The Momentive Decisions: Cram-Down Interest Rates and Make-Whole Mania
On August 26, 2014, the eyes and, perhaps more likely, ears of distressed debt investors, bond traders and secured creditors were turned toward White Plains, New York as Judge Robert D. Drain read an opinion into the record in the bankruptcy case of silicone producer Momentive Performance Materials Inc. The opinion focused on two distinct bankruptcy issues that are the subject of frequent debate in the bankruptcy community: (1) determining the proper “cram- down” interest rate for secured creditors in a Chapter 11 case; and (2) whether “make-whole” provisions entitle noteholders to certain premiums even though the underlying credit exten- sion has already been accelerated. On both of these issues, Judge Drain concluded that the debtors’ plan proposals complied with the Bankruptcy Code and other applicable law and ruled (for the most part) against the positions taken by senior creditors.
Of course, the result of the Momentive decision is more profound than the eco- nomic adjustments at stake in this spe- cific bankruptcy case. A decision by a well-regarded bankruptcy judge on hotly- disputed legal issues is always important because the market is likely to take notice and make appropriate pricing adjustments on other deals. The result of this decision, however, may even be greater because it has shifted additional leverage in chapter 11 bankruptcy cases to debtors. Thus, the decision—if allowed to stand—is a loss for secured creditors.
The Momentive debtors were confronted with assertions by senior lenders—the first lien noteholders and the 1.5 lien notehold- ers—that they were entitled to contractual “make-whole” payments, as well as certain interest and other premium payments on their claims. In response, and following months of attempted negotiations, the Momentive debtors created a plan that pro- vided an option for the senior lenders with the following alternatives: (1) vote in favor of the plan and receive prompt payment
in full, in cash but without a make-whole or other premium; or (2) vote against the plan and receive a seven year (or similar) replacement note (in an amount to be de- termined through the make-whole litiga- tion) with interest equal to the treasury rate along with a modest risk premium.
The senior lenders overwhelmingly re- jected the proposed plan. Thus, it was left to the bankruptcy court to determine whether the make-whole provisions were applicable and what interest rate the senior lenders were entitled to under a cram down scenario to satisfy Section 1129(b) (2)’s requirement that a plan be “fair and equitable.” The background and substance of each of the issues addressed by Judge Drain in his Momentive decision is ad- dressed below.
A “make-whole” provision provides premium recoveries to lenders in the event of early repayment. The purpose of make-whole provisions is to ensure that lenders with contractual entitlements to receive interest during the life of a loan
will be compensated for the loss of that in- terest stream if the loan is repaid prior to maturity.
If a borrower files for bankruptcy, however, the maturity dates of any outstanding loans are automatically accelerated. The general rule is that, after acceleration—as distinguished from an early redemption or prepayment—make-whole payments are not contractually applicable unless the contract specifically provides for such payment upon acceleration.
In recent years, make-whole claims have been intensely litigated by lenders and bondholders in cases where the contrac- tual language did not specify whether a premium was due upon a bankruptcy filing or acceleration. In some cases, lenders have pursued make-whole claims even where the relevant language was “unambiguous” that a make-whole would not be payable. For example, in the AMR bankruptcy case, lenders vigorously advo- cated (and appealed to the Second Circuit Court of Appeals) for payment of a make- whole premium where the applicable
FALL 2014 | INTERNATIONAL RESTRUCTURING NEWSWIRE 1
indenture provided that the debt owed upon a voluntary bankruptcy filing was, “for the avoidance of doubt, without make- whole amount.” See In re AMR Corp., 730 F.3d 88, 105 (2d Cir. 2013). The “make- whole mania” has continued in 2014, with make-whole litigation taking center stage in the Energy Future Holdings bankruptcy case, among others.
Judge Drain’s Ruling on Make-Whole Issues
The acceleration provisions in the inden- tures in Momentive provided that, upon a bankruptcy filing, an undefined “premium, if any,” would become due and payable immediately. The bondholders argued, among other things, that the “premium” referred to in the acceleration provi- sions could only mean the make-whole premium. In response, the Momentive debtors argued that the acceleration provi- sions could have used the term “Applicable Premium”—a defined term used elsewhere in the indentures to refer to the make- whole premium—but did not.
Judge Drain ruled that the references in the indentures to “lower case premiums, if any, to be paid” were “not specific enough” to entitle the lenders to make-whole pay- ments. He noted that, under New York law, the indentures would need to be “clear and unambiguous” that the lenders were entitled to the premium “in the event of acceleration or a new maturity set for the debt.” Judge Drain’s decision follows what
seems to be the trend in the case law— denying make-whole payments where the relevant contracts are lacking the requisite explicitness.
Introduction to Cram-Down Interest on Secured Claims Section 1129(b)(2) requires that a plan be “fair and equitable.” For dissenting classes of secured creditors, this means, according to the same subsection of the Bankruptcy Code, that the “the plan provides – (i)(I) that the holders of such claims retain the liens securing such claims . . . to the extent of the allowed amount of such claims; and
(II) that each holder of a claim or such class receive on account of such claim deferred cash payments totaling at least the allowed amount of such claims, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property.” The second sub- jection has been frequently disputed.
Determining the proper rate of inter- est to a secured creditor in a cram down scenario was most notably addressed by the Supreme Court in Till v. SCS Credit Corp., 541 U.S. 465 (2004). The Till case involved a secured creditor who objected to an individual chapter 13 debtor’s pro- posed interest rate for car payments of 9.5%, a rate substantially lower than the 21% subprime rate that was agreed to by the borrower when the loan was originat- ed. While the parties in the case proposed different methodologies to calculate the
interest rate, the Supreme Court rejected most as too complicated, costly, or incor- rectly calculated. The Supreme Court de- termined that the prime-plus formula, an approach which requires an adjustment to the prime national interest rate based on risk of nonpayment, was an appropriate method for determining the cram down rate of interest.
The Supreme Court specifically held that the adjustment under the prime-plus formula will depend on factors such as:
- the estate’s circumstances; (2) the se- curity’s nature; and (3) the reorganization plan’s duration and feasibility. Given that a number of factors should be considered, the Court noted that each side should be able to present evidence as to the calcula- tion of the proposed interest rate.
Importantly, Till involved a chapter 13 proceeding, a type of bankruptcy case which offers protection to individuals, and a different (although somewhat similar) statutory scheme than chapter 11. In ad- dition, the Till decision was a plurality decision—four justices joined the reason- ing of the opinion, one justice concurred with the judgment for a different reason, and four justices dissented. The Court did not speak with “one voice,” as no single approach could obtain a majority of the justices and the opinion was highly criti- cized. In fact, Justice Scalia’s spirited Till dissent warned that the plurality’s ap- proach would “systematically undercom- pensate” creditors, and that it was impos- sible to view the modest risk premium
Judge Drain explained that Till [and Valenti] . . . seek to put the creditor in the same economic position it would have been in had it received the value of its allowed claim immediately. The purpose is not “to put the creditor in the same . . . position that it would have been in had it ar- ranged a ‘new’ loan.” Instead, based upon Till and Valen- ti, the court stated it was to approve a “discount rate that takes the profit out [and] takes the fees out . . .”
(typically 1 - 3% in cases, but 1.5% in Till) as “anything other than a smallish number picked out of a hat.” And the Till plural- ity itself recognized in footnote number 14—which has since been cited by many, if not all arguments in favor of ignoring the Till approach in chapter 11 cases—that the prime-plus approach might not be the perfect methodology for chapter 11 cases, suggesting that courts overseeing those cases might consider an approach for cram down interest that would apply the rate an efficient market would produce.
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Despite the Till decision’s known short- falls, in the ten years that followed the Till ruling, courts frequently continued to use the Till methodology in chapter 11 busi- ness bankruptcy cases.
Judge Drain’s Decision on Applicable Interest
Pursuant to the terms of the Momentive debtors’ plan, it was clear the first prong of the section 1129(b)(2) requirement on “fair and equitable” was satisfied; that is, holders of the first lien notes and the 1.5 lien notes were to retain their liens. Less clear was the whether the second prong requirements on the interest rate was satis- fied. Did the debtors’ proposal to pay de- ferred cash payments over the next 7 years for the first lien notes paid with interest calculated at the 7-year treasury note rate plus 1.5% satisfy the obligation that the creditors receive payments “totaling at least the allowed amount of such claims, of a value, as of the effective date of the plan, of at least the value of such holder’s interest in the estate’s interest in such property”? (A slightly different proposal was made for 1.5 lien notes.) The secured creditors claimed that what they asserted to be below-market rate replacement notes failed to satisfy this standard. Judge Drain ultimately reached a different conclusion.
Judge Drain explained that Till, as well as a Second Circuit (the judicial circuit responsible for New York federal courts) case named In re Valenti, 105 F.3d 55 (2d Cir. 1997) that preceded Till but was cited favorably by the Supreme Court in Till, es- tablished the key principles for a court to follow to establish the appropriate interest rate for a secured creditor claim for cram down purposes. The court explained that these cases seek to put the creditor in the same economic position it would have been in had it received the value of its allowed claim immediately. The purpose is not “to put the creditor in the same . . . position that it would have been in had it arranged a ‘new’ loan.” Instead, based upon Till and Valenti, the court stated it
was to approve a “discount rate that takes the profit out [and] takes the fees out . . . .”
In this case, the secured creditors were arguing that the debtors were required to use a market-tested interest rate, as Till’s footnote 14 suggested. The comparable rate relied on by the secured creditors as appropriate was that proposed for the facility that the debtors had arranged to refinance the secured creditors’ notes if the secured creditors had accepted the buy-out. However, according to Judge Drain, this “coerced” or market-rate ap- proach was not viewed favorably in Till because it overcompensated creditors with profit and cost elements. In fact, Judge Drain concludes that the efficient market referenced by footnote 14 of Till cannot be found in this scenario: “there is no, generally speaking, efficient market that doesn’t violate the first principles of Till and Valenti, which is not to include a profit element or fees and costs, since that is the whole purpose of the market.”
Based on the foregoing, Judge Drain found that the market pricing had little influence over this “fair and equitable” de- termination. Relying on Till and Valenti, Judge Drain concluded that the secured creditor interest rate in a cram down sce- nario should be a risk-free rate increased by a percentage reflecting a risk factor. He found that the base rate could be the trea- sury rate, rather than the prime rate, given that treasury notes are risk-free as the U.S. Government is the obligor. (Interestingly, Judge Drain’s conclusions on the risk- free rate are largely based on the Valenti ruling and do not address the fact that Till approved the prime rate, a rate which inherently includes a risk premium.) The court also concluded that the “risk” premium was not perfectly calculated in the debtors’ proposed plan of reorganiza- tion. However, relatively modest changes (an increase of 0.5%-0.75%, depending on the type of the debt) would be found to be acceptable by the court.
Impact and Takeaways
With respect to the make-whole issues, the Momentive decision marks the first judi- cial interpretation of frequently used in- denture language—the acceleration of an undefined “premium, if any”—that many have suggested is ambiguous. As noted above, make-whole litigation has been a critical aspect of the ongoing Energy Future Holdings (“EFH”) bankruptcy case, and certain of the EFH indentures contain language that is almost identical to the language scrutinized by Judge Drain in Momentive. At the outset of the EFH bank- ruptcy case, the debtors offered to settle those make-whole clams for 50% of the disputed amount, suggesting a view that the contractual language was ambiguous. That settlement was accepted by less than half of the bondholders, with the non- settling holders opting to continue litigat- ing the make-whole dispute. According to some press reports, the relevant EFH bonds traded down approximately 5% after Judge Drain read his opinion.
Perhaps more importantly, Judge Drain’s opinion on cram down interest rates may have shifted substantial case leverage and case economics in the favor of debtors. Secured creditors could be threatened into accepting long term replacement notes that might have current market values that they would consider to be worth less than the full amount of their secured claims. However, this case is not over. The secured lenders in Momentive have appealed Judge Drain’s ruling. n
Douglas Deutsch is a partner in Chadbourne & Parke’s New York Office in the firm’s bankruptcy and financial re- structuring group. Marc Roitman is an associateinChadbourne&Parke’sNewYork office in the firm’s bankruptcy and financial restructuring group.
Update on the Recognition of the
Australian Liquidation of Octaviar: Satisfying the Debtor Eligibility Requirements in a Chapter 15 Case
By Francisco Vazquez
Chapter 15 of the United States Bankruptcy Code provides a procedure by which a United States bankruptcy court may grant recognition to a “foreign proceeding.” A foreign proceed- ing typically includes a foreign insolvency, liquidation, bankruptcy or debt restructuring. The Bankruptcy Code provides that a foreign proceeding shall be recognized if (1) the foreign proceeding is a foreign main or foreign nonmain proceeding, (2) a petition for recognition is filed by a foreign representative, and (3) the petition satisfies certain procedural requirements. Assuming all three requirements are fulfilled, courts have held that recognition should only be denied if it would be “manifestly contrary to the public policy of the United States.”
At the end of last year, the Court of Appeals for the Second Circuit, which in- cludes the Southern District of New York (the most popular federal district court for Chapter 15 case filings), imposed an additional requirement in a case involv- ing Octaviar Administration Pty Ltd., as first reported in our Winter 2014 issue. See Second Circuit Vacates Order Granting Recognition to a Foreign Proceeding, International Restructuring NewsWire at 8 (Winter 2014). In that case, Chadbourne, as counsel to the Australian liquidators of Octaviar, obtained an order from the United States Bankruptcy Court for the Southern District of New York grant- ing recognition to Octaviar’s Australian liquidation. On appeal, however, the Second Circuit vacated the Bankruptcy Court’s order after holding that a foreign debtor must satisfy the same eligibility requirements imposed in Chapter 7 and 11 cases before a foreign proceeding may be granted Chapter 15 recognition. See Drawbridge Special Opportunities Fund
LP v. Barnet (In re Barnet), 737 F.3d 238 (2d Cir. 2013). Until the Second Circuit’s ruling, no court had imposed that require- ment in a Chapter 15 case.
In light of the Second Circuit’s ruling and difficulties associated with obtaining rec- ognitionoftheAustralianliquidationinthe initial Chapter 15 case, Octaviar’s liquida- tors decided to start anew. They transferred funds to the United States, commenced another Chapter 15 case and filed a new request for recognition of the Australian liquidation in that (second) Chapter 15 case. Ultimately, the Bankruptcy Court (once again) concluded that Octaviar was eligible to be a debtor and granted recogni- tion to the Australian liquidation. See In re Octaviar Administration Pty Ltd, 511 B.R.
361 (Bankr. S.D.N.Y. 2014). This article describes the steps taken by Octaviar’s liquidators (and Chadbourne) following the Second Circuit’s decision to ensure that Octaviar fulfilled the debtor eligibility requirements.
Octaviar’s Demise and Liquidation
Octaviar was a member of a group of com- panies known as the “Octaviar Group” that operated a broad range of enterprises, in- cluding a travel and tourism business con- ducted through a collection of companies known as the “Stella Group.” Octaviar’s primary function was to operate the Octaviar Group’s bank accounts, employ staff for the Octaviar Group and act as the Octaviar Group’s treasury.
In January 2008, the Octaviar Group an- nounced its intention to separate the Stella Group from its other businesses. Following this announcement, the share price of the ultimate parent of the Octaviar Group rapidly fell, which led to an event of default under a bridge facility provided by Fortress Credit Corporation (Australia) II Pty Limited. Thereafter, the Octaviar Group sold certain interests in the Stella Group and used the proceeds to repay Fortress in full. Ultimately, Octaviar went
Speeches, Events and Publications
Howard Seife and Francisco Vazquez wrote an article titled “The Octaviar Saga: The Chapter 15 Door Opens, Closes, and then Reopens on the Foreign Representatives,” to be published in the upcoming International Issue of the Norton Journal of Bankruptcy Law and
[T]he Bankruptcy Court found that . . . [t]he debtor eligibility requirement would be satisfied upon a showing of any property in the United States. Thus, because Octaviar had property in the United States as of the filing of the second chapter 15 case, the Bankruptcy Court concluded that Octaviar was eligible to be a debtor under section 109(a).
Practice (expected Fall 2014).
Douglas Deutsch is scheduled to moderate a panel titled “Independent Directors Beware! Corporate Governance Issues in Restructurings, Chapter 11 Cases and Liquidations” at the American Bankruptcy Institute’s winter leadership conference. The conference is to be held in La Quinta, California (December 5, 2014).
Howard Seife is scheduled to speak on cross-border insolvencies at the INSOL International Santias One Day Seminar. The program, for which Mr. Seife is also a panel chair, is to be held in Santiago, Chile (November 20, 2014).
John Verrill is scheduled to speak at INSOL’s Global Insolvency Practice conference in London in a program titled “UK Restructuring Practice on the Ground” (November 11, 2014).
Francisco Vazquez spoke on a panel at the Hispanic National Bar Association’s Annual Convention in Washington, D.C. in a program titled “Las America en Quiebra: Comparisons of Bankruptcy Systems in the Americas and How They Interact” (September 11, 2014).
Douglas Deutsch was elected to the executive board of the American Bankruptcy Institute as a member-at-large.
CONTINUED ON PAGE 13
into liquidation in Australia and liquida- tors were appointed.
Liquidators Commence the Initial Chapter 15 Case
Following their appointment, Octaviar’s liquidators commenced litigation in Australia to recover certain amounts paid by the Octaviar Group to Fortress. In ad- dition, the liquidators investigated poten- tial claims related to the transaction with Fortress that could be asserted against entities related to Fortress in the United States, including Drawbridge Special Opportunities Fund LP.
Octaviar’s liquidators commenced the initial Chapter 15 case to, among other things, facilitate a further investigation of claims in the United States and to preserve these claims for the benefit of all creditors. Over the objection of Drawbridge, the Bankruptcy Court granted recognition to the Australian liquidation. On appeal, as noted above and in our Winter issue, the Second Circuit concluded that recognition of the Australian liquidation was depen- dent on, among other things, a showing by the liquidators that Octaviar satisfied the debtor eligibility requirements found in section 109(a) of the Bankruptcy Code that apply to debtors in Chapter 7 or 11 cases. Because the liquidators had not at- tempted to demonstrate that Octaviar sat- isfied the debtor eligibility requirements, the Second Circuit remanded the matter to the Bankruptcy Court. Octaviar’s liq- uidators decided not to appeal the Second Circuit’s decision.
Liquidators Commence a
Second Chapter 15 Case
An entity with property in the United States is generally eligible to be a debtor under the Bankruptcy Code. Although not considered by the Second Circuit, Octaviar’s liquidators had maintained that Octaviar had property in the United States, as of the filing of the initial Chapter 15 case, in the form of claims and causes of action against Drawbridge and other persons and entities. According to some courts, including the federal courts in New York, the location of intangible assets, such as claims, may vary depending on the circumstances. While Octaviar’s liquida- tors could have relied solely on this asset to allege that Octaviar fulfilled the debtor eligibility requirements, they decided to bolster their position.
After the Second Circuit issued its ruling, Octaviar’s liquidators transferred funds to the United States. Thereafter, recogniz- ing that there is no prohibition against multiple Chapter 15 filings by a foreign representative, Octaviar’s liquidators com- menced a new Chapter 15 case. Following the commencement of the second Chapter 15 case, Octaviar’s liquidators filed com- plaints against Drawbridge in state and federal courts in New York.
Drawbridge again objected to recogni- tion on the grounds that Octaviar did not meet section 109(a)’s debtor eligibility requirements. According to Drawbridge, Octaviar’s intangible claims and causes of action against Drawbridge were not prop- erty for purposes of section 109(a) and,
even if they were, they were located where Octaviar resides (i.e., Australia) and not the United States. Thus, Drawbridge argued that the claims and causes of action could not satisfy section 109(a)’s eligibil- ity requirements. In addition, Drawbridge asserted that the date of commencement of Octaviar’s first Chapter 15 case was the appropriate date for determining Octaviar’s eligibility to be a debtor. If Drawbridge was correct on this last point, the transfer of funds to the United States on the eve of the second Chapter 15 case filing would have rendered the consider- ation of such funds’ location irrelevant to the eligibility analysis.
The Causes of Action are Located in the United States At the outset, the Bankruptcy Court con- cluded that a claim or cause of action is, as a matter of New York law, “property” and may satisfy section 109(a)’s eligibil- ity requirements as long as it is located in the United States. Relying principally on the bankruptcy court’s decision in In re Fairfield Sentry Ltd., 484 B.R. 615 (Bankr.
S.D.N.Y. 2013), which decision was initial- ly affirmed by the district court, but there- after reversed by the Second Circuit (see 2014 WL 4783370 (2d Cir. Sept. 26, 014)),
Drawbridge argued that claims are located where the plaintiff is domiciled. Because Octaviar is incorporated in Australia, all of the claims asserted by Octaviar’s liq- uidators were, according to Drawbridge, located in Australia.
The Bankruptcy Court rejected Drawbridge’s approach and concluded that the location of a claim may differ depend- ing on the issue before a court. Unlike the claims in dispute in Fairfield Sentry, the claims in Octaviar’s chapter 15 case were United States-centric in that they were based on U.S. law, asserted against defen- dants located in the United States, and in- volved allegations of wrongful transfers of funds to the United States. Indeed, none of the defendants in the New York litigation were defendants in the Australian litiga- tion. Additionally, the Bankruptcy Court concluded that a claim may be located wherever a court has both personal juris- diction over the defendants and subject
matter over the claim. In this instance, courts located in New York had person- al jurisdiction over the defendants and subject matter jurisdiction over Octaviar’s claims. Accordingly, the Bankruptcy Court concluded that the claims were located in New York and that Octaviar was eligible to be a debtor under section 109(a).
Satisfy Section 109(a)’s
In the chapter 11 context, courts have reg- ularly held that funds in the United States would satisfy section 109(a)’s eligibility re- quirements. As noted above, prior to filing the second Chapter 15 case, Octaviar’s liq- uidators transferred certain funds to the United States to be held as a retainer by their United States counsel. Drawbridge did not contest that a retainer can satisfy section 109(a)’s eligibility requirements. Instead, Drawbridge argued that the funds in this instance should not be considered because they were the result of a bad faith and improper attempt to “manufacture eligibility” and evade the consequences of the Second Circuit’s decision regarding Octaviar’s first Chapter 15 case filing.
The Bankruptcy Court rejected Drawbridge’s contention, finding no evi- dence of bad faith. Indeed, the liquida- tors’ steps to bolster Octaviar’s assets in the United States on the eve of the second chapter 15 filing were consistent with the actions often taken by debtors in chapter 11 cases. Moreover, the Bankruptcy Court noted that the Second Circuit used a “plain meaning” approach in analyzing the applicability of the debtor eligibility re- quirements to Chapter 15 cases. Invoking that same plain meaning approach, the Bankruptcy Court found that it need not inquire into the circumstances resulting in property being found in the United States or the amount of such property. The debtor eligibility requirement would be satisfied upon a showing of any prop- erty in the United States. Thus, because Octaviar had property in the United States as of the filing of the second chapter 15 case, the Bankruptcy Court concluded that Octaviar was eligible to be a debtor under section 109(a). Having found that the
foreign representatives had satisfied all of Chapter 15’s requirements, the Bankruptcy Court granted recognition to Octaviar’s Australian liquidation in its second Chapter 15 case. Drawbridge did not appeal the Bankruptcy Court’s decision.
Eligibility Requirement is not an Insurmountable Hurdle Recognition under Chapter 15 can be criti- cal to the success of a foreign proceeding. Upon recognition of a foreign proceeding, a foreign representative, such as Octaviar’s liquidators, is granted the capacity to sue in the United States. Absent recognition, a foreign representative may be preclud- ed from bringing litigation in the United States. An objection to recognition may therefore be motivated, in part, by a desire to hinder the ability of foreign representa- tives to pursue claims in the United States.
In an appeal from the Bankruptcy Court’s order granting recognition to Octaviar’s liquidation in the first Chapter 15 case filing, the Second Circuit imposed a new requirement on recognition of a foreign proceeding. That requirement has not, to date, been adopted by any court outside the Second Circuit and, indeed, as noted in the Winter 2014 issue of the NewsWire, was rejected by the United States Bankruptcy Court for the District of Delaware soon after the Second Circuit’s decision was issued. The Delaware bank- ruptcy court further stated that the Court of Appeals for the Third Circuit would likely reject the Second Circuit’s conclu- sion. Nevertheless, until Congress amends the Bankruptcy Code or the Supreme Court addresses the issue, a foreign debtor that is the subject of a Chapter 15 case in the Second Circuit must satisfy section 109(a)’s eligibility requirements before its foreign proceeding may be recognized. As the process described above demonstrates, this should not be a difficult task in most instances. Foreign representatives should be encouraged by the Bankruptcy Court’s recent decision. n
Francisco Vazquez is counsel in Chadbourne
& Parke’s New York Office in the firm’s bank- ruptcy and financial restructuring group.
An Introduction to Puerto Rico’s New
Public Corporation Debt Enforcement and Recovery Act
By Eric Daucher
Puerto Rico recently shook up the restructuring world with a new law that would allow many of its bankruptcy-ineligible public corporations to restructure their debts without using the US Bankruptcy Code. The Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”)—as Puerto Rico’s new restructuring legislation is euphemistically named—was almost im- mediately challenged in federal court on the grounds that it violates several provisions of the US and Puerto Rico constitutions. This article provides readers with a brief overview of the Recovery Act, discusses the bases for the challenges to the Recovery Act, and addresses the current status of the Recovery Act and its legal challenges. (Additional information on the Recovery Act can be found in this issue in the article titled Q&A: Puerto Rico’s Public Corporation Debt Enforcement and Recovery Act, at page 9.)
Two Paths to Restructure Debts of Puerto Rico’s Public Corporations
Broadly speaking, the Recovery Act con- tains one general chapter of definitions and jurisdictional and procedural matters followed by two operative chapters that provide distinct tools through which Puerto Rico’s eligible public corpora- tions can restructure their debts. These restructuring tools—referred to simply as “Chapter 2” and “Chapter 3”—differ signif- icantly in character both from each other, and from the US Bankruptcy Code.
Entities eligible for relief under the act include all departments, agen- cies, districts, or instrumentalities of the Commonwealth of Puerto Rico, ex- cluding the Commonwealth itself, the Commonwealth’s 78 municipalities, and certain enumerated entities. Before a public corporation can seek relief under either Chapter of the Recovery Act, it must obtain the approval of Puerto Rico’s
Government Development Bank (the “GDB”), the entity tasked with oversee- ing Puerto Rico’s public corporations (and which itself is excluded from being a debtor under the Recovery Act).
Chapter 2 of the Recovery Act Chapter 2 is a targeted restructuring tool. A debtor may pick-and-choose classes of “affected debt instruments” that it wishes to restructure. Once the debtor identifies the obligations that it wishes to restructure and obtains all necessary approvals (in- cluding approval from the GDB), it begins the Chapter 2 process by posting a notice on its website indicating that a “suspen- sion period” (akin to the US Bankruptcy Code’s automatic stay) has begun with respect to the affected debt instruments that it wishes to restructure. The debtor may then propose one or more “consensu- al debt relief transactions” with respect to those affected debt instruments. The pro- posed consensual debt relief transactions may, subject to certain limitations, provide
for almost any modification to the affected debt instruments, including extension of maturity, reduction of interest rate, or for- giveness of principle (or any combination of these modifications).
Although a Chapter 2 restructuring is pur- portedly “consensual,” it becomes effec- tive and binding on all holders of a class of affected debt instruments if (a) holders of at least 50% of the debt in the class par- ticipate in a vote on the consensual debt relief transaction and (b) at least 75% of those participating in the vote approve the consensual debt relief transaction. Thus, a purportedly “consensual” restructur- ing of a class of affected debt instruments can be accomplished with the approval of creditors holding as little as 37.5% of those affected debt instruments (50% x 75%=37.5%). This is a far cry from the 100% consent normally required outside of a formal bankruptcy case for significant changes to debt instruments.
Chapter 3 of the Recovery Act Chapter 3 provides for a restructuring that far more closely resembles a conventional Chapter 9 or Chapter 11 bankruptcy case, but includes significant differences. A Chapter 3 case begins when a petition is filed with a specifically designated Puerto Rico commonwealth court created for the purpose of overseeing Recovery Act cases. As is typical for a case filed under the US Bankruptcy Code, the filing of a Chapter 3 petition under the Recovery Act gives rise to a global automatic stay. The Recovery Act’s automatic stay, however, is even broader than the auto- matic stay created by the US Bankruptcy Code—it protects not only the debtor, but also certain enumerated affiliates of the debtor. As in a case under Chapter 9 of the US Bankruptcy Code, after a Chapter 3 case is filed the court will hold a hearing to determine whether the debtor is eligi- ble for Chapter 3 relief. Again, like a mu- nicipal debtor under the US Bankruptcy Code’s Chapter 9, a would-be Chapter 3 debtor must establish that it is insolvent as a precondition for eligibility.
Once it has been declared eligible for Chapter 3 relief, a debtor can restructure its debts through one of two means: (a) a “plan” (quite similar to a plan of ad- justment under Chapter 9 or a planned reorganization under Chapter 11 of the US Bankruptcy Code) or (b) by selling its assets and filing a “statement of alloca- tion” as to how the sale proceeds are to be distributed.
Standards for plan confirmation are similar, although not identical, to US Bankruptcy Code standards. For example, as with a cramdown plan under the US Bankruptcy Code, a Chapter 3 plan must be approved by at least one class of affected debt. Class approval in Chapter 3—unlike Recovery Act Chapter 2 provisions—tracks the US Bankruptcy Code standard and re- quires that a majority of voting creditors and at least two thirds by outstanding debt amount of voting creditors vote in favor of the plan. Thus, in Chapter 3, and as in a cramdown plan under US Bankruptcy Code Chapter 9 or Chapter 11, a class of debt may become subject to a binding plan even if no creditor in that class votes to accept the plan as long as at least one im- paired class does accept the plan.
In contrast, the Recovery Act’s Chapter 3 asset sale/allocation statement process differs significantly from US Bankruptcy Code practice regarding asset sales and the resulting disposition of sale proceeds. Under Chapter 3, if the asset sale route is pursued, no plan is required. Instead, if an asset sale is approved by the Puerto Rico court, the debtor simply files an allocation statement setting forth what it believes to be the appropriate disposition of the sale proceeds. Creditors are given 30 days to raise objections to the debtor’s allocation statement. Once the court rules on those objections, the debtor is required to file an amended allocation statement that is con- sistent with the court’s rulings. Thereafter, creditors have 14 days to file objections to the amended allocation statement, but may
only object on the basis that the amended allocation statement does not accurately reflect the court’s rulings on the previ- ously filed objections. Once all objections to the amended allocation statement are resolved, the sale proceeds are distributed accordingly. A debtor may also choose to employ a combination of the plan and sale/ allocation statement processes if not all of the debtor’s assets are disposed of through asset sales.
One important point to note is that the Recovery Act provides much weaker pro- tections for pledged “special revenues” that would be available in an analogous case under Chapter 9 of the US Bankruptcy Code. In Chapter 9, pledged special rev- enues—meaning revenues derived from a particular source associated with a debtor municipality and that are pledged as security for debt instruments—are es- sentially sacrosanct, and have never been nonconsensually impaired in a Chapter 9 bankruptcy case. In contrast, the Recovery Act readily permits impairment of debt secured by such revenues.
Other Features of the Recovery Act The Recovery Act also contains a variety of other features and restructuring tools that echo portions of the US Bankruptcy Code, including:
- the formation of a creditors’ commit- tee (applies only in Chapter 3 cases, and provides far more limited rights than those that exist under the US Bankruptcy Code);
- voiding contractual “ipso facto” claus- es—i.e., contractual provisions that
In Chapter 9, pledged special revenues—meaning
revenues derived from a particular source associated with a debtor municipality and that are pledged as security
for debt instruments—are essentially sacrosanct, and have never been nonconsensually impaired in a Chapter 9 bankruptcy case. In contrast, the Recovery Act readily permits impairment of debt secured by such revenues.
would change or eliminate a debtor’s contractual rights simply by virtue of the debtor commencing a case under the Recovery Act (Chapter 2 and Chapter 3);
- rejection of unfavorable contracts by the debtor (applies only in Chapter 3 cases, but not limited to “executory contracts”—i.e., contracts under which both parties still have outstanding obligations that they are required to perform—as is the case under the US Bankruptcy Code); and
Q&A: Puerto Rico’s Public Corporation Debt Enforcement and Recovery Act
Three members of Chadbourne’s Bankruptcy and Financial Restructuring Group—Lawrence A. Larose, Christy Rivera and Eric Daucher—presented a webinar on the details of Puerto Rico’s Public Corporation Debt Enforcement and Recovery Act (the “Recovery Act”) and the status of the surrounding litigation as it existed at that time. This article is intended to provide the reader with brief answers to some of the questions raised by the webinar audience.
Q: Does the US Bankruptcy Code supersede the Recovery Act? A: Pursuant to the “Supremacy Clause” of the US Constitution, to the extent that the US Bankruptcy Code and the Recovery Act directly conflict, the US Bankruptcy Code would super- sede the Recovery Act. However, it is not necessarily true that the Recovery Act and the US Bankruptcy Code directly con- flict. Certain PREPA bondholders challenging the Recovery Act have argued that section 903 of the US Bankruptcy Code was intended to prevent US states and territories (including Puerto Rico) from enacting local bankruptcy legislation such as the Recovery Act. (Essentially, section 903 provides that US states cannot enact municipal restructuring laws that bind nonconsenting creditors.) Puerto Rico has responded to this claim with a variety of arguments, including that because Puerto Rico is not a state and its instrumentalities are not eligible to file for Chapter 9 relief, section 903 does not limit its ability to enact local bankruptcy legislation to provide debt relief to Chapter 9-inelligible instrumentalities.
Q: A would-be debtor is only eligible for relief under Chapter 3 of the Recovery Act if it is “insolvent.” What is the test for determining insolvency under the Recovery Act?
A: There are two closely related tests for insolvency under the Recovery Act. A public corporation is insolvent if either it (a) is currently unable to pay valid debts as they mature while continuing to perform its public functions or (b) will be unable, or will be at serious risk of being unable, to pay its valid debts as they mature while continuing to perform public functions without further legislative acts or finan- cial assistance from the Commonwealth or Puerto Rico’s Government Development Bank (the “GDB”), the entity tasked with overseeing Puerto Rico’s public corporations.
Q: Avoidance actions, meaning lawsuits to avoid and unwind certain transactions of a debtor (often referred to in the press as “clawback” actions), are frequently pros- ecuted in connection with cases under the US Bankruptcy Code. Can avoidance actions be prosecuted in connection with a case filed under the Recovery Act?
A: Avoidance actions are (purportedly) virtually elimi- nated when a case under the Recovery Act is commenced. There are three primary types of avoidance actions: (a) actual fraudulent conveyance claims (where a transfer is made with the intent to hinder creditors); (b) constructive fraudulent conveyance claims (where a transfer is made by a
financially-distressed entity for less than fair consideration or reasonably equivalent value); and (c) preference claims (where a creditor is paid shortly before a bankruptcy or in- solvency filing in an amount that would allow the creditor to receive more than it would through the formal bank- ruptcy or insolvency process). The Recovery Act specifies that preference claims and constructive fraudulent convey- ance claims may not be prosecuted once a case under the Recovery Act is commenced. Actual fraudulent conveyance actions are preserved under the Recovery Act, but can only be prosecuted by the Commonwealth of Puerto Rico (albeit for the benefit of creditors who would normally be entitled to bring such claims). This is true regardless of the law under which the avoidance action arises. For example, if New York Debtor Creditor Law provided creditors with the right to sue one of Puerto Rico’s public corporations in New York state court for a constructive fraudulent transfer, the Recovery Act would (purportedly) abolish that right upon a Chapter 2 or Chapter 3 filing by that public corporation.
Q: Power Purchase Agreements (“PPAs”) are typically long term agreements under which a supplier of electri- cal power agrees to sell that electrical power to a particu- lar buyer on specified terms. PPAs are widely used by the Puerto Rico Electric Power Authority (“PREPA”), which until recently was expected to file for relief under the Recovery Act imminently. Are PPAs considered “debt” for purposes of the Recovery Act?
A: It is possible that PPAs could be considered debt for pur- poses of the Recovery Act. The Recovery Act defines “debt instruments” to include, among other things, essentially any agreement related to a “forward contract.” PPAs are general- ly considered forward contracts (although the term “forward contract” is not itself defined by the Recovery Act). Because the US Bankruptcy Code provides forward contracts with certain heightened protections (including protections under certain of the US Bankruptcy Code’s “safe harbor” provi- sions), most PPAs explicitly state that they should be consid- ered forward contracts. However, because the Recovery Act has never been tested, it is not certain how the Act’s language will be interpreted with respect to PPAs.
Q: Can cash collateral (i.e., cash that is held by a debtor but pledged to secure payment of a particular obligation or group of obligations) that is specifically tied to a class
of existing debt be used to pay other classes of debt under the Recovery Act?
A: Yes, under certain circumstances. The Recovery Act contains significantly weaker protections for cash collat- eral than does the US Bankruptcy Code and, in certain in- stances, would seemingly permit cash collateral to be used to satisfy debt other than the debt for which it is pledged as security. This is a significant ground on which the constitu- tionality of the Recovery Act is being challenged. In particu- lar, cash collateral linked to revenue bonds (i.e., bonds that are secured by, and paid from a specific source of revenues, such as PREPA’s electric services revenue bonds) appear to be particularly vulnerable under the Recovery Act. This vul- nerability is noteworthy because revenue bonds (and related cash collateral) receive extraordinarily strong protection in a case under Chapter 9 of the US Bankruptcy Code.
Q: Can a US federal court enjoin a Chapter 3 case pending in a Puerto Rico Commonwealth court while constitution- al challenges to the Recovery Act are being considered by that federal court?
A: Yes, it is possible that a US federal court hearing constitu- tional challenges to the Recovery Act could enjoin a Chapter 3 case pending in a Puerto Rico Commonwealth court. This is not to suggest that such an injunction would be granted if requested, as there would likely be significant arguments
both for and against the imposition of such an injunction. We would expect that litigation over whether a federal court should preliminarily enjoin a pending Chapter 3 case would be hotly contested and would provide the prevailing party with significant case leverage.
Q: Would the automatic stay arising in a Chapter 3 Recovery Act case filed by a primary obligor prevent a creditor from pursuing a guaranty claim against the GDB (which would not be a debtor)?
A: Yes. The automatic stay under Chapter 3 of the Recovery Act is broader than the US Bankruptcy Code’s automatic stay. It prohibits collection against not only the primary obligor, but also against certain related “enumerated entities” (which include the GDB) if the debt could have been asserted against such enumerated entities prior to the commencement of the case. Accordingly, provided that the primary obligor (the debtor) listed the GDB-guaranteed obligation on its sched- ules of debt to be potentially affected in the case, the Chapter 3 automatic stay would prevent a creditor from pursuing a guaranty claim against the GDB.
Chadbourne is continuing to closely monitor developments in Puerto Rico and will periodically update readers on such de- velopments through either future issues of the NewsWire or Chadbourne’s bankruptcy blog (www.zoneofinsolvencyblog.com).
- the ability to obtain new financing, including financing that non-consen- sually primes existing liens (applies in both Chapter 2 and Chapter 3 cases).
to the Recovery Act
Almost immediately after the Recovery Act was signed into law, certain holders of bonds issued by the Puerto Rico Electric Power Authority (“PREPA”)—which was at the time widely expected to be the first of Puerto Rico’s public corporations to seek relief under the Recovery Act—filed a lawsuit in federal court challenging the Recovery Act as unconstitutional. These bondholders argued, among other things, that the Recovery Act violates: (a) the U.S. Constitution’s “Bankruptcy Clause”; (b) the U.S. Constitution’s “Contracts Clause”;
(c) the U.S. Constitution’s “Takings Clause”; and (d) creditors’ right to access federal court. A matter of weeks later,
a second group of bondholders filed a similar suit (the two suits have since been consolidated).
As expected, the Commonwealth of Puerto Rico and the other governmental parties named in the suits have raised a variety of arguments in defense of the constitution- ality of the Recovery Act. Perhaps the most significant defense at this stage is their claim that the challenges to the Recovery Act are not ripe for adjudication.
As a general rule, US federal courts cannot adjudicate a suit based on a specu- lative future harm that may or may not occur. Because neither PREPA nor any other Puerto Rico public corporation has sought relief under the Recovery Act, the questions raised by the PREPA bondhold- ers’ suits are, at this stage, largely specula- tive. Given the speculative nature of the disputes, and the related uncertain treat- ment of these lawsuits by the US federal
courts, a compromise was soon reached between PREPA and certain of its major creditors. The parties agreed to, among other things, the appointment of a chief restructuring officer for PREPA in ex- change for a debt forbearance through March 31, 2015. Consequently, it does not appear that the Recovery Act’s provisions will be tested imminently. Nevertheless, the Recovery Act’s mere existence will likely continue to be used as leverage in negotiations between Puerto Rico’s public corporations (including PREPA) and their creditors, particularly if the preemptive litigation challenging the Recovery Act is dismissed. n
Eric Daucher is an associate in Chadbourne
& Parke’s New York Office in the firm’s bank- ruptcy and financial restructuring group.
UK Supreme Court Modernizes
Agent’s Duty to Account
By John Verrill
Since at least 1880, the English courts have grappled with the scope of the agent’s duty to account to his principal. Opinion divided in the last century over whether monies received by an agent unlawfully were impressed with a remedial constructive trust for the benefit of the principal, or whether the agent had a duty to account as a fiduciary. In the latter instance, the property (more often than not a secret commission) did not form part of the agent’s bank- ruptcy estate. This issue was recently brought before the UK Supreme Court in the case of Cedar v. Fairmont.
Cedar v. Fairmount
In Cedar v. Fairmont, FHR European Ventures LLP & Ors v. Cedar Capital Partners LLC  UKSC 45, Cedar was Fairmont’s agent in negotiating the pur- chase by Fairmont of the Monte Carlo Grand Hotel in Monaco. Cedar had also entered into a brokerage agreement with the seller under which Cedar received a commission of €10 million on closing of the deal. Cedar did not make full disclo- sure of the commission arrangement to Fairmont. Ultimately, Fairmont sued and sought disgorgement of the commission from Cedar on equitable principles.
In the High Court (the trial court), the holding was that Cedar was liable to Fairmont, but Fairmont was denied a pro- prietary remedy in respect of the money. On appeal to the Court of Appeal, Cedar was held liable to Fairmont on construc- tive trust principles. Cedar appealed to the UK Supreme Court.
As noted, the UK Supreme Court was not addressing the issue on a clean slate. There were two Court of Appeal cases from the 19th century that were binding on the High Court and the Court of Appeals: Metropolitan Bank v. Heiron (1880) 5 Ex D
319 and Lister & Co v. Stubbs (1890) 45 Ch D 1. These cases held that, when a princi- pal had a claim for equitable compensation in respect of a bribe or secret commission paid to his agent, he had no proprietary in- terest in the receipt of money in breach of duty. However, more recent rulings were not fully consistent with the earlier rulings.
The Privy Council (the House of Lords, now the UK Supreme Court – sitting as the highest court in the Commonwealth) disapproved of Heiron and Lister and had held in AG for Hong Kong v. Reid  1
A.C. 324 that bribes received by a corrupt policeman were held on trust for his prin- cipal. In contrast, in Sinclair Investments Ltd v. Versailles Trade Finance Limited  Ch. 453, the Court of Appeals (the panel including Lord Neuberger MR – as he then was – who gave the judgment of the Supreme Court in this case as its President) had decided that its ruling should follow Heiron and Lister.
The UK Supreme Court has now held in Cedar that policy favours the imposition of a proprietary interest in the unlawful commission and disapproved of Heiron and Lister. Two 130 year old decisions have been overturned on the following bases:
- the proprietary interest is consistent with the principles of the law of agency, and the “duty of undivided loyalty” owed by an agent;
- that this approach (referred to as the “Rule” by the UK Supreme Court) applies to all unauthorized benefits an agent receives, thus providing simplic- ity, clarity and certainty in the law;
- it would be paradoxical if a principal whose agent wrongly received a bribe or secret commission was worse off than a principal whose agent obtains a benefit in far less opprobrious circum- stances; and
- whilst prejudice to the agent’s unse- cured creditors may be an attractive reason for not imposing a proprietary interest, that argument had limited force in the context of a bribe or secret commission. Prejudice to creditors was balanced by the fact that it appeared to be just that a principal whose agent has obtained a bribe or secret commission should be able to reach into the pockets of those receiving with knowledge of the secret benefit.
Put simply, if an expensive watch is handed secretly to an agent to bribe that agent, it is owned not by the agent, but by the principal. The same applies to cash payments or other goods handed as bribes in specie.
CONTINUED FROM PAGE 6
Speeches, Events and Publications
Howard Seife spoke at the New York University School of Law/American Bankruptcy Institute’s 40th Annual Lawrence P. King and Charles Seligson Workshop on Bankruptcy
& Business Reorganization in New York City. The panel was a case study of the Residential Capital bankruptcy
According to the UK Supreme Court: “The agent’s duty is … to deliver up to his prin- cipal the benefit which he has obtained, and not simply to pay compensation for having obtained it in excess of his author- ity. The only way that legal effect can be given to an obligation to deliver up specific property to the principal is by treating the principal as specifically entitled to it.”
Conclusions and Takeaways Put simply, if an expensive watch is handed secretly to an agent to bribe that agent, it is owned not by the agent, but by the princi- pal. The same applies to cash payments or other goods handed as bribes in specie.
Other Common Law jurisdictions around the world have over time embraced the rule that benefits obtained by a fiduciary in breach of his duties are owned by the principal. Thus, the UK Supreme Court opinion is not surprising in at least one respect: it is clearly “highly desirable for all [common law] jurisdictions to learn from each other, and at least to lean in favour of harmonising the development of the common law round the world.” n
John Verrill is a partner in Chadbourne & Parke’s London Office in the firm’s bankrupt- cy and financial restructuring group.
(September 17, 2014).
Douglas E. Deutsch was selected as a member of the Committee on Bankruptcy Reorganization of the New York City Bar. n
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