BUSINESS RESTRUCTURING REVIEW

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1 RECENT DEVELOPMENTS IN BANKRUPTCY AND RESTRUCTURING VOLUME 12 NO. 6 NOVEMBER/DECEMBER 2013 BUSINESS RESTRUCTURING REVIEW IN THIS ISSUE 1 The First Circuit Fires a Shot Across the Bow of Private Equity Funds: Too Much Control of Portfolio Companies May Lead to Pension Plan Withdrawal Liability 5 First Impressions: Commercial Leases May Be Assumed Within 210Day Deadline and Assigned Later 7 Newsworthy 9 Chapter 15 Recognition Mandatory and Fully Encumbered Assets Are Property of the Debtor Protected by Automatic Stay 13 Stockbroker Defense Shields Ponzi-Scheme Broker Fees and Commissions From Avoidance THE FIRST CIRCUIT FIRES A SHOT ACROSS THE BOW OF PRIVATE EQUITY FUNDS: TOO MUCH CONTROL OF PORTFOLIO COMPANIES MAY LEAD TO PENSION PLAN WITHDRAWAL LIABILITY Lisa G. Laukitis and David G. Marks Few areas of law are as confusing or as important to understand as the growing intersection of employment and bankruptcy law. In recent years, funding shortfalls in multi-employer pension plans, which cover roughly 20 percent of U.S. workers with defined-benefit plans, have increased pressure on participating employers to reduce their contributions or even withdraw entirely. Although employers taking these actions would incur withdrawal liability as a consequence, that liability can likely be discharged in bankruptcy. As a result, multi-employer pension plans have been forced to look elsewhere to collect on their withdrawal-liability claims against bankrupt employers. In a case of first impression, the First Circuit Court of Appeals considered one such attempt by a multi-employer pension plan ( MEPP ) to collect withdrawal liability 16 In Brief: Another Blow to Triangular Setoff in Bankruptcy from a private equity fund sponsor of a bankrupt debtor. In Sun Capital Partners III, 18 In Brief: Claims Trader Alert 2013), the First Circuit held that the private equity fund in that case was a trade or 19 business which could be held jointly and severally liable for the withdrawal liability European Perspective in Brief 20 Sovereign Debt Update LP v. New England Teamsters & Trucking Indus. Pension Fund, 724 F.3d 129 (1st Cir. incurred by one of its portfolio companies. As disturbing as the decision is for the

2 private equity industry, and especially for those funds that suddenly find themselves with far greater exposure than they originally anticipated, the case may also offer opportunities for savvy investors who are willing to develop the legal structures that can reduce their exposure to withdrawal liability should their investments in companies with MEPPs fail. MULTI-EMPLOYER PENSION PLANS AND CONTROL-GROUP LIABILITY MEPPs are so named because more than one employer makes contributions to the plans, which are then used to provide benefits to all the participating businesses employees upon retirement. Prior to 1980, an employer could cease making payments to, or withdraw from, a MEPP and would be liable only if the plan later became insolvent. Unfortunately, this created a perverse incentive for employers to withdraw as quickly as possible at the first sign of a MEPP s distress, or risk being left as the sole remaining contributor to fund all the benefits on its own. To ameliorate this problem, Congress amended the Employee Retirement Income Security Act of 1974 ( ERISA ), 29 U.S.C et seq., in 1980 to create withdrawal liability. In principle, under the amended ERISA, employers that cease contributing to a MEPP are obligated to pay their fair share of any unfunded liabilities study by Moody s Investors Service, the nation s largest MEPPs are underfunded by approximately $165 billion, with the number expected to continue rising. See Wesley Smyth, Growing Multiemployer Pension Funding Shortfall is an Increasing Credit Concern, Moody s Global Corporate Finance, Special Comment (Moody s Investors Serv.), Sept The impact on participating employers is believed to be severe enough to influence their ability to attract investors and financing. See id.; David Zion, Amit Varshney, and Nichole Burnap, Crawling Out of the Shadows: Shining a Light on Multiemployer Pension Plans, Credit Suisse, Mar. 26, Sun Capital represents a loss for private equity funds that currently own or regularly invest in companies with pension liabilities. Private equity funds must actively consider the decision s impact on their current and potential investments. In particular, funds should promptly reassess their potential exposure to the withdrawal liability of their portfolio companies, as that liability can arise suddenly and in devastating amounts, sometimes exceeding even the original acquisition price. At the same time, Congress also added a series of provisions to enhance the collectability of the new withdrawal liability. Among other things, the 1980 amendments made trade[s] or business[es] that are under common control which has since been defined by regulation to mean 80 percent common ownership jointly and severally liable for each other s withdrawal liability. 29 U.S.C. 1301(b)(1). In addition, withdrawal liability must be assessed without regard to any transaction whose principal purpose is to evade or avoid withdrawal liability. 29 U.S.C. 1392(c). Despite the 1980 ERISA amendments, MEPPs in the U.S. have not been fully funded in the aggregate since 2000, and the funding shortfalls are getting worse. See U.S. Gov t Accountability Office, GAO-11-79, Changes Needed to Better Protect Multiemployer Pension Benefits (2010). Between 2008 and 2009, for example, the proportion of MEPPs reported to be in endangered or critical status nearly tripled from 23 percent to 68 percent. According to a SUN CAPITAL Sun Capital Advisors, Inc. ( Sun Capital ), like most private equity firms, creates funds in which investors may pool their capital. The firm then finds underperforming companies for the funds to acquire, with the expectation that the businesses can be resold for a profit in two to five years. In most cases, the funds have no employees or offices, but the general partner of each fund (a Sun Capital affiliate) owns a Sun Capital management company that provides managerial and consulting services in exchange for fees from both the funds and the portfolio companies. As is common in the industry, when the portfolio companies pay these fees, the funds receive an offset against what they owe to the management company. See Sun Capital, 724 F.3d at In 2006, two Sun Capital funds Sun Capital III and Sun Capital IV acquired 30 percent and 70 percent stakes, respectively, in Scott Brass, Inc. ( Scott Brass ), a brass and 2

3 copper manufacturer, for the aggregate amount of $3 million. Although Scott Brass was, at the time of the acquisition, still current on payments owed to its MEPP, the New England Teamsters and Trucking Industry Pension Fund ( NETTI ), Sun Capital had reduced its purchase price by 25 percent due to concerns about the company s unfunded pension liabilities. In the fall of 2008, following a collapse in the price of copper, Scott Brass breached its loan covenants and was unable to obtain sufficient credit to stay in business. The company stopped making pension contributions in October 2008, and an involuntary-bankruptcy petition was filed against the company the following month in Rhode Island. In December 2008, NETTI demanded that Scott Brass pay more than $4.5 million in withdrawal liability and also demanded payment from the two Sun Capital funds. The funds sued NETTI in district court, seeking a declaratory judgment that they were not jointly and severally liable for the withdrawal liability. NETTI disputed the funds position and filed a counterclaim alleging that the funds had sought to evade or avoid withdrawal liability in violation of 29 U.S.C. 1392(c) by structuring their purchase of Scott Brass to keep any single fund from holding an 80 percent controlling stake. Four months later, the district court granted summary judgment in favor of the funds on both issues. The court reasoned that, since the funds were passive and had no employees or offices, neither was a trade or business under 29 U.S.C. 1301(b)(1). Moreover, the court held, the funds did not evade or avoid withdrawal liability because, at the time of the purchase, the liability was merely a prospective, uncertain future risk. See Sun Capital Partners III, LP v. New England Teamsters & Trucking Indus. Pension Fund, 903 F. Supp. 2d 107, 124 (D. Mass. 2012). NETTI appealed to the First Circuit. THE FIRST CIRCUIT S RULING A three-judge panel reversed the district court s decision on the trade or business prong of 29 U.S.C. 1301(b)(1), but affirmed the lower court s holding that the evade or avoid provisions of 29 U.S.C. 1392(c) did not apply. The panel then remanded the case to the district court to determine whether the second prong of the test for imposing joint and several liability under 29 U.S.C. 1301(b)(1) i.e., common control had been met. The First Circuit began by noting that the phrase trade or business in 29 U.S.C. 1301(b)(1) is not defined in U.S. Treasury regulations and has not been given a definitive, uniform definition by the U.S. Supreme Court. Moreover, the court reasoned, Supreme Court precedent regarding the same term s meaning for tax purposes would have little relevance to the ERISA context (citing Comm r of Internal Revenue v. Groetzinger, 480 U.S. 23, 27 (1987)). Therefore, the only relevant guidance available for the court was an unpublished 2007 letter from the Pension Benefit Guaranty Corporation (the PBGC ), in which the PBGC informally adjudicated a dispute between a pension plan and a private equity fund. There, the PBGC applied an investment plus standard, under which a private equity fund is considered a trade or business if it: (i) has engaged in an activity with the primary purpose of income or profit; and (ii) has conducted that activity with continuity and regularity. After reviewing the PBGC letter, the First Circuit panel concluded that some form of an investment plus approach is appropriate, although it expressly declined to establish any guidelines for what plus might entail. Undertaking a very fact-specific approach, the court emphasized the following facts in the case before it: The funds limited partnership agreements stated that the funds would be actively involved in the management of the portfolio companies. The funds general partners had significant management authority over the funds, including the power to make decisions about hiring, compensating, or terminating the funds employees. The funds private-placement memoranda stated that individuals who work for the funds general partners would develop and implement restructuring plans for the portfolio companies and would be involved in even small details, such as signing checks for new portfolio companies and holding frequent meetings with senior staff. 3

4 The funds controlling stake allowed them to appoint two employees of Sun Capital to Scott Brass s board of directors enough to control the board. Sun Capital provided personnel to Scott Brass who became immersed in details involving the company s management and operation. At least one of the funds, Sun Capital IV, had received an offset of $186, against fees it otherwise would have had to pay to its general partner. This offset would never have been available to an ordinary, passive investor and therefore could not be construed as an ordinary investment activity flowing solely from investment returns. According to the First Circuit, the sum of all these factors allowed the plus in the investment plus test to be met. Most significantly, the court opined, the offset of fees allowed the funds to funnel management and consulting fees to their general partners, proving that the funds received income besides dividends and capital gains. In addition, although the general partners were not the same corporate entity as the funds, the general partners had acted as the funds agents after all, the court concluded, the funds entire investment strategy could only be achieved by active management through an agent, since the Sun Funds themselves had no employees. The First Circuit then turned to the evade or avoid issue. Twenty-nine U.S.C. 1392(c) imposes withdrawal liability without regard to any transaction whose principal purpose is to evade or avoid such liability. According to the court, however, there was no way of knowing what would have occurred if the allegedly wrongful transaction i.e., the purchase of Scott Brass in 30 percent and 70 percent proportions had been disregarded. In fact, it was doubtful that Sun Capital IV would have purchased a 100 percent stake. The First Circuit noted that it was easy to distinguish the case from a scenario in which an entity with a controlling stake of 80 percent or more tries to reduce its stake in order to avoid withdrawal liability. OUTLOOK Sun Capital represents a loss for private equity funds that currently own or regularly invest in companies with pension liabilities. Private equity funds must actively consider the decision s impact on their current and potential investments. In particular, funds should promptly reassess their potential exposure to the withdrawal liability of their portfolio companies, as that liability can arise suddenly and in devastating amounts, sometimes exceeding even the original acquisition price. Should a fund discover that it has significant exposure, it may want to consider making changes to its management structure. Specifically, although a fund may wish to continue to collect management fees and participate in the active dayto-day management of its portfolio companies, there may be circumstances in which the potential downside of withdrawal liability simply outweighs the benefits of active management arrangements. Funds must also be mindful, however, that the later such changes are made, the greater the risk will be that a court will find that such changes were implemented to evade or avoid withdrawal liability under 29 U.S.C. 1392(c). Sun Capital also will likely diminish investor interest in distressed businesses that currently participate in MEPPs. The increased risk of incurring withdrawal liability may deter the very investors who offer these companies their best chance at a successful restructuring. In some cases, private equity funds may simply wait to acquire a distressed company until after it has entered bankruptcy, with the goal of purchasing the business free and clear of any withdrawal liability. Such a prospect, however, is unavailable to an underperforming, but solvent, corporation or its employees and pensioners. It bears noting that, while a private equity fund may now be considered a trade or business for purposes of ERISA in the First Circuit under Sun Capital, the case does provide some helpful guidance on how a fund should structure its investment in its portfolio companies to prevent withdrawal liability under the common control rules. The Sun Capital decision sets clear precedent that a private equity fund can structure the purchase of a company that participates in a MEPP in a manner that does not trigger the common control threshold. 4

5 FIRST IMPRESSIONS: COMMERCIAL LEASES MAY BE ASSUMED WITHIN 210-DAY DEADLINE AND ASSIGNED LATER Charles M. Oellermann and Mark G. Douglas Section 365(f) authorizes the trustee or DIP to assign an assumed contract or lease. With certain exceptions, assignment is permitted notwithstanding any provision in the contract or lease (or in applicable law) that prohibits, restricts, or conditions assignment. Commercial landlords hailed as a significant victory the enactment in 2005 of a 210-day drop dead period after which a lease of nonresidential real property with respect to which the debtor is the lessee is deemed rejected unless, prior to the expiration of the period, a chapter 11 debtor in possession ( DIP ) or bankruptcy trustee assumes or rejects the lease. However, the deadline which is imposed by amended section 365(d)(4) has been widely criticized because it forces a DIP or trustee to make premature (and potentially costly) decisions regarding leases that may be vital to the prospects for a successful reorganization. Amended section 365(d)(4) has been a magnet for controversy in the eight years since it became effective as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 ( BAPCPA ). One focus of the ongoing debate has been whether, to ward off automatic rejection, the bankruptcy court must actually enter an order approving assumption or rejection as distinguished from the DIP or trustee moving to assume or reject prior to the expiration of the 210-day period. Another bone of contention was the subject of a ruling recently handed down by a New York bankruptcy court. In In re Eastman Kodak Co., 495 B.R. 618 (Bankr. S.D.N.Y. 2013), the court, in an apparent matter of first impression, held that a commercial lease timely assumed under section 365(d)(4) may be assigned at a later date after the expiration of that subsection s 210-day deadline. ASSUMPTION, REJECTION, AND ASSIGNMENT OF EXECUTORY CONTRACTS AND UNEXPIRED LEASES Section 365(a) of the Bankruptcy Code authorizes a trustee or DIP, with court approval, to assume or reject most executory contracts and unexpired leases during the course of a bankruptcy case. If the debtor has defaulted under the contract or lease, assumption is subject to the conditions set forth in section 365(b) (e.g., cure of certain defaults and adequate assurance of future performance). Section 365(d) governs the time frame for assumption, depending upon the chapter of the Bankruptcy Code that applies and the nature of the contract or lease. For unexpired nonresidential real property leases with respect to which the debtor in any bankruptcy case (except a chapter 15 case) is the lessee, section 365(d)(4) provides as follows: (A) Subject to subparagraph (B), an unexpired lease of nonresidential real property under which the debtor is the lessee shall be deemed rejected, and the trustee shall immediately surrender that nonresidential real property to the lessor, if the trustee does not assume or reject the unexpired lease by the earlier of (i) the date that is 120 days after the date of the order for relief; or (ii) the date of the entry of an order confirming a plan. (B) (i) The court may extend the period determined under subparagraph (A), prior to the expiration of the 120-day period, for 90 days on the motion of the trustee or lessor for cause. (ii) If the court grants an extension under clause (i), the court may grant a subsequent extension only upon prior written consent of the lessor in each instance. The 210-day drop dead date (120 days plus a single 90-day extension) was added to the Bankruptcy Code in 2005 as part of BAPCPA. Prior to the amendment, section 365(d) (4) provided that a DIP or trustee was obligated to assume any nonresidential real property lease pursuant to which the debtor was the lessee within the first 60 days of the case; otherwise, the lease was deemed rejected. However, the trustee or DIP could request multiple extensions of this period for cause, and in large chapter 11 cases, extensions were commonly granted through confirmation of a plan. 5

6 BAPCPA amended section 365(d)(4) by extending this initial 60-day period to 120 days, but limiting any augmentation of this period without the landlord s written consent to a single 90-day extension, after which the lease would be deemed rejected. The purpose of the change was to limit the discretion of judges to extend time to assume or reject certain commercial contracts and to provide landlords with greater certainty as to such tenancies. Eastman Kodak, 495 B.R. at 620; accord In re Michael H. Clement Corp., 446 B.R. 394 (N.D. Cal. 2011); In re Treasure Isles HC, Inc., 462 B.R. 645 (B.A.P. 6th Cir. 2011); H.R. Rep. No , at 153 (2005) ( [The amendment] is designed to remove the bankruptcy judge s discretion to grant extensions of the time for the retail debtor to decide whether to assume or reject a lease after a maximum possible period of 210 days from the time of entry of the order of relief ). ITT objected to neither the assumption motion nor the court order approving it. On June 28, 2013, Kodak filed a motion for authority to assign the ground lease to RED-Rochester, LLC, as part of an asset sale agreement. ITT objected to the proposed assignment. ITT argued that a nonconsensual assignment of an unexpired lease of nonresidential real property must occur simultaneously with, not after, assumption of the lease and thus cannot occur outside the 210-day period set forth in section 365(d)(4). According to ITT, the use of the present tense of the verb to assume in section 365(f)(2) (authorizing assignment only if the trustee assumes such contract or lease ) leads to the inference that assignment must take place at the time of the assumption. Neither section 365(d)(4) nor any other provision of the Bankruptcy Code specifies when an assumed contract may be assigned under the provisions of section 365(f). This was the issue addressed by the bankruptcy court in Eastman Kodak. EASTMAN KODAK In 2004, Eastman Kodak Company ( Kodak ) leased land in Rochester, New York, from ITT Space Systems, LLC ( ITT ) for the purpose of operating a fire water pump. The ground lease prohibited any assignment or sublease without ITT s prior written consent. Kodak filed for chapter 11 protection in January 2012 in the Southern District of New York. On May 10, 2012, the bankruptcy court granted Kodak s motion for a 90-day extension through August 16, 2012, of the initial 120-day period specified by section 365(d)(4) for assumption or rejection of the ground lease with ITT. Kodak filed a motion for authority to assume the ground lease and various other unexpired commercial real property leases on July 17, 2012, and the court granted the motion on August 15, 2012 within the 210-day period. The assumption order expressly preserved Kodak s rights to assign any of the Assumed Leases pursuant to, and in accordance with, the requirements of section 365 of the Bankruptcy Code. THE BANKRUPTCY COURT S RULING The court acknowledged that there were no cases directly on point regarding the issue. Even so, it rejected ITT s argument, explaining that a plain reading of the statute simply does not support any requirement for simultaneous assumption and assignment. Instead, the court wrote, [t]he plain reading of the statute is that an assignment cannot occur unless the debtor has satisfied the provisions of 365 governing assumption. Moreover, the court noted that other parts of section 365 make it clear that assumption and assignment are independent concepts. For example, section 365(k), which provides that the estate is not liable for post-assignment breaches of a contract, uses the past tense of to assume (i.e., [a]ssignment by the trustee to an entity of a contract or lease assumed under this section ). Also, use of the conjunctive phrase assume or assign in section 365(c) (prohibiting nonconsensual assumption or assignment where applicable nonbankruptcy law excuses the nondebtor from accepting performance from another party) and section 365(b)(3) (establishing special rules for shopping-center leases) implies that assumption and assignment can take place at different times. Similarly, the court wrote, [section] 365(d)(4) does not contain a deadline for assigning, as opposed to assuming, a contract. According to the court, interpreting the Bankruptcy 6

7 NEWSWORTHY Jones Day was named Law Firm of the Year in the field of Bankruptcy and Creditor Debtor Rights/Insolvency and Reorganization Law by U.S. News Best Lawyers for Amy Edgy Ferber (Atlanta) was included among the Atlanta Business Chronicle s 40 Under 40, a recognition given annually to individuals who make significant career achievements and have demonstrated social responsibility. Bruce Bennett (Los Angeles) was named MVP of the Year in the practice area of Bankruptcy by Law360. Jones Day s London Office received a highly regarded designation in the practice area of Restructuring/Insolvency from Chambers UK Sion Richards (London) and Michael Rutstein (London) were named notable practitioners. Corinne Ball (New York) and Bruce Bennett (Los Angeles) were included among the 500 Leading Lawyers in America for 2013 by Lawdragon. Juan Ferré (Madrid) was included in Best Lawyers 2013 (Spain) in the field of Restructuring & Insolvency. Juan is also among the restructuring professionals advising the European Union in connection with the development of new insolvency rules for all Member States. The initial meeting of the advisory group was convened on October 7 in Brussels. Philip J. Hoser (Sydney) was named a Leading Individual in the field of Restructuring & Insolvency by The Legal 500 Asia Pacific Jones Day s London Office received a recommended designation in the field of Finance Corporate Restructuring and Insolvency in The Legal 500 United Kingdom Barnaby C. Stueck (London), Kay V. Morley (London), Michael Rutstein (London), and Sion Richards (London) were designated recommended attorneys. The transcript of an interview of Pedro A. Jimenez (Miami), entitled The Many Dimensions of a Cross-Border Practice, was published in the November 2013 edition of The Metropolitan Corporate Counsel and is posted at Corinne Ball (New York) moderated a panel discussion entitled Wall Street, Main Street and the Restructuring of American Business: Can It Be a Win Win? at the 87th annual meeting of the National Conference of Bankruptcy Judges on October 31 in Atlanta. Heather Lennox (New York and Cleveland) gave a presentation on October 4 entitled The Imperishable Hostess Brands, Inc. at the Turnaround Management Association s annual conference in Washington, D.C. An article written by Pedro A. Jimenez (Miami) and Mark G. Douglas (New York) entitled ABC Learning Highlights Important Ch. 15 Principles was published in the October 25, 2013, edition of Law360. An article written by Timothy W. Hoffmann (Chicago) and Laura L. Swanson (New York) entitled Nonmonetary Defaults in Executory Contracts: A Potential Hurdle to a Successful Restructuring was published in the 2013 edition of the Norton Annual Survey of Bankruptcy Law. An article written by Victoria Ferguson (London) entitled A Tale of Two COMIs: Kemsley v Barclays Bank plc was published in the November 2013 issue of the ABA International Law Section s International Secured Transactions & Insolvency Committee Newsletter. Thomas A. Howley (Houston), Heather Lennox (New York and Cleveland), 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), Gregory M. Gordon (Dallas), 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), Richard L. Wynne (Los Angeles), and Todd S. Swatsler (Columbus) were recognized in the field of Bankruptcy in the 2013 Super Lawyers Business Edition. An article written by Juan Ferré (Madrid) entitled Recent Developments on the Reform of Insolvency Law at the European Level was published in the 4Q 2013 issue of INSOL World. 7

8 Code to permit the assignment of a previously assumed commercial lease beyond the deadline for assumption reasonably balances the goal of providing protection to landlords and the goal of maximizing the value of a debtor s estate. By contrast, [c]onstruction of 365(d)(4) to cut off assignment rights would shift the balance in favor of landlords beyond what Congress provided and improperly undermine the policy of 365 that gives a debtor broad rights to benefit from beneficial contracts. amendments imposed a significant disadvantage on companies with large numbers of leases attempting to reorganize in chapter 11. Permitting assignment of nonresidential real property leases beyond the 210-day drop-dead date imposed by section 365(d)(4) would alleviate at least some of the burden borne by a debtor confronted with the need to decide whether particular leases are more beneficial to its own restructuring by assumption and continued performance or through assumption and assignment for value. Eastman Kodak is welcome news for debtors. If followed by other courts, the ruling may portend a slight swing of the pendulum back toward debtors after BAPCPA s landlord-friendly amendments imposed a significant disadvantage on companies with large numbers of leases attempting to reorganize in chapter 11. Furthermore, the court explained, because section 365(k) relieves the estate from liability for post-assignment breaches of assigned contracts, post-assumption assignment allows a DIP to avoid accruing administrative claims under a contract whose assumption proves to be improvident either because of issues with the contract or because the reorganization fails. Lawmakers gave landlords additional protection when they amended section 365(d)(4) in 2005, the court concluded, but [Congress] did not choose to create the same deadline for the assignment of a commercial lease as it did for the assumption of such a lease. Finally, the court rejected ITT s argument that a rule allowing assignment to occur in the later stages of a bankruptcy case is unfair to landlords. Even if it were unfair, the court wrote, the disruption of non-debtors expectations of profitable business arrangements is common in bankruptcy proceedings (citations and internal quotation marks omitted). OUTLOOK Eastman Kodak is welcome news for debtors. If followed by other courts, the ruling may portend a slight swing of the pendulum back toward debtors after BAPCPA s landlord-friendly Even with the relief provided by Eastman Kodak, however, section 365(d)(4) s 210-day drop-dead date still stacks the deck against retailers and other debtors in chapter 11 that are highly dependent upon leased properties. Section 365(d)(4) forces such a debtor to decide whether to assume or reject its unexpired leases on a highly expedited basis. Debtors with a large number of real property leases must now perform a significant amount of prepetition planning with respect to the restructuring of their operations. The level of planning required is even greater for debtors that are party to a significant number of leases subject to a master agreement. Moreover, in jurisdictions where courts take the approach that an order approving assumption must actually be entered within the 210-day period, a debtor will need to have made its assumption decision well before the deadline to ensure enough time to convene a court hearing on its motion seeking assumption of its leases and entry of the court order. It bears noting that the negative impact of being forced prematurely to assume a commercial lease is mitigated somewhat by another BAPCPA amendment. Prior to 2005, if a debtor assumed a commercial lease and later decided to reject it, the lease-rejection damages were entitled to administrative-expense priority, likely with no cap that would otherwise apply under section 502(b)(6) of the Bankruptcy Code if the lease had not been assumed prior to rejection. BAPCPA added section 503(b)(7) to the Bankruptcy Code, which provides that if a debtor assumes a lease and then later decides to reject it, the landlord is entitled to an administrativeexpense claim for up to two years of rent, but any remaining claim of the landlord is deemed a prepetition claim subject to the cap on lease-rejection damages in section 502(b)(6). 8

9 CHAPTER 15 RECOGNITION MANDATORY AND FULLY ENCUMBERED ASSETS ARE PROPERTY OF THE DEBTOR PROTECTED BY AUTOMATIC STAY Pedro A. Jimenez and Mark G. Douglas More than eight years after chapter 15 of the Bankruptcy Code became effective in 2005, the utility of a chapter 15 filing in a U.S. bankruptcy court to protect a foreign debtor and its assets from legal action or creditor collection efforts in the U.S. is undisputed. However, whether relief under chapter 15, as distinguished from its precursor, section 304, is mandatory if a foreign proceeding otherwise satisfies the statutory criteria for recognition is a question that has received relatively little scrutiny. The U.S. Court of Appeals for the Third Circuit recently filled that void in cross-border bankruptcy jurisprudence when it handed down its first ruling in a chapter 15 case. In In re ABC Learning Ctrs. Ltd., 2013 BL (3d Cir. Aug. 27, 2013), the court held that an Australian liquidation proceeding should be recognized as a foreign main proceeding under chapter 15 even though: (i) the debtor s assets were fully encumbered by liens; and (ii) an Australian receivership was pending concurrently with the liquidation. The court also ruled that the automatic stay prevented the efforts of an unsecured judgment creditor to levy on the debtor s U.S. assets because, although fully leveraged, the assets were property of the debtor. THE PURPOSE OF CHAPTER 15 Chapter 15 is unique among the chapters of the Bankruptcy Code in expressing a mission statement. Section 1501 provides that the purpose of chapter 15 is to provide effective mechanisms for dealing with cases of cross-border insolvency consistent with the following objectives: Cooperation between U.S. and non-u.s. courts and related functionaries; Greater legal certainty for trade and investment; Fair and efficient administration of cross-border cases in a way that protects the interests of all interested parties; Protection and maximization of the value of the debtor s assets; and Facilitation of the rescue of financially troubled businesses, thereby protecting investment and preserving employment. PROCEDURES AND RELIEF UNDER CHAPTER 15 Under chapter 15, the duly appointed representative of a foreign debtor may file a petition in a U.S. bankruptcy court seeking recognition of a foreign proceeding. Foreign representative is defined in section 101(24) of the Bankruptcy Code as a person or body, including a person or body appointed on an interim basis, authorized in a foreign proceeding to administer the reorganization or the liquidation of the debtor s assets or affairs or to act as a representative of such foreign proceeding. Foreign proceeding is defined in section 101(23) of the Bankruptcy Code as: [A] collective judicial or administrative proceeding in a foreign country, including an interim proceeding, under a law relating to insolvency or adjustment of debt in which proceeding the assets and affairs of the debtor are subject to control or supervision by a foreign court, for the purpose of reorganization or liquidation. More than one bankruptcy or insolvency proceeding may be pending with respect to the same foreign debtor in different countries. Chapter 15 therefore contemplates recognition in the U.S. of both a main proceeding a case pending in the country where the debtor s center of main interests is located and nonmain proceedings, which may have been commenced in countries where the debtor merely has an establishment, i.e., any place of operations where the debtor carries out a nontransitory economic activity. Section 1517 of the Bankruptcy Code provides that, subject to section 1506, an order recognizing a foreign proceeding shall be entered (emphasis added) if the proceeding qualifies as a foreign main or nonmain proceeding, the foreign representative is a person or body, and the petition itself complies with the evidentiary requirements set forth in section Section 1506 states that [n]othing in this chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States. 9

10 If a U.S. bankruptcy court recognizes a foreign main proceeding under chapter 15, section 1520(a)(1) of the Bankruptcy Code provides that actions against the foreign debtor or property of the debtor that is within the territorial jurisdiction of the United States are stayed under section 362 the Bankruptcy Code s automatic stay. Following recognition of a foreign main or nonmain proceeding, the bankruptcy court may also provide additional assistance to a foreign representative. This can include injunctive relief or authority to distribute the proceeds of all or part of the debtor s U.S. assets. However, in granting such relief, the court must conclude, consistent with the principles of comity, that such assistance will reasonably ensure, among other things, the just treatment of creditors and other stakeholders, the protection of U.S. creditors against prejudice and inconvenience in pursuing their claims in the foreign proceeding, and the prevention of fraudulent or preferential disposition of the debtor s property. In ABC Learning, the Third Circuit made its initial foray into chapter 15 territory when it considered, among other things, whether a bankruptcy court properly entered an order recognizing an Australian liquidation proceeding commenced on behalf of a debtor whose assets were fully encumbered. ABC LEARNING ABC Learning Centres Ltd. ( ABC ) was an Australian company that provided child-care and educational services in Australia, the U.S., New Zealand, the U.K., Southeast Asia, and the South Pacific through its 38 subsidiaries. ABC conducted business in the U.S. principally through its U.S. subsidiaries, ABC Developmental Learning Centres (USA) Inc. ( ABC USA ) and the Learning Care Group, which, through its Tutor Time subsidiary, was a for-profit child-care and early-education provider with more than 1,000 corporate and franchise childcare centers located throughout the U.S. In June 2008, RCS Capital Development, LLC ( RCS ), an Arizona limited liability company created for the purpose of developing child-care facilities in the United States for ABC, contracted with ABC USA to develop child-care facilities in the U.S. In October 2008, RCS sued ABC USA in Arizona state court for breach of contract. On May 14, 2010, RCS won a jury verdict against ABC USA in the amount of approximately $50 million. The Arizona court of appeals upheld the award on appeal in June On November 6, 2008, ABC s directors commenced voluntary administration proceedings under Australian law for ABC and each of its Australian subsidiaries. The directors also appointed administrators to determine whether ABC should be restructured or liquidated. Entering into voluntary administration breached ABC s loan agreements with its secured creditors, who exercised their right under Australia s Corporations Act of 2001 to appoint a receiver for the purpose of realizing on ABC s assets. Those assets were fully encumbered. In March 2009, the receiver sued RCS and certain other defendants in Nevada state court for $30 million, asserting, among other things, a constructive-trust claim over properties that the defendants had purchased with ABC s funds. ABC s directors voted to enter Australian liquidation proceedings on June 2, 2010, and appointed two of the company s administrators as liquidators. The liquidators charge was to realize assets for the benefit of all creditors, to investigate secured-creditor liens, and to pay any surplus remaining after the payment of secured claims ratably to unsecured creditors. The receivership operated in tandem with the liquidation proceedings. ABC s liquidators authorized the receiver to manage and operate ABC. On May 26, 2010, 12 days after the jury verdict in the Arizona action was rendered in favor of RCS, ABC s liquidators petitioned the Delaware bankruptcy court for an order recognizing ABC s Australian liquidation as a foreign main proceeding under chapter 15. The stated purpose of the petition was to protect ABC s U.S. assets from RCS s judgment. RCS objected to recognition and the imposition of the automatic stay. In the alternative, RCS moved for relief from the stay so that it could reduce its jury verdict in the Arizona action to judgment and assert a setoff of the judgment as a defense in the Nevada litigation. 10

11 The bankruptcy court entered an order recognizing the Australian liquidation as a foreign main proceeding on November 15, It also ruled that the automatic stay applied to ABC and its properties within the territorial United States. See In re ABC Learning Centres Ltd., 445 B.R. 318 (Bankr. D. Del. 2011). Among other things, the bankruptcy court found that the Australian liquidation proceeding met the definition of foreign proceeding under section 101(23) of the Bankruptcy Code because: (i) it was primarily administrative in character, and at times judicial in character ; (ii) it was a collective proceeding; and (iii) it was being conducted under the control or supervision of a foreign court. The court ruled further that the liquidation proceeding should be evaluated separately from the concurrently pending receivership. It also concluded that recognition was not manifestly contrary to U.S. public policy, rejecting RCS s contention that the liquidators were seeking recognition of the liquidation at the behest of the receiver and the secured creditors for the purpose of gaining an unfair advantage in the Arizona and Nevada lawsuits. However, the court granted RCS s motion for relief from the automatic stay for the limited purpose of reducing the Arizona verdict to judgment and asserting the resulting judgment as a setoff in the Nevada litigation. On appeal, the district court upheld the recognition ruling on June 18, RCS, which filed for chapter 11 protection in Arizona in October 2011, appealed to the Third Circuit. THE THIRD CIRCUIT S RULING A three-judge panel of the Third Circuit affirmed. Writing for the court, circuit judge Anthony J. Scirica examined the provenance of chapter 15 in some detail, explaining that chapter 15 is closely patterned after the Model Law on Cross- Border Insolvency (the Model Law ) promulgated in 1997 by UNCITRAL, the U.N. Commission on International Trade Law. Like the Model Law, Judge Scirica explained, chapter 15 embraces the universalism approach, whereby a multinational bankruptcy is treated as a single process in the foreign main proceeding, with other courts assisting in that single proceeding. He also explained that chapter 15 replaced section 304 of the Bankruptcy Code, which gave U.S. bankruptcy courts discretion to grant a limited range of ancillary (principally injunctive) relief by way of assistance to the duly appointed representatives of foreign debtors with U.S. assets. Such relief was to be granted (or withheld) in accordance with a statutory checklist of guiding principles designed to inform the courts discretion, the scope of which was considerable. See 11 U.S.C. 304(e) (repealed 2005). By contrast, Judge Scirica emphasized, if a foreign proceeding satisfies the criteria set forth in section 1502 of the Bankruptcy Code, recognition of the foreign proceeding under chapter 15 is required. Mandatory recognition of qualifying insolvency proceedings, Judge Scirica wrote, fosters comity and predictability, and benefits bankruptcy proceedings in the United States that seek to administer property located in foreign countries that have adopted the Model Law. Judge Scirica then examined voluntary administration and receivership under Australian law. He explained that a company s directors may initiate either reorganization or liquidation proceedings under an administration, and in the case of a liquidation, the liquidators are entrusted with collecting and distributing the company s assets to its creditors. By contrast, in a receivership, the receiver is appointed by secured creditors to realize the secured assets and distribute the proceeds to satisfy the debts secured by the property. A receivership and a liquidation, however, can function in tandem. Although the receiver represents the interests of secured creditors, the receiver has a duty to unsecured creditors to sell the assets for a fair price. Moreover, the liquidator has authority to review the appointment of the receiver and to monitor the progress of the receivership. The liquidator also investigates secured creditor claims and may challenge such claims and any liens securing them. RCS argued that the Australian receivership, rather than the liquidation, was effectively recognized by the bankruptcy court and that the receivership was not a collective proceeding as required by section 101(23), because the receiver represents only the interests of secured creditors. Judge Scirica rejected this argument, explaining that ABC s liquidation proceeding was recognized by the court, and the fact that, in this particular case, the debtor s assets were fully leveraged did not affect the collective nature of the proceeding: 11

12 Chapter 15 makes no exceptions when a debtor s assets are fully leveraged. Subject to the public policy exception, Chapter 15 recognition must be ordered when a court finds the requisite criteria are met,... replacing the Section 304 list of guiding principles.... We do not find any exception to recognition based on the debtor s debt to value ratio at the time of insolvency. Moreover, we find such an exception could contravene the stated purposes of Chapter 15 and the mandatory language of Chapter 15 recognition. RCS also contended that the Australian liquidation should not be recognized because the benefits of recognition would inure solely to the receivership a noncollective proceeding and thus, recognition would contravene U.S. public policy favoring collective insolvency proceedings. estate. He wrote that Australian law, rather than manifestly contravening U.S. policy, establishe[s] a different way to achieve similar goals. By contrast, allowing RCS to use U.S. courts to circumvent the Australian liquidation proceeding would undermine the core bankruptcy policies of ordered proceedings and equal treatment. ABC Learning illustrates the core principles of chapter 15 as a mechanism for promoting the efficient and expeditious administration of cross-border insolvency proceedings. Efforts by creditors to act outside the framework of rules erected by chapter 15 and the Model Law would undermine the entire system and the universalist (as distinguished from the territorial, or grab rule ) approach underpinning it. Judge Scirica explained that, given the express language of section 1506 (i.e., manifestly contrary to the public policy of the United States ) (emphasis added), chapter 15 s publicpolicy exception has been narrowly construed. It applies only where the procedural fairness of the foreign proceeding is in doubt or cannot be cured by the adoption of additional protections or where recognition would impinge severely a U.S. constitutional or statutory right (internal quotation marks and citations omitted). Rather than contravene public policy, Judge Scirica concluded, recognition of the Australian liquidation advances the policies that animate the collective proceeding requirement. According to the judge, RCS was attempting to attach assets before the secured creditors could realize on them. Absent chapter 15 recognition, he wrote, RCS could skip ahead of the priorities of the secured creditors, an outcome that would eviscerate the orderly liquidation proceeding, and ignores all priority of debts. Judge Scirica was not convinced, moreover, that Australian insolvency rules conflict with U.S. bankruptcy law in any way that would warrant invocation of the public-policy exception. He explained that the sole difference is that Australian law allows secured creditors to realize the full value of their debts, and tender the excess to the company, whereas secured creditors in the United States must generally turn over assets and seek distribution from the bankruptcy Judge Scirica also rejected RCS s argument that the automatic stay should not prevent it from enforcing its state-court verdict against ABC s U.S. assets. Because the assets were fully encumbered, RCS claimed, they were not property of the debtor... within the territorial jurisdiction of the United States, as required by section 1520(a) of the Bankruptcy Code. The judge concluded that, even though ABC s U.S. property was fully leveraged, ABC retained an equitable interest in the assets because, under Australian law: (i) the receiver was obligated to pay any excess remaining after realization by secured creditors to ABC; (ii) ABC had a right of redemption (i.e., by paying the secured creditor the value of its claim); and (iii) if the liquidator successfully challenged the validity of the liens encumbering the assets, ABC would be entitled to retain the property. In this regard, Judge Scirica was skeptical about the relevance of section 541 of the Bankruptcy Code (defining property of the estate ) in defining property of the debtor protected by the automatic stay in a chapter 15 case. Even if it were relevant, Judge Scirica explained, section 541(d) which excludes from the estate property in which the debtor holds only legal title and not any equitable interest would not operate to place ABC s encumbered assets outside the realm of property of the debtor by reason of this retained equitable interest. 12

13 Finally, Judge Scirica emphasized that permitting RCS to end-run the Australian liquidation proceeding by levying on ABC s U.S. assets would undermine the very purpose of chapter 15: Allowing an unsecured creditor to recover a judgment under these circumstances would require a hodgepodge of United States and Australian bankruptcy law. This is one of the outcomes Chapter 15 was designed to prevent by recognizing foreign main proceedings in United States courts. OUTLOOK ABC Learning illustrates the core principles of chapter 15 as a mechanism for promoting the efficient and expeditious administration of cross-border insolvency proceedings. Efforts by creditors to act outside the framework of rules erected by chapter 15 and the Model Law would undermine the entire system and the universalist (as distinguished from the territorial, or grab rule ) approach underpinning it. STOCKBROKER DEFENSE SHIELDS PONZI-SCHEME BROKER FEES AND COMMISSIONS FROM AVOIDANCE Dara R. Levinson and Mark G. Douglas In Grayson Consulting, Inc. v. Wachovia Securities, LLC (In re Derivium Capital LLC), 716 F.3d 355 (4th Cir. 2013), the U.S. Court of Appeals for the Fourth Circuit examined whether certain securities transferred and payments made during the course of a Ponzi scheme could be avoided as fraudulent transfers under sections 544 and 548 of the Bankruptcy Code. The court upheld a judgment denying avoidance of pre-bankruptcy transfers of securities because the debtor did not have an interest in the securities at the time of the transfers. However, in an important victory for brokers, the court also held, in a matter of first impression, that the safe harbor in section 546(e) of the Bankruptcy Code precluded avoidance of payments for broker fees and commissions because such transfers qualified as settlement payments. The ruling also reaffirms the basic idea that foreign insolvency regimes need not be identical to U.S. bankruptcy laws as a prerequisite to recognition under chapter 15. Rather, recognition is warranted so long as: (i) the foreign proceeding meets the requirements imposed by chapter 15; and (ii) the rules and procedures governing the foreign proceeding promote goals similar to those expressed in U.S. bankruptcy laws and do not manifestly offend U.S. public policy. Finally, ABC Learning highlights important differences between chapter 15 and its statutory predecessor, section 304. In keeping with the purposes of chapter 15 and the Model Law, recognition of a foreign bankruptcy or insolvency proceeding that satisfies the statutory criteria is mandatory. A version of this article appeared in the October 25, 2013, edition of Law360. It has been reprinted here with permission. AVOIDANCE OF FRAUDULENT TRANSFERS Section 548(a) of the Bankruptcy Code allows a bankruptcy 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 debtor received less than a reasonably equivalent value in exchange for such transfer or obligation and was, among other things, insolvent, undercapitalized, or unable to pay its debts as such debts matured. Section 544(b)(1) of the Bankruptcy Code similarly empowers a trustee or DIP, with limited exceptions, to avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim. This provision allows a trustee or DIP to avoid, among other things, transactions that are avoidable as fraudulent transfers under applicable state law. THE STOCKBROKER DEFENSE Section 546(e) provides a broad exception to many of the avoidance powers of a trustee or DIP with regard to certain 13

14 pre-bankruptcy payments made in connection with securities, commodity, and forward contracts. It provides that: [n]otwithstanding sections 544, 545, 547, 548(a)(1) (B), and 548(b) of this title, the trustee may not avoid a transfer that is a margin payment, as defined in section 101, 741, or 761 of this title, or settlement payment, as defined in section 101 or 741 of this title, made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, or that is a transfer made by or to (or for the benefit of) a commodity broker, forward contract merchant, stockbroker, financial institution, financial participant, or securities clearing agency, in connection with a securities contract, as defined in section 741(7), commodity contract, as defined in section 761(4), or forward contract, that is made before the commencement of the case, except under section 548(a)(1)(A) of this title. Section 546(e) expressly does not apply to section 548(a)(1) (A) of the Bankruptcy Code, which authorizes avoidance of transfers made or obligations incurred with actual intent to hinder, delay, or defraud creditors. Section 546(e), however, does apply to actions to avoid constructive fraudulent transfers under section 548(a)(1)(B) or 544. The purpose of section 546(e) and other safe harbors in the Bankruptcy Code for financial contracts is to minimize systemic risk disruption in the securities and commodities markets that could otherwise be caused by a counterparty s bankruptcy filing. Section 546(e) was amended in 2005 and 2006 to, among other things, clarify and expand its scope (e.g., by adding the phrase (or for the benefit of) and by including within the scope of the safe harbor transfers made in connection with a securities contract ). Section 101(51A) defines settlement payment as a preliminary settlement payment, a partial settlement payment, an interim settlement payment, a settlement payment on account, a final settlement payment, a net settlement payment, or any other similar payment commonly used in the forward contract trade. The term is similarly defined with respect to the securities trade in section 741(8), which applies to stockbroker liquidation cases. Most courts interpret the term settlement payment broadly to include any transfer of securities in connection with the completion of a securities transaction. Qualifying transfers include both routine securities transactions and, according to several federal circuit courts of appeal, more complicated transactions, such as transfers made during the course of a leveraged-buyout transaction ( LBO ), even LBOs that involve nonpublic securities and thus have no impact on the publicsecurities markets. In Derivium Capital, the Fourth Circuit considered whether the section 546(e) safe harbor precludes avoidance of broker-fee and commission payments made in connection with a pre-bankruptcy Ponzi scheme. DERIVIUM CAPITAL South Carolina-based Derivium Capital, LLC ( Derivium ) marketed and administered a stock loan program whereby its customers pledged publicly traded stock to Derivium in exchange for loans in the amount of 90 percent of the value of the stock. Upon maturity of the loans, the borrowers had the option of tendering principal and interest and recovering their collateral, electing to surrender the stock in satisfaction of the loans with no further obligation, or refinancing the transactions for additional terms. At Derivium s insistence, customers participating in the program deposited their stocks into brokerage accounts maintained by Wachovia Securities, LLC, and an affiliate (collectively, Wachovia ) in Derivium s name. Derivium informed customers that it would hedge the collateral, but instead it directed Wachovia to transfer the stocks into other accounts, where they were liquidated. Derivium used the proceeds to fund loans to new customers and various start-up ventures of Derivium s owners. Ultimately, Derivium could not satisfy its obligations to return customers stocks as their loans matured. Wachovia closed the accounts at issue in late 2004 and early

15 The collapse of its Ponzi scheme forced Derivium to file for chapter 11 protection in New York in September The case was converted to chapter 7 and transferred from New York to South Carolina. In August 2007, the chapter 7 trustee sued Wachovia, seeking, among other things, to avoid as fraudulent transfers under sections 544 and 548: (i) transfers into Wachovia accounts of $161 million-worth in securities serving as collateral for customer loans; and (ii) approximately $672,000 in fees, commissions, and margin interest paid to Wachovia. Later in 2007, the chapter 7 trustee assigned the litigation claims to Grayson Consulting, Inc. ( Grayson ), which was substituted as the plaintiff. The bankruptcy court granted summary judgment in favor of Wachovia on the fraudulent-transfer claims. The court concluded that the securities transferred to Wachovia were not Derivium s property and that payments to Wachovia for commissions and fees were protected from avoidance by the stockbroker defense in section 546(e). The district court affirmed, and Grayson appealed to the Fourth Circuit. THE FOURTH CIRCUIT S RULING A three-judge panel of the Fourth Circuit affirmed the rulings below. On appeal, Grayson did not contend that Derivium had an interest in its customers securities prior to their transfer to Wachovia. Instead, Grayson asserted that Derivium and Wachovia had simultaneously acquired an interest in the securities at the time they were deposited into the accounts at Wachovia. The Fourth Circuit explained that the goal of the Bankruptcy Code s avoidance powers is to prevent debtors from making transfers which diminish the bankruptcy estate to the detriment of creditors. Because Derivium did not have rights to the securities until after the transfers to Wachovia had occurred, the court concluded that the transfers were not transfers of an interest of the debtor in property and could not be avoided under section 544 or 548. For the same reason, the Fourth Circuit rejected Grayson s argument that portions of the transfers should be avoided as actual (as distinguished from constructive) fraudulent transfers under sections 548(a)(1)(A) and 546(e). According to the court, Section 546 provides only a defense to otherwise avoidable transfers; it does not establish a category of avoidable transfers of nondebtor property. The Fourth Circuit s ruling in Derivium Capital is consistent with the broad definition of settlement payment applied by other circuits and lower courts. More broadly, the decision is emblematic of the expansive application by most courts of the Bankruptcy Code s safe harbors for financialcontract transactions, in keeping with the purpose of those provisions. Next, the court considered whether the fees and commissions paid to Wachovia were protected from avoidance by section 546(e) as settlement payments. The court explained that nothing in the plain language of section 546(e) limits the definition of settlement payment to security purchase prices or excludes payments from which brokers benefit, such as fees and commissions. In fact, the Fourth Circuit noted, Congress amended section 546(e) in 2006 to add settlement payments made to or for the benefit of stockbrokers. The Fourth Circuit noted that the purpose of section 546(e) when enacted was to clarify and, in some instances, broaden the commodities market protections and expressly extend similar protections to the securities market in an effort to minimize the displacement caused in the commodities and securities markets in the event of a major bankruptcy affecting those industries. In accordance with the lawmakers intent in enacting section 546(e), the court explained that several of its sister circuits have defined settlement payment very broadly. Because Congress included the phrase any other similar payment commonly used in the securities trade as part of the definition of settlement payment, the Fourth Circuit looked to standard securities-industry practices to determine whether the term could include broker fees and commissions. The court cited several industry texts suggesting that 15

16 settlement payment means the transfer of funds paid in connection with the completion of a securities transaction. On the basis of this definition, the Fourth Circuit held that commissions and fees paid in connection with the completion of a securities transaction constitute settlement payments for purposes of section 546(e). The court underscored, however, that not all payments to brokers labeled as commissions are protected under section 546(e). For example, the court explained, commissions that are not part of the settlement of a securities transaction, such as commissions paid for the solicitation of investors or commissions whose dollar amounts indicate that they are not related to closing trades, are not covered by the safe harbor. The Fourth Circuit rejected Grayson s argument that, even if Wachovia s commissions and fees were protected by section 546(e), the court should make an exception to the stockbroker defense because applying it in the context of a Ponzi scheme would allow a broker to retain ill-gotten profits and undermine the equitable goals of the Bankruptcy Code. The court acknowledged that section 546(e) does not include a Ponzi scheme exception on its face, but wrote that the provision does provide several express exceptions to the application of the defense, including claims brought under section 548(a)(1)(A) in cases of actual fraud. The Fourth Circuit noted that courts have held that the existence of a Ponzi scheme gives rise to a presumption of actual fraud. However, in this case, neither the bankruptcy court nor the district court reached the issue of whether Grayson had established a claim for actual fraudulent intent under section 548(a) (1)(A). Furthermore, the Fourth Circuit noted that Grayson had failed to provide a convincing reason why an extra-statutory fraud exception to the stockbroker defense should be created. OUTLOOK The Fourth Circuit s ruling in Derivium Capital is consistent with the broad definition of settlement payment applied by other circuits and lower courts. More broadly, the decision is emblematic of the expansive application by most courts of the Bankruptcy Code s safe harbors for financial-contract transactions, in keeping with the purpose of those provisions. IN BRIEF: ANOTHER BLOW TO TRIANGULAR SETOFF IN BANKRUPTCY Section 553 of the Bankruptcy Code provides, subject to certain exceptions, that the Bankruptcy Code does not affect any right of a creditor to offset a mutual debt owing by such creditor to the debtor that arose before the commencement of the case under this title against a claim of such creditor against the debtor that arose before the commencement of the case. Debts are considered mutual when they are due to and from the same persons or entities in the same capacity. An exception to this strict mutuality requirement has sometimes been perceived to exist in cases involving triangular setoff, the provenance of which is commonly traced (rightly or wrongly) to a 1964 ruling by the Seventh Circuit Court of Appeals in Inland Steel Co. v. Berger Steel Co. (In re Berger Steel Co.), 327 F.2d 401 (7th Cir. 1964). In this situation, A might have a commercial relationship with B and C, where B and C are related parties. Triangular setoff occurs when A owes B, C owes A, and A attempts to set off the amount it owes to B against the amount that C owes to A. The validity of triangular setoff in the bankruptcy context, as distinguished from under state contract or common law, is subject to debate, given the lack of mutuality involved. In In re SemCrude, L.P., 399 B.R. 388 (Bankr. D. Del. 2009), a Delaware bankruptcy court ruled that triangular setoff is not permitted in bankruptcy due to the absence of mutuality. 16

17 According to the court, [M]utuality cannot be supplied by a multi-party agreement contemplating a triangular setoff. The court rejected the contention that parties can contract around section 553 s mutuality requirement. It also rejected Berger Steel as authority for the proposition that nonmutual setoff provisions in a contract can be enforced against a debtor. A Delaware district court affirmed the ruling in In re SemCrude, L.P., 428 B.R. 590 (D. Del. 2010). However, neither decision addressed whether the result would be different for derivatives and other financial contracts that fall under the safe harbor provisions of the Bankruptcy Code (sections 559 through 561). In In re Lehman Bros. Holdings Inc., 433 B.R. 101 (Bankr. S.D.N.Y. 2010) ( Lehman/Swedbank ), a New York bankruptcy court held that the safe-harbor provisions do not override the mutuality requirement for setoff, which, the court wrote, is baked into the very definition of setoff. According to the court, although the safe harbors permit the exercise of a contractual right of offset in connection with swap agreements, notwithstanding the operation of any provision of the Bankruptcy Code which could operate to stay, avoid, or otherwise limit that right, that right must exist in the first place. Lehman/Swedbank was upheld on appeal. See In re Lehman Bros. Holdings Inc., 445 B.R. 130 (S.D.N.Y. 2011). That case, however, involved not a multiparty setoff, but a setoff of prepetition claims against funds collected by the debtor postpetition. In In re Lehman Bros. Inc., 458 B.R. 134 (Bankr. S.D.N.Y. 2011) ( Lehman/UBS ), a New York bankruptcy court ruled that triangular setoff does not satisfy the Bankruptcy Code s mutuality requirement and that the safe-harbor provisions do not eliminate that requirement in connection with setoffs under financial contracts. The ruling, which involved a brokerdealer liquidation proceeding under the Securities Investor Protection Act, confirmed speculation that multiparty setoffs under financial contracts would be deemed impermissible (at least in Delaware and New York) in the wake of SemCrude and Lehman/Swedbank. The latest salvo regarding triangular setoff in bankruptcy recently came from a Delaware bankruptcy court in In re American Home Mortgage Holdings, Inc., No (Bankr. D. Del. Nov. 8, 2013) ( AHM ). Prior to filing for bankruptcy, AHM Investment was a party to a swap agreement with Barclays Capital and a repurchase agreement with Barclays Bank. After the petition date, Barclays Capital set off monies owed to AHM Investment under the swap agreement against funds owed to Barclays Bank under the repurchase agreement. AHM Investment then sued Barclays Bank and Barclays Capital for breach of the swap agreement, turnover of property of the estate, violations of the automatic stay, and a declaratory judgment that the triangular setoff was improper. Consistent with the rulings in SemCrude, Lehman/Swedbank, and Lehman/UBS, the court in AHM held that: (i) parties cannot contract around section 553 s mutuality requirement; (ii) the safe harbor provisions exceptions to the automatic stay embodied in sections cannot be interpreted as implicitly removing the mutuality requirement for setoff ; and (iii) without moving for relief from the stay, the nondebtor counterparty to a swap or repurchase agreement cannot exercise control over estate property by retaining funds in exercising alleged triangular-setoff rights. Taken together, SemCrude, Lehman/Swedbank, Lehman/ UBS, and AHM mark a clear trend against the availability of triangular setoffs in bankruptcy. In the absence of further developments in the appellate courts or subsequent case law at the bankruptcy-court level, cross-affiliate setoff without mutuality would appear to be impermissible in the two most popular business-bankruptcy jurisdictions in the U.S. the Southern District of New York and the District of Delaware. As such, financial-contract participants seeking multilateral netting would be well advised to consider alternatives to contractual triangular-setoff provisions, such as cross-collateralization under master netting agreements. 17

18 IN BRIEF: CLAIMS TRADER ALERT A ruling handed down by the Third Circuit Court of Appeals on November 15, 2013, adds yet another chapter to the ongoing controversy concerning whether sold or assigned claims can be subject to disallowance under section 502(d) of the Bankruptcy Code on the basis of the seller s receipt of a voidable transfer. The decision In re KB Toys Inc., 2013 WL (3d Cir. Nov. 15, 2013) is an unwelcome missive for claims traders. For the first time since the enactment of the Bankruptcy Code in 1978, a circuit court of appeals has concluded that: because 502(d) permits the disallowance of a claim that was originally owned by a person or entity who received a voidable preference that remains unreturned, the cloud on the claim continues until the preference payment is returned, regardless of whether the person or entity holding the claim received the preference payment. By its ruling, which the court was careful to emphasize only concerns trade claims, the Third Circuit has staked out what now can fairly be characterized as the majority approach to this issue. Accord In re Metiom, Inc., 301 B.R. 634 (Bankr. S.D.N.Y. 2003). But see Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007), vacating Enron Corp. v. Springfield Associates, L.L.C. (In re Enron Corp.), 2005 WL (Bankr. S.D.N.Y. Nov. 28, 2005), and Enron Corp. v. Avenue Special Situations Fund II, LP (In re Enron Corp.), 340 B.R. 180 (Bankr. S.D.N.Y. 2006). According to the Third Circuit, to hold otherwise would contravene the aims of section 502(d), which are to ensure equality of distribution of estate assets and to compel compliance with judicial orders. Allowing the recipient of a voidable transfer to wash [a] claim of any disability, the court explained, would undermine these goals. The Third Circuit rejected the approach taken by the district court in Enron, observing that the court s reliance on supposed state law to draw a distinction between claims that are assigned and claims that are sold is problematic for several reasons. The Third Circuit rejected the claim buyer s argument that its claims should not be disallowed because it purchased the claims in good faith and should therefore be entitled to the protections of a good-faith purchaser under section 550(b) of the Bankruptcy Code. That provision, the court wrote, protects a good faith transferee who purchases property of the estate, whereas the transferee of a claim purchases claims against the estate, which are not estate property. Furthermore, the Third Circuit emphasized, there is neither reason nor precedent to extend the principles of section 550 to protect claims traders, who knowingly and voluntarily enter the bankruptcy process. The Third Circuit is not the only Bankruptcy Code-era circuit court of appeals to address disallowance of transferred claims under section 502(d). In ASM Capital, LP v. Ames Department Stores, Inc. (In re Ames Department Stores, Inc.), 582 F.3d 422 (2d Cir. 2009), the Second Circuit held that section 502(d) does not mandate disallowance of administrative claims acquired from entities that allegedly received voidable transfers because an administrative expense does not qualify as a claim within the meaning of section 502(d). However, the Second Circuit in Ames skirted the $64,000 question on claims transfers: in view of its conclusion, the court stated that: we find it unnecessary to reach [the claim buyer s] alternative argument that, even if section 502(d) did extend to administrative expenses under section 503(b), it could be invoked only against the recipient of the alleged preferential transfer and not against a subsequent holder of a claim that originated with the alleged transferee. In Longacre Master Fund, Ltd. v. ATS Automation Tooling Systems Inc., 2012 WL (2d Cir. Sept. 14, 2012), the Second Circuit vacated a decision declining to enforce a repurchase obligation in a claims-assignment agreement triggered by the debtor s objection to the traded claim under section 502(d). However, the court did not address the lower court s observations regarding Enron and the purported protection from disallowance under section 502(d) of claims that have been sold rather than assigned. In short, the Third Circuit s ruling in KB Toys places the burden squarely on claims purchasers to incorporate adequate indemnification provisions into their claims-trading agreements as a way to manage the risk of disallowance under section 502(d). A more detailed discussion of the Enron, Ames, and Longacre rulings can be found at com/kb-toys-hobgoblins-return-to-haunt-bankruptcy- Claims-Traders and In-Brief-Claims-Trading-Hobgoblins-Redux

19 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 The Minister of Justice recently proposed legislation that would authorize the court appointment of a prospective trustee (beoogd curator) for a company prior to the commencement of formal insolvency proceedings for the purpose of exploring potential restructuring and/or sale opportunities. The proposal is part of a broader legislative initiative that includes a proposal for compulsory extrajudicial compositions and various measures designed to encourage the continuation and reorganization of insolvent companies. Existing Dutch insolvency law does not provide an explicit legal basis for the appointment of a trustee prior to the opening of formal insolvency proceedings. However, several courts have implemented the practice of confidentially disclosing the identity of the trustee that the court would appoint should a formal request for bankruptcy or suspension of payments be made, to give the future trustee an opportunity to gather adequate information concerning the company s affairs in anticipation of the proceedings. Informal guidelines have been developed by several courts in recent months to expand the trustee s role in connection with negotiations with prospective buyers and the formulation with important stakeholders of prepackaged plans for a controlled insolvency. Although experience with this relatively new practice has been generally positive, the absence of any formal legal basis has created uncertainty. Under the proposed legislation, a prospective trusteeship would not constitute a new insolvency regime. Unlike a bankruptcy trustee (curator) or an administrator in suspension of payments (bewindvoerder), a prospective trustee would have no authority over the company and no power to represent it. The debtor would retain exclusive possession of its assets. A prospective trustee would not be an agent of, or advisor to, the company. The trustee s mandate would be to represent the interests of the company s combined creditor constituency. At the company s request, the prospective trustee could apprise the company of his or her views regarding: (i) whether the actions the company intends to take in the regular conduct of its business or in paying its debts could, in the event of insolvency, reasonably be expected to withstand nullification on the grounds of fraudulent preference; (ii) the conditions under which the trustee (in the event of insolvency) might reasonably be expected to sell the company s assets (e.g., by means of a prepackaged sale); and (iii) what could be done to expedite the resolution of a bankruptcy. The prospective trustee may engage advisors (e.g., valuation experts) with the company s consent. A prospective trustee would be appointed by the court at the company s request on the basis of evidence that the appointment would best serve the interests of creditors or would be in the public interest. A prospective trusteeship could be terminated by the court on its own initiative or at the request of the company. It could also terminate upon the commencement of an insolvency proceeding for the company. The U.K. The Royal Bank of Scotland ( RBS ) on November 1, 2013, announced a new plan aimed at speeding up its restructuring, returning money to British taxpayers, and restoring the bank to profitability. RBS, which is owned principally by the British government following a 45 billion ($72 billion) bailout, announced that it would transfer approximately 38 billion ($61 billion) of toxic assets into a separate entity within the bank. The creation of the internal bad bank came after the government launched an inquiry in July into whether RBS should be dismantled, but opted against a breakup. RBS also announced that it would focus on retail and commercial banking in its home market and would move up to 2014 an initial public offering of its wholly owned U.S. subsidiary, Citizens Financial Group. Pressure from the government on RBS to accelerate the sale of its troubled-loan portfolio has been mounting in anticipation of a general election in the U.K. scheduled for Other recent European developments can be tracked in Jones Day s EuroResource, available at com/euroresource--deals-and-debt-october-2013/. 19