According to a recent report issued by the American Bankruptcy Institute, there was a 24 percent drop in business bankruptcy filings in the United States last year, resulting in the fewest filings since 2006. The larger corporate filings in 2013 were not the typical “mega” filings of years past. Unlike Lehman, Chrysler, Tribune, MF Global and others, the chapter 11 “mega-cases” filed in 2013 were smaller and less well known in the general business community. Among the more prominent were Cengage Learning, Excel Maritime, and Exide Technologies. That is not to suggest that there was nothing new in the bankruptcy world in 2013. There was. The sale of Twinkies in March may have played prominently in the headlines but even this startling event could not outshine the most prominent bankruptcy filing in 2013: the chapter 9 bankruptcy filing by Detroit in July. Detroit was the largest municipal (chapter 9) case ever to file. With $18.5 billion in debt, the 18th largest city in the United States was finally forced to grapple with its declining population (in 1950, Detroit’s population was 1.8 million; in 2012, its population was 700,000), substantial costs for retiree health care and pensions, and years of borrowing to cover substantial budget deficits. Whether Detroit could file for bankruptcy was a seriously contested issue in the bankruptcy case. Bankruptcy Judge Steven Rhodes made clear in December that his answer was “yes.” With respect to more traditional corporate bankruptcy matters, both the Second Circuit Court of Appeals (responsible for New York) and the Third Circuit Court of Appeals (responsible for Delaware) entered a number of important bankruptcy rulings in 2013. (These cases, along with all of the other 2013 decisions highlighted in this article, are summarized in more detail in the chart that immediately follows this article. Cross-links to more complete analyses of the specific decisions can also be found in the summary.) In the KB Toys case, the Third Circuit found – in contrast to a district court ruling in New York – that claims buyers remain subject to the infirmities in the claims they purchase. Meanwhile, in separate decisions entered in the Quebecor and the Tribune cases, both the Second and Third Circuits weighed in on the scope of the safe harbor contained in section 546(e) of the Bankruptcy Code that protects “securities contracts” and similar instruments. The decisions continue to help shape the bankruptcy world’s understanding of section 546(e)’s protections. The Second and Third Circuits each also resolved a number of chapter 15 issues in the Fairfield Sentry (Second Circuit), ABC Learning (Third Circuit) and Octaviar (Second Circuit) cases. Each of the chapter 15 decisions helps define specific issues related to recognition of a foreign proceeding, including with regard to the “public policy” exception for chapter 15 filings. Chadbourne represented the foreign representative in two of those chapter 15 appeals. Another chapter 15 decision that is likely to be more controversial was the Fourth Circuit’s ruling in Jaffe v. Samsung Electronics. According to the Fourth Circuit, a bankruptcy court may, under certain circumstances, apply section 365(n) (which permits a licensee to continue to use intellectual property notwithstanding the debtor’s rejection of the license) to a chapter 15 case. An act is currently being considered by Congress that would automatically make section 365(n) applicable to all chapter 15 cases. Other leading decisions during 2013 include the Fifth Circuit’s decision in Texas Grand Prairie. In that case, the court weighed in on cram-down interest rates, suggesting that secured creditors should revisit what has become, at least from the secured creditor perspective, the unfavorable “norm” for the last 10 years. Watch for future litigation on this issue. Meanwhile, private equity investors have already taken careful note of the First Circuit’s decision in Sun Capital. That case held that private equity investors may be found labile for pension liabilities if they take over substantial day-to-day management of a company. One of the final leading noteworthy cases of 2013 involved the 2011 bankruptcy case of American Airlines. While the headline 2013 story for American was its merger with U.S. Airways, the Second Circuit’s decision focused on a substantially less exciting issue for the general public: makewhole premiums. The Circuit affirmed the reasoning of a number of lower court decisions which found that makewhole premiums contained in loan agreements are enforceable in a bankruptcy case. However, and again consistent with the majority of other lower court decisions on the issue, the Second Circuit concluded that the provisions must be construed strictly in accordance with their terms. This ruling should be extremely interesting to creditors who are drafting loan agreements. So what does the 2014 hold for bankruptcy cases in the United States? A few thoughts: • We suspect that until the Federal Reserve raises borrowing rates, corporate bankruptcy filing rates will continue to be modest. We believe that municipalities will continue to restructure both in and out of bankruptcy in 2014. In fact, with four of the five largest municipal bankruptcy cases in history filed in the last several years, Chadbourne put its money where its mouth is in 2013 by taking advantage of a unique opportunity to bring two of the leading municipal bankruptcy lawyers in the country to the Firm. Larry Larose and Sam Kohn joined Chadbourne as partners in September and continue their efforts on behalf of their clients in the Detroit and Jefferson County cases, among others. See “Municipal Restructuring Efforts Join Firm,” International Restructuring NewsWire (Fall 2013). We suspect that chapter 15 cases will continue to be filed at a brisk pace given the benefits they provide to foreign entities. During 2014, the Supreme Court is also scheduled to revisit the issue of what matters a bankruptcy court can constitutionally hear and what matters must be reserved for traditional “Article III” courts. As highlighted by various articles in prior issues of the NewsWire, see, e.g., “Has Stern v. Marshall Opened a Jurisdictional Floodgate?,” International Restructuring NewsWire (October 2011), this dispute has been brewing since the Supreme Court issued its 2011 decision of Stern v. Marshall. Stay tuned. And HAPPY 2014! RECOGNITION AFFIRMED IN FIRST CHAPTER 15 CASE CONSIDERED BY THE THIRD CIRCUIT By Eric Daucher On August 27, 2013, the United States Court of Appeals for the Third Circuit affirmed the chapter 15 recognition of ABC Learning Centres’ Australian liquidation proceedings. The primary issue before the court was whether the existence of ABC’s concurrent receivership proceedings in Australia, which would not have been eligible for chapter 15 recognition, should prevent chapter 15 recognition for the liquidation proceedings or limit the relief available upon recognition. The Third Circuit ruled in favor of ABC’s liquidators, holding that chapter 15 recognition of a foreign proceeding should not be denied, nor the resulting relief limited, because of the existence of a concurrent proceeding that controlled substantially all of the foreign debtor’s assets and that would not itself have been eligible for recognition. The Third Circuit’s ruling sends a clear message that chapter 15 relief remains broadly available to ensure that a foreign debtor’s assets will be distributed in accordance with the priorities established by the applicable foreign law. Chadbourne & Parke represented ABC’s liquidators in their chapter 15 cases, including in the successful appeal to the Third Circuit. Introduction to Chapter 15 Unlike the Bankruptcy Code’s “plenary” chapters, such as chapter 7, 9 or 11, chapter 15 of the Bankruptcy Code deals with bankruptcy cases that are “ancillary” to foreign bankruptcy, insolvency or debt adjustment proceedings. Specifically, chapter 15 permits a party who is authorized in such a “foreign proceeding” to administer the foreign debtor’s affairs or to act as the proceeding’s “foreign representative” to request that a US bankruptcy court grant recognition to the foreign proceeding. If recognition is granted, a wide variety of relief in furtherance of the proceeding can be obtained from the US bankruptcy court. In order to qualify for recognition, a foreign proceeding must: (i) be a proceeding; (ii) that is either judicial or administrative; (iii) that is collective in nature; (iv) that is in a foreign country; (v) that is authorized or conducted under a law related to insolvency or the adjustment of debts; (vi) in which the debtor’s assets and affairs are subject to the control or supervision of a foreign court; and (vii) that is for the purpose of reorganization or liquidation. Where a foreign representative seeks recognition of a foreign proceeding that meets these requirements, and where certain technical and procedural requirements are met, recognition is mandatory unless it would be “manifestly contrary to the public policy of the United States.” Upon recognition of a foreign main proceeding (which is a foreign proceeding pending in the country in which the foreign debtor’s “center of main interests” is located), section 1520 of the Bankruptcy Code provides certain relief as a matter of right, including application of the Bankruptcy Code’s automatic stay with respect to the debtor and its US property. ABC’s Australian Insolvency Proceedings Prior to their insolvency, ABC Learning Centres and its subsidiaries operated one of the largest childcare center businesses in the world, with locations in Australia, New Zealand, the United States and elsewhere. However, by late 2008, the company was in dire financial straits and faced enormous projected losses. As a result, ABC’s directors voted to place the company into voluntary administration proceedings in Australia. This decision resulted in the appointment of independent administrators for the company who needed to decide whether the company should be liquidated or reorganized. When the administrators and ABC’s creditors subsequently determined that the company should be liquidated, the administration proceedings were converted to liquidation proceedings and the administrators were appointed as ABC’s “Liquidators.” The Liquidators were tasked with, among other things, ensuring that ABC’s assets were distributed to the company’s creditor body as a whole, in accordance with the priority scheme established by Australian law. Commencement of the voluntary administration proceedings, however, constituted a default under ABC’s loan agreements with its syndicate of secured lenders. Under Australian law and ABC’s loan documents, that default entitled the lending syndicate to appoint receivers to take control of the assets subject to their “charges” (i.e., their liens or security interests) and to realize upon those assets for the benefit of the secured lenders. The secured lenders exercised this right and appointed “Receivers” to operate in parallel with the liquidation proceedings. Because the syndicate’s charges covered substantially all of ABC’s assets, the Receivers essentially took control of the business and became responsible for recovering the great majority of the company’s assets. US Litigation and the Path to Chapter 15 In May 2010, and while ABC was subject to its Australian liquidation proceedings, RCS Capital Development, LLC, a USbased company, won a $47 million dollar jury verdict against ABC in a breach of contract action in Arizona state court. The Third Circuit’s decision in In re ABC Learning Centres Ltd. stands for the proposition that where a chapter 15 petition meets the technical requirements for recognition established by the Bankruptcy Code, recognition and the relief afforded to a foreign main proceeding upon such recognition are mandatory in all but the narrowest of circumstances. Although the Receivers and Liquidators were in some respects adverse in Australia, they had a common interest in preventing an individual unsecured creditor such as RCS from seizing ABC’s US assets. Accordingly, Chadbourne was retained by the Liquidators to seek chapter 15 recognition of the liquidation proceedings, with the goal of obtaining an automatic stay that would prevent RCS from seizing any of ABC’s US assets (including assets controlled by the Receivers). On May 26, 2010, Chadbourne filed chapter 15 petitions with the United States Bankruptcy Court for the District of Delaware. The bankruptcy court immediately entered a temporary restraining order prohibiting further action against ABC or its assets in the US pending a decision on whether chapter 15 recognition of the liquidation proceedings was appropriate. The Bankruptcy Court Grants Chapter 15 Recognition to the Liquidation Proceedings RCS opposed chapter 15 recognition of the liquidation proceedings, arguing, among other things, that the liquidation proceedings did not constitute “collective” proceedings entitled to recognition. To qualify as “collective,” a proceeding must be for the benefit of creditors generally, rather than a single creditor constituency. RCS argued that although the liquidation proceedings themselves nominally benefited all of ABC’s creditors, the non-collective receivership proceedings (which benefited only the secured lending syndicate) “dominated” the liquidation proceedings because the Receivers controlled substantially all of ABC’s assets. The bankruptcy court rejected RCS’s arguments, finding that the liquidation proceedings and receivership proceedings served separate functions under Australian law and that the liquidation proceedings met all the criteria for chapter 15 recognition, including collectivity. As a result, the bankruptcy court granted chapter 15 recognition to the liquidation proceedings as foreign main proceedings, which gave rise to an automatic stay protecting ABC and all of its US assets, without any carve-out for assets under the control of the Receivers. RCS appealed to the United States District Court for the District of Delaware, which affirmed the bankruptcy court’s ruling. The Third Circuit Finds Chapter 15 Recognition Appropriate Even Where Assets Fully Encumbered On appeal to the Third Circuit, RCS again argued that recognition should have been denied because ABC’s US assets — the only assets which stood to benefit from chapter 15’s automatic stay — were fully encumbered by the secured creditors’ charges and were under the control of the Receivers. The Third Circuit, however, was not swayed by this argument, finding that the existence of the concurrent receivership proceedings had no effect on the straightforward question of whether the liquidation proceedings met the statutory requirements for recognition. As the Third Circuit explained, the text of “chapter 15 makes no exceptions when a debtor’s assets are fully leveraged.” The Third Circuit also warned that judicially creating “such an exception could contravene the stated purpose of chapter 15 and the mandatory language of chapter 15 recognition.” RCS further argued that recognition should be denied because permitting ABC’s secured creditors to receive the benefits of chapter 15 recognition would be manifestly contrary to the public policy of the United States. The Third Circuit rejected this argument as well, noting that the public policy exception to chapter 15 recognition should be applied only when the most fundamental policies of the United States are jeopardized. (For a broader discussion of how the public policy exception to chapter 15 recognition and relief has previously been interpreted, see “Important 2011 Rulings on Foreign Proceedings,” International Restructuring NewsWire, February 2012.) Despite RCS’s arguments, the Third Circuit found that recognition of the liquidation proceedings furthered, rather than undermined, US public policy by ensuring an orderly distribution of ABC’s assets. As the court observed, RCS opposed chapter 15 recognition because the resulting automatic stay prevented it, as an unsecured judgment creditor, from seizing ABC’s US assets. chapter 15 recognition of the liquidation proceedings, however, ensured that the proceeds of ABC’s US assets would be distributed to creditors in accordance with Australia’s debt priority scheme, which, like the US law, prioritizes recoveries for secured creditors. In contrast, “[w]ithout chapter 15 recognition, RCS could skip ahead of the priorities of secured creditors.” The Third Circuit concluded that such a result would “eviscerate the orderly liquidation proceeding” and contravene the US policy of providing for an orderly distribution of assets to creditors. Accordingly, the Third Circuit found that recognition of the liquidation proceedings as foreign main proceedings was proper. The Third Circuit Confirms Applicability of Automatic Stay Having determined that the liquidation proceedings were properly granted chapter 15 recognition, the Third Circuit turned to the question of whether the resulting automatic stay should protect all of ABC’s US property, or whether it should have been limited to property under the control of the Liquidators. chapter 15’s statutory language states simply that the automatic stay is to be extended to “the debtor and property of the debtor that is within the territorial jurisdiction of the United States,” and does not restrict the stay to unencumbered assets. Nevertheless, RCS argued that fullyleveraged property controlled by the Receivers should not be entitled to the protection of the stay, asserting that ABC lacked any true interest in such property. The Third Circuit rejected this final attack, finding that RCS’s assertions were incorrect and that ABC retained an interest in its fully-leveraged property that was worthy of being protected by the stay. As an example, the court observed that both US and Australian law provided ABC with the right to redeem property held by the Receivers by satisfying the secured creditors’ claims. Ultimately, the Third Circuit concluded that ABC’s interest in its fully-leveraged property would not be extinguished until the Receivers actually sold the encumbered property to satisfy ABC’s debts to its secured creditors. As a result, the Third Circuit concluded that the stay properly protected fully-leveraged assets under the control of the Receivers and affirmed the bankruptcy court’s recognition orders. Takeaway Points The Third Circuit’s decision in In re ABC Learning Centres Ltd. stands for the proposition that where a chapter 15 petition meets the technical requirements for recognition established by the Bankruptcy Code, recognition and the relief afforded to a foreign main proceeding upon such recognition are mandatory in all but the narrowest of circumstances. The Third Circuit’s decision also reinforces the prevailing view that chapter 15 recognition and relief should only be limited on public policy grounds when the most fundamental policies of the US would be jeopardized. Foreign representatives and international creditors alike should take comfort from the Third Circuit’s ruling, which signifies that chapter 15 relief remains broadly available even where foreign insolvency procedures may differ from US practices in significant respects. Current Status On November 25, 2013, RCS filed a petition for a writ of certiorari with the Supreme Court of the United States requesting review of the Third Circuit’s ruling. The Liquidators, acting through Chadbourne, have opposed that petition. The Supreme Court has not yet ruled on the request. FIRST CIRCUIT HOLDS PRIVATE EQUITY FUND RESPONSIBLE FOR PORTFOLIO COMPANY’S UNFUNDED MULTIEMPLOYER PENSION OBLIGATIONS In a recent decision involving private equity firm Sun Capital Advisors, the U.S. Court of Appeals for the First Circuit held that a private equity investor’s active, day-to-day management of a portfolio company may expose it to liability for the company’s unfunded multiemployer pension obligations. The First Circuit’s ruling included a determination that a private equity fund may be a “trade or business” for purposes of ERISA. The decision will certainly be unwelcome by private equity firms and will likely cause such investors to perform a more careful analysis before investing in companies with significant multiemployer pension plan liability. Multiemployer Pension Plans Multiemployer pension plans, sometimes referred to as “Taft Hartley plans,” are benefit plans maintained by more than one employer, typically under one or more collective bargaining agreements. The employers are often from similar or related industries and are parties to collective bargaining agreements with one or more local unions. In 1974, Congress passed the Employee Retirement Income Security Act (“ERISA”), which created the Pension Benefit Guaranty Corporation (also known as the “PBGC”) and required it to insure certain single-employer pension plans. PBGC’s guaranty was extended to multiemployer plans a few years later, but Congress quickly became concerned that the relatively weak withdrawal limitations for employers in multiemployer plans risked exposing PBGC to large unfunded liabilities. To remedy this problem, Congress passed the Multiemployer Pension Plan Amendments Act of 1980 (the “MPPAA”) to “protect the viability of defined pension benefit plans, to create a disincentive for employers to withdraw from multiemployer plans, and also to provide a means of recouping a fund’s unfunded liabilities.” The MPPAA requires employers to pay their proportionate share of the pension plan’s unfunded liabilities when they withdraw from the plan or permanently cease operations. The MPPAA further provides that “all employees of trades or businesses (whether or not incorporated) which are under common control shall be treated as employed by a single employer and all such trades and businesses as a single employer.” The MPPAA thus imposes a type of alter ego liability on the affiliates of an employer where the affiliate is (1) a trade or business and (2) under common control with the employer withdrawing from the pension plan. The PBGC has adopted regulations as to the meaning of “common control” but has not done so for the meaning of “trade or business.” Sun Capital Advisors Sun Capital Advisors is a private equity firm that acquires underperforming companies. Its goal is to rehabilitate the companies, thereby increasing their value, and to sell them for a profit within a few years. Sun Capital finds investment opportunities and helps negotiate and finalize their acquisition, but it does not directly own the companies in which it invests (also known as “portfolio companies”). Instead, Sun Capital creates limited partnership funds where investor money is pooled and then used to purchase the portfolio companies. The acquiring funds often do not have offices or employees, but they contract with Sun Capital and its affiliates for management and advisory services. Sun Capital and its affiliates are compensated by the funds in the form of various management fees and a share of the funds’ profits. Sun Capital does not seek merely a passive share in the profits of the portfolio companies, but rather it actively manages the companies to implement various business strategies and improve their performance and profitability. Case Background In early 2007, Sun Capital acquired ownership of Scott Brass Inc., a producer of high quality brass, copper, and other materials used in electronics, automobiles, hardware, jewelry, and consumer products. Consistent with the strategy described above, Sun Capital acquired Scott Brass using two investment funds, Sun Capital Partners III, LP and Sun Capital Partners IV, LP, which acquired 30% and 70% ownership of Scott Brass, respectively. Each fund was managed by a general partner in the form of another Sun Capital limited partnership. The general partners were, in turn, controlled by Sun Capital’s principals, who were empowered to make decisions related to hiring, terminating and compensating Scott Brass’s employees. Through the investment funds, Sun Capital principals and employees thus “exerted substantial operational and managerial control” over Scott Brass. In the fall of 2008, declining copper prices devalued Scott Brass’s inventory and caused Scott Brass to breach various of its loan covenants. The company eventually lost its ability to obtain credit and stopped making contributions to its multiemployer pension plan. In November 2008, creditors filed an involuntary bankruptcy petition against Scott Brass, and shortly thereafter, the administrator of the pension plan sent demand letters to Scott Brass and, most importantly, to the two Sun Capital funds which had invested in Scott Brass. The letters requested payment of the company’s proportionate share of the pension plan’s unfunded liabilities (approximately $4.5 million). The Sun Capital funds sought a declaratory judgment in the federal district court in Massachusetts arguing that they were not subject to withdrawal liability on the company’s behalf because under the MPPAA, they did not meet the “common control” requirement and were not themselves “trades or businesses.” The pension plan counterclaimed that (i) the funds were jointly and severally liable for the pension liabilities because the transaction satisfied the MPPAA “common control” requirement and (ii) the funds had engaged in a transaction to “evade or avoid” withdrawal liability because the acquisition of Scott Brass was structured so that neither fund held 80% of the company—the MPPAA’s threshold for parent-subsidiary liability. The district court did not reach the “common control” issue but ruled that the funds were not jointly and severally liable because they do not have offices or employees and therefore are not “trades or businesses.” On the second issue, the district court held that the funds had not engaged in a transaction to evade or avoid withdrawal liability, because the prohibition against such transactions is “aimed at sellers, not investors.” The district court also observed that imposing such liability on investors would disincentivize investing in companies with multiemployer pension plans, thereby undermining the aim of the MPPAA. First Circuit’s Decision and Reasoning The two MPPAA issues presented to the First Circuit were (1) whether the investment funds were “trades or businesses” for purposes of liability under the MPPAA and (2) whether the purposeful acquisition of the company on a 70%-30% basis, so as to avoid the 80% parent-subsidiary common control threshold, was a transaction whose purpose was to “evade or avoid” liability under the MPPAA. On the first issue, the pension plan, joined by the PBGC, urged the court to adopt an “investment plus” standard, whereby a private equity fund would be considered a “trade or business” if its controlling stake in a portfolio company allowed it to exercise continuous control over the company with the primary purpose of income and profit. The First Circuit agreed that “some form of an ‘investment plus’ approach is appropriate,” but declined to say what exactly the “plus” is. The court instead based its ruling on a “very fact-specific” inquiry, including the following: (a) the Sun Capital funds’ principal purpose was the management and supervision of their investments; (b) the funds (acting through other Sun Capital affiliates) not only made investment-level decisions but also took part in the active management and operation of their portfolio companies; (c) the funds’ management strategy encompassed details such as signing checks and attending meetings with senior staff to discuss products, operations, and personnel; (d) the funds received a portion of their profits in the form of a management fee offset, a type of compensation a typical investor does not receive and (e) with respect to Scott Brass, the funds were able to place Sun Capital employees in two of three director positions and enjoyed exclusive and wide-ranging management authority over the company. In addition, the court noted that the funds’ general partners were empowered to make decisions about hiring, termination, and compensating employees of Scott Brass. The court determined that this level of involvement provided a direct economic benefit to the funds that a passive investor would not have enjoyed. The court explained that “a mere investment made to make a profit, without more, does not itself make an investor a trade or business,” but the sum of the funds’ involvement in the day-to-day affairs of Scott Brass satisfied the “plus” in “investor plus.” In response to the Sun Capital funds’ argument that the MPPAA was not intended to hold potential equity investors liable for unfunded pension obligations, the First Circuit acknowledged that these are “fine lines” and that while Congress may indeed wish to encourage investments in distressed companies, it had not been explicit in the MPPAA. The court also expressed dismay that the PBGC had not previously provided sufficient guidance on the MPPAA liability theories at issue. The First Circuit was careful to acknowledge the limits of its interpretation of “trade or business,” noting that while the phrase appears throughout the Internal Revenue Code, it should not necessarily be interpreted the same way across statutes. While private equity funds may now be considered “trades or businesses” for purpose of ERISA, absent additional case law developments, private equity firms’ tax treatment should remain unchanged as a result of this ruling. With respect to the second issue — whether the Sun Capital funds had engaged in a transaction to evade or avoid withdrawal liability — the First Circuit held in the funds’ favor. The relevant provision of the MPPAA states “[i]f a principle purpose of any transaction is to evade or avoid liability under this part, this part shall be applied (and liability shall be determined and collected) without regard to such transaction.” The pension plan argued that during the acquisition of the company, the funds purposefully divided ownership into 70%-30% shares to avoid the 80% threshold for the MPPAA’s parent-subsidiary common control requirement. Awards Law360 recognized Howard Seife, the global chair of Chadbourne’s Bankruptcy and Financial Restructuring Practice, as a 2013 MVP in bankruptcy law. The legal publisher awarded the MVP distinction to lawyers who “had the biggest wins and made the most significant contributions to their practice groups in the past year.” Mr. Seife worked on some of the highest profile chapter 11 cases, corporate restructurings and cross-border insolvencies in recent years, both in the US and internationally. Law360 described how Mr. Seife “oversaw the enormous investigation and subsequent report Ally Financial Inc.’s potential liability with respect to Residential Capital LLC’s bankruptcy.” Speeches, Events and Publications Douglas E. Deutsch, Robert J. Gayda and Joshua Apfel wrote an article titled “Recent Cases and the Expanding Scope of the Section 546(e) Safe Harbor” that was selected for publication in the recently published book “Best of ABI 2013: The Year in Business Bankruptcy.” Howard Seife will be a co-presenter on a program titled “ResCap and the Use of Examiners in Chapter 11 Cases” at the American Bankruptcy Institute’s (“ABI”) Valcon 2014 Conference at the Four Seasons Hotel in Las Vegas (February 26, 2014). Francisco Vazquez is scheduled to speak at the St. John’s University School of Law 2014 CLE Program on a panel entitled “Bankruptcy Law Update” (March 9, 2014). Douglas E. Deutsch was named as a co-chair of the ABI’s Federal Communications/Bankruptcy Conference, a conference co-sponsored by ABI and the Federal Communications Bar Association. The program is to be held in Washington, DC. (April 24, 2014). Lawrence A. Larose is scheduled to speak at the ABI’s Annual Spring Meeting in Washington, DC in a program titled “Municipal Bankruptcies” (April 25, 2014). Looking to the plain language of the statute, the court held that regardless of the funds’ intent, the funds could not be liable under this provision because the “without regard” language directs that the parties be put in the same position as if the offending transaction had never occurred. Here, disregarding the funds’ acquisition of Scott Brass would result in neither of the funds holding any stake in the company. Because this was “not a case about an entity with a controlling stake . . . seeking to shed its controlling status to avoid withdrawal liability,” the court held that there was simply no basis for such liability. The First Circuit’s opinion suggests that the more management authority exercised by private equity employees in their portfolio companies and the more a private equity fund’s source of profits differs from that of a typical investor, the greater the likelihood that a court will find the “investment plus” standard satisfied. The First Circuit ultimately ruled only that the Sun Capital fund holding 70% of Scott Brass was a “trade or business” and remanded the case to the district court for further factual development as to whether the fund holding 30% of the company also constituted a “trade or business” and whether both funds met the “common control” requirement. Conclusion While the Sun Capital decision does not offer much advice for structuring private equity investments so as to avoid multiemployer pension liability, private equity investors should be mindful of their day-to-day involvement in portfolio companies and of the different responsibilities of directors and managers. The First Circuit’s opinion suggests that the more management authority exercised by private equity employees in their portfolio companies and the more a private equity fund’s source of profits differs from that of a typical investor, the greater the likelihood that a court will find the “investment plus” standard satisfied. It is yet to be seen how the PBGC will respond to this decision, but given the prevalence of underfunded multiemployer pension plans, it would not be surprising for the PBGC to continue to seek potential recoveries from the deep pockets of private equity investors. THE THIRD CIRCUIT FINDS THAT A TRANSFERRED CLAIM REMAINS SUBJECT TO DISALLOWANCE Over the course of the last 20 years, the business of trading claims in bankruptcy cases has grown tremendously. Professional investors purchase claims, typically at a steep discount, with the hope that the ultimate recovery from a debtor’s estate will be much greater than the price paid. On the other side of the transaction, the creditor receives an immediate sum certain sooner than a possible (if not probable) greater future recovery from the debtor’s estate. With the growth in bankruptcy claims trading, disputes have become more frequent and, as a result, bankruptcy courts have had to grapple with relatively new and thorny issues. In the June 2012 issue of the International Restructuring NewsWire (see “Can A Claims Purchaser Acquire Claims Free of Defects”), we first reported on one such decision, the Delaware Bankruptcy Court’s ruling in the KB Toys case. There, the court was asked whether a claim that was subject to disallowance under section 502(d) — the provision which states that a claim will be disallowed if the claimholder does not turnover property of the estate — remains subject to disallowance if the original claimholder transferred its claim to a third party. The Delaware Bankruptcy Court held that the “defect” travels with the claim, such that the claim remained subject to disallowance after it was transferred. This outcome was at odds with a New York District Court’s decision in Enron. (The Enron District Court decision was controversial at the time and reversed former Chief Bankruptcy Judge Arthur J. Gonzalez’s well-regarded decision on the issue.). According to the New York District Court, the disallowance of a transferred claim depends on whether the claim is transferred by way of “assignment,” in which case the defect would travel with the claim, or a “sale,” in which case the defect would not travel with the claim. Commentators, including market participants, criticized the distinction drawn by the New York District Court for, among other things, relying on a manufactured distinction between an “assignment” and a “sale.” Moreover, because the decisions by the New York and Delaware courts conflicted and were not binding on other courts, litigants on either side of the argument could cite to at least one decision supporting their position. The result was additional uncertainty as to the risk associated with acquiring a claim. The recent ruling by the Court of Appeals for the Third Circuit in KB Toys, 736 F.3d 247 (3d Cir. 2013), deciding an appeal of the decision we previously reported on, resolves the issue in the important Third Circuit. In the Third Circuit, a claim that is subject to disallowance under section 502(d) of the Bankruptcy Code in the hands of the original claimant is now clearly subject to disallowance in the hands of the transferee. This article examines the court’s ruling. Section 502(d) of the Bankruptcy Code Disallows Certain Claims Section 502(d) of the Bankruptcy Code provides that “any claim of any entity from which property is recoverable” by a debtor’s estate shall be disallowed unless the entity has turned over such property to the estate. Thus, a creditor will not be permitted a recovery from a debtor’s estate until the creditor pays what it owes to the debtor’s estate. According to the courts, section 502(d) serves two purposes. First, it is designed to promote equality of distribution of estate assets by preventing a claimholder from receiving a distribution on account of its claim if the creditor withholds valuable property that should be shared by all creditors. Second, it coerces compliance with judicial orders by disallowing a claim until the creditor disgorges estate property. Background Of KB Toys Decision On January 14, 2004, KB Toys Inc. and its affiliates filed voluntary petitions for relief under chapter 11 of the Bankruptcy Code. KB Toys later filed its schedules and statement of financial affairs as required by the Bankruptcy Code. The statement of financial affairs disclosed, among other things, all payments made by KB Toys within the 90 days preceding the petition date. Such payments were potentially subject to being “clawed back” as preference payments under the Bankruptcy Code. After KB Toys filed its statement of financial affairs, two affiliated companies named ASM Capital, L.P. and ASM Capital II, LLP acquired nine claims against KB Toys (evidencing obligations owed by KB Toys) from various trade claimants. The acquisitions were reflected in nine separate “Assignment Agreements,” four of which contained an indemnification clause. Each of the Assignment Agreements required the original claimant to pay restitution to ASM if the transferred claim was disallowed. According to KB Toys’ statement of financial affairs, each original holder of the claims acquired by ASM was the recipient of payments made by KB Toys within 90 days of the bankruptcy filing that could potentially be “clawed back” as preferences under the Bankruptcy Code. On August 18, 2005, the Bankruptcy Court confirmed KB Toy’s plan of reorganization. That plan established a liquidating trust to liquidate and collect the debtors’ assets and pursue avoidance actions, including preference actions. A liquidating trustee was appointed to manage the liquidating trust. The liquidating trustee sought and ultimately obtained judgments against each original holder of the claims acquired by ASM for the preferential payments they received from KB Toys. The original claimants, however, did not pay the judgments. Indeed, all of the original claimants had ceased operations and apparently were unable to satisfy the judgments. As a result, the liquidating trustee sought orders disallowing the original claimants’ claims (i.e., the claims acquired by ASM) under section 502(d). The liquidating trustee did not allege that ASM itself was wrongfully withholding property of the estate, which would have resulted in the disallowance of the claims. Instead, according to the liquidating trustee, the claims should be disallowed because the original claimants had received a preference before transferring their claims to ASM. The Bankruptcy Court and, on appeal, the District Court for the District of Delaware agreed. Thereafter, ASM appealed the District Courts’ decision to the Third Circuit. Third Circuit’s Decision The primary issue on appeal was whether a claim subject to disallowance in the hands of the original claimant remains subject to disallowance after it is transferred. The Third Circuit began its analysis by focusing on the language of section 502(d) and, in particular, on the reference to disallowing “any claim of any entity.” According to the Third Circuit, this clause renders any and all claims of an entity that received an avoidable transfer disallowable, regardless of who ultimately holds the claim, unless the avoidable transfer is returned to the estate. “Because the statute focuses on claims — and not claimants — claims that are disallowable under § 502(d) must be disallowed no matter who holds them.” The Third Circuit concluded that holding otherwise would permit the transfer of disallowable claims to negate the two aims of section 502(d), and the opinion explained the court’s reasoning in detail. According to the Third Circuit, allowing the transfer of a disallowable claim to stand without any negative consequence to the transferee would conflict with the first aim of section 502(d), ensuring equality of distribution of estate assets, for two reasons. First, because the original claimant has not returned the avoidable transfer, the estate has less money and the other creditors would receive smaller amounts from the estate because it would not include the unreturned preference payment or conveyance. Second, the estate would pay on a claim that would have been otherwise disallowed. The Third Circuit further noted that allowing the transfer of a disallowable claim to stand without any negative consequence to the transferee would also undermine the second aim of section 502(d), coercing compliance with a court’s order. The court explained that section 502(d) permits the disallowance of a claim unless property of the estate is turned over. “To allow the sale to wash the [disallowable] claim entirely of the cloud would deprive the trustee of one of the tools the Bankruptcy Code gives trustees to collect assets— asking the bankruptcy court to disallow problematic claims.” ASM had also argued that its claims should not be disallowed because it purchased them in “good faith,” and therefore ASM was entitled to the protections of a good faith purchaser under section 550(b) of the Bankruptcy Code. In general, section 550(b) provides that a trustee may not recover property from a transferee that takes for value in good faith without knowledge of the voidability of the transfer avoided. That argument did not persuade the Third Circuit. Section 550(b) is applicable only to a good faith purchaser of property of the estate and is not applicable to a purchaser of claims against the estate. ASM was thus not entitled to the section 550(b) protection because it had purchased claims against KB Toys and not property of the debtor’s estate. Conclusion & Take-Aways ASM voluntarily exposed itself to the risk of disallowance by purchasing claims from recipients of transfers that were potentially avoidable. To mitigate the risk, ASM drafted its assignment agreements to require the original claimants to pay restitution to ASM in the event the claims were disallowed. Once it became clear that the original claimants would not be able to satisfy their restitution obligation, ASM tried to shift the risk to the estate. The Third Circuit, however, rejected ASM’s attempt and noted that the risk of loss in this instance is better borne by ASM than the estate because ASM could protect itself by paying a lower price. In the future, a purchaser of claims should purchase a claim only after evaluating all the risks associated with the claim, including the risk that the original claimholder is the recipient of an avoidable transfer, such as a preference payment or a fraudulent transfer. Regardless of the price paid for a claim, a transferee will remain subject to a claims objection based on section 502(d), at least in the Third Circuit. Time will tell whether other courts will be persuaded by the rationale of the Third Circuit. HAS SECTION 546( ) SAFE HARBOR FINALLY REACHED ITS OUTER LIMITS? Section 546(e) of the Bankruptcy Code prevents a trustee from unwinding or “avoiding” certain securities transactions that would otherwise be avoidable under the Bankruptcy Code. This protection is referred to as a “safe harbor.” Most recent decisions regarding this bankruptcy safe harbor have interpreted the provision broadly. See, e.g., “Protections of Section 546(e) Clarified,” International Restructuring NewsWire (Summer 2013). However, a decision issued on September 23, 2013 by the U.S. District Court for the Southern District of New York in the litigation titled In re Tribune Company, 499 B.R. 310, suggests an outer boundary for the section 546(e) safe harbor protections. The Tribune decision includes three noteworthy safe harborrelated rulings. First, the section 546(e) safe harbor only bars fraudulent transfer claims brought by a “bankruptcy trustee” (i.e., a bankruptcy estate representative), and does not impliedly preempt fraudulent transfer claims brought by individual creditors. Second, if a bankruptcy trustee does not bring fraudulent transfer claims within the two-year period (generally measured from the inception of the chapter 11 cases) provided in section 546(a) of the Bankruptcy Code, the causes of action, which are not permanently stayed in bankruptcy, automatically revert to individual creditors. Third, individual creditors lack standing to pursue avoidance actions on constructive fraud theories after the automatic reversion if the estate representative is pursuing avoidance claims arising from the same underlying transaction. Each of these rulings is discussed in more detail below. Case Background Tribune filed for chapter 11 protection in 2008, about one year after completing an LBO that paid out more than $8.2 billion to its public shareholders. During the bankruptcy case, the official committee of unsecured creditors was authorized by the bankruptcy court to stand in the shoes of the debtor and to file adversary proceedings on behalf of Tribune’s estate to avoid and recover certain alleged fraudulent transfers incurred in connection with the LBO. With this authority, the creditors’ committee commenced litigation in the bankruptcy court to avoid certain transfers made to Tribune’s shareholders and other parties in connection with the redemption of Tribune’s public equity as part of the LBO, claiming (among other things) that such transfers constituted intentional fraudulent transfers. The creditors’ committee did not, however, assert constructive fraudulent transfer claims against the former shareholders. The creditors’ committee’s decision not to include constructive fraudulent transfer claims in its complaint was quite intentional – although the section 546(e) safe harbor might defeat certain constructive fraudulent transfer claims brought by an estate representative, the safe harbor by its own terms does not apply to actual intent fraudulent transfer claims (i.e., claims alleging the actual intent to hinder, delay, or defraud creditors). Consequently, in 2011, hundreds of Tribune’s individual creditors requested permission to file state law constructive fraudulent transfer actions outside of the bankruptcy court. The bankruptcy court conditionally lifted the automatic stay to allow such lawsuits to be filed because the creditors’ committee had not brought a constructive fraudulent transfer claim within the two-year period allowed for bringing such claims under section 546(a). Thereafter, many of the individual creditors initiated state law avoidance actions across the country. These lawsuits were consolidated for pre-trial proceedings in the Southern District of New York by the Judicial Panel on Multidistrict Litigation. (Chadbourne & Parke LLP represented the creditors’ committee generally in the Tribune bankruptcy cases. Chadbourne was not involved in the Southern District of New York litigation, and in any event the creditors’ committee (the initial plaintiff) was ultimately succeeded by a thirdparty litigation trustee established by the confirmed plan of reorganization.) Subsequently, the defendants in the consolidated proceedings filed motions to dismiss the lawsuits, arguing that the individual creditors’ state law constructive fraudulent transfer claims were preempted by section 546(e) and that the creditors lacked standing to pursue such claims. District Court’s Analysis The district court first ruled that the plain language of section 546(e) limits the availability of the section 546(e) defense to actions brought by the “bankruptcy trustee,” and not, as the defendants argued, actions by individual creditors “who have no relation to the bankruptcy trustee.” The district court also rejected the defendants’ contention that section 546(e) impliedly preempted state law constructive fraudulent transfer claims brought by individual “state-law creditors.” The court noted that Congress had never added an express provision preempting state law claims on any of the eight separate occasions it amended section 546(e), even after a Delaware bankruptcy court held that section 546(e) permits individual creditors to assert state law constructive fraudulent transfer claims under certain circumstances. Similarly, the district court held that Congress did not extend section 546(e) to state law constructive fraudulent transfer claims filed pre-petition or to intentional fraudulent transfer claims filed post-petition, even though such claims “pose the very same threat to the stability of the security markets.” Based on the foregoing, the district court concluded that Congress had demonstrated its ability and willingness to explicitly preempt an individual creditor’s state law claims elsewhere in the Bankruptcy Code and, by failing to do so in this instance, made clear that it did not intend for section 546(e) to have the preemptive effect used by the shareholder-defendants. The district court’s second noteworthy ruling was that individual creditors’ state law avoidance actions are not permanently stayed in bankruptcy, but rather that they automatically revert to the individual creditors once the bankruptcy trustee’s statutory two-year time period to pursue those claims expires. The district court explained that the automatic reversion occurs irrespective of whether the debtor is discharged from bankruptcy because a fraudulent conveyance claim is not property of the bankruptcy estate. In its third and final key ruling, the district court agreed with the defendants, holding that the individual creditors’ constructive fraudulent transfer claims and the intentional fraudulent transfer claims filed by the creditors’ committee could not be pursued at the same time against the shareholders. The court reasoned that the automatic stay under section 362(a)(1) does not apply differently based on the theory or Bankruptcy Code provision under which a bankruptcy trustee brings a fraudulent transfer action. In other words, for purposes of section 362(a)(1), the Bankruptcy Code does not differentiate between constructive and intentional fraudulent transfer actions. The district court further explained that the bankruptcy process is intended to promote a fair and comprehensive resolution of a debtor’s financial affairs by consolidating multiple claims into one entity and therefore cuts off the claims of individual creditors while the trustee (here, replaced by the creditors’ committee and ultimately by the litigation trustee) is acting in order to make all creditors as close to whole as possible. The district court concluded that until the estate representative completely abandons its intentional fraudulent transfer claims, the individual creditors lack standing to bring their own claims arising from the same transactions. The district court’s decision has now been appealed to the Second Circuit Court of Appeals. Conclusions and Takeaways Although the district court ultimately dismissed the individual creditors’ claims, its rulings demonstrate that the section 546(e) safe harbor has outer limits, and that individual creditors may successfully assert fraudulent conveyance claims that a trustee or other estate representative would be barred from bringing. Parties should be aware of their potential exposure to such individual creditor state law avoidance actions. At press time for this issue of the NewsWire, many of the issues decided by the Tribune court were considered in similar litigation arising from the In re Lyondell Chemical Company bankruptcy case. In that decision, the Bankruptcy Court for the Southern District of New York found that Congress had not clearly intended to preempt state law claims, thus agreeing with the Tribune court’s analysis. The Lyondell decision is also likely to be appealled to the Second Circuit Court of Appeals. Stay tuned. WITH DETROIT ELIGIBLE FOR CHAPTER 9, PENSIONS IN JEOPARDY On December 5, 2013, the City of Detroit Michigan was officially declared eligible to be debtor under chapter 9 of the Bankruptcy Code, marking the start of the largest municipal bankruptcy in the history of the US. Although Judge Rhodes’s ruling that Detroit was eligible for chapter 9 protection was widely expected, he also took the less-expected step of preemptively ruling that Detroit’s pension obligation can be impaired as part of a plan of adjustment for the City’s debts. Although the bankruptcy court emphasized that it would not necessarily approve any given plan of adjustment, and would not lightly decide to impair pensions, it has precluded further argument that municipal pensions are sacrosanct obligations that cannot be impaired under any circumstances. If the court’s decision is not overturned on appeal, it is sure to be widely-cited in other municipal bankruptcies and is likely to shift negotiating leverage away from municipal employee unions and other parties that may be interested in preserving the status quo on municipal pensions. Introduction to Chapter 9 Chapter 9 of the Bankruptcy Code permits, under certain circumstances, state municipalities to receive the protections of the automatic stay and ultimately to modify their debts through a “plan of adjustment.” To be eligible to be a chapter 9 debtor, an entity must demonstrate that it: (i) is a municipality; (ii) is authorized under state law (or by an appropriate state officer) to become a chapter 9 debtor; (iii) is insolvent; (iv) desires to adjust its debts; and (v) (a) has obtained the consent of a majority of each class of creditors that will be impaired, (b) has negotiated with its creditors in good faith, (c) is unable to negotiate with its creditors because negotiations would be impracticable; or (d) reasonably believes that a creditor may attempt to obtain an avoidable preference. Additionally, because of the unique constitutional concerns posed by a federal court exercising power over a state municipality, chapter 9 of the bankruptcy code incorporates certain additional protections designed to preserve state sovereignty. Specifically, a bankruptcy court is prohibited, except upon consent of the debtor and incorporation of that consent into a plan of adjustment, from interfering with: (i) any of the political or governmental powers of the debtor; (ii) any of the property or revenues of the debtor; or (iii) the debtor’s use or enjoyment of any income-producing property. Additionally, the Bankruptcy Code prohibits third parties from filing involuntary chapter 9 petitions or submitting plans of adjustment for municipal debtors. Because of chapter 9’s numerous debtor-eligibility requirements and the relatively narrow scope of bankruptcy court power in chapter 9, parties interested in preventing a municipality from adjusting its debts have a variety of arguments at their disposal. Unsurprisingly, a large number of Detroit’s creditors and interested parties raised these arguments in response to the City’s chapter 9 petition. Objections to Detroit’s Eligibility Upon the recommendation of Emergency Manager Kevyn Orr, and with the authorization of Governor Rick Snyder, the City of Detroit filed for chapter 9 protection on July 18, 2013 in the United States Bankruptcy Court for the Eastern District of Michigan. Pursuant to section 921(b) of the Bankruptcy Code, Alice M. Batchelder, as Chief Judge of the United States Court of Appeals for the Sixth Circuit, appointed Judge Steven W. Rhodes to oversee the case. On August 2, 2013, Judge Rhodes entered an order granting parties until August 19, 2013 to file objections to Detroit’s eligibility to be a chapter 9 debtor. In total, 110 distinct parties filed timely objections challenging the City’s eligibility. Given the wide variety of objections raised, this article will not canvas every argument made in opposition to the City’s chapter 9 petition. However, among the most prominent arguments raised were claims that: (i) Detroit failed to negotiate in good faith with its creditors; (ii) chapter 9 is unconstitutional on its face; and (iii) Michigan law prohibits the impairment of pensions under any circumstances, rendering unconstitutional Governor Snyder’s authorization for Detroit to file for chapter 9 protection without a carve-out protecting pension liabilities (i.e., chapter 9 is unconstitutional as applied in Detroit’s case). After holding arguments concerning the purely legal objections raised and evidentiary hearings on issues that turned on genuine issues of material fact, Judge Rhodes rejected every objection to Detroit’s chapter 9 eligibility. Detroit Did Not Negotiate in Good Faith, but Nevertheless Is Eligible Perhaps the most serious challenge to Detroit’s eligibility was certain objectors’ claim that the City failed to negotiate with its creditors in good faith before filing for bankruptcy protection. Specifically, the creditors pointed to the fact that, at the few meetings the City held with its creditors prior to its bankruptcy filing, “the City affirmatively stated that the meetings were not negotiations.” Moreover, those meetings took the form of presentations to different groups of creditors during which the City “gave little opportunity for creditor input or substantive discussion.” In response, Detroit claimed that (a) its statement that the meetings were not negotiations was only intended to preserve a suspension of collective bargaining provided under applicable Michigan law and (b) the meetings and presentations were intended merely as a starting point for negotiations that would generate counter proposals from creditors. The bankruptcy court rejected the City’s claims, finding them “inadequate, bordering on disingenuous. The City simply cannot announce to creditors that meetings are not negotiations and then assert to the Court that those same meetings amounted to good faith negotiations.” Moreover, the bankruptcy court concluded that creditors could not reasonably have been expected to generate counter proposals based on the limited information provided to them by the City. Accordingly, the bankruptcy court concluded that Detroit failed to negotiate with its creditors in good faith. That finding did not, however, end the bankruptcy court’s inquiry. As noted above, a municipal debtor need not hold good faith prefiling negotiations with its creditors if it can show that such negotiations would be “impracticable.” According to established chapter 9 case law, Congress adopted this exception specifically “to cover situations in which a very large body of creditors would render prefiling negotiations impracticable.” In re Cnty. Of Orange, 183 B.R. 594, 607 (Bankr. C.D. Cal. 1995). Accordingly, “[t]he impracticability requirement may be satisfied based on the sheer number of creditors involved.” Id. Applying this test, the court noted that Detroit’s list of creditors ran over 3,500 pages, was divided into fifteen schedules reflecting different types of debt, and contained over 100,000 creditors. Based on those staggering figures, the court concluded that “when Congress enacted the impracticability section, it foresaw precisely the situation facing the City of Detroit.” Moreover, the court noted that, absent bankruptcy, there was no party that could negotiate on behalf of, and bind to the results of that negotiation, individual retired creditors. Finally, the court observed that, prior to its bankruptcy filing, the City faced an imminent liquidity crisis that threatened the City’s assets and rendered any lengthy negotiations impossible. Accordingly, Judge Rhodes concluded that the City of Detroit was excused from engaging in good-faith prefiling negotiations with its creditors. Chapter 9 is Facially Constitutional According to a number of objectors, including certain employee and retiree groups, chapter 9 is unconstitutional on its face because it violates the principles of federalism — the division of power between the Federal and State governments — that lies at the core of the U.S. Constitution. These objectors argued that chapter 9 allows “Congress to set rules controlling State fiscal self-management — an area of exclusive State sovereignty — as part of an unholy alliance in which the State receives in exchange powers in excess of those it would otherwise possess under the law.” In support of their argument, the objectors pointed to the fact that a prior iteration of the municipal bankruptcy statute was struck down by the Supreme Court in 1936 on similar grounds. Judge Rhodes, however, rejected this argument, finding that the Supreme Court had already determined that chapter 9 is constitutional. As the court noted, following the Supreme Court’s 1936 ruling that the original municipal bankruptcy statute unconstitutionally infringed on state sovereignty, Congress quickly enacted a revised statute. The revised statute was designed to alleviate the Supreme Court’s concerns by, among other things, prohibiting (i) involuntary bankruptcy filings against municipalities, (ii) interference in municipal fiscal or governmental affairs and (iii) bankruptcy court control over municipal property. In 1938, the Supreme Court upheld the revised statute, finding that Congress’s revisions to the law eliminated any basis for further challenges on Tenth Amendment grounds. Because current chapter 9 tracks the municipal bankruptcy statute approved by the Supreme Court in most important respects, Judge Rhodes found that the Supreme Court’s 1938 decision remained binding authority as applied to chapter 9. Accordingly, Judge Rhodes held that chapter 9 was not facially unconstitutional, and refused to reject Detroit’s chapter 9 petition on that basis. Detroit May Impair Pensions in Bankruptcy Finally, a number of objecting parties argued that any Michigan state law authorization for Detroit to file for chapter 9 protection that did not impose a carve-out protecting pensions from impairment in bankruptcy violated certain provisions of the Michigan Constitution designed to protect pension rights and was therefore invalid. Specifically, Article IX, Section 24 of the Michigan Constitution provides that: “[t]he accrued financial benefits of each pension plan and retirement plan shall be a contractual obligation thereof which shall not be diminished or impaired thereby.” According to Judge Rhodes, “the premise of this argument is that under the Michigan constitution, pension benefits are entitled to greater protection than contract claims.” However, as the bankruptcy court explained in great detail, that premise is, in Judge Rhodes’s view, mistaken. Before the adoption of the Michigan Constitution in 1963, public pensions in Michigan were governed by common law, which treated pensions “as gratuitous allowances that could be revoked at will, because a retiree lacked any vested right in their continuation.” In adopting the 1963 Constitution, Michigan protected retirees from at-will pension revocation by explicitly granting pensions the status of contracts. Both the legislative history of the Michigan Constitution and numerous cases have confirmed this interpretation. Indeed, as the bankruptcy court observed, in 2011 the Michigan Supreme Court explicitly held that “[t]he obvious intent of § 24 [of the Michigan Constitution], however, was to ensure that public pensions be treated as contractual obligations . . . .” In re Constitutionality of 2011 PA 38, 806 N.W.2d 683, 694 (Mich. 2011). While public pensions’ status as contractual obligations protected them from at-will revocation, impairment or diminishment (because the federal constitution prohibits all states from impairing contracts), the bankruptcy court concluded that such status provided no protection from impairment in bankruptcy. Indeed, impairment of contractual rights is the very essence of bankruptcy, without which non-consensual adjustment of debts would be impossible. The bankruptcy court further noted that, had the people of Michigan wished to provide municipal pensions with protections that would not be subject to impairment in bankruptcy, they could have done so in a variety of ways. For example, the Michigan Constitution could have been drafted to provide municipal employees with a property interest in their pensions that would have been subject to the protections of the Fifth Amendment’s Takings Clause. Indeed, certain states, including Connecticut, Maine, New Mexico, Ohio, Wisconsin and Wyoming have done just that. Instead, the Michigan Constitution expressly treats public pension obligations as contractual rights. Unsurprisingly, the objectors argued against this result, claiming that the Michigan Constitution granted pensions additional protections by forbidding them from being “diminished or impaired.” The bankruptcy court dismissed this argument, noting that the Michigan constitution similar prohibited the impairment of any contract, and that a prohibition against “impairment” is functionally identical to the prohibition against “diminishment or impairment” granted to pensions. As a result, the bankruptcy court explicitly held that Detroit’s municipal pension obligations were eligible for impairment as part of a plan of adjustment for the City’s debts. Nevertheless, the court clarified that it would “not lightly or casually exercise the power under federal bankruptcy law to impair pensions.” Takeaway Points Given the sheer size of Detroit’s balance sheet and the City’s status as an icon of both historic American industry and present municipal distress, Judge Rhodes’s decision is sure to cast a long shadow over municipal public policy. Parties with a fiscal stake in financially troubled municipalities should be aware that chapter 9 provides a viable tool for reshaping the municipal status quo. Even public pension obligations, which are often considered sacrosanct, may be subject to impairment unless they are provided even greater protections by a state constitution than is provided by the Michigan Constitution. Judge Rhodes’s decision (and any related appellate decision) could also have an impact on the currently pending chapter 9 cases of other municipalities facing similar pension difficulties, particularly San Bernardino, California (and perhaps Stockton, California). Current Status Several aspects of Judge Rhodes’s decision have been appealed, including his decision that municipal pension may be impaired under a chapter 9 plan of adjustment. Certain parties are seeking direct review of the decision by the United States Court of Appeals for the Sixth Circuit. That effort is being opposed by the City, which has argued that the bankruptcy court’s eligibility ruling is an interlocutory order that is not subject to immediate appeal. Currently, no aspect of the decision has been stayed pending appeal, and the Sixth Circuit has not indicated whether it will hear a direct appeal.