Recent Developments in Bankruptcy and RestructuringVolume 13 l No. 6 l November-December 2014 JONES DAY

BUSINESS RESTRUCTURING REVIEW

BANKRUPTCY COURT CONFIRMS CITY OF DETROIT’S CHAPTER 9 PLAN OF ADJUSTMENTJones Day Counsels City of Detroit Throughout Historic Municipal Bankruptcy CaseThe Honorable Steven W. Rhodes of the United States Bankruptcy Court for

the Eastern District of Michigan issued a bench ruling on November 7, 2014

(available at http://www.mieb.uscourts.gov/sites/default/files/notices/Oral_

Opinion_on_Detroit_Plan_Confirmation_Judge_Rhodes_FINAL_for_

Release.pdf), confirming the chapter 9 plan of adjustment for the City of Detroit

(the “City”) and paving the way for the City’s exit from the largest and most

complex municipal bankruptcy case in U.S. history. Both the City’s achieve-

ment—the adjustment of approximately $18 billion in debt—and the speed with

which the case was resolved—16 months after the City filed its chapter 9 peti-

tion—are unprecedented. The ruling follows a 24-day confirmation hearing and

many months of out-of-court mediation and negotiations with retiree represen-

tatives, bond insurers, labor unions, and other creditor representatives. Jones

Day has acted as lead restructuring counsel for the City of Detroit throughout

these negotiations and the City’s chapter 9 case.

Explained David Heiman, leader of the Jones Day team:

We are privileged to have been able to play a central role in this his-

toric matter—the rebirth of Detroit, truly a great American city. We

congratulate the many people who made this extraordinary result

possible, including Governor Rick Snyder; Kevyn Orr; the mediation

team led by U.S. district court chief judge Gerald Rosen; U.S. bank-

ruptcy judge Steven Rhodes; the county executives and boards of

Macomb, Oakland, and Wayne Counties; the mayor and city council

of Detroit; and the numerous stakeholder parties that participated in

this epic restructuring. Detroit has a great future ahead of it.

The confirmed plan reduces the City’s estimated $18 billion debt burden by

approximately $7 billion, restoring the City’s financial solvency. Equally impor-

tant, the plan establishes the framework for the reinvestment of approximately

IN THIS ISSUE

1 Bankruptcy Court Confirms City of Detroit’s Chapter 9 Plan of Adjustment

Jones Day Counsels City of Detroit Throughout Historic Municipal Bankruptcy Case

4 Voter’s Remorse: Taking Back an Acceptance or Rejection of a Chapter 11 Plan

5 Newsworthy

8 In Search of the Meaning of “Unreasonably Small Capital” in Constructively Fraudulent Transfer Avoidance Litigation

11 DIP Lender’s Knowledge of Adverse Claim to Collateral Scuttles Mootness Bar to Appeal of Financing Order Based on “Good Faith”

15 Better Late Than Never: Claims Filed Years Late Did Not Waive Subordination Agreement Priorities or Warrant Equitable Subordination

18 In Brief: Enforceability of Waivers of the Automatic Stay

19 New Chilean Insolvency Law Promotes Reorganizations

20 European Perspective in Brief

21 Sovereign Debt Update

24 The U.S. Federal Judiciary

2

$1.7 billion over 10 years in a wide array of revitalization projects

that will improve the everyday lives of the City’s residents. These

improvements include the following:

• Sweeping blight remediation initiatives;

• Renewed focus on public safety, with significant investment in

the City’s police, fire, and EMS departments;

• Comprehensive improvements to the City’s public transporta-

tion system;

• An overhaul of the City’s outdated and obsolete information

technology systems; and

• Streamlining of the operations of all City departments.

One of the most important aspects of the plan is the global

settlement of issues related to the City’s pensions and retiree

health care. As a result of months of mediation and negotiation

between the City, the official committee of retirees appointed

by the bankruptcy court, the City’s pension systems, and major

unions and retiree associations, the plan enables the City’s pen-

sioners to retain between 95.5 and 100 percent of their current

monthly pension allowance and increases the solvency of the

City’s retirement systems. This settlement also provides for the

establishment of voluntary employee beneficiary associations

(VEBAs) to assume the responsibility for providing health-care

benefits to current City retirees.

This comprehensive resolution of the City’s pension and retiree

health issues would not have been possible without another

settlement—popularly known as the “Grand Bargain”—pursuant

to which:

• The State of Michigan, certain philanthropic organizations,

and the Detroit Institute of Arts (“DIA”) committed a total of

$816 million to address the underfunding of the City’s pen-

sions; and

• The world-class art collection housed at the DIA was pro-

tected from dismemberment and placed in a perpetual

charitable trust for the benefit of the City’s residents and the

surrounding region.

This “Grand Bargain” is unprecedented—parties with no existing

obligation to the City have committed nearly $1 billion to the City’s

restructuring efforts and have preserved a critical cultural asset.

The bankruptcy court also approved other key settlements and

agreements that promise continuing revitalization of the City,

including the following:

• An agreement with Financial Guaranty Insurance Company

(“FGIC”), an insurer of more than $1 billion of the City’s debt, to

redevelop the site of the Joe Louis Arena (“JLA”) following the

relocation of the Red Wings to their new arena, pursuant to

which FGIC would fund the costs of future construction upon

the JLA site.

• A similar agreement to enter into certain redevelopment

transactions with Syncora, an active litigant in the chapter

9 case that holds or insures more than $350 million of debt.

These redevelopment transactions include: (i) an extension

of Syncora’s existing lease of the Detroit-Windsor Tunnel; (ii)

options to develop certain City properties; (iii) a concession

for Syncora to operate Detroit’s Grand Circus Parking Garage;

and (iv) Syncora’s commitment to make substantial capital

improvements to and investments in the City and its assets.

• Settlements with certain insurers and bondholders of gen-

eral obligation bonds issued by the City. These settlements

resolve significant disputes regarding the priority status of

general obligation bond claims under Michigan law while

allowing the City to retain millions of dollars in certain existing

tax revenues.

• The City’s landmark agreement with Wayne County, Oakland

County, Macomb County, and the State of Michigan to create

a regional water and sewer authority.

None of the foregoing would have been possible without the

commitment and indefatigable effort of the outstanding media-

tion team appointed by the bankruptcy court.

Other notable accomplishments and precedents in the City of

Detroit’s chapter 9 bankruptcy case include the following:

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• The tender of approximately $1.47 billion of Detroit Water and

Sewerage Department (“DWSD”) bonds, the first successful

tender transaction in a chapter 9 bankruptcy case. The DWSD

tender and related settlement with holders of DWSD bond

claims will result in approximately $130 million in savings to

DWSD.

• A settlement between the City and secured creditors aris-

ing from certain interest-rate swap contracts, resulting in a

70 percent reduction of the City’s obligations and savings of

nearly $200 million.

• Negotiation of new five-year collective bargaining agree-

ments with all major City unions.

• Adoption of a new hybrid pension plan for employees going

forward.

Crucially, the City’s achievements under the plan will be pre-

served by an independent Financial Review Commission to be

formed under recently enacted state legislation; the commis-

sion will review the City’s performance to ensure that the City

complies with the plan, uses sound budgets, develops realis-

tic financial plans, and manages its expenses to meet all of its

financial obligations going forward.

Jones Day was retained in March 2013 as lead counsel to the

City of Detroit in connection with its ongoing restructuring

efforts and has counseled and served the City throughout its

chapter 9 case. Jones Day: (a) assisted in the development and

implementation of restructuring proposals, including the chap-

ter 9 plan of adjustment; (b) participated in negotiations with the

City’s key stakeholder constituencies (including approximately

150 mediations), with the goal of reaching a consensual restruc-

turing; and (c) handled all aspects of the chapter 9 case. The

wide-ranging nature of the City’s restructuring required Jones

Day to perform an equally wide array of legal services, includ-

ing litigation in multiple venues; the documentation and closing

of a multitude of transactions, including the Grand Bargain and

redevelopment transactions discussed above; capital-raising

transactions; labor negotiations; and the structuring of pension

and health-care benefits, among others.

Th e J o n e s D a y t e a m w a s l e d by Bu s i n e s s

Restructuring & Reorganization partners David Heiman

(Cleveland), Bruce Bennett (Los Angeles), and Heather

Lennox (Cleveland and New York). The team included

the following:

Banking & Finance: Joel Te lpner (New York) ;

Business Restructuring & Reorganization: Corinne

Ball (New York), Jeff Ellman (Atlanta), Brad Erens

(Chicago), and Tom Wilson (Cleveland); Employee

Benefits & Executive Compensation: Evan Miller

(Washington) , Sarah Grif f in (Los Angeles) , and

Elena Kaplan (Atlanta); Labor & Employment: Brian

Easley (Chicago) , Jessica Kastin (New York) , and

Mike Rossman (Columbus); Litigation in Washington:

Tim Cullen (Practice Leader, Global Disputes) ,

Beth Heifetz (Practice Leader, Issues & Appeals),

Geoff Irwin (Business & Tort Litigation (USA)), Greg

Shumaker (Business & Tort Litigation (USA)) , and

Geoff Stewart (Global Disputes); and Real Estate:

Brian Sedlak (Chicago).

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VOTER’S REMORSE: TAKING BACK AN ACCEPTANCE OR REJECTION OF A CHAPTER 11 PLANCharles M. Oellermann and Mark G. Douglas

After a creditor or equity security holder casts its vote to accept

or reject a chapter 11 plan, the vote can be changed or with-

drawn “for cause shown” in accordance with Rule 3018(a) of

the Federal Rules of Bankruptcy Procedure (“Rule 3018(a)”).

However, “cause” is not defined in Rule 3018(a), and relatively

few courts have addressed the meaning of the term in this con-

text in reported decisions. A New York bankruptcy court recently

examined this issue in connection with the hotly contested plan

confirmation proceedings of specialty chemicals manufacturing

company Momentive Performance Materials Inc. (“Momentive”)

and its debtor affiliates.

In In re MPM Silicones, LLC, 2014 BL 258176 (Bankr. S.D.N.Y. Sept. 17,

2014), the court denied a motion filed by secured noteholders to

change their votes against Momentive’s chapter 11 plan. The court

concluded that there was not sufficient “cause” to authorize the

change in votes because it was “crystal clear that the requested

vote change [was] not, in effect, a consensual settlement” and

“[was] seeking to undo a choice that had originally been made”

by sophisticated creditors after due deliberation.

CHANGE OR WITHDRAWAL OF PLAN ACCEPTANCE

OR REJECTION

Rule 3018(a) provides in relevant part that “[f]or cause shown,

the court after notice and hearing may permit a creditor or

equity security holder to change or withdraw an acceptance

or rejection” of a chapter 9 plan of adjustment or a chapter 11

plan. Changing a vote is not a matter of right—court approval is

required to avoid the possibility that an entity will switch its vote

on the basis of consideration or promises outside a plan (which,

if not disclosed, may be a criminal offense). See 9 COLLIER ON

BANKRUPTCY ¶ 3018.01[4] (16th ed. 2014) (hereinafter “COLLIER”).

Prior to 1991, Rule 3018(a) provided that any motion to change

or withdraw a vote must be made before the deadline for voting

had expired. This requirement was removed in 1991, but the “for

cause shown” standard was retained. No explanation was given

for the amendment in the legislative history or the Advisory

Committee Notes. However, in light of pre-amendment court rul-

ings permitting a vote change even after expiration of the voting

deadline upon a sufficient showing of cause (or, in some cases,

“exceptional circumstances”), the change may have been moti-

vated by a desire to adjust Rule 3018(a) to reflect actual prac-

tice. See MPM Silicones, 2014 BL 258176, *2 (citing cases).

The term “cause” is not defined in Rule 3018(a). Certain provi-

sions of the Bankruptcy Code contain nonexclusive examples

of “cause” in other contexts (e.g., section 362(d) (cause for

relief from the automatic stay), section 1104(a)(1) (cause for the

appointment of a chapter 1 1 trustee), and section 11 12(b)(4)

(cause for dismissal or conversion of a chapter 11 case)), but the

Bankruptcy Code provides no such guidance with respect to

the meaning of the term in connection with a request to change

or withdraw a vote on a chapter 9 or chapter 11 plan.

Therefore, defining “cause” in this context has largely been left

to the courts. However, only a handful of courts have addressed

the issue in reported decisions (perhaps because creditors and

equity security holders infrequently seek to change or withdraw

a vote on a plan on a basis that is not fully consensual).

Concerning the “cause” standard in Rule 3018(a), COLLIER states

as follows:

The test for determining whether cause has been

shown for purposes of Bankruptcy Rule 3018(a) should

often not be a difficult one to meet. As long as the

reason for the vote change is not tainted, a change

should usually be permitted. The court must ensure

only that the change is not improperly motivated.

Examples of reasons for a change of vote might

include a breakdown in communications at the voting

entity; misreading the terms of the plan; or execution

of the first ballot by one without authority. In short, the

vote should be changed in order to allow the voting

entity to intelligently express its will.

COLLIER at ¶ 3018.01[4].

Reported decisions commonly focus more on improper moti-

vation than on human error or oversight. Courts, for example,

have uniformly denied a vote change motivated by a credi-

tor’s assessment after casting its ballot, or by an assessment

of an acquiror of the debtor’s claim, that it can gain leverage in

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NEWSWORTHYJones Day received a Tier 1 ranking in the 2015 “Best Law Firms” survey published jointly by U.S. News and Best Lawyers® in the practice areas of Bankruptcy and Creditor Debtor Rights/Insolvency and Reorganization Law and Litigation—Bankruptcy.

Barnaby C. Stueck (London), Ben Larkin (London), Corinne Ball (New York), and Sion Richards (London) received a “recommended” designation in “Finance—Corporate restructuring and insolvency” in The Legal 500 UK 2014.

Jones Day’s London Office received a “highly regarded” designation in the practice area of Restructuring/Insolvency from Chambers UK 2015. The practice area’s ranked professionals are Sion Richards (London), Ben Larkin (London), and Michael Rutstein (London).

Amy Edgy Ferber (Atlanta) has been elected a member of the Turnaround Management Association’s global board of trustees.

Volker Kammel (Frankfurt) was recommended in the 2014/2015 edition of JUVE Handbook, the annual guide to German commercial law firms, for the practice area Corporate; Restructuring & Insolvency.

David G. Heiman (Cleveland) received a Law360 MVP Award for 2014 in the field of Bankruptcy.

Thomas A. Howley (Houston), Heather Lennox (New York and Cleveland), Erin N. Brady (Los Angeles), Joshua M. Mester (Los Angeles), Bruce Bennett (Los Angeles), Lisa G. Laukitis (New York), Corinne Ball (New York), Jeffrey B. Ellman (Atlanta), Brad B. Erens (Chicago), David G. Heiman (Cleveland), James O. Johnston (Los Angeles), Paul D. Leake (New York), Sidney P. Levinson (Los Angeles), Charles M. Oellermann (Columbus), Mark A. Cody (Chicago), Bennett L. Spiegel (Los Angeles), and Richard L. Wynne (Los Angeles) were recognized in the field of Bankruptcy in the 2014 Super Lawyers Business Edition.

Ben Larkin (London) was recognized in the field of Corporate Finance in the 2014 Super Lawyers Business Edition.

Bruce Bennett (Los Angeles) participated in a panel discussion entitled “Watching the Hedges Grow: Inside the Mind of Distressed Investors” on October 10 at the 88th Annual Meeting of the National Conference of Bankruptcy Judges in Chicago.

Juan Ferré (Madrid) participated in a panel discussion entitled “Eurozone Update 2014” on October 31 at the 10th International Insolvency and Restructuring Symposium of the American Bankruptcy Institute in London.

Corinne Ball (New York) moderated a panel discussion entitled “What Every Distressed Investor Should Ask When Venturing Offshore. Are Chapter 11 Skill Sets and Experience Alive and Well (and Relevant) in Europe?” on October 9 at the 88th Annual Meeting of the National Conference of Bankruptcy Judges in Chicago.

Richard L. Wynne (Los Angeles) participated in a panel discussion entitled “All the Courtroom’s a Stage: Honing Courtroom Presentation Skills” on October 10 at the 88th Annual Meeting of the National Conference of Bankruptcy Judges in Chicago.

Pedro A. Jimenez (Miami and New York) coauthored an October 2014 INSOL International Special Report entitled “Chile’s New Insolvency Law: Restructured for Corporate Restructurings.”

Mark A. Cody (Chicago) is the author of a chapter in a book published by Thomson Reuters/Aspatore in October 2014 entitled Representing Creditors in Chapter 9 Municipal Bankruptcy: Leading Lawyers on Navigating the Chapter 9 Filing Process, Counseling Municipalities, and Analyzing Recent Trends and Cases (Inside the Minds).

Joshua M. Mester (Los Angeles) participated in a panel discussion entitled “Litigation Tactics to Protect Creditor Positions in Distressed Companies” at the American Bankruptcy Institute Claims-Trading Program held at St. John’s University in Manhattan on October 30.

An article written by Pedro A. Jimenez (Miami and New York) and Mark G. Douglas (New York) entitled “U.S. Causes of Action and Attorney Retainer Fund Are Sufficient Assets for Chapter 15 Recognition” was published in the November/December 2014 issue of Pratt’s Journal of Bankruptcy Law.

6

opposing the plan confirmation process. See, e.g., In re Windmill

Durango, LLC, 481 B.R. 51 (B.A.P. 9th Cir. 2012) (noting that cause

under Rule 3018(a) requires more than “a mere change of heart”

and was lacking where vote change would “[do the confirma-

tion] process violence,” and affirming bankruptcy court order

denying claim purchaser’s motion to change vote accept-

ing plan cast by seller of claim, where purchaser acquired

unsecured claim for sole purpose of blocking confirmation to

prevent purchaser’s other secured claim from being crammed

down); In re J.C. Householder Land Trust # 1, 502 B.R. 602, 603

(Bankr. M.D. Fla. 2013) (noting that where secured creditor pur-

chased unsecured claim previously voted in favor of plan and

sought to change vote to block confirmation, there was insuf-

ficient cause to allow vote change under Rule 3018(a)); In re

Kellogg Square Partnership, 160 B.R. 332 (Bankr. D. Minn. 1993)

(denying motion of claims assignee to change votes of assign-

ors in order to defeat confirmation of plan and ruling that,

absent evidence that votes cast by assignors did not express

their will (as distinguished from assignee’s), cause was lacking).

As noted by the court in J.C. Householder, “Allowing one credi-

tor to acquire another creditor’s claim and change that claim’s

vote to block confirmation destroys the carefully constructed

balance between debtor and creditors in the confirmation pro-

cess.” J.C. Householder, 502 B.R. at 607.

By contrast, in cases where the plan proponent does not

oppose the vote change or where other creditors would not be

prejudiced thereby, courts have generally approved the request,

even over the objection of other creditors, in furtherance of

the Bankruptcy Code’s policies promoting fair bargaining and

consensual negotiation of chapter 11 plans in order to preserve

going concerns and maximize assets available for distribution

to creditors. See, e.g., In re Eddington Thread Mfg. Co., 189 B.R.

898 (E.D. Pa. 1995); In re Bourbon Saloon, Inc., 2012 BL 61076, *2

(Bankr. E.D. La. Mar. 14, 2012) (allowing unsecured creditor to

change vote rejecting plan after debtor agreed to pay credi-

tor in full and stating that “Fifth Circuit case law suggests that

negotiating with a creditor to achieve a consensual plan is an

acceptable reason to allow a vote change”); In re CGE Shattuck

LLC, 2000 WL 33679416 (Bankr. D.N.H. Nov. 28, 2000); In re

Dow Corning Corp., 237 B.R. 374 (Bankr. E.D. Mich. 1999); In re

Cajun Electric Power Coop., 230 B.R. 715 (Bankr. M.D. La. 1999);

In re Epic Assocs. V, 62 B.R. 918 (Bankr. E.D. Va. 1986). However,

courts have denied a vote change request even with a plan

proponent’s consent if it appears that the change was improp-

erly motivated. See, e.g., In re MCorp Fin., Inc., 137 B.R. 237, 239

(Bankr. S.D. Tex. 1992) (denying unsecured creditor’s motion to

change vote rejecting plan after creditor reached agreement

with debtor regarding treatment of his claim where “the timing

of the change [was] highly suspect, and the evidence [did] not

overcome the possibility of improper motivation”).

The bankruptcy court considered whether cause existed under

Rule 3018(a) to permit secured creditors to change their votes

rejecting a chapter 11 plan in MPM Silicones.

In cases where it appears that the entity seeking to

change its vote is motivated by considerations other

than the desire to rectify mistakes or inadvertence

and that the requested change is not fully consensual,

MPM Silicones suggests that a bankruptcy court will

subject the requested change to more exacting scru-

tiny to ensure that the reason for the vote change is

not somehow tainted or improper.

MPM SILICONES

In 2012, Momentive and its affiliates issued $1.1 billion of first-lien

notes and $250 million of “1.5-lien” notes—notes ranked junior in

collateral to the first-lien notes but senior to second-lien obliga-

tions and all other unsecured debt—due 2020. The indentures

governing all of the notes provided for the payment of make-

whole premiums under certain circumstances and stated that,

unless Momentive’s obligation to pay the make-whole premiums

was triggered, the noteholders could not voluntarily redeem the

notes before October 15, 2015 (a “no-call” provision).

Momentive and its U.S. affiliates (collectively, the “debtors”)

filed for chapter 11 protection in the Southern District of New

York on April 13, 2014. On May 9, 2014, the debtors sought a

declaratory judgment from the bankruptcy court that the note-

holders were not entitled to approximately $200 million in

make-whole premiums.

The debtors filed a proposed chapter 11 plan on May 12, 2014.

The plan included a provision for the noteholders’ recovery that

is variously referred to as a “toggle,” “death trap,” or “fish or cut

bait” provision. Specifically, the plan provided that: (i) if the note-

holders voted in favor of the plan, they would receive payment

in full in cash, without any make-whole premiums; or (ii) if the

7

noteholders rejected the plan, they would receive seven-year

replacement notes in the face amount of their allowed claims,

bearing a below-market interest rate equal to the applicable

U.S. Treasury rate plus a modest risk premium, and the right to

litigate their entitlement to the make-whole premiums.

The noteholders overwhelmingly voted to reject the plan. At the

confirmation hearing, they argued that: (i) they were contractually

entitled to the make-whole premiums due to automatic acceler-

ation of their debt triggered by the bankruptcy filing and early

repayment of the notes by means of replacement notes to be

issued under the debtors’ prenegotiated chapter 11 plan; and (ii)

the proposed treatment of their claims under the plan was not

“fair and equitable,” as required by the cram-down rules in sec-

tion 1129(b)(2) of the Bankruptcy Code, because the replacement

notes did not bear a market rate of interest. After the confirma-

tion hearing, but before the court issued a ruling on those issues,

the noteholders filed a motion under Rule 3018(a) for permission

to change their votes on the plan from rejections to acceptances.

THE BANKRUPTCY COURT’S RULINGS

On August 26, 2014, the bankruptcy court ruled from the bench

that the noteholders were not entitled to make-whole premiums

and that, with a slight upward adjustment of the risk premiums,

the proposed replacement notes satisfied section 1129(b) of the

Bankruptcy Code, even though the notes would bear interest at

less than the market rate.

The court reasoned that bankruptcy default and automatic

acceleration did not equate to prepayment of the notes and

therefore, by the express terms of the indentures, the notehold-

ers were not entitled to the make-whole premium. According to

the court, although the parties could have contracted around

this problem with clear and unambiguous language providing

for the payment of a make-whole premium, even in the event

of automatic acceleration due to a bankruptcy filing, such clear

and unambiguous language was absent from the indentures.

The court also denied the noteholders’ request to rescind the

acceleration and thereby “resurrect the make-whole claim,” rul-

ing that the automatic stay precluded deceleration.

Principally on the basis of the U.S. Supreme Court’s plurality

opinion in Till v. SCS Credit Corp., 541 U.S. 465 (2004), and the

Second Circuit’s ruling in In re Valenti, 105 F.3d 55 (2d Cir. 1997),

the bankruptcy court also held that the chapter 11 cram-down

rules set forth in section 1129(b)(2) of the Bankruptcy Code

are satisfied by a plan that provides a secured creditor with a

replacement note bearing interest at a risk-free base rate plus

a risk premium that reflects the repayment risk associated with

the debtors (but excluding any profits, costs, or fees).

The court discounted the argument that a market rate of inter-

est should be applied to the replacement notes, noting that the

Supreme Court had expressly rejected such an approach in

Till. Moreover, the bankruptcy court was critical of courts that

have read Till to endorse a market-rate approach in chapter

11 cases, where, unlike in Till (a chapter 13 case), an efficient

debtor-in-possession (“DIP”) financing market exists. See, e.g.,

In re American Homepatient, Inc., 420 F.3d 559 (6th Cir. 2005);

Mercury Capital Corp. v. Milford Connecticut Associates, L.P.,

354 B.R. 1 (D. Conn. 2006); In re 20 Bayard Views LLC, 445 B.R.

83 (Bankr. E.D.N.Y. 2011). In rejecting the approach adopted by

these courts, the MPM Silicones court emphasized that volun-

tary DIP loans and cram-down loans forced on unwilling credi-

tors (such as in the case before it) are completely different.

In a ruling dated September 17, 2014, the court denied the note-

holders’ request to change their votes. Noting that “the test for

cause [under Rule 3018(a)] very much depends on the context,”

the court rejected the noteholders’ contention that permit-

ting them to change their votes would be consistent with other

cases involving vote changes sanctioned in furtherance of a

consensual chapter 11 plan. According to the court, “If it were

the case here that the plan proponent supported the requested

vote change as part of a consensual resolution of the parties’

disputes (and the facts did not indicate any extra consideration

being offered for the changed vote . . .), [the court] would have

approved the changed vote.”

However, the court concluded that the changed votes would

not be in furtherance of a consensual plan because the plan’s

toggle provision was no longer available to the noteholders. If it

were to approve the vote change, the court explained, the debtor

had already expressed its intention to amend the plan to remove

the cash-out provision, and second-lien holders who had agreed

to backstop the existing plan’s rights offering might withdraw

their support of the existing plan in favor of an amended plan.

According to the court, the noteholders—“sophisticated institu-

tions represented by knowledgeable and sophisticated profes-

sionals”—made an informed and strategic choice to vote against

8

the plan, and “they have not shown cause now . . . to change that

vote in order to undo its consequences.”

The court characterized the noteholders’ proffered justification

for permitting a vote change as the most efficient way to end

litigation with respect to plan confirmation (and among credi-

tors) as a “forced settlement.” The court rejected such a solu-

tion, writing that “this is a choice that the debtors and their allies

should have the right to make on their own.” Moreover, the court

wrote, the prospect of reaching such a settlement is not “cause”

for the court, “in such a parochial way, [to] force on plan pro-

ponents a ‘consensual’ result that the Court, but not the propo-

nents themselves, believes is advisable.”

OUTLOOK

The chapter 11 cases of Momentive and its affiliated debtors

are likely to remain fertile ground for controversy as the plan

confirmation order and various related rulings wend their way

through the appellate process. Much scrutiny will doubtless be

directed toward the bankruptcy court’s pronouncements on cal-

culating the appropriate rate of interest on secured claims in a

cram-down chapter 11 plan. In addition, the court’s ruling on the

unenforceability in the bankruptcy context of the make-whole

payment provisions in the bond indentures is a clear wake-up

call for more painstaking drafting.

Among other things, MPM Silicones demonstrates that what

constitutes “cause” justifying a vote change under Rule 3018(a)

depends very much on the circumstances. In cases where it

appears that the entity seeking to change its vote is motivated by

considerations other than the desire to rectify mistakes or inad-

vertence and that the requested change is not fully consensual,

MPM Silicones suggests that a bankruptcy court will subject the

requested change to more exacting scrutiny to ensure that the

reason for the vote change is not somehow tainted or improper.

IN SEARCH OF THE MEANING OF “UNREASONABLY SMALL CAPITAL” IN CONSTRUCTIVELY FRAUDULENT TRANSFER AVOIDANCE LITIGATIONJane Rue Wittstein and Mark G. Douglas

The meaning of “unreasonably small capital” in the context of

constructively fraudulent transfer avoidance litigation is not

spelled out in the Bankruptcy Code. As a result, bankruptcy

courts have been called upon to fashion their own definitions

of the term. Nonetheless, the courts that have considered the

issue have mostly settled on some general concepts in fash-

ioning such a definition. In Whyte ex rel. SemGroup Litig. Trust

v. Ritchie SG Holdings, LLC (In re SemCrude, LP), 2014 BL

272343 (D. Del. Sept. 30, 2014), a Delaware district court recently

reaffirmed two such guiding principles: (i) a debtor can have

unreasonably small capital even if it is solvent; and (ii) a “rea-

sonable foreseeability” standard should be applied in assessing

whether capitalization is adequate.

AVOIDANCE OF FRAUDULENT TRANSFERS IN BANKRUPTCY

Section 548(a)(1) of the Bankruptcy Code authorizes a trustee or

chapter 11 debtor-in-possession (“DIP”) to avoid any transfer of

an interest of the debtor in property or any obligation incurred

by the debtor within the two years preceding a bankruptcy filing

if: (i) the transfer was made, or the obligation was incurred, “with

actual intent to hinder, delay, or defraud” any creditor; or (ii) the

transaction was constructively fraudulent because the debtor

received “less than a reasonably equivalent value in exchange

for such transfer or obligation” and was, among other things,

insolvent, left with “unreasonably small capital,” or unable to pay

its debts as such debts matured, when or after the transfer was

made or the obligation was incurred.

For one of these categories of constructive fraud, section

548(a)(1)(B)(ii)(II) provides that a transfer or obligation, if made

or incurred by the debtor without an exchange of reasonably

equivalent value, may be avoided if, among other things, the

debtor “was engaged in business or a transaction, or was about

to engage in business or a transaction, for which any property

remaining with the debtor was an unreasonably small capital.”

Transfers or obligations may also be avoided under analogous

state laws by operation of section 544(b) of the Bankruptcy

Code, which empowers a DIP or trustee to “avoid any transfer of

9

an interest of the debtor in property or any obligation incurred

by the debtor that is voidable under applicable law by a credi-

tor holding an unsecured claim” against the debtor. Examples

of such laws are the versions of the Uniform Fraudulent Transfer

Act (“UFTA”) and the Uniform Fraudulent Conveyance Act

(“UFCA”) adopted by most states.

The UFTA (which has been adopted by 44 states, the District

of Columbia, and the U.S. Virgin Islands) includes the phrase

“the remaining assets of the debtor were unreasonably small

in relation to the business or transaction” in place of the cor-

responding language regarding “unreasonably small capital”

in section 548(a)(1)(B)(ii)(II). See UFTA § 4(a)(2)(1). The (older but

largely repealed) UFCA, which is still in effect in New York and

Maryland, tracks the “unreasonably small capital” language in

section 548(a)(1)(B)(ii)(II). See N.Y. Debt. & Cred. L. § 274.

The Bankruptcy Code and the UFCA do not define “unreason-

ably small capital” (nor does the UFTA define “unreasonably

small” assets). This has largely been left to the courts.

The leading case on this issue is Moody v. Security Pacific

Business Credit, Inc., 971 F.2d 1056 (3d Cir. 1992). In Moody, the

Third Circuit expressed the concept as follows:

[A]n “unreasonably small capital” would refer to the

inability to generate sufficient profits to sustain opera-

tions. Because an inability to generate enough cash

flow to sustain operations must precede an inability

to pay obligations as they become due, unreasonably

small capital would seem to encompass financial dif-

ficulties short of equitable solvency.

Id. at 1070. The Third Circuit further explained that, because a

debtor’s cash flow projections tend to be optimistic, the rea-

sonableness of projections “must be tested by an objective

standard anchored in the company’s actual performance.”

According to the court, relevant data include cash flow, net

sales, gross profit margins, and net profits or losses, but “reli-

ance on historical data alone is not enough.” Id. at 1073. The

Third Circuit wrote that “parties must also account for difficulties

that are likely to arise, including interest rate fluctuations and

general economic downturns, and otherwise incorporate some

margin for error.” Id.

As explained by the court in Autobacs Strauss, Inc. v. Autobacs

Seven Co. (In re Autobacs Strauss, Inc.), 473 B.R. 525, 552 (Bankr.

D. Del. 2012), in accordance with Moody, “Reasonable foresee-

ability is the standard.” Because the term is “fuzzy, and in dan-

ger of being interpreted under the influence of hindsight bias,”

courts should resist the temptation to “suppose that because a

firm failed it must have been inadequately capitalized.” Boyer v.

Crown Stock Distributions, Inc., 587 F.3d 787, 794 (7th Cir. 2009)

(citing Moody).

Many other courts have also endorsed Moody’s articulation of

the meaning of “unreasonably small capital.” See, e.g., Global

Outreach, S.A. v. YA Global Invs., LP (In re Global Outreach, S.A.),

2014 BL 275891, *15 (Bankr. D.N.J. Oct. 2, 2014); Gilbert v. Goble

(In re N. Am. Clearing, Inc.), 2014 BL 271090, *8 (Bankr. M.D. Fla.

Sept. 29, 2014); Tronox Inc. v. Kerr-McGee Corp. (In re Tronox

Inc.), 503 B.R. 239, 320 (Bankr. S.D.N.Y. 2013).

A leading bankruptcy treatise supplements Moody’s formulation

of the definition of “unreasonably small capital” with the follow-

ing commentary:

Adequate capitalization is also a variable concept

according to which specific industry of business is

involved. The nature of the enterprise, normal turnover

of inventory rate, method of payment by customers,

etc[.], from the standpoint of what is normal and cus-

tomary for other similar businesses in the industry, are

all relevant factors in determining whether the amount

of capital was unreasonably small at the time of, or

immediately after, the transfer.

COLLIER ON BANKRUPTCY ¶ 548.05[3][b] (16th ed. 2014). A

Delaware district court examined the meaning of “unreasonably

small capital” in SemCrude.

SEMCRUDE

SemGroup, L.P. (“SemGroup”), at one time the fifth-largest

privately held U.S. company, was a “midstream” energy com-

pany that provided transportation, storage, and distribu-

tion of oil and gas products to oil producers and refiners.

SemGroup’s general partner was SemGroup G.P., L.L.C. (“SGP”).

Approximately 25 percent of SemGroup’s limited partnership

interests were held by Ritchie SG Holdings, L.L.C., and two

affiliates (collectively, “Ritchie”).

10

More than 100 lenders formed a syndicate (the “bank group”)

that provided SemGroup with a line of credit from 2005 through

July 2008.

SemGroup also traded options on oil-based commodities, using

a trading strategy that was inconsistent with both its risk man-

agement policy and the agreement governing its line of credit

(the “credit agreement”). In addition, SemGroup made advances

on an unsecured basis to fund trading losses incurred by

Westback Purchasing Company, L.L.C. (“Westback”), a company

owned by SemGroup’s CEO and his wife, without any loan docu-

mentation calling for payment of principal or interest.

The district court in SemCrude reinforced the widely

held recognition in the courts that: (i) “unreasonably

small capital” is something less than insolvency but is

likely to lead to insolvency at some time in the future;

and (ii) it is not enough for a company to have small

capital—there must also be a “reasonable foreseeabil-

ity” that a corporation does not have sufficient capital

to sustain its business.

In August 2007 and February 2008, SemGroup and SGP paid

Ritchie more than $55 million in distributions with respect

to Ritchie’s limited partnership interests. Because oil prices

between July 2007 and February 2008 were volatile, SemGroup

was obligated to post large margin deposits on the options it

sold, which forced the company to increase its borrowing under

the credit agreement from $800 million to more than $1.7 billion.

In July 2008, the bank group declared SemGroup in default of

the credit agreement. SemGroup filed for chapter 11 protection

on July 22, 2008, in the District of Delaware.

SemGroup’s confirmed chapter 11 plan became effective in

November 2009. Among other things, the plan provided for

the creation of a litigation trust to prosecute avoidance claims

belonging to the bankruptcy estate. In 2010, the litigation trustee

sued Ritchie, seeking to avoid the $55 million in distributions as

constructively fraudulent transfers under section 548(a) of the

Bankruptcy Code and Oklahoma’s version of the UFTA. Among

other things, the trustee alleged in the complaint that SemGroup

was left with unreasonably small capital after both distributions.

Bankruptcy judge Brendan L. Shannon granted summary judg-

ment in favor of Ritchie on the “unreasonably small capital”

issue. He concluded that, because all available sources of capi-

tal, including bank lines, should be considered when determin-

ing whether a company is adequately capitalized, there was

no serious dispute that SemGroup had adequate capital and

liquidity to operate after the distributions to Ritchie. Judge

Shannon also found that there was no evidence that SemGroup

had engaged in fraud or that the bank group had declared

SemGroup in default due to the company’s options trading or

the Westback payments.

The litigation trustee appealed to the district court.

THE DISTRICT COURT’S RULING

The district court affirmed on appeal. After examining the

standard articulated in Moody, Judge Sue L. Robinson empha-

sized that “ ‘there must be a causal relationship between the

[fraudulent transfer] and the likelihood that the Debtor’s busi-

ness will fail . . . [and that a] debtor’s later failure, alone, is not

dispositive on the issue’ ” (quoting In re Kane & Kane, 2013

BL 79573 (Bankr. S.D. Fla. Mar. 25, 2013)). According to the

SemCrude court, “unreasonably small capital” refers to prob-

lems that “ ‘are short of insolvency in any sense but are likely

to lead to insolvency at some time in the future’ ” (quoting In re

Tronox, 503 B.R. 239, 320 (Bankr. S.D.N.Y. 2013)).

Judge Robinson found no error in the bankruptcy court’s con-

clusion that SemGroup’s substantial line of credit should be

considered in assessing whether the company was adequately

capitalized. She rejected the litigation trustee’s argument

that the complaint raised a material disputed fact concerning

whether it was reasonably foreseeable that SemGroup would be

unable to sustain its operations due to its “massive breach” of

the credit agreement:

It is not clear from the record whether or not the Bank

Group was aware of the business activities identified

by appellant as being inconsistent with SemGroup’s

obligations under the Credit Agreement. . . . As rec-

ognized by the bankruptcy court, however, it makes

no difference. If the Bank Group was aware of such,

appellant’s position collapses on itself, for there is

no forecast to make—SemGroup’s access to credit

had not been withdrawn at the time of either of the

11

distributions despite the “massive” breach of the

Credit Agreement. If the Bank Group was not aware

of such activities, one has to engage in multiple levels

of forecasting in order to embrace appellant’s posi-

tion. . . . [A]ppellant would have the court, in effect,

forecast (1) the lenders’ reaction to discovering the

conduct, and then (2) the consequences of that reac-

tion, i.e., that the only option chosen by all of the lend-

ers would have been to foreclose access to all credit,

which (3) had the reasonably foreseeable conse-

quence of bankruptcy.

Judge Robinson agreed with the bankruptcy court that “what

appellant proposes is a ‘speculative exercise’ not rooted in the

case law.”

OUTLOOK

Determining whether a debtor has unreasonably small capital as

a consequence of a transfer or obligation that is later challenged

as being constructively fraudulent is a fact-intensive inquiry.

Guided by Moody, the district court in SemCrude reinforced the

widely held recognition in the courts that: (i) “unreasonably small

capital” is something less than insolvency but is likely to lead to

insolvency at some time in the future; and (ii) it is not enough for

a company to have small capital—there must also be a “reason-

able foreseeability” that a corporation does not have sufficient

capital to sustain its business.

DIP LENDER’S KNOWLEDGE OF ADVERSE CLAIM TO COLLATERAL SCUTTLES MOOTNESS BAR TO APPEAL OF FINANCING ORDER BASED ON “GOOD FAITH”Thomas A. Howley, Paul M. Green, and Mark G. Douglas

The Bankruptcy Code provides certain protections to buyers of

bankruptcy estate assets and to entities that extend credit or

financing to a trustee or chapter 11 debtor-in-possession (“DIP”).

However, these safe harbors are available only if a buyer or

lender is deemed to have acted in “good faith,” a concept that

is not defined in the Bankruptcy Code.

In TMT Procurement Corp. v. Vantage Drilling Co. (In re TMT

Procurement Corp.), 2014 BL 244511 (5th Cir. Sept. 3, 2014), reh’g

denied, No. 13-20622 (5th Cir. Oct. 23, 2014), the U.S. Court of

Appeals for the Fifth Circuit vacated DIP financing orders of the

bankruptcy court and district court, notwithstanding express find-

ings by the lower courts that the lender had acted in good faith.

Such findings ordinarily would have mooted any appeal in the

absence of a stay pending appeal. The Fifth Circuit ruled that:

(i) the appeals were not statutorily moot because, having been

aware of an adverse claim to stock that was pledged as collat-

eral for the DIP loan, the DIP lender lacked “good faith”; and (ii)

the lower courts lacked subject-matter jurisdiction to enter the

DIP financing orders. The ruling is a cautionary tale for any pro-

spective asset purchaser or lender in a bankruptcy case.

SAFE HARBORS FOR ORDERS APPROVING SALE OF ESTATE

PROPERTY AND DIP FINANCING

Pursuant to section 363 of the Bankruptcy Code, a trustee or

DIP may: (i) under subsection (c)(1), enter into ordinary-course

transactions involving the use, sale, or lease of estate property

without court authority; and (ii) under subsection (b), with court

approval after notice and a hearing, use, sell, or lease estate

property outside the ordinary course of business (with certain

specified exceptions). Estate property may be sold free and

clear of any interest in the property asserted by a third party

under the circumstances set forth in section 363(f).

An order approving a sale under section 363(b) is stayed until 14

days after it is entered (subject to the court ordering otherwise),

at which point the order becomes “final.” See Fed. R. Bankr. P.

6004(h) and 8002. Moreover, unless the appellant obtains a fur-

ther stay pending the resolution of its appeal, section 363(m)

12

provides that any reversal or modification of the sale order on

appeal has no effect on the validity of the sale to “an entity that

purchased . . . such property in good faith.”

Section 364(a) of the Bankruptcy Code authorizes a DIP or

trustee to obtain unsecured credit and to incur unsecured debt

in the ordinary course of business without court approval. A

DIP or trustee may also obtain credit or incur debt outside the

ordinary course of business on either an unsecured or secured

basis with court approval under the circumstances specified in

sections 364(b), 364(c), and 364(d).

Like section 363(m)’s safe harbor for good-faith purchasers, sec-

tion 364(e) provides that, unless the party challenging an order

authorizing credit or financing obtains a stay pending appeal:

[ t ]he reversal or modif ication on appeal of an

authorization . . . to obtain credit or incur debt, or of a

grant . . . of a priority or a lien, does not affect the valid-

ity of any debt so incurred, or any priority or lien so

granted, to an entity that extended such credit in good

faith, whether or not such entity knew of the pendency

of the appeal.

Thus, pursuant to sections 363(m) and 364(e), the failure

to obtain a stay of an order approving a sale of assets or

authorizing financing moots any appeal of the order where the

purchaser or lender acted in good faith, a preclusion commonly

referred to as “statutory mootness.”

The court in In re EDC Holding Co., 676 F.2d 945, 947 (7th Cir.

1982), explained the purpose of the section 363(m) and 364(e)

safe harbors as follows:

These provisions seek to overcome people’s natural

reluctance to deal with a bankrupt firm whether as

purchaser or lender by assuring them that so long as

they are relying in good faith on a bankruptcy judge’s

approval of the transaction they need not worry about

their priority merely because some creditor is object-

ing to the transaction and is trying to get the district

court or the court of appeals to reverse the bankruptcy

judge. The proper recourse for the objecting creditor is

to get the transaction stayed pending appeal.

The Bankruptcy Code does not define “good faith.” Courts

have adopted various definitions. For example, in In re Mark

Bell Furniture Warehouse, Inc., 992 F.2d 7, 8 (1st Cir. 1993), the

First Circuit wrote that “[a] ‘good faith’ purchaser is one who

buys property . . . for value, without knowledge of adverse

claims” (citations omitted). Lack of good faith is typically dem-

onstrated by evidence of fraud, collusion between the buyer

and other bidders or the trustee, or an attempt to take grossly

unfair advantage of other bidders. See COLLIER ON BANKRUPTCY

¶ 363.11 (16th ed. 2014) (citing cases).

In the context of DIP financing under section 364, “good faith”

has been defined as “ ‘honesty in fact in the conduct or transac-

tion concerned.’ ” See Unsecured Creditors’ Comm. v. First Nat’l

Bank & Trust Co. of Escanaba (In re Ellingsen MacLean Oil Co.),

834 F.2d 599, 605 (6th Cir. 1987) (citing UCC § 1-201(19)). Good

faith has been found lacking in cases where the lender was

aware of the illegality of an action, extended financing or credit

for an improper purpose (e.g., to gain an advantage in litigation),

or failed to reveal material facts to the court. See In re Abbotts

Dairies, Inc., 788 F.2d 143, 147 (3d Cir. 1986).

The proponent of good faith bears the burden of proof. See

TMT Procurement, 2014 BL 244511, *6. Good faith should not

be presumed. Specific findings of good faith should gener-

ally be included in any order approving a sale of assets or

authorizing financing.

The Fifth Circuit examined statutory mootness under sections

363(m) and 364(e) in TMT Procurement.

TMT PROCUREMENT

In 2012, Vantage Drilling Company (“Vantage”), an offshore drill-

ing company, sued Hsin-Chi Su (“Su”) and certain other defen-

dants in Texas state court for fraud allegedly committed in

connection with a transaction whereby Vantage, in exchange

for Su’s services, issued approximately $100 million in stock to

F3 Capital (“F3”), an entity controlled by Su. In the litigation (the

“Vantage Litigation”), Vantage sought, among other things, a

judgment imposing a constructive trust on the stock held by F3

as well as certain other related assets.

In 2013, more than 20 foreign marine shipping companies

owned directly or indirectly by Su (collectively, the “debtors”)

filed for chapter 11 protection in the Southern District of Texas. At

13

a hearing on various creditors’ motions to dismiss the cases as

having been filed in bad faith, Su offered to place approximately

25 million shares of Vantage stock held by F3 (which did not

file for bankruptcy) into a court-administered escrow as security

for, among other things, DIP financing. According to F3 and Su,

such an escrow arrangement would not violate any court orders

(including injunctions) issued in the Vantage Litigation.

Vantage sought an injunction from the court presiding over the

Vantage Litigation that would prevent Su or F3 from transferring,

selling, pledging, or otherwise encumbering the Vantage stock.

Although it was not a creditor in the debtors’ chapter 11 cases,

Vantage also objected to the escrow motion before the bank-

ruptcy court as a “party-in-interest.”

The Vantage Litigation court ruled that any dispute over encum-

bering the Vantage stock should be resolved by the bank-

ruptcy court, and it prohibited Su from pledging or disposing

of the stock without court permission. The bankruptcy court

subsequently approved the escrow arrangement, holding that:

(i) F3 owned the Vantage stock; and (ii) because the shares

owned by F3 were not subject to a constructive trust, they could

be “placed in custodia legis without complaint by any other

party who has claimed ownership in the shares.”

TMT Procurement is an important ruling, particularly

for DIP lenders. The ruling highlights the need for any

prospective lender to conduct sufficient due diligence

to determine whether there are any adverse claims to

collateral that a DIP or trustee intends to pledge as

security for a DIP loan. It remains to be seen whether

the increased risk borne by potential DIP lenders

in connection with this issue will make DIP financing

more expensive.

Vantage appealed the order approving the escrow arrange-

ment. The district court, which had withdrawn the reference of

the chapter 11 cases to the bankruptcy court, initially denied

the appeal as interlocutory, but agreed to reconsider its ruling.

Before it could do so, the debtors filed an emergency motion

for authority to borrow up to $20 million, $6 million of which

they requested on an interim basis. The district court approved

the interim financing. The interim financing order granted an

unrelated lender (the “DIP Lender”) a first-priority lien on the

deposited Vantage stock and provided, among other things,

that the DIP Lender had extended the financing to the debtors

in good faith and was entitled to “the full protections of sections

363(m) and 364(e) of the Bankruptcy Code.”

The district court re-referred the debtors’ chapter 1 1 cases

to the bankruptcy court in October 2013. Shortly afterward,

the bankruptcy court entered a final order approving the DIP

financing. Like the district court’s interim order, the final order

provided that the DIP Lender was “extending financing to the

[debtors] in good faith and in express reliance upon the protec-

tions afforded by sections 363(m) and 364(e) of the Bankruptcy

Code and [the DIP Lender] is entitled to the benefits of sections

363(m) and 364(e) of the Bankruptcy Code.”

The bankruptcy court certified Vantage’s appeal of the court’s

final DIP financing order directly to the Fifth Circuit, which

consolidated the appeal with a pending appeal of the district

court’s interim DIP financing order. Vantage neither sought nor

obtained a stay of any of the orders.

THE FIFTH CIRCUIT’S RULING

Lack of Good Faith

A three-judge panel of the Fifth Circuit vacated the rulings and

remanded the case below. The court first addressed whether

the appeals were statutorily moot because Vantage failed to

obtain a stay pending appeal.

Vantage did not contend that the DIP Lender committed fraud,

colluded, or attempted to take grossly unfair advantage of any-

one in extending financing to the debtors. Instead, Vantage

argued that the DIP Lender could not have acted in good faith

because it was on notice of Vantage’s adverse claim to the

stock held by F3. The debtors countered that knowledge of

an adverse claim should not preclude a finding of good faith

because such a rule would undermine the purposes of section

363(m) and 364(e), both of which “contemplate situations where

the good faith purchaser or lender has knowledge of the pen-

dency of an appeal.”

The Fifth Circuit acknowledged that “there is some power” in

the debtors’ argument. Even so, the court explained that knowl-

edge of a pending appeal is distinct from knowledge of an

adverse claim:

14

There is a difference, as demonstrated by this case,

between simply having knowledge that there are

objections to the transaction and having knowledge

of an adverse claim. Having knowledge that there are

objections to the transaction usually involves those

situations in which “some creditor is objecting to the

transaction and is trying to get the district court or the

court of appeals to reverse the bankruptcy judge.” . . .

Having knowledge of an adverse claim requires some-

thing more. That is why the former does not preclude

a finding of good faith, whereas the latter does. Here,

the DIP Lender’s knowledge was not simply limited to

objections by creditors of the Debtors. The DIP Lender

had knowledge that a third-party, entirely unrelated to

the bankruptcy proceedings, had an adverse claim to

the Vantage Shares. On these facts, the DIP Lender

does not qualify as a good faith purchaser or lender.

Noting that the DIP Lender was clearly on notice that Vantage

had a competing claim to the shares held by F3 when the

DIP Lender provided financing, the Fifth Circuit ruled that the

appeals were not statutorily moot because the DIP Lender did

“not come within the meaning of ‘good faith’ as envisioned by

§ 363(m) and § 364(e).”

Lack of Subject-Matter Jurisdiction

The Fifth Circuit also held that the courts below erred in enter-

ing the financing orders because they lacked subject-matter

jurisdiction over the Vantage stock held by F3 and the Vantage

Litigation. Under 28 U.S.C. § 1334, the court explained, U.S. dis-

trict courts have exclusive jurisdiction over “all cases under

title 1 1”; this jurisdiction encompasses “all of the property,

wherever located, of the debtor as of the commencement of

such case, and of property of the estate.” District courts also

have “original but not exclusive jurisdiction of all civil pro-

ceedings arising under title 11, or arising in or related to cases

under title 11.” This jurisdiction is routinely referred to bank-

ruptcy courts but can be withdrawn.

The Fifth Circuit concluded that the Vantage stock was not

property of the debtors’ estates because: (i) the debtors had no

legal or equitable interest in the stock as of the bankruptcy peti-

tion date, such that the stock would be estate property under

section 541(a)(1) of the Bankruptcy Code; (ii) the stock was not

“[p]roceeds, product, offspring, rents, or profits of or from prop-

erty of the estate” under section 541(a)(6); and (iii) the stock did

not constitute property of the estate acquired after the petition

date under section 541(a)(7) “because that provision is limited

to property interests that are themselves traceable to ‘property

of the estate’ or generated in the normal course of the debtor’s

business.” The court rejected the debtors’ argument that they

had acquired an interest in the stock after it was deposited into

escrow pursuant to the lower courts’ orders. According to the

Fifth Circuit, the shares were not estate property under section

541(a)(7) because they “were not created with or by property of

the estate, they were not acquired in the estate’s normal course

of business, and they are not traceable to or arise out of any

prepetition interest included in the bankruptcy estate.”

The Fifth Circuit also ruled that the debtors could not rely on the

lower courts’ financing orders to support subject-matter juris-

diction. According to the Fifth Circuit, the lower courts “could

not manufacture in rem jurisdiction over the Vantage Shares by

issuing orders purporting to vest” the debtors with an interest

in the stock. Those orders, the court wrote, could not constitute

“jurisdictional bootstraps” allowing the lower courts to “exercise

jurisdiction that would not otherwise exist.”

The court rejected the debtors’ contention that the lower courts

had jurisdiction to enter the financing orders because granting

a lien on the Vantage stock was somehow “related to” the bank-

ruptcy cases within the meaning of 28 U.S.C § 1334(b). The Fifth

Circuit wrote that the dispute over the stock was unrelated to

the debtors’ pending chapter 11 cases because the outcome of

the Vantage Litigation “could not conceivably affect the Debtors’

estates.” The only discernible link between the Vantage Litigation

and the chapter 11 cases, the court explained, is that F3 and the

debtors had a common owner—Su—which “is not enough.” The

Fifth Circuit further stated that bankruptcy jurisdiction does not

extend to state law disputes “between non-debtors over non-

estate property.” Moreover, the court emphasized, the lower

courts “improperly interfered” with the Vantage Litigation by

ordering that the Vantage stock be deposited into escrow.

Finally, the Fifth Circuit rejected the debtors’ argument that

the lower courts had jurisdiction to enter orders approving

the financing “because the orders deal with core proceedings

involving the administration of the bankruptcy estate, the acqui-

sition of credit, and the use of property, including cash collat-

eral.” The court held that the Vantage Litigation was not a “core”

15

proceeding because the litigation was “not based on any right

created by the federal bankruptcy law” but was “simply a state

contract action.”

OUTLOOK

TMT Procurement is an important ruling, particularly for

DIP lenders. The ruling highlights the need for any prospec-

tive lender to conduct sufficient due diligence to determine

whether there are any adverse claims to collateral that a DIP or

trustee intends to pledge as security for a DIP loan. It remains

to be seen whether the increased risk borne by potential DIP

lenders in connection with this issue will make DIP financing

more expensive.

To be sure, the facts of TMT Procurement are unusual and

unlikely to be replicated in most cases. Apart from the statutory

mootness issue, the Fifth Circuit was plainly disturbed by what

it perceived to be the lower courts’ improper interference with

state court litigation totally unrelated to the debtors’ chapter

11 cases. The DIP Lender, however, paid the price for the lower

courts’ perceived transgressions. As an additional plot twist,

because the DIP orders had not been stayed, a portion of the

Vantage shares was sold to satisfy the DIP Lender’s claim. Thus,

as a result of the Fifth Circuit’s ruling, a number of issues remain

to be resolved by the bankruptcy court on remand.

BETTER LATE THAN NEVER: CLAIMS FILED YEARS LATE DID NOT WAIVE SUBORDINATION AGREEMENT PRIORITIES OR WARRANT EQUITABLE SUBORDINATIONJoseph A. Florczak

The Bankruptcy Code dictates the priority of distributions to the

holders of allowed secured and unsecured claims in accordance

with various statutory priority schemes. However, the Bankruptcy

Code also provides that consensual pre-bankruptcy agreements

between or among creditors that prioritize the right to receive

payments from an obligor will generally be enforced in a bank-

ruptcy case subsequently filed by the obligor.

In In re Franklin Bank Corp., 2014 BL 200948 (D. Del. July 21,

2014), a Delaware district court confronted the apparent conflict

between the priorities established by the Bankruptcy Code for

late-filed claims and a prepetition subordination agreement. The

court vacated and remanded a bankruptcy court ruling that:

(i) by filing its claims years after expiration of the claims “bar

date,” a creditor waived its right to enforce the terms of prepeti-

tion subordination agreements; or, in the alternative, (ii) the late

filings justified equitable subordination of the tardy creditor’s

claims. According to the district court, the creditor’s failure to

act in a timely manner did not rise to the level of a “clear mani-

festation of intent to relinquish a contractual protection” and

there was evidence of neither inequitable conduct nor harm to

other creditors that would warrant equitable subordination of

the late-filed claims.

BANKRUPTCY CODE PRIORITIES

Various provisions of the Bankruptcy Code establish priori-

ties for claims against the debtor or the bankruptcy estate. For

example, section 507 specifies 10 categories of unsecured

claims (e.g., administrative expense claims, certain employee

wage and benefit claims, certain tax claims, and certain per-

sonal injury claims) that have priority over the claims of general

unsecured creditors.

Section 726(a) of the Bankruptcy Code establishes the pri-

ority scheme for the distribution of estate assets in a chapter

7 liquidation. It provides that, “[e]xcept as provided in section

510,” first priority is given to timely filed claims of the kind (and

in the order) specified in section 507. Timely filed unsecured

16

claims without priority under section 507 as well as tardily

filed unsecured claims submitted by creditors without notice

or actual knowledge of the bankruptcy case (if filed in time to

permit payment) are conferred with second priority. Other tar-

dily filed unsecured claims are relegated to third priority. Fourth,

fifth, and sixth priorities are afforded, respectively, to: (a) cer-

tain fines, penalties, forfeitures, and punitive damage claims;

(b) claims for postpetition interest; and (c) the debtor’s residual

interest in the estate. Claims of higher priority must be paid in

full before any lower-priority claimant may receive a distribution

from the bankruptcy estate.

As noted, section 726(a) expressly states that this distribu-

tion scheme is subject to section 510 of the Bankruptcy Code.

Section 510(a) provides that “[a] subordination agreement is

enforceable in a case under this title to the same extent that

such agreement is enforceable under applicable nonbank-

ruptcy law.” Section 510(b) “categorically” subordinates certain

claims for damages arising from the rescission of a purchase

or sale of the securities of a debtor or its affiliate. Finally, under

section 510(c), a claim or interest can be subordinated for pur-

poses of distribution to other claims or interests “under prin-

ciples of equitable subordination.” In Franklin, the Delaware

district court examined the interplay between sections 726(a),

510(a), and 510(c) of the Bankruptcy Code.

BACKGROUND

In November 2008, Texas-based savings and loan hold-

ing company Franklin Bank Corporation (the “debtor”) filed

a chapter 7 petition in the District of Delaware. Prior to filing

for bankruptcy, the debtor: (a) issued a series of senior notes;

and (b) created four capital trusts, issuing a different class of

securities to each trust. The Bank of New York Mellon Trust

Company, N.A. (“BNY Mellon”) served as indenture trustee

for the senior notes and three of the capital trusts, whereas

Wilmington Trust Co. (“Wilmington Trust”) served as indenture

trustee for the remaining trust.

The noteholders and trust security holders were parties to a

series of prepetition subordination agreements. Under these

agreements, the notes and securities for which BNY Mellon

served as indenture trustee held higher priority of payment than

the securities for which Wilmington Trust was indenture trustee.

The bankruptcy court established a March 12, 2009, dead-

line (“bar date”) for the filing of proofs of claim in the case.

Wilmington Trust timely filed a $25.7 million proof of claim. BNY

Mellon, however, filed its $84 million in claims in November

2011—more than two and a half years after the bar date.

One takeaway from Franklin is that provisions in inter-

creditor agreements governing payment priority are

durable and will generally be enforced by bankruptcy

courts. Creditors, however, should not view the deci-

sion as a license to ignore claims bar dates.

The chapter 7 trustee issued his final report in May 2013. With

only approximately $7 million available in the estate for distri-

bution, the trustee allocated the entire amount to pay a portion

of Wilmington Trust’s $25.7 million claim. BNY Mellon objected,

asserting for the first time (more than four years after com-

mencement of the case) that Wilmington Trust’s claim was con-

tractually subordinated.

The bankruptcy court overruled BNY Mellon’s objection. First,

the court reasoned that BNY Mellon’s late-filed claims were

junior to Wilmington Trust’s timely filed claim pursuant to the pri-

ority scheme delineated in section 726(a). Next, the court found

that BNY Mellon “waived” its right to enforce the subordination

agreements by “sitting on its hands” for years prior to assert-

ing its claims. The court held that this “gross negligence” was

detrimental to the estate and prejudicial to estate administra-

tion. The bankruptcy court also hedged its ruling, stating that

if an appellate court were to find that BNY Mellon’s actions

did not constitute a waiver of its right to enforce the subordi-

nation agreements, the court would equitably subordinate the

claims under section 510(c) of the Bankruptcy Code. BNY Mellon

appealed the ruling to the district court.

THE DISTRICT COURT’S RULING

The Late Claim Filing Did Not Constitute a Waiver

The Delaware district court first analyzed whether BNY Mellon

either prejudiced administration of the debtor’s bankruptcy

estate or committed “gross negligence” when it filed its claims

years after the bar date and thereby waived its right to enforce

17

explained, equitable subordination requires egregious conduct,

such as “fraud, spoliation or overreaching.” Despite the bank-

ruptcy court’s finding that BNY Mellon’s conduct was “grossly

negligent,” the district court held that such negligence was not

egregious. In the absence of any evidence of inequitable con-

duct or harm to creditors, the district court ruled that the second

element (unfair advantage or creditor injury) was not satisfied.

The district court also held that equitable subordination of a

claim based solely upon lateness in filing a proof of claim is

inconsistent with the Bankruptcy Code. Under section 726(a),

the court reasoned, the Bankruptcy Code already “punishe[s]”

late-filed claims by giving them lower priority than timely filed

claims. The court noted that all of section 726(a), including

the provisions subordinating late-filed claims, is subject to

section 510, which specifically provides for the enforcement of

subordination agreements. The court concluded that equitable

subordination of a claim solely because it is tardily filed is

inconsistent with this statutory structure:

To equitably subordinate a claim for tardiness alone,

in my mind, is inconsistent with the statutory inter-

play between sections 726 and 510, and a violation

of the contractual framework entered into by the

parties for prioritizing the claims in this bankruptcy

proceeding. Something more than extreme tardiness

is required before [BNY Mellon’s] claim can be equi-

tably subordinated.

CONCLUSION

One takeaway from Franklin is that provisions in intercreditor

agreements governing payment priority are durable and will

generally be enforced by bankruptcy courts. Creditors, however,

should not view the decision as a license to ignore claims bar

dates. In its decision, the district court considered, in part, that

no actual prejudice to the estate occurred because no claim

distributions had yet been made by the chapter 7 trustee, and it

was a simple matter under the circumstances to substitute the

creditor that would receive a distribution. Circumstances may

vary in other cases. Moreover, although the district court ruled

that mere negligence in filing a late proof of claim is insufficient

by itself to warrant equitable subordination, it remains unclear

what other factors (or knowledge) might be deemed to justify

the equitable subordination of a claim.

the subordination agreements. The court ultimately concluded

that BNY Mellon’s conduct did not constitute a waiver as a mat-

ter of law.

Under New York law, the district court explained, a party may

waive contractual rights if such rights are “knowingly, voluntarily

and intentionally abandoned” (citing Fundamental Portfolio

Advisors, Inc. v. Tocqueville Asset Mgmt., L.P., 850 N.E.2d 653,

658 (N.Y. 2006)). In this context, abandonment requires either:

(i) affirmative action; or (ii) a failure to act that manifests a clear

intention to relinquish contractual protection.

In examining whether BNY Mellon waived its rights under the

subordination agreements, the district court questioned whether

“prejudice to estate administration” is even relevant to the ques-

tion. Nevertheless, the district court held that, since the chapter

7 trustee had not yet distributed any funds, no such prejudice

existed. Because the estate’s assets were so small in amount

compared to the asserted claim amounts, the court wrote, the

trustee merely had to “write a check in the same amount” to

BNY Mellon as he would have written to Wilmington Trust.

Despite frustration caused by the years-late filing, the district

court also concluded that BNY Mellon’s inaction, though neg-

ligent, did not clearly manifest an intent to abandon its rights

under the subordination agreements.

Equitable Subordination of the Late-Filed Claims Was

Unwarranted

The district court also determined that the bankruptcy court’s

alternative ruling equitably subordinating BNY Mellon’s late-

filed claims was erroneous. In the Third Circuit, the district court

explained, three conditions must apply for a court to equitably

subordinate a claim: (i) the claimant must have engaged in

inequitable conduct; (ii) the claimant’s misconduct must have

conferred an unfair advantage on the claimant or injured other

creditors; and (iii) equitable subordination must not be inconsis-

tent with the Bankruptcy Code (citing Schubter v. Lucent Techs.

Inc. (In re Winstar Commc’ns, Inc.), 554 F.3d 382, 411 (3d. Cir.

2009)). The district court held that none of these elements was

satisfied in the case before it.

First, the district court found that BNY Mellon did not engage in

inequitable conduct. For noninsiders like BNY Mellon, the court

18

IN BRIEF: ENFORCEABILITY OF WAIVERS OF THE AUTOMATIC STAYMichael J. Cohen

Michael J. Cohen

An article appearing in the July/August 2014 issue of the

Business Restructuring Review , available at http://www.

jonesday.com/cleverly-insidious-bankruptcy-waiver-in-

spe-operating-agreement-unenforceable-as-matter-of-public-

policy-08-01-2014/, discusses a ruling by an Oregon bankruptcy

court that held unenforceable a negative covenant in a limited

liability company’s operating agreement prohibiting the com-

pany from filing a bankruptcy petition, among other actions.

Addressing a different form of what some would consider an

inviolate bankruptcy right—a debtor’s right to the protections of

the automatic stay under section 362 of the Bankruptcy Code—

the U.S. Bankruptcy Court for the District of Puerto Rico ruled in

In re Triple A&R Capital Investment, Inc., 2014 BL 283893 (Bankr.

D.P.R. Oct. 9, 2014), that a secured lender was entitled to relief

from the stay because the debtor, in a court-approved cash

collateral stipulation, generally ratified prepetition forbearance

agreements that included a stay waiver provision.

Triple A&R Capital Investment, Inc. (“A&R”) was the owner

of a single parcel of real property and therefore subject to

the Bankruptcy Code’s special rules governing single-asset

real estate debtors when it filed for chapter 11 protection in

June 2014. Among those provisions is section 362(d)(3), which

obligates the bankruptcy court to terminate the automatic stay,

upon the request of a party-in-interest, unless the debtor, within

90 days of entry of an order for relief in the case (with certain

exceptions), either: (i) files a chapter 11 plan that has a reason-

able possibility of being confirmed within a reasonable time

frame; or (ii) makes monthly interest payments to the secured

creditor on its claim at the non-default contract rate.

A&R and secured lender PRLP 2011 Holdings LLC (“PRLP”)

entered into a series of forbearance agreements beginning in

2009. In those agreements, A&R prospectively waived the pro-

tection of the automatic stay in any future bankruptcy case,

which is not uncommon in real property financing transactions

involving distressed borrowers.

After filing for bankruptcy, A&R sought court approval of a

cash collateral stipulation in which A&R generally ratified its

prepetition loan documents, acknowledged that their terms

were valid and enforceable, and agreed that its obligations

under the agreements were not subject to further challenge.

The cash collateral stipulation itself, however, did not contain

specific language waiving the automatic stay then in force in

the bankruptcy case. In addition, A&R agreed in the cash collat-

eral stipulation to provide adequate protection to PRLP, includ-

ing monthly payments in the amount of $19,000.

One day after A&R filed the proposed stipulation with the court,

PRLP moved to lift the automatic stay on the basis of the waiver

provision. A&R later filed a chapter 11 plan within the time frame

specified in section 362(d)(3).

At the hearing on PRLP’s motion to vacate the stay, A&R con-

tended, among other things, that the prepetition waiver was

unenforceable at its inception and thus could not be ratified

later because Puerto Rico law does not recognize the validity

of any waiver of a right that is not in existence at the time the

purported waiver is executed (here, a debtor’s right to the pro-

tection of automatic stay, which is triggered only upon the filing

of a bankruptcy petition).

19

The court ultimately sided with PRLP. After carefully examining

the relevant case law and noting the absence of any control-

ling precedent in the District of Puerto Rico or the First Circuit,

the court granted relief from the stay, stating that “[t]his Debtor,

as a debtor in possession, ratified and agreed to be bound by

clauses in the Forbearance Agreement which expressly con-

tained a waiver.” A&R appealed the ruling to the district court

but did not seek a stay pending the appeal.

Case law varies on whether prepetition automatic stay waivers

are enforceable. Many courts now evaluate such waivers as part

of a multifactor analysis of whether the automatic stay should

be lifted, rather than granting stay relief solely on the basis of

such a waiver. Triple A&R adds a wrinkle to this analysis in the

form of a postpetition general ratification of prepetition loan

documents containing such a waiver.

Notably, the court did not address the absence of language

in the cash collateral stipulation unequivocally manifesting

the debtor’s knowing and specific waiver of the stay. Nor did

the court comment on what could be viewed as the unseemly

“gotcha” element of PRLP’s gambit of seeking stay relief one

day after having signed a cash collateral stipulation that led

A&R to believe that PRLP was cooperating and would refrain

from exercising its remedies, at least in the short term.

Triple A&R is a cautionary tale. If, as is sometimes the case, an

acknowledgment by a chapter 11 trustee or a debtor-in-posses-

sion of the validity, enforceability, or priority of prepetition loan

or security agreements or a waiver of claims is part of the quid

pro quo for a postpetition loan, extension of credit, or use of

cash collateral, appropriate due diligence must be performed to

ascertain exactly what the ramifications of such an acknowledg-

ment or waiver are.

NEW CHILEAN INSOLVENCY LAW PROMOTES REORGANIZATIONS

A new insolvency law was approved by the Chilean Congress

at the end of 2013 and became effective in October 2014. The

legislation substantially overhauls Chile’s prior insolvency law,

particularly with respect to business insolvency cases. It incor-

porates a number of provisions that permit the reorganization

of financially troubled businesses, with a view toward preserving

enterprise value and jobs, as well as expediting and enhancing

creditor recoveries. The new law represents a marked departure

from the previous regime, which was focused on the liquidation

of debtors’ assets.

Principal features of the new law include:

• The assignment of insolvency proceedings to specialized

insolvency courts, rather than randomly selected civil tribunals.

• Enhanced protection of the debtor and its assets, including

a provision that makes a plan of reorganization approved by

creditors holding at least two-thirds of a debtor’s liabilities

binding on all secured creditors, which will be prevented

from foreclosing on collateral deemed essential to the

debtor’s reorganization.

• A provision prohibiting termination of contracts due to the

debtor’s insolvency or failure to make payments prior to

the commencement of an insolvency proceeding; claims held

by creditors violating these rules will be subordinated.

• A provision authorizing the avoidance of transactions

effected in bad faith and to the detriment of creditors during

the two years previous to the commencement of an insol-

vency proceeding.

• A provision authorizing the avoidance of certain non-ordinary-

course payments and pledges of collateral to secure previ-

ously unsecured debt effected during the year preceding the

commencement of an insolvency proceeding.

• Invalidation of amendments to a debtor’s bylaws within six

months of an insolvency proceeding filing that cause a

decrease in the debtor’s equity.

20

• The implementation of procedures permitting the debtor to

contest an involuntary liquidation petition filed by a creditor.

• The implementation for the first time in Chile of regulations

governing cross-border insolvency proceedings, including

provisions authorizing a Chilean court that has recognized

the pendency of an insolvency proceeding abroad to, among

other things: (i) stay the commencement or continuation of

any litigation against the debtor or its assets; (ii) enjoin the

debtor from transferring or encumbering its assets; (iii) obtain

discovery of information regarding the debtor’s assets, busi-

ness, rights, obligations, or liabilities; and (iv) request the

appointment of a foreign receiver responsible for the admin-

istration or sale of the debtor’s Chilean assets.

• Disenfranchisement of insiders in reorganization and liquida-

tion proceedings and reduction of the threshold required for

approval of pre-bankruptcy reorganization agreements from

creditors holding at least three-quarters of liabilities to credi-

tors representing at least two-thirds of liabilities.

A comprehensive discussion of Chile’s new insolvency law can

be accessed at https://www.insol.org/_files/TechnicalSeries/

Special%20Reports/Special%20Report%20on%20Chile%20

-%2026%20September%202014.pdf.

EUROPEAN PERSPECTIVE IN BRIEF

Europe has struggled mightily during the last several years to

triage a long series of critical blows to the economies of the

28 countries that comprise the European Union, as well as the

collective viability of eurozone economies. Here we provide a

snapshot of some recent developments regarding insolvency,

restructuring, and related issues in the EU.

The Netherlands—In August 2014, the Dutch legislature circu-

lated a proposed bill that would introduce to Dutch restruc-

turing law U.K.-style “schemes of arrangement,” a radical

departure from existing procedures. The proposed bill follows

the introduction of a prepackaged insolvency mechanism in

2013. Acknowledging that the nation lacks a flexible corporate

rescue procedure, the Dutch legislature has proposed legisla-

tion that would make schemes of arrangement patterned on

U.K. law possible for distressed Dutch companies, but under

rules that could make such schemes even faster than their

English counterparts.

Under existing Dutch law, it is nearly impossible to alter the cap-

ital structure of a company without the unanimous approval of

all debt and equity holders. The draft bill introduces rules that

would bind dissenting creditors to a restructuring proposal

under certain circumstances. In addition, under the proposed

legislation, security rights granted to lenders that provide emer-

gency financing during the period between the introduction of

a proposed scheme and the date the court decides whether

to approve the scheme will no longer be subject to challenge

(or annulment) by any trustee who is thereafter appointed to

oversee the company’s winding-up. The public consultation pro-

cess for the draft bill commenced in August, and the legislation

may be amended before it is implemented. Implementation is

expected to take place on January 1, 2016.

Other recent European developments can be tracked in Jones

Day’s EuroResource, available at http://www.jonesday.com/

euroresource-deals-and-debt-11-24-2014/.

21

SOVEREIGN DEBT UPDATE

On September 26, 2014, the United Nations Human Rights

Council passed a resolution (A/HRC/27/L.26) condemning “vul-

ture funds” like Argentina’s holdout bondholders “for the direct

negative effect that the debt repayment to those funds, under

predatory conditions, has on the capacity of Governments to

fulfill their human rights obligations, particularly economic,

social and cultural rights and the right to development.”

Among other things, the resolution expresses concern regard-

ing “the voluntary nature of international debt relief schemes

which has created opportunities for vulture funds to acquire

defaulted sovereign debt at vastly reduced prices and then

seek repayment of the full value of the debt through litigation,

seizure of assets or political pressure.” It also notes that:

vulture funds, through litigation and other means,

oblige indebted countries to divert financial resources

saved from debt cancellation and diminish the impact

of, or dilute the potential gains from, debt relief for

these countries, thereby undermining the capac-

ity of Governments to guarantee the full enjoyment of

human rights of its population.

The resolution, which was proposed by Argentina, Brazil, Russia,

Venezuela, and Algeria, passed in the 47-member council with

33 votes in favor. Nine member states abstained, and five—the

Czech Republic, Great Britain, Germany, Japan, and the U.S.—

opposed the text. The U.S. was highly critical of the resolution,

with U.S. representative Keith Harper warning the council that it

could lead states “to use debt distress as an excuse for human

rights violations.” He also stated that “[t]he state’s responsibility

for promoting and protecting human rights and fundamental free-

doms is not contingent on its sovereign debt situation.” Harper

emphasized that “[i]f not handled appropriately, [the discussions]

risk creating uncertainties which could drive up borrowing costs

or even choke off financing for developing countries.”

On October 6, 2014, the International Monetary Fund (“IMF”)

released a series of new proposals entitled “Strengthening the

Contractual Framework to Address Collective Action Problems

in Sovereign Debt Restructuring,” available at http://www.imf.

org/external/np/pp/eng/2014/090214.pdf. The proposals include

reforms to sovereign debt agreements, including strengthened

collective action clauses and modification of pari passu clauses

akin to the provision relied on by holdout bondholders in

Argentina’s long-running sovereign debt dispute. Such reforms

would not apply to existing sovereign bonds. The IMF propos-

als state that there may be a need for action on those bonds

as well if the precedent set in the Argentina litigation begins to

impact other countries. The proposals come on the heels of the

August 29, 2014, proposal by the International Capital Market

Association (“ICMA”) to deter disruptive predatory and holdout

behavior. A principal difference between the two proposals is

that the IMF paper does not promote establishing creditors’

committees to negotiate agreements resolving disputes. The

ICMA proposal can be accessed at http://www.icmagroup.org/

resources/Sovereign-Debt-Information/.

22

RECENT DEVELOPMENTS IN THE DISPUTE BETWEEN

ARGENTINA AND ITS HOLDOUT BONDHOLDERS

On September 19, 2014, the U.S. Court of Appeals for

the Second Circuit dismissed an appeal by Citibank NA

(“Citibank”) of U.S. district court judge Thomas Griesa’s July 28,

2014, order preventing Citibank from processing an upcoming

payment on $8.4 billion in Argentine debt. Only a day after the

bank’s attorneys argued that the lower court’s ruling “put a gun

to our head,” a three-judge panel of the Second Circuit ruled

that it lacks jurisdiction over Citibank’s appeal because the July

28 order was merely a clarification, rather than a modification, of

a prior ruling. Citibank had argued that the July 28 order could

subject the bank to criminal prosecution in Argentina if allowed

to stand. “However,” the Second Circuit wrote in its order, “noth-

ing in this court’s order is intended to preclude Citibank from

seeking further relief from the district court.”

On September 22, 2014, The Bank of New York Mellon

Corporation (“BNY Mellon”) asked Judge Griesa to prevent

a group of creditors from accessing $539 million in Argentine

exchange bond payments in BNY Mellon’s custody to satisfy

money judgments against Argentina, arguing that the bank

should continue to maintain control of the funds. According

to BNY Mellon, its rights as indenture trustee for the exchange

bonds, as well as Argentina’s rights as the issuer, obligate

the bank to hold the money for other indenture trustees and

exchange bondholders. BNY Mellon has held the funds since

Judge Griesa ordered the bank to do so on August 6, 2014, prom-

ising the bank that it would suffer no liability as a consequence.

On September 26, 2014, Judge Griesa ruled that Citibank

could make a scheduled $5 million payment on approximately

$8.4 billion in bonds governed by Argentine law. However,

the judge declined to rule on the central question of whether

payment on those bonds is subject to his July 28, 2014, order

restricting such payments, concluding that this is a factual

issue requiring further briefing on an expedited basis. The

issue turns on whether the local peso- and dollar-denominated

bonds constitute “exchange bonds” covered by Judge Griesa’s

broadly worded equal payment injunction. If so, the bank’s unit

in Argentina would be prohibited from distributing future inter-

est payments to investors, which the bank contends will place

it at “serious and imminent” risk of criminal sanctions from the

Argentine government.

At a hearing held on September 29, 2014, Judge Griesa found

Argentina in contempt of court for defying his previous orders.

However, the judge deferred to a later date the determination of

the sanctions that would be levied on the South American nation.

On September 30, 2014, Argentina deposited $161 million in

an Argentine bank to make interest payments to its exchange

bondholders, despite Judge Griesa’s orders blocking the pay-

ments unless holdout bondholders were also paid and holding

Argentina in contempt for failing to comply. Argentina made

the deposits in accounts at Nación Fideicomisos S.A., which,

in defiance of Judge Griesa’s directives, Argentina selected to

replace BNY Mellon as the trustee for the bonds.

Judge Griesa on October 6, 2014, ordered Argentina to

reinstate BNY Mellon as indenture trustee for Argentina’s

exchange bonds and to “reverse the steps taken” as part of

the Argentine government’s passage on September 11, 2014, of

the Sovereign Payment Law, which, among other things, sup-

planted BNY Mellon with Nación Fideicomisos S.A. In his order,

Judge Griesa wrote that:

[t]he Republic of Argentina will need to reverse

entirely the steps which it has taken constituting the

contempt, including, but not limited to, re-affirming

the role of The Bank of New York Mellon as the

indenture trustee and withdrawing any purported

authorization of Nación Fideicomisos, S.A. to act as

the indenture trustee, and complying completely with

the February 23, 2012 injunction.

On October 22, 2014, the U.S. Court of Appeals for the Second

Circuit dismissed Argentina’s appeal of Judge Griesa’s

August 6, 2014, order blocking a $539 million payment to

bondholders via BNY Mellon, ruling that it lacks jurisdiction

because the order appealed from was a clarification rather

than a modification of prior rulings. As issued, the Second

Circuit wrote, the injunction “already prohibited BNY from

assisting Argentina in evading its terms, and the order’s lan-

guage concerning BNY’s liability does not enjoin third par-

ties, such as euro bondholders . . . , from bringing suit against

BNY.” Accordingly, the court concluded that “the order neither

expands nor modifies the existing injunction.”

23

On October 27, 2014, Judge Griesa denied a request by a

group of Argentina’s creditors to access $539 million in funds

in the custody of BNY Mellon to satisfy money judgments

against Argentina. Judge Griesa ruled that the creditors cannot

have access to the funds, which were earmarked to make pay-

ments to Argentina’s exchange bondholders, because the funds

are located outside the U.S., in Argentina. He also held that the

Foreign Sovereign Immunities Act (“FSIA”) does not authorize

the attachment or execution of sovereign property outside the

U.S. In his ruling, Judge Griesa wrote that “even if plaintiffs show

that the Republic has an interest in the funds, which the court

does not reach, turnover would not be authorized by the FSIA.”

On October 30, 2014, Argentina defaulted on its sovereign debt

for the second time since July when it failed to make a cou-

pon payment on $5.4 million in par bonds issued under foreign

law, thus increasing the risk of acceleration and economic

collapse. Although Argentina had already defaulted in July on

its discount notes, holders of the now-defaulted par bonds are

more likely to accelerate their debt because it is trading at a

steeper discount to original value. If the debt is accelerated,

Argentina could be obligated to pay investors $30 billion

immediately—$2 billion more than the South American nation

holds in its national reserves. In the aftermath of the default, Fitch

Ratings downgraded Argentina’s par bonds from C to D. Shortly

after the default was announced, Argentine Cabinet chief Jorge

Capitanich told reporters that, in lieu of accelerating, bondhold-

ers should take legal action against Judge Griesa, who blocked

debt payments when he ruled in favor of holdout bondholders.

On November 4, 2014, Argentina appealed to the U.S. Court of

Appeals for the Second Circuit Judge Griesa’s October 3, 2014,

order finding the South American nation in contempt of court

for taking steps to evade his prior orders preventing Argentina

from making payments on restructured debt without also pay-

ing holdout bondholders. Argentina filed a notice of appeal of

the contempt ruling, in which Judge Griesa held that Argentina’s

moves to strip BNY Mellon as the trustee for the bonds and

Argentina’s plans to pay exchange bondholders locally without

any recognition of the country’s obligation to its holdout bond-

holders are unlawful and must not be carried out.

On November 6, 2014, the English High Court of Justice,

Chancery Division, made two rulings in litigation commenced

by a group of investors holding euro-denominated bonds (the

“Euroholders”) issued by Argentina pursuant to its 2005 and

2010 exchange offers. In Euroholders Knighthead Master Fund

LP v. The Bank of New York Mellon (2014), Claim No. HC-2014-

00070, Mr. Justice Newey adjourned until mid-December the

Euroholders’ application for declarations with respect to their

interest in funds held by BNY Mellon and with regard to the

alleged irrelevance of the injunction issued by U.S. district court

judge Griesa to BNY Mellon’s payment obligations, pending

notice to the holdout bondholders involved in the U.S. litigation

and to give the holdout bondholders an opportunity to intervene

in the U.K. action. In addition, Mr. Justice Newey declined the

Euroholders’ application for an injunction restraining BNY Mellon

from disbursing the funds to parties other than the Euroholders.

Business Restructuring Review is a publication of the Business Restructuring & Reorganization Practice of Jones Day.

Executive Editor: Charles M. OellermannManaging Editor: Mark G. Douglas

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WASHINGTON

© Jones Day 2014. All rights reserved.

JONES DAY HAS OFFICES IN:

THE U.S. FEDERAL JUDICIARY

U.S. federal courts have frequently

been referred to as the “guardians of

the Constitution.” Under Article III of

the Constitution, federal judges are

appointed for life by the U.S. presi-

dent with the approval of the Senate.

They can be removed from office only

through impeachment and convic-

tion by Congress. The first bill consid-

ered by the U.S. Senate—the Judiciary

Act of 1789—divided the U.S. into what

eventually became 12 judicial “circuits.”

In addition, the court system is divided

geographically into 94 “distr icts”

throughout the U.S. Within each district

is a single court of appeals, regional district courts, bankruptcy

appellate panels (in some districts), and bankruptcy courts.

As stipulated by Article III of the Constitution, the Chief Justice

and the eight Associate Justices of the Supreme Court hear

and decide cases involving important questions regarding the

interpretation and fair application of the Constitution and fed-

eral law. A U.S. court of appeals sits in each of the 12 regional

circuits. These circuit courts hear appeals of decisions of the

district courts located within their respective circuits and

appeals of decisions of federal regulatory agencies. Located in

the District of Columbia, the Court of Appeals for the Federal

Circuit has nationwide jurisdiction and hears specialized cases

such as patent and international trade cases. The 94 district

courts, located within the 12 regional circuits, hear nearly all

cases involving federal civil and criminal laws. Decisions of the

district courts are most commonly appealed to the district’s

court of appeals.

Bankruptcy courts are units of the federal district courts. Unlike

that of other federal judges, the power of bankruptcy judges is

derived principally from Article I of the Constitution, although

bankruptcy judges serve as judicial officers of the district courts

established under Article III. Bankruptcy judges are appointed

for a term of 14 years (subject to extension or reappointment)

by the federal circuit courts after considering the recommenda-

tions of the Judicial Conference of the United States. Appeals

from bankruptcy court rulings are most commonly lodged either

with the district court of which the bankruptcy court is a unit or

with bankruptcy appellate panels, which presently exist in five

circuits. Under certain circumstances, appeals from bankruptcy

rulings may be made directly to the court of appeals.

Two special courts—the U.S. Court of International Trade and

the U.S. Court of Federal Claims—have nationwide jurisdiction

over special types of cases. Other special federal courts include

the U.S. Court of Appeals for Veterans Claims and the U.S. Court

of Appeals for the Armed Forces.