In Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd.,1 the United States Bankruptcy Court for the Southern District of New York refused to allow the foreign representatives of two Bear Stearns funds2 to institute ancillary proceedings under new chapter 15 of the United States Bankruptcy Code. There, Judge Lifland held that, even though the Funds were in liquidation proceedings in the Cayman Islands, those proceedings constituted neither “foreign main” nor “foreign non-main” proceedings for purposes of the U.S. cross-border insolvency provisions, and, so, would not be recognized by the Court. Although no objection was lodged, the Court refused to “rubber- stamp” the application for chapter 15 relief, finding that the Funds were nothing more than a mail-drop in the Cayman Islands. The Court noted that relief may nevertheless be available under chapter 7 or 11 of the Bankruptcy Code.

If upheld on appeal3 and followed by other courts, this decision suggests that funds registered in foreign jurisdictions, but conducting no business there, can no longer rely on the U.S. Bankruptcy Court to assist in their liquidation under the law of the foreign jurisdiction. Instead, investors in and creditors of similar funds registered in foreign jurisdictions may face increased delay and costs as a result of having to commence full bankruptcy cases in both the United States and their nominal “home” jurisdiction.

The Funds

The Funds were each incorporated as exempted limited liability companies registered in the Cayman Islands. Deloitte & Touche in the Cayman Islands audited the Funds, and had approved the Funds’ most recently audited financial statements.

The operational activities of the Funds, however, were assigned to companies conducting business in many other locations. A Massachusetts corporation, PFPC Inc. (Delaware) (the “Administrator”), provided daily administrative services to the Funds, and served as the registrar and transfer agent for the Funds. The Funds’ books and records were stored and maintained in Delaware by the same Administrator. The investor register was held in Dublin, Ireland by an affiliate of the Administrator. The Funds’ financial assets were located in New York, and Bear Stearns Asset Management Inc. managed these assets.

Poor performance first plagued one of the Funds in early 2007. Then, by late May 2007, amidst the volatility of the sub-prime lending market, both Funds were suffering from a material devaluation of their asset portfolios. Unable to meet margin calls, the Funds began to receive default notices, and creditors started to seize and liquidate the Funds’ assets.

On July 30, 2007, the boards of directors of the respective Funds passed resolutions authorizing the Funds to file petitions under the Companies Law of the Cayman Islands. Thereafter, the petitions were filed seeking authority to wind up the Funds and the appointment of joint provisional liquidators (the “Petitioners”). The Cayman Grand Court appointed the Petitioners on July 31, 2007.4 On this date, the Petitioners also filed chapter 15 petitions for the Funds in the United States Bankruptcy Court for the Southern District of New York.

Chapter 15

In 2005, Congress enacted sweeping amendments to the United States Bankruptcy Code. Although most attention in the popular media has been focused on the changes to the consumer bankruptcy provisions, an important part of the amendments was the creation of a new chapter in the Bankruptcy Code, chapter 15, to address cross-border insolvency cases. Judge Lifland, together with Daniel Glosband and Jay Lawrence Westbrook, were some of the primary drafters of chapter 15, as Judge Lifland notes in his opinion.

The goal of chapter 15 is to establish effective mechanisms for dealing with cross-border insolvency cases so as to provide greater legal certainty for trade and investment and enhance fair and efficient administration of trans-national cases. Instead of filing a chapter 11 or chapter 7 bankruptcy in the United States, which would be potentially duplicative of (or even in conflict with) the insolvency proceedings in the foreign jurisdiction, the foreign representative appointed in the foreign insolvency proceeding may file a petition for recognition of the foreign proceeding, commencing an ancillary case under chapter 15 of the Bankruptcy Code.

Chapter 15 contemplates two different types of foreign proceedings: foreign main proceedings and foreign non-main proceedings. The type of foreign proceeding may determine the relief granted to the foreign representative in the ancillary proceeding.

If a proceeding is a foreign main proceeding, certain relief is automatic, such as the imposition of the automatic stay to protect assets, as well as the right of the foreign representative to operate the debtor’s business and to use, sell or lease property in the United States. In addition, the foreign representative may also utilize certain discretionary relief with the court’s permission, such as obtaining injunctive relief beyond the stay and examining witnesses in connection with the administration of the debtor’s assets. To be able to proceed as a foreign main proceeding, the foreign insolvency proceeding must be commenced in the jurisdiction of the debtor’s “center of main interests.” Notably, the Bankruptcy Code provides that, in the absence of evidence to the contrary, the debtor’s registered office is presumed to be its center of main interests.5

The alternative to a foreign main proceeding is a foreign non-main proceeding. Under a foreign non-main proceeding, the foreign representative must petition the bankruptcy court for the specific relief sought. There is no automatic stay upon recognition of a foreign non-main proceeding. To be recognized as a foreign nonmain proceeding, the debtor must have an “establishment” in the country where the foreign insolvency proceeding is pending. The Bankruptcy Code defines an establishment as “any place of operations where the debtor carries out a nontransitory economic activity.”6

Petition for Recognition

The Petitioners filed petitions for recognition for the Funds under chapter 15 of the Bankruptcy Code. Although not stated explicitly in the case, one can presume that Petitioners sought to proceed under chapter 15, rather than under chapter 11 or chapter 7 of the Bankruptcy Code, because important tax treatment of the Funds might otherwise be jeopardized, and commencing full bankruptcy cases under those chapters would likely be more cumbersome, time-consuming and expensive. By proceeding under chapter 15, the Cayman Islands courts would remain in control of the liquidation, but the Funds could use select provisions of the U.S. Bankruptcy Code to liquidate their U.S.- located assets through a more streamlined process.

The Petitioners argued that the Cayman Islands liquidation proceedings should be recognized as foreign main proceedings,7 which would entitle them to broad protections under chapter 15 of the Bankruptcy Code. Section 1502(4) defines “foreign main proceeding” as a proceeding “pending in the country where the debtor has the center of its main interests.”8 Petitioners argued that because the Funds were registered in the Cayman Islands, that constituted their center of main interests.

Alternatively, the Petitioners argued that the Cayman Islands proceedings should be recognized as foreign non-main proceedings, pursuant to section 1502(5). To fulfill this requirement, the Funds must have proceedings pending in the country where they conduct non-transitory economic activity. 9

The Court first turned to the question of whether the Cayman Islands was, in fact, the center of the Funds’ main interests such that the proceedings could be foreign main proceedings. Pursuant to section 1516(c) and, in the absence of evidence to the contrary, the location of the debtor’s registered office is presumed to be its main center of interest.10 Although no party objected to the Petitioners’ request for recognition as a foreign main proceeding, or presented contrary evidence, the Court engaged in its own factual finding and concluded that this presumption had been rebutted by the Petitioners’ own filings. The Court found that the evidence submitted in support of the chapter 15 petitions showed that the “only adhesive connection” between the Funds and the Cayman Islands was that the Funds were registered there.11 Indeed, the petitions explicitly stated that the Funds were administered by a Massachusetts company, and that the investment manager, the books and records, the employees and managers, and the liquid assets were all located in jurisdictions other than the Cayman Islands.

In analyzing what constitutes the debtor’s main center of interest, the Court commented that it is usually equated with the place where the company’s principal place of business can be found. This was to be distinguished from “a ‘letterbox’ company not carrying out any business in the territory of the foreign jurisdiction in which its registered office is situated.”12 In the case of the Funds, the United States was the real center of its main interests because the Funds administered their business on a regular basis in the United States and such activities were ascertainable by third parties.13 The Court thus found that the Cayman Islands were not the Funds’ center of main interest.

The Court then proceeded to analyze and reject Petitioners’ alternative request for recognition of the Cayman Islands liquidation proceedings as foreign non-main proceedings. The Court was unable to find that any nontransitory economic activity was conducted in the Cayman Islands. According to the Court, the only assets in the Cayman Islands were approximately $15 million which were deposited after the initiation of the Funds’ liquidation proceedings in the Cayman Grand Court. Applying what it described as a “high bar”, the Court refused to find the Funds’ foreign liquidation constituted a foreign non-main proceeding.14

Judge Lifland distinguished his decision regarding the Funds from the facts of In re SPhinX, another recent Southern District of New York case that permitted a Cayman Islands registered hedge fund in foreign liquidation proceedings to commence a chapter 15 proceeding in the United States.15 In SPhinX, the court had found that foreign non-main proceeding status could be afforded to the fund. However, Judge Lifland noted that the court in SPhinX never considered the “establishment” requirement in its assessment of the proceedings.16 Instead, the court in SPhinX appears to have considered the issue pragmatically, and, having concluded that there were many objective factors hindering recognition of the proceedings as foreign main proceedings, concluded that there were no negative consequences to recognizing the SPhinX proceedings as foreign non-main proceedings. Judge Lifland rejected this view, concluding that such a pragmatic approach was inconsistent with the “rigid procedural structure” of chapter 15, which expressly circumscribes what types of foreign proceedings qualify.

The Court’s Proposed Alternative Relief

The Court noted that, despite the denial of recognition under chapter 15, the Petitioners were not without recourse. Judge Lifland emphasized that, pursuant to section 303(b)(4) of the Bankruptcy Code, an involuntary case could be commenced under either chapter 7 or chapter 11 of the Bankruptcy Code by a foreign representative in a foreign proceeding and could be coordinated with the foreign case.17

The Court further made reference to Bankruptcy Code section 1509(f), which provides that a court’s refusal to grant foreign recognition will not affect the foreign representative’s right to sue in a U.S. Court to collect or recover a claim that is property of the debtor.18 In addition, the Court extended for an additional thirty (30) day period a previously issued preliminary injunction in order to provide the Petitioners an opportunity to file either a chapter 7 or 11 case, while the Funds’ U.S. assets remained shielded from creditors.19

Case Analysis

The advantages of offshore funds are wellknown in the investment community. As funds cope with the challenges of a tightening credit market and the changed investment environment flowing from the sub-prime meltdown, however, some funds will face the prospect of commencing reorganization or liquidation proceedings. The ability to commence a liquidation proceeding in a foreign jurisdiction and pair it with an accompanying chapter 15 proceeding in the United States may present an ideal insolvency format for such funds. Whether it be a desire to avoid litigation, or keep costs and time commitments to a minimum, foreign-registered entities likely prefer this approach over commencing a chapter 7 or chapter 11 case in the United States.

Although Judge Lifland’s decision has not eliminated the opportunity of offshore funds to file chapter 15 cases, it has limited those who will likely be eligible. Commencing a foreign insolvency or liquidation proceeding in the place where the company is registered may no longer be sufficient to access chapter 15. While operational modifications (i.e., creating more connections to the offshore jurisdiction) may remedy such issues, for some funds it may be too late to implement these changes. If the Bear Stearns decision is upheld on appeal and adopted by other courts, it is likely that the liquidation of offshore funds will entail greater expense and delay than investors and creditors may have been expecting. As a result, in order to maximize the value of their remaining assets, foreign entities facing financial difficulties should consider ways to structure their operations so as to overcome a challenge to their ability to utilize the provisions of chapter 15 of the Bankruptcy Code.