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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