ReviewIN THIS ISSUE

B U S I N E S S R E S T R U C T U R I N G

Recent Developments in Bankruptcy and Restructuring Vol. 2 No. 4 April 2003

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Sixth Circuit UpholdsBankruptcy Jurisdiction OverUnconsenting StatesS. Todd Brown

In its landmark decision of Seminole Tribe of Florida v. Florida, the U.S. SupremeCourt held that Article I, Section 8, Clause 3 of the United States Constitution,which, among other things, authorizes Congress to legislate commerce with theIndian Tribes, does not grant Congress the power to abrogate state sovereignimmunity. Relying on the broad holding and dicta in Seminole Tribe, the over-whelming majority of courts have concluded that Congress’ attempt to abrogatestate sovereign immunity in section 106(a) of the Bankruptcy Code is uncon-stitutional. In its recent decision in Hood v. Tennessee State Assistance Corpora-tion, however, the Sixth Circuit, employing the Seminole Tribe abrogation test,concluded that the states granted Congress the power to abrogate their sover-eign immunity under Article I, Section 8, Clause 4 of the Constitution and, ac-cordingly, found that the abrogation of sovereign immunity embodied in section106(a) is constitutional.

The Bankruptcy Power and Section 106(a)Article I, Section 8, clause 4 of the United States Constitution grants Congressthe power to “establish . . . uniform Laws on the subject of Bankruptciesthroughout the United States.” In the exercise of this power, Congress has es-tablished a comprehensive Bankruptcy Code and authorized the creation ofbankruptcy courts with jurisdiction to hear bankruptcy matters.

One important element in the promulgation of a uniform, fair bankruptcylaw is to ensure that all creditors are treated equally and are subject to the juris-diction of the bankruptcy court. In recognition of the unique position of state

1 Sixth Circuit UpholdsBankruptcy Jurisdiction OverUnconsenting States

In a marked departure from recentcaselaw, the Court of Appeals ruledthat the Bankruptcy Code provi-sion abrogating state sovereignimmunity is constitutional.

3 What’s New at Jones Day

4 Limiting Discretion to RevisitProfessional Fee Arrangements

The Sixth Circuit bankruptcy ap-pellate panel addressed the circum-stances under which a court canrevisit its decision authorizing re-tention of a professional under aspecial fee arrangement.

7 Legislative Alert

9 Defining the UnconditionalRight to Intervene

A New York district court discussedthe parameters of a creditor’s rightto participate in a bankruptcy caseand related adversary proceedings.

12 Executory Contract AssumptionConundrum

A Maryland district court chosesides on a controversial issue in-volving a debtor’s ability to assumecontracts that may be assigned un-der non-bankruptcy law only withthe non-debtor’s consent.

14 From the Top

15 Up in the Air

2 I J o n e s D a y

creditors and the potential difficulties inbankruptcy administration if states donot participate on equal footing withother creditors, section 106(a) of theBankruptcy Code provides that“[n]otwithstanding any assertion of sov-ereign immunity, sovereign immunity isabrogated as to a governmental unit tothe extent set forth in this section.” Bythis provision, Congress clearly intendedto ensure uniform treatment of state andprivate creditors in the bankruptcy pro-cess and, prior to Seminole Tribe, manycourts concluded that this system was avalid exercise of Congress’ power underthe Bankruptcy Clause.

Sovereign ImmunityAs the Court noted in Seminole Tribe,the Constitution recognizes the federalgovernment and the States as separate,sovereign entities. A critical aspect ofthis dual sovereignty system is the pres-ervation of the States’ immunity fromsuit, except as altered by the plan of theConvention or certain Amendments tothe Constitution. The Supreme Courthas acknowledged that the preservationof this immunity was critical to the rati-fication of the Constitution.

Nonetheless, in its 1792 ruling inChisolm v. Georgia, the Supreme Courtheld that Article III of the Constitutionauthorized a private citizen of anotherstate to sue the state of Georgia withoutits consent. In response, Congress en-dorsed and the States ratified the Elev-enth Amendment, which states that the“[j]udicial power of the United Statesshall not be construed to extend to anysuit in law or equity, commenced orprosecuted against one of the UnitedStates by Citizens of another State, or byCitizens or Subjects of any ForeignState.” Although the language of theEleventh Amendment appears to estab-

lish a narrow range of actions subject tosovereign immunity, the Supreme Courthas repeatedly held that this immunity“is demarcated not by the text of theAmendment alone but by fundamentalpostulates implicit in the constitutionaldesign.”

Seminole TribeThe Supreme Court has long struggledto balance the broad grant of federalpowers under Article I and the preserva-tion of state sovereign immunity. Onecritical aspect of this balancing effort isto discern whether Congress has “un-equivocally expressed its intent to abro-gate the immunity” and whetherCongress has acted “pursuant to a validexercise of power.”

Although what constitutes an “un-equivocal expression” of an intent to ab-rogate is relatively well defined, thestandards for determining whether suchan abrogation is a “valid exercise ofpower” have shifted substantially in thelast 15 years. In 1989, a plurality of theSupreme Court found in Pennsylvania v.Union Gas Company that Article I, Sec-tion, Clause 3, granted Congress thepower to abrogate state sovereign immu-nity, stating that the power to regulateinterstate commerce would be “incom-plete without the authority to renderStates liable in damages.” This rationaleexpanded the prior understanding tocongressional abrogation authority sig-nificantly, and was seen by some courtsas an anomaly of little precedentialvalue.

In reversing Union Gas just sevenyears later, the Seminole Tribe Courtnoted that state sovereign immunity “isnot so ephemeral as to dissipate whenthe subject of the suit is an area . . . thatis under the exclusive control of the Fed-eral Government” and concluded that

“Article I cannot be used to circumventthe constitutional limitations placedupon federal jurisdiction.” Under Semi-nole Tribe, it must be clearly establishedthat the states granted Congress the au-thority to abrogate their immunity fromsuit, such as may be found in the Four-teenth Amendment.

In non-binding dicta, the Courtalso noted that “it has not been widelythought that the federal antitrust, bank-ruptcy, or copyright statutes abrogatedthe States’ sovereign immunity” and “al-though the copyright and bankruptcylaws have existed practically since ournation’s inception, and the antitrust lawshave been in force for over a century,there is no established tradition in thelower federal courts of allowing enforce-ment of those federal statutes against theStates.” Based on this language and thestrict limitations on Congressional au-thority established in Seminole Tribe, theThird, Fourth, Fifth, Seventh and NinthCircuits, as well as dozens of lowercourts, have concluded that Congresslacks the authority to abrogate state sov-ereign immunity on the basis of its Ar-ticle I powers.

The Hood DecisionIn Hood, a chapter 7 debtor initiated anadversary proceeding to obtain an “un-due hardship” discharge of her studentloan obligations, as required by section523(a)(8) of the Bankruptcy Code. TheTennessee Student Assistance Corpora-tion, a state entity to which the loan ob-ligations were owed, moved to dismissfor lack of jurisdiction due to its sover-eign immunity. The bankruptcy courtdenied the motion, holding that section106(a) was promulgated pursuant to avalid grant of constitutional authority,and the bankruptcy appellate panel af-firmed this decision.

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 3

Richard M. Cieri (Cleveland) and

Paul D. Leake (New York) were in-

cluded among the leading U.S. insol-

vency and restructuring attorneys in

the 2003 edition of International Fi-

nancial Review 1000. Mr. Cieri was

also selected for listing in the 2003

edition of the K & A Restructuring

Register:America’s Top 100 and was

featured in the March 2003 edition of

Lexpert in an article concerning cross-

border corporate restructuring. On

May 5, 2003, Mr. Leake will give a

presentation concerning “Confirmation

Issues: New Value Plans, Releases,

Plans for Administratively Solvent Debt-

ors, Replacing the Board” at an Ameri-

can Bankruptcy Institute Conference in

New York City.

Corinne Ball (New York) was among

the faculty for the March 6-7, 2003

“Corporate Mergers and Acquisitions”

program in San Francisco jointly spon-

sored by the American Law Institute

and the American Bar Association

Committee on Continuing Professional

Education as part of their 18th Annual

Advanced ALI-ABA Course of Study.

A two-part article co-authored by her

and John K. Kane (New York) en-

titled “A Practical Guide to Distress

M&A” appeared in the January and

February 2003 editions of The M&A

Lawyer. On May 5, 2003, she will

give a presentation concerning “Criti-

cal Analysis of Divergent Precedents

between the Second and Third Cir-

cuits” at an American Bankruptcy Insti-

tute Conference in New York City. Ms.

What’s New at Jones Day?

Log on to www.jonesday.com for additional information concerning Jones Day’sRestructuring and Reorganization Practice as well as the firm’s other practicegroups throughout the world.

continued on page 8

On appeal, the Sixth Circuit ac-knowledged the substantial body of caselaw concluding that section 106(a) wasunconstitutional, but noted that thesecases relied upon an extremely broad read-ing of the language of Seminole Tribe andthat “neither Seminole Tribe nor any of theSupreme Court’s other recent sovereignimmunity cases address Congress’s Bank-ruptcy Clause powers as understood inthe plan of the Convention.” To that end,the Sixth Circuit concluded that it mustevaluate section 106(a) under the two-steptest used in Seminole Tribe.

After concluding that there was “noquestion” that Congress intended to ab-rogate state sovereign immunity by sec-tion 106(a), the Sixth Circuit engagedin a multi-faceted review of theConstitution’s text, the Federalist Papersand the ratification debates to discernwhether states ceded their immunityfrom suit in bankruptcy matters.

First, the court emphasized that Ar-ticle I grants Congress the power tomake “uniform” laws over two issues:bankruptcy and naturalization. Thecourt noted that this requirement is

more than a geographical uniformityprovision. Rather, uniformity requiresthat “federal courts must enforce thefederal bankruptcy law.” Moreover, be-cause this is a “constitutional uniformityrequirement” and not a mere “legislativepreference for uniformity,” the courtconcluded that cases involving theBankruptcy Clause are distinct fromcases involving attempts to abrogate sov-ereign immunity by way of other ArticleI powers that do not have a constitu-tional uniformity requirement.

Ball and David G. Heiman (Cleve-

land) were among the attorneys named

in the January 15, 2003 edition of Turn-

arounds and Workouts as lead counsel

in “Successful Chapter 11s - 2002.”

Erica M. Ryland (New York) spoke

at a seminar on Telecommunications

Restructuring in New York City, spon-

sored by Law Seminars International,

on February 13-14, 2003.

Paul E. Harner (Chicago) was

quoted in the February 28, 2003 issue

of The New York Times in an article

discussing the confirmation of a plan

of reorganization in Laidlaw, Inc.’s

chapter 11 cases.

4 I J o n e s D a y

Limiting Discretion to Revisit ProfessionalFee ArrangementsMark G. Douglas

Recognizing the practical challenges as-sociated with attracting a wide range ofskilled professionals to the bankruptcyforum, the Bankruptcy Code authorizesthe retention of such professionals ac-cording to any terms and conditionsthat are “reasonable” under the circum-stances. Part and parcel of the Code’sincentives to highly qualified profession-als is the principle of certainty. A pro-fessional retained in a bankruptcy casemust be assured that it will be compen-sated according to terms and conditionsthat it agrees to, and the court approves,at the outset of the engagement. Suchterms and conditions must be clearlyand expressly defined. As illustrated bya recent ruling handed down by theSixth Circuit bankruptcy appellatepanel, ambiguity in defining those termsis a recipe for trouble. In In re AirspectAir, Inc., the panel held that once abankruptcy court approves the retentionof special litigation counsel on a contin-gency fee basis, it cannot revisit that de-cision except under the “improvidence”exception, which requires a finding thatthe arrangement was ill-advised due tocircumstances that could not have beencontemplated at the time of the retention.

Retention of Professionalsin BankruptcyBankruptcy trustees, chapter 11 debtorsand official committees are permitted toretain a wide variety of professionals, in-cluding lawyers, accountants, auction-eers and investment bankers, torepresent their interests during thebankruptcy case. Any employment ofprofessionals must be approved in ad-

vance by the bankruptcy court. In mostcases, professionals hired to represent atrustee, debtor-in-possession or com-mittee are retained pursuant to sections327 and 1103 of the Bankruptcy Code,which authorize these entities, subject tobankruptcy court approval, to employ“disinterested” professionals to representthem during the course of the bank-ruptcy.

Professionals retained under sec-tions 327 or 1103 are paid in accor-dance with the interim and finalcompensation procedures delineated insections 330 and 331 of the BankruptcyCode. Those procedures contemplatebankruptcy court scrutiny of profes-sional services for which compensationis sought, and the discretion to reduce,or in some cases augment, the allowedamount of fees (or expenses) based uponthe court’s determination of what is rea-sonable and necessary under the circum-stances. While the statute sets forth anumber of factors that a court is obli-gated to consider in making that deter-mination, the fundamentally subjectivenature of the analysis leaves open thepossibility that fees sought for servicesthat are deemed unnecessary or unrea-sonable may be disallowed or signifi-cantly reduced.

Notwithstanding the prevalence inbankruptcy of fee applications subjectedto the litmus test of subjective reason-ableness, the Bankruptcy Code expresslyprovides for the retention and compen-sation of professionals under other termsand conditions. Section 328 of theBankruptcy Code authorizes the reten-tion of professionals “on any reasonable

terms and conditions of employment,including on a retainer, on an hourlybasis, or on a contingent fee basis.”The standards applied to fee applicationsfiled by professionals retained under sec-tions 327 and 1103 do not expressly gov-ern compensation of professionalsretained pursuant to section 328.

Nevertheless, even if the bank-ruptcy court approves a fee arrangementunder section 328, it retains by statutethe discretion to revisit that decision andto modify the compensation to be paid,but only if the terms and conditionsspecified in the retention order “prove tohave become improvident in light ofdevelopments not capable of being an-ticipated at the time of the fixing ofsuch terms and conditions.” The partyseeking to employ a professional bearsthe burden of demonstrating that theterms of the employment are reasonable.

The interaction between sections328 and 330 has been the subject of afair amount of controversy. Because sec-tion 328 does not expressly incorporatethe “reasonableness” limitations of sec-tion 330, many courts have taken theposition that, once the terms of aprofessional’s engagement have been ap-proved by the court under section 328,the court does not retain any discretionto modify the fee and expense arrange-ment except according to the “improvi-dence” exception. Others, representingthe minority approach, ascribe to theopposite view, holding that all fee re-quests are subject to the test of “reason-ableness.” Even among those courtsapplying the majority rule, there is dis-agreement regarding what circumstances

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 5

continued on page 6

qualify for the “improvidence” excep-tion. In adopting the more prevalentposition in Airspect Air, the bankruptcyappellate panel articulated its view of themeaning of the exception.

BackgroundAirspect Air, Inc. (“Airspect”) had beeninvolved in litigation with the City ofAkron, Ohio over a long-term lease ofhangar and related facilities at Akron-Fulton International Airport for overthree years when it filed for chapter 11protection in 1996. Shortly after the fil-ing, Airspect removed the state courtlitigation to the bankruptcy court,where it became an adversary proceed-ing. It also sought bankruptcy courtauthority to retain its attorneys in thestate court action as special counsel un-der Bankruptcy Code section 328(a) forthe purpose of continuing the litigation.

The terms under which specialcounsel was to be employed by Airspectspecified that “[f ]ees, other than ex-penses, are to be paid on a contingencybasis and are subject to approval by” thebankruptcy court. The amount of thecontingency ranged from one-third toone-half of any recovery, dependingupon the imminence of trial. Thebankruptcy court approved Airspect’sretention of special counsel according tothe terms specified. It also approved thepayment of a $7,000 retainer to the at-torneys and ordered them to submit afee application to the court for approval.

After more than three additionalyears of hotly contested litigation in thebankruptcy and district courts, part ofwhich resulted in a ruling by the bank-

ruptcy court that the lease at issue hadbeen “rejected” because Airspect failedto “assume” it within 60 days of filingfor bankruptcy, Airspect reached a settle-ment with the City of Akron wherebyAirspect received $575,000. The settle-ment, however, was negotiated not byAirspect’s special litigation counsel, butby a lawyer hired by Airspect’s soleshareholder to intercede in the discus-sions. Nevertheless, shortly after thebankruptcy court approved the settle-ment, special counsel filed an applica-tion with the bankruptcy court seekingone-third of the settlement amount inaccordance with its contingency fee ar-rangement.

The bankruptcy court denied therequest, finding that the contingency —presumably, a resolution of the disputeconcerning the lease involving its rein-statement — had never occurred. In-stead the court awarded a fee that itdeemed to be “reasonable” under thecircumstances (roughly 15 percent ofthe contingency fee). The bankruptcyappellate panel reversed that ruling onappeal, directing the bankruptcy courtto review the fee request under the stan-dard specified in Bankruptcy Code sec-tion 328(a) rather than section 330.The bankruptcy court did just that, butdetermined that “its initial approval ofthe fee arrangement was improvident inlight of subsequent events” and onceagain awarded a fee it deemed to be rea-sonable. According to the court, it hadnot known at the time it approvedAirspect’s retention of special litigationcounsel that the lease at issue had beendeemed rejected (approximately one

week before the court authorized theengagement) due to Airspect’s inaction.Had it known that Airspect could nolonger benefit from the lease, the courtemphasized, it would never have ap-proved the contingency fee arrange-ment.

Special counsel fared better beforethe bankruptcy appellate panel for theSixth Circuit. Observing that “[t]hewidely accepted general rule is thatbankruptcy courts, once having ap-proved employment under [section]328, may not later switch to [section]330 to award fees,” the appellate panelreversed the bankruptcy court award. Itfound that the bankruptcy court had er-roneously applied the “improvidence”exception. According the court, undersection 328, “an intervening circum-stance, in order to render improvident acourt’s decision to grant a fee applica-tion, must be one that would have af-fected the court’s decision in the firstplace . . . [,] rendering it untenable orunwise in hindsight.” The deemed re-jection of Airspect’s lease, the panel re-marked, did not vitiate the purpose forwhich special counsel was retained “be-cause the damages that [special counsel]has been retained to recover were action-able whether the lease was terminated ornot.”

Finally, the appellate panel rejectedthe argument that the bankruptcy courthad never expressly approved specialcounsel’s engagement under section328(a), but had reserved the right to re-view any fee request under the reason-ableness standard of section 330.

6 I J o n e s D a y

continued from page 5

Noting that there is a disagreementamong the Circuit Courts of Appeal asto whether a proposed retention mustspecifically reference section 328 to in-sulate a professional’s fee request fromscrutiny under the “reasonableness”standard, the panel concluded that ex-press reference to the statute is unneces-sary where the facts indicate that thebankruptcy court approved an engage-ment under terms clearly contemplatedby section 328. According to the appel-late panel, had the bankruptcy courtwished to approve the employment ofspecial counsel on some basis other thana contingency fee basis, “it had the duty,in all fairness, to propose a differentemployment.” The panel also con-cluded that its determination was bol-stered by the absence of anyrequirement in the procedural rules gov-erning the employment of professionalsin bankruptcy that a retention applica-tion specifically refer, as its predicate, toa particular provision of the BankruptcyCode.

AnalysisThe attorneys retained in Airspect Airwere fortunate that the appellate panelrejected the strict approach applied bymany other courts to professional feerequests in bankruptcy. Others mightnot be so lucky. The message borne bythe ruling and other decisions constru-ing the interaction between BankruptcyCode sections 328 and 330 is manifest:Compensation specified in a retentionagreement, engagement letter or contin-gency agreement may be subject tomodification unless the operative agree-ment, the application seeking its ap-proval and the bankruptcy court orderapproving it unequivocally specify thatthe professional is being retained undersection 328, and that the specified com-pensation is not subject to subsequentreview by the bankruptcy court in accor-dance with the reasonableness standardset forth in section 330. This should beof particular concern to investmentbankers and other financial profession-

als. These professionals commonly seekto be retained under a fee arrangementcontaining built-in success fees or simi-lar fee enhancements triggered by eventsoccurring during the course of the bank-ruptcy, such as confirmation of a plan ofreorganization or a sale of substantiallyall of the debtor’s assets.

Bankruptcy courts are inherentlycourts of equity. As such, there can beno absolute assurance that a court willrefrain from scrutinizing a fee arrange-ment under section 330 despite havingspecifically authorized it pursuant to sec-tion 328, particularly in cases where thefees involved appear to have been exces-sive in light of the results achieved, orwhere they represent a substantial por-tion of the estate’s administrative costsand may result in a significant reductionof funds available to distribute to othercreditors. Moreover, both the Office ofthe United States Trustee, whose statu-tory mandates include supervision of allfee and expense applications filed under

Compensation specified in a retention agreement, engagement letter or con-

tingency agreement may be subject to modification unless the operative

agreement, the application seeking its approval and the bankruptcy court or-

der approving it unequivocally specify that the professional is being re-

tained under section 328, and that the specified compensation is not subject

to subsequent review by the bankruptcy court in accordance with the rea-

sonableness standard set forth in section 330.

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 7

L E G I S L A T I V EA L E R TRound seven of lawmakers’ efforts to win approval of sweeping bankruptcy

reform legislation first proposed in 1997 began on March 19, 2003, when the

House of Representatives passed a bill (H.R. 975) by a margin of 315 to 133

closely resembling, with one significant exception, the one that died in confer-

ence at the end of 2002. Denominated “The Bankruptcy Abuse Prevention

and Consumer Protection Act of 2003,” the bill does not contain a controver-

sial provision making debts incurred by abortion protesters non-dischargeable

in a bankruptcy case. Lawmakers’ inability to reach agreement concerning this

provision last year effectively scuttled bankruptcy reform proponents’ hopes for

securing passage of the long-delayed legislation.

The bill approved by the House differed from the previous version in certain

other respects as well. Among the amendments added by legislators are pro-

visions applying the financial “netting” provisions in the bill to both bank and

credit unions and increasing the monetary cap on priority wage and employee

benefit claims. The House also adopted an amendment increasing the

reachback period during which fraudulent transfers can be rescinded from one

to two years and providing that compensation paid to corporate insiders dur-

ing the two-year period can be recovered under certain circumstances. An

amendment that would have modified the “means test” incorporated into the

previous bill and required the bankruptcy court to consider a debtor’s reason-

able and necessary expenses in considering a motion to dismiss or convert a

chapter 7 case was defeated.

According to Capitol Hill watchdogs, the Senate is likely to pass a substan-

tially similar version, also without the anti-abortion protestor provision, with little

difficulty. However, advocates of the provision, which was first introduced by

Senator Charles Schumer, will almost certainly try to amend the Senate bill to

add it back again, re-igniting a dispute that is politically charged and has al-

ready proved to be a deal breaker. However, given Congress’ current focus

on proposed tax cuts and funding the war with Iraq, it appears that bankruptcy

reform and other formerly high-profile domestic issues have been put on the

back burner for the moment.

section 330 and the right to interposeany objections it may have in the court,and official committees entrusted withoversight of a chapter 11 case on behalfof their creditor/shareholder constituen-cies can be expected to look much moresearchingly at a proposed retention andfee arrangement under section 328.Where the ultimate success of a chapter11 reorganization is uncertain, these en-tities may attempt to block a section328 retention in favor of a more tradi-tional, and retrospectively reviewable,engagement pursuant to section 330.

Whether bankruptcy professionalsare retained under section 328 or section330 of the Bankruptcy Code will, inthe final analysis, depend on thepracticalities of the bankruptcy case andwhat all parties-in-interest intend to ac-complish by means of it. Nevertheless,any professional contemplating a pro-posed engagement must recognize thenecessity of bargaining for and obtain-ing specific court approval of any fee ar-rangement up-front. Otherwise, aprofessional risks having the terms andconditions of its engagement modifiedby leaving open the door to scrutinyunder the microscope of subjective rea-sonableness.___________________________________________In re Airspect Air, Inc., 288 B.R. 464(6th Cir. B.A.P. 2003).

Circle K Corp. v. Houlihan, Lokey,Howard & Zukin, Inc. (In re Circle KCorp.), 279 B.R. 669 (9th Cir. 2002).

Friedman Enterprises v. B.U.M. Interna-tional, Inc. (In re B.U.M. International,Inc.), 229 F.3d 824 (9th Cir. 2000).

In re National Gypsum Co., 123 F.3d861 (5th Cir. 1997).

8 I J o n e s D a y

continued from page 3

Second, the Sixth Circuit notedthat, “[a]s it was initially understood,the Bankruptcy Clause represented thestates’ total grant of their power to leg-islate on bankruptcy.” Given the“chaos” that marked the bankruptcy sys-tem prior to 1789, the court stated thatthe grant of exclusivity was “not a meredesire to have one system, but a systemthat rose above individual states’ inter-ests.” In this way, “the Constitutionprevented runaway states from defeatingbankruptcy’s goals.”

Notwithstanding the exclusivegrant of legislative authority over bank-ruptcy matters to Congress, however,the Sixth Circuit acknowledged that it ispossible that the states retained theirimmunity from suit and that, generally,the “decision to cede one aspect [of sov-ereignty] to the federal government doesnot by itself imply a surrender of theother.” In order to consider whether thestates ceded sovereign immunity whenthey agreed to the uniformity provisionof the Bankruptcy Clause, the Courtlooked to the analysis of sovereignty and

alienation of sovereignty in The Feder-alist. In the first step of this analysis,the court looked to The Federalist No.81, which stated, among other things,that unless “there is a surrender of [sov-ereign] immunity in the plan of the con-vention, it will remain with the states,”and referred the reader to The Federal-ist No. 32 for the circumstances inwhich this surrender of state sovereigntycould be found. In The Federalist No.32, Alexander Hamilton argued thatstates retained all rights of sovereigntythey had prior to the Constitution, ex-cept for those that were “exclusively del-egated to the United States.” This“alienation of sovereignty,” according toHamilton, included areas in whichstates granted authority to the federalgovernment, “to which a similar author-ity in the states would be absolutely andtotally contradictory and repugnant.”As an example of this type of authority,Hamilton offered the naturalizationpower, because of the grant of uniformpower to the federal government con-cerning such matters, and the Sixth Cir-cuit concluded that “the same reasoningapplies to bankruptcy.” After reviewingthe text, the Court of Appeals observedthat this discussion “can only suggestthat, in the minds of the Framers, ced-ing sovereignty by the methods de-scribed in No. 32 implies cedingsovereign immunity as discussed in No.81.” The court then concluded that“there is no other explanation” for thecross-reference between the two.

Finally, the Sixth Circuit looked tothe state ratification debates and foundno objection “specifically targetedagainst enforcing federal bankruptcylaws against the states.” Acknowledgingthat this could simply “reflect a gap inan otherwise careful debate,” the Court

of Appeals remarked that it could alsoreflect the recognition inherent in theneed for a uniform bankruptcy law thatsuch a system “could cure the previoussystem’s ills only if it applied uniformlyto all creditors and debtors,” and, ac-cordingly, Congress must have thepower to abrogate the states’ sovereignimmunity.

AnalysisIf the Hood decision stands, it will rep-resent a dramatic development in theequitable administration of bankruptcycases and, in particular, in the manner inwhich state creditors participate inbankruptcy proceedings. For example,although prior cases required states towaive sovereign immunity in order toparticipate in a bankruptcy case, statesremained free under those decisions toelect not to participate. Under the Hoodrationale, however, states may becomeunwilling participants in the bankruptcycases of individual and corporate debt-ors. This result is in stark contrast to thesubstantial deference afforded to statesovereign immunity in Seminole Tribeand other recent decisions by the Su-preme Court.

_____________________________________

Hood v. Tenn. Student Assistance Corp.,319 F.3d 755 (6th Cir. 2003).

Seminole Tribe of Florida v. Florida, 517U.S. 44 (1996).

Alden v. Maine, 527 U.S. 706 (1999).

Pennsylvania v. Union Gas Co., 491 U.S.1 (1989).

If the Hood decisionstands, it will repre-sent a dramatic de-velopment in theequitable adminis-tration of bank-ruptcy cases and, inparticular, in themanner in whichstate creditors par-ticipate in bank-ruptcy proceedings.

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 9

Defining the Unconditional Right to InterveneHelena C. Huang and Mark G. Douglas

The right of creditors and official com-mittees to participate generally in abankruptcy case is a basic tenet of U.S.bankruptcy law. However, whether thatentitlement encompasses the right tointervene in adversary proceedings com-menced during a case or to prosecutelitigation on behalf of the bankruptcyestate is controversial. Decisions re-cently handed down by courts in theSecond and Third Circuits address thelimits of creditor participation, but withmixed results that hold little promise forresolving a long-standing debate. In themost recent of these, In re Sunbeam Cor-poration, a New York district court ruledthat the unqualified right of a creditor tointervene in an adversary proceeding doesnot confer derivative standing upon thecreditor to prosecute estate claims.

Right to Be Heard in BankruptcyUnlike most ordinary litigation com-menced in federal courts, a bankruptcycase generally affects the substantiverights of a large group of creditors,shareholders and other parties with astake in the outcome of the case. As aconsequence, bankruptcy courts, whichare technically “units” of the federal dis-trict courts, permit anyone whose rightsor remedies are affected by the case toappear before them and petition for theforms of relief contained in the Bank-ruptcy Code, such as relief from the au-tomatic stay or “adequate protection” tothe extent the debtor is using or leasinga creditor’s collateral during the case.Specific provisions of the BankruptcyCode confer what may be loosely re-ferred to as “standing” upon the entityinvolved to seek certain kinds of reliefunder certain circumstances.

Still, with one exception (discussedbelow), the Bankruptcy Code does notexpressly delineate the entities that havethe right to participate generally in abankruptcy case. Procedural rules en-acted to implement the Code and vari-ous provisions of the statute suggest thatparticipation is limited to debtors, trust-ees, creditors, shareholders, official com-mittees and other entities whose rightsare affected by the outcome of the case.The bankruptcy court may permit anyentity who presumably does not fall intoone of these categories “to intervenegenerally or with respect to any specifiedmatter” in a “case” under the Bank-ruptcy Code, but the Code itself offerslittle guidance on this issue.

This stands in marked contrast toprocedural rules that govern other fed-eral litigation and the ability of partiesother than the initial litigants to partici-pate, or “intervene,” in a lawsuit. Theserules provide for intervention under twocircumstances: as of right and with thepermission of the court. “Interventionof right” is appropriate when a federalstatute “confers an unconditional rightto intervene” or when the potential in-tervenor “claims an interest relating tothe property or transaction which is thesubject of the action and the applicantis so situated that the disposition ofthe action may as a practical matterimpede the applicant’s ability to pro-tect that interest, unless theapplicant’s interest is adequately rep-resented by existing parties.” By con-trast, if the applicant’s statutory rightto intervene is only conditional, or ifthe applicant has a claim or defensebased upon a question of law or factthat will be determined in the litiga-

tion, a federal court has the discretionto allow or disallow intervention.

The exception to the BankruptcyCode’s silence regarding who may par-ticipate in a bankruptcy case is con-tained in section 1109(b). That sectionprovides that “[a] party in interest, in-cluding the debtor, the trustee, a credi-tors’ committee, an equity securityholders’ committee, a creditor, an equitysecurity holder, or any indenture trustee,may raise and may appear and be heardon any issue in a case under this chap-ter.” Section 1109(b) applies only tocases under chapter 11. Its reference to“a case under” chapter 11 has led to aconsiderable amount of confusion re-garding whether the statute confersupon parties in interest the right to ap-pear and participate in adversary pro-ceedings, as opposed to the mainbankruptcy case.

Case v. Proceeding“Case” and “proceeding” have distinctmeanings in bankruptcy. It is generallyrecognized that where the BankruptcyCode and Rules refer to a “case,” itmeans the main bankruptcy case thatwas commenced when the bankruptcycourt entered an order for relief. Bycontrast, a “proceeding” means an “ad-versary proceeding” filed in the maincase sometime afterward. An adversaryproceeding is discrete but related litiga-tion commenced during a bankruptcycase for the purpose of, among otherthings, determining the validity, priorityor extent of a lien, subordinating aclaim, recovering assets that were prefer-entially or fraudulently transferred, ob-taining injunctive relief beyond thescope of the automatic stay or objecting

10 I J o n e s D a y

to the discharge of a debt. Other typesof disputed issues that arise in a bank-ruptcy case that do not qualify as adver-sary proceedings are referred to as“contested matters.” Different proce-dural rules apply to adversary proceed-ings and contested matters.

Several provisions of the Bank-ruptcy Code, other related statues andprocedural rules distinguish between a“case” and a “proceeding.” All of thishas led many courts to conclude thatBankruptcy Code section 1109(b)’s ref-erence to “any issue in a case” meansthat the right of a party in interest toparticipate is limited to the main chap-ter 11 case. According to this view, in-tervention in an adversary proceedingmust be sought in accordance with pro-cedural rules expressly governing inter-vention, and section 1109(b) alone doesnot represent a federal statute that “con-fers an unconditional right to intervene”upon any party in interest in a chapter11 case. Among the courts subscribingto this approach is the Fifth Circuit,which ruled in Fuel Oil Supply &Terminaling v. Gulf Oil Corporation thatCongress drew distinctions betweencases and proceedings in various statutesand procedural rules and did not intendto create an unconditional right to inter-vene in Bankruptcy Code section1109(b). The First, Fourth and TenthCircuits have indicated that they favorthe Fifth Circuit’s view.

The Third Circuit and, most re-cently, the Second Circuit take the op-posite view. In In re Marin Motor Oil,the Court of Appeals for the Third Cir-cuit examined the language of section1109(b) and its predecessor under theformer Bankruptcy Act and concludedthat section 1109(b) should be inter-preted broadly to afford a creditors’committee an absolute right to intervenein an adversary proceeding. The Second

Circuit recently adopted an expansiveapproach to standing in In re The CaldorCorporation. In that case, the Court ofAppeals held that any party in interest ina chapter 11 case has an unconditionalright to intervene in any adversary pro-ceeding commenced during the courseof the case. According to the SecondCircuit, the language of section 1109(b)does not distinguish between cases andproceedings, but provides merely that aparty in interest has the right to beheard “on any issue in a case.” It rea-soned that while the bankruptcy rulesdistinguish between different types oflitigated matters that arise during abankruptcy case and divide them into“contested matters” and “adversary pro-ceedings,” the plain text of section1109(b) “does not distinguish betweenissues that occur in these different typesof proceedings within a Chapter 11case.” The Second Circuit accordinglyheld that the phrase “any issue in a case”plainly grants a right to raise, appear andbe heard on an issue regardless of whetherit arises in a contested matter or an adver-sary proceeding.

Derivative StandingRelated to the right of a party-in-inter-est to be heard and to intervene is theconcept of standing to prosecute claimson behalf of the estate. In general,

claims that belong to a debtor becomeproperty of its bankruptcy estate whenthe debtor files for bankruptcy, and onlya debtor-in-possession or trustee has theright to prosecute them. Most courts,however, hold that official committees,and in some cases, individual creditors,have an implied qualified right to ini-tiate, with court approval, adversary pro-ceedings in the name of a debtor, butonly when the trustee or debtor unjus-tifiably fails to bring suit. In one of theseminal cases addressing this issue, theSecond Circuit ruled in In re STN En-terprises that in considering a committee’smotion for leave to commence an actionagainst a director for misconduct, a courtis required to consider whether the debtorunjustifiably failed to sue the director andwhether the action is likely to benefit thedebtor’s estate.

The Second Circuit broadened thisdoctrine in In re Commodore Interna-tional Ltd., which involved litigationbrought by a committee against variousofficers and directors for fraud and mis-management. Unlike in STN Enter-prises, the debtor in Commodore agreedto permit the committee to litigate theclaims on behalf of the estate. TheCourt of Appeals ruled that a commit-tee may bring suit even if the debtordoes not unjustifiably refuse to do so aslong as: (1) the trustee or debtor con-

Sunbeam illustrates the important distinction be-

tween a creditor’s unconditional right to be heard

and intervene, on the one hand, and the condi-

tional right to prosecute estate claims with the ap-

proval of the court, on the other.

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 11

sents; and (2) the court finds that thelitigation is (a) in the best interests ofthe estate and (b) necessary and benefi-cial to the fair and efficient resolution ofthe bankruptcy proceedings. The Sec-ond Circuit recently reaffirmed its broadinterpretation of derivative standing inIn re Housecraft Industries USA, Inc.,holding that official committees andeven individual creditors may be autho-rized to commence litigation on theestate’s behalf where doing so is: (1) inthe best interests of the estate and is nec-essary and (2) beneficial to the fair andefficient resolution of the bankruptcyproceedings.

The Second Circuit’s approach rep-resents the prevalent view, but not theonly one. A distinct minority has inter-preted the absence of express authorityin the Bankruptcy Code as an indicationof lawmakers’ intent to confer standingto prosecute estate claims only upon adebtor-in-possession or bankruptcytrustee. Exemplary of this view is theThird Circuit’s highly controversial rul-ing in Official Committee of UnsecuredCreditors v. Chinery (In re CybergenicsCorporation). In that case, the Court ofAppeals held that because section544(b) of the Bankruptcy Code explic-itly provides that the “trustee” may com-mence litigation to avoid certain liens, acommittee may not be authorized to doso under any circumstances. Highlycriticized as being contrary to long-standing practice as well as provisions inthe Bankruptcy Code recognizing thepower of a bankruptcy court to autho-rize creditors to recover property orprosecute claims on the estate’s behalf,Cybergenics was subsequently vacated bythe Third Circuit. A New York districtcourt was called upon to take a positionon the standing issue in Sunbeam Cor-poration.

BackgroundShortly after appliance maker SunbeamCorporation filed for chapter 11, thecreditors’ committee appointed in thecase sued Sunbeam’s lenders seeking toequitably subordinate their claims andto avoid allegedly fraudulent transfers.Two of the defendants moved to dis-miss, contending that the committeelacked standing to commence the actionon behalf of the estate, given its failureto obtain leave of the court to do so.The bankruptcy court dismissed thecomplaint, finding, among other things,that the committee had not satisfied therequirements for derivative standing de-tailed in STN Enterprises, Commodoreand Housecraft. According to the bank-ruptcy court, the committee failed toshow that Sunbeam unjustifiably refusedto commence an action against its lend-ers. Emphasizing, moreover, that allow-ing the committee’s action would delaythe reorganization process by impedingapproval of a pending plan of reorgani-zation, the court concluded that confer-ring standing on the committee was notin the best interests of the estate.

The committee appealed the dis-missal, but settled its claims againstSunbeam’s lenders before the appeal wasactually heard by the district court. Aspart of that settlement, the committeeagreed to withdraw its appeal. Before itcould do so, a member of the commit-tee holding $600 million in bonds is-sued by Sunbeam (Oaktree CapitalManagement, LLC) sought to intervenefor the purpose of prosecuting the ap-peal. Oaktree was dissatisfied with theterms of the settlement and contendedthat it had not been properly approvedby the bankruptcy court.

The district court denied Oaktree’smotion. Initially, it distinguished acreditor’s conditional right to intervenein an adversary proceeding from the

right to prosecute an appeal. Oaktree,the court emphasized, sought not onlyintervention, which entailed the right toparticipate in the litigation, but also theright to pursue individually claims be-longing to Sunbeam’s bankruptcy estate.It found Oaktree’s reliance on Caldor asa basis for its right to intervene to bemisplaced. Remarking that “Caldor didnot overrule prior Second Circuit prece-dent establishing criteria for the bank-ruptcy court to determine when to allowcreditors to assert claims on behalf of anestate,” the district court held thatOaktree should not be permitted to in-tervene because the bankruptcy courthad never authorized anyone to pros-ecute the claims at issue on Sunbeam’sbehalf.

AnalysisSunbeam illustrates the important dis-tinction between a creditor’s uncondi-tional right to be heard and intervene,on the one hand, and the conditionalright to prosecute estate claims with theapproval of the court, on the other.Though related, these rights are distinct.Sunbeam demonstrates that they are alsonot without limitations.

Sunbeam also reinforces the signifi-cance of the Second Circuit’s ruling inCaldor. By construing the BankruptcyCode in a way that affords all parties-in-interest ready access to every aspect of achapter 11 case, the Second Circuit re-affirmed the idea that a fundamentalpremise of the U.S. bankruptcy law isactive participation by all concerned en-tities to encourage a negotiated solutionfor a debtor’s financial woes. Still,Caldor engendered a fair amount of con-fusion. The Second Circuit never reallyexplained whether the unconditionalright to intervene carries with it the en-tire panoply of rights customarily af-

continued on page 16

12 I J o n e s D a y

Executory Contract Assumption ConundrumRyan Routh

Should a concert promoter who con-tracts for a performance by LucianoPavarotti be required to accept a perfor-mance from Michael Jackson if Pavarottideclares bankruptcy and seeks to assignhis performance contract to the “Kingof Pop”? Bankruptcy judges wouldunanimously concur that the concertpromoter need not accept MichaelJackson’s performance. Yet despite judi-cial agreement on this topic, there is noagreement regarding whether the con-cert promoter could free itself from thecontract even if Pavarotti himselfplanned to perform. It is this issue thathas produced a split among the federalcircuit, district and bankruptcy courtsover the past 15 years. And it is on thisissue that a Maryland district court heldin favor of the debtor (i.e., Pavarotti) inits recent decision in RCC TechnologyCorp. v. Sunterra Corp.

Assumption and Assignment ofContracts in BankruptcyAs most persons with some experiencewith the bankruptcy process are aware,the Bankruptcy Code grants a debtorthree options with respect to its execu-tory contracts and unexpired leases. Adebtor may “reject,” or cease performingunder, contracts and leases that containunfavorable terms. For contracts andleases containing favorable terms, adebtor may “assume” them, therebybinding the debtor to perform under thecontract or lease going forward. Alter-natively, the debtor may seek to assumeand assign to third parties (usually forsome monetary or other consideration)favorable contracts and leases that the

debtor will have no use for upon its re-organization or from which it can derivesignificant value (e.g., a below-marketlease) Such an “assumption and assign-ment” to a third party can be made un-der the Bankruptcy Code even if thecontract or lease expressly prohibits suchaction.

Despite these broad powers grantedto a debtor, certain non-debtor partiesthat contract with a debtor are granteda measure of protection by the Bank-ruptcy Code. Specifically, section365(c) of the Bankruptcy Code providesthat a debtor may not “assume or assign”an executory contract or unexpired leaseif “applicable law excuses a party, otherthan the debtor, to such contract or leasefrom accepting performance from orrendering performance to an entityother than the debtor” and such partydoes not consent to assumption or as-signment.

Accordingly, whenever “applicablelaw” (which courts generally construe tomean state law or federal non-bank-ruptcy law) would prevent assignmentof a contract or lease without consent, adebtor is required to obtain that consentfrom the non-debtor party. Courts haveapplied this provision to a wide varietyof contracts. Among these are: (a) per-sonal service contracts, including em-ployment agreements, which, understate law, an employer generally cannotassign to another employer without theemployee’s consent; (b) contracts withthe United States government, whichcannot be freely assigned under federallaw; (c) certain kinds of franchise agree-ments that are unassignable under cer-

tain state laws; and (d) licenses of intel-lectual property, which cannot be as-signed without consent under federalintellectual property law. Thus, manydebtors (especially debtors in the tech-nology industry) find that their rightswith respect to certain executory con-tracts and unexpired leases are signifi-cantly curtailed.

The Statutory MuddleAs noted in the introduction to this ar-ticle, all courts would agree that section365(c) prevents a debtor from assigningto a third party a contract without thenon-debtor’s consent if the contractcould not be assigned outside of bank-ruptcy without such consent. The lan-guage of section 365(c), however, wouldseem to mean that the debtor cannoteven assume the contract itself and agreeto perform thereunder, even if it has nointention of assigning the contract to athird party. It is this interpretation ofthe statute that has troubled courts be-ginning with the 1988 decision of theCourt of Appeals for the Third Circuitin In re West Electronics, Inc. and givenrise to the dispute at issue in RCC Tech-nology.

The cause of the confusion stemsfrom the statute’s use of the phrase “maynot assume or assign” instead of “assumeand assign.” Many courts, under a lit-eral interpretation, hold that this phrasemeans that the statute applies to adebtor who seeks to either assume theagreement and perform itself as well asto a debtor who seeks to assume theagreement and assign it to a third party.Under this approach, the court posits a

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 13

Debtors and non-debtors alike can have no degree of certainty regarding the

effect of a bankruptcy filing on contracts and leases that cannot be assumed

without the non-debtor’s consent under applicable non-bankruptcy law.

hypothetical question: Could thedebtor assign the contract to a thirdparty under applicable non-bankruptcylaw? If the answer is no, then the debtornot only cannot assign the contract, itcannot assume the contract either.Thus, this approach is commonly re-ferred to as the “hypothetical” test. InWest Electronics, the Third Circuit ap-plied this approach in ruling that thedebtor could not assume a contract withthe federal government calling for pro-duction of military equipment becausefederal law prohibited assignment of thecontract without the government’s con-sent.

Other courts find that, despite thelanguage of the statute, the phrase “maynot assume or assign” should be inter-preted to mean “may not assume andassign” and apply it only when thedebtor is seeking to assign the contractor lease at issue to a third party. Underthis approach, the court enquireswhether the debtor is actually trying toassign the contract to a third party. Ifnot, the court will not prevent assump-tion. Therefore, this approach is com-monly referred to as the “actual” testbecause the court looks to what thedebtor’s actual intentions are. Promi-nent among adherents to this view is theCourt of Appeals for the First Circuit,which ruled in Institut Pasteur v. Cam-bridge Biotech Corp. that federal com-

mon law and contractual restrictionsagainst assignment of patents did notpreclude assumption of a patent by achapter 11 debtor.

Courts adopting the “hypothetical”test have generally done so because theyfeel constrained by the plain, unambigu-ous language of the statute. To thesecourts, no reason is sufficient to permitthem to disregard this plain language.Courts adopting the “actual” test, how-ever, cite a variety of problems with thecompeting view. Such courts note theconflict of the “hypothetical” test ap-proach with “the general goals of Chap-ter 11 [in allowing] . . . licensees tobenefit from the protections of thebankruptcy law while encouraging themaximization of the economic value ofthe debtor’s estate.” Further, such courtssuggest that the odd result required bythe “hypothetical” test, where a non-debtor party (such as the concert pro-moter posited in the first paragraph ofthis article) obtains the ability to free it-self from some kinds of contracts simplydue to the fact of the debtor’s bank-ruptcy filing, could not be supported byany bankruptcy policy. In fact, thesecourts emphasize, the “hypothetical” testwould seem to be contrary to recognizedbankruptcy policies, including prevent-ing non-debtors from terminating con-tracts simply due to the filing ofbankruptcy under so-called ipso facto

provisions to promote the likelihood ofrehabilitation and maximize the value ofthe debtor’s bankruptcy estate. Finally,“actual” test courts often state that thelanguage appears to be a result of asimple drafting error: Congress meant“and” but said “or.” It is the choice be-tween these two approaches, neither ofwhich is wholly satisfying, that faced thedistrict court in RCC Technology.

The RCC Technology CaseChapter 11 debtor Sunterra Corpora-tion was party to a software licenseagreement with RCC Technology Cor-poration. RCC filed a motion in thebankruptcy court seeking an order di-recting that the agreement at issue couldnot be assumed under federal copyrightlaw and was therefore “deemed re-jected.” The bankruptcy court deniedthe motion and RCC appealed.

On appeal, the district court foundthat the agreement at issue was the typeof agreement that could not be assignedto a third party under federal copyright.It accordingly ruled that BankruptcyCode section 365(c) did in fact apply tothe contract, finding clear error in thebankruptcy court’s determination belowthat the license was not an executorycontract capable of being assumed orrejected in the first place. Observingthat courts disagree about the meaning

continued on page 14

14 I J o n e s D a y

of the statute, the court concluded thatit found “the actual test to be far moreharmonious with the statutory scheme.”The court recognized that the “plainmeaning” of the statute supported the“hypothetical” test, but emphasized that“there is a competing principle that stat-utes should not be interpreted to pro-duce results that are unreasonable inlight of the drafters’ intentions.” Ac-cording to the court, there is no evi-dence that Congress intended to createthe odd result mandated by “hypotheti-cal” test courts. Finally, noting thePavarotti example, the court found thatpermitting the non-debtor party to bereleased from the contract was “quiteunreasonable” given the fact thatSunterra, rather than some third party,would be performing under the con-tract, if it were assumed.

AnalysisWhether or not the court in RCC Tech-nology Corp. v. Sunterra Corp. reachedthe right result for the right reasons, thedecision highlights the need for clarifi-cation of the meaning of the statute byeither Congress or the Supreme Court.Neither has acted so far to resolve a con-flict that has been smoldering for 15years. As such, debtors and non-debt-ors alike can have no degree of certaintyregarding the effect of a bankruptcy fil-ing on contracts and leases that cannotbe assumed without the non-debtor’sconsent under applicable non-bank-ruptcy law. Indeed, some commentatorshave observed that the provisions of theBankruptcy Code governing the as-sumption and assignment of contractsare “generally perceived to be the mostconvoluted and worst drafted section ofthe Bankruptcy Code.” Section 365(c),specifically, has “come in for its share of

scholarly disdain.” Help does not ap-pear to be on the way any time soon.The Supreme Court has yet to agree tohear a case on whether the “hypotheti-cal” or the “actual” test is the properone. Lawmakers have not been movedto solve the problem either. Sweepingbankruptcy reform legislation that hasbeen mired in Capitol Hill trenches for sixyears is devoid of any attempt to clarify aprovision that has and will continue tobedevil courts.

With no resolution of this matteron the horizon, the practical challengesconfronting parties to these kinds ofcontracts can only be accurately assessedon a case-by-case basis by reference tothe particular court presiding over thedebtor’s bankruptcy case. To date, theThird, Ninth and Eleventh Circuitshave adopted or expressed approval ofthe “hypothetical” approach, while theFirst Circuit has rejected it in favor ofthe “actual” test. Lower courts line upon both sides of a rift that does notshow any promise of being mended inthe foreseeable future._________________________________________

RCC Technology Corp. v. Sunterra Corp.,287 B.R. 864 (D. Md. 2003).

In re West Electronics Inc., 852 F.2d 79(3d Cir. 1988).

Institut Pasteur v. Cambridge BiotechCorp., 104 F.3d 489 (1st Cir.1997).

Perlman v. Catapult Entm’t, Inc. (In reCatapult Entm’t, Inc.), 165 F.3d 747(9th Cir. 1999).

City of Jamestown v. James Cable Part-ners, L.P. (In re James Cable Partners,L.P.), 27 F.3d 534 (11th Cir. 1994).

From the TopThe U.S. Supreme Court handed

down its second bankruptcy deci-

sion of 2003 on March 31. In Ar-

cher v. Warner, a seven-to-two

majority of the High Court ruled

that a debt owed under a settlement

agreement in which an underlying

fraud claim was released in ex-

change for an obligation to pay on

a promissory note should be con-

sidered a debt for money “obtained

by fraud” such that it is not dis-

chargeable in bankruptcy. Resolv-

ing a split among the Circuit Courts

of Appeal on this issue, Justice

Breyer, writing for the majority, con-

cluded that the settlement agree-

ment did not act as a “novation”

creating an entirely different debt

that would fall outside the scope of

the Bankruptcy Code provision pre-

cluding a discharge of debts predi-

cated on fraud. Emphasizing that

Congress intended the fullest pos-

sible enquiry to ensure that all

fraud-based debts are excepted

continued on page 16

continued from page 13

B u s i n e s s R e s t r u c t u r i n g R e v i e w I 15

Up in the AirNotwithstanding the emergence of U.S.Airways from chapter 11 on March 31,the outlook for the embattled airline in-dustry is anything but rosy. $10 billionin loan guarantees and $5 billion in di-rect aid approved by the federal govern-ment in the aftermath of the September11 attacks is proving to be little morethan a Band-Aid for the hemorrhagingair-transport sector. Even if Congressapproves another relief package thatcould pump an additional $3 billioninto the U.S. industry, a significant re-alignment of the sector is inevitable.Sagging demand caused by the Septem-ber 11 attacks, the wars in Afghanistanand Iraq, fears fueled by the outbreak ofsevere acute respiratory syndrome inAsia, inflated fuel prices and skyrocket-ing labor costs have already forced U.S.Airways, United Airlines, Swiss Air, AirCanada and Hawaiian Air into bank-ruptcy. American Airlines may not befar behind, judging by its recent impassewith employees concerning high-costlabor contracts. Other airlines, particu-larly smaller carriers that feed off routesthat have traditionally been overlookedby major carriers, are likely to feel thepain as industry giants scramble to fillseats.

The first week of war in Iraq hitU.S. carriers so hard that they laid offmore than 10,000 employees and begandouble-digit capacity cuts in what, formany, is a desperate attempt to fend offbankruptcy. Overall traffic for U.S. car-riers fell 10%, but the Air Transport As-sociation reports that war fears hittransatlantic travel the hardest, droppingit 25%, with transpacific loads off 13%.

The future is even uglier: Advancedtransatlantic bookings are off 40% andtranspacific bookings are down 30%.Domestic advanced bookings are down20%. Still, the Iraq war has not pro-duced as precipitous a U.S. traffic dropas the September 11 attacks, but tradi-tional hub-and-spoke carriers continueto operate with cost structures that aretoo high for the revenues they generate.Simply put, carriers cannot cut ex-penses fast enough to offset the drop inticket sales.

None of this comes as any great sur-prise. Even before the assault on Iraqbegan, the gravely weakened U.S. airlineindustry turned to the federal govern-ment for $4 billion in financial relief. Itexpects to lose that amount if the warlasts three months, a prediction thatmay prove to have been overly optimis-tic. When President Bush asked Con-gress for a supplemental appropriationsrequest of $74.7 billion at the end ofMarch, airline relief and other specialinterest appeals took a back seat to the“first installment” of a funding plan forthe true costs of the conflict.

European and other non-domesticcarriers are closely monitoring develop-

ments in the U.S. Analysts abroad werehighly critical of measures taken by theU.S. to come to the industry’s aid afterSeptember 11, claiming that the bailoutpropped up weak U.S. carriers that aredestined to fail while making it harderfor foreign carriers to compete againstthem. European airlines have also beenhurt by developments in the post-Sep-tember 11 era. In a recent statement,the International Air Transport Associa-tion emphasized that “air transport hasbeen going through its worst crisis in its100-year history, accumulating over$30-billion losses since the tragic eventsof September 11.” Yet, according to in-dustry analysts, the operations of Euro-pean carriers have not been significantlyaffected by the war. Although they havesuspended services into the Gulf region,IATA and the International Civil Avia-tion Organization implemented an airroute contingency plan rerouting flightsaround the war zone to minimize dis-ruption in international flights that wereformerly routed through the region.

All things considered, the shakeoutof the industry at home and abroad isunavoidable. Less certain is which car-riers will ride out the storm.

16 I J o n e s D a y

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continued from page 11

forded to intervenors in federal litiga-tion. Bankruptcy courts, like the courtpresiding over the chapter 11 case ofAdelphia Communications Corp., havebeen scrambling in Caldor’s aftermath tobalance the rights of committees as in-tervenors against the need to managein an orderly way the potential profusionof discovery requests and motion practiceassociated with intervenor status._____________________________________

In re Sunbeam Corp., 287 B.R. 861(S.D.N.Y. 2003).

Fuel Oil Supply & Terminaling v. GulfOil Corp., 762 F.2d 1283 (5th Cir.1985).

Official Unsecured Creditors’ Committee v.Michaels (In re Marin Motor Oil), 689F.2d 445 (3rd Cir. 1982), cert. denied,459 U.S. 1206 (1983).

Term Loan Holder Committee v. OzerGroup, L.L.C. (In re The Caldor Corpo-ration), 303 F.3d 161 (2d Cir. 2002).

Unsecured Creditors Committee v. Noyes(In re STN Enterprises), 779 F.2d 901(2d Cir. 1985).

Commodore Int’l Ltd. v. Gould (In reCommodore Int’l Ltd.), 262 F.3d 96 (2dCir. 2001).

Glinka v. Fed. Plastics Mfg. (In reHousecraft Indus. USA, Inc.), 310 F.3d64 (2d Cir. 2002).

Adelphia Communications Corp. v. Rigas(In re Adelphia Communications Corp.),285 B.R. 848 (Bankr. S.D.N.Y. 2002).

from discharge regardless of their form,the Court reasoned that the fundamen-tal nature of the debt in question couldnot be transformed merely because itwas denominated as something else —i.e., a “settlement agreement.” In doingso, the Supreme Court relied upon its1979 ruling in Brown v. Felson. In thatcase, the Court held that a bankruptcycourt may look beyond the record of astate court proceeding to determinewhether a debtor’s agreement in a stipu-lation embodied in a consent decree topay a certain amount to the plaintiff wasa debt for money obtained by fraud.According to the Archer v. WarnerCourt, the same reasoning applied tothe case before it. The fact that Browninvolved a state court consent degreewhile in Archer the debt was based upona settlement agreement, the Court re-marked, was a distinction of no rel-evance. The Court remanded the caseto the Fourth Circuit Court of Appeals

continued from page 14

with instructions to consider certain ad-ditional arguments raised by the debtor.

Justice Thomas, joined by JusticeStevens, filed a dissenting opinion.They argued that neither section523(a)(2) of the Bankruptcy Code (ex-cepting fraud-based claims from dis-charge) nor the express terms of thesettlement agreement at issue supportedthe majority’s ruling. Unlike in Brownv. Felson, the dissent emphasized, theparties in this case executed a blanketrelease of “any and every right, claim ordemand . . . arising out of” the fraudaction commenced by the plaintiff. Thedissent found this to be a critical distinc-tion, for it demonstrated that the partiesintended, by the language of the generalrelease, “to replace an ‘old’ fraud debtwith a new ‘contract’ debt.” The newobligation, the dissent concluded, is nota debt “obtained by fraud” within themeaning of the statute.