5th Circuit: International comity can’t save flawed bankruptcy plan

November 29, 2012

Distressed debt investors need strong stomachs. Consider the events of Wednesday afternoon, in cases in opposite corners of the country that featured big-money claims by Elliott Capital and Aurelius Capital. In New York, the 2nd Circuit Court of Appeals stepped in to save Argentina from economic catastrophe, staying a ruling by U.S. District Judge Thomas Griesa that would have required the country to cough up $1.3 billion for the hedge funds if it wanted to make good on payments to bondholders who participated in Argentina’s debt restructuring. That was a huge blow to Elliott and Aurelius, which had hoped the injunction would finally break Argentine defiance of U.S. judgments. But perhaps the pain was dulled by a ruling from the 5th Circuit in New Orleans, which affirmed U.S. Bankruptcy Judge Harlin Hale’s decision that the Mexican glassmaker Vitro can’t use the Mexican bankruptcy process to block Elliott and Aurelius from pursuing more than $1 billion in claims against Vitro subsidiaries.

The long-running Argentine debt saga is still the ultimate example of the risks of litigating for a return on defaulted bonds, but in the Vitro case, the hedge funds confronted similarly delicate foreign relations issues, since they were challenging the propriety of a Mexican court’s judgment in a matter that the Mexican government joined as an amicus. The 5th Circuit’s ruling Wednesday, as my Reuters colleague Tom Hals was the first to report, should embolden distressed-debt investors. It stands for the principle that foreign debtors can’t rely on international comity to shaft U.S. creditors, whoever those creditors might be.

Vitro’s bankruptcy plan was particularly brazen. After its revenues went into steep decline in 2008, the company went through an extremely complicated restructuring that converted its biggest creditor into an ally and several of its subsidiaries into creditors. It subsequently underwent bankruptcy in the Mexican courts. A group of noteholders led by Elliott and Aurelius opposed the reorganization plan, which left them in the hole but preserved $500 million in Vitro equity. But because the pre-bankruptcy restructuring made Vitro subsidiaries into creditors, insiders had enough votes to push the bankruptcy through the Mexican courts despite noteholders’ objections.

Vitro then sought recognition and enforcement of its Mexican bankruptcy through Chapter 15 of the federal Bankruptcy Code, a device enacted in 2005 to permit debtors to translate foreign insolvency proceedings into relief in U.S. courts. Vitro asserted that the Mexican proceeding extinguished claims by its hedge fund creditors. The hedge funds, represented principally by Dechert, set up a howl of protest, since they had previously obtained a declaratory judgment in New York State Supreme Court upholding their rights. Vitro, they argued, was improperly attempting to use Chapter 15 to stop them from proceeding with their billion-dollar claims against its subsidiaries. Judge Hale agreed. The Dallas judge ruled that the Mexican bankruptcy plan was contrary to U.S. public policy and refused to enforce it.

In Vitro’s appeal, the company’s lawyers at Thompson & Knight and Milbank, Tweed, Hadley & McCloy told a three-judge 5th Circuit panel (Judges Carol King and Jerry Smith and Senior Judge Rhesa Barksdale) that Hale had not paid sufficient deference to the concept of international comity. Chapter 15 acknowledges that foreign bankruptcies may not produce the same results as U.S. procedures. So U.S. bankruptcy courts, Vitro argued, are bound to enforce the legitimate judgments of their foreign counterparts. (Hale had specifically declined to accept claims by Elliott and Aurelius that Vitro’s Mexican bankruptcy process was corrupt.) Comity, according to Vitro, should outweigh concerns about the specifics of its plan.

The Mexican government expounded on that point in an amicus brief filed late in the U.S. appeals process byGoldstein & Russell. “A contrary result would signal to dissatisfied parties (creditors and debtors alike) that they may seize upon any deviation from U.S. bankruptcy law as a basis to challenge the enforcement of a foreign plan, and comity shall be reduced from a strong norm of international cooperation to mere rhetoric,” the Mexican brief said.

The painstaking 50-page opinion that the 5th Circuit issued Wednesday acknowledges Chapter 15’s profound interest in international comity. But the law, wrote Judge King for the panel, “does impose certain requirements and considerations that act as a brake or limitation on comity.” Much of the court’s discussion of the limits on relief available to foreign debtors through Chapter 15 is too technical to be of interest to anyone who isn’t paid by the hour to parse it. For the rest of us, suffice to say that the appeals court considered the extremely broad relief Vitro would receive through Chapter 15 — nullifying judgments against it and its subsidiaries, permanently barring pending and future enforcement actions and releasing Vitro from liability in connection with the Mexican bankruptcy — and concluded that the company could not have obtained it through a U.S. bankruptcy proceeding.

The 5th Circuit said its precedent explicitly holds that U.S. debtors can’t obtain the release of claims against non-bankruptcy subsidiaries through the Chapter 11 process. The law in other circuits is less black-and-white, the panel said, but even those circuits that permit such releases only do so in extraordinary circumstance. The same standard, the court suggested, should apply to Chapter 15 debtors. Indeed, according to the 5th Circuit, the only Chapter 15 that approved a release of claims against someone other than the debtor was a Canadian case in which the creditors supported the release. Here, by contrast, creditors other than Vitro insiders vehemently opposed it.

And besides, the 5th Circuit said, Vitro could hardly complain about a lack of international comity when Mexico’s own courts hadn’t shown deference to the New York state court judgments obtained by the hedge funds. Comity is the rule of Chapter 15, the court said, but the circumstances of the Vitro case are exceptional.

“Many of the factors that might sway us in favor of granting comity and reversing the bankruptcy court to that end are absent here,” the 5th Circuit said. “Vitro has not shown that there existed truly unusual circumstances necessitating the release. To the contrary, the evidence shows that equity retained substantial value. The creditors also did not receive a distribution close to what they were originally owed. Moreover, the affected creditors did not consent to the plan, but were grouped together into a class with insider voters who only existed by virtue of Vitro reshuffling its financial obligations between it and its subsidiaries.”

Ironically, a Mexican appeals court issued its affirmation of Vitro’s bankruptcy plan on Tuesday, the day before the 5th Circuit ruling. But that won’t help the company block actions by the hedge funds in the United States. In a press release on the U.S. appellate ruling, Vitro said its restructuring was “fully consistent with Mexican law, which has been consistently recognized and respected in the U.S. legal system.” The company said it is analyzing the 5th Circuit ruling and considering its options.

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