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US insolvency law developments leave much to be resolved in the year to come

Peter A Ivanick
Hogan Lovells
New York

From the US Supreme Court to the Treasury Department to insolvency forums, including state courts in insurance insolvency cases, 2013–2014 developments were significant.

The US Treasury Department, through the Financial Stability Oversight Council, designated a number of bank and non-bank entities as being sufficiently significant to require supervision by the Federal Reserve Board of Governors ('Fed'), subject to enhanced prudential standards under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Fed also announced in the first week of August 2014 that the 'second round of resolution plans submitted by 11 large, complex banking organisations in 2013' suffer from 'unfair and inadequate assumptions' and fail to make or identify structural and practice changes needed for orderly resolution. These events of 2013–2014 suggest that the resolution of systemically significant entities is not yet clear-cut.

The US Supreme Court heralded 2014 by resolving the procedure for resolution of claims that are designated as 'core' by 28 U.S.C. section 157(b) but are not allowed to be treated as 'core' because of the Constitutional limits stated in Stern v. Marshall1. In Executive Benefits Ins. Agency v. Arkison2, the Court held that bankruptcy courts can resolve these 'gap' claims that invoke private rights between the debtor and a claimant the same way the bankruptcy court would handle non-core matters – i.e., by issuing findings of fact and conclusions of law for review by an Article III district judge. While this decision answered one open question, the Executive Benefit Court reserved more significant issues 'for another day'. A month later, however, the Court granted certiorari to an appeal that questions whether a debtor may consent to a bankruptcy court's entry of a final judgment on a Stern claim3. A decision on this issue has the potential either to preserve or – if the court determines that consent cannot overcome constitutional limitations – procedurally mire the current bankruptcy system.

Last year also saw the restructuring of two financial guaranty insurers. Courts in Wisconsin and New York confirmed plans crafted by state regulators to resolve the obligations of the Segregated Account of Ambac Assurance Corporation and Financial Guaranty Insurance Corporation. In both cases, regulators' actions prompted objections from sophisticated policyholders, and, in each state, courts looked to the best interests of policyholders as a whole rather than the best interests of individual creditors. These decisions marked a departure in the realm of insurance insolvency from the traditional 'best interests' test known to federal bankruptcy practitioners.

Puerto Rico enacted its own statute addressing 'enforcement of debts' of certain commonwealth public authorities. Bondholders of Puerto Rico's electric utility authority have filed declaratory judgment actions raising constitutional issues under the contracts clause, bankruptcy clause, and takings clause, questioning, inter alia, whether the commonwealth may impair public contracts and asserting that the new statute allows the commonwealth to seize secured creditors property without compensation. This debate is likely to continue and has the potential to revise the landscape for obligations owed by states.

Proper treatment of pension obligations in chapter 9 cases was questioned in the resolution of the City of Detroit's woes. The city's plan was confirmed, notwithstanding that the Michigan Constitution prohibits impairment of pension obligations. Judge Rhodes found Detroit eligible for chapter 9 relief and concluded that pension obligations are properly classified as contract – not property – rights and thus could be impaired in the city's reorganisation. And, in the past year, Stockton, California became a battleground for a similar issue, as pensioners and bond insurers took sides over whether a chapter 9 plan that favoured pension obligations discriminated unfairly against bondholders or properly preserved contract rights of pensioners. That case settled, however, denying practitioners a decision but preserving pension benefits for retirees.

Debtors this year minimised time spent in chapter 11. In three months, Sbarros confirmed a pre-packaged chapter 11 plan, swapping $148 million in senior debt for equity, while cramming down landlords and trade creditors, to whom $1.25 million was ultimately paid in settlement of objections. In almost the same time frame, Quiznos confirmed a pre-packaged plan that crammed down its unsecured creditors, who received a bit of equity and a stake in pending lawsuits. In those cases, the companies were such 'melting ice cubes' that, unless the cases resolved quickly, junior creditors may have received nothing. Given the success of such cram-down features, pre-packaged plans may continue to accelerate the chapter 11 process. Many other melting ice-cube debtors have continued to use quick sales under section 363 of the Bankruptcy Code to preserve value. Furthermore, '363' sales are, on average, occurring three times as quickly (i.e., within the first 100 days of a case) than was the case five to 10 years ago, when sales usually occurred a year after commencement.

In two early 2014 key decisions, bankruptcy courts limited credit bidding to the amount paid by the lender to acquire the debt being bid.4 In those cases, haste to proceed to auction by secured creditors whose liens were contested resulted in the imposition by courts of bid caps in order to protect the fairness of the sales, because a bid equal to the claimed value of the liens would otherwise have far exceeded the value of the assets. Both decisions were primarily intended to balance the challenge to the liens at issue with the need for a fair auction, but questions linger. What is the impact of limiting secured creditors' credit bids on the 'fair market value' safeguard supposedly supplied by section 363(k) (which allows a secured lender to credit bid)? Should a party holding a lien be allowed to use the value of that lien if the asset is auctioned before a determination of lien validity?

Lastly, the surge of chapter 15 cases has generated debate. In particular, the Second Circuit ruled that a foreign entity seeking relief under chapter 15 must also satisfy the eligibility requirements of section 109(a) by residing or having a domicile, place of business, or property in the United States5. The Third Circuit took a different tack, emphasising that chapter 15 incorporates 'a universalism approach to transnational insolvency...'. 6 Subsequently, the New York bankruptcy court indicated that the bar for 109(a) eligibility set by Barnet is low in chapter 15, as funds on retainer and causes of action in the US were sufficient.7 The difference in the approaches to chapter 15 by the Second Circuit and Third Circuit is, however, fundamental, and it remains unclear if this difference will lead many international debtors to Delaware.

In sum, stay tuned. Much has happened in the past year, and much remains to be resolved.

1 564 U.S. ___, 131 S. Ct. 2594, 180 L.Ed. 2d 475 (2011).

2 573 U.S. __ --- S. Ct. ---, 59 Bankr. Ct. Dec. 160, 2014 WL 2560461 (Supreme Court of the United States, June 9, 2014).

3 See Wellness Int'l Network, et al. v. Sharif, 727 F.3d 751 (7th Cir. 2013), cert. granted , __ U.S. __, 134 S.Ct. 2901 (July 1, 2014).

4 In re Fisker Auto. Holdings, Inc., 2014 Bankr. LEXIS 230, Case No. 13-13087-KG (Bankr. D. Del. Jan. 17, 2014); In re Free Lance-Star Publ'g Co., 2014 Bankr. LEXIS 1611, Case No. 14-30315-KRH (Bankr. E.D. Va pr. 14, 2014).

5 Drawbridge Special Opportunities Fund LP v. Barnet (In re Barnet), 737 F.3d 238 (2d Cir. 2013)

6 See In re ABC Learning, 728 F.3d 301 (3d Cir. 2013).

7 See In re Octaviar Administration Pty Ltd (Debtor in a Foreign Proceeding), 2014 WL 2805264 (Bankr. S.D.N.Y. June 19, 2014)