Bankruptcy Update. Good News for Bankruptcy Claims Buyers. in this issue

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1 October 2007 Good News for Bankruptcy Claims Buyers A claim held by a creditor who engaged in certain inequitable conduct can be equitably subordinated to the claims of other creditors under section 510(c) of the Bankruptcy Code, if that conduct gave an unfair advantage to the claimant or otherwise resulted in injury to the estate. A claim can be disallowed entirely under section 502(d) of the Bankruptcy Code if the claimant received an avoidable transfer, e.g., a preference, and fails to return it to the estate. But what happens when the claim is no longer held by the creditor who engaged in the misconduct or received the avoidable transfer? When a claim is transferred to another party, is it still subject to equitable subordination or disallowance based solely on the acts or omissions of the original creditor? Or can the claim be effectively washed through sale or assignment to an innocent transferee? On August 27, 2007, a district court ruled in the Enron case that a claim sold to another party may not be equitably subordinated or disallowed based solely on the acts or omissions of the transferor. But if the claim is transferred by assignment rather than sale, the disabilities of the claim may travel with the claim and result in subordination or disallowance even in the hands of an innocent assignee. Enron Corp. v. Springfield Associates, LLC, 2007 U.S. Dist. LEXIS (S.D.N.Y., Aug. 27, 2007)(Scheindlin, J.) in this issue 1 Good News for Bankruptcy Claims Buyers 3 The Appointment of a Patient Care Ombudsman 5 Recent Supreme Court Decision on CERCLA Could Have Significant Impact in Bankruptcy Cases 7 Court: No Rubber Stamps for Chapter 15 Petitions The court warned that the mere label of the instrument of transfer is not conclusive on the sale versus assignment question. Citibank held claims against Enron pursuant to certain loan agreements. After Enron filed its petition in bankruptcy, Citibank transferred portions of its claims to other entities, including Springfield. Enron later filed an adversary proceeding against Springfield, alleging that the transferred claims should be equitably subordinated due to the misconduct of Citibank and/or disallowed due to Citibank s receipt of preferential transfers. Springfield was not alleged to have acted inequitably or received any preference that would subject its claims to subordination or disallowance. Springfield moved to dismiss Enron s complaint, contending that neither equitable subordination nor section 502(d) disallowance should apply to claims held by transferees based solely on the alleged conduct of the transferor. The bankruptcy court denied the motion to dismiss, holding that the transfer of a claim does not alter the characteristics of that claim. If the claim would have been subject to subordination or disallowance in the hands of the transferor, then, according to the bankruptcy court, the claim remains subject to the same defenses and remedies in the hands of the transferee. On appeal, the district court reached the opposite conclusion. In what it described as a case of first impression, it decided that equitable subordination and section 502(d) disallowance are attributes of the claimant, not the claim. Examining legislative history and case law, the court found

2 that the subordination and disallowance remedies were intended to be specific to the individual who acted inequitably or received an avoidable transfer. The court viewed these infirmities as personal disabilities of the claimant and not defects in the claim. The court then analyzed the difference between an assignment and a sale, a point not addressed by the bankruptcy court. According to the court, an assignee of a claim takes no more than the assignor has to give, while a purchaser of a claim may take more. Consequently, a personal disability of the assignor may travel with the claim to the assignee, but a personal disability of a seller does not. The purchaser of a claim receives the claim free of any taint it may have had in the hands of the seller. The court was admittedly influenced by realities of the distressed debt market, where sellers are often anonymous and a purchaser may have no way of ascertaining whether the seller or a preceding transferor acted inequitably or received a preference. Parties to true assignments, by contrast, can easily contract around the risk of equitable subordination or disallowance by entering into indemnity agreements to protect the assignee. The court remanded the case to the bankruptcy court to determine whether the claim was transferred to Springfield by way of a sale or a pure assignment. If the transfer was a sale, then Citibank s disabilities did not travel with it, and the claim may not be subordinated or disallowed based solely on Citibank s acts or omissions. The court warned that the mere label of the instrument of transfer is not conclusive on the sale versus assignment question. It noted, however, that sales of claims on the open market are indisputably sales, while the subrogation of a surety to a claim is indisputably an assignment. The court also cautioned that not every claim purchaser will automatically be immune from equitable subordination. Bad faith purchasers or purchasers with actual notice of the seller s misconduct may be subject to equitable subordination based on their own misconduct. And the court suggested that a claim purchaser with actual notice of its seller s receipt of a preference might be subject to subordination for its own misconduct in buying the claim. Likewise, not every assignee will automatically be subject to equitable subordination even where the assignor behaved inequitably. For example, an assignee may qualify as a holder in due course and take the claim free from such Recent and Upcoming Events Kay Kress will participate in a panel called Recent Developments Regarding Claims in Bankruptcy presented by the Business Bankruptcy Committee of the ABA Section of Business Law during the Annual Meeting of the National Conference of Bankruptcy Judges to be held in Orlando during October. Vicki Harding will be speaking on a panel and at a workshop during the annual meeting of the American College of Real Estate Lawyers (ACREL). The panel and workshop are part of a program called : What Real Estate Lawyers Need to Know to Stay in the Know. Vicki s specific topic is Current Developments in Buying Real Estate Out of Bankruptcy: Sales Free and Clear and Other Provisions. Fran Lawall and Bonnie Kistler will be teaching in October at the Annual Meeting of The International Energy Credit Association. The courses they will present include Credit 101 and Do You Know What Is In Your Credit File? Bill Cohen will speak on October 22 to credit representatives from national food and drug manufacturers at a quarterly dinner meeting sponsored by F&D Reports. His topic will deal with The limits of adequate assurance in bankruptcy when can a debtor in possession compel sale and delivery post petition? Publications Dave Stratton and Evelyn Meltzer published an article in the latest issue of the ABI Journal. The article is about In re Meridian Automotive Systems, Inc. et al, Case No (Bankr. D. Del. August 23, 2007), where the court ordered a creditor who failed to comply with the terms of the critical vendor order and applicable trade agreement to return the critical vendor payment to the estate. -2-

3 -defects. And, in certain states, the doctrine of third party latent equities may shield an assignee who takes without notice of the equitable rights of third parties. But as a general proposition, in New York and beyond, to the extent the district court s reasoning is embraced by other courts transfers that are structured as pure sales will effectively wash the claims of the misconduct of the transferor and insulate them from equitable subordination or 502(d) disallowance. This result seemed to represent a victory not only for Springfield but for all participants in the distressed debt market. Springfield, however, sought certification for an interlocutory appeal and was joined in that effort by three amici the Securities Industry and Financial Markets Association, the International Swaps and Derivatives Association and the Loan Syndications and Trading Association all arguing that the result should not turn on whether the transfer was by sale or assignment, because that distinction is not recognized in the market. But in an opinion dated September 24, 2007, Judge Scheindlin found no substantial ground for a difference of opinion that a sale and a transfer are distinct, and she refused to certify the appeal. The case will now proceed on remand to the Bankruptcy Court. Author: Bonnie MacDougal Kistler kistlerb@pepperlaw.com The Appointment of a Patient Care Ombudsman While the number of bankruptcy cases filed has significantly declined over the past few years, bankruptcy filings by health care providers, nursing homes and hospitals are increasing. It should come as no surprise that when Congress amended the Bankruptcy Code in 2005, it chose to address patient rights and interests in health care related bankruptcy cases. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 amended the Bankruptcy Code to include section 333, which provides that where the debtor is a health care business, the bankruptcy court must appoint a patient care ombudsman, unless the court finds that the appointment of such ombudsman is not necessary for the protection of patients under the specific facts of the case. In general, the ombudsman is required to monitor the quality of care provided to patients of the debtor, report to the court every 60 days regarding the quality of care provided to patients and inform the court immediately of any issues materially and adversely affecting patient care. Only a few cases have determined whether the appointment of an ombudsman is necessary for the protection of patients under the specific facts of the case. An interesting recent case is In re Williams L Saber, M.D., P.C., 2007 WL (Bankr. D. Colo. 2007) where a bankruptcy Don t Miss Future Issues Be sure to receive future s from Pepper Hamilton llp. Please subscribe online at cfm, or you may fill out the form below and mail it to Pepper Hamilton llp, Attn: Kathy Rebechi, 3000 Two Logan Square, Eighteenth and Arch Streets, Philadelphia, PA , or fax it to Kathy Rebechi at How would you like to receive this newsletter: * Mail Name Title Company Address Phone Fax *

4 -court in Colorado held that the appointment of an ombudsman under section 333 was not necessary. In reaching this conclusion, the court noted the following: (i) the debtor filed for bankruptcy not because of allegations of deficient patient care or privacy concerns, but because of the entry of a state court judgment against the debtor obtained by a former employee; (ii) the debtor personally secured and maintained patient records at his office and an off-site location for a minimum of seven years following any medical services provided to a patient; (iii) the debtor s financial projections predicted a positive cash flow during the pendency of the debtor s bankruptcy case, so it was unlikely that a financial crisis would impair the debtor s ability to continue to provide quality medical care and to protect the privacy of patients and (iv) the debtor had practiced medicine for more than 20 years and remained in good standing with the state. The bankruptcy court also stated that it believed that the potential expenses associated with the appointment of a patient care ombudsman might preclude the debtor from reorganizing its affairs. The bankruptcy court noted, however, that such concerns did not mean that the court would not appoint an ombudsman if necessary to protect patients rights. Because the statutory provision authorizing the appointment of an ombudsman is relevantly new, significant questions remain about how it will work in practice. These questions include: What are the qualifications for serving as a patient care ombudsman? Must the individual be a medical professional? Are a minimum number of years of medical experience required? To what extent, if any, might an ombudsman be subject to civil liability or criminal liability for failing to properly perform his or her job? Who is responsible for the cost of any necessary liability insurance? What is the appropriate interface between the patient care ombudsman and the state regulatory authorities? What is the scope of the ombudsman s role in the bankruptcy case? Does the ombudsman have a status similar to that of the debtor, the Committee or a party in interest under section 1109 of the Bankruptcy Code? In general, the ombudsman is required to monitor the quality of care provided to patients of the debtor, report to the court every 60 days regarding the quality of care provided to patients and inform the court immediately of any issues materially and adversely affecting patient care. Only time and the developing case law will tell how courts will interpret Bankruptcy Code section 333 and resolve the questions set forth above. However, the decision in In re Williams L Saber, M.D., P.C makes clear that regardless of the potential expenses associated with the appointment of a patient care ombudsman, and the effect such expenses could have on a debtor s ability to reorganize, if the court determines that an ombudsman is necessary to protect the rights of patients, the court is required to appoint an ombudsman. Authors: Henry J. Jaffe jaffeh@pepperlaw.com Francis J. Lawall lawallf@pepperlaw.com Evelyn J. Meltzer meltzere@pepperlaw.com

5 Recent Supreme Court Decision on CERCLA Could Have Significant Impact in Bankruptcy Cases This article is a revised version of an article that will appear in the ABI Journal and is published here with their permission. A June 2007 U.S. Supreme Court decision that resolved a long-standing controversy in environmental law could have a significant impact in bankruptcy cases. United States v. Atlantic Research Corp., 127 Sup. Ct. 2331, involved the interpretation of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CER- CLA). The Supreme Court held that a private party may recover funds it expends for environmental cleanup from other parties liable for the cleanup not only under 113(f) of CERCLA, which provides for contribution among potentially responsible parties (PRPs) targeted by the government, but also under 107(a) of CERCLA, which permits parties to recover the costs of voluntary cleanups. Atlantic Research Corporation (ARC) voluntarily cleaned up a government-owned property it had contaminated while retrofitting rocket motors for the U.S. government. ARC then sought to recover some of its costs by suing the U.S. government under 107(a) of CERCLA. The government moved to dismiss, arguing that ARC was a PRP and, as such, was not authorized to assert a claim under 107(a). The district court agreed and granted the government s motion to dismiss, but the Eighth Circuit reversed, holding that a PRP may assert a direct cost recovery claim under 107(a). The Supreme Court affirmed the Eighth Circuit s decision. Section 107(a) of CERCLA defines four categories of PRPs that are liable for, among other things, (A) all costs of removal or remedial action incurred by the United States Government or a State or an Indian tribe not inconsistent with the national contingency plan and (B) any other necessary costs of response incurred by any other person consistent with the national contingency plan. The issue before the Supreme Court in Atlantic Research was whether PRPs fall within the scope of the phrase any other person under 107(a)(4)(B) of CERCLA and are entitled to bring suit under that provision. The government argued that any other person excludes all of the entities listed in 107(a)(1)-(4) including all PRPs. ARC argued that any other person includes anyone (including all PRPs) other than the entities expressly authorized to sue Atlantic Research may expand significantly the number of claimants who potentially might pursue CERCLA claims against a reorganized debtor subsequent to its emergence from bankruptcy. under 107(a)(4)(A), i.e., the federal government, states and Indian tribes. The Supreme Court agreed with ARC. So what does this mean for bankruptcy cases? The potential impact was anticipated, at least to some extent, by the Reading Company, which filed an amicus curiae brief in Atlantic Research that specifically focused on the potential impact on bankruptcy cases of allowing private parties to assert claims under 107(a). The Reading Company, which had received a bankruptcy discharge approximately three weeks after CERCLA was enacted, was concerned that a decision allowing private party claims under 107(a) could hinder the effectiveness of its bankruptcy discharge. Noting the tension between the policy goals of CERCLA (prompt cleanup of contamination and comprehensive assessment of liability) and the policy goals of bankruptcy law (affording an honest debtor comprehensive relief from liability and a fresh start ), the Reading Company identified two major problems: (1) a settlement or discharge of CERCLA liability to the government during a bankruptcy case would have diminished value to the debtor; and (2) debtors obtaining bankruptcy discharges would be unable to determine the effect of their discharge on CERCLA liability related to operations started and finished before the bankruptcy ended. The Reading Company noted that one site where it had incurred significant environmental liability before filing for bankruptcy involved over 600 PRPs, only 36 of whom --

6 -were sued by the government. Faced with what could be hundreds of post-bankruptcy claims by PRPs, the former debtor would need to be able to demonstrate that each and every such CERCLA 107(a)(4)(B) claim somehow was discharged or settled during its bankruptcy. As a practical matter, that burden is not sustainable, and it is highly unlikely that all such claims could be recognized and discharged in a bankruptcy, the company said in its brief. Determining whether and when a particular party is deemed to hold an environmental claim susceptible to discharge in bankruptcy also is a complex and sometimes difficult issue, the company noted. Generally, it is necessary to establish the existence of some sort of relationship between that party and the debtor, or other facts sufficient to impute at least a contingent claim to the putative claimant before the conclusion of the bankruptcy. While the scope of claim under the Bankruptcy Code is broad, in some instances it will be difficult, if not impossible, for the court to find that a PRP held and could have asserted a claim to recover response costs from the debtor before the conclusion of the debtor s bankruptcy case. Consider the following hypothetical: Company A owns a contaminated site at which Company B has been identified by the EPA as a PRP. Company B files a chapter 11 petition. It then files a plan of reorganization that resolves its CERCLA liability to the EPA and Company A and provides for a comprehensive discharge of all of its environmental liabilities. The bankruptcy court confirms the plan. After Company B emerges from bankruptcy, Company A transfers the site, which is still partly contaminated, to Company C. Prior to Atlantic Research, Company B would have been fairly confident that it would have no liability under CERCLA to Company C because, as a result of its bankruptcy plan and the confirmation order, Company B no longer had common liability to the government, a predicate for liability under CERCLA 113(f), and Company C, as the private owner of the site, could not assert a claim against Company B under 107(a). 1 However, as a result of Atlantic Research, Company C may have a claim against Company B under 107(a), and that claim would not have been affected by Company B s bankruptcy discharge because the claim did not arise until after Company B s bankruptcy case was over. Atlantic Research may expand significantly the number of claimants who potentially might pursue CERCLA claims against a reorganized debtor subsequent to its emergence from bankruptcy. Atlantic Research raises another potential problem for debtors in bankruptcy. Common liability, which is an element of a claim under CERCLA 113(f), is not an element of a claim under CERCLA 107(a). Under 502(e)(1)(B) of the Bankruptcy Code, if a creditor asserts a claim for reimbursement or contribution against the debtor based upon an obligation on which the creditor and the debtor are liable to a third party, and the claim is contingent at the time the bankruptcy court considers it, the claim will be disallowed. A classic example is a claim for subrogation or reimbursement filed by a guarantor against the bankruptcy estate of the principal obligor where the guarantor has not yet paid the creditor. Another example is a claim filed by a PRP under CERCLA 113(f) against a debtor for contribution as to future environmental response costs that the PRP expects to incur at a contaminated site at which the debtor also is a PRP. Most courts have held that the latter-type claim will be disallowed under 502(e)(1)(B). As a result of Atlantic Research, a PRP seeking to recover future response costs from a debtor may assert the claim under CERCLA 107(a), and argue that the claim is not barred because the claimant is not liable with the debtor to the government under that section (in contrast to 113(f)) and so one of the elements for disallowance under 502(e)(1)(B) is absent. Indeed, in at least one recorded case such a theory has already been asserted. In In re APCO Liquidating Trust, 2007 WL (Bankr. D.Del, Jun 29, 2007), the claimant, the City of Wichita, Kansas, whose claim for contribution under 113(f) of CERCLA was disallowed by the bankruptcy court under 502(e)(1)(B) of the Bankruptcy Code, sought to assert a claim under 107(a) of CERCLA based upon Atlantic Research, which had been decided earlier that month. However, the bankruptcy court disallowed the 107(a) claim without reaching the merits. The city s claim was based upon a pre-bankruptcy judgment which expressly awarded the city a contribution claim under 113(f) of CERCLA. The bankruptcy court held that to assert a 107(a) claim, the city would need to obtain relief from the judgment under Fed. R. Civ. P. 60(b). Since there was no basis for relief under that rule, the city was barred from asserting a claim under 107. It is too early to tell what impact Atlantic Research will have on bankruptcy cases. However, it is very likely that this decision will receive a great deal of attention and require a significant amount of analysis by debtors seeking to free themselves of CERCLA liability through bankruptcy proceedings, non-debtor potentially responsible parties CERCLA, continued on page 8

7 Court: No Rubber Stamps for Chapter 15 Petitions In a recent decision, the U.S. Bankruptcy Court for the Southern District of New York denied two petitions filed by off-shore hedge funds seeking recognition of foreign insolvency proceedings under Chapter 15 of the Bankruptcy Code. 1 The petitioners were provisional liquidators from the Cayman Islands who sought recognition of the insolvency proceedings pending there as foreign main proceedings or, in the alternative, as foreign non-main proceedings. Although no objections to the petitions were filed, Bankruptcy Judge Burton R. Lifland, who was one of the authors of the Model Law on Cross-Border Insolvency (Model Law) and Chapter 15, denied the petitions because, while the funds were organized under the laws of the Cayman Islands, their management and operations were in New York. Chapter 15 of the Bankruptcy Code was enacted as part of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 and incorporates the Model Law, which was promulgated by the United Nations Commission on International Trade Law. Chapter 15 was designed to foster cooperation among U.S. and foreign courts, protect the interests of creditors and debtors, and maintain the fair and efficient administration of cross-border insolvencies. Recognition under Chapter 15 allows a debtor subject to a foreign insolvency proceeding to obtain the benefits of the U.S. Bankruptcy Code. A principal reason for seeking such relief is to protect assets of the debtor in the United States. To obtain recognition, the representative of the foreign debtor must file a petition for recognition of the foreign proceeding. The petitioner may seek recognition of the foreign insolvency proceeding as either a foreign main or foreign non-main proceeding. A foreign main proceeding is pending in the country where the debtor has the center of its main interests, akin to the principal place of business under U.S. law. A foreign non-main proceeding is pending in a country where the debtor has an establishment. Along with the Chapter 15 petition, the debtor s representative also must provide documents supporting the debtor s asserted basis for the petition. The court held that a close examination of the facts is required even if no one objects to the Chapter 15 petition. The Court found that each petitioner s own pleadings revealed that its center of main interests was in the United States, not in the Cayman Islands, and the only connection to the Cayman Islands was that the funds were registered The burden is on the petitioner to prove that the center of the debtor s main interests is in the same country as the registered office. there. Section 1516(c) of the Bankruptcy Code provides that in the absence of evidence to the contrary, the debtor s registered office is presumed to be the center of the debtor s main interests. The burden is on the petitioner to prove that the center of the debtor s main interests is in the same country as the registered office. Factors that the court considered relevant to determining a debtor s center of main interests (although such factors are not specified in the Code) included: the location of the debtor s headquarters, management and creditors (especially those affected by the Chapter 15 case), the location of the debtor s primary assets and the jurisdiction whose law would apply to most disputes. In this case, the court found sufficient evidence to overcome the registered office presumption: no employees or managers of the funds were in the Cayman Islands, the investment manager of the funds was in New York, the administrator that ran the back-office operation of the funds was in the United States, along with the funds books and records, and before the start of the foreign proceeding, all the funds liquid assets were in the United States. The court also held that the funds insolvency proceedings pending in the Cayman Islands would not be recognized as foreign non-main proceedings. Section 1504 of the Bankruptcy Code requires that the debtor have an establishment in the country where the insolvency proceeding is pending to be considered a foreign non-main proceeding. An establishment means any place of operations where the debtor carries out non-transitory economic activity. Here, the court found no pertinent non-transitory economic activity was conducted in the Cayman Islands by the funds, and that the only deposits on the Cayman Islands migrated there after the foreign proceedings started. -7-

8 While denying the Chapter 15 petitions, the court granted a 30-day stay to allow the foreign representatives of the funds to file a petition under Chapter 7 or 11 of the Bankruptcy Code to protect their United States assets. The foreign representatives of the funds appealed Judge Lifland s decision to the U.S. District Court for the Southern District of New York and asked Judge Lifland to extend the stay while the appeal is pending, but decided against seeking Chapter 7 or 11 bankruptcy protection. With the recent collapse of the subprime market and the myriad offshore hedge funds with United States operations, an increase in the number of Chapter 15 petitions filed in the near future is likely. Petitioners and creditors alike should be familiar with the factors the bankruptcy courts are likely to examine and be aware that the recognition of a foreign insolvency proceeding is not automatic. Endnotes Author: Thomas A. Spratt, Jr sprattt@pepperlaw.com 1 In re Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd. (In Provisional Liquidation), Case No ; In re Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund, Ltd. (In Provisional Liquidation), Case No ; Decision and Order Denying Recognition (Bankr. S.D.N.Y. August 30, 2007); Amended Decision and Order Denying Recognition (Bankr. S.D.N.Y. September 5, 2007). CERCLA, continued from page 6 seeking to maximize their recoveries from debtors, and the current owners of property who believe that they may hold a private claim under 107 of CERCLA against a party whose CERCLA liability regarding the site was previously discharged in bankruptcy. Endnotes Author: Michael H. Reed reedm@pepperlaw.com 1 In Atlantic Research, in response to the government s argument that a landowner whose land was contaminated by another might be eligible to assert a claim under 107(a)(4)(B) as an innocent private party, the Supreme Court noted that under the broad statutory language even parties not responsible for contamination could be found to be PRPs under 107(a)(1)-(4). 127 Sup. Ct. at However, in 2002, Congress amended CERCLA to exempt certain bona fide prospective purchasers from liability under 107(a). See 42 U.S.C. 9607(r)(1) (2000 Ed., Supp. IV). Thus, even without the holding in Atlantic Research, Company A might have been subject to a claim by Company C under 107(a) if Company C qualified as a bona fide prospective purchaser not deemed a PRP. The material in this publication is based on laws, court decisions, administrative rulings and congressional materials, and should not be construed as legal advice or legal opinions on specific facts. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2007 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. --