RECENT DEVELOPMENTS IN BANKRUPTCY AND RESTRUCTURING

VOLUME 3 NO. 7 DECEMBER 2004

BUSINESS RESTRUCTURING REVIEW

BACK TO THE DRAWING BOARD FOR ASBESTOS PRE-PACKS?THE THIRD CIRCUIT’S RECENT OPINION IN COMBUSTION ENGINEERINGErica M. Ryland and Tanvir Alam

The Third Circuit’s recent opinion overturning confirmation of a plan of reorganiza-

tion in the Combustion Engineering (“CE”) bankruptcy case has significant conse-Combustion Engineering (“CE”) bankruptcy case has significant conse-Combustion Engineering

quences for mass tort bankruptcies, and specifically for asbestos “pre-pack” cases.

While circuit courts have traditionally given mass tort debtors some leeway and

flexibility in interpreting the Bankruptcy Code, this court was clearly troubled by the

novel design of the CE case. In a lengthy and far-reaching opinion that discussed

several important aspects of asbestos bankruptcy cases, the Third Circuit’s rulings

may have fundamentally changed the strategy, negotiation dynamic, and structure of

a pre-packaged asbestos bankruptcy case.

THE COMBUSTION ENGINEERING APPROACH

In a pre-packaged case the debtor has already solicited the votes of all creditors

prior to filing the case. Outside of the mass tort context, the advantage of a “pre-

pack” is speed and less volatility: Because the debtor has already obtained the

votes for approval of a plan of reorganization, it can file its disclosure statement and

plan as a “first-day” pleading and expect to move swiftly towards confirmation of its

plan and exiting bankruptcy.

IN THIS ISSUE1 Back to the Drawing Board for Asbestos

Pre-Packs?A ruling handed down by the Third Circuit may have fundamentally changed the strategy, negotiation dynamic, and structure of a pre-packaged asbestos bankruptcy case.

4 Making the Case for a “Good Faith” FilingCourts are casting a critical eye on chapter 11 fi lings motivated by something other than the debtor ’s desire to remedy its overall financial distress in bankruptcy.

5 What’s New at Jones Day?

8 Lenders Feel the Sting of Substantive ConsolidationA Delaware bankruptcy court’s ruling substantively consolidating the estates of affi liated debtors dealt a blow to a group of bank lenders holding inter-company guarantees.

12 Bankruptcy Courts May Authorize Rejection of FERC-Regulated ContractsThe Fifth Circuit ruled that FERC’s discretion to establish reasonable utility rates does not confl ict with a bankruptcy court’s discretion to authorize rejection of a rate agreement, but suggested that a higher standard should apply.

15 Cash Collateral Usage Not Conditioned on Benefi t to Secured CreditorThe Ninth Circuit bankruptcy appellate panel ruled that the Code’s requirements for adequate protection and collateral surcharge are distinct.

2

Facing tremendous asbestos liability, CE, a subsidiary of

European conglomerate ABB Ltd., filed a precedent-setting

pre-packaged chapter 11 bankruptcy case in February 2003.

Prior to the filing, CE had negotiated a settlement with the

leading asbestos plaintiffs lawyers and created a pre-peti-

tion trust to make payments under the settlement (the “Pre-

Petition Trust”). CE’s ultimate parent, ABB Ltd., also paid a

$20 million “success fee” to a single, prominent asbestos law-

yer whose job was to garner support for the CE plan among

other asbestos lawyers. The Pre-Petition Trust would be

funded by the insurance policies of CE and a contribution by

ABB. The majority of asbestos claimants that settled with CE

prior to the bankruptcy case would receive a 100% recovery:

95% to be paid out from the Prepetition Trust and a 5% stub

claim (the “Stub Claims”) to be paid out post-petition under

the chapter 11 plan. The settling claimants were primarily

individuals who purported to have been exposed to asbestos

but had no evidence of illness or incapacity. The non-set-

tling claimants were those who were actually suffering from

cancer and other diseases, who viewed the settlement offer

as inadequate.

Although the Court did not completely rule out the

possibility of asbestos pre-packaged cases, it called

into question the fundamental architecture used by

CE, which has since been used in other asbestos

pre-pack cases. It remains to be seen if this novel

form of using the Bankruptcy Code to address mass

tort liability will survive.

These Stub Claims were the linchpin of CE’s pre-pack strat-

egy. By leaving 5% to be paid to holders of Stub Claims

under the chapter 11 plan, those claimants would technically

still be creditors under the Bankruptcy Code and were there-

fore entitled to vote on the plan. These settling claimants

without any recognizable injury outnumbered those claimants

who were actually sick. By lumping the two groups of claim-

ants in one class for voting on the CE plan, the larger group

of claimants who were not sick outvoted those who were.

Finally, CE had two affiliates, Lummus and Basic, that were

also facing asbestos liability but did not file for bankruptcy.

Some of this liability derived from legal connections between

the affiliates and CE (derivative liability) but the majority of

lawsuits concerned the affiliates’ direct liability (non-deriva-

tive liability). An important aspect of CE’s bankruptcy plan

was to enter court-approved releases for Lummus and Basic.

CE’s own asbestos liability would be channeled to a post-

petition trust (the “Post-Petition Trust”) created under section

524(g) of the Bankruptcy Code. CE’s plan also provided that

asbestos liability threatening Lummus and Basic, both deriva-

tive and non-derivative, would be channeled to post-petition

trusts. While third-party releases for non-debtors are not

uncommon in bankruptcy cases, the breadth of the releases

for Lummus and Basic could be considered unusual.

THE THIRD CIRCUIT’S ANALYSIS

The CE plan was confirmed by the bankruptcy court and

affirmed by the district court. Certain non-settling asbestos

claimants who had contracted cancer from asbestos expo-

sure, as well as a number of ABB’s insurance companies who

feared their rights were improperly compromised by the plan,

took the case to the Third Circuit Court of Appeals. The Third

Circuit overturned the lower courts and found that the CE

plan did not satisfy the jurisdictional and legal requirements

for confirmation.

First, the Third Circuit held that insurance companies did have

limited standing to challenge certain aspects of the plan.

The standard to be applied in order to determine whether a

party has a right to appeal in a bankruptcy case (bankruptcy

appellate standing) is not the usual “party in interest” stan-

dard but the more restrictive “persons aggrieved” standard:

A party has appellate bankruptcy standing if its rights or

interests are directly and adversely affected pecuniarily by an

order or decree of the bankruptcy court. As such, insurance

companies could challenge a “super-preemptory” provision in

3

majority…. This type of manipulation is especially problematic

in the asbestos context, where a voting majority can be made

to consist of non-malignant claimants [i.e. not sick] whose i.e. not sick] whose i.e.

interests may be adverse to those claimants with more severe

injuries.” As such, the CE plan could not be approved.

CONCLUSIONS

The most interesting aspect of the Third Circuit’s ruling was

the tone and strength of the opinion, written by the chief

judge, Anthony Scirica. The court was clearly concerned

about how CE had structured its pre-pack, and used words

and phrases like “manipulation,” “problematic,” “engineer-

ing literal compliance,” and “artificial impairment.” The Court

called the practice of creating massive stub claims “trou-

bling.” Generally, circuit courts have provided significant

leeway to mass tort debtors. In the Johns-Manville, Drexel

Burnham Lambert Group, A.H. Robins, and recently, A.H. Robins, and recently, A.H. Robins Dow

Corning cases, circuit courts have demonstrated great flex-Corning cases, circuit courts have demonstrated great flex-Corning

ibility when analyzing the Bankruptcy Code such that these

cases came to successful, negotiated conclusions. Thus,

the Third Circuit’s almost complete renunciation of the

Combustion Engineering paradigm is notable. This may have Combustion Engineering paradigm is notable. This may have Combustion Engineering

been due to some unusual decisions that, taken together,

troubled the court: (1) the use of vast numbers of stub claims;

(2) a $20 million “success fee” given to a single tort lawyer;

(3) the lack of a future claims representative for the claims

of CE’s affiliates; (4) the totally disparate treatment of asbes-

tos claimants who settled pre- versus post-petition; (5) a shell

corporation issuing securities for asbestos trusts; (6) a pos-

sible $400 million fraudulent transfer to the Pre-Petition Trust;

and, of course, (7) the attempt to use section 105 to cleanse

non-debtor affiliates of non-derivative liability. Although the

Court did not completely rule out the possibility of asbestos

pre-packaged cases, it called into question the fundamental

architecture used by CE, which has since been used in other

asbestos pre-pack cases. It remains to be seen if this novel

form of using the Bankruptcy Code to address mass tort lia-

bility will survive.

________________________________

In re Combustion Engineering, Inc., 2004 WL 2743565 (3d Cir. In re Combustion Engineering, Inc., 2004 WL 2743565 (3d Cir. In re Combustion Engineering, Inc.

Dec. 2, 2004).

the plan. The original plan provision was designed to make

sure that insurance companies’ rights were not altered by

the plan. However, in approving confirmation of the plan, the

district court had modified this provision to be less advan-

tageous to the insurance companies. The Third Circuit con-

cluded that because this change “diminishes their property,

increases their burdens, or impairs their rights,” the insurers

had the right to appeal. The practical consequence of this

holding may be to give insurance companies more leverage

during negotiation and formulation of a plan, because previ-

ously their rights were less clear.

Second, the Court held that in this situation, the bankruptcy

court had no jurisdiction to implement releases of non-deriv-

ative liability for non-debtor affiliates. Neither mere corporate

affiliation between peer companies, nor significant financial

contributions by the affiliates, nor shared insurance between

CE and its affiliates Lummus and Basic could support the

“related to” connection needed to justify the exercise of juris-

diction over these non-debtors and their creditors by the

bankruptcy court.

Additionally, the Third Circuit concluded that the broad power

given to bankruptcy courts by section 105 of the Bankruptcy

Code does not go so far as to give the court the power to

release non-derivative liability of non-debtors because sec-

tion 524(g) of the Bankruptcy Code, which specifically

addresses releases of third-party liability, does not allow

release of non-derivative liability. Section 524(g) was inserted

by Congress into the Bankruptcy Code to deal with releases

in asbestos cases. Because section 524(g) specifically

addresses the situation while section 105 generally addresses

releases, the court relied on one of the fundamental canons

of statutory interpretation: A specific provision trumps a gen-

eral provision.

Third, the Court found the practice of creating thousands of

stub claims to be “troubling” and held that CE may have “arti-

ficially impaired” the settling asbestos claimants in order to

improperly manipulate the voting process. This violates the

bedrock bankruptcy principle of equality among similarly

situated creditors: “Combustion Engineering made a pre-

petition side arrangement with a privileged group of asbes-

tos claimants, who as a consequence represented a voting

4

MAKING THE CASE FOR A “GOOD FAITH” CHAPTER 11 FILINGPaul D. Leake

The distinction between recourse to chapter 11 protection

as a legitimate means to maximize the value of a company’s

assets and/or to restructure its financially troubled yet oth-

erwise viable operations, on the one hand, and clear bank-

ruptcy abuse, on the other, is sometimes murky. A court

called upon to make such a distinction is obliged to “get

into the debtor’s head” and investigate the board’s motives

for commencing a bankruptcy case and, in some cases, to

decide whether the debtor’s otherwise permissible use of the

powerful provisions of federal bankruptcy law is impermissi-

ble because the debtor’s motives are antithetical to the basic

purposes of bankruptcy.

The Bankruptcy Code contains a variety of mechanisms that

abridge, alter or delay creditor rights and remedies, includ-

ing the automatic stay, discharge of debts, avoidance of

preferential transfers, rejection of unfavorable contracts and

limitations on the amount of certain employee and landlord

claims. However, it is generally recognized that a debtor can

avail itself of these mechanisms only if its decision to seek

chapter 11 protection in the first place comports with lawmak-

ers’ intentions in 1978 in enacting the Bankruptcy Code. At

the heart of this analysis lurks chapter 11’s “good faith” filing

requirement. The “good faith” standard is an integral part of

the balancing process between debtor and creditor interests

that is manifest in many provisions of the Bankruptcy Code.

Unfortunately, caselaw guidance on the concept of “good

faith” is often abstruse, offering little concrete guidance, and

sometimes contradictory.

CHAPTER 11’S GOOD FAITH FILING REQUIREMENT

Chapter 11 of the Bankruptcy Code has been interpreted to

create two separate good faith requirements in connection

with a debtor’s authority to avail itself of and use the pro-

tections of the Bankruptcy Code. First, section 1129(b)(3)

expressly provides that every plan of reorganization be “pro-

posed in good faith and not by any means forbidden by law.”

This provision has been construed to require that a plan be

proposed with “honesty and good intentions” and with “a

basis for expecting that a reorganization can be effected.” In

keeping with that mantra, bankruptcy courts are required to

determine whether a chapter 11 plan, viewed in light of the

“totality of the circumstances,” fairly achieves a result consis-

tent with the purposes of the Bankruptcy Code.

However, a bankruptcy court may be called upon to make

a good faith ruling well before confirmation of a chapter 11

plan. Bankruptcy Code section 1112 delineates a catalogue

of abuses or failures, including continuing loss to or diminu-

tion of the estate, the inability to effectuate a plan, or unrea-

sonable delay by the debtor, that can lead to the outright

dismissal of a chapter 11 case or its conversion to a liquida-

tion. Courts have consistently found that the prosecution of

a chapter 11 case in “bad faith” — although not listed as one

of the examples — also constitutes “cause” for dismissal or

conversion under section 1112(b).

The good faith filing requirement is designed “to ensure that

the hardships imposed on creditors are justified by fulfillment

of the statutory objectives.” Bad faith generally refers to a

chapter 11 filing with the purpose of abusing the judicial pro-

cess. For instance, a chapter 11 filing for the sole purpose

of fending off litigation (e.g., foreclosure) if the debtor has e.g., foreclosure) if the debtor has e.g.

no real prospect of reorganizing its business is often found

to qualify as the kind of abuse that rises to the level of bad

faith. Similarly, a filing by a solvent debtor merely to obtain

a tactical litigation advantage has also been found to be

abusive. When challenged, the debtor bears the burden of

demonstrating that its bankruptcy petition was filed in good

faith. The courts must make that determination on a case

by case basis, undertaking an examination of the totality of

the circumstances to decide where “a petition falls along the

spectrum ranging from the clearly acceptable to the patently

abusive.”

In the courts, the basic thrust of the good faith inquiry has

traditionally been whether the debtor needs chapter 11 relief.

“Need” is informed by the Supreme Court’s identification of

two of the basic purposes of chapter 11 protection as “pre-

serving going concerns” and “maximizing property avail-

able to satisfy creditors.” Thus, where a chapter 11 filing is

motivated by something other than a desire to rehabilitate a

financially distressed yet viable entity or to preserve or maxi-

mize asset values for the creditor-beneficiaries of an orderly

5

WHAT’S NEW AT JONES DAY?David G. Heiman (Cleveland) headed a team of Jones Day attorneys representing WL Ross & Co., the leader of a note-

holder investor group that acquired the operating assets of chapter 11 debtor Horizon Natural Resources, a major U.S. pro-

ducer of bituminous (steam) coal, for approximately $300 million in cash and $480 million in credit-bid notes. Other prac-

tice group lawyers involved in the representation included Corinne Ball (New York), Charles M. Oellermann (Columbus),

Brian L. Gifford (Columbus), David A. Beck (Columbus) and Veerle Roovers (New York).

Erica M. Ryland (New York), Helena Huang (New York) and Robert Shansky (New York Real Estate) assisted Levitz Home

Furnishings, Inc. in its successful acquisition of certain significant retail store leases from chapter 11 debtor Brueners

Home Furnishings.

Corinne Ball (New York) was appointed by the National Conference of Commissioners on Uniform State Laws as an offi-

cial Observer to the Drafting Committee of the Business Trust Act. She will be a featured speaker on January 11, 2005 at

the Practicing Law Institute’s “Guide to Mergers & Acquisitions 2005” in New York City. The topic of her presentation will

be “Advising the Board of Directors.”

Eric Messenzehl (Frankfurt) gave a speech on “Workout Strategies for Real Estate Loans in NPL Transactions” at the

Distressed Property Debt Conference held in Frankfurt on November 17, 2004 by Columbia University, PACT, Frankfurt

Economic Development Institute and the European Business School.

Erica M. Ryland (New York) was recently featured in a New York Law Journal article published on November 12, 2004, New York Law Journal article published on November 12, 2004, New York Law Journal

providing advice for young lawyers considering a career as a restructuring lawyer.

liquidation, a court will dismiss the case as having been filed

in bad faith. The debtor’s solvency may be relevant to the

analysis, but it does not end the inquiry — the Bankruptcy

Code does not establish insolvency as a prerequisite to filing

for chapter 11 (or any form of bankruptcy relief). If the debtor

is insolvent, a “good faith” ruling is fairly assured because

the filing “implements Congress’ scheme of debt priorities

and the policy of equal distribution among creditors with the

same priority.”

The analysis becomes more difficult if the debtor is solvent or

otherwise financially healthy. Here, many courts find that the

only bankruptcy policy implicated is avoidance of piecemeal

liquidation that destroys going concern value. Absent circum-

stances surrounding the filing that pose this risk, these courts

rule that a chapter 11 petition was not filed in good faith.

RECENT RULING ON GOOD FAITH FILING REQUIREMENT

A decision recently handed down by the Third Circuit Court

of Appeals in In re Integrated Telecom Express, Inc. confirms In re Integrated Telecom Express, Inc. confirms In re Integrated Telecom Express, Inc.

that courts will strictly scrutinize the circumstances surround-

ing a chapter 11 filing. Integrated, a software and equipment

supplier to the broadband communications industry, entered

into a commercial real property lease in 2001. After suffer-

ing net losses of over $36 million that year and stymied in its

efforts to locate a potential purchaser, the company resolved

to dissolve under state law. At the time, Integrated and cer-

tain of its officers, directors and underwriters were defen-

dants in a securities class action seeking over $90 million in

damages.

6

Integrated later decided to sell its intellectual property assets

to a company newly formed by certain of Integrated’s officers

and directors for $1.5 million. Recognizing that resolution

of the lease issue could complicate the sale, the company

attempted to negotiate with its landlord to reduce its lease

exposure. During the course of the negotiations, Integrated’s

lawyers sent the landlord a letter indicating that the com-

pany “was prepared to avail itself of various provisions in the

Bankruptcy Code, including the cap on landlord’s claims . . .

[and that] even if [Integrated] were to file bankruptcy solely

to cap the Lessor’s claim using Bankruptcy Code § 502(b)(6),

a use for which this Code section is intended, [Integrated]

would not violate the good faith filing doctrine.” Integrated’s

board of directors even went so far as to adopt a resolution

with similar language. Integrated and the landlord never

settled.

Integrated filed a chapter 11 petition in 2002, scheduling

over $105 million in cash on hand and other assets, and list-

ing miscellaneous liabilities of approximately $430,000. The

landlord submitted a proof of claim in which it denominated

Integrated’s lease obligations (including future rent) at $26

million. Integrated immediately sought court authority to sell

its intellectual property assets at auction and to reject its

lease. The bankruptcy court ultimately approved the sale of

Integrated’s intellectual property assets for $2.5 million in two

separate transactions.

The landlord responded to the lease rejection motion by

seeking dismissal of Integrated’s chapter 11 petition as hav-

ing been filed in bad faith. After conducting an evidentiary

hearing, the bankruptcy court noted that Integrated “was

experiencing a dramatic downward spiral” and that “the

Board had an obligation . . . to give the investors their money

back.” Addressing Integrated’s efforts to limit the landlord’s

claim for future rent, the court observed that “even assum-

ing or accepting the landlord’s position . . . that the principal

reason for the Chapter 11 case was to cap the damage claim

for the landlord, I conclude that as a matter of law, that is not

a debilitating fact.” The court then explained that caselaw

supports the proposition that a solvent debtor can avail itself

of the section 502(b)(6) cap, stating that the landlord elected

to “ride with the bulls” when it decided to enter into a lease

with Integrated, and “must suffer the consequences” of its

instincts being wrong.

The court confirmed a liquidating chapter 11 plan that limited

the landlord’s future rent claim in accordance with section

502(b)(6) and set aside a reserve of $5 million to supplement

$20 million in insurance proceeds available to pay any judg-

ment against Integrated in the pending securities litigation.

The landlord appealed the confirmation order to the district

court, which affirmed. Among other things, the district court

found that the bankruptcy court soundly interpreted relevant

caselaw and did not abuse its discretion in ruling that a chap-

ter 11 filing for the principal purpose of limiting a landlord’s

claim does not amount to bad faith.

The landlord fared better on appeal to the Third Circuit.

Initially, the Court explained that in the realm of “good faith,”

cases have focused on two inquiries: (1) whether the peti-

tion serves a valid bankruptcy purpose, e.g., by preserving a e.g., by preserving a e.g.

going concern or maximizing the value of the estate; and (2)

whether the case is filed merely to obtain a tactical litigation

advantage. Because Integrated had gone out of business

and was being liquidated, the Court observed, there was no

going concern value to preserve, and it need only determine

whether the company’s chapter 11 petition might reasonably

have maximized the value of its estate.

The court in Integrated Telecom makes clear that,

to pass muster, a chapter 11 case must be com-

menced by a debtor that is in financial distress,

which distress can be addressed in some manner

by the bankruptcy case.

The Third Circuit concluded that it would not have. At the out-

set, the Court emphasized that “[t]o say that liquidation under

Chapter 11 maximizes the value of an entity is to say that

there is some value that otherwise would be lost outside of

bankruptcy.” As such, the Third Circuit reasoned, good faith

necessarily requires that the debtor be in some kind of finan-

cial distress that the bankruptcy case can address, although

it need not be in extremis before resorting to bankruptcy, or in extremis before resorting to bankruptcy, or in extremis

even insolvent. Turning to the facts, the Court concluded that

7

the lower courts’ determination that Integrated faced financial

distress because it “was losing a lot of money” and “expe-

riencing a dramatic downward spiral” was not an adequate

basis for finding good faith because a chapter 11 filing could

not remedy these problems, which had “no relation to any

debt owed by Integrated.” Accordingly, the Third Circuit ruled

that “[b]ecause Integrated’s ‘dramatic downward spiral’ did

not establish that Integrated was suffering from financial dis-

tress, it does not, standing alone, establish that Integrated’s

petition was filed in good faith.”

The Court of Appeals rejected Integrated’s contention that

the chapter 11 petition served a valid bankruptcy purpose

because the case provided a framework for resolving the

securities litigation. Faulting the courts below for failing to

make specific findings on this point, the Third Circuit rea-

soned that the litigation itself did not place Integrated in

financial distress regardless of the damages sought given the

available insurance proceeds and Integrated’s own assess-

ment that the action could be settled within the policy lim-

its. The fact that the plaintiffs voted in favor of a plan that

effectively limited their maximum recovery to $25 million, the

Court emphasized, only reinforced the idea that Integrated

was aware that its potential exposure was manageable when

it filed for bankruptcy. Instead, the Court remarked, the cir-

cumstances suggested “that Integrated filed for Chapter 11 in

part to gain a litigation advantage over the securities class, a

use of Chapter 11 that we emphatically reject[].”

The Third Circuit rejected Integrated’s remaining arguments

as well. Turning to the claim that chapter 11 provided an

efficient procedure to dissolve Integrated and distribute its

assets, the Court explained that dissolution of a corporation

is not an objective that can be attained in bankruptcy, “[n]or

is ‘distribution,’ standing alone, a valid bankruptcy purpose.”

Next, the Third Circuit addressed Integrated’s contention that

chapter 11 provided court oversight to the proposed sale of its

intellectual property as well as certain other protections not

available outside of bankruptcy. According to the Court, any

increase in value obtained for those assets after Integrated

filed for chapter 11 was due not to the bankruptcy filing itself,

but Integrated’s failure to adequately market the assets out-

side of bankruptcy to potential bidders other than corporate

insiders and objections by Integrated’s equity committee to

the inadequacy of the original deal. Given the absence of

any evidence that “inchoate claims” against Integrated were

lurking in the wings, the Court also discounted the debtor’s

argument that chapter 11 enabled it to establish a bar date

“and define the universe of claims against it to ensure that

any distributions to its creditors and stockholders account”

for any such claims.

Finally, the Third Circuit directed its attention to the propo-

sition that Integrated’s desire to take advantage of the sec-

tion 502(b)(6) cap established good faith in and of itself. The

Court rejected this idea, specifically holding that it does not.

According to the Third Circuit, “[t]he question of good faith is

. . . antecedent to the operation of § 502(b)(6).” The Court of

Appeals summarized its ruling on this issue as follows:

To be filed in good faith, a petition must do more

than merely invoke some distributional mechanism

in the Bankruptcy Code. It must seek to create or

preserve some value that would otherwise be lost

— not merely distributed to a different stakeholder

— outside of bankruptcy. This threshold inquiry is

particularly sensitive where, as here, the petition

seeks to distribute value directly from a creditor to a

company’s shareholders.

WHERE DO WE GO FROM HERE?

The threat of a bankruptcy filing has long been part of a

distressed company’s negotiating tactics when attempt-

ing to resolve certain types of exposure, particularly when

it involves litigation and onerous contracts and leases. The

Third Circuit’s decision in Integrated Telecom and other deci-Integrated Telecom and other deci-Integrated Telecom

sions like it, including a California bankruptcy court’s ruling in

In re Liberate Technologies, send a clear message that bust-In re Liberate Technologies, send a clear message that bust-In re Liberate Technologies

ing leases and gaining a tactical litigation advantage cannot

act as the sole basis for a chapter 11 filing. Instead, bank-

ruptcy courts, as courts of equity, will apply a “good faith”

standard to determine whether a debtor’s commencement of

a chapter 11 case is legitimately within the permissible pur-

poses underlying the Bankruptcy Code.

The court in Integrated Telecom makes clear that, to pass Integrated Telecom makes clear that, to pass Integrated Telecom

muster, a chapter 11 case must be commenced by a debtor

that is in financial distress, which distress can be addressed

in some manner by the bankruptcy case. The question,

8

then, becomes what exactly qualifies as “financial distress.”

Integrated Telecom indicates that minimizing exposure under Integrated Telecom indicates that minimizing exposure under Integrated Telecom

a commercial lease and managing litigation do not, at least

when the debtor is clearly solvent and the real stakehold-

ers in any chapter 11 case are the company’s shareholders.

Query what these courts would have done if presented with a

good faith challenge under the circumstances present in the

chapter 11 cases filed by Texaco and its affiliates in 1987 to

deal with a $10 billion judgment awarded to Pennzoil?

In Integrated Technologies, the Third Circuit was faced with a Integrated Technologies, the Third Circuit was faced with a Integrated Technologies

debtor that had ceased doing business, had no intention of

reorganizing as a going concern, had no reasonable expec-

tation that the chapter 11 case would maximize the value of its

estate, and sought chapter 11 protection solely to take advan-

tage of the provision of the Bankruptcy Code that caps land-

lord damages. The Court even had the benefit of a “smoking

gun” — the board resolution — that confirmed the motive for

the filing. All these appeared to make the Court’s call on the

question whether the case had been filed in good faith rela-

tively easy. (Of course, in a clear indicator of how uncertain

this area of the law can be, notwithstanding all of those facts,

both courts below had still reached the opposite conclusion.)

At the other end of the spectrum, distressed scenarios often

involve a combination of many different elements that make

a showing of good faith less difficult for a debtor, including

overleveraged balanced sheets, poor earnings, significant

litigation exposure that diverts management resources and

impediments to divestiture of assets due to lurking liabilities

or successor liability concerns. In between these extremes is

everything else that may be a much closer call.

________________________________

In re Integrated Telecom Express, Inc., 384 F.3d 108 (3rd

Cir. 2004).

In re Liberate Technologies, 314 B.R. 206 (Bankr. N.D. In re Liberate Technologies, 314 B.R. 206 (Bankr. N.D. In re Liberate Technologies

Cal. 2004).

This article originally appeared in the November 2004 edition of TheBankruptcy Strategist. It has been reprinted here with permission.

LENDERS FEEL THE STING OF SUBSTANTIVE CONSOLIDATIONMark G. Douglas

Although relatively uncommon, the substantive consolidation

of two or more bankruptcy estates is an important tool avail-

able to a bankruptcy court overseeing the cases of related

debtors whose financial affairs are hopelessly entangled.

Deciding whether to apply this equitable remedy can be dif-

ficult. The court must conduct a factually intensive inquiry

and carefully balance the competing concerns of all par-

ties concerned. The ramifications of substantive consolida-

tion for a bank group were the subject of a decision recently

handed down by a Delaware bankruptcy court in In re Owens

Corning.

SUBSTANTIVE CONSOLIDATION

The bankruptcy court is a court of “equity.” Although the

distinction between courts of equity and courts of law has

largely become irrelevant in modern times, courts of equity

have traditionally been empowered to grant a broader spec-

trum of relief in keeping with fundamental notions of fairness

as opposed to principles of black-letter law. This means that

a bankruptcy court can exercise its discretion to produce fair

and just results “to the end that fraud will not prevail, that sub-

stance will not give way to form, that technical considerations

will not prevent substantial justice from being done.” One of

the remedies available to a bankruptcy court in exercising

this broad equitable mandate is the power to treat the assets

and liabilities of two or more separate but related debtors as

inhering to a single integrated bankruptcy estate. Employing

this tool, courts “pierce the corporate veil” in order to satisfy

claims of the creditors of the consolidated entities from their

common pool of assets.

This remedy is referred to as “substantive consolidation.” The

Bankruptcy Code does not expressly countenance it. Rather,

substantive consolidation is “a product of judicial gloss.”

Courts have consistently found the authority for substantive

consolidation in the bankruptcy court’s general equitable

powers as set forth in section 105(a) of the Bankruptcy Code,

which authorizes the court to “issue any order, process, or

judgment that is necessary or appropriate to carry out the

9

provisions of [the Bankruptcy Code].” Because of the dan-

gers of forcing creditors of one debtor to share equally with

creditors of a less solvent debtor, “substantive consolidation

‘is no mere instrument of procedural convenience . . . but a

measure vitally affecting substantive rights’” Accordingly,

courts generally hold that it is to be used sparingly.

Different standards have been employed by courts to deter-

mine the propriety of substantive consolidation. All of them

involve a fact-intensive examination and an analysis of con-

solidation’s impact on creditors. For example, in Eastgroup

Properties v. Southern Motel Assoc., Ltd., the Eleventh Circuit Properties v. Southern Motel Assoc., Ltd., the Eleventh Circuit Properties v. Southern Motel Assoc., Ltd.

adopted, with some modifications, the standard enunciated

by the District of Columbia Circuit in In re Auto-Train Corp.,

Inc. At the outset, the Eleventh Circuit emphasized, the over-Inc. At the outset, the Eleventh Circuit emphasized, the over-Inc.

riding concern should be whether “consolidation yields ben-

efits offsetting the harm it inflicts on objecting parties.”

Under this standard, the proponent of substantive consoli-

dation must demonstrate that (1) there is substantial identity

between the entities to be consolidated; and (2) consoli-

dation is necessary to avoid some harm or to realize some

benefit. Factors that may be relevant in satisfying the first

requirement include, but are not limited to:

• the presence or absence of consolidated financial

statements.

• any unity of interests and ownership between various

corporate entities.

• the existence of parent and intercorporate guarantees on

loans.

• the degree of difficulty in segregating and ascertaining

individual assets and liabilities.

• the existence of transfers of assets without formal

observance of corporate formalities.

• any commingling of assets and business functions.

• the profitability of consolidation at a single physical

location.

• whether the parent owns the majority of the subsidiary’s

stock.

• whether the entities have common officers or directors.

• whether a subsidiary is grossly undercapitalized.

• whether a subsidiary transacts business solely with the

parent.

• whether both a subsidiary and the parent have disregarded

the legal requirements of the subsidiary as a separate

organization.

If the proponent is successful, a presumption arises “that

creditors have not relied solely on the credit of one of the

entities involved.” The burden then shifts to any party oppos-

ing consolidation to show that it relied on the separate credit

of one of the entities to be consolidated, and that it will be

prejudiced by consolidation. Finally, if an objecting creditor

makes this showing, “the court may order consolidation only

if it determines that the demonstrated benefits of consolida-

tion ‘heavily’ outweigh the harm.”

The Second Circuit, in In re Augie/Restivo Baking Co., Ltd.,

established a somewhat different standard for gauging the

propriety of substantive consolidation. The Court concluded

that the various elements listed above, and others consid-

ered by the courts, are “merely variants on two critical fac-

tors: (i) whether creditors dealt with the entities as a single

economic unit and did not rely on their separate identity in

extending credit, . . . or (ii) whether the affairs of the debt-

ors are so entangled that consolidation will benefit all credi-

tors.” With respect to the initial factor, the Court of Appeals

explained that creditors who make loans on the basis of a

particular borrower’s financial status expect to be able to

look to the assets of that borrower for repayment and that

such expectations create significant equities. Addressing the

second factor, the Second Circuit observed as follows:

[E]ntanglement of the debtors’ affairs involves cases

in which there has been a commingling of two firms’

assets and business functions. Resort to consolida-

tion in such circumstances, however, should not be

Pavlovian. Rather, substantive consolidation should

be used only after it has been determined that all

creditors will benefit because untangling is either

impossible or so costly as to consume the assets.

The Augie/Restivo test was recently adopted by the Ninth Augie/Restivo test was recently adopted by the Ninth Augie/Restivo

Circuit in In re Bonham. Other circuit and lower courts have In re Bonham. Other circuit and lower courts have In re Bonham

adopted tests similar to the Augie/Restivo and Augie/Restivo and Augie/Restivo Eastgroup

standards.

10

SUBSTANTIVE CONSOLIDATION IN OWENS CORNING

Owens Corning and 17 of its wholly owned subsidiaries, a

major supplier of building and industrial materials based in

Toledo, Ohio, sought chapter 11 protection in 2000 in an effort

to manage skyrocketing asbestos litigation exposure. At the

time that the companies filed for chapter 11, a consortium of

more than 40 banks had loaned or committed to loan the

parent company and five of its subsidiaries more than $2 bil-

lion in a series of revolving loans, competitive advance loans,

swing line loans and letter of credit commitments under a

master credit agreement that could be drawn on from time to

time by the borrowers.

The parent guaranteed all loans made under the master

credit agreement to either itself or its subsidiaries. Each

major subsidiary (those with assets having a book value

of $30 million or more) also guaranteed the loans. Among

the companies’ other creditors at the time of the filing were

bondholders, trade creditors and asbestos litigants. These

and other creditor interests were represented during the case

by an official unsecured creditors’ committee, a committee

or sub-committee representing bondholders and trade credi-

tors, an official committee of asbestos claimants and a legal

representative for future claimants.

In connection with their efforts to devise a plan of reorgani-

zation, the debtors sought a court order substantively con-

solidating their estates. Nearly all creditors, other than the

banks, supported the request. According to the banks, the

cross-guarantees elevated their claim for $1.6 billion outstand-

ing under the credit agreement to a higher priority than other

claims because it represented a direct claim against both

the parent company and each of the subsidiary guarantors,

whereas other creditors asserted direct claims only against

the parent.

After conducting a four-day evidentiary hearing, the bank-

ruptcy judge granted the motion to substantively consolidate

the Owens Corning estates, observing that “I have no diffi-

culty in concluding that there is indeed substantial identity

between the parent debtor . . . and its wholly-owned subsid-

iaries.” Each of the subsidiaries, the court explained, were

controlled by a single committee, from central headquarters,

without regard to the subsidiary structure. Among other

things, this meant that the officers and directors of the sub-

sidiaries did not establish business plans or budgets, and

did not appoint senior management except at the direction

of the central committee. Subsidiaries were established for

the convenience of the parent, principally for tax reasons.

Also, the subsidiaries were entirely dependent on the parent

for funding and capital, and the financial management of the

entire enterprise was conducted in an integrated manner.

Substantive consolidation, the court emphasized, would

greatly simplify and expedite the successful completion of

the bankruptcy proceedings. More importantly, the court

remarked, “it would be exceedingly difficult to untangle the

financial affairs of the various entities,” despite the consider-

able sums expended by the debtors to sort out the financial

affairs of each individual entity.

Owens Corning conveys a clear message to lenders

considering the prospect of extending financing to

a company or group of companies that have a net-

work of affiliates. To minimize the possibility that the

entire network or different parts of it will be consoli-

dated in a bankruptcy filing down the road, a lender

must clearly identify at the outset which borrower’s

credit it is relying on for repayment.

Having concluded that the proponents of consolidation estab-

lished a prima facie case, the court then examined whether prima facie case, the court then examined whether prima facie

the banks proved that they relied on the separate credit of

the subsidiaries. It ruled that they did not, remarking that

“[t]here can be no doubt that the Banks relied on the overall

credit of the entire Owens Corning enterprise.” According to

the court, the evidence showed that each bank’s loan com-

mitment was to the entire enterprise, and the decision as to

11

whether funds would be borrowed by the parent or one or

more subsidiaries was made by the borrowers, not the banks.

In obtaining guarantees from the major subsidiaries, the court

emphasized, the banks knew only that each guarantor had

assets with a book value greater than $30 million — they had

no information regarding the debts of the guarantor subsid-

iaries. The very existence of the cross-guarantees, the court

explained, was a reason to substantively consolidate the

estates because “[a]ny guarantor held liable on its guaran-

tee would have a right of indemnification against whichever

entity or entities borrowed the money . . . . [and] [i]t would

be extremely difficult to sort out the inter-subsidiary claims.”

Moreover, the court observed, the claims based upon the

guarantees were not as clear cut as the banks maintained,

and had in fact been challenged by the debtor and various

creditor groups as fraudulent conveyances.

Finally, in ruling that substantive consolidation of the debtors’

estates was a “virtual necessity,” the bankruptcy court did not

rule out the possibility that some portion of the banks’ claim

(based upon the cross-guarantees) might ultimately enjoy

a higher priority than other unsecured creditors of the con-

solidated estates. However, the court stated, this issue was

more properly joined in connection with “fair and equitable”

analysis undertaken as part of confirmation of a chapter 11

plan of reorganization.

ANALYSIS

Owens Corning is noteworthy for a number of reasons. First, Owens Corning is noteworthy for a number of reasons. First, Owens Corning

the opinion portrays a factual scenario so unusual that the

Delaware bankruptcy court had little difficulty concluding that

substantive consolidation of the related debtors’ estates was

appropriate. However, because the ruling does not contain

specific factual findings made by the court during the course

of its evidentiary hearing, it is difficult to judge to what extent

the facts were so one sided. Relatively few courts have the

luxury of such a situation when asked to balance the ben-

efits of consolidation against the harm that it will inflict on

creditors. Scenarios are far more likely to be complicated by

more balanced conditions that require painstaking and factu-

ally intensive analysis. It is for precisely this reason that sub-

stantive consolidation is a remedy sparingly resorted to by

the courts.

Substantive consolidation of affiliated debtors’ estates in a

negotiated plan of reorganization as a means of simplifying

a complicated corporate structure is not uncommon, partic-

ularly as corporate structures are increasingly driven by tax

considerations that may cease to become viable once an

affiliated network of companies files for bankruptcy. Owens

Corning is unusual because it involves a request for consoli-Corning is unusual because it involves a request for consoli-Corning

dation by the debtors outside of a plan of reorganization over

the objection of a significant creditor bloc. More commonly,

the creditors of an asset-poor debtor whose affiliates have

also filed for bankruptcy seek substantive consolidation of

the related debtors’ estates as a means of enhancing their

recoveries.

Finally, Owens Corning conveys a clear message to lenders Owens Corning conveys a clear message to lenders Owens Corning

considering the prospect of extending financing to a com-

pany or group of companies that have a network of affiliates.

To minimize the possibility that the entire network or different

parts of it will be consolidated in a bankruptcy filing down

the road, a lender must clearly identify at the outset which

borrower’s credit it is relying on for repayment. Lenders may

also be more exacting in their scrutiny of a potential borrow-

er’s (or guarantor’s) organization, internal management and

finances.

________________________________

In re Owens Corning, 316 B.R. 168 (Bankr. D. Del. 2004).In re Owens Corning, 316 B.R. 168 (Bankr. D. Del. 2004).In re Owens Corning

Drabkin v. Midland-Ross Corp. (In re Auto-Train Corp., Inc.),

810 F.2d 270 (D.C. Cir. 1987).

Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d Eastgroup Properties v. Southern Motel Assoc., Ltd., 935 F.2d Eastgroup Properties v. Southern Motel Assoc., Ltd.

245 (11th Cir. 1991).

In re Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir. 1988).In re Augie/Restivo Baking Co., 860 F.2d 515 (2d Cir. 1988).In re Augie/Restivo Baking Co.

In re Bonham, 229 F.3d 750 (9th Cir. 2000).In re Bonham, 229 F.3d 750 (9th Cir. 2000).In re Bonham

12

BANKRUPTCY COURTS MAY AUTHORIZE REJECTION OF FERC-REGULATED CONTRACTSDebra K. Simpson and Mark G. Douglas

Conflicts arising from the seeming incongruity between the

Bankruptcy Code and other federal statutes governing the

way that companies in various industry sectors are regu-

lated have figured prominently in recent headlines involv-

ing companies such as PG&E, Enron and a number of tele-

coms. Bankruptcy and appellate courts are increasingly

called upon to resolve these conflicts in a way that harmo-

nizes as nearly as possible the competing policy concerns

involved. One such dispute was the subject of a ruling

recently handed down by the United States Court of Appeals

for the Fifth Circuit in connection with the chapter 11 cases of

Mirant Corporation and its affiliates. The decision contains

both good and bad news for energy companies facing bank-

ruptcy. The good news is that FERC-regulated contracts may

be rejected as part of a reorganization proceeding. The bad

news is that the decision to reject may be subject to height-

ened scrutiny.

BANKRUPTCY JURISDICTION AND REJECTION

OF EXECUTORY CONTRACTS

By statute, U.S. district courts are given original, but not exclu-

sive, jurisdiction over “all civil proceedings arising under”

the Bankruptcy Code as well as those “arising in or related

to cases under” the Code. In addition, district courts are

granted exclusive jurisdiction over all the property of a debt-

or’s estate, including, as relevant here, contracts, leases and

other agreements that are still in force when a debtor files for

bankruptcy protection. That jurisdiction devolves automati-

cally upon the bankruptcy courts, each of which is a unit of a

district court, by standing court order.

A bankruptcy court’s exclusive jurisdiction over unexpired —

or “executory” — contracts and leases empowers it to autho-

rize a bankruptcy trustee or chapter 11 debtor-in-possession

(“DIP”) to either “assume” (reaffirm) or “reject” (breach) almost

any executory contract during the course of a bankruptcy

case in accordance with the strictures of Bankruptcy Code

section 365. Assumption allows the DIP to continue perform-

ing under the agreement, after curing outstanding defaults,

or to assign the agreement to a third party as means of gen-

erating value for the bankruptcy estate. Rejection frees the

DIP from rendering performance under unfavorable contracts.

Rejection constitutes a breach of the contract, and the result-

ing claim for damages is deemed to be a pre-petition claim

against the estate on a par with other general unsecured

claims. Accordingly, the power granted by Congress under

section 365 is viewed as vital to the reorganization process

because it can relieve the debtor’s estate from burdensome

obligations that can impede a successful reorganization. The

court will authorize assumption or rejection if it is demon-

strated that either course of action represents an exercise of

sound business judgment. This is a highly deferential stan-

dard akin in many respects to the business judgment rule

applied to corporate fiduciaries.

THE FEDERAL POWER ACT AND THE FILED RATE DOCTRINE

Public and privately operated utilities providing interstate util-

ity service within the U.S. are regulated by the Federal Power

Act (“FPA”) under the supervision of the Federal Energy

Regulatory Commission (“FERC”). Under the FPA, although

contract rates for electricity are privately negotiated, “those

rates must be filed with FERC and certified as ‘just and rea-

sonable’ to be lawful.” FERC has “exclusive authority” to

determine the reasonableness of the rates.

Based on this statutory mandate, courts have developed the

“filed-rate doctrine,” which provides that a utility’s “right to a

reasonable rate [under the FPA] is the right to the rate [that

FERC] files or fixes, and, . . . except for review of [FERC’s]

orders, [a] court can assume no right to a different one on

the ground that, in its opinion, it is the only or the more rea-

sonable one.” Under the filed rate doctrine, the reasonable-

ness of rates and agreements regulated by FERC “may not

be collaterally attacked in state or federal courts. The only

appropriate forum for such a challenge is before [FERC] or a

court reviewing [FERC’s] order.”

If a utility files for bankruptcy, FERC’s exclusive discretion in

this realm could be interpreted to run afoul of the bankruptcy

court’s exclusive jurisdiction to authorize the rejection of an

electricity supply agreement based on the debtor’s business

13

judgment that the rates charged under the agreement are

unreasonable. This was the thorny issue addressed by the

Fifth Circuit Court of Appeals in Mirant.

BACKGROUND

Mirant Corporation and 82 of its subsidiaries (collectively,

“Mirant”) filed voluntary chapter 11 petitions in 2003. Prior

to filing for bankruptcy, Mirant, one of the largest regulated

public utilities in the U.S., agreed to purchase certain electric

generation facilities from Potomac Electric Power Company

(“PEPCO”). In connection with the sale, PEPCO was to assign

to Mirant several purchase power agreements (each, a “PPA”),

which are long-term fixed-rate contracts pursuant to which

PEPCO agreed to purchase electricity from outside suppliers.

Because certain of the PPAs required PEPCO to obtain the

PPA supplier’s consent to assignment, the purchase agree-

ment provided that, if PEPCO could not obtain such consent,

the unassigned PPAs would be subject to a “back-to-back”

agreement.

Even though the Court of Appeals acknowledged

that the Bankruptcy Code does not on its face con-

tain any special restrictions on the ability of a trustee

or DIP to reject a FERC regulated rate agreement,

its ruling suggests that a different standard should

apply to these kinds of contracts.

Under a back-to-back agreement, PEPCO would continue to

comply with the terms of any unassigned PPAs, and Mirant

would agree to purchase an amount of electricity from PEPCO

equal to PEPCO’s obligations under the unassigned PPAs at the

rate set forth in the applicable PPA. After PEPCO was unable

to obtain the required consent to assign two of the PPAs,

Mirant and PEPCO entered into such an agreement, which

the parties filed with FERC. FERC subsequently approved the

wholesale electricity rates set forth in the agreement.

Because of the significant financial losses experienced by

Mirant under the back-to-back agreement, Mirant sought

court authorization to reject the agreement after it filed for

bankruptcy. It also sought an injunction preventing FERC or

PEPCO from taking any actions to require Mirant to abide by

the terms of the agreement. The bankruptcy court granted

Mirant’s request for injunctive relief, but did not rule on

Mirant’s motion to reject the back-to-back agreement.

Instead, the litigation continued in the district court, which

withdrew the reference of the proceeding to resolve the

potential conflict between the FPA and the Bankruptcy Code.

The court ultimately ruled that FERC has exclusive authority

under the FPA to determine the reasonableness of whole-

sale rates charged for electric energy sold in interstate com-

merce, and those rates can be challenged only in a FERC

proceeding, not through a collateral attack in state or federal

court. According to the district court, the Bankruptcy Code

does not provide an exception to FERC’s authority under the

FPA, and therefore, Mirant had to seek relief from the filed

rate in the back-to-back agreement in a FERC proceeding.

The court accordingly denied Mirant’s motion to reject the

agreement and vacated the injunction issued below. Mirant

appealed to the Fifth Circuit.

THE FIFTH CIRCUIT’S DECISION

The Court of Appeals reversed. Initially, it determined that

although the filed-rate doctrine prevents a district court from

hearing breach of contract claims that challenge a filed rate,

a court is permitted to grant relief in situations where the

claim is based upon another rationale. Thus, the Fifth Circuit

explained, the FPA does not prevent a court from ruling on

a motion to reject a FERC approved rate setting agreement

so long as the proposed rejection does not represent a chal-

lenge to the agreement’s filed rate. PEPCO’s claim arising

from rejection of the agreement, the Court of Appeals empha-

sized, would be calculated based on the filed rate. Moreover,

the Fifth Circuit emphasized, even though Mirant’s desire

to reject the agreement was motivated in part by the lower

prevailing market rate, its business justification was also pre-

mised on the existence of excess supply and the consequent

lack of any need for the energy covered by the contract. The

Court of Appeals accordingly concluded that rejection of the

14

agreement was not a challenge to the filed rate, and that the

FPA did not preempt a ruling on Mirant’s motion.

The Fifth Circuit rejected FERC’s argument that anything

less than full payment would constitute a challenge to the

filed rate, observing that “any effect on the filed rates from

a motion to reject would result not from the rejection itself,

but from the application of the terms of a confirmed reorga-

nization plan to the unsecured breach of contract claims.” It

went on to note that, although the Bankruptcy Code contains

numerous limitations on a debtor’s right to reject contracts,

“including exceptions prohibiting rejection of certain obliga-

tions imposed by regulatory authorities,” there is no excep-

tion that prohibits a debtor’s rejection of wholesale electricity

contracts that are subject to FERC’s jurisdiction. Concluding

that “Congress intended § 365(a) to apply to contracts sub-

ject to FERC regulation,” the Fifth Circuit held that the court’s

power to authorize rejection of the back-to-back agreement

does not conflict with the authority conferred upon FERC to

regulate rates for the interstate sale of electricity. It accord-

ingly reversed the decision below.

The decision contains both good and bad news for

energy companies facing bankruptcy. The good

news is that FERC-regulated contracts may be

rejected as part of a reorganization proceeding.

The bad news is that the decision to reject may be

subject to heightened scrutiny.

ANALYSIS

Mirant is emblematic of the way that the majority of courts Mirant is emblematic of the way that the majority of courts Mirant

approach a potentially irreconcilable conflict between two

federal statutes. Wherever possible, most courts attempt to

resolve such conflicts in a way that gives due consideration

to the important policy considerations associated with both

statutes. In Mirant, that resolution was reached by means of Mirant, that resolution was reached by means of Mirant

a determination that the rejection of an executory agreement

establishing presumptively reasonable utility rates is not tan-

tamount to a collateral attack on the reasonableness of the

rates — provided rejection is not motivated solely by a desire

to take advantage of lower market rates. Stated differently, the

Fifth Circuit found that there was no conflict between the stat-

utes.

Still, certain aspects of the Fifth Circuit’s ruling are troubling.

Even though the Court of Appeals acknowledged that the

Bankruptcy Code does not on its face contain any special

restrictions on the ability of a trustee or DIP to reject a FERC

regulated rate agreement, its ruling suggests that a different

standard should apply to these kinds of contracts. In con-

nection with its decision to reverse the district court ruling

and remand the case for further consideration of Mirant’s

motion to reject, the Fifth Circuit stated that “[u]se of the busi-

ness judgment standard would be inappropriate in this case

because it would not account for the public interest inherent

in the transmission and sale of electricity.”

Instead, the Court of Appeals suggested, rejection of an

executory power contract should be permitted only upon a

showing that: (a) the contract is burdensome to the estate;

(b) the equities favor rejection; and (c) the rejection “would

further the Chapter 11 goal of permitting the successful reha-

bilitation of debtors.” In applying this test, the Fifth Circuit

observed, courts should give particular consideration to the

public interest and should ensure that the rejection will not

disrupt power delivered “to other public utilities or to consum-

ers.” Such a heightened standard for the rejection of FERC

regulated rate agreements, however, is found nowhere in the

Bankruptcy Code. Congress has clearly delineated restric-

tions on the ability to reject other kinds of agreements (e.g.tions on the ability to reject other kinds of agreements (e.g.tions on the ability to reject other kinds of agreements ( ,

collective bargaining agreements) where it saw fit to provide

special consideration to the non-debtor parties to the agree-

ment. The absence of any such express limitations with

respect to FERC regulated rate agreements suggests that

the Fifth Circuit’s approach may be open to challenge.

________________________________

Mirant Corp. v. Potomac Electric Power Co. (In re Mirant

Corp.), 378 F.3d 511 (5th Cir. 2004).Corp.), 378 F.3d 511 (5th Cir. 2004).Corp.)

15

CASH COLLATERAL USAGE NOT CONDITIONED ON BENEFIT TO SECURED CREDITORNicholas M. Miller

The Bankruptcy Code incorporates various special rights and

protections for holders of secured claims as a kind of quid

pro quo for suspending a secured creditor’s ability to enforce pro quo for suspending a secured creditor’s ability to enforce pro quo

its remedies so long as the automatic stay is in force during

a bankruptcy case. Among these safeguards is the debtor’s

obligation to provide “adequate protection” of a secured

creditor’s interest in collateral, a concept designed to ensure

that a secured creditor’s interest does not diminish in value

as a consequence of the stay, the debtor’s use, sale or lease

of the collateral or the grant of any additional liens on the

property. Another secured creditor-friendly provision in the

statute limits the estate’s ability to “surcharge” a secured

creditor’s collateral for costs incurred in preserving or dispos-

ing of an encumbered asset to situations where a clear “ben-

efit” is conferred on the secured creditor, as opposed to the

estate.

What conditions a debtor must fulfill before it will be permit-

ted to use encumbered property during a bankruptcy case

are sometimes the subject of heated dispute between the

debtor and its secured creditors. The Ninth Circuit bank-

ruptcy appellate panel recently considered this issue in In re

ProAlert, LLC, holding that the standards regarding adequate ProAlert, LLC, holding that the standards regarding adequate ProAlert, LLC

protection of a secured creditor’s interest and surcharge of

collateral are distinct, such that a debtor need not provide a

benefit to the secured creditor as a prerequisite to using its

collateral during a bankruptcy case.

ADEQUATE PROTECTION

The overarching goal of many chapter 11 cases is to reorga-

nize a troubled enterprise’s finances so that it may continue

to operate, provide its employees with jobs and pay its credi-

tors. In furtherance of this goal, the Bankruptcy Code allows

a debtor to use encumbered estate assets, including “cash

collateral,” under certain circumstances. Because a secured

creditor may, therefore, be deprived of the right to immedi-

ate possession of its property, the Bankruptcy Code recog-

nizes that a secured creditor’s interest in estate assets must

be protected during the course of the chapter 11 case. One

such safeguard is the debtor’s obligation under section 363

of the Bankruptcy Code to provide “adequate protection” of

certain creditor interests in property.

Other than as parties-in-interest with the right to be

heard generally in connection with a DIP’s proposed

use of estate assets outside the course of business,

a secured creditor generally has little or no ability

to direct the way that estate assets not subject to

its liens are used during the course of a bankruptcy

case.

Section 363 describes the rights and powers of a chap-

ter 11 debtor-in-possession (“DIP”) or bankruptcy trustee with

respect to the sale or use of estate property. In part, it pro-

vides that a DIP may not use “cash collateral” — cash in which

both the debtor and the secured party have an interest (e.g.both the debtor and the secured party have an interest (e.g.both the debtor and the secured party have an interest ( ,

proceeds of inventory or accounts receivable) — unless the

court authorizes such use in accordance with the provisions

of section 363(e). Under that section, a court must prohibit or

condition the use of estate property as is necessary to pro-

vide “adequate protection.” In accordance with Bankruptcy

Code section 361, “adequate protection” commonly takes the

form of periodic cash payments, replacement liens on other

assets or other equivalent measures designed to protect

against diminution in the value of a creditor’s interest in col-

lateral during a bankruptcy case. If unable to provide ade-

quate protection of a secured creditor’s interest in property,

the DIP cannot use it for any reason.

SURCHARGING A SECURED CREDITOR’S COLLATERAL

Other provisions in the Bankruptcy Code strive to strike a bal-

ance between the competing concerns of secured creditors

and the estate vis-à-vis encumbered assets. The statute pro-

16

vides that, absent an express agreement to the contrary, the

expenses associated with administering a bankruptcy estate

are not chargeable to a secured creditor’s collateral and,

instead, must be satisfied from the unencumbered assets of

the estate. To that extent, it recognizes that secured credi-

tors should not forfeit bargained-for rights as a result of a

debtor’s bankruptcy filing.

The requirement of adequate protection, the court

explained, balances the divergent interests of the

debtor and the secured creditor, whereas the “ben-

efit to the creditor” test reflects Congress’ attempt

to balance the interests of secured creditors against

those of the estate’s unsecured creditors. In other

words, the court emphasized, adequately pro-

tected creditors are, by definition, not subject to a

surcharge that would bring section 506(c) into play.

Accordingly, the appellate court held that nothing

in section 506(c) could prevent ProAlert from using

cash collateral to pay estate professionals.

However, the Code creates an exception to this rule under

circumstances that would otherwise permit a secured credi-

tor to benefit from a windfall at the estate’s expense. Thus,

section 506(c) permits a DIP or trustee to recover from col-

lateral any costs of preserving or disposing of the property in

question “to the extent of any benefit” to the secured creditor.

Because such costs would normally be borne by a secured

creditor outside of bankruptcy, section 506(c) ensures that

the estate and its creditors are not penalized by going out of

pocket for expenditures that inure solely and directly to the

benefit of a secured creditor. Courts generally allow payment

of an administrative expense from the proceeds of secured

collateral only when the expense was “incurred primarily for

the benefit of the secured creditor or when the secured cred-

itor caused or consented to the expense.”

The secured creditor protections incorporated in section 363

and 506 of the Bankruptcy Code — adequate protection and

the prohibition of surcharge absent benefit — are distinct

and arise in different contexts. Still, as demonstrated by the

Ninth Circuit bankruptcy appellant panel’s ruling in ProAlert,

there may be some confusion concerning the circumstances

under which they apply.

THE APPELLANT PANEL’S RULING IN PROALERT

ProAlert LLC (“ProAlert”) was in the business of installing and

monitoring security systems. Its primary asset was recurring

monthly revenue from customer contracts. Security Leasing

Partners LP (“SLP”) had a lien on ProAlert’s assets, including

monthly revenues, but was significantly undersecured.

After filing for chapter 11, ProAlert sought court approval to

use the monthly revenues pledged to SLP to fund future oper-

ating costs. SLP consented to the use of its cash collateral

for ordinary operating expenses, but it objected to the use of

cash collateral to pay the fees and expenses of professionals

retained by the bankruptcy estate. SLP’s position was that

ProAlert’s section 363 cash collateral motion was, in reality, an

effort to effectuate a surcharge under section 506(c) without

showing the requisite “benefit” to SLP.

The bankruptcy court ruled that ongoing payment of profes-

sional fees from cash collateral is permissible under sec-

tion 363(c)(2) without satisfying the “benefit to the creditor”

test under section 506(c). According to the court, ProAlert

could use the cash collateral to pay a retainer to its valua-

tion expert because SLP’s interest was adequately protected

through a dollar-for-dollar replenishment of funds that had

been advanced to the estate professional from future rev-

enues.

17

On appeal, SLP argued that, notwithstanding adequate pro-

tection of its interest, the bankruptcy court erred in allowing

the use of cash collateral without considering whether the

surcharge requirements set forth in section 506(c) were sat-

isfied. The bankruptcy appellate panel rejected this argu-

ment. Examining the language of the statute, the court noted

that on its face section 363 neither prohibits a debtor from

using cash collateral to pay estate professionals nor condi-

tions such use on satisfaction of section 506(c)’s “benefit to

the creditor” caveat. The court further noted that section

506(c) is wholly inapplicable to the facts at hand because it

serves an entirely different purpose than that served by sec-

tion 363. The requirement of adequate protection, the court

explained, balances the divergent interests of the debtor

and the secured creditor, whereas the “benefit to the credi-

tor” test reflects Congress’ attempt to balance the interests

of secured creditors against those of the estate’s unsecured

creditors. In other words, the court emphasized, adequately

protected creditors are, by definition, not subject to a sur-

charge that would bring section 506(c) into play. Accordingly,

the appellate court held that nothing in section 506(c) could

prevent ProAlert from using cash collateral to pay estate pro-

fessionals.

ANALYSIS

ProAlert is noteworthy because it illustrates the nature and ProAlert is noteworthy because it illustrates the nature and ProAlert

limitations of, as well as the differences between, certain

rights and protections afforded to secured creditors under

the Bankruptcy Code. A secured creditor’s ability to control

the way that estate assets are used or expended depends

in large part upon the nature of its security interest and the

value of its collateral. ProAlert involved an attempt by an ProAlert involved an attempt by an ProAlert

undersecured creditor to bootstrap its lack of sufficient col-

lateral value into a controlling position vis-à-vis property to

which its secured interest did not extend. The bankruptcy

appellate panel’s decision resoundingly rejects reliance upon

section 506(c) as a means of expanding a secured creditor’s

scope of influence and overall role in a chapter 11 case.

________________________________

Security Leasing Partners, LP v. ProAlert, LLC (In re ProAlert,

LLC), 314 B.R. 436 (B.A.P. 9th Cir 2004).LLC), 314 B.R. 436 (B.A.P. 9th Cir 2004).LLC)

FOR THE RECORD

THE NUMBER OF U.S. BANKRUPTCY FILINGS

REMAINED AT HIGH LEVELS IN FISCAL YEAR

2004, BUT RECEDED SLIGHTLY FROM THE PRE-

VIOUS 12-MONTH PERIOD, THE ADMINISTRATIVE

OFFICE FOR U.S. COURTS REPORTED ON

DECEMBER 3. BANKRUPTCY FILINGS FELL

2.6 PERCENT IN THE FISCAL YEAR ENDING

SEPTEMBER 30, 2004, THE ADMINISTRATIVE

OFFICE REPORTED, WITH 1,618,987 BANKRUPT-

CIES FILED, DOWN FROM THE 1,661,996 BANK-

RUPTCY CASES FILED IN FISCAL YEAR 2003.

EVEN WITH THE FILING DECLINE, BANKRUPT-

CIES REMAINED AT “HISTORIC HIGHS,” THE

ADMINISTRATIVE OFFICE SAID IN A STATEMENT,

WELL ABOVE THE 1.5 MILLION RECORD FIRST

SET IN 2002. BUSINESS BANKRUPTCIES FELL

3.8 PERCENT TO 34,817 IN FISCAL YEAR 2004, A

DROP FROM 36,183 THE PREVIOUS YEAR. NON-

BUSINESS OR PERSONAL BANKRUPTCIES FELL

2.6 PERCENT IN THE SAME 12-MONTH PERIOD,

TOTALLING 1,584,170 IN 2004 AND 1,625,813 IN

2003. ONLY CHAPTER 11 FILINGS ROSE OVER

FISCAL YEAR 2003 RESULTS. THEY TOTALLED

10,368 IN FISCAL YEAR 2004, UP 2.2 PERCENT

FROM 10,144 CHAPTER 11 FILINGS IN FISCAL

YEAR 2003.

18

LARGEST PUBLIC COMPANY BANKRUPTCY FILINGS 2004

Company Filing Date Description Assets ($mil)

US Airways Group, Inc. 9/12/2004 Passenger Airline $8,349.00

RCN Corporation 5/27/2004 Bundled Communication $2,346.00 Services

Atlas Air Worldwide 1/30/2004 Aircraft, Crew and $2,084.00Holdings Maintenance

Trump Hotels & 11/21/2004 Casino and Hotel $2,031.00Casino Resorts

Metropolitan Mortgage 2/4/2004 Insurance $1,787.00& Securities Co., Inc.

Interstate Bakeries 9/22/2004 Baking Distribution $1,646.00Corp.

ATA Holdings Corp. 10/26/2004 Passenger and Charter $870.00 Air Service

Cornerstone Propane 6/3/2004 Propane Providers $868.00Partners

Footstar, Inc. 3/2/2004 Retail Distributors of $866.00 Athletic Footwear

19

LARGEST PUBLIC COMPANY BANKRUPTCY FILINGS 2004 (continued)

Company Filing Date Description Assets ($mil)

Maxim Crane Works, 6/14/2004 Provides Crane $789.00LLC Rental Services

Oglebay Norton 2/23/2004 Mines, Processes and $688.00Company Markets Minerals

Intermet Corporation 9/29/2004 Ductile Castings $687.00

MTS, Inc. (Tower 2/9/2004 Recorded Media and $476.00Records, Inc.) Electronic Products

Dan River, Inc. 3/31/2004 Manufactures Home $466.00 Textile Products

New World Pasta 5/10/2004 Manufactures Retail $426.00Company Branded Dry Pasta

Fibermark, Inc. 3/30/2004 Manufactures Fiber- $400.00 Based Materials

Choice One 10/5/2004 Telecommunications $383.00Communications, Inc.

20

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