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Second Circuit Affirms Bankruptcy Court’s Nullification of Chapter 15 Debtor’s Sale of Claim Due to Woefully Inadequate Price

July/August 2017

In the March/April 2013 edition of the Business Restructuring Review, we reported on an opinion by the U.S. Bankruptcy Court for the Southern District of New York concluding that a chapter 15 debtor’s sale of claims against Bernard Madoff’s defunct brokerage company was not subject to review as an asset sale under section 363(b) of the Bankruptcy Code. The Court of Appeals for the Second Circuit vacated that decision in 2014 and remanded the case to the bankruptcy court, with specific instructions to subject the sale to review under section 363.

In October 2015, the bankruptcy court granted a motion by the chapter 15 debtor’s foreign representative to abandon the sale. After conducting a section 363(b) analysis, the court held that the liquidator of the debtor’s estate should be permitted either to collect on distributions made in respect of the claims or to sell them at a much higher price. After the district court affirmed that ruling on appeal, the decision was appealed to the Second Circuit. In Farnum Place, LLC v. Krys (In re Fairfield Sentry Ltd.), 2017 BL 169478 (2d Cir. May 22, 2017), the Second Circuit affirmed the decisions below.

Fairfield Sentry

Fairfield Sentry Limited ("Fairfield Sentry") was established for the purpose of investing in Bernard L. Madoff Investment Securities ("BLMIS"). Shortly after Madoff’s Ponzi scheme came to light and BLMIS collapsed, Fairfield Sentry was placed into liquidation in a British Virgin Islands ("BVI") court. On July 22, 2010, the U.S. bankruptcy court issued an order recognizing the BVI proceeding as a foreign main proceeding under chapter 15.

BLMIS was placed in liquidation in the U.S. under the Securities Investor Protection Act ("SIPA"). Fairfield Sentry filed customer claims in this proceeding. Pursuant to a settlement agreement, these claims were allowed in the amount of $230 million. In 2010, the U.S. bankruptcy court entered an order under section 1521(a)(5) of the Bankruptcy Code "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." Following a competitive auction, Fairfield Sentry’s foreign representative accepted an offer from Farnum Place, LLC ("Farnum") to purchase the claims for approximately 32 percent of their allowed amount. In December 2010, shortly after the parties signed a trade confirmation, the pool of assets available for distribution to BLMIS customers increased by approximately $7.2 billion due to a separate settlement. As a result, the prices offered for claims against BLMIS rose sharply.

By its terms, the trade confirmation was subject to: (i) approval by the BVI court; and (ii) orders of both the BVI court and the U.S. bankruptcy court approving the assignment of Fairfield Sentry’s claims. The BVI court approved the trade confirmation and the claim assignment after a three-day evidentiary hearing. Fairfield then sought approval from the U.S. bankruptcy court, which had to determine whether it was bound to review the assignment under section 363 and, if so, whether the transaction was in the best interests of Fairfield Sentry’s estate.

The Bankruptcy Court’s Decision

The bankruptcy court found in In re Fairfield Sentry Ltd., 484 B.R. 615, 617 (Bankr. S.D.N.Y. 2013), that section 363(b) was inapplicable to the assignment because the property at issue—Fairfield Sentry’s SIPA claim—was not "within the territorial jurisdiction of the United States." Pursuant to section 1520(a)(2) of the Bankruptcy Code, section 363 applies to chapter 15 debtors only when the 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 nonbankruptcy 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 court held that BVI—not the United States—was the situs of the intangible SIPA claim "under applicable nonbankruptcy law" (agreed by the parties to be the law of New York). The bankruptcy court also found that the BVI court had the paramount interest in the sale, whereas the New York court lacked any meaningful interest. Under circumstances where U.S. interests are minimal, the court reasoned, comity dictates deference to the BVI court and its judgment.

The district court affirmed the ruling in Krys v. Farnum Place, LLC (In re Fairfield Sentry Ltd.), 2013 BL 370732 (S.D.N.Y. July 3, 2013).

The Second Circuit’s Initial Ruling

In Krys v. Farnum Place, LLC (In re Fairfield Sentry Ltd.), 768 F.3d 239 (2d Cir. 2014), the Second Circuit vacated the orders below and remanded the case to the bankruptcy court.

While the Second Circuit agreed with the bankruptcy court’s determination that the "property" at issue was the SIPA claims, the court disagreed with the bankruptcy court’s finding that these claims were not "within the territorial jurisdiction of the United States." According to the Second Circuit, the bankruptcy court’s analysis of section 1520(a)(2) was incomplete because section 1502(8) deems "any property subject to attachment or garnishment that may be properly seized or garnished by an action" in a U.S. court to be "within the territory of the United States."

The SIPA claims, the Second Circuit reasoned, are subject to attachment or garnishment and may be properly seized by an action in a U.S. 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). Moreover, the court 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)).

Although Fairfield Sentry and BLMIS’s SIPA trustee do not have a contractual relationship, the Second Circuit noted, the SIPA trustee is statutorily obligated to distribute to Fairfield Sentry its pro rata share of the recovered assets. Therefore, the SIPA trustee’s location is the situs of the SIPA claims. Because the SIPA trustee is located in New York, the assignment is 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), and pursuant to section 1520(a)(2), the bankruptcy court must apply section 363 to the sale.

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 SIPA claims. According to the Second Circuit, "[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." Given the Bankruptcy Code’s plain language on the applicability of section 363, the bankruptcy court should not have deferred to the BVI court’s determination.

The Second Circuit vacated the ruling and remanded the case below. It directed the bankruptcy court to conduct the section 363 review, taking into consideration, among other things, "the increase in value of the SIPA Claim[s] between the signing of the Trade Confirmation and approval by the bankruptcy court." According to the Second Circuit, "Nothing in the language of section 363 or our case law limits the bankruptcy court’s review to the date of signing the Trade Confirmation."

The Bankruptcy Court’s Ruling on Remand

On remand, the bankruptcy court granted a motion by Fairfield Sentry’s foreign representative to abandon the sale, ruling that the liquidator of Fairfield Sentry’s estate should be permitted either to retain the claims and receive recoveries for the fund’s creditors or to sell the claims at a much higher price. See In re Fairfield Sentry Ltd., 539 B.R. 658 (Bankr. S.D.N.Y. 2015).

According to the court, the foreign representative demonstrated a sound business reason under the standard established 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 sale of the SIPA claims. If the sale were consummated, the representative would be obligated to pay Farnum in excess of $112 million in distributions in respect of the SIPA claims in exchange for Farnum’s payment of approximately $74 million. Thus, the court found that: (i) the sale price of the claims was disproportionately low in light of their increased value; and (ii) retention of the claims by the foreign representative and the receipt of distributions or sale of the claims at a much higher price was in the best interest of Fairfield Sentry’s estate.

Mindful of concerns regarding the integrity and finality of bankruptcy asset sales, the court noted that the decision whether to reopen an auction is committed to a bankruptcy court’s discretion. Exercising that discretion in this case was appropriate, the court concluded, because changed circumstances made the purchase price "woefully inadequate."

The bankruptcy court also denied Farnum’s motion for an order modifying the July 22, 2010, chapter 15 recognition order to provide that section 363 does not apply in the chapter 15 case, or alternatively, even if section 363 does apply, that section 363 review of the sale transaction is not required because, among other things, the sale was an ordinary course transaction. According to the bankruptcy court, the motion "attempts an end run around the Second Circuit’s mandate." The bankruptcy court ruled, among other things, that section 1520(a)(2) "unambiguously makes § 363 applicable to chapter 15 cases" and that, although the foreign representative’s current mandate may be to liquidate Fairfield Sentry’s assets, that activity was never Fairfield Sentry’s "normal, daily business." After the district court affirmed the bankruptcy court’s ruling on remand, Farnum appealed to the Second Circuit.

The Second Circuit’s Most Recent Ruling

A three-judge panel of the Second Circuit affirmed in a summary order. The panel rejected Farnum’s arguments that the bankruptcy court: (i) erred in disapproving the sale because its 2010 order under section 1521(a)(5) entrusted the realization of the debtor’s U.S. assets to the foreign representative; and (ii) gave insufficient weight in section 363(b) analysis to comity.

Reiterating its previous conclusion that section 1520(a)(2) mandates the application of section 363(b) to a proposed transfer of a chapter 15 debtor’s U.S. assets, the Second Circuit held that Farnum’s arguments were largely nullified by the express terms of its 2014 ruling. In that ruling, the panel explained, the Second Circuit had specifically directed the bankruptcy court to "consider as part of its section 363 review the increase in value of [the claim against BLMIS] between the signing of the [sale agreement] and approval by the bankruptcy court." The Second Circuit noted that it had also rejected the bankruptcy court’s alternative holding regarding comity. In this decision, the panel 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."

Given its previous ruling, the Second Circuit panel held that, under the "mandate rule," Farnum was foreclosed from relitigating these issues. It also denied Farnum’s request that the court reconsider its previous ruling, observing that "[w]e here identify no clear error" which would warrant consideration.

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