Review. Sixth Circuit Upholds Bankruptcy Jurisdiction Over Unconsenting States S. Todd Brown IN THIS ISSUE

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1 Review BUSINESS Recent Developments in Bankruptcy and Restructuring Vol. 2 No. 4 April 2003 RESTRUCTURING Sixth Circuit Upholds Bankruptcy Jurisdiction Over Unconsenting States S. Todd Brown In its landmark decision of Seminole Tribe of Florida v. Florida, the U.S. Supreme Court held that Article I, Section 8, Clause 3 of the United States Constitution, which, among other things, authorizes Congress to legislate commerce with the Indian Tribes, does not grant Congress the power to abrogate state sovereign immunity. Relying on the broad holding and dicta in Seminole Tribe, the overwhelming majority of courts have concluded that Congress attempt to abrogate state sovereign immunity in section 106(a) of the Bankruptcy Code is unconstitutional. In its recent decision in Hood v. Tennessee State Assistance Corporation, however, the Sixth Circuit, employing the Seminole Tribe abrogation test, concluded that the states granted Congress the power to abrogate their sovereign immunity under Article I, Section 8, Clause 4 of the Constitution and, accordingly, found that the abrogation of sovereign immunity embodied in section 106(a) is constitutional. The Bankruptcy Power and Section 106(a) Article I, Section 8, clause 4 of the United States Constitution grants Congress the power to establish... uniform Laws on the subject of Bankruptcies throughout the United States. In the exercise of this power, Congress has established a comprehensive Bankruptcy Code and authorized the creation of bankruptcy courts with jurisdiction to hear bankruptcy matters. One important element in the promulgation of a uniform, fair bankruptcy law is to ensure that all creditors are treated equally and are subject to the jurisdiction of the bankruptcy court. In recognition of the unique position of state continued on page Three-ring binders are available to readers of the Business Restructuring Review. To obtain a binder free of charge, send an message requesting one to mgdouglas@jonesday.com. IN THIS ISSUE 1 Sixth Circuit Upholds Bankruptcy Jurisdiction Over Unconsenting States In a marked departure from recent caselaw, the Court of Appeals ruled that the Bankruptcy Code provision abrogating state sovereign immunity is constitutional. 3 What s New at Jones Day 4 Limiting Discretion to Revisit Professional Fee Arrangements The Sixth Circuit bankruptcy appellate panel addressed the circumstances under which a court can revisit its decision authorizing retention of a professional under a special fee arrangement. 7 Legislative Alert 9 Defining the Unconditional Right to Intervene A New York district court discussed the parameters of a creditor s right to participate in a bankruptcy case and related adversary proceedings. 12 Executory Contract Assumption Conundrum A Maryland district court chose sides on a controversial issue involving a debtor s ability to assume contracts that may be assigned under non-bankruptcy law only with the non-debtor s consent. 14 From the Top 15 Up in the Air

2 creditors and the potential difficulties in bankruptcy administration if states do not participate on equal footing with other creditors, section 106(a) of the Bankruptcy Code provides that [n]otwithstanding any assertion of sovereign immunity, sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section. By this provision, Congress clearly intended to ensure uniform treatment of state and private creditors in the bankruptcy process and, prior to Seminole Tribe, many courts concluded that this system was a valid exercise of Congress power under the Bankruptcy Clause. Sovereign Immunity As the Court noted in Seminole Tribe, the Constitution recognizes the federal government and the States as separate, sovereign entities. A critical aspect of this dual sovereignty system is the preservation of the States immunity from suit, except as altered by the plan of the Convention or certain Amendments to the Constitution. The Supreme Court has acknowledged that the preservation of this immunity was critical to the ratification of the Constitution. Nonetheless, in its 1792 ruling in Chisolm v. Georgia, the Supreme Court held that Article III of the Constitution authorized a private citizen of another state to sue the state of Georgia without its consent. In response, Congress endorsed and the States ratified the Eleventh Amendment, which states that the [j]udicial power of the United States shall not be construed to extend to any suit in law or equity, commenced or prosecuted against one of the United States by Citizens of another State, or by Citizens or Subjects of any Foreign State. Although the language of the Eleventh Amendment appears to establish a narrow range of actions subject to sovereign immunity, the Supreme Court has repeatedly held that this immunity is demarcated not by the text of the Amendment alone but by fundamental postulates implicit in the constitutional design. Seminole Tribe The Supreme Court has long struggled to balance the broad grant of federal powers under Article I and the preservation of state sovereign immunity. One critical aspect of this balancing effort is to discern whether Congress has unequivocally expressed its intent to abrogate the immunity and whether Congress has acted pursuant to a valid exercise of power. Although what constitutes an unequivocal expression of an intent to abrogate is relatively well defined, the standards for determining whether such an abrogation is a valid exercise of power have shifted substantially in the last 15 years. In 1989, a plurality of the Supreme Court found in Pennsylvania v. Union Gas Company that Article I, Section, Clause 3, granted Congress the power to abrogate state sovereign immunity, stating that the power to regulate interstate commerce would be incomplete without the authority to render States liable in damages. This rationale expanded the prior understanding to congressional abrogation authority significantly, and was seen by some courts as an anomaly of little precedential value. In reversing Union Gas just seven years later, the Seminole Tribe Court noted that state sovereign immunity is not so ephemeral as to dissipate when the subject of the suit is an area... that is under the exclusive control of the Federal Government and concluded that Article I cannot be used to circumvent the constitutional limitations placed upon federal jurisdiction. Under Seminole Tribe, it must be clearly established that the states granted Congress the authority to abrogate their immunity from suit, such as may be found in the Fourteenth Amendment. In non-binding dicta, the Court also noted that it has not been widely thought that the federal antitrust, bankruptcy, or copyright statutes abrogated the States sovereign immunity and although the copyright and bankruptcy laws have existed practically since our nation s inception, and the antitrust laws have been in force for over a century, there is no established tradition in the lower federal courts of allowing enforcement of those federal statutes against the States. Based on this language and the strict limitations on Congressional authority established in Seminole Tribe, the Third, Fourth, Fifth, Seventh and Ninth Circuits, as well as dozens of lower courts, have concluded that Congress lacks the authority to abrogate state sovereign immunity on the basis of its Article I powers. The Hood Decision In Hood, a chapter 7 debtor initiated an adversary proceeding to obtain an undue hardship discharge of her student loan obligations, as required by section 523(a)(8) of the Bankruptcy Code. The Tennessee Student Assistance Corporation, a state entity to which the loan obligations were owed, moved to dismiss for lack of jurisdiction due to its sovereign immunity. The bankruptcy court denied the motion, holding that section 106(a) was promulgated pursuant to a valid grant of constitutional authority, and the bankruptcy appellate panel affirmed this decision. 2 I J ones Day

3 What s New at Jones Day? Richard M. Cieri (Cleveland) and Paul D. Leake (New York) were included among the leading U.S. insolvency and restructuring attorneys in the 2003 edition of International Financial Review Mr. Cieri was also selected for listing in the 2003 edition of the K & A Restructuring Register:America s Top 100 and was featured in the March 2003 edition of Lexpert in an article concerning crossborder corporate restructuring. On May 5, 2003, Mr. Leake will give a presentation concerning Confirmation Issues: New Value Plans, Releases, Plans for Administratively Solvent Debtors, Replacing the Board at an American Bankruptcy Institute Conference in New York City. Corporate Mergers and Acquisitions program in San Francisco jointly sponsored by the American Law Institute and the American Bar Association Committee on Continuing Professional Education as part of their 18th Annual Advanced ALI-ABA Course of Study. A two-part article co-authored by her and John K. Kane (New York) entitled A Practical Guide to Distress M&A appeared in the January and February 2003 editions of The M&A Lawyer. On May 5, 2003, she will give a presentation concerning Critical Analysis of Divergent Precedents between the Second and Third Circuits at an American Bankruptcy Institute Conference in New York City. Ms. Ball and David G. Heiman (Cleveland) were among the attorneys named in the January 15, 2003 edition of Turnarounds and Workouts as lead counsel in Successful Chapter 11s Erica M. Ryland (New York) spoke at a seminar on Telecommunications Restructuring in New York City, sponsored by Law Seminars International, on February 13-14, Paul E. Harner (Chicago) was quoted in the February 28, 2003 issue of The New York Times in an article discussing the confirmation of a plan of reorganization in Laidlaw, Inc. s chapter 11 cases. Corinne Ball (New York) was among the faculty for the March 6-7, 2003 Log on to for additional information concerning Jones Day s Restructuring and Reorganization Practice as well as the firm s other practice groups throughout the world. On appeal, the Sixth Circuit acknowledged the substantial body of case law concluding that section 106(a) was unconstitutional, but noted that these cases relied upon an extremely broad reading of the language of Seminole Tribe and that neither Seminole Tribe nor any of the Supreme Court s other recent sovereign immunity cases address Congress s Bankruptcy Clause powers as understood in the plan of the Convention. To that end, the Sixth Circuit concluded that it must evaluate section 106(a) under the two-step test used in Seminole Tribe. After concluding that there was no question that Congress intended to abrogate state sovereign immunity by section 106(a), the Sixth Circuit engaged in a multi-faceted review of the Constitution s text, the Federalist Papers and the ratification debates to discern whether states ceded their immunity from suit in bankruptcy matters. First, the court emphasized that Article I grants Congress the power to make uniform laws over two issues: bankruptcy and naturalization. The court noted that this requirement is more than a geographical uniformity provision. Rather, uniformity requires that federal courts must enforce the federal bankruptcy law. Moreover, because this is a constitutional uniformity requirement and not a mere legislative preference for uniformity, the court concluded that cases involving the Bankruptcy Clause are distinct from cases involving attempts to abrogate sovereign immunity by way of other Article I powers that do not have a constitutional uniformity requirement. continued on page 8 Business Restructuring Review I 3

4 Limiting Discretion to Revisit Professional Fee Arrangements Mark G. Douglas Recognizing the practical challenges associated with attracting a wide range of skilled professionals to the bankruptcy forum, the Bankruptcy Code authorizes the retention of such professionals according to any terms and conditions that are reasonable under the circumstances. Part and parcel of the Code s incentives to highly qualified professionals is the principle of certainty. A professional retained in a bankruptcy case must be assured that it will be compensated according to terms and conditions that it agrees to, and the court approves, at the outset of the engagement. Such terms and conditions must be clearly and expressly defined. As illustrated by a recent ruling handed down by the Sixth Circuit bankruptcy appellate panel, ambiguity in defining those terms is a recipe for trouble. In In re Airspect Air, Inc., the panel held that once a bankruptcy court approves the retention of special litigation counsel on a contingency fee basis, it cannot revisit that decision except under the improvidence exception, which requires a finding that the arrangement was ill-advised due to circumstances that could not have been contemplated at the time of the retention. Retention of Professionals in Bankruptcy Bankruptcy trustees, chapter 11 debtors and official committees are permitted to retain a wide variety of professionals, including lawyers, accountants, auctioneers and investment bankers, to represent their interests during the bankruptcy case. Any employment of professionals must be approved in advance by the bankruptcy court. In most cases, professionals hired to represent a trustee, debtor-in-possession or committee are retained pursuant to sections 327 and 1103 of the Bankruptcy Code, which authorize these entities, subject to bankruptcy court approval, to employ disinterested professionals to represent them during the course of the bankruptcy. Professionals retained under sections 327 or 1103 are paid in accordance with the interim and final compensation procedures delineated in sections 330 and 331 of the Bankruptcy Code. Those procedures contemplate bankruptcy court scrutiny of professional services for which compensation is sought, and the discretion to reduce, or in some cases augment, the allowed amount of fees (or expenses) based upon the court s determination of what is reasonable and necessary under the circumstances. While the statute sets forth a number of factors that a court is obligated to consider in making that determination, the fundamentally subjective nature of the analysis leaves open the possibility that fees sought for services that are deemed unnecessary or unreasonable may be disallowed or significantly reduced. Notwithstanding the prevalence in bankruptcy of fee applications subjected to the litmus test of subjective reasonableness, the Bankruptcy Code expressly provides for the retention and compensation of professionals under other terms and conditions. Section 328 of the Bankruptcy Code authorizes the retention of professionals on any reasonable terms and conditions of employment, including on a retainer, on an hourly basis, or on a contingent fee basis. The standards applied to fee applications filed by professionals retained under sections 327 and 1103 do not expressly govern compensation of professionals retained pursuant to section 328. Nevertheless, even if the bankruptcy court approves a fee arrangement under section 328, it retains by statute the discretion to revisit that decision and to modify the compensation to be paid, but only if the terms and conditions specified in the retention order prove to have become improvident in light of developments not capable of being anticipated at the time of the fixing of such terms and conditions. The party seeking to employ a professional bears the burden of demonstrating that the terms of the employment are reasonable. The interaction between sections 328 and 330 has been the subject of a fair amount of controversy. Because section 328 does not expressly incorporate the reasonableness limitations of section 330, many courts have taken the position that, once the terms of a professional s engagement have been approved by the court under section 328, the court does not retain any discretion to modify the fee and expense arrangement except according to the improvidence exception. Others, representing the minority approach, ascribe to the opposite view, holding that all fee requests are subject to the test of reasonableness. Even among those courts applying the majority rule, there is disagreement regarding what circumstances 4 I J ones Day

5 qualify for the improvidence exception. In adopting the more prevalent position in Airspect Air, the bankruptcy appellate panel articulated its view of the meaning of the exception. Background Airspect Air, Inc. ( Airspect ) had been involved in litigation with the City of Akron, Ohio over a long-term lease of hangar and related facilities at Akron- Fulton International Airport for over three years when it filed for chapter 11 protection in Shortly after the filing, Airspect removed the state court litigation to the bankruptcy court, where it became an adversary proceeding. It also sought bankruptcy court authority to retain its attorneys in the state court action as special counsel under Bankruptcy Code section 328(a) for the purpose of continuing the litigation. The terms under which special counsel was to be employed by Airspect specified that [f]ees, other than expenses, are to be paid on a contingency basis and are subject to approval by the bankruptcy court. The amount of the contingency ranged from one-third to one-half of any recovery, depending upon the imminence of trial. The bankruptcy court approved Airspect s retention of special counsel according to the terms specified. It also approved the payment of a $7,000 retainer to the attorneys and ordered them to submit a fee application to the court for approval. After more than three additional years of hotly contested litigation in the bankruptcy and district courts, part of which resulted in a ruling by the bankruptcy court that the lease at issue had been rejected because Airspect failed to assume it within 60 days of filing for bankruptcy, Airspect reached a settlement with the City of Akron whereby Airspect received $575,000. The settlement, however, was negotiated not by Airspect s special litigation counsel, but by a lawyer hired by Airspect s sole shareholder to intercede in the discussions. Nevertheless, shortly after the bankruptcy court approved the settlement, special counsel filed an application with the bankruptcy court seeking one-third of the settlement amount in accordance with its contingency fee arrangement. The bankruptcy court denied the request, finding that the contingency presumably, a resolution of the dispute concerning the lease involving its reinstatement had never occurred. Instead the court awarded a fee that it deemed to be reasonable under the circumstances (roughly 15 percent of the contingency fee). The bankruptcy appellate panel reversed that ruling on appeal, directing the bankruptcy court to review the fee request under the standard specified in Bankruptcy Code section 328(a) rather than section 330. The bankruptcy court did just that, but determined that its initial approval of the fee arrangement was improvident in light of subsequent events and once again awarded a fee it deemed to be reasonable. According to the court, it had not known at the time it approved Airspect s retention of special litigation counsel that the lease at issue had been deemed rejected (approximately one week before the court authorized the engagement) due to Airspect s inaction. Had it known that Airspect could no longer benefit from the lease, the court emphasized, it would never have approved the contingency fee arrangement. Special counsel fared better before the bankruptcy appellate panel for the Sixth Circuit. Observing that [t]he widely accepted general rule is that bankruptcy courts, once having approved employment under [section] 328, may not later switch to [section] 330 to award fees, the appellate panel reversed the bankruptcy court award. It found that the bankruptcy court had erroneously applied the improvidence exception. According the court, under section 328, an intervening circumstance, in order to render improvident a court s decision to grant a fee application, must be one that would have affected the court s decision in the first place... [,] rendering it untenable or unwise in hindsight. The deemed rejection of Airspect s lease, the panel remarked, did not vitiate the purpose for which special counsel was retained because the damages that [special counsel] has been retained to recover were actionable whether the lease was terminated or not. Finally, the appellate panel rejected the argument that the bankruptcy court had never expressly approved special counsel s engagement under section 328(a), but had reserved the right to review any fee request under the reasonableness standard of section 330. continued on page 6 Business Restructuring Review I 5

6 continued from page 5 Compensation specified in a retention agreement, engagement letter or contingency agreement may be subject to modification unless the operative agreement, the application seeking its approval and the bankruptcy court order approving it unequivocally specify that the professional is being retained under section 328, and that the specified compensation is not subject to subsequent review by the bankruptcy court in accordance with the reasonableness standard set forth in section 330. Noting that there is a disagreement among the Circuit Courts of Appeal as to whether a proposed retention must specifically reference section 328 to insulate a professional s fee request from scrutiny under the reasonableness standard, the panel concluded that express reference to the statute is unnecessary where the facts indicate that the bankruptcy court approved an engagement under terms clearly contemplated by section 328. According to the appellate panel, had the bankruptcy court wished to approve the employment of special counsel on some basis other than a contingency fee basis, it had the duty, in all fairness, to propose a different employment. The panel also concluded that its determination was bolstered by the absence of any requirement in the procedural rules governing the employment of professionals in bankruptcy that a retention application specifically refer, as its predicate, to a particular provision of the Bankruptcy Code. Analysis The attorneys retained in Airspect Air were fortunate that the appellate panel rejected the strict approach applied by many other courts to professional fee requests in bankruptcy. Others might not be so lucky. The message borne by the ruling and other decisions construing the interaction between Bankruptcy Code sections 328 and 330 is manifest: Compensation specified in a retention agreement, engagement letter or contingency agreement may be subject to modification unless the operative agreement, the application seeking its approval and the bankruptcy court order approving it unequivocally specify that the professional is being retained under section 328, and that the specified compensation is not subject to subsequent review by the bankruptcy court in accordance with the reasonableness standard set forth in section 330. This should be of particular concern to investment bankers and other financial professionals. These professionals commonly seek to be retained under a fee arrangement containing built-in success fees or similar fee enhancements triggered by events occurring during the course of the bankruptcy, such as confirmation of a plan of reorganization or a sale of substantially all of the debtor s assets. Bankruptcy courts are inherently courts of equity. As such, there can be no absolute assurance that a court will refrain from scrutinizing a fee arrangement under section 330 despite having specifically authorized it pursuant to section 328, particularly in cases where the fees involved appear to have been excessive in light of the results achieved, or where they represent a substantial portion of the estate s administrative costs and may result in a significant reduction of funds available to distribute to other creditors. Moreover, both the Office of the United States Trustee, whose statutory mandates include supervision of all fee and expense applications filed under 6 I J ones Day

7 section 330 and the right to interpose any objections it may have in the court, and official committees entrusted with oversight of a chapter 11 case on behalf of their creditor/shareholder constituencies can be expected to look much more searchingly at a proposed retention and fee arrangement under section 328. Where the ultimate success of a chapter 11 reorganization is uncertain, these entities may attempt to block a section 328 retention in favor of a more traditional, and retrospectively reviewable, engagement pursuant to section 330. Whether bankruptcy professionals are retained under section 328 or section 330 of the Bankruptcy Code will, in the final analysis, depend on the practicalities of the bankruptcy case and what all parties-in-interest intend to accomplish by means of it. Nevertheless, any professional contemplating a proposed engagement must recognize the necessity of bargaining for and obtaining specific court approval of any fee arrangement up-front. Otherwise, a professional risks having the terms and conditions of its engagement modified by leaving open the door to scrutiny under the microscope of subjective reasonableness. In re Airspect Air, Inc., 288 B.R. 464 (6th Cir. B.A.P. 2003). Circle K Corp. v. Houlihan, Lokey, Howard & Zukin, Inc. (In re Circle K Corp.), 279 B.R. 669 (9th Cir. 2002). Friedman Enterprises v. B.U.M. International, Inc. (In re B.U.M. International, Inc.), 229 F.3d 824 (9th Cir. 2000). In re National Gypsum Co., 123 F.3d 861 (5th Cir. 1997). L E G I S L A T I V E A L E R T Round seven of lawmakers efforts to win approval of sweeping bankruptcy reform legislation first proposed in 1997 began on March 19, 2003, when the House of Representatives passed a bill (H.R. 975) by a margin of 315 to 133 closely resembling, with one significant exception, the one that died in conference at the end of Denominated The Bankruptcy Abuse Prevention and Consumer Protection Act of 2003, the bill does not contain a controversial provision making debts incurred by abortion protesters non-dischargeable in a bankruptcy case. Lawmakers inability to reach agreement concerning this provision last year effectively scuttled bankruptcy reform proponents hopes for securing passage of the long-delayed legislation. The bill approved by the House differed from the previous version in certain other respects as well. Among the amendments added by legislators are provisions applying the financial netting provisions in the bill to both bank and credit unions and increasing the monetary cap on priority wage and employee benefit claims. The House also adopted an amendment increasing the reachback period during which fraudulent transfers can be rescinded from one to two years and providing that compensation paid to corporate insiders during the two-year period can be recovered under certain circumstances. An amendment that would have modified the means test incorporated into the previous bill and required the bankruptcy court to consider a debtor s reasonable and necessary expenses in considering a motion to dismiss or convert a chapter 7 case was defeated. According to Capitol Hill watchdogs, the Senate is likely to pass a substantially similar version, also without the anti-abortion protestor provision, with little difficulty. However, advocates of the provision, which was first introduced by Senator Charles Schumer, will almost certainly try to amend the Senate bill to add it back again, re-igniting a dispute that is politically charged and has already proved to be a deal breaker. However, given Congress current focus on proposed tax cuts and funding the war with Iraq, it appears that bankruptcy reform and other formerly high-profile domestic issues have been put on the back burner for the moment. Business Restructuring Review I 7

8 continued from page 3 If the Hood decision stands, it will represent a dramatic development in the equitable administration of bankruptcy cases and, in particular, in the manner in which state creditors participate in bankruptcy proceedings. Second, the Sixth Circuit noted that, [a]s it was initially understood, the Bankruptcy Clause represented the states total grant of their power to legislate on bankruptcy. Given the chaos that marked the bankruptcy system prior to 1789, the court stated that the grant of exclusivity was not a mere desire to have one system, but a system that rose above individual states interests. In this way, the Constitution prevented runaway states from defeating bankruptcy s goals. Notwithstanding the exclusive grant of legislative authority over bankruptcy matters to Congress, however, the Sixth Circuit acknowledged that it is possible that the states retained their immunity from suit and that, generally, the decision to cede one aspect [of sovereignty] to the federal government does not by itself imply a surrender of the other. In order to consider whether the states ceded sovereign immunity when they agreed to the uniformity provision of the Bankruptcy Clause, the Court looked to the analysis of sovereignty and alienation of sovereignty in The Federalist. In the first step of this analysis, the court looked to The Federalist No. 81, which stated, among other things, that unless there is a surrender of [sovereign] immunity in the plan of the convention, it will remain with the states, and referred the reader to The Federalist No. 32 for the circumstances in which this surrender of state sovereignty could be found. In The Federalist No. 32, Alexander Hamilton argued that states retained all rights of sovereignty they had prior to the Constitution, except for those that were exclusively delegated to the United States. This alienation of sovereignty, according to Hamilton, included areas in which states granted authority to the federal government, to which a similar authority in the states would be absolutely and totally contradictory and repugnant. As an example of this type of authority, Hamilton offered the naturalization power, because of the grant of uniform power to the federal government concerning such matters, and the Sixth Circuit concluded that the same reasoning applies to bankruptcy. After reviewing the text, the Court of Appeals observed that this discussion can only suggest that, in the minds of the Framers, ceding sovereignty by the methods described in No. 32 implies ceding sovereign immunity as discussed in No. 81. The court then concluded that there is no other explanation for the cross-reference between the two. Finally, the Sixth Circuit looked to the state ratification debates and found no objection specifically targeted against enforcing federal bankruptcy laws against the states. Acknowledging that this could simply reflect a gap in an otherwise careful debate, the Court of Appeals remarked that it could also reflect the recognition inherent in the need for a uniform bankruptcy law that such a system could cure the previous system s ills only if it applied uniformly to all creditors and debtors, and, accordingly, Congress must have the power to abrogate the states sovereign immunity. Analysis If the Hood decision stands, it will represent a dramatic development in the equitable administration of bankruptcy cases and, in particular, in the manner in which state creditors participate in bankruptcy proceedings. For example, although prior cases required states to waive sovereign immunity in order to participate in a bankruptcy case, states remained free under those decisions to elect not to participate. Under the Hood rationale, however, states may become unwilling participants in the bankruptcy cases of individual and corporate debtors. This result is in stark contrast to the substantial deference afforded to state sovereign immunity in Seminole Tribe and other recent decisions by the Supreme Court. Hood v. Tenn. Student Assistance Corp., 319 F.3d 755 (6th Cir. 2003). Seminole Tribe of Florida v. Florida, 517 U.S. 44 (1996). Alden v. Maine, 527 U.S. 706 (1999). Pennsylvania v. Union Gas Co., 491 U.S. 1 (1989). 8 I J ones Day

9 Defining the Unconditional Right to Intervene Helena C. Huang and Mark G. Douglas The right of creditors and official committees to participate generally in a bankruptcy case is a basic tenet of U.S. bankruptcy law. However, whether that entitlement encompasses the right to intervene in adversary proceedings commenced during a case or to prosecute litigation on behalf of the bankruptcy estate is controversial. Decisions recently handed down by courts in the Second and Third Circuits address the limits of creditor participation, but with mixed results that hold little promise for resolving a long-standing debate. In the most recent of these, In re Sunbeam Corporation, a New York district court ruled that the unqualified right of a creditor to intervene in an adversary proceeding does not confer derivative standing upon the creditor to prosecute estate claims. Right to Be Heard in Bankruptcy Unlike most ordinary litigation commenced in federal courts, a bankruptcy case generally affects the substantive rights of a large group of creditors, shareholders and other parties with a stake in the outcome of the case. As a consequence, bankruptcy courts, which are technically units of the federal district courts, permit anyone whose rights or remedies are affected by the case to appear before them and petition for the forms of relief contained in the Bankruptcy Code, such as relief from the automatic stay or adequate protection to the extent the debtor is using or leasing a creditor s collateral during the case. Specific provisions of the Bankruptcy Code confer what may be loosely referred to as standing upon the entity involved to seek certain kinds of relief under certain circumstances. Still, with one exception (discussed below), the Bankruptcy Code does not expressly delineate the entities that have the right to participate generally in a bankruptcy case. Procedural rules enacted to implement the Code and various provisions of the statute suggest that participation is limited to debtors, trustees, creditors, shareholders, official committees and other entities whose rights are affected by the outcome of the case. The bankruptcy court may permit any entity who presumably does not fall into one of these categories to intervene generally or with respect to any specified matter in a case under the Bankruptcy Code, but the Code itself offers little guidance on this issue. This stands in marked contrast to procedural rules that govern other federal litigation and the ability of parties other than the initial litigants to participate, or intervene, in a lawsuit. These rules provide for intervention under two circumstances: as of right and with the permission of the court. Intervention of right is appropriate when a federal statute confers an unconditional right to intervene or when the potential intervenor claims an interest relating to the property or transaction which is the subject of the action and the applicant is so situated that the disposition of the action may as a practical matter impede the applicant s ability to protect that interest, unless the applicant s interest is adequately represented by existing parties. By contrast, if the applicant s statutory right to intervene is only conditional, or if the applicant has a claim or defense based upon a question of law or fact that will be determined in the litigation, a federal court has the discretion to allow or disallow intervention. The exception to the Bankruptcy Code s silence regarding who may participate in a bankruptcy case is contained in section 1109(b). That section provides that [a] party in interest, including the debtor, the trustee, a creditors committee, an equity security holders committee, a creditor, an equity security holder, or any indenture trustee, may raise and may appear and be heard on any issue in a case under this chapter. Section 1109(b) applies only to cases under chapter 11. Its reference to a case under chapter 11 has led to a considerable amount of confusion regarding whether the statute confers upon parties in interest the right to appear and participate in adversary proceedings, as opposed to the main bankruptcy case. Case v. Proceeding Case and proceeding have distinct meanings in bankruptcy. It is generally recognized that where the Bankruptcy Code and Rules refer to a case, it means the main bankruptcy case that was commenced when the bankruptcy court entered an order for relief. By contrast, a proceeding means an adversary proceeding filed in the main case sometime afterward. An adversary proceeding is discrete but related litigation commenced during a bankruptcy case for the purpose of, among other things, determining the validity, priority or extent of a lien, subordinating a claim, recovering assets that were preferentially or fraudulently transferred, obtaining injunctive relief beyond the scope of the automatic stay or objecting Business Restructuring Review I 9

10 to the discharge of a debt. Other types of disputed issues that arise in a bankruptcy case that do not qualify as adversary proceedings are referred to as contested matters. Different procedural rules apply to adversary proceedings and contested matters. Several provisions of the Bankruptcy Code, other related statues and procedural rules distinguish between a case and a proceeding. All of this has led many courts to conclude that Bankruptcy Code section 1109(b) s reference to any issue in a case means that the right of a party in interest to participate is limited to the main chapter 11 case. According to this view, intervention in an adversary proceeding must be sought in accordance with procedural rules expressly governing intervention, and section 1109(b) alone does not represent a federal statute that confers an unconditional right to intervene upon any party in interest in a chapter 11 case. Among the courts subscribing to this approach is the Fifth Circuit, which ruled in Fuel Oil Supply & Terminaling v. Gulf Oil Corporation that Congress drew distinctions between cases and proceedings in various statutes and procedural rules and did not intend to create an unconditional right to intervene in Bankruptcy Code section 1109(b). The First, Fourth and Tenth Circuits have indicated that they favor the Fifth Circuit s view. The Third Circuit and, most recently, the Second Circuit take the opposite view. In In re Marin Motor Oil, the Court of Appeals for the Third Circuit examined the language of section 1109(b) and its predecessor under the former Bankruptcy Act and concluded that section 1109(b) should be interpreted broadly to afford a creditors committee an absolute right to intervene in an adversary proceeding. The Second Sunbeam illustrates the important distinction between a creditor s unconditional right to be heard and intervene, on the one hand, and the conditional right to prosecute estate claims with the approval of the court, on the other. Circuit recently adopted an expansive approach to standing in In re The Caldor Corporation. In that case, the Court of Appeals held that any party in interest in a chapter 11 case has an unconditional right to intervene in any adversary proceeding commenced during the course of the case. According to the Second Circuit, the language of section 1109(b) does not distinguish between cases and proceedings, but provides merely that a party in interest has the right to be heard on any issue in a case. It reasoned that while the bankruptcy rules distinguish between different types of litigated matters that arise during a bankruptcy case and divide them into contested matters and adversary proceedings, the plain text of section 1109(b) does not distinguish between issues that occur in these different types of proceedings within a Chapter 11 case. The Second Circuit accordingly held that the phrase any issue in a case plainly grants a right to raise, appear and be heard on an issue regardless of whether it arises in a contested matter or an adversary proceeding. Derivative Standing Related to the right of a party-in-interest to be heard and to intervene is the concept of standing to prosecute claims on behalf of the estate. In general, claims that belong to a debtor become property of its bankruptcy estate when the debtor files for bankruptcy, and only a debtor-in-possession or trustee has the right to prosecute them. Most courts, however, hold that official committees, and in some cases, individual creditors, have an implied qualified right to initiate, with court approval, adversary proceedings in the name of a debtor, but only when the trustee or debtor unjustifiably fails to bring suit. In one of the seminal cases addressing this issue, the Second Circuit ruled in In re STN Enterprises that in considering a committee s motion for leave to commence an action against a director for misconduct, a court is required to consider whether the debtor unjustifiably failed to sue the director and whether the action is likely to benefit the debtor s estate. The Second Circuit broadened this doctrine in In re Commodore International Ltd., which involved litigation brought by a committee against various officers and directors for fraud and mismanagement. Unlike in STN Enterprises, the debtor in Commodore agreed to permit the committee to litigate the claims on behalf of the estate. The Court of Appeals ruled that a committee may bring suit even if the debtor does not unjustifiably refuse to do so as long as: (1) the trustee or debtor con- 10 I J ones Day

11 sents; and (2) the court finds that the litigation is (a) in the best interests of the estate and (b) necessary and beneficial to the fair and efficient resolution of the bankruptcy proceedings. The Second Circuit recently reaffirmed its broad interpretation of derivative standing in In re Housecraft Industries USA, Inc., holding that official committees and even individual creditors may be authorized to commence litigation on the estate s behalf where doing so is: (1) in the best interests of the estate and is necessary and (2) beneficial to the fair and efficient resolution of the bankruptcy proceedings. The Second Circuit s approach represents the prevalent view, but not the only one. A distinct minority has interpreted the absence of express authority in the Bankruptcy Code as an indication of lawmakers intent to confer standing to prosecute estate claims only upon a debtor-in-possession or bankruptcy trustee. Exemplary of this view is the Third Circuit s highly controversial ruling in Official Committee of Unsecured Creditors v. Chinery (In re Cybergenics Corporation). In that case, the Court of Appeals held that because section 544(b) of the Bankruptcy Code explicitly provides that the trustee may commence litigation to avoid certain liens, a committee may not be authorized to do so under any circumstances. Highly criticized as being contrary to longstanding practice as well as provisions in the Bankruptcy Code recognizing the power of a bankruptcy court to authorize creditors to recover property or prosecute claims on the estate s behalf, Cybergenics was subsequently vacated by the Third Circuit. A New York district court was called upon to take a position on the standing issue in Sunbeam Corporation. Background Shortly after appliance maker Sunbeam Corporation filed for chapter 11, the creditors committee appointed in the case sued Sunbeam s lenders seeking to equitably subordinate their claims and to avoid allegedly fraudulent transfers. Two of the defendants moved to dismiss, contending that the committee lacked standing to commence the action on behalf of the estate, given its failure to obtain leave of the court to do so. The bankruptcy court dismissed the complaint, finding, among other things, that the committee had not satisfied the requirements for derivative standing detailed in STN Enterprises, Commodore and Housecraft. According to the bankruptcy court, the committee failed to show that Sunbeam unjustifiably refused to commence an action against its lenders. Emphasizing, moreover, that allowing the committee s action would delay the reorganization process by impeding approval of a pending plan of reorganization, the court concluded that conferring standing on the committee was not in the best interests of the estate. The committee appealed the dismissal, but settled its claims against Sunbeam s lenders before the appeal was actually heard by the district court. As part of that settlement, the committee agreed to withdraw its appeal. Before it could do so, a member of the committee holding $600 million in bonds issued by Sunbeam (Oaktree Capital Management, LLC) sought to intervene for the purpose of prosecuting the appeal. Oaktree was dissatisfied with the terms of the settlement and contended that it had not been properly approved by the bankruptcy court. The district court denied Oaktree s motion. Initially, it distinguished a creditor s conditional right to intervene in an adversary proceeding from the right to prosecute an appeal. Oaktree, the court emphasized, sought not only intervention, which entailed the right to participate in the litigation, but also the right to pursue individually claims belonging to Sunbeam s bankruptcy estate. It found Oaktree s reliance on Caldor as a basis for its right to intervene to be misplaced. Remarking that Caldor did not overrule prior Second Circuit precedent establishing criteria for the bankruptcy court to determine when to allow creditors to assert claims on behalf of an estate, the district court held that Oaktree should not be permitted to intervene because the bankruptcy court had never authorized anyone to prosecute the claims at issue on Sunbeam s behalf. Analysis Sunbeam illustrates the important distinction between a creditor s unconditional right to be heard and intervene, on the one hand, and the conditional right to prosecute estate claims with the approval of the court, on the other. Though related, these rights are distinct. Sunbeam demonstrates that they are also not without limitations. Sunbeam also reinforces the significance of the Second Circuit s ruling in Caldor. By construing the Bankruptcy Code in a way that affords all parties-ininterest ready access to every aspect of a chapter 11 case, the Second Circuit reaffirmed the idea that a fundamental premise of the U.S. bankruptcy law is active participation by all concerned entities to encourage a negotiated solution for a debtor s financial woes. Still, Caldor engendered a fair amount of confusion. The Second Circuit never really explained whether the unconditional right to intervene carries with it the entire panoply of rights customarily afcontinued on page 16 Business Restructuring Review I 11

12 Executory Contract Assumption Conundrum Ryan Routh Should a concert promoter who contracts for a performance by Luciano Pavarotti be required to accept a performance from Michael Jackson if Pavarotti declares bankruptcy and seeks to assign his performance contract to the King of Pop? Bankruptcy judges would unanimously concur that the concert promoter need not accept Michael Jackson s performance. Yet despite judicial agreement on this topic, there is no agreement regarding whether the concert promoter could free itself from the contract even if Pavarotti himself planned to perform. It is this issue that has produced a split among the federal circuit, district and bankruptcy courts over the past 15 years. And it is on this issue that a Maryland district court held in favor of the debtor (i.e., Pavarotti) in its recent decision in RCC Technology Corp. v. Sunterra Corp. Assumption and Assignment of Contracts in Bankruptcy As most persons with some experience with the bankruptcy process are aware, the Bankruptcy Code grants a debtor three options with respect to its executory contracts and unexpired leases. A debtor may reject, or cease performing under, contracts and leases that contain unfavorable terms. For contracts and leases containing favorable terms, a debtor may assume them, thereby binding the debtor to perform under the contract or lease going forward. Alternatively, the debtor may seek to assume and assign to third parties (usually for some monetary or other consideration) favorable contracts and leases that the debtor will have no use for upon its reorganization or from which it can derive significant value (e.g., a below-market lease) Such an assumption and assignment to a third party can be made under the Bankruptcy Code even if the contract or lease expressly prohibits such action. Despite these broad powers granted to a debtor, certain non-debtor parties that contract with a debtor are granted a measure of protection by the Bankruptcy Code. Specifically, section 365(c) of the Bankruptcy Code provides that a debtor may not assume or assign an executory contract or unexpired lease if applicable law excuses a party, other than the debtor, to such contract or lease from accepting performance from or rendering performance to an entity other than the debtor and such party does not consent to assumption or assignment. Accordingly, whenever applicable law (which courts generally construe to mean state law or federal non-bankruptcy law) would prevent assignment of a contract or lease without consent, a debtor is required to obtain that consent from the non-debtor party. Courts have applied this provision to a wide variety of contracts. Among these are: (a) personal service contracts, including employment agreements, which, under state law, an employer generally cannot assign to another employer without the employee s consent; (b) contracts with the United States government, which cannot be freely assigned under federal law; (c) certain kinds of franchise agreements that are unassignable under certain state laws; and (d) licenses of intellectual property, which cannot be assigned without consent under federal intellectual property law. Thus, many debtors (especially debtors in the technology industry) find that their rights with respect to certain executory contracts and unexpired leases are significantly curtailed. The Statutory Muddle As noted in the introduction to this article, all courts would agree that section 365(c) prevents a debtor from assigning to a third party a contract without the non-debtor s consent if the contract could not be assigned outside of bankruptcy without such consent. The language of section 365(c), however, would seem to mean that the debtor cannot even assume the contract itself and agree to perform thereunder, even if it has no intention of assigning the contract to a third party. It is this interpretation of the statute that has troubled courts beginning with the 1988 decision of the Court of Appeals for the Third Circuit in In re West Electronics, Inc. and given rise to the dispute at issue in RCC Technology. The cause of the confusion stems from the statute s use of the phrase may not assume or assign instead of assume and assign. Many courts, under a literal interpretation, hold that this phrase means that the statute applies to a debtor who seeks to either assume the agreement and perform itself as well as to a debtor who seeks to assume the agreement and assign it to a third party. Under this approach, the court posits a 12 I J ones Day

13 hypothetical question: Could the debtor assign the contract to a third party under applicable non-bankruptcy law? If the answer is no, then the debtor not only cannot assign the contract, it cannot assume the contract either. Thus, this approach is commonly referred to as the hypothetical test. In West Electronics, the Third Circuit applied this approach in ruling that the debtor could not assume a contract with the federal government calling for production of military equipment because federal law prohibited assignment of the contract without the government s consent. Other courts find that, despite the language of the statute, the phrase may not assume or assign should be interpreted to mean may not assume and assign and apply it only when the debtor is seeking to assign the contract or lease at issue to a third party. Under this approach, the court enquires whether the debtor is actually trying to assign the contract to a third party. If not, the court will not prevent assumption. Therefore, this approach is commonly referred to as the actual test because the court looks to what the debtor s actual intentions are. Prominent among adherents to this view is the Court of Appeals for the First Circuit, which ruled in Institut Pasteur v. Cambridge Biotech Corp. that federal common law and contractual restrictions against assignment of patents did not preclude assumption of a patent by a chapter 11 debtor. Courts adopting the hypothetical test have generally done so because they feel constrained by the plain, unambiguous language of the statute. To these courts, no reason is sufficient to permit them to disregard this plain language. Courts adopting the actual test, however, cite a variety of problems with the competing view. Such courts note the conflict of the hypothetical test approach with the general goals of Chapter 11 [in allowing]... licensees to benefit from the protections of the bankruptcy law while encouraging the maximization of the economic value of the debtor s estate. Further, such courts suggest that the odd result required by the hypothetical test, where a nondebtor party (such as the concert promoter posited in the first paragraph of this article) obtains the ability to free itself from some kinds of contracts simply due to the fact of the debtor s bankruptcy filing, could not be supported by any bankruptcy policy. In fact, these courts emphasize, the hypothetical test would seem to be contrary to recognized bankruptcy policies, including preventing non-debtors from terminating contracts simply due to the filing of bankruptcy under so-called ipso facto provisions to promote the likelihood of rehabilitation and maximize the value of the debtor s bankruptcy estate. Finally, actual test courts often state that the language appears to be a result of a simple drafting error: Congress meant and but said or. It is the choice between these two approaches, neither of which is wholly satisfying, that faced the district court in RCC Technology. The RCC Technology Case Chapter 11 debtor Sunterra Corporation was party to a software license agreement with RCC Technology Corporation. RCC filed a motion in the bankruptcy court seeking an order directing that the agreement at issue could not be assumed under federal copyright law and was therefore deemed rejected. The bankruptcy court denied the motion and RCC appealed. On appeal, the district court found that the agreement at issue was the type of agreement that could not be assigned to a third party under federal copyright. It accordingly ruled that Bankruptcy Code section 365(c) did in fact apply to the contract, finding clear error in the bankruptcy court s determination below that the license was not an executory contract capable of being assumed or rejected in the first place. Observing that courts disagree about the meaning continued on page 14 Debtors and non-debtors alike can have no degree of certainty regarding the effect of a bankruptcy filing on contracts and leases that cannot be assumed without the non-debtor s consent under applicable non-bankruptcy law. Business Restructuring Review I 13

14 continued from page 13 of the statute, the court concluded that it found the actual test to be far more harmonious with the statutory scheme. The court recognized that the plain meaning of the statute supported the hypothetical test, but emphasized that there is a competing principle that statutes should not be interpreted to produce results that are unreasonable in light of the drafters intentions. According to the court, there is no evidence that Congress intended to create the odd result mandated by hypothetical test courts. Finally, noting the Pavarotti example, the court found that permitting the non-debtor party to be released from the contract was quite unreasonable given the fact that Sunterra, rather than some third party, would be performing under the contract, if it were assumed. Analysis Whether or not the court in RCC Technology Corp. v. Sunterra Corp. reached the right result for the right reasons, the decision highlights the need for clarification of the meaning of the statute by either Congress or the Supreme Court. Neither has acted so far to resolve a conflict that has been smoldering for 15 years. As such, debtors and non-debtors alike can have no degree of certainty regarding the effect of a bankruptcy filing on contracts and leases that cannot be assumed without the non-debtor s consent under applicable non-bankruptcy law. Indeed, some commentators have observed that the provisions of the Bankruptcy Code governing the assumption and assignment of contracts are generally perceived to be the most convoluted and worst drafted section of the Bankruptcy Code. Section 365(c), specifically, has come in for its share of scholarly disdain. Help does not appear to be on the way any time soon. The Supreme Court has yet to agree to hear a case on whether the hypothetical or the actual test is the proper one. Lawmakers have not been moved to solve the problem either. Sweeping bankruptcy reform legislation that has been mired in Capitol Hill trenches for six years is devoid of any attempt to clarify a provision that has and will continue to bedevil courts. With no resolution of this matter on the horizon, the practical challenges confronting parties to these kinds of contracts can only be accurately assessed on a case-by-case basis by reference to the particular court presiding over the debtor s bankruptcy case. To date, the Third, Ninth and Eleventh Circuits have adopted or expressed approval of the hypothetical approach, while the First Circuit has rejected it in favor of the actual test. Lower courts line up on both sides of a rift that does not show any promise of being mended in the foreseeable future. RCC Technology Corp. v. Sunterra Corp., 287 B.R. 864 (D. Md. 2003). In re West Electronics Inc., 852 F.2d 79 (3d Cir. 1988). Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir.1997). Perlman v. Catapult Entm t, Inc. (In re Catapult Entm t, Inc.), 165 F.3d 747 (9th Cir. 1999). City of Jamestown v. James Cable Partners, L.P. (In re James Cable Partners, L.P.), 27 F.3d 534 (11th Cir. 1994). From the Top The U.S. Supreme Court handed down its second bankruptcy decision of 2003 on March 31. In Archer v. Warner, a seven-to-two majority of the High Court ruled that a debt owed under a settlement agreement in which an underlying fraud claim was released in exchange for an obligation to pay on a promissory note should be considered a debt for money obtained by fraud such that it is not dischargeable in bankruptcy. Resolving a split among the Circuit Courts of Appeal on this issue, Justice Breyer, writing for the majority, concluded that the settlement agreement did not act as a novation creating an entirely different debt that would fall outside the scope of the Bankruptcy Code provision precluding a discharge of debts predicated on fraud. Emphasizing that Congress intended the fullest possible enquiry to ensure that all fraud-based debts are excepted continued on page I J ones Day