By Ronit J. Berkovich (Weil Gotshal & Manges) and Eric Einhorn (Weil Gotshal & Manges)
In a recent decision, In re Highland Cap. Mgmt., L.P.,1 the Bankruptcy Court of the Northern District of Texas held that a debtor’s rejection of an executory contract with an arbitration clause precludes the court from compelling the debtor to arbitrate—notwithstanding the strong federal policy supporting enforcement of arbitration clauses, even in bankruptcy. Although rejection of a contract constitutes a breach and may give rise to a claim for monetary damages, the Court found that specific performance of an arbitration clause was not an appropriate remedy post-rejection. Highland provides an example of how bankruptcy courts may disregard contractual provisions—including an agreement to specifically perform—where they may irreconcilably conflict with the policy of the Bankruptcy Code.
Over the past several years, certain circuits criticized the Equitable Mootness doctrine for its lack of statutory basis and effect of avoiding review of chapter 11 plans on the merits. However, the Third Circuit recently held in In re Nuverra Environmental Solutions, Inc. v. Hargreaves, Case No. 18-3084, 834 Fed. Appx. 729 (3d Cir. Jan. 6, 2021), that the Equitable Mootness doctrine is still alive and well.
The Third Circuit rejected the appeal of Hargreaves, a creditor who timely objected to the chapter 11 plan and timely appealed the bankruptcy court’s entry of the plan’s confirmation order, because the plan was already substantially consummated and could not be unwound. Further, the Third Circuit held that it could not grant Hargreaves “individualized relief” because such relief would violate Bankruptcy Code § 1123(a)(4)’s restriction on preferential treatment of class members and § 1129(b)(1)’s prohibition on unfair discrimination between classes.
In a concurring opinion, Judge Krause rejected the application of Equitable Mootness, finding the majority did not sufficiently analyze whether disparate treatment of creditors within a class is permissible on appeal when parties choose not to object to, or appeal confirmation of, the plan. Judge Krause also noted that denial of the appeal on Equitable Mootness grounds precluded consideration of substantive arguments and development of the Third Circuit’s bankruptcy jurisprudence.
While Judge Krause’s concurring opinion highlights difficulties plan objectors face when appealing plan confirmation, the majority opinion signals that Equitable Mootness is still a healthy doctrine in the Third Circuit.
On November 26, 2019, the Fifth Circuit granted a petition for rehearing en banc and issued a revised opinion in In re Ultra Petroleum Corp., No. 17-20793 (5th Cir. Nov. 26, 2019). The new opinion reaffirmed the court’s prior holding that the alternation of a claim by the Bankruptcy Code does not render a claim impaired under 11 U.S.C. § 1124(1), while withdrew the court’s earlier guidance that make-whole premium was the “economic equivalent of ‘interest’” together with its prior suggestion on setting the appropriate post-petition interest rate via reference to general post-judgment interest statute or bankruptcy court’s equitable discretion.
Noting that issues relating to make-whole premiums is a common dispute in modern bankruptcy, the Fifth Circuit retracted its dicta and emphasized in the revised opinion that specific facts are essential in determining the difficult question of whether any premiums are effectively unmatured interest. The court concluded that “[t]he bankruptcy court is often best equipped to understand these individual dynamics – at least in the first instance.”
Firms took notice of the issues remain unsolved and offered perspectives on implications of this case. Morgan Lewis specifically notes that the revised opinion did not alter the original opinion’s reversal of the bankruptcy court’s ruling that creditors who are unimpaired in a bankruptcy plan pursuant to section 1124(a)(1) must receive the full amount of their claim under state law. Weil finds the opinion “does not answer the question of whether, or when, a make-whole may be payable in the Fifth Circuit”, but acknowledges that the ruling is “viewed by some as a victory” for certain creditors. Cleary highlights that the court’s revised opinion “withdrew essentially all of the guidance it had offered in its prior opinion” which had cast doubt on the enforceability of make-whole claims in bankruptcy. “Given the legal and economic significance of the questions left to be resolved”, debtors and creditors alike are likely to watch closely how the questions will proceed at the bankruptcy court, says Mayer Brown.
On January 13, 2020, the United States Bankruptcy Court for the District of Delaware issued an opinion in In re La Paloma Generating Company, LLC., Case No. 16-12700 [Adv. Pro. No.19-50110], which examined the implied covenant of good faith and fair dealing in the context of an intercreditor agreement (ICA) governing the relationship between the First Lien Lender (First Lien Lender) and the Second Lien Lenders (Second Lien Lenders) to the Debtors. The bankruptcy court held a party cannot be in breach of the covenant of good faith and fair dealing under New York law when merely enforcing a contractual right, in this case the First Lien Lender enforcing the ICA.
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.
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.
On February 27, the Supreme Court decided Merit Management Group, LP v. FTI Consulting, Inc., holding unanimously that the § 546(e) safe harbor does not protect allegedly fraudulent transfers “in which financial institutions served as mere conduits.” The Court’s decision resolves a circuit split on the reach of § 546(e). In reaching its conclusion, the Court focused on the “end-to-end transfer” that the trustee seeks to avoid, rather than any “component parts of the overarching transfer.” In FTI, because the overarching transfer was made between two parties not otherwise shielded by the safe harbor, the transfer will now fall outside the safe harbor.
As many law firms recognize, this decision will have wide-ranging implications on the finality of securities transactions effected through financial institutions, especially leveraged buyouts. Mayer Brown notes that as the decision enhances a trustee’s ability to recover fraudulent transfers, it also increases the bankruptcy estate’s leverage against recipients of pre-petition transfers. Cleary observes that “debtors or trustees may strategically frame avoidance actions in order to limit the scope of the safe harbor.” Mayer Brown concludes that the decision may also expose investors, investment funds and similar entities to fraudulent transfer litigation risks.
The bottom line, as Davis Polk notes, is that the § 546(e) safe harbor is no longer a blanket safe harbor for the recipients of transactions that pass through financial institutions. But the safe harbor will still shield financial institutions operating as escrow agents or clearinghouses, as the Court expressly stated that a financial institution under § 546(e) is protected whether the institution acts as a principal or as an intermediary.
Firms have noted that the decision also left open some ambiguities. First, Schulte Roth & Zabel writes that the Court leaves open possible arguments that any “customer” of a “financial institution” is also itself a “financial institution” under § 546(e). Second, Mayer Brown points out that the Court did not address whether the transaction at issue actually qualified as a transfer that is a “settlement payment” or made in connection with a “securities contract” under § 546(e). These ambiguities will draw the attention of defendants in future fraudulent transfer litigation.
Finally, Weil notes that the decision raises the question of how the preemption of state-law creditor remedies under § 546(e) will be applied in light of the Supreme Court’s now-narrow construction of the safe harbor.
On October 28, 2017, the United States Court of Appeals for the Second Circuit handed down its decision in In re MPM Silicones, L.L.C., holding that where an efficient market exists, the appropriate cram-down interest rate in Chapter 11 cases is the market rate, distinguishing the formula rate applied by the Supreme Court in Till v. SCS Credit Corp.in Chapter 13 cases. The Second Circuit wrote that “the market rate should be applied in Chapter 11 cases where there exists an efficient market. But where no efficient market exists for a Chapter 11 debtor, then the bankruptcy court should employ the formula approach endorsed by the Till plurality.” The Second Circuit also disallowed the senior creditors’ claim for a make-whole payment, although the Third Circuit had allowed such a claim in In re Energy Future Holdings Corp.
Law firms have so far reacted unanimously that this decision is a win for secured creditors as it ameliorates the risk that unsecured creditors could extract value from the debtor at the secured creditors’ expense. Weil writes that “it seems like the Bankruptcy Court, now freed from Till, will find that an efficient market exists, and will adjust the interest rate on the replacement notes accordingly.”
Nevertheless, some firms predict that there may still be areas future controversy. Davis Polk warns that this decision “could result in expensive litigations between debtors and secured creditors as to whether there exists an efficient market and, if so, what the efficient market rate should be.” Norton Rose Fulbright also emphasizes that the next step for secured creditors is to focus on when an efficient market exists.
Firms have also noticed the decision’s implication for debtor-side strategy. Baker McKenzie suggests the possibility that “a debtor may engage in forum shopping to file its case in a jurisdiction that applies the formula approach,” or “be even more sensitive to the potential for exit financing quotes to be used as evidence against [debtors] in establishing a market rate.”
On the issue of the make-whole premium, Davis Polk highlights that the circuit split may increase forum shopping for distressed issuers with potentially significant make-whole obligations. It expects future issuers to draft clearly around the issue of make-whole obligation to provide for future Chapter 11 cases.
Last week, the Second Circuit decided Marblegate Asset Management, LLC v. Education Management Corp., holding that § 316(b) of the Trust Indenture Act (“TIA”) protects only bondholders’ formal, legal right to repayment, not their practical ability to recover. The Second Circuit’s 2–1 decision thus resolves uncertainty surrounding out-of-court bond workouts and returns to the pre-Marblegate practice.
The majority viewed the statute’s text as ambiguous and consulted the legislative history; it emphasized legislative history supporting the idea that § 316(b) protects only against the formality of a bondholder vote altering payment terms and discarded legislative history to the contrary as shards. The dissent concluded that the transaction “annihilated” a bondholder’s right to payment and, hence, ran afoul of statute’s plain language — which requires that a bondholder’s right to payment cannot be affected or impaired without the affected bondholder’s consent.
Squire Patton Boggs highlights limitations, arguing that the law remains “neither clear nor predictable” on when an out-of-court restructuring goes so far as to impair bondholders’ right to repayment. They caution against assuming that any action short of a direct alteration of core repayment terms is now permissible.
In his American Bankruptcy Institute column, Bill Rochelle notes that the decision’s focus on legislative history, including views contemporaneous with the statute’s passage, was unusual and, by implication, indicates that the dissent’s textual decision-making mode fits better with current Code interpretation. Seyfarth Shaw notes the decision’s limited practical effect because of the widespread use of binding votes in pre-packaged Code restructurings, which avoid § 316(b)’s restrictions.
The Roundtable has posted previously on Marblegate and § 316(b). In one post, Mark Roe argued that bondholders should not be barred by statute from choosing in their indenture whether to be allowed to reposition their bonds via a fair vote. Other posts include a summary of the National Bankruptcy Conference’s proposed amendments to the Bankruptcy Code to facilitate bond restructuring; a 28-law firm legal opinion white paper on transactional complications arising from the Marblegate district court decision; and an international perspective on the TIA’s prohibition on collective action clauses.
Recently, the United States Bankruptcy Court for the Western District of Louisiana considered whether a bankruptcy termination provision in a forward contract continues to be safe harbored under section 556 if its enforcement is conditioned on other factors – in this case, the debtor’s failure to perform under the contract. Consistent with prior case law, the court held that termination is only safe harbored if it is based solely on a condition specified in 365(e)(1) (i.e., the financial condition of the debtor, bankruptcy, or the appointment of a trustee).
The contract in Louisiana Pellets contained a standard ipso facto provision that permitted either party to terminate the agreement upon commencement of a bankruptcy case by the other party. But the debtor’s counterparty could only invoke the provision if the debtor was also in breach of its obligations under the agreement. The counterparty alleged that both requirements of the ipso facto provision – bankruptcy and breach – had been satisfied, and sought to terminate.
The court held that because the ipso facto provision contained an additional condition to enforcement (the debtor’s breach), it no longer fell within the 556 safe harbor. Thus, even if both conditions were satisfied (bankruptcy and breach), the automatic stay applied and the termination clause could not be exercised absent relief from the automatic stay.
The lesson of Louisiana Pellets is that ipso facto provisions in financial contracts should be drafted carefully so that their enforcement depends solely on one of the conditions specified in Section 365(e)(1) of the Bankruptcy Code.