 You're watching FJTN, the Federal Judicial Television Network. Federal Judicial Center program, bankruptcy law update. And now here's our moderator, Dean Lawrence Ponaroff of the Tulane University Law School. Hello and welcome to the Federal Judicial Television Network's bankruptcy law update program. Today we've invited three of the country's leading bankruptcy law academics to join us in talking about topics and issues we believe you'll find interesting and useful. Professor Laura Bartell of Wayne State University School of Law is going to clue us in on the intricacies of an important federal law that we may not have been paying enough attention to in the practice of bankruptcy. Professor Michelle Dickerson, who teaches in the law school at the College of William and Mary, will discuss the potential bankruptcy application of some legal devices more commonly associated with criminal practice. And last, but certainly not least, Professor Bruce Markell from the William S. Boyd School of Law at the University of Nevada Las Vegas and a previous guest on this show will discuss the increasingly important issue of asset securitization in bankruptcy. Thank you all for coming today. Laura, why don't we begin with you during the last recession, as opposed to the current one, in 1988, I believe. Congress passed an act known as the Worker Adjustment and Retraining Notification Act, appropriately called WARN, which, if I understand it correctly, requires employers to give 60 days notice to employees of planned closings or mass layoffs. Needless to say, companies that are thinking about mass layoffs or planned closings, often companies that may be having some financial problems and later find themselves in, for example, Chapter 11. So the question that we'd like to start off with is what is the relationship of the WARN notice requirements in bankruptcy? Apparently there's some case law on this now, a Department of Labor interpretation and as the author of a recent article on the subject, you were the leading expert, so bring us in on it. Well, let's first important to understand that the WARN Act was not enacted because of troubled companies. What Congress was really responding to was the fear that companies would close down operations in the United States and move them offshore to enable them to access cheaper labor. In fact, the problem of financially troubled companies was not a major focus of Congress when it was crafting the WARN Act. There are provisions in the WARN Act that may in fact have application to financially troubled companies, but the WARN Act itself does not distinguish between financially troubled companies and other companies that choose to engage in planned closings or mass layoffs. Now, I said that there are some provisions that may have particular applicability to troubled companies. In particular, there are exceptions that reduce the amount of notice that needs to be given by companies in certain circumstances. There are three in particular that may have applicability to financially troubled companies. The first is colloquially called the faltering company exception where Congress was concerned that the notice itself might prevent a company that was in financial difficulty from obtaining needed business or needed capital that if it were obtained would prevent the need to close down a plant or to lay off people. So there is that exception which may in fact have applicability to financially troubled companies. There is also another exception that is known as the unforeseeable business circumstances exception where there is something that happens dramatically and unexpectedly in the business environment such as the withdrawal of a needed contract that prompts the company to close down very suddenly. There is also a natural disaster exception so that if there's a flood or an earthquake or something that damages a plant that may result in the company being forced to lay off people very suddenly. But in all of those circumstances the company is required to give as much notice as possible even if that's less than 60 days. But none of those exceptions are specifically aimed at bankrupt companies. So if I'm understanding you correctly an entity filing bankruptcy the mere filing of the bankruptcy does not exempt the company from the worn requirements if they otherwise apply. Exactly right. Now when the Department of Labor which was statutorily authorized to adopt implementing regulations under the worn act was crafting its final rule it received a comment on its interim rule suggesting that of course bankruptcy fiduciaries should not be subject to the requirements of the worn act and the Department of Labor in response to this comment said no we can't agree with that however we do agree that a fiduciary whose sole function in the bankruptcy process is the liquidation of the business is not an employer in the usual sense because they're not engaged in business and therefore this liquidating fiduciary is not subject to the worn act. By contrast a fiduciary who is continuing to operate the business in bankruptcy is subject to the worn act requirements. All right well I'm going to have to ask your your opinion of that distinction the Department of Labor is drawn in a moment but I'd like to be clear on one point initially the worn act only applies to statutorily defined employers is that correct and is that tied to a minimum number of employees or an asset level how do you become subject to the the definition of employer is a business enterprise and that is a term that is not defined in the worn act that employs a hundred or more employees that are essentially full-time employees so there is a you have to be a big enough business enterprise to even be subject to the worn act and then there are additional limitations in the definition of plant closing and mass layoff so that if you do not lay off enough people you are not going to be subject to the worn act. Okay so if I am a employer within the meaning of the act and I end up having to file let's say a chapter 11 petition and neither of the exceptions that you mentioned unforeseeable circumstances or faltering business exception apply then whether or not the debtor in possession succeeds to the worn obligations of the pre-petition debtor is going to depend at least according to the Department of Labor on whether the business is continuing as an ongoing entity or is in a liquidation mode exactly right exactly right okay and the penalties for not complying with the worn requirements the penalties for not complying with the worn act is that the employer is required to pay as damages to each aggrieved employee that being the employees who did not receive the notice that they were supposed to receive back pay and benefits for the period of non-compliance up to a maximum of the 60 days prior notice that they should have gotten well if we're in a bankruptcy context how do you handle that back pay obligation with that the priority that depends when the notice should have been given if the violation of the worn act occurred pre-petition you have a pre-petition claim on the part of the employees that pre-petition claim is treated as any other pre-petition claim with the exception that it may be entitled to the priority treatment that is afforded to workers wages it has been equated with weight a wage priority under 507 but that's capped by a dollar that is capped by a dollar amount which is currently four thousand six hundred and fifty dollars if the failure to give notice is post petition the courts have been quite consistent in interpreting that damage claim by the employees to be an administrative expense priority claim 507 a1 507 a1 let's go back to this distinction that you mentioned that the department of labor has drawn in its implementing regulations or interpretation about when worn will apply in bankruptcy and when it will not has has the case law that we have so far and understand there is some circuit case law on the issue has the case law generally deferred to this interpretation it has to defer to that interpretation because that interpretation has the force of law it is a very problematic distinction as far as i'm concerned you could say all right if a company is in chapter seven that must mean it's liquidate if it's in chapter 11 that must mean it's continuing to operate the business but of course that's far too simplistic a company in chapter seven may in fact continue to operate the business if that is the best way to liquidate you can get more value for the assets on an ongoing basis than you can by an asset sale that is exactly what the trustee should do as it's in fulfilling its fiduciary obligations to the creditors in chapter 11 we all know that you can have a liquidating chapter 11 and in a liquidating chapter 11 theoretically you are not continuing to operate the business and so you should fall on the other side of the department of labor's line but then how do you tell if you're in chapter 11 whether you are in a liquidating chapter 11 or you are in a reorganizing chapter 11 perhaps there are circumstances such as there was in a in a recent case the the health care case where from the very inception it was clear that the company was not going to be able to reorganize but many companies go into chapter 11 assuming they're going to be able to reorganize and at some point during the chapter 11 process change their collective corporate minds and turn into a liquidating chapter 11 how do you know when that has occurred they don't generally announce to the public well now we've decided we are going to be a liquidating chapter 11 and what if it's a sort of a creeping liquidation where they liquidate a little bit and then try to reorganize around the rest and then they liquidate a little more at what point does it become a liquidating chapter 11 and what if the plan calls for the sale of the business is that a liquidation certainly at that point you have an intent to liquidate but think of what happens then generally there are still employees they are still coming into work they are selling whatever product this particular bankrupt company manufacturers or retails you really can't say that there is no business being operated until the liquidation is complete and you certainly can't say that at that point we will ex post facto say you didn't have to give any worn act notice Laura is is it the case that there is liability for giving a worn act notice and then not closing down no there's no what no no liability for a false start I mean so presumably a I mean employees often in large businesses are brought together when a company files and they said you know we're filing for bankruptcy this is this is what's going to happen if they just say and by the way here's a worn act notice at that time would that help the chapter 11 well the worn act notice has to be reasonably complete and specific as to exactly which employees are going to be affected congress did not want companies to be putting in sort of precatory worn act notices all the time to protect themselves in the event something bad happened in the future but it certainly would seem that it would be wise at least from the employer's perspective to give the worn act notice the day before the filing because you can then at least based on your discussion of the cases you can fairly well fairly sure be fairly confident that it would be a prepetition claim rather than an administrative expense and is that fair that's part of the problem I have with all of this the gamesmanship the gamesmanship of it why should a company who gives a notice and lays off people prior to bankruptcy be totally subject to the worn act and if they wait two days and give the notice afterwards and are deemed to be a liquidating fiduciary they have no liability whatsoever that certainly wasn't in congress's mind when it adopted the worn act those employees of a bankrupt company are equally in need of the notice in order to make sense of their lives the worn act is a very modest piece of legislation 60 days knows how would any of us feel if we were told we were going to lose our jobs and not have at least 60 days noticed to try to find another job to get retraining congress thought this was going to save the government money this was going to save welfare benefits it was going to to enable these people to pay taxes become productive citizens people who are laid off in bankruptcy have exactly the same need of worn act notice as people outside of bankruptcy all right then let's get to the nuts and bolts given the fact that the this department of labor interpretation as you say has the force of law how should our audience how should bankruptcy judges deal with or treat worn claims by employees well i view the statutory requirements as a minimum obviously a bankruptcy judge cannot relieve a company otherwise subject to federal law of its statutory obligations however i say it's a minimum there is nothing that precludes a bankruptcy judge from requiring a bankrupt employer to give as much notice of a plant closing or mass layoff as the bankruptcy judge wishes to do the bankruptcy judge can refuse to approve a going out of business sale or the rejection of a lease at a particular facility until 60 days has passed that's perfectly within the purview of a bankruptcy judge the bankruptcy judge can also interpret the exceptions to warrant the warrant act very narrowly say this is not a faltering company situation situation this is not an unforeseeable business circumstance that a troubled company would have to close down its operations and interpret very narrowly the good faith exception which i didn't mention the penalties can be abated to the extent that a company in good faith believed it was not subject to the warrant act interpret that very narrowly as well so as to maximize the coverage of the warrant act both in bankruptcy and outside bank so bottom line bankruptcy judges should not necessarily feel that their discretion has been constrained by this act and recognize that there's still the opportunity to administer the case in accordance with the broad powers that they have that would be my contention in this very good all right well i think we've all been warned and i wish we had more time to spend on that topic but we do want to move along laura thank you very much michelle we're going to turn to you next asset concealment and fraudulent transfers by individual debtors continue to generate a lot of case law although empirically it's not clear how much of a problem it really is in any event when debtors engage or alleged to engage in that behavior they do take some serious risks potentially placing their discharge in jeopardy and maybe even facing um criminal prosecution on the other hand traditionally from the trustee usually trustee sometimes creditor point of view proving fraud bad intent is not an easy task short of a directed mission from the debtor which is rarely forthcoming or a frontal lobotomy which is rarely permitted right but um we now have at least one bankruptcy court case that may have given trustees a new weapon as i understand it an exparte inspection order and that decision and that analysis takes bankruptcy lawyers and bankruptcy judges someplace most of us have not been since law school which is fourth amendment search and seizure law so let's start by by having you tell us a little bit about what this is what this new weapon is all about it's interesting that it is referred to as the exparte inspection order but i think if we were talking to people in the fourth amendment criminal law constitutional law world they'd say it's a search warrant because that's essentially the effect of the inspection order the barman case which is cited in the materials involves a debtor who appears to have done lots of asset concealment it's a chapter seven debtor there were vending and poker machines which the debtor had in his business and they seem to have disappeared or they at least the trustee wasn't able to get the debtor to disclose of the location of the assets there were also some somewhat suspicious real property transfers three homes were involved none of the homes were titled in the debtor's name the first two homes were titled in the debtor's parents name the third one was titled in the debtor's spouse the not the debtor's spouse and his spouse did not file for bankruptcy filed in her name there was allegations that there was forty thousand dollars worth of furniture in one home potentially five thousand dollars of additional furniture that the debtor's parents had given him but on its bankruptcy schedules he listed about five hundred dollars in apparel as his sole asset so certainly that would at least suggest or trigger that there must be some sort of asset concealment that's taking place this was a bad facts case this was a horrible bad facts case but i would also suggest that it's probably similar to the bad facts cases that are involved in a lot of the criminal searches that the debtor or in that case the criminal defendant probably did everything that the person was accused of but sort of that that's not the point so we do have horrible facts in this case at least from the perspective of trying to protect a debtor probably doesn't need to be doesn't have doesn't pass the smell test not very sympathetic exactly tell us though about the nature of the order that the trustee or the warrants that the trustee sought in this case how broad quite broad the trustee went to the court again was ex parte and essentially told the court because of all of the things that this debtor has done or i would say alleged to have done we need to inspect his home and we need to inspect everything in his home everywhere in his home and so it was quite broad at least from the perspective of and i won't spend a lot of time talking about the the criminal law or constitutional law aspects of the barman case but certainly in most criminal cases the search warrants have to sort of allege the places to be searched with particularity and you need to have some sort of allegations as to the type of property that you're looking for well in the barman case it was a very broad order and in addition to the breadth of the order the trustee convinced the court that i need to have a us marshal to accompany me and so it's somewhat disheartening when you have a private lawyer saying i need to have an armed marshal to go with me because i think the response is well perhaps that's something the private lawyer shouldn't be doing in a civil setting that's what we should be doing in a criminal context with people who are tasked to do that there clearly are searches outside of the criminal setting certainly yeah there are civil searches there are administrative searches but in those searches it's almost always some sort of a public welfare a safety issue you're allowed to search a a building because you think that there are fire code violations you're allowed to there was a very an older supreme court case also cited in the materials where workers under the program then called afdc were allowed to go in to make sure that there was no harm to the children that were taking place in the home but in this case it's essentially a commercial dispute between creditors who want to be paid and someone who chooses either not to pay or tries to find ways to hide assets to ensure that the creditors won't be paid and you don't have the public safety kind of an exception that you see in those to the supreme court cases well michelle now don't get mad at me i just asked this question of play devil's advocate for a moment but we have a debtor who is seeking the benefits of relief under the bankruptcy statute by submitting to an administration with all the disclosure requirements that are entailed by the statute does not that diminish the debtor's expectation of privacy privacy certainly but privacy and what i mean for example if the the debtor obviously is going to have to prepare the schedules and list all sorts of information in the schedules that perhaps he wouldn't ordinarily be required to disclose to the public public documents anybody that wants to could go down to the court and see social security number credit card numbers and sort of as an aside i know that there has been a fair amount of controversy involved in the districts that have now gone to the electronic case filing the concern being that now all of this information is available potentially online to the world to review as opposed to in the past where you at least physically had to go to the courthouse so certainly a diminished expectation of privacy in the debtor's papers and in the information that the debtor includes in the papers but there's a difference between saying anybody that wants to can go in and read about your financial history and a private attorney can come in and search your home there's always been different treatment given to a debtor a criminal defendants rights to privacy in the home and the rights to privacy everywhere else well you keep emphasizing private attorney if this were truly a private attorney there's no fourth amendment issue the only time there's a fourth amendment issue is if we've got state action and the barman case said because of the particular role of the trustee in this proceeding and in fact because he took along a us-martial that was clear that he was acting as an estate actor so this is not a private lawyer issue this is a state actor who is acting pursuant to a warrant that is not in a criminal proceeding this is a civil proceeding and therefore in order to get a warrant he has to make a showing he has to make a showing that the public interest in getting this search accomplished outweighs the private interest of in this case the debtor his interest in privacy in his own and the judge the bankruptcy judge made that balance looking at the public interest in the integrity of the bankruptcy system in the likelihood in this bad facts situation that they were going to find things which is also part of the balance and weighing those decided that the public interest outweighed the interest of privacy in the home he made that balance he sent them out on the warrant now isn't it true that judge Rhodes should have dismissed this case summarily by saying this was a civil action what are you seeking debtor you're seeking exclusion of what they found the exclusionary rule is not applicable to anything but a criminal proceeding well i guess i would say the case should have been dismissed but i would say much earlier because it seems to me that the distinction between it's not a criminal matter it's a civil matter i think is somewhat of a red herring in this case because the reality is whatever the trustee and the marshal and the trustee's lawyer and the appraiser found in the house was going to be turned over to whether it's a task force of the u.s. attorney or however it works in a particular jurisdiction which could then trigger and most likely would trigger a bankruptcy prosecution and so to say that well it really isn't criminal it's not criminal it's just civil i really think that's a distinction without much much of a distinction i think what the bankruptcy court could have done and arguably should have done in the case was to tell the debtor you've come to the bankruptcy court you're relying on this federal statute we think you're hiding assets we think you're lying we think you're doing whatever and either you allow a search of your home or you're gone we're going to dismiss the case you're you're not going to receive the discharge and i think that would be quite appropriate to require the debtor to consent to the search in exchange for the show what's going to happen when he says that to the debtor the debtor is going to take all of those assets move them out of his home and put them somewhere else that's why these warrants are always ex parte and that would be a perfectly appropriate warrant but you characterized it as being the public interest and i suppose in any bankruptcy case you can argue that there is a public interest we may disagree about the balance there's no question that that reasonable people can disagree about the balance and if judge Shapiro the bankruptcy judge got it wrong then if in fact barman is prosecuted based on evidence found in his house at that point he can make an exclusionary a motion to exclude the evidence as as obtained in violation of his fourth amendment rights and in that criminal proceeding they'll decide whether judge Shapiro did it right or wrong but that's not what was before judge rose but i guess my argument is and i'm not trying to pick on any particular judge that it never should have come up in the civil side of bankruptcy so your position i take it is that listen rather than just ex parte going out and looking for evidence you say listen as long as we have some reasonable threshold of evidence that you are there may be some problems here this is what this is what's at issue this is a civil proceeding either consent to the search or you don't get a discharge and i guess that's fine and then by the way we're going to make a referral to the u.s. attorney and they can do whatever they want to do with the case at that point and so your focus is this is just about the discharge this isn't about doing wrong that's the criminal side if they ever want to bring a criminal fraud action what this is about is the discharge and i may take it that we we might all agree that these kind of orders just issued as a matter of course in regular proceedings would not be a good thing and so i guess the question that michelle's asking is how do you distinguish any case that walks in from this case and if you've got enough evidence to go after a warrant here is that a different standard than denying the discharge i mean i guess i'm trying to see is this a is this a halfway measure to denial of a discharge or is this just confirming what everybody knew when you say confirming what everybody knew that he that he would that the that he had done acts which under 727 would have denied the discharge exactly and i guess i would say there there are other i think creative ways that a bankruptcy court could address this for example you could have the debtor to show up and say at the hearing either you allow us to search your home or we're going to deny you the discharge your concern was well of course all the assets are going to disappear you can say and we're coming by in an hour or the the trustee is at the home now or the marshal is at the home now i mean there are ways that you could prevent the assets from walking out of the home or disappearing there were there were to talk about bad facts i mean there were really bad facts in this case you had a process server that saw video games in the home i think 15 to 20 video machines were in the home even though he claimed you didn't have the assets you had someone else involved in private litigation a prospeititon litigation with the debtor who saw a trailer behind the home and that the debtor was had certain personal property in the home but you can have somebody out there with a video camera watching him or his family or his friends or whatever removing the property in the hour that it takes to get so i'm not suggesting that there would never be an appropriate use of a search of an inspection order in this case but i think the way that it was handled in this case really doesn't give much i think the balance is off in terms of the protection given to the debtor's privacy interest now the debtor's spouse as i recall the facts did consent does that alter your opinion at all of the appropriateness of what ultimately transpired a non-debtor a non-debtor gave consent but a spouse who resided at the property right well to the extent that it was a criminal search i'm not sure that saying that the non-defendant would be able to consent to something that would then be used against the defendant i'm not as familiar obviously with the criminal cases i am with the bankruptcy cases uh but it seems to me that you're if you're if you're concerned about the assets leaving that there are other ways that you can handle it short of showing up at someone's home and there was some dispute in the case about consent but i think that the debtor's probably did consent but there are other ways that you can address it short of having a marshal an armed marshal show up with the trustee and the appraiser and debtors and a trustee's council to search the home michelle has the department of justice weighed in on this because it seems to me important the one brought up which is which is very good that you might you might going to have another hearing in a future criminal case it seems to me that if in fact you push this civil warrant too far you're going to wind up screwing up the criminal case because you will do stuff that might be okay in a civil setting but then when it gets to the time to prosecute the person criminally which is really it seems to be the interest we seem to be vindicating here that that evidence will have been tainted um and i just do you know of any action by the department of justice on that point and also the other point that i would add is that the the u.s trustee's office is or i think developing a pilot program to look at a number of initiatives somewhat in response to the bankruptcy legislation to see well what can we do if there really is all of this fraud and asset concealment to someone go back to your initial comment larry that is there empirically is there a lot of asset concealment that's actually taking place not surprisingly there is nothing in the initiative that suggests that they're now going to be actively pursuing ex parte or any sort of inspection orders instead they're focusing in on the remedies that are currently available let's deny the discharge let's go after it from a bankruptcy fraud prosecution but not to really go this far into the criminal law arena well it's interesting i mean i think what you're suggesting is on the facts of this case the trustee probably fairly easily could have gotten to where he wanted to get revocation of the discharge without resorting to this fairly extraordinary remedy and if in fact there's a second bite at the apple if there's a criminal prosecution to seek to suppress what was obtained during the course of the inspection then tactically it may have been a very poor decision to seek the order in the in the first place all right well that's our foray into fourth amendment law i don't know when we'll be i'm back but it will be interesting to see if there's more case law on this or whether the pilot program seeks to expand trustee's powers to to include that type of authority well we want to turn to our third topic now which is very different topic asset securitization perhaps the most rapidly expanding segment of the u.s credit markets and indeed about a year ago we did a segment on this show dealing with the impact that we anticipated revised article nine was going to have in making the world safe for asset securitization well revised article nine is now here but one thing revised article nine did not do was it did not change the analysis for distinguishing sale versus loan basically left to the facts and circumstances sort of test well since that last segment that we did on this program we've had some case law and now congress is at least hinting that they might turn the dial a notch or two in in providing more protection for securitization so in light of the fact that securitizations are becoming so popular in light of the fact that chapter 11 filing seemed to be tweaking up just a bit and may continue we anticipate that bankruptcy judges are going to be seeing more and more of these securitization transactions there may even be a couple in the enron bankruptcy case and therefore we thought it quite appropriate to bring back if not the leading expert in the country on this subject certainly the leading expert at this table so bruce i'll take the lab where we at thanks larry what i want to do is basically three and maybe four things one i want to talk a little bit about the phenomenon of securitization and try and walk us through kind of a standard transaction and i think i need to do that because the real point i want to make is there are some frailties in the structures that are currently used some legal frailties and i think you have to understand the structure a little bit to understand kind of what the current debate is about and then as you indicated i want to talk about how bankruptcy courts might see these issues brought to them because there's a there's a one thing about securitization it's designed to avoid bankruptcy from the get go that's the purpose the purpose is to trying to get to a transaction that can be priced on the basis of not having bankruptcy and so to actually talk about how would get into bankruptcy seems a little bit odd but i think there are some ties i want to make that and then i want to end with a little discussion about the section you referenced in the reform bill section nine twelve which you said would turn the dial i think it would take the dial off of these types of transactions first what is securitization to pay on who you listen to it's either a two trillion or ten trillion with a t industry it is global it is the wave of high finance that has although it's as old as jenny may certificates the real crest hasn't happened until the last five to ten years and the type of transactions that happen here again arise in part because the great rise in pension assets in this country all those assets need someplace to go to earn money and so the mavens on wall street came up with an idea of securitization and what securitization is in essence is lending on the assets of a company without worrying about the bankruptcy of that company and what i've done hopefully that will show up on the screen and also the materials is to give a couple charts to indicate a structure or a common structure called a two-tiered structure and then to walk through that structure again with a recent transaction just close this week which is the last week of of january and then to use that as a springboard to talk about it so in chart a what i have is i mean it looks like someone threw spaghetti on the piece of paper but really i have here we weren't going to mention that i understand but i can try and make it actually it's there more complicated than these charts would indicate which part of the mystique behind it it's kind of hard to penetrate it in essence securitization as i've said before in other contexts is really nothing more than factoring on steroids what we're doing is we're taking receivables or some type of payment obligation bundling it up transferring it in a sale to another entity and then getting paid for it well that's all fine and good if i sell you my car and i file bankruptcy next week nobody would think normally excuse me that the trustee could go after the car in your hands it was a sale after all as long as it was a fair price for us yeah a fair price you know you took all the risk of ownership but if i lent the car to you for as long as i was in bankruptcy with the idea that i'd get it back maybe the trustee could go after it or maybe there there wasn't the economic risk we've seen this in the sale lease distinction in in great numbers under the ucc and that's kind of the issue here but what happens is is that again securitization has its own lingo the company what we would call the debtor is called the originators the person who originates the receivables they then take those and package those and sell them and there's going to be a couple sales here they all occur simultaneously so you have to kind of keep them all in your mind at once they sell them to a company they create wholly for that purpose and that company is usually a wholly owned subsidiary and the articles of incorporation and biologists all say that it can't file bankruptcy the the people the sponsors the underwriters of the transaction ensure that the organizing organizational documents indicate that you have to have a super majority to file and they always make sure that they have enough directors to prevent that in essence this is the so-called bankruptcy remote notion and so you sell it to them and then in the two tier transaction that entity turns around and sells it again to another entity usually structured as a tax pastor and a trust a partnership an LLC something like that and that is the entity that then borrows money if you will from the public issuing notes and so we've had the receivables drop down into a subsidiary sell across to the trust and then they borrow money now the thing about receivables and payment obligations they're self-liquidating as they pay out then the money comes in and so these transactions are structured so as the money comes in the money is paid out now if it's a sale then each entity along the way takes the risk of ownership if you transfer them at a price which doesn't cover all the ultimate collections the buyer ought to suffer the consequences conversely if you sold them for too low a price then the buyer gets the benefit and that's kind of the the kernel of the true sale notion what happens in these transactions however is that the transaction from the first from the first entity sometimes called a special purpose vehicle the subsidiary to the trust they will sell the receivables usually at a discount but then they will take back from that entity some type of instrument a subordinated note that will completely consume the receivables so what happens is is that if the originator says well you know i'll sell you these but i want to make sure that if i got too low price i capture them back they're my receivables after all let's say fine you give us a hundred dollars receivable we'll give you a a ninety dollar loan and they're doing this through this kind of remote entity well what the way they capture the extra ten dollars they'll then take a ten dollar subordinated note from that entity so that if in fact the receivables pay out too much um or they collected a higher rate than people thought they can simply take that money back as it collects out so the real economic risk in these transactions doesn't necessarily pass in the same way that we would think of the normal sale you can see that in chart b which is an example of a transaction for my financially as far as i know a financially solvent company honda motor honda motor uh is big in securitization they have over ten billion dollars of securitizations and that tends to be where a lot of these securitizations are they're in car loans credit card receivables and the like let me stop for you but we need to get this on the table why does the originator what we would call the debtor why do they want to go through this complicated structure in lieu of simply a loan against receivables or other assets that's if you will is the ten billion dollar question of the two trillion dollar question what has happened is that uh the the the financiers have convinced themselves that uh they can loan a low rate of interest if there's no bankruptcy risk and so if this transaction is structured so that if the originator files uh the investors uh don't have to worry about the dotamax stay if they don't have to worry about ultimate payment then they can give a better interest rate to the debtor and of course the debtor is going to go along with that because it's this is cheaper financing than they can get from banks and other traditional avenues of corporate finance uh even sometimes cheaper than they can get from uh floating commercial paper on their own so this type of transaction and this type of transaction has arisen uh because people think that it provides a lower cost financing for these larger entities that can afford to do this and it keeps growing i mean the the autos are a traditional notion of it but there are some very exact for example they have securitized discharge bankruptcy debt now huge discount right uh you know you're not you're not talking about paying anything like a dollar per dollar but you know we all know that some debtors will voluntarily pay and if you can calculate it uh you can securitize it i mean you can you know if it moves or changes you can securitize it basically and that's a little bit what's going on here and you see that a little bit in the Honda motor thing what Honda did in using the same structure is to sell face about 2.08 billion dollars uh worth of receivables ultimately receiving 2.03 billion uh in cash big transaction the difference the 0.05 which is actually 50 million it's not small change for most of us is going to be taken back as subordinated no so just like i had said before this transaction winds up with Honda getting low basically a secured loan for 2.03 billion and then getting collecting out on with respect to the subordinated no it's whatever would be in excess this is the 52 or 50 million is a 2.5 percent discount that is to say they're getting 97.5 percent of what they're selling now that's because Honda's good other and other transactions and by the way these transactions are on the web you can go to booty's standard and poor's website they will just list these data that's how i got the information here another transaction which didn't fit as well for this was budget which right now is having some financial difficulties their discount was 20 so for every 80 dollar or every hundred dollars excuse me of car rental obligations they were going to get 80 dollars back and they were then going to take to take the example further 20 dollars in subordinated no it's now all of this is driven in large part by getting a rating on the investments because again i mentioned earlier the pension funds they want to get high rated and all of these things tend to be driven towards investment grade rating that's why there's all these discounts and some cash collateral well heavily into this process are moody's standard and poor's fidget the rating agencies and you can actually go on the web and they will tell you what they require from lawyers and from structuring they will tell you what the legal opinions that the originator debtors council has to give has to say you for example they say and this will be in the materials as well that you cannot say it's not free from doubt or that that it's more likely than not that the judge will hold this they're actually requiring lawyers to say courts will hold that these transactions will withstand scrutiny brings me to my next point will they well we've seen a little bit already in the ltv case that this type of structure may not be immune or impervious now what happens is is because this is structured to avoid bankruptcy you try and make sure there are no points of contact between the bankers in essence they've sold the receivables they're not owned by the debtor in ltv they did what most people think is kind of if you will the first wave of attacks they say listen we all know that under article nine and and other laws whether it's a sale or a loan is a substantive not a formal distinction and so substantively in ltv i think they had something like four hundred and twenty million dollars of receivables against which they had they had bought if you will for three hundred and eighty million and so for that difference ltv said we think we really have the ownership we want to use those receivables as cash collateral and so they brought an x part a cash collateral motion in essence bringing in a bank who thought it was an owner not a lender and said we want to use this as cash collateral well tremendous number of procedural problems in ltv and thus it's not a particularly good ultimate decision but the judge there very I think very properly said this is something I want to look at and so I'm going to temporarily let you use cash I want you to bring in the evidence and we'll take a look at it in a little bit but you know let's do this in a quick time frame well they settled I mean they rolled over this into a debtor in possession financing so we don't have any definitive rulings and that's kind of the only the tip of the iceberg but more and more companies large companies have securitized their credit card receivables have securitized their inventory sir anything inherently I mean you're talking about some transactions where there's been I would describe perhaps some corruption of the process because the true indicia of ownership really haven't changed hands and I think that the sale lease cases are a good analogy to that but is there in cheaper lower cost of credit is a good thing without getting into the argument about the efficiency or non-efficiency of secured debt I think we all agree with that if there's fair value and the risks and rights of ownership pass is there anything I mean these assets are outside now the bankruptcy stayed not available as cash collateral not subject to the stay but is there anything inherently nefarious about asset securitization I don't think so but you know it's it's like saying is there anything nefarious in your family you may have a cousin or two that are that are pretty bad we don't want to go or a weird uncle but you know for the most part you know if it is in fact a true sale and in these kind of incidents of ownership do pass absolutely nothing wrong with it each stage you can say that it's fine the problem is that when you have these type of structure and then you say well since each stage alone looks good we don't have to stand back and look at the whole thing that's the problem I think if you look at this generally who's getting hurt it's going to be the unsecured creditors of the originator instead of having kind of the recourse to the business is going at most they're going to have the ownership interest in a subsidiary that may have a subordinated note on the back end and so you have passed without really compensation the unsecured creditors are a far greater risk to them and maybe that's that's that's the point someone who likes securitization would say well that's the low-cost financing that's you know we're going of of course we're going to put that on the unsecured creditors that's where it always happens the trouble is is this really hasn't been kind of up and above borders I indicate I think every major law from the country has issued securitization opinions and again under the standard and poor guidelines they don't have a lot of discretion what they can say indeed the latest is I think it's either Moody's or sanitary and poor's are putting the exact paragraphs they want to see in the in either the opinion letters or the agreements otherwise they won't rate the deal they don't rate the deal no one buys it now there's another wave or possible wave of attack on these that we may see and we may not actually I think in some respects it's it's more problematic because I think you might be able to get around some of the true sale issues and that's substantive consolidation we know some consolidation is not something that's expressed in the terms of the statute if you want to situate it anywhere it's section 105 it is a doctrine which you can consolidate two debtors you can consolidate a debtor with a non-debtor one of the first us supreme court cases on this sam cell consolidated a non-debtor with a debtor and one way to look at this is to step back as I said and say you know the economic risk haven't part these are this is all part of the one entity I mean one thing I didn't mention earlier is often the originator debtor continues to service the receivables after they've been sold so from the the car buyers perspective it's still Honda you know from from the economic risk position it's still Honda I think those arguments given the admittedly uncertain state of substantive consolidation law could pose some very big problems down the road for some securitization now the problem is that you have to get from the filing of the reorganization to the point where you can bring that because that's going to be a fact intensive difficult theory to prove and debtors may not have that much time I think overall though it might be the better of the two and not surprisingly these are the types of opinions that standard and fours and movies require they require a true sale opinion for each sale down the line they require a substantive consolidation opinion down the line and if you take a look at these opinions and I've had some you know some of my good friends on the on the corporate side sympathy you'll these are 40 to 50 page opinions that are wonderful textbook examples the trouble is that we have all of these lawyers passing these transactions these rating agencies we never had the court system look at them we have everyone kind of guessing what the court system will do without necessarily involving kind of a neutral judge who has the interest of all parties at heart which is really the essence of the doctrines that we're talking about in terms of Bruce the whole point of this is to avoid having to have a judge involved right in each of these transactions if you sell your car no matter what you get for it whether the the buyer over pays for it under pays for it that car is not going to be subject to your bankruptcy you've sold it right the problem is accounts receivable are not subject to physical delivery to the purchaser they are still going to be this amorphous thing that it's going to collect now you've agreed that a classic factoring operation where the actual risks and rewards of collecting those receivables has actually been transferred that's a true sale right would you agree that should not be subject to review by a judge well uh no i wouldn't oh you wouldn't so you you don't think that any sort of any sort of sale of intangible assets should be be able to be accomplished and immunized from the bankruptcy system no because again if we go go back to state law one of the reasons that article nine covers more than just secure transactions it covers the sale of accounts it covers the sale is because it's too hard to tell the difference and one of the things that to me means it's always substance over form i would resist any attempt to say that lawyers through all their craft can construct barriers of form that will not allow the bank's court to get to the substance and the bank's court has jurisdiction to do all sorts of things that it never does because it usually doesn't seem economically worthwhile to do so but uh just because there has been if i have a sale of a cartel area then i file the bankruptcy trustee and the bankruptcy judge have have all the ability to look into that transaction if it was a preference if it was a fraudulent transfer why shouldn't they look into it if it was a true sale and they can today certainly judges have the authority to collapse what you describe as a step transaction and look at the entirety and try to get to the economic reality of the transaction uh section 912 though would severely limit that description we talk about that sure section 912 is uh part of the current pending bankruptcy bill hr 333 which as we sit here is in conference it's in the financial netting provisions although it has nothing to do with financial netting what section 912 does in essence is to say if you have a securitization transaction that involves receivables like we've said here they call financial assets in which securities are issued and in which a nationally recognized securities rating agency rates them investment grade or better those assets are forever excluded from the originators bankruptcy estate because 912 is an amendment to 541 of the code which deals with property estate and so what happens is is that if you get moody's or stand in force to give you an investment grade rating then those assets then we do have an iron gate that drops down that doesn't allow the bankruptcy judge to go beyond it and say under old law uh i mean it's it's very odd it doesn't become property estate it doesn't get rid of the state law distinctions between sale and uh lease or sale and um kind of lease back or whatever these are uh so it it'll be interesting in operation and it actually doesn't necessarily although people will disagree on the reason it doesn't necessarily bar the substance consolidation issue either it does limit the fraudulent transfer but your substantive consolidation sort of backup right which still potentially be on the table yeah now a substance consolidation there are at least two if not three lines of cases uh especially at the circuit level with that and a lot of the cases will look at prejudice to creditors if in fact because you almost always when you combine estates you're gonna you're gonna hurt the creditors and the asset rich asset richer estate and and vice versa to the extent that comes in there's going to be some interesting issues because i think everybody to these transactions understands and knows these risks if they read these 40 to 50 page opinions the question is is that enough of an is that enough notice that was at risk that you don't have to worry about their quote prejudice if you collapse the transaction or whether there really is some true prejudice here in terms of entering into these transactions that remains to be seen i mean the it's hard to underestimate because say around this table we all kind of think of bankruptcy and kind of accept it it's hard to underestimate the sheer loathing that most of the people in the financial industry have for bankruptcy they call the automatic state of the bankruptcy tax uh on transactions um and those those in the audience and those who who work with people from other countries um you know they think our bankruptcy system is loony at one point in the in the early 90s the european union tried to have chapter 11 declared an unfair business practice as as it related to airlines i mean that there's a lot of sentiment going against this and the other thing that's happening larry regardless of whether 912 passes or not securitization is really going global one of the things that you see is that uh in emerging economies the ability to securitize payment streams toll road streams power streams telephone is a is a major way a lot of emerging economies are bolstering their infrastructure and the types of transactions that are coming out i mean small secret i know a lot about the bankruptcy laws of other countries and um because i read the standard and poor's website because they will they will they have these research papers on what the law of other countries means and can do to securitization you learn a lot i mean there's a tremendous amount invested in this and a tremendous amount to bring america in line with the rest of the world so this is an issue that's going to be here for a while well the efforts to contract out and around bankruptcy will probably continue unabated and the efforts to resist uh will continue in the same fashion and i suspect that uh that particular dialectic will go on for the rest of our lives unfortunately uh that's all we have time for today uh i do want to thank uh all three of our guests for coming in to explore and explain these important issues for us we hope you found it informative and worthwhile and finally i want to remind our viewers to please fill out the one page evaluation form that's on the fjc website in fact sit back to us at the number at the bottom of the form it really is the only way for us to know if you found this program useful and informative for the federal judicial television network i'm lauren sponeroth thanks for watching