Weil Complex Commercial Litigation associate Eleanor Gilbane is author of the article “Investing in an Appeal,” published in the May 2013 issue of the American Bankruptcy Institute Journal.

The article focuses on appeals of confirmation orders and discusses the challenges facing appellants given the sizable bond requirement necessary to secure a stay and the risk of equitable mootness in the absence of a stay. Specifically, it discusses the appeal of the Adelphia confirmation years ago (Weil represented the appellants in that case) and compares it to the appeal of the Tribune confirmation order late last year.  It recommends that given these challenges, objectors to the confirmation order might be better served by negotiations and a settlement before the order is entered.

Please click here to read the full article.

As part of our efforts to bring you the latest information on restructuring and bankruptcy issues, we at the Bankruptcy Blog are rolling out a new series called “What We’re Watching.”  Once a month, we will preview to our readers the cases on appeal that we are monitoring.  We’ll be sure to post updates periodically with the latest developments on those appeals.  Below are some of the issues on appeal that have caught our eye this month:

Executive Benefits Agency

We’ve already covered the circuit split between the Sixth and Ninth Circuits as a result of the Stern v. Marshall decision.  Perhaps not surprisingly, petitions for certiorari were filed in both cases.  The petition in Waldman v. Stone, No. 12-933, 2013 WL 326585 (U.S. Jan. 24, 2013) was denied, but the petition for writ of certiorari in Exec. Benefits Ins. Agency v. Arkison, No. 12-1200, 2013 WL 1329527 (U.S. Apr. 3, 2013) is pending. As we’ve noted, in Executive Benefits Agency, the appellants seek review of whether bankruptcy courts (i) may issue final orders where they would otherwise lack such authority on the basis of the litigants’ consent (or implied consent) and (ii) have constitutional authority to enter a proposed findings of fact and conclusions of law in “core” matters, just as they are permitted to do in “non-core” matters.

Ames

On April 23, 2013, Cellmark Paper Incorporated filed a petition for writ of certiorari, styled as Cellmark Paper Inc. v. Ames Merchandising Corp. (In re Ames Dep’t Stores, Inc.), No. 12-1280, 2013 WL 1771080 (U.S.) (Apr. 23, 2013), to the Supreme Court of the United States asking for review of the Second Circuit’s decision in Cellmark Paper Inc. v. Ames Merchandising Corp. (In re Ames Dep’t Stores, Inc.).  Cellmark is asking the Supreme Court to decide, firstly, how much a payment must deviate from the parties’ historical payment practices to fall outside of the “ordinary course of business” exception found in section 547(c)(2)(B) of the Bankruptcy Code and, secondly, what standard of review should be applied when an appellate court reviews a bankruptcy court’s ruling that a payment was not made in the “ordinary course of business.”

Lyondell Chemical

On January 24, 2013, Route 21 Associates of Belleville, LLC, a creditor in Lyondell Chemical’s chapter 11 case, appealed an order of the United States District Court for the Southern District of New York, which affirmed an order of the United States Bankruptcy Court (Judge Gerber) denying Route 21’s motion for specific performance of a prepetition remediation agreement and denying Route 21’s administrative expense claim for prepetition and postpetition clean-up costs. The appeal, styled as Route 21 Associates of Belleville, LLC v. Millennium Custodial Trust (In re Lyondell Chemical Company), Case No. 13-230 (2d Cir. Jan. 24, 2013) is currently pending before the United States Court of Appeals for the Second Circuit.  Although there are many factual and legal issues on appeal, here are some of the ones we are watching:

• Are money damages a viable alternative to specific performance of the debtor’s obligations under a remediation agreement to clean up contamination on a property previously owned by the debtor?  The district court said yes.
• Is the ability to estimate damages the same as monetization, which equates to a right to payment under 11 U.S.C. § 101(5)(B)?  The district court said yes.
• Does the right to specific performance under an executory contract terminate once the executory contract is rejected?  The district court said yes.
• Did Route 21’s cleanup of the contaminated property benefit the debtor’s estate, which was liable for the contamination, even though the debtor no longer owned the property?  The district court said no and affirmed the bankruptcy court’s denial of Route 21’s administrative expense claim.

Regions Bank

On December 13, 2012, chapter 7 debtor Rafia N. Kahn filed an appeal (captioned Kahn v. Regions Bank, No. 12-6567 (6th Cir. Dec. 17, 2012)) with the United States Court of Appeals for the Sixth Circuit claiming that her prior appeal to the United States District Court for the Eastern District of Tennessee had been dismissed improperly for lack of standing.  At issue is what degree of financial stake an appellant must have in a bankruptcy court judgment to have standing to appeal and, more specifically, the circumstances under which an out-of-the-money chapter 7 debtor can appeal from a decision affecting claims against their estate.

Loop 76

In In re Loop 76, LLC, No. 12-60021 (9th Cir. Mar. 27, 2012), the appellant, Wells Fargo, is appealing a November 2012 decision issued by the Bankruptcy Appellate Panel for the Ninth Circuit, which we wrote about here in which the Ninth Circuit BAP held that a bankruptcy court may consider the existence of a third-party (non-debtor) source of recovery (a guarantee) when determining whether unsecured claims are “substantially similar” for purposes of plan classification under section 1122(a) of the Bankruptcy Code.

Despite a valiant effort by the United States Bankruptcy Court for the District of New Mexico to give the debtor the benefit of every conceivable doubt, the debtor in In re Deming Hospitality, LLC  was unable to obtain approval of its proposed disclosure statement over the objections of, among others, a junior lien holder.  The junior lien holder objected to approval of the debtor’s proposed disclosure statement on the grounds that the debtor’s proposed chapter 11 plan was “facially unconfirmable.” 

The debtor’s proposed plan provided the following classifications relevant to the junior lien holder’s objection:

• Class 2 Secured: Junior lien holder’s $1.5 million claim. 
  • Treatment:  Junior lien holder’s lien would be stripped, and its claim treated as wholly unsecured and reclassified as a class 7 unsecured claim.
• Class 5 Executory Contract:  Claim of franchisor under a licensing agreement. 
  • Treatment:  Debtor proposes to assume the contract and pay an agreed amount in satisfaction of the prepetition arrearage owed the franchisor.
• Class 6 General Unsecured Claims:
  • Treatment:  To be paid 75% of their claims 30 days after the effective date.
• Class 7 Deficiency Claim:  The junior lien holder’s deficiency claim.
  • Treatment:  To be paid $25,000 (1.67%) on its $1.5 million deficiency claim.
• Class 8 Equity Interest: 
  • Treatment:  Equity interests would retain their equity, in exchange for investing $150,000 of “new value” into the debtor.

Faced with such obviously disparate treatment, the junior lien holder raised various objections:

• the classification of its deficiency claim in a separate class from the general unsecured creditor class violated section 1122(a) of the Bankruptcy Code;
• the remarkably disparate treatment provided to the junior lien holder’s deficiency claim vis-à-vis other general unsecured constituted unfair discrimination under section 1129(b)(1) of the Bankruptcy Code;
•  the general unsecured claims, which totaled roughly $10,000 in the aggregate, were artificially impaired to manufacture a consenting impaired class;
• the executory contract holder has no “claim” against the estate and should not be entitled to vote; and
• the plan violated the absolute priority rule reflected in section 1129(b)(2)(B)(ii) of the Bankruptcy Code despite the purported “new value” contributed by equity. 

The bankruptcy court evaluated each objection in turn and, although telegraphing that it found almost nothing about the proposed plan confirmable or proper, generally determined that it would defer consideration of all but one of the junior lien holder’s objections until confimation.  The one objection on which it ruled, however, sunk the debtor’s plan at the disclosure statement phase.

With regard to the section 1122(a) based objection, the court summarized the case law on the subsection as prohibiting “a debtor from separately classifying similar claims to ‘gerrymander’ a consenting class.”  The court stated that it would “place the burden on the plan proponent to justify any separate classification of substantially similar claims,” but that the debtor should be afforded the opportunity to satisfy that burden.  Thus, the Court held that, although the junior lien holder’s claim “could well” have been classified separately to gerrymander the vote, “the court [would] not rule on the issue until the debtor was given the opportunity to present evidence to explain its classification scheme.”

The court reached a similar conclusion in regard to the allegedly unfairly disparate treatment of the junior lien holder’s deficiency claim versus the treatment of the claims of the general unsecured creditors – 1.67% payment for the deficiency claim versus 75% payment for the general unsecured claims.  After surveying the caselaw and finding the reasonable basis test favored in certain districts too vague and the rebuttable presumption standard favored in other districts too restrictive, the court settled on an in-between standard based on what it found to be the one agreed upon standard in every jurisdiction: that “if the treatment of substantially similar claims” is “grossly disparate,” plan proponents face an uphill battle in demonstrating that the disparate treatment is the result of “fair discrimination.”  The court stated that, although the treatment of the claims in the present case clearly resulted in a “gross disparity,” the proposed plan, nonetheless, was not unconfirmable on its face because the debtor might be able to carry the “heavy burden” of justifying the disparate treatment as fair. 

The court continued that theme with its evaluation of the debtor’s alleged artificial impairment of the general unsecured claims, holding that the debtor “should be given a chance to present evidence to explain the reason for” returning only 75% of the general unsecured claims aggregate claims of roughly $10,000 in the face of a “new value” contribution by equity of $150,000 that clearly was enough to provide payment in full to the general unsecured creditor class. 

In considering the debtor’s unprecedented inclusion of a class for the franchisor’s assumed executory contract, the court determined that the debtor’s inclusion of such a class was a “harmless error” because “[s]o long as the Debtor and [the franchisor] understand that [the franchisor] may not vote,” the error could be corrected by a plan amendment or in a confirmation order. 

Although compliance with the absolute priority rule is also a confirmation issue, the bankruptcy court reached its limit in considering the debtor’s assertion that equity holders could retain their interests under the new value exception.  The debtor’s plan proposed to allow existing equity holders to retain their equity while providing a 1.67% recovery to the junior lien holder on the basis of a $150,000 infusion of “new capital.”  The debtor, however, had not set up a competitive bidding process or permitted the junior lien holder to credit bid its substantial claim.  The debtor argued that it was premature to consider the absolute priority rule at the disclosure statement hearing because the debtor “may still be able to convince [the junior lien holder] to vote in favor of the Plan, in which case no . . . auction would be required.”  Although the court had proved willing to defer consideration of other plan issues, the court found this argument to be the straw that broke the camel’s back.  Thus, the court held that, although the debtor’s contention was “theoretically true,” the junior lien holder’s “opposition to the current Plan [was] strong enough, and the Debtor’s treatment of [the junior lien holder’s] claim [was] harsh enough” that the debtor must comply with the market/competition requirements elucidated in the absolute priority rule caselaw before the court would allow it to proceed with the proposed disclosure statement.  Thus, the court sustained the junior lien holder’s objection and refused to approve the proposed disclosure statement.    

Deming demonstrates that courts will grant wide latitude to debtors at the disclosure statement stage to allow debtors to explain or resolve any potential defects or concerns during the plan confirmation process, but even the most lenient courts have their limits.

The third installment of our four-part series on the tax issues raised in United States v. Bond centers on the Prepetition 2001 Period.  As discussed in Part One, the debtors (collectively referred to as “PT-1” in this series) had filed a tax return for the Postpetition 2001 Period reporting and paying tax.  PT-1 later filed two late, unsigned tax returns:  one for the Prepetition 2001 Period reporting net losses and one covering all of 2001 (presumably showing a refund).  The IRS refused to accept both returns on the ground that PT-1 was part of the Star Group during the Prepetition 2001 Period and should have been included in the Star Group’s consolidated return.  Because the Star Group did not file a return for 2001, the IRS argued that it could not determine whether PT-1’s reported net losses for the Prepetition 2001 Period should have offset net income of the Star Group as required by the consolidated return rules (in which case such losses would not be available for carry forward to PT-1’s postpetition periods).  The liquidating trustee responded that the Star Group had been liquidated, and neither he nor PT-1 had access to its records.  The bankruptcy court ordered the IRS to accept PT-1’s tax return for the Prepetition 2001 Period and to pay a refund of approximately $3.8 million for the Postpetition 2001 Period based in part on losses carried forward from the Prepetition 2001 Period.

On appeal, the IRS argued that the Administrative Procedures Act did not provide a basis for the bankruptcy court to compel the IRS to accept PT-1’s Prepetition 2001 Period return.  Moreover, according to the IRS, the Tax Anti-Injunction Act proscribed the bankruptcy court from compelling the IRS to accept the return.  Even if jurisdiction existed, the IRS argued that it did not act arbitrarily and capriciously when it refused to accept the return, and thus the bankruptcy court’s order was improper.

The district court first addressed the Administrative Procedures Act, which provides for judicial review of the actions of administrative agencies, subject to certain exceptions set forth in the statute.  Specifically, judicial review applies “except to the extent that – (1) statutes preclude judicial review; or (2) agency action is committed to agency discretion by law.”  The IRS asserted that each of these exceptions applied, thereby precluding the bankruptcy court from compelling the IRS to accept the Prepetition 2001 Period return.  The district court cited the U.S. Supreme Court case Heckler v. Chaney, where the Supreme Court “describes the agency discretion exception to judicial review as applying to Congressional statutes drawn so broadly that they can be taken to have committed the decisionmaking to the agency’s judgment absolutely.”  The district court observed that the rule upon which the IRS relied in giving the IRS discretion over whether to accept the return is a regulation enacted by the Secretary of the Treasury, and not a statute as in Heckler, and thus concluded that the IRS could not, by its own regulation, insulate its decisions from judicial review unless the governing statute grants the IRS absolute discretion.  Turning to the governing provision of the Internal Revenue Code, which gives the Secretary of the Treasury authority to promulgate regulations governing the making of consolidated tax returns, the district court observed that the statute directed such regulations to provide that such returns “clearly [] reflect the income tax liability” of the consolidated tax group and its members.  Because the statute provided a standard against which the IRS’s actions could be judged, the district court concluded that the statute did not preclude judicial review.

The district court then turned to the Tax Anti-Injunction Act, which the IRS asserted as another reason why the bankruptcy court lacked jurisdiction to compel the IRS to accept PT-1’s Prepetition 2001 Period return.  The Act provides that, except for certain exceptions not relevant here, “no suit for the purpose of restraining the assessment or collection of any tax shall be maintained in any court by any person.”  Agreeing with the bankruptcy court’s reasoning, the district court held that the Tax Anti-Injunction Act does not apply because requiring the IRS’s acceptance of PT-1’s Prepetition 2001 Period return does not affect the IRS’s ability to collect taxes.  Instead, the liquidating trustee was attempting to obtain a refund of tax already paid for the Postpetition 2001 Period, and the net losses reported on the Prepetition 2001 Period return were a predicate to this refund.

Having found that the bankruptcy court had jurisdiction to consider whether the IRS exceeded its discretion, the district court agreed with the bankruptcy court’s conclusion that the IRS’s refusal to accept PT-1’s Prepetition 2001 Period return was arbitrary and capricious.  The district court stated that, among other reasons, the IRS could not refuse to accept the return based on the “remote possibility” that the Star Group would absorb PT-1’s losses for the Prepetition 2001 Period, particularly because the Star Group lost millions of dollars in 2000, filed for bankruptcy in 2001 and thus likely lost more money during the Prepetition 2001 Period.  As additional support for its holding that the IRS acted arbitrarily and capriciously, the district court noted that the Star Group did not file a return for 2001 and had since liquidated, the IRS withdrew its claim against the Star Group for Prepetition 2001 Period taxes in the Star Group bankruptcy, and, according to uncontradicted statements of the liquidating trustee’s counsel, two members of the IRS district counsel stated that the Star Group did not have any tax liability during the Prepetition 2001 Period.

For a further discussion of the issues raised in this Part, see Section 1013.3 of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2013 ed.).  Stay tuned for Part Four of our series, where we will focus on whether the bankruptcy court had jurisdiction to enjoin the IRS from its future exercise of setoff or recoupment rights against the liquidating trustee.

NORTH OF THE BORDER UPDATE

This article has been contributed to the blog by Mary Paterson and Patrick Riesterer. Mary Paterson is a senior associate in the litigation group of Osler, Hoskin & Harcourt LLP and Patrick Riesterer is an associate in the insolvency and restructuring group of Osler, Hoskin & Harcourt LLP.

In the ongoing Sino-Forest Corporation insolvency saga, the Ontario Superior Court of Justice approved: (i) a settlement of the class action against Ernst & Young LLP and (ii) a plan of compromise and arrangement in respect of Sino-Forest filed in the proceedings commenced by Sino-Forest under the Companies’ Creditors Arrangement Act. Among other things, the Plan provided Ernst &Young with a third party release of all claims against it in the Sino-Forest class action.

As explained in our previous post on the Sino-Forest proceedings, certain shareholders and noteholders of Sino-Forest commenced a class action in Ontario (and other jurisdictions) against Sino-Forest, Ernst &Young and a number of other entities. The plaintiffs alleged that Sino-Forest misrepresented its assets and financial situation, artificially inflating the price of Sino-Forest’s shares and notes. Ernst &Young’s potential liability related to its activities as Sino-Forest’s former auditor. Sino-Forest was subsequently granted protection under CCAA.

The Ad-Hoc Committee of Purchasers of the Applicant’s Securities (“Ad Hoc Committee”), representing the plaintiffs in the Class Action, brought a motion in the CCAA proceedings for approval of the settlement and approval of the Plan, including the third party release of Ernst & Young. The settlement created a fund of $117 million for distribution to the security holders of Sino-Forest and included a provision that prohibited any Security Holder from opting out of the settlement. The settlement was conditional on, among other things, the Plan containing the release of Ernst & Young.

A small number of the security holders objected to the approval of the settlement and the release. The objecting security holders argued that the Ontario Class Proceedings Act, 1992 requires class action settlements to permit class members to opt out of the settlement. In addition, the objecting security holders argued that the settlement and the release were not necessary for the success of or even related to the Sino-Forest’s restructuring plan.

The Court Approves the Settlement

The Court recognized that a class action settlement must ordinarily include an opt out provision: the right to opt out of a class action settlement is a fundamental element of procedural fairness in the Ontario class actions regime. 

However, the Court observed that it is not possible to ignore the CCAA proceedings when assessing whether or not the objecting security holders should have a right to opt out of the settlement. The Court noted that claims, including contingent claims such as class action claims, are regularly compromised and settled in the CCAA. Such compromises occur where (i) a majority of creditors representing two thirds in value of the claims against the estate vote in favour of a plan, and (ii) a court approves the plan as fair and reasonable. A creditor who has a claim that is compromised by a plan and who voted against the plan does not have a right to opt-out of the compromise. Instead, the compromise is imposed on such creditor despite the creditor’s objections. In the case of Sino-Forest, the Plan contemplated the settlement and had been approved by the requisite majority of creditors; it would therefore be contrary to the CCAA to permit the objecting security holders to opt out of the settlement.

The Court also Approves the Third Party Release

The Court also found that the third party release was reasonable in the circumstances. The Court explained that the CCAA contains a mechanism for the compromise, arrangement and release of claims against third parties where: (i) the release is rationally related to the purpose of the plan; (ii) the release is necessary for the plan; (iii) there is a tangible contribution to the plan by the released parties; (iv) the release is beneficial for both the debtor and the creditors generally; (v) the plan has been approved by creditors who have knowledge of the nature and effect of the release; and (vi) the release is fair and reasonable and not overly broad or offensive to public policy.

The Court found that the release exhibited all the elements necessary for court approval:

1. The release was rationally related to the purpose of the Plan because the Plan provided for a distribution to Sino-Forest’s creditors and the $117 million to be contributed by Ernst & Young pursuant to the settlement was the only identifiable value available to Sino-Forest’s creditors. 
2. The release was necessary for the Plan because the claims against Ernst & Young were inseparable from the claims against Sino-Forest (see our post on the equity claims). The claims of the Ad-Hoc Committee and the objecting security holders against Ernst & Young were also inseparable from their claims against Sino-Forest.  Furthermore, Ernst & Young had a claim for contribution and indemnity from Sino-Forest.
3. The release involved a tangible contribution to the Plan because the settlement and the release were inextricably intertwined and resulted in value to be distributed to creditors, the withdrawal of many objections to the Plan and the avoidance of protracted and uncertain litigation.
4. The release provided a benefit to the debtor and the creditors generally for all of the reasons set out above.
5. The release was part of a Plan that was approved by the requisite majority of creditors, all of whom had knowledge of the nature and effect of the release.
6. The release was fair and reasonable and not overly broad or offensive to public policy.

The Court therefore approved the settlement and the Plan containing the third party release of Ernst & Young.

 Implications

This decision shows the power of the CCAA in facilitating the settlement of all claims in respect of an insolvent enterprise, even where that settlement is in respect of third parties and requires the Court and parties to deviate from the legal regime that would ordinarily apply to such a settlement. Second, the decision sets out the factors governing whether or not the parties should take comfort from the Court’s willingness to grant releases to third parties who are making a tangible contribution to the restructuring plan put forward by an insolvent company.

The objecting security holders have since filed an appeal of the Court’s decision. We will keep you updated of any interesting developments on appeal.

The views and opinions expressed herein are exclusively the personal views of the guest contributors only, unless otherwise attributed.  Information and opinions expressed herein do not necessarily represent the views of Weil, its attorneys, or its clients. Please see the complete Disclaimer for additional terms and conditions of use of this blog.

CROSS-BORDER UPDATE

UK’s Supreme Court rules it a question of judgment and steers a U–turn from ‘Point of No Return’ analysis

UK’s Supreme Court has this week considered the application of the balance sheet test for insolvency in BNY Corporate Trustee Services Limited v Eurosail and others [2013] UKSC 28.  The decision is one of major and widespread significance. This is the first time that UK’s highest court has had to interpret the balance sheet test at S123(2) of the Insolvency Act 1986.  In doing so, the Supreme Court has also provided helpful confirmation of the correct approach to the interpretation of the cash-flow test for insolvency at S123(1)(e). 

The Supreme Court agreed with the conclusions of the High Court and the Court of Appeal that Eurosail, a special purpose securitisation vehicle which had issued loan notes by way of financing, was not balance sheet insolvent, but it did so based in part on slightly different reasoning from the lower courts.

Continue reading >>>

A debtor in a foreign insolvency proceeding may petition a United States bankruptcy court for recognition of the foreign proceeding under chapter  15 of the Bankruptcy Code, which provides certain relief similar to that provided to debtors in bankruptcy cases pending in the United States and its territories.  When a foreign debtor seeks such recognition of its bankruptcy proceeding, a U.S. court must determine the location of the foreign debtor’s “center of main interests” (COMI).  If the debtor’s COMI is located in the same jurisdiction where the insolvency proceeding is taking place, the proceeding is recognized as a “foreign main proceeding,” and certain sections of the Bankruptcy Code (such as the automatic stay set forth in section 362) will apply to the debtor and any of its property located in the United States.  If the debtor’s COMI is located in a different jurisdiction than where the insolvency proceeding is pending, the proceeding may be recognized as a “foreign nonmain proceeding.”  Under such circumstances, the bankruptcy court has discretion to grant the foreign debtor the protection of the automatic stay.

But what if a debtor’s COMI changes? What is the appropriate time period to analyze in determining the location of a debtor’s COMI?  Is it when the foreign proceeding was filed, or when the foreign representative files a chapter 15 petition for recognition?  This was precisely the question that the United States Court of Appeals for the Second Circuit considered in Morning Mist Holdings Ltd. v. Krys (In re Fairfield Sentry Ltd.).  The answer: the time of the filing of the chapter 15 petition, with an opportunity to look back in time, but only to ensure that a foreign debtor’s COMI is not being manipulated.  In reaching its conclusion, the Second Circuit embraced the Fifth Circuit’s reasoning from Lavie v. Ran (In re Ran), and rejected the reasoning of a decision from the Bankruptcy Court for the Southern District of New York—In re Millennium Global Emerging Credit Master Fund.  But because the bankruptcy court clearly found—and the Second Circuit agreed—Sentry’s COMI was located in the BVI when its liquidation commenced and when it filed its petition for recognition, the distinction between Ran and Millennium Global appears to be—in this case—of no consequence.

Background

Fairfield Sentry Limited was the largest of the so-called “feeder funds” of Bernard L. Madoff Investment Securities LLC.  Formed in 1990, Sentry was incorporated under the laws of the BVI, where it also had its registered office, agent, secretary, and corporate documents.  After the discovery of Madoff’s massive Ponzi scheme and his arrest in December 2008, Sentry’s independent directors began winding down its business and preserving its assets in anticipation of litigation and bankruptcy.  While the directors were located across the globe, much of the winding down process was centered in the BVI.  Sentry subsequently became “engulfed in lawsuits.”  One such lawsuit was filed by Morning Mist Holdings Ltd., a Sentry shareholder that filed a derivative suit against Sentry in New York state court in May 2009.

On July 21, 2009, the High Court of Justice of the Eastern Caribbean Supreme Court (the BVI Court) entered an order commencing liquidation proceedings of Sentry and appointing a BVI-based liquidator.  On June 14, 2010, almost a year after the commencement of the BVI-based liquidation proceeding, the liquidator petitioned the bankruptcy court for recognition of the BVI liquidation as a foreign main proceeding under chapter 15 of the Bankruptcy Code.  The liquidator asserted that Sentry’s COMI was located in the BVI.

Recognition of the BVI liquidation as a foreign main proceeding stayed, among others, Morning Mist’s derivative action in the US.  Consequently, Morning Mist appealed, arguing that determining COMI required consideration of the foreign debtor’s entire operational history. 

The Lower Courts’ Analysis

In determining Sentry’s COMI, the bankruptcy court examined the period between December 2008 (when Sentry stopped doing business), and June 2010 (when the liquidator filed the chapter 15 petition).  Concluding that Sentry’s COMI was in the BVI between December 2008 and the date the Sentry’s foreign representative sought recognition under Chapter 15, the bankruptcy court entered an order recognizing the BVI liquidation as a foreign main proceeding.  Citing and implicitly rejecting Ran, the bankruptcy court wrote, treating COMI “like a migrating concept that—roulette wheel-like—gets measured at the moment . . . the wheel stops . . . leaves the door open for an untoward gaming of the proceedings.”

Morning Mist appealed. On September 16, 2011, the United States District Court for the Southern District of New York affirmed the bankruptcy court’s order recognizing the BVI liquidation as a foreign main proceeding.  Again, Morning Mist appealed, arguing that “the bankruptcy court should have looked at Sentry’s entire operational history.”  The liquidator argued in favor of the lower courts’ determination of COMI with reference to the period between the commencement of Sentry’s liquidation and the date Sentry filed its chapter 15 petition. 

In favor of its doomed “operational history” argument, Morning Mist argued in favor of applying the Millennium Global decision’s flexible approach to determining COMI, discussed below.  Morning Mist argued such an approach would warrant consideration of Sentry’s entire operational history.  The Second Circuit disagreed and held that the so-called “wheel” stops when a debtor files its chapter 15 petition for recognition.

The Second Circuit’s Decision

In identifying the relevant time period, the court implicitly rejected Morning Mist’s argument that the debtor’s “entire operational history” should be considered for purposes of a COMI determination, narrowing the analysis to a choice between the date of the filing of the foreign insolvency proceeding and the date on which chapter 15 recognition is sought.  In rendering its decision, the court considered the text of section 1517 of the Bankruptcy Code, the decisions of other courts—most notably Ran (decided by the Fifth Circuit Court of Appeals) and Millennium Global (previously decided by the bankruptcy court), and the decisions of foreign courts interpreting chapter 15.

The court began its analysis by stating that the Bankruptcy Code’s use of the present tense in section 1517(b) of the Bankruptcy Code strongly suggested that the relevant date for determining COMI was the date the petition for recognition is filed.  The Bankruptcy Code allows a court to recognize a foreign proceeding as a foreign main proceeding “if it is pending in the country where the debtor has the center of its main interests.  11 U.S.C. § 1517(b) (emphasis added).  This factor eventually proved decisive.

Ran involved an individual who accumulated debt in Israel, where an insolvency proceeding was initiated, who later established residence in Texas.  When the foreign representative filed a petition for recognition—some ten years after the debtor relocated—the court concluded that the debtor’s COMI was in the United States.  The Fifth Circuit in Ran held that section 1517 requires courts to determine COMI as of “the time the petition for recognition was filed.”  As a consequence, the foreign representative was barred “from obtaining any relief before any court in the United States, no matter what the nature of Ran’s derelictions in Israel.”

In Millennium Global, two Bermuda investment funds were liquidated after they encountered financial difficulty.  Approximately three years after the commencement of foreign liquidation, the liquidator filed a chapter 15 petition in the United States Bankruptcy Court for the Southern District of New York.  The bankruptcy court in Millennium – specifically disagreeing with Ran—held that COMI should be determined as of the commencement of the liquidation.  In support of its conclusion, the bankruptcy court wrote that “reference to the commencement date of the insolvency proceeding for which recognition is sought does not invite a ‘meandering’ inquiry” as the Ran court suggested.  Rather, using the date of the commencement of the liquidation of the foreign debtor “avoids the use of chapter 15 as a shield by absconding debtors,” and such a date will ensure that a debtor’s COMI is truly ascertainable by third parties.

The Second Circuit disagreed with the Millennium Global court’s reasoning.  It held that “a debtor’s COMI should be determined based on its activities at or around the time the Chapter 15 petition is filed, as the statutory text suggests.”  The court did qualify its holding, however, by writing that “a court may consider the period between the commencement of the foreign insolvency proceeding and the filing of the Chapter 15 petition to ensure that a debtor has not manipulated its COMI in bad faith.”

Recognition is Not Contrary to U.S. Public Policy

The court also quickly dismissed the argument made by Morning Mist that the, because the proceedings in the BVI liquidation were sealed, recognition of the proceeding would be contrary to U.S. public policy.  “Important as public access to court documents may be, it is not an exceptional and fundamental value.”  Accordingly, the court found “no basis on which to hold that recognition of the BVI liquidation is manifestly contrary to U.S. public policy.”

Conclusion

The Second Circuit’s decision provides guidance to courts that need to determine the location of a foreign debtor’s COMI.  In this particular case, the rules advocated by either the Ran or the Millennium Global courts would have led to the same result.  While not outcome determinative in this case, in other cases, the Second Circuit’s decision may ultimately affect the scope of relief available under the Bankruptcy Code to a foreign debtor.

Asset sales are commonplace in the restructuring industry.  Numerous cases and articles have been written of the “363 sale” process that takes place under the Bankruptcy Code.  The assets of current and former household names such as Lehman Brothers, General Motors, Chrysler, and Blockbuster have all changed hands through that mechanism.  Although it garners less attention in academia and in the media, creditors of financially distressed entities may also force asset sales pursuant to Article 9 of the Uniform Commercial Code.  Perhaps because most secured creditors find themselves dealing with a chapter 11 case before they can exercise their remedies under Article 9, the law is less developed on the appropriate procedures for conducting an Article 9 sale.

Under Article 9 of the UCC, a secured creditor’s remedies include a sale of its collateral.  As with a sale under section 363 of the Bankruptcy Code, the secured lender may choose to credit bid in connection with a sale of its collateral and thereby become the owner of the collateral.  Section 9-610 of the UCC, however, requires that any disposition of the lender’s collateral be conducted in a “commercially reasonable” manner.  Because, unlike a 363 sale, an Article 9 sale does not require judicial oversight, questions of process and price are examined after the fact.  The recent Court of Chancery of Delaware decision in Edgewater Growth Capital Partners LP v. H.I.G. Capital, Inc. provides a detailed analysis of what satisfies the “commercially reasonable” standard of an Article 9 sale; in the process, it discusses the issues of process and price that lurk in the context of any distressed transaction.

The Article 9 Sale Process (abridged)

Except under limited circumstances that permit a creditor to accept a debtor’s collateral in full satisfaction of a debt, after default, a secured creditor must conduct an asset sale to recover value from the collateral.

Under UCC 9-610, “[e]very aspect” of such sale, “including the method, manner, time, place, and other terms, must be commercially reasonable.”  A commercially reasonable sale includes one conducted “in conformity with reasonable commercial practices among dealers in the type of property” being sold.

A UCC sale must be “public” unless “the collateral is of a kind that is customarily sold on a recognized market or the subject of widely distributed standard price quotations,” in which case a private sale is permitted.  A “public” sale means “the public has had a meaningful opportunity for competitive bidding,” and a meaningful opportunity implies “that some form of advertisement or public notice” precedes the sale and that the public has “access to the sale.”

Although the official comments to the UCC provide guidance as to key terms such as “public” and “meaningful opportunity,” and the UCC has an entire section dedicated to “commercially reasonable,” it is unsurprising that squabbles over such terms make their way into courtrooms; Edgewater is one such example.

The Pendum Sale

Edgewater, a private equity fund, purchased and consolidated several businesses that provided services related to the operation of ATMs.  The resulting consolidated company became Pendum.  The companies were acquired with “a relatively small equity check,” approximately $70 million in senior debt, and “millions more” in subordinated debt.  The senior debt held a lien on substantially all of Pendum’s assets.

The consolidation proved to be somewhat unsuccessful: the company fell short of expectations and began to trip numerous performance related financial covenants on the debt.  After each default on the senior debt, the company and its senior lenders executed an amendment to the credit agreement.  After seven such occurrences of default and subsequent amendments of the credit agreement, HIG Capital, previously uninvolved with the company, began purchasing the company’s senior debt.  As a condition to a ninth amendment of the credit agreement, HIG required that Edgewater-appointed directors be replaced by “experienced restructuring consultants.”

In anticipation of another default, the lenders and the company were faced with three options: (i) bankruptcy, (ii) an out-of court restructuring, or (iii) an Article 9 sale.  Because a bankruptcy would have been “a disastrous route to take” and the company could not unite the lenders to orchestrate an out-of-court restructuring, the Pendum board and the senior lenders, led by HIG, negotiated a consensual Article 9 sale of all the assets of Pendum.

Pursuant to a sale agreement, Pendum hired a financial advisor, Miller Buckfire, to find a buyer for Pendum’s assets.  Miller Buckfire conducted a “comprehensive” marketing process, but was unable to secure a buyer.  Without having found a buyer by an agreed upon deadline, HIG commenced a public disposition of its collateral under Article 9.  HIG sent notice of the auction to Edgewater, the other senior lenders, Allied Capital (the only subordinated lender), and the “potential buyers” that had been identified by Miller Buckfire.  HIG also published notice of the auction in The Wall Street Journal.  On the day of the auction, HIG was the only party that showed up and bid, and so, HIG purchased Pendum’s assets.

Edgewater, Pendum’s shareholder, filed a suit against HIG to challenge the sale.  Edgewater’s primary goal was to avoid payment of a $4 million guaranty it made to Pendum’s senior lenders as a condition the third amendment to the credit agreement.  Edgewater first argued that the sale was not a public sale.  Edgewater also contended that, even if the sale was public, it had not been conducted in a commercially reasonable manner.

Public v. Private Sale

Under the credit agreement, senior creditors had the right to exercise their Article 9 remedies with 10 days’ notice.  The sale agreement, however, allowed Pendum to take the first shot at selling the senior lenders’ collateral by hiring an investment bank and taking control of the sale process.  Edgewater argued that the sale “must have been private” because Pendum’s assets were sold pursuant to the sale agreement, which was negotiated privately between Pendum’s board and HIG.  The fact that the assets were publicly sold pursuant to a privately negotiated agreement did not make the sale itself public.  As the court noted, the sale agreement did not convert the lenders’ subsequent Article 9 sale into a private sale:

If a court deemed a sale ‘private’ whenever a debtor-company negotiated substantial contractual concessions from the foreclosing party in order to give the debtor more of a chance to find another buyer, but the secured lender ends up buying it, it would create counterproductive incentives for secured creditors exercising their rights under the Uniform Commercial Code to the detriment of debtors.

The court emphasized that through Miller Buckfire, Pendum was able to “vigorously market” itself.  Failure to consider the use of an independent financial advisor, the could observed, would have “perverse results.”

Commercially Reasonable

Reasonableness in the UCC sale context is analyzed through the lens of the type of property being sold.  Just as a reasonable sale of real property would logically involve substantially different efforts than the sale of a pre-owned guitar, the court found that what is reasonable in the sale of a healthy company is not the same as in the sale of a distressed company.  As the court noted, “the analysis turns on whether HIG sold Pendum’s assets in conformity with the practices of a financial advisor who sells distressed entities.”  The court further emphasized,

A distressed — nay, in this case, basically insolvent — going concern must be sold in a commercially reasonable process that takes into account the stark reality of the company’s economic facts, not based on a false assumption that the foreclosing party must prop up the failing entity for the lengthy period that a very healthy going concern could use to test the market.

The court discussed numerous efforts that HIG undertook to ensure that the transaction was reasonable.  Among them were HIG’s (i) provision of $10 million in interim financing to continue operating during the sale process, (ii) direct payment of Pendum’s financial advisor, and (iii) a “fiduciary out” allowing the board to consider superior transactions after the sale deadline.  All-in-all, the sale process lasted 55 days and involved discussions with 67 potential buyers.

The court also discussed the reasonableness of the price paid for Pendum’s assets, finding that “the possibility of obtaining a higher price is ‘no preclusion of commercial reasonableness.’”  Again, the court held that the sale price must be examined in the context of the company’s distress.

Takeaway

The court held that the sale was commercially reasonable in all aspects.  Instead of an unreasonable sale process, “it was Pendum’s less than reliable financial reporting, operational mess, poor revenue stream, and distressed situation . . . that scared bidders away.”  The case provides helpful guidance on somewhat ambiguous terms in the UCC and reminds us that sales in the distressed context are a unique creature.  A distressed company on the auction block is often described as a “melting ice cube”: cash, goodwill, and operational capability tend to deteriorate at an increasingly rapid rate.  Under Edgewater, a seller of such entities may consider this deterioration in conducting the sale.

Our loyal readers might recall that on Tax Day, we published the first installment of our four-part series on United States v. Bond, a decision from the United States District Court for the Eastern District of New York, which examines actions for federal income tax refunds sought by three affiliated telecommunications entities (collectively referred to in this series as “PT-1”). In this installment, we examine the court’s discussion of whether sections 106(a) and 106(b) of the Bankruptcy Code had waived the sovereign immunity of the Internal Revenue Service with regard to tax refund actions filed by the trustee of the liquidating trust that succeeded to PT-1’s assets. In our third installment, we will discuss whether the bankruptcy court had jurisdiction to compel the IRS to accept a tax return filed by PT-1. Finally, our fourth installment will focus on whether the bankruptcy court had jurisdiction to enjoin the IRS from its future exercise of setoff or recoupment rights against the trustee.

Waiver of Sovereign Immunity

Faced with the issue of whether sovereign immunity had been waived concerning tax refund actions filed by the liquidating trustee, the bankruptcy court ruled that it was and relied on both section 106(a) and section 106(b). The district court agreed that section 106(a) applied (although for somewhat different reasons), but disagreed that section 106(b) applied.

The district court observed that section 106 of the Bankruptcy Code is a statute that expressly waives sovereign immunity “both with respect to proceedings under various provisions of the Bankruptcy Code [citing subsection (a)] and for claims that are property of the estate and arise out of the same transaction or occurrence as a proof of claim filed by a Governmental unit in the bankruptcy proceeding [citing subsection (b)].” The court then analyzed the decision of the bankruptcy court and the arguments of the liquidating trustee and the IRS regarding subsections (a) and (b) of section 106.

Regarding section 106(a), the bankruptcy court had held that the tax issues before it fell under section 505(a) of the Bankruptcy Code, one of the sections enumerated in section 106(a), which therefore waived sovereign immunity with respect to such tax issues. (We discussed section 505(a) in our February “Breaking the Code” entry, which you can find here.)

On appeal, the IRS argued that section 505(a)(2)(B), which limits the bankruptcy court’s authority to rule on tax refund actions until the earlier of 120 days after the trustee properly requests such refund from the government or an adverse determination of such request by the government, precludes the bankruptcy court from ruling on actions that are brought on behalf of a liquidating trust (because it is not a bankruptcy estate contemplated by the section) and by a liquidating trustee (because it is not a bankruptcy trustee contemplated by the section). The district court rejected both arguments, finding that (i) PT-1’s chapter 11 plan provided that actions belonging to the debtors would be transferred to the liquidating trust, (ii) the liquidating trustee represented the remainder of the estate in such actions pursuant to section 1123(b)(3)(B), and (iii) section 505(a)(2)(B) does not limit the court’s authority to adjudicate tax disputes solely to those brought by bankruptcy trustees. Rather, the district court concluded that section 505(a)(2)(B) is a “timing and exhaustion of remedies provision” and observed that every decision cited by the parties on this point rejected the IRS’s narrow reading of the section.

The IRS also argued that by not properly filing a refund request with the IRS prior to filing its tax refund actions for the Postpetition 2001 Period in the bankruptcy court, the liquidating trustee failed to comply with section 505(a)(2)(B). The trustee had filed such request with the IRS only after bringing the refund action. Section 7422(a) of Title 26 of the United States Code, which courts have construed to be incorporated in the phrase “properly filed,” requires the filing of a claim for refund or credit with the IRS prior to maintaining a suit or proceeding for the recovery of a federal tax refund. The bankruptcy court, relying upon a line of cases and legislative history, had held that this requirement does not apply to a refund suit filed as a counterclaim in a bankruptcy case. The district court disagreed, viewing the language of section 505(a)(2)(B) as unequivocal in not providing any such exception. Nevertheless, the district court observed that section 505(a)(2)(B) merely states that the bankruptcy court “may not so determine” a tax refund action before a request for refund has been filed with the government, and that 26 U.S.C. § 7422(a) merely provides that no suit “may be maintained” until such request has been filed. Relying upon the statutes’ use of the words “determine” and “maintained” rather than use of language prohibiting the filing of a suit, the district court held that the trustee’s failure to comply with section 505(a)(2)(B) was not an absolute jurisdictional bar, that his subsequent filing of the refund request with the IRS was sufficient to exhaust administrative remedies, and that his attachment of this administrative request to his motion for summary judgment amounted to an amendment of or supplement to his initial pleading, thus curing the defect.

Regarding section 106(b) of the Bankruptcy Code, the bankruptcy court had held that the IRS, by filing a claim against PT-1 for unpaid taxes and penalties for the Postpetition 2001 Period, waived its sovereign immunity. Section 106(b) waives sovereign immunity for counterclaims arising out of the same transaction or occurrence as the claim set forth in the government’s proof of claim. The district court agreed with the IRS that the IRS’s assertion of administrative expenses (as opposed to prepetition claims, all of which were withdrawn by the IRS six months after filing) did not waive sovereign immunity under section 106(b) because the section refers to proofs of claim, which are filed by “creditors” under section 501 of the Bankruptcy Code. Because “creditors” are defined in section 101(10) of the Bankruptcy Code as entities with claims arising prepetition (subject to certain exceptions not relevant here), the district court held that requests for administrative expenses could not serve as a predicate for a waiver of sovereign immunity under section 106(b).

For a further discussion of sections 106 and 505(a), see Sections 1005.1 and 1013, respectively, of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2013 ed.). In the meantime, stay tuned for the third installment of our four-part series on United States v. Bond.

As we have written in prior posts (see here, here, here, here, and here), the arbitrability of disputes in bankruptcy is still largely uncharted territory when the disputes involve consideration of bankruptcy and non-bankruptcy issues.  Every freshly published case that tackles the topic is a valuable nugget that sheds light on the judicial analysis leading to the grant or denial of arbitration in cases pending before bankruptcy courts.  What appears to be clear, though, is that without an agreement to arbitrate, “there is no obligation to arbitrate.”  This is the recent holding of Judge Gross of the United States Bankruptcy Court for the District of Delaware.  The decision is straightforward and sensible.  It stands to reason that when prompted with the same issue in the future, courts may very well choose to follow the decision.

Background

The Nortel group of companies comprised a massive telecommunications conglomerate.  At the height of the “dot com bubble,” Nortel employed nearly 93,000 and reported annual revenues of $30 billion.  After a series of setbacks and accounting irregularities related to the subsequent “burst” of the bubble, Nortel spent nearly a decade attempting to return its operations to success.  Such attempts were not fruitful, and in 2009, Nortel Networks, Inc., the United States subsidiary of Canadian Nortel Networks Corporation, filed for bankruptcy protection.  Nortel Canada filed similar proceedings in Canada, and a major group of approximately 20 European subsidiaries were placed into joint administration in the United Kingdom.  Being one of the most significant multinational bankruptcies of the 21st century, the Nortel cases continue to raise novel cross-border insolvency issues.

This matter revolves around a dispute between the debtors in the United States and Canada on one side, and the debtors in Europe on the other.  Nortel U.S. and Nortel Canada sold nearly all of their businesses and intellectual property, leading to sales proceeds just shy of $9 billion.  As Judge Gross described, this created a “stickey wicket.”  With numerous debtors around the world competing for their share of the sales proceeds, an agreement providing for allocation of such proceeds was necessary.  To address the issue, the Nortel debtors in the United States, Canada, and Europe entered into, and courts overseeing their respective cases approved, an Interim Funding and Settlement Agreement.  The settlement agreement provided, among other things, that

1. sales proceeds would be placed into an escrow account;
2. the numerous Nortel debtors would then agree upon a protocol for resolving disputes regarding the allocation of proceeds; and
3. any disputes arising under the settlement agreement would be decided in a joint hearing of U.S. and Canadian bankruptcy courts.

The Nortel debtors could not agree upon a protocol to resolve disputes regarding the allocation of proceeds, which led to the instant cases. The U.S. debtors filed motions with both the U.S. and Canadian bankruptcy courts to establish a timeline and protocol for joint hearings to determine the allocation of sale proceeds.  This motion outlined procedures for the U.S. and Canadian bankruptcy courts to determine the allocations jointly.  The European debtors opposed the motion in the U.S. proceedings, arguing that the settlement agreement contained an implicit and enforceable agreement to arbitrate.  The European debtors also argued that the U.S. and Canadian bankruptcy courts lacked jurisdiction to allocate the proceeds, but the court found “beyond cavil” that they had submitted to such jurisdiction under the plain language of the settlement agreement.

Agreement to Arbitrate?

The issue before the U.S. bankruptcy court was whether there was an agreement to arbitrate sales proceeds allocation disputes.  The joint administrators for certain European Nortel debtors argued that the settlement agreement reflects that all parties agreed to arbitrate and that “arbitration is the only practical and efficient procedure.”  Although the words “arbitrator” or “arbitrators” appear nowhere in the settlement agreement, the joint administrators argued that the language of the agreement evidenced the intent to submit the allocation disputes to arbitration.

The court held that the settlement agreement was unambiguous on its face and evidenced no agreement to arbitrate.  The court’s holding accordingly read something like a 1L contracts case, discussing standard principles of contract formation and the admissibility of extrinsic evidence.  Addressing the particularities of agreements to arbitrate, the court acknowledged the public policy in favor of arbitration.  At the same time, Judge Gross noted, “[W]hile courts favor enforcing arbitration provisions that exist, courts are not predisposed to find parties agreed to arbitration.”  Among the factors considered in the court’s holding was that the parties were represented by sophisticated counsel.  Thus, they were capable of drafting an express arbitration clause if their intent was to arbitrate.

Fitting Nortel into the Bankruptcy and Arbitration Rubric

In our earlier posts, we discussed a framework outlining how courts generally analyze arbitration in bankruptcy (see here).  We have not, however, addressed the first step of any bankruptcy and arbitration analysis, which is whether an agreement to arbitrate exists in the first place.  The Nortel court’s analysis was complete without any inquiry into conflict between arbitration and the Bankruptcy Code.  And although the takeaway may be rather simple, it is worth repeating: notwithstanding the public policy in favor of arbitration, courts will not compel arbitration in the absence of a clear, valid, and binding agreement.