In December 2020, Burford Senior Vice President, Elizabeth Fisher and Director, Connor Murphy directed questions concerning insolvency trends to a respected group of experts in contentious insolvency and restructuring. Their perspectives are excerpted and gathered below.
How have recent decisions on avoidance actions and the evolution of the law around the 11 U.S.C. 546(e) bankruptcy safe harbor affected the chances of creditor recovery?
James Vincequerra: In light of the US Supreme Court's refusal or denial of cert for the Tribunes II bankruptcy case coming out of the Second Circuit, I think that the market is finally learning the parameters of the Supreme Court decision in the Merit[1] case and the implications for large leveraged buy-out (LBO) situations and other similar transactions involving financial institutions that could result in a fraudulent conveyance action. I think many of those transactions will be structured to fall within the new parameters of 546(e). After Merit, everyone understood that the 546(e) safe harbor does not protect transfers against a potential fraudulent conveyance argument where the financial institution is neither the transferor nor the transferee. What Tribune II in the Second Circuit set out for us was that if you structure your transaction with your qualifying financial institution properly, you the transferor or transferee can be deemed a customer of that financial institution and be brought within the ambit of the safe harbor. I think for the larger potential fraudulent conveyance action in the LBO space, we are going to see those transactions structured more carefully to fall within the Tribune fact pattern. The transferor uses the financial institution as an agent, and at least in the Second Circuit that brings the transaction under the ambit of 546(e). Less sophisticated parties or smaller transactions may not get the benefit of that advice and there will be transactions being done outside the 546(e) safe harbor, but the reasoning behind the Tribune II decision is likely going to inform a lot of LBO structuring activity moving forward. Which should show us a diminution in the anticipated creditor recoveries where 546(e) is implicated.
Stephanie Wickouski: The Second Circuit’s broad interpretation of the safe harbor defense has curtailed creditors’ ability to clawback payments and other transfers made in the context of LBOs and mergers. A recent example is Nine West, in which the United States District Court for the Southern District of New York dismissed the trustee’s suit against dozens of shareholders who received redemption payments in connection with the Jones Group LBO. The Court dismissed the trustee’s state law claims as well, finding those claims were also precluded by the safe harbor.
The Nine West trustee, in light of the Second Circuit's Tribune case, had tried to avoid the Southern District of New York as a venue by commencing the cases elsewhere, but the cases ultimately ended up in the SDNY.
What surprises me is that litigation continues to be waged by some litigation trustees, in spite of legal barriers to recovery. I suspect that the trustees do this because there is always the chance that defendants will simply settle to avoid litigation expense or the possibility that the Second Circuit might revisit its prior decisions or be overturned by the Supreme Court. Most of us believe that a change in the Second Circuit law on the safe harbor is extremely unlikely.
Kevin Carey: This is a fascinating legal issue—a bit intricate and one I have a long history with it. Tribune was my case when I was sitting on the bench in Delaware, and the case that made it to the Supreme Court in Merit originated out of another case that I had while I was on the bench. This came from the Seventh Circuit to the Supreme Court because the confirmation liquidating trustee did not want to bring a lawsuit concerning the safe harbor issue in the Third Circuit because the Third Circuit had already issued an opinion giving a broad reading to the safe harbor in 546(e). The litigation trustee went to the Seventh, which had not yet ruled on the issue, in hopes of having a better shot and it made it to the Supreme Court, and then we have Merrit Management, which said conduits cannot be tagged with liability.
In Tribune, during Chapter 11, when the debtor said it was not going to pursue state law constructive fraudulent transfer claims, creditors who otherwise under state law would have had the right to bring them came in and wanted relief from the state and wanted me to rule that they had the right to bring them. I did not feel that that ruling was necessary to get the company to give a confirmation of a plan. So I said, “Look I’ll give you relief from the state to the extent you need it, but I will take no position on whether you have the right to bring it.” They ended up in multi-district litigation in federal court in the Southern District of New York and that went up and down the appellate chain. In the meantime, the Supreme Court decided Merit Management, yet the Second Circuit said there is no standing to bring such a claim. In any event, federal law preempts state law—many saw this decision as the Second Circuit trying to get away around the Supreme Court decision of Merit Management.
What’s happened since then: There has been a petition for certiorari filed; the Supreme Court has asked the Solicitor General to weigh in; and there is a view the Second Circuit decision is out of line with what Supreme Court held in Merit Management—but that remains to be seen.
Legal finance affects the insolvency landscape only positively. With the increased liquidity[…], entities in distress have more flexibility to do the things that they otherwise would not be able to do. James Vincequerra
One effect it may have is that other individuals who are federal receivers may choose to stay out of the Second Circuit when bring a receivership action if they can because there is now an anomalous situation in which the claims may be good or not good depending on whether you are in a bankruptcy proceeding or not. I think many people are hoping the Supreme Court will pick up the case and address what the Second Circuit did in Tribune.
The Economist estimates that the current economic crisis will expose a decade's worth of corporate fraud. Where an insolvent company has clear claims as against its directors, but the de jure directors have little visible assets, how can insolvency practitioners recover value for creditors?
Geoff Carton-Kelly: It is rare that the true asset position of potential targets such as directors would be clear at the commencement of a case. Using investigators and deploying other search and data analytics can throw up hidden assets for the purposes of securing value in the event of a successful claim. Some directors or boards might have D&O cover, which should be invoked immediately upon appointment and extended if necessary.
The various antecedent provisions within the insolvency legislation also allow a look back to previous transactions and behavior that might give rise to claims against third parties, including recipients of assets at undervalue and preferences and, increasingly, potential claims against advisors such as auditors and even banks under recent reported cases.
Stephanie Wickouski: Cases brought against directors and officers who lack recoverable assets can be settled for insurance coverage. As a practical matter, these cases do not go to trial for numerous reasons, including the risk of triggering a policy exclusion upon a finding of fraud.
Most cases are brought so they can be settled, not tried. Defendants always have more resources to settle a case than what is on their balance sheet. No defendant wants to be the subject of judgment enforcement.
James Vincequerra: I've run into this issue in years past and the most straightforward answer is the D&O insurance. Any practitioner who’s been confronted with this issue is going to know that in the absence of a bankruptcy filing, you will often in D&O claims run into the typical problem of Insured v. Insured exceptions to coverage in D&O policies. Outside a bankruptcy scenario, the workaround to those Insured vs Insured exceptions in D&O policies is that it does not cover in most cases the scenario where the claiming party is a trustee in the bankruptcy or a creditors committee in the bankruptcy case. If there are substantial D&O recoveries that have significant D&O insurance coverage, we will see a potential trend there in filings.
Kevin Carey: For many years because of the over-leveraging of companies, the only source of recovery for unsecured creditors has been D&O claims and, of course, you look for insurance coverage for that. If there is insurance coverage and you have good D&O claims and you either get a judgment or you settle, there is something to recover for the unsecured creditors. If there is no insurance, there may be no recovery for creditors—and that’s a problem.
To the corporate fraud issue, there is always fraud to be found. Will the current economic crisis be the cause of the fraud? I’m not so sure, except when you look at the pandemic overlay and government relief. Any time you have a massive government relief program of the magnitude the government has enacted in the US, you are bound to find fraud in the implementation and use of the loans and other relief that has been granted. For that reason, I would not be surprised if there was a lot of fraud. Does that fall on directors and officers? Perhaps. But again, it will be a question of whether or not there is insurance coverage that will determine if there may be value available for creditors.
How will the increased availability of legal finance capital and new products such as monetization help distressed companies or insolvency practitioners recover value for creditors in the coming months?
James Vincequerra: Legal finance affects the insolvency landscape only positively. With the increased liquidity that comes from having Burford out there and making its financing available, entities in distress—whether they are in bankruptcy or not—have more flexibility to do the things that they otherwise would not be able to do. And with that flexibility will likely come a larger appetite for risk in terms of taking actions to have more substantial recoveries for their creditors. Under those circumstances, I would imagine that the increased availability of legal finance capital should most certainly lead to greater returns for creditors and distressed entities.
Geoff Carton-Kelly: There are more products, more funders and a lot more innovation in the market now which is a good thing for practitioners. For instance, many are looking to buy claims—not just fund them. However, we expect there to be a lag in the commencement of claims in insolvencies arising from this period.
It will take a while, but I think we will be looking back on 2020 and perhaps the early part of 2021 for many years to come in relation to the behavior of directors. It is certainly true to say that the increasing range of facilities available at increasingly competitive rates will make it easier for cases with no obvious assets to be taken on in the interests of creditors by insolvency practitioners. Not all insolvency practitioners like taking on contingent work nor indeed bringing proceedings but there are plenty of us out there who are willing and able to do so and to work alongside lawyers and counsel on the same basis for the ultimate benefit of the creditor constituency.
Kevin Carey: Litigation financing is a practice and industry that has grown rapidly over the last five to ten years. It’s a good thing for liquidation or litigation trustees that are post-confirmation entities. It will allow them to pursue claims that have merit where there is not much cash. We are going to see more and more of it because it is the only way, as a practical matter, value can be extracted: Contingency plaintiff’s firms often will not take cases unless they have that kind of support.
With respect to monetization, I think of that more as distressed debt trading—trading on the secondary market—which has been very active for many years. It is a way of providing liquidity to creditors or companies who might not otherwise have it available. To the extent there are now direct distressed debt lenders, those loans come at high rate of interest, high cost and other constraints on the company. But again, when there are people with money available and traditional lenders or sources are unavailable to a company, they will take advantage of that. At the end of the day, that might be something you could question directors and officers about approving such arrangements, because some of them can be expensive and one-sided. But if a company is in distress and running out of liquidity, sometimes the choices are limited.
Stephanie Wickouski: There is no question that legal financing is bringing about a dramatic change in creditor recovery. Going forward, litigation financing may be the single most important factor in recovering value for creditors. Many companies are extremely over-leveraged, making a recovery to anyone other than that most senior tranche of creditors either non-existent or insufficient. Those out-of-the-money creditors will have to look beyond the enterprise value and pursue litigation in order to get any recovery.
As suggested by The Economist, systematic schemes to remove value from creditor groups (i.e., corporate fraud) will be exposed in the next round of Chapter 11 cases. Legal finance will provide the means for many of these defrauded groups to pursue recoveries.
[1] Merit Management Group, L.P. v. FTI Consulting, Inc. (“Merit”).
Participants
The Honorable Kevin Carey (Ret.) is a partner at Hogan Lovells in Philadelphia. Judge Carey joined the firm following his time on the U.S. Bankruptcy Court, District of Delaware, where he earned a reputation as one of the nation's top bankruptcy judges. He is a fellow of the American College of Bankruptcy, sits on the Executive Committee of the Board of Directors of the American Bankruptcy Institute, and serves as Vice President of Membership.
Geoff Carton-Kelly is a partner and Licensed Insolvency Practitioner at FRP in London. He has more than 35 years’ experience, and has been taking appointments since 1998. More recently his primary focus has been on international cases, real estate, contentious insolvency and charities. He advises boards and stakeholders, claimants, and government agencies on a range of contentious insolvency and restructuring matters.
James Vincequerra is a partner at Alston & Bird's Financial Restructuring & Reorganization Group. His primary practice is representing businesses in a variety of commercial transactions and matters. He has significant experience representing debtors, lenders, and other creditors, committees, bondholders, and asset acquirers (in and out of court) in high-stakes matters across industries, including finance, retail, education, real estate, hospitality, new media, e-commerce, and telecommunications.
Stephanie Wickouski is a partner at Locke Lord LLP in New York in the Bankruptcy, Insolvency and Restructuring practice. With more than 35 years of experience handling complex reorganization cases throughout the country, Stephanie has served as lead bankruptcy counsel in multiple high-profile cases. She is the author of three books: Indenture Trustee Bankruptcy Powers & Duties, an essential guide to the legal role of bond trustee, Bankruptcy Crimes, an authoritative resource on bankruptcy fraud, and her most recent book, Mentor X – The Life-Changing Power of Extraordinary Mentors.
