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.

First Offshore Wind Project in United States to Launch This Fall

Mainbrace | September 2016 (No. 4)

Jonathan K. Waldron and Joan M. Bondareff

Although skeptics said it couldn’t happen, the first offshore wind project in the United States is scheduled to begin opera- tion by the end of this year, bringing wind power to shore from waters off Block Island, Rhode Island. Bragging rights can go to Jeffrey Grybowski and his team at Deepwater Wind. The project may be relatively small—five turbines producing only 30 megawatts (“MW”) of wind and providing power to about 17,000 homes—but it is a giant step forward in the world of offshore wind in the United States. Continue reading “First Offshore Wind Project in United States to Launch This Fall”

What the Heck Is “Privity”? Is the Limitation of Liability Act Still Relevant?

Mainbrace | September 2016 (No. 4)

Jeffrey S. Moller

In the aftermath of a major shipping disaster, a vessel owner may be expected to exercise its right to file a petition to limit its liability in accordance with the U.S. Shipowner’s Limitation of Liability Act, 46 USC §30501, et seq. This may evoke negative press and social media reaction with a now-familiar refrain: Why should a shipowner escape full liability for a disaster by hiding behind a 19th-century (i.e., outdated, antique, and ancient) statute? One might well ask whether the Limitation Act has outlived its usefulness, but this author’s belief is that the statute need not be repealed. Modern safety management systems, communication systems, and vessel tracking systems have served to make it far more difficult for owners to limit their liability, and the procedural benefits of the statute are helpful to all concerned. It may, however, be time for the United States to become signatory to the existing up-to-date international treaty on a limitation of liability. Continue reading “What the Heck Is “Privity”? Is the Limitation of Liability Act Still Relevant?”

A Note from the Editor

Mainbrace | September 2016 (No. 4)

Thomas H. Belknap, Jr

It’s hard to believe another summer has come and gone. The kids are back in school, the commuter trains are a bit more crowded, and everyone is back from their holidays, hopefully refreshed and ready to get back down to business. We know we are. Continue reading “A Note from the Editor”

IMO Interim Guidelines: Recent Developments in Maritime Cyber Risk Management

Mainbrace | September 2016 (No. 4)

Kate B. Belmont

Cyber risk management continues to be one of the most significant  challenges currently facing the maritime industry. With an overreliance on information technology (“IT”) and operational technology (“OT”), the shipping industry is vulnerable to cyber risks, cyber threats, and cyber attacks that could result in significant damages and loss, including loss of business and damage to reputation and property. While the maritime industry has yet to be regulated, various stakeholders have recognized the need for the industry to address cyber risk. As the United States Coast Guard continues to assess and evaluate cyber risk throughout the marine  transportation system, the International Maritime Organization (“IMO”) and various industry organizations have issued guidelines on cyber risk management this past year. Most notably, on May 20, 2016, the IMO approved Interim Guidelines on Maritime Cyber Risk Management (“IMO Interim Guidelines”). Continue reading “IMO Interim Guidelines: Recent Developments in Maritime Cyber Risk Management”

Is the Maritime Industry Ready to Embrace Drones?

Mainbrace | September 2016 (No. 4)

Sean T. Pribyl

Unmanned aerial systems (“UAS”), or “drones” in common parlance, have not been a part of the historical maritime vocabulary. At least, not yet. While UAS may conjure images from science fiction, the reality is that companies are designing commercial UAS for the private sector. In fact, UAS are gradually permeating our daily lives, and over the next five years, the commercial UAS industry is predicted to surpass that of the defense industry. Continue reading “Is the Maritime Industry Ready to Embrace Drones?”

SBA Rule Expands Mentor-Protégé Program, Creates New Opportunities for the Maritime Industry

Mainbrace | September 2016 (No. 4)

David M. Nadler and Justin A. Chiarodo

After a long wait and much anticipation, the Small Business Administration (“SBA”) issued its final rule expanding the mentor-protégé program to all small businesses on July 25, 2016. The new rule broadly expands upon the existing 8(a) mentor-protégé program, and is projected to result in two billion dollars in federal contracts to program participants. The final rule makes some key changes to the February 2015 proposed rule, including changes regarding size certification and reporting. As the new rule is now final, contractors in the maritime industry, both large and small, should prepare now to take advantage of what the newly expanded program has to offer.


The SBA mentor-protégé program has long-allowed large businesses to provide technical, management, and financial assistance to small businesses, and for the mentor and protégé to compete together for contracts. The program was designed to help protégé businesses by leveraging the experience and expertise of the larger mentor contractors. Originally limited to 8(a) concerns, the program was extremely successful. Large businesses were attracted to the program because it allowed them to pursue small business set-aside contracts as a joint venture with a protégé and foster small business relationships, and small businesses benefited from the resources and expertise of their mentors.

In 2010 and 2013, Congress authorized the expansion of the mentor-protégé program. In February 2015, SBA issued its proposed rule expanding the program to include all small businesses, although the 8(a) program will also remain independent of the new program. The proposed rule indicated that the SBA was contemplating a number of changes to the 8(a) model, including size certification approval requirements from the SBA and additional reporting and compliance requirements, particularly with regard to the structure of the joint venture. Many of these new requirements remain in the final rule, but there are some significant changes that government contractors in the maritime industry should be aware of.

Key Provisions of the Final Rule

The key changes and provisions of the final rule are discussed below.

1. Size Status Determination: The proposed rule contained a requirement for formal SBA verification of the size status of the protégé. This requirement was removed from the final rule. The SBA will  continue to allow protégés to self-certify, and will rely on the size protest mechanism to ensure that businesses are accurately certifying their size.

2. NAICS Code Standard: Under the final rule, businesses that do not qualify as small under their primary NAICS code can still participate under a secondary NAICS code if the protégé can show that it would benefit from the progression into a secondary industry to enhance its current capabilities.

3. Financial Condition of the Mentor: Under the proposed rule, a mentor was required to demonstrate to the SBA that it was in “good financial condition.” This requirement was removed from the final rule. The SBA acknowledged that as long as the mentor can meet all obligations under its mentor-protégé agreement, then the “good financial condition” requirement was unnecessary and created too much confusion, since the term was undefined.

4. Duration of the Agreement: The proposed rule limited the mentor protégé agreement to three years. It also only allowed for a protégé to engage in one three-year agreement with one entity and one with a separate entity, or two three-year agreements with the same entity. Commentors did not believe that three years was long enough. SBA’s final rule allows for two three-year agreements with different mentors, but also allows for each agreement to be extended for an additional three years as long as the protégé continues to receive the agreed-upon business development assistance.

5. Joint Venture Entity: The SBA clarified in the final rule that a joint venture need not be, but could be, a separate legal entity. The SBA sought to clarify that formal or informal joint ventures were permissible. Also, consistent with the proposed rule, the SBA clarified that a joint venture may not be populated with employees who are performing the contract, as this would defeat the purpose of the protégé learning from the mentor. A mentor may, however, own up to 40 percent of their small business protégé under the final rule. If ownership continues after the mentor-protégé agreement expires, the SBA indicated that its affiliation rules would apply.

6. Compliance and Reporting: In order to ensure the program serves its purpose and is not abused, the SBA has enacted rigid reporting requirements under the final rule. The SBA requires both the mentor and protégé to certify the joint venture’s compliance with the regulations, the terms of the joint venture agreement, and the performance requirements of the particular contract. The protégé is also required to engage in annual reporting on compliance. Penalties for non-compliance can include suspension and debarment.

Impacts on Government Contractors

Contractors should be aware that nearly all future small business set-aside contracts will draw bids from mentor-protégé joint ventures. Given this expansion to all small businesses, mentors will now have a wider selection of protégés to choose from. The new rule is expected to result in thousands of additional applications for the program. Indeed, the SBA has created an entirely new division within the Office of Business Development to process and review applications, and has left open the possibility of imposing open and closed enrollment periods for the program. Companies that are interested in participating in the program should make sure they obtain appropriate guidance on the final rule to ensure that all application, performance, and reporting requirements can be met.

%d bloggers like this: