Creative Finance: U.S. Bankruptcy Courts Will Not Tolerate Manipulation of COMI and Bad Faith Uses of Chapter 15

Mainbrace | September 2016 (No. 4)

Michael B. Schaedle

In chapter 15 practice, recognition of a foreign proceeding (whether a main or nonmain proceeding) focuses on specific statutory bona fides. To prosecute a chapter 15 in the United States, a properly authorized representative of a foreign debtor has to provide a U.S. Bankruptcy Court with straightforward evidence of the raising of a proceeding under foreign insolvency laws, which are designed to create a collective remedy, in a jurisdiction where a foreign debtor either has an “establishment” or a “center of main interests.” 11 U.S.C. §1517(a) (statute mandates recognition where requirements of (a)(1-3) are met). Courts have noted that chapter 15 does not contain a provision for dismissal for cause and that the intentions of the foreign representative in seeking relief generally are not germane to the findings required of an American bankruptcy court under sections 1515 and 1517 of Title 11 of the United States Code, 11 U.S.C. §101, et seq. (the “Bankruptcy Code”).

Further, the United States Court of Appeals for the Second Circuit in Morning Mist Holdings Ltd. v. Krys (In the Matter of Fairfield Sentry Ltd.), 714 F.3d 127 (2d Cir. 2013) has held that a foreign debtor’s “center of main interests” (“COMI”) is to be determined as of the commencement of the chapter 15 case. This has permitted foreign debtors in liquidation in so-called “letterbox” jurisdictions—places where a liquidating or liquidated debtor did not operate, but where the debtor is registered as a business organization—to obtain recognition of foreign liquidation proceedings pending in the “letterbox” jurisdictions. There is nothing generally improper about this, as a liquidation in bankruptcy can serve a collective purpose and can be very complex.

Public Policy and Abstention Limits on Recognition Obtained in Extraordinary Circumstances

Chapter 15 does restrain improper uses of ancillary proceedings by refusing recognition and other actions that are “manifestly contrary to the public policy of the United States.” 11 U.S.C. §1506.2 And Bankruptcy Code section 305 expressly states that a bankruptcy court can either suspend or dismiss a recognized chapter 15 case if the purposes of chapter 15 would be fulfilled by such dismissal or suspension or if such abstention is sought by the foreign representative. 11 U.S.C. §305(a)(2), (b). But these constraints on recognition are extraordinary. Courts do not lightly find that international law contravenes the fundamental policy of the United States, and abstention requires a court to find that the pendency of a chapter 15 case actually frustrates the purposes of chapter 15 itself—an extraordinary finding.

“Bad faith” bankruptcy filings on the other hand, while not exactly commonplace in plenary bankruptcy practice in the United States, are not extraordinary. Generally, “bad faith” exists where the use of bankruptcy itself is futile, and thus, the debtor cannot or will not create a fair, collective remedy. A “bad faith” filing constitutes “cause” under the Bankruptcy Code, see, e.g., 11 U.S.C. §1112, to dismiss a case. “Bad faith” actions in using bankruptcy are also cause for the appointment of an independent fiduciary in American bankruptcy, a trustee. In chapter 11 practice, for example, if “bad faith” use of bankruptcy is at issue, creditors and other stakeholders will often litigate with debtors, seeking to force dismissal or the appointment of a trustee.

Quintessential “bad faith” is the use of bankruptcy to ratify or obscure a prior fraudulent act. And Judge Gerber, the author of the Millard decision cited in fn 1, confronted this quintessence in In re Creative Finance Ltd. (In Liquidation), 543 B.R. 498 (Bankr. S.D.N.Y. 2016), a chapter 15 case.

Insider Strips Creative Finance and Cosmorex of All Assets on the Eve of Marex Judgment

The Creative Finance case arose from litigation in the United Kingdom. Marex brought suit against Creative Finance and Cosmorex (foreign exchange traders) in the English High Court of Justice and succeeded in obtaining a USD$5.6 million judgment against the companies. On the eve of the final entry of judgment, and weeks after the High Court had circulated a draft of its judgment to the parties, the Creative Finance/Cosmorex principal, Carlos Sevillja, transferred all of the companies’ cash (USD$9.5 million) out of the United Kingdom, where Creative Finance/Cosmorex had operated, to accounts in Dubai and Gibraltar. Marex was the two companies’ only non-insider creditor. Primary remaining company assets were significant and valuable claims in the chapter 11 cases of In re Refco, Inc., Bankr. Case No. 05-60006 (Bankr. S.D.N.Y.) and the proceeds of those claims. Interim distributions on the Refco claims appear to have been diverted by Sevillja away from Creative Finance/Cosmorex.

A BVI Liquidation Proceeding Commences, and Chapter 15 Relief Is Sought and Contested in New York

Marex domesticated its U.K. judgment in the New York Supreme Court and immediately began process to capture future Refco distributions.

Sevillja then caused Creative Finance/Cosmorex to file a voluntary liquidation proceeding in the British Virgin Islands (where each of Creative Finance and Cosmorex were organized). In the BVI proceeding, a liquidator was appointed and the liquidator was funded by Sevillja. The liquidator did the statutory minimum in respect of the Creative Finance/Cosmorex debtors (limited notices to creditors, formal establishment of BVI bank accounts, and basic establishing process before the BVI court and reporting, etc.). He never obtained the debtors’ books and records and the liquidator never investigated the Sevillja-controlled transfer of debtor cash or Refco distribution proceeds.

In order to restrain Marex process against Refco distributions, the liquidator filed a voluntary petition under chapter 15 in the New York Bankruptcy Court, seeking provisional and permanent relief staying Marex in the United States from enforcing its judgment and entrusting the liquidation estate with the Refco distributions. Provisional relief was resolved by an agreement by and among the liquidator, Marex, and the Refco liquidating fiduciary to deposit Refco distributions in the New York Bankruptcy Court registry (a form of interpleader).

The Recognition Battle

The liquidator then pressed his petition for recognition, which was opposed  by Marex. The liquidator focused on chapter 15 basics. BVI liquidation laws are intended to benefit a creditor collective. The debtors’ registered offices are in the BVI. Formal process had been raised under the BVI liquidation laws and the status of the liquidation case was evidenced by certified orders of the BVI court. Likewise, after the commencement of the BVI liquidation, the liquidator was now the sole person authorized to act for the debtors. And per Fairfield Sentry, as of the chapter 15 commencement date, the debtors had no operations or business activity anywhere but the BVI.

The purpose of the chapter 15 was to capture and ratably share the Refco distributions with multiple creditors, including Marex. In the liquidator’s view, all 1517 requirements were met and recognition was required. The liquidator argued that chapter 15 does not contemplate “bad faith” dismissal as a form of relief and that such relief exists to be had only in plenary American bankruptcy proceedings.

Marex argued that the BVI liquidation should not be recognized because the act of recognition would violate fundamental U.S. public policy given Sevillja’s actually fraudulent conduct, apparent influence over the liquidator, and the liquidator’s complete failure to investigate Sevillja and his bad acts. Marex also sought dismissal of the chapter 15 case as a “bad faith” filing and under Bankruptcy Code section 305 for the same reason.

Finally, Marex contested whether the liquidator could establish that the BVI liquidation was either a foreign main or nonmain proceeding since BVI  could not be considered a “center of main interests” for either debtor, nor did either debtor have an “establishment” in BVI. In so doing, Marex drew the New York Bankruptcy Court’s attention to its ability to consider pre commencement facts that demonstrated COMI or the establishment of a facility was manipulated by a foreign debtor to frustrate the goals of a collective remedy under Fairfield Sentry.

Judge Gerber and the Bankruptcy Court’s Ruling

Judge Gerber, who just retired, is one of the most distinguished bankruptcy judges in the United States, having sat in one of the preeminent U.S. jurisdictions for complex bankruptcies, the Southern District of New York. He has encountered every species of fraudulent conduct that commercial legal practice can produce. For the judge to characterize the Creative Finance chapter 15 as part of “the most blatant effort to hinder, delay and defraud a creditor” that he and the New York Bankruptcy Court had ever seen is notable (this is, after all, the same court that administered the Enron, Adelphia, and WorldCom chapter 11 cases, which all dealt with various kinds of fraud on a grand, systemic scale).

The court found that Sevillja defrauded Marex by stripping the debtors of all of their assets. In doing so, Sevillja defied the orders and judgments of the High Court in the U.K. and the New York Supreme Court, while violating all applicable laws relating to the Marex claims and judgments. Per the court, he then traduced the international insolvency system, using BVI insolvency laws to stop Marex enforcement, while controlling the liquidator and asserting that the claims of companies he controlled against the debtors should dilute Marex recoveries.

Acknowledging the important case law favoring efficient recognition of foreign liquidations and the need for swift ancillary relief to support international restructuring and liquidation process, Judge Gerber, however, was clear that the New York Bankruptcy Court does not and will not tolerate schemes that use chapter 15 to implement actual fraud. He, however, refused to conflate a finding that the Creative Finance chapter 15 was part of such a scheme as evidence that BVI insolvency law is unfair and “manifestly contrary to the public policy of the United States.” He did this because the invidious aims and schemes of Carlos Sevillja and the administrative failures of the liquidator do not impugn the essential fairness of the BVI law.

The court also did not explore the U.S. bankruptcy law on abstention or how it might enforce a rule of essential good faith as a prerequisite to recognition. In important dicta, the court noted that the abstention/dismissal/good faith question remained open for another day, and that even if there is no “bad faith” dismissal right per se in a chapter 15 case, the court can always limit the effect of the stay upon recognition and limit a foreign debtor’s access to the protections of U.S. bankruptcy laws or courts if chapter 15 is being used in bad faith. In his decision, the judge focused on a narrower and more limited question under the Bankruptcy Code: whether the liquidator had failed to demonstrate that the debtors properly raised a foreign main or nonmain proceeding in BVI.

If a company has a COMI in the BVI or in any foreign state, subject to the other requirements of Bankruptcy Code section 1517, then the company’s foreign proceeding can be recognized as a foreign main proceeding. To prove that COMI exists in a foreign state, the foreign representative ultimately has to demonstrate that the foreign debtor’s known center of financial, legal, and business decision-making is located in that state. If a company has an “establishment” in the BVI or in any foreign state, subject to the other requirements of Bankruptcy Code section 1517, then the company’s foreign proceeding can be recognized as a foreign nonmain proceeding. To prove that an establishment is located in a foreign state, the foreign representative has to show that the foreign debtor conducts non-transitory, local business in the state.

In Creative Finance, although the court reflected that a liquidation in a “letterbox” jurisdiction can and often is properly recognized, here the liquidator had done so little work, so little administration of assets, so little investigation into debtor assets and liabilities and Sevillja, that the debtors could not be said to have COMI or an establishment in the BVI. Accordingly, recognition as either a foreign main or foreign nonmain proceeding was denied. Upon denial of recognition, Marex was relieved of its duties under the order for provisional relief and authorized to seek recovery of Refco interim distributions to satisfy its judgment.

In Creative Finance, Judge Gerber acted vigorously to protect the integrity of judicial processes in the United Kingdom, the British Virgin Islands, and in the United States from fraud, including bankruptcy fraud, but he did so in a conservative manner that preserves the 1517 mandate to order recognition by reference to a straightforward evidentiary standard, focusing his ruling on the definition of COMI.