A recent decision by Judge Jed Rakoff of the Southern District of New York highlights the risks faced by directors and officers of companies in financial distress who fail to undertake properly their duties to the company and its stakeholders. In mostly denying a motion to dismiss claims brought against former directors and officers of Nine West Holdings and Jones Group, its predecessor company, Judge Rakoff’s opinion highlights the limits of protective legal doctrines such as the business judgment rule, which typically shields from subsequent inquiry corporate decisions made in good faith and with appropriate care, and prophylactic measures such as the delivery of solvency opinions.

In 2014, Jones Group, the financially distressed owner of footwear and apparel brands such as Nine West, Anne Klein, and Gloria Vanderbilt, was taken private in a leveraged buyout by private equity firm Sycamore Partners and became Nine West Holdings. When Nine West Holdings filed for bankruptcy in 2018, creditors unsurprisingly began scrutinizing the acquisition effectuated four years earlier. Potential claims against Sycamore in connection with the 2014 transactions were resolved as part of the chapter 11 case. Claims against former directors and officers of Jones Group were not settled and were given over to a litigation trust for prosecution on behalf of Nine West Holdings’ creditors following the confirmation of the chapter 11 plan.

Broadly stated, the 2014 acquisition of Jones Group was initially proposed to involve five separate transactions:

  • Jones Group was first to merge with a Sycamore affiliate to become Nine West Holdings.
  • Sycamore committed to contribute $395 million in equity to Nine West Holdings.
  • Following the merger of Jones Group with the Sycamore affiliate, Nine West Holdings, which already had $1 billion in debt on its balance sheet, would take on additional debt of $200 million.
  • The former Jones Group shareholders would receive $1.2 billion ($15 per share).
  • Also following the merger, certain valuable brands would subsequently be carved out of Nine West Holdings and sold to a separate Sycamore affiliate for less than fair market value.

The claims brought by the litigation trustee primarily focused on alleged breaches of fiduciary duty by Jones Group’s former directors and alleged fraudulent transfers to Jones Group’s former officers. Certain key facts considered by Judge Rakoff:

  • The terms of the transactions changed prior to the closing of the merger and became much less favorable for Nine West Holdings. Sycamore’s equity commitment was reduced to $120 million, and Nine West Holdings’ debt load increased by an additional $350 million, to $1.55 billion.
  • An investment banker engaged by the Jones Group’s board in 2012 had advised that the company could support a debt ratio of 5.1 times its projected 2013 earnings. However, the changed terms meant that Nine West Holdings would have a debt ratio of 7.8 times its projected earnings. Moreover, Nine West Holdings’ earnings would no longer include revenue from the brands being carved out and sold to Sycamore separately.
  • The Jones Group directors went forward with the merger despite the change in terms, even though they had the right to terminate the transactions under a “fiduciary out” clause in the agreements. Although the vote to approve the merger did not include approval of the increase in debt for Nine West Holdings and the sale of the carved-out brands, the Jones Group directors were aware that those transactions were expressly contemplated as part of the overall deal structure.
  • Following the merger, new directors were appointed for Nine West Holdings, and the new directors approved the transactions to increase the debt and to sell the carved-out brands.
  • In connection with the separate sale of the carved out brands, Sycamore engaged an investment bank to provide a solvency opinion for Nine West Holdings. The opinion concluded that Nine West Holdings had an enterprise value in excess of its contemplated debt load of $1.55 billion and was therefore solvent. However, the investment bank used earnings projections expressly provided by Sycamore and did not undertake an independent analysis.
  • Following the merger, Jones Group officers received “change of control” payments from Nine West Holdings ranging from $450,000 to $3 million.

The former Jones Group directors requested dismissal of the claims that they breached their fiduciary duties to the company and its stakeholders on the basis of the business judgment rule. Corporate laws vary from state to state, but the business judgment rule, as described by Judge Rakoff, typically protects decisions made by corporate directors and officers that were made (i) in good faith, (ii) by persons who have no financial interest in the subject of the decision, (iii) by persons reasonably and properly informed with respect to the subject of the decision, and (iv) with a reasonable basis for the belief that the decision was in the best interests of the corporation. The directors further sought the dismissal of claims with respect to the increase in debt and sale of the carved-out brands transactions undertaken by Nine West Holdings following the merger.

The former officers sought dismissal of the claims that the change of control payments constituted constructive fraudulent transfers which could be recovered by the litigation trustee. A constructive fraudulent transfer requires a showing that the transferor was insolvent at the time of the transfer was made and did not receive reasonably equivalent value in return. The former officers contended that the solvency opinion obtained by Sycamore for Nine West Holdings established that Nine West Holdings was not insolvent at the time that the payments were made, and that one of the necessary elements of a constructive fraudulent transfer therefore could not be shown.

Judge Rakoff declined to dismiss most of the claims. In determining that the former Jones Group directors were not shielded by the business judgment rule, he concluded that they had failed to undertake an appropriate investigation into whether the five transactions, taken as a whole, would damage the company by rendering it insolvent, particularly after the deal terms were unfavorably changed. He further ruled that the directors could not escape potential liability for the post-merger debt and sale transactions even though they were approved by a subsequent board of directors. Noting that the former Jones Group directors had expressly disclaimed undertaking any independent investigation of those transactions, he pointedly observed that “the business judgment rule presupposes that directors [actually] made a business judgment[.]” Those directors, he held, even after having been expressly informed that the debt ratio of the post-merger company would substantially exceed the maximum recommended limit, ignored numerous “red flags” as to the potential negative impact of the post-merger transactions, and therefore could not claim the protections of the business judgment rule.

The fraudulent transfer claims against the former Jones Group officers also mostly survived dismissal. Judge Rakoff gave short shrift to the officers’ contentions that the solvency opinion obtained by the investment bank engaged by Sycamore provided any protection in this regard, referencing the litigation trustee’s allegations that it was based on “Sycamore’s allegedly bloated enterprise value, which was alleged to have been specifically engineered to be ‘just above the $1.55 billion of debt.’” He particularly noted the impact of the loss to Nine West Holdings of the value of the carved-out brands in ruling that insolvency could readily be inferred from the litigation trustee’s allegations, and that the trustee could therefore proceed to trial on those claims.

The rulings in the Nine West D&O litigation serve as an important reminder to corporate directors and officers that there are limits to the protection from liability that legal doctrines such as the business judgment rule, and transactional protections such as solvency opinions, can provide when major decisions regarding a company in financial distress are being made. Given the extensive review that will be undertaken if a company subsequently falls into bankruptcy, extra care must be taken to show that potential red flags have been properly considered and weighed, and that any relied-upon work product provided by professional advisors is derived from genuinely independent analysis.


The much-ballyhooed COVID relief bill passed by Congress at the end of last year, in addition to providing for $600 checks to millions of people, includes several COVID-related amendments to the U.S. Bankruptcy Code. Some of these changes will have a significant direct impact, at least temporarily, on the rights of commercial landlords and tenants in chapter 11 cases.

  • The bill amends Section 365(d)(4) of the Bankruptcy Code, which provides that a commercial property lease is deemed rejected unless it is assumed by a debtor within 120 days following the filing of the bankruptcy case. The 120 day period has been increased by an additional 90 days, so that a debtor will now have 210 days after commencing the case to decide whether to assume or reject a commercial property lease.
    • Under existing law the bankruptcy court already has the discretion at the request of a debtor to increase this period by 90 days; accordingly, a debtor can now have up to 300 days to decide whether to assume or reject the lease.
    • This change to the Bankruptcy Code will sunset in two years, but will continue to apply in subchapter V small business chapter 11 cases commenced before the sunset date of December 27, 2022.
  • The bill also amends Section 365(d)(3) of the Bankruptcy Code to extend the time for a debtor to pay rent under a commercial real property lease. This change will apply only to subchapter V small business chapter 11 cases.
    • Under existing law, a debtor must begin complying with its lease obligations no later than 60 days after commencing the case. Under this amendment, if the bankruptcy court finds the debtor has experienced and is continuing to experience a material financial hardship, directly or indirectly, as a result of the COVID-19 pandemic, the court may extend this period by an additional 60 days.
    • Any claim arising from such extension shall be treated as an administrative priority expense for purposes of confirmation of a chapter 11 plan in a subchapter V small business chapter 11 case.
    • This change will sunset on December 27, 2022, but will continue to apply to any subchapter V small business chapter 11 bankruptcy case commenced before that date.
  • Another important amendment is a change to Section 547 of the Bankruptcy Code, which allows a debtor or a trustee to recover payments made by the debtor during the 90 day period prior to the commencement of the bankruptcy case.
    • Current law permits the recovery (subject to certain defenses) of payments on account of existing obligations made within such 90 day period that were outside of the ordinary course of business.
    • The amendment will protect a commercial landlord from possibly having to return any such payments if they were made under an agreement to defer rent subsequent to March 13, 2020.
    • The change is intended to encourage rent deferral arrangements between landlords and tenants. It applies only to rent payments, and not to the payment of fees, penalties, or interest the debtor may otherwise have owed without the deferral.
    • This change will also sunset on December 27, 2022, but will continue to apply to any bankruptcy case commenced before such date.


The New York Court of Appeals recently handed down an important opinion on out of court restructurings involving bond debt. In CNH Diversified Opportunities Master Account, L.P., v. Cleveland Unlimited, Inc., the Court of Appeals, in a 4–3 ruling, diverged from the Second Circuit’s ruling a few years ago in Marblegate Asset Mgt., LLC v Education Mgt. Fin. Corp. and resuscitated rights of minority bondholders under the Trust Indenture Act which were limited under Marblegate. The CNH decision, by making it easier for minority bondholders to impede remedial action taken by an indenture trustee at the direction of a majority of bondholders under a trust indenture and related documents, will result in fewer consensual out of court restructurings and require more chapter 11 filings for the implementation of such deals.

Section 316(b) of the Trust Indenture Act provides that “the right of any Holder to receive payment of principal . . . and interest . . . on a Note . . . or to bring suit for the enforcement of any such payment . . . shall not be impaired or affected without the consent of such Holder.” The Second Circuit in Marblegate rejected a challenge under Section 316(b) to an out of court restructuring that stripped nonconsenting minority unsecured bondholders of their practical ability to collect payment on their bonds. The transaction at issue in Marblegate consisted of an intercompany sale of the issuer’s assets to a new subsidiary, effectuated through a foreclosure by the holders of senior secured bank debt together with certain other steps. Unsecured bondholders were given the choice of (i) exchanging their bonds for equity in the new subsidiary, or (ii) retaining their bonds and their rights against the issuer, which no longer held any assets and was effectively an empty shell. The Second Circuit held that Section 316(b) was not violated with respect to the nonconsenting bondholders because there had been no formal amendment of the payment terms of the indenture that governed the bonds.

In CNH, following the issuer’s default, a group of bondholders representing 96.3% of the bonds negotiated a settlement which would have provided for the issuer’s parent company to distribute 100% of the issuer’s equity, which had been pledged in support of the bond debt, to a new holding company to be owned by all of the bondholders on a pro rata basis. The deal failed when the holders of the remaining 3.7% of the bonds refused to consent. As a workaround, the majority bondholders directed the indenture trustee (which was also the collateral agent) to undertake a foreclosure of the pledged equity under the Uniform Commercial Code and distribute the equity to all bondholders in full satisfaction of the debt and to cancel the bonds.

The minority bondholders commenced an action against the issuer and its affiliated guarantors to enforce the remaining amounts owed under the bonds, citing Section 316(b) and identical language incorporated in the indenture. The lower courts in CNH, relying in part on Marblegate, ruled in favor of the defendants. Those courts found that, as in Marblegate, there had been no amendment to any terms of the indenture that impaired the minority bondholders’ rights.

However, the New York Court of Appeals reversed, holding that the rights of the minority bondholders to seek payment under the bonds survived the foreclosure. Although there was no question about the authority of the indenture trustee, under the security documents that governed the pledge of the issuer’s equity, to undertake the actions it did at the direction the majority bondholders, the Court of Appeals held that the Section 316(b) language incorporated in the indenture meant that the rights of the minority bondholders to enforce the bonds could not be extinguished. The majority opinion determined that in Marblegate, even though the practical ability of nonconsenting bondholders to recover had been impaired because they were left with rights against a shell company with no assets, the legal right of such holders to enforce the bonds had remained intact.  By contrast, in CNH, the bonds were cancelled.

The dissenting opinion disagreed with the majority’s interpretation of the Section 316(b) language, and expressed concern about the confusion likely to ensue from having a split between the Second Circuit and the New York Court of Appeals on such an important issue and its likely impact on the corporate debt markets: “The majority strikes at the consistency between the law of this Court and that of the United States Court of Appeals for the Second Circuit with respect to the rules by which disputes related to an indenture of this nature are to be resolved.” The dissent also argued, among other things, that the majority opinion failed to consider the security documents and whether those documents, which were expressly incorporated by reference in the indenture, effectively evidenced the consent of the minority bondholders for the actions taken by the indenture trustee, including the cancellation of the bonds.

The Second Circuit in Marblegate limited the ability of nonconsenting minority bondholders to block a consensual arrangement between an issuer and majority bondholders. The CNH decision, in contrast, by empowering recalcitrant minority bondholders, will make consensual out of court restructurings more difficult to achieve. More issuers will need to resort to chapter 11 filings and the provisions of the U.S. Bankruptcy Code which override Section 316(b) and prevent a small minority of bondholders from impeding restructuring transactions which have the support of at least 66% of a class of bondholders. The New York Court of Appeals’ determination to distinguish Marblegate may be justifiable based on a technical reading of the language of Section 316(b). As a practical matter, however, the CNH dissent is correct that the difference in outcomes of the two rulings will create uncertainties and complicate the calculations of distressed issuers, bondholders and indenture trustees that are seeking to engage in out of court restructurings.

2020 is on pace to set a record as the busiest year for bankruptcy filings since the Great Recession.  In this episode on Kelley Drye Legal Download podcast, Bankruptcy and Restructuring Partner Bob LeHane and Special Counsel Jennifer Raviele discuss the current state of retail and restaurant bankruptcy cases, the impact of the global pandemic, and what to expect in the future.

Listeners can tune into their episode of Kelley Drye Legal Download podcast here and get future episodes on their preferred platform – Apple Podcasts, Google Play or Spotify.

The impact of COVID-19 is being felt at all levels of the economy and will work its way through bankruptcy courts for years to come.  In these early days, many creditors who are themselves suffering are providing assistance to troubled companies.  Suppliers and commercial landlords are agreeing to various forms of relief, including modified credit terms and rent relief to allow customers to bridge this period of unprecedented disruption.  While these corporate good Samaritans are providing immediate aid they may be subjecting themselves to the risk of future losses.

Consider the supplier extending terms now to a customer who inevitably files for bankruptcy.  As creditors to troubled businesses know, payments received from a debtor within 90 days of bankruptcy are subject to potential avoidance as a preference.  One of the primary preference defenses is the “ordinary course” defense, which insulates payments received in the ordinary course of business with the debtor.  The defense can be weakened if the payments at issue are made later than historic averages or eliminated if the payments are made by special arrangement.  As a result, under current law, the supplier who works with its customer and modifies payment terms to help them confront the economic fallout of COVID-19 may suffer increased future exposure because one of the most common statutory preference defenses is harder to prove.  

The risk to landlords is similar as courts have held that (i) an agreement to forbear from eviction does not insulate back rent payments from avoidance, and (ii) deferred rent payments are avoidable because payments made pursuant to unique agreements are not in the ordinary course of business.

Lenders that agree to loan amendments and forbearances to address COVID-19 will face similar concerns.  What of the lender that agrees to amend a financing agreement, extending maturity or offering interest-only terms during the crisis, and takes a lien on additional collateral as protection against the increased risk?  If the borrower ultimately files for bankruptcy, the lien on new collateral may be subject to preference attack.  

Absent fraud or other misconduct, should such creditors be penalized for working to find solutions during times of crisis?  Congress could make clear that, absent fraud or misconduct, creditor concessions granted during the COVID-19 crisis are presumptively immune from avoidance under the Bankruptcy Code.  This would protect parties that proactively step in to help, and might encourage others to do the same.  

The economic fallout from the COVID-19 pandemic will leave in its wake a significant increase in commercial chapter 11 filings. Many of these cases will feature extensive litigation involving breach of contract claims, business interruption insurance disputes, and common law causes of action based on novel interpretations of long-standing legal doctrines such as force majeure. These issues could be particularly problematic to resolve because of questions stemming from recent Supreme Court decisions regarding the constitutional authority of United States bankruptcy courts to make final rulings on these types of disputes. Fortunately, however, a recent decision by the U.S. Court of Appeals for the Third Circuit in the case of Millennium Lab Holdings suggests a different approach for addressing these constitutional concerns. The Third Circuit’s approach anticipates where the Supreme Court’s jurisprudence appears to be heading, and should provide useful guidance to bankruptcy courts during what is going to be a challenging period for both judges and practitioners.

Uncertainties regarding the authority of bankruptcy courts to issue final orders in certain types of cases have existed for decades, but were mostly quiescent until the Court’s opinion nine years ago in Stern v. Marshall.  In that case, which 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 constitutional questions regarding the United States bankruptcy courts.  Since then, practitioners and lower courts have struggled to deal with the ramifications of that decision.

The problems created by Stern, in a nutshell, are as follows:

Congress has the express power under Article I, Section 8 to pass uniform laws on bankruptcy. It used that power to create the modern bankruptcy court system pursuant to Article I of the Constitution rather than under Article III, the source of the federal government’s judicial power.

However, the Supreme Court has long held that “separation of powers” concerns require that Article I courts be 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.

Prior to Stern, it was generally believed that matters pertaining (in the Court’s words) to “the restructuring of debtor-creditor relations, which is at the core of federal bankruptcy power” under Article I, constituted a type of “public right” that could be heard and decided by an Article I bankruptcy judge.

The Court, however, never handed down a clear ruling as to where the line between “public rights” and “private rights” should be drawn in bankruptcy proceedings, even though “the restructuring of debtor-creditor relations” often necessitates the resolution of “private rights” disputes. Moreover, the Court, both in Stern and in recent non-bankruptcy cases, has significantly narrowed the “public rights” doctrine.

This has created confusion and given rise to substantial litigation in bankruptcy cases over the constitutional authority of bankruptcy judges to issue final orders on numerous issues which could implicate “private rights.”

In Millennium, the Third Circuit affirmed lower court opinions that turned aside a constitutional challenge to the authority of a bankruptcy court to confirm a plan of reorganization. The plan included the non-consensual release by third parties of certain claims against various non-debtor entities. The debtor’s equity holders had been accused of orchestrating fraudulent activity in connection with the debtor’s Medicare and Medicaid reimbursement requests.  The plan embodied a compromise, whereby the equity holders were to pay $325 million in exchange for a release of all claims against them held either by the debtor’s estate or directly by third parties.

Certain of the debtor’s lenders had commenced separate litigation against the equity holders, and objected to the releases in the plan that would preclude their claims. The lenders contended that under Stern the releases were tantamount to resolving a “private rights” dispute between two non-debtor parties, and that the bankruptcy court therefore lacked constitutional authority to enter a final order resolving it.

The Third Circuit rejected the lenders’ arguments. However, the decision avoids the thicket of the Supreme Court’s “public rights” jurisprudence, and strongly implies that such jurisprudence no longer provides support for bankruptcy courts’ constitutional authority to issue final orders which are dispositive of parties’ “private rights.” The Third Circuit reviews the Court’s recent decisions in this area and suggests that the Court is heading towards an alternative approach:

Judge Kent A. Jordan, writing for the court, steps away from the “public rights” doctrine and towards a straight-forward alternative – an express recognition that specialized bankruptcy courts under Article I should be viewed as an additional category of historical exception to the judicial power of Article III.

This would place the constitutional authority of bankruptcy courts to make dispositive rulings in cases involving “private rights” on far firmer ground than it currently rests under the “public rights” doctrine. Judge Jordan cites a passage that appears to endorse the “historical exception” rationale from a recent separate opinion by Chief Justice Roberts, who authored Stern:

“When the Framers gathered to draft the Constitution, English statutes had long empowered nonjudicial bankruptcy ‘commissioners’ to collect a debtor’s property, resolve claims by creditors, order the distribution of assets in the estate, and ultimately discharge the debts. This historical practice, combined with Congress’s constitutional authority to enact bankruptcy laws, confirms that Congress may assign to non-Article III courts adjudications involving ‘the restructuring of debtor-creditor relations, which is at the core of the federal bankruptcy power.’”

This approach has also been suggested in a separate opinion by Justice Thomas, who was part of the Court’s majority in Stern:

“Congress . . . has assigned the adjudication of certain bankruptcy disputes to non-Article III actors since as early as 1800. . . Bankruptcy courts clearly do not qualify as territorial courts or courts-martial, but they are not an easy fit in the “public rights” category, either. . . We have nevertheless implicitly recognized that the claims allowance process may proceed in a bankruptcy court, as can any matter that would necessarily be resolved by that process, even one that affects core private rights. . . . For this reason, bankruptcy courts . . . more likely enjoy a unique, textually based exception, much like territorial courts and courts-martial do. . .  That is, Article I’s Bankruptcy Clause serves to carve cases and controversies traditionally subject to resolution by bankruptcy commissioners out of Article III, giving Congress the discretion, within those historical boundaries, to provide for their resolution outside of Article III courts.”

The Supreme Court has attempted for many years to force bankruptcy courts to fit within the permissible parameters for courts created under Article I – territorial courts, military tribunals, and courts created to hear cases involving public rights – but that effort appears to have run its course and has led to uncertainty and confusion. Judge Jordan’s opinion indicates that the Third Circuit believes that the Supreme Court is in the process of abandoning its efforts to apply “public rights” jurisprudence to the specialized system of bankruptcy courts created by Congress, and is on course instead to recognize such courts as a fourth category of exception to Article III courts.

Millennium is now binding precedent in the Third Circuit. It will likely be interpreted broadly by the judges in the District of Delaware, one of the most influential bankruptcy districts in the country, and be viewed as persuasive authority by judges elsewhere. With a plethora of “private rights” litigation in bankruptcy cases on the immediate horizon, the reasoning of Millennium, if ultimately adopted by the Supreme Court, will place bankruptcy courts’ ability to make final rulings in such matters on firmer constitutional footing, and end much of the uncertainty and needless litigation over bankruptcy judges’ authority.


Last week, the Coronavirus Aid, Relief, and Economic Security (CARES) Act was signed into law, implementing broad relief for individuals and businesses affected by COVID-19.  One of the sections of the CARES Act receiving less attention is a temporary amendment to the Bankruptcy Code to provide streamlined reorganization procedures for businesses with debt of less than $7.5 million. 

In February 2020, President Trump signed into law the Small Business Reorganization Act (SBRA) designed to decrease the cost and complexity of reorganization for small businesses with debt of less than $2,725,625.  The SBRA allows these smaller businesses to confirm a plan without the need for a disclosure statement and owners to retain their business without providing new value under the plan.  In an SBRA bankruptcy, an unsecured creditors’ committee will generally not be formed, and each case will have a trustee who can assist the debtor in negotiating a plan and administering plan payments. 

For the next year, the CARES Act expands eligibility for the SBRA by increasing the debt limit under the SBRA from $2,725,625 to $7.5 million.  This increase temporarily opens the door to streamlined chapter 11 tools to assist larger businesses than originally contemplated facing unprecedented challenges during this time.  

We expect additional changes to the Bankruptcy Code will be enacted to address the economic fallout from COVID-19.  At Kelley Drye, we have a team of legal advisors across practices and geographies collaborating to help clients navigate this uncertain environment.  We invite you to access the Kelley Drye COVID-19 Resource Center for information and webinars on these rapidly evolving circumstances.

As the nation hunkers down to combat the novel coronavirus (COVID-19), bankruptcy courts throughout the country have moved quickly to implement procedures to preserve access to the courts while limiting in-person interaction during the crisis.  Each court’s specific COVID-19 procedures are different, but they largely prohibit in-person hearings, recognize the need for flexibility and adjournments for non-emergent matters whenever possible, and encourage the creative use of technology to allow as many matters to go forward as scheduled, including evidentiary hearings.  A schedule summarizing COVID-19 procedures adopted in various jurisdictions can be accessed HERE.  We expect regular amendments as the crisis unfolds and the economic fallout increases the volume of cases requiring bankruptcy court intervention.

Please do not hesitate to reach out to the Kelley Drye bankruptcy team with any questions or for any assistance during this time.  For additional up-to-date information about the potential legal and business implications of the evolving coronavirus pandemic and the latest advisories and legal updates on COVID-19 we invite you to visit Kelley Drye’s COVID-19 Resource Center website.

Social distancing.  Elbow bumps.  Flatten the curve.  These are the new phrases and behaviors we have learned to avoid exposure to the novel coronavirus (COVID-19).  This epic struggle forces us to reexamine and reevaluate our daily habits, lifestyles and customs as we work collectively to minimize the harm to our families, friends and neighbors throughout the United States.  While some of the lifestyle changes and limitations will be temporary, the human and economic effects of COVID-19 will be profound and, as always, the disruption undoubtedly will lead to increased innovation and societal change.

In the restructuring arena, many effects are direct and foreseeable.  Workers and businesses in the travel, restaurant, retail, hospitality and gaming industries will be immediately and severely challenged as their customers choose or are forced to stay home. The Centre for Aviation reports that without a significant government bailout, several major airlines will be bankrupt by mid-May.  Government mandated shopping center and restaurant closures will exacerbate the already severe challenges facing the retail industry, and disruptions in the global supply chain create inventory pressures for retailers and manufacturers alike.  And, as employees suffer reductions in the work-force, reduced income, medical debt and stock market losses, discretionary spending will decrease.  Regardless of whether you were bullish or bearish on 2020 last week, the financial impact of COVID-19 will be real and undeniable.

Continue Reading A Season of Viral Disruption

U.S. Bankruptcy Judge Dennis Montali recently ruled in the Chapter 11 case of Pacific Gas & Electric (“PG&E”) that the Federal Energy Regulatory Commission (“FERC”) has no jurisdiction to interfere with the ability of a bankrupt power utility company to reject power purchase agreements (“PPAs”). Although this question has divided courts which have considered it, Judge Montali made clear that he would not allow FERC to limit either PG&E’s rights under the U.S. Bankruptcy Code, or his own power to oversee PG&E’s bankruptcy case. (Kelley Drye & Warren LLP represents certain creditors in the PG&E case but took no part in the issues discussed here.)

The U.S. Bankruptcy Code provides an enterprise that is seeking to reorganize under chapter 11 with a number of tools to rehabilitate its business prospects. One of the most important is the ability, under Section 365, to reject burdensome executory contracts. An executory contract is generally considered to be any contract of the debtor for which there are material obligations to be performed by both parties. In considering a debtor’s request to reject a contract, courts typically defer to the debtor’s “reasonable business judgment” as to whether rejection would be in the best interest of its creditors and its bankruptcy estate — a very low standard to meet. The rejection of such a contract frees the debtor from any ongoing obligations under the contract, and is deemed to be a breach of such contract as of immediately prior to the filing of the bankruptcy petition. The non-debtor party to the contract is afforded a claim for damages arising from the breach, which is treated in the bankruptcy case as a general unsecured claim.

In the bankruptcy cases of power utility companies such as PG&E, the question of whether the debtor can reject its PPAs has become a crucial issue. PPAs are unquestionably executory in nature. Due to the volatile nature of power pricing, such agreements can often be significantly burdensome for the debtor. It would therefore appear that PPAs can readily be rejected by utility companies in bankruptcy.

Nevertheless, there is a significant split among courts on this issue. Some courts have determined that power utility companies do not have the unfettered ability to reject PPAs, under the rationale that, because the purchase and sale of energy for distribution to consumers “is affected with a public interest,” the Federal Power Act (“FPA”) requires the approval of FERC before a PPA can be terminated in a bankruptcy proceeding.

The dispute in the PG&E case arose last January when PG&E disclosed that it intended to file for protection under Chapter 11 of the Bankruptcy Code due to its potential massive liabilities for wildfire damage claims in California. PG&E is party to numerous PPAs for electricity generated by alternative sources such as solar and wind. The price for such energy sources has dropped considerably in the last few years. Two of PG&E’s power suppliers, anticipating that PG&E could want to extricate itself from having to pay above-market rates, petitioned FERC to rule that PG&E could only reject PPAs with FERC’s consent. In response, FERC issued a decision stating that it had “concurrent jurisdiction” with the bankruptcy court “to review and address the disposition of [PPAs] sought to be rejected through bankruptcy.” PG&E, immediately after filing its Chapter 11 petition, commenced an adversary proceeding in the bankruptcy case, seeking a declaratory judgment that the bankruptcy court has exclusive jurisdiction over this question.

Judge Montali noted the “unsettled” law regarding the rejection of PPAs in bankruptcy. Some courts have looked at the “filed rate doctrine,” which is FERC’s mandate under the FPA to certify contract rates for electricity as “just and reasonable,” and have determined that FERC has authority over PPAs in bankruptcy. In the chapter 11 case of NRG Energy, for example, a district court judge in New York ruled that FERC retained its regulatory authority over the debtor’s PPAs notwithstanding the bankruptcy filing, and that the FPA required deference to FERC. A few years later, in the chapter 11 case of Calpine Corp., another New York district court judge concluded that Congress had granted FERC substantial authority over energy contracts and found no evidence that it intended for the Bankruptcy Code to supersede such authority.

Judge Montali, however, dismissed the argument that FERC’s authority with respect to energy contract prices provided it with jurisdiction over the rejection of such contracts in a chapter 11 case. His starting point in the jurisdictional analysis was Section 1334(a) of the U.S. Judicial Code, which provides federal district courts (and by extension bankruptcy courts) with “exclusive” jurisdiction over all bankruptcy cases.

He observed that “[n]othing in the FPA or the Bankruptcy Code grants FERC concurrent jurisdiction with this court over Section 365 motions to reject executory contracts covering federal power matters. The issue here is Section 365 and not any of the permutations and applications of the filed rate doctrine.” He held that the matter before him did not arise under the FPA and he was not reviewing any decision by FERC regarding energy prices; instead he was considering only whether PG&E, a debtor in a Chapter 11 case, could exercise a statutory right to reject, i.e., effectively breach, a contract. He therefore determined that “[t]he rejection of an executory contract is solely within the power of the bankruptcy court, a core matter exclusively this court’s responsibility.”

Judge Montali agreed with the reasoning of the Fifth Circuit, the only circuit Court of Appeals that has considered the issue. In the case of Mirant Corp., the Fifth Circuit found no conflict between the FPA and Bankruptcy Code. The court determined that FERC’s authority under the FPA deals only with energy prices, and that a bankruptcy court’s decision to permit rejection of a PPA therefore does not interfere with such authority. Judge Montali also cited a recent decision in the FirstEnergy chapter 11 case in Ohio, which followed the Fifth Circuit in ruling that there is no inherent conflict between FERC’s jurisdiction under the FPA and the authority of a bankruptcy court to permit the rejection of a PPA under the Bankruptcy Code.

Judge Montali viewed FERC’s assertion of “concurrent jurisdiction” over PPAs as an improper encroachment by an executive branch agency on the authority of United States bankruptcy courts. He concluded, “Section 365(a) and 28 U.S.C. § 1334, taken together, clearly lead to the inescapable conclusion that only the bankruptcy court can decide whether a motion to reject should be granted or denied, and under what standards.”

The ruling is heading to the Ninth Circuit following Judge Montali’s certification for a direct appeal. With the Sixth Circuit also now considering the FirstEnergy decision on appeal, it appears likely that this issue will be before the Supreme Court in the near future.