response to Judge Sontchi’s comments on the bidding procedures, separate counsel had been retained for the independent directors of each of EFH, EFIH, and TCEH.

Despite Earlier Ruling, Stockton Judge Confirms Plan Leaving Pension Obligations Intact

Posted in Chapter 9

One month ago, Judge Christopher Klein ruled in the city of Stockton, CA bankruptcy case that public employee pension obligations can be impaired in municipal bankruptcy cases under Chapter 9 of the Bankruptcy Code.  Last week, however, Judge Klein approved the plan of adjustment for Stockton that left public pension obligations intact over the vociferous objection of Franklin Investments, a major city bondholder whose claim was substantially reduced.  The confirmation of the Stockton plan underscores that even as there now appears to be a sound legal foundation for distressed municipalities to utilize Chapter 9 to reduce public pension claims, achieving such a result will remain an arduous process

 Judge Klein ruled that sufficient differences exist between public pension obligations and the debt evidenced by the city’s bonds to justify the disparate treatment.  He found that the city had proposed the plan in good faith, that it was feasible, and overall in the best interests of the city’s creditors, and accepted the city’s judgment that maintaining the pension obligations was necessary in order not to lose key employees.  He also noted that city employees were being affected in other ways, as the plan eliminated retiree medical benefits and certain cost of living adjustments.  Painfully aware that a contrary decision could put the parties back to “square one” and  lead to months if not years of additional litigation at a cost of millions of dollars, Judge Klein reluctantly concluded that the plan “is the best that can be done in terms of the restructuring and adjustments of the debts of the city of Stockton.”   

 The impact of Judge Klein’s earlier ruling nevertheless should not be disregarded.  Up until now, many practitioners and legal scholars believed that state law preferential treatment for public pension obligations would be insulated in Chapter 9 bankruptcy cases.  The key question has been whether state laws protecting public employee pension obligations are protected under the Tenth Amendment, which reserves to a state rights not granted to the federal government under the Constitution, or are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy.   

 Judge Klein unequivocally found that Congress’s Article I power controls here.  While there was a similar decision one year ago by Judge Stephen Rhodes in the Detroit bankruptcy case, that ruling was more limited, as it relied on a detailed parsing of Michigan statutes and the Michigan state constitution.  Judge Klein took a broader view, stating that  because the State of California had expressly authorized municipalities to seek protection under Chapter 9, it “open[ed] the gate” and was approving a process that it knew would be governed by federal law.   “Once the city passes through the gate, it’s what’s specified in the United States Bankruptcy Code.  Otherwise, you come to the conclusion that the California Legislature can edit . . . federal law.”

 Judge Klein’s decision will significantly affect negotiations between distressed municipalities and advocates for public employee pension rights.  Until now, for municipalities that wished to impair their pension obligations, there was nothing but uncertainty as to whether a Chapter 9 bankruptcy proceeding could succeed.  That uncertainty has now been effectively eliminated.  At the same time, the takeaway from the final outcomes of both the Stockton and Detroit cases is that if public employee pensions are to be impaired, it will require a lengthy, expensive and determined effort.

Stockton Judge: Pension Obligations Are Not Impervious to Impairment In Chapter 9 Bankruptcy. What Comes Next?

Posted in Chapter 9

The perception that public employee pension obligations cannot be impaired in bankruptcy suffered a damaging blow several months ago in the City of Detroit bankruptcy case, and has now been fatally wounded by the recent ruling of Judge Christopher Klein in the Chapter 9 case of Stockton, California.  Although Judge Klein’s decision is not likely to lead to a spate of municipal bankruptcy filings in an effort to escape burdensome pension liabilities (indeed, it may not even lead to the actual diminishment of pension claims in the Stockton case itself), this is an important decision.  Unless reversed on appeal, it will alter the legal landscape for distressed municipalities.  Together with the similar Detroit decision, the Stockton ruling will affect negotiations among municipalities, employee unions, pension system representatives and financial creditors across the country. 

Issues regarding the appropriate legal treatment of public employee pension obligations, and the Tenth Amendment implications in connection therewith, have been a crucial overhang for distressed municipalities and in Chapter 9 municipal bankruptcy cases for several years.  The Tenth Amendment reserves to a state rights not granted to the federal government under the Constitution.  The key question has been whether state laws protecting public employee pension obligations are protected under the Tenth Amendment, or are pre-empted and superseded by Congress’s Article I, Section 8 authority to establish uniform laws regarding bankruptcy. 

In Stockton, the city proposed a plan that recognizes California’s pension protections and that does not seek to impair those obligations, while at the same time substantially reducing the claim of Franklin Investments, a major city bondholder.  Under the U.S. Bankruptcy Code, plans of adjustment for municipal debtors, similar to plans of reorganization for corporate debtors, prohibit “unfair” discrimination among classes of similarly situated creditors.  The City of Stockton and the California public employee pension system (“Calpers”) contend that the disparity between Franklin’s claims and Calpers’ claims is permissible, because the preference under California law for public employee pension obligations is protected under the Tenth Amendment.  Franklin has objected to the plan, claiming that the disparate treatment is impermissible, because California law regarding public employee pension obligations is pre-empted by the Supremacy Clause of the Constitution

Judge Klein agreed with Franklin: on this issue, the Supremacy Clause overrides state law.  There is no abrogation of the Tenth Amendment because the State of California has expressly authorized municipalities to seek protection under Chapter 9.  In Judge Klein’s view, when the California legislature enacted the authorization law, it “open[ed] the gate” and was approving a process that it knew would be governed by federal law. “Once the city passes through the gate, it’s what’s specified in the United States Bankruptcy Code.  Otherwise, you come to the conclusion that the California Legislature can edit . . . federal law.”

This decision may actually have more impact outside of the Stockton case than within it.  Judge Klein ruled that public employee pension obligations can be impaired, but he did not make a ruling on the Stockton plan and the proposed disparate treatment.  Stockton has proffered several other justifications for the different treatment between pension claims and Franklin’s claims, and one or more of those may be sufficient for Judge Klein to approve the plan.  The parties may also find a way to reach a settlement, which could moot Judge Klein’s ruling. 

Regardless of what happens in Stockton, however, the decision will reverberate in distressed municipalities throughout the country.  Because Chapter 9 is such an onerous and expensive process, it is unlikely that there will be a rush of municipalities into the bankruptcy courts.  But the Stockton decision will tilt the playing field.  It will provide leverage to parties that wish to impair pension obligations, which will significantly affect negotiations on these matters.  Until now, for municipalities that wished to impair their pension obligations, there was nothing but uncertainty as to whether a Chapter 9 bankruptcy proceeding could succeed.  That uncertainty has now been substantially reduced.

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