Corporate Restructuring and Bankruptcy Update

Transcription

1 Corporate Restructuring and Bankruptcy Update March 2008 Delaware Bankruptcy Court Issues Decision on Enforceability of X-Clause in Subordinated Note Indenture The Delaware Bankruptcy Court recently found that an X-Clause does not relieve subordinated noteholders of their agreement to subordinate their right to payment or distribution from the debtors until the senior noteholders are paid in full. Following a majority of courts that have previously interpreted X-Clauses, the Honorable Kevin J. Carey, in Kurak v. Dura Automotive Systems, Inc., et al., (Bankr. D. Del. December 7, 2007), ruled in favor of the debtors and the senior lenders, finding that the X-Clause did not relieve the subordinated noteholders of their agreement to subordinate their right to payment or distribution from the debtors until the senior noteholders were paid in full. The Delaware Bankruptcy Court considered the enforceability of an X-Clause in a subordinated note indenture. Subordination provisions typically have the effect of prohibiting a subordinated debt holder from recovering anything until the senior debt holder is paid in full. An X-Clause is often inserted in an indenture or other form of subordination agreement to allow a holder of subordinated debt to receive a reorganized debtor s securities that are junior to those received by the senior lender. in this issue 1 Delaware Bankruptcy Court Issues Decision on Enforceability of X-Clause in Subordinated Note Indenture 4 Hedge Fund Broker s Actions May Establish Good Faith Defense Against Ponzi Scheme 6 Court Offers Insight into Limiting Effect of Tax Injunction Act to Bankruptcy Plans According to the bankruptcy court, the indenture as a whole supported the conclusion that the subordinated noteholders were not expected to receive any payment or distribution from the debtors until the senior noteholders were paid in full. Stated another way, it sets forth an exception to the basic subordination promise in the context of a bankruptcy case, by permitting a distribution to the subordinated holder under certain circumstances. The opinion was issued in the context of a proposed Chapter 11 plan of reorganization that offered common stock to general unsecured creditors via a rights offering. Specifically, the plan contemplated that unsecured claimants would receive approximately 60 percent of the new common stock in the reorganized debtors; however, distributions that would otherwise be made to the subordinated noteholders would instead be distributed to the senior noteholders, giving effect to the subordination agreement. Certain of the debtors subordinated noteholders filed an adversary proceeding prior to confirmation seeking declaratory relief that because of the X-Clause, they were entitled to receive equity distributions from the debtors. The complaint also alleged that the debtors plan unfairly discriminated against the subordinated noteholders under Section 1129(b) of the Bankruptcy Code because it reallocated the subordinated noteholders proposed common stock distributions to the senior noteholders.

2 As the subordinated noteholders saw things, the X-Clause at issue excepted Permitted Junior Securities from the scope of subordination, notwithstanding that the senior noteholders were not being paid in full. The subordinated noteholders purely semantic argument was that the rights offering constituted a distribution of Permitted Junior Securities, and the X-Clause permitted a distribution of stock irrespective of the fact that the senior noteholders would receive plan distributions of the same priority. The debtors and the senior noteholders (who intervened in the proceeding) disputed this contention and moved for summary judgment on the ground that the X-Clause did not affect the subordination promise delineated in the indenture, since the senior noteholders were not being paid in full under the debtors plan. The bankruptcy court found that the X-Clause was less than clear, writing that the X-Clause here, while not legally ambiguous, lacks the utter clarity that [the senior noteholders] and the Debtor would now surely prefer. The court further held that applicable state law in this instance, New York required it to consider the X-Clause within the overall purpose of the indenture, not in isolation. In this connection, Judge Carey wrote, The X- Clause must be read in context. When read as a whole, the Subordinated Note Indenture clearly manifests the intent to assure payment in full of the Senior Notes before permitting payment (in whatever form) to the Subordinated Noteholders. The court rejected the subordinated noteholders invitation to interpret the X-Clause generously in favor of those who are its intended beneficiaries, finding that such an approach was inconsistent with the fact that an X-Clause, as a general proposition, creates only limited exceptions to the otherwise applicable subordination provisions and, therefore, must be read narrowly. According to the bankruptcy court, the indenture as a whole supported the conclusion that the subordinated noteholders were not expected to receive any payment or distribution from the debtors until the senior noteholders were paid in full. As such, the court rejected the subordinated noteholders position that the debtors proposed rights offering constituted Permitted Junior Securities, observing that this argument would eviscerate the purpose of the subordination provisions contained in the indenture. Moreover, the court noted that the subordinated Recent and Upcoming Events Kay Standridge Kress chaired a seminar on Bankruptcy Alternatives sponsored by the Debtor/Creditor Rights Committee of the Business Law Section of the Michigan State Bar and spoke on Federal Court Receiverships on February 11. Francis J. Lawall and Bonnie MacDougal Kistler will speak on the topic Anatomy of a Contract: Inside the Standard Terms and Conditions as part of the program sponsored by the International Energy Credit Association Spring Education Conference, March 16-18, in Napa, California. Mr. Lawall will serve as a moderator on a program entitled Financial Analysis of Municipals and Member Cooperatives, jointly sponsored by the Commercial Credit Group. Pepper lawyers David B. Stratton, Kay Standridge Kress and Michael H. Reed will be speaking at the Spring Meeting of the ABA Section of Business Law in Dallas, TX on April 12. Mr. Stratton will serve as a panelist on the program Getting the Work, Avoiding the Sanctions Ethical Issues in Soliciting for Committee Representation, jointly sponsored by the Subcommittee on Bankruptcy Committees and Subcommittee on Professional Ethics of the Business Bankruptcy Committee. Ms. Kress will speak on Current Developments with Bankruptcy Claims as part of a program sponsored by the Current Developments Task Force of the Business Bankruptcy Committee. Mr. Reed will participate in a mock appellate argument before a panel of federal judges as part of a program on Successor Liability Following 363 Bankruptcy Sales and Article 9 Foreclosures sponsored by the Uniform Commercial Code Committee. Francis J. Lawall and Bonnie MacDougal will speak on Vendors Rights in Bankruptcy and Guaranties as part of a program sponsored by the National Petroleum Energy Credit Association, April 22, in Savannah, Georgia. Francis J. Lawall will serve as a panelist on a program entitled Homebuilder Restructuring and Bankruptcy Issues, sponsored by the American Bankruptcy Institute on April 30, in Cambridge, Maryland. -2-

3 Kay Standridge Kress will speak on a program addressing bankruptcy and alternative measures available to residential developers and builders at the AIRA Annual Meeting in Las Vegas, NV in June. Honors Anne Marie Aaronson was recently elected to the Board of Director of the Professional Women s Roundtable. On January 24, Gregg Miller received the Outstanding Volunteer Award 2008 from the Consumer Bankruptcy Assistance Project (CBAP), the main pro bono arm of the Philadelphia bankruptcy bar. Mr. Miller served as President of CPBP s Board of Directors from 2006 to 2008 and helped to guide the organization through the changes required by BAPCPA for consumer Chapter 7 filings. Mr. Miller practices corporate Chapter 11 law and heads the corporate restructuring and bankruptcy practice in the Philadelphia office. Barbara Rom was recently elected a member of the board of the American Board of Certification which certifies specialists in bankruptcy law. Notable In November 2007, the Advisory Committee on Bankruptcy Rules of the Committee on Rules of Practice and Procedure of the Judicial Conference of the United States published for comment a proposed amendment to Rule 8002 of the Federal Rules of Bankruptcy Procedure that would lengthen the appeal period from orders of Bankruptcy Courts from the current period of 10 days to 14 or more days. On February 11, 2008, the House of Delegates of the American Bar Association adopted a resolution opposing the proposed rule change. Michael H. Reed, a member of the ABA House, spoke in favor of the resolution (opposing the rule change) on behalf of the ABA Section of Business Law. noteholders position was illogical, since a senior creditor simply would not agree to a subordination agreement in which its priority depended upon the form of consideration chosen by the debtor. Therefore, the subordinated noteholders in Dura Automotive could not participate in the debtors contemplated rights offering; any common stock that would otherwise be distributed to the subordinated noteholders under the debtors Chapter 11 plan of reorganization would instead be re-distributed to the senior noteholders. The court did not reach the legal issue raised by the subordinated noteholders that the debtors proposed plan of reorganization unfairly discriminated against the subordinated noteholders, given that they were not permitted to participate in the rights offering, in contravention of Section 1129(b) of the Bankruptcy Code. Pepper Perspective While Section 510(a) of the Bankruptcy Code generally recognizes the enforceability of subordination agreements in bankruptcy to the same extent as under applicable state law, disagreements remain as to the interpretation of important provisions in such agreements as they relate to fundamental bankruptcy rights. Indeed, the holding in Dura Automotive can be fairly limited to the particular language in the X- Clause. The increased popularity of second lien financings in recent years, coupled with the shift in the credit cycle, should continue to present interesting issues regarding the enforceability of various aspects of intercreditor agreements among competing tiers in the capital structure. Author: Leon R. Barson barsonl@pepperlaw.com

4 Hedge Fund Broker s Actions May Establish Good Faith Defense Against Ponzi Scheme A recent New York District Court opinion found that a diligent broker might be able to establish a good faith defense, to claims arising from its customer s Ponzi scheme. In Gredd v. Bear, Stearns Secs. Corp. (In re Manhattan Inv. Fund Ltd.), 359 B.R. 510 (Bankr. S.D.N.Y. 2007), the United States Bankruptcy Court for the Southern District of New York found a prime broker liable to return, to the bankruptcy estate of a hedge fund, more than $141 million in margin payments made by the hedge fund in the course of a massive Ponzi scheme. On appeal in Bear, Stearns Secs. Corp. v. Gredd (In re Manhattan Inv. Fund Ltd.), 2007 U.S. Dist. LEXIS (S.D.N.Y. Dec. 17, 2007), the District Court affirmed most of the Bankruptcy Court s rulings but found, nevertheless, that the broker s actions may have been sufficient to establish a good faith defense to liability. Ponzi Scheme Hedge Fund The Manhattan Investment (MI) Fund was a hedge fund that purported to make profits by short selling technology stocks. In reality, the MI fund was losing massive amounts of money and using money from new investors to cover its losses and pay returns to old investors. As a short seller, the MI fund was required to maintain a margin account with a stockbroker and keep a reserve to cover trading losses. Under the account agreement between Bear Stearns and the MI fund, Bear Stearns held a security interest in the monies in the account and could, at its sole discretion, use such monies to cover any open short positions of the MI fund. In early December 1998, Bear Stearns had concern that something was amiss with the MI fund. During a 1998 Christmas party, a Bear Stearns executive had a conversation with an investor in the MI fund, who mentioned that fund was reporting a 20 percent profit for the year. This conflicted with the executive s impression that the fund was losing money. Bear Stearns held a conference call with the MI fund s manager, who explained that the discrepancy was because Bear Stearns was only one of eight or nine prime brokers used by the fund. Bear Stearns accepted this explanation, although a diligent review of the notes to the MI fund s The District Court agreed with the Bankruptcy Court that the MI fund operated as a Ponzi scheme; that the margin payments were made in furtherance of the Ponzi scheme; and that such payments were therefore avoidable as fraudulent conveyances. financial statements would have revealed that Bear Stearns was, in fact, the only prime broker used by the fund. Bear Stearns subsequently learned that at least one institution was pulling its investments from the MI fund, and that a former marketer was suing the fund s manager for breach of contract. Bear Stearns took the step of contacting the MI fund s auditor to urge caution in its upcoming audit. Finally, in December 1999, Bear Stearns contacted credit bureaus and other prime brokers, learning that there were no other prime brokers for the fund and that the MI fund was, in fact, losing money. The MI fund scheme collapsed and it filed for bankruptcy in March A month later, the fund s court-appointed trustee filed suit against Bear Stearns to recover $141 million in margin payments, plus interest. The Bankruptcy Court granted summary judgment in favor of the trustee, and Bear Stearns appealed. Most of Bankruptcy Court s Rulings Affirmed The District Court agreed with the Bankruptcy Court that the MI fund operated as a Ponzi scheme; that the margin payments were made in furtherance of the Ponzi scheme; and that such payments were therefore avoidable as fraudulent conveyances.

5 The District Court affirmed the Bankruptcy Court s holding that Bear Stearns was an initial transferee of the margin payments under 11 U.S.C. 550(a), concurring with the Bankruptcy Court s findings that Bear Stearns was not a mere conduit, and that it exercised sufficient dominion and control over the margin account to give rise to initial transferee status. The District Court concurred with the Bankruptcy Court s ruling that Bear Stearns was put on inquiry notice by what it learned in the aftermath of the conversation between the Bear Stearns executive and the MI fund investor at the December 1998 Christmas party, and thus was required to exercise some measure of due diligence in order to establish a good faith defense to recovery of the transfers. RSS on Subscribe to the latest Pepper articles via RSS feeds. Visit today and click on the RSS button to subscribe to our latest articles in your news reader. Broker s Actions May Offer Liability Insulation Despite having been put on inquiry notice, Bear Stearns could still prevail on a good faith defense if its investigation of the MI fund was diligent. Here the District Court departed from the Bankruptcy Court s decision. Although Bear Stearns took a gradual approach to its investigation, it did take a variety of steps to uncover the truth about the MI fund. The District Court held that it cannot say that no reasonable jury could find that Bear Stearns s actions were diligent. In reaching this conclusion, the District Court also considered the fact that the law does not charge prime brokers with know-your-customer responsibilities in situations involving an introducing broker while emphasizing that some action was required under the circumstances. The District Court remanded for trial on the issue of whether Bear Stearns demonstrated diligence in its investigation of the MI fund. Author: Deborah Kovsky-Apap kovskyd@pepperlaw.com

6 Court Offers Insight into Limiting Effect of Tax Injunction Act to Bankruptcy Plans It is not uncommon for a plan of reorganization filed in a Chapter 11 case involving a closely held business to seek to relieve insiders of personal liability for the tax debts of the debtor. However, practitioners representing plan proponents in cases involving taxing authorities where the plan contains a provision purporting to release corporate officers from liability should review the Pazzo Pazzo, Inc. v. New Jersey decision. This ruling provides insight regarding what measures to take prior to plan confirmation in order to avoid the limitations imposed by the federal Tax Injunction Act. On November 20, 2007, the U.S. District Court for the District of New Jersey addressed a controversy involving a conflict between the provisions of the Tax Injunction Act and the express terms of a confirmed Chapter 11 plan of reorganization. The Tax Injunction Act provides that the district courts shall not enjoin, suspend or restrain the assessment, levy or collection of any tax under state law where a plain, speedy and efficient remedy may be had in the courts of such State. In Pazzo Pazzo, the court held that the Tax Injunction Act stripped the bankruptcy court of jurisdiction to enjoin New Jersey from filing tax liens against the property of the president of the debtor, even though the express terms of the debtor s confirmed plan barred such actions by the state. In 2002, Pazzo Pazzo, Inc. filed a Chapter 11 bankruptcy petition in New Jersey. The State of New Jersey filed proofs of claims for tax liabilities that had accrued prior to the debtor filing for bankruptcy and for nonpayment of post-petition taxes. The debtor subsequently filed a plan of reorganization that expressly released all insiders from any causes of action by the debtor, its creditors and other parties in interest. The state of New Jersey objected to the plan, arguing that it failed to address the state s tax claims. The IRS also objected to the plan, arguing that the release provision was overly broad. The debtor modified various plan provisions to meet the state s objections. The debtor also modified the The court reasoned, if the Tax Injunction Act deprives federal courts of jurisdiction to enjoin New Jersey from engaging in unconstitutional activity, a fortiori it deprives federal courts of jurisdiction to enjoin a state from violating the terms of a confirmed, valid bankruptcy plan. release provision in the plan in response to the IRS s objections. With regard to the IRS, the plan was modified to provide: notwithstanding the release provided herein, no insider or other persons shall be released from any obligations that may be due and owing thereby to the IRS as a result of the IRS s claims against the Debtor; provided, however, so long as the Debtor is in substantial compliance with the payment terms to the IRS as set forth herein, the IRS shall be enjoined from pursuing any insider or Persons for payment of its pre-petition claims against the Debtor. However, no comparable qualifying language was included in the plan s release provision with regard to the state. In July 2004, the bankruptcy court confirmed the debtor s second modified plan. After the debtor emerged from Chapter 11, the state of New Jersey filed two certificates of debt against the debtor s president, Larry Berger, as a responsible officer in the corporation having personal liability for the unpaid tax liabilities. The debtor filed an adversary proceeding in the bankruptcy court seeking an injunction to compel the state to comply with the terms of the confirmed bankruptcy plan and to release its liens against Berger.

7 The bankruptcy court dismissed the adversary proceeding, holding that it lacked jurisdiction to grant the requested injunction, citing the Tax Injunction Act. The debtor filed a motion for reconsideration arguing, The Tax Injunction Act does not prevent a bankruptcy court from enforcing the provisions of the bankruptcy code that affect the collection of state taxes. The debtor also argued equitable mootness because it contended that the state should be barred from challenging the validity of the bankruptcy plan upon which it and Berger had relied. The bankruptcy court denied the debtor s motion for reconsideration and reaffirmed its prior holding that the Tax Injunction Act prohibited it from issuing the injunction requested. The court noted that, although there was some case law supporting the debtor s argument, the majority of decisions hold that the bankruptcy court lacks jurisdiction to enjoin taxing authorities from assessing or collecting responsible officer taxes from non-debtor principals. With regard to the equitable mootness argument, the court declined to consider it because the debtor had failed to raise this argument in the earlier hearing. On appeal to the district court, the debtor raised the same three issues, i.e., that the state s claims were precluded by res judicata, equitable mootness and an exception to the Tax Injunction Act that permitted the bankruptcy court to issue the requested injunction. The state argued that the release provision in the plan was invalid, and thus, unenforceable. The state contended that the Tax Injunction Act precluded the bankruptcy court from issuing an injunction enjoining the state s filing of tax liens against Berger and also that the act precluded the bankruptcy court from approving the release of Berger in the plan in the first place. The district court conceded that the debtors first two arguments might have merit. Nevertheless, it ultimately ruled against the debtor: Even if the provision of Pazzo Pazzo s bankruptcy plan releasing Berger from all creditor claims is valid and enforceable, perhaps under the doctrines of res judicata and equitable mootness, this court still may not enjoin New Jersey from violating that release provision. The court noted that the Tax Injunction Act is powerful and strips district courts of jurisdiction to enjoin states even from engaging in unconstitutional activity. The court reasoned, if the Tax Injunction Act deprives federal courts of jurisdiction to enjoin New Jersey from engaging in unconstitutional activity, a fortiori it deprives federal courts of jurisdiction to enjoin a state from violating the terms of a confirmed, valid bankruptcy plan. Finally, with respect to the debtor s argument that an exception to the Tax Injunction Act applied, the court noted that the exception is limited and supersedes the act only where the bankruptcy code specifically so provides. The court noted that in this instance, there was no specific provision in the bankruptcy code empowering the court to enjoin the State. Accordingly, the district court affirmed the bankruptcy court s decision. The court noted that the Court of Appeals for the Third Circuit had already rejected a similar argument. In In re Becker s Motor Transportation, Inc., the court held that the Anti-Injunction Act, an act similar to the Tax Injunction Act, precluded bankruptcy courts from enjoining the IRS s collection of taxes from a nondebtor. 632 F.2d 242, (3d Cir. 1980). In reaching its holding, the court In re Becker noted that the Bankruptcy Code contained no express provision allowing such an injunction. The issue of the power of a bankruptcy court to enjoin creditors from asserting claims against nondebtor third parties under a Chapter 11 plan is a frequently litigated and debated issue. In addition to the other constraints on the power of bankruptcy courts in this area, where the creditor is a taxing authority, the Tax Injunction Act must be considered. Authors: Michael H. Reed reedm@pepperlaw.com Leigh-Anne M. Raport raportl@pepperlaw.com

8 Don t Miss Future Issues Be sure to receive future Bankruptcy Updates 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 * 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. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Please send address corrections to phinfo@pepperlaw.com. Berwyn Boston Detroit Harrisburg New York Orange County Philadelphia Pittsburgh Princeton Washington, D.C. Wilmington 2008 Pepper Hamilton llp. All Rights Reserved. This publication may contain attorney advertising. -8-