Secured Creditor’s “Net Economic Damages” Estimate of Disputed Claims “Plainly Insufficient” to Establish Collateral Value

By Paul M. Green and Mark G. Douglas (Jones Day)

Paul M. Green
Mark G. Douglas

Valuation is a critical and indispensable part of the bankruptcy process. How collateral and other estate assets (and even creditor claims) are valued will determine a wide range of issues, from a secured creditor’s right to adequate protection, postpetition interest, or relief from the automatic stay to a proposed chapter 11 plan’s satisfaction of the “best interests” test or whether a “cram-down” plan can be confirmed despite the objections of dissenting creditors. Depending on the context, bankruptcy courts rely on a wide variety of standards to value estate assets, including retail, wholesale, liquidation, forced sale, going-concern, or reorganization value. Certain assets, however, may be especially difficult to value because valuation depends on factors that may be difficult to quantify, such as the likelihood of success in litigating estate causes of action.

The U.S. Court of Appeals for the First Circuit recently addressed this issue in In re Montreal, Maine & Atlantic Railway, Ltd., 956 F.3d 1 (1st Cir. 2020) (“MMA Railway”). The First Circuit affirmed a ruling that a secured creditor failed to satisfy its burden of establishing that collateral in the form of indemnification claims settled by the estate had any value entitled to adequate protection. According to the court, with respect to a disputed claim, a showing of possible damages is not enough. Instead, the creditor must establish the likely validity of the claim and the likelihood of recovery.

MMA Railway is a cautionary tale for secured creditors. Creditors bear the ultimate burden of proof in establishing the value of their collateral under section 506(a) of the Bankruptcy Code—a determination that has important consequences in many contexts in a bankruptcy case. The First Circuit’s ruling highlights the importance of building a strong evidentiary record to support valuation. It also indicates that certain types of collateral (e.g., disputed litigation claims) are more difficult to value than others.

The full article is available here.

Tribune II: Law Firm Perspectives

By Xiao Ma (Harvard Law School)

Xiao Ma

On December 19, 2019, the Second Circuit issued its amended opinion in In re Tribune Company Fraudulent Conveyance Litigation, 2019 WL 6971499 (2d Cir. Dec. 19, 2019), which held the “safe harbor” provision in section 546(e) of the Bankruptcy Code covers Tribune Company’s payments made to public shareholders as Tribune constitutes a “financial institution” in pursuance with the Bankruptcy Code definition, and such definition includes the “customer” of a financial institution when the financial institution acts as the customer’s “agent or custodian…in connection with a securities contract”.

The Second Circuit’s opinion was controversial in light of the Supreme Court’s recent ruling in Merit Management Group, LP v. FTI Consulting, Inc., 138 S.Ct. 883 (2018) on the scope of safe harbor, with law firms perceiving it as moving away from the position of Merit by opening new room for application of safe harbor protection. Jones Day suggests that the Tribune’s reasoning “avoided the strictures of Merit”, while Nelson Mullins finds it “shifting the focus from the financial institution as a ‘mere conduit’ to an ‘agent’.” Kramer Levin comments that the decision represents a “dramatic, and perhaps unexpected, extension of the safe harbor from the position it occupied in the immediate aftermath of Merit.” Weil calls it throwing the 546(e) safe harbor a lifeline.

Firms also find the case paving a way to protect LBO payments from subsequent attacks. King & Spalding notes that the Second Circuit’s opinion provides protection for recipients involved in LBO transaction where the debtor is the “customer” of the intermediary financial institutions. Cadwalader believes that the decision may “narrow the impact” of Merit, as market participants could structure their transaction to involve a financial institution thereby bypassing the “mere conduit” carve-out. Skadden agrees on the likely trend of structured LBOs, highlights that the customer defense is “likely to continue gaining momentum” after the Second Circuit’s decision. Parties would ensure they meet the “financial institution” and “customer” criteria methodically articulated in Tribune. “An appropriately structured principal/agent relationship could continue to shelter transfers or distributions within the ambit of section 546(e) safe harbors,” says Weil, adding that the operative facts will be key to strengthen the position.

Finally, Gibson Dunn notes that Tribune is not binding on other circuits. It remains to be seen whether such holding will be extended to different circumstances by other courts. “Some courts may find (in contrast to the Second Circuit) that the Supreme Court in Merit could not possibly have intended that its narrowing of the section 546(e) safe harbor be so easily vitiated by an argument that the Court itself acknowledged in a footnote,” says Kramer Levin.

In a prior Roundtable post, Professor Bussel noted that a plain meaning interpretation of the term “financial institution” should not include the customers of commercial banks, thus precluding a sharp change from Merit.

For Roundtable’s other posts on Tribune, see Bankruptcy Court Disagrees with Second Circuit’s Holding in Tribune, Tribune Fraudulent Conveyance Litigation Roundup. For Roundtable discussions relating to the 546(e) safe harbor, please refer to the tag #Safe Harbors.

Crossing The Line In Cross-Border Insolvencies

By Jonathan C. Gordon (Jones Day).

Consider an insolvency proceeding outside the United States. To obtain ancillary relief in the U.S., an authorized representative from that foreign proceeding can file a petition with a U.S. court under chapter 15 of the Bankruptcy Code. In chapter 15, the foreign representative acts as a liaison between the U.S. proceeding and the foreign proceeding. For example, the representative must update the U.S. court of substantial developments in the foreign proceeding.

But what happens when that foreign representative (appointed by a foreign court) commits misconduct in the U.S. proceeding; what can the U.S. court do? As I explain in my paper, courts have struggled with a solution. For one, the Bankruptcy Code does not address this situation (nor does the related UNCITRAL Model Law). And common law is equally unavailing; courts have tried and suggested potential solutions, but those approaches (and others) fall short.

In my paper, I propose a novel solution that is simple yet effective: the U.S. court should request the foreign court to replace the foreign representative. I also analyze legal issues related to the solution’s implementation, such as judicial authority, burden of proof, timing, and interim relief.

The full paper, recently published in the ABI Law Review, can be accessed here.

Fifth Circuit Adopts Flexible Approach to Collateral Valuation in Cramdown Chapter 11 Cases

posted in: Cramdown and Priority, Valuation | 0

By Peter S. Saba (Jones Day).

In In re Houston Regional Sports Network, L.P., 886 F.3d 523 (5th Cir. 2018), the U.S. Court of Appeals for the Fifth Circuit held that bankruptcy courts have flexibility in selecting the date on which to value collateral, “so long as the bankruptcy court takes into account the purpose of the valuation and the proposed use or disposition of the collateral at issue.”  In so holding, the Fifth Circuit rejected the proposition that a bankruptcy court must value collateral as of either the bankruptcy petition date or the effective date of a cramdown chapter 11 plan.  However, because the bankruptcy court failed to consider the proposed use of the collateral in assigning it a value, the Fifth Circuit remanded the case below for additional findings.

In declining to establish a bright-line rule mandating the valuation date for a creditor’s collateral in cramdown chapter 11 cases, the Fifth Circuit’s ruling, informed by section 506(a), gives bankruptcy courts the flexibility to consider an appropriate valuation date based on the actual use or disposition of a creditor’s collateral and the purpose of the valuation.  The principal benefit of this approach is that it recognizes that any valuation in this context should consider developments in a chapter 11 case which may have an impact on value.  Even so, secured creditors should be aware that consideration of the proposed or actual use of collateral under a plan may in some cases mean that collateral may be assigned a lower value as of plan confirmation or effectiveness than as of the bankruptcy petition date.

The article is available here.

Fifth Circuit Rules That Corporate Charter Provision Requiring Shareholder Consent for Bankruptcy Filing Is Enforceable but Declines to Rule on Validity of “Golden Shares”

By Mark A. Cody and Mark G. Douglas (Jones Day).

In a highly anticipated decision, the U.S. Court of Appeals for the Fifth Circuit affirmed a bankruptcy court order dismissing a chapter 11 case filed by a corporation without obtaining—as required by its corporate charter—the consent of a preferred shareholder that was also controlled by a creditor of the corporation. In Franchise Services of North America, Inc. v. Macquarie Capital (USA), Inc. (In re Franchise Services of North America, Inc.), 891 F.3d 198 (5th Cir. 2018), a Fifth Circuit panel ruled that: (i) state law determines who has the authority to file a voluntary bankruptcy petition on behalf of a corporation; (ii) federal law does not strip a bona fide equity holder of its preemptive voting rights merely because it is also a creditor; and (iii) the preferred shareholder-creditor was not a controlling shareholder under applicable state law such that it had a fiduciary duty to the corporation which would impact any decision to approve or prevent a bankruptcy filing.

However, to the disappointment of many observers, the Fifth Circuit declined to decide whether “blocking provisions” and “golden shares”—either generally or when wielded by a party that is both a creditor and an equity holder—are valid and enforceable. Such provisions have been increasingly relied upon by creditors, including private equity sponsors and other investors who take both equity and debt positions in a portfolio company, as a means of managing or limiting access to bankruptcy protection, but with mixed results in the courts. Franchise Services does little to remedy the unsettled state of bankruptcy jurisprudence regarding this important issue. Moreover, because the case involved a minority shareholder-creditor without any fiduciary obligations, the decision did not involve many of the more difficult questions posed by other cases involving these issues.

The article is available here.

Debate Intensifies as to Whether the Bankruptcy Code’s Avoidance Provisions Apply Extraterritorially

by Charles M. Oellermann and Mark G. Douglas (Jones Day).

The ability to avoid fraudulent or preferential transfers is a fundamental part of U.S. bankruptcy law. However, when a transfer by a U.S. entity takes place outside the U.S. to a non-U.S. transferee—as is increasingly common in the global economy—courts disagree as to whether the Bankruptcy Code’s avoidance provisions apply extraterritorially to avoid the transfer and recover the transferred assets. Several bankruptcy courts have addressed this issue in recent years, with inconsistent results.

In a recent example, in In re CIL Limited, 582 B.R. 46 (Bankr. S.D.N.Y. 2018), the U.S. Bankruptcy Court for the Southern District of New York, disagreeing with other courts both within and outside its own district, ruled that the “transfer of an equity interest in a U.K. entity to a Marshall Islands entity was a foreign transfer” and that the Bankruptcy Code’s avoidance provisions do not apply extraterritorially because “[n]othing in the language of sections 544, 548 and 550 of the Bankruptcy Code suggests that Congress intended those provisions to apply to foreign transfers.”

The decision further muddies the waters on an issue that has become increasingly prominent as the volume of cross-border bankruptcy cases continues to grow and cross-border transactions become ubiquitous. The split on this issue exists not merely between courts in different jurisdictions, but also among courts in the Southern District of New York, where the majority of cross-border bankruptcy cases have traditionally been filed.

The full article is available here.

The Year in Bankruptcy: 2017

by Charles M. Oellermann and Mark G. Douglas (Jones Day).

In their annual chronicle of business bankruptcy, financial, economic, and related developments in the U.S., Charles M. Oellermann and Mark G. Douglas of Jones Day review the most significant events of 2017, including business bankruptcy filing statistics and industry trends; newsworthy developments regarding sovereign and commonwealth debt; the top 10 public-company bankruptcies of the year; notable private and cross-border bankruptcy cases; significant business bankruptcy and U.S. Supreme Court bankruptcy rulings; bankruptcy-related legislative and regulatory developments; noteworthy chapter 11 plan confirmations and exits from bankruptcy; and more.

The article is available here.

Fraudulent Transfer Avoidance Recovery Not Limited to Total Amount of Creditor Claims

posted in: Avoidance, fraudulent transfer | 0

By Jane Rue Wittstein and Mark G. Douglas (Jones Day)

Courts disagree as to whether the amount that a bankruptcy trustee or chapter 11 debtor-in-possession can recover in fraudulent transfer avoidance litigation should be capped at the total amount of unsecured claims against the estate. The U.S. Bankruptcy Court for the District of Delaware recently weighed in on this issue in PAH Litigation Trust v. Water Street Healthcare Partners, L.P. (In re Physiotherapy Holdings, Inc.), 2017 WL 5054308 (Bankr. D. Del. Nov. 1, 2017). Noting the absence of any guidance on the question from the U.S. Court of Appeals for the Third Circuit, the bankruptcy court ruled that, unlike most state fraudulent transfer laws, which limit a creditor’s recovery to the amount of its unpaid claim against the transferor, section 550 of the Bankruptcy Code imposes no such limitation on the estate’s recovery. The ruling reinforces the idea that federal and state fraudulent transfer avoidance laws are intended to be remedial rather than punitive. Under state law, this understandably means that an avoidance recovery is limited to the amount necessary to make an injured creditor whole. Under federal bankruptcy law, recoveries must benefit the bankruptcy estate, which includes the interests of creditors and other stakeholders.

The article is available here.

Recent Rulings Deepen the Divide on Whether the Bankruptcy Code’s Avoidance Provisions Apply Extraterritorially

By Charles M. Oellermann and Mark G. Douglas (Jones Day)

The ability to avoid fraudulent or preferential transfers is a fundamental part of U.S. bankruptcy law. However, when a transfer by a U.S. entity takes place outside the U.S. to a non-U.S. transferee—as is increasingly common in the global economy—courts disagree as to whether the Bankruptcy Code’s avoidance provisions apply extraterritorially to avoid the transfer and recover the transferred assets.

Several bankruptcy courts have addressed this issue in recent years, with inconsistent results. For example, in In re Ampal-Am. Israel Corp., the Bankruptcy Court for the Southern District of New York ruled that the avoidance provisions of the Bankruptcy Code do not apply outside the U.S, disagreeing with other courts both within and outside its own district. The Bankruptcy Court for the District of Delaware, however, held to the contrary in In re FAH Liquidating Corp., where it held that the presumption against territoriality did not prevent a trustee from avoiding an overseas transfer.

More recently, in a pair of adversary proceedings commenced in the chapter 11 case of Arcapita Bank, the Bankruptcy Court for the Southern District of New York held that the “presumption against extraterritoriality” did not defeat claims against foreign banks under sections 362 and 542 (while also ruling it need not decide whether sections 547 and 550 apply extraterritorially because it concluded that the challenged transfers occurred within the U.S.).

Taken together, these recent decisions further muddy the waters on an issue that has become increasingly prominent as the volume of cross-border bankruptcy cases continues to grow.

The article is available here.

FTI Roundup

The Seventh Circuit held last July in FTI Consulting, Inc. v. Merit Management Group, LP, 2016 BL 243677 (7th Cir. July 28, 2016), that § 546(e) of the Bankruptcy Code is not a safe harbor for “transfers that are simply conducted through financial institutions.” This decision deepens a circuit split on this issue. While the Second, Third, Sixth, Eighth, and Tenth Circuits have held that the plain language of § 546(e) protects transfers through financial institutions as settlement payments, the Seventh Circuit’s interpretation agrees with the Eleventh Circuit’s older decision in In re Munford, 98 F.3d 604, 610 (11th Cir. 1996). The legislative purpose of § 546(e) was to prevent the insolvency of one financial institution from causing systemic harm to the market as a whole. However, its text also has deep implications for leveraged buyouts that might render target corporations insolvent because payments to selling shareholders almost invariably pass through brokers and clearinghouses that are covered by the safe harbor.

Several law firms have now written memos on the FTI decision. Schiff Harden postulates that debtors will be more likely to forum shop when filing for bankruptcy when they have recently undergone a leveraged buyout. Jones Day makes clear that shareholders selling into a leveraged buyout face differing levels of risk depending on which forums the corporation could legally avail itself of in a bankruptcy proceeding. And Dechert argues that FTI Consulting will result in different treatment for parties selling identical securities in leveraged buyouts: financial institutions, stockbrokers, and the like will remain protected by the safe harbor when they are beneficial owners of stock, but other shareholders will be subject to avoidance action.

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