Bankruptcy Law Insights

Bankruptcy Law Insights

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

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.

No Easy Road – GM Ignition Switch Litigation Raises Difficult Bankruptcy-Related Questions

Posted in Distressed M&A

General Motors LLC (“New GM”) came into being in the summer of 2009, when it acquired substantially all of the assets of General Motors Corporation (“Old GM”) in a sale undertaken pursuant to section 363 of the Bankruptcy Code.  The July 2009 Sale Order approved by U.S. Bankruptcy Judge Robert Gerber transferred the assets to New GM “free and clear” of claims against Old GM (other than a narrow range of expressly assumed liabilities), and contained an express injunction to prevent Old GM creditors from proceeding against New GM.  (Kelley Drye & Warren LLP represents certain major creditors of Old GM.)

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 is seeking to structure a non-judicial compensation arrangement to address such claims arising from ignition switch defects.)

New GM’s efforts in the Old GM bankruptcy case to enjoin the ignition switch litigation raise numerous difficult issues regarding the Sale Order, and the extent to which purchasers of assets in bankruptcy cases may fully insulate themselves from claims against a seller that arise at a future date.  New GM contends that it is fully protected by the Sale Order from all ignition switch liabilities of Old GM, and that “free and clear” asset sales are an essential component of the Bankruptcy Code.  The plaintiff vehicle owners argue that to enforce the Sale Order against them when they could not have been aware in 2009 of the potential ignition switch defects would violate essential precepts of due process

The Supreme Court has long held that due process in bankruptcy cases requires such notice that is “reasonably calculated, under all of the circumstances, to apprise interested parties” that their rights are being affected and provide them with a reasonable opportunity to appear and be heard.  Proper notice to creditors and potential creditors whose claims are being discharged and whose rights are being affected is essentially the life blood of a bankruptcy proceeding; however, in large cases such as Old GM’s, giving direct notice to every potential creditor is simply not possible. The crucial questions here primarily go to what was known about the ignition switch defects, and by whom, within Old GM at the time of the 2009 bankruptcy and, given such knowledge, was the publication notice provided at the time by Old GM reasonable in view of all circumstances.          

The vehicle owner plaintiffs further argue that Old GM’s failure in 2009 to disclose the existence of potential claims arising from ignition switch defects constituted a fraud on the Bankruptcy Court.  New GM has responded that if any such claims do exist, they must be asserted against Old GM.  The creditor trust that is the successor-in-interest to Old GM asserts that Old GM’s plan of liquidation was confirmed and substantially consummated back in 2011, and that even if claims against Old GM can now be asserted, such claims should be denied on the grounds of equitable mootness (i.e., most of the value provided to creditors under the Old GM plan was long ago distributed).    

Since the filing of New GM’s motion earlier this year, Judge Gerber and lawyers for New GM, the Old GM creditor trust and the vehicle owner plaintiffs have focused intensively on the development of a process that would both identify the “threshold” issues that must be addressed before taking any further steps towards addressing the merits of the claims, and permit an expeditious adjudication of such issues.  So far, the parties have agreed that the following “threshold” issues can be resolved with minimal discovery or based on stipulated facts: (i) whether the plaintiffs’ due process rights were violated by the entry of the Sale Order in July 2009, (ii) if so, what remedies could be fashioned, (iii) should the remedies be asserted against New GM or Old GM (effectively, the creditor trust), and (iv) if against Old GM, the applicability of the doctrine of equitable mootness and related arguments.  In addition, the parties have agreed to brief and set forth their respective views as to the legal standards that would need to be met in order to prove that a “fraud on the court” occurred based on the failure by Old GM in 2009 to disclose information regarding the ignition switch defects.

Judge Gerber last week approved a proposed briefing schedule regarding the “threshold” issues.  It is likely that he will rule early in 2015.

Still Trying to Close the Stern v. Marshall Can of Worms – The Supreme Court To Grapple Again With Thorny Questions of Bankruptcy Court Jurisdiction

Posted in Bankruptcy

Three years ago, in Stern v. Marshall, a case that arose out of the endless litigation between Anna Nicole Smith and the son of her late husband, the Supreme Court stunned the commercial legal community by reopening what many had believed were long-settled questions regarding the constitutionality of the United States bankruptcy courts.  Although the Court’s opinion in Stern purported to be limited, its analysis made clear that the jurisdictional underpinnings of the entire bankruptcy court system rested on shaky ground.  Since then, practitioners and lower courts have struggled to deal with the ramifications of that decision.   

In essence, courts created by Congress pursuant to its powers under Article I of the Constitution (which includes the power to establish uniform laws on bankruptcy), rather than under Article III, are limited 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, however, 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.

Stern v. Marshall upended this understanding of bankruptcy court authority and made clear that the scope of what constitutes a “public right” susceptible to final determination by an Article I judge was 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 Court granted certiorari last year in the bankruptcy case of Executive Benefits Insurance Agency v. Arkison.  The Ninth Circuit held in Executive Benefits that the entitlement to have a “private right” dispute heard by an Article III judge was an individual right that could be waived.  Many observers believed, based on Stern, that the Supreme Court in Executive Benefits would either strike down or substantially limit the power of U.S. bankruptcy court judges to render final determinations in matters before them.  Relief was therefore palpable in the bankruptcy bar after a unanimous Court instead issued a narrow decision that substantially ignored the constitutional questions stemming from Stern.

The Court, however, only postponed the inevitable need to articulate the full scope of Stern.  Because Executive Benefits did nothing to clarify the two crucial issues raised by Stern – the extent of what constitutes a “public right” in the context of a bankruptcy proceeding, and whether the right to have a matter heard by an Article III judge is an individual right that can be waived – the Court ensured that uncertainty would continue to hover over the jurisdiction of bankruptcy courts.  Likely recognizing this, only a few weeks after its ruling in Executive Benefits, the Court has given itself another chance to consider those questions, granting certiorari in Wellness International Network v. Sharif

Wellness International 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 the 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 v. Marshall, 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 expressly sought the jurisdiction of an Article I bankruptcy court by filing a bankruptcy petition.  The Seventh Circuit ruled for Sharif on these points. 

Wellness International highlights the inherent conundrum posed by Stern with respect to bankruptcy court jurisdiction.  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? 

The Supreme Court’s answer will determine whether the current structure of the bankruptcy courts remains viable.

No More Ugly American: Judge Refuses to Allow Madoff Trustee to Pursue Foreign Indirect Investors

Posted in Bankruptcy

Judge Jed S. Rakoff of the Southern District of New York last week ruled that the U.S. Bankruptcy Code does not permit a bankruptcy trustee to recover foreign transfers.  Specifically, Judge Rakoff refused to allow Irving Picard, the trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”), to recoup monies initially transferred from BLMIS to non-U.S. investment firms that were direct investors in BLMIS, and then subsequently transferred to such firms’ non-U.S. customers.  Picard argued that Section 550(a)(2) of the Bankruptcy Code empowers a bankruptcy trustee to recover fraudulently transferred funds from subsequent transferees of the initial recipient.  Judge Rakoff declined, however, to give that provision extraterritorial application, and denied recovery against the non-U.S. indirect BLMIS investors.  (Kelley Drye & Warren LLP represents certain alleged subsequent transferees.) 

To date, Picard has recovered over $9.8 billion through litigation and settlements and distributed over $5.3 billion to former Madoff customers.  Among other things, for over five years Picard has been diligently pursuing claims against so-called “net winners,” i.e., BLMIS investors who withdrew from BLMIS amounts in excess of their invested capital.  These investors include investment firms located outside of the United States that acted as “feeder funds” for BLMIS; they solicited capital from non-U.S. customers and invested it with BLMIS.  Nearly all of the withdrawals made by these firms from BLMIS prior to its downfall were in turn transferred back to their customers.  Picard obtained judgments avoiding the initial transfers from BLMIS to the investment firms as fraudulent transfers, and then sought under Section 550(a)(2) to recover the subsequent transfers from the non-U.S. defendants.       

A recent Supreme Court decision, Morrison v. National Australia Bank Ltd., held that U.S. statutes are presumed “to apply only within the territorial jurisdiction of the United States,” unless Congress clearly intended otherwise.  Judge Rakoff broke the Morrison ruling into two parts.  He first considered whether the utilization of Section 550(a)(2) to recover the transferred BLMIS funds would in fact constitute an “extraterritorial” application of that section.  Picard argued that because the intent of the fraudulent conveyance provisions of the Bankruptcy Code and Section 550 is to allow bankruptcy trustees to recover the property of debtors that are situated within the United States, the application of Section 550(a)(2) is inherently within U.S. territorial jurisdiction.  Judge Rakoff disagreed, stating that Section 550(a)(2) focuses on the actual transfer of property from the entity that initially received an improper transfer from the debtor to an alleged subsequent transferee, and not on “the relationship of that property to [the] debtor.”  He determined that because the actual transfers from the investment firms to their customers took place outside of the U.S., Picard required Section 550(a)(2) to apply extraterritorially in order to prevail. 

Judge Rakoff then examined whether Congress had intended for Section 550(a)(2) to apply outside of U.S. territory.  Section 541(a) of the Bankruptcy Code, for example, contains clear evidence of such intent.  It expressly states that the “bankruptcy estate” created upon the commencement of a case consists of property interests of the debtor “wherever located and by whomever held.”  In contrast, Section 550 contains no such language of congressional intent.  Picard argued that express language in Section 550 was not necessary.  He contended that the reference in Section 550 to “property” transferred sufficed to apply the extraterritorial intent expressly stated in Section 541 to Section 550(a)(2) as well. 

Judge Rakoff rejected that argument.  He held that under the precise language of Section 541, “fraudulently transferred property becomes property of [the bankruptcy] estate only after it has been recovered by the Trustee.”  Picard could not rely on Section 541 with respect to property not yet recovered for evidence of congressional intent to apply Section 550(a)(2) beyond the ambit of U.S. territory. 

Judge Rakoff held that, because section 550(a) does not apply extraterritorially and Picard’s use of that section to recover foreign transfers “would be precluded by concerns of international comity,” Picard has the burden to allege specific facts showing domestic transfers.  He ruled that because both the transferors and the transferees reside outside of the United States, Picard could not plausibly do so. 

In essence, the decision means that Picard has to wait alongside other creditors in the foreign liquidation proceedings of the “feeder fund” firms; he cannot use the U.S. Bankruptcy Code to bypass those proceedings.  Judge Rakoff observed that permitting Picard to go against non-U.S. customers of the feeder funds would improperly interfere with those liquidation proceedings.  He stated that even if Section 550(a)(2) were to apply extraterritorially, such application should be precluded under principles of international comity. 

Judge Rakoff further noted that Picard had argued strenuously in previous actions that the non-U.S. customers, having had no direct relationship with BLMIS, could not assert claims against BLMIS and share in recoveries with direct BLMIS customers.  He therefore rejected Picard’s argument that the non-U.S. customers would be receiving improper preferential treatment by virtue of being shielded from his efforts to recover fraudulent transfers.

Judge Rakoff also turned aside Picard’s concerns that a failure to apply Section 550(a)(2) extraterritorially would create a loophole that will enable fraudulent U.S. debtors to hide their assets offshore through a series of multiple transfers.  The presumption against extraterritorial application of U.S. statutes, Judge Rakoff stated, needs to take precedence in order “to protect against unintended clashes between our law and those of other nations.”  Judge Rakoff noted that if any such intentional fraud were to occur, it could properly be addressed through the utilization of applicable foreign laws. 

This decision puts substantial limitations of the extraterritorial reach of the Bankruptcy Code.  In particular, it will limit the effect of the clear congressional intent to apply Section 541 to property “wherever located and by whomever held.”  But if the ruling stands on appeal, it should provide substantial comfort to investors outside of the United States that invest indirectly with U.S. firms or companies.  If those investments ultimately fail, non-U.S. indirect investors will not find themselves subject to the threat of recovery actions in U.S. bankruptcy cases.

Supreme Court Decides Not to Destroy the Current Bankruptcy Court System

Posted in Bankruptcy

The U.S. Supreme Court yesterday, in Executive Benefits Insurance Agency v. Arkinson, limited somewhat the ramifications of its landmark opinion two years ago in Stern v. Marshall.  The Court in Executive Benefits could have thrown the entire federal bankruptcy court system into disarray by advancing Stern’s hard line view on the limited powers of Article I bankruptcy judges.  Instead, it issued a simple and pragmatic decision that will have only minimal impact.  However, by not addressing certain key questions, the Court ensured that uncertainty will continue to hover over issues pertaining to bankruptcy court jurisdiction.    

In Stern, the Supreme Court surprised many observers by re-opening separation of powers issues that most bankruptcy practitioners thought had been long settled.  Although the Court’s opinion in Stern purported to be limited, its analysis in that case made clear that the jurisdictional construct of the Bankruptcy Act of 1984 was constitutionally suspect.  Some observers believed that the Court might use Executive Benefits to issue a decision similar in scope to its sweeping 1982 ruling in Northern Pipeline Construction v. Marathon Pipe Line, which struck down on separation of powers grounds the original grant of jurisdictional authority to bankruptcy courts.  However, in Executive Benefits, the Court, in a unanimous opinion handed down by Justice Thomas, seemed intent on keeping the effect of Stern as narrow as possible.   

The current structure of the federal bankruptcy courts dates back to the last complete overhaul of federal bankruptcy law in 1978.  At that time, Congress created the bankruptcy courts pursuant to its authority under Article I of the Constitution to establish uniform laws on bankruptcy.  But in Northern Pipeline Construction, the Court held that the exercise of federal judicial power could only be undertaken by judges appointed under Article III of the Constitution, noting that the exceptions to that rule were territorial courts, military tribunals, and cases involving “public” rights.  Northern Pipeline involved a common law breach of contract dispute commenced by a company that happened to be in bankruptcy.  Although it struck down the ability of a non-Article III bankruptcy court judge to make a final determination in an action that clearly pertained to a “private” state common law right, the Court strongly suggested that the system of Article I bankruptcy courts was itself permissible, stating that “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power,” in likelihood constituted the type of “public” rights which could be heard and decided by an Article I judge.

The question of what constitutes a “public” right has never been clear. Some earlier cases had suggested that the scope of a “public” right was fairly narrow, involving only rights between individuals and the government.  Other cases suggested broader parameters.  Although the Court in Northern Pipeline did not expressly state that “the restructuring of debtor-creditor relations” under federal bankruptcy law actually constituted a “public” right, Congress accepted the Court’s evident suggestion and in 1984 granted new jurisdictional authority to the United States Bankruptcy Courts.  Under Section 157(b) of the Bankruptcy Act of 1984, bankruptcy court judges became authorized to render final decisions in “core” matters under the Bankruptcy Code.  Section 157(c) directed bankruptcy court judges to hear and submit findings of fact and conclusions of law to Article III district court judges with respect to “non-core” matters.

Even though the Court never ruled on the constitutionality of the “core” and “non-core” bankruptcy jurisdictional construct, in other cases involving Article I tribunals the Court took an expansive view of the “public” rights doctrine, one that certainly appeared to be broad enough to encompass the list of “core” matters enumerated in the Bankruptcy Act of 1984.  The separation of powers issues raised by Northern Pipeline appeared to have been laid to rest.  Therefore, the Court’s ruling in Stern, that a matter could be a “core” matter under Section 157(b) but also not be a “public” right and thus not subject to final adjudication by an Article I bankruptcy court judge, was completely unexpected.  Executive Benefits raised the possibility that the Court would go further by striking down the constitutionality of the “core” and “non-core” construct, and by strictly circumscribing the power of Article I bankruptcy judges. 

The dispute in Executive Benefits involved a fraudulent transfer lawsuit.  Although such an action is listed as a “core” matter under the Bankruptcy Act of 1984, the Ninth Circuit determined (and the Court assumed for purposes of the opinion) that it does not fit within the parameters of a “public” right under Stern and could not be adjudicated by a non-Article III judge.  However, the Ninth Circuit also held that the bankruptcy court could prepare recommendations for review by the district court even though Section 157(b) of the Bankruptcy Act of 1984 does not explicitly authorize bankruptcy judges to submit proposed findings and conclusions in a “core” proceeding (as Section 157(c) does for “non-core” proceedings).  It also held that the right to have a matter heard by an Article III judge was an individual right that could be waived, and that the defendant had implicitly consented to bankruptcy court jurisdiction.

Justice Thomas in Executive Benefits noted the “gap” created by what he referred to as “Stern” claims, i.e., matters listed as “core” under Section 157(b) but outside the scope of “public” rights.  He also noted that, with respect to such Stern claims, the statute did not provide any direct authority for bankruptcy court judges to issue findings of fact and conclusions of law for review by an Article III district court judge.  He had little difficulty, however, in finding that a severability provision in the statute (i.e., a provision that ensures the viability of the statute even if a portion of it is invalidated) “closes the so-called ‘gap’ created by Stern claims.”  In other words, the Court avoided what could have been a huge logistical mess by stating that bankruptcy courts should simply deal with Stern claims under Section 157(c) as they would with “non-core” claims. 

Moreover, because the dispute in Executive Benefits was subsequently reviewed by an Article III district court judge, the Court ruled that there was no need to address the separate constitutional question of whether the right to have a matter heard by an Article III judge was an individual right that could be waived.        

Even a narrow ruling for the petitioner in Executive Benefits – that bankruptcy courts lack statutory authority to issue findings of fact and conclusions of law for review by an Article III district court judge with respect to “core” matters that fall beyond the scope of “public” rights that Article I judges may permissibly determine – could have wreaked havoc on the bankruptcy courts and placed huge burdens on district court judges.  Such a ruling also would have raised questions about the wide-spread use of federal magistrates (who are also Article I judges) to hear and determine a wide array of criminal and civil matters.  The result of Executive Benefits suggests strongly that the Court weighed the substantial disruptions which would result from extending Stern, and used Executive Benefits to walk it a few steps back. 

The Court obviously left key questions unanswered.  It did not address the scope of what constitute “public” rights, the extent to which they dovetail with the list of “core” matters set forth in Section 157(b) of the Bankruptcy Act of 1984, and whether the right to have a matter heard by an Article III judge is an individual right that can be waived.  The Court’s ruling in Stern makes it inevitable that, at some point, each of these issues will need to be directly confronted.    

None Too Appealing – District Court Turns Aside Free Lance-Star Publishing Credit Bid Lender

Posted in Distressed M&A

A recent ruling in the Chapter 11 case of Free Lance-Star Publishing limited the credit bidding rights of a secured creditor.  The ruling has called into question the ability of the holder of secured debt to utilize such debt to acquire companies on a going concern basis in bankruptcy cases, particularly in instances where the debt was acquired at a discount for such express purpose.  Because this has been a common strategy of numerous hedge funds and investment vehicles that have found no shortage of willing sellers among commercial banks and other traditional lenders holding large portfolios of troubled loans, the Free Lance-Star Publishing decision and an earlier substantially similar ruling in the Chapter 11 case of Fisker Automotive have justifiably received wide attention.

Less attention has been given to efforts by the secured lenders in those cases to appeal the decisions of the bankruptcy courts.  DSP Acquisition, the holder of the secured debt in Free Lance-Star Publishing, sought to appeal to the U.S. District Court for the Eastern District of Virginia.  In a decision handed down on May 7, 2014, the District Court held that DSP could not appeal as a matter of right, and denied DSP’s request to appeal on an interlocutory basis.  Perhaps not surprisingly, just as U.S. Bankruptcy Court Judge Kevin Huennekens had looked to Fisker Automotive in determining to limit DSP’s ability to credit bid, U.S. District Court Judge Henry Hudson relied heavily on the decision denying the appeal in Fisker Automotive issued by Judge Gregory Sleet of the District of Delaware. 

These decisions make clear that the ruling of a bankruptcy court judge with respect to a secured creditor’s right to credit bid will effectively be dispositive.  District court judges that follow Judge Sleet’s and Judge Hudson’s rulings will not intervene to enjoin an auction process.  Any vindication of a right to credit bid will therefore not occur until long after the auction has taken place and the assets have been sold.

Judge Hudson first examined whether DSP could appeal as a matter of right, either because it would suffer “irreparable harm” if the auction occurred and it was not permitted to credit bid, or because the decision to limit DSP’s credit bid constituted a “final order.”  He ruled that irreparable harm did not exist because the bankruptcy court was making no determination as to how the proceeds from the auction would be allocated.  Similarly, the decision was not “final” because, citing Judge Sleet’s ruling in Fisker Automotive, he held that DSP would still have an effective remedy “because the secured lender ‘could then either receive a cash return of the difference between the full credit entitled, or if a third-party bidder won the auction, [the secured lender] could receive its entitlement out of the cash paid by this party.’” 

Having found that DSP could not appeal Judge Huennekens’ order as a matter of right, Judge Hudson denied leave for DSP to appeal on an interlocutory basis.  He stated that interlocutory appeals should only be permitted where there is a “narrow question of pure law whose resolution will be completely dispositive of the litigation.”  Although there was a legal question of whether “cause” existed to limit credit bidding under Section 363(k) of the Bankruptcy Code in order to avoid chilling the bidding process and to “restore enthusiasm” for the sale, Judge Hudson noted that Judge Huennekens had also ruled on the extent and validity of certain of DSP’s liens.  Again citing Judge Sleet’s Fisker Automotive decision, Judge Hudson determined that “there is no reason why the auction . . . cannot proceed with [the secured lender] bidding alongside other parties and [the secured lender] receiving a cash adjustment should the Bankruptcy Court ultimately decide that [the secured lender’s] credit bid should not have been capped.” 

One potential flaw in Judge Sleet’s and Judge Hudson’s reasoning is that credit bidding’s essential purpose is to protect a secured creditor from being forced to accept a cash payment that is below that value the secured creditor believes the collateral possesses.  If the auction takes place and another bidder wins, and the secured creditor’s right to credit bid is only vindicated afterwards, then “a cash adjustment” if the purchase price is below the face value of the secured debt could be an empty remedy.  Accordingly, decisions by bankruptcy judges as to whether to limit credit bidding rights “for cause” under Section 363(k) in order to foster competitive auctions will resonate all the more sharply.

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