Bankruptcy Law Insights : Kelley Drye & Warren LLP Bankruptcy and Restructuring Practice Group

Opposing lawyers for Jefferson County, the debtor in the largest Chapter 9 municipal bankruptcy case ever filed, and the holders of its sewer warrants squared off last week in the ongoing fight over control of the County’s sewer system and the right to its revenues. (Expert witness Jay Goldin provided a notable link back to the New York City fiscal crisis of the 1970’s.) The dispute over the County’s sewer system, with it’s underlying tale of corruption and the use of complex derivatives gone rampant, has garnered nearly all of the attention that has been focused on the County’s financial travails and its Chapter 9 case.  

In some ways, however, the sewer system disputes are a sideshow. The true source of the County’s present dire circumstances lies in the invalidation last year of the County’s occupational tax that had accounted for nearly 40% of its general revenues. The sewer system may be a veritable Gordian knot, but it is essentially self-contained. The holders of the sewer warrants have no recourse against the County’s general revenues. The loss of the funds from the occupational tax, however, has left the County virtually non-functional, barely able to provide basic governmental services. 

The crisis can be alleviated only by the Alabama State Legislature. Under Alabama law, the County has no authority to replace the tax. The Legislature’s current session is rapidly drawing to a close, and no relief for Jefferson County appears to be at hand.  

The sewer system dispute will probably generate precedential opinions from the Eleventh Circuit Court of Appeals, which will widely influence and affect the course of Chapter 9 cases going forward. But regardless of how the sewer system dispute gets resolved, Jefferson County’s only hope of being able to emerge from Chapter 9 with a feasible plan of adjustment lies with the State Legislature.

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U.S. Bankruptcy Court Judge Thomas Bennett last month upheld the Chapter 9 bankruptcy filing of Jefferson County, Alabama, the largest municipal bankruptcy case in history. As has been widely reported, the County’s financial woes were precipitated by the disastrous funding of upgrades to its sewer system. Not surprisingly, given the billions of dollars at stake and the lack of applicable Chapter 9 precedents, the Jefferson County case has already produced a torrent of briefs and two extensive opinions from Judge Bennett. The main antagonists in this case - the County one side, and a group comprised of the holders of the County’s sewer warrants (the “Sewer Warrants”), the Indenture Trustee for the Sewer Warrants, the monoline insurers of the Sewer Warrants, and the state court appointed receiver for the sewer system (the “Sewer Warrant Parties”), on the other - have already fought bitterly over the County’s eligibility to be a debtor under Chapter 9, and over which party – the County or the receiver – would maintain control of the sewer system during the Chapter 9 case. The County has prevailed in both battles.     

The two sides are now preparing to square off again next week on another crucial issue for which there exists no caselaw guidance. Section 922 of the Bankruptcy Code permits the holders of bonds or warrants that are secured by “special revenues”, such as those generated from the Jefferson County sewer system, to continue to receive payment from the application of such revenues during the course of a Chapter 9 case. However, Section 928(b) provides that the lien on such revenues is subject to the sewer system’s “necessary operating expenses”. With no governing definition as to what constitutes “necessary operating expenses” in the Bankruptcy Code and no previous court rulings on the scope of Section 928(b), the two sides predictably have staked out positions at opposite poles. 

The parties agree that “Operating Expenses”, defined in part under the Indenture governing the Sewer Warrants as “the reasonable and necessary expenses of efficiently and economically administering and operating the [Sewer] System”, should be deducted from the sewer revenues collected by the County before payment to the holders of the Sewer Warrants. The dispute centers on certain specific categories of additional expenditures that the County now wants to subtract, including what a Joint Statement filed by the parties describes as “maintenance expenditures”, “project expenditures”, “professional fees and related costs”, and “reserves for depreciation and amortization and for future operating and/or capital expenditures”. Prior to the Chapter 9 Case, the Indenture Trustee was receiving $9.6 million each month to pay over to the holders of the Sewer Warrants. According to the Sewer Warrant Parties, the additional deductions sought by the County would reduce this amount to $4.25 million.   

In an 83 page brief, the County forcefully argues that the statutory term “necessary operating expenses” in Section 928(b) must be read more broadly than the Indenture definition of “Operating Expenses”, and permits the County to withhold amounts evidencing the disputed expenditures. The Sewer Warrant Parties, with equal vigor and nearly equal length, assert that Section 928(b) must be read narrowly, that the statutory term “necessary operating expenses” encompasses what they describe as “the commonly used definition of ‘Operating Expenses’” under the Indenture, and that the County improperly seeks to use the Bankruptcy Code to reduce the payments properly due to the sewer warrant holders. 

The County’s argument regarding expenditures for “professional fees and related costs” provides an interesting twist, particularly given the contentiousness of the case so far. The County believes that such expenditures should include litigation costs incurred with respect to the Sewer Warrants in the Chapter 9 case. The County thereby wants to deduct as “necessary operating expenses” under Section 928(b) its own legal expenses from the sewer revenues otherwise payable to the holders of the Sewer Warrants. Because the holders of the Sewer Warrants have no recourse to any County revenues or assets other than the sewer revenues, they effectively would find themselves paying the County’s legal costs out of their own pockets.    

Corporate debtors in Chapter 11 cases typically must pay the legal costs and expenses of their secured lenders. This customary feature of loan documents acts to discourage debtors (or other parties acting on behalf of a debtor’s estate) from pursuing litigation against lenders, as the debtor’s estate funds the litigation costs of both sides. The County’s gambit, if successful, would turn this dynamic completely on its head, and could significantly alter the direction of the Chapter 9 case.

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At the end of the day, Picard really did not have a case, but there was no way that Wilpon and Katz could risk a trial.  It looks to be a fair and reasonable outcome. 

http://espn.go.com/new-york/mlb/story/_/id/7708498/new-york-mets-settle-madoff-trustee-162-million

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On the surface, Irving Picard, the trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”), had a very good day. Judge Jed S. Rakoff granted Picard’s motion for summary judgment against Fred Wilpon and Saul Katz, the owners of the New York Mets, and their families and affiliated enterprises (the “Wilpon/Katz Group”) with respect to the $83 million of fictitious profits received by the Wilpon/Katz Group in the two year period before the filing of the BLMIS case. At the same time, Judge Rakoff denied the Wilpon/Katz Group’s summary judgment motion that sought to prevent Picard from clawing back any payments other than fictitious profits on the grounds that he could not prove that the Wilpon/Katz Group acted in bad faith in investing in BLMIS. 

The Wilpon/Katz Group can take some comfort, however, from Judge Rakoff’s blunt skepticism regarding Picard’s ability to recover any further amounts. The ruling with respect to fictitious profits was hardly a surprise. In a ruling last September, Judge Rakoff had issued what amounted to a virtually gold-plated invitation when he said, “[T]he Trustee might well prevail on summary judgment seeking recovery of [such] profits.” However, with respect to the $300 million of invested principal that the Wilpon/Katz Group received from BLMIS during the two year period, Judge Rakoff reiterated his earlier expressed doubts in even stronger terms, stating that Picard’s efforts to demonstrate bad faith amounted to “nothing but bombast.” 

The trial is scheduled to begin in two weeks on March 19. At this point, however, a settlement very likely makes sense for both parties. Although Picard has virtually no chance of recovering invested principal, Rakoff is going to allow him to present his evidence with respect to bad faith to a jury. The Wilpon/Katz Group, even if victorious after what will undoubtedly be an embarrassing and widely publicized trial, will thereafter face a lengthy appeal period. Picard has been successful before the Second Circuit, and may very well prevail in his appeal of Judge Rakoff’s earlier ruling from last September that, among other things, reduced the amount of fictitious profits which could be recovered from approximately $295 million. 

The mediation efforts of former Governor Mario Cuomo may yet succeed.

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Irving Picard, the trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”), and Fred Wilpon and Saul Katz, the owners of the New York Mets, and their families and affiliated enterprises (the “Wilpon/Katz Group”), each submitted their final arguments last week in support of their respective motions for summary judgment. As previously discussed on this site, Judge Jed S. Rakoff’s rulings on the motions could largely resolve this year-long legal battle. 

Judge Rakoff’s decision last September dismissed most of the counts set forth in Picard’s complaint and substantially narrowed the focus of Picard’s adversary proceeding. Section 548(a) of the Bankruptcy Code allows a trustee to avoid transfers made up to two years prior to the commencement of the bankruptcy case if made with deliberate fraudulent intent. However, the rights of a good faith transferee are recognized and protected under Section 548(c). That section provides that a transferee “that takes for value and in good faith” may retain the property transferred to it “to the extent that such transferee . . . gave value to the debtor in exchange” for such transfer.

The briefs filed last week showed each side closely adhering to the paths provided by Judge Rakoff in his ruling last year. Rakoff strongly intimated that no value was provided with respect to the $83 million of fictitious profits received by the Wilpon/Katz Group in the two year period before the filing of the BLMIS case, and Picard accordingly contends now that no material facts or valid defenses exist with respect to those payments. On the other hand, Rakoff ruled that the Wilpon/Katz Group’s invested principal clearly did provide “value” to BLMIS, thus requiring Picard to demonstrate a lack of “good faith” in order to recover payments that constituted the return of such principal. The Wilpon/Katz Group argues strenuously that Picard’s mélange of supposed “red flags” fails to approach the standard of “willful blindness” that Judge Rakoff stated must be shown in order to show an absence of good faith. 

Judge Rakoff must find with respect to each motion that there are no genuine factual issues to be determined at a full trial. Picard would appear to have the stronger chance for immediate success here.  Unless Judge Rakoff determines to apply a different legal standard now than he did last year, the issue of fictitious profits looks to be clear and straight forward. On the other hand, the issue of good faith appears to be less susceptible to immediate disposition. While it does not appear that Picard will be able to satisfy Rakoff’s “willful blindness” standard, Judge Rakoff will probably allow Picard to present his evidence to a jury.

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The adversary proceeding of Irving Picard, the trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”), against Fred Wilpon and Saul Katz, the owners of the New York Mets, and their families and affiliated enterprises (the “Wilpon/Katz Group”), could be substantially resolved over the next few weeks. Although the trial is scheduled to begin on March 19, each side intends to ask Judge Jed S. Rakoff at a hearing on February 23 to rule in its favor with respect to certain of the transfers made by BLMIS to the Wilpon/Katz Group during the two-year period prior to the commencement of the BLMIS liquidation case in December 2008. Picard asserts that there are no material disputed issues of fact with respect to at least $83 million that evidences the fictitious profits received by the Wilpon/Katz Group during that period, and the Wilpon/Katz Group makes the same contention regarding the remaining payments over that time that constituted the return of principal. 

Between them, Picard and the Wilpon/Katz Group have covered virtually all of the payments that remain at issue following Judge Rakoff’s ruling last September that dismissed most of Picard’s claims. This “Jack Sprat” approach could resolve the entire case. 

Both sides are following paths essentially laid out by Judge Rakoff in the September ruling. Judge Rakoff dismissed most of the counts against the Wilpon/Katz Group based on his reading of the “safe harbor” provisions Section 546(e) of the Bankruptcy Code, which substantially reduced Picard’s potential recovery from nearly $1 billion to approximately $384 million. Judge Rakoff also set a very high standard for Picard to meet in order to recover any payments other than “fictitious profits”, stating that “the principal invested by . . . Madoff’s customers ‘gave value to the debtor,’ and therefore may not be recovered by the Trustee absent bad faith.” In Judge Rakoff’s view, Picard can only recover payments evidencing a return of principal by showing a lack of good faith tantamount to “willful blindness”. The Wilpon/Katz Group details the so-called “red flags” that Picard has set forth to show that the Wilpon/Katz Group should have suspected Madoff, and argues that in total they do not come close to clearing the hurdle established by Judge Rakoff.  

Picard, on the other hand, has taken Judge Rakoff up on his virtually gold-plated invitation to seek summary judgment for the fictitious profits. “[G]iven the difficulty defendants will have in establishing that they took their net profits for value, the Trustee might well prevail on summary judgment seeking recovery of the profits[,]” the judge wrote in the September ruling. While Judge Rakoff has not yet ruled on the appropriate method for calculating the portion of the $384 million attributable to fictitious profits, Picard has consistently taken the position that the amount is approximately $83 million. 

A ruling in favor of both motions would constitute a far larger victory for the Wilpon/Katz Group than for Picard. The Wilpon/Katz Group will have reduced its potential $1 billion exposure down to a level that will likely allow them to retain ownership of the Mets, and avoid the time, costs, and publicity of a lengthy trial. On the other hand, even with a victory regarding the $83 million, an appeal by Picard of the September ruling is highly likely.

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Judge Jed S. Rakoff this week denied the request of Irving Picard, the trustee of Bernard L. Madoff Investment Securities LLC (“BLMIS”), to pursue an immediate appeal of Judge Rakoff’s recent decision to dismiss most of the counts set forth in Picard’s adversary proceeding against Fred Wilpon and Saul Katz, the owners of the New York Mets, and their families and affiliated enterprises (the “Wilpon/Katz Group”). He reaffirmed that the trial on Picard’s claims against the Wilpon/Katz Group will begin on March 19, 2012.   

In his earlier ruling, Judge Rakoff held that the “safe harbor” provisions in Section 546(e) of the Bankruptcy Code limit Picard’s power to recover any transfer from a “stockbroker” that was a “settlement payment” made “in connection with a securities contract”. Crucially, this interpretation of 546(e) only permits a recovery of intentionally fraudulent transfers pursuant to Section 548(a)(1)(A) of the Bankruptcy Code, which has a two-year look back period.  It completely eliminates Picard’s ability to rely on the six-year look back period under New York state law fraudulent transfer provisions, and reduces the maximum amount that Picard could possibly recover from the Wilpon/Katz Group from nearly $1 billion to approximately $384 million.        

In yesterday’s opinion, Judge Rakoff held that Picard had failed to show the necessary “extraordinary circumstances” which would warrant the “interlocutory” appeal and justify the indefinite delay of the pending trial. He directed Picard to wait until after the trial, when “an appellate court will be able to review, on a full record, not just [the] rulings of which the Trustee now complains, but all relevant rulings in this [complicated] proceeding[.]” Judge Rakoff disregarded Picard’s contention that the Second Circuit’s recent opinion, rejecting customer claims based upon Madoff’s fabricated BLMIS account statements, should prevent Ponzi scheme transfers from qualifying for “safe harbor” protection under Section 546(e), because no stocks or securities were actually ever sold. Judge Rakoff noted that the extent of the Wilpon/Katz Group defendants’ knowledge of Madoff’s activities, “one of the key issues in the forthcoming trial,” could be highly relevant to the question of whether transfers made as part of a Ponzi scheme should qualify for “safe harbor” treatment, and that “the factual record thus developed will be useful for assessing [those] issues now raised by the Trustee.”   

Judge Rakoff’s earlier decision also set a very high standard for Picard to meet in order to recover any distributions to the Wilpon/Katz Group other than “fictitious profits”.  As previously discussed on this site, while amounts paid out by BLMIS to investors such as the Wilpon/Katz Group as part of the Ponzi scheme can satisfy the requirement of actual fraud under Section 548(a) of the Bankruptcy Code, under Section 548(c) the Wilpon/Katz Group defendants can defeat Picard’s efforts to recover such distributions to the extent that they can show that they provided value, such as invested principal, in exchange for such distributions. Judge Rakoff has not yet ruled on the key question of how much of the $384 million in aggregate distributions during the two-year look back period should constitute “fictitious profits” and how much should be deemed to be the return of invested principal. He requested the parties to brief this issue following his earlier decision. Insofar as Judge Rakoff noted in the earlier decision that Picard “might very well prevail on summary judgment seeking recovery of the [fictitious] profits”, his ruling on the method for the calculation of such profits will likely be the determinative issue in this case.

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The travails of Jefferson County, Alabama are well known. Ordered by a federal court to upgrade its sewer system in the late 1990’s, the project was marred by corruption, cost overruns and financing with complex derivatives that ultimately saddled the County with over $3 billion in debt. In addition, an occupational tax that provided the primary source of its unrestricted general fund revenues was invalidated, and the County faces both huge refund claims and operating revenue shortfalls. There is no dispute that Jefferson County is deeply insolvent, and there was little surprise when the County filed a petition under Chapter 9 of the Bankruptcy Code in early November in the Northern District of Alabama, commencing the largest municipal bankruptcy case in history. 

For all of its problems, however, the County may not be eligible for Chapter 9 protection. The County’s bankruptcy petition has been challenged and a colorable issue exists as to whether the County can satisfy the strict requirements which must be met in order for a municipality to use Chapter 9 to seek adjust its debts. Among other things, those requirements, set forth in Section 109(c) of the Bankruptcy Code, state that a municipal entity seeking to be a debtor under Chapter 9 must demonstrate that it “is specifically authorized . . . by State law . . . to be a debtor under such chapter.”  In Jefferson County’s case, the question is whether the nature of its debt obligations fall within the parameters of the Alabama authorization statute, Alabama Code Section 11-81-3. As strange as it sounds, Jefferson County’s staggering debt may not be the right kind of debt to enable it to utilize Chapter 9 of the Bankruptcy Code. 

Jefferson County issued its debt in the form of warrants; it has no outstanding bond debt. The differences between warrants and bonds may be highly technical but they are evidently cognizable under Alabama law. The debt holders opposing the Chapter 9 petition contend that the first sentence of Alabama Code Section 11-81-3 only authorizes a Chapter 9 filing by the “governing body of any county, city or town . . . which shall authorize the issuance of refunding or funding bonds”, and that the distinction between bonds and warrants is sufficient to render Jefferson County ineligible for Chapter 9, since it cannot show that has been “specifically authorized” to use Chapter 9 under Alabama law. One bankruptcy judge in the Southern District of Alabama recently dismissed the Chapter 9 case of another Alabama municipality that had no outstanding bond debt. The federal district judge hearing the appeal of that dismissal has certified the question to the Alabama Supreme Court.    

The County argues in response that the second sentence of Alabama Code Section 11-81-3, which contains express language that “authorizes each county, city or town . . . to proceed under the provisions of the acts for the readjustment of its debts”, is not limited by the reference to bond debt in the first sentence. It alternatively contends that even if the first sentence of Section 11-81-3 does provide such a limitation, the County’s previous issuances of bonds, even if not currently outstanding, satisfies the requirement. 

Judge Thomas Bennett, the bankruptcy judge overseeing the Jefferson County case, has indicated that he may also certify the issue to the Alabama Supreme Court.

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The U.S. Supreme Court will rule this term in RadLAX Gateway Hotel Inc. v. Amalgamated Bank on whether the Bankruptcy Code permits a debtor in a chapter 11 case to sell encumbered assets without providing the secured lender an opportunity to credit bid its debt. Determination of this question will require the Court essentially to choose between two opposing approaches to statutory interpretation, and decide whether the so-called “plain meaning” of a highly formalistic reading of the Bankruptcy Code should trump decades of established commercial practice.   

A circuit split arose earlier this year, when the Seventh Circuit in River Road Hotel Partners, a companion case to RadLAX Gateway Hotel, declined to follow the Third Circuit’s 2010 decision in Philadelphia Newspapers, and instead expressly adopted the position set forth in the dissenting opinion from that case of Judge Tom Ambro. As previously described on this site, the debtor in River Road sought to rely on Philadelphia Newspapers in putting forward a plan of reorganization that proposed an auction of the secured lenders’ collateral, but would have expressly denied the lenders the right to credit bid their debt.  Section 1129(b)(2)(A) of the Bankruptcy Code describes three different means by which a plan of reorganization can be found to be “fair and equitable” and thus capable of being confirmed without the consent of a secured lender class (i.e., “crammed down”):

(i) lender retention of liens securing the obligations and receipt of the present value of its secured claim,

(ii) sale of collateral free and clear of liens but subject to credit bidding, or

(iii) the realization by the creditor of the “indubitable equivalent” of its secured claim.

Notwithstanding the express reference in subsection (ii) of Section 1129(b)(2)(A) to the right to credit bid in connection with a sale “free and clear” of liens, the Third Circuit in Philadelphia Newspapers held that a sale “free and clear” could also take place without allowing the lenders to credit bid under subsection (iii), the “indubitable equivalent” prong.  The Third Circuit concluded that the “plain meaning” of the use of the disjunctive “or” in the statute shows that subsection (ii) is not the “exclusive means” by which a secured lender’s collateral may be sold “free and clear” under a plan of reorganization and that, so long as the debtor or other plan proponent could show that the “indubitable equivalent” prong were being satisfied, the opportunity to credit bid need not be provided. 

Judge Ambro, a longtime bankruptcy practitioner before being named to the bench, castigated the majority’s refusal to look beyond what it viewed as the sole plausible reading of Section 1129(b)(2)(A).  In Judge Ambro’s view, the result flew in the face of both the established principle that property rights in bankruptcy look to applicable non-bankruptcy law, and the expectation that the Bankruptcy Code expressly protects such non-bankruptcy rights -- particularly the right of a secured creditor to look to its collateral in the event of non-payment. As he wrote, “In effect, a single ‘or’ becomes the bell, book and candle that excommunicates Congressional intent from the Bankruptcy Code . . . [and] upset[s] three decades of secured creditors’ expectations[.]”

The bankruptcy judge in River Road expressly rejected the reasoning of the Philadelphia Newspapers majority. The Seventh Circuit unanimously agreed, stating that “like the bankruptcy court, we find the statutory analysis articulated by Judge Ambro in his Philadelphia Newspapers dissent to be compelling.” 

The RadLAX Gateway Hotel debtor sought a writ of certiorari from the Supreme Court. They were joined by the Loan Syndication and Trading Association (“LSTA”), a loan market participants’ industry group that has been strongly supportive of lenders’ credit bidding rights. The LSTA announced that it “decided to support the appeal to the Supreme Court because, although [RadLAX Gateway Hotel] is a favorable ruling, the benefit to the market of certainty on credit bidding is an opportunity that cannot be missed.” 

The Supreme Court has not been consistent in its approach to Bankruptcy Code interpretation. While it has strictly applied the “plain meaning” approach in several recent bankruptcy cases, at other times it has been willing to look to underlying Congressional purpose. The latter approach here will unquestionably result in an affirmation of the Seventh Circuit. The former will leave the LSTA regretting that it got what it asked for.

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