Corporate Restructuring and Bankruptcy-NY Law Journal

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Corporate Restructuring and Bankruptcy


New York Law Journal

12-05-2011



Equitable Disallowance Rears Its Head in 'WaMu'



In bankruptcy, a creditor's ability to recover on its claim against a debtor results from two basic factors—the amount for which the claim is allowed and the priority granted to the claim in the waterfall of payments made by the debtor under a chapter 11 plan.

In addition to applying the statutory priorities for certain categories of claims and seeking subordination of claims under §510 of the Bankruptcy Code,1 debtors and other parties in interest have in certain instances sought—with varying success—the equitable disallowance of claims. A recent decision in the Washington Mutual (WaMu) chapter 11 case pending in the U.S. Bankruptcy Court for the District of Delaware again raises the possibility that equitable disallowance of claims may be within the power of bankruptcy courts, although the WaMu court did not actually disallow claims in its ruling or define the precise standards for granting such a remedy.2

Equitable Disallowance

Since the enactment of the Bankruptcy Code in 1978, courts have split as to whether the remedy of equitable disallowance of a claim exists in addition to the statutory claims provisions set forth under the Code. However, in considering this question, courts generally start at the same place—by examining the other remedies that indisputably do exist.

Section 510 of the Bankruptcy Code, aptly titled "Subordination," sets forth three instances in which an otherwise allowed claim may be subordinated in payment priority.3 First, §510(a) provides that a bankruptcy court will respect a contractual subordination agreement to the same extent as enforceable under non-bankruptcy law.

Second, §510(b) provides for the statutory subordination of claims arising from the rescission of a securities transaction or damages arising from a securities transaction, which subordination is generally intended to prevent an otherwise subordinated securities holder from improving its recovery against the debtor by asserting additional contract or tort claims.4 Finally, §510(c) provides that a court may "under principles of equitable subordination, subordinate for purposes of distribution all or part of an allowed claim [or interest] to all or part of another allowed claim [or interest]" or transfer any lien securing such a claim to the debtor's estate.5

Courts have occasionally grappled with the question of whether an additional remedy—equitable disallowance of a claim—exists in addition to the codified subordination provisions. This analysis usually begins with an examination of the historic availability of equitable disallowance, starting with the seminal 1939 U.S. Supreme Court decision in Pepper v. Litton.6

In Pepper, the trustee sought to disallow a claim based on a state court judgment obtained on account of alleged salary claims by the dominant controlling stockholder of the bankrupt company. The prior judgment and underlying claim were alleged to be the result of a "planned and fraudulent scheme."7 The Supreme Court, reversing the U.S. Court of Appeals for the Fourth Circuit, held that the bankruptcy court had the equitable power to subordinate or disallow the claim based on a prior court judgment, where there was evidence of collusion in obtaining the judgment or no valid underlying debt existed, particularly where the claim would inure to the benefit of an insider such as an officer, director or shareholder.8

Several decades later, shortly before the adoption of the Bankruptcy Code that replaced the prior Bankruptcy Act, the U.S. Court of Appeals for the Fifth Circuit again considered the issue in In re Mobile Steel.9 There, the Fifth Circuit was presented with the question of whether two groups of claims—one based on alleged contributions to capital in the form of debentures, and another based on promissory notes given for the purchase of commercial property—should be disallowed or subordinated based on the inequitable conduct of the debtor's directors and officers.

In reversing the lower court's exercise of equitable disallowance, the Court of Appeals concluded that recognizing an independent remedy of equitable disallowance would not aid creditors who would be fully protected by subordination alone, and it seemed superfluous to remedy instances of particularly extreme behavior, where a claim should be defeasible without the exercise of the court's general equitable powers.10

With this backdrop, both proponents and opponents of equitable disallowance look to the legislative history surrounding §510 to support their position as to whether the remedy should be recognized. The House Judiciary Committee Report accompanying the bill proposing a subordination provision (which provision ultimately was codified as §510(b)) explained that it intended to codify decisions such as Pepper and the provision "is not intended to limit the court's power in any way…[nor] preclude a bankruptcy court from completely disallowing a claim in the appropriate circumstances."11

However, a bill proposed by the Senate Judiciary Committee contained a subsection specifically providing for the equitable disallowance of claims that ultimately was not included in the Bankruptcy Code.12 Courts rejecting the authority to equitably disallow claims have relied on the considered omission of an equitable disallowance remedy and on the Mobile Steel13 decision to demonstrate equitable disallowance neither exists nor is necessary, while courts ruling the other way cite to Pepper and to bankruptcy courts' generally broad equitable powers.14

The WaMu court fell squarely in the second camp. In WaMu, the official committee of equityholders brought a motion for standing to pursue the equitable subordination and equitable disallowance of certain noteholders' claims. In support of their motion, the equityholders alleged the noteholders had engaged in insider trading during the time they were negotiating a settlement with WaMu in its bankruptcy case.

In partly granting the motion, U.S. Bankruptcy Judge Mary Walrath held that the equity committee lacked standing to seek equitable subordination of the noteholder claims under §510(c), as such a remedy (which only would subordinate the noteholder claims to other claims) would not affect equityholders' recoveries in the case. However, the court granted the equityholders standing to pursue equitable disallowance of the noteholder claims. While conceding that its authority should be exercised in only extreme instances, the WaMu court determined that based on the legislative history of §510 and the Pepper decision, it had the authority to equitably disallow claims in certain extreme and rare circumstances.15 The court did not make any ruling with respect to the ultimate merits of whether the noteholder claims should be disallowed.

The Standard

Since the adoption of the Bankruptcy Code, equitable disallowance has been recognized as an available remedy in only one other bankruptcy case, In re Adelphia Communications Corp.,16 while several other courts have considered and rejected the existence of this potential remedy.17 In Adelphia, as in the recent WaMu decision, the court did not articulate a precise standard to determine whether the claims in question (claims of bank creditors that were challenged by the official creditors committee appointed to the case) could be either equitably subordinated or disallowed.

Rather, Judge Robert Gerber of the U.S. Bankruptcy Court for the Southern District of New York described equitable disallowance as a "draconian" remedy only appropriate in extreme and "perhaps very rare" situations.18 On appeal, the U.S. District Court for the Southern District of New York affirmed the availability of equitable disallowance and concurred with the bankruptcy court's limitations regarding the actual exercise of equitable disallowance.19 The Adelphia courts did not have to articulate a more precise standard or rule on the facts at hand, as the equitable subordination and disallowance actions were dismissed in that case for failure to allege an injury.

Characterization of equitable disallowance as a rare and draconian remedy is understandable when one considers the availability of alternative remedies that would be sufficient for most circumstances. Equitable subordination, which is generally available on a showing of inequitable conduct and injury to other creditors or unfair advantage to the claimant, demotes a claimant's right to get paid behind the claims of other creditors, and in most cases effectively deprives the claimant of the right to get paid at all.

Furthermore, claims may be disallowed based on other available non-bankruptcy defenses. As the Mobile Steel court noted, "if the misconduct directed against the bankrupt is so extreme that disallowance might appear to be warranted, then surely the claim is either invalid or the bankrupt possesses a clear defense against it."20

Given the existence of these alternative remedies and other available defenses and counterclaims to a claim that a debtor likely would have in the face of egregious conduct by a claimant, it remains to be seen whether an instance exists where debtors are not adequately protected by such other rights and remedies. In fact, the WaMu court did not prejudge the adequacy of other alternative remedies in that case, noting that the debtors could well have a defense to the challenged claims outside of bankruptcy, under securities law.21 Although the remark is not entirely clear, the suggestion may be that both remedies are valid and available. Why equitable disallowance should be necessary or whether it should be granted in the presence of an alternative securities law defense is a question WaMu does not address.

Who Is at Risk?

The WaMu decision raises further questions regarding whether equitable disallowance is intended to remedy inequities in having to make distributions on a specific claim, to a specific creditor, or both. The WaMu decision indicates in a footnote that to the extent claims are equitably disallowed, they would be disallowed regardless of who holds them. The court does not elaborate on this statement, which potentially raises its own questions.

Taken at its face, the proposition articulated by the WaMu court could be argued to be noncontroversial. If a court were to rule that a claim should be equitably disallowed, such disallowance cannot subsequently be remedied merely by selling or transferring the disallowed claim to a third party. However, it is less clear whether a court would equitably disallow a claim held by a transferee who purchased the claim in good faith and both without knowledge of and prior to any allegation of the alleged inequitable conduct (such as a transferee of notes held by a target noteholder in the WaMu case). In fact, in other circumstances, courts have concluded that similar equitable remedies do not necessarily travel with a claim.

In In re Enron Corp., the debtors filed an action seeking equitable subordination under §510(c) and disallowance of certain claims under §502(d),22 based on the alleged inequitable conduct of the claims' original holders.23 The debtors sought subordination or disallowance of the claims held by good-faith purchasers for value as well. The U.S. District Court for the Southern District of New York declined to subordinate or disallow the claims held by purchasers, ruling that subordination is a "personal disability" of the original creditor that travels with claim assignment, but not in a sale of the claim.24 While Enron does not address equitable disallowance directly, the court's broad policy reasoning—that equitable subordination is remedial instead of penal and that a good-faith purchaser need not suffer from the wrongful conduct of the original claimant—could certainly apply to a situation in which equitable disallowance is sought with respect to a claim. The importance of whether an equitable disallowance remedy is personal to a claimant or follows a claim is particularly heightened where, as in WaMu, the claim arises from public securities of a debtor freely and regularly traded by parties on an arms-length basis prior to and during a debtor's bankruptcy case.

To Be Continued

It remains to be seen whether equitable disallowance will ever become a firmly recognized remedy available in bankruptcy cases. The WaMu decision is currently on appeal to the District Court for the District of Delaware (pending the mediation appointed by the bankruptcy court), so a district court may have the chance to further consider the availability of such a remedy. Moreover, both the Adelphia and WaMu courts recognized that to the extent such a remedy is available, its use would be reserved for the most extreme and rare circumstances of egregious conduct.

However, the WaMu decision serves as a reminder to creditors and claimants regarding the importance of dealing with a debtor in good faith, both prior to and during a bankruptcy proceeding, and the willingness of bankruptcy courts to consider what remedies may be available to address wrongful conduct to protect the interests of the debtor and its stakeholders.

Lisa Schweitzer is a partner, and Martin Kostov an associate, at Cleary Gottlieb Steen & Hamilton.

Endnotes:

1. Unless otherwise indicated, all section references herein are to the Bankruptcy Code.

2. In re Washington Mut. Inc., 2011 Bankr. LEXIS 3361 (Bankr. D. Del. Sept. 13, 2011).

3. 11 U.S.C. §510.

4. See, e.g., Baroda Hill Inv. Inc. v. Telegroup Inc. (In re Telegroup Inc.), 281 F.3d 133, 142 (3d Cir. 2002) (Section 510(b) is meant to "prevent disappointed shareholders from recovering their investment loss by using fraud and other securities claims to bootstrap their way to parity").

5. 11 U.S.C. §510(c).

6. Pepper v. Litton, 308 U.S. 295 (1939).

7. Id. at 312.

8. Id. at 306.

9. In re Mobile Steel Co., 563 F.2d 692 (5th Cir. 1977).

10. Id. at 699, n.10.

11. H.R. Rep. No. 595, 95th Cong., 1st Session 359 (1977). See, e.g., Adelphia Communs. Corp. v. Bank of Am., N.A. (In re Adelphia Communs. Corp.), 365 B.R. 24, 70-73 (Bankr. S.D.N.Y. 2007).

12. See Adelphia Recovery Trust v. Bank of Am., N.A., 390 B.R. 64, 75 (S.D.N.Y. 2008).

13. See, e.g., 80 Nassau Assocs. v. Crossland Fed. Sav. Bank (In re 80 Nassau Assocs.), 169 B.R. 832, 837 (Bankr. S.D.N.Y. 1994); Official Comm. of Unsecured Creditors of Lois/USA Inc. v. Conseco Fin. Servicing Corp. (In re Lois/USA Inc.), 264 B.R. 69, 132-33, n.158 (Bankr. S.D.N.Y. 2001); Austin v. Chisick (In re First Alliance Mortg. Co.), 298 B.R. 652, 666 (C.D. Cal. 2003).

14. See In re Adelphia, 365 B.R. at 73; Adelphia Recovery Trust, 390 B.R. at 76.

15. WaMu, 2011 Bankr. LEXIS 3361 at *141.

16. In re Adelphia, 365 B.R. 24; Adelphia Recovery Trust, 390 B.R. 64.

17. Other courts have considered the availability of equitable disallowance without reaching a ruling. See Citicorp Venture Capital v. Committee of Creditors Holding Unsecured Claims, 160 F.3d 982, 991 (3d Cir. 1998); Official Comm. of Unsecured Creditors of Sunbeam Corp. v. Morgan Stanley & Co. (In re Sunbeam Corp.), 284 B.R. 355, 369 (Bankr. S.D.N.Y. 2002); Congoleum Corp. v. Pergament (In re Congoleum Corp.), 2007 Bankr. LEXIS 4357 at *34 (Bankr. D.N.J. Dec. 28, 2007).

18. In re Adelphia, 365 B.R. at 73.

19. Adelphia Recovery Trust, 390 B.R at 76.

20. Mobile Steel, 563 F.2d at 699.

21. WaMu, 2011 Bankr. LEXIS 3361 at *142.

22. Section 502(d) deals with the estate's ability to disallow claims against creditors who have failed to transfer back property of the estate that was the subject of an avoidable transfer. 11 U.S.C. §502(d).

23. Enron Corp. v. Springfield Assocs., L.L.C. (In re Enron Corp.), 379 B.R. 425 (S.D.N.Y. 2007).

24. Id. at 436.



Navigating Dodd-Frank's Resolution Plan Requirement


The reduction of systemic risk is among the chief aims of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank).1

Recognizing that the disorderly failure and subsequent bankruptcy of a large financial institution can be an acute source of financial instability, Congress included in §165(d) of Dodd-Frank a requirement that large bank holding companies and certain foreign banking institutions—as well as other financial companies deemed systemically important by the Financial Stability Oversight Council—file plans demonstrating that they can be resolved under the Bankruptcy Code in a manner that does not pose a systemic threat to the nation's financial system.2

Such resolution plans, often referred to as "living wills," are expected to be among the most challenging compliance exercises facing the banking industry in 2012. After a rulemaking process that lasted nearly nine months, the Federal Deposit Insurance Corporation (FDIC) and the Board of Governors of the Federal Reserve System (FRB) recently finalized the implementing rule for the resolution plan requirement, a rule that became effective on Nov. 30, 2011.3 It is estimated that among those entities subject to Dodd-Frank's living will requirement are nearly a dozen bank holding companies headquartered in New York and almost 100 foreign banks that have one or more subsidiaries, branches or offices in New York.4

What to Include

A resolution plan of the kind contemplated by Dodd-Frank is a comprehensive and detailed road map of the financial institution's operations and its procedure for implementing a "rapid and orderly resolution" under the Bankruptcy Code and any other applicable insolvency proceeding5 in a manner that mitigates risk to the U.S. financial system should financial distress occur. Primarily, the plan must detail how the financial institution intends to maintain critical operations (which may include a sale or transfer of assets to third parties), to resolve material entities under the appropriate insolvency regime, and to account for scenarios of both an isolated failure of the institution and a larger systemic crisis.

In addition, the plan must include an analysis of:

(i) the financial institution's strategy to address funding, liquidity and capital requirements of core business lines, critical operations and material entities;

(ii) the key assumptions underlying the plan;

(iii) the potential impact of the resolution plan on its domestic subsidiaries and international operations; and

(iv) the impact on the institution in the event of a failure of each of its major counterparties.

Lastly, the plan must include a description of the financial institution's corporate governance procedures for resolution planning, information about the institution's overall organizational structure, details regarding its management information systems, a description of interconnectedness and, finally, interdependencies among the financial institution's material entities. The financial institution will then have to update the plan on an annual basis and must notify the regulators of any material event or change that would affect its resolution plan no later than 45 days after that event or change. Institutions with assets totaling $250 billion or more must submit their resolution plans in July 2012, while other financial institutions must do so at various points in 2013 depending on their asset size.6

Although preventing systemic risk—rather than maximizing value—is the paramount goal of a resolution plan, Dodd-Frank's living will requirement, as a practical matter, necessitates that each covered financial institution undertake the type of analysis that is performed in every large corporate restructuring. Although regulators estimated in the final rule that a financial institution may be required to spend up to 12,400 hours to complete a "credible" resolution plan, the actual time required for a particularly large or complex institution may far exceed that estimation. Given the vast scope of information demanded by the statute and rule, each institution would be wise to form an internal team to coordinate its resolution planning. The internal resolution planning team, along with external legal and financial advisors, will be required to synthesize voluminous data to perform the restructuring analysis, understand the institution's cash management systems and identify all material legal entities in order to examine the "domino effects" of an insolvency of one or more businesses on the entire corporate group.

As §165(d)(4)-(5) provides, it is critical that the plan submitted to the FDIC and the FRB "credibl[y]" demonstrates that its implementation would result in the institution's "orderly resolution." The regulators have broad discretion to determine whether the plan is in fact credible and may impose "more stringent capital, leverage, or liquidity requirements, or restrictions on the growth, activities or operations" if the financial institution fails to satisfy that standard. In extreme cases, regulators may require the institution to divest certain assets or operations if deemed necessary to facilitate an orderly resolution.7 Given the regulators' broad authority in this regard, financial institutions have been undertaking the requirements of §165(d)—as implemented by the recent final rule—with great care.

Issues Remain

The final rule, for its part, reflects a number of helpful clarifications and improvements upon prior proposals—particularly with respect to the timing and scope of filing and the plan's relationship with the Bankruptcy Code and other insolvency proceedings. But the rule still leaves a substantial degree of uncertainty as to what exactly it will take to ensure a plan is "credible." For this reason, the FDIC and the FRB have acknowledged that they "expect the process of submission and review of the initial resolution plan iterations to include an ongoing dialogue."8

While waiting for that dialogue to occur, financial institutions in New York and elsewhere presently have been confronting a number of unresolved legal issues as they begin the process of resolution planning, including: protecting the confidentiality of submitted information; avoiding compulsory subsidiarization; reconciling the objectives of the Bankruptcy Code and Dodd-Frank's goal of mitigating systemic risk; complying with parallel foreign and international requirements for resolution planning; and understanding how the living will requirement squares with other prudential measures to be imposed under Dodd-Frank.9

Confidentiality tops the list of concerns for many financial institutions. In the final rule, the FDIC and the FRB have alleviated some prior concerns on this point by dividing the required submissions into public and non-public sections and stating their intention to rely on specified exemptions of the Freedom of Information Act (FOIA) to protect from disclosure the non-public portion of the plan.10 Yet considerable uncertainty remains. The interpretation of the potentially applicable FOIA provisions is far from settled. Further adding to the uncertainty in this area is the fact that recent decisions interpreting FOIA in other contexts suggests the U.S. Supreme Court's hesitancy to adopt anything beyond a narrow reading of FOIA's exemptions.11

Another critical issue left open by the final rule is "subsidiarization," or the process of conducting the institution's operations in various countries or across differing business lines through separately capitalized legal entities. During a series of roundtable discussions held prior to the issuance of the final rule, regulators suggested that they might encourage some degree of subsidiarization as part of the resolution planning process. Some believe that subsidiarization can prevent failures from spreading across jurisdictions. But subsidiarization can also be costly to implement and may have the unintended consequence of weakening a subsidiary by preventing the institution from allocating its collective capital and liquidity resources where they are most needed in a time of crisis.

One also needs to recognize that the final rule does not acknowledge that the resolution plan concept itself presents somewhat of a paradox: Institutions must demonstrate they are resolvable under the Bankruptcy Code and other insolvency regimes in a manner that mitigates any risk to U.S. financial stability, yet these regimes were not created for such a purpose. Indeed, the primary objective of a living will under Dodd-Frank is to avoid or mitigate any systemic impact on U.S. financial markets. In contrast, the primary objective in bankruptcy is to maximize value for all stakeholders.12 Reconciling these differing objectives is not impossible, but it requires a focus on nuances within the Bankruptcy Code and other insolvency regimes as well as on the specific issues that will face the financial institution in the event of its failure.

It remains to be seen how the realities of bankruptcy may play out in comparison to resolution planning in the event a large financial institution actually fails. What is more, the fiduciary charged with overseeing the financial institution's liquidation or reorganization and the company's stakeholders will be forced to make decisions in the shadow of Title II of the Dodd-Frank Act, which establishes the Orderly Liquidation Authority (OLA). If at any time the FDIC and the FRB determine that a bankruptcy proceeding is jeopardizing the stability of the U.S. financial system, and the Treasury Secretary concurs, the government may remove the case from the bankruptcy process entirely. The company then would face eventual liquidation under the OLA, with the FDIC serving as receiver and subject to only minimal court oversight and creditor input. When creating a resolution plan, therefore, considered judgment will be necessary in harmonizing these various competing goals and scenarios.

It is also worth noting that §165(d) is intended for large complex financial institutions, of which few have purely domestic operations. Another important open question, accordingly, is how U.S. regulators will interact with their foreign counterparts in the supervision and possible resolution of institutions with a global reach. The description of the final rule states that each U.S.-based financial institution "with foreign operations…should identify [in its plan] the extent of the risks related to its foreign operations" and "take into consideration, and address through practical responses, the complications created by differing national laws, regulations and policies."13

The lack of specificity with respect to foreign requirements is frustrating but perhaps to be expected in light of the fact that the international community is still in the process of implementing uniform guidelines for resolution planning. In particular, the Financial Stability Board (FSB)—an organization comprising governmental and other financial authorities from the G-20 nations, established to coordinate the work of national regulators—only recently published a final set of recommendations on resolution planning.14 Authorities in the United Kingdom are also developing comprehensive requirements for resolution planning.15 It remains to be seen how resolution planning initiatives developed by the FSB, U.K. authorities and various European regulators will ultimately comport with U.S. requirements.

Finally, institutions are left to confront the issue of how the resolution plan requirement of §165(d) squares with other prudential measures authorized elsewhere in Dodd-Frank. Section 165(a)-(k), for example, vests in the FRB the power to establish enhanced capital and leverage requirements, additional liquidity provisioning, mandatory contingent capital instruments, various concentration and short-term debt limits, supplemental public disclosures, periodic stress testing and other risk management protocols.16 Even in the review of seemingly more mundane matters, such as mergers and acquisitions and the approval of new activities, Dodd-Frank requires the FRB and other regulators to consider the potential impact on systemic risk.17 A resolution plan that convincingly demonstrates that a particular institution can be resolved under applicable law without posing a systemic risk could, in theory, eliminate or reduce the need for the additional prudential measures Dodd-Frank establishes and enable the institution to engage in further acquisitions and activities under existing banking laws.

In sum, Dodd-Frank's resolution plan requirement will be a major focus for many U.S. and foreign financial institutions during the next few years, and the complexity of the task should not be underestimated. Nor should institutions expect that answers will come easily; it seems likely that many open issues will be resolved only during the iterative process of ongoing dialogue with the FDIC and the FRB. Despite the inherent challenges in creating a living will, however, both financial institutions and their regulators continue to believe that the very process of creating a resolution plan—even with no intent to execute it—will serve as a valuable tool in understanding and managing risk on a integrated basis.

Marcia L. Goldstein is a partner at Weil, Gotshal & Manges in New York; Heath P. Tarbert is senior counsel at the firm's Washington D.C. office; and Kathlene M. Burke is an associate in the New York office.

Endnotes:

1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. 111-203, 124 Stat. 1376 (2010) [hereinafter Dodd-Frank Act].

2. Dodd-Frank Act §165(d) (to be codified at 12 U.S.C. §5365(d)).

3. Resolution Plans Required, 76 Fed. Reg. 67323 (Nov. 1, 2011) (to be codified at 12 C.F.R. pt. 381).

4. The following entities are required to file a resolution plan under Dodd-Frank and the final rule: (i) U.S. bank holding companies (BHCs) with assets of $50 billion or more, (ii) foreign banks or companies with global assets of $50 billion or more that are treated as BHCs under §8(a) of the International Banking Act of 1978 and (iii) nonbank financial companies supervised by the FRB.

5. Not all companies are eligible or required to file under the Bankruptcy Code. There are several other insolvency regimes that could apply. For example, insured depository institutions are subject to receiverships pursuant to the Federal Deposit Insurance Act (FDIA), broker dealers are subject to proceedings under Securities Investor Protection Act (SIPA) and insurance companies are subject to state resolution or rehabilitation proceedings.

6. Resolution Plans Required, 76 Fed. Reg. 67323, 67330 (Nov. 1, 2011) (to be codified at 12 C.F.R. pt. 381).

7. Dodd-Frank Act §165(d)(5)(B) (to be codified at 12 U.S.C. §5365(d)(5)(B)).

8. Resolution Plans Required, 76 Fed. Reg. 67323, 67328 (Nov. 1, 2011) (to be codified at 12 C.F.R. pt. 381).

9. For a more in-depth discussion of these issues, see Sylvia A. Mayer & Heath P. Tarbert, "Test Your Resolution: Living Wills in an Era of Regulatory Uncertainty," 128 BANKING L.J. 916 (2011).

10. See Freedom of Information Act, 5 U.S.C. §552(b)(4) (2007) (exempting matters that are "trade secrets and commercial or financial information obtained from a person and privileged or confidential"); 5 U.S.C. §552(b)(8) (2007) (exempting matters "contained in or related to examination, operating, or condition reports prepared by, on behalf of, or for the use of an agency responsible for the regulation or supervision of financial institutions").

11. See Milner v. Dept. of Navy, 131 S. Ct. 1259 (2011) (slip op., at 2, 8 n.5, 17) (explaining that FOIA exemptions "must be narrowly construed" and refusing to assess "whether disclosure interferes with good government"); see also FCC v. AT&T Inc., 131 S. Ct. 1177 (2011) (slip op., at 4, 11-12) (refusing to extend exemption related to "personal privacy" to corporations, even though definition of "person" governing FOIA includes "an individual, partnership, corporation, association, or public or private organization"); 5 U.S.C. §551(2) (2011).

12. Alternate insolvency regimes are similarly not designed to focus on systemic risk, but to protect certain creditors. The primary goal of FDIA receiverships and SIPA proceedings are to protect depositors or brokerage customers respectively, while state insurance proceedings are to protect claim holders.

13. Resolution Plans Required, 76 Fed. Reg. 67323, 67329 (Nov. 1, 2011) (to be codified at 12 C.F.R. pt. 381).

14. Financial Stability Board, "Key Attributes of Effective Resolution Regimes for Financial Institutions" (Nov. 4, 2011), available at http://www.financialstabilityboard.org/publications/r_111104cc.pdf.

15. See generally Financial Services Authority, "Consultation Paper CP11/16: Recovery and Resolution Plans" (August 2011) (covering the proposed requirements for certain financial services firms in the U.K. to prepare and maintain recovery and resolution plans).

16. Dodd-Frank Act §165(a)-(k) (to be codified at 12 U.S.C. §5365(a)-(k)).

17. Throughout Dodd-Frank, several of the banking laws have been amended to include a system risk factor in the context of applications for mergers and acquisitions. See, e.g., Dodd-Frank Act §604 (amending the Bank Holding Company Act of 1956 §§3(c)(7), 4(j)(2)(A), and 4(k)(6)(B) and the Federal Deposit Insurance Act of 1950 §§18(c)(5) & 44(b)(4)(B)).

Keeping It Personal



Intellectual property licensors are perpetually concerned about whether their licensees can use the bankruptcy process to assign their license rights to third parties, especially to third parties to whom the licensor would not want to grant a license, or at least not on the existing license terms. This concern can be particularly acute for trademark licensors, who want to protect their trademarks against undesired uses and keep the trademark license rights "personal" to their licensees.

The U.S. Court of Appeals for the Seventh Circuit recently provided some comfort for trademark licensors when it concluded in In re XMH Corp., 647 F.3d 690 (7th Cir. 2011), that a licensee under a non-exclusive trademark license cannot assign its license in bankruptcy under §365 of the Bankruptcy Code without consent from the licensor. While the Seventh Circuit's pronouncements with respect to the assignability of the license were ultimately dicta, this case is noteworthy for several reasons.

First, in contrast to the fairly well-established body of case law prohibiting a licensee from assigning its non-exclusive patent and copyright licenses without the consent of the licensor,1 the ability of a trademark licensee to assign its license has been relatively unclear. The Seventh Circuit's decision provides welcome clarity on the issue. Second, the Seventh Circuit essentially ignored the usual predicate for a finding that a license is not assignable by a licensee in bankruptcy; that is, whether "applicable law"—federal, state, or otherwise—would prohibit assignment of the license without the consent of the licensor outside of bankruptcy. Instead, the Seventh Circuit summarily characterized its conclusion that a trademark license cannot be assigned without consent as the "universal rule."

Finally, the Seventh Circuit's statement that "if the contract still included a trademark sublicense when [the debtor] attempted to assign the contract to the purchasers, [the contract] was not assignable," highlights an important issue: that a party to a contract containing a trademark (or other intellectual property) license to the debtor, regardless of how minor a part the license may play, could prevent assignment of the entire agreement by the debtor on the grounds that the "licensor" does not consent to assignment of the license contained within the agreement.

This issue raises the possibility that a contracting party will try to use minor aspects of a contract containing a trademark license to prevent assignment of the contract by the debtor in the event of the debtor's bankruptcy. A licensee, for its part, may try to negotiate a license agreement as a stand-alone contract, separate from other rights in its contractual relationship, to preserve the potential assignability of its other contractual rights in bankruptcy to the maximum extent possible.

Contracts and Section 365

Section 365 of the Bankruptcy Code permits a debtor to assume and assign its executory contracts.2 Courts have generally deemed intellectual property licenses to be "executory" within the meaning of §365.3 A debtor's right to assume and assign its executory contracts is subject to certain exceptions. One such exception is found in §365(c)(1) of the Bankruptcy Code, which prevents a debtor from assuming or assigning an executory contract without the consent of the other party to the contract, when applicable law excuses that party from accepting performance from someone other than the debtor. In jurisdictions applying the so-called "hypothetical test," §365(c)(1) will also generally prevent a debtor from assuming the contract, even if the debtor is planning to restructure itself within its existing corporate entity and does not contemplate assigning the contract to a third party.4

Assignment Before 'XMH'

With regard to the treatment of trademark licenses in bankruptcy, the primary question under §365(c)(1) is whether applicable trademark law excuses the non-debtor party from accepting performance from someone other than the debtor. Until recently, relatively little case law has addressed this issue. Of the cases that have considered it, the approaches and conclusions vary, resulting in uncertainty for licensors of trademarks, and for licensees of trademarks who may find themselves in bankruptcy (and, indeed, for potential acquirors of assets from licensees in bankruptcy).

A case often cited for the proposition that trademark licenses may be assigned by licensees in bankruptcy without regard to the licensor's consent is In re Rooster Inc., 100 B.R. 228 (Bankr. E.D. Pa. 1989). The debtor in Rooster was the licensee under a trademark sublicense giving it the right to use the "Bill Blass" name to manufacture and sell men's ties. The licensor moved for relief from the automatic stay for permission to terminate its sublicense with the debtor on the grounds that (i) the debtor conceded that it could no longer perform under the agreement and (ii) the license was not assignable to a third party because it was a personal services contract.

The court evaluated whether the contract was a contract for personal services under Pennsylvania law. Under Pennsylvania law, a contract for personal services "contemplates performance of contracted-for duties involving the exercise of special knowledge, judgment, taste, skill or ability." Rooster, 100 B.R. at 232. The court concluded that the debtor retained little discretion over the creation or design of the trademarked neckwear. Instead, the licensor retained the right to control the final design. Accordingly, the court held that the "actual control over [the debtor's] performance removes [the debtor's] duties from the sphere of personal service and from the ambit of §365(c)(1)(A)." Id. at 234.

Rooster is often cited for the proposition that trademark licenses should be evaluated through the lens of whether they are personal services contacts under state law—which turns on the particular license at issue, rather than a bright-line rule. Rooster, however, has also been criticized as being of limited utility, because the parties to the dispute had stipulated that Pennsylvania law was "applicable law" for the purposes of §365(c)(1) and had narrowly framed the issue before the court as whether the contract was one for personal services. Moreover, the Rooster court itself noted that it is generally accepted that §365(c) prohibits the assignment of more than just personal services contracts; instead, it applies to any contract that is subject to a law restricting assignment.

A case dealing with the assignability of franchise agreements, which generally contain within them trademark licenses, is also cited in support of the application of a personal services contract analysis to determine whether a debtor may assign trademark licenses without the consent of the licensor. In In re Sunrise Restaurants Inc., 135 B.R. 149 (Bankr. M.D. Fla. 1991), the debtor moved to assume and assign a fast food franchise agreement in connection with a sale of its assets.

The court examined the franchise agreement in the context of whether it was a personal services contract, which under applicable law would excuse the licensor from accepting performance from a party other than the debtor. The court concluded that the relationship between the parties was strictly a business relationship, and that the running of the fast food establishment did not require special knowledge, taste, skill or ability, in part because the franchise agreement imposed strict rules and conditions on the licensee. Notably, the court did not directly address the assignability of the trademark license contained within the franchise agreement, instead permitting assignment of the entire agreement, without consent, on the grounds that it was not a personal services contract.

The court in In re Travelot Company, 286 B.R. 447 (Bankr. S.D. Ga. 2002), reached the opposite conclusion of the courts in Rooster and Sunrise Restaurants, stating that a trademark license is not assignable by a debtor-licensee without consent of the licensor. Although the court in Travelot ultimately concluded that the agreement at issue did not contain a trademark license at all, it stated in dicta that federal trademark law constitutes "applicable law" under §365(c) and that, under federal trademark law, the grant of a non-exclusive trademark license is "an assignment in gross" that is personal to the assignee and thus not freely assignable to a third party.

In 2005, the U.S. District Court for the District of Nevada squarely addressed the issue of whether trademark licenses may be assigned by a licensee in bankruptcy in N.C.P. Marketing Group Inc. v. Billy Blanks (In re N.C.P. Marketing Group Inc.), 337 B.R. 230 (D. Nev. 2005). In N.C.P., the debtor was the licensee under an agreement permitting it to use the "Tae Bo" trademark in marketing and selling products. The owner of the trademark moved to compel the debtor to reject the agreement on the grounds that, under federal law, the trademark license could neither be assigned nor assumed by the debtor.

The court applied federal trademark law to conclude that trademarks are personal and non-assignable without the consent of the licensor. As a result, a licensee cannot assume and assign a trademark license without the licensor's consent. The court noted that copyrights and patents had frequently been held assignable only with the consent of the licensor. The court rejected an argument by the debtor that, unlike copyrights and patents, the purpose of which is to encourage authorship and invention by protecting the rights of the creator of the work, the sole value of a trademark is to protect consumers from deception and confusion.

While the court acknowledged that trademarks do protect the public from confusion, it stated that they are also used by trademark owners to preserve the value of their business name and products by protecting them from unauthorized use. The court reasoned that the owner of a trademark "has an interest in the party to whom the trademark is assigned so that it can maintain the good will, quality, and value of its products and thereby its trademark." Id. at 236. The U.S. Court of Appeals for the Ninth Circuit affirmed the district court's decision.

Despite the N.C.P. court's clear articulation of the standard for evaluating whether trademark licenses can be assigned by a debtor, there remained uncertainty after its decision for several reasons. First, it remained unclear whether other courts would agree with the selection of the federal trademark law as "applicable law" within the meaning of §365(c)(1). Second, even if courts agreed that federal trademark law was "applicable law," it was uncertain whether other courts would agree with the N.C.P. court's analysis of the result under that law. This is due in part to the fundamental differences in copyright and patent law, on the one hand, and trademark law, on the other hand-the differences that the N.C.P. debtor highlighted in its argument in the district court.

'In re XMH Corp.'

The Seventh Circuit's decision in In re XMH arose out of the chapter 11 case of XMH Corp., a clothing company. XMH sought permission under §363 of the Bankruptcy Code to sell the assets of its subsidiary, Simply Blue. As part of the sale, Simply Blue would assume and assign an executory contract between it and Western Glove Works. The contract had two parts: For the initial period of the contract, Western granted to Simply Blue a trademark sublicense that allowed Simply Blue to design, manufacture, and sell certain apparel in exchange for the payment of royalties to Western. Following the initial period, the trademark sublicense was to expire, after which Western would sell the trademarked apparel on its own, and Simply Blue would provide a variety of marketing, sourcing, and other services in exchange for a fee.

Western objected to the proposed assignment of the contract on the grounds that the contract contained a trademark sublicense and therefore, under §365(c)(1) of the Bankruptcy Code, could not be assigned without Western's consent, which Western would not give. The debtor, on the other hand, argued that the trademark sublicense had expired long before its attempt to assume and assign the contract and that §365(c) posed no bar to assignment. The U.S. Bankruptcy Court for the Northern District of Illinois agreed with Western, ruling that the contract could not be assigned over Western's objection. Simply Blue appealed this ruling to the U.S. District Court for the Northern District of Illinois, which reversed the Bankruptcy Court on the grounds that the trademark sublicense contained within the contract had expired by the time of the proposed assignment. Western appealed to the Seventh Circuit.

Although the district court's ruling was based upon a conclusion that the trademark sublicense had expired, the Seventh Circuit began its analysis with a discussion of whether trademark licenses are, in fact, assignable without the consent of the licensor under §365(c)(1) of the Bankruptcy Code. The Seventh Circuit concluded that trademark law, as opposed to, for example, state law governing personal services contracts, constituted "applicable law" within the meaning of §365(c)(1). The Seventh Circuit did not reach the issue of whether the applicable trademark law was federal, state, or even that of another nation (Western was a Canadian company). Instead, the Seventh Circuit declared that it did not matter, because: "[T]he universal rule is that trademark licenses are not assignable in the absence of a clause expressly authorizing assignment."5 In re XMH, 647 F.3d at 695.

In reaching its conclusion, the Seventh Circuit reasoned that a trademark conveys information about a brand to a consumer. If the seller of the branded product reduces the quality of the brand, then the trademark becomes deceptive, because its assurance of quality is not accurate. Of critical importance, the owner of the trademark must be able to control the quality of the brand. If the trademark owner has licensed it to a third party, the owner will normally not want to allow that person to sublicense the trademark without the owner's consent because the owner may not have the same level of confidence in the sublicensee that it had in the licensee. Thus, the Seventh Circuit reasoned, it makes sense that the "default" rule in all circumstances is that a trademark license is not assignable without the owner's express permission.

Ultimately, after its analysis of whether the agreement would have been assignable if it contained a trademark license, the Seventh Circuit concluded that the license portion of the contract had expired before the attempted assignment. Therefore, at the time of the assignment, the agreement was merely a services agreement that was freely assignable by Simply Blue. Nevertheless, based on its analysis, the Seventh Circuit stated that: "[I]f the contract still included a trademark sublicense when [the debtor] attempted to assign the contract to the purchasers, [the contract] was not assignable." In re XMH, 647 F.3d at 695.

'XMH' Effects

The Seventh Circuit's decision in XMH is important not only for what it says about the assignability of trademark licenses in bankruptcy, but also because it leaves certain questions unanswered. Rather than definitely conclude whether federal, state, or some other law constitutes "applicable law" for the purposes of §365(c)(1), the Seventh Circuit stated that it is the universal rule that trademark licenses are not assignable without the consent of the licensor. In reaching this conclusion, the Seventh Circuit did not discuss decisions like Rooster, Sunrise Restaurants, and others, which at least call into question the universality of this rule.

Notwithstanding the "universal rule" announced by the Seventh Circuit, the determination of what constitutes "applicable law" for the purposes of §365(c)(1) could be extremely important if the application of different laws would lead to different results. While the trend after N.C.P. and XMH seems to be toward the application of federal trademark law as applicable law, it remains possible that a court will apply the state law analysis employed by the court in Rooster to conclude that a contract is (or is not) a personal services contract. Alternatively, a court may disagree with the courts in N.C.P. and XMH and adopt the debtor's argument in N.C.P. that federal trademark law, unlike federal patent or copyright law, permits a licensee to assign its license without the consent of the licensor.

XMH is more important, however, for what it says about agreements that contain trademark licenses. The Seventh Circuit's unequivocal statement that the debtor could not assign the contract if it contained a trademark license at the time that the debtor sought to assume and assign it has serious ramifications for debtors whose businesses may depend on agreements that contain within them trademark licenses, or licenses of other intellectual property.

It is possible, and perhaps likely, that under the Seventh Circuit's reasoning in XMH, a debtor seeking to assume and assign a contract containing a trademark license may be prohibited from doing so. In a "hypothetical test" jurisdiction, this may also mean that a debtor cannot even assume the agreement for its own use. Due to the adverse consequences that may result from a debtor's inability to assume and assign a particular contract, the characterization of a contract as a license, or as containing a license, could become extremely important. It is also possible, though perhaps less likely, that a court would permit a debtor to sever the license portion of the contract from the remainder of the agreement, thus permitting the debtor to assume and assign the non-license portion for the purposes of its reorganization. This analysis depends on whether the court applies the well-accepted general rule that an executory contract must be assumed in its entirety,6 or whether a court would view the separate components of the contract as distinct agreements as courts have allowed in other contexts.7

While the Seventh Circuit's ruling in XMH may provide some comfort to licensors seeking to protect their trademarks in the event of a bankruptcy by their licensees, it may also result in licensees seeking to protect their rights at the contract negotiation and drafting stage. In particular, a licensee may try to negotiate a license agreement as an independent contract, so that even if it is ultimately unable to assume and assign the license in bankruptcy, it may be able preserve the potential assignability of its other contractual rights. On the other hand, a savvy party seeking to ensure that a contract is deemed "personal" and, therefore, nonassignable in bankruptcy by the other party to the contract, may try to include elements of a "license" in the contract, if it can colorably do so under the circumstances of the transaction.

James Millar is a partner, and Benjamin Loveland, a senior associate, in WilmerHale's bankruptcy and financial restructuring practice group in New York and Boston, respectively.

Endnotes:

1. Courts have consistently held that a debtor may not assign its non-exclusive patent and copyright licenses without the consent of the licensor. See, e.g., In re Access Beyond Technologies Inc., 237 B.R. 32, 45-47 (Bankr. D. Del. 1999) (non-exclusive patent license); In re Patient Education Media Inc., 210 B.R. 237, 242-43 (Bankr. S.D.N.Y. 1997) (non-exclusive copyright license).

2. The Bankruptcy Code does not define the phrase "executory contract," but courts have generally accepted the Countryman definition, that:

[An executory contract is] a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.

Sharon Steel Corp. v. National Fuel Gas Distribution Corp., 872 F.2d 36, 39 (3d Cir. 1989), quoting Vern Countryman, "Executory Contracts in Bankruptcy," Part 1, 57 Minn. L. Rev. 439, 460 (1973).

3. See, e.g., In re Golden Books Family Entertainment Inc., 269 B.R. 300, 308 (Bankr. D. Del. 2001) ("Applying the Countryman definition of executory contracts, courts generally have found intellectual property licenses to be "executory" within the meaning of section 365(c)…").

4. Applying a strict interpretation of the phrase "may not assume or assign" as used in §365(c)(1), some courts apply a "hypothetical test" to hold that if a debtor may not assign an executory contract to a third party, then the debtor may not assume the contract for its own use, even if no assignment is contemplated. See, e.g., In re West Elec. Inc., 852 F.2d 79 (3d Cir. 1988). Other courts, applying the so-called "actual test" look to whether the debtor actually plans to assign the contract to a third party; if not, these courts will permit the debtor to assume the contract for its own use. See, e.g., Institut Pasteur v. Cambridge Biotech Corp., 104 F.3d 489 (1st Cir. 1997). Some bankruptcy judges, including some in the Southern District of New York, have adopted a third test, the Footstar test. See In re Footstar Inc., 323 B.R. 566 (Bankr. S.D.N.Y. 2005). The results are generally the same under the Footstar test as under the actual test, and the technical differences between the Footstar and actual tests are beyond the scope of this article.

5. The Seventh Circuit cited to the U.S. District Court for the District of Nevada's decision in In re N.C.P. Marketing Group Inc. in support of this absolute rule.

6. See, e.g., In re Leslie Fay Companies Inc. v. Corporate Property Associates 3 (In re Leslie Fay Companies), 166 B.R. 802, 808 (Bankr. S.D.N.Y. 1994) (A debtor must assume or reject an executory contract in its entirety; contracts may not be assumed in part and rejected in part.).

7. See, e.g., In re Adelphia Business Solutions Inc., 322 B.R. 51, 54 n.10 (Bankr. S.D.N.Y. 2005) (Recognizing that "many courts…allow a single contract to be separately assumed and rejected if the contract is 'divisible' or 'severable' under state law").



Pushing Boundaries


In recent years, there has been a number of noteworthy decisions in the United States and abroad that have illustrated the tension faced by courts in their efforts to give effect to foreign judgments or apply foreign laws while effecting jurisdictional and other limitations that exist in the local jurisdiction.

The Model Law on Cross-Border Insolvency (the model law), prepared by the U.N. Commission on International Trade Law in 1997, was a major step towards orderly cross-border insolvency proceedings, but did not entirely close the gap and resolve all open issues faced by litigants and judges. While the powers afforded to the U.S. bankruptcy courts are wide ranging under Chapter 15,1 it is noteworthy that some courts, and in particular U.S. courts, have recently ruled in a manner that highlights limitations on courts' ability to apply their rulings to parties or assets beyond their jurisdiction.

Fairfield Sentry Litigation

A recent decision has garnered attention as much for the fact that it is related to the fraud perpetrated by Bernard L. Madoff as for the fact that it authoritatively delineates a limitation on the bankruptcy court's jurisdiction. Chief Judge Loretta Preska of the U.S. District Court for the Southern District of New York recently reversed an order of the Bankruptcy Court for the Southern District of New York (the Bankruptcy Court) and remanded to state court approximately 40 clawback suits that the joint liquidators of British Virgin Islands (BVI)-based Fairfield Sentry Limited and its offshore feeder funds (the Fairfield Funds) filed against its investors in the Bankruptcy Court.2

The Fairfield Funds were organized under the laws of the BVI and existed largely for the purpose of directing investors' money to Bernard L. Madoff Investment Securities LLC (BLMIS). Upon discovery of the Madoff fraud, the investments with Madoff all but vanished and the Fairfield Funds entered BVI liquidation proceedings in early 2009. The BVI courts appointed liquidators for the Fairfield Funds and within the year these estate representatives filed numerous lawsuits in New York state court against banks that had invested in the Fairfield Funds and certain beneficial holders that invested through the banks.

The claims initially asserted were common law claims of money had and received, unjust enrichment, mistaken payment and constructive trust. Subsequently, in June 2010, the foreign representatives commenced an ancillary proceeding under Chapter 15 of the Bankruptcy Code in the Bankruptcy Court seeking recognition of the BVI proceedings as foreign main proceedings. The petition was granted shortly thereafter.

Following recognition, the foreign representatives filed nearly identical actions in the Bankruptcy Court as to those filed originally in state court in the BVI. The foreign representatives also removed to the Bankruptcy Court those actions commenced in state court. The nearly 200 actions that were commenced have been consolidated in the Bankruptcy Court. After certain defendants sought to have the removed actions remanded to state court or, alternatively, to have the Bankruptcy Court abstain for lack of subject matter jurisdiction, the foreign representatives amended a number of the complaints to include new causes of action arising under the BVI insolvency statute's avoidance provisions (the BVI Avoidance Claims). In May 2011, the Bankruptcy Court rejected the defendants' arguments concluding that it could properly assert subject matter jurisdiction over both the U.S. state law claims and the BVI Claims as they "directly affect[ed] th[e] Court's core bankruptcy functions under Chapter 15."3

On appeal, Judge Preska reversed, finding that the provisions of Chapter 15 upon which the foreign representatives relied (11 U.S.C. §§1521(a)(5) and (7)) did not confer core jurisdiction on the Bankruptcy Court over actions seeking to recover assets located outside of the territorial jurisdiction of the United States.4

Addressing these provisions, the district court held that §1521(a)(5) of the Bankruptcy Code could not be the basis for concluding that core jurisdiction exists because it only authorizes the court to entrust the "administration or realization…of the debtor's assets" to the foreign representatives to the extent that those assets are "within the territorial jurisdiction of the United States."5 The court noted that nowhere in the complaints, the parties' briefing or at oral arguments was there a "nonfrivolous reference" to the recovery of any assets located within the territorial United States.6 In fact, the only asset identified by plaintiff was the lawsuit itself. The plaintiffs are seeking permission to appeal Judge Preska's order.

The court also rejected the foreign representatives' reliance on §1521(a)(7) of the Bankruptcy Code, a catch-all clause that permits a court to grant "any additional relief that may be available to a trustee."7 Importantly, this provision carves out the Bankruptcy Code's avoidance powers, which are only available for use in a plenary case. The court emphasized that, unlike plenary cases under Chapter 7 or 11, the text, structure, and purpose of Chapter 15 demonstrate Congress's intent to limit a foreign representative's ability to obtain relief within a Chapter 15 ancillary case to those instances where the assets are located in the United States.8 In reaching this conclusion, the court found support in another S.D.N.Y. bankruptcy court decision where it was held that the automatic stay in a Chapter 15 case that has gained recognition is limited to assets located within the territorial jurisdiction of the United States.9

The district court's analysis of §1521(a)(7) also provides an important distinction drawn with the U.S. Court of Appeals for the Fifth Circuit's holding in In re Condor Insurance Limited, a case of first impression on the issue of whether Chapter 15 permits a foreign representative the use of foreign law to avoid asset transfers.10 There, the court reached a controversial conclusion when it held that a bankruptcy court is authorized under 11 U.S.C. §1521(a)(7) to permit relief under foreign avoidance laws. Unlike the cases concerning the Fairfield Funds, however, in Condor the assets sought were within the territorial jurisdiction of the United States, a distinction highlighted by the defendants seeking remand in the Fairfield Sentry Litigation case.

Comity Principle

The Fairfield Sentry Litigation case tells us that where the defendants and assets are beyond the reach of the court's jurisdiction, the court may refuse to allow a party to pursue such suits. The result is not terribly novel, and the result may have been compounded, or at least impacted, by the forum shopping aspects of the case.

A more common issue that arises in such cases is the acknowledgement or endorsement of a foreign ruling, commonly referred to as comity. This principle was a bedrock of the predecessor to Chapter 15 and is a key concept of the model law. However, it has long been recognized that public policy can preclude such enforcement. As globalization increases, even this common exception to the principle of comity can be challenged.

The case of Rubin v. Eurofinance SA received worldwide recognition due to the English Court of Appeal's determination that a monetary default judgment entered by a U.S. bankruptcy court was enforceable—without need for a separate litigation in England—as against Eurofinance and certain British citizens that were not under the jurisdiction of the U.S. bankruptcy court. The court's holding demonstrates the adoption of a "universal" approach in which one insolvency proceeding will be recognized and enforced in all jurisdictions in order to streamline cross-border insolvency proceedings by allowing for efficient administration of the estate.11

Eurofinance, a BVI company, created The Consumers Trust, a trust governed by the laws of England. The beneficiaries of The Consumers Trust were consumers who successfully participated in a sales promotion scheme in the United States and Canada. The promotion was a cashable voucher program where merchants offered customers a cashable voucher promising a rebate of up to 100 percent of the purchase price for products sold in three years. The promotion was financed by merchants paying to The Consumers Trust a portion of the face amount of each cashable voucher. The Consumers Trust would transfer some of that money, but also retained a percentage in bank accounts in the United States.

Because the procedure for redemption proved to be a near impossible feat, the Missouri attorney general brought proceedings under that state's consumer protection laws, resulting in a $1,650,000 settlement. To head off proceedings in other states, Eurofinance had The Consumers Trust file for protection under Chapter 11 of the U.S. Bankruptcy Code.

The bankruptcy judge applied to the English High Court for recognition of the Chapter 11 proceeding as a foreign main proceeding under the Cross-Boarder Insolvency Regulations of 2006 (CBIR). Subsequently, adversary proceedings were commenced in the Chapter 11 proceedings against Eurofinance and its owners (the respondents). The respondents deliberately did not answer or defend the proceedings and a default judgment was entered against them. The receivers for Eurofinance and The Consumer Trust applied to the Chancery Division under the CBIR for an order enforcing a portion of the U.S. default judgment against the respondents in the U.K. Although the Chancery Division recognized the Chapter 11 proceeding as a foreign main proceeding, it dismissed the application for enforcement of the default judgment, finding that form of relief was not contemplated by the model law.12

On appeal, Lord Justice Ward affirmed the decision that the U.S. proceeding was a foreign main proceeding but ruled that the ordinary bases for not enforcing foreign judgments did not apply to insolvency proceedings. The English Court of Appeal enforced the default judgments, finding that the underlying actions were for the purposes of the collective enforcement regime of the insolvency proceeding. The court stated:

There should be a unitary bankruptcy proceeding in the court of the bankrupt's domicile which receives world-wide recognition and it should apply universally to all the bankrupt's assets. …Add to that the further principle that recognition carries with it the active assistance of the court which should include assistance by doing whatever this court could have done in the case of domestic insolvency.13

Therefore, the court held that ordinary private international law rules preventing enforcement of judgments when defendants were not subject to the jurisdiction of the foreign court do not apply. That is, even though the respondents did not submit to the U.S. court's jurisdiction, its judgments will be enforced by the English courts.

The Eurofinance court apparently dispensed with cross-border insolvency laws, foreign and domestic, to reach its holding and relied on the common law. Although the Court of Appeal was not required to state whether it would have reached the same result under the CBIR, there is a suggestion by Lord Justice Ward in the decision that it would. The respondents were granted an appeal by the U.K. Supreme Court in October 2010 for final determination and a hearing on the appeal is likely in the Spring 2012.

Although issued several years before Eurofinance (and before Canada adopted the model law), the Supreme Court of Canada, in Beals v. Saldanha, demonstrated an understanding of the need for cross-border cooperation when it applied the same test to foreign judgments as was used in connection with the recognition and enforcement of interprovincial judgments.14 The court's decision to extend the test to foreign judgments was premised upon "international comity and the prevalence of international cross-border transactions and movement call[ing] for a modernization of private international law."15

The Saldanhas were residents of Ontario who sold real properties in Florida to the Beals. After a dispute arose concerning ownership of the properties, the Beals brought an action against the Saldanhas in Florida. The Saldanhas filed an answer to the original complaint, but failed to respond to subsequent amended complaints resulting in a default judgment. A Florida jury awarded the Beals damages in the amount of $260,000. After consulting with a Canadian attorney, the Saldanhas decided not to defend the action so as not to submit to Florida jurisdiction. The Beals then brought an action in Ontario seeking to enforce the Florida judgment, which by then had grown to $800,000 with interest.

At trial in Canada, the court held that the Florida jury had not been made aware of certain facts and therefore the judgment was not enforced on the basis of fraud. The court also held that the judgment was unenforceable as contrary to public policy. On appeal, however, the judgment was enforced.16 In holding that the foreign judgments were enforceable in Canada, the Supreme Court of Canada applied a "real and substantial connection" test—that is, there must be a significant and substantial connection between the foreign jurisdiction and the cause of action.17

The court determined that this test was indeed met: (i) the transaction concerned Florida property; and (ii) the contract was entered into in Florida. Accordingly, Florida courts had a substantial connection to both the subject matter of the dispute and the parties. The Canadian court held that since the Florida court properly took jurisdiction and the three exceptions to enforcement did not apply (i.e., the judgment was not (i) contrary to Canadian public policy, (ii) contrary to natural justice, or (iii) obtained through fraud), the Florida judgment must be recognized and enforced.18 This case is most notable for its establishment, as concerns Canadian courts, of a test for enforcing foreign judgments, thereby providing a degree of clarity in the law.

Conclusion

Since the drafting of the model law, courts in the United States and abroad have sought to fill in any "gaps" in their local law and to determine any limitations to recognition of foreign insolvency proceedings. There is an inherent tension in abiding by constitutional or statutory jurisdictional limitations and "cooperating" with courts and parties beyond a country's borders. Undoubtedly, this tension will continue for some time as cross-border disputes become prevalent and the common law and legislative responses are tested and modified to meet the needs of modern business, resulting in a growing body of jurisprudence that will hopefully yield further certainty and clarity in the global economy.

Edward J. Estrada is a partner at Reed Smith in New York and co-head of the firm's U.S. commercial litigation group. Christopher A. Lynch is a senior associate at the firm. Lili Worthley, an associate, assisted in the preparation of this article.

Endnotes:

1. Chapter 15 of the Bankruptcy Code incorporates the model law and was enacted as part of the Bankruptcy Abuse, Prevention and Consumer Protection Act of 2005.

2. In re Fairfield Sentry Ltd., et al. Litigation, 2011 WL 4359937 (S.D.N.Y Sept. 19, 2011).

3. In re Fairfield Sentry Ltd., 452 B.R. 64, 85 (Bankr. S.D.N.Y. 2011).

4. Fairfield Sentry Litigation, 2011 WL 4359937 at *12, 16 and 29.

5. Id. at *16-17.

6. Id. at *17.

7. Id. at *16 (quoting 11 U.S.C. §1521(a)(7)).

8. Id. at *19, 22-23.

9. In re JSC BTA Bank, 434 B.R. 334 (Bankr. S.D.N.Y. 2010).

10. In re Condor Ins. Ltd., 601 F.3d. 319 (5th Cir. 2010).

11. Rubin v. Eurofinance SA, [2010] EWCA Civ 895 [paras. 61-62].

12. Rubin v. Eurofinance SA, [2009] EWHC Civ 2129.

13. Rubin v. Eurofinance SA, [2010] EWCA Civ 895 [para. 62].

14. Beals v. Saldanha, [2003] 3 S.C.R. 416, paras. 19 and 79 (Can.).

15. Id. at para. 28.

16. Id. at para. 79.

17. Id. at para. 32.

18. Id. at para. 79.