American Bankruptcy Institute Update

February 10, 2005

In This Issue

Highlights

Legislation Update

Senate Bankruptcy Hearing Features Disagreements Over Causes, Process

Today’s 2 1/2-hour hearing on the new/old bankruptcy bill (S. 256) featured many familiar arguments for and against change of the bankruptcy laws, with a few new twists. Witnesses representing credit unions, community bankers and multi-family housing interests focused on consumer debtor abuse of current law, in support of the bill. Witnesses representing labor unions criticized the bill for failing to address corporate debtors who’ve engaged in pre-bankruptcy fraud or who left workers and retirees without pension plans and health benefits. Prof. Elizabeth Warren called attention to a “broken” U.S. health care system as a root cause of why Americans need bankruptcy as a social safety net. She also criticized the bill for its imbalance of provisions favoring creditors who already profit financially from high interest rates and fees, who seek to further “squeeze” honest debtors in need of a fresh start. Click here for the available witness statements.

Senate Judiciary Committee Chairman Arlen Specter (R-Pa.), noting that this was the 11th hearing on bankruptcy over the last eight years (the last Senate hearing was in 2001), announced an intention to move the bill to a markup next Thursday and thereafter to the Senate floor. However, several members of the committee, such as Sens. Richard Durbin (D-Ill.) and Russ Feingold (D-Wis.) objected that this was premature. The bill’s opponents will likely offer dozens of amendments at the committee level on issues ranging from the means test for chapter 7 eligibility to credit industry practices, the homestead exemption and more.

Other critics of the bill such as Ranking Member Sen. Patrick Leahy (D-Vt.) noted that much has changed in the national economy during the period of consideration for the bill, including corporate scandals leading to bankruptcy and the economic impact of job losses, not addressed by S. 256. Several of the bill’s sponsors, including Sens. Charles Grassley (R-Iowa) and Orrin Hatch (R-Utah) were on the Senate floor for consideration of the class-action reform legislation and thus did not participate extensively at the hearing. The Congressional Research Service has produced a summary of
S. 256
, and consumer issues in bankruptcy. A companion bill was introduced in the House
(H.R. 685) yesterday.

Sen. John Cornyn (R-Texas) a former Attorney General of Texas, made a pitch for his reform of corporate venue rules (S. 314). The bill would, among other things, change the affiliate rule permitting a corporation to file for chapter 11 in the location of a minor affiliated entity, far from the corporate home of the debtor. Enron, a Texas company, used this rule to file in the Southern District of New York. Read an analysis of the bill prepared by ABI Resident Scholar Jeffrey Morris below.

Sen. Dianne Feinstein (D-Calif.) expressed support for special consideration for debtors in bankruptcy due to medical hardship, citing a recent Harvard report that as many as half of all consumer cases arise from health care costs, even for those with medical insurance. Sen. Charles Schumer (D-N.Y.) reaffirmed his strong support for language that would bar a discharge for any debts arising from violations of the Freedom of Access to Clinics law, protecting abortion providers. The Schumer amendment has passed the Senate in the past but is viewed as a killer provision by the House of Representatives. Maria Vullo, a New York lawyer who represents abortion clinics, testified today.

S. 314 -- Fairness In Bankruptcy Litigation Act of 2005 -- Restricting Venue Choices For Corporate Debtors

By Jeffrey Morris, ABI Resident Scholar

Sen. John Cornyn (R-Texas) introduced legislation on Feb. 8 to amend 28 U.S.C. §1408 “to combat forum shopping” that the Senator in his remarks on the Senate Floor asserted hurts “consumers, creditors, workers, pensioners, shareholders, and small businesses.” Conspicuously absent from the list of injured parties are large corporations. They are assumed to be the debtors who are scouring the country for just the right location to file their chapter 11 petition.

The current law gives the potential debtor several venue options. The debtor can file in the district where its principal place of business is located, and it can also choose the district where its principal assets are located. More “exotic” venues are also available under the statute. The corporate debtor can file a petition in which it is domiciled. As noted in the Report of the National Bankruptcy Review Commission, “the ‘residence’ and ‘domicile’ of a corporation were treated identically, as the state of incorporation.” [1] Consequently, the state of incorporation offers another venue option for a corporate debtor. The even more “exotic” form of venue selection is available under §1408(2). This provision permits a debtor to file a case wherever an affiliate of the debtor has a case pending. A subsidiary corporation is an affiliate as that term is defined in Bankruptcy Code §101(2). This is the venue provision that allowed Miami-based Eastern Airlines to file its case in the Southern District of New York by joining its affiliate debtor, Ionosphere Inc. [2] The proposed legislation is intended to combat these acts and restrict the discretion in the selection of the court that will hear the case.

State of Incorporation

Because the statute applies to all debtors, the bill does not delete the reference to residence and domicile as a basis for venue. Instead, it amends §1408 by inserting a new subsection (b)(1) that defines a corporation’s domicile and residence as “where the debtor’s principal place of business is located.” This definition would prevent the debtor from filing in a district where the debtor is incorporated unless that district also happens to be the debtor’s principal place of business. This is consistent with the reform proposed in the 1997 Report of the National Bankruptcy Review Commission. The Commission noted that when other federal venue provisions allow filing of cases in the district of the state of incorporation, it is the defendant’s state of incorporation that provides the venue option, not the plaintiff’s state of incorporation. These provisions effectively recognize that the venue being selected is one that the defendant has already voluntarily used in the past. In a bankruptcy case, on the other hand, it is the debtor who is acting like a plaintiff and is selecting the venue. Thus, the other federal venue provisions do not offer a relevant example to follow.

The Commission also noted that amending §1408 to remove the state of incorporation as a basis for venue of a case returns the law to the practice under the law up to 1979, the effective date of the Bankruptcy Code. From 1973 until 1979, state of incorporation was not a ground for venue of cases. [3] The Bankruptcy Code returned that concept to the law beginning in 1979, and the state of incorporation has been a basis for venue of cases since then.

Employing the state of incorporation as a proper venue might be appropriate in the sense that corporate governance issues can arise in these cases, and the law applicable to those questions would be the law of the state in which the court sits. There would presumably be greater familiarity with that law by the bench, and this would provide a more efficient forum for the resolution of those issues. The problem, however, is that corporate governance issues typically are not nearly as important in the case as issues relating to the debtor’s relationships with its creditors and other parties in interest. Thus, the “extra” expertise regarding the applicable state corporate law gained by the case being filed in the state where it is incorporated is relatively limited. Filing a case in a district in the state where the debtor is incorporated can present significant difficulties for the non-debtor parties who may have no connection to the state. Distance from the courthouse can present problems for these parties. Participation in the case will require hiring local counsel (probably in addition to the attorney who represents the creditor in its locale). If the entity wants to (or must) participate personally in the case, travel expenses and the related costs such as time away from other business make the real cost of participation even greater. Removing the state of incorporation as a ground for the venue of cases does not completely solve this problem because the creditor or other party in interest may not be located where the debtor has its principal place of business. Nevertheless, more creditors are probably located at or near the debtor’s principal place of business as compared to its state of incorporation.

The “Affiliate” Rule

The more controversial venue provision is the rule that allows a debtor to file a case in any district in which there is already pending a case commenced by or against an affiliate. This venue provision, set out in current §1408(2) is intended to allow connected entities to proceed in the same court so as to avoid inconsistent rulings and to improve the prospects for providing full relief for the related parties. While well intentioned, the rule has been used in the past to create a right to venue for a troubled company by initiating a case by a subsidiary (or other type of affiliate) and then following the first filing with a filing by the larger company that is facing financial difficulties and which could not have filed a petition in the particular jurisdiction other than by means of the affiliate venue rule. As noted above, Eastern Airlines took advantage of this provision. More recently, Enron Corp. followed this path when its subsidiary, EMC, a commodities trading firm, properly filed its chapter 11 petition in the Southern District of New York. Enron Corp. then followed its subsidiary and commenced its chapter 11 case in the Southern District. [4] As Sen. Cornyn noted in his floor remarks when introducing the Bill, "Houston was where the majority of employees and others who were victimized by that corporate scandal called home.” Yet, the affiliate venue rule permitted Enron to file in New York.

The amendment would not entirely reject affiliate filings, but it would substantially curtail the practice and probably effectively put an end to it. Under the amendment, a corporate debtor can file its case in the same district where a case is pending for a corporation that is in control of the entity that now wants to be a bankruptcy debtor. Control is defined in the amendment by cross reference to the definition of control in section 2 of the Bank Holding Company Act of 1956. Therefore, under the amendment, a corporate debtor may file a case in a district in which it does not maintain its principal place of business if there is already pending in that court a case of a corporation that is in control of that debtor. In other words, the subsidiary can follow the parent into a particular bankruptcy court, but the parent cannot follow the subsidiary. In “biblical” terms, the amendment says “Thou shalt not allow the tail to wag the dog.”

The Senator cited several other examples of forum shopping that he asserts demonstrate the need for enactment of the bill. Among the cases listed as examples of blatant forum shopping are Polaroid (Boston company filed in Delaware ), K-Mart (Michigan company filed in Chicago), and WorldCom (Mississippi company filed in Delaware ). The venues selected in these cases would be improper under the proposed amendment to §1408. Sen. Cornyn also appended to his remarks correspondence he has received in support of the proposal from a number of bankruptcy professors and practitioners who believe that the current venue provision is fatally flawed.

A message that one can derive from the bill and the Senator’s remarks is that debtors forum shop to obtain improper advantage over other parties. The advantages can result simply from the court being in a location distant from significant constituencies in the case, to a veiled suggestion that some courts will not sufficiently protect the legitimate interests of victims of corporate scandals because the “remote” court will not be sensitive to the interests of the “local” harms being suffered.

Venue should be irrelevant to these matters. Venue does not change the uniform federal law that is applicable to the pending case, it simply involves the physical location of the court in which the disputes will be heard. Nonetheless, as the Bankruptcy Commission recognized, the reality is that venue selection can have a significant impact not just on the specific case before the court, but on the development of the bankruptcy law generally. As more and more decisions are rendered by just a few courts, those courts arguably take on a greater significance than is appropriate in a national, uniform bankruptcy system as contemplated by the Constitution.

One thing that can safely be said about the bill is that it will not go unchallenged in Congress. When the Commission engaged in its study of the problem, the State Bar of Delaware presented a substantial report to the Commission in support of the affiliate and state of incorporation venue provisions. Such groups have strong advocates in the Senate and on the Judiciary Committee in particular, such as Sen. Biden of Delaware.

It might be interesting to keep an eye on Sen. Cornyn’s positions in the debate. He has staked out a position that chastises the perpetrators of corporate fraud who take advantage of a “troubling loophole” in the venue provisions to evade their financial commitments to the detriment of their creditors. Amendments will be offered to restrict the use of state homestead exemptions on the grounds that some state exemptions are really just “troubling loopholes” that protect debtors in palatial residences who live in luxury while leaving their creditors high and dry. Texas is prominent on the list of states with unlimited homestead exemptions. Will Sen. Biden remind Sen. Cornyn of that fact during the debates on the bill to restrict the venue of bankruptcy cases?

See the full text of the bill here.

[1] Report of the Nat’l Bankr. Rev. Comm. at 772 ( October 27, 1997)(citations omitted).

[2] Id. at 775. The Commission Report also noted that “there was no indication that Ionosphere was in need of bankruptcy protection or a financial restructuring.” Id.

[3] Id. at 772.

[4] See, In re Enron Corp., 274 B.R. 327, 341 (Bankr. S.D.N.Y. 2002)

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