The Year In Bankruptcy: 2007 - Part 2

A number of significant rulings during 2007 were emblematic of both the breadth of discretion given to a bankruptcy court in granting (or refusing to grant) relief under chapter 15 and the new chapter's shortcomings in providing clear guidance as to how it is to be applied in all cases. In a decision issued on August 30, 2007, Bankruptcy Judge Burton R. Lifland of the U.S. Bankruptcy Court for the Southern District of New York denied chapter 15 petitions seeking recognition as a "foreign main proceeding" of winding-up proceedings commenced in the Cayman Islands for two failed hedge funds that were casualties of the subprime mortgage meltdown. In In re Bear Stearns High-Grade Structured Credit Strategies Master Fund, Ltd. (In Provisional Liquidation), 2007 WL 2479483 (Bankr. S.D.N.Y. Aug. 30, 2007), amended and superseded by, 374 B.R. 122 (Bankr. S.D.N.Y. 2007), the court ruled that the representatives of the hedge funds, which had little or no contact with the Caymans other than a certificate of incorporation, failed to demonstrate either that their "center of main interests" ("COMI") was located, or that they even had an "establishment," in the Caymans.

Bear Stearns was not the first ruling denying recognition under chapter 15 of a foreign main proceeding involving a Cayman Islands hedge fund. In 2006, Bankruptcy Judge Robert D. Drain, in In re SPhinX, Ltd., 351 B.R. 103 (Bankr. S.D.N.Y. 2006), denied a petition seeking recognition of liquidation proceedings in the Cayman Islands as foreign main proceedings because the evidence did not support a finding that the debtor-hedge funds' COMI was in the Cayman Islands, and it appeared that the liquidators' motive for seeking recognition was to gain a tactical advantage in pending litigation involving the debtors. However, the judge ruled that recognition as a foreign nonmain proceeding was warranted, even though the Cayman liquidation did not qualify as a main proceeding and even though no such proceeding was pending elsewhere. Judge Drain's ruling was affirmed in all respects in 2007 by a New York district court in In re SPhinX, Ltd., 371 B.R. 10 (S.D.N.Y. 2007).

Key Employee Retention Plans

One of the most controversial changes made to the Bankruptcy Code by BAPCPA was the addition of section 503(c), which significantly restricts the circumstances under which a DIP may implement programs designed to encourage key employees to continue working for the company during its stay in bankruptcy. In substance, new section 503(c) provides that a debtor may not agree to pay any form of compensation to a corporate insider for the purpose of inducing the insider to continue working for the debtor, unless the court finds that the compensation is essential to retention because the insider has a bona fide job offer elsewhere at the same or a greater rate of compensation, the services provided by the insider are essential to the survival of the debtor's business, and the compensation does not exceed certain amounts specified in the statute. The statute also severely limits severance payments to insiders of a debtor. Given the historical prevalence of "key employee retention plans" in large chapter 11 cases, the new rules were bound to invite challenges in the courts concerning the scope of their limitations.

Several noteworthy rulings were handed down in 2007 concerning section 503(c), including In re Nellson Nutraceutical, Inc., 369 B.R. 787 (Bankr. D. Del. 2007), in which the bankruptcy court held that a modification made by DIPs to their employee incentive plan for a prior year, which provided for payment of bonuses despite the debtors' failure to achieve the lowest threshold for bonuses under the original plan, had the primary purpose of motivating employees' performance, even though it had some retentive effect, and therefore the plan payments were not restricted or precluded by section 503(c). In In re Global Home Products, LLC, 369 B.R. 778 (Bankr. D. Del. 2007), the court ruled that management and sales bonus plans proposed by the DIPs were performance incentive, not retention, plans and therefore were not subject to review under section 503(c).

Venue of a Bankruptcy Case

One of the most significant considerations in a prospective chapter 11 debtor's strategic prebankruptcy planning is the most favorable venue for the bankruptcy filing. Given varying interpretations of certain important legal issues in the bankruptcy courts (e.g., the ability to pay the claims of "critical" vendors at the inception of a chapter 11 case, to include nondebtor releases in a chapter 11 plan, or to reject collective bargaining agreements) and the reputation, deserved or otherwise, that certain courts or judges may be more "debtor-friendly" than others, choice of venue (if a choice exists) can have a marked impact on the progress and outcome of a chapter 11 case.

Developments during 2007 suggest that bankruptcy courts may be casting a more critical eye on a chapter 11 debtor's chosen venue, particularly if the nexus between the venue and the debtor's business, assets, and creditors is no more than tenuous. For example, in In re Malden Mills Industries, Inc., 361 B.R. 1 (Bankr. D. Mass. 2007), the debtor, a Massachusetts-based manufacturer of Polartec fleece blankets, filed for chapter 11 protection in Delaware for the purpose of effectuating a sale of substantially all of its assets one day after a Massachusetts bankruptcy court entered an order closing a previous chapter 11 case filed in 2001, based upon representations that the company was merely trying to tie up loose ends. A creditor trust appointed in the previous chapter 11 bankruptcy case, claiming it had been misled into agreeing to the closure, moved to vacate the final decree and to transfer venue of the new case to Massachusetts, where substantially all of the debtor's operations, assets, employees, managers, and creditors were located. The Massachusetts bankruptcy court granted both requests, making clear that it felt deceived by conduct it obviously considered duplicitous and bordering on sanctionable.

The Sixth Circuit also addressed the chapter 11 venue rules in 2007, ruling in Thompson v. Greenwood, 507 F.3d 416 (6th Cir. 2007), that a bankruptcy court does not have the discretion to retain an improperly venued bankruptcy case if a timely objection is interposed by a party-in-interest.

Settlements

"Give-ups" by senior classes of creditors to achieve confirmation of a plan have become an increasingly common feature of the chapter 11 process, as stakeholders strive to avoid disputes that can prolong the bankruptcy case and drain estate assets by driving up administrative costs. Under certain circumstances, however, senior-class "gifting" or "carve-outs" from senior-class recoveries may violate a well-established bankruptcy principle commonly referred to as the "absolute priority rule," a maxim predating the enactment of the Bankruptcy Code that established a strict hierarchy of payment among claims of differing priorities. The rule's continued application under the current statutory scheme has been a magnet for controversy.

Most of the court rulings handed down recently concerning this issue have examined the rule's application to the terms of a proposed chapter 11 plan that provides for the distribution of value to junior creditors without paying senior creditors in...