Make-Whole Claims in Bankruptcy

By Sam Lawand (White & Case LLP)

The well-established “perfect tender in time rule” dictates that debt must be repaid only upon maturity, and no earlier. Under this rule, early repayments of debt are prohibited absent a contrary provision under the debt instrument. Debt instruments bar early repayments altogether through a “nocall” provision or permit early repayments through a “make-whole” provision. By modifying the “perfect tender in time rule,” make-whole provisions allow debtors to repay debt in advance of stated maturity, in exchange for a predetermined premium, usually based on the discounted value of the stream of future scheduled interest payments.

To determine whether make-whole claims are allowed in bankruptcy, courts undertake a two-pronged analysis. Because make-whole provisions are contractual, courts rely on contract construction principles to determine whether the debt instrument contains a make-whole provision, and, if so, the circumstances in which such provision is triggered. If a make-whole provision is triggered, courts then proceed to determine whether such provision is enforceable under state law.

If the make-whole provision is enforceable under state law, courts proceed to determine whether such provision is enforceable under bankruptcy law. Section 101(5)(A) of the Bankruptcy Code defines “claim” as a “right to payment,” which encompasses make-whole claims. Section 502(a) provides that “claims” are allowed, except to the extent disallowed under section 502(b). In turn, section 502(b)(1) disallows “claims” that are “unenforceable . . . under any agreement or applicable law,” and section 502(b)(2) disallows “claims” on account of “unmatured interest.” In certain circumstances, section 506(b) allows “secured claims” to include “interest” and “any reasonable fees, costs, or charges provided for under an agreement or State statute.” The confluence of these Bankruptcy Code provisions is murky.

Given that make-whole provisions, in essence, liquidate damages arising out of the loss of future scheduled “interest” payments, which by definition are “unmatured,” the allowance of make-whole claims in bankruptcy compels a demanding analysis.

In resolving whether make-whole claims are allowed in bankruptcy, this article examines the application of contract construction principles, reconciles conflicting precedent on such  principles, and construes applicable Bankruptcy Code provisions. This article recognizes that, in applying the provisions of the Bankruptcy Code, bankruptcy courts are courts of equity and that considerations of bankruptcy and commercial policies, including practicality and predictability, bear on the application of such provisions. This article concludes that make-whole claims are generally not allowed in bankruptcy, unless (1) the default or “early repayment” by the debtor is “voluntary”; or (2) the debt instrument contains a “clear and unambiguous” provision calling for a make-whole payment in all circumstances of early repayment.

In accordance with this two-pronged analysis, the first-half of this article covers the state-law analysis, and the second-half of this article covers the bankruptcy-law analysis.

The complete article is available for download here.

Triangular Setoff Impermissible Under Section 553: No Contracting or Theorizing Around It, Section 553 Requires Mutuality

By Ronit J. Berkovich, Andriana Georgallas and Aarti Gupta (Weil, Gotshal & Manges LLP).

In a recent decision, In re Orexigen Therapeutics, Inc., No. 18-10518 (KG) (Bankr. D. Del. Nov. 13, 2018), Judge Kevin Gross of the United States Bankruptcy Court for the District of Delaware analyzed setoff under section 553 of the Bankruptcy Code.  Setoff is a contractual or equitable right that allows entities that owe each other money to apply their mutual debts against each other.  Whether a party has a setoff right is a twofold inquiry.  First, the party seeking setoff must acquire such right prepetition under applicable nonbankruptcy law.  Second, once the party establishes its setoff right, the party must meet the requirements of section 553(a) of the Bankruptcy Code, namely: (1) the party seeking setoff must be a “creditor” and (2) that party must have a “mutual debt” where that party’s debt to the debtor arose prepetition and that party’s claim against the same debtor arose prepetition.

In In re Orexigen Therapeutics, Inc., Judge Gross held that the mutuality requirement must be strictly construed, declining to find mutuality in a triangular setoff between the debtor, a parent entity that owed the debtor money, and that entity’s subsidiary, which was a creditor.  Specifically, Judge Gross held that there is no contractual exception to the mutuality requirement and that mutuality may not be satisfied under a third-party beneficiary theory.

The full article is available here.

Second Circuit Backs Foreign Clawback Claims in Madoff Bankruptcy Action

By Adam J. Goldberg, Christopher Harris, Robert J. Malionek, Kevin L. Mallen (Latham & Watkins)

In In re Picard, Tr. for Liquidation of Bernard L. Madoff Inv. Sec. LLC, No. 17-2992(L), 2019 WL 903978 (2d Cir. Feb. 25, 2019), the Second Circuit held that the trustee administering Bernie Madoff’s insolvent estate could use Section 550(a) of the Bankruptcy Code to claw back purely foreign transactions between foreign entities. The money at issue had been initially transferred by Madoff to foreign funds, then subsequently transferred by the foreign funds to the foreign defendants. The defendants argued that the Madoff trustee’s clawback claims were barred by the presumption against extraterritoriality and the principles of international comity.

While the Southern District of New York had focused its analysis on the subsequent transfers by the foreign funds to the foreign defendants, the Second Circuit focused on the initial transfer from Madoff to the foreign funds when determining whether the subsequent transfers could be recovered. The Second Circuit reasoned that since the initial transfers were from New York-based Madoff, the presumption against extraterritoriality and the principles of international comity did not bar the Madoff trustee’s attempts to recover these foreign subsequent transfers.  In so holding, the Second Circuit reversed the Southern District of New York’s prior ruling that such foreign transfers could not be recovered, and removed a protection for foreign investors who may not have anticipated that their investments — and their returns — could otherwise be subject to clawback under US law.

The full article is available here.

The Social Costs of Dividends and Share Repurchases

By J. B. Heaton (J.B. Heaton, P.C.)

The issue of share repurchases has captured the attention of United States senators on both sides of the aisle, with Senate Minority Leader Chuck Schumer, D-NY, Senator Bernie Sanders, I-VT., and Senator Marco Rubio, R-FL, each proposing legislation limiting share repurchases and dividends. One need not agree with all parts of their plans to acknowledge that excessive dividends and share repurchases can have severe negative social consequences.

In a new paper forthcoming in the Journal of Business, Entrepreneurship and the Law, I explore five negative consequences of dividends and share repurchases. First, they dramatically increase the riskiness of corporate debt, diverting resources into credit monitoring and credit speculation. Voluntary creditors must charge a high price for credit ex ante – subsidized by tax payers through interest expense deductions – to protect them from the ex post effects of the existing legal regime, and many resources are spent on monitoring and trading on the fluctuating risks of default and only partial recovery on corporate debt. Second, the existing legal regime requires a bankruptcy system to process large and complex corporate failures. Third, it leaves firms less resilient to financial crises.  Fourth, it unfairly shifts costs to involuntary and unsophisticated creditors in violation of the implicit social bargain of limited liability.  Finally, it distorts the supply of securities toward riskier debt that is publicly subsidized through the deductibility of interest, reducing the supply of safer assets.

One possible solution that deserves further study is restricting dividends and share repurchases to corporations that have low debt and adequate insurance against harm to involuntary creditors and pay reasonable wages and benefits. Such a rule would still allow corporations with high debt, little insurance, and low wages and benefits to operate, but they could pay shareholders only after meeting all their other obligations.

This proposal is consistent with what corporate law is supposed to provide to investors and society alike. A long-held view in the academy is that shareholders are “residual claimants” in the sense that they are paid in full only after the corporation pays its creditors. The reality, of course, is far different. Corporations give away significant assets to their shareholders in the form of dividends and share repurchases long before they have satisfied creditors, both voluntary contract creditors and involuntary tort creditors.  Existing law is quite permissive in allowing indebted corporations to distribute this cash to shareholders. As a result, shareholders are hardly “last paid” capital providers of corporate-law folklore but rather “first-in, first-out, and then some” capital providers. They receive their capital back and much more while the corporation has often very large liabilities outstanding.  As my paper explores, neither corporate law nor voidable transfer law are strong enough to prevent the destructive social impact of dividends and share repurchases.

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J.B. Heaton is a data scientist, financial economist and legal scholar. His paper, “The Social Costs of Dividends and Share Repurchases,” is available here.

 

A New PDVSA? The Transfer of Venezuela’s Oil Assets to a Successor Entity and Fraudulent Conveyance

By Richard Levin (Jenner & Block LLP) and Roland Pettersson (LEC Abogados).

This Working Paper analysis the hypothetical transfer and conveyance of Petróleos de Venezuela, S.A.’s assets to a new state-owned entity by the Venezuelan Government, and the possible creditor responses to such action, on account of the Venezuela’s NOC current financial-distress situation. The study is conducted from the perspective of Venezuelan law, which might provide certain legal remedies under Civil, Commercial and Administrative law—although with somehow little practical success expectations, given other factors and externalities—as well as from the perspective of U.S. law, which is of particular relevance, given (i) significant asset exposure in the U.S., where PDVSA—through CITGO—maintains an important operation, (ii) the contractual terms in the bulk of Venezuela and PDVSA’s financial indebtedness relies on U.S. law and provides for submission to the jurisdiction of NY courts, and (iii) many creditors are actually U.S. persons. Thus, this Working Paper examines the above situation, given the multiple issues and complexities on the case, starting from the very nature of PDVSA as an state-owned entity under Venezuelan law, but with particular emphasis on the creditors’ side of the equation and the theory of fraudulent transfer, which is analyzed both from the standpoint of Venezuelan law, as well as from U.S. insolvency framework and international law in general.

The full working paper is available here.

Restructuring Venezuela’s Debt: An Update

By Mark Walker (Guggenheim Securities)

Lee Buchheit and Mitu Gulati have proposed an innovative and aggressive strategy to facilitate the restructuring of Venezuela’s external debt based on consensual agreement between Venezuela and a supermajority of its broad creditor universe. Borrowing from the United Nations Security Council’s decision (supported by action of the United States) to shield Iraq’s assets from seizure by its creditors in order to promote a restructuring of Iraq’s debts, they propose that the Security Council or (more likely) the President of the United States by Executive Order shield Venezuela’s assets (particularly revenues from the sale of oil into the United States) from legal process. The rationale for their proposal rests on the premises that (1) virtually all of Venezuela’s foreign exchange is generated by sales of oil into the United States, (2) the revenues from exports of oil to the United States are vulnerable to attachment by creditors and therefore a small group of aggressive creditors could strangle the entire economy of the country, (3) existing restructuring techniques are inadequate to the task and (4) the policy of the United States is to promote the restructuring of sovereign debt based on an agreement between the debtor state and a supermajority of its creditors in the context of a process in which all creditors are bound by the vote of a supermajority.

This article argues that (1) a new Venezuelan government (which all agree is a prerequisite to a restructuring) will have substantial means to shield the country’s oil revenues from seizure by creditors, (2) a new government will also be able to expand its foreign exchange earnings to include sale of oil outside the United States, (3) the proposals do not create a mechanism to allow all of Venezuela’s creditors to have a voice in the terms of a restructuring — by supermajority or otherwise — and would treat U.S. and non U.S. creditors differently and (4) the unintended consequences of the proposals advanced by Buchheit and Gulati would negatively affect the ability of emerging market sovereigns, and Venezuela in particular, to fund themselves in the debt markets and would be disruptive of the sovereign debt market generally. Referring to the paper that the author and Richard Cooper wrote one year ago, the author argues that there are tested, market-based mechanisms to achieve the goal of a consensual restructuring arrived at by a supermajority vote of creditors, in particular a restructuring of PDVSA’s debts under a newly enacted Venezuela law that is implemented with the support of a Chapter 15 proceeding under the United States Bankruptcy Code.

The full article is available here.