We are pleased to share with our readers the Hughes Hubbard Bankruptcy Year-End Review for 2017. We thank our friends for entrusting us with these rewarding engagements and look forward to building on these successes in 2018.
On December 21, the Bankruptcy Court for the Southern District of New York recognized and agreed to enforce the unopposed foreign restructuring plan of oil exploration company C.G.G. S.A. (“C.G.G.,” or the “Company”) under Chapter 15 of the Bankruptcy Code. C.G.G.’s restructuring marks one of the few times a U.S. bankruptcy court has been asked to enforce a French court-sanctioned bankruptcy plan.
C.G.G.’s French Bankruptcy
C.G.G. is a nearly 90-year-old French company specializing in geophysical services. Its business comes predominantly from the Oil and Gas Exploration and Production (“E&P”) industry. Like other companies in E&P, as oil and gas prices dropped, C.G.G.’s revenues dropped precipitously, from more than $3.4 billion in 2012 to $1.2 billion in 2016. C.G.G. simultaneously faced nearly $3 billion in funded indebtedness. C.G.G. initially divested non-core assets and reduced its headcount to save money, but soon determined that those measures were insufficient, and that restructuring was necessary. The Company initiated restructuring in France in February 2017. Negotiations with stakeholders eventually resulted in a June 2017 Lock-Up agreement, through which the company’s shareholders agreed not to sell their shares. Negotiations also led to a restructuring support agreement that would swap nearly $2 billion in debt for most of the reorganized Company’s equity.
C.G.G. simultaneously commenced insolvency proceedings in French court through a sauvegarde, or Safeguard proceeding, which halted debt payments, acceleration, and enforcement of securities against the company. C.G.G. then filed a Chapter 15 petition in the Southern District on June 14. Some of C.G.G.’s subsidiary companies also filed under Chapter 11. In July 2017, the New York court recognized the French case as a “foreign main proceeding” – occurring in the country of the debtors’ “center of main interests,” as described in section 1520 of the Code, rather than a “nonmain proceeding,” taking place in a country where the debtor only has an “establishment.”
C.G.G. passed the restructuring agreement, called the Safeguard plan, with more than 90% of voting creditors approving. The French court accepted the plan via a “Sanctioning Order” on December 1.
On December 6, C.G.G., through its Foreign Representative, filed a new motion in the Southern District, requesting the court (a) give full force and effect to the Sanctioning order; (b) permanently enjoin actions against the Safeguard Plan within the U.S.; (c) declare securities given to the creditors under the plan (the “Safeguard Securities”) exempt from Section 1145 registration; (d) authorize C.G.G.’s Foreign Representative to seek entry of a final decree to close the Chapter 15 case under Rule 5009(c); and (e) waive the 14-day stay of effectiveness for the order.
Bankruptcy Judge Martin Glenn granted the motion on all counts. The court first determined that the Sanctioning Order (the “Order”) fell within “any appropriate relief,” as required under section 1521(a)(7). The court cited the creditors’ overwhelmingly support for the Safeguard Plan and reasoned that the plan’s effectiveness, and the concurrent Chapter 11 cases, was conditioned on the court’s acceptance of the Order.
The court then found that, as required under Section 1522, the interests of creditors and all interested parties in the case were “sufficiently protected.” The court reasoned that, without the court’s approval of the Order, the Plan might not be fully implemented. Further, the French court had already fully determined, after a hearing with interested parties, that the Safeguard plan gave sufficient protection. The court also agreed to permanently enjoin actions against the Safeguarding Plan.
The court also determined the Safeguard Securities were exempt from federal and state registration requirements. It found that section 1145, which allows exemptions from Securities laws, can be applied to Chapter 15 cases through sections 1507 and 1521 as long as the securities (a) were offered or sold under a plan; (b) were securities of the debtor or an affiliate in a joint plan; and (c) were sold in exchange for a claim against the debtor or affiliate, as per section 1145(a)(1). The court found that all three requirements were satisfied.
Last, the court found that, upon its order becoming final, section 350(a)’s requirements for closing a case were satisfied, and thus the case could be closed following the procedures of rule 5009(c). The court also waived the 14-day stay of effectiveness, in order to allow the restructuring to begin immediately.
The Southern District has frequently recognized and enforced foreign court orders in approval of a foreign debtor’s restructuring plan – including recent plans from Hong Kong, Australia, Canada, the Caymans, and South Africa. But as Judge Glenn remarks in his opinion, French Safeguard plans have rarely been brought to U.S. bankruptcy courts for recognition and enforcement. The ruling suggests that French plans that are widely approved by creditors will receive a stamp of approval from the Southern District. It suggests moreover that the court will defer to the findings of French courts that have fully heard all parties to the restructuring on issues like section 1522 sufficient protection.
On January 12, 2018, the U.S. Supreme Court granted certiorari over the Eleventh Circuit’s decision in R. Scott Appling v. Lamar, Archer & Cofrin, LLP, which held that a fraudulent statement regarding a single asset may constitute a statement concerning the debtor’s financial condition, thereby allowing a debt incurred in reliance on the false statement to be discharged through a bankruptcy. The Eleventh Circuit’s decision focused on the dichotomy established in sections 523(a)(2)(A) and (B) of the Bankruptcy Code between fraudulent statements regarding the debtor’s “financial condition,” which only prevent the discharge of a debt if the false statement is made in writing, and other fraudulent statements giving rise to a debt, which can prevent a discharge even if the statement is only made orally. R. Scott Appling v. Lamar, Archer & Cofrin, LLP will allow the Supreme Court to address a split between the Circuits on this issue, as the Eleventh Circuit’s ruling is consistent with the approach adopted by the Fourth Circuit, but contrary to the standard adopted by the Fifth, Eighth, and Tenth Circuit’s approach, which holds that a statement about a single asset does not “respect” a debtor’s financial condition as required by 523(a)(2)(A).
The case arises out of an adversary proceeding initiated by Lamar, Archer & Cofrin, LLP (“Lamar”) against one of its clients, R. Scott Appling. Appling incurred certain legal fees when Lamar represented him in lawsuits against the former owners of his business; however, Appling was unable to pay his legal bills when they became due. During a meeting with attorneys from Lamar, Appling conveyed that he was expecting a substantial tax refund, which he represented would be sufficient to pay his outstanding legal bill as well, as to pay any future fees incurred during the ongoing litigation. In reliance of this statement, Lamar continued its representation of Appling and did not take any steps to immediately collect its overdue fees. However, Appling’s statement was false as he only received a modest refund, which he put into his business rather than to satisfy the outstanding legal fees owed to Lamar. Lamar eventually filed suit against Appling to collect the outstanding fees, and Appling subsequently filed for bankruptcy. The central issue is whether Appling’s oral statements regarding his tax refund, which pertained to a single asset, respected his financial condition and is therefore dischargeable.
The Supreme Court’s decision could have ramifications on the discharge of debts in bankruptcy. The narrower interpretation of the statute favored by the majority of circuits will limit the scope of the “financial condition” exception contained in section 523(a)(2)(B). This “gives effect to the fundamental bankruptcy policy that the bankruptcy courts will not provide safe haven for the perpetuators of fraud.” Indeed, the exception was originally conceived by Congress to address certain consumer-finance companies that were deliberately encouraging customers to submit false statements for the purpose of insulating the creditor’s claim from discharge. However, application of the majority view is difficult in practice because it creates “substantial line-drawing problems and may cause unjustified differential treatment of functionally equivalent scenarios.”
On the other hand, applying the broader interpretation put forth by the Eleventh Circuit could promote predictability and accuracy while protecting debtors from abusive credit practices. It encourages creditors to rely on written statements, which are more reliable as evidence, if they later seek an exemption. The office of U.S. Solicitor General advanced this position and filed a brief as Amici Curiae agreeing with the Eleventh Circuit’s ruling. The Solicitor General argued that the broader interpretation best served Congress’s policy goals because it “gives creditors an incentive to create writings before the fact,” which may reduce fraud in the first instance. By creating reliable evidence for future litigation, “such writing helps both the honest debtor prove his honesty and the innocent creditor prove a debtor’s dishonesty.” Nevertheless, the Eleventh Circuit’s interpretation could expand the exception’s reach beyond its intended scope because “virtually every statement by a debtor that induces the delivery of goods or services on credit relates to his ability to pay.” With the “financial condition” exception taking center stage, this Supreme Court decision will certainly be one to watch.
* This post was prepared with assistance from Jiun-Wen Bob Teoh.
 See Engler v. Van Steinburn, 744 F.2d 1060, 1061 (4th Cir. 1984) (holding that “a debtor’s assertion that he owns certain property fees and clear of other liens is a statement respecting his financial condition”).
 See, e.g., In re Bandi, 683 F.3d 671, 676 (5th Cir. 2012); In re Lauer, 371 F.3d 406, 413-14 (8th Cir. 2004); In re Joelson, 427 F.3d 700, 706 (10th Cir. 2005).
 Brief for Petitioner at 20, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Apr. 11, 2017).
 Brief for Petitioner at 22, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Apr. 11, 2017).
 Brief of United States as Amici Curiae at 18, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Nov. 9, 2017).
 Brief for Respondent at 20, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (May 25, 2017).
 Brief for Respondent at 20, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (May 25, 2017).
 Brief of United States as Amici Curiae at 8, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Nov. 9, 2017).
 Brief of United States as Amici Curiae at 17-18, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Nov. 9, 2017).
 Brief for Petitioner at 22, Lamar, Archer & Cofrin, LLP v. Appling, No. 16-1215 (Apr. 11, 2017).
In its recent decision in In re Peregrine Financial Group, the Seventh Circuit became the first circuit to accept a definition of “customer property” which excludes retail foreign exchange contracts, or “forex contracts”, and spot metal contracts. The Court’s ruling highlights the risk parties that transact in foreign exchange transactions and OTC metal transactions may face in the event that a future commodities merchant is forced into liquidation.
Peregrine was a registered “Future Commission Merchant” (“FCM”) and a registered “Forex Dealer Member” of the National Futures Association. Peregrine, in addition to futures, dealt in retail foreign currency transactions and spot metal transactions. In 2012, it was discovered that over a twenty-year period Peregrine’s CEO, Russel L. Wasendorf, had embezzled nearly $200 million from Peregrine’s segregated customer future accounts. In July 2012, as a result of this defalcation, Peregrine filed for bankruptcy and a trustee was appointed to administer the Peregrine estate. Subchapter IV of Chapter 7 of the Bankruptcy Code, 11 U.S.C. §§ 761–767, governs the bankruptcy of a futures commissions merchant such as Peregrine, and provides for the distribution of “customer property” in priority to all other claims. “Customer property” is defined as including funds received in connection with a commodity contract, 17 C.F.R. § 190.08(a)(1)(i)(A), which in turn is defined in § 761(4) of the Bankruptcy Code.
The Peregrine Trustee excluded certain former account holders of Peregrine from receiving priority distributions of customer property based on his determination that the forex and spot metal transactions they had conducted through Peregrine did not constitute “commodity contracts” as defined by the Bankruptcy Code. In response to the Trustee’s determination, certain former account holders (the “Plaintiffs”) commenced an adversary and assert that their forex and spot metal contracts should be treated as commodity contracts, which would entitle them to priority distributions.
Decision: Forex and Spot Metal Contracts are not “similar to” Commodities Contracts
The Seventh Circuit’s ruling turned on the definition of “commodity contract” contained in section 761 of the Bankruptcy Code. The Plaintiffs alleged that their forex and spot metal contracts should be treated as commodity contracts under the “similar to” clause in Chapter 7 of the Bankruptcy Code. The question of whether the forex and spot metal contracts are considered commodity contracts was vital to the Plaintiffs’ potential for recovery as Chapter 7 gives priority distribution to “customer property” which is defined as “property received, acquired, or held to margin, guarantee, secure, purchase, or sell a commodity contract.”
As defined in section 761 of the Bankruptcy Code, a “commodity contract” includes futures contracts, or a contract “similar to” a futures contract. In Peregrine, the Plaintiffs pointed to both the language of the statute and congressional intent that they suggested supported the finding that their retail forex contracts and spot metal contracts were “similar to” futures contracts and therefore fell within the definition of commodity contract contained in the Bankruptcy Code. Based largely on its previous ruling in In re Zelener, 373 F.3d 861 (7th Cir. 2004), the Seventh Circuit disagreed.
In Zelener, the Seventh Circuit considered whether “[forex transactions] are contracts of sale of a commodity for future delivery regulated by the Commodity Futures Trading Commission.” The Seventh Circuit held that retail forex transactions were distinguishable from futures contracts because the “customer buys foreign currency immediately rather than as of a defined future date, and because the deals lack standard terms. [The defendant] buys and sells as a principal; transactions differ in size, price, and settlement date. The contracts are not fungible and thus could not be traded on an exchange.” The Court expanded on this reasoning to find that the retail forex transactions and spot metal transactions were also not “similar to” futures contracts because “Zelener illustrated these two types of transactions were not alike in substance or essentials.” As the Court explained, “[f]utures contracts are fungible instruments that allow parties to trade in the contract with a clearinghouse accepting the risk of any counterparty default. Retail forex, in contrast, involves private transactions that bear no fungible features.” The Court also rejected the Plaintiff’s argument that the legislative history of section 761 indicates that Congress intended for retail forex transactions to be treated as commodities contractions, noting “Congress has had opportunities to include OTC metal and retail forex transactions in the definition of ‘commodity contract’ but has declined to do so. For example, in 2010, as part of Dodd-Frank, Congress amended section 761(4) to include ‘cleared swap’ transactions, 11 U.S.C. § 761(4)(F)(ii), yet declined to include retail forex or OTC metals.” The Court noted that this reasoning was further strengthened by the overall goals of the commodity broker provisions of chapter 7, which are to promote market stability during events of insolvency; a concern that is not implicated with retail forex or OTC metals because they are uncleared transactions where the customer assumes the risk of default.
The decision provides an important warning to lesson to forex and spot metal traders. Namely, that forex and spot metal transactions are not protected under Chapter 7 of the Bankruptcy Code, and will not receive priority distribution in a liquidation.
* Olivia Bensinger assisted with the preparation of this post.
 In re Peregrine Fin. Grp, Inc., 866 F.3d 775 (7th Cir. 2017), adopting the opinion of Secure Leverage Grp., Inc. v. Bodenstein, 558 B.R. 226, 241 (N.D. Ill. 2016).
 11 U.S.C. § 761(4)(F)(i) (2012).
 Id. at § 761(10)(A)(i).
 Id. at § 761(4)(A).
 Id. at § 761(4)(F)(i).
 In re Zelener, 373 F.3d 861, 862 (7th Cir. 2004).
 Id. at 864.
 Secure Leverage Grp., 558 B.R. at 241.
 Id. at 242.
What happens when property that a trustee wants to sell in a section 363 sale is subject to unexpired leases that the trustee is empowered to reject under section 365(h)? The Ninth Circuit faced this conundrum in a recent case involving a luxury real estate development in Montana, Pinnacle Restaurant at Big Sky, LLC v. CH SP Acquisitions, LLC (In re Spanish Peaks Holdings II, LLC), 892 F.3d 892 (9th Cir. 2017). Wrestling with a split between its sister circuits, the Ninth Circuit ultimately concluded that, “[w]here there is a sale, but no rejection (or a rejection, but no sale), there is no conflict,” and the trustee could properly proceed with the sale.
Spanish Peaks, a 5,700-acre resort in Big Sky, Montana, was financed by a $130 million loan secured by a mortgage and assignment of rents from Citigroup Global Markets Realty Corp. Citigroup assigned the note and mortgage to Spanish Peaks Acquisition Partners LLC (“SPAP”).
At issue on appeal were two leases at the resort. The first was a restaurant space that Spanish Peaks Holdings, LLC (“SPH”) leased for $1,000 per month to Spanish Peaks Development, LLC (“SPD”). SPH and SPD later replaced the lease with a 99-year leasehold for $1,000 per year in rent. SPD assigned its interest to The Pinnacle Restaurant at Big Sky, LLC (“Pinnacle”). The second was a parcel of commercial real estate SPH leased to Montana Opticom, LLC (“Opticom”), for a term of 60 years and annual rent of $1,285.
SPH defaulted on its loan payments and filed, along with two related entities, Chapter 7 petitions in Delaware. SPAP, SPH’s largest creditor with a claim of $122 million secured by the mortgage, assigned its claim to CH SP Acquisitions, LLC (“CH SP”). The trustee and SPAP agreed to a plan to liquidate “substantially” all of the debtors’ property through an auction with a minimum bid of $20 million. The trustee sought approval for sale of the property “free and clear of all liens,” except for certain enumerated encumbrances and liens to be paid out of the sale proceeds or otherwise protected.
The Pinnacle and Opticom leases were mentioned neither on the list of surviving encumbrances nor on the list of protected liens.. Both entities thus objected to any sale “free and clear of [their] leasehold interests.” 872 F.3d at 895. The bankruptcy court authorized the sale but did not rule on Pinnacle’s and Opticom’s objections. The court instead deferred them until the hearing on the motion to approve the sale.
At the auction and approval hearing on June 3, 2013, CH SP won the auction with a bid of $26.1 million. Pinnacle and Opticom renewed their claim that their leases allowed them to retain possession and objected to the “free and clear” language in the proposed approval order.
The bankruptcy court approved the sale, holding that the sale was free and clear of any “Interests,” including any leases “except any right a lessee may have under 11 U.S.C. § 365(h), with respect to a valid and enforceable lease, all as determined through a motion brought before the Court by proper procedure.” Id. at 896. After some procedural back-and-forth and another evidentiary hearing, the bankruptcy court found defects in Pinnacle’s and Opticom’s leases, and noted that they had neither requested adequate protection for their interests nor proven that they would suffer economic harm if their interests were terminated. The bankruptcy court thus held the sale was free and clear of the Pinnacle and Opticom leases, and the district court affirmed.
On appeal, the Ninth Circuit considered whether the leases survived the sale to CH SP, which gave rise to an apparent conflict between the trustee’s ability to sell property of the estate under section 363 and authority to assume or reject unexpired leases under section 365(a) and (h). Section 365 gives a lessee in possession with two choices: “treat the lease as terminated (and make a claim against the estate for any breach), or retain any rights—including a right of continued possession—to the extent those rights are enforceable outside of bankruptcy.” Id. at 898.
Other circuits had taken one of two approaches to the apparent conflict. The majority held that section 365 outweighed section 363 “under the canon of statutory construction that ‘the specific prevails over the general.’” Id. (internal citation omitted).
In contrast, the Seventh Circuit had held that “the statutory provisions themselves do not suggest that one supersedes or limits the other.” Id. (quoting Precision Industries, Inc. v. Qualitech Steel SBQ, LLC (In re Qualitech Steel Corp. & Qualitech Steel Holdings Corp.), 327 F.3d 537, 547 (7th Cir. 2003)). In other words, section 363 confers a right to sell property free and clear of “any interest” without exempting leases protected under section 365, while section 365(h) focuses on the specific event of the rejection of an executory contract without reference to sales of estate property under section 363. The Seventh Circuit explained:
Where estate property under lease is to be sold, section 363 permits the sale to occur free and clear of a lessee’s possessory interest—provided that the lessee (upon request) is granted adequate protection for its interest. Where the property is not sold, and the [estate] remains in possession thereof but chooses to reject the lease, section 365(h) comes into play and the lessee retains the right to possess the property. So understood, both provisions may be given full effect without coming into conflict with one another and without disregarding the rights of lessees.
327 F.3d at 548.
The Ninth Circuit agreed with the Seventh Circuit’s approach as the best way to reconcile the two statutes, noting that while “[a] sale of property free and clear of a lease may be an effective rejection of the lease in some everyday sense, . . . it is not the same thing as the ‘rejection’ contemplated by section 365.” 872 F.3d at 899.
Here, then, the trustee had not rejected the Pinnacle and Opticom leases, so section 365 was not in play, and section 363(f)(1) authorized the sale of the property free and clear of the leases. The Ninth Circuit therefore affirmed the judgment of the district court.
An increasingly common aspect of Chapter 11 plans is non-consensual third party releases, which are often a vital tool required to obtain global peace among competing constituencies whose support is often needed for a debtor to obtain confirmation of a Chapter 11 plan. However, the parameters of a bankruptcy court’s Constitutional authority to approve such non-consensual releases has, to date, been unclear. Clarity, however, has been provided by the recent decision by the United States Bankruptcy Court for the District of Delaware In re Millennium Lab Holdings II, LLC, where the Court concluded that it had constitutional authority to confirm a restructuring plan that released third parties from liability to certain creditors, even though those creditors had not consented to the releases. The Bankruptcy Court’s ruling will be of interest to potential debtors and other potential releasees who may seek to employ or benefit from non-consensual third party releases as well as to lenders and other creditors who may find themselves bound by non-consensual release contained in a Chapter 11 plan.
Debtor Millennium Lab Holdings II, LLC and certain affiliates commenced their Chapter 11 Cases in 2015 following a settlement with the United States federal government and certain states relating to alleged violations of the Anti-Kickback Statute, the False Claims Act, and the Stark Act (which relates to physician referrals for Medicare and Medicaid services). In December 2015, the Bankruptcy Court confirmed a Plan of Reorganization which contained settlements with certain equity holders (the “Non-Debtor Equity Holders”), who contributed $325 million to the estate and received third party releases. Immediately prior to the confirmation hearing, certain dissenting creditors (the “Opt-Out Lenders”) commenced a lawsuit asserting common law fraud and RICO claims against the Non-Debtor Equity Holders. The Opt-Out Lenders also filed an objection to the non-consensual third party releases in the proposed Plan. The Opt-Out Lenders argued that the Plan’s non-consensual releases went beyond the scope of the Bankruptcy Court’s authority.
The Bankruptcy Court overruled the Opt-Out Lenders’ arguments and confirmed the Plan in a bench ruling on December 11, 2015. Thereafter, in a January 12, 2016 written opinion, the Bankruptcy Court certified an appeal directly to the Third Circuit on the following question: “Do Bankruptcy Courts have the authority to release a non-debtor’s direct claims against other non-debtors for fraud and other willful misconduct without the consent of the releasing non-debtor?” The Third Circuit denied the petition for permission to appeal, and the appeal was docketed with the Delaware District Court.
In the District Court, the Opt-Out Lenders principally pursued an argument based on the Supreme Court’s decision in Stern v. Marshall. According to the Opt-Out Lenders, the Bankruptcy Court lacked constitutional authority to enter a final order releasing direct, non-bankruptcy claims against non-debtors. The District Court remanded the case to the Bankruptcy Court to decide that issue. In doing so, however, the District Court provided its own view of the merits and voiced agreement with the Opt-Out Lenders’ Stern argument. The District Court stated that it was “persuaded by [the Opt-Out Lenders’] argument that the Plan’s release, which permanently extinguished [the Opt-Out Lenders’] claims, is tantamount to resolution of those claims on the merits” and that it believed that “[i]f Article III prevents the Bankruptcy Court from entering a final order disposing of a non-bankruptcy claim against a nondebtor outside of the proof of claim process, it follows that this prohibition should be applied regardless of the proceeding (i.e., adversary proceeding, contested matter, plan confirmation).”
On remand, the Bankruptcy Court concluded that it did have the authority to grant the release of the Opt-Out Lenders’ claims via confirmation of the Plan. In its analysis, the Bankruptcy Court laid out a continuum of interpretations of Stern. On one end of the continuum, the narrow interpretation reads Stern only as prohibiting a bankruptcy court from entering a “final judgment on a state law counterclaim that is not resolved in the process of ruling on a creditor’s proof of claim.” Next, a relatively broad interpretation of Stern would prohibit a bankruptcy court from entering a final judgment on “all state law claims, all common law causes of action or all causes of action under state law.” Finally, the broadest view of Stern holds “that bankruptcy judges should examine their ability to enter final orders in all enumerated or unenumerated core proceedings.”
The Bankruptcy Court held that it possessed constitutional authority to confirm the Plan under both the narrow and broad views of Stern because confirmation of a plan is neither a state law counterclaim nor a state law claim of any kind. Furthermore, even under the broadest interpretation of Stern, the Bankruptcy Court maintained constitutional authority to confirm the plan because (1) confirmation is at the core of a bankruptcy judge’s power, (2) confirmation applies a “federal standard,” and (3) the confirmation of the Plan met the Third Circuit’s “standard of fairness and necessity to the reorganization.”
The Bankruptcy Court also rejected the Opt-Out Lenders’ interpretation of Stern. The Opt-Out Lenders argued that confirmation would violate Stern’s statement that “the question is whether the action at issue stems from the bankruptcy itself or would necessarily be resolved in the claims allowance process.” The Bankruptcy Court questioned whether that disjunctive test was the appropriate measure of the constitutionality of a restructuring plan, and further held that confirmation of the Plan was constitutional because the Plan stemmed from the Chapter 11 Cases and “the releases were integral to confirmation and thus integral to the restructuring of the debtor-creditor relationship.”
The Bankruptcy Court also dismissed the Opt-Out Lenders’ functionalist argument that, because confirmation had the effect of extinguishing their RICO lawsuit, the confirmation constituted an “impermissible adjudication of the litigation being released.” Relying on pre-Stern Third Circuit precedent, the Bankruptcy Court concluded that a confirmation order can permissibly impact and even extinguish lawsuits in non-core proceedings. The Bankruptcy Court went on to note that, if taken to its logical conclusion, the Opt-Out Lenders’ interpretation of Stern would apply to an eye-popping range of core bankruptcy matters, including substantive consolidation, recharacterization and subordination of debts, and practically every section 363 sale.
In short, the Bankruptcy Court held that, regardless of Stern, bankruptcy courts have constitutional authority to confirm restructuring plans that include non-consensual releases of claims against third parties. Furthermore, Stern does not extend to core proceedings concerning federal law that implicate state law rights.
Although Stern is now nearly eight years old, its meaning remains a source of controversy and litigation in bankruptcy courts. The range of possible interpretations of Stern described by the Bankruptcy Court—as well as the differing view offered by the District Court—show that courts have not yet settled how Stern affects even routine and fundamental bankruptcy court business. Perhaps not surprisingly in light of the long history of the dispute and the District Court’s decision, the Opt-Out Lenders have filed a notice of appeal of the Bankruptcy Court’s decision. Stay tuned to the HHR Bankruptcy Report to stay apprised of further developments.
* James Henseler assisted with the preparation of this post.
. In re Millennium Lab Holdings II, LLC, No. 15-12284, 2017 WL 4417562 (Bankr. D. Del. October 3, 2017).
. According to the Bankruptcy Court, the Opt-Out Lenders raised four objections to the releases: (i) the court lacked subject matter jurisdiction to grant nonconsensual third party releases, (ii) the releases were impermissible, (iii) the Plan impermissibly did not allow parties to opt-out of the releases, and (iv) the releases were inconsistent with the Third Circuit’s holding in Gillman v. Continental Airlines (In re Continental Airlines), 203 F.3d 203 (3d Cir. 2000).
. In re Millennium Lab Holdings II, LLC, 543 B.R. 703, 711 (Bankr. D. Del. 2016).
. In re Millennium Lab Holdings II, LLC, 242 F. Supp. 3d 322, 335 (D. Del. 2017).
. Stern v. Marshall, 564 U.S. 462 (2011).
. In re Millennium Lab Holdings II, LLC, 242 F. Supp. 3d 322, 339 (D. Del. 2017).
. 2017 WL 4417562, at *12 (quoting Stern, 564 U.S. at 503).
. Id. at *13 (emphasis removed).
. Id. at *14 (internal quotation marks omitted).
. Id. at *15 (citing In re Cont’l Airlines, 203 F.3d 203, 214 (3d Cir. 2000)).
. 2017 WL 4417562, at *18.
On August 10, 2017, the Supreme Court dismissed the writ of certiorari in PEM Entities LLC v. Levin as improvidently granted. See No. 16-492, 2017 WL 3429146, at *1 (U.S. Aug. 10, 2017). This decision leaves the circuit courts split on the issue of whether to use federal or state law in recharacterizing insider debt as equity, a critical distinction that can be dispositive as to the treatment of debt claims made by insiders of debtors.
In PEM Entities LLC, Province Grande Old Liberty, LLC (the “Debtor”) borrowed approximately $6.5 million from Paragon Commercial Bank (the “Loan”). The Debtor subsequently defaulted on the Loan, eventually resulting in foreclosure proceedings. The Debtor, its principal, and other related entities entered into a settlement agreement with the lender. Under the settlement, Paragon Commercial Bank sold the $6.5 million Loan to PEM Entities, LLC (“PEM”) for around $1.2 million. Critically, PEM was owned by insiders of the Debtor, relied solely upon principals of the Debtor to negotiate the settlement agreement, and failed to set out formal interest rates and payment schedules with the Debtor after the settlement of the loan. When the Debtor could not maintain liquidity despite PEM’s intervention, the Debtor filed this Chapter 11 case, wherein PEM filed a secured claim for $7 million. The Debtor’s unsecured debtholders moved to recharacterize the secured claim as equity.
Using the 11 factor federal test for recharacterizing insider debt claims laid out in Fairchild Dornier GmbH v. Official Comm. of Unsecured Creditors (In re Dornier Aviation (N. Am.), Inc.), 453 F.3d 225, 231 (4th Cir. 2006), the United States Bankruptcy Court for the Eastern District of North Carolina held that PEM’s claim would be recharacterized as equity rather than debt, moving the claim to lower priority status than the unsecured debtholders. Both the district and circuit courts affirmed on appeal, with the Fourth Circuit signaling that the federal, rather than state, test for recharacterization would be proper and that PEM’s actions, while arguably debt in name, was at its core a capital investment in the company’s success rather than the temporary borrowing of money.
The Unresolved Circuit Split
The Supreme Court’s decision to dismiss the writ of certiorari in PEM Entities LLC leaves in place a Circuit split on whether to use federal or state law standards to recharacterize debt. The Sixth, Tenth, Third, and Fourth Circuits all use a multi-factor test similar to the one used in PEM Entities, LLC that looks beyond form and to the substance of the transaction to decide whether it should be categorized as debt or equity. Similarly, the Eleventh Circuit applies a two-prong federal standard that also attempts to reach the substance of the transaction. On the other hand, the Fifth and Ninth Circuits have applied an approach to recharacterization based on the state law of the forum. These state laws vary greatly from state to state, but they are often more friendly to debtor insiders who invest in debt and look to the form of the transaction rather than the substance.
Reason for Dismissal
The circumstances of the dismissal further dampen the hopes of a quick resolution to this circuit split. On October 11, 2016, PEM petitioned the Supreme Court for a writ of certiorari to review the Fourth Circuit decision on the issue of whether federal or state law should be applied to recharacterize debt as equity. On June 27, 2017, this writ was granted only to be dismissed as improvidently granted six weeks later, prior to merits briefing, on August 10, 2017. The Supreme Court is not obligated to explain its reasoning for dismissing certiorari and did not here. Usually, certiorari is dismissed as improvidently granted if a party attempts to change its argument in its merits brief, if the dispute seems overly fact determinative, or if the Justices believe that the case has secondary issues that may prevent the court from reaching the merits also known as “vehicle” problems.
Here, certiorari was dismissed shortly after the parties filed a joint motion to confirm party status on July 21, 2017. The original respondents for this action had settled a state court action which caused them to cease having a stake in the outcome of this case. Instead, the parties moved the court for the Debtor to step into the unsecured debtors shoes as the respondents in this action, as they had a continued interest in defending the judgment below. Given the short period of time between the filing of this motion and the dismissal of certiorari as improvidently granted, as well as the fact that merits briefing was never even completed, it is likely that the Court dismissed this case due to “vehicle” issues. That is, the Court decided that, due to the complexity of the party’s status and procedural posture, the likelihood that the Court would not reach the merits of the action had risen and it was no longer worth the risk of using its limited resources to hear the case. This issue may continue to hamper attempts to bring the issue of this circuit split to the Supreme Court, as the interconnected and complex nature of relationships between parties in cases dealing with recharacterizing insider debt as equity rarely make the best simple and clear-cut vehicles for Supreme Court rulings.
. See Bayer Corp. v. MascoTech, Inc. (In re AutoStyle Plastics, Inc.), 269 F.3d 726, 749-750 (6th Cir. 2001); Sender v. Bronze Grp., Ltd. (In re Hedged-Investments Assocs., Inc.), 380 F.3d 1292, 1298 (10th Cir. 2004); Cohen v. KB Mezzanine Fund II, LP (In re SubMicron Sys. Corp.), 432 F.3d 448, 455-456 (3d Cir. 2006); In re Dornier Aviation (N. Am.), Inc., 453 F.3d at 233-234.
. In re N & D Properties, Inc., 799 F.2d 726, 733 (11th Cir. 1986) (two-pronged test, shareholder loans may be deemed capital contributions “where the trustee proves initial undercapitalization or where the trustee proves that the loans were made when no other disinterested lender would have extended credit.”).
. See Grossman v. Lothian Oil Inc. (In re Lothian Oil Inc.), 650 F.3d 539, 543 (5th Cir. 2011); Official Comm. of Unsecured Creditors v. Hancock Park Capital II, L.P. (In re Fitness Holdings Int’l, Inc.), 714 F.3d 1141, 1148 (9th Cir. 2013).
Next week, the Supreme Court will hear oral argument in Merit Management Group v. FTI Consulting to decide the correct way to apply the safe harbor of section 546(e) of the Bankruptcy Code. The Court will review the Seventh Circuit’s decision splitting from the Second, Third, Sixth, Eighth and Tenth Circuits and holding that section 546(e) does not protect a transfer that is conducted through a financial institution (or other qualifying entity) where that entity is neither the debtor nor the transferee but acts merely as the conduit for the transfer. The Seventh Circuit’s decision is consistent with a two-decades-old decision of the Eleventh Circuit.
Under Chapter 5 of the Bankruptcy Code, bankruptcy trustees have the power to avoid certain types of transfers made by an insolvent debtor. The safe harbor of Bankruptcy Code section 546(e) is one of a number of provisions in Chapter 5 that limit the trustee’s avoidance powers. Section 546(e) prevents the bankruptcy trustee from avoiding a transfer that is a “margin payment” or a “settlement payment” “made by or to (or for the benefit of)” a financial institution or five other qualified entities. It also protects transfers “made by or to (or for the benefit of)” the same types of entities “in connection with a securities contract.”
The case arises out of a bankruptcy trustee’s action to avoid as a fraudulent transfer a $16.5 million payment by the debtor, Valley View Downs—an aspiring owner of a “racino” (a combination horse track and casino establishment), to Merit Management in exchange for Merit’s shares in Bedford Downs, a racino industry competitor. The transfer was effected through Citizens Bank, acting as escrow agent, and Credit Suisse, serving as lender.
The parties do not dispute that neither Valley View nor Merit Management is a financial institution or other qualified entity enumerated in section 546(e). Instead, Merit takes the position that the transfer sought to be avoided by the trustee (i.e., the transfer by Valley View to Merit) is protected by the safe harbor because it involved three transfers “made by or to” institutions qualifying for section 564(e) protection: a transfer by Credit Suisse (the lender) to Citizens Bank (the escrow agent) and two transfers by Citizens Bank to Merit. On the other hand, the trustee takes the position that section 564(e) is an exception to the trustee’s avoidance power and, as such, the “transfer” that the trustee “may not avoid” under section 546(e) is the same transfer that the trustee seeks to avoid under the antecedent and textually cross-referenced avoidance powers. The trustee does not seek to avoid any of the component parts of the transfer by Valley View to Merit (i.e., any of the transfers Merit identifies as “made by or to” institutions qualifying for section 564(e) protection)—nor could it have, because the trustee’s avoidance power is limited to transfers by the debtor. Thus, according to the trustee, the safe harbor of section 564(e) does not protect the transfer by Valley View to Merit from avoidance.
Bankruptcy practitioners and scholars are watching this case with great interest. The National Association of Bankruptcy Trustees filed a Brief as Amici Curiae in Support of Respondents in which it warns that Merit’s application of section 564(e) would prevent a trustee from attempting to unwind a failed leveraged buyout—even a purely private one, as most are—despite the unique hazard to unsecured creditors that these transactions pose. Several prominent bankruptcy law professors also filed a separate Amici Curiae Brief in Support of Respondents. These law professors agree with the Seventh Circuit that the Bankruptcy Code’s system for avoiding transfers and safe harbor from avoidance are two sides of the same coin—the safe harbor applies to transfers that are eligible for avoidance in the first place. They view the contrary decisions of many Circuits as mistaken applications of the safe harbor to protect transactions that pose no threat to the integrity of the security settlement and clearance process—the purpose for which the safe harbor was enacted.
The Court’s decision in this case may also materially affect former shareholders and unsecured creditors of the Tribune Company and the Lyondell Chemical Company, both of which went into bankruptcy following failed leveraged buyouts. The former shareholders currently are defendants in constructive fraudulent transfer actions seeking to avoid and recover settlement payments for their shares, effected through national securities clearance and settlement systems. The Second Circuit Tribune decision holding that section 564(e) bars the avoidance and recovery of these payments is inconsistent with the Seventh Circuit’s decision, and a petition for certiorari review of the Second Circuit decision is pending. The Tribune and Lyondell former shareholders submitted an Amici Curiae brief in support of Petitioners, and the Tribune unsecured creditors submitted a brief in support of Respondent.
Visit HHR’s Bankruptcy Report for future updates on this case.
*Jiun-Wen Bob Teoh assisted with the preparation of this post.
 FTI Consulting Inc. v. Merit Management Group, LP, 830 F.3d 690 (7th Cir. 2016).
 11 U.S.C. § 546(e).
 Brief for Petitioner at 2, Merit Management Group v. FTI Consulting, No. 16-784 (July 13, 2017).
 Brief for Respondent at 2, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 11, 2017).
 Brief of National Association of Bankruptcy Trustees as Amici Curiae Supporting Respondent, at 3, 13-18, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).
 Brief of Bankruptcy Law Professors Ralph Brubaker, et al. as Amici Curiae Supporting Respondent, at 4, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).
 Id. at 1-2.
 Brief of Various Former Tribune and Lyondell Shareholders as Amici Curiae Supporting Petitioners, Merit Management Group v. FTI Consulting, No. 16-784 (July 20, 2017).
 Brief of Tribune Company Retirees and Noteholders as Amici Curiae Supporting Respondent, Merit Management Group v. FTI Consulting, No. 16-784 (Sept. 18, 2017).
We are pleased to share with you the Hughes Hubbard Bankruptcy Mid-Year Review for 2017. The review recaps a number of notable developments from this year. We thank our clients for their continued confidence and look forward to providing you with bankruptcy and restructuring guidance.
The United States Bankruptcy Court for the Southern District of New York recently held that it had personal jurisdiction over a foreign defendant that was paid funds pursuant to the Court’s order approving the debtors’ post-petition financing (the “DIP order”), denying defendant Immigon’s motion to dismiss an adversary proceeding commenced by the Motors Liquidation Company Avoidance Action Trust seeking to clawback the funds.
In 2006, General Motors entered into a $1.5 billion Term Loan Agreement under which JP Morgan Chase Bank, N.A. and several other large financial institutions committed to provide funding and had the right to sell interests in the loan in the secondary market. In 2008, in connection with terminating a completely separate transaction, JP Morgan mistakenly authorized the termination of the security interest in the General Motors’ assets securing the loan.
Under the debtors’ DIP order, the Court authorized the debtors’ to pay in full all of General Motors’ obligations under the Term Loan Agreement, subject to the Official Committee of Unsecured Creditors’ right to investigate and challenge the perfection of the liens securing the loan. Following entry of the order, GM paid approximately $1.4 billion to its lenders under the Term Loan Agreement, including approximately $9.8 million to defendant Immigon on account of its $10 million interest in the loan purchased on the secondary market from JP Morgan.
In denying Immigon’s motion to dismiss, including on the grounds that the Court lacked personal jurisdiction over Immigon, the Court found that under the Term Loan Agreement, Immigon had expressly consented to personal jurisdiction in New York and waived the right to object to any New York State or Federal Court as the forum for any disputes arising out of the Agreement. Moreover, the Court found that the consent to jurisdiction and forum selections clauses should be enforced because Immigon “enjoyed the benefits and protection of New York law” in connection with the Agreement.
As a separate basis for exercising jurisdiction, the Court also held that Immigon consented to jurisdiction under the DIP order, which provided that any party receiving funds under the order consented to the jurisdiction of the Bankruptcy Court. Relying on evidence showing that an employee of Immigon had actually received and viewed the DIP order before receiving payment, the Court found that Immigon had knowingly consented to the jurisdiction provision in the DIP order by accepting payment of the funds.
As a third distinct basis for exercising jurisdiction over Immigon, the Court held that even if Immigon had not consented to the Court’s jurisdiction, sufficient minimum contacts existed between the litigation, New York and Immigon for the Court to exercise specific personal jurisdiction over Immigon. Specifically, the Court noted that “the lending relationship under the Term Loan Agreement was centered in New York, governed by New York law, and allowed all of the parties, including [Immigon], to enjoy the benefits of the U.S. banking system and New York’s status as a financial capital.” Immigon selected Bank of New York Mellon for its correspondent bank account and JP Morgan made the disputed payment to Immigon’s New York bank account. The Court found these contacts, among others, sufficient to show that Immigon had purposefully availed itself of the privilege of doing business in New York.
Finally, the Court found that subjecting Immigon to personal jurisdiction on any of these three grounds would not offend due process because the Court has a strong interest in adjudicating claims that arise under the Bankruptcy Code and the Trust has a strong interest in obtaining convenient and effective relief in the Bankruptcy Court. Moreover, the Court found that Immigon’s burden in having to litigate in New York is mitigated by the convenience of modern communication and transportation.
The outcome of this case suggests the need for parties to carefully review proposed Bankruptcy Court orders affecting their rights. Here, in finding that Immigon had knowingly consented to the Bankruptcy Court’s jurisdiction in the DIP order, the Bankruptcy Court relied on evidence showing that an employee of Immigon had received and viewed the DIP order, despite the fact that the consent to jurisdiction provision was on page 26 of the 30-page order. The case also suggests the need for caution by parties purchasing interests in transactions governed by agreements with consent to jurisdiction clauses.
. Immigon, or Immigon Portfolioabbau AG, is a wind-down company operating under Austrian law, and is the successor in interest to OEVAG, or Osterreichische Volksbanken Aktiengesellschaft, which was the central institute of the Austrian co-operative of banks named Volksbanken.
. Motors Liquidation Co. Avoidance Action Trust v. J.P. Morgan Chase Bank, N.A. (In re Motors Liquidation Co.), (Bankr. S.D.N.Y. 2017).