America Now! What’s New on the Other Side of the Pond?

INTRODUCTION:

The most important new development in U.S. bankruptcy law and practice from the transnational perspective is the enactment in 2005 of new Chapter 15 of the Bankruptcy Code.  Chapter 15 is based on the UNCITRAL Model Law on Cross-Border Insolvency and provides for greater co-ordination and co-operation in cross-border bankruptcy proceedings.  Included in the materials for our panel is an overview of Chapter 15 that provides a summary of the new rules and procedures.  These materials supplement the Chapter 15 overview and highlight a few of the new trends in Chapter 15 cases and in business cases generally that are appearing in U.S. bankruptcy proceedings.

CHAPTER 15 – CENTER OF MAIN INTEREST

The proper venue for a bankruptcy proceeding has long been a contentious issue in U.S. domestic cases.  Under the U.S. Bankruptcy Code, the venue rules are quite liberal, giving a U.S. debtor the choice of a large number of possible U.S. districts in which to file its reorganization case.  Rules that permit related entities to file in the same district where a case involving an affiliate is filed further expand the options available to most business debtors.  This statutory regime led to the District of Delaware and more recently the Southern District of New York becoming venues of choice for most large corporate reorganization cases.  There is no “center of main interest” (“COMI”) restriction on U.S. venue choices, although courts may consider COMI factors in exercising discretion to order a change of venue if the case is filed in a venue that is not optimal.  Thus, the mere fact that Delaware is the U.S. state in which a corporation is incorporated is sufficient to support the filing of a bankruptcy by that corporation in the District of Delaware, even if the debtor has no operations there.

The early interpretations of the Chapter 15 COMI rules indicate that, unlike U.S. domestic bankruptcy practice, the jurisdiction of a debtor’s registered office is not alone sufficient to support a finding that a foreign proceeding pending in that jurisdiction of organization will receive recognition as a “foreign main proceeding.”  While so called “letter-box” companies may file a liquidation proceeding in their jurisdictions of organization, they may find that the U.S. courts are not willing to provide assistance under Chapter 15 to the representatives appointed in those proceedings.  Although Chapter 15 creates a presumption that the jurisdiction of a debtor’s registered office is its COMI, and thus an insolvency proceeding pending there would be the primary or “foreign main proceeding,” that presumption may be rebutted.

The Chapter 15 COMI concept is quite similar to the COMI concept embodied in the EC Regulation 1346/2000 on Insolvency Proceedings (“EC Regulation”).  Fortunately, the early U.S. cases appear to be adopting a COMI interpretation that is consistent with the EC Regulation view of COMI.  The European Court of Justice in Eurofood IFSC Ltd., Case C-341/04, 2006 WL 1142304 (May 2, 2006), considered the status of “letter-box” companies under the COMI standard of the EC Regulation.  There the Court held that the presumption could be rebutted only by factors that are objective and ascertainable by third parties.  In addition, the Eurofood case recognized that public policy could be considered in refusing to recognize a foreign insolvency proceeding.

The early U.S. case of In re SPhinX, Ltd., 351 B.R. 103 (Bankr. S.D.N.Y. 2006), aff’d, 371 B.R. 10 (S.D.N.Y. July 3, 2007), adopts the Eurofood approach of looking to objective and ascertainable factors to rebut the presumption that the jurisdiction of the registered office is the COMI of a debtor.  In SPinX, the New York bankruptcy court refused to recognize Cayman Island proceedings as foreign main proceedings where the debtors had no Cayman operations.  Of interest, the Court held that the Cayman proceedings were not main proceedings even though they were the only pending insolvency proceedings involving the debtors.  Like Eurofood, the Court also gave weight to public policy considerations since it viewed the attempt to gain recognition of the Cayman proceedings as an improper attempt to forum shop and to frustrate an existing judgment involving the debtor entities that had been rendered in the Refco bankruptcy case that was also pending in New York.  Shortly after SPhinX, the California bankruptcy court recognized as foreign main proceedings winding up proceedings pending in St. Vincent and the Grenadines where the debtors were both organized there and conducted regular business operations at their registered office.  See In re Tri-Continental Exchange Ltd., 349 B.R. 627 (Bankr. C.D. Cal. 2006).

The SPhinX Court did grant recognition to the Cayman proceeding as a foreign non-main proceeding and noted that the distinction between recognition as a main or non-main proceeding was not that significant because Chapter 15 gives the U.S. Bankruptcy Court discretion to order appropriate relief to assist a non-main proceeding that is virtually equivalent to that available in the case of a main proceeding.

The SPhinX approach was drawn into question in Judge Lifland’s recent Bear Stearns opinion.  See In re Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd., 2007 WL 2683661 (Bankr. S.D.N.Y. Sept. 5, 2007).  While still adopting the Eurofood approach to the COMI letter-box companies and looking at factors ascertainable to third parties, the Court emphasized that the Chapter 15 presumption is different from that in the EC Regulation or the Model Law.  Chapter 15 replaced the requirement of “proof” with one of mere “evidence” that the COMI was not in the jurisdiction of the registered office.  This greatly weakens the presumption since the foreign representative must bear the burden of proving that the COMI is at the registered office whenever any contrary evidence is introduced.  Further, the Court rejected the argument that recognition is automatic if no one objects.  In the Bear Stearns case, the Court found contrary evidence in the foreign representative’s verified petition for recognition, because it disclosed facts indicating that the COMI was in the United States.

Of perhaps greater importance, the Bear Stearns Court distinguished SPinX and refused to grant even non-main recognition to the Cayman proceeding.  The Court reasoned that Chapter 15 requires recognition as either a main or non-main proceeding before the U.S. Bankruptcy Court can provide any relief or assistance under Chapter 15.  According to the Court, non-main recognition is available only if there is “an ‘establishment’ in the Cayman Islands for the conduct of nontransitory economic activity, i.e., a local place of business.” (Emphasis in original.)  The Court rejected the view that the presence of assets was sufficient.  Thus, since Cayman law prohibits exempted companies like the Bear Stearns funds from engaging in business in the Cayman Islands, the Cayman winding up proceeding was entitled to no recognition whatsoever under Chapter 15.  The Court noted that the SPhinX opinion did not address the “establishment” issue.  Thus, although the results are at odds, the SPhinX opinion is not contrary to the Bear Stearns opinion.

TRADING IN CLAIMS – DISCLOSURE, DESIGNATION AND SUBORDINATION

Trading in bankruptcy claims has become big business in U.S. bankruptcies.  Hedge funds and other strategic investors may acquire both claims and interests in several different parts of the debtor’s capital structure and may try to use their influence to affect the outcome of the proceeding.  Often, these investors are very aggressive actors in a bankruptcy case.  Other players in the bankruptcy process are responding to the new leverage exerted by these investors using a variety of approaches and theories.

Investors may combine with other similar investors and jointly hire a single law firm to represent the group’s shared interests in the case.  For hedge funds, who often wish to keep their holdings and strategies secret, such combinations may lead to mandated disclosure of holdings.  In a February 2007 decision, the Bankruptcy Court for the Southern District of New York held that an ad hoc equity committee was a “committee” within the meaning of Bankruptcy Rule 2019 and that the members of the ad hoc committee were therefore required to disclose the claims and interests they held in the debtor, when they were acquired, the amounts paid for them and any sales or dispositions of their claims or interests.  See In re Northwest Airlines Corp., 363 B.R. 701 (Bankr. S.D.N.Y. 2007).  The ad hoc committee members argued that they were not representing any class and were merely representing their own interests, but the Court rejected that argument based in part on the ad hoc committee’s representations that it represented the interests of equity holders generally.  The Court noted that members of the committee held debt as well as equity and that it was important to the bankruptcy process that those holdings be disclosed.  In a later ruling, the Court denied the committee members’ request to file the disclosures under seal pursuant to Bankruptcy Rule 9018.  The Court reasoned that the members’ interest in protecting what they claimed was proprietary and confidential commercial information was outweighed by the purposes served by the Rule 2019 disclosure.  See In re Northwest Airlines Corp., 363 B.R. 704 (Bankr. S.D.N.Y. 2007).  In contrast, the Bankruptcy Court for the Southern District of Texas rejected a similar disclosure request with respect to members of an Ad Hoc Noteholders Group.  See In re Scotia Development LLC, 2007 WL 2726902 (Bankr. S.D. Tx. 2007) (denying motion for reconsideration).  The difficult issue is determining whether a group is a committee.  Until clear lines are drawn, investors acting together run some risk of mandated disclosure.

One concern of the Northwest Airlines Court was that by holding positions at several levels of the debtor’s capital structure, the supposed ad hoc equity committee members might be inclined to use their leverage at one level to advance their interests as a holder at a different level.  With the growth of loan to own strategies and hedge fund attempts to acquire the business through control of its debt, an old issue might reappear in future cases.  This is the power, under section 1126(e) of the Bankruptcy Code to “designate” any entity whose vote on the plan of reorganization was “not in good faith.”  The effect of having a vote designated is that the vote not counted in determining whether the plan has been accepted by the class.  If a distressed debt trader acquires a controlling position in one class and then uses that voting power to cause the class to accept or reject a plan contrary to the economic interests of that class can its vote be designated if it is shown that the vote was for the ulterior motive of advantaging the holder’s position in some other class?  Faced with a similar issue, the Court in In re Adelphia Communications Corp., 359 B.R. 54 (Bankr. S.D.N.Y. 2006), held that such an ulterior motive was not sufficient to justify designation.  In Adelphia both of the warring factions appear to have been distressed debt traders.  The argument was that the targeted holders of ACC Senior Notes also held notes of an indirect subsidiary.  The two positions were in conflict since any recovery by ACC Senior Noteholders would decrease the recovery of the subsidiary’s noteholders, and visa a versa.  Thus, the entities holding both types of notes were alleged to be using their votes in the ACC class to disadvantage that class in order to enhance their personal recoveries as noteholders of the subsidiary.  Although “ulterior” motives can result in designation, the Court reasoned that a creditor’s efforts to enhance its overall recovery in a case were not the type of ulterior motive that justified designation.  While this holding may provide comfort to claims traders, the issue will no doubt arise again and the Court’s opinion was subject to several caveats that may be of importance in future cases.

A final issue of great concern to distressed debt traders is the question of whether they acquire their claims subject to the same liabilities as a prior holder.  This concern arose from orders issued by the Bankruptcy Court in the Enron bankruptcy case holding that a transferee of a claim was subject to both disallowance of its claim because of a preference received by a prior holder under section 502(d) and to equitable subordination of its claim under section 510(c) based on the alleged acts or omissions of its transferor.  That holding threatened to create havoc in the market for distressed debt.  The recent reversal of those orders by the District Court may have removed a cloud on active claims trading . . . or maybe not.  In In re Enron Corp., 2007 WL 2446498 (S.D.N.Y. Aug. 27, 2007), the District Court held that disallowance and equitable subordination are not attributes of a claim, but rather are personal disabilities of individual claimants.  Drawing on the good faith purchaser for value principles in the UCC Article 8 provisions governing securities, the Court held that a purchaser of a claim was not subject to disallowance or subordination based on the attributes of its transferor.  However, the Court drew a distinction between the sale of a claim and the assignment of a claim, holding that an assignee stands in the shoes of its assignor and generally would be subject to disallowance or subordination.  While the Court made clear that sales of claims on the open markets clearly are sales, it did not provide clear guidance as to the distinction between sales and assignments in other contexts.  The difficulty in distinguishing between the sale of a claim and the assignment of a claim is highlighted by the documentation at issue in the Enron case. The transfers of the claim at issue were documented both by a “Purchase and Sale Agreement” and an “Assignment and Acceptance.”  On remand, the Bankruptcy Court was instructed to determine whether the transfer was a sale or an assignment.  In addition, the Court’s reliance on Article 8 suggests that its holding may be limited to trading in bond debt and may not extend to trading in trade debt or other claims that do not constitute securities.

DERIVITIVES – WHEN IS A SWAP NOT A SWAP?

An issue of great importance in the current financial climate is the treatment of financial derivatives contracts in bankruptcy cases.  The recent 2005 amendments to the U.S. Bankruptcy Code included sweeping provisions designed to provide special protection to a wide range of derivatives.  In general, these provisions limit the effect of the bankruptcy automatic stay, limitations on ipso facto bankruptcy forfeiture clauses and other provisions in order to permit a non-debtor counter-party to accelerate, terminate and liquidate security or commodity contracts, forward contracts, repurchase agreements, swap agreements and master netting agreements with the debtor.  The Code’s definitions of such contracts are extremely broad and appear to be very formalistic – in other words, they appear to incorporate the market practices and, for example, appear to require bankruptcy courts to treat as a “swap” anything that the financial markets treat as a “swap.”  This raises a concern that ordinary financial transactions, like certain commercial loans, could be documented in the form of a protected derivative and thereby be insulated from bankruptcy.  The first reported case under the 2005 amendments rejects the formalistic approach and looks at both the substance of the transaction and the goals of bankruptcy and the derivative exclusions to exclude ordinary commodity supply contracts from the swap definition.  In the case of In re Nat’l Gas Distributors, LLC, 369 B.R. 884 (Bankr. E.D.N.C. May 24, 2007), Judge Small limited the exemptions to financial instruments that are themselves regularly the subject of trading.  The protections did not extend to an agreement by a single end-user to purchase a commodity.

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