Bankruptcy

August 12, 2015 By Juan Palacio Moreno

Why The Lack of Interest in Interest? Another Look at Preferences and Secured Creditors

Samuel D. Krawiecz*

I. Introduction

The Bankruptcy Code (sometimes referred to herein as the Code) disallows preferential payments made to creditors.^{^[1]} Bankruptcy preference law “ha[s] been hailed as ‘the single greatest contribution of the Bankruptcy Act to the field of commercial law.’”^{^[2]} Preference law is “designed to prohibit insolvent debtors, on the eve of filing for bankruptcy, from paying off their debts held by ‘preferred’ creditors—those creditors whom the soon-to-be bankrupts wish to favor.”^{^[3]} One purpose the preference provisions serve is that of “facilitat[ing] the prime bankruptcy policy of equality of distribution among creditors of the debtor.”^{^[4]} The other purpose of preference law is to discourage creditors “from racing to the courthouse to dismember the debtor during his slide into bankruptcy.”^{^[5]} This gives the debtor an opportunity to rescue his business and remove it from insolvency.^{^[6]}

The preference rule has five elements.^{^[7]} The payment must be (1) a transfer to a creditor, (2) for the benefit of an antecedent debt, (3) while the debtor was insolvent, (4) within ninety days of the filing of the petition (unless the creditor is an insider), and (5) the payment must “enable[] such creditor to receive more than such creditor would receive” in a Chapter 7 liquidation.^{^[8]} This Article will analyze how the fifth and last element is applied, particularly with regard to fully secured creditors.

II. The Hypothetical Liquidation Test

The fifth element is sometimes called the “hypothetical liquidation test.”^{^[9]} The full text of paragraph 547(b)(5) reads:

[T]he trustee may avoid any transfer of an interest of the debtor in property . . .
(5) that enables such creditor to receive more than such creditor would receive if—
(A) the case were a case under chapter 7 of this title;
(B) the transfer had not been made; and
(C) such creditor received payment of such debt to the extent provided by the provisions of this title.^{^[10]}

A court must “construct a hypothetical chapter 7 case and determine what the creditor would have received if the case proceeded under chapter 7.”^{^[11]}

A. Secured v. Unsecured Creditors

Generally, an unsecured creditor receiving a prepetition payment will have received more than in a chapter 7 liquidation.^{^[12]} This is true because, in a typical bankruptcy, the distribution made to unsecured creditors is less than 100% of their outstanding debt. Therefore, “any payment . . . will enable [an unsecured] creditor to receive more than” in a liquidation.^{^[13]}

The opposite rule holds true for secured creditors.^{^[14]} Prepetition payments to a fully secured creditor “generally ‘will not be considered preferential because the creditor would not receive more than in a chapter 7 liquidation.’”^{^[15]} This rule seems appropriate because the underlying rationale for preference law “appl[ies] to a lesser degree to creditors with fully secured claims.”^{^[16]} The fairness rationale does not apply in the case of a fully secured creditor because a fully secured creditor “is not required to share with other creditors on a pro rata basis” due to his security interest and there is less fear of a fully secured creditor “dismember[ing] a financially unsound debtor” because he is certain of his payment to the extent of his security interest.^{^[17]}

B. Application of the Hypothetical Liquidation Test

When applying the hypothetical liquidation test, courts construct a counterfactual in which (1) there was a Chapter 7 liquidation proceeding, (2) the transfer was not made, and (3) the debtor’s debt was discharged pursuant to the Bankruptcy Code.^{^[18]} The court then estimates how much the creditor would receive in the hypothetical case, which I will refer to as Scenario B, for the debt that was repaid with the allegedly preferential payment.^{^[19]} If this amount is lower than the amount of the prepetition payment, what we will call Scenario A, then the fifth prong of the preference analysis is satisfied.^{^[20]}

The hypothetical is not “conducted in a vacuum.”^{^[21]} For example, when a creditor has a contract with the debtor, a court must estimate whether the contract would be assumed or rejected before concluding whether the prepetition payment benefitted the creditor.^{^[22]} When making this assessment, courts do not mechanically construct and apply a Chapter 7 liquidation model, but take into account the “actual facts of the case.”^{^[23]} The hypothetical “assume[s] that [all] persons would act in a commercially reasonable and businesslike manner.”^{^[24]}

III. Post-Petition Interest and the Hypothetical Liquidation Test: Why Secured Creditors Are Usually “Preferenced”

Although courts consider issues such as liquidation costs and contract assumption, they do not consider post-petition interest when performing the hypothetical liquidation test.^{^[25]} For example, consider the effect of post-petition interest^{^[26]} on a fully secured creditor with a $1 million debt, a $1 million security interest in the debtor, and the ability to receive a semi-annual interest rate of 4%. In Scenario A, he receives a $1 million cash payment on January 1 and the debtor files for bankruptcy on February 1 of the same year. Because the money is in the creditor’s hands and not subject to the automatic stay, he will employ this cash and receive a semi-annual interest rate of 4%. This will result in him earning forty thousand dollars every six months.

In Scenario B, a court would hypothesize either that the money was returned before February 1 or never paid to the creditor and the debtor then files for Chapter 7 on February 1. The creditor will then submit a claim for $1 million. However, even though he is fully secured, he will not receive interest until the conclusion of the Chapter 7 proceedings. In a liquidation proceeding with “extensive or complex litigation”, the case can take years.^{^[27]} Supposing it takes half a year, he will receive $1 million in six months’ time in Scenario B; in Scenario A, he will have $1.04 million.^{^[28]}

Another way of analyzing this is by comparing the present value of the payments in Scenario A and B. In Scenario A, the payment is today and the present value would therefore equal the payment, or one million dollars. In Scenario B, supposing the Chapter 7 takes six months, the present value of the million dollars is only $961,538.^{^[29]} Secured creditors seem to “flunk” the hypothetical liquidation test. This analysis runs counter to the legal dogma that secured creditors are not preferenced by prepetition payments.^{^[30]}

A. This Analysis Fits with the Statutory Text of Bankruptcy Code § 547(b)

The statutory language of the hypothetical liquidation test requires only that the prepetition payment “enable” the creditor “to receive more” than in hypothetical liquidation.^{^[31]} The term enable indicates that the analysis should encompass more than the prepetition payment itself. If Congress meant to limit the court’s consideration to the actual payment, it could have stated “(5) that is greater than such creditor would receive if . . . ” Additionally, the text of § 547 does not require that the benefit from the preference derive from the debtor themselves.^{^[32]}

B. This Analysis Follows the “Not Conducted in a Vacuum” and “Commercially Reasonable and Businesslike Manner” Approaches Taken by Courts

Preference case law also supports a contextual approach to constructing the hypothetical liquidation.^{^[33]} In In re LCO Enterprises,^{^[34]} the question of whether a creditor benefitted from a prepetition payment depended on whether the creditor’s contract with the debtor would be assumed or rejected in Scenario B.^{^[35]} If assumed, the debtor would be obligated to cure any default,^{^[36]} the creditor would therefore be paid in full, and the payment would not be a preference.^{^[37]} In the actual facts of that case, the contract was assumed but the question the court was considering was whether that fact should affect the hypothetical test.^{^[38]}

The court began its analysis by invoking the Supreme Court’s ruling in Palmer Clay Products Co. v. Brown^{^[39]} that:

The preferential effect of the payment must be determined “not by what the situation would have been if the debtor’s assets had been liquidated and distributed among his creditors at the time the alleged preferential payment was made, but by the actual effect of the payment as determined when bankruptcy results.”^{^[40]}

This principle was applied in In re Tenna Corp.^{^[41]} to disregard a post-petition development of a super-priority in constructing the hypothetical liquidation.^{^[42]} Both cases seem to indicate that in a hypothetical liquidation, the court can only look at events as of the day of the filing.^{^[43]}

Despite this, the court in In re LCO Enterprises stressed that “the hypothetical liquidation . . . should not . . . be conducted in a vacuum,”^{^[44]} and that it “must be based on the actual facts of the case.”^{^[45]} The court therefore ruled that, because the contract was assumed, there was a legal obligation on the debtor to repay the debt in full and therefore there was no benefit to the creditor due to the prepetition payment.^{^[46]}

Just as a court can consider post-petition events such as a contract assumption,^{^[47]} so too it can consider the length of a hypothetical liquidation in determining the amount that would be received in that proceeding, relative to what a prepetition payment “enabled” a creditor to receive.

C. Applying Preference Law to Payments to Secured Creditors Fits with the Rationale for Preference Law

Allowing secured creditors to receive prepetition payments and ignoring the practical benefits accruing to them due to the time value of money runs counter to the policy rationales underlying preference law. These reasons are described in the legislative history of section 547:

The purpose of the preference section is two-fold. First, by permitting the trustee to avoid prebankruptcy transfers that occur within a short period before bankruptcy, creditors are discouraged from racing to the courthouse to dismember the debtor during his slide into bankruptcy. The protection thus afforded the debtor often enables him to work his way out of a difficult financial situation through cooperation with all of his creditors. Second, and more important, the preference provisions facilitate the prime bankruptcy policy of equality of distribution among creditors of the debtor. Any creditor that received a greater payment than others of his class is required to disgorge so that all may share equally.^{^[48]}

Payments to secured creditors should be avoided pursuant to both of these reasons.

1. The dismemberment fear

As noted in In re Fuel Oil Supply & Terminaling, Inc., there is an incentive, albeit reduced, even for secured creditors to obtain prepetition payments due to the time value of money.^{^[49]} If a bank has knowledge that a debtor is having financial difficulties and may need to enter bankruptcy, there is a very real incentive for them to try to force the debtor to use whatever cash is available to pay their debts. Their alternative, in the real world, is to wait for the conclusion of a Chapter 11 proceeding. Although Congress is attempting to shorten the duration of Chapter 11 cases by limiting the period of exclusivity for debtors to file plans of reorganization,^{^[50]} even a secured creditor must fear that his money will be tied up for the duration of the proceedings. If there are many creditors, the case can take a long time.^{^[51]} Thus, the first rationale for preferences applies to secured creditors as well.

2. The fairness concern

Additionally, fairness should dictate that payments to secured creditors are avoidable preferences. First, as the Ninth Circuit formulated the fairness argument, preference law was meant to “prohibit insolvent debtors, on the eve of filing for bankruptcy, from paying off their debts held by ‘preferred’ creditors—those creditors whom the soon-to-be bankrupts wish to favor.”^{^[52]} Given the interest of a creditor in avoiding having his money tied up in a bankruptcy, this consideration is very real even for secured creditors. Supposing a debtor has several secured creditors with claims of one million dollars, and the debtor has only one million in cash, he can favor a “preferred” creditor by paying them the cash and allowing them to avoid waiting out the ensuing bankruptcy.

Additionally, there is a fairness concern that prepetition payment to a secured creditor will result in less money for the other creditors, secured or otherwise. Allowing the debtor to keep its cash means that the debtor, and not the secured creditor, will capture the benefit of the time value of money. This value can be obtained either by lending out the money, or, as is more likely, if the debtor needs the cash to operate in bankruptcy, keeping its cash allows the debtor to avoid obtaining expensive debtor-in-possession financing. Thus, avoiding prepetition payments for secured creditors “facilitate[s] the prime bankruptcy policy of equality of distribution among creditors of the debtor.”^{^[53]}

IV. Conclusion

Current case law clearly holds that payments made to a secured creditor are not voidable because the creditor was guaranteed to be repaid that amount, due to his security. However, this does not account for the real world practicality that receiving a prepetition payment is greatly beneficial to the secured creditor as it allows him to receive interest on that money during the pendency of the Chapter 11 proceedings.

The statutory text seems to allow for this consideration, as it states that a prepetition payment need only “enable” the creditor to receive more. Additionally, current bankruptcy doctrine has other instances where courts create a hypothetical scenario (such as would need to be created to account for post-petition interest) in analyzing if a creditor is better off.^{^[54]}

The underlying preference law rationale militates for such a rule as well. Allowing secured creditors to keep prepetition payments will lead to such creditors rushing the debtor and actually causing a filing, which is precisely the result preference law was meant to prevent.

Preferred citation: Samuel D. Krawiecz, Why The Lack of Interest in Interest? Another Look at Preferences and Secured Creditors, 5 Harv. Bus. L. Rev. Online 107 (2015), https://journals.law.harvard.edu/hblr//?p=4024.

* J.D., Harvard Law School, 2015. I am especially grateful to Professor Mark J. Roe for his thoughtful guidance and feedback.

[1] See 11 U.S.C. § 547 (2012).

[2] Isaac Nutovic, The Bankruptcy Preference Laws: Interpreting Code Sections 547(c)(2, 550(a)(1), and 546(a)(1), 41 Bus. Law. 175, 175 (1985) (quoting Maclachlan, Bankruptcy 284 (1956)).

[3] In re Taylor, 599 F.3d 880, 888 (9th Cir. 2010).

[4] Union Bank v. Wolas, 502 U.S. 151, 161 (1991) (quoting H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.N. 5963, 6138).

[5] Union Bank, 502 U.S. at 161 (quoting H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.N. 5963, 6138).

[6] See Union Bank, 502 U.S. at 161.

[7] See 11 U.S.C. § 547(b) (2012).

[8] See id.

[9] E.g., In re Friedman’s Inc., 738 F.3d 547, 555–56 (3d Cir. 2013).

[10] 11 U.S.C. § 547(b)(5).

[11] In re LCO Enters., 12 F.3d 938, 941 (9th Cir. 1993).

[12] See e.g., In re Powerine Oil Co., 59 F.3d 969, 972 (9th Cir. 1995).

[13] Id. This is because for the portion of debt that is paid prepetition, the unsecured creditor is being repaid at rate of 100%, as opposed to during a bankruptcy where unsecured creditors receive less than 100% for the entirety of their loan.

[14] See id.

[15] Id. (quoting 4 Collier on Bankruptcy ¶ 547.08, at 547–45 (Lawrence P. King ed., 15th ed. 1995)).

[16] See In re Fuel Oil Supply & Terminaling, Inc., 837 F.2d 224, 227 (5th Cir. 1988).

[17] See id.

[18] See e.g., In re Friedman’s, 738 F.3d at 556; In re Smith’s Home Furnishings, Inc., 265 F.3d 959, 963 (9th Cir. 2001).

[19] See In re Smith’s Home Furnishings 265 F.3d at 963.

[20] See id.

[21] In re LCO, 12 F.3d at 942.

[22] See id. at 941.

[23] See id. at 942–43.

[24] See In re ML & Assocs., Inc., 301 B.R. 195, 202 (Bankr. N.D. Tex. 2003).

[25] See e.g., In re LCO Enters., 12 F.3d at 942–44; In re ML & Assocs., 301 B.R. at 202–03. But see In re Fuel Oil Supply & Terminaling, Inc., 837 F.2d at 227 n.10 (noting that a fully secured creditor’s incentive to obtain prepetition payments is merely “reduced” but still present, partly because he “forgoes earning interest on the retained collateral during bankruptcy”).

[26] This argument applies only to the interest that could be earned after the filing. With regard to the interest between the preference and the filing though, there is no argument to say that there is a benefit. This is because the creditor’s claim is accruing interest even in Scenario B, which means that on the day of the filing, there is no difference between Scenarios A and B. In both cases, he will have a right to the one million dollars with its accompanying interest for January 1st through February 1st.

[27] See William J. Factor, When is Chapter 7 the Best Option for Liquidating a Business?, in Chapter 7 Commercial Bankruptcy Strategies 91, 97 (2010), available at 2010 WL 895211 (noting that “it can take longer than a decade to administer a case involving extensive or complex litigation claims”).

[28] This is equal to the one million dollars paid prepetition and an additional forty thousand dollars earned as interest over six months (1,000,000 x 1.04).

[29] This is equal to one million divided by 1.04.

[30] See e.g., In re Smith’s, 265 F.3d at 964.

[31] 11 U.S.C. § 547(b)(5).

[32] See id.

[33] A contextual approach, as opposed to a mechanical one, is crucial to this analysis. Most of the cases cited use this approach when constructing Scenario B (for example, by assessing if a contract will be assumed) while in this Essay’s analysis the main effect is in Scenario A. Just as courts look beyond the petition date when constructing Scenario B, this analysis looks at the length of the proceedings after the petition date to either discount the payment in Scenario B or to calculate interest that can be earned in Scenario A.

[34] 12 F.3d 938 (9th Cir. 1993).

[35] See id. at 941.

[36] See id. (citing 11 U.S.C. § 365(b)).

[37] See In re LCO Enters., 12 F.3d at 941.

[38] See id. at 942.

[39] 297 U.S. 227 (1936).

[40] In re LCO Enters., 12 F.3d at 942 (quoting Palmer Clay, 297 U.S. at 229).

[41] 801 F.2d 819 (6th Cir. 1986).

[42] See id. at 823.

[43] See In re LCO, 12 F.3d at 942.

[44] See id. (quoting In re LCO Enters., 137 B.R. 955, 959 (B.A.P. 9th Cir. 1992)).

[45] See In re LCO, 12 F.3d at 940.

[46] See id. at 942.

[47] See id.

[48] H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6138.

[49] 837 F.2d at 227 n.10.

[50] See Bankruptcy Abuse Protection and Consumer Protection Act of 2005 § 411, 11 U.S.C. § 1121(d)(2) (2012).

[51] See M. Todd Henderson, Paying CEOs in Bankruptcy: Executive Compensation When Agency Costs are Low, 101 Nw. U. L. Rev. 1543, 1607 n.327 (“The average time a firm spends in Chapter 11 is about 18 months.”).

[52] In re Taylor, 599 F.3d at 888.

[53] H.R. Rep. No. 95-595, at 177–78 (1977), reprinted in 1978 U.S.C.C.A.N. 5963, 6138.

[54] See supra, note 18.

March 8, 2015 By Juan Palacio Moreno

Fatally Foreign: Extraterritorial Recovery of Avoidable Transfers and Principles of Comity in the Madoff Securities SIPA Liquidation Proceeding

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Timothy Graulich, Brian M. Resnick, and Kevin J. Coco*

Bernie Madoff’s investment firm, Bernard L. Madoff Investment Securities LLC (Madoff Securities), famously imploded in December 2008 under the weight of the largest Ponzi scheme in U.S. history.^{^[1]} Some of Madoff’s largest customers were offshore “feeder funds” that pooled capital from various investors around the world principally in order to “feed” investments into Madoff Securities. In many cases the vast majority, or all, of the capital in the feeder funds was channeled directly to, and as investments in, Madoff Securities. When feeder funds received distributions from Madoff Securities, they would often in turn distribute assets to their own customers, many of whom were foreign institutions and individuals. In an important recent decision from the United States District Court for the Southern District of New York, the court dismissed recovery claims asserted by the Madoff Securities trustee against foreign subsequent transferees that had received distributions from foreign Madoff feeder funds on the basis that section 550(a)(2) of the Bankruptcy Code^{^[2]} does not apply extraterritorially under the circumstances and, alternatively, international comity considerations prohibit recovery from these foreign entities.

I. Cross-Border Clawbacks

The trustee appointed under the Securities Investor Protection Act (SIPA) to administer the Madoff Securities estate has engaged in a multiyear global effort to recoup funds for the estate’s customers and creditors using the powers of SIPA and the Bankruptcy Code.^{^[3]} This effort extended to several offshore feeder funds that received distributions from Madoff Securities, many of which are subject to liquidation proceedings in their respective foreign jurisdictions. In addition to claims against the feeder funds themselves, the Trustee brought avoidance and recovery actions against the foreign customers of the funds that had received subsequent distributions. As a statutory matter, the Trustee pursued clawbacks against these foreign subsequent transferees under section 550(a)(2),^{^[4]} which allows a trustee to recover property that is the subject of an avoided transfer from “any immediate or mediate transferee” of an initial transferee. The foreign subsequent transferees moved to withdraw the reference to the bankruptcy court, and the U.S. District Court for the Southern District of New York granted their request and consolidated the cases with respect to the issue of whether section 550(a)(2), as incorporated into SIPA, applies extraterritorially such that the Trustee can recover transfers made from foreign feeder funds to foreign investors in those funds.^{^[5]}

II. Extraterritorial Applications

The foreign subsequent transferees moved to dismiss the Trustee’s complaints on the basis that section 550(a)(2) does not apply extraterritorially and therefore cannot be used by the Trustee to claw back transfers made abroad by a foreign feeder fund to its foreign customer. In the consolidated case, Securities Investor Corp. v. Bernard L. Madoff Investment Securities LLC,[6] Judge Jed S. Rakoff granted the motion to dismiss, holding that (i) the application of 550(a)(2) to the particular facts of the case would constitute an extraterritorial application of the statute,^{^[7]} (ii) Congress did not clearly intend such an application,[8] and (iii) even if the statute could be applied extraterritorially, principals of international comity would preclude such an application under the circumstances.^{^[9]}

Judge Rakoff began his opinion by recalling the longstanding presumption that congressional legislation is meant to apply only within the United States in the absence of contrary intent.^{^[10]} Citing the recent Supreme Court decision in Morrison v. Nat’l Australia Bank Ltd.,^{^[11]} Judge Rakoff wrote that the court must first determine whether the factual circumstances of the case require extraterritorial (as opposed to domestic) application of the relevant statute.^{^[12]} In answering “yes” to this inquiry, Judge Rakoff evaluated the “focus” of the transactions that section 550(a) seeks to regulate.^{^[13]} For their part, the Trustee and the Securities Investor Protection Corporation (SIPC) interpreted the inquiry broadly by arguing that the focus in a SIPA liquidation is the domestic broker-dealer and the maximization of its assets, meaning that any application of section 550(a) and other Bankruptcy Code provisions incorporated into SIPA is inherently domestic.^{^[14]} Judge Rakoff rejected this approach in favor of the more specific interpretation advocated by the defendants, which analyzes the regulatory focus of section 550(a).^{^[15]} The statute focuses on the nature of the transactions at issue – here, transfers between foreign parties abroad, rather than the U.S. debtor more generally, leading the court to conclude that the Trustee’s attempted recovery of the “predominantly foreign” transactions would require an extraterritorial application of section 550(a).^{^[16]} The court repeatedly highlighted the foreign-to-foreign aspect of the transfers and the fact that they did not come directly from the U.S. debtor.^{^[17]}

III. Congressional Intent

The second step of the Morrison analysis is whether Congress intended the statute to apply extraterritorially. Under Morrison, the congressional intent must be affirmative and clear in order to overcome the presumption.^{^[18]} The Trustee and SIPC had argued that, although extraterritorial intent is not present in the plain language of section 550(a), the court should look to section 541(a)^{^[19]} for statutory context, which provides that “property of the estate” is estate property “wherever located and by whomever held,” and is understood generally to apply regardless of whether the property is present in the United States.^{^[20]} According to the Trustee and SIPC, the words “wherever located and by whomever held” are incorporated into the Bankruptcy Code’s avoidance and recovery provisions, meaning that Congress intended section 550(a) to apply extraterritorially.^{^[21]} The court dismissed this argument as “clever [but] neither logical nor persuasive” and cited Supreme Court and Second Circuit precedent to explain that “fraudulently transferred property becomes property of the estate only after it has been recovered by the Trustee.”^{^[22]} Responding to the Trustee’s policy-based contention that refusing to apply section 550(a) extraterritorially would permit a U.S. debtor to transfer its assets abroad and then retransfer them to another foreign entity, thus escaping liability, the court noted that such concerns “must be balanced against the presumption against extraterritoriality[,]” which is intended to avoid international conflict.^{^[23]} The court ultimately held that the Trustee had not adequately rebutted the presumption against extraterritoriality and was therefore prohibited from utilizing section 550(a) to recover transfers to the foreign investors of the offshore feeder funds.^{^[24]}

IV. Comity Matters

In an alternative ruling, Judge Rakoff determined that even if the Trustee were to overcome the presumption against extraterritoriality, recovery from the foreign subsequent transferees in this case would be prohibited by considerations of international comity.^{^[25]} International comity is “the recognition which one nation allows within its territory to the legislative, executive, or judicial acts of another nation.”^{^[26]} In the United States, comity requires a comparison of U.S. interests against foreign interests. Here, the court recognized that many of the other Madoff feeder funds are subject to liquidation proceedings in their home countries where their own avoidance and recovery statutes govern.^{^[27]} As the defendants noted in their briefing, the British Virgin Islands trial court and appellate court had already addressed, and rejected, one feeder fund liquidator’s attempt to recover these same transfers pursuant to local common law.^{^[28]} The defendants criticized the Trustee’s approach as seeking a type of unfair double recovery, arguing that the Trustee should not be permitted to first recover initial transfers to the feeder funds and then recover subsequent transfers to the feeder fund’s customers, but rather should be required to stand in line alongside the feeder fund customers and share as a creditor of the feeder fund’s estate.^{^[29]} On the other hand, SIPC focused on U.S. interests in stating that comity is not implicated where the Trustee attempts to recover property stolen from investors in a U.S. broker-dealer as part of a Ponzi scheme with its “center of gravity” in the U.S.^{^[30]} In the end, Judge Rakoff agreed with the defendants with respect to the comity issue, describing the proceedings before him as an attempt by the Trustee to “reach around” the foreign proceedings and pull in foreign investors with no direct relationship to the U.S. estate and no reason to expect that U.S. law would apply to distributions received from foreign investment funds.^{^[31]}

V. International Deference

Comity is an influential thread woven throughout Judge Rakoff’s opinion. Indeed, the longstanding presumption against extraterritoriality, which the Madoff court established as its analytical starting point, is itself a comity-based rule that was recognized more than twenty years ago by the Supreme Court as an effort to “protect against unintended clashes between our laws and those of other nations which could result in international discord.”^{^[32]} Judge Rakoff repeated this principle in finding that section 550(a)(2) does not apply extraterritorially, further commenting that the Trustee’s proposed actions “could raise serious issues of international comity.”^{^[33]}

More broadly, the Madoff decision illustrates a growing (albeit not universal) trend in both U.S. and non-U.S. courts’ willingness to employ comity principles to address cross-border insolvency disputes. Beginning with the 1996 In re Maxwell Communications Corp.^{^[34]} case, in which the U.S. bankruptcy judge cooperated effectively with her U.K. counterpart to improvise and implement a cross-border protocol between simultaneous bankruptcy cases,^{^[35]} courts in many countries have moved toward a practice that substantially defers to the insolvency laws of the home country. This trend follows the Second Circuit’s observation in the Maxwell decision that “[c]omity is especially important in the context of the Bankruptcy Code.”^{^[36]} The Maxwell case initiated a series of discussions and decisions endorsing the doctrine of universalism, which posits that a single set of governing rules promotes market symmetry, or that, since modern markets are global, the same legal rules should apply in a consistent manner across borders.^{^[37]} Eventually, in 1997, the United Nations Commission on International Trade Law promulgated the Model Law on cross-border insolvency, which employs universalism and comity as its guiding principles.^{^[38]} Since then, more than twenty countries have adopted some version of the Model Law, including the United States Congress when it passed chapter 15 of the Bankruptcy Code in 2005.^{^[39]}

The Madoff decision reflects a universalist approach and courts’ growing hesitation to reach over international borders where competing insolvency regimes govern. Universalism seeks not only to defer to the laws of the country with the greater interest but also recognizes that economic actors, when transacting, have a right to rely on their expectation that the “home” jurisdiction’s laws will govern.^{^[40]} Otherwise, global markets may suffer from unpredictability, inefficiency and, some would argue, unfairness.

VI. Further Applications

The Madoff ruling should give a measure of comfort to foreign customers of foreign investment funds regarding the ability of a U.S. trustee to utilize U.S. bankruptcy law to claw back their distributions. However, in exploring potential future applications of Judge Rakoff’s Madoff decision, it is useful to consider whether a slight change in circumstances would lead to a different outcome. For instance, consider a situation where an offshore feeder fund is created by a U.S. broker-dealer for the purpose of helping investors avoid U.S. taxes. In that case, a trustee could argue that the feeder fund is a “sham entity” and seek a ruling from the U.S. bankruptcy court that the offshore entity and U.S. entity should be treated together as a single estate pursuant to a substantive consolidation or alter ego theory. Accordingly, if the offshore fund made distributions to its foreign customers, the trustee may argue that such transfers were not foreign-to-foreign transactions as in Madoff but instead U.S.-to-foreign transfers that are recoverable under a purely domestic application of section 550(a).^{^[41]}

Just three days prior to the Madoff decision, the Ninth Circuit addressed a similar scenario in Kismet Acquisition, LLC v. Icenhower.^{^[42]} In Icenhower, a U.S. debtor transferred a Mexican coastal villa to a Nevada shell company during the pre-petition period and then, post-petition, the shell company sold the asset to a Mexican couple.^{^[43]} The Ninth Circuit upheld the rulings of both lower courts, confirming that the shell company was the alter ego of the debtor and should be substantively consolidated with the bankruptcy estate.^{^[44]} Section 549(a) of the Bankruptcy Code,^{^[45]} which permits a trustee to avoid post-petition transfers of property of the estate, applied in this case. As a result of the substantive consolidation finding, property of the debtor’s estate as of the petition date included the villa in the hands of the shell company and the successor to the trustee was able to claw back the villa into the estate.^{^[46]} The court explained that, under Morrison and applicable Ninth Circuit precedent, Congress intended an extraterritorial application of the Bankruptcy Code as it applies to property of the estate, including with respect to section 549(a).^{^[47]}

The Icenhower decision suggests that Madoff may have been decided differently if the feeder funds were consolidated into the Madoff Securities estate, even considering the fact that section 548(a) uses the term “interest of the debtor in property” rather than “property of the estate.”^{^[48]} The Trustee may have found more success if, for example, he was able to show that Madoff Securities and the feeder funds colluded to defraud other Madoff customers by distributing assets to the foreign subsequent transferees. In an alternative scenario, the defendants’ arguments may have been stronger if the feeder funds at issue invested a smaller portion of their assets in Madoff Securities (say 5% rather than 95% or 100%). Under those facts, as a due process matter, it would seem even less appropriate to bring the foreign subsequent transferees into the Madoff Securities bankruptcy case.

With respect to comity, it is important to note that the doctrine requires a comparison of jurisdictional interests that does not always result in deference. In a recent chapter 15 case, In re Elpida Memory Inc.,^{^[49]}the bankruptcy court conducted a de novo review of a sale transaction that had been previously approved by the Japanese bankruptcy court in the main proceeding, stating that comity “is not the end all be all of the [Chapter 15] statute.”^{^[50]} In Madoff, the court found persuasive the fact that many of the feeder funds were undergoing liquidation proceedings in their respective home countries.^{^[51]} Consequently, the Trustee could seek recovery from subsequent transferees pursuant to the laws of the feeder funds’ home countries.^{^[52]} Without those facts, or if the feeder funds’ home jurisdictions had been ones with undeveloped insolvency laws such that the U.S. retained a stronger interest in seeing the subsequent transfers recovered from the feeder funds’ customers, the result may have been different.

Ultimately, extraterritorial application of the Bankruptcy Code and international comity require courts to examine congressional intent while balancing the competing interests of different jurisdictions. Absent contrary intent within the statute, debtors and trustees in cases under both SIPA and the Bankruptcy Code likely face an uphill battle in overcoming the presumption against extraterritoriality. The recent gravitation toward universalism and respect for foreign laws reinforces that presumption and seeks to establish international deference as the governing baseline.

Preferred citation: Timothy Graulich, Brian M. Resnick, & Kevin J. Coco, Fatally Foreign: Extraterritorial Recovery of Avoidable Transfers and Principals of Comity in the Madoff Securities SIPA Liquidation Proceeding, 5 Harv. Bus. L. Rev. Online 53 (2015), https://journals.law.harvard.edu/hblr//?p=3971.

* Timothy Graulich and Brian M. Resnick are partners in the Insolvency and Restructuring Group of Davis Polk & Wardwell LLP, and Kevin J. Coco is an associate in that group.

[1] See Robert Frank, Madoff Jailed After Admitting Epic Scam, Wsj.com (Mar. 13, 2009), http://www.wsj.com/articles/SB123685693449906551.

[2] 11 U.S.C § 550(a)(2) (2012).

[3] See generally The Madoff Recovery Initiative: Substantively Consolidated SIPA Liquidation of Bernard L. Madoff Investment Securities LLC & Bernard L. Madoff, http://www.madofftrustee.com (last visited Mar. 2, 2015).

[4] 11 U.S.C § 550(a)(2).

[5] See Sec. Investor Prot. Corp. v. Bernard L. Madoff Inv. Sec. LLC, 513 B.R. 222, 225 (S.D.N.Y. July 28, 2014).

[6] Id.

[7] Id. at 228.

[8] Id. at 231.

[9] Id.

[10] Id. at 226.

[11] 561 U.S. 247 (2010).

[12] See Sec. Investor Prot. Corp., 513 B.R. at 226 (citing Morrison, 561 U.S. at 264–73).

[13] See id. at 226.

[14] Id.

[15] Id.

[16] Id.

[17] Id. at 225, 232.

[18] 561 U.S. at 255 (quoting E.E.O.C. v. Arabian Am. Oil Co., 499 U.S. 244, 248 (1991)).

[19] 11 U.S.C. § 541(a).

[20] Sec. Investor Prot. Corp., 513 B.R. at 228.

[21] Id. at 228–29.

[22] Id. at 229.

[23] Id. at 231 (quotingIn re Midland Euro Exch. Inc., 347 B.R. 708, 718 (Bankr. C.D. Cal. 2006)).

[24] Id.

[25] Id. at 232.

[26] JPMorgan Chase Bank v. Altos Hornos de Mexico, S.A. de C.V., 412 F.3d 418, 423 (2d Cir. 2005) (quoting Hilton v. Guyot, 159 U.S. 113, 164 (1895)).

[27] See Sec. Investor Prot. Corp., 513 B.R.at 232.

[28] Id. (quoting Decl. of Marco E. Schnabl dated July 13, 2012, Ex. C., No. 12 Misc. 115, ECF No. 236 (S.D.N.Y. filed July 13, 2012)).

[29] Transcript of Oral Argument. at 29 (Sept. 28, 2012), Sec. Investor Prot. Corp., 513 B.R. 222.

[30] Id. at 15-16.

[31] See Sec. Investor Prot. Corp., 513 B.R.at 232.

[32] EEOC v. Arabian American Oil Co., 499 U.S. 244, 248 (1991).

[33] Sec. Investor Prot. Corp., 513 B.R. at 227.

[34] 93 F.3d 1036 (2d Cir. 1996).

[35] Id. at 1054-55.

[36] Id. at 1048.

[37] Law Business Research Ltd, The International Insolvency Review 2 (Donald S. Bernstein ed., 2d ed. 2014).

[38] See United Nations Commission On International Trade Law, UNCITRAL Model Law on Cross-Border Insolvency with Guide to Enactment and Interpretation 109 (2014), available at www.uncitral.org/uncitral/en/uncitral_texts/insolvency/1997Model.html.

[39] 11 U.S.C. § 1501 (2005); Status – UNCITRAL Model Law on Cross-Border Insolvency (1997), http://www.uncitral.org/uncitral/en/uncitral_texts/insolvency/1997Model_status.html (last visited Mar. 2, 2015).

[40] See, e.g., Jay Lawrence Westbrook, Theory and Pragmatism in Global Insolvencies: Choice of Laws and Choice of Forum, 65 Am. Bankr. L.J. 457, 461 (1991).

[41] 11 U.S.C. § 550(a).

[42] 757 F.3d 1044 (9th Cir. 2014).

[43] Id. at 1048.

[44] Id. at 1053.

[45] 11 U.S.C. § 549(a) (2012).

[46] Icenhower, 757 F.3d at 1051.

[47] Id. at 1050.

[48] See 11 U.S. Code § 548(a) (2012).

[49] No. 12-10947 CSS, 2012 WL 6090194 (Bankr. D. Del. Nov. 20, 2012).

[50] Id. at *8.

[51] See Sec. Investor Prot. Corp., 513 B.R.at 232.

[52] Id.

November 17, 2014 By wpengine

Make-Whole Claims and Bankruptcy Policy

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Douglas P. Bartner and Robert A. Britton*

Loan agreements and bond indentures frequently contain “make-whole” or “yield maintenance” provisions that are designed to give the lender or bond investor the benefit of its interest rate bargain in the event that the obligor repays its debt obligation prior to maturity. Generally, although formula and calculation methodologies vary, upon a prepayment the obligor will be required to pay an additional amount that is calculated to be the interest rate differential between the loan or bond contract rate and the interest rate at which the prepaid funds can be reinvested through maturity. The hypothetical reinvestment rate typically references treasury yields along a curve plus a margin, with a present-value discount. When interest rates have fallen between the time the debt was incurred and the prepayment, the formula often will produce a positive number and the obligor will be required to pay a make-whole claim.

In a bankruptcy of the obligor, a claim for a make-whole payment may be very significant, especially today, when interest rates have fallen to historic lows and may stay at these levels for an extended time. The effect of significant make-whole claims is to dilute the recovery to other creditors; indeed, unsecured creditors that are not entitled to receive a make-whole payment could be viewed as effectively subsidizing a lender or bond investor’s contractual make-whole right.

In this article, we will discuss the state of the law regarding the enforceability in bankruptcy proceedings of make-whole provisions, as well as policy considerations that suggest the beneficiaries of make-wholes may be unfairly enriched at the expense of other creditors. We will begin by focusing on two recent high-profile bankruptcy decisions by the United States Bankruptcy Courts for the Southern District of New York and the District of Delaware, respectively, that have garnered considerable interest from insolvency practitioners and the lending community. The decisions in American Airlines^{^[1]}and School Specialty^{^[2]} each address the enforceability in bankruptcy of “make-whole” payments, and stand generally for the proposition that courts in these key bankruptcy jurisdictions will honor the strict terms of a make-whole negotiated in good faith between a debtor and its lenders to the extent that such provision is enforceable under applicable state law.^{^[3]} The decisions appear to be in line with both the majority of precedential cases from these districts and others. We will then consider these decisions in light of fundamental policy goals of the bankruptcy code, and policy choices that have been made by Congress to achieve those goals.

I. Make-Whole Provisions in Bankruptcy

Historically, bankruptcy courts have split on whether to allow the payment of make-whole amounts to lenders. A minority of courts has likened the payment of make-whole amounts to the payment of unmatured interest, something that is expressly forbidden by the bankruptcy code.^{^[4]}^{^[5]} Another line of cases relied on the ability to award post-petition reasonable “charges” to oversecured creditors in approving the payment of make-whole amounts in the limited circumstances where make-wholes arise under oversecured creditors’ debt instruments, but only to the extent that the court determined the amount of the make-whole payment to be reasonable.^{^[6]}

The majority trend, however, has been to permit the payment of make-whole amounts so long as the relevant make-whole provision is enforceable under applicable state law, in some cases regardless of whether the lender is oversecured.^{^[7]} This line of cases holds that prepayment charges are not in the nature of unmatured interest since they fully mature in accordance with the terms of the contract.^{^[8]} Courts adhering to this line of reasoning examine the loan agreement or indenture at issue to determine whether any applicable prepayment premium has become payable in accordance with its terms, and if so, analyze whether such premium is permissible under applicable state law. Recently, the courts in American Airlines and School Specialty each took this approach in their review of the enforceability of a debtor’s make-whole obligations and reached different conclusions based on the facts in each case.

In American Airlines, the debtor sought to enter into a postpetition financing arrangement and use the proceeds, in part, to prepay certain of its prepetition debt which carried a significantly higher interest rate.^{^[9]} The trustee for the prepetition debt that was proposed to be prepaid objected, arguing that the debtor could not prepay its obligations without also paying a make-whole amount provided for in the prepetition indenture.^{^[10]} The American Airlines court analyzed the prepetition indenture, and found that the filing of a voluntary bankruptcy proceeding constituted an event of default that automatically accelerated the maturity of the debt.^{^[11]} The indenture also specifically provided that no make-whole payment was due upon such an acceleration.^{^[12]} As a result, the court found that under the plain language of the indenture, no make-whole payment was due the debtor’s bondholders in connection with its prepayment of the prepetition debt.^{^[13]}

In contrast, the decision in School Specialty upheld a lender’s entitlement to payment of a significant make-whole amount.^{^[14]} In that case, the debtor entered into a prepetition credit agreement that provided for an “early payment fee” upon either prepayment or acceleration of the loan.^{^[15]} Prior to the petition date, the debtor and its lenders entered into a forbearance agreement that acknowledged an event of default and the acceleration of the debt, and, consequently, fixed the lenders’ right to receive the early payment fee.^{^[16]} The debtor’s official committee of unsecured creditors challenged the early payment fee, not under the terms of the contract but rather under applicable state law.^{^[17]} The School Specialty court determined that under New York law (as with the law in many jurisdictions), “early termination fees are analyzed under the standards applicable to liquidated damages.”^{^[18]}

Under New York state law, contractual liquidated damages provisions are enforceable if, as of the time the parties entered into their agreement, actual potential damages were difficult to determine and the amount of the liquidated damages were not “plainly disproportionate” to potential losses.^{^[19]} The School Specialty unsecured creditors’ committee argued that the prepayment calculation, which resulted in a prepayment fee equal to 37% of the principal balance of the loan, failed this test because it provided for a fee that was “grossly disproportionate” to the lenders’ expected loss.^{^[20]} Upon examination, however, the School Specialty court determined that the prepayment fee calculation was reasonable at the time the parties negotiated the loan in good faith, and could not be invalidated simply because it ultimately resulted in a significant prepayment fee.^{^[21]}

II. Tension Between Enforcement of Make-Whole Provisions and Bankruptcy Policies

Bankruptcy laws are intended to address numerous public policy considerations that, at times, are in tension with one another. Most fundamentally, bankruptcy is intended to provide a debtor with a fresh economic start, and to provide recoveries for similarly situated creditors fairly vis a vis one another.^{^[22]} In addition, the bankruptcy code applies applicable non-bankruptcy law in determining creditor rights, except where exceptions are required to further the policy goals of a fresh start and creditor equality.^{^[23]}

In limited circumstances, Congress has determined that certain recoveries by creditors that are otherwise permissible under applicable non-bankruptcy law should be disallowed or capped in bankruptcy. A prime example is claims for damages filed by lessors of non-residential real property where the debtor has rejected the lease.^{^[24]} Long-term commercial leases that are rejected by a debtor could give rise to very significant claims for damages. The bankruptcy code caps the amount of such claims to further the goal of equitable recoveries by all creditors.^{^[25]} Courts have observed that such claims may be “disproportionate in amount to any actual damage suffered, particularly in the event of a subsequent rise in rental values.”^{^[26]} That observation is true as far as it goes, but landlords also may be forced to cover a debtor’s default during a period when real estate demands significantly lower rents than the debtor’s lease rate. In such a scenario, and as a result of the policy decisions reflected in the bankruptcy code, the landlord may not look to the bankruptcy court or the market for full, or even pro rata, compensation for its losses.

In other contexts, claimants are required to mitigate damages. For example, suppliers who are party to a contract with a debtor are entitled to assert a claim for damages that are measured by application of non-bankruptcy law if the debtor rejects the contract. Under applicable law, a non-breaching contract counterparty is entitled to damages, which includes consequential damages or lost profits. The non-breaching party, however, is required to make a good faith effort to mitigate its damages. A supplier of product to the debtor, for example, is required to make a good faith effort to find another buyer for its product and a purchaser of goods from the debtor is required to make good faith efforts to find a replacement source for those goods.^{^[27]}

Courts that have found make-whole provisions enforceable in bankruptcy have not required the financial creditor with a make-whole right to mitigate damages by re-investing the proceeds of a prepayment, if possible, to reduce the formulaic make-whole amount. Rather, courts that have upheld make-whole payments have turned to the liquidated damages doctrine to determine whether the formulaic claim amount is permissible under non-bankruptcy law.

III. Conclusion

Following the decisions in American Airlines and School Specialty, it is clear that financial creditors with a contractual make-whole entitlement have an opportunity to assert a claim in bankruptcy proceedings designed to make such creditors whole; and in certain circumstances may also receive a windfall.^{^[28]} Their make-whole claim is not subject to a statutory cap, like lessors of non-residential real property, and there is no requirement to mitigate damages, as there is for most other creditors. Although the payment of make-whole amounts clearly may be enforced under applicable state law in many instances, there appears to be tension between a claim in bankruptcy for such a payment and public policies underlying the bankruptcy code, including maximizing recoveries and the fair treatment of all creditors.

Preferred citation: Douglas P. Bartner & Robert A. Britton, Make-Whole Claims and Bankruptcy Policy, 5 Harv. Bus. L. Rev. Online 21 (2014), https://journals.law.harvard.edu/hblr//?p=3926.

* Douglas P. Bartner is a partner in the Financial Restructuring and Insolvency Group of Shearman & Sterling LLP. Robert A. Britton is a senior associate in that group. The authors regularly represent debtors, creditors, and other parties in interest in bankruptcy proceedings and out-of-court restructurings. The authors wish to thank Joshua Rivera, an associate at Shearman & Sterling, for his research assistance in connection with this article.

[1] U.S. Bank Trust Nat’l Assoc. v. American Airlines Inc. (In re AMR Corporation), 485 B.R. 279 (Bankr. S.D.N.Y. 2013).

[2] In re Sch. Specialty, Inc., No. 13-10125 (KJC), 2013 WL 1838513 (Bankr. D. Del. April 22, 2013).

[3] See In re AMR Corporation at 288; In re Sch. Specialty at 15. See also Transcript of Oral Decision on Confirmation of Debtors’ Joint Chapter Plan of Reorganization for Momentive Performance Materials Inc. & its Afilliated Debtors at 44, In re MPM Silicones, L.L.C., No. 14-2503-rdd (Bankr. S.D.N.Y. Aug. 26, 2014) (relying on the American Airlines decision in connection with an analysis of the disallowance of make-whole premiums under New York law).

[4] See, e.g., In re Ridgewood Apartments of DeKalb Cnty., Ltd., 174 B.R. 712, 720 (Bankr. S.D. Ohio 1994) (“[B]ecause the . . . claim is for interest which is not yet due at the time the bankruptcy was filed . . . it would not be allowed to an undersecured creditor”); In re Doctors Hosp. of Hyde Park, Inc., 508 B.R. 697, 708 (Bankr D. Ill. 2014) (finding that “[t]he Yield Maintenance Premium represents unmatured interest”)

[5] 11 U.S.C. § 502(b)(2) (2012).

[6] See, e.g.,11 U.S.C. § 506(b) (2012) (“To the extent that an allowed secured claim is secured by property the value of which . . . is greater than the amount of such claim, there shall be allowed to the holder of such claim . . . any reasonable fees, costs, or charges provided for under the agreement . . .”); Premier Entm’t Biloxi LLC v. U.S. Bank Nat’l Assoc. (In re Premier Entm’t Biloxi LLC), 445 B.R. 582, 618 (Bankr. S.D. Miss. 2010) (“In general, a prepayment premium is encompassed under the term ‘charges.’”).

[7] Section 502(b)(1) of the bankruptcy code forbids the payment of any claim to the extent that “such claim is unenforceable against the debtor and property of the debtor under . . . applicable law.” 11 U.S.C. § 502 (2012); Cf. In re Trico Marine Services, Inc., 450 B.R. 474, 481 (Bankr. D. Del. 2011) (finding that an unsecured creditor held an allowed claim for a make-whole payment).

[8] E.g., In re Outdoor Sports Headquarters, Inc., 161 B.R. 414, 424 (Bankr. S.D. Ohio 1993) (“Prepayment amounts, although often computed as being interest that would have been received through the life of a loan, do not constitute unmatured interest because they fully mature pursuant to the provisions of the contract.”); In re Trico Marine Services, Inc., 450 B.R. at 481.

[9] U.S. Bank Trust Nat’l Assoc. v. American Airlines Inc. (In re AMR Corporation), 485 B.R. 279, 283-84 (Bankr. S.D.N.Y. 2013).

[10] Id.

[11] Id. at 289.

[12] Id. at 289-90.

[13] Id. at 298.

[14] In re Sch. Specialty, Inc., No. 13-10125 (KJC), 2013 WL 1838513, at *5 (Bankr. D. Del. April 22, 2013).

[15] Id. at *1.

[16] Id. at *2.

[17] Id. at *1.

[18] Id. at *2.

[19] Id.

[20] Id. at *3, *4 n.7.

[21] Id. at *4.

[22] See Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934) (“[o]ne of the primary purposes of the Bankruptcy Act is to ‘relieve the honest debtor from the weight of oppressive indebtedness, and permit him to start afresh’”) (quoting Williams v. U.S. Fid. & Guar. Co., 236 U.S. 549, 554-555 (1915)); Sampsell v. Imperial paper & Color Corp., 313 U.S. 215, 219 (1941) (“the theme of the Bankruptcy Act is equality of distribution”).

[23] See Board of Trade of City of Chicago v. Johnson, 264 U.S. 1, 10 (1924) (“Congress derives its power to enact a bankrupt law from the federal Constitution and the construction of it is a federal question. Of course, where the Bankrupt Law deals with property rights which are regulated by state law, the federal courts in bankruptcy will follow the state courts; but when the language of Congress indicates a policy requiring a broader construction of the statute than the state decisions would give it, federal courts cannot be concluded by them”) (quoting Bd. of Trade v. Weston, 243 F. 332 (7th Cir. 1917)).

[24] This is not the only example, though. For instance, an employee’s claim for damages arising from the termination of an employment contract is also capped by the bankruptcy code. 11 U.S.C. § 502(b)(7) (2012).

[25] 11 U.S.C. § 502(b)(6) (2012).

[26] Oldden v. Tonto Realty Corp., 143 F.2d 916, 920 (2d Cir. 1944).

[27] E.g., In re Orion Refining Corp., 445 B.R. 312, 315 (D. Del. 2011) (upholding a Bankruptcy Court decision that a creditor failed to mitigate damages as required by applicable state law).

[28] As noted, generally, make-whole formulas are tied to Treasury yields along an applicable curve. Of course, an investment in Treasuries is typically considered “risk-free,” while the obligor’s credit profile likely involved some degree of risk at the time the loan was made or bond was issued. Financial creditors with a make-whole right, therefore, may recover the lion’s share of their anticipated yield, and redeploy that make-whole amount as well as recovered principal in investments with significantly greater yield than Treasuries.

March 17, 2011 By wpengine

Corporate Reorganization as Corporate Reinvention: Borders and Blockbuster in Chapter 11

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Ruth Sarah Lee*

At its heart, Chapter 11 is supposed to be about giving struggling businesses a new beginning, predicated on the idea that “a failing business can be reshaped into a successful operation . . . a predictable creation from a people whose majority religion embraces the idea of life from death and whose central myth is the pioneer making a fresh start on the boundless prairie.”[1] However, major Chapter 11 cases filed in the past few months, and the subsequent discussions they provoked, raise a new question to peruse: how new should the new beginning be—how fresh the fresh start? When a corporation vows to change its business model in order to pay back its debts and become more successful, how much is it supposed to change? Can it morph into a completely different corporation after it emerges? Corporations like Borders Group, Inc. (“Borders”) or Blockbuster Inc. (“Blockbuster”) might be making Chapter 11 the fashionable, new way to metamorphose.

As far as large corporations are concerned, Chapter 11 should be about capturing, retaining, and protecting something that is of value. If a corporation has nothing of worth that can be preserved through reorganization, there are very few reasons why it should not be liquidated immediately, its parts dissembled and auctioned, whatever lifeblood leftover to be given to its creditors. All reorganization efforts “proceed in the shadow of the [liquidation] alternative…[r]eorganizations are designed and evaluated by comparison with the outcomes available” under liquidation.[2] What this means is that some corporations should file for Chapter 11 bankruptcy, while others should liquidate, depending on what they have to offer.

In practice, however, Congress created powerful incentives for all corporations to choose Chapter 11 in the past three decades.[3] Among these incentives are strong presumptions in favor of letting the debtor stay in control and the elimination of the insolvency requirement.[4] Related to this, legal academics have criticized reorganization procedures, regarding the system to be corrupt, due to forum-shopping, judicial irresponsibility, and competition.[5] But, these forces that guide corporations toward corruption are also steering companies into a new sort of reinvention bankruptcy—that is, a corporation that is popularly agreed to be not-viable nonetheless files for Chapter 11 with hopes of not only refinancing, re-designing, or changing its business model—by changing the entire business itself.

In reorganization, corporations need to have their reorganization plans confirmed by the bankruptcy judge, who, in turn needs to ascertain, inter alia, that confirmation “is not likely to be followed by the liquidation, or the need for further financial reorganization, of the debtor or any successor to the debtor under the plan, unless such liquidation or reorganization is proposed in the plan.”[6] As a result, at least theoretically, corporations should come up with plans that sound at least potentially successful. Blockbuster, which recently put itself up for sale when its reorganization plan collapsed,[7] can hardly be mentioned without an obligatory nod to Netflix and Redbox, both often credited with putting Blockbuster out of business, and both often cited as reasons why Blockbuster should have just liquidated instead of putting up a fight.[8] Netflix and Redbox are Blockbuster’s more digital age savvy competitors, famous for cheaper by-mail and vending-kiosk movie rentals, respectively. But now, Blockbuster is planning on “closing old-fashioned stores, installing new kiosks, and diving into digital delivery.”[9] In other words, Blockbuster is trying to turn into Netflix.

Observers have noted similarities between Blockbuster’s Chapter 11 and Borders’ Chapter 11.[10] Both are companies victimized by the digitalization of media and burdened with chains of large physical stores.[11] Borders’ bankruptcy has been attributed to “its failure to establish a strong online sales operation and a slow embrace of electronic books.”[12] Like Blockbuster, Borders is playing the chameleon by changing its identity: shifting “the focus away from its physical presence” and at the same time “overhaul[ing] its website and introduc[ing] a digital book store.”[13]

Borders and Blockbuster are merely two examples of companies that seem somewhat antiquated to the electronic generation. And as they flounder around in Chapter 11, they both have their eyes on becoming digitized, unrecognizable from their former selves. It is one thing to do a balance-sheet reorganization, refinance, close unprofitable chain stores, and rethink a business model, but it is another thing entirely to turn yourself from a video rental store into an online streaming service; or from a physical bookstore into Amazon.com. Yet this is what these corporations are considering.

In one sense, this is the same old story we have all heard before, that a bankrupt corporation must find new ways to make profits. However, practically speaking, this means that the 11 U.S.C. § 1129 hurdle should be relatively easy to clear as long as a corporation is flexible enough about its future. Any out-of-date corporation can turn around, point its finger at a more successful, technologically fashionable company and say, “I am going to be like that!” It is true that a judge might be skeptical about the ability of the corporation to change, especially in light of its debts, but Blockbuster is an example that is very established in its ways, with almost $1 billion in debt at the time of filing.[14]

Furthermore, this is actually a radical shift in the essence of reorganizational bankruptcy: We are no longer considering a corporation that has any worth to preserve at the beginning of the reorganization, we are considering a corporation that wants to create worth by reinventing itself.[15] We are no longer dealing with a viable business that has fallen on hard times and needs some tweaking; we are dealing with businesses that are so admittedly unviable that they need to transform into a completely different business in order to convince the bankruptcy judges that they have a fighting chance at life.

Borders is transforming into Amazon.com. Blockbusters is transforming into Netflix. What is Chapter 11 reorganization transforming into? Perhaps—rebirth.

* J.D. Candidate, 2012, Harvard Law School. The author would like to thank Kevin Cooper, Jason Iuliano, Mike Patrone, and especially Emily Zand for their help with this Commentary; also Professor Lynn LoPucki and Professor Katherine Porter for inspiring her foray into the world of Bankruptcy Law. All errors remain my own.

[1] Elizabeth Warren & Jay Lawrence Westbrook, The Success of Chapter 11: A Challenge to the Critics, 107 Mich. L. Rev. 603, 604 (2009).

[2] See Elizabeth Warren, Business Bankruptcy 28 (1993).

[3] Michael Bradley & Michael Rosenzweig, The Untenable Case for Chapter 11, 101 Yale L.J. 1043, 1045 (1992) (noting that the “presumption favoring management’s continued control, when combined with other provisions of Chapter 11 affording the corporate debtor considerable latitude regarding its treatment of creditors,effectively gave managers powerful incentives to pursue bankruptcy reorganization.”).

[4] See 11 U.S.C. § 1107 (2006).

[5] See, e.g., Bradley & Rosenzweig, supra note 3; see also Lynn M. LoPucki & Joseph W. Doherty, Delaware Bankruptcy: Failure in the Ascendancy, 73 U. Chi. L. Rev. 1387 (2006); Lynn M. LoPucki & Sara D. Kalin, The Failure of Public Company Bankruptcies in Delaware and New York: Empirical Evidence of a ‘Race to the Bottom’, 54 Vand. L. Rev. 231 (2001).

[6] 11 U.S.C. §1129(a)(11) (2006).

[7] See Ben Fritz, Blockbuster To Put Itself Up For Sale, L.A. Times, Feb. 21, 2011, http://articles.latimes.com/2011/feb/21/business/la-fi-ct-blockbuster-20110222.

[8] See, e.g., The Feldman File, http://feldmanfile.blogspot.com/ (Mar. 1, 2011, 13:32 CST); Mae Anderson, Blockbuster, Creditors Agree on Sale Plan, Bloomberg Businessweek, Mar. 10, 2011, http://www.businessweek.com/ap/financialnews/D9LSLSVO0.htm; Scott Gordon, What is the Future of Blockbuster?, NBC Bus. News, July 9, 2010, http://www.nbcdfw.com/news/business/What-Is-the-Future-of-Blockbuster-98149184.html; Blockbuster Files for Chapter 11 Business Reorganization, Business First, Sept. 23, 2010, http://www.bizjournals.com/louisville/stories/2010/09/20/daily39.html (noting that Blockbuster “lost out because Netflix and RedBox gained ground quickly with new platforms, and Blockbuster moved too late . . . like the Captain of the Titanic [Keyes, Blockbuster’s CEO] got on the ship after it hit the iceberg. He has been trying to bail it out with a bucket.”)

[9] Gordon, supra note 8.

[10] Nathan Borney, Blockbuster’s Proposed Bankruptcy Sale is Uncomfortable Reminder for Borders, Ann.Arbor.com Business News, Feb. 22, 2011, http://www.annarbor.com/business-review/blockbusters-proposed-bankruptcy-sale-is-uncomfortable-reminder-for-borders/.

[11] Id.

[12] Id.

[13] Joseph Checkler, Borders Files for Chapter 11 Bankruptcy Protection, Wall St. J. Online, Feb. 17, 2011, http://online.wsj.com/article/SB10001424052748703373404576147922340434998.html.

[14] See Checkler, supra note 13.

[15] An argument that could be made is that the brand name itself (Borders or Blockbuster) is value worth preserving through Chapter 11, even if the companies themselves completely change into unrecognizably new companies. However, this departs from most of the traditional Chapter 11 discussions (which are mainly about preserving assets and jobs).

Preferred citation: Ruth Sarah Lee, Corporate Reorganization as Corporate Reinvention: Borders and Blockbuster in Chapter 11, 1 Harv. Bus. L. Rev. Online 53 (2011), https://journals.law.harvard.edu/hblr//?p=1002.

November 29, 2010 By wpengine

One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code

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Harvey R. Miller & Maurice Horwitz^*

On October 19, 2010, the FDIC published a proposed rule governing the implementation of Title II of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”).[1] Title II of Dodd-Frank creates an orderly liquidation authority for the resolution of systemically important financial institutions.[2] According to the FDIC’s Notice of Proposed Rulemaking Implementing Certain Orderly Liquidation Authority Provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act, “[t]he liquidation rules of Title II are designed to create parity in the treatment of creditors with the Bankruptcy Code and other normally applicable insolvency laws.”[3]

One of the criticisms of Title II, however, is that creditors lack the same degree of certainty with respect to their probable treatment under an FDIC receivership as compared with the bankruptcy process. The FDIC’s typical response to this concern is that the statute guarantees creditors no less than the amount they would have received if the covered financial company had been liquidated under chapter 7 of the Bankruptcy Code.[4]

This response is inherently flawed because it assumes that one could state objectively what a creditor’s probable recovery would be in a hypothetical chapter 7 case. All judgments of value are subjective, even if based to some extent on objective facts. It is for this reason that valuation disputes are among the most common forms of litigation in Bankruptcy Courts. However, Title II does not appear to provide any recourse to creditors who disagree with the FDIC’s determination of value in most contexts. What follow are some examples of how the subjective value determinations of the FDIC may affect creditor treatment under Title II. These examples demonstrate the lack of transparency and creditor rights that is a general issue with FDIC receiverships.

Bifurcation of Secured Claims. To the extent that the FDIC determines that a claim is undersecured, Title II gives the FDIC the authority to bifurcate claims and treat the undersecured portion as an unsecured claim.[5] The FDIC may make payments to a secured creditor pursuant to the disposition of its collateral, but is under no obligation to make any payment with respect to the undersecured portion of the claim.[6] One cannot imagine a more likely scenario for a valuation dispute. If the FDIC cannot dispose of a secured creditor’s collateral, then the FDIC will value the underlying security and determine to what extent the security is insufficient, and pay the secured creditor based on that valuation. Moreover, even if the FDIC disposes of a secured creditor’s collateral, secured creditors may wish to be involved in the development and administration of the sale process, as well as the determination of the price that the FDIC decides is acceptable. Creditors whose claims are secured by highly illiquid or distressed assets will be particularly disadvantaged, both by the FDIC’s absolute discretion in valuing or disposing of such assets and by its relative inexperience in managing such assets.

Transfer of Assets To A Bridge Financial Company. Title II gives the FDIC the ability to organize a “bridge financial company,”[7] and transfer any assets and liabilities of the covered financial company to the bridge financial company without assignment, consent, or obtaining any approval under federal or state law.[8] It is not clear, however, what sort of value a bridge financial company would be required to provide in exchange for such assets. The statute provides that a bridge financial company may either “assume” liabilities, or “purchase” assets of the covered financial company.[9] Presumably, therefore, Congress intended that the bridge financial company would provide some consideration for the transferred assets. But what consideration? This question will be crucial for those unsecured creditors whose liabilities are not assumed by the bridge financial institution, as they will be left to rely on the proceeds of such a transfer in the subsequent distribution of the remaining assets. Title II does not appear to provide any recourse for creditors who believe that the bridge financial institution has not paid fair value.

Adequate Protection for Priming Liens. Title II may also affect secured claims if the FDIC transfers encumbered assets to a bridge financial company. In these circumstances, the FDIC may authorize the bridge company to issue debt with first priority liens (i.e., “priming liens”) on such assets.[10] Fortunately, in such circumstances and unlike for other actions by the FDIC, a hearing is required before a federal district court: the FDIC must demonstrate to the court that secured creditors’ preexisting liens are adequately protected.[11] However, the statute does not define the nature of this process, even though it is an area likely to give rise to significant litigation over valuation of the collateral security and what would constitute adequate protection for the secured creditor.

Liquidation Analysis. Under Title II, the FDIC may favor certain creditors over others that are similarly situated, or pay certain creditors before others.[12] Similar results can be obtained in a chapter 11 case, but typically require creditor consent and court approval. Not so under Title II: the FDIC has complete discretion in making this decision. To allay creditor fears, the FDIC cites the statutory “guarantee” that creditors will receive no less, in any event, than they would have received in a chapter 7 liquidation. To ensure that this guarantee is met, however, will require a comparison of the distributions proposed by the FDIC in a Title II liquidation with the probable distributions that would be available to creditors in a chapter 7 liquidation. Who will make this comparison? Who will prepare the liquidation analysis to demonstrate that the FDIC has met its burden? The FDIC should craft rules not only to address these questions, but also to ensure that the liquidation analysis is credible—ideally, performed by an independent third party—and not dependent on the FDIC’s subjective view of an institution’s liquidation value.

If, through the rulemaking process, value determinations such as the foregoing can be placed in the hands of independent third party arbiters, Title II may yet achieve parity with the Bankruptcy Code. Meaningful dialogue on this subject will require the FDIC, industry executives, investors, and academics to recognize that any potential outcome for creditors under Title II, as it currently stands, depends disproportionately more on the subjective value determinations of a single party—the FDIC receiver—than would ever be the case in a chapter 7 bankruptcy

* Mr. Miller is a Partner, and Mr. Horwitz is an Associate, at Weil, Gotshal & Manges LLP.

[1] Pub. L. No. 111-203, 124 Stat. 1376 (2010) (to be codified at 15 U.S.C. § 78o-7).

[2] §§ 201–217.

[3] 75 Fed. Reg. 64,182, 64,175 (proposed Oct. 19, 2010) (to be codified at 12 C.F.R. pt. 380).

[4] See §§ 210(a)(7)(B), (d)(2)(B).

[5] See § 210(a)(3)(D)(ii).

[6] § 210(a)(2)(D).

[7] See § 210(h)(1)(A).

[8] See § 210(h)(5)(A), (D).

[9] See § 210(h)(1).

[10] See § 210(h)(16)(C).

[11] See § 210(h)(16)(C)(ii).

[12] See § 210(b)(4).

Preferred citation: Harvey Miller & Maurice Horwitz, One Way That Dodd-Frank’s Liquidation Authority Could Achieve Parity With The Bankruptcy Code, 1 Harv. Bus. L. Rev. Online 1 (2010), https://journals.law.harvard.edu/hblr//?p=350.

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