SPRING.2006
Supreme Court Holds Preference Actions Against
States Do Not Violate Sovereign Immunity
Central Virginia Community College v. Katz
IN THIS ISSUE
1 Supreme Court Holds Preference
Actions Against States Do Not
Violate Sovereign Immunity
6 Defining the Limits of the Newly
Enacted Disclosure Requirements
for Creditors’ Committees
10 Fifth Circuit Adopts the Minority
“Actual” Approach; Termination
Based on Ipso Facto Clause
Requires Actual Assignment
14 Recommendations and Conclusions
of Examiner’s Report Held
Admissible as Expert Opinion
FOCUS Stories
4 Shearman & Sterling Advises on
Dana DIP Financing
11 Shearman & Sterling Involved
in Claims Against Bankrupt
Mortgage Originator
15 Shearman & Sterling Advises
Oneida on Its Reorganization
The sovereign immunity granted to States under the Eleventh
Amendment of the US Constitution limits the power of federal courts
to entertain suits by individual citizens against States absent the
States’ consent or a valid congressional abrogation of State immunity.
In order to abrogate States’ sovereign immunity, Congress must
“unequivocally express its intent to abrogate the immunity” and must
act “pursuant to a valid exercise of power.” 1 In recent years, the
Supreme Court has held that, even where Congress acted with the
unequivocally express intent to abrogate sovereign immunity, such
immunity persisted because the Constitution did not grant Congress
the power to abrogate sovereign immunity. These rulings called into
question the continuing validity of section 106 of the Bankruptcy Code,
which expressly limits the sovereign immunity of governmental units
with respect to various bankruptcy matters.
In Central Virginia Community College v. Katz,2 a 5-4 majority of the United
States Supreme Court held that a bankruptcy trustee’s proceeding to
recover a debtor’s alleged preferential prepetition transfers to State
agencies was not barred by the doctrine of sovereign immunity. The Court
found that when the States rati>ed Article I, § 8, cl. 4 of the Constitution
(the Bankruptcy Clause), which grants Congress the power to enact
“uniform Laws on the subject of Bankruptcies,”3 they waived sovereign
continued on page 2
1 Green v. Mansour, 474 US 64, 68 (1985).
2 126 S. Ct. 990 (2006).
3 US Const. art. I, § 8, cl. 4 (emphasis added).
In Central Virginia
Community College v. Katz,
a 5-4 majority of the
United States Supreme
Court held that a
bankruptcy trustee’s
proceeding to recover
a debtor’s alleged
preferential prepetition
transfers to state
agencies was not barred
by the doctrine of
sovereign immunity.
Sovereign Immunity | continued from page 1
immunity as to matters within the scope of the Bankruptcy Clause. Given
this interpretation of the Bankruptcy Clause, the Court found it unnecessary
to address the question on which it had granted certiorari: whether section
106(a) of the Bankruptcy Code is a valid abrogation of States’ sovereign
immunity. Although the Court suggested in a footnote that not all statutes
bearing a “bankruptcy” label “could properly impinge upon state sovereign
immunity”4 and despite a vigorous dissent which found the majority’s
opinion di;cult to reconcile with the Court’s prior pronouncements
regarding the relationship between the bankruptcy laws and sovereign
immunity, Katz reasonably can be read to recognize a broad exception to
States’ sovereign immunity for matters relating to bankruptcy.
SOVEREIGN IMMUNITY UNDER SEMINOLE TRIBE AND HOOD
The Court’s evolving views regarding States’ sovereign immunity and its
role in bankruptcy cases have been indicated in a series of cases over the
past two decades. Two of these cases were discussed by both the majority
and the dissent as having particular relevance to the Court’s decision
in Katz: Seminole Tribe v. Florida 5 and Tennessee Student Assistance
Corporation v. Hood.6
In Seminole Tribe, the Court considered whether Article I of the
Constitution – speci>cally, the Indian Commerce Clause – authorized
Congress to pass legislation that abrogated States’ sovereign immunity.
The Seminole Tribe had sued the State of Florida in federal court, alleging
violations of the Indian Gaming Regulatory Act (IGRA), a federal statute.
The IGRA required States to negotiate with Indian tribes to reach agreements permitting the tribes to engage in gaming activities, and expressly
allowed the tribes to sue the States in federal court if the States failed to
negotiate in good faith. Florida moved to dismiss the Seminole Tribe’s
action on the basis of sovereign immunity. In a 5-4 decision, the Court
held that, although Congress had intended by enacting the IGRA to
abrogate States’ sovereign immunity, Article I of the Constitution did not
provide the basis for a congressional power to do so. In so holding, the
Court reversed an earlier plurality decision that had found such a power in
the Commerce Clause of Article I.7
A footnote in Seminole Tribe noted that “it has not been widely thought
that the federal . . . bankruptcy . . . statutes abrogated the States’ sovereign
immunity.”8 Seminole Tribe thus cast doubt on the validity of section 106(a)
of the Bankruptcy Code, in which Congress expressly provided that States’
sovereign immunity was abrogated with respect to many sections of the
Bankruptcy Code, including those relating to the recovery of preferential
transfers. 9 Lower courts’ uncertainty as to the enforceability of such
provisions against States led to con?icting decisions on the issue in the
various circuits. In 2003, the Court granted certiorari in Hood in order to
address the validity of section 106(a) and resolve this con?ict.
4 126 S. Ct. at 1005 n.15.
5 517 US 44 (1996).
6 541 US 440 (2003).
7 517 US at 94 (reversing Pennsylvania v. Union Gas Co., 491 US 1 (1989)).
8 Id. at 72 n.16.
9 Id. at 90.
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In Hood, the Respondent, a chapter 7 debtor, commenced an adversary
proceeding seeking an “undue hardship” discharge of the outstanding
balance on student loans that were guaranteed by the Tennessee Student
Assistance Corporation (TSAC), a State entity. TSAC moved to dismiss on
the basis of sovereign immunity. The bankruptcy court and bankruptcy
appellate panel denied the motion, and the Sixth Circuit a;rmed, holding
that, by enacting section 106(a) of the Bankruptcy Code, Congress had
abrogated States’ sovereign immunity in bankruptcy cases, and that the
Bankruptcy Clause authorized Congress to do so.
The Supreme Court a;rmed without reaching the section 106(a) issue,
holding that the discharge sought in Hood did not implicate the State’s
Eleventh Amendment immunity. The Court based its decision on the
nature of bankruptcy jurisdiction as primarily in rem rather than in personam
in that it focuses on the debtor and the estate rather than on the creditors.
The Court found that the in rem analysis applied notwithstanding that the
procedure required for the student loan discharge involved the service of a
complaint on the State. “A debtor does not seek damages or a;rmative
relief from a State or subject an unwilling State to a coercive judicial
process by seeking to discharge his debts,” the Court stated, noting that
“[t]his case is unlike an adversary proceeding by a bankruptcy trustee
seeking to recover property in the State’s hands on the grounds that the
transfer was a voidable preference. Even if this court were to hold that
Congress lacked the ability to abrogate state sovereign immunity under
the Bankruptcy Clause, the Bankruptcy Court would still have authority to
make the undue hardship determination Hood seeks.”10
T H E M A J O R I T Y O P I N I O N I N K AT Z
The Petitioners in Katz were several educational institutions in Virginia that
were deemed arms of the State and thus entitled to sovereign immunity.
Wallace Bookstores, the debtor, had engaged in business with the
Petitioners before it >led for relief under chapter 11 of the Bankruptcy
Code. Respondent Bernard Katz was the court-appointed liquidating
trustee for the debtor. In that capacity, the Respondent commenced an
adversary proceeding in the bankruptcy court pursuant to sections 547(b)
and 550(a) of the Bankruptcy Code in order to avoid and recover alleged
preferential transfers made by the debtor to the Petitioners prior to bankruptcy.
The Petitioners moved to dismiss on the basis of sovereign immunity.
The United States Bankruptcy Court for the Eastern District of Kentucky
denied the motion to dismiss. The District Court and the Sixth Circuit
a;rmed, based on the Sixth Circuit’s holding in Hood, that section 106(a)
of the Bankruptcy Code abrogated States’ sovereign immunity in
bankruptcy cases. The Supreme Court granted certiorari to consider the
question it had left open in Hood: whether Congress’ attempt to abrogate
State sovereign immunity in section 106(a) is valid.
continued on page 4
10 541 US at 441-42.
| 3 |
The Court based its
conclusion on the history
of and reasons for the
Bankruptcy Clause as well
as its characterization
of avoidance actions
as “ancillary to”
the bankruptcy court’s
in rem jurisdiction.
Sovereign Immunity | continued from page 3
As in Hood, however, the Supreme Court did not reach the issue of
abrogation pursuant to section 106(a) of the Bankruptcy Code. Instead,
the Court held that the States, in ratifying the Bankruptcy Clause of
Article I of the Constitution, had consented to suits within the scope of
that clause. The Court based its conclusion on the history of and reasons
for the Bankruptcy Clause as well as its characterization of avoidance
actions as “ancillary to” the bankruptcy court’s in rem jurisdiction.11
The Court >rst considered that, at the time the Constitution was drafted,
each State had its own laws governing the discharge of debts and often
States did not acknowledge one another’s orders. Because the purpose
of the early bankruptcy laws was to ensure the payment of debts, the
consequences of non-recognition could be dire, including the debtor’s
imprisonment in the second State until the debt was paid. To address
these issues, the framers authorized Congress under the Bankruptcy
Clause to make “uniform laws on the subject of bankruptcies.” 12 The
Court noted that the Article I powers were rati>ed by all States without
objection at a time when concern for State sovereign immunity was high,
and inferred from this fact, as well as from early bankruptcy legislation
that provided for orders requiring States to discharge debtors from prison,
the States’ agreement not to assert sovereign immunity as a defense in
bankruptcy matters. Although the Court acknowledged that “statements
in [Seminole Tribe] re?ect an assumption that that case’s holding [that
Article I did not empower Congress to abrogate sovereign immunity]
would apply to the Clause, careful study and re?ection convince this Court
that that assumption was erroneous.”13
11 126 S. Ct. at 1001.
12 Id. at 1007.
13 Id. at 996.
Shearman & Sterling Advises on Dana DIP Financing
Shearman & Sterling is representing Citicorp North America, Inc., as Administrative Agent, and the initial lenders in
connection with the $1.45 billion debtor-in-possession credit facility for Dana Corporation. Dana is a leading supplier
of components for original equipment manufacturers and service customers in the light, commercial and off-highway
vehicle markets, and filed for chapter 11 protection in the Bankruptcy Court in the Southern District of New York on
March 3, 2006.
The credit facility, which was negotiated and documented on an expedited basis in light of Dana’s deteriorating
liquidity position, provided for the refinancing of Dana’s existing receivables program and approximately $500 million
in existing secured debt. The credit facility’s structure, together with the scope of security interests and protections
provided to lenders in connection with debtor-in-possession financings, permitted Dana to obtain a lower blended
interest rate than was applicable to its existing secured debt. The credit facility was approved by the Bankruptcy
Court on a final basis on March 29, 2006.
Over the past six months, Shearman & Sterling has represented chapter 11 debtors and lenders in connection with
debtor-in-possession credit facilities in the aggregate amount of approximately $4.5 billion.
S H E A R M A N & S T E R L I N G | B A N K R U P T C Y & R E O R G A N I Z AT I O N F O C U S | 4
Although Katz, like Hood,
leaves open the question
whether section 106(a)
is a valid exercise of
congressional power, Katz
may render that question
academic – at least
with respect to avoidance
actions – since the waiver
of sovereign immunity
is deemed to derive from
the Bankruptcy Clause
and not section 106(a).
The Katz Court also cited Hood as providing support for its decision,
notwithstanding its statement in Hood distinguishing the dischargeability
of debts at issue in that case from avoidance and recovery actions. The
Court reasoned that, because bankruptcy courts historically have had the
power to issue ancillary orders to enforce in rem adjudications, it was not
necessary that particular powers under the Bankruptcy Code >t squarely
within the Court’s in rem jurisdiction. The Court found that the drafters
were familiar with bankruptcy actions to avoid preferential transfers and
to recover transferred property and therefore implicitly intended to
include such actions within the laws authorized by the Bankruptcy Clause.
T H E K AT Z D I S S E N T
Four justices dissented, arguing that the historical record did not indicate
that States agreed to a waiver of sovereign immunity simply because the
purpose of the Bankruptcy Clause was to provide uniformity. That goal,
they argued, could be achieved with or without suits against States by
private parties. The dissent also charged that the majority opinion overruled, sub silentio, prior rulings of the Court that preference actions do
implicate sovereign immunity and that, at a minimum, clear legislative
action would be required to overcome that immunity.14 The dissent noted
that, under the majority’s analysis, there need not be any legislative action
by Congress in order to abrogate sovereign immunity in bankruptcy
because the Bankruptcy Clause itself manifests the consent of the States
to be sued. Finally, the dissent argued that the avoidance of preferential
transfers in an adversary proceeding falls outside any possible in rem
exception to sovereign immunity – an exception that the dissent questioned
in any event – because such actions seek to recover a sum of money, not
a particular res to which in rem jurisdiction could attach.15 The dissent
found the majority’s attempt to characterize such proceedings as in rem to
be “unconvincing.”16
A N A LY S I S
Although Katz, like Hood, leaves open the question whether section 106(a)
is a valid exercise of congressional power, Katz may render that question
academic – at least with respect to avoidance actions – since the waiver of
sovereign immunity is deemed to derive from the Bankruptcy Clause and
not section 106(a). The Court indicated, however, that there may be some
actions to which this waiver does not apply; thus, a decision on section
106(a) may at some stage be unavoidable in order to clarify whether any
aspect of States’ sovereign immunity that was not waived under the
Bankruptcy Clause was abrogated under section 106(a). Given the strong
dissent in Katz and the change in the makeup of the Court since it was
decided, the outcome and reasoning of such a future case may well di=er
from that of the Katz majority.
14 Id. at 1008.
15 Id. at 1013.
16 Id.
| 5 |
Defining the Limits of the
Newly Enacted Disclosure
Requirements for
Creditors’ Committees
BACKGROUND
Section 1102(b)(3) of the Bankruptcy Code,1 newly enacted as part of the
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (the
“Act”), requires creditors’ committees appointed in cases commenced on
or after October 17, 2005 to (i) provide access to information for creditors
who hold claims of the kind represented by that committee but are not
committee members and (ii) solicit and receive comments from such
creditors. As noted in our earlier Client Publication, “Impact of the 2005
In re Refco, Inc. Bankruptcy Amendments on Chapter 11,”2 the Act is silent as to speci>c
mechanisms committees must adopt to meet both the new information
dissemination requirement, especially when dealing with potential
dissemination of sensitive or con>dential information, and the new
requirement to solicit and receive comments. The >rst of these two open
issues was addressed in a lengthy memorandum opinion in the recent
In re Refco, Inc.3 case.
Given the importance
of the Southern District of
New York as a venue
for major chapter 11 cases
and the detailed analysis
of the opinion, the Refco
procedures establish
a framework that courts
may follow in future
chapter 11 cases.
Recognizing the lack of statutory guidance in the newly enacted section
1102(b)(3), it is perhaps not surprising that, just three days after its
appointment, the O;cial Committee of Unsecured Creditors (the
“Creditors’ Committee”) in In re Refco, Inc. sought immediate and
retroactive relief clarifying the extent of its obligations under section
1102(b)(3). Judge Robert Drain of the United States Bankruptcy Court for
the Southern District of New York, in the >rst reported opinion to address
section 1102(b)(3), approved an order establishing procedures governing
the manner and extent of the disclosure required by section 1102(b)(3).
Given the importance of the Southern District of New York as a venue for
major chapter 11 cases and the detailed analysis of the opinion, the Refco
procedures establish a framework that courts may follow in future
chapter 11 cases.
COURT’S DECISION
Preliminarily, the Court noted that it was providing guidance to the
Creditors’ Committee via a “comfort order” and that “as the law develops,
the need for comfort orders should end.”4
Turning to section 1102(b)(3)(A), the Court determined that the Creditors’
Committee’s obligation to disclose information under that section
was not absolute and had to be interpreted in light of countervailing
considerations, such as con>dentiality and privilege. Swiftly dismissing
the legislative history as failing to provide “meaningful guidance,”5 the
Court engaged in a two-pronged analysis consisting of (i) comparing
section 1102(b)(3) with analogous provisions and (ii) identifying particular
functions and duties of a committee that may require information
disclosure to be restricted.
1 11 U.S.C. § 1102(b)(3).
2 This April 19, 2005 Client Publication, as well as other past Client Publications, Focus Newsletters and published
articles, can be found online at www.shearman.com under the Bankruptcy & Reorganization Practice Group tab.
3 336 B.R. 187 (Bankr. S.D.N.Y. 2006).
4 Id. at 190.
5 Id.
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Comparison with Analogous Provisions. Finding that the facial di=erences
between section 1102(b)(3) and section 704(7) of the Bankruptcy Code,
which imposes similar obligations on trustees and debtors in possession,
were not material, the Court surveyed the case law relating to section
704(7) and observed that: (i) a trustee’s duty under section 704(7) is fairly
extensive, re?ecting the overriding duty to keep interested parties
informed; (ii) the trustee’s duty to provide information under section
704(7) is not unlimited in that a trustee may seek a protective order to
prevent the disclosure of privileged, con>dential or proprietary information;
and (iii) a trustee’s right to a protective order under section 704(7) is
informed by the trustee’s >duciary duties to the creditors and the estate.6
The Court held that each of these three principles should apply, by analogy,
to section 1102(b)(3).
The Court also cited with approval a case interpreting section 339(1) of the
Bankruptcy Act of 1898,7 which held that a committee should not have to
“‘forward all of the raw data it receives and considers,’ as if it were a virtual
information bank for its constituents.”8
Duties and Functions of an Official Creditors’ Committee and the Need to
Preserve Confidentiality and/or Privilege. The Court acknowledged that
the multiple roles of a committee, which include acting as the primary
negotiating body for a chapter 11 plan and being responsible for the
supervision and oversight of the debtor, might give rise to situations in
which full disclosure of all known information to any creditor upon
request simply would not be in the interests of the unsecured creditor
body. Such restrictions on disclosure might be necessary: (i) in the context
of plan negotiations or settlement discussions to prevent communications
between the committee and third parties and among committee members
from being curtailed improperly or to prevent harm to the debtor which
might result in a decline in the creditors’ recovery; and (ii) where the
debtor has public stock or debt, to avoid committee members’ breaching
their >duciary duties of loyalty and care to all unsecured creditors by
pro>ting from, or enabling select creditors to pro>t from, non-public
information obtained as a result of committee membership.9 Accordingly,
the Court concluded that, “maintaining the parties’ reasonable expectations
of con>dentiality . . . is often critical to a committee’s performance of its
oversight and negotiation functions, compliance with applicable securities
laws, and the proper exercise of committee members’ >duciary duties.”10
continued on page 8
6 Id. at 193.
7 Section 339(1) of the Bankruptcy Act had required committees to “report from time to time concerning the progress of
the proceeding.” See id. at 194.
8 See id. (citing In re Gilchrist Co., 410 F. Supp. 1070, 1078 (E.D. Pa. 1976)).
9 Id. at 196.
10 Id. at 197.
| 7 |
The Refco decision, while
emphasizing the need
for creditors’ committees
to comply with the
new mandate to provide
information, recognizes
the various roles of a
creditors’ committee
and the need, in certain
circumstances, for the
availability of information
to be constrained.
Creditors’ Committees | continued from page 7
Additionally, the Court observed that keeping certain information
con>dential and not disclosing it to unsecured creditors generally also
may be necessary to preserve a committee’s attorney-client privilege,
especially where a committee has been given standing to pursue a claim
on behalf of the debtor’s estate.
Balancing the Tension – the Refco Committee Information Protocol. Seeking
to resolve this tension between the Creditors’ Committee’s needs to limit
access to sensitive information, to preserve attorney-client privilege,
and to comply with securities laws, on the one hand, and the right, now
codi>ed in section 1102(b)(3), of unsecured creditors to be kept informed
of material developments in the case, on the other, the Court approved
the Committee Information Protocol (the “Protocol”) proposed by
the Creditors’ Committee. The Protocol provides that the Creditors’
Committee is not required to disclose, in the >rst instance, without
further order of the Court, information (i) that could reasonably be
determined to be con>dential and non-public or proprietary, (ii) the
disclosure of which could reasonably be determined to result in a general
waiver of the attorney-client privilege or (iii) the disclosure of which could
reasonably be determined to violate an agreement, order or law, including
applicable securities laws. 11 Any such determination as to disclosure,
however, should take account of the requesting party’s willingness to agree
to be bound by con>dentiality and/or trading constraints. The Protocol also
established a mechanism for the Court promptly to decide disputes over the
provision of such information if they are not resolved between the parties.
Proactive Measures. Finally, the Refco court not only established mechanisms
to permit the Creditors’ Committee to refuse to provide protected information
in response to individual creditors’ requests in certain circumstances, but also
imposed additional obligations on the Creditors’ Committee to provide all
non-protected information to its creditor constituents proactively. Indeed,
the Protocol expressly provides that, except with respect to con>dential,
proprietary, privileged and other protected information, the Creditors’
Committee is required to: (i) establish a website; (ii) proactively provide
speci>ed types of information on that website, including general information regarding the debtors’ chapter 11 cases, monthly committee reports
and a calendar of upcoming signi>cant events; (iii) distribute “real time”
case updates via e-mail to creditors that register for this service; and
(iv) establish and maintain a telephone number and e-mail address for
creditors to submit questions and comments.12
11 Id. at 197-98.
12 The Court acknowledged, however, that “obviously, [such measures] may not be justified in a smaller case.” Id. at 198.
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Refco attempts to
clarify the creditors’
committee’s new
statutory mandate
to disseminate
information to
its constituents.
A N A LY S I S
The Refco decision, while emphasizing the need for creditors’ committees
to comply with the new mandate to provide information, recognizes
the various roles of a creditors’ committee and the need, in certain
circumstances, for the availability of information to be constrained.
Creditors’ committees may >nd themselves battling with their own
constituents over the terms on which those constituents are entitled to
receive information. In particular, the expanded participation of the
number of investment funds in corporate reorganizations may put them
at odds with o;cial committees and debtors over restrictions on debt
trading placed on creditors that receive non-public information from the
committee. If protocols can be worked out, it is not clear whether section
1102(b)(3) will limit the willingness of certain creditors to serve on
committees because information will be available to them without
devoting the substantial time that a committee representation can require.
Creditors’ committee websites may become increasingly commonplace,
at least in larger chapter 11 cases. Creation of such websites, along
with obligations to provide information proactively and distribute
information in “real time,” may result in substantially increased costs
to the bankruptcy estates.
Refco attempts to clarify the creditors’ committee’s new statutory mandate
to disseminate information to its constituents. The decision does
not, however, address another aspect of amended section 1102(b) – the
requirement that the committee “solicit and receive comments” from
the creditors it represents. As Refco and other cases commenced after
October 17, 2005 develop, there could be a signi>cant impact on their
direction and timing if creditors, armed with the additional information
provided under section 1102(b)(3), demand greater input in the negotiation
of a plan of reorganization.
| 9 |
Fifth Circuit Adopts the Minority
“Actual” Approach; Termination
Based on Ipso Facto Clause
Requires Actual Assignment
Section 365(e) of the Bankruptcy Code invalidates ipso facto and other
bankruptcy termination clauses in executory contracts. Section 365(e)(2)(A)
provides an exception to this general rule prohibiting termination where
applicable law excuses the nondebtor party to the contract from accepting
performance from an assignee of the contract. Recently, the United States
Court of Appeals for the Fifth Circuit held, in In re Mirant Corp., 1 that a
nondebtor party to an executory contract may terminate the contract
pursuant to section 365(e)(2)(A) only where there is an assignment of the
In re Mirant Corp. contract that would be prohibited by applicable nonbankruptcy law.2 In
reaching this conclusion, the Court adopted the so-called “actual”
approach previously announced by the First Circuit, and rejected the
“hypothetical” approach followed by the Third, Fourth, Ninth and Eleventh
Circuits. 3 The latter approach would permit termination pursuant to a
contractual default provision if nonbankruptcy law would prohibit assignment
as a general principle, whether or not such an assignment would actually
occur in the particular case.
In reaching this conclusion,
the Court adopted the
so-called “actual”
approach previously
announced by the
First Circuit, and rejected
the “hypothetical”
approach followed by
the Third, Fourth, Ninth
and Eleventh Circuits.
BACKGROUND
Prior to Mirant Corp. and its a;liates >ling for chapter 11 relief, Mirant
Americas Energy Marketing L.P. (Mirant) entered into several contracts for the sale and purchase of power with the Bonneville Power
Administration (BPA), a federal power marketing agency within the
US Department of Energy (collectively, the “Agreement”).4 Under the
terms of the Agreement, BPA had an option to purchase electricity at a
>xed price, which, if unexercised, would expire on December 23, 2003.
BPA did not exercise its option prior to the commencement of Mirant’s
chapter 11 case in July 2003,5 and, as both parties later conceded, BPA
would not have exercised its option as a practical matter through the
December 23, 2003 strike date because the option price exceeded the market
price for energy during the entire period.6
The Agreement contained a default provision, commonly referred to as an
ipso facto clause, that allowed BPA to terminate the Agreement and
demand a termination payment equal to the cost of replacing the option
if Mirant >led for bankruptcy prior to the end of the option period. 7
Generally, such default clauses are unenforceable under section 365(e) of
1 Bonneville Power Admin. v. Mirant Corp. (In re Mirant Corp.), 440 F.3d 238 (5th Cir. 2006). As was noted in our Winter
2006 Focus Newsletter, Shearman & Sterling represented the Official Committee of Unsecured Creditors of Mirant
Corporation, et al., composed of creditors holding in excess of $6 billion in debt claims.
2 Id. at 247-50.
3 Id.; see also Summit Inv. & Dev. Corp. v. Lerous, 69 F.3d 608, 613 (1st Cir. 1995); In re West Elecs., Inc., 852 F.2d 79, 83
(3d Cir. 1988); RCI Tech. Corp. v. Sunterra Corp. (In re Sunterra Corp.), 361 F.3d 257 (4th Cir. 2004); Perlman v. Catapult
Entm’t, Inc. (In re Catapult Entm’t, Inc.), 165 F.3d 747, 750 (9th Cir. 1999); Jamestown v. James Cable Partners, L.P. (In
re James Cable Partners, L.P.), 27 F.3d 534, 537 (11th Cir. 1994).
4 In re Mirant Corp., 440 F.3d at 241-42.
5 Id. at 242.
6 Id.
7 Id.
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the Bankruptcy Code.8 However, section 365(e)(2)(A) provides a narrow
exception that permits enforcement of an ipso facto clause when “applicable
law” would excuse the nondebtor contract party “from accepting performance from or rendering performance to the trustee or to an assignee.”9
After the Mirant entities >led for protection under the Bankruptcy Code,
BPA, without seeking or obtaining relief from the automatic stay, terminated
the Agreement and demanded the termination payment, which it calculated
to be approximately $1,000,000.10 In response, Mirant moved in the bankruptcy court to enforce the automatic stay and for contempt, arguing that
BPA’s termination was an attempt to take property of the estate in violation
of the automatic stay.11 BPA countered that (i) the Anti-Assignment Act, 41
U.S.C.A. § 15 (which prohibits the transfer of contracts to which the
United States government is a party), blocked any assignment of the
Agreement, (ii) the Anti-Assignment Act constituted “applicable law” that
excused BPA from accepting performance of the Agreement from an
assignee of Mirant and (iii) therefore BPA was permitted, under section
365(e)(2)(A) of the Bankruptcy Code, to terminate the Agreement pursuant
to the ipso facto clause.12 Mirant had not sought to assume or assign the
Agreement in the chapter 11 case.
continued on page 12
8 11 U.S.C. § 365(e).
9 11 U.S.C. § 365(e)(2)(A); In re Mirant Corp., 440 F.3d at 246.
10 In re Mirant Corp., 440 F.3d. at 243.
11 Id. at 244.
12 Id. at 241, 244.
Shearman & Sterling Involved in
Claims Against Bankrupt Mortgage Originator
Shearman & Sterling recently obtained a jury award of $43,856,746.03 for HSA Residential Mortgage Services of
Texas, Inc. (RMST) following a three-week trial against State Bank of Long Island (SBLI). The claim arose out of
SBLI’s involvement with Island Mortgage Network, Inc., a bankrupt mortgage originator. Shearman & Sterling also
represented RMST’s parent company, American General Finance, Inc., in Island Mortgage’s bankruptcy proceedings.
The 10-member jury in the US District Court for the Eastern District of New York rendered a unanimous verdict in
favor of RMST, and the amount of the damages – the full amount of the damages RMST sought – is believed to be
one of the largest jury verdicts ever awarded in the Eastern District.
RMST, a subsidiary of American General Finance, Inc., was a mortgage warehouse lender. In 1999 and 2000,
Island Mortgage defrauded RMST and other warehouse lenders by diverting money wired by the warehouse lenders
to purchase residential mortgages around the country. In June 2002, RMST and two other warehouse lenders filed
a lawsuit alleging that SBLI aided and abetted the fraud of Island Mortgage. RMST’s two co-plaintiffs settled their
claims against SBLI just before the trial began.
| 11 |
The Fifth Circuit noted the
split in the circuits between
the “hypothetical” and
“actual” interpretations of
section 365(e)(2)(A)’s
reference to “applicable
law” and characterized
the issue as one of
first impression in the
Fifth Circuit.
Minority “Actual” Approach | continued from page 11
The bankruptcy court ruled in favor of the debtor and held that BPA’s
termination violated the automatic stay. 13 Although BPA subsequently
moved to modify the stay, the bankruptcy court denied the motion for
failure to demonstrate “cause” for relief, >nding that BPA would su=er no
harm by continued enforcement of the stay. BPA appealed both orders
and the district court a;rmed.14
COURT’S DECISION
On appeal, the Fifth Circuit considered three issues: (i) whether the
Anti-Assignment Act was an “applicable law” that would trigger section
365(e)(2)(A) notwithstanding that the Agreement had not actually been
assigned by the debtor; (ii) whether modi>cation of the automatic stay
must precede any enforcement of an ipso facto clause pursuant to section
365(e)(2)(A); and (iii) whether “cause” to modify the stay had been shown
given the facts of the case.
The Fifth Circuit noted the split in the circuits between the “hypothetical”
and “actual” interpretations of section 365(e)(2)(A)’s reference to “applicable
law” and characterized the issue as one of >rst impression in the Fifth
Circuit. Under the “hypothetical” approach, the relevant inquiry is
whether a nonbankruptcy law, like the Anti-Assignment Act, makes the
contract unassignable as a matter of law, such that the nondebtor party
could refuse to accept performance from any party other than the party
with whom it contracted, including the debtor in possession. “If so, then
irrelevant is the fact that the debtor did not actually assign, intend to
assign, or attempt to assign the contract, and consequently the executory
contract is terminable by its ipso facto provision. . . .”15 BPA argued in favor
of the hypothetical approach, which, if applied, would make the ipso facto
exception of § 365(e)(2)(A) applicable because, under the Anti-Assignment
Act, the Agreement is unassignable. Conversely, Mirant argued for the
application of the “actual” approach to section 365(e), which would require
“on a case-by-case basis a showing that the nondebtor party’s contract will
actually be assigned or that the nondebtor party will in fact be asked to
accept performance from or render performance to a party – including the
trustee – other than the party with whom it originally contracted. . . . The
actual test contemplates that in a case where no assignment has taken
place, § 365(e)(2)(A)’s exception is not available and, as such, an ipso facto
clause is invalidated.”16
13 Id. at 244. The bankruptcy court also ruled that BPA, as a governmental entity, was not a forward contract merchant as
that term is defined in the Bankruptcy Code and therefore did not enjoy the exceptions to the automatic stay provided to
forward contract merchants under the Bankruptcy Code’s safe harbor provisions for derivative contracts. BPA waived its
challenges to this part of the bankruptcy court’s ruling on appeal. See id. at 244 n.11.
14 Id. at 245.
15 Id. at 248.
16 Id.
S H E A R M A N & S T E R L I N G | B A N K R U P T C Y & R E O R G A N I Z AT I O N F O C U S | 1 2
The Court found that,
because the Agreement
would not be assumed or
assigned in this case,
the Anti-Assignment Act
was not “applicable”
and the section 365(e)(2)(A)
exception permitting
enforcement of the
ipso facto clause did
not apply.
The Fifth Circuit adopted the “actual” approach and ruled that section
365(e)(2)(A) applies only in the case of an actual assignment of the executory
contract.17 The Court concluded that the “plain text of § 365(e)(2)(A) requires
an actual test for determining whether a law is ‘applicable’ under the
exception, permitting enforcement of an ipso facto clause. . . . It is axiomatic
that an applicable law must apply to a set of circumstances . . . .”18 The Court
found that, because the Agreement would not be assumed or assigned in
this case, the Anti-Assignment Act was not “applicable” and the section
365(e)(2)(A) exception permitting enforcement of the ipso facto clause did
not apply.
Second, on the issue of whether the automatic stay must be modi>ed in
order to attempt to enforce an ipso facto clause pursuant to section
365(e)(2)(A), the Court held that “the automatic stay must precede any
enforcement of an ipso facto clause ultimately permitted by a Bankruptcy
Court under § 365(e)(2)(A).” 19 The Court reasoned that “[e]ven when
§ 365(e)(2)(A) will ultimately permit a nondebtor party to terminate an
executory contract by virtue of the combined e=ect of § 365(e)(2)(A),
applicable law, and an ipso facto clause, the nondebtor party must seek
relief from the stay before the bankruptcy court.”20
Finally, the Court held that, because section 365(e)(2)(A) was not triggered
in this case, and thus BPA could not terminate the Agreement and pursue
a claim for termination damages, it had shown no “cause” that would
warrant a modi>cation of the automatic stay. Accordingly, the Fifth Circuit
a;rmed the decision of the district court.
17 Id. at 249.
18 Id. at 249-50.
19 Id. at 251.
20 Id. at 252.
| 13 |
Recommendations and
Conclusions of Examiner’s Report
Held Admissible as Expert Opinion
In a case of >rst impression, the United States Bankruptcy Court for the
District of Vermont in In re FiberMark, Inc.1 held that the recommendations and conclusions in a report by an independent examiner appointed
by a bankruptcy court could be introduced into evidence as an expert
opinion. The Court, however, denied the admission of the balance of the
report – including factual >ndings by the examiner based on documents
In re FiberMark, Inc. and out-of-court examinations – as hearsay.
BACKGROUND
In a case of first
impression, the
United States Bankruptcy
Court for the District
of Vermont in In re
FiberMark, Inc. held that
the recommendations
and conclusions in a report
by an independent
examiner appointed by a
bankruptcy court could
be introduced into evidence
as an expert opinion.
FiberMark, Inc., FiberMark North America, Inc., and FiberMark
International Holdings, Inc. (the “Debtors”) >led for chapter 11 relief on
March 31, 2004. During the case, a stalemate occurred over an issue
of post-reorganization corporate governance, leading the Debtors to
withdraw their proposed plan of reorganization. In addition, several
parties made allegations regarding the motives of the Debtors’ principals
and the members of the O;cial Committee of Unsecured Creditors (the
“Creditors’ Committee”) in connection with certain disputed transactions.
The Court, with the participation and support of all interested parties,
appointed an independent examiner (the “Examiner”) pursuant to section
1104 of the Bankruptcy Code to investigate, among other things, alleged
breaches of >duciary duty and to make recommendations based on the
Examiner’s >ndings.
The Examiner spent 11 weeks conducting his investigation and >led a
298-page report (the “Report”) at a cost to the bankruptcy estate of
$1.75 million. The Report was initially >led under seal. The Court later
entered an order unsealing the Report but requiring a cautionary legend
to be printed on each page, including a statement that several parties
disputed the accuracy of the contents of the Report and no portion of the
Report had been admitted into evidence.
The Debtors subsequently sought to introduce the Report into evidence as
an expert opinion in connection with their objection to the fee application
of the Creditors’ Committee’s >nancial advisor, Chanin Capital Partners LLC
(Chanin), arguing that the Report established that Chanin was not
disinterested and acted with an interest adverse to the bankruptcy estate,
and was therefore not entitled to compensation from the bankruptcy
estate under section 327 of the Bankruptcy Code. Chanin did not oppose
the admission of the Examiner’s recommendations and conclusions, but
objected to admission of the remainder of the Report as hearsay.
C O U R T ’ S A N A LY S I S
Section 1104(c) of the Bankruptcy Code authorizes a bankruptcy court to
appoint an independent examiner to investigate matters relating to a
debtor’s estate, “including an investigation of any allegations of fraud,
dishonesty, . . . [or] mismanagement.”2 As the Court noted, the Bankruptcy
Code is silent on the issue of how the report of such an examiner may be
used. Moreover, neither the parties nor the Court had identi>ed a case
that squarely addressed the circumstances under which an examiner’s
report may be admitted into evidence over the objection of an interested
1 In re FiberMark, Inc., __ B.R. __, 2006 WL 679903 (Bankr. D. Vt. Mar. 10, 2006).
2 11 U.S.C. § 1104(c).
S H E A R M A N & S T E R L I N G | B A N K R U P T C Y & R E O R G A N I Z AT I O N F O C U S | 1 4
While acknowledging that
party, or how an examiner’s report >ts into the rubric of the Federal Rules
of Evidence.3 Thus, the Court considered the dispute to present a case of
>rst impression.
courts routinely consider the
conclusions of examiners
The Court >rst considered the purpose for which an examiner is appointed
in a bankruptcy case. The Court noted that an examiner acts as an objective,
non-adversarial party and that the record compiled by an examiner is
intended as a source of information to assist the debtors and their creditors
and shareholders in making informed decisions regarding their substantive rights. Indeed, the examiner’s report often “serves as a road map
for parties in interest as they evaluate and pursue” such rights in the
bankruptcy case.4
and often rely on their
reports in contested
matters, the Court found
that “the decision not to
The Court found that an examiner’s report need not be admissible in
evidence to achieve these bene>ts, which ?ow directly to the interested
parties. While acknowledging that courts routinely consider the conclusions
of examiners and often rely on their reports in contested matters, the
Court found that “the decision not to admit the examiner’s written
explanation of how he or she reached the conclusions does not diminish
the value of the examiner’s conclusions.”5 In other words, “an examiner’s
report is helpful to the court in understanding facts, but is not intended to
establish evidence.”6
admit the examiner’s
written explanation of how
he or she reached the
conclusions does not
diminish the value of the
continued on page 16
examiner’s conclusions.”
3 In re FiberMark, Inc., 2006 WL 679903, at *3.
4 Id. at *4.
5 Id. at *3.
6 Id. at *4.
Shearman & Sterling Advises Oneida on Its Reorganization
Shearman & Sterling represents Oneida Ltd. and certain of its domestic direct and indirect subsidiaries in their
prenegotiated chapter 11 reorganization pending in the United States Bankruptcy Court for the Southern District of
New York. Oneida is one of the world’s largest sourcing and distribution companies for consumer and foodservice
stainless steel and silverplated flatware, as well as the largest supplier in North America of dinnerware to the
foodservice industry.
Prior to filing for chapter 11 relief, Oneida, with the assistance of Shearman & Sterling, (a) arranged for $40 million of
debtor-in-possession financing, (b) secured a commitment from Credit Suisse for $170 million of exit financing and
(c) obtained support for its restructuring from 94% of its Tranche A Lenders, holding approximately $115 million of
debt, and 100% of its Tranche B Lenders, holding approximately $100 million of debt. As part of the reorganization
process, Oneida also is seeking to terminate one or more of its defined benefit plans. Oneida’s proposed prenegotiated
plan of reorganization provides that, among other things, the then-outstanding debtor-in-possession financing and
the Tranche A Loan will be refinanced in full with proceeds from the $170 million exit facility, and the Tranche B
Lenders will be issued 100% of the equity of the reorganized Oneida.
Bankruptcy & Reorganization Focus
is intended only as a general discussion of the issues
presented. It should not be regarded as legal advice.
We would be pleased to provide additional details or
advice about specific situations if desired. For more
information on our Bankruptcy & Reorganization
practice or the topics covered in this issue,
please contact:
PARTNERS
Douglas P. Bartner | New York
+1.212.848.8190
[email protected]
Constance A. Fratianni | New York
+1.212.848.8560
[email protected]
James L. Garrity, Jr. | New York
+1.212.848.4879
[email protected]
Fredric Sosnick | New York
+1.212.848.8571
[email protected]
Andrew V. Tenzer | New York
+1.212.848.7799
[email protected]
Examiner’s Report | continued from page 15
The Court then considered the Debtors’ argument that the Report is
admissible as an expert report pursuant to Federal Rule of Evidence 706.
The Court noted that the Examiner’s status as an expert in the >eld of
bankruptcy and reorganization law, while qualifying him to testify as to
his opinion and conclusions on these subjects, “does not change the fact
that the factual portions of his report contain an abundance of statements
that are the purest sort of hearsay.”7 For example, the Report was based on
the Examiner’s review of 65,000 pages of emails and other documents, as
well as numerous out-of-court examinations of interested persons.8 The
Court found that “while Fed. R. Evid. 706 can be used to justify the
admission of the Examiner’s conclusions, that rule does not permit the
underlying rationale, or facts, of the Examiner to be introduced into
evidence.”9 The Court stated that, in order to rely on those “facts” as true,
the Debtors would have to introduce admissible evidence to prove them.10
The Court distinguished cases cited by the Debtors, stating that those
cases involved situations in which either an examiner was appointed
simply to conduct an analysis of objective issues on which experts in the
>eld of business routinely rely, rather than an analysis of disputed facts,
or the examiner’s report was not a subject of dispute.11 In reaching its
conclusion, the Court relied instead on the reasoning in Rickel &
Associates, Inc. v. Smith, 12 which held, in a di=erent context, that the
“evidence and >ndings” in an examiner’s report constitute hearsay and a
party could not rely on such a report, without more, to provide the factual
basis for its claim or defense.13
7 Id. at *5. As the Court noted, hearsay is defined in the Federal Rules of Evidence as a
Steven E. Sherman | Bay Area
+1.415.616.1260
[email protected]
statement by an out-of-court declarant that is offered in evidence to prove the truth of
the matter asserted. Fed. R. Evid. 801(c). Such evidence is generally not admissible.
Fed. R. Evid. 802.
8 In re FiberMark, Inc., 2006 WL 679903, at *5.
Clifford Atkins | London
+44.20.7655.5957
[email protected]
9 Id.
10 Id. at *5.
11 Id. at *4.
12 In re Rickel & Assocs., Inc., 272 B.R. 74, 87-88 (Bankr. S.D.N.Y. 2002).
Caroline Leeds Ruby | London
+44.20.7655.5944
[email protected]
13 Id.
COUNSEL
Marc B. Hankin | New York
+1.212.848.7577
[email protected]
Lynette C. Kelly | New York
+1.212.848.8768
[email protected]
The Court found that “while Fed. R. Evid. 706
Sandor E. Schick | Singapore
+65.6230.8901
[email protected]
conclusions, that rule does not permit the
Scott C. Shelley | New York
+1.212.848.8955
[email protected]
to be introduced into evidence.”
w w w. s h e a r m a n . c o m
can be used to justify the admission of the Examiner’s
underlying rationale, or facts, of the Examiner
Copyright © 2006 Shearman & Sterling LLP. As used herein, “Shearman & Sterling” refers to Shearman & Sterling LLP, a limited liability partnership
organized under the laws of the State of Delaware.