Restructuring

Contributed by Maurice Horwitz
Last week, we reviewed the recent decision of the Bankruptcy Court for the Southern District of New York that granted recognition to the Brazilian bankruptcy proceedings of three entities in the OAS Group (“OAS”), a Brazilian infrastructure enterprise. Part I of this series focused on the facts of the OAS cases and the objections to recognition interposed by two significant holders (the “Noteholders”) of OAS’s aggregate $875 million senior notes due 2019 (the “2019 Notes”). We also analyzed in closer detail the Noteholders’ argument that Renato Fermiano Tavares was not qualified to serve as OAS’s “foreign representative,” as that term is defined by the Bankruptcy Code. In Part II, we examined the bankruptcy court’s holding that OAS’s Austrian financing subsidiary actually has its center of main interests in Brazil. 
In this final post, we briefly consider the Noteholders’ third objection – that the bankruptcy court should deny recognition of OAS’s Brazilian bankruptcy proceedings because certain aspects of Brazilian bankruptcy law, or the Brazilian proceedings themselves, are “manifestly contrary to public policy.”
The Public Policy Exception
Chapter 15 is equipped with a “safety valve” known as the public policy exception. Section 1506 of the Bankruptcy Code provides:

Nothing in this chapter prevents the court from refusing to take an action governed by this chapter if the action would be manifestly contrary to the public policy of the United States.

Given the nature of chapter 15, a safety valve such as this is a necessity. As we explained in Part I of this series, in chapter 15, Congress codified the Model Law on Cross Border Insolvency (the “Model Law”) drafted by the United Nations Commission on International Trade Law (“UNCITRAL”). Section 1506 itself is modeled almost verbatim from Article 6 of the Model Law, which provides that

[n]othing in this Law prevents the court from refusing to take an action governed by this Law if the action would be manifestly contrary to the public policy of this State.

Chapter 15 also provides that

[i]n interpreting this chapter, the court shall consider its international origin, and the need to promote an application of this chapter that is consistent with the application of similar statutes adopted by foreign jurisdictions.

While chapter 15’s stated purpose is “to provide effective mechanisms for dealing with cases of cross-border insolvency,” often the practical result of these “mechanisms” is to extend the reach of foreign bankruptcy proceedings into the territorial United States of America. The public policy exception ensures that chapter 15 cannot require U.S. courts to run roughshod over fundamental U.S. policies.
This may seem powerful, but the public policy exception is rarely employed by courts. As the bankruptcy court noted, the Second Circuit has taken a “narrow reading” of section 1506. This narrow reading is based on international usage rather than any trend in U.S. case law. When the Second Circuit first considered the application of section 1506, in Fairfield Sentry, the Court stated, citing the House Report, that Article 6 of the Model Law

is standard in UNCITRAL texts, and has been narrowly interpreted on a consistent basis in courts around the world. The word “manifestly” in international usage restricts the public policy exception to the most fundamental policies of the United States.

The Second Circuit also relied on the Guide To Enactment Of The UNCITRAL Model Law Of Cross-Border Insolvency (the “Guide”) promulgated by UNCITRAL, which states that “the exception should be read ‘restrictively’ and invoked only ‘under exceptional circumstances concerning matters of fundamental importance for the enacting State.’” Given this reading, arguments based on the public policy exception are generally difficult to win.
The Noteholders’ Arguments
Despite these odds, the Noteholders argued that recognition of the OAS cases would be manifestly contrary to public policy. Their argument centered on the December 2014 transactions discussed in Part I of this series. The Noteholders have alleged that as a result of these transactions, certain OAS subsidiaries who guaranteed the 2019 Notes either transferred assets to, or were merged with, non-guarantors in the OAS enterprise, thus diluting the assets available for Noteholder recoveries. In objecting to recognition before the bankruptcy court, the Noteholders argued that the Brazilian Court ordered a “substantive consolidation” order on an ex parte basis, thus robbing the Noteholders of due process; and furthermore, because “the Brazilian plan will likely be based on substantive consolidation,” any fraudulent transfer actions that the Noteholders endeavored to pursue would be pointless. For these reasons, the Noteholders argued, distributions under the Brazilian plan would deviate materially from the distributions that would occur in the U.S (where, presumably, substantive consolidation would not be granted, and the Noteholders would be free to pursue their fraudulent transfer claims).
After noting that “Brazil has a comprehensive bankruptcy law that in many ways mirrors our own,” the bankruptcy court rejected the Noteholders’ arguments. Specifically, the bankruptcy court rebutted the Noteholders’ due process argument by stating that the Brazilian court’s substantive consolidation order has not been “definitively granted” – a fact that the Noteholders conceded. So, the Noteholders would have an opportunity to challenge substantive consolidation at a later time. The bankruptcy court also compared the Brazilian court’s ex parte order to other types of orders that U.S. courts routinely grant on an ex parte basis, e.g., for Rule 2004 examinations or temporary restraining orders. “Due process is satisfied,” according to the bankruptcy court, “because these ex parte proceedings and orders are subject to ex post review, just as the consolidation order has been subject to ex post review in Brazil.”
The Noteholders’ arguments were also premised on the premature assumption that the Brazilian court will approve a substantive consolidation plan that moots the Noteholders’ fraudulent transfer claims. According to the bankruptcy court,

Objections based on the speculation that the Brazilian Court will approve a plan or plans that permit substantive consolidation, unfair distributions or the elimination of creditor fraudulent transfer claims are premature. They depend on the contents and effect of one or more plans that the Brazilian Court has not yet approved and may never approve.

In other words, the Noteholders are not without a remedy – they should still have an opportunity to challenge substantive consolidation and the elimination of their fraudulent transfer claims. In fact, they may even have two opportunities to raise this challenge. The first would be at the plan approval stage in Brazil, when the issue is ripe for the Brazilian court to consider. And even if they lose in Brazil, they may have a second chance in New York, if OAS seeks to enforce the terms of its Brazilian restructuring plan in the U.S. through its chapter 15 case, as Rede Energia did (see our post on the Rede case here).
Conclusions
Is the bankruptcy court signaling that the Noteholders should try their public policy arguments later, when OAS seeks a chapter 15 enforcement order? This seems unlikely; the bankruptcy court telegraphed how it would view such an objection, stating that “even a ‘definitive’ substantive consolidation order is not manifestly contrary to United States law,” and adding that “[a]lthough Brazilian law may impose different requirements for substantive consolidation, the different standards, standing alone, do not signify that Brazilian Bankruptcy Law is manifestly contrary to public policy.”
Nevertheless, in concluding that recognition is not manifestly contrary to the public policy of the United States, the court added this qualification:

This conclusion is without prejudice to [the Noteholders’] right to challenge any action that [the foreign representative] seeks to take in this Court, including, in particular, a request to recognize and enforce a plan or plans approved by the Brazilian Court.

In opposing recognition, the Noteholders have deployed many of the same arguments as were raised by the noteholders in In re Vitro S.A.B. de C.V. If the Noteholders continue to follow the Vitro playbook, then it is likely that their challenge to the Brazilian restructuring plan will be much broader than the public policy exception. In Vitro, the Fifth Circuit declined to consider the public policy exception as a basis for denying enforcement to a Mexican concurso plan. But that is because the Fifth Circuit found other reasons to block the plan’s enforcement, as we covered here. As noted above, the Noteholders have argued that substantive consolidation, combined with the December 2014 transactions, will ultimately yield a distribution outcome that deviates materially from the distributions that would occur in the U.S. The bankruptcy court rejected this argument for purposes of granting recognition, but the same argument, which resonated with the Fifth Circuit in Vitro, could be renewed if OAS seeks enforcement of its restructuring plan through the chapter 15 case.
It is worth noting, finally, that the Noteholders also accused OAS’s foreign representative of “refus[ing] to cooperate in discovery,” and evidencing “a disregard for United States process.” The bankruptcy court disagreed, finding these allegations unsupported by the record. While a win for OAS, this detail highlights one of the potential downsides of seeking chapter 15 relief – U.S. law and procedure offer creditors and other interested parties a powerful set of tools for obtaining leverage. If the benefits outweigh the costs, then opening a second front in your restructuring battles makes sense. We will continue to monitor the OAS cases and provide our thoughts on this cost-benefit analysis as the cases progress.