On Thursday, August 6, 2009, the United States Senate confirmed Justice Sonia Sotomayor to the Supreme Court of the United States. As a former Judge on the Court of Appeals for the Second Circuit, Judge Sotomayor’s jurisprudence includes a number of decisions involving noteworthy bankruptcy cases. This article provides a brief survey of these decisions. While the cases before her covered a broad range of bankruptcy issues, as a group, Judge Sotomayor’s Second Circuit bankruptcy rulings show a judge willing to grant wide scope to the jurisdiction of the Bankruptcy Court and the provisions of the Bankruptcy Code.

In re Worldcom, Inc. 1

During the Worldcom bankruptcy case, the Securities and Exchange Commission (“SEC”) settled certain claims that it had brought against the debtors (“Worldcom”) under a settlement that required Worldcom to pay a penalty of $750 million for the violation of certain securities laws. The Bankruptcy Court approved the settlement, noting the support of the official committee of unsecured creditors (the “Worldcom Creditors’ Committee” or “Committee”).

After Worldcom emerged from bankruptcy, the SEC sought the district court’s approval to distribute Worldcom’s settlement payment to defrauded investors pursuant to a distribution plan, as mandated by the “Fair Fund provision” of the Sarbanes-Oxley Act of 2002 (the “Distribution Plan”). Because the Distribution Plan lacked sufficient funds to fully compensate all of the victims of Worldcom’s securities fraud, the Distribution Plan excluded investors that had recovered thirty-six cents or more on the dollar under the Chapter 11 reorganization plan or through the sale of their securities, and investors that made a net profit through the trading of their securities during the period in which the fraud occurred. The district court approved the Distribution Plan. The Worldcom Creditors Committee appealed, challenging the plan’s favoring of shareholders over other creditors, as well as the exclusion of certain creditors from the plan.

The Worldcom Creditors’ Committee was not a party to the proceedings before the district court nor a signatory to the SEC settlement. However, because the Committee had a “plausible affected interest” in the outcome of the appeal, Judge Sotomayor granted the Committee nonparty standing to pursue the appeal.2 In its appeal, the Committee argued that the Distribution Plan’s exclusion of certain creditors on account of their prior recoveries wrongfully upset the Bankruptcy Code’s priority scheme whereby creditors recover ahead of shareholders. This result threatened to “undermine time-honored principles of the Bankruptcy Code, . . . a result Congress could not have intended.”3

Judge Sotomayor, writing on behalf of a unanimous Second Circuit Court of Appeals, rejected the Committee’s contentions on appeal, and found that the district court did not abuse its discretion in approving the Distribution Plan.4 Judge Sotomayor recognized that “there is a tension between the priority assigned to claims under the Bankruptcy Code and the Fair Fund provision, which empowers the SEC to distribute funds among injured investors outside the bankruptcy proceeding.”5 Yet there was “no indication in the Fair Fund provision” of the Sarbanes-Oxley legislation that required the SEC to follow the Bankruptcy Code’s claim priorities when developing a distribution.6 As a result, Judge Sotomayor concluded, “it is not our role to mitigate this tension,” therefore, the district court’s approval of the Distribution Plan was not an abuse of its discretion.7

In re Millenium Seacarriers, Inc. 8

In a “putative clash between bankruptcy law and admiralty law,” Judge Sotomayor sought to clarify the scope of a bankruptcy judge’s jurisdiction to administer a debtor’s maritime assets.9 Millenium Seacarriers (“Millenium” or the “Debtor”) was a holding company for various vessel-owning subsidiaries. During its Chapter 11 case, Millenium sought to sell substantially all of its assets to its secured lenders free and clear of liens pursuant to section 363 of the Bankruptcy Code. Certain parties in interest objected to the sale, claiming they held maritime liens arising from unpaid Liberian tonnage taxes, pursuant to the Ship Mortgage Act.10

The maritime lienholders argued that, according to the traditional tenets of admiralty law, only an admiralty court can deliver a vessel free and clear of maritime liens.11 Furthermore, the objecting parties asserted that, because the vessels had been arrested in foreign ports, they were outside the in rem jurisdiction of the district court. Because the Bankruptcy Court’s jurisdiction is derivative of the jurisdiction of the district court, and the district court’s jurisdiction did not extend to the vessels, the objecting parties argued that the Bankruptcy Court had no authority to authorize a sale of the vessels “free and clear” of liens.12

In addressing the “complex question of the scope of bankruptcy jurisdiction when the debtor’s estate consists of maritime assets,” Judge Sotomayor, writing for a unanimous court, reasoned that jurisdiction over an in rem suit against a vessel, brought for the purpose of quieting title to the vessel, resides exclusively within the province of Article III courts sitting in admiralty.13 However, in this case, the objecting lienors had actively litigated their maritime liens before the Bankruptcy Court, and had therefore submitted voluntarily to the Bankruptcy Court’s jurisdiction. Thus, the lien holders had consented to the Bankruptcy Court’s equitable jurisdiction to adjudicate and extinguish their liens.14

In resolving only the “narrow question” of whether a Bankruptcy Court may adjudicate maritime liens where the lienors voluntarily submit to its jurisdiction, Judge Sotomayor recognized that the decision “does not answer the question of whether the Bankruptcy Court could have expunged the vessels of . . . liens had it not had jurisdiction over the lienors.”15 Accordingly, those who utilize a bankruptcy proceeding to purchase maritime assets from a debtor’s estate should be aware that they “take a calculated commercial risk that they have not received clean title.”16

In re Adelphia Commc’ns Corp. 17

In Adelphia, an official committee of equity security holders appointed in the debtors’ Chapter 11 cases (the “Equity Committee”) received derivative standing to pursue certain claims on behalf of the debtors’ estates against the debtors’ bank lenders and investment banks. The Bankruptcy Court subsequently confirmed the debtors’ plan of reorganization that provided for, among other things, the transfer of certain of the debtors’ claims – including those asserted by the Equity Committee on behalf of the debtors’ estates – to a litigation trust managed by appointees of the unsecured creditors committee. Recoveries by the trust would first be paid to unsecured creditors who had not realized the full value of their claims, and remaining funds (if any) would be distributed to shareholders.

The Equity Committee objected to the transfer of its derivative claims, arguing that the litigation trust lacked incentive to maximize the value of those claims. The Equity Committee argued that the trustees might quickly resolve litigation in order to satisfy creditors’ senior claims, instead of pursuing larger recoveries that potentially could be of value to shareholders. 18 The Equity Committee’s objections were overruled, their appeal was dismissed by the district court, and the district court’s judgment was affirmed by the Court of Appeals for the Second Circuit.

In dismissing the Equity Committee’s appeal, Judge Sotomayor ruled that a Bankruptcy Court may withdraw a committee’s derivative standing and transfer the management of its claims, even in the absence of that committee’s consent, if the court concludes that such a transfer is in the best interests of the bankruptcy estate.19 Judge Sotomayor, writing for the majority, emphasized that “it is the court’s role – and not that of a derivative plaintiff – both to oversee the litigation and to check any potential for abuse by the parties.”20

The debtors’ plan of reorganization required that the litigation trust maximize the value of the transferred claims, and that the trustees would be liable in the event of violation of their fiduciary duties. The Bankruptcy Court had conducted an analysis of the costs and benefits of the Equity Committee’s continued management of the claims and found that the debtors’ plan to transfer the claims served the best interests of the estate.21 Given the “debtor’s central role in handling the estate’s legal affairs,” the Bankruptcy Court’s approval of the plan to transfer the claims to the litigation trust was not unreasonable.22

Judge Sotomayor sought to “place in context” the role of the derivative plaintiff, vis-à-vis the Court and the debtor. In doing so, Judge Sotomayor stated that the derivative plaintiff “serves ‘with the approval and supervision of a Bankruptcy Court’ and shares the ‘labor’ of litigation with the debtor-in-possession . . . however, it does not usurp the central role of the court or debtor in overseeing and managing the estate’s legal claims.” 23

In re Bd. of Directors of Telecom Argentina, S.A. 24

Argentinean telecommunications company (“Telecom”) filed a petition to commence a U.S. bankruptcy case ancillary to a foreign proceeding pursuant to former section 304 of the Bankruptcy Code (repealed effective October 17, 2005). Telecom’s petition sought to give full force and effect to a privately negotiated restructuring plan approved under Argentinean insolvency law and known as an acuerdo preventivo extrajudicial (“APE”). The APE modified Telecom’s obligations to its multinational bond holders, including investors located in the United States.

After finding that the U.S. investors were afforded an adequate opportunity to vote on and object to the restructuring plan in the Argentine insolvency proceedings – though they chose not to do so – the U.S. Bankruptcy Court confirmed the petition.25 A creditor of Telecom, Argo Fund Ltd. (“Argo”), challenged the petition and appealed to the district court. The district court affirmed the Bankruptcy Court’s ruling and Argo then appealed to the Court of Appeals for the Second Circuit. Judge Sotomayor, writing on behalf of a unanimous court, rejected Argo’s arguments and affirmed the judgments of the district court and Bankruptcy Court.

Argo’s challenge contended that the Argentine proceedings violated U.S. public policy considerations. First, Argo asserted that, pursuant to the Trust Indenture Act (“TIA”), the rights of holders of bonds issued under a qualified indenture are protected from majority-imposed impairment. Since Telecom proposed to restructure the rights of U.S. bond holders without their consent, the APE violated the TIA and should not have been given effect. Second, Argo claimed that, unless a foreign proceeding provided a “best interests of creditors” requirement analogous to the protections found in section 1129(a)(7) of the Bankruptcy Code, the foreign reorganization should not be entitled to comity.

In ruling on Argo’s first argument, Judge Sotomayor, writing for the majority, stated that TIA protections do not apply to the restructuring of bonds under bankruptcy law, and since section 304 is part of U.S. bankruptcy law, a Bankruptcy Court may grant enforcement of foreign insolvency proceedings that restructured TIA-protected bonds.26 Holding otherwise would “turn the principle of comity on its head,” and “fail to promote” the “‘friendly intercourse between the sovereignties’ particularly necessary in bankruptcy proceedings.”27

With respect to Argo’s second contention, that comity requires the foreign jurisdiction to have a standard similar to the “best interest of creditors” standard, Judge Sotomayor stated, “[c]omity . . . does not require that foreign proceedings afford a creditor identical protections as under U.S. bankruptcy law,” and the amount of a distribution in a foreign insolvency proceeding need not be equal to the amount the creditor might have received in a U.S. proceeding. 28 On the contrary, Judge Sotomayor reasoned, there is a “longstanding recognition that foreign courts have an interest in conducting insolvency proceedings concerning their own domestic business entities.”29 Courts must be mindful that section 304 review should be “guided by what will best assure an economical and expeditious administration of insolvency proceedings.”30

In re Bethlehem Steel Corp. 31

In Bethlehem Steel, a former employee of the Chapter 11 debtors sought an administrative claim for certain payments incident to his postpetition termination. The Bankruptcy Court denied the employee’s claim for administrative priority, reasoning that the debtor’s obligations to the employee were for services rendered prepetition. Judge Sotomayor affirmed the judgments of the district court and the Bankruptcy Court, finding that a debtor’s obligation to a former employee in connection with early termination is only an administrative expense if the debtor received the consideration for the obligation after the commencement of bankruptcy proceedings.

Unlike severance payments, which are compensation for hardships associated with dismissal and therefore “earned” at the time of termination, a benefit earned over the course of prepetition employment is not an “expense of preserving the estate” under the Bankruptcy Code.32 Regardless of when a debtor’s obligation to pay benefits incident to termination arises, if the payment represents an acceleration of benefits accrued over the course of prepetition employment, it is not an expense attributable to the postpetition administration of the debtors estate.33

Judge Sotamayor’s work on bankruptcy cases affords a small window into her likely bankruptcy views as Justice Sotamayor. She has typically written pragmatic opinions, taking an expansive view of the role of the Bankruptcy Courts and the parameters of the Bankruptcy Code.