RECENT DEVELOPMENTS IN BANKRUPTCY AND RESTRUCTURING

VOLUME 12 NO. 4 JULY/AUGUST 2013

BUSINESS RESTRUCTURING REVIEW

A CAUTIONARY TALE FOR INSIDER LENDERS: NINTH CIRCUIT ENDORSES RECHARACTERIZATION REMEDY IN BANKRUPTCYLisa G. Laukitis and Mark G. Douglas

The ability of a bankruptcy court to reorder the priority of claims or interests by

means of equitable subordination or recharacterization of debt as equity is gener-

ally recognized. Even so, the Bankruptcy Code itself expressly authorizes only the

former of these two remedies. Although common law uniformly acknowledges the

power of a court to recast a claim asserted by a creditor as an equity interest in an

appropriate case, the Bankruptcy Code is silent upon the availability of the remedy

in a bankruptcy case.

This has led to uncertainty in some courts concerning the extent of their power to

recharacterize claims and the circumstances warranting recharacterization. The

Ninth Circuit Court of Appeals recently had an opportunity to consider this issue.

In Official Committee of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re

Fitness Holdings International, Inc.), 714 F.3d 1141 (9th Cir. 2013), the court ruled that

“a court has the authority to determine whether a transaction creates a debt or an

equity interest for purposes of § 548, and that a transaction creates a debt if it cre-

ates a ‘right to payment’ under state law.”

By its ruling, the Ninth Circuit overturned longstanding Ninth Circuit bankruptcy

appellate panel precedent to the contrary and became the sixth federal circuit

court of appeals to hold that the Bankruptcy Code authorizes a court to recharac-

terize debt as equity. The decision is a cautionary tale for private equity sponsors

IN THIS ISSUE

1 A Cautionary Tale for Insider Lend-ers: Ninth Circuit Endorses Rechar-acterization Remedy in Bankruptcy

6 Safe Harbor Redux: The Second Cir-cuit Revisits the Bankruptcy Code’s Protection Against Avoidance of Securities Contract Payments

7 Newsworthy

12 Tenth Circuit: Fraudulently Trans-ferred Assets Not Estate Property Until Recovered

15 Breaking New Ground: Delaware Bankruptcy Court Grants Admin-istrative Priority for Postpetition, Prerejection Lease Indemnification Obligations

19 Eurosail Supreme Court Judgment: Delineating the Boundaries of Insolvency

22 Sovereign-Debt Update

23 European Perspective in Brief

24 The U.S. Trustee’s New Chapter 11 Fee Guidelines

2

and other corporate insiders who advance money to their

businesses, as well as lenders considering taking an equity

stake in a borrower.

EQUITABLE SUBORDINATION AND RECHARACTERIZATION

Although the distinction between courts of equity and law

has largely become irrelevant in modern times, courts of

equity have traditionally been empowered to grant a broader

spectrum of relief in keeping with fundamental notions of

fairness, as distinguished from principles of black-letter law.

One of the tools available to a bankruptcy court in exercising

its broad equitable mandate is “equitable subordination.”

Equitable subordination is a remedy developed under com-

mon law prior to the enactment of the current Bankruptcy

Code to remedy misconduct that results in injury to credi-

tors or shareholders. It is expressly recognized in Bankruptcy

Code section 510(c), which provides that the bankruptcy

court may, “under principles of equitable subordination, sub-

ordinate for purposes of distribution all or part of an allowed

claim to all or part of another allowed claim or all or part of

an allowed interest to all or part of another allowed interest.”

However, the statute explains neither the concept nor the

standard that should be used to apply it.

This has been left to the courts. In In re Mobile Steel Co., 563

F.2d 692 (5th Cir. 1977), the Fifth Circuit Court of Appeals artic-

ulated what has become the most commonly accepted stan-

dard for equitable subordination of a claim. Under the Mobile

Steel standard, a claim can be subordinated if the claimant

engaged in some type of inequitable conduct that resulted

in injury to creditors (or conferred an unfair advantage on the

claimant) and if equitable subordination of the claim is con-

sistent with the provisions of the Bankruptcy Code. Courts

have refined the test to account for special circumstances.

For example, many courts make a distinction between insid-

ers (e.g., corporate fiduciaries) and noninsiders in assessing

the level of misconduct necessary to warrant subordination.

A related but distinct remedy is “recharacterization.” Like

equitable subordination, the power to treat a debt as if it

were actually an equity interest is derived from principles

of equity. It emanates from the bankruptcy court’s power to

ignore the form of a transaction and give effect to its sub-

stance. However, because the Bankruptcy Code does not

expressly empower a bankruptcy court to recharacterize

debt as equity, some courts disagree as to whether they have

the authority to do so and, if so, the source of such author-

ity. According to some courts (albeit a minority), because

the statute authorizes subordination but is silent concerning

recharacterization, Congress intended to deprive bankruptcy

courts of the power to recharacterize a claim.

Taken as a whole, the Ninth Circuit’s rulings are a

cautionary tale to corporate insiders (including pri-

vate equity sponsors) that make loans to a com-

pany or attempt to cash out in a refinancing or

dividend recapitalization transaction shortly before

the company files for bankruptcy.

This was the approach taken by a Ninth Circuit bankruptcy

appellate panel in In re Pacific Express, Inc., 69 B.R. 112 (B.A.P.

9th Cir. 1986). Pacific Express has been widely criticized,

however, for failing to distinguish between equitable subor-

dination and recharacterization. See, e.g., In re Daewoo Motor

America, Inc., 471 B.R. 721 (Bankr. C.D. Cal. 2012); In re The 3Do

Co., 2004 Bankr. LEXIS 2345 (Bankr. N.D. Cal. July 2, 2004).

In fact, no fewer than four federal circuit courts of appeal

have held that a bankruptcy court’s power to recharacter-

ize debt derives from the broad equitable powers set forth

in section 105(a) of the Bankruptcy Code, which provides

that “[t]he court may issue any order, process, or judgment

that is necessary or appropriate to carry out the provisions

of [the Bankruptcy Code].” See Committee of Unsecured

Creditors for Dornier Aviation (North America), Inc., 453 F.3d

225 (4th Cir. 2006); Cohen v. KB Mezzanine Fund, II, LP (In

re SubMicron Systems Corp.), 432 F.3d 448 (3d Cir. 2006);

Sender v. Bronze Group, Ltd. (In re Hedged-Invs. Assocs., Inc.),

380 F.3d 1292 (10th Cir. 2004); Bayer Corp. v. MascoTech, Inc.

(In re AutoStyle Plastics, Inc.), 269 F.3d 726 (6th Cir. 2001).

In Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650

F.3d 539 (5th Cir. 2011), the Fifth Circuit adopted a nuanced

approach to the question, ruling that a bankruptcy court’s

ability to recharacterize debt as equity is part of the court’s

authority to allow and disallow claims under section 502

of the Bankruptcy Code. In Lothian Oil, the Fifth Circuit

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explained that the U.S. Supreme Court’s ruling in Butner v.

United States, 440 U.S. 48 (1979), makes clear that when a

bankruptcy court is called upon to rule on an objection to

a claim under section 502(b), state law determines whether,

and to what extent, a claim is “unenforceable against the

debtor and property of the debtor, under any agreement or

applicable law.” “Taken together,” the court reasoned, “Butner

and § 502(b) support the bankruptcy courts’ authority to

recharacterize claims.” Thus, if an asserted interest would be

classified as equity rather than debt under applicable state

law, the bankruptcy court would be empowered to recharac-

terize, rather than disallow, the claim.

The Fifth Circuit distanced itself from sister circuits that pred-

icate the power to recharacterize debt as equity upon the

bankruptcy courts’ equitable authority under section 105(a).

According to the court, given its interpretation of section

502(b), “resort to § 105(a) is unnecessary.” “We agree with sis-

ter circuits’ results,” the Fifth Circuit wrote, “but not necessar-

ily their reasoning.”

Courts also disagree about the law that should apply in

deciding whether a purported debt should be recharacter-

ized as equity. Some, including the Fifth Circuit in Lothian,

view applicable state law as being determinative on this

issue. Others have adopted or fashioned tests that include

various factors drawn from a wide variety of sources under

state, federal, and common law. For example, in AutoStyle

Plastics, the Sixth Circuit applied an 11-factor test derived

from federal tax law first articulated in Roth Steel Tube Co.

v. Commissioner of Internal Revenue, 800 F.2d 625, 630 (6th

Cir. 1986). Among the enumerated factors are the labels given

to the debt; the presence or absence of a fixed maturity

date, interest rate, and schedule of payments; whether the

borrower is adequately capitalized; any identity of interest

between the creditor and the stockholder; whether the loan

is secured; and the corporation’s ability to obtain financing

from outside lending institutions. Under this test, no single

factor is controlling. Instead, each factor is to be considered

in the particular circumstances of the case.

In SubMicron, the Third Circuit rejected a factor-based

inquiry as a “mechanistic scorecard,” opting instead to focus

on the parties’ intent at the time of the transaction through

a common-sense evaluation of the facts and circumstances.

Even so, the Third Circuit affirmed a ruling below refusing to

recharacterize debt as equity using a factor-based analysis

derived in part from state law, noting that the lower court’s

findings “overwhelmingly support the Court’s decision to

characterize the [funding transaction] as debt (under any

framework or test).”

The Ninth Circuit had an opportunity to weigh in on these

and other issues in Fitness Holdings.

FITNESS HOLDINGS

California-based Fitness Holdings International, Inc. (“FHI”)

was a seller of treadmills, cross-trainers, and exercise bikes

for home use. Between 2003 and 2006, FHI borrowed nearly

$25 million from Hancock Park Capital II, L.P. (“Hancock Park”),

its sole shareholder. The loans were evidenced by a series of

unsecured subordinated promissory notes with stated maturity

dates bearing interest at 10 percent per annum.

In July 2004, Pacific Western Bank (“Pacific Western”) pro-

vided financing to FHI in the form of a $7 million revolving

loan and a $5 million installment loan, both of which were

secured by a lien on all of FHI’s assets. Hancock Park guar-

anteed the loans. Due to FHI’s ongoing financial difficulties,

the loan agreements were amended several times during the

next three years to extend maturities and waive defaults.

In June 2007, FHI and Pacific Western entered into a refi-

nancing agreement whereby: (i) Pacific Western provided

new financing to FHI in the form of a $17 million term loan

and an $8 million revolving line of credit, both of which were

secured by a lien on all of FHI’s assets; (ii) $9 million of the

loan proceeds was used to pay off Pacific Western’s original

secured loan; (iii) $12 million of the loan proceeds was dis-

bursed to Hancock Park to pay off its unsecured loans; and

(iv) Hancock Park was released from its guaranty obligations.

The refinancing did not rescue FHI from its financial dif-

ficulties, and the company filed for chapter 11 protection in

California on October 20, 2008. FHI’s unsecured creditors’

committee was subsequently authorized to commence liti-

gation on the estate’s behalf against Hancock Park, Pacific

Western, and certain individual insider defendants to

recover the payments made to Hancock Park as part of the

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refinancing transaction. Among other things, the complaint

stated causes of action for actual and constructive fraudu-

lent transfers under section 548 of the Bankruptcy Code and

California’s version of the Uniform Fraudulent Transfer Act,

recharacterization, breach of fiduciary duty, and equitable

subordination under section 510(c) of the Bankruptcy Code.

In January 2010, the bankruptcy court dismissed each count

of the complaint for failure to state a claim. Among other

things, the bankruptcy court concluded that: (i) because the

$12 million payment to Hancock Park was a dollar-for-dollar

satisfaction of an antecedent debt (i.e., “reasonably equiva-

lent value”), there was no constructive fraudulent transfer

under either California state law or federal bankruptcy law;

(ii) the ruling in Pacific Express defeated the count of the

complaint seeking recharacterization; and (iii) the complaint

insufficiently pleaded inequitable conduct to support a claim

for equitable subordination.

After FHI’s chapter 11 case was converted to a chapter 7

liquidation, the trustee (who succeeded to the committee as

plaintiff in the avoidance litigation) appealed the order dis-

missing the adversary proceeding to the district court. The

district court affirmed. Addressing the trustee’s recharacter-

ization claim, the court wrote that “[w]hile Plaintiff correctly

points out that other circuits have allowed claims for rechar-

acterization, In re Pacific Express remains good author-

ity here and the Court therefore rejects Plaintiff’s claim for

recharacterization.” The trustee appealed to the Ninth Circuit.

THE NINTH CIRCUIT’S RULING

A three-judge panel of the Ninth Circuit reversed and

remanded the case below for additional determinations

consistent with its ruling. Writing for the court, circuit judge

Sandra S. Ikuta explained that, in the context of avoidance

litigation under section 548(a)(1)(B) (dealing with construc-

tive fraudulent transfers), “reasonably equivalent value” is

not defined in the Bankruptcy Code, but “value” is defined

in section 548(d)(2)(A) to include the “satisfaction or secur-

ing of a present or antecedent debt of the debtor.” “Under

this definition,” she wrote, “ ‘[p]ayment of a pre-existing debt

is value, and if the payment is dollar-for-dollar, full value is

given’ ” (quoting 5 Collier on BankruptCy ¶ 548.03[5] (16th ed.

2012)). Therefore, the judge concluded, a transaction involv-

ing dollar-for-dollar repayment of an antecedent debt cannot

be constructively fraudulent.

Judge Ikuta then examined the meaning of the term “debt,”

which is defined in section 101(12) of the Bankruptcy Code to

mean “liability on a claim.” The term “claim” is defined in sec-

tion 101(5)(A) in relevant part to mean “a right to payment,

whether or not such right is reduced to judgment, liquidated,

unliquidated, fixed, contingent, matured, unmatured, disputed,

undisputed, legal, equitable, secured, or unsecured.” In accor-

dance with these “interlocking definitions,” the judge wrote, “to

the extent a transfer is made in satisfaction of a ‘claim’ (i.e., a

‘right to payment’), that transfer is made for ‘reasonably equiva-

lent value’ for purposes of § 548(a)(1)(B)(i),” thereby precluding

avoidance of the transfer as being constructively fraudulent.

According to Judge Ikuta, U.S. Supreme Court precedent,

including Butner and Travelers Cas. & Sur. Co. of Am. v. Pac.

Gas & Elec. Co., 549 U.S. 443 (2007), establishes that, unless

Congress provides otherwise, the “scope of a right to pay-

ment is determined by state law.” Relying on Butner, she

explained, the Supreme Court held in Travelers that a court

should not use a federal rule to determine whether a prepeti-

tion contract guaranteeing attorneys’ fees created a “right to

payment” giving rise to a “claim” under the Bankruptcy Code.

On the basis of this authority, the judge concluded that

a court may not “fashion a rule ‘solely of its own creation’

in determining what constitutes a ‘claim’ for purposes of

bankruptcy.” Instead, she wrote, “subject to any qualifying

or contrary provisions of the Bankruptcy Code, . . . a court

must determine whether the asserted interest in the debtor’s

assets is a ‘right to payment’ recognized under state law”

(citations omitted). Judge Ikuta explained that, in the context

of fraudulent-transfer litigation, if a defendant claims that a

transfer constituted the repayment of a debt, the court must

determine whether the purported “debt” constitutes a right to

payment under state law. If no right to payment exists as a

matter of state law, “the court may recharacterize the debt-

or’s obligation to the transferee under state law principles.”

According to Judge Ikuta, the district court erred by relying

on Pacific Express. She explained that an Article III district

court is not bound by the rulings of a bankruptcy appellate

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panel. Moreover, the judge wrote, “Pacific Express erred in

holding that the ‘characterization of claims as equity or debt’

is governed by § 510(c).” According to Judge Ikuta, rechar-

acterization and equitable subordination address distinct

concerns. A court considering a motion to avoid a construc-

tively fraudulent transfer, she emphasized, “must determine

whether the transfer is for the repayment of a ‘claim’ at all.”

Although Judge Ikuta agreed with rulings by sister cir-

cuits concluding that the Bankruptcy Code gives courts the

authority to recharacterize claims, she took issue with circuits

that “have fashioned a federal test for recharacterizing an

alleged debt in reliance on their general equitable authority

under 11 U.S.C. § 105(a).” Instead, the judge concluded that

the Fifth Circuit’s approach in Lothian Oil is more consistent

with Supreme Court precedent. “Given the Supreme Court’s

direction,” she wrote, “courts may not rely on § 105(a) and fed-

eral common law rules ‘of [their] own creation’ to determine

whether recharacterization is warranted” (quoting Travelers).

Having determined that state law must govern whether a

“right to payment” exists, Judge Ikuta ruled that dismissal

of the complaint was improper because the lower courts’

assumption that they did not have the ability to recharacter-

ize a debt as equity was erroneous. She therefore vacated

the ruling and remanded the case below for consideration of

the matter “under the proper legal framework.”

OUTLOOK

With the ruling in Fitness Holdings, six federal circuit courts

of appeal—and the great majority of bankruptcy and lower

appellate courts—have now ruled that recharacterization

is among the powers conferred upon a court under the

Bankruptcy Code. This is a positive development for chapter

11 debtors in possession, bankruptcy trustees, and stakehold-

ers standing to benefit by the potential for enhanced recov-

ery from a bankruptcy estate.

Even so, by aligning itself with the Fifth Circuit—and against

the Third, Fourth, Sixth, and Tenth Circuits—on the issue of

choice of law in determining whether a debt should be rechar-

acterized as equity, the Ninth Circuit in Fitness Holdings has

added to the already considerable confusion in the courts

concerning the circumstances under which the remedy should

be applied. Under the approach adopted by the Fifth and

Ninth Circuits, choice-of-law provisions in loan agreements

may have an important role in litigation concerning whether a

purported loan is treated as debt or a capital contribution.

Does this rift among the circuits create a distinction largely

without a difference? Perhaps and perhaps not. Some states

apply a factor-based analysis drawn from federal tax law

(some citing AutoStyle Plastics or Roth Steel) in deciding

whether a debt should be recharacterized as equity. See, e.g.,

Dealer Services Corporation v. American Auto Auction, Inc., No.

NNH cv 095028282S, 2013 BL 150455 (Conn. Super. Ct. May

14, 2013); see also Idaho Development, LLC v. Teton View Golf

Est., 152 Idaho 401, 272 P.3d 373 (Idaho 2011) (using factors to

infer intent of the parties consistent with Third Circuit’s ruling

in SubMicron). Other states do not. See James M. Wilton and

Stephen Moeller-Sally, Debt Recharacterization Under State

Law, 62 Bus. law. 1257 (Aug. 2007) (discussing development of

federal and state law governing recharacterization, including

common law of Massachusetts and Wisconsin, and conclud-

ing that inconsistent application of the law in state and federal

courts creates undesirable commercial uncertainty).

In a separate unpublished memorandum decision, the Ninth

Circuit affirmed dismissal of the complaint seeking avoid-

ance of the payment to Hancock Park as an actual fraudu-

lent transfer. The court wrote that “[w]e cannot reasonably

infer that [FHI] was attempting to ‘hinder, delay, or defraud’

its creditors . . . simply because it took on secured debt to

replace unsecured debt; borrowers regularly give secu-

rity interests to obtain financing.” See In re Fitness Holdings

International, Inc. , No. 1 1-56677 (9th Cir. Apr. 30, 2013).

However, the court reversed dismissal of the cause of action

seeking equitable subordination, writing that “[t]he trustee’s

allegations . . . that insiders ‘contrived’ to benefit themselves

by knowingly funneling money to themselves out of a failing

company plausibly alleged the elements of a claim for equi-

table subordination.”

Taken as a whole, the Ninth Circuit’s rulings are a cautionary

tale to corporate insiders (including private equity sponsors)

that make loans to a company or attempt to cash out in a

refinancing or dividend recapitalization transaction shortly

before the company files for bankruptcy.

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SAFE HARBOR REDUX: THE SECOND CIRCUIT REVISITS THE BANKRUPTCY CODE’S PROTECTION AGAINST AVOIDANCE OF SECURITIES CONTRACT PAYMENTSCharles M. Oellermann and Mark G. Douglas

“Safe harbors” in the Bankruptcy Code designed to mini-

mize “systemic risk”—disruption in the securities and com-

modities markets that could otherwise be caused by a

counterparty’s bankruptcy filing—have been the focus of

a considerable amount of judicial scrutiny in recent years.

The latest contribution to this growing body of sometimes

controversial jurisprudence was recently handed down by

the U.S. Court of Appeals for the Second Circuit. The rul-

ing widens a rift among the federal circuit courts of appeal

concerning the scope of the Bankruptcy Code’s “settle-

ment payment” defense to avoidance of a preferential or

constructively fraudulent transfer. In Official Committee of

Unsecured Creditors v. American United Life Insurance Co.

(In re Quebecor World (USA) Inc.), 2013 WL 2460726 (2d Cir.

June 10, 2013), the Second Circuit held that securities trans-

fers may qualify for this section 546(e) safe harbor even if

the financial institution involved in the transfer is “merely a

conduit.” The court affirmed dismissal of the $376 million suit

brought by an official creditors’ committee on behalf of the

bankruptcy estate against a group of insurer-investors.

SECTION 546: LIMITATIONS ON AVOIDING POWERS

The Bankruptcy Code empowers a bankruptcy trustee or

chapter 11 debtor in possession (“DIP”) to invalidate certain

transfers (or obligations incurred) by a debtor during pre-

scribed periods immediately prior to (and even after) filing for

bankruptcy protection. Among these are the ability to “avoid”

transfers that are fraudulent by design or because an insol-

vent transferor did not receive fair consideration in exchange

(sections 544 and 548), the power to avoid transfers that pre-

fer one creditor over others (section 547), and the ability to

avoid postbankruptcy transfers that are not authorized by the

Bankruptcy Code or the court (section 549).

Section 546 of the Bankruptcy Code, however, imposes impor-

tant limitations on the rights and powers granted to the trustee

or DIP elsewhere in the Bankruptcy Code. These include,

among others, statutes of limitations for avoidance actions

(section 546(a)), limitations based upon the perfection rights

afforded under applicable nonbankruptcy law to entities with

interests in the debtor’s property (section 546(b)), and limita-

tions based upon reclamation rights arising under applicable

nonbankruptcy law (sections 546(c) and 546(d)).

The restrictions also include provisions prohibiting avoidance

in most cases of: (i) transfers that are margin or settlement

payments made in connection with securities, commodity, or

forward contracts (section 546(e)); (ii) transfers made by, to,

or for the benefit of a repo participant or financial participant

in connection with a repurchase agreement (section 546(f));

(iii) transfers made by, to, or for the benefit of a swap par-

ticipant or financial participant under or in connection with a

prepetition swap agreement (section 546(g)); and (iv) subject

to certain exceptions, transfers made by, to, or for the benefit

of a “master netting agreement participant” under certain cir-

cumstances (section 546(j)).

Section 546(e), which creates a safe harbor for margin or set-

tlement payments, provides as follows:

Notwithstanding sections 544, 545, 547, 548(a)(1)(B),

and 548(b) of this title, the trustee may not avoid

a transfer that is a margin payment, as defined in

section 101, 741, or 761 of this title, or settlement pay-

ment, as defined in section 101 or 741 of this title,

made by or to (or for the benefit of) a commodity

broker, forward contract merchant, stockbroker,

financial institution, financial participant, or securi-

ties clearing agency, or that is a transfer made by

or to (or for the benefit of) a commodity broker,

forward contract merchant, stockbroker, financial

institution, financial participant, or securities clear-

ing agency, in connection with a securities contract,

as defined in section 741(7), commodity contract, as

defined in section 761(4), or forward contract, that

is made before the commencement of the case,

except under section 548(a)(1)(A) of this title.

Prior to the enactment of the Bankruptcy Code in 1978, U.S.

bankruptcy law did not protect margin or settlement pay-

ments from avoidance, and such payments were held

to be avoidable. Lawmakers changed this by enacting

7

NEWSWORTHYDavid G. Heiman (Cleveland), Bruce Bennett (Los Angeles), Corinne Ball (New York), Heather Lennox (New York and

Cleveland), and Jeffrey B. Ellman (Atlanta) are leading a team of Jones Day professionals advising the City of Detroit in

connection with its historic filing for protection under chapter 9 of the Bankruptcy Code. Detroit’s chapter 9 filing is the

largest municipal-bankruptcy filing ever by a U.S. city.

Paul D. Leake (New York) and Corinne Ball (New York) were named “Leading Lawyers” in the practice area “Finance—

Corporate restructuring” in The Legal 500 United States 2013.

Corinne Ball (New York) was among The International Who’s Who Legal for 2013 in the field of Insolvency

& Restructuring.

Brett P. Barragate (New York) and Robert J. Graves (Chicago) were recommended in the field of “Finance—Bank lend-

ing” in The Legal 500 United States 2013.

Bruce Bennett (Los Angeles), David G. Heiman (Cleveland), James O. Johnston (Los Angeles), Paul D. Leake (New

York), Joshua M. Mester (Los Angeles), Corinne Ball (New York), Monika S. Wiener (Los Angeles), Richard L. Wynne (Los

Angeles), and Sidney P. Levinson (Los Angeles) were recommended in the field of “Finance—Corporate restructuring” in

The Legal 500 United States 2013.

Heather Lennox (New York and Cleveland), Bruce Bennett (Los Angeles), James O. Johnston (Los Angeles), Joshua

M. Mester (Los Angeles), and Sidney P. Levinson (Los Angeles) were recommended in the field of “Finance—Municipal

bankruptcy” in The Legal 500 United States 2013.

David G. Heiman (Cleveland), Paul D. Leake (New York), Bruce Bennett (Los Angeles), Heather Lennox (New York and

Cleveland), Richard L. Wynne (Los Angeles), Michael Rutstein (London), and Corinne Ball (New York) were awarded a

“most highly regarded” designation in the field of Insolvency & Restructuring in Who’s Who Legal 100 2013.

Paul D. Leake (New York) participated in a panel discussion on May 16 entitled “Who’s Running the Company?” at the

American Bankruptcy Institute’s 15th Annual New York City Bankruptcy Conference.

Mark A. Cody (Chicago) participated in a panel discussion on June 7 entitled “Real Estate Distress: Workout Options

in Real Estate” at the Association of Insolvency & Restructuring Advisors’ 29th Annual Bankruptcy & Restructuring

Conference in Chicago.

Lori Sinanyan (Los Angeles) moderated a bankruptcy judges’ panel discussion on July 18 entitled “Is That LBO a

Fraudulent Transfer? Things to Consider to Avoid This Outcome and What Happens When You Can’t” at the Turnaround

Management Association’s 5th Annual Western Regional Conference in Laguna Beach, California.

8

section 764(c) of the Bankruptcy Code as part of the

Bankruptcy Reform Act of 1978. That provision, which applied

only in commodity-broker liquidation cases under chapter

7, prohibited a trustee from avoiding a transfer that was: (i)

a margin payment or a deposit with a commodity broker or

forward-contract merchant; or (ii) a settlement payment by a

clearing organization. Its purpose was to facilitate prebank-

ruptcy transfers, promote customer confidence in commodi-

ties markets, and ensure the stability of those markets.

Section 764(c) was repealed in 1982 and replaced by a pro-

vision that was designated subsection (e) of section 546 in

1984. Section 546(e) clarified prior section 764(c) and made it

applicable to both the securities and commodities markets,

again in an effort to ensure the public’s confidence in and

the stability of those markets. In 1984, Congress enacted sec-

tion 546(f) to expand the safe harbor to include protection

for repo participants in connection with repurchase agree-

ments. Most recently, sections 546(e) and (f) were amended

in 2005 by the Bankruptcy Abuse Prevention and Consumer

Protection Act to include protection for “financial partici-

pants” in connection with repurchase agreements and in

2006 by the Financial Netting Improvements Act to clarify

and expand their scope (e.g., by adding the phrase “(or for

the benefit of)” to section 546(e) and by including within the

scope of the section 546(e) safe harbor transfers made in

connection with a “securities contract”).

The limitations in section 546(e) expressly do not apply to

section 548(a)(1)(A) of the Bankruptcy Code, which authorizes

avoidance of transfers made or obligations incurred with the

actual intent to hinder, delay, or defraud creditors. Section

546(e), however, does apply to actions to avoid construc-

tively fraudulent transfers under section 548(a)(1)(B) or 544.

(The latter authorizes, among other things, the pursuit of con-

structively fraudulent transfers under applicable state law.) In

addition, section 546(e) does not restrict the trustee’s rights

and powers with respect to postpetition transfers under sec-

tion 549 of the Bankruptcy Code. Although not mentioned

in section 546(e), avoidance of prepetition setoffs involving

margin and settlement payments is prohibited under section

553(b)(1) of the Bankruptcy Code.

Section 546(e) applies when a “margin payment” or “set-

tlement payment” is made by, to, or for the benefit of a

commodity broker, forward-contract merchant, stockbroker,

financial institution, financial participant, or securities clearing

agency, all of which are defined elsewhere in the Bankruptcy

Code, prior to the commencement of a bankruptcy case.

The payment may be made by any of these entities to a third

party or by a third party to one of the entities listed.

Section 101(51A) defines “settlement payment” as “a pre-

liminary settlement payment, a partial settlement payment,

an interim settlement payment, a settlement payment on

account, a final settlement payment, a net settlement pay-

ment, or any other similar payment commonly used in the

forward contract trade.” The term is similarly defined with

respect to the “securities trade” in section 741(8), which

applies to stockbroker liquidation cases.

Most courts interpret the term “settlement payment” broadly

to include any transfer of securities in connection with the

completion of a securities transaction. Qualifying transfers

include both routine securities transactions and, according

to several federal circuit courts of appeal, more complicated

transactions, such as transfers made during the course of a

leveraged-buyout transaction (“LBO”). See, e.g., Lowenschuss

v. Resorts Int’l, Inc. (In re Resorts Int’l, Inc.), 181 F.3d 505 (3d

Cir. 1999); Kaiser Steel Corp. v. Pearl Brewing Co. (In re Kaiser

Steel Corp.), 952 F.2d 1230 (10th Cir. 1991). Moreover, the Third,

Sixth, and Eighth Circuits have recently held that the safe

harbor extends even to LBOs that involve nonpublic securi-

ties and thus have no impact on the public-securities mar-

kets. See Brandt v. B.A. Capital Co. (In re Plassein Int’l Corp.),

590 F.3d 252 (3d Cir. 2009); QSI Holdings, Inc. v. Alford (In re

QSI Holdings, Inc.), 571 F.3d 545 (6th Cir. 2009); Contemporary

Indus. Corp. v. Frost, 564 F.3d 981 (8th Cir. 2009).

In In re Enron Creditors Recovery Corp. v. Alfa, S.A.B. de C.V.,

651 F.3d 329 (2d Cir. 2011), the Second Circuit considered, as

a matter of first impression, whether section 546(e) extends

to an issuer’s payments to redeem commercial paper prior

to maturity. The plaintiff in Enron sued to avoid $1.1 billion in

prepetition redemption payments made by the debtor to

retire unsecured commercial paper. It argued that the pay-

ments were not shielded from avoidance as “settlement pay-

ments” under section 546(e) because: (i) the payments were

not “commonly used in the securities trade,” as required by

the definition of “settlement payment” in section 741(8); (ii) the

9

redemption payments were made to retire debt and not to

acquire title to commercial paper, meaning no title to the

securities changed hands, as required for a transaction to

be considered a “settlement payment”; and (iii) the payments

did not involve a financial intermediary that took title to the

securities, and therefore they did not create the risks to the

financial markets that prompted Congress to enact the safe-

harbor provisions.

Broadly interpreting the plain language of section 546(e),

the Second Circuit disagreed, holding that the redemption

payments were “settlement payments” entitled to the pro-

tection of the safe-harbor provision. The court rejected the

argument that the phrase “commonly used in the securities

trade” in section 741(8)’s definition of “settlement payment”

applied to each preceding term, thus limiting the definition

of “settlement payment” to transactions which are commonly

performed in the securities trade. Applying the “last anteced-

ent” rule of construction, the court held that the phrase “com-

monly used in the securities trade” modifies only the term

immediately preceding it, i.e., “any other similar payment.”

The phrase, therefore, was intended to be a catchall under-

scoring the breadth of section 546(e), and not a limitation.

The Second Circuit also found no support for the contention

that title to securities must change hands in order for a pay-

ment to qualify as a “settlement payment,” and it refused to

read such a requirement into the statute.

Finally, the court rejected the argument that the payments

at issue were not “settlement payments” because the trans-

action lacked a financial intermediary which took a benefi-

cial interest in the securities. For support, the Second Circuit

cited Plassein, QSI Holdings, and Contemporary Industries, in

which sister circuits rejected similar arguments in the context

of LBOs because, regardless of whether a financial interme-

diary takes a beneficial interest in the exchanged securities,

undoing settled LBOs would have a substantial impact on the

stability of financial markets. The court reasoned that avoid-

ing debt-retirement payments would have a similarly nega-

tive effect on the financial markets. As a result, applying the

safe harbor to these payments, the court concluded, would

further congressional intent regarding section 546(e).

In a dissenting opinion, district judge John G. Koeltl, sitting by

designation, argued that the majority’s expansive reading of

the term “settlement payment” and its accompanying legisla-

tive intent would bring virtually every transaction involving a

debt instrument within the safe harbor of section 546(e). As

illustrated by Quebecor World, his prognostication may have

hit the mark.

QUEBECOR WORLD

One month after Enron was decided, a New York bankruptcy

court, in In re Quebecor World (USA) Inc., 453 B.R. 201 (Bankr.

S.D.N.Y. 2011), aff’d, 480 B.R. 468 (S.D.N.Y. 2012), aff’d, 2013 WL

2460726 (2d Cir. June 10, 2013), examined section 546(e) in

the context of a debtor’s repurchase and subsequent cancel-

lation of privately placed notes.

Canada-based Quebecor World, Inc. (“QWI”) and its affili-

ates once operated the second-largest commercial print-

ing business in North America. In 2000, QWI subsidiary

Quebec World Capital Corp. (“QWCC”) raised $371 million

for the Quebecor entities by issuing private-placement

notes (the “Notes”) to a variety of institutional investors (the

“Noteholders”) pursuant to note purchase agreements (the

“NPAs”). QWI and subsidiary Quebecor (USA) Inc. (“QWUSA”),

to which a portion of the Note proceeds was eventually trans-

ferred, guaranteed the Notes.

The NPAs gave QWCC the option to prepay the Notes so

long as it paid the outstanding principal, the accrued interest,

and a special “make-whole amount.” The agreements also

prohibited any Quebecor affiliate from purchasing the Notes

unless the buyer complied with the prepayment provisions.

Finally, the NPAs provided for the acceleration of the maturity

of the Notes if QWI’s debt-to-capitalization ratio fell below a

certain threshold. Under a separate $1 billion revolving credit

facility provided to QWI, any default under the NPAs would

also trigger a default under the credit facility agreement.

After QWI confronted financial difficulties in 2007, it negotiated

a cooperation agreement with the Noteholders under which

the Noteholders agreed not to sell their Notes to any entity

other than another existing Noteholder. QWI approved the pre-

payment of all of the Notes in September 2007. However, upon

realizing that redemption would have severe tax implications

10

under Canadian law, QWI restructured the prepayment so that

QWUSA would purchase the Notes for cash and QWCC would

then redeem them from QWUSA in exchange for forgiveness

of debt which QWUSA owed to QWCC.

On October 29, 2007, QWUSA transferred $376 million to the

Noteholders’ trustee, CIBC Mellon Trust Co. (“CIBC”). CIBC

then distributed the funds to the Noteholders and eventually

surrendered the Notes directly to QWI in Canada.

On January 20, 2008, QWI and its Canadian affiliates filed

for protection under the Canadian Companies’ Creditors

Arrangement Act in Montreal. QWUSA filed for chapter 11 pro-

tection in New York on January 21, 2008, less than 90 days

after making the payment for the Notes.

QWUSA’s official creditors’ committee was later authorized to

sue the Noteholders on behalf of the estate, seeking to avoid

the $376 million transfer as a preference. The Noteholders

moved for summary judgment, arguing that the transfer was

exempt from avoidance under section 546(e). Relying heav-

ily on Enron (which was decided shortly after the committee

filed its complaint), the bankruptcy court held that the pay-

ment was covered by the safe harbor.

Specifically, the court concluded that, because of Enron,

courts no longer need: (i) to consider conflicting evidence

about usage of the term “settlement payment” within the

private-placement sector of the securities industry; or (ii) to

decide whether prepetition transfers of value to the defen-

dants should be characterized as a “redemption” of private-

placement notes rather than a repurchase. Instead, the court

ruled, any transaction involving a transfer of cash to com-

plete a securities transaction is a “settlement payment” and

thus cannot be avoided.

The district court affirmed on appeal, agreeing that QWUSA’s

payment was a “settlement payment” under Enron. However,

the court did not agree that a transfer to “redeem” securities

can qualify as a “transfer made . . . in connection with a secu-

rities contract” because section 741(7)(A)(i) of the Bankruptcy

Code defines a “securities contract” as a contract “for the pur-

chase, sale, or loan of a security.” Even so, the district court

affirmed the bankruptcy court’s alternative ruling because the

transaction was in fact a “purchase” instead of a “redemption.”

THE SECOND CIRCUIT’S RULING

A three-judge panel of the Second Circuit affirmed the rul-

ing below. Writing for the court, circuit judge Denny Chin

acknowledged that there is a split of authority regarding the

role which a financial institution must play in the transaction

in order to qualify for the safe harbor. Three circuits—the

Third Circuit in Resorts International, the Sixth Circuit in QSI

Holdings, and the Eighth Circuit in Contemporary Industries—

have concluded that the plain language of section 546(e)

encompasses any transfer to a financial institution, even if it

serves only as a conduit or intermediary. Only the Eleventh

Circuit, Judge Chin explained, has held that the financial

institution must acquire a beneficial interest in the transferred

funds or securities in order to trigger the safe harbor. See

Munford v. Valuation Research Corp. (In re Munford, Inc.), 98

F.3d 604 (11th Cir. 1996); accord Rushton v. Bevan (In re D.E.I.

Systems, Inc.), 2011 WL 1261603 (Bankr. D. Utah Mar. 31, 2011).

“In Enron,” the judge wrote, “we cited the Third, Sixth, and

Eighth Circuits’ decisions with approval and concluded that

‘the absence of a financial intermediary that takes title to the

transacted securities during the course of the transaction is

[not] a proper basis on which to deny safe-harbor protec-

tion.’ ” “To the extent Enron left any ambiguity in this regard,”

Judge Chin ruled, “we expressly follow the Third, Sixth, and

Eighth Circuits in holding that a transfer may qualify for the

section 546(e) safe harbor even if the financial intermediary

is merely a conduit.”

Quebecor World continues the recent trend toward

expansive interpretation of the Bankruptcy Code’s

safe harbors for securities and commodities trans-

actions, in which courts typically cite the underly-

ing purpose of the provisions: to manage systemic

risk posed by a counterparty’s bankruptcy. With

Quebecor World and Enron, the Second Circuit has

adopted a broad approach to both the “settlement

payment” and “securities contract” prongs of sec-

tion 546(e).

Judge Chin explained that the plain language of section

546(e) indicates that a transfer may be either “for the ben-

efit of” a financial institution or “to” a financial institution, but

need not be both. This construction of the provision furthers

11

the purpose behind the exemption: to minimize displacement

caused in the commodities and securities markets in the

event of a major bankruptcy affecting those industries:

A transaction involving one of these financial inter-

mediaries, even as a conduit, necessarily touches

upon these at-risk markets. Moreover, the enu-

merated intermediaries are typically facilitators

of, rather than participants with a beneficial inter-

est in, the underlying transfers. A clear safe har-

bor for transactions made through these financial

intermediaries promotes stability in their respec-

tive markets and ensures that otherwise avoidable

transfers are made out in the open, reducing the

risk that they were made to defraud creditors.

In a footnote, Judge Chin explained that the phrase “(or

for the benefit of)” was added to section 546(e) in 2006 as

part of the Financial Netting Improvements Act. Because

the change was made after the circuit split arose regarding

the “mere conduit” issue, the Second Circuit wrote that “it is

arguable that Congress intended to resolve the split with the

2006 Amendments,” yet omitted any mention of the contro-

versy in the legislative history. Even so, given his finding that

the text of section 546(e) is unambiguous, the judge con-

cluded that resort to the legislative history was unnecessary.

Judge Chin declined to address whether the $376 million

payment was a “settlement payment,” concluding that the

court need not reach the issue due to the undisputed facts

that: (i) QWUSA’s payment “fits squarely” within the plain

meaning of the securities-contract exemption because it was

a “transfer made by (or for the benefit of) a . . . financial insti-

tution . . . in connection with a securities contract”; (ii) CIBC

is a financial institution; and (iii) the NPAs were clearly “secu-

rities contracts” because they provided for both the original

purchase and the “repurchase” of the Notes.

Judge Chin also concluded that the court need not decide

whether the transfer would still be exempt if QWUSA had

“redeemed” its own securities. Noting that the common

definition of “redeem” is “to regain possession by payment

of a stipulated price,” he agreed with the district court that

QWUSA made the transfer to “purchase,” rather than redeem,

the Notes because “it was acquiring for the first time the

securities of another corporation.” In fact, Judge Chin noted,

under the NPAs, only QWCC had the right to “pre-pay” or

redeem the Notes—its affiliates could “purchase” the Notes

only if they complied with the prepayment provisions.

OUTLOOK

Quebecor World continues the recent trend toward expan-

sive interpretation of the Bankruptcy Code’s safe harbors for

securities and commodities transactions, in which courts typ-

ically cite the underlying purpose of the provisions: to man-

age systemic risk posed by a counterparty’s bankruptcy. With

Quebecor World and Enron, the Second Circuit has adopted

a broad approach to both the “settlement payment” and

“securities contract” prongs of section 546(e).

Perhaps acknowledging the dissent’s concern in Enron regard-

ing overly broad application of section 546(e), the Second

Circuit wrote in a footnote in Quebecor World that “[o]f course,

the ‘securities contract’ safe harbor is not without limitation,

and, for example, mere structuring of a transfer as a ‘securities

transaction’ may not be sufficient to preclude avoidance.” As

an example, the court cited the possibility that a transfer could

still be avoided if it were found to be actually fraudulent.

The importance of the Bankruptcy Code’s safe harbors has

been a recurring theme in bankruptcy and appellate rulings

since the advent of the Great Recession. Yet another impor-

tant development in that connection was the Fourth Circuit’s

ruling in Grayson Consulting, Inc. v. Wachovia Securities, LLC

(In re Derivium Capital LLC), 716 F.3d 355 (4th Cir. 2013). In

addition to finding that the transfer of certain securities as

part of a Ponzi scheme could not be avoided because it did

not involve “property of the debtor,” the court, as a matter of

first impression at the appellate level, ruled that commission

payments can be shielded from recovery by the “settlement

payment” defense of section 546(e).

In addition, in Whyte v. Barclays Bank PLC, 2013 BL 152743

(S.D.N.Y. June 11, 2013), a New York district court rejected a

fraudulent-transfer suit with respect to payments made to

a swap participant. In Whyte, the trustee of a litigation trust

created by the chapter 11 plan of SemGroup LP, to which

trust certain creditors’ state-law claims had been assigned,

attempted to avoid payments made to a swap participant as

12

constructive fraudulent transfers under state law and section

544(b) of the Bankruptcy Code, despite the safe harbor for

such transfers in section 546(g).

The trustee argued that, because section 546(g) applies only

to “an estate representative who is exercising federal avoid-

ance powers under [section 544 of] the Bankruptcy Code,”

section 546(g) should not apply to “claims asserted by credi-

tors” after the bankruptcy concludes without a release of

such claims. Since creditors’ state-law fraudulent-transfer

claims had been assigned to the litigation trust, the trustee

contended that she was not asserting such claims as the

trustee of a bankruptcy estate and that section 546(g) was

therefore irrelevant.

The court rejected this contention, writing that “[t]he trouble

with this clever argument is that it would, in effect, render

section 546(g) a nullity.” It held that section 546(g) impliedly

preempted the trustee’s attempt to resuscitate fraudulent-

avoidance claims as the assignee of certain creditors “where,

as here, she would be expressly prohibited by section 546(g)

from asserting those claims as assignee of the debtor-in-

possession’s rights (or, indeed, as the functional equivalent of

a bankruptcy trustee).” According to the court:

The patent purpose and intended effects of section

546(g) would be totally undercut if, at the same time

that a trustee in bankruptcy was prohibited from

avoiding swap transactions, a Chapter 11 ‘litigation

trustee’ could hold swap-related avoidance actions

in abeyance for eventual litigation as the mere

assignee of creditors’ claims.

TENTH CIRCUIT: FRAUDULENTLY TRANSFERRED ASSETS NOT ESTATE PROPERTY UNTIL RECOVEREDJennifer L. Seidman

The U.S. Court of Appeals for the Tenth Circuit—in Rajala

v. Gardner, 709 F.3d 1031 (10th Cir. 2013)—has joined the

Second Circuit and departed from the Fifth Circuit by hold-

ing that an allegedly fraudulently transferred asset is not

property of the estate until recovered pursuant to section

550 of the Bankruptcy Code and therefore is not covered

by the automatic stay. According to the court, its decision

“gives Congress’s chosen language its ordinary meaning, and

abides by a rule against surplusage.”

BANKRUPTCY CODE STAYS ACTS TO OBTAIN POSSESSION

OF PROPERTY OF THE ESTATE

Section 362(a)(3) of the Bankruptcy Code provides that the

filing of a bankruptcy petition “operates as a stay, appli-

cable to all entities, of . . . any act to obtain possession of

property of the estate or of property from the estate or to

exercise control over property of the estate.” Sections 541(a)

(1) and 541(a)(3) of the Bankruptcy Code, respectively, define

“property of the estate” to include, with certain exceptions,

“all legal or equitable interests of the debtor in property as of

the commencement of the case” and “[a]ny interest in prop-

erty that the trustee recovers under section . . . 550” of the

Bankruptcy Code.

Under section 550(a) of the Bankruptcy Code, a trustee may

recover, for the benefit of the estate, transferred property “to

the extent that a transfer is avoided under section 544 . . . [or]

548.” Sections 544 and 548 of the Bankruptcy Code, in turn,

enable the trustee to avoid fraudulent transfers. The question

before the Rajala court was whether allegedly fraudulently

transferred property, prior to the recovery of that property

pursuant to section 550(a), is “property of the estate” under

section 541(a) and therefore subject to the automatic stay

imposed by section 362(a).

13

THE FACTS

Generation Resources Holding Company, LLC (“GRHC”) was

formed in 2002 for the purpose of developing wind-generated

power projects. In June 2005, GRHC entered into a memoran-

dum of understanding (“MOU”) with Edison Capital (“Edison”)

that contemplated Edison’s purchase of three GRHC wind-

power projects, including the “Lookout” project.

In late 2005, several GRHC insiders formed Lookout

Windpower Holding Co., LLC (“LWHC”). Not long after its for-

mation, LWHC closed a deal with Edison for the sale of the

wind-power projects that were the subject of the MOU with

GRHC. The GRHC insiders did so by causing a switch in the

identity of the projects’ developer from GRHC to LWHC. In

March 2007, LWHC entered into a contract with an Edison

subsidiary (the “Lookout Redemption Agreement”), which

provided that once Lookout achieved commercial operation,

Edison would pay 25 percent of a “Final Installment” contin-

gency fee to FreeStream Capital, LLC (“FreeStream”), which

GRHC had employed to provide advisory services, and 75

percent of the “Final Installment” to LWHC. Overburdened

with $6 million in debt, GRHC filed for chapter 7 protection in

Kansas on April 28, 2008.

In April 2009, LWHC and FreeStream sued Edison in fed-

eral district court in Pennsylvania for payment of the Final

Installment due under the Lookout Redemption Agreement.

In September 2009, GRHC’s chapter 7 trustee brought suit

against GRHC insiders (and others) in federal district court

in Kansas, asserting, among other things, that the defendants

had fraudulently transferred GRHC’s development and

redemption opportunities to LWHC.

The trustee sought an order from the Kansas district court

staying the Pennsylvania action, arguing that any proceeds

of the litigation were property of GRHC’s estate. The Kansas

district court denied the motion.

Shortly before the Pennsylvania case went to trial, the trustee

filed a motion in the Pennsylvania federal court for an order

staying the proceedings or, in the alternative, transferring the

litigation to Kansas. The basis for this motion was the trustee’s

argument that the Lookout sale price was property of the

GRHC estate and therefore subject to the automatic stay.

The court denied the motion in part and entered judgment

in favor of LWHC and FreeStream for approximately $9 mil-

lion. However, the court transferred to the Kansas bankruptcy

court the issue of whether the judgment was part of GRHC’s

estate and ordered that the judgment funds be deposited

with the bankruptcy court pending the outcome.

The reference to the Kansas bankruptcy court was then with-

drawn to the Kansas district court, where the Pennsylvania

case was consolidated with the trustee’s pending claims.

The Kansas district court held that the bankruptcy estate

does not include fraudulently transferred property until

recovered through a fraudulent-transfer action, and it accord-

ingly granted the motions to distribute the $9 million judg-

ment to LWHC and FreeStream. The district court also held

that because the Lookout Redemption Agreement provided

for FreeStream to be paid directly by Edison, FreeStream’s

contingency fee could not be considered part of GRHC’s

bankruptcy estate. The trustee appealed to the Tenth Circuit.

THE TENTH CIRCUIT’S RULING

A three-judge panel of the Tenth Circuit affirmed. As an ini-

tial matter, the court concluded that it had jurisdiction to

review the district court’s order. According to the Tenth

Circuit, because the order “deemed § 362 inapplicable to

the judgment proceeds, [it] was essentially an order grant-

ing relief from the automatic stay,” which is generally con-

sidered an “appealable final order.” The court also rejected

the defendant-appellees’ argument that the appeal was

moot because the trustee had no effective remedy, finding it

likely that at least some measure of effective relief could be

fashioned were the stay reimposed on the disbursed funds.

In addition, the Tenth Circuit affirmed the district court’s rul-

ing that FreeStream’s fee could not be considered property

of GRHC’s bankruptcy estate because, among other things,

the plain language of the Lookout Redemption Agreement

required FreeStream’s payment to come directly from Edison

(as owner of Lookout).

The Tenth Circuit then turned to the question of whether the

automatic stay applies to unrecovered property that is the

subject of a fraudulent-transfer claim. The court began by

acknowledging the circuit split on the issue. Under the Fifth

14

Circuit’s ruling in Am. Nat’l Bank of Austin v. MortgageAmerica

Corp. (In re MortgageAmerica Corp.), 714 F.2d 1266 (5th Cir.

1983), property alleged to have been fraudulently transferred

is considered property of the estate pursuant to section

541(a)(1) and is therefore subject to the automatic stay even

before it is recovered, because the debtor continues to have

a “legal or equitable interest” in the property fraudulently

transferred. By contrast, in Fed. Deposit Ins. Corp. v. Hirsch

(In re Colonial Realty Co.), 980 F.2d 125 (2d Cir. 1992), the

Second Circuit held that, because section 541(a)(3) expressly

provides that estate property includes “[a]ny interest in prop-

erty that the trustee recovers under section . . . 550,” the

automatic stay does not apply to allegedly fraudulently trans-

ferred property until the transfer is avoided under section

544 or 548 and the property is recovered under section 550.

Rajala widens a rift in the federal circuit courts of

appeal concerning inclusion in the bankruptcy

estate of property that is subject to avoidance by

a bankruptcy trustee, chapter 11 debtor in posses-

sion, or other estate representative (e.g., a creditors’

committee or plan-liquidation trustee). The ruling

is a cautionary tale. It places the burden squarely

on estate representatives to be proactive in investi-

gating potential avoidance claims and, where such

claims are deemed to be meritorious, to seek provi-

sional relief in a timely manner to ensure that poten-

tial estate property is preserved for the benefit of all

stakeholders.

The Tenth Circuit sided with the Second Circuit. First, citing

the “plain meaning” rule of statutory construction, the court

stated, “although § 541 is very broad, . . . it plainly does not

include fraudulently transferred property until that property is

recovered.” Therefore, the court wrote, “because the statute’s

plain meaning is not demonstrably at odds with Congress’s

intent, it should control.”

The court rejected the trustee’s argument that the judgment

proceeds were estate property because GRHC retained an

“equitable interest” in the funds. After considering the defini-

tion of “equitable interest”—an interest held by virtue of an

equitable title or claims on equitable grounds, such as the

interest held by a trust beneficiary—the Tenth Circuit con-

cluded that “[r]eading ‘equitable title’ to include any prop-

erty a trustee merely alleges to have been fraudulently

transferred would violate the concept of equity.” According

to the court, fundamental principles of equity jurisprudence

demand that, before a complainant can have standing in

court, he must show that he has a good and meritorious

cause of action. “[A] mere allegation, without any showing of

merit,” the court wrote, “cannot create ‘equitable title.’ ”

Again invoking principles of statutory construction, the court

explained that, “if it can be prevented, no clause, sentence, or

word shall be superfluous, void, or insignificant.” In this case,

the court wrote, Ҥ 541(a)(3) provides that the estate includes

‘[a]ny interest in property that the trustee recovers’ pursuant

to his avoidance powers.” The court agreed with the Second

Circuit’s view in Colonial Realty that “interpreting § 541(a)(1)

to include fraudulently transferred property would render §

541(a)(3) meaningless with respect to property recovered in a

fraudulent transfer action.”

The Tenth Circuit rejected the trustee’s argument that sec-

tion 541(a)(3) is “a belt and suspenders” designed to ensure

that assets will be available to satisfy creditor interests, rea-

soning that “there are already several mechanisms for safe-

guarding debtor assets.” For example, the court explained,

the trustee may seek a preliminary injunction or temporary

restraining order pending resolution of a fraudulent-transfer

claim. Because this was not one of the “rare cases” where the

plain meaning of the statute leads to an absurd result, the

Tenth Circuit concluded that the plain meaning of the statute

should control.

Lastly, though not addressed by either party, the court noted

that a broad reading of section 541 could potentially violate

the Due Process Clause (u.s. Const. amends. V and XIV, § 1) by

allowing the trustee to enjoin another party’s property rights

solely on the basis of allegations of fraud. For example, the

court explained, because the stay imposed by section 362

is automatic, the “[m]ere filing of a fraudulent-transfer claim

could deprive a bona fide purchaser of his property without

judicial supervision, a finding of probable cause, the post-

ing of a bond, or a showing of exigent circumstances—let

alone a pre-deprivation opportunity to be heard.” For this

15

additional reason, the Tenth Circuit was reluctant to adopt

the trustee’s broad interpretation of section 541. Instead, the

court adopted the statute’s plain meaning. It held that fraud-

ulently transferred property is not part of the bankruptcy

estate until recovered, and it accordingly affirmed the district

court’s determination that the automatic stay did not pre-

vent disbursement of the judgment proceeds to LWHC and

FreeStream.

OUTLOOK

Rajala widens a rift in the federal circuit courts of appeal

concerning inclusion in the bankruptcy estate of property

that is subject to avoidance by a bankruptcy trustee, chap-

ter 11 debtor in possession, or other estate representative

(e.g., a creditors’ committee or plan-liquidation trustee). The

ruling is a cautionary tale. It places the burden squarely on

estate representatives to be proactive in investigating poten-

tial avoidance claims and, where such claims are deemed to

be meritorious, to seek provisional relief in a timely manner

to ensure that potential estate property is preserved for the

benefit of all stakeholders.

BREAKING NEW GROUND: DELAWARE BANKRUPTCY COURT GRANTS ADMINISTRATIVE PRIORITY FOR POSTPETITION, PREREJECTION LEASE INDEMNIFICATION OBLIGATIONSJohn H. Chase and Mark G. Douglas

Under the Bankruptcy Code, a bankruptcy trustee or chapter

11 debtor in possession (“DIP”) is required to satisfy postpe-

tition obligations under any unexpired lease of commercial

property pending a decision to assume or reject the lease.

Specifically, section 365(d)(3) requires the trustee, with lim-

ited exceptions, to “timely perform all the obligations of the

debtor . . . arising from and after the order for relief” under

any unexpired lease of nonresidential real property with

respect to which the debtor is the lessee.

The application of section 365(d)(3) and, in particular, the

timing of certain “obligations” arising under an unexpired

lease has created some controversy. A Delaware bankruptcy

court added fuel to the fire in a ruling handed down earlier

this year. In a matter of first impression, the court held in WM

Inland Adjacent LLC v. Mervyn’s LLC (In re Mervyn’s Holdings,

LLC), 2013 BL 5408 (Bankr. D. Del. Jan. 8, 2013), that a claim

arising from an indemnification obligation under a com-

mercial lease was entitled to administrative expense status

under section 365(d)(3).

PAYMENT OF POSTPETITION COMMERCIAL LEASE

OBLIGATIONS

As noted, section 365(d)(3) provides that a trustee or DIP,

with certain exceptions, “shall timely perform all the obliga-

tions of the debtor . . . arising from and after the order for

relief under any expired lease of nonresidential real property,

until such lease is assumed or rejected, notwithstanding sec-

tion 503(b)(1) of this title.” Added to the Bankruptcy Code in

1984, the provision was intended to ameliorate the immediate

financial burden borne by commercial landlords pending the

trustee’s decision to assume or reject a lease. Prior to that

time, landlords were routinely compelled to seek payment of

rent and other amounts due under a lease by petitioning the

bankruptcy court for an order designating those amounts as

administrative expenses. The process was cumbersome and

time-consuming. Moreover, the landlord’s efforts to get paid

16

were hampered by the standards applied in determining

what qualifies as a priority expense of administering a bank-

ruptcy estate.

Section 503(b)(1) of the Bankruptcy Code provides that

allowed administrative expenses include “the actual, nec-

essary costs and expenses of preserving the estate.” Rent

payable under an unexpired commercial lease during a

bankruptcy case arguably falls into this category. Even so,

section 503(b)(1) has uniformly been interpreted to require

that in addition to being actual and necessary, an expense

must benefit the bankruptcy estate to qualify for adminis-

trative priority. Prior to the enactment of section 365(d)(3),

“benefit to the estate” in this context was determined on a

case-by-case basis by calculating the value to the debtor of

its “use and occupancy” of the premises, rather than looking

to the rent stated in the lease. Moreover, even if a landlord’s

claim for postpetition rent was conferred with administrative

priority, the Bankruptcy Code did not specify when the claim

had to be paid.

Section 365(d)(3) was designed to remedy this prob-

lem. It requires a trustee or DIP to remain current on lease

obligations pending assumption or rejection of a lease.

Nevertheless, courts have struggled with the precise mean-

ing of the provision. For example, courts are at odds over

whether the phrase “all the obligations of the debtor . . . aris-

ing from and after the order for relief” means: (i) all obliga-

tions that become due and payable upon or after the filing of

a petition for bankruptcy; or (ii) obligations that “accrue” after

filing the bankruptcy petition. The former approach—com-

monly referred to as the “performance” or “billing date” rule—

has been adopted by some courts. See, e.g., Centerpoint

Properties v. Montgomery Ward Holding Corp. ( In re

Montgomery Ward Holding Corp.), 268 F.3d 205 (3d Cir. 2001);

Koenig Sporting Goods, Inc. v. Morse Road Co. (In re Koenig

Sporting Goods, Inc.), 203 F.3d 986 (6th Cir. 2000); HA-LO

Indus., Inc. v. Centerpoint Props. Trust, 342 F.3d 794 (7th Cir.

2003). The second approach is sometimes referred to as

the “proration” or “pro rata” approach. According to this view,

real estate taxes and other nonrent expenses that accrue in

part prior to a bankruptcy filing but are payable postpetition

are akin to “sunken costs” that need not be paid currently as

administrative expenses pending a decision to assume or

reject the lease. See, e.g., In re Treesource Indus., Inc., 363

F.3d 994 (9th Cir. 2004); In re Handy Andy Home Improvement

Ctrs., 144 F.3d 1125 (7th Cir. 1998).

Mervyn’s is a logical application of section 365(b)

(3) and applicable case law. However, it does cre-

ate the potential for doubt about certain claims that

may appear to be unsecured, prepetition claims.

The decision suggests that although a claim may

exist before bankruptcy, if the obligation to pay

arises postpetition, it may be treated as an obliga-

tion which must be paid immediately under section

365(d)(3). Any potential increase in such payment

obligations could make it a challenge for some

debtors to reorganize successfully.

Section 365(d)(3) has also been controversial in cases where

the timing of a bankruptcy filing creates “stub rent.” Stub rent

is the rent that is due for the period following the bankruptcy

petition date until the next rent-payment date. For example,

if a lease calls for the prepayment of rent on the first of each

month, and the petition date falls on the 10th day of the

month, assuming that rent was not paid prior to the petition

date, the stub-rent period would be from the 10th day of the

month through the end of the month. Because section 365(d)

(3) requires current payment of obligations “arising from and

after the order for relief,” it could be argued that stub rent

need not be paid under section 365(d)(3) because the pay-

ment was due prior to the petition date. Some courts have

rejected this approach, ruling that section 365(d)(3) requires

a debtor to pay stub rent on a prorated basis as part of its

duty to “timely perform” its obligations arising under its unex-

pired leases. Other courts reject this interpretation, holding

that stub rent need not be paid under section 365(d)(3).

Courts also disagree whether section 365(d)(3), rather than

section 503(b)(1), is an appropriate basis for conferring

administrative priority on (as distinguished from requiring

performance of) a postpetition-lease obligation. For exam-

ple, in In re Goody’s Family Clothing Inc., 610 F.3d 812 (3d Cir.

2010), the Third Circuit ruled that section 365(d)(3) does not

supplant or preempt section 503(b)(1). The court concluded

that the DIP’s use of the leased premises postpetition to pro-

duce income provided an “actual and necessary” benefit

to the estate and that commercial landlords were thus enti-

17

tled to stub rent as an administrative expense. Other courts

have held that section 365(d)(3) provides authority to con-

fer administrative status on a claim independent of section

503(b)(1). See, e.g., In re The Leather Factory Inc., 475 B.R. 710

(Bankr. C.D. Cal. 2012).

By its terms, section 365(d)(3) requires performance of all

postpetition “obligations” under an unexpired commercial

lease, not merely the payment of postpetition rent, pending

the trustee’s decision to assume or reject. Whether an obli-

gation other than payment of rent should be treated as an

administrative expense was among the issues addressed by

the Delaware bankruptcy court in Mervyn’s.

MERVYN’S

In January 2008, Mervyn’s Holdings, LLC, and certain affili-

ates (collectively, the “debtors”), operators of a California-

based department-store chain, leased commercial property

in San Bernardino, California, from WM Inland Adjacent LLC

(“Inland”). The debtors also entered into a separate construc-

tion agreement with Inland governing prospective improve-

ments to the leased premises. Both agreements contained

provisions requiring the debtors to indemnify Inland for vari-

ous liabilities arising prior to, during, and after the lease term.

These obligations included a duty to keep the premises free

of mechanics’ liens and to pay all amounts, charges, and

attorneys’ fees due under the lease.

The debtors later entered into a separate agreement with

contractor Fisher Development Inc. (“Fisher”) to provide labor

and materials for building improvements to the leased prem-

ises. The debtors filed for chapter 11 protection in Delaware in

July 2008 while construction was still underway.

Fisher reacted to the bankruptcy filing by stopping all work

on the premises and by filing two mechanics’ liens against

the property to secure claims aggregating $5.5 million. Fisher

then filed suit against Inland in October 2008 to foreclose

on the liens. To settle the case, Inland agreed to pay Fisher

approximately $1.8 million in February 2010.

The debtors rejected the lease effective November 21, 2008.

Inland filed two proofs of claim for amounts due under the

lease and the construction agreement. Inland sought admin-

istrative priority under section 365(d)(3) for the $1.8 million

paid to Fisher under the indemnification provisions of the

lease and construction agreements.

Inland maintained that the indemnity claim arose postpeti-

tion and prior to rejection of the lease and was therefore

entitled to administrative priority pursuant to section 365(d)

(3). According to Inland, the indemnity-claim obligation arose

either when Fisher’s liens were recorded or when Fisher

sued the landlord, both of which occurred postpetition prior

to rejection of the lease. Inland cited Montgomery Ward as

authority for the proposition that section 365(d)(3) creates

administrative expense priority, in the context of unexpired

commercial leases, for “all obligations that arise after an

order for relief is entered and before the lease is rejected.”

The debtors countered with four principal arguments. First,

they maintained that the indemnity claim arose from rejection

of the lease and was therefore a prepetition unsecured claim

pursuant to section 502(g). Second, citing Jeld-Wen, Inc. v.

Van Brunt (In re Grossman’s Inc.), 607 F.3d 114 (3d Cir. 2010),

for the proposition that common-law and statutory claims

arise when the conduct giving rise to the injury occurs,

rather than when the injury manifests, the debtors argued

that the indemnity-obligation claim arose when they and

Inland entered into the lease and construction agreements

and derived from prepetition improvements to the premises

by Fisher, both “billing dates” prior to the bankruptcy-petition

date. Third, the debtors asserted that there is no precedential

authority applying Montgomery Ward to a lease-indemnifica-

tion claim, and contrary precedent indicates that indemnifi-

cation obligations in executory contracts should be treated

as prepetition unsecured claims. Fourth, the debtors argued

that, even if Montgomery Ward applies and the indemnifica-

tion obligation arose postpetition, Inland cannot meet its bur-

den under section 503(b)(1).

THE BANKRUPTCY COURT’S RULING

The bankruptcy court granted summary judgment in favor

of Inland. Addressing the debtors’ first argument, the court

noted that “the damages arose from the filing of mechan-

ics’ liens against the [p]remises,” rather than from rejection of

the lease. Next, the court concluded that the argument that

the debtors’ contractual obligation to indemnify Inland arose

18

prepetition “runs counter to the holding in Montgomery Ward”

because it ignores the meaning of the term “obligation” in

section 365(d)(3).

“In the context of section 365(d)(3),” the court wrote, “the rel-

evant time is when an ‘obligation’ arises, which is different

from when a ‘claim’ arises.” In Montgomery Ward, the court

explained, the Third Circuit distinguished a “claim,” which is

“an unmatured right to payment,” from an “obligation,” which

is “something one is legally required to perform under the

terms of the lease.” According to the court in Mervyn’s, the

indemnity obligation arose when Fisher filed the mechanics’

liens and sued Inland, rendering the obligation legally bind-

ing under the lease.

Addressing the debtors’ third argument, the court reasoned

that “the strictures of the analyses by the Third Circuit Court

of Appeals are not inapplicable merely because this question

has not yet been posed.” “The issue is one of first impres-

sion,” the court wrote, “and the Court is both guided and

constrained by the holdings of Montgomery Ward where the

Court of Appeals determined that such obligations in nonres-

idential real property leases fall under section 365(d)(3).”

The court also rejected the debtors’ argument that the

indemnification claim was not entitled to administrative treat-

ment because it did not confer a substantial benefit on the

estate, as required by section 503 of the Bankruptcy Code.

The court explained that section 503(b)(1) sets forth a two-

part test for whether a claim is entitled to administrative pri-

ority: (i) the expense must have arisen from a postpetition

transaction involving the debtor; and (ii) the transaction must

have substantially benefited the estate.

Even so, the court concluded that Inland’s claim was not sub-

ject to this two-part administrative expense test. Because the

express language of section 365(d)(3) includes the clause

“notwithstanding section 503(b)(1),” the court reasoned, sec-

tion 365(d)(3) “creates a new and different obligation—one

that does not necessarily rest on the administrative expense

concept.” According to the court, “The phrase operates as a

‘carve-out’ exempting these expenses from ‘the usual bur-

dens and procedures’ ” (citing Goody’s). Therefore, the court

ruled that, because the indemnification claim stemmed from

a postpetition obligation under section 365(d)(3), “section

503(b)(1) is inapplicable.”

Finally, the court was not persuaded by the debtors’ argu-

ment that “applying the section 503(b)(1) exemption set forth

in Goody’s creates bad public policy” because elevating

Inland’s claim to administrative status “simply by conspir-

ing with a third-party plaintiff” would encourage “a wait-and-

see hedging of bets regarding an anticipated bankruptcy.”

“This is not gamesmanship among pre-petition unse-

cured creditors,” the court wrote, concluding that its hold-

ing “fits squarely” into section 365(d)(3) and the rationale of

Montgomery Ward.

OUTLOOK

Mervyn’s is a logical application of section 365(b)(3) and

applicable case law. However, it does create the poten-

tial for doubt about certain claims that may appear to be

unsecured, prepetition claims. The decision suggests that

although a claim may exist before bankruptcy, if the obliga-

tion to pay arises postpetition, it may be treated as an obli-

gation which must be paid immediately under section 365(d)

(3). Any potential increase in such payment obligations could

make it a challenge for some debtors to reorganize success-

fully. One of the effects of the decision may be that a DIP or

trustee might be forced to accelerate the decision to assume

or reject an executory contract or unexpired lease to mini-

mize the risk that a postpetition, prerejection “obligation” will

create a substantial immediate-payment obligation.

The court in Mervyn’s was careful to point out that, in its

view, the landlord and the contractor were not engaging in

“gamesmanship” which would justify denial of the landlord’s

request as a matter of public policy. However, the story might

be otherwise in other cases—it is not difficult to imagine

an astute landlord making a strategic decision to time the

assertion of claims for obligations due under a lease in a way

designed to maximize its recovery in 100 cent dollars.

19

EUROSAIL SUPREME COURT JUDGMENT: DELINEATING THE BOUNDARIES OF INSOLVENCY

“TO BE SOLVENT OR NOT TO BE SOLVENT, THAT IS THE QUESTION”Michael Rutstein and Victoria Ferguson

Odd as it may seem, you have to plough through 122 sections

of the UK Insolvency Act 1986 (the “Act”) before you finally

reach the section that sets out the criteria for establishing

insolvency. Section 123 of the Act lists a series of circum-

stances under which a company may be deemed insolvent.

Some of these circumstances are factual—for example,

owing a debt of more than £750 for more than 21 days after

a demand for payment—but two rely on a legal test of com-

pany insolvency. These two tests are colloquially known as

the “cash-flow test” and the “balance-sheet test.” Direct or

indirect reference to these tests is prevalent throughout

English-law finance documents, including those based on

Loan Market Association standard forms, as a way of deter-

mining whether an event of default has occurred and/or ter-

mination clauses have been triggered.

The UK Supreme Court has now unanimously confirmed the

test for balance-sheet insolvency under section 123 of the

Act in its decision in BNY Corporate Trustee Services Limited

v Eurosail and others [2013] UKSC 28. In particular, the court

declined to follow the intermediate court of appeal’s sugges-

tion that a debtor can be insolvent only after it has reached

the “point of no return.” The three court rulings in this mat-

ter concluding with the recent Supreme Court judgment are

the first reported cases to interpret the balance-sheet test of

insolvency—namely, are the liabilities of a company greater

than its assets?

CASH FLOW V BALANCE SHEET

The circumstances under which a company is to be “deemed

unable to pay its debts” (i.e., insolvent) under section 123 of

the Act include:

• if “the company is unable to pay its debts as they fall

due”; or

• if “the value of the company’s assets is less than the

amount of its liabilities, taking into account its contingent

and prospective liabilities.”

Even a casual observer can see that many companies are

balance-sheet insolvent, while still being able to comfortably

meet current debts. Following a line of cases, the accepted

position was that the cash-flow test took precedence over

the balance-sheet test. However, courts would sometimes

accept that a company, despite meeting day-to-day debts,

was balance-sheet insolvent, since its long-term liabilities

(very often pension deficits) were such that there was no

chance that they would be repaid, however long one waited.

IN THE BEGINNING . . .

The first hearing in the long-running Eurosail case was in

2010, although the event under scrutiny occurred before that.

Eurosail (as issuer) purchased a portfolio of high-risk mort-

gages for securitisation and issued notes. (The ones sub-

ject to the hearing were due to mature in 2045.) Although

the underlying mortgage payers paid only in pounds ster-

ling, Eurosail issued notes in various currencies, entering

into swap arrangements with two Lehman Brothers entities

to reduce its exposure to currency-rate fluctuations. These

swap arrangements ceased in 2008 with the collapse of

Lehman Brothers. Without the protection of the hedging

arrangements, Eurosail’s net-asset position weakened sub-

stantially, but it was still able to pay its debts as they arose.

The security trustee was entitled to declare an event of default

under the notes and enforce the security if, among other con-

ditions, Eurosail could be deemed unable to pay its debts

under the balance-sheet test of section 123(2) of the Act. A

notification of an event of default would also alter the priori-

ties between noteholders such that subordinated “A3” note-

holders would then rank equally with, rather than behind, “A2”

noteholders. Naturally, this would also reduce the distribu-

tion for A2 noteholders. Additionally, a post-enforcement call

option (“PECO”) had been granted under the securitisation.

The PECO provided that in the event the security for the notes

was enforced and found to be insufficient to pay all amounts

due in respect of them, an affiliate of Eurosail had a call option

for the notes for nominal consideration. PECO provisions are

20

a common feature of securitisations with a UK-incorporated

issuer as a means of satisfying rating-agency requirements

for insolvency remoteness. The expectation is that an affili-

ate would release the issuer from further liabilities rather than

allow the issuer to enter into an insolvent liquidation.

The court was asked to decide whether Eurosail was unable to

pay its debts under the section 123(2) balance-sheet test and

whether the PECO would have any effect on that decision.

FIRST-INSTANCE DECISION: ASSETS V LIABILITIES

The first-instance court decided that Eurosail was able to pay

its debts within the meaning of section 123(2); the key point

was the interpretation of “taking into account contingent and

prospective liabilities.” It decided that the assets to be val-

ued were the present assets of the company. According to

the court, the nature of Eurosail’s business meant that it was

not necessary to consider whether valuation was on a going-

concern or breakup basis, but the court did explicitly include

the as-yet unallowed claims against the Lehman Brothers

estate as an asset of Eurosail.

In contrast, the court narrowed which liabilities needed to be

counted and how much weight to give them. The court rejected

the idea of comparing liabilities on their face value to assets

on their face value, deeming it “commercially illogical” not to

give weight to the maturity date of the obligations. The judge

also noted that section 123(2) refers to “taking into account”

liabilities, not “includ[ing]” liabilities. Thus, the court reasoned, a

straight aggregation of present and prospective liabilities was

not what Parliament intended when it enacted the provision.

The court also rejected the company’s financial statements

as a means of establishing insolvency, concluding that such

records considered elements which were deemed to go

“beyond what [section] 123(2) requires,” while also excluding

assets which the court held ought to be counted.

The court also took into account the fact that: (i) the notes

in question were not due to mature until 2045; (ii) any valua-

tion of liabilities relating to currency fluctuations was “entirely

speculative”; and (iii) the notes were actually fully funded, as

any losses in the underlying asset pool would also reduce

the liabilities due to the noteholders through the operation

of the “principal deficiency ledger” governing the notes (a

mechanism for distributing the risk of principal losses among

noteholders in reverse order of seniority).

Since the court concluded that Eurosail was solvent, there

was no need to consider the PECO, although the judge

made side comments that in his opinion the PECO had

no effect on the liabilities because, until the option holder

should decide to release the issuer from liability, the issuer’s

liabilities would remain.

COURT OF APPEAL: “THE POINT OF NO RETURN”

The court of appeal agreed with the lower court that Eurosail

was solvent and able to meet its debts. In its reasoning, the

court agreed with the lower court that examining only a bal-

ance sheet or a company’s financial statements was not

the test. Many solvent and successful companies, the court

noted, had greater liabilities than assets, especially early

in their history, yet it would be “mechanistic, even artificial”

to deem such a company insolvent. However, the court of

appeal went on to state that a company would be found bal-

ance-sheet insolvent only if the company “had reached the

point of no return.” It stated that future or contingent credi-

tors face an inherent risk that the company’s assets might

be used to pay current creditors or for other purposes, but

they are not prejudiced by that risk until those payments,

in the judge’s colourful phrase, “may be vernacularly char-

acterised as a fraud on the future or contingent creditors.”

According to the court, only at that point may a company

be deemed to have reached the point of no return. Even so,

the court acknowledged that that test would be “imprecise,

judgement-based and fact-specific.”

A supporting judgment drew back from endorsing the “point

of no return” idea, suggesting that it illuminated rather than

paraphrased the legislation. Instead, the concurring judge

focused on the idea that a court would make proper allow-

ance for contingent and prospective liabilities but that the

more distant the liabilities, the harder it would be to establish

that such liabilities would not be satisfied.

THE SUPREME COURT: THE IMPONDERABLE FACTORS

The Supreme Court backed the view that insolvency may

occur before the point of no return and that this phrase should

21

not “pass into common usage.” According to the court, the

true test should be whether on a balance of probabilities the

debtor has insufficient assets to be able to meet all of its lia-

bilities, applying a discount for contingencies and future liabili-

ties. This test would come into play once any attempt to apply

a cash-flow test became too speculative as the time frame

lengthened beyond the reasonably near future. That said, the

court acknowledged that it was “still very far from an exact

test” and that the burden of proof would be on the party trying

to prove balance-sheet insolvency.

Given that it is an inexact test, the Supreme Court concluded

that the available evidence in the circumstances was the crit-

ical factor. Eurosail’s business, the court explained, was quite

unlike a normal trading business. In fact, the only important

management decision to be made in this context would have

been to attempt to find alternative hedging cover in light of

Lehman Brothers’ demise. Although it might then be quite

easy to list Eurosail’s assets against its liabilities, the court

held that there were three “imponderable factors” which pre-

vented it from finding Eurosail insolvent. Those factors were:

(i) fluctuation of the US dollar against the pound sterling for

hedging arrangements; (ii) movement in the London inter-

bank offered rate (LIBOR) affecting the interest rates of the

loans; and (iii) changes in the UK real estate market, which

affected the value of the underlying pool of assets.

Because maturities on some obligations could be deferred

for more than 30 years and Eurosail was paying its debts

as they fell due, the Supreme Court expressed the greatest

reluctance to make a finding of insolvency. Generally, the

Court wrote, any court should proceed with “the greatest

caution in deciding that a company is in a state of balance-

sheet insolvency under [section] 123(2).”

Like the first-instance court, the Supreme Court concluded

that it was not necessary to make a finding on the status of

the PECO, but given the frequency with which PECOs are

used, the court did consider it useful to make some passing

comments. It held that PECOs were irrelevant in the exercise

of balancing assets and liabilities to establish balance-sheet

insolvency. According to the court, it is not possible to dis-

tinguish the intended commercial effect of these provisions

from their legal effect, so PECOs have no role to play when

assessing a company’s liabilities.

WHERE TO NEXT?

In some ways, the Supreme Court judgment in Eurosail

does not tell us anything new. Crucially, it pushed back on

the court of appeal’s “point of no return” concept, keeping

to a fairly common-sense view of proving insolvency via a

balancing of potential assets and liabilities based on evi-

dence and allowing for judicial discretion. The court also

allowed market practice to prevail regarding securitisations

and PECOs, while noting that it had not been persuaded

purely on that basis.

Nonetheless, the series of Eurosail rulings has brought some

judicial interpretation to a previously unconsidered section

of legislation. The judgment has also helped clarify some

points that were previously open or unclear. This is especially

important as the statutory language has been utilised, some-

times with modifications, in a range of contracts and market-

standard documents. Thus, securitisations and PECOs can

continue to operate as they did before Eurosail.

Points of clarification provided by the Eurosail rulings include

the following:

• The cash-flow test should look only to what is the reason-

ably near future in the relevant circumstances. How far

ahead the test should look will vary depending on the facts,

but some forward-looking analysis should be included.

• Although a court should be wary of finding a company’s

balance sheet insolvent, it need not establish that the

company has reached the point of no return to conclude

that it is balance-sheet insolvent. The party trying to claim

insolvency bears the burden of proof.

• A company’s financial statements are only a starting point

for an analysis of balance-sheet insolvency. Full consid-

eration of all evidence of assets and liabilities should be

taken into account.

• There can be different weighting and discounting of liabili-

ties. For example, the longer the maturity of the obligation,

the lower the value that may be attributed to it (since it

is more likely that the company will be able to satisfy it,

resulting in a relative decline in the value of the liability). In

the same way, an assessment should be made as to the

likelihood that a contingent liability will become an actual

one; the more likely the event, the greater the value that

should be attributed to the claim.

22

SOVEREIGN-DEBT UPDATEOn July 26, 2013, the French government filed an amicus curiae (“friend of the court”) brief supporting Argentina’s petition

requesting the U.S. Supreme Court to review a ruling handed down by the U.S. Court of Appeals for the Second Circuit on

October 26, 2012 (see NML Capital, Ltd. v. Republic of Argentina, 699 F.3d 246 (2d Cir. 2012)) upholding a lower-court order

enjoining Argentina from making payments on restructured defaulted debt without making comparable payments to holdout

bondholders. The protracted legal saga arising from Argentina’s $100 billion default in 2001 has come to involve the International

Monetary Fund (the “IMF”), the U.S. and, now, France, due to its implications for future sovereign-debt restructurings. In its

amicus brief, France argues, among other things, that: (i) the Second Circuit’s ruling deviates from fundamental tenets of equity

jurisprudence; and (ii) the Second Circuit’s decision threatens wider public interests. The IMF recently backed away from a plan

to support Argentina’s appeal after U.S. Treasury officials counseled that it was not the right time for the fund to get involved in

the case. The Supreme Court will not decide until this fall whether to hear Argentina’s appeal. A copy of the amicus brief can be

accessed at http://www.scribd.com/doc/156852371/NML-2013-07-26-France-Amicus-Brief.

23

EUROPEAN PERSPECTIVE IN BRIEF

Europe has struggled mightily during the last several years

to triage a long series of critical blows to the economies of

the 28 countries that comprise the European Union, as well

as the collective viability of eurozone economies. Here we

provide a snapshot of some recent developments regarding

insolvency, restructuring, and related issues in the EU.

The Netherlands—On July 11, 2013, the Enterprise Chamber

of the Amsterdam Court of Appeal handed down a highly

anticipated ruling regarding the compensation offered by the

Dutch Minister of Finance in relation to the expropriation by

the Dutch state of shares and subordinated debt issued by

the SNS Reaal Group (“SNS”). The February 1, 2013, nation-

alization of SNS was the first-time application of the Dutch

Intervention Act. On February 25, 2013, the Dutch Council of

State ruled that the Dutch Minister of Finance was entitled to

expropriate the shares and subordinated debt, but not future

claims. The expropriation was effected for the purpose of shift-

ing from the Dutch taxpayers to the private sector the burden

of the SNS rescue package, which totals more than €1 billion.

In a widely reported decision that raises questions about the

viability of the European Union’s policy of imposing bail-ins

as a condition for any future rescue packages, the Enterprise

Chamber refused to bless the Finance Minister’s zero-com-

pensation offer. Specifically, the court ruled that the Minister

failed to justify the offer, which in any case would have been

unlikely to comply with the full-compensation standard

required by both Dutch and international law. A valuation will

now be performed by three independent experts appointed

by the court.

The dec is ion may have rami f ica t ions beyond the

Netherlands, with many European states and banks likely to

require emergency support in the coming years. Questions

may also be raised regarding the impact of the ruling on

the bail-in elements of the Cyprus rescue package. Certain

claims are already pending in connection with the EU’s

actions in Cyprus.

Jones Day acted for various bondholders in the Enterprise

Chamber proceeding. A copy of the ruling (in Dutch) can

be found at http://www.jonesday.com/files/upload/SNS%20

REAAL--beschikking%20110713.pdf.

The U.K.—In a much-awaited judgment, In the Matter of

the Nortel Companies and In the Matter of the Lehman

Companies [2013] UKSC 52 (24 July 2013), the U.K.

Supreme Court has decided that the liability of a company

in administration or liquidation to contribute to an under-

funded defined-benefit pension fund following a finan-

cial support direction or contribution notice issued by the

U.K. Pensions Regulator after the commencement of the

insolvency process was a provable debt ranking equally

with the claims of other unsecured creditors. Crucially, the

court held that the liability was not an expense of admin-

istration or liquidation which would cause it to rank ahead

of the claims of all other creditors, except fixed-charge

(secured) holder claims and the claims of an administrator

or liquidator for remuneration.

This decision provides helpful guidance, as it brings certainty

after several unsettled years over the treatment of these pen-

sion liabilities, which, because of their size, are able to alter

fundamentally the center of gravity of any administration or

liquidation. A more detailed discussion of the ruling can be

accessed at http://www.jonesday.com/to-rank-or-not-to-rank-

uk-supreme-court-decision-in-lehman_nortel-07-25-2013/.

Other recent European developments can be tracked in

Jones Day’s EuroResource, available at http://www.jonesday.

com/euroresource--deals-and-debt-07-30-2013/.

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JONES DAY HAS OFFICES IN:

THE U.S. TRUSTEE’S NEW CHAPTER 11 FEE GUIDELINES

Following the culmination of two public comment peri-

ods spanning more than a year, the Office of the United

States Trustee, a unit of the U.S. Department of Justice (the

“DOJ”) assigned to oversee bankruptcy cases, issued new

final guidelines on June 11 governing the payment of attor-

neys’ fees and expenses in large chapter 11 cases—cases

with $50 million or more in assets and $50 million or more

in liabilities. The guidelines, which will apply to cases filed

on or after November 1, 2013, are intended to “enhance dis-

closure and transparency in the compensation process and

to help ensure that attorneys’ fees and expenses are based

on market rates,” according to a June 11 press release from

the DOJ. According to the DOJ, the new guidelines reflect

“significant changes that have occurred in the legal industry

as well as the increasing complexity of business bankruptcy

reorganization cases.”

Among other things, the new guidelines provide for: (i) man-

datory use of budgets and staffing plans; (ii) disclosure

of rate increases that occur during a representation; (iii)

fee rates based upon the location of the attorney’s home

office; (iv) submission of billing records in an open, search-

able electronic format; (v) use of independent fee commit-

tees and fee examiners; and (vi) use of model forms and

templates for applications seeking payment of fees and

reimbursement of expenses.

During the course of the public comment periods before and

after the U.S. Trustee issued an updated version of the pro-

posed guidelines on November 2, 2012, some bankruptcy

practitioners and industry commentators expressed conflict-

ing views concerning the need for new guidelines. Some crit-

ics warned that the extensive disclosure requirements were

burdensome and could reveal litigation strategy or confi-

dential information. The DOJ altered or clarified some of the

guidelines in response, but many bankruptcy professionals

remain unconvinced.

According to the DOJ press release, the original bank-

ruptcy-fee guidelines, which were issued in 1996, will be

updated in phases, and the changes governing large chap-

ter 11 cases will be the first phase. The release also states

that until additional superseding guidelines are adopted,

the 1996 guidelines will “continue in effect for the review of

fee applications filed in larger chapter 11 cases by profes-

sionals who are not attorneys; in all chapter 11 cases below

the large case threshold; and in cases under other chapters

of the Bankruptcy Code.”

The new fee guidelines are not legally binding, but the U.S.

Trustee intends to lobby bankruptcy courts to incorporate

them into their local rules of procedure.

The guidelines are available at: http://www.justice.gov/ust/eo/

rules_regulations/guidelines/index.htm.