Bankruptcy Law Insights

Bankruptcy Law Insights

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

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.

Loan to Moan? Judge Limits Right to Credit Bid in Chapter 11 Case of Free Lance-Star Publishing Co.

Posted in Distressed M&A

A few months ago, a ruling in the Chapter 11 case of Fisker Automotive narrowed a secured creditor’s right to credit bid its debt in connection with a sale of the debtor’s assets.  The decision surprised many observers and resurrected uncertainty about a debtor’s ability to limit a secured lender’s credit bidding rights (a dispute that appeared to have been firmly resolved in favor of secured creditors only two years ago by the Supreme Court’s decision in RadLax Gateway Hotel).  Fisker Automotive put the issue of credit bidding back on the table, particularly in so-called “loan to own” situations where secured debt is purchased at a substantial discount for the purpose of effecting the acquisition of a distressed borrower.  An opinion issued last week in the Chapter 11 case of Free Lance-Star Publishing Co. is certain to further the uncertainty.  

Section 363(k) of the Bankruptcy Code provides that secured creditors may credit bid the full amount of their debt when their collateral is sold, “unless the court for cause orders otherwise . . . .”  Credit bidding in bankruptcy protects the expectations of secured creditors under non-bankruptcy law to be able to look to their collateral in the event of a default.  The Bankruptcy Code does not define what constitutes “cause”, but it has generally been viewed as being narrow in scope, such as a creditor’s bad faith or misconduct.  A controversy arose a few years ago when the U.S. Court of Appeals for the Third Circuit unexpectedly limited a secured creditor’s right to credit bid in the absence of “cause” in the Philadelphia Newspapers case.  That decision was effectively overruled by the Supreme Court’s ruling in RadLax

The new dispute over credit bidding arising from Fisker Automotive and Free Lance-Star Publishing Co. turns on how broadly courts can define the meaning of “for cause” under Section 363(k).  Specifically, can “cause” be based solely on the goal of fostering a competitive auction process?  Moreover, could the credit bidding rights of purchasers of debt for less than face value be different from those of original lenders?  

In Fisker Automotive, Judge Kevin Gross granted a motion to cap the right to credit bid “for cause” of Hybrid Tech Holdings, a secured creditor that purchased a $165 million loan at a substantial discount.  There was a genuine dispute as to the extent of Hybrid’s security interests on Fisker’s assets (at least a portion of the assets that were to be sold did not appear to be encumbered by Hybrid’s liens, and therefore could not be the subject of a credit bid), and  Judge Gross also excoriated Hybrid’s actions during the case, thus inferring inequitable conduct.  A ruling that “cause” existed to limit credit bidding for these reasons would not have been particularly remarkable. 

However, the decision also suggested a much broader reading of the term “for cause”.  Judge Gross ruled that Hybrid’s right to credit bid could be limited to $25 million (the amount it paid to acquire the loan) on the basis that it would improve the ability of other bidders to compete at an auction.  He wrote, “bidding will not only be chilled without the cap; bidding will be frozen.”  This last statement raised numerous eyebrows, suggesting as it did that credit bidding could be limited even in the absence of any malfeasance by the holder of the debt. 

The first shoe following Fisker Automotive has now dropped.  The facts of Free Lance-Star Publishing Co. are in many ways similar to Fisker Automotive.  A secured creditor, DSP, acquired the secured debt of Free Lance-Star Publishing at a discount, intending to use the full face amount of $38 million to credit bid for the debtor’s assets.  The debtor and the creditors’ committee objected to the credit bid, contending that the lender from which DSP acquired its secured debt did not hold valid and perfected liens over certain of the debtor’s key assets, including FCC licenses and the real property on which the debtor’s radio transmission towers sit, and alleging various forms of “inequitable conduct” on the part of DSP.  Unsurprisingly, the debtor and the creditors’ committee also cited Judge Gross’s statement in Fisker Automotive, arguing that “cause” existed to limit DSP’s right to credit bid in order to avoid chilling the bidding process and to “restore enthusiasm” for the sale. 

Judge Kevin Huennekens held that DSP’s credit bid will be limited to $13.9 million.  His opinion noted the three separate arguments advanced by the debtors and the creditors’ committee against permitting DSP to credit bid its full debt.  He determined that DSP’s liens did not extend to the transmission towers or to the proceeds from the sale of FCC licenses, and also found inequitable conduct on the part of DSP, stating that he was “troubled by DSP’s efforts to frustrate the competitive bidding process.”  As in Fisker Automotive, a ruling to limit credit bidding based on these findings alone would have been narrow and un-noteworthy.  But, just as Judge Gross did in Fisker Automotive, Judge Huennekens went further, and also found that “it is necessary to limit DSP from bidding the full amount of its claim against all of the Debtors’ assets in order to foster a fair and robust sale.” 

This last statement of Judge Huennekens (if the decision stands on appeal), will be the focus of attention.  In Free Lance-Star Publishing Co., as in Fisker Automotive, credit bidding could have been limited based solely on the basis of the asserted inequitable conduct.  Credit bidding can nearly always be said to “chill” competing offers.  In one sense, that is its very purpose – 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.  Given the extent to which Chapter 11 is used these days to effect sales of distressed businesses under Section 363 rather than reorganizations, and the common “loan to own” practice of purchasing secured debt at a discount for purposes of credit bidding, Judge Huennekens’ language is going to be cited in many objections to Section 363 sales.  

Of course, the full impact of Fisker Automotive and Free Lance-Star Publishing Co. remains to be seen.  The key question now is whether other courts will limit credit bidding rights “for cause” in the absence of any inequitable conduct, but instead solely on the basis that it is necessary to “restore enthusiasm” among other potential bidders so as to improve the chances of a competitive auction.  If a “loan to own” secured creditor acquired the debt and exercised its rights in good faith, will a court still limit its ability to credit bid?  

If so, then these cases will have a broad effect on both Chapter 11 and commercial law practice, and could significantly alter the secondary trading market for distressed debt.  Another credit bidding case is likely to make its way to the Supreme Court.

Sbarro and Quiznos Serve Up Prepackaged “Cramdown” Plans

Posted in Uncategorized

The chapter 11 filings this month of Sbarro and Quiznos share many similarities.  Both companies are looking to survive in a difficult sector of a tough industry.  Both were forced to seek bankruptcy despite recent successful efforts to reduce debt – an out-of-court restructuring for Quiznos and a 2011 chapter 11 case for Sbarro.  In addition, both cases also continued a strong trend of corporate bankruptcies that look to minimize the duration of the case.  

Each proceeding is a true “prepackaged” case – a phrase that is often used to describe any number of negotiated arrangements between a debtor and its major creditors, but that is in fact a term of art that properly refers to cases where the requisite votes for approval of the plan of reorganization are solicited and obtained prior to the filing of the bankruptcy petition.  The approach works well for effecting balance sheet restructurings, such as where the debtor and its lenders agree to swap out existing debt in exchange for equity in the reorganized enterprise.

Because the entire purpose of a “prepackaged” plan is to allow the debtor to spend as little time in bankruptcy as possible, the debtor and the supporting lenders usually attempt to avoid delays and objections.  Such plans therefore will often provide for payment in full to general unsecured creditors.  By treating such creditors as “unimpaired” under the plan, their acceptance of the plan can be assumed, the time and expense of soliciting their votes can be forgone, and objections to the plan are minimized. 

Sbarro and Quiznos, however, are both deviating from this approach.  The plans in both cases are “cramdown” plans.  Quiznos’s plan provides a minimal recovery, and Sbarro’s provides nothing, for general unsecured creditors.  The time and expense of solicitation can still be forgone, because the assumption here is that such creditors are rejecting the plan.  Sbarro and Quiznos intend to ask the bankruptcy judges in their respective cases to approve their plans notwithstanding the presumed rejections (i.e., “cram down” the plan).  Both companies will contend that recent severe declines in revenues have reduced the value of their respective enterprises by so much that senior creditors are receiving far less than what they are owed, and no value can flow down to general unsecured creditors.

Unsecured creditors in both cases, unsurprisingly, can be expected to object vehemently.  Opponents of the Sbarro and Quiznos plans will use all arguments at their disposal to derail confirmation of the plans.  The valuation assumptions will be challenged, as will Sbarro’s and Quiznos’s assertions that they have satisfied the numerous requirements for plan confirmation under Section 1129 of the Bankruptcy Code.            

Plan confirmation can be difficult and time-consuming even where consensus exists among creditor constituencies.  Therefore, in recent years most chapter 11 cases of so-called “melting ice cube” companies such as Sbarro and Quiznos have involved quick sales under Section 363 of the Bankruptcy Code in order to preserve a debtor’s going concern value.  For the lenders who wind up taking control of these business enterprises, however, there can be numerous advantages obtained from confirming a plan of reorganization (for example, valuable tax attributes can often be preserved).  In seeking quick confirmation of a non-consensual plan, lenders are effectively making a bet that Sbarro and Quiznos are at this point in such poor shape that there will be no way for unsecured creditors to argue successfully for a share of enterprise value, and that there will be no other valid arguments against plan confirmation that can be asserted.

Detroit’s Proposed Plan of Adjustment – Two Crucial Questions

Posted in Chapter 9

The chapter 9 bankruptcy case of the City of Detroit has been as complex and litigious as anticipated.  Nevertheless, Emergency Manager Kevyn Orr has kept plodding forward, and last week filed a proposed plan of adjustment, the road map for the Motor City to emerge from bankruptcy.  There are two key components to the plan.  The first is that it will seek to inflict somewhat less pain on retired employees than on bondholders.  The second is that it will direct approximately $1.5 billion towards Detroit’s future rather than to the payment of creditors.    

 While the plan raises numerous issues on top of the thorny disputes with which Detroit and its creditors are already grappling, these components of the plan raise two fundamental questions that go to the heart of what municipal bankruptcy may be able to accomplish: how much disparate treatment of different creditor classes can be tolerated, and to what extent can the city invest in its own future, rather than pay back creditors?  The plan will be the subject of intense negotiations over the next few months, and is almost certain to be revised substantially.  However, if Mr. Orr cannot reach deals with the City’s retirees and bondholders, these questions will be at the forefront of the issues that Judge Steven Rhodes will need to adjudicate.        

 The Bankruptcy Code provides that a plan may not “unfairly discriminate” among classes of creditors holding claims of equal priority.  So what level of discrimination is fair?  The Detroit plan proposes to pay police and fire retirees approximately 90% and general retirees approximately 70% of their earned pensions (in both cases after elimination of cost of living allowances).  The holders of general obligation bonds, on the other hand, are slated to receive approximately a 20% recovery.  Emergency Manager Orr will contend that such discriminatory treatment is not “unfair”, given the competing equities between the retirees and the bondholders arising from the probable hardships that retirees will face from pension reductions.  The bondholders are likely to have a different view

 The plan must also be “in the best interests of creditors”.  In a corporate bankruptcy, satisfying this requirement is fairly straight-forward: creditors must receive more under a reorganization than if the debtor were to be liquidated.  A municipal debtor, however, cannot be liquidated, so the determination of what constitutes the “best interests of creditors” in a chapter 9 case is much more nebulous.  The Detroit plan contemplates spending $1.5 billion over ten years on essential infrastructure spending and on fostering growth and redevelopment.  Detroit has seen impressive private sector growth over the last several years, but its ability to once again be a thriving municipality (albeit on a far smaller scale than in its heyday) depends on its ability to emerge from the chapter 9 process with a debt structure that fits its reduced size, and with sufficient free cash to support at least a minimum threshold of functionality.  It’s a noble vision; however, it may not be one that can be deemed to be “in the best interests of creditors”, who will argue that the City’s future should not be funded on their backs. 

 There are numerous other hurdles for the Detroit plan.  A deal on the termination of certain interest rate swap obligations that would free up crucial casino revenues must be reached. Bondholders will additionally argue against the proposal that seeks to monetize the collection of the Detroit Institute of Art and use the proceeds to shore up the City’s pension funds.  The retirees, notwithstanding their proposed favorable treatment, have not yet agreed to any reductions in their pensions, and are appealing the ruling of Judge Rhodes late last year that not only found Detroit eligible for chapter 9 protection, but also held that the City’s pension obligations could be impaired in a federal bankruptcy proceeding.     

 These are fascinating and complex issues in their own right.  However, it is the resolution of the two overarching questions that will largely determine the extent to which Detroit’s chapter 9 case can ultimately provide a model for future municipal bankruptcy cases. 

Fisker Automotive Chapter 11 Case: a Two-Headed Stalking Horse and a New Credit Bidding Controversy

Posted in Distressed M&A

Fisker Automotive’s chapter 11 case began in what has become a depressingly familiar fashion – a fast-tracked sale to a secured lender.  However, two rulings by Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware have made this a fascinating case to follow.  Judge Gross has directed  Fisker to proceed with an auction in which two bidders have been granted “stalking horse” status on the same assets.  He is also limiting the ability of one of the bidders to credit bid its secured debt, a determination that could give rise to a new controversy on an issue that appeared to have been resolved two years ago with the Supreme Court’s RadLax decision

Back in 2010, Fisker obtained capital from the U.S. Department of Energy (“DOE”) in the form of secured debt to support its development of electric automobiles.  In October 2013, Hybrid Tech Holdings LLC (“Hybrid”) bought the outstanding DOE debt, paying only $25 million for DOE’s position of $165 million.  In late November, Fisker filed its chapter 11 case for the purpose of effecting a quick sale of its assets to Hybrid in exchange for a credit bid of Hybrid’s recently-acquired secured debt.  Fisker’s creditors’ committee objected to the sale and located another potential bidder, Wanxiang America Corporation (“Wanxiang”).  The committee also objected to Hybrid’s right to credit bid. 

Credit bidding in bankruptcy protects the expectations of secured creditors under non-bankruptcy law to be able to look to their collateral in the event of a default.  The Bankruptcy Code has always permitted courts to limit the right to credit bid “for cause”, a term not defined but generally viewed as being narrow in scope, such as a creditor’s bad faith or misconduct.  A controversy arose a few years ago when the U.S. Court of Appeals for the Third Circuit unexpectedly limited a secured creditors right to credit bid in the absence of “cause” in the Philadelphia Newspapers case.  That decision was effectively overruled by the Supreme Court’s ruling in RadLax.    

In Fisker, Judge Gross agreed with the committee’s contention that “cause” exists to limit Hybrid’s credit bid to the $25 million that it paid for the DOE secured debt.  However, the basis for his ruling is not entirely clear.  There appears to be a bona fide dispute as to the extent of Hybrid’s liens on Fisker’s assets; at least a portion of the assets that will be sold may not be encumbered by Hybrid’s liens.  If that is the case, then Hybrid should not be able to use its debt to pay for such unencumbered assets, and Judge Gross’s decision would be unremarkable. 

But Judge Gross also stated that he found “cause” to limit Hybrid’s right to credit bid because “bidding will not only be chilled without the cap; bidding will be frozen.”  Finding “cause” to limit credit bidding on that basis would be a much broader reading of the term.  Credit bidding can nearly always be said to “chill” competing offers.  In one sense, that is its very purpose – to protect a secured creditor from being forced to accept a cash payment that is below that value the secured creditor believes the collateral has.  Forcing a secured creditor to pay cash for an asset on which it already has a valid lien is a somewhat superfluous exercise, since if the secured creditor wins the auction it would be writing a check to itself.    

In another unusual decision, Judge Gross has ruled that both Hybrid, which has changed its bid to $30 million in cash in addition to its $25 million credit bid, and Wanxiang, which is offering $35 million in cash plus 20% of the equity in the reorganized debtor, are entitled to have stalking horse status.  This means that they will each receive a break-up fee of $750,000 if a third party comes in with a topping bid. 

Even as Hybrid is participating in the auction with its revised offer, it is seeking an immediate appeal of Judge Gross’s decision that “cause” exists to limit its right to credit bid.  What makes this case all the more interesting is the possibility that Hybrid’s appeal will at some point be heard by the Third Circuit Court of Appeals, the same court that issued the Philadelphia Newspapers decision.

Judge Slams Bankruptcy Trustee’s Suit to Recover Parochial School Tuition Payments

Posted in Bankruptcy

A parochial elementary school and high school were recently sued in the U.S. Bankruptcy Court for the Eastern District of New York by Robert Geltzer, a bankruptcy trustee.  The suits, Geltzer v. Our Lady of Mt. Carmel-St. Benedicta School and Geltzer v. Xavarian High School, were brought in an effort to recover tuition payments made by a student’s parents who had later filed for bankruptcy. (Kelley Drye & Warren LLP represented Our Lady of Mt. Carmel-St. Benedicta School on a pro bono basis).  Judge Carla Craig, the U.S. Bankruptcy Judge before whom the cases were argued, wrote an opinion granting motions to dismiss that appropriately rejected the trustee’s legal arguments and that should deter other such cases from being brought.

Geltzer sought to have the payments avoided as “fraudulent conveyances”.  Transactions undertaken by people or companies when they are insolvent, and for which they received less than “reasonably equivalent value”, can later be unwound by a bankruptcy court, which can require the funds or assets transferred by the debtor to be paid over to a bankruptcy trustee.  Geltzer’s theory in the Mt. Carmel-St. Benedicta and Xavarian cases was straight forward – the tuition paid by the parents before they filed for bankruptcy were “fraudulent conveyances” because the parents received no benefit from the payments; only the debtors’ children received any actual “value”, in the form of the education that they, and not the parents, received. Geltzer therefore claimed the right to sue the schools and recover the payments.

The lawsuits appeared at first glance to be frivolous to the point of warranting sanctions.  Surprisingly, however, there were no precedent cases explicitly against Geltzer’s position.  Moreover, he was able to cite to two similar cases involving college tuition payments, made by parents on behalf of adult children, that provided at least a veneer of support for his argument.

In their motions to dismiss, Mt. Carmel-St. Benedicta and Xavarian both made similar contentions.  The implications of Geltzer’s position were disturbing.  If his theory were correct, then virtually any expenditures on behalf of a minor son or daughter, made by parents who were later to file for bankruptcy, could subsequently be challenged and recovered by a bankruptcy trustee.

The troubling potential ramifications of Geltzer’s argument aside, the schools strongly attacked his arguments that no “value” was received by the parents for paying school tuition for their children.  The Second Circuit Court of Appeals ruled in a tax case many years ago that a parent could not claim a charitable tax deduction for parochial school tuition “because the [parent] expects, and in fact receives, a definite economic benefit” for the payments.  In another highly analogous case, a bankruptcy trustee sought to recover residential mortgage payments made by a man who voluntarily paid the mortgage for the house in which his acknowledged minor son and the boy’s mother lived.  The bankruptcy court in that case rejected the trustee’s argument that the man could only have received “value” for the mortgage payments if he were legally obligated to make them, noting that the debtor received “reasonably equivalent value” from the “psychic and other intangible benefits that he received from payments that he . . . made for the benefit of [his] child.”

At the hearing, Judge Craig made no secret about how she viewed the lawsuit, at various points characterizing Geltzer’s positions as “ridiculous” and “absurd”.  Her opinion, while slightly more measured than her comments during oral argument, dismissed Geltzer’s claims as “based on a fundamentally flawed legal theory that is . . . at odds with common sense.” There could be no parsing out the value received for the tuition payments, “because the Debtors and their minor children must be viewed as a single economic unit for these purposes.” She then went even further, noting that parents are legally obligated to provide their children with life’s necessities, and their choices cannot be subjected to later review by bankruptcy trustees.  “The fact that they chose [to send] their children to private or parochial school . . . does not render the payments subject to scrutiny by the Trustee for avoidance, any more than the Trustee would be entitled to second-guess other choices made by debtors pre-petition in providing clothing, food [or] shelter . . . to their minor children.”

Before Judge Craig’s ruling, Geltzer had sent letters to several other parochial and private schools in the New York area, demanding the return of tuition payments.  While Geltzer’s legal argument against Mt. Carmel-St. Benedicta and Xavarian perhaps may have fallen just short of frivolous in narrow legal terms, it was, as Judge Craig made clear, “at odds with common sense”.  Her opinion disposed of it appropriately and should prevent similar cases from being commenced.

Heard About Detroit? The First Word on Treatment of Public Employee Pension Benefits in Chapter 9 (And Absolutely Not the Last)

Posted in Chapter 9

Last week’s ruling by Judge Stephen Rhodes finding the City of Detroit eligible for protection under Chapter 9 of the U.S. Bankruptcy Code has rightly received considerable attention. The determination that Detroit has met the standards under Section 109(c) of the Bankruptcy Code to be a debtor under Chapter 9 was widely expected. The surprising part of the opinion lies in Judge Rhodes’s express ruling that the pension rights of Detroit’s current and former public employees are simple contractual obligations that may be subject to impairment in bankruptcy. Uncertainty regarding the appropriate legal treatment of pension obligations, and the Tenth Amendment implications in connection therewith, has been a crucial overhanging issue in Chapter 9 municipal bankruptcy cases for several years, and Judge Rhodes’s opinion is the first opinion directly to address it.

In Judge Rhode’s view, Michigan’s public pension rights are not vested property interests, but instead are contractual rights.

The [Michigan] constitution could have given pensions protection from impairment in bankruptcy in several ways. It could have created a property interest that bankruptcy would be required to respect . . . Or, it could have established some sort of a secured interest in the municipality’s property. It could even have explicitly required the State to guaranty pension benefits. But it did none of these.

Instead, both the history . . . and the language of the pension provision . . . make it clear that the only remedy for impairment of pensions is a claim for breach of contract.

As such, Judge Rhodes held that public pension rights may be impaired in bankruptcy, similar to rights arising under any other contract. Judge Rhodes saw no abrogation of the Tenth Amendment, which reserves to states rights not granted to the federal government under the Constitution, because the State of Michigan had expressly authorized municipalities to seek protection under Chapter 9.

Impairing contracts is what the bankruptcy process does. . . For Tenth Amendment and state sovereignty purposes, nothing distinguishes pension debt in a municipal bankruptcy case from any other debt.

The importance of Judge Rhodes’s opinion should not be understated, but at the same time it should not be overstated. His analysis is detailed and well-reasoned. However, the extent to which it will affect or apply to pension obligations in other cities and states, particularly in the California cases where similar issues have been playing out, remains very much an uncertainty. Judge Rhodes’s opinion relied on a detailed parsing of the Michigan statutes and the provisions in the Michigan state constitution, which by itself could limit its applicability.

Other courts are going to weigh in, beginning with the U.S. Court of Appeals for the Sixth Circuit, which will probably hear a direct appeal of Judge Rhodes’s decision. It is likely that at least one court will come to a different conclusion, either due to different underlying facts or a good faith disagreement with Judge Rhodes’s analysis. It is a near certainty that this issue will ultimately wind up before the Supreme Court.

.