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Is it is or is it ain't US Property? Review of claims traded with non-US Insolvent Entity as an asset sale under section 363(b) of the US Bankruptcy Code

25 September 2020

Seven years (and a trip to the US Supreme Court) later, British Virgin Islands ("BVI") based Fairfield Sentry Limited ("Fairfield ") was in 2017 finally allowed to abandon the 2010 sale transaction ("Deal") it had entered into with Farnum Place, LLC ("Farnum") in which Farnum had agreed to purchase Fairfield’s claims (collectively, the "Claim") filed in the liquidation proceeding of Bernard L. Madoff Investment Securities LLC ("BLMIS").

See Farnum Place, LLC v. Krys (In re Fairfield Sentry Ltd.), 690 F. App’x 761 (2d Cir. 2017). Fairfield was able to terminate the Deal pursuant to its rights under section 363(b) of the US Bankruptcy Code claiming that the expected loss of approximately US$100 million on the Deal demonstrated a sound business reason to abandon the sale.

Key to this outcome was whether the Deal involved property within the territorial jurisdiction of the United States. For anyone purchasing claims from a non-US insolvent entity, it is important to be aware of the Second Circuit’s decision and figure out:

  1. Does section 363(b) of the US Bankruptcy Code apply to the non-US insolvent entity? If so, then -
  2. Are the claims being purchased "within the territorial jurisdiction of the United States"?

If the answer to each of these two questions is “yes”, then it is possible that the sale might be undone under US Bankruptcy Code section 363(b) if the debtor-seller can demonstrate a sound business reason to abandon the sale.

Why did Fairfield want to abandon the Deal?

Fairfield is a BVI investment fund that invested approximately 95% of its assets with BLMIS. When the Ponzi scheme perpetrated by Bernard Madoff was revealed during 2008, BLMIS collapsed and it was placed into liquidation by the US Bankruptcy Court for the Southern District of New York (the “Bankruptcy Court”) under the Securities Investor Protection Act (“SIPA”). In July 2009, Fairfield itself was placed into liquidation in the BVI. On July 22, 2010, the Bankruptcy Court granted a request made by Fairfield’s liquidator to recognize the BVI liquidation as a “foreign main” proceeding under Chapter 15 of the US Bankruptcy Code.

Among Fairfield’s assets in the BVI liquidation was its Claim in the BLMIS proceeding pending before the Bankruptcy Court. During the summer of 2010, Fairfield’s liquidator conducted an auction with respect to the Claim and the winning bid was made by Farnum. In December 2010, Fairfield and Farnum negotiated, documented and signed a trade confirmation setting forth the material terms and conditions of the Deal by which Fairfield would sell to Farnum the Claim (“Trade Confirmation”), which was allowed as a $230 million customer claim in the BLMIS liquidation proceedings, for the then-existing market price of approximately 32% of the face amount of the Claim. By its terms, the trade confirmation was governed by New York law and subject to the approval by both the BVI court and the Bankruptcy Court.

However, three days after the Trade Confirmation was signed by Fairfield and Farnum, the BLMIS trustee, Irving Picard, announced that he had reached a settlement with the estate of Jeffry Picower. The amount of the Picower settlement far exceeded market expectations, and the market value of BLMIS customer claims doubled overnight. As a result, Fairfield stood to lose over US$100 million on the Deal.

How did section 363(b) of the US Bankruptcy Code apply to Fairfield?

As mentioned above, Fairfield was placed into liquidation in a BVI court and Fairfield’s liquidator had obtained an order from the Bankruptcy Court recognizing the BVI proceeding as a foreign main proceeding under Chapter 15. The Bankruptcy Court’s recognition order included Bankruptcy Code section 1521(a)(5)’s authorization related to "entrusting the administration or realization of all or part of the debtor’s assets within the territorial jurisdiction of the United States to the foreign representative."

Pursuant to section 1520(a)(2) of the US Bankruptcy Code, section 363 applies to Chapter 15 debtors only when a sale or assignment involves property within the territorial jurisdiction of the United States. Section 1502(8) defines the phrase "within the territorial jurisdiction of the United States" as:

[T]angible property located within the territory of the United States and intangible property deemed under applicable non-bankruptcy law to be located within that territory, including any property subject to attachment or garnishment that may properly be seized or garnished by an action in a Federal or State court in the United States

The question was whether the Claim, as an intangible asset, met this definition and qualified as property within the territorial jurisdiction of the United States.

What happened next?

In October 2011, because Fairfield’s liquidator had failed to submit an application asking the BVI Court to approve the terms of the Deal, Farnum filed an application seeking an order compelling Fairfield’s liquidator to satisfy the terms of the Deal and the BVI court granted such request during March, 2012. A month later, Fairfield’s liquidator filed an application with the Bankruptcy Court seeking a review of the Deal under US Bankruptcy Code section 363(b) and an order disapproving it. The Bankruptcy Court denied the application, holding that a section 363 review was not warranted under US Bankruptcy Code section 1520(a)(2) because the sale of the Claim did not involve an interest of Fairfield in property located within the territorial jurisdiction of the United States. The US District Court affirmed the order of the Bankruptcy Court.

When the US District Court’s decision was appealed, the Second Circuit reversed the lower courts and remanded the matter to the Bankruptcy Court, with specific instructions to subject the Deal to review under sections 363 and 1520(a)(2). See Krys v. Farnum Place, LLC (In re Fairfield Sentry Ltd.), 768 F.3d 239 (2d Cir. 2014).

The Second Circuit did not agree with the Bankruptcy Court’s conclusion that the BVI—rather than the United States—was the proper situs of the intangible Claim "under applicable non-bankruptcy law" (the law of New York by agreement) because section 1502(8)’s definition includes "any property subject to attachment or garnishment that may be properly seized or garnished by an action in a Federal or State court in the United States". 768 F.3d at 244-245. The court held that the Claim is subject to attachment or garnishment and may be properly seized by an action in a US federal or state court because, under New York law, "any property which could be assigned or transferred’ is subject to attachment and garnishment" (citing N.Y. C.P.L.R. §§ 5201(b) and 6202). Id. Moreover, the Second Circuit explained, "[f]or attachment purposes, with respect to intangible property that has as its subject a legal obligation to perform, the situs is the location of the party from whom performance is required pursuant to the obligation" (citing In ABKCO Industries, Inc. v. Apple Films, Inc., 39 N.Y.2d 670 (N.Y. 1976) (“a contractual agreement could constitute contingent property interests attachable and assignable, and thus subject to CPLR 5201(b)”)). Id.

Because there was a statutory obligation to distribute to Fairfield its pro rata share of the recovered assets in the BLMIS liquidation, the Second Circuit ruled that the location of the BLMIS liquidation (i.e., the location of the SIPA trustee) is the situs of the Claim, i.e., New York. Id. As the Deal represents a "transfer of an interest of the debtor in property that is within the territorial jurisdiction of the United States" under section 1520(a)(2), the court concluded that the Bankruptcy Court must apply section 363 to the sale. Id.

The Second Circuit also held that the Bankruptcy Court erred in using principles of comity to defer to the BVI court’s approval of the transfer of the Claims because the Bankruptcy Code language plainly makes applicable section 363. "[T]he language of section 1520(a)(2) is plain; the bankruptcy court is required to conduct a section 363 review when the debtor seeks a transfer of an interest in property within the territorial jurisdiction of the United States." Id. at 246 (emphasis in the original). The Second Circuit also stated "[n]othing in the language of section 363 or our case law limits the bankruptcy court’s review to the date of signing the Trade Confirmation." Id. at 247.

What did the Bankruptcy Court say second time around?

On remand, the Bankruptcy Court allowed Fairfield to abandon the Deal. In re Fairfield Sentry Ltd., 539 B.R. 658 (Bankr. S.D.N.Y. 2015). The Bankruptcy Court ruled that Fairfield should be permitted either to retain the Claim or be able to sell the Claim at a much higher price as Fairfield had demonstrated a sound business reason for doing so under the standards established by the Second Circuit in Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063 (2d Cir. 1983) for seeking disapproval of the Deal as: (i) the sale price of the Claim was disproportionately low in light of its increased value; and (ii) retention of the Claim by Fairfield and the receipt of distributions from the BLMIS proceeding or a sale of the Claim at a much higher price was in the best interest of Fairfield’s estate.

The Bankruptcy Court commented that the decision whether to reopen an auction is committed to its own discretion. However, the Bankruptcy Court remarked that it was not being asked to reopen the auction, but instead to disapprove a bid where the purchase price was “woefully inadequate” in light of changed circumstances.

Also, in answer to applications by Farnum, the Bankruptcy Court ruled, among other things, that section 1520(a)(2) "unambiguously makes § 363 applicable to chapter 15 cases".

More Appeals by Farnum?

After the US District Court affirmed the Bankruptcy Court’s ruling on remand, Farnum appealed to the Second Circuit, which in 2017 affirmed the decisions of the lower courts. 690 F. App’x 761. The Second Circuit reiterated the holding from its 2014 decision that section 1520(a)(2) mandates the application of section 363(b) to a proposed transfer of a Chapter 15 debtor’s US assets. The Second Circuit remarked that its 2014 decision had specifically directed the Bankruptcy Court to "consider as part of its section 363 review the increase in value of [the Claims] between the signing of the [Deal] and approval by the bankruptcy court." The Second Circuit provided some guiding principles to aid in that task, including instructing that a bankruptcy judge determining a § 363(b) application is required to expressly find from the evidence presented at the hearing whether a good business reason exists to grant the sale request.

The Second Circuit also instructed that although comity is a "central" component of Chapter 15, section 1520(a)(2)’s requirement for section 363(b) review operates as a "brake or limitation on comity."

Farnum finally sought to appeal to the US Supreme Court seeking review of whether Chapter 15 of the Bankruptcy Code requires a US bankruptcy court to independently analyse a foreign debtor’s sale of a US asset but the certiorari petition was rejected.

Is this a problem?

It could be. If the foreign representative of a non-US insolvent debtor-seller of claims has obtained Chapter 15 recognition, then such claims (and other assets of the debtor-seller) could be deemed to be subject to US territorial jurisdiction depending upon how extensively a US bankruptcy court would apply in the Chapter 15 case substantive non-bankruptcy law to determine the location of the seller-debtor’s intangible assets. Nevertheless, the question remains whether Fairfield can be distinguished because of the existence of a condition precedent to the Deal—that it was subject to approval by both the BVI court and the US bankruptcy court. Absent such a term such approval may be unnecessary. Although this approach has not yet been tested by the courts, parties seeking to avoid the jurisdiction of the US bankruptcy court should ensure that the terms of the relevant trade confirmation or sale documents do not require approval of the transaction by the US bankruptcy court.


Author - Laura Hatfield, Partner.

This article was first published in the Claim Trading Committee September 2020 Newsletter on the American Bankruptcy Institute website.


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